Economi cs l 01A

Problem Set Number 8

DUE: Tuesday November 29 (after Thanksgiving)
L A competitive firm has a cost function C(V):
ll2.
Suppose that the owner of the firm is risk
neutral and is given the following options:
Option 1: (no price stabilization) the selling price of output is a random variable that equals $1
with probability .5 and $2 with probability.5.
Option 2: (price stabilization) the selling price of output is $1.50 for sure.
(a) Suppose that the firm can make its output choice after the price of output is known. Show
that the owner prefers to have an unstabilized price, Explain why,
hint: Show that the firm' s profit function n(p): max
{
p' y
*
C(V)
}
is convex
Explain why this means that the firm likes a variable price,
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What is the first-order condition for the optimal choice of y under option I ? Would the owner
prefer option I or option 2 in this case? Why does this differ from your answer in (a)?
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owner prefers a stabilized
Price?
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fficertaindemandforitsproductisattemptingtoputtogetherawage
package for prospective workers.
In periods of low dernand, the firm
puts its workers on
temporary
layoff and pays them an "unemployment
benefit" $z'
In periods of high demand' each
worker works full time and earns $y.
The probability of low dernand is p' workers evaluate
alternative wage
packages as follows: the utility of income x is U(x)' If a worker is asked to
work, however, his/her net utility is
U(x)
-
b,
where b represents the "cost"
of foregone leisure'
(a) what is the expected utility ofjoining a firm that pays $y for working
(with probability I'p1
and $z during
periods of lay-off
(with probability p))? what is the expected cost to the firm of
offering such a
Package?
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Problem Set #8
Continued
(b) Suppose that the firm hires an economist to set up their compensation package. The
economist observes that
jobs
are available elsewhere in the economy that pay
$y*, and have no
risk of layoff. The economist proposes to choose y and z such that the package (y,z) minimizes
the expected cost of compensation, subject to the constraint that workers have the same expected
utility as they can achieve on the alternative (riskless) job. Solve the constrained optimization
problem. What is true about y and z7 How do ttrey vary with the probability of layofl?
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3. A consumer with income y faces the risk of a loss L. Suppose the probability of a loss is
P,
and
insurance coverage is available at the rate n>p. Assume the consumer's von-Neumann
Morgenstern utility function is:
u(z)
: -
exp (- Rz)
where R>0.
a) For an arbitrary von-Neumann Morgenstern utility function v, the "coefficient of risk
aversion" at income z is defined as r(z)=-u'rrrlv'(z). Show that for u(z) defined above'
r(z):R.
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4. An assistant professor at Berkeley is trying to decide how hard to work. If she gets tenure at
her currentjob, her salarywill be y,. Ifshe is denied tenure, she can get ajob at Second Chance
State College for a lower salary yr. The probability of tenure is p(a), where a is the number of
articles published. Her expected utility depends on income y and effort spent on writing: u(y)
-
fia, where u(y) is concave and s
>
0. Note that articles have to written before the tenure
decision.
a) Develop an expression for her e*p"cted uttttrr^
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b) Assume p' (a)>0
and p"(a) <
0. Find an expression for a*, tne opiin ar cnorce ora
Show that a rise in the salary y, leads to an increase in the number of articles.
HINT: look at the f.o.c. for a*, and draw a diagam illustrating
the optimum.
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c) Suppose some people have a high value of s (s:4"), andothers have a low value of a (a:ar).
Berkeley wants to keep the "low oo'professors, because it thinks that they will work harder even
after they get tenure! Show that Berkeley can do this by requiring a minimum number of articles
for tenure,
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5. Here are 2 "shoit answer questions" on auctions of the type that are likely to appear on the
final exam, For each question, indicate if the statement is true, false or uncertain, and explain
why, using diagrams, equations, etc'
a. ln a private values English
(ascending bid) auction, each bidder should keep bidding up to his
or her own valuation.
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b, A tract of national
forest is being sold off for logging using an English
auction'
Each logging
contractor
sends a team to evaluate
the forest'
If a team reports an estimate
that the timber is
worth l0 million dollars,
the company's
managers
should bid up to 10 million for the right to log
the land.
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