Solution Manual for Microeconomic Theory

Department of Economics Hong Kong University of Science and Technology September 2006

Hong Kong University of Science & Technology, 2006

I expect many errors in my solutions. I did not spend effort in eliminating errors. Please send me an email if you find an error.

1. Exercises for Chapter 1

Exercise 1.1. A farm produces yams Y using capital K , labor L , and land according to the production technology described by:
1 1 1

Y = 3K 3 L3 3 .
The firm faces prices ( p, q, w, r ) for (Y , K , L, ). (a) Suppose that, in the short run, K and are fixed. Derive the short-run supply and profit functions of the firm. (b) Suppose that, in the long run, K and L are marketable but is fixed. Derive the longrun supply and profit functions. If there were a market for land, how much would the firm be willing to pay for one more unit of land (the internal price of land)? (c) Suppose that, in the long run, all the factors K , L and are marketable. Does this production function exhibit diminishing, constant, or increasing returns to scale? Suppose that competitive conditions ensure zero profits. Derive the long-run supply and demand functions. Answer: (a) The short-run profit is
1

SR max pY wL = max 3 p ( KL ) 3 wL,

L L

implying

p ( KL ) 3 K = w,
implying
1 2 p 2 L = ( K ) , w 3

implying
1 2 p y = 3( KL ) = 3 ( K ) 2 , w 1 3 1

implying
3

SR = 2 p 2 w

1 2

K .
Page 2 of 73

(b) The Long-run profit is

The FOC's are:

LR

max pY wL qK = max 3 p( KL ) wL qK

K ,L

1 3

p ( KL ) K = w,
implying

2 3

p ( KL ) L = q,

2 3

w K = q L

or

K=

w L. q

Substituting this solution into the first FOC, we can solve for L :

L=
implying

p3 , qw2

p3 K = 2 , q w
implying

p2 Y =3 , qw

LR = pY wL qK =
The internal price of land will then be

p3 . qw

LR p3 = . qw
(c) By the definition, the production exhibits CRS. The Long-run cost function is

C ( q, w, r, Y ) min wL + qK + r s.t. Y = 3( KL )

1 1 3

Take L wL + qK + r + Y 3( KL ) 3 . Then the FOC's are

( KL ) 3 K = w,
implying

( KL ) 3 L = q,

( KL ) 3 KL = r ,

w K = , q L
which imply that K =

w = , r L

w w L and = L. Substituting these into the constraint, we can solve q r

for L and then K and : Page 3 of 73

3 1 qr L= Y, w2 3
implying

3 1 wr K= Y, 3 q2

3 1 qw = Y, r2 3

C ( q, w, r, Y ) = ( wqr ) 3 Y ,
implying
1

= max

pY C ( q, w, r , Y ) = [ p ( wqr ) 3 ]Y .

Competitive market ensures zero profit, which requires that

1

p = ( wqr ) 3
in the long run. This means that no matter how much the firm produces the profit is always zero. Therefore, the output Y is indeterminate, meaning that the firm may produce any amount.
n Exercise 1.2. Show that f ( x ) = f ( x ), x R+ , > 1 implies n f ( x ) = f ( x ), x R+ , > 0. n Answer: For any y R+ and 0 < t < 1, let x ty and . We then have

f ( y ) = f ( x ) = f ( x ) =

1 f (ty ). t

1 t

n Therefore, tf ( y ) = f (ty ), t > 0, y R+ , where the equality for t 1 is already given.

Exercise 1.3. Use a Lagrange function to solve c( w1 , w2 , y ) for the following problem:

c( w1 , w2 , y ) min w1 x1 + w2 x2
x1 , x2 s.t. x1 + x2 = y .

Answer: See Varian (2nd ed.) p.31-33, or Varian (3rd ed.) p.55-56. Exercise 1.4. Use a graph to solve the cost function for the following problem:

c( w1 , w2 , y ) min w1 x1 + w2 x2
x1 , x2

s.t. y = ax1 + bx2 .

Answer: From Figure 1.1, we see that the minimum point is ( , 0) or (0, the ratio of

y a

y ) depending on b

w w1 w . Therefore, the cost is 1 y or 2 y. That is, w2 a b w1 w2 c( w1 , w2 , y ) = min y, b a y .

Page 4 of 73

x2

ax1 + bx2 = y
Isoquant

w1 x1 + w2 x2 = c

y/a

x1

Figure 1.1. Cost Minimization with Linear Technology Exercise 1.5. Find the cost function for the following problem:

c( w1 , w2 , y ) min w1 x1 + w2 x2
x1 , x2

s.t.

y = min {ax1 , bx2 }.

Answer: Since the production is not differentiable, we cannot use FOC to solve the problem. One way to do is to use a graph.

x2
ax1 = bx2

y b
y/a

y = f ( x)

x1

Figure 1.2. Cost Minimization with Leontief Technology From Figure 1.2, we see that the minimum point is ( ,

y y ). Therefore, the cost function is: a b w1 w2 c( w1 , w2 , y ) = + y. a b

Exercise 1.6. In the short run, assume x2 is fixed: x2 = k . Find STC, FC, SVC, SAC, SAVC, SAFC, SMC, LC, LAC, and LMC for the following problem:

c( w1 , w2 , y ) min w1 x1 + w2 x2
x1 , x2

s.t.
Answer: See Varian, Example 2.16, p.55 and p.66.

1a y = x1a x2 .

Page 5 of 73

Exercise 1.7. Prove the first two properties of the cost function. Answer: The cost function and the expenditure function in consumer theory are mathematically the same. Exercise 1.8. Prove the three properties of the demand and supply functions in Proposition 1.10. Answer: (1) Since ( p, w) is linearly homogeneous and since xi ( p, w) = is homogeneous of degree 0 in ( p, w). Similarly for y ( p, w).

( p , w ) , xi ( p, w) wi

(2) By Hotelling's lemma, we have y p x 1 2 p D ( p, w) = x n p

This immediately implies

y w1 x1 w1 xn w1

x1 wn 0. xn wn y wn

y 0, p
which gives the second property.

xi 0, wi

(3) By the symmetry of the matrix D 2 ( p, w), we immediately have

x j xi = . w j wi
Exercise 1.9. Consider the factor demand system:
1 w2 2 y, x1 ( w1 , w2 , y ) = b11 + b12 w1 1 2 w1 y, x2 ( w1 , w2 , y ) = b22 + b21 w2

where b11 , b12 , b21 , b22 > 0 are parameters. Find the condition(s) on the parameters so that this demand system is consistent with cost minimization. What is the cost function? Answer: If the demand system is a solution of a cost minimization problem, then it must satisfy the properties listed in Proposition 1.9. Property (1) in the proposition is obviously satisfied. Property (2) requires symmetric cross-price effects, that is,

x1 x2 = w2 w1
Page 6 of 73

or

1 b12 2

y 1 = b21 w1 w2 2

y . w1w2

Therefore, b12 = b21 . With b12 = b21 , the substitution matrix is

x1 w1 x2 w1
We have

1 1 1 3 1 x1 1 2 2 2 2 w w y w w 1 2 1 2 y w2 2 2 = b12 . 1 1 1 3 x2 1 1 2 2 2 2 2 w1 w2 y 2 w1 w2 y w2

x1 < 0, w1
and

x1 w1 x2 w1

1 1 2 2 w1 2 w22 y w1 w2 y 1 2 2 1 1 2 2 2 1 1 = b12 = b12 y ( w2 w1 w1 w2 ) = 0. 1 1 1 3 x2 4 1 2 2 1 2 2 w1 w2 y w1 w2 y w2 2 2

x1 w2

Thus, the substitution matrix is negative semi-definite. Finally, property (4) is implied by the fact that the substitution matrix is negative semi-definite. Therefore, to be consistent with cost minimization, we need and only need condition: b12 = b21 . Let b b12 = b21 . Then the cost function is

c( w1 , w2 , y ) = w1 x1 + w2 x2 = [ w1b11 + w2 b22 + 2b w1 w2 ] y.
Exercise 1.10. Show that if G satisfies Assumptions 1.1 and 1.2 and ( x ) > 0, x R m , then F ( y ) G ( y ) also satisfies Assumptions 1.1 and 1.2. Answer: Since Fyi ( y ) = [G ( y )]G yi ( y ) > 0, Assumption 1.1 is satisfied. Since

Fyi y j = G yi G y j + G yi y j ,
we have

0 Fy1 Fyn

Fy1 Fy1 y1 Fyn y1

Fyn Fy1 yn Fyn yn =

0 Gy1 G yn

G y1 Gy1Gy1 +Gy1 y1 Gyn Gy1 +Gyn y1

G yn G y1 G yn + G y1 yn G yn G yn + G yn yn .

G y j and then add what you have got Multiply the first column of the right determinant by
to the jth column. This operation wont affect the value of the determinant. Thus, Page 7 of 73

0 Fy1 Fyn

Fy1 Fy1 y1 Fyn y1

Fyn Fy1 yn Fyn yn =

0 Gy1 G yn

G y1 Gy1 y1 Gyn y1

G yn G y1 yn G yn y n
= n+1

0 Gy1 G yn

G y1 Gy1 y1 Gyn y1

G yn G y1 yn G y n yn < 0,

for any n = 2, 3, m. Therefore, F also satisfies Assumption 1.2. Exercise 1.11. A firm buys inputs at levels x1 and x2 on competitive markets and uses them to produce a level of output y. Its technology is such that the minimum cost of producing y at input prices w1 and w2 is given by the cost function
b c( w1 , w2 , y ) = A1 w1 + A2 w2 + Aw1a w2 y ,

where A, A1 , A2 , a , b > 0 and 2 are constant parameters. (a) What parameter condition does the homogeneity of this cost function imply? (b) Derive the conditional demand functions x1 ( w1 , w2 , y ) and x2 ( w1 , w2 , y ). Verify that the cross price effects are symmetric for these demand functions. (c) Show that the MC curve is upward sloping and that the AC curve is U-shaped (convex). Answer: (a) By
b c( w1 , w2 , y ) = A1 w1 + A2 w2 + A a+b w1a w2 y ,

we immediately see that the linear homogeneity of cost function implies that a + b = 1. (b) We have

x1 ( w1 , w2 , y ) =
Then,

c b = A1 + aAw1a1 w2 y , w1

x2 ( w1 , w2 , y ) =

c b1 = A2 + bAw1a w2 y . w2

x1 x b1 = abAw1a1 w2 y = 2. w2 w1
(c) When the functions are differentiable, taking derivatives is often the easiest way to find monotonicity and convexity.

MC ( y )

c d b 1 b 2 = Aw1a w2 y , MC ( y ) = ( 1) Aw1a w2 y > 0. y dy Aw Aw b 1 AC ( y ) = 1 1 + 2 2 + Aw1a w2 y , y y Aw Aw d b 2 AC ( y ) = 1 2 1 2 2 2 + A( 1) w1a w2 y , dy y y 2A w 2A w d2 b 3 AC ( y ) = 13 1 + 23 2 + A( 1)( 2) w1a w2 y > 0. 2 dy y y

Page 8 of 73

Therefore, MC is upward sloping and AC is U-shaped.

a b c Exercise 1.12. Given a function c( w, y ) Aw1 w2 y , where A, c > 0,

(a) Under what conditions, is this function a cost function? (b) If the production function that results in this cost function is homogeneous, what is the degree of homogeneity for this production function? Answer: (a) Using Proposition 1.5, increasingness in w implies

a, b 0.
Linear homogeneity implies that

(1)

a + b = 1.
We have

(2)

c b c y , = aAw1a1 w2 w1
and
b c a ( a 1) Aw1a2 w2 y Dw c = a1 b1 c abAw1 w2 y

c b1 c y , = bAw1a w2 w2

b1 c abAw1a1 w2 y . b2 c b(b 1) Aw1a w2 y

This implies that, using (2),

2c b c = a ( a 1) Aw1a2 w2 y , 2 w1
and

2 c b2 c = b(b 1) Aw1a w2 y , 2 w2

2( b1) 2 c Dw c = A2 w12( a1) w2 y ab(1 a b) = 0.

Then, concavity requires that

a 1,

b 1.

(3)

(b) By Proposition 1.4, the degree of homogeneity must be 1/c.

2. Exercises for Chapter 2

Exercise 2.1. Show that strong monotonicity implies local nonsatiation but not vice versa. Answer: Since in any neighborhood of x, we can always find a point y such that x y and

x y , strong monotonicity thus implies local nonsatiation.

Page 9 of 73

Suppose the preferences are defined by u ( x1 , x2 ) min{x1 , x2 }. It is easy to see that the preferences satisfy local nonsatiation. But for two points x = (0, 1) and y = (0, 0), we have

x y and x y but x y. That is, the preferences don't satisfy strong monotonicity.
Exercise 2.2. A consumer has a utility function u ( x1 , x2 ) = (a) Compute the ordinary demand functions. (b) Show that the indirect utility function is (c) Compute the expenditure function. (d) Compute the compensated demand functions. Answer: The consumer's problem is

1 1 . x1 x2

p1 + p2 ) I .
2

v ( p, I ) = max s.t.
Let L

1 1 x1 x2

p1 x1 + p2 x2 = I .

