EC9011

THE UNIVERSITY OF WARWICK

January Examinations 2013/2014
Economic Analysis: Microeconomics

Time Allowed: 2 Hours.

Answer THREE questions; AT LEAST ONE question must be FROM SECTION A and AT
LEAST ONE question must be FROM SECTION B.
Read carefully the instructions on the answer book provided and make sure that the particulars
required are entered on each answer book.
SECTION A
(Figures in brackets indicate the mark allocated to each part of the question out of a total of 100)
1.

Consider a consumer with a Cobb-Douglas utility function over three goods of the form
u ( x1 z1 ) ( x2 z2 ) ( x2 z3 ) with 1 , and zi , , , 0 . The consumer
has income m, and pays prices p1 , p2 , p3 for the three goods.
(a)

Find the Marshallian demands for goods 1, 2 and 3 for this consumer, using the
Lagrangean method. (15 marks)

(b)

Are the goods Marshallian complements or substitutes? Comment on what you

find. (15 marks)

(c)

Find the indirect utility function of the consumer. Show that it is homogenous of
degree zero in prices and income. (15 marks)

(d)

Using your answer in (b), find the expenditure function for the consumer. Using
your answer, find the Hicksian demand for good 1. (15 marks)

(e)

Using your answer in (d), determine whether the goods are Hicksian complements
or substitutes. (15 marks)

(f)

Consider an increase in the price of good 1 from p1 to p '1 . Define the

compensating variation of this price increase to be

CV e( p '1 , p2 , p3 , u) e( p1 , p2 , p3 , u)
where e( p1 , p2 , p3 , u) is the expenditure function in part (d). Give a formula for
the CV in this case. What is the economic interpretation of CV? (25 marks)

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2.

Explain the difference between exponential and hyperbolic discounting. How can
hyperbolic discounting by individuals give rise to self-control problems? Illustrate with
an example.

3.

Consider the following portfolio design problem. An investor has initial wealth of W,
and invests a fraction s of this wealth in a risky asset, and a fraction 1-s of this wealth
in a safe asset. The safe asset pays a return of zero. The risky asset pays a return
of r (where 0 < r < 1) with probability p, and a return of -r with probability 1-p. The
c1
investor has a utility function , u (c)
, 0 , where c is the final wealth (and
1
consumption) of the investor.

4.

(a)

Derive the expected utility of the investor, V, as a function of s, and the

parameters of the problem, W, p and r. (15 marks)

(b)

Compute the first derivative of V with respect to s. (15 marks)

(c)

Using your answer to (b), find conditions on W, p and r such that the investor
will invest a share s strictly between 0 and 1 in the risky asset. (15 marks)

(d)

Assuming that the conditions in (c) hold, find the value of s between 0 and 1
that maximizes the investors expected utility. (15 marks)

(e)

How does this value of s change with W, p, and r ? Give an economic intuition
for your findings. (15 marks)

(f)

Prove the general result that an investor choosing between a safe and a risky asset
will invest a positive amount in the risky asset if and only if the expected return
on the risky asset is greater than the return on the safe asset. Explain how this
result generalizes to the case of n risky assets. (25 marks)

There are two rice farmers, Alice and Ben. In state of the world 1, Alice can grow 1 a
units of rice, and in state of the world 2, her crop fails and she can grow nothing. In state
of the world 2, Ben can grow 1 b units of rice, and in state of the world 1, his crop fails
and he can grow nothing. Both farmers believe that state of the world 1 will occur with
probability , 1 0 .
In this question, it is permissible to use the following mathematical result without proof: the
solution to the problem of maximizing ln x1 (1 ) ln x2 subject to p1 x1 p2 x2 m is
x1

m
m
, x2 (1 ) .
p1
p2

(Question (4) continued overleaf)

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(Question (4) continued)

(a)

What does it mean for there to be complete contingent markets for rice in this
economy? Do we observe complete contingent markets in practice? If not, why
not? (15 marks)

(b)

Assume that there are complete contingent markets for rice. Find the aggregate
excess demand for rice in state of the world 1. You may take good 2 as the
numeraire. (20 marks)

(c)

Using your answers in (b), find the equilibrium price for rice in state of the world
1, and the Arrow-Debreu allocation for both farmers, i.e. the levels of
consumption of rice in both states at Arrow-Debreu equilibrium. (20 marks)

(d)

Find the values of a, b, such that both farmers are fully insured, i.e. have the
same levels of consumption in both states of the world. (20 marks)

(e)

Suppose now that there are no longer complete contingent markets for rice, but
that the two farmers can trade Arrow securities before the state of nature is
revealed. Find the relative price of these two securities in equilibrium. Does
trade in securities lead to the same outcome as complete contingent markets in
this example? Explain. (25 marks)

SECTION B
(Figures in brackets indicate the mark allocated to each part of the question out of a total of 100)
5.

