W3211 Spring 2011

Professor Vogel
Review for Midterm #1: Solutions
Review Questions and solutions:
1. Consider the following payo matrix:
L R
T r
1
.
1
r
2
.
2
B r
3
.
3
r
4
.
4
In the following questions, suppose this is a simultaneous move game:
(a) What are the weakest conditions under which (1. 1) is a strict dominant strategy
equilibrium?
Solution: r
1
r
3
, r
2
r
4
,
1

2
,
3

4
(b) What are the weakest conditions under which (1. 1) is a dominant strategy equi-
librium?
Solution: r
1
r
3
, r
2
r
4
,
2

1
,
4

3
(c) What are the weakest conditions under which (1. 1) is a pure strategy Nash
equilibrium?
Solution: (B, R) is a pure strategy Nash equilibrium if no player has an incentive
to deviate, given the strategy of the other player.
)
4

3
and r
4
r
2
(d) Suppose (/

. :

) is a strict mixed strategy Nash equilibrium, where /

is the equi-
librium probability Player 1 plays 1 and :

is the equilibrium probability Player

2 plays 1. Solve for /

and :

as functions of the rs and s. What must be true

of /

and :

for a strict mixed strategy Nash equilibrium to exist?

Solution: If (/

. :

) is a strict mixed strategy Nash Equilibrium, then both

players must be indierent between playing their respective pure strategies given
the other players strategy. This gives:
(1 :

)r
1
+:

r
2
= (1 :

)r
3
+:

r
4
(1)
(1 /

)
1
+/

3
= (1 /

)
2
+/

4
(2)
We can rearrange (1) and (2) to get:
:

=
r
1
r
3
r
1
+r
4
r
2
r
3
(3)
/

=

1

4
+
1

3
(4)
Review for Midterm 1 2
There is a strict mixed strategy Nash Equilibrium if both 0 < /

< 1 and 0 <

:

< 1 hold.
(e) What are the weakest conditions under which both (1. 1) and (1. 1) are pure
strategy Nash equilibria?
Solution: From (c), (B, R) is a pure strategy Nash equilibrium if
4

