EC2066 Exam Commentary - May 2023

Examiners’ commentaries 2023 (May)

EC2066 Microeconomics
Important note
This commentary reflects the examination and assessment arrangements for this course in the
academic year 2022–23. The format and structure of the examination may change in future years,
and any such changes will be publicised on the virtual learning environment (VLE).
Information about the subject guide and the Essential reading

references
Unless otherwise stated, all cross-references will be to the latest version of the subject guide (2016).
You should always attempt to use the most recent edition of any Essential reading textbook, even if
the commentary and/or online reading list and/or subject guide refer to an earlier edition. If
different editions of Essential reading are listed, please check the VLE for reading supplements – if
none are available, please use the contents list and index of the new edition to find the relevant
section.
General remarks
Learning outcomes
At the end of this course, and having read this guide, completed the Essential reading and activities,
you should:
be able to define and describe:
• the determinants of consumer choice, including inter-temporal choice and choice under
uncertainty
• the behaviour of firms under different market structures
• how firms and households determine factor prices
• behaviour of agents in static as well as dynamic strategic situations
• the nature of economic interaction under asymmetric information
be able to analyse and assess:
• efficiency and welfare optimality of perfectly and imperfectly competitive markets

• the effects of externalities and public goods on efficiency
• the effects of strategic behaviour and asymmetric information on efficiency
• the nature of policies and contracts aimed at improving welfare
be prepared for further courses which require a knowledge of microeconomics.
1
Time management
Section A comprises five questions, all of which must be answered (accounting for 40% of the total
marks). Section B comprises four questions of which three must be answered (accounting for 60%
of the total marks). Candidates are strongly advised to divide their time accordingly. On average,
only fourteen minutes should be allocated to any individual Section A question. On average, only 36
minutes should be allocated to any individual Section B question.
Key steps to improvement
You need to be able to apply relevant microeconomic theory to questions that you may not have
encountered before. To prepare for this, you need not only to gain a thorough understanding of
microeconomic models but also (and importantly) to practise using relevant models to answer
specific questions. Practice is the key, not the learning of specific answers.
You should spend time planning your answers and make sure that you respond to all parts of a
question and to key words like ‘define’, ‘explain’ and ‘compare’. Precise and concise answers are to
be preferred to vague and long-winded answers.
You should be aware that, for most answers, diagrams and/or mathematical analysis are essential.
These should be correct and diagrams should be well-labelled. In addition, you should always
accompany them with appropriate explanations. Again, ‘practice makes perfect’.
Essential reading: Important information
The subject guide refers to Nicholson & Snyder as the principal text. There are also some references
to Perloff. In addition to this, you should practise questions from other texts. A few ‘auxiliary’ texts
that are good sources for practice questions are listed below. Further, the auxiliary texts often
develop applications not covered in the principal text. You should study these to broaden, as well as
deepen, your understanding. In some cases, reading several treatments of the same topic might help
to clarify the basic idea. You should use the auxiliary texts for this purpose as well.
The coverage of game theory is often inadequate in texts. For this topic, you should primarily rely
on the exposition in the subject guide. You should make sure that you understand the key ideas
covered in some detail in the subject guide.
Principal text
Nicholson, W. and C. Snyder, Intermediate Microeconomics and its Application (Cengage

Learning 2015) twelfth edition [ISBN 9781133189039].
Auxiliary texts
Perloff, J.M. Microeconomics with Calculus (Pearson Education, 2014) third edition [ISBN
9780273789987].
Besanko, D. and R. Braeutigam, Microeconomics (John Wiley & Sons, 2014) fifth edition,
international student version [ISBN 9781118716380].
Varian, H.R. Intermediate Microeconomics: A Modern Approach (W.W. Norton, 2014)
ninth edition [ISBN 9780393920772].
Pindyck, R.S. and D.L. Rubinfeld, Microeconomics (Prentice–Hall/Pearson, 2012) eighth
edition [ISBN 9780133041705].
2
Examination revision strategy
Many candidates are disappointed to find that their examination performance is poorer than they
expected. This may be due to a number of reasons, but one particular failing is ‘question
spotting’, that is, confining your examination preparation to a few questions and/or topics which
have come up in past papers for the course. This can have serious consequences.
We recognise that candidates might not cover all topics in the syllabus in the same depth, but you
need to be aware that examiners are free to set questions on any aspect of the syllabus. This
means that you need to study enough of the syllabus to enable you to answer the required number of
examination questions.
The syllabus can be found in the Course information sheet available on the VLE. You should read
the syllabus carefully and ensure that you cover sufficient material in preparation for the
examination. Examiners will vary the topics and questions from year to year and may well set
questions that have not appeared in past papers. Examination papers may legitimately include
questions on any topic in the syllabus. So, although past papers can be helpful during your revision,
you cannot assume that topics or specific questions that have come up in past examinations will
occur again.
If you rely on a question-spotting strategy, it is likely you will find yourself in difficulties
when you sit the examination. We strongly advise you not to adopt this strategy.
3

