Revision Lecture

EC2066 Microeconomics

Arup Daripa

April 2023

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Preparing for the exam

◮ The exam consists mainly of problem-solving questions,

which also ask for explanations and intuitions
◮ You should prepare by solving problems from the end of
chapters in the subject guide, from past questions and from
texts.
◮ Explanations are very important.
◮ Some parts may be more difficult than others - plan carefully

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Corner Solution

A general point about optimisation. Suppose

u(x) = −1/x

where x ∈ [0, 1]. What is the optimal value of x?

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IE and SE

◮ Two goods: x, y. Relative price of x is p. Suppose p falls from

p0 to p1 .
◮ To get SE, calculate indirect utility before and after price
change, and then make appropriate income adjustment to
make them equal: u(p0 , M) = u(p1 , M − ∆M)
◮ SE is x(p1 , M − ∆M) − x(p0 , M)

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IE and SE

◮ Suppose u(x, y) = min[αx, βy].

◮ At the optimum αx = βy, so u(p, M) = αx(p, M)
◮ Therefore we need αx(p1 , M − ∆M) = αx(p0 , M) implying SE
is zero. IE equals total price effect.

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◮ Now try the same question for the quasi-linear utility function
u(x, y) = α ln x + y, where income is M > α.
◮ MUx /MUy = α/x. α/x = p implies x = α/p.
◮ In this case the demand for x does not depend on income, so
IE is 0. Here substitution effect is equal to total price effect.

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In general, you should get to know the following functional forms,
often used in questions
◮ Substitutes: u(x, y) = αx + βy, α, β positive constants
◮ Complements: u(x, y) = min[αx, βy]
◮ Quasi-linear: u(x, y) = α ln x + y, M > α
◮ Cobb-Douglas: u(x, y) = xα yβ

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Calculating elasticities

◮ Large number of mistakes when asked to calculate an

elasticity.
◮ Calculate the price elasticity and income elasticity for the
demand for x under the utility functions discussed above.

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Hicksian demand
◮ Derive uncompensated and compensated demand for each
good if u(x, y) = x(1/2) y(1/2) .
◮ Equating MRS to p, we get y/x = p. Using this in the budget
constraint, the uncompensated demands are

M M
x(p, M) = and y(p, M) = .
2p 2
◮ Next, minimise expenditure subject to a utility constraint:
x(1/2) y(1/2) = U to derive the compensated demands at
utility U. Same MRS equal to p condition at minimum, so
√
y/x = p, implying y = xp. Use in constraint to get x p = U,
implying

U √
hx (p, U) = √ and hy (p, U) = U p
p

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Saving and Borrowing

◮ Response to a change in the interest rate.

◮ The argument is simple, but there are many mistakes - try to
argue in words whenever possible.
◮ Limits of change in the behaviour of savers when the interest
rate rises - can’t become borrowers.
◮ However, when interest rate rises, borrowers might become
savers
◮ Similarly, when interest rate falls, borrowers can’t become
savers - but savers might become borrowers

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Perfect competition in a single market

◮ Determine the short-run and long-run supply functions for a

competitive firm
◮ Do non-competitive firms have supply functions?
◮ Determine the short-run and long-run supply functions for a
competitive industry
◮ Impact of tax, subsidy
◮ Impact of price ceiling: who gets the supply? Can there be
resale?

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Monopoly

◮ What is the source of the social cost under monopoly? Does

social cost change under negative externality?
◮ Monopoly and policy
◮ Natural monopoly and policy
◮ Monopoly and the inefficiency from externality
◮ Monopoly and price discrimination

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Oligopoly

◮ Cournot - nature of externality - quantity too high relative to

joint optimum?
◮ Differentiated product Bertrand - follower gains. Nature of
externality.

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Game Theory

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Simultaneous-Move Games

◮ What do we mean by solution concepts?

◮ Dominance
◮ Nash equilibrium - pure and mixed strategies

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Consider the following game.

Player 2
A2 B2
A1 3,1 2,3
Player 1 B1 2,1 3,0

Notice that this game has no pure strategy Nash equilibrium.

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Mixed strategy NE

◮ Indifference: key idea

◮ How does this indifference come about? 2 must choose q
such that 1 is made indifferent between A1 and B1 :

3q + 2(1 − q) = 2q + 3(1 − q),

which implies q = 1/2.

