Homework #3 SUGGESTED SOLUTIONS

University of Michigan, Department of Economics

Econonomics 101, Section 104 (Adam Cole) - Principles of Economics I
Due June 23, 2005
1 Competitive Equilibrium and Pareto Eciency
1. What is a Pareto ecient economic state?
SOLUTION: A Pareto ecient, or economically ecient, or simply ecient eco-
nomic state is one in which if any one person is made happier (achieves a higher total
utility level) then at least one other person must be made less happy (achieves a lower
total utility level).
2. Suppose $100 is to be allocated between Juan, Jose and Juanita. Each of them always
prefers more money to less.
What are the Pareto ecient allocations of the $100?
SOLUTION: Any allocation of all of the $100 is Pareto ecient.
Give an example of a Pareto inecient allocation of the $100.
SOLUTION: Any allocation of less than all of the $100 is Pareto inecient.
Is any of the Pareto ecient allocations fair?
SOLUTION: What is fair? If you believe that equal shares is fair, then the only
fair and ecient allocation is allocating one-third of the $100 to each of Juan,
Jose and Juanita. If instead you think that fair means that each of the three
people should get at least one quarter of the $100, then any allocation of the entire
$100 that gives at least $25 to each person will be both fair and Pareto ecient.
You decide.
Is any of the Pareto ecient allocations unfair?
SOLUTION: Again, what is fair? For example, if you still think that fair means
that each of the three people should get at least $25, then any allocation of all
$100 that gives less than $25 to at least one person will be Pareto ecient but
unfair. Some ecient allocations would be regarded as unfair by most people. For
example, if all $100 are given to Juan then, while he might consider this to be
fair, probably Jose and Juanita would consider it to be unfair.
1
Is any inecient allocation of the $100 fair?
SOLUTION: Yet again, what is fair? Since an inecient allocation must mean
that not all of the $100 is allocated to the three people, for such an allocation to
be fair you must believe that wasting some dollars is fair. Particularly, you would
have to believe that it would be fair not to allocate the wasted dollars to any one
of the three people, even while not taking from any one of them the dollars already
allocated.
3. This is an extension of the question above. This time we will consider allocation a
freshly baked chocolate cake between Juan, Jose and Juanita. Each person always
prefers more cake to less. The whole cake is now divided into slices and all of the slices
are allocated to our three consumers. After the allocation has been made we observe
that Juan values the last piece of cake he has at $4, that Jose values his last piece of
cake at $4, and that Juanita values her last piece of cake at $6.
Is the total value generated by consumption of the cake maximized?
SOLUTION: No.
Is the allocation of the cake economically ecient?
SOLUTION: No. While it is true that all of the cake is allocated, the allocation
does not maximize the total consumption value of the cake. An allocation is e-
cient if and only if any reallocation of the cake that improves someones happiness
necessarily reduces at least one other persons happiness. In part (iii) we will see
that it is possible to reallocate the cake so as to make someone better o without
making anyone else worse o. Thus the cake allocation must be inecient.
If your answer to either part (i) or part (ii) is No, then what reallocation(s)
would increase the total value of cake consumption and improve the economic
eciency of the allocation of the cake?
SOLUTION: Notice that Juanita values her last piece of cake at $6, which is
more than the $4 values that Juan and Jose place upon their last pieces of cake.
So suppose that Juanita and Juan enter into a trade in which Juanita pays Juan
$5 for his last piece of cake. Juanita is better o since for an expenditure of $5 she
obtains a piece of cake that she values at $6 (her additional Consumers Surplus
is $6 - $5 = +$1). Juan is also better o since he was paid $5 to give up a piece
of cake that he valued at $4 (his additional Producers Surplus is $5 - $4 = +$1).
Reallocating in this way Juans last piece of cake to Juanita results in two people
being happier with nobody made less happy. Therefore the original cake allocation
was inecient. Note that the total gain from trading this piece of cake is $1 +
$1 = $2, which is the dierence in the values that Juan and Juanita place on a
last piece of cake. For the same reasons Jose and Juanita could also enter into
a mutually benecial trade of Joses last piece of cake. Juan and Jose, however,
cannot benet from trade since each of them places the same $4 value of their last
pieces of cake.
4. (Q12, Fall 2004 2
nd
Midterm (Morgan)) Joe, John and Jim divide a whole pizza into
a lot of small slices and then allocate all of the slices between them. Joes valuation
2
of his last slice of pizza is $12. Johns valuation of his last slice of pizza is $6. Jims
valuation of his last slice of pizza is $1. Is the total consumption value of the pizza as
large as it can possibly be? Answer Yes or No. If your answer is No, then how
can the pizza be reallocated to increase its total consumption value?
SOLUTION: No. Take a little pizza from Jim and give it to Joe.
5. (Q13, Fall 2004 2
nd
Midterm (Morgan)) Mike and Amy are given an 8-slice pizza. Mikes
loves pizza and always prefers more to less. Amy likes pizza, but after she consumes
3 slices she feels full and then eating any additional slices makes her feel worse. List
two Pareto ecient allocations and two Pareto inecient allocations.
SOLUTION: Let the allocation of slices be denoted by (M, A), where M is the num-
ber of slices allocated to Mike and A is the number of slices allocated to Amy. The
Pareto ecient allocations are (8, 0), (7, 1), (6, 2), and (5, 3). The Pareto inecient
allocations are (4, 4), (3, 5), (2, 6), (1, 7), and (0, 8).
2 Monopoly, Its Regulation, and Price Discrimination
6. (Q33, Winter 2003 Final Exam) The table below shows the total revenue and total
cost schedules of a monopoly.
Quantity Total Total
Cost ($) Revenue ($)
1 60 60
2 70 70
3 80 90
4 90 120
5 100 90
6 110 70
7 120 60
In order to maximize its prots, how many units should the rm produce, and what
price should it charge?
SOLUTION: Prots are maximized when Q

= 4 units are produced ( = $120

$90 = $30). Next, since total revenue is the price the rm receives times the quantity
it produces, the price the rm charges is P

=
$120
4 units
= $30/unit.
3
7. (Q34, Winter 2003 Final Exam) The graph below depicts the demand curve, the
marginal revenue curve, and the marginal cost curve of an unregulated, prot-maximizing
monopoly. The rms xed cost is $10.
-
6
$/unit
units
@
@
@
@
@
@
@
@
@
@
@
@
A
A
A
A
A
A
A
A
A
A
A
A

