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You are on page 1of 88

A. Daripa

EC2066

2016

Undergraduate study in

Economics, Management,

Finance and the Social Sciences

This is an extract from a subject guide for an undergraduate course offered as part of the

University of London International Programmes in Economics, Management, Finance and

the Social Sciences. Materials for these programmes are developed by academics at the

London School of Economics and Political Science (LSE).

For more information, see: www.londoninternational.ac.uk

This guide was prepared for the University of London International Programmes by:

Dr Arup Daripa, Lecturer in Financial Economics, Department of Economics, Mathematics and

Statistics, Birkbeck, University of London.

This is one of a series of subject guides published by the University. We regret that due to

pressure of work the author is unable to enter into any correspondence relating to, or arising

from, the guide. If you have any comments on this subject guide, favourable or unfavourable,

please use the form at the back of this guide.

Publications Office

Stewart House

32 Russell Square

London WC1B 5DN

United Kingdom

www.londoninternational.ac.uk

Published by: University of London

University of London 2016

The University of London asserts copyright over all material in this subject guide except where

otherwise indicated. All rights reserved. No part of this work may be reproduced in any form,

or by any means, without permission in writing from the publisher. We make every effort to

respect copyright. If you think we have inadvertently used your copyright material, please let

us know.

Contents

Contents

1 Introduction

1.1

1.2

1.3

Syllabus . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

1.4

1.5

1.6

1.6.1

1.6.2

Essential reading . . . . . . . . . . . . . . . . . . . . . . . . . . .

1.6.3

Further reading . . . . . . . . . . . . . . . . . . . . . . . . . . . .

1.6.4

1.6.5

The VLE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

1.6.6

Examination advice . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

1.7.1

1.7.2

Types of questions . . . . . . . . . . . . . . . . . . . . . . . . . .

1.7.3

1.7

2 Consumer theory

2.1

11

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

11

2.1.1

11

2.1.2

Learning outcomes . . . . . . . . . . . . . . . . . . . . . . . . . .

11

2.1.3

Essential reading . . . . . . . . . . . . . . . . . . . . . . . . . . .

12

2.2

12

2.3

12

2.3.1

12

2.3.2

Indifference curves . . . . . . . . . . . . . . . . . . . . . . . . . .

13

2.3.3

Budget constraint . . . . . . . . . . . . . . . . . . . . . . . . . . .

16

2.3.4

Utility maximisation . . . . . . . . . . . . . . . . . . . . . . . . .

16

Demand curves . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

20

2.4

Contents

2.4.1

20

2.4.2

Elasticities of demand . . . . . . . . . . . . . . . . . . . . . . . .

23

2.4.3

24

2.4.4

25

2.5

Labour supply . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

29

2.6

. . . . . . . . . . . . . . . .

30

2.7

33

2.7.1

Bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

34

2.8

34

2.9

35

2.9.1

35

3.1

37

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

37

3.1.1

37

3.1.2

Learning outcomes . . . . . . . . . . . . . . . . . . . . . . . . . .

37

3.1.3

Essential reading . . . . . . . . . . . . . . . . . . . . . . . . . . .

38

3.2

38

3.3

Preliminaries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

38

3.4

38

3.5

Risk aversion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

39

3.6

. . . . . . . . . . . . . . . . . .

40

3.6.1

40

3.6.2

42

3.7

43

3.8

44

3.9

Reducing risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

46

46

46

46

4 Game theory

4.1

ii

49

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

49

4.1.1

49

4.1.2

Learning outcomes . . . . . . . . . . . . . . . . . . . . . . . . . .

49

4.1.3

Essential reading . . . . . . . . . . . . . . . . . . . . . . . . . . .

50

Contents

4.1.4

Further reading . . . . . . . . . . . . . . . . . . . . . . . . . . . .

50

4.2

50

4.3

50

4.3.1

51

4.3.2

52

4.3.3

Nash equilibrium . . . . . . . . . . . . . . . . . . . . . . . . . . .

53

4.3.4

Mixed strategies . . . . . . . . . . . . . . . . . . . . . . . . . . . .

55

4.3.5

58

4.3.6

59

59

4.4.1

59

4.4.2

61

4.4.3

61

63

4.5.1

64

4.5.2

65

4.5.3

66

68

4.6.1

69

4.6.2

Folk theorem . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

70

4.7

74

4.8

74

4.8.1

74

4.4

4.5

4.6

5.1

79

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

79

5.1.1

79

5.1.2

Learning outcomes . . . . . . . . . . . . . . . . . . . . . . . . . .

79

5.1.3

Essential reading . . . . . . . . . . . . . . . . . . . . . . . . . . .

79

5.2

80

5.3

80

5.4

80

5.4.1

80

5.5

81

5.6

83

5.6.1

83

Isoquants . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

iii

Contents

5.6.2

Diminishing MRTS . . . . . . . . . . . . . . . . . . . . . . . . . .

83

5.6.3

Returns to scale . . . . . . . . . . . . . . . . . . . . . . . . . . . .

84

5.6.4

84

Cost curves . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

84

5.7.1

84

5.7.2

85

5.7.3

Short run . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

85

5.7.4

Long run . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

86

5.8

Profit maximisation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

90

5.9

91

91

91

5.7

6.1

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

93

6.1.1

93

6.1.2

Learning outcomes . . . . . . . . . . . . . . . . . . . . . . . . . .

93

6.1.3

Essential reading . . . . . . . . . . . . . . . . . . . . . . . . . . .

94

6.2

94

6.3

94

6.4

95

6.4.1

95

6.4.2

Short-run supply . . . . . . . . . . . . . . . . . . . . . . . . . . .

95

6.4.3

Long-run supply

. . . . . . . . . . . . . . . . . . . . . . . . . . .

97

97

6.5.1

Short run . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

97

6.5.2

Long run . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

98

6.6

Producer surplus . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

99

6.7

99

6.7.1

99

6.7.2

Price ceiling . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

102

6.7.3

Price floor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

103

6.7.4

Quota . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

105

6.7.5

105

6.7.6

106

108

6.5

6.8

iv

93

Contents

6.9

109

6.9.1

109

7.1

111

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

111

7.1.1

111

7.1.2

Learning outcomes . . . . . . . . . . . . . . . . . . . . . . . . . .

111

7.1.3

Essential reading . . . . . . . . . . . . . . . . . . . . . . . . . . .

112

7.2

112

7.3

112

7.4

Existence of equilibrium . . . . . . . . . . . . . . . . . . . . . . . . . . .

119

7.5

Uniqueness . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

119

7.6

Welfare theorems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

120

7.6.1

120

7.6.2

Implications . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

121

7.6.3

122

7.6.4

Implications . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

123

7.7

Production

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

124

7.8

126

7.9

127

7.9.1

127

8 Monopoly

8.1

129

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

129

8.1.1

129

8.1.2

Learning outcomes . . . . . . . . . . . . . . . . . . . . . . . . . .

129

8.1.3

Essential reading . . . . . . . . . . . . . . . . . . . . . . . . . . .

130

8.2

130

8.3

130

8.4

130

8.5

Price discrimination . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

132

8.6

Natural monopoly . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

134

8.7

135

8.8

135

8.8.1

135

Contents

9 Oligopoly

9.1

137

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

137

9.1.1

137

9.1.2

Learning outcomes . . . . . . . . . . . . . . . . . . . . . . . . . .

137

9.1.3

Essential reading . . . . . . . . . . . . . . . . . . . . . . . . . . .

138

9.2

138

9.3

Cournot competition . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

138

9.3.1

Collusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

140

9.3.2

141

9.3.3

Stackelberg leadership . . . . . . . . . . . . . . . . . . . . . . . .

142

Bertrand competition . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

143

9.4.1

Collusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

143

143

9.5.1

Sequential pricing . . . . . . . . . . . . . . . . . . . . . . . . . . .

144

9.6

146

9.7

146

9.7.1

146

9.4

9.5

vi

149

10.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

149

150

150

150

151

151

152

152

153

153

155

155

158

159

160

160

Contents

161

11.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

161

161

161

162

162

162

164

164

165

165

166

166

166

169

170

170

170

173

12.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

173

174

174

174

174

175

12.3 Externalities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

175

177

178

182

182

184

185

12.5.1 Evidence . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

185

186

187

vii

Contents

188

188

viii

Chapter 1

Introduction

1.1

In this introductory chapter, we will look at the overall structure of the subject guide

(in the form of a Routemap); we will introduce you to the subject area; to the aims and

learning outcomes for the course; and to the learning resources available to you. Finally,

we will offer you some Examination advice.

We hope that you enjoy this course and we wish you every success in your studies.

We start by analysing individual choice. In Chapter 2, we analyse consumer choice. We

specify properties of preferences, how to go from preferences to utility and optimal

choice by maximising utility under a budget constraint. We show how to obtain demand

functions from optimal solutions to the consumer choice problem. We discuss what

happens to the consumers welfare when prices and/or income change, and appropriate

measures to evaluate these changes. We also consider the labour supply decision of

individuals, and the intertemporal choice problem faced by savers and borrowers. We

provide a brief exposition of some basic algebra of intertemporal choice problems with

more than two periods. In Chapter 3, we model the agents behaviour in situations

involving risk, and analyse insurance problems. We then introduce strategic interaction

in Chapter 4 and provide an exposition of the basic tools of game theory. Next, we turn

to the supply side of the economy. In Chapter 5, we describe the production technology,

structure of costs and principles of profit maximisation by firms. Chapter 5 of the

subject guide is essentially a toolbox for analysis in subsequent chapters. Using these

tools, we analyse the problem of competitive firms as well as the equilibrium in a

competitive market in Chapter 6. In Chapter 7, we then introduce the general

equilibrium across all competitive markets and study the two welfare theorems that are

fundamental to our understanding of market economies. We also consider some

applications of the supply-demand model, and analyse the impact of policies on welfare.

Next, we consider markets that are imperfectly competitive. In Chapter 8, we analyse

the problem of monopoly, the associated inefficiencies and policy prescriptions aimed at

restoring efficiency. This is followed by an analysis of the problem of oligopolistic

competition in Chapter 9. Next, we turn to the problem of asymmetric information and

analyse the problems of adverse selection (in Chapter 10) and moral hazard (in Chapter

11). Finally, in Chapter 12, we consider the problem of externalities and public goods

and consider policy prescriptions arising from associated market failures.

Given the emphasis of the EC2066 Microeconomics syllabus on using analytical

methods to solve economic problems, you are encouraged to spend a considerable

amount of time doing the problems or questions given in the textbooks. Learning by

doing is likely to be more profitable than simply reading and re-reading textbooks.

1. Introduction

Nevertheless, a thorough reading of, and careful note-taking from, the recommended

textbook and the subject guide is a prerequisite for successful problem solving. The

subject guide aims to indicate as clearly as possible the key elements in microeconomic

analysis that you need to learn. The subject guide also presents detailed algebraic

derivations for a variety of topics. For each topic, you should consult both the subject

guide and the suggested parts of the textbook to understand fully the economic

principles involved.

1.2

knowledge

The syllabus and subject guide assume that you are competent in basic economic

analysis up to the level of the prerequisite courses EC1002 Introduction to

economics, ST104a Statistics 1, MT105a Mathematics 1 or MT1174 Calculus.

They build on the foundations provided in these courses by specifying how your

understanding of the microeconomic principles developed so far should be deepened and

extended. Like EC1002 Introduction to economics, EC2066 Microeconomics is

designed to equip you with the economic principles necessary to analyse a whole range

of economic problems. To maximise your benefit from the subject, you should continue

to think carefully about:

the assumptions, internal logic and predictions of economic models

how economic principles can be applied to solve particular economic problems.

The appropriate analysis will depend on the specific facts of a problem. However, you

are not expected to know the detailed facts about specific economic issues and policies

mentioned in textbook examples. Rather, you should use these examples (and the

end-of-chapter Sample examination questions) to aid your understanding of how

economic principles can be applied creatively to the analysis of economic problems.

If you are taking this course as part of a BSc degree you will also have passed ST104a

Statistics 1 and MT105a Mathematics 1 or MT1174 Calculus before beginning

this course. Every part of the syllabus can be mastered with the aid of diagrams and

relatively simple algebra. The subject guide indicates the minimum level of

mathematical knowledge that is required. Knowledge (and use in the examination) of

sophisticated mathematical techniques is not required. However, if you are

mathematically competent you are encouraged to use mathematical techniques when

these are appropriate, as long as you recognise that some verbal explanation is always

necessary.

1.3

Syllabus

The course examines how economic decisions are made by households and firms, and

how they interact to determine the quantities and prices of goods and factors of

production and the allocation of resources. Further, it examines the nature of strategic

role of policy as well as economic contracts in improving welfare. The topics covered are:

Consumer choice and demand, labour supply.

Choice under uncertainty: the expected utility model.

Producer theory: production and cost functions, firm and industry supply.

Game theory: normal-form and extensive form games, Nash equilibrium and

subgame perfect equilibrium, repeated games and cooperative equilibria.

Market structure: competition, monopoly and oligopoly.

General equilibrium and welfare: competitive equilibrium and efficiency.

Pricing in input markets.

Intertemporal choice: savings and investment choices.

The economics of information: moral hazard and adverse selection, resulting

market failures and the role of contracts and institutions.

Market failures arising from monopoly, externalities and public goods. The role of

policy.

1.4

This subject guide enables you to fully interpret the published syllabus for EC2066

Microeconomics. It identifies what you are expected to know within each area of the

syllabus by emphasising the relevant concepts and models and by stating where in

specific textbooks that material can be found. This subject guide aims to help you make

the best use of textbooks to secure a firm understanding of the microeconomic analysis

covered by the syllabus. The subject guide also complements your textbook in certain

areas where the coverage in the textbook is deemed inadequate.

1.5

At the end of this course, and having completed the Essential reading and activities,

you should:

be able to define and describe:

the determinants of consumer choice, including inter-temporal choice and

choice under uncertainty

the behaviour of firms under different market structures

how firms and households determine factor prices

behaviour of agents in static as well as dynamic strategic situations

1. Introduction

be able to analyse and assess:

efficiency and welfare optimality of perfectly and imperfectly competitive

markets

the effects of externalities and public goods on efficiency

the effects of strategic behaviour and asymmetric information on efficiency

the nature of policies and contracts aimed at improving welfare

be prepared for further courses which require a knowledge of microeconomics.

Each chapter includes a list of the learning outcomes that are specific to it. However,

you also need to go beyond the learning outcomes of each single chapter by developing

the ability of linking the concepts introduced in different chapters, in order to approach

the examination well.

1.6

1.6.1

The subject guide

The Essential reading lists the relevant textbook chapters and sections of chapters,

even though a more detailed indication of the required reading is listed throughout

the chapter.

The sections that follow specify in detail what you are expected to know about

each topic. The relevant sections of the recommended textbooks are referred to.

Wherever necessary, the sections integrate the textbook with additional material

and explanations. Finally, they draw attention to any problems that occur in

textbook expositions and explain how these can be overcome.

The boxes that appear in some of the sections give you exercises based on the

material discussed.

The learning outcomes show you what you should be able to do by the end of the

chapter.

A final section gives you questions to test your knowledge and understanding.

