IE54500 – Problem Set 3

Dr. David Johnson

Fall 2020
1. Three Examples of Monopoly
a) In 2003, a law went into effect allowing cell phone customers to keep their existing phone number if
they switched a different cell phone service. Prior to that time, changing providers meant being assigned
a new number. Explain how this law increased competition in the market for cell phone service.

Prior to the law being in place, an individual’s cell phone company had a monopoly on that individual’s
phone number. This increased the cost of switching to a new carrier, in terms of the costs of time, effort,
and money spent updating one’s phone number with contacts, purchasing new business cards, etc. With
the new law, multiple companies could compete by offering not only cell phone service, but they could
also offer the same phone number as a product.

b) Suppose you are at an airport and notice that candy bars are sold at a price somewhat comparable to
what you would find at a local store, but that renting a luggage cart seems ridiculously expensive. What
would explain this?

Candy bars can be brought into the airport from outside, where they can be purchased at many different
locations; marking up the price too much would provide greater incentive for travelers to plan ahead and
bring their own. However, people do not own their own luggage carts or bring them outside, because
they cannot be left at the airport behind security while the owner travels. This gives the airport operator
a natural monopoly on luggage carts, resulting in a higher-than-competitive price. Note that modern
airport security restrictions also result in beverages being sold at a higher markup than candy bars.

c) Longshoremen at the Port of Los Angeles belong to a strong union that negotiates labor contracts on
their behalf.
a. In what sense does this union act as a monopoly? If port workers all belong to the same union,
then the union effectively holds a monopoly on labor supply, giving them market power to
influence the wages and benefits associated with labor contracts.
b. Explain why negotiations between the union and the Port of Los Angeles are likely to result in
wages for longshoremen that exceed the competitive wage and employment that falls short of
the competitive level of employment. Even if not all workers belong to the union, the union has
market power to supply a large portion of the labor for various port jobs. Particularly if the jobs
are skilled labor, the port authority is likely unable to find sufficient labor outside of the union
without substantial disruption to operations. The union is thus able to extract higher-than-
competitive wages, which ultimately leads to the port authority hiring less labor due to the
greater expense.
c. Explain why, in recent negotiations, the union objected strenuously to the increased use of
automated loading and unloading machinery at the Port. When wages are above a competitive
level, the port authority wishes to substitute away from labor towards capital in order to
minimize costs. Automation reduces the average cost of capital, which would lead to reduced
investments in labor from a firm that wants to equate marginal costs of labor and capital in
equilibrium.
2. Risk Aversion
Suppose utility is governed by the following function, 𝑈(𝑥) = 100 − (𝑥 − 10)2 and that 0 ≤ 𝑥 ≤ 10.

a) Graph this utility function.

b) Suppose the individual must choose between two options. The first option is to receive 7 units of 𝑥 with
certainty. The second option is to receive 3 units with probability 1/3 or 9 units with probability 2/3.
a. Label the utility of the first option on your graph.
b. Demonstrate mathematically that the expected utility of option 2 lies on the chord between
𝑢(𝑥 = 3) and 𝑢(𝑥 = 9).
99−51
The slope of the chord is = 8. Therefore, the chord is the line 𝑦 = 8𝑥 + 𝑐 for some
9−3
constant 𝑐. We know it goes through (3,51), so 51 = 8 ∙ 3 + 𝑐 ⇒ 𝑐 = 27.

1 2
We know the expected utility is 𝔼[𝑢(𝑋)] = 3 ∙ 51 + 3 ∙ 99 = 83, and 𝔼[𝑋] = 7, so we can verify
the expected utility is on the chord by noting that 83 = 8 ∙ 7 + 27.
c. Compute the utility of Option 1 and the expected utility of Option 2, and compare.
See previous part. 𝔼[𝑢(𝑋)] = 83 < 91 = 𝑢(𝔼[𝑥]).
d. Note that the first option, receiving 7 units, is the same as the expected value of the number of
units received from Option 2. How many of those 7 units would this individual be willing to give
up in order to avoid being given Option 2 in favor of receiving a fixed amount with certainty?
(Assume that 𝑥 can be split into fractional numbers of units.)
The individual would be willing to give up however many units of x would result in them still
having the same level of utility as the expected utility from the gamble, 𝔼[𝑢(𝑋)] = 83.
100 − (𝑥 − 10)2 = 83 ⇒ 𝑥 = 5.877 ∴ 7 − 5.877 = 1.123

