Graduate Micro Exam

June I, 2009
IVIICROECONOIVIICS
1. You are identified by a number. The grading is meant to be anonyrnolls, so we
suggest that YOll do not use your Cornell J.D. number. Select an identifying number
and keep a record of it for .yom information. Put this n'LlTnbeT on each exain book, NOT
your name, and DO NOT sign exam book(s).
2. This exam has five parts. Each part is worth 20 points. You have "1 hours to write
the exam.
3. Each part llll1St be 8.llswercd ill a separate exam book \Vhen you arc finished,
please write down the total number of exam books you are submitting, and get the 'Iwmber
veTified by the proctor.
4. This is a closed-book exam. In a.ddit.ion, you are not allowed to use allY calculat.or
during the ('XaJ11.
5. If Y()l1 find ,lIlV qlH'.stion fll1lhig11olls, expla.in your confusion and make whatf:vcr
assumptions \'011 thillk llecessary t.o "U1s\\,('r t lw question. Clearly state any additiollal as-
sumptions make.
GOOD LUCK"
Part I
[( 8) = 7 point::;; (b) = 7 points; (c) = 6 points]
Let P, with typical element J! = (PI, P2, P3), be the set of objective probabilities over
the set of prizes Z = (ZI: Z2, Z:3). Consider an individual who is an (objective) expected
utility maximizer with preferences C:: over the probabilities in P which are represented by
the von-Neumann j\/iorgenstern utility function 11 on prizes Z. Let ll(ZI) = 1l1, 1[(Z2) = 112
and u(z;,} = U:3.
(a) Show that if {J, () E P, p ~ q and T = o:p + (1 - ct)q for some 0: E [0,1]' theIl r '" p.
(b) Show tllC1,t this individual's ind.ifference curves are parallel line segments.
(c) Consider the probabilities a = (D, 1, D), b = (0.5,0,0.5), c = (0.15, D.7, 0.15) and d =
(CU, 0.2, OA). Suppose that according to this individual's preferences a >- b. Is d >- c
possible according to this individual's preferences? Explain why or why not,
Part II
[( a) = 7 points: (b) = 6 points; (c) = 6 points]
Consider all exchange economy with L goods and N consumers. Each consumer's utility
funct.ion is of the forlll nll(Tj, ... ,:r:d = Ll Vn(Xz) , where each V
Il
is strictly concave; strictly
increasing, differentiable and satisfies an Inada condition at t.he origin. Suppose that each
consumer has a strictly positive endowment Wn = (1..0'nL'" ,WnL) o.
(a.) Show t.hat if LII '-"'Ill = Ln LG'n2 = ... = Ln 1..0'nL; then the economy has at most Olle
equilibrium.
(b) Show that. if LII ~ ' l I l > LII W
n
2 > ... > Ln WnL, then for the cOlllpetitive equilibriulll
price vector p'. Pl' < Ji2 < ... < P'L'
(c) How does -,,'OUl answer to part (a) change if the Vn are continuous but not necessarily
differentiable?
PART III
[( a) = f) points; (b) = 5 points; (c) = 5 POilltS; (c1) = 5 points]
A profi t rnaxirnizing firm uses N inputs, x E to proclllce one output, .IJ E R
I
I
,
usillg the production function j (:c). The production funct.ioIl is strictly increasillg, strictly
concave, twice continuously differentiable, and for each input n and for Cill.Y amounts of the
other inputs, Dj(:c)/8:r
n
l +00 as Xn 1 O. Input prices arc 'W E and the output price is
fJ > D.
(a) DC'iim: the Jinll's profit hlllction.
(L) Show that for any input 'fl. t.he negative of t.he partial of the pwfit fllnction
witl] respect to the price of input n is the input demand function for inputn.
(c) Now suppose that when the firm chooses x and y it knows input prices, but it does
not know the output price. Instead the output price is a random variable with mean
j). The firm chooses inputs and output to maximize expecteel profit. Is the claim ill
part (b) still true for the new (expected) profit fundion? Explain
(d) COlltinuing with the scenario in part (c) suppose tha.t a sInall tax rate t will be imposed
on th(, output price. The firm is aware of this tax before it chooses inputs:c. As ill
part (e) it does not know the output price at. the time it chooses inputs, but it !lO\\"
knows that for (lllY realized output price pit \vill receive (1 - t)p per unit of output it
sells Huw \yill tllis tax affect the firm's output.? Exphlin.
PART IV
[( a) = 4 points; (b) = 4 points; (c) = 4 poillts; (cl) = 4 points; (e) = 4 poillt.s]
,John likes apples and peaches. Let d(A) C A denote the set of apple-peach bundles he
chuoses out of any closed and bounded set of non-negative bundles.
(a) Suppose that on the set A = {(x, Y) E : T + 2y :S: 3}, d(A) = {(3/2, 3(1)} and on
B = {(:r, y) E : 2x + y :S: 3}, d(B) is the closed line segment conllectillg (1/2,2)
and (5/4,1/2). Is there a complete anc! transitive weak order for which this choice
behavior is preference maxima!? Explain IJl'idly
(b) Suppose now that d(A) is the closeclline segment. connecting (3/2,3/4) (l,ne! (1/2,5/4)
\vllilc d(B) is as above. Is there a complete and transitive weak order for which this
chuice behavior is preference maxima!? Explain briefly.
(c) Suppose that John has preferences described by a binary order >- as follows: (x, y) >-
(ow, z) if and only if x + y > ow + z + 1/4. Which of the following properties does the
corresponding weak (" at least as good as") order not have: Transitivity, reflexivity and
completeness? Explain briefly.
(e]1 Suppose John chooses from A and B using the order of part (c). Find d(A) and d(B)
alld graph them in a picture.
I,C') Is there a complete and weak order for whidl the choices Y011 have fuum! are
preference maximal?
PARTY
[(a) = 5 points; (b) = 5 points: (c) = 5 points; (d) = 5 points]
Consider an economy, in which a COIlSlllller is born at each point in time t E NU {O}.
Each consumer lives for two periods. In the first period of her life, the consumer has an
initial endowment of 1 unit of a perishable good. As part of a social insurance scheme,
the state confiscates s E [0, units of the consumer's ene!OV\'lllent at the time of her birth
alld transfers them to the ole! consumer living at that time. Each cOllsmner call sell part of
ller initial endowment when young and transfer wealth into the second period llsing money.
Borrowing is not allowed. The cunsurner hom at time t has a utility fund.icJll given by:
Here cY denotes the consumption of the young ConSUlYler in period t I is the consump-
tion of the old consumer in perioel t -I- 1. III t = 0, there is an old conSUlllCr with an initial
endowment of units of money.
(a) State the utility maximization problem of a consumer born at time t. Derive his
demand for consurnptioll.
(1)) Derive the offer curve of a consumer blJrll (l L time t. For s
offer curve in a graph.
() Cllld .'i I draw the
'1'
(.) For a given value of S E [0. J, ddirw a stationary cCjuilihrimn fnr rhi:-, economy. For
each s E [0, J, derive a st.ational) equilibrium with (\ :-;tricth positive value of rnoney.
(d) Suppose that in t = 0, a. unit of nlOllt'y call be exclw.llged for ,\ unit uf tht' cOllsumpt.ion
good. Sketch the a.llocations a.long the dynamic eqllilibriulll path:-; in a graph for the
cases of s = 0 and s = Show that the equilibrium allocation obtained for s = is
Pareto-superior to the olle obtained for s = 0.
August 3, 2009
GRADUATE NIICROECONOMICS EXAM
1. You are identified by a number. The grading is meant to be anonymous, so we
suggest that you do not use your Cornell J.D. number. Select an identifying number
and keep a record of it for your information. Put this number on each exam book, NOT
your name, and DO NOT sign the exam book(s).
2. This exam has five part.c;. Each part. is worth 20 points. 'IT(m have 4 hours to write
the exam.
3. Each part must be answered in a separate exam book. \iVhen you are finished,
please write down the total number of exam books you are submitting, and get the number
verified by the proctor.
4. This is a closed-book exalll. III additioll, you i1re not i1110wed to Ui:le any calculator
cl uring the exam.
S. If you find any question 8lnhignons, explain yom cOllfusion and make whatever
assumptions you think necessary to answer the question. Clearly state any a.dditional as-
sumptions you make.
GOOD LUCK"
Part I
[ ( a) = 7 point.s; (b) = 6 points; (c) = 7 points]
An individual has preferences over consumption goods in I R ~ represented by the utility
function u : I R ~ -} IRl. This utility function is strictly concave, strictly increasing and twice
continuously differentiable. The prices of the goods are given by p' E I R ~ + and the individual
has wealth w* > o. Let x' E I R ~ + be the individual's optimal consumption bundle at the
prices p* and wealth w*. Assume that the amount the individual plans to spend on good 2
is more than the amount he plans to spend on good 1, i.e. p;x; > pixi.
(a) Now the individual i:-; offcrf'd all opportunity to have the prices of goods 1 and 2 changed
as follows. The price of good 1 will be increased to (1 + 0' )pj and the price of good
2 will be decreased to (l - 0)]).; for some small, strictly positive 0:. The prices of all
other goods, and wealth, remain unchanged. Prove that the individual will accept this
offer.
(b) Now suppose that there are only two goods (l = 2). Explain your answer to part
(a) in terms that a Freshman who has just completed Introductory Microeconomics
can understand. This studellt doesn't know anything about indirect utility functions,
expenditure functions, reveled preference or calculus. They do know about indifference
curves and budget lines.
(c) Now lets again suppose t.hat I = 2. Suppose that the offer to have the prices changed as
described in part (a) occurs after the illdividual has purchased the old optimal bundle
x*. The consumer can buy or sell goods at the llew prices described in part (a). \Vill
the consumer accept t.he offer t.o h,\\"(' prices changed? vVhat role does the condition
P:2X2 > pixi play in your argument? Explain.
PART II
[(a) = 5 points; (lJ) = ,S points; (c) = 5 points; (d) = 5 points]
An individual is considering the investments (lotteries):
A If the Dow closes above 10,000 in 2009 then you win $10,000 with probability p and
$0 with probability 1 - p; if it does not then you win $0 for sure, i.e. your investment
is worthless.
B If the Dow closes above HL 000 in 2009 then you win $0 for sure, i.e. your investment is
worthless; if it does not then you win $10,000 with probability q and $0 with probability
1 - q.
C You win $10,000 with prohability 1/2 and $0 with probability 1/2.
Suppose that for this individual $10,000 >- $0. Also assume that this individual has
state independent preferences. [You do not need to know anything about the stock market
to ansvver this question; the Dow closing above 10,000 in 2009 is just a state.]
(a) Suppose that p and q are such thaJ the individual is indifferent between investments
A and B. Assume that thiR individllal is a subjective expected utility maximizer.
Determine the individual's subjective probability that the Dow will close above 10,000
in 2009.
(b) vVhat role does the aRsulllptioll that the individual has state independent preferences
play in your argumellt for part (a)? Explain.
(c) Now suppose that p = II = 1. NO\v the individual says that C >- A and C >- B. We
do not know how the individual ranks A and B. Show that in this case the individual
cannot be a subject.ivp expected utility maximizer with state independent preferences.
(d) Continue to assume that jJ = q = 1, C >- A and C >- B, and that we do not know
how the individual rallks A aml B. Suppose that the individual acts as if he has a
utility function u on money, a set of probabilities II on the states-the Dow closes
above 10,000 in 2009 and the Dow cloes not close above 10,000 in 2009, and evaluates
each lottery using the element of II that minimizes the expected utility of the lottery.
What do you know about II? Explain.
PART III
[(a) = 5 points; (b) = 5 points; (c) = 5 points; (d) = 5 points]
Consider an economy, with two consumers, A and B and two assets, 1 and 2. There are
t.hree units of asset 1 and three units of asset 2 in the economy. The initial endowment of A
at t = 0, is given by (a], (12) = (2,1), where ai denotes the quantity of asset i E {l, 2} that
A owns. The initial endowment. of B at t = 0 is (b], b
2
) = (1,2). The price of asset 1 is (j])
the price of a.sset 2 is q2 = 1.
At. t = L there are two possible stat.es of the world, WI and W2, which occur wit.h equal
probabilit.y. The st.ate-contingellt. asset payoffs are given by:
W] W2
Asset 1 2 0
Asset 2 1 1
Consumers' preferences for state-contingent wealth x are described by the von-Neumann-
Morgenstern utility functions II.'! (:r) = 5In.1: + 2 for consumer A and UB (x) = 13:1' for
B.
(a) At t = 0, the two consulllers choose portfolios of assets so as to maximize their expected
utility of state-contingent. consumption. State the optimization problems of the two
consulllers at t = O. Suppose t.hat q1 = 2.5. Dra\.v the budget constraint of COllsumer
A. \Vhat is t.he optimal choice of consumption in state W2 for this consumer? Derive
t.he set of values of (jJ for \vhiclJ the budget. set.s of both consumers are bounded.
(b) For t.he set. of val ues of q J deri vee! in pa.rt (a), solve the optimiza.tion problems of bot.h
consumers. Set. up the condit.ions for a market equilibrium and derive t.he equilibriulll
consumption and asset prices. IIlust.rate the equilibrium in an Edgeworth box.
(c) Which of the two consumers is fully insured in equilibrium? Show that this consumer
will be fully insured in equilibrium for any distribution of initial endowments such that:
a] > 0, 0.2 > 0, b] > 0, b
2
> 0, 0.
1
+ b
l
= 3, 0.
2
+ b
2
= 3, and (11 + 0.2 ::; 3.
(d) New research has uncovered a third state, W3 which can occur at t = 1 with probabilit.y
0.2. States WI and W2 are still considered to be equally probable. The payoff of asset
1 in stat.e W3 is 1, the payoff of asset. 2 is 2. Is it possible to determine whether t.he
equilibrium of this economy is Pareto-optimal without actually comput.ing it? How
would your allswer to this questioll change, if t.here were a third asset in this economy
with ::;t.ate-contingent. payoffs:
W] W2 W3
Asset 3 3 1 T
for some T E l R ~ ?
PART IV
[(a) = 7 points: (b) = 7 points; (c) = 6 points]
A finn produces two outputs YJ and Y2 using two factors of productioll, 'VJ alld 1'2 ThE'
prices of the outputs are PJ and P2, the factor prices are WI and W2. Assume t.hat the finll
has the following profit function:
with
(a) Show that if is homogenolls of degree 1, non-decreasing in the output price::; ,llld llOll-
increasing in the input prices.
(b) Derive the dema.nd of the finn for factors of production and its supply of outputs
Check whether the la.w of sllJ)ply holds.
(c:) Specify a production functioll which is consistent with the profit fUIlctim1 if. ill the
sense that a firm characterized by this production function and maximizing prufi ts
would exhibit the profit fUllction if given above. Show the consistency by explicitly
solving the profit maximization problem.
PART V
[(a) = 5 points; (b) = 5 points; (c) = 5 points; (d)=5 points]
Consider an exchange economy with N infinitely lived consumers. Consumer n is endowed
with w;' > 0 units of the single perishable consumption good at each date t. Each cOllsurncr's
utility fUIlction is of the form 'lLn(XO, Xl, ... ) = L ~ o ,6tvn(Xt) where 'Un is strictly concave,
strictly increasing, differentiable and satisfies an Inada concli tion at the origin, and 0 < ,:3 < 1.
Note that the discount factor ,6 is identical for all traders. Let WI (no superscript.) denute
tIle aggregate endowment. at dat.e t.
(a) Show that if, for any t ami s, Ws > Wt, then ,6-sps < ,iJ-t pt . Providc a onc-sentence
illtllitive explanation. Two sentences are allowed if you need one f()r delllalld nnd O])e
for supply.
(b) Show that the competitive equilibrium IS unique if Wo
equilibrium price vector?
What. is the
(c) Suppose that a linear storage technology is available that. turns each st.ored unit of date
t good into 0: units of date t + 1 good. Suppose that each conSllllwr's endowJllent is
positive only in the first period. Find the unique competitive cCjuililJrinlTl pricc' vector
for this ecollomy .. _
(d) For t.he economy of part (c), show that if 0:,6 > 1, then cOllsurn pt.ion increases through
time for each consumer.
August 4, 2008
GRADUATE MICROECONO]VIICS EXA]VI
1. You are identified by a number. The grading is meant to be anony-
mous, so we suggest that you do not use your Cornell J.D. number.
Select an identifying number and keep a record of it for your information.
Put this number on each exam book, NOT your name, and DO NOT
sign the exam book(s).
2. This exam has five parts. Each part is worth 20 points. You have
4 hours to write the exam.
3. Each part must be answered in a separate exam book \iVhen you
are finished, please write down the total number of exam books you are
submitting, and get the number verified by the Pl'OctOT.
4. This is a closed-book exam. In additioll. YOl1 are llot allowed to
use any calculator during the exam.
5. If you find any question ambiguous, explain your confusion and
make whatever assumptions you think necessary to answer the Cjuestion.
Clearly state any additional assumptions you make.
GOOD LUCK"
1
Part I
[(a) = 8 points; (b) = 4 points; (c) = [1 points; (cl) = 4 points]
A firm uses K inputs, x = (Xl, ... , xl{) ;:: 0, to produce a single output
Y ;:: 0. Input prices are denoted W = (WI, ... , n,I<) for the K inputs and
the output price is denoted by p. Suppose that this finn operates under
conditions of perfect competition.
We have data on the firm's input and output choices at various prices. The
collection of observations consists of N input-output pairs ((:J:I: yJ), ... , (x IV, YIV))
and the N pairs of input prices and output price at which t.hese input-output
pairs were chosen ((WI, PI)' ... , (W IV, P IV))' The vVeak Axiom of Revealed
Profit Maximization (WAPM) for this collection of observations is
(Pi - pj)(Yi - Yj) - (Wi - Wj) . (Xi - 1:j) ;:: 0,
for all 'i, j E {I, ... ,N}.
(a) Show that WAPM is a necessary conditioll for profit. maximization by
the firm.
(b) Let 5(w,p) be the firm's output supply fUllction. Suppose that the
firm's choices satisfy WAPM for all prices. Show that lhis implies that for
any input price W ;:: 0, if pi> P then 5(W,pl) ;:: 5(11.I,p).
(c) Now suppose that there is only one input (J( = 1) and that there
are four observations: ((Xl, YI), ... , (1;4, Y4)) = ((16,8), (4, L1), (8, 12), (27,27))
and ((WI,PI),"" (W4,P4)) = ((1,4), (1, 2), (2,2), (2,3)). Is this data consis-
tent with vVAPM? Explain.
( d) Suppose now that the observations in part (c) were collected over four
consecutive years and that between years two and three there was a change
in the firm's technology. Is the data consistent with the firm maximizing
profit using two different technologies? Explain.
2
Part II
[(a) = 5 points; (b) = 5 points; (c) = 5 points; (c1) = 5 points]
An interval order on a set X of alternatives is a binary relation >- with
the properties:
(i) For all a, b, c, dE X, b>- a and d >- c implies that d>- a or b >- c.
(ii) >- is irreflexive; that is, for all a EX, (Z 'I- a.
An important special case of an interval order is just noticeable difference
preferences. These are described by a "titility function" 'U : X -) R and a
"tolerance" f. > O. The alternative x is better than y if u(x) > v.(y) + c, that
is, x is "better enough" than y to be noticed.
(a) Show that any interval order is transitive.
(b) Given two functions .r 9 : X --) R such that g(:1:) 2: f(T) for all
x E X, define x >- y iff f(:r) > g(y). Shu\\' that >- is an interval order. The
pair (j, g) is said to be an (j, g) -,epresentation for >-.
(c) Suppose that the interval order >- has all (j, g)-representation as de-
fined in part (b). In what sense is this representation ordinal? Prove your
claim.
(d) Suppose that X c Rn and that f and 9 are continuous, so that
maxima exist on non-empty compact sets. Show that if C c X is compact
and if x maximizes either f or 9 on C. then 1 maximizes >- 011 C.
3
PART III
[(a) = 5 points; (b) = ;) points; (c) = ;) points; (d) = 5 points]
Consider an economy \-vith two consumers, A and B and two goods, X
and Y. X is a private good, while Y is a public good. Each consumer has an
endowment of x = 1 of the private good. The initial endowment of the public
good is O. The public good can be produced from the private according to
the technology:
where z denotes the amount of the private good X devoted to the production
ofY and Ct E (0, ~ ) .
Both consumers voluntarily provide resources for the production of the
public good. Denote the amount of the private good supplied by consumer i
by Zi, i E {A, B}.
The utility functions of tlw tlvo consumers are given by:
:r .. \ +y
lin (T[j, y) = :I'n + /3 y,
where :1:, denotes the amount of the private good consumed by i E {A, B}, y
is the amount of public gooe! am1 ,3 is a non-negative constant.
For parts ( a) and (b). assume /3 = 1.
(a) Define the voluntary contribution equilibrium for this economy. Find
all such equilibria. In particular, for each equilibrium, determine the pro-
duced amount of the public good. as well as the private contributions of the
consumers.
(b) Derive the amount of the public good which would be produced in a
Pareto-optimal allocation. Check whether t.here is an underprovision of the
public good in the volunt.ary contribution equilibria you derived in part (a).
For parts (c) and (d), assume that ,3 E [0,1).
(c) Show that for fJ E [0.]). only one of the consumers will contribute
towards the production of the public good in the voluntary contribution
equilibrium. \i\'hich consumer will that be? How much will she contribute?
(d) For which values of ,8 E [0,1), does the amount of the public good
produced in a voluntary contribution equilibrium correspond to the Pareto-
optimal one? Provide a short. interpretation for your result.
4
PART IV
[( a) = 7 points; (b) = 6 points; (c) = 7 points]
Consider an economy with two consumers (indexed i = 1,2) and two
goods (indexed j = L 2). Good 1 will be called leisure, and good 2 will be
called food. Consumer 1 has an endowment of Ll = 3 units of leisure (and
nothing of food); consumer 2 has an endowment of L2 = 9 units of leisure
(and nothing of food). Food can be produced 'vvith the labor input of the
consumers; that is, by giving up leisure. Labor input of consumers 1 and 2
are perfect substitutes in this production process, which is represented by a
production function, f, from IR+ to IR+.
Production of food is carried out by a competitive firm. The shares
of consumers 1 and 2 in the profit of the firm are denoted by 8
1
and 8
2
respectively, with (Jj 2 a for i = L 2, and 8
1
+ 8
2
= L
Denote by Xl == [0,3] x IR+ the consumption set of consumer 1, and
by X
2
== [0,9] x IR+ the consumption set of consumer 2. Denote by
(XIl' X21) E Xl the consumption bundle of goods 1 and 2 for consumer 1,
and by (Xl2' X22) E X
2
the consumption bundle of goods 1 and 2 of consumer
2. Consumers are assumed to behave competitively.
It is known that there always exists a competitive equilibrium for this
economy. Denote a competitive eqllihbTium by {(Xll' X21), (X12' X22), (p, WI, W2)},
where p is the price per unit of food, and Wl and W2 represent the wage per
unit of labor provided by consumers 1 and 2 respectively.
A competitive equilibrium is said to be of type I if both consumers have
positive wage incomes in equilibrium: otherwise, it is said to be of type II.
Assume that the function f : IR+ ----) IR+ is given by:
f(z) = 2 z ~ for all z E IR+
where z denotes labor input.
Consumer 1 's utility function (011 leisure and food) is given by:
1 J
lLl(Xll,T2l) = TflTil for all (XIl,X2l) E Xl
and consumer 2's utility function (on leisure and food) is given by:
1 J
12(1:12, X22) = 1:i
2
:ri2 for all (Xl2' X22) E X2
5
(a) Show that the same amollllt of food is produced in every competitive
equilibriuIllof type I.
(b) When 0
1
= 02, obtain a competitive equilibrium of type I, showing
your procedure clearly.
(c) When 0
1
= 1 (0
2
= 0) 1 show that a competitive equilibrium must be of
type II, and show that more food is produced in this equilibrium, compared
to (b) above.
6
PART V
[(a) = 7 points; (b) = 6 points; (c) = 7 points]
Consider the special case of the Arrow-Debreu framework in 'which there
is one physical good and two states of nature. There are two consumers,
whose endowments are given by:
vvllcrc the first component of each vector denotes the endowment if state 1
occurs, and the second component of each vector denotes the endowment if
state 2 occurs.
Suppose that the consumption set of each consumer is X = J R . ~ and the
preferences of consumer i (where i = 1,2) can be represented by a utility
function, U
i
: J R . ~ -7 JR., which satisfies the following assumptions:
(A.l) U
i
is continuous ane! monotone on X.
(A.2) For all (0, b) EX, ,vith a f. b,
U( a + b. 0 + b) > U.(o b)
I 2 . 2 1.,
(n) Shm\" that an allocation ((Xll: X21), (X12' X22)) is Pareto efficient if and
only if it ensures full-insurance for each consumer; that is: .
(b) Show that assumption (A.2) is satisfied if the utility function, U
i
: is
given by:
Ui(a, b) = min{o, b} for all (a, b) EX
(c) Obtain all Arrow-Debreu contingent claims equilibria, when the utility
function of each consumer i (where i = 1,2) is of the form specified in (b)
above.
7
June 2, 2008
GRADUATE NIICROECONOIVIICS EXidvl
1. '{Oil arc identified by a number. The grading is meant to \ll' dnolly-
1ll00lCi. CiO ,vc suggest that you do not use your Cornell J.D. number.
Select all identifying number and keep a record of it for your information.
Put this n,'umbc7' on each exam book, NOT your name, and DO NOT
sign t.he rxam book(s).
2. ThiCi exam has five parts. Each part is worth 20 pointCi. You have
:j homs t.o ,\Tite the exam.
:3. Each part must be answered in a separate exam book. \\fhell y(m
clTt: finiCihed. please write down the total number of exam hoob .YOll are
submittillg, and get the number verified by the proctor.
4. This is a closed-book exam. In addition, you arc not allowed t (J
UCil' nil\, calculat.or during t.he exam.
,) 1f you find any question ambiguous, explain your confusion ;me!
make what.ever assumptions you think necessary to answer t.he quest.ion.
Cblrly stat.e any additional assumptions you make.
GOOD LUCK"
1
PART I
(a) All individual considers the set of alternatives X = {u: b.e}. Suppose
that you observe the individual make the following choices froIll subsets of X:
C({a,b}) = {b}, C({b,e}) = {b}, C({a,e}) = {e}, and C({a,b:c}) = {b}.
(i) Does the individual's choice rule satisfy the Weak Axiolll of Hcvenhl
Preference (WARP)? If yes, explain why. If no. show that it doeCi 1l0t. satisfy
WARP.
(ii) Is the revealed preference relation induced by these choices cOIllplete
allCl transitive? If yes, briefly explain why. If no, show that it is not complete
or show that it is not transitive.
(b) Now suppose that you observe a different individual make the follow-
ing choices from subsets X: C({a,b}) = {a,b}, C({b:c}) = {b}, ('({u,e}) =
{u.,c}, and C({a,b,e}) = {a,b}.
(i) Does the individual's choice rule satisfy the \Veak Axiom of Hevealed
Preference (\VARP)? If yes, explain why. If no, show that it does not satisfy
\VARP.
(ii) Is t,he revealed preference relation induced by these choices com plete
and transitive? If yes, briefly explain why. If no, show that. it is not complete'
or Cillo\V that it is not transitive.
(c) This second individual (the one you observed in part b) 110\V explains
to you that in the instances in which the set of alternative" 'chosen: \Va" (l
and another alternative, that they did not mean that they were illdifferent.
between a and the other alternative; instead, they meant that they were
unable to choose between a and the other alternative. Suppose t.hat in fact
thic; person is never indifferent between two alternativec; in X. Let us say that
for two alternatives x and y in X, alternative x is clearly-revealed preferred,
>--', to alterna.tive y if we observe C( {x, y}) = {:r}.
Derive the clearly-revealed preference relation induced by this person's
choices (the choices in part b). Is this preference relation complete and
transitive? If you think the answer is yes, explain why. If you think the
answer is no, explain why not.
2
PART II
[(a) = 5 points; (b) = 5 points; (c) = 5 points: (ell = 5 points]
A competitive firm has the production function 1/ = III (.17(:1') + 1) where
1/ is output, inputs are x E R ~ , and 9 : R ~ ---) R ~ is hOlnogencous of degree
one. Input prices are w > > 0 and the output. price is p > o.
(a) Define the cost function C(w,1/) as the vidllf' of a minilllization prob-
lem.
(b) Show that the marginal rate of technical substitution between any
two inputs i and j is constant along any ray through the origin
(c) Show that the cost function can be written as C(VJ, y) = t(y)C(w, 1)
for some fUllction t(y), where C(w, 1) is the cost function evalu8.tcd nt OIlE'
unit of output.
(el) Show that conditional input dernanels Cilll be' \vritten as :r(w, y) =
t(y)x(w, 1) where x(w, 1) is the conditional inpllt demand evaluated at one
unit of output. [You may use the claim above, that C(II', y) = l,(y)('(IO, 1), to
t)how that conditional input demands can be writ t.ell as :r(w, y) = t (U):r(w, 1 ).]
3
PART III
[(a) = 10 (b) =: 10
Consider an economy in which there i:-; one public good (:1:) and one pri-
vate good (y). There are N individuals. indexed i = 1, .... 1\! (with N 2:2).
Individual i has an endowment Qi > 0 of tlw private good, and none of the
public good. The total endowment of the private good, (uJ + ... + aN),
normalized to 1. The public good can be produced from the private good,
a production function, 1 : lR+ --7 Ill!+- Assnme that. 1 has the follmving
form:
1(z) = z for z E IR+
Each individual's consumption set is and consun'leri'::f preferences are
represented by a utility function:
Ui(X,Yi) = l:Yi for (.1",));) E
(a) Let (Cl' ... , C1) be a voluntary contributiolls equilibrium (VeE), with
r\ E [0, ail for each i E {I, ... , N}. As usual, the as:-;ocia tcd allocation (:i:, YJ , ... , in)
is defined by:
I
i = L Ci and Yi = ai - Ci for alL.1 E {1, ... , N}
i=l
Show that the amount of public gooel, :i;, must be at least. [l/(N + 1)], re-
gardless of the distribution of endowments.
(b) Specialize now to the case in which the economy has two individuals
(N = 2), with a2 al.
(i) Solve for the VeE provision of the public good, in terms of the pa-
rameters (al,a2).
(ii) Obtain algebraically a function, g : [1, OG) --7 IR!.+, such that when the
distribution of endowments, (aI, a2), (a2/ ad = T, the VeE prcwision
of the public good is g(r). Show that g(r) --7 (1/2) as r --7 00.
(iii) Based on (ii), what relationship indicated between wealth inequal-
ity in the economy and public good provision in a VeE? Explain.
(iv) If (x, fh) is any Pareto efficient allocatioll, show that, x, the
amount of the public good provided, equals (1/2).