◮ Similarly, 1 must choose p such that 2 is made indifferent
between A2 and B2 .
1 = 3p
which implies p = 1/3.
◮ Therefore the mixed strategy Nash equilibrium is as follows. 1
plays A1 with probability 1/3 and B1 with probability 2/3, while
2 plays A2 with probability 1/2 and B2 with probability 1/2.

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Sequential-Move Games

◮ First, we need to understand the difference between actions

and strategies in such games.
◮ Once we clarify this, we show how to derive Nash equilibria.
◮ Finally, we propose a refinement of Nash equilibrium:
subgame perfect Nash equilibrium.
◮ In games where all moves of previous players can be
observed, subgame perfect Nash equilibria can be derived by
backward induction. This does not work for games involving
imperfect information.

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 1

a1 a2

2 2

b1 b2 b1 b2

(3,1) (1,0) (4,1) (0,1)

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Strategies

◮ A strategy in a sequential-move game is a complete plan of

actions. In other words, a strategy for a player must specify an
action at every node at which that player can possibly move.
◮ For player 1, the set of actions and the set of strategies is the
same. Player 1 can simply decide between a1 and a2 .
Therefore, the strategy set of player 1 is simply {a1 , a2 }.

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Strategies

◮ Player 2, on the other hand, must plan for two different

contingencies. He must decide what to do if 1 plays a1 , and
what to do if 1 plays a2 . Note that such decisions must be
made before the game is actually played.
◮ Player 2 can choose 2 possible actions at the left node (after 1
plays a1 ) and 2 possible actions at the right node (after a2 ). So
there are 2 × 2 = 4 possible strategies for 2. These are
1. If 1 plays a1 , play b1 and if 1 plays a2 , play b1 (short form:
b1 , b1 )
2. If 1 plays a1 , play b1 and if 1 plays a2 , play b2 (short form:
b1 , b2 )
3. If 1 plays a1 , play b2 and if 1 plays a2 , play b1 (short form:
b2 , b1 )
4. If 1 plays a1 , play b2 and if 1 plays a2 , play b2 (short form:
b2 , b2 )

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Strategies

◮ Suppose instead of 2 actions, player 2 could choose between

b1 , b2 and b3 at each node. In that case, 2 would have
3 × 3 = 9 strategies.
◮ Suppose 1 had 3 strategies a1 , a2 and a3 and after each of
these, 2 could choose between b1 and b2 , Then 2 would have
2 × 2 × 2 = 8 strategies.

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Normal form

◮ To find NE, first write the normal form

Player 2
b1 b1 b1 b2 b2 b1 b2 b2
◮
Player 1 a1 3,1 3,1 1,0 1,0
a2 4,1 0,1 4,1 0,1
Pure NE:

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Imperfect Information

a1 a2

b1 b2 b1 b2

(3,1) (1,0) (4,1) (0,1)

Figure:

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Normal form

Player 2
b1 b2
a1 3,1 1,0
Player 1 a2 4,1 0,1

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◮ Nash equilibria of such games can involve incredible threats.

Firm E

In Out
Firm I

A F 0,2

2,1 -1,-2

◮ (Out,F) and (In, A) are both NE.

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Subgame-Perfect Nash Equilibrium

◮ Subgme:
◮ A subgame is a part of a game that starts from a singleton
node and includes all successors of that node.
◮ You cannot cut information sets: if one node in an information
set is in a subgame, then all other nodes in that information set
must also be in the same subgame.
◮ Note that a subgame cannot start from an information set -
only from single nodes.

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Subgame-Perfect Nash Equilibrium

◮ A strategy combination is a subgame-perfect Nash equilibrium

(SPNE) if
◮ it is a Nash equilibrium of the whole game, and
◮ for every subgame: the part of the strategies that apply to the
subgame form a Nash equilibrium in that subgame.
It should be clear from the definition that the set of
subgame-perfect equilibria is a refinement of the set of Nash
equilibria.
◮ Can be found by backward induction in games of perfect
information

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SPNE

◮ Solving backwards in the entry game, we see that Firm I

would choose A if firm E chose In. Knowing this, Firm E would
compare 0 (from Out) with 2 (from In and A), and choose In.
Therefore the SNPE is (In, A).

