ECON 3010

Midterm 2
November 5, 2021

● This exam has two numbered pages and 16 questions, each worth 3 points..

All questions require explanations. “Magical” answers that appear without any
justification/explanation will not be accepted.

Lucy views butter and margarine as perfect substitutes. Initially margarine is cheaper.
However, a price increase makes margarine more expensive than butter.
1. In a diagram measuring the quantity of margarine on the horizontal axis, show
the substitution, income and total effect of this price change.

The local fitness club charges non-members $20 per visit. If you become a member,
you can work out for $10 per visit, but you have to pay an annual fee of F. For simplicity
assume the price of all other goods is $1.
2. Use an indifference curve diagram to find (graphically, not numerically) the value
of F such that you are indifferent between buying a membership or not.

Suppose the club charges you the highest membership fee that you would buy, and you
buy a membership.
3. Would you go to the club more or fewer times than if you do not become a
member?

Marcia spends her money on tee and biscuits and sugar, which she sees as perfect
complements. She eats two biscuits with every cup of tea. A cup of tea costs $2 and
one biscuit costs $0.2, and she spends $33.60 on tea and biscuits every week.
4. Use a diagram measuring the number of biscuits on the horizontal axis to show
her compensated variation and equivalent variation if the price of a biscuit
decreases to $0.1.
5. What can you say about the change in her consumer surplus?.

Bob (who lives in Canada and has an utility of money 𝑢(𝑤) = 3 𝑤) has two
necklaces each worth $1,600, but they can only be sold in Thailand, where his sister
lives. He is concerned about the safety of shipping: he believes that the probability that
any box shipped will not reach its destination is 0.2. Assume shipping cost is zero.
6. Assuming Bob ships his necklaces in one box, what is his expected utility?
7. What is the risk premium would Bob pay to avoid bearing the shipping risk?
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 8. Should Bob ship the items together, or in two separate shipments?

Assume from this point on that Bob ships the necklaces together, and Bob can buy an
insurance policy for $340 that would reimburse him $1,600 in case his shipment is lost.
9. What is the actuarially fair price for this insurance policy?
10. Should he buy this insurance policy?
11. What is the most he is willing to pay for this insurance policy?

Assume from this point on that Bob is offered a fair insurance policy where he can
choose the coverage.
12. How much coverage would Bob choose, and how much would he have to pay
for it?

As CEO of firm A, you and your management team face the decision of whether to
undertake a $150 million R&D effort to create a new mega-medicine. Your research
scientists estimate there is a 50 percent chance of successfully creating the drug.
Success means securing a worldwide patent worth $550 million (implying a net profit of
$400 million). However, firm B (your main rival) has just announced that it is spending
$100 million to pursue development of the same medicine (by a scientific method
completely independent of yours). You judge that B’s chances of success is 30 percent.
Furthermore, if both firms are successful, they will split equally the available worldwide
profits ($275 million each) based on separate patents.
13. Draw the decision tree for your firm.
14. Assuming firm A is risk neutral, should it undertake the $200 million R&D
effort?

Now suppose that it is feasible for firm A to delay its R&D decision until after the result
15. Draw the new decision tree for your firm.
16. Is it advantageous for firm A to wait?

END OF EXAM

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