MODEL ANSWERS

QUESTION 1 [20 marks]

1 1
A consumer has the utility function U = 6 x 2 y 2 where x and y are the two goods.

(a) Find the marginal rate of substitution between the two goods when x =
25 and y=200. [5 marks]

Solution:

See Besanko and Braeutigam p.83

Along an indifference curve with given U, the slope is given by

1
 y 2
3 
∂y MU y
= −  1 = −
x x
U =U =−
∂x MU y x
 x 2
3
y 
 

When x=25 and y=200, the MRSxy = -(200 ÷ 25) = -8.

(b) Suppose the consumer has a budget of $2,700 to spend, and that the price of
good x is $90 and the price of good y is $15. What is the optimal consumption
bundle of x and y? [5 marks]

Solution:

See Besanko and Braeutigam pp.132-133.

The Lagrangian is:

1 1
Λ = 6 x 2 y 2 + λ( 2700 − 90 x − 15 y )

First-order conditions:

1 1
∂Λ y2 y2
= 3 1 − 90λ = 0 ⇒ λ =
∂x 1
x 2 30 x 2

1 1
∂Λ x2 x 2
=3 − 15λ = 0 ⇒ λ =
∂y 1 1
y 2 5y 2
 1 1
x2 y2 y
Whence 1
= 1
⇒ 30 x = 5 y ⇒ x = and y = 6x
6
5y 2 30 x 2

∂Λ
= 2700 − 15 y − 15 y = 0 ⇒ 30 y = 2700 ⇒ y = 90 and x = 15
∂λ

(c) What is the demand curve equation for x if the price of y is fixed at $1
and the budget remains $2,700? [5 marks]

Solution:

x x MU P y
Optimality requires MU = P ⇒
x
= Px ⇒ y = PxX
y y

Substituting into the budget constraint gives the demand curve:

2700 − 2 PX x = 0

1350
⇒x =
Px
 (d) Holding the price of y at Py=1, use a linear approximation to the demand curve
to calculate roughly the change in consumer surplus when the price of x falls
from Px=10 to Px=6.

Solution:

Diagrammatically, we need the sum of areas A and B in the diagram:

Px

10
Linear approximation
A B

6
True demand curve,
x=1350 ÷ Px

x
135 225

A = $4 x 135 = $540

B = 0.5 x 4 x 90 = $180

A + B = $720 which is roughly the consumer surplus.

QUESTION 2 [20 marks]

(a) Using clearly-labelled diagrams, show how the labour supply curve is
derived from the labour/leisure tradeoff faced by a representative worker.
[5 marks]

SOLUTION

See Besanko and Braeutigam pp.172-175. The student is required to draw some
variant of Figure 5.24 or Figure 5.26. A backward-bending segment is not
necessary but credit goes to students who show it and relate it to the income and
substitution effects.
 (b) Suppose a tax on wage income is imposed, and that as a result labour supply
falls. Does this mean that the substitution effect is more powerful than the
income effect, or the other way round? Explain your answer carefully.
[5 marks]

From the worker’s point of view the tax is a reduction in the wage rate. This relates
directly to slide 67 in my Lecture 6, which showed the case where the tax increased
labour supply (see also Besanko and Braeutigam p.175 Figure 5.26):

Dollars of wages
W
BL
To get the opposite result asked for here– a fall in labour supply – the substitution
effect must dominate over the income effect (J is the “decomposition bundle”):

Dollars of wages
W
B
Careful and thorough labelling of the diagram is to be rewarded along with quality of

BLwith tax
explanation.
 (c) Returning to the initial situation, suppose all workers are charged a lump-
sum tax payable in cash. The amount of the tax is the same regardless of
hours worked. Could this tax have the effect of reducing labour supply?
Explain your answer, using an appropriate diagram. [5 marks]

SOLUTION:

There are two possible diagrams the student might use. One is the case of a tax on
non-wage income, as set out in my Lecture 6 slide 65:

Dollars

The point here is that no change in the relative price of labour and leisure has
occurred, so there is no substitution effect. The effect of falling income is always
negative for leisure and positive for labour, given that leisure is a normal good. So
labour supply rises from (24-L1) to (24-L3) (ignore L2, which is labour supply if non-
wage income is zero)
.
An alternative diagram from Lecture 6 slide 61 showing the effect of a poll tax
imposed on a peasant population with no access to cash income except from wages:

BLwith th
Money wage
income
per day
BLwage
The optimal solution at B is a corner, not a tangency. In the absence of the tax no
labour would be supplied and 24 hours of leisure would be taken.

