ASSIGNMENT REFERENCE MATERIAL (2019-20)

MEC-001/101
MICRO ECONOMIC THEORY

SECTION-A

Q1. (a) What are the assumptions on which the First fundamental theorem of welfare
economics rests?

Ans:- The first fundamental theorem of welfare economics (also known as the “Invisible-
Hand Theorem”) states that every competitive equilibrium is efficient. To be clear, as a
mathematical theorem, given its assumptions about human nature, it is correct. But as it is
almost always stated, only the assumptions about the market are referenced (with the word
“competitive”). In this form it is false, even if we grant all of the assumptions of “perfect
competition,” because it is not true for all types of economic actors.

In particular, it is not true for humans. In fact there is no evidence that it is even
approximately true for humans, because the flaw in the rationality assumption is not due to
small mistakes in human rationality. The problem is that the proof of the mathematical
theorem assumes away what may be the most important part of human preferences,
preferences concerning social status.

Proof: First recall that a theorem must be true in all the cases it claims to cover. So disproof
requires only one counter example. Our counter example consists of a larger number of
individuals endowed with the ability to expend 10 units of effort per day. This effort can be
used to produce bananas or build houses. Assumptions:

Each person is endowed with 10 units of effort per day.

One unit of effort produces one banana.

The size of your house will be H = 10 Eh, where Eh is the daily effort to build and maintain
the house.

Each person’s utility is U = sqrt(H) + B + Pride, where B = bananas/day.

Pride is the utility from being above average = [H − Average(H)]/22.

People can trade bananas for house-building efforts.

The bigger a house gets, the more repairs it needs, and so if you keep putting effort into it, it
will eventually reach an equilibrium size where all your effort is going into repairs. This
equilibrium size is given by assumption 2.
[Notice that the utility functions contains pride or, as it is customarily called, a desire to keep
up with the Joneses. This means that the consumption of others enters your utility function.
The mathematical proof of the fundamental theorem assumes this is impossible.]

Notice that if all houses are size H = 0, and you put all your effort into growing bananas, your
utility will be U = 0 + 10 − 0 = 10. But if everyone one puts 1 unit of effort per day into their
house (so all H = 10 in equilibrium), your utility will be U = sqrt(10) + 9 − 0 = 3.16 + 9 =
12.16. For every Eh, U = sqrt(10 Eh) + (10−Eh) − 0.

The maximum possible individual utility in such a uniform equilibrium is 12.5 when Eh =
2.5, H=25, the utility from the house is 5, and 7.5 bananas are produced and consumed. (You
can easily check this with a spreadsheet.)

But is this the competitive equilibrium? No. Because any individual can choose to put more
effort into building a bigger house. Say you choose Eh = 5. Your house will be size H=50,
twice as big a average. You will get 7.07−5 extra utility from a bigger house, and 25/22 =
2.27 units of utility from Pride in being ahead of the Joneses. Combined, this more than
compensates for your reduced banana consumption. So you start adding to your house.

Of course everyone else has the same idea, and the race is on. But the bigger the houses get,
the less utility you get from expanding your house. And so the race finally comes to an end
when extra house utility plus extra Pride just equals the loss in utility from non-house
spending (spending on bananas in this model). That occurs at Eh = 8.4, H = 84, B = 2.6, and
total utility = 10.77. Of course, since everyone is identical, everyone ends up with the same
size house and everyone gets zero utility from pride.

This is obviously inefficient. Everyone just spent half of there wealth (4.9 units of effort) on
building larger houses in order to get ahead of the Joneses and no one succeeded. Everyone
ended up with less utility (10.77 vs 12.5). Everyone could be better off than they are in the
competitive equilibrium (by spending 2.5 instead of 8.4 on housing). This contradicts the first
fundamental theorem of welfare economics—the heart of neoclassical economics.

