0830397 Calculators may be used in this examination but must

not be used to store text. Calculators with the ability

to store text should have their memories deleted prior
to the start of the examination.

Department of Economics, Business School

Economics Department Programmes, Year 2

LI Microeconomics 0830397

Mock Examination 2022

Time Allowed: 2 Hours

Please answer ONE question from Section A and TWO questions from Section B.
Both sections are worth 50 marks.
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Section A

Answer ONE question. Marks for each question are in brackets.

QUESTION 1

a) Explain the concept of the income expansion path (IEP) and describe how an
expression for IEP can be obtained. (10 marks)
IEP shows the collection of all optimal bundles of goods demanded by consumer for
different levels of income. Graphically IEP can be seen as a line through all tangency
points between indifference curves and shifted budget constraint. Algebraically, IEP
is the expression of one good in terms of another (including prices and income). To
find this expression we can first write the tangency condition (or Lagrangian) and
then find the optimal combination of goods one in terms of the other.

b) A representative rational consumer consumes just two goods, s and h.

Preferences of this consumer can be described by the following utility function:
U(s,h)=s2h2
where s is the amount of good S consumed and h is the amount of good H
consumed. The income of this consumer is 40. The price of good S is 2 and the
price of good H is 4.
Find the demand function for each of the two goods, S and H. Provide
explanations for each calculation step and describe the theory used in your
calculations.
(10 marks)
This is a Cobb-Douglas production function, so we will have an interior tangency
solution and therefore we can use the tangency condition (please note that we
could have used the Lagrangian method). The tangency condition wants the
marginal rate of substitution to be equal to opportunity cost or we have:
𝑀𝑈(𝑠) 𝑝𝑠
𝑀𝑈(ℎ)
= 𝑝ℎ
We can calculate the marginal utilities from the utility function and substitute
them into this condition and we will have:
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2𝑠ℎ
2
ℎ 𝑝𝑠
2 = 𝑠
= 𝑝ℎ
2ℎ𝑠
Substituting the values for prices of these goods we have:
ℎ 𝑝𝑠
𝑠
= 𝑝ℎ
In other words we have hph=sps. We can substitute this relationship into the
budget constraint (sps+hph=m, where m is the income m=40) and we have
2sps=m or 2hph=m.
From these expressions we can find the expressions for the demand of good s
and good h: s=m/2ps and h=m/2ph.

c) The price of good H is 4 and the income is 40. Using the demand function for
good H found in (b), compute income and substitution effects for Slutsky
decomposition if the price of good H decreases to 2. Provide explanations for
each step.
(10 marks)

We will follow several steps to answer this question: first we will find the new
demand of the good h and we will be able to determine the overall effect, then
we will calculate the imaginary income, holding the purchasing power constant
(as we are asked to do the Slutsky decomposition) and this imaginary or
hypothetical income will allow us to calculate the imaginary bundle separating
the substitution effect from the income effect.
1. The new demand of the good h is h’=40/2*2=10. The overall effect is
Δh=h’-h=10-5=5. The consumption of good h has increased by 5 units following
the price decrease of 2 (from 4 to 2, Δp=-2).
2. The imaginary income that would hold the purchasing power constant is:
m’=m+Δm=m+Δph=40-2*5=40-10=30.
3. The imaginary bundle is therefore hSSE= m’/2p’h=30/2*2=7.5. The substitution
effect is the difference between the imaginary bundle and the original bundle
(SSE=7.5-5=2.5) and the income effect is the difference between the new bundle
and the imaginary bundle (SIE=10-7.5=2.5). The income effect can also be
calculated as total effect minus substitution effect (5-2.5=2.5).
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(Please note that in the exam I would expect more extensive comments,
including a schematic illustration, definition of Slutsky decomposition, etc.)

d) Suppose a rational consumer has preferences described by the following utility

function: 𝑉(𝑑, 𝑓) = 𝑑 + 3𝑓, where 𝑓 is the amount of good 𝐹 consumed and 𝑑 is
the amount of good 𝐷 consumed. The price of good 𝐷 is 3 and the price of good
𝐹 is 9. The disposable income of the consumer is 30. Find the optimal
consumption bundle. (10
marks)

This utility function describes perfect substitutes. Thus, we will not be able to
answer this question with tangency condition or Lagrangean. 𝑀𝑈(𝑑) = 1 and
𝑀𝑈(𝑓) = 3. The price ratio is 3/9 = 1/3. We observe that none of these two
goods is relatively cheaper and thus any bundle belonging to the budget
constraint 3𝑑 + 9𝑓 = 30 or 𝑑 + 3𝑓 = 10 will satisfy the optimality condition. It
could be bundle (10,0) or (1,3) for example.

