ENDTERM EXAM WS 2022

NAME:

1: Production (3 Points)

Joe owns an ice-cream shop that produces ice-creams y according to the production function
y = αL, where L are the number of hours of labor hired by Joe.

w
1. Show that the cost function is c(y) = α y, where w is the wage rate.
w
Solution: y = αL, thus, L(y) = y/α. Hence, C(y) = wL(y) = α y.

2. Suppose that the demand for ice-cream is y = 1 − p and that Joe is the only ice-cream shop
in town. Compute Joe’s marginal revenue curve and derive the condition that determines
the optimal quantity of ice-cream he should produce. How many hours of work should he
hire? Is the allocation efficient?
Solution: y = 1 − p, P (y) = 1 − y. Thus,

M R = P (y) + P 0 (y)y = 1 − y − y = 1 − 2y

The monopolist chooses M R = M C and hence 1 − 2y = w 1 w

α . It follows that y = 2 − 2α .
1 w
Hence, L = 2α − 2α 2 . The allocation is inefficient because consumers with valuation
w 1 w
( α , 2 + 2α ) are left without ice-cream but they value an ice-cream more than its marginal
cost of production.

3. Suppose another ice-cream shop with the same technology locates directly in front of Joe’s
and that they compete in prices. Describe the new equilibrium.
Solution: Bertrand competition leads to p = M C as any alternative outcome in which a
firm makes positive profits (p > M C) gives incentives to at least one of the firms to
undercut its rival to a slightly lower price and capture the whole market. Thus, p = w α

4. Joe is unhappy with the new ice-cream shop and he argues that it provides no social value,
since it just copied his business. Is this true?
Solution: There are two perspectives on this question.

• From a social perspective, the efficient allocation with and without the new firm are
equivalent. In that sense, the new firm provides no social value.
• The new firm, however, changes the equilibrium and the resulting allocation is now
efficient while the old allocation was inefficient. In this sense, the new firm provides
social value.

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 ENDTERM EXAM WS 2022

3: Market Failures (3 Points)

Answer one (and only one) of the following two questions.

1. Consider an economy with two individuals, Cain and Abel. Cain owns cattle while Abel
grows grain in his field. The manure from Cain’s cattle increases the productivity of Abel’s
land. Let π C (x) = ln(x) − x denote the profits of Cain as a function of the number of
animals he owns and π A (x) = ln(x) denote the profits for Abel

(a) Find the private optimum and argue that it is inefficient.

Solution: In the private optimu, Cain can choose the number of animals he owns to
maximize his own profit. Hence, x∗ = 1. The social optimum maximizes the sum of
profits, so 2 ln(x) − 1 and thus, xs = 2 > 1. Hence, the private optimum is inefficient.
(b) Suppose we allow Abel to approach Cain and offer him a transfer in exchange for an
increase in the amount of cattle he owns. Describe the offer that we would expect Abel
to make? Will Cain accept? What if Cain would make the offer?
Solution: Coase theorem says that absent any other costs, negotiation would yield the
social optium: xs = 2. If Abel gets to make the offer he will make sure that Cain is
indifferent: offer T so that ln(2) − 2 + T = ln(1) − 1 = −1. Hence, T = 1 − ln(2). If
instead Cain makes the offer, he will extract all extra profits from Abel: T is such that
ln(2) − T = ln(1) = 0. Hence, T = ln(2).
(c) What if Abel offers to purchase Cain’s farm?
Solution: This is a classical implementation of Coase’s theorem. Abel would sell his
farm for an amount equal to his profit, ln(2), and then own both farms and get
2 ln(x) − x.

2. Ann is considering investing in her friends’ startup. A consultant claims that q% of the
startups in this sector are worth 1M while the rest are worth nothing. The consultant has
told her also that entrepreneurs are willing to sell at a discount of 30% (i.e. if the company
is worth 1M, an entrepreneur would be willing to sell for 700K).

(a) Suppose first that neither Ann’s friend nor Ann know whether the company is
successful or not. Find a price such that both Ann is willing to buy and her friend is
willing to sell. Argue that this is the efficient allocation.
(b) Suppose now that Ann’s friend knows whether her company will successful. How much
is Ann willing to pay for her friend’s firm if q = 0.75? And if q = 0.5? Would there be
a sale?
(c) The government wants to know if they should intervene in this market. They want to
know if there is adverse selection. Suppose you have a list of startups, some of them
were sold and some not. How would you test for the presence of adverse selection?