Joseph Kim

Economic Development
Professor Ray
10/1/14
Assignment #3
1.
(a) The graph would have an upward sloping function because fax machines are
complementarities. The more users there are, the more appealing it becomes to use it.
Concavity/convexity of the graph depends on if theres increasing returns to scale or decreasing
returns to scale.
(b)

y
1,000,000

A+1
A
10

1,000,000

(c) Equilibrium always occurs at = 1,000,000 because of the upper bound and the fact that
expected numbers must match actual numbers. To get the other equilibrium we must set the
equation given for the companies and set it equal to x (45 degree line). We then take the
derivative of this equation w.r.t to x and set it equal to 0 to find the maximum A:
!
+=
1000

( =
+) ===>
=1
=0

1000

500
= 500, = 250
!!

At = 250, the 45 degree line, x, is tangent to !""" + . This means if > 250 then there is a
unique equilibrium at = 1,000,000 . At = 250, there are two equilibriums and when
< 250 there are three equilibrium. This can be seen in the graph below:

2. = ,
!
!
!
(a) Case 1: = ()(!) + (0)(1 !) = !
!

Case 2: = ()(! ) + (0)(1 ! ) = !

In case 1, there are no complementarities because if number of tax evaders increase, then
likelihood of being caught remains the same since N is not changing.
In case 2, there are complementarities because as number of tax evaders increase, then the
likelihood of being caught decreases making it more appealing to tax evade when E is larger.
(b)
3.
(a) Looking at the equations, ! = (1 + ) and ! = (1 + ) , we can see that the incomes for
both high and low-skilled workers are determined by the fraction () of the population that
decides to become high skilled. So if increases, then both ! and ! increase. This is a
complementarity because more and more people will seek higher education since income will
increase for both groups. We can also see that the income difference between the two groups
widens as because > .
(b) In the case where everyone acquires skills, = 1. Given this condition, the income equations
will give us: ! = 2 and ! = 2
The difference in income between the two groups is given by: ! ! = 2 2 = 2( )
Because < 2( ), that means the gains from acquiring education is greater than the cost of
education which will encourage everyone to gain education if they believe everyone else will do
the same.
In the case where nobody does, = 0. Given this condition, the income equations give us:
! = and ! =
Difference in income between the two groups is then given by: ! ! =
Because < , that means the gains from acquiring education is less than the cost of
education which will discourage everyone from gaining education if they believe everyone else
will do the same.
In the case where only a certain fraction of the population acquires education, that must mean
! ! = so that gains from acquiring education is the same as the cost of education. To find
that fraction , we start with the equation ! ! = and plug in the terms:
! ! =
(1 + ) (1 + ) =
+
=

Unlike the other two equilibriums, this one is unstable because as soon as one person makes the
sacrifice to change income class, then the fraction will slide down or up to the previous
equilibriums.
(c) In the case where = 1, we have:

! ! = (1 + ) (1 + ) = 2 (1 + ) , if we allow > 1, then we get:

2 (1 + ) < 2( )
We can see that increasing will decrease the difference in income levels for a given . At
= 1, we are no longer sure if the gain of acquiring education (! ! ) is greater than the cost
of education (C) and if is increased substantially then the cost will actually be greater. Thus
discouraging people from
In the case where = 0, we have:
! ! = (1 + ) (1 + ) = , the same as before. We can now see that if is
increased substantially, the new unique equilibrium will be at = 0 since there is no longer any
incentive to acquire higher education.
(d) Already explained in parts (b) and (c)
(e)
If = , then that means cost of education is equal to the gains of acquiring education.
1
1
=
===> =

+1
This is the unstable equilibrium where the population is indifferent to acquiring education.
If = 1, then () = (1 1)/1 = 0
This means that the cost of education is essentially free. And if > , then everyone will want
to acquire education to get the higher income.
If = 0, then () = (1 0)/0 = . In that case, the cost of education will be much
higher than the gains of acquiring education so the population will be discouraged from trying to
acquire education.
!

4.Throwing away garbage: () = !

