Comprehensive Exam in Microeconomic Theory

Summer 2016

Procedural Instructions:

(1) Write your answers only on the paper we will provide.

(2) We will be distributing a numbered sign-in sheet in a moment. The number next to your
signature will be your student number.

(3) Every sheet of paper you turn in to us must have your student number written at the top-
center of the sheet and circled.

(4) Every sheet of paper you turn in to us must have a page number written at the top-right-
corner of the sheet.

(5) When you have finished, or when time is up (whichever comes first), prepare a cover sheet
for your exam. This cover sheet should not have a page number, but must have the following
things on it:
(a) Your student number at the top-center, circled.
(b) The phrase "Microeconomics Comprehensive Exam Summer 2016".
(c) The sentence "My last page is page number X", where X is your total number of
pages of answers.
 Be sure to show your work to receive partial credit. No calculators allowed.

1. (35 points, as indicated) Assume a competitive firm has the following production function
y = f(x1, x2) = (x12 + x22)a/2
where a > 0, y is output and x1 and x2 are inputs.
a. (15 points) For what values of a is f a quasi-concave function? For what values of a is f a
concave function? Explain your answers.
b. (10 points) The firm faces fixed factor prices w1 > 0 and w2 > 0. Let a = 1. Find the firms
conditional factor demand functions for x1 and x2.
c. (10 points) Given the same assumptions described in part (b), find the firms cost function.

2. (40 points, 8 each part ) A consumer is given x0 > 0 units of good x, and this consumer can
purchase additional units or sell his existing units at price px. Write total consumption of this
good as (x0 + x), where x > 0 if additional units are purchased and x < 0 if some units are sold.
The consumer can also purchase good y at price py. Assume the consumer maximizes utility
subject to the budget constraint pxx + pyy = m, where m is exogenous income.
a. Determine the Marshallian demand functions for goods x and y for a consumer with utility
function u(x, y) = (x + x0)y.
b. Determine the indirect utility and expenditure functions for this person.
c. Now suppose the nonnegativity restriction x 0 is imposed on the consumer. That is, the
consumer can add to x0, but cannot reduce the consumption of this good to less than x0.
Write down the necessary conditions for the optimal solutions for x and y.
d. Suppose pxx0 > m. Solve the conditions determined in part (c) for the optimal x and y.
e. Continue to assume that pxx0 > m. Using the expenditure function determined in part (b),
write down an expression representing the income that is equivalent to having x0 but facing
the requirement that x 0, the restriction imposed in part (c).

1
3. (45 points, as indicated) Consider an exchange economy. Suppose Ann is endowed with x1

units of good x1 and 0 units of good x2 and Bob is endowed with 0 units of good x1 and x2 units

of good x2. Assume x1 > 0 and x2 > 0 . Let Ann and Bobs utility functions be u A = x1A x2A and

u B = x1B x2B , respectively.

a. (15 points) Sketch and label the Edgeworth Box for the case where x1 = 2 x2 . Identify the
set of Pareto Efficient allocations for this two-person exchange economy. Also give the
equation for the Pareto Efficient allocations in ( x1A , x2A ) space.
b. (10 points) Determine the competitive equilibrium price p2 in this exchange economy for
arbitrary values for x1 and x2 . Assume that p1 = 1.
c. (10 points) Compute the indirect utility function for person A in general equilibrium (as a
function of the endowments).
d. (10 points) Suppose person B's endowment of good x2 is increased from x2 to x2 + 1.

Determine the compensation that must be given to person A as a change in x1 so that person

A's utility in equilibrium is the same as before the change in person B's endowment. Explain
in simple economic terms why your answer is what it is.

4. (45 points, as indicated) This question is about two games based on the following
simultaneous game:

Player 2
L C R
U 3a, 1 1a, 2 2a, 3
Player 1 D 2a, 5 0, 0 3a, 2

I. (25 points) Players 1 and 2 are going to play the following game. First, Player 2 chooses a
value a > 0. Next, Player 1 decides whether to remove action R for player 2 (if R is removed, 2 is
left with two possible actions, L and C).
Finally, the resulting simultaneous game is played using either pure or mixed strategies.
What is the outcome of this game using the appropriate solution concept?

2
II. (20 points) Now suppose that a = 1 and restrict attention to pure strategies. With probability
1/2, Players 1 and 2 will play the simultaneous game as given above. With probability 1/2, action
R will be removed for Player 2 (so he is left with two possible actions, L and C).
Player 2 will know which game they are playing, 1 will not.
What is the outcome of this game using the appropriate solution concept?

5. (32 points, as indicated) Consider the following game between a regulator and two polluting
firms. First, the two firms engage in Cournot competition choosing their levels of production q1
and q2. Production Q = q1 + q2 generates pollution equal to Q where > 0 is a constant. Next,
the regulator decides the level of fines f it will collect from each firm.
Payoffs for the two firms are given by
(3 Q - f)qi for i = 1,2.
The regulators payoff is given by
2fQ f 2 Q.

a. (20 points) What is the Subgame Perfect Nash Equilibrium?

b. (12 points) Let = 16. Suppose that instead of the regulator choosing the fine, this was
exogenously set to f = 2. Show that the regulator would be better off than in the equilibrium
you found in (a). Given this fact, why doesnt the regulator choose f = 2 in (a)?

3
6. (43 points, as indicated) Consider the following contracting problem between a manager and
a worker. The managers utility is given by
u(y, w) = y w,
where y is output and w is the wage. The workers utility is
u(w) = 2w0.5 e,
where e {0, 1} is the level of effort.
If the worker chooses e = 0, with probability 1/4 the output is yH and with probability 3/4 it is yL,
where y yH yL > 0. If the worker chooses e = 1, the probability of high output becomes 3/4
and the probability of low output decreases to 1/4. The manager observes y.
The timing is as follows. First, the manager offers a contract to the worker, which the worker can
either accept or refuse. If the worker accepts, he chooses an effort level e. Output is realized, and
the contract is implemented. If the worker refuses, he receives an outside option u0 = 1 and the
game ends.
a. (15 points) Suppose the manager observes the workers effort level. Solve for the contract
that the manager will offer the worker. Show that the worker will exert high effort as long as
y > 3/2.
b. (20 points) Suppose that the manager does not observe the workers effort level. Solve for
the contract that the manager will offer in this case.
c. (8 points) Compare the workers effort in (a) and (b) for different values of y. Provide an
explanation for the difference or similarity in each case.