IB9T90

University of Warwick
January 2023
Analysis of Economic Behaviour

Instructions

This is closed book examination.

Time allowed: 2 hours

There are 5 questions. Please answer all parts of all questions.

Use of calculator is permitted

The weights of each question are provided in parentheses.

Continued…/

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Question 1: (18 marks)

a. (6 marks) State the ‘Law of demand’ and explain the implications it might impose on
demand curves.

Answer: The ‘Law of demand’ states that (assuming all else is fixed) the demand for a good
decreases when its price increases and vice versa, the demand increases when its price
decreases.

b. (6 marks) Ben’s demand curve for X, ( ), satisfies (4) = 5 and (2) = 3. Does Ben’s
demand curve satisfy the Law of demand? Explain your answer.

Answer: No, it does not (since 4 > 2 yet (4) is greater than (2)).

c. (6 marks) Assume that Ben’s income and the price of Y are fixed. Does Ben prefer the price
of X to be equal to 4 or to 2? Show your work and explain your answer.

Answer: Ben prefers the price of X to be equal to 2.

The decrease of from 4 to 2 expands the budget set by moving the intersection of the
budget line with the X-axis to the right, from I/4 to I/2 (the intersection with the Y-axis
does not change). Let and denote the optimal baskets for = 4 and = 2,
respectively. Being a rational consumer, Ben’s choice of B when drops from 4 to 2,
while A is still affordable, indicates that he prefers B to A. Hence, Ben prefers the price of X
to be equal to 2.
__________________________________________________________________________________

Question 2: (15 marks)

a. (5 marks) Provide definitions of the concepts ‘interior optimal consumption basket’ and
‘boundary optimal consumption basket’.

Answer: An optimal consumption basket (a basket that belongs to the budget line and
maximizes utility over the budget set) is an interior optimal consumption basket if it belongs
to the interior of the non-negative XY-plane. That is, if both X > 0 and Y > 0.
An optimal consumption basket is a boundary optimal consumption basket if it belongs to
the boundary of the non-negative XY-plane. That is, it is either (0, ) or ( , 0) .

b. (5 marks) Is the following statement correct? Either prove it or provide a counter example
[Explain your answer]:

“At an interior optimal consumption basket, the marginal rate of substitution must be equal
to ratio of the prices.”

Answer: The statement is correct, assuming that the indifference curve through the interior
optimal basket is smooth and that the MRS is well-defined. To prove it, note that if (at that
basket) the MRS is greater than the ratio of the prices then > and hence >

. This implies that a slight increase in the consumption of X at the expense of Y, by

moving along the budget line, improves the utility level. Similarly, if the MRS is smaller than

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the ratio of the prices then the utility can go up by a slight increase in the consumption of Y
at the expense of X.

c. (5 marks) Is the following statement correct? Either prove it or provide a counter example
[Explain your answer]:

“At a boundary optimal consumption basket, the marginal rate of substitution must be
different from ratio of the prices.”

Answer: The statement is incorrect since the MRS at boundary optimal consumption basket
may be equal to the ratio of the prices.
Example. Assume ( , ) = ( + 1), = 2, = 2, = 1 and consider the boundary
point (0,2). At this point = =2= , hence it is a boundary optimal basket and
the MRS is equal to the ratio of the prices.
__________________________________________________________________________________

Question 3: (27 marks) A production function is given by = 10! ⁄"$ ⁄" , where is output, ! is
labor, and $ is capital. Consider the following three input-pair points E = (16,100), A = (40,40) and F
= (80,20), all lie in the labor-capital plane.

a. (3 marks) Verify that all three points belong to the same isoquant.

Answer: Note that (!, $) = 10! ⁄" $ ⁄" = 10(!$) ⁄" and that for all three points,
(!$) ⁄" = (1600) ⁄" = 40. Hence all points belong to the = 400 isoquant.

b. (7 marks) Find input prices, w for labor and r for capital, such that A will be the point that
minimize cost of producing = 400 . Show your work and explain your answer.

Answer: To minimize cost at A = (40,40), the inputs price ratio w/r must be equal to the
MRTS at this point (the tangency condition). For this production function, ()*+(!, $) =
( ! $ 40
( $
(!, $) = ! , and ()*+(40,40) = 40 = 1 . Hence, 1 = w/r and w = r. For instance,
take w = r = 5.

c. (7 marks) For the same labor price found in part b, find a different price for capital such
that E will be the point that minimize cost of producing = 400 . Show your work and
explain your answer.

Answer: At E, and assuming w = 5, the tangency condition is 100/16 = 5/r. Hence the new
capital price is r = 0.8.

d. (8 marks) Assume that w = r = 5 and find the long-run total cost curve for this production
function. Show your work and explain your answer.

, .
Answer: For all output levels Q, the tangency condition = . = 1 implies K = L. Therefore,
-
/
the constraint becomes = 10! ⁄"
$ ⁄"
= 10! ⁄"
! ⁄"
= 10!, and hence !( ) = and
0
/
$( ) = 0
.
Therefore,

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*1( ) = 2!( ) + 3$( ) = 5 +5 = .

10 10

e. (2 marks) Does this production function satisfy increasing, constant, or decreasing returns
to scale? Explain you answer.

Answer: It satisfies constant returns to scale since for all t > 1,

⁄" ⁄" ⁄" ⁄"

(4!, 4$) = 10(4!) (4$) = 4[10! $ ] = 4 (!, $)

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Question 4: (20 marks) Consider the following simultaneous move game:

Player 2

Left Right

Top 10 , -10 8 , -8

Player 1 Middle -20 , 20 -30 , 30

Bottom X,Y -X , 15

a. (4 marks) Define a ‘zero-sum game’. For what values of X and Y will this game be a zero-
sum game? Explain your answer.
Answer: In a zero-sum game, for any pair of strategies of the two players (i.e., at each cell
of the payoff matrix) the sum of the players’ payoffs is zero. Hence, X = 15 and Y = -15.

b. (8 marks) Assume X = Y = 12. Does this game have a pure strategy Nash equilibrium? If it
does, find all pure strategy Nash equilibria. Explain your work.
Answer:
Player 2

Left Right

Top 10 , -10 8 , -8

Player 1 Middle -20 , 20 -30 , 30

Bottom 12 , 12 -12 , 15

As can be seen by underlying the best-response strategies, the pair (Top, Right) is a pure
strategy Nash equilibrium, and is the only such equilibrium (note that Right is a dominant
strategy for Player 2).

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c. (8 marks) Assume X = 7 and Y = 20. Can (in this game) a process of sequential elimination
of dominated strategies lead to a unique pair of strategies? Explain your work.

Answer:
Player 2

Left Right

Top 10 , -10 8 , -8

Player 1 Middle -20 , 20 -30 , 30

Bottom 7 , 20 -7 , 15

Yes. As can be seen, Middle and Bottom are dominated by Top, hence Player 1 will never
choose any of them and they can be eliminated. Realizing this, Player 2 will prefer Right
and hence Left can be eliminated. Consequently, only one pair of strategies is left: (Top,
Right).

__________________________________________________________________________________

Question 5: (20 marks) Charles has a utility function 7( ) = 1 − , where > 0 denotes his total
wealth.

a. (3 marks) Determine his attitude towards risk. In other words, is Charles risk-neutral, risk-
averse or risk-loving? Explain your answer.

"
Answer: Charles is risk-averse since 7′′( ) = − : is negative for all > 0.

b. (9 marks) Suppose that Charles must choose between the following two options.

Option A: yielding total wealth of 10, with certainty;

Option B: yielding total wealth of 4, with a probability of 0.98, or 400, with a probability of
0.02.

Which option will Charles choose? Give your answer to 2 decimal places and explain your
work.

Answer: Charles attains a utility level of 7(10) = 1 − 0

= 0.9 from Option A. Option B yields
an expected utility level of
1 1
< ( ) = 0.987(4) + 0.027(400) = 0.98 >1 − ? + 0.02 >1 − ? = 0.75
4 400
Hence, Charles prefers Option A.

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c. (8 marks) Suppose that Charles learns about an expert who charges 3 for her services and
can correctly predict the outcome of Option B. Will Charles choose to pay for this service?
Explain your work.

Answer: Paying for the service will enable Charles to choose optimally depending on the
prediction. That is, Option A if B’s outcome is going to be 4, and Option B otherwise. And as
he needs to pay for the service in advance (before hearing the prediction), buying it yields
an expected utility level of
1 1
< (AB3CDEB) = 0.987(10 − 3) + 0.027(400 − 3) = 0.98 >1 − ? + 0.02 >1 − ?
7 397
= 0.86

As Option A is still better, Charles will choose not to pay 3 for this service.
3 is too high a price for Charles

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