EC903-7-AU, Microeconomics MRes

Simon Weidenholzer
Class 1
1. Show that if f : R R is a strictly increasing function and u : X R is a utility
function representing the preference relationship , then the function v : X R
defined by v( x ) = f (u( x )) is also a utility function representing the preferences
.
2. Consider lexicographic preferences  defined on R2 as

( x1 , x2 )  (y1 , y2 ) x1 > y1 or x1 = y1 and x2 y2 .

(a) Interpret this preference ordering.
(b) Sketch an indifference curve for a bundle ( x1 , x2 ) in a diagram.
(c) Show that the preferences are complete, transitive, strongly monotone, and
strictly convex.
(d) Show that there does not exist a utility function that represents these preferences.
(e) Show that the preferences are not continuous.
(f) Assume that the consumption set is given by {0, 1, 2, . . . , n} {0, 1, 2, . . . , k}.
Provide a utility function that represents the lexicographic preference relationship .

Class 2
1. Consider a CES utility function with

u ( x1 , x2 ) = ( x1 + x2 )
(a) Show that the CES utility function is homothetic.
(b) Interpret the CES function in each of the cases = 1, 0, and = .
(c) Derive demand functions and the indirect utility function.
2. A utility maximizing consumer has strictly convex, strictly monotonic preferences and consumes two goods, x1 and x2 . Prices ar given by p1 = p2 = 1.
The consumer cannot choose negative quantities of the goods. The consumer has
an income of m and currently chooses x1 > 0 and x2 > 0. Suppose the consumer
is given a grant g x1 which must be entirely spent on x1 . The consumer may
reject the grant.
(a) True of false? If good 1 is a normal good, then the effect of the grant on his
consumption must be the same as the effect of an unconstrained lump sum
grant of the same amount. Justify your answer.
(b) True of false? If good 1 is an inferior good at all incomes m > x1 + x2 , then
the effect must be the same as the one of an unconstrained grant of the equal
amount. Justify your answer.
(c) Suppose that our consumer has homothetic preferences and is currently consuming x1 = 12 and x2 = 36. Draw a graph with g1 on the horizontal axis
and x1 on the vertical axis. Use this graph to show that the amount of good
1 the consumer will demand if his ordinary income is m = 48 and if he is
given a grant of g which must be spent on good 1. At what level of g will
this graph have a kink? Also provide a numerical answer.

Class 3
1. Reconsider the CES utility function.

u ( x1 , x2 ) = ( x1 + x2 )
Determine the expenditure function. Use Shephards lemma to calculate the
Hicksian demand functions.
2. Consider the indirect utility function
v ( p1 , p2 , m ) =

m
.
p1 + p2

Determine the demand functions, the expenditure functions, and the direct utility
function.
3. Show that if u() is homogenous of degree one, then h( p, u) and e( p, u) are homogenous of degree one in u.

4. Consider the Cobb Douglas utility function u( x1 , x2 ) = x1 x2 , with , > 0. Calculate the substitution matrix. Verify that the diagonal elements are negative and
the cross price effects are positive.

Class 4
1. Let Y be a production set. A technology is said to be additive if y Y and y0 Y
implies that y + y0 Y. A technology is divisible if y Y and 0 1 implies
that ty Y. Show that if a technology that is both additive and divisible, then Y
must be convex and exhibit constant returns to scale.
2. The elasticity of substitution measures the curvature of an isoquant and is given
by:
d( x2 /x1 ) TRS
.
=
dTRS x2 /x1
(a) Provide an economic interpretation of .
(b) Show that an equivalent form of is given by
=

d ln( x2 /x1 )
.
d ln | TRS|

(The absolute sign in the denominator makes sure that the logarithm is well
defined.)
(c) Calculate for the CES technology previously introduced.
3. A competitive profit-maximizing firm has a profit function
( w1 , w2 ) = ( w1 ) + ( w2 ) .
The price of output is normalized ton one.
(a) What can you say about the first and second order derivatives of the functions i (wi )?
(b) If xi (w1 , w2 ) is the factor demand function for factor i, what can you say
xi
about the sign of w
?
j

(c) Let f ( x1 , x2 ) be the production function that generated the profit function.
Looking at the first order conditions, what can you say about the form of
this production function?
4. Given the production function f ( x1 , x2 ) = min{ x1 , x2 } , calculate the profit maximizing demand and supply functions, and the profit function. Provide restrictions on such that these function are well defined.