1 1 + ( I p1 x1 p2 x2 ). The FOC's x1 x2 1 = p1 , x12 1 = p2 2 x2

imply x1 =

p2 x2 . Substituting this into the budget constraint will immediately give us p1

* x2 =

I p2 + p1 p2

By symmetry, we also have

* x1 =

I p1 + p1 p2

(b) Substituting the consumer's demands into the utility function will give us

p1 + p1 p2 p2 + p1 p2 p1 + p2 + 2 p1 p2 ( p1 + p2 ) 2 v ( p, I ) = = = . I I I I
(c) Let u = v ( p, e), i.e.

u =

( p1 + p2 ) 2 e

which immediately gives us the expenditure function:

e( p , u ) =

( p1 + p2 ) 2 . u
Page 10 of 73

(d) Substituting e( p, u ) for I in the consumer's demand functions we get

( p1 + p2 ) 2 p + p2 e( p , u ) 1 1 + x1 ( p, u ) = = = 1 = u p1 + p1 p2 ( p1 + p1 p2 )u u p1
By symmetry,

p2 . p1

1 1 + x2 ( p , u ) = u

p1 . p2

Exercise 2.3. Let xi ( p, I ) be the consumer's demand for good i. The income elasticity of demand for good i is defined as ei

I xi ( p, I ) . Show that, if all income elasticities are xi I

constant and equal, they must all be one. Answer: Using the adding-up condition

p x ( p, I ) = I
i i

we can take derivative w.r.t. I on both sides of the equation to get:

pi
implying

xi = 1, I

1=
If e1 = e2 =

pi xi I xi pi xi = I ei . I xi I

= en , then 1 = ei pi xi = ei I

that is, e1 = e2 =

= en = 1.
xi ( p, I ) x j ( p, I ) = . p j pi

Exercise 2.4. Show that the cross-price effects for ordinary demand are symmetric iff all goods have the same income elasticity: Answer: By Shephard's lemma,

xi 2 e( p, u ) 2 e( p, u ) x j = = = . p j p j pi pi p j pi
By Slutsky equation,
x xi xi xi xi x j xi j xi I xi xi = xj = = ei , p j p j I p j I xi I p j I

(4)

Page 11 of 73

where ei is the income elasticity of demand for good i. Similarly,

x j

xi x x j xi x j I x j j = x = = ej. pi pi I pi I x I p I j i

x j

x j

x j

By (4) and the fact that ei = e j , then

xi x j = . p j pi

1/4 b p2 u. What is the value Exercise 2.5. A consumer has expenditure function e( p1 , p2 , u ) = p1

of b ? Answer: Since e( p, u ) is linearly homogeneous in p, b =

3 . 4

Exercise 2.6. Suppose that the consumer's utility function is linearly homogeneous. Show that the consumer's demand functions have constant income elasticity equal to 1. Answer: We can easily show that v ( p, I ) = v ( p, I ), > 0, given that fact that

u( x ) = u( x ), > 0. Then, v p ( p, I ) is linearly homogeneous in I , and vI ( p, I ) is homoi geneous of degree 0 in I . By Roy's identity, we then have xi ( p, I ) = v p ( p, I )
i

v I ( p, I )

v p ( p, I )
i

v I ( p, I )

= xi ( p, I ).

Taking the derivative w.r.t. , we then have

I
Setting = 1, we then have

xi ( p, I ) = xi ( p, I ). I

I xi ( p, I ) = 1. xi I
Exercise 2.7. Use the envelope theorem to show that the Lagrange multiplier associated with the budget constraint is the marginal utility of income; that is, = Answer: The problem is

v ( p , I ) . I

v ( p, I ) = max u ( x )
x

s.t.
The Lagrange function for this problem is

p x = I.

L( x, ) u( x ) + ( I p x ).
We have Page 12 of 73

v ( p, I ) = max L( x, ) = u( x ) + ( I p x ).
x ,

Then by the Envelop Theorem,

v ( p , I ) = . I
Exercise 2.8. Suppose that the consumer's demand function for good i has constant income elasticity . Show that the demand function can be written as xi ( p, I ) = xi ( p, I 0 )( I/I 0 ) . Answer: Given

I xi ( p, I ) = xi I
for all I , we have

dxi dI = xi I
Thus,

d log xi = d log I .

I I0

d log xi = d log I
I0

log xi ( p, I ) log xi ( p, I 0 ) = (log I log I 0 ).

Therefore,

I x ( p, I ) = x ( p, I 0 ) I
i i

. 0

xi ( p, u ) Exercise 2.9. Consider the substitution matrix of a utility-maximizing consumer. p j

(a) Show that

k i =1

u( x ) xi ( p, u ) = 0. xi p j

(b) Conclude that the substitution matrix is singular and that the price vector p lies in its null space. (c) Show that this implies that there is some entry in each row and column of the substitution matrix that is nonnegative. Answer: (a) We have

u = u[ x ( p, u )],

p 0, u 0.

By taking derivative w.r.t. p j on both sides of above equation, we have

0=
i =1

u( x ) xi , xi p j

j.

(5)

Page 13 of 73

(b) Part (a) implies

D p x ( p, I )]Du ( x ) = 0,
where

(6)

x i D p x ( p, I ) p j
is the substitution matrix, and

u ( x ) x1 Du( x ) . u ( x ) x n
By the assumption that Du( x ) = 0, (6) implies that D p x must be singular. By the FOC

Du( x ) = p,
we then have [ Du ( x ) = 0 = 0]

( Dp x ) p = 0.
This means that

p ( D p x ) (0)
where ( D p x ) (0) denotes the null space of D p x 's. (c) For each j, by (5), since by assumption must be nonnegative. Exercise 2.10. An individual has a utility function for leisure L and food F of the form:
1 2

xi u ( x ) > 0, i, one of the , i = 1, n, xi p j

u ( L, F ) L3 F 3 .
Suppose that the individual has an income I , with wage rate w and price of food p. (a) Derive the individual's compensated demand functions for food and leisure. (b) Verify Shephard's lemma and Roy's identity for this individual's demand functions. (c) Suppose that there is an increase in the price of food. Divide the total effect on the consumer demand for leisure into income and substitution effects. (d) Is there a price of food at which a further rise in the price will lead to a decrease in consumer demand for leisure?

Page 14 of 73

Answer: (a) We have

1 2 e( p, w, u ) min pF + wL | u = L3 F 3

p L =2 w F

implying
3 pF 3 2 p 3 u = F = F 2w 2w 1 1

3 2w u, F = p

3 p L = u, 2w

implying

e( p, w, u ) = 3 2
(b) Taking derivatives w.r.t. the prices,
3 e 2w = u, p p 1

2 3

p 3 w 3 u.

3 e p = u. w 2 w

Therefore, the Shephard's Lemma is verified. From utility maximization, we can find the consumer demand functions:

F* =
From the expenditure function,

2I , 3p

L* =

I . 3w

1 v ( p, w, I ) = 2 3 p 3 w 3 I , 3

implying

vp vI

2I , 3p

vw I = . vI 3w

Therefore, the Roy's Identity is verified. (c) We have

substitution effect: income effect:

L 2 3 2I = p (2 w) 3 v ( p, w, I ) = p 3 9 pw

F *

L* 2I 1 2I = = . I 3 p 3w 9 pw L is zero. That is, p

(d) We see that the two effects cancel out, and thus the total effect changes in the price of food will not affect the demand for leisure.

Exercise 2.11. One popular functional form in empirical work for ordinary demand functions
x1 ( p, I ) and x2 ( p, I ) is the double logarithmic demand system:

Page 15 of 73

 log x1 = a1 + b11 log p1 + b12 log p2 + c1 log I , log x2 = a2 + b21 log p1 + b22 log p2 + c2 log I ,

where I is the income and p ( p1 , p2 ) the price vector. The parameters ai , ci , bij are unknown and are to be estimated. (a) Interpret b11 , b22 , c1 and c2 in terms of elasticity, where the price elasticity of demand for good i is

pi xi I xi , and the income elasticity of demand for good is . i xi pi xi I

(b) Show that in order that the above demand functions can be interpreted as having been derived from utility maximizing behavior, the following parameter restrictions must be imposed:

b11 + b12 + c1 = 0,

b21 + b22 + c2 = 0.

If good 1 is a normal good and is not a Giffen good, are there additional parameter restrictions implied by this fact? If goods 1 and 2 are gross substitutes, are there additional parameter restrictions? Answer: (a) We have

income elasticity of demand for good i price elasticity of demand for good i

log xi* = ci , log I

log xi* = bii . log pi

( p, I ) is homogeneous of degree 0, we have (b) For any > 0, since x1 log x1 ( p, I ) = log x1 ( p, I ) = a1 + b11 log( p1 ) + b12 log( p2 ) + c1 log( I )

= a1 + b11 log p1 + b12 log p2 + c1 log I + (b11 + b12 + c1 ) log

= log x1 ( p, I ) + (b11 + b12 + c1 ) log .

Therefore,

b11 + b12 + c1 = 0.

Similarly,

using
1

the

2nd

equation,

we

also

have

b21 + b22 + c2 = 0. Normality implies that

x > 0. We hence have I

log x1 I x1 = = c1 > 0. x1 I log I x1 < 0. We hence have Since good 1 is not a Giffen good, p1 p1 x1 log x1 = = b11 < 0. x1 p1 log p1 x1 If good 1 is a substitute for good 2, then > 0. We hence have x1 p2

Page 16 of 73

 p2 x1 log x1 = = b12 > 0. x1 p2 log p2 x2 > 0. We hence have p1

If good 2 is a substitute for good 1, then

p1 x2 log x2 = = b21 > 0. x2 p1 log p1

Exercise 2.12. A consumer has an intertemporal utility function u = c1 + 3 c2 of present consumption c1 and future consumption c2 . He takes as given the spot prices p1 = p2 = $1. He can borrow and lend freely at an interest rate r = 100%. He has an initial endowment of

c1 = 6 units of the commodity in the present and c2 = 4 units of the commodity in the future.
(a) Find the utility-maximizing consumption bundle of the consumer, and compute his marginal rate of substitution between present and future consumption. (b) What is the effect of a change in the interest rate on savings? (c) Suppose, in addition to his endowment, the consumer owns a firm with a production function y2 = 8 x1 , where is the input in period 1 and y2 is the output in period 2. (NOTE: x1 and c1 are in the units of the commodity in period 1; y2 and c2 are in the units of the commodity in period 2.) Determine the level at which the consumer will operate the firm and the utility-maximizing consumption bundle he attains. (d) Demonstrate that Fisher's Separation Theorem holds by showing that the problem can be decomposed into two separate problems: a maximization of profits; and a maximization of utility subject to a wealth constraint. Answer: (a) The consumer's problem is

max c0 + 3 c1 1 1 s.t. c0 + c1 6 + 4 1+ r 1+ r
The marginal rate of substitution between present and future consumption is

uc

uc

2 c1 . 3

This should be equal to the price ratio at the optimal consumption levels. That is,

2 c1 * * = 1 + r. Thus, c1 = 9, and hence c0 = 3.5 from the budget constraint. 3

(b) By (a),
* c1 =

9 (1 + r ) 2 . 4
Page 17 of 73

Then, by the budget constraint,

* c0 = 6+

4 9 (1 + r ) 1+ r 4

* * which implies that c0 decreases as r increases, and hence savings c0 c0 increases as r

increases. This is what we would expect in reality. (c) The consumer's problem is

max c0 + 3 c1 s.t. y1 8 y0 0 1 1 c0 + c1 c0 + y0 + ( c1 + y1 ) 1+ r 1+ r
where y0 x0 . This problem can be reduced to the following problem by eliminating c0 and

y1 using the two restrictions: 1 max 8 + y0 + 4 y0 c1 + 3 c1 . y0 , c1 2

* * * * We then have y0 = 4 and c1 = 9. Then, y1 = 16 and c0 = 7.5.

(d) The profit maximization problem is

1 max y0 + 1 + r y1 s.t. y1 8 y0 0
which gives solution y0 = 4, y1 = 16, = 4. The problem of utility maximization subject to

wealth constraint is

max c0 + 3 c1 1 1 s.t. c0 + c1 c0 + c1 + 1+ r 1+ r
which gives solution c0 = 7.5, c1 = 9. Since the solutions in (d) and (c) are the same, Fisher's

Separation Theorem is verified.

3. Exercises for Chapter 3

Exercise 3.1. Suppose that an expected utility function has constant absolute risk aversion

r:

u ( x ) = r, x. What must the form of the utility function be? u ( x )

Answer: We have

Page 18 of 73

u ( x ) du ( x ) =r = rdx u ( x ) u ( x ) ln u ( x ) = rx + C

du ( x ) = rdx u ( x )

where C is some constant. Then

u ( x ) = Derx

u( x ) = D erx dx = A

D rx e = A + Berx r

u ( x ) = r , x, if and only if u ( x ) there are two constants A and B = 0 such that u ( x ) = A + Berx , x.
where A, B and D are some constants. Therefore, for r = 0, Exercise 3.2. Given any constant x and a zero-mean random variable , define r by

u[ x (1 r )] = Eu[ x (1 + )].
2 Denote var(). Derive

r
Answer: By definition,

1 2 Rr ( x ). 2

u[ x (1 r )] = Eu[ x (1 + )].
By Taylor's expansion,

()

the left side of (A) = u( x xr ) u( x ) u ( x ) xr ,

and

the right side of (A)

1 = E[u( x + x )] E u( x ) + u ( x ) x + u ( x ) x 2 2 2 1 2 = u ( x ) + u ( x ) x 2 . 2

Equalizing above two formulae immediately implies an approximated solution of r :

1 2 Rr ( x ). 2

Exercise 3.3. For a quadratic utility function u ( x ) = a0 + a1 x a2 x 2 , show that the expected utility of a random payoff x is a function of the mean and variance of x. Answer: We have

E[u( y )] = E ( a0 + a1 y a2 y 2 ) = a0 + a1 E ( y ) a2 E ( y 2 ) = a0 + a1 E ( y ) a2 {E[ y E ( y )]2 + [ E ( y )]2 } = a0 + a1 E ( y ) a2 var( y ) a2 [ E ( y )]2 .

Page 19 of 73

Exercise 3.4. A sports fan's preferences can be represented by an expected utility. He has subjective probability p that the Lions will win their next football game and probability 1 p that they will not win. He chooses to bet $ x on the Lions so that if the Lions win, he wins $ x and if the Lions lose he loses $ x. The fan's initial wealth is W . (a) How can we determine his subjective odds

p by observing his optimal bet x ? 1 p

(b) Under what condition does an increase in p lead to a higher bet x ? Answer: (a) The individual problem is

max

pu (W0 + x ) + (1 p )u (W0 x ).

