Problem Set 1 - Advanced Microeconomics

Nicola Pavoni TA: Alessandro Ferrari Winter 2014

Exercise 1 - Financial Contracts Consider the following asymmetric information problem in the nancial market. The principal is a lender who provides a loan of size k to a borrower. Capital costs Rk to the lender since it could be invested elsewhere in the economy to earn the risk-free interest rate R. The lender has thus a utility function V = t Rk . The borrower makes a prot U = f (k ) t where f (k ) is the production with k units of capital and t is the borrowers repayment to the lender. We assume that f > 0 and f < 0. The parameter is a productivity shock drawn from = , with respective probabilities 1 and . 1. Write down incentive and participation constraints directly in terms of the borrowers information rents U = f (k )t and U = f (k ) t. 2. Write down and solve for the optimal contract assuming the lender perfectly observes the productivity of the borrower. 3. Write down the principals maximization problem. Clearly denote the constraints. 4. Which constraints are binding at the optimum? Explain. Is there a capital distortion with respect to the rst-best outcome?

Exercise 2 - My Little Red Corvette Everybody likes red Corvettes (testimony to this is the famous song by Prince My Little Red Corvette ). Assume that there exist two types of potential Corvette purchasers. On one hand, snobs are willing to pay 25000 for a red Corvette but only 20000 for a Corvette of another colour. On the other hand, less snobbish purchasers are willing to pay 22000 for a red Corvette and 20000 if it is any other colour. The percentage of snob purchasers is , so that (1 )% of purchasers

are less snobbish. The production cost of a Corvette is independent of its colour. Assume the car seller does not know the type of the buyer (or, even if he knew it, the law would prevent him from price discrimination). Why are Corvettes of all colours seen on the streets? What parameters does your answer depend on? Exercise 3 - Price Discrimination I A company oers the only ight service between two cities. The cost per passenger is 400. Assume that the airlines potential clients can be divided into two groups: executives who travel for business reasons, and tourists who travel for vacations. For this particular service, if the meeting that an executive wants to attend takes place, then he is willing to pay a price of 1000. On the other hand, tourists are willing to pay 600 for the same trip. 1. What price will the airline charge if it can perfectly observe whether an individual is an executive or a tourist? What are the prots of the airline in this case? Now assume that the airline cannot distinguish between tourists and executives. 1. 2. What price (or prices) will the company charge for a ticket? What are the prots of the airline now? Assume that tourists are perfectly informed as to when they have their vacations, and the probability that they must cancel their trip is zero. On the other hand executives believe that there is a 50% chance that their meeting will be cancelled or will be changed to another date. Assume now that the company can x not only the price of the ticket but also the refund conditions when a ticket is cancelled. 1. 3. What contracts (or tickets) will the airline oer? Discuss. Exercise 4 - Price Discrimination II Air Shangri-la is the only airline allowed to y between the islands of Shangri-la and Nirvana. There are two types of passengers, tourist and business. Business travelers are willing to pay more than tourists. The airline, however, cannot tell directly whether a ticket purchaser is a tourist or a business traveler. The two types do dier, however, in how much they are willing to pay to avoid having to purchase their tickets in advance. More specically, the utility levels of each of the two types net of the price of the ticket, P , for any given amount of time W prior to the ight that the ticket is purchased are given by Business: v B P W, Tourist: v T P W, 2

where 0 < B < T . (Note that for any given level of W ), the business traveler is willing to pay more for his ticket. Also, the business traveler is willing to pay more for any given reduction in W.). The proportion of travelers who are tourists is . Assume that the cost of transporting a passenger is c. Assume in (1) to (4) that Air Shangri-la wants to carry both types of passengers. 1. Draw the indierence curves of the two types in (P, W )-space. Draw the airlines isoprot curves. Now formulate the optimal (prot-maximizing) price discrimination problem mathematically that Air Shangri-la would want to solve. (Hint : Impose nonnegativity of prices as a constraint since, if it charged a negative price, it would sell an innite number of tickets at this price). 2. Show that in the optimal solution, tourists are indierent between buying a ticket and not going at all. 3. Show that in the optimal solution, business travelers never buy their ticket prior to the ight and are just indierent between doing this and buying when tourists buy. 4. Describe fully the optimal price discrimination scheme under the assumption that they sell to both types. How does it depend on the underlying parameters , B , T , and c? 5. Under what circumstances will Air Shangri-la choose to serve only business travelers? Exercise 5 - Regulation The regulator is concerned with costumer welfare, therefore he wants to force a natural monopoly to charge competitive prices. The problem is that the regulator does not know as much about the rms cost structure as he would like to. More precisely, we will consider a natural monopoly with an exogenous cost parameter which can take on two values: L and H , where L < H . The rms cost of producing the good is c = e, where e stands for eort. Exerting eort has cost (e) = e2 , 2

which is increasing and convex in e. We will assume that the regulator wants the good to be produced for the lowest possible payment P = s + c, which consists of two parts: the subsidy s and the accounting cost c. The payo of the rm is P c (e). 3

It the regulator has perfect information, that is, he can observe and c. The optimization problem for the regulator is: min s + e
s,e

s.t. s

e2 0. 2

(IR)

1. Comment on and solve the previous problem. From now on we consider the incomplete information case. The regulator can observe c and can not observe , but he believes it is H with probability (1 ) and L with probability . 1. 2. Write down the regulators minimization problem. 2. 3. Show that the IR (participation) constraint for type L is redundant. 3. 4. Argue that the IR constraint for type H is binding at the optimum. 4. 5. Argue that the IC constraint for type L is binding at the optimum. 5. 6. Show that IC constraints imply cH cL . 6. 7. Argue that the IC constraint for the high type is redundant at the optimum. 7. 8. Now we get to one of our favorite after-class activities. Compute the regulators minimization problem.

Exercise 6: Car Insurance Recently, a friend of ours mentioned that he had gone to insure his car and he had been oered several dierent policies. He could choose between an expensive contract with full insurance, or a contract with voluntary excess of $ 900 (a voluntary excess clause means that the company will pay all losses from accidents over and above the rst $900 but not below). The policy with excess was signicantly cheaper. Our friend argued the insurance companies oer contracts with excess clause since that way they make the drivers who suer many accidents pay each time $ 900. Is this a reasonable argument? Whether your answer is armative or not, you should argue in terms of an adverse selection situation (the insurance company cannot observe whether or not the driver is reckless).