3. Absolute and Relative Risk Aversion

a) Let 𝑢 and 𝑣 be two utility functions, with 𝑣(𝑊) = 𝑓(𝑢(𝑊)) where 𝑓 is a concave function. Prove that
the coefficient of absolute risk aversion is greater for 𝑣 than for 𝑢. Why does this result make sense?
The coefficient of absolute risk aversion is −𝑣 ′′ /𝑣′ and −𝑢′′ /𝑢′ for functions 𝑣 and 𝑢, respectively. We
are told that 𝑓 is concave, so for 𝑣 to be a rational utility function, 𝑓 ′ > 0 and 𝑓 ′′ < 0.

Therefore, 𝑣 ′ = 𝑓 ′ (𝑢(𝑤)) ∙ 𝑢′ (𝑤) and 𝑣 ′′ = 𝑓 ′′ (𝑢(𝑤)) ∙ 𝑢′ (𝑤)2 + 𝑓 ′ (𝑢(𝑤)) ∙ 𝑢′′(𝑤), so we find that
 𝑣 ′′ 𝑓 ′′ 𝑢′2 + 𝑓 ′ 𝑢′′ 𝑢′′ 𝑓 ′′ 𝑢′2
− = − = − −
𝑣′ 𝑓 ′ 𝑢′ 𝑢′ 𝑓′𝑢′

𝑊𝑒 𝑘𝑛𝑜𝑤 𝑡ℎ𝑎𝑡 𝑓 ′′ < 0, 𝑢′2 > 0, 𝑓 ′ > 0, and 𝑢′ > 0, so

𝑣 ′′ 𝑢′′ 𝑓 ′′ 𝑢′2 𝑢′′

− = − − > −
𝑣′ 𝑢′ 𝑓 ′ 𝑢′ 𝑢′
𝑊 1−𝑎
b) Verify that the function 𝑢(𝑊) = has a constant coefficient of relative risk aversion equal to 𝑎.
1−𝑎

(1 − 𝛼)𝑊 −𝛼
𝑢′ = = 𝑊 −𝛼
1−𝛼

𝑢′′ = −𝛼𝑊 −𝛼−1

Therefore, the coefficient of relative risk aversion is

𝑢′′ 𝛼𝑊 −𝛼−1
− 𝑊 = 𝑊=𝛼
𝑢′ 𝑊 −𝛼

c) Verify that the function 𝑢(𝑊) = ln 𝑊 has a constant coefficient of relative risk aversion equal to 1.

𝑢′ = 1/𝑊 and 𝑢′′ = −1/𝑊 2 , so the coefficient of relative risk aversion is

𝑢′′ −1/𝑊 2
− 𝑊 = − 𝑊=1
𝑢′ 1/𝑊

4. Investing in a Risky Asset

An individual seeks to maximize the expected utility, 𝔼[𝑢(𝑠 + 𝑎)], of investing their exogenous wealth, 𝑊, in a
safe asset, 𝑠, and a risky asset, 𝑎. (They invest all of their wealth, such that 𝑠 + 𝑎 = 𝑊.) The safe asset earns a
rate of return equal to zero. The risky asset earns a rate of return of 𝑟̅ > 0 with probability 𝑝 and a rate of return
𝑟 < 0 with probability 1 − 𝑝.

a) Write down this individual’s expected utility function.

