Micro 2014 ZA ZB MS

Examiners’ commentaries 2014

EC2066 Microeconomics
Important note
This commentary reflects the examination and assessment arrangements for this course in the
academic year 2013–14. The format and structure of the examination may change in future years,
and any such changes will be publicised on the virtual learning environment (VLE).
Information about the subject guide
Unless otherwise stated, all cross-references will be to the latest version of the subject guide (2011).
You should always attempt to use the most recent edition of any Essential reading textbook, even if
the commentary and/or online reading list and/or subject guide refers to an earlier edition. If
different editions of Essential reading are listed, please check the VLE for reading supplements – if
none are available, please use the contents list and index of the new edition to find the relevant
section.
General remarks
Learning outcomes
By the end of this course, and having completed the Essential readings and activities, you should:
• be able to define and describe:

• the determinants of consumer choices, including inter-temporal choices and those
involving risk
• firms’ behaviour
• how firms’ behaviour differs in different market structures and may help to determine
those structures
• how firms and households determine factor prices.
• be able to analyse and assess:
• efficiency and welfare optimality of perfectly and imperfectly competitive markets
• the effects of externalities and public goods on efficiency
• government policies aimed at improving welfare.
• be prepared for further units which require a knowledge of microeconomics.
Time management
Section A comprises eight questions, all of which must be answered (accounting for 40% of the total
marks). Section B comprises six questions of which three must be answered (accounting for 60% of
the total marks). Candidates are strongly advised to divide their time accordingly. On average, only
nine minutes should be allocated to any individual Section A question. On average, only 36 minutes
should be allocated to any individual Section B question.
1
Key steps to improvement

