Pisanuor N SCHOOL OF ECONOMICS ECO2003F: INTERMEDIATE MICROECONOMICS, FINAL EXAMINATION MAY 2013 Time: 3 hoursand 15 minutes ‘Total marks: 180 marks Examiner: Katherine Eyal Internal Moderator: Leonard Smith External Examine Gideon Du Rand Instructions: 1. There are 30 multiple choice questions in this exam, MCQs that are correctly answered will earn you 3 marks, while each incorrectly answered question attracts a penalty of 1 negative mark. 2. All questions are compulsory. 3. Please answer part B, C and D in 3 separate answer books.Part A: Multiple Choice Questions (1). The graph below shows the utility function for an individual with an initial wealth of 40, and facing a fair gamble in which the gambler either loses 30, or gains 30, with probability of 50% for each option. Fill in the blanks: Given this graph, we can say that the individual would obtain an expected utility of from accepting the gamble, and would accept gambles with an expected value greater than (A) 28:12 (B) 28:52 (© 32:52 (D) 32,12(2). For the average person, an insurance contract in the real world is (A) a fair gamble (B) an unfair gamble (©) nota gamble (D) — auseless option (3). ‘The "backward bending" portion of the labour supply curve implies that (A) _ higher wages lead to an increase in hours of work supplied (B) the law of diminishing marginal returns to labour has settled in (©) _ higher wages lead to fewer hours of work supplied (D) a minimum wage law is in effect (4). Ifyou hire me at R10 an hour, but have to pay R12 an hour to attract a second labourer to work with me, I will feel unfairly treated and I will stop working for you, You will then have only one worker anyway, so you might as well have continued employing me for R10 an hour. To prevent this problem, you hire both of us and pay us R12 each. This means that the marginal factor cost (MFC) of employing the second worker is (A) RI2 (B) R24 (©) RIO (D) R14(5). _ Fill in the blanks. If we minimise the cost function C = LK + 2L subject to the cost constraint 4L + 2K = 60, using the Lagrangian method, we obtain Lt- :Kt= and 2* = (A) L*=8:K*=14; =4 (B) L*=14:K*=8: 0 =4 (©) L*=4:K*= 14: 04 =8 (D) L*=8:K*=14; 4*= 128 (6). When costs are at a minimum, (A) MPUMPK The government wishes to encourage the consumption of healthy food. It does so by subsidising the consumption of healthy food and so lowering its price relative to unhealthy food. However, the government must finance the subsidy: It does this by taxing people’ incomes. As a result of the subsidy the budget line changes from AC to AE, but once the income tax is implemented the budget line is AD For the representative individual the subsidy alone increases the consumption of healthy ‘meals from 2 10 6 meals per week (point I to point 2), but when the income tax is implemented consumption only increases to 4 meals per week (point 3). (a) Given the preferences shown above, what can be inferred about the extent to which healthy food and unhealthy food are substitutes given the slope of the indifference curves? [4 marks] (b) Inthe above situation, the income tax is based on allowing one to afford the original consumption bundle (2; 7.5) (point 1), but we see that even though this bundle is affordable, the representative consumer's optimal consumption bundle changes. Why does the consumer do this? You should refer to the income and substitution effects related to the subsidy. [10 marks} (©) Do you think that it is feasible to use an income tax to subsidise the consumption of healthy food? Should poor and rich consumers be required to pay the same amount of taxation? [4 marks] (@) If the government's intention is to improve the health of the population, which boosts productivity (through lower absenteeism due to illness, for example), does it mean that the consumers should be required to pay the tax? How else could the government finance the healthy food subsidy? [4 marks] (©) Inpractice, we are more likely to see this type of pricing incentive implemented by a health insurance/medical aid scheme. Discovery Medical Aid subsidises the prices of 16(a) Healthy Food for example. Please explain why a medical aid might subsidise the consumption of healthy food, What benefits might accrue to the medical aid scheme? What benefits might accrue to the individual member of the scheme? How do you think these policies are funded, or the medical aid’s costs are reduced, through the provision of healthy living incentives? [8 marks] END OF PART : 30 Marks in Total Part C Please start this question in a new answer book Read the following quotation, and refer to it when answering the questions which follo “A vital clue about the nature of the problem of our materialism I didn't even recognize as a clue until my brother pointed it out. The clue was that plunging into the literature on the subject of our economy gave ‘me a somewhat flat, empty, dead feeling The study of war was not like that (except perhaps the works of military game theorists). To enter the realm of war is to enter a field where passions are at play--the rage, the desperation, the pain. L always felt close to the core of the human condition. When I turned to the economic dimension of modern life, Lfelt like some spark went out of me. I complained to my brother, Ed, that my thinking felt mechanical. I was having trouble getting to the living, palpitating heart of the