PART IV
[(a) = 5 points; (b) = 5 points; (c) = 5 points; (d) = 5 points]
Consider an economy with two states of the world, 1 and 2, and two
consumers -- Angelina and Brad. Angelina's and Brad's initial ene!mvments
of state-contingent wealth are given by (w;\, W21) and (wf, wf), respectively.
Assume that w ~ = wf and w
2
4
= wf. Brad is a risk-neutral expected utility
maximizer, who assigns a probability 1Tj to state 1. Angelina ane! Brad can
trade in state-contingent wealth at prices]Jj andlh
(a) Angelina is an expected utility mcjJ(imizer and also assigns a proba-
bility of 1TI to state 1. For any value of 1T], for any values of the initial endow-
ments, and for any prices p] and P2, whenever Angelina prefers to consume
her initial endowment rather than insure herself completely, so does Brae!.
vVhat conclusion can you draw about Angelina's Bernoulli utility function?
For the rest of the problem, assume 'iTl E (0,1).
(b) Angelina is an expected utility maximizer with a strictly concave
Bernoulli utility function 11..1 (1.:) and assigns a probability of 1Tf\ E (Tt], 1) to
state 1. Derive the conditions for an interior market equilibrimll. Cornpare
Angelina's consumption in the two states of the world. \i\/iU she be completely
insured in equilibrium?
For parts_ (c) and (d), suppose that Angelina's evaluation of state-contingent
wealth ( x ~ , x ~ ) is given by the functional:
for some "I E (0, I), where Tt] is the probability Brad assigns to state I, and
'if2 == (1 - 'if1) is the probability he assigns to state 2.
(c) Draw Angelina's indifference curve through her initial endowment.
Set up her maximization problem ane! derive her optimal consumption for
arbitrary prices PI and P2
(d) Show that in an interior equilibrium Angelina will be completely in-
sured by Brad. Illustrate the equilibrium in an Edgeworth's box.
5
PARTY
Consider an economy with two consumers (indexed i = 1,2) anel two
goods (indexed l = 1,2). Good 1 will be called leisure, and good 2 will be
called food. Each consumer has an endowment of 6 units of leisure (and noth-
ing of food). Food can be produced wit.h the labor input of the consumers;
that is, by giving up leisure. Labor input of consumers 1 ane! 2 are perfect
substitutes in this production process, whicll is representeel by a production
function, f, from IR+ to IR+.
Denote by X == [0,6] x IR+ the consumption set of each consumer. Denote
by (Xl1' x2d E X the consumption bundle of goods 1 and 2 for consumer 1,
and by (X12' :t
22
) E X the consumption bundle of goods 1 and 2 of consumer
2. A feasible allocution is (l.ll assignment {(.rl1,x21),(:rI2,:r22)} such that
(Xl1' X21) EX, (.1:12,2:22) EX. and:
;1:21 + X22 ::; f((6 - 1:]]) + (6 - :]:12))
It is inteTiO'l if :1:11 E (0,6) and :r12 E (0,6).
Assume that the function f : R
f
--> Rr is given hy:
f(;:) = 2A for all 2 E iR+
where z denotes labor input.
Consumer l's utility function (on leisure and food) is given by:
1 1
11 (I'll, 1:2J) = ];i1Xi1 for all (T11' :1"21) E X
and consumer 2's utility function (on leisure and food) is given by:
1 1
Vd1.:12 , 1.:22) = .Tf
2
:ri2 for all (xu, :1:22) E X
(a) Show that the same amount of output of fooel is produced at every
interior Pareto efficient allocation {( Xll, X21), (.7:12 ,x22)}. Find this output
level.
(b) Using ( a), obtain the set of interior Pareto efficient allocations {( :rll, :r:21), (:;; 12, :C22)} ,
showing your procedure clearly.
(c) Depict the interior Pareto efficient allocatiolls {(:l:11 , :r21), (X12' X22)}
in a suitable Edgeworth box diagram.
6
August I, 2007
GRADUATE.l\lICROECONOlVIICS EXAM
mous, so we suggest that you do not use your Cornell LD. number.
4 hours to write the exam.
3. Each part must be answered in a separate exam book. vVhen you
are finished, please write clown the Lotal mimber of exam books you are
submitting, and get the nmnhcruc7'ififCl by the pmctor-.
4. This is a closed-book exam'. You are not allowed to use any calcu-
lator during the exam.
make whatever assumpt.ions YOll think necessary to' answer the question.
GOOD LUCK"
1
PART 1
A firm produces output y using the production function y = ](x) where
x E i R ~ , for n 2: 1. The production function is continuous, monotone in-
creasing, concave and ](0) = o. The output price is p > 0 and input prices
are w > > o. The firm is run by a manager who wants to minimize output
(as he has to work to sell the output and he dislikes working) subject to the
constraint that the firm makes a profit of at least 'if > O. Assume that at the
current prices (p, w) there are inputs x such that p] (x) - w . X > 7r.
1. Suppose that there is only one input (n = 1). What happens to the
optimal output if the output price increases? What happens to the
optimal amount of the input if the input price increases? Explain your
answers. [A graph will be helpful.]
2. Now suppose thaL there are several inputs (n > 1). \iVhat happens
to the optimal output if the output price increases? Explain how an
increase in the price of an input affects the demand for that input.
3. How clo your answers cliffer from the usual case of the profit maximizing
firm?
2
PART II
Robinson Crusoe grows food (F) on two plots of land, A and B. In any
year one and only one of these plots succeeds and actually produces food;
the other plot produces nothing. The probability that the successful' plot.
will be A is p, and the probability t.hat the successful plot will be B is 1 - p.
Robinson has T > 0 units of time available in a year to use in growing food.
Let A be the fraction of this available time that Robinson uses to grow food
on plot. A. If Robinson works AT units of time on A and A is successful the
amount of food that is produced is aAT, where a > O. Similarly, the amount
of food that is produced is b(l - A)T, where b > 0, if B is the successful plot.
Robinson is an expected utility maximizer and his Bernoulli utility for
food, F, is In(F).
1. Setup and solve Robinson's t.ime allocation problem.
2 ~ Does the optimal amount of time to spend growing food on plot. A
depend on a? Explain.
3. Write t.he value of Robinson's problem as a function \I oft.he parameters
of t.he problem.
4. Now Robinson can use some of his time to improve the productivit.y of
plot.s A and B. Let Tl be the number of uni t.s of time used to produce
food and T2 the number of units of t.ime used to improve product.ivit.y.
Assume t.hat T ? Tl + T2 and T
1
, T2 ? O. If T2 unit.s of t.ime are used
t.o improve product.ivity t.he set of available productivity paramet.ers is
determined by a + b = T
2
, where a? 0 and b ? O. That is, if Robinson
allocates T2 unit.s of time to product.ivity improvement he can chose any
productivity paramet.ers a ? 0 and b ? 0 that satisfy t.he constraint
a + b = T
2
. Find the optimal division of time between improving
productivity and grovving food, the opt.imal productivity pararneters
and the optimal allocation of time used to grow food on each plot.
3
PART III
Consider a 2 x 2 exchange economy, with two goods (1 and 2) and two
consumers (1 and 2). The endowment bundles of consumers 1 ane! 2 me
denoted by WI and W2 respectively, and are given by:
WI (Wll,W2I) = (bI , 1)
W2 (WI2,W22) = (b2 , 1)
where b
I
> 0 and b
2
> 0 are endowment parameters. The utility function of
consumer 1 is given by:
a.nd the utility fUllction of consumer 2 is given by:
where (LI > 0 and 02 > 0 are taste parameters.
(a") Suppose (PI, P2) is a competitive equilibrium price for the econolll.y.
satisfying PI 2 0 and P2 = O. 'A/hat restrictions must be satisfied lw t.he
parameters (CLI' CL2,b], b
2
)? Explain.
(b) Suppose (PI, P2) is a competitive equilibrium price for the economy,
satisfying P2 2 0 and PI = o. vVhat restrictions must be satisfied by t.he
parameters (CL1' CL2, b
1
, b
2
)? Explain.
(c) Obtain the market excess demand function for good 1 for all prices
(P1, P2) satisfying P1 > 0 and P2 > 0, showing your procedure clearly.
(d) Suppose the parameters (CL1,CL2,b1,b2) satisfy the restrictions:
Obtain the set of competitive equilibrium allocations for the econorny, SllO\\"-
ing your procedure clearly.
4
PART IV
Suppose two individuals 1 and 2 can trade each of two good::; X and Y
at two location::; A and B. That is, each individual i has an endowment
(e
XA
' e
XB
' e ~ A ' eYB)' Preferences of individual i are as follows:
Suppose that the markets at location A and B are completely ::;eparate. So,
for instance, one cannot sell at A and use the proceeds to buy at B, l?ut one
can sell X at A and use the proceeds tO,buy Y at A, and one can sell X at
B and use the proceeds to buy Y at B.
1. Define a market clearing equilibrium for this economy.
2. Suppose el
A
= ekl = 1 and elB = d'B = 2. SUPPOc;(' t.hat e
2
\"A
e ~ A = 2, e ~ ' B = e ~ B = 1. Compute the market clearing (qliilibrium.
3. Find the Pareto frontier. Is the equilibrium allocation u]) it?
"1. Suppose that X and Y can be freely shipped between location::; A and
B. How do your answers to the three question::; above challge?
5
PART V
In a two-period economy, apples can be used both as production factor
(to plant apple trees) or as consumption good. An apple orchard in this
economy produces apples according to the production function:
Ys = 2s.jYo,
whereby Yo denotes the input of apples at time t = 0, ane! S E {I, 2} denotes
the realized state of the world at t = 1. Both states occur with probability
1
2'
There are two consumers - A and B, who consume only apples. The
utility function for apples for consumer i is given by:
E {A.B}
TO is the amount consumed by i in t = 0, and :1:; and denote the
Cjuant.ity consumed by i in states 1 and 2 respectively. In period 0, each
consumer has an initial endmvment of fo = 4. Commlller i E {A, B} owns a
share (ti of the apple orchard with
a-
A
+ a-
B
= 1.
For part a), assume that a-
A
= a-
B
= Assume as welL that. in period
t = 0, the market for apples in period 0 opens simultaneously vvith the
contingent markets for apples in states 1 and 2. No trade is pos.sible in
period I, when the state is realized and the state-contingent claims a.re paid.
a) Derive the competitive market equilibrium for this economy.
For parts b) and c), assume that state-cont.ingent. markets for apples are
absent in the economy. There are spot markets for apples at each date and
state of the world. There are also two Arrow securities for the two states of
the world, with 0 net supply, which can be traded by the consumers and by
the firm at prices ql and q2'
b) Derive the competitive market equilibrium for this economy.
c) Compare and contrast your answers in parts (a) and (b).
G
June 4,2007
GRADUATEMITCROECONOMITCSEXAM
mous, so we suggest that you do not use your Cornell I.D. number.
<"'1 hours to write the exam.
3. Each part must be answered in a separate exam book. In addition,
you should answer Part I( a) and Part I(b) in separate exam books. \\Then
you are finished, please write down the total number of exall1 books you are
submitting, and get the numberuerified by the proctor.
4. This is a closed-book exam. )'cm are not allo\H,c! to use any calcu-
lator during the exam.
make whatever assumptions you think necessary to answer the question.
Clearly state any additional assumption::; you make.
GOOD LUCK"
1
PART I
(a) Suppose a decision-maker has maxim.in expected utility 'with some
set P of prior distributions over three states of the 'world, 5' = {I, 2, 3},
and suppose, for concreteness, that that payoff is linear in money, so that
u(x) == x.
Suppose the decision maker tells you that at payoH vector (1,1,2) his
utility is computed by taking the expectation wit.h respect to the probability
distribution pI = 0, 0, ~ ) . Suppose at. some other payoff vector (x, y, z),
his utility is computed with prior distribution ])2 = ( O , ~ , ~ ) . What can be
inferred about the values of x, y and z? Explain.
(b) In a two person exchange economy, when the endowments are (5, 0)
tor consumer A and (4,13) for B, the equilibrium prices are Per = 10 and
Py = 20. When the endowments are (10,0) for A and (10,8) for B, the prices
are P,r = 15 and Py = 5. In the first equilibrium consumer A consumes (3, 1)
and in the second he consumes (8,6). In. the first equilibrium consumer B
consumes (6,12), and in the second he consumes (12; 2). Are these equilibria
consistent with utility maximization? Explain.
2
PART II
Consider an agent who lives for three periods, indexed by t = 1,2,3. In
period 1 she maximizes the utilit:y function:
where (3, fj E (0,1] and c[ is the consumption in period t. vVhen period 2
arrives, the agent ma.ximizes the utility function:
where (3 and fj are as before. Finally, in period 3, she simply maximizes
U
3
(C3) = In C3.
(a) Suppose that at time 1 the agent makes a complete plan for her future
consumption, finding the (nonnegative) consumption profile c = (Cl' C2, C3) E
lRt that maximizes U) (c) snbject to the following set of budget constraints:
c) < IV
(:2 < (1\ . _.- (I )( 1 + r)
C3 < [(1r - (1)(1 + T) - C2] (1 + 7)
where W is the agent's wealth at the beginning of her life and r ~ 0 is the
interest rate. The interpretation here, of course, is that the agent can freely
transfer wealth tmvards the future by lending at the market interest rate T.
(i) Solve for the agent's optimulll consumption path (c;',C
2
,C
3
).
(ii) How do ci (and thus 1rst- period savings VV - cn depend on the interest
rate? To answer the question precisely, determine the Slutsky substitution
effect S;,. for first-period consumption that is associated to a (small) wealth-
compensated change dT in the interest rate. (Here, we speak of a "wealth-
compensated change" as the adjustment on the consumer's wealth that allows
her to purchase exactly the same consumption bundle as before the change.)
Now, interpret the effect displayed by the consumption demand at period
1 when the interest rate changes, in terms of the income and substitution
effects.
(b) Now assume that, at t = 2, the agent reconsiders her original con-
sumption plan (ci, c;, <3) and decides afresh on the consumption for periods
3
2 and 3 solving the problem of finding C2 and C3 that maximize U2 (C2, C3)
subject to the budget constraints:
C2 < (W - ci) (1 + '1')
C3 < [(iV - c ~ ) ( l + '1') - C2] (1 + '1')
where (VV - c';') represents the arnount she saved at time l.
(i)Solve for her optimal consnmption path ((2, (3), as a function of 'I' and
the parameters (3 and b.
(ii) Suppose first that ,6 = 1. Will the agent then stick to her original
I
. (. ~ 1 ~ *)'7
P an I.e. C2 = c
2
anc C3 = c
3
.
(iii) Now consider how the previous conclusion is affected if (3 < 1. If the
optimal consumption paths diffcr in either casc ((3 = 1 and (3 < 1), how do
they differ? Give an intuition for your conclusions.
4
PART III
Consider an economy with endowments R, Land N of capital, labor and
land respectively. It can produce food (F) and clothing (C). Food is produced
with labor and land, according to the production fWlction:
where 0 < a < 1 is a production parameter, and NF and LF denote the
amounts of land and labor used as inputs in the production of food. Clothing
is produced with labor and capital, according to the production function:
where o < b < 1 isa production parameter, and Kc and Lc denote the
amounts of capital and labor used (J.':> inputs in the production of clothing.
The economy engages in free trade at vvorld prices of food and clothing,
given by p and q respectively.
(a) Assume that the economy is in a free-trade competitive equilibrium,
in \vhich it produces both food alld clothing. Denoting the competitive factor
returns of capital, labor and land by T, wand s respectively, write down the
equations that characterize such an equilibrium (you do not need to solve
the system of equations).
(b) Suppose the price of clothing (q) goes up, while the price of food
remain.':> the same. Show that the return to labor must go up. (It is enough
to discuss the local comparative static result). Draw an appropriate diagram
to illustrate your answer.
(c) Obtain the effects of the increase of q on the returns to land and
capital, showing your reasoning clearly.
(d) Show that the return to labor goes up proportionately less than the
price of clothing.
5
PART IV
Consider an economy with one consumer. The consumer owns one unit
of good X.
There is a technology that turns good X into good Y. The production
function is y =x
2
, where y is the output of good Y that can be produced
with 1; units of good X.
Another technology turns goods X and Y into good Z. Its production
function is z = xay
f3
, where z is. the output of good Z that can be pro-
duced with x units of good X and y units of good Y, and 0: > 0, fJ > 0 are
technological parameters.
The consumer cares only about consumption of good Z; more is better.
Consider two different managerial regimes for the two technologies. In
regime A each technology is owned by a single profit-maximizIng firm. In
regime B a single firm owns both technologies and manages them jointly.
Profits, if any. go to the consumer.
Compare competitive equilibrium and optimal outcomes in regimes A
and B for different parameter values 0: > 0 and fJ > O. For every case you
consider:
(a) Explain why competitive equilibrium is or is not optimal if it exists.
(b) If competitive equilibrium does not exist, explain why not.
6
PART V
Consider an economy with N individuals which consume only goods X
and Y. All consumers have identical preferences for X and Y given by the
utility fUllction:
u (.T,; y,) = min {Xi; Yi}
where :r:i and Yi denote the quantities of goods X and Y consumed by in-
dividual I E {L.N}. Each consumer i E {L.N} has a strictly posit.ive
endowment of X and Y, denoted by
The two goods cl:re traded in perfectly competitive markets at prices ]Jx and
]Jy, respectively.
For part a) ass) 1l11e that N = 2 and
:[;1 = 2; fh = 8; X2 = 8; f12 = 2.
a) Illust.rate t.he economy in an Edgeworth box: draw the initial endowment
and t.he indifference curves through the initial endowment. of both incli-
yiduals. Find all market. equilibrium allocations and the corresponding
prices. Illust.rate one such equilibrium in your graph.
For part.s b) -- d), assume that N > 2 and:
N N
2:: Xi > 2:: Vi
i=l i=l
b) Check whether vValras' law holds for this economy. vVrite dmvn the con-
dit.ions for a market equilibrium and find all equilibria for this economy.
Is the equilibrium price / equilibrium allocation unique?
c) Derive all Pareto-optimal allocations. Either prove that all equilibria in
this economy are Pareto-optimal or provide a counter-example.
7
d) Suppose that the economy described above has reached a Pareto-optimal
equilibrium ,x,rjth equilibrium prices Px and py. Assume that there are
two possible trading arrangements in this economy:
1) Everyone trades their initial endowment at the economy-wide mal'-
kets for X and Y at the equilibrium prices Px, py
2) Individuals 1 and 2 can exchange their initial endowments onl)- be-
tween each other, at prices, potentially different from Px, pi"
They are not allowed to enter into transactions \\rjth other in-
dividuals.
Show that individuals 1 and 2 will never be both strictly better-off
under ~ h e second arrangement than under the first one.
8
June 5, 2006
GRADUATEWllCROECONOWllCSEXAM
mous, so we suggest that you not use your Cornell I.D. number. Select
an identifying number and keep a record of it for your information. Put
this nU7nber on each exam book, NOT your name, and DO NOT sign
your name on the exam book(s) either.
2. Each part must be answered in a separate exam book. When you
are finished, please write do-..yn the total number of exam books you are
submitting, and get the number verified by the proctor.
make whatever assumptions you think necessary to (lns,ver the question.
GOOD LUCK"
1
Part I
Two horses, A and B, will run a race and exactly one horse will win. For
every dollar bet on A the bettor receives qAdollars if A wins and 0 dollars
if A loses. For every dollar bet on B the bettor receives qB dollars if B wins
and 0 if B loses. There are I bettors indexed by i = 1) ... , I. Investor i has
wi> 0 dollars of initial wealth. Every bettor is a subjective expected utility
maximizer with Bernoulli utility of wealth, W, log( 'tv). Bettors have beliefs
(pi,l - pi) where pi, 0 < pi < 1, is bettor i's subjective probability of horse
A winning the race. Bettors must bet all of their wealth on horses A and B.
Let a
i
be the fraction of wealth bet on horse A by bettor i.
1. Find the optimal fraction of wealth for bettor i to bet on horse A.
2. Equilibrium odds (the qA and qB) are determined so that the total
amount bet, L{=l wi == w, equals the total amount paid out to bettors
no matter which horse wins the race. Find the equilibrium odds. Call
these qdds (qA' q'B)
3. The cost to a bettor of one dollar in the state ill which A wins, we will
call this state A, is -+. Similarly, the cost to a bettor of one dollar in
qA
the state in which B wins, we will call this state B, is -+. These inverse
qB
odds are also called "state prices". Interpret the following statement
in light of this model: "State prices are an average of bettors (or
investors) probabilities of states."
4. In an equilibrium, does the restriction that each bettor must bet all of
his or her wealth matter? Is there a ,vay for a bettor to bet one dollar
and be certain that he or she will receive one dollar after the race?
2
Part II
An economy consists of I consumers indexed by i = 1, ... , I. These
consumers have wealths wi > 0 and preferences over consumption goods
x E R+ that can be represented by utility functions, u
i
: R+ -7 R, which
are homogeneous of degree one. These consumers need not have identical
preferences and there are no restrictions on how the aggregate wealth, w ==
~ { = l wi, is shared among the consumers. Let pER+. be the vector of prices
for the consumption goods.
1. Show that for. any utility function representing consumer i's prefer-
ences the indirect utility function can be written as t(Vi(p)w
i
).
2. Show that a positive representative consumer may not exist for this
economy. [An example is sufficient.]
3. Suppose that in the economy described above ,ve also have u
i
(.) =
u
j
(.), for all i and j. Does a positive representative consumer exist?
4. In part 3 \ve assumed that consumers have identical utility functions.
Is this alone enough to yield a positive representative consumer or
did we need the assumption that preferences could be represented by
utility functions which are homogeneolls of degree one?
3
Part III
Consider the following signalling game, in which Nature (N) first chooses
the type of player A (h, m or I) according to the probabilities indicated in
the graph. Then, A chooses an action (U or D). Afterwards, player B
chooses an action (x or V), without knowing the type of A. Assume that
a E lR.
/2;2
1;2
U
x
Ah
D B
y
1;0
,CY
1
~ 1 ' 1
0;1
"2
U ' x
N
1
Am
B' ~ D
Y
2;0
, /3
0;0
1
U ~
-1;0
4:
:r
Al
D B'
y
I
1; a
Figure 1: Signalling game
1. Check whether the game has a separating perfect-Bayesian equilibrium
in pure strategies. How does your answer depend on the value of a?
2. Find all pure-strategy pooling equilibria of t.he game. Are there values
of a E JR., for which the game has no pooling equilibrium?
3. Check which of the pooling equilibria satisfy the intuitive criterion.
4
Part IV
Consider a tennis club with n members. At the beginning of the playing
season, each member i must announce for how many hours ti she plans to use
the tennis court. All members make their announcements simultaneously.
The payoff (for the season) of i is given by:
with T > O.
Assume first that club members face no costs.
1. Represent the situation as a game in strategic form. Check whether
the game exhibits strategic complementarities or strategic substitutes.
Determine the symmetric Nash equilibrium.
2. How does the payoff of a club member in equilibrium change with n?
Derive the symmetric Pareto-optimum and compare it to the Nash
equilibrium.
Assume now that the club raises a fixed membership fee per season
c > O. c must be paid only by those members who announce a positive k
The membership fee is subtracted from the payoff of player i.
3. Find those values of c, for which the symmetric Nash equilibrium of the
game will be identical to the one you determined in part 1. Find also
those values of c, for which at least one of the Nash equilibria of the
game will be Pareto-optimal.
5
Part V
A single consumer owns one unit of seeds at date 0 which he does not
consume. A farming firm has T + 1 different linear technologies. Technology
t E {O ... T} can turn any amount x of seeds at date 0 into 5
t
x units of date
t output. The consumer owns the farm, and operates the farm to maximize
profit. The consumer derives utility from consuming output, and his utility
function is
T
u(co, ... ,CT) = ~ , 6 t l n c t ,
t=O
where In x is the natural logarithm of x. Assume that ,6,5 > O. In the
computations to follow, take the input price to be the numeraire good.
1. Computethe competitive equilibrium prices, consumptions, and factor
input to the date t production process. Under what conditions on
parameters is Ct increasing in t?
2. Suppose the government taxes the sale of date 0 input at rate T. The
revenues are ret.urned to the consumer. What are the welfare effects of
the tax? To justify your answer, compute the equilibrium with taxes.
Explain the intuition of how and why the tax does or does not distort
consumption and production decisions.
3. Suppose the government taxes the sale of date 0 output at rate T
(and taxes no other commodity). The revenues are returned to the
consumer. vVhat are the welfare effects of the tax? To justify your
answer, compute the equilibrium with taxes. Explain the intuition
of hmv and why the tax does or does not distort consumption and
production decisions.
6
Part VI
Suppose there are two states of the world, 31 and 32. State 3i occurs
with probability Pi. An act x assigns to each state a non-negative dollar
payoff, Xi to state 3i. Rank Dependent Utility is a decision model which
works as follows: Let xl = max{xl,x2} and x
2
= min{xl,x2}, and let
pI and p2 denote the corresponding probabilities of realization of the max
and min payoffs, respectively. That is, pI = PI if xl = Xl, and so forth.
Let u : R+ ---) R be a strictly increasing concave payoff function. Let
w : [0,1] ---) [0,1] be a strictly increasing weighting function with w(O) = 0
and w(l) = 1. Define
V(x) = u(xl)w(pl) + u(x
2
) (w(pl + p2) _ w(pl))
= U(Xl)W(pl) + u(x2)(1- w(pl))
These preferences weight probabilities according to the rank of the associated
payoff.
1. Drmv some indifference curves over acts.
2. Suppose that w(p) = -/p. Is the decision-maker risk-averse? Either
prove that any lottery is less good than receiving its expected value
for sure, or provide a function 1L and a lottery x such that the lottery
is preferred to the sure thing.
3. Suppose that two RDU decision-makers with w(p) = -/p trade in a
market contingent claims to money payoffs in two states of the world.
Suppose they have common beliefs about the probabilities of the two
states. Suppose there is no aggregate uncertainty. Find the set of
Pareto optimal allocations.
7
August 2, 2006
GRADUATE IvllCROECON01'v1ICS EXAM
1. You are identified by a number. Select an identifying number
and keep a record of it for your information. Do not use your Cornell
J.D. number. Put your number on each exam book, NOT your name,
and DO NOT sign your name on the exam book(s) either.
submitting, and get the number verified by the proctor .
. '3. If you find any question ambiguous, explain your confusion and
GOOD LUCI\: II
. I
I
Part I
An individual with initial wealth 0 has the utility function for gains and
losses
, {X' ifx>O
U(J.:) = -3(1 _ X)1/2 + 3 if x ~ 0,
(1)
Thus the individual treats gains (x 2 0) and losses (x SO) around his initial
wealth (0) asymmetrically, Suppose the individual evaluates any galllble
according to its expected utility using the payoff function U(1:)
1. Show that ,the individual is indifferent between: (i) the fair gamble
in which the probability of winning 3, x = 3, is one-half and the
probability of losing 3, :r = -3, is also one-half, and, (ii) keeping his
initial wealth for sure,
2, Show that for sufficiently small E > the individual strictly prd"rs:
(i) keeping his initial wealth for sure, to, (ii) the gamble ill which i he
probability of winning E is one-half and the probability of losing ( IS
also une-half. Lel IE' be such a value of E,
:3, Suppose now that the individual accepted the gamble in (1) and '.'.'OIl 3,
From this point the individual evaluates any new gamble according to
the gains (x 2 0) or losses (x S 0) from this gamble alone using U (),
How does this individual rank: (i) the gamble in which the probability
of losing :3 - E*, (:1: = - (3 - E*)), is one-half and the probability of losing
3 + E*, (x = -(3 + E*)), is also one-half, to, (ii) losing 3, (:1 = -3) for
sure, (* is the value you found in (2).
4, Is this individual an expected utility maximizer for utility defined uver
final wealth? Explain.
2
Part II
There are two consumption goods x :2: 0 and y :2: O. An inciividmd has
homothetic preferences with typical indifference curve I as illustrated below
y
2
1
1 2
x
These goods can be purchased at prices p = (Px, Pv)
J. Provide a utility function, in which] is assigned utility levell, that
represents this individual's preferences
2. Find t.he expendit.ure function for utility 1, i.e e(p, 1)
3. Find the Hicksian demand for good x at utility J, i.p. h
x
(]J,l)
4. Is there a clual relationship between e(p, 1) and h:r(p, 1) for this iwli-
vidual? Explain.
:3
Part III
Consider an economy with two goods and three consumers, i E {A, B, C}.
Each conSllmer i has Cobb- Douglas preferences with exponents O:i and 1 - 0:,
for goods 1 and 2, respectively, and a strictly positive endowment v"cLeJr e,.
Let e denote the aggregate endowmEnt.
1. Under what conditions on the parametEr vector (Oi' ei)iE{A,B,C') does
there exist a single representative Cobb-Douglas consumer with expo-
nents {31 and 1 - {31 for goods 1 and 2, and endowment. e such that
the excess demand function for the representative consumer economy
is identical with that of the original three-person economy?
2. Under what conditions on the parameter vector (ni' eJiE{A,B,C) docs
there exist two representative Cobb-Douglas consumers with expo-
nents {3j and 1 - (3j, .i = 1,2, for goods 1 and 2, and endowments
Ij with I:;j fj = e such that the excess demand [unctioIl for the twe>-
person representative consumer economy is identical with that. of t.he
original three-person economy?
3. How do these examples generalize IC) n consumer, k good
with n > k?
4
Part IV
The city of I plans the reconstruction of an ancient bridge. Ther" ;ue
two construction firms A and B which can execute the project. It is COID-
man knowledge that the costs of the two finns are distributed identically
and independently according to the uniform distribution on the int.erval
[10,000; 20, 000]. Each firm kno\',s the cost of the project to itself, but not
The municipal council uses the following rule to determine which of the
to the other firm.
firms will be hired. Both firms simuluweously submit their cost estimates
of the project in sealed envelopes. The f1rm which submits t.he luv;cr cost
estimate is hired to execute the project ilnd is paid its cost estimate. If the
two firms submit the same cost estimat.e a fnm is chosen by the Hip of a fair
COlJl.
1. Represent. the situation as a game with incomplet.e informat.ion.
2 Derive the expect.ed payoli of a firm given its own cos\.
Assume that t.he bidding functiun of a firm 1 E {A: H} is givpn by
Oi (Ci) ==, 20,000- (20, (JOO - Ci)(J,
where Ci is the actual cost of firm i and (3 :> 0 is a c:onst.ant
3. Show that the game has a Bayes-Nash equilibrium, in which the bid-
ding functions of both firms have the form specified a.ho\e. Find the
equilibrium value of ;3. Is the equilibriuIll lruth-telling, or do the firms
either overestimate or underestimak their costs?
Part V
Consider the following game in strategic form:
PlayeT 2
e f
Player' 1
c
2;2 x; 1
d 1; x 0;0
where x E R, x < 1 is a paramet.er.