Of course, this only shows that the theorem is wrong on planet Earth. In other words, it is an
interesting math theorem, but it is without any scientific merit. Neoclassical economics is not
a science, it is not even a social science, it is an ideology with a mathematical formalization

(b) Consider a pure-exchange economy of two individuals (A and B) and two goods (X
and Y). Individual A is endowed with 1 unit of good X and none of good Y, while
individual B with 1 unit of good Y and none of good X. Assuming utility function of
individual A and B to be
Ans:- There are two individual (A and B) in the economy. They consume true good (X and

Y) with their unitial endowments= WX 1,= A A

WY 0 ,= WXB 0,= WYB 1. If both have
different cob-Douglas preferences, compute the equilibria of the following

U A = max (X A )α (YA ) 1– α and Uβ = max (X B )β (YB )1– β

Subject to

A'S: PX . WX + Py . WY = PX . X A + PY . YA
A A

B'S: PX . WYB + PY .WYB =PX . X B + PY . YB

The endowment for the agents ( 1 and 2) are

Agent 1=
: WX 1=
A
; WYA 0

Agent=
2: WX 0=
B B
; WY 1

We need to compute the demands:

α (P1.1 + P2 .0)
X11 (P1 , P2 ) = = α
P1 ...(1)

(1 – α) (P1 .1 + P2 .0) P
X12 (P1 , P=
2) = (1 – α) 1 ...(2)
P1 P2

Similarly for the case of Individual B

β (P1. 0 + P2 .1) P
X12 (P1 , P2 ) = =β 2 ...(3)
P1 P1

(1 – β) (P1.0 + P2 .1) P
X 22 (P1 , P=
2) = (1 – β) 2 ...(4)
P2 P2

Setting demand = Supply in equilibrium, we get

From equation (1) and (3), we get

P2
α+β = e11 + e12= 1 ...(5)
P1

from equation (2) and (4) we get

 P1
(1 – α) +1 – β
= e 21 + e 22= 1 ...(6)
P2

To Solve for the prices ratio by solving eq (5) and (6)

P2 1 – α
=
P1 β

Q2. (a) Elucidate price and output determination under any two non-collusive models of
Oligopoly.

Ans:- Sweezy’s Kinked Demand Curve Model: The credit of this model goes to Paul M.
Sweezy. The model explains the rigidity of price in oligopolistic market.

Rivals ignore
price increase
H
P
Revenue/Cost

E
AR2
Rivals match
F price decrease

AR1 MR2
O Q Output
MR1

Fig.: Slope of a non-collusive oligopolist’s demand and

marginal revenue curves

The Fig. shows that the slope of a non-collusive oligopolist’s demand and marginal revenue
curves depends on whether its rivals match (straight lines AR 1 and MR 1 ) or ignore (straight
lines AR 2 and MR 2 ) any price changes which it may initiate from the current price P.

MC1
H
Revenue/cost

P
MC2
E

AR1
O Q Output
MR1

Fig. : Sweezy’s Kinked Demand Curve Model

In the above Fig., in all likelihood an oligopolist’s rivals will ignore a price increase but
follow a price decrease. This causes the oligopolist’s demand curve to be kinked at the point
H and the marginal revenue curve to have a vertical break or gap EF. Because any shift in
marginal costs between MC1 and MC2 will cut the vertical dashed segment of the marginal
revenue curve, no change in either price P or output Q will result from such a shift.

The Model is criticised due to following reasons:

(a) It does not tell how the price P is arrived at.

(b) When the macro-economy is unstable, oligopoly prices are not as rigid as the
kinked demand theory implies.

2) Cournot’s Duopoly Model: The credit of this model goes to a French economist Augustin
Cournot. The model is based on the following assumptions:

(a) There are two firms X and Y which produces homogeneous products.

(b) The cost of production is constant, i.e. MC = 0.

(c) Each firm assumes that the output of other firms as given/constant.

