LONDON SCHOOL OF ECONOMICS AND POLITICAL SCIENCE (University of London) B.Sc. (Economics) Part 1, Diploma and General Course Examination 1996 MICROECONOMIC PRINCIPLES I Time allowed: 3hours, Tuesday 21st May 1996 2.30pm - 5.30pm ‘The paper is divided into two sections. Candidates should answer eight short questions from Section A and three long questions from Section B. Section A has a weight of 40% (a 5% weight for each question). Section B has a weight of 60% (a 20% weight for each question). Candidates are advised not to spend a disproportionate amount of time on any one question. Section A: Short Questions 1. The price of'a substitute for a good produced by a perfectly competitive industry increases permanently. ‘What effect does this have on the industry price, the total amount sold by the industry, and the number of firms in the industry in the short and long term? 2. Two firms produce different goods. If firm 1 sets a price p, and firm 2 sets a price p. firm 1 faces demand q, = 20 - 2p, + p; and firm 2 faces demand q; = 20- 2p, + p1. Both firms produce under constant returns to scale with average cost 2. Define the Bertrand-Nash equilibrium. What prices are set and quantities sold by the firms in this equilibrium? 3. @ Explain what is meant by the statement that the production function y = f(K,L) displays decreasing returns to scale. Does y = KL display decreasing returns to scale? (ii) Would you expect an industry in which all firms had a production function £(K,L) = KL to be perfectly competitive? Explain your answer briefly. PLEASE TURN OVER © University of London 96/Ec201There is a single firm in an industry, the incumbent, which is considering whether to invest ina new technology. Another firm, the potential entrant is considering whether or not to enter the industry. The profits of the two firms are given by the following table. In this table 60, 20 means that the incumbent makes profits of 60 and the potential entrant makes profits of 20. Firm 2, potential entrant enter not enter Firm 1 invest - 50, - 50 80,0 incumbent not invest 60, 20 70,0 (i) Suppose the incumbent decides whether to invest or not before the potential entrant decides whether to enter. The potential entrant knows the incumbent's decision before making its own decision. What would you expect to happen? (ii) Does this game have a Nash equilibrium? Does it have more than one Nash equilibrium? A utility maximizing consumer buys two goods x, and x, at prices p, and p, . The following incomplete table gives some information about prices and the consumer's demand for goods in two situations A and B. utility PP XB % A 4 2 4 200 100 B 4 3004 (What is the numerical value of the consumer's expenditure function in situation A? (ii) Could the demand for good 1 in situation B be greater than the demand for good 1 in situation A? Why? iii) Is the value of the expenditure function in situation B less than 1000, exactly 1000 or more than 1000? Explain your answer. PLEASE TURN OVER © University of London 96/Ec20110. Explain how taxation of a good creates deadweight loss. How does the size of the loss depend on the elasticity of the demand curve? Use the example of a two person exchange economy to show that, even out of equilibrium, the value of excess demands sums to zero. ‘An individual has utility function U = W!? and initial wealth of 16. He is offered a bet which costs 7, and pays gross winnings of 16 with probability ™. () What is his expected utility if he accepts the bet? (ii) At what value of 7 is he indifferent between accepting and rejecting the bet? ii) Given this probability, what is the expected value of the bet? Show that majority voting may lead to intransitive social decision making. What are the implications of this? A risk averse individual can hold wealth in either a safe or a risky asset. Use a diagram ‘with consumption in two states of nature to analyse the effects of an increase in the return to the risky asset on the individual's portfolio. Does the share of the risky asset in the portfolio necessarily increase’? PLEASE TURN OVER © University of London 96/Ec201Long questions: un @ Gi) Gi) (iv) ) wi) 2 @ (ii) (iii) Define a normal good. Define compensating variation. A tax is imposed on a good which increases its price from £10.00 to £15.00. The good is normal. Use a diagram to show the information you would need to calculate the loss of consumer surplus and the compensating variation due to this tax. Which is larger, the loss of consumer surplus or the compensating variation? Why? Under what circumstances is the difference between the change in consumer surplus and the compensating variation small? Why is the change in consumer surplus used as a measure of the welfare effects of a tax on households? What are its limitations? What is a natural monopoly? Give an example of an industry which is likely to be a natural monopoly. A firm faces a demand curve q = 10-p, where q is quantity and p is price. It has a fixed cost F and a constant marginal cost of 2. For what values of F is this firm a natural monopoly? Explain your answer. Suppose that a firm has a cost function F + cq where q is the output, F fixed cost and ca constant marginal cost, ‘The firm is the only supplier of a good, its monopoly position is protected by law, and the price it sets is determined by a regulator. What price should the regulator set and why? Would a change in the Taw which allowed new firms to enter the industry eliminate the need for price regulation? PLEASE TURN OVER © University of London 96/Ec20113, @ A household has income M and utility U(H,C) = HC* where H and C are the household's consumption of two goods. ‘The price of H is 1 and the price of C is p. Find the household's demand for H and C. (ii) A perfectly competitive firm produces output y which sells at price p using an input L which has price 1 according to the production function y = L’?. Find the firm's profit maximizing output and input and the amount of profit which it makes. (iii) Aneconomy has equal numbers of firms and households. Firms produce widgets from labour according to the production function y = LY. If members of a houschold work for 24 - H hours and consume C widgets the household's utility is U(H,C) = HC*. Each household has equal shares in each firm. (@) Calculate the market clearing price of widgets if the wage is 1. (b) How many widgets does each houschold consume? 14, (i) Define competitive general equilibrium. (ii) Define a Pareto efficient allocation. (iii) Show that, under appropriate conditions, competitive equilibrium is Pareto efficient. (iv) ‘The theorems of welfare economics establish that the government does not need to engage in microeconomic policy’. Discuss. PLEASE TURN OVER © University of London 96/Ee20115, There are two countries, 1 and 2, each containing a steel firm. ‘The world demand for steel is perfectly elastic at price p. The output of the firm in country | is x, and its total private costs of producing x, are cx,?. The firm in 2 has output x, and total private costs, cx,2. Steel production creates a global externality, and the cost of this to individuals in country 1 is proportional to world output, with cost a{x, + x]. The cost to individuals in country 2 is also a[x, + x,). (i) Find the equilibrium output of the industry, in the absence of any pollution control. (ii) Country 2 has no pollution policy, and country 1 decides to tax its firm's output to regulate pollution. What is the optimal rate of taxation? Who gains and who loses from the policy? How does the policy depend on whose interests the country 1 government is representing? (iii) Suppose that the two firms are internationally mobile. How does this change your answer to (ii)? What other policy instruments might the country 1 government consider using? (iv) Comment on the implications of your analysis for the design of policy towards global environmental issues. 16 (i)_—_Explain what is meant by (a) moral hazard (b) adverse selection. (ii) What problems does adverse selection create for the insurance market? © University of London 96/5201