MANAGERIAL ECONOMICS

Indian School of Business

Term 1, 2020-21

Homework 3 Solutions

Problem 1:
Consider two farmers and two pieces of land1 . We want to know what the effect is of each
farmer working his own piece of land (we denote these independent farmers) versus the
farmers cooperating and jointly working on the two pieces of land (collective farmers).
Assume that each farmer (whether independent or collective) can decide on his own
how much time to spend on farming. Let farmer’s weekly time spent on farming be
denoted hi (in hours per week; so h1 for farmer 1 and h2 for farmer 2). The farmer’s
productivity (expressed in bushels of grain) is directly proportional to the time he spends
on farming. In particular, an independent farmer produces (80 ∗ hi ) bushels of grain if
he works hi hours per week. Farmers in a collective are more productive since they can
specialize: a collective farmer produces (90 ∗ hi ) bushels of grain if he works hi hours per
week. Collective farmers share the output of their farm equally. Let bi be the bushels
of grain that farmer i can take home at the end of the year, then bi = 80hi for an
independent farmer, while bi = (90h1 + 90h2 )/2 for a cooperative farmer.
Farmers dislike working and more so as they work more. In particular, farmer’s utility
is

h2i
Ui = bi −
2
We assume that a farmer i will choose hi to maximize his utility Ui .

(a) Write out the utility functions of an independent farmer and the collective farmers
completely in terms of h1 and h2 .

(b) How many hours will an independent farmer work (assuming that farmers choose
hi to maximize their utility)? What is his utility?

(c) How many hours will a collective farmer work? What is his utility?

(d) What is the problem with a collective farm? What would happen (qualitatively) if
100 farmers worked jointly in a collective farm? How could the farmers solve that
problem?
1
This question is from Berndt, Chapman, Doyle and Stoker’s course at MIT Sloan

1
Answer:
(a) The utility of the independent farmer is

h2i
Ui = 80hi −
2

and that of the collective farmer is

h1 + h2 h2i
Ui = 90 −
2 2

(b) Taking derivative of the independent farmer’s utility w.r.t. hours of work and
setting it equal to zero yields 80 − hi = 0, that is, hi = 80. The utility of the
independent farmer is 3200.
h2
(c) Consider farmer 1 with utility U1 = 45(h1 + h2 ) − 21 . Taking derivative of his utility
w.r.t. his hours of work and setting it equal to zero yields 45 − h1 = 0, that is,
h1 = 45. Accordingly U1 = 45(45 + 45) − 2025/2 = 3037.5 By symmetry, the same
result holds for farmer 2 as well.

(d) The problem of the collective farm is that the output is common property, so
farmers get only part of the output they produce. The incentives to work change
from M R = M C to a fraction of M R = M C. Compare, in particular, independent
and collective farmers who consider the gain from putting in one more hour after
they have already worked 45 hours. The cost to each of working the 46th hour is
462 /2–452 /2 = 45.5.
The gain for an independent worker is 80, which outweighs the cost of 45.5. For a
cooperative worker, the gain is only 45 (since half of his output goes to the other
farmer), so working the extra hour is not worth it. Note that farmer 1 putting
in more hours does not change how many hours farmer 2 works. This problem
is magnified with more farmers, as the share of the marginal bundle kept by the
farmer (1/no. of farmers) decreases with the number of farmers.
Of the number of hours that someone works is observable, the farmers could write
a contract that exploits the gains from specialization and maximizes utility. (The
optimal number of hours for each farmer is 90 per week in the cooperative and
farmers would get utility of 4050.) If effort is not observable, we would have to
explore incentive schemes or screening mechanisms to align incentives.

2
Problem 2:
The business district of Bombay2 , Hariman’s Joint, sits on an island3 . Most of the people
who work in this district commute from the mainland. Specifically, 400,000 people make
this commute. Bombayites are in love with their cars, so each of the 400,000 people drives
to and from work in a private car; there is no carpooling.
There are two routes from the mainland into (and out of) the business district, the
Borli Bridge (B)4 and the Tycoon’s Tunnel (T). The time it takes to commute across the
bridge and through the tunnel depend on the number of individuals nB and nT who take
the bridge and the tunnel, respectively. Specifically, if nB people come via the bridge,
the commute time via the bridge is 30 + nB /20000 minutes, and if nT people come via
the tunnel, the commute time via the tunnel is 40 + nT /5000 minutes.

(a) Suppose each of the 400,000 people who make this commute takes either the bridge
or the tunnel; that is, nB + nT = 400, 000. People choose whether to take the bridge
or the tunnel depending on which takes less time, so in equilibrium, the numbers
nB and nT are chosen so that the two commute times are equal. What are nB and
nT ?

(b) We define the total commute time as nB times the commute time via the bridge
plus nT times the commute time via the tunnel. In your answer to part (a), what
is the total commute time?

(c) Suppose Bombay’s mayor could control the number of people who come via the
bridge and via the tunnel. She chooses these numbers to minimize the total com-
mute time. How should she allocate the 400,000 commuters between the bridge and
the tunnel to minimize total commute time?