Thus whichever analysis is used, the lump-sum tax cannot have the effect of reducing
labour supply.

QUESTION 3 [20 marks]

(a) If the price of labour increases by 35% while all other input prices remain the
same, would the long-run total cost of producing a given output rise by more than
35%, less than 35%, or 35% exactly? Explain your answer carefully, using a
clearly labelled diagram or diagrams. Assume that the underlying production
function is Cobb-Douglas.
SOLUTION:

The production function has smooth convex isoquants which ensures that substitution
of other inputs for labour is possible in the long run. As the relative price of labour
has increased, such substitution will reduce the share of labour in the total input mix,
and this will bring the total cost increase down below 35%. The question is looking
for students’ understanding of the intuition of factor substitution. But there is also
another step in the argument that cuts in the same direction.

Only one isoquant is needed for quantity of output Q , and the argument can be made
with just two inputs, K and L. The optimal input bundle with the first set of factor
prices is ( K 0 , L0 ) at point A where isocost line C0C0 is tangent to the isoquant.
Raising the price of labour causes the isocost lines to steepen and the optimal input
bundle for Q =Q changes to ( K 1 , L1 ) at point B, where the isoquant is tangent to
isocost line C1C1.
C1
K

C0
. B
K1

A
K0

Q =Q

C1
C0
L1 L0

L
If no substitution had taken place when the price of labour rise, production would
have taken place at A but with isocost line JJ. By inspection, B is a lower-cost
combination at the new price ratio. Therefore if the cost of the original bundle at A
rises by less than 35%, then so too must the new bundle at B cost less than 35 more
than the original total cost.
J

C1
K

.
C0

K1 B

A
K0

Q =Q

C1
J C0
L1 L0
L
Before the increase the total cost at A was

TC 0A = rK 0 + w0 L0

After the increase, total cost at A is

TC 1A = rK 0 + 1.35 w0 L0

The cost of the bundle at A has increased as the isocost line rotates from C0C0 to JJ by

∆TC A = rK 0 − rK 0 + 1.35 w0 L0 − w0 L0 = 0.35 w0 L0 < 0.35( rK 0 + w0 L0 )

So total cost of producing at A has risen less than 35%, from which it follows that the
input bundle at B costs, at the new prices, less than 135% the cost of the bundle at A
at the original prices.

There will be lots of ways for students to demonstrate this result – marks for elegance,
conciseness, completeness…
 (b)Would a perfectly competitive firm continue to produce if price fell below its
minimum level of short-run average variable cost? Clearly explain your answer.
[5 marks]

SOLUTION:

This is the definite shut-down price even for a firm with all its fixed costs sunk; see
Besanko and Braeutigam p. 308 Figure 9.2. There is no way the firm can do better
continuing to produce than by shutting down in this situation.

The answer will need to show good understanding of the principles behind the shut-
down price. If the firm cannot recover all its avoidable costs (variable costs plus non-
sunk fixed costs) it is better-off to shut down and avoid them.

With all fixed costs sunk, the minimum of AVC sets the shutdown price.

(c) Would a perfectly competitive firm continue to produce if price fell below the
minimum of its short-run average cost? Clearly explain your answer.
[5 marks]

SOLUTION:

See Besanko and Braeutigam p. 31 Figure 9.3. The answer to this question depends
on the extent to which fixed costs are non-sunk and hence avoidable. If all fixed costs
are non-sunk, then the firm will shut down at any price below SAC. If all fixed costs
are non-sunk, then the shutdown point is reached only when price falls to the
minimum of AVC as in (b) above. With some fixed costs sunk and some non-sunk,
the shutdown price will lie somewhere between AVC and SAC – students should
reproduce the diagram from Figure 9.3 and the accompanying analysis.

