2066 Microeconomics

SECTION A

Answer all questions from this section (5 marks each).

1. A firm hires workers from a competitive labour market. The firm faces
the problem that employees might shirk (avoid working hard). The firm’s
policy is to monitor the workers occasionally and fire any worker caught
shirking. This policy does not reduce shirking if the firm pays its workers
the market clearing wage. However, if the firm pays a wage greater than
the market clearing wage, this policy is effective in reducing shirking. Is
this true or false? Explain your answer.

Reading for this question Subject Guide Ch. 11.

Approaching the question The statement is true. The key point is that
at the market clearing wage, the threat of firing is ineffective in reducing
shirking because another job at the same wage is easy to obtain. If a firm
pays its workers a higher-than-market-clearing wage, losing the job is now
costly for a worker. They can get another job, but only at a lower wage. This
reduces shirking.
While the above suffices to answer the question, one can take the analysis
further. Suppose wm denotes the market clearing wage. The natural next
question is that if a single firm finds it profitable to pay a wage w∗ > wm , is
it not the case that other firms would do the same? But if all firms now pay
the same wage w∗ does the incentive effect of a higher wage vanish?
In fact that is not the case. The advantage persists because of a different
reason. If all firms pay w∗ > wm , the market does not clear. There is excess
supply at w∗ . In other words, there are workers who are looking for a job
but have not yet found a job. Given this pool of unemployed workers, a
worker who loses their job is not guaranteed to find another job quickly.
They enter the pool of unemployed and it might take a while to get matched
with another job. Job search itself might be costly given that there are lots
of people applying for every vacancy. So now if someone gets fired, they
incur a cost (waiting, costly job search) before they can find another job.
Therefore the threat of firing is still effective in reducing shirking.

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2. Short-run average cost exceeds long-run average cost only when there are
economies of scale. Is this true or false? Explain your answer.

Reading for this question Subject Guide Ch 5.

Approaching the question This is false. Short-run average costs exceed

long-run average costs because the firm is locked into a certain input mix in
the short run that may not be cost minimizing when all inputs are variable.
This condition holds regardless of the presence of economies of scale.

3. If the wage rate falls in a competitive labour market, demand for leisure
by workers must increase. Is this true or false? Explain your answer.

Reading for this question Subject Guide Ch 2.

Approaching the question This is false. If the wage rate falls, leisure be-
comes relatively cheaper so the substitution effect implies that more leisure
is demanded. However, a worker becomes poorer with a wage rate fall so
that if leisure is a normal good, the income effect implies that less leisure
is demanded. Therefore, if leisure is a normal good and the income effect
overwhelms the substitution effect, the demand for leisure would fall as the
wage rate falls. Therefore demand for leisure does not necessarily increase
as the wage rate falls.

4. A monopolist faces a constant marginal cost c and sets a price p = λc

where λ > 1. The absolute value of market demand elasticity is given by
|ε| = 3. Calculate the profit maximizing value of λ.

Reading for this question Subject Guide Ch. 8.

Approaching the question At the monopolist’s optimum

p 1
=
MC 1 − |1ε|

The left hand side is λ. The right hand side is 3/2. Thus the optimum λ is
3/2.

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5. u( x, y) = x2 + y2 . The price of x is 3 and the price of y is 2. The consumer’s

income is 18. What is the optimal consumption bundle? [Hint: Compare
interior bundles to corner solutions.]

Reading for this question Subject Guide Ch 2.

Approaching the question An indifference curve is given by x2 + y2 = k

where k is any positive constant. Note that this is the equation of a circle.
Ignoring the quadrants where either x or y or both are negative, you should
see that the indifference curves are quarter-circles, as shown in the diagram
below. You should be able to see that the MRS is x/y which is increas-
ing as x increases and y falls, giving rise to non-convex indifference curves
(normally, under decreasing MRS, the MRS should fall as x increases and y
falls). There is no interior maximum in this case. Indeed, the interior tan-
gency point is in fact the point of minimum utility on the budget line - any
other point on the budget line yields a higher utility. You should see that
the optimal consumption bundle lies at a corner. Spending all 18 on x yields
a utility 36. Spending all on y yields 81. Therefore the optimal consumption
bundle is to spend all income on y, implying buying 9 units of y.

