TSE Micro 1 Master 2

Final Exam Fall 2012

Prof. Renato Gomes

TDs Luc Bridet and George Lukyanov

Exercise 1 : Let the consumption set be X = RL

+ with L 2, and consider a
preference relation over X. Assume that:
is quasilinear and strongly monotone in the first coordinate,

x (0, . . . , 0) for all x X,

x, y X, if x y, there exits v 0 such that x (y1 + v, y2 , . . . yL ).
Prove that there is a utility function of the form u(x) = x1 + v(x2 , . . . , xL )
representing . (2 points)

Exercise 2: Let the consumption set be X = RL + with L 1. The Stone-Geary

utility function has the form
L
bl
u(x) = l=1 (xl al ) if xl > al l
0 otherwise,
L
where al , bl 0 for all l, and l=1 bl = 1. The terms al are often interpreted
as the subsistence levels of the respective commodities. Define the discretionary
L
income under prices p and income w according to D(p, w) w l=1 al pl ,
i.e., D(p, w) is the amount of income in excess of what is necessary to purchase
subsistence levels of all commodities. Assume that D(p, w) 0.
1. Derive the associated expenditure function e(p, u) and show that e(p, u) =
A(p) + B(p) u for suitable functions A(p) and B(p). (1 point)

2. Derive the associated indirect utility function v(p, w). Show that v(p, w) =
D(p, w) for some 0. (1 point)
3. Show that bl measures the share of discretionary income that will be spent
on discretionary purchases of good l, i.e., purchases in excess of the sub-
sistence level al . (1 point)

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Exercise 3: A firm produces one output, q, with two inputs, z1 and z2 . The
technology is represented by a continuous, strictly increasing and concave pro-
duction function f : R2+ R+ , with f (0, 0) = 0.
1. Show that the production set

Y = {(z1 , z2 , q) : z1 , z2 , q R+ , q f (z1 , z2 )}

is closed and satisfies free disposal. (1 point)

2. Show that the set
{z1 , z2 R+ : q f (z1 , z2 )}
is convex for every q R+ . (1 point)

3. Suppose that the firms cost function is

q
c(w1 , w2 , q) = min{w1 , w2 } ,
1q

where w1 , w2 > 0 are input prices. Restrict attention to q [0, 1]. Deter-
mine the functional form of f (z1 , z2 ). (2 points)

Exercise 4: We say that the distribution F () first-order stochastically domi-

nates G() if, for every nondecreasing function u : R R, we have

u(x)dF (x) u(x)dG(x).

1. Prove that if F () first-order stochastically dominates G(), then F (x)

G(x) for every x. (1 point)
2. Assume that u() is dierentiable. Show that if F (x) G(x) for every x,
then F () first-order stochastically dominates G(). (Hint: use integration
by parts). (1 point)

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Exercise 5: Consider an exchange economy that does not allow for free dis-
posal. There are n consumers and two goods, X and Y . A consumption bundle
is denoted by (x, y), meaning x units of good X and y units of good Y . Each
consumers consumption set is R+ R (notice that negative consumption of
good Y is feasible). Every consumer is utility function is quasilinear of the
form
ui (x, y) = vi (x) + y.
Every function vi is strictly concave. The total endowment is (
x, y).
I
1. Prove that a feasible allocation {xi , yi }i=1 is Pareto ecient if and only if
I
{xi }i=1 solves
n
n

max v(
xi ) s.t x
i = x
.
xi }Ii=1
{
i=1 i=1

(2 points)
2. Prove that any two Pareto ecient allocations have the same allocation
of good X. (1 point)

Exercise 6: Consider an economy

{Xi , i }Ii=1 , {Yj }Jj=1 , ,

and assume that preferences i are represented by the continuous utility func-
tions ui (). The utility possibility set associated to is

U = (u1 , ..., uI ) RI : f easible (x, y) s.t ui ui (x) i .

The Pareto Frontier associated to is

U P = {(u1 , ..., uI ) U : (u1 , ..., uI ) U s.t ui ui i and ui > ui f or some i} .

The Maximization of Social Welfare (MSW) consists in

max u s.t u (u1 , ..., uI ) U,

u

where the vector (1 , ..., I ) describes the weights assigned to each consumer i
in the social welfare function.
1. Prove that if Xi is convex for all i, Yj is convex for all j, and ui () is
concave for all i, then the set U is convex. (1 point)
2. Prove that if U is convex, then for all u
U P , there exists 0, = 0,
such that u
solves the MSW problem with weights . (2 points)

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Exercise 7: Consider an Arrow-Debreu economy with I consumers, N goods,
T = 2 dates, and S = 2 states of nature to be realized at date t = 2. There is
trade of Arrow-Debreu securities at t = 1. There is no consumption of goods
at t = 1, only at t = 2. The probability of each state is s , s {1, 2}. We
will focus on one consumer with expected utility preferences. His utility from
consuming the bundle xs RN + at state s is given by u(xs ) (note that utilities
are not state-dependent).
Suppose that p = ( 2 ) is the vector of state-contingent commodity prices
p1 , p
that prevail in an Arrow-Debreu equilibrium, where p ++ is the price of
s RN
each commodity at state s. Let x = ( 2 ) be the bundle of state-contingent
x1 , x
commodities that our consumer purchases at t = 1 given the equilibrium price
vector p = ( 2 ). In what follows, you will be asked to show that in an
p1 , p
Arrow-Debreu economy there is no remaining role for spot markets at t = 2.
1. Show that if our consumer wishes to trade in spot markets at some state
s with spot prices p s , then our consumers budget constraint is p
s xs
s . (1 point)
s x
p
2. Conclude that our consumer can ultimately choose any (x1 , x2 ) such that
s xs p
p s for all s {1, 2}. (1 point)
s x

3. Prove that the consumer can do no better than to choose xs = x s at

each state s by showing that any bundle that is feasible through trading
in sport markets is feasible in the state-contingent commodity market at
t = 1. You should obviously assume that the consumer is forward-looking,
and has correct expectations about the spot market prices at each state
s {1, 2}. Argue that spot markets clear at prices ( 2 ), at which there
p1 , p
is no trade. (1 point)