~~EC2066 ZA d0

This paper is not to be removed from the Examination Halls

UNIVERSITY OF LONDON EC2066 ZA

BSc degrees and Diplomas for Graduates in Economics, Management, Finance

and the Social Sciences, the Diplomas in Economics and Social Sciences and
Access Route

Microeconomics

Thursday, 15 May 2014 : 10:00 to 13:00

Candidates should answer ELEVEN of the following FOURTEEN questions: all EIGHT
from Section A (5 marks each) and THREE from Section B (20 marks each).
Candidates are strongly advised to divide their time accordingly.

A calculator may be used when answering questions on this paper and it must comply
in all respects with the specification given with your Admission Notice. The make and
type of machine must be clearly stated on the front cover of the answer book.

If more questions are answered than requested, only the first answers attempted will be
counted.

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© University of London 2014

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SECTION A

Answer all EIGHT questions from this section (5 marks each).

1. Consider the following simultaneous-move game with two players, 1 and 2.

If 1 and/or 2 have any dominated strategies, eliminate them. Once you have
done this, consider the remaining game. In this remaining game, eliminate any
dominated strategies of 1 and/or 2 and so on. This method is called ‘iterated
elimination of dominated strategies’. Find the equilibrium using this method.
Your answer must show each round of elimination clearly.

Player 2
A2 B2 C2
A1 2,2 4,2 0,4
Player 1 B1 4,0 6,8 2,2
C1 6,4 4,0 0,6

2. Consider an exchange economy with two goods (milk and honey) and two con-
sumers (A and B). There are 10 units available of each of the two goods. Con-
sumer A is endowed with 6 units of milk and 4 units of honey. Consumer B is
endowed with 4 units of milk and 6 units of honey. Let M denote units of milk
and H denote units of honey. Consumer A has the following utility function:

U A ( M, H ) = min[ M, H ]

Consumer B has the following utility function:

UB ( M, H ) = M + H

Draw an Edgeworth box and show the area of mutually beneficial trades be-
tween the two consumers.

3. A monopolist has a well-defined supply function. Is this true or false? Explain

your answer.

4. A bond pays a fixed sum of 100 per year for ever (i.e. the bond is a perpetuity).
The annual interest rate is 5%. What is the maximum amount an agent should
pay to buy this bond?

5. In 2010, price of petrol was 10 and Kara purchased 600 units over the year. In
2013, price of petrol was 15 and Kara consumed 800 units over the year. It
follows that Kara’s demand function for petrol is upward sloping. Is this true
or false? Explain your answer.

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 6. The compensated (Hicksian) demand curve for a Giffen good is upward slop-
ing. Is this true or false? Define a Giffen good and explain your answer.

7. There are 3 consumers of a public good. The demand functions of the con-
sumers are as follows:

P1 = 60 − Q (Consumer 1) (1)
P2 = 100 − Q (Consumer 2) (2)
P3 = 140 − Q (Consumer 3) (3)

where Q is the quantity of public good and Pi is the price consumer i is willing
to pay, i ∈ {1, 2, 3}. The public good can be produced at a constant marginal
cost of 180, and there are no fixed costs. Find the efficient level of production of
the public good.

8. Identical firms in a competitive industry use both capital (K) and labour (L)
to produce output (Q). The labour supply curve is upward sloping, while the
supply of capital is infinitely elastic in the long run. It follows that the long run
industry supply curve is upward sloping. Is this true or false? Explain your
answer.

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SECTION B

Answer THREE questions from this section (20 marks each).

9. Suppose there are two identical firms in an industry. The output of firm 1 is
denoted by q1 and that of firm 2 is denoted by q2 . Each firm can produce output
at a constant marginal cost of 6. There are no fixed costs. Let Q denote total
output, i.e. Q = q1 + q2 . The inverse demand curve in the market is given by

P = 30 − 2Q

(a) Find the Cournot-Nash equilibrium quantity produced by each firm and
the market price. [5 marks]

(b) What would be the quantities produced by each firm and market price
under Stackelberg duopoly if firm 1 moves first? [5 marks]

(c) Calculate the deadweight loss arising from Cournot-Nash and Stackelberg
duopoly. Which market structure is more efficient? [5 marks]

(d) Suppose, as in part (b), firm 1 moves first and decides how much to pro-
duce. Firm 2 moves second and makes its production decision. There is
then a third stage at which firm 1 can change its mind about how much to
produce and makes a final decision. Find the equilibrium quantities pro-
duced by the two firms under this three-stage game. [5 marks]

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 10. (a) Consider the following simultaneous-move game with two players, 1 and
2. Let p denote the probability with which player 1 plays A1 , where 0 6
p 6 1. B1 is played with the residual probability. Next, let q denote the
probability with which player 2 plays A2 , where 0 6 q 6 1. B2 is played
with the residual probability.
Draw a picture with p along the horizontal axis and q along the vertical
axis and draw the best response functions of players 1 and 2. Clearly label
any equilibrium points in the picture. [6 marks]
Player 2
A2 B2
Player 1 A1 2,2 3,0
B1 3,5 1,6