C x

Indifference curves with increasing MRS. Point A

satisfies the first-order condition, but is does not maximise
utility. In fact utility is minimised at A. The optimum
occurs at a corner - in this case at point B.

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SECTION B

Answer three questions from this section (20 marks each).

6. Consider the following extensive-form game with two players, 1 and 2.

Out
1 (2,1)

In
1

A B

C D C D

(0,1) (5,2) (2,4) (-1,3)

Reading for this question Subject Guide Ch 4.

(a) Find the pure-strategy Nash equilibria of the game. [8 marks]

Approaching the question

The normal form of the game is given by
Player 2
C D
Out A 2,1 2,1
Player 1 Out B 2,1 2,1
In A 0,1 5,2
In B 2,4 -1,3

You should be able to see from this that the pure-strategy Nash equi-
libria are: (Out A, C), (Out B, C), (In A, D ) and (In B, C).

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(b) Find the pure-strategy subgame-perfect equilibria of the game.[6 marks]

Approaching the question The normal form of the subgame is given

by
Player 2
C D
Player 1 A 0,1 5,2
B 2,4 -1,3

This has two pure strategy Nash equilibria {( A, D ), ( B, C)} .

Any pure NE of the whole game that involves playing (A,D) or (B,C)
is a pure subgame-perfect Nash equilibrium.
Therefore, the set of pure-strategy subgame perfect equilibria is

{(OutB, C), ( InA, D ), ( InB, C)}

(c) Derive the mixed strategy Nash equilibrium of the subgame. If play-
ers play this mixed Nash equilibrium in the subgame, would 1 play
In or Out at the initial node? [5 marks]
[Hint: Write down the normal-form of the subgame and derive the
mixed strategy Nash equilibrium of the subgame. Next, compare
the payoff of player 1 from the mixed strategy equilibrium with 1’s
payoff from playing Out.]

Approaching the question The mixed Nash equilibrium in the sub-

game is: 1 plays A with 1/2 and B with 1/2, 2 plays C with 3/4 and
D with 1/4. The payoff of 1 from this mixed Nash equilibrium is 5/4.
This is less than 1’s payoff from paying Out, which is 2. So 1would
play Out at the initial node.
The question does not ask you to do this, but using the above, you can
construct a mixed strategy subgame-perfect equilibrium as follows: 1
plays Out A with 1/2 and Out B with 1/2, while 2 plays C with 3/4
and D with 1/4.

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7. Suppose there are two identical firms in an industry. The output of firm
1 is denoted by q1 and that of firm 2 is denoted by q2 . The cost function
of firm 1 is given by C(q1 ) = q21 /2 and the cost function of firm 2 is given
by C(q2 ) = q22 /2. Let Q denote total output, i.e. Q = q1 + q2 . The inverse
demand curve in the market is given by

P = 420 − Q

Reading for this question Subject Guide Ch 9.

(a) Find the Cournot-Nash equilibrium quantity produced by each firm

and the market price. [5 marks]

Approaching the question Firm 1 maximizes profit given by Pq1 −

q21 /2 which is (420 − (q1 + q2 ))q1 − q21 /2. The first order condition for
maximum is
420 − 2q1 − q2 − q1 = 0
from which we get the best response function of firm 1:

420 − q2 q
q1 = = 140 − 2
3 3
At this point we can impose symmetry: q1 = q2 = q∗ and then solve
for q∗ . (Alternatively, we can write down 2’s best response function
q1
q2 = 140 −
3
and solve the two equations in two unknowns.) Solving, we get

3
q1 = q2 = 140 = 105
4
The total output is 210. The market price is then P = 420 − 210 = 210.

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(b) What would be the quantities produced by each firm and market
price under Stackelberg duopoly if firm 1 moves first? [5 marks]

Approaching the question Firm 1 is the Stackelberg leader. Firm 1

maximizes (420 − (q1 + q2 ))q1 − q21 /2 where q2 = 140 − q1 /3. Substi-
tuting the value of q2 , 1 maximizes
  q1  q21
420 − q1 + 140 − q1 −
3 2
which simplifies to
q21
 
2
280 − q1 q1 −
3 2
Maximizing this, we get
4
280 − q1 − q1 = 0
3
or
7
q1 = 280
3
which implies
q1 = 120
Substituting in 2’s best response function, q2 = 100. The total output is
220, so that the market price is P = 420 − 220 = 200.