• You need to be able to apply relevant microeconomic theory to questions that you may not
have encountered before. To prepare for this, you need not only to gain a thorough
understanding of microeconomic models but also (and importantly) to practise using
relevant models to answer specific questions. Practice is the key, not the learning of specific
answers.
• You should spend time planning your answers and make sure that you respond to all parts
of a question and to key words like define, explain and compare. Precise and concise
answers are to be preferred to vague and long-winded answers.
• You should be aware that, for most answers, diagrams and/or mathematical analysis are
essential. These should be correct and diagrams should be well-labelled. In addition, you
should always accompany them with appropriate explanations. Again, ‘practice makes
perfect’.
Essential reading: Important information
The subject guide refers to Morgan, Katz and Rosen as the principal text. In addition to this, you
should practise questions from other texts. Two ‘auxiliary’ texts that are good sources for practice
questions are listed below. Further, the auxiliary texts often develop applications not covered in the
principal text. You should study these to broaden, as well as deepen, your understanding. In some
cases, reading several treatments of the same topic might help to clarify the basic idea. You should
use the auxiliary texts for this purpose as well.
The coverage of game theory is often inadequate in texts. You should make sure that you
understand the key ideas covered in some detail in the subject guide.
• Principal text
• Wyn Morgan, Michael Katz and Harvey Rosen, Microeconomics (Boston, Mass.:
Irwin/McGraw-Hill, 2009) second edition [ISBN 9780077121778].
• Auxiliary texts
• Jeffrey M. Perloff, Microeconomics with Calculus (Pearson Education, 2013) third edition
[ISBN 9780273789987].
• Robert S. Pindyck and Daniel L. Rubinfeld, Microeconomics (Upper Saddle River, New
Jersey: Prentice Hall/Pearson, 2012) eighth edition [ISBN 9780133041705].
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Question spotting
Many candidates are disappointed to find that their examination performance is poorer
than they expected. This can be due to a number of different reasons and the Examiners’
commentaries suggest ways of addressing common problems and improving your perfor-
mance. We want to draw your attention to one particular failing – ‘question spotting’, that is,
confining your examination preparation to a few question topics which have come up in past
papers for the course. This can have very serious consequences.
We recognise that candidates may not cover all topics in the syllabus in the same depth, but
you need to be aware that Examiners are free to set questions on any aspect of the syllabus.
This means that you need to study enough of the syllabus to enable you to answer the required
number of examination questions.
The syllabus can be found in the ‘Course information sheet’ in the section of the VLE dedi-
cated to this course. You should read the syllabus very carefully and ensure that you cover
sufficient material in preparation for the examination.
Examiners will vary the topics and questions from year to year and may well set questions
that have not appeared in past papers – every topic on the syllabus is a legitimate examination
target. So although past papers can be helpful in revision, you cannot assume that topics or
specific questions that have come up in past examinations will occur again.
If you rely on a question spotting strategy, it is likely you will find yourself in difficulties
when you sit the examination paper. We strongly advise you not to adopt this strategy.
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Important note
section.
Comments on specific questions – Zone A
Text: We use the following abbreviations:
• M,K& R - Wyn Morgan, Michael Katz and Harvey Rosen, Microeconomics, McGraw-Hill,
second edition, 2009, ISBN: 978-0077121778.
For each question, we point out the relevant sections from the main text (M,K & R) as well as the
subject guide.
Candidates should answer ELEVEN of the following FOURTEEN questions: all EIGHT of Section
A (5 marks each) and THREE from Section B (20 marks each). Candidates are strongly advised to
divide their time accordingly.
If more questions are answered than requested, only the first answers attempted will be counted.
1
Section A
Answer all eight questions in this section (5 marks each).
Question 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
Reading for this question
The coverage of game theory in M,K& R (Chapter 16) is not ideal. See Chapter 9 (Game theory:
an introduction) of the subject guide for a detailed discussion.
Approaching the question
If you know what a dominated strategy is, this is easy. However, many candidates seem to
confuse dominated strategy calculation with best response calculation. When you say for player
1 strategy B1 dominates strategy A1 – that means the payoff of 1 from playing B1 is better than
that from playing A1 no matter what player 2 does. In other words, for every box in the row B1 ,
the first number (1’s payoff) must be higher than the first number in the box above. As you can
see, this is true here. So we can conclude that B1 dominates A1 .
A best response, on the other hand, refers to the best response against a specific strategy. For
player 1, the best response to A2 is C1 . This sort of calculation is not useful here – we want to
compare all possible payoffs of one strategy against all possible payoffs of another to determine
whether one of these dominates the other.
Once you understand the above, the answer is straightforward. Here B1 dominates A1 , and C2
dominates A2 . So eliminate A1 and A2 . After eliminating A1 and A2 , we have the following
reduced game:
Player 2
B2 C2
Player 1 B1 6,8 2,2
C1 4,0 0,6
In this game, B1 dominates C1 . Eliminate C1 . We now have the further reduced game:
Player 2
B2 C2
Player 1 B1 6,8 2,2
In the game above, B2 dominates C2 . Eliminate C2 . We are then left with B1 , B2 . Therefore, using
the method of iterated elimination of dominated strategies, we get the equilibrium B1 , B2 .
2
Question 2
Consider an exchange economy with two goods (milk and honey) and two consumers (A and
B). There are 10 units available of each of the two goods. Consumer 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 between the two
consumers.
M,K& R Chapter 12; subject guide Chapter 11 (General equilibrium and welfare economics)
Milk and honey are perfect substitutes for consumer A and perfect complements for consumer
B. You should know how to draw indifference curves for these preferences. The area of
mutually beneficial trades is given by the shaded area EYZ. The question does not ask you this,
but let us also understand where the equilibrium trades would lie in this box. Any equilibrium
must be on the contract curve. So equilibrium trades lie somewhere on the part of the contract
curve contained in the area EYZ. This is shown in the picture as the line ZA.
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Question 3
A monopolist has a well-defined supply function. Is this true or false? Explain your answer.
M,K& R Chapter 13; subject guide Chapter 8 (Competition and monopoly).
Many candidates answered this question by saying that the statement is false because profit
maximisation by the monopolist gives rise to a deadweight loss. You should understand that the
presence or absence of deadweight loss has nothing to do with presence or absence of a supply
function. Consider, for example, a firm in a competitive market. We know that a competitive
firm has a well-defined supply function. Of course, we also know that there is no deadweight
loss in the market. But now suppose the government imposes a per-unit tax. You know that this
would distort the market equilibrium and give rise to a deadweight loss. But the supply
function is still well-defined.
So what is the answer? The crucial point is that a monopolist’s optimisation is not independent
of the market demand curve. Given a market demand (which is the average revenue curve), the
monopolist chooses the best point on this curve (the point where marginal revenue equals
marginal cost). So if demand changes, the monopolist’s optimal price-quantity bundle changes.
Therefore, for a monopolist, there is no unique relationship between price and quantity supplied.
Therefore a monopolist does not have a well-defined supply function. The statement is false.
Question 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?
M,K& R Chapter 5.3; subject guide Chapter 5 (Saving, investment and choice over time).
1
The discount factor is δ = where r is the interest rate. The maximum price P should equal
1+r
the present value of payments received from next period onwards:
δ
P = δ100 + δ2 100 + · · · = 100.
1−δ
Using the value of δ, P = 100/r. Since r = 0.05 = 1/20, P = 2000.
Question 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.
M,K& R Chapter 3; subject guide Chapter 3 (Consumer theory).
4
This is false. From the data it does not follow that the demand is upward sloping. Another
possible explanation (and a much more likely one) is that the demand curve is downward
sloping as usual, but the demand shifted up between 2010 and 2013. This could happen because
of a variety of factors. For example, Kara’s income might have increased over the years and
petrol is a normal good, or Kara’s preferences for driving might have changed so that at any
price of petrol she used more petrol in 2013, or the price of alternative means of transport might
have increased forcing a substitution towards greater car use.
Question 6
The compensated (Hicksian) demand curve for a Giffen good is upward sloping. Is this true
or false? Explain your answer.
This is an easy question. You should know that only the substitution effect matters for the
compensated demand curve. Since the substitution effect is always negative, the compensated
(Hicksian) demand curve is always downward sloping. The statement is therefore false.
Question 7
There are 3 consumers of a public good. The demand functions of the consumers 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.
M,K& R Chapter 18; subject guide Chapter 13 (Externalities and public goods).
All you need to do here is to calculate the total willingness to pay at any quantity, and see at
which quantity this equals 180. In other words, Q should be such that the total willingness to
pay at Q equals 180:
60 − Q + 100 − Q + 140 − Q = 180
which gives us 3Q = 120 implying Q = 40.
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Question 8
Identical firms in a competitive industry use 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.
M,K& R Chapter 10.1; subject guide Chapter 8 (Competition and monopoly).
This is true. While the cost of capital is constant, higher demand for labour implies a higher
wage rate. Therefore this is an increasing cost industry. It follows that the long run supply curve
is upward sloping. In the long run, the industry can produce higher output only at a higher
price, which is needed to compensate for the rise in unit labour costs.
Section B
Answer three questions from this section (20 marks each).
Question 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 produce. 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 produced by the two firms under this three-stage game.
(5 marks)
M,K& R Chapter 15; subject guide Chapter 10 (Oligopoly and strategic behaviour).
(a) Firm 1 maximises:

π1 = (30 − 2(q1 + q2 ))q1 − 6q1 .
6
The first order condition is 24 − 4q1 − 2q2 = 0, which gives us the best response function of
firm 1:
q2
q1 = 6 − .
2
Similarly, the best response function of firm 2 is:
q1
q2 = 6 − .
2
Solving, q1 = q2 = 4. The market price is then P = 30 − 2 × 8 = 14.
(b) Firm 2’s best response is as above. Firm 1 maximises in stage 1 knowing that 2 will use this
best response function at stage 2. Therefore firm 1’s problem is:
q1
max(30 − 2(q1 + 6 − ))q1 − 6q1 .
q1 2
This simplifies to:

max(12 − q1 )q1 .
q1
This gives us q1 = 6. It follows that q2 = 3. The market price is P = 30 − 2 × 9 = 12.

