LONDON SCHOOL OF ECONOMICS Department of Economics

Template Solutions to the Exam

EC487: Advanced Microeconomics
Lent Term 2018

1. Sketch of the answers:

(i) [13 marks] Notice first that (5, 4) = 13 (3, 6) + 23 (6, 3). Convexity of 
implies that u(5, 4) ≥ u(6, 3) = u(3, 6). Since (3, 6) and (6, 3) solve
UMP, u(5, 4) ≤ u(3, 6) = u(6, 3) and hence (5, 4) also solves UMP.
(ii) [20 marks] Take z ∈ RL+ . We know that ∃y ∈ RL+ , y 6= z such that
y  z, otherwise z is a bliss point. Choose  > 0. For any δ ∈ (0, 1),
(1 − δ)z + δy ∈ RL+ . For δ sufficiently small, (1 − δ)z + δy ∈ B (z).
By strict convexity, (1 − δ)z + δy  z. This establishes that for each
z ∈ RL+ and each  > 0, ∃w ∈ B (z) such that w  z, as desired.

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2. Sketch of the answers:

(i) [6 marks] Since a cost function is homogeneous of degree 1 in

(w1 , w2 ) then from
 
c(k w1 , k w2 , y) = k 2β β w1β w2β y 4 = k 2β c(w1 , w2 , y)

we conclude that
1
β=
2
and the cost function is:

1 √
c(w1 , w2 , y) = ( w1 w2 ) y 4
2

(ii) [4 marks] The supply function for commodity y of each individual

producer is obtained from:

1 √
max py − ( w1 w2 ) y 4
y 2

with first order conditions

√
p = 2 w1 w2 y 3

and it is:   31
p
y(p, w1 , w2 , ) = √
2 w1 w2

(iii) [4 marks] Therefore the aggregate supply function is:

  13
p
Y (p, w1 , w2 , ) = n √
2 w1 w2

(iv) [4 marks] The Marshallian demand for each individual consumer is

the solution to the following problem:

max u(y) s.t. p y ≤ 2 p

y

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 that is y(p, m) = 2 from the monotonicity of u(·).
(v) [3 marks] The aggregate demand in this market is then

Y (p, m) = 2 n.

(vi) [6 marks] Equating aggregate demand and aggregate supply in this

market we obtain that the equilibrium quantity is:

Y ∗ = 2n

while the equilibrium price is:

√
p∗ = 16 w1 w2 .

Clearly the perfectly inelastic demand (due to a one consumption

good economy) implies that the equilibrium quantity is completely
demand determined.
(vii) [3 marks] The equilibrium supply of commodity y ∗ of each individual
producer is then
y ∗ = y(p∗ , w1 , w2 ) = 2.

(viii) [3 marks] Each individual producer makes positive profits. These

are:

1 √ √
π(p∗ , w1 , w2 ) = p∗ y ∗ − ( w1 w2 ) (y ∗ )4 = 24 ( w1 w2 ) > 0.
2

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3. When α = 1 and β = 1 the economy can be described in the Edgeworth
box represented below.

B
 E
s =ω
@
@ @ e
@@ @ U Be
@
@ @ e
@
@ @ e
@@ @ e
@
@ @ e
@ @
@ @ e
@ @
@ @
@ @@ @
x2 @ @.
@ @
@ @
@ @
@ @
@ @
@ @ @@
@ @
@ @
@
@ @ @
@
@ @ @
@
@ @ @@
@ @ @@
@ UA o1
@sF
@ @
@
@ @ @ -

A x1 o2

(i) [4 marks] The offer curve of consumer A, denoted o1 , is the solution to

A’s utility maximization problem:

max xA A
1 + x2
xA A
1 ,x2 (1)
s.t. xA A
1 + p x2 ≤ p x̄

for every value of p where we normalize the price of x1 to 1. This offer

curve is plotted in the Edgeworth box above.
The offer curve of consumer B, denoted o2 , is instead the solution to B’s

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 utility maximization problem:

max xB B
1 + x2
xB B
1 ,x2 (2)
s.t. xB
1 + p xB
2 ≤ x̄

and it is also represented in the same Edgeworth box above.

(ii) [8 marks] The Walrasian equilibrium allocations are all the allocations
in the interval EF . The equilibrium relative price is p∗ = 1.

(iii) [5 marks] The set of Pareto-efficient allocations is the set of all allo-
cations (points) in the Edgeworth box. The Walrasian equilibrium alloca-
tions EF are therefore Pareto efficient.

When α = β = 2 the economy can be described in the Edgeworth box

represented below.

B
 s ω s
AHHH o2 A b
b UB
b
A HH A b
o1A
A H HH A
A b
b
b
A H HH A b
b
A AH b
A A HH
HH A A HH
HHA A HH
x2 HAH . A HH
A A HH A H
A A HH A
A A HH A
A A HHA
A A H
AH
A A A HH
A A A HH
A A A
A UA 0
sE
A A
s A A A -

A x1
?

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(iv) [4 marks] The offer curves of consumers A and B are o1 and o2 , re-
spectively, as represented in the Edgeworth box above.

(v) [8 marks] The Walrasian equilibrium allocation is denoted by E 0 . The

equilibrium relative price is p∗ = 1.

(vi) [4 marks] The Pareto efficient allocations are all the allocations (points)
in the two segments AE 0 and BE 0 . Clearly the Walrasian equilibrium al-
location is Pareto efficient.