(a)

Using an example of a strategic form game with two players and in which each
player has two pure strategies, explain what is meant by a dominated strategy.(20 marks)

(b)

Derive all the pure-strategy Nash equilibria of the following strategic-form game,
involving two players, Jack and Gill. Each of them simultaneously makes a demand
for a share of ten dollars. Let dG and d J denote the demands of Gill and Jack,
respectively, where 0 dG 10 and 0 d J 10 . If dG d J 10 , then an
agreement is reached, and Gill's payoff is dG and Jack's payoff is d J . However, if
dG d J 10 , then Gill and Jack fail to agree on how to divide the ten dollars, and
each of them gets a payoff of zero. (25 marks)
(Question (5) continued overleaf)

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(Question (5) continued)

(c)

6.

7.

Two countries, 1 and 2, simultaneously set their respective rates of capital

taxation, t1 and t2 , where 0 t1 , t2 1 . The total amount of capital invested
in country 1 is k1 1 t1 0.5t2 , and in country 2 is k2 1 t2 0.5t1 . Each
country wants to maximise its total revenue from capital taxation, where revenue
to country i is Ri ti ki , where i 1, 2 .
(i)

Derive the Nash equilibrium tax rates of this game (30 marks), and

(ii)

Show that the Nash equilibrium is Pareto-inefficient. (25marks)

(a)

Explain the differences between the First-Price and the Second-Price Auctions.
(15 marks)

(b)

Sotheby's is auctioning a painting by Rembrandt via a second-price auction.

There are two buyers who wish to buy it. Their valuations are independent and
private, and lie between zero and one. Furthermore, these are drawn from a
uniform distribution. Derive each buyer's bidding strategy (35 marks).

(c)

Consider the following Bayesian game between two competing firms. Firm A's
constant marginal cost of production is one, and this is common knowledge
between the two firms. Firm B's constant marginal cost of production however is
its private information. It is either one or two. Firm A attaches equal probability
to it being one and two. These beliefs are common knowledge. The market price
is p 5 Q , where Q is total quantity produced and supplied to the market.
Derive the Bayes-Nash equilibrium to this game. (50 marks)

(a)

A firm and its union bargain as follows. First the union makes a wage demand, w .
The firm observes (and accepts) w , and then chooses employment, L . The firm's
1
payoff is 6L2 wL , and the union's payoff is u (w ) L , where 0 .
(i)

Derive the unique subgame perfect equilibrium outcome. (30 marks)

(ii)

Show that the equilibrium level of employment is inefficient. (20 marks)

(Question (7) continued overleaf)

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(Question (7) continued)

8.

(b)

Consider a market with two firms, A and B , each of whom produces the
homogeneous good at a constant marginal cost of 1. The market operates over an
infinite number of periods: 1, 2,3, . Assume that, in each period, market
demand is q 5 p . Each firm wants to maximise the present value of its
discounted (per-period) profits, where denotes the common discount factor,
with 0 1 . In each period, the firms simultaneously set quantities (a la
Cournot), after observing the quantities that they set in all preceding periods.
Assume that explicit collusion is prohibited. Derive a subgame perfect
equilibrium in which, along the equilibrium path, each firm sets quantity equal to
one-half of the monopoly quantity in each period, and state the condition on the
discount factor under which this equilibrium holds. (50 marks).

(a)

Consider the following simple version of Spence's job signalling model. A

worker can be of high ability ( 5 ) or low ability ( 4 ), with equal probability.
The productivity of a worker in a job is . Each worker chooses a level of
education e 0 . The total cost of obtaining education level e is e / . The
worker's wage is equal to his expected productivity.

(b)

(i)

Find the separating perfect Bayesian equilibrium with the lowest

education level. (35 marks)

(ii)

Are workers of type 5 better off in the separating equilibrium

described in part (i) or in the pooling perfect Bayesian equilibrium in
which no one gets education? (15 marks)

If an employee chooses effort level e , then with probability e the project is a

success (denoted s H ) in which case the firm obtains revenue v . If the
project is not a success ( s L ), the firm's revenue is zero. All are risk-neutral.
Should the firm pay wage w to the worker, the firm's expected payoff is
f (w, e) ev w , while the worker's payoff is w (w, e) w 0.5ce2 . Assume

0 , c 2v and that the worker's outside option has value equal to zero.
(i)

Show that the contract curve (the set of Pareto efficient effort and wage
allocations) implies e v / c . (10 marks)
(Question (8) continued overleaf)

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(Question (8) continued)

(ii)

Suppose the firm does not observe effort e , but that the project's success
is verifiable. Hence the firm can offer a wage contract ( wH , wL ) where
the wage paid depends on the outcome of the project s H , L .
Assuming the worker chooses e to maximise expected utility, show that
setting wH wL v implies the worker will choose the jointly efficient
effort level. (15 marks)

(iii)

Assuming that the worker is liquidity constrained, so that wH , wL 0 ,

derive the subgame perfect equilibrium wage contract and effort level.
(25 marks)

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