The first-order condition implies that

pu (W0 + x* ) = (1 p)u (W0 x* ),

implying

(7)

u (W0 x * ) p = . 1 p u (W0 + x * )
By knowing x * and u,

p can then be determined using above equation. 1 p

(b) By taking the derivative w.r.t p on the FOC (7), we get

u (W0 + x ) + u (W0 x ) dx = . dp pu (W0 + x ) + (1 p )u (W0 x )

By (8), for a risk averse person u < 0 with increasing utility function u > 0, we have

(8)

dx > 0. dp
Exercise 3.5. Suppose that a consumer has a differentiable expected utility function for money with u ( y ) > 0. The consumer is offered a bet with probability probability bet. Answer: We need to show that

2 of winning $t and 3

1 of losing $t. Show that, if t is small enough, the consumer will always take the 3

2 1 u( y + t ) + u( y t ) > u( y ), 3 3
By Taylor expansion, there are and , y y + t , y t y , such that

(9)

when t is small for a differentiable utility function u with u ( y ) > 0 ( u may not be concave).

Page 20 of 73

2 1 2 1 u ( y + t ) + u ( y t ) = [ u ( y ) + u ( ) t ] + [ u ( y ) u ( ) t ] 3 3 3 3 2 1 = u ( y ) + u ( ) u ( ) t . 3 3
Therefore, (9) is true if and only if

2u ( ) u ( ) > 0.
Letting t 0, we have y and y , and then

2u ( ) u ( ) 2u ( y ) u ( y ) = u ( y ) > 0.
Therefore, when t is small, (9) is true. Exercise 3.6. Let individual A have an expected utility function A( x ), and let individual B have an expected utility function B ( x ), where x is income. Let G : R R be a monotonic increasing, strictly concave function, and suppose that A( x ) = G[ B ( x )]. That is, A() is a concave monotonic transformation of B (). (a) Show that individual A is more risk-averse than individual B in the sense of the absolute risk aversion. (b) Let be a random variable with E () = 0. Define risk premiums A and B by

A(W A ) = E[ A(W + )],

B(W B ) = E [ B (W + )].

Here W is initial wealth. If A( x ) = G[ B( x )], show that A B . (c) Interpret the risk premium in words. Answer: Since

A( x ) = G [ B( x )]B ( x ),
if B ( x ) 0, we have

A( x ) = G [ B( x )][ B ( x )]2 + G [ B( x )]B ( x ),

A( x ) G [ B( x )] B ( x ) B ( x ) = B ( x ) . A( x ) G [ B( x )] B ( x ) B ( x )

(b) We know that if f is a convex function, then1 f [ E ( X )] E[ f ( X )]. By definition,

G B(W A ) = E[G B(W + )] B(W A ) = G1 { E[G B (W + )]} .

Since G is concave, G 1 is convex. Therefore,

For those who want to know, let x1 < x2 < < xn be a partition of the value space of the random variable X and P ( xi ) the probability of X = xi , i = 1, , n. Then, by the continuity and convexity of f , we have x P( xi ) lim f ( xi ) P( xi ) = f ( x )dF ( x ) = E[ f ( X )]. f ( EX ) = f lim xi P( xi ) = lim f n n i n

Page 21 of 73

B(W A ) = G1 { E[G B (W + )]} E G1 G B (W + ) = E[ B (W + )] = B(W B ).

Assuming B is strictly increasing, then A B . (c) The risk premium is the maximum amount of money that an expect utility maximizer is willing to pay to avoid risk. Exercise 3.7. For Exercise 3.4, when the probability p of winning x goes up, do you expect the amount x that a person is willing to gamble to go up? Prove your claim. Answer: For a risk averse person with increasing utility function, the answer is Yes. The firstorder condition is

pu (W0 + x ) = (1 p)u (W0 x )

By taking the derivative w.r.t. p on above equation, we get

u (W0 + x ) + u (W0 x ) dx = > 0. dp pu (W0 + x ) + (1 p )u (W0 x )

Of course, for a risk loving person with increasing utility function, the opposite is true. Exercise 3.8. Suppose a farmer is deciding to use fertilizer or not. But there is uncertainty about the rain, which will also help the crops. Suppose that the farmer's choices consist of two lotteries:

1 1 fertilizer (50, ; 10, ), 2 2

1 1 no fertilizer (30, ; 20, ). 2 2

Suppose that the farmer is an expected utility maximizer and has monotonic preferences. What would the farmer choose if he were (i) risk loving? (ii) risk neutral? (iii) risk averse? Answer: If he is risk loving, then
1 u (fertilizer) = 1 2 u (50) + 2 u (10) u (30).

Since by monotonicity u (30)

1 1 u(30) + u(20), this farmer will choose fertilizer. If he is 2 2

risk neutral, then he only cares about the expected income. Since
1 1 1 E (fertilizer) = 1 2 50 + 2 10 > 2 30 + 2 20 = E (nofertilizer),

this farmer will still choose fertilizer. If he is risk averse, then

1 u (fertilizer) = 1 2 u (50) + 2 u (10) u (30).

this farmer's choice will depend on his particular preferences. From the given information, we don't know what this farmer will choose.

Page 22 of 73

Note that by comparing the two distribution functions, the two lotteries don't dominate each other by FOSD or SOSD. Thus, stochastic dominance cannot help determine the preferences. Exercise 3.9. What axiom is violated by the following preference?

(0, 0.75; 100, 0.25)

Answer: If RCLA were not violated, then

0, 0.5; (0, 0.5; 100, 0.5), 0.5].

0, 0.5; (0, 0.5; 100, 0.5), 0.5] (0, 0.75; 100, 0.25)
which would immediately imply a contradiction. Therefore, RCLA must has been violated. Exercise 3.10. Show that the following two utility functions one is a monotonic transformation of the other imply the same preferences with certainty consumption bundles, but not with uncertainty consumption bundles:

u A ( x, y ) = xy ,

u B ( x, y ) = ln x + ln y.

Answer: Let : R+ R, (t ) = ln t. Then u B = u A . Since is a strictly increasing function, u A and u B are equivalent over certainty consumption bundles. But for uncertainty consumption bundles:

X [ (1,1), 1]
we have

and

1 Y ( e, e), ; (e1 , e1 ), 2

1 2

E[u A ( X )] < E[u A (Y )]

and

E [u B ( X )] = E[u B (Y )].

Hence, u A and u B are not equivalent over uncertainty consumption bundles.

4. Exercises for Chapter 4

Exercise 4.1. There are two consumers A and B with utility functions and endowments:
2 1 2 u A ( x1 A , x A ) = a ln x A + (1 a ) ln x A , 2 1 2 u B ( x1 B , x B ) = min( x B , x B ),

wA = (0,1) wB = (1, 0)

Calculate the equilibrium price(s) and allocation(s).

2 1 a 2 1a Answer: Individual A's utility function is equivalent to u A ( x1 . Let p = p1 A , xA ) = ( xA ) ( xA )

and p2 = 1. Then the income is I A = p 0 + 1 1 = 1, and the demands are:

x1 A =

aI A a = , p p

2 xA =

(1 a ) I A = 1 a. 1

Page 23 of 73

2 For individual B, by its utility function, we know that the demands must satisfy x1 B = x B . Then 2 by budget constraint px1 B + x B = I B = p 1 + 1 0 = p, the demands are: 2 x1 B = xB =

IB p = . 1+ p 1+ p

In equilibrium, the total supply of good 1 must be equal to the total demand for good 1:

a p + = 1. p 1+ p
Therefore, p =

a and the allocation is 1 a

2 ( x1 A ) = ( x A ) = 1 a, 2 ( x1 B ) = ( x B ) = a.

Exercise 4.2. We have n agents with identical strictly concave utility functions. There is some initial bundle of goods w. Show that equal division is a Pareto efficient allocation.

1 wi . If xi = w, i = 1, , n, is not Pareto optimal, then there is ann , , xn ) such that other allocation x = ( x1, x2
Answer: Denote w

x = w
i

(10)

and

u ( xi) u( w), i;
By (10), w =

and

j suchthat u ( x j ) > u( w).

(11)

1 xi. Then, by concavity of u, n 1 1 u ( w) = u xi u( x ). n n i

By (11),

u( x ) > u( w) = nu( w). Then

i

above inequality implies u ( w) > u ( w). This is a

contradiction. Therefore, allocation xi = w, i = 1, , n, must be Pareto optimal. Exercise 4.3. We have two agents with indirect utility functions

v1 ( p, I ) = ln I a ln p1 (1 a ) ln p2 ,
and initial endowments

v2 ( p, I ) = ln I b ln p1 (1 b) ln p2 ,

w1 = (1,1),
Calculate the equilibrium prices.

w2 = (1,1).

Answer: Let p1 = p and p2 = 1. Then the incomes are I1 = I 2 = 1 + p. By Roy's Identity,

Page 24 of 73

1 x1 =

v1 p v1 I

a p1 aI1 a (1 + p ) = = = , 1 p1 p I1

1 x2 =

v2 p v2 I

b p1 bI 2 b(1 + p ) = = = . 1 p1 p I2

In equilibrium, the total supply of good 1 must be equal to the total demand of good 1:
1 x1 + x1 2 = 2

or

a (1 + p ) b(1 + p ) + = 2. p p

Therefore, the equilibrium price ratio ( p1 /p2 ) is:

p =

a+b . 2a b

Exercise 4.4. Suppose that we have two consumers A and B with identical utility functions

u A ( x1 , x2 ) = uB ( x1 , x2 ) = max( x1 , x2 ).
Suppose that the total available amount of good 1 is 1 and the total available amount of good 2 is 2, i.e., w = (1, 2). Draw an Edgeworth box to illustrate the strongly Pareto optimal and the (weakly) Pareto optimal sets. Answer: In the following charts, the left chart indicates the Edgeworth box and the indifference curves. The right chart indicates the Pareto optimal points.
B
F B

uB

uA

Figure 4.1. Pareto Optimal Points As indicated by the right chart, the set of weakly P.O. points consists of five intervals AC, CD, DE, EF, and FB:

the set of P.O. allocations = AC CD DE EF FB,

the set of strong P.O. points consists of only two points C and F:

the set of strong P.O. allocations = {C, F}.

Page 25 of 73

Exercise 4.5. Consider a two-consumer, two-good economy. Both consumers have the same Cobb-Douglas utility functions:

ui ( xi1 , xi2 ) = ln xi1 + ln xi2 ,

worth box.

i = 1, 2.

There is one unit of each good available. Derive the contract curve and show it in an Edge-

Answer: By Proposition 4.2, the following equation defines the set of P.O. points:
1 1/x1 1/x1 2 = 2 2 1/x1 1/x2

or

2 x12 x2 = . 1 1 x1 x2

Feasibility requires
1 x1 + x1 2 =1

and

2 x12 + x2 = 1.

1 Let x x1 and y x12 . Then above two equations imply

y 1 y = x 1 x
Therefore,

y = x.

the set of P.O. allocations = {[( x, y ), (1 x, 1 y )] | x = y , x 0} .

This set is the diagonal line in the following diagram.
y
2

P.O.

y=x

Figure 4.2. P.O. Allocations Exercise 4.6. Consider an economy with two firms and two consumers. Denote g as the number of guns, b as the amount of butter, and x as the amount of oil. The utility functions for consumers are

u1 ( g , b) = g 0.4 b0.6 ,

u2 ( g , b) = 10 + 0.5ln g + 0.5ln b.

Each consumer initially owns 10 units of oil: x1 = x2 = 10. Consumer 1 owns firm 1 which has production function g = 2 x; consumer 2 owns firm 2, which has production function b = 3 x. Find the competitive equilibrium. Page 26 of 73

Answer: Denote g = guns, x = oil, b = butter, price of guns Pg , price of butter Pb , price of oil

Px = 1 (we can arbitrarily choose one of prices. We can do that because of the homogeneity of
demand functions). The two consumers are:

consumer1: consumer2:
Firm 1's problem:

u1 ( g , b) = g 0.4 b0.6 , u2 ( g , b) = g 0.5b0.5 ,

g = 2 x, g = 3x ,

x1 = 10. x2 = 10.

1 max Pg g x = max (2 Pg 1) x.
x x

It implies

x1 isindeterminate,

Pg =

1 , 2

1 = 0.

Note that the only possible equilibrium is when Pg = here. Firm 2's problem:

1 . Zero-profit argument is not accurate 2

2 max Pb b x = max (3Pb 1) x.

x x

It implies

x2 isindeterminate,
Consumer 1's problem:

1 Pg = , 3

2 = 0.

0.4 0.6 max u1 ( g , b) = g b g ,b

s.t. Pg g + Pb b = x1 + 1
Its solution is

g1 =
Consumer 2's problem:

0.4 x1 = 8, Pg

b1 =

0.6 x1 = 18. Pb

0.5 0.5 max u2 ( g , b) = g b g ,b

s.t.
The solution is

Pg g + Pb b = x2 + 2 .

g2 =
Market clearing conditions:

0.5 x2 = 10, Pg

b2 =

0.5 x2 = 15. Pb

Page 27 of 73

x1 + x2 = x1 + x2 ,

g1 + g2 = 2 x1 ,

b1 + b2 = 3x2 .

Because of Walras Law, we only need two of these three conditions to determine the equilib rium. They imply that x1 = 9 and x2 = 11. Therefore, the equilibrium is: = 9, x1 = 11, x2 = 8, g1 = 10, b1 = 18, b2 = 15, g2

Pg =

1 , 2

1 Pb = . 3

Exercise 4.7. Suppose that there are one consumer, one firm, and one good x. The firm is owned by the consumer. The consumer has an endowment of 1 unit of time for working and enjoying leisure, and has utility function u ( x, y ) = a ln x + (1 a ) ln y for good x and leisure time y. The firm inputs l amount of labor to produce x = al amount of good. Find the competitive equilibrium. Answer: Firm's problem:

= max px wl = max ( ap w)l.

x ,l l

The solution is

, if l = 0, ], if if 0,
d

ap > w, ap = w, ap < w.

