EC201 Microeconomic Principles I

ST Exam EC201 Commentary

Summer Term 2021

This commentary provides some collective feedback on performance in the Summer 2021 EC201
examination, as well as guideline answers to the questions.
Overall, performance was strong. Candidates who sat the ST examination generally demonstrated
a very good understanding in the core models and theory and performed to a very high standard in
many places. Out of 618 students enrolled on the course, 567 sat the Summer examination. Of these,
27 percent scored a first class mark, 49 percent scored a 2A mark, 17 percent a 2B mark, 6 percent
a passing mark and 2 percent failed the examination. 8 percent of students enrolled deferred the
Summer examination.
Coursework was introduced for the first time in 2020-21, as a means of engaging students and en-
couraging the development of broader skills. 93 percent of students enrolled on the courses achieved
a first class mark in the coursework component, in most cases scoring 100. This served to raise the
overall performance of students, as did the January examination, in which 55 percent of students
scored a first class mark.
Overall for EC201, 544 students have attempted all assessments. Of these, 53 percent completed
the course with a first class mark, which is very high compared to historic distributions. 36 percent
completed the course with a 2A mark, 9 percent with a 2B mark, 2 percent with a third class mark, and
1 percent failed overall on first attempt.

The main cause for losing marks was a lack of explanation, especially in numerical problems. Marks
are assigned for explaining the economics rationale behind computations, and this was lacking in
some scripts. Some candidates did not define key concepts before using them, or lacked precision in
their answers.
In general, students performed strongest where questions were closest to problems seen before in the
course (such as Question 4). The key aspect that distinguished first class from upper second class
scripts was evidence of accurate reasoning in sub-questions that required students to go slightly
beyond problems seen before, or make connections between ideas. The scripts of candidates that
scored a 2B tended to contain errors and un-attempted sub-questions. They also tended to show
excess reliance on lecture content, rather than an ability to apply knowledge to the specific problem.
For example, drawing the Lorenz curve as in the lecture slides, rather than constructing the Lorenz
curve based on the information provided. Or computing effort level in Question 6 by following the
equation in the lecture, rather than considering the idiosyncracies of the specific question. Despite
repeatedly indicating (e.g. in mock exam solutions) that readings need to be fully cited with author(s)
and year, a number of students did not do this, losing marks in each reading question. In general,
students who engaged with class material and mock exam solutions tended to benefit from this.

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 Section A
[Answer ALL FOUR questions. If during this examination you feel you need to make additional as-
sumptions in order to proceed, then please do so stating your assumptions clearly].

Question 1
Suppose that Beyoncé and Madonna have utility functions xJ + θJ ln (g) where J = B for Beyoncé
and J = M for Madonna. xJ is a private good and g is a public good. θB = 2 and θM = 4. Each of
them has 10 units of the private good that can be transformed into units of the public good on a one
to one basis. Consider four possible allocations of these goods:

Allocation 1: g = 0, xB = xM = 10
Allocation 2: g = 2, xB = xM = 9
Allocation 3: g = 6, xB = 10, xM = 4
Allocation 4: g = 2, xB = 8, xM = 10

(a) Is allocation 1 Pareto efficient? [3 marks]

Guideline Answer : [3 marks]

A Pareto efficient allocation is one in which no one can be made better off without making some-
one else worse off. Allocation 1 is thus Pareto inefficient. The amount of public good provided
is zero in this outcome and the utility of the two consumers tends to −∞. Any allocation (in-
cluding the 3 proposed in the exercise) where g > 0 is a Pareto improvement upon Allocation
1, regardless of who pays for the public good-e.g. if Beyoncé contributes 1 towards g she gets
U B = 9 + ln(1) = 9 in utility and Madonna gets U M = 10 + ln(1) = 10 so both are better off.
Marking Scheme:
Give 1 mark for the definition of Pareto efficiency and 2 marks for a Pareto improvement.