3
and
r
4
r
2
. Similarly, (T, L) is a pure strategy Nash equilibrium if
1

2
and
r
1
r
3
. For both (T, L) and (B, R) to be pure strategy Nash equilibria, these 4
conditions should hold simultaneously.
(f) If (1. 1) is a pure strategy Nash Equilibrium, can there exist a strict mixed
strategy Nash equilibrium?
Solution: Yes. Recall the Battle of the Sexes game. There are two pure strategy
NE and one strictly mixed strategy NE.
(g) If (1. 1) is a strict dominant strategy equilibrium, can there exist a strict mixed
strategy Nash equilibrium?
Solution: No, because in order for a player to place positive probability on at
least two pure strategies, those two pure strategies need to give that player the
same utility. This is not possible if the palyer has a strict dominant strategy.
Now suppose this is a sequential game in which Player 1 moves rst and Player 2
moves second after observing Player 1s move
2. Suppose Bobs utility function is l (r. ) = 4 +10r +10 ln and Joes utility function
is \ (r. ) = r + ln .
(a) Will Bob and Joe always make the same choices about how to allocate their money
between goods if they face the same budget constraint?
Solution: Yes, because we can write \ (r. ) = 1 [l (r. )], where 1 (.) = 4 +
10., so that 1
0
(.) = 10 0.
(b) Will Bob and Joe always make the same choices about how to allocate their money
between goods if Bob has twice as much wealth as Joe and Bob faces prices that
are twice as high?
Solution: Yes, Bobs price ratio and MRS are still same with those of Joe.
3. Suppose Bobs preferences satisfy all the desirable properties: (i) complete, (ii) tran-
sitive, (iii) continuous, (i) more-is-better, and () a diminishing marginal rate of
substitution. Then out of the three consumption bundles below, can you identify any
one bundle that is strictly worse than another? Once youve identied one such bundle,
thats enough for each question. However, a given question might not have any two
bundles that can be ranked:
(a) (3. 4) . (2. 5) . (2.5. 4.5)
Review for Midterm 1 3
Solution: Bundle 1 is(3, 4) ; Bundle 2 is (2, 5) ; Bundle 3 is (2.5, 4.5). We dont
have any two bundles that can be ranked in this case.
(b) (8. 2) . (9. 1) . (8.5. 2)
Solution: Bundle 1 is(8, 2) ; Bundle 2 is (9, 1) ; Bundle 3 is (8.5, 2). We cant
rank bundles 1 and 2, nor can we rank bundles 2 and 3. But we can say that
bundle 3 is preferred to bundle 1 because it has more of good one and no less of
good 2.
4. Suppose Bobs preferences satisfy all the desirable properties: (i) complete, (ii) tran-
sitive, (iii) continuous, (i) more-is-better, and () a diminishing marginal rate of
substitution. In each question below I rst list two bundles between which Bob is
indierent. You have to answer whether you are able to say whether Bob prefers the
third bundle to the rst two or vice versa. However, in a given question you might not
be able to rank them:
(a) Bob is indierent between (3. 4) and (2. 5). Can you say whether he prefers either
of the previous bundles or this bundle: (2.5. 4.5)?
Solution: Since we assumed diminishing MRS, we know that indierence curve
is convex. Thus, any convex combination of the bundles (3. 4) and (2. 5) will be
preferred to these bundles. Note that (2.5. 4.5) is a convex combination of these
bundles since (2.5. 4.5) = (0.53+0.52. 0.54+0.55), so (2.5. 4.5) is preferred.
(b) Bob is indierent between (3. 4) and (2.9. 5). Can you say whether he prefers
either of the previous bundles or this bundle: (3.1. 3.9)?
Solution: We cannot say anything about which bundle Joe prefers. The bundle
(3.1. 3.9) is not a convex combination of (3. 4) and (2.9. 5). It does not provide
more of both goods in comparison to the other two bundles.
5. Suppose Bob has a budget of 1 0 and can buy two goods, A and 1 . The price of
good A is j
x
0. Bob faces a price j
y
0 for all purchases of good 1 up to
0
0
units of 1 . After purchasing
0
units of good 1 , he pays j
y
+ t, with t 0, for all
purchases up to purchase
00
, with
00

0
. After purchasing
00
units of good 1 , he
pays j
y
+ 2t for all subsequent purchases of good 1 .
(a) What must be true of
0
(in terms of 1 and j
y
) in order for Bob to be able to
purchase more than
0
units of good 1 if he allocates all of his income to good
1 ?
Solution: We must have
0
j
y
< 1.
Review for Midterm 1 4
(b) What must be true of
00
(in terms of 1, j
y
,
0
, and t) in order for Bob to be able
to purchase more than
00
units of good 1 if he allocates all of his income to good
1 ?
Solution: We must have j
y

0
+ (j
y
+t) (
00

0
) < 1
(c) Suppose the above two conditions hold. Then draw Bobs budget constraint (with
consumption of A on the r-axis and consumption of 1 on the -axis). You need
not identify the points at which the budget constraint hits either intercept or
the points at which the budget constraints slope changes. However, I want your
budget constraint to have the correct number of "kinks" (places where the budget
constraints slope changes) and I want the slopes to change in the correct way.
Solution:
6. Bobs preferences are l (r. ) = r

1
, where c 2 (0. 1). Bobs income (or budget) is
1 0, the price of A and 1 are j
x
0 and j
y
0, respectively.
(a) Solve for Bobs demand function for r and for .
Solution: r =
B
px
. =
(1)B
py
.
(b) What is Bobs `1o (marginal rate of substitution) at his optimal consumption
bundle?
Solution: `1o =
Ux
Uy
=
px
py
(c) If j
x
doubles, what must Bobs new income be (in terms of 1 and c) so that hes
just as happy as he was before the price changed?
Solution: Let his new income be 1.New demand functions are r
0
=
I
2px
.
0
=
(1)I
py
. His utility after the change in j
x
is l
1
=

