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415 Ansichten24 SeitenSummary/methods for the EC202 course that is taught at the London School of Economics and Political Science as per the previous years syllabus.

Nov 18, 2014

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Summary/methods for the EC202 course that is taught at the London School of Economics and Political Science as per the previous years syllabus.

© All Rights Reserved

Als PDF, TXT **herunterladen** oder online auf Scribd lesen

100%(1)100% fanden dieses Dokument nützlich (1 Abstimmung)

415 Ansichten24 SeitenSummary/methods for the EC202 course that is taught at the London School of Economics and Political Science as per the previous years syllabus.

© All Rights Reserved

Als PDF, TXT **herunterladen** oder online auf Scribd lesen

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(A) PRINCIPLES & CONCEPTS

(1) The firm: Basics

Increasing returns to scale (IRTS): Decreasing AC (MC

is lower than AC)

= > =

, <

! ! = ,

Let =

>1

,

,

<

=

(MC is higher than AC)

= < =

, >

! ! = ,

Let =

>1

,

,

=

>

=

equal AC)

= = =

Shephards lemma: Cost function must be (i) nondecreasing, (ii) continuous, (iii) homogenous of degree

one, (iv) concave in , (v) increasing in at least one ! .

If so, then the cost minimizing point of any ! with

price ! is unique

,

= !

!

Conditional/Hicksian demand: Demand for ! ,

conditional upon the given output level

! , = !

Unconditional/Ordinary demand: Demand for ! in

response to changes in ouput price

! , = !

(5) Consumption basics

Weak axiom of revealed preferences (WARP): The

consumer always makes a rational choice by selecting

the most preferred bundle that is available and

affordable. WARP does not rule out cylical

preferences

If ! , then ! when both are affordable

If ! then is not affordable

Axioms of consumer theory: (i) Completeness, (ii)

transitivity, (iii) continuity axioms determine the

existence of utility function/indifference curve

Completeness: All bundles can be ranked

, =

! ! = ,

, = , 1 =

=

,

= (constant)

cnstant elasticity of substitution for all . A

homogenous function is a subset of homothetic

functions. Specifically, if inputs are multiplied by ,

then outouts increase by !

Elasticity of substitution: Degree of responsiveness of

output to changes in input ratio

!

!

=

log

log

!

=

!

EC202 (2012-13 syllabus), ivantwk@gmail.com

Transitivity: ! , ! !! !!

Continuity: , all bundles and

Additional rules: Determine shape of indifference

curves

Greed: No bliss point

Strict quasiconcavity: < 1, + 1

(6) Consumer: Optimization

Indirect utility function: A mapping of priecs and

budget onto maximal utility. Properties include: (i)

Decreasing in all ! , (ii) envelope theorem, (iii)

homogenous of degree zero, (iv) mirrors cost function,

(v) Roys identity

= ! ,

= ,

Roy's identity:

! ,

! ,

!

! !

=

=

!

! !

prices and budget for maximal utility. Properties

include: (i) Homogenous of degree zero, (ii) linear

restriction

Homogeneous od degree zero: ! , = ! ,

Linear restriction:

! ! , =

Offer curve: Path of equilibrium bundles mapped out

by varying price ratios. It is dependent on the

endowment point (pivot point) which passes through

both the endowment and competitive equilibrium

Slutsky equation: Decomposition into substitution (SE)

and income effects (IE)

!! , = !! , ! !! ,

!"

!"

!! , = !! , + ! ! !! ,

!"

!"

definite Giffen good. If income is endogenously

determined, higher prices may cause the consumer to

switch from being a net supplier to a net demander.

! ! may become so negative such that the supply

curve bends back on itself

(9) A simple economy

Failure of the price system: Presence of nonconvexities result in production responses not

supporting the consumer optimum. However, nonconvexities may be eliminated by convexifying the

attainable set (e.g. trade)

Competitive allocation (CA): A set of utility-maximizing

bundles (1 for each household) and a set of profitmaximizing bundles (1 for each firm) with a set of

prices used by firms and households

Competitive equilibrium (CE): Assuming no public

goods, no non-rival commodities and no externalities,

a CE is a CA that satisfies the materials balance

condition

(11) General equilibrium: Price taking

Blocking: A proposed allocation is blocked by a

coalition 1,2 , ! if , ! ! ! ! and

for some , ! ! > ! ! . is feasibile if

!