(b) Which allocation maximizes the sum of utilities? [5 marks]

Guideline Answer : [5 marks]

The sum of utilities is xM + xB + 6ln(g) = 20 − g + 6ln(g). We can maximize this function by
taking the first order condition −1 + g6 = 0 to see that the utilitarian optimum is when g = 6.
Alternatively, students can find the sum of utilities corresponding to each of the allocations in
the exercise and point out that Allocation 3 is the one that gives rise to the highest sum of
utilities.
Marking Scheme:
2 marks for the allocation that gives the highest sum of utilities and 3 marks to justify it- this
means taking away marks from students who plug in the numbers and compute the sum of
utilities of each allocation without any explanation.

(c) Which is Beyoncé’s preferred allocation? Does this mean that Beyoncé is a Utilitarian?
[7 marks]

Guideline Answer : Intuitively Beyoncé’s optimum allows her to keep her entire endowment
and have the highest possible amount of public good. Her unconstrained optimal bundle is
where xB = 10 and g = g M = 10. Within the feasible allocations Beyoncé’s optimum is
Allocation 3, like in part c- students can set up the utility maximization or use the MRS=price
ratio to reach the answer, or find the utility corresponding to each of the allocation and notice
that Allocation 3 also maximizes her utility. Trivially, they could explain that good g can be
provided by Madonna and Beyoncé can keep all her endowment, so that this is her preferred

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 allocation. This decision, however, does not mean that she is a utilitarian. Utilitarians maximize
the sum of utilities, whereas she is free-riding on the public good provided by Madonna without
giving up her endowment.
Marking Scheme:
3 marks to explain Beyoncé’s optimal allocation, 1 mark to define the utilitarian criterion and 3
marks to point out that Beyoncé is not utilitarian.

(d) Now suppose that Kanye who has utility function xK + 2 ln(g) joins with Beyoncé and Madonna
to form a community of three people. He has an endowment of ten units of x and can propose
a referendum with a majority vote over any pair of allocations. What will the outcome be? Does
this mean that Kanye is a Utilitarian? [10 marks]

Guideline Answer : [10 marks]

Kanye now enters the economy with the same incentives we saw from Beyoncé in the previous
part. He would also prefer an allocation with the highest amount of the public good (not paid by
him). Allocation 3 is thus his preferred allocation and he can obtain it by proposing a referen-
dum that has Allocation 3 as one of the options and any of the other alternatives. If Allocation
3 is one of the options Beyoncé will always vote for it, allowing Kanye to maximize his utility.
Just like Beyoncé Kanye finds that his utility maximizing bundle is the utilitarian optimum but
not because he is a utilitarian.
Marking Scheme:
3 marks to discuss Kanye’s incentives, 5 marks to show that Kanye can always achieve Alloca-
tion 3 by proposing a referendum and explain that this is thanks to Beyoncé’s vote and 2 marks
to point out that he, like Beyoncé, prefers the utilitarian outcome over the others, but not because
he is utilitarian.

Question 2
√
Suppose that there is a group of four individuals who have utility functions u(y) = y where y is
income. Suppose that the social welfare function has no intrinsic preference for inequality and that
the income distribution is y = {1, 1, 9, 9}.

(a) Draw the Lorenz curve associated with this income distribution and illustrate a measure of in-
equality using your graph. [4 marks]

Guideline Answer : [4 marks]

This is a standard Lorenz curve with a kink where the share of people is equal to 0.5 and the
2
share of income equal to 20 = 0.1. An easy way to show a measure of inequality is to show that
the Gini coefficient can be obtained by taking the ratio of the area bounded below by the Lorenz
curve and above by the line of perfect equality over the entire area below the line of perfect
equality.
To obtain full marks students needed to ensure that their graphs were detailed (including the
axes, the numbers at the kink and the line of perfect equality). There was no need to compute
the Gini coefficient.

