EC411 Microeconomics

Martin Pesendorfer

Problem Set 1. Monopoly

1. Why is the 'Supply Curve' not defined for a monopolist?

2. Comment on the use of

(a) a lump sum tax
(b) a tax or subsidy per unit of output
(c) a 'maximum price' control on a monopolist, in respect of their effects on (i)
allocative efficiency, (ii) income distribution.

3. A monopolist has constant marginal cost c. Her demand schedule shifts as a result of the
entry of a new group of consumers to the market. The distribution of income and tastes
among the newcomers is identical to that of the original population of consumers. Show
that the monopolist's optimal price is unchanged.

4. Estate agents typically quote their fees (to sellers) as a percentage of the sale price of a
house. Why? Can you deduce anything about the effectiveness of competition in this
market?

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Martin Pesendorfer

Problem Set 2. Price Discrimination and Cournot

1. Consider the following model of “Clearance Sales” (Lazear, AER 1986). Suppose that a
monopolist has 2 periods to sell a good before it becomes obsolete. There are many
consumers with total mass N. Every consumer wishes to purchase one unit of the good
and has a valuation independently distributed according to a uniform distribution on the
interval [0,A]. The monopolist discounts the future with discount factor δ and incurs a
cost of production equal to zero. Assume that every consumer buys with no delay
whenever the unit price drops below the willingness to pay. What is the optimal price in
each period? What is the effect of the discount factor on the optimal prices?

2. Up to the mid 1970s, Black and White whisky was a popular UK brand, which was also
sold elsewhere in Europe. The European court ruled, however, that the distillers were
not entitled to sell the whisky at a higher price in other European countries than in the
UK. The manufacturer responded by removing the brand from the UK market. Discuss.
In your discussion, it may be useful to assume that the inverse demand in the UK is
given by P=60-Q, while the inverse demand in Europe (not including the UK) is given
by P=100-Q.

3. Consider a Cournot duopoly (i.e. a market in which two firms offer an identical product;
and where the strategy chosen by each firm is its output level. Payoffs (profits) are
determined by equating total output with market demand, to determine price.

Market demand is described by P = a – bQ where Q = q1 + q2.

The firms have cost schedules

C1 = α + β1q1 (firm 1)
C2 = α + β2q2 (firm 2)

For what range of parameters (a,b,α,β1,β2) is there a Nash Equilibrium (q*1,q*2) at which:
1
q1 = (a - 2  1 +  2 )
*

3b

 1 4  1 2 *
Show also that in equilibrium: = - q*1 ; = q
 1 3  2 3 1

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Martin Pesendorfer

Problem Set 3. Oligopoly Theory

1. Consider a market with two products. The inverse demand curves are given by
1 1
P1 = 1 − q1 + q2 and P2 = 1 − q2 + q1 , where Pi is the price of good i and qi the output
2 2
of good i, i=1,2. The cost of production is zero for both goods.

(a) Characterize the monopoly output choices when a single firm produces both products.

(b) Characterize the Nash equilibrium output choices when there are two firms, each
producing one product.

(c) Discuss the effect of competition on total output by comparing your answers to parts (a)
and (b).

(d) Now redo part (b) when choice is sequential, with firm 1 choosing output first, and firm
2 choosing output only after observing firm 1’s choice. Is there a first mover or a second
mover advantage? What intuition can you provide for this result?

(e) Now assume that the two firms compete on prices rather than outputs, and that choice is
again sequential, with firm 1 choosing price first, and firm 2 choosing price only after
observing firm 1’s choice. Is there a first mover or a second mover advantage? What
intuition can you provide for this result?

2. Consider a seller’s problem in which two risk-neutral buyers submit prices for an object and the
high price buyer wins the object at a price equal to the high price. In case of a tie, the item is
given to each buyer with equal probability. The buyers have common values for the object but
are asymmetrically informed. Buyer I is informed and knows whether the value equals 1 or 0.
Buyer II is uninformed and does not know the value of the object but knows that it takes values
of either 0 or 1 with equal probability equal to ½. Is there a Nash equilibrium in which both
buyers use pure strategies? Why or why not? Is there a mixed strategy Nash equilibrium? If
there is, derive the mixed strategies employed by each player.