MC
D MR
8
12
4
6
4 6 12
Please nd the rms prot-maximizing quantity and price. Then please nd the
rms revenue, variable cost, producer surplus, and prot. What is the deadweight
loss associated with this monopoly?
SOLUTION: Prot-maximization requires that on the last unit produce, MR = MC.
Thus, the rm produces 4 units. Then we go up to the demand curve to deter-
mine the price the rm charges; here the rm charges a price of $8/unit. Vari-
able costs are computed as the area under the marginal cost curve; variable costs are
(0.5)($4/unit)(4 units) = $8. Producer surplus is PS = TR V C = $32 $8 = $24.
Prot is = TR TC = $32 $8 $10 = $14. The Pareto ecient level of out-
put is where the marginal benet of the last unit consumed is equal to its marginal
cost of production. Thus, the Pareto ecient level of output is 6 units at a price of
$6/unit. The deadweight loss associated with the monopoly is DWL = (0.5)($8/unit
$4/unit)(6 units 4 units) = $4.
4
8. (Q35, Winter 2003 Final Exam) Acme Auto Insurance is a monopoly that sells in-
surance to two types of customers, Maniacs (who crash frequently) and Moms (who
dont). These two types have dierent demand curves for auto insurance.
-
6
-
6
A
A
A
A
A
A
A
A
A
A
A
A
A
A
A
C
C
C
C
C
C
C
C
C
C
C
C
C
C
C
a
a
a
a
a
a
a
a
a
a
a
a
a
aa
$/policy $/policy
policies policies
MC MC
D
MR
MR
D
Maniac Market Mom Market
80
60
40
20 40
120
80
40
10 20 30
At rst, the rm charges only one price to all its customers. Its producer surplus is
$720, and prot is $600. Then, it discovers it can distinguish Moms from Maniacs
and thus charges dierent prices in the dierent markets. By how much do producer
surplus and prot change?
SOLUTION: In the Maniac market, the rm should supply 10 policies and charge a
price of $80/policy. Revenue will be $800. Variable cost is the area under the marginal
cost curve; thus V C = $400. Producer surplus from the Maniac market is $400. In
the Mom market, the rm should supply 20 policies and charge a price of $60/policy.
Revenue is $1,200, variable cost is $800, and producer surplus is $400. Therefore,
producer surplus increases from $720 to $800, an increase of $80. Recall, the change
in prot is equal to the change in producer surplus; prot increases by $80.
5
9. (Q36, Winter 2003 Final Exam) The graph below depicts a natural monopoly.
-
6
$/unit
units
@
@
@
@
@
@
@
@
@
@
@
@
@
@
@
@
A
A
A
A
A
A
A
A
A
A
A
A
A
A
A
A
9
6
5
2
7 10 14
ATC
MC
MR
D
What is the monopoly outcome?
SOLUTION: Prot maximization requires on the last unit produced MR = MC;
the rm produces 7 units. The rm charges $9/unit.
What is the Pareto ecient outcome?
SOLUTION: The Pareto ecient outcome is where the marginal benet of the
last unit produced equals the marginal cost of producing the last unit. The Pareto
ecient outcome is 14 units being produced at a price of $2/unit.
Under marginal cost pricing, how much must the government pay the rm to
make it produce in the long-run?
SOLUTION: With marginal cost pricing, we get the Pareto ecient level of
output (14 units at a price of $2/unit). At this quantity and price, though, the
rm loses money. The average cost of producing 14 units is $5/unit. The rm is
losing $3/unit; losses total $42. To produce in the long-run, the rm must have
prots greater than or equal to zero. So, the rm must be paid at least $42 to
produce in the long-run.
Under average cost pricing, how much is the deadweight loss?
SOLUTION: Under average cost pricing, 10 units are traded at a price of
$6/unit. The deadweight loss is DWL = (0.5)($6/unit $2/unit)(14 units
10 units) = $8.
6
10. (Q16 Fall 2004 3
rd
Midterm) A local monopoly produces water for the town. It has
collected information about price, quantity, and marginal costs, which are given in the
table below. In addition, its xed costs are $20.
Units Price MC
($/unit) ($/unit)
1 13 3
2 12 4
3 11 5
4 10 6
5 9 7
6 8 8
7 7 9
What is the Pareto ecient level of output and price?
Please nd the prot-maximizing quantity and price. What is the rms producer
surplus and prot?
If the government were to regulate by marginal cost pricing, how much would the
government have to pay the rm to ensure it stays in business in the long-run?
If the government were to regulate by average cost pricing, how many units would
be traded and at what price?
SOLUTION: Ive constructed a table that contains values need to answer the questions
at hand.
Units Price TR MR MC VC TC ATC
($/unit) ($) ($/unit) ($/unit) ($) ($) ($/unit)
1 13 13 13 3 3 23 23.00
2 12 24 11 4 7 27 13.50
3 11 33 9 5 12 32 10.67
4 10 40 7 6 18 38 9.50
5 9 45 5 7 25 45 9.00
6 8 48 3 8 33 53 8.83
7 7 49 1 9 42 62 8.86
The Pareto ecient level of output is the one where price equals marginal cost; the
Pareto ecient level of output is 6 units of output at a price of $8/unit. Left to its
own devices, the rm maximizes prots by producing 4 units of output and charging
a price of $10/unit. Revenue is $40, variable costs are $18. Producer surplus is thus
$22, and prot is thus $2.
Under marginal cost pricing, the rm would produce 6 units. Its losses would be $5. So,
the government would need to pay the rm at least $5 to stick around in the long-run.
Under average cost pricing, the rm would produce 5 units at $9/unit.
7
11. (Q16, Winter 2004 3
rd
Midterm) Titanic Airlines is a prot-maximizing monopolist in
the market for short ights across the Atlantic. It has two types of customers, poor
artists P and rich heirs R. Their market demands are given in the following table.
Price Q
R
D
Q
P
D
($/ticket) (tickets) (tickets)
6,000 2 0
5,000 6 1
4,000 8 4
3,000 10 7
2,000 14 12
1,000 20 20
Titanic has a constant marginal cost of $2,000 per passenger. What is the dierence
between the prices in the two markets with third-degree price discrimination? What
is the rms producer surplus?
SOLUTION: Ive constructed the following table that contains the data needed to
solve the problem. From this, we see that the rm should sell 6 tickets to rich heirs
at a price of $5,000/ticket and sell 4 tickets to poor artists at a price of $4,000/ticket.
Total revenue is $46,000, variable cost is $20,000, and producer surplus is $26,000.
Price Q
R
D
Q
P
D
TR
R
TR
P
MR
R
MR
P
($/ticket) (tickets) (tickets) ($) ($) ($/ticket) ($/ticket)
6,000 2 0 12,000 0 6,000
5,000 6 1 30,000 5,000 4,500 5,000
4,000 8 4 32,000 16,000 1,000 3,666
3,000 10 7 30,000 21,000 -1,000 1,666
2,000 14 12 28,000 24,000 -500 600
1,000 20 20 20,000 20,000 -1,333 -500
12. (Q30, Winter 2004 3
rd
Midterm Exam) A monopolist sells lemonade to a thirsty con-
sumer and call tell exactly the consumers willingness to pay for each glass of lemonade
consumed. This information is summarized in the following table.
Glasses 1 2 3 4 5 6
Marginal Willingness to Pay 9.00 5.00 3.00 2.00 1.00 0
($/glass)
The monopolists marginal cost is constant and equal to $2.50/glass. If the monopolist
perfectly price discriminates and charges $2.50/glass, what is the additional payment
