Erasmus University Rotterdam International Program in Business Administration BAP 56- MICROECONOMICS AND MARKETS Final Exam 1 Version

A July 2008
Instructions: Check right now that you have got 50 questions in this exam. Of these, the last 16 questions are clustered in 4 groups, each one containing 4 questions that belong to a single problem. Read the questions carefully and provide your answers by filling in the answer form. The answer you provide should make the statement true, unless otherwise indicated. As a general rule, and unless stated otherwise in the question, Q refers to quantity, P refers to price, M to income, C to cost, K refers to capital, L to labor, w is the cost of a unit of labor, r is the cost of a unit of capital. Graphical calculators are not allowed. All 50 questions carry equal weight. The answers of the exam and your grade will be published in BlackBoard as soon as possible. Good luck!

1. a) b) c) d)

The winner's curse occurs: only in English auctions. only in second-price sealed bid auctions. in a common-values auction. in a private-values auction.

Key: Winners curse relates to common value auction. The winner of the auction is likely to have had too optimistic a valuation of the good. 2. A local video store estimates their average customer's demand per year is Q = 7 - 2P, and knows the marginal cost of each rental is $0.5. How much should the store charge for each rental if it engages in optimal two-part pricing? a) $0.35. b) $0.5. c) $0.7. d) $1.0. Key: Should charge marginal cost per unit. 3. a) b) c) d) Which of the following statements is true? The more elastic the demand, the higher is the profit-maximizing markup. The more elastic the demand, the lower is the profit-maximizing markup. The higher the marginal cost, the lower the profit-maximizing price. The higher the average cost, the lower the profit-maximizing price.

Key: Follows directly from optimal mark-up rule

4. You are the manager of a store in a remote area where you are the single seller of milk. You can buy milk from a supplier at $3.00 per gallon. If you believe the elasticity of demand for milk by customers at your store is -4, then your profit-maximizing price is a) $2.00. b) $2.50. c) $4.00. d) $5.00. Key: Another application of optimal mark-up 5. a) b) c) d) A Nash equilibrium with a non-credible threat as a component is: a subgame perfect equilibrium. not a subgame perfect equilibrium. an equilibrium in dominant strategies. a somewhat perfect equilibrium.

Key: Subgame perfection specifically rules out non-credible threats 6. Consider the following entry game. Here, firm B is an existing firm in the market, and firm A is a potential entrant. Firm A must decide whether to enter the market (play "enter") or stay out of the market (play "not enter"). If firm A decides to enter the market, firm B must decide whether to engage in a price war (play "hard"), or not (play "soft"). By playing "hard", firm B ensures that firm A makes a loss of $1 million, but firm B only makes $1 million in profits. On the other hand, if firm B plays "soft", the new entrant takes half of the market, and each firm earns profits of $5 million. If firm A stays out, it earns zero while firm B earns $10 million. Which of the following are Nash equilibrium strategies? a) (enter, hard) and (not enter, hard) b) (enter, soft) and (not enter, soft) c) (not enter, hard) and (enter, soft) d) (enter, hard) and (not enter, soft) Key: 1) If B plays hard then A prefers to stay out. Given that A does not enter B is indifferent between soft and hard, so in particular hard is a best response. 2) If B plays soft, A prefers to enter. If A enters then B prefers to play soft. 7. a) b) c) d) Two firms compete in a Stackelberg fashion and firm two is the leader, then firm one views the output of firm two as given. firm two views the output of firm one as given. all of the above none of the above

Key: When firm one is given the opportunity to move she can observe how much the leader has decided to produce.