(d) Suppose firm i’s long-run production function is Qi = 10 KL and that in

the short run K is fixed at 900. How much labour will be demanded in the
short run at a wage of 10?

[5 marks]

SOLUTION:

The cost-minimising firm will hire labour to equate its marginal product with the
wage.

The trap is that students may be tempted to look for the long-run optimal
combinations of K and L, which would give the long-run demand for labour. Besanko
and Braeutigam pp.248-251 show (Figure 7.15) the short-run expansion path
contrasted with the long-run one, and in their Learning-by-Doing Exercise 7.6 part (c)
show how to get labour demand with only one of the inputs variable if output is
known. In this case output is not known but the wage is.

Here, the short-run production function is

1
Qi = 10 * 900 * L = 300 L2

Marginal product of labour is

1
∂Qi −
= 150 L 2
∂L

Labour demanded is found by setting marginal product equal to the wage:

150
1
= 10
L2

2
 150 
⇒L=  = 225
 10 

QUESTION 4 [20 marks]

(a) Suppose that the supply curve for an individual firm is

 0 w h Pe < n5
Q f i r = m
 − 4 +83 P8 w h Pe ≥ n5
There are 1000 identical firms in the industry.

There are two groups of consumers in the market. The representative

consumer of type A has demand QconsumerA = 25 − P and the representative
consumer of type B has demand QconsumerB = 100 − 5 P .

There are 40,000 Type A consumers and 10,000 Type B consumers.

Find the market equilibrium price and quantity.

[15 marks]
SOLUTION:

The industry supply curve for P ≥ 5 is

Qindustry = 1000 * Q firm = −25 ,000 + 38 ,000 P

The choke price for Type A consumers is P = 25 and their aggregated demand curve
is

Q A = 1,000 ,000 − 40 ,000 P

The choke price for Type B consumers is P = 20 and their demand curve is

Q B = 1,000 ,000 − 50 ,000 P

The market demand curve is therefore

 0 f o rP > 2 5

Q d =  1,0 0 ,0 0 0− 4 0,0 0 P0 f o r2 0< P ≤ 2 5
 2,0 0 ,0 0 0− 9 0,0 0 P0 f o rP ≤ 2 5

[up to 8 marks for correct derivation including identification of the choke price and
the “kink” at P=20, if the final answer has not been successfully found]

To see which segment of the demand curve will be relevant, check for excess demand
or supply when P=20:

d
QP =20 = 1,000 ,000 −800 ,000 = 200 ,000
d
QindustryP =20 = −48 ,000 +760 ,000 = 808 ,000 > Q P =20

At this price there is excess supply, so equilibrium will be on the lower segment of the
demand curve.

[3 marks for using the correct supply and demand curves for the calculation, if final
answer is wrong]

Solving

Qindustry = −48 ,000 +38 ,000 P = Q d = 2 ,000 ,000 −90 ,000 P

⇒2 ,048 ,000 =128 ,000 P
⇒P = 2 ,048 ,000 ÷128 ,000 =16
⇒Q = 2 ,000 ,000 −90 ,000 * 16 = 2 ,000 ,000 −1,440 ,000 = 560 ,000

The price is above the industry shutdown price of P=5, so this is the answer.
[keep 1 mark in reserve for this last point, ensuring the price is above shutdown]

(b) Explain, using a clearly-labelled diagram and accompanying text, how a

negative network externality can lead to the observed demand curve having a
different slope from the demand curve that would be obtained simply from
aggregating individual consumers’ constrained-optimisation-based demands.

SOLUTION:

See Besanko and Braeutigam p.172 Figure 5.23. The negative-externality case gives
a steeper demand curve at industry level than the curve that would result from
aggregation of individual demands.

QUESTION 5 [20 marks]

Consider the simultaneous-move game below.

