All questions refer to LT material except question 5

Collective Feedback on ST Exam in 2016/7

This document sketches solutions to the EC201 ST 2016/7 exam, as well as list common
errors. Overall, many students lost mark for giving wrong definitions, omitting conditions for
theorems and methods to apply, mislabelling diagrams, etc., in all sorts of combinations and
permutations that are not listed. The best advice is to learn the material thoroughly—especially
definitions—and be careful!
Section A: Answer ALL questions (10 marks each)

1 A competitive firm in Industry A has the cost function c(q) = 2q 2 . For every unit it produces,
it exerts the external marginal cost e(q) = 5q on consumers in Industry B. Demand in
Industry A is q = 25 − p.

(a) What are the efficient and competitive levels of output in Industry A?
The competitive output happens when marginal private cost (MPC) = marginal private
benefit (MPB), namely 4q = 25 − q, or q = 5. The efficient output happens when
marginal social cost (or social marginal cost) SM C = M P C + EM C = M P B, where
EMC = external marginal cost. This happens when 4q + 5q = 25 − q, or q e = 2.5.
(b) Define Pigouvian taxation and find the Pigouvian tax that leads to the efficient output.
Pigouvian taxation is the imposition of a per-unit tax on producers equal to the external
marginal cost of production. It sufficed to say that the tax is 5q. A better answer would
be that the tax equals the external marginal cost of production at the efficient output
= EM C(q e ) = 5q e = 12.5.
Overall, answers were good on this question.

2 Consider a two-person exchange economy with two goods, x and y. Person A has utility
uA = 10xA + y A . Person B has utility uB = xB + 10y B .

(a) Define what it means for an allocation to be a general-competitive-equilibrium alloca-

tion.
The allocation z = (z A , z B ), where z i = (z1i , z2i ), is a GCE allocation (with corre-
sponding prices p = (p1 , p2 )) if markets for both goods clear (z1A + z1B ≤ eA B
1 + e1 and
z2A +z2B ≤ eA B i
2 +e2 ) and each consumer i maximises her utility u within her budget set,
as defined by the GCE prices p and her endowment ei , by choosing her own alloca-
tion: (z i solves max ui (z i ) s.t. p·z i ≤ p·ei ). Many students lost marks for not giving the
right definition in various ways. One common way was not properly explaining each
consumer’s utility maximisation within her budget set. One of the more subtle ways
was not making it clear that the p in the budget set corresponds to the GCE p.

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 (b) Can the allocation that gives each person 5 units of each good be a general-competitive-
equilibrium allocation? Explain. It is Pareto dominated by ẑ A = (10, 0), ẑ B = (0, 10),
which is feasible whenever the proposed allocation is. By the First Welfare Theorem,
since preferences are non-satiated, and there are no externalities, the GCE allocation
must be Pareto efficient, and therefore cannot be the one described. Many students
lost marks for not giving the right reason for Pareto inefficiency. In particular, it does
not suffice to note the unequal MRS’s, as there will be PE allocations with that prop-
erty on the boundary of the Edgeworth box. Others lost marks because they did not
explain the the assumptions of the FWT hold, which allows them to conclude that if an
allocation is Pareto inefficient, then it is not a GCE allocation.

3 Joan inhabits a Robinson-Crusoe economy in which labour time L can be transformed into
coconuts according to the production function f (L) that is increasing and concave, with
f (0) = 0. As consumer, Joan is endowed with one unit of time and all profits earned by
the competitive firm; she chooses how to divide her time between leisure and working for
the wage rate w, and how many coconuts to consume at per-unit price p. As firm, Joan
maximises profits, taking both p and w as given.

