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EC202 MT METHODS

(2) The firm: Optimization

(A) PRINCIPLES & CONCEPTS
(1) The firm: Basics
Increasing returns to scale (IRTS): Decreasing AC (MC
is lower than AC)
= > =
, <

! ! = ,

Let =

>1

,
,
<
=

Decreasing returns to scale (DRTS): Increasing AC

(MC is higher than AC)
= < =
, >

! ! = ,

Let =

>1

,
,
=
>
=

Constant returns to scale (CRTS): Constant AC (MC

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)

Homothetic function: A production function with

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

!

=
!
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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:

! ,
! ,

!
! !
=
=
!
! !

Marshallian demand: Demand of a good mapped by

prices and budget for maximal utility. Properties
include: (i) Homogenous of degree zero, (ii) linear
restriction
Homogeneous od degree zero: ! , = ! ,
Linear restriction:

! ! , =

(7) Household demand and supply

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)
!! , = !! , ! !! ,
!"

!"

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

!"

Backward-bending supply curve: Does not imply a

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
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

General equilibrium (GE): Characterized by (i) excess

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 ! = ! ! !

Standard production axioms: (i) Inaction, (ii) no free

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

Irreversability: = 0
Free disposal: , ! !
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
!

!!!

!
!!!

Existence of GE: (i) Excess demand functions must be

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
!

Axioms of uncertainty: (i) State irrelevance, (ii)

independence, (iii) revealed likelihood. The 3 axioms,
together, allows a utility function to be written in vNM
form

: =

State irrelevance: Relabelling states do not

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

Insurance setup (different from LT)

= ! + 1 + 1 !

! =

! if !
if !

If ! ! some and ! , ! ! , !
(14) Risk

Risk aversion: Increasing ARA means increasing RRA

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
: = !!"

Relative risk aversion (RRA): A measure of the

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

Universality axiom: is defined over all

logically possible profiles of individual
orderings

Pareto unanimity axiom: If all households

prefer one social state to another, than society
should rank the same

Attitudes to risk: Risk aversion > , risk

neutrality = , risk seeking <

Portfolio setup

Revealed likelihood: Imposes probability

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

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For any , ! ; If ! ! , !

Independence of irrelevant alternatives axiom:

For two different profiles identical over some
, then the social orderings
corresponding to each of these profiles are
identical over

Non-dictatorship axiom: No one person alone

can determine the social ordering
, ! : ! ! !

Arrows impossibility theorem: If there are more than

two social states, there exists no constitution that
satisfies all four constitution axioms
(17) Welfare: Efficiency
3

Pareto superiority: is Pareto superior to

, ! ! ! 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
!!!

Accessibility downfalls: Income gains are hypothetical

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

Excess demand function

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

! = !! + !! ! = 0

= ! ! + ! ! +
Solve for

,
,
=0
! !

Solve ! by subsituting into FOC

Shephard's lemma: ! =

,
,
or ! =
!
!

Solving for ordinary demands

Optimal consumption approach

= ! ! + ! ! +

= + ! !

! ! + ! ! =

Rewrite in the form of ! + ! =

= ,

Write as a function of , ! , !
Lagrangean with short-run constraints
!

No constraints =

! ! +
!!!
!!!

! ! + ! !
!!!

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!,!,!

! ! +
!!!

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

Replace with and with

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

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! !
+

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

! !
,

Touching both axes

Interior solution solve using Lagrangean

= ! + !

= ! ! + ! ! + ! !

z2

Solve for interior solutions ! and !

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

Touching one axis

Interior solution solve using Lagrangean

= !!!! + !

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

z2

Solve for interior solutions ! and !

Corner solutions

(q+a)/r
!

!
<
!

0 otherwise

Interior solution if

Interior solution if
!

q=k

q/r

z1

, =

!
>
!

+
otherwise

! ! + ! !
if

!
<
!

+
otherwise

Firm and the market

MC intersects AC at its minimum point

1
1
, ! , = 0
!

! , =
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Deriving a supply function for perfectly competitive firms

Number of firms

Supply graph

MC

Supply function
= ! ,

AC

= ,
Solve for = ! , =

Sub into ! , =

, if >

0, if =
0 if <

MC

AC

Let there be firms, such that

produce and produce 0
, if >

0, if =
0 if <

Function becomes thick as

Monopolist
Monopolist type

Production

Unregulated monopolist

The monopolist produces at = ,

corresponding to = on the curve
= + ! = ! ,

MC

1+

MR

AR

= ! ,

! ,
, where < 0
1
1+

MC

p_max

AR

MR

Regulated case (2): > max > !

p
Output increases (MC intersects MR in the region of
indeterminacy)

MC

p_max
AR

MR
q*

max if
if >

max if <
if

Regulated case (3): max < !

