Summer 2007 examination

EC411
Microeconomics for MSc students

2006/2007 syllabus only not for resit candidates

Instructions to candidates

Time allowed: 3 hours

This paper contains fourteen questions. Answer all eight questions from Section A,
and any two questions from Section B. Each section will be given equal weight
(50%).

Calculators are not permitted in this examination.

LSE 2007/EC411 Page 1 of 7

Section A

1. A consumer with preferences over two commodities, X and Y, has a

Marshallian demand function for commodity X equal to

2p X
X(p X , p Y ,M) =
pY

where p X is the price of X, p Y is the price of Y, and M is the consumers

income.

(a) Find the Slutsky equation for changes in p X .

(b) Is the above demand function consistent with utility maximisation? Explain
your answer.

2. A consumer has an expenditure function given by

e(p1,p 2 , u) = (p1 ) (p 2 ) u

where pi is the price of commodity i, i=1,2, and u is the utility level. For what
values of and are the properties of the expenditure function satisfied?

3. A perfectly competitive industry consists of N identical firms. Each firm has a

profit function

p2
(p, w ) =
2w

where p is the price of output and w is the price of the sole input. The
100
aggregate demand for the output in this industry is D(p) = . Calculate the
p
elasticity of the equilibrium price of output with respect to w and determine the
sign.

4. Show that the indirect utility function is quasi-convex in prices.

LSE 2007/EC411 Page 2 of 7

5. Consider a risk neutral monopolist that can produce at a cost of 5 per unit. All
production costs arise only at the time of sale and not before. There is one
buyer that may wish to buy one unit of the good. The buyers valuation is
random. It equals 9 with probability and 8 with probability .

(a) Suppose the monopolist does not observe the buyers valuation. What is the
monopoly price and profit?
(b) Suppose the monopolist has the option to learn the buyers valuation before
deciding on the monopoly price. The option to learn the buyers valuation costs
1. Is it optimal for the monopolist to take up the option? Explain your answer.

6. Consider a two stage selling game in which a seller can sell one item to a buyer.
In the first stage the seller makes a take-it or leave-it offer by announcing a price
at which the seller is willing to sell the item. In the second stage the buyer decides
whether to accept the offer or not. If the offer is accepted the item changes hands;
otherwise no trade occurs. The buyer values the item at v and the seller values
the item at c, with 1>v>c>0. The values c and v are publicly known.

(a) Can it be a Nash equilibrium that no trade takes place? If so, characterize a
no-trade Nash equilibrium.
(b) Characterize the set of subgame perfect Nash equilibria.

7. Consider a seller that wishes to sell one item to one of N buyers with N>1. The
seller uses a second-price auction. The rules of the auction are that buyers
submit sealed bids and the high bidder receives the item at a price equal to the
second highest bid. In the event of a tie, the winning high bidder is chosen
randomly. The seller does not impose a reserve price. Each buyer values the
item privately at vi>0 for i=1,...,N.

(a) Suppose buyers are risk-neutral. Show that bidding the own private value is
an equilibrium.
(b) Suppose buyers are risk-loving. Does bidding the own private value remain
an equilibrium? Why, or why not?

8. Consider Akerlofs Lemons problem with 100 car sellers and 200 car buyers.
Each seller knows the quality Q of his car, while buyers only know that Q is
distributed uniformly on the interval [0,1]. The monetary value placed by a seller
on a car of quality Q is equal to 3Q. Each buyer buys exactly one car, or none.
Buyers buying a car of quality Q at a price P have a utility increment equal to 4Q-
P. What type of cars will be traded in equilibrium, if any? Characterize the
equilibrium price and quantity of traded cars. Explain your reasoning.

LSE 2007/EC411 Page 3 of 7

Section B
9. Consider an exchange economy with two consumers, A and B, and two goods,
X and Y. The initial endowment of consumer A consists of zero units of X and
4 units of Y. The initial endowment of consumer B consists of 2 units of X and
zero units of Y. Consumer As utility function is U A ( x A , y A ) = min{ x A , y A + } ,
where x A is her consumption of X, y A is her consumption of Y, and is a
positive parameter. Consumer B's utility function is UB ( x B , y B ) = x B y B , where
x B is his consumption of X and y B is his consumption of Y. Both consumers
are price-takers.

(a) Suppose that = 1. Find the demand functions of consumer A for X and Y.
(b) Suppose that = 1. Find the set of Pareto efficient allocations.
(c) Find the general equilibrium prices for all values of in the interval (0,3).

