Académique Documents
Professionnel Documents
Culture Documents
Solutions Manual
Frank A. Cowell
STICERD and Department of Economics
London School of Economics
Revised March 2007
ii
Contents
Contents
iii
1 Introduction
2 The Firm
31
4 The Consumer
41
63
6 A Simple Economy
81
7 General Equilibrium
93
115
9 Welfare
137
10 Strategic Behaviour
153
11 Information
195
12 Design
231
265
iii
CONTENTS
CONTENTS
iv
Chapter 1
Introduction
This manual contains outline answers to all 132 of the end-of-chapter exercises in
Microeconomics: Principles and Analysis by Frank Cowell (Oxford University
Press 2006). For convenience the (slightly edited) versions of the questions are
reproduced here as well. Almost every question begins on a new page so that
instructors can print o individual problems and outline answers for classroom
use.
Some of the exercises are based on key contributions to the literature. For
the bibliographic references consult the original question in the printed text .
Microeconomics
CHAPTER 1. INTRODUCTION
Chapter 2
The Firm
Exercise 2.1 Suppose that a unit of output q can be produced by any of the
following combinations of inputs
0:2
0:5
z1 =
0:3
0:2
; z2 =
; z3 =
0:5
0:1
Outline Answer
z2
0.5
z1
z4
z2
0.2
0.1
0.2 0.3
z3
q=1
z1
0.5
Microeconomics
z2
z1
z4
0.5
z2
0.2
z3
0.1
0.2 0.3
q=1
z1
0.5
z2
0.5
z1
q=2
z2
0.2
z3
0.1
0.2 0.3
q=1
z1
0.5
Microeconomics
1. See Figure 2.1 for the simplest case. However, if other basic techniques
are also available then an isoquant such as that in Figure 2.2 is consistent
with the data in the question.
2. See Figure 2.3. Draw the rays through the origin that pass through each
of the corners of the isoquant for q = 1. Each corner of the isoquant for
q = 2. lies twice as far out along the ray as the corner for the case q = 1.
3. Clearly z4 should not be included in the isoquant since z4 requires strictly
more of either input to produce one unit of output than does z2 so that it
cannot be e cient. This is true whatever the exact shape of the isoquant
in see Figures 2.1 and 2.2
Microeconomics
Exercise 2.2 A rm uses two inputs in the production of a single good. The
input requirements per unit of output for a number of alternative techniques are
given by the following table:
Process
Input 1
Input 2
1
9
4
2
15
2
3
7
6
4
1
10
5
3
9
6
4
7
The rm has exactly 140 units of input 1 and 410 units of input 2 at its disposal.
1. Discuss the concepts of technological and economic e ciency with reference to this example.
2. Describe the optimal production plan for the rm.
3. Would the rm prefer 10 extra units of input 1 or 20 extra units of input
2?
Outline Answer
1. As illustrated in gure 2.4 only processes 1,2,4 and 6 are technically e cient.
2. Given the resource constraint (see shaded area), the economically e cient
input combination is a mixture of processes 4 and 6.
z2
4
Economically Efficient
Point
Attainable
Set
z1
Microeconomics
20
Original
Isoquant
10
Microeconomics
Exercise 2.3 Consider the following structure of the cost function: C(w; 0) =
0, Cq (w; q) = int(q) where int(x) is the smallest integer greater than or equal to
x. Sketch total, average and marginal cost curves.
Outline Answer
From the question the cost function is given by
C(w; q) = kq
k + 1; k
1<q
k; k = 1; 2; 3:::
k
q
;k
1<q
k; k = 1; 2; 3:::
C(w,q)
Cq(w,q)
C(w,q)/q
q
1
Microeconomics
Exercise 2.4 Suppose a rms production function has the Cobb-Douglas form
q = z1 1 z2 2
where z1 and z2 are inputs, q is output and
1,
z1
Outline Answer
1. The isoquants are illustrated in Figure 2.7. They do not touch the axes.
2. The elasticity of substitution is dened as
ij
:=
z1
z2
1 (z)
2 (z)
(2.1)
Microeconomics
z1
z2
z1
z2
= log
1 (z)
log
2 (z)
or
1
u = log
3. This is a Cobb-Douglas production function. This will yield a unique interior solution; the Lagrangean is:
L(z; ) = w1 z1 + w2 z2 + [q
z1 1 z2 2 ] ;
(2.3)
1 z1
@L(z; )
= w2
@z2
2 z1
z2 2
z2 2 = 0 ;
1
(2.4)
=0;
(2.5)
@L(z; )
= q z1 1 z2 2 = 0 :
(2.6)
@
Using these conditions and rearranging we can get an expression for minimized cost in terms of and q:
w1 z1 + w2 z2 =
1 z1
z2 2 +
2 z1
z2 2 = [
2]
q:
w1
w2
=0
=0
which implies
z1 =
z2 =
w1
2
w2
q
q
(2.7)
w1
c Frank Cowell 2006
w2
10
=q
Microeconomics
which implies
q= q
w1
w2
1
1+ 2
(2.8)
= w1 z1 + w2 z2
=
2]
w1
w2
1
1+ 2
[tz2 ]
1+
=t
(z):
H (w; q) = q
H 2 (w; q) = q
1 w2
1
1+ 2
1
1+ 2
2 w1
2 w1
1 w2
11
Microeconomics
Exercise 2.5 Suppose a rms production function has the Leontief form
z1 z2
;
q = min
=
=
1 z1
2
1 z1
+
+
2 z2
2
2 z2
B
z1
Outline Answer
1. The Isoquants are illustrated in Figure 2.8 the so-called Leontief case,
2. If all prices are positive, we have a unique cost-minimising solution at A:
to see this, draw any straight line with positive nite slope through A
and take this as an isocost line; if we considered any other point B on the
isoquant through A then an isocost line through B (same slope as the one
through A) must lie above the one you have just drawn.
c Frank Cowell 2006
12
Microeconomics
z2
z1
z2
z1
13
Microeconomics
1 q;
1q
2 q)
+ w2
2 q:
1q
2 q:
1 z1
2 z2
C(w; q) = q min
8
>
>
>
>
>
<
>
>
>
>
>
:
z2 2 0;
q
2
q
2
w1
w2
<
w1
w2
w1
w2
>
if
w1
w2
<
if
w1
w2
if
w1
w2
>
Case 3 is a test to see if you are awake: the isoquants are not convex
to the origin: an experiment with a straight-edge to simulate an
isocost line will show thatpit is almost like case 2 p
the solution will
be either at
the
corner
(
q=
;
0)
if
w
=w
<
1
1
2
1 = 2 or at the
p
p
corner (0; q= 2 ) if w1 =w2 >
1 = 2 (but nowhere else). So the
cost function is :
r
p
q
C(w; q) = min w1
; w2 q= 2 :
1
14
Microeconomics
The conditional demand function is similar to, but slightly dierent
from, the previous case:
8
q
q
w1
1
>
if w
<
>
1
2
2
>
>
>
>
>
<
o
n
q
1
1
if w
=
z1 2 0; q1
H 1 (w; q) =
w2
2
>
>
>
>
>
q
>
>
1
1
:
0
if w
w2 >
2
H 2 (w; q) =
8
>
>
>
>
>
>
>
<
>
>
>
>
>
>
>
:
n
z2 2 0;
q
2
q
2
if
w1
w2
<
if
w1
w2
if
15
w1
w2
>
q
q
q
1= 2
1
2
1
2
1
2
Microeconomics
(z) =
1 z1 +
i1
2 z2
2. Explain what happens to the form of the production function and the elasticity of substitution in each of the following three cases: ! 1, ! 0,
! 1.
3. Relate your answer to the answers to Exercises 2.4 and 2.5.
Outline Answer
1. Dierentiating the production function
(z) :=
1 z1
2 z2
i1
:=
1 z1
1 (z)
2 (z)
2 z2
1
2
i1
1
i zi
(2.9)
z1
z2
(2.10)
which implies
log
z1
z2
1
1
log
1
2
log
1 (z)
2 (z)
Therefore
@ log
=
@ log
z1
z2
1 (z)
2 (z)
1
1
2 z2 g),
1 z1
! 0 yields
2 z2 ).
16
Microeconomics
Exercise 2.7 For the CES function in Exercise 2.6 nd H 1 (w; q), the conditional demand for good 1, for the case where 6= 0; 1. Verify that it is decreasing
in w1 and homogeneous of degree 0 in (w1 ,w2 ).
Outline Answer
From the minimization of the following Lagrangean
L(z; ; w; q) :=
we obtain
1
2
m
X
wi zi + [q
(z)]
i=1
[z1 ]
1 1
= w1
(2.11)
[z2 ]
1 1
= w2
(2.12)
On rearranging:
1
q1
1
q1
w1
1
w2
2
[z1 ]
[z2 ]
w1
1
1
1
q1
w2
2
2
=q
Rearranging we nd
1
q1
1
1
[w1 ]
[w1 ]
[w2 ]
q1
w1 =
1 [z1 ]
[w2 ]
q1
z1 =
"
1 w2
2 w1
17
Microeconomics
Exercise 2.8 For any homothetic production function show that the cost function must be expressible in the form
C (w; q) = a (w) b (q) :
z2
z1
Outline Answer
From the denition of homotheticity, the isoquants must look like Figure
2.11; interpreting the tangents as isocost lines it is clear from the gure that
the expansion paths are rays through the origin. So, if H i (w; q) is the demand
for input i conditional on output q, the optimal input ratio
H i (w; q)
H j (w; q)
must be independent of q and so we must have
H i (w; q)
H j (w; q)
= j
i
0
H (w; q )
H (w; q 0 )
for any q; q 0 . For this to true it is clear that the ratio H i (w; q)=H i (w; q 0 ) must
be independent of w. Setting q 0 = 1 we therefore have
H 1 (w; q)
H 2 (w; q)
H m (w; q)
=
=
:::
=
= b(q)
H 1 (w; 1)
H 2 (w; 1)
H m (w; 1)
and so
H i (w; q) = b(q)H i (w; 1):
c Frank Cowell 2006
18
Microeconomics
Therefore the minimized cost is given by
C(w; q)
=
=
m
X
i=1
m
X
wi H i (w; q)
wi b(q)H i (w; 1)
i=1
= b(q)
m
X
wi H i (w; 1)
i=1
= a(w)b(q)
where a(w) =
Pm
i=1
wi H i (w; 1):
19
Microeconomics
1 z1
2 z2
3 z3
1. Find the long-run cost function and sketch the long-run and short-run
marginal and average cost curves and comment on their form.
2. Suppose input 3 is xed in the short run. Repeat the analysis for the
short-run case.
3. What is the elasticity of supply in the short and the long run?
Outline Answer
1. The production function is clearly homogeneous of degree 1 in all inputs
i.e. in the long run we have constant returns to scale. But CRTS implies
constant average cost. So
LRMC = LRAC = constant
Their graphs will be an identical straight line.
z2
z1
1 z1
2 z2
(2.14)
20
3 z3
(2.15)
Microeconomics
Note that the isoquant is
2
z2 =
1 z1
1:
From the Figure 2.12 it is clear that the isoquants do not touch the axes
and so we will have an interior solution. The rst-order conditions are
wi
i zi
which imply
zi =
= 0; i = 1; 2
(2.16)
(2.17)
wi
; i = 1; 2
2
X
1=2
j
j
from which we nd
where
b :=
(2.18)
wj
j=1
1 w1
b
k
(2.19)
2 w2 :
2
X
wi zi + w3 z3
(2.20)
i=1
2
=
=
b
+ w3 z3
k
qb2
1 + w3 z3 :
1
3 z3 q
(2.21)
(2.22)
Marginal cost is
b2
1
3 z3
(2.23)
b2
w3 z3
:
1 +
q
3 z3 q
(2.24)
Let q be the value of q for which MC=AC in (2.23) and (2.24) at the
minimum of AC in Figure 2.13 and let p be the corresponding minimum
value of AC. Then, using p =MC in (2.23) for p p the short-run supply
8
if p <p
> 0
>
>
>
>
<
0 or q
if p =p
curve is given by q = S(w; p) =
>
>
>
h
i
>
>
: q = z3 1 pb
if p >p
p
3
21
Microeconomics
>0
Note that the elasticity decreases with b. In the long run the supply curve
coincides with the MC,AC curves and so has innite elasticity.
marginal
cost
average
cost
22
Microeconomics
Exercise 2.10 A competitive rms output q is determined by
q = z1 1 z2 2 :::zmm
where zi is its usage of input i and i > 0 is a parameter i = 1; 2; :::; m. Assume
that in the short run only k of the m inputs are variable.
1. Find the long-run average and marginal cost functions for this rm. Under
what conditions will marginal cost rise with output?
2. Find the short-run marginal cost function.
3. Find the rms short-run elasticity of supply. What would happen to this
elasticity if k were reduced?
Outline Answer
Write the production function in the equivalent form:
log q =
m
X
log zi
(2.25)
i=1
1
2
(2.26)
i=1
i zi
= 0; i = 1; 2; ::; m
(2.28)
; i = 1; 2; ::; m
(2.29)
which imply
zi =
wi
q=
m
Y
wi
zi i =
i=1
23
; i = 1; 2; ::; m
m
Y
i=1
wi
(2.30)
(2.31)
Microeconomics
where :=
we nd
Pm
j=1
Qm
and A := [ i=1
1=
1=
q
i=1 wi
= A Qm
1=
= A [qw1 1 w2 2 :::wmm ]
(2.32)
Substituting from (2.32) into (2.29) we get the conditional demand function:
i
1=
H i (w; q) = zi =
A [qw1 1 w2 2 :::wmm ]
(2.33)
wi
and minimised cost is
C (w; q)
m
X
1=
wi zi = A [qw1 1 w2 2 :::wmm ]
(2.34)
i=1
Bq 1=
(2.35)
1=
(2.36)
T 1.
2. In the short run inputs 1; :::; k (k m) remain variable and the remaining
inputs are xed. In the short-run the production function can be written
as
k
X
log q =
(2.37)
i log zi + log k
i=1
where
k
m
X
:= exp
i=k+1
log zi
(2.38)
:=
k
X
(2.39)
j=1
and Ak :=
hQ
k
i=1
1=
wi
Ak
24
q
k
1=
w1 1 w2 2 :::wk k
(2.40)
Microeconomics
and minimised cost in the short run is
C~ (w; q; zk+1 ; :::; zm )
k
X
wi zi + ck
i=1
k Ak
k Bk q
where
m
X
ck :=
1=
1=
w1 1 w2 2 :::wk k
k
+ ck
+ ck (2.41)
(2.42)
wi zi
(2.43)
i=k+1
1=
k
k
Bk q
k
k
=p
(2.44)
where p is the price of output so that, rearranging (2.44) the supply function is
k
p 1 k
q = S (w; p; zk+1 ; :::; zm ) =
(2.45)
Bk
wherever MC AC. The elasticity of (2.45) is given by
@ log S (w; p; zk+1 ; :::; zm )
=
@ log p
1
It is clear from (2.39) that k
k 1
elasticity in (2.46) must fall as k falls.
25
k 2 :::
>0
(2.46)
Microeconomics
Exercise 2.11 A rm produces goods 1 and 2 using goods 3,...,5 as inputs. The
production of one unit of good i (i = 1; 2) requires at least aij units of good j, (
j = 3; 4; 5).
1. Assuming constant returns to scale, how much of resource j will be needed
to produce q1 units of commodity 1?
2. For given values of q3 ; q4 ; q5 sketch the set of technologically feasible outputs of goods 1 and 2.
Outline Answer
1. To produce q1 units of commodity 1 a1j q1 units of resource j will be
needed.
q1 a1i + q2 a2i Ri :
2. The feasibility constraint for resource j is therefore going to be
q1 a1j + q2 a2j
Rj :
Taking into account all three resources, the feasible set is given as in Figure
2.14
q1
points
points satisfying
satisfying
qq11aa1313 +
+ qq22aa2323 RR33
points
points satisfying
satisfying
qq11aa1414 +
+ qq22aa2424 RR44
Feasible
Set
points
points satisfying
satisfying
qq11aa1515 +
+ qq22aa2525 RR55
q2
26
Microeconomics
Exercise 2.13 An agricultural producer raises sheep to produce wool (good 1)
and meat (good 2). There is a choice of four breeds (A, B, C, D) that can be
used to stock the farm; each breed can be considered as a separate input to the
production process. The yield of wool and of meat per 1000 sheep (in arbitrary
units) for each breed is given in Table 2.1.
wool
meat
A
20
70
B
65
50
C
85
20
D
90
10
Outline Answer
1. See Figure 2.15.
2. See Figure 2.15.
3. The MRT if A and B are used is
is going to be
20
85
50
=
65
3
:
2
70
20
50
=
65
4
. If B and C are used it
9
n inputs are
27
Microeconomics
80
meat
60
40
20
0
0
20
40
60
80
100
wool
6. As we can observe in Figure 2.16 now the technological frontier has moved
outwards: one of the former techniques is no longer on the frontier.
80
meat
60
40
20
0
0
20
40
60
80
wool
28
100
Microeconomics
Exercise 2.14 A rm produces goods 1 and 2 uses labour (good 3) as input
subject to the production constraint
2
where qi is net output of good i and A is a positive constant. Draw the transformation curve for goods 1 and 2. What would happen to this transformation
curve if the constant A had a larger value?
Outline Answer
1. From the production function it is clear that, for any given value q3 ,
the transformation curve is the boundary of the the set of points (q1 ; q2 )
satisfying
2
[q1 ] + [q2 ]
q1 ; q 2
Aq3
0
q2
Large A
Small A
q1
Figure 2.17: Transformation curves
29
Microeconomics
30
Chapter 3
2. What are the implications for the shape of average and marginal cost
curves?
3. May one conclude that a monopoly must be more e cient in producing
this good?
Outline Answer
1. If q 0 = q then
C (w; 2q) < 2C (w; q) .
Hence
C (w; q) + C (w; 2q) < 3C (w; q) .
0
31
Microeconomics
j=1 qj
where
1.
1. Assuming that each rm takes the output of all the other rms as given,
write down the rst-order conditions yielding rm 1s output conditional
on the outputs q2 ; :::; qn . Hence, using the symmetry of the equilibrium,
show that in equilibrium the optimal output for any rm is
qi =
A [n 1]
n2 c
A qi2
K2
c=0
(3.2)
If all rms are identical, then in equilibrium all rms must produce the
same amount and so
K = nqi
(3.3)
c Frank Cowell 2006
32
Microeconomics
Substituting (3.3) in (3.2) we get
A
n
A
n2
cqi = 0
(3.4)
qi
K
(3.5)
=
=
=
Aqi
C0 cqi
K
A
A[n 1]
C0
n
n2
A
C0
n2
(3.6)
(3.7)
33
Microeconomics
1
F0 + aqi2
2
marginal cost is aqi and average cost is F0 =qi + 12 aqi . Marginal cost intersects average cost where
1
aqi = F0 =qi + aqi
2
i.e. where output is
q :=
and marginal cost is
p :=
p
2F0 =a
p
2aF0
(3.9)
(3.10)
For p > p the supply curve is identical to the marginal cost curve qi = p=a;
for p < p the rm supplies 0 to the market; at p = p the rm supplies
either 0 or q. There is no price which will induce a supply in the interior
of the interval 0; q . Summarising, rm is optimal output is given by
8
p=a; if p > p
>
>
>
>
<
q 2 f0; qg if p = p
qi = S(p) :=
(3.11)
>
>
>
>
:
0; if p < p
34
Microeconomics
2. The equilibrium, if it exists, is found where supply=demand at a given
price. This would imply
p
a
b
aA
a+b
A
a+b
(3.13)
4. Given that in the limit the average supply curve is continuous and of the
piecewise linear form (3.13), and that the demand curve is a downwardsloping straight line, there must be a unique market equilibrium. The
equip
p
A p
A
2aF0
which, using (3.10) is
.
2aF0 ;
librium will be found at p; b
b
Using (3.9) this can be written p; q where
:=
In the equilibrium a proportion
rms produce 0.
A p
bp=a
35
of the
Microeconomics
p=A
(where A > a and B > 0) nd the expression for the rms marginal
revenue in terms of output. Illustrate the optimum in a diagram and show
that the rm will produce
A a
q :=
b+B
What is the price charged p and the marginal cost c at this output
level? Compare q and q :
3. The government decides to regulate the monopoly. The regulator has the
power to control the price by setting a ceiling pmax . Plot the average and
marginal revenue curves that would then face the monopolist. Use these
to show:
(a) If pmax > p
and p
(b) If pmax < c
1
F0 + aq + bq 2
2
F0
b
(3.14)
p
2bF0 + a
(3.15)
q=
where average costs are
Marginal and average costs are illustrated in Figure 3.1: notice that MC
is linear and that AC has the typical U-shape if F0 > 0. For a price above
the level (3.15) the rst-order condition for maximum prots is given by
p = a + bq
c Frank Cowell 2006
36
Microeconomics
a+bq
marginal
cost
F/q+a+0.5bq
average cost
q* = Pa
b
from which we nd
q :=
a
b
1 2
Bq = A
2
Bq
Bq = a + bq
(3.16)
=A
Bq
1
Bq
2
=
=c
Ab + Ba
B+b
1 A a
+ B
2 b+B
we also get
(3.17)
(3.18)
pmax if q q0
A 12 Bq if q
q0
(3.19)
37
Microeconomics
marginal
cost
p**
a+bq
F/q+a+0.5bq
average cost
c**
average
revenue
marginal
revenue
A Bq
A 0.5Bq
q**
marginal
cost
p**
pmax
c**
average
revenue
q**
marginal
revenue
q0
38
Microeconomics
Exercise 3.5 A monopolist has the cost function
1 2
C(q) = 100 + 6q + [q]
2
1. If the demand function is given by
1
q = 24
p
4
calculate the output-price combination which maximises prots.
2. Assume that it becomes possible to sell in a separate second market with
demand determined by
3
p:
q = 84
4
Calculate the prices which will be set in the two markets and the change
in total output and prots from case 1.
3. Now suppose that the rm still has access to both markets, but is prevented
from discriminating between them. What will be the result?
Outline Answer
1. Maximizing the simple monopolists prots
0
= (96
4q)q
100 + 6q +
q2
2
90
106:
12
Hence the total output is identical to that under discrimination, p1 < pb <
p2 and 12 > b : These results are quite general.
39
Microeconomics
40
Chapter 4
The Consumer
Exercise 4.1 You observe a consumer in two situations: with an income of
$100 he buys 5 units of good 1 at a price of $10 per unit and 10 units of good 2
at a price of $5 per unit. With an income of $175 he buys 3 units of good 1 at
a price of $15 per unit and 13 units of good 2 at a price of $10 per unit. Do the
actions of this consumer conform to the basic axioms of consumer behaviour?
x2
x = (3,13)
x = (5,10)
p1 / p 2 = 2
p1 / p2 = 1.5
x1
41
Microeconomics
Exercise 4.2 Draw the indi erence curves for the following four types of preferences:
Type
Type
Type
Type
A
B
C
D
:
log x1 + [1
:
x1 + x2
2
2
:
[x1 ] + [x2 ]
: min f x1 ; x2 g
] log x2
x2
x2
x1
x1
x2
x2
x1
x1
Use the fact that expenditure minimisation for the household and costminimisation for the rm are essentially the same problem. The indierence
curves in Figure 4.2 are identical to the isoquants depicted in Exercises 2.4, 2.5.
So, substituting the notation in Exercise 2.4 and 2.5we get:
Case A: C(p; ) = C(p; ) = e
p1
Case B: C(p; ) =
min(p1 = ; p2 )
p
p
Case C: C(p; ) =
min(p1 = ; p2 )
Case D: C(p; ) =
p1
+ p2
42
p2
1
i1
Microeconomics
Exercise 4.3 Suppose a person has the Cobb-Douglas utility function
n
X
ai log(xi )
i=1
log xi +
i=1
"
n
X
pi xi
i=1
(4.1)
; i = 1; 2; :::; n:
pi
n
X
=
pi xi
=
(4.2)
(4.3)
i=1
iy
; i = 1; 2; :::; n:
pi
Pn
i=1
i=
(4.4)
43
i y;
(4.5)
Microeconomics
Exercise 4.4 The elasticity of demand for domestic heating oil is 0:5, and
for gasoline is 1:5. The price of both sorts of fuel is 60c/ per litre: included
in this price is an excise tax of 48c/ per litre. The government wants to reduce
energy consumption in the economy and to increase its tax revenue. Can it do
this (a) by taxing domestic heating oil? (b) by taxing gasoline?