𝔼[𝑢(𝑠 + 𝑎)] = 𝑝𝑢(𝑠 + 𝑎(1 + 𝑟)) + (1 − 𝑝)𝑢 (𝑠 + 𝑎(1 + 𝑟)) = 𝑝𝑢(𝑊 + 𝑎𝑟) + (1 − 𝑝)𝑢(𝑊 + 𝑎𝑟)
b) Derive the individual’s optimal choice of the risky asset 𝑎.

The expected utility function above has been reduced to a single decision variable 𝑎, so the first-order
condition characterizing a solution is

𝑝𝑟 ∙ 𝑢′ (𝑊 + 𝑎𝑟) + (1 − 𝑝)𝑟 ∙ 𝑢′ (𝑊 + 𝑎𝑟) = 0

c) Use the implicit function theorem to show that the individual will invest more in the risky asset 𝑎 as 𝑝
increases. Hint: for a given implicitly defined function 𝐹(𝑥, 𝑦; 𝛼) = 0, the implicit function theorem
states that
 𝜕𝐹
𝜕𝑥
= − 𝜕𝛼
𝜕𝛼 𝜕𝐹
𝜕𝑥
If we consider the FOC to be a function implicitly equal to zero, then

𝜕𝐹⁄
𝜕𝑎 𝜕𝑝
=−
𝜕𝑝 𝜕𝐹⁄
𝜕𝑎
We can find that
𝜕𝐹
= 𝑟𝑢′ (𝑊 + 𝑎𝑟) − 𝑟𝑢′ (𝑊 + 𝑎𝑟)
𝜕𝑝
and
𝜕𝐹 2
= 𝑝𝑟 𝑢′′ (𝑊 + 𝑎𝑟) + (1 − 𝑝)𝑟 2 𝑢′′ (𝑊 + 𝑎𝑟)
𝜕𝑎
so
𝜕𝐹⁄
𝜕𝑎 𝜕𝑝 𝑟𝑢′ (𝑊 + 𝑎𝑟) − 𝑟𝑢′ (𝑊 + 𝑎𝑟)
=− =− 2
𝜕𝑝 𝜕𝐹⁄ 𝑝𝑟 𝑢′′ (𝑊 + 𝑎𝑟) + (1 − 𝑝)𝑟 2 𝑢′′ (𝑊 + 𝑎𝑟)
𝜕𝑎

𝐵𝑒𝑐𝑎𝑢𝑠𝑒 𝑟 < 0, we know that the numerator is greater than 0. Further, 𝑢′′ < 0, so the denominator
𝜕𝑎
must be less than 0. Combining these facts with the minus sign in front, we get that 𝜕𝑝 > 0.
d) Use the implicit function theorem to show that the individual will invest more in the risky asset 𝑎 as 𝑟
increases, but that the effect of increasing 𝑟 on the choice of 𝑎 is ambiguous.

Taking a similar approach as above, we find that

𝜕𝐹
= 𝑝𝑢′ (𝑊 + 𝑎𝑟) + 𝑝𝑟𝑎𝑢′′ (𝑊 + 𝑎𝑟)
𝜕𝑟
and
𝜕𝐹
= (1 − 𝑝)𝑢′ (𝑊 + 𝑎𝑟) + (1 − 𝑝)𝑟𝑎𝑢′′ (𝑊 + 𝑎𝑟)
𝜕𝑟

𝜕𝐹
In the second expression,we know 𝑟 < 0 and 𝑢′′ < 0, so 𝜕𝑟 is unambiguously greater than 0, so
𝜕𝐹⁄
𝜕𝑎 𝜕𝑟
=−
𝜕𝑟 𝜕𝐹⁄
𝜕𝑎

𝐻𝑜𝑤𝑒𝑣𝑒𝑟, 𝑖𝑛 𝑡ℎ𝑒 𝑝𝑎𝑟𝑡𝑖𝑎𝑙 𝑤𝑖𝑡ℎ 𝑟𝑒𝑠𝑝𝑒𝑐𝑡 𝑡𝑜 𝑟, the first term is positive but the second is negative. Lacking
more information, we cannot determine whether the sum is greater than, equal to, or less than zero. This
means that the effect of increasing 𝑟 on the choice of 𝑎 is ambiguous.

