ECN201

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DEPARTMENT OF ECONOMICS Spring Semester 2008-2009

Microeconomic Principles 2 Hours

There are THREE sections to this exam paper. Answer THREE questions in A,
ONE question from Section B and ONE question from Section C. All sections
carry equal weight.

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SECTION A

1. Define and explain the use in economics of THREE of the following:

a) Concave preferences.

Indifference curves have increasing MRS. With a standard budget constraint will
consume X or Y (not a mix of both) i.e. corner solution. Will not have smooth reaction
to price changes – will switch consumption with critical price ratio.

b) Consumer rationality.

Complete preferences; transitive preferences; reflexive preferences. Each needs to be

explained.

c) Voting paradox.

Standard 3 option 3 person example with non-transitive social preferences. Implies

either illogical decisions and/or an ability to exploit agenda setting. Very good answers
might mention Arrow’s theorem as a generalisation.

d) CES production function.

Standard presentation of CES function needed: X = A[bK c + (1 − b)Lc ]1 / c with

explanation of A, b and c. Good answers will point out this is a generalisation of CD,
perfect substitute and fixed proportions technologies.

e) Cost-plus pricing.

Used in practice by firms: p = AVC(1 + m).

With constant AVC: p = MC(1 + m).
If a firm profit maximises: (1 + m) = |e|/(|e| - 1)

f) Von Neumann-Morgenstern utility.

Standard definition: U = p1U(C1) + p2U(C2) + …., Σp = 1

Based on standard assumptions: continuity, rationality etc.

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SECTION B
Answer ONE question from this section

Numbers in brackets show the percentage distribution of marks within each

question.

2. A market exists in which there are two identical firms that react to each other
and competitive conditions. The inverse market demand function is
p = 200 – 2Q, where p is market price and Q is market demand. Both firms
have constant marginal costs of 20. Fixed costs are zero.

a) Discuss, in general terms the types of behaviour that might exist in this
market and the performance outcomes that will result. (20%)

Two relevant models: Cournot and Bertrand with output and prices as strategic
variables and zero conjectural variation.
With Cournot positive profit in equilibrium. With Bertrand zero profit in equilibrium.

b) Derive the Cournot reaction functions for the two firms. (20%)

p = 200 – 2(qA + qB)

MRA = 200 – 2qB – 4qA
MRB = 200 – 2qA – 4qB

set MR = MC

RFA: qA = 45 – 0.5qB
RFB: qB = 45 – 0.5qA

c) Calculate the Cournot equilibrium firm outputs, market price and firm profits.
(20%)

qA = qB = 30
Q = 60
p = 80
πA = πB = (80 – 20)30 = 1800

d) On a Cournot reaction function diagram draw the functions derived in (b). On

the same diagram identify the cartel contract curve and the cartel outputs for
each firm. Show the position that will result if one firm cheats on the cartel. In all
cases explain your reasoning. (20%)

q1 and q2 are cartel outputs – student need to explain why these are equal.
q3 is firm A’s output if it cheats on the cartel

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qB
90
RFA
cartel contract curve

45

q1 RFB

q2 q3 45 90 qA

e) Calculate the cartel output identified graphically in (d) and the firm shares of
this cartel output. Also calculate the outputs of both firms if one firm cheats on
the cartel. In both cases calculate market price and profits. Comment on your
results. (20%)

Cartel output is 45. This can either be read off the diagram or calculated as a monopoly
problem:
p = 200 – 2Q
MR = 200 – 4Q
MR = MC
200 – 4Q = 20
Q = 180/4 = 45
qA = qB = 22.5
p = 110
πA = πB = (110 – 20)22.5 = 2025

Firm A cheats
Firm B produces 22.5 units. From A’s reaction function
qA = 45 – 0.5qB = 33.75
Q = 56.25
p = 87.5
πA = (87.5 – 20)33.75 = 2278.125
πB = (87.5 – 20)22.5 = 1518.75

Comments: good students will realise the profits produce a prisoner’s dilemma game.

3. The outputs of two firms (A and B) are defined by the following Cobb-Douglas
production functions:

qA = 10LA0.75KA0.25

qB = 10LB0.5KB0.25

where subscripts denote the firm, q is firm output and L and K are inputs of
labour and capital.