Outline Answer
Let p be the untaxed price, and
the excise tax. Government revenue
is T = x, and the purchase price is p + . Clearly an increase in would
reduce consumption, and =[ + p] = 0:8: The eect on tax revenue is given by
@T =@ = x + @x=@ = x[1 + 0:8"]. If (a) " = 0:5 then this is positive. If (b)
" = 1:5 then it is negative.
pj @H i (p; )
pj @Di (p;y)
; "ij :=
xi
@pj
xi
@pj
y @Di (p;y)
:
xi
@y
Show how the Slutsky equation can be expressed in terms of these elasticities
and the expenditure share of each commodity in the total budget.
Use the fact that each demand function Di is homogeneous of degree zero
in all prices and income. Then, using the standard lemma for homogenous
functions, we have for each i = 1; :::; n :
n
X
pj
j=1
which implies
@Di (p; y)
@Di (p; y)
+y
@pj
@y
n
X
0 Di (p; y)
"ij + "iy = 0:
j=1
vj "iy
pj xj
is the expenditure share of commodity j.
y
44
Microeconomics
Exercise 4.6 You are planning a study of consumer demand. You have a data
set which gives the expenditure of individual consumers on each of n goods. It
is suggested to you that an appropriate model for consumer expenditure is the
Linear Expenditure System:
2
3
n
X
ei = i pi + i 4y
pj j 5
j=1
Outline Answer
1. We have
xi =
pi
n
X
4y
j=1
pj j 5
(4.6)
=
=
=
(4.7)
pi
i j
pi
"
if j 6= i
pi
(4.8)
Pn
j=1
pi
pj
(4.9)
=
=con tant
45
xj
pi
, if j 6= i
(4.10)
Microeconomics
log(xi
i=1
46
i)
(4.11)
Microeconomics
Exercise 4.7 Suppose a consumer has a two-period utility function of the form
labelled type A in Exercise 4.2. where xi is the amount of consumption in period
i. The consumers resources consist just of inherited assets A in period 1, which
is partly spent on consumption in period 1 and the remainder invested in an
asset paying a rate of interest r.
1. Interpret the parameter
in this case.
Outline Answer
1. The parameter captures the consumers impatience: the higher is
the more steeply sloped will be the indierence curves in Figure 4.3. Note
1
is the price of consumption in period 2 relative to the price of
that 1+r
consumption in period 1; so the lifetime budget constraint, expressed in
terms of period-1 prices, is:
x2
1+r
] log x2 +
x1 +
(4.12)
x1
x2
1+r
(4.13)
1
A
x1
x2
=
=
1
1+r
= A
=
=
A
[1 + r] [1
]A
(4.14)
(4.15)
So we can see that the smaller is (the lower is the level of impatience), or
the larger is r (the rate of interest), the more consumption will be tilted
toward period 2.
c Frank Cowell 2006
47
Microeconomics
x*
1+r
x1
(4.16)
[1 + r] [1
(4.17)
[1
(4.18)
]A
(4.19)
x2
=constant
@x1
@y
(4.20)
+
=constant
x2 @x1
[1 + r]2 @A
(4.21)
48
Microeconomics
then be found (using 4.16 and 4.18) as:
dx1
dr
=
=constant
49
@x1
@r
x2 @x1
[1 + r]2 @A
x2
[1 + r]2
<0
(4.22)
Microeconomics
x1
a
Figure 4.4: Ration
50
Microeconomics
Exercise 4.9 A person has preferences represented by the utility function
U (x) =
n
X
log xi
i=1
i=1
1
xi
pi = 0; i = 1; :::; n
(4.23)
n
X
pi xi = 0:
(4.24)
i=1
51
y
npi
(4.25)
Microeconomics
The
Pn indirect utility function V is given by
i=1 log xi . So, from (4.25) we have:
= V (p; y) = U (x ) =
yn
nn p1 p2 p3 :::pn
= log
(4.26)
(4.27)
(4.28)
x1 = p1 n [p2 p3 p4 :::pn e ] n
(b) From (4.25) we have the elasticities
@ log x1
@ log p1
y=const
@ log x1
@ log pj
y=const
1;
0; j = 2; :::; n:
n
n
=const
=
=const
< 0;
1
> 0; j = 2; :::; n
n
log xi + log An
i=1
subject to
n
X1
pi xi
y0 ;
i=1
y0
y pn An
=
[n 1] p1
[n 1] p1
2
x1 = p1n
n
1
[p2 p3 p4 :::pn
1e
]n
(4.29)
(4.30)
@ log x1
@ log p1
y=const
@ log x1
@ log pj
y=const
=
=
52
1;
0; j = 2; :::; n
1:
Microeconomics
(as before) but
@ log x1
@ log pn
pn An
<0
y0
=
y=const
The reason for this last result is that if the person is forced to buy the
xed amount An then changing pn is equivalent to a simple income
eect (think about what happens to y 0 ).
(b) From (4.28) we have
@ log x1
@ log p1
@ log x1
@ log pj
=const
@ log x1
@ log pn
=const
=
=const
=
=
2
n
n
< 0;
1
1
; j = 2; :::; n
1:
0:
log xi + log A0
i=1
Pm
Qn
subject toP i=1 pi xi
y 0 , where m := n r 1, A0 := k=n r Ak and
n
0
y := y
k=n r pk Ak . Ordinary and compensated demands are
Pn
y
y0
k=n r pk Ak
=
(4.31)
x1 =
mp1
mp1
1
x1 = p1 m [p2 p3 p4 :::pm e ] m
(4.32)
and so we have .
@ log x1
@ log p1
@ log x1
@ log pj
=const
@ log x1
@ log pk
=const
=
=const
m
< 0;
m
(4.33)
1
> 0; j = 2; :::; m:
m
(4.34)
0; k = n
(4.35)
r; :::; n:
=
y=const
pk Ak
< 0; k = n
y0
r; :::; n
The model can be used to illustrate in part the comparative statics of someone who is subject to a quota ration xi
Ai where the rationing constraint
is assumed to be binding in the case of goods n r to n. However, it is not
rich enough to allow us to determine which commodities are consumed at a
conventional equilibrium with MRS =price ratio, like (4.29), and which will be
constrained by the ration. Parts 2 and 3 show clearly how the compensated
demand becomes steeper (less elastic with respect to its own price) the more
external constraints are imposed as in the short-run problem of the rm.
c Frank Cowell 2006
53
Microeconomics
Exercise 4.10 Show that if the utility function is homothetic, then ICV = IEV
Outline Answer
Let x0 be optimal for p0 at
x2
x1
x1
x0
x0
0
x1
0
Figure 4.5: Homothetic preferences
Because of homotheticity, x0 must be optimal for p0 at
optimal for p1 at 1 : see Figure 4.5.
Hence
X
C(p0 ; 0 ) =
p0i x0i ;
X
C(p0 ; 1 ) =
p0i x0i ;
X
C(p1 ; 0 ) =
p1i x1i ;
X
C(p1 ; 1 ) =
p1i x1i
So in this special case we have
P 1 1
p x
ICV = P 0i 0i
pi xi
P 1 1
p x
IEV = P i0 i0
pi xi
54
and
x1 be
Microeconomics
Exercise 4.11 Suppose an individual has Cobb-Douglas preferences given by
those in Exercise 4.3.
1. Write down the consumers cost function and demand functions.
2. The republic of San Serrife is about to join the European Union. As a
consequence the price of milk will rise to eight times its pre-entry value. but
the price of wine will fall by fty per cent. Use the compensating variation
to evaluate the impact on consumers welfare of these price changes.
3. San Serrife economists have estimated consumer demand in the republic
and have concluded that it is closely approximated by the demand system
derived in part 1. They further estimate that the people of San Serrife
spend more than three times as much on wine as on milk. They conclude
that entry to the European Union is in the interests of San Serrife. Are
they right?
Outline Answer
1. Using the results from previous exercises we immediately get
1
p1
C(p; ) =
p2
:::
pn
This is su cient. However, it may be useful to see the proof from rst
principles. The relevant Lagrangean is
#
"
n
n
X
X
(4.36)
pi xi +
i log xi
i=1
i=1
xi =
; i = 1; 2; :::; n:
pi
=
n
X
(4.37)
log xi
(4.38)
i=1
i=1
n
X
log
+ log
i=1
n
X
i=1
Pn
i=1
log
Pn
55
i=1
n
X
= 1. From (4.38)
log pi
(4.40)
i=1
y = Ae p1 1 p2 2 :::pnn = C(p; ):
c Frank Cowell 2006
(4.39)
i=1
(4.41)
Microeconomics
This is the required cost function. The demand functions are known from
Exercise 4.2 or are obtained immediately from (4.37) and (4.39):
xi =
iy
; i = 1; 2; :::; n:
pi
(4.42)
(4.43)
where
1
(4.44)
[ ] wine = 23 milk wine
2
Using the denition in the notes the compensating variation is therefore
b := [8]
milk
CV(p ! p
^ ) := C(p; )
C(^
p; ) = [1
b] C(p; )
(4.45)
56
Microeconomics
Exercise 4.12 In a two-commodity world a consumers preferences are represented by the utility function
1
U (x1 ; x2 ) = x12 + x2
where (x1 ; x2 ) represent the quantities consumed of the two goods and
non-negative parameter.
is a
x1
First sketch the utility function. Note that the indierence curves touch
the axes it is possible that one or other commodity is not consumed at the
optimum See Figure 4.6. In this case it is easiest to substitute directly from
the budget constraint (binding at the optimum)
p1 x1 + p2 x2 = y
into the utility function. The consumer will then choose x1 to maximise
1
x12 +
c Frank Cowell 2006
57
p1 x1
p2
Microeconomics
The FOC is
2
p1
=0
p2
1
2
[x1 ]
D (p1 ; p2 ; y)
D2 (p1 ; p2 ; y)
=4
p2
2p1
i2
2
y
p2
p2
4 p1
3
5
But this neglects the possibility that we may be at a corner. Note that a strictly
positive amount of good 2 requires
2
p1 > p1 :=
p22
4 y
x1 = D1 (p1 ; p2 ; y) =
x2 = D2 (p1 ; p2 ; y) =
Also, if p1 > p1 , maximised utility is
V (p1 ; p2 ; y)
Otherwise V (p1 ; p2 ; y) =
implies:
y
p1 :
8 h
i2
>
< 2pp12
>
:
8
<
y
p1
2 p
2
4 p1
y
p2
= U (x1 ; x2 )
2
p2
y
=
+
2p1
p2
2
p2
y
=
+
4p1
p2
if p1 > p1
(4.46)
otherwise
if p1 > p1
(4.47)
otherwise
p2
4p1
(4.48)
V1 (p1 ; p2 ; y)
V2 (p1 ; p2 ; y)
Vy (p1 ; p2 ; y)
p2
x1
=
<0
4p21
p2
2
y
x2
=
<0
4p1
p22
p2
1
>0
p2
so that we immediately see that Roys identity holds. To nd the cost function
write = V (p; y) and solve for y in terms of p and . This gives
2
=
C(p; )
c Frank Cowell 2006
p2
C(p; )
+
4p1
p2
2 2
p2
p2
4p1
58
(4.49)
Microeconomics
for the case p1 > p1 and
C(p; ) = p1
otherwise.
h i2
V (p1 ; p2 ; y)
V (p01 ; p2 ; y
CV)
CV(p ! p0 ) =
=
=
2 2
p2
y
p2
+
4p1
p2
2
y CV
p2
+
4p01
p2
1
p01
1
p1
(4.50)
59
Microeconomics
Outline Answer
1. It is easy to see that the cost function is subadditive and therefore the
rm is a natural monopoly.
2. Because consumers are identical we can just multiply the demand of one
consumer by N to get the market aggregates. We use this throughout the
answer.
If p2 is normalized to 1 then, given that there are N identical consumers
the market demand curve is given by
2
q = N x1 = N
2p1
N
q
(4.51)
p
This gives the average revenue curve. So total revenue is 2 N q. Given
the structure of costs specied in the question the monopolists prots are
p
N q C0 cq
(4.52)
p1 q [C0 + cq] =
2
Dierentiating (4.52) we nd the FOC characterising the monopolists
optimum as
s
N
c=
(4.53)
4 q
c Frank Cowell 2006
60
Microeconomics
where the expression on the right-hand side of (4.53) is marginal revenue.
Using (4.53) we nd that the monopolists equilibrium output is given by
h i2
q =N
4c
N
2
N [ =4c]
in other words
p1 = 2c
(4.54)
cq
C0
2cN
2
N
16c
4c
i2
cN
4c
i2
C0
C0
1
N 2 1
4
c 2c
2
N
>0
8c
=
=
(4.56)
= K
= K
L(p1 )
N 2 1
4
c
1
p1
(4.57)
(4.58)
C0
cq + B =
p
Nq
61
cq + K
C0
N
4c
(4.59)
Microeconomics
N
=c
q
and so
q
p1
= N
2c
= c < p1
i2
>q
Of course this is just the solution price equal to marginal cost.The bonus
scheme has made the monopolist simulate the outcome of a competitive
industry.
62
Chapter 5
a] log (x2
k)
where good 1 is rice and good 2 is a basket of all other commodities, and
0 < a < 1, k 0.
1. Briey interpret the parameters a and k.
2. Assume that the peasant is endowed with xed amounts (R1 ; R2 ) of the two
goods and that market prices for the two goods are known. Under what
circumstances will the peasant wish to supply rice to the market? Will the
supply of rice increase with the price of rice?
3. What would be the e ect of imposing a quota ration on the consumption
of good 2?
Outline Answer
1. k is the minimum amount of other goodsrequired for subsistence. Consider the amount of income that is in excess of this minimum (i.e. the
amount y k): the parameter a is the proportion of this that will be
spent on cereal consumption.
2. The persons budget constraint is
px1 + x2
(5.1)
where
y := pR1 + R2 ;
(5.2)
] log (x2
63
k) + [y
px1
x2 ]
Microeconomics
x1
1
x2
x2
=
=
[y
k]
R1 +
[R2
k]
(5.3)
The person will want to supply to the market if (5.3) is less than R1 . The
supply of rice is
S(p) := R1 x1
(5.4)
so that
S(p) = R1 [1
[R2
k]
(5.5)
R2
c
p
(5.6)
Supply of rice to the market must be less than without the ration and is
given by c pR2 ; if supply is positive, it must be decreasing in the price of
rice.
64
Microeconomics
Exercise 5.2 Take the model of Exercise 5.1. Suppose that it is possible for
the peasant to invest in rice production. Sacricing an amount z of commodity
2 would yield additional rice output of
b 1
1=0
z (p;b)
z (p; b)
x1 =
y (p; b)
p
e
65
z (p;b)
y (p; b)
p
Microeconomics
3. Evaluating y for p
1=b we have
pR1 + R2 + bp
log (bp)
and so
S (p; b) = R1 + b 1
1
bp
pR1 + R2 + bp
log (bp)
which simplies to
S (p; b) = [1
] R1 + b
1
p
R2
log (bp)
p
(5.7)
Dierentiating (5.7):
@S (p; b)
= [1
@p
R2
1
+
2
p
@S (p; b)
= [1
@b
]+
log (bp)
p2
bp
Clearly supply increases with b. For small p supply increases with p; this
may be reversed for large p.
66
Microeconomics
Exercise 5.3 Consider a household with a two-period utility function of the
form
log x1 + [1
] log x2
where xi is the amount of consumption in period i. . Suppose that the individual receives an exogenously given income stream (y1 ; y2 ) over the two periods,
assuming that the individual faces a perfect market for borrowing and lending at
a uniform rate r.
1. Examine the e ects of varying y1 ,y2 and r on the optimal consumption
pattern.
2. Will rst-period savings rise or fall with the rate of interest?
3. How would your answer be a ected by a total ban on borrowing?
Outline Answer
1. If the individual can lend or borrow as much as he wishes at the going
interest rate the given income stream is equivalent to an asset A in period
1 where
y2
(5.8)
A = y1 +
1+r
x2
x*
y
1+r
x1
S
Figure 5.1: Equilibrium of a saver
67
Microeconomics
x2
x*
1+r
x1
B
Figure 5.2: Equilibrium of a borrower
x2
x = y
x1
68
Microeconomics
a saver and a borrower is illustrated in Figures 5.1 and 5.2 respectively.
Savings in the rst period must be:
S := y1
x1 = y1
A = [1
] y1
y2
1+r
(5.9)
69
Microeconomics
Exercise 5.4 A consumer lives for two periods and has the utility function
log (x1
k) + [1
] log (x2
k)
where xt is consumption in period t, and , k are parameters such that 0 < < 1
and k 0. The consumer is endowed with an exogenous income stream (y1 ; y2 )
and he can lend on the capital market at a xed interest rate r, but is not allowed
to borrow.
1. Interpret the parameters of the utility function.
2. Assume that y1
y where
y := k +
y2 k
1+r
Outline Answer
1. The number k represents a subsistence minimum consumption; is the
share of period-1 non-subsistence consumption in non-subsistence lifetime
income.
2. The budget constraint is
x1 +
x2
1+r
(5.10)
y := y1 +
y2
:
1+r
(5.11)
] log (x2
k) +
where
The Lagrangean is
log (x1
k) + [1
k
1
1+r
70
x1
1
x2
1+r
Microeconomics
which , on rearranging give
x1
x2 k
1+r
k
= [1
1+r
]k +
y1 +
y2 k
1+r
(5.12)
The person will save a positive amount if (5.12) is less than y1 . Saving is
given by:
y2 k
(5.13)
S(r; y1 ; y2 ) := [1
] [y1 k]
1+r
which is positive if
y1 > y := k +
y2 k
1+r
k
= [1
1+r
@x1
@y1
@x1
@y2
@x1
@r
=
=
]k +
y1 +
>0
1+r
y2 k
1+r
(5.14)
(5.15)
>0
2
[1 + r]
(5.16)
[y2
k]
(5.17)
71
Microeconomics
v (xt ; t)
(5.18)
t=1
(5.19)
3. Suppose that v in (5.19) has the property that, whenever the consumption
vector is the same in all periods, the MRS of good i in period t for good
i in period t + 1 is independent of t. Show that within-period utility can
then be written
v (x; t) = t u (x)
(5.20)
Outline Answer
1. Consider the utility function
U (x1 ; x2 ; :::; xT )
If MRS between two goods in period t < T is independent of consumption
in period T then, by Leontief s Theorem there exist functions and
such that
U (x1 ; x2 ; :::; xT ) =
( (x1 ; x2 ; :::; xT
1 ) ; xT )
(5.21)
Given that is a continuous monotonic function and that a utility function is dened up to an arbitrary monotonic transformation we can rewrite
the right-hand side of (5.21 as
(x1 ; x2 ; :::; xT
1)
+ f (xT )
1; T
1, T
1) + v (xT ; T )
72
2, ...
Microeconomics
2. Without loss of generality let t0 = 1. If the consumption bundle in period
t is given as x then the condition on the MRSij implies
vi (x; 1)
vi (x; t)
=
vj (x; t)
vj (x; 1)
which means
vi (x; t)
vj (x; t)
=
vi (x; 1)
vj (x; 1)
But this means that each side of the equation is independent of x i and j;
we may write it as ' (t). Therefore we may write
vi (x; t) = ui (x) ' (t)
where u ( ) is some function independent of t and ui ( ) is the partial derivative with respect to the ith component. Integrating yields the result.
3. The required MRS is given by
' (t + 1)
ui (x) ' (t + 1)
=
:
ui (x) ' (t)
' (t)
If the right-hand side of this is independent of t then call this ratio . We
have
' (2)
' (3)
' (t)
dening ' (1) arbitrarily as
=
=
' (1)
2
' (1)
:::
= t 1 ' (1)
73
Microeconomics
Exercise 5.6 Suppose an individual lives for T periods and has a utility function of the form (5.18) where within-period utility is given by (5.20), consumption in period t is given by the scalar xt and the function u has the isoelastic
form
1
u (x) =
x1
(5.22)
1
where is a non-negative parameter.
1. Suggest an appropriate limiting form for u as
! 1.
2. The individual has a known exogenous income stream (y1 ; y2 ; :::; yT ) and
the interest rate in period t is rt . Find the rst-order condition for maximising utility.
3. Using the approximation log (1 + z) ' z show that the optimum consumption path is approximated by
log (xt ) = k + rt :
where k and are
4. How is
constants.
Outline Answer
1. Note that, taking x1
1 as a function of , we have
@
@
x1
x1
1 =
log x
(5.23)
x1
1
1
!1
lim
log x
!1
x1
log x
1
t
Y
1
; t = 2; 3; :::
1
+
ri
i=2
:=
1
1
; t = 2; 3; :::
1 + ri
pt xt
t=1
74
(5.24)
Microeconomics
where
A :=
T
X
pt y t
(5.25)
t=1
is the present value of lifetime income. The problem is then in the familiar form of consumer optimisation with many goods and is a simple
generalisation of the problem in Exercise 5.3. The Lagrangean is
"
#
T
T
X
1 X t 1
xt +
A
pt xt
(5.26)
1 t=1
t=1
The FOC for a maximum is
t
xt
pt = 0
log xt = log
+ log pt
(5.27)
1] log
log xt
= log
+ log pt
=
=
log
log pt
log + log (1 + rt )
:= 1= .
75
(5.28)
Microeconomics
max [[w` + y] [1
`]
` 0
(5.29)
Take log of the maximand in (5.29) and dierentiate with respect to ` to get:
1
1
w
w` + y
(5.30)
which is zero if
0
w` + w
` =
[1
y
] :
w
[1
]y
76
0 which requires
(5.31)
::
(5.32)
Microeconomics
Exercise 5.8 A household consists of two individuals who are both potential
workers and who pool their budgets. The preferences are represented by a single
utility function U (x0 ; x1 ; x2 ) where x1 is the amount of leisure enjoyed by person
1, x2 is the amount of leisure enjoyed by person 2, and x0 is the amount of the
single, composite consumption good enjoyed by the household. The two members
of the household have, respectively (T1 ; T2 ) hours which can either be enjoyed as
leisure or spent in paid work. The hourly wage rates for the two individuals are
w1 , w2 respectively, they jointly have non-wage income of y, and the price of
the composite consumption good is unity.
1. Write down the budget constraint for the household.
2. If the utility function U takes the form
U (x0 ; x1 ; x2 ) =
2
X
log(xi
i)
(5.33)
i=0
[[y + w1 T1 + w2 T2 ]
+ w1
+ w2
2 ]]
3. Write down the labour supply function for the two individuals.
4. What is the response of an individuals labour supply to an increase in
(a) his/her own wage,
(b) the other persons wage, and
(c) the non-wage income?
Outline Answer
The time endowments of the two individuals along with the non-wage income
correspond to the resources Ri . Given that the price of good 0 is normalised
to1 the budget constraint is therefore
x0 + w1 x1 + w2 x2
y + w1 T1 + w2 T2
(5.34)
wi
[[y + w1 T1 + w2 T2 ]
+ w1
+ w2
2 ]]
(5.35)
`1 := T1
x1 = [T1
1 ] [1
1]
w1
[[y + w2 T2 ]
+ w2
2 ]]
(5.36)
Therefore we have:
@`1
= 12 [[y + w2 T2 ]
@w1
w1
c Frank Cowell 2006
77
+ w2
2 ]]
(5.37)
Microeconomics
=
=
w1
1
w1
[T2
<0
2]
<0
(5.38)
(5.39)
The other persons wage acts on person 1s labour supply in a manner that is
very similar to non-wage income.
78
Microeconomics
Exercise 5.9 Let the demand by household 1 for good 1 be given by
9
8
y
if p1 > a =
<
4p1
y
if p1 < a
;
x11 =
;
: y 2p1 y
or
if
p
=
a
i
4a
2a
where a > 0.
1. Draw this demand curve and sketch an indi erence map that would yield
it.