3. Firms 1 and 2 are oil-drilling firms that own adjacent land lots under which a common
pool of oil is located. Each firm chooses an amount of oil to extract. Let E1 be the
number of gallons of oil extracted by firm 1, and E2 be the number of gallons of oil
extracted by firm 2. The total cost for firm i of extracting Ei gallons of oil is
Ci(E1,E2)= Ei(E1+E2) for i=1,2 (notice that the cost of extracting oil for any one firm is
increasing in the total amount of oil (E1+E2) extracted). The firms are price takers in
the world oil market.

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Martin Pesendorfer

(a) Assuming that the firms select their respective levels of oil extraction
simultaneously, compute the Nash equilibrium levels for E1 and E2.

(b) Now assume that firm 1 chooses E1 first and then, after observing E1, firm 2
chooses E2. In this sequential game, compute the levels of E1 and E2 that are selected
in a subgame perfect equilibrium.

(c) Compare the equilibria obtained in (a) and (b). Interpret your findings.

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Martin Pesendorfer

Problem Set 4 / Homework 1: Oligopoly Continued

1. [40 points]
i. [10 points] ('Bertrand Equilibrium'). Two firms i = 1,2 produce an identical
product subject to marginal cost c < 1. Market demand is given by q = 1-p. The
strategy of firm i is to set price p1  c. The payoff to firm 1 is
π = (p1 - c)(1 - p1) if p1 < p2
= ½(p1 - c)(1 - p1) if p1 = p2
=0 if p1 > p2
and similarly for firm 2.
Prove that the unique Nash Equilibrium is p1 = p2 = c.

ii. [10 points] Now consider the following 2-stage game. In stage 1, each firm
decides to 'Enter' (in which case it pays a very small sunk cost ε > 0) or 'Don't
Enter'. In stage 2, if one firm has entered he acts as a monopolist facing the
market demand schedule p = 1 - q; if both firms enter they play the Bertrand
game described in part (a). Describe the pure-strategy Subgame Perfect Nash
Equilibrium outcome of this 2-stage game.

iii. [10 points] What difference does it make in question (b) if we assume that the 2
firms 'play Cournot' (i.e. we seek a Nash Equilibrium in quantities at the second
stage).

iv. [10 points] What conclusions can you draw as to the relationship between price
competition and entry?

2. [60 points] Suppose two firms i=1,2 can produce an identical product at no cost. Firms
set prices p1, p2. There is a continuum of consumers of mass one. Each consumer has a
willingness to pay of v = 1 and buys one product if the price of the item is less than the
willingness to pay. Consumers come in two types which differ according to which
firms they consider for their purchase. A fraction α of consumers can only buy from
firm 1, while the remaining fraction 1- α are shoppers who can buy from either firm 1
or 2. Shoppers buy from the low price firm. If firms 1 and 2 offer the same price, then
shoppers buy from firm 2.

(a) [30 points] Suppose 0 < α <1, and that firms make the price choices simultaneously.
Characterize the set of Nash equilibrium strategies and payoffs. Explain your
reasoning.

[Hint: argue by contradiction that there cannot be a pure strategy equilibrium. That is,
suppose there were a pure strategy equilibrium, then find a contradiction. Next,
characterize a mixed strategy equilibrium using the property that profits must be
constant for any price in the support of the mixed strategy. Finally, argue uniqueness.]

(b) [30 points] Suppose that 0 ≤ α <1. Consider a two stage game in which firm 1 sets
price p1 first. Then, after observing p1 firm 2 sets price p2. Characterize the set of
subgame-perfect Nash equilibrium strategies and payoffs. Explain your reasoning and
compare your answer with the equilibria found in part (a).