Important note

references
section.
Comments on specific questions – Zone A
Candidates should answer EIGHT of the following NINE questions: all FIVE from Section A (8
marks each) and THREE from Section B (20 marks each). Candidates are strongly advised to
divide their time accordingly.
Section A
Answer all FIVE questions from this section (8 marks each).
Question 1
Consider the following simultaneous move game with two players.
2
A2 B2
1 A1 3, 3 −1, 2
B1 2, −1 1, 1
Find all Nash equilibria of the game above. Relate the equilibria of the game
informally to the phenomenon of runs on banks that are solvent.
Reading for this question
Subject guide, Chapter 4.
4
Approaching the question
Nash equilibria are (A1 , A2 ), (B1 , B2 ) and the mixed strategy equilibrium: 1 plays A1 with
probability 2/3 and B1 with 1/3, 2 plays A2 with 2/3 and B2 with 1/3.
All agents running on a solvent bank is a Nash equilibrium (the bad one, in which the bank fails
because of illiquidity and everyone is worse off) and no one running against a solvent bank is
another (in which the bank survives and all agents are better off).
Question 2
Highways are built using tax revenue. Therefore asking tax payers to pay a toll to
drive on a highway reduces efficiency. Is this true or false? Explain your answer
carefully.
This is false. Highways are public goods – these must be built using tax revenue. This has no
implication on the inefficiency due to congestion, which can be addressed using toll charges that
internalise the externality.
Question 3
A risk neutral principal employs an agent to work on a project that can yield a high
profit or a zero profit. High effort (eH ) by the agent makes high profit more likely
compared to low effort (eL ).The agent’s utility function is u(w) − c(e) where w is
the wage paid to the agent, e is the effort level, and c(e) is the cost of effort, where
c(eH ) > c(eL ) > 0.
Suppose the principal can observe the agent’s effort level, and suppose u0 (w) > 0,
u00 (w) < 0.
In this case, the best policy for the principal is to pay the agent a wage that is
independent of the profit level. Is this true or false? Explain your answer carefully.
This is true. Since the agent is risk-averse and the principal is risk-neutral, an optimal
risk-sharing result is for the principal to take all risk. Since the agent is risk averse, if the
principal puts risk on the agent, the expected wage bill is higher than the optimal fixed wage
that just satisfies the agent’s participation constraint. Since putting risk on the agent is not
necessary for incentive reasons because effort is observable, the first best solution is for the
principal to take all risk and completely insure the agent.
Question 4
If the price elasticity of supply is zero, while the absolute value of demand elasticity
is strictly positive and finite, a per-unit tax of t on consumers will (a) lower the
5
market price by t and (b) create a deadweight loss. Is (a) true or false? Is (b) true
or false? You must explain your answer using a suitable diagram.
Statement (a) is true, (b) is false. Since supply is completely inelastic, while demand is elastic to
an extent, the incidence of tax is entirely on suppliers. Hence (a) is true. Since supply is
completely inelastic, market quantity does not change after tax, hence (b) is false.
Question 5
Externalities would not lead to market failures if all relevant markets were present.
Is this true? If true, what might cause some markets to not be present? Explain
using any result from your course, and provide relevant examples.
The Coase theorem says that if there are no transactions costs of bargaining (we typically
assume frictionless trading for competitive economies when proving the first welfare theorem, so
this amounts to assuming the usual conditions for competitive markets), so long as property
rights are well defined, externalities can be traded away. We can think of such trading as
introducing markets for externalities. If all such relevant markets were present, all externalities
would be internalised through market prices, and there would be no market failures. However,
there might be any reasons why such markets do not exist, and are even impossible to create.
Asymmetric information is an important problem that leads to inefficient bargaining. Also, with
larger number of parties and multilateral externalities, it could be difficult or impossible to
identify who generates how much of the externality, and who should have property rights, and
whom should they bargain with. A good answer would have a couple of real-life examples.
Section B
Answer THREE questions from this section (20 marks each).
Question 6
In a competitive market for corn, the demand function is Q = 30 − P and the