the consumer must also make while paying $2.50/glass?
8
SOLUTION: At a price of $2.50/glass, the individual is willing to purchase 3 glasses
of lemonade. The consumers surplus before the pay to play fee is ($9/glass
$2.50/glass) + ($5/glass $2.50/glass) + ($3/glass $2.50/glass) = $9.50. Since
the monopolist perfectly price discriminates, it will make the consumers surplus zero
by charging a fee of $9.50. .
3 Monopolistic Competition
13. (Q4, Winter 2005 3
rd
Midterm) True/False and Justify: In a monopolistically com-
petitive market, barriers to entry will result in zero prots for all rms in the long-run.
SOLUTION: False - Monopolistically competitive rms do not have prohibitive bar-
riers to entry. Entry and exit drive prots to zero in monopolistically competitive
markets.
14. (Q18, Winter 2005 3
rd
Midterm) Groundskeeper Willies Haggis Hut is a prot-maximizing
monopolistic competitor in Springelds haggis market. The price of a (wee) sheeps
stomach, an input needed for each serving of haggis, rises. Which of the following
statements is false?
(a) Willie buys fewer (wee) sheeps stomachs.
(b) The consumer surplus from buying Willies haggis is now lower.
(c) Even if price is less than the minimum average variable cost, Willie will produce
in the short-run because he has market power.
(d) Willie sells fewer servings of haggis and charges a higher price per serving.
(e) Willies Haggis Hut will earn zero prots in the long-run.
SOLUTION: C - An increase in input prices will cause Willies marginal cost curve
to shift upward. This will cause the prot-maximizing quantity to be less (thus he buys
fewer wee sheeps stomachs), and Willie should charge a higher price. Since consumers
are buying fewer servings at a higher price per serving, consumer surplus is now lower.
Since he is in a monopolistically competitive market, free entry and exit will force prots
to zero in the long-run. Thus C must be the answer. Market power has nothing to do
with the rms shut-down rule.
9
4 Game Theory
15. This problem has two purposes: (1) to show how the geniuses behind A Beauti-
ful Mind botched their explanation of Nash equilibrium and (2) to give you some
practice at analyzing a normal-form game.
Adam and John Nash are in a bar. They spot a rather attractive blonde woman, say
Portia De Rossi,
1
and a less attractive brunette, say Jennifer Garner.
2
Their expected
payos from approaching these women are listed in the matrix below; Johns payo
is listed rst, Adams is listed second. They both prefer the blonde, but if they both
approach her, their expected payos are lower than if one goes for the brunette and
one goes for the blonde. The story is similar if they both approach the brunette. This
game is symmetric:
Adam
Blonde Brunette
Blonde (2, 2) (10, 5)
John
Brunette (5, 10) (1, 1)
Does John have a dominant strategy? If so, what is it?
SOLUTION: NO If Adam goes for the blonde, John should go for the brunette
(5 > 2). If Adam goes for the brunette, John should go for the blonde (10 > 1).
These are Johns best responses given what Adam does.
Does Adam have a dominant strategy? If so, what is it?
SOLUTION: NO If John goes for the blonde, Adam should go for the brunette
(5 > 2). If John goes for the brunette, Adam should go for the blonde (10 > 1).
These are Adams best responses given what John does.
If they both go for the brunette, does either have an incentive to change his
behavior?
SOLUTION: YES Suppose the players are at (Brunette, Brunette). The
makers of the movie suggested this outcome is an equilibrium of the game. The
problem is, however, Adam has an incentive to change his behavior and go for
the blonde (10 > 1). Similarly, John has an incentive to change his behavior and
go for the blonde (10 > 1). So, we cannot support (Brunette, Brunette) as an
equilibrium of this game! Both players have an incentive to change their behavior.
(Note, to show (Brunette, Brunette) isnt an equilibrium, we only needed to show
one player has an incentive to change his behavior.)
If John approaches the blonde, what is Adams best response? If John approaches
the brunette, what is Adams best response?
SOLUTION: This was answered above. If John goes for the brunette, Adams
best response is to go for the blonde. If John goes for the blonde, Adams best
response is to go for the brunette.
1
Nevermind that shes a lesbian. . .
2
Personally, I wouldnt say shes less attractive. Just work with me here. . .
10
If Adam approaches the blonde, what is Johns best response? If Adam ap-
proaches the brunette, what is Johns best response?
SOLUTION: This was answered above. If Adam goes for the brunette, Johns
best response is to go for the blonde. If Adam goes for the blonde, Johns best
response is to go for the brunette.
What is the pure strategy Nash equilibrium (or equilibria) of this game? Is this
equilibrium (or equilibria) Pareto ecient?
SOLUTION: Based on what was just said, we have two Nash equilibria in pure
strategies: (Brunette, Blonde) and (Blonde, Brunette). If were at either of those
two outcomes, neither player has an incentive to change his behavior. Thats why
theyre equilibria! These equilibria are also Pareto ecient. Deviating from these
outcomes, neither player can be made better o without making the other player
worse o. Indeed, in this game, deviating from these outcomes, both players would
be made worse o.
Now suppose that Adam approaches the blonde with probability p and approaches
the brunette with probability (1 p). What value of p would make John indif-
ferent from approaching the blonde and from approaching the brunette?
SOLUTION: If Adam approaches the blonde with probability p and approaches
the brunette with probability (1 p), Johns expected payo from approaching the
blonde is p 2+(1p) 10. Similarly, Johns expected payo from approaching the
brunette is p 5+(1p) 1. John would be indierent from approaching either the
blonde or the brunette when p2+(1p)10 = p5+(1p)1. Rearranging, we nd
10 8p = 1 + 4p 12p = 9; this implies John is indierent from approaching
either the blonde or the brunette when p = 0.75, i.e., when Adam chooses the
Blonde with probability 0.75.
Similarly, suppose that John approaches the blonde with probability and ap-
proaches the brunette with probability (1 ). What value of would make
Adamindierent from approaching the blonde and from approaching the brunette?
SOLUTION: Given the symmetry of the game, we had better nd that =
0.75 makes Adam indierent from approaching either the blonde or the brunette.
Lets check to make sure. If John approaches the blonde with probability and
approaches the brunette with probability (1 ) , Adams expected payo from
approaching the blonde is 2 + (1 ) 10. Similarly, Adams expected payo
from approaching the brunette is 5+(1)1. Solving for , we see Adam would
be indierent from approaching either the blonde or the brunette when = 0.75.

