ECON3010-E1

The University of Nottingham

SCHOOL OF ECONOMICS

LEVEL 3 MODULE, AUTUMN SEMESTER 2019-2020

ECON3010 ADVANCED MICROECONOMICS

Time allowed TWO Hours

Candidates may complete the front cover of their answer book and sign their desk card but
must NOT write anything else until the start of the examination period is announced

Answer ALL questions from Section A and TWO questions from Section B
Sections A and B are given the same weight

Where individual questions have separately itemised parts (e.g. (a), (b), etc.) each part is
given the same weight unless otherwise stated.

Only a calculator from APPROVED LIST A may be used in this examination.

Dictionaries are not allowed with one exception. Those whose first language is not English
may use a standard translation dictionary to translate between that language and English
provided that neither language is the subject of this examination. Subject specific translation
dictionaries are not permitted.

No electronic devices capable of storing and retrieving text, including electronic dictionaries,
may be used.

DO NOT turn examination paper over until instructed to do so

ADDITIONAL MATERIAL:

INFORMATION FOR INVIGILATORS:

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SECTION A
Answer ALL of the following

1. Suppose that the inflation rate (measured in percentages) can take two equiprobable
values: t = 1 and 2. After privately observing the inflation rate, the CBI sends a cheap
talk message to the Bank of England, which then chooses the (nominal) interest rate,
denoted a. If the Bank of England sets an interest rate of a when the true inflation rate
is t then the CBI earns a payoff of −(t − a)2 and the Bank of England earns a payoff of
−(t + x − a)2: where x is some non-negative number.
a) Explain why this game has a separating equilibrium if and only if x ≤ 1/2.
[50%]

b) Now consider a variant on the game in which the CBI’s signal is a verifiable
message, rather than cheap talk. Explain why this game does not have a pooling
equilibrium. [50%]

2. Three friends, Anna, Beto, and Charlie, walk into a casino, each with £1,000 in her/his
pocket. Their preferences over their wealth are given by the following utility function:
1−𝛾
𝑤𝑖 𝑖
𝑢𝑖 (𝑤𝑖 ) =
1 − 𝛾𝑖
The three individuals use expected utility to evaluate uncertain wealth. Here, 𝑤𝑖 , denotes
the wealth of individual 𝑖, with 𝑖 ∈ {A,B,C}, and 𝛾𝑖 ≠ 1 is an individual-specific parameter,
with the following risk attitude for each individual:
1
Anna: 𝛾𝐴 = −1 Beto: 𝛾𝐵 = 0 Charlie: 𝛾𝐶 =
2

The three friends are invited to bid as much of their wealth as they like on the toss of a
𝑗
fair coin, which can come up either heads (h) or tails (t). Let 𝑏𝑖 denote 𝑖’s bet on side 𝑗,
𝑗
with 𝑗 ∈ {ℎ, 𝑡}. If the bet is successful (i.e. the coin lands on 𝑗), 𝑖 receives 1.8 × 𝑏𝑖 back
(i.e. her/his bet plus 0.8 times her/his bet as profit). If the bet is unsuccessful (i.e. the
𝑗
coin does not land on 𝑗), 𝑖 earns nothing (i.e. (s)he loses 𝑏𝑖 ).

(a) Derive each individual’s coefficient of absolute and relative risk-aversion.

Comment on their risk-preferences. [40%]

(b) Given your answer in (a) determine the optimal bet for (i) Anna, (ii) Beto,
and (iii) Charlie. [40%]

(c) Consider an alternative scenario where only Charlie now faces a different
gamble where (s)he would get £16 with probability equal to ½ and £4 with
probability equal to ½. Calculate the following:

(i) Certainty Equivalent [10%]

(ii) Risk Premium [5%]

(iii) Probability premium (Hint: Use 𝑥 = 10 and 𝜀 = 6) [5%]

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SECTION B
Answer TWO of the following

3. A worker is privately informed of her productivity, which is equally likely to be 0 or 1. She

can signal her productivity to a firm by investing in (nonnegative) levels of education, which
do not affect her productivity. Each unit of education costs her 2 if her productivity is 0,
and costs her 1 otherwise. The worker wants to maximise the difference between her wage
and the cost of education, whereas the firm seeks to minimise the squared difference
between the wage and productivity.
a) At which levels of education can workers with productivity 1 separate from workers
with productivity 0? Explain your answer. [50%]
b) At which levels of education can all workers pool? Explain your answer. [50%]

4. a) Why does mandatory disclosure of the Sender’s type not affect play in a verifiable
message game where each type of the Sender is better off, the higher is the Receiver’s
chosen action?
b) Is the evidence consistent with this prediction?

5. An object is worth 𝑣 to its owner and 1.5𝑣 to a potential buyer. The potential buyer must
make a take-it-or-leave-it offer, 𝑝, which the owner can accept or reject. If the owner
rejects then no trade takes place and both players get a payoff of 0. If the owner accepts
trade takes place at a price 𝑝 and the payoffs are 𝑝 − 𝑣 for the seller and 1.5𝑣 – 𝑝 for the
buyer. Suppose the value 𝑣 is drawn from a uniform distribution on [0, 2], but not revealed
to either player until after the owner’s accept/reject decision. This information structure is
common knowledge.
a) Derive the equilibrium and comment on its welfare properties. [50%]
b) Now, suppose instead that the value of 𝑣 is the seller’s private information. That is,
the value of 𝑣 is revealed to the owner but not the buyer before decisions are made.
This information structure is common knowledge. Derive the equilibrium and
comment on its welfare properties. [50%]

6. Jane has an initial wealth of £912. Since Jane lives in Lenton there is a positive
probability that her house gets robbed and thus suffer a potential loss of £702. If she stays
at home all the time (i.e., Jane is careful) the probability of a robbery is 1/3. On the other
hand, if she goes out often (i.e., Jane is careless), the probability of robbery is 1/2. The
utility function is given by:
√𝑤, if careless
𝑢(𝑤) = { 1
√𝑤 − , if careful
2

(a) What is the expected wealth for each of the two levels of effort (i.e., careless and
careful) without insurance? [10%]
(b) In the absence of insurance will the individual be careful or careless? (Explain your
answer) [10%]
(c) Assume that insurance companies make zero profits, so that the client gets all the
gains from trade. Also assume that insurance companies can observe Jane’s effort
level. What is the equilibrium? [Hint: An equilibrium here is defined as a combination
of wealth levels for each state: (𝑊𝐺𝑜𝑜𝑑 , 𝑊𝐵𝑎𝑑 )] [20%]
(d) Derive and comment on the equilibrium if it is not possible for an insurer to observe
whether Jane is careful or careless? [60%]

END

ECON3010-E1