Do not turn over until you are told to do so by the Invigilator.

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1 UNIVERSITY OF EAST ANGLIA School of Economics Main Series PG Examination ECONOMIC THEORY I ECO-M005 Time allowed: 2 hours This exam has three sections. Section A (40 marks) asks true/false questions, Section B (40 marks) is problem-based, and Section C (30 marks) is discursive. You may attempt all questions. Please note that there are 110 points available in total, but that your final mark will be capped at 100. (So, if you collect 55 out of 110 points, your final mark will be 55%, not 50%; and if you collect 100 or more points, your final mark will be 100%.) Notes are not permitted. Do not turn over until you are told to do so by the Invigilator. Do not take this document out of the exam room; submit it along with the answer booklet. ECO-M005 Module Contact: Prof Franz Dietrich, ECO Copyright of The University of East Anglia Version 1

2 Page 2 SECTION A (true/false questions) [40 marks] Exercise 1 [40 marks] Which of these statements are true, which are false? Give your answers on the separate sheet provided. (2 marks are given for each correct answer, 0 marks for every answer that is incorrect or left blank.) Consumer Theory. (Here you should consider a standard consumer s problem.) (1) The indirect utility of a prices-income combination must be a strictly increasing function of income. (2) The expenditure function tells the cost of reaching a particular consumption level as a function of prices. (3) The agent's utility function fully determines his indirect utility function. (4) Whenever two utility functions differ, the corresponding Marshallian demand functions differ. (5) Given an agent s preference relation, one can define the money-metric utility function; this utility function depends on prices. (6) At least one good is a normal good. (7) The Hicksian demand for a good x may be calculated by first calculating the Marshallian demands for all goods, then deriving the indirect utility function, then inverting the latter to obtain the expenditure function, and then differentiating the latter with respect to price of good x. Social Choice and Welfare. (Here you should consider a society of individuals; each individual has a level of welfare that depends on the social state, where the social state could for instance be thought of as the distribution of the various kinds of goods available across people.) (8) If welfare is level-incomparable across people, then it follows that one cannot meaningfully state that citizen Ann is better off than citizen Bob in the current society. (9) A non-ordinal notion of welfare is needed to meaningfully state that citizen Ann is better off now than if she switched house with her neighbour. (10) If Peter is the worst-off in society, then any redistribution which benefits him (although he stays the worst-off) improves society according to welfare prioritarianism (in the maximin-version).

3 Page 3 (11) Some strict Pareto-improvements make society worse from an egalitarian perspective. (12) If everyone is allocated the same amount from each good, the allocation is necessarily Pareto-efficient since any re-allocation would reduce at least one person s allocation. (13) A welfarist theory of the social good does not consider people's freedoms and rights as goals in themselves, but may care about any effect they may have on people's levels of welfare. (14) Welfare prioritarianism (in the maximin version) requires non-ordinal welfare. Firm theory. (You should consider a standard profit-maximizing firm.) (15) Profit maximization implies that the firm produces an amount of output for which average cost is minimal. (16) In a competitive market (in which all firms are price takers), two firms which produce the same good and both make a profit must have the same production function. Free markets and market failure. (17) In a Walrasian equilibrium of a production economy (under the idealizing assumptions of general equilibrium theory), price ratios reveal at the same time the relative value of goods for people and the relative production costs of goods (measured by the marginal rate of substitution and marginal rate of transformation, respectively). Game Theory. (18) There are static games in which each player can play a best response to the other players' moves regardless of how well he predicts these moves. (19) Any static game with perfect information can be seen as a special Bayesian game in which each player has only one possible type, so that beliefs about types are trivial. (20) In any perfect Bayesian equilibrium, the strategies fully determine the beliefs which an agent must hold as his information sets, because the strategies imply what is correct to believe. TURN OVER

4 Page 4 SECTION B (problem-type) [40 marks] Exercise 2 [20 marks] Bob has a budget of 300 Pounds and chooses between two goods, food (bought at shops) and films (bought at an art cinema). Each unit of food costs 1 Pound, and each film costs 3 Pounds. (a) Draw a diagram with Bob s budget line. Consider three hypothetical utility functions (personalities) that Bob might have: (i) U(x, y) = y (ii) U(x, y) = min{x, y} (iii) U(x, y) = max{x, y}. For each one, tell (without justification) which food-film bundle Bob will buy, and on the previous diagram plot this bundle and draw the indifference curve containing it. [8 marks] (b) For each of the utility functions (i), (ii) and (iii), show, for instance by two examples, that the function is neither increasing (monotonic) nor quasiconcave. (So Bob, a typical consumer, will probably not have the preferences (i), (ii), or (iii).) [4 marks] (c) Now assume more realistically that Bob s utility function is given by, /. How many films does he consume, depending on the price of films q (keeping the price of food at p = 1)? [6 Marks] (d) Suppose the government would like people to consume more art films and also to spend less money on art films. The government forces the cinema to lower its price of films q. Does this measure achieve the government s two goals? You should take Bob as a representative consumer with the utility function specified in (c). [2 Marks] Exercise 3 [20 marks] We consider a small society of three individuals. Its government needs to decide how to reform the society. It faces the choice between three potential new states of society, labelled a, b, and c (they might differ in the distribution of goods across people). The three states result in the following distributions of utility/welfare to the three individuals: a: (1,1,1) b: (8,2,2) c: (10,30,-10).

5 Page 5 (a) Rank the four social states in terms of (i) utilitarianism, (ii) welfare egalitarianism with inequality measured by the first absolute moment, (iii) welfare prioritarianism in the (extreme) sense of maximinimization, and (iv) Paretianism, i.e., the Pareto criterion. [10 marks] (b) One minister believes that the government s limited empirical data about people does not allow it to make comparisons between people s levels of welfare. If he is right, the government cannot decide on egalitarian or prioritarian grounds. Explain this point by showing that the egalitarian and prioritarian rankings of the three states are not robust to adding a level k to the second individual s welfare level in each state (you only need to specify a value of k for which the egalitarian ranking changes, and another value of k for which the prioritarian ranking changes). [6 marks] (c) Another minister believes that welfare is only ordinally measurable (but interpersonally comparable). If he is right, the government cannot decide on utilitarian grounds. Explain this point by showing through an example that the utilitarian judgment on which of the states is best can change if individual welfare is re-scaled by applying an increasing transformation. [4 marks] SECTION C (discursive) [30 marks] Choose and answer only one of the following two exercises: Exercise 4 Even if a firm is a pure profit-maximiser, it might care about its external effects if its reputation is at risk Explain and discuss critically. Exercise 5 In some interactive settings (strategic games), individually optimal behaviour of every person leads to a bad outcome for the group. Explain and discuss, also using an example. TURN OVER

6 Page 6 Write down your student registration number here: Give your answers for Part A in this table: Statement Tick if true Tick if false END OF PAPER