(c) Using the picture below, the deadweight loss under Cournot competition is:
1
DWLC = (14 − 6)(12 − 8) = 16.
2
The deadweight loss under the Stackelberg market structure is:
1
DWLS = (12 − 6)(12 − 9) = 9.
2
It follows that the Stackelberg market structure is more efficient.
7
(d) This is a little tricky. Try to see why a Stackelberg leader gets an advantage. This is because
the first mover can choose an output it is committed to, and the second mover just plays a
best response to that. It is the fact that the first mover can commit to an output before the
follower has a chance to choose output is the source of the first mover advantage. Here, in
contrast, firm 1 can change its mind about how much to produce and makes a final decision
after 2 decides. Therefore the initial stage has no commitment value. But 2 can commit to an
output at stage 2 knowing that 1 will readjust and choose a best response at stage 3. It
follows that Firm 2 can now act like the Stackelberg leader, and 1 becomes the follower.
Therefore, now q1 = 3 and q2 = 6.
Question 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)
(c) Suppose the following game is repeated infinitely. Players discount the future, 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 cooperation (which in this case involves
each player playing C every period) in the infinitely repeated game for high enough
values of δ.
(8 marks)
8
Player 2
C D
Player 1 C 2,2 0,3
D 3,0 1,1
(a) There are no pure NE. The mixed Nash equilibrium is p = 1/3 and q = 2/3. The best
response function of player 1 is given by:

0
 if q > 2/3
p = [0, 1] if q = 2/3

1 if q < 2/3

The best response function of player 2 is given by:

0
 if p < 1/3
q = [0, 1] if p = 1/3

1 if p > 1/3

The picture below draws the best response functions and shows the mixed strategy Nash
equilibrium.
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(b) To solve for the subgame-perfect Nash equilibrium in this game, we can simply solve
backwards. At 2’s decision node, 2 would choose R (which gives a payoff of 3 compared to
a payoff of 2 from L). Knowing this, 1’s best choice is to stay out (which gives a payoff of 0
compared to a payoff of -1 from choosing “In.”).
It follows that the SPNE is (Out, R).
Some of you prefer to write 2’s strategy as “R if 1 plays In.” That is fine as well, although
since there is exactly one node at which 2 chooses a move, the qualifier is unnecessary here.
(c) Cooperation can be sustained in equilibrium if players are patient enough, i.e. δ close
enough to 1. This can be seen as follows. Suppose each player follows the following
strategy: play C to start with, and continue to play C so long as there is no deviation. After
any deviation, play D always.
Let us compare the payoff from conforming to the payoff from deviating. Consider a
deviation in period t by player 1. Note that the payoff until t − 1 plays no role in comparing
deviation payoff with the payoff from conforming. The payoffs only differ staring at t, so
we might as well just consider the payoff starting at period t. Since this is an infinitely
repeated game, the players face an infinite future starting at any period t, and the nature of
calculations is exactly the same no matter when you start the calculations.
Given the strategy of each player specified above, the payoff from always cooperating
(starting at t) is as follows. A player gets 2 at t, 2 at t + 1 which is worth δ2 at t and so on. So
the payoff starting at period t from conforming is:
2
2 + 2δ + 2δ2 + · · · =
1−δ
By deviating at period t, 1 gets 3 in period t, but then from t + 1 onwards each player plays
D and so 1 gets a payoff of 1 every period. Therefore, the payoff at t from deviating at t is:
δ
3 + δ + δ2 + · · · = 3 +
1−δ
Cooperation can be sustained if such a deviation is not profitable. Therefore to sustain
2 δ
cooperation we need 1− δ > 3 + 1−δ which implies δ > 1/2.
Question 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 ( q1 , p1 ) = q1 − p1
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 , pi ) = pi −
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∗ )
maximizes π (qi , pi ) subject to ui (qi , pi ) = 0. Find the optimal quality-price pairs
(q1∗ , p1∗ ) and (q2∗ , p2∗ ).
(5 marks)
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(b) Suppose a consumer’s own type is known only to the consumer. The monopolist 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 monopolist 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)
M,K& R Chapter 17; subject guide Chapter 12 (Asymmetric information).
Before trying to answer the question, it is useful to have a general understanding of its structure.
Once you understand the idea behind the questions, it is very easy to do the calculations. In
questions on asymmetric information, it is typical to first set the full information benchmark. We
then compare the outcome under asymmetric information to the benchmark, allowing us to
quantify the impact of asymmetric information. The first part of the question asks you to solve
the monopolist’s profit maximisation problem when there is no asymmetric information. The
next part demonstrates that asymmetric information is a non-trivial problem: the price-quantity
pairs offered under full information fail to be incentive compatible under asymmetric
information. As the calculations below show, if the monopolist simply offers the
full-information contracts under asymmetric information, type 2 consumers gain by pretending
to be type 1 consumers. If the monopolist wants to induce different types to accept different
contracts, he must design these contracts so that no type has an incentive to accept the contract
designed for the other type. In other words, contracts must be incentive compatible. Parts (c)
and (d) are simple exercises based on this idea.
(a) Maximise p1 − q21 /2 subject to q1 − p1 = 0. Using the constraint to substitute the value of
p1 , the maximisation problem becomes:
q21
max q1 −
q1 2
which implies q1∗ = 1 which in turn implies p1∗ = 1.

Similarly, maximise p2 − q22 /2 subject to 2q2 − p2 = 0. Using the constraint to substitute the
value of p2 , the maximisation problem becomes:
q22
max 2q2 −
q2 2

(b) A type 1 consumer gets 0 from (q1∗ , p1∗ ). The utility from (q2∗ , p2∗ ) is 2 − 4 < 0. Therefore a
type 1 consumer chooses (q1∗ , p1∗ ).
A type 2 consumer gets 0 from (q2∗ , p2∗ ). The utility from choosing (q1∗ , p1∗ ). is 2 − 1 > 0.
Therefore a type 2 consumer would switch to buying the quality q1∗ at price p1∗ rather than
choose the quality-price pair (q2∗ , p2∗ ).
In other words, if the monopolist cannot observe the type of a consumer, but still offers the
same price-quality pairs as in part (a), both types will choose (q1∗ , p1∗ ).
11
(c) We need:
2q2 − p2 > 2q1 − p1 .
Using the values given:
1
4 − p2 > 1 −
2
which implies:
7
p2 6 .
2
So the maximum value of p2 for which type 2 would choose (q2 , p2 ) rather than (q1 , p1 ) is
given by 7/2.
(d) A type 1 consumer gets a utility of 0 from (q1 = 1/2, p1 = 1/2). The utility from
(q2 = 2, p2 = 7/2) is 2 − 7/2 < 0. Therefore a type 1 consumer would indeed choose
(q1 , p1 ) rather than (q2 , p2 ).
Question 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 compensating 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)
M,K& R Chapters 3 and 4; subject guide Chapter 3 (Consumer theory).
1
(a) Here MUX = √ , and MUY = 1. So at the optimum:
X
1
√ =p
X
which gives us:

1
X= .
p2
12
From the budget constraint, Y + pX = M, so:
1
Y = M− .
p
Clearly, X is independent of M. This is quasi-linear utility. There is no income effect on the

demand for X.
1
(b) Initially price is 1/2 and X = (1/2)2
= 4. When price falls to 1/5, demand for X rises to
1
(1/5)2
= 25.
As noted above, in this case there is no income effect on the demand for X. The entire price
effect of 21 constitutes simply of substitution effect.
(c) Given the optimal demands, the utility is u∗ = 2/p + M − 1/p = M + 1/p. At M = 10,
p = 1/2, u0∗ = 12. With a price fall, u1∗ = 10 + 5 = 15. If we now take away 3, utility falls
back to u0∗ . So CV is 3.
(d) As noted above, there is no income effect. It follows that CV and EV are equal.
You can also check this directly. If the price is not allowed to fall, utility is
M + 1/p = 10 + 2 = 12. If we now increase M by 3, we get 15, which is the utility after the
price fall. Therefore EV = 3.
Question 13
You are advising the minister responsible for housing. The minister is concerned 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 building permits
would not be an effective policy.
(6 marks)
M,K& R Chapter 11; subject guide Chapter 8 (Competition and Monopoly).
13
(a) If supply is inelastic, rent control works well. As you can see from the picture, in this case
the deadweight loss is small.
14
(b) If supply is elastic and demand is not very elastic, any subsidy would mostly go to tenants
and the deadweight loss would be relatively small.
15
(c) If demand is very elastic (indicating consumers already have a lot of choice), raising supply
would not reduce rents much.
Question 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 ) = − − t a
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 calculations are needed.)
(5 marks)
16
(a) Note that u0 ( a) = 1/( a2 ) > 0, i.e. u( a) is increasing in a. Therefore agent 1’s optimal choice
is to choose the highest possible level of a. Thus a∗ = 1.
(b) Let a0 denote the socially optimal level. To get the value of a0 , you need to maximise the
u1 ( a) + u2 ( a) = −(1/a) − 4a2 . The first order condition for maximum is 1/( a2 ) = 8a, and
thus a0 = 1/2. (You can check that the second order condition is satisfied at this point.)
Clearly, a0 < a∗ . You should, of course, expect this even before you do any calculations.
Since agent 2’s utility is decreasing in a, it is clear that 1 exerts a negative externality on 2.
Therefore, the individual optimum calculated in part (a) must be higher than the social
optimum. The calculations in parts (a) and (b) simply reflect this.
(c) Agent 1 now maximises −(1/a) − ta. The first order condition is 1/( a2 ) = t. You need to
set t so that this first order condition is satisfied at a = a0 . In other words, t must be such
that 1/( a20 ) = t. It follows that the optimal choice of t, denoted by t0 , is given by t0 = 4.
(d) The magic phrase here is ‘Coase theorem.’ Hopefully, as soon as you read the question, this
is the phrase that pops up in your mind. To answer the question, say that the government
should ensure that property rights are well defined. From the Coase theorem, we know that
once property rights are well defined, so long as there are no transactions costs, bargaining
would lead to the socially optimal outcome. In this case, once property rights are defined,
bargaining among the two agents would result in a0 being chosen. This completes the
answer.
Note that it does not matter whether 1 or 2 is given the property right. Agent 1 might have
the right to choose a, or 2 might have the right to prevent 1 from taking action a. In either
case, the outcome would be a0 .
The question does not ask you to show this formally, but let us do it here. First, suppose 1
has the right to choose a. In this case, if there is no bargaining between 1 and 2, 1 chooses
a∗ = 1. If 2 wants 1 to lower the level of a, 2 must pay 1.
How much can 1 extract from 2? Suppose 1 charges T1 , and agrees to choose a. Then 2’s
utility is u2 ( a) − T1 . In the absence of any agreement, 2 gets u2 (1). Therefore, the maximum
value of T1 is given by:
u2 ( a) − T1 = u2 (1).
Now 1 maximises u1 ( a) + T1 with respect to a subject to the above constraint. Substituting
the value of T1 , 1’s problem is:
max u1 ( a) + u2 ( a) − u2 (1).
a
Now, u2 (1) is just a constant. So we are simply maximising the sum of utilities. From part
(b), you already know that the above maximisation problem leads to the socially optimal
level a0 being chosen.
Next, suppose 2 has the right to choose a. The question simply states a1 > 0. But to do the
calculations here, we need to define a minimum feasible level of a. Suppose the minimum
feasible level of a is given by some ε > 0. In this case, in the absence of bargaining, 2 would
prevent 1 from the externality-generating activity by choosing a = ε. So the maximum
payment T2 that 2 can extract from 1 under bargaining is given by:
u1 ( a) − T2 = u1 (ε).
Agent 2 maximises u2 ( a) + T2 with respect to a subject to the above constraint. Substituting
the value of T2 , 2’s problem is:
max u2 ( a) + u1 ( a) − u1 (ε).
a
Now, u1 (ε) is just a constant. As before, from part (b) you already know that the above
maximisation problem leads to the socially optimal level a0 being chosen.
17

