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 ASSIGNMENT SOLUTIONS GUIDE (2017-2018)
M.E.C.-1
Micro Economic Theory
Disclaimer/Special Note: These are just the sample of the Answers/Solutions to some of the Questions given in the
Assignments. These Sample Answers/Solutions are prepared by Private Teacher/Tutors/Authors for the help and guidance
of the student to get an idea of how he/she can answer the Questions given the Assignments. We do not claim 100%

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accuracy of these sample answers as these are based on the knowledge and capability of Private Teacher/Tutor. Sample

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answers may be seen as the Guide/Help for the reference to prepare the answers of the Questions given in the assignment.

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As these solutions and answers are prepared by the private teacher/tutor so the chances of error or mistake cannot be
denied. Any Omission or Error is highly regretted though every care has been taken while preparing these Sample Answers/

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.
Solutions. Please consult your own Teacher/Tutor before you prepare a Particular Answer and for up-to-date and exact
information, data and solution. Student should must read and refer the official study material provided by the university.

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SECTION-A
Answer all the questions from this section.
i n
welfare economics.

80 N a a
Q. 1. Discuss the basic difference in approach adopted by Pigou and Pareto to deal with problems of
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Ans. Two Fundamental Welfare Theorems: According to the first theorem, every competitive equilibrium is
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Pareto-optimal. The second theorem says every Pareto-optimal allocation can be achieved as a competitive equilibrium
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after a suitable redistribution of initial endowments.

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Abba Lerner (1934) has proved the two theorems graphically, while Harold Hotelling (1938), Oskar Lange
91 UT

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(1942) and Maurice Allais have proved them mathematically.

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Graphically, the basic idea of the first theorem is if we have a competitive equilibrium, all three of the Pareto-
optimal allocation fulfils three conditions:
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(a) Consumption Efficiency: MRSWAB = MRSYAB for any pair of households, W, Y and any two goods A, B.
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(b) Production Efficiency: MRTSAKL = MRTSBKL for any pair of outputs, A, B, and any two factors K, L.

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(c) Production Mix Efficiency: MRSWXY = MRPTAB for any household, W and any pair of outputs, A, B.

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The second theorem is also clear that any Pareto-optimal allocation fulfils the three conditions. So, assuming
differentiability, we can put price lines with slope pA/pB between the indifference curves so that MRSWAB = pA/pB =

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MRSYAB. Further, we can put the same price lie with the same slope between the CIC and the PPF so that: MRSWXY
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= pA/pB = MRPTAB are on the PPF (by the production efficiency). Then, we can put a factor price line with slope r/
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w between the isoquants of the production Edgeworth-Bowley box so that MRTSAKL = MRTSBKL.
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Q. 2. Consider an industry with three firms each having marginal costs equal to zero. The inverse demand

w Th
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curve facing this industry is:

P (q1, q2, q3) = 60 – (q1 + q2 + q3).
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w(a) If each firm behaves as a cournot competitor, what is firm 1’s best response function?
Ans. Firms is profits is
60 – (q1 + q2 + q3) = 0
Taking the derivative of this profit with respect to q1 and setting the derivative equal to zero, we obtain
q1 = 60 – q2 – q3.
Thus the best response function of firm 1 given by (q1) = (60 – q2 – q3).
(b) Calculate cournot equilibrium of this problem.
Ans. P = 60 – (q1 + q2 + q3)
Firm 1 = P. q1
TR1 = (60 – q1 – q2 – q3). q1

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 ∂TR1
MR1 = = 60 – q1 – q2 – q3 . Similar as:
∂R1
MR2 = 60 – q1 – q2 – q3
MR3 = 60 – q1 – q2 – q3.
(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.
Ans. MR1 + MR2 = 0
60 – q1 – q2 – q3 + 60 – q2 – q3 = 0
120 – 2 (q1 + q2 + q3) = 0.
Section-B

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Answer all the questions from this section.

 r 2
Q. 3. Suppose Ashok’s utility function is u = 
 1000 
1

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His initial income when healthy is 36,000. However,,

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there is a 50% chance that she will face financial loss on being taken ill will face financial loss on being taken

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ill and the income is liely to reduce by 20,000/-
(a) Find the expected value of his income.
Ans. The utility function is given by:
 y 
½

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1000 

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The marginal utility when income 36,000 per month

R  ∂U 

y
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(MU)y = 36000 =  ∂y  y = 36000

B
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uld
The marginal utility when income redue by 20000.
n
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 dv 
( )
n oo
= 20, 000 =   y = 20, 000

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MU
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y
 dy 

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s
(b) What expected utility he will have given the possible state of her health?
r -
Ans. Expected utility = MUy = 36000 – MUy = 20000b
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 ∂U   ∂U 
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=  ∂y  y = 36000 –  ∂y  y = 20000.
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(c) What is the risk premium he will be willing to pay to cover the risk of sickness?
Ans. Total premium is the sum of fair premium and risk premium i.e.
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RT = U (y) 36000 + U(y)20,000.

