John Riley Draft 4 Spring 2013

Econ 201C Microeconomic Theory

Homework 3

Hand in by the beginning of the TA session on Friday May 11.

1. Sealed bid auctions with two identical items for sale.

There are two identical items for sale. There are four bidders each of whom has a value which is
an independent draw from a distribution with support [0, β ] and c.d.f. F (θ ) ∈  .

Sealed own bid auction

(a) Suppose that the two highest bidders pay their own bid. If the other buyers bid according to
the equilibrium bidding strategy B(θ ) and buyer 3 bids B( x) obtain an expression for the win
probability w( x) . Hence obtain an expression for the equilibrium bid function in terms of the
win probability.

(b) For this part only, solve for the equilibrium bid function if values are uniformly distributed
on [0,1].

BONUS POINT As you can confirm, the equilibrium bid function with a uniform distribution is
lower than the bid function with three buyers and one item for sale. Is this a general result?

Sealed second price

(c) If the seller sells to the two highest bidders at the second price, explain carefully whether it is
a dominant strategy for buyers to bid their values.

(c) Compare the equilibrium expected buyer payoffs and hence expected seller revenue in the
two auctions.

2. Portfolio choice

An investor with wealth W can purchase a riskless asset with a return of 1 + r per dollar invested
and can invest in a risky asset with a yield of 1 + r + θ per dollar invested. The random variable
θ has support [α , β ] and c.d.f F (θ ) ∈  . Her utility function is v(c) = ln c .

(a) Show that if she invests x in the risky asset and the rest of her wealth in the riskless asset her
expected utility is
β
=
U ( x) ∫
α
ln(W (1 + r ) + xθ ) F ′(θ ) .

(You may assume that final wealth is always positive.)

John Riley Draft 4 Spring 2013

(a) Show that for some function g ( x, θ ) , U ′( x) can be written as follows.

β
U ′( x) = ∫ g ( x, θ ) F ′(θ )dθ
α

(b) Show that U ′(0) > 0 if and only if E{θ } > 0 . Thus she invests in the risky asset if and only if
it has a higher expected return.

(c) Why is it that a risk averse investor will invest in what may be a highly risky asset even if its
mean return is only slightly larger than the riskless return?

(d) Show that U ( x) is concave.

(e) Show that g ( x, θ ) is a strictly concave function of θ .

(f) The difference in returns changes from θA to θB . If the latter is a mean preserving spread of
the former show that U A′ ( x) > U B′ ( x) .

(g) What does this imply about the optimal holding of the risky asset?

3. Principal agent Problem

Consider the problem on the spreadsheet with three output levels and three actions. The
information constrained PE frontiers that induce each action are computed on three sheets and
the results are displayed graphically on the results sheet. The upper envelope of the three curves
depicts the information constrained efficient payoffs. The agent is risk averse with utility
function V ( w) = −α (1 + w)1− β , β > 1 . The principal is risk neutral.

(a) Suppose that the agent has an outside opportunity that pays a wage of wo = 800 and has an
“effort” cost Co = 1.25 . Which action will an expected profit-maximizing principal induce?

(b) The cost C ( x2 ) of taking action x2 rises. For what values of this cost is x2 never Pareto
efficient?