Course: Intermediate Microeconomics

Södertörn University
Fall term 2019 (HT19)
Dept. of Social Sciences
Teacher: Theodoros Rapanos

Exam in Intermediate Microeconomics

2019–11–12

I NSTRUCTIONS
Please read carefully before proceeding with the exam.

 You have four (4) hours to answer this exam.

 This exam consists of two parts:

– Part A is worth 80 points. All students should answer all Questions in Part A.

– Part B is worth 20 points. Students who have handed in both Assignments 1 and 2, and
would like to keep their scores from these assignments should skip Part B. Students who
did not hand in Assignment 1, or would like to give up their score in Assignment 1, should
answer Question B1. Students who did not hand in Assignment 2, or would like to give
up their score in Assignment 2, should answer Question B2.

 Write if you have handed in any Assignments.

 Please write clearly.

 Answer each Question on a separate sheet of paper. On the top of each sheet write the number

of the Question you are answering to.

 Write only on one side of each paper.

 Some Questions consist of several parts, and you are asked to select and answer only n (a

specific number) of them. Please do not answer more; if you do, only the n first will be
graded. For example, if you are asked to answer 2 out of 4 parts, and you answer 3 out of 4,
only the first two answers will be graded.

 Tip: Where graphs are required, it would be helpful to draw them on a large scale, and very

clearly. It is much easier to show changes and draw different lines on a larger, clear graph
rather than on a very small and sloppy one that may get you confused!

Lycka till! / Good luck!

PART A

Question A.1 [18p]

Answer three (3) out of the four (4) questions below in no more than 7 to 10 lines. Use any
graphs or equations that can help you justify your answer.

a. Would it ever be optimal for a competitive firm that generates losses (makes negative profit)
to continue operating? If yes, under what conditions? Explain.[6p]

b. The supply-and-demand model discussed extensively in this course is one of the most well-
known models in Economics. Do you think that its predictions are going to be reliable in
each of the following markets? Why or why not? [6p]

(i) the market for electricity distribution

(ii) the market for carrots
(iii) the market for used cars

c. In an article published in a daily newspaper, some academic researchers claimed that in order
to offset the carbon emissions of commercial flights, the European Union should set a fixed
tax on each airplane ticket sold. A few days later, a group of readers wrote in the debate
section of that newspaper to state that they agree with the researchers’ proposal, but that it
is the airlines that should pay this tax per ticket, and not the passengers. Another reader,
Anders, commented: “It makes no difference who will be legally liable to pay this tax. In
competitive markets, the tax incidence is determined by the market forces.” What is meant
by tax incidence, and how is it determined in a perfectly competitive market? Do you agree
with Anders’ opinion on this topic? Explain. [6p]

d. Ida and Manja are single, of the same age, work for the same firm, and have similar income
and wealth. In December they will receive an end-year bonus of 15,000 kronor each. Ida
plans to invest this amount mostly in the stocks of an energy company, while Manja will
invest instead in Eurozone sovereign (country) bonds. Assuming that both individuals are
expected utility maximizers, does the fact that they choose different investments imply that
(at least) one of them is making a bad choice? If not, provide some reasons as to how this
difference in choices could be justified. [6p]

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Question A.2 [12p]

Choose four (4) out of the six (6) statements below. Then write whether you believe each
of them to be TRUE, FALSE, or UNCERTAIN (if you believe that the information provided is
not sufficient for you to judge). Justify your answer in no more than 4 to 5 lines of text. You
are encouraged to use any mathematical formulas or graphs that may help your argument. Be
careful to indicate clearly (using the corresponding letter, [a]–[f]) which statement you are
discussing in each case.

a. Linn consumes only cheese cream bagels and smoked salmon sandwiches. Assume that she
loses her job, and manages to find a new one with lower salary. As a result, her (disposable)
income decreases by 30%. It is possible then that her demand for smoked salmon sandwiches
decreases by 50%. [3p]

b. Consider a consumer with income m, and only two goods in her choice set, good 1 and
good 2, with prices p1 > 0 and p2 > 0 respectively. Assume that the price of good 2 decreases
to p20 < p2 , while price p1 and income m remain unchanged. Then the size of that consumer’s
budget set increases. [3p]

c. A positive statement is a scientific statement that has been proven to be true, while a norma-
tive statement may not be true with certainty. [3p]

d. The (ordinary) demand curve of a good captures both the substitution and the income effects
of a change in the price of that good. [3p]

e. The cost function of a firm shows that firm’s cost to produce a specific amount of output,
using any combination of inputs (any “production technique”). [3p]

f. Producer’s surplus and profits are always equal, since they are basically the same thing. [3p]

Question A.3 [20p]

Answer only one (1) out of the two (2) Problems in this Question.

