Microeconomics (Econometrics)

Final 2020
December 17th 2020

1 Demand and Supply (13 points)

Consider the market for coffee. Market demand is given as P d = 11 − 2Qd , and
supply is given as P s = 1 + 3Qs . Quantities are expressed in kilograms, and
prices are expressed in euros per kilogram.
(a) Calculate the elasticity of supply when this market is in equilibrium. (4
points)
Equilibrium: P d (Q∗ ) = P s (Q∗ ) ⇔ Q∗ = 2 ⇔ P ∗ = 7 (2 points) Elasticity
 s −1
P∗ dP
of supply: εs = Q ∗ dQs = 67 . (2 points)
(b) Draw the consumer surplus in market equilibrium. How large is the
consumer surplus? (6 points)

(4 points, with 2 points

for correct supply and demand curves, and 2 points for correct CS area)
Consumer surplus: (11−7)2
2 = 4 (2 points)
(c) Suppose the government levies a tax of T = 5 euros per kilogram on the
consumer side. What are the price and the quantity in the new equilibrium? (3
points)
New equilibrium: P d (QT ) − T = P s (QT ) ⇔ QT = 1 ⇔ P T = 4
1.5 point each

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2 Consumer Theory (15 points)
Assume that Doris has a weekly allowance of 250 euros, all of which she spends
on meals and notebooks. Her utility function is U (M, N ) = M 0.8 N 0.2 . The
price of a notebook is PN = 5 euros per notebook. The original price of a meal
is PM 0 = 10 euros per meal. The price of meals then increases to PM 1 = 20
euros.

a) Calculate the optimal consumption bundles, before and after the price
change.
At the initial situation, Gossen’s Law yields: 4N 1
M = 2 ⇔ N = 2 M . 1 point for
Gossen’s Law (or setting-up correct Lagrangian).
Substitute in the budget constraint: 250 = 10M + 25 M .

Therefore: M0 = 20 and N0 = 10.

1 point per correct answer.
Same exercise after price change yields: M1 = 10 and N1 = 10. 2 points

b) Draw a graph where you clearly indicate the original optimal consumption
point and the final consumption point. On the graph, indicate the income and
substitution effects following the price increase. Set meals on the horizontal axis
and notebooks on the vertical axis. Note: on the graph, you can approximate the
indifference curve(s). You are not asked to precisely calculate the substitution
and income effects..

10 points total: 3 points for correct substitution effect, 3 points for correct in-
come effect, 2 points if A and D are aligned, 2 points for all rest is correct in
the graph.

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3 Search (13 points)
Pedro is interested in buying a second-hand bike. To simplify his search, he
uses an app, where he entered the criteria he is interested in for the second-
hand bike. The app suggests several bikes that fit his criteria. Before buying a
bike, he would like to see and test it. The opportunity cost of each bike that
he tests is equal to 3 euros. Assume that Pedro is risk neutral. Further assume
that each time he decides to test a bike, he draws a random bike from a uniform
distribution among the ones he pre-selected. The consumer surpluses of the
bikes he looks at are uniformly distributed between 100 euros and 250 euros.
a) When will Pedro stop searching? When answering this question, assume
that Pedro can decide to buy any of the bikes that he has already tested (no
bike is sold to somebody else in the meantime). Use the following notation: B ∗
is the consumer surplus of the last bike that he tests. 10 points
Answer:
When Pedro tests a new bike, the probability that it has a higher surplus
than B ∗ equals:
250 − B ∗ 250 − B ∗
P (B > B ∗ ) = = .
250 − 100 150
2 points
If he tests a bike with a higher surplus, the expected surplus of the new bike
equals:
250 + B ∗
E [B|B > B ∗ ] = .
2
2 points
To find the benefit of drawing a better bike, one must subtract the value of
the best model already found:
250 + B ∗ 250 − B ∗
E [B|B > B ∗ ] − B ∗ = − B∗ = .
2 2
2 points
The expected benefit of testing a new bike thus equals:
2
(250 − B ∗ )
P (B > B ∗ ) ∗ (E [B|B > B ∗ ] − B ∗ ) = .
300

The expected benefit of testing a new bike is higher than the cost if:
(250−B ∗ )2 2
300 > 3 ⇔ (250 − B ∗ ) > 900 ⇔ 250 − B ∗ > 30 ⇔ B ∗ < 220.
2 points

