EC411 Microeconomics for MSc Students 1

London School of Economics Dr Francesco Nava

Department of Economics Office LIF 3.20
EC411 2013/2014


Problem Set 1: Consumer Theory

1. The preferences of a consumer are represented by the utility function

y x ) y , x ( u + =

The price of a unit of good x is 2, the price of a unit of good y is
y
p , and the
income of the consumer is M. Moreover, the consumer is given a lumpsum
subsidy of
y
M that can only be used to purchase good y. Suppose that 2 p
y
= .

(a) Define the utility maximization problem of the consumer.
(b) Find the optimal amounts of x and y as functions of
y
p ,
y
M and M.


2. A consumer is paid each week 4 units of x
1
and 4 units of x
2
which she may
consume directly or trade with other customers at the going rate of exchange. In the
first week she trades, and finally consumes 5 units of x
1
and 3 units of x
2
. In the
second week there is a new rate of exchange and she finally consumes 6 units of x
1

and 1 unit of x
2
. Assuming that her tastes remain unchanged for these two weeks:

(i) At what rates can x
1
be exchanged for x
2
in the two weeks?
(ii) In which week is the consumer better off?
(iii) Is x
1
an inferior good for this consumer?
(iv) Is x
1
a Giffen good for this consumer?


3. Answer the following questions:

(a) A consumer has a utility function
2
2
2
1 2 1
x x ) x , x ( U + = . Find the Marshallian
demand functions for
1
x and
2
x

EC411 Microeconomics for MSc Students 2

(b) True or false? In order to aid the poor, the government introduces a scheme
whereby the first 1kg of butter a family buys is subsidised and the remaining amounts
are taxed. Consider a family which consumes butter and is made neither better off nor
worse off as a result of this scheme. Thus, the total amount of tax it pays cannot
exceed the subsidy it receives.

(c) True or false? During a war, food and clothing are rationed. In addition to a
money price, a certain number of ration points must be paid to obtain a good.
Each consumer has an allocation of ration points which may be used to purchase
either good, and also has a fixed money income. Suppose the money income of a
consumer is raised and he buys more food and less clothing. If follows that
clothing is an inferior good.

(d) A consumer has a utility function } x 3 , x min{ ) x , x ( U
2 1 2 1
+ = . Find the
Marshallian demand functions for
1
x and
2
x .


4. Suppose that the utility function has the form
) ( ) , (
2 1 2 1
q q q q u | + =

(i) Show that the Marshallian and Hicksian curves for q
2
coincide. What is the
significance of this for the estimation of the welfare changes due to an increase in the
price of q
2
?

(ii) Suppose the price of q
1
is held at 1 and the price of q
2
rises from 1 to 4. Calculate
the welfare change if it is known that
2 2
q / 1 ) q ( = |

5. The expenditure function of a consumer is denote by e(p,u), where p is the
price vector and u the utility level. Show that if 0
u p
e
j
2
>
c c
c
commodity j cannot be
an inferior good.



EC411 Microeconomics for MSc Students 3
London School of Economics Dr Francesco Nava
Department of Economics Office LIF 3.20
EC411 2013/2014


Problem Set 2: Theory of the Competitive Firm

1. Sketch the isoquants for the technologies defined by

(i)
2
2
1
2
2
1
1
] [ x x y + =

(ii)
2
1
2
2
2
1
] [ x x y + =

Comment on the economic significance of the differences between the technologies.


2. Can a singleoutput production process exhibit both diminishing marginal
productivity for a factor and constant returns to scale? Do increasing returns to scale
rule out diminishing marginal productivity?


3. Consider the following production function:


| o
=
2 1
x x y where , > 0.

i. Sketch the production possibility set, Y, in each of the three cases:

(a) + < 1 (b) + > 1 (c) + = 1

For each case, draw the marginal product, average product, and marginal rate
of technical substitution, as functions of x
1
.

ii. Is the production function homothetic and/or homogeneous? In what
arguments? To what degree? What returns to scale are there?

EC411 Microeconomics for MSc Students 4

iii. For each of the three cases, discuss the implications of assuming both profit
maximizing and pricetaking behaviour.


4. Consider the production function from question 3, taking the case (a): + < 1.

i. Derive the factor demands x
1
(p,w) and x
2
(p,w).
ii. Derive the supply function y(p,w).
iii. Find all of marginal price effects. Confirm the signs (and, where appropriate,
relative magnitudes) that were derived in lectures.
iv. Find the profit function (p,w). Confirm its properties.


5. Consider the production function from question 4 for the general case (i.e. make no
assumptions on + .

i. Derive the conditional factor demands h
1
(w,y) and h
2
(w,y).

ii. Find all of the marginal price effects. Confirm the signs (and, where
appropriate, relative magnitudes) that were derived in lectures.

iii. Find the cost function c(w,y). Confirm its properties.

iv. Sketch c(w,y) as a function of y for each of the three cases (a)(c) in question
2(i). Also sketch the marginal and the average costs as functions of y, for each
of the three cases. Why is it not necessary to assume + < 1 for cost
minimization?

v. Confirm that Shephard's Lemma holds.



