~~EC2066 ZA d0

This paper is not to be removed from the Examination Halls

UNIVERSITY OF LONDON EC2066 ZB

BSc degrees and Diplomas for Graduates in Economics, Management, Finance

and the Social Sciences, the Diplomas in Economics and Social Sciences and
Access Route

Microeconomics

Thursday, 15 May 2014 : 10:00 to 13:00

Candidates should answer ELEVEN of the following FOURTEEN questions: all EIGHT
from Section A (5 marks each) and THREE from Section B (20 marks each).
Candidates are strongly advised to divide their time accordingly.

A calculator may be used when answering questions on this paper and it must comply
in all respects with the specification given with your Admission Notice. The make and
type of machine must be clearly stated on the front cover of the answer book.

If more questions are answered than requested, only the first answers attempted will be
counted.

PLEASE TURN OVER

© University of London 2014

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SECTION A

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

1. Consider the following simultaneous-move game with two players, 1 and 2.

If 1 and/or 2 have any dominated strategies, eliminate them. Once you have
done this, consider the remaining game. In this remaining game, eliminate any
dominated strategies of 1 and/or 2, and so on. This method is called ‘iterated
elimination of dominated strategies’. Find the equilibrium using this method.
Your answer must show each round of elimination clearly.

Player 2
A2 B2 C2
A1 2,2 4,2 0,4
Player 1 B1 4,0 6,8 2,2
C1 6,4 4,0 0,6

2. Consider an exchange economy with two goods (milk and honey) and two con-
sumers (A and B). There are 10 units available of each of the two goods. Con-
sumer A is endowed with 6 units of milk and 4 units of honey. Consumer B is
endowed with 4 units of milk and 6 units of honey. Let M denote units of milk
and H denote units of honey. Consumer A has the following utility function:

U A ( M, H ) = min[ M, H ]

Consumer B has the following utility function:

UB ( M, H ) = M + H

Draw an Edgeworth box and show the area of mutually beneficial trades be-
tween the two consumers.

3. A monopolist has a well-defined supply function. Is this true or false? Explain

your answer.

4. A bond pays a fixed sum of 100 per year for ever (i.e. the bond is a perpetuity).
The annual interest rate is 5%. What is the maximum amount an agent should
pay to buy this bond?

5. Growth in the economy leads to a rise in the demand for labour. It follows that
the equilibrium quantity of labour (measured in the number of hours worked)
must rise. Is this true or false? Explain your answer.

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 6. Suppose the inverse demand curve is given by P = 10 − Q. This is shown in
the picture below. At the point A shown in the picture, is the demand elastic or
inelastic (with respect to price change)? Explain your answer.

10

Price A

P = 10 - Q

0
5 10
Quantity

7. The short run supply function of a competitive firm is given by

(
0 if P < 10
Q=
3P − 30 if P > 10

where Q is the quantity supplied and P is the price of output. Derive the equa-
tion for the firm’s marginal cost curve.

8. Too few people use public transport in London relative to the social optimum.
Provide an economic argument in support of this statement.

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SECTION B

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

9. 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 . Each firm can produce output
at a constant marginal cost of 6. There are no fixed costs. Let Q denote total
output, i.e. Q = q1 + q2 . The inverse demand curve in the market is given by

P = 30 − 2Q

(a) Find the Cournot-Nash equilibrium quantity produced by each firm and
the market price. [5 marks]

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

(c) Calculate the deadweight loss arising from Cournot-Nash and Stackelberg
duopoly. Which market structure is more efficient? [5 marks]

(d) Suppose, as in part (b), firm 1 moves first and decides how much to pro-
duce. Firm 2 moves second and makes its production decision. There is
then a third stage at which firm 1 can change its mind about how much to
produce and makes a final decision. Find the equilibrium quantities pro-
duced by the two firms under this three-stage game. [5 marks]

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 10. (a) Consider the following simultaneous-move game with two players, 1 and
2. Let p denote the probability with which player 1 plays A1 , where 0 6
p 6 1. B1 is played with the residual probability. Next, let q denote the
probability with which player 2 plays A2 , where 0 6 q 6 1. B2 is played
with the residual probability.
Draw a picture with p along the horizontal axis and q along the vertical
axis and draw the best response functions of players 1 and 2. Clearly label
any equilibrium points in the picture. [6 marks]
Player 2
A2 B2
Player 1 A1 2,2 3,0
B1 3,5 1,6

(b) Consider the following extensive-form game with two players. Player 1
can end the game by choosing ‘Out’. If player 1 chooses ‘In’, Player 2 then
chooses between ‘L’ and ‘R’. The payoffs are written as (Payoff to 1, Payoff
to 2). Identify any subgame perfect Nash equilibrium. [6 marks]

