Advanced Mathematical Economics Tutorial 2 Answers

There are two states alternate in deciding on allocation of resources for either consumption or
military purposes. Depending on the rival state’s military capacity, the state either attacks the
rival or maintains the status quo. If the state attacks the rival, the war will end up in either one of
them taking over the other. The probability of victory depends on the military technology and the
relative size of the military budgets of the states. If the state decides to maintain the status quo, in
the next period the other state makes the same decision of allocation of resources either for
consumption or military purposes and the decision of either attacking the rival or maintaining the
status quo. We will analyze the equilibrium path where none of the states chooses to attack and
peace perpetuates infinitely. This is the peaceful Markov perfect equilibrium.

2. THE PEACEFUL MARKOV PERFECT EQUILIBRIUM

In the peaceful Markov perfect equilibrium, State 2 sets her defense spending so that State 1 is
indifferent between staying with the status quo and undertaking the offense to change the status
quo. This level of defense for State 2 we denote it as d 2* .

⎧ * ⎛ 1 ⎞⎫
⎨( R1 + g1 − d1 ) ⎜ ⎟⎬
⎩ ⎝ 1 − δ ⎠⎭
1
⎧ ⎛ δ ⎞⎫
− ⎨( R1 + g1 − a1* ) + P ( a1* , d 2* ) ( R1 + R2 + G − C ) ⎜ ⎟⎬ = 0
⎩ ⎝ 1 − δ ⎠⎭

The first bracket in equation 1 is the payoff to staying at the status quo. The second bracket is the
payoff to attacking. For convenience, we denote equation 1 as Y .

In equation 1, a1* is optimal military allocation of State 1 should State 1 choose to attack State 2.
d1* is the optimal peacetime military allocation of State 1.1 d 2* is the optimal peacetime
military allocation of State 2. P denotes the probability of victory for State 1 when State 1
undertakes the offensive. R1 is the gross payoff of State 1 (net of gains from trade and other
forms of international economic cooperation with State 2) under the status quo. R2 is the gross
payoff of State 2 (net of gains from trade and other forms of international economic cooperation
with State 1) under the status quo. C is the destruction caused by war. R1 + R2 + G is the payoff
from the unified empire won by war. G refers to the level of potential gains from full economic
integration under a political union. δ is the time discount factor.

We use the offence defense version of conflict technology function.

1
The superscript * denotes that the entity is at the optimal value. The subscripts 1 and 2 denote that the entity
belongs to either State 1 or 2.
 β a1
P= 2
β a1 + d 2

is the probability that the attacker, State 1, prevails. β measures the advantage of being on the
offense. When β is greater (smaller) than one, offense (defense) has the advantage.

a1* in equation 1 is the optimal solution to the following problem:

⎛ δ ⎞
max A1 = ( R1 + g1 − a1* ) + P ( a1* , d 2* ) ( R1 + R2 + G − C ) ⎜ ⎟ 3
a1
⎝ 1− δ ⎠

The first order condition is

∂ A1 β d2 ⎛ δ ⎞
2 ( 1
= −1 + R + R2 + G − C ) ⎜ ⎟=0 4
∂ a1 ( β a1 + d 2 ) ⎝ 1− δ ⎠

For convenience, we refer to equation 4 as U .

The second order condition is:

∂ 2 A1 −2 β 2 d 2 δ
= ( R1 + R2 + G − C ) ⎛⎜ ⎞
⎟<0 5
∂ a1 ( β a1 + d 2 )
2
⎝ 1− δ ⎠

Similarly, State 1 chooses d1* so that State 2 is indifferent between attacking and staying with the
status quo.

⎧ * ⎛ 1 ⎞⎫
⎨( R2 + g 2 − d 2 ) ⎜ ⎟⎬
⎩ ⎝ 1 − δ ⎠⎭
6
⎧ ⎛ δ ⎞⎫
− ⎨( R2 + g 2 − a2* ) + Q ( a2* , d1* ) ( R1 + R2 + G − C ) ⎜ ⎟⎬ = 0
⎩ ⎝ 1− δ ⎠⎭

The first bracket is the payoff to staying at the status quo. The second bracket is the payoff to
attacking. a2* is optimal military allocation of State 2 should State 2 chooses to attack State 1.
For convenience, we refer to equation 6 as Z .

β a2
Q= 7
β a2 + d1

denotes the probability of victory for State 2 when State 2 undertakes the offensive.
a2* in above equation is the optimal solution to the following problem:

⎛ δ ⎞
max A2 = ( R2 + g 2 − a2* ) + Q ( a2* , d1* ) ( R1 + R2 + G − C ) ⎜ ⎟ 8
a2
⎝ 1−δ ⎠

The first order condition is

∂ A2 β d1 ⎛ δ ⎞
2 ( 1
= −1 + R + R2 + G − C ) ⎜ ⎟=0 9
∂ a2 ( β a2 + d1 ) ⎝1−δ ⎠

For convenience, we refer to equation 9 as V .

The second order condition is:

∂ 2 A2 −2β 2 d1 ⎛ δ ⎞
3 ( 1
= R + R2 + G − C ) ⎜ ⎟<0 10
∂ a2 ( β a2 + d1 )
2
⎝ 1− δ ⎠

3. COMPARATIVE STATICS

For comparative statics, we first derive the followings:

∂Y −1
= <0
∂ d1 1 − δ

∂Y β a1 ⎛ δ ⎞
2 ( 1
= R + R2 + G − C ) ⎜ ⎟>0
∂ d 2 ( β a1 + d 2 ) ⎝ 1− δ ⎠

∂Y
=0
∂ a1

∂Y
=0
∂ a2

∂Z β a2 ⎛ δ ⎞
2 ( 1
= R + R2 + G − C ) ⎜ ⎟>0
∂ d1 ( β a2 + d1 ) ⎝ 1− δ ⎠

∂Z −1
= <0
∂ d2 1 − δ
∂Z
=0
∂ a1

∂Z
=0
∂ a2

∂U
=0
∂ d1

∂ U β ( β a1 − d 2 ) ⎛ δ ⎞
3 ( 1
= R + R2 + G − C ) ⎜ ⎟>0
∂ d 2 ( β a1 + d 2 ) ⎝ 1− δ ⎠

(It is assuming that State 1 chooses to attack only when it has a higher probability of winning.)

∂U −2β 2 d 2 δ
= ( R1 + R2 + G − C ) ⎛⎜ ⎞
⎟<0
∂ a1 ( β a1 + d 2 ) ⎝ 1− δ ⎠

∂U
=0
∂ a2

∂ V β ( β a2 − d1 ) ⎛ δ ⎞
3 ( 1
= R + R2 + G − C ) ⎜ ⎟>0
∂ d1 ( β a2 + d1 ) ⎝ 1− δ ⎠

(It is assuming that State 1 chooses to attack only when it has a higher probability of winning.)

∂V
=0
∂ d2

∂V
=0
∂ a1

∂V −2 β 2 d1 ⎛ δ ⎞
3 ( 1
= R + R2 + G − C ) ⎜ ⎟<0
∂ a2 ( β a2 + d1 ) ⎝ 1− δ ⎠

The Jacobian is
 ∂Y ∂Y ∂Y ∂Y ∂Y ∂Y
0 0
∂ d1 ∂ d2 ∂ a1 ∂ a2 ∂ d1 ∂ d2
∂Z ∂Z ∂Z ∂Z ∂Z ∂Z
0 0
∂ d1 ∂ d2 ∂ a1 ∂ a2 ∂ d1 ∂ d2
J = =
∂U ∂U ∂U ∂U ∂U ∂U
0 0
∂ d1 ∂ d2 ∂ a1 ∂ a2 ∂ d2 ∂ a1
∂V ∂V ∂V ∂V ∂V ∂V
0 0
∂ d1 ∂ d2 ∂ a1 ∂ a2 ∂ d1 ∂ a2
∂V ∂U ⎛ ∂Y ∂ Z ∂Y ∂ Z ⎞
= ⎜ − ⎟<0
∂ a2 ∂ a1 ⎝ ∂ d1 ∂ d 2 ∂ d 2 ∂ d1 ⎠

At the peaceful Markov perfect equilibrium where d1* and d 2* are optimally set at the
∂Z ∂Y
∂ d1 ∂ d1
minimum levels required for maintaining peace, − has a greater slope than −
∂Z ∂Y
∂ d2 ∂ d2
and the Jacobian is negative.2

Proposition 1:

An increase in the offense advantage increases defense expenditures of both countries.

Proof:
∂Y ( a1d 2 ) δ ⎞
=− ( R1 + R2 + G − C ) ⎛⎜ ⎟<0
∂β ( β a1 + d 2 ) ⎝ 1−δ ⎠
2

∂Z ( a2 d1 ) R + R + G − C ⎛ δ ⎞ < 0
2 ( 1 )⎜
=− ⎟
∂β ( β a2 + d1 ) ⎝ 1−δ ⎠
2

∂ U d 2 ( d 2 − β a1 ) ⎛ δ ⎞
3 ( 1
= R + R2 + G − C ) ⎜ ⎟<0
∂β ( β a1 + d 2 ) ⎝ 1−δ ⎠

(It is assuming that State 1 chooses to attack only when it has a probability of winning greater
than half.)

∂ V d1 ( d1 − β a2 ) ⎛ δ ⎞
3 ( 1
= R + R2 + G − C ) ⎜ ⎟<0
∂β ( β a2 + d1 ) ⎝ 1− δ ⎠

(It is assuming that State 2 chooses to attack only when it has a probability of winning greater

2 Refer to Powell (1993; 1999, Ch. 2).

∂Y ∂Y
− 0 0
∂β ∂ d2
∂Z ∂Z
− 0 0
∂β ∂ d2
∂U ∂U ∂U
− 0
∂β ∂ d2 ∂ a1
∂V ∂V
− 0 0
∂d *
∂β ∂ a2 1 ∂V ∂U ⎛ ∂ Y ∂ Z ∂ Y ∂ Z ⎞
=
1
= ⎜− + ⎟>0
∂β J J ∂ a2 ∂ a1 ⎝ ∂β ∂ d 2 ∂ d 2 ∂β ⎠

∂Y ∂Y
− 0 0
∂ d1 ∂β
∂Z ∂Z
− 0 0
∂ d1 ∂β
∂U ∂U
0 − 0
∂β ∂ a1
∂V ∂V ∂V
− 0
∂d *
∂ d1 ∂β ∂ a2 1 ∂V ∂U ⎛ ∂ Y ∂ Z ∂ Y ∂ Z ⎞
=
2
= ⎜− + ⎟>0
∂β J J ∂ a2 ∂ a1 ⎝ ∂ d1 ∂β ∂β ∂ d1 ⎠

Q. E. D.

A greater offense advantage in war makes wars of conquests and taking over more attractive.
Consequently, deterrence requires higher level of defense spending. A good example was that
the gunpowder military revolution which made castles and fortifications less effective ushered in
a period of ballooning size of armies and military spending among European nations.

Proposition 2:

Greater costs of destruction from war lower military expenditures.

Proof:

∂Y ⎛ δ ⎞
= P ( a1 , d 2 ) ⎜ ⎟>0
∂C ⎝ 1−δ ⎠
∂Z ⎛ δ ⎞
= Q ( a2 , d1 ) ⎜ ⎟>0
∂C ⎝ 1−δ ⎠
∂U β d2 ⎛ δ ⎞
=− 2 ⎜ ⎟<0
∂C ( β a1 + d 2 ) ⎝ 1 − δ ⎠
∂V β d1 ⎛ δ ⎞
=− 2 ⎜ ⎟<0
∂C ( β a2 + d1 ) ⎝ 1 − δ ⎠
∂Y ∂Y
− 0 0
∂C ∂ d2
∂Z ∂Z
− 0 0
∂C ∂ d2
∂U ∂U ∂U
− 0
∂C ∂ d2 ∂ a1
∂V ∂V
− 0 0
∂d *
∂C ∂ a2 1 ∂V ∂U ⎛ ∂ Y ∂ Z ∂Y ∂ Z ⎞
=
1
= ⎜− + ⎟<0
∂C J J ∂ a2 ∂ a1 ⎝ ∂ C ∂ d 2 ∂ d 2 ∂ C ⎠

∂Y ∂Y
− 0 0
∂ d1 ∂C
∂Z ∂Z
− 0 0
∂ d1 ∂C
∂U ∂U
0 − 0
∂C ∂ a1
∂V ∂V ∂V
− 0
∂d *
∂ d1 ∂C ∂ a2 1 ∂V ∂U ⎛ ∂ Y ∂ Z ∂ Y ∂ Z ⎞
=
2
= ⎜− + ⎟<0
∂C J J ∂ a2 ∂ a1 ⎝ ∂ d1 ∂ C ∂ C ∂ d1 ⎠

Q. E. D.

A higher level of war destruction costs makes wars less profitable. Consequently, deterrence
requires lower levels of defense spending. This agrees with the argument of “nuclear peace”.

Proposition 3:

An increase in the payoffs to a state under the status quo lowers military expenditures of both
states.

Proof:
∂Y δ
=
∂ R1 1 − δ
(
1 − P ( a1* , d 2* ) > 0)
∂Z ⎛ δ ⎞
= Q ( a2* , d1* ) ⎜ ⎟>0
∂ R1 ⎝ 1− δ ⎠

∂U β d2 ⎛ δ ⎞
= 2 ⎜ ⎟>0
∂ R1 ( β a1 + d 2 ) ⎝ 1 − δ ⎠
∂V β d1 ⎛ δ ⎞
= 2 ⎜ ⎟>0
∂ R1 ( β a2 + d1 ) ⎝ 1 − δ ⎠
∂Y ∂Y
− 0 0
∂ R1 ∂ d2
∂Z ∂Z
− 0 0
∂ R1 ∂ d2
∂U ∂U ∂U
− 0
∂ R1 ∂ d2 ∂ a1
∂V ∂V
− 0 0
∂d *
∂ R1 ∂ a2 1 ∂V ∂U ⎛ ∂ Y ∂ Z ∂ Y ∂ Z ⎞
1
= = ⎜− + ⎟<0
∂ R1 J J ∂ a2 ∂ a1 ⎝ ∂ R1 ∂ d 2 ∂ d 2 ∂ R1 ⎠

∂Y ∂Y
− 0 0
∂ d1 ∂ R1
∂Z ∂Z
− 0 0
∂ d1 ∂ R1
∂U ∂U
0 − 0
∂ R1 ∂ a1
∂V ∂V ∂V
− 0
∂d *
∂ d1 ∂ R1 ∂ a2 1 ∂V ∂U ⎛ ∂ Y ∂ Z ∂ Y ∂ Z ⎞
2
= = ⎜− + ⎟<0
∂ R1 J J ∂ a2 ∂ a1 ⎝ ∂ d1 ∂ R1 ∂ R1 ∂ d1 ⎠

∂Y ⎛ δ ⎞
= P ( a1* , d 2* ) ⎜ ⎟>0
∂ R2 ⎝ 1− δ ⎠

∂Z δ
=
∂ R2 1 − δ
(
1 − Q ( a2* , d1* ) > 0 )
∂U β d2 ⎛ δ ⎞
= >0
∂ R2 ( β a1 + d 2 ) ⎝ 1 − δ ⎟⎠
2 ⎜
∂V β d1 ⎛ δ ⎞
= 2 ⎜ ⎟>0
∂ R2 ( β a2 + d1 ) ⎝ 1 − δ ⎠

∂Y ∂Y
− 0 0
∂ R2 ∂ d2
∂Z ∂Z
− 0 0
∂ R2 ∂ d2
∂U ∂U ∂U
− 0
∂ R2 ∂ d2 ∂ a1
∂V ∂V
− 0 0
∂d *
∂ R2 ∂ a2 1 ∂V ∂U ⎛ ∂ Y ∂ Z ∂ Y ∂ Z ⎞
1
= = ⎜− + ⎟<0
∂ R2 J J ∂ a2 ∂ a1 ⎝ ∂ R2 ∂ d 2 ∂ d 2 ∂ R2 ⎠

∂Y ∂Y
− 0 0
∂ d1 ∂ R2
∂Z ∂Z
− 0 0
∂ d1 ∂ R2
∂U ∂U
0 − 0
∂ R2 ∂ a1
∂V ∂V ∂V
− 0
∂d *
∂ d1 ∂ R2 ∂ a2 1 ∂V ∂U ⎛ ∂ Y ∂ Z ∂ Y ∂ Z ⎞
2
= = ⎜− + ⎟<0
∂ R2 J J ∂ a2 ∂ a1 ⎝ ∂ d1 ∂ R2 ∂ R2 ∂ d1 ⎠

Q. E. D.

If a state has a higher payoff under the status quo, then it is more satisfied with the status quo.
Consequently, the rival state needs only a lower level of military expenditures to deter it from
starting a war to change the status quo. As the rival state saves on military expenditures, it also
becomes satisfied with the status quo. Consequently, a lower level of military spending is
enough to prevent it from starting a war to change the status quo too.

Proposition 4:

A larger time discount factor increases military expenditures of the states.

Proof:
∂Y ⎡
2
⎛ 1 ⎞
= ⎣( R1 + g1 − d1* ) − P ( a1* , d 2* ) ( R1 + R2 + G − C ) ⎤⎦ ⎜ ⎟ <0
∂δ ⎝ 1−δ ⎠
∂Z ⎡
2
⎛ 1 ⎞
= ⎣( R2 + g 2 − d 2* ) − Q ( a2* , d1* ) ( R1 + R2 + G − C ) ⎤⎦ ⎜ ⎟ <0
∂δ ⎝ 1−δ ⎠
∂U β d2
2
⎛ 1 ⎞
2 ( 1
= R + R2 + G − C ) ⎜ ⎟ >0
∂δ ( β a1 + d 2 ) ⎝1−δ ⎠
∂V β d1
2
⎛ 1 ⎞
2 ( 1
= R + R2 + G − C ) ⎜ ⎟ >0
∂δ ( β a2 + d1 ) ⎝1−δ ⎠

We therefore have

∂Y ∂Y
− 0 0
∂δ ∂ d2
∂Z ∂Z
− 0 0
∂δ ∂ d2
∂U ∂U ∂U
− 0
∂δ ∂ d2 ∂ a1
∂V ∂V
− 0 0
∂d *
∂δ ∂ a2 1 ∂V ∂U ⎛ ∂ Y ∂ Z ∂ Y ∂ Z ⎞
=
1
= ⎜− + ⎟>0
∂δ J J ∂ a2 ∂ a1 ⎝ ∂δ ∂ d 2 ∂ d 2 ∂δ ⎠

∂Y ∂Y
− 0 0
∂ d1 ∂δ
∂Z ∂Z
− 0 0
∂ d1 ∂δ
∂U ∂U
0 − 0
∂δ ∂ a1
∂V ∂V ∂V
− 0
∂d *
∂ d1 ∂δ ∂ a2 1 ∂V ∂U ⎛ ∂ Y ∂ Z ∂ Y ∂ Z ⎞
=
2
= ⎜− + ⎟>0
∂δ J J ∂ a2 ∂ a1 ⎝ ∂ d1 ∂δ ∂δ ∂ d1 ⎠

Q. E. D.

As states become more patient, they care more about the future and therefore the potential gains
from wars of conquests becomes more attractive. Consequently, deterrence involves greater
defense expenditures.

Proposition 5:
A higher level of realized gains from trade and economic cooperation accruing to either state
lowers military expenditures of both states.

Proof:

∂Y δ
= >0
∂ g1 1 − δ
∂Z
=0
∂g1
∂U
=0
∂ g1
∂V
=0
∂ g1

∂Y ∂Y
− 0 0
∂ g1 ∂ d2
∂Z ∂Z
− 0 0
∂ g1 ∂ d2
∂U ∂U ∂U
− 0
∂ g1 ∂ d2 ∂ a1
∂V ∂V
− 0 0
∂d *
∂ g1 ∂ a2 1 ∂V ∂U ⎛ ∂ Y ∂ Z ∂ Y ∂ Z ⎞
1
= = ⎜− + ⎟<0
∂ g1 J J ∂ a2 ∂ a1 ⎝ ∂ g1 ∂ d 2 ∂ d 2 ∂ g1 ⎠

∂Y ∂Y
− 0 0
∂ d1 ∂ g1
∂Z ∂Z
− 0 0
∂ d1 ∂ g1
∂U ∂U
0 − 0
∂ g1 ∂ a1
∂V ∂V ∂V
− 0
∂d *
∂ d1 ∂ g1 ∂ a2 1 ∂V ∂U ⎛ ∂Y ∂ Z ∂Y ∂ Z ⎞
2
= = ⎜− + ⎟<0
∂ g1 J J ∂ a2 ∂ a1 ⎝ ∂ d1 ∂ g1 ∂ g1 ∂ d1 ⎠

∂Y
=0
∂g 2
∂Z δ
= >0
∂ g2 1 − δ
∂U
=0
∂ g2
∂V
=0
∂ g2

∂Y ∂Y
− 0 0
∂ g2 ∂ d2
∂Z ∂Z
− 0 0
∂ g2 ∂ d2
∂U ∂U ∂U
− 0
∂ g2 ∂ d2 ∂ a1
∂V ∂V
− 0 0
∂d *
∂ g2 ∂ a2 1 ∂V ∂U ⎛ ∂ Y ∂ Z ∂ Y ∂ Z ⎞
1
= = ⎜− + ⎟<0
∂ g2 J J ∂ a2 ∂ a1 ⎝ ∂ g 2 ∂ d 2 ∂ d 2 ∂ g 2 ⎠

∂Y ∂Y
− 0 0
∂ d1 ∂ g2
∂Z ∂Z
− 0 0
∂ d1 ∂ g2
∂U ∂U
0 − 0
∂ g2 ∂ a1
∂V ∂V ∂V
− 0
∂d *
∂ d1 ∂ g2 ∂ a2 1 ∂V ∂U ⎛ ∂ Y ∂ Z ∂ Y ∂ Z ⎞
2
= = ⎜− + ⎟<0
∂ g2 J J ∂ a2 ∂ a1 ⎝ ∂ d1 ∂ g 2 ∂ g 2 ∂ d1 ⎠

Q. E. D.

Higher levels of realized gains from international trade and other forms of economic cooperation
make wars less attractive and lower the levels of defense spending required for deterrence.

Proposition 6:

A higher level of unrealized potential gains from full economic integration increases military
expenditures of both states.

Proof:

∂Y ⎛ δ ⎞
= − P ( a1* , d 2* ) ⎜ ⎟<0
∂G ⎝ 1− δ ⎠
∂Z ⎛ δ ⎞
= −Q ( a2* , d1* ) ⎜ ⎟<0
∂G ⎝ 1− δ ⎠
∂U β d2 ⎛ δ ⎞
= >0
∂ G ( β a1 + d 2 ) ⎝ 1 − δ ⎟⎠
2 ⎜

∂V β d1 ⎛ δ ⎞
= 2 ⎜ ⎟>0
∂ G ( β a2 + d1 ) ⎝ 1 − δ ⎠

∂Y ∂Y
− 0 0
∂G ∂ d2
∂Z ∂Z
− 0 0
∂G ∂ d2
∂U ∂U ∂U
− 0
∂G ∂ d2 ∂ a1
∂V ∂V
− 0 0
∂d *
∂G ∂ a2 1 ∂V ∂U ⎛ ∂Y ∂ Z ∂Y ∂ Z ⎞
=
1
= ⎜− + ⎟>0
∂G J J ∂ a2 ∂ a1 ⎝ ∂ G ∂ d 2 ∂ d 2 ∂ G ⎠

∂Y ∂Y
− 0 0
∂ d1 ∂G
∂Z ∂Z
− 0 0
∂ d1 ∂G
∂U ∂U
0 − 0
∂G ∂ a1
∂V ∂V ∂V
− 0
∂d *
∂ d1 ∂G ∂ a2 1 ∂V ∂U ⎛ ∂Y ∂ Z ∂Y ∂ Z ⎞
=
2
= ⎜− + ⎟>0
∂G J J ∂ a2 ∂ a1 ⎝ ∂ d1 ∂ G ∂ G ∂ d1 ⎠

Higher levels of potential gains from full economic integration under political unification make
war of conquests and taking over more lucrative. Consequently, deterrence requires higher level
of defense spending.