EC411 Microeconomics for MSc Students 5
London School of Economics Dr Francesco Nava
Department of Economics Office LIF 3.20
EC411 2013/2014


Problem Set 3: The Competitive Industry

1. Suppose that every firm in the kitchen foil industry has a production function

2
1
2
1
L ) T A ( Y + =

where Y is the amount of foil, A is aluminium, T is tin, and L is labour. The
production function of tin and the production function of aluminium exhibit
constant returns to scale. In particular, one unit of tin can be produced with one
unit of labour and one unit of aluminium can be produced with | units of
labour, 2 0 < | < . All the markets are perfectly competitive. The supply of
labour is perfectly elastic at a wage equal to 4.

(a) Find the cost function of each firm.
(b) For all values of | in the interval (0,2), determine how much tin and how
much aluminum will be used in equilibrium for the production of one unit of foil.
(c) For all values of | in the interval (0,2), find the equilibrium price of foil.


2. In a competitive industry there are 100 firms each of which has the cost function

)
`

>
s
+
=
10
10
100 10
10
) (
2
y
y
y y
y
y c

where y is the amount of output produced by the firm and c(y) is its total cost in
pence. There are a further 100 firms with cost functions

)
`

>
s
+
=
10
10
100 8
12
) (
2
y
y
y y
y
y c

EC411 Microeconomics for MSc Students 6

(a) Sketch the industry's supply curve.
(b) If the market demand curve is described by

Y
D
= 2400 100p
where y
D
is demand and p is the price in pence, find the price, the total output
of the industry, and the outputs of the individual firms in equilibrium.
(c) If the tax of 1 pence is imposed on sales of the good, what will happen to the
price paid by consumers to the price received by firms and to output? What
would be the effects of an increase in tax to 2 pence?
(d) Set out an analysis of the costs and benefits of the 2 pence tax.


3. Consider a competitive industry with downwardsloping demand and freeentry. The
industry is composed of identical firms with Ushaped average total cost curves.
Initially we are in longrun equilibrium.

i. The government announces that a substantial fixed annual licence fee will be
imposed on all firms choosing to remain in the industry. How does each of
the following change, (a) industry output, (b) output per firm, and (c)
numbers of firms active in the industry.

ii. Suppose that instead of the licence fee, the government imposes a per unit
sales tax. Relative to the original situation with no tax, what is the longrun
effect on: (a) output per firm, and (b) number of firms active in the industry?

iii. If the tax in part ii were chosen to result in the same aggregate output that is
produced in part i, will the per unit tax raise more or less revenue than the
licence fee? Explain.




EC411 Microeconomics for MSc Students 7
London School of Economics Dr Francesco Nava
Department of Economics Office LIF 3.20
EC411 2013/2014


Problem Set 4: Competitive General Equilibrium

1. Consider a pure exchange economy with two commodities, x and y, and two agents, A
and B. Their utility functions are

A B B A B B B A A A A A
x log 2 y log 2 x log ) x , y , x ( u y log x log ) y , x ( u + + = + =

Agent A has an initial endowment of 1 unit of x and 4 units of y. Agent B has 6 units
of x and 3 units of y.

(i) Find the competitive equilibrium price ratio, and the equilibrium allocation of
commodities ignoring the final term in B's utility function.

(ii) Repeat part i, using the utility functions as printed.

(iii) What is the economic significance of the final term in B's utility function and
what effect does it have on the solution?

(iv) Find the necessary conditions for a Pareto Optimal allocation of resources
subject to the condition that agent A achieves the same level of welfare as
obtained in competitive equilibrium. Confirm that these are satisfied at the
following solution (you are not expected to find these solutions)
(v) Comment on the economics of the relationship between the solutions to parts
(ii) and (iv).

2. Consider an economy with two consumption goods, x and y, and one factor of
production, z, with prices denoted by
x
p ,
y
p , and
z
p , respectively. There are two

91
490
= y ,
18
35
=
x
,
91
147
= y ,
18
91
=
x
B
B
A
A


EC411 Microeconomics for MSc Students 8
types of agents, and . The utility function of a type i agent, i=,, is
} y , x min{ ) y , x ( U
i i i i i
= , where
i
x and
i
y are is consumption of x and y.
Each type agent owns a firm that produces good x using z via a technology
characterised by the profit function

z
2
x
p 4
p
= t
o
.

Each type agent owns a firm that produces good y using z via a technology
characterised by the profit function

z
2
y
p
p
= t
|
.

The initial endowments of x and y are equal to zero and the initial endowment of z is
equal to 10 for both types of agents. The proportion of type agents in this economy
is 1/2. All the agents are pricetakers.

(i) Find the supply and the input demand functions of types and .
(ii) Find the competitive equilibrium prices.