1.6.2

Essential reading

This subject guide is specifically designed to be used in conjunction with the textbook:

Nicholson, W. and C. Snyder Intermediate Microeconomics and its Application.

(Cengage Learning, 2015) 12th edition [ISBN 9781133189039].

Henceforth in this subject guide this textbook is referred to as N&S.

This is available as an e-book at a discounted price via the VLE. Please visit

the course page for details.

Students may use the previous edition instead:

Nicholson, W. and C. Snyder Theory and Applications of Intermediate

Microeconomics. (Cengage Learning, 2010) 11th edition, international edition

[ISBN 9780324599497].

Note that the title of the twelfth edition differs slightly from that of the eleventh. If

using this edition, students should refer to the reading supplement on the VLE for

customised references.

N&S is more adequate for some parts of the syllabus while less so for others; as a

consequence we integrate some topics more with the extra material provided in the

subject guide. The textbook employs verbal reasoning as the main method of

presentation, supplemented by diagrammatic analyses. The textbooks use of algebra is

not uniformly satisfactory. The subject guide supplements the textbook in many cases

in this regard. There are also some references to the following textbook:

Perloff, J.M. Microeconomics with Calculus. (Pearson Education, 2014) 3rd edition

[ISBN 9780273789987].

Detailed reading references in this subject guide refer to the editions of the textbooks

listed above. New editions of these textbooks may have been published by the time you

study this course. You can use a more recent edition of any of the textbooks; use the

detailed chapter and section headings and the index to identify relevant readings. Also,

check the virtual learning environment (VLE) regularly for updated guidance on

readings.

Unless otherwise stated, all websites in this subject guide were accessed in February

2016. We cannot guarantee, however, that they will stay current and you may need to

perform an internet search to find the relevant pages.

1.6.3

Further reading

Please note that as long as you read the Essential reading you are then free to read

around the subject area in any textbook, paper or online resource. You will need to

support your learning by reading as widely as possible and by thinking about how these

principles apply in the real world. To help you read extensively, you have free access to

the virtual learning environment (VLE) and University of London Online Library (see

below).

Other useful textbooks for this course include:

Besanko, D. and R. Braeutigam Microeconomics. (John Wiley & Sons, 2014) 5th

edition, international student version [ISBN 9781118716380].

Varian, H.R. Intermediate Microeconomics, a Modern Approach. (W.W. Norton,

2014) 9th edition [ISBN 9780393920772].

Pindyck, R.S. and D.L. Rubinfeld Microeconomics. (Pearson, 2014) 8th edition

[ISBN 9781292081977].

1. Introduction

1.6.4

In addition to the subject guide and the Essential reading, it is crucial that you take

advantage of the study resources that are available online for this course, including the

VLE and the Online Library.

You can access the VLE, the Online Library and your University of London email

account via the Student Portal at:

http://my.londoninternational.ac.uk

You should have received your login details for the Student Portal with your official

offer, which was emailed to the address that you gave on your application form. You

have probably already logged in to the Student Portal in order to register! As soon as

you registered, you will automatically have been granted access to the VLE, Online

Library and your fully functional University of London email account.

If you have forgotten these login details, please click on the Forgotten your password

link on the login page.

1.6.5

The VLE

The VLE, which complements this subject guide, has been designed to enhance your

learning experience, providing additional support and a sense of community. It forms an

important part of your study experience with the University of London and you should

access it regularly.

The VLE provides a range of resources for EMFSS courses:

Electronic study materials: All of the printed materials which you receive from

the University of London are available to download, to give you flexibility in how

and where you study.

Discussion forums: An open space for you to discuss interests and seek support

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1.6.6

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1.7

1.7.1

Examination advice

Format of the examination

Important: the information and advice given here are based on the examination

structure used at the time this subject guide was written. Please note that subject

guides may be used for several years. Because of this we strongly advise you to always

check both the current Regulations for relevant information about the examination, and

the VLE where you should be advised of any forthcoming changes. You should also

carefully check the rubric/instructions on the paper you actually sit and follow those

instructions.

In this examination you should answer eleven of fourteen questions: all eight questions

from Section A (5 marks each) and three out of six from Section B (20 marks each).

1.7.2

Types of questions

Examples of the types of questions which will appear on the examination paper appear

not only in the Sample examination paper on the VLE, but also at the end of chapters.

However, in the examination you should not be surprised to see some questions which

are not necessarily specific to one particular topic. For example, a question may require

knowledge about markets which are oligopolistic as well as those which are monopolistic

or competitive.

1. Introduction

Numerical questions will sometimes require the use of a calculator. A calculator may be

used when answering questions on the examination paper for this course and it must

comply in all respects with the specification given in the Regulations.

Questions will not require knowledge of empirical studies or institutional material.

However, you will be awarded some marks for supplementary empirical or institutional

material which is directly relevant to the question.

1.7.3

You should follow all the excellent advice to candidates which is published in the annual

Examiners commentaries. For this course, the following advice is also worth noting:

Prepare thoroughly for the examination by attempting the problems/questions in

the textbooks and in this subject guide and, in particular, past examination papers

(for which there are Examiners commentaries where you can check examiners

responses).

Occasionally, you may be unsure exactly what a question is asking. If there is some

element of doubt about the interpretation of a question, state at the beginning of

your answer how you interpret the question. If you are very uncertain of what is

required, and the question is in Section B, do another question.

Explain briefly what you are doing: an answer that is simply a list of equations or

numbers will not be credited with full marks even if it gets to the correct solution.

Moreover, by explaining what you are doing, you will be awarded some marks for

correct reasoning even if there are mistakes in some part of the procedure.

It is essential to attempt eight questions in Section A. Even if you think you do not

know the answer, at least define any terms or concepts which you think may be

relevant (including those in the question!) and, if possible, present the question in

diagrammatic or algebraic form. The same applies to a specific part of a multi-part

question in Section B. The examiners can give no marks for an unattempted

question, but they can award marks for relevant points. A single mark may make

the difference between passing and failing the examination.

Although you should attempt all the questions and parts of questions that are

required, to avoid wasting time you should make sure that you do no more than is

required. For example, if only two parts of a three-part question need to be

answered, only answer two parts.

Note the importance of key words. In some of the True or false? type questions,

the words must, always, never or necessarily usually invite you to explain why

the statement is false. Notice that this is simply a way in which you can start

approaching the problem, but there is no way to know in advance the correct

answer without analysing every specific question.

It is worth noting that in this type of question, simply writing true or false will

not earn you any marks, even if it happens to be the right answer. The examiners

are looking for reasoning, not blind guesses.

terms to be defined. Also, do use the term ceteris paribus (meaning other things

being equal), where appropriate. If you are asked to examine the effects of a

change in a particular exogenous variable, you should not complicate your answers

unnecessarily by positing simultaneous changes in other exogenous variables.

For many questions, good answers will require diagrammatic and/or algebraic

analysis to complement verbal reasoning. Good diagrams can often save much

explanation but free-standing diagrams, however well-drawn and labelled, do not

portray sufficient information to the examiners. Diagrams need to be explained in

the text of the answer. Similarly, symbols in algebraic expressions should be defined

and the final line of an algebraic presentation should be explained in words.

The examiners are primarily looking for analytical explanations, not descriptions.

On reading a question, your first thought should be: what is the appropriate

hypothesis, theory, concept or model to use?

Remember, it is important to check the VLE for:

up-to-date information on examination and assessment arrangements for this course

where available, past examination papers and Examiners commentaries for the

course which give advice on how each question might best be answered.

1. Introduction

10

Chapter 2

Consumer theory

2.1

Introduction

How do people choose what bundle of goods to consume? We cannot observe this

process directly, but can we come up with a model to capture the decision-making

process so that the predictions from the model match the way people behave? If we can

build a sensible model, we should be able to use the model to understand how choice

varies when the economic environment changes. This should also help us design

appropriate policy. This is the task in this chapter and as we go through the various

steps, you should keep this overarching goal in your mind and try to see how each piece

of analysis fits in the overall scheme.

Once we build such a model, we use it to analyse how optimal consumption choice

responds to price and income variations. We also extend the analysis to cover

labour-leisure choice as well as intertemporal consumption choice.

2.1.1

This chapter introduces you to the theory of consumer choice. You should be familiar

with many of the ideas here from EC1002 Introduction to economics, but we aim

to investigate certain aspects at relatively greater depth. The chapter also aims to

encourage you to ask questions about the meaning of concepts and their usefulness in

understanding the world. For example, you have come across utility functions before.

But surely no-one has a utility function so where do these functions come from? Why

is this concept useful? You should not accept such concepts just because they appear in

textbooks and are taught in classes. To convey this message is an important aim here.

2.1.2

Learning outcomes

By the end of this chapter, the Essential reading and activities, you should be able to:

explain the implications of the assumptions on the consumers preferences

describe the concept of modelling preferences using a utility function

draw indifference curve diagrams starting from the utility function of a consumer

draw budget lines for different prices and income levels

solve the consumers utility maximisation problem and derive the demand for a

consumer with a given utility function and budget constraint

11

2. Consumer theory

explain the notion of a compensated demand function

explain measures of the welfare impact of a price change: change in consumer

surplus, equivalent variation and compensating variation, and use these measures

to analyse the welfare impact of a price change in specific cases

construct the market demand curve from individual demand curves

explain the notion of elasticity of demand

analyse the decision to supply labour

analyse the problem of savers and borrowers

derive the present discounted value of payment streams and explain bond pricing.

2.1.3

Essential reading

N&S Chapters 2 and 3, the Appendix to Chapter 13, from Chapter 14: Sections 14.1,

14.2, 14.5 and from Appendix 14A: Sections A143, A144.

In addition, Chapter 1 and Appendix 1A provide a review of the basics of economic

models and some basic techniques. You should be familiar with this material from

earlier courses. Nevertheless, you should read this chapter and the appendix and make

sure that you understand the content. Throughout this subject guide, we will assume

that you are familiar with this material.

2.2

We start by analysing preferences, utility and choice. Next, we learn how to construct

demand curves, and analyse their properties. We also explain various welfare measures.

We then analyse the labour supply decision of an individual before moving on to saving

and borrowing with two periods. Finally, we learn to carry out present value

calculations with many periods and analyse bond pricing.

2.3

See N&S Chapter 2. See also Perloff Sections 3.1 and 3.2 for a good discussion on the

connection between preferences and utility.

2.3.1

The theory of choice starts with rational preferences. Generally, preferences are

primitives in economics you take these as given and proceed from there. The task of

explaining why certain preferences exist in certain societies falls largely under the

domain of subjects such as anthropology or sociology. However, to be able to create a

12

model of choice that has some predictive power, we do need to put some restrictions on

preferences to rule out irrational behaviour. Just a few relatively sensible restrictions

allow us to build a model of choice that has great analytical power. Indeed, this idea of

creating an analytical structure that can be manipulated to understand how changes in

the economic environment affect economic outcomes underlies the success of economics

as a tool for investigating the world around us.

Section 2.2 of N&S sets out three restrictions on preferences: completeness, transitivity

and non-satiation (more is better). These restrictions allow us to do something very

useful. Once we add some further technical requirements (a full specification must await

Masters level courses but the main extra condition we need is that preferences have

certain continuity properties), these restrictions allow us to represent preferences by a

continuous function. This is known as a utility function.

Note that a utility function is an artificial concept no-one actually has a utility

function (you knew that of course, since you surely do not have one). But because we

can represent preferences using such a function, it is as if agents have a utility function.

All subsequent analysis using utility functions and indifference curves has this as if

property.

Ordinal versus cardinal utility

Preferences generally give us rankings among bundles rather than some absolute

measure of satisfaction derived from bundles. You might prefer apple juice to orange

juice but would have difficulty saying exactly how much more satisfaction you derive

from the former compared to the latter. Preferences, therefore, typically give us an

ordinal ranking among bundles of goods. Since utility is simply a representation of

preferences, it is also an ordinal measure. This means that if your preferences can be

represented by a utility function, then a positive transformation of this function which

preserves the ordering among bundles is another function that is also a valid utility

function. In other words, there are many possible utility functions that can represent a

given set of preferences equally well.

However, there are some instances where we use cardinal utility and make absolute

comparisons among bundles. Money, for example, is a cardinal measure you know that

20 pounds is twice as good as 10 pounds. In general, though, you should understand

utility as an ordinal concept.

2.3.2

Indifference curves

Once we can represent preferences using a continuous utility function, we can draw

indifference curves. An indifference curve is the locus of different bundles of goods that

yield the same level of utility. In other words, an indifference curve for utility function

u(x, y) is given by u(x, y) = k, where k is some constant. As we vary k, we can trace out

the indifference map. Note that an indifference curve is simply a level curve of a utility

function. Just as you draw contours on a map to represent, say, a mountain, so

indifference curves drawn for two goods are contour plots of a utility function over these

two goods. You can see Figure 3.3 in Perloff for a pictorial representation. You should

read carefully the discussion in N&S (Sections 2.3 to 2.5) on indifference curves. You

13

2. Consumer theory

should know how different types of preferences generate different types of indifference

curves.

Activity 2.1 For each of the following utility functions, write down the equation for

an indifference curve and then draw some indifference curves.

(a) u(x, y) = xy.

(b) u(x, y) = x + y.

(c) u(x, y) = min{x, y}.

Previously, we put some restrictions on preferences. What do these restrictions imply

for indifference curves? We have the following properties:

1. If an indifference curve is further from the origin compared to another indifference

curve, any point on the former is preferred to any point on the latter (implied by

the assumption that more is better).

2. Indifference curves cannot slope upwards (implied by more is better).

3. Indifference curves cannot be thick (again, implied by more is better).

4. Indifference curves cannot cross (implied by transitivity).

5. Every bundle of goods lies on some indifference curve (follows from completeness).

The marginal rate of substitution

A further important property concerns the rate at which a consumer is willing to

substitute one good for another along an indifference curve. The marginal rate of

substitution of a consumer between goods x and y is the units of y the consumer is

willing to substitute (i.e. willing to give up) to obtain one more unit of x.

The slope of an indifference curve (with good y on the y-axis and good x on the x-axis)

is given by:

MUx

dy

=

.

dx u constant

MUy

The marginal rate of substitution is the absolute value of the slope:

MRSxy =

MUx

.

MUy

Typically, preferences have the following property. Consider a point where a lot of y and

very little x is being consumed. Starting from any such point, a consumer is willing to

give up a lot of y in exchange for another unit of x while retaining the same level of

utility as before. As we keep adding units of x and reducing y while keeping utility

constant (i.e. we are moving down an indifference curve), consumers are willing to give

up less and less of y in return for a further unit of x. One way to interpret this is that

14

people typically have a taste for variety and want to avoid extremes (i.e. avoid

situations where a lot of one good and very little of the other good is being consumed).

This implies that MRS falls along an indifference curve. This property is referred to as

indifference curves being convex to the origin in some textbooks. This works as a

visual description, but you should be aware that in terms of mathematics, this is not a

meaningful description there is no mathematical concept where something is convex

relative to something else. The correct idea of convex indifference curves is as follows.

Consider a subset S of Rn . S is a convex set if the following property holds: if points s1

and s2 are in S, then a convex combination s1 + (1 )s2 is also in the set S for any

0 < < 1.