1. Determine all Nash equilibria (including those in mixed strategies) of
the game for all x < I, Which of these equilibria are trembling-
hand perfect?
Now consider the following game tree:
0'
(' ,/ '
,0 '/ 2,'2
/
!- 1 Il
2. Derive the strategic form of the game.
3. Find all pure strategy Nash equilibria. Determine which of the Nash
equilibria are subgarne perfect. depending on the value of x,
4. Assume that :r = 0 Check whet.her the st.rategy combination (( b, d) ; (f, g)) is
aperfect Bayesian equilibrium of t.he game? Is it. trembling-hand
perfect? COJ1lment 11I'ielly OIl the statement:
1
"A perfect. Bayesw71 eqlL1i1.brimnis always trembling-hand pe7fect"
6
Part V1
A single competitive consumer Ims preferences over leisure-widget bun-
dles (L, x) which can be re.presented by the 11 ti lity [unct.ion u( L, x) = L + x.
The consumer is endowed with une unit each of time, which can be allo-
cated to labor or tu leisuIC; and capital. A single firm with a linear ho-
mogeneous Cobb-Douglas production function turns capital and labor into
widgets: Output is q = k,,/l-o The fi.nn is owned by the consumer.
1. Find the compet.itivc equilibrium. Take I\S numeraire the market price
of widgets.
2. Suppose the government taxes the firm's capital expenditures at rate
T. That is, tax rewnues arc nk where k is the capital stock used by
the firm and Y' is tlIe price of capital. Tax revenues are returned as a
lump SUln to tlw ('OJIsunwrs. Compute the equilibrium. Is
theequilibriullI eflkifmt.? PrU\'ide S()!)1e ii1tuit.ion for your answer.
3. Suppose the goverlllll"ll( l.axf>:;tJw firm's Ia.bor expenditures at rate T.
That is, tax rtc':l'llIICS are ,[1'[ where I is the labor used by the firm and
1U is the price of Llbu! Til:: are returned as a lump sum to the
consumers. CumjJute the equilibrium. Is the equilibrium
efficient.? PIm'ide some intuition for your answer.
7
June 6, 2005
GRADUATE IVIICROECONOMICS EXAM
1. You are identified by it number. The grading is meant to be anony-
this number on each exam book, NOT your name, ane! DO NOT sign
the exam book(s).
2. Each part must be answered in a separate exam book. V/hen you
are finished, please write down t.he total number of exam books you are
submitting, and get the number- verified by the proctor.
make whatever assumptions you t.hink necessary to answer the quest.ion.
Clearly state any additional asslllllPtions you make.
GOOD LUCK"
Part I
[(1) =20 points, (2) = 10 points, (:3) = 20 pointsj.
An investor has w > 0 dollars that can be kept in the bank or invested
in a risky project. l\,loney left in the bank, or money borrowed from the
bank, pays or earns no interest. The risky project will have a f\lture value
v which can be 0 or 2. Let p = P1"(v = 2).
Let Cl" ;::: 0 be the fraction of wealth invested in the risky project. We do
not allow the investor to go short in the risky project (so Cl" must be greater
than or equal to 0), but we do allow borrowing (so ct can be greater than
1). The investor is an expect.ed ut.ilit.y maximizer wit.h Bernoulli utility
u(:r) = A - eJ:p(-v)
where I > 0 and x is future wealth.
1. Find the optimal fraction of wealth t.o invest in t.he risky project.
2. What is the effect of a change in init.iH.l wealth IL' on the t.otal amount
invested in the risky project? Explain.
3. Now suppose that p = 1 = 1/2. The investor call purchase a signal
3 E {H, L} which he observes before lIlaking the illvestmellt. decision.
Suppose Fr(3 = fJ) = FI(s = L) = 1/2. Fr(v = 215 = H) = 3/4 and
Fr(v = 21
3
= L) = 1/,1. If the invest.or decides to purchase the signal
he must pay c dollars if the signal is H; if the signal is L he does not
have to pay anything. What is the maximum c the investor is willing
to pay?
2
Part II
[(1) =10 points, (2)(a) = 15 points, (2)(b) = 25 points].
Consider a Crusoe-Friday economy in which one good (food) can be
produced by using the labor of Crusoe and Friday (indexed i = 1,2, respec-
tively). The production function of food, J : IH:+ ----) IH:+, is given by:
for (Z1 + Z2) E [0,1]
for (Z1 +Z2) > 1
(P)
The economy has aggregate endowments of the two factors of production
(Crusoe's labor endowment and Friday's labor endowment), given by:
where a E (1/16, I).
Crusoe and Friday derive utility only from the consumption of food (and
not their labor /leisure). Crusoe's utility function is given by:
Friday's utility function is given by:
A firm hires labor (,0 produce food, using the technology specified by the
production function ill (1). The shares of Crusoe and Friday in the profits
of the firm are given bye and (1 - e) respectively, where e E [0,1].
Assume that Crusoe and Friday act competitively (that is, as price tak-
ers), and so does the firm.
1. Verify that the price of food is positive ill any competitive equilibrium.
Normalizing the price of food to 1, show that there is a unique COIll-
petitive equilibrium, and obtain the profit of the firm and the wages
paid to Crusoe and Friday in the competitive equilibrium.
2. Suppose, now, that a new method of producing food is available to
the firm. The new method allows food to be produced from labor
according to the production function, g : lR+ ----) lR+, given by:
(a) Show that there is a unique competitive equilibrium, and if e =
1, then Friday is worse off in the new competitive equilibrium,
compared to the situation in (1) above.
(b) Find the range of values (in terms of the parameter a) of e for
which both Crusoe and Friday are better off, compared to their
respective situations in (1) above, showing your procedure clearly.
4
Part III
1(1) = 10 points, (2) = 15 points, (3) = 10 points, (4) = 15 points]
A community has n households, and each household must decide how
milch to invest in the education of its children. Each household must choose
investment level 0 or 1. The educational attainment household i realizes
from an investment of J;i is (Cl. + !Yi-
i
+ Ci)Xi, where 1:-i is the average
investment of all households other than i, and Ci is a household-specific
random variable, which is known to, and only to, household i. The random
variables Ci are independent and identically distributed, with a density 1
on R+ which is strictly positive. Let F denote the cdf of the shocks. Let
[ denote the vector of shocks. The cost of investment Xi to householdi is
eXi. Household utility is linear in educational attainment and the cost of
investment. Households maximize
E{ (0- + /31:-i + c;)xilc;} - eXi.
Assume that (t + i3 < e.
1. Show that in any Bayes Nash equilibrium there is an Ei such thR.t
Xi(c,:) = 1 for ti > C; and :ri(ci) = 0 for OJ < E; (or C; = 0)
2. Characterize a symmetric Bayes-Nash equilibrium in terms of the dis-
tribution function F and the parameters Ct, i3 and e.
3. Show that if f3f(c) < 1 for all c, then equilibrium is unique.
4. Define an optimal tlt7'cshold Tule as one which maximizes t.he expected
payoff over Ci of household i. Is the optimum bigger or smaller than
c' when /31(c) < 1.
5
Part IV
[(1) = 15 points, (2) = 10 points, (3) = 15 points, (4) = 10 points]
Consider an economy with two goods, Xl and X2, and consumers l
1,. " , I. Consumer i has utility function
where 0 < ,.i < 1 and xi = (xl' x ~ ) is consumer i's allocation. Aggregate
. .. l'
wealth w > 0 is shared in fixed proportions at, i.e. w' = a'w and Li=l 0' =
1,0 < Cyi < 1, where wi is consumer i's wealth. Note that hi, a
i
) may diller
across the population. Let P = (PI, P2) be the price vector.
1. Show that a positive representative consumer exists.
2. Is the fixed proportions sharing rule necessary for this conclusion?
Explain.
3. For this eCOJlomy is the positive representative consumer a Ilormativ/:;
representative consumer relative to the social welfare function
I
lV(uJ, ... ,1LI) = La
i
ll
i
.
i=l
4. Consider a pllre exchange economy with these consumers ill which
consumer i's endowment is e
i
= (ai, a
i
). (Now wealth is the value
of endowment.) Does a positive representative consumer exist for the
exchange economy, i.e. can aggregate demand :r(p) = (Xl(p),:r2(p))
be generated from a single utility maximization problem? Explain.
6
Part V
((l)(i) = 5 points, (l)(ii) = 5 points, (2)(i) = 5 points, (2)(ii) = ;) points,
(3) = 20 points, (4) = 10 points]
Consider an economy in which there is one public good (x) and one
private good (y). The public good is indivisible, being available in integer
amounts only, while the private good is divisible. The economy has it total
endowment ex > 0 of the private good, and none of the public good. The
public good can be produced from the private good, using a production
function, f : IR+ -> N, where N = {O, 1,2,3, ... } is the set of non-negative
integers. Assume that f has the following form:
f ( z) = n for n ~ z < n + 1
where n E N, and z is the input of the private good.
There are I ;:: 2 individuals, indexed i = 1, ... , I. The consumptioll set
of individual i E {I, ... , I} is N x IR+, where N = {O, 1,2,3, .. } is the set uf
non-negative integers. Consumer it s preferences are represented b\ a utility
function:
x
1L,(T, Vi) = fJi (1 + x) + Yi for (x, Vi) E N x IRI
where fJi > 0 is a taste parameter. Assume, in what follows. that c> >
1 + LiEI /k
1. Give precise definitions of (i) an allocation, and (ii) i\ I'MeV, dli,.i('llt
allocation, for the economy described above.
2. Suppose ((z,x), (Y), .,YI)) is a Pareto efficient allocation. Sllo\\ lhat
(i) z = x, and (ii) LYi + T = o. (1)
iEI
3. Show that if ((z,X),(Yl, ... ,YI)) is any Pareto efficient alloCiltioll. sat-
isfying:
Yi ;:: fJi for all i E {I, ... , I} (2)
and x = fj ;:: 1, then:
( 8)
4. Interpret the two conditions in (S).
7
Part VI
[(1) = 5 points, (2) = 10 points, (3) = 10 points, (4) = 15 poillts, (5) =
10 points].
There are two possible states of the world, Hand T. A single conSllmp-
tion good is available in both states. Consumer 1 is endowed wi til one uni t
of good in state H and none in state T, and consumer 2 is endowed with
1 uni t of good in state T and none in state H. Let Pa and Pb denote two
probabilities of state H, with Pa > Po. Consumers have identical IILility
fUIlctions, each of the form
\vhere l1i is a concave function.
1. Plot some typical indifference curves carefully. Show that U, (:1'11, x,rl
is quasi-concave.
2. Find all the Pareto optimal allocations. Use an Edgeworth hox to
show how the set of optimal allocations changes a , ~ the funct.ions 1/)
change.
3. Find all the competitive equilibria.
4. Suppose now that consumer 2 pays a sales tax of t pr,r unit. OIl her
purchases of the good in state H. The revenues of lhis Lax are givell
to consumer 1 as a lump-sum transfer. Assume that Po :> Pb ane! show
that if the sales tax t is small enough relative to the price of good 1,
then Pareto optimal competitive equilibrium allocations will exi:ot.
5. Normally sales taxes create inefficiencies. In this case there is no enJ-
ciency loss. \Vb}' is it the case that sales taxes normally cre;ct.l' ineffi-
ciencies? Why is there no efficiency loss here?
8
August 3, 2005
GRADUATE MICROECONOIVIICS EXAIVI
mous, so we suggest that you not use your Cornell J.D. number. Select
an identifying number and keep a record of it for your informat.ion. Put
this number on each exam book, NOT your name, and DO NOT sign
the exam book(s).
2. Each part must be answered in a separate exam book. \Vhen you
submitting, and get the nv.mber verified by the proctor .
.3. If you find any question ambiguous, explain yom confusion and
make whatever assumptions you think necessary to answer t.he question.
GOOD LUCK"
1
Part I
[(1) =20 points, (2) = 10 points, (3) = 20 points].
A firm produces a good, y, using capital, K, and iabor, L, as inputs.
The production function is f(K, L) : R ~ --+ R which is strictly increas-
ing, strictly concave and satisfies lim]{ ->0 hdK, L) = 00 for all L > 0 and
limL->o h(K, L) = 00 for all K > O. The output price is p > 0 and input
prices are r > 0 for capital and w > 0 for labor. The manager of this firm
makes all input decisions. The manager's objective is to maxirnize sales, py,
subject to a constraint that profits be at least 'iT ::::: O.
1. In the short run, capital is fixed at K > O. Assume that there is an
amount of labor L > 0 such that pf(K, L) - rK- wL > 'iT. Find the
amount of labor that the manager will chose. How does this amount
of labor compare to the profit maximizing choice of labor?
2. Continue to assume that capital is fixed at K and that there is an
amount of labor L > 0 such that pf(K, L) - rK - wi > 'iT. How
does an increase in the cost of capital affect t.he amount of labor that.
t.he manager choses? How cloes it affect t.hp. profit maximizing choicp.?
Why?
3. Now consider the long run in which the manager can chose capital and
labor. Suppose that he decides to produce y* units of output. Will
the amounts of capit.al and labor that he choses minimize the cost of
producing y*? Explain.
2
Part II
[(1) =20 points, (2) = 15 points, (3) = 15 pointsj.
Consider an economy with a single consumption good and a single pe-
riod in which consumption takes place. One of S states will be realized in
the consumption period. States are indexed by 5 = (L ... ,8). There are I
consumers who hold a common probability P = (PI, ... ,Ps) on states. Con-
sumer i's endowment is e
i
= (el"'" es) > > O. AggTegate endowment is
e = 2:{=1 e
i
. Suppose that aggregate endowment is constant across states,
i.e. e
s
= e
s
, for all 5 and 5'.
Let c
i
= (ci, ... , c ~ ) denote a consumption plan for consumer i. All con-
sumers are expected utility maximizers with Bernoulli utility functions ui(x)
which satisfy: ui'(x) > 0 and uil/(x) < 0 for all x 2: OJ and, limJ>_-+oui'(x) =
00.
Suppose that there are complete markets for trade of consumption plans
and let qs denote the price of the consumption good in state s.
L Suppose that ui(x) = In(x-) for all i. Find consumer i's demand func-
tion.
2. Suppose that ui(x) = In(;r;) for all i. Show that q = (q], ... , qs)=
(PI, ... ,ps) = p is a cOlllpetitiw equilibrium price. Vlhat is consumer
i's equilibrium consumption plan?
3. Suppose now that consumers may have differing Bernoulli utility func-
tions which need not be logarithmic. vVhat can you say about com-
petitive equilibrium prices and consumption plans?
3
Part III
[(i)=13 points; (ii) = 12 points; (iii) = 12 points; (iv) = 13 points]
Consider an exchange economy with three consumers (i = 1,2,3) and
three goods (j = 1, 2, 3). The consumption set Xi of every consumer i E
{I, 2, 3} is ~ t . Assume that the preference relations of consumers 1, 2, 3 can
be represented by the following utility fUllctions: .
1.Ll(Xll,X21,X3J) = min{xll,x2d
1.L2(:7;12, X22, X32) = min{x22' X32}
1i3(X13, X23, X33) = min{x13, X33}
The endowments of the three consumers are given by:
Wl = (1,0,0), W2 = (0, b, 0), W3 = (0,0,1)
where 1 :::: b < 2.
(i) Show that if (xl,:r2,:7:3,P) is any competitive equilibrium, then p E
~ t +
(ii) Obtain the market excess-demand function, z(p), for p E ~ t + , show-
ing your procedure clearly.
(iii) Choosing good 3 as the numeraire good, show that there is a unique
vector (Pl,P2) such that (Pl,P2,l) is a competitive equilibrium price, and
that there is a unique competitive equilibrium allocation.
(iv) Compare the competitive equilibrium (Xl, X2, X3,P) when b = 1,
with the competitive equilibrium (Xl, X2, X3, p) when 1 < b < 2. Are all
consumers better off in the competitive equilibrium (Xl, X2, X3, p) than in
the competitive equilibrium (Xl, X2, X3, p)7 Explain.
4
Part IV
[(1) =10 points, (2) = 10 points, (3) = 10 points (4) = 10 points, (5) = 10
points].
There are two states of the world. The column player knows the state
while the row player does not. Let p denote the probability of state A. The
payoff matrices are
D
u ~ _ 3 - , - , 2_t--1...:..., _0 ---j
1,-2 2,0
U
D f---'-----/--'-----j
A B
1. Is LA, RB part of a Bayes-Nash Equilibrium (BNE)? If so, for what
values of p, and what does the row player choose?
2. Is RA, RF3 part of a Bayes-Nash Equilibrium (BNE)? If so, for what
values of p. and what does the row player choose?
3. Is RA, LB part of a Bayes-Nash Equilibrium (BNE)? If so, for what
values of p, and what c10es the row player choose?
4. vVill the column player randomize in state A as part of a Bayes-Nash
Equilibrium (BNE)? If so, for what values of p, and what does the row
player choose?
5. Will the column player randomize in state B as part of a Bayes-Nash
Equilibrium (BNE)? If so, for what values of p, and what does the row
player choose?
5
Part V
[(i)=lO points, (ii)=15 points, (iii)(a)=12 points, (iii)(b)=13 points]
Consider a Crusoe-Friday economy in which there are two goods (indexed
j = 1,2), each of which is produced by using the labor of Crusoe and Friday
(indexecli = C, F). The production functions of the two goods are denoted
by iJ for j = 1,2. Assume that the function h : -- is given by:
.!"J(ZCJ,ZFl) = +
Assume that the function h : -- lR+ is given by:
h(ZC2, ZF2) = ZC2 + ZF2
The economy has aggregate endowments of the two factors of production
(Crusoe's labor endowment and Friday's labor endowment), given by:
(iC, iF) = (1,1)
(i) \Vrite down the optimizatioll problem that one would solve to obtain
the production possibility frontier of this economy.
(ii) Show that the set of points {(Yl,g(yIl) : Yl E [O,2]}, where 9 :
[0,2] -- [0,2] is given by:
describes completely the production possibility frontier of this production
economy. [Here Yl represents the output of good 1, and g(Yl) represents the
output of good 2 ]. Draw the production possibility curve.
(iii) Suppose Crusoe and Friday derive utility only from the consumption
of the two goods (and not their labor jleisure). Crusoe's utility function is
given by:
Uc(XC1,:rC2) = min{xcI,xC2} for all (XCI,XC2) E
Friday's utility function is given by:
up(:rFl:Z:F2) = min{xFl,XF2} for all (XFl,XF2) E
( a) Show that the allocation:
{(ZC1, ZFl), (ZC21 ZF2), (YI, Y2), (XCI, XC2), (XFl, XF2)}
1 1 3 3 1 3 1 3
= {(4'4)'(4'4),(1,1.5)'(2'4)'(2'4)}
is not a Pareto Efficient allocation.
(b) Obtain algebraically the utility possibility frontier of this economy,
showing :your procedure clearly. Draw the utility possibility curve.
6
Part VI
[(1) =15 points, (2) = 10 points, (3) = 15 points, (4) = 10 points].
Here is t.he "3 color" version of Ellsberg's paradox. There is one urn
with with 300 balls: 100 of these balls are red (R) and the rest are either
blue (B) or yellow (Y). Consider the following two choice situations:
1: a. '\Tin $100 if a ball drawn from the urn is R and nothing otherwise.
b. '\Tin $100 if a ball drawn from the urn is B and nothing otherwise.
II: c. Win $100 if a ball drawn from the urn is not B and nothing
otherwise.
d. Win $100 if a ball drawn from the urn is not R and nothing
otherwise.
Suppose a elecisionmaker's preferences are such that a >- b anel d >- c.
1. Show that these preferences have no SED representation. That is,
define the st at e space, the set of prizes, lotteries as maps from states
to prizes, and show t.hat there is no SED representation with respect
to your choices.
:2. Which axiom of Savage do these preferences violate?
3. Prove ~ ' o u r assertion. That is: show explicitly using the state space:
outcomes: and lotteries that you used in part (a) exactly how this
axiom is violated.
4. The probability that a reel ball is drawn is obviously 1/3. Show there
is a set of probability distributions P on colors such that p(red) =
1/3: and such that the utility function which assigns to each bet the
minimnm c:xpc:ct.ed payoff among all probability distributions in P
represents >-.
7
. \
August 4, 2004
GRADUATE Iv11CROECONOMlCS EXAM
mous, so we suggest that you not use your Cornell J.D. number. Select
this number on each exam book, NOT your name, and DO NOT sign
the exam book(s).
2. Each part must be answered in a separate exam book. V/hen you
3 If you find any question ambiguous, explain your confusioll and
GOOD LUCK 11
1
Part I
Consider an economy with consumers i = 1, ... , n who have a common
utility function u(x) for x E This utility function is continuous and
homogeneous of degree one. Prices are p E IRt+ and consumers' wealths are
Wi> O.
a. Show that the indirect utility function can be written as
V(p, w) = W v(p).
b. Does this economy have a positive representative consumer? Prove
your answer.
c. Consider a pure exchange economy with the consumers above. No\v
wealths are the value of endowments ei E that is, Wi = P . ei. The
aggregate endowment, e = [;7=1 e;, is shared proportionally among the
consumers so that ei = D:ie and D:i = 1. One reason that we care about
represent'ative consumers is that we hope to get the weak axiom satisfied by
aggregate excess demand. Does aggregate excess demand for this economy
satisfy the weak axiom?
d. Assuming a cardinal property of utility, such as homogeneity of degree
one, is not really satisfactory. Is there an assumption that can be made about
preferences, rather than about a particular utility function representing the
preferences, that yields the existence of an indirect utility function of the
form in part (a)? Explain.
2
Part II
There are two periods t = 0,1 and two possible states s = 1,2 in the
second period. There is one consumption good with price 1. At time
there are two assets with prices PI, P2 which payoff at time 1 in units of
the consumption good. Asset one pays 1 if titate 1 occurs and 0 otherwise;
asset 2 pays 1 if state 2 occurs and 0 otherwise. There are two traders
indexed by i = 1,2. Each trader is endowed in period 0 with one unit of
the consumption good and with one-half a unit of each asset. Trader i's
beliefs about states are given by the probability (ql, q ~ ) . Traders have log
utility of consumption and discount future utility with common discount
factor 0 < p < 1. At time 0, trader 1: r.hooses current consumption cb and
asset purchases (zL z ~ ) to maximize
In(cb) + p(qiln(cl (1)) + q2ln(d (2)))
subject to his budget constraints
where
Wi = 1 + pd2 + ])2/2.
Note that we use the convention that the individual sells his endowment and
buys any current consumption and assets in the market.
a. Find optimal period 0 consumption and asset purchases for consumer
i as functions of (Pl,P2,W
i
).
b. Suppose (qf, q ~ ) = (ql, q2) for all i. Find equilibrium asset prices and
quantities.
c. Now allow beliefs to differ across consumers and find equilibrium asset
prices and quantities.
d. A student who has seen the consumption-based capital asset pricing
model notes that in this economy there is no aggregate risk and so claims
that in equilibrium consumers should not hold portfolios that expose them
to risk. Is this correct? How does this claim relate to the equilibria you
found in (b) and (c)?
3
Part III
A monopolist can sell her product in two "separated" markets. The
demand functions of the product in t.he two markets are given by:
xI(pd = {
A - ap1 Jar 0 S P1 ::; (A/a)
0 faT P1 > (A/a)
X2(P2) = {
B - bP2 for 0 S P2 ::; (B/b)
0 JOT ])2 > (B / b )
Here A, a, B, b are demand parameters which are positive, PI and P2 are
prices charged for the product in markets 1 and 2 respectively.
The cost of producing the good is given by:
c(X) = kx JOT X 2 0
where x = (Xl + X2) is the total aIllount of the good produced, and k is a
cost parameter, which is positive. Assume that the parameters satisfy the
condition:
(P)
a. When the monopolist can price discriminate between the two markets,
show that the monopolist will sell in both markets. Find the prices charged
by the monopolist in the two markets.
b. Suppose it is illegal for the monopolist to price discriminate, so that
the monopolist has to charge a uniform price for all customers. Assume that
the monopolist sells in both markets under the uniform pricing restrictioD.
Show that the aggTegate output sold under price discrimination is identical
to the aggregate output sold under the uniform pricing restriction.
c. Find a (sufficient) condition (call this Condition Q) on the parameters
under which the monopolist will not sell in both markets under the uniform
pricing restriction .
. d. Suppose Condition Q holds. Will the result stated in (b) above still
be valid? Explain.
4
Part IV
Consider a 2 x 2 production economy in which there are two goods (in-
dexed j = 1,2), each of which is produced by using two factors of production
(indexed i = 1,2). The production functiolls of the two goods are denoted
by fj for j = 1,2. Assume that the function h : I R ~ _ ---t IR+ is given by:
Assume that the function 12 : I R ~ ---t IR+ is given by:
Here, aij for i = 1,2 and j = 1,2 represent technological parameters which
are positive and satisfy
all a12
->-
a21 a22
(1)
. The economy has aggregate endowments of the two factors of production,
given by (Z}, Z2) > > O.
a. Obtain explicitly a function 9 : [0, all 21 + (121 Z2] ---t IR-t-> such that
the set of points {(Y1,g(yd) : Y1 E [O,anZ1 + a21z2]} describes completely
the production possibility frontier of this economy. [Here Y1 represents the
output of good 1, and g(yd represents the output of good 2].
b. Draw a graph of the production possibility frontier of this econ-
omy, labeling it appropriately to illustrate its key features.
c. Suppose the economy represents a small country facing free-trade
world prices for the two goods, given by (P1, P2) > > O. Assume that:
(2)
d. Show that in a free-trade competitive equilibrium, the economy
will be incompletely specialized, and will produce output levels (yj, Y2) given
by:
(3)
c2_ Relate the result in (3) to the (standard textbook statement of
the) Rybczynski theorem.
5
Part V
An economy has a single consumer endowed v.;ith 2 units of labor and
who receives utility from two consumption goods, X and Y. Her utility
function is u( x, y) = log x + log y, where x and yare the quantities of X and
Y, respectively. She receives no utility from leisure. Goods X and Yare
each produced from labor by a profit-maximizing firm. Each firm's output
is linear in the input.. The marginal product of labor in X production is 1
x = I x,
where Ix is the labor input to X production. The marginal product of labor
in Y production depends upon X output
y = ma.x{ 1 + C1:, O}ly,
where.l
y
is the labor input to Y production. Suppose that -1 < c < 1. You
may make use of both calculations and general results about the properties
of equilibrium models in t he following questions.
a. Find the competitive equilibrium.
b. For which values of c is the competitive equilibrium Pareto optima]?
c.For which values of c is the competitive equilibrium producer-efficient?
d. Suppose that the two firms merge. Does the competitive mechanism
solve the Pareto-optimal allocation problem? Explain.
6
Part VI
Here is a quick model of racial profiling. Two individuals, one black and
one white, choose independently whether or not to commit a crime. If an
individual has committed a crime, he will be caught and pay a penalty of
1 if he is searched, but otherwise he receives a reward R > l. Should the
individual not commit a crime, he receives payoff e from legal activities.
The payoff e is individual-specific, and observable only to the individual.
After the individuals choose, they are confronted by a police officer who
does not know if they have committed a crime. The officer can, however,
observe their race, and he knows both R and the distribution of rewards to
legal activity un for each race. He can only conduct one search, and his
goal is to maximize the probability of catching a criminal. A policing policy
is a policy that assigns to each reward R a pair of probabilities (PB,PW),
the probabilities of searching each type. Since there can be only one search,
PB + pw = l.
This problem is concerned with equilibrium searches, efficient searches
and fair searches. A fair search policy would have each group being searched
with equal intensity, which in this simple problem means that the proba-
bility of searching each group is 1/2 for all values of R. An efficient policy
minimizes the expected number of crimes for each value of R.
Make the following technical assumptions: The cumulative distribution
functions of e for each race, FB and Fw for blacks and whites, respectively,
have differentiable densities f Band fw, respectively, on [0, Ell, which are
strictly positive on the interior.
a. Describe the equilibria. That is, what can be said about each group's
amount of crime in equilibrium.
b. Give a necessary first order condition under which the equilibrium
policy will be efficient at a given value of R. Interpret it in terms of the
elasticities of crime supply.
c. Give a necessary and sufficient condition for a fair policing policy to
be an equilibrium policing policy.
d. Give a necessary condition for a fair policing policy to be efficient.
How does this condition compare to the conditions of part c?
7
.Julie 7,2004
GRADUATE MICROECONOMICS EXAivI
1. You are identified by il number. The grading is meant to be anony-
an identifying number ilnd keep a record of it for your information. Pllt
this rwmbcr on each eXillll book, NOT your name, and DO NOT sign
your names on the exam book(s) either.
submitting, and get the !l.11Tnber verified by the proctoT.
:3. If 'yOU f1nd al1\' quest ion ambiguous, explain your confusion and
lllake whatever aSsulllptiuns you think necessary to answer the questioll.
Clearly sLille illl)' addit.iullill aSSlllllptions you make.
GOOD LUCK"
Part 1
A consumer ha:; the expenditure function:
where n I + 02 + 0:) = 1. (ti ~ 0 for all i, 1L is a level of utility and the Pi are
prices.
(a)
Derive this cO!lsumer's indirect utility function.
(b)
Derive this consumer's demand functions for goods oj = 1,2,3.
(c)
Consider the following claim: The function:
generates the demands ill part (b). Is this claim correct? Explain.
(d) Consider the following claim: The function:
represent.s this consumer's prderences. Is this claim correct? Explain.
2
Part II
A financial a.sset pays off 0 in state 51 and 1 in state 52. The price of the
a.sset is q per unit. An investor has an initial wealth w. She must choose
whether to buy one unit, sell one unit or take no position in tbe She
cares about the utility of end-state wealth, which is the sum of the ret.urn
on her asset posi tion and her weal th net of any ,\.Sset transaction.
Her preferences are described as follows: Her payoff function is:
u(x) = x
Her beliefs on states are described by an interval of probability
described by p E [PL,PHL where p is the probability of state 51. The utilit.y
of a portfolio is the minimum of its expected utility under all beliefs ]J in the
int.erval. Thus the utility of a portfolio that pays off (] in state 51 and b ill
state 52 is:
min bJCl + (l - p)b)
PL::: P::: PH
(a) Describe the decision-maker's net demand lor t.he fiJlallci:ti
as a funct.ion of the ,\.Sset price q. For which prices \\'ill she, ])\1\. sell. and
take no
(b) Now suppose there are a continuum of decision-makers. of lllas::; I.
For each decision-maker, PH== PL + 6, where 5 is a strictly positive constallt
less than 1. Suppose that ]J L is distribu ted uniformly on the interval leL 1 - 5).
Describe per-capita demand and supply as a function of the a .. sset price q.
(c) Find the equilibrium price and volume. ("Volume" is the mass
of the sellers.)
(d) How do the equilibrium price and volume change as a fUllction
of fJ? Interpret the effect of a change in b.