!

!! !! . In that case, is blocked by

Core: A set of unblocked, feasible allocations ie. the

segment of the contract curve that lies between both

agents reservation utilities. Cloning the economy

times may result in the core comprising only of CE

allocations in the limit. This is because only pricetaking behavior survives due to blocking

(12) General equilibrium: Excess demand and the role

of prices

Inaction: 0

demand functions one corresponding to each good.

This means that there are effectively goods with

prices. (ii) Homogenous of degree zero, (iii) Walras

law. The 3 properties, together, mean that if 1

markets clear, then the th market must clear as well.

This applies to any CA not just CE

No free lunch: ! = 0

i ! = ! where ! = ! ! !

lunch, (iii) irreversability, (iv) free disposal, (v) additivity,

(vi) divisibility

Irreversability: = 0

Free disposal: , ! !

Additivity: , ! + !

Divisibility: , 0 1

(10) General equilibrium: Basics

Decentralizing role of prices: The price system is a

separating hyperplane that maximizes profits over the

attainable set and minimizes expenditure over the

better than set. Both the attainable and better than

sets are convex

ii

1

! ! = 0 ! = 0

!

!!!

!

!!!

continuous and (ii) bounded from below (otherwise

suggesting unlimited demand, which is unlikely)

Uniqueness of GE: GE is unique if all WARP

conditions are satisfied

Stability of GE

< 0 Stable

> 0 Unstable

!

< 0 Unstable from below

!

=0

!

> 0 Unstable from above

!

independence, (iii) revealed likelihood. The 3 axioms,

together, allows a utility function to be written in vNM

form

: =

affect utility only payoffs corresponding to

those states matter

Independence: One and only one state of the

world can be actualized. The level at which

payoff is fixed has no bearing on the ordering

over prospects where payoffs differ

= ! + 1 + 1 !

! =

! if !

if !

If ! ! some and ! , ! ! , !

(14) Risk

but not vice versa (increasing RRA could be possible

with constant or even decreasing ARA)

Absolute risk aversion (ARA): A measure of the

concavity of the felicity function. The higher

the concavity, the higher the degree of risk

aversion. Consequently, indifference curves

are more convex

=

!!

!

Averse > 0

Neutral = 0

1

: = !!"

elasticity of marginal utility

=

!!

!

! + 1

Wealth: = + 1 + = +

Tax on wealth: 1 + =

(16) Welfare: Basics

Constitution: Aggregate function of a set of utility

profiles a list of orderings, one for each member of

society assuming that social values are

individualistic

Axioms of the constitution: (i) Universality, (ii) Pareto

unanimity, (iii) independence of irrelevant alternatives,

(iv) non-dictatorship

logically possible profiles of individual

orderings

prefer one social state to another, than society

should rank the same

neutrality = , risk seeking <

Portfolio setup

weights for various states of the world

! if !

if !

Insurance

Tax on gains: + 1 =

! some ,

! =

No insurance

Healthy

1

Sick

! = !! =

If

1

!!!

1

= ()

Neutral = 0

For any , ! ; If ! ! , !

For two different profiles identical over some

, then the social orderings

corresponding to each of these profiles are

identical over

can determine the social ordering

, ! : ! ! !

two social states, there exists no constitution that

satisfies all four constitution axioms

(17) Welfare: Efficiency

3

, ! ! ! and at least one : ! > ! !

Pareto efficiency (PE): is Pareto efficient

Feasibility:

No Pareto superior alternatives !