Problem A.3.1
A firm produces grejer using specialized workers (x1 ) and machines (x2 ), both hired in purely
1
competitive markets. The firm’s production function is given by f (x1 , x2 ) = 2 x1 x2 , and the
associated marginal products are MP1 (x1 , x2 ) = 21 x2 and MP2 (x1 , x2 ) = 12 x1 . Suppose that the
wage of a worker specialized in making grejer is w1 = 800 kronor per day, and the rental cost of
a machine is w2 = 1200 kronor per day.

a. What relationship holds true along an isocost curve corresponding to a specific cost level, say
C? [2p]

3
b. On a graph with workers on the horizontal axis, and machines on the vertical axis draw an
isocost curve such as the one described in part (a) above. Write explicitly at which points
this curve crosses the axes. [2p]
c. Calculate the technical rate of substitution (TRS) for the production technology that this firm
uses. [3p]
d. A client places an order for yo grejer. Write down formally the firm’s cost minimization
problem for that output level. [2p]
e. Find mathematically the conditional factor demand functions of that that firm for specialized
workers and machines; that is, solve for the production technique (the “input bundle”) that
minimizes the cost of producing yo units of output. [5p]
f. What is the cost-minimizing amount of specialized workers (x1∗ ) and machines (x2∗ ) if the
order placed is for 300 units? Draw an isoquant, and depict this bundle on the graph you
draw in part (b) above. [3p]
g. What will be the firm’s minimum cost to produce this level of output (300 grejer)? [1p]
h. Does this firm’s production technology exhibit decreasing, constant, or increasing returns to
scale? Justify your answer briefly. [2p]

Problem A.3.2
The demand for a good is given by D(p) = 25 − 12 p, where p is its price, measured in thousand
kronor. There a single firm supplying this good, with its cost function given by c(q) = 200 + 6q,
where q is the quantity supplied of that good, measured in thousand units

a. Write down the inverse demand function for that good, P (q), and the firm’s revenue function,
r(q). [3p]
b. What is the marginal cost function of this firm, MC(q)? [1p]

Assume that the firm’s marginal revenue function is given by MR(q) = 50 − 4q.

c. Find the quantity that maximizes the profit of this monopolistic firm. What will be the price
of this good? [4p]

d. Calculate the firm’s profits. [2p]

e. Use a graph with units of output on the horizontal axis, and price on the vertical axis to draw
the demand, marginal revenue, and marginal cost curves, and depict the equilibrium in this
market. [3p]

f. What price would maximize social welfare, and what would be the socially optimal amount
of output in this market? [3p]

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g. Calculate numerically the deadweight loss due to this market being a monopoly instead of
perfectly competitive, and mark the area representing this loss on the graph drawn in part (e)
of this Question. [4p]

Question A.4 [21p]

The daily demand for hamburgers in the perfectly competitive pub market of a town is given by

D(p) = 1500 − 5p − 2pb ,

where p is the price of a hamburger, and pb is the price of a pint of beer, both denominated in
kronor. The supply for hamburgers is given by function

S(p) = 60 + 3p.

a. Find the equilibrium price of hamburgers as a function of the price of beer. [4p]

b. Based on your answer in part (a) above, would you say that consumers in that town consider
hamburgers and beer to be substitutes or complements? Explain briefly. [2p]

Assume now that pb = 60 kronor in all pubs in that town.

c. Find explicitly the equilibrium price of hamburgers in that town. [1p]

d. Write the demand function for hamburgers as a function only of their own price. How many
hamburgers are sold in equilibrium? [1p]
e. Draw the demand and the supply curves, and show graphically the equilibrium in the ham-
burger market. Write explicitly at which points the curves cross the axes. [2p]
f. What are the price elasticities of demand (D ) and supply (S ) of hamburgers in equilibrium?
Are they elastic or inelastic? [3p]
g. Calculate mathematically the level of consumers’ surplus in equilibrium, and show how it is
depicted on the graph you drew in part (e) above. [3p]

In order to discourage the consumption of alcohol, the government introduces a tax on alcoholic
beverages. As a result, the price of beer increases by 20 kronor.

h. How do you expect this to affect the number of hamburgers sold in equilibrium and why?
Find the new equilibrium price and quantity in the market for hamburgers. [3p]
i. Write down the new demand function for hamburgers, and depict the new equilibrium in the
hamburger market on the supply–and–demand graph you drew in part (e) above. [2p]