supply function is Q = P − 10, where Q denotes quantity and P denotes price.
(a) To raise the earnings of corn producers, the government announces a support
price PS = 25. This is a minimum price guaranteed by the government. If this
is higher than the market price, the government buys up all excess supply at
the support price. Calculate the producer surplus under the price support
policy. How much do producers gain under the policy?
(7 marks)
(b) Instead of a price support, suppose the government announces a per-unit
subsidy of s to suppliers. Calculate the producer surplus under the subsidy.
6
Using this, calculate the value of s for which the producer surplus is the same as
in part (b).
(6 marks)
(c) Suppose one of the two policies must be chosen. Based on economic
considerations, which of the two policies above would you recommend? Explain
your answer carefully, using any appropriate calculations, diagrams or
arguments. Can you recommend any policy (other than the two policies above)
that would generate the same producer surplus as in part (a), but not create
any deadweight loss?
(7 marks)
(a) Without the price support, the market price is given by 30 − P = P − 10 implying P = 20,
and therefore Q = 10. The producer surplus is (1/2)(20 − 10)10 = 50.
At price 25, the quantity supplied is 15. Any excess supply is purchased by the government,
so the quantity sold is 15.
Producer surplus is now given by (1/2)(25 − 10)15 = 112.5, implying a gain of 62.5.
Figure 1: The producer surplus under the price support is A + B + C.
(b) The supply curve is now P + s = 10 + Q, implying that market quantity is given by
30 − Q = 10 + Q − s, implying Qs = 10 + s/2.
The price is Ps = 20 − s/2.
Producers receive Ps + s = 20 + s/2.
Producer surplus is:
1 1 s 2
PS = (Ps + s − 10)Qs = 10 + .
2 2 2
The PS in part (b) is 112.5. Therefore, for the same PS, we need:
1 s 2
10 + = 112.5
2 2
which implies:
s 2
10 + = 225
2
which implies:
s
10 + = 15
2
which implies s = 10.
7
Figure 2: The producer surplus under a subsidy is D + E + F .
(c) The price support policy has a large DWL. Note that area A in Figure 1 is the original
producer surplus, area B is transfer from consumers to producers, and area C is a net gain
in surplus. The deadweight loss is the cost of the policy minus area C. The cost is
25 × 10 = 250, and area C is 25.
Therefore DWL of price support is given by 250 − 25 = 225.
This is the blue shaded area in Figure 3.
Figure 3: The blue shaded area is the deadweight loss from price support.
The DWL under the subsidy is area G in Figure 2. Given s = 10, this area is
(1/2)(25 − Ps )(15 − 10). Since Ps = 15, this is 25.
Based on efficiency considerations, subsidy policy is better.
With a free choice of policy, the best policy is not to intervene in the market at all,
preserving full efficiency, and simply give a transfer of 62.5 to producers. This is a transfer
from taxpayers to producers, so there is no deadweight loss involved.
Question 7
An agent consumes good X and a composite of all other goods Y . The agent’s
preferences are represented by the utility function
√ √
u(X, Y ) = X Y .
The price of Y is 1, and the price of good X is p. The agent has an income of M > 0.
Suppose M = 144. Suppose initially the price of X is 16, and then the price falls to
9.
8
(a) Calculate the total price effect of the fall in price on the demand for X.
(5 marks)
(b) Calculate the income effect and substitution effect of the fall in price on the
demand for X.
(5 marks)
(c) Calculate the compensating variation of the price change.
(5 marks)
2 2
(d) Now suppose the agent’s utility function is u(X, Y ) = X + Y . Calculate the
income effect and substitution effect of the fall in price on the demand for X in
this case. Explain the intuition for your result. (Hint: If you have the correct
intuition, the result would follow immediately.)
(5 marks)
(a) Equating MRS to p, we have Y /X = p. Using this in the budget constraint pX + Y = M ,

the demand function for X is M/2p and that for Y is M/2. Therefore the total price effect
on X is:
M M 144 144
− = − = 8 − 4.5 = 3.5.
2p1 2p0 18 32
√
(b) Substitution effect: Since Y = pX, u(X, Y ) = pX.
√
Now, at the initial price, X is 144/32 = 4.5. The utility at initial prices is 164.5 = 18. Let
Xc denote the compensated demand for X. If price changes to 9, but utility remains at 18,
we must have 3Xc = 18, implying Xc = 6.
Thus the substitution effect on X is 6 − 4.5 = 1.5. The rest, 8 − 6 = 2, is the income effect.
(c) The utility from optimal consumption is:
s
MM M
u(X, Y ) = = √ .
2p 2 2 p
For price change from p0 to p1 , the compensating variation is CV given by:
M M − CV
√ = √ .
2 p0 2 p1
Here:
144 − CV
18 =
6
which implies CV = 36.
(d) In this case, we have a utility function with increasing MRS, implying corner solutions. This
can also be confirmed from drawing indifference cures, which are the parts of circles in the
positive quadrant. For p > 1, the corner solution would be to spend all income on Y . That
is, demand for X is zero under both prices, and the total price effect as well as the income
effect and substitution effect are all zero.
Question 8
Two firms each produce an output of 10 units. The production process for each firm
generates 72 units of pollution. Firm 1 can reduce pollution to 72β1 units, where
0 ≤ β1 ≤ 1, by incurring a cost of
72(1 − β1 )2
9
while firm 2 can achieve a reduction to 72β2 units, where 0 ≤ β2 ≤ 1, by incurring a