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a) Define isoquant equations for both firms for output levels 10 and 20. (20%)

Firm A
qA = 10
KA = 1/LA3

qA = 20
KA = 16/LA3

Firm B
qB = 10
KB = 1/LB2

qB = 20
KB = 16/LB2

b) On a diagram sketch the four isoquants defined in (a) and discuss the key
features involved.

qA=20

qB=20
qA=10
qB=10
L

Key features of the sketch:

Returns to scale differ: A is constant, B is diminishing (sum of exponents)
MRTSs differ: A is smaller than B for any K/L (ratio of exponents)

(20%)

c) For the case when the prices of capital and labour are both £10 per unit for both
firms derive the optimal labour:capital ratios for firms A and B. (20%)

Students might use Lagrangian or logic of MRTS = pL/pK

Firm A: L/K = 3
Firm B: L/K = 2

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d) Using the optimal labour:capital ratios defined in (c) and the isoquants in (b)
calculate the efficient labour and capital inputs for outputs 10 and 20 for both firms.
Using these results calculate the long-run total and average costs of the firms at
these outputs. Comment on your results. (20%)

Firm A: L/K = 3
q = 10
K = 1/L3
K = 1/(3K)3
K = 0.44
L = 1.32

q = 20
K = 16/L3
K = 16/(3K)3
K = 16.25/3.75
K = 0.88
L = 2.64

Firm B L/K = 2
q = 10
K = 1/L2
K = 1/(2K)2
K = 0.63
L = 1.26

q=20
K = 16/L2
K = 16/(2K)2
K = 1.59
L = 3.18

Firm A
q=10, TC = 10(1.32) + 10(0.44) = 17.6, AC = 1.76
q=20, TC = 10(2.64) + 10(0.88) = 35.2, AC = 1.76

Firm B
q=10, TC = 10(1.26) + 10(0.63) = 18.9, AC = 1.89
q = 20, TC = 10(3.18) + 10(1.59) = 47.7, AC = 2.39

Comments : Effects of returns to scale on ACs

Firm B has higher TC because of lower labour productivity.

e) With capital fixed at the optimal level necessary to produce 10 units of output for
both firms (as calculated in (d)) define the short-run production functions for both
firms. Using the optimal labour inputs necessary to produce 20 units of output for
both firms (as calculated in (d)) calculate the outputs for both firms from the short-run
production functions. Using isoquant diagrams sketch the short and long-run
relationships you have found. (20%)

Short-run PFs
Firm A
q = 10L0.75K0.25
q = 10(0.44.25)L0.75
q = 8.14L.75

Firm B
q = 10L0.5K0.25
q = 10L0.50.630.25

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q = 8.91L.5

With higher L
Firm A
q = 8.14L.75
L= 2.64
q = 16.86 i.e. < 20

Firm B
q = 8.91L.5
L= 3.18
q = 15.89 < 20

In general the diagram should look like this:

q<20

q=20

q=10

4. Two individuals (A and B) own a scrap metal yard. If these two people behave
honestly they earn an annual income of £10,000 each. If they are dishonest
they can accept stolen goods in which case they can each double their annual
incomes. If they do accept stolen goods, and they get caught doing so, their
incomes are zero. The utility of income functions of the two people are

UA = YA0.5

UB = YB2

where subscripts denote the person, U is utility and Y is income.

a) On two separate diagrams (one for each person) sketch the utility of income
functions and the three income levels of £0, £10,000 and £20,000. Using these
diagrams explain the attitudes to risk that the two people have. (20%)

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U(20)
U(10)
Person
A
EU

As U(10) > EU this person is risk averse.