(b) Consider the following extensive-form game with two players. Player 1
can end the game by choosing ‘Out’. If player 1 chooses ‘In’, Player 2 then
chooses between ‘L’ and ‘R’. The payoffs are written as (Payoff to 1, Payoff
to 2). Identify any subgame perfect Nash equilibrium. [6 marks]

In Out

2
0,1
L R

2,2 -1,3

(c) Suppose the following game is repeated infinitely. Players discount the fu-
ture, so that, for each player, a payoff of x received t periods from today is
worth δt x today, where 0 < δ < 1. Show that it is possible to sustain coop-
eration (which in this case involves each player playing C every period) in
the infinitely repeated game for high enough values of δ. [8 marks]
Player 2
C D
Player 1 C 2,2 0,3
D 3,0 1,1

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 11. A monopolist can vary the quality of a good he produces. The cost of producing
quality q is
q2
C (q) =
2
There are two types of consumers. From consuming a good of quality q1 at price
p1 , type 1 consumers get a utility of

u1 ( q 1 , p 1 ) = q 1 − p 1

Type 2 consumers get a higher marginal benefit from quality. From consuming
a good of quality q2 at price p2 , type 2 consumers get a utility of

u2 (q2 , p2 ) = 2q2 − p2

Consumers buy the good so long as they get at least 0 utility. The profit of the
monopolist from a quality-price pair of (qi , pi ) where i ∈ {1, 2} is then given by

q2i
π ( qi , p i ) = p i −
2
(a) Suppose the monopolist knows the type of any consumer. In this case
the monopolist produces a quality q1 for a type 1 consumer and charges
a price p1 . Similarly, type 2 consumers are offered quality q2 at price p2 .
For any i ∈ {1, 2}, the optimal pair (qi∗ , pi∗ ) maximises π (qi , pi ) subject to
ui (qi , pi ) = 0. Find the optimal quality-price pairs (q1∗ , p1∗ ) and (q2∗ , p2∗ ).
[5 marks]

(b) Suppose a consumer’s own type is known only to the consumer. The mo-
nopolist cannot identify the type of any consumer. In this case, suppose
the monopolist still offers the quality-price pairs (q1∗ , p1∗ ) and (q2∗ , p2∗ ) from
part (a). Which quality-price pair would a type 1 consumer choose? Which
pair would a type 2 consumer choose? [5 marks]

(c) Suppose the monopolist sets q1 = 1/2, p1 = 1/2 and q2 = 2. The monop-
olist wants to set p2 such that type 2 consumers would have the incentive
to choose (q2 , p2 ) rather than (q1 , p1 ). What is the highest value of p2 that
satisfies the monopolist’s objective? [5 marks]

(d) Given the values of q1 , q2 , p1 and p2 from part (c), would a type 1 consumer
have the incentive to choose (q1 , p1 ) rather than (q2 , p2 )? [5 marks]

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 12. Maya spends her income on chocolate (X) and a composite of all other goods
(Y). Her preferences are represented by the utility function
√
u(X, Y ) = 2 X + Y

The price of the composite good is 1, and the price of chocolate is p. Let M
denote Maya’s income.

(a) Derive Maya’s demand for X and Y. [5 marks]

(b) Suppose M = 10. Suppose initially the price of X is 1/2, and then the price
falls to 1/5. How much does Maya’s demand for X change? How much of
this change in demand can be attributed to income effect and how much to
substitution effect? [5 marks]

(c) Consider the change in price of X from 1/2 to 1/5. Calculate the compen-
sating variation of the price change. [5 marks]

(d) For the change in price noted in part (c), is the equivalent variation greater
than, equal to or less than the compensating variation? [5 marks]

13. You are advising the minister responsible for housing. The minister is con-
cerned that rents are too high and wants to reduce the rent payments by tenants
without causing too much inefficiency.

(a) Using appropriate diagrams explain the circumstances under which you
would advise the minister to impose rent control. [7 marks]

(b) Using appropriate diagrams explain the circumstances under which you
would advise the minister to give a rent subsidy to tenants. [7 marks]

(c) Using appropriate diagrams describe a case in which issuing more build-
ing permits would not be an effective policy. [6 marks]

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 14. Consider a society with 2 agents. Agent 1 takes an action a where

0<a61

Action a generates an utility of

1
u1 ( a ) = −
a
for agent 1. The action also affects agent 2. The utility of agent 2 if 1 takes action
a is given by
u2 ( a ) = − 4 a2

(a) Let a∗ denote the individually optimal level of a for agent 1. Calculate a∗ .
[5 marks]

(b) Let a0 denote the socially optimal level of a. Calculate a0 and compare to
a∗ from part (a). [5 marks]

(c) Suppose the government imposes a proportional tax of t on a on agent 1.

The utility function of agent 1 is now

1
u1 (a, t) = − −ta
a
Let at denote the after-tax individually optimal choice of a by 1. Calculate
the value of t for which at is equal to a0 . [5 marks]

(d) Suppose the utility functions of both agents are known to each agent, but
the government does not know the utility functions. In this case the tax
policy of part (c) will not work. Can you suggest an alternative policy that
the government can adopt that will result in a0 being chosen by agent 1?
(You only need to suggest an appropriate policy informally - no calcula-
tions are needed.) [5 marks]

END OF PAPER

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