Under the above said assumptions we can develop the model as follows:

Supposing the market demand function is defined as follows:

P = a – bQ

Here, a and b are constants, P = Price and Q = total output of both the firms X and Y

Therefore, the revenue curve of X, i.e. R 1 can be defined as follows:

R 1 aQ1 − bQQ1
=

Putting Q
= Q1 + Q 2

R 1 =aQ1 − b ( Q1 + Q 2 ) Q1

R1 =aQ1 − b ( Q12 + bQ1 ) Q 2

Similarly, the revenue curve of Y. R 2 can also be derived and we will get the following:

R 2 =aQ 2 − bQ 2 2 + bQ1Q 2

Now, Cournot lays down the concept of Reaction curve. A reaction curve is a curve showing
the relationship between output of a firm and the output of other firm.
To derive reaction curve of the firm X we consider the following profit maximising rule, i.e.
MR = MC

dR 1
MR 1 =
= a − 2bQ1 − bQ 2
dQ1

By the assumption of the model cost of production is assumed to be constant, then MC must
be zero

Therefore, when

MR 1 =
a − 2bQ1 − bQ 2 =
0

−a + bQ 2
Q1 =
−2b

a − bQ 2
Q1 = ...(1)
2b

This is the reaction curve of the firm X

Similarly, we have the reaction of the curve of the firm Y

−a + bQ1
Q2 =
−2b

a − bQ1
Q2 = ...(2)
2b

Putting (2) into (1) we get the values of Q1 and Q2 and these values are Cournot’s equilibrium
values

a − bQ 2 
a − b  
Q1 =  2b 
2b

a + bQ 2
Q1 = 2
2b

a + bQ 2 a + bQ1
Q1 = and Q 2 =
4b 4b

Cournot’s equilibrium price is defined as follows:

P= a − bQ
 a − b ( Q1 + Q 2 )
P=

 a + bQ 2 a + bQ1 
P=
a − b + 
 4b 4b 

 a + bQ 2 + a + bQ1 
P= a − b  
 4b 

 2a + b ( Q1 + Q 2 ) 
P= a −  
 4 

4a − 2a − b ( Q1 + Q 2 )
P=
4

2a − b ( Q1 + Q 2 )
P=
4

(b) Consider a market structure comprising two identical firms (A and B), each with the
cost function given by

(i) Find Cournot equilibrium.

1
Ans:- q i = 60 – q i ,q*= 40, Q= 80, P= 90π= (90 – 30)40= 2,400
BR

(ii) What will be the outcome if the firms decide to collude? Compare it with the results
under the Cournot equilibrium.

Ans:- Firms will mar joint profits when they jointly act as a monopoly and produce total Q
such that market MR = MC: 210–3Q=30, QM=60 and charger price P = 120. Since firms
have identical costs, cash will produce half of the monopoly output qm=30 and earn profits
=πi (120
= – 30) 30 2,700
No, if it is a one-shot game then firm has an incentive to defect on the agreement and produce
1
according to its=
BR;q1 60=
D
– 30 45 units of output, Q = 75, P==
97.5, π1 (97.5
= – 30)15 3,037.5
2
 SECTION B

Q3. What is meant by a Subgame Perfect Nash equilibrium? What will be the Subgame
Perfect Nash equilibria for the following game?

Ans:- Subgames are a part of a game that can be considered a game in its own right. Each
game is a subgame of itself, and other subgames are called proper subgames. We often
require an equilibrium to make sense not only in the whole game but in every subgame. This
is the notion of subgame perfect Nash Equilibrium, abbreviated as SPE for short. A joint
strategy is a subgame perfect Nash Equilibrium if it induces a Nash Equilibrium in every
subgame. Any SPE is also a Nash Equilibrium.
Subgame has an initial node, which may or may not have its predecessors. It includes all
successors, and includes all other nodes in the same information set as each node in the
subgame. In other words, a node x is said to define a subgame if whenever y is a node
following x and z is in the same information set containing y, then z must follow x. This can
be best explained by the below figures. Hence, we can answer the above question why SPE is
also a Nash Equilibrium.

x x
y z z y

(a) (b)
Fig. (a) x defines a subgame (b) z does not define a subgame.

The Subgame has only one Nash equilibrium as 5 dominates T In the unique Nash
equilibrium, Player 1 Plays S and Players 2 Plays S, yielding
Player 1

S T

Player 2 Player 2

S T S T

1, 3 0, 00, 0 (3, 1)
Figure Equilibrium in the subgame. The strategies are in thicker arroues payoff vector (1, 3)
in figure. Given this the game reducer to
Player 1

B G

(2, 2) (1, 3)

Player 1 choose B in this reduced game. Therefore, the subgame –perfect equilibrium is as in
figure.