8. Two firms (L=Leader, F=Follower) compete as a Stackelberg duopoly. The inverse market demand they face is P = 62 4.5Q. The cost function for each firm is C(Q) = 8Q. The outputs of the two firms are: a) QL = 48; QF = 24 b) QL = 35; QF = 6 c) QL = 6; QF = 3 d) None of the above Key: Solving by backwards induction, the profit function of the follower is: QF(624.5(QL+QF))-8QF. From profit max: QF=(54-4.5QL)/9 (*). Substituting into leaders profit function, and finding first order condition yields: QL=6, substituting into (*) yields QF=3. 9. Two identical firms compete as a Cournot duopoly. The demand they face is P = 100 - 2Q. The cost function for each firm is C(Q) = 4Q. Each firm earns equilibrium profits of: a) $1,024. b) $2,048. c) $4,096. d) $512. Key: Profit of firm i: Qi(100-2(Qi+Qj))-4Qi, solving for best response: Qi = (96-2Qj)/4. Solving system yields Q*=16. Substituting back into profitfunction yields answer. 10. Which of the following signals to owners of scarce resources the best use of those resources? a) profits of businesses. b) government regulations. c) economic indicators. d) the accounting cost of those resources. Key: Resources should be directed to activities that yield economic profits to the owners of those resources. 11. When the marginal benefit is given by MB = 300 - 12Y and total costs are given by TC = 12Y + 108, the optimal level of Y is: a) 25. b) 4.5. c) 8. d) 24. Key: Set MB = MC => 300 -12Y = 12

12. An ad valorem tax causes the supply curve to: a) shift to the right. b) become flatter. c) become steeper. d) shift to the left. Key: An ad valorem tax is a percentage tax so the higher the price the higher the absolute increase. 13. Suppose market demand and supply are given by Q d = 100 - 2P and Q S = 5 + 3P. The equilibrium quantity is: a) 92. b) 81. c) 19. d) 62. Key: Setting Qd=Qs yields P*=19, substituting this in either equation yields the result. 14. Suppose the demand for X is given by Q xd = 100 - 2PX + 4PY + 10M + 2A, where PX represents the price of good X, PY is the price of good Y, M is income and A is the amount of advertising on good X. Based on this information, we know that good X is a) a substitute for good Y and a normal good. b) a complement for good Y and an inferior good. c) a complement for good Y and a normal good. d) a substitute for good Y and an inferior good. Key: From definitions of substitutes and normal goods. 15. Suppose the demand for product X is Q xd = 10 - lnPx + 3lnPy then the own price elasticity of X is a) Elastic. b) Inelastic. c) Unitary elastic. d) Cannot be determined without more information. Key: When written in logs elasticity is equal to the coefficient. 16. Suppose Q xd = 10,000 - 2 Px + 3 Py - 4.5M , where Px = $100, Py = $50, and M = $2,000. What is the own-price elasticity of demand for X? a) -2.34. b) -.78. c) -.21. d) -1.21. Key: Own price elasticity: dQ/dP*(P/Q). Inserting yields: Q=950. so elasticity: 2*(100/950).

17. You are the manager of a supermarket, and know that the income elasticity of peanut butter is exactly -0.7. Due to recession, you expect incomes to drop by 15% next year. How should you adjust your purchase of peanut butter? a) buy 10.5% more peanut butter. b) buy 2.14% more peanut butter. c) buy 6.2% less peanut butter. d) buy 9.8% less peanut butter. Key: Income elasticity: (dQ/Q)/(dM/M) = -.7. so dQ/Q = -.7*(-.15) = .105. 18. After a price decrease for good X, the new consumer equilibrium level of good X will be: a) higher than before the price change. b) lower than before the price change. c) indeterminate without more information. d) the same as before the price change. Key: depends upon two effects: substitution effect and income effect. 19. Mitchell's money income is $150, the price of X is $2, and the price of Y is $2. Given these prices and income, Mitchell buys 50 units of X and 25 units of Y. Call this combination of X and Y bundle J. At bundle J Mitchell's marginal rate of substitution (MRS) between X and Y is 2. Given these prices and income, what is Mitchell's equilibrium consumption of X? a) X < 50. b) X = 50. c) X > 50. d) none of the above. Key: MRS(X,Y) = 2 > market rate of substitution which is Px/Py=1, so Mitchell can increase utility by consuming more X than at bundle J. 20. A recent consultancy report solicited by a firm that uses labor, L, and capital, K, to produce a fixed number of units as output, show that marginal products are currently given by: MPL = 80, and MPK = 40. If the cost of a unit of labor is w = $80, and the cost of capital is r = $20, then: a) the firm is cost minimizing. b) the firm should use less L and more K to cost minimize. c) the firm should use more L and less K to cost minimize. d) the firm is profit maximizing but not cost minimizing. Key: MPL/MPK = 80/40 < w/r = 80/20, so should substitute towards capital.

