LONDON SCHOOL OF ECONOMICS Department of Economics

Template Solutions to the Sample Lent Exam

EC487: Advanced Microeconomics

1. Let X be a finite set of choices, A a non-empty set of non-empty subsets

of X, and c : A → 2X \{∅}, where for each A ∈ A, ∅ =
6 c(A) ⊂ A, a choice
rule. We say that c satisfies expansion (E) if for each A, B, A ∪ B ∈ A,
x ∈ c(A) ∩ c(B) ⇒ x ∈ c(A ∪ B).

(i) State the Weak Axiom of Revealed Preference (WARP). WARP states
that for each A, B ∈ A, x, y ∈ A ∩ B, x ∈ c(A), y ∈ c(B) implies that
x ∈ c(B).
(ii) Prove or disprove that WARP implies E. Assume x ∈ c(A)∩c(B) and
let z ∈ c(A ∪ B), which implies that z ∈ A or z ∈ B. Wlog assume
z ∈ A. Then x, z ∈ A ∩ (A ∪ B). Since x ∈ c(A), z ∈ c(A ∪ B), WARP
implies x ∈ c(A ∪ B) as desired.
(iii) Prove or disprove that E implies WARP. It does not.
Let A = {{x, y, z}, {w, x, y}}, which c({x, y, z}) = {x} and
c({w, x, y}) = {w}. This satisfies E but violates WARP.

1
2. Sketch of the answers:

(i) Recall that when a technology is characterized by a production func-

tion f (x1 , x2 ) homogeneous of degree r in (x1 , x2 ) then its asso-
ciated cost function c(w1 , w2 , y) is homogeneous of degree 1/r in
y. Recall also that from the cost function we can only recover the
convex hull of each isoquant, hence since c(w1 , w2 , y) is homoge-
neous of degree 1 in y then we conclude that the convex hull of the
isoquants are associated with a production function that is homo-
geneous of degree 1 in the two inputs x1 and x2 , implying that it
exhibits constant returns to scale.
(ii) The Production function associated with the convex hull of the iso-
quants can be identified using Shephard’s Lemma:

∂c
= β α w1α−1 w21−α y = x1 (w1 , w2 , y),
∂w1

∂c
= β (1 − α) w1α w2−α y = x2 (w1 , w2 , y).
∂w2
Solving for w2 /w1 we obtain:

 1
 1−α  − α1
x1 x2
= .
βαy β (1 − α) y

Solving for y we then get the production function:

y = κ xα1 x21−α ,

where
1
κ= .
β αα (1 − α)1−α
(iii) The aggregate supply function for commodity y in this market is:

p∗ = β w1α w21−α

2
 (iv) The Marshallian demand for each individual consumer is the solu-
tion to the following problem:

max u(y) s.t. p y ≤ p

y

that is y ∗ = 1 from the monotonicity of u(·).

(v) The aggregate demand for this market is then

Y ∗ = 100.

(vi) The equilibrium price in this market is

p∗ = β w1α w21−α

while the equilibrium quantity is

Y ∗ = 100.

Clearly the constant returns to scale technology in a one consump-

tion good economy implies that the equilibrium price is completely
supply determined while the equilibrium quantity is completely de-
mand determined.
(vii) The supply of commodity y of each individual consumer is indeter-
minate because of the constant returns to scale.
(viii) Each individual producer makes zero profit. Indeed his revenues are
p∗ y while his costs are β w1α w21−α y the formula for the equilibrium
price p∗ above implies that his profits are null.

3
3. The economy can be described in the Edgeworth box represented below.

B
...
...
...
...
...
... UB
...
...
...
...
...
x1 ...r
...
...
ω ...
... o2
...
...
A ...
U ...
...
o1 ...
...
..r
A x2 E

(i) The offer curve of consumer A, denoted o1 , is the solution to A’s

utility maximization problem:

max xA
2
xA A
1 ,x2
(1)
x̄1 x̄2
s.t. p xA A
1 + x2 ≤ p +
2 2

for every value of p where we normalize the price of x2 to 1. This

offer curve is plotted in the Edgeworth box above.
The offer curve of consumer B, denoted o2 , is instead the solution
to B’s utility maximization problem:

max xB
1
xB B
1 ,x2
(2)
x̄1 x̄2
s.t. p xB
1 + xB
2 ≤p +
2 2

4
 and it is also represented in the same Edgeworth box above.
(ii) The Walrasian equilibrium is denoted by E. The equilibrium alloca-
tion is: xA A B B
1 = 0, x2 = x̄2 , x1 = x̄1 and x2 = 0. The equilibrium
relative price is p∗ = 1.
(iii) The unique Pareto-efficient allocations is xA A B
1 = 0 x2 = x̄2 , x1 = x̄1
and xB
2 = 0. This allocation corresponds to point E in the graph
above. Therefore the Walrasian equilibrium allocation in (ii) above is
Pareto efficient.

5
4. Sketch of the answers:

(i) Player 1’s strategy M is strictly dominated by her strategy U while

player 2’s strategy C is strictly dominated by his strategy L. Notice
that no player will ever play a strictly dominated strategy with positive
probability in any mixed strategy Nash equilibrium.
(ii) The three mixed strategy Nash equilibria of the normal form game
are: (U, L) with payoff (4, 4), (D, R) with payoff (4, 4), and a non-
degenerate mixed strategy Nash equilibrium. Given that both strate-
gies M and C are strictly dominated in the latter equilibrium player
1, respectively 2, will play these strategies with probability zero. The
non-degenerate mixed strategy Nash equilibrium is then such that:
- player 1 plays action U with probability 21 , action M with proba-
bility 0 and action D with probability 12 ,
- player 2 plays action L with probability 12 , action C with probabil-
ity 0 and action R with probability 12 .
The players’ expected payoffs associated with such a non-degenerate
mixed strategy Nash equilibrium are (2, 2).
(iii) In what follows we propose Subgame perfect equilibrium strategies
for the two-periods dynamic game that supports the players payoffs
(5, 5) in the first period.
Player 1’s strategies are:
• Play M in period 1.
• If in period 1 the outcome of the game is (M, C) play U in period
2.
• If in period 1 the outcome of the game is different from (M, C)
then in period 2 play the non-degenerate mixed strategy Nash
equilibrium of game where player 1 randomizes with probability
1
2
on action U , with probability 0 on action M and with probability
1
2
on action D.
Player 2’s strategies are:

6
 • Play C in period 1.
• If in period 1 the outcome of the game is (M, C) play L in period
2.
• If in period 1 the outcome of the game is different from (M, C)
then in period 2 play the non-degenerate mixed strategy Nash
equilibrium of game where player 2 randomizes with probability
1
2
on action L, with probability 0 on action C and with probability
1
2
on action R.
Notice that it is subgame perfect to punish deviations in period 2
since in the second period whatever the history of the game the
players play a mixed strategy Nash equilibrium of the stage game.
Moreover the strategies above are Subgame Perfect for both players
if and only if:
   
1−δ 1−δ
(5 + δ 4) ≥ (6 + δ 2)
1 − δ2 1 − δ2

or
1
δ≥ . (3)
2