cost of
(1 − β2 )2

72 .
2
Suppose a regulator sets an overall cap at 72 units of pollution and allocates 36
units of pollution rights to each firm.
(a) Suppose each firm must reduce pollution to the number of units of allocated
pollution rights. What is the total cost of reducing pollution to the overall cap?
(6 marks)
(b) Suppose pollution rights could be reallocated across firms so that 1 reduces
pollution to 72β1 and 2 reduces pollution to 72β2 where β1 and β2 are positive
numbers and β1 + β2 = 1. In this case, what would be the lowest cost of
reducing pollution to the overall cap? Do you get a corner solution? Explain
the intuition for your answer.
(8 marks)
(c) Suppose the firms can trade pollution rights between themselves, and the price
of a unit of pollution right is p. For what values of p is it possible to achieve the
lowest cost of reducing pollution as derived in part (b)?
(6 marks)
(a) Here β1 = β2 = 1/2, so the cost is 72/4 = 18 for firm 1, and 72/8 = 9 for firm 2, adding to
27.
(b) In this case, we must minimise the total cost:
1
min (1 − β1 )2 72 + (1 − β2 )2 72
β1 ,β2 2
where β1 + β2 = 1. Using this, and ignoring the constant term 72, the problem is to:
1
min(1 − β1 )2 + (β1 )2 .
β1 2
The first-order condition is −2(1 − β1 ) + β1 = 0, which implies β1 = 2/3 and therefore

β2 = 1/3. (Check that the SOC for minimisation holds.)
We do not get a corner solution here – and the reason for that is the convexity of the cost
function. Given that an interior solution arises, the solution makes intuitive sense – 2 has a
lower cost of reducing pollution, so more of the reduction is done by 2, transferring some
rights to 1.
(c) Without any extra rights, firm 1 must choose β1 = 1/2, implying an abatement cost of
(1/4)72 = 18. By buying q units of permits at price p per unit, the cost is:
2
36 + q
pq + 1 − 72.
72
Here, β1 = 2/3, implying firm 1 has (2/3)72 permits, that is 48 permits. So, firm 1 buys 12
permits. The total cost from buying 12 permits must not exceed the cost without buying
permits:
2
2
12p + 1 − 72 ≤ 18.
3
10
This implies:
12p ≤ 10
or:
10
p≤ .
12
From firm 2’s perspective, not selling any permits implies a cost of 9.
Selling q units implies a net cost of:
2
1 36 − q
1− 72 − pq.
2 72
With q = 12, (36 − q)/72 = 1/3, so the above expression is (4/18)72 − 12p = 16 − 12p. We
need:
16 − 12p ≤ 9
which implies:
7
p≥ .
12
Therefore, we need 7/12 ≤ p ≤ 10/12.
Question 9
Consider the following exchange economy. There are two goods, tea and coffee, and
two consumers, 1 and 2.
Consumer 1 has utility function
1 1
U1 (t1 , c1 ) = ln(t1 ) + ln(c1 )
2 2
where t1 and c1 are the amounts of tea and coffee (respectively) that Consumer 1
consumes. Similarly, Consumer 2 has utility function
3/4 1/4
U2 (t2 , c2 ) = t2 c2
where t2 and c2 denote the amounts of tea and coffee (respectively) that Consumer
2 consumes. Consumer 1 is endowed with 25 units of tea and 15 units of coffee.
Consumer 2 is endowed with 15 units of tea and 55 units of coffee.
Suppose the price of coffee is normalised to 1, and let p denote the price of tea.
(a) Derive the competitive equilibrium price of tea, and the equilibrium allocation
of tea and coffee.
(7 marks)
(b) Derive the contract curve for this economy as a function of c1 and t1 . Using
this, explain whether the equilibrium allocation derived in part (a) is efficient.
If we change the preferences so that the marginal rate of substitution of
consumer 1 changes, would the resulting equilibrium allocation still be efficient?
What general result supports your conclusion?
(7 marks)
(c) If we can redistribute endowments suitably, is it possible to sustain the
allocation with t1 = 1, c1 = 5 as an equilibrium? Explain, using any relevant
result from your course to support your arguments.
(6 marks)
11
(a) The demand functions are given by:

25p + 15 25p + 15
t1 = , c1 =
2p 2
and:
3(15p + 55) 15p + 55
t2 = , c2 = .
4p 4
Clearing the coffee market, c1 + c2 = 70, which implies:
2(25p + 15) + 15p + 55 = 280
which further implies:

65p = 195
and ultimately p = 3.
The allocation is therefore:
t1 = 15, c1 = 45, t2 = 25, c2 = 25.
(b) The contract curve can be derived by equating the MRS of 1 and 2:
c1 3c2
= .
t1 t2
Using c2 = 70 − c1 and t2 = 40 − t1 , we have:
c1 3(70 − c1 )
= .
t1 40 − t1
This implies:
40c1 − t1 c1 = 210t1 − 3t1 c1 .
Rearranging, we get:
105t1
c1 = . (1)
20 + t1
The contract curve is the locus of efficient points in the economy. Putting t1 = 15, the
right-hand side becomes:
105 × 15 1575
= = 45.
20 + 15 35
Therefore, the equilibrium allocation is on the contract curve and is therefore efficient.
In general, the First Welfare Theorem establishes that general equilibrium is efficient.
Therefore, even if the MRS of 1 changes, the resulting equilibrium allocation would be
efficient.
(c) First, see whether this is on the contract curve. Putting t1 = 1 in equation (1),
c1 = 105/21 = 5. Therefore the allocation is on the contract curve. It then follows from the
Second Welfare Theorem that the allocation can be sustained as an equilibrium allocation if
we can redistribute endowments (a specific redistribution would be to make transfers so that
1’s initial allocation is (1, 5)).
12

Important note

references
section.
Comments on specific questions – Zone B
Candidates should answer EIGHT of the following NINE questions: all FIVE from Section A (8
marks each) and THREE from Section B (20 marks each). Candidates are strongly advised to
divide their time accordingly.
Section A
Answer all FIVE questions from this section (8 marks each).
Question 1
In the signalling model of education, separating equilibria in which education acts as

a signal of ability would break down if the costs of acquiring education are equal for
individuals with different abilities. Is this true or false? Explain your answer.
This is true. Education works as a separating signal only if one type finds it costly enough to not
send the signal. Combined with the assumption that higher ability types would have a lower cost
of sending the signal delivers the separating signalling equilibrium. More formally, we need
ch > b > cl where b is the benefit arising from signalling high ability (say, the gain in payoff from
matching with high-end jobs relative to low-end jobs), ch and cl are the costs of acquiring a
certain number of years of education for low-ability and high-ability types, respectively. If
ch = cl , it is not possible to separate types using education as signal.
13
Question 2
The utility function of a consumer over two goods x and y is given by
u(x, y) = 20 ln x + 2y.
The price of y is 1. Let p denote the price of x. The consumer has an income of
M > 10. The consumer’s price elasticity of demand for x has a lower absolute value
compared to the income elasticity of demand for y. Is this true or false? Explain by
calculating both elasticities.
The consumer’s optimal consumption is obtained by equating MRS to price ratio:

20
= p.
2x
Thus x = 10/p. The budget constraint is px + y = M . Using px = 10 in the budget constraint,
y = M − 10. Since px is constant, it is clear that the price elasticity of demand for x is 1. Also,
income elasticity of demand for y is:
M dy M M
= = > 1.
y dM y M − 10
Therefore the statement is true.
Direct calculations for price elasticity of demand for x:
p2 10

p dx p 10
εx = − =− − 2 = = 1.
x dp x p 10 p2
Question 3
A society consists of 3 identical individuals who derive utility from a public good.
The public good can be provided at a constant marginal cost of 2. Let xi denote the
level of public good provision by i, where i = 1, 2, 3. Let X = x1 + x2 + x3 be the
total provision. The net benefit enjoyed by individual i from providing xi units of
the public good is given by
U (xi , X) = 4 ln X − 2xi
where i = 1, 2. Is the total provision X ∗ under individual optimisation higher or

lower than the socially optimal level of provision X 0 ? Explain the intuition for your
result.
The social optimum maximises the sum of utilities:
max 12 ln X − 2X
X
14
which implies 12/X = 2, or X 0 = 6.
Under individual optimisation, 1 maximises:
max 4 ln x1 + x2 + x3 − 2x1
x1
implying 4/(x1 + x2 + x3 ) = 2, or x1 + x2 + x3 = 2. Imposing symmetry, x1 = x2 = x3 = x = 2/3

and total private provision is 3x = 2, which is lower than the socially optimal provision level.
For intuition, any discussion pointing out the fact that since total provision enters the utility
function, each individual free-rides on the provision by others, hence private provision is
inefficiently low.
Question 4
If the price of a factor of production rises, a profit maximising firm might use more
of that factor. Is this true or false? Explain your answer by drawing comparison for
consumer choice for a Giffen good.
Subject guide, Chapters 5 and 6.
The statement is false. The key point to understand is that the Giffen effect for household
demand arises from the presence of a budget constraint. A profit maximising firm, on the other
hand, was free to use more of a factor before the price rise, and since it did not, it certainly will
not use more after the price rise.
Question 5
Consider an economy with two goods, A and B. Suppose the price of good A is p
and let the price of good B be 1. There is a large number of identical consumers.
The indifference curves of consumers have the usual shape with diminishing
marginal rate of substitution between the two goods. Suppose the government must
raise a tax revenue of R, and can do this either by imposing a per-unit tax of t on
good A, or by imposing a lump-sum tax T on each consumer. Which policy would
the consumers prefer? Explain your reasoning carefully, using any appropriate
diagram, and explain the intuition behind your result.
Per-unit tax t moves the budget line from HG to HE. CD is the per-head tax revenue. The
crucial point to understand is that an equivalent lump-sum tax moves the budget line down to
JF. In other words, the budget line moves down to pass through the point D which is optimally
chosen by the consumer on the budget line HE. Once you realise this, the result is immediate.
Clearly, the lump-sum tax is better, as it is possible to move to a higher indifference curve. The
intuition for this is that a lump-sum tax does not distort the relative price of good A.
15
Section B
Answer THREE questions from this section (20 marks each).
Question 6
(a) For the following extensive-form game:

i. Identify the pure and mixed strategy Nash Equilibria.
(8 marks)
ii. Is the set of pure and mixed strategy Subgame Perfect Nash equilibria of the
game different from the set of equilibria identified in part (a)? Explain (a
couple of sentences should suffice).
(6 marks)
(b) Consider the simultaneous-move game below with two players, 1 and 2. Each
player has two pure strategies. If a player plays both strategies with strictly
positive probability, we call it a strictly mixed strategy for that player. Show
that there is no Nash equilibrium in which both 1 and 2 play a strictly mixed
strategy.
16
Player 2
b1 b2
Player 1 a1 3, 0 0, 1
a2 2, 1 2, 1
(6 marks)
(a) i. The normal form is:

Player 2
C D
Player 1 A 3, 1 −2, −2
B 2, 5 0, 7
Pure strategy Nash equilibria: (A, C), (B, D).

Mixed strategy Nash equilibrium: Suppose 1 plays A with probability p, and 2 plays C
with probability q. Then indifference of player 1 implies:
3q − 2(1 − q) = 2q
which implies q = 2/3. Indifference of 2 implies:
p + 5(1 − p) = −2p + 7(1 − p)
which implies p = 2/5.

Therefore the mixed strategy Nash equilibrium is: 1 plays A with probability 2/5, B
with probability 3/5, and 2 plays C with probability 2/3 and D with probability 1/3.
ii. There is no strict subgame. The only trivial subgame is the whole game. Therefore any
Nash equilibrium of the whole game is also a subgame perfect Nash equilibrium. All
three Nash equilibria here are therefore subgame perfect Nash equilibria.
(b) Suppose 1 plays a mixed strategy, a1 with probability p and a2 with (1 − p). Consider 2’s
best response. If p > 0, b2 strictly dominates b1 (1 > 1 − p). Therefore if 1 plays a strictly
mixed strategy, 2’s best response is to play a pure strategy (b2 ). Therefore there is no Nash
equilibrium in which both players play a strictly mixed strategy. If a candidate notes that b1
is a weakly dominated strategy and so if 1 has a strictly mixed strategy, 2 would clearly
strictly prefer to play b2 , that would also be a good answer.
Question 7
A risk-neutral principal hires an agent to work on a project at wage w. The agent’s

