Microeconomics–Endterm Exam 2015

PGDM Batch 16
Full marks = 100
Solutions

Aug 26, 2015

PART-A
√ √
1. Suppose the production function of a firm is given by q = L K, where q is quantity
of output, L is the amount of labour used and K is the amount of capital. Suppose
the stock of capital is fixed at K = 4. Suppose price of labour is w = 3 and that of
capital is r = 5. [4 + 4 + 4 + 4 = 16 marks]

(a) What is the short run total cost function of the firm?
√ 3q 2
Ans. Putting K = 4 we get q = 2 L and hence C SR = 4
+ 20
(b) Use the answer to part (a) to find the average and marginal cost functions.
Ans. AC SR = 3q
4
+ 20
q
and M C SR = 3q 2

(c) Suppose average cost is minimized at qm . Find qm . Verify that at qm , marginal

cost is equal to average cost. Draw a rough diagram of the average and marginal
cost curves.
Ans.
dAC 3 20
= − 2
dq 4 q
dAC
Setting dq
= 0 we get q ∗ = 5.16. Now for q = 5.16, M C = AC = 7.74
(d) Suppose the firm is a price taker and the market price is 9. Find the profit
maximizing output of the firm. What is the maximum profit?
Ans. We have to set P = M C i.e. 3q 2
= 9, solving we get q ∗ = 6 and Π∗ =
T R − T C = 54 − 47 = 7.

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2. Suppose you are the manager of a watchmaking firm operating in a competitive market.
Your cost of production is given by C = 200 + 2q 2 , where q is total output and C is
total cost. The market price is 100. [6+4+6=16 marks]

(a) How many watches should you produce to maximize profit?

Ans. To find the profit maximizing level of output, we set p = M C(q). M C(q) =
dT C(q)
dq
= 4q. Hence, we solve 100 = 4q which gives q ∗ = 25.
(b) What will the profit level be?
Ans. Profit is given by Π(q) = T R(q) − T C(q). T R(q ∗ ) = 100 × 25 = 2500.
T C(q ∗ ) = 200 + 2 × 252 = 1450. Hence, Π∗ = 1050.
(c) Suppose the firm is already established in the market so that the fixed cost cannot
be avoided even if output is zero. Suppose that there is a sudden fall in price. At
what minimum price will the firm continue to produce a competitive output in
the short run?
Ans. A competitive firm will produce a positive output as long as p > min AV C,
where AV C is average variable cost. AV C = VqC = 2q. Clearly, min AV C = 0.
Hence, the firm will produce positive output for any p > 0.

3. Suppose the inverse demand function for a monopolist is given by P = 100−2Q and the
cost function is given by C(Q) = 5 + 2Q. Now answer the following: [4 + 4 + 4 + 4 = 16
marks]

(a) Determine the profit-maximizing price.

Ans. M R = 100 − 4Q and M C = 2. Equating M R = M C, we get Q∗ = 24.5.
Hence, P ∗ = 100 − 2 × 24.5 = 51.
(b) Determine the profit-maximizing quantity.
Ans. Q∗ = 24.5
(c) Determine the maximum profits earned by the monopolist.
Ans. Π∗ = 51 × 24.5 − (5 + 2 × 24.5) = 1195.5.
(d) Compute the deadweight loss.
Ans. DW = 21 × 49 × 24.5 = 600.25.

4. Suppose the inverse demand function for two firms in a homogeneous-product Stack-
elberg oligopoly is given by P = 50 − (Q1 + Q2 ) and cost functions for the two firms
are as follows:

C1 (Q1 ) = 2Q1
C2 (Q2 ) = 2Q2

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 Firm 1 is the leader, and firm 2 is the follower. Given this setting, answer the following
questions: [4+4+4+4=16 marks]

(a) What is firm 2’s reaction function or best-response function?

Ans. Using the formula for the follower’s reaction function, we find

1
Q2 = R2 (Q1 ) = 24 − Q1
2

(b) What is firm 1’s output?

Ans. Using the formula given for the Stackelberg leader, we find

50 + 2 − 4
Q1 = = 24
2

(c) What is firm 2’s output?

