Advanced Microeconomics class lecture short

notes & Questions

Chapter 1 Consumer Theory

1. Explain with the help of graph the two properties of the objective
function.
The two properties of the objective function are continuity and concavity or

quasi-concavity.

a) Continuity: means the objective function’s curve is smooth and there are

no holes or jumps.

b) Concavity: A function is said to be concave if

f(tX2 + (1-t)X1) ≥ tf(X2) + (1-t) f(X1)

c) Quasi-concavity: a function f(x) is quasi-concave

If f(X2) ≥ f(X1) implies

f(tX2 + (1-t)X1) ≥ f(X1)

where 0 ≤ t ≤ 1

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 For example, for the two curves shown below, only graph a is quasi-

concave, because it fulfils f(X2) > f(X1) and f(X*) > f(X1) Graph b is not

quasi-concave because even if f(X2) > f(X1) but f(X*) < f(X1) which should

have been the reverse.

2. Explain the four properties of the feasible set.

Refer to Gravelle pages 23-24.

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3. If x' x'' and x'' x' then what does this imply? (Short notes_Reev
page 1)
4. If x' x'' and not x'' x', then what does this imply? (Short
notes_Reev page 1)
5. Which assumption of consumer preference implies that indifference
curves have no intersection? (Short notes_Reev page 2)
6. Suppose X1 and X2 are goods and X' = (X'1 , X'2) is a consumption
bundle in the figure below. Answer the following based on this: (Short
notes_Reev page 3)
a. Identify the bundles which are preferred to X'.
b. Identify the bundles which are inferior to X'.
c. Identify the bundles which are indifferent to X'.

7. What is weakly preferred set?

A weakly preferred set of bundles are those bundles that are at least as good as the

bundle (X1, X2). Consider the figure below, all consumption bundles in the

shaded area are weakly preferred to the consumption bundle (X1, X2).

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8. What is a convex set?
A set of bundles weakly preferred to (X1 , X2 ) is a convex set. From the above

figure, all the consumption bundles in the shaded area are convex sets to (X1,

X2).

To test for convex set, connect any two points in set such as X1 & X2 and if the

line segment connecting the two lies in the set, then it is a convex set.

9. For the following preferences, which one is a convex set and which
one is not? Why?

Only the first preference is a convex set because the line joining the two bundles

(x1, x2) and (y1, y2) lies in the set (shaded area). However, for the second and

third preferences, this line is not fully lied in the set or shaded area.

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10. State a practical example for a convex set of preference.
If I like mango juice separately, strawberry juice separately and like the mixture

of the two fruits juices then this is a convex set of preference.

However, if I like mango juice separately, strawberry juice separately but I donot

like the mixture of the two fruits juices then this is a concave set of preference,

indicated by the third figure above.

11. Compare and contrast convexity and strict convexity.

Convexity as explained on (6), shows only the line joining any two bundles is in

the set. However, strict convexity means the weighted average of two indifferent

bundles (the midpoint of the line connecting the two bundles ) is strictly preferred

to the two extreme bundles. From the figure on (5), the averaged bundle is strictly

preferred to the (x1,x2) and (y1,y2) bundles.

12. Explain the assumption given any consumption bundle X', its
better set is strictly convex.
13. Which assumption said the consumer always prefers a mixture
of two consumption bundles which are indifferent to each other, to
either one of those bundles. (short note page 5)
14. What kind of indifferent curves do strictly convex preferences
have?
Strictly convex preferences have always rounded indifference curves, they

cannot have line segments. However, convex preferences may have flat spots.

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15. What should an objective function fulfil to ensure that a
solution exists according to the Wierstrass theorem? (lecture note, 7)
16. What are the two conditions for a local maximum to be always
a global maximum?
17. Explain the three basic properties of consumer
preferences?(lecture, 19)
18. Fill the right term among transitivity, completeness, reflexivity
on the spaces provided below:
Every bundle (---------) can be put into one indifference set (----------) and no more

than one indifference set (-----------------).