3
Part III
Two firms are racing to develop a new kind of pizza OVel} TIIPY can
invest either 0 or 3 hundred thousand dollars in product li>velopmcllt If a
firm in\'ests 0, with probability q = 1/4 it will develop tlw product allyway.
If it. invests :3 hundred thousand, it.s development effort will sllcceed wiLh
probability P = :3/4. The social gain to the innovation is v = 1 Illillion
dollars. Firms are able to capture all the social gain: 1f unly ()ne succeeds,
it will get the entire million, If they both succeed, t.hey split the gaill,
and if neither succeed, they get nothing. VVe SUpp()se I.llat. ill idelltical
circumstances, firms behave identically.
(a) 'What is the socially optimal allocation of inllovative effort '!
(b) Vihat is the equilibrium allocation of innovat.ive dTort. ?
(c) Could a (cent.ral planner devise a t;l.X and COlllpcllsa-
t.ion scheme that wuuld cost nothing and implement tIll' socially ujlLilllal
o u tCOIlH:
7
4
Part IV
A monopolist can produce a good (:1:), using a Cllst function given by:
The inverse demand curve for the good is given b.\"
_ { 18 - T
P - 0
for () c:; .r' J F
for:r > 10
(a) Obtain the monopolist's profiL-lllc.xirnizilig OlIt.puL and the price it
charges, showing your procedure clearly.
(b) Assume now that there is another firm (a potential entrant) which
can also produce the same good. Let Firm I be the illCllll1lwlli flrm and Firl1l
2 the potential entrant; denote their Ollt-put levels In' :1'J illlci Xl respectively.
The cost functions of the two firms <Ire gil-ell lJ)
C] (:I:J) = 2:rJ
C2 (.r]) = (U2
where a E (2,10). The potential entrant hi,S ;Ill inkrinr IPdlllOlogy, so that
its cost of production is higher.
Firm 2 will enter only if by cntering, it call lila);\.' a pmhl. [An output
level of X2 = 0 is equivalent to saying that the Firm 2 ducs )lot enter the
industry]. Firm 2 acts as a follower: given any Olltput of Firm 1, Firm 2
maximizes its profit and decides whether or not t.o enter and how much to
produce if it enters. Obtain the reaction functioIl of Firm 2. showing your
procedure clearly.
(c) Firm 1 acts as a leader: it produces the output level which will
maximize its profit, taking into account the fact that. given an)' output level
it produces, Firm 2 will respond to it according to it.s reaction function.
Find the set of values (call this set A) of the parameter (1 for which Firm 2
will not enter the industry, showing your proced me clearly.
(d) For a not in the set A, drav,' a graph to illust.riltc the (typical) proi1t
function of Firm 1.
(e) 0 btain the price, p( a), that wi II lw charged for t.he guod as a function
of the parameter eL, for a E (2,10). For (L E ,4, where Firm 1 continues to be
a monopolist (in eqlliJibrium), ill what. \,'ay does its pricing differ from the
usual textbook monopoly pricing? Explain.
Part V
Consider a 2 x 2 exchange econOillY, wilh t.wu goods (1 alld 2) and two
consumers (1 and 2). The COIlSlIlllpt.ion sel of each consumer is X = IR!.
The utility function of consumer 1 is )!;ivclI by:
for (:[11,]:21) E 1R"t+
olht'Twi8c
and the utility function of COI1SlIlller :2 is given hy:
for (:rI2,.i:'n) E IR!+
otherwise
Here a > 0 is a taste p,nameter (which is the same for both consumers).
The endowment of Cl1l1S1lfIWr 1 is == (h. 0), where Ii :::- J is an endow-
ment parameter, and the clI,j')I':meliL of CUlISlllller 2 is u,'2 == (0, J).
(a) Obtain the compet.itil"(-' equilihriulll price ratio, and the compet.it.ive
equilibrium allocation, as fUllctions of tht:: paral1ll'rts u and II. your
procedure clearly.
(b) Fix the parameter () ,= 2. Show that jf the elllic)I\'JlICllt of consuiller
1 increases from WI = (LUi Ii) ",,; = (2,0), thl'Il l'onSUllwr I will be worse
off in the new competitive eljllilibriul1l, cOl1lpared to the old one. Provide
an intuitive explanation for t.hi!i phenOIltellOIl lIf "immiserizing growth".
(c) Suppose we wish to compare the utility levels of cOllsumer 1 in two
equilibria, the first corresponding to the case in which consumer 1 '8 endow-
ment is WI = (b,O) = (1. 0), and tbe secoIld corresponding to the case in
which consumer 1 's endowment is ",-,; = (b',O), where Ii' > I. Find the set
of parameter values of a for which consumer J's utility is lower in the sec-
ond equilibrium compared t.o the f1rst. equilibriulll, showing your procedure
clearly.
6
Part VI
N identical consumer::; UP about. appl(,s (.I:) and Brit ne:.' Spears albums
(b). Their utility frolll cullsuIlling BS albuIlls also depends upon per-capita
BS consumption:
D=N-11'L
b
,!

In fact each consumer's ut ilit) fUllction is:
Li(.T, /Y. B) = 1: + IJob
Assume that N is sufficiently brge so that c<lch consumer takes B as given.
Also assume 0 < 0' < 1. Each consumer is endowed with 1 unit of apples.
Apples are the sole input in making BS albums. (Don'L even think about
how this works.) The pI<ld I!(:tinn function is
if = /0
where q is the total lIuIll\wr of BS-alllllms produced and !I is the apple input.
The BS album proclucn aci;.; ;\> a perfect CUJ1Ip',titur: it. t.akes lhe pricep of
BS albums as fixed.
(a) Find all the "l!J1lpctiti\'C equilibria
(b) Are any of these equilibria
7
June 9,2003
GRADUATE MICROECONOMICS EXAM
1. You are identified by a number. The grading is meant to be anonymous, so we suggest
that you lIot use your Cornell I.D.number. Select an identifying number and keep a
record of it for your information. Pllt this Ilumber on each exam book, NOT your name,
and DO NOT sign your names on the exam book(s} either
2. Each part must be answereclll1 a separate exam book. When you are finished, please
write down the total number of exam books you are submitting, and get the number
3. If you find any question ambiguous, explain your confusion and make whatever
assumptions you think necessary to answer the question. Clearly state any additional
assumptions you make.
GOOD LUCK"
Part I
The set of alternatives is A = {Z\,z2,Z3}. A decision maker's strict preference relation >- on A is
described by a collection ofthrec element vectors x == {x\,.x
2
""J} each consisting of one I, Olle
and one -I. We call such vectors feasible. Ifx;== I andx
j
== -1 then z, >- z)" So (1,0,-1) isz, :-- Z3
The collection of vectors x that are equivalent to >- is an n x 3 matrix JvJ in which each of the n
rows describes a relationship between two of the alternatives. We consider only Msuch that if x
is a row of M then -x is not a row of ivi.
(a) Suppose M consists of the two rows (l ,0,- I) and (0,1 ,-1). What do you know aoout >-?
Suppose ~ . was derived from a "weak preference" relation c on A. Is c necessarily
complete? Explain.
(b) Define transitivity of a strict preference relation using the notation (lvf and rows ufJ'vf)
above. (Hint: for x and y rows of M consider x + y.) Show that your definition agrees with
the usual definition of transitivity for >-.
(c) A function U. A -. R representing the strict preference relation can be described by the
vector /.I = (U\,U
2
,113) of utilities for each element of A. Show that ifu represents tbe
preferences then A1u' > 0 (u' is 11 written as a column vector.)
Cd) Using your definition of transitivity above provide an example of an M describing
non-transitive preferences such that there is no solution II to j\111' > 0.
Part II
A firm operates in a perfectly competitive CI1vironment at two dates t = 0, I. At date 0 a single
input, Xo 2: 0, is used to produce an output, Yn, with the production functionf(x
o
) This finl1
experiences "learning by doing", i.e. the more it produces at date the more productive it is at
date 1. At date I the input (now in quantity XI;>' 0) is used to produce the output,Y;. The
production function is nov./ YI = j(xi )g(yo)' Assume that g(O) 2: 1, g'(y) ;>. and g" (}I) :; 0 for all y.
The production function satisfies/cO) = O,/(x) > andj"(x) < for all x and limx_o/(x) '" +eo.
Output price is p > 0 in both periods, the price of the input is w > 0 in both periods and the
interest rate is 0
(a) The firm knows all prices before it makes decisions and its objective is to maximize the
sum of profits over time. Write the fim1's decision problem.
(b) Suppose for the remainder of this problem thatj(x) = Xl/2 and g(F) = 0:( I +y)I!2, where
0: > 0 Find the optimal le\"els of Xo and XI'
(c) If 0: increases what happens to the optimal level oLeo?
(d) Because prices are constant over time and the interest rate is zero this ilrm acts ilS if it is
producing one good in quantity Yo +)"1 from two inputs Xo and XI' We arc lIltercsted in the
effect of output price on the total amount produced. Instead of computing [his effect
directly could we use Botclling's Lemma? Ifso, set up the framework for the lemma. If
not, then explain why Hotelling does not apply.
Part III
Consider a continuum economy with two types of consumers. The utility functions and
endowments of type I consumers are given as
The utility functions ,mel endowments of type 2 consumers are given as
1
The mass of type I consumers is A E [0,1]. In the following, assume that A ";:>
2
(a) In this economy, we may conjecture that type 2 consumers would be better off as Ie
increases, since XL will become relatively more scarce. Verify jfthis conjecture is indeed
U
l
correct by calculating U
2
at the Walrasian equilibrium allocation.
(b) Suppose that the utility functions of type I consumel's are given as
Repeat part (a). (1n part (b), consider only positive prices for the equilibrium prices)
Compare your results in (a) and (b), and comment on them.
Part IV
Consider the following game played by a seller and a buyer of a used car. The used car coule! be
1
a good one or a bad one, and it will be good with probability - . The seller has prrvate
2
infom1ation about the quality of the car. That is, he knows the quality of the car, whIch is not
known to the buyer. The game will be played as follows. The seller first asks for a hIgh price or
low price for the car After the seller quotes his price, the buyer will accept or reject the offer.
The payoffs of the players are summarized in the following. (The first number in each cell is the
payoffofthe seller.)
When the car is gooe!
High
Low
Accept
2,4
-4, I 0
When the car is bad
Accept
High 10,-4
Low 4.2
Reject
0,0
0,0
RCJect
0,0
0,0
(a) Draw the game tree of the above game, and find all the pure strategy Bayesian Nash
equilibria.
(b) Find all the pure strategy sequential equilibria of the above game.
Part V
Consider a community with a continuum of individuals and two goods - a public good and a
numeraire private good. The public good, which could be thought of as a swimming pool or a
park, has capacity k E (0,1] and is subject to congestion. It is also excludable. Individuals differ
in how much they like the public good. Specifically, if the public good is consumed by a fi"action
A of the population, an individual of type 0: E [0, I] who consumes x units of the numeraire
obtains utility ~ ( o : ) (k- A) + x ifhe consumes the public good and x ifhe does not. Higher types
like the public good less so that ~ ' ( o : ) < o. In addition, ~ ( i ) '" 0 Types are distributed unifonnly
on [0, I] so that the fraction of individuals with types less than or equal to 0: is just IX. All
individuals have endowment of the I1umeraire or "income" y.
(a) Taking as given the capacity k, describe how the public good should be allocated among
the individuals if the objective is to maximize aggregate surplus. (tlint: The optimal
allocation mle will be of the foml "types with 0: 0; 0:* get to consume the gex)(\, those with
types ex. > 0:* do not". Your job is to derive the FOC that chmacterizes 0:* and explain it
intuitively.)
(b) Again taking as given the capacity k, describe how the public good would be allocated
among the individuals if it were owned by a profit maximizing monopoly who chargee! ,m
access price p. Comparing your answer with (a), will more or less people consume the
public good than is optimal or is it ambiguous? (\' ou lllay assume that y is large enough
so that the constraint that individuals consume non-negative quantities of the I1uJl1erairc is
satisfied.)
(c) Suppose now that the capacity k is a choice variable allellet the cost ofpruvlding the
public gooe! with capacity k be c(k) = c k Characterize the capacity level that would
maximize aggregate surplllS and the capacity level that \vmllc! be chosen by the
monopoly. How do they compare?
Part VI
Consider the market for dental insurance. There are a continuum of consumers each of whom
might need deI)tal work costing an amount L Consumers differ in the quality of their teeth. A
consumer of type n E [0,1] needs dental work with probability n. The fraction of citizens with
types less than n is F(n), where F(O) = 0, F(I) = I and F'(n) > O. Consumers are endowed with
income y and obtain utility from consumption x according to the utility function u(x). They are
expected utility maximizers and are'risk averse so tilJt u'(x) > 0 and u"(x) < O. Consumers lmow
their types.
(a) Suppose that insurance can be supplied by' a rim1 whose objective is expected profit
maximization and that this firm is unable to observe consumers' teeth quality. Suppose
that the finn offers a contract that covers the full cost of dental work for a premium p.
Describe the circumstances uncler which the firm will be unable to make money at any
premIUm.
(b) Suppose now that there are just two types 01' conSllmers ("good" and "bad") so that
n E {ng) n
b
} where 0 < ng < nb <: J. Let ), E 10, I ) be the fraction 0 f good types. Suppose
that the firm offers a pair of contracts (Po,CJ anci (Ph'C
h
) one intended for good types and
the other for bad. A consumer who t a k e ~ C(;ntr(lct (p;,C;) (i E {b,g}) pays a premium Pi
and receives a payment C
i
ifhe gets dental work. Write down the maximization problem
the firm must solve.
(c) Prove that if C" < C
b
and the bad types' Incentive constraint holds with equality, then the
gooe! types' incentive constraint is satisfied D(les this suggest a procedure for solving the
maximization problem?
August 6, 2003
I. You are identified by a number. The gradlIlg is meant to be anonymous, so we suggest
that YOll not use your Cornell LD. number SL:icct an identifying number and keep a
record of it for 'your information PlIr rills !l1I1It/,{,/" on each ex am hook, NOT your name,
and DO NOT sign your names OIl the exam book!s) either.
2. Each part mllst be ans\verecl ill a separate exam hook. When YOlI are finished, please
write down the total number of exam books YOl! are submitting, and get the number
3. If you find any questjon cxplaJI1 your confusion and J11ake \vhatever
Part I
An expected utility maximizing gambler has a Bernoulli utility function which is logarithmic in
wealth w. He is offered a gamble that with probability p, 0< p < 1, pays n > 1 dollars for every
dollar bet and with probability I-p pays nothing The gambler has initial wealth x > O. Any
amount not bet he keeps.
I. What fraction, CX, of his initIal wealth should he bct"
2 Now suppose the gambler has the BCrl1()ulli utility function u(w) where: (i) u'(w) > 0 and
ul/(w) < 0 for all w ;:: 0, and (il) 11111 u'(W)= + ex, [u(w) is not necessarily logarithmic.]
, ~ L II
Assume that np > 1. Show that the opt I m ~ d choice of ex is not O.
3. For the gambler of (2) how docs a change J11 p affect the optimal fraction bet?
Part II
You have a technology that produces output z from Il1puts x >0 and y ~ according to z = xUyP,
where ex ~ 0, p ~ 0 and ex + P :; I. The output price is p> () ,md input prices are Px > 0 and
py > O. You have a fixed amount of money C > 0 that you may use to purchase inputs. Any
money that you do not use you can keep Your objective is to maximize the sum of profits plus
any money not used to purchase inputs.
l. Write the decision problem as a maximiDltion problem
2. Under what conditions on the parameters, prices and C will the constraint to spend no
more than C be binding') Solve the deciSion problem for the optimal choices of x and y
under these conditions.
3. Now consider a general technology z = r(x,y) which IS concave and has positive marginal
products. Assume that the constraint to spend no morc than C is binding, Let
x(p, Px' Py,C), yep, Px, Py,C) and z(p. {1" py,C) be input demand and output supply
functions for this problem. Let R(p, {1" I\.C) be the rC\'Cllue function - the maximum
revenue that can be obtamcd given (p. p" I\,C), Suppose that R(a) is .differentiable.
Consider the follo\ving conjecture
(a)
(b)
x(p, 1\, py,C) =
cA<'(P,P"P"C)
- ~ - - - - - --"_. --_.- - ~
( ~ ) )
'1 .\
d\ ( P , P \ ' P y C) ,
(1.'
J ~ I P . P, ' P ~ , C )
z(p, p" I\,C) = ( ~
Is this conjecture correct'! If so, prove It. If not, explalJl carefully why not.
Part III
Consider an economy with two groups of individuals - lie capitalists and I1w workers. There is a
single firm which is owned by the capitalists. The fllll1 produces a consumption good x using
labor l supplied by the workers. Each worker has preferences over consumption and labor
12
represented by the quasi-linear utility function ulICd) = x - - where x denotes consumption and
2 .
llabor. Capitalists do no work and have preferences over consumption represented by llC(X) = x.
I
Each capitalist owns a share - of the firm. The firm's production function is X = aL where L is
Il(
the aggregate amount of labor employed, X is the aggregate output of the consumption good and
a >0.
(i) Let W denote the wage rate and let consllmption be the numeraire. Derive the aggregate
supply curve of labor.
(ii) Since the firm is the sole employer, it has the ability to set wages. Assuming that its
objective is to m ~ 1 X i m i z e profits, \vhat wage will it choose') What are the equilibrium
utility levels of capitalists and workers')
(iii) Suppose that the govemment were to Impose a minimum wage w higher than the wage
you derived in (ii) hut less than the "competitive" wage cc What would happen? What
would be the new equilibrillm utility levels of capitalists and workers')
(iv) Prove that Imposing the minimum wage Increases aggregate surplus. Explain why this is
the case.
Part IV
Consider the following model. There are two firms, 1 and 2, and a single worker. The worker can
be one of two types L (low) or H (high). The probability that the worker is a high type is
A E (0,1). A high type produces output of value 8
11
if employed, while a low type produces
output of value 8
L
where 0 < 8
L
< 8
11
. The finns are unable to observe the worker's type.
However, prior to enteIing the labor market, the worker can obtain a (discrete) qualification (for
example, a college degree). The cost of obtaining this qualification is c
H
for a high type and C
L
for
a low type, where 0 < C
Il
< CL" The finns can observe whether or not the worker has obtained the
qualification at the time of hiIing.
The timing of the interaction is as follows: (a) nature draws the worker's type; (b) knowing his
type, the worker decides whether or not to obtam the qualification; (c) observing whether he has
the cjualification but not his type, the firms compete for the worker by making wage offers; CeI)
the worker goes to the highest bidder (or tosses a coin if the two firms bid the same) and
production takes place.
(i) This Interaction defines a game between the two firms and the worker. What is a (pure)
strategy for the worker'} What is a strategy for a firm? What else do you need to specify
for the firms'? What is an equilibrium of the game (explain informally)?
(ii) Find conditions on the prImitIves (8
L
, l)/I. c
H
, c
L
) uncler which there exists a separating
equIlibrium in which only the high type gets the qualificatIOn.
(iii) Under the conclitions thai you found in (ii), show that there also eXIsts a pooling
eqUIlibrium in which neither type obtains the qualification.
(iv) Find conclItJllI1s on )c unckr which both worker types are better off under the pooling
equilibrium in (Iii) than under the separating equilibrium in (ii).
Part V
Two players, Row player and Column player, are going to play the following normal form game.
L M R
T 4,4 -2,9 0,0
M 9,-2
??
-,-
0,0
D 0,0 0,0 1,1
(a)
Find all the pure strategy Nash equilibria.
(b) Now suppose that the above game will be repeated 6 times. What will be the highest
payoff of the Row player in a pure strategy sub game perfect Nash equilibrium') (The
payoff of each player in the repeated game will be the sum of stage game payoffs, and the'
common discount factor of the players is 1.)
Part VI
Consider an exchange economy with two commodities, and two people, A and B. A and B have
a common utility function given by:
TheIr endowments are
)114 = (1,3) and f/' = (1,0)
(a) Illustrate the set of Pareto efficient allocations and the core in an Edgeworth box diagram.
(b) Find all the Waltasian equilibria of this economy. (Nonnalize the pnces so thatPI = 1.)
(C) Novv suppose that the endowments are
H/A = (l ,0:) and }V
B
= (1,3 - 0:)
where 0 s 0: S 3. Describe the Walrasian equilibrium pnce of x
2
as ~ I function of 0:
June 10, 2002
I. You are identified by a number. The grading is meant to be anonymous, so \ve suggest
that you not use your Cornell I.D. number. Select an identifying number and keep a
record of it for your information. Put this number on each exam book, NOT your name,
and DONaT sign your nameson the exam book(s) either.
2. Each part must be answered in a separate exam book. When you are finished, please
write down the total number of exam books you are submitting, and get the number
veri fied by the proctor.
GOOD LUCK!!
Part I
An economy consists ofl consumers indexed by i = 1, ... ,I. Consumers incomes are {y i } ~ = I.
There are N goods, x = (xj, ... ,x
N
). All consumers have the same utility function U(x) which is
strictly increasing, strictly concave, twice continuously differentiable, and homogeneous of
degree one.
(a) Show that the form of individual i's indirect utility function is V(p,yJ = V(p, 1 )Yi
where p = (pj, ... ,PN) is the price vector.
(b) Does there exist a positive representative consumer for this economy? Prove your
answer.
Part II
Consider the following variation of Beer-Quiche game.
(3,1)
F F
(2, -I)
(4,0)
\vcak 0.25
(1,0)
1
N
')1
'-I
1
(2;2) strong
I
0.75
1
(1,2)
1
F
(4,0)
N (3,3)
( a) Find the normal form represen tati on 0 [ the abo ve extensive [onn game. In so doing,
carefully describe the set of strategies of each player. Find all the pure strategy Bayesian
Nash equilibria of the normal form game.
(b) Which of the Bayesian Nash equilibria in (a) is perfect Bayesian equilibrium?
Part III
In the U.S. there is only one finn producing and selling a good with demand function
d(q) = a - b q, where q is the quantity of the good and a, b > 0. This finn's cost function is
[
k+ m q
c(q)= 0
Assume that a > m > 0, k> and (a - m)2 > 4b k.
if q> 0
if q= 0
(a) Find this finn's profit maximizing output level and the price in the U.S.
There is one other country in which the good is demanded and produced. Let's call this country
X. In country X the demand for the good is D(Q) = A - B Q, where Q is the quantity of the good
in country X and A, B > 0. The cost function of the single finn in country X is
[
K+ mQ
C(Q)= O.
if Q> 0
if Q = 0
Assume that A > m > 0, K> 0, (A - m ) ~ :> lOB k and (A - m)2 > lOB K. Do not assume that
parameters A, Band K are the same as those for the U.S. Marginal cost is m in both countries.
(b) Assuming for now that the U.s. firm does not compete in country X what is the quantity
and price of the good in country X?
(c) If the U.S. finn enters the market for the good in country X then assume that the two
finns will behave as a Coumot duopoly in X. (The X finn is not allowed to enter the U.S.
market.) Find the Coumot equilibrium price and quantities for the two finns in country
X.
(d) The U.S. finn might be accused of "dumping" if it sells in X, and the price in X is below
its average cost (or its marginal cost). Is this possible? Explain.
(e) The government of X is considering a proposal from the X finn to prohibit the U.S. finn
from selling its product in country X. If this proposal is adopted what will happen to
consumer surplus in X and to the profit of the X firm. Is it possible for the sum of the
country X consumer surplus and the X firm's profit to rise? Explain.
Part IV
A regulator is in charge of regulating a monopoly. The monopoly produces output q with linear
cost function c q where the marginal cost c could equal c
L
or c
H
where 0 <c
L
< c
H
. The inverse
demand function for the monopoly's output is p(q) where p(.) is continuous, decreasing and
satisfies p(O) > c
H
and lim
q
_
oo
p(q) = O. The regulator instructs the monopoly what output to
produce and may offer the monopoly a transfer for producing this output. In addition to any
transfer, the monopoly receives the revenues from selling the output. The monopoly will not
produce if it earns negative profits. The regulator's payoff when the monopoly produces q units
of output and receives transfer Tis r p(x)dx - p(q)q - T. The monopoly's payoff is
(P(q) - c)q + T.
(a) Suppose that the regulator could observe the monopoly's marginal cost c. Characterize
the outputs that it would require the monopoly to produce and the transfers it would
provide when c = c
L
and c = c
H
.
(b) Suppose that the regulator could not observe the monopoly's marginal cost, knowing only
that it is C
L
with probability 1 - 1-1 and C
ll
with probability 1-1. Is your answer to (a) incentive
compatible? Explain carefully.
(c) Describe the optimization problem you would solve to find the regulator's optimal
contract under imperfect information. (Hill. Use the revelation principle!)
Cd) Explain how you would go about solving this problem. (Hint: Explain how to convert it
to a simpler problem).
(e) Explain in what ways the optimal contract under imperfect information differs from that
you described in part (a). (Hint: If you can solve for the optimal contract under imperfect
information then do it. lfnot, then guess how it might differ based on your knowledge of
this type of problem and your answer to (b).)
Part V
Consider an economy with three dates: t = 0, 1,2. The date-event tree of this economy is as
follows.
A B
o
1.
o
t=O 1=1 t=2
Two long-lived assets, A and B, are traded in the markets, which will be open at each node at
t = and t = 1. There will be no endovv1nent, and hence no consumption at t = 0,1. We do not
know more about this economy except that if market were open only at t = 0, in which Arrow
securities were traded, then the Arrow-Debreu equilibrium prices of the Arrow securities would
be (1,2,1,4).
(a) Suppose that the asset market equilibrium is unique. Find the equilibrium prices of asset
A and B at each node at t = and t = I. (Nonnalize the prices such that the price of asset
A is always 1.)
(b) Suppose that a consumption profile (3,6,6,3) at t = 2 is the solution to a consumer's utility
maximization problem under the equilibrium prices in (a). Describe this consumer's
portfolio at each node at t = and t = 1.
Part VI
The government desires to redistribute to shareholders of firms in the widget industry. Direct
lump sum transfers are not feasible and it is considering two alternative distortionary policies.
The first alternative involves introducing a price subsidy for consumers of widgets with the hope
of boosting widget demand and raising widget prices. The subsidy would be financed by a
unifonn tax levied on all citizens. The second alternative involves introducing a unifonn
production quota for each widget firm with the aim of restricting widget supply and boosting
widget prices.
(a) Set vp a simple economic model to shed light on the relative merits of these two
alternatives. (Hint: Assume two groups of individuals - shareholders and widget
consumers. Suppose that widget consumers have identical preferences and do not own
shares in widget firms. Suppose that all widget finns have identical cost functions.)
(b) In the context of this model, analyze the impact of a price subsidy policy. TIlustrate your
findingsdiagranlillatically. Are there any circumstances under which the government will
be unable to redistribute to widget tlnn shareholders using this policy? Explain carefully.
(c) Analyze the impact of a quota policy. Illustrate your findings diagrammatically. Are
there any circumstances under \vhich the government will be unable to redistribute to
widget fiml shareholders using this policy? Explain carefully.
(d) Suppose that the price subsidy and quota were such as to give rise to the same level of
gains for widget shareholders. Is it clear which one would lead to the smallest reduction
in utility for widget consumers? Explain carefully
August 7, 2002
J. You are identified by a number. The grading is meant to be anonymous, so we suggest
that you !lot use your Cornelll.D. number. Select an identifying number and keep a
record of it for your infom1ation. Put this number on each exam book, NOT your name,
and DONOT sign your names on the exam book(s) either.
2. Each part must be answered in a separate exam book. When you are finished, please
write down the total number of exam books you are SUbmitting, and get the number
GOOD LUCK!!
Part I
Goods x E 9i ; have prices p Em; + . A consumer with income y > 0 has utility function u:
9t ; ~ 91
1
The utility function is continuous and strictly increasing.
a. Let v(p,y) be the consumer's indirect utility function. Show that any positive monotonic
transformation ofv(p,y) can also serve as this consumer's indirect utility function.
b. Let e(u,p) be the consumer's expenditure function. Show that e(v(p,y),p) = y for all
pE91;+.
c. The consumer's expenditure function is strictly increasing in u. Using (a) can we
conclude e(v(p,y),p) can be used as the consumer's indirect utility? Then using (b) can
we conclude that the conswner's indirect utility function is y? Explain.
Part II
I t is often argued that individuals nearing retirement should reduce the fraction of wealth invested
in risky assets. In this problem we will examine a small part of this issue. The individual will
retire and immediately consume all of his wealth two periods from now. His wealth now, t = 0,
is woo Wealth at the intermediate period, t = 1, and when he retires, t = 2, will depend on his
portfolio choices and on returns. There are two assets:
1. A risk free asset, b, with a (gross) return of R > in .each period.
2. A risky asset, s, with a random (gross) return of Xl in period t to an investment
made in period t-l. Assume that XI and X
2
are independent and identically
distributed. Also assume that E[xJ > R.
Let at be the fraction of wealth invested in the stock in period 1. Then random wealth Wt+1 is
given by
The individual's objective is to maximize the expected utility of wealth, w
2
, at retirement. The
ii1dividual is strictly risk averse.
3. Will eveD' such individual decrease the portion of his \vealth invested in the risky asset?
b. For some such individuals is it optimal to decrease the fraction of wealth invested in the
risky asset?
In answering (a) and (b) it maybe helpful to consider constant relative risk averse and/or constant
absolute risk averse individuals.
If you find it useful you may assume that the return on the risky asset is normally distributed.
Part III
Bill, who is a first year graduate student majoring in economics, wants to auction off an item.
There will be two bidders, and their private values of the item, v
J
and v
2
, are independent and
identically distributed uniformly on [0,1]. He learned in his game theory course that the expected
revenues from a second price auction and a first price sealed bid auction are the same in this case.
He, however, heard that there exist other kinds of auctions where he can expect greater revenues.
So, he wants to find one. But, he decided to investigate only the foHowing limited class of
auction mles. Fol1owing the suggested steps, find the optimal auction for him in this class of
auctions.
Auction Rule: The bidder with highest bid will win the auction, and have to pay
a max{b
J
,b
2
}+(l - a) min{b
J
,b
2
}, where b
i
is the bid of bidder i, i = 1,2, and 0 s a s 1 is the
parameter that Bil1 is going to select. In case of a tie, bidder 1 wil1 win the auction.
a. Given a, find.an equilibrium bidding strategy which is symmetric and linear.
b. Calculate Bill's expected revenue at this equilibrium.
c. Now, based on the result of (b), find the optimal a for Bill.
Part IV
In a standard 2 x 2 model, labor and capital are used to produce commodity 1 and 2. The
production functions are given as
XI = 2LI + KI
X
2
= LI + 2K
2

The aggregate supply of labor and capital is (L, K) = (200,100). The prices of commodity 1
and 2, P = (P1,P2)' are determined in the world market.
a. Suppose P = (1,1). Find the equilibrium input prices. Find also the equilibrium output
levels of commodities 1 and 2.
b. Now consider the price of commodity 2 as a variable. How do the equilibriurn input
prices and output levels vary as P2 'changes? Answer with graphs.
