Mock Exam 2020: Commentaries

2066 Microeconomics

Important note
This commentary reflects the examination and assessment arrangements for this
unit in the academic year 2019–20. The format and structure of the examination
may change in future years, and any such changes will be publicised on the vir-
tual learning environment (VLE).

Specific comments on questions

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 2066 Microeconomics

SECTION A

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

1. A firm hires workers from a competitive labour market. The firm faces
the problem that employees might shirk (avoid working hard). The firm’s
policy is to monitor the workers occasionally and fire any worker caught
shirking. This policy does not reduce shirking if the firm pays its workers
the market clearing wage. However, if the firm pays a wage greater than
the market clearing wage, this policy is effective in reducing shirking. Is
this true or false? Explain your answer.

Reading for this question Subject Guide Ch. 11.

Approaching the question The statement is true. The key point is that
at the market clearing wage, the threat of firing is ineffective in reducing
shirking because another job at the same wage is easy to obtain. If a firm
pays its workers a higher-than-market-clearing wage, losing the job is now
costly for a worker. They can get another job, but only at a lower wage. This
reduces shirking.
While the above suffices to answer the question, one can take the analysis
further. Suppose wm denotes the market clearing wage. The natural next
question is that if a single firm finds it profitable to pay a wage w∗ > wm , is
it not the case that other firms would do the same? But if all firms now pay
the same wage w∗ does the incentive effect of a higher wage vanish?
In fact that is not the case. The advantage persists because of a different
reason. If all firms pay w∗ > wm , the market does not clear. There is excess
supply at w∗ . In other words, there are workers who are looking for a job
but have not yet found a job. Given this pool of unemployed workers, a
worker who loses their job is not guaranteed to find another job quickly.
They enter the pool of unemployed and it might take a while to get matched
with another job. Job search itself might be costly given that there are lots
of people applying for every vacancy. So now if someone gets fired, they
incur a cost (waiting, costly job search) before they can find another job.
Therefore the threat of firing is still effective in reducing shirking.

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2. Short-run average cost exceeds long-run average cost only when there are
economies of scale. Is this true or false? Explain your answer.

Reading for this question Subject Guide Ch 5.

Approaching the question This is false. Short-run average costs exceed

long-run average costs because the firm is locked into a certain input mix in
the short run that may not be cost minimizing when all inputs are variable.
This condition holds regardless of the presence of economies of scale.

3. If the wage rate falls in a competitive labour market, demand for leisure
by workers must increase. Is this true or false? Explain your answer.

Reading for this question Subject Guide Ch 2.

Approaching the question This is false. If the wage rate falls, leisure be-
comes relatively cheaper so the substitution effect implies that more leisure
is demanded. However, a worker becomes poorer with a wage rate fall so
that if leisure is a normal good, the income effect implies that less leisure
is demanded. Therefore, if leisure is a normal good and the income effect
overwhelms the substitution effect, the demand for leisure would fall as the
wage rate falls. Therefore demand for leisure does not necessarily increase
as the wage rate falls.

4. A monopolist faces a constant marginal cost c and sets a price p = λc

where λ > 1. The absolute value of market demand elasticity is given by
|ε| = 3. Calculate the profit maximizing value of λ.

Reading for this question Subject Guide Ch. 8.

Approaching the question At the monopolist’s optimum

p 1
=
MC 1 − |1ε|

The left hand side is λ. The right hand side is 3/2. Thus the optimum λ is
3/2.

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5. u( x, y) = x2 + y2 . The price of x is 3 and the price of y is 2. The consumer’s

income is 18. What is the optimal consumption bundle? [Hint: Compare
interior bundles to corner solutions.]

Reading for this question Subject Guide Ch 2.

Approaching the question An indifference curve is given by x2 + y2 = k

where k is any positive constant. Note that this is the equation of a circle.
Ignoring the quadrants where either x or y or both are negative, you should
see that the indifference curves are quarter-circles, as shown in the diagram
below. You should be able to see that the MRS is x/y which is increas-
ing as x increases and y falls, giving rise to non-convex indifference curves
(normally, under decreasing MRS, the MRS should fall as x increases and y
falls). There is no interior maximum in this case. Indeed, the interior tan-
gency point is in fact the point of minimum utility on the budget line - any
other point on the budget line yields a higher utility. You should see that
the optimal consumption bundle lies at a corner. Spending all 18 on x yields
a utility 36. Spending all on y yields 81. Therefore the optimal consumption
bundle is to spend all income on y, implying buying 9 units of y.