19. An agent has ____________ preferences she can compare any two
objects.
20. An agent has ___________ preferences if her preferences are
internally consistent.
21. Suppose that, given any two cars, the agent prefers x to y if it
is both faster and bigger. Explain if this preference is transitive? And
if it Is complete?
22. Suppose that an agent prefers a BMW over a Prius because it is
faster, an SUV over a BMW because it is bigger, and a Prius over an
SUV because it is more environmentally friendly. Explain if this
preference is complete and if it is transitive?
23. Are Completeness, Reflexivity and Transitivity necessary or
sufficient or both conditions for the preference ordering to be
represented by a utility function? Why? (lecture, 22)
24. Explain why indifference curves cannot intersect each other and
if so it will violate the transitivity of preferences. (Short notes
Nicholson, page 2)

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25. For the below two indifference curves shown on (a) and (b),
which one obeys the assumption of a diminishing MRS and which one
doesnot? Why? (Short notes Nicholson, page 3)

26. If the utility a person receives from two goods is represented by

U(x, y), show that the MRS of x for y is equal to the ratio of the
marginal utility of x to the marginal utility of y. (Microeconomics by
Nicholson short notes, page 5)
27. For the below utility functions, check if their indifference curve
is convex. (Hint: check if the MRS is diminishing first).
(Microeconomics by Nicholson short notes, page 6)

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28. What are the four properties of the consumer feasible set?
Explain how it fulfills each property. (Gravelle page 23)
29. How is the consumer feasible set responds to the following
different cases? Construct the relevant graph and derive the slope for
each. (Gravelle & Varian)
a. Income increases from M0 to M1.
b. Increase in P1 keeping P2 and M constant.
c. Equal proportionate increase in both prices.

d. Good 1 is subjected to a quantity tax of t dollars per uni.

e. Good 1 is subjected to sales tax of λ.

f. The government subsidizes good 1 by s dollars per unit of
consumption.
g. Good 1 is subjected to a value subsidy at a rate of σ.
h. If a consumer could consume good 1 at a price of P1 up to some level
̅ ,and then had to pay a tax t on all consumption in excess of 𝑿
𝑿 ̅.

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30. Suppose that a budget equation is given by P1X1+ P2X2 = m . The
government decides to impose a lump-sum tax of u, a quantity tax on
good 1 of t, and a quantity subsidy on good 2 of s. What is the
formula for the new budget line?
31. For a utility function given by

U = 10 = √𝑿. 𝒀
And its graph shown below, show that how the indifference curve
demonstrates convexity and how it obeys the diminishing MRS.
(Microeconomics by Nicholson short notes, page 4-5)

32. Derive the below equation where MRS is the marginal rate of
substitution of 2 by 1, u1 and u2 are the marginal utilities of items 1
& 2 and p is the price. (Gravelle, page 26)

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 Which says, the consumer is in equilibrium (choosing an optimal bundle) when

the rate at which he can substitute one good for another on the market is equal to

the rate at which he is just content to substitute one good for another.

33. Derive and interpret the value of the Langragian multiplier

shown below:

(Nelson, 11th ed., page 123-124)

34. Derive the below relationship between MRS and MU.

(Varian short notes, page 8)

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35. When do we say a transformation of a utility function, u, a
positive monotonic transformation of u? (Samiran book page 49)
36. Verify that the following functions are positive monotonic
transformation:

a. v = ur for r > 0;

b. v = ln u;

c. v = au + b where a > 0;

d. v = eu.

37. Show that given a utility function, the marginal rate of

substitution at any point on an indifference curve remains unchanged
under positive monotonic transformations of the utility function.
(Samiran book page 49-50)

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38. What is strong monotonicity? (lecture note page 21)
39. What does it mean when we say a bundle set is:
a. A better set for bundle X'?
b. An indifferent set for bundle X'?
c. The worse set for bundle X'?
40. What is a lexicographic ordering? Provide an example. (Gravelle
page 41)
41. Which of the following bundles is preferred according to the
lexicographic preference? Why? (lecture note, page 23)
a. Bundle A has (7, 10) and bundle B has (6, 150).
b. Bundle A has (7, 10) and bundle B has (7, 150).
42. When are preferences monotone? (lecture note, page 24)
43. What are the assumptions of monotonicity? (lecture note, page
24)
44. Show a case where the optimum utility is not always at the
tangency point of the budget constraint line and utility function.
(Nelson short notes, page 6)
45. When is the condition of tangency is both a necessary and
sufficient condition? (Nelson short notes, page 6)
46. For the Cobb-Douglas utility function given by the below
equation:

Assuming α + β = 1, solve for the utility maximizing values of x and y

for any prices (px, py) and income (I). (Nelson book page 125) or
(Class lectures page 33)

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47. Suppose that x sells for $1 and y sells for $4 and that total
income is $8, and suppose α = β = 0.5 for the above function on (43).
Calculate the optimum x, y, utility and λ. Then interprete the result of
λ. (Nelson book page 126)

48. Show that the optimal bundle x* must satisfy

u1/p1 = u2/p2 = … = un/pn = λ* > 0

for interior solutions. (lecture note)

49. For the Cobb-Douglas utility function given by:

U = X1αX2(1-α) Or its monotone transformation: U = αlnX1 + (1-α)lnX2

Show that the indirect utility function will be:

Answer:

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50. Explain briefly the properties of the indirect utility function.

51.

52.
(For both (48 & 49) refer to Samiran short notes page 8-9)

Note:
• Specifying quantities as a function of prices and total expenditure is

referred to us Marshallian demand function. That is:

qt = gi(x,p)

• The expenditure function and the Hicksian demand function are related
as follows:

• Marshallian demand and the indirect utility function are related as

follows:

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 Where Y is income.

• Marshallian demand and Hicksian demand are related as follows:

This equation is called the Slutsky Equation.

where we evaluate, for given prices p and income level m, the Marshallian

demand at those prices and that income, and, for the Hicksian demand function,

the utility level achieved at that Marshallian demand point.

53. In the two good case, the Slutsky equation looks like the below
matrix notation:

Expanding the last term gives:

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54. Derive the Slutsky Equation. (lecture page 71-72 or Varian 9th
ed page 157)
55. Important Identities

56. Given the indirect utility function, how is the Marshallian

demand derived?
57. A consumer who purchases burgers and fries has a utility
function U(B,F) =√𝑩𝑭= B0.5 F0.5 and income of $20. Initially, the prices of
burgers and fries are $5 and $2, respectively. (Micro book by
Goolsbee, page 197)
a. What is the consumer's optimal consumption bundle and utility
at the original prices?
b. The price of burgers increases to $10 per burger, and the price
of fries stays constant at $2. What does the consumer consume
at the optimum at these new prices? Decompose this change
into the total, substitution, and income effects.
58. Roy’s identity
If x(p,m) is the Marshallian demand function, then

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 That is, the Marshallian demand function of good i is equal to the negative of the

partial derivative of the indirect utility function wrt price of i divided by the

partial derivative of the indirect utility function wrt income.

59. Express the money metric utility function interms of

expenditure function. (lecture)
60. Explain the indirect money metric utility function using graph.
(lecture)
61. Compute the direct and indirect money metric utility function
from a utility function given by: (lecture note, page 67-)
U(x1,x2) = x1ax21-a

62. What is comparative statics?

63. Show normal and inferior goods using indifference curves and
budget constraint lines. (Varian , 9th ed.)
64. What is the income offer curve and Engel curve? (Varian , 9th
ed.)
65. For the Engel curve shown below,
a. What is the elasticity?
b. If the consumption of good 1 increases by 50%, by how much
will the consumption of good 2 increase? why?

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66. For the below shown income expansion path (Engel Curve),
which good is luxury and which good is necessary good? Why?

67. For the below shown income expansion path (Engel Curve),
which good is inferior? Why?

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68. Explain which one is an ordinary good and which one is a Giffen
good from the graphs provided below: (lecture note, page 77)

69. Compute the example on lecture notes page 49.

70. What is the slope of the Engel curve for the following goods:
a. Perfect substitutes
b. Perfect complements
c. Cobb-Gouglas preferences (Varian , 9th ed.)
71. What is a Giffent good? Show it using indifference curves and
budget constraint. (Varian , 9th ed.)
72. What is a price offer curve and demand curve? Show using
indifference curves and budget constraint. (Varian , 9th ed.)
73. Show with the help of graph the consumer will be better off
with income tax than quantity tax. (Varian, 9th ed., page 88 figure
5.9)
74. For which kinds of goods does the substitution effect negative?
For which goods does the income effect negative?
75. When is a good a Giffen and when is it an inferior good with
respect to price decrease? (Relations, page 8)
76. When are two goods i & j Hicksian complements and Hicksian
substitutes? (lecture p-95)