Part V
Consider an economy with two goods ~ a discrete public good g E {O, I} and a numeraire
private good x. The public good is excludable. There are n consumers, indexed by i E 1 =
{ I , ... ,n}. Each consumer i is endowed with y, units of the numeraire. If consumer i consumes
the public good and Xi units of the numeraire his utility is given by Vi + Xi. Ifhe just consumes the
numeraire his utility is Xi. Assume that VI > V
2
> ... >vn > 0. To produce the public good requires
c units of the numeraire, where c < ~ . v. You may assume throughout that consumers'
i...J 'EJ '
endowments of the numeraire are sufficiently large that non-negativity constraints are not
binding.
a. Suppose that the provision of the public good is left to a private profit maximizing firm.
The firm will provide the public good if and only if the revenues it can generate from
selling access to it exceeds its cost. Show that if the firm cannot price discriminate and if
Vn < c/n, then the firm will not provide the public good efficiently; i.e., aggregate surplus
will not be maximized.
b. Many goods are "impure" public goods in the sense that adding consumers reduces the
benefits to other users because of congestion. Prominent examples are swimming pools,
parks, and highways.
(i) Extend the above model in a tractable way to capture the case of an impure public
good and explain how such a good should be provided to maximize aggregate
surplus. (Hint: you need to explain not only when the good should be provided but
who should use it if it is provided.)
(ii) Consider the impure public good model you have constructed in your answer to
b(i). Suppose that the good is provided by a firm who charges a price p for access.
How many consumers would purchase access? Does there exist a price that would
be sufficient to finance the public good and result in the good being provided in a
surplus maximizing way?
J>art VI
Two firms are deciding where to locate their operations. The location space is [0,1] and
consumers are uniformly distributed along the location space. Each consumer purchases exactly
one unit of the product. A consumer located at point x E [0,1] purchasing the product from a
firm located at pointy with price p enjoys a payoff v - p - t(x-y)2, where t> O. It costs each firm c
to produce one unit of the product.
a. Suppose that government regulations require each firm to charge a fixed price J5 > c for
its product. Where would the two firms choose to locate?
b. Show that the locations you identified in your answer to a. would not be chosen if the
firms were to compete for consumers via prices once they had located.
August 8, 200 1
GRADUA TE MICROECONOMICS EXAM
1. You are identified by a number. The grading is meant to be anonymous, so
we suggest that you not use your Cornell J.D. number. Select an
identifying number and keep a record of it for your information. Put that
number on each exam book, NOT your name, and DO NOT sign your
name on the exam book(s) either.
2. Each pmt must be answered in a sepm"ate exam book. When you are
finished, please write down the total number of exam books you are
3. If you find any question ambiguous, explain your confusion and make
whatever assumptions you think are necessary to answer the question.
GOOD LUCK "
Micro-Q 2 August 8, 200 I
PART I
Answer four of the following six questions.
1. The price of a painting will increase by 5% per year. The interest rate for borrowing and
lending is 10%. There are no transaction costs in buying or selling the painting.
(3) You would be willing to pay $500 a year to own the painting. If you plan to sell
the painting a year from now, how much would you be willing to pay for the
painting now?
(b) A law is enacted which requires the owner of any painting to give one-half of the
profit made from buying and then selling a painting to the painter. How much
would you be willing to pay for the painting?
2. A family has an income of $500 per week. Because of a subsidy to education, each dollar
of education that the family buys is matched by a dollar of education from the
government.
(a) Draw the family's budget line between "education" and "other goods" before and
after the subsidy.
(b) Under the subsidy scheme, the family is observed to spend $400 on goods other
than education. Under a proposed voucher system, the family would be given
vouchers, each of which would buy one dollar's worth of education. How many
vouchers would the family have to be given to afford the decision observed under
the subsidy scheme (assuming that there is now no subsidy)?
(c) Under which scheme would the family consume more education? Which scheme
would they prefer?
3. There are 50 tickets available for a concert and 100 potential concert-goers. 20 of these
have a willingness to pay for the concert of $15, another 40 have willingness to pay $10
and the remaining 40 have willingness to pay $5.
(a) Compute the market clearing price, the concert-goers' consumer surplus and
ticket sale revenues.
(b) Suppose that a price control of $3 were imposed 9n tickets and the tickets were
randomly allocated to those interested in going. What would be the loss in
aggregate surplus (defined as consumer surplus plus ticket revenues)?
(c) How would your answer change if you knew that the $3 tickets were sold to the
first 50 individuals waiting at the ticket booth on the morning of the concert?
Explain.
** Continued **
4. A firm has invented a new product which costs it c per unit to produce. Consumers are
unaware of the existence of the product, but market research reveals that if a consumer
were made aware of it, his willingness to pay for it would be the realization of a random
variable uniformly distributed on (0, w) where w> c. The finn can inform consumers
about its product and its price via advertising. If so informed, a consumer will buy the
product if and only if his willingness to pay exceeds the advertised price. It costs the firm
d to advertise to 11 consumers.
(a) Assuming that the firm does advertise, what price should it charge?
(b) Under what conditions should the firm advertise?
5. Consider the following two stage game. In Stage 1, a pharmaceutical firm chooses
whether or not to invest in the development of a new drug. The investment costs B > 0
and is successful with probability J[ dO, 1). If successful, the project creates a new
drug the demand function for which is Q(p) = IX - [Jp, where IX> 0 and [J> O. The
drug can be produced at zero marginal cost. If unsuccessful, the project yields no
benefits. In Stage 2, if the new drug has been created, the government regulates its price
with the objective of maximizing consumer plus producer surplus.
(a) Describe the subcgame perfect equilibrium' of the game.
(b) When is the equilibrium outcome Pareto inefficient?
6. The government plans to license firms to serve a market whose demand curve IS given by
p = 40 - q. The technology is such that each finn can produce any level of output at a
constant marginal cost of 20, but once each firnl's output is chosen, it cannot be altered.
If more than one firm has a license the firms will pay a Cournot game.
(a) The government announces that 11 licenses will be sold. What is the most that
any firm would be willing to pay for a license?
(b) One official says that the total amount collected from the sale of licenses is
decreasing in 11 and argues that only one license should be offered for sale. A
second official says that consumer surplus plus the total amount collected from
the sale of licenses is increasing in 11 and argues that many licenses should be
offered for sale. Evaluate this debate.
** Contillued**
l'vlicro-Q 4 August 8,200 I
PART II
Consider an exchange economy with 2 consumers indexed by i E (1,2) and 2 goods
indexed by l E (1,2). Each consumer has consumption set 911. Consumer I has preferences
represented by the utility function U I = Xll + YI X
21
and consumer 2 has preferences represented
by the utility function U
2
= X
12
+ Y2xn, where 0 < YI < Y2' The economy is endowed with 2
units of each good.
(a) Describe the entire set of Pareto efficient allocations.
(b) Assume that each consumer has an endowment of I unit of each good; (i.e.,
((VIi' (V2i) = (1,1) for i E (l,2}) and solve for the competitive equilibrium. (Let good 1
be the numeraire and let p be the price of good 2. Specify the equilibrium price of good
2 and the equilibrium allocation.)
** Continued **
Micro-Q 5 August 8,2001
PART III
A firm produces output y from inputs x = (XI' x
2
) > 0 with a production function f(x}.
q (x) 0
The function f: 911 -7 9 1 ~ is twice continuously differentiable, --> for all X and
C2r:
i
i = 1,2, and the Hessian of f is negative definite at all x E911
The output y sells at price p > 0, input prices are Hi = (WI' IV
2
) > > 0 and all markets
are perfectly competitive.
(1) Let < (p, w) be the profit maximizing input demand function for input i = 1,2. Prove
h
ax j' (p, w) 0 [If d k . h I f II ]
t at <. you nee to rna e any assumptIOns t en state t lem care u y.
aW
j
(2) Setup the firm's cost minimization problem with A as the Lagrange multiplier on the
output constraint. Let Cry, w) be the firm's cost function and prove that marginal cost
function, JC(y,I\'), is the Lagrange multiplier evaluateu at an optimum
()y
(3) In the theory of the consumer it is possible to have goods with upward sloping demand
functions. These goods are necessarily inferior goods. In the theory of the firm inferior
f
f d bl d."t(y,w) O 'tl f . .
actors 0' pro uctlOn are POSSl e, I.e., < IS POSS]) e or some IJ1put /,
, dy
output y and input plices w, where x(y, w) is the cost mlllimizing or conditional-
input demand. In part (l) you showed that all input demand functions are downward
sloping. Why are these two theories so different?
In your answer be sure to address why the following reasoning by analogy with consumer
theory is wrong: "When the price of an input rises there are two effects on ,the demand for
the input. There is a substituting effect (keeping output constant) which always causes
the fiml to demand less of the input. There is also an output effect. The firm produces
less and if the input is infelior this increases demand for the input. If this output effect is
large then input demand is upward sloping."
** Continued **
Micro-Q 6 August 8,2001
PART IV
Consider the following game between two firms and a single worker. The worker is
characterized by his productivity e which is the realization of a random variable uniformly
distributed on [O,1}. The worker knows his productivity, but the firms cannot directly observe
it. However, for a cost C E (0, ~ ) , the worker can undertake a test that reveals his productivity
2
to the finns. The timing of the interaction is as follows. In Stage 1, the worker decides whether
or not to undertake the test. In Stage 2, the firms bid for the worker having observed the test
result if it is undertaken. The worker's payoff is his wage minus the test cost if he takes it. A
firm's payoff is the worker's productivity less his wage if it hires the worker and 0 otherwise.
An equilibrium of the game is a strategy for the worker that maximizes his payoff given finns'
wage schedules; strategies for the firms that maximize their expected payoffs gi ven their beliefs,
what they observe about the worker, and each others' strategies; and beliefs for the firms that are
consistent with the worker's strategy.
(a) What is a strategy for the worker? What is a strategy for firm J? What should firm ]
have beliefs about?
(b) Assuming that the firms have the same beliefs, what are the equilihrium wage offers?
(Assume that the equiliblium is symmetric in the sense that the firms employ the same
strategies.)
(c) Taking as given the firms' wage offers, what is the equilibrium strategy for the worker?
(Assume that he takes the test if indifferent.)
(d) What is the equilibrium belief about untested workers?
(e) Would banning the test improve the welfare of the worker no matter what his productivity
type? Explain.
** Continued **
PART V
There are two cities a and b and two consumption goods x = (XI' x
2
) with prices
pO incity a and pb incity b. The consumer lives in city a and
has income IO > O. His preferences over consumption goods satisfy local non-satiation and are
strictly convex.
(1) Suppose that pf =(l+c5)pf and for some 820. Suppose also that
the consumer does not care whether he lives in city a or city b - only consumption
goods x matter to him.
(a) Write an equation defining the income /' (8) , as a function of c5, that the
consumer would need in city b to be indifferent between living in a or b.
(b) Compute dt(O)ld 8 anel interpret it.
() N
s; 0 1 el I b I a (1) ( a <l {j. (j ) 'I . . a - ( . (j a) th
c ow u=. an = +. Pixi -P2t2 \\-lele.t - "I ,x2 IS e
consumer's optimal bunelle in city a. Will the consumer prefer to live in a orb?
Why?
(2) There are many consumers with identical preferences. Some live in (/ and some live in
b. Consumers preferences depend on X and Oil the city in which they live. All
consumers in city a have income t' and all consumers in city b have income t.
There are no moving costs and any consumer who moves to a, or b, will have income
t', or t. A national magazine has published an article claiming that, based on quality of
life and cost of living, city b is the best place to live. Would you recommend moving
from a to b? Why or why not?
** End of Exam **
June 11, 200 1
we suggest that you not use your Cornell I.D. number. Select an
2. Each part must be answered in a separate exam book. When you are
. whatever assumptions you think are necessary to answer the question.
GOOD LUCK"
Micro-Q 2 June 11,2001
PART I
Answer four of the following six questions.
1. John cares only about his consumption of Big Macs, french fries and Diet Cokes. He
always spends all of his income on these three goods. John used to live in the U.S. where
Big Macs cost $2, french fries cost $1.50 and Diet Cokes cost $1. He purchased 5 Big.
Macs, 5 orders of french fries and 6 Diet Cokes per day. Now John lives in England
where Big Macs cost 1.50, french fries cost 1.00 and Diet Cokes cost 1.00. He buys 6
Big Macs, 5 orders of french fries and 5 Diet Cokes per day.
Observing that the pound () is worth about $1.50, John notes that prices in England are
generally higher than in the U.S .. John complains that he is worse off in England than he
was in the U.S .. Assuming that his preferences are unchanged and that he makes rational
consumption decisions, is he right') Explain.
2. A community is considering building a bridge. The bridge will cost F. The demand for
bridge crossings is estimated to be Q(p) where p is the toll price. The marginal cost
of an individual crossing the bridge is O. The community'S chamber.of commerce
repolts that the demand function is such that the bridge cannot befinanced from toll
revenues. Does this mean it should not be built? Explain carefully with the appropriate
diagram(s).
3. A bottle of wine costs $6 to produce. The amount that people are willing pay to drink it
t years after it was produced is $8 + t per bottle. The interest rate is 10% per year.
(a) How long will the wine be stored before it is consumed?
(b) How much would a rational investor be willing to pay for a bottle of the wine in
the year that it is produced')
(c) If the wine maker spends an extra $2 per bottle on producing the wine he can
change its consumption value to $8 + 2[. Should the wine maker do this? [You
DO NOT NEED TO SIMPUFY YOUR ANSWER. A NUMERJCAL FORMULA IS A
SUFFICIENT ANSWER.]
** Continued **
4. Consider a household choosing where to send its child to school. The household has
- -
income y. The range of feasible school qualities are !q, q J where 0 < q < q. The cost
- -
of sending the child to a private school of quality q is pq. A public school is available
-
at no cost to the household and the public school quality is qg E( q, q).
(a) Represent the household's choice possibilities in a diagram. Provide a
diagrammatic proof that if the household chooses to send itschiJd to a private
school, it will be to a school of higher quality than the public school.
(b) Suppose that a voucher program were introduced whereby each household is
given a voucher of value pqg to spend on education. Illustrate how this would
change the household's problem. Assuming that it costs the government pqg to
educate a child in the public schoo.!, how would the voucher program impact the
government's costs?
5. The government is considering a new environmental regulation which will increase the
fixed cost of each firm in a perfectly competitive industry by $F. The firms in the
industrfhave V-shaped long run average cost curves, prices of inputs are constant and the
industry is currently in a long run equilibrium. There are N firms each producing qo
units and selling them for $Pa each. An undergraduate economics student claims: "If
theregulation is passed then in the long run the price will rise to $(Pa+ F/qa) so that the
firms will again have zero profits."
Is this correct? Illustrate graphically what will happen.
6.n cities are vying to host the next Olympics. The net economic gain from hosting to
each of these cities is B. The decision is made by a committee, members of which are
swayed by rent seeking activities such as expensive dinners, gifts, etc. Indeed, the
probability that city i E (1, ... , n) is selected by the committee is
where rj denotes the rent seeking expenditures of city j. Solve for the Nash
equilibrium level of rent seeking activity by each city (assume a symmetric pure strategy
equilibrium) and show that as n - "", aggregate rent seeking expenditures approach B.
** Continued **
PART II
Consider the following economy. There are n citizens, indexed by i E {1, ... ,nj; 1
finn; and 2 goods, denoted x and z. Good x is the numeraire and the price of good z is
denoted p. Each citizen i is endowed with Yi units of good x. Good z may be produced
from good x by the firm; specifically, for the firm to produce z> 0 units of good z
requires F + cz units of good x. Thus, F represents the fixed cost of production and c
the marginal cost. Citizen i has preferences over the two goods that may be represented by the
quasi-linear utility function u, (x" z,) = x, + OZ; -( ~ } / ' where Ct> 0, fJ> O. Citizen i
owns a share 8
i
of the firm. Assume that
, ,
a' - c'
arid that for all i = I, ... ,n, y, > ---
4{3
n(a - C)2
4{3
I
n cn(a-c)
> F, that y > F + ----
1;:::-1 I {3'
(a) Compute the aggregate demand function for good z and, assuming that the firm
maximizes profits, find the price it will charge and the output it will produce.
Prove that the equilibrium allocation is Pareto inefficient.
(b) Suppose that the government sets up a regulatory agency to regulate the firm's
price. Assume that the agency can only choose price, that it mllst leave the firm
with non-negative profits, and that its objective is to maximize aggregate
MarshalWm surplus. Compute the price that the agency will set. Will the sening
up of the agency lead to a Pareto improvement over the status quo?
** Continued **
Micro-Q 5 June 11.2001
PART III
An individual has to decide how to allocate his wealth w> 0 between current
consumption, Co' at time 0 and the purchase of two assets. Asset payoffs at time 1 are
. stochastic. There are two possible states of the world at time 1, 1 and 2, with probabilities q
and 1-q, where 0 < q < 1. There is a single consumption good at times 0 and 1, and the
assets payoff in units of this good. Asset 1 pays XI > 0 per unit in state 1 and 0 in state 2; asset
2 pays x
z
> 0 per unit in state 2 and 0 in state 1. Let Q
I
and a
z
represent the number of
units of assets 1 and 2 that the consumer purchases. Let PI> 0 and Pl > 0 be the prices of
assets 1 and 2. Consumption at time 0 is the numeraire good; its price is 1.
The consumer's expected discounted utility of consumption at time 0, co; consumption
at time 1 in state 1, c
l
; and consumption at time 1 in state 2, c
2
' IS
where u: ' ) \ ~ --7 ')\1 is the consumer's utility function and 0 < P < 1.
1. The consumer's objective is to maximize expected discounted utility subject to the time 0
budget constraint. Since c
i
= alx
l
and C
2
= QC-'(2 the consumer's decision problem
can be written with co' a
J
and a
z
as choice variables. Set up this problem.
2. Suppose that u( c) = In( c). Solve the consumer's decision problem for the optimal
consumption and asset purchases at time O.
3. Suppose that there is one consumer in the economy. This consumer acts competitively.
There is one unit of the consumption good at time 0 and one unit of each of the assets.
The consumer owns these endowments, so his time 0 wealth is w = 1 + PI + Pz' Solve
for equilibrium asset prices. Continue to assume that u(c) = In(c).
4. Continue analyzing the economy in (3) but now assume that u( c) is a twice
continuously differentiable function from 9 l ~ to 9\1, which is strictly increasing and
strictly concave and u'(c)-)-too as c -0. Showthatinequilibrium
(3qIl'(X
I
)X
I
PI = u'(1)
** Continued **
PART IV
Consider a private ownership exchange economy with 2 consumers indexed by i E (1. 2)
and 2 goods indexed by lE {I. 2}. Each consumer has consumption set 9'\:. Let X'i denote
consumer i' s consumption of good e. Consumer 1 has preferences which can be represented '
by the utility function U
1
= Xu - (X22' where Y E (O, 1) and consumer 2 has preferences that
are represented by the utility function Il
z
= X 1 1 ~ 2 X ~ ~ 2 . Thus consumer 1 does not get any benefit
from his own consumption of good 2 and is also negatively impacted by consumer 2's
consumption of good 2. Each consumer has an endowment of 1 unit of each good; i.e.,
(6)1i' 6)2) = (1. 1) for i E ! 1. 2}. Good 1 is the numeraire and the price of good 2 is denoted
by p.
(a) Find the competitive equilibrium price and allocation for this economy.
(b) Assuming that units of good 2 may be freely disposed of, for what values of y
is the equilibrium allocation Pareto efficient? Explain carefully.
** Continued **
PART V
Consider the following two player extensive form game.
1
D
u
Q
3, 3
1, 1
L
0, 2
2,0
The payoff vectors at terminal nodes gi ve the payoffs to players 1 and 2, respecti vely.
1. Find the subgame perfect equilibrium.
2. Write thIS game in normal form.
3. Find all pure strategy Nash equilibria.
4. Which pure strategies are weakly or strictly dominated in the normal form?
5'. For this game is the following claim true or false? Why?
"Any strategies that survive iterated deletion of weakly dominated strategies, with ("my
order of deletions, generate the subgame perfect equilibrium."
** End of Exam **
June 7, 2000
1. . . You are identified by a number. The grading is meant to be anonymous, so
GOOD LUCK!!
Micro-Q 2 June 7, 2000
PART I
Answer anyfour of the following six questions.
1. Mandy and Torn, who live in Eugene, Oregon, have identical tastes. They both plan to
attend a Paula Cole concert at the State Theater. The tickets cost $20. Mandy has bought
her ticket by phone using her credit card, but Torn, who doesn't have a credit card, plans
to buy his ticket at the door. On the same evening the university announces a surprise free
fireworks display on campus. If Mandy had known about the fireworks display in
advance, she would not have bought the theater ticket. True or False: Assuming Mandy
and Tom are rational, and that Mandy cannot resell her ticket, it follows that Mandy will
go to the concert, while Tom will go to the fireworks display. Explain briefly.
2. Two airplane are considering the production of a new product, a 150-
passenger jet. Both are deciding whether to enter the market and produce the new planes.
The payoff matrix is as follows (payoff values are in millions of dollars):
Produc
Boeing
Don't
Produc
Produce
-5 for each
o for Boeing
] 00 for Airbus
Airbus Don't
Produce
100 for Boeing
o for Airbus
o for each
The implication of these payoffs is that the market demand is large enough to support
only one manufacturer. Ifboth firms enter, both will sustain a loss.
(a) Identify two possible pure strategy equilibrium outcomes in this game.
(b) Consider the effect of a subsidy. Suppose the European Union decides to
subsidize the European producer, Airbus, with a check for $25 million if it enters
the market. Revise the payoff matrix to account for this subsidy. What is the new
equilibrium outcome?
(c) Compare the two outcomes (pre- and post-subsidy). What qualitative effect does
the subsidy have?
3. The Rainflower Cactus Nursery is the only employer in a small town in Nevada. It sells
potted cacti at $5 each, and its weekly output of cacti varies with the number of workers, as
shown in the following table:
Number of workers Potted cacti per week
0 0
1 50
2 90
3 120
-
4 140
5 ISO
6 155
There are six people in town potentially available to work at Rainflower. The six people,
together with their reservation wages, are shown in the following table:
Worker Reservation wage ($!wk)
. Jon
75
Joe 80
Jenny 85
Jeff 90
Jessica . 100
Luke 150
(a) If Rainflower must pay the same wage to all workers, how many workers will the
firm hire? What wage will it pay?
(b) What is the socially optimal number of workers to hire?
( c) If Rainflower could pay each worker exactly his or her reservation wage, how
many workers would the company hire?
4. The municipal water works of Cortland draws water from 2 sources, an underground
spring and a nearby lake. Water from the spring costs 2 cents per hundred gallons to
deliver, and the spring has a capacity of one million gallons per day. Water from the lake
costs 4 cents per hundred gallons to deliver and is available in unlimited quantities. The
demand for water in the summer months in Cortland is P = 20 - O.OOlQ, where P is the
price of water in cents per hundred gallons, and Q is quantity demanded in hundreds of
gallons per day. The demand curve for water in the winter months is P = 10- 0.001 Q.
(a) If the water works wants to encourage efficient water use, how much should it
charge for water in the summer months? In the winter months?
(b) By how much would total economic surplus go down if, in response to complaints
from summer residents, the Cortland city council passed a law requiring all water
to be sold at 3 cents per hundred gallons throughout the year.
5. Harold is one of 1,000 employees in a new startup company. In lieu of being paid a
salary, he and his coworkers were each given an equal number of shares in the company's
stock. Together they own half of all stock in the company. If Harold works hard at home
on company projects each evening and on weekends for the next year, the present value
of the company's current and future accounting profit will grow by $1 million.
(a) How much of that gain will Harold receive?
(b) If Harold's reservation price for working evenings and weekends for the next year
is $10,000, what fraction ofthe company's stock would he have to own to induce
him to put in the extra effort? On the basis of your answer, do you think the
widely-touted incentive effects of employee stock ownership plans may have been
exaggerated?
6. You have just inherited the secret formula for a new drug that improves performance on
the SATs. The drug has no other effect and you are the only one who can supply it. Each
of the drug's 1 million potential customers has the demand curve shown below. Your
marginal cost of producing and selling the drug are constant at $4/ounce. Your only other
costs are $2 million annual fixed costs for your manufacturing and sales facility. Your
goal is to maximize your economic prOfit.
P ($/ounce)
12
4 f---------">...,;::--- Me
D
12 Q (ounces/year)
(a) If you must sell the drug at a single price to all customers, how many ounces per
year will you sell at what price, and how much economic profit will you make?
(b) Now suppose you can charge each customer a fixed annual membership fee to
belong to your buyer's club. Membership entitles the member to buy as much of
the drug as he pleases at a constant fee per ounce. Nonmembers cannot buy the
drug at all. If you set your price per ounce at the level that produces the largest
economic surplus, what is the largest membership fee you can charge, and how
much economic profit will you earn?
Part II
A consumer's consumption set is X =]Rm +, with typical element x = (xl, ... ,x
m
). Prices
of the m goods will be denoted by p = (Pl, ... ,Pm)' The consumer's wealth will be denoted by w.
Assume that the consumer makes her choices of consumption bundles according to a
demand function, x(p,w), which satisfies Walras Law.
1. (a) [3 points] Show that if the demand function, x(P,w), satisfies the Weak Axiom
of Revealed Preference, it must satisfy homogeneity of degree zero in prices and
wealth.
(b) [7 points] Show that if the demand function, x(p,w), satisfies the Weak Axiom
of Revealed Preference, it must satisfy the compensated law of demand.
2. A finite set of demand data ofthe consumer consists of the following type of
information: Xl is chosen at (pI, WI), x
2
is chosen at (p2, w
2
), ...... , xn is chosen at
(pn, wn). Consider the following demand- data generated by the consumer. [There are
three commodities, so m=3, and three data points, so n=3 also]. The consumption
bundle Xl = (10,10,10) is chosen when pI = (10,10,10) and WI = 300; x
2
= (9, 25,
7.5) is chosen when p2 = (10, 1, 2) and w
2
= 130 ; x
3
= (15, 5, 9) is chosen when
p3 = (1,1,10) and w
3
= 110.
(a) [6 points] Does the data show that the demand function x(P,w) violates the Weak
Axiom of Revealed Preference? Explain.
(b) [4 points] "The above demand data cannot be generated by a consumer who is
maximizing a complete, transitive, locally non-satiated and strictly convex
preference relation, subject to her budget constraint." Do you agree? Explain.
PART III
Consider that the market demand for a good is given by the following equation:
Q = A - P
where Q is the quantity, p the price (in dollars) of the good, and A> 1 a demand parameter.
[It will be understood that for prices greater than A, the demand for the good is zero]. The good
can be produced at a constant per unit cost of $1.
(1) [2 points] Assume, first, that the market is served by only one firm (called Fin11 1). Find
the market price of the good charged by the firm.
(2) Consider, next, that another firm (called Firm 2) is considering entering the market. If
Firm 2 does not enter, we have the situation as in (1) above. If Firm 2 enters, then the
firms will engage in price competition. Both firms will announce prices simultaneously. If
the prices are different, all the demand will be met by the firm charging the lower price. If
the prices are the same, t h ~ demand will be split equally by the two firms.
(a) Assume that A = 3, and the firms can only charge prices which are whole dollar
amounts.
(i)
(ii)
[ 4 points] Depict the game in extensive form.
[4 points] Find the subgame perfect equilibrium of the game, showing
your procedure cleariy, and find the price charged for the good in such an
equilibrium. You can confine your analysis to pure strategies and assume
that firms never playa (weakly or strongly) dominated strategy.
(b) Assume that A = 5, and firms can only charge prices which are whole dollar
amounts.
(i) [5 points] Find the subgame perfect equilibrium of the game, showing
your procedure clearly, and find the price charged for the good in such an
equilibrium. You can confine your analysis to pure strategies and assume
that firms never playa (weakly or strongly) dominated strategy.
(ii) [5 points] Assume that there is an entry cost of $ c (where c > 0) that
Firm 2 has to pay to enter the market. Draw a diagram, with c on the
horizontal axis and the equilibrium price on the vertical axis, to indicate
how the equilibrium price (in the resulting pure strategy subgame perfect
equilibrium) changes with the entry cost, explaining your procedure
clearly.
PART IV
Consider the following economy. There are N citizens, indexed by i = 1, ... , N; M
firn1s; and 2 goods, denoted x and z. Each citizen is endowed with Yi units of good x .
. Good z may be produced from good x' by the M firms, each of whom has the linear
1
technology z = -x, where y > 0. Citizens i = 1, ... , n (n < N) have preferences over the
y
two goods that may be represented by the quasi-linear utility function
u.(x .. z.) :0: X. + ciz. - ~ Z 1 2 , where a > 0, A > O. Citizens i = n + 1, ... , N have
1 1 ~ 1 1 1. 2. p
preferences over the two goods that may be represented by the utility function u J ~ , Z) = Xi - KZ
where Z is the aggregate production of good z and K> 0. Assume that a> y + NK and
a
2
that for all i = 1, ... ,n, y. > -
1 2P
(a) . Find the competitive equilibrium for this economy. (Let x be the numeraire and
let the price of z be p. You must solve for the equilibrium price and
allocation.) .
(b) Show that the competitive equilibrium allocation is Pareto inefficient.
(c) Find the competitive equilibrium under the following tax system: for each unit of
z produced, each firn1 pays a tax t and the tax revenues tZ are redistributed
to the citizens in a uniforn1 way (i.e., each citizen gets a transfer tZ). (You
. N
should make the "competitive" assumption that each citizen thinks he is too small
to affect his government transfer.)
(d) Calculate the level of t which results in the competitive equilibrium allocation
being Pareto efficient. Would introducing this tax make all the citizens better off?
(e) Suppose that if a tax system of the form described in (c) were introduced, the tax
level chosen would be that preferred by the majority of citizens. Calculate this tax
rate under the assumption that n < N12. Compare it with your answer to (d) and
explain why it differs.
(f) In light of your answers to (c), (d), and (e), critically evaluate the idea that
government intervention in the form of a per-unit tax on producers is justified
when the production of a good creates negative externalities.
PART V
A risk neutral insurance company wishes to provide insurance to a risk averse driver. The
driver is endowed with wealth W. There are two possible states of the world: either he has an
accident or he does not. In the former state, he incurs a loss L. The probability of his having an
accident depends on whether he drives fast or slow. Denote these two actions by 0 and I,
respectively, and let TI
j
denote the probability of an accident when the driver takes action
i E {O,l}. Obviously, TIo> TIl' The driver's payoff if he takes action 0 (drives fast) and has
consumption x is In x. Ifhe takes action 1 (drives slow) his payoff is Ip x - c, reflecting
the fact that he dislikes driving slowly ( c > 0). The insurer's problem is to choose a contract to
offer to the driver. A contract specifies a premium p, a payout in the event of loss '1', and an
action i. The driver's reservation utility is u, so that the contract must offer him at least this
utility level.