(1)
1
I
2

x
p
1
y
. His original utility
was l
0
=

(1)
1
B
p

x
p
1
y
. We have l
0
= l
1
if and only if 1 = 2

1.
(d) If j
x
gets cut in half and j
y
doubles, what must Bobs new income be (in terms
of 1 and c) so that hes just as happy as he was before both prices changed?
Solution: Again, let his new income be \. New demand functions are r
0
=
2W
px
.
0
=
(1)W
2py
. His utility after the change in j
x
is l
1
=
2

(1)
1
W
p

x
p
1
y
2
1
=

(1)
1
B
p

x
p
1
y
= l
0
. Then, \ = 2
12
1.
7. Suppose demand for good A is inelastic and good A is a normal good:
(a) If the price of good A increases, then can you say if total spending on good A
will increase, decrease, or stay constant? Which property of demand for good A,
i.e. that its inelastic or normal, allowed you to answer this question?
Solution: From lecture notes we know that
@(pxx)
@px
= r[c
x;px
+1] Since demand is
inelastic, c
x;px
1 ) total spending increases when price increases.
Review for Midterm 1 5
(b) If the price of good A increases, then can you say if total consumption of good
A will increase, decrease, or stay constant? Which property of demand for good
A, i.e. that its inelastic or normal, allowed you to answer this question?
Solution: Since the good is normal, both substitution and income eect have the
same sign and an increase in price of X means a decline in its total consumption.
8. Suppose Bobs utility is given by l (r. . .) = r
1=4

1=2
.
1=2
. Bobs income is 1 0 and
the prices of goods A, 1 , and 2 are j
x
0, j
y
0, and j
z
0, respectively.
(a) Solve for Bobs demand for A, 1 , and 2.
Solution: First, we cannot have a boundary solution b/c if r = 0, or = 0, or
. = 0, we have l = 0, which is the minimum utility Bob can obtain. Hence, we
only look for the interior solution.
First-order conditions from the Lagrangian:
1
4
r
3=4

1=2
.
1=2
= j
x
`
1
2
r
1=4

1=2
.
1=2
= j
y
`
1
2
r
1=4

1=2
.
1=2
= j
z
`
j
x
r +j
y
+j
z
. = 1
Combining the rst two FOCs gives r =
ypy
2px
and combining the second and third
FOCs gives . =
ypy
pz
. Substituting into the fourth FOC and solving for gives
j
x

ypy
2px
+ j
y
+ j
z

ypy
pz
= 1 !

=
2I
5py
. Substituting into the formula for r
and . gives r

=
2I
10px
and .

=
2I
5pz
(b) Solve for the price elasticity of demand for A,
x;px
. Is demand for A inelastic,
elastic, or unit elastic?
Solution:
x;px
=
2I
10p
2
x

px
2I
10px
= 1. Demand for r is unit elastic
(c) Solve for the income elasticity of demand for 1 ,
y;I
. Is 1 a normal or an inferior
good?
Solution:
y;I
=
2
5py