The only possible equilibrium is when ap w = 0. We thus only consider

l d isindeterminate,
Consumer's problem:

x s = al d ,

= 0.

a 1a max u ( x, y ) = x y x, y

s.t. px + wy = w 1 +
gives solution

xd =
Market clearing conditions:

aw , p

yd =

(1 a ) w = 1 a. w

l d + y d = 1,

xd = xs .

Because of Walras Law, we only need to use one of conditions to determine the equilibrium.

w aw implies The first condition implies that l = a. Then, x = al = a , and x = = a. p p

Therefore, the equilibrium is:

l = a,

x =a ,

w = a. p
Page 28 of 73

Exercise 4.8. Suppose that the economy is the same as in Exercise 4.7 except that the firm has production function x =

l . Find the competitive equilibrium.

Answer: We can arbitrarily set p = 1. Firm's problem:

= max x wl = max l wl ,
x,l l

gives

1 2 l

=w

ld =

1 4w2

xs =

1 , 2w

1 . 4w

Consumer's problem:
a 1a max u ( x, y ) = x y x, y

s.t. x + wy = w 1 +
gives solution

xd =

a( w + ) 1 = a w + , 1 4w

yd =

(1 a )( w + ) 1 = (1 a ) 1 + . w 4w2

Market clearing conditions:

l d + y d = 1,

xd = xs .

Because of Walras Law, we only need to use one of conditions to determine the equilibrium. It implies that w =

2a . Therefore, the equilibrium is: 4a x =

a l = , 2a

a , 2a

w = p

2a , 4a

1 a . 2 2a

Exercise 4.9. There are two goods x and y with prices p x and p y , respectively, and two individuals u1 ( x, y ) = x y1 and u2 ( x, y ) = x y1 with w1 = ( x1 , y1 ) and w2 = ( x2 , y2 ). (a) Derive the contract curve. Suppose 0 < < < 1. Draw it in an Edgeworth box. (b) Derive the equilibrium price ratio(s) p p x /p y . Answer: (a) We have

u1 x u2 x = u1 y u2 y

( y1 + y2 y ) y = (1 ) x (1 )( x1 + x2 x ) y= (1 ) ( y1 + y2 ) x (1 )( x1 + x2 ) + ( ) x

which gives the contract curve as x goes from x = 0 to x = x1 + x2 . We have Page 29 of 73

yx =

(1 ) (1 )( x1 + x2 )( y1 + y2 ) > 0, [(1 )( x1 + x2 ) + ( ) x ]2 (1 ) (1 )( x1 + x2 )( y1 + y2 ) y xx = 2( ) < 0. [(1 )( x1 + x2 ) + ( ) x ]3

y
B

.
uA uB

Contract curve A

x
y

Figure 4.3. Contract Curve and Equilibrium (b) We have

x1 =

I1 ( px1 + y1 ) = , p p

x2 =

I 2 ( px2 + y2 ) = . p p

Equilibrium condition

x1 + x2 = x1 + x2
implies

p ( x1 + x2 ) = ( px1 + y1 ) + ( px2 + y2 )
which can be solved to get the equilibrium price ratio

p=

y1 + y2 . (1 ) x1 + (1 ) x2

Exercise 4.10. There are two goods x and y , and two individuals

u1 ( x, y ) = u2 ( x, y ) = min{x, y}
with w1 = (3, 6) and w2 = (7, 4). (a) Find all the Pareto optimal allocations. Are they strongly Pareto optimal? (b) Find all the equilibrium price ratio(s) p p x /p y . Answer: (a) The contract curve is the diagonal line in the chart. The points on the contract curve are strongly P.O.

Page 30 of 73

. W

contract line

.
u2

u1

Figure 4.4. Contract Curve and Equilibria (b) The set of equilibria is { p | 0 p }. That is, all the possible values of p Px /Py are equilibria.

5. Exercises for Chapter 5

There are no exercises for Chapter 5.

6. Exercises for Chapter 6

Exercise 6.1. You have just been asked to run a company that has two factories producing the same good and sells its output in a perfectly competitive market. The production function for each factory is:

yi = Ki Li ,

i = 1, 2.

Initially, the capital stocks in the two factories are respectively K1 = 25 and K 2 = 100. The wage rate for labor is w, and the rental rate for capital is r. In the short run, the capital stock for each factory is fixed, and only labor can be varied. In long run, both capital and labor can be varied. (a) Find the short-run total cost function for each factory. (b) Find the company's short-run supply function of output and demand functions for labor. (c) Find the long-run total cost function for each factory and the long-run supply curve of the company. (d) If all companies in the industry are identical to your company, what is the long-run industry equilibrium price? (e) Let r = 1. Suppose the cost of labor services increases from $1.00 to $2.00 per unit. What is the new long-run industry equilibrium price? Can you determine whether the quantity Page 31 of 73

of capital used in the long run will increase or decrease as a result of the increase in the wage rate from $1.00 to $2.00 ? Answer: (a) For each factory with capital stock K ,

c( y , K ) min {wL + rK | y = KL } =
L

w 2 y + rK . K

Therefore, the short-run cost functions are

c1 ( y ) =

w 2 y + 25r, 25

c2 ( y ) =

w 2 y + 100r. 100

(b) The firm cares about the total profit from its two factories. The objective of firm is therefore to maximize the total profit:

= max p ( y1 + y2 ) c1 ( y1 ) c2 ( y2 ).
y1 , y2

The FOCs give us the well-known equality:

p = MC1 = MC2 .
We have MC1 ( y ) =

2w w y and MC2 ( y ) = y. Then p = MC1 ( y1 ) and p = MC2 ( y2 ) imply 25 50 2w w 25 p 50 p y1 and p = y2 . Thus, y1 = and y2 = . Therefore, the short-run that p = 25 50 2w w 25 50 p p y = y1 + y2 = + p = 62.5 . 2w w w
The labor demands for the factories are:

supply function is:

1 2 1 25 p 25 p , L1 = y1 = = 2w w K1 25 4
Therefore, the labor demand is

p 1 2 1 50 p L2 = y2 = = 25 . w w K2 100

125 p L = L1 + L2 = . 4 w
(c) The cost for each factory is

ci ( yi ) min {wL + rK | yi = KL } .
L,K

The Lagrange function is

L wL + rK + yi KL ,
implying

Page 32 of 73

Li =
The total cost is then

w yi , r

Ki =

r yi . w

c( y ) = c1 ( y1 ) + c2 ( y2 ) = 2 wr ( y1 + y2 ) = 2 y wr .
From the profit function = py c( y ) = ( p 2 wr ) y , we immediately find the long-run supply function:

if s y = [0, ] if 0 if

p > 2 wr p = 2 wr p < 2 wr .

That is, the long-run industry supply curve is horizontal. (d) In a competitive market, with a horizontal industry supply curve, the long-run equilibrium price must be p = 2 wr , whatever the industry demand curve is. (e) The original long-run equilibrium price is p = 2, and the new price is p = 2 2. The total capital investment is

K = K1 + K 2 =

r ( y1 + y2 ) = w

r y. w

With an increase in w and p, output y is reduced, implying K will be reduced.

.
p

ys

y
Exercise 6.2. Suppose that two identical firms are operating at the cooperative solution and that each firm believes that if it adjusts its output the other firm will adjust its output to keep its market share equal to

1 . What kind of industry structure does this imply? 2

Answer: Let p (Y ) be the market price of the good when the output is Y , c( yi ) is the cost of firm i when its output is yi . The two firms have the same cost function. The cartel maximizes their total profit:

Page 33 of 73

max i p( y1 + y2 )( y1 + y2 ) c( y1 ) c( y2 ).
y1 , y2

The FOCs are

p (Y ) + p (Y )Y = c ( yi ).

(12)

= y2 (the symmetric solution). Thus, the FOC becomes We look for a solution for which y1

Y p(Y ) + p (Y )Y = c . 2

(13)

We can rewrite (13) as

Y MR (Y ) = c , 2

where R (Y ) p (Y )Y . On the other hand, the Cournot output is determined by

Y 1 MR(Y ) p (Y )Y = c . 2 2

Y c 2

.B

A . C .
MR(Y )

D
1 MR(Y ) p(Y )Y 2

Figure 6.1. A market-share Cournot equilibrium In the diagram, point A is the competitive solution, for which each firm takes the market price as given; point B is our solution, for which each firm acts upon a decreasing demand and assume equal market share as the other's reaction; point C is the Cournot equilibrium. From the diagram, we can conclude that The equilibrium output at B is lower than the output at the competitive solution and the output at the Cournot equilibrium. The equilibrium price at B is higher than the price at the competitive solution and the price at the Cournot equilibrium. Exercise 6.3. Consider an industry with two firms, each having marginal costs equal to zero. The industry demand is Page 34 of 73

P(Y ) = 100 Y ,
where Y = y1 + y2 is total output. (a) What is the competitive equilibrium output? (b) If each firm behaves as a Cournot competitor, what is firm 1's optimal output given firm 2's output? (c) Calculate the Cournot equilibrium output for each firm. (d) Calculate the cooperative output for the industry. (e) If firm 1 behaves as a follower and firm 2 behaves as a leader, calculate the Stackelberg equilibrium output of each firm. Answer: (a) For competitive output, firms take price as given in maximizing their own profits:

max i Pyi ,
which implies

if + yi = [0, + ) if

P>0 P = 0.

That is, the firms' supply curve is the horizontal line at P = 0. So is the industry supply curve. The equilibrium industry supply is thus Y = 100 and the equilibrium price is P = 0. (b) Firm 1 maximizes his own profit, given any y2 :

max
which gives the FOC:

i P ( y1 + y2 ) y1 = (100 y1 y2 ) y1 ,

100 2 y1 y2 = 0. 1 = Firm 1's reaction function is thus y 1 (100 y2 ). 2 1 100 (100 y1 ), which gives y1 = . Therefore, 2 3 100 . 3

(c) By symmetry, the outputs for the two firms should be the same in equilibrium. By the reaction function in (b), we hence have y1 = the Cournot equilibrium is
y1 = y2 =

(d) Suppose the two firms collude. They form a monopoly and maximizes their total profit:

max

P (Y )Y = (100 Y )Y ,

which gives the cartel output: Y = 50.

Page 35 of 73

(e) Firm 1 will behave as in (b), and reacts according to his reaction function

1 = y

1 (100 y2 ). Firm 2 will take this into consideration when maximizing his own profit: 2 max 1 ( y 2 ) + y 2 ] y 2 = 2 P[ y 1 (100 y2 ) y2 , 2

which implies y2 = 50. Then, y1 = 25.

In summary, the competitive industry output is the highest, the Stackelberg industry output is the second, the Cournot industry output is the third, and cartel output is the lowest. Exercise 6.4. Consider a Cournot industry in which the firms outputs are denoted by

y1 , , yn , aggregate output is denoted by Y = i =1yi , the industry demand curve is denoted

n

by P (Y ), and the cost function of each firm is given by ci ( yi ) = cyi . For simplicity, assume

P (Y ) < 0. Suppose that each firm is required to pay a specific tax of ti on output.
(a) Devise the first-order conditions for firm i. (b) Show that the industry output and price only depend on the sum of tax rates

n i =1

i =1 i

t.

(c) Consider a change in each firm's tax rate that does not change the tax burden on the industry. Letting ti denote the change in firm i 's tax rate, we require that

ti = 0. As-

suming that no firm leaves the industry, calculate the change in firm i 's equilibrium output yi . [Hint: use the equations from the derivations of (a) and (b)]. Answer: (a) The profit maximization for firm i is

max
The FOC is

n i = P yj y ( k + ti ) yi . i j =1

P(Y ) + P (Y ) yi = k + ti .
(b) By summarizing (14) from i = 1 to n, we have

(14)

nP(Y ) + P (Y )Y = nk + ti .
j =1

(15)

This equation determines the industry output Y , which obviously depends on than the individual tax rates ti 's. (c) Since the total output depends only on

t , rather
i j =1

t
j =1

and the latter has no change, Y doesn't

change for a tax change. Then, by (14), ti = P (Y )yi , i.e.,

Page 36 of 73

 yi =
where Y is determined by (15).

ti , P' (Y )

Exercise 6.5 (Entry Cost in a Bertrand Model). Consider an industry with an entry cost. Let

ci ( y ) = cy,
stage game.

p d ( y ) = a y,

where a > 0 and c 0 are two constants. Find the equilibrium solution for the following two-

Stage 1. All potential firms simultaneously decide to be in or out. If a firm decides to be in, it pays a setup cost K > 0. Stage 2. All firms that have entered play a Bertrand game. Answer: This is from Example 12.E.2 on page 407 of MWG (1995). Once n identical firms are in the industry, they play a Bertrand game. As we know, if n 0, the result is the competitive outcome, i.e., p = c and the profit without including the entry cost K is zero for all the firms. This means that each firm loses K in the long run. Knowing this, once one firm has entered the industry, all other firms will stay out. Therefore, more intense competition in stage 2 results in a less competitive industry! This single firm will be the monopoly and produces at the monopolist output qm = resulting the monopoly price pm =

ac , 2b

a+c . The monopoly profit is 2 m = (a c)2 K. 4b

As long as m 0, a firm will enter and that is the only firm in the industry. Exercise 6.6. Verify the socially optimal number of firms to be n o = 6.9. Answer: We have

