January 2022 Exam

EC1A3
Microeconomics I

2021/22 syllabus only – not for resit candidates

Instructions to candidates

This paper contains two sections. Section A contains 5 multiple choice questions. Section B contains two
long questions with subquestions. Answer ALL questions.

Time Allowed Writing Time: 2 hours

You are supplied with: no additional material

You may also use: no additional material

Calculators: Calculators are allowed in this exam

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SECTION A: Answer all questions.
There are 5 questions. Each question carries 6 points.
Choose the correct answers, no explanation needed.
For each question, there might be more than one correct answer.
All correct answers get proportionate points. For example, if there is only one correct answer to a question,
the correct answer gets 6/1=6 points; if there are two correct answers to a question, each correct answer
gets 6/2=3 points; if there are three correct answers to a question, each gets 6/3=2 points; if there are four
correct answers to a question, each gets 6/4=1.5 points; and so on.
If one or more wrong answers to a question are chosen, 0 points are given for the whole question no matter
how many correct answers are also chosen.

Question 1 [6 marks]

You are planning your consumption over two periods (today and tomorrow). There are two local banks, 1
and 2, each offering a different interest rate you can borrow and lend at. Your income is 50 today and 50
tomorrow. Which of the following statements are true?

a. Suppose that with interest that bank 1 offers you, your optimal consumption plan includes
consuming 40 today and whatever is left to consume tomorrow. If the interest rate of bank 2 is
higher than that of bank 1 you surely prefer to switch to bank 2.
b. Suppose that with interest that bank 1 offers you, your optimal consumption plan includes
consuming 60 today and whatever is left to consume tomorrow. If the interest rate of bank 2 is
higher than that of bank 1 you surely prefer to switch to bank 2.
c. Suppose that with interest that bank 1 offers you, your optimal consumption plan is 50 today and 50
tomorrow. In this case you might be worse off by going to bank 2.
d. Suppose that with interest that bank 1 offers you your optimal consumption plan is 50 today and 50
tomorrow. In this case you can never be worse off by going to bank 2.
e. Suppose that the two rates are different from each other. The only way you can be indifferent
between the two banks is when in one of them your optimal plan involves borrowing and in the other
your optimal plan involves saving.

__________________________________________________________________________________________________________

Question 2 [6 marks]

Which of the following statements are true?

a. The model of rationality implies that people’s decision utility is different from their experience utility.
b. The model of rationality implies that people’s decision utility is the same as their experience utility.
c. A rational player will never play a strictly dominated action.
d. A rational player might play a strictly dominated action, but only in a Nash equilibrium.
e. Assuming that an individual is altruistic contradicts our model of rationality.

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Question 3 [6 marks]

Consider the following game. Which of the statements below are true for this game?

L M R

U 4,2 -1,-1 1,1

M -1,-1 -2,1 1,-5

D 2,1 -7,1 0,-1

a. The Row player has a strictly dominated action.

b. The Column player does not have a strictly dominated action.
c. There is no mixed-strategy Nash equilibrium for this game.
d. The row player playing M and the column player playing L constitutes a Nash equilibrium of this
game.
e. There are two Pure strategy Nash equilibria to this game.

__________________________________________________________________________________________________________

Question 4 [6 marks]

Which of the following statements are true?

a. The fact that baldness is correlated with higher salaries is not conclusive evidence of discrimination.
b. In highway searches, if police want to maximise the probability of detecting criminals and if they do
not engage in taste-based discrimination, they might search women drivers more often than they
search male drivers.
c. In highway searches, if police want to maximise the probability of detecting criminals and if they do
not engage in taste-based discrimination, they might have higher hit rates when stopping women
drivers than they do when stopping male drivers.
d. In highway searches, if police want to maximise the probability of detecting criminals and if they do
not engage in taste-based discrimination, they might have higher hit rates when stopping white
drivers than they do when stopping Hispanic drivers.
e. When an insurance company sets different premia for drivers in London than for drivers elsewhere,
just because they have different accident rates, this is evidence of belief-based discrimination.