What is the Nash equilibrium in mixed strategies of this game?

SOLUTION: It turns out that if Adam approaches the blonde with probability
p = 0.75 and John approaches the blonde with probability = 0.75, both as found
above, this too is a Nash equilibrium of this game! Its a Nash equilibrium in
mixed strategies, because the players are mixing whether they go to the blonde
or the brunette. Notice this makes some intuitive sense. They both prefer the
11
blonde, so its reasonable to think they would approach the blonde with a relatively
high probability.
Congratulations, you now know more game theory than the lacky that Ron Howard
hired to be the game theory expert on A Beautiful Mind.
16. (Q3, Winter 2004 3
rd
Midterm) True/False and Justify: The prisoners dilemma
shows that players acting in their own best interest will always obtain a Pareto ecient
outcome.
SOLUTION: FALSE - If both players act in their own self interest, the Nash equi-
librium of the prisoners dilemma is (Confess, Confess). This is not Pareto ecient.
Remember, a Pareto ecient outcome is one where no one can be made better o
without making someone else worse o. If we could somehow commit both players to
playing Don

tConfess, both players would be better o.

17. (Q38, Winter 2003 Final Exam) There are only two rms in a market, A and B. Each
rm can produce either a low quantity (Low) or a high quantity (High). The matrix
below describes the prots of each player depending on its level of output chosen and
the level of output chosen by its competitor.
Firm B
Low High
Low (10, 10) (0, 20)
Firm A
High (30, 5) (8, 8)
Please solve for the Nash equilibrium of this game. Is it an equilibrium in dominant
strategies? What are the Pareto ecient outcomes of this game?
SOLUTION: To nd the Nash equilibrium (if it exists), we rst nd each rms best
response function. If A plays Low, B should play High (20 > 10); if A plays High, B
should play High (8 > 5). Thus B has a dominant strategy to play High. If B plays
Low, A should play High (30 > 10); if B plays High, A should play High (8 > 0).
Thus A has a dominant strategy to play High. Thus the Nash equilibrium of this game
is (High, High). It is an equilibrium in dominant strategies. The Nash equilibrium in
this case is not Pareto ecient; we could make both parties better o if we somehow
forced them to play (Low, Low). We can see that, starting from (Low, Low), if we
deviated, we could make one player better o, but it would be at the expense of the other.
Thus (Low, Low) is Pareto ecient outcome of this game. We can similarly show that
(High, Low) and (Low, High) are Pareto ecient; deviating from that outcome, we
can make one player better o, but it is at the expense of the other player.
18. (Q22, Fall 2004 3
rd
Midterm) Consider Bob and Toms strategies in the game presented
below.
Bob
Nice Tough
Nice (x, 100) (300, 50)
Tom
Tough (75, 300) (200, 175)
12
Does Bob have a dominant strategy? If so, what is it?
SOLUTION: Yes. Since (100 > 50) and (300 > 175), Bob has a dominant
strategy to play Nice.
For what values of x will Tom have a dominant strategy?
SOLUTION: Since (300 > 200), for Tom to have a dominant strategy, it must
be to play Nice. Therefore, in order for Nice to be a dominant strategy, we need
x > 75.
Suppose x = 50. What is the equilibrium of the game?
SOLUTION: We determined above that Bob has a dominant strategy to play
Nice. Tom knows this, so if x = 50, Tom should play Tough. The equilibrium
(through iterated removal of weakly dominated strategies) is (Tough, Nice).
19. (Q19, Winter 2004 3
rd
Midterm) Two airplane manufacturers, Moeing and Airfuss, are
competing to sell two airplanes to Bumpy Rides Airlines. Both producers must choose
between a price of $10,000,000/plane and $20,000,000/plane. Taking into considera-
tion the cost of producing airplanes for these two rms, the following matrix describes
prots for each possible combination of prices. Prots are measured in millions of
dollars.
Moeing
$10M $20M
$10M (2, 5) (16, 0)
Airfuss
$20M (0, 10) (8, 15)
Does either rm have a dominant strategy? If so, what is it?
What are the Nash equilibria in pure strategies?
What is the Nash equilibrium in mixed strategies?
SOLUTION: If Airfuss goes $10M, Moeing should go $10M; if Airfuss goes $20M,
Moeing should go $20M. Thus, Moeing does not have a dominant strategy. If Moeing
goes $10M, Airfuss should go $20M; if Moeing goes $20M, Airfuss should go $10M.
Thus, Airfuss does not have a dominant strategy.
We can see there are no Nash equilibria in pure strategies. Starting from ($10M, $10M),
Airfuss would want to deviate and play $20M; then at ($20M, $10M), Moeing would
want to deviate to $20M. At ($20M, $20M), Airfuss would want to deviate to $10M,
and at ($10M, $20M), Moeing would want to deviate to $10M.
Let the probability that Airfuss plays $10M be and the probability Airfuss plays $20M
be (1). Similarly, let the probability that Moeing plays $10M be and the probability
Moeing plays $20M be (1 ). Airfuss mixes to make Moeing indierent from playing
$10M or $20M: (5) + (1 )(10) = (0) + (1 )(15) 10 5 = 15 15
10 = 5 = 0.5.
13
Similarly, Moeing mixes to make Airfuss indierent from playing $10M or $20M:
(2) + (1 )(16) = (0) + (1 )(8) 16 18 = 8 8 10 = 8 = 0.8.
So, the Nash equilibrium in mixed strategies is for Airfuss to play $10M with probability
0.5 and $20M with probability 0.5 and for Moeing to play $10M with probability 0.8
and play $20M with probability 0.2.
5 Oligopoly
20. (Q39, Winter 2003 Final Exam) Paula and Jan are duopolists in the coee industry.
The graph below shows the market demand curve and Jans supply curve.
-
6
$/unit
units
l
l
l
l
l
l
l
l
l
l
l
l
l
l
l
l
ll
18
15
12
9
6
3
1 2 3 4 5 6
MarketDemand
Jan

