Graduate Micro Course

Advanced Microeconomics: Problems
Atsushi Kajii
Institute of Economic Research, Kyoto University

September 1, 2013
Abstract
This is a master copy - do not think my students do all of them! I do cut and paste from this
master copy to create assignments for my advanced microeconomics course. Some of the problems
are original, but many are copied from various textbooks and slightly modied to my taste.
There is a solution manual I wrote. It contains not only solutions but also discussions on
related topics. It is available upon request.
1 Mathematics
1. Let ) and p be functions on R
2
given by ) (a
1
, a
2
) = ca
1
+aa
2
and p (a
1
, a
2
) = (a
1
)
2
+(a
2
)
2
,
where c, a, and are constants.
(a) Let c = 1, a = 2, and draw
_
(a
1
, a
2
) R
2
: ) (a
1
, a
2
) = 3
_
.
(b) Let = 1, and draw
_
(a
1
, a
2
) R
2
: p (a
1
, a
2
) _ 1
_
. Also write the vector 1p (a
1
, a
2
) +
(a
1
, a
2
) for (a
1
, a
2
) = (1, 1) , where 1p (a
1
, a
2
) is the gradient vector
_
J
Ji
1
p (a
1
, a
2
) ,
J
Ji
2
p (a
1
, a
2
)
_
.
(c) Solve min
i
1
,i
2
) (a
1
, a
2
) subject to p (a
1
, a
2
) _ 1, using the Kuhn-Tucker method. Explain
the rst order condition graphically for c = 1, a = 2, = 1.
(d) What about min
i
1
,i
2
) (a
1
, a
2
) subject to p (a
1
, a
2
) _ 1? What is the rst order condition
for this problem? Is it necessary and/or sucient for minimization?
2. A set A in R
1
is convex if for any a, j A, and for any t [0, 1], ta + (1 t) j A.
(a) Show that
_
(a
1
, a
2
) R
2
: (a
1
)
2
+ (a
2
)
2
_ 1
_
is a convex set, by verifying the property
above (i.e., not just drawing a picture).
(b) Let j R
1
. Show that
_
a R
1
: j a = 0
_
is a convex set, by verifying the property above
(i.e., not just drawing a picture).
(c) Prove that if A and 1 are convex sets in R
1
, then A 1 is a convex set in R
1
.
3. Let C be a convex set in R
1
. A function ) on C is convex if for any a, j C, and for any
t [0, 1], t) (a) + (1 t) ) (j) _ ) (ta + (1 t) j).
(a) Let j R
1
. Verify that the function a j a is convex.
(b) Let ) be a convex function on C. Prove that the set (a, `) C R : ) (a) _ ` is a convex
set (remark. this set is called the epigraph of )).
Most problems are written by Atsushi Kajii, but some of them are taken form variaous textbooks or academic
papers without acknowledgement (in fact he does not remember where they are taken from).
1
2
(c) Let ) be a function on C. Suppose that (a, `) C R : ) (a) _ ` is a convex set. Verify
that ) is a convex function.
(d) Let ) and p be convex functions on C. Show that max ), p (that is, the function a
max ) (a) , p (a)) is a convex function. [Hint. look at the epigraph.]
4. Show that:
(a) p (a
1
, ..., a
1
) =

1
|=1
p
|
(a
|
) is a concave function if each p
|
, / = 1, ..., 1 is a concave
function.
(b) if ) (a
1
, ..., a
1
) is quasi concave and homogeneous of degree one, ) is concave.
5. [Homogeneity and convexity] A function ) : R
1
+
R is homogeneous of degree 0 if ) (ta) =
t
0
) (a) for any a and t 0. A set C in R
1
is said to be convex if for any a, j C and t [0, 1] ,
ta + (1 t) j C. A function ) : C R is said to be convex if for any a, j C, and for any
t [0, 1], t) (a) + (1 t) ) (j) _ ) (ta + (1 t) j). A function ) : C R is said to be concave
if ) is convex. A function ) : C R is said to be quasi-convex if a : ) (a) _ c is a convex
set for any c. A function ) : C R is said to be quasi-concave if a : ) (a) _ c is a convex
set for any c.
(a) Show that ) (a
1
, ..., a
1
) = (a
1
)
o
1
(a
2
)
o
2
(a
1
)
o
K
with c
|
0, / = 1, ..., 1 and c
1
+
c
2
+ c
1
= 1 is homogeneous with degree 1.
(b) Show that if a function ) : R R is non-decreasing, it is quasi-convex and quasi-concave.
(c) Give a simple example of a quasi-concave function which is not concave.
(d) Show that p (a
1
, ..., a
1
) =

1
|=1
p
|
(a
1
, ..., a
1
|
, / = 1, ..., 1
is a concave function.
(e) Show that if / : R R is increasing and ) : C R is concave, then /() (a)) is a quasi-
concave function of a.
(f) Show that if ) (a
1
, ..., a
1
(g) Show that ) (a
1
, ..., a
1
) = (a
1
)
o
1
(a
2
)
o
2
(a
1
)
o
K
is concave if c
|
0, / = 1, ..., 1 and
c
1
+c
2
+ c
1
_ 1.
6. Duality. Let n be a function on R
1
+
and j R
1
++
is a vector. Fix a number c and assume that
both : := inf j a : n(a) _ c and := supn(a) : j a _ : exist (note that since n may
not be continuous, inf and sup are dierent from min and max in general).
(a) Prove that if a : n(a) _ c is closed, _ c holds Give an example which shows < c
can occur if a : n(a) _ c is not closed.
(b) Prove that if a : n(a) c is open, _ c holds. Give an example which shows c
can occur if a : n(a) c is not open.
(c) Show that = c if n is continuous.
7. A simpler version of the Gale Nikaido theorem. Let be the 11 dimensional simplex
in R
1
, i.e., :=
_
_
j
1
, ..., j
1
_
_ 0 :

1
l=1
j
l
= 1
_
, and let ) : R
1
be a continuous function
such that j ) (j) _ 0 for any j . (Note that ) is dened even for the case where some
prices are zero.) Let

) (j) := max
l
)
l
(j), and (j) := :
l
= 0 if )
l
(j) <

) (j). So,
(j) if and only if ) (j) =

) (j).
(a) Show that satises the conditions for Kakutanis xed point theorem.
Microeconomic Theory problems by A. Kajii 3
(b) So by Kakutanis theorem, there is j
(j
). Show that ) (j
) _ 0 (i.e., )
l
(j
) _ 0 for
every |) must hold.
(c) Assume in addition that j ) (j) = 0 for any j , and if j
l
= 0 for some |, there is |
0
(may be the same as |) such that j
l
0
= 0 and )
l
0
(j) 0. Show that a xed point j
found
above in fact must satisfy ) (j
) = 0.
8. A xed point theorem. Let be the 1 1 dimensional simplex in R
1
, and let ) : R
1
be a continuous function such that

1
l=1
)
l
(j) = 0 for any j . The Fan-Brouwer theorem
says that ) has a xed point if ) is inward pointing, that is, if j
l
= 0 implies )
l
0
(j) 0 for
some |
0
with j
l
0
= 0 (|
0
may be same as |). This question asks you to establish this result from
the Gale-Nikaido theorem:
(a) Show that if ) is inward pointing, then j
l
= 0 implies )
l
(j) _ 0. [Hint: consider a sequence
j
n
convergent to j, such that elements of j
n
are positive except for |]
Assume on the contrary that ) does not have a xed point from now on.
(b) Dene c(j) :=
_
:
l
= 0 if )
l
(j) < j
l
_
. Show that c is non-empty convex valued
and its graph is closed (i.e., upper hemicontinuous).
(c) So by Kakutanis theorem there is j such that j c( j). Show that this contradicts
the assumption that ) is inward - pointing.
2 Producer Theory
1. For a Cobb-Douglas production function ) (.
1
, .
2
) = (.
1
)
o
(.
2
)
o
where .
1
and .
2
are inputs,
c +a _ 1, c, a 0,
(a) Find the prot function, supply correspondence, cost function, factor demand function.
(b) Suppose .
2
is xed, but not sunk. That is, the producer can use either .
2
units of factor
2 or choose zero input (and then ) = 0 by construction). Find the average cost curve, the
marginal cost curve, and the supply curve. Draw graphs.
(c) As .
2
changes, how do they change?
(d) What happens if c 1? And if c +a 1? Interpret.
2. Show that:
(a) p (a
1
, ..., a
1
) =

1
|=1
p
|
(a
|
|
, / = 1, ..., 1 is a concave
function.
(b) if ) (a
1
, ..., a
1
3. For a CES production function with 1 factors of production ) (.) = )
_
.
1
, .
2
, ..., .
1
_
=
_
1
|=1
a
|
_
.
|
_
o
_ 1
,
where a
|
0, / = 1, ..., 1, are constants with

|
a
|
= 1, and c _ 1, c ,= 0,
(a) Show that this technology exhibits constant returns to scale.
(b) Show that ) is a concave function.
(c) Find the cost function and the conditional factor demand function
4. Let c (n, j) be the cost function and . (n, j) be the conditional factor demand function. Prove:
(a) c (tn, j) = tc (n, j) for any t 0,
4
(b) 1
u
c (n, j) = . (n, j)
(c) if the corresponding technology exhibits constant returns to scale, c (n, tj) = tc (n, j) for
any t 0.
(d) c (n, j) is concave in n.
(e) c (n, j) is convex in j, if the corresponding production function ) is concave.
5. Consider a general class of linear activity production set 1 =
_
1
|=1
t
|
a
|
: t
|
_ 0
_
, where a
|
,
/ = 1, ..., 1, is a xed technology vector in R
1
.
(a) For an example, let 1 = 2, 1 = 3, and a
1
= (3, 1) , a
2
= (2, 2) , a
3
= (1, 5). Draw
production set 1 . If price vector j is given by j = (1, 1), what is the supply (set)? What
if j = (5, 1) , or j = (2, 1)?
(b) Show that production set 1 exhibits CRS.
(c) Show that for a given price vector j: if j a
|
0 for some /, then the maximum prot is
+. If j a
|
_ 0 for all /, then the maximum prot is zero, and the supply correspondence
is given by y (j) =
_
1
|=1
t
|
a
|
: t
|
_ 0, and t
|
= 0 if j a
|
< 0
_
.
6. Consider a competitive rm with a concave production function )
_
.
1
, ..., .
1
_
, where .
|
is the
amount of good / used as an input. The price of output is one, and the price of good / is n
|
, so
the total cost of inputs is

1
|=1
n
|
.
|
. The rm is under a nancial constraint so that there is
a maximum amount it can spend for purchase of factors of production. Let be this maximum
amount. So the total cost of rms inputs must be no larger than . Answer the following
questions.
(a) Write this rms prot maximization problem.
(b) Show that if is large enough, the total cost of prot maximizing combination of inputs
will be less than . (That is, the nancial constraint does not matter.)
(c) Show that the rms prot is non decreasing in ; that is, as the nancial constraint gets
less severe, the prot tends to increase.
3 Consumer Theory
1. For a Cobb-Douglas utility function n
_
a
1
, a
2
_
=
_
a
1
_
o
_
a
2
_
o
with c + a 0, c, a 0, nd
the demand function, the minimum expenditure function, Hicksian demand function, and the
indirect utility function.
2. Consider utility function n
_
a
1
, a
2
_
= min
_
c
1
a
1
, c
2
a
2
_
where c
1
and c
2
are positive constants.
Draw the indierence curve corresponding to n
_
a
1
, a
2
_
= 1. Find the demand function, the
minimum expenditure function, Hicksian demand function, and the indirect utility function.
3. Consider utility function n
_
a
1
, a
2
_
= c
1
a
1
+c
2
a
2
where c
1
and c
2
are positive constants. Draw
the indierence curve corresponding to n
_
a
1
, a
2
_
= 1. Find the demand function, the minimum
expenditure function, Hicksian demand function, and the indirect utility function.
4. For a quasi-linear utility function n
_
a
1
, a
2
_
=
_
a
1
_
+ a
2
, where
0
0,
00
< 0, show that
the demand for good 1 does not depend on income. Can you say anything about the form of
the minimum expenditure function, Hicksian demand function, and the indirect utility function?
[Do not worry about the boundary: do as if negative consumption is allowed.]
5. Let a(j, :) =
_
a
|
(j, :)
_
1
|=1
be a demand function.
(a) Show that