Now consider any indifference curve yielding utility level u. Consider the set of all

points that yield utility u or more. This is the set of all points on an indifference curve

plus all points above. Call this set B. Diminishing MRS implies that B is a convex set.

Figure 2.1 below shows a convex indifference curve. Note that the set B (part of which

is shaded) is a convex set. Try taking any two points in B and then making a convex

combination. You will find that the combinations are always inside B.

Next, Figure 2.2 shows an example of non-convex indifference curves. Note that the set

B of points on or above the indifference curve is not convex. If you combine points such

as a1 and a2 in the diagram, for some values of , the convex combinations fall outside

the set B.

Note that when two goods are perfect substitutes, you get a straight line indifference

curve. At the other extreme, the two goods are perfect complements (no

substitutability) and the indifference curve is L-shaped. Indifference curves with

diminishing MRS lie in between these two extremes.

15

2. Consumer theory

Here is an activity to get you computing the MRS for different utility functions.

Activity 2.2 Compute the MRS for the following utility functions.

(a) u(x, y) =

xy.

(b) u(x, y) = ln x + ln y.

(c) u(x, y) = 20 + 3(x + y)2 .

2.3.3

Budget constraint

Once we have specified our model of preferences, we need to know the set of goods that

a consumer can afford to buy. This is captured by the budget constraint. Since

consumers are generally taken to be price-takers (i.e. what an individual consumer

purchases does not affect the market price for any good), the budget line is a straight

line. See Section 2.7 of N&S for the construction of budget sets. You should be aware

that budget lines would no longer be a straight line if a consumer buys different units at

different prices. This could happen if a consumer is a large buyer in a market or if the

consumer gets quantity discounts. See Application 2.6 in N&S for an example.

2.3.4

Utility maximisation

The consumer chooses the most preferred point in the budget set. If preferences are

such that indifference curves have the usual convex shape, the best point is where an

indifference curve is tangent to the budget line. This is shown as point A in Figure 2.3.

At A the slope of the indifference curve coincides with the slope of the budget

16

constraint. So we have:

MUx

Px

= .

MUy

Py

MRSxy =

Px

.

Py

Let us derive this condition formally using a Lagrange multiplier approach. This is the

approach you are expected to use when faced with optimisation problems of this sort.

Note that the more is better assumption ensures that a consumer spends all income (if

not, then the consumer could increase utility by buying more of either good). Therefore,

the budget constraint is satisfied with equality. It follows that the consumer maximises

u(x, y) subject to the budget constraint Px x + Py y = M . Set up the Lagrangian:

L = u(x, y) + (M Px x + Py y).

The first-order conditions for a constrained maximum are:

u

L

=

Px = 0

x

x

L

u

=

Py = 0

y

y

L

= M Px x + Py y = 0.

Px

u/x

=

= MRSxy .

Py

u/y

17

2. Consumer theory

Second-order condition

The first-order conditions above are, by themselves, not sufficient to guarantee a

maximum. We also need the second-order condition to hold. It is better to derive this

formally once you have learned matrix algebra, which allows a relatively simple

exposition of the second-order condition. For our purposes here, note that the

diminishing MRS condition is sufficient to guarantee that a maximum occurs at the

point satisfying the first-order conditions. This should also be clear to you from the

graph. If indifference curves satisfy the usual convexity property, there is an interior

tangency point with the budget constraint line at which the maximum utility is

attained.

Figure 2.4 below demonstrates that if preferences are not convex, the first-order

conditions are not sufficient to guarantee optimality.

Figure 2.4: Violation of the second-order condition under non-convex preferences. Note

that MRS is not always diminishing. Point A satisfies the first-order condition MRS equal

to price ratio, but is not optimal. (Source: Schmalensee, R. and R.N. Stavins (2013) The

SO2 allowance trading system: the ironic history of a grand policy experiment, Journal

of Economic Perspectives, Vol. 27, pp.10321. Reproduced by kind permission of the

American Economic Association.)

Read Sections 2.7 to 2.9 of N&S carefully and work through all the examples therein.

Note that if two goods are perfect substitutes or complements, the tangency condition

does not apply. For perfect substitutes, there is either a corner solution or the budget

line coincides with the indifference curve. In the latter case, any point on the budget

line is optimal. For the case of perfect complements, the optimum occurs where the kink

in the indifference curve just touches the budget line. Note that this is not a tangency

point the slope of the indifference curve is undefined at the kink. N&S clarifies these

cases with appropriate diagrams.

18

Demand functions

The maximisation exercise above gives us the demand for goods x and y at given prices

and income. As we vary the price of good x, we can trace out the demand curve for

good x. See Section 3.6 of N&S for a discussion. The activities below compute demand

functions in specific examples.

u(x, y) = x y

where , > 0. The price of x is normalised to 1 and the price of y is p. The

consumers income is M . Derive the demand functions for x and y.

The consumers problem is as follows:

max x y subject to x + py = M.

x, y

MUx

Px

=

.

MUy

Py

This implies:

x1 y

1

=

.

x y 1

p

Simplifying:

y

1

= .

x

p

Using this in the budget constraint and solving, we get the demand functions:

x(p, M ) =

M

+

y(p, M ) =

M

.

p( + )

u(x, y) = min{x, y}

where , > 0. The price of x is normalised to 1 and the price of y is p. The

consumers income is M . Derive the demand functions for x and y.

The consumer would choose the bundle at which the highest indifference curve is

reached while not exceeding the budget. This is point E in Figure 2.5 where the

indifference curve just touches the budget constraint (Figure 2.5 is drawn using

/ = 1/2). Note that this is not a tangency point as the slope of the indifference

curve is undefined at the kink.

19

2. Consumer theory

Since we are at the kink, it must be that x = y. Using this in the budget

constraint, we get the demand functions:

x(p, M ) =

M

+ p

y(p, M ) =

M

.

+ p

Figure 2.5: The optimum occurs at point E. Note that this is not a tangency point. The

slope of the indifference curve at the kink is undefined.

2.4

2.4.1

Demand curves

The impact of income and price changes

See N&S Chapter 3. Now that we have derived demand curves, we can try to

understand various properties of demand by varying income and prices.

Income changes

Section 3.2 of N&S explains the classification of goods according to the response of

demand to income changes.

Normal goods: a consumer buys more of these when income increases.

Inferior goods: a consumer buys less of these when income increases.

20

Note that it is not possible for all goods to be inferior. This would violate the more is

better assumption. The full argument is left as an exercise.

Activity 2.3 It is not possible for all goods to be inferior. Provide a careful

explanation of this statement.

The income-consumption curve

The income-consumption curve of a consumer traces out the path of optimal bundles as

income varies (keeping all prices constant). Using this exercise, we also plot the

relationship between quantity demanded and income directly. The curve that shows this

relationship is called the Engel curve. See Perloff Section 4.2 for an exposition of the

income-consumption curve and the Engel curve.

The slope of the income-consumption curve indicates the sign of the income elasticity of

demand (explained below).

Price changes

See Sections 3.3 to 3.8 of N&S. It is very important to understand fully the

decomposition of the total price effect into income and substitution effects. This

decomposition is, of course, a purely artificial thought experiment. But this thought

experiment is extremely useful in understanding how the demand for different goods

responds to a change in price at different levels of income and given different

opportunities to substitute out of a good. You should understand how these effects

(and, therefore, the total price effect) differ across normal and inferior goods, and

understand how the effect known as Giffens paradox can arise.

The idea of income and substitution effects can help us understand the design of an

optimal tax scheme. See Section 3.4 of N&S for a discussion of this issue.

Finally, you should also study the impact on the demand for a good by changes in the

price of some other good, and how this effect differs depending on whether the other

good is a substitute or a complement.

Example 2.3 Suppose u(x, y) = x1/2 y 1/2 . Income is M = 72. The price of y is 1

and the price of x changes from 9 to 4. Calculate the income effect (IE) and the

substitution effect (SE).

Let (px , py ) denote the original prices and let p0x denote the lower price of x.

Under the original prices, the Marshallian demand functions (you should be able to

calculate these) are:

M

x =

2px

and:

y =

M

.

2py

21

2. Consumer theory

M

u0 =

2 px p y

where the subscript of u is a reminder that this is the original utility level (before

the price change).

The total price effect (PE) from a price fall is:

PE =

M

M

.

0

2px 2px

In Figure 2.6, the movement from A to C is the total price effect.

To isolate the SE, we must change the price of x, but also take away income so that

the consumer is on the original indifference curve. In other words, we must keep the

utility at u0 . In Figure 2.6, the dashed budget line is the one after the compensating

reduction in income. The point B is the optimal point on this compensated budget

line. The movement from the original point A to B shows the substitution effect.

How much income should we take away to compensate for the price change? This

can be calculated as follows.

Suppose M is the amount of income we take away. We need M to be such that:

M M

p

= u0

0

2 p x py

which implies:

M M

M

p

=

.

2 px py

2 p0x py

Using the values supplied, M = 24 so that M M = 48.

Under a reduced income of 48, and given the new price p0x = 4, the demand for x is

6. The original demand for x was 4. Under the compensated price change, the

demand is 6. Therefore, the SE is 2. It follows that the rest of the change must be

the IE. Since the total price effect is 5, the IE is 3.

In terms of algebra:

SE =

M M

M

.

0

2px

2px

M

M

M M

M

IE =

.

2p0x 2px

2p0x

2px

Simplifying:

IE =

M

.

2p0x

variation. We will study this concept later in this chapter.

22

Figure 2.6: As the price of x falls, the change from A to C shows the total price effect.

The movement from A to B (under a compensated price change) shows the substitution

effect, while the movement from B to C shows the income effect.

From individual demand curves, we can construct the market demand curve by

aggregating across individuals. See N&S Section 3.10 for a discussion.

2.4.2

Elasticities of demand

such as prices and income. The elasticity of market demand for a good can be estimated

from data, and these elasticity estimates are important for firms in setting prices and for

formulation of policy. Throughout the course, we will come across several such examples.

Sections 3.11 to 3.16 of N&S contain a detailed analysis of elasticities, which you must

read carefully. Here, let us summarise the main concepts.

Price elasticity of demand

This is the percentage change in quantity demanded of a good in response to a given

percentage change in the price of the good, given by:

=

dQ/Q

P dQ

=

.

dP/P

Q dP

elastic if < 1, unit elastic if = 1, and inelastic if > 1.

N&S outlines a variety of uses of this concept, which you should read carefully. You

should know how to calculate demand elasticity at different points on a demand curve,

and how the elasticity varies along a linear demand curve.

23

2. Consumer theory

Price elasticity of demand is the most common measure of elasticity and often referred

to as just elasticity of demand.

Other than price elasticity, we can define income elasticity and cross-price elasticity.

Income elasticity

Denoting income by M , income elasticity of demand is given by:

M =

P dM

.

M dP

This is positive for normal goods, and negative for inferior goods. When M exceeds 1,

we call the good a luxury good. Necessities like food have income elasticities much lower

than 1.

Cross-price elasticity

Let us consider the elasticity of demand for good i with respect to the price of good j.

The cross-price elasticity of demand for good i is given by:

ij =

Pj dQi

.

Qi dPj

You should take a long look at the elasticity estimates presented in Section 3.16 of

N&S. Practical knowledge of elasticities forms an important part of designing and

understanding a variety of tax and subsidy policies in different markets.

price elasticity, cross-price elasticity and income elasticity of demand for x.

2.4.3

We derived the demand function for a good above. To derive the demand function for

good x, we vary the price of good x but hold constant the prices of other goods and

income. Of course, as the price changes so that the optimal choice changes, the utility of

the consumer at the optimal point also changes. This is the usual demand curve, and is

also known as the Marshallian demand curve, or the uncompensated demand curve.

Indeed, if we simply mention a demand curve without putting a qualifier before it, it

refers to the Marshallian, or uncompensated, demand curve.

A compensated, or Hicksian, demand curve can be derived as follows. Suppose as the

price of a good changes, we keep utility constant while allowing income to vary. In other

words, if the price of x, say, falls (so that the new optimal bundle of the consumer

would be associated with a higher level of utility if income is left unchanged), we take

away enough income to leave the consumer at the original level of utility. It is clear that

this process eliminates the income effect and simply captures the substitution effect.

Below, we list some properties of compensated demand curves.

24

For a normal good, the compensated demand curve is less elastic compared to the

uncompensated demand curve.

For an inferior good, the compensated demand curve is more elastic compared to

the uncompensated demand curve.

You should understand that all three properties result from the fact that only the

substitution effect matters for the change in compensated demand when the price

changes.

The next example asks you to calculate the compensated demand curve for a

CobbDouglas utility function.

Example 2.4 Suppose u(x, y) = x1/2 y 1/2 . Income is M . Calculate the compensated

demand curves for x and y.

To do this, we must first calculate the Marshallian demand curves. These are given

by (you should do the detailed calculations to show this):

x=

M

2px

and

y=

M

.

2py

M

V =

.

2 px py

Holding utility constant at V implies adjusting M to the value M so that:

M = 2V

px py .

This is the value of income which is compensated to keep utility constant at the level

given by the original choice of x and y. It follows that the compensated demand

functions are:

r

M

py

xc =

=V

2px

px

and:

M

yc =

=V

2py

px

.

py

Note that the Marshallian demand for x does not depend on py , but the Hicksian, or

compensated, demand does. This is because changes in py require income

adjustments, which generate an income effect on the demand for x.

2.4.4

See Section 3.9 of N&S for a discussion of consumer surplus, but this does not cover the

other two measures: compensating variation (CV) and equivalent variation (EV). We

provide definitions and applications below.

25

2. Consumer theory

When drawing demand curves, we typically draw the inverse demand curve (price on

the vertical axis, quantity on the horizontal axis). In such a diagram, the consumer

surplus (CS) is the area under the (inverse) demand curve and above the market price

up to the quantity purchased at the market price. This is the most widely-used measure

of welfare. We can measure the welfare effect of a price rise by calculating the change in

CS (denoted by CS).

Much of our discussion of policy will be based on this measure. Any part of CS that

does not get translated into revenue or profits is a deadweight loss. The extent of

deadweight loss generated by any policy is a measure of inefficiency associated with that

policy.

However, CS is not an exact measure because of the presence of an income effect.

Ideally, we would use the compensated demand curve to calculate the welfare change.

CV and EV give us two such measures. You should use these measures to understand

the design of ideal policies, but when measuring welfare change in practice, use CS.

Compensating variation (CV)

CV is the amount of money that must be given to a consumer to offset the harm

from a price increase, i.e. to keep the consumer on the original indifference curve

before the price increase.

EV is the amount of money that must be taken away from a consumer to cause as

much harm as the price increase. In this case, we keep the price at its original level

(before the rise) but take away income to keep the consumer on the indifference curve

reached after the price rise.

Consider welfare changes from a price rise. For a normal good, we have

CV > CS > EV, and for an inferior good we have CV < CS < EV. The measures

would coincide for preferences that exhibit no income effect.

The example that follows shows an application of these concepts.