Important note
section.
Comments on specific questions – Zone B
Text: We use the following abbreviations:
• M,K& R - Wyn Morgan, Michael Katz and Harvey Rosen, Microeconomics, McGraw-Hill,
second edition, 2009, ISBN: 978-0077121778.
For each question, we point out the relevant sections from the main text (M,K & R) as well as the
subject guide.
Candidates should answer ELEVEN of the following FOURTEEN questions: all EIGHT of Section
A (5 marks each) and THREE from Section B (20 marks each). Candidates are strongly advised to
divide their time accordingly.
If more questions are answered than requested, only the first answers attempted will be counted.
1
Section A
Answer all eight questions in this section (5 marks each).
Question 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
If you know what a dominated strategy is, this is easy. However, many candidates seem to
confuse dominated strategy calculation with best response calculation. When you say for player
1 strategy B1 dominates strategy A1 – that means the payoff of 1 from playing B1 is better than
that from playing A1 no matter what player 2 does. In other words, for every box in the row B1 ,
the first number (1’s payoff) must be higher than the first number in the box above. As you can
see, this is true here. So we can conclude that B1 dominates A1 .
A best response, on the other hand, refers to the best response against a specific strategy. For
player 1, the best response to A2 is C1 . This sort of calculation is not useful here – we want to
compare all possible payoffs of one strategy against all possible payoffs of another to determine
whether one of these dominates the other.
Once you understand the above, the answer is straightforward. Here B1 dominates A1 , and C2
dominates A2 . So eliminate A1 and A2 . After eliminating A1 and A2 , we have the following
reduced game:
Player 2
B2 C2
Player 1 B1 6,8 2,2
C1 4,0 0,6
In this game, B1 dominates C1 . Eliminate C1 . We now have the further reduced game:
Player 2
B2 C2
Player 1 B1 6,8 2,2
In the game above, B2 dominates C2 . Eliminate C2 . We are then left with B1 , B2 . Therefore, using
the method of iterated elimination of dominated strategies, we get the equilibrium B1 , B2 .
2
Question 2
Consider an exchange economy with two goods (milk and honey) and two consumers (A and
B). There are 10 units available of each of the two goods. Consumer 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 between the two
consumers.
M,K& R Chapter 12; subject guide Chapter 11 (General equilibrium and welfare economics).
Milk and honey are perfect substitutes for consumer A and perfect complements for consumer
B. You should know how to draw indifference curves for these preferences. The area of
mutually beneficial trades is given by the shaded area EYZ. The question does not ask you this,
but let us also understand where the equilibrium trades would lie in this box. Any equilibrium
must be on the contract curve. So equilibrium trades lie somewhere on the part of the contract
curve contained in the area EYZ. This is shown in the picture as the line ZA.
3
Question 3
A monopolist has a well-defined supply function. Is this true or false? Explain your answer.
Many candidates answered this question by saying that the statement is false because profit
maximisation by the monopolist gives rise to a deadweight loss. You should understand that the
presence or absence of deadweight loss has nothing to do with presence or absence of a supply
function. Consider, for example, a firm in a competitive market. We know that a competitive
firm has a well-defined supply function. Of course, we also know that there is no deadweight
loss in the market. But now suppose the government imposes a per-unit tax. You know that this
would distort the market equilibrium and give rise to a deadweight loss. But the supply
function is still well-defined.
So what is the answer? The crucial point is that a monopolist’s optimisation is not independent
of the market demand curve. Given a market demand (which is the average revenue curve), the
monopolist chooses the best point on this curve (the point where marginal revenue equals
marginal cost). So if demand changes, the monopolist’s optimal price-quantity bundle changes.
Therefore, for a monopolist, there is no unique relationship between price and quantity supplied.
Therefore a monopolist does not have a well-defined supply function. The statement is false.
Question 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?
M,K& R Chapter 5.3; subject guide Chapter 5 (Saving, investment and choice over time).
1
The discount factor is δ = where r is the interest rate. The maximum price P should equal
1+r
the present value of payments received from next period onwards:
δ
P = δ100 + δ2 100 + · · · = 100.
1−δ
Using the value of δ, P = 100/r. Since r = 0.05 = 1/20, P = 2000.
Question 5
Growth in the economy leads to a rise in the demand for labour. It follows that the
equilibrium quantity of labour (measured in the number of hours worked) must rise. Is this
true or false? Explain your answer.
M,K& R Chapter 5.1; subject guide Chapter 4 (Labour supply and the effect of taxes).
4
The important question is how you connect demand for labour to the equilibrium quantity of
labour. You need to understand that the equilibrium quantity arises from the intersection of
supply and demand. Therefore the change in equilibrium wage and quantity of labour as
demand shifts up depends on the nature of the supply curve. If we are shifting demand along a
positively sloped supply curve, clearly quantity and wage would rise. But as you know, the
supply of labour is somewhat different from supply of standard goods, and could be backward
bending. So we might be operating on a negatively sloped part of the labour supply curve. In
this case, as demand shifts up, we would have a lower quantity of labour and a higher wage.
Therefore, the statement is false.
Question 6
Suppose the inverse demand curve is given by P = 10 − Q. This is shown in the picture
below. At the point A shown in the picture, is the demand elastic or inelastic (with respect to
price change)? Explain your answer.
At point A, demand is elastic. To see this, note that the price elasticity of demand is:
dQ P
ε=− .
dP Q
dQ
Since P = 10 − Q, the slope dP is -1 at all points, so we simply have:
P
ε= .
Q
It is clear from the picture that at point A, P > Q. It follows that at point A, ε > 1.
5
Question 7
The short run supply function of a competitive firm is given by

(
0 if P < 10
Q=
3P − 30 if P > 10
where Q is the quantity supplied and P is the price of output. Derive the equation for the
firm’s marginal cost curve.
M,K& R Chapter 10.1; subject guide Chapter 8 (Competition and monopoly).
From the supply function:

Q
P= + 10.
3
Since the supply function is P = MC, the marginal cost is given by:
Q
MC = + 10.
3
Question 8
Too few people use public transport in London relative to the social optimum. Provide an
economic argument in support of this statement.
This tests whether you understand the basic problem of externalities. When an activity
generates negative externalities (e.g. activities that lead to pollution, congestion, noise,
environmental degradation), the unregulated market outcome is too high relative to the social
optimum. For example, everyone driving a car only takes into account own costs and benefits
but does not take into account social costs of pollution, and so the aggregate amount of car use is
higher than the social optimum.
Similarly, when an activity generates positive externalities, individuals do not take into account
the benefit of others when deciding on the level of the activity. Therefore the unregulated market
outcome is too low compared to the social optimum. Here, the words ‘too few people . . . relative
to the social optimum’ should immediately trigger the phrase ‘positive externality’ in your mind.
Now try to think of some benefit that people using public transport confer on society. For
example, assuming that commuters must travel to work, they could use public transport or
drive private vehicles. The latter, of course, is worse for the environment. The presence of any
such positive externality would tend to make the market outcome on public transport use too
small relative to the social optimum.
It should be clear to you that to provide an economic argument in support of the given
statement, you simply need to suggest some positive externality from using public transport.
6
Section B
Answer three questions from this section (20 marks each).
Question 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 produce. 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 produced by the two firms under this three-stage game.
(5 marks)
M,K& R Chapter 15; subject guide Chapter 10 (Oligopoly and strategic behaviour).
(a) Firm 1 maximises:

π1 = (30 − 2(q1 + q2 ))q1 − 6q1 .
The first order condition is 24 − 4q1 − 2q2 = 0, which gives us the best response function of
firm 1:
q2
q1 = 6 − .
2
Similarly, the best response function of firm 2 is:
q1
q2 = 6 − .
2
Solving, q1 = q2 = 4. The market price is then P = 30 − 2 × 8 = 14.
(b) Firm 2’s best response is as above. Firm 1 maximises in stage 1 knowing that 2 will use this
best response function at stage 2. Therefore firm 1’s problem is:
q1
max(30 − 2(q1 + 6 − ))q1 − 6q1 .
q1 2
This simplifies to:

max(12 − q1 )q1 .
q1
This gives us q1 = 6. It follows that q2 = 3. The market price is P = 30 − 2 × 9 = 12.
7
(c) Using the picture below, the deadweight loss under Cournot competition is:
1
DWLC = (14 − 6)(12 − 8) = 16.
2
The deadweight loss under the Stackelberg market structure is:
1
DWLS = (12 − 6)(12 − 9) = 9.
2
It follows that the Stackelberg market structure is more efficient.
(d) This is a little tricky. Try to see why a Stackelberg leader gets an advantage. This is because
the first mover can choose an output it is committed to, and the second mover just plays a
best response to that. It is the fact that the first mover can commit to an output before the
follower has a chance to choose output is the source of the first mover advantage. Here, in
contrast, firm 1 can change its mind about how much to produce and makes a final decision
after 2 decides. Therefore the initial stage has no commitment value. But 2 can commit to an
output at stage 2 knowing that 1 will readjust and choose a best response at stage 3. It
follows that Firm 2 can now act like the Stackelberg leader, and 1 becomes the follower.
Therefore, now q1 = 3 and q2 = 6.
Question 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.
8
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)
(c) Suppose the following game is repeated infinitely. Players discount the future, 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 cooperation (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
(a) There are no pure NE. The mixed Nash equilibrium is p = 1/3 and q = 2/3. The best
response function of player 1 is given by:

0
 if q > 2/3
p = [0, 1] if q = 2/3

1 if q < 2/3.

9
The best response function of player 2 is given by:


0
 if p < 1/3
q = [0, 1] if p = 1/3

1 if p > 1/3.

The picture below draws the best response functions and shows the mixed strategy Nash
equilibrium.
(b) To solve for the subgame-perfect Nash equilibrium in this game, we can simply solve
backwards. At 2’s decision node, 2 would choose R (which gives a payoff of 3 compared to
a payoff of 2 from L). Knowing this, 1’s best choice is to stay out (which gives a payoff of 0
compared to a payoff of -1 from choosing “In.”).
It follows that the SPNE is (Out, R).
Some of you prefer to write 2’s strategy as “R if 1 plays In.” That is fine as well, although
since there is exactly one node at which 2 chooses a move, the qualifier is unnecessary here.
(c) Cooperation can be sustained in equilibrium if players are patient enough, i.e. δ close
enough to 1. This can be seen as follows. Suppose each player follows the following
strategy: play C to start with, and continue to play C so long as there is no deviation. After
any deviation, play D always.
Let us compare the payoff from conforming to the payoff from deviating. Consider a
deviation in period t by player 1. Note that the payoff until t − 1 plays no role in comparing
deviation payoff with the payoff from conforming. The payoffs only differ staring at t, so
we might as well just consider the payoff starting at period t. Since this is an infinitely
repeated game, the players face an infinite future starting at any period t, and the nature of
calculations is exactly the same no matter when you start the calculations.
Given the strategy of each player specified above, the payoff from always cooperating
(starting at t) is as follows. A player gets 2 at t, 2 at t + 1 which is worth δ2 at t and so on. So
10
the payoff starting at period t from conforming is:
2
2 + 2δ + 2δ2 + . . . = .
1−δ
By deviating at period t, 1 gets 3 in period t, but then from t + 1 onwards each player plays
D and so 1 gets a payoff of 1 every period. Therefore, the payoff at t from deviating at t is:
δ
3 + δ + δ2 + . . . = 3 + .
1−δ
Cooperation can be sustained if such a deviation is not profitable. Therefore to sustain

2 δ
cooperation we need: 1− δ > 3 + 1−δ which implies δ > 1/2.
Question 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 ( q1 , p1 ) = q1 − p1
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 , pi ) = pi −
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∗ )
maximizes 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 monopolist 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 monopolist 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)
11
M,K& R Chapter 17; subject guide Chapter 12 (Asymmetric information).
Before trying to answer the question, it is useful to have a general understanding of its structure.
Once you understand the idea behind the questions, it is very easy to do the calculations. In
questions on asymmetric information, it is typical to first set the full information benchmark. We
then compare the outcome under asymmetric information to the benchmark, allowing us to
quantify the impact of asymmetric information. The first part of the question asks you to solve
the monopolist’s profit maximisation problem when there is no asymmetric information. The
next part demonstrates that asymmetric information is a non-trivial problem: the price-quantity
pairs offered under full information fail to be incentive compatible under asymmetric
information. As the calculations below show, if the monopolist simply offers the
full-information contracts under asymmetric information, type 2 consumers gain by pretending
to be type 1 consumers. If the monopolist wants to induce different types to accept different
contracts, he must design these contracts so that no type has an incentive to accept the contract
designed for the other type. In other words, contracts must be incentive compatible. Parts (c)
and (d) are simple exercises based on this idea.
(a) Maximise p1 − q21 /2 subject to q1 − p1 = 0. Using the constraint to substitute the value of
p1 , the maximisation problem becomes:
q21
max q1 −
q1 2