Player 2
Left Center Right
Top -1, 3 3, -1 5, -2
Player 1 Middle 3, -1 -1, 3 5, -2
Down -2, 5 0, 6 1000, 4

(a) Find the pure-strategy Nash equilibria of this game (if any). [5 marks]

(b) Apply iterated deletion of strictly dominated strategies to obtain a 2x2 payoff
matrix. Explain your work. [5 marks]

(c) Consider the 2x2 payoff matrix obtained in part (b). Find the mixed-strategy
Nash equilibrium of that game. [5 marks]

(d) Now we return to the payoff matrix from part (a). Suppose that player 1 moves
first. Draw and label the game tree. What is the subgame-perfect equilibrium
outcome? [5 marks]
Answer:

a. Let us mark the best responses in the payoff matrix.

Player 2
Left Center Right
Top -1, 3* *3, -1 5, -2
Player 1 Middle *3, -1 -1, 3* 5, -2
Down -2, 5 0, 6* *1000, 4
There is no pure strategy profile such that each player’s strategy is a best
response to the opponent’s strategy. Thus, there is no pure-strategy Nash
equilibrium.

b. First, notice that for player 2 strategy Center dominates strategy Right. Thus,
player 2 will never play Right and we can delete it from the payoff matrix:
Player 2
Left Center
Top -1, 3* *3, -1
Player 1 Middle *3, -1 -1, 3*
Down -2, 5* 0, 6*
Next, consider player 1. We see that strategy Down is strictly dominated by
strategy Top. So we can delete Down. We will end up with the following
payoff matrix:
Player 2
Left Center
Top -1, 3* *3, -1
Player 1 Middle *3, -1 -1, 3*

c. Suppose that player 2 chooses Left with probability p and Center with
probability 1-p. Player 1’s expected payoff from choosing Top will be -1*p +
3*(1-p). Player 1’s expected payoff from choosing Middle will be 3*p + (-
1)*(1-p). Player 1 will be willing to randomize between Top and Middle only
if his expected payoffs are the same. Thus, p must satisfy –p + 3(1-p) = 3p –
(1-p). Solving for p yields p = ½. A symmetric argument applies to the other
player. To recap, the mixed strategy equilibrium involves player 1
choosing Top with probability ½ and player 2 choosing Left with
probability ½.

d. The game tree is shown below (the top numbers are player 1’s payoffs, the
bottom numbers are player 2’s payoffs).
 Player 1

Top Middle Down

Player 2 Player 2 Player 2

Left Center Right Left Center Right Left Center Right

-1 3 5 3 -1 5 -2 0 1000
3 -1 -2 -1 3 -2 5 6 4

To find the subgame perfect Nash equilibrium, we use backward induction.

Player 1 knows that if he chooses Top, player 2 will choose Left (as 3 is
bigger than -1 and -2), so player 1 will get a payoff of -1; if player 1 chooses
Middle, player 2 will choose Center (as 3 is bigger than -1 and -2), so player 1
will get -1; if player 1 chooses Down, player 2 will choose Center (as 6 is
bigger than 5 and 4), so player 1 will get 0. Thus, the subgame-perfect
equilibrium involves player 1 choosing Down and player 2 choosing Center.
Player 1 gets 0 and player 2 gets 6.

QUESTION 6 [20 marks]

A monopolist serves a market with an aggregate demand function given by Q = 36 –

3P. The monopolist’s cost function is given by C(Q) = 2Q.

(a) What is the monopolist’s profit maximizing output? What price will he set? [5
marks]

(b) How much profit can the monopolist generate with first-degree price
discrimination?
[5 marks]

(c) Suppose that the monopolist can partition his market into two separate
submarkets. The demand function for submarket 1 is given by Q1 = 20 – 2P1
and the demand function for submarket 2 is given by Q2 = 16 – P2. What
prices would this monopolist set if he practices third degree price
discrimination? [5 marks]