Example 2.5 The government decides to give a pensioner a heating fuel subsidy of

s per unit. This results in an increase in utility from u0 before the subsidy to u1

after the subsidy. Could the government follow an alternative policy that would

result in the same increase in utility for the pensioner, but cost the government less?

Let us show that an equivalent income boost would be less costly. Essentially, the

EV of a price fall is lower than the expenditure on heating after the price fall. The

intuition is that a per-unit subsidy distorts choice in favour of consuming more

heating, raising the total cost of the subsidy. To put the same idea differently, an

equivalent income boost would raise the demand for fuel through the income effect.

26

But a price fall (the fuel subsidy results in a lower effective price) causes an

additional substitution effect boosting the demand for heating.

To see this, consider Figure 2.7. The initial choice is point A and after the subsidy

the pensioner moves to point B. How much money is the government spending on

the subsidy? Note that after the subsidy, H1 units of heating fuel are being

consumed. At pre-subsidy prices, buying H1 would mean the pensioner would have

E 0 of other goods. Since the price of the composite good is 1, M is the same as total

income. It follows that the amount of income that would be spent on heating to buy

H1 units of heating at pre-subsidy prices is given by M E 0 . Similarly, at the

subsidised price, the amount of income being spent on heating fuel is M B 0 . The

difference B 0 E 0 is then the amount of the subsidy. This is the same length as

segment BE.

Once we understand how to show the amount of spending on the subsidy in the

diagram, we are ready to compare this spending with an equivalent variation of

income. This is added in Figure 2.8 below.

The pensioners consumption is initially at A, and moves to B after the subsidy.

Since the composite good has a price of 1, the vertical distance between the budget

lines (segment BE) shows the extent of the expenditure on the subsidy (as explained

above). An equivalent variation in income, on the other hand, would move

consumption to C. It follows that DE is the equivalent variation in income, which is

smaller than the expenditure on the subsidy. Therefore, a direct income transfer

policy would be less costly for the government.

27

2. Consumer theory

u(x1 , x2 ) = x1/2 y 1/2 . He originally faces prices (1, 1) and has income 100. Then the

price of good 1 increases to 2. Calculate the compensating and equivalent variations.

Suppose income is M and the prices are p1 and p2 . You should work out that the

demand functions are:

M

M

and

x2 =

.

x1 =

2p1

2p2

Therefore, utility is:

M

u (p1 , p2 , M ) =

.

2 p1 p2

At the initial prices, u = M/2. Once the price of good 1 increases, u = M/2 2.

The CV is the extra income that restores utility to the original level. Therefore, it is

given by:

M + CV

M

=

.

2

2 2

Solving:

CV = ( 2 1)M.

Using the value M = 100, this is 41.42.

The EV is the variation in income equivalent to the price change. This is given by:

M

M EV

=

.

2

2 2

Solving:

( 2 1)M

EV =

.

2

Using M = 100, this is 29.29.

28

2.5

Labour supply

See Appendix 13A of N&S. The analysis presented here complements the somewhat

basic coverage in the textbook.

The tools developed above can also be used to analyse the labour supply decision of an

agent. Every economic agent has, in a day, 24 hours. An agent must choose how many

of these hours to spend working, and how many hours of leisure to enjoy. Working earns

the agent income, which represents all goods the agent can consume. But the agent also

enjoys leisure. If the hourly wage is w, this can be seen as the price that the agent must

pay to enjoy an hour of leisure.

The agent, therefore, faces the following problem. Let Z denote the number of hours

denote

worked, N denote the number of leisure hours, M denote income and M

unearned income (inheritance, gifts etc). The utility maximisation problem is:

max u(N, M )

N, M

subject to:

Z = 24 N

.

M = wZ + M

, or M + wN = 24w + M

.

We can simplify the constraints to M = w(24 N ) + M

Therefore, we have a familiar utility maximisation problem:

max u(N, M )

N, M

.

M + wN = 24w + M

At the optimum we have the slope of the indifference curve (MRS) equal to the slope

of the budget line (w). Therefore:

MUN

= w.

MUM

How does the optimal choice of labour respond to a change in w? We can analyse this

using income and substitution effects. In this case, a change in w also changes income

directly (as you can see from the budget constraint), so the exercise is a little different

compared to that under standard goods.

Suppose w rises.

Income effect

The rise in w raises income at current levels of labour and leisure. Assuming leisure

is a normal good (this should be your default assumption), this raises the demand

for leisure.

29

2. Consumer theory

Substitution effect

The rise in w makes leisure relatively more expensive, causing the agent to substitute

away from leisure. This reduces demand for leisure.

The two effects go in opposite directions, therefore the direction of the total effect is

unclear. In most cases, the substitution effect dominates, giving us an upward-sloping

labour supply function. However, it is possible, especially at high levels of income (i.e.

when wage levels are high), that the income effect might dominate. In that case we

would get a backward-bending labour supply curve which initially slopes upward but

then turns back and has a negative slope.

If leisure is, on the other hand, an inferior good, the two effects would go in the same

direction and labour supply would necessarily slope upwards.

Figure 2.9 (a) below shows a backward-bending labour supply curve while Figure 2.9

(b) shows an increasing labour supply curve.

2.6

See N&S Sections 14.1 and 14.2. The discussion below complements the somewhat basic

discussion in the textbook.

We focus on a two-period problem. Suppose the agents endowment is Y0 in period 0

and Y1 in period 1. Given a rate of interest r, the present value of income in period 0 is

Y0 + Y1 /(1 + r). If the individual consumes all income in period 0, C0 is equal to this

present value, and C1 = 0. If all income is saved for period 1, then income at period 1 is

(1 + r)Y0 + Y1 . In this case, C1 is this amount and C0 = 0. Therefore, we have

30

problem is then as follows:

max u(C0 , C1 )

C0 , C 1

C0 +

C1

Y1

= Y0 +

.

1+r

1+r

This is similar to a standard optimisation problem with two goods, C0 and C1 , where

the price of the former is 1 and the price of the latter is 1/(1 + r). Unsurprisingly, the

optimum satisfies the property that:

MUC0

= 1 + r.

MUC1

If the optimal consumption bundle is C0 = Y0 and C1 = Y1 , the agent is neither a saver

nor a borrower. If C0 > Y0 the agent is a borrower, and if C0 < Y0 the agent is a saver

(lender).

How does the intertemporal consumption bundle change when r changes? Again, we can

see this by decomposing the effect into income and substitution effects. Let us look at

the problem of borrowers and savers separately.

Throughout the following analysis, we assume that both C0 and C1 are normal goods.

This should be your default assumption.

Note that the total income available to consume in period 1 is Y1 + (Y0 C0 )(1 + r).

The problem of a borrower

Income effect

For a borrower, Y0 < C0 , so that a rise in the interest rate lowers income tomorrow.

Given consumption is normal in both periods, the agent should consume less in

period 0 (borrow less).

Substitution effect

A rise in the interest rate makes immediate consumption more costly. Therefore,

the substitution effect suggests that the individual should choose to lower C0 and,

therefore, borrow less.

Since the two effects go in the same direction, the direction of change is unambiguous: a

rise in the rate of interest lowers borrowing.

31

2. Consumer theory

Income effect

For a saver, Y0 > C0 , so that a rise in the interest rate raises income tomorrow. Given

consumption is normal in both periods, the agent should consume more in period 0

(save less).

Substitution effect

A rise in the interest rate makes immediate consumption more costly. Therefore,

the substitution effect suggests that the individual should choose to lower C0 (save

more).

Since the two effects go in opposite directions, the total effect on saving is uncertain.

Usually, the substitution effect dominates so that agents save less when the interest rate

rises, but it could go the other way.

Figure 2.10 shows the intertemporal budget constraint. The endowment point is

(Y0 , Y1 ). As the rate of interest increases, the budget constraint pivots around the

endowment point as shown.

Note that consumers reaching an optimum in the part of the budget constraint above

the endowment point are savers, and those reaching an optimum somewhere in the

lower part are borrowers.

32

Activity 2.5 Using Figure 2.10 above, explain that a saver cannot become a

borrower if the rate of interest rises.

2.7

The previous section discussed the calculation of present value for a two-period stream

of payoffs. We can extend this easily to multiple (or infinite) periods. This calculation is

useful in many cases for example, in calculating the repeated game payoff in game

theory. This is also useful in understanding bond pricing.

In this course, you need to know only the basics, which we present below.

Suppose we have a stream of payoffs y0 , y1 , . . . , yn in periods 0, 1, . . . , n, respectively.

Suppose the rate of interest is given by r. The present value in period 0 of this stream

of payoffs is given by:

PV = y0 +

y2

yn

y1

+

+

+

.

1 + r (1 + r)2

(1 + r)n

PV = y0 + y1 + 2 y2 + + n yn .

Suppose y0 = y1 = = yn = y. In this case:

PV = y(1 + + 2 + + n ).

We can sum this as follows. Let:

S = 1 + + 2 + + n.

Then:

S = + 2 + + n+1 .

We have:

S S = 1 n+1 .

Therefore:

S=

1 n+1

.

1

So:

PV = y

1 n+1

.

1

2

PV = y(1 + + + ) = y

1

1

.

33

2. Consumer theory

2.7.1

Bonds

A bond typically pays a fixed coupon amount x each period (next period onwards) until

a maturity date T , at which point the face value F is paid. The price of the bond, P , is

simply the present value given by:

P = x + 2 x + + T F.

Note that the price declines if falls, which happens if r rises. Therefore, the price of a

bond has an inverse relationship with the rate of interest.

A special type of bond is a consol or a perpetuity that never matures. The price of a

consol has a particularly simple expression:

P = x + 2 x + = x

.

1

1/(1 + r)

1

=

= .

1

r/(1 + r)

r

It follows that:

x

.

r

This makes the inverse relationship between P and r clear.

P =

2.8

Having completed this chapter, the Essential reading and activities, you should be able

to:

explain the implications of the assumptions on the consumers preferences

describe the concept of modelling preferences using a utility function

draw indifference curve diagrams starting from the utility function of a consumer

draw budget lines for different prices and income levels

solve the consumers utility maximisation problem and derive the demand for a

consumer with a given utility function and budget constraint

analyse the effect of price and income changes on demand

explain the notion of a compensated demand function

explain measures of the welfare impact of a price change: change in consumer

surplus, equivalent variation and compensating variation, and use these measures

to analyse the welfare impact of a price change in specific cases

construct the market demand curve from individual demand curves

34

analyse the decision to supply labour

analyse the problem of savers and borrowers

derive the present discounted value of payment streams and explain bond pricing.

2.9

2.9.1

Sample examination questions

2. The Hicksian demand curve for a good must be more elastic than the Marshallian

demand curve for a good. Is this true or false? Explain.

3. Savers gain more when the rate of interest rises. Is this true or false? Explain.

4. Consider the utility function u(x, y) = x2 + y 2 .

(a) Does this satisfy the property of diminishing MRS? Show algebraically, and

also show by drawing indifference curves.

(b) Show that using the tangency condition (MRS equals price ratio) would not

lead to an optimum in this case.

(c) Show (in a diagram) the possible optimal bundles.

5. Consider the quasilinear utility function u(x1 , x2 ) = ln x1 + x2 (this is linear in x2 ,

but not in x1 , hence the name quasilinear). Let p1 and p2 denote the prices of x1

and x2 , respectively. Let m denote income.

(a) Calculate the demand functions.

(b) Draw the income-consumption curve.

(c) Calculate the price elasticity of demand for each good.

(d) Calculate the income elasticity of demand for each good.

35

2. Consumer theory

36

Chapter 3

Choice under uncertainty

3.1

Introduction

element of uncertainty. However, many important economic decisions are made in

situations involving some degree of risk. In this chapter, we cover a model of

decision-making under uncertainty called the expected utility model. The model

introduces the von NeumannMorgenstern (vNM) utility function. This is unlike the

ordinal utility functions we saw in the previous chapter and has special properties. In

particular, the curvature of the vNM utility function can indicate a consumers

attitude towards risk. Once we introduce the model, we use it to derive the demand for

insurance and also introduce a measure of the degree of risk aversion.

3.1.1

This chapter aims to introduce the expected utility model which tells us how a

consumer evaluates a risky prospect. We aim to show how this helps us understand

attitudes towards risk and analyse the demand for insurance. We also aim to set up a

measure of the degree of risk aversion.

3.1.2

Learning outcomes

By the end of this chapter, the Essential reading and activities, you should be able to:

calculate the expected value of a gamble

explain the nature of the vNM utility function and calculate the expected utility

from a gamble

explain the different risk attitudes and what they imply for the vNM utility

function

analyse the demand for insurance and show the relationship between insurance and

premium

explain the concept of diversification

calculate the ArrowPratt measure of risk aversion for different specifications of the

vNM utility function.

37

3.1.3

Essential reading

N&S Sections 4.1, 4.2 and 4.3 up to and including the discussion on diversification (up

to page 135). N&S does not cover the expected utility model or the ArrowPratt

measure of risk aversion. We provide details below. These topics are also covered in

Perloff Section 16.2 (exclude the last part on willingness to gamble).

3.2

This chapter covers expected utility theory and uses the theory to derive the demand

for insurance. It also covers the ArrowPratt measure of risk aversion.

3.3

Preliminaries

You should already be familiar with concepts such as probability and expected value.

Do familiarise yourself with these concepts if this is not the case. Section 4.1 of N&S

discusses these.

Random variable

A variable that represents the outcomes from a random event. A random variable

has many possible values, and each value occurs with a specified probability.

Suppose X is a random variable that has values x1 , . . . , xn . For each i = 1, 2, . . . , n,

the value xi occurs with probability pi , where p1 + p2 + + pn = 1. The expected

(or average) value of X is given by:

X

E(X) = p1 x1 + p2 x2 + + pn xn =

p i xi .

i

3.4

Expected utility theory was developed by John von Neumann and Oscar Morgenstern

in their book The Theory of Games and Economic Behavior. (Princeton University

Press, 1944; expected utility appeared in an appendix in the second edition in 1947).

A proper exposition of their theory must await a Masters level course, but let us try to

give a rough idea of what is involved.

Suppose an agent faces a gamble G that yields an amount x1 with probability p1 , x2

with probability p2 , . . . , and xn with probability pn . How should the agent evaluate this

gamble? Von Neumann and Morgenstern specified certain axioms, i.e. restrictions on

38

choice under uncertainty that might be deemed reasonable. They showed that under

their axioms, there exists a function u such that the gamble can be evaluated using the

following expected utility formulation:

E(U (G)) = p1 u(x1 ) + p2 u(x2 ) + + pn u(xn ).

The function u is known as the von NeumannMorgenstern (vNM) utility function.

The vNM utility function is somewhat special. It is not entirely an ordinal function

like the utility functions you saw in the last chapter. Starting from a vNM u function,

we can make transformations of the kind a + bu, with b > 0 (these are called positive

affine transformations), without changing the expected utility property but not any

other kinds of transformations (for example, u2 is not allowed). The reason is that, as

we discuss below, the curvature of the vNM utility function captures attitude towards

risk. Transformations other than positive affine ones change the curvature of this

function, and therefore the transformed u function would not represent the same

risk-preferences as the original. Thus vNM utility functions are partly cardinal.