(a) Under the assumption that the insurer can observe the driver's action choice,
characterize the contract that the insurer should offer the driver.
(b) Under the assumption that the insurer cannot observe the driver' s action choice,
explain how to characterize the contract that the insurer should offer the driver.
(c) . Characterize the optimal contract in the unobservable action case under the
assumption that it involves slow driving. Prove that the contract does not fully
insure the driver for his loss.
August 7, 2000
3. if you find any question ambiguous, explain your confusion and make
GOOD LUCK!!
Micro-Q 2 August 7, 2000
PART I
Answer/our of the following six questions.
1. Jill and Jack both have two pails that can be used to carry water down from a hill. Each
makes only one trip down the hill, and each pail of water can be sold for $5. Carrying the
pails of water down requires considerable effort. Both Jill and Jack would be willing to pay
$2 each to avoid carrying one bucket down the hill, and an additional $3 to avoid carrying
a second bucket down the hill.
a. Given market prices, how many pails of water will each child fetch from the top of
the hill?
b. Jill and Jack's parents are worried that the two children don't cooperate enough with
one another. Suppose they make Jill and Jack share their revenues from selling the
water equally. Given that both remain non-cooperative, construct the payoff matrix
for the decisions Jill and Jack face regarding the number of pails of water each should
carry.
c. What is the equilibrium outcome from (b)?
2. John and Karl can live together in a 2-bedroom apartment for $500/mo, or each cari rent a
single-bedroom apartment for $350/mo. Aside from the rent, the two would be indifferent
between living together and living separately, except for one problem: John leaves dirty
dishes in the sink every night. Karl would be willing to pay up to $ 1 75/mo to avoid John's
dirty dishes. John, for his part, would be willing to pay up to $225 to be able to continue his
sloppiness. [Assume that they are both dispassionate economics graduate students and have
perfect information about each others' preferences.]
a. Should John and Karl live together? Ifthey do, will there be dirty dishes in the sink?
Explain.
b. How, if at all, would your answer to the preceding question differ if John would be
wilting to pay up to $30/mo to avoid giving up his privacy by sharing quarters with
Karl?
Micro-Q
)
August 7, 2000
3. Tom and Al are the only two members of a household. Each gets satisfaction from 3 things:
his income, his safety at work, and his income relative to his roommate's income. Suppose
Tom and Al must each choose between two jobs: a safe job that pays $1 OO/wk and a risky
job that pays $130/wk. The value of safety to each is $40/wk. Each person evaluates relative
income as foHows: having more income than his roommate provides the equivalent of
$30/wk worth of satisfaction; having less implies a reduction of $30/wk worth of
satisfaction; and earning the same income as his roommate means no change in satisfaction.
a. Will Tom and Al choose optimally between the two jobs?
b. If Tom and Al could negotiate binding agreements with one another at no cost, which
job would they choose?
c. Suppose negotiation is impractical, and that the only way Tom and Al can achieve
greater workplace safety is for the government to adopt safety regulations. If
enforcement of the regulations costs $25 per week, would Tom and Al favor their
adoption?
4. Suppose the demand curves for hour-long episodes of the Jerry Springer Show and
Masterpiece Theater are as shown in the diagram below. A television network is considering
whether to add one or both programs to its upcoming fall lineup. The only two time slots
remaining are sponsored by which is under contract to pay the network 10 cents for
each viewer who watches the program, out of which the network would have to cover its
production costs of$400,OOOper episode (both springer and MT cost $400,000 per episode).
(Viewership can be estimated accurately with telephone surveys.) Any time slot the network
does not fill with Springer or MT will be filled by infomercials for a weight-loss program,
for which the network incurs no production costs and for which it receives a fee of$500,000.
Viewers receive $5 million in economic surplus from watching each installment of the
infomercial.
($/episod e)
16
($/episod e)
8
o
12
Milliol15 of viewers per episode
a. How will the network fill the two remaining slots in its fall lineup?
b. Is this outcome socially efficient?
c. By how much would total economic surplus be higher if each episode of
Masterpiece Theater were shown on PBS free of charge than if it were shown by a
profit-maximizing pay-per-view network?
5. You are going to buy a laptop computer, and you know that by visiting an additional
store, you are equally likely to be quoted a price of $2000, $2200, $2400, $2600, or
$2800. If your opportunity cost of an additional visit is $100, what is your reservation
price for a laptop computer? (If you visit a store that quotes a higher price than the one
you've already found, you are free to buy at the lower price.)
6. An electric utility has access to two types of generating equipment, baseload and peaker.
Suppose the marginal operating cost of a baseload generator is 2 centslkwh, while a
peaker's marginal operating cost is 14. centslkwh. Daily rental costs of two types are
$6.20Ikw and $51kw respectively, and the company's daily load profile is as shown in the
diagram.
lew
200 - - - -- - - - .,-----,
10u1lt-----l
Midnight 9 AM 3 PM Midnight
a. What is the marginal cost of providing 1 kw of additional power from noon till 2
PM?
b. What is the marginal cost of providing I kw of additional power from midnight
till 2 AM?
c. What is the marginal cost of providing 1 kw of additional power from 6 PM till
midnight?
PART II
Consider an individual, whose preferences can be represented in the expected utility
form. Her Bernoulli utility function will be denoted by u: m - m, where u is twice
continuously differentiable, with u' > 0 and u" < 0 on m.
The individual's initial wealth is W> O. She faces a risk of losing some of her wealth.
Specifically, the set of states of the world she faces is 1= {I ,2,3}, and she will suffer a loss of
wealth equal to Xi?' 0 if state i E I occurred, where = XI < X
2
<X
J
. The probability that
state i E I will occur is Pi> 0, where, of course, (PI + P2 + PJ ) = I. Assume in what follows
that W = 50; Xl = 4, XJ = 8; and, P2 = P3 = (114).
The individual can buy insurance policies. An insurance policy is described by an
insurance premium, R> 0 (paid by the individual to the insurance company), and a
specification of benefits (payments to the individual by the insurance company), denoted by
(B I , B" ,B,), where Bi? 0 is the payment made if state i E I occurred.
Suppose that the insurance policies available to the individual are those for which the
insurance premium R is fixed at the level I, and the individual can select any set of B i ~ O for
which the expected value a/benefits, (PIB
I
+ P2B2 + pJB
J
), cannot exceed the fixed level 2. The
individual can, of course, choose not to buy any of the insurance policies available to her; in this
case, she pays no premiwn, and receives no benefits.
Note that a "full insurance policy" (that is, B I = 0, B2 = 4, B
J
= 8) is not available to the
individuaL since the expected value of benefits of such a policy is 3.
(i) Show that there is some insurance policy available to the individual, which she
strictly prefers to being uninsured.
(ii) Given 0), write down precisely the constrained optimization problem to be solved
to determine the individual's optimal insurance policy.
(iii) Denote by (BI*' B/, B)*) the solution. to the individual's constrained
optimization problem. Show that there is a constant, c, such that:
Bi* - Xi 2: C for i = 1,2,3
and equality holds in the above inequality for those i for which Bi* > o.
(iv) Using (iii), show that BI * = 0, B2 * > 0, and B) ~ > 0.
(v) Show that the optimal insurance policy provides full protection beyond a
deductible.
Micro-Q - 6 August 7,2000
PART III
Consider a duopoly market in which two firms, indexed i = 1,2, produce a homogenous
product. The strategic variable of firm i (i = 1,2) is (in Coumot fashion) its output level, Yi; the
strategy set, Si' offirm i (i == 1,2) is ~ t . The payoff to each firm is its profit, which depends, of
course, on the output levels of both firms.
The demand function of the homogenous product is gi ven by :
y =A - p for 0 ::; p ::; A
and it is understood that the demand, y = 0 for p > A. The cost function is the same for both
firms; the cost of production per unit of the product is c, where 0 < c < A.
(a) Show that (y,*, y/) = ((A-c)/3, (A-c)l3) is a Nash Equilibrium of this game.
(b) Show that any output level y, E ((A-c)/2, (0) is a strictly dominated strategy for
Firm 1, and any output level Y2 E ((A-c)/2, (0) is a strictly dominated strategy for
Firm 2.
(c) If neither finn will playa strictly dominated strategy, and both firms know this,
then (b) above shows that both firms know that Firm I will only produce output
levels belonging to the restricted strategy set [0, (A-c)I2], and Firm 2 will only
produce output levels belonging to the restricted strategy set [0, (A-c)/2]. Given
their knowledge of their rival's upper bounds on the part of the two firms, show
that any output level y, E [0, (A-c)/4) is a strictly dominated strategy for Firm 1,
and any output level Y2 E [0, (A-c)/4) is a strictly dominated strategy for Firm 2.
(d) What is the set of strategies for Firms 1 & 2 which survive iterated deletion of
strictly dominated strategies? Explain carefully.
PART IV
Consider a market for used cars. Cars are owned by "owners" and demanded by
"buyers." There are more buyers than owners. Cars are of two quality types: good and bad.
Good cars are worth b to owners and B > b to buyers, while bad cars are worth m to
owners and M > m to buyers. The proportion of good cars is A and that of bad cars I - A.
(a) Suppose that a car's type is observable to both owners and buyers. What would
be the equilibrium prices of good and bad cars?
(b) Suppose that a car's type is observable to owners and unobservable to buyers.
What are the possible equilibrium prices?
(c) Explain how to extend the model to allow for a continuum of quality types.
(d) Under the assumption that a car's type is observable to owners and unobservable
to buyers, solve for the equilibrium price in the continuum model.
August 10, 1999
we suggest that you not use your Cornell LD. number. Select an
GOOD LUCK"
~ I
PART I
Choose four (4) 0 f the six (6) questions from Part 1.
I. Tom and Mike are players in a simple game. The game begins with Tom being given
$100. Tom must then propose how to divide this money between Mike and himself His
proposal must take the form, "X for Mike, $lOO-X for me," where X is an integer number
of dollars between 0 and I 00. Mike must then choose between two responses. He can
accept, in which case Mike gets X and Tom gets $1 OO-X. Or he can refuse, in which case
both players get O.
(a) If Tom and Mike know one another to be rational and know that each wants to
maximize his earnings from this game, what will Tom offer and how will Mike
respond?
(b) How would your answer differ if the first move called for Mike to submit his
reservation value of X in a sealed envelope, followed by Tom's proposal?
(c) In the original form of this game, suppose Tom is risk averse and he knows that
Mike's utility from playing this game depends positively on his own payoff, but
negatively on'Tom's payoff. rfthe specific form of Mike's utility function for the
game is U = 0.6X - 0.2(100 - X), what will Tom propose?
2. A government owned electric utility company in Vermont has two sources of power-a
hydroelectric generator and a coal-burning steam generator. Electricity from the
hydroelectric facility can be delivered to households at a cost of2 cents per kiloWatt-hour
(kWh) for any amount up to 4 million kWh per day. Electricity can be produced in
unlimited quantities from the steam generator at a cost of 6 cents per kWh. The
company's daily demand curve for electricity during the summer months is P = 4 - 2Q,
where P is price in cents per kWh and Q is millions of kWh per day. The corresponding
demand curve for electricity in the winter months is P = 12 - Q.
(a) How much should this utility charge for electricity during the summer months?
During the winter months? _
(b) Should a family that receives its power directly from the hydroelectric generator
during the winter months pay less than one that receives its power from the
hydroelectric facility? Explain.
3. When theprice of gasoline is $1 per gallon, you consume 1,000 gallons per year. Then
two things happen: 1) The price of gasoline rises to $2/gal; and 2) a distant uncle dies and
with the instruction to his executor to send you a check for $1000 per year. If no other
changes in prices or income occur, do th{{se two changes leave you better off than before?
i'v1icro-Q J August 10, 1999
4. Sue spends all her income on tennis balls and basketball tickets. Her price elasticity of
demand for tennis balls is -2. True or false.
(a) A one-percent fall in the price of tennis balls will cause an increase of
approximately two percent in her expenditure on baBs. Explain.
(b) Ifthe price of tennis balls rises, Sue will consumes more basketball tickets.
Explain.
5. In the event he requires an appendectomy, David's demand for hospital accommodations
is as shown in the diagram. David's current insurance policy fully covers the cost of
hospital stays. The marginal cost of providing a hospital room is $300/day.
Price ($/day)
30
3
Length of Hospi tal
Stay (days)
(a) If David's only illness this year results in an appendectomy, how many days \-vill
he choose to stay in the hospital?
(b) By how much would total economic surplus have been higher this year if David's
hospital insurance covered only the cost of hospital stays that exceed $1000 per
illness?
6. CD players are offered as an option in the new Ford Escorts (base price, $15,000).
Buyers who forgo this option can save $300. But buyers of the new BMW 740 (base
price, $70,000) have no choice in the matter. Their cars come equipped with CD player
whether they want them or not. Why this difference? And why are buyers of Ford
Escorts not given the option of saving even more money by ordering their cars without
heaters?
August 10, 1999
4
Micro-Q
PART II
A competitive flOn produces the vector of outputs Y 0 (y I' ... ,y.) using inputs
x 0 (x1, ... ,x.,) Its technology is described by the transformation function
F(y,x) c 0 where x _ ;)(1 The output price vector is P (pp''''P.) and the
input price vector is w =: (Vi\, ... ,w
m
)
(1) Define the pro fit function n(p, w) for this finn.
(2) ShoW that n(p,w) is homogennUS of degree one in (P,w)
(3) Show that n:(p,w) is convex in (p,w).
(4) Show that a generalized (to multiple outputs) version of Hotelling's Lemma holds for this
firm.
(5)
Oyi(P,W)
ls-
ap.
J
for all (p,w> O? Explain.
PART III
Consider a pure exchange economy with one physical commodity and two states. There
are two consumers i= 1,2 and the allocation for consumer i is denoted (Xi' yJ where Xi is
consumer i's amount of the good in the first state and Yi is his amount in the second state.
Consumer i's utility function is P ui(xJ + (l-p) ui(yJ where p is the probability of the first
state. Assume that 0 < p < I; ui(c) > 0, u
i
(c) < 0 for all c > 0; and, lim llj'(C) == +=
for all l.
CIO
Let the consumers' endowments be (wt,w/) for consumer I and (w
2
x
,w/) for
consumer 2. Assume that wt + w
2
x
::: w
t
Y
+ w/' so there is no aggregate uncertainty.
(1) Show that in any Pareto optimal allocation Xl == YI and X
z
= Yz
(2) Assume that there are complete markets. Find the competitive eqLlilibriu111
allocation and prices (Nonnalize prices so that they sum to I.)
(3) In parts (1) and (2) the answers do not depend on the consumer's utility functions.
Why?
(4) Suppose now that w/ + w/ ::: 2(wt + W2x), and u;(c;) = log c, for all i.
Find the complete markets competitive equilibrium price for the good contingent
on the first state. Is this price greater than or less than p? Why?
Micro-Q 6 August 10, 199()
PART IV
Consider a community consisting ofan odd number n citizens, indexed by i=l, ... ,n.
Citizens in the community consume two goods, a numeraire private good x and a public good
g. Each citizen has an identical endowment y of the numeraire and the public good can be
purchased from outside the community for a price (in terms of the numeraire) of p per unit.
Citizen i has preferences which can be represented by the utility function
ui(xl'g) = Xi + e
i
log(g), where e
l
< ... < en
(a) Suppose that the conununity provides the public good by voluntary contributions.
How much would be provided and how much \vould each citizen contribute?
(b) Now suppose that the community collectively finances the public good, with each
citizen paying lInlh of its cost. The level of the public good is detennined as
follows: each citizen is asked to repoli his desired level of the public good (given
the unifon11 financing) and the median of the reported levels is selected. Calculate
each citizen's desired level of the public good and prove that it is a Nash
equilibrium for each citizen to report his desired level truthfully.
(c) Prove that the public good level selected in this way has the property that it is
preferred by a majority of citizens to any other level.
(d) Does the public good level selected in this way maximize aggregate surplus?
Explain.
PART V
A risk neutral owner wishes to hire a manager to operate a project. If he undertakes the
project, the manager must choose an action from the set {a, ,a]}. The utility cost to the manager
of action a
i
is C
j
where c, < C
2
. The project yields a return for the owner of either Tell or
TeL where Te
H
> TeL' The probability that the return is Te
H
when the manager takes action J
j
is Yi where YI < Y2' The manager's utility of income fiJI1ction is u(y) == log y, so that ifhe
receives payment w for doing the project and undertakes action a; he obtains a payoff
log w - c
j
. The owner's problem is to choose a contact to offer to the manager. The manager's
reservation utility is 0, so that the contract must offer him at least this level.
(a) Under the assumption that the owner can observe the manager's action choice,
write down the necessary and sufficient cOIldition for the optimal contract to
involve the manager taking action a
2
.
(b) Prove that if the optimal contract in the unobservable action case involves the
manager taking action a
2
, then the payment the manager receives when the
project yields a high return exceeds that which he receives when it yields a low
return.
(C) Prove that if Y 2 == 1 the optimal contact in the unobservable case yields the
principal the same utility level as the optimal contract in the observable case.
June 4, 19Q9
we suggest that you not use your Cornell LD. number. Select an
finished, please write down-the total number of exam books you are
GOOD LUCK!!
PARTr
Choose four (4) of the six (6) questions from Part r.
1. Wired Espresso Bar (WEB) has been gradually adding to its stock of espresso brewing
machines, and it now has three machines available whose capacities and marginal costs
(including labor, materials, and other costs) are as given in the table below:
Machine
A
B
C
Capacity
20 cupslhr
50 cups/hr
200 cupslhr
Marginal cost per cup
$1
$0.80
$0.50
a) During WEB's busiest hour of the day, from 7 to 8 AM, it serves 260 cups of
espresso. During that hour, what is the marginal cost of serving a customer whose
espresso is brewed on Machine A? On Machine B? On Machine C?
b) Between 8 and 9 AM each day, WEB serves 220 cups of espresso. What is the
marginai cost of serving a customer during that hour?
c) Between 9 and 10 AM each day, WEB serves 50 cups of espresso. What is the
marginal cost of serving a customer during that hour?
2. There are two groups, each of whose members has a utility function given by
U(M) = 12 -1001M, where M = 100 is the initial wealth level for every individual. Each
member of group 1 faces a loss of 50 with probability 0.6. Members of group 2 each face
the same loss with probability 0.1. Both groups.have the same number of members.
a)
b)
c)
What is the most a member of each group would be willing to pay to insure
against this loss?
If it is impossible for insurance companies to discover which individuals belong
to which groups, will it be practical for members of group 2 to insure against this
loss in a perfectly competitive insurance market? Explain. At what price(s) will
the insurance sell? (For simplicity, you may assume that insurance companies
charge only enough in premiums to cover their expected claims payments.)
Explain.
At what prices would insurance be sold if insurance companies acquired a costless
test that can reveal each applicant's group identity with 90 percent accuracy? (If
the test says an applicant belongs to group i, the probability that he actually does
belong is 0.9.)
. I
I
Micro-Q 3
June 4, 1999
3. Kiplinger and Intuit are two rival firms in 'the tax-software industry. Each faces a choice
for the coming year between developing a simple tax-advice program or a comprehensive
one. The matrix below shows how the profits of each firm depend on the combination of
choices made by the two.
Kiplinger
Simple Comprehensive
Simple
III"" 120 III = 110
ilK"" 50 IlK = 200
Intuit
III = 220 III = 50
ilK = 120 UK "" 1 00
Comprehensive
a) Identify the pure strategy Nash equilibria of this game.
b) Suppose a uniquely talented programmer exists who would enable her employer
to bring its product to market before the employer's rival even had a chance to
choose its development strategy. Either firm's failure to hire this programmer
will result in her being hired by the other. If the programmer's decision rule is to
work for the highest bid_der and both firms are rational profit-maximizers, for
whom will the programmer work, and how much will she be paid?
4. You are searching for a job, and you know that by visiting an additional employer, you
are equally likely to be quoted a salary of $70,000, $80,000, $90,000, or $100,000. If the
cost of an additional visit is $6,000 and you are risk-neutral, what is your reservation
salary? (If you visit an employer that quotes a lower salary than the one you've already
found, you are free to work at the higher salary.)
5. A small village has six people. Each can either fish in a nearby lagoon, or work in a
factory. Wages in the factory are $4 per day. Fish sell in competitive markets for $1
apiece. If L persons fish the lagoon, the total number of fish caught is given by
F = 8L - 2L2. People prefer to fish unless they expect to make more money working in
the factory.
a)
b)
c)
If people decide individually whether to fish or work in the factory, how many
will fish? What will be the total earnings for the village?
What is the socially optimal number of fishermen? With that number, what will
total earnings of the village be?
Why is there a difference between the equilibrium and socially optimal numbers
of fishermen?
.1
Micro-Q 4 June 4. 1999
6, Tom and Karen are economists. In an atte'mpt to limit their son Harry's use of the family
car, they charge him a user fee of 25 cents per mile. At that price he still uses the car
more than they would like, but they are reluctant to antagonize him by simply raising the
price further. So Tom and Karen ask him the following question: What is the minimum
increase in your Vv'eekly allowance you would accept in return for having the fee raised to
50 cents per mile? Harry, who is a known truth-teller and has conventional preferences,
answers $20 per week.
a) If Tom and Karen increase Harry's allowance by $20/wk and charge him 50 cents
per mile, will he drive less than before? Explain, .
b) Will the revenue from the additional mileage charges be more than, less than, or
equal to $20/wk? Explain.
Micro-Q 5 June 4, i ')'1'1
Part II
A consumer who will Ii ve for two periods, t = 1,2, must decide how much to save at
t = I and how to invest this savings. The consumer has VNM utility for consumption in period
t, c
p
given by u(c
t
) = y -l(el for y < l. The consumer discounts future utility using
discount factor p, < p < I. The consumer has wealth $w at t = 1 and chooses a savings
rate s; so C
I
= (l-s)w. There are two assets, a = 1,2, in which this savings can be invested.
There are two possible states at time two, s = 1,2, with probabilities ql > 0, q2 >. 0. Asset a
pays off $1 in state s = a and $0 otherwise. The asset prices at time one are PI and Pl'
Consumption always has a price of $1 per unit. Let a be the fraction of savings, sw,
invested in asset 1.
(I) Show that the optima! savings rate, s', and portfolio choice, (a', I-a'), are
independent of w. Explain why this occurs.
(2) Show that as y 1 0 the optimal portfolio choice (a'(y), I-a'(y)) - (ql' q2)'
(3) Suppose that ql = ql and PI = P2' What is the optimal a? Does a reduction in the
common asset price cause the savings rate to increase or decrease?
PART III
An object is to be allocated to a player in {I, ... , n} in exchange for a payment. Player
i's valuation of the object (in monetary tenus) is Vi E [O,vi The values (v[, ... , v
n
) are drawn
independently from a commonly known distribution on [O,v]. Player i knows Vi but not
Vj for j to i.
The allocation mechanismrisa second price auction. Each player submits a bid fiom
[0, v] in a sealed envelope. The envelopes are opened and the player with the highest bid wins
the object and pays the second highest bid. rf there is a tie the high bidder with the lowest index
Il1 {l, ... , n} wins.
(1) Show that bidding Vi is a weakly dominant strategy for player I. Is this the unique
weakly dominant strategy? Explain.
(2)
(3)
(4)
Is bidding Vi a strictly dominant strategy for player i? Explain.
Suppose that in some nonnal fonn game G player i has a strictly dominant strategy,
Sj. Could G have a Nash equilibrium in which player i does not use Sj? What if
s
1
is i' s unique weakly dominant strategy? Explain.
Is there a Nash equilibrium of the Second Price Auction in which the object is not won by
the bidder with highest value? Explain carefully.
PART IV
Consider a private ownership exchange economy with 2 consumers indexed by
i E {1,2} and 2 goods indexed by I E {1,2}. Each consumer has consumption set m:.
Consumer I has preferences which can be represented by the utility function
0: 1-0:
U
1
(X
1
i':.sI) X
ll
x
21
' while consumer 2's preferences are represented by
Each consumer has an endowment of I unit of each good; i.e.,
((,) I I' (,)2) := (1,1) for i E {l,2} . Good 1 is the numeraire and the price of good 2 is denoted
by p.
(a) Find the Walrasian equilibrium for this economy.
(b) Suppose (hat the social planner does not like the Walrasian equilibrium allocation,
preferring instead the Pareto efficient allocation
(
X X"_) (2a 2(l-a and (x X"__ ) == ( P, )
11"-11 := a+pl2' l-a+(l-p)12 . 12'--1l 'a+pl2 l-a+(l-p)/2
in which consumer I has relatively more consumption. The Second Welfare
Theorem tells us that this allocation can be achieved as a price equilibrium with
transfers. Calculate the price p and the wealth levels WI and W
z
associated
with this equilibrium.
PART V
A risk neutral owner wishes to hire a manager to operate a project. If he undertakes the
project, the manager must choose an action from the set {ai' az}, The utility cost to the
manager of action ~ is C
j
where C
1
< c
z
' The project yields a return for the owner of either
TIH or TeL where TIH > Ttl' The probability that the return is TtH when the manager takes
action a
j
is Yj where YI<Yz' Themanager'sutilityofincomefunctionis u(y) = (y)I!2,
so that if he receives payment w for doing the project and undertakes action ~ he obtains a
payoff (W)112 - c
j
' The owner's problem is to choose a contract to'offer to the manager. The
manager's reservation utility is 0, so that the contract must offer him at least this leveL The
parameters satisfy the inequality Yz > YIC/C(,
(a) Under the assumption that the owner can observe the manager's action choice,
characterize the contract that the owner should offer the manager.
(b) Under the assumption that the owner cannot observe the manager's action choice,
characterize the contract that the owner should offer the manager.
(c) Prove that if the optimal contract in the unobservable action case involves the
manager taking action a
z
, then so does the optimal contract in the observable
action case.
August 17, 1998
1. You aTe identified by a number. The grading is meant to be anonymous, so
we suggest that you /lot use your Cornell LD. number. Select an
number on each exam book, NOT your name, and DO NOT sign your name
on the exam book( s) either.
fmished, please write down the total number of exam books you are
3. If you fmd any question ambiguous, explain your confusion and make
CleaTly state any additional assrnnptions you make.
GOOD LUCK!!
Micro-Q 2 August 17, 199X
PART I
I. A particular one-lane bridge (one that is wide enough to accommodate traffic in only one
direction at a time) takes one minute to cross. Beginning at exactly 12:00 noon, the first
car of a five-car caravan arrives at the bridge heading north. Each of the other four cars in
this caravan is 30 seconds behind the car ahead of it At fifteen seconds past noon, a lone
car arrives at the bridge heading south
(a) Assuming that alJ motorists share the self-interested goal of wishing to cross the
bridge with as little delay as possible, and that no motorist will enter the bridge if
another motorist has already entered from the opposite direction, at what time will
thc lone southbound motorist entcr the bridge'7 Explain.
(b) Motorists in Ithaca, which has severa! one-lane bridges, appear to follow a socia!
norm according to which no motorist enters a ollc-Iane bridge until all motorists
who have arrived earlier from the opposite direction have crossed. Under this rule,
at what time would the lone southbound motorist enter the bridge? If we measure
the social effIciency of each scheme by the total amount of waiting time it
produces, is the rthaca norm efficient'7 Exp!ain
(c) What property of the utility function might motivate the adoption of a norm like
Ithaca's?
2. You are going to buy a laptop computer, and you know that by visiting an additional
store, you are equally likely to be quoted a price 0[$1800, $1900, $2000, $2100, or
$2200. If the cost of an additional visit is $55, what is your reservation price for a laptop
computer? (If you visit a store that quotes a higher price than the one you've already
found, you are free to buy at the lower price.)
Cont'd --
Micro-Q J August [7, 1998
3. Gainesville, Florida, has three potential sources of water: an underground spring, a nearby
lake, and the Atlantic Ocean. The spring can supply up to I million gallons per day at a
cost of2 cents per gallon The lake can supply an additional 2 million gallons per day at a
cost of 8 cents per gallon. Additional water for the citizens of Gainesville must be distilled
from ocean water at a cost of 40 cents per gallon. lfthe demand curve for water is as
shown in the diagram below, how much should Gainesville charge a citizen whose water
comes from the spring? How much should it charge someone whose water comes from
the lake?
Price
(ceatslgal.)
'--____ --1'--______ Millions of gallons per day
1.5
4. The state has announced its plans to license two firms to serve a market whose demand
curve is given by P = 16 - Q. The technology is such that each can produce any given
level of output at zero cost, but once each firm's output is chosen, it cannot be altered.
(a) What is the most you would be wi!l[ng to pay for one of these licenses if you knew
you would be able to choose your level of output first (assuming your choice was
observable by the rival firm)?
(b) How much would your rival be willing to pay for the right to choose second?
5. There are two groups, each with a utility function given by U(M)== 1- (11M), where M == 4
is the initial wealth level for every individual. Each member of group I faces a loss of 2
with probability OS Members of group 2 each face the same loss with probability 0.2.
(a) What is the most a member of each group would be willing to pay to insure against
this loss?
(b) If it is impossible for outsiders to discover which individuals belong to which
group, how large a share of the potential client pool can the members of group I
be before it becomes impossible for a private company with a zero-proth constraint
to provide insurance for the members of group 2? (for simplicity, you may assume
that insurance companies charge only enough in premiums to cover their expected
benefit payments and that people will always buy insurance when its price is equal
to or below their reservation price.) Explain
6. Tom and Harry are trying to decide whether to share an apartment. To live separately,
each would have to pay $ IOOO/month in rent. An apartment large enough to share costs
$1800/month. Joint living produces two conflicts Tom smokes and Harry plays the
French horn, which disturbs Tom's sleep. Tom would be willing to pay up to $400/month
to avoid;having his sleep disturbed, and $200/mol1tl1 rather than give up smoking. Harry
would pay up to$500/month to continue playing his horn and up to $600/month to avoid
living with a smoker.
Will they live together? If so, describe how they should divide the rent so that each
benefits equally from the shared' living arrangement. If not, explain why no mutually
beneficial division of the rent is possible. (20 points)
August 17. 1998
5
Micro-Q
Part II
I. An individual with wealth w>O has to decide how much to invest in a risky asset The
net return on the risky asset will be one of the values { r; 1:0 r with probabilities {p;l :'0 r
The values r; are all greater than -w, some are negative and some are positive and
E[r;l>O If the individual invests 0 oflris wealth in the risky asset and return rr is
realized his wealth will be (W -0) + (I +rr)o 0 w + orr' The individual is an expected
utility maximizer with Bernoulli utility function u(') satislying: u'(w) > 0 and
u'(w)<O for all w>O. The Bernoulli utility function also exhibits increasing absolute
risk aversion
(a) Will the individual choose to iovest in the risky asset? Explain carefully or prove
your answer.