C x

Indifference curves with increasing MRS. Point A

satisfies the first-order condition, but is does not maximise
utility. In fact utility is minimised at A. The optimum
occurs at a corner - in this case at point B.

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6. Suppose the market demand curve is infinitely elastic. In a diagram,

show the deadweight loss from a per-unit subsidy to producers. What
causes the deadweight loss to arise in this case?

Reading for this question Subject Guide Ch 6.

Approaching the question The figure below shows the deadweight loss
from a subsidy. You should understand that the loss arises because after
the subsidy, production extends to levels where the marginal benefit (given
by the demand curve) is lower than the marginal cost (given by the supply
curve). Many students identify a wrong area as the deadweight loss. Once
you understand why the deadweight loss arises, it should be straightfor-
ward to see what the correct area is in the diagram.

Price

Supply
Supply after subsidy of s per unit
Deadweight Loss

P Demand

Q Q Quantity
0 1

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7. Data from a third-world country shows that as the price of potatoes rises,
consumption of rice falls. From this we can conclude that rice might be a
Giffen good. Is this true or false? Explain your answer carefully.

Reading for this question Subject Guide Ch 2.

Approaching the question This is false. The cross price substitution effect
implies more rice consumption when potatoes become relatively more ex-
pensive. But here rice consumption falls, implying that this must be driven
by the income effect. The fall in income from the rise in price of potatoes
induces the consumption of rice to fall. This implies that rice is a normal
good. Therefore, we can rule out the possibility that rice is a Giffen good.

8. A monopolist can only charge a single price to all customers. In the pres-
ence of positive externalities from output, the inefficiency under such a
monopoly must be greater than that under a competitive market struc-
ture. Is this true or false? Explain your answer carefully.

Reading for this question Subject Guide Chs 8 and 12.

Approaching the question This is true. Under positive externalities, even

the competitive output is too low compared to the social optimum. Since
a monopolist produces less than a competitive industry, the statement is
true. Note that if the monopolist could capture consumer surplus by some
price-discrimination mechanism, the monopoly output may equal the com-
petitive output. The question puts in the statement restricting the monop-
olist to a single price to rule out such a possibility and to make the answer
unambiguous.

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SECTION B

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

9. Consider the following extensive-form game with two players, 1 and 2.

Out
1 (2,1)

In
1

A B

C D C D

(0,1) (5,2) (2,4) (-1,3)

Reading for this question Subject Guide Ch 4.

(a) Find the pure-strategy Nash equilibria of the game. [8 marks]

Approaching the question

The normal form of the game is given by
Player 2
C D
Out A 2,1 2,1
Player 1 Out B 2,1 2,1
In A 0,1 5,2
In B 2,4 -1,3

You should be able to see from this that the pure-strategy Nash equi-
libria are: (Out A, C), (Out B, C), (In A, D ) and (In B, C).

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(b) Find the pure-strategy subgame-perfect equilibria of the game.[6 marks]

Approaching the question The normal form of the subgame is given

by
Player 2
C D
Player 1 A 0,1 5,2
B 2,4 -1,3

This has two pure strategy Nash equilibria {( A, D ), ( B, C)} .

Any pure NE of the whole game that involves playing (A,D) or (B,C)
is a pure subgame-perfect Nash equilibrium.
Therefore, the set of pure-strategy subgame perfect equilibria is

{(OutB, C), ( InA, D ), ( InB, C)}

(c) Derive the mixed strategy Nash equilibrium of the subgame. If play-
ers play this mixed Nash equilibrium in the subgame, would 1 play
In or Out at the initial node? [5 marks]
[Hint: Write down the normal-form of the subgame and derive the
mixed strategy Nash equilibrium of the subgame. Next, compare
the payoff of player 1 from the mixed strategy equilibrium with 1’s
payoff from playing Out.]

Approaching the question The mixed Nash equilibrium in the sub-

game is: 1 plays A with 1/2 and B with 1/2, 2 plays C with 3/4 and
D with 1/4. The payoff of 1 from this mixed Nash equilibrium is 5/4.
This is less than 1’s payoff from paying Out, which is 2. So 1would
play Out at the initial node.
The question does not ask you to do this, but using the above, you can
construct a mixed strategy subgame-perfect equilibrium as follows: 1
plays Out A with 1/2 and Out B with 1/2, while 2 plays C with 3/4
and D with 1/4.