EC411 Microeconomics for MSc Students 9
London School of Economics Dr Francesco Nava
Department of Economics Office LIF 3.20
EC411 2013/2014


Problem Set 5: Risk & Uncertainty

1. A consumer who has an initial wealth of 36 pounds must choose between
two options, (X) and (Y). (X) is a lottery which gives zero with probability 1/4
and 28 pounds with probability 3/4; (Y) is 13 pounds with probability equal to
one. The consumer is an expected utility maximizer with a utility function ) w ( u ,
where w is the consumers wealth in pounds. ) w ( u is continuous and strictly
increasing in w.

(a) Suppose that the consumer is riskaverse. Can you determine which
option she will choose?

(b) Suppose that someone who knows the outcome of the lottery in option
(X) is willing to sell the information to the consumer. If the consumer is
riskneutral, how much would she be willing to pay to know the outcome
of the lottery before making her choice between (X) and (Y)?

(c) Suppose that the consumer is riskloving and, as in (b), she can buy
information about the outcome of the lottery prior to making her choice
between (X) and (Y). Will the consumer pay a positive amount to know
the outcome of the lottery? Explain carefully.


2. A farmer can grow wheat, or potatoes, or both. If the weather is good, an acre of land
yields a profit of 2,000 if devoted to wheat, of 1,000 if devoted to potatoes. Should
the weather be bad, an acre of wheat yields 1,000 and of potatoes 1,750. Good and
bad weather are equally likely. Assuming the farmer has utility of income (m)
function log m, what proportion of his land should he turn over to wheat?
(ii) Suppose the farmer can buy an insurance policy which pays, for every 1 of
premium, 2 if the weather is bad, and nothing if the weather is good. How much

EC411 Microeconomics for MSc Students 10
insurance will he take out and what proportion of his land will he devote to wheat?
What would the answers be if the policy paid only 1.50 to compensate for bad
weather?

3. Write down your preferences in the following situations:

Situation 1 Choose between lotteries A and B:
A yields 1 million with certainty
B yields 5 million with probability 0.1
1 million with probability 0.89
nothing with probability 0.01


Situation 2 Choose between lotteries C and D:
C yields 1 million with probability 0.11
nothing with probability 0.89
D yields 5 million with probability 0.1
nothing with probability 0.9

Having made your two choices, write down the restrictions which these imply on
your utility function of income if they are to be consistent. Are they consistent?

4. In a portfolio selection model, let

W = initial wealth
I = final wealth
B = amount invested in a "risky asset"
M = amount of wealth held as money; money is a "sure asset" and a zero return
r = the (random) return on the risky asset; E(r) > 0.

[If B are placed in the risky asset, the random amount (1+r)B will be realised.]

Suppose that the investor has the von NeumannMorgenstern utility function
u(I) = I
2
+ I, where , > 0.

EC411 Microeconomics for MSc Students 11

i. Graph this utility function and show that it exhibits risk aversion. Interpret
and .

ii. Write out the choice problem which determines the utilitymaximising
division of initial wealth between the risky asset and money.

iii. Compute the optimal level B and prove that it increases with . Interpret the
result.

EC411 Microeconomics for MSc Students 12
London School of Economics Dr Francesco Nava
Department of Economics Office LIF 3.20
EC411 2013/2014


Problem Set 6: Game Theory


1. Identify the Nash Equilibria (in pure strategies) in the following games






























2
1
a b
A ( 2, 1) ( 2, 2)
B ( 3, 1) ( 1, 0)
( i i )
2
1
a b
A ( 0, 1) ( 2, 2)
B ( 3, 0) ( 0, 3)
( i )
2
1
a b
A ( 0, 2) ( 2, 2)
B ( 3, 0) ( 0, 3)
( i i i )

EC411 Microeconomics for MSc Students 13
2. Show that the game below has no Nash Equilibrium in pure strategies. Suppose
player 1 'tosses a coin' to decide which action to take; i.e. he has probability p of
playing A and probability (1p) of playing B. Similarly, suppose 2 plays a with
probability q and b with probability (1q). Find values of p and q such that these
strategies form a Nash Equilibrium. Can you see any property which this
equilibrium shares with game (iii) of Problem 1?







3. In the game shown below, identify the unique Nash Equilibrium in pure strategies.
Now consider a sequential adaptation with the same payoffs as the game below:
player 1 first chooses a strategy, and then player 2, knowing 1's choice, chooses his
action. What are the pure strategy Nash equilibria in this game? What are the
pure strategy subgame perfect equilibria?












4. Consider a game in which players I and II bargain over a pie of size 1. Player I
proposes a division of the pie, denoted by (x,1x). If player II accepts the proposal,
player I receives x and player II receives 1x. If player II rejects the proposal, the
game ends and both players receive nothing.

(a) What is the set of divisions that can arise in Nash equilibrium?
(b) What is the set of divisions that can arise in a subgame perfect equilibrium?
2
1
a b
A ( 1, 0) ( 0, 1)
B ( 0, 1) ( 1, 0)
2
1
a b
A ( 6, 4) ( 3, 5)
B ( 5, 3) ( 2, 2)