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77. What is an isoquant? (Varian, 9th ed., page 352)
78. What does the isoquants of a fixed proportion [f(x1,x2) =
min(x1,x2)] and perfect substitutes look like? (Varian, 9th ed., page
352-)
79. What does it mean when we say technologies are monotonic?
(Varian, 9th ed., page 354)
80. What does it mean when we say technologies are convex?
(Varian, 9th ed., page 354)
81. For two factors of production, how is the marginal product of
factor 1 calculated and what does it mean? (Varian, 9th ed., page
356)
82. What is the technical rate of substitution and how is it
calculated? (Relations, p-10-11)
83. Derive the TRS = dx2/dx1 = MP1/MP2. (Nelson 299)
84. Explain the law of diminishing marginal product. When does it
apply? (Relations, p-11)
85. Explain what the diminishing TRS means. (Relations, p-11)
86. Prove mathematically the diminishing TRS. (Nelson 299)
87. Explain the difference between diminishing marginal product
and diminishing TRS. (Relations, p-11)
88. Compute the MRTS and the elasticity of substitution for the
production function:

(relations, page 26)

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89. Explain the following with example and give their
mathematical expressions: (Relations, p-11-12)
a. Constant returns to scale
b. Increasing returns to scale
c. Decreasing returns to scale
90. Check if the following two production functions exhibit
constant, increasing or decreasing returns to scale?

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91. Show how the different returns to scale of a Cobb-Douglas
production function given by f(k,l) = Akalb is determined based on a
and b. (Nelson, page 309)

92. The technical rate of substitution between factors x2 and x1 is −4.

If you desire to produce the same amount of output but cut your use

of x1 by 3 units, how many more units of x2 will you need?

93. Derive the cost function of a Cobb-Douglas production function

given by:
q=(x1x2)1/2 (Relations, p-18)
94. Derive the cost function of a Leontief technology given by q =
min{ax1, bx2}. (Relations, p-20)
95. Show what the elasticity of substitution of a Cobb-Douglas
function is 1. (Relations, p-13)
96. For a profit function given by Π (q) = R(q) – C(q) = p(q).q – C(q),
derive the necessary and sufficient conditions for choosing the value
of q that maximizes profits. (Relations, p-17)

97. What are isoprofit lines? What is the equation for an isoprofit
line? What is its slope and vertical intercept with the second input ,x2,
being fixed? (Relations, p-17)
98. How is the profit maximizing combination of input and output
found? Show graphically & mathematically. (Relations, p-19)
99. Show how the marginal revenue and the elasticity of the
demand curve are related mathematically. (Relations, p-19)
100. Explain the four properties of the profit function. (Relations, p-
20)
101. Derive the firm’s supply function and input demand functions
from the profit function. (Relations, p-21)
102. Derive MP1 = w1/P and MP2 = w2/P. (Relations, p-21)

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 𝒘𝟏
103. Derive = TRS for to minimize the total cost of a production
𝒘𝟐

function given by q = f(x1, x2). (Relations, p-22)

104. Derive the relationship between input costs and their respective
inputs for a cost minimization of a Cobb-Douglas production function
given by q = f(k,l) = kαlβ. (Nelson, p-329)
105. Derive the cost function of a Cobb-Douglas production function
of q=(x1x2)1/2 (Relations, p-23)
106. Derive the cost function of a general two-input Leontief
technology: q = min{ax1, bx2} (Relations, p-24)
107. Derive the Cost function for a linear technology q = ax1 + bx2
(Relations, p-25)
108. Explain how CV, EV & CS are determined. (relations)
109. What is the order of CV, EV & CS for a normal good under price
increase?
110. What is allocative efficiency?
111. For the figure below, identify the points which are technical
efficient, allocative efficient and neither of the two.