21. For a cost function C = 100 + 10Q + Q2, the average fixed cost of producing 10 units of output is a) 10. b) 5. c) 1. d) none of the above. Key: AFC(Q) = F/Q = 100/10. 22. Changes in the price of an input cause: a) Isoquants to become steeper. b) Slope changes of the isocost line. c) Parallel shifts of the isocost lines. d) Changes in both the isoquants and isocosts of equal magnitude. Key: Input prices determine slope of isocost lines. 23. Suppose you are a manager of a factory. You purchase five (5) new machines at one million dollars each. If you can resell two of the machines for $500,000 and three of the machines for $200,000, what are the sunk costs of purchasing the machines? a) $5 million. b) $500,000. c) $3.4 million. d) $1.6 million. Key: Sunk costs are non-recoverable costs: 5mil 2*(500,000)-3*(200,000). 24. Which of the following is true under monopoly? a) profits are always positive. b) P > MC. c) P = MR. d) all of the above are true for monopoly. Key: Only b) is true, as monopolist sets MC=MR, but MR is steeper than demand. 25. Which of the following features is common to both perfectly competitive markets and monopolistically competitive markets? a) Firms produce homogeneous goods. b) Prices are equal to marginal costs in the long-run. c) Long run profits are zero. d) Prices are above marginal costs in the long-run. Key: In both market structures entry and exit ensure long run profit of zero.

26. You are the manager of a firm that has an exclusive license to produce your product. The inverse market demand curve is P = 900 1.5Q . Your cost function is C (Q ) = 2Q + Q 2 . The optimal price to charge for your product is: a) $520.70 b) $630.60 c) $840.50 d) none of the above
Key: MC = MR implies: 2+2Q = 900-3Q => Q*==179.6, substitute into demand. 27. Suppose a typical consumers inverse demand function for bottled water at a resort area where one firm owns all the rights to a local spring is given by P = 15 3Q . The marginal cost for gathering and bottling the water is $3 per gallon. The optimal number of bottles to package together for sale is: a) 3 b) 4 c) 5 d) 6 Key: Should package quantity where MC intersects demand: 15-3Q = 3, solving yields result. 28. Suppose the cost function is C(Q) = 50 + Q - 10Q2 + 2Q3. At 10 units of output, the average cost curve a) is in the increasing stage. b) is in the declining stage. c) is at the minimum level. d) is at the maximum level. Key: AC(Q) = 50/Q + 1 -10Q + 2Q2. The slope of AC(Q): AC(Q) = -50/Q2 10 + 4Q. Evaluated at Q = 10, yields AC(Q)>0, so increasing. 29. A monopolist faces an inverse demand function P=50-5Q, and has constant marginal cost of 5$. When the monopolist can engage in first-degree price discrimination her profits are: a) 250.0 b) 500.0 c) 202.5 d) 225.0 Key: Monopolist should sell until P=MC under first degree pd. Setting P = MC, yields Q=9. Area between MC curve and demand is profits: .5*(50-5)*9 = 202.5