I
2I
5py
= 1. is a normal good
(d) Solve for the cross-price elasticity of demand for 2 in terms of the price of good
A,
z;px
.
Solution:
z;px
= 0 .
9. Bobs utility as a function of his wealth, n, is l (n) = ln n, where c 2 (0. 1). His initial
wealth is 10. He is faced with the following decision. If he pays his entire wealth of 10,
then he enters the following lottery. With probability j 2 (0. 1) he receives r 0, and
with probability 1 j he receives 0. If he doesnt pay, he doesnt get the lottery.
(a) If r = 12 and = 8, what is the value of j at which this is a fair game?
Solution: j (12 10) + (1 j) (8 10) = 0 if and only if j = 1,2
Review for Midterm 1 6
(b) If j = 0.75 and r = 12, what is the value of at which this is a fair game?
Solution:
3
4
(12 10) +
1
4
( 10) = 0 if and only if = 4
(c) Will Bob pay to enter the lottery if it is a fair game? What if his utility as a
function of wealth was \ (n) = n
2
?
Solution: Bob will not pay to enter the lottery if its a fair game b/c hes
risk averse. A risk averse person prefers high expected value and low risk. We
know hes risk averse b/c the second derivative of his utility function is negative:
l
00
(n) = 1,n
2
< 0. On the other hand, if his utility function is \ , then hes
risk seeking and would take the lottery.
(d) Suppose j = 0.8 and = 1 (and his utility is l (n) = ln n). Write an equation
that determines the lowest value of r at which Bob would choose to enter the
lottery [You dont need to solve the equation though]
Solution: ln (10) =
4
5
ln (r 10 + 10) +
1
4
ln (1 10 + 10) if and only if ln (10) =
4
5
ln (r). We could easily solve this for r, but I didnt ask you to.
(e) Suppose this is worse than a fair game (the expected value is negative). Is there
any number of people including Bobcall this number of people : (where there are
: 1 other people and theres Bob)that would enter into an equal partnership
(in which each pays
1
n
of the cost of entering the lottery and each receives
1
n
of the
payments from the lottery) with whom Bob would be willing to enter into this
lottery? If so, provide the equation at which Bob would be indierent between
entering the lottery in this group or not entering the lottery [You dont need to
solve the equation].
Solution: No. No matter how many people he joins, the expected value is always
negative. And entering the lottery is never less risky than not entering it.
(f) Finally, suppose Bob is forced to enter into this lottery (and is forced to pay his
total wealth of 10 to do so). Suppose j = 0.75, r = 12, and = 10. An insurance
company oers Bob the following contract. Bob pays . 0 and in exchange,
the insurance company will guarantee that Bob receives 12 no matter what the
outcome of the lottery. Write the equation that determines the most Bob would
be willing to pay to enter into this contract [You dont need to solve the equation]
Solution: Bobs expected utility if he enters the lottery and does not buy the
insurance contract is 1 (no contract) =
3
4
ln (12 10 + 10) +
1
4
ln (10 10 + 10),
so that 1 (no contract) =
3
4
ln (12) +
1
4
ln (10). If Bob enters the lottery and buys
the insurance, his expected utility is 1 (contract) =
3
4
ln (12 .)+
1
4
ln (12 .), so
that 1 (contract) = ln (12 .). Bob is indierent between accepting the contract
or not if
ln (12 .) =
3
4
ln (12) +
1
4
ln (10)
10. An investor is has the following choice: invest in bonds or in stocks. If the economy
goes into a recession, the stock market will collapse and the price of his bonds will fall
Review for Midterm 1 7
slightly. If the economy booms, the stock market will go way up and the price of his
bonds will go up slightly. The probability the economy goes into a recession is 1,3
while the probability the economy booms is 2,3. The investors nal wealth in the four
possible cases are given by:
Bonds Stocks
Recession 10 0
Boom 20 40
The investor can only invest in either stocks or bonds. Can you say what the investor
will choose to invest in if shes:
(a) Risk averse? If so, which?
Solution: We cannot say which she prefers unless without having the utility
function. The reason is that 1\
Bonds
=
1
3
10 +
2
3
20 =
50
3
whereas 1\
Stocks
=
1
3
0 +
2
3
40 =
80
3
. Hence, we have 1\
Stocks
1\
Bonds
. However, Stocks are riskier
than Bonds. Hence, we dont know which a risk-averse agent will pick.
(b) Risk neutral? If so, which?
Solution: Stocks, since she only cares about expected wealth.
(c) Risk seeking? If so, which?
Solution: Stocks, since 1\
Stocks
1\
Bonds
and Stocks are riskier.