2. Let household 2 have identical income y: write down the average demand
of households 1 and 2 for good 1 and show that at p1 = a there are now
three possible values of 21 [x11 + x21 ].
3. Extend the argument to nh identical consumers. Show that nh ! 1 the
possible values of the consumption of good 1 per household becomes the
y
y
; 2a
entire segment 4a
.
Outline Answer
1. From the question the demand function for 1 consumer looks like that
in the gure 5.4 below: there is a discontinuity between the two points
y
y
4a ; a and 2a ; a . By analogy with the analysis of the rm it is clear
that the indierence curve must look like that depicted in the following
Figure 5.5.
p1
x1
y/4a
y/2a
Both households at
y
4a :
so 12 x11 + x12 =
79
y
4a .
Microeconomics
x2
x1
Figure 5.5: Non-quasiconcave U
y
1
1
1
2a : so 2 x1 + x2
y
y
4a , the other at 2a :
Both households at
One household at
so
y
2a .
1
1
2 x1
+ x12 =
3y
4a .
h
nh h y
nh + h y
+
=
nh
nh
4a
nh 4a
h y
: h = 0; 1; :::; nh
nh 4a
80
y
y
4a ; 2a
y
2a
Chapter 6
A Simple Economy
Exercise 6.1 In an economy the activity of digging holes in the ground is carried out by self-employed labourers (singleperson rms). The production of
one standard-sized hole requires a minimum input of one unit of labour. No
self-employed labourer can produce more than one hole.
1. Draw the technology set Q for a single rm.
2. Draw the technology set Q for two rms.
3. Which of the basic production axioms are satised by this simple technology?
Outline Answer
q2
q2
q1
q1
Microeconomics
82
Microeconomics
Exercise 6.2 Consider the following four examples of technology sets Q:
q : q12 + q22 + q3 + q4 0; q1 ; q2 0; q3 ; q4 0
n
o
B :
q : q1 [ q2 ]
[ q3 ]
0; q1 0; q2 ; q3 0
1
log (q2 q3 ) 0; q1 0; q2 ; q3 0
2
n
q4
D :
q : q1 + q2 + max q3 ;
0; q1 ; q2 0; q3 ; q4
C
q : log q1
o
0
< 1:
> 0:
[ q2 ]
C: Similar to B.
(q) = log q1
[ q3 ]
1
log (q2 q3 )
2
q2 and z3 =
83
q4
q3 . Then:
Microeconomics
Exercise 6.3 Suppose two identical rms each produce two outputs from a
single input. Each rm has exactly 1 unit of input. Suppose that for rm 1 the
amounts q11 , q22 it produces of the two outputs are given by
q11
q21
=
=
[1
=
=
]:
0
0
=
=
0 2
0
[1
= 1+2 1
= 1 + 2[1
]:
1
2
and
Outline Answer:
1
1. The production possibility set for rm 1 if rm 2 sets 2 = are given by
2
the top left-hand panel of Figure 6.2 below. Firm 2s position if rm 1 sets
1
1
=
is given in the top right-hand panel. The combined production
2
possibility set is as shown in the lower panel.
1
; then by denition
=
= 2, and rm 1s production
2
1
1
1
boundary is given by all the points (2 ; 2[1
]) where 0
1. A
similar argument applies to rm 2. Now consider the sum of their outputs.
1
2
This will be given by points such as 1 + 2 + 4 1 2 , 2
+ 4[1
1
2
2
1
2
][1
]. So, for example, if
=
= 0 we get output (0; 6); if
1
1
= 2 = 1 we get (6; 0) but if 1 = 2 = we get (2; 2).
2
2. Let
84
Microeconomics
q2`1
q2`2
Firm 1
Firm 2
q1`1
q2
Combined
Firms
85
Microeconomics
Exercise 6.4 Take the model of Exercise 2.14. Assuming that production is
organised to maximise prots at given prices show that prot-maximising net
outputs of goods 1 and 2 are:
q1
q2
A
p1
2
A
p2
2
3
X
pi y i
(6.1)
i=1
If prots are maximised then production must take place on the transformation
curve. Therefore, substituting we get:
2
To maximise
FOCs:
[y1 ] + [y2 ]
A
= p1 y 1 + p2 y 2
(6.2)
2
yi = 0
A
y1
y2
(6.3)
i = 1; 2, and so
A
p1
2
A
p2
2
(6.4)
(6.5)
=A
[p1 ] + [p2 ]
:
4
86
(6.6)
Microeconomics
Exercise 6.5 Take the model of Exercise 5.3 but suppose that income is exogenously given at y1 for the rst period only. Income in the second period can
be obtained by investing an amount z in the rst period. Suppose y2 = (z),
where is a twice-di erentiable function with positive rst derivative and negative second derivative and (0) = 0, and assume that there is a perfect market
for lending and borrowing.
1. Write down the budget constraint.
2. Explain the rle of the Decentralisation Theorem in this model
3. Find the households optimum and compare it with that of Exercise 5.3.
4. Suppose (z) were to be replaced by
a ect the solution?
(z) where
Outline Answer:
1. The budget constraint is
x1 +
x2
1+r
A(z)
(6.7)
z+
(z)
1+r
(6.8)
x2
iy
ixA= y
ix
1+r
x1
Figure 6.3: Lifetime income: self investment
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Microeconomics
y2
(z)
z
Figure 6.4: The production of human capital
1+
z (z)
=0
1+r
(6.9)
for an interior solution. This rst-order condition implies that the optimal
value z must satisfy
(6.10)
z (z ) = 1 + r;
the marginal rate of transformation of current income into future income
equals the price ratio.
1. It is obvious that if were to be replaced by
( > 1) the opportunity
set is stretched in the direction of the vertical axis in Figure 6.4. We
expect that maximised lifetime income will increase. So consumption will
increase in both periods. What happens to optimal investment? From the
rst-order condition (6.9) we nd
z (z
)=1+r
(6.11)
) d +
dz
=
d
zz (z
z (z
) dz = 0
)
>0
(z
)
zz
88
(6.12)
Microeconomics
Exercise 6.6 Apply the model of Exercise 6.5 to an individuals decision to
invest in education.
1. Assume the parameter represents talent. Will more talented people demand purchase more education?
2. How is the demand for schooling related to exogenous rst-period income
y1 ?
Outline Answer:
The optimal purchase of education z increases with ability , but is independent of initial money income y1 .
89
Microeconomics
Exercise 6.7 Take the savings model of Exercise 5.4. Suppose now that by
investing in education in the rst period the consumer can augment his future
income. Sacricing an amount z in period 1 would yield additional income in
period 2 of
1 e z
where
1=0
(6.13)
1+r
(6.14)
= M (r; ) := y1
= y1 + log
log
1+r
y2 +
1+
1+r
1+r
y2 +
[1 e
1+r
(6.15)
y1
k + log
1+r
1+
y2
k+
1+r
Borrowing is given by
B (r; ) := x1 + z (r; )
c Frank Cowell 2006
90
y1
(6.16)
Microeconomics
and so, on evaluating this from (6.13) and (6.16), we have
B (r; ) =
y2
k+
1+r
1 + [1
] log
1+r
[y1
k]
Deierentiating we have
@B (r; )
@r
@B (r; )
@
y2
k+
2
[1 + r]
1
+
1+r
1
1+r
>0
91
Microeconomics
92
Chapter 7
General Equilibrium
Exercise 7.1 Suppose there are 200 traders in a market all of whom behave
as price takers. Suppose there are three goods and the traders own initially the
following quantities:
100 of the traders own 10 units of good 1 each
50 of the traders own 5 units of good 2 each
50 of the traders own 20 units of good 3 each
All the traders have the utility function
1
Outline Answer:
For each group of traders the Lagrangean may be written
1
1
1
log xh1 + log xh2 + log xh3 +
2
4
4
[y h
p1 xh1
p2 xh2
p3 xh3 ]
where h = 1; 2; 3 and y 1 = 10p1 ; y 2 = 5p2 and y 3 = 20p3 : From the rstorder conditions we nd that for a trader of type h:
xh1
xh2
xh3
yh
2p1
yh
4p2
yh
4p3
Microeconomics
E1
E2
=
=
1000
250
500 + 125
p1
p2
250
p3
p2
= 2 and
= 21 .
p1
p1
Using good 1 as numeraire we immediately see that y 1 = y 2 = y 3 = 10: All
are equally well o.
that implies
94
Microeconomics
Exercise 7.2 Consider an exchange economy with two goods and three persons.
Alf always demands equal quantities of the two goods. Bills expenditure on group
1 is always twice his expenditure on good 2. Charlie never uses good 2.
1. Describe the indi erence maps of the three individuals and suggest utility
functions consistent with their behaviour.
2. If the original endowments are respectively (5; 0), (3; 6) and (0; 4), compute
the equilibrium price ratio. What would be the e ect on equilibrium prices
and utility levels if
(a) 4 extra units of good 1 were given to Alf;
(b) 4 units of good 1 were given to Charlie?
Outline Answer:
1. Let
p1
so that values are measured in terms of good 2.
p2
xb2
2+
+ 2:
95
Microeconomics
x2
x1
(5,0)
x2
(3,6)
x1
96
Microeconomics
(c) Charlies budget constraint is
xa1 + xa2 = 4
Given the information in the question we have
xc1
xc2
= 4=
= 0
and utility is
U c = xc1
see Figure 7.3.
x2
(4,0)
x1
5
+ +2
+1
10:
10
5
+ +2
+1
10:
97
Microeconomics
Exercise 7.3 In a two-commodity economy assume a person has the endowment (0; 20).
1. Find the persons demand function for the two goods if his preferences are
represented by each of the types A to D in Exercise 4.2. In each case
explain what the o er curve must look like.
2. Assume that there are in fact two equal sized groups of people, each with
preferences of type A, where everyone in group 1 has the endowment (10; 0)
with = 21 and everyone in group 2 an endowment (0; 20) with = 34 . Use
the o er curves to nd the competitive equilibrium price and allocation.
Outline Answer:
1. The income of person h is 20.
(a) If he has preferences of type A then the Lagrangean is
log xh1 + [1
] log xh2 +
xh1
20
xh2
(7.1)
20
Solving these we nd
1
20
xh2
xh =
20 [1
(7.2)
and the oer curve will simply be a horizontal straight line at xh2 =
20 [1
].
(b) If h has preferences of type B then demand will be
xh
xh
xh
= x0 , if >
2 [x0 ; x00 ], if =
= (20= ; 0), if <
where x0 := (0; 20), x00 := (20= ; 0), and their oer curve will consist
of the union of the line segment [x0 ; x00 ] and the line segment from
x00 to (1; 0).
(c) If group-2 persons have preferences of type C then their demands will
be
p
xh = x0 , if >
p
xh = x0 or x00 , if =
p
xh = (20= ; 0), if <
p
where x0 := (0; 20), x00 := (20= ; 0), and their oer curve will
consist of the union of the point x0 and the line segment from x00 to
(1; 0).
c Frank Cowell 2006
98
Microeconomics
x'
20
ce
ren
iffe
ind curve
20[1-]
x1
x1
x''
x2
x2
x'
x1
x1
x''
(d) If group-2 persons have preferences of type D then their demands will
be
#
"
xh =
20
+
20
+
and their oer curve is just the straight line xh2 = xh1 . These are
illustrated in Figure 7.4.
2. If a type-A person had an income of 10 units of commodity 1 then, by
analogy with part 1, demand would be
x1 =
10
10 [1
(7.3)
and the oer curve will simply be a vertical straight line at xh1 = 10 .
From (7.2) and (7.3) we have x11 = 10 21 = 5, x22 = 20 1 43 = 5.
Given that there are 10 units per person of commodity 1 and 20 units per
person of commodity 2 the materials balance condition then means that
c Frank Cowell 2006
99
Microeconomics
Solving for
must be 3.
x1
5
15
x2
5
5
100
Microeconomics
Exercise 7.4 The agents in a two-commodity exchange economy have utility
functions
U a (xa ) = log(xa1 ) + 2 log(xa2 )
U b (xb ) = 2 log(xb1 ) + log(xb2 )
where xhi is the consumption by agent h of good i, h = a; b; i = 1; 2. The property
distribution is given by the endowments Ra = (9; 3) and Rb = (12; 6).
1. Obtain the excess demand function for each good and verify that Walras
Law is true.
2. Find the equilibrium price ratio.
3. What is the equilibrium allocation?
4. Given that total resources available remain xed at R := Ra + Rb =
(21; 9), derive the contract curve.
Outline Answer:
1. To get the demand functions for each person we need to nd the utilitymaximising solution. The Lagrangean for person a is
La (xa ;
[9p1 + 3p2
p1 xa1
p2 xa2 ]
p1 = 0
a
p2 = 0
9p1 + 3p2 p1 x1a
p2 x2a = 0
9
>
=
>
;
Subtracting the rst two equations from the third in (7.4) we can see that
1
a
= 1+3
. Substituting back for the Lagrange multiplier a into the
rst two parts of (7.4) we see that the rst-order conditions imply:
x1a
x2a
3+ 1
6 +2
(7.5)
8+ 4
4 +2
(7.6)
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Microeconomics
E1
E2
10
10
5
(7.8)
(7.9)
thus conrming WalrasLaw. In equilibrium the materialsbalance condition must hold and so excess demand for each good must be zero, unless
the corresponding equilibrium price is zero (markets clear).
2. Solving for E1 = 0 in (7.8) we nd
prices.
3. The allocation is
x1b
x2b
1
2
16
4
(7.10)
(7.11)
21 xa1
9 xa2
(7.12)
xa1
xa2 ]
(7.13)
102
12xa1
:
xa1 + 7
(7.14)
Microeconomics
Exercise 7.5 Which of the following sets of functions are legitimate excess demand functions?
9
E1 (p) = p2 + p101 =
E2 (p) = p1
(7.15)
;
E3 (p) = p103
9
3
>
E1 (p) = p2p+p
=
1
3
E2 (p) = p1p+p
(7.16)
2
>
2 ;
E3 (p) = p1p+p
3
p3 9
E1 (p) = p1 =
E2 (p) = pp32
(7.17)
;
E3 (p) = 2
Outline Answer:
The rst system is not homogeneous of degree zero in prices. The second
violates WalrasLaw. The third one is both homogeneous and satises Walras
Law.
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Microeconomics
4 +5
]2 [1
= [1
can be written
2 ]:
So that
dE( )=d =
4 + 10
see Figure 7.5. From this we see that there are two equilibria as follows:
1.
= 0:5. Here dE( )=d < 0 and so it is clear that the equilibrium is
locally stable
= 1. Here dE( )=d = 0. But the graph of the function reveals
that it is locally stable from above (where > 1) and unstable
from below (where < 1).
If there were an increase in the stock of commodity 1 the excess demand
function would be shifted to the left in Figure 7.5 then there is only one,
stable equilibrium.
1.5
0.5
-1
-0.5
E
0.5
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Microeconomics
Exercise 7.7 Consider the following four types of preferences:
Type
Type
Type
Type
A
B
C
D
:
log x1 + [1
:
x1 + x2
2
2
:
[x1 ] + [x2 ]
: min f x1 ; x2 g
] log x2
x1
x2
10
10 [1
= 3.
= 1.
Outline Answer:
1. Indierence curves have the shape shown in the gure 7.6.
2. The income of a group-1 person is 10 . If group-1 persons have preferences
of type A then the Lagrangean is
log x11 + [1
c Frank Cowell 2006
] log x12 +
105
10
x11
x12
Microeconomics
z2
z2
(1)
(2)
z1
z1
z2
z2
(4)
(3)
z1
z1
10
Solving these we nd
1
10
x12
x1 =
10
10 [1
and the oer curve will simply be a vertical straight line at x11 = 10 .
3. The income of a group-2 person is 20. So, if group-2 persons have preferences of type A, then their demands will be
20
x2 =
20 [1
and their oer curve will simply be a horizontal straight line at x22 =
20 [1
]. If group-2 persons have preferences of type B then their demands will be
x2
x2
x2
c Frank Cowell 2006
= x0 , if >
2 [x0 ; x00 ], if =
= (20= ; 0), if <
106
Microeconomics
where x0 := (0; 20), x00 := (20= ; 0), and their oer curve will consist of
the union of the line segment [x0 ; x00 ] and the line segment from x00 to
(1; 0). If group-2 persons have preferences of type C then their demands
will be
p
x2 = x0 , if >
p
x2 = x0 or x00 , if =
p
x2 = (20= ; 0), if <
p
where x0 := (0; 20), x00 := (20= ; 0), and their oer curve will consist
of the union of the point x0 and the line segment from x00 to (1; 0). If
group-2 persons have preferences of type D then their demands will be
"
#
20
+
20
+
x2 =
and their oer curve is just the straight line x22 = x21 .
4. In each case below we could work out the excess demand function, set
excess demand equal to zero, nd the equilibrium price and then the equilibrium allocation. However, we can get to the result more quickly by
using an equivalent approach. Given that an equilibrium allocation must
lie at the intersection of the oer curves of the two parties the answer in
each case is immediate.
(a) From the above computations we have x11 = 10 21 = 5, x22 =
20 1 34 = 5. Given that there are 10 units per person of commodity 1 and 20 units per person of commodity 2 the materials balance
condition then means that the equilibrium allocation must be
Solving for
x1
5
15
x2
5
5
x11
(b) We have
= 5, and so x21 = 5. Using the fact that the equilibrium
must lie on the group-2 oer curve we see that the solution must lie
on the straight line from (0; 20) to (20=3; 0) we nd that x22 = 5 and,
from the materials balance condition x12 = 20 5 = 15 (as in the
previous case). By the same reasoning as in the previous case the
equilibrium price must be = 3.
(c) Once again we have x11 = 5, and so x21 = 5. Given that the group2 oer curve in this case is such that the person always consumes
equal quantities of the two goods we must have x22 = 5 and so again
x12 = 20 5 = 15 (as in the previous cases). As before the equilibrium
price must be 3.
5. Note that the demand function and the oer curve for the group-2 people
is discontinuous. So, if there are relatively small numbers in each group
c Frank Cowell 2006
107
Microeconomics
there may be no equilibrium (the two oer curves do not intersect). In the
large numbers case we could appeal to a continuity argument and have
an equilibrium with proportion of group 2 at point x0 and the rest at x00 .
The equilibrium would then look very much like case 4b.
108
Microeconomics
Exercise 7.8 In a two-commodity exchange economy there are two equal-sized
groups of people. Those of type a have the utility function
1 a
[x ]
2 1
U a (xa ) =
1 a
[x ]
2 2
and a resource endowment of (R1 ; 0); those of type b have the utility function
U b xb = xb1 xb2
and a resource endowment of (0; R2 ).
1. How many equilibria does this system have?
2. Find the equilibrium price ratio if R1 = 5, R2 = 16.
Outline Answer:
For consumers of type a the relevant Lagrangean is
1 a
[x ]
2 1
1 a
[x ]
2 2
pxa1
+ [pR1
xa2 ]
where p is the price of good 1 in terms of good 2. The FOC for a maximum are
[xa1 ]
3
[xa2 ]
1=3
1=3
= p
1=3
=
h
i
pxa1 + xa2 = p2=3 + 1
xa2
So
1=3
xa2 =
1=3
= pR1
pR1
p2=3 + 1
R2
pxb1
xb1
xb2
p
1
xb1
xb2
=
109
1
p
1
xb2
Microeconomics
So
xb2 =
= R2
R2
2
R2
2
p2=3
1=0
110
Microeconomics
Exercise 7.9 In a two-person, private-ownership economy persons a and b
each have utility functions of the form
V h p; y h = log y h
h
1
p1
1
log (p1 p2 )
2
h
2
p2
xhi =
Now we have
h h
=
i [y
h
= [y
p1
Vih
Vyh
p1
h
1
h
1
p2
p2 h2 ]
h 1
:
2]
1=2pi ;
xhi =
Dening
good 2:
a
i
E2 =
+
b
i
1 h h h
p1 R 1
2pi
h
1
h
+ p2 R2h
h
2
ii
1
[p1 [R1
2p2
1]
+ p2 [R2
2 ]]
111
2
1
Microeconomics
2p2
A
p1
2
1
2
2 [p1 ]
A
p2
2
where
is the expression
for prots found in Exercise 6.4. Show that in
p
equilibrium p1 =p2 = 3 and hence show that the equilibrium price of good
1 (in terms of good 3) is given by
1=3
3
2A
p1 =
3. What is the ratio of the money incomes of workers and capitalists in equilibrium?
Outline Answer:
1. Given that the capitalist utility function is
xc1 xc2
it is immediate that in the optimum the capitalists spend an equal share
of their income on the two consumption goods and so
xci =
2pi
Worker utility is
xw
1
(7.18)
xw
3
(7.19)
xw
3]
[R3
R3
xw
3]
112
[R3
xw
3] :
(7.20)
Microeconomics
The FOC is
1
2 [R3 xw
3]=0
p1
which gives optimal labour supply as:
xw
3 =
R3
(7.21)
1
2p1
(7.22)
2:
(7.23)
2 [p1 ]
y1
xc2
y2
2p1
2p2
A
p1
2
1
2
2 [p1 ]
A
p2
2
(7.24)
(7.25)
To nd the equilibrium set each of (7.24) and (7.25) equal to zero. This
gives
p1 + 1
(7.26)
(7.27)
= A [p1 ]
= A [p2 ]
[p1 ] + [p2 ]
2
= [p2 ]
4
and so
p
p1
= 3:
p2
and p2 we get
Substituting for
(7.28)
[p1 ] + 31 [p1 ]
3
+ 1 = A [p1 ]
4
and, on rearranging, this gives
p1 A
p1 =
3
2A
1=3
(7.29)
1+
4
1
3
[p1 ] =
A
A 3
2
[p1 ] =
3
3 2A
2=3
A
3
1=3
2=3
1
1 3
=
2p1
2 2A
113
1=3
A
3
1=3
2=3
Microeconomics
So, workers and capitalists get the same money income in equilibrium!
Note that this is unaected by the value of A; increases in A could be
interpreted as technical progress and so the income distribution remains
unchanged by such progress.
114
Chapter 8
=
=
=
1
2
log (10 2 + 19) + log (10
3
3
1
2
log (27) + log (8)
3
3
log 3 + log 4 = log 12
2)
1
2
[10 2 + 19] + [10
3
3
27 16
43
1
+
=
= 14
3
3
3
3
2]
$12 = $2 31 .
3. If the person does not enter the lottery he has just his initial wealth, $10.
So, in view of the answer to part (a) it makes sense to enter the lottery.
115
Microeconomics
116
Microeconomics
Exercise 8.3 Consider the following denition of risk aversion. Let P :=
f(x! ; ! ) : ! 2 g be a random prospect, where x! is the payoPin state !
and ! is the (subjective) probability of state ! , and let Ex := !2 ! x! ,
the mean of the prospect, and let P := f( x! + [1
]Ex; ! ) : ! 2 g be a
mixture of the original prospect with the mean. Dene an individual as risk
averse if he always prefers P to P for 0 < < 1.
1. Illustrate this concept in (xred ; xblue )-space and contrast it with the concept
of risk aversion used in the text
2. Show that this denition of risk aversion need not imply convex-to-theorigin indi erence curves.
Outline Answer:
1. See Figure 8.1.
xBLUE
P
P
P
xRED
2. Let P be the prospect and P its mean. P can be any point in the line
joining them. The denition implies that moving along this line towards
P puts the person on a successively higher indierence curves. In Figure
8.1 it is clear that this condition is consistent with there being indierence
curves that violate the convex-to-the-origin property locally.
117
Microeconomics
Exercise 8.4 Suppose you are asked to choose between two lotteries. In one
case the choice is between P1 and P2 ;and in the other case the choice o ered is
between P3 and P4 , as specied below:
P1 :
P4 :
It is often the case that people prefer P1 to P2 and then also prefer P3 to P4 .
Show that these preferences violate the independence axiom.
Outline Answer:
Let there be only three possible states of the world: red, blue and green,
with probabilities 0.01, 0.10, 0.89 respectively. Then the payos in the four
prospects can be written
P1
P2
P3
P4
red
1
0
0
1
blue
1
5
5
1
green
1
1
0
0
where all the entries in the table are in millions of dollars. Note that P1 and P2
have the same payo in the green state; P3 and P4 form a similar pair, except
that the payo in the green state is 0. Axiom 8.2 states that if P1 is preferred
to P2 than any other similar pair of prospects (1; 1; z) and (0; 5; z) ought also
to be ranked in the same order, for arbitrary z: but this would imply that P4
is preferred to P3 , the opposite of the preferences as stated.
