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University of Toronto | Department of Economics | ECO 204 | 2011 - 2012 | Ajaz Hussain
TEST 3
TIME: 1 HOUR AND 50 MINUTES
YOU CANNOT LEAVE THE EXAM ROOM DURING THE LAST 10 MINUTES OF THE TEST
REMAIN SEATED UNTIL ALL TESTS ARE COLLECTED, COUNTED AND THE PROCTOR ANNOUNCES THAT YOU CAN LEAVE THE ROOM
IF YOU DETACH PAGES ITS YOUR RESPONSIBILITY TO RE-STAPLE THESE - GRADERS ARE NOT RESPONSIBLE FOR LOOSE PAGES
DO NOT HAVE A CELL PHONE ON YOUR DESK OR ON YOUR PERSON. ONLY AID ALLOWED: A CALCULATOR
THERE IS A WORKSHEET AT THE END OF THE TEST
GOOD LUCK!
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SCORES
Question Total Points Score
1 25
2 25
3 25
4 25
Total Points = 100


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Question 1 [25 Points]
The following table contains estimates of Cobb-Douglas production function parameters for select US sectors:

Tobacco Products 0.18 0.33 0.51
Food and Kindred Products 0.43 0.48 0.91
Transportation equipment 0.44 0.48 0.92
Apparel and other textiles 0.70 0.31 1.01
Furniture and fixtures 0.62 0.40 1.02
Electronics and electric equipment 0.49 0.53 1.02
Paper and allied products 0.44 0.65 1.09
Petroleum and coal products 0.30 0.88 1.18
Primary metal 0.51 0.73 1.24

(a) [5 Points] Which of these sectors exhibit increasing, constant, and decreasing returns to scale? Give a brief
explanation (including general proofs of returns to scale) and state any assumptions. You can assume that estimates of
have a margin of error.

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(b) [5 Points] Which of these sectors exhibit increasing, constant, and decreasing returns to capital (assuming labor is
fixed)? Give a brief explanation (including general proofs of returns to capital) and state any assumptions. You can
assume that estimates of have a margin of error.

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(c) [5 Points] In which of these sectors will there be cost savings due to a horizontal merger of two companies within the
sector? Give a brief explanation (including any general proofs) and state any assumptions. You can assume that
estimates of have a margin of error. Hint: The long run cost function for the Cobb-Douglas production
function can be written as ()

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(d) [10 Points] Please sketch (rough) graphs of versus for the Tobacco, Furniture and fixtures, and Primary
Metals sectors. Provide a brief explanation next to each graph.
Answer:
Explanation

Tobacco
Explanation

Furniture and Fixtures

Explanation

Primary Metals


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Question 2 [25 Points]
The following table contains Motorolas and Research in Motions (RIM) Closing Monthly Price, Monthly Returns, and
Monthly Capital Gains in 2010:
Date
(M/D/Year)
Motorola Stocks Research in Motion (RIM) Stocks
Closing Monthly Price Returns Capital Gains Closing Monthly Price Returns Capital Gains
1/29/2010 $ 6.15 -0.207474 -0.207474 $ 62.91 -0.068551 -0.068551
2/26/2010 $ 6.76 0.099187 0.099187 $ 70.88 0.126687 0.126687
3/31/2010 $ 7.02 0.038462 0.038462 $ 73.97 0.043595 0.043595
4/30/2010 $ 7.07 0.007123 0.007123 $ 71.19 -0.037583 -0.037583
5/28/2010 $ 6.85 -0.031117 -0.031117 $ 60.69 -0.147493 -0.147493
6/30/2010 $ 6.52 -0.048175 -0.048175 $ 49.26 -0.188334 -0.188334
7/30/2010 $ 7.49 0.148773 0.148773 $ 57.53 0.167885 0.167885
8/31/2010 $ 7.52 0.004005 0.004005 $ 42.84 -0.255345 -0.255345
9/30/2010 $ 8.53 0.134309 0.134309 $ 48.69 0.136555 0.136555
10/29/2010 $ 8.16 -0.043376 -0.043376 $ 56.92 0.169029 0.169029
11/30/2010 $ 7.66 -0.061275 -0.061275 $ 61.83 0.086261 0.086261
12/31/2010 $ 9.07 0.184073 0.184073 $ 58.13 -0.059842 -0.059842

(a) [5 Points] True or false: neither Motorola nor RIM paid a monthly dividend in 2010? Give a brief explanation and
provide a formula to justify your answer.