(a) In a diagram with leisure time on the horizontal axis and coconuts on the vertical axis,
draw the PPF and the consumer’s budget set.

c
Budget Line with gradient -pl/pc

fs
(π)/pc PPF

0 ←Labour Input ls 24 leisure

1

(b) Suppose that the government subsidises labour by s, which it funds through a lump-

2
sum tax on the consumer. Is the equilibrium allocation Pareto efficient? Explain in
your diagram.
The question is ambiguous as to whether the consumer or firm receives the subsidy.
If the consumer, we have the following:

Pareto Inefficiency of Subsidisation

Indifference curve not tangent to PPF
at equilibrium allocation

c Budget Line with Tax Revenue -T

Isoprofit Line
with slope -pl/pc
and subsidy has slope -(pl+s)/pc

Pareto Improvement upon (ls,cs)

cs
PPF
(π-T)/pc
0 ←Labour Input ls 24 leisure
1

If the firm, we have the following:

Pareto Inefficiency of Subsidisation

Indifference curve not tangent to PPF
at equilibrium allocation

c Budget Line with Tax Revenue -T

Isoprofit Line and subsidy has slope -pl/pc
with slope -(pl-s)/pc

Pareto Improvement upon (ls,cs)

cs
PPF
(π-T)/pc
0 ←Labour Input ls 24 leisure
1

3
 One answer suffices. Overall in the question, many students failed to draw the cor-
rect diagram, in particular missing that at the equilibrium, the indifference curve and
PPE pass through the same point, as well as that equilibrium prices change with the
imposition of the subsidy.

4 (a) Define what it means for someone to be risk averse. For every lottery L, the person
likes the getting the expected value of L with certainty at least as much as getting the
lottery L.
(b) Is someone who is loss averse necessarily risk averse? Explain. No, loss averse
people can be risk loving over losses. See diagram.

Kahneman & Tversky’s S-

Shaped Value Function
value

Concave here
outcome relative to reference point

Gains: x>r x-r

Losses: x<r

Convex here

Overall, answers were good on this question.

5 Workers can be of two types, high and low. High types have marginal revenue product of
10. Low types have marginal revenue product of 2. The labour market is competitive such
that each worker gets paid the market expectation of his or her marginal revenue product.
Firms do not know individual workers’ type but do observe whether each worker chose to
obtain a BSc before entering the labour market. They also know that half the workers are
high types and half low types. The utility cost of a BSc to a low-type worker is 10, whilst the
cost to a high-type worker is 5. Assume that all workers have utility of money u(w) = w.

(a) Explain whether there is a pooling equilibrium in which every worker gets a BSc. No,
there is not. If there were, then BSc holders would get paid 12 10 + 12 2 = 6. Someone

4
 who does not get a BSc would get paid at least 2, the MRP of the low type. Low types
would prefer to not get BSc and paid at least 2 to obtaining a BSc at utility cost of 10
for a wage of 6, leaving net utility 6 − 10 = −4 < 2. (So too would high types.) Many
students erred by arguing simply that because a type’s utility from getting a BSc is
negative, they prefer not to get one; one must point out that not getting a BSc gives
a higher utility than not getting one. (We could have written payoffs such that even
those without BSc get negative payoffs, as 0 has no especial meaning in utility theory,
a point that many students do not appreciate.) Most students get that this is not a
pooling equilibrium, but many give the wrong reason, either this one, or assuming
that a high type who does not get a BSc must necessarily get paid 10 in the pooling
outcome. The correct argument is that *however* workers without BSc are perceived,
they will get paid at least 2, in which case both types want to deviate.
(b) Explain whether there is a separating equilibrium in which only high types obtain a
BSc. Yes. In this case, the firm rationally concludes that all workers with BSc’s are
high types and pays them 10; it rationally concludes that all worker without degrees
are low types and pays them 2. High types then compare the payoff from BSc 10 − 5
to the payoff from no BSc, 2, and get BSc. Low types would not want to get a BSc
as their payoff from BSc 10 − 10 = 0 is less than that from no BSc, 2. Many students
checked these conditions in the *wrong way* by thinking that a low type who deviates
to get a BSc would get paid 6, as per the pooling outcome in part (a).

