UniversityofToronto,DepartmentofEconomics,ECO20420092010.

AjazHussain
Test2
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Question Points Score
1 15
2 25
3 35
4 25
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Question1[15Points]
Inthis1periodproblem,aconsumerallocatesherincome betweenconsumptionC and
savingsS.Herutilityfunctionis:
u = C +
(S - o)
2
2[

Assumeo, [, > u.

(a)[10Points]SolvetheconsumersUMP.Showallcalculationsandclearlystateany
assumptions.

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(b)[5Points]Isitpossiblethatthisconsumergoeshungry(i.e.consumenothing)?

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Question2[25Points]
Anindividuallivesfortwoperiods(I = 1and2)inanecornomy(i.e.theonlygoodis
corn).Herrealincome(measuredincorn)is
1
inI = 1 and
2
intimeI = 2 .

I = 1isthebaseperiodsothatP
1
= 1andallowforthepossibilityofinflation(i.e.itmaybe
thatP
1
= P
2
).Denotethenominalinterestratebyi,inflationbynandthe terestbyr. realin
ConsideraconsumerwiththefollowingutilityfunctionforconsumptioninI = 1 and
consumptioninI = 2:

u = C
1
+
(C
2
- o)
2
2[

Assumeo, [ > u.

Inthisquestionyoudonothavetoderivetheintertemporalbudgetconstraintfrom1
st

principles(i.e.youcanstatetheconstraint).

(a)[10Points]CalculatetheconsumersoptimalconsumptioninI = 1, 2.Showallcalculations
andclearlystateanyassumptions.

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(b)[5Points]WhenwillthisconsumerborrowinI = 2?Asr l, willshecontinuetobea

borrower?Showallcalculations.

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(c)[5Points]AssumetheconsumerisaborrowerinI = 2.Ifinflationrises,willsheborrow
moreorless?
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(d)[5Points]Ifthenominalinterestrateequalsinflation,whenwillthisconsumerexhibit
consumptionsmoothing?Showallcalculations.

Question3[35Points]
ThreecompetitivefirmsA,BandChireworkersatP
L
= $SandleasemachinesatP
K
= $4.
Theirproductionfunctionsare:
FirmA
= A|I
2
+ K
2
]
1
2

FirmB
= Amin(I, K)

FirmC
= A|I + ] K
AssumeA = 1.Assumeallfirmshavetargetoutputq.
(a)[5Points]Characterizeeachfirmsreturnstoscale.Showallcalculations.

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(b)[5Points]CalculatefirmAsoptimallabor,capitalandcostfunction.Showallcalculations.
Hint:theoutputconstraintA|I
2
+ K
2
]
1
2
= q isequivalenttoA
2
|I
2
+ K
2
] = q
2
whichis
equivalenttoA
2
|I
2
+ K
2
] -q
2
= u.

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(c)[5Points]CalculatefirmBsoptimallabor,capitalandcostfunction.Showallcalculations.

(d)[5Points]CalculatefirmCsoptimallabor,capitalandcostfunction.Showallcalculations.

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(e)[5Points]Assumethereare3TypeAfirms,2TypeBfirmsand10TypeCfirms.EachTypeA
firmhasacapacityof100units,eachTypeBfirmhasacapacityof200units,andeachTypeC
firmhasacapacityof400units.Graphthecompetitivemarketsupplycurve,assumingallfirms
arerational.

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(f)[5Points]Supposethemarketpriceis$6.Whatistheequilibriummarketoutput?

(g)[5Points]NowsupposeallTypeAfirmsareirrational.Graphtheirrational+rationalmarket
supplycurve.

Foryourconvenience,hereisthecapacityinformation:thereare3TypeAfirms,2TypeBfirms
and10TypeCfirms.EachTypeAfirmhasacapacityof100units,eachTypeBfirmhasa
capacityof200units,andeachTypeCfirmhasacapacityof400units.

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Question4[25Points]
FromThePrestigeTelephoneCompany(PTC)case,recallintercompanyhourswerebilledat
$400/hour,commercialhoursbilled functionwasestimatedtobe: at$800/hr,andthecost
C(q) = 21S,118 +28q
Hereq ismeasuredinhours.Foryourconvenience,hereisExhibit1fromthecase:
Exhibit1
PrestigeDataServicesSummaryofComputerUtilization,FirstQuarter2003
RevenueHours January February March

Intercompany 206 181 223
Commercial 123 135 138
Totalrevenuehours 329 316 361

Servicehours 32 32 40
Availablehours 223 164 143
Totalhours 584 512 544

(a)[5Points]InMarch2003,thePrestigeTelephoneCompanychargedcommercialcustomers
$800/hourandsold138hours(seeexhibit1).Question3parts(a)and(b)inthecasestate
thatraisingthecommercialpriceto$1,000/hourwillreducedemandby30%whileloweringthe
commercialpriceto$800/hourwillraisecommercialdemandby30%.DerivethePrestige
TelephoneCompanysMarch2003commercialdemandcurve.

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(b)[10Points]Supposeintercompanyhoursarenolongercappedat205hoursmonthbut
continuetobebilledatafixedpriceof$400/hour.AssumePTCmustuse40hoursinMarch
2003toservicecomputers.Iftheremaininghourscanbeallocatedbetweencommercialand
intercompanyhours,whatistheprofitmaximizingnumberofcommercialandintercompany
hours?Hint:Sol vethisproblembytheKuhnTuckertechnique:
max

i
,
c
=
C
+

s. t.

+
c
Total Bouis -Seivice Bouis

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(c)[5Points]SupposePTCinvestsinnewcomputerequipment,resultinginhigherfixedcosts.
ShouldPTCraiseintercompanyandcommercialprices?Brieflyexplainwhyorwhynot.

(d)[5Points]Attheprofitmaximizingcommercialprice,whatmustbetrueoftheprice
elasticity?Proveyouranswer.

THEEND.NICE!

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