Note also that if the preferences had been such that P4 was preferred to P3
then the independence axiom would imply that P1 was preferred to P2 .
118
Microeconomics
Exercise 8.5 This is an example to illustrate disappointment. Suppose the
payo s are as follows
x00 weekend for two in your favourite holiday location
x0 book of photographs of the same location
x
sh-and-chip supper
Your preferences under certainty are x00 x0 x . Now consider the following
two prospects
8 00
with probability 0:99
< x
x0 with probability 0
P1 :
:
x with probability 0:01
8 00
with probability 0:99
< x
x0 with probability 0:01
P2 :
:
x with probability 0
Outline Answer:
It is possible that, given the information that the rst event (with payo x00 )
has not happened you would then prefer x to x0 : photographs of your favourite
holiday spot may be too painful once you know that the holiday is not going to
happen. So you may prefer P1 over P2 .
These preferences violate the independence axiom. To see this, note that,
by the revealed likelihood axiom, since x0 is strictly preferred to x , it must be
the case that P20 is strictly preferred to P10 , where
P10 :
x0
x
with probability 0
with probability 1
P20 :
x0
x
0:99
0
0:01
0:99
0:01
0
119
Microeconomics
!)
:!2 g
P 0 := f(x0! ;
!)
:!2 g
Now consider the choices amongst prospects presented in Exercise 8.4. Show
that if a person is concerned to minimise expected regret as measured by (8.1),
then it is reasonable that the person select P2 when P1 is also available and then
also select P4 when P3 is available.
Outline Answer:
Denote the regret in (8.1) by r (P; P 0 ).
If I choose P2 when P1 is also available then the regret is
r (P2 ; P1 )
Whereas, had I chosen P1 when P2 was available, then the regret would have
been
r (P1 ; P2 )
Whereas, had I chosen P3 when P4 was available, then the regret would have
been
r (P3 ; P4 )
120
Microeconomics
Exercise 8.7 An example of the Ellsberg paradox . There are two urns marked
Left and Right each of which contains 100 balls. You know that in Urn L
there exactly 49 white balls and the rest are black and that in Urn R there are
black and white balls, but in unknown proportions. Consider the following two
experiments:
1. One ball is to be drawn from each of L and R. The person must choose
between L and R before the draw is made. If the ball drawn from the chosen
urn is black there is a prize of $1000, otherwise nothing.
2. Again one ball is to be drawn from each of L and R; again the person must
choose between L and R before the draw. Now if the ball drawn from the
chosen urn is white there is a prize of $1000, otherwise nothing.
You observe a person choose Urn L in both experiments. Show that this
violates the Revealed Likelihood Axiom.
Outline Answer
The implication of the revealed likelihood axiom is that there exist subjective
probabilities ! . The result is proved by showing that it the stated behaviour
is inconsistent with the existence of subjective probabilities.
In this case the revealed likelihood axiom implies that for each urn there is
a given subjective probability of drawing a black ball L (left-hand urn) and R
(right-hand urn) such that preferences can be represented as
vblack (xblack ; xwhite ) + [1
(8.2)
where = L or R and xblack and xwhite are the payos if a black ball or a
white ball are drawn respectively.
Note that the representation (8.2) does not impose either the State Irrelevance Axiom (which would require that vblack ( ) and vwhite ( ) be the same
function) or the Independence axiom (which would require that vblack ( ) be a
function only of xblack etc.). Nor does it impose the common-sense requirement
that L = 0:49. All we need below is the very weak assumption that preferences
are not perverse:
vblack (1000; 0) > vwhite (1000; 0)
(8.3)
and
vblack (0; 1000) < vwhite (0; 1000)
(8.4)
Condition (8.3) simply says that if the $1000 prize is attached to a black ball
then the utility to be derived from having selected a black ball is higher than
selecting a white ball; condition (8.4) is the counterpart when the prize attaches
to the white ball..
Experiment 1 suggests that
L vblack
>
c Frank Cowell 2006
(1000; 0) + [1
R vblack (1000; 0) + [1
121
L ] vwhite
(1000; 0)
R ] vwhite (1000; 0)
(8.5)
Microeconomics
>
(0; 1000) + [1
v
R black (0; 1000) + [1
L ] vwhite
(0; 1000)
]
v
R white (0; 1000)
(8.6)
[vblack (1000; 0)
[vblack (1000; 0)
>
R.
122
Microeconomics
Exercise 8.8 An individual faces a prospect with a monetary payo represented
by a random variable x that is distributed over the bounded interval of the real
line [a; a]. He has a utility function Eu(x) where
u(x) = a0 + a1 x
1
a2 x2
2
var(x)]:
a2 x:
where and 0
(x)
(x)
%(x)
xmax :=
uxx (x)
=
ux (x)
1
xmax x
1
xmax =x 1
a1
a2 :
123
a2
a1 + a2 x
Microeconomics
Exercise 8.9 A person lives for 1 or 2 periods. If he lives for both periods he
has a utility function given by
U (x1 ; x2 ) = u (x1 ) + u (x2 )
(8.7)
where the parameter is the pure rate of time preference. The probability of
survival to period 2 is , and the persons utility in period 2 if he does not
survive is 0.
1. Show that if the persons preferences in the face of uncertainty are represented by the expected-utility functional form
X
(8.8)
! u (x! )
!2
(8.9)
2. What is the appropriate form of the utility function if the person could live
for an indenite number of periods, the rate of time preference is the same
for any adjacent pair of periods, and the probability of survival to the next
period given survival to the current period remains constant?
Outline Answer:
1. Consider the persons lifetime utility with the consumption x1 and x2
in the two periods. If the person survives into the second period utility
is given by u (x1 ) + u (x2 ) otherwise it is just u (x1 ). Given that the
probability of the event survive to second period is expected lifetime
utility is
[u (x1 ) + u (x2 )] + [1
] u (x1 ) :
On rearranging we get
u (x1 ) +
in other words the form (8.9) with
u (x2 ) ;
0
(8.10)
(8.11)
124
] u (x2 )
(8.12)
Microeconomics
So now view the situation from the position of the beginning of the lifetime.
The person gets utility
u (x1 ) + [u (x2 ) +
u (x3 )]
(8.13)
u (x3 )]]
u (x2 ) +
2 2
u (x2 ) :
(8.14)
It is clear that the same argument could be applied to T > 2 periods and
that the resulting utility function would be of the form
u (x1 ) +
u (x2 ) +
2 2
u (x2 ) + ::: +
T T
u (x2 ) :
(8.15)
125
Microeconomics
Exercise 8.10 A person has an objective function Eu(y) where u is an increasing, strictly concave, twice-di erentiable function, and y is the monetary value
of his nal wealth after tax. He has an initial stock of assets K which he may
keep either in the form of bonds, where they earn a return at a stochastic rate
r, or in the form of cash where they earn a return of zero. Assume that Er > 0
and that Prfr < 0g > 0.
1. If he invests an amount in bonds (0 < < K) and is taxed at rate t
on his income, write down the expression for his disposable nal wealth y,
assuming full loss o set of the tax.
2. Find the rst-order condition which determines his optimal bond portfolio
.
3. Examine the way in which a small increase in t will a ect
4. What would be the e ect of basing the tax on the persons wealth rather
than income?
Outline Answer:
1. Suppose the person puts an amount
in bonds leaving the remaining
K
of assets in cash. Then, given that the rate of return on cash is
zero and on bonds is the stochastic variable r, income is
[K
]0 + r = r
If the tax rate is t then, given that full loss oset implies that losses and
gains are treated symmetrically, disposable income is
[1
t] r
[K
]+
+ [1
[value of b onds]
[cash]
= K + [1
t] r
[incom e]
t] r:
(8.16)
Note that x is a stochastic variable and could be greater or less than initial
wealth K.
2. The individuals optimisation problem is to choose
Using (8.16) the FOC for an interior solution is
E (ux (x) [1
to maximise Eu(x).
t] r) = 0;
which implies
E (ux (x)r) = 0:
(8.17)
126
Microeconomics
3. Take the FOC (8.17). Substituting for x from (8.16) and dierentiating
with respect to t we get
E uxx (x)
@
[1
@t
r+
E uxx (x)r2
t] r r
@
[1
@t
= 0;
t]
= 0:
so that
+
@
[1
@t
t]
@
@t
= 0
=
t] K + [1
t] r
(8.18)
r+
@
[1
@t
t] r r
= 0;
@
[1
@t
t]
= 0:
This implies
K
E (uxx (x)r)
@
+
[1
2
E (uxx (x)r )
@t
@
[1
@t
@
=
@t
1
t] =
+K
+
K
1
t] = 0:
E (uxx (x)r)
:
E (uxx (x)r2 )
E (uxx (x)r)
:
t E (uxx (x)r2 )
The rst term on the right-hand side is positive; as for the second term,
the denominator is negative and the numerator is positive, given DARA.
So the impact of tax on bond-holding is now ambiguous.
127
Microeconomics
= y tx;
= [1 t st] y + stx:
] u (cnoaudit ) + u (caudit ) :
= y
= y
tx
ty + t [y
x]
= y tx [1 + s] t [y
= [1 t st] y + stx
x]
] u (y
tx) + u ([1
st] y + stx)
t [1
] uc (y
tx) + st uc ([1
128
st] y + stx)
Microeconomics
(a) If there is an interior maximum at x then the following FOC must
hold
[1
] uc (y tx ) = s uc ([1 t st] y + stx ) :
(b) If the person reports fully then
@Eu(c)
@x
t [1
[1
] uc (y
ty) + st uc ([1
t] y)
x=y
s ] tuc (y
ty)
Given that t and uc are positive it is clear that the above expression
is negative if 1
s > 0. Therefore the individuals expected
utility would increase if he reduced x below y.
3. Dierentiating the FOC with respect to s and rearranging we get
@x
@x
s2 t ucc ([1 t st] y + stx )
@s
@s
st] y + stx ) + st [x
y] ucc ([1 t st] y + stx )
t [1
] ucc (y
uc ([1
tx )
(a) Therefore
uc (caudit ) + st [x
t
@x
=
@s
y] ucc (caudit )
(8.19)
where
:=
[1
] ucc (y
tx )
s2 ucc ([1
Given that uc > 0, x < y and ucc < 0 it is clear that the numerator
of (8.19) is positive.x increases with s so t [y x ] decreases.
(b) Dierentiating the FOC with respect to y we get
[1
] ucc (y
= s ucc ([1
tx ) 1
@x
@y
st] y + stx ) [1
st] + st
@x
@y
Therefore we have
@x
=
@y
s [1
t
t [[1
@ [y x ]
s [1 t st] ucc (caudit ) [1
] ucc (cnoaudit )
=1+
@y
[[1
] tucc (cnoaudit ) + s2 tucc (caudit )]
@ [y x ]
=
@y
t [1
t [[1
] ucc (cnoaudit )
succ (caudit )
] ucc (cnoaudit ) + s2 ucc (caudit )]
129
Microeconomics
Exercise 8.12 A risk-averse person has wealth y0 and faces a risk of loss
L < y0 with probability . An insurance company o ers cover of the loss at
a premium > L. It is possible to take out partial cover on a pro-rata basis,
so that an amount tL of the loss can be covered at cost t where 0 < t < 1.
1. Explain why the person will not choose full insurance
2. Find the conditions that will determine t , the optimal value of t.
3. Show how t will change as y0 increases if all other parameters remain
unchanged.
Outline Answer:
1. Consider the persons wealth after taking out (partial) insurance cover
using the two-state model (no loss;loss). If the person remained uninsured it would be (y0 ; y0 L); if he insures fully it is (y0
; y0
). So
if he insures a proportion t for the pro-rata premium wealth in the two
states will be
([1
t] y0 + t [y0
] ; [1
t] [y0
L] + t [y0
])
which becomes
(y0
t ; y0
[1
t] L)
] u (y0
t ) + u (y0
[1
t] L)
Therefore
@Eu
=
@t
[1
] uy (y0
t ) + [L
] uy (y0
[1
t] L)
[1
] uy (y0
) + [L
] uy (y0
t=1
[L
] uy (y0
] uy (y0
) + [L
130
] uy (y0
[1
t ] L) = 0
Microeconomics
3. Dierentiating the above equation with respect to y0 we get
[1
] uyy (y0
) 1
@t
+[L
@y0
] uyy (y0
[1
t ] L) 1
which gives
[1
] uyy (y0 t ) + [L
@t
=
@y0
[1
] 2 uyy (y0 t ) + [L
] uyy (y0
2
] uyy (y0
[1
t ] L)
[1
t ] L)
131
L]
@t
=0
@y0
Microeconomics
C(q)
E(u ( ))Cq = 0
[p
Cq ]2 )
E(u
)Cqq < 0:
Notice that since the rst term is negative for a risk-averse rm then the
condition can be satised not only if Cqq > 0 but also if Cqq < 0 and jCqq j
is not too large. Now consider transforming p to pb thus: pb = (1
)p + p
then pb has the same mean as p but is less dispersed. Maximised utility for
the random variable pb is
Eu([(1
)p + p]q
C(q ))
p])]q + [E(u [b
p
132
Cq ])]
@q
@
Microeconomics
where the last term vanishes because of the rst order condition. So
@Eu
has the sign of E(u [p p]): But this must be positive if u is
@
decreasing with and will be zero if u is constant. Hence the rm strictly
prefers certainty if it is risk averse and is indierent between certainty and
uncertainty if it is risk neutral.
2. For any known realization p we may write q = S(p) where S is the competitive rm supply curve. Prots as a function of P may thus be written:
(p) = pS(p)
C(S(p))
which implies
d (p)
= [p
dp
(8.20)
133
(p):
Microeconomics
Exercise 8.14 Every year Alf sells apples from his orchard. Although the market price of apples remains constant (and equal to 1), the output of Alf s orchard
is variable yielding an amount R1 ; R2 in good and poor years respectively; the
probability of good and poor years is known to be 1
and respectively. A
buyer, Bill, o ers Alf a contract for his apple crop which stipulates a down payment (irrespective of whether the year is good or poor) and a bonus if the year
turns out to be good.
1. Assuming Alf is risk averse, use an Edgeworth box diagram to sketch the
set of such contracts which he would be prepared to accept. Assuming that
Bill is also risk averse, sketch his indi erence curves in the same diagram.
2. Assuming that Bill knows the shape of Alf s acceptance set, illustrate the
optimum contract on the diagram. Write down the rst-order conditions
for this in terms of Alf s and Bills utility functions.
xRED
xBLUE
R2
xBLUE
R1
xRED
134
Microeconomics
b
xRED
a
xBLUE
xBLUE
xRED
xRED
xBLUE
R2
xBLUE
R1
At E we have that
ua0 (xa1 )
ub0 (xb )
= b0 1b :
a
a0
u (x2 )
u (x2 )
135
xRED
Microeconomics
Exercise 8.15 In exercise 8.14, what would be the e ect on the contract if (i)
Bill were risk neutral; (ii) Alf risk neutral?
Outline Answer:
In case (i) Bills indierence curves become lines with slope [1
] = and
the optimum is at E in Figure 8.5. In case (ii) Alfs indierence curves become
lines with slope [1
] = and the optimum is at the endowment point D.
b
xRED
a
xBLUE
R2
b
xBLUE
R1
136
Chapter 9
Welfare
Exercise 9.1 In a two-commodity exchange economy there are two large equalsized groups of traders. Each trader in group a has an endowment of 300 units
of commodity 1; each person in group b has an endowment of 200 units of
commodity 2. Each a-type person has preferences given by the utility function
U a (xa ) = xa1 xa2
and each b-type persons utility can be written as
U b (xb ) =
xb1 xb2
xa1
1
1 200
300 +
2
2
Microeconomics
CHAPTER 9. WELFARE
100
300
x1b
x2b
1
2
1
2
1
2
1
2
300
300
150
100
(9.1)
200=
200
150
100
(9.2)
=
=
=
1
xb1
1
xb2
xb2
1 2
1
+
150 100 3
1
xa1 > 0
150
xb1 +
1
xa1
xa1
1
xa1
150
138
Microeconomics
Exercise 9.2 Consider a constitution based on a system of rank-order voting
whereby the worst alternative gets 1 point, the next worst, 2, ... and so on, and
the state that is awarded the most points by the citizens is the one selected. Alf s
ranking of social states changes during the week. Bills stays the same:
Monday:
Alf Bill
Tuesday:
Alf Bill
0
0
00
0
00
00
00
139
Microeconomics
CHAPTER 9. WELFARE
Exercise 9.3 Consider an economy that consists of just three individuals, fa; b; cg
and four possible social states of the world. Each state-of-the-world is characterised by a monetary payo y h thus:
0
00
000
a
3
1
5
2
b
3
4
1
6
c
3
4
3
1
Outline Answer:
000
1. We nd that majority voting produces the ranking 0
but also
000
0
0 000
0
; i.e. the states f ; ; g form a cycle. (ii)
would be strictly
preferred to the state of perfect equality . (iii) Since the probability of
being assigned any one of the three identities is 13 , the utility payos are:
140
Microeconomics
0
00
000
a
3
1
5
2
b
3
4
1
6
c
3
4
3
1
Expected Utility
1
3 log(27)
1
3 log(16)
1
3 log(15)
1
3 log(12)
0
00
000
Distribution
[3,3,3]
[1,4,4]
[1,3,5]
[1,2,6]
Expected Utility
1
3 log(27)
1
3 log(16)
1
3 log(15)
1
3 log(12)
If each child perceives an equal chance of being assigned any plate the
expected utility of the perceived pie distribution is
nh
1 X
u yh
nh
h=1
where u is an increasing function. If u is concave then this utility function will rank more equal distributions as being preferable to less equal
distributions.
5. Inequality aversion is identical to risk aversion.
6. In practice the problem of receiving a particular pie allocation will not be
the same individuals; personal risk-aversion may not be an appropriate
basis for inequality aversion with reference to life chances.
141
Microeconomics
CHAPTER 9. WELFARE
Exercise 9.4 Table 9.1 shows the preferences over three social states for two
groups of voters; the row marked # gives the number of voters with each set
of preferences; preferences are listed in row order, most preferred at the top.
1. Find the Condorcet winner among right-handed voters only.
2. Show that there is a cycle among left-handed voters only.
3. Suppose that the cycle among the left-handed voters is broken by ignoring
the vote that has the smallest winner. Show that the winner is then the
same as that among the right-handed voters.
4. Show that if the two groups are merged there is a Condorcet winner but is
di erent from the winners found for the left-handers and the right-handers
separately!
5. Would the above paradox occur if one used de Borda voting?
Left-handers
10
6
0
0
00
6
0
Right-handers
12
18
00
00
00
00
17
00
0
Outline Answer:
Use to denote beats in a bilateral vote.
0
00
1. Clearly, from the right-hand part of the table
and
, both
by a majority of 18 to 17. So is unambiguously the Condorcet winner
among the right-hand voters
versus
So 00
00
So there is a cycle
00
. So
00
.So
00
142
Microeconomics
4. For the two groups together:
versus 0 . There are 10+12+18+17 votes for
0
for 0 . So
by 57 to 12
0
00
versus
for 00 .So
00
00
unambiguously.
00
5. Borda voting where 3 is the score given to the best alternative, 1 to the
worst. Votes are as in Table 9.2. wins in each subgroup and overall.
Left-handers
0
00
10
3
2
1
6
2
3
1
6
1
3
2
12
2
1
3
tot
72
68
64
Right-handers
17 tot
18
3
1
2
2
1
3
88
35
87
143
Both groups
160
103
151
Microeconomics
CHAPTER 9. WELFARE
nh
X
(y h )
h=1
x1
1
is a non-negative parameter.
take for
lim
2. Dierentiating
= lim
x1
!1
log x
= log x.
1
we get
d (x)
dx
d2 (x)
dx2
= x
=
and so (x) = .
3. For the case = 1 contours will be rectangular hyperbolas and ede-income
is the geometric mean. For = 0 contours will be diagonal straight lines
and ede-income is the arithmetic mean. For = 1 contours will be Lshapes and ede-income is the smallest of the incomes y h .
4.
W
=
=
=
=
Z
Z
(y)f (y)dy
yf (y)dy, if
=0
log yf (y)dy, if
144
=1
=1
Microeconomics
Exercise 9.6 In a two-commodity exchange economy there are two groups of
people: type a have the utility function 2 log(xa1 ) + log(xa2 ) and an endowment
of 30 units of commodity 1 and k units of commodity 2; type b have the utility
function log(xb1 ) + 2 log(xb2 ) and an endowment of 60 units of commodity 1 and
210 k units of commodity 2.
1. Show that the equilibrium price, , of good 1 in terms of good 2 is
[Hint: use the answer to Exercise 7.4].
210+k
150 .
=
=
30 + k
60 + [210
(9.3)
(9.4)
k]
30 +k
[30 + k]
60 +210 k
[60 + 210
k]
This means that the excess demand for commodity 2 at price must
1
10 + k + 40 + 140
3
c Frank Cowell 2006
145
2
k
3
210
be
Microeconomics
CHAPTER 9. WELFARE
yb
210 + 6k
5
1470 3k
5
(9.5)
(9.6)
or, using the formula for the equilibrium price, we have equivalently:
ya
yb
=
=
180
420
210
90
(9.7)
(9.8)
1 a
y :
2
This is depicted as the solid line segment in Figure 9.1 are the incomes
that the government could generate by choosing k in eect a lump-sum
transfer between the two persons. The shaded area gives all the possible
combination of incomes if income can be thrown away.
yb
300
(42,294)
200
(294,168)
100
ya
0
100
200
300
146
Microeconomics
4. If the government tries to maximise
W = log(y a ) + log(y b )
subject to the (truncated) straight line given in gure 9.1, the best it can
achieve is a corner solution giving all of resource 2 to person a.
^ = y a + y b . So even
5. But this of course is exactly what happens with W
though the SWF W exhibits inequality aversion, you get the same outcome
^ which ignores distributional issues and just seeks to
as with the SWF W
maximise total income.
147
Microeconomics
CHAPTER 9. WELFARE
cf
:= PN
j=1
(9.9)
cj
where
cf
K + cf
N
X
K :=
(9.10)
cj :
j=1;j6=f
cf
cf
cf
K + cf
1 = 0:
(9.11)
2. If the rms are identical then the optimal lobbying expenditure is the same
c for each rm f . So K + cf is just N c and (9.11) becomes
Nc
c
Nc
1 = 0:
(9.12)
(9.13)
This implies
Nc =
148
Microeconomics
Exercise 9.8 In an economy there are n commodities and nh individuals, and
there is uncertainty: each individual may have good or poor health. The state
of health is an independently distributed random variable for each individual
and occurs after the allocation of goods has taken place. Individual h gets the
following utility in state-of-the-world !:
uh xh ; ! := ah xh1 ; ! +
n
X
bh xhi
i=2
where xh := xh1 ; xh2 ; :::; xhn , xhi is the amount of commodity i consumed by h,
the functions ah ,bh are increasing and concave in consumption, and ! takes one
of the two values poor health or good health for each individual; good 1 is
health-care services.
1. The government estimates that for each individual the probability of stateof-the-world ! is ! . If aggregate production possibilities are described
by the production constraint (x) = 0 (where x := (x1 ; x2 ; :::; xn ) and xi
is the aggregate consumption of commodity i) and the government has a
social-welfare function
nh X
X
!u
xh ; !
h=1 !
(x)
j (x)
(x)
; i; j = 2; :::; n
j (x)
i
"P
h h
! a1
h
! a1
xh1 ; !
xh1 ; !
; j = 2; :::; n
Outline Answer:
1. The Lagrangean for the social optimum is
L x1 ; x2 ; :::; xm ;
c Frank Cowell 2006
:=
m X
X
h=1 !