Class 5
1. Consider the following exchange economies with two household (H = A, B) and
two goods (i = 1, 2). xiH and iH denote the consumption, respectively endowment, of household H of good i.
u A ( x1A , x2A )

x1A + x2A , u B ( x1B , x2B ) = ln x1B + x2B , A = (6, 3), B = (2, 1).
q
A
A
A
A
B
B
(b) u A ( x1 , x2 ) = min{ x1 , 2x2 }, u B ( x1 , x2 ) = 2 x1B + x2B , A = (5, 1), B =
(0, 4).
(a)

(c) u A ( x1A , x2A ) = x1A + x2A , u B ( x1B , x2B ) = x1B x2B , A = (6, 1), B = (2, 3).
q
q
(d) u A ( x1A , x2A ) = ( x1A )2 + ( x2A )2 , u B ( x1B , x2B ) = ( x1B )2 + ( x2B )2 , A = (1, 1), B =
(1, 1).
For each of these exchange economies,
(a) Draw an Edgeworth box with multiple indifference curves and depict the
endowments.
(b) Determine the set of Pareto efficient allocations and depict it in your Edgeworth box.
(c) Determine equilibrium prices and allocations.
2. There are three goods in an economy: time (x1 ), an intermidate good (x2 ), and
a consumption good (x3 ). Prices are given by p1 , p2 and p3 . There are two consumers, A und B. The preferences of both consumers are described by the utility
function
u H ( x1 , x2 , x3 ) = x1H x3H .
The consumers endowments are given by H = (8, 0, 0), H = A, B. There a two
firms. Firm 1 is jointly owned by the two consumers and produces good 2 (using
good 1 as an input) according to the production function x2 = f ( x1 ) = 2 x1 Firm
2, is owned by consumer A and produces good 3 from good 2 according to the

production function x3 = g( x2 ) = 2 x2 .
(a) Determine whether the firm is operating under constant, decreasing or increasing returns to scale. Are there any implications for equilibrium prices?
(b) Determine the demand, supply and profit functions of the two firms.
(c) Determine the demand and supply functions of the two consumers.
(d) How many markets are there in this economy? Provide the market clearing
conditions and determine the equilibrium prices and allocations.

Class 6
1. A coin has probability p of landing heads. You are offered a bet in which you will
be paid GBP 2 j if the first head occurs on the jth flip.
(a) What is the expected value of this bet when p = 12 ?
(b) Suppose that your expected utility function is u( x ) = ln x. Express the utility of this game.
(c) Let w0 be the amount of money that would give you the same utility as you
would have solved the game. Solve for w0 .
2. Let R1 and R2 be the random returns on two assets. Assume that R1 and R2 are
independently and identically distributed. Show that an expected utility maximizer will divide her wealth between the two assets provided she is risk averse
and will invest all of her wealth in one asset of she is risk loving.
3. Consider the game of Rock-Scissors-Paper-Lizard-Spock, as in
https://www.youtube.com/watch?v=iSHPVCBsnLw.
(a) Formulate this as a game.
(b) Determine the set of pure strategy equilibria.
4. Lucy and Pete are returning from a remote Pacific island and find that the airline
has damaged the identical antiques that each had purchased. An airline manager
says that he is happy to compensate them but is handicapped by being clueless
about the value of these strange objects. Simply asking the travelers for the price
is hopeless, he figures, for they will inflate it. Instead he devises a more complicated scheme. He asks each of them to write down the price of the antique as
any GBP integer between 2 and 100 without conferring together. If both write the
same number, he will take that to be the true price, and he will pay each of them
that amount. But if they write different numbers, he will assume that the lower
one is the actual price and that the person writing the higher number is cheating.
In that case, he will pay both of them the lower number along with a bonus and
a penalty - the person who wrote the lower number will get GBP 2 more as a
reward for honesty and the one who wrote the higher number will get GBP 2 less
as a punishment.
(a) Formulate this situation as a game.
(b) Determine the set of Nash equilibria of this game.

Class 7
1. Reconsider the game of Rock-Scissors-Paper-Lizard-Spock.