matter... There is an aroma of deadness in the subject of our materialism. Our economy, with its focus on the material and the mechanical, embodies an 7approach to human life with the spirit drained out of it. Our material becomes dead stuff.. The cost of worshipping Mammon is evidently high, for lke Midas's touch it turns our living treasures into dead material, Contact with the dead stuff of our economic system tends to be deadening... Market society understands itself-through the ideology of the market-~ as a selfregulated machine. Human affairs are reduced to terms of ‘mechanism, comprehensible in terms of number and calculation. It is like the Newtonian clockwork universe that epitomized the world-view of the era in which the market arose and developed its power and rationale. To free ourselves from the machine, it will be necessary to understand better the nature of the machine. But as we descend into this mechanical world-view, with its contagious lifelessness, I hope it will be possible for us to keep contact with the flesh and blood, spiritually important realities that are at stake in the struggle between ways of understanding the dynamism of the market machine.” (Quoted from The Lllusion of Choice by Andrew B. Schmookler, Suny Press, 1993, pp. 33- 35.) () Which important economic theory might Schmookler be referring to when he talked “about a mechanical world view, with contagious lifelessness”? [1 mark] Let's think through a few examples where a mechanical view of human behaviour does not serve us, and try to identify why. 18(ii Gi) ) What do we call a cost which curred but which cannot be refunded, or returned to us, for instance the effort put into studying for atest? [1 mark] Ifa test is cancelled at the last minute and rescheduled (for a later date), should we be angry about it? Why or why not? In practice, do we tend to be angry? Why or why not? Assume that knowledge gained through studying does not degrade over time. [4 marks] Students are told on the same day that an essay hand-in is cancelled, and that an extra tutorial must now be submitted place. The essay would have taken 30 hours to complete, while the tutorial will take 25 hours. The students have not yet started to work on the essay. Would students tend to be unhappy or happy when receiving an announcement of'a change like thi Name the two econo’ sts who helped us to understand whether or not students will be happy after the changes are announced. Use thei heory, and a well labelled graph, to illustrate and explain why students could be unhappy after the change in submissions is announced. [8 marks} How would students' happiness levels change. \stead we subscribed to the theory referred to in question (i Explain your answer. [3 marks} You are given the production function Q = min(aK, bL) where a and b are constants, Describe the isoquants of this production function in words and graphically, and in words describe the nature of the tradeoff implied by the shape of the isoquants. 19(©) Indicate on your graph a portion of the isoquant where marginal produet of labour is zero, and another where marginal produet of capital is zero. [5 marks] A monopsonist’s demand curve for labour is given by w = 120-202, where w is the hourly wage rate, and Lis the number of person-hours hired. (i) Ifthe monopsonist’s average factor cost (AFC), or supply curve is given by w= 20L, which gives rise to a marginal factor cost curve of MFC = 402., how many units of labour will she employ, and what wage will she pay? [3 marks] How would your answers in (i) be different if the monopsonist were required to pay her labourers a minimum wage of at least R70/hi [2 marks} (iii) How would your answers to (i) and (ii) be different ifthe employer in question ‘was not a monopsonist, but rather a perfect competitor in the labour market? [3 marks} END OF PART C: 30 Marks in Total 20Part D Please start this question in a new answer book The proposed electricity price increases by Eskom, the South Affican government regulated national provider of electricity, has generated much controversy, Eskom is generally considered to be an example of a natural monopoly. Assume that Eskom’s marginal cost of producing electric costs of the local electrical power station is R7 million, and it R2 per kilowatt hour, its fixed P=6-0.25Q where Q is units measured in millions of kilowatt hours. (a) Calculate Eskom’s profit maximising (i) output, (ii) price and (iii) profits [6 marks] (b) Assume that the regulator forced Eskom to price at marginal cost (i.e. R2 per kilowatt hour). Calculate the impact of the regulator's decision on Eskom’s output and profits. Discuss with the aid of a diagram the welfare implications of the regulator's decision. [14 marks} (©) Eskom has also been accused of unfairly granting aluminium smelters such as BHP Billiton preferential prices. For example, according to the Business Report (22 March 2013), the Hillside smelter is paying on average 22.65 cents per kilowatt hour (kWh) to Eskom compared to an average of R1.40 per kWh paid by households. Explain, using a diagram, how 1g behaviour could be explained by second degree price discrimination (quantity discrimination). Discuss whether such price discrimination should be prohibited, taking into account the efficiency and fairness criterion [10 marks] END OF PART D: 30 Marks in Total END OF EXAM: 180 Marks in Total 21