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Department of Economics ECO 204 Microeconomic Theory for Commerce 2013 - 2014
Test 2 Solutions

IMPORTANT NOTES:
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the exam

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published by the Faculty of Arts and Sciences.

Exam details:
Duration: 2 hours and 20 minutes
Total number of questions: 3 (see next page of test for breakdown of points)
Total number of pages: 34 (including title page and two worksheets at the back of the test)
Total number of points: 100

Please answer all questions. To earn credit you must show all calculations.

Exam aids:
This is a closed note and closed book exam.
You may use a non-programmable calculator. Sharing is not allowed.

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THIS TABLE IS FOR GRADERS USE ONLY
QUESTION MAXIMUM POINTS SCORE COMMENTS
1 25
2 20
3 55
TOTAL SCORE OUT OF 100 POINTS













GOOD LUCK!
GIVE BRIEF ANSWERS AND SHOW ALL NECESSARY CALCULATIONS
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Question 1 [25 points]
This question consists of two parts A and B
Part A
(a) [3 points] [This part is independent of all other parts below] Consider production processes which use to
produce output. Give a real life example of each of the following production functions: (i) a long run Cobb-Douglas
production function (ii) a long run complements production function (iii) a long run linear production function. Provide a
brief explanation for your answers.

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(b) [5 points] [This part is independent of all other parts below] A company uses to produce output according to
the Cobb-Douglas production function. Let the price of labor be

and the price of capital be

Set up and
solve the Cobb-Douglas long run CMP in parametric form:

Assume that the CMP has an interior solution (i.e. Case D) which means that the non-negativity constraints can be
dropped.
Show that the optimal labor and capital are:

Do NOT solve for any Lagrange multipliers. Show all necessary calculations.


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(c) [5 points] The Cobb-Douglas long run cost function can be expressed as:

()

Use this expression to derive the Lagrange multiplier corresponding to the constraint

in the following long
run CMP:

Assume that the CMP has an interior solution (i.e. Case D) which means that the non-negativity constraints can be
dropped.

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Part B
In a tutorial, Michelle gave you data on a companys labor (), capital (), and output () and used regression analysis to
estimate the parameters of the companys Cobb-Douglas production function:

Here is the regression output (this question does not require you to use statistics such as t-stats etc.):
SUMMARY OUTPUT





Regression Statistics


Multiple R 0.96


R Square 0.92


Adjusted R Square 0.91


Standard Error 0.43


Observations 30.00





ANOVA


df SS MS F Significance F


Regression 2.00 56.28 28.14 151.81 0.00


Residual 27.00 5.01 0.19


Total 29.00 61.29





Independent Variable Coefficients Standard Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0%
Intercept 0.42 0.14 3.08 0.00 0.14 0.71 0.14 0.71
0.74 0.07 11.18 0.00 0.60 0.87 0.60 0.87
0.95 0.06 15.09 0.00 0.82 1.08 0.82 1.08

(d) [5 points] Use the regression output above to write down the production function

in numerical
form Show all calculations and state all assumptions.

1
Note: In ECO 220 format this takes the form:

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(e) [3 points] The Cobb-Douglas long run production function can be expressed as:

()

Use this expression to prove (not state) whether Michelles company:
Has a strictly concave, linear or strictly convex cost function?
and curves rise, fall, or stay constant as ?
?
Make sure to answer this question using parameter values for Michelles company (youre not being asked to prove
general results). Show all necessary calculations and state all assumptions.
Will and curves rise, fall, or stay constant as ?
Is ?
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(f) [2 points] Michelle used Excel Solvers to solve the following long run CMP for her company (notice the max below):

Reproduced below is a portion of her Excel sensitivity report:
Microsoft Excel 14.0 Sensitivity Report Constraints

Final Lagrange
Cell Name Value Multiplier
$C$12 Q 0.50 -1.21

Interpret the Lagrange multiplier what does it mean? Give a brief explanation.





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(g) [2 points + 2 bonus points] Suppose that in the short run, Michelles company has the following production function:

True or false: producing more output by always doubling labor results in a U-shaped short run curve? You do not
have to prove your answer: rather, state the answer and give a brief explanation. Bonus points awarded for proving your
answer?

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Question 2 [20 points]
Consider a risk free asset and two risky assets A and B. The following table provides partial information on returns
and variances of the three assets:
Asset Return Variance
A

Risk Free

The following table contains partial information on the covariance of asset returns:

Covariance of Returns
A B Risk free
A
B

Risk free





(a) [3 points] What are

You do not need to prove your answer.

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(b) [17 points] Portfolio X has been formed by combining the risk free asset and risky assets A and B. Fill the
blanks in the following table. Show all calculations.

Portfolio
Fraction of
portfolio
In Risky
Asset
Fraction of
portfolio
In Risky
Asset
Fraction of
portfolio
in risk-free
asset
Portfolio
Return
Portfolio
Risk
Portfolio
Risk Premium

Portfolio
Price of risk
X 0.1 0.9 0 ? ? ? ?