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 1

L R

2 2

ℓ r ℓ r

(3,3) (-1,0) (4,0) (0,4)

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 Out
1 (1,3)

In
1

A B

C D C D

(-2,-2) (2,0) (0,2) (-5,-5)

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Repeated Games

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 2
C D
1 C 2,2 0,3
D 3,0 1,1
◮ In a one-shot game, rational players simply play their
dominant strategies. So (D, D) is the only possible
equilibrium.
◮ First, consider the case of finite number of repetitions. Say the
game is played twice. Would anything change? How about if
the game is played a 100 times?
◮ To escape from the logic of backward induction, we can
assume that when a game is repeated many times, players
play them as if the games are infinitely repeated.

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Infinitely repeated games: Strategies

Always write down strategies. Consider the following trigger

strategy.
◮ Start by playing C (that is, cooperate at the very first period
t = 0)
◮ In period t > 1,
◮ if (C, C) was played last period, play C
◮ if anything else was played last period, play D
Suppose each player follows this strategy. Note that cooperation
(playing (C, C)) would work only until someone deviates to D. After
the very first deviation, each player switches to D.
Once a switch to (D, D) has been made, the players play (D, D)
for ever afterwards. This is why this is a trigger strategy.

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◮ Check that this sustains cooperation.
◮ Suppose a player deviates in period t. We only need to
consider what happens from t onwards.
◮ The payoff starting at period t is given by
δ
3 + δ + δ2 + . . . = 3 +
1−δ
◮ If the player did not deviate in period t, the payoff from t
onwards would be
2
2 + 2δ + 2δ2 + . . . =
1−δ
◮ For deviation to be suboptimal, we need
2 δ
> 3+
1−δ 1−δ
which implies
1
δ>
2
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General Equilibrium

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General Equilibrium: Preparing for this topic

◮ Problems (as in past questions, end of chapter problems)

◮ Draw Edgeworth box under different specifications of utility
functions, identify contract curve, part of the contract curve
where trade can take place (part that Pareto dominates the
endowment point) and the equilibrium price line.
◮ Write short paragraphs on each of the two welfare theorems:
what is the implication, under what circumstances are they
violated (it is sufficient to study the discussion in the subject
guide)

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◮ Suppose an economy has two agents 1, 2 and two goods x, y.
Suppose u1 (x, y) = x1/3 y2/3 and u2 (x, y) = x1/4 y3/4 . The
endowments are (10,10) for 1 and (20,5) for 2.
◮ Let p be the relative price of x.
◮ Derive the contract curve equation, equilibrium relative price
of x, and equilibrium allocation.

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Contract Curve

◮ Suppose an economy has two agents 1, 2 and two goods x, y.

1/3 2/3 1/4 3/4
Suppose u1 (x1 , y1 ) = x1 y1 and u2 (x2 , y2 ) = x2 y2 . The
endowments are (10,10) for 1 and (20,5) for 2.
◮ Contract curve: MRS of 1 equal to MRS of 2

1 y1 1 y2
=
2 x1 3 x2
◮ To further solve, substitute: x2 = 30 − x1 and y2 = 15 − y1
Then, by simplifying, we get

30x1
y1 =
90 − x1
◮ Here is a computer plot of this contract curve and indifference
curves.

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Contract Curve

x2 Agent 2
15

y1

y2

Agent 1 30
x1

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Equilibrium
◮ Let p denote the relative price of x.
◮ Calculate the equilibrium value of p
◮ First calculate demand functions
M1 2M1
x1 = and y1 =
3p 3
where M1 = 10p + 10.
M2 3M2
x2 = and y2 =
4p 4
where M2 = 20p + 5.
◮ Market clearing: y1 + y2 = 15. This gives us p = 11/52.
◮ The price line is (11/52)x1 + y1 = (11/52)10 + 10. This is
shown in the next picture
◮ Given the equilibrium p, we can calculate the equilibrium
allocation from the demand functions. These are:
x1 = 210/11, y1 = 105/13, x2 = 120/11 and y2 = 90/13.
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Equilibrium price line

Agent 2
15

Price line
Endowment
10
Equilibrium

Agent 1 10 30

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Another example: with possible corner solutions

◮ Suppose ua = x1/2 y1/2 and ub = 2x + y. Suppose A has

endowment (2,2) and B has endowment (8, 8).
◮ Derive the equilibrium price.