30. An isoquant represents: a) Input combinations that can be employed at the same cost. b) Input combinations that can efficiently produce the same output. c) Output combinations that can be efficiently produced using the same input combination. d) Output combinations that can be produced for the same cost. Key: Definition. 31. In the short run, a perfectly competitive firm will shut down and produce nothing if: a) excess profits equal zero. b) total cost exceeds total revenue. c) variable cost exceeds total revenue. d) the market price falls below the minimum average total cost. Key: If variable costs cannot be covered the firm should shut down immediately. 32. A situation where a consumer says he does not know his preference ordering for bundles X and Y would violate the property of: a) more is better. b) completeness. c) substitutability. d) complementarity. Key: From def. Consumer is able to order any two bundles of goods. 33. A husband and a wife must decide where too meet and cannot coordinate their decisions by communicating with each other. If they both go to the stadium, the husband gets utility 10 and the wife gets utility 5. If they both go to the opera, the husband gets utility 5 and the wife gets utility 10. If the husband goes to the stadium and the wife goes to the opera they both get utility zero. If the husband goes to the opera and the wife goes to the stadium they both get utility zero. Which of the following statements is correct: a) There is no Nash equilibrium in pure strategies b) The only Nash Equilibrium in pure strategies is for both husband and wife to go to the opera c) There are precisely two Nash equilibria in pure strategies d) None of the answers above are correct Key: A variant of the Battle of the sexes game.

34. Jane provides cheese (H) and milk (M) to the market with the following total cost function C(H, M) = 10 + 0.4 H2 + 0.2M2. The price of cheese and milk in the market are $2 and $5 respectively. Assume that the cheese and milk markets are perfectly competitive. What output of Milk maximizes profits? a) 5. b) 12.5. c) 10 d) 2. Key: Perfect competition so P(M)= MC(M), 5 = .4M yields the answer.

Problem 1:
Answer the next four questions using the following information: Suppose that there are two types of cars, good and bad. The pool of used cars consists of 50% cars of bad quality and 50% cars of good quality. Risk-neutral buyers and sellers have their own valuation (in dollars) of these two types of cars as follows: Types of Cars Good (50% Probability) Bad (50% Probability) Buyer's Valuation 5000 3000 Seller's Valuation 4500 2500

35. Suppose that both buyers and sellers can observe the quality of cars. What happens? a) Both good and bad cars are traded. b) Only good cars are traded. c) Only bad cars are traded. d) Neither good nor bad cars are traded. Key: Both buyers and sellers know whether a car is good or bad. For each car type buyers have a higher valuation than sellers, so there is room for trade of both cars. 36. Suppose sellers know the quality of the cars, but that buyers do not observe the quality. Ignoring adverse selection the highest price a buyer will offer for a used car is: a) $2,500. b) $3,000. c) $4,000. d) $4,500. Key: If the buyers do not take adverse selection into account, they are willing to pay for the expected quality of the car: 50%*5000+50%*3000 = 4000 37. What is the highest price risk neutral buyers will offer for a used car if they recognize adverse selection? a) $2,500. b) $3,000. c) $4,000. d) $4,500. Key: When buyers are only willing to pay 4000, a seller with a good car is not willing to sell, since they value such a car at 4500. A seller with a good car will not go to the market. Therefore only bad cars are up for sale. Buyers value such cars at 3000.

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38. In the situation where buyers do not observe car quality, what happens in the market? a) Both good and bad cars are traded. b) Only good cars are traded. c) Only bad cars are traded. d) Neither good nor bad cars are traded. Key: Same reasoning as previous question.

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Problem 2:
Answer the following four questions referring to the payoff matrix below: Firm B Low Price Firm A Low Price High Price (10, 9) (-10, 7) High Price (15, 8) (11, 11)

39. Which of the following is true? a) A dominant strategy for Firm A is "high price". b) There does not exist a dominant strategy for Firm A. c) A dominant strategy for Firm B is "low price". d) none of the above Key: A has a dominant strategy namely low price, B does not have a dominant strategy. 40. What is/are the Nash equilibrium strategies for Firm A and Firm B respectively in a one-shot game? a) (low price, low price) b) (high price, high price) c) (low price, high price) d) a and b Key: Low price is a dominant strategy for A. Bs best response to low price is also low price. 41. Suppose the game is repeated three times. In each period the Nash equilibrium payoffs for firms A and B will be: a) (10, 9) b) (11, 11) c) (-10, 7) d) Answer depends on the interest rate Key: The one-shot game has a unique Nash Equilibrium, which is played in each period.