Utility possibility set: A map of all possible utilities

corresponding to all feasible allocations in the

attainable set. PE points lie on the boundary of the

utility possibility set

Welfare theorem 1: If all consumers are greedy and

there are no externalities, a competitive equilibrium is

efficient

Welfare theorem 2: If, in addition to theorem 1, there

are no non-convexities, a PE allocation can be

supported by a CE (for instance, via an appropriate

price ratio)

Pareto potential superiority: is potentially superior to

! ( is accessible from )

and is Pareto superior to

!!

! ! > 0

!!!

and not actually paid. Transfers do not necessarily

take place, making gains or losses unpredictable.

There exists much ambiguity in the form of

contradictions (for example, ! may be potentially

superior to , when is potentially superior to ! )

Measuring social loss: Aggregating CV over agents to

yield a measure of loss

(19) Welfare: Fairness

Fairness of CE: If all households have equal incomes

then a competitive equilibrium is a fair allocation

(nobody would prefer anothers bundle)

Same attainable sets: ! = ! :

! !! ! = !

is a CE ! ! and ! ! ! !

For all pairs , = 1,2 ! , ! ! ! !

(20) Welfare: Social welfare function

Social welfare function: An aggregate of utilities, not

orderings (ie. constitution) represented as contours to

the boundary of the utility possibility set

! ! , ! ! ! ! = ! , ! !

EC202 (2012-13 syllabus), ivantwk@gmail.com

EC202 MT METHODS

(B) PROBLEM SOLVING

Lagrangeans

Deriving a cost function (minimizing costs subject to a production/utility constraint)

Lagrangean

Cost function

Producer problem

= ! ! + ! ! +

, = ! ! + ! !

Consumer problem

= ! ! + ! ! +

, = ! ! + ! ! =

Finding optimal given a utility function (maximizing utility subject to a budget constraint)

Lagrangean

Consumer problem

Cost function

= + ! !

, =

!

= + !

1+

Intertemporal problem

Finding a competitive equilibrium

General equilibrium

Lagrangean

= ! + !! + !! !! !!

! = !! + !! ! = 0

= ! ! + ! ! +

Solve for

,

,

=0

! !

Shephard's lemma: ! =

,

,

or ! =

!

!

Optimal consumption approach

= ! ! + ! ! +

= + ! !

! ! + ! ! =

= ,

Write as a function of , ! , !

Lagrangean with short-run constraints

!

No constraints =

! ! +

!!!

!!!

! ! + ! !

!!!

!,!,!

! ! +

!!!

! ! + ! , ! !!! , where = 1

!!!

Production and utility function

Type of utility function

Solution

Cobb-Douglas

!

= !! !

z2

= ! ! + ! ! +

Solve for ! , ! (interior solution)

, = ! ! + ! !

z2*

q=k

z1

z1*

Leontief

= min ! , !

z2

Corner solutions are non-differentiable

! =

, =

!

, = ! ! + ! !

k/

q=k

1/

q=1

1/a

k/a

! !

+

z1

Linear

= ! + !

Entire function may be a solution

z2

!

k/

!

if

< Corner solution

!

0, if

= Interior solution

!

!

0 if

> Corner solution

!

1/

!

< Corner solution

!

!

0,

if

= Interior solution

!

!

if

> Corner solution

!

0 if

! =

q=1

q=k

1/a

k/a

, = min

z1

! !

,

Concave

Corner solutions only

= !! + !!

!

if

<

z2

!

0,

0 if

Corner solution

!

if

=

!

>

!

Corner solution

!

< Corner solution

!

!

0,

if

=

!

!

if

> Corner solution

!

0 if

! =

q=1

q=k

z1

!!

, =

min

! !

,

Interior solution solve using Lagrangean

= ! + !

= ! ! + ! ! + ! !

z2

Corner solutions

k/

Interior solution if

!

1/

!

q=1

q=k

(1/a)^2 (k/a)^2

otherwise

!

!

>

! 2

0 otherwise

Interior solution if

! ! + ! ! if

z1

!

!

>

! 2

!

!

>

! 2

otherwise

Interior solution solve using Lagrangean

= !!!! + !

= ! ! + ! ! + + !!!! !

z2

Corner solutions

(q+a)/r

!

!

<

!