(c) Suppose the firms can collude and produce a total quantity Q. Sup-
pose firm 1 produces a fraction α of Q (so q1 = αQ) and firm 2 pro-
duces a fraction (1 − α) of Q (so q2 = (1 − α)Q). What value of α
minimises total cost of producing Q? [5 marks]
[Hint: Write the expression for C(q1 ) + C(q2 ) and minimise with re-
spect to α.]

Approaching the question Firm 1 produces a fraction α of Q and firm

2 produces a fraction (1 − α) of Q. Therefore the total cost of produc-
tion is
(αQ)2 ((1 − α)Q)2 Q2 2
+ = ( α + (1 − α )2 )
2 2 2
We need to minimise α2 + (1 − α)2 with respect to α. The first order
condition is
2α − 2(1 − α) = 0
which implies
α = 1/2.
You should check that the second order condition for a minimum holds.

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(d) Using the cost-minimising value of α from part (c), find the quantity
produced by each firm under collusion and the market price.
[5 marks]

Approaching the question Using α = 1/2, the total cost of production

is Q2 /4.
Therefore, the optimal profit given Q is

Q2
(420 − Q)Q −
4
Maximising with respect to Q, we get

420 − 2Q − Q/2 = 0

which implies 5Q/2 = 420 or Q = 168. Each firm produces half of

this, i.e. 84.
The market price is 420 − 168 = 252.

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8. Reading for this question Subject Guide Ch. 3.

(a) Lee does not have insurance against car theft. His car is worth 45. He
can park his car on the street or pay to park in a garage. If parked
on the street, the car is stolen with probability 1/3. If parked in a
garage, the car is safe from theft. Including the value of his car, Lee
has a wealth of 81. His utility from wealth W is
√
u(W ) = W.

i. Calculate the maximum amount that Lee is willing to pay to park

in a garage. [5 marks]

Approaching the question Expected utility is

√ √
2/3 81 + 1/3 36 = 8.
√
The certainty equivalent is given by CE = 8, i.e. CE = 64. There-
fore the maximum willingness to pay is 81 − 64 = 17.

ii. Now suppose Lee’s risk preference changes so that he becomes

risk neutral, The utility function representing his preference over
wealth levels is given by

u(W ) = W.

In this case, what is the maximum amount that Lee is willing to

pay to park in a garage? [5 marks]

Approaching the question Expected utility is

2 1
81 + 36 = 66.
3 3
The maximum willingness to pay is P such that 81 − P = 66, which
implies P = 15.

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(b) Rachel has 100 to invest. Two assets, 1 and 2, are available for in-
vestment. An amount y invested in asset 1 yields a total return of
1.1y. An amount x invested in asset 2 yields a risky total return of x
with probability 0.5 and 1.21x with probability 0.5. Rachel’s utility
function is given by
U (w) = ln(w)
where w is wealth after investing.
Let any portfolio be denoted by ( x, y) where x is the amount invested
in the risky asset (asset 2) and y = 100 − x is the amount invested in
the safe asset (asset 1).
How much should Rachel invest in the risky asset? [10 marks]

Approaching the question Rachel’s expected utility as a function of

the amount of investment in the risky asset (x) is:
   
EU ( x ) = 0.5 ln (100 − x )(1.1) + x (1.21) + 0.5 ln (100 − x )(1.1) + x

This simplifies to
   
EU ( x ) = 0.5 ln 110 + 0.11x + 0.5 ln 110 − 0.1x

The first order condition for maximization with respect to x is

0.055 0.05
− = 0.
110 + 0.11x 110 − 0.1x
This implies

(0.055 − 0.05)(110) = x (0.055(0.1) + 0.05(0.11))

Which simplifies to 0.55 = x (0.011) implying x = 50.