(b) Suppose that the government intervenes and equalizes income in the economy.
i) At what equal level of income per capita is total utility the same as with {1, 1, 9, 9}?
[4 marks]

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 Figure 1: Q2a: Lorenz curve

ii) How does this government intervention impact average income? [3 marks]
iii) What does your answer to (ii) tell us about the welfare consequences of income redistri-
bution? [4 marks]

Guideline Answer : [11 marks]

i) We
√ need√ to first find the total utility corresponding to the initial distribution:
2 1 + 2 9 = 8. If the government wants to have an equal income per capita that
√
gives the same sum of utilities it sets 4 y = 8 which solves for y = 4.

ii) The average income has now dropped- due to diminishing marginal utility of income we
only need an average income of 4 to obtain the same sum of utilities which we had in
a society that was highly unequal but had an average income of 1+1+9+9 4 = 5. Many
students failed to link this part to part (i) and so claim that the average income has not
changed in society.
iii) Income redistribution in a society with diminishing marginal utility is justified even without
a social welfare function that dislikes inequality. Redistribution allows to reach the same
sum of utilities with fewer resources. Perfect redistribution (giving 5 to each person) would
thus lead to a higher social welfare than the initial one, even under a utilitarian criterion.

√
(c) Suppose the utility of the two individuals with an income of 9 is now u(y) = θ y with θ > 1.
i) Does this alter the case for equalising incomes? [5 marks]
ii) Discuss how different criteria might be used to justify redistribution even when θ is high.
[5 marks]

Guideline Answer : [10 marks]

i) Now the richer people in society derive a higher marginal utility of income. There is still
diminishing marginal utility of income, but the increase in the marginal utility of the rich

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 might drive some to believe that redistribution is not as desirable as it was before. This
new functional form lowers the incentive to redistribute from the UPF’s perspective, but
doesn’t alter the social welfare function we use to make the decision.
The rich here have higher marginal utility so a utilitarian society doesn’t benefit as much
from taking money from the rich and giving them to the poor to increase total utility. How-
ever, this does not directly imply that redistribution is not desirable.
ii) Inequality has remained the same- neither the Lorenz curve nor the Gini coefficient has
changed from part a), so many criteria would still find redistribution desirable in the same
way as before. There is also still diminishing marginal utility of income for both rich and
poor so the UPF is still concave. Students could also discuss Sen’s ideas from the lectures:
if the rich can keep increasing their marginal utility of income it does not mean that they
getting richer is desirable for society. Students could point out that the utilitarian social
welfare function, an inequality averse social welfare function and the maximin social wel-
fare function still favour redistribution, although the utilitarian criterion would redistribute
less and less as the value of θ grows.

Question 3
Consumers have preferences over two goods x and y denoted by u(x, y) = x + Ay − y 2
The price of good x is one and good y is p. All consumers have income M . Consumers have decision
utility with A = 2 and experience utility with A = 1. A monopolist supplies good y with marginal
cost 0.5. Experience utility captures the welfare of consumers. In what follows, concentrate on cases
where consumers have enough income so that there is an interior solution, i.e. they consume positive
amounts of both goods.

(a) Derive the demand function for good y . [4 marks]

Guideline Answer : [4 marks]

We can find the demand function by substituting the budget constraint x + py = M or x =
M − py in the utility function to obtain M − py + 2y − y 2 as the consumer’s decision utility.
The FOC is then −p + 2 − 2y and solves for y = 1 − p2 . The SOC is negative − 21 , so this is a


utility-maximizing demand function.
Many students set up the maximization correctly, but did not offer any explanation, which led to
losing some marks.

(b) Derive the monopoly and competitive prices and demands. [4 marks]

Guideline Answer : [4 marks]

The monopolist maximizes profits

π = P Q(P ) − C(Q(P ))
   
P P
P 1− − 0.5 1 −
2 2
F OC : 1 − P + 0.25 = 0
SOC : −1 < 0
5
P = 1.25 =
4

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 The corresponding demand is
p 5 3
1−=1− =
2 8 8
p
. The competitive price would be P = M C = 0.5 and competitive quantity 1 − 2 = 0.75.
As in part a) many students set up the maximization correctly, but did not offer any explanation,
which led to losing some marks.