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The following table contains the return on 30-day US Treasury Bills issued on December 31
st
2010 as well as Motorola
and RIMs average monthly returns; variance of monthly returns; and the covariance of Motorolas and RIMs monthly
returns for the period February 26
th
, 1999 to December 31
st
, 2010:
30 Day U.S. T-Bill Return (Dec 31
st
2010) 0.00081

The following figures are for the period February 26
th
, 1999 to December 31
st
, 2010

Average Motorola Monthly Returns 0.002616887
Variance of Motorola Monthly Return 0.013877326
Average RIM Monthly Returns 0.054275605
Variance RIM Monthly Returns 0.052027303
Covariance of Motorola and RIM Monthly Returns 0.012945617

(b) [5 Points] Are Motorola stocks riskier than RIM stocks, or the other way around? Give a brief explanation and justify
your answer by calculating the risk premium for each stock.




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(c) [15 Points] An investor has the following mean-variance utility function over expected portfolio returns [

] and
portfolio variance

where is a parameter reflecting the investors attitude towards risk:

[

Suppose . Suppose this investor wants to invest in a portfolio consisting of US 30 day T-Bills and a risky asset that
is a composite blend of Motorola and RIM stocks. Solve for the optimal fraction of this portfolio that will be in US 30 day
T-Bills, Motorola and RIM stocks. Show all calculations and state all assumptions.
Hint: Construct the optimal blend of Motorola and RIM stocks Construct a portfolio of US 30 day T-bills and
the blended risky asset.
Note that in a portfolio consisting of two risky assets designed to maximize the price of risk:

The fraction ( ) allocated to risky asset (the least risky of the two risky assets) is:


[(

[(

[(

[(

[(

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Question 3 [25 Points]
Youve received a letter from the Canadian Revenue Agency (CRA) stating that you made a mistake in your 2010 tax
returns and that you owe the CRA $5,000 in back taxes. You must choose one of the following two (mutually exclusive)
decisions:
Either pay the CRA $5,000 in back taxes
Or request the CRA for an audit of your 2010 tax returns. The audit process will cost you $500 in expenses
and may result in one of two uncertain outcomes:
o With probability

the audit will agree with the CRA and you will have to pay the back taxes plus
50% of back taxes (dont forget youll also pay the $500 audit expenses)
o With probability the audit will reject the CRAs claim in which case you will owe no back taxes and
the CRA will reimburse you the $500 in audit expenses.
(a) [10 Points] Please graph the decision tree for this decision making problem under uncertainty and solve for the
optimal decision with the assumption that you are a risk neutral decision maker. Show all calculations.

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Now suppose that you can make your decision whether to pay the back taxes or request an audit after meeting with an
accountant who (for a testing fee) will conduct a test on your tax returns and tell you the probabilities that the audit
will side with the CRA (a positive test result) or whether the audit will side with you (a negative test result). The
following probability table shows the accountants track record in the past:
Actual Outcome of Audits
Audit agreed with CRA Audit rejected the CRA Total Probabilities
Positive Test Result (+)

Negative Test Result (-)






Total Probabilities

1

(b) [15 Points] Please graph the decision tree for this decision making problem under uncertainty with testing. What is
the maximum testing fee that the accountant can charge you? Assume you are a risk neutral decision maker and show
all calculations.


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Question 4 [25 points]
[Short Questions. All parts are independent of each other]

(a) [5 points] What is actuarially fair insurance? Please give a brief explanation and a proof. Be sure to state any
assumptions.

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(b) [5 points] Give a brief explanation for how Dell Computers reduced inventory period through learning by doing.

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(c) [5 points] What are the economies of scope from a merger of a beer manufacturer and a U.S. wine manufacturer?

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(d) [5 points] True or false: if a companys average cost () falls over time, it must be due to learning by doing?

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(e) [5 points] A company uses fixed and variable labor, fixed and variable capital, and variable materials to produce
output according to a Cobb-Douglas production function:

What is the interpretation of the Lagrange multiplier in this companys Cost Minimization Problem below?

]
Note: You do not need to solve the CMP.


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