ECON 103 Principles of Microeconomics

Final Exam Fall 2021

Solutions

May 18, 2022

This exam is text only submission on Safe Assign / Blackboard on campus

during the designated exam time. Only pdf and Word documents are allowed.
If you write the answer on papers, please take pictures and convert to pdf or a
Word file and upload. Exam duration is 2 hours. This exam is open book. The
course textbook (Mankiw Principles of Economics, any edition) and the course
slides are allowed in soft or hard copy. You might bring and take notes. Any
calculators e.g. on the laptop are permitted, but not necessary. Internet sources
are not allowed.
Answer all subquestions.
1. Consider a market of two farmers which are also consumers. The following
table contains the maximum production levels over a time period of 8
hours for both wheat and wine. As usual, we assume linear production
possibility frontiers.
Farmer Wheat Wine
Noah 10kg 5l
Emma 15kg 3l
(a) Identify absolute advantages for each good.
Emma has an absolute advantage in wheat, Noah has an absolute ad-
vantage in wine. No one has an absolute advantage in both products.
(b) Identify comparative advantage.
Noahs opportunity cost of wheat over wine is 2:1, Emmas opportunity
cost of wheat over wine is 5:1. Emma has a comparative advantage
of wheat over wine. Noah has a comparative advantage of wine over
wheat.
(c) How does the comparative advantage change when calculated over 1
hour of production time?
Not at all. The absolute production time cancels out.
(d) How should Noah and Emma specialise? Who will trade what?
Emma should specialise in wheat and trade wheat for wine. Noah
should specialise in wine and trade wine for wheat.

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 (e) Given their production and consumption before trade,
Production/Consumption Wheat Wine
Noah 5kg 2.5l
Emma 7.5kg 1.5l
Assume production changes to the following .
Production Wheat Wine
Noah 3kg 3.5l
Emma 12.5kg 0.5l
Find an example of trade which makes everybody better off and
calculate the gains of trade for both Noah and Emma. (Difficult)
Emma could sell 3kg of wheat in exchange for 1l of wine. This leads
to the following consumption after trade
Consumption Wheat Wine
Noah 6kg 2.5l
Emma 9.5kg 1.5l
The gains of trade are
Gain Wheat Wine
Noah 1kg 0l
Emma 2kg 0l
Both persons gain in trade in wheat.
2. Consider the following experimental market:
Seller WTA Buyer WTP
Aya $1.10 Adil $1.70
Basma $1.30 Barack $1.50
Dalia $1.60 Dawoud $1.50

(a) State the equilibrium quantity and price.

There is only one equilibrium. The equilibrium quantity is Q=2, and
the price is P=$1.50.
(b) Calculate the maximum surplus.
The maximum surplus is $0.90= $1.70-$1.10 + $1.50-$1.30. Here
we have assumed that Aya and Adil as well as Basma and Barack
trade, but this is just one example. For example instead of Barack,
also Dawood could trade with Basma, leading to the same result. Also
Aya could trade with Barack and Adil with Basma. The individual
surplus changes, but not the total.
(c) Identify extramarginal buyers and sellers.
An extramarginal buyer has a WTP below the equilibrium price. There
is none. An extramarginal seller has a WTA above the equilibrium
price. Dalia is the only extramarginal seller.
(d) Find a buyer and a seller which can make an extramarginal trade.
As Dalia is the only extramarginal seller, and there is no extra-
marginal buyer, the only potential extramarginal trade could be be-

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 tween Dalia and Adil, as no other buyer accepts a price at $1.60 or
above.
(e) Given the extramarginal trade from (d), how many quantities can
be traded maximally? Compare with the equilibrium quantity. Will
this market be efficient?
Dalia and Adil conduct an extramarginal trade. This leaves Barack
and Dawood as the only buyers still to trade. They can trade with
Aya and Basma. This yields altogether 3 trades, or Q=3, one quan-
tity more than the equilibrium. The market will be inefficient as the
extramarginal buyer induces a loss in surplus. (The total surplus is
$0.10+$0.20+$0.40 = $0.70, which gives an efficiency of $0.70/$0.90
= 78%.)
3. Monopoly
(a) How does the demand curve a monopoly is facing look in the long
run compared to a perfectly competitive firm?
The monopolist faces the whole market demand curve, which is down-
ward sloping both in the long and short run. In the long run, the
demand curve in a perfectly competitive firm is horizontal.
(b) A monopolist increases production. Explain the two effects he is fac-
ing regarding his or her revenue.
The quantity effect means that the quatity increases, which could in-
crease revenue. However, at the same time the price is decreasing due
to the downward sloping demand curve. Both effects go in opposite
directions.
(c) Why does marginal cost pricing often fail as a price regulation for
monopolies?
When marginal costs lies between Average Total Cost, the firm will
make losses and exit the market. This is a greater loss in welfare
than by the deadweight loss of the monopolist.
(d) Why is the monopoly inefficient?
The monopolist is a price maker. He will reduce the quantity to be
able to charge a higher price, as long as the price increases faster
than the quantity. Therefore some customers with WTP below the
monopoly price will not be served. This creates a deadweight loss.
(e) Explain the failure of privatisation of a Natural Monopoly in the ex-
ample of the British Railtrack.
For-profit privatisation of a natural monopoly generates moral haz-
ard, as there is an incentive not to comply with security standards.
The lack of competition leads to low quality standards.
4. Monopolistic Competition. Assume a market with differentiated products.
(a) How does monopolistic competition eliminate economic profit in the
long run? Through free exit and entry the firm’s demand curve shifts

