LONDON SCHOOL OF ECONOMICS Department of Economics
Template Solutions to the Exam
EC487: Advanced Microeconomics
Lent Term 2016/7
1. Sketch of the answers:
(i) [20 marks] Notice first that, for any x ∈ X, (0, 1) - x - (3, 5) by
strict monotonicity and continuity. If such αx exists it is unique by
strict monotonicity. To show that αx exists for any x, use apply stan-
dard arguments using the continuity axiom as in the lectures (the
arguments are slightly simpler because of strict monotonicity).
(ii) [13 marks] Define u(x) = αx . Apply standard arguments as in the
lectures.
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2. Sketch of the answers:
(i) [6 marks] Since a cost function is homogeneous of degree 1 in
(w1 , w2 ) then from
c(k w1 , k w2 , y) = k α min{w1α , w2α } y = k α c(w1 , w2 , y)
we conclude that
α=1
and the cost function is:
c(w1 , w2 , y) = min{w1 , w2 } y
(iv) [4 marks] The supply function for commodity y of each individual
producer is obtained from:
max p y − min{w1 , w2 } y
y
and it is perfectly elastic:
p = min{w1 , w2 }
(iii) [4 marks] Therefore the aggregate supply function is also perfectly
elastic:
p = min{w1 , w2 }
and it is plotted in the the following graph.
(iv) [4 marks] The Marshallian demand for each individual consumer is
the solution to the following problem:
max u(y) s.t. p y ≤ 2 p
y
that is y(p, m) = 2 from the monotonicity of u(·).
2
(v) [2 marks] The aggregate demand in this market is then
Y (p, m) = 16.
Aggregate supply and demand in this market are plotted in the fol-
lowing graph:
p 6
Y (p, m) = 16
p = min{w1 , w2 }
(vi) [6 marks] Equating aggregate demand and aggregate supply in this
market we obtain that the equilibrium quantity is:
Y ∗ = 16
while the equilibrium price is:
p∗ = min{w1 , w2 }.
Clearly the perfectly elastic supply in a one consumption good econ-
omy implies that the equilibrium price is completely supply deter-
mined while the equilibrium quantity is completely demand deter-
mined.
(vii) [3 marks] The equilibrium supply of commodity y of each individual
consumer is indeterminate being each producer’s supply identical
3
and perfectly elastic.
(viii) [4 marks] Each individual producer makes zero profit. Indeed his
revenues are p∗ y while his costs are min{w1 , w2 } y the formula for
the equilibrium price p∗ above implies that his profits are null.
4
3. The economy can be described in the Edgeworth box represented below.
B
.
oA .....
U B .
.....
.
oB ω F....
s s
..
.....
.
.....
.
.....
x2 .
.....
.....
...
E ..s...
.
.....
.
.....
. UA
...
A x1
(i) [4 marks] The offer curve of consumer A, denoted oA , is plotted in
the Edgeworth box above.
The offer curve of consumer B, denoted oB , is also represented in
the same Edgeworth box above.
(ii) [8 marks] There exists a continuum of Walrasian equilibria in this
economy. These WE are supported by any strictly positive relative
price p of commodity x1 and they correspond to the allocations in
the segment EF in the Edgeworth box above.
(iii) [5 marks] The set of Pareto-efficient allocations is defined by any
allocation of the main diagonal of the Edgeworth box above. The
WE allocations are therefore Pareto efficient.
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Consider now the economy with the modified endowments.
P B
.. . ...
. .
oA
. .... U B
.....
. .
..... .....
ωs oB . .
...s.. .....
. .
..... E ..... F
. .
..... .....
. .
x2
..... .
.....
. .
..... .....
..... .....
. .
..... .....
. .
..... .. ...
. .
..... U A
. ....
... ...
A M x1
(iv) [4 marks] The offer curves of consumers A and B are oA and oB ,
respectively, as represented in the Edgeworth box above.
(v) [8 marks] The unique Walrasian equilibrium price is p∗ = 0 however
there exists a whole set of Walrasian equilibrium allocations. These
correspond to the segment EF in the Edgeworth box above. No-
tice that there may exist Walrasian equilibrium allocations such that
there exists excess supply of commodity x1 (For example the alloca-
tion of consumer A might be the one corresponding to E while the
allocation of consumer B might be the one corresponding to F .
(vi) [4 marks] The Pareto-efficient allocations are all the allocations in
the box in the area AP BM . Clearly all the Walrasian equilibrium
allocations in (v) above are Pareto efficient.
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4. Sketch of the answers:
(i) [10 marks] We proceed by backward induction. Assume that n = 2
Consider the subgame starting in the t = T = 4 period, clearly the
extensive for of this subgame is the extensive form of a take-it-or-
leave-it offer of player B. This implies that A will accept any offer x
such that x ≥ 0 and B will offer x = 0 and the payoffs associated
with these strategies are (0, 1). Move back one period to t = 3 since
it is still the case that by rejecting the offer and moving to next period
A can guarantee herself a payoff of 0 then A will accept any offer x
such that x ≥ 0 and B will offer x = 0.
Consider now period t = 2. By rejecting the offer and moving to next
period B can guarantee himself a payoff of 1 hence it is a best reply
for B in this subgame to accept any offer 1 − x ≥ δ. This implies
that A’s subgame perfect equilibrium strategy is to offer x = 1 − δ in
this subgame. Consider now period t = 1. By rejecting the offer and
moving to next period B can guarantee himself a payoff of δ hence
it is a best reply for B in this subgame to accept any offer 1 − x ≥ δ 2 .
This implies that A’s subgame perfect equilibrium strategy is to offer
x = 1 − δ 2 in this game.
(ii) [7 marks] The payoffs associated with these subgame perfect equi-
librium strategies are
(1 − δ 2 , δ 2 ).
(iii) [10 marks] Notice that the game described above is equivalent to a
bargaining game where players alternate every period in making an
offer there are n periods and both players discount the future at the
rate
τ = δ2. (1)
The equilibrium payoffs of the unique SPE of such a transformed
game, given that n is even, are:
1 − τn τ + τn
ΠA = , ΠB = (2)
1+τ 1+τ
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Substituting (1) in (4) we get:
1 − δT δ2 + δT
ΠA = , ΠB = (3)
1 + δ2 1 + δ2
(iv) [6 marks] The equilibrium payoffs of the unique SPE of the trans-
formed game, given that n is odd, are:
1 + τn τ − τn
ΠA = , ΠB = (4)
1+τ 1+τ
Substituting (1) in (4) we get:
1 + δT δ2 − δT
ΠA = , ΠB = (5)
1 + δ2 1 + δ2