149
(!)
xh ; !
m
X
h=1
xh
Microeconomics
CHAPTER 9. WELFARE
(9.14)
h
i
xhi
and
(x) ; i = 2; :::; n
(9.15)
n
X
phi xhi
i=1
h
i
xhi = phi
(9.17)
h
i
h
j
xhi
xhj
phi
; i; j = 2; :::; n
phj
h
j
xhj
h
j
xhj
1
j
(x)
1
P
(x) ! (!) h1 xh1 ; !
ph1
P
phj !
h (!) h
1
xh1 ; !
150
Microeconomics
Exercise 9.9 Revisit the economy of San Serrife (Exercise 4.11) Heterogeneity
amongst the inhabitants of San Serrife was ignored in Exercise 4.11. However, it
is now known that although all San Serrife residents have preferences of form A
in Exercise 4.2 they di er in their tastes: Northern San Serrifeans spend 34%
of their budget on milk and only 2% on wine, while Southern San Serrifeans
spend just 4% of their budget on milk and 32% on wine. The question of entry
to the EU is to be reviewed; the consequences for the prices of milk and wine of
entry to the EU are as in Exercise 4.11.
1. Assume that there are eight times as many Southerners as Northerners in
the San Serrife population, but that the average income of a Northerner is
four times that of a Southerner. On the basis of the potential-superiority
criterion, should San Serrife enter the EU?
2. Suppose Northerners and Southerners had equal incomes. Should San Serrife enter the EU?
3. What would be the outcome of a straight vote on entry to the EU?
Outline Answer:
1. Given that the i have the interpretation of expenditure shares it is clear
that Northerners would lose by EU entry and Southerners would gain. So
what should happen? The total CV (summed over all San Serrife) is
X
CVh (p ! p
^ ) = [1
(9.18)
N ]nN yN + [1
S ]nS yS
h
S]
0:04
]=7
22:96 > 0:
3. Simple voting would have given the opposite answer to the potential
Pareto gain rule.
151
Microeconomics
CHAPTER 9. WELFARE
152
Chapter 10
Strategic Behaviour
Exercise 10.1 Table 10.1 is the strategic form representation of a simultaneous
move game in which strategies are actions.
sa1
sa2
sa3
sb1
0; 2
2; 4
1; 1
sb2
3; 1
0; 3
2; 0
sb3
4; 3
3; 2
2; 1
153
Microeconomics
Exercise 10.2 Table 10.2 again represents a simultaneous move game in which
strategies are actions.
sa1
sa2
sa3
sb1
0; 2
2; 0
1; 3
sb2
2; 0
0; 2
1; 3
sb3
3; 1
3; 1
4; 4
154
Microeconomics
Exercise 10.3 A taxpayer has income y that should be reported in full to the
tax authority. There is a at (proportional) tax rate on income. The reporting
technology means that that taxpayer must report income in full or zero income.
The tax authority can choose whether or not to audit the taxpayer. Each audit
costs an amount ' and if the audit uncovers under-reporting then the taxpayer
is required to pay the full amount of tax owed plus a ne F .
1. Set the problem out as a game in strategic form where each agent (taxpayer,
tax-authority) has two pure strategies.
2. Explain why there is no simultaneous-move equilibrium in pure strategies.
3. Find the mixed-strategy equilibrium. How will the equilibrium respond to
changes in the parameters , ' and F ?
Outline Answer
1. See Table 10.3.
sa1
conceal
sa2
report
Tax-Authority
sb1
sb2
Audit
Not audit
] y F; y + F '
y; 0
[1
Taxpayer
[1
] y;
'
[1
] y;
[[1
]y
a
+ [1
F] + 1
[1
y
b
]y + 1
[1
So we have
= [1
]y +
d
d
a
a
= 1
155
a b
F:
]y ;
Microeconomics
b
1
taxpayer
reaction
*b
tax authority
reaction
*a
It is clear that
d
d
a
a
T 0 as
:=
where
y
:
y+F
(10.1)
[ a[ y+F
b
+ 1
[
'] + [1
a
[0] + [1
] [ y ']]
] [ y]]
= [1
So we have
d
d
It is clear that
d
d
b
b
] y+
b
b
T 0 as
=
a
[ y + F]
[ y + F]
a b
:=
'
'
where
'
:
y+F
(10.2)
156
as illus-
Microeconomics
(d) The eect of a change in any of the model parameters on the equilibrium can be found by dierentiating the expressions (10.1) and
(10.2). we have
@
@
'y
2
[ y + F]
> 0;
@ b
Fy
=
2 > 0:
@'
[ y + F]
@ a
1
=
> 0;
@'
y+F
@ a
=
@F
'
2
[ y + F]
< 0;
157
@ b
= 0:
@'
@ b
=
@F
y
2
[ y + F]
< 0:
Microeconomics
sa1
sa2
sb1
sb2
[West]
[East]
2,1
0,0
0,0
1,2
[West]
[East]
1. Show that, in addition to the pure strategy Nash equilibria there is also a
mixed strategy equilibrium.
2. Construct the payo -possibility frontier . Why is the interpretation of this
frontier in the battle-of-the-sexes context rather unusual in comparison
with the Cournot-oligopoly case?
3. Show that the mixed-strategy equilibrium lies strictly inside the frontier.
4. Suppose the two players adopt the same randomisation device, observable
by both of them: they know that the specied random variable takes the
value 1 with probability and 2 with probability 1
; they agree to play
sa1 ; sb1 with probability and sa2 ; sb2 with probability 1
; show that
this correlated mixed strategy always produces a payo on the frontier.
Outline Answer
1. Suppose a plays [West] with probability
ability b . The expected payo to a is
a
=
=
=
b
a b
+ [1
d
d
a b
T 0 as
d
d
b
[1]
(10.3)
1+3
a b
[0] + [1
] [2]]
(10.4)
b
b
] [0]] + 1
] 1
+3
And so
It is clear that dd b T 0 as
where a ; b = 32 ; 13 .
[0] + 1
a
a
[1] + [1
+ 2 [1
a b
d
d
It is clear that
[0] + [1
] 1
+3
So we have
[2] + 1
2+3
158
Microeconomics
2. See Figure 10.2. Note that, unlike oligopoly where the payo (prot)
is transferable, in this interpretation the payo (utility) is not so the
frontier has not been extended beyond the points (2,1) and (1,2). The
lightly shaded area depicts all the points in the attainable set of utility
can be thrown away. The heavily shaded area in Figure 10.2 shows the
expected-utility outcomes achievable by randomisation. The frontier is
given by the broken line joining the points (2,1) and (1,2).
2 2
3; 3
and
4. Given that the probability of playing [West] is , the expected utility for
each player is
a
= 2 + [1
]=1+
b
+ 2 [1
]=2
If we allow to take any value in [0; 1] this picks out the points on the
broken line in Figure 10.2.
159
Microeconomics
Exercise 10.5 Rework Exercise 10.4 for the case of the Chicken game in Table
10.5.
sb1
2; 2
3; 1
sa1
sa2
sb2
1; 3
0; 0
Outline Answer
b
(1, 1)
a
0
[2] + 1
b
+3
d
d
d
d
a
a
T 0 as
a
+3
[3] + 1
[0]
(10.5)
a
a
=1
] [1]] + 1
a b
And so
d
d
c Frank Cowell 2006
[1] + [1
[2] + [1
a
a b
So we have
It is clear that
[3] + [1
] [0]]
(10.6)
b
b
=1
160
Microeconomics
b
It is clear that dd b T 0 as
where a ; b = 21 ; 12 .
2. See Figure 10.3. The lightly shaded area depicts all the points in the
attainable set of utility can be thrown away. The heavily shaded area
shows the expected-utility outcomes achievable by randomisation
3. The utility associated with the mixed-strategy equilibrium is 1 12 ; 1 21 and
clearly lies inside the frontier.
4. Once again a correlated strategy would produce an outcome on the broken
line.
161
Microeconomics
[LEFT]
Bill
[left]
[right]
[left]
[right]
Charlie
[L]
0
1
3
[M]
2
2
2
[R]
[L]
0 0
1 0
0 0
[M]
0
0
0
[R]
[L]
0 1
0 1
0 1
[M]
2
2
0
[R]
[L]
1 1
1 0
0 0
[M]
2
2
2
[R]
1
0
3
Exercise 10.6 Consider the three-person game depicted in Figure 10.4 where
strategies are actions. For each strategy combination, the column of gures in
parentheses denotes the payo s to Alf, Bill and Charlie, respectively.
1. For the simultaneous-move game shown in Figure 10.4 show that there is
a unique pure-strategy Nash equilibrium.
2. Suppose the game is changed. Alf and Bill agree to coordinate their actions by tossing a coin and playing [LEFT],[left] if heads comes up and
[RIGHT],[right] if tails comes up. Charlie is not told the outcome of the
spin of the coin before making his move. What is Charlies best response?
Compare your answer to part 1.
3. Now take the version of part 2 but suppose that Charlie knows the outcome of the coin toss before making his choice. What is his best response?
Compare your answer to parts 1 and 2. Does this mean that restricting
information can be socially benecial?
Outline Answer
1. The strategic form of the game can be represented as in Table 10.6 from
c Frank Cowell 2006
162
Microeconomics
sb1
sb2
sc1
L
0; 1; 3
0; 0; 0
[left]
[right]
sa1 :[LEFT]
sc2
sc3
M
R
2; 2; 2 0; 1:0
0; 0; 0 0; 0; 0
sa2 :[RIGHT]
sc1
sc2
sc3
L
M
R
1; 1; 1 2; 2; 0 1; 1; 0
1; 0; 0 2; 2; 2 1; 0; 3
Heads
Tails
[left,LEFT]
[right,RIGHT]
sc1
L
0; 1; 3
1; 0; 0
sc2
M
2; 2; 2
2; 2; 2
sc3
R
0; 1:0
1; 0; 3
=
=
=
=
=
=
RIGHT
fLEFT; RIGHTg
fLEFT; RIGHTg
RIGHT
RIGHT
RIGHT
BRb (LEFT; L)
BRb (LEFT; M)
BRb (LEFT; R)
BRb (RIGHT; L)
BRb (RIGHT; M)
BRb (RIGHT; R)
BRc (LEFT; left)
BRc (LEFT; right)
BRc (RIGHT; left)
BRc (RIGHT; right)
=
=
=
=
=
=
left
left
left
left
fleft; rightg
left
= L
= fL; M; Rg
= L
= R
163
Microeconomics
3. Charlie now knows both the coordination rule and the outcome of the coin
toss. From Table 10.7 it is clear that his best response is L if it is heads
and R if it is tails. Now he gets a payo of 3 and the others get an
equal chance of 0 or 1: total payo is 4, less than that under part 2 but
more than under part 1.
164
Microeconomics
Exercise 10.7 Consider a duopoly with identical rms. The cost function for
rm f is
C0 + cq f ; f = 1; 2:
The inverse demand function is
q
where C0 , c,
q = q1 + q2 .
and
Outline Answer
1. Firm 2s prots are given by
2
= pq 2
=
C0 + cq 2
q1 + q2
q2
C0 + cq 2
q1 =
1 1
q
2
(10.7)
2
165
1 2
q
2
(10.8)
Microeconomics
q2
prof
it
q1
q2
2()
q1
166
Microeconomics
The Cournot-Nash solution is where (10.7) and (10.8) hold simultaneously,
i.e. where
c 1
c 1 1
0
q1 = 0
q
(10.9)
2
2
2
2
The solution is at q 1 = q 2 = qC where
qC =
see Figure 10.7. The price is
2
3
(10.10)
3
+ 13 c.
q2
1()
qC
2()
q1
Figure 10.7: Cournot-Nash equilibrium
= pq [2C0 + cq]
= [ 0
q] q [2C0 + cq]
2 q=0
(10.11)
167
Microeconomics
(each indicates the amount that one rm would produce if it knew that the
other was producing zero). The solution lies somewhere on the line joining
these two points. In particular the symmetric joint-prot maximising
outcome (qJ ; qJ ) lies exactly at the midpoint where the isoprot contour
of rm 1 is tangent to the isoprot contour of rm 2.
q2
1()
(0,qM)
qC
qJ
2()
q1
(qM,0)
q1 +
q1
q1
C0 + cq 1
q1 +
1 1
q
2
q1
1
c
q 1 q 1 C0
2 0
The FOC for the leaders problem is
=
1
[
2
so that the leaders output is
qS1 =
(10.12)
q1 = 0
c]
168
C0 + cq 1
Microeconomics
output
Cournot
1
3
1
2
1
4
1
4
Stackelberg leader
Stackelberg follower
2
0
price
[
0
0
+ c]
3
4c
3
4c
+
0
prot
2
3 c.
+
+
9
8
8
c]2
c]2
c]2
c]2
16
C0
C0
C0
C0
1
4
+ 34 c.
q2
qC
qS
2()
q1
(qM,0)
Figure 10.9: Firm 1 as Stackelberg leader
5. The outcomes of the various models are given in Table 10.8.and the possible payos are illustrated in Figure 10.10. Note that maximum total prot
on the boundary of the triangle is exactly twice the entry in theJoint
2
prot maxrow, namely 41 [ 0 c] =
2C0 . This holds as long as there
are two rms present i.e. right up to a point arbitraily close to either of
the end-points. But if one rm is closed down (so that the other becomes
a monopolist) then its xed costs are no longer incurred and the monop2
C0 . In Figure 10.10 the point
olist makes prot M := 14 [ 0 c] =
marked is where both rms are in operation but rm 1 is getting all
of the joint prot and the point ( M ; 0) is the situation where rm 1 is
operating on its own.
169
Microeconomics
(0, M)
( , )
J
(C,C)
( , )
1
S
2
S
C0
(,0)
170
Microeconomics
Exercise 10.8 An oligopoly contains N identical rms. The cost function is
convex in output. Show that if the rms act as Cournot competitors then as N
increases the market price will approach the competitive price.
Outline Answer
The assumption of convex costs will ensure that there is no minimum viable
size of rm. Prots for a typical rm are given by
p qf + K qf
where
K :=
N
X
C qf
(10.13)
qj
j=1
j6=f
is the total output of all the other rms, which of course rm f takes to be
constant under the Cournot assumption. Maximising this by choice of q f gives
the FOC for an interior solution
pq q f + K q f + p q f + K
Cq q f = 0
(10.14)
Given that all the rms are identical we may rewrite condition (10.14) as
pq (q)
q
+ p (q)
N
Cq = 0
(10.15)
Cq
1 + 1N
(10.16)
p (q)
qpq (q)
171
Microeconomics
Exercise 10.9 Two identical rms consider entering a new market; setting up
in the new market incurs a once-for-all cost K > 0; production involves constant
marginal cost c. If both rms enter the market Bertrand competition then takes
place afterwards. If the rms make their entry decision sequentially, what is the
equilibrium?
Outline Answer
1. The rms rst decide whether to enter (and hence incur the xed cost K),
then they play the Bertrand pricing game. K is thus considered a sunk
cost when the second-stage game is played. When both rms decide to
enter, the unique Nash equilibrium of the Bertrand pricing game is to set
prices equal to marginal cost, (p1 ; p2 ) = (c; c). This yields overall prots
for the two rms ( 1 ; 2 ) = ( K; K).
2. The extensive form is shown in Figure 10.11.
3. To nd the Subgame Perfect Nash Equilibrium, solve the game by backwards induction. If rm 1 decides to enter, rm 2s optimal strategy is
not to enter (prot of 0 compared to K). If rm one decides not to
enter, then rm 2 should enter. Firm two can observe the action of rm
1, thus it can form history-dependent strategies. The optimal strategy is
not to enter if rm 1 entered, and to enter if rm 1 did not enter the market, (not enter;enter). Thus, the decision for rm 1 is between entering
and receiving prots of M K, or not entering and receiving 0. For K
small, rm 1 will decide to enter. The unique Subgame Perfect Nash
Equilibrium in strategies is thus
(enter; (not enter,enter));
yielding the equilibrium outcome (enter;not enter).
c Frank Cowell 2006
172
(10.18)
Microeconomics
4. Clearly, there is a rst-mover advantage, since even a small xed cost leads
to the monopoly outcome and hence strictly positive prots for the rst
mover.
173
Microeconomics
Exercise 10.10 Two rms have inherited capacity from the past so that production must take place subject to the constraint
qf
q f ; f = 1; 2
p
1
q2 + q2 .
q2 .
Outline Answer
1. If p1 < p2 then, if q 1 = q 1 rm 1 could make higher prots by raising its
price. Otherwise rm 1 would be undercutting rm 2 so that rm 2 would
be forced to reduce its price or lose all its sales to rm 1. Hence we must
have p1 = p2 = p in equilibrium.
2. Consider two cases:
(a) If p > p q 1 + q 2 .then for one or both rms it must be the case that
q f < q f the price is too high to exhaust capacity. In which case
one of the rms could reduce the price slightly, capture sales from
the other rm and increase prots.
(b) If p < p q 1 + q 2 .then both rms are producing to capacity. Each
could increase prots just by raising prices to its (rationed) customers.
Therefore
p = p q1 + q2
3. If p < p
(10.19)
p and
(10.20)
q2 p
174
q2 + q2
Microeconomics
with
q1 =
q2
(10.21)
q2 + q2
(10.22)
4. Suppose
q1 >
q2 :
175
q2 + q2
(10.23)
Microeconomics
Exercise 10.11 In winter two identical ice-cream rms have to choose the capacity that they plan to use in the summer. To install capacity q costs an amount
k q where k is a positive constant. Production in the summer takes place subject
to
q f q f ; f = 1; 2
where q f is the capacity that was chosen in the previous winter. Once capacity is
installed there is zero marginal cost. The market for ice-cream is characterised
by the inverse demand function p q 1 + q 2 . There are thus two views: the
before problem when the decision on capacity has not yet been taken; the
after problem (in the summer) once capacity has been installed.
1. Let ( ) be the Cournot reaction function for either rm in the after
problem (as in Exercise 10.10). In the context of a diagram such as Figure
10.6 explain why this must lie strictly above the Cournot reaction function
for the before problem.
2. Let qC be the Cournot-equilibrium quantity for the beforeproblem. Write
down the denition of this in terms of the present model.
3. Suppose that in the summer competition between the rms takes place in
terms of prices (as in Exercise 10.10). Show that a pure-strategy Bertrand
equilibrium for the overall problem is where both rms produce qC .
Outline Answer
q2
low
hig
hc
cos
t
ost
q1
1.
2
176
1 1
q
2
(10.24)
Microeconomics
q2
afte
r
bef
ore
afte
bef
ore
q1
Figure 10.13: Reaction functions before and after capacity costs are sunk
see Exercise 10.7. So for high and low values of c we have the situation
depicted in Figure 10.12. Before installation capacity costs are proportional to the amount of capacity (marginal cost of capacity is k). But
once the capacity has been installed it represents sunk costs so, from the
rms point of view it is as though the marginal cost of production has
been cut. So the after-installation reaction functions must be as in Figure
10.13.
q2
(q2) k/
qC
(q1) k/
q1
2.
Figure 10.14: Equilibrium capacity
177
Microeconomics
q1 =
1 1
q
2
(10.25)
1 2
q
2
(10.26)
2
2
k
:
2
178
Microeconomics
Exercise 10.12 There is a cake of size 1 to be divided between Alf and Bill.
In period t = 1 Alf o ers Bill a share: Bill may accept now (in which case the
game ends), or reject. If Bill rejects then, in period t = 2 Alf again makes an
o er, which Bill can accept (game ends) or reject. If Bill rejects, the game ends
one period later with exogenously xed payo s of to Alf and 1
to Bill.
Assume that Alf and Bills payo s are linear in cake and that both persons have
the same, time-invariant discount factor < 1.
1. What is the backwards induction outcome in the two-period model?
2. How does the answer change if the time horizon increases but is nite?
3. What would happen if the horizon were innite?
Alf
[offer 1 1]
period 1
Bill
[accept]
[reject]
(1, 1 1)
Alf
period 2
[offer 1 2]
Bill
[accept]
[reject]
(2, [1 2])
(2, 2[1 ])
period 3
1. Begin by drawing the extensive form game tree for this bargaining game.
Note that payos can accrue either in period 1 (if Bill accepts immediately), in period 2 (if Bill accepts the second oer), or in period 3 (Bill
rejects both oers). Using this time frame to discount all payos back
to period 1 we nd the game tree shown in Figure 10.15. We can solve
this game using backwards induction. Assume the game has reached period 2 where Alf makes an oer of 1
2 to Bill (keeping 2 for himself).
Bill can decide whether to accept or reject the oer made by Alf.: the
c Frank Cowell 2006
179
Microeconomics
if 1
2
otherwise
[1
Since Alf wants to maximize his own payo, he would not oer more than
[1
] to Bill, leaving him (Alf) with 2 =1
+ . The other option
is to oer less today and receive tomorrow, discounted back to date 2.
But since < 1,
1
+
>
and hence Alf would oer 1
= [1
if 1
1
otherwise
[1
(keeping
2. Now consider a longer, but nite time horizon. The structure of the backwards induction solution outlined above shows that as the time horizon
increases from T = 2 bargaining rounds to T = T 0 , the oer made by Alf
reduces to
T0
1
[1
]
1 =
which is accepted immediately by Bill; Alfs share is
=1
T0
[1
].
3. Now consider an innite time horizon. The solution for the nite case
would suggest that as T ! 1, ( 1 ; 1
1 )!(1; 0). However, this reasoning is inappropriate for the innite case, since there is no last period from
which a backwards induction outcome can be obtained. Instead, we use
the crucial insight that the continuation game after each period, i.e. the
game played if Bill rejects the oer made by Alf, looks identical to the
game just played. In both games, there is a potentially innite number of
future periods. This insight enables us to nd the equilibrium outcome of
this game. Assume that the continuation game that follows if Bill rejects
has a solution with allocation ( ; 1
). Then, in the current period, Bill
will accept Alfs oer 1
if
1
[1
], as before. Thus, given
1
1
a solution ( ; 1
), Alf would oer 1
=
[1
]. But if 1
is a
1
solution to the continuation game, it has to be a solution to the current
game as well, and hence 1
. It follows that
1 =1
1
Alf will oer 1
c Frank Cowell 2006
=
[1
= 1
Microeconomics
Exercise 10.13 Take the game that begins at the node marked * in Figure
10.16.
[NOT
INVEST]
[INVEST]
[In]
2
[In]
[Out]
1
[FIGHT`]
(F ,0)
**
[Out]
1
[CONCEDE]
_
(M, )
[FIGHT`]
(J, J)
(F ,0)
[CONCEDE]
(M k, )
_
(J k, J)
>
Outline Answer
1. Consider the concept of an equilibrium here.
(a) First note that there are several Nash equilibria as we can see from the
strategic form in Table 10.9, where the rst part of the monopolists
strategy species the action after the entrant played [in], while the
second species the action after [out].
181
Microeconomics
([concede]; [concede])
([concede]; [ ght])
([ ght]; [concede])
([ ght]; [ ght])
1 (incumbent)
2 (Entrant)
[in]
[out]
J; J
M;
J; J
M;
F; 0
M;
F; 0
M;
Ei
[In]
[Out]
Ii
[FIGHT`]
(F ,0)
[CONCEDE]
(M, )
_
(J, J)
Figure 10.17: Challenge i
182
Microeconomics
which both yield the backwards induction outcome. Hence, we nd
that the threat to ght after entry is not a credible strategy. However, if there were a precommitment device, such that the threat of
ghting became credible, then it would be better for the entrant
not to enter, so the equilibrium outcome would be ([ ght]; [out])
or ([concede]; [out]), which imply Subgame-Perfect Nash equilibrium
strategies (([ ght]; [concede]); [out]) or (([ ght]; [ ght]); [out]).
2. We may now consider an extension of essentially the same model. The
incumbent has stores I1 ; I2 ; :::; IN in local markets 1; 2; :::; N . There is sequence of challenges in each market from potential entrants E1 ; E2 ; :::; EN
A typical encounter is depicted in Figure 10.17. The outcome in this market is independent of actions in markets 1; 2; :::; i 1. So the equilibrium
behaviour of Ii and Ei is determined by the situation in local market i
alone. By the result in part 1 the outcome is
([concede]; [in]):
183
Microeconomics
Exercise 10.14 In a monopolistic industry rm 1, the incumbent, is considering whether to install extra capacity in order to deter the potential entry of
rm 2. Marginal capacity installation costs, and marginal production costs (for
production in excess of capacity) are equal and constant. Excess capacity cannot
be sold. The potential entrant incurs a xed cost k in the event of entry.