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 as customers change the brands until any economic proit or loss is
driven down to zero.
(b) What can be said of the technical efficiency or scale of production?
Even in the long run, there is always an excess capacity. The firm
operates at increasing return to scale and high average total cost.
Because of monopolistic competition, each firm faces its own demand
curve, hence it can’t increase production.
(c) Why does monopolistic competition come with a loss of welfare (dead-
weight loss) compared to the perfectly competitive market?
For each firm, production level is below the efficient scale. Do to the
firms acting at price makers, some consumers are excluded from the
market. Their surplus (and the surplus of potential high-cost firms)
constitute a deadweight loss.
(d) Advertisement is costly. Why do firms nevertheless engage in adver-
tising?
Advertisement works as a signal which differentiates the label from
other labels and helps to match it to self-perception of consumers.
The money spent into advertisement is a credible signal for the mar-
ket power of the firm, which can attract customers.
(e) What are possible disadvantages of advertisement to consumers?
Advertisement maybe misleading. It may suggest differnces in almost
homogenous goods, which are practically non-existent. The cost of
advertisemnt is paid by the consumer.
5. Oil producing Oligopoly.
(a) Consider a market of two oil producers. Both firms can either choose
a low or high level of production. What will the firms do when acting
individually? Describe the Cournot-Nash equilibrium.
(Mankiw Chapter 16) Both firms, acting for themselves, will choose
a high level of production independently of what the other firm does.
This is their dominant strategies. When both firms chooses high out-
come, they reach an outcome which is worse for both firms compared
to the cartel. Both firms act as price makers, but have an incentive to
increase production until the Cournot-Nash Equilibrium is reached.
(b) In terms of overall welfare, compare the oligopoly with the competi-
tive equilibrium and the monopoly cartel.
(Mankiw Chapter 16) The Competitive Equilibrium is the most effi-
cient for total welfare, since there is no deadweight loss. The Cournot-
Nash Equilibrium is second best in total welfare and from the con-
sumer perspective. The price making behaviour and reduction of
quantity creates a deadweight loss on the cost of the consumers. The
monopoly cartel has the greates welfare (deadweight) loss due to ab-
sence of competition and strategic interaction.

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(c) Why is an oil cartel so difficult to uphold?
(Mankiw Chapter 16) As long as there is no punishment mechanism,
each firm will be better off unilaterally moving away from the car-
tel. The oil cartel is between souvereign states and can’t be easily
enforced. The members of an oligopoly would be better off forming
a cartell sharing the monopoly profit, which is hard to sustain with
selfish preferences. A monopolist can reduce production further and
increase the price more, exacerbating the deadweight loss, increasing
the loss of consumer surplus.
(d) Was the OPEC cartel stable? State the empirical evidences by (Gülen
1996).
S. Gürcan Gülen (1996), Is OPEC a Cartel? Evidence from Coin-
tegration and Causality Tests, The Energy Journal Vol. 17, No. 2,
43-57; cited in the slides: From 1982 to 1993, seven members of
the OPEC were able to co-ordinate their production and increase the
oil price. Outside that period, no evidence of price control has been
found. There is no long-run relation between the production of the
individual states and the total production of the OPEC.
(e) What was the influence of the non-OPEC oil producing states on the
total market according to Gülen?
(Gülen 1996, in the slides) Not all oil producing countries were OPEC
members. When OPEC reduced production, the non-OPEC oil pro-
ducing countries increase their production, which partially offset the
cartel monopoly. Hence the OPEC is not a pure oligopoly.