Similarly, maximise p2 − q22 /2 subject to 2q2 − p2 = 0. Using the constraint to substitute the
value of p2 , the maximisation problem becomes:
q22
max 2q2 −
q2 2

(b) A type 1 consumer gets 0 from (q1∗ , p1∗ ). The utility from (q2∗ , p2∗ ) is 2 − 4 < 0. Therefore a
type 1 consumer chooses (q1∗ , p1∗ ).
A type 2 consumer gets 0 from (q2∗ , p2∗ ). The utility from choosing (q1∗ , p1∗ ). is 2 − 1 > 0.
Therefore a type 2 consumer would switch to buying the quality q1∗ at price p1∗ rather than
choose the quality-price pair (q2∗ , p2∗ ).
In other words, if the monopolist cannot observe the type of a consumer, but still offers the
same price-quality pairs as in part (a), both types will choose (q1∗ , p1∗ ).
(c) We need:
2q2 − p2 > 2q1 − p1
Using the values given:
1
4 − p2 > 1 −
2
which implies:
7
p2 6 .
2
So the maximum value of p2 for which type 2 would choose (q2 , p2 ) rather than (q1 , p1 ) is
given by 7/2.
(d) A type 1 consumer gets a utility of 0 from (q1 = 1/2, p1 = 1/2). The utility from
(q2 = 2, p2 = 7/2) is 2 − 7/2 < 0. Therefore a type 1 consumer would indeed choose
(q1 , p1 ) rather than (q2 , p2 ).
12
Question 12
Consider an economy with two goods, 1 and 2. There is a competitive market for the goods.
There are a 100 identical firms in the competitive industry producing good 1, and the cost of
the representative firm producing q1 units of good 1 is given by
q21
C ( q1 ) = q1 +
2
There are a 100 identical consumers. The representative agent consuming q1 units of good 1
and q2 units of good 2 obtains an utility
u(q1 , q2 ) = ln q1 + ln q2
The price of good 1 is denoted by P and the price of good 2 is 1. Each consumer has an income
of 12.
(a) Derive the market supply function for good 1.

(5 marks)
(b) Derive the market demand function for good 1.
(5 marks)
(c) Calculate the market equilibrium price and quantity of good 1.
(5 marks)
(d) Calculate the price elasticity of demand for good 1 at the market equilibrium.
(5 marks)
M,K& R Chapters 4 and 10.1; subject guide Chapters 3 (Consumer theory) and 8 (Competition
and monopoly).
(a) Here MC = 1 + q1 , which always exceeds the AC (same as AVC) of 1 + q1 /2. Thus the
supply curve of an individual firm is given by P = 1 + q1 or:
q1 = P − 1.
The industry supply is given by Q1S = 100q1 , which gives us:
Q1S = 100P − 100.
Be careful to add up the firm supply curves correctly. Far too many candidates lose points
because having found P = 1 + q1 for a firm, they then multiply the right hand side by 100.
But this is of course multiplying the price by 100, a meaningless exercise.
M M
(b) For any consumer with income M, q1 = and q2 = . Here M = 12, so q1 = 6/P and
2P 2
D
q2 = 6. The market demand for 1 is Q1 = 100q1 which is:
Q1D = 600/P.
(c) The equilibrium P is given by:

100P − 100 = 600/P
implying:
P2 − P − 6 = 0.
13
Solving:
√
1± 1 + 24
P= .
2
Rejecting the negative solution, we get:
P=3
Therefore the equilibrium quantity Q1 is:
Q1 = 200.
(d) The elasticity of demand for 1 is given by:
P dQ1D

P 600 600
ε1 = − =− − 2 =
Q1 dP Q1 P Q1 P
at P = 3, Q1 = 200:
600
ε1 = = 1.
600
Note that the above calculations are not really necessary. Each individual simply spends
1/2 their income on each good – so you can directly conclude that demand is unit elastic at
all prices.
Question 13
Rai spends her income on fuel for heating her house (H) and a composite of all other goods
(Y). Her preferences are represented by the utility function
u( H, Y ) = H α Y 1−α
The price of the composite good is 1, and the price of heating fuel is p. Let M denote Rai’s
income.
(a) Derive Rai’s demand for H and Y.

(5 marks)
(b) Suppose M = 300 and α = 2/3. Also suppose currently the unit price of fuel is p = 20.
The energy company offers Rai the option to switch to a different tariff. Under the new
tariff, Rai must pay a fixed fee of 100 and then she can buy fuel at a unit price of 10.
Would Rai switch to the new tariff? Explain.
(8 marks)
(c) The government decides to give Rai a heating fuel subsidy of s per unit. This results in
an increase in utility from u0 before the subsidy to u1 after the subsidy. Could the
government follow an alternative policy that would result in the same increase in utility
for Rai, but cost the government less? Explain using a suitable diagram.
(7 marks)
M,K& R Chapters 3, 4; subject guide Chapter 3 (Consumer theory).
14
MUH
(a) = p, which implies:
MUY
α Y
= p.
1−α H
Using this in pH + Y = M, we get:

M
H=α
p
and:
Y = (1 − α) M.
(b) At M = 300, α = 2/3, p = 20, H = (2/3)(300/20) = 10. Thus Y = 300 − 10 × 20 = 100.