( a c ) 2/3 1 in Section K 1/3

W (n ) =

nyn 0

( a y )dy ncyn nK =
2

1 2 a ( a nyn ) 2 cnyn nK 2

cn a c nK n +1 2 n 1 a c ac = a (a c) n cn nK n + 1 n +1 2 n +1

1 a c = a 2 a n 2 n + 1

Page 37 of 73

n 1 a c (a c )2 n nK n +1 2 n + 1 2 n 1 n 2 = 2 ( a c ) nK 2 n + 1 n + 1 1 = 1 (1 )2 ( a c ) 2 K, 2 1 =
where

n . Then, n +1 0=

W K = (1 )( a c )2 , (1 )2

implying

K , = 1 ( a c ) 2
o

1/3

implying

no =

o = 1 o

K 1 ( a c ) 2 K ( a c ) 2

1/3

1/3

( a c )2/3 1. K 1/3

7. Exercises for Chapter 7

Exercise 7.1 (Mixed-Strategy Nash Equilibrium). A principal hires an agent to perform some service at a price (which is supposed to equal the cost of the service). The principal and the agent have initial wealth w p = 1.3 and wa = 0.5, respectively. The principal can potentially lose l = 0.8. If the agent offers low quality, the probability of losing l is P 1 = 80%; if the agent offers high quality, the probability of losing l is P3 = 50%. The quality is unobservable to the principal. The price of a low quality product is (paid to the agent) is c1 = 0.08 and the price of a high quality product is c3 = 0.2; by the competitive market assumption, c1 and c3 are the costs of producing the products (the agent bears the costs). The agent is required by regulation to provide high-quality services, but he may cheat. After such a bad event happens, the principal can spend F = 0.32 in an investigation; if the agent is found to have provided low-quality services, the agent will have to pay for the loss l to the principal. This game can be written in the following normal form:

investigate, not to investigate, 1

low quality, w p c3 P 1 F , wa + c3 c1 Pl 1 w p c3 Pl 1 , wa + c3 c1

high quality, 1 w p c3 P3 ( F + l ), wa w p c3 P3l, wa

Page 38 of 73

where

= probabilityoftheprincipalinvestigating, = probabilityofagentdeliveringlowquality.
Find the mixed-strategy Nash equilibria. Answer: Assume that the principal can commit ex ante to investigate or not before a loss occurs. In other words, the principal can only make up his mind on investigation before she has suffered a loss. Before a loss occurs, the game box of surpluses is

investigate, not to investigate, 1

low quality, w p c3 P 1 F , wa + c3 c1 Pl 1 w p c3 Pl 1 , wa + c3 c1

high quality, 1 w p c3 P3 ( F + l ), wa w p c3 P3l, wa

In each cell, the value on the left is the surplus of the principal and the value on the right is the surplus of the agent. The optimal choice of is to make the principal indifferent between investigation and no investigation:

w p c3 P 1 F (1 ) P 3 ( F + l ) = w p c3 Pl 1 (1 ) P 3l ,
implying

(16)

P1 F (1 ) P3 F = Pl 1 ,
implying

( Pl 1 +P 3F P 1F ) = P 3F ,
implying

P3 F 0.5 0.32 = = 0.29. Pl 0.8 0.8 + 0.5 0.32 0.8 0.32 1 +P 3F P 1F

The choice of is to make the agent indifferent between cheating and no cheating:

wa + c3 c1 Pl 1 = wa ,
implying

(17)

c3 c1 0.20 0.08 = = 0.19. Pl 0.8 0.8 1

Exercise 7.2 (Pure-Strategy Nash Equilibrium). Find the pure-strategy Nash equilibria in the above exercise. Answer: By substituting the parameter values into the game box of surpluses, we have

investigate,

cheat, 0.84, 0.02

not to cheat, 1 0.54, 0.5

Page 39 of 73

not to investigate, 1

0.46, 0.62

0.7, 0.5

By Proposition 7.2, to find pure-strategy Nash equilibria, we can restrict to pure strategies only. Thus, simply by inspecting each cell one by one, we know that there is no pure-strategy Nash equilibrium. Exercise 7.3. For the following game, find the pure-strategy NEs. Show whether or not they are trembling-hand perfect.

Player 1 :

L1 R1

Player 2 L2 R2 1, 6 0, 5 1, 1 1, 2

Answer: This is a situation in which a player is indifferent from two alternative strategies, one of which is the equilibrium strategy. This player has no incentive to deviate if other players don't make any mistakes. However, the situation changes if possible mistakes by other players are taken into account. There two NEs: ( L1 , L2 ) and ( R1 , R2 ). In ( L1 , L2 ), given L2 , player 1 is indifferent from L1 and R1 . However, if player 2 may make some mistakes by taking R1 with probability > 0, no matter how small is, player 1 will be strictly prefer R1 to L1 . Thus,

( L1 , L2 ) is not a trembling-hand NE, while ( R1 , R2 ) is.

Exercise 7.4. For the game in Example 7.14, find all the pure-strategy Nash equilibria. Answer: The strategy sets for players 1 and 2 are simple:

S1 = {L1 , R1 },

S 2 = {L2 , R2 }.

There are three information sets for player 3. Denote a typical strategy of player 3 as

s3 = ( a1 , a2 , a3 ), where a1 is the action if the information set on the left is reached, a2 is the action if the information set in the middle is reached, and a3 is the action if the information
set on the right is reached. Player 3 has eight strategies:

s13 = (l , l , l ), s23 = ( r , l , l ), s33 = (l , l , r ), s43 = ( r, l , r ), s53 = (l , r, l ), s63 = ( r , r, l ), s73 = (l , r , r ), s83 = ( r, r, r ).

The normal form is

P1 plays L1 P2: L1 R2

P3 s13 2,0,1 2,0,1 s23 -1,5,6 -1,5,6 s33 2,0,1 2,0,1 s43 -1,5,6 (-1,5,6) s53 2,0,1 2,0,1 s63 -1,5,6 -1,5,6 s73 2,0,1 2,0,1 s83 -1,5,6 (-1,5,6)

P1 plays R1 P2: L2 R2

s13 3,1,2 0,-1,7

s23 3,1,2 0,-1,7

s33 3,1,2 -2,2,0

P3 s43 s53 s63 s73 s83 3,1,2 (5,4,4) (5,4,4) (5,4,4) (5,4,4) -2,2,0 0,-1,7 0,-1,7 -2,2,0 -2,2,0
Page 40 of 73

All the pure strategy Nash equilibria are indicated in the boxes. To find all the Nash equilibria, we can check each cell one by one. A cell cannot be a Nash equilibrium if one of the players doesn't stick to it. In each cell, we can first check to see if player 3 will stick to his strategy, by which we can quickly eliminate many cells. A sequentially rational NE must be an outcome from backward induction. Example 7.14 shows that backward induction only leads to one outcome: s1 = R1 , s2 = L2 , s3 = s53 , which is one of the Nash equilibria. Exercise 7.5. In Example 7.16, explain why there are mixed-strategy NEs in which P1 mixes

M 1 and R1 arbitrarily and P2 chooses R2 .

Answer: ? Exercise 7.6. Find all the pure-strategy Nash equilibria of the following game (in Example 7.21).
P1
o

L1

R1

P1

0 0

.
L2 2 1

L 1
1

R 1

2 L2

P2

R2

R2

1 2

1 1

2 3

Answer: P2 has one information set H containing two nodes. Based on this information, P2 has two strategies:

s12 = L2 ,

s22 = R2 .

P1 has two information sets H1 and H 2 , where H 1 contains the initial node. Denote P1's strategies as s1 = a1 , a2 , where a1 is an action at H 1 and a2 is an action at H 2 . We can then find the normal form: P1

L1 , L 1
P2:

L1 , R 1
(0, 0) 0, 0

R1 , L 1
-1, -2 -2, 1

R1 , R 1
1, -1 (3, 2)

L2 R2

(0, 0) 0, 0

Page 41 of 73

We can easily find the pure-strategy Nash equilibria, as indicated in the above box. Among these three NEs, there is one SPNE, which is

, s1 = R1 , R 1

s2 = R2 .

at node x. Then, since choosing R means a payoff of 1, P1 chooses L at the chooses R 1 1 1

beginning. Hence, any belief system with 1 > 2/3 can support a BE that leads to the payoff pair (0, 0). Such a BE is:
, s = L , > 2 . = L1 , R s1 1 2 2 1 3

Given = (1 , 2 ) , P2 chooses L2 iff 1 + 2 > 21 + 32 or 1 > 2/3. If so, P1

(18)

By a similar argument and with the consistency of beliefs on the equilibrim path, there is another BE in which P2 chooses R2 :
, s = R , = 1. s1 = R1 , R 1 2 2 2

(19)

Further, if 1 = 2 / 3, P2 is indifferent between L2 and R2 . Let P2s mixed strategy in this case

and R . This turns out to be impossible. Hence, there is no BE in be indifferent between L 1 1

this case. Hence, there are only two possible BEs, which are in (18) and (19). Since the BE in (18) is not a SPNE, we conclude that BEs may not be SPNEs. Exercise 7.7. A revised version of Exercise 9.C.7 in Mas-Colell et al. (1995, p.304)]. (a) For the following game in Figure 7.1, find all the pure-strategy NEs. Which one is the SPNE?
P1
o

be 2 = (t ,1 t ), where t [0, 1]. If H is on the equilibrium path, since 1 (0, 1), P1 must

P2
1

U 2 1 1

.
D

P2

4 2

5 1

2 2

Figure 7.1. NEs and SPNEs (b) Now suppose that P2 cannot observe P1's move. Draw the game tree, and find all the mixed-strategy NEs. (c) Following the game in (b), now suppose that P1 may make a mistake in implementing his strategies. Specifically, after P1 has decided to play T , he may actually implement T with probability p and mistakenly implement B with probability 1 p; symmetrically, after

Page 42 of 73

P1 has decided to play B, he may actually implement B with probability p and mistakenly implement T with probability 1 p. 2 Draw the game tree and find all the BEs. Answer: (a) There are two information sets for P2. Let ( a1 , a2 ) be a typical P2's strategy, where a1 is an action taken at the left information set and a2 is an action taken at the right information set. The normal form of the game is P2 (D, D) P1: B T 4, 2 5, 1 (D, U) (4, 2) 2, 2 (U, D) 1, 1 5, 1 (U, U) 1, 1 (2, 2)

There are two pure-strategy NEs: = [ B, ( D, U )] and = [T , (U , U )]. The first one is the SPNE. (b) The game tree is:

P1
o

.
D

P2

H2
U 2 1 1
1

.
D U

4 2
The normal form is

5 1

2 2

P2 P1: B T D 4, 2 5, 1 U 1, 1 (2, 2)

There is a pure-strategy NE: = (T , U ). Since playing T is a strictly dominant strategy for P1, this NE is the only mixed-strategy NE. (c) The game tree is

In Mas-Colell et al. (1995), it is P2 who may make a mistake in observing P1's strategies. In this case, there is no mistake in implementation; it is just a mistake in identifying the actual strategy.

Page 43 of 73

P1
o

.
D

P2

2
p 2 + (1 p) 1

p 1 + (1 p) 2

H2

U 2 1 1
Figure 7.2.

.
U

4 2

5 1

2 2

In this game tree, the beliefs are

1 = p1 + (1 p ) 2 ,

2 = p 2 + (1 p )1 ,

which are derived from Bayes rule by allowing the possibility of an error in implementation, where i 0 and 1 + 2 = 1. We have 1 + 2 = 1. We can also have the following game tree, where P2's beliefs are also derived from Bayes rule. Since the two game trees are equivalent, we will thus use Figure 7.2 only.

P1
o

.
p

Nature

.
B 1 p
(1 p) 2

.
D 4 2

B T 1 p
(1 p) 1

p 1

.
U

P2 H2 D

pT

p 2

.
U 1 1

1 5 1 1

5 2 2 1

4 2 2 2

We now solve for BEs in the game tree of Figure 7.2. We solve by backward induction. We find

D
Then, first, if D

U 21 + 2 > 1 + 22 (1 2 p ) 2 > (1 2 p )1 .

(20)

U , P1 will choose T , i.e., 1 = 0 and 2 = 1. To be consistent with (20), we 1 1 need p < . Thus, we have one BE when p < : 1 = 0 and 1 = 1. 2 2
Second, if D U , P1 will also choose T , i.e., 1 = 0 and 2 = 1. To be consistent with (20), we need p >

1 1 . Thus, we have another BE when p > : 1 = 0 and 1 = 0. 2 2

Page 44 of 73

Third, if D U , (20) implies (1 2 p ) 2 = (1 2 p )1 . If p

1 , we have 1 = 2 , i.e., 2

1 . P1 compares the expected profits for the two choices: B = 41 + 2 and 2 T = 51 + 22 . Since T > B , P1 chooses T , i.e., 1 = 0 and 2 = 1, which is inconsistent 1 1 with i = . If p = , we still have B = 41 + 2 and T = 51 + 22 . Since T > B , P1 2 2 1 chooses T , i.e., 1 = 0 and 2 = 1. Thus, we have another BE when p = : 1 = 0 and 1 2 can be any value in [0, 1]. i =
In summary, we have three BEs: Error BE P1 plays T , P2 plays D P1 plays T , P2 plays U P1 plays T , P2 plays any strategy (pure or mixed)

p< 1 2 p> 1 2 p=
1 2

Exercise 7.8. One problem with a BE is that it may not be trembling-hand perfect. Consider Example 7.10 with the game in Figure 7.3.

P1
o

.
L2 1 2

L1
1

R1

2
R2 0 2 L2 0 1

P2

R2 3 3

Figure 7.3. Trembling-Hand Perfect Equilibrium (a) Show that we have the following BE:
s1 = L 1 , s2 = L2 , 1 = 1, 2 = 0,

with payoff pair (1, 2). (b) Show that this BE is a SE. Note that we already know in Example 7.10 that this strategy
profile ( s1 , s2 ) is not trembling-hand perfect.