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Martin Pesendorfer

Problem Set 5. Bargaining and Search

1. Two individuals are bargaining over successive periods as to how to divide a 'pie' of size 1 between
them. If they reach agreement at time t, and player 1 (resp. player 2) receives share x (resp. share
y), then the payoff to player 1 (resp. player 2) is δt.x (resp. δt.y) where δ represents their common
discount factor, 0<δ<1.

i. Now suppose player 1 calls out a demand x in period 0. Player y immediately replies 'yes' or
'no'. If he says 'yes', the game ends and player 1 receives payoff x while player 2 receives the
remainder, 1-x. If player 2 refuses 1's offer, then the game continues to period 1. Player 2 makes a
demand y in period 1, and player 1 immediately replies 'yes' (payoffs are then δ(1-y) and δy
respectively) or 'no'; in the latter case, both players receive zero, and the game ends.
What partitions of the pie can be supported as a Nash equilibrium in this game? What
partitions can be supported as a Subgame Perfect Nash equilibrium?

ii. Suppose the game in (ii) is modified to allow further alternating offers up to some date (2n+1),
at which the game ends, the size of the cake at round t being δt. What will happen to the Subgame
perfect Nash equilibrium outcome of the game as n becomes arbitrarily large?

2. Consider a two-stage selling game in which a seller can sell one item to a buyer. In the first stage
the seller makes a take-it or leave-it offer by announcing a price at which the seller is willing to
sell the item. In the second stage the buyer decides whether to accept the offer or not. If the offer
is accepted the item changes hands; otherwise no trade occurs. The buyer values the item at v
and the seller values the item at c, with 1>v>c>0. The values c and v are publicly known.

(a) Can it be a Nash equilibrium that no trade takes place? If so, characterize a no-trade Nash
equilibrium.

(b) Characterize the set of subgame perfect Nash equilibria.

3. Stigler's 'Fixed Sample Size' Search Rule. A homogenous good is offered by a large number of
suppliers; the prices of different suppliers are described by a uniform distribution of [0,1]. A
consumer can obtain a block of n price quotations at a cost of nc prior to entering the market. She
then buys one unit of the good at the lowest quoted price. Thus, her decision rule reduces to a
choice of n, the number of quotes to obtain.

i. Calculate the expected value of the minimum price from among n randomly selected
prices, as a function of n.

ii. Show how the optimal value of n varies with the unit search cost c.

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Martin Pesendorfer

Problem Set 6. Sequential Search & Adverse Selection

1. Consider a sequential search problem in which a consumer samples sequentially from

the uniform distribution on the interval [0,1]. The cost of each sample equals c=1/8.

(a) Explain that the optimal search rule is a reservation value rule. Characterize the
rule.

(b) What is the effect on the optimal search rule if the search cost of each sample
increases to 9/32?

2. Market for Lemons: One hundred sellers each hold one car. Each seller knows the
quality q of his car, while buyers only know that q is distributed uniformly on the unit
interval [0,1]. The monetary value placed by a seller on a car of quality q equals 2q.

Each buyer buys exactly one car, or none. Buyers buying a car of quality q at a price p
have a utility increment equal to 3q-p. The total number of buyers equals 100. Sketch
the supply and demand function with price on the vertical axis and quantity on the
horizontal axis. What type of cars will be traded in equilibrium and at what price?
Explain your reasoning.

3. Consider Akerlof's Lemons problem with one seller and one buyer. The seller owns
one car of quality q, with q in [a,b] and 0<a<b. Consider a two-stage game: First,
the buyer proposes a price p. Second, the seller either accepts or rejects the price p.
If the seller accepts the price offer, then the seller gets a payoff of p and the buyer
gets a payoff of 3/2q - p. If the seller rejects the price offer, then the seller gets a
payoff of q and the buyer gets nothing.

(a) Suppose both, the buyer and the seller, know the quality q. Find the SPNE price
offer of the buyer as a function of the parameters a and b.

(b) Suppose the seller knows privately the quality q. The buyer only knows that
quality q is distributed uniformly on the interval [a,b]. Find the SPNE price offer of
the buyer as a function of the parameters a and b.

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Martin Pesendorfer

Problem Set 7 / Homework 2. Public Goods and Auctions

1. [40 points] Consider a two-player public goods problem. Players simultaneously

make their choice, invest at a cost ci or not invest, i=1,2. The resulting payoffs are the
following:

Invest Don’t Invest

Invest 1-c1, 1-c2 1-c1, 1

Don’t Invest 1, 1-c2 0,0

Player 1 has a publicly known cost c1<1/2; Player 2 knows her cost c2 privately.
Player 1 knows that c2 equals c with probability p and C with probability 1-p, with
0<c<1<C and p<1/2. Characterize the Bayesian Nash equilibrium.

