GRA6031 Microeconomics Problem Set
12: Hidden Characteristics II
1. Price discrimination in smartphones
Note: this is a tedious exercise. Any exercise related to this on the exam will be shorter.
The total population of prospective buyers for smartphones is P. A buyer wants to buy at most one
casual ones comprise a fraction, 𝜇, of the population, and the rest, (1- 𝜇), are intensive users.
smartphone. There are two types of prospective buyers: casual users (C) and intensive users (I). The
Mictel Corporation has a world monopoly on the production of smartphones. It can make two kinds of
smartphones, low-end (L) and high-end (H). Mictel wants to maximize its expected profit by
choosing its price policy regarding the low-end and high-end smartphones.
The cost of production of the two kinds of smartphones, and the benefits gained from the two
smartphones by the two types prospective buyers, are given in the following table (all figures in
hundreds of euros).
Cost Benefit for Casual user Benefit for Intensive user
Low-end iPhone 1 4 5
High-end iPhone 3 5 8
Each type of buyer calculates the net payoff (benefits minus price) he would get from each type of
smartphone and buys the type that would give the higher net payoff provided this is nonnegative. If
both types give equally nonnegative net payoffs for a buyer, he goes for the high end; if both types have
negative net payoff for a buyer, he does not purchase.
Suppose Mictel is omniscient, then knowing the type of a prospective customer, the company could
offer to sell him just one type of smartphone at a stated price, on a take-it-or-leave-it basis.
A. Present the extensive form (in which 4 stages have to be distinguished).
B. Provide an example of a strategy regarding the price policy of Mictel.
C. Determine the subgame perfect equilibrium, and explain in words what kind of iPhone Mictel will
offer, at what price, to what kind of buyer?
D. Determine the profit level of Mictel Corporation.
In reality though, Mictel Corporation does not know the type of any particular buyer. It just makes its
‘catalog’ available for all buyers to choose from.
E. Present the extensive form.
F. Provide an example of a strategy regarding the price policy of Mitchel.
The payoff maximizing price policy of Mictel Corporation (part N) when Mitchel Corporation does
not know the type of any particular buyer, will be determined by comparing three policies: Mictel
produces only low-end iPhones (parts G and H); Mictel produces only high-end iPhones (parts I and
J); Mitchel sells both iPhones (parts K-M). Consider first the two pooling equilibria.
G. Suppose Mictel Corporation produces just the low-end iPhones and sells them for price x. What
value of x will maximize its profit? How does the answer depend on c, the proportion of casual users
in the population?
H. Determine the profit level of Mictel Corporation as a function of 𝜇.
I. Suppose Mictel Corporation produces just the high-end phones and sells them for price y. What
value of y will maximize its profit, and how does the answer depend on c?
J. Determine the profit level of Mictel Corporation.
Finally, consider the separating equilibrium. Suppose the company produces both types of phones,
selling the low-end ones for price x and the high-end for price y.
K. What are the incentive-compatibility constraints on x and y that the company must satisfy if it
wants the casual users to buy the low-end smartphones and the intensive users to buy the high-end
ones?
L. What are the participation constraints on x and y that the company must satisfy if it wants the
casual users to buy the low-end smartphones and the intensive users to buy the high-end ones?
M. What values of x and y will maximize the expected profit of Mictel Corporation in this scenario?
N. Determine the profit level of Mictel Corporation.
does the answer depend on 𝜇?
O. Putting all of this together, what production and pricing policy should the company pursue? How
P. Are there values of 𝜇 for which the omniscient Mictel earns more than the Mictel with the catalog?
2. Selection into wage contracts
Assume that there are different types of employees in an industry. The productivity of the employees
(q) varies uniformly between 0 and 1.
A. What is the average productivity of an employee when the different types of employees
are uniformly distributed?
Employees have to choose whether they will work for company Fixedwage or company Piecerate.
Company Fixedrate pays all employees the same wage, where the wage is equal to the average
production by the employees at Fixed wage. Assume that the value of a unit of production is equal to
€1.
Assume that the productivity of an employee cannot be determined without costs. Company Piecerate pays
each employee according to the value of the quantity produced minus the measurement costs .
B .Under which condition do workers decide to work for Piecerate vs. Fixedwage?
[Link] employee is in equilibrium indifferent between working for Fixedwage and Piecerate, and how
does this employee’s productivity compare to the other employees’ productivity at the respective
companies. Show your calculation and explain the logic of your answer.
[Link] which values of is there a separating equilibrium?
Two companies are active in the above industry. The Central Bureau of Statistics has made available the
following data about these two companies:
Company Piecerate Company Fixedwage
# employees 100 100
Production 50 25
Average salary 0,5 0,25
Maximum salary 0,75 0,25
Minimum salary 0,25 0,25
E. Which workers work at Fixedwage? And which workers are therefore at Piecerate?
F. What is the value of ?
Questions are being asked in parliament about these numbers. A member of the conservative party
argues that fixed wages have to be forbidden by law. The argument boils down to the productivity of
employees being higher in a companies with piecerate wages than in a companies with fixed wages,
which is illustrated by referring to the above numbers. A member of the socialist party proposes to
outlaw piecerate wages. The large salary differences in company Piecerate are considered unfair.
G. Which proposal results in the highest total surplus in the industry?
3. Seniority wages
The departure of employees is expensive for a company, especially when it has invested heavily in
their education and training. It will therefore try to attract employees who intend to stay. However, it
is usually impossible for a company to identify such applicants because the characteristic ‘intention to
stay’ is hard to observe. The appropriate design of labor contracts may provide a solution, i.e. labor
contracts can be designed such that only employees with a small probability of leaving are attracted.
Wages are often determined to a certain extent by seniority. There are various explanations for this.
More experience results in higher productivity, and more responsibilities are allocated to persons with
more years of service. Even if the data are corrected for such factors in empirical studies, a positive
relationship remains between age and salary.
Consider two labor contracts. Contract P consists of a salary structure based only on productivity
(which is assumed to be observed). Contracts S consists of a salary structure based partly on
productivity and partly based on seniority. Both contracts result in the same wage over the whole
career.
A. Depict the two labor contracts P and S in a figure with the number of years of having a job (on the
horizontal axis) and earnings in each time period (on the vertical axis).
Consider two types of employees. Both types are assumed to be equally productive, but type L has a
low probability of staying, while type H has a high probability of staying.
B. Depict an iso-utility curve of the L- as well as the H-type in a figure with on the horizontal axis
the extent to which wages are based on seniority wages and on the vertical axis the wage at the end
of the career.
C. Depict in this figure also the two labor contracts P and S.
D. Illustrate in a diagram and in words which salary policy attracts the desired employees.
E. How do you explain that a positive relationship between salary and seniority is usually
accompanied by mandatory retirement?