1
|=1
j
| J
Jn
a
|
= 1.
(b)
J
J
l
a
l
(j, :)
_
i
l
l
_
is called the price elasticity of demand for good | (with respect to its
own price). Show that the consumer will spend less on good | as j
l
(marginally) goes up if
and only if the price elasticity is more than one.
(c) If
J
Jn
a
l
(j, :) _ 0, good | is said to be normal at (j, :). A good is called a normal good
if it is normal at any (j, :), otherwise it is called an inferior good. If
J
J
l
a
l
(j, :) 0
occurs, good | is called a Gien good. Show that a Gien good cannot be normal. Show
graphically that an inferior good is not necessarily a Gien good.
6. Consider an additively separable utility function n(a) = n
1
_
a
1
_
+ +n
1
_
a
1
_
.
(a) Show that the preference relation represented by a Cobb-Douglas utility function in (1)
can be represented by an additively separable utility function.
(b) Show that if each n
l
is concave, so is n.
(c) Show that goods are normal.
7. Prove that the derivatives of the minimum expenditure function give the Hicksian demand.
8. Revealed Preference. Let there be two goods and consider a consumer with income : facing
prices j =
_
j
1
, j
2
_
. Suppose that this consumer exhibits the consumption pattern as in the
following table:
prices j
|
income :
|
chosen bundle
(a) (1, 2) 5 (3, 1)
(b) (2, 1) 5 (1, 3)
(c) (1, 1) 4
_
j
1
, j
2
_
(d)
_
1
2
,
1
3
_
3 (4, 3)
(e) (1, 3) 6 (1, 2)
For instance, this consumer chooses to consume (3, 1) when prices are (1, 2) and : = 5. The
chosen bundle j =
_
j
1
, j
2
_
for case (c) is missing in the data.
(a) By drawing a picture, show that choices (a) and (b) above are consistent with utility
maximization.
(b) By drawing a picture, show that choices (a) and (e) above are inconsistent with utility
maximization.
(c) By drawing a picture, nd the area for a that choices (a), (b) and (c) above are consistent
with utility maximization.
(d) Now assume that
_
j
1
, j
2
_
= (2, 2). Dene utility function n on R
2
by the rule n(a) =
min
|2fo,b,c,Jg
`
|
(j
|
a) +c
|
, where / denote each case (i.e., j
o
= (1, 2)), each `
|
is
some positive number, and c
|
is a constant. Show that by appropriately choosing `
|
s and
c
|
s, n(a) is a concave function which justies cases (a) to (d). [Hint. Let `
o
= `
b
= 1 and
`
c
=
5
4
, and c
o
= c
b
= c
c
= 0. Draw the indierence curve for utility level 5, pretending
that / = d is never a minimizer, i.e., as if n(a) = min
|2fo,b,cg
`
|
(j
|
a) +c
|
. Play with
`
J
to accommodate (d).]
6
4 Risk and Uncertainty
1. Consider an agent with concave vNM utility function n. He can spend \ for a gamble (a
1
, a
2
)
- he receives a
1
with probability j and a
2
with probability 1 j. Show that he accepts more
gambles as the ratio r (\) =
u
00
(V)
u
0
(V)
[Arrow-Pratt measure of absolute risk aversion] gets
smaller. Do the same exercise for relative gambles (i.e., a
1
and a
2
represent the fractions of the
initial wealth and so he receives (a
1
\, a
2
\)) and
u
00
(V)V
u
0
(V)
[Arrow-Pratt measure of relative
risk aversion.]
2. Prove that the EU representation is unique up to positive ane transformation. [You may
assume that the set of outcomes is [a, a]. ]
3. Let n be a vNM utility function. The certainty equivalent for a random income A is a number
c that is dened by the rule 1 [n(A)] = n(c). Assume that A is a discrete random variable.
(a) Interpret c.
(b) Let A be the lottery which yields 4 with probability j and 1 with probability 1 j. Find
the certainty equivalent of A for the following utility functions:
i. n(a) =
_
a
ii. n(a) = aa where a 0 is a constant.
iii. n(a) = a
2
(c) Show that if is a positive ane transformation of n, the certainty equivalent of A for
is the same as that for n. That is, the certainty equivalent depends on the underlying risk
preferences, not a particular choice of vNM function.
(d) Show that c _ 1 [A] if n is concave (thus risk averse).What about the converse?
Suppose that there is another random variable o that may be correlated with A. Dene the
conditional certainty equivalent C (o) by the rule 1 [n(A) n(C (o)) [o] = 0, where 1 [[o]
denotes the conditional expectation given o. That is, C (o) is the certainty equivalent after
observing the realization of signal o. So o can be considered as a piece of information about
A that is revealed before the level of income gets known.
(e) Show that 1 [n(C (o))] = n(c).
(f) Show that 1 [C (o)] _ c.
(g) Is information o valuable?
4. By a lottery A we mean that a random variable whose cumulative distribution function is 1
.
We assume that the lotteries are bounded, so there is numbers c and a, c < a, such that every
outcome of each lottery we consider is included in [c, a]. A lottery A is said to (weakly) rst
order stochastically dominates (FOSD) a lottery 1 if 1
(.) 1
Y
(.) _ 0 for any . [c, a].
A lottery A is said to (weakly) second order stochastically dominates (SOSD) a lottery 1 if
_
:
o
[1
(-) 1
Y
(-)] d- _ 0 for any . [c, a], and
_
o
o
[1
(-) 1
Y
(-)] d- = 0.
(a) Let A be the lottery which yields 1 with probability one. Let 1 be a lottery which yields
2 with probability and 0 with probability 1 , where 0 < < 1.
i. Does A FOSD 1 ? Does 1 FOSD A?
ii. Does A SOSD 1 ? Does 1 SOSD A?
(b) Show that:
i. If A FOSD 1 , then 1 (A) _ 1 (1 ), i.e., A yields a higher outcome on average.
ii. If A SOSD 1 , then \ ar (1 ) _ \ ar (A) .
[Hint. You may assume that A and 1 are continuous random variable. Use integration
by parts.]
5. Consider the following situation. Your income today is zero, and that for tomorrow is given by
\, which may be a random variable. If you invest in a risky project, it will yield an additional
random income A. Let r be the (compensation) value of this investment for you, in the sense
that r is a constant that solves 1 [n(A +\)] = 1 [n(r +\)] .
(a) Show that if \ is not random and n is risk averse, we have r _ 1 [A].
(b) Show that if \ and A are independent, we have r _ 1 [A]. [Hint. Use the conditional
Jensens inequality]
(c) Give an example to show that if \ and A are not independent, r 1 [A] is possible.
6. Simple investment problem. Suppose your income today is :
0
and tomorrow is :
1
, and
you can invest part of your income today. The gross return from a unit of investment is given by
a random variable 1. You are risk averse and your vNM utility function for income is denoted
by n, and you discount the future utility level by factor a. So, to sum up, you would solve
max
i
n(:
0
a) +aE[n(a1 +:
1
)]
where E is the expectation with respect to 1.
(a) Write down the rst order condition for this problem.
(b) Suppose your income today :
0
increases. Does it imply that the demand for the risky
asset a increases? If not, give a sucient condition for this to be true.
(c) Suppose the return 1 gets more risky in the sense of the second order stochastic dominance.
Does it mean that the demand for the risky asset decrease? If not, give a sucient condition
for this to be true. (Hint: consider the property of the function an
0
(a)
7. Prudence and precautionary saving. Suppose your income is : today and 1 tomorrow.
You can save part of your income : today, and the rate of interest is r, r 1. Your income
1 tomorrow may be random but you may not insure against the income risk generated by
this randomness. Your vNM utility function for todays income is denoted by n and that for
tomorrow is denoted by . Assume that both are concave. To sum up, you would solve
max
i
n(:a) +E[ ((1 +r) a +1 )]
where E is the expectation with respect to random variable 1 .
(a) Write down the rst order condition for this problem.
(b) Show that when your future income is not random, i.e., 1 = j
0
for sure, your saving
increases if j
0
decreases.
(c) If todays income : increases, how does your saving change?
(d) How does your saving change when interest r increases? Discuss.
From now on, we are only concerned with change in income so set r = 0 to simplify notation.
8
(e) Suppose that 1
0
and 1
1
are random variables of the same mean and 1
1
is riskier than
1
0
. (i.e., 1
0
second order stochastically dominates 1
1
) Show that you save more under the
income risk 1
1
than you do under 1
0
if
000
0 (i.e.,
0
is convex). Interpret.
(f) The coecient of absolute prudence of is dened as the coecient of absolute risk aversion
for
0
. Assume that n = . Show that if the coecient of absolute prudence for increases,
you save more.
8. Variance and risk. Let A, 1 , 7 be random variables with 1 = A +7. We say 1 is at least
as risky as A if 1 [7[A] = 0.
(a) Show that if 1 is at least as risky as A, 1 [7] = 0 and Co [A, 7] = 0, and \ ar [1 ] _
\ ar [A].
(b) Show by an example that 1 [7] = 0 and Co [A, 7] = 0 do not imply that 1 is at least as
risky as A.
9. Simple insurance problem. Suppose your income is j
1
when the state of nature is H and
j
1
when the state of nature is 1. You believe that state H will occur with probability
1
and
the state 1 will occur with probability
1
(= 1
1
). There is an insurance which pays one
dollar per unit if state is -, - = H, 1. You may buy or sell these insurance contracts, and the
price of insurance that pays out in state - is given by j
~
. Writing a
~
for the amount of insurance
which pays out in state - (so negative a
~
means you sell), you are interested in maximizing
expected utility by choosing appropriate amounts of a
1
and a
1
, i.e.,
1
n(j
1
+a
1
) +
1
n(j
1
+a
1
)
subject to j
1
a
1
+j
1
a
1
= 0, where n is a concave vNM utility function.
(a) Setting c
~
= j
~
+ a
~
for - = H, 1, and write some indierence curves exhibiting your
preferences among (c
1
, c
1
) pairs.
(b) What is the marginal rate of substitution when c
1
= c
1
?
(c) Show that if

H
L
=
t
H
t
L
, you will choose a
1
and a
1
in such a way j
1
+a
1
= j
1
+a
1
.
(d) If

H
L

t
H
t
L
, in which state will you consume more?
10. Risk and demand. Suppose there are o equally likely states, and write a R
S
for a contingent
consumption plan: that is, a
~
, - = 1, ..., o, is consumption in state -.
(a) Assuming o = 2, write the set of contingent consumption plans with average consumption
equal to c in a graph measuring a
1
horizontally and a
2
vertically.
(b) Assuming o = 2, and x a R
2
with a
1
a
2
0. Write the graph of cumulative
distribution function induced by a. (Hint: Pr(. _ c) =
1
2
if a
1
c a
2
.)
(c) Assuming o = 2, and x a R
2
with a
1
a
2
0. Write the set of contingent consumption
plans which rst order stochastically dominates a. Also write the set of contingent plans
which second order stochastically dominates a.
(d) Imagine an investor with an increasing and concave vNM utility n, n
0
0 and n
00
< 0, with
positive income n. There are o states, all equally likely. Denote the price of consumption
good in state - by j
~
0, and denote by j the vector of prices, i.e., j = ( , j
~
, ) .
Thus the investor wants to choose a contingent plan a =
_
a
1
, .., a
S
_
, where a
~
is the
amount of consumption in state -, which maximizes the expected utility

S
~=1
~
n(a
~
)
given the budget

S
~=1
j
~
a
~
_ n, where
~
=
1
S
for - = 1, ..., o. Denote by a(j, n) :=
_
a
1
(j, n) , ..., a
S
(j, n)
_
the contingent plan which maximizes the expected utility.
i. Write the rst order condition of the maximization problem above.
ii. Show that when n increases, the investor will increase demand a
~
for all -; that is,
a
~
(j, n) is increasing in n for all -.
iii. Show that if n
0
n, the random consumption resulting from a(j, n
0
) rst order
stochastically dominates that from a(j, n).
iv. Show that if j
~
= j
~
0
, then a
~
(j, n) = a
~
0
(j, n) . (i.e., if the price in state - and that
in state -
0
are the same, the investor consumes the same amount in these states.)
v. Show that the price and the consumption must be inversely related; that is, j
~
j
~
0
if and only if a
~
(j, n) < a
~
0
(j, n).
vi. [Harder] Show that if the price j and the consumption a are inversely related, then
there is a vNM utility function n such that a is utility maximizing.
11. The common ratio paradox. Denote by the lottery that yields $3000 for sure, by 1 the
lottery that yields $4000 with probability 0.8, and $0 otherwise. Also denote by C the lottery
that yields $3000 with probability 0.25, and $0 otherwise, and by 1 the lottery that yields
$4000 with probability 0.2, and $0 otherwise. Many studies have shown a systematic tendency
for subjects to express a preference for over 1 and for 1 over C. Show that this choice pattern
violates the expected utility hypothesis.
12. The Ellsberg paradox. There are two urns identical balls. Urn 1 contains 49 white and 51
red balls. Urn 2 has 100 balls, but with unknown proportion of white and red balls. Consider
the following two bets: Bet 1: if red, $1000, otherwise 0; Bet 2: if white $1000, otherwise 0.
Write these problems in the Savage framework, and show that if an agent prefer urn 1 for both
bets, his preferences violate the sure-thing principle.
5 Classical Partial Equilibrium Analysis
1. Consider a quasi-linear utility function n
_
a
1
, a
2
_
=
_
a
1
_
+ a
2
, where
0
0,
00
< 0. Suppose
the price of good one changes from j to j. Verify that the change in consumer surplus measures
the exact change of utility level.
2. Consider a quasi-linear utility function n
_
a
1
, a
2
_
=
_
a
1
_
+ a
2
, where
0
0,
00
< 0. Suppose
the price of good one changes from j to j. Verify that the change in consumer surplus measures
the exact change of utility level. Also show that the equivalent variation and compensated
variation coincide, and relate these to the change in consumer surplus.
3. Aggregation of producers. Consider J producers, producing a homogeneous good from an
homogenous input. Price of output is j and that of input is 1. Producer using a technology
represented by a cost function c
). Assume for each , c
(0) = 0 and c
0
0 and c
00
0,
and hence the supply is characterized by c
0
) = j. Write -
(j) =
_
c
0
_
1
(j), i.e., -
I
(j) is the
quantity supplied by the rm at price j. By the assumptions, each -
is increasing function,
and so is the aggregate supply o (j) :=

=1
-
(j). So we can dene the inverse aggregate

supply function 1 () := o
1
(). Notice that by construction o (1 ()) = .
Now consider a ctitious, representative rm, whose cost function is given by C () =

=1
c
(-
(1 ())).
Notice that this function has the following interpretation. For the target output level , calculate
the price level 1 (), and ask each rm to produce taking 1 () as given. Then C () is the
total cost incurred by the rms.
Show that the representative rm with cost function C as given above will supply o (j) when
price is j (thus, o constitutes the supply curve for this ctitious rm.)
10
4. Producer surplus. Consider a rm with cost function c () = ) () + (), where (1) (0) = 0
and
0
0 and
00
< 0; (2) ) () = 1 0 if 0, and ) (0) = 0. So the constant 1 represents
a xed (but not sunk) cost of production.
(a) Find the quantity this rm will supply when the price of output is j 0.
(b) We shall write (j) for this quantity supplied found above, and j () for its inverse. Write
the graph of j () taking horizontally.
(c) Suppose the rm produces a positive amount at price j 0. The area to the left of the
marginal cost curve is called producer surplus: That is, the producer surplus is j ( j)
_
j( )
0

0
() d. Is the producer surplus the same as prots?
5. Ineciency of taxation. Let
1
(j) be a downward sloping demand curve and
S
(j) be
upward sloping supply curve, and denote by j
the equilibrium price. Consider tax t per unit

of trade, and write j (t) for the price for the buyers after the taxation (so j (0) = j
), and let
(t) be the quantity traded. Assume these functions are dierentiable, and
0
(0) < 0.
(a) Show graphically that taxation leads to a loss in social welfare (consumer surplus + pro-
ducer surplus + tax revenue).
(b) Write the amount of social welfare explicitly, and dierentiate it with respect to t. Show
that the derivative is zero at t = 0.
(c) Dierentiate the social welfare twice in t. Can you sign the derivative at t = 0?
(d) Interpret your results above.
6. Monopoly. Consider a monopoly rm with a convex cost function c (). Given decreasing
inverse demand function j (), write
for the amount that the rm produces.

(a) Assume that the revenue function j () is concave in . Write the rst and second order
conditions that characterize
.
(b) Show that the price elasticity of demand,

0
j
, must be more than one at
.
(c) Show that the revenue function j () is concave if j () = a /, where a 0, / 0 are
positive constants (that is, the concavity assumption in 6a is satised for linear demand
models). Show that when a increases, both quantity
and the rms prots increase.

(d) Find the price elasticity of demand for linear demand j () = a /, and verify that it is
decreasing in . (So the elasticity of demand is dierent from the slope of demand curve.)
(e) Derive a demand function of constant elasticity . Conrm that the monopoly problem has
no solution if < 1.
7. A Large rm and small rms. Consider an industry with one large rm, and small rms.
Small rms are price takers, but the large rm behaves as a monopoly rm, setting the price
taking the demand as well as the supply of small rms into account. Each small rm has an
identical cost function c () =
1
2
2
. The large rm can produce costlessly (i.e., zero marginal
cost and no xed cost). The demand for the product is given by j = 1 Q, j is the price of the
product and Q is the total demand. So if Q
1
is the amount the large rm produces, and Q
S
is
the sum of quantities the small rms produce, then the market price will be j = 1(Q
1
+Q
S
).
(a) Find the total quantity produced by the small rms when the price is j.
(b) Write the problem that the large rm solves, and nd the quantity which the large rm
will produce.
(c) If the social welfare is to be maximized, how much should the large rm produce? What
about the small rms?
(d) As the number of small rms increases, does the equilibrium approach a socially desirable
state? What if the large rms technology were also given by a convex cost function?
Discuss.
8. Third degree price discrimination. Consider a monopoly rm with a cost function with
constant marginal cost c. There are two types of consumers, and the demand of type t, t = 1, 2,
consumers is given by a downward sloping demand curve d
|
(j).
(a) Suppose the rm cannot price discriminate; that is, the rm must charge the same price j
for both types. Characterize the monopoly price.
(b) Suppose that the rm can price discriminate, thus the rm charges j
|
for type t consumers.
Write down the rms problem and the corresponding rst order condition.
(c) Show that the ability of price discrimination is advantageous to the rm (i.e., the rm will
get at least as much prots as in the case of non-discrimination).
(d) Show that if the rm sets j
1
j
2
, the demand of type 1 at j
1
is more elastic than that of
type 2 at j
2
.
9. Ramsey taxation. Consider a central authority who needs to raise tax revenue of ` by
specic (per unit) taxes on 1 goods. There are 1 + 1 goods, and the representative consumers
utility function is linear in the 1+1 st good. (This 1+1st good is not taxed). More specically,
assume that it is given by

1
l=1
l
_
a
l
_
+ a
1+1
. Write the demand for good | as a
l
_
j
l
_
. Given
price j
l
, the demand for good | when tax t
l
is levied will be a
l
_
j
l
+t
l
_
, and so the tax revenue
from good | will be a
l
_
j
l
+t
l
_
t
l
. Currently, the prices of goods are given by j =
_
j
1
, ..., j
1
_
and the price of good 1 + 1 is one.
(a) Write the problem to minimize the loss of consumer surplus, given that the tax revenue
must be at least as much as `.
(b) Show that price elastic goods tend to get taxed less. Interpret.
10. Policy mix. Consider a monopoly rm with a positive constant marginal cost c. A decreasing
inverse demand function j () is given. Assume that the revenue function j () is concave in
. Write (c) for the amount that the rm produces. Also denote by
(c) the socially optimal

amount of output.
(a) Write the rst order condition which determines (c) . Show that
(c) (c) .
(b) Compare the following two policies. (1) quantity control polity, which requires the rm
to produce an amount ; (2) tax/subsidy policy, which requires the rm to pay t to the
governement per unit produced. Show that both policies can induce the socially optimal
amount. What is the sign of t? Discuss.
From now on assume a linear inverse demand function j () = 1 c, where c 0.
(c) Suppose now that the government does not know c although the rm does: the government
knows c is either c
1
or c
1
, where 1 c
1
c
1
1, and these are equally likely.
i. Find the quantity control policy which maximize the social welfare. Explain why the
social optimal amount is not necessarily induced?
12
ii. Also nd the tax/subsidy policy which maximize the social welfare, and explain the
source of ineciency.
iii. Consider the following policy mix: there is a xed target production level ^ , and the
rm must produce at least this amount. But the rm may produce more, and in such
a case the rm pays t per unit of the amount for the excess production: i.e., the rm
pays t ( ^ ) to the government if ( ^ ) 0. Show that this policy mix is better
than the two policies above.
6 Competitive Markets: General Equilibrium
1. Characterization of Pareto eciency. Consider a pure exchange economy where 1 goods
are traded. The total endowments are c R
1
++
, and assume each n
I
is strictly increasing and
continuous.
(a) Give the denition of a Pareto ecient allocation of this economy.
Now consider the following maximization problems: 1) Given `
I
0, i = 1, ..., 1,
àai:i.c
i
1
2R
L
++
,...,i
I
2R
L
++
I
`
I
n
I
(a
I
) subject to

I
a
I
= c; (1)
2) Given n
I
0, i = 2, ..., 1,
àai:i.c
i
1
2R
L
++
,...,i
I
2R
L
++
n
1
(a
1
) subject to n
I
(a
I
) _ n
I
, i = 2, ..., 1 and