Note that the expected utility representation is very convenient. Once we know the

vNM utility function u, we can evaluate any gamble easily by simply taking the

expectation over the vNM utility values.

3.5

Risk aversion

We can show that an agent with a concave vNM utility function over wealth is

risk-averse. Let us show this by establishing that an agent with a concave u function

would reject a fair gamble.

Recall that a function f (W ) is concave if f 00 (W ) < 0, i.e. the second derivative of the

function with respect to W is negative.

Suppose G is a gamble which yields 20 with probability 1/2, and 10 with probability

1/2. Suppose an agent has wealth 15 and is given the following choice: invest 15 in

gamble G, or do nothing. Note that the expected value of the gamble, E(G), is exactly

15, so that this is a fair gamble (the expected wealth is the same whether G is accepted

or rejected).

An agent who simply cared about expected value, and not about risk, would be

indifferent between accepting and rejecting G. However, a risk-averse individual would

reject a fair gamble.

The expected utility of an agent from G is:

1

1

u(20) + u(10).

2

2

As Figure 3.1 shows, given a concave u-function:

E(U (G)) =

Therefore, the agent would not accept a fair gamble. This shows that a concave

u-function implies risk aversion.

Note that one of the implications of a concave vNM utility function is that the

marginal utility of wealth is declining. The point is noted in N&S Section 4.2.

39

Figure 3.1: The vNM utility function for a risk-averse individual. Note that the function

is concave and u(E(G)) > E(U (G)) so that the agent does not accept a fair gamble.

3.6

A risk-averse individual would pay to obtain insurance. To see that, it is useful to define

the certainty equivalent (CE) of a gamble. The CE of a gamble is the certain wealth

that would make an agent indifferent between accepting the gamble and accepting the

certain wealth. As Figure 3.1 shows, the CE is lower than the expected income of 10.

Suppose an agent simply faced gamble G (i.e. did not have the choice between G and

10, but simply faced G). Clearly, since the CE is lower than the expected outcome of G,

this agent would be willing to pay a positive amount to buy insurance. How much

would the agent be willing to pay? The amount an agent pays for insurance is called the

risk premium.

We now work through an example to understand how to calculate the risk premium.

3.6.1

Kims utility depends on wealth W . Kims vNM utility function is given by:

u(W ) =

W.

Kims wealth is uncertain. With probability 0.5 wealth is 100, and with probability 0.5

a loss occurs so that wealth becomes 64. In what follows, we will assume that Kim can

only buy full insurance. In other words, the insurance company offers to pay Kim 36

whenever the loss occurs and in exchange Kim pays them a premium of R in every state

(i.e. whether the loss occurs or not). In what follows, we will calculate the maximum

and minimum value of R.

40

How do we know Kim would be prepared to pay to buy full insurance? You can draw a

diagram as above to show that Kim would be prepared to pay a positive premium if

wealth is fully insured. Alternatively, you could point out that the expected utility of

the uncertain wealth (which is 9) is lower than the utility of expected wealth since:

This implies that the premium that Kim is willing to pay is positive.

You could also point out that W is a concave function (check that the second

derivative is negative), implying that Kim is risk-averse. Then draw the CE point as

above and point out that since expected wealth exceeds the certainty equivalent, the

premium is positive.

Let us now calculate the maximum premium that Kim would be willing to pay to

buy full insurance.

First, calculate the certainty equivalent of the gamble Kim is facing. This is given by:

u(CE) = E(U ).

Therefore:

CE = 9

implying that CE = 81. Therefore, the maximum premium Kim is willing to pay is

100 81 = 19.

There is another way of finding this, which considers the maximum premium in terms of

expected wealth (i.e. how much expected wealth would Kim give up in order to fully

insure?). You need to understand this, since some textbooks use this way of identifying

the premium. For example, this is the approach adopted by Perloff. Unfortunately,

textbooks (including Perloff) never make clear exactly what they are doing, which can

be very confusing for students. Reading the exposition here should clarify the matter

once and for all.

The maximum premium in terms of expected wealth is calculated as follows. Note that

under full insurance the gross expected wealth Kim would receive is E(W ) = 82. We

also know that CE = 81. Therefore, the maximum amount of expected wealth Kim

would give up is 82 81 = 1. (Note that this should explain why in the diagram on risk

aversion in Perloff Section 16.2, and subsequent solved problems, the risk premium is

identified as the difference between expected wealth and the CE.)

To connect this approach to the one above, consider the actual premium and coverage.

Kim loses 36 with probability 0.5. So full insurance means a coverage of 36, which is

paid when the loss occurs. In return, Kim pays an actual premium of 19 in each state.

Therefore, the change in expected wealth for Kim is:

0.5 (19) + 0.5 (36 19) = 18 19 = 1.

In other words, Kim is giving up 1 unit of expected wealth, as shown above.

41

Once again, the purpose of writing this out in detail is to make you aware that

textbooks vary in their treatment of this. Some talk about premium in terms of

expected wealth, while others calculate the actual premium, but they do not make it

clear what it is that they are doing. In answering questions of this sort in an

examination, it is easiest (and clearest) to calculate the actual premium. You can follow

the other route and define the premium in terms of expected wealth, but in that case

you should make that clear in your answer.

Next, we calculate the minimum premium.

Assuming the insurance company is risk-neutral, it must break even. So the minimum

premium (or fair premium) is Rmin such that it equals the expected payout, which is

0.5 (100 64) = 18. (Note that this is simply 100 E(W ), where E(W ) is expected

wealth, which is 82 in this case.)

As above, the other way of answering the question is to say that in terms of the expected

wealth that Kim needs to give up, the minimum is zero. Think of this as follows. Kim

simply hands over her actual wealth to the insurance company, and in return receives

the expected wealth in all states. The insurance company is risk-neutral, and in

expected wealth terms it is giving and receiving the same amount, and breaks even.

3.6.2

We calculated the premium for full insurance above. But suppose we gave a risk-averse

agent a continuous choice of levels of insurance. Can we say something general about

how much insurance an agent would choose? As it turns out, we can. If insurance is

actuarially fair (which is another way of saying that the insurance company just breaks

even, so that the premium is equal to the expected payment to the agent), we can show

that any risk-averse agent would buy full insurance. If the premium is higher than this,

less than full insurance would be bought. To relate this to the section above, note that

there the agent was given a simple choice between full insurance and no insurance, and

in that case the maximum willingness to pay for insurance is 19, even though the fair

premium is 18. However, if a more continuous choice of insurance levels was provided to

that agent, the agent would optimally buy full insurance only at a premium of 18, and

optimally buy less-than-full insurance at a premium of 19.

If insurance is fair, it does not matter what the degree of risk-aversion is. Every

risk-averse agent would buy full insurance. If, on the other hand, the insurance

premium is greater than the fair level, how much insurance an agent buys depends on

their degree of risk-aversion. No agent with a finite degree of risk-aversion would buy

full insurance anymore, but the extent of insurance purchased increases as the agents

degree of risk-aversion rises.

Let us now show that full insurance is purchased when the premium is fair.

Suppose a risk-averse agent has wealth W , but faces the prospect of a loss of L with

probability p, where 0 < p < 1. The agent can buy a coverage of X by paying the

premium rX.

The wealth if loss occurs is given by WL = W L + X rX, and the wealth when no

loss occurs is given by WN = W rX. The expected utility of the agent is:

E(U ) = pu(W L + X rX) + (1 p)u(W rX) = pu(WL ) + (1 p)u(WN ).

42

pu0 (WL )(1 r) (1 p)u0 (WN )r = 0.

Note that the second-order condition for a maximum is satisfied since the agent is

risk-averse implying that u00 < 0 (u is concave). Therefore, we have:

u0 (WL )

(1 p)r

=

.

0

u (WN )

(1 r)p

If insurance is fair, that implies the insurance company breaks even, i.e. the expected

payout pX equals the expected receipt rX. Since pX = rX, we have:

p = r.

It follows that:

u0 (WL ) = u0 (WN ).

Since u0 is a decreasing function (because u00 < 0), it is not possible to have this equality

if WL 6= WN . (Note that if u0 was a non-monotonic function and was going up and

down, it would be possible to have WL different from WN but have the same value of u0

at these two different points.)

It follows that WL = WN , i.e. we have:

W L + X rX = W rX

implying that X = L. Therefore, the agent would optimally fully insure (cover the

entire loss) at the fair premium.

Note also what would happen if r > p. Then (1 p)r > (1 r)p. Therefore:

u0 (WL )

(1 p)r

=

> 1.

u0 (WN )

(1 r)p

This implies that:

u0 (WL ) > u0 (WN ).

Again, because u0 is a decreasing function (u00 < 0), this implies that WL < WN , which

in turn implies that X < L. Thus if the premium exceeds the fair premium, less than

full insurance would be purchased.

3.7

Just as a concave vNM utility function represents risk aversion, the opposite a convex

vNM utility function (so that we have u00 > 0) represents risk-loving behaviour, and

the vNM utility function is a straight line (u00 = 0) for a risk-neutral agent.

A risk-neutral agent does not care about risk and only cares about the expected value

of a gamble. In other words, a risk-neutral agent is indifferent between accepting and

rejecting a fair gamble. For a risk-neutral agent, we can write the vNM utility function

of wealth simply as:

u(W ) = W.

43

Figure 3.2: The vNM utility function for a risk-neutral individual. Note that the function

is linear and u(E(G)) = E(U (G)) so that the agent is indifferent between a fair gamble

and the safe alternative of 15.

Figure 3.2 shows the vNM utility function for a risk-neutral agent. The figure refers to

the gamble introduced in the section on risk aversion (either keep 15 or invest in a fair

gamble yielding 20 with probability 0.5, and 10 with probability 0.5).

A risk-loving agent, on the other hand, prefers a risky bet to a safe alternative when

they have the same expected outcome. In other words, a risk-loving agent would prefer

to accept a fair gamble. As Figure 3.3 below shows, for a risk-loving agent, the CE of a

gamble is higher than the expected value of the gamble (you would have to pay a

risk-loving agent to give up a risky gamble in favour of the safe alternative of getting

the expected value of the gamble).

Figure 3.3 shows the vNM utility function for a risk-loving agent.

3.8

We discussed different degrees of risk aversion in the section above. How do we measure

the degree of risk aversion? As you might guess, the degree of risk aversion has to do

with the curvature of the vNM utility function u. The more concave it is, the greater

the degree of risk aversion. The closer it is to a straight line, the lower the degree of risk

aversion. Since the second derivative captures the curvature, a measure of risk aversion

might be u00 . However, this would not be ideal for the following reason. We know that a

positive affine transformation of u, say u

b = a + bu, where a and b are positive constants,

does not change attitude towards risk. But such a transformation would change the

second derivative and, therefore, change the risk measure. This problem could be

avoided if u00 is divided by u0 . Furthermore, since the most common risk attitude is risk

aversion, and for this case u00 < 0, putting a negative sign in front of u00 would deliver a

44

Figure 3.3: The vNM utility function for a risk-loving individual. Note that the function

is convex and u(E(G)) < E(U (G)) so that the agent prefers a fair gamble to the safe

wealth of 15.

positive risk measure under risk aversion. These help to interpret the ArrowPratt

measure of risk aversion, which is given by:

u00

= 0.

u

That is, the ArrowPratt measure of risk aversion is 1 times the ratio of the second

derivative and the first derivative of the vNM utility function. This is the most

common measure of risk aversion. There are other measures, which you will encounter

in Masters level courses.

It can be shown that the larger the ArrowPratt measure of risk aversion, the more

small gambles an individual will take. A derivation of this result must await a Masters

level course as well.

As noted above, for a risk-averse individual, u00 < 0, so the minus sign in front makes

the measure a positive number. For a risk-neutral agent, u00 = 0 so that = 0, and for a

risk-loving agent u00 > 0 so that the measure is negative.

Example 3.1 Let us calculate the ArrowPratt measure for different specifications

of the vNM utility function.

(a) Suppose u(W ) = ln W . Then u0 (W ) = 1/W and u00 (W ) = 1/W 2 . It follows

that:

1

=

.

W

This agent has risk aversion that is decreasing in wealth.

45

=

( 1)W 2

1

.

=

1

W

W

the risk aversion measure goes to 0, which is right since at = 1 the agent is

risk-neutral.

(c) Next, suppose u(W ) = e . Then u0 (W ) = e and u00 (W ) = 2 e .

Therefore, = . In this case the degree of risk aversion does not depend on the

wealth level.

3.9

Reducing risk

Insurance provides a way to reduce risk. Diversification is also another way to reduce

risk. You should read carefully the discussion on this in N&S Section 4.3 (you do not

need to study this section beyond diversification).

3.10

Having completed this chapter, the Essential reading and activities, you should be able

to:

calculate the expected value of a gamble

explain the nature of the vNM utility function and calculate the expected utility

from a gamble

explain the different risk attitudes and what they imply for the vNM utility

function

analyse the demand for insurance and show the relationship between insurance and

premium

explain the concept of diversification

calculate the ArrowPratt measure of risk aversion for different specifications of the

vNM utility function.

3.11

3.11.1

1. A risk-averse individual is offered a choice between a gamble that pays 1000 with a

probability of 1/4, and 100 with a probability of 3/4, or a payment of 325. Which

would they choose? What if the payment was 320?

46

2. Suppose u(W ) = 1/W . What is the risk attitude of this person? Calculate the

ArrowPratt measure of risk aversion for this preference.

3. Suppose an agent has vNM utility function u(W ). Under what condition

p would

a + bu(W ) also be a valid vNM utility function for this agent? Would u(W ) be

a valid vNM utility function for this agent?

4. Suppose u(W ) = ln W for an agent. The agent faces the following gamble: with

probability 0.5 wealth is 100, and with probability 0.5 a loss occurs so that wealth

becomes 64. The agent can buy any amount of insurance: a coverage of X can be

purchased by paying premium rX.

(a) Work out the insurance coverage X that the agent would optimally purchase

as a function of r.

(b) Plot the optimal X as a function of r.

(c) Calculate the value of r for which full insurance is purchased.

(d) Calculate the value of r for which no insurance is purchased.

47

48

Chapter 4

Game theory

4.1

Introduction

In many economic situations agents must act strategically by taking into account the

behaviour of others. Game theory provides a set of tools that enables you to analyse

such situations in a logically coherent manner. For each concept introduced, you should

try to understand why it makes sense as a tool of analysis and (this is much harder) try

to see what its shortcomings might be. This is not the right place to ask questions such

as what is the policy-relevance of this concept?. The concepts you come across here are

just tools, and that is the spirit in which you should learn them. As you will see, some

of these concepts are used later in this course (as well as in a variety of other economics

courses that you might encounter later) to analyse certain types of economic

interactions.

4.1.1

The chapter aims to familiarise you with a subset of basic game theory tools that are

used extensively in modern microeconomic theory. The chapter aims to cover

simultaneous-move games as well as sequential-move games, followed by an analysis of

the repeated Prisoners Dilemma game.

