Econ 6000 Microeconomic Theory I; Assignment 2

University of Guelph
Due November 22, 2012; Answer all questions. Explain your answers
Instructor: J. Atsu Amegashie

1. Consider a contest between two economists (candidates), 1 and 2, competing for a job in the
South Korean department of finance. The person in charge of selecting the successful candidate
is Mr. Oppa Gangnam Style.

Candidate k exerts an effort of e
k
in order to impress Gangnam, k = 1, 2. However, Gangman
does not only consider effort in choosing the successful candidate. For example, he may consider
a candidate's looks, how s/he dresses, the school s/he attended, his own mood, etc. The
candidates do not really know how these factors affect Gangman's decision but they know that
they are summarized by a random variable which is uniformly distributed on [0,1]. In
particular, when Gangman chooses candidate 1, his (i.e., Gangnam) payoff is
U
1
(, e
1
) = (1 )f(e
1
) and if he chooses candidate 2, his (i.e., Gangnam) payoff is
U
2
(, e
2
) = f(e
2
), where f(e
k
) is a strictly increasing function, k = 1, 2. Therefore, a higher effort
increases a candidate's chance of success but does not necessarily imply that s/he will be chosen
for sure because the decision also depends on the draw of .

Gangman will choose the candidate who gives him the higher payoff. Suppose that
t
= ) e ( ) e ( f
k k
, where > 0. Prove that the probability that candidate k will get the job is
t t
t
+
=
k k
k
k
e e
e
P , which is the contest success function we used in class, k = 1, 2.
2. Consider an individual who chooses x to maximize the function, (x) = PV(x) C(x), where
P is a positive parameter, V(x) is strictly increasing and strictly concave in x, and C(x) is strictly
increasing and strictly convex in x. The first-order condition for an interior solution is
P ) x ( C ) x ( V ' ' = 0. The optimal value x* is unique because (x) is strictly concave. Using the
implicit function theorem we know that there exists x*(P) and we get .
) x (
) x ( V
P
* x
H' '
'
=
c
c
This
derivative is positive since (x) is strictly concave and ) x ( V' > 0.
Consider two different values of P: P
H
and P
L
. Then x*/P > 0 implies the following result:
Result 1: If P
H
> P
L
, then
H
x x*(P
H
) >
L
x x*(P
L
).
Using the first-order condition above, prove result 1 without differentiating the first-order
condition or without using the implicit function theorem methodology (comparative statics
methodology).
3. Consider a contest between two groups each of size N > 0. Call them groups 1 and 2. The
effort of player k in group j is e
kj
0, j = 1, 2; k = 1, 2, ..., N. Player k in group j values the prize
at V
kj
> 0. The members of the same group have the same goal: to be successful in the contest.
The payoff of player k in group 1 is:
1 k 1 k
N
1 k
2 k
N
1 k
1 k
N
1 k
1 k
1 k
e V
e e
e

+
= H


= =
=
.
An analogous payoff is defined for player k in group 2. Let the valuations in each group be
ordered as follows: V
1j
> V
2j
> .... > V
Nj
, j = 1, 2.
(i) Write down the Kuhn-Tucker conditions for each player's problem.
(ii) Find the Nash equilibrium of this game.
(iii) Will your answer in (ii) necessarily stay the same if the cost of effort was a strictly
increasing and strictly convex function. Briefly explain.
In his book titled "The Ruling Class", the Italian scholar Gaetano Mosca observed that: "The
domination of an organized minority ... over the unorganized majority is inevitable. The power
of any minority is irresistible as against each single individual in the majority, who stands alone
before the totality of the organized minority. At the same time, the minority is organized for the
very reason that it is a minority."
(iv) How would you establish this claim in the model above by tweaking it? You only have to
describe how you will go about doing this.


4. (a) Let
c
) w b ( ) w ( u = be an individual's utility of wealth function, w is his wealth. What
restrictions on w, b, and c are required to ensure that u(w) is strictly increasing and strictly
concave? Show that under these restrictions, u(w) displays increasing absolute risk aversion.
(b) Suppose Rick has to pay $2 for a ticket to enter a competition. The prize is $19 and the
probability that he will win is 1/3. Rick has an expected utility of wealth function
u(w) = log (w) and his current wealth is $10.

(i) What is the certainty equivalent of this competition?
(ii) What is the risk premium?
(iii) Should Rick enter the competition?
(c) Jennifer is sending a package worth $10,000 to a friend through the mail. She estimates that
there is a 0.1% chance that the package will be lost or completely destroyed in transit. An
insurance company offers her insurance against this eventuality for a premium of $15. If Jennifer
is risk-neutral, explain whether or not she should accept the insurance company's offer.


November 7, 2012