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10. 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 . The cost function
of firm 1 is given by C(q1 ) = q21 /2 and the cost function of firm 2 is given
by C(q2 ) = q22 /2. Let Q denote total output, i.e. Q = q1 + q2 . The inverse
demand curve in the market is given by

P = 420 − Q

Reading for this question Subject Guide Ch 9.

(a) Find the Cournot-Nash equilibrium quantity produced by each firm

and the market price. [5 marks]

Approaching the question Firm 1 maximizes profit given by Pq1 −

q21 /2 which is (420 − (q1 + q2 ))q1 − q21 /2. The first order condition for
maximum is
420 − 2q1 − q2 − q1 = 0
from which we get the best response function of firm 1:

420 − q2 q
q1 = = 140 − 2
3 3
At this point we can impose symmetry: q1 = q2 = q∗ and then solve
for q∗ . (Alternatively, we can write down 2’s best response function
q1
q2 = 140 −
3
and solve the two equations in two unknowns.) Solving, we get

3
q1 = q2 = 140 = 105
4
The total output is 210. The market price is then P = 420 − 210 = 210.

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

Approaching the question Firm 1 is the Stackelberg leader. Firm 1

maximizes (420 − (q1 + q2 ))q1 − q21 /2 where q2 = 140 − q1 /3. Substi-
tuting the value of q2 , 1 maximizes
  q1  q21
420 − q1 + 140 − q1 −
3 2
which simplifies to
q21
 
2
280 − q1 q1 −
3 2
Maximizing this, we get
4
280 − q1 − q1 = 0
3
or
7
q1 = 280
3
which implies
q1 = 120
Substituting in 2’s best response function, q2 = 100. The total output is
220, so that the market price is P = 420 − 220 = 200.

(c) Suppose the firms can collude and produce a total quantity Q. Sup-
pose firm 1 produces a fraction α of Q (so q1 = αQ) and firm 2 pro-
duces a fraction (1 − α) of Q (so q2 = (1 − α)Q). What value of α
minimises total cost of producing Q? [5 marks]
[Hint: Write the expression for C(q1 ) + C(q2 ) and minimise with re-
spect to α.]

Approaching the question Firm 1 produces a fraction α of Q and firm

2 produces a fraction (1 − α) of Q. Therefore the total cost of produc-
tion is
(αQ)2 ((1 − α)Q)2 Q2 2
+ = ( α + (1 − α )2 )
2 2 2
We need to minimise α2 + (1 − α)2 with respect to α. The first order
condition is
2α − 2(1 − α) = 0
which implies
α = 1/2.
You should check that the second order condition for a minimum holds.

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 Mock exam commentaries 2020

(d) Using the cost-minimising value of α from part (c), find the quantity
produced by each firm under collusion and the market price.
[5 marks]

Approaching the question Using α = 1/2, the total cost of production

is Q2 /4.
Therefore, the optimal profit given Q is

Q2
(420 − Q)Q −
4
Maximising with respect to Q, we get

420 − 2Q − Q/2 = 0

which implies 5Q/2 = 420 or Q = 168. Each firm produces half of

this, i.e. 84.
The market price is 420 − 168 = 252.

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11. Reading for this question Subject Guide Ch 10.

(a) Consider a market for used cars. There are 10 low quality cars and
10 high quality cars. There are 20 potential sellers with a car each,
and 20 buyers. A seller values a high quality car at 8000 and a low
quality car at 4000. A buyer values a high quality car at 10,000 and a
low quality car at 5000. All agents are risk-neutral.
i. Suppose quality is observable to sellers but not to buyers. Buy-
ers only know that out of the 20 sellers, 10 offer high quality cars
and 10 offer low quality cars. How many cars of each quality
would be sold? Write down the interval(s) of possible prices.
[8 marks]

Approaching the question If all cars are offered for sale, buyers
are willing to pay at most the average value 7500. But at this price
high quality cars are not offered. Does this mean that low quality
cars can trade at prices between 4000 and 7500? The key step is to
realise that the answer is no. The reason is that buyers are rational,
and therefore they would also know that at any price equal to or
less than 7500, high quality cars will not be offered. Therefore they
would correctly conclude that the only cars that are being offered
for sale are low quality cars.
Knowing this, buyers would also not buy any cars at any price
above 5000 (which is their value for low quality cars). Therefore
high quality cars are not traded while low quality cars are traded
at some price between 4000 and 5000.

ii. Is the market outcome in part (b) efficient? If you answer yes,
explain why. If you answer no, suggest (informally) a way to
reduce the inefficiency. [4 marks]

Approaching the question The market outcome is not efficient.