I
a
I
= c (2)
(b) Show that (a
I
)
J
I=1

_
R
1
++
_
J
is Pareto ecient if and only if (a
I
)
J
I=1
solves problem 2 above
with some n. Is this true if n
I
were not strictly increasing?
(c) Suppose every n
I
is concave, dierentiable, and 1n
I
(a
I
) 0, n
I
(a
I
) 0 for any a
I
0.
Show that (a
I
)
J
I=1

_
R
1
++
_
J
solves problem 1 for some ` if and only if (a
I
)
J
I=1
solves problem
2 with some n. (Hint. Both problems are then concave so compare the Kuhn-Tucker
condition.)
2. Characterization of Pareto eciency in a production economy. Consider an economy
with 1 goods. The total resource endowments are given by a vector c R
1
++
, and there is one
producer with an increasing and quasi-convex production transformation function 1: that is, a
production plan j R
1
can be carried out by the rm if and only if 1 (j) _ 0. Assume for each
consumer i, A
I
= R
1
+
and utility function n
I
is strictly increasing and continuous.
(a) Give the denition of a Pareto ecient allocation of this economy.
Now consider the following maximization problems: 1) Given `
I
0, i = 1, ..., 1,
àai:i.c
i
1
2R
L
++
,...,i
I
2R
L
++
I
`
I
n
I
(a
I
) subject to

I
a
I
= c; (3)
2) Given n
I
0, i = 2, ..., 1,
àai:i.c
i
1
2R
L
++
,...,i
I
2R
L
++
n
1
(a
1
) subject to n
I
(a
I
) _ n
I
, i = 2, ..., 1 and

I
a
I
= c (4)
(b) Show that (a
I
)
J
I=1

_
R
1
++
_
J
is Pareto ecient if and only if (a
I
)
J
I=1
solves problem 2 above
with some n. Is this true if n
I
were not strictly increasing?
(c) Suppose every n
I
is concave, dierentiable, and 1n
I
(a
I
) 0, n
I
(a
I
) 0 for any a
I
0.
Show that (a
I
)
J
I=1

_
R
1
++
_
J
solves problem 1 for some ` if and only if (a
I
)
J
I=1
solves problem
2 with some n. (Hint. Both problems are then concave so compare the Kuhn-Tucker
condition.)
3. Pareto ecient allocations and competitive equilibria in Edgeworth Box. Consider
Edgeworth box economies given as follows. For each economy, show graphically, the set
of Pareto ecient allocations, the set of weakly Pareto ecient allocations, and the set of
competitive equilibria.
(a) n
1
_
a
1
1
, a
2
1
_
= min
_
a
1
1
, a
2
1
_
, n
2
_
a
1
2
, a
2
2
_
= a
1
2
+a
2
2
, c
1
= (1, 0), c
2
= (0, 1)
(b) n
1
_
a
1
1
, a
2
1
_
= min
_
a
1
1
, a
2
1
_
, n
2
_
a
1
2
, a
2
2
_
= min
_
a
1
2
, a
2
2
_
, c
1
= (1, 0), c
2
= (0, 1)
(c) n
1
_
a
1
1
, a
2
1
_
= a
1
1
, n
2
_
a
1
2
, a
2
2
_
= a
1
2
, c
1
= (1, 0), c
2
= (0, 1) .
(d) n
1
_
a
1
1
, a
2
1
_
= a
2
1
, n
2
_
a
1
2
, a
2
2
_
= a
1
2
, c
1
= (1, a), c
2
= (0, 1 a), where a [0, 1]
4. Eciency charcterization in Robinson Crusoe: In the Robinson Crusoe economy, prove
that a feasible consumption a =
_
a
1
, a
2
_
is Pareto Ecient if and only if it is a solution of the
following maximization problem:
max
(i
1
,i
2
)
n
_
a
1
, a
2
_
subject to a
2
_ )
_
c a
1
_
.
5. Pateto Ecient share of random income. Consider an economy with 1 agents. Each
agents preferences are represented by a vNM utility function n
I
. The aggregate income of this
economy is denoted by j. For simplicity, suppose that there are only nitely many possible
income level, and denote by j (j) the probability that the aggregate income is j. Denote by
a
I
(j) the amount agent i receives when aggregate income is j, and we call (a
I
)
J
I=1
an income
sharing rule if it is feasible allocation of income, i.e.,

J
I=1
a
I
(j) = j for any j. (Assume an
interior throughout.)
(a) Give the denition of Pareto ecient income sharing rule.
(b) Assuming each n
I
satises n
0
I
0 and n
00
I
< 0, write the Pareto maximization of weighted
sum of utility functions and the rst order condition for Pareto eciency.
(c) Fix a positive `
I
, for i = 1, ..., 1, and let p (t) =

J
I=1
(n
0
I
)
1
_
|
X
i
_
, where (n
0
I
)
1
is the
inverse of n
0
I
. Show that if we set a
I
(j) = (n
0
I
)
1
_
1
()
X
i
_
, then (a
I
)
J
I=1
is a Pareto ecient
sharing rule.
(d) Assume further n
I
(.) =
1
o
i
exp[c
I
.], where c
I
is a positive constant, for every agent i.
Find the (class of) Pareto ecient income sharing rule.
(e) Do the same exercise for n
I
(.) =
1
1
i
.
1
i
where where
I
is a positive constant, for every
agent i.
6. State and prove the rst fundamental theorem of welfare economics. Discuss why completeness
of markets is important in this result.
7. weak eciency to eciency. Say that the budget is tight at prices j and income n for n
I
if j a
0
< n and a
0
A
I
implies that a
0
is not a utility maximizing demand vector (i.e., to
maximize utility, all the given income must be spent).
14
(a) Show that the budget is tight at prices j and income n for n
I
if and only if any demand
vector is cost minimizing in the following sense: if a maximizes utility n
I
in the budget set,
then for any a
0
A
I
, n
I
(a
0
) _ n
I
(a) implies j a
0
_ j a.
(b) Assume that A
I
= R
1
+
and n
I
is non-decreasing. Given positive prices j and income n
suppose that the following holds: if a is a demand vector given j and n, then it is cost
minimizing. Show that the budget must be tight.
(c) Argue graphically that the budget might not be tight when n
I
is not strictly increasing
(i.e., a thick indierence curve is possible)
(d) Let (a
, j
, j
) be a competitive equilibrium of a private ownership economy ((n

I
)
J
I=1
, (1
=1
,
_
.
I
, (0
I
)
=1
_
J
I=1
). Show that (a
, j
) is Pareto Ecient if the budget is tight at a
I
(given
prices j
and income j
.
I
+
0
I
_
j
_
) for n
I
for all consumer i.
8. Second fundamental theorem. Let j R
1
be a price system, j ,= 0. We say that a
is a
quasi-utility maximizer if n
I
(a
0
) n
I
(a
) implies j a
0
_ j a
. (Note: this will be triviall if all

the prices are zero)
(a) Show that if a
is utility maximizing given prices j and income n, it is quasi utility

maximizing.
(b) Set 1 = 2 and let the consumption set to be R
1
+
. Consider a consumer with utility function
n
_
a
1
, a
2
_
= a
1
+a
2
with initial endowments (1, 0). Show that a quasi-utility maximizer is
not necessarily a utility maximizer under some prices.
(c) In general, suppose that A
I
is convex, n
I
is continuous, and there is ^ a A
I
such that
j ^ a < j .
I
. Show that if a
is quasi-utility maximizing, then it is utility maximizing.

[Hint. Suppose this does not hold. Then there will be a
0
A
I
such that n
I
(a
0
) n(a
)
but j a
0
= j a
. Consider (1 t) a
0
+t^ a with small t 0].
(d) Comment on the second fundamental theorem of welfare economics discussed in the class.
9. the quasi-linear economy. There are two goods, a and :, and there are : traders. There
are 1 traders and each trader i has a quasi-linear utility function n
I
(a
I
) +:
I
and endowed with
( a
I
, :
I
), where n
I
is strictly increasing and concave. The price of good a in units of good j is
denoted by j. To avoid a boundary consumption, assume that n
0
I
(0) = +, and also that a
negative consumption of good : is allowed.
(a) Show that (a
I
, :
I
)
J
I=1
is Pareto ecient if and only if (a) (a
I
)
J
I=1
maximizes

J
I=1
n
I
(a
I
)
subject to

I
a
I
=

I
a
I
, and (b)

I
:
I
=

I
:
I
hold.
(b) Show that the (general) equilibrium price j
depends on a =

I
a
I
only (so in particular,
it is independent of the way the total resource is initially allocated).
(c) Show that the (general) equilibrium price j
maximizes the social welfare (i.e., the sum of

consumer surplus and the prots cannot be increased further.)
(d) Suppose a
1
increases by a small amount, whereas the other a
I
, i = 2, ..., :, are kept xed.
What can you say about (i) the change in the equilibrium price and (ii) who benets from
this change?
10. the quasi-linear economy. There are two goods, a and :, and there are : traders. There
are 1 traders and each trader i has a quasi-linear utility function n
I
(a
I
) +:
I
and endowed with
( a
I
, :
I
), where n
I
is strictly increasing and concave. The price of good a in units of good j is
denoted by j. To avoid a boundary consumption, assume that n
0
I
(0) = +, and also that a
negative consumption of good : is allowed.
(a) Show that a trader may be interpreted as a producer with a convex cost function, if we allow
a negative consumption of a
I
as well. [Hint: think of n
I
as the negative of cost function,
and check that utility maximization given budget is equivalent to prot maximization.]
(b) Show that (a
I
, :
I
)
J
I=1
is Pareto ecient if and only if (a) (a
I
)
J
I=1
maximizes

J
I=1
n
I
(a
I
)
subject to

I
a
I
=

I
a
I
, and (b)

I
:
I
=

I
:
I
hold.
(c) Show that the (general) equilibrium price j
depends on a =

I
a
I
only (so in particular,
it is independent of the way the total resource is initially allocated).
(d) Show that the (general) equilibrium price j
maximizes the social welfare (i.e., the sum of