MC

AR

MR

p_max
q*

Output decreases

General equilibrium
Utility type
Cobb-Douglas/convex utilities

!! , !!

!
!! !

Finding an equilibrium allocation

! : ! ! + ! !
Normalize prices ! + !
Lagrangean ! = !! , !! + !! + !! !! !!
Solve for !! and !!

10

Solve for

Check if materials balance condition holds

!! + !! !

Leontief utilities
! : ! ! + ! !

!! , !! = min ! , !

Normalize prices ! + !
w endogenous income !! + !! ! + !
Cannot use Lagrangean
At the kink, !! = !! !! =

k/

q=k

1/

q=1
1/a

Sub into BC:

!
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

Determining number of competitive equilibria (CE)

Excess demand function: ! = !! + !! ! = 0
Solve for
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11

Number of solutions/roots = Number of CE

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

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! is a constant, independent of

12

Leontief
! , ! = min ! , !

! =

+ !
!

Rearranging, ! =

+1

and solve for !

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

Deriving a contract curve with convex utilities

! =

! !
! !
! !
!
=

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

Scenario (2): Wealth tax

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

!!

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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

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

(2) State action set

Definition: ! !! = arg max ! ! , !!

!!

Expression: ! ! , !!

Dominant strategy equilibrium (DSE): Strategy profile

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: ! ! , !!

For any player

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 ! ! , ! !
!! !!

Pure strat. BNE: ! ! ! ! ! , !! ! , , ! !

NE for a strategic form game

For any action profile

(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 ! ! , !!
!!! !!! !!! !!

Folk theorem: (i) For any discount factor , the

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 ! =

(5) Checking for Nash equilibrium

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

(6) Justifying a Bayes NE

Strategies for a player with perfect information
! , ,
Strategies for a player with imperfect information
! State 1, State 2 , ,
! , = ! = ! ,

16

The pure Bayes NE are ! = , ! State 1 = ,

! State 2 = , ! State 3 =

17

Characterizing an extensive form game

(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)

The unique SPE of the game is !.! a = 1, !.! c = 1, !.! A = 1

(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

BC

BD

AE

Play A when player 1 plays A

Play C when player 1 plays B

BD

BE

CD
CE

18

Oligopoly pricing games

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

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

Rearrange to obtain best response functions ! = ! ! = !

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 ! , ! , , ! , !

Profit allocation unknown

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 ! + ! =
!
!

Solve simultaneously to obtain ! and !

(4) Stackelberg competition: Let firm 1 be the Stackelberg leader
Start with the follower ! = ! + ! ! ! !

!
! + !
! !
= ! + ! +

=0
!
!
!

Rearrange to obtain best response function ! = !

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

! ! !

!
= 0 and solve for !
!

Sub ! back into ! to obtain !

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

! = ! , ! 1
19

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

!"#

!"#

! = ! 2

! = ! 3

Sub 1 , 2 into 3 and solve for ! , ! , ! , ! + ! , ! + !

Monopolist problem
(1) Single consumer, single tariff, perfect information ( = ! )
Participation constraint : = !

!"#

= !

Monopolist maximizes profits max ! = max

Solve for
Sub into to find marginal price !
(2) Single consumer, 2-part tariff, perfect information ( = ! + ! )
: = ! !

!"#

= !

PC holds with equality = 0 = ! + !

Monopolist maximizes profits max ! = max
Solve for
Sub into to find unit price !
Because = ! + !

Substitute !

! = !

(3) Multi-consumer, 2-part tariff, perfect information

! : ! ! ! ! = 0
Monopolist maximizes profits

= ! ! ! !

max

!! ,!! !!
!! ,!! !!

!"#

! = !! ! = Marginal prices

! ! ! !

+ ! ! ! !

+ ! ! ! !

+ ! ! ! !

subject to ! , !

+ ! ! ! !

,
,
,
=0
! ! ! !

Solve for ! and !

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
! ! ! !

Solve for ! and !

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 !

Under perfect information, insurers charge ! = ! =

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

! ! !!
! ! !!

= 1 ! ! = ! ! . Replace ! with ! and

(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

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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
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!!
b's payoff for getting <p education

! = ! 1

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!!

! :

g's payoff for getting p education

!!
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 b education

!
b's payoff for getting g education

! 1

!!

! :

g's payoff for getting g education

!
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

Principal's profit function: = ! ! + ! !

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

Equate (1) and (2) to align agent's incentives with principal's

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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New contract , corresponding to ! , !

(3) Discrete effort, perfect information
Effort levels: ,
,

! = !|! ! !

+ !|! ! !

! = !|! ! !

!|! ! !

Choose that yields highest

Substitute into = to find
(4) Discrete effort, imperfect information
Agent's : !|! ( , + !|! ,
Agent's : !|! ,

+ !|! ,

!|! ,

1
+ !|! ,

Solve (1) and (2) simultaneously to obtain ,

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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