sSupply
Paula has a marginal cost equal to zero and knows Jans supply. How many units
should Paula produce? What will be the market price?
SOLUTION: We need to subtract Jans supply from the market demand curve to get
Paulas residual demand curve. At a price of $12/ton, Paulas residual demand is 0
tons, and at a price of $0/ton, Paulas residual demand is 4 tons. Next, with a linear
demand curve, the marginal revenue curve cuts intersects the horizontal axis at the
midpoint between 0 tons and where the demand curve intersects the horizontal axis.
In this case, marginal revenue is $0/ton at 2 tons. Now, prot maximization requires
marginal revenue to be equal to marginal cost on the last unit produced. Since Paula
has zero marginal cost, she should produce 2 tons. So, Paula supplies 2 tons, and Jan
supplies 2 units. Going to the market demand curve, we see that, with a quantity of 4
tons, the market price will be $6/ton.
21. (Q23, Fall 2004 3
rd
Midterm) You own Heavenly Chocolate Cake Factory, and your
only competitor is Cocoa Dreams Bakery. You are certain that Cocoa Dreams Bakery
will bake 100 cakes regardless of the price of cakes. You also know that you have xed
costs of $500. Knowing this and the cost information about your rm given in the
table below, please nd your prot-maximizing quantity and the market price.
14
Market Market Price MC
Demand ($/unit) ($/unit)
100 20 6
200 18 7
300 16 8
400 14 9
500 12 10
600 10 11
SOLUTION: To get your derived demand, we subtract o from the market demand
the 100 cakes you think your competitor will make. Then your rm maximizes prots.
You should produce 300 cakes. The market price will be $14/cake.
Market Derived Market Price TR MR MC
Demand Demand ($/unit) ($) ($/unit) ($/unit)
100 0 20 0 - 6
200 100 18 1,800 18 7
300 200 16 3,200 14 8
400 300 14 4,200 10 9
500 400 12 4,800 6 10
600 500 10 5,000 -2 11
22. (Cournot Duopoly) There are two rms in a market A and B. The market (inverse)
demand curve is P = 10 Q, where market output Q is the sum of the two rms
outputs, i.e., Q = q
A
+ q
B
. Firm As total cost is TC
A
= 4 + 2q
A
, and rm Bs total
cost is TC
B
= 3 + 3q
B
.
Suppose rm A produces q
A
units of output and rm B produces q
B
units of
output. What is rm As revenue from producing this level of output? What is
rm Bs revenue from producing this level of output?
SOLUTION: Firm As revenue is the price it receives times the number of units
it produces: TR
A
= P q
A
= (10Q)q
A
= (10(q
A
+q
B
))q
A
= 10q
A
q
2
A
q
A
q
B
.
Similarly, Firm Bs revenue is TR
B
= P q
B
= (10Q)q
B
= (10(q
A
+q
B
))q
B
=
10q
B
q
2
B
q
A
q
B
.
Write down each rms prot from producing this level of output.
SOLUTION: Firm As prot is
A
= TR
A
TC
A
= 10q
A
q
2
A
q
A
q
B
42q
A
.
Firm Bs prot is
B
= TR
B
TC
B
= 10q
B
q
2
B
q
A
q
B
3 3q
B
.
What are rm As marginal revenue and marginal cost? What are rm Bs
marginal revenue and marginal cost? [Hint: Recall that if y = x
n
, then
dy
dx
=
nx
n1
.]
SOLUTION: Firm As marginal revenue is MR
A
=
dTR
A
dq
A
= 10 2q
A
q
B
, and
its marginal cost is MC
A
=
dTC
A
dq
A
= 2. Firm Bs marginal revenue is MR
B
=
dTR
B
dq
B
= 10 2q
B
q
A
, and its marginal cost is MC
B
=
dTC
B
dq
B
= 3.
15
What is rm As prot-maximizing level of output as a function of rm Bs level
of output? What is rm Bs prot-maximizing level of output as a function of
rm As level of output? These are the rms best-response functions. They tell
rm As (Bs) prot-maximizing level of output given what rm Bs (As) level
of output.
SOLUTION: To maximize prot, n the last unit produced, marginal revenue
must equal marginal cost. So, for rm A, MR
A
= MC
A
10 2q

A
q
B
= 2.
This implies q

A
= 0.5(10 2 q
B
); this is Firm As best-response function.
Similarly, for rm B, MR
B
= MC
B
10 2q

B
q
A
= 3. This implies Firm
Bs best-response function is q

B
= 0.5(10 3 q
A
).
Please solve these two equations to nd the prot-maximizing level of output for
each rm: q