Q4. (a) A CES production function approaches a Cobb-Douglas production function as

a special case. Comment.

Ans. CES stands for constant elasticity of substitution. A CES production is defined as follows:

−1
f ( L,K=
) A δK −ρ + 1( 1 − δ ) L−ρ  ρ

Or

A
f ( L,K ) = 1
δK −ρ + ( 1 − δ ) L−ρ  ρ

Or

A
f ( L,K ) =
ρ
δK −ρ + ( 1 − δ ) L−ρ 

Here, A, δ and ρ are constants such that 0 < δ < 1; ρ > −1and A > 0;
L = Labour and K = Capital

Economic meanings of A, δ and ρ

A is an efficiency factor.

The parameter δ is called distribution parameter. It means the relative share of an input in
total output.

The parameter ρ is called substitution parameter. It determines the value of elasticity of

substitution. CES is a homogeneous function having degree “1”. Therefore, CES is a linearly
homogeneous production function. Using partial differential techniques from Calculus
marginal production of labour, capital can be calculated easily. We get the following
marginal production functions:
 1+ρ
( 1 − δ )  f ( L,K ) 
MPL =
Aρ  L 


and

1+ρ
( δ )  f ( L,K ) 
MPK =
Aρ  K 


We notice from the above two equations that both marginal production functions are
f ( L,K )
dependent on Output-input ratio, i.e. .
L

Elasticity of Substitution in case of CES Production Function

1
σ=
1+ ρ

Relationship between CES Production Function and Cobb-Douglas Function

If ρ = 0, σ = 1 and in case of Cobb-Douglas function also elasticity of substitution is also 1,

hence, Cobb-Douglas function is a special case of CES production function.

(b) Given the production function Q = F(P, R), where Q denotes output produced using
factors P and R. Assume v and s to be price of factor P and R, respectively. Using the
given information, represent the expression for the Shephard’s Lemma.

Ans. There are two inputs, capital and labour, the total cost of the firm can be written as
TC = wP + rR where L and K represent labour and capital with prices w and r. Assuming that
the firm produces one output, its total revenue is given by price (p) of its product and quantity
of output (q), produced by the production function Q = F(R,P). Then profit (π) of the firm is
given by the difference between total revenue (TR) and total costs (TC) for an output level
Q0 .

Thus, π = TR – TC = pQ – wL – rR.

Cost-Minimising Factor Demand Functions

From the FOC we can get the cost-minimising factor. demand functions or conditional factor
demand functions. To derive these, let us consider from the three equations of FOC above R,
P and λ as three unknowns. Given any parameter values for r, w, and Q, we can, solve these
equations for the unknowns. It may be necessary to note that these functions are different
from the factor demand functions derived from the profit maximisation problem where output
was produced keeping total cost fixed.

Shephard's Lemma

There is an alternative method of deriving the input demand. from the cost minimisation
objective of a firm. The compensated demand functions can be computed directly from the
expenditure function for inputs by partial differentiation of the expenditure with respect to
input prices, which is known as the Shephard's Lemma.

Since output is held constant in the cost minimisation problem and the firm is a price taker, so
that r and w are given; from the constrained optimisation problem,

1 =wP + rR – λ Q0 – F ( R, P )  , we get from the method offered by envelope

theorem,

δ1 δw =P and

δ1 δr =R.

Again, the total cost function yields

P and δ
δ ( TC ) δw = ( TC ) δr =R . Therefore,

δ ( TC ) δw =δ1 δw =P and δ ( TC ) δr =δ1 δr =R .

The input demand functions are also constant output demand functions.