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42. Suppose the game is repeated an infinite number of times and the players play the following trigger strategy. Both players charges high price as long as no player has been charging any other price. If some player has charged a price different from high price then in any following period a player charges low price. In order to sustain equilibrium the interest rate, i, must satisfy: a) i > .80 b) i < .50 c) i < .25 d) The strategy pair does not form an equilibrium for any interest rate. Key: Note that B earns her highest possible payoff. Thus we need only look at A. Using the usual formula, if sticking to agreement A gets: 11(1+i)/i. If she cheats she will get 15 in the first period and 10 thereafter, discounted payoff from cheating: 15+10/i. For equilibrium we then require: 11(1+i)/i > 15+10/i. Solving yields i<.25

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Problem 3:
You are a monopolist with the following demand and cost conditions: P = 100 2Q and C (Q ) = 50 + Q 2 . 43. The profit maximizing output is given by: a) 50/6 b) 100/6 c) 100/4 d) 30 Key: Setting MR = MC => 100 4Q = 2Q. Solving yields result. 44. Profits are given by: a) 567.36 b) 783.33 c) 1018.67 d) None of the above Key: Substituting optimal Q yields P = 66.67. Substituting into profit function yields result. 45. The deadweight loss of monopoly is given by: a) 138.88 b) 215.67 c) 350.88 d) 404.33 Key: Deadweightloss is efficiency loss occurring due to monopolist restricting output. Efficiency equals the perfectly competitive output where P=MC. Solving yields: Qeff = 25, and Peff = 50. DWLoss is triangle where MC crosses MR (Q=100/6, P= 33.33), Efficient output (Q=25, P=50), and Monopoly outcome (Q=100/6, P=66.67). Size of triangle is: .5(66.67-33.33)(25-16.67)=138.88. 46. If you could engage in first degree price discrimination your total profits would be given by: a) 783.03 b) 817.22 c) 922.19 d) 999.00 Key: If you can engage in First degree price discrimination, you would sell until P=MC, i.e. the perfectly competitive output. Thus your profits would be monopoly profits + dead weight loss+consumer surplus under monopoly, i.e. 783.33+138.88+.5*(100/6)*(10066.67) =1200. Not one of the answers. Question will be dropped.

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Problem 4:
A firm is operating with production function: Q = K1/2L1/2. The price of a unit of capital is given by r and the price of a unit of labor is given by w. 47. The marginal rate of technical substitution between capital and labor is given by: a) K/L b) L/K c) 2L/K d) 2K/L Key: MRTS(K,L) = MPL/MPK = (K1/2/ 2L1/2)/(L1/2/ 2K1/2)= K/L 48. Suppose that w=2r. Which of the following input combinations are compatible with cost minimization? a) 12 units of labor, 12 units of capital b) 24 units of labor, 12 units of capital c) 12 units of labor, 24 units of capital d) 3 units of labor, 12 units of capital Key: Optimal mix: MRTS =L/K = r/w = r/2r = , so K = 2L. 49. Suppose that capital is fixed at 25 units, and w=r. The marginal product of labor when 50 units of labor are used is: a) .175 b) .354 c) .5 d) 2 Key: K=25 => Q=5*sqrt(L), so MPL = 5/(2*sqrt(L)). Inserting L = 50 yields result. 50. Continue to suppose that capital is fixed at 25 units. Further assume that w=r=$10. The firm operates in a perfectly competitive industry where the market price of a unit of output equals $10. How many units of labor should the firm hire in the short run? a) 0 (shutdown) b) 5 c) 6.25 d) 8 Key: Short run, so price of capital immaterial. Perfect competition, so set P=MC. Production function Q = 5*sqrt(L), so L = Q2/25. Variable cost is then given by: VC(Q)=w*Q2/25, and so MC = 2wQ/25. Setting MC = P = 10: 2*10*Q/25 = 10, so Q=12.5, inserting into labor production yields: L = 6.25

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