All assets must be considered in your calculations (i.e. calculations of the portfolio return, risk, risk premium, and price
of risk must include all three assets).


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S. Ajaz Hussain, Dept. of Economics, University of Toronto (STG)

ECO 204, 2013 - 2014, Test 2
This test is copyright material and cannot be used for commercial purposes or posted anywhere without prior permission. Report violations to eco.204@utoronto.ca
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S. Ajaz Hussain, Dept. of Economics, University of Toronto (STG)

Question 3 [55 points]
[This question is loosely based on the Ivey Business School case Gold Claims at Sturgeon Lake]
This question consists of three parts A, B, and C. Answer all parts to two decimal places.
Andrew McKendry, a geologist, has been hired by a Toronto based mining company to advise them about the following
two mutually exclusive decisions regarding gold mining operations at Sturgeon Lake (near Thunder Bay, Ontario):
Road Drill: First attempt to build a permanent road to the drill site at Sturgeon Lake and if the road project is
successful to then drill for gold. The cost of constructing the road is $33,484.56 and theres a 70% chance that the road
construction project will be a success. The cost of drilling is $98,154.02 and theres a 22% chance of finding gold. If the
road construction project and drilling are both successful then the of mining profits (before construction and drilling
costs) is $2,194,937.12.
Drill Road: First build a temporary ice road (with a 100% chance of success) and drill for gold. The ice road costs
nothing to build. The cost of drilling is $98,154.02 and the probability of drilling for gold is 0.22. If drilling is successful
the mining company will attempt to build a permanent road; the cost of constructing the permanent road is $33,484.56
and theres a 70% chance that the road construction project will be a success. If both drilling and road construction are
successful, then the of mining profits (before drilling and construction costs) is $2,194,937.12.
For your convenience, here is a summary of the numbers:

( )

( )
( )

ECO 204, 2013 - 2014, Test 2
This test is copyright material and cannot be used for commercial purposes or posted anywhere without prior permission. Report violations to eco.204@utoronto.ca
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(a) [5 points] Draw the decision tree for this problem. Do NOT solve the decision tree just yet. HINT: You might want to
first sketch the decision tree on a worksheet at the back of this test before drawing the final version below.
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. Part A
(b) [10 points] Suppose that the Toronto based gold mining company is risk neutral: what are its optimal decision and
optimal course of action? Show all calculations and state all assumptions.



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(c) [5 points] [This part is independent of all other parts below] Let probability that drilling for gold is a success. For
what values of will the mining company make the same decision as your answer to part (b)? Show all calculations and
state all assumptions.
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Part B
[Part B is independent of Part C below]
(d) [10 points] Return to the original numbers at the beginning of the question:

( )

( )
( )
For this question you should use the decision tree in part (a). Now suppose that the Toronto based gold mining company
is risk averse and its board of directors is of the opinion that:
( )

}
{

}
What is the optimal decision and the optimal course of action? Show all calculations and state all assumptions.
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S. Ajaz Hussain, Dept. of Economics, University of Toronto (STG)

ECO 204, 2013 - 2014, Test 2
This test is copyright material and cannot be used for commercial purposes or posted anywhere without prior permission. Report violations to eco.204@utoronto.ca
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(e) [5 points] [This part is required to answer part (f) only] Suppose a risk averse agent has wealth . With probability
the agents wealth will be reduced by . Suppose this agent wants to insure against the risky situation { (
) }. What is the optimal amount of the insurance policy if the insurance industry is charging actuarially fair
prices? Show all calculations and state all assumptions.

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(f) [5 points] Consider the decision you have made in part (d) (not the whole tree; just the decision). Suppose the mining
company has purchased actuarially fair insurance against the risk of drilling. Given your answer to part (b), what is the
insurance premium? Show all calculations and state all assumptions.











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Part C
[To be answered independently of Part B above]
(g) [15 points] Return to the original numbers at the beginning of the question:

( )

( )
( )
For this question you should use the decision tree in part (a). Assume that the gold mining company is risk neutral and
now suppose that the gold mining must choose between the following two mutually exclusive decisions:
The optimal decision in part (b) above.
The optimal decision in part (b) above but now with the option of testing the site prior to drilling. The test results
will come back as either positive or negative. Based on historical data, the following table contains the probabilities
of test results and actual outcomes of drilling:

Drilling

S F Total
Test
Result
+ 0.20 0.30 0.5
- 0.02 0.48 0.5

Total 0.22 0.78 1.00

Draw the decision tree for the optimal decision in part (b) above with the option of testing prior to drilling and
recommend whether you will make the decision in part (b) with or without testing. The cost of the test is not known.
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WORKSHEET
[This page will NOT be graded]


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WORKSHEET
[This page will NOT be graded]