10. A consumer must allocate her wealth of X pounds among three assets, A, B,
and C. There are two possible and equally likely states of the world, H and T.
K units of asset A yield K pounds with certainty. K units of asset B yield zero
pounds if state H occurs and K pounds if state T occurs, where > 1 . K units
of asset C yield zero pounds if state H occurs and f (K ) pounds if state T
occurs, where f () is an increasing function. The unit price of each asset is
fixed and equal to one pound. The consumer is an expected utility maximiser
with utility u( w ) , where w is the consumers wealth in pounds.

(a) State the consumers utility maximisation problem.

(b) Suppose that u( w ) = w , = 2 , and f (K ) = 2 K . Find the consumers
optimal allocations of wealth.
K2
(c) Suppose that u( w ) = w , = 10 , and f (K ) = . Is it optimal for the
10
consumer to choose positive amounts of both asset B and asset C? Find the
consumers optimal allocation of wealth when X < 100 .

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11. Consider the following two-stage game. In the first stage, player 2 decides
whether players 1 and 2 will play either game X or game Y, which are defined
as follows:

In the second stage, player 1 learns player 2s decision and the players play the
game that player 2 has selected by choosing the corresponding actions
simultaneously (in both games, the actions of player 1 are labelled by {T,M,B}
and the actions of player 2 are labelled by {L,R}).

(a) Find a Nash Equilibrium such that, in the first stage, player 2 chooses game
Y.
(b) Find a Nash Equilibrium such that, in the first stage, player 2 chooses game
X.
(c) Suppose now that in the first stage player 2 can also choose an outside
5
option Z that gives her a payoff equal to . Does there exist a Subgame
2
Perfect Equilibrium in which player 2 chooses Z?

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12. Consider a market with two products. The demand curves are given by
1 1
Q1 = 1 - P1 - P2 and Q 2 = 1 - P2 - P1 , where Pi is the price of good i and Qi the
2 2
output of good i, i=1,2. The cost of production is zero for both goods.

(a) Characterize the monopoly price choices when a single firm sets prices for
both products.
(b) Characterize the Nash equilibrium price choices when there are two firms,
each producing one product, and firms choose prices simultaneously. Discuss
the effect of competition on prices by comparing your answer to the answer in
part (a).
(c) Characterize the subgame perfect Nash equilibrium price choices when
there are two firms, each producing one product, and firms choose prices
sequentially. Discuss the effect of sequential competition on prices by
comparing your answer to the answers in parts (a) and (b).

13. Consider a search problem in which a worker chooses the number of

simultaneous offers she wishes to receive. Each wage offer is drawn
independently from a wage offer distribution characterised by wages of 12 pounds
and 6 pounds, each with equal probability. The cost of each offer is 1 pound.

(a) Suppose that the worker is risk neutral and wishes to maximise expected
utility. State the workers maximisation problem.
(b) Suppose that the worker is risk neutral and wishes to maximise expected
utility. What is the optimal number of offers?
(c) Suppose that, after having selected a job, the worker is approached by a firm
that offers a new wage draw from the wage offer distribution characterised by
wages of 12 pounds and 6 pounds, each with equal probability. The cost to the
worker of obtaining the new wage offer is c. Suppose the worker is risk neutral
and wishes to maximise expected utility. For what values of c will the worker pay
the cost c to obtain another wage offer?

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14. Consider a homogenous goods duopoly. Production is a binary choice, Q1,Q2 in
{0,1}, meaning that each firm can produce either one unit or none. Demand is
given by the inverse demand curve P = 3 Q1 Q2.

(a) Producing one unit costs 1, while it is costless to produce zero units.
Suppose firms make their output choices simultaneously. Characterize the set
of Nash equilibria.
(b) Producing one unit costs 1, while it is costless to produce zero units.
Suppose firms make their output choices sequentially with firm 1 moving first.
What are the subgame perfect Nash equilibria?
(c) Producing one unit costs 1/2, while it is costless to produce zero units. What
is the set of Nash equilibria when firms choose output simultaneously? What is
the set of subgame perfect Nash equilibria when firms choose output
sequentially?

LSE 2007/EC411 Page 7 of 7

 @X
Q1: (i) First note that
@M
= 0. Hence, the substitution eect is
2
> 0 and the income eect is equal to zero.
pY
(ii) Since the substitution eect is positive, X (pX ; pY ; M ) is inconsistent
with utility maximisation.

Q2: The expenditure function is non-decreasing in prices ! ; 0.

The expenditure function is homogeneous of degree one in prices ! + =
1. The function p1 p12 u, 0 1, is concave.

Q3: The supply function of each rm is y = wp . The market eq condi-

pN 100
tion is = . Hence,
w p r
100w
p=
N
1
The elasticity is > 0:
2

Q4: Standard.