Section B: Answer BOTH questions (25 marks each).

6 Ani and Bill interact in an exchange economy with two goods, kiwis (k) and mangoes (m).
1 2
Ani is endowed with two units of each fruit and has the utility uA (k A , mA ) = (k A ) 3 (mA ) 3 ,
while Bill is endowed with one unit of each fruit and has the utility uB (k B , mB ) = (k B )(mB )2 .

(a) 7 marks Explain whether the endowment is Pareto efficient.

Students need to do two things. First, show that preferences are non-satiated and
convex so that they can check Pareto efficiency by checking that MRS’s are equal;
second, check that MRS’s are equal.
The marginal utilities are easier to find by taking logs (although taking logs is by no
mean necessary),

v A = (1/3) ln(k A ) + (2/3) ln(mA )

∂v A 1 ∂v A 2
Note ∂kA
= 3kA
> 0, and ∂mA
= 3mA
> 0, so preferences are non-satiated.

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 To check that preferences convex, solve for mA as a function of k A on an indifference
curve (with utility C)

C = (1/3) ln(k A ) + (2/3) ln(mA ) ⇒ mA = exp{3C/2 − (1/2) ln k A }

Then

∂mA −1
= exp{3C/2 − (1/2) ln k A } A < 0
∂k A 2k

∂ 2 mA 1 2
A 2
= exp{3C/2 − (1/2) ln k A } A 2
+ exp{3C/2 − (1/2) ln k A } >0
∂(k ) 4(k ) 4(k A )2

A’s MRS is

∂v A 1
∂kA 3kA 1
∂v A
= 2 =
3mA
2
∂mA
Again, taking logs of B’s utility function gives

v B = ln(k B ) + 2 ln(mB )

We can once more check that B’s preferences are non-satiatied and convex, but be-
cause they are the same as A’s, we can omit this.
B’s MRS is
∂v B 1
∂kB kB 1
∂v B
= 2 =
mB
2
∂mB

Since A and B have non-satiated and convex preferences, M RS A = M RS B implies

Pareto efficiency for interior allocations like the endowment. Many students lost marks
for not explaining the role of non-satiation and convexity.
It was alright to answer this question through the First Welfare Theorem (FWT): in (d),
we find that GCE allocation coincides with endowment; since preferences are non-
satiated, and there are no externalities, the FWT tells us that the GCE allocation—and
identically, the endowment—is Pareto efficient.
(b) 5 marks Find Ani’s demand for kiwis using any method you want.
Normalise pm = 1. Students know from lecture that someone maximising a Cobb-
Douglas utility function of the form u(x, y) = xa y 1−a , for a ∈ [0, 1], spends the fraction
a of the money value of their goods endowment on good x (and the remainder on y).
1
They are free to use this simple lemma. Ani spends 3 income on kiwis, so

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 1 pk eA A
k + em 1 1
kA = = (eA A
k + em /pk ) = (2 + 2/pk )
3 pk 3 3
(c) 5 marks Find Bill’s demand for kiwis using any method you want.
1
Bill spends 3 income on kiwis, so

1 pk eB B
k + em 1 1
kB = = (eB + eB
m /pk ) = (1 + 1/pk )
3 pk 3 k 3
(d) 8 marks Find the general competitive equilibrium allocation and describe the pattern
of Ani and Bill’s trade.
Finding the market-clearing price

1 1
(2 + 2/pk ) + (1 + 1/pk ) = 2 + 1
3 3
1
gives pk = 2 . Plugging that into demand returns the endowments. They do not trade.
Many students failed to find GCE prices.

7 There are two types of health-care consumers, sickly and healthy. Sickly consumers get
sick with probability 13 , whereas healthy ones only get sick with probability 16 . A consumer
who gets sick incurs a loss of £900. Each begins with wealth £2500 and is an expected
√
utility maximiser with utility-of-wealth function u(w) = w.