There are gains from trading high quality cars since buyers value
these more than sellers. This gain is not realised. A potential solu-
tion to the problem is for high quality sellers to differentiate them-
selves from low quality sellers by offering warranties. A warranty
offer can serve as a separating device if high quality car sellers
could offer a warranty that would satisfy their participation con-
straint, and if low quality sellers would not find worthwhile to
offer the same warranty. In this case buyers no longer face any in-
formation asymmetry: they know that cars that come with a war-
ranty are high quality and cars that come without a warranty are

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low quality. In this case high quality cars sell at some price be-
tween 8000 and 10000 and low quality cars sell at some price be-
tween 4000 and 5000. All gains from trade are then realised and
the market outcome is efficient.
(b) A firm can hire two types of workers: A-type workers who have high
productivity and B-type workers with low productivity. Once hired,
a worker is employed for 10 years. The market rate of interest is
zero. The competitive wage for a A-type worker is 500 per year and
that for a B-type worker is 300 per year.
Suppose the type of a worker is private information of the workers.
Suppose workers have the option of obtaining a few years of edu-
cation before they start working. Each year of education (which in-
cludes the psychological costs of study effort) costs an A-type worker
100, while each year costs a B-type worker 250. Show that the firm
can solve the problem of information asymmetry by setting wages
based on the number of years a worker spends in education. Your
answer must explicitly derive the relation between the firm’s wage
offer and a worker’s years of education. [8 marks]

Approaching the question Calculate the benefit and cost of education

for each type. Suppose the firm would pay the higher wage to anyone
who has acquired y years of education. The benefit of such education
is 200 per year for 10 years. Since the market interest rate is zero, the
present value of benefit is 2000.
Now, for the firm to be able to separate the types successfully, y must
be such that B-types have no incentive to acquire y years of education,
while A types do have an incentive to acquire such education. B-type
workers do not obtain education as long as

2000 6 250y

or y > 8. A-type workers obtain education as long as

2000 > 100y

or y < 20. Therefore the firm should set a wage of 500 if it observes
y > 8, and 300 otherwise.

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12. Reading for this question Subject Guide Ch. 3.

(a) Lee does not have insurance against car theft. His car is worth 45. He
can park his car on the street or pay to park in a garage. If parked
on the street, the car is stolen with probability 1/3. If parked in a
garage, the car is safe from theft. Including the value of his car, Lee
has a wealth of 81. His utility from wealth W is
√
u(W ) = W.

i. Calculate the maximum amount that Lee is willing to pay to park

in a garage. [5 marks]

Approaching the question Expected utility is

√ √
2/3 81 + 1/3 36 = 8.
√
The certainty equivalent is given by CE = 8, i.e. CE = 64. There-
fore the maximum willingness to pay is 81 − 64 = 17.

ii. Now suppose Lee’s risk preference changes so that he becomes

risk neutral, The utility function representing his preference over
wealth levels is given by

u(W ) = W.

In this case, what is the maximum amount that Lee is willing to

pay to park in a garage? [5 marks]

Approaching the question Expected utility is

2 1
81 + 36 = 66.
3 3
The maximum willingness to pay is P such that 81 − P = 66, which
implies P = 15.

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(b) Rachel has 100 to invest. Two assets, 1 and 2, are available for in-
vestment. An amount y invested in asset 1 yields a total return of
1.1y. An amount x invested in asset 2 yields a risky total return of x
with probability 0.5 and 1.21x with probability 0.5. Rachel’s utility
function is given by
U (w) = ln(w)
where w is wealth after investing.
Let any portfolio be denoted by ( x, y) where x is the amount invested
in the risky asset (asset 2) and y = 100 − x is the amount invested in
the safe asset (asset 1).
How much should Rachel invest in the risky asset? [10 marks]

Approaching the question Rachel’s expected utility as a function of

the amount of investment in the risky asset (x) is:
   
EU ( x ) = 0.5 ln (100 − x )(1.1) + x (1.21) + 0.5 ln (100 − x )(1.1) + x

This simplifies to
   
EU ( x ) = 0.5 ln 110 + 0.11x + 0.5 ln 110 − 0.1x

The first order condition for maximization with respect to x is

0.055 0.05
− = 0.
110 + 0.11x 110 − 0.1x
This implies

(0.055 − 0.05)(110) = x (0.055(0.1) + 0.05(0.11))

Which simplifies to 0.55 = x (0.011) implying x = 50.