2. [40 points] Consider a sealed bid, first price auction with n bidders. The object being
sold is worth vi to bidder i. Each bidder knows her own value vi, but not the other’s.
Each bidder knows only that the other bidder’s value is an independent random draw
from the uniform distribution on (0,1). The rules of the auction are that the high bid
wins, and the winner pays an amount equal to her bid. Assume that bidders are risk
neutral. Thus, if bidder 1 wins with a bid b, her monetary payoff is v1-b. There is no
reserve price, R=0.

(a) [10 points] What is a strategy in this game?

(b) [10 points] Compute the symmetric equilibrium bidding strategies.

(c) [10 points] Show that the expected revenue to the seller goes to 1 as the number of
bidders n goes to infinity.

(d) [10 points] How could the rules of the auction (described in the second paragraph)
be altered so that the equilibrium bids equal the values, i.e., so that bi=vi in
equilibrium? Explain.

3. [20 points] Consider a seller that wishes to sell one item to one of two risk- neutral
buyers. The seller uses a second-price auction. The rules of the auction are that buyers
submit sealed bids and the highest bidder receives the item at a price equal to the
second highest bid. If the bidders submit equal bids, then the seller gives the item to
either buyer with equal probability. The seller does not impose a reserve price.
Suppose that buyer 1 values the item at v1 = 2 and buyer 2 at v2 = 1. The values are
publicly known.

(a) [10 points] Is bidding one’s own value an equilibrium? Explain your answer.

(b) [10 points] Is bidding the opponent’s value an equilibrium? Explain your answer.

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Martin Pesendorfer

Problem Set 8. Auctions and Empirics of Auctions

1. Consider a N buyer all-pay auction for a single item. The rules of the all-pay auction
are that the item is sold to the high bidder and all bids are retained by the seller. There
is no reserve price, R=0. Buyers are risk neutral. Each buyer’s valuation is
independently and uniformly distributed on [0,1].

Characterize a symmetric Bayesian Nash equilibrium.

2. Consider a sealed bid, first price auction with n bidders. The object being sold is
worth vi to bidder i. Each bidder knows her own value, but not rival bidders’ values.
Each bidder knows only that rival bidders’ values are randomly drawn from the
uniform distribution on [0,1].

The rules of the auction are that the high bid wins, and the winner pays an amount
equal to her bid. Bidders are risk averse with the same von Neumann-Morgenstern
utility function, which exhibits constant relative risk aversion of 1-, where 0 <  < 1.
The common utility function, therefore, is u(w) = w.

(a) Define the Bayesian Nash equilibrium and derive the symmetric equilibrium
bidding strategies. [Hint: guess that the bidding strategies are of the form b(v) = β + µ
v. Find β and µ.]

(b) Show that risk averse bidders bid more aggressively than risk neutral bidders.

3. A researcher has bid data ((bit)i=1N)t=1T stemming from a sequence of T identical-object

private-values second-price auctions with a fixed (and known) number of N bidders.
Further suppose that the researcher knows that bidders are risk-neutral and their
valuations are independently distributed from a distribution function F.

(a) Suppose the bid data were generated from a Bayesian Nash equilibrium. What is the
relationship between valuations and bids?

(b) Describe a consistent estimator for the distribution function F. State all assumptions
clearly.

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Martin Pesendorfer

Problem Set 9. Mechanism Design

1. Consider a seller of a single object who faces one potential buyer. The buyer is
privately informed about the value of the object. The value is denoted with v and
drawn from the cdf F with support [0,1]. Assume that the associated virtual valuation
is increasing. The Seller offers the object for a fixed price p. The buyer can accept or
reject the offer. If the buyer accepts then there is trade at price p. If the buyer rejects
there is no trade. Characterize the optimal selling price p that maximizes the seller’s
revenues. What is the value of the selling price when F is uniform? Interpret the
finding. Is the outcome efficient?

2. Consider a seller of a single object who faces 2 potential buyers. Buyers are privately
informed about the value of the object. The value of buyer 1 is drawn from a uniform
distribution on the unit interval. The value of buyer 2 is drawn from a uniform
distribution on the interval [0,2]. Valuation draws are independent.

(a) Find the optimal selling strategy that maximizes the seller’s revenues. Interpret
the finding. Is the outcome efficient?