0 otherwise

Interior solution if

Interior solution if

!

q=k

q/r

z1

, =

!

>

!

+

otherwise

! ! + ! !

if

!

<

!

+

otherwise

MC intersects AC at its minimum point

1

1

, ! , = 0

!

! , =

EC202 (2012-13 syllabus), ivantwk@gmail.com

Number of firms

Supply graph

MC

Supply function

= ! ,

AC

= ,

Solve for = ! , =

Sub into ! , =

, if >

0, if =

0 if <

MC

AC

produce and produce 0

, if >

0, if =

0 if <

Monopolist

Monopolist type

Production

Unregulated monopolist

corresponding to = on the curve

= + ! = ! ,

MC

1+

MR

AR

= ! ,

! ,

, where < 0

1

1+

MC

p_max

AR

MR

p

Output increases (MC intersects MR in the region of

indeterminacy)

MC

p_max

AR

MR

q*

max if

if >

max if <

if

MC

AR

MR

p_max

q*

Output decreases

General equilibrium

Utility type

Cobb-Douglas/convex utilities

!! , !!

!

!! !

! : ! ! + ! !

Normalize prices ! + !

Lagrangean ! = !! , !! + !! + !! !! !!

Solve for !! and !!

10

Solve for

!! + !! !

Leontief utilities

! : ! ! + ! !

!! , !! = min ! , !

Normalize prices ! + !

w endogenous income !! + !! ! + !

Cannot use Lagrangean

At the kink, !! = !! !! =

k/

q=k

1/

q=1

1/a

!

1

!

!

+ !! ! + !

!

Solve for !!

Sub back into 1 to find !!

k/a

Linear utilities

! : ! ! + ! !

!! , !! = !! + !!

Normalize prices ! + !

w endogenous income !! + !! ! + !

k/

Constant MRS

1/

= a constant

! !

Price ratio, =

q=1

q=k

1/a

= MRS

k/a

Excess demand function: ! = !! + !! ! = 0

Solve for

EC202 (2012-13 syllabus), ivantwk@gmail.com

11

Determining if a CE is stable: Tatonmnet process

Excess demand

0

Stable: Excess

demand, higher

prices; excess

supply, lower prices

Unstable: Excess

demand, lower

prices; excess

supply, higher prices

< 0 Stable

> 0 Unstable

!

< 0 Unstable from below

!

=0

!

> 0 Unstable from above

!

Excess supply

Offer curves (assume fixed income of good 2)

Utility type

Solution

Cobb-Douglas

!

! , ! = !! !

E

Lagrangean = log ! + log ! + ! !

Offer curve

! is a constant, independent of

12

Leontief

! , ! = min ! , !

! =

+ !

!

Rearranging, ! =

+1

Linear

! , ! = ! + !

When ! = 0, 0, ! =

p>a/

When ! = 0, = ! ! =

E

Constant MRS

p=a/

= a constant

! !

0, if >

p<a/

! , !

0, ,

y/a

,0

if =

, 0 if <

When ! = 0, 0, ! = !

Concave

! , ! = !! + !!

When ! = 0, ! = !! ! =

Constant "MRS"

=

! !

a constant

0, if >

! , !

0, ,

, 0

if =

, 0 if <

13

! =

! !

! !

! !

!

=

=

= !! , !!

!

!

!! !!

!! !!

Equate ! = ! ie. !! , !! = !! , !! 1

Substitute !! = ! !! ,

!! = ! !! in 1

!! , !! = ! !! , ! !! 2

Rearrange 2 : !! = !!

Deriving reservation utility

! !! , !! = ! !! , !! (a constant) 1

Rearrange (1): !! = !!

Risk: Bond portfolio problem

Notation

Pre-investing wealth:

Investment in bonds:

Post-investing wealth: + 1 + = + , for 0

Scenario (1): Income tax with full loss offset

Ex-post wealth (net tax): + 1 =

Expected utility: = + 1

= ! 1 = 1 !

= ! + 1

=0

= 0 1

= !! + !! 1

=0

! !!

