M.A. and B.Sc.

Examination School of Economics & Finance EC2001 Intermediate Microeconomics January 2009 Time allowed: 2 hours

This paper has TWO sections. Answer FOUR questions from Section A [60 marks]. Answer ONE question from Section B [40 marks].

(Please turn over for Section A)

Section A [60% of the total marks]. Answer FOUR questions. Each question carries equal weight.

1.

A monopolist is selling a magazine in two markets: through student subscriptions and newsstands. The demand curves in the two markets are as follows: Q1 = 1000 20 P1 (students demand) and Q2 = 1400 40 P2 (newsstands demand). a. Find the marginal revenue functions in each market. When the publisher is maximizing profits with a different price in each market, which market will yield the higher marginal revenues, or will marginal revenues be the same in each market? Assuming that the monopolists marginal cost is MC = 10 , find the quantity sold in each market and the price in each market. What is the corresponding producer surplus in each market? Suppose a regulator issues an order requiring the monopolist to charge the same price to all consumers. Now what is the profit maximizing output level, price, and producer surplus for the monopolist?

b.

c. d.

2.

A producer of light bulbs has the following production function Q = 10 LK , where Q is the number of light bulbs produced per year, L is amount of labor used per year, and K is the amount of capital used per year.

a. b. c. d.

Define and compute the marginal product of labour. Define and compute the marginal product of capital. Define and compute the marginal rate of technical substitution. What is the cost minimizing combination of capital and labour if the cost of labour is 4, the cost of capital is 4, and 90 light bulbs are to be produced? Illustrate your answer by drawing the relevant isoquant and isocost line. Does the production function of the firm exhibit constant, increasing or decreasing returns to scale? Explain.

e. f.

(Please turn over for Question 3)

3.

Suppose that a consumers utility function is given by U ( x, y ) = xy + 4 x . The marginal utilities of good x and good y are MU x = y + 4 and MU y = x respectively. a. State the utility maximisation problem for this consumer if the price of good x is p x , the price of good y is p y , and income is M . Derive and interpret the marginal rate of substitution for this consumer. Solve the consumers utility maximisation problem for the optimal demand functions for goods x and y . What are the own-price and cross-price elasticities of demand for good x ?

b. c.

d. 4.

Suppose a competitive firm takes the price P of its output as given and faces a shortrun total cost function TC (Q) = Q 3 10Q 2 + 40Q + 20 . a. b. c. d. What is the equation for the average total cost function of the firm? What is the equation for the average variable cost function of the firm? What is the equation for the marginal cost function of the firm? Define and calculate the firms shutdown price in the short-run. Explain your answer using a diagram. If the price is P = 20 , how much will the firm produce? What is the firms profit and producer surplus when P = 20 ?

e. f. 5.

Jenny has preferences represented by the utility function U ( M ) = M , where M represents income in thousands of pounds.
a. b. Is Jenny risk-loving, risk-neutral or risk-averse? Explain. Suppose Jennys income in her current job is 10,000 ( M = 10 ) and can earn that income next year with certainty. She is offered the chance to take a new job that offers a 0.5 probability of earning 16,000 ( M = 16 ) and a 0.5 probability of earning 5,000 ( M = 5 ). Should she take the new job? In (b), would Jenny be willing to buy insurance to protect against the variable income associated with the new job? If so, how much would she be willing to pay for that insurance? (Hint: What is the risk premium?)

c.

(Please turn over for Question 6)

6.

Assume that two profit-maximizing firms produce a homogenous product. The output levels of firms 1 and 2 are denoted by q1 and q 2 respectively. Each firm decides how much it will produce. The market price of the product is P . The inverse industry demand curve is P = 260 12Q , where aggregate output equals Q = q1 + q 2 . Both firms have identical marginal costs, equal to 5, and zero fixed costs. a. If the firms compete by choosing the quantities q1 and q 2 , derive the reaction functions for the two firms and illustrate them in a diagram. Solve for the Cournot equilibrium by characterising the outcome of this game in terms of outputs, price and profits. Suppose the firms collude and split the monopoly profits equally. Characterize the market equilibrium in terms of outputs, price and profits. Compare the outcome in parts (b) and (c) and provide an economic interpretation for the results of the comparison.

b.

c.

d.

Section B [40% of the total marks]. Answer ONE question. Each question carries equal weight.

1.

For each of the following types of insurance, explain (i) how the moral-hazard problem might arise, and (ii) how the adverse-selection problem might arise: a. b. c. d. Homeowners insurance Health insurance Automobile insurance Unemployment insurance

How might an insurance company adjust the insurance contract to mitigate the moralhazard and adverse-selection problems?

2.

What is the Coase Theorem, and when is it likely to be helpful in leading a market with externalities to provide the socially efficient level of output? Illustrate your answer with an example.

(Please turn over the Question 3)

3.

A politician remarks Our recent increase in the wage rate of teachers has been a total success! The shortage of teachers has been reduced drastically. Another similar wage increase should eliminate this teacher shortage entirely! a. Explain and illustrate in a diagram what is meant by income effects and substitution effects of a wage rate change. Explain and illustrate how you would model the labour supply decision of a potential teacher. Do you agree that the wage increase will increase the labour supply in this case? Carefully outline the assumptions underlying your argument.

b.

4.

Answer parts (a) and (b) a. The first welfare theorem of economics states that a competitive equilibrium is Pareto efficient. Using either algebra or a diagram to help you, demonstrate why this is true. (You may restrict attention to a pure exchange economy.) What is the second welfare theorem of economics and what are its implications for the allocation of resources.

b.

_________________________________