Birkbeck College

MSc Economics ETA1

Exam 2004 Answers

SECTION A
1. False. Use Slutsky Equation:
xj hj xj
= xi
pi pi m
xj hj x
Here i =coee, j =tea. So for pi < 0, pi mj xi must be negative. But we know for certain
hj
that pi > 0:

Tea = j

B pi / pj
A

Coffee = i

h x x m xj
and hence for pji mj xi to be negative mj must be positive. Hence xj m > 0, or the income
elasticity for tea is positive (i.e. a normal good).

3. False. A consumer is risk averse if,

00
U (w) is concave rA (w) = UU 0 (w)
(w)
>0
E[U (w)] U (E[w])
Certainty equivalent CE E[w]
Risk premium (w) = E[w] CE 0

U(E[w])
E[U(w)]

w1 CE E[w] w2 w
 A risk-averse consumer will thus still buy a share in a company with an uncertain return
if the share price is less than the CE.

4. True. The aggregate excess demand function in an exchange economy is

I
X
z(p) = [xi (p, p.ei ) ei ]
i=1

where xi (p, p.ei ) = (xi1 , xi2 ) is consumer is vector of demands for the two goods when his
endowment is ei = (ei1 , ei2 ), and p is the price vector. Then Walras Law states that for any
price vector p, the value of the excess demand is identically zero, i.e.

p.z(p) = p1 z1 + p2 z2 0

Thus if z1 = 0 at certain price (p1 , p2 ), then for this to hold z2 must also be zero, i.e. the
other market must also clear.

5. True. Without price discrimination, a monopoly would produce at the output level where
M R = M C which is less than the perfect competition output level:

P
Consumer Surplus
Pm Monopoly Equilibrium
Perfect Competition Equilibrium
MC

Qm MR D Q
Monopoly Rent Deadweight Loss

However if the monopoly has the information on how much the consumers are willing to pay
for its good, then it can price discriminate and charge dierence prices. Under perfect price
discrimination the firm will price each unit of output along the demand curve and extract all
consumer surplus (i.e. the whole CS triangle under perfect competition becomes the monopoly
rent) until there are no more CS extractable, i.e. at p = M C, which is the competitive output
level.

2
SECTION B
9. (a) The Marshallian demand functions are the solution to the utility maximisation problem.
Thus they must satisfy the budget constraint,
N
X
pi xi (p, m) = m
i=1

First dierentiate this w.r.t. pj , j = 1, ..., N ,

N
X xi
pi + xj = 0 j (Cournot aggregation)
pj
i=1

Next dierentiate w.r.t. m,

N
X xi
pi =1 (Engel aggregation)
m
i=1

(b) Here the Marshallian demand function x(p, m) is given by x(p, p.w). Dierentiating
the demand for good i w.r.t. pj gives,

xi (p, p.w) xi (p, p.w) xi (p, p.w)
= + wj
pj pj p.w = constant m

The Slutsky Equation for fixed income is given by,

xi (p, p.w) hi (p, U ) xi (p, p.w)
= xj
pj p.w = constant pj m

Substituting this into the first equation gives,

xi (p, p.w) hi (p, U ) xi (p, p.w)

= + (wj xj )
pj pj m

The first term is the substitution eect and the second is the income eect. Thus when
the consumers income arises from endowment of goods, the eect of a price increase on
the consumers income is no longer always negative (as in the case of the fixed m), but
depends on whether the consumer is a net buyer (wj xj < 0) or net seller (wj xj > 0)
of the good whose price changes. In the latter case, an increase in pj raises the consumers
income.

3
11. (a) The utility when the product turns out to be du is,
1
1 2 1 1 1 1
x y 2 = x2 y 2
4 2

Thus the expected utility is,

1 1 1 1 1 1 1 3 1 1
x2 y 2 + . x2 y 2 = x2 y 2
2 2 2 4
So we want to maximise this w.r.t. (x, y) subject to x + y = 32. We know that the
solution is invariant under a positive monotonic transformation and thus the solution is
the same as that for xa y b when a = b = 12 , i.e.

a m 1/2 32
x = = = 16
a + b px 1 1
b m 1/2 32
y = = = 16
a + b py 1 1
1 1
(b) This time it is the straight forward maximisation max x 2 y 2 s.t. x + y = 32, the solution
(x,y)
3 12 12
to which is again x = y
= 16. However the welfare is raised from 4x y =
1 1
3 12 12 1 1
4 16 16 = 12 to x y = 16 2 16 2 = 16, i.e. by a third.
2 2

1 1
(c) The problem is now max 34 x 2 y 2 s.t. 16
25 x + y = 32. Then,
(x,y)

a m 1/2 32
x = = = 25
a + b px 1 16/25
b m 1/2 32
y = = = 16
a + b py 1 1
1 1 1 1
with the expected utility 34 x 2 y 2 = 34 25 2 16 2 = 15 which is still less than in (b).
Thus despite consuming more, the consumers utility is less. This is due to the consumers
1 1
risk aversion. Check the concavity of the utility function: given the function x 2 y 2 , the
1 1
utility of the expected income 12 x + 12 . 14 x = 58 x is 58 x 2 y 2 . But we already know that
1 1 1 1 1
the consumers expected utility is 34 x 2 y 2 , which is less than 58 2 x 2 y 2 , and hence the
utility function is concave. Thus in this case the price 16 25 is still not low enough to
compensate for the uncertainty.

4
SECTION C
14. (a) Solve first the firms profit-maximisation when the price of coee is 1:

max y(A, L) rA wL s.t. y(A, L) = A L1

A,L

The Lagrangian is
max y rA wL (y A L1 )
A,L

FOCs are:
y
= r
A
y
(1 ) = w
L
y = A L1

which yields
r L
=
w 1 A
(b) Next solve the consumers utility maximisation:

max c (1 l)1 s.t. c = rah + wl

l
or
max (rah + wl) (1 l)1
l
The FOC is then,
1
1 l rah + wl
w (1 ) =0
rah + wl 1 l
Thus

w (1 l ) = (1 ) (rah + wl )
(1 )wl + wl = w (1 )rah
r
l = (1 )ah
w
(c) In equilibrium wr adjusts so that the demand A equals that total supply A, and the
total labour supply L = H (1 )A wr equals the labour demand L . Hence,
!
r H (1 )A wr
=
w 1 A
r
or when solved for w ,
r H
=
w 1 A

5
(d) Substitute this result back into the individual labour supply in (b),
H
l = (1 )ah
1 A
(1 )A (1 )ah H
=
(1 )A
But we know that 0 < < 1 so for this to be positive, we require

(1 )A > (1 )ah H

or
1 ah H
>
(1 ) A
Thus the required condition is that is close to 1 (leisure is not valuable), and/or
close to 0 (labour is very productive).
(e) Note first that the result in (b) only applies for an internal solution, i.e. for the non-
landowners, who supply positive labour, and not for the landowners (whose solution is
a corner solution). Thus for non-landowners as ah = 0,

l =

Then the Walrasian equilibrium is a wr such that L = N and A = A. Hence from
(a),
r N
=
w 1 A
The condition for landowners not to supply any labour is
" #
d A 1
r + wl (1 l) 0 l 0
dl M

Thus

A
w (1 l ) (1 ) r + wl
M
A r
(1 ) l
Mw
This must hold for all values of l 1, and in particular at l = 0. Thus, by
r0
substituting the expression for w above,

A N
(1 ) 0
M 1 A
M (1 )

N 1