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13. 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.

Reading for this question Subject Guide Ch 8

Approaching the question 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) 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]

Approaching the question 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.

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(b) Now suppose the monopolist cannot differentiate between the cus-
tomers and must charge them the same price. Calculate the monop-
olist’s optimal single price P as well as the quantity sold to each cus-
tomer. [5 marks]

Approaching the question If a single price is set, the monopolist max-

imizes 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) Is the total surplus (consumer surplus plus profit) higher under a
single price or under price discrimination? Explain. [5 marks]

Approaching the question Under price discrimination, consumer sur-

plus 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 sin-
gle price is
Ssingle = 5200

Therefore the total surplus is higher when a single price is charged.

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(d) Suppose, as in part (b), the monopolist cannot differentiate between

the customers. However, in addition to a per-unit price P, the mo-
nopolist can also charge a fixed fee F. 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]

Approaching the question 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
Maximizing, 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 maximize 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 = =
2
5000. The profit of the 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).

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14. Alice and her brother Bill support their elderly parents. There is a single
good (call it money). All consumptions are measured in units of money.
Alice cares about the number of units she consumes directly (denoted by
y A ) and the number of units her parents consume (denoted by x). Her
utility function is
1
u A ( x, y A ) = x 3 y A

Similarly, Bill’s utility function is

1
uB ( x, yB ) = x 3 yB

where yB is his direct consumption. The parents’ consumption x is sim-

ply the sum of the support contributions from Alice (x A ) and Bill (x B ),
i.e.
x = x A + xB

Alice and Bill have an income of 42 each.

Reading for this question Subject Guide Chs 9 and 12

(a) Suppose Alice is unable to contribute anything toward the parents’

support, so that Bill must provide for both his own consumption yB ,
and his parents’ consumption x. Determine Bill’s optimal choice of
x and yB . [5 marks]

Approaching the question This is a straightforward constrained op-

1
timization problem. Maximize x 3 y B subject to x + y B = 42. At the
optimum,
1 −2 1
x 3 (42 − x ) = x 3
3
which implies 3x = 42 − x. Therefore Bill’s optimal choice is x ∗ = 10.5,
and y∗B = 31.5.

(b) Now suppose Alice is also going to contribute toward the parents’
support. Given any level of contribution from Bill, Alice chooses
her optimal contribution. Similarly, for any level of contribution by
Alice, Bill chooses his optimal contribution. What are their equilib-
rium contributions to support their parents? [10 marks]

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2066 Microeconomics

Approaching the question You should realise that this is like solving
for a Cournot equilibrium. The best response function of Bill is given
by:
1
max( x A + x B ) 3 (42 − x B )
xB

which implies

1 2 1
( x A + x B )− 3 (42 − x B ) = ( x A + x B ) 3
3
which simplifies to
3( x A + x B ) = 42 − x B
Similarly, Alice’s best response function is

3( x A + x B ) = 42 − x A

Adding the two best response functions, 7( x A + x B ) = 84, i.e. x A +

x B = 12. Using this in each best response function gives us x A = x B =
6. This can be seen also from the diagram below.

14

Alice’s best response function

10.5

x
B
6
Bill’s best response function

6 10.5 14

xA

Equilibrium contributions by Alice and Bill

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 Mock exam commentaries 2020

(c) Does the equilibrium contributions in part (b) add up to the Pareto
optimal level of support? Explain informally (you do not need to
derive the Pareto optimal level of support). [5 marks]

Approaching the question The key point is that a contribution by

each agent also benefits the other agent. In other words, these are con-
tributions to a public good, and therefore private provision leads to an
inefficient level of contribution. Alternatively, you might say that the
contribution by one agent generates a positive externality for the other,
implying that the total equilibrium level of contribution would be too
low relative to the social optimum.

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