5. Personal Discount Rate

𝑢(𝑐2 )
A consumer maximizes an additively separable utility function, 𝑉(𝑐1 , 𝑐2 ) = 𝑢(𝑐1 ) + 1+𝜌
, given wealth in period
one, 𝑊1 , and an interest rate, 𝑟, where 𝑐1 is consumption in period 1 and 𝑐2 is consumption in period 2.
 a) Demonstrate that the slope of this consumer’s indifference curve at the point where consumption is
equalized across periods equals the consumer’s personal discount rate, (1 + 𝜌). What is the intuition
behind this result?
Totally differentiate 𝑉 with respect to 𝑐1 and 𝑐2 and set to 0 to remain on the indifference curve:

1
𝑑𝑉 = 0 = 𝑢′ (𝑐1 )𝑑𝑐1 + 𝑢′ (𝑐2 )𝑑𝑐2
1+𝜌

𝐴𝑡 𝑡ℎ𝑒 𝑝𝑜𝑖𝑛𝑡 𝑤ℎ𝑒𝑟𝑒 𝑐𝑜𝑛𝑠𝑢𝑚𝑝𝑡𝑖𝑜𝑛 𝑖𝑠 𝑒𝑞𝑢𝑎𝑙𝑖𝑧𝑒𝑑 𝑎𝑐𝑟𝑜𝑠𝑠 𝑝𝑒𝑟𝑖𝑜𝑑𝑠, 𝑐1 = 𝑐2 and 𝑢′ (𝑐1 ) = 𝑢′ (𝑐2 ), so

𝑑𝑐2
= −(1 + 𝜌)
𝑑𝑐1

𝑇ℎ𝑖𝑠 𝑚𝑎𝑘𝑒𝑠 𝑠𝑒𝑛𝑠𝑒 𝑏𝑒𝑐𝑎𝑢𝑠𝑒 𝑤𝑒 𝑘𝑛𝑜𝑤 𝑡ℎ𝑎𝑡 𝑖𝑓 𝑐1 = 𝑐2 , 𝑢′ (𝑐1 ) = 𝑢′ (𝑐2 ), so that an additional unit of
consumption in time 1 would produce (1 + 𝜌) times the marginal utility than consuming it in time 2. In
other words, this is similar to the definition of the discount rate, that all else equal (i.e., starting with
equal consumption in both time periods), consumption in a future time period is worth 1/(1 + 𝜌)
relative to consumption now, once that consumption is converted to the utility it provides us. That means
we should be willing to trade 1 unit now for (1 + 𝜌) units in the next time period.

b) Now suppose that the consumer maximizes a Cobb-Douglas utility function, 𝑉(𝑐1 , 𝑐2 ) = 𝑐1𝑎 𝑐2𝑏 .
Demonstrate that this consumer’s implicit discount rate equals 𝑎/𝑏. What is the intuition behind this
result?
Following the same logic as above, the discount rate should equal the ratio of the marginal utility
between 𝑐1 and 𝑐2 at the point where 𝑐1 = 𝑐2 = 𝐶. Therefore, differentiate to get

𝜕𝑉
= 𝑎𝑐1𝑎−1 𝑐2𝑏
𝜕𝑐1
𝜕𝑉
= 𝑏𝑐1𝑎 𝑐2𝑏−1
𝜕𝑐2
Where 𝑐1 = 𝑐2 = 𝐶, we find that
𝜕𝑉 𝑎 𝜕𝑉
= 𝑎𝑐 𝑎+𝑏−1 =
𝜕𝑐1 𝑏 𝜕𝑐2
Therefore, a marginal unit of consumption in the first time period is worth 𝑎/𝑏 in the second.

The key takeaway here is that additive separability, as in part a), provides a convenient means of
parameterizing the personal discount rate, but that all utility functions defined over consumption in
multiple periods implicitly define a personal discount rate.