!!

=0

!!

=

> 0 (higher income taxes, higher bond holdings)

1

Ex-post wealth (net tax): 1 + =

Expected utility: = 1 +

= 1 !

= ! 1 +

=0

= 0 2

14

2

= !!

!!

+ !! 1

+ ! !!

=0

=0

!!

=

! !!

!!

!!

=

+

1 1 ! !!

!!

!!

2

= !! 1

!!

=

! !!

0 (ambiguous)

!!

+ !! 1

=0

!!

15

EC202 LT METHODS

Characterizing a strategic form game

Game theory definitions

(1) State player set

Best response correspondence: Action taken by

player that maximizes his utility given the action

profiles of other players

(2) State action set

!!

Expression: ! ! , !!

that maximizes utility given that the utility-maximizing

action profiles of all other players are played by all

other players. Any DSE is a Nash equilibrium

Definition: ! ! , !!

Let the action set be , for representing

! !! , !!

! !! , !!

!!

MSE definition: ! ! ! ! , !! ! !

DSE for incomplete information games: Strategy

profile that maximizes expected utility given that the

utility-maximizing strategy profiles of all other players

are played by all other players

Defn: ! ! ! , !! ! !! ! , !! !! : ! !

Best response: ! !! ! = arg max ! ! , ! !

!! !!

NE for a strategic form game

(4) Checking for dominated/dominated strategies: If all

are not and strictly > for some alternative actions

(e.g. ), then is not a dominant strategy

Let !! denote the profile of actions taken by all

players excluding : , ,

! , !! = ! = ! , !!

!

Let !!

denote the profile of actions taken by all

players excluding : , ,

!

!

! , !!

= !! !!! = ! , !!

! ! !! , !! !! !

Subgame: Subset of an extensive form game that (i)

begins on a single node, (ii) contains all successors

and (iii) information set with multiple nodes are either

all-in or none-in

Subgame perfect equilibrium (SPE): Any NE such that

for every subgame, the restriction of strategies to this

subgame is also a NE for the subgame

Minmax

! = arg min max ! ! , !!

!!! !!! !!! !!

average discounted payoff of each player in the SPE

is at least his minmax value, (ii) Any feasible payoff

profile that yields to all players at least their minmax is

the average discounted payoff of an SPE if 1, (iii) If

a stage game has a NE with minmax payoffs, then the

infinitely repeated game has an SPE in which every

players average discounted payoff is his minmax

value

if ! =

if ! =

State the NE first In a NE, players will play ,

Let !! denote the profile of actions taken by all

players excluding : State NE actions less

! , !! = > ! = ! , !!

!

Let !!

denote the profile of actions taken by all

players excluding : State NE actions less

!

!

! , !!

= !! > !!! = ! , !!

Strategies for a player with perfect information

! , ,

Strategies for a player with imperfect information

! State 1, State 2 , ,

! , = ! = ! ,

16

! State 2 = , ! State 3 =

17

(1) State player set

Let the set of players be 1,2 for 1 representing

(2) State action set

For any player , let the action set be , for representing

(3) Finding an SPE always start at terminal nodes (example)

c

A

a

1:2

2:1

d

B

1:1

b

(k, n)

(k, n)

(k, n)

(k, n)

(4) Finding a NE drawing game tables

Type 1 strategic form

A

A

A

3:1

2:1

1:1

A

1\2

A

D

E

2:2

C

D

1:2

B

B

1:1

2:1

B

B

1\2

A

1\2

AC

AD

BC

BD

AD

AE

Play C when player 1 plays B

BD

BE

CD

CE

18

(1) Cournot competition: True NE, intersection of best reponses

! = ! + ! ! + ! !

!

! + !

! !

= ! + ! +

!

=0

!

!

!

Solve simultaneously to obtain ! and !

(2) Collustion/cartel: Both firms cooperate to maximize joint profits however the monopolist outcome is unstable (ie.

a profitable deviation exists)

Scenario (2): ! ! 2 !

Scenario (1): ! ! = ! !

! = ! ! ! !