1. Let qS1 be rm 1s output level at the Stackelberg solution if rm 2 enters.
Suppose qS1 6= qM , where qM is rm 1s output if its monopolistic position is
unassailable (i.e. if entry-deterrence is inevitable). Show that this implies
that market demand must be nonlinear.
2. Let q 1 be the incumbents output level for which the potential entrants best
response yields zero prots for the entrant. In the case where entry deterrence is possible but not inevitable, show that if qS1 > q 1 , then it is more
protable for rm 1 to deter entry than to accommodate the challenger.
Outline Answer
1. We begin by modelling the use of capacity as deterrence.
q2
2 ;0)
(q
q1 =
2 ;c)
(q
q1 =
C
q2 =
(q 1
;0
q1
qM,
(a) Suppose the two rms were to choose capacity z 1 and z 2 simultaneously a minor variation on the standard Cournot model. Firm 1s
problem is
1
max
= p q 1 + q 2 q 1 cz 1
(10.28)
1 1
q ;z
subject to
q1
c Frank Cowell 2006
184
z1
(10.29)
Microeconomics
with solution
q1 = z1 =
q2 ; c
(10.30)
= p q1 + q2
cz 2
(10.31)
subject to
q2
z2
(10.32)
Note that the term k in (10.31), being a xed entry cost, will not affect the rst order condition that characterises rm 2s best-response
output, given that it enters the market. So its behaviour conditional
on entry is also given by the reaction function :
q2 = z2 =
q1 ; c .
(10.33)
Taking (10.30) and (10.33) together we get the symmetric CournotNash solution (qC ; qC ) see point qC .in Figure 10.18.
q2
q2 =
(q 1
;0
q1
185
q2 ; 0 :
(10.34)
Microeconomics
q2
q1
z_
_
z
q1
186
Microeconomics
q 1 2 [z; z]. Firm 2 will make a loss for any capacity choice by rm
1 such that q 1 < z z. Here rm 1 may either (a) be assured of
deterring rm 2s entry and and choose monopoly output or (b)
choose capacity z so as to deter entry or (c) accommodate entry
as above
q2
S
2()
z_
q1
qM_
q1
_
z
q 1 = qM =
(10.35)
q1 =
1 1
q
2
(10.36)
187
Microeconomics
188
Microeconomics
Exercise 10.15 Two rms in a duopolistic industry have constant and equal
marginal costs c and face market demand schedule given by p = k q where
k > c and q is total output..
1. What would be the solution to the Bertrand price setting game?
2. Compute the joint-prot maximising solution for this industry.
3. Consider an innitely repeated game based on the Bertrand stage game
when both rms have the discount factor < 1. What trigger strategy,
based on punishment levels p = c; will generate the outcome in part 2?
For what values of do these trigger strategies constitute a subgame-perfect
Nash equilibrium?
Outline Answer
1. Suppose rm 2 sets a price p2 > c. Firm 1 then has three options: It can
set a price p1 >p2 , it can match the price of rm 2, p1 = p2 , or it can
undercut, since there exists an > 0 such that p1 = p2
> c. The prots
for rm 1 in the three cases are:
8
if p1 > p2
< 0
2
1
k
p
2
=
if p1 = p2
p
c 2
: 2
2
p
c k p
if p1 = p2
For su ciently small prots in the last case exceed those in the other
two, and hence rm 1 will choose to undercut rm two by a small and
capture the whole market. The rms will choose to share the market if
they are playing a one-shot simultaneous move game, where they will set
p1 = p2 = c
q] q
cq
The FOC is
k
2q
c=0
c
2
k+c
2
1
[k
4
189
c]
Microeconomics
" < pM
rm 1:
rm 2:
2
pM
pM
3
pM
p
4
c
c
5
c
c
:::t
If " is small then for that one period rm 2 would get the whole market so 2 = M . Thereafter 2 = 0. If the rm had cooperated it would
have got 2 = 12 M . The present discounted value of the net gain from
defecting is
1
2
if and only if
M
1
2
1
2
1.
190
+ ::: =
1
2
1 2
1
Microeconomics
Exercise 10.16 Consider a market with a very large number of consumers in
which a rm faces a xed cost of entry F . In period 0, N rms enter and in
period 1 each rm chooses the quality of its product to be High, which costs
c > 0, or Low, which costs 0. Consumers choose which rms to buy from,
choosing randomly if they are indi erent. Only after purchasing the commodity
can consumers observe the quality. In subsequent time periods the stage game
just described is repeated indenitely. The market demand function is given by
8
< '(p) if quality is believed to be High
q=
:
0
otherwise
where ' ( ) is a strictly decreasing function and p is the price of the commodity.
The discount rate is zero.
1. Specify a trigger strategy for consumers which induces rms always to
choose High quality. Hence determine the subgame-perfect equilibrium.
What price will be charged in equilibrium?
2. What is the equilibrium number of rms, and each rms output level in
a long-run equilibrium with free entry and exit?
3. What would happen if F = 0?
Outline Answer
1. For a given price p prots for i are given by
#
"
1
1
+
+ :::
= qi [p c]
1 + r [1 + r]2
qi [p c]
F
(10.38)
r
if it produces High quality for ever and
qi p
F
1+r
if it produces low quality in one period and then never sells any product
thereafter. The trigger strategy is to stay with the rm unless it is observed
to have changed its quality to Low, in which case the rm will never again
have customers. This punishment ensures SPNE (Note the zero demand
for Low quality.) To ensure that this strategy is incentive-compatible,
and thus consistent with SPNE, we need
"
#
1
1
qi p
qi [p c] 1 +
+
+ :::
1 + r [1 + r]2
=
1+r
qi [p
r
c]
(10.39)
[1 + r] c
(10.40)
Hence
p
191
Microeconomics
c]
(10.41)
(10.42)
p c
rF
(10.43)
1 rF
Np c
(10.44)
3. Without entry cost, but with demand elastic, q(p) is determined, but qi
and N are indeterminate.
192
Microeconomics
Exercise 10.17 In a duopoly both rms have constant marginal cost. It is
common knowledge that this is 1 for rm 1 and that for rm 2 it is either 43
or 1 14 . It is common knowledge that rm 1 believes that rm 2 is low cost with
probability 21 . The inverse demand function is
2
where q is total output. The rms choose output simultaneously. What is the
equilibrium in pure strategies?
Outline Answer
Let marginal cost be denoted by c. Firm 1s and rm 2s prots are given
by, respectively:
1
:= 2 q 1 q 2 q 1 C1 q 1
(10.45)
2
q1
:= 2
q2 q2
cq 2
C2
(10.46)
2q 2
c=0
q1 ; c = 1
1 1
q
2
1
c
2
(10.47)
(compare the answer for Exercise 10.7). The two cases (low-cost and high-cost)
for rm 2 are therefore
qL2
2
qH
5
8
3
8
1 1
q
2
1 1
q
2
(10.48)
(10.49)
q1
qL2 q 1
2
q1 +
C1
q1
1 2
q
2 L
1
2
1 2 1
q q
2 H
q1
2
qH
q1
C1
C1
q1
q1
2
Under the Cournot assumption rm 1 takes qL2 and qH
as given. So the FOC
for rm 1 is
1 2 1 2
2 2q 1
q
q
1=0
2 L 2 H
which implies
1 1 2
2
q + qH
2 4 L
as the best response of rm 1 to rm 2.
Substituting from (10.48) and (10.49) into (10.50) we have
q1 =
q1 =
c Frank Cowell 2006
1
2
1 5
4 8
1 1 3
q +
2
8
193
1 1
q
2
(10.50)
(10.51)
Microeconomics
which simplies to
q1
=
=
1 1
1
2 4
1 1 1
+ q
4 4
q1
q1
qL2
2
qH
1
3
5
8
3
8
194
1
29
=
6
48
1
17
=
6
48
(10.52)
(10.53)
Chapter 11
Information
Exercise 11.1 A rm sells a single good to a group of customers. Each customer either buys zero or exactly one unit of the good; the good cannot be divided
or resold. However, it can be delivered as either a high-quality or a low-quality
good. The quality is characterised by a non-negative number q; the cost of producing one unit of good at quality q is C(q) where C is an increasing and strictly
convex function. The taste of customer h is h the marginal willingness to
pay for quality. Utility for h is
U h (q; x) =
q+x
;
a
with
>
(11.1)
Microeconomics
a
b
quality
2 = F2 C(q)
inc
pro reas
fit ing
1 = F1 C(q)
0 = F0 C(q)
quality
196
Microeconomics
F
aq
F*a
bq
F*b
q
q*b
q*a
quality
(b) Given that each persons type can be observed the rm can tailor
the fee schedule exactly to personal characteristics, charging F a to
an a-type and F b to an b-type The rms prots from each of the two
groups of consumers are
Fa
Fb
C (q a )
C qb
(11.2)
(11.3)
Fa + y
or, equivalently
a a
Fa
0;
(11.4)
it likewise chooses q and F to maximise (11.3) subject to the btypes participation constraint
b b
Fb
0:
(11.5)
The full information solution is found at the tangency of an isoprot curve with a reservation indierence for each of the two types,
as shown in gure 11.3 Clearly, at the optimum (q a ; F a ) and
q b ; F b , each of the participation constraints (11.4) and (11.5) is
binding and each person just gets his reservation utility y.
3. Now it is no longer possible to condition the fee schedule directly on a
persons type.
c Frank Cowell 2006
197
Microeconomics
aq
pre
fer
en
ce
F*a
bq
F*b
q
q*b
q*a
quality
Fb
b a
Fa
(11.7)
C (q a )] + [1
] Fb
C qb
(11.8)
Fa
a b
Fb
b b
Fb
(11.9)
198
Microeconomics
since it would then be possible for the rm to increase both F a
and F b and increase prots. Hence (11.5) must be binding.
Given that F b > 0 at the optimum (11.5) then implies that
q b > 0: However (11.1). (11.9) and q b > 0 imply
a a
Fa
a b
Fb >
b b
Fb = 0
(11.10)
Fa > 0
(11.11)
= qa
aq
pre
fer
en
ce
Fa
bq
Fb
q
qb
q*a
quality
C (q a )]
+ [1
+
+
199
] F b C qb
q
Fb
a a
a b
q
Fa
q + Fb
b b
(11.13)
Microeconomics
where and are the Lagrange multipliers for the constraints (11.5,
11.6) respectively. The rst-order conditions are
[1
] Cq
Cq (q a ) +
q + b
1
=
=
=
=
and
0
0
0
0
(11.14)
(11.15)
(11.16)
(11.17)
= 1. Using these
(11.18)
<
(11.19)
200
Microeconomics
Exercise 11.2 An employees type can take
The benet of the employees services to his
amount of education that the employee has
years of education for an employee of type
C (z; ) = ze
C (z; )
where y is the payment received from his employer. The risk-neutral employer
designs contracts contingent on the observed gross benet, to maximise his expected prots.
1. If the employer knows the employees type, what contracts will be o ered?
If he does not know the employees type, which type will self-select the
wrong contract?
2. Show how to determine the second-best contracts. Which constraints bind?
How will the solution to the second-best problem compare with that in part
1?
Outline Answer
This is a problem of hidden information: The type of the employee is
exogenously given, but private information. The problem for the employer is to
design a contract that leads the employee to reveal his true type.
The employer is interested in truthful revelation since it is less costly for employees of type 2 to attain a given level of education. Hence, the employer would
have to reward 2 types by less to get the same level of education. However,
type 2 would like to pretend to be of type 1 to receive the higher payment.
The reservation utility of the employee corresponds to the case where the
employee receives 0 years of education, for which he receives 0 from the employer:
=
1:
ze
For further reference, we can deduce the shape of the indierence curves for a
given type. The rst and second derivatives, respectively, are:
dy
dz
d2 y
dz 2
= ey
= ey
>0
dy
= e2[y
dz
(11.20)
i]
>0
See Figure 11.6 for an illustration of the reservation indierence curves for the
two types, which go through the origin. The shaded areas are the acceptance
sets for the two types of individuals. Note that as dy
dz is independent of z, the
indierence curves for a given type must be horizontally parallel in (z; y) space.
Also note that the single crossing property is satised.
c Frank Cowell 2006
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Microeconomics
_1
_2
y2*
y1*
z1*
z2*
1. If the employer knows the employees type, then, as before, the employer
can implement full-information contracts, maximising the return from
each type separately. Let be the type. Then the problem of the employer
is to
max := z y
z;y
ze
(11.21)
=
=
e
1+ e
=0
(11.22)
(11.23)
=0
ze
(11.24)
= e
c Frank Cowell 2006
202
e
1>0
Microeconomics
Thus the employer oers two dierent contracts to the two types, where
the level of education is zi = e i 1, and the compensation is yi = i .
Since the slope of the indierence curve in Figure 11.6 was given by
equation 11.20, we see that the contracts are located where the slope of
the reservation indierence curves are equal to 1.
2. Now assume that the employer cannot observe the type of the employee.
(a) Given the contracts found in part 1 an employee of type 2 will selfselect the wrong contract. To see this, compare the utility of type 2
when choosing the type-2 contract
2
[e
1] e
[e
1] e
y1
z1 e
(11.25)
y2
z2 e
y1
z1 e
(11.26)
[z1
y1 ] + [1
] [z2
y2 ]
[z1 y1 ] + [1
] [z2
+ [1 e y1 z1 e 1 ]
+ [e y1 e y2 + z1 e
203
y2 ]
2
z2 e
Microeconomics
where and are the Lagrange multipliers associated with the constraints (11.25) and (11.26), respectively. Maximising this yields the
FOCs
@L
=
e 1+ e 2 =0
(11.27)
@z1
@L
(11.28)
=
+[
] e y1 = 0
@y1
@L
(11.29)
= [1
]
e 2 =0
@z2
@L
(11.30)
=
[1
] + e y2 = 0
@y2
As
0 by Kuhn-Tucker conditions, and
> 0, equation 11.27
implies that > 0. Hence, constraint (11.25) will bind. Considering equation 11.29, we see similarly that > 0, so that constraint
(11.26) will bind. Since both constraints will bind, and the rst order
conditions are satised, we have a system with six equations and six
variables. Call the solutions to this system (^
z1 ; y^1 ) and (^
z2 ; y^2 ).
(d) Since the incentive-compatibility constraint (11.26) is binding, these
two contracts will lie on the same type 2 indierence curve. But the
type-1 incentive compatibility constraint is slack, so type 1 strictly
prefers (^
z1 ; y^1 ) to (^
z2 ; y^2 ). Given the Single Crossing Property and
the fact that the type 2 indierence curves are atter that of type
1, we must have z^1 < z^2 and y^1 < y^2 . Consider equations 11.29
and 11.30. We nd that y^2 = 2 , the no distortion at the top
result. Clearly, the marginal rate of substitution for type 2 at this
point is
e 2 =e y2 = 1;
which is the same as the slope of the isoprot contour. Now compare
the second-best contracts with the full-information solution. Type 2
was on his reservation indierence curve 2 under the full-information
contract. But under the second-best, the participation constraint for
type 2 is slack, and hence he is now on an indierence curve I2 above
2 . But since
y^2 = y2 = 2 ;
this must mean that z^2 < z2 .
(e) Finally, how far has the solution moved from 2 ? There are two
possibilities: The new (^
z1 ; y^1 ) could be below and to the left of the
full-information (z1 ; y1 ), or above and to the right. We will show
that z^1 < z1 and y^1 < y1 (recall that (11.25) is still binding, so the
new solution will be on the reservation indierence curve for type 1).
The slope of the indierence curve 1 at (^
z1 ; y^1 ) is
e 1
:
e y^1
From equations (11.27) and (11.28) we have
e
e
c Frank Cowell 2006
y^1
1
204
=
=
+ e
+ e
y^1
2
Microeconomics
hence the slope of the indierence curve is
+ e
+ e
y^1
<1
(11.31)
This follows because y^1 < y^2 = 2 which implies e 2 < e y^1 . We
found that the slope of the type 1 indierence curve at (z1 ; y1 ) was 1,
so condition (11.31) implies that z^1 < z1 and y^1 < y1 . See gure 11.7.
_1
y
_2
^y
2
^y
1
0
z
^z
2
^z
1
205
Microeconomics
_b
y
_a
y*a = 1
slope = 1
slope = 1
y*b =
x
x*a = 2
x*b =
1. Full-information.
(a) The principal knows the type and so maximises x
p
where
=0
c Frank Cowell 2006
206
y subject to
Microeconomics
for each individual type. We know that the participation constraint
binds and that there is no distortion. So
=
(11.32)
(11.33)
y =
Using the fact that
get
(11.34)
x =
(11.35)
as
b
a
1
2
b 2
1
2
1
2
> 0:
y a ] + [1
207
] xb
yb
Microeconomics
xb
(11.36)
xa
ya
L xa ; y a ; xb ; y b ; ;
:=
xb
yb
(11.37)
[xha y a ] + [1i
] xb
p
b
+
y b xb
hp
p
a
+
y a xa
yb +
9
yb >
>
=
xb
>
>
;
(11.38)
where and are the Lagrange multipliers for the constraints (11.36)
and (11.37) respectively.
(c) Let the solution values for maximising (11.38) be denoted x
^a , y^a , x
^b ,
b
y^ . Dierentiating (11.38) the FOC are:
[1
+ p a
2 y^
0;
(11.39)
p
2 y^b
0;
(11.40)
0;
(11.41)
0:
(11.42)
]+ p
2 y^b
1
=
=
+ p a
2 y
b
[1
which implies
y^ =
c Frank Cowell 2006
208
]+ p
2 y^b
y^a =
1
[
4
b
2 [1
p
2 y^b
a 2
Microeconomics
And so, using the participation constraint (11.32) we have
p
b
x
^b =
y^b
b
2 [1
a 2
b
b
x
^b :
_b
y
_a
^ya
^yb
0
x
^xa
^xb
< x
< x
= y
< y
a
b
a
b
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Microeconomics
Exercise 11.4 The analysis of insurance in the text (section 11.2.6) was based
on the assumption that the insurance market is competitive. Show how the
principles established in section 11.2.4 for a monopolist can be applied to the
insurance market:
1. In the case where full information about individualsrisk types is available.
2. Where individuals risk types are unknown to the monopolist.
Outline Answer
1. See Figure 11.10
xBLUE
s,
pr
of
its
profit
ya
yL
xRED
ya
(a) The endowment point for both types of individual is at (y; y L).
Given that the probability of an accident for high-risk type a is a
an insurance rm would break even if it sold insurance against the
loss L for a premium a where
a
L:
(11.43)
Dene
y a := y
a
L=
(11.44)
The line with slope 1 a passing through the endowment point and
the point (y a ; y a ) is an isoprot contour for the rm when dealing
with the high-risk types. Prots must increase to the South-West
(consider the impact on prots if the rm were able to charge a higher
premium , all other things being equal).
c Frank Cowell 2006
210
Microeconomics
(b) For the low-risk types the isoprot contours are a family of lines with
b
slope 1 b .
(c) Clearly the reservation indierence curve for each type of person is
given as the contour passing through the endowment point. It has
h
slope 1 h ; h = a; b where it intersects the 45 line see Figure
11.11.
xBLUE
_ _
(yb, yb)
_ _
(ya, ya)
(y, y L)
xRED
(d) So the full-information outcome is where the high-risk types are located at (y a ; y a ) and the low-risk types at y b ; y b : the monopoly
insurance rm rationally oers better insurance terms to the lowrisk.
2. Take the case where the individuals risk type is unknown to the insurer.
(a) Given that there is imperfect information it is clear that a high-risk
type would like to masquerade as a low-risk type and so take advantage of the more favourable terms. In Figure 11.12 see the a-type inyb ; yb .
dierence
curve
passing
through
the
point
The monopolist must take account of this possibility in setting up
the second-best optimisation problem.
(b) The solution to this problem will be of the following form: restrict the
low-risk b-types in the amount of insurance that they can purchase so
that they choose the prospect P~ which lies on the b-type reservation
indierence curve in Figure 11.12; oer full insurance at point (~
y a ; y~a )
c Frank Cowell 2006
211
Microeconomics
xBLUE
_ _
(yb, yb)
~ a ~a
(y , y )
(y, y L)
xRED
only the a-types will wish to take up this oer. The formal analysis
closely follows that of section 11.2.4.
212
Microeconomics
Exercise 11.5 Good second-hand cars are worth a1 to the buyer and a0 to
the seller where a1 > a0 . Bad cars are worth b1 to the buyer and b0 to the
seller where b1 > b0 . It is common knowledge that the proportion of bad cars is
. There is a xed stock of cars and e ectively an innite number of potential
buyers
1. If there were perfect information about quality, why would cars be traded
in equilibrium? What would be pa and pb , the equilibrium prices of good
cars and of bad cars respectively?
2. If neither buyers nor sellers have any information about the quality of an
individual car what is p, the equilibrium price of cars?
3. If the seller is perfectly informed about quality and the buyer is uninformed
show that good cars are only sold in the market if the equilibrium price is
above a0 .
4. Show that in the asymmetric-information situation in part 3 there are only
two possible equilibria
The case where pb <
The case where p
a
b
0 : equilibrium price is p .
a
0 : equilibrium price is p.
Outline Answer.
1. If there is perfect information about quality then:
(a) Cars of whatever quality will always be traded if the value of the
buyer is greater than that to the seller, as in the question.
(b) Equilibrium prices are
pa
pb
a
1
b
1
=
=
2. Given that neither party can verify the quality of a car ex ante, but both
know that the probability of a bad car is :
(a) The expected value of a car to the buyer is
[1
a
1
b
1
(11.45)
a
0
b
0
(11.46)
(b) Given that (11.45) is greater than (11.46) the equilibrium price is
p = [1
a
1
b
1
(11.47)
3. Sellers will only be willing to supply good cars to the market if the price
is at least as great as their private valuation a0 .
c Frank Cowell 2006
213
Microeconomics
214
a
1
b
1
a
0:
(11.48)
Microeconomics
Exercise 11.6 In an economy there are two types of worker: type-a workers
have productivity 2 and type-b workers have productivity 1. Workers productivities are unobservable by rms but workers can spend their own resources to
acquire educational certicates in order to signal their productivity. It is common knowledge that the cost of acquiring an education level z equals z for type-b
workers and 21 z for type-a workers.
1. Find the least-cost separating equilibrium.
2. Suppose the proportion of type-b workers is . For what values of
the no-signalling outcome dominate any separating equilibrium?
3. Suppose
will
Outline Answer
1. There is some z such that rms believe a worker to be of type a if z z
and type b otherwise. Beliefs are self-conrming if type-a workers choose
z = z and type-b workers choose z = 0. This is satised if
1
z
2
1
1
in other words
1
2:
]=2
>1
1
2
< 12 .
z=1
3
4
3
4
> 1
<
215
3
4
Microeconomics
3
4
1
z
2
z
216
> 1
<
1
2
1
2
Microeconomics
Exercise 11.7 A workers productivity is given by an ability parameter >
0. Firms pay workers on the basis of how much education, z, they have: the
wage o ered to a person with education z is w (z) and the cost to the worker of
acquiring an amount of education z is ze .
1. Find the rst-order condition for a type person and show that it must
satisfy
dw (z )
(11.49)
= log
dz
2. If people come to the labour market having the productivity that the employers expect on the basis of their education show that the optimal wage
schedule must satisfy
w (z) = log (z + k)
(11.50)
where k is a constant.
3. Compare incomes net of educational cost with incomes that would prevail
if it were possible to observe directly.
Outline Answer
1. Individual income, net of educational costs is
w (z)
ze
=0
dw (z)
dz
= w (z)
(11.51)
dw (z)
=1
dz
(11.52)
(11.53)
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Microeconomics
y1 ] + [1
][
y2 ]
(11.54)
subject to
u (y1 ; z) + [1
] u (y2 ; z)
(11.55)
y1 ] + [1
][
y2 ]
(11.56)
subject to
u (y1 ; z) + [1
] u (y2 ; z)
(11.57)
in the low-eort case, where (11.55) and (11.57) are the participation
constraints that will be binding at the optimum.