Answer: It is simple. You do by yourself.

Page 45 of 73

8. Exercises for Chapter 8

Exercise 8.1 (Akerlof). In the Akerlof model, we now suppose that the buyers can be guaranteed a minimum quality of the car by inspection and test drive. Specifically, instead of the minimum quality q = 0 for used cars in the market, suppose that all the cars have a minimum quality t > 0. (1) Will adverse selection disappear? (2) Is it possible to have cars with a range of qualities to be traded in the market? Answer: Since the seller will still sell her car for a price p q, the car quality is uniformly distributed along interval [t , p ]. Thus, the average quality of cars on the market is = Since there is demand if

t+ p . 2

3 p, any car can be sold for p 3t. This means that any car with 2 quality 3t or less will be traded in the market, i.e., the seller with car quality q 3t will be able to find a buyer and trade the car at a price p [ q, 3t ]. So, there is a market, and the market is for cars with quality in the range t q 3t. However, it is still a market for lemons
since it is only for low-quality cars. In summary, there is a range of qualities in which cars with those qualities are sold. However, adverse selection still exists, since only low-quality cars are chosen by sellers to be on the market. Exercise 8.2 (Akerlof). In the Akerlof model, what would be the result if we changed the buyer's utility to

U b = M + 3qn?
That is, the buyer's MU for a car is now 3q, instead of

3 q. How will such an increase in desire 2

for a car change the results? Explain your conclusion intuitively. Answer: For the case with asymmetric information, the decision rule for the buyer is p 3 and for the seller is still p q. By the decision rule, the average quality is still =

p . Thus, 2

any car can be sold and the buyer's decision is to buy any car at the market price. The intuition is this: the buyer is desperate for a car so that as long as the price and quality are not too far apart, he will buy the car. Since all the used cars will be on the market, the mean is = 1. Thus, the market price is p = 2. With this price, the buyer will buy any car and the seller is willing to sell her car.

Page 46 of 73

Exercise 8.3 (RS Insurance). Consider the RS insurance model under complete information. The insurance company offers a price q for an insurance policy that pays a compensation

qz if an accident happens. Let u( I ) = ln( I ).

d ( q ). (a) Compute the demand functions I1d ( q ) and I 2

(b) Compute the slopes of demand

d I1d ( q ) I 2 ( q) and and interpret. q q

d (c) Under what price would a person demands full insurance, i.e., I1d ( q ) = I 2 ( q) ?

Answer: (a) With u ( I ) = ln I , the FOC becomes

(1 ) I 2 1 q = . I1 q
The budget constraint is

(21)

(1 q ) I1 + qI 2 = w qL.
The two equations (21) and (22) determine the two unknowns I1 and I 2 . The solution is

(22)

I1d =

1 ( w qL) , 1 q

d I2 =

( w qL) . q

(23)

(b) The slopes of demand are

I1d ( q) 1 = w L) > 0, 2 ( q (1 q)

d I 2 ( q) = 2 w < 0. q q

d are respectively the demands for income in good and bad times. The signs of the I1d and I 2

slopes can be interpreted as: if the price of insurance against the bad time is high, the individual will buy less insurance for the bad time but will try to enjoy more in the good time.
d (c) By (23), we find that I1d ( q ) = I 2 ( q) if and only if q = . That is, only if the company

behaves like a perfectly competitive firm, the individual will choose full insurance. Exercise 8.4 (RS Insurance). Consider the RS insurance model under asymmetric information. Suppose that insurance companies offer price-quantity contracts. There are two types of agents with type i = H or L. The initial wealth for all agents is w. An agent with type i has the probability i of losing an amount L when the bad event happens. All agents have the same initial wealth w, the same possible loss L and the same utility function u ( I ) of income

I . Let
w = 24, L = 16, u( I ) = 2 I , L = 1 , 2 H = 3 . 4

(a) Compute the marginal rates of substitution for the two types and explain their relative magnitudes. Page 47 of 73

(b) Compute the separating equilibrium, assuming its existence. (c) Determine the condition under which the separating equilibrium survives. Answer: (a) The MRS is a typical person with probability is

MRS =

(1 )u ( I1 ) . u ( I 2 )

Thus, the MRS for the two types are respectively

MRS L =

1 L L

I2 , I1

MRS H =

1 H H

I2 . I1

At each point ( I1 , I 2 ), we always have MRS L > MRS H . That is, since the slope of an indifference curve is the MRS, the indifference curve for type L is always steeper than the indifference curve for type H at any point. The intuition is clear; since MRS is an individual's internal price of the good time, type L values the good time highly since they are less likely to have a bad time. (b) The zero-profit line for type H is

(1 H ) I1 + H I 2 = w H L,
i.e.,

I1 + 3I 2 = 48.
Thus, the point B on Figure 8.1 where I1 = I 2 is B (12,12). The indifference curve going through B is

(1 H )u ( I1 ) + H u( I 2 ) = u(12),
i.e.,

I1 + 3 I 2 = 4 12.
I2
pooling

(24)

P H
uH

L
A

45 line

. C

* H

.C

* L

.o

uL

I1
Figure 8.1. Separating Equilibrium Page 48 of 73

The zero-profit line for type L is

(1 L ) I1 + L I 2 = w L L,
i.e.,

I1 + I 2 = 32.
Then, the point E on Figure 8.1 is determined jointly by (24) and (25):

(25)

I1 + I 2 = 32, I1 + 3 I 2 = 4 12.
To solve this equation set, let x1

I1 and x2 I 2 . Then,
2 x12 + x2 = 32,

x1 + 3x2 = 4 12.
It implies
2 5 x2 24 3 x2 + 80 = 0,

which gives

x2 =

24 3 8 2 12 3 4 2 = . 10 5

There are two possible values for x2 . As indicated by Figure 8.1, we should pick the lower value. Thus,

12 3 4 2 , 5 4 3 + 12 2 x1 = 8 3 3 x2 = . 5 x2 =
Hence, the point E is

E = (22.85, 9.15).
The separating equilibrium is a set of contracts B and E . (c) The indifference curve going through E is

(1 L )u( I1 ) + L u ( I 2 ) = (1 L )u (22.85) + L u (9.15) ,

i.e.,

I1 + I 2 = 7.8.
The budget line for a pooling equilibrium is

(26)

(1 P ) I1 + P I 2 = 24 16P ,

Page 49 of 73

where P = L + (1 ) H =

3 1 , and is the population proportion of type L. Thus, 4 4

(27)

3 1 1 (1 + ) I1 + I 2 = 12 + 4. 4 4 4

In order for the separating equivalent to be sustainable, we need to show that (26) and (27) don't intersect. In other words, we need to show that the following equation set has no solution:

I1 + I 2 = 7.8,

(1 + ) I1 + (3 ) I 2 = 48 + 16.
Again, let x1

I1 and x2 I 2 . The equation set now becomes x1 + x2 = 7.8,

(1 + ) x12 + (3 ) x22 = 48 + 16,

which implies

(1 + ) x12 + (3 )(7.8 x1 ) = 48 + 16,

implying

4 x12 15.6 (3 ) x1 + 60.84 (3 ) = 48 + 16,

implying

x12 3.9 (3 ) x1 + 33.63 19.21 = 0.

As we know, an equation ax 2 + bx + c = 0 doesn't to have a solution if and only if

b2 4ac < 0. For our problem, this condition is

3.9 (3 ) < 4 (33.63 19.21 ) ,
i.e.,
2

9 6 + 2 < 8.84 5.05,

i.e.,

2 0.95 + 0.16 < 0.

The solutions of 2 0.95 + 0.16 = 0 are

(28)

1 =

1 0.95 + 0.952 0.64 = 0.73, 2

2 =

1 0.95 0.952 0.64 = 0.22. 2

As indicated by the following chart, (28) holds if and only if 0.22 < < 0.73. Therefore, when the population share of type L is less than 73%, there exists a separating equilibrium, defined by ( B, E ). Page 50 of 73

y
y = 2 0.95 + 0.16

0.22

0.73

Figure 8.2. Notice that we should ignore the situation with 0.22. When 0.22, the pooling line

P -line will cut the indifference curve uL -curve, but the cutting is below the initial point O,
which will not upset the separating equilibrium. See the figure below.
I2

L
uH

uL

45 line

.B

.E

..

P
I1

Exercise 8.5 (Spence). For the Spence Model in Example 8.1, suppose that the employers hold the following belief: If a job applicant has education e < e1 , he is of type L for certain. If a job applicant has education e > e2 , he is of type H for certain. If a job applicant has education e satisfying e1 e e2 , he is type L with probability p and is type H with probability 1 p. Given this belief, find the wage contract in a competitive labor market, and then find an equilibrium for each of the following three cases. Let q be the population share of type L. (a) For p = q, find a pooling equilibrium in which both types choose e = e1 . (b) For p = 0, find a separating equilibrium in which type L chooses e = 0 and type H chooses e = e1 .

Page 51 of 73

(c) For any p 0, find a separating equilibrium in which type L chooses e = 0 and type H chooses e = e2 . Answer: With zero-profit, this belief implies the following pay scheme:

1, if w( e) = 2 p, if if 2,

e < e1 e1 e < e2 e e2 .

Workers decide to choose e = 0 or e = e1 or e = e2 (no point to choose other levels). (a) Let us try to find a pooling equilibrium. Consider a pooling equilibrium in which both types choose e = e1 . For type L, he will choose e = e1 iff

w( e1 ) cL ( e1 ) w(0) cL (0) and

i.e.,

w( e1 ) cL ( e1 ) w( e2 ) cL ( e2 ),

2 p e1 1 and
i.e.,

2 p e1 2 e2 ,

e1 1 p and
For type H, he will choose e = e1 iff

e2 e1 + p.

(29)

w( e1 ) cH ( e1 ) w(0) cH (0) and

i.e.,

w( e1 ) cH ( e1 ) w( e2 ) cH ( e2 ),

2 p
i.e.,

e1 1 and 2

2 p

e1 e 2 2 , 2 2

e1 2(1 p ) and
Thus, if

e2 e1 + 2 p.

(30)

e1 1 p and
thus have a pooling equilibrium.

e2 e1 + 2 p,

(31)

then both (29) and (30) are satisfied. In this case, if p = q, the employers' belief is correct. We

(b) Let us now find a separating equilibrium. We first try to find a separating equilibrium in which type L chooses e = 0 and type H chooses e = e1 . The conditions for type L to choose

e = 0 are w( e1 ) cL ( e1 ) w(0) cL (0) and

i.e.,

w( e2 ) cL ( e2 ) w(0) cL (0),

2 p e1 1 and

2 e2 1,
Page 52 of 73

i.e.,

e1 1 p and
The conditions for type H to choose e = e1 are

e2 1.

(32)

w( e1 ) cH ( e1 ) w(0) cL (0) and

i.e.,

w( e1 ) cH ( e1 ) w( e2 ) cH ( e2 ),

2 p
i.e.,

e1 1 and 2

2 p

e1 e 2 2 , 2 2

e1 2(1 p ) and
Conditions (32) and (33) are satisfied if

e2 e1 + 2 p.

(33)

1 p e1 2(1 p ) and

e2 e1 + 2 p.

(34)

Note that (34) implies e2 1. In this separating equilibrium, the employers' belief is correct if

p = 0. Then, condition (34) becomes

1 e1 2 and e = 0 and type H chooses e = e1 .
(c) Let us now find another separating equilibrium. We want to find a separating equilibrium in which type L chooses e = 0 and type H chooses e = e2 . The conditions for type L to choose e = 0 are

e2 e1 .

(35)

That is, with p = 0, under (35), there is a separating equilibrium in which type L chooses

w( e1 ) cL ( e1 ) w(0) cL (0) and

i.e.,

w( e2 ) cL ( e2 ) w(0) cL (0),

2 p e1 1 and
i.e.,

2 e2 1,

e1 1 p and
The conditions for type H to choose e = e2 are

e2 1.

(36)

w( e2 ) cH ( e2 ) w(0) cL (0) and

i.e.,

w( e2 ) cH ( e2 ) w( e1 ) cH ( e1 ),

2
i.e.,

e2 1 and 2

e2 e 2 p 1 , 2 2

Page 53 of 73

e2 2 and
Conditions (36) and (37) are satisfied if

e2 e1 + 2 p.

(37)

1 e2 2,

e1 e2 2 p,

e1 1 p.

(38)

In this separating equilibrium, the employers' belief is correct for any p. That is, under (38), there is a separating equilibrium in which type L chooses e = 0 and type H chooses e = e2 . Exercise 8.6 (Spence). Efficiency analysis for the above problem. (a) In comparison with the full-information solution, who is better off and who is worse off in the pooling solution? Why? (b) In comparison with the full-information solution, who is worse off in a separating solution? Why? (c) In Exercise 8.5 (c), why does type H want to choose a higher education e2 when e1 is enough to distinguish themselves from type L? Answer: (a) In the full-information solution, uL = 1 and uH = 2. Thus, in the pooling solution, type L is better and type H is worse off. The reason is that in the pooling solution, type H subsidies type L. Why then does type H choose e1 so that they are pooled with type L? The reason is that e2 turns out to be too costly for type H to distinguish themselves from type L. (b) Type L is indifferent between a separating solution and the full-information solution. Type H is worse off in a separating solution. The reason is that type H is forced to spend on education in order to distinguish themselves from type L. The possibility of disguised type L forces type H to spend on a signal. (c) The reason is that for e1 , the employers are not quite sure which type a person is. For the employers, a person with e1 still have a chance of p for being of type L. If e2 is not too high, type H finds that it is worthwhile to completely convince the employers of their type. Exercise 8.7 (RS Insurance under Monopoly). Consider the RS insurance model under asymmetric information. Instead of a competitive insurance market, assume that there is single monopoly in the insurance market. What is this monopoly's profit maximization solution? Answer: You try out first. We will show you the solution later in Chapter 9.