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Question A.5 [9p]

Viktoria works at an art gallery. She has a total wealth of 75,000 kronor. During a business trip
in Egypt she sees a painting being sold at a street market, and suspects that it might be a genuine
Romantic era painting. After bargaining with the seller, she manages to lower the price to the
equivalent of 4,000 kronor. That’s the minimum amount that the seller would accept for the
painting. Viktoria believes that there is a 12% chance that the painting is genuine. If this is true,
then she will be able to sell it for 25,000 kronor when she gets back home. There is however
an 8% probability that the painting will be damaged, lost or stolen during transportation, in
which case Viktoria will of course get zero. If the paint gets back home safely, but it’s not a
genuine Romantic era one, she will be able to sell it for only 5,000 kronor.

a. Calculate the expected value of the painting for Viktoria. [2p]

b. What is the expected value of her wealth if she buys the painting, and what is she doesn’t?
[2p]

c. Given the above information, can you tell whether Viktoria will buy the painting or not?
Explain. [3p]

Assume that Viktoria buys the painting. When she returns to her hotel, she meets Daniel, another
guest she met at the hotel. Knowing that Viktoria is risk averse, Daniel offers to buy the painting
from her right away.

d. Do you believe that an offer of 7,000 kronor would convince Viktoria to sell him the painting?
Explain why, or why not. [2p]

PART B

Question B.1 [10p]

Instructions: If you did not hand in Assignment 1, answer this question in order to be able to
achieve a full score. You do not have to answer this question if you handed in Assignment 1. If you
handed in Assignment 1, but you would like your answer to this Question to count instead, please write this
explicitly (e.g. “Do not count Assignment 1”). Observe that if you choose to do so, it will be your grade in the
present Question that will count, and NOT your grade in Assignment 1, even if your grade in Assignment 1
was higher.

Niklas has well-behaved preferences. He derives utility from consuming food (x1 ) and fancy
designer clothes (x2 ). Let m denote Niklas’ income, and p1 and p2 the prices of food and designer
clothes respectively.

a. On a graph with food on the horizontal axis, and designer clothes on the vertical axis, draw
Niklas’ budget constraint. Then draw a typical indifference curve of Niklas, labelled I 1 , and

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 show graphically his optimal bundle Xa . Be careful to write explicitly at which points the
constraint crosses the axes. [2p]

In order to raise revenue to fund public healthcare, the government imposes a specific tax of t
kronor per unit on designer clothes.

b. How does this tax affect Niklas’ budget constraint? Show graphically his new (after-tax)
optimal bundle, Xb , assuming that he considers both food and designer clothes to be normal
goods. Label the new indifference curve that Niklas achieves I 2 . [2p]

c. What is the substitution effect, and what the income effect of a price change? [2p]

d. Illustrate the substitution effect and the income effect graphically on the graph you drew
above. [3p]

e. Do these two effects push Niklas’ consumption toward the same direction or toward opposite
directions? [1p]

Question B.2 [10p]

Instructions: If you did not hand in Assignment 2, answer this question in order to be able to
achieve a full score. You do not have to answer this question if you handed in Assignment 2. If you
handed in Assignment 2, but you would like your answer to this Question to count instead, please write this
explicitly (e.g. “Do not count Assignment 2”). Observe that if you choose to do so, it will be your grade in the
present Question that will count, and NOT your grade in Assignment 2, even if your grade in Assignment 2
was higher.

The production function of a firm operating in a perfectly competitive environment is given by

1 1
f (x1 , x2 ) = 3x13 x23 , where x1 and x2 are the levels of production factors 1 and 2 respectively
employed by the firm.

a. Do you believe that this is the short-run or the long-run production function of that firm?
Explain briefly. [2p]
b. Does the production technology used by that firm exhibit increasing, constant, or decreasing
returns to scale? Why? [3p]

Assume that the prices of the two production factors are w1 and w2 respectively, and that the
price of the firm’s output in the market is p kronor per unit. We can calculate the marginal
−2 1 1
−2
products of the two factors to be MP1 (x1 , x2 ) = x1 3 x23 and MP2 (x1 , x2 ) = x13 x2 3 respectively.

c. Write down the conditions that the profit-maximizing (optimal) choice of production factors
(x1∗ , x2∗ ) must satisfy. [3p]

d. What do you think that the long-run profit level of this firm will be? Explain briefly. [2p]