A
and q

B
.
SOLUTION: Taking rm Bs best response function and plugging q

B
into rm
As best response function, we get q

A
= 0.5(10 2 q

B
) = 0.5(10 2 0.5(10
3 q

A
)) = 0.5(8 3.5 + .5q

A
) = 2.25 + 0.25q

A
. This implies 0.75q

A
= 2.25 and
thus q

A
= 3. Plugging this into the best response function for rm B, we nd
q

B
= 0.5(10 3 q

A
) = 0.5(10 3 3) = 2.
What is the total level of output in the market and the market price? What is
each rms revenue, producer surplus, and prot?
SOLUTION: Since rm A produces 3 units and rm B produces 2 units, total
output in the market is Q = q
A
+q
B
= 5 units. The market price is P = 10Q =
10 5 = $5/unit. Firm As revenue is $15, its variable cost is V C = 2(3) = $6,
its producer surplus is $9, and its prot is $5. Similarly, for rm B, its revenue
is $10, its variable cost is $6, its producer surplus is $4, and its prot is $1.
16
6 Externalities
23. (Q22, Fall 2004 3
rd
Midterm) The graph below depicts the market for cell phones. The
production of cell phones causes a negative externality. There is no mechanism that
makes the cell phone users pay for this damage.
-
6
$/unit
units
78
42
24
6
20 35
MSC
MPC
MB
Please answer the following questions.
What is the competitive equilibrium?
What is the Pareto ecient solution?
What is the deadweight loss generated by the competitive equilibrium?
What per-unit tax would the government need to levy in order to get the Pareto
ecient solution produced?
Moving from the competitive outcome to the Pareto ecient outcome,. . .
By how much will private costs, external costs, and social costs decrease?
By how much will private benets decrease?
By how much will the deadweight loss be reduced?
SOLUTION: The competitive equilibrium is the quantity where marginal private ben-
et equals marginal (private) cost. This occurs at a quantity of 35 units at a price
of $24/unit. The Pareto ecient solution is the quantity where marginal social ben-
et equals marginal (social) cost. This occurs at a quantity of 20 units at a price of
$42/unit. As is the case with negative externalities, the competitive solution gives us
too much output at too low a price. The deadweight loss generated by the competitive
equilibrium is DWL = 0.5($78/unit $24/unit)(35 units 20 units) = $405.
To get the Pareto ecient quantity produced, at this quantity, we need to make MPB =
MSB = MSC. Thus, we need to levy a tax of = $42/unit $6/unit = $36/unit.
Private costs will decrease by (0.5)($24/unit + $6/unit)(35 units 20 units) = $225.
17
Social costs will decrease by (0.5)($42/unit + $78/unit)(35 units 20 units) = $900.
Thus, external costs decrease by $675. Private benets decrease by (0.5)($42/unit +
$24/unit)(35 units 20 units) = $495. The change in total surplus is $495
($900) = +$405. The deadweight loss is eliminated.
24. (Q30, Winter 2005 3
rd
Midterm) Consider the graph below.
-
6
$/unit
units
MC
MSB
MPB
600 500
220
250
300
320
Please answer the following questions.
What is the competitive equilibrium?
What is the Pareto ecient solution?
What is the deadweight loss generated by the competitive equilibrium?
What per-unit subsidy would the government need to bestow in order to get the
Pareto ecient solution produced?
Moving from the competitive outcome to the Pareto ecient outcome,. . . . . .
By how much will private benets, external benets, and total benets in-
crease?
By how much will variable costs increase?
By how much will the deadweight loss be reduced?
SOLUTION: The competitive equilibrium is the quantity where marginal private ben-
et equals marginal (private) cost. This occurs at a quantity of 500 units at a price
of $250/unit. The Pareto ecient solution is the quantity where marginal social ben-
et equals marginal (social) cost. This occurs at a quantity of 600 units at a price of
$300/unit. As is the case with positive externalities, the competitive solution gives us
too little output at too low a price. The deadweight loss generated by the competitive
equilibrium is DWL = 0.5($320/unit $250/unit)(600 units 500 units) = $3, 500.
18
To get the Pareto ecient quantity produced, at this quantity, we need to make MPB =
MSB = MSC. Thus, we need to bestow a subsidy of s = $300/unit $220/unit =
$80/unit. Private benets will increase by (0.5)($250/unit + $220/unit)(600 units
500 units) = $23, 500. Total benets will increase by (0.5)($320/unit+$300/unit)(600 units
500 units) = $31, 000. Thus, external benets increase by $7,500. Variable costs in-
crease by (0.5)($300/unit +$250/unit)(600 units500 units) = $27, 500. The change
in total surplus is $31,000-$27,500=$3,500. The deadweight loss is eliminated.
25. (Q13, Fall 2004 3
rd
Midterm) Corporation Ukim produces paper. During production,
Ukim emits pollution. The marginal private cost to Ukim of abating this pollution is
given by the MCA curve in the graph below. The marginal social benet of abatement
curve MSB is given below as well. Assume there are no private benets to Ukim of
abating its pollution.
-
6
$/ton
tons
@
@
@
@
@
@
@
@
@
@
@
@
@
@
@
450 200
60
90
MCA
MSB
How much will it cost Ukim to reduce its pollution to the socially optimal level?
SOLUTION: The socially optimal level of pollution is given where the marginal cost
of abatement equals the marginal social benet of abatement. So, 200 tons of pollution
would be socially optimal. Abatement costs are measured under the MCA curve from
the original number of tons of pollution to the socially optimal level: (0.5)($60/ton)(450 tons
200 tons) = $7, 500.
19
26. (Q31, Winter 2003 Final Exam) There are two rms, X and Y . As a byproduct of
their production, rms emit some pollutant into the air. The graph below depicts the
marginal cost of abatement for each rm.
-
6
$/ton
tons
@
@
@
@
@
@
@
@
@
@
@
@
@
@
@
@
@
@
@
@
@
@
@
@
@
@
@
100
80
60
40
20
200 400 600 800
1,000
MCA
X
+
MCA
Y
Suppose that the government issues 1,000 pollution permits, which may be tradable
between the two rms (with a permit, a rm is allowed to emit one ton of pollution);
initially the government allocates all 1,000 permits to Firm X. In equilibrium. . .
What is the price of the last permit traded
How many tons of pollution will each rm emit?
Assuming all permits sell at the same price, what are Firm Xs revenues from
selling permits? What are Firm Y s expenditures from selling permits?
How much will each rm spend on pollution abatement?
SOLUTION: In equilibrium, (1) the price of the last permit traded must be equal to the
marginal cost of abatement of the last ton of pollution produced by each rm, and (2)
the total number of tons of pollution produced must be 1,000. This occurs when X pro-
duces 600 tons, Y produces 400 tons, and the price of the last permit is $40/ton. Since
X sold 400 of its permits, its revenues from the sale of permits is $16,000; Y s expen-
ditures on permits are $16,000. The total cost of abatement is the area below the rms
marginal cost of abatement curve from the original number of tons of pollution to the
tons produced in equilibrium. For X, this is (0.5)($40/ton)(1, 000 tons 600 tons) =
$8, 000. For Y , this is (0.5)($40/ton)(800 tons 400 tons) = $8, 000.
20
27. (Q14, Fall 2004 3
rd
Midterm) The EPA operates a tradable permits program for the
chemical pollutant noryl phenol. Originally, the agency issued 100 permits to each of
two rms A and B. Each permits gave its owner the right to discharge one ton of noryl
phenol. Due to lobbyist pressure, the agency agreed to increase each rms number of
permits to 400. Firms are allowed to buy and sell the permits they are issued both
before and after the increase. The marginal cost of abatement for each rm is given in
the graph below.
6
$/ton
-
tons
H
H
H
H
H
H
H
H
H
H
H
H
H
H
H
H
H
H
H
H
H
H
H
@
@
@
@
@
@
@
@
@
@
@
@
@
@
@
1,250
1,000
750
500
250
100 200 300 400 500 600 700 800
MCA
A
MCA
B
Before the increase in permits, give a range of prices for the last permit traded.
Note, 0 < P