utility function is √
U (w, ei ) = w − g(ei )
where g(ei ) is the disutility associated with the effort level ei exerted on the project.
The agent can choose one of two possible effort levels, e1 or e2 , with associated
disutility levels g(e1 ) = 4, and g(e2 ) = 2.5. If the agent chooses effort level e1 , the
project yields 100 with probability 1/2, and 0 with probability 1/2. If he chooses e2 ,
the project yields 100 with probability 1/4 and 0 with probability 3/4.
The reservation utility of the agent is 0.
17
(a) If effort is observable, which effort level should the principal implement? Derive
the bestwage contract that implements this effort. Does this involve sharing risk
with the agent? Explain your answer.
(6 marks)
(b) If effort is not observable, which effort level should the principal implement?
What is the best wage contract that implements this effort?
(7 marks)
(c) Suppose an insurance company observes the wage contract offered to the agent
in part (b), and knows the probabilities associated with each wage level, and
assumes these to be fixed. Suppose the insurance company offers the agent full
insurance at a premium of 24 (the premium is paid by the agent to the
insurance company whether the wage is high or low, and the insurance company
covers the loss in income if the wage is low). Would the agent accept this,
andwould the insurance companymake a profit from this?
(7 marks)
(a) Under observable effort, there is no reason for the principal to put risk on the agent.
Putting risk on the agent implies paying a higher expected wage to compensate the agent
for the risk, therefore the principal should not share risk with the agent, and give the agent
a fixed wage contract (fixed across the different levels of profit of the firm).
√
Using a fixed wage, pay w∗ to implement e1 where w∗ = 4, i.e. w∗ = 16.
√
Pay w∗∗ to implement e2 where w∗∗ = 2.5, i.e. w∗∗ = 6.25.
The principal’s profit from e1 is:
1 1
π(e1 ) = 100 + 0 − 16 = 34.
2 2
The profit from e2 is:
1 3
π(e2 ) = 100 + 0 − 6.25 = 18.75.
4 4
Therefore under observable effort, the principal should implement e1 and pay a fixed wage of
16.
(b) If effort is not observable, to implement e1 , the wage schedule {wH , wL } such that
wH > wL . In this case, some risk sharing is necessary to provide incentive to take high effort
– risk sharing aligns the agent’s incentives with the principal’s objective. Here, the wage
schedule is such that:
1√ 1√ 1√ 3√
wH + wL − 4 = wH + wL − 2.5 (IC)
2 2 4 4
and:
1√ 1√
wH + wL − 4 = 0. (PC)
2 2
√ √
From (IC), ( wH − wL )/4 = 1.5, which implies:
√ √
wH − wL = 6.
From (PC):
√ √
wH + wL = 8.
√ √
Solving the two equations above, wH = 7 and wL = 1. Therefore, wH = 49 and wL = 1.
18
Therefore, the principal’s profit from implementing e1 is:
1 1 51 1
π
b(e1 ) = (100 − 49) + (0 − 1) = − = 25.
2 2 2 2
The principal’s payoff is lower compared to the observable effort case because the contract
puts risk on the agent.
To implement e2 , the problem is the same as under full information. Thus, the principal’s
profit from e2 is 18.75.
Therefore, if effort is not observable, the principal should still implement the high effort e1 .
The wage contract to implement e1 is (wH = 49, wL = 1).
(c) If the agent gets a guaranteed income of 49 at premium 24, the agent’s expected payoff is
u(25) − g(e) = 5 − g(e). With an insured income, the agent has no incentive to choose high
effort, therefore the agent’s payoff is 5 − 2.5 = 2.5. The agent is of course happy to accept
this, since under the original contract the payoff was zero.
The insurance company had naively assumed the probability distribution to be (1/2, 1/2), so
they expected to break even – the insurance company’s payoff is 24 − p48, where p is the
probability of payout. The payoff is zero if p = 1/2. However, the insurance company fails to
take into account the impact of its own contract on the probability of payout. With p = 3/4,
the insurance company would make a loss.
Question 8
Suppose there are two identical firms in an industry who compete by setting
quantities. The output of firm 1 is denoted by q1 and that of firm 2 is denoted by
q2 . Each firm faces a constant marginal cost of 3. Let Q denote total output, i.e.
Q = q1 + q2 . The inverse demand curve in the market is given by
P = 15 − Q.
(a) Find the Cournot–Nash equilibrium quantity produced by each firm and the
market price.
(5 marks)
(b) If the firms could collude, what would be the total output in the market?
Assuming each firm produces half of the collusive output, what is the profit of
each firm?
(5 marks)
(c) Suppose each firm produces half of the collusive output identified in part (b).
Firm 1 considers a deviation from this arrangement. What would be the best
deviating output of firm 1 and its deviation profit?
(5 marks)
(d) Suppose firms interact repeatedly over an infinite horizon, and firms have a
common discount factor δ ∈ (0, 1). Specify a trigger strategy for each firm to
sustain the collusive arrangement as an equilibrium outcome. Calculate the
minimum value of δ for which such a trigger strategy can sustain collusion as an
equilibrium in the repeated interaction.
(5 marks)
19
(a) For 1, maximise:

(15 − (q1 + q2 ) − 3)q1 .
The first-order condition is:
q2
q1 = 6 − .
2
Impose symmetry: q1 = q2 = q ∗ , where 3q ∗ /2 = 6, implying q1 = q2 = 4. Market price is
15 − 8 = 7. The profit of each firm is (7 − 3)4 = 16.
(b) Joint profit is:
(15 − Q − 3)Q = 12Q − Q2 .
Maximising, Q∗ = 6. Profit of each firm producing Q∗ /2 = 3 units is:
Q∗
(15 − Q∗ − 3) = 18.
2
(c) Firm 1 can maximise:

(15 − (q1 + 3) − 3)q1 = q1 (9 − q1 )
implying that the best deviating output is q1D = 4.5. The profit of 1 would be (4.5)2 = 20.25.
(d) Trigger strategy profile: Start by producing Q∗ /2, Q∗ /2. Produce the same in any period
t > 0 if the same was produced in period t − 1. Otherwise, after any deviation, switch to the
Cournot–Nash equilibrium.
If a firm sticks to the collusive arrangement, they obtain a repeated game payoff of
18/(1 − δ). The deviation payoff is:
16
20.25 + δ .
1−δ
Therefore we need:
18 16
≥ 20.25 + δ .
1−δ 1−δ
This implies 18 ≥ 20.25(1 − δ) + 16δ, which implies:
4.25δ ≥ 2.25
which implies δ ≥ 0.53.
Question 9
A monopolist produces a good at a constant marginal cost of 4. Suppose the

