‘THE LONDON SCHOOL OF ECONOMICS AND POLITICAL SCIENCE (University of London) 1999 Examination EC201 Microeconomic Principles | Instructions to candidates Time allowed: 3 hours. This 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, Electronic calculators may be used. These should be of a hand-held non- programmable type and the name and model should be stated CLEARLY on the front of your answer book. TURN OVER © University of London 1999/EC201SEC MON A (short Questions): Answer eight questions 1. Consider the introduction of a 10% rate of income tax, which changes the income tax system in the following way. Before the change the first £4000 of annual income is not taxed. The marginal rate of income tax is 20% on incomes between £4000 and £8000 and 25% on incomes above £8000. After the change the first £4000 of annual income is not taxed. The marginal rate of income tax is 10% on incomes between £4000 and £6000 and 25% on incomes above £6000. @ ©) 2 @) ) Show, using a diagram, the effect of the tax change on the constraints which people face in choosing how much labour to supply. ‘What effect would the tax change have on the labour supply of people who prior to the tax change were earning £5000? Define a Laspeyre’s price index. Inflation, as measured by a Laspeyre’s price index, is 10%. A household’s income increases by 10%. Does the household’s wility increase, decrease or stay the same? 3. A firm uses two inputs, capital K and labour L. Its output is given by the production function y = min(K,3L). (@) Show the isoquamts for this production function. () If the price of K is r and the price of L is w, what is the cost of producing two units of output? (©) _ Define the cost function of this firm. Derive the firm’s long run cost function. (@) Suppose that capital is fixed at K = 10. What is the maximum level of output which the firm can produce? Derive the firm's short run cost function. TURN OVER © University of London 1999/EC201 1ood produced by the industry is Q = 10 - P where Q is the quantity demanded and p is the price of the good. @ What quantity is sold and what is the price if the industry is perfectly Competitive? How much profit do firms in the industry make? How big is consumer surplus? (©) All the firms in the industry are taken over by a single monopolist. What uantity is sold at what price? How much profit does the monopolist make? How big is consumer surplus? (©) fall the consumers of the good are shareholders in the monopoly do they gain oF lose from the monopolization of the industry? 5. Two firms in an industry are considering innovating by introducing a new product, Their profits are described by the following matrix game. innovate ‘Rot innovate 5,5 1,3 3,7 6,6 (Define a Nash equilibrium. Does this game have a Nash equilibrium? (b) What would you expect to happen in this game if the firms compete only once? © ‘What would you expect to happen in this game ifthe firms compete many times? 6 Consider the portfolio decision of a risk averse individual who can invest her wealth in cither a safe asset (with a certain zero net return) or a risky asset (with a negative return in the bad state and a positive return inthe good state). Analyse the effect ofa decrease in the expected return tothe risky asset, using the state preference diagram. Could the amount of wealth invested in the risky asset increase? © University of London 1999/EC201 27. Consider a pure exchange economy with two consumers, two goods and no production. Albert drinks gin (G) and tonic (T) in fixed proportions of two parts gin to one part tonic, so his preferences can be represented as: U* = min (G*/2, T*) Beatrice has the utility function, U® = G®-T®, The total endowment in the economy is 30 units of gin and 20 units of tonic, (@) Suppose the initial endowment of Albert was 18 units of gin and 6 units of tonic. Draw the Edgeworth box diagram and show the total dimensions, the initial endowment point, the indifference curves for A and B and the contract curve. (©) At this initial endowment, can Albert and Beatrice gain from trade? Why? (©) _ Ifthe initial endowment were to change such that Albert now has 16 units of gin and 8 units of tonic, could Albert and Beatrice gain from trade? Why? 8. Define the “voting paradox”and give an example of the conditions under which it can occur. What are its implications for majority voting as a social decision rule? 9. Compare the conditions for the efficient supply of a public good with those for the efficient supply of a private good. Why do the two differ? Under what conditions can a public good be allocated efficiently by the private market? 10. Consider the Spence model of education as signalling, with two types of individuals (A, B) who represent proportions 1-q and q, respectively, of the population and who have productivities w* > w* and costs of education @4y < 6y. (@) Under what conditions will there be a separating equilibrium? () Is the separating equilibrium efficient? TURN OVER © University of London 1999/EC201 3SECTION B (Long Questions): Answer three questions 11. A consumer has a utility function u(x,,x,) = oOo @ ) © @) @ ) © 9. Define compensated demand and state which variables the compensated demand function depends on. Derive the compensated demand function for goods x, and x, for the utility function given above. Can the compensated demand for a good be an increasing function of its own price? Define the expenditure function and state which variables the expenditure function depends on. Derive the expenditure function for the utility function given above. Can the expenditure function be an increasing function of the price of a ‘good? Gii) ‘The consumer has utility u, the price of good 1 is £8 and the price of good 2 is £4. For the utility function given above, what quantities of goods 1 and 2 does the consumer consume? (iv) Define the compensating variation. For the utility function given above, calculate the compensating variation if the price of good 1 rises from £8 to £16 whilst the price of good 2 is unchanged at £4. 12, The 1999 budget increased the tax on the diesel fuel used by heavy goods vehicles (tucks and lorries). (@) Use a model to discuss the likely impact on the road haulage industry. Discuss critically the assumptions you make about the nature of the market and the costs of firms. (>) How should the government take environmental considerations into account in setting levels of fuel taxation? © University of London 1999/EC201 413. i) (i) Under what conditions does production of a good involve large fixed costs? Discuss, giving examples of particular industries. Consider the following model. An industry consists of n identical firms. Firm i produces output q, and has a cost function F + cq,. The price of the good is p = a- bQ where Q is industry output. (a) Assume the number of firms is fixed at n. Find the Cournot-Nash equilibrium of this industry. What quantity does each firm sell? What is the total output of the good? What is the price of the good? [Hint: assume a symmetric equilibrium in which all firms produce the same output. Use notation s, for the total output of all the firms other than firm i.) (>) Now assume that firms can enter or leave the industry. How many firms will there be in the industry in the long run equilibrium? (©) How well does this model capture the behaviour of real industries? 14. An individual has initial wealth of 100 and utility function U = W”. She faces a 25% probability of an accident with cost 64. @ 0) © @ © ‘What is her expected wealth and her expected utility? If actuarially fair insurance were available, what would be the premium for full insurance? What would be the individual's utility with full insurance? What is the highest premium the individual would be willing to pay for full insurance? What would her utility be if that premium were paid? Using the two-state model, illustrate the no insurance point in (a) and the actuarially fair full insurance equilibrium in (b). What is her marginal rate of substitution between consumption in state one (accident) and in state two (no accident) at the full insurance point in (b)? Why, in practice, do insurance companies often not offer full insurance? TURN OVER © University of London 1999/EC201 5"Why do private markets fail to achieve Pareto efficiency in the presence of externalities? Under what conditions are private bargaining solutions to the market failure possible? How can taxes be used to achieve efficiency? 16. — Consider a model of the insurance market with two types of individuals: high risk (H) and low risk (L). (@) Using the state preference diagram, carefully describe the equilibrium under perfect information with actuarially fair insurance. () Whats a pooling equilibrium? Ifa fraction q of the population is high risk (H), what will be the actuarially fair insurance policy offered in a pooling equilibrium? Will such an equilibrium exist? (©) Whatisa separating equilibrium? What actuarially fair insurance policies would be offered? Will such an equilibrium exist? (@) How, if at all, would your answers to (b) and (c) be affected if individuals did not know whether they were high or low risk (and nor did insurance companies)? © University of London 1999/EC201 6