4.1.2

Learning outcomes

By the end of this chapter, the Essential reading and activities, you should be able to:

analyse simultaneous-move games using dominant strategies or by eliminating

dominated strategies either once or in an iterative fashion

calculate Nash equilibria in pure strategies as well as Nash equilibria in mixed

strategies in simultaneous-move games

explain why Nash equilibrium is the central solution concept and explain the

importance of proving existence

specify strategies in extensive-form games

analyse Nash equilibria in extensive-form games

explain the idea of refining Nash equilibria in extensive-form games using backward

induction and subgame perfection

49

4. Game theory

analyse collusive equilibria using trigger strategies

explain the multiplicity of equilibria in repeated games and state the folk theorem

for the Prisoners Dilemma game.

4.1.3

Essential reading

N&S Chapter 5. However, the content of this chapter is not sufficient by itself. This

chapter of the subject guide fleshes out the basic tools that you are required to know in

some detail, and you should also read this and follow the exercises carefully. For

repeated games, the interpretation of payoffs presented here is slightly different from the

textbook. While the analyses are formally equivalent, the approach in this subject guide

follows the standard one in the literature. You are likely to find this fits better with

analyses found in other, more advanced, courses or research papers.

4.1.4

Further reading

You might find the following textbook useful for further explanations of the concepts

covered in this subject guide.

Osborne, M.J. An Introduction to Game Theory (Oxford University Press 2009)

International edition [ISBN 9780195322484].

4.2

well as Nash equilibrium. Next, the chapter introduces sequential-move games and

analyses Nash equilibrium as well as subgame-perfect Nash equilibrium. Finally, the

chapter introduces repeated games and analyses the infinitely-repeated Prisoners

Dilemma.

4.3

elements. First, a set of players. Second, each player must have a set of strategies. Once

each player chooses a strategy from their strategy set, we have a strategy profile. For

example, suppose there are two players, 1 and 2, and 1 can choose between Up or Down

(so 1s strategy set is {U, D}) and 2 can choose between Left or Right (so 2s strategy

set is {L, R}). Then if 1 chooses Up and 2 chooses Left, we have the strategy profile

{U, L}. There are altogether 4 such strategy profiles: the one just mentioned, plus

{D, L}, {U, R} and {D, R}.

Once you understand what a strategy profile is, we can define the third element of a

game: a payoff function for each player. A payoff function for any player is defined over

the set of strategy profiles. For each strategy profile, each player gets a payoff.

50

Suppose Si denotes the set of strategies of player i. In the example above, S1 = {U, D}

and S2 = {L, R}. Let si denote a strategy of i (that is, si is in the set Si ). If there are n

players, a strategy profile is (s1 , s2 , . . . , sn ). For any such strategy profile, there is a

payoff for each player. Let ui (s1 , s2 , . . . , sn ) denote the payoff of player i.

Continuing the example above, suppose u1 ({U, L}) = u1 ({D, R}) = 1 and

u1 ({D, L}) = u1 ({U, R}) = 2. Furthermore, suppose u2 ({U, L}) = u2 ({D, R}) = 2,

u2 ({D, L}) = 3 and u2 ({U, R}) = 1.

We write this in a convenient matrix form (known as the normal form) as follows. The

first number in each cell is the payoff of player 1 and the second number is the payoff of

player 2. Note that player 1 chooses rows and player 2 chooses columns.

Player 1

U

D

Player 2

L

R

1, 2 2, 1

2, 3 1, 2

is the profile of strategies of all players other than player i. So:

si = (s1 , s2 , . . . , si1 , si+i . . . . , sn )

(the ith element is missing). With this notation, we can write the payoff of player i as

ui (si , si ).

4.3.1

Let us now try to understand how rational players should play a game. In some cases,

there is an obvious solution. Suppose a player has a strategy that gives a higher payoff

compared to other strategies irrespective of the strategy choices of others. Such a

strategy is called a dominant strategy. If a player has a dominant strategy, his

problem is simple: he should clearly play that strategy. If each player has a dominant

strategy, the equilibrium of the game is obvious: each player plays his own dominant

strategy.

Consider the following game. Each player has two strategies C (cooperate) and D

(defect, which means not to cooperate). There are 4 possible strategy profiles and each

profile generates a payoff for each player. The first number in each cell is the payoff of

player 1 and the second number is the payoff of player 2. Again, note that player 1

chooses the row that is being played and player 2 chooses the column that is being

played.

Player 1 C

D

Player 2

C

D

2, 2 0, 3

3, 0 1, 1

Here each player has a dominant strategy, D. This is the well-known Prisoners

Dilemma game. Rational players, playing in rational self-interest, get locked into a

51

4. Game theory

where both players cooperate. However, cooperating cannot be part of any equilibrium,

since D is the dominant strategy. Later on we will see that if the game is

infinitely-repeated, then under certain conditions cooperation can emerge as an

equilibrium. But in a one-shot game (i.e. a game that is played once) the only possible

equilibrium is that each player plays their dominant strategy. In the game above, the

dominant strategy equilibrium is (D, D).

In terms of the notation introduced before, we can define a dominant strategy as follows.

Dominant strategy

Strategy si of player i is a dominant strategy if:

ui (si , si ) > ui (si , si )

That is, si performs better than any other strategy of player i no matter what others

are playing.

4.3.2

Even if a player does not have a dominant strategy, he might have one or more

dominated strategies. A dominated strategy for i is a strategy of i (say si ) that yields a

lower payoff compared to another strategy (say s0i ) irrespective of what others are

playing. In other words, the payoff of i from playing si is always (i.e. under all possible

choices of other players) lower than the payoff from playing s0i . Since si is a dominated

strategy, i would never play this strategy. Thus we can eliminate dominated strategies.

Indeed, we can eliminate such strategies not just once, but in an iterative fashion.

If in some game, all strategies except one for each player can be eliminated by

iteratively eliminating dominated strategies, the game is said to be dominance solvable.

Consider the game in Section 4.3. Note that no strategy is dominant for player 1, but

for player 2 L dominates R. So we can eliminate the possibility of player 2 playing R.

Once we do this, in the remaining game, for player 1 D dominates U (2 is greater than

1). So we can eliminate U . We are then left with (D, L), which is the equilibrium by

iteratively eliminating dominated strategies. The game is dominance solvable.

Here is another example of a dominance solvable game. We find the equilibrium of this

game by iteratively eliminating dominated strategies.

Player 1

Top

Middle

Bottom

Left

4, 3

5, 5

3, 5

Player 2

Middle Right

2, 7

0, 4

5, 1 4, 2

1, 5

1, 6

52

2. In the remaining game, for player 2, Right is dominated by Middle. Eliminate

Right.

3. In the remaining game, for player 1, Top is dominated by Middle. Eliminate Top.

4. In the remaining game, for player 2, Middle is dominated by Left. Eliminate

Middle.

This gives us (Middle, Left) as the unique equilibrium.

4.3.3

Nash equilibrium

However, for many games the above criteria of dominance do not allow us to find an

equilibrium. Players might not have dominant strategies; moreover none of the

strategies of any player might be dominated. The following game provides an example.

A1

Player 1 B1

C1

A2

3, 1

1, 0

2, 3

Player

B2

1, 3

3, 1

2, 0

2

C2

4, 2

3, 0

3, 2

As noted above, the problem with dominance criteria is that they apply only to some

games. For games that do not have dominant or dominated strategies, the idea of

deriving an equilibrium using dominance arguments does not work. If we cannot derive

an equilibrium by using dominant strategies or by (iteratively) eliminating dominated

strategies, how do we proceed?

If we want to derive an equilibrium that does not rely on specific features such as

dominance, we need a concept of equilibrium that applies generally to all games. As we

show below, a Nash equilibrium (named after the mathematician John Nash) is

indeed such a solution concept.

Pure and mixed strategies

Before proceeding further, we need to clarify something about the nature of strategies.

In the discussion above, we identified strategies with single actions. For example, in the

Prisoners Dilemma game, we said each player has the strategies C and D. However,

this is not a full description of strategies. A player could also do the following: play C

with probability p and play D with probability (1 p), where p is some number

between 0 and 1. Such a strategy is called a mixed strategy; while a strategy that just

chooses one action (C or D) is called a pure strategy.

We start by analysing Nash equilibrium under pure strategies. Later we introduce

mixed strategies. We then note that one can prove an existence result: all games have at

least one Nash equilibrium (in either pure or mixed strategies). This is why Nash

equilibrium is the central solution concept in game theory.

53

4. Game theory

mutual best response. In other words, for every player i, the strategy si is a best

response to si (as explained above, this is the strategy profile of players other than i).

In yet other words, if (s1 , s2 , . . . , sn ) is a Nash equilibrium, it must satisfy the property

that given the strategy profile si of other players, player i cannot improve his payoff by

replacing si with any other strategy.

A more formal definition is as follows.

Nash equilibrium in pure strategies

A strategy profile (si , si ) is a Nash equilibrium if for each player i:

ui (si , si ) ui (si , si ) for all strategies si in the set Si .

To find out the Nash equilibrium of the game above, we must look for the mutual best

responses. Let us check the best response of each player. Player 1s best response is as

follows:

Player 2s strategy

A2

B2

C2

A1

B1

A1

Player 1s strategy

A1

B1

C1

B2

B2

A2

Note from these that the only mutual best response is (B1 , B2 ). This is the only Nash

equilibrium in this game.

You could also check as follows:

If player 1 plays A1 , player 2s best response is B2 . However, if player 2 plays B2 ,

player 1 will not play A1 (B1 is a better response than A1 ). Therefore, there is no

Nash equilibrium involving A1 .

If player 1 plays B1 , player 2s best response is B2 . If player 2 plays B2 , player 1s

best response is B1 . Therefore, (B1 , B2 ) is a Nash equilibrium.

If player 1 plays C1 , player 2s best response is A2 . However, if player 2 plays A2 ,

player 1 would not play C1 (A1 is a better response). Therefore, there is no Nash

equilibrium involving C1 .

From the three steps above, we can conclude that (B1 , B2 ) is the only Nash equilibrium.

54

Let us also do a slightly different exercise. Suppose you want to check if a particular

strategy profile is a Nash equilibrium. Suppose you want to check if (A1 , C2 ) is a Nash

equilibrium. You should check as follows.

If player 2 plays C2 , player 1 cannot do any better by changing strategy from A1 (4 is

better than 3 from B1 or 3 from C1 ). However, player 2 would not want to stay at

(A1 , C2 ) since player 2 can do better by switching to B2 (3 from B2 is better than 2

from C2 ). We can therefore conclude that (A1 , C2 ) is not a Nash equilibrium.

You can similarly check that all boxes other than (B1 , B2 ) have the property that some

player has an incentive to switch to another box. However, if the players are playing

(B1 , B2 ) no player has an incentive to switch away. Neither player can do better by

switching given what the other player is playing. Since player 2 is playing B2 , player 1

gets 3 from B1 which is better than 1 from A1 or 2 from C1 . Since player 1 is playing

B1 , player 2 gets 1 from B2 which is better than 0 from A2 or C2 . Therefore (B1 , B2 ) is

a Nash equilibrium.

Nash equilibrium is not necessarily unique. Consider the following game.

A

Player 1 B

Player 2

A

B

2, 1 0, 0

0, 0 1, 2

Note there are multiple pure strategy Nash equilibria. Both (A, A) and (B, B) are Nash

equilibria.

Dominance criteria and Nash equilibrium

Note that while a dominant strategy equilibrium is also a Nash equilibrium, Nash

equilibrium does not require dominance. However, the greater scope of Nash equilibrium

comes at a cost: it places greater rationality requirements on players. To play (B1 , B2 ),

player 1 must correctly anticipate that player 2 is going to play B2 . Such a requirement

is even more problematic when there are multiple Nash equilibria. On the other hand, if

players have dominant strategies, they do not need to think at all about what others are

doing. A player would simply play the dominant strategy since it is a best response no

matter what others do. This is why a dominant strategy equilibrium (or one achieved

through iterative elimination of dominated strategies) is more convincing than a Nash

equilibrium. However, as noted before, many games do not have dominant or dominated

strategies, and are therefore not dominance solvable. We need a solution concept that

applies generally to all games, and Nash equilibrium is such a concept.

4.3.4

Mixed strategies

A1

Player 1 B1

Player 2

A2

B2

3, 1 2, 3

2, 1 3, 0

55

4. Game theory

Notice that this game has no pure strategy Nash equilibrium. However, as you will see

below, the game does have a Nash equilibrium in mixed strategies.

Let us first define a mixed strategy.

Mixed strategy

A mixed strategy si is a probability distribution over the set of (pure) strategies.

In the game above, A1 and B1 are the pure strategies of player 1. A mixed strategy of

player 1 could be A1 with probability 1/3, and B1 with probability 2/3. Notice that a

pure strategy is only a special case of a mixed strategy.

A Nash equilibrium can then be defined in the usual way: a profile of mixed strategies

that constitute a mutual best response.

A mutual best response in mixed strategies has an essential property that makes it easy

to find mixed strategy Nash equilibria. Let us consider games with two players to

understand this property.

Suppose we have an equilibrium in which both players play strictly mixed strategies:

player 1 plays A1 with probability p and B1 with probability (1 p) where 0 < p < 1,

and player 2 plays A2 with probability q and B2 with probability (1 q) where

0 < q < 1.

In this case, whenever player 1 plays A1 , she gets an expected payoff of:

1 (A1 ) = 3q + 2(1 q).

Whenever player 1 plays B1 , she gets an expected payoff of:

1 (B1 ) = 2q + 3(1 q).

What must be true of these expected payoffs that player 1 gets from playing A1 and

B1 ? Suppose 1 (A1 ) > 1 (B1 ). Then clearly player 1 should simply play A1 , rather than

any strictly mixed strategy, to maximise her payoff. In other words, player 1s best

response in this case would be to choose p = 1, rather than a strictly mixed strategy

p < 1. But then we do not have a mixed strategy Nash equilibrium.

Similarly, if 1 (A1 ) < 1 (B1 ), player 1s best response would be to choose p = 0 (i.e. just

to play B1 ), and again we cannot have a mixed strategy Nash equilibrium.

So if player 1 is going to play a mixed strategy in equilibrium it must be that she is

indifferent between the two strategies. How does such indifference come about? This is

down to player 2s strategy choice. Player 2s choice of q must be such that player 1 is

indifferent between playing A1 or B1 . In other words, in equilibrium q must be such

that 1 (A1 ) = 1 (B1 ), i.e. we have:

3q + 2(1 q) = 2q + 3(1 q)

which implies q = 1/2.

But if player 2 is going to choose q = 1/2 it must be that he is indifferent between A2

and B2 (otherwise player 2 would not want to mix, but would play a pure strategy).

How can such indifference come about? Well, player 1 must choose p in such a way so as

56

such that 2 (A2 ) = 2 (B2 ), i.e. we have:

1 = 3p

which implies p = 1/3.

Therefore, the mixed strategy Nash equilibrium is as follows. Player 1 plays A1 with

probability 1/3 and B1 with probability 2/3, while player 2 plays A2 with probability

1/2 and B2 with probability 1/2.

We can also show this in a diagram. Let us first write down the best response function

of each player.

Player 1s best response function is given by:

q > 1/2 = p = 1 is the best response.

q = 1/2 = any p in [0, 1] is a best response.

q < 1/2 = p = 0 is the best response.