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Another example: with possible corner solutions

◮ Suppose ua = x1/2 y1/2 and ub = 2x + y. Suppose A has

endowment (2,2) and B has endowment (8, 8).
◮ Here
ya
MRSa = and MRSb = 2
xa
◮ For any interior solution, the contract curve is ya /xa = 2 or
ya = 2xa .
◮ Further, A’s optimization implies ya /xa = p.
◮ Therefore p = 2

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Contract Curve
xb
10 B

ya

2
Endowment
y
b
A 2
xa 10

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Equilibrium price line
xb
10 B

ya

Price line coincides with

B’s indiff curve

Equilibrium

2
Endowment
y
b
A 2
xa 10

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Welfare Theorems

◮ You should be able to write short paragraphs describing the

implications of the two welfare theorems and the cases in
which they might fail.
◮ It is sufficient to study the discussion in the subject guide for
this

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Welfare Theorems
◮ Suppose an economy has two agents 1, 2 and two goods x, y.
Suppose u1 (x, y) = x1/3 y2/3 and u2 (x, y) = x1/4 y3/4 . The
endowments are (10,10) for 1 and (20,5) for 2. Derive the
contract curve equation, equilibrium price ratio and
equilibrium allocation.
◮ Is the equilibrium allocation efficient?
◮ Ans: Yes. First welfare theorem. Equilibrium allocation is
efficient.
◮ If we pick an allocation on the contract curve that is different
from the equilibrium allocation you just derived, is it possible
to support this new point as an equilibrium allocation? What
would we need to do for this to be possible?
◮ Ans: Yes. Second welfare theorem. So long as preferences
are convex, this is possible after a suitable redistribution of the
initial endowment. Here preferences are convex.

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Adverse selection

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Adverse Selection

◮ You should prepare for both conceptual questions and

problem solving questions
◮ You should be familiar with the three models covered in the
subject guide
◮ The lemons problem
◮ The price discrimination model
◮ Job market signalling through education

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A Model of Price Discrimination

◮ A seller sells a unit of quality q at price t.

◮ Cost of producing quality q is c(q) = q2 .
◮ Profit of the seller is

π(t, q) = t − q2

and utility of the buyer is

u(t, q, θ) = θq − t.

◮ θ is the buyer’s ‘type’ - this is the buyer’s private information.

◮ Here we suppose θ can take two values, θ1 and θ2 , where
θ2 > θ1 .

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Moral Hazard

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Moral hazard

◮ A risk-neutral principal hires a risk-averse agent to carry out a

particular project.
◮ Once hired, the agent chooses an effort level, which affects
the outcome of the project in a probabilistic sense: higher
effort leads to a higher probability of success, and that
translates into higher expected profit for the principal.
◮ If the choice of effort was observable contract could specify
effort.
◮ If effort is unobservable, the principal must provide the agent
the right incentive using a wage contract. Form of wage
contract: risky wage or riskless fixed wage.

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Externalities, Public Goods,
Commons Goods
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Preparing for Externalities and Public goods

◮ Problems
◮ Should be able to describe the Coase theorem, briefly
describe its implications and shortcomings
◮ Should be able to show, using the model of externalities in the
subject guide, that bargaining leads to the efficient outcome
irrespective of who is given the property right
◮ Should understand basics of an emissions trading market.
How can you tell if such a market is working well?
◮ Public goods: basic concept, show that private provision
results in underprovision, problems
◮ Commons problem: understand the basic concept, show
overexploitation in a model, problems. Also you should be
able to discuss briefly the different types of solutions
(following the discussion in the subject guide)

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Coase theorem: the property rights solution

◮ Consider a situation involving two parties where an externality

arises from the action of one party.
◮ You should be able to write down what the Coase theorem
says
◮ The Coase theorem says that under conditions of perfect
competition (that is, under the standard assumption in the
economic analysis of competitive markets that there are no
transactions costs of trading), if property rights are well
defined, bargaining between parties would lead to the efficient
outcome. This is true irrespective of who the property rights
are allocated to (to the party generating the externality or to
the party affected).

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