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Q. 4. Consider the following game given in extensive form:
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 (i) Use backwards induction to compute equilibrium of the game.
Ans. Looking ahead player 2’ s decision node, her optimal choice is r. So we can convert her decision node
into a terminal node with pay off (4).
In the smaller game player 1 can either choose L.R. but player 1’s optimal choice is R. (b, r). Backword induc-
tion leads to the strategy profile R(b, r) with pay off (+).
(ii) Write this game in normal form.
Ans. A normal form game.
Player 2 Left Right
Player 1
Top (1, 0) (0, 2)
Bottom (0, 0) (2, 1) .

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

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Ans. Differentiation in static game from that of a dynamic game: In a static or simultaneous move game

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players move one time simultaneously. Any game with sequential moves falls under the category of dynamic games.

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A key difference is that in a static game no new information is revealed to any of the players during the game

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before they make their play. The prisoner’s dilemma is an example of a static game. The centipede game is an
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example of a dynamic game.

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

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the future at the rates of A and B respectively, find the conditions under which they sustain the outcome

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(2, 2) in every period.
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Player B

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Low High
Player A
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Low (1, 1) (4, 0)
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High (0, 4) (2, 2)
Ans. The outcome (2,2) can be achieved in the first stage in a pure strategy sub-game profeet Nash equilibrum.
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If we denote the outcome of the simultaneous game as [(w, x), (y, z)] where (x, 2) is the second stage outcome. Thus,

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[High, High] can be achieved in the simplified one shot game.
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Q. 5. Derive the indirect utility function form the given direct utility function u = a log x1 + x2. Use Roy’s

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identity to construct demand functions for the two goods x1 and x2. Are these same as demand functions
derived fromt he direct utility function?

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Ans. Indirect Utility Functions

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U* (Px, Py, M) = max {U (x, y) Pxx + Pyy ≤ M}
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= U (x*, y*)
H = U (Dx (Px, Py, M) Dy (Px, Py, M)

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Ray’s Law as price changes

∂x* ∂U
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∂U * ∂U

w ∂Px
=

=
∂x

 ∂x*
∂x
+
∂y

∂y* 
 Px ∂x + Py ∂Px 

∂U * ∂M
x* = – + .
∂Px ∂U *

Q. 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 UA = XA1 XA2 and UB = XBI XB2. Their initial endowments are WA = (1,2) and WB = (2,1).

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

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0 1 2 3 Xa

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

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Ans. In the contract curve the two indifference curves must touch only once. They cross-over only point of the corner of B’s
indifference curve can be part of the contract curve, in contract curve XB2 = XB2.

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(c) Find the demand functions of A and B for prices P1, P2 and incomes mA of A and mB of B.

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Sol. Maximizing utility gives the value of intial endowments, we get:

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3
xA = /2 WA

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and xB =
4WA +1
WA + 1
.
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(d) Find the competitive equilibrium price P* and equilibrium allocation

*
b
, X*A2,X*B1, X*B2) of this economy.
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( X

A1

Sol. In equilibrium price

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xA + xB = 4

w Th (4 is the total endowment of good 1)

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2  3Px + 1  1  Px + 3 

w
After solving, we get
+
3  Px  3  Px 

Pi = 1
=4

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 YA
4

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Xa
0 1 2 3 4

Q. 7. Write short notes on the following:

(a) Hotelling’s Lemma

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Ans. Hotelling Lemma

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To derive firm’s net supply function from the profit function by differentiating it, equation (14) can be related to
g
zi(p) =
∂ε(p)
∂pi
for i = 1, 2, …,n
d a r
the method used in the Hotelling Lemma. If we take zi(p) as the firm’s net supply function for good i. Then,

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Here, we assume that the derivatives exists and that pi > 0.

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(b) First welfare theorem
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Ans. The first welfare theorem is the statement that a Walrasian equilibrium is weakly Pareto optimal. Such a
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theorem is true in a large and important class of general equilibrium models (usually static ones). The standard case

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is if every agent has a positive quantity of every good, and every agent has a utility function that is convex, continuous,

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and strictly increasing, the then the First Welfare Theorem holds.