(c) Is consumer utility higher or lower with monopoly or competition? Explain. [12 marks]

Guideline Answer : [12 marks]

Under monopoly each person consumes

5 3 15
x = M − py = M − ∗ =M−
4 8 32
and y = 83 . The corresponding utility is

15 3 9
x + y − y2 = M − + − =
32 8 64
15
Um = M −
64

Under perfect competition each person consumes

13 3
x = M − py = M − =M−
24 8
and y = 34 . The corresponding utility is:

3 3 9
x + y − y2 = M − + − =
8 4 16
3
UPC = M −
16
.
A lower amount of good y would make utility increase if the price had been kept constant, but
under monopoly the consumer consumes less of the good but also experiences higher prices.
This means that overall they buy less of the good they will regret buying, but they will also be
relatively poorer and consume less of good x so their utility will be lower than under perfect
competition. Students should highlight the trade-off between making the consumers demand
less of the good they demand because of their behavioural biases, but the lower welfare that
comes from this.
Many students simply compare the utility the consumer derives under perfect competition and
monopoly but fail to explain the intuition.

(d) What other considerations might be relevant in deciding whether monopoly or competition is
welfare superior in this example? [5 marks]

Guideline Answer : [5 marks]

Guideline Answer: Having a monopoly lowers welfare here, but lowers the consumption of the
behavioural good. Whether this is desirable depends on the nature of the good and the social

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 welfare function we use to evaluate the situation. The students could discuss a number of
things here, e.g. our previous result depends on the assumption that all the consumers suffer
from the same bias and overvalue good y in their decision utility, but different groups might have
different biases, affecting the desirability of a higher price in the market. Distributional concerns
also suggest that perfect competition would be better than a monopoly. Moreover, a monopoly
may not be desirable even if it raises experience utility- a nudge could obtain the same result
and avoid inefficiency in the market. Many students here discuss the incentives to innovate the
firm has, but the question does not mention innovation, so this explanation received only partial
credit. Similarly, some students mention including the profits of the firm in the social welfare
function. This could persuade the government to tolerate monopolies, but notice the consumer
would suffer a utility loss and we don’t know anything about the location of the firm (including
in the social welfare calculation of our country the profits of a firm in a different country would
be a bit counterintuitive).

Question 4
There are 200 identical consumers, each with preferences u(x, y) = x + θ ln (y) where x denotes
consumption of lentils and y denotes waffles. 100 consumers each owns 10 units of lentils and 100
consumers each own 20 units of waffles. Let the price of lentils be 1. In the following, focus on interior
solutions.

(a) Derive the demand function for waffles and find the general equilibrium price of waffles.
[6 marks]

Guideline Answer : [6 marks]

∂U ∂U θ
We can easily check for non-satiation: ∂x = 1 > 0 and ∂y = > 0 so we can find the demand
y
for good y by substituting the budget constraint into the utility function: BC : x + py = mJ →
x = mJ − py and substituting this into the utility function:

x + θln(y) = mJ − py + θln(y)
θ
F OC : −p + =0
y
1
SOC : − θy −3/2
2
θ
y=
p
All the consumers have the same demand for good y so we can find the equilibrium prices by
solving:
θ
200 = 100(20)
p
θ
p=
10

Many students solve for the correct price ratio, but offer no explanation, which leads to only
partial credit.

© LSE ST 2021/EC201 Page 7 of 15

(b) How do the price of waffles and the distribution of income depend on θ? [6 marks]

Guideline Answer : [6 marks]

As θ increases the marginal utility each consumer derives from waffles increases and so the
demand increases. However, the supply of waffles is fixed, so this increase in demand will
drive the price up and make the incomes of waffle producers higher. The incomes of the lentils
producers remains constant but their purchasing power drops.
Many students point out the increase in the incomes of waffle producers but fail to link this
increase to a reduced purchasing power of lentil producers.

(c) Is there a case for government intervention to make a transfer from owners of waffles to owners
of lentils if θ increases? Draw on the course reading in formulating your answer. [13 marks]

Guideline Answer : [13 marks]

Students here could use the arguments put forward by Starmans et al (2017), discussing the
desirability of income inequality. The authors claim that differences in incomes due to differ-
ences in effort (e.g. if waffle producers are likely to spend more effort in their activity than lentils
producers) are not disliked by people.
Students could also refer to different papers. The best answers summarized the arguments
made in the paper and linked them to the situation at hand- e.g. if waffle producers are exert-
ing more effort to produce their good an increase in their income (and thus inequality) may be
justified.

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 Section B
[Answer BOTH questions. If during this examination you feel you need to make additional assump-
tions in order to proceed, then please do so stating your assumptions clearly].