(d) Except for the congestion on the bridge and tunnel, there is a 0 marginal cost of
getting commuters across the bridge and the tunnel. For this reason, transit across
the bridge and through the tunnel has been kept free. But the mayor is considering
whether to impose a toll on one or the other. If a toll of tB is imposed on the
bridge and tT on the tunnel, consumers will rearrange their commute so that (10tB
+ commute time through the bridge in minutes) equals (10tT + commute time
through the tunnel in minutes). In other words, 10 minutes of commute time is
worth Rs. 1 to commuters. Find values for tB and tT , where one is 0, so that,
2
Any resemblance to the actual city of Mumbai is purely coincidental.
3
This problem is adapted from Krep’s Microeconomics for Managers.
4
The local press grandly calls this a “sealink”

3
 facing these tolls, commuters arrange their commute in the manner that minimizes
total commute time.

Answer
nT nB
(a) Equate commute time, that is, 40 + 5000 = 30 + 20000 . Also note that nT + nB =
400000. Solving these we get nT = 40000 and nB = 360000.

(b) This gives a commute time of 48 minutes for both routes, and hence total commute
time of 19.2 million minutes.

(c) We want to minimize

 nB   nT 
30 + nB + 40 + nT
20000 5000

subject to nB + nT = 400000. One way to solve is to substitute 400000 − nB for nT ,

take the derivative and set it equal to zero. We get nB = 60, 000 and nT = 340, 000.
The optimal commute time is 47 minutes by bridge and 52 minutes by tunnel.

(d) You can read the answer right off of the last line of part c. To get commuters to
divide 60000 via tunnel and 340000 via the bridge, the toll has to be set to overcome
the 5 minute difference in commute times, in favor of the bridge. So set a toll of
Rs. 0.50 for the bridge.

4
Problem 3:
Awbrey Butte is an exclusive neighborhood of big, modern houses surrounded by native
pines in the Oregon mountains (see attached article). Resident Susan Taylor likes to use
a clothesline to dry her laundry, and thus saves $80 on average in annual energy costs
(apart from the obvious environmental benefits). Neighborhood manager Carol Haworth
is concerned that seeing laundry outside might give potential home-buyers the idea that
residents are too poor to afford dryers, and that will drive down property values. Suppose
the decline in property values is proportional to the number of weeks a year Susan dries
her laundry outside. Consider 10 weeks as the unit of measurement.

Number of weeks Total benefits to Total annualized

clothesline is used Susan Taylor loss to Carol Hay-
worth
0 0 0
10 $16 $10
20 $32 $25
30 $48 $45
40 $64 $70
50 $80 $100

(a) In the absence of bargaining, how many weeks would Susan dry her laundry if she
has a right to do so?

(b) In the absence of bargaining, how many weeks would Susan dry her laundry if Carol
has a right to protect her property value?

(c) What is the socially optimal number of weeks the clothesline should be used?

(d) With bargaining, how many weeks would Susan dry her laundry if she has a right
to do so? What is the minimum Carol would pay Susan?

(e) With bargaining, how many weeks would Susan dry her laundry if Carol has a right
to protect her property value? What is the minimum Susan would pay Carol?

Answer
(a) 50 weeks

(b) 0 week

5
(c) 20 weeks

(d) 20 weeks. Carol will pay Susan $48. Susan’s payoff is preserved ($ 80). Carol will
be better off because her cost is 25 + 48 = 73 dollars which is less than $ 100.

(e) 20 weeks. Susan will pay Carol $25. Carol’s payoff is preserved ($0). Susan will be
better off because her cost is $32 − $25 = $7 > $0.

6
Problem 4:
An old lady is looking for help crossing the street 5 . Only one person is needed to help
her; more are okay but no better that one. Sunny and Simran are the two people in the
vicinity who can help; each has to choose simultaneously whether to do so. Each of the
two will get utility worth 3 from the old lady’s success (no matter who helps her). But
each one who goes to help will bear a cost of 1, this being the utility value of the person’s
time taken up in helping. Set this up as a game. Write the payoff table, and find all
pure-strategy Nash equilibria.

Answer
The payoff matrix is below. Best-response analysis shows there are two pure-strategy
Nash equilibria: (Help, Not Help) with payoffs (2, 3) to (Sunny, Simran) and (Not Help,
Help) with payoffs (3, 2).

Simran

Help Not Help

Help 2,2 2,3

Sunny
Not Help 3,2 0,0

5
This problem is from Dixit and Skeath’s Games of Strategy.

7
Problem 5:
Having muscled out the other bhelpuri vendors on Chowpatty Beach in Bombay, the
proprietors of Royal Bhelpuri and Modern Bhelpuri have to decide where to locate their
stalls. Customers are situated uniformly along the beach, and will purchase from the
vendor closest to them.

(a) If the beach is 1 km long, what are the Nash equilibrium locations for Royal and
Modern?

(b) If a new entrant, Tasty Bhelpuri, enters the market, what are the equilibrium
locations?

Answers:
(a.) 2 players => Both will locate at the 0.5 km point.

(b.) 3 players => No Nash equilibrium, each has an incentive to deviate.