Person
B
U(20)

EU
U(10)

As U(10) < EU this person is risk loving

b) If there is a 10% chance that the two people are caught if they receive stolen
goods, will they behave honestly or dishonestly? (20%)
[Calculate and explain your answer there is no need to draw a diagram]

Person A
U(10,000) = 100
0.9U(20,000) = 127.28
Person A will be dishonest

Person B
Will also be dishonest

c) If there is a 50% chance that the two people are caught if they receive stolen
goods will this change the conclusions in (b)? (20%)
[Calculate and explain your answer there is no need to draw a diagram]

Person A
U(10,000) = 100
0.5U(20,000) = 70.71
Person A is honest

Person B
U(10,000) = 100million

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0.5U(20,000) = 200 million
Person B is dishonest

d) On two separate diagrams (one for each person and not the ones used in (a))
show the critical expected incomes from dishonest behaviour that make the two
people indifferent between honest and dishonest behaviour. (20%)

U(20)
U(10)
Person
A

Y*

Person
B
U(20)

U(10)
Y*

Critical expected incomes are Y*

e) Calculate the critical probabilities the produce the critical expected incomes
identified diagrammatically in (d) for the two people. Also calculate the expected
incomes. (20%)

Person A
100 = (1-p)141.42
p = (approx) 0.3
Y* = 14,000 (approx)

Person B
100million = (1-p)400million
1-p = 0.25
p = 0.75
Y* = 5,000

5. Two people (A and B) consume two goods (X and Y). Initially A has 90% of X
(and B the remaining 10%) and they share Y equally between them.

a) On an Edgeworth box diagram identify the initial endowment point. On the

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same diagram use two indifference curves (one for each person) to identify all
the possible gains from trade that might exist. (20%)

A
X

Initial endowment at E
Area defined by A and B indifference curves through E shows all possible gains from trade

b) On a different Edgeworth box diagram, and with the same initial endowment,
identify possible prices for X and Y that produce an excess supply of X and an
excess demand for Y. (30%)

A
X

c) On a separate diagram with the same initial endowment identify a set of prices
that generate equilibrium demands and supplies of X and Y. Explain why this
solution conforms to the First Law of welfare economics. (30%)

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A
X

Equilibrium exhausts gains from trade i.e. is Pareto optimal. Each person is maximising
utility given the prices they face. So will be achieved in a perfect market.

d) Discuss the significance of Walras’ Law to the positions identified in the diagrams
in (b) and (c). (20%)

W’s law: the sum of excess demands (valued at relevant prices) must sum to zero.
In (b) there is a set of prices that make this true

In c if D=S for one good thisd must also hold for the other.

If W’s law holds a general equilibrium always exists.

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SECTION C
Answer ONE question from this section

6. Using both Hicks and Slutsky methods, show how we can identify how much a
price reduction makes someone better off. Why might the different methods you
identify give (in general) different results?
[Restrict your answer to the case of a normal good.]

Standard diagrams here. For a normal good Hicks EV > CV.

Slutsky CV < Hicks CV
Slutsky EV > Hicks EV
Because Slutsky does not all substitution towards a lower priced good.

7. Using a model of two-period inter-temporal decision making, set out the decision
a student makes to get into debt to do a degree. Analyse how a reduction in
interest rates might impact on this decision.

Standard diagram. Answer must define current income and consumption and future income
and consumption. For a student current income < current consumption. Hence a requirement
for borrowing. Should show this as the equilibrium with an appropriate indifference curve.

Reduction in interest rates will pivot the budget line through the point defined by current
and future income. Good students will indentify income and substitution effects to see the
response.

8. Using indifference curve analysis, show how a risk averse person will always
buy full insurance if this insurance is fair. Also show how a risk loving person will
never buy such insurance. For the case of a risk averse individual, consider how
your conclusions might be affected if insurance companies suffer from hidden
information about individual risks.

Risk averse person convex indifference curves.

Risk loving person concave ICs.
In both cases the MRS = ratio of probabilities of the two events on the certainty line.
Risk averse person will maximise utility by equalising income in both states of the world.
Risk loving person will maximise utility at the endowment point.

With hidden information equilibrium depends on whether price is above or below the fair
price. High risks will benefit.

9. Show how in theory shareholders can optimally motivate managers in the

presence of shareholder hidden action. Also discuss why this motivation system
might fail.

Shareholders will maximise profit subject to a managerial participation constraint. A diagram

defined by managerial effort and firm profit with the participation constraint defined by a
managerial indifference curve. Good students will identify the full information solution and
the effect of hidden action and how this can be controlled with an appropriate managerial
contract.

Complexities: high degrees of managerial risk aversion and inability of shareholders to

identify managerial indifference curves and production function.

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END OF QUESTION PAPER

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