! = ! + ! ! + ! ! ! ! !

!

!

! !

= !

!

=0

!

!

!

! !

,

=0

! !

Solve for ! , !

Solve for ! , ! , , ! , !

Defecting from collusion

Sub ! , ! or ! into the best response function (found in Cournot model)

The best responded will yield higher profits for the defector at the expense of lower prices and profits for the other

Only by producing at = is there no profitable deviation by lowering prices

(3) Bertrand competition: Both firms produce at P = MC (perfectly competitive outcome)

= ! + ! =

! !

! !

and ! + ! =

!

!

(4) Stackelberg competition: Let firm 1 be the Stackelberg leader

Start with the follower ! = ! + ! ! ! !

!

! + !

! !

= ! + ! +

=0

!

!

!

Leader considers follower's best response ! = ! + !

! ! !

!

= 0 and solve for !

!

(5) Bayes NE and uncertain costs: Assume firm 1s costs be known, but firm 2s costs are unknown (high or low)

! = ! ! + ! ! + 1 ! ! + ! ! ! !

EC202 (2012-13 syllabus), ivantwk@gmail.com

!"#

! = ! , ! 1

19

! = ! + ! ! ! !

! = ! + ! ! ! !

!"#

!"#

! = ! 2

! = ! 3

Adverse selection problems

Monopolist problem

(1) Single consumer, single tariff, perfect information ( = ! )

Participation constraint : = !

!"#

= !

Solve for

Sub into to find marginal price !

(2) Single consumer, 2-part tariff, perfect information ( = ! + ! )

: = ! !

!"#

= !

Monopolist maximizes profits max ! = max

Solve for

Sub into to find unit price !

Because = ! + !

Substitute !

! = !

! : ! ! ! ! = 0

Monopolist maximizes profits

= ! ! ! !

max

!! ,!! !!

!! ,!! !!

!"#

! = !! ! = Marginal prices

! ! ! !

+ ! ! ! !

+ ! ! ! !

+ ! ! ! !

subject to ! , !

+ ! ! ! !

,

,

,

=0

! ! ! !

Because ! ! = ! + !

Substitute !

! = ! ! !! ! !

(4) Multi-consumer, 2-part tariff, imperfect information: Under imperfect information, ! > ! . L type preferences

are distorted, however no distortion happens at the top

! : ! ! ! ! ! ! ! !

! : ! ! ! ! ! ! ! !

Rearrange into ! ! . The 'higher' IC binds

= ! ! ! !

+ ! ! ! !

+ ! ! ! ! ! ! + ! !

!!!

+ ! ! ! !

!!!

20

,

,

,

=0

! ! ! !

Use ! = !! ! to solve for marginal prices

Because ! ! = ! + !

! : ! ! ! ! ! ! + ! ! = 0

Substitute !

Substitute

! = ! ! !! ! !

! ! ! ! ! !! ! + ! ! = 0

! = ! ! ! ! !! ! + ! !

Insurance market

(1) Insurance market under perfect information

Utility when healthy: ! ! ! = !

Utility when sick: ! ! ! + ! = !

! = ! ! + 1 ! ! = ! ! ! ! + ! + 1 ! ! ! !

Maximize ! wrt !

!

= 1 ! ! ! ! ! 1 ! ! ! = 0

!

Rearrange =

! !

1 !

!

=

!

!

!

1 !

solve for ! - both high and low-risk types fully insure

! ! !!

! ! !!

(2) Insurance market under imperfect information: Low-risk types underinsure or take up no insurance

At zero-profit pooling prices = ! ! + ! !

! !

1

!

=

! ! = ! !

!

!

1 !

Replace ! with ! in ! and solve for !