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Perhaps even more importantly technical economists seem to think that the First Theorem is the ultimate expression
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of “ The invisible hand” or what makes markets good but in fact the First Theorem is but a pinched and limited
expression of the virtues of markets. The First Theorem, for example, says nothing about innovation, experimentation,

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or the discovery process. Nor does the First Theorem say anything about markets and political philosophy.
(c) Public goods.
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Ans. Public Goods and Market Failure: A highly idealized, picture of the market system is that when certain
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conditions are met, the market economy serves to secure an efficient use of resources in providing for private goods.
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Consumers must thus reveal their preferences to producers and bid for what they wish to buy and producers will
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produce what consumers want to buy and will do so at least cost. Competition will ensure that the mix of goods
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produced corresponds to consumers preferences. In reality, there are various difficulties in market. Market may be

w
imperfectly competitive, production may be subject to decreasing cost, consumers may lack sufficient information
or be misled by the advertising, and so forth. For these reasons the market mechanism is not as ideal a provider of
private goods as it might be. But even so, it does a good job and a better one than can be done otherwise.
The market also cannot solve the entire economic problem. First, it cannot function effectively if there are
externalities. Second, the market can respond only to the effective demands of consumer as determined by the
prevailing state of income distribution. Third, there are problems or unemployment, inflation and economic growth
which do not take care of them automatically.
A public good thus is difficult to produce for private profit and it is difficult to get people to pay for its beneficial
externality. By definition, a public good possesses two properties: (i) It is non-rivalrous, meaning that its benefit do
not exhibit scarcity of consumption. Once it is produced, each person can benefit from it without diminishing any

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one else’s enjoyment. (ii) It is non-excludable, meaning that once it has been created, it is impossible to prevent
people from gaining access to the good. Public goods are pure when they possess these properties absolutely. Public
goods those confined to particular localities are impure.
The problem with public good is that a free market is unlikely to produce its optimum amount. Important public
goods such as national defence will be under-produced due to the free rider problem. In practice, this problem has
been solved through government intervention and the provision of the public goods by the state. However, there are
critics who argue that that such intervention can lead to too many resources being allocated to a public good’s
production.
A public good is the opposite of a private good, which can be sold in the market. A piece of soap, for example,
is a private good. Its owner can exclude others from using it, and once it has been consumed, it cannot be used again.

Private

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PPF

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Scitovsky Contour

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Public t i n g
a
Fig.: Scitovsky Contour

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Suppose in a society there are two individuals–Joe and Percy, and there is a single private goods and a single
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public goods. There is a production condition that we cannot produce more public goods without diverting resources

with the PPF.

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from production of private goods. Here, we can derive the Scitovsky contour and look for a condition of its tangency
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Scitovsky Contour for Public Goods

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Take there are certain amount of the public good. To derive a Scitovsky Contour, we add vertically indifference
i k
curves of A and B. The slope of the PPF (the rate of product transformation) should be equal to the slope of the
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Scitovsky contour. In case of private goods, the slope of the contour was the common MRS of a single individual.

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For public goods, its slope is the summation of the MRS (summed over all people). So, for public goods: RPT =
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ΣMRS.

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This is because the opportunity cost of producing the public good is the RPT. Since all people get to consume

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that unit of the public good, its value to different consumers from consuming that unit should be equal to the value
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of the resources what went into producing it, it has to be worth it to him to pay for all the resources that went into
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producing it. With a public good, because all get to use it simultaneously, it has to be worth it for all collectively to
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pay for the resources that went into producing it.

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Private

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A’s
Public
Fig. : Distribution of Public School Education

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Inefficient Provision of Public Goods
It does not involve extra cost to let someone use a public good (say toll bridge). If we try to charge vehicles for
using it and set the price higher than what is worth to the bridge – liking person then we end up with an inefficient
outcome. There is a need to devise some pricing scheme where people would correctly reveal how much the bridge
is worth to them. It is very difficult, however, to get people to reveal what the bridge is worth them.
Due to its non-rival nature, pubic good consumption has important bearing on (i) what constitutes efficient
resource allocation, that is allocation of resources to produce at least cost what consumers want most, and
(ii) the procedure by which their provision is to be achieved. These points we will examine by comparing it with the
provision of private goods as shown in figure below.
Price
Price Social Good
Private Good

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S

E
S

c
K

U
DA+H

.
E
V
D

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DA+B S

g
r
S
S

n
G

i
DA

a
DH Quantity of
Quantity of
X W Y Z Private Hood
d X H private good

80 N a
Fig. : Demand and Supply of Public Goods

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We can compare the familiar demand and supply diagram for private goods with a corresponding construction
R
for public goods in a hypothetical market setting.