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112. How is monotonicity described mathematically?
113. What is the difference between technical rate of substitution
and elasticity of substitution?
114. Formula for elasticity of substitution for a two inputs factors
case?
115. Describe a homothetic function mathematically.
116. What is the difference between homogenous and homothetic
functions?
117. How is the elasticity of scale determined?
118. What is the SOC condition for a profit maximizing function
under multiple inputs?
119. From a given production function f(x) derive its input demand
function, supply function and profit functions.
120. Explain how the profit function is non-decreasing in the output
price and it is convex.
121. What is Hotelling's lemma about?
122. In the short run, the average cost curve first decreases and
then increases. Why?
123. Depict the shapes of the AVC, AFC and AC curves.
124. What are the relationships between AVC and MC?
125. When in the long run does average cost, average variable cost,
and marginal cost are all equal to each other?
126. Depict the shapes of SAC, SMS, LMC and LAC curves.
127. How is the cost function concave in the input price?
128. What is Shephard’s Lemma about?
129. Derive a Cobb-Douglas function from a cost function given by

C(w1, w2, y) = yw1αw11- α (lecture note)

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130. Derive the budget constraint equation for the consumptions of
a good over a two time periods denoted by c1 and c2, the prices of
consumption in each period are constant at 1 and the amount of
money the consumer will have in each period is denoted by (m1,m2)
when the consumer is a
a. Saver
b. Borrower
131. Show graphically the saver and borrow cases.
132. Expresses the above derived budget constraint in terms of
future value and present value.
133. Derive the slope of the budget constraint on (131), the vertical
and horizontal axis intercepts.
134. How does a lender and borrower consumer react to a change of
interest rate? Explain using a graph for each.
135. Derive the amount of money the consumer spends in the second
period with period 1 price p1 and p2 be the price of the second
period.
136. Express the budget constraint in terms of the inflation rate and
the real interest rate with price p1 and p2 for the two periods
respectively.
137. Derive the budget constraint for three periods with prices p1,
p2 and p3 and let the rate of interest be r1 from period 1 to 2 and r2
from period 2 to 3.

138. When do we say that a function v(u) is a positive affine

transformation?
139. What is the use of subjecting an expected utility function to a
positive affine transformation?
140. Find the MRS of the below expected utility function between
goods 1 and 2.
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141. How is the curvature of the utility function determines the
consumer’s attitude towards risk?
142. For a linear utility function, how is the expected utility of and
the utility of its expected value related? What will be risk type of this
consumer?

143. A consumer has some wealth w and is considering investing

some amount x in a risky asset. This asset could earn a return of rg in

the “good” outcome, or it could earn a return of rb in the “bad”

outcome. If the good outcome occurs with probability π and the bad

outcome with probability (1 − π), determine the optimal amount for

the consumer to invest.

144. For the above question, determine the optimal amount to invest
when you tax its return?
145. How is the two optimal amounts under no tax and with tax
related?
146. Suppose an individual whose initial wealth is w and whose utility
function given below which exhibits constant absolute risk aversion is
facing a 50–50 chance of winning or losing $1,000. How much would
he or she pay to avoid the risk?

U(W) = -𝑒 −0.0001𝜔

Ans:

Let y be the amount he would pay then we set the utility of (w-y) equal to the

expected utility from the gamble, that is:

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 -𝑒 −0.0001(𝑤−𝑦) = -1/2 𝑒 −0.0001(𝑤+1000) -1/2𝑒 −0.0001(𝑤−1000)

-𝑒 −0.0001𝑤 𝑒 0.0001𝑦 = -1/2 𝑒 −0.0001𝑤 𝑒 −0.1-1/2 𝑒 −0.0001𝑤 𝑒 0.1

𝑒 −0.0001𝑤 can be factor out and cancelled and we left with:

−𝑒 0.0001𝑦 = -1/2 𝑒 −0.1 - 1/2 𝑒 0.1 = -1/2 (𝑒 −0.1 + 𝑒 0.1 )

𝑒 0.0001𝑦 = 1/2 (𝑒 −0.1 + 𝑒 0.1 )

Y = 49.9

147. An individual whose behavior is characterized by a constant

relative risk aversion utility function, ln(w), will be concerned about
proportional gains or loss of wealth. Therefore, we can ask what
fraction of initial wealth ( f ) such a person would be willing to give up
to avoid a fair gamble of, say, 10 percent of initial wealth.
Ans:

The percentage of initial wealth the individual is willing to give us is fW. Note f is

in percentage. Hence the remaining wealth will be W – fW = (1-f)W.