Q5: (a) Expected Monopoly prots equal

[P 5] for P 8
[P 5] 1=2 for 8 < P 9
0 for P > 9

Now, Monopoly prots at p = 8 equal 8 5 = 3, while at p = 9 expected

prot equals (9 5) 1=2 = 2. Hence the monopoly price equals 8 and
monopoly prots equal 3.
(b) Paying the cost of 1 yields
1 1 5
(9 5) + (8 5) 1=
2 2 2

1
which is less than 3. Hence the monopolist will not pay the cost to learn
buyers valuations, and instead charge a price of 8 as in (a).

Q6: (a) Sellers strategy

any p such that p v

Buyers strategy
reject all oers.

(b) Solve backwards. Second stage

accept any p v

First stage oer

p = v:

Q7: Standard

Q8: A seller is willing to sell the car if P > 3Q, or Q < P=3. The
average quality car oered for sale qa is equal to min(P=6; 1=2). A buyer is
willing to buy if and only if P < 4qa . Now, since

P > 2=3 P
4qa

no buyer is willing to buy and total demand D(P ) is equal to zero for all P .
Hence the equilibrium price is equal to zero and no cars are traded.

4pY 4pY
Q9 (a) As income is 4p Y. If
pX
1, the optimal choice is xA =
pX
4pY
and yA = 0. If > 1, utility maximisation implies that xA = 1 + yA .
pX
4pY + pY 4pY pX
Hence, xA = and yA = .
pX + pY pX + pY

2
 (b) The set of Pareto e cient allocations is (xA ; yA ; xB ; yB ) = ( ; 0; 2
; 4), 0 1, (xA ; yA ; xB ; yB ) = ( ; 1; 2 ;4 + 1), 1 2,
(xA ; yA ; xB ; yB ) = (2; ; 0; 4 ), 1 4.
4 4
(c) Set pY = 1. If , As optimal choice is xA = and yA = 0. If
pX pX
4 4+
> , utility maximisation implies that xA = + yA . Hence, xA =
pX pX + 1
4 pX
and yA = . We rst try an equilibrium with interior demands. Bs
pX + 1
demands are xB = 1 and yB = pX . The equilibrium condition for the X
market is
4+
+ 1 = 2 =) pX = + 3:
pX + 1
We need 4 > ( + 3) =) < 1. If 1, the equilibrium condition for the
X market is
4
+ 1 = 2 =) pX = 4:
pX

Q10 (a) The consumer chooses (x A ; xB ; xC ) to maximise

1 1
u (xA ) + u (xA + xB + f (xC ))
2 2
subject to xA + xB + xC = X

(b) The consumer chooses (xA ; xB ; xC ) to maximise

1 1 p
xA + (xA + 2xB + 2 xC )
2 2
subject to xA + xB + xC = X

=)the consumer chooses (xA ; xB ) to maximise

p
xA + xB + X (xA + xB )

Denote xA + xB by S. The rst order condition is

1
1= p
2 X S

3
=) S = X 1=4 and xC = 1=4. Any combination of (xA ; xB ) such that
xA + xB = X 1=4 is optimal. Of course, if X < 1=4, the boundary solution
is S = 0, xC = X.
(c) The consumer chooses (xA ; xB ; xC ) to maximise
r
1p 1 x2
xA + xA + 10xB + C
2 2 10
subject to xA + xB + xC = X
Denote the optimal amount of asset i by xi . It is never optimal for the
consumer to choose positive amounts of both xB and xC . At the optimal
x2C
solution, the consumer maximises 10xB + subject to xB + xC = X xA .
10
2
x
Since B + 10xC is a convex function, the solution is not interior.
10
In particular, X xA 100 implies that xC = 0. The rst order condition
is then
1 9
p = p
4 xA 4 10X 9xA
1 8
Hence, 10X 9xA = 81xA =) xA = X, xB = X.
9 9

Q11: (a) Player 1 chooses T after Y , B after X. Player 2 chooses Y ,

L after Y , R after X, etc.
(b) Player 1 chooses (T with prob 1/2, M with prob 1/2) after X, B after
Y ; Player 2 chooses X, (L with prob 1/2, R with prob 1/2) after X, R (or
L) after Y . Player 1 chooses (T with prob 1/2, M with prob 1/2) after X,
(T with prob 4/7, M with prob 3/7) after Y ; Player 2 chooses X, (L with
prob 1/2, R with prob 1/2) after X, (L with prob 3/7, R with prob 4/7)
after Y .
(c) Yes. Player 1 chooses (T with prob 1/2, M with prob 1/2) after X,
(T with prob 4/7, M with prob 3/7) after Y ; Player 2 chooses Z, (L with
prob 1/2, R with prob 1/2) after X, (L with prob 3/7, R with prob 4/7)
after Y . Player 1s payo in X is 2, and in Y is 12=7.