e y
As shown in figure, the critical difference from the private good case than arises in that the market demand curve
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DA+B is obtained by vertical addition of DA and DB, with DA+B showing the sum of the prices which A and B are

l
willing to pay for any given amount. This follows as both consume the same amount and each is assumed to offer a

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price equal to his or her true evaluation of the marginal unit. The price available to cover the cost of the service

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equals the sum of prices paid by each. SS is again the supply schedule, showing marginal cost (A and B pays) for
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various outputs of the public good.
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The level of output corresponding to equilibrium output XZ in the private good case now equals XH, the quantity

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consumed by both A and B. XK is the combined price, but the price paid by A is XG whereas that paid by B is XL,
thus XG + XL = XK.

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In the case of the private good, the vertical distance under each individual’s demand curve reflects the marginal
n
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benefits. At equilibrium E, both the marginal benefit derived by A in consuming XW and the marginal benefit
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derived by B in consuming XY equals marginal cost ZE. This is an efficient solution because marginal benefit equals
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marginal cost for each consumer.
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If output falls short of XZ, marginal benefit surpasses marginal cost and individuals will be willing to pay more
than is needed to cover cost. Net benefits will be obtained by expanding output so long as the marginal benefit
IG

w
exceeds the marginal costs of so doing, and net benefits are therefore optimized by producing XZ units, at which
point marginal benefit equals marginal cost. Welfare losses would occur where output expanded beyond XZ, for
marginal cost would thereby exceed the marginal benefits.
In case of public goods, while the vertical distance under each consumer’s demand curve again shows the
marginal benefits obtained, the marginal benefit generated by any given supply is obtained by vertical addition.
Hence, the equilibrium point E now reflects the equality between the sum of the marginal benefits and the marginal
costs of the public good. If output falls short of XH, it will again be advantageous to expand because the sum of the
marginal benefits crosses cost. An output is excess of XH, on the contrary, would imply welfare losses, since marginal
costs outweigh the summed marginal benefits.
Therefore, the two cases are analogous, but with the important difference. In case of the private good, efficiency
needs equality of marginal benefit derived by each individual with marginal costs. For the public good, the marginal

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benefits derived by the two consumers defer and it is the sum of the marginal benefits that should equal marginal
cost.
The figure shows that an application of the same pricing rule where the price payable by each consumer equals
the individual marginal benefit yields different results for public and private goods.
In case of private good, A and B pay the same price but purchase different amounts, whereas in the public good
case, they bought the same amount but pay different prices. Yet, in both cases, the same pricing rule is applied. Each
consumer pays a single price for successive units of the good purchased, with the price equal to the marginal benefit
that the purchaser derives.
The Lindahl Formula
For supporting the efficient allocation of public goods, Erik Lindahl has developed a price system. In the pricing
rule, Lindahl viewed the sharing of costs by two customers of the public good as a supply demand relationship. The
figure below presented his results.

SE
It is assumed that the vertical axis measures K or the fraction of unit cost contributed by A. The unit cost, C, is

o m
assumed as constant. kC is the price paid by A, and DA is his demand schedule for the public good S. Since B’s price
equals (1 – k) C, and as both share the same quantity of S, B’s demand curve drawn with regard to k is given by D B.

U
‘A’ may then look upon DB as showing the price at which various quantities of S are available to him, that is, as
a supply schedule for the public good which confronts him.

. c

50 HO
Similarly, B may regard DA as his supply curve. The fraction of the price which both are willing to pay [k for A
and (1 – k) for B] adds to I at the intersection of DA and DB, at output XH.
K = 100%

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K = 0%

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Fig. : Lindahl Pricing for Public Goods

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(d) VNM utility function

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s
Ans. In the theorem, an individual agent is faced with options called lotteries. Given some mutually exclusive
r - b
outcomes, a lottery on them is a scenario where each outcome will happen with a given probability, all summing to

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one. For example,
U

L = 0.25 A + 0.75 B

b d
denotes a scenario where P(A) = 25% and P(B) = 75% (and exactly one of them will occur). More generally, for

n
we
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a lottery with many possible outcomes Ai, we write:

u a L = ∑ρiAi,

H
The outcomes in a lottery can themselves be lotteries between other outcomes, and the expanded expression is
N

w Th
considered an equivalent lottery: 0.5(0.5A + 0.5B) + 0.5C = 0.25A + 0.25B + 0.50C.
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We also declare that L = M if the agent is indifferent between L and M. This is not necessary, however, and can
be handled using a more explicit indifference relation instead.

w n n

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