If he wins, his wealth will be W+0.1W = 1.1W and if he loses his wealth will be W-

0.1W = 0.9W

Setting the utility of this individual’s certain remaining wealth equal to the

expected utility of the 10 percent gamble yields:

ln[(1-f)W] = 0.5ln(1.1W) + 0.5ln(0.9W)

this can be written as:

ln(1-f)+ lnW= 0.5[ln1.1+lnW + ln0.9+ lnW]

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 lnW can be cancelled out from both sides and

ln(1-f)= 0.5[ln1.1 + ln0.9]

ln(1-f) = ln (0.99)0.5

1-f = (0.99)0.5

f = 0.005 that is 0.5%

Thus, this person will sacrifice up to 0.5 percent of wealth to avoid the 10 percent

gamble.

148. Ms. Fogg is planning an around-the-world trip on which she

plans to spend $10,000. The utility from the trip is a function of how
much she actually spends on it (Y), given by

U(Y) = ln Y

a. If there is a 25 percent probability that Ms. Fogg will lose

$1,000 of her cash on the trip, what is the trip’s expected
utility?
b. Suppose that Ms. Fogg can buy insurance against losing the
$1,000 (say, by purchasing traveler’s checks) at an ‘‘actuarially
fair’’ premium of $250. Show that her expected utility is higher
if she purchases this insurance than if she faces the chance of
losing the $1,000 without insurance.
c. What is the maximum amount that Ms. Fogg would be willing to
pay to insure her $1,000?
Ans:

a. Note that the utility from the trip is a function of how much she actually

spends. Hence a loss of 1000 cash implies the utility will be based on the

spend of 10,000-1000 = 9000

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 EU = 0.25U(9000) + 0.75U(10,000)

= 0.25 ln(9000) + 0.75 ln (10,000)

= 9.184

b. When she buys an insurance premium of 250, her spending will decrease by

10,000-250 = 9750. Hence

EU = U(9750) = ln (9750) = 9.185 which is greater than 9.184

c. Let the max amount of the insurance payment be p, then the total spending

will decrease to 10,000-p . Equating this value to the EU with no insurance:

EU = EU(10,000-p)

9.184 = ln (10,000-p)

Raising both values by e,

e9.184 = 10,000-p

p = 260.

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149. All dominant strategy equilibria are Nash equilibria, although
the opposite is not necessarily so.
150. Strategies are in a subgame perfect (Nash) equilibrium (SPNE) in an
extensive form game when the strategies constitute a Nash
equilibrium in each subgame.
151. Derive the demand functions for present (period 0) and future
(period 1) consumption as functions of wealth and the rate of
interest, for a consumer who has the Cobb–Douglas utility function
u = Ma αM1(1-α) .
Ans:

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152. Construct the payoff matric for:
Roger and Colleen play a game. Each one has a coin. They will both show a side of

their coin simultaneously. If both show heads, no money will be exchanged. If

Roger shows heads and Colleen shows tails then Colleen will give Roger $1. If

Roger shows tails and Colleen shows heads, then Roger will pay Colleen $1. If

both show tails, then Colleen will give Roger $2.

Ans:

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153. Construct the payoff matrix for:
Ruth and Charlie play a game. At each play, Ruth and Charlie simultaneously

extend either one or two fingers and call out a number. The player whose call

equals the total number of extended fingers wins that many pennies from the

opponent. In the event that neither player's call matches the total, no money

changes hands.

Ans:

154. Construct the payoff matrix for:

Two players bid for $10 and each player has 3 choices to bid ($0, $1, or $2).

Construct the payoff matrix.

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 Ans:

• For the (5,5) cell, since each of them bid for 0, they will get half of 10.

• For cell (0,9) as player 1 bids higher than player 2, player 1 gets (10-1=9)

while player 2 gets negative of its bid that is -0 which is 0.

• For cell (4,4) both bid for the same with 1. Hence they will share equally

the remaining from 10,that is, (10-2)/2=4 each.

• For cell (-1,8) since player 2 bids more than player 1, player 2 gets 10-2=8

while player 1 gets -1.

• For cell (3,3) both players bid with 2 hence they will share (10-4)/2 = 3

each

155. What is the difference between uncertainty and risk?

156.
Where q = 2p.

This is called reduction of compound lotteries.