Pedro will stop searching and testing bikes when he finds a bike with surplus
B ∗ ≥ 220. 2 points

b) In second-hand markets like the one described above, a typical economic

problem might arise–which Pedro is trying to overcome. Give the name of this

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problem, and very briefly (one or two sentences) name and describe its cause.
3 points
He is trying to solve the problem of adverse selection, i.e. a situation of
asymmetric information, where the seller knows the quality of the bike better
than the buyer. 2 points for adverse selection. 1 point for explaining asymmetric
information

4 Competition (34 points)

Several firms are racing to discover a vaccine for a new virus that emerged. One
pharmaceutical company, Health First, discovers the formula to a vaccine that
works. Initially, Health First is the only company that sells this vaccine. Indeed,
it benefits from a patent, which enables it to behave as a monopolist.

The market demand for this vaccine is: P (Q) = 10, 000 − 2Q, where P (Q)
is the price of the new drug and Q is the quantity.

Health First’s total cost function is given by:

T C(Q) = 3Q2 + 500.
a) Determine the optimal (Q, P ) choice of Health First. (6 points)

The economic profit is equal to:

π = P (Q) × Q − T C(Q) (1)

2
= (10, 000 − 2Q)Q − (3Q + 500) (2)
= 10, 000Q − 5Q2 − 500 (3)

(2 points for setting up the profit function) To find the profit maximizing quan-
tity, calculate the first order conditions:

∂π
∂Q = 0 ⇔ 10000 − 10Q = 0 ⇔ Q∗ = 1, 000.
(2 points for quantity) The profit optimizing price is therefore equal to:

P ∗ = 10, 000 − 2 × 1, 000 = 8, 000. (4)

(2 points for price)

b) Explain very briefly why the quantity sold when the vaccine is free (when
P = 0), is more than double of the optimal quantity supplied by the monopolist
in subquestion (a).
Note: One or two sentences suffice. There is no need to do additional calcula-
tions for your answer. (5 points)

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 The monopolist thus chooses a quantity on the elastic half of the demand
curve, where the quantity is smaller than the intercept Q(0). Alternative ex-
planation: The monopolist chooses a quantity on the elastic half of the demand
curve, which is the upper half of the (inverse) demand curve. Any formulation
of this concept is valid.

Because the virus affects a large share of the population, the government
would like for a larger share of the population to get vaccinated. It is studying
several options, which are described below.

First, the government is considering allowing another firm, WeCare, to enter

the market and also produce the vaccine. Assume that WeCare has the same
cost function as Health First. Further assume that the two firms form a Cournot
duopoly.

c) Calculate the reaction functions of the firms. Please use the following
notations: QH the quantity produced by Health First, and QW the quantity
produced by WeCare. (8 points)

The market demand is now:

P (Q) = 10, 000 − 2(QH + QW ). (5)
2 points
We can calculate the profit function of Health First:
πH = P (Q) × QH − T C(QH ) (6)
= (10, 000 − 2(QH + QW )) × QH − (3Q2H + 500) (7)
= 10, 000 × QH − 2 × QH QW − 500 − 5 × Q2H (8)
2 points
Differentiating profit:
∂πp
= 0 ⇔ 10, 000 − 2 × QW − 10 × QH = 0 (9)
∂QH
1
⇔ QH = 1, 000 − × QW . (10)
5

2 points
1
Symmetrically, the reaction function of WeCare is: QW = 1, 000 − 5 × QH .
2 points

d) Calculate the quantities for both firms in the Nash equilibrium. Note:
you can present results using fractions (5 points)
First, substitute the reaction function of WeCare in the reaction function of
Health First:

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 1 1
QH = 1, 000 − 5 × (1, 000 − 5 × QH ).(3 points)
Solving yields:
2,500
Q∗W = Q∗H = 3 . (2 points)

The government would like for a larger share of the population to be vacci-
nated, to reach herd immunity. It considers the following option: it makes all
the information about the production method available for free. All firms who
wish to produce the vaccine, are allowed do so without paying royalties. There
is perfect competition with free entry.

e) Assume that all firms i in the market have the following long run cost
function:
LT C(Qi ) = Q3i − 4Q2i + 9, 000Qi .
The market demand for the vaccine is still given by: P (Q) = 10, 000 − 2Q.
What is the total quantity of vaccines that will be produced in this market? (7
points)

First, calculate the quantity produced by each firm, at the market price. Un-
der perfect competition, price is equal to the minimum of the long run average
cost.

LAC(Qi ) = Q2i − 4Qi + 9, 000.