(b) Find an efficient selling strategy that ensures that the buyer that values the item
the most gets the item.

3. Consider a seller of a single object who faces 2 potential buyers. Buyers are privately
informed about the value of the object. The value for buyer i is binary and contained
in {0,1}. It equals 1 with probability ai and zero with probability 1- ai.

(a) Find the optimal selling strategy that maximizes the seller’s revenues. Interpret
the finding. Is the outcome efficient?

(b) Suppose now that bidders are symmetric, that is a1 = a2, and the seller considers
using a first price sealed bid auction in which the high bid bidder wins the item at a
price equal to his/her bid. Is the outcome revenue maximizing? If not, what could the
auctioneer do to increase revenues?

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 EC411 Microeconomics
Martin Pesendorfer

Problem Set 10. Signaling and Moral Hazard

1. Consider the job market signaling problem. There are two firms competing for one
worker. The worker has ability 2 with probability ½ and ability 0 with probability
½. The output produced by the worker equals his ability. The worker can acquire a
degree y, where y=A,B. The degree A costs 1 and the degree B costs nothing. The
firms cannot observe the worker’s ability but can observe the degree. The firms can
offer a wage to the worker which the worker can accept or reject. Characterize the
set of pure-strategy equilibria.

2. (Price as signals of product quality). A monopolist produces a good of quality θ.

The firm knows the quality, the consumers do not. If quality were observable, the
firm would face a demand curve Q=θ-P. Quality can be either high, θ=2, or low,
θ=1. The marginal cost to the firm of producing a low quality good is zero. The
marginal cost of producing a high quality good is c > 0. There is no fixed cost. The
firm chooses prices as a function of θ. Let μ(P) denote the probability that
consumers assign to the good being high quality given a price P. The demand curve
is:

Q = 2μ(P) + (1-μ(P)) - P.

(a) What are the complete information optimal prices and profits?

(b) Find a c* such that for c>c*, the full information optimal prices constitute a
separating equilibrium. [Hint: The lectures considered the case in which
education may signal ability. There were two 'no-mimicking' conditions that
needed to hold for a separating equilibrium. How would you write these two
conditions in the context of pricing?]

(c) Assume now that c < c*. What is the price that will be chosen by a low quality
firm in a separating equilibrium? Find the range of price that can be charged by
the high quality firm in a separating equilibrium. What is the optimal price in a
separating equilibrium for the high quality firm?

[Hint: In a separating equilibrium the high quality firm's price choice is now
constrained by the incentive constraint for the low quality firm. The incentive
constraint needs to guarantee that the low quality firm does not mimic the high
quality firm's price choice. What is this incentive constraint? With the incentive
constraint in hand, the problem of the high quality firm is to find the price that
maximizes it's profit subject to this incentive constraint.]

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Martin Pesendorfer

3. A CEO can exert high effort at a cost of 1 or low effort at no cost. If the CEO
works hard the profit of the company is 7 with probability ¾ and equal to 1 with
probability ¼. If the CEO does not work hard the profit of the company is 7 with
probability ¼ and 1 with probability ¾. Suppose the CEO is risk averse with von-
Neumann-Morgenstern utility function √w - e where w denotes the wage and e the
effort cost. The reservation wage equals 1 million. An economic advisor designs the
optimal CEO wage structure with the objective to maximize the profit to the risk-
neutral owner of the company. The owner does not observe the effort choice of the
CEO but observes the profit realization.

(a) Suppose the economic advisor considers a wage structure that induces low
effort. What is the optimal wage contract? What does the company owner get?

(b) Suppose the economic advisor considers a wage structure that induces high
effort. Describe the incentive and individual rationality constraint of the CEO.
Illustrate why both constraints must hold with an equality. Illustrate the objective
function for the economic advisor. What is the optimal wage structure and return to
the company owner? Does the company owner prefer the optimal wage contract
under high effort to the wage contract in part (a)?

(c) Suppose due to a boom the company profit in the good state is increased. Now,
if the CEO works hard the profit of the company is 9 with probability ¾ and equal
to 1 with probability ¼. If the CEO does not work hard the profit of the company is
9 with probability ¼ and 1 with probability ¾. How does the new profit structure
affect the optimal wage with low and high effort? What is the preferred wage
contract for the company owner?

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