consumer surplus and the prots cannot be increased further.)
(e) Suppose a
1
increases by a small amount, whereas the other a
I
, i = 2, ..., :, are kept xed.
What can you say about (i) the change in the equilibrium price and (ii) who benets from
this change?
11. Symmetric Quasi-linear economies
There are two goods, a and j, and there are 2 consumers. The consumers characteristics are
summarized below: Consumer 1: utility function n(a
1
) + j
1
, endowed with ((1 c) ., c.),
Consumer 2: utility function a
2
+ n(j
2
), endowed with (c., (1 c) .), where n
0
0 and
n
00
< 0, and . 0 and c are xed numbers. Notice that the total supply of each good is .,
independent of c. Assume that negative consumption of linear good is allowed (so consumers
have dierent consumption sets). Normalize the price of j good to be one, and write j for the
price of good a. Assume that n is increasing and concave. Write c = (n
0
)
1
. Since n
0
is a
positive and decreasing function, c is also a positive and decreasing function.
(a) Find the demand for good a for both consumers, and the market excess demand function
. (j) for good a.
(b) Show that j = 1 is an equilibrium, i.e., . (1) = 0. Find the equilibrium allocation of
consumption goods.
(c) Compute
J
J
. (1). Show that if the equilibrium allocation is close to the initial endowments
(1 c, c) and (c, 1 c), then
J
J
. (1) < 0 (i.e., the index of j = 1 is +1).
(d) Show that
J
J
. (1) 0 is possible for some c. What can you conclude from this observation?
12. There is one consumer and one producer in the economy. The consumers preferences are
represented by utility function n(a
1
, a
2
) =
1
2
lna
1
+ a
2
. Good 2 is leisure and initially the
consumer owns one unit of good 2, and no good 1. The producer is a price taker (competitive
rm) and its production function is ) (.) = /., where / 0 is a constant; that is, the producer
produces /. units of good 1 from . units of good 2 (i.e., with one unit of labor / units of good
1 is produced.) All the prots are distributed to the consumer. Good 2 is the numraire; i.e.,
j
2
= 1 in the following, and write j instead of j
1
for simplicity.
(a) What does the constant / represent?
(b) Argue that the rm cannot make prots (nor losses) in equilibrium.
(c) Derive the demand curve for good 1, assuming that there is no prot distribution (so his
income is always 1).
(d) Derive the supply curve for good 1.
(e) Find the (partial) equilibrium price and quantity in the good 1 market. Is this a general
equilibrium, too?
16
(f) As / changes, how the equilibrium quantity change? Interpret.
(g) Let / = 1. Suppose the producer has to pay $1 per unit of input (so eectively, the producer
needs two units of labor to produce one unit of good 1). The tax revenue will be given to
the consumer as a lump-sum subsidy. Find the general equilibrium. Does this tax-subsidy
policy make the consumer better o? Do you think that your conclusion might change if
preferences and/or production technology were dierent form the ones above?
13. In the same setting as in question 12, but with production function ) (.) = .
o
, c (0, 1);
(a) Find a competitive equilibrium price and the consumers equilibrium consumption bundle.
(b) We can transform this economy to a CRS economy by adding an additional good, good 3,
to the economy. The consumer does not care good 3 per se; his utility function does not
depend on the amount of good 3 he consumes. The consumer owns one unit of good 3.
The rms production function is ) (., ) =
_
:
:
_
o
=
o+1
.
o
, where is the amount of
good 3 used for production. Notice that if = 1, we have the same production function as
before. [This is called the McKenzie transformation]
i. Check that the technology is CRS.
ii. So in equilibrium, the prots to the rm will be zero. Interpret the equilibrium price
of good 3.
14. There are two countries, A and B. There are two consumers, 1 and 2, in country A and there is
one consumer, 3, in country B. Price of good 2 is set to be 1 throughout, and write j instead of
j
1
. Utility and endowments of consumers are summarized below:
utility endowments
1 2 lna
1
+ 2 lna
2
(6, 4)
2 lna
1
+ 3 lna
2
(8, 4)
3 lna
1
+ lna
2
(4, 16)
(a) Find individual excess demand functions.
(b) First assume that there is no international trade. Find the equilibrium in each country.
(c) Suppose consumers can trade internationally. Find the equilibrium.
(d) Does free world trade make everybody better o? Is this consistent with the rst funda-
mental theorem of welfare economics? Discuss.
15. Linear model of international trade and gains from trade. In the following, assume that
there are two goods, and consumers consumptions sets are R
2
+
. Normalize the price of good 2
to be 1, and denote by j the price of good 1. Here is the list of consumers to be considered in
the following questions (0 < c <
1
2
):
utility function n
_
a
1
, a
2
_
endowments
_
c
1
, c
2
_
consumer A (1 c) a
1
+a
2
(1, 1)
consumer B (1 c) a
1
+a
2
(1, 0)
consumer 1 a
1
(1, 1)
consumer 2 a
2
(1, 1)
(a) Find the demand for good 1 for consumer A and consumer 1, as a (possibly set valued)
function of j.
(b) Find a competitive equilibrium of the pure exchange economy consisting of consumer 1 and
consumer 2. Draw an Edgeworth box to illustrate the equilibrium.
(c) Find a competitive equilibrium of the pure exchange economy consisting of consumer A
and consumer 1. Draw an Edgeworth box to illustrate the equilibrium.
(d) Is there a competitive equilibrium of the pure exchange economy consisting of consumer A
and consumer 2? If there is, nd one and illustrate it in an Edgeworth box. If not, verify
nonexistence.
(e) Is there a competitive equilibrium of the pure exchange economy consisting of consumer B
and consumer 2? If there is, nd one and illustrate it in an Edgeworth box. If not, verify
nonexistence.
(f) Find a competitive equilibrium of the pure exchange economy consisting of consumer A,
consumer 1 and consumer 2.
(g) Imagine that consumers A and 1 live in the same country, and consumer 2 lives in another
country. Discuss the welfare eect of a free trade agreement of the two countries, i.e., before
the agreement, only consumers in the same country could trade but after the agreement
all three consumers can trade.
16. Consider two rms, each producing a consumption good from two inputs, .
1
and .
2
, by pro-
duction function )
1
_
.
1
1
, .
2
1
_
=
_
.
1
1
_
o
_
.
2
1
_
1o
and )
2
_
.
1
2
, .
2
2
_
=
_
.
1
2
_
o
_
.
2
2
_
1o
, respectively, and
0 < c < a < 1. The total amount of inputs available in the economy is .
1
and .
2
, respectively.
The price of consumption good is given at j
1
and j
2
. We can interpret that this is a small coun-
try with two outputs and two inputs, and output prices are determined in the world markets,
whereas inputs are not mobile and their prices are determined domestically.
(a) Give the condition for prot maximizing inputs. (recall section 1, (1))
(b) Given factor (input) prices n
1
and n
2
, nd the ratio of inputs used in each rm. Interpret.
Will this property hold when production function is not Cobb-Douglas?
(c) Derive equations that characterize the factor prices that clear the input markets. (Do not
forget the prot maximization condition.)
(d) Show that the equations above can be solved as follows: rst, nd the input ratio
_
.
1
.
2
_
that satises the prot maximization condition for each rm. Then nd a unique allocation
of inputs that has the ratio. Draw a picture like Edgeworth box to explain how this is done.
(e) Show that for given j
1
and j
2
, the factor prices that clear the input markets do not depend
on .
1
or .
2
.
(f) Stolper-Samuelson theorem. How do the equilibrium factor prices n
1
and n
2
change
when j
1
increases? State this in terms of factor intensity c and a.
(g) Rybcszynskis theorem. How do the equilibrium factor inputs .
1
and .
2
change when
.
1
increases? State this in terms of factor intensity c and a.
17. Consider an economy with three goods one consumer and two rms as follows. The prices of
good 1 and 2 are denoted by n
1
and n
2
respectively, and the price of good 3 is denoted by j.
Consumer. utility function n
_
a
3
_
+ a
2
, and he does not care good 1. He is endowed with
1 units of good 2. (Think of good 3 as a consumption good, good 2 as leisure, good 1 as
a productive intermediate good, necessary for production of good 3, which is not initially
endowed thus must be produced from labor. ) The function n satises the standard
conditions. The consumer receives prots from the rms.
18
Firm 1 produces good 3 with production function )
_
.
1
, .
2
_
=
_
.
1
_
o
_
.
2
_
1o
where .
1
and
.
2
are the amount of good 1 and 2 used as inputs. So the conditional factor demand given
j are
z
1
(n, j) =
_
cn
2
(1 c) n
1
_
1o
j.
z
2
(n, j) =
_
(1 c) n
1
cn
2
_
o
j
Firm 2 produces /.
2
units of good 1 from .
2
units of good 2, where / is a given constant.
(a) Find the market clearing conditions for good 1 and good 3.
(b) Find a general equilibrium price system.
(c) How will the prices change when / and/or c.
18. Consider an economy with three goods one consumer and two rms as follows. The prices of
good 1 and 2 are denoted by n
1
and n
2
respectively, and the price of good 3 is denoted by j.
Assume that the prices are all positive.
Consumer. His utility function is n
_
a
3
_
+ a
2
, where a
l
is the consumption of good |.
Assume n
0
0 and n
00
< 0. For simplicity allow a
2
< 0. Note that he does not care good 1.
He is endowed with 1 unit of good 1. The consumer receives prots from the rms. Denote
by the total amount of prots he receives.
Firm 1 produces good 2 from good 1. It produces /
1
.
1
1
units of
good 1, where /
1
is a given positive constant.
Firm 2 produces good 3 from good 2. It produces /
2
.
2
2
units of
good 2, where /
2
is a given positive constant.
(a) Write the utility maximization problem of the consumer. Find the rst order condition
which characterize the demand for goods.
From now on, write c(j) := (n
0
)
1
(j).
(b) To nd a general competitive equilibrium, we can assume = 0. Explain why.
(c) To nd a general competitive equilibrium, we can assume j = 1. Explain why.
From now on assume j = 1 and = 0.
(d) Assuming that each rm produces a positive quantity in equilibrium, nd the conditions
which prices n
1
and n
2
must satisfy.
(e) From the market clearing condition (i.e., demand = supply) for good 1, nd the quantity
of good 2 that rm 1 produces in equilibrium.
(f) Write the market clearing conditions for good 2 and good 3.
(g) Show that if the market clearing condition for good 3 is satised, the market for good 2
automatically clears. Is this a coincidence? Explain.
(h) Suppose that /
2
increases. What will happen to the equilibrium prices? Is this good for
the consumer? Interpret your nding.
(i) Suppose that /
1
increases. What will happen to the equilibrium prices? Is this good for
the consumer? Interpret your nding.
19. In Section 6 (12), suppose the rm behaves as a monopoly rm, and assume that the consumer
has utility function n(a
1
, a
2
) = 2
_
a
1
+ a
2
; that is, the rm takes the demand for a
1
as given,
and set the price. Note in particular that the dividend is also taken as given by the rm,
although it wont matter in the following since the demand does not depend on .
(a) Given , nd the price that the rm sets.
(b) Compute the prot level at the price you found above, and nd the dead weight loss.
20. There is one consumer and one rm in the economy. There are two periods and there is one
perishable good in each period. The price of the good is always normalized to be one. The con-
sumers preferences are represented by utility function n
_
a
0
, a
1
_
= a
0
+
1
2
lna
1
. The consumer
owns one unit of the consumption good in period 0, and nothing in period 1. The rm is a price
taker (competitive rm) and its production function is a
1
= /
_
a
0
, (a
0
_ 0) where / 0 is a
constant; that is, it produces /
_
c units of good in period 1 from c units of good in period 0.
In period 0, the consumer may save by purchasing a discount bond issued by the rm. Denote
by / the amount of bond the consumer holds at the end of period 0, and by the price of bond.
The rm issues - units of bond on period 0, and so purchases - units of good for input. The
consumer owns the rm in the sense that he receives the entire realized prots in period 1.
(a) Given , nd the supply of the discount bond by the rm.
(b) Given , nd the prot distribution (dividend) .
(c) Find the demand / for bond as a function of and .
(d) Find the equilibrium price of the discount bond.
(e) Study how the equilibrium interest rate changes as / changes. Interpret.
21. Consider an economy as follows. There are two consumers, i = 1, 2. There are two periods, and in
each period, consumers trade a single, perishable commodity (i.e., they cannot store the good).
There is no uncertainty. Consumer is preferences are represented by n
I
_
a
0
I
, a
1
I
_
= lna
0
I
+c
I
lna
1
I
where c
I
(0, 1) is a constant. Every consumer is endowed with one unit of the good in each
period. Thus consumers preferences are identical, except for the discount factor c
I
. The price
of good in period 0 is j
0
, and that in period 1 is j
1
. In period 0, consumers can save: denote by
-
I
the amount that consumer i saves in period 0. Let r be the interest rate. That is, if consumer
i saves -
I
dollars, he receives (1 +r) -
I
dollars at the beginning of period 1 before the trade of
the consumption good takes place. Hence consumer i chooses
_
a
0
I
, a
1
I
, -
I
_
R
+
R
+
R. Notice
that negative saving, i.e., borrowing is allowed.
(a) Consumer i faces budget constraint j
0
a
0
I
+ -
I
= j
0
with a
0
I
_ 0 in the rst period. Write
the second period budget constraint.
(b) Find demand x
0
I
, x
1
I
, and s
I
as functions of j
0
, j
1
, and r.
(c) Show that when the saving market clears, i.e., -
1
_
j
0
, j
1
, r
_
+ -
2
_
j
0
, j
1
, r
_
= 0, the good
market clears in both periods 0 and 1.
(d) Find all the equilibrium prices and the corresponding interest rate. Show that any interest
rate r, r 1 can arise in equilibrium.
(e) What about the real interest rate - the relative price of period 2 good - in equilibrium?
22. First Fundamental Theorem of Welfare Economics. Let a maximize utility n
I
given
prices j and income n. Say that the budget is tight at prices j and income n for n
I
if j a
0
< n
implies that a
0
is not a utility maximizing demand vector (i.e., to maximize utility, all the given
income must be spent).
20
(a) Show that the budget is tight at prices j and income n for n
I
if and only if any demand
vector is cost minimizing in the following sense: if a maximizes utility n
I
in the budget set,
then n
I
(a
0
) _ n
I
(a) implies j a
0
_ j a.
(b) Argue graphically that the budget might not be tight when n
I
is not strictly increasing
(i.e., a thick indierence curve is possible)
(c) Let (a
, j
, j
) be a competitive equilibrium of a private ownership economy ((n

I
)
J
I=1
, (1
=1
,
_
.
I
, (0
I
)
=1
_
J
I=1
).
Show that (a
, j
) is Pareto Ecient if the budget is tight at a
I
(given prices j
and income
j
.
I
+
0
I
_
j
_
) for n
I
for all consumer i.
23. Altruism and the welfare theorem: Consider an exchange economy with 2 consumers and 1
goods, with initial endowments . = (.
1
, .
2
). Each consumers utility function can be expressed
as l
1
(a
1
, n
2
(a
2
)) for consumer 1 and l
2
(a
1
, n
2
(a
2
))
24. Uniquness of no-trade equilibrium. Consider an exchange economy with 1 consumers and
1 goods. Suppose that the initial endowments . = (.
1
, ..., .
J
) 0 constitute a competitive
equilibrium; that is, there is no trade in this equilibrium. Show that . is in fact a unique
equilibrium allocation if utility functions are strictly quasi-concave.
25. Gross substitution. Let ) : R
1
++
R
1
be a dierentiable market excess demand function.
The excess demand function exhibits the gross substitution property if the demand for good |
goes up if the price of good |
0
goes up.
(a) Show that if the market excess demand exhibits the gross substitution property, an equi-
librium must be unique.
(b) Consider an exchange economy where each consumer is endowed with c
I
with c
I
_ 0 and
its preferences are represented by a utility function:
n
I
(a) =
_
1
|=1
a
|
I
_
a
|
I
_
o
i
_
1
i
, where a
|
I
0, / = 1, ..., 1,

|
a
|
I
= 1, and c
I
_ 1, c
I
,= 0.
Does the market excess demand function exhibit the gross substitution property? If not in
general, nd some sucient condition.
26. The Negishi Method. Consider an exchange economy with 1 consumers and 1 goods with dif-
ferentiable utility functions. Assume that for each `
J1
:=
_
(`
1
, ..., `
J
) _ 0 :

J
I=1
`
I
= 1
_
,
there is a unique Pareto Ecient allocation a
(`) = ( , a
I
(`) , ) which is obtained by max-
imizing the weighted utility sum
I
`
I
n
I
(a
I
) subject to
I
(a
I
.
I
) = 0, and the corresponding
supporting price vector j
(`) (that is, if n

I
(a
I
) n
I
(a
I
(`)), j
(`)a
I
j
(`)a
I
(`)). Assume
further that a
(`) and j
(`) are continuous functions of `. Set c

I
(`) := j
(`) (a
I
(`) .
I
),
and c(`) := (c
I
(`))
J
I=1
.
(a) Show that

I
c
I
(`) = 0 for any `.
(b) Show that if c
_
`
_
= 0 (i.e., c
I
_
`
_
= 0 for all i),
_
a
`
_
, j
`
__
constitutes a competitive
equilibrium.
(c) Assume that 1 = 2. Argue using a graph, that under the standard assumptions, there will
be

` such that c
_
`
_
= 0.
27. The full insurance theorem. Consider an exchange economy where each household / receives
a random endowment vector c
~
|
R
1
if state - occurs. Household /, / = 1, .., H, has utility
function

S
~=1
~
n
|
(a
~
|
) where n
|
is strictly concave, and a
~
|
is the consumption vector in state
-. Note that probability weights
~
, - = 1, .., o, do not depend on /. Assume that there is
no aggregate risk; that is, there is a vector c such that c =

1
|=1
c
|
(-) for all -. Show that
consumption does not depend on states in any Pareto ecient allocation.
28. Insurance Markets. Consider an exchange economy with H households, where each household
/ receives a random endowment vector c
~
|
R
1
if state - occurs. Household /, / = 1, .., H, has
utility function

S
~=1
~
n
|
(a
~
|
) where n
|
is strictly concave, and a
~
|
is the consumption vector
in state -. Note that probability weights
~
, - = 1, .., o, do not depend on /. Assume that there
is no aggregate risk; that is, there is a vector c such that c =

1
|=1
c
~
|
for all -.
(a) Show that the consumption does not depend on states in any Pareto ecient allocation;
that is, if a is a Pareto ecient allocation, a
~
|
= a
~
0
|
for any -, -
0
for every /.
(b) From now on, assume that o = H,and consider the sequential trade model with H assets,
where the asset / pays $1 if state - = / occurs. (i.e., these are the Arrow securities).
Assume moreover that c
~
|
= c if - = /, c
~
|
= a otherwise, where a c 0. Notice
that asset / can be interpreted as insurance for household /s income risk. Write .
~
|
for
the amount of asset - household / holds at the beginning of period 1, and there is no
consumption in period 0 (so only assets are traded).
i. Show that household / must buy the insurance for / (i.e., .
|
|
0) in any equilibrium.
ii. Does any household other than / buy insurance / in some equilibrium?
(c) Let H = o = 2, and 1 = 1, n
1
(.) = n
2
(.) = ln., c
1
= (1, 0), c
2
= (0, 1). Write
_
1
,
2
_
= (, 1 ). Consider the sequential trade model, and nd the equilibrium price
of the Arrow security which pays $1 in state -, as a function of , with normalization that
the sum of Arrow security prices is one. Also nd the price of a discount bond which pays
$1 in every state.
29. Sequential trade and asset structure. Consider an 1 -consumers exchange economy under
uncertainty, with one good in each state - = 1, ..., o. Let be a linear subspace of R
S
. Consider
the following optimization problem:
(*) max
i
n
I
(a) subject to

S
~=0
j
~
(a
~
I
.
~
I
) = 0 and
_
a
1
I
.
1
I
, ..., a
S
I
.
S
I
_
.
We say that (j, a) R
1
_
R
1
_
J
constitute an -equilibrium if every consumer i solves the
problem above at a
I
and

J
I=1
(a
~
I
.
~
I
) = 0 for - = 1, ..., o. So an Arrow - Debreu equilibrium
of this economy is an -equilibrium where = R
S
.
(a) Now consider a two period sequential trade model: in the rst period before the realization
of states, the consumers trade J assets,
_
r
1
, ..., r
, which pay in the good (that is, these

are vectors of real payos). Show that a rational expectation equilibrium of this economy
is an -equilibrium for some linear space .
(b) Establish the following converse implication as well: Given an -equilibrium, for any lin-
early independent vectors r
1
, ..., r
of real payos which span , in the economy with these

assets there is a rational expectations equilibrium with equilibrium consumption identical
to the -equilibrium consumption.
(c) Show that if two collections of linearly independent assets,
_
r
1
, ..., r
and
_
^ r
1
, ..., ^ r
^
_
of
real payos, generate the same linear subspace , then the corresponding sets of rational
expectations equilibrium consumption allocations must coincide.
22
30. No arbitrage pricing for long and short bond. Consider an exchange economy which lasts
for three periods, 1,2, and 3. There is one perishable good in each period. There are 1 consumers
and consumer i has preferences represented by a discounted sum of payos: l
I
_
a
1
I
, a
2
I
, a
3
I
_
:=
n
I
_
a
1
I
_
+an
I
_
a
2
I
_
+a
2
n
I
_
a
3
I
_
, where a 0. Each consumer i is endowed with c
I
=
_
c
1
I
, c
2
I
, c
3
I
_
.
In period 1, two assets, called o1 and 1, are traded in addition to the good. Asset o1 yields one
unit of the consumption good in period 2, and asset 1 yields one unit of the consumption good
in period 3 (but nothing in period 2 - so this is a long term bond). In period 2, one asset,
asset o2 is traded in addition to the good. Asset o2 yields one unit of the consumption good in
period 3. The net supply of any of these assets is zero. Denote by .
S1
I
, .
S2
I
, and .
1
I
the amount
of asset o1, o2, and 1 held by consumer i at the end of each respective trading period. Write
S1
,
S2
, and
1
for the price of assets in units of the good (so
S1
,
S2
corresponds short term
interest rates in periods 1 and 2, and
1
corresponds to a long term interest rate in period 1).
Then the budget constraint for consumer i in period 1 is a
1
I
+
S1
.
S1
I
+
1
.
1
I
_ c
1
I
.
For simplicity, you may assume that all the budget inequalities hold with equality at an optimum.
and you may ignore the non negativity constraint for consumption.
(a) Write the budget constraints for consumer i in period 2 and 3.
(b) Using the law of one price, derive a condition which relates
S1
,
S2
, and
1
.
(c) If in addition, an additional asset which yields one unit of the good in both periods 2 and
3 is traded in period 1, how is the price of this asset related to
S1
, and
S2
?
(d) Write the denition of a one shot (Arrow Debreu) equilibrium for this economy.
(e) If
S1
,
S2
, and
1
are dynamic equilibrium prices, what are the corresponding one shot
equilibrium prices?
31. Sequential Trade and Consumption Smoothing. There are nitely many periods, t =
0, 1, ..., T. There is a single perishable consumption good in each period t = 1, ..., T. There are
1 consumers. The preferences of consumer i, i = 1, ..., 1, is represented by a discounted sum of
utilities:

T
|=1
(c
I
)
|
n
I
(a
|
I
), where c
I
(0, 1] is a constant, n
I
is strictly increasing and strictly
concave function on [0, ), and a
|
I
is the consumption in period t. There are T trees in
this economy, and the consumption good is produced by these trees. Tree t, t = 1, ..., T, yields
j
|
0 units of the consumption good in period t, and nothing in the other periods. Thus the
total supply of the consumption good in period t is j
|
. The trees are owned by the consumers.
Initially, consumer i owns a share