Page 54 of 73

9. Exercises for Chapter 9

Exercise 9.1. For the buyer-seller model with quasi-linear utility in Section 9.4, let

V ( x , p, ) = p

2 x , 2

2 1 U ( x, p, ) = + x p, 4

where is the quality of a product, x is the quantity traded, and p is the payment from the buyer to the seller. Quantity x and payment p are observable, but quality is not observable to the buyer. Given a payment, higher quality and higher quantity yield higher satisfaction for the buyer but costs more for the seller. Let the distribution function F ( ) be the uniform distribution function on = [0, 1], i.e., f ( ) = 1 for [0, 1]. (a) Find the optimal solution x ( ) under asymmetric information and x ( ) under complete information using the direct mechanism that maximizes the buyer's expected utility. (b) Draw a figure for x ( ) and x ( ).

1 2 2 Answer: We have u (, x ) = + x and v (, x ) = x , with v x = x < 0. 2

(a) Equation (9.73) in the book becomes

1 2 + x = 0, 4
implying

x ( ) = +
We have

1 . 4

dx ( ) 1 = 1 2 , d 4
Thus, x is decreasing when

d 2 x ( ) 1 = 3. 2 d 8

1 1 , and x is increasing when . Since v x = x < 0, 2 2 we need x ( ) 0. Thus, if x ( ) is decreasing around a point , by the first argument followx ( ) = x ( )

ing (9.77) in the book, we have (39)

1 , x ( ) cannot be strictly 2 1 1 decreasing if . By the requirement x ( ) 0, x ( ) must be constant on [ , 1]. Let 2 2 1 x( ) = c for b, 1], where b . By (9.78) and (9.79) in the book, we have 2
around the point . Thus, since x ( ) is not decreasing if

Page 55 of 73


implying

1 b

2 1 + c d = 0, 4

x ( b ) = c,

1 1 c (1 b3 ) + (1 b) (1 b2 ) = 0, 3 4 2 1 b+ = c, 4b
implying

1 1 c (1 + b + b2 ) + (1 + b) = 0, 3 4 2 1 b+ = c. 4b
By substituting the second equation into the first one, we have an equation for b :

1 1 1 b + 1 (1 + b + b2 ) + (1 + b) = 0. 3 4 2 4b

(40)

The solution is b = 0.323. In [0, b], since x ( ) is strictly decreasing, by the condition (39), it is impossible to have an open internal on which x ( ) is constant. That is, x ( ) must be strictly decreasing on [0, b], implying x ( ) = x ( ) for [0, b]. In summary,

1 x ( ) = + , 4

1 + 4 , if x ( ) = 1 b + , if 4b

0 b b < 1,

where b is determined by (40).

1 1 , and x is increasing when . Also, x ( ) is con2 2 vex. By this knowledge, we can now draw the picture for x ( ).
(b) x is decreasing when

x ** ( )

x ( )

1 Figure 9.1. x ( ) and x ( )

1 2

Page 56 of 73

Exercise 9.2. Prove Proposition 9.4 (Revenue Equivalence Theorem). Hint: verify that the seller's expected revenue

R = E iNci ( ) is dependent on [1 ( ), , n ( ) ] and

[U1 (1 ), , U n ( n )] only.
Answer: By the revelation principle, we know that any social choice function that is implementable by a Bayesian Nash equilibrium must be incentive compatible. We can thus restrict ourselves to incentive compatible social choice functions only. The seller's expected revenue is R = E Proposition 9.3, we have

i I

ti ( ) . By the condition U i(i ) = vi (i )

E[ti ( )] = E [ ti (i )] = [i yi (i ) U i (i ) ]i (i )d i i
i i i = i yi (i ) U i ( i ) yi ( s )ds i (i )d i i i i i = i yi (i ) yi ( s )ds i (i )d i U i ( i ). i i

Moreover, by integration by parts,

i i

i i i yi ( s )ds i (i )d i = yi ( s )ds yi (i )i (i )d i = yi (i ) [1 i (i ) ] d i , i i i

where i is the distribution function of i . Thus,

E[ti ( )] =

1 i (i ) yi (i ) i ( )d i U i ( i ) i i i ( ) i i 1 I 1 i (i ) = y ( ) j ( j )d 1 I i i i (i ) 1 i I
i

d I U i ( i ).

Therefore, the revenue is

R=

1 1

I I

1 i (i ) y ( ) j ( j )d 1 i i i (i ) iI i I

d I U i ( i ).
i I

By inspection of the above formula, we see that any two Bayesian incentive compatible social choice functions that generate the same functions [ y1 (1 ), , y I (I ) ] and the same value

[U1 (1 ), , U I ( I )] must imply the same expected revenue for the seller.
Exercise 9.3. For the optimal auction in Section 2, assume two symmetric bidders with

i = and J i () = J () for both i = 1 and 2, where > 0 is large enough so that J ( ) > 0.
Show that the transfer scheme is based on the second price. Answer: The optimal transfer scheme is

ti (i ) = U i (i ) i yi (i ) = u + yi ( s )ds i yi (i ).

Page 57 of 73

Here, the term i yi (i ) says that the winner pays i , but the term

yi ( s )ds reduces the

actual payment. We have u = 0. If 1 2 , since y1 ( s ) = 1 when s 2 and y1 ( s ) = 0 when

s < 2 , we have

y1 ( s )ds = 1 2 ,

implying t1 (1 ) = 2 . That is, the transfer scheme is based on the second price. Thus, the optimal solution is the second-price sealed-bid auction.

10. Exercises for Chapter 10

Exercise 10.1 (Insurance). This exercise is from HelpmanLaffont (1975). Consider an economy with one period and one good. The initial income is w dollars. During the period, each agent has probability of having an accident that results in a loss of L dollars. The risk of each individual is independent of others. An agent's utility function is state-dependent and is defined by

u1 ( I ) = I , u2 ( I ) = 0,
reasons, assume w > L + ln ( L) and L > 1.

if there is no accident; if there is an accident.

Each agent is restricted to have no borrowing, i.e., income I 0 in any state. For technical

(a) Find the simplest Pareto equilibrium solution. It is the equilibrium solution for the ArrowDebreu world under complete markets. (b) There is a competitive insurance company that offers a contract that makes a payment z when there is no accident, but no payment when there is an accident.3 Each agent can buy any amount of insurance z for a constant price q (i.e., the insurance premium is qz ). Find the competitive equilibrium. Is this solution a Pareto optimum? (c) Reconsider the problem in (b), but now suppose that the agent can influence the probability by spending x dollars. Let the probability of having an accident be ( x ) = e x . First find the equilibrium solution for the Arrow-Debreu world with complete markets. Also find the competitive equilibrium solution for which the insurance company cannot observe

x and show that it is not a Pareto optimum. Explain why.

(d) Consider a tax scheme that levies a proportional tax t on x and redistribute the tax revenue to those who do not have an accident using a uniform lump-sum transfer T . Assume

Consider this as a pension plan, for which the dead get nothing and what the dead have left is shared among the living population.

Page 58 of 73

the government can observe x. Can this tax scheme restore the Pareto optimum? Are there any other ways to restore the Pareto optimum? Answer: (a) There is a proportion of agents who have an accident. The total income is thus

(1 ) w + ( w L) = w L.
The egalitarian Pareto optimum yields an ante identical income to all those who can profit from it. Thus, by dividing this income among those who don't have an accident, we obtain the egalitarian Pareto optimum at which each of those who doesn't have an accident receives

I1 =

w L and each of those who has an accident receives nothing I 2 = 0. 1

This solution is also the complete-market solution in the Arrow-Debreu world. (b) The individual's income is

I1 = w + z qz, if there is no accident, I 2 = w L qz , if there is an accident.

Given price q, the individual's problem is

max (1 )[ w + (1 q) z ]
z

s.t.

w L qz 0

If q 1, we have z = 0, i.e., there is no demand and thus no profit. So, we must have q < 1, in which case there is a demand for insurance and the individual wants to buy as much as possible, but he is limited by the no-borrowing condition. The solution is z =

w L . The q

insurance company's profit is qz (1 ) z. Zero profit then implies q = 1 . Thus,

z =
The incomes are

w L . 1

I1 =

w L , 1

I 2 = 0.

This solution is the same as the complete-market solution in (a). Thus, the competitive equilibrium is a Pareto optimum. (c) To find the equilibrium solution for the Arrow-Debreu world with complete markets, we repeat the derivation in (a). The total income is thus

1 ( x ) w + ( x )( w L) x = w L x.

Page 59 of 73

At the egalitarian Pareto optimum, each of those who doesn't have an accident receives

I1 =

w ( x) L x 1 ( x)

and each of those who has an accident receives nothing I 2 = 0. A typical

individual solves the following problem

max 1 ( x ) x0
i.e.,

w ( x) L x 1 ( x)

x max w e L x, x0

which yields

x = ln ( L) .
To find the competitive equilibrium solution, we repeat the derivation in (b). The individual's income is

I1 = w + z qz x, if there is no accident, I 2 = w L qz x, if there is an accident.

Given price q, the individual's problem is

max 1 ( x ) [ w + (1 q) z x ] z, x s.t. w L qz x 0
We must have q < 1, otherwise there would be no demand for insurance. Without the budget limit, as long as q < 1, the individual would buy as much z as possible. Thus, with the budget,

z=

w L x . The problem can thus be simplified to q w L x max U ( x ) = 1 ( x ) L+ . x q

The FOC is

1 ( x) U ( x ) L + w L x = e x = 0. q q x
The insurance company's profit is qz (1 ) z. Zero profit then implies q = 1 . Thus,

U ( x ) w L x = e x L+ 1. 1 ( x ) x
Thus, the competitive solution x is the solution of the following equation:
w L x = 1. e x L + x 1 e

Page 60 of 73

We have

U ( x ) 1 w L ln ( L) w L ln ( L) = L+ 1 = . 1 x L L 1 1 L

We have

U ( x ) x

> 0 if w > L + ln ( L) . By the concavity of U in x, this implies x < x .

This means that in the competitive equilibrium, each individual will invest too much in x, and thus the competitive equilibrium cannot be a Pareto optimum. Collective waste occurs because each agent tries to protect himself against an accident. E.g., each agent buys his own fire engine when it would be better for the society to provide one fire engine for all. The marginal private gain from spending x is larger than the marginal social benefit at the social optimum. (d) Given price q, T and t , the individual's problem is

max 1 ( x ) w + T + z qz (1 + t ) x z, x s.t. w L qz (1 + t ) x 0
Again, without the budget limit, the individual would buy as much z as possible. Thus,

z=

w L (1 + t ) x . The problem can thus be simplified to q

w L (1 + t ) x L + T + . max U ( x ) = 1 ( x ) x q
The FOC is

w L (1 + t ) x 1+ t ( x ) L + T + 1 ( x ) = 0. q q
Zero profit qz (1 ) z = 0 implies q = 1 . Thus,

w L (1 + t ) x e x L + T + = 1 + t. 1 x ( )
We also have

1 ( x ) T = tx.
Thus,

w L x e x L + = 1 + t. 1 ( x)
The government will then solve the social welfare maximization problem: Page 61 of 73

 w L x = 1 + = 1 ( x ) L + w L x U x x L ) ) ( ( max t, x 1 ( x) w L x s.t. e x L + = 1 + t. 1 ( x)
The Lagrangian is

L + w L x . 1 t L 1 ( x ) L + w L x + e x 1 x ( )
The FOC are

x ( w L x ) w L x x x ( x) 1 e +e 0 = e L 1 + e L + 2 1 ( x) 1 ( x ) 0 = .
x

Thus, = 0 and

x = ln ( L) .
Therefore, the tax scheme restores the competitive equilibrium to Pareto optimality. We can then solve for the optimal tax rate:

t =e

w L ln ( L) w L x w L x L + 1 = = . L 1 1 ( x ) L 1 ( x ) U ( x ) x .

Notice that t is the same as

Are there any other ways to restore the Pareto optimum? Yes, there are obviously other ways. For example, the government can impose a restriction limiting the use of x such as

x ln ( L) . Given price q, the individual's problem is max 1 ( x ) [ w + z qz x ] z, x s.t. w L qz x 0 x ln ( L) .

Given x, the individual would like to buy as much z as possible. Thus, z = problem becomes

w L x . The q

w L x L+ max 1 ( x ) x q s.t. x ln ( L) .

Page 62 of 73

As shown in (c), if there is no restriction, the individual will want more than x = ln ( L) . Thus, the solution must be x = ln ( L) . Exercise 10.2 (Insurance). Reconsider the competitive insurance industry in Chapter 8 (the RS model). There are two types of individuals. The individuals know their own types but the company cannot observe the types. Assume now that the individuals can affect their probability of having an accident by taking some level of precaution x. The level of precaution x costs $ x. By investing more x, an individual lowers his probability of loss. Assume that no matter how high x is, the probability of loss for the high type is always higher than that for the low type. (a) Find an equilibrium (if one exists) under these circumstances. [That is, find one policy or a pair of policies such that, when each individual chooses the policy (and the level of x, in the case of a high-risk individual) that is the best for him, no firm can increase its profit by dropping a policy or by offering a different one.] Clearly indicate the equilibrium policies in a diagram and state the level of x chosen in equilibrium. (b) Now suppose that the low-risk individuals, rather than the high-risk individuals, can choose a level of x that affects their probability of loss. Assume that even if x = 0, this probability is lower than the probability of loss for the high risk individuals. What can you say about the value of x chosen in an equilibrium in this case? Given the value of x chosen, illustrate in a diagram the policies offered in an equilibrium (if it exists). (c) Is there a welfare improvement for individuals with accident prevention? Answer: Given a price of insurance q, for an individual with probability ( x ) of accident, his problem is

max [1 ( x ) ] u ( I1 ) + ( x )u ( I 2 )
x

s.t. (1 q) I1 + qI 2 = w qL x,
where w is the initial wealth, L is the potential loss of wealth and x is the expenditure on accident prevention. The individual maximizes his expected utility subject to his budget line. Zero profit for the insurance companies implies that q must equal the probability ( x ) of accident for those who bought the policy. Thus, the break-even line is the budget line with

q = ( x ).
We can write the budget line as

(1 q) I1 + qI 2 = (1 q)( w x ) + q( w x L),
which means that the budget line goes through the point ( w x , w x L) and has a slope

1 q . q
Page 63 of 73

(a) The break-even line for high-risk individuals is

1 H ( x )]I1 + H ( x ) I 2 = [1 H ( x )]( w x ) + H ( x )( w x L),

where H ( x ) decreases as x increases. This line will be becoming steeper and at the same time shifting to the left as x increases. The high-risk individuals may improve welfare if the break-even line becomes steeper; however, if x has increased too much, the break-even line will be moved too much to the left. That is, there is a tradeoff between a steeper break-even line and the line being moved too much to the left. The optimal x is the value that gives the optimal tradeoff. The separating equilibrium is the pair ( B, E ) of contracts.