In Out

2
0,1
L R

2,2 -1,3

(c) Suppose the following game is repeated infinitely. Players discount the fu-
ture, so that, for each player, a payoff of x received t periods from today is
worth δt x today, where 0 < δ < 1. Show that it is possible to sustain coop-
eration (which in this case involves each player playing C every period) in
the infinitely repeated game for high enough values of δ. [8 marks]
Player 2
C D
Player 1 C 2,2 0,3
D 3,0 1,1

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 11. A monopolist can vary the quality of a good he produces. The cost of producing
quality q is
q2
C (q) =
2
There are two types of consumers. From consuming a good of quality q1 at price
p1 , type 1 consumers get a utility of

u1 ( q 1 , p 1 ) = q 1 − p 1

Type 2 consumers get a higher marginal benefit from quality. From consuming
a good of quality q2 at price p2 , type 2 consumers get a utility of

u2 (q2 , p2 ) = 2q2 − p2

Consumers buy the good so long as they get at least 0 utility. The profit of the
monopolist from a quality-price pair of (qi , pi ) where i ∈ {1, 2} is then given by

q2i
π ( qi , p i ) = p i −
2
(a) Suppose the monopolist knows the type of any consumer. In this case
the monopolist produces a quality q1 for a type 1 consumer and charges
a price p1 . Similarly, type 2 consumers are offered quality q2 at price p2 .
For any i ∈ {1, 2}, the optimal pair (qi∗ , pi∗ ) maximises π (qi , pi ) subject to
ui (qi , pi ) = 0. Find the optimal quality-price pairs (q1∗ , p1∗ ) and (q2∗ , p2∗ ).
[5 marks]

(b) Suppose a consumer’s own type is known only to the consumer. The mo-
nopolist cannot identify the type of any consumer. In this case, suppose
the monopolist still offers the quality-price pairs (q1∗ , p1∗ ) and (q2∗ , p2∗ ) from
part (a). Which quality-price pair would a type 1 consumer choose? Which
pair would a type 2 consumer choose? [5 marks]

(c) Suppose the monopolist sets q1 = 1/2, p1 = 1/2 and q2 = 2. The monop-
olist wants to set p2 such that type 2 consumers would have the incentive
to choose (q2 , p2 ) rather than (q1 , p1 ). What is the highest value of p2 that
satisfies the monopolist’s objective? [5 marks]

(d) Given the values of q1 , q2 , p1 and p2 from part (c), would a type 1 consumer
have the incentive to choose (q1 , p1 ) rather than (q2 , p2 )? [5 marks]

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 12. Consider an economy with two goods, 1 and 2. There is a competitive mar-
ket for the goods. There are a 100 identical firms in the competitive industry
producing good 1, and the cost of the representative firm producing q1 units of
good 1 is given by
q2
C ( q1 ) = q1 + 1
2
There are a 100 identical consumers. The representative agent consuming q1
units of good 1 and q2 units of good 2 obtains an utility

u(q1 , q2 ) = ln q1 + ln q2

The price of good 1 is denoted by P and the price of good 2 is 1. Each consumer
has an income of 12.

(a) Derive the market supply function for good 1. [5 marks]

(b) Derive the market demand function for good 1. [5 marks]

(c) Calculate the market equilibrium price and quantity of good 1. [5 marks]

(d) Calculate the price elasticity of demand for good 1 at the market equilib-
rium. [5 marks]

13. Rai spends her income on fuel for heating her house (H) and a composite of all
other goods (Y). Her preferences are represented by the utility function

u( H, Y ) = H α Y1−α

The price of the composite good is 1, and the price of heating fuel is p. Let M
denote Rai’s income.

(a) Derive Rai’s demand for H and Y. [5 marks]

(b) Suppose M = 300 and α = 2/3. Also suppose currently the unit price of
fuel is p = 20. The energy company offers Rai the option to switch to a
different tariff. Under the new tariff, Rai must pay a fixed fee of 100 and
then she can buy fuel at a unit price of 10. Would Rai switch to the new
tariff? Explain. [8 marks]

(c) The government decides to give Rai a heating fuel subsidy of s per unit.
This results in an increase in utility from u0 before the subsidy to u1 after
the subsidy. Could the government follow an alternative policy that would
result in the same increase in utility for Rai, but cost the government less?
Explain using a suitable diagram. [7 marks]

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 14. 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.

(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]

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

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

(d) Suppose, as in part (b), the monopolist cannot differentiate between the
customers. However, in addition to a per-unit price P, the monopolist 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]

END OF PAPER

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