(a) 5 marks Draw the two types’ endowments and preferences in a diagram whose axes
depict money when sick and money when healthy.

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 Complete Information: Full Actuarially Fair
Insurance for Both Types
Zero-Profit Line on Safe Types

wsick
Indifference Curve for Risky Type Indifference Curve for Safe Type

SlopeSAFE=-5

£1600
SlopeRISKY=-2
45º Zero-Profit Line on Risky Types

£2500 whealthy

Students lost marks for wrong endowment, wrong gradients, indifference curves that
slope up, etc.
(b) 5 marks Assume the presence of a risk-neutral insurance company. Is the endowment
Pareto efficient? Explain. No, giving each consumer full insurance at a price that is
actuarially fair for her generates a Pareto improvement: the risk averse agent gets the
expected value of her starting position, leading to higher utility; the risk-neutral insurer
is indifferent. (Indeed, giving just one consumer partial insurance at actuarially fair
prices does the same trick.) Many students did not explain what the Pareto improve-
ment actually is, nor explain that the insurer is just as well off under the described
Pareto improvement. Many other did not explain that this Pareto improvement entails
that the consumer actually get full insurance and is not merely offered it.
Another valid answer that you might see is that it is a Pareto improvement to give both
consumers full insurance at prices that are actuarially fair for the entire population.
Clearly this leaves the insurance company equally well off. Equally clear is that the
risky types prefers this outcome to his starting position. But one must actually show
that the safe type benefits too, as done below in part (d).
(c) 7 marks Under complete information, describe the equilibrium in the insurance market
with perfect competition and free entry and exit.
Under perfect competition with free entry and exit, firms earn zero (expected profits) on
each type, for they are essentially two different markets under complete information.

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 Therefore, the price of insurance for each type must be actuarially fair for that type.
1
Each consumer gets full insurance at the actuarially fair price for her, sickly paying 3
1
per pound of coverage and health 6 per pound of coverage. Hence, healthy types get
£2500 − (1/6)900 = 2350 in both states, and sickly types get £2500 − (1/3)900 = 2200
in both states. No entrant can profitably enter the market. Many students failed to
mention that the firm earns zero profits, and neglected to mention the lack of profitable
entry opportunities. Some also wrongly called this a separating equilibrium.
(d) 8 marks Now assume that consumers know their types; firms do not know whether
any individual consumer is sickly or healthy but know that half of consumers are sickly
and the other half healthy. Explain whether there is a pooling equilibrium in the insur-
ance market with perfect competition and free entry and exit in which all consumers
obtain full insurance in return for paying 21 13 + 16 £900 = £225.

Clearly risky types prefer this better-than-fair insurance to no insurance. But safe
types do not as

√ √
2500 − 225 = 2275 ≈ 47.7 < (5/6)50 + (1/6)40 ≈ 48.3

Another reason that this is not an equilibrium (that requires no calculation) is because
an entrant could come in and offer less than full insurance to healthy types at a lower
price and make positive profits by attracting only healthy types, namely by cream-
skimming. In the figure, an entrant who offers P attracts only Safe types because it
lies above the Safe types’ indifference curve through full insurance at price £225, but
below Safe types’ indifference curve through full insurance at price £225. Since it is
actuarially fair for the entire population, P generates positive profits when only risky
types accept. (Obviously P is not the only such contract, nor are all such contracts
on the line that is actuarially fair for the entire population.) To obtain full marks, stu-
dents must provide such a diagram or other cogent explanation for why such cream-
skimming is possible. Simply stating that safe types prefer partial insurance at this
price is not sufficient: students must describe the profitable entry opportunity.

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Entrant Could Skim Off Safe Types with P

Zero-Profit Line on Both Types

wsick Indifference Curve for Safe Type

£2275
P
£1600
Indifference Curve for Risky Type

45º
£2275 £2500
whealthy

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