(d) Now assume that the monopolist can charge different prices in the two markets.
However, he is required by law to sell identical quantities in these markets, i.e.
Q1 = Q2. What quantities will he choose to sell? At what prices? [5 marks]
Answer:

a. The monopolist’s inverse demand is P = 12 – Q/3. Thus, the marginal

revenue is given by MR = 12 – 2Q/3. The marginal cost is 2. The profit-
maximizing quantity satisfies 12 – 2Q/3 = 2. Solving for Q gives us Q = 15.
The profit maximizing price is P = 12 – 15/3 = 7.

b. See the graph below

12

NSS
2

30 36 q

Net social surplus is equal to the red area: NSS = 10*30/2 = 150. If the
monopolist can implement first-degree price discrimination, he can extract the
entire net social surplus as profits. So the monopolist can attain a profit of 150.
c. The inverse demands of the two markets are P1 = 10 - Q1/2 and P2 = 16
- Q2. Therefore, the marginal revenues are MR1 = 10 - Q1 and MR2 = 16 - 2Q2.
Since the marginal cost is constant, in each market the monopolist will sell
quantities that equalize marginal revenue and marginal cost: 2 = 10 - Q1 and 2
= 16 - 2Q2. Thus, Q1 = 8 and Q2 = 7. The corresponding profit maximizing
prices are P1 = 10 - 8/2 = 6 and P2 = 16 – 7 = 9.

d. The monopolist’s joint profit is

π = P1Q1 + P2 Q2 − C (Q1 + Q2 ) = (10 − Q1 / 2)Q1 + (16 − Q2 )Q2 − 2(Q1 + Q2 ) .
Since the monopolist is restricted to sell the same quantities in the two
markets, we have Q1 = Q2 = Q . So the monopolist’s profit can be written as
π = (10 − Q / 2)Q + (16 − Q)Q − 4Q . The optimal output choice will satisfy
dπ
the first-order condition dQ = 10 − Q +16 − 2Q − 4 = 0 . Thus,
Q = 22 / 3 = 7.33 . Substitute in the inverse demands to get
P1 = 10 − 7.33 / 2 = 6.33 and P2 = 16 − 7.33 = 8.67 .
QUESTION 7 [20 marks]

An incumbent firm, Firm 1, faces a potential entrant, Firm 2, with a lower marginal
cost. The market demand curve is p = 120 − q1 − q 2 . Firm 1 has a constant marginal
cost of $20 and no fixed costs, while Firm 2 has a marginal cost of $10 and a fixed
cost of $400.

(a) Suppose that if Firm 2 enters, the two firms will compete by simultaneously
choosing quantities. What are the Cournot equilibrium quantities, price and
profits if there is no government intervention? [5 marks]

(b) Assume that Firm 2 can credibly commit to produce a half of whatever output
Firm 1 chooses to produce. What are the equilibrium output levels of the two
firms? [5 marks]

(c) Suppose that no firm can commit. To block entry, the incumbent appeals to the
government to require that the entrant incur extra costs. What happens to the
Cournot equilibrium if the government causes the marginal cost of the second
firm to rise to that of the first firm, i.e. $20? [5 marks]

(d) What is the lowest value of Firm 2’s marginal cost that will prevent the entry of
that firm? Hint: this is the marginal cost which will set Firm 2’s Cournot
equilibrium profit to zero. [5 marks]

Answer:

a. The profit of Firm 1 is π 1 = (120 − q1 − q 2 )q1 − 20 q1 . Given q2 , Firm

1’s optimal choice of output satisfies the first-order condition
∂π 1
= 120 − 2q1 − q 2 − 20 = 0 . The profit of Firm 2 is
∂q1
π 2 = (120 − q1 − q 2 )q 2 − 10 q 2 − 400 . Its first-order condition is
∂π 2
= 120 − q1 − 2q 2 − 10 = 0 . Solve this for q1 to get q1 = 110 − 2q 2 . Substitute
∂q 2
in Firm 1’s first-order condition: 120 − 2(110 − 2q 2 ) − q 2 − 20 = 0 . Solving for
q2 yields q 2 = 40 . Therefore, q1 = 110 − 2 * 40 = 30 . To find the equilibrium
price substitute these quantities in the inverse demand: p = 120 − 40 − 30 = 50 .
Firm 1’s equilibrium profit is π 1 = 50 * 30 − 20 * 30 = 900 . Firm 2’s equilibrium
profit is π 2 = 50 * 40 − 10 * 40 − 400 = 1200 .