Show that the mixed
strategy profile = (1 , 2 ) =
equilibrium.

( 15 , 15 , 51 , 15 , 15 ), ( 15 , 15 , 51 , 15 , 15 ) is a mixed strategy

2. Two players i = 1, 2 negotiate over the devision of a pie of size 1. Each player
i writes down her demand Fi Si = [0, 1] and puts it in a closed envelope. A
mediator opens the letters and distributes the pie as follows:
If F1 + F2 1, player i obtains F1 +

1 F1 F2
.
2

If F1 + F2 > 1 both players obtain nothing.

(a) Find all pure strategy equilibria of this game.
(b) Prove that the following strategy profile is a Nash equilibrium in mixed
strategies: (1 , 2 ) such that

1/2 if Fi = 1/4,
1/2 if Fi = 3/4,
i ( Fi ) =

0
if Fi 6= 1/4, Fi 6= 3/4.
3. Consider the following game in extensive form.

a
2 b








A 
I20

0
a

I
1


2 b
1
B


X




2
HH

H 
2
0
C
c
1
I2
Y HH
HH
H
HH

Hd
HH
HD
I100
HH
00
HH
I2
H
HH
H2
c
HH
H d
HH
H
HH

1,0
2,2
4,0
0,1

6,6
0,10
10,0
1,1

Player 1 has two information sets I10 , I100 (which are singletons). Player 2 has three
information sets I20 , I20 , I200 .
(a) Find all subgames of this game.
(b) Analyze the subgame that begins at I10 (after X). Write down its normal form.
Find Nash equilibria of this subgame.

(c) Analyze the subgame that begins at I100 (after Y). Write down its normal
form. Find Nash equilibria of this subgame.
(d) Find a subgame perfect equilibrium of the whole game.
(e) Consider the strategy profile s = (s1 , s2 ) such that s1 = ( A, C ) and s2 =
( X, b, d). Is s a Nash equilibrium of the whole game? If yes, is it subgame
perfect?
(f) Consider the strategy profile s = (s1 , s2 ) such that s1 = ( B, D ) and s2 =
(Y, a, d). Is s a Nash equilibrium of the whole game? If yes, is it subgame
perfect?
4. Consider the following game in extensive form. Find all Nash equilibria and
subgame perfect equilibria in pure strategies.
 1,1
2 a

PP
P

P
b PPP -1,-1

c  -1,0
2 


PP
PP

B 






P
PP
PPC
PP

PP
P

c 
PP


PP
P
2 PPPP
P
d

0,1
-1,1

1,2

Class 8
1. Consider a Cournot industry in which the firms outputs are denoted by y1 , y2 , . . . , yn ,
aggregate output is denoted by Y = in=1 yi , the industrys demand curve is denoted by P(Y ), and the cost function for each firm is c(yi ) = cyi . Assume that
P00 (Y ) < 0. Assume that each firm is required to pay a tax ti for each unit of
output produced.
(a) Write down the first order conditions for firm i.
(b) Show that the industry output and price only depend on the sum of tax
rates, in=1 ti .
(c) Consider a change in the each firms tax rate that does not change the tax
burden on the industry. Letting ti denote the change in firm is tax rate, we
require that in=1 ti = 0. Assuming no firm leaves the industry calculate
the change in equilibrium output yi . (Hint: Think carefully about your
answers for the previous two subquestions).
2. Consider a duopoly where two firms compete in prices. Assume that marginal
and fixed costs are equal to zero. Assume there are two types of consumers: U
consumers are uninformed and buy from either of the two firms at random. I
consumers are informed and buy from the firm offering the cheapest price. Both
consumers only demand one unit of the good and their maximal willingness to
pay for this good is given by r > 0.
(a) Consider the case U = 0 and I > 0 and determine the equilibrium pricing
strategies.
(b) Consider the case U > 0 and I = 0 and determine the equilibrium pricing
strategies.
(c) Consider the case U > 0 and I > 0 and show that no equilibrium in pure
strategies exists.
(d) Let f ( p) denote the probability density function of p and F ( p) the associated
cumulative distribution function. Assume that f ( p) is continuous, which
implies that the probability of the two firms charging the same price is zero.
Characterize the symmetric price distributions F ( p) in a symmetric Nash
equilibrium.