LONDON SCHOOL OF ECONOMICS AND POLITICAL SCIENCE (UNIVERSITY OF LONDON) B.Sc. (Economics) Part II Examination 1998 Diploma Examination 1998 General Course Examination 1998 EC201 MICROECONOMIC PRINCIPLES I Instructions to candidates Time allowed: 3 hours. “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 48% (a 6% weight for each question). Section B has a weight of 52% (each question will be marked out of 18%, giving candidates two bonus points). Candidates are advised not to spend a disproportionate amount of time on any one question. You may use: Electronic calculator (as prescribed in the examination regulations) i © University of London 1998/EC201SECTION A (Short Questions) Men pe Ky 1. A firm has a production function y = f(x,,x:) = %!%_"*. The prices of the two inputs are w, and w,. Define and derive the firm's cost function. New technology changes the production function to g(x,,%;) = 2x:""%". What effect does this have on the cost function? 2. British beef cannot be exported at present, due to concern about health risks to humans from the cattle disease B.S.E.. Use a model to predict the effect of the export ban on the price and quantity of beef sold in the UK, and the number and profitability of beef farms. Explain your choice of model, 3. Child benefit is paid to parents and is not at present taxed. The government is considering a proposal to tax the child benefit paid to mothers who are on the highest ‘marginal rate of income tax. Explain using a diagram the effect this would have on the mother’s supply of labour. 4. Define the expenditure function. What variables does it depend on? What is it used to measure? Explain the relationship between the expenditure function and compensated demand. How can this be used to estimate the equivalent variation? 5. Explain what is meant by "present discounted value". Under what circumstances would the shareholders of a firm wish it to. maximize the present discounted value of its profits? 6. An individual has utility 100 from wealth 10, and utility 0 from wealth 0, so U(10) = 100 and U(0) = 0. We know the following two things about the individual. (i He is indifferent between wealth 6 with certainty and a 50: 50 chance of wealth 10 and wealth 0. (ii) He is indifferent between wealth 4 with certainty and wealth 10 with probability 1/3, wealth 0 with probability 2/3. In the initial situation his wealth is 10, and he faces a 2/3 probability of losing 6, (i) What is his expected wealth? (i) What is his expected utility? (iii) He is offered fair insurance against the loss. Will he accept it? Comment on the individual's attitude to risk PLEASE TURN OVER © University of London 1998/EC201 210, Mayr hy An economy has a fixed endowment of two factors of production (K and L), and uses these factors to produce two goods (X and Y). (i) How is the production possibility frontier of this economy constructed? (ii) Under what circumstances is the production possibility frontier a straight line? (iii) Under what circumstances would an increase in production of good X Jead to an increase in the wage rate (price of factor L)? ‘Two oil companies A and B are extracting quantities of oil x* and x* respectively from the same oilfield. Each company’s costs depend on its own and the other company’s production level according to total cost functions, CA = AP + xh + x, CBs PP + xP + xt Oil is sold at fixed price, p (i) What are the privately optimal production levels? (ii) What are the socially optimal production levels? ii) Comment briefly on the externality that causes your answers to parts i and ii to differ ‘There are two goods, X and Y, and good X has price greater than marginal cost because of a fixed and irremovable distortion, What is the (second best) welfare maximising way of setting the price of good Y? 50 sellers each have 1 unit of a low quality good which they will sell if price is greater than or equal to 10. Another 50 sellers each have 1 unit of a high quality 200d which they will sell if price is greater than or equal to 15. Consumers cannot observe the quality of the good they purchase, but know the proportion of goods sold that are of high quality. ‘The demand function is D = 150 + 200g - 10p where p is price, and q is the proportion of goods sold that are high quality Show that there are two equilibria, and discuss their welfare ranking. © University of London 1998/EC201 3Manat, SECTION B (Long Questions) 11. a. Consider the following model of a duopoly. There are two firms producing quantities q, and q) of the same good. Firm 1 has cost function F, + ¢; q, Firm 2 has cost function F, + ¢; q; - The price p of the good is given by p=a-b@q + @), Define the Cournot-Nash equilibrium of this industry. Find the price of the good and the quantities produced in the Cournot-Nash equilibrium. Show that the profits of firm 1 and firm 2 are I, = (1/9) (@- 2c, + e) - Fy Th = (1/9b) (a- 2c. + GF b. Suppose a firm has two plants. The cost of producing output q in plant 1 is 2-+4q. The cost of producing output q in plant 2 is 7+2q Would the firm ever find it optimal to use both plants at the same time? For what levels of output is it optimal to use plant 1? ¢. Suppose now that the two firms are operating as a cartel. The price of the good is given by p = 8 - q, - q;. Firm 1's cost function is 2 + 4q,. Firm 2's cost function is 7 + 2q.. How much should the industry produce and how should production be divided between the two firms if the objective is to maximize profits? 4. What competitive structure would you expect in this industry? Why? 12. Explain what is meant by “economies of scale’. What features of a technology give rise t0 economies of s le? What are the implications of economies of scale for the nature of competition in an industry? 13. How can the impact on households, firms and government of imposing a tax on a good be measured? What justifies the use of these measures? Are there any additional factors to be considered if the good is cigarettes? PLEASE TURN OVER © University of London 1998/EC201 414, 15. 16. Mon bro ‘Show how permits (quotas) may be used to obtain an optimal level of pollution. What benefits are derived from making the permits tradeable? Comment on the desirability of tradeable pollution permits relative to other policy measures that might be introduced to control pollution. What difficulties does asymmetric information pose for the operation of private health insurance markets? Would the situation be improved by insurance companies insisting on individuals undergoing medical examinations before offering health insurance? An economy contains a single individual and a single firm; both are price-takers. The individual has preferences u = min[x, 2 - y], where x is consumption of good, y is labour supply, and the individual is endowed with 2 units of labour (so consumes 2 - y units of leisure). ‘The firm has production function x = y"*, a. Sketch the production function and indifference curves, and find the welfare maximising quantities of x and y. b. __Ifprices of x and y are p and w respectively, and the firm maximises profits, find its output supply and input demand functions. ¢c. If the individual receives lump sum income M and faces prices p, w, find his demand for x and supply of y functions. 4. Find the competitive equilibrium price ratio. Sketch the equilibrium. €. Suppose now that good x is taxed. ‘The firm receives price p, the individual has to pay p + t, and revenue raised is redistributed to the individual as a lump sum. Illustrate the equilibrium diagrammatically, and compare it the equilibrium found in part iv. How might the effect of the tax be different if the individual had ditferent preferences? © University of London 1998/EC201 5