Player 2s best response function is given by:

p > 1/3 = q = 0 is the best response.

p = 1/3 = any q in [0, 1] is a best response.

p < 1/3 = q = 1 is the best response.

Figure 4.1 below shows these best response functions and shows the equilibrium point

(where the two best response functions intersect).

Figure 4.1: The best-response functions. They cross only at E, which is the mixed strategy

Nash equilibrium. There are no pure strategy Nash equilibria in this case.

57

4. Game theory

game is that each players chosen probability distribution must make the other player

indifferent between the strategies he is randomising over. In a k-player game, the joint

distribution implied by the choices of each player in every combination of (k 1)

players must be such that the kth player receives the same expected payoff from each of

the strategies he plays with positive probability.

The game above has no Nash equilibrium in pure strategies, but has a mixed strategy

Nash equilibrium. However, in other games that do have pure strategy Nash equilibria,

there might be yet more equilibria in mixed strategies. For instance, we could find a

mixed strategy Nash equilibrium in the Battle of the sexes.

Activity 4.1 Find the mixed strategy Nash equilibrium in the following game. Also

show all Nash equilibria of the game in a diagram by drawing the best response

functions.

A

Player 1 B

4.3.5

Player 2

A

B

2, 1 0, 0

0, 0 1, 2

Once we include mixed strategies in the set of strategies, we have the following

existence theorem, proved by John Nash in 1951.

Existence theorem

Every game with a finite number of players and finite strategy sets has at least one

Nash equilibrium.

Nash proved the existence theorem for his equilibrium concept using a mathematical

result called a fixed-point theorem. Take any strategy profile and compute the best

response to it for every player. So the best response is another strategy profile. Suppose

we do this for every strategy profile. So long as certain conditions are satisfied, a

fixed-point theorem says that there is going to be at least one strategy profile which is a

best response to itself. This is, of course, a Nash equilibrium. Thus upon setting up the

strategy sets and the best response functions properly, a fixed-point theorem can be

used to prove existence. You will see a formal proof along these lines if you study game

theory at more advanced levels. Here, let us point out the importance of this result.

The importance of proving existence

The existence theorem is indeed very important. It tells us that no matter what game

we look at, we will always be able to derive at least one Nash equilibrium. If existence

did not hold for some equilibrium concept (for example, games do not necessarily have a

dominant strategy equilibrium), we could derive wonderful properties of that concept,

but we could not be sure such derivations would be of any use. The particular game

58

that we confront might not have an equilibrium at all. But being able to prove existence

for Nash equilibrium removes such problems. Indeed, as noted before as well, this is

precisely what makes Nash equilibrium the main solution concept for

simultaneous-move games.

4.3.6

We have so far analysed games with discrete strategy sets. However, the above analysis

can easily extend to certain classes of games with continuous strategy sets. We will

analyse a few such games (the Cournot game, the Bertrand game, and the Bertrand

game with product differentiation) in detail later in discussing oligopoly (in Chapter 9

of the subject guide). Also see N&S Section 5.7 for an example of a commons problem

game with continuous strategy sets. We will also refer to this game when discussing

externalities (in Chapter 12 of the subject guide).

4.4

Let us now consider sequential move games. In this case, we need to draw a game tree

to depict the sequence of actions. Games depicted in such a way are also known as

extensive-form games. In this subject guide we will consider the phrases

sequential-move game and extensive-form game as interchangeable.

To start with, we assume that each player can observe the moves of players who act

before them. 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. We then introduce some simple cases

where information is imperfect, and show how the notion of strategies differs, and how

to derive subgame perfect Nash equilibria.

Consider the following extensive-form game. Each player has two actions: player 1s

actions are a1 and a2 and player 2s actions are b1 and b2 . Player 1 moves before player

2. Player 2 can observe player 1s action and, therefore, can vary his action depending

on the action of player 1. For each profile of actions by player 1 and player 2 there are

payoffs at the end. As usual, the first number is the payoff of the first mover (in this

case player 1) and the second number is the payoff of the second mover (here player 2).

We can define the game as a graph: it has decision nodes and branches from decision

nodes to successor nodes. However, such formal definitions are useful only at a later

stage. If you simply look at Figure 4.2 below, the depiction of the sequence of players,

their action choices at each stage and their final payoffs should be clear to you.

4.4.1

The notion of a strategy is fairly straightforward in a normal form game. However, for

an extensive-form game, it is a little bit more complicated. A strategy in an extensive

form game is a complete plan of actions. In other words, a strategy for player i must

59

4. Game theory

Consider the game above. As already noted, each player has 2 actions. 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 }.

Player 2, on the other hand, must plan for two different contingencies. He must decide

what to do if player 1 plays a1 , and what to do if player 1 plays a2 . Note that such

decisions must be made before the game is actually played. Essentially, game theory

tries to capture the process of decision-making of individuals. Faced with a game such

as the one above, player 2 must consider both contingencies. This is what we capture by

the notion of a strategy. It tells us what player 2 would do in each of the two possible

cases.

Now player 2 can choose 2 possible actions at the left node (after player 1 plays a1 ) and

2 possible actions at the right node (after a2 ). So there are 2 2 = 4 possible strategies

for player 2. These are:

1. If player 1 plays a1 , play b1 and if player 1 plays a2 , play b1 .

2. If player 1 plays a1 , play b1 and if player 1 plays a2 , play b2 .

3. If player 1 plays a1 , play b2 and if player 1 plays a2 , play b1 .

4. If player 1 plays a1 , play b2 and if player 1 plays a2 , play b2 .

For the sake of brevity of notation, we write these as follows. Just as we read words

from left to right, we read strategies from left to right. So we write the strategy if

player 1 plays a1 , play b2 and if player 1 plays a2 , play b1 as b2 b1 . Reading from left to

right, this implies that the plan is to play b2 at the left node and play b1 at the right

node. This is precisely what the longer specification says.

So the strategy set of player 2 is {(b1 b1 ), (b1 b2 ), (b2 b1 ), (b2 b2 )}.

Suppose instead of 2 actions, player 2 could choose between b1 , b2 and b3 at each node.

In that case, player 2 would have 3 3 = 9 strategies.

60

Suppose player 1 had 3 strategies a1 , a2 and a3 , and after each of these, player 2 could

choose between b1 and b2 . Then player 2 would have 2 2 2 = 8 strategies.

4.4.2

the normal form. To find Nash equilibria in an extensive-form game, the most

convenient method is to transform it into its normal form. This is as follows. Note that

player 1 has two strategies and player 2 has four strategies. Therefore, we have a 2-by-4

matrix of payoffs as follows:

Player 1 a1

a2

b1 b1

3, 1

4, 1

Player 2

b1 b2 b2 b1

3, 1 1, 0

0, 1 4, 1

b2 b2

1, 0

0, 1

Note that if we pair, say, a1 with b2 b1 , only the first component of player 2s strategy is

relevant for the payoff. In other words, since player 1 plays a1 , the payoff is generated by

player 2s response to a1 , which in this case is b2 . Similarly, if we pair a2 with b2 b1 , the

second component of player 2s strategy is relevant for the payoff. Since player 1 plays

a2 , we need player 2s response to a2 , which in this case is b1 , to determine the payoff.

Once we write down the normal form, it is easy to find Nash equilibria. Here let us only

consider pure strategy Nash equilibria. There are three pure strategy Nash equilibria in

this game. Finding these is left as an exercise.

Example 4.1 Find the pure strategy Nash equilibria of the extensive-form game

above.

It is easiest to check each box. If we start at the top left-hand box, player 1 would

switch to a2 . So this is not a Nash equilibrium. From (a2 , b1 b1 ) no player can do

better by deviating. Therefore, (a2 , b1 b1 ) is a Nash equilibrium.

Next try (a1 , b1 b2 ). This is indeed a Nash equilibrium. Note that you must write

down the full strategy of player 2. It is not enough to write (a1 , b1 ). Unless we know

what player 2 would have played in the node that was not reached (in this case the

node after a2 was not reached), we cannot determine whether a strategy is part of a

Nash equilibrium. So while (a1 , b1 b2 ) is indeed a Nash equilibrium, (a1 , b1 b1 ) is not.

Finally, (a2 , b2 b1 ) is also a Nash equilibrium. These are the three pure strategy Nash

equilibria of the game.

4.4.3

So far we have assumed perfect information: each player is perfectly informed of all

previous moves. Let us now see how to represent imperfect information: players may not

be perfectly informed about some of the (or all of the) previous moves.

Games of imperfect information give rise to certain types of problems that require more

sophisticated refinements of Nash equilibria than we study here. In particular, if a

61

4. Game theory

player does not observe some past moves, what he believes took place becomes

important. We do not study these problems here the analysis below simply shows you

how to represent situations of imperfect information in some simple cases.

Consider the extensive-form game introduced at the start of this section. Suppose at the

time of making a decision, player 2 does not know what strategy player 1 has chosen.

Since player 2 does not know what player 1 has chosen, at the time of taking an action

player 2 does not know whether he is at the left node or at the right node. To capture

this situation of imperfect information in our game-tree, we say that the two decision

nodes of player 2 are in an information set. We represent this information set as in

Figure 4.3: by connecting the two nodes by a dotted line (another standard way to do

this is to draw an elliptical shape around the two nodes you will see this in N&S).

Note that player 2 knows he is at the information set (after player 1 moves), but does

not know where he is in the information set (i.e. he does not know what player 1 has

chosen). Since player 2 cannot distinguish between the two nodes inside his information

set, he cannot take different actions at the two nodes. Therefore, the strategy set of 2 is

simply {b1 , b2 }. In other words, now, for both players the strategy set coincides with the

action set. This is not surprising: since player 2 takes an action without knowing what

player 1 has done, the game is the same as a simultaneous-move game. Indeed, the

normal form of the game above coincides with a game in which the two players choose

strategies simultaneously. This is shown below. Now the Nash equilibrium is simply

(a2 , b1 ).

a1

Player 1 a2

62

Player 2

b1

b2

3, 1 1, 0

4, 1 0, 1

4.5

perfection

Let us now consider whether Nash equilibrium is a satisfactory solution concept for

extensive-form games. As you will see, when players move sequentially, Nash

equilibrium allows for some strategies by later movers that seem like threats which are

incredible. Parents often try to control unruly children by saying things like sit quietly,

or we will never let you . . . (insert favourite activity), even though they have no

intention of carrying out the threat. Children sometimes believe their parents and

respond to the threat, but they are often clever enough to see through the ruse and

ignore incredible threats. As we will see, Nash equilibria often depend precisely on such

incredible threats by later movers. In Nash equilibrium, a player is just supposed to

take a best response to the other players strategy choices so the way Nash

equilibrium is constructed does not allow the player to ignore certain strategy choices of

others as incredible. Once we look at some examples of the problem, we will try to see

whether we can refine the set of Nash equilibria to eliminate the possibility of such

threats (i.e. come up with extra conditions that an equilibrium must satisfy so that

equilibria which depend on incredible threats will not satisfy these extra conditions).

Consider the game shown in Figure 4.4. Firm E, where E stands for entrant, is deciding

whether to enter a market. The market has an incumbent firm (Firm I). If the entrant

enters, the incumbent firm must decide whether to fight (start a price war, say) or

accommodate the entrant. The sequence of actions and payoffs is as follows.

Firm E

In

Out

Firm I

A

F

2, 1 1, 2

0, 2

0, 2

Note that there are two pure strategy Nash equilibria: (In, A) and (Out, F). The latter

equilibrium involves an incredible threat. Clearly, if the entrant does decide to enter the

63

4. Game theory

market, the incumbent has no incentive to choose F. Hence the threat of F is incredible.

Yet, Nash equilibrium cannot preclude this possibility. Out is the best response to F,

and once Firm E decides to stay out, anything (and in particular F) is a best response

for Firm I.

The game in Figure 4.5 presents another example.

(a) Write down the strategies available to each player.

(b) Write down the normal form of the game.

(c) Identify the pure strategy Nash equilibria.

When you write the normal form and work out the Nash equilibria, you should see

that (R, rr) is a Nash equilibrium. Look at the game above and see that this

involves an incredible threat. Player 2s strategy involves playing r after L. Player

1s strategy is taking a best response given this, and so player 1 is playing R. Given

that player 1 is playing R, the threat is indeed a best response for player 2 (indeed,

given that player 1 plays R, anything that player 2 can choose after L is trivially a

best response since it does not change the payoff, but, of course, not every choice

would lead to an equilibrium in which player 1s best response is R).

4.5.1

Let us now describe a solution concept that imposes extra conditions (i.e. further to the

requirement that strategies be mutual best responses) for equilibrium and leads to a

refinement of the set of Nash equilibria. Several such refinements have been proposed by

game theorists. Here, we will look at only one such refinement, namely subgame

perfection. To understand the refinement, you first need to understand the idea of a

subgame.

64

Subgame

A subgame is a part of a game that starts from a node which is a singleton (i.e. a

subgame does not start at an information set), and includes all successors of that node.

If one node in an information set belongs to a subgame, so do all other nodes in that

information set. In other words, you cannot cut an information set so that only part of

it belongs to a subgame. That would clearly alter the information structure of the

game, which is not allowed.

We can now define a subgame perfect equilibrium.

Subgame perfect Nash equilibrium

A strategy combination is a subgame perfect Nash equilibrium (SPNE) if:

it is a Nash equilibrium of the whole game

it induces a Nash equilibrium in every subgame.

It should be clear from the definition that the set of subgame perfect equilibria is a

refinement of the set of Nash equilibria.

4.5.2

How do we find subgame perfect equilibria? In perfect information games (recall that,

in a game of perfect information, each player knows all past moves of other players),

this is easy. Subgame perfect Nash equilibria can be derived simply by solving

backwards, i.e. by using backward induction.

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 SPNE is (In, A).

Let us see that this equilibrium derived using backward induction fits with the

definition of SPNE given above. The game has a subgame starting at the node after

Firm E plays In (also, the whole game is always trivially a subgame). In the subgame

after E plays In, there is only one player (Firm I), and the Nash equilibrium in this

subgame is simply the optimal action of Firm I, which in this case is to choose A.

Therefore the Nash equilibrium in the subgame is A. It follows that any Nash

equilibrium of the whole game that involves playing A in the subgame is a subgame

perfect Nash equilibrium. Here, the only Nash equilibrium of the whole game that

satisfies this property is (In, A). Therefore, this is the only SPNE.

Next, consider the game in which player 1 chooses between L, R and player 2 moves

second and chooses between `, r. In this game there are two strict subgames, one

starting after each action of player 1. In the left subgame, player 2s optimal choice is `,

and in the right subgame player 2s optimal choice is r. Given this, player 1 would

compare 3 from R and 0 from L, and choose R. The choices obtained by backward

induction are shown in Figure 4.6.

It follows that the SPNE is (R, `r). Note that it is not sufficient to write (R, `) the

equilibrium specification is meaningless unless you specify the full strategy for player 2.

65

4. Game theory

What player 2 plays at the unreached node is crucial. If player 2 played ` after L, R

would not be the optimal choice. Therefore, you must specify player 2s full strategy

and identify (R, `r) as the SPNE.

In these games, the SPNE is unique, but it need not be. The next activity presents an

example.