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4. Sketch of the answers:

(i) [4 marks] Let q=1, the game is then a two period alternating offers
bargaining game. We proceed by backward induction. Consider the
second period, player B who gets to make the offer is making a take-
it-or-leave-it offer in which he demands the entire pie for himself:
x2 = 0 (where x2 is player A’s share of the pie in the second period).
The offer is accepted.
Consider now the subgame starting in the t = 1, it is player B that
has to decide whether to accept or reject the offer. Notice that if
player B rejects the offer his expected discounted payoff is δ. This
implies that it is subgame perfect for player B to accept any offer x1
such that 1 − x1 ≥ δ and reject all offers such that x1 > 1 − δ. Moving
now to the beginning of period 1 it is a subgame perfect equilibrium
strategy for player A to offer x1 = 1 − δ.
In other words, the unique subgame perfect equilibrium of the game
is such that agreement is reached in period 1 and the subgame
perfect equilibrium strategies are:
• A offers share x1 = 1 − δ in period 1;
• B accepts any share x ≤ 1 − δ in period 1;
• B rejects any share x > 1 − δ in period 1;
• B offers share x2 = 0 in period 2;
• A accepts any share x ≥ 0 in period 2.
(ii) [4 marks] The expected subgame perfect equilibrium payoffs are

(π A = 1 − δ, π B = δ) .

1
If δ = 2
we get that the expected subgame perfect equilibrium payoff
to both player A and B is π A = π B = 12 .
(iii) [8 marks] Let 0 < q < 1 and consider the game in period 2. Clearly
the player who gets to make the offer is making a take-it-or-leave-it
offer in which he demands the entire pie for himself: x2 = 1 if player

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A makes the offer and x2 = 0 if player B makes the offer. The offer
is accepted.
Consider now the end of period 1. Assume that the outcome of the
randomization device in period 1 is β then it is player A that has
to decide whether to accept or reject the offer. Notice that if player
A decides to reject the offer his expected payoff is δ (1 − q). This
implies that it is subgame perfect for player A to accept any offer
x1 ≥ δ (1 − q) and reject all offers such that x1 < δ (1 − q).
Now if, in this case, player B makes an offer x1 < δ (1 − q) player
A will reject it and player B’s payoff will be: δ q. If instead player B
offers δ (1 − q) to A she will accept it and player B’s payoff will be
1 − δ (1 − q). Notice that 1 − δ (1 − q) > δ q since 1 > δ. Hence,
if the outcome of period 1’s randomization device is β player B’s
equilibrium offer is x1 = δ (1−q) and his payoff is 1−x1 = 1−δ (1−q).
Assume now that the outcome of the randomization device in the
first period is α then it is player B that has to decide whether to
accept or reject the offer. Notice that if player B decides to reject
the offer his expected payoff is δ q. This implies that it is subgame
perfect for player B to accept any offer such that 1 − x1 ≥ δ q and
reject all offers such that 1 − x1 < δ q.
Now if, in this case, player A makes an offer such that 1 − x1 < δ q
player B will reject it and player A’s payoff will be: δ (1 − q). If instead
player A makes an offer such that 1 − x1 = δ q to B, he will accept it
and player A’s payoff will be 1−δ q. Notice that 1−δ q > δ (1−q) since
1 > δ. Hence, if the outcome of period 1’s randomization device is
α player A’s equilibrium offer is such that 1 − x1 = δ q and her payoff
is x1 = 1 − δ q.
In other words the unique subgmae perfect equilibrium is such that
agreement is reached in period 1 and the subgame perfect equilib-
rium strategies are:
• In period 1 if the outcome is α
– A offers share x1 = 1 − δ q;

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 – B accepts any share x ≤ 1 − δ q;
– B rejects any share x > 1 − δ q.
• In period 1 if the outcome is β
– B offers share x1 = δ (1 − q);
– A accepts any share x ≥ δ (1 − q):
– A rejects any share x < δ (1 − q).
• In period 2 if the outcome is α
– B offers share x2 = 0;
– A accepts any share x ≥ 0.
• In period 2 if the outcome is β
– A offers share x2 = 1;
– B accepts any share x ≤ 1.
(iv) [8 marks] The expected Subgame Perfect equilibrium payoff to player
A is:

π A = q (1 − δ q) + (1 − q) δ (1 − q) = q(1 − δ) + (1 − q)δ

while the expected Subgame Perfect equilibrium payoff to player B

is:

π B = (1 − q) (1 − δ (1 − q)) + q δ q = (1 − q)(1 − δ) + q δ.

1
If δ = 2
we get that the expected subgame perfect equilibrium payoff
to both player A and B is π A = π B = 12 .
(v) [9 marks] Let now δ = 1. In the case q = 1 the unique subgame
perfect equilibrium outcome is such that player B appropriates all
the surplus, π B = 1, while player A receives a zero share of the
surplus, π A = 0. Notice however that in this case there is a whole
multiplicity of subgame perfect equilibria. In particular there exists
an equilibrium where player A offer x1 = 0 in period 1 to B and
B accepts. There exists however a continuum of subgame perfect
equilibria where player A offers x1 > 0 in period 1 to B, B rejects the

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offer and in period 2 player B offers x2 = 0 and player A accepts.
In the case 0 < q < 1 the unique subgame perfect equilibrium ex-
pected payoffs are π A = (1 − q) for player A and π B = q for player B
however once again these payoffs can be associated with a whole
set of subgame perfect equilibria: one equilibrium where agreement
is reached in period 1 (similar in structure to the subgame perfect
equilibrium described in (iii) above) and a continuum of subgame
perfect equilibria where agreement is reached in period 2.

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