(b) Since the owner can observe the managers action, and since the
manager is risk-averse, the owner will set y1 = y2 = y in the solution
to (11.54, 11.55) and we can solve for y simply by setting
u (y; z) = 0
which implies
y 1=2
z=0
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Microeconomics
(c) Using the numerical values given in the question, we obtain
y
y
=
=
4
1
2. From part 1 the optimal payments in the case of high and low eort yield
expected prots to the owner of
= 8:5
= 4:5
Thus, the owner would indeed like to induce the manager to take action
z. By construction, the manager is indierent between taking z or z, since
he receives his reservation utility in either case.
3. However, if the manager could convince the owner that he was using z,
and get the owner to pay him y, while in fact only using z, his payo
would be
u(y; z) = y 1=2 z = 1 > 0
and hence the incentive-compatibility constraint would be violated. Thus,
we now consider the second-best contract, where the owner cannot observe
the action of the manager, but can induce him to take the right eort
level.
(a) Under the second-best contract, the owner has the choice of inducing
the manager to choose either high or low eort levels. Since there
is no incentive compatibility problem with the low eort level, the
full-information solution continues to hold. The interesting case is
inducing the manager to take the high eort level with a second-best
contract.
(b) Under the second-best contract, the participation constraint continues to hold. In addition, however, we have an incentive compatibility
constraint that guarantees that the manager would choose z over z,
given the contract. Thus, the owner has to solve the problem
max
y1 ;y2
y1 ] + [1
][
y2 ]
y12 + [1
which becomes
] y22
3y12 + y22
(11.58)
y12 + [1
which becomes
] y22
y12 + [1
y12
y22
219
] y22
z
(11.59)
Microeconomics
i
h 1
8 + y12
y22
1
1
1 21
1
+
y
y 2 = 0 if y2 > 0
4
2 2
2 2
h 1
i
1
@L
= 3y12 + y22 8 = 0
@
h 1
i
1
@L
=
y12 y22 2
@
From (11.60) and (11.61) we have
[6 + 2 ] y1
2[
] y2
1
2
1
2
(11.61)
(11.62)
(11.63)
(11.64)
(11.65)
We need to determine whether the constraints will be binding. Consider = 0. By equations (11.64) and (11.65), this implies that
1
2
and hence that y1 = y2 . But this would violates the incentivecompatibility constraint, as before. Thus,
> 0, and, by (11.62)
the incentive-compatibility constraint (11.59) must bind. But equation (11.65) implies that
> , and hence (11.58) must bind as
well. We can now solve for y1 and y2 using the participation and
incentive-compatibility constraints, and obtain that
y1
1
2
= y2
1
2
25
4
1
y2 =
4
It can be shown that the expected prots associated with this contract are higher than those under a rst best contract with low eort
level, but lower than those under rst best contract with high eort
level.
y1
4. We observe that y1 > y > y2 . The manager receives more than under
rst best in the good outcome, but less in the bad outcome. While it was
rational for the owner to bear all the risk under rst best, given that he
was risk-neutral while the manager was risk-averse, under the second-best
contract the risk is shared between the owner and manager. This induces
the manager to take the action which yields a higher probability of a good
outcome.
220
Microeconomics
Exercise 11.9 The manager of a rm can exert an e ort level z = 34 or z = 1
and gross prots are either 1 = 3z 2 or 2 = 3z. The outcome 1 occurs with
probability = 23 if action z is taken, and with probability = 13 otherwise. The
managers utility function is u(y; z) = log y z, and his reservation utility is
= 0. The risk neutral owner designs contracts which specify a payment yi to
the manager, contingent on obtaining gross prots i .
1. Solve for the full-information contracts. Which action does the owner wish
the manager to take?
2. Solve for the second-best contracts. What is the agency cost of the asymmetric information?
3. In part 1, the managers action can be observed. Are the full-information
contracts equivalent to contracts which specify payments contingent on effort?
Outline Answer
1. The structure of the problem is identical to that of Exercise 11.8 so we
may follow the same logic.
(a) Since the owner can observe the managers action, and since the
manager is risk-averse, the owner will set y1 = y2 = y in the solution
to the counterpart to (11.54, 11.55) and we can solve for y by setting
u (y; z) = 0:
In the present case, this implies
log y
z=0
z=0
Substituting in the specic values given in the questions, we immediately obtain that the full-information contract puts
y = e4=3
(11.66)
y = e:
(11.67)
and
(b) To ascertain which action the owner would like the manager to take,
compare expected prots under the two actions:
=
and
=
c Frank Cowell 2006
2
3
1
3
221
1
3
2
3
e4=3
(11.68)
e :
(11.69)
Microeconomics
Clearly
h
i
1
4=3
[ 1
]
e
e
2
3
which is positive. Hence, the owner would like the manager to take
z.
=
2. To solve for the second-best contract, we again use the structure developed
in the Exercise 11.8.
(a) The goal is to nd a contract that induces the manager to take the
high eort level. From the Exercise 11.8, we know that both the
participation and incentive-compatibility constraints will be binding.
Hence, denoting v(y) = log(y), we have the participation constraint:
log (y1 ) + [1
] log (y2 )
z=0
(11.70)
] log (y2 )
z=
log (y1 ) + [1
] log (y2 ) z
(11.71)
log (y2 ) =
(11.72)
(11.73)
] log (y2 )
z=0
y2 = e 3
(11.74)
y1 = e 3
[
(11.75)
y1 ] + [1
] [ 2 y2 )]
i
h
i
5
2
1
3z 2 e 3 +
3z e 3
3
3
1
2h
> 0
c Frank Cowell 2006
y] + [1
{z
][
222
y]
}
y1 ] + [1
{z
][
[under second-best]
y2 ]
}
Microeconomics
which becomes
[y1
y] + [1
] [y2
y]
i 1h 2
4
e3 +
e3
3
i 2 5
4
1 2
e3 = e3 + e3
3
3
e3
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Microeconomics
x2
1
>
>
>
2 x2
>z
x1 > 0
2 > 0:
y :=
2 x2
4. Plot the graph of the banks expected prots against y. Show that the bank
will set y = y if 1 y > 2 x2 and y = x2 otherwise.
5. Suppose there are N such rms and that the bank has a xed amount M
available to fund credit to the rms where
z < M < Nz
Show that if 1 y >
tioning otherwise.
2 x2
Outline Answer.
1. The expected payo to the rm if project i is selected is given by
i
[xi
y]
(11.76)
2. If there were perfect information then the bank can observe which project
is carried out and whether or not it succeeds. Only project 1 (with the
higher probability of success) will be funded and carried out and the bank
will require a repayment y = x1 . The rm is eectively forced on to its
reservation indierence curve so that no rm gets less in the absence of
credit than with credit; there is no credit rationing.
c Frank Cowell 2006
224
Microeconomics
(y)
y
x2
3. The rm will choose the project that gives the greatest prots so that,
given z, project 1 is chosen if and only if:
1
[x1
y]
y :=
[x2
y]
y where
2 x2
2
if y
if y < y
y
x2
see Figure 11.13. There are clearly two local maxima for
bank would set y = y if
1 y > 2 x2
and the
(11.77)
and set y = x2 if
1
<
2 x2 :
(11.78)
225
Microeconomics
Take the case (11.77). From (11.76) the rms expected payo from
the loan is
y] > 0:
1 [x1
All rms would wish to apply for the loan, so that the total demand
is N z. However, the amount available is M so that there is credit
rationing.
226
Microeconomics
Exercise 11.11 The tax authority employs an inspector to audit tax returns.
The dollar amount of tax evasion revealed by the audit is x 2 fx1 ; x2 g. It
depends on the inspectors e ort level z and the random complexity of the tax
return. The probability that x = xi conditional on e ort z is i (z) > 0 i = 1; 2.
The tax authority o ers the inspector a wage rate wi = w(x), contingent on
the result achieved and obtains the benet B (x w). The inspectors utility
function is
U (w; z) = u(w) v(z)
and his reservation level of utility is . Assume
B 0 ( ) > 0; B 00 ( )
0; u0 ( ) > 0; u00 ( )
0; v 0 ( ) > 0; v 00 ( )
0:
2
X
i (z)B(xi
wi )
i=1
i (z)u(wi )
v(z)
B 0 (xi wi )
>0
u0 (wi )
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Microeconomics
Authority
x2
w2
x2- w2
45o
Inspector
x1
w1
( + v(z))
wi = constant > 0
which implies
w(xi ) = xi
This is a franchise contract where the inspector keeps the result xi but
pays a xed amount k for the privilege independent of the results. The
participation constraint implies
X
k(z) =
v(z)
i (z)xi
Thus
X
c Frank Cowell 2006
i (z)B(xi
wi )
= B(k(z))
= B(k(z))
228
i (z)
Microeconomics
x1- w1
Authority
x2
x2- w2
w2
45o
Inspector
x1
w1
As B 0 ( ) > 0 the tax authority seeks to induce an eort level which maximises k. This implies that it chooses z to maximise
X
v(z)
i (z)xi
i
so
i (z)xi
v 0 (z) = 0
00
(z)xi
v(zL )
u(wL )
v(zH )
229
There is no moral
Microeconomics
230
Chapter 12
Design
Exercise 12.1 In a two-good exchange economy there are two persons a and b
with utility functions, respectively:
h
i
a
a
1 e x1 + xa2
b b
x1
+ xb2
where xhi is the amount of good i consumed by person h, and h > 0 is a taste
parameter for person h (h = a; b), where b < a . Person b owns the entire
stock of good 1, R1 ; a and b each own half of the stock of good 2, R2 .
1. Assuming that both persons act as price-takers:
(a) Find the o er curve for person a.
(b) Describe the competitive equilibrium allocation. What would have
happened if b > a ?
2. Now suppose that person b can act as a simple monopolist in the supply of
good 1 while person a continues to act as a price-taker. Show that b will
set a price strictly greater than b ; comment on the outcome in terms of
e ciency.
3. Now suppose that person b can set a fee (xed charge) for the right to
purchase good 1 as well as setting the unit price of good 1. For any given
price of good 1 what is the maximum fee that person b can set so that a is
still willing to trade? Find bs optimal fee and price of good 1; comment
on the outcome in terms of e ciency.
Outline Answer
1. Given the utility function
a
xa
1
xa1 + xa2 =
231
+ xa2
(12.1)
1
R2
2
(12.2)
Microeconomics
xa1 ( ) = log
(12.3)
Using (12.3) we nd
xa2 ( ) =
1
R2
2
log
(12.4)
(a) Person as oer curve is given by the locus of (xa1 ( ); xa2 ( )), using
(12.3) and (12.4).
(b) Given the utility function
b b
x1
+ xb2
(12.5)
x1 a
x1a
log
x2a
1
R2
2
a
b
x1a =
1
R2
2
log
x1b
= R1
x2b
log
1
R2 +
2
b
b
log
a
where * denotes CE values. Obviously we require b
for this
b
a
solution; if it had been the case that
>
no trade would have
taken place.
2. Person b now assumes that he can announce the price and that a will
continue to act as a price-taker. His goal is therefore to maximise (12.5)
under this regime and therefore to choose so as to maximise
( ) :=
[R1
xa1 ( )] + R2
xa2 ( )
(12.6)
R1
1
+ R2 + log
2
log
1
R1 + R2 +
2
232
(12.7)
log
we have
a
1+
(12.8)
Microeconomics
Given that b < a it is clear that (12.8) is strictly positive at = b
and will become negative for su ciently large: so the value of which
maximises ( ) must be strictly greater than b . Given that MRSa21 =
and MRSb21 = b this implies that the monopoly solution is Paretoine cient, as we would expect.
3. Notice that inserting the xed charge F in (12.2) leaves as demand for
good 1 unaltered (12.3), but that as demand for good 2 changes from
(12.4) to
a
1
log
F
(12.9)
xa2 ( ; F ) = R2
2
Person a is just willing to trade if the attainable utility with trade equals
the attainable utility without trade. This requires
a
xa
1
+ xa2 =
1
R2
2
(12.10)
(12.11)
log
xa1 ( )] + R2
[R1
xa2 ( ; F ( ))
(12.12)
[R1
log (
1
)] + R2 +
2
log ( )
(12.13)
(12.14)
233
Microeconomics
Exercise 12.2 Consider a collective choice problem where the set of options is
given by the interval
:= ; . Three agents, Alf, Bill and Charlie are to
select a particular 2 . They all have single-peaked preferences over
and
h
is the element of
at which agent h has peak preference, h = a; b; c. The
mechanism designer does not know the preferences of the agents and sets out
to design a direct revelation mechanism. Show that the following mechanism is
manipulable:
The designer chooses
<
<
preference
Alf
Charlie
Bill
12:00
11:00
10:00
13:00
> max
n
o
and max a ; b ; c
o
a b c
; ;
then choosing a
; b;
n
<
would be strictly preferred by all agents by switching from 0 to you
are movingnin the direction
of each persons peak. A similar argument follows
o
for 0 < min a ; b ; c
Now let utility functions v a ; v b ; v c be such that a < b < c < 0 and
0
v
> v c ( a ). Clearly 0 is not e cient because it does not lie between the
min and the max of the peaks. So if agents truthfully reveal their preferences
the outcome is a . However, by misrepresenting preferences and announcing v~c
c
234
Microeconomics
c
235
Microeconomics
0 00 000
Exercise 12.3 Two voters are to select one element from
; ;
: Each
voter has a strict preference over the alternatives. Show that the following rule
is manipulable: if 0 is e cient, then it is selected; if 0 is not e cient, but 00
is, then 00 is selected; if neither 0 nor 00 is e cient, then 000 is selected.
Outline Answer
1. One approach to solving the problem is by dening the voting rule extensively. This gives Table 12.1.
voter 2
voter 1
0 00 000
0 000 00
00 0 000
00 000 0
000 0 00
000 00 0
0 00 000
0 000 00
00 0 000
00
00
00
00 000 0
00
00
00
00
000 0 00
00
000
000
000 00 0
00
00
000
000
(b)
(c)
236
Microeconomics
00 0 000
237
Microeconomics
Exercise 12.4 Two rms are considering whether to undertake a joint project.
It is common knowledge that the value of the project to rm 1 must be either
200 or 700 and that the value to rm 2 must be either 400 or 700. However,
information about the precise value is private to the rm. The rms would like
to undertake the project if the sum of their values exceeds the cost of the project
which is known to be 1000. The rms use the pivotal mechanism.
1. Find the amount each rm will have to pay as a function of its announcement.
2. Show that the mechanism cannot be manipulated.
3. Check that there will always be enough money if they decide to undertake
the project.
Outline Answer
1. The project will be undertaken if (v1 ; v2 ) = (700; 400) or (700; 700). Consider the outcome in each case.
(a) Case (200; 700). It is clear that rm 1 is pivotal in this case In fact
rm 2s valuation is greater than the amount necessary on average
to undertake the project even though the project is not undertaken.
Under the pivotal mechanism case rm 1 pays
X
vj [n 1] c = 700 500 = 200:
j6=i
(b) Case (700; 400). Firm 1 is also pivotal here. In fact rm 2s valuation
is lower than the cost of the project on average, even though the
project is undertaken. In this case, rm 1 pays
X
nc
vj = 1000 400 = 600:
j6=i
(c) Other cases. Firm 1 pays the average cost. Firm 2 is never pivotal.
(d) So the payments in the various cases are as in Table 12.2
Firm 1
v1 = 200
v1 = 700
Firm 2
v2 = 400
v2 = 700
(0; 0)
(200; 0)
(600; 500) (500; 500)
238
Microeconomics
v^1 = 200
v^1 = 700
v^1 = 200
v^1 = 700
239
Microeconomics
' (p)
( ).
' (p)] [N
1]
d' (p)
+ ' (p) = 0
dp
(12.15)
N
N
(12.16)
1
N
(12.17)
5. Use the result that the expected value of the kth smallest member of a
sample of size N drawn from a rectangular distribution on [0; 1] is
k
N +1
(12.18)
to show that the expected price received by the seller in the special case
= 0, = 1 is
N 1
:
p (N ) =
N +1
6. Use this to nd the optimal bid function and the expected price received by
the seller for a rectangular distribution with support [ ; ].
240
Microeconomics
Outline Answer
1. The density function is
1
f( )=
and the distribution function is
F( )=
2. Take the case where there are just two bidders, agent h and one other
agent. If the other agents value is and his bid is determined by his type
then agent h wins the auction if he bids p > ( ) where is the other
agents bid function. This is equivalent to requiring
' (p) >
If the other agents value is unknown, but is assumed to be rectangularly
distributed with support [ ; ] then the probability that agent h wins the
auction is
:= F (' (p))
which, from part 1, is
' (p)
If there are two other, agents each with values independently drawn from
the same distribution, then the probability of winning is just 2 . So, if
there are N 1 other agents, all with values independently drawn from
the same distribution then the probability of winning is N 1 , in other
words
N 1
' (p)
Pr (win) =
:
3. If agent hs value is
Given that
= 0,
expected return is
p] Pr (win)
p]
N 1
=[
N 1
p] [' (p)]
(12.19)
p] [N
N 2
1] [' (p)]
d' (p)
dp
N 1
[' (p)]
= 0:
On rearranging we have:
[p
c Frank Cowell 2006
] [N
1]
d' (p)
+ ' (p) = 0
dp
241
(12.20)
Microeconomics
such that
( )
If all agents are identical then this bid function applies to all N agents
and so it must be true that
= ' (p)
in equation (12.20). Making this substitution we have (12.15) as required.
4. Given that (12.15) is homogenous in ' and p, try the solution of value
proportional to bid:
' (p) = kp
for which we have
d' (p)
= k:
dp
kp] [N
1] k + kp = 0
(12.21)
which implies
1
(12.22)
N 1
from which the result (12.16) follows. However, by denition ' is just the
inverse of the bid function ; so (12.16) implies
k
1=
N
N
(12.23)
which implies
p=
(12.24)
which is (12.17).
5. If there are N agents we can represent their values as
[1]
:::
[2]
[N ]
where [k] is the kth order statistic of the given distribution. Obviously
the person with the highest valuation gets the object at the price
p=
(12.25)
[N ]
= Ep
N 1
=
E
N
[N ]
1
N
242
N
N +1
Microeconomics
6. Instead of (12.19) the expected return to bidding p is now
[
' (p)
p]
N 1
(12.26)
' (p)] [N
1]
d' (p)
+ ' (p)
dp
=0
(12.27)
1
N
]+ :
(12.28)
N 1
[
N +1
243
]+
Microeconomics
Exercise 12.6 Suppose that in the model of exercise 12.5 a second-price (English) auction were used rather than a rst-price auction
1. What is the optimal bid function?
2. Use the result in (12.18) to determine the expected price paid by the winner.
3. Use the results on order statistics in Appendix A to draw the distribution
of the price paid to the seller in the case of the rst and the second price
auction.
Outline Answer
1. In a second-price auction we know that truth-telling is a dominant strategy
and so the optimal bid function is just
( )= :
2. Given a sample of N from the distribution of values the price paid under
the English auction is [N 1] . So, given a rectangular distribution with
support [0; 1] we have expected value of the price is
p (N ) = E
[N 1]
Using the result on order statistics stated in Exercise 12.5 we have immediately that
N 1
:
p (N ) =
N +1
if the support of the rectangular distribution were [ ; ] then
E
where
[N 1]
=[
]E
[N 1]
N 1
[
N +1
]+ :
(12.30)
1
N
[N ]
(12.31)
[k]
[N 1]
(12.32)
Microeconomics
F(p)
1
English
Dutch
p
0
So, use the result (given in Appendix A) that, if has the distribution
F then F[k] ( ), the distribution of the kth order statistic is given by
F[k] ( ) =
N
X
N
F ( )j [1
j
N j
F ( )]
(12.33)
j=k
(12.35)
and
F[N
1] (
= N
N 1
= N
N 1
[1
]: +
: + [1
N]
(12.36)
N
N
(12.37)
Using (12.35), therefore, the distribution of price for the Dutch auction is given by
)
(
N
N
N
F (p) = min
p ;1
N 1
c Frank Cowell 2006
245
Microeconomics
4p2
1
0
1
2
p
p
1
2
For the English auction in the case N = 2 we have, using (12.32) and
(12.36), the following:
F (p) = N p: + [1
N ] p2 : = 2p:
p2 :
The two distributions are illustrated in Figure 12.2 for the case N =
2.
246
Microeconomics
Exercise 12.7 Alf and Bill are bidding in a conventional English auction for
an object of unknown market value: Alf s valuation of the object is a , Bills
valuation is b and the true total value is expected to be a + b , but at the
time of the auction neither bidder knows the others valuation. However, it is
common knowledge that a and b are drawn from a rectangular distribution
with support [ ; ].
1. What is the expected value of the object?
2. From Alf s point of view, what is the expected value of the object, conditional on his winning the object?
a
is an equilibrium.
=
=
=
2E (
)
1
[ + ]
2
2
+ :
va
= E
=p =
b
b
+E
j
1
a
+ p
2
247
=p
=p
(12.39)
Microeconomics
The same applies to Bill which establishes that ( ) is indeed a best response. So the equilibrium is indeed at the point where
a
p = 2 min
(12.40)
1
[
3
]+
]+2
which is less than the expected value of the the object found in part 1.
4. This bidding strategy will imply that the average winning price will exceed
the value of the object.
248
Microeconomics
Exercise 12.8 A Principal hires an Agent to manage a rm. The Agent produces an outcome q given by
q = (z; )
where z is e ort and is the talent of the Agent that may or may not be observable by the Principal; the function
is twice di erentiable, increasing in
both arguments, concave in z, and has a positive cross derivative. The Principal
contracts to pay the Agent an amount of income y in return for output q:The
Principals utility is
q y
and the Agents utility is
# (y)
Outline Answer
1. We need to nd the eect of a change in the parameter
the indierence curve.
on the slope of
or equivalently as
# (y)
(q; )
(12.41)
(z; ) =
( (q; ) ; ) :
( (q; ) ; )
249
(q; )
(12.42)
Microeconomics
which implies
q
1
>0
(
(q;
); )
z
(q; ) =
(12.43)
( (q; ) ; )
(q; ) +
( (q; ) ; ) :
which implies
( (q; ) ; )
< 0:
(
(q; ) ; )
z
(q; ) =
(12.44)
(q; ) =
zz
( (q; ) ; )
z
(q; ) +
z
2
( (q; ) ; )
( (q; ) ; )
<0
(12.45)
(b) Now nd the slope of the indierence curve in (q; y)-space. Dierentiating (12.41) we have
0 = #y (y) dy
so that we have
(q; ) dq
dy
q (q; )
=
dq
#y (y)
dq
dy
= #y (y) [
( (q; ) ; )
(12.46)
on (12.46):
( (q; ) ; ) +
zz
( (q; ) ; )
(q; )]
(12.47)
From the question we have z > 0 and zz < 0; from (12.44) we
have
< 0. Therefore it is clear from (12.47) that an increase in
will increase dq=dy; so an increase in will decrease dy=dq. The
indierence curves therefore look like those depicted in Figure 12.3
where a and b are the reservation indierence curves for two talent
types, with a representing the higher talent.
2. The Principals objective is to maximise q
constraint for an individual of type :
# (y)
(q; )
(12.48)
the shaded areas in Figure 12.3 represent contracts that satisfy this constraint for the two talent types. The optimisation problem can be represented by the Lagrangean
L (q; y; ; ) := q
c Frank Cowell 2006
250
y + [# (y)
(q; )]
(12.49)
Microeconomics
where is the Lagrange multiplier for the participation constraint (12.48).
The FOCs for an interior maximum of (12.49) with respect to q; y; are
@L
@q
@L
@y
@L
@
(q ; ) = 0
#y (y ) = 0
= # (y )
(q ; ) = 0
(12.50)
for each talent type and the requirement that (12.48) be binding. Condition (12.50) characterises an e cient outcome. The solution is illustrated
by points (q a ; y a ) and q b ; y b in Figure 12.3.
_b
_a
y*a
~
ya
slope = 1
slope = 1
slope = 1
y*b
~
yb
0
~
qb q*b
~
qa
q*a
3. It is clear that if the Principal cannot observe the Agents type then the
e cient solution in part 1 cannot be implemented.