Activity 4.3 Derive the pure strategy subgame perfect Nash equilibria of the game

in Figure 4.2.

4.5.3

Backward induction need not work under imperfect information: you cannot fold

backwards when you come up against an information set. Indeed, this is why the

concept of a subgame perfect Nash equilibrium is more general compared to backward

induction. If we always had perfect information, we could simply define backward

induction equilibria. However, we present below an example to show you that subgame

perfection is more general than backward induction, and works in many games in which

backward induction does not give us any result.

Before we present the example referred to above, consider the imperfect information

game introduced in Section 4.4.3. Note that this game does not have any strict

subgames (recall that you cannot start a subgame from an information set or cut an

information set), so the only subgame is the whole game. Therefore, any Nash

equilibrium of the whole game is trivially subgame perfect. As discussed above, the pure

strategy Nash equilibrium in this game is (a2 , b1 ). This is also the subgame perfect Nash

equilibrium.

Next, consider the game in Figure 4.7.

Initially player 1 decides whether to come in (and play some game with player 2) or

stay out (in which case player 2 plays no role). If the choice is to come in, player 1

66

decides between A and B, and player 2 decides between C and D. When player 2 makes

his decision, he knows that player 1 has decided to come in (if not then player 2 would

not have been asked to play), but without knowing what player 1 has chosen between A

and B. In other words, the situation is just as if once player 1 comes in, player 1 and

player 2 play a simultaneous-move game (as the game structure shows, they do not

move simultaneously player 1 moves before player 2, but since player 2 has no

knowledge of player 1s move, it is similar to the decision problem faced in a

simultaneous move game).

1. Pure strategy Nash equilibria. Let us first identify the pure strategy Nash

equilibria. Note that player 1 has 4 strategies: Out A, Out B, In A and In B, while

player 2 has 2 strategies: C and D. You might think strategies like Out A do not make

sense, but in game theory we try to model the thought process of players, and even if

player 1 stays out, she would do so only after thinking about what she would have done

had she entered. Strategies reflect such thinking (it is as if player 1 is saying I have

decided to finally stay out, but had I come in I would have chosen A).

Let us now write down the normal form of the game.

Player 1

Out A

Out B

In A

In B

Player 2

C

D

1, 3

1, 3

1, 3

1, 3

2, 2

2, 0

0, 2

5, 5

You should be able to see from this that the pure strategy Nash equilibria are

(Out A, C), (Out B, C) and (In A, D).

67

4. Game theory

2. Pure strategy subgame perfect Nash equilibria. Note that backward induction

does not work here: we cannot fold back given the information set of player 2. However,

subgame perfection still works. Let us see how applying subgame perfection can refine

the set of Nash equilibria.

Note that apart from the whole game, there is just one strict subgame, which starts at

the node after player 1 chooses In. Below we write down the normal form of the

subgame.

Player 1

A

B

Player 2

C

D

2, 2

2, 0

0, 2

5, 5

As you can see, the subgame has two pure strategy Nash equilibria: (B, C) and (A, D).

If (B, C) is played in the subgame, player 1 compares 1 (from Out) with 0 (from In

followed by (B, C)) and decides to stay out. Therefore, a SPNE of the whole game is

(Out B, C).

If, on the other hand, (A, D) is played in the subgame, player 1 compares 1 with 2 and

decides to come in. Therefore, another SPNE of the whole game is (In A, D).

It follows that the pure strategy SPNE of the whole game are (Out B, C) and (In A, D).

Another way to derive these is as follows. Since the set of SPNE is a subset of the set of

Nash equilibria, and since (B, C) and (A, D) are the Nash equilibria in the subgame, it

must be that any Nash equilibria of the whole game that involves playing either (B, C)

and (A, D) in the subgame are subgame perfect. Considering the set of Nash equilibria

derived above, we can immediately infer that (Out A, C) is Nash but not subgame

perfect, while the other two are subgame perfect.

4.6

Player 1 C

D

Player 2

C

D

2, 2 0, 3

3, 0 1, 1

In a one-shot game, rational players simply play their dominant strategies. So (D, D) is

the only possible equilibrium. Suppose the game is repeated. Can we say something

about the behaviour of players in such supergames that differs from the behaviour in

the one-shot game?

First, consider the case of a finite number of repetitions. Say the game is played twice.

Would anything change? The answer is no. In the second round, players simply face a

one-shot game and they would definitely play their dominant strategies. Given that

(D, D) will be played in the next period, playing anything other than D today makes no

sense. Therefore, in each period players would play (D, D). But this logic extends to any

68

finite number of repetitions. If the game is played a 100 times, in the last period (D, D)

will be played. This implies that (D, D) will be played in the 99th period, and so on.

While the logic is inescapable, actual behaviour in laboratory settings differs from this.

Faced with a large finite number of repetitions, players do cooperate for a while at least.

Therefore, it is our modelling that is at fault. 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. In that case, we must apply forward-looking logic

as there is no last period from which to fold backwards.

(A quick note: you should be aware that there are other games with multiple Nash

equilibria where some cooperation can be sustained even under a finite number of

repetitions. You will encounter these in more advanced courses. Here we only consider

the repeated Prisoners Dilemma.)

Let us now analyse an infinitely repeated Prisoners Dilemma game.

Payoffs: discounted present value

First, we need to have an appropriate notion of payoffs in the infinitely repeated game.

Each player plays an action (in this case either C or D) in each period. So in each

period, the players end up playing one of the four possible action profiles (C, C), (C, D),

(D, C) or (D, D). Let at denote the action profile played in period t. Then in period t,

player i receives the payoff ui (at ). The payoff of player i in the repeated game is simply

the discounted present value of the stream of payoffs.

Let denote the common discount factor across players, where 0 < < 1. If todays

date is 0, and a player receives x in period t, the present value of that payoff is t x. The

discount factor can reflect players time preference. This can also arise from a simple

rate of interest calculation, in which case can be interpreted as 1/(1 + r), where r is the

rate of interest. Note that higher values of indicate that players are more patient (i.e.

value future payoffs more). If is very low, the situation is almost like a one-shot game,

since players only value todays payoff, and place very little value on any future payoff.

Given such discounting, the payoff of player i in the repeated game is:

ui (a0 ) + ui (a1 ) + 2 ui (a2 ) + .

More concisely, the payoff is:

t ui (at ).

t=0

If the payoff is the same every period (x, say), this becomes:

x(1 + + 2 + ) =

4.6.1

x

.

1

Next, we need to consider strategies by players. The history at t is the action profile

played in every period from period 0 to t 1. A strategy of a player consists of an

initial action, and after that, an action after every history. Consider the following

trigger strategy.

69

4. Game theory

Trigger strategy

Start by playing C (that is, cooperate at the very first period, when there is no

history yet).

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. Since anything other than (C, C) implies playing (D, D) next period,

once a switch to (D, D) has been made, there is no way back: the players must play

(D, D) forever afterwards. This is why this is a trigger strategy.

Another way of stating the trigger strategy is to write in terms of strategy profiles.

Start by playing (C, C).

In period t:

if (C, C) is played in t 1, play (C, C)

otherwise play (D, D).

Let us see if this will sustain 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:

.

3 + + 2 + = 3 +

1

If the player did not deviate in period t, the payoff from t onwards would be:

2 + 2 + 2 2 + =

2

.

1

2

>3+

1

1

which implies:

1

> .

2

Thus if the players are patient enough, cooperation can be sustained in equilibrium. In

other words, playing (C, C) always can be the outcome of an equilibrium if the discount

factor is at least 1/2.

4.6.2

Folk theorem

We showed above that the cooperative payoff (2, 2) can be sustained in equilibrium.

However, this is not the only possible equilibrium outcome. Indeed, many different

payoffs can be sustained in equilibrium.

70

For example, note that always playing (D, D) is an equilibrium no matter what the

value of is. Each player simply adopts the strategy play D initially, and at any period

t > 1, play D irrespective of history. Note that both players adopting this strategy is a

mutual best response. Therefore, we can sustain (1, 1) in equilibrium. In fact, by using

suitable strategies, we can sustain many more in fact infinitely more payoffs as

equilibrium outcomes. For the Prisoners Dilemma game, we will describe the set of

sustainable payoffs below.

The result about the large set of payoffs that can be sustained as equilibrium outcomes

is known as the folk theorem. These types of results were known to many game

theorists from an early stage of development of non-cooperative game theory. While

formal proofs were written down later, we cannot really trace the source of the idea,

which explains the name.

Here we state a folk theorem adapted to the repeated Prisoners Dilemma game. To

state this, we will need to compare payoffs in the repeated game to payoffs in the

one-shot game that is being repeated. The easiest way to do that is to normalise the

repeated game payoff by multiplying by (1 ). Then if a player gets 2 every period,

the repeated game payoff is (1 ) 2/(1 ) = 2. As you can see, this normalisation

implies that the set of normalised repeated game payoffs now coincide with the set of

payoffs in the underlying one-shot game. So now we can just look at the set of payoffs of

the one-shot game and ask which of these are sustainable as the normalised payoff in

some equilibrium of the repeated game.

For the rest of this section, whenever we mention a repeated game payoff, we always

refer to normalised payoffs. Note that in this game, a player can always get at least 1 by

simply playing D. It follows that a player must get at least 1 as a (normalised) repeated

game payoff.

To see the whole set of payoffs that can be sustained, let us plot the payoffs from the

four different pure strategy profiles. These are shown in Figure 4.8 below. Now join the

payoffs and form a convex set as shown in the figure. We now have a set of payoffs that

can arise from pure or mixed strategies.

The Folk theorem is the following claim. Consider any pair of payoffs (1 , 2 ) such

that i > 1 for i = 1, 2. Any such payoff can be supported as an equilibrium payoff for

high enough .

As noted above, for the Prisoners Dilemma game we can also sustain the payoff (1, 1)

as an equilibrium outcome irrespective of the value of .

The set of payoffs that can be supported as equilibrium payoffs in our example is shown

as the shaded part in Figure 4.8.

Example 4.2 Consider the following game.

Player 1

C

D

Player 2

C

D

3, 2 0, 1

7, 0 2, 1

(a) Find conditions on the discount factor under which cooperation can be

sustained in the repeated game in which the above game is repeated infinitely.

71

4. Game theory

Figure 4.8: The set of payoffs that can be supported as equilibrium payoffs under an

infinitely-repeated game.

(b) Under what conditions is there an equilibrium in the infinitely-repeated game in

which players alternate between (C, C) and (D, D), starting with (C, C) in the

first period?

(c) Draw the set of payoffs sustainable in a repeated game equilibrium according to

the folk theorem.

(a) First, note that player 2 has no incentive to deviate from (C, C). To ensure that

player 1 does not deviate, consider the following strategy profile. Play (C, C)

initially. At any period t > 0, if (C, C) has been played in the last period, play

(C, C). Otherwise, switch to (D, D).

Under this strategy profile, player 1 will not deviate if:

7+2

3

6

1

1

(b) We want to support alternating between (C, C) and (D, D), starting with

(C, C) in period 0, as an equilibrium.

Note first that player 2 has no incentive to deviate in odd or even periods.

Player 1 cannot gain by a one-shot deviation in odd periods, when (D, D) is

supposed to be played. So the only possible deviation is by player 1 in even

periods, when (C, C) is supposed to be played.

To prevent such a deviation, consider the following strategy profile.

Start by playing (C, C) in period 0.

In any odd period t (where t = 1, 3, 5, . . .) play (D, D) (irrespective of

history).

72

play (C, C) if (C, C) has been played in the previous even period t 2

otherwise play (D, D).

Note that this is a version of the trigger strategy. After any deviation from

cooperation in even periods, (D, D) is triggered forever.

If player 1 does not deviate in any even period t, player 1s payoff (t onwards) is:

Vt = 3 + 2 + 3 2 + 2 3 +

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

=

3 + 2

.

1 2

Vtdev = 7 + 2 + 2 2 + = 7 + 2

.

1

period if:

3 + 2

>

7

+

2

1 2

1

which simplifies to 5 2 4 > 0, implying:

r

4

0.89.

>

5

Note also the repeated game payoff generated in this equilibrium. To see this, first

normalise the payoff by multiplying by (1 ). The normalised payoff of player 1

starting any even period is:

(1 )

3 + 2

3 + 2

=

.

2

1

1+

(2 + 3)/(1 + ). Note that either payoff goes to 5/2 as 1.

For player 2, the normalised payoff from the equilibrium is (2 + )/(1 + ) starting

any even period, and (1 + 2)/(1 + ) starting any odd period. Note that either

payoff goes to 3/2 as 1.

In other words, this exercise shows you an example of an equilibrium that sustains a

payoff in the interior of the set of payoffs which is sustainable according to the folk

theorem (which, in this case, is anything strictly above (2, 1), or the point (2, 1)

itself).

73

4. Game theory

4.7

Having completed this chapter, the Essential reading and activities, you should be able

to:

analyse simultaneous-move games using dominant strategies or by eliminating

dominated strategies either once or in an iterative fashion

calculate Nash equilibria in pure strategies as well as Nash equilibria in mixed

strategies in simultaneous-move games

explain why Nash equilibrium is the central solution concept and explain the

importance of proving existence

specify strategies in extensive-form games

analyse Nash equilibria in extensive-form games

explain the idea of refining Nash equilibria in extensive-form games using backward

induction and subgame perfection

analyse the infinitely-repeated Prisoners Dilemma game with discounting and

analyse collusive equilibria using trigger strategies

explain the multiplicity of equilibria in repeated games and state the folk theorem

for the Prisoners Dilemma game.

4.8

4.8.1

Sample examination questions

1. Consider the strategic form game below with two players, 1 and 2. Solve the game

by iteratively eliminating dominated strategies.

A1

Player 1 B1

C1

Player 2

A2

B2

C2

3, 3 1, 4 0, 5

2, 1

3, 2 1, 0

1, 0 0, 1

1, 0

2. Identify actions and strategies of each player in each of the following games (Figure

4.9 to Figure 4.11).

74

75

4. Game theory

(a) Write down the actions and strategies for each player.

(b) Identify the pure and mixed strategy Nash equilibria.

(c) Identify the pure and mixed strategy subgame perfect Nash equilibria.

4. Consider the extensive-form game in Figure 4.13.

(a) Write down the actions and strategies for each player.

(b) Identify the pure strategy Nash equilibria.

(c) Identify the pure strategy subgame perfect Nash equilibria.

76

(a) Write down the actions and strategies for each player.

(b) Identify the pure strategy Nash equilibria.

(c) Identify the pure strategy subgame perfect Nash equilibria.

6. Find the pure strategy subgame perfect Nash equilibria for the game in Figure 4.9

in Question 2.

7. Suppose the following game is repeated infinitely. The players have a common

discount factor , where 0 < < 1.

Player 1

C

D

Player 2

C

D

3, 2 0, 3

5, 0 2, 1

(a) Find conditions on the discount factor under which cooperation (which implies

playing (C, C) in each period) can be sustained as a subgame perfect Nash

equilibrium of the infinitely-repeated game. Your answer must specify the

strategies of players clearly.

(b) In a diagram, show the set of payoffs that can be supported in a repeated

game equilibrium according to the folk theorem.

77

4. Game theory

78

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