The basket consumed is 10 of H and 100 of Y.
Under the new tariff, Rai would have 200 to spend on H and Y after paying the fixed fee. At
a unit price of 10 for H, the previous basket costs 10 × 10 + 100 = 200. So the new budget
line passes through the old basket. Since the new budget line is flatter as shown in the
picture below, Rai can achieve a higher utility under the new tariff. So she would switch.
MUH
Algebraically, at the old basket, is equal to p = 20, but price of H is now pb = 10, so
MUY
MUH
we have > pb. This implies that starting from the old basket, more H and fewer Y
MUY
would improve utility.
(c) An equivalent income boost would be less costly. The EV of a price fall is lower than the
expenditure on H after the price fall. The intuition is that a per-unit subsidy distorts choice
in favour of H, raising the total cost of the subsidy.
15
Question 14
A monopolist has two customers with the following demand functions:
Q1 = 70 − P1 (Demand of customer 1)
Q2 = 110 − P2 (Demand of customer 2)
Here Pi is the price charged to customer i, i ∈ {1, 2}. The monopolist has a constant marginal
cost of 10, and no fixed costs.
(a) Suppose the monopolist can differentiate between the customers, and the customers
cannot trade between themselves, allowing the monopolist to engage in third-degree
price discrimination. What is the price charged to each consumer?
(5 marks)
(b) Now suppose the monopolist cannot differentiate between the customers and must
charge them the same price. Calculate the monopolist’s optimal single price P as well as
the quantity sold to each customer.
(5 marks)
(c) Is the total surplus (consumer surplus plus profit) higher under a single price or under
price discrimination? Explain.
(5 marks)
(d) Suppose, as in part (b), the monopolist cannot differentiate between the customers.
However, in addition to a per-unit price P, the monopolist can also charge a fixed fee F.
16
A customer must pay this fee irrespective of the quantity purchased when a positive
amount is purchased. Derive the monopolist’s optimal price and fee.
(5 marks)
Parts (a) and (b) are very easy. Part (c) is also conceptually straightforward, but a bit more
difficult calculation-wise. To answer part (d), you need to know exactly what you are doing. In
other words, the steps involved in calculating the optimal fixed fee must be clear to you at the
outset. If you try to figure it out as you answer the question, chances are you will get it wrong.
(a) With third degree price discrimination, the monopolist sets MR = MC for each customer.
For customer 1:
70 − 2Q1 = 10
so Q1 = 30, and P1 = 40. Profit is:
π1 = 30(40 − 10) = 900.
For customer 2:
110 − 2Q2 = 10
so Q2 = 50 and P2 = 60. Profit is:
π2 = 50(60 − 10) = 2500.
Total profit is 3400.

(b) If a single price is set, the monopolist maximises total profit. The total demand is
Q = Q1 + Q2 . Here:
Q = 70 − P + 110 − P = 180 − 2P.
Revenue is (90 − Q/2) Q. MR is 90 − Q. Setting MR = MC, 90 − Q = 10, so Q = 80, and
P = 50.
At a price of 50, the quantity for customer 1 is Q1 = 70 − 50 = 20 and the quantity for
customer 2 is Q2 = 110 − 50 = 60.
In this case, the profit of the monopolist is π = 80(50 − 10) = 3200.
(c) Under price discrimination, consumer surplus is:
1 1 1 1
30(70 − 40) + 50(110 − 60) = 900 + 2500 = 1700.
2 2 2 2
The profit (producer surplus) is 3400. So the total surplus under price discrimination is:
Sdisc = 5100.
Under a single price, consumer surplus is:
1 1 1 1
20(70 − 50) + 60(110 − 50) = 400 + 3600 = 2000.
2 2 2 2
The profit (producer surplus) is 3200. So the total surplus under a single price is:
Ssingle = 5200.
Therefore the total surplus is higher when a single price is charged.
17
(d) At any price P < 70, if the fixed fee is set equal to the surplus of consumer 1 (given by
(70 − P)2 /2), the total demand is Q1 + Q2 = 180 − 2P, and the revenue is:
(70 − P)2
2 + ( P − 10)(180 − 2P)
2
Maximising, the first order condition is:
−2(70 − P) + 180 − 2P − 2( P − 10) = 0
which simplifies to 60 − 2P = 0, which implies P = 30. The fixed fee is then 800 and the
revenue is 1600+ 2400 = 4000.
If the fixed fee is set equal to the surplus of consumer 2, then 1 does not buy. The
monopolist is just dealing with customer 2. In this case, since the monopolist can set a fixed
fee to extract all consumer surplus, it is best to maximise surplus by setting price equal to
marginal cost, and then extracting full surplus.
(110 − 10)2
Thus optimal price is P = 10 and the fixed fee is F = = 5000. The profit of the
2
monopolist is 5000, which is higher than the previous case.
Therefore the monopolist’s optimal price is 10 and the optimal fixed fee is 5000.
Note that the total surplus in this case is also 5000, which is lower than the total surplus in
parts (a) and (b).
18

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Examiners’ commentaries 2014

Examiners’ commentaries 2014

Information about the subject guide

• be able to define and describe:

Key steps to improvement

Essential reading: Important information

Examiners’ commentaries 2014

Information about the subject guide

Comments on specific questions – Zone A

Text: We use the following abbreviations:

Answer all eight questions in this section (5 marks each).

Reading for this question

Approaching the question

Consumer B has the following utility function:

Reading for this question

Approaching the question

Reading for this question

M,K& R Chapter 13; subject guide Chapter 8 (Competition and monopoly).

Approaching the question

Reading for this question

Approaching the question

Reading for this question

M,K& R Chapter 3; subject guide Chapter 3 (Consumer theory).

Approaching the question

Reading for this question

M,K& R Chapter 4; subject guide Chapter 3 (Consumer theory).

Approaching the question

Reading for this question

Approaching the question

which gives us 3Q = 120 implying Q = 40.

Reading for this question

M,K& R Chapter 10.1; subject guide Chapter 8 (Competition and monopoly).

Approaching the question

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

Reading for this question

Approaching the question

(a) Firm 1 maximises:

This simplifies to:

This gives us q1 = 6. It follows that q2 = 3. The market price is P = 30 − 2 × 9 = 12.

Reading for this question

Approaching the question

The best response function of player 2 is given by:

Reading for this question

M,K& R Chapter 17; subject guide Chapter 12 (Asymmetric information).

Approaching the question

which implies q1∗ = 1 which in turn implies p1∗ = 1.

which implies q2∗ = 2 which in turn implies p2∗ = 4.

(a) Derive Maya’s demand for X and Y.

Reading for this question

M,K& R Chapters 3 and 4; subject guide Chapter 3 (Consumer theory).

Approaching the question

which gives us:

From the budget constraint, Y + pX = M, so:

Clearly, X is independent of M. This is quasi-linear utility. There is no income effect on the

Reading for this question

M,K& R Chapter 11; subject guide Chapter 8 (Competition and Monopoly).

Approaching the question

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

Reading for this question

Approaching the question

Examiners’ commentaries 2014

Information about the subject guide

Comments on specific questions – Zone B

Text: We use the following abbreviations: