MEC-001: MICRO ECONOMIC THEORY

(Assignment)
Course Code: MEC-001
Asst. Code: MEC-001/TMA/2017-18
Total Marks: 100

Section A

Answer all the questions from this section. 2×20=40

1. Discuss the basic difference in approach adopted by Pigou and Pareto to deal with
problems of welfare economics.

2. Consider an industry with three firms each having marginal costs equal to zero. The

inverse demand curve facing this industry is:

P ,  ,   60     .

(a) If each firm behaves as a cournot competitor, what is firm 1’s best response

function?

(b) Calculate cournot equilibrium of this problem.

(c) Firms 2 and 3 decide to merge and form a single firm (MC is still zero). Calculate

the new industry equilibrium and comment on combined profits from firms 2 and

3 considering pre and post merger profits.

Section B

Answer all the questions from this section. 5×12=60


 
3. Suppose Ashok’s utility function is   . His initial income when healthy is

36,000. However, there is a 50% chance that she will face financial loss on being taken ill

and the income is likely to reduce by 20,000.

3
 (a) Find the expected value of his income

(b) What expected utility he will have given the possible state of her health?

(c) What is the risk premium he will be willing to pay to cover the risk of sickness?

4. Consider the following game given in extensive form:

(i) Use backwards induction to compute equilibrium of the game.

(ii) Write this game in normal form.

(iii) How would you differentiate a static game from that of a dynamic game?

(iv) Suppose the following game is played for an infinite number of periods. If the

players are discounting the future at the rates of δ and δ respectively, find the

conditions under which they sustain the outcome (2, 2) in every period.

4
 Player B

Low High

Player A Low (1,1) (4,0)

High (0,4) (2,2)

5. Derive the indirect utility function form the given direct utility function   !

!. Use Roy’s identity to construct demand functions for the two goods ! and !. Are

these same as demand functions derived from the direct utility function?

6. Consider a world with two agents, A and B. there are two goods 1 and 2. The utility

functions of A and B are given as U X  X  and U X  X  . Their initial

endowments are W 1,2 and W 2,1

(a) Draw the Edgewroth Box for the agents considering their initial endowments and

commodity consumptions.

(b) Find the contract curve through your Edgework Box.

(c) Find the demand functions of A and B for prices P and P and incomes m of A

and m of B.

(d) Find the competitive equilibrium price P* and equilibrium allocation

*
(), ) *, ),
* *
) + of this economy.

7. Write short notes on the following:

(a) Hotelling’s lemma

(b) First welfare theorem
(c) Public goods
(d) VNM utility function

5
 ASSIGNMENT SOLUTION GUIDE
SESSION: (2017-2018)

MEC-001
MICRO ECONOMIC THEORY
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ANSWERS

Q1. Discuss the basic difference in approach adopted by Pigou and Pareto to deal with
problems of welfare economics

ANS.
Pigou's approach

According to him welfare resides in a man's state of mind or consciousness that is made up of his
utilities or satisfactions. So the basis of welfare is the extent to which an individual's desires are fulfilled.
Pigou treated matter by definition in his economic approach to economic welfare.

Pareto's approach

Pareto's principle is also known as the 80 / 20 rule. According to it 80% of the output from a given
situation or system is determined by 20% of the input. He subjected the redistribution of economic
goods to analytical treatment in his sociological approach to social welfare maximization.

pg. 1
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Q2. A) If each firm behaves as a cournot competitor, what is firm 1’s best response
function?

pg. 2
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Q2. B) Calculate cournot equilibrium of this problem.

pg. 3
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 pg. 4
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Q3.

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Q4. Consider the following game given in extensive form:

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Q4 (iii) How would you differentiate a static game from that of a dynamic game?

ANS.
In a static or simultaneous move game players move one time simultaneously. Any game with
sequential moves falls under the category of dynamic games.

A key difference is that in a static game no new information is revealed to any of the players during the
game before they make their play. The prisoner's dilemma is an example of a static game. The centipede
game is an example of a dynamic game.

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 pg. 8
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 pg. 10
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Q7. Write short notes on the following:

(a) Hotelling’s lemma

(b) First welfare theorem
(c) Public goods
(d) VNM utility function

ANS.
a) Hotelling's lemma is a result in microeconomics that relates the supply of a good to the profit of the
good's producer. It was first shown by Harold Hotelling, and is widely used in the theory of the firm.

b) The First Theorem states that a market will tend toward a competitive equilibrium that is weakly
Pareto optimal when the market maintains the following three attributes:

1. complete markets - No transaction costs and because of this each actor also has perfect
information, and
2. price-taking behavior - No monopolists and easy entry and exit from a market.

Furthermore, the First Theorem states that the equilibrium will be fully Pareto optimal with the
additional condition of:

3. local no satiation of preferences - For any original bundle of goods, there is another bundle of goods
arbitrarily close to the original bundle, but that is preferred.

c) A public good is a product that one individual can consume without reducing its availability to another
individual, and from which no one is excluded. Economists refer to public goods as "no rivalrous" and
"nonexcludable." National defense, sewer systems, public parks and other basic societal goods can all be
considered public goods.

d) the von Neumann-Morgenstern function shows that, under certain axioms of rational behavior, a
decision-maker faced with risky (probabilistic) outcomes of different choices will behave as if he is
maximizing the expected value of some function defined over the potential outcomes at some specified
point in the future. This function is known as the von Neumann-Morgenstern utility function.

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Q6. Consider a world with two agents, A and B. there are two goods 1 and 2. The utility
functions of A and B are given as 𝑼𝑨 = 𝑿𝑨𝟏 𝑿𝑨𝟐 and 𝑼𝑩 = 𝒀𝑩𝟏 𝒀𝑩𝟐 . Their initial
endowments are Wa(1,2) and Wb(2,1).

a) Draw the Edgewroth Box for the agents considering their initial endowments and
commodity consumptions.

Sol.

b) Find the contract curve through your Edgework Box.

Since both the curves are smooth and convex , MR𝑆𝐴 = 𝑀𝑅𝑆𝐵 in an efficient allocation. In addition, all
resources must be allocated. Then we have that in the contract curve

𝑌𝐴 𝑌𝐵
=
𝑋𝐴 𝑋𝐵

𝑋𝐴 + 𝑋𝐵 = 3

𝑌𝐴 + 𝑌𝐵 = 3

𝑤𝑒 𝑔𝑒𝑡 𝑟𝑖𝑑 𝑜𝑓 𝑋𝐵 𝑎𝑛𝑑 𝑌𝐵 𝑏𝑦 𝑢𝑠𝑖𝑛𝑔 𝑙𝑎𝑠𝑡 𝑡𝑤𝑜 𝑒𝑞𝑢𝑎𝑡𝑖𝑜𝑛𝑠 ∶ 𝑋𝐵 = 3 − 𝑋𝐴

𝑎𝑛𝑑 𝑌𝐵 = 3 − 𝑌𝐴 , 𝑠𝑢𝑏𝑠𝑡𝑖𝑡𝑢𝑡𝑖𝑛𝑔 𝑡ℎ𝑒𝑠𝑒 𝑡𝑤𝑜 𝑒𝑞𝑢𝑎𝑡𝑖𝑜𝑛𝑠 𝑖𝑛𝑡𝑜 𝑓𝑖𝑟𝑠𝑡 𝑒𝑞𝑢𝑎𝑡𝑖𝑜𝑛 𝑤𝑒 𝑔𝑒𝑡:

𝑌𝐴 3 − 𝑌𝐴
=
𝑋𝐴 3 − 𝑋𝐴

𝑋𝐴 (𝑌𝐴 + 1)
𝑌𝐴 =
2
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 c) Find the demand functions of A and B for prices 𝑷𝟏 and 𝑷𝟐 and incomes 𝒎𝑨 of A
and 𝒎𝑩 of B.
sol.
𝑼𝑨 = 𝑿𝑨𝟏 𝑿𝑨𝟐 ; 𝑼𝑩 = 𝑿𝑩𝟏 𝑿𝑩𝟐
𝑛𝑜𝑤 𝑡ℎ𝑒 𝑏𝑢𝑑𝑔𝑒𝑡 𝑐𝑜𝑛𝑠𝑡𝑟𝑎𝑖𝑛𝑡𝑠 𝑎𝑟𝑒 ∶

𝑚𝐴 = 𝑃1 𝑋𝐴1 + 𝑃2 𝑋𝐴2

𝑚𝐵 = 𝑃1 𝑋𝐵1 + 𝑃2 𝑋𝐵2

𝑛𝑜𝑤, 𝑓𝑜𝑟 𝐴𝑔𝑒𝑛𝑡 𝐴

𝑉 = 𝑃1 𝑃2 + 𝜆(𝑚𝐴 − 𝑃1 𝑋𝐴1 − 𝑃2 𝑋𝐴2 )

𝑑𝑉
= 𝑃2 − 𝜆𝑋𝐴1 = 0 − (1)
𝑑𝑃1

𝑑𝑉
= 𝑃1 − 𝜆𝑋𝐴2 = 0 − (2)
𝑑𝑃2

𝑑𝑉
= 𝑚𝐴 − 𝑃1 𝑋𝐴1 − 𝑃2 𝑋𝐴2 = 0 − (3)
𝑑𝜆

𝑃1 = 𝜆𝑋𝐴2 ; 𝑃2 = 𝜆𝑋𝐴1 − (4)

𝑓𝑟𝑜𝑚 (4) 𝑃1 𝑋𝐴1 = 𝑃2 𝑋𝐴2

𝑛𝑜𝑤 𝑓𝑟𝑜𝑚 (3)

𝑚𝐴 = 2𝑃1 𝑋𝐴1 ; 𝑚𝐴 = 2𝑃2 𝑋𝐴2

𝑚𝐴 𝑃 + 2 𝑃1
𝑤ℎ𝑖𝑐ℎ 𝑤𝑖𝑙𝑙 𝑔𝑖𝑣𝑒 𝑢𝑠 𝑋𝐴1 = = 𝑤ℎ𝑒𝑟𝑒 𝑃 = 𝑎𝑛𝑑
2𝑃1 2 𝑃2

𝑃+2
𝑠𝑖𝑚𝑖𝑙𝑎𝑟𝑙𝑦 𝑓𝑜𝑟 𝑋𝐴2 =
2

𝑛𝑜𝑤 , 𝑓𝑜𝑟 𝐴𝑔𝑒𝑛𝑡 𝐵

𝑉 = 𝑃1 𝑃2 + 𝜆(𝑚𝐵 − 𝑃1 𝑋𝐵1 − 𝑃2 𝑋𝐵2 )

𝑑𝑉
= 𝑃2 − 𝜆𝑋𝐵1 = 0 − (1)
𝑑𝑃1

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 𝑑𝑉
= 𝑃1 − 𝜆𝑋𝐵2 = 0 − (2)
𝑑𝑃2

𝑑𝑉
= 𝑚𝐴 − 𝑃1 𝑋𝐵1 − 𝑃2 𝑋𝐵2 = 0 − (3)
𝑑𝜆

𝑃1 = 𝜆𝑋𝐵2 ; 𝑃2 = 𝜆𝑋𝐵1 − (4)

𝑓𝑟𝑜𝑚 (4) 𝑃1 𝑋𝐵1 = 𝑃2 𝑋𝐵2

𝑛𝑜𝑤 𝑓𝑟𝑜𝑚 (3)

𝑚𝐴 = 2𝑃1 𝑋𝐵1 ; 𝑚𝐴 = 2𝑃2 𝑋𝐵2

𝑚𝐴 2𝑃 + 1 𝑃1
𝑤ℎ𝑖𝑐ℎ 𝑤𝑖𝑙𝑙 𝑔𝑖𝑣𝑒 𝑢𝑠 𝑋𝐵1 = = 𝑤ℎ𝑒𝑟𝑒 𝑃 = 𝑎𝑛𝑑
2𝑃1 2𝑃 𝑃2

2𝑃 + 1
𝑠𝑖𝑚𝑖𝑙𝑎𝑟𝑙𝑦 𝑓𝑜𝑟 𝑋𝐴2 =
2𝑃

d) Find the competitive equilibrium price P* and equilibrium allocation

( 𝑿∗𝑨𝟏 , 𝑿∗𝑨𝟐 , 𝑿∗𝑩𝟏 , 𝑿∗𝑩𝟐 ) of this economy.

Sol.
The equilibrium price must clear the market of both goods , From Walras law, it is enough to find the
price that clears one of the market.
𝑃+2 2P+1
Let’s choose market : X: 2 + 2P = 3 which 𝒈𝒊𝒗𝒆𝒔 us 𝑃2 − 2P + 1 = 0 ; P = 1

𝑃1
as P = 𝒇𝒓𝒐𝒎 above we the equillibrium price P ∗ must be when 𝑃1 = 𝑃2 or P ∗ = 1
𝑷𝟐

∗
1+2 3 ∗
1+2 3 ∗
2(1) + 1 3 ∗
3
For equillibrium allocation 𝑋𝐴1 = = ; 𝑋𝐴2 = = ; 𝑋𝐵1 = = ; 𝑋𝐵2 =
2 2 2 2 2(1) 2 2

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Q.1 Discuss the basic difference in approach adopted by Pigou and Pareto to
deal with problems of welfare economics.
ANS.
Pigou in his book Quotes: The Economics of Welfare (1932) coined the concept of social indicators
(economic) well-being. He introduced the quality of life indicators - environmental conditions,
recreation access to education, public order, health care and more. He believed that the optimum
well-being is possible only if state interventions in the process of resources usage and income
distribution and emphasized that economic prosperity is is not interchangeable with the general
welfare, as it doesn’t contain such elements as environment, the relationship between people,
housing, public order. Pigou devoted considerable attention to income redistribution from rich to
poor transfer income.

According to him welfare resides in a man's state of mind or consciousness that is made up of his
utilities or satisfactions. So, the basis of welfare is the extent to which an individual's desires are
fulfilled. Pigou treated matter by definition in his economic approach to economic welfare.
According to Pigou, welfare resides in a man’s state of mind or consciousness which is made up
of his satisfactions or utilities. The basis of welfare, therefore, is necessarily the extent to which
an individual’s desires are met.

Social welfare is regarded as the summation of all individual welfares in a society. Since general
welfare is a very wide, complicated and impracticable notion, Pigou delimits the range of his study
to economic welfare. As he himself observes, economic welfare is by no means an index of total
welfare because many other elements in the latter, like the quality of work, one’s environment,
human relationships, status, housing, and public security are absent from economic welfare.

Pareto in his Book Quotes; Manual of Political Economy (1906) not only rejected quantitative
utility. He believed that the only changes that can be evaluated are the ones that make all either
good or evil, or the ones that make the best at least for one person and don’t make worse for
anyone else. Pareto formulated the principle according to which the maximum prosperity is
achieved with optimal resource allocation, if any redistribution does not increase their usefulness
in society. Improvement according to Pareto is such distribution of resources when the welfare
of some people does not worsen the welfare of others. He was looking for sources of social
welfare in public finance, believing that through fiscal policies state is to enforce certain ethical
democratic ideals.

Pareto's principle is also known as the 80 / 20 rule. According to it 80% of the output from a given
situation or system is determined by 20% of the input. He subjected the redistribution of
economic goods to analytical treatment in his sociological approach to social welfare
maximization.

pg.15

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In view of the distinct and seminal contributions of Pareto and Pigou to the economics of welfare,
Pigou’s enduring influence in the field of public finance and Pareto’s hostility to developments in
that field of study, the lack of a comparative study of their contributions is unfortunate. This study
contrasts the place of ophelimity and utility and in these authors’ approaches to welfare studies.
Attention is also given to the place of individuals’ consciousness of consumption by others in the
treatment of economic welfare and total welfare. It is found that the substantive differences in
the welfare studies of these two scholars have less to do with Pigou’s direct and Pareto’s less
direct materialistic focus of welfare economics or the differing ordinal/cardinal dimensions to
their analysis, than with Pareto’s and Pigou’s diverse views: on the theoretical representation of
the economic phenomenon when individual behaviour is influenced by the consumption by
others; and on the character of science. These last two differences are important because they
have direct consequences for the scope of economic and social welfare theories and the choice
between.

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