Question 5
Astravax and Zenevax are price-setting pharmaceutical firms. Each firm has paid 100, 000 to develop a
vaccine against Covid-19 that cannot be recouped. Each has a production capacity of 300 and faces a
marginal cost of production of 100. Both vaccines are equally safe and effective and so are perceived
as identical by governments, who purchase vaccines to roll out in their respective countries.
Let p1 denote the price of the Astravax vaccine and p2 the price of the Zenevax vaccine. Prices are
set simultaneously by the two firms.
Demand qi for vaccines of firm i is 1000 − pi if pi is strictly lower than the price of the rival firm, is 0 if
pi is strictly higher than the price of the rival firm and is 21 (1000 − pi ) if both firms set the same price,
where i = {1, 2}.

(a) Find the Nash Equilibrium prices, explaining your reasoning carefully. Are Astravax and Zenevax
willing to produce and sell vaccines at these prices? [10 marks]

Guideline Answer : [10 marks]

This is a Bertrand model (homogeneous good, simultaneous price decision) with symmetric
capacity constraints.
(Note, this is not an example of the Kreps-Scheinkman model as firms do not choose their capac-
ity in the first stage of a two-stage game. Instead, capacities are exogenously given. Capacities
of 300 reflect Cournot quantities, though candidates were not expected to recognise this).
A Nash Equilibrium (NE) is a set of strategies, one for each player, where strategies are best
responses to each other i.e. where there is no incentive to deviate. In this context, the firms are
the players and a strategy is the choice of price.
Whereas the standard Bertrand NE is for firms to set price equal to marginal cost (due to under-
cutting incentives), prices will not be undercut all the way down to p1 = p2 = 100 here, because
at these prices the demand for vaccines is 450 per firm, which exceeds firm capacity. Instead,
prices are competed down up until the point where firms are selling at capacity. This implies a
total demand of vaccines of 600 sold at p1 = p2 = 400.
The prices p1 = p2 = 400 constitute a NE. To see this, we must show that neither firm has an
incentive to deviate.
If Astravax were to deviate by setting a price below 400, all governments would wish to purchase
from Astravax, but as Astravax is already at capacity, it cannot satisfy the extra demand gener-
ated. All that is achieved is selling the same quantity at a lower price, which makes Astravax
worse off.
If Astravax were to deviate by setting a price above 400, then all governments would prefer to
buy from Zenevax. However, Zenevax has a capacity of only 300, so cannot satisfy the whole
market. What about the rest of the governments who cannot buy from Zenevax? Some are
willing to buy from Astravax at a price above 400. Since Zenevax supplies the market with 300,
Astravax faces a residual demand curve of 700 − pi (deducting 300 from industry demand),
over which Astravax has monopoly power as it is the sole supplier. It’s operating profits are
(pi − 100)(700 − pi ), which are maximised at pi = 400! In other words if Zenevax is selling at
capacity, the profit maximising strategy of Astravax is to set a price of 400 and sell at capacity
also...so charging above 400 and curtailing sales below 300 would make Astravax worse off.
Hence p1 = p2 = 400 are best responses to each other and thus a NE.
With p1 = p2 = 400 it follows that q1 = q2 = 300, profits are:
Π1 = Π2 = (400 − 100)(300) − 100, 000 = −10, 000

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 , corresponding to losses.
As vaccine development costs are sunk costs (cannot be recouped), zero production gives prof-
its Π1 = Π2 = 100, 000 < −10, 000. Therefore, as development costs are sunk, firms are
willing to produce and supply the market while operating at a loss.
Many students understood the importance of the capacity constraint but failed to argue why
setting a price equal to 300 was optimal. Some students simply stated that due to Bertrand
competition firms would set P=MC.