2 points
Find the minimum for LAC:
dLAC(Qi )
dQi = 0 ⇔ Qi = 2.

Each firm produces 2 units.

2 points
LAC(2) = 4 − 8 + 9, 000 = 8, 996 = P .

The equation for market demand can be rewritten as: 2Q = 10, 000 −
P (Q) ⇔ Q = 5, 000 − P (Q)
2 . 2 points
The market demand for this vaccine at this price: Q∗ = 5, 000 − 8,996
2 = 502.
1 point
f) How many firms will enter the market? (3 points)
The number of firms thus equals: Q∗ /Qi = 251.

5 Externalities (15 points)

a) Explain the theorem of Coase. Do not forget to mention when it is valid. (5
points)

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 When all agents who cause an externality, and all agents who are affected
by the externality, can negotiate and make binding agreements with each other
at negligible cost, then the outcome is efficient, regardless of how property rights
are distributed.
1.5 points for negligible cost of negotiation, 2 points for efficient outcome,
1.5 points for "regardless of property rights"
b) Suppose there are two polluting firms. For Firm A, the cost of reducing
its pollution by QA equals CA (QA ) = Q2A /2 + 500QA . For Firm B, the cost of
reducing its pollution by QB equals CB (QB ) = Q2B . The government wants to
reduce the total pollution by Q = 400 at minimal total cost, by imposing a tax
T on pollution. How high should this tax be? What is the total cost of reducing
pollution? (10 points)
Firm A has marginal cost of reducing pollution: M CA (QA ) = QA + 500,
and marginal benefit of reducing pollution M BA (QA ) = T. It will thus reduce
its pollution by QA = T − 500. (2.5 points)
Similarly, firm B has a marginal cost of reducing pollution: M CB (QB ) =
2QB , and a marginal benefit M BB (QB ) = T . It will thus reduce its pollution
by QB = T /2. (2.5 points)
The total reduction in pollution should equal 400: T − 500 + T2 = 400.
Solving the latter equation yields T = 600. (3 points)
Firm A then reduces by QA = 600 − 500 = 100, with a total cost reduction
of CA = 1002 /2 + 500 · 100 = 55, 000. Firm B reduces by QB = 600/2 = 300,
with a reduction cost of CB = 90, 000. The total reduction cost thus equals
145,000. (2 points)

6 General equilibrium (10 points)

Alan (A) and Bernard (B) are stranded on an island. On the island, there are a
fixed number of coconuts (C) and a fixed number of fish (F). Alan starts out with
0
initial endowment (CA , FA0 ) = (40, 60), and Bernard starts out with initial en-
0 0
dowment (CB , FB ) = (80, 40). Alan’s preferences for coconuts and fish are rep-
1/2 1/2
resented by the following utility function: UA (CA , FA ) = CA FA . Bernard’s
preferences are represented by the following utility function: UB (CB , FB ) =
1/4 3/4
CB FB . Denote the equilibrium price of coconuts as PC , and the equilibrium
price of fish as PF . Calculate the equilibrium allocation of fish and coconuts.
Answer:
There are many ways to derive the equilibrium. Points are given for the
essential elements, indicated below. Note that one of the budget/resource equa-
tions needs to be dropped due to Walras’ law. Different students might choose
to drop a different equation. They do not need to explicitly mention this.
Calculate the marginal rates of substitution for both individuals:
1 −1/2 1/2
2 CA FA FA
M RSA = 1 1/2 −1/2
= CA ,
2 CA FA
1 −3/4 3/4
4 CB FB FB
M RSB = 3 1/4 −1/4
= 3CB .
4 CB FB

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 In equilibrium, the MRS between fish and coconuts equals the relative price
for each individual. We thus have:
PC FA PC FB
= (1) and = (2).
PF CA PF 3CB
(2 points for equating the MRS to relative prices)
Both individuals must satisfy their budget constraints. We thus have:
PC (CA − 40) = −PF (FA − 60),
PC (CB − 80) = −PF (FB − 40).
Substitute (1)–(2):
PF
CA = 20 + 30 P C
,
PF
CB = 20 + 10 PC .
(2 points for correctly using individual budget constraints)
Resources constraint for coconuts: CA + CB = 120. Summing the last two
equations:
PF
= 2 (3),
PC
(2 points for correctly using economy’s resource constraints) and thus:
CA = 80 (1 point)
CB = 40. (1 point)
We can now derive from (1),(2),(3):
FA = 40 (1 point)
and
FB = 60 (1 point)