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9. A monopolist has two customers with the following demand functions:

Q1 = 70 − P1 (Demand of customer 1)
Q2 = 110 − P2 (Demand of customer 2)

Here Pi is the price charged to customer i, i ∈ {1, 2}. The monopolist has
a constant marginal cost of 10, and no fixed costs.

Reading for this question Subject Guide Ch 8

Approaching the question Parts (a) and (b) are very easy. Part (c) is also
conceptually straightforward, but a bit more difficult calculation-wise. To
answer part (d), you need to know exactly what you are doing. In other
words, the steps involved in calculating the optimal fixed fee must be clear
to you at the outset. If you try to figure it out as you answer the question,
chances are you will get it wrong.

(a) Suppose the monopolist can differentiate between the customers,

and the customers cannot trade between themselves, allowing the
monopolist to engage in third-degree price discrimination. What is
the price charged to each consumer? [5 marks]

Approaching the question With third degree price discrimination, the

monopolist sets MR = MC for each customer. For customer 1,

70 − 2Q1 = 10

so Q1 = 30, and P1 = 40. Profit is

π1 = 30(40 − 10) = 900

For customer 2,
110 − 2Q2 = 10
so Q2 = 50 and P2 = 60. Profit is

π2 = 50(60 − 10) = 2500

Total profit is 3400.

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(b) Now suppose the monopolist cannot differentiate between the cus-
tomers and must charge them the same price. Calculate the monop-
olist’s optimal single price P as well as the quantity sold to each cus-
tomer. [5 marks]

Approaching the question If a single price is set, the monopolist max-

imizes total profit. The total demand is Q = Q1 + Q2 . Here

Q = 70 − P + 110 − P = 180 − 2P

Revenue is (90 − Q/2)Q. MR is 90 − Q. Setting MR = MC, 90 − Q =

10, so Q = 80, and P = 50.
At a price of 50, the quantity for customer 1 is Q1 = 70 − 50 = 20 and
the quantity for customer 2 is Q2 = 110 − 50 = 60.
In this case, the profit of the monopolist is π = 80(50 − 10) = 3200.

(c) Is the total surplus (consumer surplus plus profit) higher under a
single price or under price discrimination? Explain. [5 marks]

Approaching the question Under price discrimination, consumer sur-

plus is

1 1 1 1
30(70 − 40) + 50(110 − 60) = 900 + 2500 = 1700
2 2 2 2
The profit (producer surplus) is 3400. So the total surplus under price
discrimination is
Sdisc = 5100

Under a single price, consumer surplus is

1 1 1 1
20(70 − 50) + 60(110 − 50) = 400 + 3600 = 2000
2 2 2 2
The profit (producer surplus) is 3200. So the total surplus under a sin-
gle price is
Ssingle = 5200

Therefore the total surplus is higher when a single price is charged.

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(d) Suppose, as in part (b), the monopolist cannot differentiate between

the customers. However, in addition to a per-unit price P, the mo-
nopolist can also charge a fixed fee F. A customer must pay this
fee irrespective of the quantity purchased when a positive amount is
purchased. Derive the monopolist’s optimal price and fee. [5 marks]

Approaching the question At any price P < 70, if the fixed fee is set
equal to the surplus of consumer 1 (given by (70 − P)2 /2), the total
demand is Q1 + Q2 = 180 − 2P, and the revenue is

(70 − P)2
2 + ( P − 10)(180 − 2P)
2
Maximizing, the first order condition is

−2(70 − P) + 180 − 2P − 2( P − 10) = 0

which simplifies to 60 − 2P = 0, which implies P = 30. The fixed fee

is then 800 and the revenue is 1600+ 2400 = 4000.
If the fixed fee is set equal to the surplus of consumer 2, then 1 does
not buy. The monopolist is just dealing with customer 2. In this case,
since the monopolist can set a fixed fee to extract all consumer surplus,
it is best to maximize surplus by setting price equal to marginal cost,
and then extracting full surplus.
(110 − 10)2
Thus optimal price is P = 10 and the fixed fee is F = =
2
5000. The profit of the monopolist is 5000, which is higher than the
previous case.
Therefore the monopolist’s optimal price is 10 and the optimal fixed
fee is 5000.
Note that the total surplus in this case is also 5000, which is lower than
the total surplus in parts (a) and (b).

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