0
|
I
of tree t: thus

J
I=1

0
|
I
= 1 for every t. In period 0, the
ownership shares of the trees are traded. Write j
|
for the price of the tree t share. So consumer
is income in the period 0 markets is

T
|=1
j
|
0
|
I
.
(a) Write 0
|
I
for the share of tree t which consumer i owns at the end of period 0. Thus for
instance consumer i will consume 0
|
I
j
|
units of the consumption good in period t. Write
the utility maximization problem for consumer i in period 0.
(b) Dene a competitive equilibrium for the markets of the shares. Is a competitive equilibrium
ecient?
(c) Dene an anonymous (in net trade) allocation of the shares. Is a competitive equilibrium
necessarily anonymous?
(d) Consider a new asset which promises to pay r
|
units of the consumption good in period t,
for t = 1, ..., T. How should this asset be priced in the markets?
(e) Suppose that j
|
= j for every t, and c
I
=

c for every i. Show that in any competitive equi-
librium, the consumption of any consumer is constant over time (i.e., a
|
I
will be independent
of t).
32. Consumption Smoothing Consider an economy with two periods, where a single consumption
good is available in each period. Each consumer i receives c
|
I
units of the good in period t = 1, 2.
Consumer i, i = 1, .., 1, has utility function n
I
_
a
1
I
_
+ c
I
n
I
_
a
2
I
_
where n
I
is smooth, increasing
and strictly concave, c
I
(0, 1] is a constant (discount factor) and a
|
I
is the consumption in
period t. Denote by c
|
:=

J
I=1
c
|
I
the total amount of the good available in period t. The good
cannot be stored, so the feasibility of consumption will require

J
I=1
a
|
I
= c
|
for both t = 1 and
2. There are markets where each consumer can buy/sell the good to be consumed in period t,
before these time periods. Denote by j
|
for the price of the good to be consumed in period t.
So the income of consumer i is j
1
c
1
1
+j
2
c
2
1
in the markets. You may assume an interior solution
throughout, i.e., ignore the non-negativity constraints.
(a) (5 points) Write the denition of a competitive equilibrium.
(b) (5 points) Saving is implicit in this model. Discuss briey how the rate of interest is
determined if there is a market for saving and loan.
(c) (5 points) Write the Pareto problem to nd a Pareto ecient allocation, and derive the
rst order condition for eciency, assuming an interior solution.
(d) (5 points) Suppose that utility function n
I
is the same for all the consumers, and it is
given as n
I
(.) =
1
1o
.
1o
, where c 0. (when c = 1, set n
I
(.) = ln(.)). Show that in
any competitive equilibrium, if c
I
c
then
i
2
i
i
1
i

i
2
j
i
1
j
holds, i.e., more patient consumer
consumes relatively more in the second period.
(e) (5 points) Suppose that c
I
is the same for all the consumers and that c
1
= c
2
, i.e., the total
amount of the good is constant over periods. Show that in any competitive equilibrium,
the consumption must be perfectly smoothed, i.e., a
1
I
= a
2
I
holds for every consumer i.
33. Comonotonicity of ecient risk sharing. Consider an exchange economy with a single
good and o states. Each consumer i receives a c
~
I
units of the good if state - occurs. Consumer
i, i = 1, .., 1, has utility function

S
~=1
~
n
I
(a
~
I
) where n
I
is increasing and strictly concave, and
a
~
I
is the consumption in state -. Note that probability weights
~
, - = 1, .., o, do not depend
on i. Denote by c
~
:=

J
I=1
c
~
I
the total resource available in state -.
(a) Denote by `
I
the welfare weight for consumer i, and write the welfare maximization
problem which characterizes the Pareto ecient allocations.
(b) Write the rst order condition for Pareto eciency.
(c) Show that if a is a Pareto ecient allocation, a
~
I
_ a
~
0
I
implies a
~
_ a
~
0
for all consumers.

That is, at ecient allocation, consumption is monotonic to each other (this property is
called comonotonicity).
(d) Show that consumption must be monotonic with respect to the total resource in any Pareto
ecient allocation, i.e., for every i, a
~
I
_ a
~
0
I
holds if and only if c
~
_ c
~
0
I
.
(e) Show that the set of Pareto ecient allocations is invariant with respect to the probability
assignment ; that is, an allocation is ecient for a common belief , it is ecient for any
common belief.
(f) Do the results above hold if the beliefs are not common?
34. Comonotonicity of ecient risk sharing and contingent markets. Consider an economy
with a single good and o uncertain states. Each consumer i receives a c
~
I
units of the good if
state - occurs. Consumer i, i = 1, .., 1, has utility function

S
~=1
~
n
I
(a
~
I
) where n
I
is increasing
and strictly concave, and a
~
I
~
,
- = 1, .., o, do not depend on i. Denote by c
~
:=

J
I=1
c
~
I
the total resource available in state -.
24
(a) Denote by `
I
problem which characterizes the Pareto ecient allocations.
(b) Write the rst order condition for Pareto eciency.
(c) Show that if a is a Pareto ecient allocation, a
~
I
_ a
~
0
I
implies a
~
_ a
~
0
for all consumers.

That is, at ecient allocation, consumption is monotonic to each other (this property is
called comonotonicity).
(d) Show that consumption must be monotonic with respect to the total resource in any Pareto
ecient allocation, i.e., for every i, a
~
I
_ a
~
0
I
~
_ c
~
0
I
.
(e) Show that the set of Pareto ecient allocations is invariant with respect to the probability
assignment ; that is, an allocation is ecient for a common belief , it is ecient for any
common belief.
(f) Do the results above hold if the beliefs were not common?
From now on, imagine that there are markets for the good before the uncertainty is re-
vealed
1
. Denote by j
~
the price of the good available in state -. So consumer i has
income

~
j
~
c
~
I
to spend in these markets, and the total expenditure of consumption plan
a
I
= ( , a
~
I
, ) is

~
j
~
a
~
I
.
(g) Write the denition of a competitive equilibrium in this setup.
(h) Show that a competitive equilibrium is Pareto Ecient.
(i) Suppose c
~
= c
~
0
, i.e., in states - and -
0
the total consumption good available is the same.
How
~
and
~
0
are related with j
~
and j
~
0
?
(j) Now suppose that o = 1, i.e., the number of the individuals is the same as the number of
the states. Suppose further that c
~
I
= 1 if - ,= i, and c
I
I
= 0. That is, state i is the bad state
for consumer i where his income drops to 0. Show that at any competitive equilibrium a
~
I
is independent of -, and
~
and j
~
are monotonically related. Interpret.
35. Gains from trade in general equilibrium. Consider a pure exchange economy with 1 con-
sumers and 1 goods. Denote by c R
1
++
the total endowment vector. Write a
I
=
_
a
1
I
, ..., a
1
I
_
_ 0 for consumer is consumption, and write a = (a
1
, ..., a
I
, ...., a
J
). Each consumer i is char-
acterized by utility function n
I
. Assume that utility functions are concave, dierentiable, and
1n
I
0. Answer the following questions.
(a) Write the denition of a competitive equilibrium of this economy.
We say that a feasible consumption allocation (a
1
, ..., a
J
) R
1
+
R
1
+
allows no
gains from bilateral trade, if for any pair of consumers i, , there is no . R
1
such that
n
I
(a
I
+.) n
I
(a
I
) and n
(a
.) n
(a
).
(b) Show that if a feasible consumption allocation (a
1
, ..., a
J
) is Pareto ecient, it allows no
gains from bilateral trade.
(c) Let (a
1
, ..., a
J
) be a feasible consumption allocation such that a
I
0 for each i. Show
that if (a
1
, ..., a
J
) allows no gains from bilateral trade, (a
1
, ..., a
J
) is Pareto ecient. [Hint:
express the rst order condition for no gains from bilateral trade by a constrained maxi-
mization problem.]
1
This setup is often referred to as the contingent commodity markets model.
36. An Equilibrium model for interest rate. Consider a two period economy with one per-
ishable good in each period, 0 and 1. There is a representative consumer with a concave,
dierentiable vNM utility function n and his utility is additively separable with discount factor
c (0, 1). The consumer is endowed with c
0
units of the good in period 0, and his endowment
of the good in period 1 is random, and it is represented by a random variable 1 . There is a
market for a riskless discount bond, which is a security which promises to pay one unit of good
in the second period for sure. The net supply of the bond is zero. Denote by a the amount of
the discount bond the consumer chooses to own. The price of the bond is . To sum up, the
representative consumer solves
max
i
n
_
c
0
a
_
+cEn(a +1 )
where E is the expectation with respect to 1 .
(a) Write down the rst order condition for the consumers problem.
(b) Show that a competitive equilibrium occurs when the representative consumer wants to
choose a = 0; that is, when a = 0 is chosen then both of the markets for the good in period
0 and the good in period 1 are clearing.
(c) Derive the equilibrium bond price and the interest rate of this economy.
(d) When the consumer becomes more patient, i.e., the discount factor increases, what happens
to the equilibrium bond price?
(e) When the second period endowment gets riskier, that is, the random variable 1 changes
to 1
0
and 1
0
is a riskier random variable than 1 , what happens to the equilibrium bond
price?
37. An Equilibrium model for interest rate with background labor productivity shock.
There are two periods. Your gross income is : in the rst period, part of which may be invested.
Writing a for the amount of investment, your net income in the rst period is :a. The rate
of return on the investment is r. You own 1 units of labor available in the second period. Your
utility is independent of labor, thus you will supply the whole 1 units in the labor market. But
the productivity of your labor is subject to some random shock. The shock is given by a positive
random variable 0 with E[0] = 1. Denote by n the wage per productivity unit in the labor
market, so your income from labor will be n01. To sum up, your income in the second period
is (1 +r) a + n01. Your vNM utility function for todays income is denoted by n and that for
tomorrow is denoted by , and you are interested in maximizing the sum of n and the expected
value of . Assume that both functions are smooth, increasing, and concave. You may ignore
the non-negativity condition for income throughout.
(a) (5 points) Write down the maximization problem you need to solve to determine how much
to invest.
(b) (15 points) How does your investment change for the following cases?
i. wage n goes up.
ii. labor endowment 1 increases.
iii. period 1 income : increases.
iv. the shock parameter 0 gets riskier in the sense of the second order stochastic dominance.
v. the rate of return r increases.
26
38. Equilibrium asset pricing model. Consider an economy with a single (representative) con-
sumer with concave vNM utility index n and discount factor a. There is one good in each period,
period 0 and 1. The representative consumers endowment in period 0 is n
0
R, and the total
random endowment is \ in period 1. There are J assets with zero net supply, which may be
traded before the uncertainty is resolved. Denote by 1
the (random) dividend of asset and

by j
the price of asset . The price of good is normalized to be one in each period, and also
the units of assets are normalized so that the expected dividend 1 [1
] = 1 for all assets. Thus

the problem of the consumer is to solve, given j,
max
i,
n(a) +a1
_
_
n
_
_
\ +

=1
j
_
_
_
_
subject to (5)
a +
= n
0
.
(a) Assume that the rst order condition is sucient for utility maximization. Write the FOC.
(b) Since there is a single consumer and assets are in zero net supply, j
= 0 must hold in a
competitive equilibrium. Find the equilibrium price j
of asset .
(c) Note that for any random variables A and A, we have 1 [A1 ]1 [A] 1 [1 ] = CO\ [A, 1 ],
where CO\ indicates the covariance. Using this relation, re-write the equilibrium pricing
formula above.
(d) Now assume that utility function is quadratic, n(a) = aa
1
2
a
2
, where a is positive. Re-
write the formula you obtained above. Among those assets and asset / have the same
expected dividend. at type of assets tend to have high market price?
39. Equilibrium asset pricing model. Consider an economy with a single (representative) con-
sumer with concave vNM utility index n and discount factor a. There is one good in each period,
period 0 and 1. The representative consumers endowment in period 0 is n
0
R, and the total
random endowment is \ in period 1. There are J assets with zero net supply, which may be
traded before the uncertainty is resolved. Denote by 1
the (random) dividend of asset and

by j
the price of asset . The price of good is normalized to be one in each period. Thus the
problem of the consumer is to solve, given j,
max
i,
n(a) +a1
_
_
n
_
_
\ +

=1
j
_
_
_
_
subject to (6)
a +
= n
0
.
(a) Find the equilibrium price of asset .
(b) From now on, assume 1
1
= 1 for sure; that is Asset 1 is riskless. Suppose the random
endowment \ improves in the sense the new random endowment \
0
rst order stochas-
tically dominates the original \. What will happen to the price of asset 1? Can you say
anything about the prices of the other assets?
(c) Suppose the random endowment \ improves in the sense the new random endowment
\
0
second order stochastically dominates the original \, i.e., the endowment is less risky.
Assume in addition that n
000
0. What will happen to the price of asset 1? Can you say
anything about the prices of the other assets?
40. Consider an agent with concave vNM utility function n. His total wealth is \ and he can invest
(save) in a riskless or a risky asset. The riskless asset pays 1 per unit in the next period and costs
1
per unit in this period. The risky asset pays r with probability 1 j and r with probability
j, and it costs
2
. Denote by j
1
(resp. j
2
) his demand for the riskless (resp. risky) asset.
(a) Write the budget constraint, for the case where short sales is allowed (i.e., he can hold a
negative amount of asset), and for the case it is not.
(b) What is the relationship between
1
and interest rate?
(c) Assuming short sales are allowed, show that assets are normal goods.
(d) Suppose he owns one unit of each asset. So his initial wealth is
1
+
2
. Suppose further
that he is the only trader in the markets (i.e., he is a representative trader (consumer).
Find the equation that characterizes the equilibrium asset prices.
(e) Assume n(.) = .
1
.
2
. Find the capital asset pricing formula in the question above.
41. Risk sharing. Consider an economy with 1 agents. Each agents preferences are represented
by a vNM utility function n
I
. Assume that each n
I
satises n
0
I
0 and n
00
I
< 0. The aggregate
income of this economy is denoted by j 0, and it will be distributed among the agents. Denote
by a
I
(j) _ 0 the income the agent i receives when the aggregate income is j, so

I
a
I
(j) = j
must hold. For simplicity, suppose that there are only nitely many possible aggregate income
levels, j
1
, , j
1
and denote by j (j
|
) 0, / = 1, ..., 1, the probability that the aggregate
income is j
|
(so

1
|=1
j (j
|
) = 1).
(a) Assume 1 = 1 = 2. So the utility of agent i, i = 1, 2, can be written as n
I
(a
I
(j
1
)) j (j
1
) +
n
I
(a
I
(j
2
)) j (j
2
).
i. Let j
1
j
2
. Think of a
I
(j
|
) as consumption of good /, and draw an Edgeworth box
which represents feasible income distributions among the agents. Explain graphically
the conditions a Pareto ecient allocation must satisfy.
ii. Show that if j
1
= j
2
, a
I
(j
1
) = a
I
(j
2
) must hold for both i, for any Pareto ecient
allocation.
(b) Now assume 1 2, 1 2. So agent i receives a vector of income a
I
:= (a
I
(j
|
))
1
|=1
, which
yields the expected utility l
I
(a
I
) :=

1
|=1
n
I
(a
I
(j
|
)) j (j
|
)
i. Give the denition for a feasible allocation a :=
_
, (a
I
(j
|
))
1
|=1
,
_
. Give the
denition of a Pareto ecient allocation, which does not rely on special properties of
utility functions such as dierentiability.
ii. Fix `
I
0, i = 1, ..., 1, and write the Pareto maximization problem of weighted sum of
expected utility functions,

J
I=1
`
I
l
I
, and derive the rst order condition for Pareto
eciency for interior points.
iii. Assume that n
I
(.) =
1
1
i
.
1
i
where where
I
is a positive constant, for every agent
i. Show that if a =
_
, (a
I
(j
|
))
1
|=1
,
_
is Pareto ecient, then a
I
(j
|
) = a
I
j
|
for
/ = 1, ..., 1 where a
I
0 is a constant.
42. Contingent commodities and risk sharing. Consider an exchange economy with a single
good and o states. Each consumer i receives c
~
I
units of the good if state - occurs. Consumer
i, i = 1, .., 1, has utility function

S
~=1
~
n
I
(a
~
I
) where n
I
is smooth, increasing and strictly
concave, and a
~
I
~
, - = 1, .., o, do
not depend on i. Denote by c
~
:=

J
I=1
c
~
I
the total resource available in state -. Assume an
interior solution throughout, i.e., ignore the non-negativity constraints.
28
(a) Suppose that there are competitive markets for the contingent consumption goods. That
is, each consumer can buy/sell the good to be consumed in state -. Denote by j
~
for the
price of the good to be consumed in state -, so the income for consumer i is

S
~=1
j
~
c
~
I
.
Give the denition of a competitive equilibrium in these markets.
(b) Denote by `
I
problem which characterizes the Pareto ecient allocations, and write the rst order
condition for Pareto eciency.
(c) Show that if a is a competitive equilibrium allocation, then a consumer with a higher
income consumes more in every state: that is, if j is an equilibrium price and a is the
corresponding consumption allocation,