6. Illegal Parking
Consider a driver who is considering whether to park illegally. By parking illegally, drivers save time and effort
worth 𝐸. But, by doing so, they expose themselves to the possibility of receiving a parking ticket with a fine 𝐹,
such that 𝐹 > 𝐸. The probability of being fined is 𝑝. Assume the driver has exogenous wealth equal to 𝑊.

a) What is the driver’s expected utility associated with parking illegally?

𝔼[𝑈] = 𝑝𝑈(𝑊 + 𝐸 − 𝐹) + (1 − 𝑝)𝑈(𝑊 + 𝐸)

b) Suppose 𝑝, 𝐸, and 𝐹 are such that 𝑝(𝑊 + 𝐸 − 𝐹) + (1 − 𝑝)(𝑊 + 𝐸) = 𝑊. Demonstrate graphically
that a risk-averse individual would prefer not to park illegally in this case.
This can be shown using the same graphical argument that we have discussed multiple times regarding
risk aversion (including one of the previous problems). The chord between 𝑈(𝑊 + 𝐸 − 𝐹) and
𝑈(𝑊 + 𝐸) represents 𝔼[𝑈] for varying levels of 𝑝. It lies below the utility function itself, so because we
start out with an endowment of W, if this is the expected value of the outcome with respect to illegal
parking, we know that 𝔼[𝑈] < 𝑈(𝑊).

c) Demonstrate that raising the probability of receiving a fine lowers the expected utility of illegal parking.
𝜕𝔼[𝑈]
= 𝑈(𝑊 + 𝐸 − 𝐹) − 𝑈(𝑊 + 𝐸) < 0
𝜕𝑝
This is true because 𝐹 > 0 and 𝑈 ′ > 0.

d) Demonstrate that raising the fine lowers the expected utility of illegal parking.

𝜕𝔼[𝑈]
= −𝑝𝑈 ′ (𝑊 + 𝐸 − 𝐹) < 0
𝜕𝐹

e) Show that a proportionate increase in the fine for illegal parking will have a greater deterrent effect on
illegal parking than an equivalent proportionate increase in the probability of receiving a fine. [Hint: use
the Taylor series approximation 𝑈(𝑊 + 𝐸 − 𝐹) ≈ 𝑈(𝑊 + 𝐸) − 𝐹 ∙ 𝑈 ′ (𝑊 + 𝐸).]
To show this, we must first convert these derivatives into elasticities:

𝜕𝔼[𝑈] 𝑝 𝑝(𝑈(𝑊 + 𝐸 − 𝐹) − 𝑈(𝑊 + 𝐸))

∙ =
𝜕𝑝 𝔼[𝑈] 𝔼[𝑈]
𝜕𝔼[𝑈] 𝐹 𝑝𝐹𝑈 ′ (𝑊 + 𝐸 − 𝐹)
∙ =−
𝜕𝐹 𝔼[𝑈] 𝔼[𝑈]

𝜕𝔼[𝑈] 𝐹 𝜕𝔼[𝑈] 𝑝
𝐼𝑓 𝜕𝐹
∙ 𝔼[𝑈] < 𝜕𝑝
∙ 𝔼[𝑈] < 0 , then

−𝐹𝑈 ′ (𝑊 + 𝐸 − 𝐹) < 𝑈(𝑊 + 𝐸 − 𝐹) − 𝑈(𝑊 + 𝐸)

The Taylor series approximation of 𝑈(𝑊 + 𝐸 − 𝐹) is 𝑈(𝑊 + 𝐸) − 𝐹𝑈 ′ (𝑊 + 𝐸), which means that

𝑈 ′ (𝑊 + 𝐸) − 𝑈 ′ (𝑊 + 𝐸 − 𝐹) < 0

𝑏𝑒𝑐𝑎𝑢𝑠𝑒 𝑈 ′′ < 0. Thus, the inequality for the elasticities holds. So increasing the fine for illegal parking
lowers the likelihood an individual will park illegally by more than increasing the probability of receiving
the fine. In other words, raising the fine is a more effective deterrent than raising the probability of
detection.