(b) How does the amount invested in the risky asset vary with the individuals wealth?
Explain carefully or prove your answer
Micro-Q 6 A ugllst I 7, ! 99l\
Part III
l. Consider an oligopolistic framework, with many identical potential firms, each with a cost
function, given by C( q) == c q, where c > 0, and q is the amount of the output it
produces. The inverse demand curve for the good is given by p = a - b q, where
(a, b) 0 .
Consider a two-stage entry game in this framework, in which firms decide "in" or "out"
in the first stage. If a finn decides to enter (that is, decides "in"), it pays a setup cost of
K > 0 rn the second stage, all firms that have entered play the Coumot game, and the
outcome is the unique symmetric pure-strategy Nash equilibrium.
Assume, in what follows, that b == I, c = I, K == I, and a ~ 4.
(a) If a == 4, show that in an equilibrium of this two-stage game, the number of
active firms in the industry equals 2.
(b) More generally, for a::: 4, denote by lea) the number of active firms in the
industry in an equilibrium of the two stage game Show that when the parameter,
a, belongs to the interval [n + 2, n + 3 ) For some integer n in the set
{2,J,4, ... }, then J(a) = n .
(c) For a::: 4, denote by pea) the price in an equilibrium of the two-stage game.
When the parameter, a, belongs to the interval [n + 2, n + 3) For some integer
n in the set {2,3,4, ... }, what is pea)? Explain.
(d) Draw a graph to indicate how the equilibrium price, pCa), varies with the
demand parameter, a, for a in the interval [4, 6). Show, with this graph,
that it is possible for the equilibrium price, pCa), to fall when the demand
parameter, a, rises.
I
Micro-Q 7 Augus( 17. (99){
Part IV
1. Consider a two-commodities (k == I, 2), two consumers (i == 1, 2) exchange economy,
in which each consumer's consumption set is m: Consumer 1 's preferences can be
represented by the utility function:
Consumer 2's preferences can be represented by the utility function
The total endowment of the exchange economy is W = (1, 1)
(a) Obtain the set of Pareto-Optimal allocations of this economy, and depict these
allocations in an Edgeworth box diagram.
(b) Suppose the endowment of consumer I is Wi = (0, I) and the endowment of
consumer 2 is W
z
= (1, 0). For prices (PI> P2) 0, denote (Pi / P2) by
p, and obtain the excess demand function of good I as a function of p,
showing your procedure clearly. Draw a graph of the excess demand curve.
(c) For the distribution of endowments indicated in (b) above, show that (PI"' pz') =
(1, 1), Xi" = ((1/3), (2/3, Xl" = ((2/3), (1/3 is a competitive equilibrium.
(d) Given the distribution of endowments (indicated in (b) above) is the competitive
equilibrium allocation, obtained in (c) above, unique? If so, prove it Otherwise,
find all other competitive equilibrium allocations, showing your procedure clearly.
Micro-Q 8 August! 7, 19(]X
PART V
A firm uses two inputs, Xl and xz, to produce an output, y, according to the production
function [(xl> x
2
) = y. The production function f m: -m. is twice continuously differentiable,
concave, increasing and [(O, x
2
) == 0 == [(XI' 0) for all X
2
E m ~ , Xl E m ~ . The firm purchases
input one in a competitive market at price WI > 0 The price per unit that the finn pays for input
two is given by the function wlx
2
) where w
2
: m ~ - 8i t is twice continuously differenti'able
, " I
with W
z
(x2) 2: 0 and w
2
(x
2
) 2: 0 for all X
2
E m+
The cost function for this firm can be written as
WI Xl t wzCX
Z
)X
2
s.t. [(X
I
,X
2
)
where the argument w
2
c) indicates that cost depends on the input price function wk).
1. Consider the claim C(awl' awl'),y) = aC(wI' wi'),y) for all a> 0. [s this claim true?
If so, prove it If not, explain why not
2. Does Shepard's Lemma-hold for inputone? Explain carefully or prove.
3. In the usual, competitive case in which wz(x
2
) = Wz, a constant, we know that if the
production function exhibits constant returns to scale than the cost function is homogenous
of degree one in output. Is this true for general wzCx
2
)? Explain.
4. Suppose that W
2
(X
2
) = ax
z
for a> 0 and that [(xI> Xl) =xt Xz for alP> 0, a + P ~ 1.
Compute the firm's cost function.
June 5, 1998
1. You are identified by a Ilmnber. The grading is meant to be anonymous, so
identifying number and keep a record of it for your infonnation. Put that
number all each exam book, NOT your name, and DO NOT sign your name
GOOD LUCK!!
I
Micro-Q 2 June 5, 1')98
PART I
Choose five (5) of the six (6) questions below:
1. You have just inherited the secret fonnula for a new drug that improves perfonnance on
the SATs. The drug has no other effect and you are the only one who can supply it. Each
of the drug's I million potential customers has the demand curve shown below. Your
marginal costs of producing and selling the drug are constant at $4/0unce. Your only
other costs are $2 million annual fixed costs for your manufacturing and sales facility.
Your goal is to maximize your economic profit.
P ($Iounce)
12
4 I - - - - - - - ~ - M C
D
12 Q (ounces/year)
(a) If you must sell the drug at a single price to all customers, how many ounces per
year will you sell at what price, and how much economic profit will you make?
(b) Now suppose you can charge each customer a fixed annual membership fee to
belong to your buyer's club. Membership entitles the member to buy as much of
the drug as he pleases at a constant fee per ounce. Nonmembers cannot buy the
drug at all. What is your profit-maximizing membership fee and charge per ounce,
and how much economic profit will you earn?
2. Einar Torvaldson, proprietor of Moose Lake Summer Cottages, rents to customers who
want the inside temerature of their cottages to be constant at 70 Fahrenheit. The outside
temperature in the community of Moose Lake is invariably as shown in the graph below
during the 8-week summer seai)on.
Outside Temperature
(degrees Fahrenheit)
and
10 51- - - - - - - - - - - - - - - - -
9 51- - - - - - - -
- --
85
70
I
I
I
I
I
I
I I
I
I
I
I I
I
I I
Week
2 3 4 5 6 7 8
Torvaldson is about to install a central air-conditioning system to serve his cottages.
Cooling units come in two types, diesel-powered and electric-powered. The cooling
capacity of each type (measured by the number of degrees Fahrenheit by which it can cool
the air inside Torvaldson's cottages) is continuously variable ex ante, but once chosen is
fixed for the entire summer season.
The annual costs of the two types are as follows:
where Ko and KE are the respective cooling capacities of the two types, measured in
degrees Fahrenheit, and QD and Q
E
are the respective amounts of cooling contributed by
each type, measured in degree-weeks (For example, a diesel unit capable of reducing the
inside temperature from 85 to 70 would have a capacity of 15 degrees and would cost
15($50)=$750 to lease for the season; its operating cost would be $2(15)=$30 per week;
the corresponding figures for the electric unit would be $150 per season and $150 per
week.)
(a) IfTorvaldson's goal is to minimize the cost of air conditioning his cottages, how
much of each type of capacity should he instalI, and what will be his total cooling
cost for the season?
(b) Scientists predict that global warming will come in the form of a two-week stretch
oflOSo weather beginning with week I, with no other changes. If this prediction
holds true, and Torvaldson responds optimally to it, by how much will his seasonal
cooling costs increase?
J. A crime is observed by a group of N people. Each person would like someone to calland
report the crime, but would rather it be someone else. Each person can either call or not.
Suppose each person's payoffs are as follows: 0 to any pure strategy profile in which no
one calls; 3 to any pure strategy profile in which she calls; 4 to any pure strategy profile in
which she does not call but someone else does.
(a) This game has N pure strategy equilibria In equilibrium n only person n caUs.
These are not attractive equilibria because identical people are treated differently.
There is also a symmetric mixed strategy equilibrium in which each person has the
same probability p of calling Find it.
(b) What is the equilibrium probability that no one caUs to report the crime?
4. Merlin is like all other managers in a perfectly competitive industry except in one respect:
because of his great sense of humor, people are willing to work for him for half the going
wage rate. All other firms in the industry have short-run total cost curves given by
STC(Q) = M + 8Q + wQ2, where M is the salary paid to ordinary managers and w is the
going wage rate for the industry. The firm that hires Merlin will have short-run total cost
curve STCm(Q) = M.n + 8Q + W Q2 where ~ is the salary paid to Merlin. If all firms in
2
the industry face an output price of 40, and ifw = 4, how much more will Merlin be paid
than the other managers in the industry?
5. In his current job, Smith can work as many hours per day as he chooses, and will be paid
$11hr for the first 8 hr he works, $2.501hr for each hour over 8. Faced with this payment
schedule, Smith chooses to work 12 hr/day. If Smith is offered a new job that pays
$1.501hr for as many hours as he chooses to work, will he take it? Explain.
6. A monopsonist's demand curve for labor is given by w = 18 - 2L, where w is the hourly
wage rate and L is the number of person-hours hired.
(a) If the monopsonist's supply (AFC) curve is given by w = 2L, how many units of
labor will he employ and what wage will he pay?
(b) How would your answers to part a be different if the monopsonist were confronted
with a minimum wage bill requiring him to pay at least $81hr.
Micro-Q - 5 -
Part II
Consider the extensive fonn game:
Quit
Play
2
L R
r
(1) Find all (pure strategy) Nash equilibria.
(2) Find aU (pure strategy) subgame perfect Nash equilibria.
(3) Change the payoff vector (-1,3) to (1,3). Find all (pure strategy) Nash and
subgame perfect Nash equilibria of this game.
June 5, 19n
(4) The only change to the game in part 3 was an increase in 1 's payoff. Explain how
this affects the sets of equilibria.
Micro..() 6 June 5, 1998
PART III
A consumer with income )'" > 0 faces prices pOE m:
t
and enjoys utility U
O
= v(po,)"').
When prices change to pi, the cost ofliving is affected. One way to measure the impact of
price changes is to define a cost of living index as
= e(p I,U 0)
e(p o,u 0)
where e(p,u) is the consumer's expenditure function Assume that the consumer's utility
function is continuous and that it represents locally nonsatiated preferences on m:.
(a) Suppose the consumer's preferences are represented by the utility function
U(X
l
,X
2
) = (Xl)1n + x
2
Let pO = (1,2), y" = I 0 and pl = (2,1). Compute the
index.
(b) Would the value of the index you computed in part 1 change if the consumer's
preferences were represented by a((xl)ll2 + x
2
) for some a>O? Explain.
(c) Show that if the consumer's preferences are homothetic then the index is
independent of the initial utility uo.
Micro-Q 7 June 5, 199R
PART IV
The owner of a finn wishes to hire a manager for a one-time project. The manager has two
possible effort levels, e
l
= I Of ez = 2. The owner's gross profit level is RI =:= to if the
project is successful, and it is R2 = 0 if the project fails. The probability that the project will be
successful is o. I if the manager puts in effort level e
l
= 1, and it is 0.5 if he puts in effort
level ez = 2.
The manager's utility function is given by:
u(w,e) = .fW - e
where w is the wage received and e the effort level. The manager's reservation utility is
u = o.
The owner is risk-neutral and wishes to maximize expected net profit (gross profit minus wage
payment to the manager).
(a) Assume that the owner can observe the effort level of the manager. Show that the
owner will write a contract so that the manager puts in effort level e
2
= 2.
(b) Assume, now, that the owner cannot observe the effort level of the manager.
Show that the owner will write a contract so that the manager puts in effort level
e
l
= 1.
(c) Suppose, now, that the manager can choose between three effort levels, e
1
= 1,
ez = 2, and e
3
= 3. The probability that the project will be successful, when the
manager puts in effort level ~ = 3, is p, where 0.5 < P < 1. [The probability
that the project will be successful when the manager's effort level is e
1
= 1 (resp.
ez = 2) is 0.1 (resp. 0.5), as described above.] Show that if the owner can
observe the effort level of the manager, she will write a contract so that the
manager puts in effort level ez = 2.
(d) Continue to consider the situation described in (c) above, but now suppose that the
owner cannot observe the effort level of the manager. Is it possible in this
situation that the owner will write a contract so that the manager puts in effort
level ez = 27 Explain.
(e) Continue to consider the situation in (d) above. Show that if p is sufficiently
close to 1, the owner will write a contract so that the manager puts in effort level
e
3
=:: 3. [Hint: Consider what happens if p is sufficiently close to 1 (say 0.99)
and the owner offers a contract to the manager in which the manager is paid a
wage close to, but less than, 10 (say, (3.1)2 = 9.61) in case the project is
successful, and a wage of 0 otherwise. J
PART V
Consider an economy with n ~ 3 consumers, indexed i = 1, ... ,n, a private good (y) and a
public good (x). The utility function of each consumer is given by:
for all
2
(x, y) E m.
The endowment of consumer i is (0, aJ where 3; > 0; thus, consumers have positive
endowments of the private good and no endowment of the public good. Assume that the
n
distribution of endowments satisfies a, < ~ < .. , < ~ and L a
i
> (n + 1)a
1
.
i=t
The public good can be produced from the private good. Assume that in order to produce an
output of z ~ 0 units of the public good, one needs an input of z units of the private good.
Production of the public good is carried out by a "Public Good Board." The Board asks each
consumer to voluntarily contribute some of their private good endowment for the purpose of
public good production. Let C
i
denote the voluntary contribution of consumer i. Then C
i
E
[0, a;] for each i = 1, .. ,1. The Public Good Board will use the total contributions collected as
input in the public good production. Thus, given the production possibilities described above,
(c
1
+ ." + cJ of the public good will be produced. This rule is made known to the consumers.
Recall that a voluntmy contributions equilibrium (VCE) is a vector (ct, ... ,c
n
) such that
(i) 0 SCi' S 3; for all i = 1, ... ,n
(ii) For each i = 1, ... ,n,
+ c
i
' a
i
- c) :s uj(L c
j
* + cj*, a
i
-C
j
*)
j .j
for all c E[O a.]
I ' I
(a) Showthatif (c,, ... ,c
n
") isaVCE,then cj"<a; foreach i=I, ... ,n and
n
L c
j
* > O.
i= 1
(b) Show that if (c,", ... , c
n
*) is a VCE, then there is an integer m, satisfYing
2 S m < n, such that ~ " > 0 for i E {m, ... ,n}, and ~ " = 0 for
i E {l, ... ,m-l}.
(c) Assume that n = 3, and at = O. 9, ~ = 2, ~ = 3.1. Show that in a voluntary
contributions equilibrium (c
t
", Cz", ~ *), the amount of public good production is
x"= 1.7.
Micro-Q 9 June),I')'JX
(d) Continue to assume n = 3, but suppose now that the distribution of endowments
is given by a
l
= l. 2, Ci-z = 2, ~ = 2.8. [Notice that this distribution of
endowments can be obtained from the distribution of endowments in (c) above by
transferring income from the rich to the poor.] Show that in a voluntary
l
', ~ ' , C:J'), the amount of public good production
falls to x' = 1.6.
(e) Assume n= 3 and (a) / 2) < Ci-z. Show that there is a unique VCE, and solve
for it explicitly, showing your procedure clearly.
Micro-Q
JU11\'" _', " . I ' ' ' ~ '
(d) Continue to assume n = 3, but suppose now that the distribution of endowments
is given by a, = 1.2, ~ = 2, <l:! = 2.8. [Notice that this distribution of
endowments can be obtained from the distribution of endowments in (c) above by
transferring income from the rich to the poor. J Show that in a voluntary
l
', Cz', C:J ,), the amount of public good production
falls to x' = 1.6.
(e) Assume n = 3 and (a)/2) < ~ . Show that there is a unique VCE, and solve
for it explicitly, showing your procedure clearly.
August 14, 1997
1. You are identified by a number. The grading is meant to be anonymous, so we
suggest that you not use your Cornell LD. number. Select an identifying
number and keep a record of it for your infonnation. Put that number on each
exam book, NOT your name, and DO NOT sign your name on the exam
book( s) either.
2. Each part must be answered in a separate exam book. When you are finished,
please write down the total number of exam books you are submitting, and get
the number verified by the proctor.
assumptions you think are necessary to answer the question. Clearly state any
additional assumptions you make.
GOOD LUCK!!
Microeconomics Exam August 14, 1997
PART I
1. For many years, Disney World charged a single entrance fee that entitled visitors
to use all rides for ''free,'' a policy that resulted in hour-long waiting lines for the
most popular rides.
a. If all consumers are rational in the way they spend their incomes, is the
Disney pricing policy optimal? Explain.
b. At the urging of its microeconomics consultant, Disney raised the price
on its most popular rides until the lines were eliminated. As a result,
parents complained bitterly and park attendance dropped precipitously.
Why do you think parents complained? Does the consumer reaction to
the new pricing policy invalidate your answer in part a?
2. A number will be drawn from the uniform distribution on [0, 100]. A risk-
neutral individual who knows the distribution is invited to submit a bid before
the drawing. If the bid is less than or equal to the number drawn the individual
wins a dollar payoff equal to the bid. Otherwise she wins nothing.
a. What is the optimal bid?
b. Would the person bid more or less if she were risk averse? Explain
carefully or prove your answer.
3. Smith and Jones are trying to decide whether to share an apartment. To live
separately, each would have to pay S500/mo. in rent. An apartment large
enough to share can be rented for $800/mo. Costs aside, they are indifferent
between living together and living separately except for this problem: Smith likes
to play his stereo late at night, which disturbs Jones's sleep. Smith would
sacrifice up to $JOO/mo. rather than stop playing his stereo late at night. Jones
would tolerate Smith's stereo in return for a compensation payment not less than
S150/mo. Should they live together? If so, indicate how they can split the rent
so that each benefits equally relative to living alone. If not, explain why no such
arrangement is feasible. '
Micro-Q - J - August 14, 1997
4. There are two occupations in Islandia, potting and singing. Each person must
choose between working as a potter for a wage of 100 or competing for one
recording contract that pays W(R) = 2000(R)1f2, where R is the number of
people who . compete for the recording contract. Losers in the smgmg
competition eam zero. There are 1000 identical people in Islandia.
a. If people are risk neutral, how many will compete for the recording
contract and what will be the resulting level of national income?
b. What is the socially optimal number of contestants and the corresponding
level of national income?
c. Find the socially optimal tax on the winning singer's income?
5. The market demand curve for mineral water is given by P = 10 - Q. There are
two firms that produce mineral water, each with a constant marginal cost of 2
per unit. Firm 1 is a Stackelberg leader, Finn 2 a Stackelberg follower. Find
:'each fum's output level, profit, and the market price for mineral water.
6. In March, Charles was accepted to the University of Wisconsin's MBA
program, to which he sent the required nonrefundable $2000 deposit, which will
'be deducted from his tuition when (and if) he enrolls. Then in May, he received
a letter advising him that he had been accepted from the waiting list at Cornell's
lohnsonSchool. Forfeiting the $2000 deposit is the only cost associated with
turning Wisconsin down in May. If Charles had known in advance he would be
accepted by the Johnson school, he would have chosen it over Wisconsin.
TRUE or FALSE:
If Charles is rational, he will go the Johnson School anyway. Explain.
Micro-Q - 4 - August 14, 1m
PART II
. Consider an economy with two goods (xl' X2) E with prices (PH p21 E m
2
+to
There are two rational consumers, a and b, with incomes (ma' mb) E m
2
+to Consumer
a has functi?n V.(p., P2' mJ = c. + lny + ain PI + Pin P2- Consumer
b has llld4"ect utility functIOn V b(PI' P2' mb) = Cb P IP 2
m
b-
C
a
' Cb' a, 13, y, and () are constants.
1. Compute the Slutsky substitution matrix for consumer a.
2. What restrictions on C
a
, a, and p are implied by the statement that Va is an
indirect utility function for a rational consumer? Explain carefully or prove your
answer.
3. In this economy aggregate income is always shared in a fixed proportion; m/mb
= E for some number E. Does there exist a positive representative consumer for
tIlis economy? Explain carefully or prove your answer.
Micro-Q - .s - August 14,1997
PART III
A landlord wishes to hire a tenant to farm his land to produce food grain. The
tenant has only two possible effort levels, eH == 2 (high) or er- == I (low). Because of the
uncertainty of weather conditions, the food grain production and consequently the gross
profit level of the landlord can fluctuate (given the effort level of the tenant). Assume,
for simplicity, that the gross profit level of the landlord can take one of three values,
R
1
, R
2
, R
3
, where Rl < R2 < R
3
. The probability of obtaining gross profit level
R
i
(i=1,2,3) when effort level is jG==1,2) is denoted by PiG), where PiG) > 0 for all i, j.
Denote by FG) the cumulative distribution function corresponding to effort level j,
where j==l,2.
TIle tenant's utility function is given by:
u(q,e) == y(q) - e
whereq is the payment received by the tenant and e is his effort level. Assume that y
is twice continuously differentiable, with y' > 0 and yH < O. The tenant's reservation
utility is u *.
The landlord is risk-neutral and wishes to maximize expected net profit (gross
profit minus payment to the tenant). Assume that he 'cannot observe the effort level of
the tenant, but would like the tenant to work hard.
(a) Write down the optimization problem that the landlord must solve, in order to
find the optimal contract.
(b) Show that the optimal contract cannot have a constant payment to the tenant,
independent of the gross profit level.
(c) Suppose pt(l) = 0.2, P2(1) = 0.3, P3(1) = 0.5; and pt(2) = 0.1. Assume that the
cumulative distribution function F(2) first-order stochastically dominates the
cumulative distribution function F(l). Find the interval of values to which Pl(2)
must belong.
(d) Continue to assume the information provided in (c) above, and that F(2) first-
order stochastically dominates F{l). Find the range of values Ofp2{2} for which
the payment to the tenant is not monotonically increasing in the gross profit, in
the optimal contract.
Micro-Q - 6 - August 14,19'91
PART IV
Two bidders. i = 1,2 will bid for a single object in a second price auction. Let
the value of the object to bidder i bedenoted VI. Assume that Vi and VI are drawn
independently according to a strictly positive density ron [0, I). Both bidders know f,
but each bidder only observes his own draw of a value. In the auction the bidders
simultaneously submit sealed bids. The object is awarded to the bidder who submits
the highest b i d ~ this bidder pays a price equal to the second highest bid. The low
bidder pays nothing. If both submit the same bid each gets the object with probability
Yz and the bidder who gets the object pays the common bid (the other bidder pays
nothing).
1. Write down the game described above.
2. Show that bidding Vi is the unique weakly dominant strategy for bidder i.
3. Suppose instead of the second price auction we now use a first price auction.
In this auction the object is awarded to the bidder who submits the highest bid.
This bidder pays his bid and the other bidder pays nothing. If both bidders
submit the same bid each gets the object with probability Yl and the bidder who
gets the object pays the common bid (the other bidder pays nothing). Are any
strategies weakly dominated in this game? Explain carefully or prove your
answer.
".-t.
Micro-Q - 7 - August 14, 1 m
PART V
Cons(der a two-commodities (k = 1,2), two consumer (i = 1,2) exchange
economy, in which commodity 1 is a divisible good, but commodity 2 is an
indivisible good. Denote by N the set of non-negative integers {O,I,2, . }, by P
the set m
1
++> and by Q the set m+ x N. Each consumer's consumption set is Q.
Consumer 1 's preferences can be represented by the utility function:
Consumer 2's preferences can be represented by the utility function:
The endowment vector of Consumer 1 is (0, 5), and the endowment vector of
Consumer 7- is (14, 0).
Denote by P = (PI, P2) the price vector of the two commodities. For P in P,
denote by z(p) the excess-demand function (correspondence) of this exchange
economy.
(a)
(b)
(c)
(d)
(e)
For P in P, does the excess.demand function z(p) satisfy WaIras Law? Explain.
* * * * * * .
Show that (x 11' x 11) = (6, 2), (x 11' x 21) = (8, 3), (p 17 p 1) = (1, 2) IS a
Walrasian equilibrium of this economy.
For p in P, obtain the excess demand function of commodity 2 as a function of
p. Draw this excess demand function in an appropriate diagram.
Is there any Walrasian equilibrium of this economy other than that descnbed in
(b) above? Explain.
Is the allocation corresponding to the Wrurasian described in (b)
above, Pareto Optimal? Explain.
June 6, 1997
we suggest that you not use your Cornell J.D. number. Select an
identifying number and keep arecord of it for your information. Put that
GOOD LUCK!t
Micro-Q - 2 - JWle 6, 1997
Microeconomics Exam June 6, 1997
PART I
1. NBC is trying to decide between two programs for a late night time.slot: Bookworld (a
talk show about non- fiction books) and Lifestyles of the Rich and Famous (interviews
with celebrities at home). The market research department estimates that the viewer
demand curve for Bookworld is given by P=20-5Q, where P is the price viewers pay for
the program in dollars and Q is millions of viewers. The corresponding demand curve for
Lifestyles is P=8-Q. The total cost of producing the program is the same in the two cases,
and the marginal cost of serving extra viewers under both free TV and pay-per-view is
zero.
a. If the program chosen is to be financed solely by the sale of advertising slots on
free TV, which will NBC choose? Explain carefuUy.
b. Ifthe program is to be financed solely by the sale of pay-per-view subscriptions
and NBC sets its price as a single-price profit-maximizing monopolist,
which program will NBC choose? Explain carefully.
c. Describe the potential sources of inefficiency inherent in each financing method.
Which is more serious? Explain carefully.
2. Thomas John is the proprietor of a steak house that has only one entree on the menu: steak
and potatoes. He knows that each of his potential patrons has a reservation price of $40 for
the steak dinner, and a demand curve. for wine given by P=24-4Q, where P is the price per
glass of wine in dollars and Q is the number of glasses consumed per meal.
If the marginal cost of wine is $3 per glass and if all potential diners know the restaurant's
selling price of wine before going to dinner, how much should Thomas charge for the steak
dinner and how much per glass of wine if his" goal is to maximize profit?
3. An economy has n consumers, i=l, ... ,n, each with indirect utility function
v i(p, I i) = a i(p) + b(p)I i ,
where p E + is consumer i' s income. Prove that the aggregate demand for good j depends
n
on p and I = L Ii.
i=1
- 8 -
PART V
A firm produces output in two periods, 1 and 2, using the production functions:
= L 113 K 113
q1 1
q2 = ~ 1 1 3 K 113
where qt is output in period t, L
t
is labor input in period t and K is capital stock. The capital stock,
K, is purchased exactly once before production begins and can be used in both periods. Labor is
purchased in each period. The price of output is p in both periods, the price of labor is w in both
periods and capital costs 1 per unit. The interest rate is zero and the firm's objective is to maximize
total profits.
(a) Find the profit maximizing levels ofK, Ll and ~ .
(b) Compute the fum's cost function, C(ql,qZ'W). What is the marginal cost of ql? Why
does it depend on q2?
(c) Suppose now that the firm has selected the optimal capital stock K and that period
1 is over. In period 2, the price of output unexpectedly changes to P2' Compute the
firm's period 2 output supply as a function of pz, wand, p (the originally conjectured
output. price for both periods).
June 10, 1996
1. You are identified by a number. TIle grading is meant to be anonymous, so
identifying number and keep a record of it for your infonnation. Put that
on the exam book( s) eitiler.
submitting, and get the munber verified by the proctor.
GOOD LUCK I!
Microeconomics Exam June 10, 1996
PART I
1. Lifetime income for an individual who could obtain a Cornell Ph.D. in economics
is i = 8
0
+ ee where e is 0 vdthout the degree and 1 with the degree, 8
0
> 0 and e
is randomly distributed over [0,8}. The random income term is observed only after
obtaining the Ph.D. The individual's von Neumann-Morgenstern utility is u(I) which is
strictly concave and strictly increasing. Tuition T is, currently paid in a lump Supl out of
8
0
, 8
0
>T. At the current level of tuition, T, the individual is better off with a Cornell
Ph.D. than without one.
Cornell will offer a new tuition plan where the individual pays a from 8
0
and
then pays a fraction b oftlle increase in income, e, due to the Ph.D. The individual can
choose any a and b such that 0 ~ a ~ 8
0
, 0 ~ b ~ 1 and a + bE[8} = T. What tuition
plan will be chosen if she is a good economist? Justify your result.
2. Abner is offered a choice between the following two gambles.
Gl: He draws a ball from urn #1,. known to contain 50% white balls and 50%
red balls. If he draws a white ball he wins $1000, and otherwise nothing.
G2: He flips a fair coin: if the result is Heads he draws a ball from urn #2, if Tails
from urn #3. Urn #2 contains 80% white balls, and urn #3 has 20% white balls - so, on
average, G2 also involves a 50% chance of getting a white ball. Once again, he wins
$1000 only if he ends up with a white ball.
If Abner definitely prefers G 1 over G2, is he necessarily violating expected-utility theory -
or might his answer, consistent with expected-utility theory, depend upon his attitudes
toward risk? Explain.
3. A consumer buys 7 units of X and 3 units of Y when the price of X is 1 and the
price of Y is 1. The consumer buys 4 units of X and 12 units of Y when the price of
X is 2 and the price of Y is Yl. Assume that X and Y are the only goods and that the
consumer spends all of his income. Could this consumer be a utility maximizer? Explain
briefly.
Micro-Q - J - June 10, 199(j
4. Smith must choose between two careers - investment banking and manufacturing. Ifhe
chooses manufacturing his wealth will be 14,400 with probability L JIhe chooses
investment banking, his wealth will be 1,000,000 with probability .01 and 10,000 with
probability .99. These are his only two career options. Smith is an expected-utility
maximizer whose von Neumann-Morgenstern utility function is given by U = /W, where
W is his wealth.
(a) Which careet has the higher expected income and which should Smith choose?
(b) Suppose there is an infinitely elastic supply of perfect prognosticators, anyone of
whom can conduct a briefintemew with Smith and discover, with probability 1,
what will happen if Smith chooses investment banking. The prognosticators are
risk neutral, always teU the truth and each has an opportunity cost of 100 per
interview. If prognosticators are able to use a contingent pricing scheme (i.e., one
in which the interviewee's payment depends on the outcome of the interview),
what will be the equilibrium fee structure?
-S. You have just purchased a new Ford Taurus for $25,000. Now you learn that Toyota is
offering its Camry, which normally sells for $28,000, at a special sale price of$26,000. If
you had known before buying the Taurus that you could buy a Camry for that price, you
would have definitely chosen the Camry. Your Taurus is new, and the dealer has offered
to purchase it back from you for $24,000, True or false: From what we are told of your
preferences, it follows that if you are a rational utility max:im.iZer, you' showddefinitely sell
back the Taurus and buy the Carmy. Explain.
6. Kim regards butter and bread as perfect complements - one pound of butter per loaf of
bread. Butter costs $2/lb.
(a) If she spends a total of$16 per week on butter and bread combined, draw both her
price-consumption and demand ClJIVes for loaves of bread.