< + doesnt cut it, smart guy.

Before the increase in permits, which rm sold permits, and which rm purchased
permits?
After the increase in permits, give a range of prices for the last permit traded.
Again, 0 < P

< + doesnt cut it.

After the increase in permits, which rm sold permits, and which rm purchased
permits?
SOLUTION: In equilibrium, (1) the price of the last permit traded must equal the
marginal cost of abatement for both rms, and (2) the number of tons of pollution
emitted must equal the number of permits. Originally, each rm has 100 permits. So
in equilibrium, 200 tons of pollution are produced. The equilibrium price will be between
$750/permit and $1,000/permit. In that case, Firm A will produce a less than 100 tons
of pollution, and Firm B will produce between 100 and 200 tons of pollution. The total
amount of pollution produced must be equal to 200 tons, though. Since each rm was
endowed with 100 permits, Firm A must sell some of its permits to Firm B. Another
way of seeing this, Firm B will purchase permits from Firm A since its marginal cost
of abatement at 100 tons of pollution is greater. Similarly, with 400 permits, the price
of the last permit must be between $250 and $500. Firm A will purchase permits from
Firm B since its marginal cost of abatement at 400 tons of pollution is greater.
21
28. Larry Landlord owns a building containing 12 apartments. One of the neighboring
houses is owned by a bunch of party animals. The monthly rent that Larry can charge
his tenants depends upon the number of parties the neighbors have each month. If
there are no parties then Larry can charge a monthly rent of $800 for each apartment.
If there is one party then the rent decreases to $750. If there are two parties then
the rent is lowered to $650. If there are three parties then the rent is only $200 per
apartment. If there are four parties then the apartments cannot be rented at all. A
recent court decision assigned to Larry the right to veto any party. The neighbors
get a value of $800 from each party. Larry decides that he will allow as many parties
as the neighbors want, but for each party they must pay Larry a fee. What is the
economically ecient number of parties per month? What range of fees will ensure
this outcome?
SOLUTION: We can actually place some bounds on the level of the fee. Clearly, its
got to be less than $800/party; otherwise Animal House wont go for it. Next, for one
party to be allowed, the revenue has to be at least $9,600 (the revenue Larry would
receive if no parties are allowed). Let F be the fee per party (measured in dollars).
The revenue from having one party is $9, 000 +F. Thus, the fee must be such that the
revenue from having one party is at least the revenue received if no parties are had:
$9, 000 + F $9, 600. This implies the fee must be at least $600. So, the fee must be
between $600/party and $800/party, i.e., $600 F $800.
Why cant two or three parties be optimal? If two parties are allowed instead of one,
we would need the revenue to be greater by having two parties as opposed to one:
$7, 800 + 2F $9, 000 + F. Solving for F, we nd that that F $1, 200. The guys
at Animal House wont pay more than $800 for a party. Thus, two parties cant be the
optimal number of parties. Similarly, for three parties to be allowed, $2, 400 + 3F
$7, 800 + 2F. Solving for F, we nd that F $5, 400; again, Animal House isnt
willing to pay more than $800 for a party, so three parties cant be the optimal number
of parties either.
7 Labor Markets and Monopsony
29. (Q24, Winter 2004 3
rd
Midterm) To increase the employment level, the government
will pay rms $4/hour for each worker employed. Prior to the subsidy, the equilibrium
level of employment and the wage are 45 million and $5/hour, respectively. What
predictions would you make about the employment and the wage received by workers
after the subsidy? Is there a deadweight loss associated with this policy?
SOLUTION: With upward-sloping labor supply and downward-sloping labor demand,
the equilibrium level of employment will rise, and the wage received by workers will rise
with the subsidy in place. There is a deadweight loss because too many labor hours are
being hired.
30. Lets revisit Alladin Sane. Hopefully this problem will make a little more sense this
time. He has preferences over consumption C and leisure l. Utility is increasing in
22
consumption and leisure (more consumption, more utility. . . similarly for leisure). Let
the price of consumption be $1/unit, and let the wage rate be w (measured in dollars
per labor hour). Further suppose that leisure is a normal good. Finally, suppose he
has R
0
in non-labor income and L
0
hours in the day to divide between labor L and
leisure.
What is his expenditure?
SOLUTION: His expenditures are what he spends on the consumption good.
Since it has a price of $1/unit, expenditures are C.
What is his labor income?
SOLUTION: Labor income is the wage rate times the number of hours he works,
i.e., wL.
What is his total income?
SOLUTION: His total income is his labor income plus his non-labor income,
i.e., wL +R
0
.
What is his budget constraint?
SOLUTION: Expenditures cannot exceed income, i.e., C wL +R
0
.
What is his time constraint?
SOLUTION: His time constraint is the hours he works plus the hours he doesnt
work must equal the time he has in a day, i.e., L +l = L
0
.
Substitute the time constraint into his budget constraint, and rearrange it to
have consumption and leisure on the left-hand side, and potential income (the
income he would have if he worked all the time) on the right-hand side. What is
the price of leisure?
SOLUTION: Substituting, we get C w(L
0
l) + R
0
. This implies C + wl
wL
0
+ R
0
. The price of leisure is the wage rate; the opportunity cost of an hour
of leisure is the foregone wage he would have earned had he been working.
Suppose the wage rate rises to w