Q12: (a) The monopoly problem is

P2 P1
max 1 P1 P1 + 1 P2 P2
P1 ;P2 2 2

4
The rst order condition yields

1 2P1 P2 = 0
1 2P2 P1 = 0

with symmetric solution P1 = P2 = 31 (= 0:333), and monopoly prots equal

to
1 1 1 1 1
+ =
2 3 2 3 3
(b) The duopoly problem is

P2
max 1 P1 P1
P1 2
P1
max 1 P2 P2
P2 2

The rst order conditions yield

P2 P1
1 2P1 = 0 and 1 2P2 =0
2 2
with solution P1 = P2 = 25 (= 0:4), and duopoly prots equal to

4 4
and each
25 25
The products are complements. The monopolist internalizes the demand
externality while the duopolists do not. Duopolists charge a higher price
(and sell less) than the monopolist.
(c) The second stage problem is

P1
max 1 P2 P2
P2 2

The rst order condition yields

P1 1 P1
1 2P2 =0 or P2 (P1 ) =
2 2 4
The rst stage problem is

5
 1 P1 3 7
max 1 P1 + P1 or max P1 P 1
P1 4 8 P1 4 8
The rst order condition yields
3 7 3
P1 = 0 and P1 = (= 0:429)
4 4 7
with P2 (P1 ) = 12 28 3 11
= 28 (= 0:393). The sequential duopoly has the feature
that
(i) the leader and follower charge a higher price than the monopolist, and
(ii) the leaders (followers) price is higher (lower) than in the simultaneous
duopoly pricing game.

Q13: (a) The probability that all N draws are low wages is given by
1 N
2
. At least one wage draw is high with the complementary probability
N
1
1
2
The worker chooses N to maximise
" #
N N
1 1
U (N ) = 12 1 +6 N
2 2

(b) The function U (N ) is concave as the rst two derivatives yield

N
@U (N ) 1 1
= 6 ln( ) 1
@N 2 2
N 2
@ 2 U (N ) 1 1
= 6 ln( ) < 0:
@N @N 2 2
The optimal search rule is N = 2 as
1 1
U (1) = (12) + (6) 1 = 8;
2 2
3 1
U (2) = (12) + (6) 2 = 8:5;
4 4
7 1
U (3) = (12) + (6) 3 = 8:25:
8 8

6
 (c) If the current wage is 12, then the worker would not pay the cost for
another wage oer. If the current wage is 6, then the worker would take
another wage oer provided the expected benets exceed the cost,
1
6 c;
2
or c 3.

Q14: (a) Let i (Qi ; Qj ) denote the payo function of rm i. We nd

i (0; 0) = 0; i (0; 1) = 0; i (1; 0) = 1; and i (1; 1) = 0. The resulting payo
matrix is given by
0 1
0 (0; 0) (0; 1)
1 (1; 0) (0; 0)
The game has three pure strategy Nash equilibria with (Q1 ; Q2 ) 2 f(1; 0); (0; 1); (1; 1)g.
There is no mixed strategy equilibrium.
(b) Solving backwards, if Q1 = 0, then Q2 = 1 yielding zero payo for
rm 1 and a payo of 1 for rm 2.
If Q1 = 1, then Q2 = 0 or 1 yielding a payo of 1 respectively 0 for rm
1 and a payo of 0 for rm 2.
There are thus three subgame perfect Nash equilibria:

1. Q1 = 1; Q2 (0) = 1, and Q2 (1) = 0:

2. Q1 = 0; Q2 (0) = 1, and Q2 (1) = 1:
3. Q1 = 1; Q2 (0) = 1, and Q2 (1) = 1:
4. Q1 = 1; Q2 (0) = 1, and Q2 (1) = any randomisation:

3
(c) Now the payos are i (0; 0) = 0; i (0; 1) = 0; i (1; 0) = 2
; and
1
i (1; 1) = 2 . The resulting payo matrix is given by

0 1
0 (0; 0) (0; 23 )
1 ( 23 ; 0) ( 12 ; 21 )

7
The game has one simultaneous move Nash equilibrium with (Q1 ; Q2 ) =
(1; 1).
Solving backwards, if Q1 = 0, then Q2 = 1 with zero prots for rm 1 and
a payo of 32 for rm 2. If Q1 = 1, then Q2 = 1 yielding payos of 12 each.
There is one subgame perfect Nash equilibrium with Q1 = 1; Q2 (0) = 1; and
Q2 (1) = 1.