Q5. (a) What is meant by the Dual problem in context of the utility and expenditure
optimization exercise?
 Ans. Suppose we have a production function Q = f ( L,K ) of labour (L) and capital (K). Further, we
also assume a family of isocost lines defined as follows:

C wL + rK
=
where, C = Cost; w = price of labour, i.e. wage rate; r = price/rent of capital

Now, we have to find a combination (L, K) so that C is minimum but subject to

= ( L,K ) Q
Q f=

Hence, the Lagrangian function is given as follows:

Z= C + λ Q − f ( L,K ) 

Z wL + rK + λ Q − f ( L,K ) 
=

The first order conditions of minimisation are as follows:

∂Z
∂L
= w − λf' L,K = 0 ( ) ...(1)

∂Z
∂K
(
= r − λf' L,K = 0 ) ...(2)

∂Z
Q − f ( L,K ) =
= 0 ...(3)
∂λ

Solving (1), (2) simultaneously, we get

w f ' L,K
=
( )
r f ' L,K( ) ...(4)

But we now that

MPL = f ' L,K( )

and MPK = f ' ( L,K )

Therefore, the equation (4) becomes

w MPL
=
r MPK ...(5)
 Therefore, least cost combination of inputs, i.e. L and K is arrived where the ratio of input prices
is equal to the ratio of their marginal products. Geometrically, the ratio of input prices (w/r) is a
slope of an isocost line and the ratio of marginal products ( MPL / MPK = MRTS ) is the slope of
isoquant curve given, hence, for least/minimum cost we must have equality between the slope of
an isocost line and the slope of the isoquant curve given.

Second order condition of the minimisation is as follows:

We must have bordered Hessian determinant negative for minimisation. This is the second
order condition is as follows and the left hand side is the expansion of bordered Hessian
determinant

{ ( )
λ f' L,K 
2 ∂

∂L
f' L,K  − 2f' L,K f' L,K ∂ f' L,K  + f' L,K  ∂ f' L,K  < 0
 ( ) ( ) (
∂L   )

(
2
)
 ∂K  ( ) ( )}
(b) Derive the Hicksian Demand functions for good X and Y given the following utility
function:

Ans:- We can calculate Hicksian demand functions by minimising utility constraint, i.e.

Min=
E P1 X + P2 Y

Subject to U (X,=
Y) X + Y

L P1 X + P2 Y + λ {u – u (X, Y)} , λ > 0

Now,=

Or=
L P1 X + P2 Y + λ U – { ( X +2 Y )}
We have to minimise w.r.t. X1 , X 2 and λ, i.e.,

=
Min L Min [P1 X + P2 Y + λ U – { ( X +2 Y )} w.r.t. X , X and λ
1 2

First order condition of minimisation are:

∂L λ
=
P1 + =
0 ...(i)
∂X 2 X

∂L λ
=P2 + =0
∂Y Y ...(ii)

∂L
= U–
∂X
( X + 2 Y= 0 ) ...(iii)
 Solving (i) and (ii) Simultaneously we get,

P1 λ Y
= ×
P2 2 X λ

P1
Y =2 X
P2
2
P 
Y= 4 ×  1  ...(iv)
 P2 

2
P 
U= X + 2× 4× 1 
 P2 

P1
=
U X +4 X
P2

 4P 
= X 1 + 1 
 P2 
2
 P2 
X=  U ...(v)
 P2 + 4P1 
2 2
 P2   P1 
Y =4  U 
 P2 + 4P1   P2 
2
 P1 
= 4  U ...(vi)
 P2 + 4P1 

V and (vi) are equilibrium values of X and Y, Hence

X* = h1 (P1 , P2 , U)
2
 P2 
=  U
 P2 + 4P1 
2
 P1 
=Y h= *
2 (P1 , P2 , U) 4  U
 2
P + 4P1 

X* and Y* and Hickrain demand function

Q6. What is a von Neumann-Morgenstern expected utility function? An individual’s
von Neumann-Morgenstern (vNM) utility function is given by

where M denotes money. Assume this individual has Rs 4 with him. A lottery ticket that
will be worth Rs 12 with probability 1/2 and zero otherwise is available in the market.
What is the maximum price he would pay to obtain it?