(b) Astravax and Zenevax consider colluding to set prices to maximise industry profits. Find the
prices firms would set under such a collusive arrangement, as well as their vaccine sales and
profits. Can they sustain collusion? [10 marks]

Guideline Answer : [10 marks]

By colluding they jointly act like a monopolist. Total industry demand is 1000 − p where p1 =
p2 = p. Industry profits are:

Π = (1000 − p)(p − 100) − 200, 000 = 1100p − p2 − 300, 000

F OC : 1100 − 2p = 0
which gives monopoly price pM = 550. SOC is negative and so this is a maximum.
With p1 = p2 = pM = 550, industry demand is 450, which is split evenly at 225 per firm (within
capacity). Profit per firm is

(550 − 100)225 − 100, 000 = 1, 250 > 0

.
Collusion cannot be sustained as the prices p1 = p2 = 550 are not best responses to each
other. Each firm has an incentive to deviate by undercutting by a tiny margin , which increases
sales from 225 to 300 increasing profits.
Many students performed well on this question, but some failed to explain the setup, profitable
deviations from collusion and/or check the second order condition.

(c) Trials show that antibodies from Covid-19 vaccination fade, and so the population needs to be
periodically revaccinated. Astravax and Zenevax therefore interact repeatedly and indefinitely
into the future, setting prices simultaneously in every time period t. Astravax and Zenevax have
a common discount factor δ = 0.1.
i) Can Astravax and Zenevax sustain collusion each period as an equilibrium of the infinitely
repeated game if cheating is punished as severely as possible forever after? [Hint: cheat-
ing is lowering price by an amount  where  → 0] [10 marks]
ii) Astravax and Zenevax decide to offer governments a ‘low price guarantee’ (LPG). This is a
promise to automatically match a lower selling price offered by the rival firm in any period
t. Show that this facilitates collusion between Astravax and Zenevax, again assuming that
deviations from collusion are subsequently punished as severely as possible forever after?
[Hint: cheating is lowering price by an amount  where  → 0], with the rival also doing so]
[10 marks]
iii) Astravax hires a consultant to review its pricing policy. The consultant suggests adding a
number of restrictions to the LPG. Governments can still claim the lower price, but only if
they provide sufficient evidence of a price gap, submitted using a special form by a strict
deadline. Does this amendment to the LPG harm or benefit governments seeking to buy
vaccines? [Refer to the course reading when answering this question]. [10 marks]

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 Guideline Answer : [30 marks]
i) Both collude: Firm operating profits are 101, 250 (and sales 225) each period.
Cheating: Operating profit = (550 −  − 100)(300) = 135, 000 − 300, which tends to
135, 000 as  → 0 Rival makes zero operating profit as they have no sales.
Punishment: most severe outcome is to revert back to Bertrand NE prices where operating
profit is 90, 000 forever after (grim trigger strategy with minmax punishment).
Will a firm cheat assuming the other colludes?
Collude: 1,250, 101,250, 101,250. . .
Cheat: 35,000 90,000, 90,000. . .
It is strictly preferable to collude if:

1, 250 + 101, 250δ + 101, 250δ 2 + ... > 35, 000 + 90, 000δ + 90, 000δ 2 + ...
11, 250δ
> 33, 750
1−δ
11, 250δ > 33, 750 − 33, 750δ
45, 000δ > 33, 750
3
δ>
4

If the firms are sufficiently patient, i.e. have a discount factor above 0.75, then they will
be able to sustain collusion. Here they have a discount factor of 0.1, so collusion remains
unsustainable even in the infinitely repeated game. Students could also check the sustain-
ability of the cartel without accounting for the investment cost. In this case the calculation
becomes: Collude: 101,250, 101,250, 101,250. . .
Cheat: 135,000 90,000, 90,000. . .
It is strictly preferable to collude if:

101, 250 + 101, 250δ + 101, 250δ 2 + ... > 135, 000 + 90, 000δ + 90, 000δ 2 + ...
101, 250 90, 000
> 135, 000 +
1−δ 1−δ
11, 250
> 135, 000
1−δ
11, 250 > 135, 000 − 135, 000δ
135, 000δ > 123, 750
11
δ>
12
The argument is as above: for a sufficiently high discount rate (very close to 1 here) collu-
sion is sustainable but not with the current one.
Many students failed to see what would happen after the deviation and stated that the
opponent would set P=MC. This is not a best response, but the answer was given partial
credit.
ii) Both collude: Firm operating profits are 112, 500 (and sales 225) each period.
Cheating: If a firm lowers price to a price 550˘, the rival automatically matches this price
reduction and they share the market. Sales per firm are 21 (450+). Thus profit from cheat-
ing is (550 −  − 100) 21 (450 + ), which tends to (450)(225) = 101, 250 as  → 0.
Punishment: most severe outcome is to revert back to Bertrand NE prices where operating
profit is 90, 000 forever after (grim trigger strategy with minmax punishment).

