Microeconomic Theory Frank Yong Wang (SITE, UIBE)

Microeconomic Theory, Problem Set 2

Due: 4, Dec

Question 1. Suppose that a firm produces a single output q from two inputs x1 and x2 . You ar given
100 monthly observations, and two of these monthly observations are shown in the following table:

Inputs prices Inputs levels Output price Output level

Month w1 w2 x1 x2 p q
3 3 1 40 50 4 60
9 2 2 55 40 4 60

Is there any contradiction between the profit-maximization assumption and these two monthly observa-
tions?

Question 2. Consider the following profit function that has been obtained from a technology that uses
a single input, z:
π(p, w) = p2 wα ,

where p is the output price, w is the input price, and α is a parameter value.

1. Find the value of α for the profit function to be homogeneity of degree one in both p and w.

2. Assuming the value of α for which the profit function satisfies homogeneity of degree one, check if
the profit function π(p, w) satisfies the following properties: (1) nondecreasing in output price p,
(2) nonincreasing in input price w, and (3) convex in prices p and w.

3. Calculate the supply function of the firm, q(p, w), and its demand for input, z(p, w).

Question 3. Consider a strictly risk-averse decision maker who has an initial wealth of w but who runs
a risk of a loss of D dollars. The probability of the loss is θ. It is possible, however, for the decision
maker to buy some insurance. One unit of insurance costs q dollars and pays 1 dollar if the loss occurs.
What is the optimal level of insurance? For simplicity you can take the assumption q = θ.

Question 4. Assume that there are only two assets. The first is a riskless asset that pays $1, and the
second pays amounts a and b (b > a) dollars with probabilities of π ∈ (0, 1) and 1 − π, respectively.


Denote the demand for the two assets by x1 , x2 .
Consider a risk averse decision-maker with initial wealth $1. Prices of both assets are equal to 1, and
short-selling is prohibited for both assets. Thus budget constraint is

x1 + x2 = 1, x1 , x2 ∈ [0, 1]

1. Give a necessary condition (involving a and b only) for the demand for the riskless asset to be
strictly positive.

2. Give a necessary condition (involving a, π and b only) for the demand for the risky asset to be
strictly positive.
Following suppose that the conditions obtained in (1) and (2) are satisfied.

1. Write down the first order conditions for expected utility maximization in the asset demand prob-
lem.
dx1
2. Assume that a < 1. Show by analyzing the first order conditions that < 0.
da

Question 5. Consider an optimal portfolio problem. Suppose there are two assets: a safe one and a
risky one. Without loss of generality, suppose that the net rate of return on the safe asset is 0. The
rate of (random) return on the risky asset is denoted by a random variable z̃. The average return on the
risky asset is assumed to be higher than that on the safe asset, that is, E(z̃) > 0.
Consider an investor with concave (Bernoulli) utility function u(x) who has initial wealth w to invest.
Let α ≥ 0 and β = w − α ≥ 0 denote the amounts of wealth invested in the risky and safe asset.

1. Show that the optimal demand for the risky asset, denoted by α∗ , is strictly positive.
Then, we take the interior solution following, that is, α∗ ∈ (0, w), therefore FOC is sufficient and
necessary for optimality.

2. If the investor exhibits DARA, show that α∗ increases with w. That is, the risky asset is a normal
good.

3. Denote γ ∗ = α∗ /w. Show that γ ∗ decrease with w if the investor exhibits IRRA. (This result
implies that the elasticity of the demand for risky asset to wealth is smaller than 1, therefore is a
necessary good.)

4. Now consider another investor, named Frank, who is more risk averse in the sense of more concave
utility function. Show that Frank demands less risky asset than α∗ .

Question 6. Suppose that there are five states of nature denoted by ωn , n = 1, 2, . . . , 5, all of which
are of equal probability. Consider two risky assets with rates of returns r̃A and r̃B as follows:

state ω1 ω2 ω3 ω4 ω5
r̃A 0.5 0.5 0.7 0.7 0.7
r̃B 0.9 0.8 0.4 0.3 0.7

Which asset a risk averse investor will prefer to?