Microeconomics–Solutions to Final.

September 25, 2008

1. (a) With perfect price discrimination, the seller can charge each consumer the reservation
price for each of the two goods. Hence, the prices charged from each consumer will be

Consumer Good 1 Good 2

A 25 100
B 40 80 .
C 80 40
D 100 25

Total revenue (and hence profit since cost is zero) earned by the seller is 125 + 120 +
120 + 125 = 490.
(b) Consider good 1. The seller can charge either 25, 40, 80 or 100. Note that there is no
point charging any other price. Suppose the seller charges something between 25 and
40, for example 30. In this case, only B, C and D will buy the product. But they will
also buy the product if the seller charges 40. Clearly, charging 40 is better than 30.
We need to determine which of these three prices will maximize profits, or equivalently,
total revenue, since cost is zero. Note that if price is 25, 40, 80 or 100, number of buyers
are respectively 4, 3, 2 and 1. Hence total revenue is respectively 100, 120, 160 and 100.
Clearly, it is optimal for the seller to charge 80 for good 1.
A similar argument establishes that it is optimal for the seller to charge 80 for good 2
too.
Total revenue earned is 160 + 160 = 320.
Hence, if the two goods are to be sold separately without discrimination, then the optimal
price is 80 each.
(c) Now the seller can bundle the two product. The total value attached by A, B, C and D
to the two products are 125, 120, 120 and 125 respectively. If the seller charges 120 for
the bundle, he will have four buyers and earn 480 as total revenue. If he charges 125, he
has two buyers and earns 250. Clearly, it is optimal to charge 120 for the bundle.
(d) Clearly, pricing scheme (a) is the best for the seller since it enables him to capture all
the consumer surplus, i.e. charge a price equal to the reservation price. On the other

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 hand, (b) is the worst. If the seller sells the goods separately, the optimal strategy is to
sell the products to only two sellers. The differences in the willingness to pay is so high
that it makes no sense to attempt to sell to all four consumers. On the other hand, with
bundling, the dispersion in the willingness to pay is not too high. So the seller is able
to profitably target all four consumers.

2. (a) The Nash equilibria are (U, R) and (D, L).

(b) The outcome of the game is (U, R). See Figure 1 for the extensive form of the game.
(c) Of the two Nash equilibria, player 2 prefers (D, L). To achieve this, player 2 can deliber-
ately reduce the payoff from R by 3. By doing so, player 2 can compel player 1 to play
strategy D. This is because player 1 now knows that if he plays U, player 2 will find it
optimal to play L which gives a payoff of −1 to player 1. But if player 1 plays D, player
2 plays L giving player 1 a payoff of 1. Note that by committing himself to strategy L
in this way, player 2 ensures a higher payoff for himself than would otherwise have been
the case.
See Figure 2 for the extensive form of the revised game.

3. (a) First, we find each firms reaction function. To find Firm 1’s profit function is

π1 = P Q1 − T C1
= (30 − (Q1 + Q2 ))Q1 ,

since T C1 = 0. The profit maximization condition is given by

∂π1
= 30 − 2Q1 − Q2 = 0
∂Q1

30−Q2
which implies Q1 = 2 . Hence, firm 1’s reaction function is

30 − Q2
R1 (Q2 ) = .
2

This is firm 1’s best response function. Firm 2’s profit function is

π2 = (30 − (Q1 + Q2 ))Q2 − 10Q2 .

Differentiating with respect to Q2 and setting it equal to zero, we obtain firm 2’s reaction
function
20 − Q1
R2 (Q1 ) = .
2
We now solve Q1 = R1 (Q2 ) and Q2 = R2 (Q1 ). This gives Q∗1 = 13.3333 and Q∗2 = 3.3333.
Since total output is 16.6667, price is 13.3333. So, the profit of firm 1 is P Q1 = 177.7778
whereas the profit of firm 2 is P Q2 − 10Q2 = 11.1111.

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 Form drawing.pdf

U D

2 2

L R L R

(-1,-1) (0, 0)
(2, 1) (1, 2)

Figure 1: Extensive form of the game in Question 2(b). The arrow marks represent the moves of
the two players. The outcome of the game is (U,R).