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 Will a firm cheat assuming the other colludes?
Collude: 1,250, 101,250, 101,250. . .
Cheat: 1,250 90,000, 90,000. . .
Colluding is now a dominant strategy (it is better in each and every time period!). It is
preferable to collude for any value of δ ! Collusion is now certain, so yes, it facilitates col-
lusion.
Mathematically (though not needed):

1, 250 + 101, 250δ + 101, 250δ 2 + ... > 1, 250 + 90, 000δ + 90, 000δ 2 + ...
101, 250δ 90, 000δ
>
1−δ 1−δ
which is satisfied for all δ ∈ (0, 1). Alternatively students can compare the two streams of
profits without accounting for the initial investment: Collude: 101,250, 101,250, 101,250. . .
Cheat: 101,250 90,000, 90,000. . .
This doesn’t change the conclusion on collusion.
As in the previous part many students failed to see what would happen after the deviation
and stated that the opponent would set P=MC. This is not a best response, but the answer
was given partial credit.
iii) Key reading here is Arbatskaya et al (2004).
The authors examine characteristics and motivations for different LPGs.
One key dimension is ‘hassle costs’ to claiming the low price. Where there are multiple re-
strictions or stipulations, it makes it more difficult for governments to claim the low price.
Rather than price matching being automatic, it depends on conditions being satisfied. If
so, then it’s possible the matching won’t happen.
While at face value it appears harmful to governments to introduce hassle costs, it could
be beneficial if such costs serve to undermine collusion. In the Bertrand NE the govern-
ment pays 400 per vaccine, whereas under collusion 550 per vaccine; so putting in place
impediments to the LPG can be beneficial to the government if it makes it harder for firms
to collude.
Many students cite the correct paper but lose marks in not explaining that while making
it harder to claim at first appears to be harmful to governments, this provision is, in fact
beneficial because it undermines the effect of the LPG and makes it harder to sustain col-
lusion. Hassle costs make it harder to sustain collusion and thus lead to lower prices for
governments, which is beneficial!

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Question 6
Camilla wishes to employ Charles to repair her lawn mower. The value of the lawn mower is 10 if it
is working and 0 if it remains broken. Charles can put in effort into fixing the lawn mower denoted
by e ∈ [0, 1] where e is the probability of fixing the lawn mower and the effort costs 10e2 . However,
Camilla can only observe whether the lawn mower is fixed and not Charles’ effort.

(a) Show that if Camilla can repair the lawn mower herself at an effort cost of 10e2 , then the prob-
ability of the lawn mower being repaired is 0.5. [5 marks]

Guideline Answer : [5 marks]

If Camilla can mow her lawn she will be able to reward herself based on the effort she exerts.
She solves:
max10e − 10e2
F OC : 10 − 20e = 0
SOC : −20 < 0
e = 0.5

Many students find the correct first order condition and solution, but fail to mention that Camilla
will be able to observe (and hence reward) her effort. Many also fail to check the second order
condition.

(b) Why might asking Charles to fix the lawn mower create a moral hazard problem? [3 marks]

Guideline Answer : [3 marks]

3 points to consider here: 1) effort is unobservable (Camilla can only see whether her lawn
mower is fixed or not), 2) effort is costly (Charles pays a quadratic cost of effort) and 3) the ben-
efits of effort accrue to the principal and not the agent (if Charles exerts effort Camilla stands
to gain but not him).

(c) What advice would you give Camilla about the kinds of incentive schemes that might be relevant
and the evidence for them being effective? [Refer to the course reading when answering this
question]. [10 marks]

Guideline Answer : [10 marks]

Here the key paper is by Lazear (2018), who in the Journal of Economic Perspectives, considers
incentives in the workplace and how they depend on whether the person is working on their
own or a group, and considers different types of incentives payments.