Ans. By plugging the answer from part(b) into the reaction function in part(a),
we find the follower’s output which is Q2 = 24 − 12 24 = 12
(d) What is the market price?
Ans. The market price is obtained from the inverse demand function: P =
50 − (12 + 24) = 14

5. Suppose there are two firms, A and B, in a duopoly market for a homogeneous good.
Suppose the cost of production of both firms is zero. The market demand curve is

P = 30 − Q,

where Q = Q1 + Q2 . [4+4+4+4=16 marks]

(a) Suppose both firms decide their quantity choice simultaneously (Cournot compe-
tition). What is the output and profit of each firm?
Ans. First, we find each firms reaction function. To find Firm 1’s profit function
is

π1 = P Q1 − T C1
= (30 − (Q1 + Q2 ))Q1 ,

since T C1 = 0. The profit maximization condition is given by

∂π1
= 30 − 2Q1 − Q2 = 0
∂Q1

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 30−Q2
which implies Q1 = 2
. Hence, firm 1’s reaction function is

30 − Q2
R1 (Q2 ) = .
2

This is firm 1’s best response function. Firm 2’s profit function is

π2 = (30 − (Q1 + Q2 ))Q2 .

Differentiating with respect to Q2 and setting it equal to zero, we obtain firm 2’s
reaction function
30 − Q1
R2 (Q1 ) = .
2
We now solve Q1 = R1 (Q2 ) and Q2 = R2 (Q1 ). This gives Q∗1 = Q∗2 = 10. Since
total output is 20, price is 10. So, the profit of each firm is 100.
(b) Now suppose the two firms collude. What is the profit maximizing output level
and the associated profit?
Ans. Under collusion, the two firms maximize the joint profit

πm = P (Q1 + Q2 )(Q1 + Q2 )
= (30 − Q1 − Q2 )(Q1 + Q2 )
= 30Q1 + 30Q2 − Q21 − 2Q1 Q2 − Q22 .

We obtain

∂πm
= 30 − 2Q1 − 2Q2
∂Q1
∂πm
= 30 − 2Q1 − 2Q2 .
∂Q2

Setting these equations to zero and solving, we obtain Qm m

1 = Q2 = 7.5. Hence,
total monopoly output is Qm m
1 + Q2 = 15 and the monopoly price is 15. Monopoly
profit is πm = 225.
(c) Suppose the two firms interact only once. Can such collusion be sustained? Why
or why not? Give a precise quantitative answer.
Ans. If the two firms interact only once, collusion cannot be sustained. Each firm
will deviate from the monopoly output. To see this, note that

30 − Qm
2
R1 (Qm
2 ) = = 11.25 > Qm
1
2

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 and
30 − Qm1
R2 (Qm
1 ) = = 11.25 > Qm
2 .
2
Therefore, both firms end up producing more than its share of monopoly output.
As a result total output is greater than the monopoly output of 15.
(d) Suppose the two firms interact repeatedly. In this situation, can collusion be sus-
tained? Describe in words the nature of a strategy that can sustain the collusion.
Ans. If the two firms interact repeatedly, then collusion can be sustained by the
threat of future punishment. If any firm deviate from the monopoly output, then
the two firms would revert to the Cournot-Nash equilibrium. Hence, if the firms
sustain collusion, they can each earn half the monopoly profit ( 2252
= 112.5) for
ever. But if any one deviates, the deviator would get a momentary high profit
but the lower Cournot profit of 100 from the next period. If both players are
sufficiently patient, then they would find sustaining collusion better.

6. Consider the market for baseball caps. You are the CEO of a company, which is the
only producer of baseball caps. Initially, you had been maximizing profits by producing
quantity Q = 90. However, a new firm is considering entering the baseball cap market
to get a share of the positive economic profits being earned. The following decisions
must be made: you must decide whether to continue producing quantity Q = 90 (the
profit maximizing level of production for a monopoly) or to produce Q = 150 (you
would produce 150 baseball caps in an effort drive market price down so low that the
new firm would rather not enter the cap making industry); the new firm must decide
whether to enter the market and produce Q = 50 or not enter the market and produce
nothing (Q = 0). We are therefore assuming that you can produce Q = 90 or Q = 150
and the new firm can produce Q = 0 or Q = 50. This situation is depicted using a
payoff matrix. For parts (a) - (c), assume you and the new firm must decide how much
to produce simultaneously.
 