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 Form drawing1.pdf

U D

2 2

L R L R

(-1,-1) (0, -3)

(2,-2) (1, 2)

Figure 2: Extensive form of the game in Question 2(c). The arrow marks represent the moves of
the two players. The outcome of the game is (D, L).

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 (b) This is now a sequential game with firm 1 as the leader and firm 2 as the follower. We
solve this game through backward induction.
First, we consider firm 2’s behaviour given firm 1’s behaviour. Given any choice of Q1
by firm 1, firm 2’s best response is given by R2 (Q1 ) that we obtained in part (a). Firm 1
knows this and hence will take R2 (Q1 ) as firm 2’s output when deciding its own optimal
behaviour. Firm 1’s profit is

π1 = (30 − Q1 − Q2 )Q1
 
20 − Q1
= 30 − Q1 − Q1
2
 
40 − Q1
= Q1 .
2

where we have replaced Q2 with R2 (Q1 ) . The derivative of π1 is

∂π1
= 20 − Q1 .
∂Q1

20−Q∗1
Setting this equal to zero, we obtain Q∗1 = 20. Hence, Q∗2 = 2 = 0. Hence,
P∗ = 30 − Q∗1 − Q∗2 = 10. So, π1 = P ∗ Q∗1 = 200 and π2 = P ∗ Q∗2 = 0.
(c) Firm 1’s profit is higher in (b). In fact, it is able to keep firm 2 completely out of the
market. This is a result of the first mover advantage that firm 1 enjoys in this situation.
Firm 1 is able to commit itself to producing 20 which forces firm 2 to select the zero
output situation since that is firm 2’s best response to an output of 20 from firm 1.

4. (a) The total returns from using x boats is given by

√
πs = x − x,

where x is the total cost of using x boats (note that the price of a boat is 1). To find
the socially optimum number of boats, we maximize πs .

dπs 1
= √ −1
dx 2 x

. Setting the derivative equal to zero, we find the optimal number of boats x∗ = 14 .
(b) The actual number of boats is
√
obtained by equation the average output to the price of
x
the boat. Average output is x . So the actual number of boats is given by
√
x
= 1,
x

which implies x = 1.
(c) Since the river is a common resource, the output obtained by a villager is only that that

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 is produced by his own boats. Hence, a particular villager is not concerned about the
socially optimal number of boats that should be used in the river. Instead, his focus is
on whether given the existing number of boats in the river, would the output obtained
from an additional boat be sufficient to cover the cost
√
of the extra boat. But the output
x
obtained from the new boat is the average output x . So, the villagers would continue
to add new boats till this average output is equal to the price of a boat. This leads to
overfishing in the river.

5. (a) Given any fixed wage, the worker will always exert low effort. So, the optimal wage
level is 1. At this wage, the worker receives his reservation utility and exerts low output.
Expected output is 0.3 × 1 + 0.4 × 2 + 0.3 × 3 = 2. Since the wage is 1, the owner’s
expected profit is 1. Note that due to risk neutrality, the owner is only concerned with
expected profit.
(b) In order to induce the worker to exert high effort, the owner offers a bonus scheme α
such that the expected utility of the worker from choosing high effort is equal to the
reservation utility. The expected utility from high effort, denoted UH under the bonus
scheme α is

UH = 0.3 × (2α)0.5 + 0.4 × (3α)0.5 + 0.3 × (4α)0.5 − 0.2

= 1.7171α0.5 − 0.2

Setting UH equal to the reservation utility 1, we obtain α = 0.4884.

We now need to verify that at this bonus scheme, the worker will actually exert high
effort. Given α = 0.4884, the utility from low effort UL is

UL = 0.3 × (α)0.5 + 0.4 × (2α)0.5 + 0.3 × (3α)0.5 = 0.96812.

Since UH > UL , the worker chooses to exert high effort.

6. We have seen that under the wage scheme, the owner’s expected profit is 1. Under the bonus
scheme, the worker exerts high effort. So expected output is EY = 0.3×2+0.4×3+0.3×4 = 3.
On the other hand, expected payment to the worker is αEY = 0.4884 ∗ 3 = 1.4652. Hence,
expected profit for the owner is EY − αEY = 1.5348. So, the owner prefers to bonus scheme.