__________________________________________________________________________________________________________

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Question 5 [6 marks]

Consider Cournot competition between two identical firms, selling identical products, facing the market
demand curve p=32-4Q where p is price and Q is quantity demanded. Each firm’s total cost curve is C=4q
where C is total cost and q is quantity produced.

a. The combined quantity that the two firms produce in equilibrium will be lower than the combined
quantity that would have been produced if they were to compete in prices (Bertrand competition)
b. The combined quantity that the two firms produce in equilibrium will be higher than the combined
quantity that would have been produced if they were to compete in prices (Bertrand competition)
c. The quantity that each firm produces in equilibrium is 8/3
d. The price they sell in equilibrium is 40/3
e. If there was a monopoly in this market the price would be higher.
f. The sum of the profits of the two firms in equilibrium is higher than the profits of a monopoly in this
market.

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SECTION B: Answer the following TWO questions
Each question carries 35 points.

Question 6 [35 marks]

In this question you will work out a model of price competition (Bertrand competition) with differentiated
products, i.e., when the two firms that compete produce slightly different products. Consider two price-setting
firms, 1 and 2, each with marginal cost 𝑐, that produce goods, 1 and 2, that are imperfect substitutes. Some
customers are loyal to a particular variety of the good so both firms can still have positive sales when they set
different prices. Demand for firm 1’s output, 𝑞! , as a function of the prices of both products, 𝑝! and 𝑝" , is
given by 𝑞! = 2 − 3𝑝! + 3𝑝" . And the demand for firm 2’s output, 𝑞" , is given by 𝑞" = 6 − 2𝑝" + 𝑝! .

a. How can we tell, by looking at the demand functions above, that in the preferences of consumers the two
products are substitutes? Explain your answer. [7 marks]
b. Write this strategic situation as a simultaneous game between the two firms, specifying the set of players,
the set of alternatives and the preferences of each firm. Write down the profit equation of each firm as a
function of the price it sets and that of the other firm. [7 marks]
c. For each firm, maximise the firm’s profit given the price set by the other firm to find the reaction functions
𝑝! (𝑝" ) and 𝑝" (𝑝! )of both firms. [7 marks]
d. Find the Bertrand-Nash Equilibrium prices if marginal cost 𝑐 = 1. Do the firms make profits? If yes, what are
their profits? [7 marks]
e. How does the outcome above differ from the Bertrand competition with homogenous goods (that is both
firms produce the exact same product) we studied in lectures? Explain intuitively why the outcome above
differs to the Bertrand competition model we did in lectures. [7 marks]

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Question 7 [35 marks]

Your parents give you an allowance of 100 pounds for this year and 110 for the next. Credit markets are
perfect, and the interest rate is 10%. You are planning your consumption for this year, 𝑐# , and for the next
year, 𝑐! . Your utility from a consumption plan (𝑐# , 𝑐! ) is given by 𝑈(𝑐# , 𝑐! ) = 𝑐# $ 𝑐!!%$ .where 𝜃 is between
zero and one.

a. Write down the expression of your budget constraint for consumption plans (𝑐# , 𝑐! ) for current and
next year. [7 Marks]
b. Compute the MRS between 𝑐# and 𝑐! as a function of 𝜃. [7 Marks]
c. Compute the optimal consumption plan (𝑐# , 𝑐! ) as a function of 𝜃. For what values of θ will you be a
saver and for what values of θ will you borrow? [7 Marks]
d. Assume that 𝜃 = 0.5. Suppose that the interest rate has increased. Will you be better off or worse off
because of the change? Suppose that the interest rate has decreased. Will you be better off or worse
off because of the change? Explain your answer. [7 Marks]
e. Now assume that 𝜃 = 0.7. Suppose that the interest rate has increased. Will you be better off or
worse off because of the change? Suppose that the interest rate has decreased. Will you be better
off or worse off because of the change? [7 Marks]

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