Solution to Q2 - Problem set 9 Intermediate microeconomics: Information Economics –

Fall 2020

Question 2: Ch. 5, Pg. 356. Q. 10

a. 𝑈’(𝑤) = 50 − 2𝑤

𝑈’’(𝑤) = −2 < 0

Marginal utility decreases as wealth increases → individual is risk averse.

b. max 𝐸𝑈 = 𝜋(50𝑥 − 𝑥 $ ) + (1 − 𝜋)(50𝑦 − 𝑦 $ ) (1)

s. t. 𝜋𝑥 + (1 − 𝜋)𝑦 = 𝜋10 + (1 − 𝜋)20 (2)

%&'((&*%)$' %
From (2): 𝑦 = &*%
− &*% 𝑥

We plug it in (1):

max 𝐸𝑈 = 𝜋(50𝑥 − 𝑥 $ )
!,#
$
𝜋10 + (1 − 𝜋)20 𝜋 𝜋10 + (1 − 𝜋)20 𝜋
+ (1 − 𝜋) :50 ; − 𝑥< − ; − 𝑥< =
1−𝜋 1−𝜋 1−𝜋 1−𝜋

% $% %&'((&*%)$' %
F.O.C: 𝜋(50 − 2𝑥) + (1 − 𝜋) >50 ?− &*%@ + &*% ? &*%
− &*% 𝑥@A = 0 ↔

𝜋10 + (1 − 𝜋)20 𝜋
↔ 𝜋(50 − 2𝑥) − 50𝜋 + 2𝜋 ; − 𝑥< = 0 ↔
1−𝜋 1−𝜋

𝜋10 + (1 − 𝜋)20 𝜋
↔ −2𝜋𝑥 + 2𝜋 ; − 𝑥< = 0 ↔
1−𝜋 1−𝜋

𝜋10 + (1 − 𝜋)20 𝜋
↔𝑥=; − 𝑥< ↔ 𝑥(1 − 𝜋) + 𝜋𝑥 = 𝜋10 + (1 − 𝜋)20 ↔
1−𝜋 1−𝜋

↔ 𝑥 = 𝜋10 + (1 − 𝜋)20

𝜋10 + (1 − 𝜋)20 𝜋
→𝑦= − (𝜋10 + (1 − 𝜋)20) = 𝜋10 + (1 − 𝜋)20
1−𝜋 1−𝜋

→ 𝑥 = 𝑦 = 𝜋10 + (1 − 𝜋)20

Note: we have covered the general proof in class. See Lecture on Decisions under Uncertainty.

1
 c. Zero-profit line: 0.1𝑥 + 0.9𝑦 = 0.1 × 10 + 0.9 × 20 = 19 ↔ 0.1𝑥 + 0.9𝑦 = 19

max 𝐸𝑈 = 0.1(50𝑥 − 𝑥 $ ) + 0.9(50𝑦 − 𝑦 $ ) (1)

s. t. 0.1𝑥 + 0.9𝑦 = 19 (2)

From (2): 𝑥 = 190 − 9𝑦

We plug in (1):

max 𝐸𝑈 = 0.1(50(190 − 9𝑦) − (190 − 9𝑦)$ ) + 0.9(50𝑦 − 𝑦 $ )

F.O.C: 0.1(50(−9) − 2(190 − 9𝑦)(−9) + 0.9(50 − 2𝑦) = 0 ↔

↔ −0.9(50 − 2(190 − 9𝑦)) + 0.9(50 − 2𝑦) = 0 ↔

↔ 50 − 2𝑦 = 50 − 2(190 − 9𝑦) ↔ 20𝑦 = 380 ↔ 𝑦 = 19

→ 𝑥 = 190 − 9(19) = 19

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Alternative (shorter) answer: We can apply the complete insurance theorem:

𝑥 = 𝑦 = 19

d. 𝑥 = 𝑦 = 0.2 × 10 + 0.8 × 20 = 18

e.

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Computations for separating equilibrium.

H types: full information contract → 𝑥 = 𝑦 = 18 → 𝐸𝑈 = 50 × 18 − 18$ = 576

L types:

$ $
max 𝐸𝑈, = 0.1 ?50𝑥,- − 𝑥,- @ + 0.9 ?50𝑦,- − 𝑦,- @ (1)
!,#

s. t. 0.1𝑥,- + 0.9𝑦,- = 19 (2)

$ $
From (3): 0.2 ?50𝑥,- − 𝑥,- @ + 0.8 ?50𝑦,- − 𝑦,- @ = 576

From (2): 𝑥,- = 190 − 9𝑦,-

We plug in (3) to get:

$
0.2(50(190 − 9𝑦,- ) − (190 − 9𝑦,- )$ ) + 0.8 ?50𝑦,- − 𝑦,- @ = 576 ↔
$
↔ (50(190 − 9𝑦,- ) − (190 − 9𝑦,- )$ ) + 4 ?50𝑦,- − 𝑦,- @ = 2880 ↔
$ $
↔ 9500 − 450𝑦,- − ?36100 − 3420𝑦,- + 81𝑦,- @ + 200𝑦,- − 4𝑦,- − 2880 = 0 ↔
$ $
↔ −85𝑦,- + 3170𝑦,- − 29480 = 0 ↔ −8.5𝑦,- + 317𝑦,- − 2948 = 0

−317 ± √317$ − 4 × 8.5 × 2948

→ 𝑦,- = 19.59
→ 𝑥,- = 190 − 9 × 19.59 = 13.69

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Check:

0.2(50(13.69) − (13.69)$ ) + 0.8(50(19.59) − 19.59$ ) = 576