S
~=1
j
~
c
~
I

S
~=1
j
~
c
~
implies a
~
I
a
~
at every -.
(d) Show that in any Pareto ecient allocation a, the consumption must be monotonic with
respect to the total resource, i.e., if a is a competitive equilibrium allocation, for every i,
a
~
I
_ a
~
0
I
~
_ c
~
0
I
.
43. Consider an economy as follows. There are two consumers, i = 1, 2. There are two periods, and in
each period, consumers trade a single, perishable commodity (i.e., they cannot store the good).
There is no uncertainty. Consumer is preferences are represented by n
I
_
a
0
I
, a
1
I
_
= lna
0
I
+c
I
lna
1
I
where c
I
(0, 1) is a constant. Each consumer is endowed with one unit of the good in each
period. Thus consumers preferences are identical, except for the discount factor c
I
. The price
of good is normalized to be 1 in both periods. In period 0, consumers can save: denote by -
I
the
amount that consumer i saves in period 0. Let r be the interest rate. That is, if consumer i saves
-
I
units of the good, he receives (1 +r) -
I
units of good at the beginning of period 1 before the
trade of the consumption good takes place. Hence consumer i chooses
_
a
0
I
, a
1
I
, -
I
_
R
+
R
+
R.
Notice that negative saving, i.e., borrowing is allowed.
(a) Write the consumer i s budget constraint.
(b) For each i, derive the saving function -
I
(r), that is, -
I
(r) is the amount of good consumer
i saves in period 0 when the interest rate is r.
(c) Show that when the saving market clears, i.e., -
1
(r) + -
2
(r) = 0, the good market clears
in both periods 0 and 1.
44. no gains from bilateral trade. Consider a pure exchange economy with 1 consumers and 1
goods. Each consumer i is characterized by utility function n
I
and endowments c
I
=
_
c
1
I
, ..., c
1
I
_
.
Write a
I
=
_
a
1
I
, ..., a
1
I
_
_ 0 for consumer is consumption, and write a = (a
1
, ..., a
I
, ...., a
J
).
Denote by j =
_
j
1
, ..., j
1
_
the prices of goods. Assume that utility functions are concave,
dierentiable, and 1n
I
0. Answer the following questions.
(a) Write the denition of a competitive equilibrium of this economy.
We say that a feasible consumption allocation (a
1
, ..., a
J
) R
1
+
R
1
+
allows no
gains from bilateral trade, if for any pair of consumers i, , there is no . R
1
such that
n
I
(a
I
+.) n
I
(a
I
) and n
(a
.) n
(a
).
(b) Show that if a feasible consumption allocation (a
1
, ..., a
J
) is Pareto ecient, it allows no
gains from bilateral trade.
(c) Let (a
1
, ..., a
J
) be a feasible consumption allocation such that a
I
0 for each i. Show
that if (a
1
, ..., a
J
) allows no gains from bilateral trade, (a
1
, ..., a
J
) is Pareto ecient. [Hint:
express the rst order condition for no gains from bilateral trade by a constrained maxi-
mization problem.]
45. [core (non)-convergence] Consider an economy with two goods, two consumers. The con-
sumers 1 and 2 have an identical utility function n
I
_
a
1
I
, a
2
I
_
= min
_
a
1
I
, a
2
I
_
, and their endow-
ments are (2, 1) and (1, 2), respectively.
(a) Find the core of this economy (you may answer graphically).
(b) Suppose that this economy is replicated. What will happen to the core?
46. [Replica economy] Consider an economy with two goods, two types of consumers. The type 1
and 2 consumers have an identical utility function n
I
_
a
1
I
, a
2
I
_
= lna
1
I
+ lna
2
I
, and their endow-
ments are (8, 2) and (2, 8), respectively.
(a) Verify that the allocation a
1
= (4, 4), a
2
= (6, 6) belongs to the core of the two consumers
exchange economy where there is one consumer of each type.
(b) Suppose that this economy is replicated once so that there are two consumers of each
type. Show that the allocation where type one consume a
1
= (4, 4), and type 2 consume
a
2
= (6, 6) is not in the core of this economy.
47. [fair allocation] Consider an exchange economy with 1 consumers and 1 goods, where the total
endowments of goods is . 0. A feasible allocation a = ( , a
I
, ) is called envy-free if
for any i and , n
I
(a
I
) _ n
I
(a
). A feasible allocation is called a fair allocation if it is Pareto

ecient and envy-free.
(a) Give an example where a competitive equilibrium allocation is not a fair allocation.
(b) Show that under the standard assumptions, there exists a fair allocation.
48. [Matching] There are two types of agents, type M and type F. There are three type M agents
and four type F agents, and consider make pairs of one M agent and one F agent. A matching
is a function j : 1, 2, 3 1, 2, 3, 4 where j(i) is the type F agent to whom type M agent i
is paired with. Every type M agent wants to be paired with some F agent while some F agent
prefers not being paired at all to being matched with some agent. Type M agents preferences
over type F agents as well as Type F agents preferences over M agents are given in the following
two tables (0 means not being paired):
M agents name
1 1 2 3 4
2 1 3 4 2
3 1 4 2 3
F agents name
1 3 2 0 1
2 1 3 2 0
3 1 2 0 3
4 1 2 3 0
For instance, M agent 1 prefers F1, F2, F3 and F4 in this order, and F agent 1 prefers M3, M2,
but she would rather not matched than paired with M1.
(a) Give the denition of an ecient matching.
(b) Consider j(i) = i, i = 1, 2, 3. Is this ecient?
(c) Consider j(1) = 2, j(2) = 3, j(3) = 1. Is this ecient?
(d) Find all the ecient matchings.
30
7 Strategic Market and Game theory
7.1 Nash Equilibrium of strategic form games
1. In a game in strategic form, a strategy -
I
o
I
is strictly dominated if there is a strategy -
0
I
o
I
such that n
I
(-
I
, -
I
) < n
I
(-
0
I
, -
I
) for all -
I
o
I
. A strategy is said to be weakly dominated
if if there is a strategy -
0
I
o
I
such that n
I
(-
I
, -
I
) _ n
I
(-
0
I
, -
I
) for all -
I
o
I
, where <
holds for some -
I
o
I
.
(a) Show that a strictly dominated strategy cannot be part of a Nash equilibrium strategy
prole.
(b) Give a 2-person game example where there is a Nash equilibrium in which both players
choose weakly dominated strategies.
2. Find all (i.e., pure and mixed) Nash equilibria of the following two person games.
(a)
L R
T (2, 2) (0, 0)
B (0, 0) (1, 1)
(b)
L C R
T (2, 2) (1, 3) (1, 0)
M (1, 1) (2, 0) (1, 2)
B (0, 1) (1, 2) (1, 1)
(use the domination argument as much as possible)
(c)
L R
T (., 1) (1, 1)
B (1, 1) (1, 1)
,
where . is a positive number. Observe that the equilibrium strategy of ROW player is
independent of .! Interpret.
3. A $100 bill is to be sold in a simple second price auction with 1 participants. Formulate this as
a game in strategic form, and show that bidding $100 is a weakly dominant strategy but not a
strictly dominant strategy.
4. Show that in a nite strategic form game, a mixed strategy o
I
of a player is a best response to
other players strategy prole o
I
if and only if o
I
(-
I
) = 0 for any pure strategy -
I
o
I
that
is not a best response to o
I
. Consider a game in strategic form, represented by the following
table.
player 2
a / c d
a (2, 2) (1, 1) (1, 0) (1, 1)
player 1 j (1, 1) (2, 4) (0, 5) (3, 0)
. (0, 1) (5, 2) (5, 3) (1, 3)
Answer the following questions about this game. For questions (a) to (g), you do not have
to explain your answers.
(a) How many strategy proles are there?
(b) Is Strategy a is a dominant strategy?
(c) Is Strategy a is a dominant strategy?
(d) Is Strategy d is a dominated strategy?
(e) Is Strategy / is a best response to strategy a?
(f) Is there any strategy for which a best response is not unique?
(g) Does iterative deletion of dominated strategies result in a single strategy prole?
(h) Find all Nash equilibria of this game.
(i) Now consider mixed strategies as well. Find all mixed strategy equilibria of this game, if
any, which are dierent from the Nash equilibria you found above.
5. Mixed Strategy. Consider a sporting contest between two players, row and column. So either
row wins or column wins, not both. If loose, the player receives 0 yen. If row wins, he receives
a yen (a 0) and if column wins, he receives j yen (j 0). So, this strategic situation is
characterized by the following matrix.
1 1
l
(1
11
, j)
(
11
, a)
(1
12
, j)
(
12
, a)
1
(1
21
, j)
(
21
, a)
(1
22
, j)
(
22
, a)
where for instance if row plays l and column plays 1, row wins a with probability
11
. It is
assumed that
11

21
and
12
<
22
. Rows vNM utility index is n and columns vNM utility
index is , and we normalize n(0) = (0) = 0. Hence for instance if row plays l and column
plays 1, row receives an expected utility of
11
n(a).
(a) Show that there is no pure strategy Nash equilibrium.
(b) Write j for the chance row plays l, and denote by the probability column plays 1. When
the players choosing these mixed strategies, write the expected utility of playing l for the
row player.
(c) Write all the conditions that j and must satisfy in a mixed strategy equilibrium.
(d) Show that an equilibrium strategy prole of this game does not depend on a and j (thus
the equilibrium play of this sporting event is invariant of the size of prize).
6. A $100 bill is to be sold in a rst price auction with 2 participants. Formulate this as a game
in strategic form, and show that there is no Nash equilibrium in pure strategy but there is a
(symmetric) mixed strategy equilibrium.
7. Nash Demand Game. Consider the following demand game of two players. Each of two
players announces the share -
I
[0, 1] he demands out of an amount of money that may be split
between them. If both of the demands can be satised, i.e., if the sum of the demanded amount
does not exceed one, then the money is split as is demanded. If not, neither player receives any
money, which shall be referred to as a disagreement.
(a) Describe this game formally.
(b) Show that any prole (-
1
, -
2
) with -
1
+-
2
= 1 is a Nash equilibrium.
32
(c) Is (1, 1) a Nash equilibrium?
(d) Show that a prole (-
1
, -
2
) with -
1
< 1 and -
2
< 1 such that -
1
+ -
2
,= 1 is not a Nash
equilibrium.
(e) Let - be a number with 0 < - <
1
2
. Show that there is a mixed strategy equilibrium where
both players randomly demand - or 1 -.
(f) Notice that in the mixed strategy equilibrium above, a disagreement occurs with posi-
tive probability. Prove that in any mixed strategy equilibrium (i.e., at least one player
randomizes his strategy) a disagreement must occur with a positive probability.
(g) Show that any mixed strategy equilibrium is Pareto dominated by a pure strategy equilib-
rium (i.e., there is a pure strategy equilibrium where each player receives a payo higher
than his expected payo in the mixed strategy equilibrium).
7.2 Simple Models of Strategic Competition
1. Cournot Competition. There are two identical rms with constant marginal cost of produc-
tion c. The total demand for the product is given by = a /j, where a, / 0 are constants.
Each rm , = 1, 2, freely determines the quantity
to produce.
(a) Formulate this problem as a strategic form game.
(b) Find a Nash equilibrium. Is it in dominant strategies?
(c) Find quantity
1
per rm that maximizes the sum of prots of the two rms. The formulate
a strategic form game where each rm can choose either
1
or the quantity you found in
( 1b) above. Find a Nash equilibrium of this game. Is it in dominant strategies? Discuss.
2. Cournot Competition and iterative deletion of dominated strategies. There are two
identical rms with constant marginal cost of production 0. The total demand for the product
is given by = 1 j. Each rm , = 1, 2, freely determines the quantity
to produce.
(b) Find a Nash equilibrium. Is it in dominant strategies?
(c) Find dominated strategies. (Hint. Will the rm ever produce less than a monopoly rm
produces?)
(d) Assuming that the other rm will never choose a dominated strategy, nd dominated
strategy. (Hint. If a rm is sure that the other rm never produces more than the monopoly
amount, it should produce some positive amount.)
(e) Repeat this process of iteratively eliminating dominated strategies What do you get in the
limit?
3. Bertrand Competition. There are two identical rms with constant marginal cost of produc-
tion c. The total demand for the product is given by = a /j, where a, / 0 Each rm freely
sets its price, but if they set dierent prices, every consumer chooses to buy the product from
the rm with the cheaper price. The demand will be split evenly if the prices are the same.
(b) Find a Nash equilibrium.
4. Price competition with capacity constraint. In the setting in (3), we shall assume that
each rm , = 1, 2, can sell only up to a preset capacity limit /
0. When rm sets a
higher price j
than that of the other rm, rm does not necessarily lose all the demand if the
other rm is selling at its capacity /
I
. In such a case, demand for rm is the residual demand
1 /
I
j
. To simplify computation, set a = / = 1 for the demand function, and c = 0 for the
marginal cost.
(b) Show that if /
1
_ 1 and /
2
_ 1, j
1
= j
2
= 0 constitute a Nash equilibrium.
(c) Show that j
1
= j
2
= 0 is not a Nash equilibrium if /
1
< 1 or /
2
< 1.
(d) Assume /
1
= /
2
=
1
3
. Find a Nash equilibrium.
5. Monopolistic Competition. There are two rms, 1 and 2, with constant marginal cost of
production c
, 0 < c
< 1, = 1, 2. Each rm sets the price j
of its own product. The

demand for rm s product is given by
= 1 j
, where
are positive constants,

= 1, 2, and j
is the price of the other rms product.

(b) Find a Nash equilibrium.
(c) Do comparative statics on
. Discuss.
6. Free Rider Problem. Consider a community with 2 individuals. Each individual owns 1 unit
of a consumption good. Individual is utility depends on private consumption of the good as
well as the amount of public good available in the community. Specically, individual is utility
is a
I
+ j, where a
I
is the amount of the good privately consumed, and j is the amount of the
public good. The public good can only be produced from the consumption good: from . units of
the consumption good, ) (.) units of the public good can be produced. So when each individual
i decides to consume a
I
units of the consumption good privately, ) (2 (a
1
+a
2
)) units of the
public good is produced. Assume that ) (0) = 0, )
0
0, and )
00
< 0. Each individual i chooses
a
I
strategically, and negative consumption is not allowed.
(a) Dene a feasible allocation of the consumption good and the public good; that is, describe
(a
1
, a
2
, j) which can be achieved in this community. Then write the denition of a Pareto
ecient allocation of this community.
(b) Assume that )
0
(2)
1
2
. Find all Pareto ecient allocations.
(c) Will a Pareto ecient allocation be realized when )
0
(2)
1
2
? Explain.
(d) Will a Pareto ecient allocation be realized when )
0
(0) <
1
2
? Explain.
7. Consider a community with 2 individuals. Each individual owns 1 unit of consumption good.
Individual is utility depends on private consumption of the good as well as the amount of public
good available in the community. Specically, individual is utility is a
I
+ j, where a
I
is the
amount of good privately consumed, and j is the amount of the public good. The public good
can only be produced from consumption good: from . units of consumption good, ) (.) units
of public good can be produced. So when each individual i decides to consume a
I
units of the
consumption good privately, ) (2 (a
1
+a
2
)) units of public good is produced. Assume that
) (0) = 0, )
0
0, and )
00
< 0, and )
0
(0)
1
2
)
0
(2) . Negative consumption is not allowed.
(a) Dene a feasible allocation of consumption good and public good, and write the denition
of a Pareto ecient allocation of this community.
34
(b) Find the rst order condition which characterizes Pareto ecient allocations.
(c) Consider a game where both individuals simultaneously choose a
1
and a
2
. Give the den-
ition of a Nash equilibrium of this game.
(d) Is a Nash equilibrium Pareto ecient? Why?
(e) Consider a game where the game above is repeated twice as follows: in each of the periods,
each individual is endowed with one unit of consumption good, and simultaneously choose
private consumption level. The utility is a discounted sum of utilities with discount factor
a (0, 1). Is there a subgame perfect Nash equilibrium where the rst period allocation
or the second period allocation are ecient? Why?
8. Eciency loss by campaigning. players compete for an award by campaigning. The
award is worth if acquired, and 0 if not. If a
I
hours are spent for campaigning by player
i, i = 1, ..., , player is chance of getting the award is a
I
=1
a
(by assumption it is 0 if
nobody campaigns). The cost of campaigning is c per hour. So player is expected benet from
campaigning a
I
hours is
.i
i
P
N
j=1
i
j
ca
I
.
(a) Find a symmetric Nash equilibrium.
(b) What will happen when increases for campaigning hours in the equilibrium above?
(c) Suppose that a player is selected at random, and give the award to the selected player.
Argue that this rule is better than the competitive campaign as far as the total welfare is
concerned. What about by the Pareto criterion?
(d) Suppose that the award is valued dierently across the players, i.e., the value of the award
to player i is
I
. How would you modify the answer to the question above?
9. An Exhaustible Resource Commons Problem. (Dutta) Suppose two players, 1 and 2,
share a xed supply of j sh. Each player lives for exactly two periods. In the rst period, each
player i can consume a non-negative amount of sh, c
I
, provided that c
1
+c
2
_ j. In the second
period, any remaining sh, j c
1
c
2
, are divided equally between the players. Player is utility
is given by
n
I
(c
I
, c
I
) = lnc
I
+ ln
_
j c
1
c
2
2
_
,
where lna is the natural logarithm of a. By convention, utility is if consumption of sh is
zero in the second period.
(a) Consider this as a simultaneous move game where each player chooses a strategy -
I
such
that 0 _ -
I
< j (that is, choosing -
I
= j is not possible). If -
1
+ -
2
_ j then c
I
= -
I
, but
if -
1
+-
2
j then c
1
= c
2
= j2. Find each players best response rule and nd the Nash
equilibrium of the game.
(b) Suppose that a central planner can set c
1
and c
2
(subject to c
1
+ c
2
_ j). Assume the
planner aims to maximize social welfare given by n
1
+n
2
. Find her choice of c
1
and c
2
.
Now consider an analogous situation with players. Player is utility is now given by
n
I
(c
I
, c
I
) = lnc
I
+ ln
_
j c
1

6=I
c
_
where

6=I
c
is the sum of other players rst period consumptions.