monopolist is able to practice first-degree price discrimination (FDPD). The
(inverse) market demand function for the good is given by
P = 10 − bQ
where P is price, Q is quantity and b > 0 is a constant. Let DL(Q) denote the
deadweight loss at quantity Q, and let CS(Q) denote the consumer surplus at Q.
(a) Under FDPD, the marginal revenue function of the monopolist is the same as
the market demand function. Is this true or false? Explain carefully.
(8 marks)
∗
(b) Let Q be the monopolist’s optimal quantity under FDPD. Calculate the value
of CS(Q∗ ) − DL(Q∗ ).
(7 marks)
20
(c) Suppose a regulator imposes a per-unit tax of t on the monopolist and

redistributes tax revenue to consumers, so that tax revenue becomes part of
consumer surplus. Let Q∗t be the monopolist’s optimal quantity under FDPD
given a per-unit tax of t. Calculate the value of t that maximises
CS(Q∗t ) − DL(Q∗t ).
(5 marks)
(a) The revenue from quantity Q is the area under the demand curve up to Q. Let P (Q) be the
price for the last unit, given by P (Q) = 10 − bQ. The revenue is:
1 1 b
P (Q)Q + (10 − P (Q))Q = (10 − bQ)Q + bQ2 = 10Q − Q2 .
2 2 2
Alternatively,
Z Q
b
(10 − bs) ds = 10Q − Q2 .
0 2
Therefore, marginal revenue (M R) at Q is:
M R(Q) = 10 − bQ
which implies that the M R function is simply the demand function. Producing an extra
unit implies that the entire willingness-to-pay for the additional unit is extracted – therefore
M R is simply read off the demand curve.
(b) FDPD monopolist produces up to the point where marginal willingness to pay is the same
as marginal cost. This is the efficient quantity and the monopolist extracts full surplus, so
both deadweight loss and consumer surplus are zero – hence the expression has value 0.
Calculations for efficient quantity are not required for the answer, but a candidate might
calculate as follows. The optimal quantity produced by the monopolist is given by:
10 − bQ = c
implying Q∗ = (10 − c)/b. Since c = 4, Q∗ = 6/b. This is the same as the efficient quantity.
(c) Q∗t is given by 10 − bQ = c + t, implying:
10 − c − t 6−t
Q∗t = = .
b b
Consumer surplus is simply tax revenue, so CS(Q∗t ) = tQ∗t = t(6 − t)/b. Here, deadweight
loss is positive and:
t2

∗ 1 ∗ ∗ t 6 6−t
DL(Qt ) = t(Q − Qt ) = − = .
2 2 b b 2b
Therefore:
t2 3t2

t(6 − t) 1
CS(Q∗t ) − DL(Q∗t ) = − = 6t − .
b 2b b 2
Maximising:
6 − 3t = 0
(note that SOC holds), which implies t∗ = 2 is the optimal tax rate given the objective
function.
21

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Examiners’ commentaries 2023 (May)

Examiners’ commentaries 2023 (May)

Information about the subject guide and the Essential reading

be able to define and describe:

be able to analyse and assess:

• efficiency and welfare optimality of perfectly and imperfectly competitive markets

be prepared for further courses which require a knowledge of microeconomics.

Key steps to improvement

Essential reading: Important information

Nicholson, W. and C. Snyder, Intermediate Microeconomics and its Application (Cengage

Examination revision strategy

Examiners’ commentaries 2023 (May)

Information about the subject guide and the Essential reading

Comments on specific questions – Zone A

Answer all FIVE questions from this section (8 marks each).

Consider the following simultaneous move game with two players.

Reading for this question

Subject guide, Chapter 4.

Approaching the question

Reading for this question

Subject guide, Chapter 12.

Approaching the question

Reading for this question

Subject guide, Chapter 11.

Approaching the question

Reading for this question

Subject guide, Chapter 6.

Approaching the question

Reading for this question

Subject guide, Chapter 12.

Approaching the question

Answer THREE questions from this section (20 marks each).

In a competitive market for corn, the demand function is Q = 30 − P and the

Approaching the question

Figure 1: The producer surplus under the price support is A + B + C.

Figure 2: The producer surplus under a subsidy is D + E + F .

Reading for this question

Subject guide, Chapter 2.

Approaching the question

(a) Equating MRS to p, we have Y /X = p. Using this in the budget constraint pX + Y = M ,

while firm 2 can achieve a reduction to 72β2 units, where 0 ≤ β2 ≤ 1, by incurring a

Reading for this question

Subject guide, Chapter 12.

Approaching the question

The first-order condition is −2(1 − β1 ) + β1 = 0, which implies β1 = 2/3 and therefore

Consumer 1 has utility function

Reading for this question

Subject guide, Chapter 7.

Approaching the question

(a) The demand functions are given by:

2(25p + 15) + 15p + 55 = 280

which further implies:

t1 = 15, c1 = 45, t2 = 25, c2 = 25.

Examiners’ commentaries 2023 (May)

Information about the subject guide and the Essential reading

Comments on specific questions – Zone B

Answer all FIVE questions from this section (8 marks each).