I2
* H

45 line

B .

.E ..o
w z* w

uH

w L z*

wL

I1

Figure 10.1. Separating equilibrium with a precaution spending by high-risk individuals (b) The break-even line for low-risk individuals is

1 L ( x )]I1 + L ( x ) I 2 = [1 L ( x )]( w x ) + L ( x )( w x L),

where L ( x ) decreases as x increases. This line will be becoming steeper and at the same time shifting to the left as x increases. The low-risk individuals may improve welfare if the break-even line becomes steeper; however, if x has increased too much, the break-even line will be moved too much to the left. That is, there is a tradeoff between a steeper break-even line and the line being moved too much to the left. The optimal x is the value that gives the optimal tradeoff. The separating equilibrium is the pair ( B, E ) of contracts.

Page 64 of 73

I2

* L

45 line

w L w L z*

.E u .. o
w z* w

I1

Figure 5.2. Separating equilibrium with a precaution spending by low-risk individuals (c) In (a), both the high-risk and low-risk individual are better off with accident prevention by the high-risk individuals. In (b), only the low-risk individuals are better off, and the high-risk individuals are indifferent. Notice that the low-risk individuals have been better off otherwise they would have chosen x = 0. Exercise 10.3 (The Standard Agency Model). For the standard agency model in Section 1, let
x

3 u( x ) = 2 x ; u = ; c(a ) = a 2 ; 4
mean E ( x ) = a and variance Var ( x ) = a 2 . (a) Show that the second-best solution is

1 f ( x, a ) = e a for x 0, + ). a

The density function f ( x, a ) states that the output follows the exponential distribution with

a =
[Hint: assume +

1 , 2

1 s ( x ) = x+ . 4

f a ( x, a ) > 0 for any x 0 and verify this later]. f ( x, a )

(b) Find the first-best solution a and s ( x ). [Hint: equation 8 3 = 1 + 3 2 has a numerical solution of = 0.66]. Answer: (a) We have

x a a e , a3 x x 2 4ax + 2a 2 a f aa ( x, a ) = e . a5 f a ( x, a ) =
The IC condition is: Page 65 of 73

 u[s( x )] f
The IR condition is

( x, a )dx c ( a ).

u[ s( x )] f ( x, a )dx c(a ) + u .
Let and be the Lagrange multipliers. Then, the Lagrangian is

L = [ x s ( x )] f ( x, a )dx + u[ s( x )] f a ( x, a )dx c ( a ) + u[ s( x )] f ( x, a )dx c(a ) u .

The Hamiltonian for L is

H ( x s ) f ( x, a ) + u( s ) f a ( x, a ) + u( s ) f ( x, a ),
We have

f ( x, a ) f ( x, a ) f ( x, a ). Hs = u ( s ) + a f ( x, a )
The first-order condition for the Hamiltonian implies the Euler equation:

f ( x, a ) 1 = + a , u [ s( x ) ] f ( x, a )

if +

f a ( x, a ) > 0. f ( x, a )

Together with the limited liability condition, the optimal contract is

2 xa + 2 , if a s ( x ) = 0, if

xa 0; a2 xa + 2 < 0. a

We will assume that +

xa 0 for any x 0 and verify this later. a2

( x, a )dx + u[ s( x )] f aa ( x, a )dx c ( a ) = 0.

The FOC for a is La = 0, which implies

[ x s( x )] f

(41)

Three conditions, the IC condition, the IR condition and (41), can determine the three parameters , and a . The IR condition implies
x x 1 a xa 2 1 a a + u = 2 + 2 e dx = 2 + 2 ( x a ) e dx 0 a a a 0 a 2 = 2 + 2 E ( x a ) = 2 , a 2

implying

=
By the IC condition, we have

1 2 (a + u ) . 2

(42)

Page 66 of 73

2
implying

x x a x a a + 2 e dx = 2a, a3 a

a =

x x x a 1 x a 1 a a + e dx e dx 0 a 0 a2 a2 a x a 1 + = E var ( x ) = var ( x ) = , 2 4 4 a a a a2

implying

= a3.
By (41),

(43)

0= x

x a a x a a x a e dx + e dx 3 2 0 0 a3 a a x x 2 4ax + 2a 2 a x a 3 +a 2 + e dx 2 2 5 0 a a x x 2 xa ( x a) = a e a dx + e a dx 3 3 0 0 a a x 2 xa 2 + 2a ( x a ) + a 2 ( x a ) 3 e a dx a 0 x 3 x a 2 2 1 a +2 +a ( x a ) 2ax + a 2 e dx 2a 3 2 0 a a x x 1 1 2 2 3 1 = E ( x a ) + 2 var ( x ) 2a 3 2 E ( x a ) Var ( x ) ( x a ) e a dx 0 a a a a a x x 2 1 2 1 + [ + a ( x a ) ] ( x a )2 e a dx [ + a ( x a ) ] (2ax a 2 ) e a dx a 0 a a 0 a x x 1 2 2 3 = 1 2a 3 2a ( x a ) e a dx + var ( x ) + ( x a )3 e a dx a 0 a a 0 x x 2 1 2 1 [ + a ( x a ) ] 2a ( x a ) e a dx [ + a ( x a ) ] a 2 e a dx a 0 a a 0 a x

= 1 2a ( x a ) de
3 3 0

x a

4 [ E ( x a ) + aVar ( x ) ] 2a [ + aE ( x a ) ]

x = 1 2a 3 a 3 e a d ( x a ) 3 4a 3 2a 0

= 1 7a 3 + 3 ( x a ) 2 e a dx 2a
0

= 1 7a + 3aVar ( x ) 2a = 1 4 a 3 2 a ,
implying Page 67 of 73

4a 3 + 2a = 1.
In summary, we have

1 2 (a + u ) , 2 = a3 , = 4a 3 + 2a = 1.
Then,

4a 3 + a (a 2 + u ) = 1,
implying

5a 3 + ua 1 = 0.
Since u =

3 , we have 4
3 1 3 1 3 + 3 0 = 5a + a 1 = 5 a a 2 4 4 2 3

2 1 3 1 1 5 = a a + a + + , 4 2 2 4
implying

a =
Then,

1 . 2 1 1 3 1 + = . 4 4 2 2

=
The contract is

1 2 (a + u ) = 2

2 1 s ( x ) = + a ( x a ) = x + . 4

By (42) and (43), we have

f a ( x, a ) 1 2 xa 1 1 = (a + u ) + a 3 2 = (a 2 + u ) + ax a 2 = ax + (u a 2 ). f ( x, a ) 2 a 2 2

We need u a 2 , which is obviously satisfied. (b) With a verifiable a , the principal's problem

max s.t.

sS , aA

[ x s( x )] f ( x, a )dx u[ s( x )] f ( x, a )dx c(a ) + u .

Page 68 of 73

The first-best solution corresponds the case with = 0. From the expression of se ( x ), we immediately find

s ( x ) = 2 .
By the IR constraint, we have

2 f ( x, a )dx = a 2 + u ,
implying

=
Then, the objective function becomes

1 2 ( a + u ). 2

[ x s( x )] f ( x, a )dx = E ( x )
The FOC is

1 = a (a 2 + u )2 . 4

1 = ( a 2 + u )a
implying4

or

1 = 2 a ,

a =
where satisfies

1 , 2

2 =
Since u =

1 + u. 4 2

3 , we have 4 8 3 = 1 + 3 2 .

The numerical solution is = 0.66. Then, the solution is

4

Using the Lagrange method, the FOC for a is

[ x s( x )] f
implying

( x, a )dx + u[ s( x )] f a ( x, a )dx c ( a ) = 0,

0 = (x 2 )

x a a e dx + 2 f a ( x, a )dx 2a 0 a3 x x x a xa e a dx 2a = ( x a ) 3 e a dx + (a 2 ) 0 0 a a3 1 1 = 2 Var ( x ) + ( a 2 ) 2 E ( x a ) 2a = 1 2a , a a

implying a =

1 . 2

Page 69 of 73

a =

1 , 1.32

s ( x ) = 0.437,

= 0.66.

Exercise 10.4. For the sharing contract in the case of double moral hazard and double risk neutrality in Section 10.2, consider the following parametric case:

h( e1 , e2 ) = 1e1 + 2 e2 , X ( h ) = Ah, 1 ci ( ei ) = ei2 , 2

where 1 ,2 > 0, A is a random variable with A > 0 and E ( A) = 1. (a) Derive the second-best solution. (b) Derive the first-best solution. Do we have larger efforts in the first best? Answer: (a) We have

R( e1 , e2 ) = 1e1 + 2 e2 .
By Proposition 10.2, we have
e1 = , 1 1 We now solve for ( e1 , e2 ) from e2 = . 2 2

VJ max s.t.

e1 , e2 E

R( e1 , e2 ) c1 ( e1 ) c2 ( e2 ) R1(e1 , e2 ) = c1(e1 ) + h1( e1 , e2 ) ( e2 ). c2 h2 ( e1 , e2 )

(44)

With the specific functions, (44) becomes

VJ max s.t.
or

e1 , e2 E

1 1 2 1e1 + 2 e2 e12 e2 2 2 1 = e1 + 1 e2 . 2

VJ max s.t.
The Lagrange function is

e1 , e2 E

1 1 2 1e1 + 2 e2 e12 e2 2 2 e e 1= 1 + 2 . 1 2

Page 70 of 73

 e1 e 1 1 2 L = 1e1 + 2 e2 e12 e2 + + 2 1 2 2 1 2 1 1 2 = 1 + e + + e2 e12 e2 . 1 2 1 2 2 2

The FOCs are

ei = i +
And,

. i

1 = 1+
implying

+1+ 2 , 2 1 2

1 1 1 + 2 2 1 2

2 12 2 . 2 12 + 2

Thus,

ei = i
Thus,

2 2 i2 12 2 12 2 1 1 = 1 = . i i 2 2 2 2 2 12 + 2 i 12 + 2 1 + 2 i

13 e = 2 , 2 1 + 2
1

3 2 e = 2 . 2 1 + 2 2

Then,

i =
(b) The first best is determined by

i2 . 2 12 + 2

R1( e1 , e2 ) = c1( e1 ),
implying

(e1 , e2 ) = c2 ( e2 ), R2

e1 = 1 , e2 = 2 .

Obviously, the effort levels are higher in the first best.

Page 71 of 73

11. Exercises for Chapter 11

Exercise 11.1. We have two agents with identical strictly convex preferences and equal endowments. Describe the core and illustrate it with an Edgeworth box. Answer: Using Figure 11.1 done in the book, one can easily figure out the core to be the initial endowment point. The core contains a unique point, which is the initial endowment point. Exercise 11.2. For a two-good two-agent economy, (a) Explain graphically that the core depends on the initial endowments. (b) Is it true that if the initial allocation is already in the core, then it is the only point in the core? Explain. (c) Try to suggest some mild conditions under which the statement in (b) is correct. Answer: (a) The dependency of the core on the initial endowment point W is shown clearly by the following diagram.
y 2

core

core

W core

.W
1

(a)

(b)

.W

(c)

Figure 11.1. The Core (b) No. Let u1 ( x, y ) = u1 ( x, y ) = x + y with w1 = (1, 0) and w2 = (0,1). We see in the above diagram (b) that all the points on the diagonal line are in the core. (c) The weakest conditions are strict quasi-concavity and strict monotonicity for all the utility functions. Exercise 11.3. In a two-agent two-good economy, suppose that the two agents are identical (with the same endowment w ( x 1 , x 2 ) and preferences) and they have strict monotonic and strict convex preferences. Show that the initial endowment point ( w, w) must be in the core.5 Answer: There are two alternative ways to prove. Proof 1: Suppose ( w, w) is not in the core. Then, there is a feasible allocation ( x A , xB ) that blocks ( w, w). That is, x A convexity of the preferences,
5

w and xB

w (or x A

w and xB

w). By the strictly

Strict convexity of preferences means that: x

z and y

z x + (1 ) y

z , for (0, 1).

Page 72 of 73

1 1 x A + xB 2 2
By the feasibility, however, x A + xB 2 w, i.e.,

w.

1 1 x A + xB w. This contradicts with strict 2 2

monotonicity. Therefore, ( w, w) must be in the core. Proof 2: Obviously, no single person would block the distribution ( w, w). We thus only need to show that it is also Pareto optimal, i.e., the whole society won't block it either. By Proposition 4.4, the Pareto optimality of ( x A , xB ) is

u ( x A ) u ( x B ) = , x1 x1

u ( x A ) u ( x B ) = . x 2 x 2

where x jj is the demand of individual i in good j. Obviously, the feasible allocation ( w, w) satisfies the above two conditions, and is thus Pareto optimal. ( w, w) is thus in the core.

End

Page 73 of 73