(c) Consider the corresponding -player game where 0 _ -
I
< j, as before, and
c
I
=
_
-
I
if

I
-
I
_ j
j otherwise
Find the Nash equilibrium. What happens to total sh consumption in the rst period as
goes to innity? Give an intuition.
(d) Consider the social planner who aims to maximize the sum of the players utilities:

I
n
I
.
What c
I
s will she choose? Compare your answer to part (b) and give an intuition.
(e) How do the Nash and social welfare maximization outcomes compare when = 1? Give
an intuition.
(f) Compare all your answers above to Cournot competition. Comment briey.
7.3 Dynamic games and commitment
1. A dynamic oligopoly game. There are three rms, 1, 2, and 3 producing a consumption
good whose inverse demand is given by j = 1 Q. Each rm , = 1, 2, 3, chooses quantity
as a strategic variable. The marginal cost of production is zero.

(a) Suppose three rms choose quantities simultaneously. Find a Nash equilibrium.
(b) Suppose that the decisions are made sequentially by rms 1, 2, and 3 in this order. That is,
after rm 1 chooses
1
, rm 2 chooses
2
observing
1
, and so on. Find a Nash equilibrium
consistent with the backward induction principle.
(c) Suppose that after rm 1 chooses its quantity, rms 2 and 3 choose their quantities simul-
taneously. Thus at the time of decision making both rms 2 and 3 know
1
but do not
know each others choice of quantity. Find a subgame perfect Nash equilibrium.
(d) Suppose that rm 1 chooses its quantity after rms 2 and 3 choose their quantities simul-
taneously. Thus rm 1 knows
2
and
3
, but rms 2 and 3 must decide without knowing
any other rms decision. Find a subgame perfect Nash equilibrium.
2. A dynamic oligopoly game with a global player: Consider two countries, 1 and 2. There
is one domestic rm in each country. There is one global rm, which operates in both countries.
These rms produce an identical good at zero marginal cost. Demand for the product is given
by an inverse demand function j = 1 in each county (so the demand is identical). Denote
by
1
and
2
the quantity produced by the domestic rms in country 1 and 2, respectively, and
denote by
C
1
and
C
2
the quantities the global rm produces in country 1 and 2, respectively.
The price of the good in a country is determined by the demand and the supply in the domestic
market: for instance, the price of good in country 1 will be 1
_
1
+
C
1
_
. The global rm
maximizes the sum of prots in the two countries. (You may take it for granted that a solution
to max
i
(a a) a is a =
o
2
)
(a) (5 points) Suppose that the rms behave strategically a la Cournot. Find equilibrium
quantities ^
1
,^
2
, and
_
^
C
1
, ^
C
2
_
.
(b) (5 points) Suppose that the global rm is the leader in both countries: that is, the global
rm chooses
_
^
C
1
, ^
C
2
_
and then the domestic rms make their decisions. Find quantities
each rm produces in equilibrium.
36
(c) (5 points) Suppose that the global rm is a follower in both countries, and moreover it
must produce exactly the same amount due to some technical reasons. That is, after
1
and
2
are chosen,
C
1
=
C
2
=
C
is chosen. Find an equilibrium strategy prole as well as
the equilibrium quantities induced by the prole.
(d) (10 points) Suppose that the rms behave strategically a la Cournot as in (a), but suppose
that the global rm (but not the domestic rm) is taxed in both countries as follows: rst,
each country i x a per unit tari t
I
on the global rm, and then the rms compete a la
Cournot fashion. Thus the global rm must pay t
I
C
I
to country is tax oce.
i. Find equilibrium quantities after (t
1
, t
2
) is selected.
ii. The tax oce in country i is interested in the welfare in country is consumers and its
domestic rm as well as the tax revenue. Show that there is a dominant strategy for
each countrys tax oce.
3. Entry deterrence. Consider two rms, Incumbent and Entrant. Both rms can produce a
consumption good with a constant marginal cost c, 0 _ c < 1. The inverse demand for the
good is given by 1 Q, where Q is the total production of the good. Entrant however incurs a
xed entry cost 1 _ 0 if it chooses to produce. Denote by
J
and
J
the level of production of
Entrant and Incumbent, respectively.
(a) Suppose that once Entrant pays the entry cost, both rms will compete in the Cournot
fashion.
i. Find a subgame perfect equilibrium in which Entrant does enter, when 1 is small
enough.
ii. Find a subgame perfect equilibrium where Entrant chooses not to enter if 1 is large.
iii. Is subsidizing entry cost 1 (thus Entrants eective cost for entry is zero) a good policy
from the point of view of social welfare?
(b) Suppose that Incumbent can commit to its quantity produced
J
before Entrant makes its
entry decision, and its level of production.
i. Let 1 = 0. Find a subgame perfect equilibrium.
ii. Let 1 0. Will Incumbent produce more than the amount for the case of 1 = 0? If
so, why? [in this example this is going to be a degenerate case]
iii. Is subsidizing entry cost 1 (thus Entrants eective cost for entry is zero) a good policy
from the point of view of social welfare?
(c) Suppose that Incumbent can invest to reduce its marginal cost of production to 0, before
Entrant makes its entry decision. The xed cost of the investment is c 0. Once entry
takes place, both rms compete a la Cournot.
i. Show that if c is small and 1 is large, there is a subgame perfect equilibrium where
Incumbent invests, and Entrant does not enter.
ii. Is the cost reducing investment above socially desirable?
4. Imagine a developer building houses near a lake. There are two periods, t = 1 and 2. In each
period, the developer can construct houses, and the construction cost per unit is c 0. Denote
by a
|
the total unit the developer chooses to construct in period t. Also denote by j
|
the price of
house in period t which the developer determines. The developer is interested in the discounted
sum of prots with discount factor a, 0 < a _ 1. That is, the developer maximizes the sum of
period 1 prot and a times period 2 prot. Because of nancial reasons, the developer must
sell all units of houses in the period they are built. In other words, unsold houses at the
end of period t = 1 will be conscated without compensation and so the houses to be sold in
period 2 must be constructed in period 2.
In each period, after houses are constructed, many potential buyers come to see the houses.
Each buyer buys at most one unit, and the house cannot be sold later for other buyers. Also,
a buyer who comes in period 1 cannot choose to come back in period 2. That is, it is assumed
that a buyer who comes in period 1 cannot wait till period 2 for a bargain. If a potential buyer
buys a house, his payo (in terms of money) is a (a
1
+a
2
), where a is a positive constant
with a c. If he does not buy a house, his payo is 0. Note that in period 1, the second period
houses are yet to be constructed, thus the buyers decision will depend on the expectation of a
2
.
Assume that if a buyer is indierent between buying a house and not buying, he will buy. Also
assume that if the demand for the houses exceeds the supply of the houses then the buyers will
be rationed (say by a lottery). Assume that a
|
s are real numbers to simplify the question.
(a) Note that the payo from a house depends is decreasing in the sum of houses a
1
+ a
2
.
Interpret this assumption in economic terms.
(b) Suppose that a
1
units have already been sold in period 1.
i. Consider the stage where the developer has constructed a
2
units of houses. So, each
buyers payo from a house is a ( a
1
+a
2
), so all the a
2
houses will be sold if and
only if j
2
_ a ( a
1
+a
2
). What j
2
should the developer choose?
ii. Find the number of houses a
2
the developer constructs.
(c) Suppose that at the beginning of period 1, the developer can somehow convince the buyers
that the number of houses sold in the next period will be ^ a
2
, and assume that the developer
keeps his promise and construct ^ a
2
units of houses in the second period.
i. If the developer wishes to sell a
1
units of houses in period 1, what will be the prices of
houses in period 1 and period 2?
ii. What will be the number of houses constructed in period 1?
iii. Find ^ a
2
which maximizes the total prot.
iv. In the solution above, will the developer has incentive to construct ^ a
2
units in period
2, after the rst period houses are all sold?
(d) Suppose that the developer cannot commit to the number of houses to be constructed in the
second period, thus the buyers will take into account what the developer will do in period
2. How many houses will be constructed in period 1, and what will the total number of
houses?
5. Trade war. Consider two countries, 1 and 2. There is one domestic rm in each country and
they produce an identical good at zero marginal cost. Demand for the product is given by an
inverse demand function j = 1 in each county (so the demand is identical). Denote by
1
and
2
the quantity produced towards the domestic market in each country and denote by c
1
and c
2
the quantity exported form country 1 and 2 to the other country. So for instance the
price of good in country 1 will be 1 (
1
+c
2
).
(a) Suppose the rms behave as price takers, and there is no international trade. Find the
equilibrium production level for each country.
(b) Suppose the rms behave strategically a la Cournot. That is, rm 1 maximizes the sum
of prots from country 1 and 2 by changing
1
and c
1
, given
2
and c
2
, for instance. Find
equilibrium quantities
I
, c
I
, i = 1, 2.
38
(c) Consider the following game: rst, each country i x a per unit tari t
I
on import, and
then the rm compete a la Cournot fashion. Thus for instance the rm in country 1 must
pay t
2
c
1
to country 2s tax oce. Solve this game by rst nding the second stage (i.e.,
the game where (t
1
, t
2
) is already selected) equilibrium.
(d) Suppose that each countrys tax oce is interested in the social welfare, dened as (con-
sumer surplus) + (prots of domestic rm) + (tari revenue). Finding a pair of tari
(t
1
, t
2
) which arises in a subgame perfect equilibrium of the game where taris are set rst,
and then the rms make decisions as in (5c).
6. Ination targeting. Consider two players, the public (P) and the monetary authority (M).
The payo of P is given by (
t
)
2
, where
t
is the expected rate of ination held by P
and is the actual rate of ination. The payo of M is given by
2
(j j)
2
, where j is
the realized GDP of the economy and j is the natural (full employment) level of GDP. That
is, ination as well as over/under production are costly to M. Suppose that there is a trade-o
between the rate of ination and GDP (i.e., a Phillips curve) given by (c j j) + (
t
) = 0
where 0 < c _ 1 is a constant, and this relation is known to the both players. So if c < 1, the
full employment GDP can be realized only with a surprise ination, i.e.,
t
0.
(a) Suppose P selects
t
and M controls simultaneously. Find a Nash equilibrium of this
game.
(b) Suppose P moves rst. That is, M can select the rate of ination after observing the
expected rate of ination. What happens?
(c) Suppose M moves rst. That is, M can commit to its target rate of ination before P
forms its expectation. What happens?
7. Alternative for prot maximization. Consider two rms, 1 and 2, producing an identical
good at marginal cost c (suciently low, say c < 1). The demand for the product is given by
j = 1. The quantity produced
1
and
2
by the rms 1 and 2 are simultaneously determined.
But for each rm, the production decision is done by a manager who is independent of the
owner of the rm; that is, the managers hired by the rms decide
1
and
2
. The rm needs
to pay for the manager, thus the total cost of production from the view point of the rm is c
plus the payment to the manager. The manager of rm is paid times c
(revenue of rm
)+(1 c
) (prots of rm ), where is a given parameter which is determined exogenously

in labor market and c
[0, 1] is determined by the owner of rm before production takes

place: that is, c
1
and c
2
are chosen simultaneously by the owners who want to maximize the
rms prot, and then
1
and
2
are chosen by the managers simultaneously. For instance if
the revenue of rm i is 1 and prot is , the manager of rm i is paid (c
I
1 + (1 c
I
) ).
So if c
= 0, the manager of rm wants to maximize the prot of the rm, but otherwise
he may not be interested in prot maximization. If c
= 1 the manager wants to maximize

the revenue, so the rm will look as if it adopts revenue maximization rule. The parameter
represents the share of managerial labor, but in what follows lets assume is negligibly small
from the viewpoint of the rm. Thus when you compute the rms prot, ignore the payment
to the manager.
(a) How much will the managers choose to produce after (c
1
, c
2
) have been set (and the pair
(c
1
, c
2
) is mutually observable)?
(b) Suppose that c
1
and c
2
are chosen simultaneously. What will happen?.
(c) Suppose that rm 1 choose c
1
rst and then rm 2 choose c
2
. What will happen?
8. (30 points) Consider two rms, 1 and 2, producing an identical good at constant marginal cost
c = 1. The inverse demand for the product is given by j = 2 . The rms simultaneously
determine their quantity produced
1
and
2
. Suppose that for each rm, the production deci-
sion is done by a manager who is independent of the owner of the rm. The rm needs to pay
for the manager, thus the total cost of production from the view point of the rm is c
(=
)
plus the payment to the manager. The manager of rm is paid times c
(revenue of rm
)+(1 c
) (prots of rm ), where 0 is a given parameter which is determined exoge-

nously in labor market and c
[0, 1] is determined by the owner of rm before production

takes place. For instance, if the rm s revenue is 1
and prot (= revenue minus cost) is
,
the manager of rm receives (c
+ (1 c
). The manager of rm will chooses
in
such a way to make this number as large as possible. So if c
= 0, the manager will be interested

in maximizing the prot, and if c
= 1, he will be interested in maximizing the revenue. The

parameter represents the share of managerial labor, but in what follows lets assume is neg-
ligibly small from the viewpoint of the rm. Thus when you compute the rms prots, ignore
the payments to the managers. That is, for each rm , assume that 1
= (2
1

2
)
and
= 1
. Firm is interested in maximizing
.
(a) (2 points) Show that the payo for the manager of rm 1 is
1
((1 +c
1
)
1