> w. What would the substitution eect imply

about his choice between labor and leisure? What would the income eect imply
about this choice?
SOLUTION: With the wage rate rising, the price of an hour of leisure is now
greater. The substitution eect would say he will decrease his quantity of leisure
demanded and thus increase the quantity of labor supplied. At the same time, the
increase in the wage rate implies that his potential income has increased. All
else equal, since leisure is a normal good, this would imply demand for leisure
would increase and the supply of labor would decrease.
If the substitution eect is greater than the income eect, what does this increase
in the wage imply about the total number of hours of labor he supplies?
SOLUTION: The substitution eect says supply more labor, but the income
eect says supply less labor. If the substitution eect dominates, the increase in
the wage rate will lead to an increase in the number of labor hours he supplies.
The labor supply curve will be upward-sloping of this range of wages.
23
If the income eect is greater than the substitution eect, what does this increase
in the wage imply about the total number of hours of labor he supplies?
SOLUTION: The substitution eect says supply more labor, but the income eect
says supply less labor. If the income eect dominates, the increase in the wage
rate will lead to a decrease in the number of labor hours he supplies. The labor
supply curve will be downward-sloping of this range of wages.
Suppose Alladin marries Jean Genie. This increases his non-labor income to
R

0
> R
0
. What does this imply about his labor supply?
SOLUTION: This is a pure income eect. The wage rate hasnt change, thus
the relative prices of consumption and leisure havent changed. Since leisure is
a normal good, for each wage rate, Alladin will demand more leisure and thus
supply less labor. His labor supply curve shifts to the left.
31. The employment of GSIs by the University of Michigan may be modeled as a monop-
sony. Suppose the (inverse) demand curve for GSIs is W = 29, 000 100L
D
, where
W is the wage (as an annual salary) and L
D
is the quantity of GSIs demanded. The
supply of GSIs is given by the following (inverse) supply curve: W = 2, 000 + 100L
S
.
If the University did not use its monopsony power, what would be the market-
clearing wage rate and number of GSIs hired? Graph this outcome.
SOLUTION: In equilibrium, the quantity of labor demanded equals the quan-
tity of labor supplied: L
D
= L
S
= L

, which implies W

= 29, 000 100L

=
2, 000 + 100L

. This implies 27, 000 = 200L

and thus L

= 135 and W

=
$15, 500. In a competitive market, the university would hire 135 GSIs at a salary
of $15,500/year.
What is the Universitys labor expenditures as a function of the quantity of labor
supplied?
SOLUTION: The universitys average expenditure is the supply curve of labor:
W = 2, 000 +100L
S
. The rms labor expenditures then are W L
S
= 2, 000L
S
+
100L
2
S
.
What is the Universitys marginal expenditure on labor?
SOLUTION: The universitys marginal expenditure is the change in labor ex-
penditures given a change in the quantity of labor hired: ME =
d(WL
S
)
dL
S
= 2, 000+
200L
S
.
What is the prot-maximizing number of GSIs the University should hire? What
will be the prot-maximizing wage rate the University pays these GSIs? Graph
these outcomes on the graph you drew above.
SOLUTION: We nd this by setting the marginal value of hiring a worker (the
demand curve) equal to the marginal expenditure from hiring a worker: 29, 000
100L
M
= 2, 000 + 200L
M
. This implies 27, 000 = 300L
M
; the university should
hire 90 GSIs. To determine the wage rate paid, we plug this quantity into the labor
supply function because the monopsonist pays its laborers the minimum price it
can to hire them: W = 2, 000 + 100(90) = $11, 000/year.
24
What is the deadweight loss associated with this monopsonist? Show this in the
graph you constructed.
SOLUTION: We can see from the question above the monopsonist hires fewer
GSIs and pays a lower wage than in a competitive market. On the last GSI hired,
the marginal value exceeds the marginal cost. Therefore, there is a deadweight
loss due to monopsony. The deadweight loss is given by DWL =

135
90
(29, 000
100L(2, 000+100L))dL =

135
90
(27, 000200L)dL = $202, 500. Graphically, this
is given by DWL = 0.5($20, 000/GSI $11, 000/GSI)(135 GSIs 90 GSIs) =
$202, 500.
-
6
$/GSI
GSIs

90 135
20,000
11,000
15,500
MV = 29, 000 100L
AE = 2, 000 + 100L
ME = 2, 000 + 200L
A
B
DWL = A +B
8 Asymmetric Information
32. (Q26, Fall 2004 3
rd
Midterm) Imagine that there are two types of workers in the labor
market: high quality workers and low quality workers. The value to a rm of each
type of worker is given in the table below. Unfortunately, rms cannot distinguish high
quality types from low quality types, but the rm conjectures that
1
3
of the workers
are high quality. If rms oer a wage equal to the expected marginal revenue product
of the worker, what wage is oered to workers?
Worker Type Marginal Revenue Product
($/labor unit)
High Quality $9/hour
Low Quality $3/hour
SOLUTION: Since rms dont know a workers type, barring any ability by the worker
to signal his type, the wage oered will be the expected marginal revenue product: w =
1
3
$9/hour +
2
3
$3/hour = $5/hour.
25
33. (Q22, Winter 2004 3
rd
Midterm) Consider the Ann Arbor market for used cars. There
are two kinds of cars, lemons and peaches. Buyers and sellers value lemons and peaches
dierently, as shown in the table.
Peach Lemon
Buyers Valuation $1,000 $500
Sellers Valuation $800 $400
Buyers know only the proportion of lemons and peaches in the market. Each seller
knows whether the car she is selling is a lemon or a peach. Under what condition will
both lemons and peaches be sold?
SOLUTION: Let the probability the buyer gets a peach be and the probability the
buyer gets a lemon be (1 ). The expected value of a car to a buyer is ($1, 000) +
(1 )($500). If this expected value exceeds $800, then both types of cars will be sold.
Thus, we need ($1, 000) +(1 )($500) $800 $500 $300
3
5
= 0.6. We
need 37.5% of the cars to be peaches. Only lemons will be sold if the probability of a
peach is less than 37.5%.
26