(d) Unless employed by Camilla, Charles expect to be unemployed and so to earn 0. Camilla offers
to pay Charles a cash bonus for fixing her lawn mower. What is the optimal bonus that Camilla
should offer Charles, to be paid, if he successfully repairs her lawn mower? What is the proba-
bility that that the lawn mower will be fixed with this bonus payment? [10 marks]

Guideline Answer : [10 marks]

We need to first find the level of effort that Charles would exert for any bonus level B and then
solve for the optimal bonus. For Charles:

maxeB − 10e2

© LSE ST 2021/EC201 Page 13 of 15

 F OC : B − 20e = 0
SOC : −20 < 0
B
e=
20
Camilla anticipates this and maximizes:

B
e(10 − B) = (10 − B)
20
1 B
F OC : − =0
2 10
B=5
5
and correspondingly Charles will exert e = 20 = 25%, which gives us the probability of the lawn
mower being fixed.
Many students obtain the right numbers but forget to explain the setup, check the second or-
der conditions or check that Charles is indeed better off accepting the contract than not doing
anything and achieving a utility of 0.

(e) Camilla offers Charles the option to sit on the lawn with her if he repairs the lawn mower suc-
cessfully. Charles gets utility of 5 from sitting on the lawn with Camilla. Camilla does not mind
Charles’ company so it costs her nothing to allow him to sit on the lawn. He may also be of-
fered a financial bonus if he repairs the lawn mower. Is the possibility of sitting on the lawn
with Camilla an incentive for Charles? Does Camilla’s offer to sit on the lawn affect the optimal
bonus she chooses for Charles? Does Camilla benefit from offering Charles the option to sit on
the lawn with her? [10 marks]

Guideline Answer : [10 marks]

Here Charles is intrinsically motivated so intuitively the optimal bonus will be lower (sitting with
Camilla is already a bonus for Charles as he will only get to do so if the lawn mower is repaired),
the optimal effort will be higher and because of this so will the probability of Camilla’s lawn
mower to be fixed. Mathematically, for Charles:

maxe(B + 5) − 10e2

F OC : B + 5 − 20e = 0
SOC : −20 < 0
B+5
e=
20
Camilla then maximizes:
B+5
maxe(10 − B) = (10 − B)
20
B+5 B+5
F OC : −B =0
2 20
B = 2.5
Correspondingly e = B+5 20 = 0.375
Again many students reach the correct numbers but fail to explain the intuition: Camilla benefits
from the utility Charles receives from spending time with her on the lawn, effectively a bonus
for Charles.

© LSE ST 2021/EC201 Page 14 of 15

(f) Charles receives a phone call from Elizabeth who offers him work that yields a payoff of 2 but
means he is no longer available to repair Camilla’s lawn mower. Camilla is keen to retain Charles
as a lawn mower repairer. Discuss how this affects the bonus Camilla offers Charles for repair-
ing the lawn mower, assuming she offers him the option to sit on the lawn with her? Will this
offer of employment by Elizabeth increase the probability that Camilla gets her lawn mower re-
paired? [12 marks]

Guideline Answer : [12 marks]

We need to consider whether the bonus set in the previous part is enough to make Charles better
off than his outside option. If B = 0.375 Charles’ utility is e(B + 5) − 10e2 = 1.40625, which
is lower than his outside option. The outside option becomes binding for Camilla, who will now
need to pay Charles more. With a higher bonus Charles will work harder and the probability of
the lawn mower being repaired increases. Mathematically she solves:
 2
B+5 B+5
(B + 5) − 10 =2
20 20
which solves for
B ≈ 3.94
. With this bonus e = B+520 = 0.447.
Many students obtain the correct bonus Camilla will need to give Charles but fail to discuss the
consequences: this new possibility means that Charles’ bonus will be higher and so the optimal
effort, and so the probability of fixing the lawn mower, will be higher. However, Camilla will not
be achieving the highest possible payoff as the bonus will be higher than under the outcome
in part e). Students need not show the full calculation and can stop at the first equation above
(without solving for B ), but they should explain the result intuitively.

END OF PAPER

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