QY = 90 QY = 150
 QN F = 0 0, 8000 0, 4500 ,
 

QN F = 50 500, 3600 −2500, −3000

where QN F denotes the new firm’s output and QY denotes your output. The numbers
in the matrix denote profits. [3+3+3+7=16 marks]

(a) Do you have a dominant strategy? If so, what is it? Justify your answer.
Ans. The existing firm’s dominant strategy is QY = 90. Irrespective of what the
new firm does, the existing firm always gets a higher payoff with QY = 90.
(b) Does the new firm have a dominant strategy? If so, what is it? Justify your

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 answer.
Ans. The new firm does not have a dominant strategy. If QY = 90, the new
firm’s best response is QN F = 50 and if QY = 150, the new firm’s best response is
QN F = 0. So the new firm’s best response depends upon the action of the existing
firm. Hence, it does not have a dominant strategy.
(c) Find the Nash Equilibrium for this game.
Ans. The Nash equilibrium is (QN F = 50, QY = 90).
(d) Now suppose your firm (being more established and trusted by the consumer) is
the dominant firm in the industry such that you decide how much to produce
first and the new firm decides how much to produce second. Find the Stackelberg
Equilibrium for this game. State how much you and the new firm produce. (For
full credit, you must demonstrate the procedure used to obtain the Stackelberg
Equilibrium).
Ans. The Stackelberg equilibrium is (QN F = 0, QY = 150).

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 PART-B
(Instructions: Answer all the questions. Write the correct answer beneath the question
number in capitals. Circled or tick-marked answers will NOT be graded.)

Question no Questions
1 A market is a natural monopoly when
A. A good is produced most economically by several firms
B. A good is produced most economically by one firm
C. The government grants a firm a patent on a good
D. The firm's average cost function is everywhere upward sloping

2 Suppose Kate's Great Crete (KGC) has annual variable costs of VC=30Q+0.0025Q2 and
marginal costs of MC=30+0.005Q, where Q is the number of cubic yards of concrete it
produces per year. In addition, it has an avoidable fixed cost of $50,000 per year. KGC's
demand function is Qd=20,000-400P. What is the profit maximizing sales quantity?
A. 20
B. 2,000
C. 8,000
D. 0

3 Refer to the pay-off matrix of the game given in figure d at the end, Travis's dominant
strategy is
A. North
B. South
C. East
D. West

4 Refer to figure d. What is the Nash equilibrium in figure d above?

A. Travis north, Darren east
B. Travis north, Darren west
C. Travis south, Darren east
D. Travis south, Darren west

5 A player is playing a mixed strategy when

A. He chooses a rule to randomize over the choice of a strategy
B. He chooses a strategy without randomizing
C. There is no uncertainty in his choice
D. It is perfectly predictable
6 In a mixed strategy equilibrium
A. A players' probabilities are chosen to make sure that he is indifferent
B. Players choose mixed strategies, but the mixed strategy chosen by each is not
necessarily a best response to the mixed strategies chosen by the others
C. Players choose mixed strategies and the mixed strategy chosen by each is a best
response to the mixed strategies chosen by the others
D. A and C

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7 The economic gain that a positive externality provides to others is called
A. An internal benefit
B. An external benefit
C. An external cost
D. An internal benefit

8 Common property resources include

A. Lakes
B. Movies
C. Oceans
D. A and C
9 A good is nonexcludable if
A. There is no way to prevent a person from consuming or using it
B. More than one person can consume it at the same time without affecting its value to
others
C. Consumption of it involves perfect rivalry
D. Consumption is completely excludable

10 Kate (K) and Alice (A) are small-town ready-mix concrete duopolists. The market
demand function is Qd=20,000−200P, where P is the price of a cubic yard of concrete
and Qd is the number of cubic yards demanded per year. Marginal cost is $80 per cubic
yard. The Cournot model describes the competition in this market. Find Alice's best
response function.
A. QK=200−0.01QA
B. QA=100−0.005QK
C. QA=2,000−0.5QK
D. QK=2,000−0.5QA

Figure d