(b) Ifbread and butter are the only two goods Kim consumes, calculate her Laspeyres
(CPI-type) cost of living index when the price of bread rises from $2 to $3 per
loaf
( c) Is the index you calculated in part (b) greater than, less than, or exactly equal to
the true increase in Kim's cost of living?
Micro-Q 4 - June 10,19%
PART II
Srllith has a child we will call I r who he cares for deeply, while I r only cares about himself
In particular, Smith's utility, denoted Us, is given by Us = (W s- + U
Jt
, while Ir's utility is
given by U
jT
= (WJr+T)H. Above Ws denotes Smith's wealth, W
jt
denotes Ir's wealth and T
denotes a transfer (gift) that Smith gives to Jr.
Assume W s >- W
jt

(a) Derive the equilibrium transfer as a function of \V s and W
Jt
.
Suppose now that lr can spend money on a vacation prior to Smith choosing his
transfer, and that Ir's utility is now given by U
Jr
== V + .
(b) Derive a first order condition which characterizes lr's choice of V. Assume that
Ir knows the manner in which Smith chooses T.
(c) Is Ir's choice of V characterized in (b) "optimal" from the family's viewpoint?
Discuss why or why not.
(d) Suppose Smith could make a binding announcement concerning his choice of T
prior to J r' s choice of V. How would that change the problem? In particular,
could Smith make both himself and Ir better off?
Micro-Q - 5 - June 10, 1996
PART III
The population consists of two groups of agents, denoted groups 1 and 2, where all
agents have the same utility function: U = w
lll
withW denoting wealth. A proportion p of
the population is in group 1, while a proportion (l-p) is in group 2. Agents in group 1 have a
probability of accident equal to Yz, while agents in group 2 have a probability of accident equal
to 114. All events are independently distributed. All agents begin with an initial wealth level of
100 and an accident costs 72.
There are two risk neutral insurance inns whose only cost of providing insurance is the
pay-out in case of an accident. We will study pure strategy subgarne perfect Nash equilibria of
the following game:
Stage 1: Each finn simultaneously announces a set of contracts. A contract is a pair (a,b)
where a is the payment from the firm to the agent if an accident occurs and b is the payment
from the agent to the fiml if an accident does not occur.
Stage 2: Given the contracts offered, each agent chooses whether to accept any contract
and if so which one. If any agent is indifferent between any two contracts she randomizes.
I. Assume that whether an agent is in group 1 or group 2 is observable. Find the
equilibrium contract for each group. Callthese contracts (al,bl) and (a2,b2) for
groups one and two, respectively.
2. Suppose now that no agents identity is observable:
(i) Is the contract structure that you found above, (al,bl) and (a2,b2), an equili-
brium? Explain.
(li) Is there an equilibrium involving just one common contract offered by each fum?
Explain.
(iii) Assume that an equilibrium exists. Find the contract that is purchased by members
of group 1. Characterize the contract that is purchased by members of group 2
(you do -not need to solve explicitly for this contract).
Micro-Q - 6 -
PART IV
Consider an exchange economy with two consumers, indexed i ~ 1,2, and two
commodities, indexed j = 1,2.
The preferences of consumer 1 can be represented by the utility function:
for all
and the preferences of consumer 2 can be represented by the utility function:
for aU
where 0 < a < b < 1.
JW1C 10,19%
The endowment vector of consumer 1 is WI = (2,1) and the endowment vector of
consumer 2 is W
1
= (1,2).
(a)' Obtain the set of Pareto Optimal allocations of this exchange economy, and depict
these allocations in an Edgeworth box economy.
(b) For positive prices PI> 0 and Pl > 0, denote (PI! Pl) by r. Obtain the excess-
demand of commodity 1 as a function of r.
(c) Obtain a competitive equilibrium for the exchange economy, showing your
procedure clearly.
(d) A tax-transfer system is now instituted according to the following rule: the
consumer with wealth above the mean of the population must contribute half of the
excess over the mean to the consumer below the mean. Obtain the new excess-
demand function for this exchange economy.
(e) Obtain the new equilibrium (with tax-transfers) for this exchange economy,
showing your procedure clearly.
(f) Is the equilibrium allocation, obtained in ( e) above, a Pareto Optimal allocation?
Explain.
Micro-Q 7 June 10, 19%
PART V
Consider an industry in which 0 firms produce goods which are perfect substitutes. The
cost function for finn i, i=l, ... ,o, is givenby
C(qJ = yql
where ql is fim) i's output and y>O.
The market demand is given by
D
P == a -P L q,
1=1
where p is the market price and a, P>O. Assume that cPy.
The fiffils are quantity setters and play an infinitely repeated game with conunon discount
factor 0,0<0 <1.
1. Find the (symmetric, pure strategy) Nash equilibrium of the stage game.
2. Suppose that in any collusive agreement the inns produce equal outputs and split profits
evenly. What is the maximum profit per finn that can be obtained by a collusive
agreement in the stage game?
3. Suppose 0=2 and 0=.75. Can the profits per firm that you found in (2) be supported in
a subgame perfect equilibrium of the infinitely repeated game where strategies are trigger!
Nash reversion strategies? What is the minimum 0, for 0=2, for which this can be
done?
4. Now suppose that 0 is fixed with 0<0<1. Show that as 0 ....
00
the per fum profits from
(2) cannot be supported in any subgame perfect equilibrium of the infinitely repeated game
where strategies are triggertNash reversion strategies.
August 16, 1996
we suggest that you flat use your Cornell 1.0. number. Select an
identifying number and keep a record of it for your info nnation. Put that
on the exam book(s) either.
3. Note: To simplify decision making there is no choice on this exam. Do all
parts and subparts.
GOOD LUCK!!
lvficroeconomics Exam August 16, 1996
PART I
1. Suppose that reckless driving imposes costs (in the form of medical bills) on both the
drivers themselves and on pedestrians. Each unit [e.g., thousand miles J of reckless driving -
costs drivers $1 and pedestrians $0.25. The marginal value to drivers of their reckless
driving is indicated by the dOwnward sloping curve in the foUowing figure:
$ per mile
S l.50
$1.25
B
F
S1.00
J
$0.75
G
K
P
SO.50
L 0
Q
R S
T
MV
2 3 4
U nits of Recl.:Iess Driving
Suppose that we look only at total surplus and that transactions costs are zero.
a) In terms oflabeled areas on the graph, what is the social gain from reckless
driving?
. b) Suppose that you could require drivers to pay all the pedestrians' medical
bills. According to the graph, how much would social gain increase?
In the remainder of this problem, suppose that drivers can acquire air bags which reduce
the cost (to them) of their reckless driving from $1 per unit to $0.50 per unit. The cost to
pedestrians remains $0.25 per unit regardless of.whether drivers use air bags, and
pedestrians pay their own medical bills.
c) Suppose you want to predict whether having air bags will increase or
decrease drivers' medical costs. Which areas would you want to measure
and compare?
d)
-\
Suppose you want to know whether air bags will increase or decrease the
social gains from reckless driving Which areas would you want to
measure and compare?
C''''''''AC'P t h ~ t transactions costs are high, what implications do air bags
4.
Micro-Q . J - August 16, 19%
2. (i) Charles is ri.sk-averse and is endowed with a certainty income CO. Suppose he is
offered a specific gamble with a positive expectation of gain. Would he always,
possibly, or never accept it? [Choose the correct answer, and explain.]
(ii) Suppose that, instead of having to accept or reject the gamble in its entirety, he
could accept any fractional share he likes. [f so, would he accept some positive
fractional share - always, possibly, or never? Explain.
3. An electric utility has access to two types of generating equipment, base10ad and peaker.
A base load generator must be run continuously for 24 hours a day. A "peaker" can be
costlessly turned on or off at any time. Suppose the hourly marginal operating cost of a
baseload generator is 5 centslkwh, while a peaker's marginal operating wst is 25
centslkwh. Daily rental costs of two types are $41kw and $l/kw respectively, and the
company's daily load profile is as shown in the diagram below.
kw
200
100
- - - - - - - .,...-----------,1
I
I
I
I
I
I
I
Mdnight 6 M-f 10 M-f Nooo
(a) How much of each type of generating capacity should the wmpany install?
(b) What is the marginal cost of providing one additional kw of power from 6 AM to
lOAM?
True or False. A profit-maximizing firm must necessarily also be a cost-minimizing
one. Explain clearly, USING NO MA TIIEMA TICS
WHATSOEVER.
5. A mineral water vendor can produce with zero marginal cost and occupies the fixed
location labeled A at one end of a one-mile beach:
------------------------
A
Micr\)-Q - 4 - August 16, t 9%
There are 1,000 people distributed unifom11y over the beach and each person buys one
bottle of mineral water provided the inclusive price (money price plus round-trip
transportation cost) is below $1. In each direction transportation cost is equal to $2fmi_
a) What is the profit-maximizing money price for the vendor to charge?
b) Suppose that the vendor can costlessly relocate. Where will [s ]he chose to locate?
c) What is the new profit maximizing price in b?
d) Suppose that there is a small cost of relocation given by Ed, where d is the
distance of relocation from A and E-O. Where will [s]he relocate?
e) In d, how does consumer surplus change (total and distribution) from a? (You
may use either the math or a picture/graph.)
August 16, 19%
- 5 -
Micro-Q
PART II
The function e(p,u)==g(p)f(u), for P==(PI! ... ,P.J a vector of prices and u;::O a utility
level, is a consumer's expenditure function.
(l) What properties must g and f satisfY for e to be an expenditure function1
(2) Assume that f is strictly increasing. Find the demand function ,,(p.l). where 1
is the consumer's income, for good i.
(3) Does the function f affect the demand functions? Why or why not?
(4) Verify the Slutsky equation for the demand system you found (2).
- 6 -
AUgust 16. 19C;{)
Micro-Q
PART III
There are N consumers each of whom has the utility function for goods I
and y. Assume that O<a, p<l and Individuals endowments i.,y are drawn
independently from the distribution given by
Prx,y) == (1,0)) == q
PI-x.,y) == (0,1)) = l-q
where O<q<l.
Let k be the proportion of individuals who have endown1ent (1,0). The markets for
trade of x. and yare open only after endowments are known
1. Sho\\' that equilibrium prices depend on k, but not on N.
2. Call an individual who receives endowment (1,0) a type I and one who receives (0,1) a
tyV
e
rr Compute the indirect utility of a trader of type i, i=I, II, as a function of k. Call
these indirect utilities V/k).
3. Now consider a trader who knows that he will participate in a market where the
proportion of type I traders is k. The individual does not yet know whether he will be a
type I or type II. Show that his expected utility is
Show that W is concave.
4. The expected utility from participating in a market with N traders is thus
u(N) == Ek[\V(k)INl
How does u behave as a function of N?
Micro-O - 7 August 16,19%
PART IV
There exists a buyer and a seller. The buyer is either a high valuation type (i=H) or a
low valuation type (i=L). The high valuation type's reservation value for the good is b and the
low valuations type's reservation value is Q (where b>Q>O). The seHer does not know with
certainty whether the buyer is a high valuation type or a low valuation type. Suppose the seller's
marginal cost of producing the good is O.
The high valuation buyer's payoff from agreeing to a price of P at time t IS
ub"(p,t) == ot(b -p) where 0 is the discount factor. The low valuation buyer's payoff from
agreeing to a price of p at time t is u!!(p,t) = o((Q - p) where 0 is the discount factor.
a) Show that the single crossing property exists between the high valuation buyer and
low valuation buyer. (Hint: ~ ( 2 J = r: In 2).
ax
b) Depict the single crossing property by drawing in (p,t) space a representative
indifference curve for the high valuation buyer and for the low valuation buyer.
Suppose a separating equilibrium occurs where PH is the price that the high valuation
buyer pays, PL is the price the low valuation buyer pays, tH is the time of agreement for the high
valuation buyer and (L is the time of agreement for the low valuation buyer.
c) State the incentive compatibility (Iq constraint for the high valuation buyer and
for the low valuation buyer.
d) Prove that PH> PL and t({ < tL in all separating equilibrium outcomes. (If you
are having difficulty with the proo( make a graphical argument.)
e) Suppose the separating equilibrium is such that PH = b!2, tH = 0 and PL = QI2.
What is the possible range of values for tL?
Micro-Q - 8 - AliglL'rt 16, 19%
PART V
Consider an exchange economy with two commodities and three consumers. Each
consumer's consumption set is 51!. The preferences of the three CDnsumers are represented by
the following three utility functions:
u
t
(X
t
l':Sl) =
f""
1- 111 I
U
1
(X
12
':S1)
:::
f" -',
1- III I .
for aU

if
Itt =
or
for all
(xl2'Xu)
if
III :::
or
in
m
Z
..
=
in
8\2 ..
Ixz = 0
1
'0 m.2
U\.
(a) Suppose the endowments of the three consumers are w
1
=(2,O), w1=(O,1), wJ=(l,O).
Show that p'={(1I9), (8/9 is a competitive equilibrium price, and obtain the
corresponding competitive equilibrium allocation.
(b) Verify that the CDmpetitive equilibrium obtained in (a) above is unique.
(c) Suppose now that the endowments of the consumers are altered to w1={1,O), w290,l),
"'3=(2,0), For this new distribution of endowments, show that p "=(0.5,0.5) is a
competitive equilibrium price, and obtain the corresponding competitive equilibrium
allocation.
(d) . Verity that the competitive equilibrium obtained in (c) above is unique.
(e) Comparing the competitive equilibrium allocations in the two situations above, verify that
consumer 1 is better offin the new equilibrium (described in (c compared with the old
equilibrium (described in (a. This phenomenon is known as a "transfer paradox."
Explain why_
August 15, 1995
1. You are identified by a number. The grading is meant to be anonymous, so yve
suggest tllat you flot use your Cornell LD. number. Select an identifying
number and keep a record of it for your i.nfonnation. Put that number on each
book(s) either.
2. Each part must be alls'wered in a separate exam book. When you are finished, .
please write down the total number of exam books you are submittillg, and get
the number verified by the proctor.
GOOD LUCK!!
Microeconomics Exam August 15, 1995
PART I
Choose four (4} of the six (6) questions below:
1. In Co lIecti vi a, all electricity is provided by the Public Power Authority. The PPA has two
ways of generating electricity: Coal-powered generators and diesel-powered generators. The
daily rental costs per kilowatt (kw) and operating costs per kilowatt-hour (kwh) for the two
types of equipment are as follows:
Steam: $3. OOlkw of capacity &
$.IOlkwh
Diesel: $2.001kw of capacity &
$.IS/kwh.
The PP A can install and operate as many kw of each type of generator as it wishes. Selling
all of its power at marginal cost, its daily customer usage profile is as shown in the diagram.
Kilowatts
20c,.. - - - - - - - - - - -r----------.
I
10(4----------4
8PM
I
I
I
I
gAM
(
(
(
I
I
I
I
I
I
I
I
gPM
a) How much of each type of capacity should it install?
b) A new customer arrives who uses I kw continuously from 8 PM to 8 AM. How
much should the PP A charge tlus customer?
c) How much should it charge a customer who uses I kw continuously from 8 AM to
8 PM?
d) How much profit will the PP A make with marginal cost pricing applied to the usage
profile shown?
2
2. You are the owner/manager of a small competitive firm that manufactures house paints. You
and all your 1000 competitors have total cost curves given by TC = 16 + 8Q + Q2, and the
industry is in long-run equilibrium. Now you are approached by an inventor who holds a
patent on a process that wiiI reduce your costs by half at each level of output.
a) What is the most you would be willing to pay for the exclusive rights to use this
invention? .
b) Would the inventor be willing to sell at that price?
3. Crusoe will live this period and the next period as the lone inhabitant of his desert island. His
only income is a crop of 100 coconuts that he harvests at the beginning of each period.
Coconuts not consumed in the current period spoil at the rate of 10 percent per period.
a) Draw Crusoe's intertemporal budget constraint, and describe his optimal consumption
bundle if he regards each unit of CUfTent CDnsumption as worth exactly 2 units of
future consumption.
b) How would your answer to part a) be affected if an inter-island trading ship gave
Crusoe the opportunity to borrow against next period's harvest at an interest rate
r = 2/3?
4. Consider a two-sector economy that employs a total of 200 units of a single input, labor. N I
of the units are allocated to sector 1, where the wage is 20(NI)'Iz for the top 5 workers in that
sector and 0 for all others. (Both the wage for the top workers and the number who receive
that wage are invariant to changes in NI.) The remaining N2 ::= 200 - Nl units oflabor serve
in sector 2, where every worker receives a wage of 10. All workers in sector 1 have an equal
probability of being among the top five workers, SIN I, and all workers are risk neutral.
a) How many workers will work in sector I?
b) What will be the value of GNP for the economy?
c) What tax: rate on the earnings of workers in sector 1 will result in the largest attainable
value of GNP?
3
5. An author has contract offers from two publishers, each of which promises to pay her 20
percent of the gross sales receipts from her book. Publisher A has fixed costs of $50,000 for
producing her book and marginal costs of$2Ibook. TIle fixed and marginal costs of Publisher
B are $20,000 and $4Ibook, respectively.
a) lfthe publishers and the author care only about their financial retUl11 fTom the project,
which publisher should the author choose? Explain.
b) If the author had complete faith in the integrity of her chosen publisher, how could her
contract be modified to the advantage of both parties?
6. In this question we consider the markets for Japanese cars and for Amelican cars .. The supply
curve of Japanese cars in the US. is peliectly elastic at a price of20 The demand curve in
the US. for Japanese cars is 30 - P
J
where P
J
is tile price of a Japanese car. The supply curve
of American cars is 10 + P A where PAis the price an American car. The demand curve for
American cars is 15 - P A + PJ'
a) Find the equilibrium prices and quantities of American and Japanese cars.
b) Now the U.s. govemment imposes a tax (paid by the supplier) of 5 011 each Japanese
car sold in the U.S. At what price will American cars be sold?
c) If the U.S. govemment imposes a ta-x of 5 on Japanese cars and offers a subsidy of 1
on American cars will it break even? Explain.
4
PART II
A consumer purchases and consumes only goods I and 2 In year I, the CDnsumer has an
income of $200, both goods cost $10 per unit and the consumer buys equal quantities of the two
goods. In year 2, good I still costs $10 pet unit and the consumer purchases 12 units of it. In year
2, good 2 costs $8 per unit and the CDnsumer purchases x units of it. [Do not assume that the
consumer has equal incomes in year I and 2.J
I. a) For what x is the consumer's behavior inconsistent with utility maximization?
b) For what x is the year 1 bundle revealed preferred to the year 2 bundle?
c) For what x is the year 2 b!Jndle revealed prefelTed to the year I bundle?
2 Assume now that the CDl1SUmer's behavior satisfies the strong Axiom of Revealed Preference
a) For what x would you conclude that good I is an inferior good?
b) For what x would you conclude that good 2 is an inferior good?
5
PART III
. The prices that a finn will face next year are uncertain, but its production decisions will be
made after the uncertainty is resolved. Rather than waiting until the randomnessis resolved, the firm
can have nonrandom prices equal to the expected v-alue of the random prices. The firm is owned by
an expected utility maximizer with objective expectations and vNM utility function u(rr), where rr is
the firm's profit
I. Suppose that the owner is risk neutraL Will he prefer random prices or the expected value
prices? Provide a proof for your answer.
2. Now suppose that the owner's vNM utility function is such that he prefers the nonrandom,
expected value prices. Also suppose that in the economy there is an unlimited number of
individuals with the same expectations and utility function as the firm's O\vner. Specifically
everyone has vN1v1 utility uCrr), wealth 0 in the absence of profits from the fim1 and 11(0)=0.
Could the owner of the firm sell shares in the firm's profits and make himself better off?
Provide a proof for you answer.
6
PARTlY
Consider the following two period partial equilibrium modeL A monopolist faces an inverse
demand function, in each period, of pC q)=a-bq. Cost per un.it in period I is constant at C I. Cost per
unit in period 2 is cOnstant at C
2
=C
I
-aQI. Cost per unit in period 2 is declining in ql (a>O) because
of learning by doing. The monopolist does not discount profits. Assume that a>c
1
and 2b>a
1. Find the monopolist's profit maximizing output levels.
2 Suppose now that the monopolist is replaced by ?- perfectly competitive industry with the
same technology as above. Cost per unit in period 2 is declining in the aggregate industl),
output in pcriod 1. Find the competitive output levels in the two periods.
3. Could society be better ofT with a monopolist than with perfect competition? Explain.
4 If output levels are selected by a social planner to maximize the sum of producer and
consumcr surplus will they equal those you found in part 2? Vlhy or why not?
7
PART V
Consider an economy with two goods: one private and one public. The public good is
produced according to a linear technology in which one unit of the private good yields one of the
public good There are two consumers, both with the utility fimctions u(x,y)=x+2 log y, where x is
consumption of the private good and y is consumption of the public good. One consumer has an
endowment of 1 unit of private good; the other has an endowment of 5 units of the private good.
There is initially no public good available.
1. Find all the Pareto efficient allocations. (Do not neglect the comer solutions.)
2. Suppose that consumers buy the public good from a private finn with the linear technology
described above. (Because of the good's "publicness" each consumer gets to consume the
quantity of public good that the other consumer has purchased.) Find a competitive
equilibrium, where each consumer takes as given the quantity of public good purchased by
the other. (I-Ent: Given the linear technology, you should be able to deduce the equilibrium
price of the public good in terms private good without considering demand) Is there more
than one equilibrium? Explain in economic tenns why competitive equilibrium fails to be
Pareto efficient.
3. Suppose that., as in (2), the public good is sold on the market. Assume that the goverrunent
wishes to maximize the sum of consumers' utilities but cannot tdI which consumer is wh.ich.
Devise a tax/subsidy plan that attains an optimum. Make sure that the budget balances, i.e.,
that subsidies paid out equal taxes received. (Hint: What must relative prices be in order to
induce consumers to demand the optimal level of public good? Consider a subsidy on
purchases of public good. This subsidy is financed by a lump-sum tax, which consumers take
as given and which, in view of the indistinguishability of consumers, must necessarily be the
same for both consumers.)
June 9, 1995
1. You are identified by a nwnber. The grading is meant to be anonymous, so we
suggest that you not use your Cornell J.D. number. Select an identifying
number and keep a record of it for your information. Put thai number on each
book(s) either.
2. Each question must be answered in a separate exam book. When you are
finished, please write doml the total number of exam books you are submitting,
and get the number verified by the proctor.
3. You are required to work four parts of this exam: PART I and any tlu'ee
selected from PARTS II _ V. Each part is worth 25 points. You have four hours
to write this exam.
4. !fyou find any question anlbiguous, explain your confusion and make whatever
GooD LUCK I!
MicroeconorrUcs Exam June 9, 1995
PART I
Answer FOUR questions from this part.
1. There are two groups, each of whose members flis a utility function g1ven by U(M)=l-(ll1\'1),
where M=5 is the initial wealth level for every individual: Each member of group 1 faces a
loss of 1 with probability 0.5. Members of group 2 each face the same loss with probability
0.1.
a. What is the most a member of each group would be willing to pay to insure against
tlus loss?
b Ifit is impossible for outsiders to discover which individuals belong to wluch group,
how large a share of the potential client pool can the members of group 1 be before
it becomes impossible for a private company with a zero-profit constraint to provide
insurance for the members of group 27 (For simplicity, you may assume that
insurance CDmpanies charge only enough in premiums to cover their expected benefit
payments and that people will always buy insurance when its price is equal to or
below their reservation price) Explain
2. You are searching for a low price from a price distribution that is unifoml on the interval
[0,401. The cost of each search is 1.25. What is the largest price you should accept?
3. If Tom chooses to become an engineer, his wealth will be 64 with probability 1. If he chooses
to become a tort lawyer, his wealth will be 400 with probability .3 and 0 with probability. 7.
These are his only two career options. Tom is an expected-utility maximizer whose von
Neumann-Morgenstern utility function is given by U==WYi, where W is his wealth.
a. Which career should Tom choose?
b. Maria can conduct a brief interview with John and discover, with probability 1, what
will happen if Tom chooses to become a la\vyer. If Maria charges a price of 39 for
the interview, wiD Tom pay it?
c. Is there a two-part pricing scheme that will enable Maria to raise her expected gain
from providing the interview?
4. Harry runs a small movie theater whose customers all have identical tastes. Each customer's
reservation price for the movie is $8, and each customer's demand curve for popcorn at
Harry's concession stand is given by Pc =3-Q
c
' where Pc is the price per quart of popcorn in
dollars and Q
c
is the amount of popcorn in quarts. The marginal cost of allowing another
patron to watch the movie is zero, the marginal cost of popcorn is $1, and Harry is costlcssly
able to inform all potential movie goers about his admission and popcorn prices. [f his goal
is to maximize his profits, at what price should he seU tickets and popcorn?
- 3 -
5. All book buyers have the same preferences and, under current arrangements, those who buy
used books at $21 receive the same utility as those who buy new books at $54. The annual
interest rite is 5 percent and there are no transaction costs involved in the buying and selling
of used books. Each new textbook costs $m to produce and lasts for exactly 2 years.
a. What is the buyer's reservation price for the right to use a book for one year?
b. How low would m have to be before a publisher would find it worthwhile to print
books with disappearing ink -- ink that vanishes one year from the point of sale of a
new book, thus eliminating the used book market? (Assume that eliminating the used
book market will exactly double the publisher's sales.)
6. There are two occupations in Islandia, potting and singing. Each person must choose
between working as a potter for a wage of 10 or competing for a recording contract that pays
W(R)=100RV" where R is the number of people who compete for the recording contract.
Losers in the singing competition earn zero .. There are 300 people in Islandia.
7.
a. If people are risk neutral, how many will compete for the recording contract and what
will be the resulting level of national income?
b. What is the socially optimal number of contestarits and the corresponding level of
national income?
c. Find the socially optimal tax on the winning singer's income?
The state has announced its plans to license two finns to serve a market whose demand curve
is given by P=4O-Q. The technology is such that each can produce any given level of output
at a constant marginal cost of20, but once each firm's output is chosen, it cannot be altered.
a. What is the most you would be willing to pay for one of these licenses if you knew
you would be able to choose your level of output first (assuming your choice was
observable by the rival firm)?
b. How much would your rival be willing to pay for the right to be the second firm in
this market?
; 1
1
1
1
" I
- 4 -
PART II
An economy has N identical towns, each with M identical firms; M and N are large. Finns
produce output (priced at 1) from labor 2 according to the smooth, concave production function
and hire workers competitively at a wage w. Suppose each worker supplies one unit of labor and that
the total number of workers is exactly equal to the number offirms. In this problem you will compare
partial and generaI-equilibrium analyses of the effect ofa tax on the useoflabor in one of the towns.
(a) Find the competitive for the economy when there are no taxes; that is,
determine the equilibrium wage and level of profit for a typical firm.
(b) Now suppose the city council in Town 1 imposes a tax, to be paid by firms, of t per
unit oflabor purchased by firms in that town. The proceeds of a tax are used to pay
for schools in Ville 1, Town 1 's sister city, which is located in a foreign county.
Assume that = 2 - and that O<t<1. For the partial equilibrium analysis of
the effects of this tax, assume that since N is large, there is no effect on the wage.
Compute the new level of hiring of Town 1 firms and their profits. Who gains and
who loses from the tax (assume that none of the workers owns any of the firms)?
( c) Now analyze the tax using a general equilibrium approach. That is, take account of
the fact that workers will move among the towns, thereby affecting the wage.
(Assume that moving is costless in both financial and utility terms.) Let x be the
aggregate amount oflabor hired in Town 1.
(i) Show that in equilibrium, x satisfies
(
N - xl
t + f' M
N - 1
= f'
M
(ii) Using the same functional form as in part (b), find the labor allocation, the
wage and profits for all finns. Compare your assessment of gainers and losers
with that found in part (b).
(d) Analyze the (general equilibrium) effects of the tax if firms as well as workers can
change towns at no cost.
- 5 -
PARTll
Consider a Walrasian exchange economy with two consumers "a" and up". The goods are
denoted by ~ x " and 'Y". The initial endowments of a and P are given as:
The utility functions of "a" and "P" are given by
o < a < 1
o < P < 1
(a) Take the price ofy to be equal to 1; and let up" > 0 be the price ofx (relative to y).
Show that the excess demand, function for x is given by
e(p) = p:Y/p - (1 - a)x (i)
Hence, an equilibrium p'" > 0 is given by p'" = p"Y/(l-a)x.
(b) Show that the Walrasian equilibrium is Pareto optimal.
(c) Following a "very old idea" [going back to Adam Srnith, ... ], the following dynamic
process has often been studied to describe price adjustment out Qj equilibrium; with
no market mediation, etc.
(li)
where Pt is "price of x in period t", e(p J is the excess demand in period t, and A>O
is the "speed" of market adjustment. [Strictly speaking, we should write
if we wish to ensure that the prices are non-negative in each period, but, this more
careful specification is not needed in the following context].
- 6 -
SimplifY the description of the above economy by choosing
x = 1, Y = 1, a = P = 112.
Call p'" a steady state or an equilibrium of the process (ii) if p'" = G(p"'). If
I G' (p "') I < 1, this equilibrium is locally stable.
Provide a sufficient condition on the speed of adjustment). under which the
equilibrium p'" in (i) is locally stable if we follow the adjustment process (ii)
[with the simplified economy].
Is it necessarily true that the process will be in equilibrium, or will cycle (as
in the Scarf type examples), or will converge to an equilibrium or a cycle?
- 7 -
PART IV
A (Bergson-Samuelson) social welfare function for an economy with N consumers is a
function W: - m + assigning a utility value W(ut,,,,,UN) to each vector of utility levels
(ut"",uN) for the N consumers. Suppose that W is strictly increasing, concave and differentiable.
For each price vector p E and income Ii E m+ let vj(p,IJ represent consumer its indirect
utility. For any given prices p and aggregate wealth I the social planner redistributes consumer's
wealths to solve:
.MAX W(v l(p,I
t
)"",vN(P,I
N

II,,I
N
N
S.t. L Ii'" 1.
i=I
. Let (II (p,I), ... ,IN(p,I) be the solution to this problem and let v(p,I) be the value 9f this.
problem, i.e.
(a) Show that v(p,I) is an indirect utility function.
(b) Suppose that all consumers have preferences represented by utility
N
functions homogenous of degree 1. Suppose that W(u t,,,,,uN) = I (Xi (U
i
) with
N i=I
(Xi> 0 for all i and I a = 1. Find (It(p,I), ... ,IN(p,I).
i=I N
(c) Let represent consumer its demand function: Let X(p,I) = L Xi(p,Ii(p,I).
i=!
F or the functional forms of utility and social welfare given in part (b) is
N
v(p,!) = L (Xi en [vi(p,Ii(p,I)J,
i=!
i. e. the "indirect utility function" given in (a), an indirect utility function for a
"representative consumer" with demand function X(p,I)?

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June I, 2009

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