Not throwing away garbage: () =

The threshold is , which is given in terms of , , & in the graph above. This was determined
by equating the two payoff equations and then using the quadratic formula.
(a) If < , then payoff for not throwing away on the street is greater than throwing away
garbage. As a result, less and less people will want to throw away their garbage thus decreasing
until it hits 0.
(b) This threshold population size is = . We can see if > , then payoff for throwing
garbage on the street is always greater than not throwing it on the street. As a result, everyone
will be encouraged to do so.
(c) As explained in part b, if all of the population is throwing garbage on the street ( is very
high), then payoff for continuing to throw garbage on the street will always be greater than not
throwing it away on the street. There is not incentive for the people to switch their habits.
This is similar to the keyboard complementarities situation. If everyone is already using
QWERTY, then there is no incentive for people to switch to Dvorak since they would be losing
benefits by being one of the only few to use it. The first people to switch would have to make a
sacrifice.
(d)

In the graph above, we can see that a fine of would shift the curve down by so that the
!
equation is now () = ! . We can also see that the threshold has now increased to
.
(e) If the fine is large enough so that is always less than the threshold , then everyone
would then stop throwing trash on the street. The reason is because at this point, payoff for
throwing trash on the street will always be less than the payoff for not throwing trash on the
street. Eventually everyone will stop doing so resulting in = 0. Once the fine is removed, the
threshold will move back to its original position . But because = 0 no one will want to want
to throw trash on the streets because it is now at the stable equilibrium (part a).

5.
(a) There are three equilibrium points. Two occur when = 1 intersects the equation
=

!!
!

. The other occurs at = 0. They are shown in the graph below:

(1)The reason this occurs is because when there are no city dwellers ( = 0), payoff is 0 so it
becomes more appealing to live in the countryside where there is a greater payoff of 1. As a
result, no one will want to live in the city and so they will all stay in the countryside. The same
case can be seen when < ! 2
(2) When = ! 2, payoff for both living in the city and living in the countryside are
equal to 1. That means the population is indifferent to moving but also means this is an unstable
equilibrium.
(3) When ! 2 < < + ! 2, the payoff for living in the city is always greater
than the payoff for living in the countryside. As a result, more people will want to live in the city
and will continue to increase until the payoff for city dwellers is equal to 1 at
= + ! 2.
When > + ! 2, payoff for city dwellers is less than living in the countryside and
actually becomes negative when > 2. As a result, people will move out of the city to the
countryside until both payoffs are equal again at = + ! 2.
(b) In this case, there are also three equilibriums at the same places. Even with the ability to build
new cities, no one wants to be the first inhabitants of the new cities since the payoff will be less
than living in the countryside.

6. Using the assumption that the index i is evenly distributed among the population, we can set
= so that we have the following payoff equation:
honesty: () = 1 , dishonesty: () =
The below shows these two equations on a graph:

To find where they intersect, we simply equate the two:

1
1 = ===> =
+
!
We can see from the graph that when < !!! , honesty always has a greater payoff. Conversely
!

when > !!! , dishonesty always has a greater payoff.

When the fraction of individuals being dishonest (x) is less than !!! , they will see that honesty
has a better payoff and so they will switch to honesty until the fraction (x) decreases hit 0. So
= 0 is a stable equilibrium.
!
When the fraction of individuals being honest (x) is greater than !!! , the fraction of people who
are honest will see that being dishonest has a higher payoff. As a result, less people will be
honest causing to become 1. So = 1 is another stable equilibrium.
!
When = !!!, the payoff for both decisions are equal so the people will be indifferent. So
!

= !!! is an unstable equilibrium.

We can easily see that when or increases, then the unstable equilibrium point decreases.
Conversely, when or decreases, then the unstable equilibrium point increases. If and
move in opposite directions, then the movement with the higher magnitude will dictate the
movement of the unstable equilibrium point. The stable equilibrium points though will remain
constant at = 0 and = 1 regardless of changes in and .

7.
(a)

(b) In a monopoly, the socially optimal output level occurs when =

because that is when the industry is allocatively efficient.
!
!
= !" (100) = 100, = !" (10000 ) = 5000 !!/!
5000 !!/! = 100 ===> = 2500

(c)

The graph above shows the MC, ATC, and the demand curve (price). When producing at the
socially optimal output level = 2500, the monopolist is breaking even because ATC is equal
to the price. But if the monopolist is able to perfectly price discriminate, then he is able to profit
by capturing the consumer surplus (shown in pink) along with the producer surplus (shown in
blue). As a result, all of the social surplus will go to the diamond monopolist.
(d) In a perfectly competitive market, there is no profit in the long run so equilibrium price will
remain at $100 which is the marginal cost. And in a perfectly competitive market, a producer
faces a market price ( in part b) equal to its marginal cost (). As a result the socially optimal
output level will be produced again. The social surplus will then be divided as shown in the
graph in part c. Pink = consumer surplus, blue = producer surplus
(e) In this case, the monopoly will try to make a profit by selling at a higher price. You can see
this by observing the increase in producer surplus when raising the price along the demand curve
in the graph above. As price increases along the curve, we will see that the output level drops
below the socially optimal level as well.