b. If Firm 2 can commit to produce q 2 = q1 / 2 , then Firm 1’s profit will

be given by π1 = (120 − q1 − q1 / 2)q1 − 20 q1 . Firm 1’s optimal output choice
∂π 1
satisfies the first-order condition = 120 − 2q1 − q1 − 20 = 0 . Solving for q1
∂q1
yields q1 = 33 .33 . Since Firm 2 is committed to producing half of that, we have
q 2 = 16 .66 .
 c. If Firm 2’s marginal cost is $20, then the reaction functions of the two
firms will be symmetric. So in equilibrium it must be true that q1 = q 2 = q .
Substitute in Firm 1’s first-order condition from part (a) to get q = 100 / 3 = 33 .33
. The equilibrium price is p =120 − 2 * 33 .3 = 53 .33 . Firm will make a profit of
53.33*33.33 – 20*33.33 = 1100.889. Firm 2’s profit will be 1100.889 – 400 =
700.889.

d. Suppose that Firm 2’s marginal cost is c. Then Firm 1’s first-order
condition will be 100 − 2q1 − q 2 = 0 , while Firm 2’s first-order condition will be
120 − 2q 2 − q 2 − c = 0 . Solving for q1 , q 2 will give us the Cournot equilibrium
80 + c 140 − 2c
output levels: q1 = , q2 = . Thus, the equilibrium profit of Firm 2 is
3 3
80 + c 140 − 2c 140 − 2c
π 2 = (120 − − − c)( ) − 400 . This expression simplifies to
3 3 3
140 − 2c 2
π2 = ( ) − 400 . The lowest c which will prevent entry sets the
3
140 − 2c 2
equilibrium profit of Firm 2 to zero: ( ) − 400 = 0 . Solving this equation
3
for c yields c = 40.

QUESTION 8 [20 marks]

Jane is a farmer who can plant either potatoes or corn on her land. Both choices are
risky, and her profits will depend on the weather according to the following table:

Weather Potatoes Corn

Cold 4000 1000
Normal 8000 8000
Warm 6000 11000

There is a ¼ probability that the weather will be cold, a ½ probability that the weather
will be normal, and a ¼ probability that the weather will be warm.

(a) Calculate Jane’s expected profits for each crop. [6 marks]

(b) If Jane’s utility over income is u ( y ) = y and she has $2000 from other
sources (so her total income is crop profits plus $2000), which crop would she
rather plant?
[7 marks]

(c) Now suppose that Jane’s utility is u ( y ) = log( y ) . She can plant a fraction α of
her land with potatoes and a fraction 1- α with corn. That is, if α = 0.6, then
Jane would get 60% of the potato profits and 40% of the corn profits for
whatever type of weather occurred. She has no additional income. What α will
d log( y ) 1
Jane choose? Note: = .
dy y
 [7 marks]

Answer:

a. Jane’s expected profit from planting potatoes is 0.25*4000 + 0.5*8000 +

0.25*6000 = 6500. Jane’s expected profit from planting corn is 0.25*1000 +
0.5*8000 + 0.25*11000 = 7000.

b. If Jane plants potatoes, her expected utility will be

0.25 6000 +0.5 10000 + 0.25 8000 = 91 .73 . If Jane plants corn, her
expected utility will be 0.25 3000 +0.5 10000 +0.25 13000 = 92 .20 .
Thus, Jane will prefer to plant corn.

c. Jane’s expected utility will be

U = 0.25 log( α4000 + (1 −α)1000 ) + 0.5 log( 8000 ) + 0.25 log( α6000 + (1 −α)11000 )
The optimal α satisfies the first-order condition
dU 3000 5000
= 0.25 − 0.25 = 0 . Solving for α yields
dα 3000 α + 1000 11000 − 5000 α
α = 0.9333 .