2
) .
(b) (2 points) In this economy, the total surplus is the consumer surplus plus the total prots,
since payments to the managers are ignored. Show that the total surplus when
1
and
2
are chosen is
1
2
(
1
+
2
) (4 (
1
+
2
))
(c) (5 points) How much will the managers choose
1
and
2
produce after (c
1
, c
2
) have been
set (and the pair (c
1
, c
2
) is observable to everybody)?
(d) (5 points) Suppose that c
1
and c
2
are chosen simultaneously by the rms, and then the
managers behave as in 8c. Find c
1
and c
2
which will be chosen in a subgame perfect
equilibrium.
(e) (5 points) Suppose that rm 1 choose c
1
rst and rm 2 choose c
2
after observing c
1
. And
then the managers behave as in 8c. Find c
1
and c
2
which will be chosen in a subgame
perfect equilibrium.
(f) (4 points) Interpret your results 8d and 8e above from the view point of prot maximization
of rms.
(g) (7 points)In the sequential choice case 8e above, suppose that a government wants to
maximize the total surplus (see 8b), but it can only regulate c
1
[0, 1]. How should the
government choose c
1
?
9. Centipede Game. Consider the two player game in the gure below. (For instance, the game
ends if player I chooses S at the rst node, and player Is payo is 1.)
(a) Find all subgame perfect Nash equilibria.
(b) Write the strategic form of this game. Find all Nash equilibria. Are there any Nash
equilibrium that is not subgame perfect?
40
I
1
0
S
C
II
C
I
0
2
S
C
II
3
1
S
5
3
C
2
4
S
Centipede Game
10. A Strategic Bargaining Problem. There are 100 Yen coins to be allocated to two players.
The game goes as follows.. Player 1 makes an oer j (integer) to player 2, and if player 2 accepts,
then the game ends and player 2 receives j coins and player 1 receives the rest. If player 2 rejects
the oer, then the game continues it becomes player 2s turn to make an oer a, but the total
number of the coins will be reduced by one, thus player 2 receives 1 a coins if his oer is
accepted by player 1. If rejected, player 1 makes an oer to divide 2 coins, and so on. The
game ends if there is no coin left. Assume that the players have common discount factor a < 1
that is very close to one.
(a) Find a subgame perfect equilibrium strategy prole of this game.
(b) Find a Nash equilibrium strategy prole that is not subgame perfect.
11. Simple model of incentive contracts. Consider 2 agents who are to invest in a joint project.
Each agent can invest up to one unit of some productive resource. Denote by a
I
the amount
agent i invests (thus a
I
[0, 1]) and then / (a
1
+a
2
) will be obtained as the nal output of the
joint project, where / is a constant with 1 < / < 2. Let j
I
the amount agent i receives after the
project is completed, so j
1
+j
2
_ / (a
1
+a
2
) must hold. Agent is utility is given by j
I
a
I
.
(a) Dene a feasible allocation of the resource and the output ((a
1
, j
1
) , (a
2
, j
2
)) , and describe
the set of Pareto ecient allocations.
(b) Suppose that the nal output is divided equally, i.e., j
I
=
|
2
(a
1
+a
2
). Find a Nash
equilibrium of the game where a
1
and a
2
are chosen simultaneously. Interpret.
(c) Suppose that the nal output is paid out proportionally to the individual investment: e.g.,
2
=
i
1
i
2
when both a
I
are positive. Find a Nash equilibrium of the game where a
1
and a
2
are chosen simultaneously. Interpret.
(d) Suppose that investments are done sequentially: rst, agent 1 decides a
1
, and agent 2
decides a
2
. The nal output is divided equally, i.e., j
I
=
|
2
(a
1
+a
2
). Write the strategy
prole which is obtained by the backward induction. Interpret.
(e) Suppose that investments are done sequentially as above, but this time agent 1 can promise
the amount n paid to agent 2: rst, agent 1 decides both a
1
and n _ 0. Then agent 2
decides a
2
, and consequently j
2
= n, and j
1
= / (a
1
+a
2
). Write the strategy prole
which is obtained by the backward induction. Interpret.
(f) Suppose that investments are done sequentially as above, but this time agent 1 can demand
the amount r to be paid to himself as well: rst, agent 1 decides both a
1
and r _ 0. Then
agent 2 decides a
2
1
= r and j
2
= / (a
1
+a
2
) r. Write the strategy
prole which is obtained by the backward induction. Interpret.
(g) Suppose that investments are done sequentially as above, but this time agent 1 can set up
a sharing scheme: rst, agent 1 decides both a
1
and the shares (-
1
, -
2
) with -
1
+ -
2
= 1,
-
1
_ 0 and -
2
_ 0. Then agent 2 decides a
2
I
= -
I
/ (a
1
+a
2
). Write
the strategy prole which is obtained by the backward induction. Interpret.
12. Suppose Bertrand competition (question 3) is repeated innitely may times (with the same
demand every period). Show that if discount factor is suciently close to one, there is an
equilibrium where the monopoly price emerges on an equilibrium path.
13. Consider the game where the following one shot game is repeated twice.
C D M
C 3,3 -1,4 0,0
D 4,-1 0,0 0,0
M 0,0 0,0 c,c
,
where c is a positive constant with c < 3. The payo of the game is given by the sum of payos
from the results of the two one shot games.
(a) How many strategies are they for each player?
(b) Suppose one player believes that the opponent will play M regardless of the result of rst
round in a subgame perfect equilibrium. Is it possible that a player chooses C in the rst
round in this equilibrium?
(c) Consider the following strategy: play C in the rst round. In the second round, if (C,C) is
the result of the rst round, play C. Otherwise, play D. If both players adopt this strategy,
does it constitutes a subgame perfect Nash equilibrium?
(d) Consider the following strategy: play C in the rst round. In the second round, if (C,C)
is the result of the rst round, play M. Otherwise, play D. If both players adopt this
strategy, does it constitutes a subgame perfect Nash equilibrium?
(e) Consider the following strategy: play M in the rst round. In the second round, if neither
player plays D in the rst round, play M. Otherwise, play D. If both players adopt this
strategy, does it constitutes a subgame perfect Nash equilibrium?
14. Repeated prisoners dilemma. Consider two shops. Every day, each can either try maintain
a monopoly price j
1
, or cut price to some competitive level j
C
. The resulting prots are
summarized by the following table.
j
1
j
C
j
1
2, 2 0, 3
1
C
3, 0 1, 1
.
They do not see each others prices directly but they learn the choice of prices in the past. They
are interested in maximizing the sum of discounted prots, with discount factor a (0, 1].
(a) Suppose that there are two days for sales, and the price can be set each day independently.
Describe a subgame perfect Nash equilibrium
15. Role of commitment in a supermodular game: Suppose that (o, n) is a two person super
modular game, where o
I
= [0, ) and payos are increasing in all players strategy. Assume that
payo function n
I
as well as the best response function are dierentiable, and there is a Nash
equilibrium -
which is in the interior (so the usual rst order condition for a interior solution is
42
necessary). Suppose now player 1 moves rst, and player 2 chooses their actions after observing
player 1s action. So player 1 maximizes n
1
(-
1
, 11
2
(-
1
)), and assume that it is concave in -
1
.
Prove that in the dynamic game, player 1s choice is larger than -
1
.
8 Economics of Information
1. Auction. There is a single seller who has one unit of an indivisible good to be sold in a rst
price auction. There are two buyers, 1 and 2. The good has no value to the seller, whereas
the value to the buyer i is \
I
. Although there is no value, the seller may commit not to sell
under a specied minimum price j. That is, if both bids from the buyers are less than j, no
transaction takes place and the good will be discarded. Each buyer i knows his own valuation
\
I
, but not the others. But both knows that each \
I
is uniformly distributed on [0, 1] and \
I
s
are independently distributed. This auction can be modeled as a 2 player Bayesian game: each
I
[0, 1] is regarded as a type of player i, and a strategy of player i is a function /
I
from [0, 1]
to [0, 1] with the understanding of /
I
(
I
) is the bid of player i when his type is
I
. Since the
minimum price j is xed exogenously for the players, it is clear that if
I
< j, player i has no
incentive to bid. So for simplicity, assume that 0 _ j < 1 and /
I
must be dierentiable, and
increasing on [j, 1] and /
I
(
I
) =
I
if
I
< j, and that its inverse /
1
I
is well dened on a suitable
domain.
(a) Assuming that buyer 2 uses strategy /
2
, write the interim payo to bid a
1
[j, 1] for
buyer 1 who has learned that his value \
1
is
1
. Then write the rst order condition that
characterizes the payo maximizing bid.
(b) Assuming that buyer 2 uses strategy /
2
, write the ex ante payo to strategy /
1
for buyer
1.
(c) Find a symmetric, Bayesian Nash equilibrium. [Hint. Look at the rst order condition you
derived is a dierential equation. Try /() = /( +
c
u
). Since a buyer with value less than
j has no reason to bid, you may assume that /
I
(j) = j.]
(d) Show that the expected revenue from this auction is maximized at a positive minimum
price. Discuss the eciency of transaction.
2. Joint Venture under asymmetric information. Consider two players, i = 1, 2, who are
to invest in a joint project. Denote by a
I
_ 0 the amount invested by player i. The payo to
player i is 0 (a
1
+a
2
)
1
2
(a
I
)
2
, where 0 is a positive number. Before investment, each player i
observes a private signal -
I
about the protability of the project. It is commonly known that
each -
I
is independently, uniformly distributed on [0, 1], and 0 = -
1
+-
2
.
(a) Suppose that each player can observe the others private signal as well, thus each player
already knows 0 at the time of investment decision. Suppose investment decisions are done
simultaneously. Find a Nash equilibrium.
(b) Suppose that each player cannot observe the others signal.
i. Denote by )
2
(-
2
) the amount player 2 invests if he observes -
2
. Write the interim
payo maximization of player 1 who has observed -
1
, and nd the amount player 1
should invest.
ii. Find a Bayesian Nash equilibrium.
(c) Find the rst best outcome, that is, the amount of investment which maximizes the sum
of the payos of the two players. Compare this with the total amount of investment (i.e.,
a
1
+a
2
) in the two cases (a) and (b) above. Discuss.
3. Investment with privately known protability Consider two players, i = 1, 2, who are
to invest in a joint project. Denote by a
I
_ 0 the amount invested by player i. The payo to
player i is 0 (a
1
+a
2
)
1
2
(a
I
)
2
, where 0 is a non negative number. So we can think of 0 as
the protability of the joint project per person, and
1
2
(a
I
)
2
as the cost of investment. Each
player i observes a private signal -
I
about the protability of the project. Here -
1
, -
2
, and 0 are
random variables, and it is commonly known that each -
I
, i = 1, 2 is independently, uniformly
distributed on [0, 1], and there is a relation 0 = -
1
+ -
2
. So for instance, the average of -
I
is
1
2
, and the average of 0 is 1. To help your computation, you may use the following results:
_
1
0
_
(a +j)
2
_
da = j
2
+j +
1
3
and
_
1
0
_
_
1
0
_
(a +j)
2
_
da
_
dj =
7
6
.
(a) (5 points) Suppose that investment decision must be done simultaneously before observing
the private signal, and thus each investor is interested in maximizing the (ex ante) expect
payo (=
_
1
0
_
1
0
_
(-
1
+-
2
) (a
1
+a
2
)
1
2
(a
I
)
2
_
d-
1
d-
2
). Find a Nash equilibrium level of
investment.
(b) (5 points) Suppose that each player can observe the others private signal as well, thus each
player already knows 0 at the time of investment decision. Suppose investment decisions
are done simultaneously. Find a Nash equilibrium after 0 is known.
(c) (10 points) Suppose that each player cannot observe the others signal: an investment
decision is made after -
I
is learned but before -
I
is revealed.
i. Denote by )
2
(-
2
) the amount player 2 will invests if he observes -
2
. Write the interim
payo maximization problem of player 1, that is, the problem to maximize the expected
returns after -
1
is observed.
ii. Find a Bayesian Nash equilibrium.
(d) (5 points) Compare the ex ante expected equilibrium payos of each player, i.e., the ex-
pectation taken before the random signals are drawn, for the three cases considered above.
Interpret your ndings.
4. The Hirshleifer eect. Consider the following game (Nature chooses left or right with
even chance.
1. (a) Does Player 2 observes Player 1s choice of action? Does the players observe Natures move?
(b) Show that both players choosing left at every information set constitutes a perfect
Bayesian equilibrium.
(c) Suppose instead Natures move is observable to both players. Write this environment in an
extensive form game. Find the unique subgame perfect equilibrium.
(d) Compare ex ante utility levels of players in (1b) and (1c). Comment.
2. A risk neutral principal and a risk averse agent. The agent chooses eort level c in [0, 1], which
is not observable. The agents concave vNM utility function is n(a) c, where a is the amount
of wage received. The output may be j
1
or j
1
, with j
1
j
1
. The conditional probability of
achieving j
1
given c is denoted by (c), where
0
0,
00
< 0. The realized output is observable
and veriable. Wage schedule is written as (n
1
, n
1
), i.e., when the observed output is high, the
agent receives n
1
, otherwise n
1
. The reservation utility level for the agent is normalized to be
0. Assume enough degree of dierentiability in the following.
(a) Suppose c were observable. Write down the rst order condition that characterize the
optimal eort level for the principle. Find the wage level that implements the optimal.
From now on, assume that c is not observable.
44
!
!
!
!
!
!
!
!
!
a
a
a
a
a
a
a
a
@
@
@
@
@
@
T
T
T
T
T
T
C
C
C
C
C
C
C
C
C
C
C
C
C
C
C
C
C
C
C
C
C
C
C
C
C
C
C
C
C
C
C
C
C
C
C
C
C
L
L
L
L
L
L
L
L
L
u
u u
u
u
u u
(8,8)
Nature
Player 1
Player 2
Player 2
(8,8) (10,0) (10,0)
(10,0) (0,10) (0,10) (0,10)
Figure 1: Game
(b) Write down the agents utility maximization problem, given (n
1
, n
1
).
(c) Write down the principles problem. Show that at the optimum:
i. The rst best eort level you found in 2a cannot be achieved.
ii. The individual rationality constraint must be binding;
iii. n
1
n
1
.
3. Consider the Spence job market signaling model, with the following parameters:
output of high type 4
output of low type 2
cost of education for low type 1
wage for educated worker n
wage for non-educated worker 1
Assume high type and low type are equally likely. The wage for non-educated worker is xed at
1 by law, and the reservation payo for workers is 0.
(a) Suppose n 1 has been xed. Formulate the problem as in a simple game as in the
previous question. Find an equilibrium which yields the best outcome for the employer.
(b) Suppose the employer rst pick n, then the game considered above takes place. Find an
equilibrium that yields the best outcome for the employer.
(c) Suppose that n is chosen after education is nished, but before the productivity is revealed.
Find an equilibrium that yields the best outcome for the employer.
4. Consider a two player game as follows. Player 1 (Sender) observes his type rst, and then send
a message to Player 2. Player 2 (Receiver) chooses an action after observing the message. The
Player 1s types are, t
1
, or t
2
, and possible messages are -
1
or -
2
, and Player 2s actions are a
1
or a
2
. The types are equally likely. The payos are given in the following table, where c is a
constant. Notice that the payos are independent of the choice of messages. In words, there is
no cost for sending a message, i.e., player 1 is just talking.
Player 1s payos
a
1
a
2
t
1
1 0
t
2
c 1
Player 2s payos
a
1
a
2
t
1
2 1
t
2
1 2
(a) Write this game in extensive form.
(b) Consider the following strategy prole: Player 2 chooses a
1
or a
2
with probability
1
2
whichever signal she receives (i.e., she ignores the message), and Player 1 sends -
1
or
-
2
with equal chance whichever the type is. Show that this prole constitutes a perfect
Bayesian equilibrium with appropriate beliefs.
(c) Consider the following strategy prole: Player 1 sends -
1
if his type is t
1
and -
2
if his type
is t
2
, and Player 2 chooses a
1
or a
2
with probability
1
2
whichever signal she receives. Does
this constitute a perfect Bayesian equilibrium with appropriate beliefs?
(d) Consider the following strategy prole: Player 1 sends -
1
if his type is t
1
, and -
2
if t
2
.
Player 2 chooses a
1
if the message is -
1
, chooses a
2
if the message is -
2
. Show that this
constitutes a perfect Bayesian equilibrium with appropriate beliefs, if c < 1. (So, in this
case, the message conveys some meaning.)
(e) Is there a perfect Bayesian equilibrium where the message conveys some meaning when
c 1?
5. Imagine a two player game of sequential moves where one of the player moves rst and the other
follows. Player is payo is given by 0c
I
a
I

1
2
(a
I
)
2
+ a
I
a
I
a
where ,= i and a
I
_ 0 and
a := a
12
a
21
<
1
2
. Assume that 0c
I
0 is large so that the payo function is increasing in the
relevant range for i = 1, 2.
(a) Suppose that 0 is a known parameter to both players.
i. Find a subgame perfect equilibrium where player i moves rst and player follows.
ii. Suppose you are interested in maximizing the sum a
1
+a
2
in equilibrium. Which player
do you want to move rst?
(b) Suppose that player 1 moves rst, and 0 is unknown parameter continuously distributed
on [0
0
, 0
1
] with mean

0.
i. Find a subgame perfect equilibrium when neither player learns 0 (thus the payos are
eectively

0c
I
a
I

1
2
(a
I
)
2
+a
I
a
I
a
)
ii. Find a fully revealing Bayesian equilibrium when player learns 0 before he makes his
move.

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Advanced Microeconomics: Problems

Institute of Economic Research, Kyoto University

). Assume for each , c

(j). So we can dene the inverse aggregate

the equilibrium price. Consider tax t per unit

for the amount that the rm produces.

and the rms prots increase.

(c) the socially optimal

) be a competitive equilibrium of a private ownership economy ((n

) is Pareto Ecient if the budget is tight at a

. (Note: this will be triviall if all

is utility maximizing given prices j and income n, it is quasi utility

is quasi-utility maximizing, then it is utility maximizing.

maximizes the social welfare (i.e., the sum of

maximizes the social welfare (i.e., the sum of

) be a competitive equilibrium of a private ownership economy ((n

) is Pareto Ecient if the budget is tight at a

(`) (that is, if n

(`) are continuous functions of `. Set c

, which pay in the good (that is, these

of real payos which span , in the economy with these

for all consumers.

for all consumers.

the (random) dividend of asset and

] = 1 for all assets. Thus

the (random) dividend of asset and

). A feasible allocation is called a fair allocation if it is Pareto

< 1, = 1, 2. Each rm sets the price j

of its own product. The

are positive constants,

is the price of the other rms product.

is the sum of other players rst period consumptions.

as a strategic variable. The marginal cost of production is zero.

plus the payment to the manager. The manager of rm is paid times c

) (prots of rm ), where is a given parameter which is determined exogenously

[0, 1] is determined by the owner of rm before production takes

= 1 the manager wants to maximize

) (prots of rm ), where 0 is a given parameter which is determined exoge-

[0, 1] is determined by the owner of rm before production

and prot (= revenue minus cost) is

). The manager of rm will chooses

= 0, the manager will be interested

= 1, he will be interested in maximizing the revenue. The

. Firm is interested in maximizing

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