1 Consumption

Two rational consumers spend all their incomes on their two favorite goods. Con-
sumer 1 consumes goods A and B. Consumer 2 consumes goods C and D. Consumer
1 has income 20 and utility U1 (xA , xB ) = (xA )0.4 (xB )0.6 . Consumer 2 has income
equal to 10 euros and utility U2 (xC , xD ) = (xC )0.8 (xD )0.2 . The unit prices of the
four goods are given by pA = 1, pB = 1 + x∗C , pC = 4 and pD = 1, where x∗C are the
optimal consumption choices of goods A and C by consumers 1 and 2.

1. Showthat the optimal consumption choices of the two consumers are given



 x∗A = 8


 x∗ = 4

B
by:



 x∗C = 2


 x∗ = 2

D

2. Using the terminology seen in class, explain what effect the consumption de-
cisions of consumer 2 have on the utlity of consumer 1.

1.1 Answers

1. After writing the lagrangian and taking the two FOCs, we find that optimum
0.4xB 1 0.8xD
consumption conditions are 0.6xA
= 1+x∗C
and 0.2xC
= 4. The second opti-
mum condition implies x∗C = x∗D , which, plugged into consumer 2’s budget
constraint, yields 5x∗C = 10 ⇐⇒ x∗C = 2 and thus x∗D = 2.
0.4xB
Now that we know x∗C , consumer’s 1 optimum condition becomes 0.6xA
=
1
3
⇐⇒ x∗B = 21 x∗A . Plugging this condition into consumer 1’s budget con-
straint yields x∗A + 32 x∗A = 20 ⇐⇒ x∗A = 8 and thus x∗B = 4. QED

2. Negative externality. For full marks we expect description of what a negative

externality is and why we have such a case in the present exercise.

1
2 Engel curve

Max spends all his income on food, f and the compisite good, y. His utility function
is given by U (y, f ) = yf . The unit prices of both goods is 1. Hiis income is M .

• Derive the Engel curve of Max for food.

• Derive the income elastiicity of the demand for food.

2.1 answers

• The budget constraint is M = y + f . Plugging this constraint into the utility

function or maximizing the lagrangian yields M − 2y = 0, that is y = 12 M .
Substitution into the budget constraint yields the engel curve for food: f =
1
2
M

df M df 1M
• η= dM f
. Using the Engel curve we have dM
= 1/2. Thus η = 2 M
= 1.
2

3 Search

Mark is looking for a good advisor. Each applicant must take a test. The test result
is uniformly distributed between 0 and 8. Mark’s utility is equal to his income. His
initial income is 0. Each extra test point yields 1000 euros in income to Mark. Mark
bears the cost of each test. The cost function linking the number of tests Mark
1000 2
carries out and the cost he must bear is given by: C (n) = 16
n, where n is the
number of tests carried out.

• What test grade does Mark need to get for him to stop searching for a advisor?
Explain and justify all your computations and conclusions.

• Is it possible that Mark carries out more than 100 tests? Explain

2
3.1 answers

• Let x be the test result. Gains from an extra test (for full marks, students
should mention what the following two parts of the gains function are (prob-
ability of getting a higher mark and expected gain conditional on getting a
higher mark)): 8−x 1
1000 = 125 (8 − x)2 . Cost of an extra test:


8
∗ 2
(8 + x) − x 2
1000 2
16
n = 125 2
2
n. Equating costs and benefits yields x∗ = 8 − n

• No, for n = 100 the costs are always very much higher than gains. An ex-
planation along the following lines is necessary to get full points: costs for
1000
n ≥ 100 are at least 16
∗ 10000 = 125 ∗ 5000 = 725000, which is higher than
the highest benefit possible, 8000

4 Vaccines

Jan works as an independent. He worries about the consequeces the pandemic may
3
have on him. With probability 8
he gets infected by the new variant of the virus.
5
His income is then a mere M = 1. With probability 8
he does not get infected and
his income is then M = 5. His utility function is given by:

1
U (M ) = 1 −
M

• Is Jan risk-averse?

• Jan can purchase a vaccine. The price of the vaccine is p and with a vaccine
Jan is certain to not get infected. Determine the maximal price Jan is willing
to pay for the vaccine. Report and justify your computation.

4.1 Answers

• students should show that U 0 > 0 and U 00 < 0, and therefore the answer is yes.

3
 • Jan’s expected utility without a vaccine is 83 ∗0+ 85 ∗ 1 − 15 = 12 . The equation


   
we have to solve is therefore 12 = 38 ∗ 1 − 5−p1
+ 58 ∗ 1 − 5−p
1 1
= 1 − 5−p , or
1 1
5−p
= 2
⇐⇒ 5 − p = 2 ⇐⇒ pmax = 3

5 Production and costs

A firm that produces rock garden furniture uses three inputs: labour, L, capital,
√
K, and rock, R. The firm’s production function is given by Q(L, K, R) = LKR.
Rock is a fixed input, ficed at R = 16. Labour and capital are both variable.

• Check whether or not the law of diminishing returns holds for labour and
capital. Justify your answer

• Check what type of returns to scale does this production function exhibit.
Justify your answer.

• Suppose that the unit price of labour is w = 3, that of capital is r = 12.

Currently the firm employs L = 16, and K = 4, (and R = 16, which is fixed
for the firm). Argue, using algebra when needed, whether or not the firm is
using the optimal input mix to produce.