No pooling equilibrium: No pooling equilibrium can exist in a competitive insurance market. P is the zero-profit

pooling contract taken up by both high and low types, involving overinsurance by high-risk types (who previously

purchased the HF contract, ending up on a higher IC) and underinsurance by low-risk types (who previously

purchased the LF contract, ending up on a lower but still optimal IC). High-risk types will prefer to pool with low-risk

types in order not to be recognized and be charged a higher price. But this is not a pooling equilibrium, as a

profitable deviation exists. The insurer can propose a contract D that runs positive profits. This is because low-risk

types will choose D to end up on a higher IC (insurance is now cheaper than before but still more expensive than at

LF hence earning positive profits), but high-risk types will continue purchasing contract P to avoid ending up on a

lower IC (so losses by high-risk types are not incurred). Hence P cannot be a pooling equilibrium

21

PL

x (Sick)

PP

LF

PH

P

HF

D

E

y (Healthy)

No separating equilibrium: A separating equilibrium may or may not exist depending on the position of the pooling

profit line. Consider a separating equilibrium where low-risk types underinsure by purchasing contract LU and highrisk types overinsure by purchasing contract HF (indifferent to LU). This cannot be a separating equilibrium, because

a profitable deviation exists. The insurer can propose any contract in D with lower prices and is preferred by both low

and high-risk types, allowing both types to consume on a higher IC. D is also profitable, because the contract lies

below the pooling price (profits from the low-risk types purchasing more insurance nullify the losses incurred due to

high-risk types)

No separating equilibrium

PL

x (Sick)

Separating equilibrium

PL

x (Sick)

PP

PP

LF

PH

LF

PH

D

HF

LU

LU

HF

y (Healthy)

y (Healthy)

Separating equilibrium: If the proportion of high-risk types is sufficiently high, the pooling zero-profit line may pivot

downwards such that the region D is empty. In this case, no separating equilibrium exists. Even though agents prefer

higher IC contracts in the northeast direction, the insurer will not offer them because they lie above the pooling zeroprofit line and are hence loss incurring (losses incurred due to high-risk types erode profits from the low-risk types

purchasing more insurance). If a separating equilibrium exists, the prices for low-risk types are distorted (allowing

them to retain some surplus by underinsuring) so that high-risk types can reveal their types. As in the monopoly

example, no distortion occurs at the top and the full-insurance outcome for high-risk types is efficient

Signaling

(1) Pooling perfect Bayes equilibrium for education games

c

Wage beliefs, ()

If ! , ! + ! =

If < ! ,

If ! , !

If < ! , 0

!!

! :

!

b's payoff for getting p education

g

0

EC202 (2012-13 syllabus), ivantwk@gmail.com

!!

b's payoff for getting <p education

! = ! 1

22

!!

! :

!!

g's payoff for getting <p education

! = ! 2

Find a common range where (1) and (2) overlap - a continuum of equilibria

(2) Separating perfect Bayes equilibrium for education games

Wage beliefs, ()

If ! , = !

If < ! , = !

If ! , 1

If < ! , 0

!!

! :

!

b's payoff for getting g education

! 1

!!

! :

!

g's payoff for getting b education

! 2

From (1) and (2), find lowest possible ! maximize payoffs to types . ! = 0 by separation

Moral hazard: Principal-agent problem

(1) Continuous effort, perfect information

Always start with agent's PC ,

Substitute (1)

Find profit-maximizing

= 1

! !

+ ! !

=0

Solve for

Substitute into 1 to solve for

(2) Continuous effort, imperfect information

Agent's PC holds with equality ! ,

Effort that maximizes agent's utility:

+ ! ,

Solve for , a function of , 2

Liquidity constraints (e.g. a fixed lower bound in the form of a minimum wage)

Set = (the absolute lower bound), otherwise both and can be reduced while incentivizing the same effort

= ! ! + ! !

= 0 Solve for

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(3) Discrete effort, perfect information

Effort levels: ,

,

! = !|! ! !

+ !|! ! !

! = !|! ! !

!|! ! !

Substitute into = to find

(4) Discrete effort, imperfect information

Agent's : !|! ( , + !|! ,

Agent's : !|! ,

+ !|! ,

!|! ,

1

+ !|! ,

Check that >

Non-negativity constraints: Wages must always be non-negative. If < 0, then the IC binds at = 0, and is

derived accordingly from the IC

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