e) Explain the concept of an inferior good using the income and substitution effects
decomposition. (10 marks)

The key point here is to recall that for any inferior goods, the income and
substitution effects point in opposite directions. In case of an inferior good, the
substitution effect is larger in volume that the income good and thus the demand
behaves “as expected” following price change. We can note that in the case of
extreme income inferior good, also known as Giffen good, the income effect
doesn’t only point in the opposite direction but is also larger in terms of volume.
Unless a very detailed description is given, a schematic illustration should be
provided. Please also remember to give definitions for all the concepts used in
the answer.
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QUESTION 2
Assume there are two manufacturers, A and B and they sell a similar product. B
faces constant marginal cost of 3 per product and B has a marginal cost of 4 per
product. A and B have zero fixed costs. The inverse demand function for this product
is P(q)= 120-0.2q where q is the total number of products sold per day. Assume A
and B operate as a Stackelberg Oligopoly in which A is the leader and B is the
follower.
a) What does Stackelberg Oligopoly mean? (10 Marks)
Stackelberg is a sequential quantity setting system. It occurs in markets
where there is a dominant firm and a follower. The leader sets the quantity
and then the follower chooses their quantity. There is perfect information
between the firms. You can give some examples of Stackelberg oligopoly.
b) What is A’s output and price? (10 Marks)
Please refer to the consolidation answer 4.4
c) What is B’s output and price? (10 Marks)
Please refer to the consolidation answer 4.4
d) Work out the profits for both A and B (15 Marks)
Please refer to the consolidation answer 4.4
e) What does this tell you about the profits of both firms? (5 Marks)
The leader has much higher profits then the follower. They also have a much
larger market share. Therefore, it pays to be a leader.
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Section B
Answer TWO questions only. This part is worth 50 marks (25 marks
per question)

1. “Monopolies are always bad, for consumers and for society in general.”
Comment on this statement
(25 Marks)

A definition of monopolies is needed with an example. You can mention the

characteristics of a Monopoly and how that is different to other market structures
like perfect competition and oligopoly. Think of around 3 reasons why
Monopolies are bad for consumers and societies. Think about negative
externalities and lack of competition. For each point mentioned try to think of a
case study/evidence/example to back up your argument/claim. Then you will
need to present the counter argument side and that is Monopolies are not
always bad. Same as before you can come up with around 3 points (positive
externalities and job opportunities). Make sure your examples are relevant and
real.

2. Choose one of the types of non-well-behaved preferences (violating one or

more of the following assumptions: the strict convexity, monotonicity, and
continuity) and explain how utility is maximized in the case you have chosen.
Describe this process using a generic, but realistic real-life example from your
own experience. You must provide diagrammatic illustrations and algebraic
expressions, where possible (you can provide a simplified numerical example).
(25 Marks)

Appropriate examples include: satiated preferences, perfect substitutes or perfect

complements, etc. Depending which type of preferences you choose, you should
provide an adequate example and discussion. This doesn’t need to be very
precise, but should go beyond textbook examples of left & right shoes or black &
blue pens – you need to show that this was a “problem” you were facing. Providing
a schematic illustration is essential; you can solve the problem of the utility
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maximization for your simplified example giving it some numerical values, which do
not need to be precise, but should be realistic (for example, it’s reasonable to
assume that a coffee costs £3 even if it’s rounded up). Excellent answers will
include a discussion of limitations of chosen example and/or whether your choice
(made in real life) corresponds to the prediction of the model.

3. Describe three different types of private-value auctions and explain how/why

these mechanisms can be adopted in real life. Explain whether the outcome is
efficient and discuss the principles of auction design. You can give examples
from your own personal experience or from wider knowledge. (25
Marks)

A definition of private value auctions need to be provided. Appropriate examples

include: English auction (with or without reserve price), Dutch auction, first-price or
second-price sealed bid auction, etc. Choosing three examples you need to
describe rules for each and then discuss whether the outcome is efficient (for
example it will be for an English auction without reserve price, but not for an
English auction with reserve price). It’s good to give examples for each of the type
to illustrate that you understand the applications and then to conclude by
discussing the principles of auction design in general.
 Calculators may be
0830397 used in this
examination but must
not be used to store
text. Calculators with
the ability to store text
should have their
memories deleted prior
to the start of the
examination.

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