5.1 Answers

• The FOD wrt to L and K is positive but the SOD is negative, so law of
decreasing returns applies.
√ √
• Let c > 1. Then Q(cL, cK, 4) = 4 cLcK = 4c LK = cQ(L, K, 4). Then we
have CRS (if student did the general version – Q(cL, cK, cR) = c3/2 Q(L, K, R) >
cQ(L, K, R) thus IRS – they also get full points)

• In equilibrium we must have that M P L/w = M P L/3 is equal to M P K/r =

K K w
M P K/12 (M RT S is equal to L
, optimum thus requires L
= r
= 1/4 or

4
 L∗ = 4K ∗ ):

√ √
MP L 1 4 × 16 8 1 1 162 MP K
= √ = = = √ =
3 3 2 16 24 3 12 2 4 12

Thus the input mix of the firm is indeed optimal.

6 Monopoly and price discrimination

Consider a monopolist which produces a good. Its total cost function is equal to
C(q) = 9q + 10. The market demand for its good is: P (q) = 25 − 2q.

• Compute its profit when the firm maximizes its profits.

• Suppose the firm can now practice first degree price discrimination on this
market. Compute its optimal strategy and its profits.

6.1 Answers

• Profts are given by (25 − 2q) q − 9q − 10. Profit maximization requires FOC:
25 − 4q − 9 = 0 ⇐⇒ q ∗ = 4 ⇐⇒ p∗ = 17. Then profits are equal to
4 ∗ 17 − 9 ∗ 4 − 10 = 4 ∗ 8 − 10 = 22.

• The monopolist sets its price equal to marginal cost, 9 (implying q ∗ = 8),
and charges an entry fee equal to the consumer surplus: (25 − p∗ )(q ∗ − 0)/2 =
(25−9)∗(8−0)/2 = 16∗8/2 = 8∗8 = 64. Profits are then equal to 64−10 = 54
(as p = M C, total revenue minus total costs is equal to the fixed costs only,
−10).

7 Game Theory

Ahmed (A) and Beatrice (B) play a game. Ahmed must split 5 euros between
Beatrice and himself. The game is as follows. Ahmed makes an offer to Beatrice,

5
x. x is restricted to be a multiple of a euro: x ∈ {1, 2, 3, 4, 5} . Beatrice can then
accept or reject the offer. If she rejects the offer neither of them gets anything. If
she accepts the offer than the 5 euros are split according to Ahmed’s proposal.. If
indifferent, Beatrice reject the proposal. For both players the marginal utility of a
euro is equal to 1. Beatrice is a fully selfish, rational agent. Ahmed is in love with
Beatrice: he cares half as much about her as he cares about himself.

• Derive the subgame perfect equilibrium (not the outcome!). Justify all your
derivations and conclusions.

7.1 Answers

• We are asked about the SPE, not the SPO. We need to derive the equilibrium
strategies of both players. Drawing a game tree can help but was not required.
We first take a stand on the two players’ utility functions. Whatever Ahmed
offers to Beatrice, if she accepts the offer he gets 5 − x and she gets x. As
Ahmed cares half as much about Beatrice as he cares about himself, his utility
function is of the form a (5 − x + x/2) = a (5 − x/2), where a is a strictly
positive number. For the sake of simplicity, we set a = 1. Ahmed’s utility is
then simply 5 − x/2. Whatever is Beatrice’s utility function, we know that if
she rejects the offer she gets nothing. Let’s assume that Beatrice’s utility in
this case is 0. In line with the standard assumptions of the course, we also
assume that Beatrice’s utility is inctreasing in x (how so we do not need to
specify).
Now, we use backward induction and start with Beatrice’s problem. Given x,
she needs to choose between rejecting the offer, then getting 0, and accepting
the offer, then getting some U (x) ≥ 0 with U (0) = 0 and U (x) > 0, ∀x > 0.
Thus her strategy is to accept any strictly postive offer (x = 1, 2, 3, 4, 5, thus)
but to reject the offer when x = 0.

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 Given this, Ahmed’s problem is to maximize 5 − x/2 subject to x > 0 (as
for x = 0 Beatrice rejects the offer and they both get 0). Ahmed will thus
offer x = 1. The SPE is thus: Ahmed offers x = 1; Beatrice accepts the offer
for any strictly positive x (x = 1, 2, 3, 4, 5, thus) but to reject the offer when
x = 0. A possible shorthand notation is (x = 1; R, A, A, A, A, A).
(This was not asked, but to see the difference between a SPE and a SPO, the
SPO is that Ahmed get 4, which yields him a utility of 4.5 and Beatrice gets
1. Using the previous shorthand notation the SPO is thus (x = 1; A)).

8 Duopoly

The market for skates has two producers, K and A. They compete in quantities,
as in the Cournot model of duopoly. qK refers to how much K produces and qA
to how much A produces. The market demand for skates is given by P (qK , qA ) =
135 − qK − qA . Each firm has constant marginal cost equal to 15.

• Compute the equilibrium price on this market. Justify your answers.

8.1 Answers

The profit function of both firms is given by (135 − qi − qj ) qi − 15qi . The FOC to
their problem is 135 − qj − 2qi − 15 = 0 ⇐⇒ 120 − qj − 2qi = 0. We have two
identical FOCS. Either solving the two FOCS as a system or invoking symmetry
(at this point! Not before profit maximization!) yields qA∗ = qK
∗
= 40. Then
p∗ = 135 − 40 − 40 = 55.