(a) Consider two talent types a and b where
person accepts the contract designed for =
# (y a )
c Frank Cowell 2006
251
(q a ;
) = 0:
a
a
> b . If a type-a
then utility is
(12.51)
Microeconomics
q b;
>0
(12.53)
which follows because of condition (12.44) and the fact that a > b .
So any a-type has an incentive to misrepresent himself as a b-type in
order to obtain a more favourable contract.
(b) In view of the above the above the incentive-compatibility constraint
is
# (y a )
(q a ; a ) # y b
qb ; a
(12.54)
4. In the asymmetric-information case it may be assumed that the probability
that a potential manager is of type a is .
(a) The second-best problem for the Principal is to choose q a , q b , y a , y b
to maximise expected utility
[q a
y a ] + [1
] qb
yb
where and
and (12.54).
:=
[q a y a ] + [1
] qb yb
b
b b
+ # y
q ;
+ # (y a )
(q a ; a ) # y b +
qb ; a
(12.55)
are the Lagrange multipliers for the constraints (12.48)
(b) Let q~a ; q~b ; y~a ; y~b denote the values for that maximise (12.55). The
FOCs for a maximum are
@L
@q a
@L
@q b
@L
@y a
@L
@y b
=
=
=
=
(~
qa ;
)=0
q~b ;
(12.56)
+
+ #y (~
ya ) = 0
1+
+ #y y~b
=
=
#y y~b = 0
#y (~
ya )
1
+
#y (~
y b ) #y (~
ya )
252
=0
(12.57)
(12.58)
q~b ;
(12.59)
9
=
;
Microeconomics
So that, from (12.56),
(~
qa ; a )
=1
#y (~
ya )
(12.60)
"
q~b ;
#y (~
ya )
q~b ;
<1
(12.61)
where the last part of (12.61) follows from (12.45) and the fact that
a
> b.
(c) The solution is illustrated by points (~
q a ; y~a ) and q~b ; y~b in Figure
12.3. Condition (12.60) establishes the point that there is no distortion at the top note that the MRS=1 as in the full-information
case..
253
Microeconomics
(12.62)
Zq
p (x) dx
[1
]R
C0
(a) What is the relevant participation constraint and Lagrangean for the
problem?
(b) How will the authority set q and F ?
(c) Interpret this full-information result.
3. Assume that C0 is known but marginal cost is unknown; however it is
known that the e ciency of the rm is either a or b where
a
>
254
Microeconomics
Outline Answer
1. Consumers surplus is given by:
CS(q) :=
Zq
p (x) dx
pq
C0
cq
p (x) dx
pq
F+
[pq + F
C0
cq]
Zq
p (x) dx
[1
]R
C0
cq
(12.63)
where R is total revenue for the rm (sales pq plus fee F ). Note that
Vq (q; R) = p (q)
VR (q; R) =
1
(12.64)
(12.65)
V (q; R) + [R
C0
cq]
(12.67)
=
c+ c
= 1
and so
p (q ) = c + c
c Frank Cowell 2006
255
c=c
(12.68)
Microeconomics
so that
q =p
Given
< 1 we have
(c) :
(12.69)
> 0 and so
R
C0
cq = 0
(12.70)
Therefore
R
F
= C0 + cq
= C0 + cq
p (q ) q = C0
(12.71)
(12.72)
C0
cq (^
c)]
C0
c^q (^
c)] + [^
c
c] q (^
c)
(12.73)
C0
ca q a
Rb
C0
Ra
ca q a
Rb
ca q b
ca q b
C0
cb q b
256
(12.75)
Microeconomics
(c) If it is known that there is a probability that the rm is low cost
then the rational thing for the regulator to do is to choose (q a ; Ra )
and q b ; Rb so as to maximise the expected value of V (q; R) dened
in (12.63). The relevant Lagrangean is
9
L q a ; q b ; Ra ; Rb ; ;
:=
V (q a ; Ra ) + [1
] V q b ; Rb =
+ Rb C0 cb q b
;
+ Ra ca q a Rb + ca q b
(12.76)
where is the Lagrange multiplier for constraint (12.75) and is
the Lagrange multiplier for constraint (12.74), both of which will be
binding at the optimum.
(d) Let the (quantity, revenue)-values that maximise (12.76) be denoted
~ a and q~b ; R
~ b . Then the FOCs for the maximum are
by q~a ; R
given by
@L
@q a
@L
@q b
@L
@Ra
@L
@Rb
~a
Vq q~a ; R
=
=
ca = 0
~b
] Vq q~b ; R
[1
cb + ca = 0
~a +
VR q~a ; R
=
=
=0
~b +
] V q~b ; R
[1
=0
ca ]
ca
b
c + ca
[
1] +
1] +
[1
[1
][
= 0
= 0
= 0
= 0
(12.77)
(12.78)
(12.79)
(12.80)
[1
] [1
[1
] p q~
[p (~
qa )
cb
[1
]+
and
=1
into (12.77) and (12.78) we
ca ]
[1
b
] c + [1
] ca
] ca
= 0
= 0
257
(12.81)
(12.82)
Microeconomics
where
[1
] cb ca
(12.83)
1
This implies that price equals marginal cost for the low-cost rm but
is above marginal cost for the high-cost rm. Note that the size of
the distortion depends on the proportion of low-cost rms, the cost
dierence and the weight attached to prots by the regulator. Also,
from the constraint (12.75) we have
:=
~b
R
cb q~b = 0
C0
(12.84)
so that
F~ b = C0
q~b p q~b
cb = C0
q~b
ca + ca q~a
(12.85)
which yields
F~ a = C0 + q~b cb
ca
(12.86)
q~
~
Fb
= p 1 (ca )
= C0 + cb
1
= p
c +
= C0
258
c +
(12.87)
(12.88)
(12.89)
c +
(12.90)
Microeconomics
Exercise 12.10 An economy consists of two equal-sized groups of people. The
gifted, with an ability parameter = 2 and the deprived, for whom = 1. All
persons have a utility function given by
U (x; z) = log x + log (1
z)
1. Con-
3. Use the above diagram to show the case where a gifted person is just indi erent between acting as though utility were observable and pretending
to be deprived.
4. Show that deprived peoples utility could be increased by restricting the
amount that they are allowed to earn.
Outline Answer
1. Using w as the control variable and noting that z = w= the problem is
to maximise
w
log (w + T ) + log 1
(12.91)
This has the solution at
w = max 0;
259
1
[
2
T]
Microeconomics
Gifted
pretending to
be deprived
Gifted
Deprived
w1 = w*
w2
2
1
w**
w2
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Microeconomics
2. It is clear from (12.91) that utility at rst rises with earnings and then
falls; also the graph of utility against earnings is shifted upwards by an
increase in ability and by an increase in transfer T . So for individuals
who are able (and so who should have T < 0) but in fact pretend to be
deprived and get T > 0 we have a graph such as the broken line in Figure
12.4.
3. See Figure 12.4.
4. The situation in Figure 12.4 means that resources that should support
the deprived will be siphoned o by some of the gifted. This could be
prevented if the earnings of the deprived were limited to w in Figure 12.5
this reduces their utility innitesimally ( 1 ' 0) but it substantially
reduces the utility of the gifted who are masquerading ( 2 < 0) see
Figure 12.5. So the policy forces the gifted to reveal themselves and
enables the income support scheme for the deprived to be viable.
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Microeconomics
Exercise 12.11 The government has to raise a xed sum K through income
tax. It is known that there are two types of worker a and b in the economy and
that the output (gross income) produced by each is given by
qj =
j j
z ; j = a; b
= qj
Tj +
>
. It
zj
and K.
3. If the value of
for each worker is private and unknown to the government, write down the Lagrangean for the governments optimisation
problem.
4. Show that the second-best solution in this case is identical to the fullinformation solution.
5. Set up the problem in an alternative, equivalent way where the governments budget constraint is modelled as a separate constraint in the Lagrangean. What must be the value of the Lagrange multiplier on this constraint at the optimum?
Outline Answer
1. If K is the amount to be raised per person in the economy the governments
budget constraint is
K
T a + [1
]Tb
(12.92)
At the optimum we can ignore the < part of (12.92) if the sum of
taxes exceeded K you could increase individual utility and therefore social
welfare by cutting the taxes can always. So we may write the constraint
as
K = T a + [1
] T b:
(12.93)
a
2. By denition the objective function is
+ [1
the individual expressions for utility we have
[q a
Ta +
(z a )] + [1
] qb
Tb +
. Substituting in
zb
(z a )] + [1
] qb +
zb
T a + [1
]Tb
(12.94)
(z a )] + [1
262
] qb +
zb
K:
(12.95)
Microeconomics
3. The governments problem is to maximise (12.95) by choice of T a and
T b . Each individual chooses the amount of eort z. The government can
inuence the choice of eort by choice of the pairs (q a ; y a ) and q b ; y b
but, given that the values of a and b are private information, the values
of these pairs must be chosen so as to satisfy the participation constraint
for the b-types
qb
yb +
(12.96)
ya +
qb
yb
(12.97)
fq a ;q b ;y a ;y b g
qa +
h
+ yb +
h
+ ya +
qa
a
qb
h
] qb +
+ [1
yb
b
a
qb
b
K
(12.98)
where and are the Lagrange multipliers for the constraints (12.96) and
(12.97) which will be binding at the optimum.
4. The FOC for a maximum of (12.98) are
[1
] 1+
qb
qa
1+
qa
1
a
qb
qb
= (12.99)
0
= (12.100)
0
= (12.101)
0
= (12.102)
0
] 1+
qa
1
z
qb
1
b
qb
z
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Microeconomics
5. If there are just two types and again then the problem can be written
h
i
h
i
qa
qb
max
ya +
+ [1
] yb +
a
b
fq a ;q b ;y a ;y b g
+ h [q a
+ yb +
h
+ ya +
y a ] + [1 i ] q b
b
q
yb
(12.103)
qa
yb
qb
a
where
is the Lagrange multiplier for the binding budget constraint
(12.93) and and have the same interpretation as before. The FOC
for maximising (12.103) are
qa
1
a
[1
qb
1
z
+ [1
]+
qb
1
b
qa
1
a
qb
+
1
[1
]+
= 0
= 0
1]
1
Substituting these back into the other FOC and rearranging we have:
qa
z
qb
z
qb
z
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Chapter 13
Microeconomics
if they would achieve higher utility by doing so. Using the diagram from
part 4 show that this migration mechanism may lead to multiple equilibria,
some of which will be unstable.
6. Show that the stable equilibria in part 5 may be ine cient.
Outline Answer.
1. For a given size N the maximum amount of (locally public) good 1 that
could be available if all resources were used to produce it is (N ); the corresponding maximum amount per person of the private good is (N ) =N .
So production possibilities are given by the shaded area in Figure 13.1.
x2
(N)/N
(N)
x1
2. In this case the problem is eectively just a version of the club model.
The simple materials balance condition in this economy is given by
(N )
| {z }
total output
x1
|{z}
1
(N )
N
x2 N
|{z}
x1
N
Given the standard utility function in the question the individual seeks to
maximise
1
x1
(N )
(13.1)
U x1 ;
N
N
c Frank Cowell 2006
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Microeconomics
The FOCs for a maximum give
1
1
U2 x1 ;
(N )
N
N
(N )
N
(N )
N2
x1
N
+ U1 x1 ;
1
(N )
N
x1
1
U2 x1 ;
(N )
2
N
N
x1
N
x1
N
=0
=0
(13.2)
(13.3)
which implies
1=N
U1 (x1 ; x)
U2 (x1 ; x)
(13.4)
and
x1 =
(N )
(N )
(13.5)
If workers are paid their marginal products then the total wage-bill is
N N (N ). So the amount required to nance the public good is exactly
the dierence between the wage bill and the total product.
3. Consider the extension of the production possibilities in Figure 13.1. to a
case where there are three possible sizes of community: this is depicted as
the intersection of the triangular shapes in the left-hand panel of Figure
13.2. By extension the general case is as in the right-hand panel of Figure
13.2. Given the non-convexity of the attainable set it is clear that for some
types of indierence curve one could have multiple solutions at (0; (1))
N ;0 .
and
x2
x2
(a)
(b)
x1
Figure 13.2: Production possibilities for (a) three values of N (b) many values
of N
4. If there is a well-dened interior solution then the optimum must look like
that depicted in Figure 13.3. Clearly this implies that utility at the point
(0; (1)), where N = 1, and at
N ; 0 , where N = N , is less than
at the optimum. So maximised utility for a representative individual as
a function of the size of the municipality (N ) must look like one of the
two cases in Figure 13.4.
c Frank Cowell 2006
267
x1
Microeconomics
x2
x1
(N)
(N)
268
(N N )
(N)
Microeconomics
5. Given that there are two municipalities we may plot the maximised utility
for each on the same diagram as (N ) and
N N see Figure 13.5
where ( ) is assumed to have the form illustrated on the left-hand side
of Figure 13.4. Now consider the migration mechanism: individuals will
move to the municipality where there is the higher utility. Now, on the
left-hand side of Figure 13.5 we have
N
N >
(N )
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Microeconomics
270
Microeconomics
Exercise 13.2 (A continuation of Exercise 4.13) There is a single rm producing good 1 with costs xed cost
C0 + cq
(13.6)
U (x1 ; x2 ) = x12 + x2
(13.7)
as in Exercise 4.12. The government allows the rm to charge what price it likes
but o ers to pay the rm a subsidy equal to the consumers surplus generated by
the price that it charges.
1. Is the regulation mechanism e cient?
2. Does the government as regulator need to know (a) the cost function? (b)
the utility function?
3. Show that this mechanism allows the rm to exploit consumers completely
.
Outline Answer
1. Given (13.6) the rms prots can be written
= pq
C0
cq + B
(13.8)
where p is the price that the monopoly charges for good 1 and B is the
subsidy. Given (13.7) the consumer seeks to maximise
1
x12 + [y
px1 ]
where y is the consumers income and the price of good 2 has been normalised at 1. The FOC for an interior maximum is
1
x
2 1
1
2
p=0
(13.9)
x1 =
(13.10)
4p2
(the condition on the cost function in Exercise 4.12 will ensure that the
corner solution, where the person spends everything on good 1, is irrelevant), From (13.9) the inverse demand function is
p (x1 ) =
c Frank Cowell 2006
271
1
x
2 1
1
2
Microeconomics
x1
p (t) dt
p (x1 ) x1
Z0 x1
1 12
x
2 1
1
1
t 2 dt
2
0
1
1 12
x12
x
2 1
1 12
x
2 1
=
=
=
(13.11)
4p
c] q
C0 + B:
[p
c]
C0 +
4p2
4p
=
The FOC is
2p
2
2p2
C0 :
4p2
(13.12)
+c
2p3
=0
2p
4p2
C0
0;
(13.13)
in other words
CS
C0
(13.14)
C0
272
cq + F
(13.15)
Microeconomics
and the consumers budget constraint (if he chooses to buy good 1) would
be
px1 + x2 F y
(13.16)
Given that the persons utility if he does not consume good 1 (he spends
all of his income on good 2) is simply y then the rm knows that the
consumers participation constraint is
1
x12 + x2
(13.17)
x12
px1
(13.18)
F =
2p
4p2
(13.19)
in other words
F = CS:
Hence the scheme whereby the rm is subsidised by the amount of the
consumers surplus (and this subsidy is raised from the consumers as a
lump-sum tax) is equivalent to the scheme where the rm is allowed to
charge an entry fee. The consumer is forced back on to reservation utility
level where (13.16) and (13.18) are binding.
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Microeconomics
Exercise 13.3 The government of the tiny island of Mugg is considering whether
it would be a good idea to install piped gas. Once the gas distribution system
is installed each unit of gas (commodity 1) costs a xed amount m of other
goods (commodity 2); there is additionally a xed cost F incurred in setting up
a distribution system on the island. Before the system is installed Mugg enjoys
a total amount R2 of commodity 2. The residents of Mugg are assumed to be
identical in every respect and their tastes are represented by the utility function
1
x1
+ x2
where (x1 ; x2 ) represent the quantities consumed of the two goods and
non-negative parameter.
is a
= e
x1
=const
which means that they are vertically displaced in (x1 ; x2 )-space, they
get steeper as the parameter increases and they can touch the x2 -axis .
Clearly picks up the strength of the willingness-to-pay for gas.
3. If < mex1 then there can be no solution on the x1 -axis. There remain
two dierent types of solution, depending on the values of :
The high-valuation tastes (high- indierence curves) have steep intercepts on the vertical axis: clearly the optimum in this case would
be as in Figure 13.8.
c Frank Cowell 2006
274
Microeconomics
x2
R2
F
m
x1
[R2F]/m
m log
satises
> F:
log
x2
= R2
m log
m + R2
m log
;
m
At (x1 ; x2 ) utility is
m
Evidently this yields greater utility than the no-installation case. The gassupply corporation can induce the (x1 ; x2 ) outcome by making consumers
pay F as a xed charge and then a (marginal) price of m per unit of gas.
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Microeconomics
x2
R2
x1
x2
R2
x1
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Microeconomics
Exercise 13.4 Take the model of the Island of Mugg (Exercise 13.3) again.
Suppose that the government of Mugg has a horror of public enterprise and decides to delegate the decision on installation and supply by selling o MuggGas.
1. Will this generate an improvement on the no-gas situation?
2. Will it generate an e cient allocation?
3. How would your answers be a ected if MuggGas were split into a number
of private companies, or if consumers were allowed to resell gas to each
other?
Outline Answer
1. The answer depends on whether the rm is allowed to make a xed charge
to cover the xed cost. If the rm is restricted to charging a uniform price
to all customers then privatisation here could be a disaster. There are two
possibilities:
x2
R2
x1
277
x1
p=0
Microeconomics
which implies
x1 (p) = log
mx1 :
This becomes
(p)
= px1 (p)
=
[p
m] log
mx1 (p)
F
(13.20)
p
p
m
p
=0
(13.21)
[p
m]
p
in other words:
p log
) log
>0
which implies
<
(13.22)
p log
>
m log
which implies
h
m 1
p
p i
+ log
> [p
m
m
m] log
(13.23)
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Microeconomics
2. If the rm were sold of as a simple monopoly then clearly the solution
would not be e cient. If it were a regulated monopoly (as in Exercise
13.3) or could make a xed charge then it is possible to achieve an e cient
outcome.
3. Assume that the residents of Mugg are all high-valuation consumers.
Given that they can resell gas to each other (and if it is possible to do so
at low cost) there is no possibility of one of the privatised MuggGas rms
imposing a xed charge upon them. If gas is supplied the price would be
driven down to the marginal cost m, but the prot-maximising solution
will not be at point A but at B. No gas will be supplied, even though this
is a Pareto-inferior outcome to A (see the broken line in Figure 13.10).
279
Microeconomics
Exercise 13.5 In an economy there are two rms each producing a single output from a single non-produced resource according to
p
q1 = z
q2 = max
q1 ; 0
where qi is the amount produced of good i, z is the amount of the resource used
in the production of good 1, R is the total stock of the resource and
is a
parameter.
1. What phenomenon does this model represent?
2. Draw the production-possibility set.
3. Assuming that all consumers are identical, sketch a set of indi erence
curves for which (a) an e cient allocation may be supported by a pseudo
market in externalities; (b) a pseudo market is not possible.
4. What role does the parameter
Outline Answer
1. There is a simple production externality: production of good 1 reduces
the amount of good 2 that can be produced for a given amount of input
devoted to the production of good 2.
280
R
1+
(13.24)
Microeconomics
The production-possibility set is as illustrated in the two panels of Figure
p
p
13.11.Note that the line segment L from
z0 ; 0 to
R; 0 belongs to
the set. The set is non-convex.
3. In panel (a) the solution is at the point of tangency and can be decentralised using prices shown by the broken line. However in panel (b) this
decentralisation is not possible. If the prices given by the broken line are
used then production takes place, not at the point of tangency, but at
p
R; 0 .
point
4. From equation (13.24) shows that as gets larger so too does the line L
and the problem raised by the non-convexity becomes more salient.
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Microeconomics
Exercise 13.6 In a large economy all agents have a utility function of the form
(x1 ) + xh2
where x1 is the amount provided of a public good and xh2 is agent hs consumption
of a private good. All agents are endowed with the same amount of private good
R2h = 1. Each individual can choose whether to contribute to the public good:
z2h =
1
0
contribute
not contribute
The unit contribution costs an amount ch to agent h; the individual costs are
unobservable but the distribution function F ( ) of costs is known. The production
of the public good is given by
x1 = ( )
where
1. Show that an e cient outcome implies that there is cost level c0 such that
z2h =
1
0
ch c0
ch > c0
2. The government introduces a tax-subsidy scheme based on individual actions as follows. Each contributor receives a subsidy s and each noncontributor has to pay t. Given c0 and the distribution of costs F what is
the condition for a balanced budget if agents behave as in part 1?
3. Under the conditions of part 2 what is the utility of someone with ch < c0 ?
Of someone with ch > c0 ?
4. By requiring that someone with ch = c0 be indi erent between contributing and non-contributing show that this tax-subsidy scheme induces an
e cient equilibrium.
5. How much of the public good is provided and what is the tax rate and
subsidy rate?
Outline Answer
1. Pick a given level of provision of the public good x1 . This then determines
a given number representing the proportion of the population that must
contribute. Consider the situation where there is some c0 such that z2h = 0
if and only if ch > c0 . Under this scheme
= F c0
x1 = (F c0 ):
Take a high-cost type individual that does not contribute (ch > c0 ) and
a low-cost type individual who does contribute (c` < c0 ). Now change the
situation described above so that h contributes and ` does not. The utility
loss to h is ch which is strictly greater than the utility gain c` to individual
`. Clearly no such perturbation can lead to a Pareto improvement.
c Frank Cowell 2006
282
Microeconomics
2. Under the above scheme there is a proportion F c0 who are contributing,
so that the total subsidy required is given by sF c0 . Given that there
is a proportion 1 F c0 who are not contributing, the tax raised is
t 1 F c0 . So the budget constraint is
sF c0 = t 1
F c0
(13.25)
c0 + s =
}
(x1 ) + 1
{z
utility if contribute
(x1 ) + 1
{z
t
}
(13.26)
c` + s >
(x1 ) + 1
(x1 ) + 1
ch + s <
(x1 ) + 1
(13.27)
t F c0 = t 1
F c0
(13.28)
F (c0 ) ;
(13.29)
F c0
F c0
(13.30)
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Microeconomics
w0
1
1
t
t
4. If the government seeks to maximise the after-tax cash income of the poorest person (the welfare function with = 1 in Exercise 9.5) subject to the
above constraints show that the optimal tax rate is
t =
Outline Answer
1. The operation of the tax and transfer system is illustrated in Figure 13.12:
t is the marginal tax rate, y0 is the break-even income and ty0 gives a
minimum guaranteed income.
2. The consumers problem is exactly the same as that of Exercise 5.7 with
the eective wage rate [1 t] w and nonwage income ty0 . So we can just
adapt the result from there to get
` =
[1
] 1 t t yw0 , if w
0 , otherwise
w1
(13.31)
where
w1 := y0
t
1
1
t
(13.32)
is the reservation wage. Equation (13.31) gives labour supply as a function of w, t and y0 .
c Frank Cowell 2006
284
Microeconomics
disposable income
y0
pre-tax income
y0
3. To ensure that everyone works the government must set the tax parameters so that w0 > w1 in (13.31). From (13.32) this requires y0 < y1 :=
1 t
w0 : Net revenue raised in this system is given by
t 1
Z
t[w` y0 ]dF (w)
(13.33)
and if the tax is purely redistributive, then (13.33) should be zero. If
everyone works then (13.31) and (13.33) imply
Z
t
t w
[1
]
y0 y0 dF (w) = 0
(13.34)
1 t
Simplifying we get
Z
w dF (w) =
1
1
t
y0 dF (w)
t
(13.35)
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Microeconomics
w0 +
1
1
2t
w0 +
t
w0 = 0
[1
t]
(13.38)
which implies
1=
1
1
2t
+
t
1
[1
t
2
t]
(13.39)
1] t2
2t [
1] +
1 = 0:
(13.40)
(13.41)
If we rearrange (13.41) and ignore the irrelevant root we get the result.
Note that the optimal tax rate increases with : the larger is the mean
wage (relative to the lowest wage) the more well-o people there are to
pay for transfers.
286