Ans. John von Neumann a Hungarian-American mathematician, Oskar Morgenstern a

German economist developed a utility theory known as vNM expected utility theory.
Neumann and Morgenstern established some axioms of rationality of an agent facing two
lotteries X and Y. These axioms are as follows:

(1) Axiom of Completeness: An agent can always specify whether X  Y (read as X is

preferred to Y) or Y  X (read as Y is preferred to X) or X = Y (read as both are equally
preferred). This axiom can also be stated as X  Y (read as X is at least as good as Y) or
Y  X (read as Y is at least as good as X).

(2) Axiom of Transitivity: If X  Y and Y  Z , then according to this axiom X  Z. If X = Y

and Y = Z, then X = Z. This axiom can also be stated as X  Y and Y  Z, then X  Z.

(3) Axiom of Continuity: According to this axiom if X  Y  Z and the probability of X is

p and that of Z is 1-p such that p ∈0, 1, then pX + ( 1 – p ) Z ~ Y.

(4) Axiom of Independence: According to this axiom if X  Y and for a lottery Z and
p ∈0, 1, then pX + ( 1 – p ) Z  pX + ( 1 – p ) Z.

vNM theorem

If X is a lottery yielding prize Xi with probability Pi : i = 1, 2, 3…, k and another lottery Y yielding
prize Y i with probability Ri : j = 1, 2, 3…, t, then X  Y iff

k t

∑P U ( X ) > ∑R U ( Y )
i=1
i i
j=1
j j

where, U ( X i ) is known as vNM utility index and it denotes the utility received from the prize
X i and similarly U ( Yi ) denotes the utility received from the prize Y i .

k t

The expressions ∑Pi U ( X i )  and ∑R i U ( Yi ) in the above inequality are called expected
i=1 j=1

of vNM utility indices.

Thus, as per the theorem if the expected utility derived from a lottery X is greater than the
expected utility derived a lottery Y, then lottery X is preferred to Y.
The converse of the theorem is that any agent obeying the above axioms and maximising the
expectation of a function U, then U is called vNM utility function.

Expected utility with lottery ticket:

1 1
EU = µ (4 + 12) + µ(4)
2 2

1 1
= 16 + 4
2 2
4 2
= + =3
2 2

Utility of selling at price P is: µ (4 + P) = 4 + P. She will sell the ticket if this utility
is less Than The expected expected utility of keeping the ticket.

4+P ≤3 or (Squaring both side)

4+P≤9
P≤9–4
P≤5
Q7. Write short notes on the following:

(i) Significance of Value judgments in Welfare Economics.

Ans:- Prof. S.K. Nath in his book “A Reappraisal of Welfare Economics” has described some
value judgements embedded in Paretian welfare economics.

• The concern/focus should be on welfare of all individuals instead of

society/state/group/class.

• Non-economic factors affecting welfare should be ignored.

• An individual should be assumed to be the best judge of his/her economic welfare.

This value judgement is sometimes called “Complete consumer sovereignty”.

• Any change in the allocation of resources increases the income and leisure of
everyone or at least one person without disturbing the welfare of other, then such change
should be recognised as increase in social welfare.

(ii) A. C. Pigou’s contribution to Welfare Economics.

Ans:- Pigou’s two Welfare Conditions

Condition 1: Higher National Income means higher Welfare

Pigou says that welfare will increase if national income (or GDP) increases and welfare
achieves it maximum value when national output is maximised. Therefore, there is a positive
relationship between GDP and welfare. In this way, it can be said that welfare (W) is directly
proportional to national income/output (Q). Symbolically,

WαQ

Condition 2: Distribution of National Income/Output is Very Important to maximise

Welfare

Since Pigou assumes that the marginal utility of money for rich people is less than the
marginal utility of money for poor people, hence, transfer of income from rich people to poor
people will improve/increase welfare.

Pigou’s Diseconomies and Welfare

Pigou observed some diseconomies, which cause the welfare to decline. These diseconomies
are air and water pollution, unemployment due to technical change, occupational disease (like
Computer vision syndrome, Radiation sickness, etc.), child labour, industrial accidents (like
Bhopal Gas Tragedy in 1984, India).