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157. Suppose we want to represent a situation with three prizes x, y,
and z where the probability of getting each prize is one third.
Represent this using compound lotteries.
Ans:

158.
If and only if

159. The expected utility theory

160. If the premium per dollar of insurance coverage is equal to the

probability of loss then the insurance is said to be fair insurance.
That is:
π=p

161. Derive the marginal utility of consumption under loss and

noloss conditions with respect to π and p. Derive also the actuarially
fair premium and state the condition for full insurance.
Ans:

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162. What does it mean when we say an agent with utility function
A(w) is more risk averse than an agent with utility function B(w), that
is:

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163. Let the expected utility from investing in a risky asset is
expressed as:

Where:

w is the original wealth, a is the dollar amount invested in the risky asset, R is the

rate of return on the risky asset.

Then

is:

• Positive for decreasing absolute risk aversion r(w).

• Negative for increasing absolute risk aversion r(w).

• Zero for constant absolute risk aversion r(w).

164. Consider a consumer with wealth w and suppose that she is

offered gambles with probability p she will receive x percent of her
current wealth; with probability (1 -p) she will receive y percent of
her current wealth. If the consumer evaluates lotteries using
expected utility, how should the utility of this lottery be expressed?

Ans:

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165. How is the Arrow-Pratt measure of relative risk aversion
expressed?
166. What are the five elements of a game? Briefly explain each.
167. What are the classifications of the game theory problems?
Briefly explain each.
168. Explain the two forms of describing a game.
169. What are the differences between cooperative and non-
cooperative games?
170. What is a widely accepted tenet of non-cooperative game
theory?
171. Cities 1, 2 and 3 want to be connected with a nearby power
source with the possible transmission links and their costs are shown
in the following picture.

These players can form coalitions: any subset S of N is called a coalition.

The following table presents the costs as well as the savings of each coalition.

• The numbers c(S) are obtained by calculating the cheapest routes

connecting the cities in the coalition S with the power source.

• The cost savings v(S) are determined as;

v(S) = Ʃ C(i)-C(S)

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 • The cost savings v(S) for coalition S are equal to the difference in costs

corresponding to the situation where all members of S work alone and the

situation where all members of S work together.

For S = {1,2}, v(2) = C(2) – C(1,2) = 140-50 = 90.

For S= {1,3}; v(3) = C(3) – C(1,3) =130-30 = 100.

For S= {2,3}; v(3) = C(3) – C(2,3) =130-10 = 120.

For S= {1,2,3}; v(3) = [C(3) – C(1,3)] + [C(3) – C(2,3)] =100-120 = 220.

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172. Explain what prefect and imperfect information means in game
theory.
173. Explain what complete and incomplete information means in
game theory.
174. Explain the difference between complete and perfect
information in game theory.
175. What is asymmetric information?
176. What is pure strategy?
177. Nash equilibrium is solution to -------------games.
178. Subgame perfect Nash Equilibrium is solution to -------------games.
179. When is a two-player game constitute a Nash equilibrium?
180. Explain Nash equilibrium in pure strategies. (page 34)
181. For a given Row and Column strategies and a payoff of (r,c),
when is a Nash equilibrium in pure strategies happen?
182. What is the implication for a set of strategies not having a Nash
equilibrium?
183. Define the Nash equilibrium. (page 36)
184. For below shown payoff, determine the mixed strategy Nash
equilibria and the expected payoff of the two players using the
maximization problem and FOC.

Assume the complementary slackness conditions .

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185. What is a dominant strategy equilibrium?
186. A dominant strategy equilibrium is a Nash equilibrium, but not
all Nash equilibria are dominant strategy equilibria.
187. What is the difference between zero-sum games and
coordination games?
188. Find the mixed strategy Nash equilibria for the below payoff
matrix:

189. On the below prisoner’s dilemma payoff matrix, why do the

players end up defecting (Nash equilibrium) while cooperation is
mutually more beneficial? (page 76)

190. Suppose that there are two firms who produce an identical
good at zero cost under Cournot duopoly game and each firm
considers only two output levels: 10 and 12 units. The price is given
by: P = 40 - X1 - X2. Construct the profit payoff matrix for the two
firms.
191. What is the difference between uncertainty and risk?

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