Introductory Microeconomics Econ10004 Final Exam 2011 Solutions Section A 1.B 2. A 3. A 4. C 5. D 6. B 7. D 8. A 9. B 10.

C Section B Question B1 Alan Accountant and Edwina Economist are discussing the governments recent decision to stop paying subsidies to home-owners who buy solar panels to provide a source of power to their homes. Alan says: This change in policy will not have a big effect. Because supply of solar panels is price-elastic, therefore removing the subsidy only causes a small decrease in the quantity of panels sold. Edwina disagrees. She says: The fact that supply is priceelastic means that the change in policy will cause a relatively large decrease in the quantity of panels sold. Alan is incorrect, and Edwina is correct. Where supply is relatively price-elastic then imposing or removing a subsidy will cause a relatively large change in the quantity of solar panels traded. A subsidy paid to consumers for solar panels causes a change in consumers willingness to pay which shifts the demand curve along the supply curve; and because the supply curve is relatively price elastic, this movement will be associated with a relatively large change in the quantity traded. The effect of removing a subsidy, for two supply curves with different price elasticities, is shown in the diagram below:

Price

S(Ps)-inelastic

S(Ps)-elastic

D(Ps) D(Pc)

Quantity

Qty traded with no subsidy elastic supply

Qty traded with no subsidy Inelastic

Qty traded with

Question B2 Alan Accountant and Edwina Economist are advising their friend Mardi Manager on operating her business. Mardi sells ice-creams, and because of their distinctive flavours, the business has a high degree of market power. Mardi is trying to decide whether to increase her daily sales as a way of earning higher profits. Alan says: Mardi can produce the extra ice-creams at the same marginal cost as the ice-creams she is already producing. Hence she will definitely earn higher profits by increasing her sales. Edwina disagrees. She says: That Mardi has a constant marginal cost of supply does mean that her ATC will decrease when she sells more. But we would need more information to know that her profits would increase when she sells more ice-cream. Alan is incorrect and Edwina is correct. It is correct that Mardis ATC will decrease if she produces extra ice creams. With constant MC, therefore Mardis AVC will remain constant; and we know that AFC decreases with the quantity produced. Since ATC equals AFC plus AVC, therefore ATC will decrease as the quantity produced increases. It is also correct that, the fact that ATC will decrease if Mardi produces a higher quantity, does not imply she will make higher profits. This will depend on what happens to total revenue compared to total cost. For example, suppose at the quantity Mardi was originally supplying that MR equals MC then it follows that she is already maximising profits, and any increase in the quantity traded will cause a decrease in her profits, regardless of what happens to her average costs.

P*

Beyond q* increases in qty cause lower profits although ATC decreases ATC MC MR q* Demand

Quantity

Question B3 Alan Accountant and Edwina Economist are advising their friend Gerry Gameplayer who is going to play in the World Championship of Scissors, Paper, Rock. Gerry will be playing a sequence of games against each opponent in the contest. Edwina Economist says: My advice is to choose randomly between the three strategies in each game you play. Alan Accountant disagrees. He says: If you choose randomly you will only have a one-third chance of winning each game. But I have a better strategy. Noone ever makes the same choice two games in a row. So I advise you in each game to choose the best response to one of the two strategies that your opponent did not choose in the last game. That way you will always have at least a one-half chance of winning each game. Edwina is correct, and Alan is incorrect. In a game such as SPR you need to make sure that your strategy cannot be predicted. If your strategy can be predicted, that is, if it can be predicted whether you are going to choose scissors, paper or rock, then effectively it turns the game into one with a second-mover advantage; the other player uses the information they have on your strategy, and will always be able to win the game (since there is always a winning response to play against whatever action you choose). Hence the key aspect of a successful strategy will be for your choice of scissors, paper or rock to be unpredictable. This will happen, if, as Edwina suggests, Gerry chooses his strategy randomly. By contrast Alan is suggesting a strategy that has some degree of predictability. After a while it will become evident to other players that Alan is always choosing a best response to one of the two actions which they did not choose in their last game. Hence there would be a (partial) second-mover advantage for whoever was playing against Gerry. Also, if Alan is incorrect that players never choose the same strategy twice in a row, then his suggestion for what strategy Gerry should use is not sensible.

[Note: To the extent that Alans strategy involves some degree of randomisation, it would be OK to say that there is some sense to his strategy. But it would also be important to then acknowledge that, as Edwinas strategy involves full randomisation, it is to be preferred.] Section C Question C1 (15% of total marks) In the market for bananas in Australia demand for and supply of bananas are as follows: QD = 12,000 6000P QS = 2,000 + 4000P (where QD = Kilograms of bananas demanded by Australian consumers, QS = Kilograms of bananas supplied by Australian suppliers, and P = price (in dollars) per kilogram of bananas). a) (2 marks) What will be the equilibrium price per kilogram of bananas and total kilograms of bananas traded? Solve by equating QD and QS: QD = 12,000 6000P = 2000 + 4000P = QS P* = 1 => Q* = 6,000 Suppose now that Australian consumers can buy bananas from international suppliers at a price of 50cents per banana. b) (5 marks) What will be the effect of introducing the possibility of buying bananas from international suppliers on: i) The equilibrium price of bananas in Australia? ii) The total quantity of bananas supplied by Australian suppliers? iii) The total hours of bananas demanded by Australian consumers? iv) The quantity of bananas imported? Price from which bananas can be bought on world markets is less than the Australian equilibrium price; hence the world price becomes the equilibrium price. P* = $0.50 Qty bought by Australian consumers = 9,000 (from QD = 12000-6000(0.5)) Qty supplied by Australian suppliers = 4,000 (from QS = 2000+4000(0.5)) Imports = 9,000 4,000 = 5,000 Now suppose that there is a cyclone that adversely affects supply of bananas by Australian suppliers. The supply becomes:

QS = -3,000 + 4000P c) (2 marks) In the case where there is no international trade, what will be the effect on the equilibrium price per kilogram of bananas and total kilograms of bananas traded? In the absence of international trade, then: QD = 12,000 6000P = -3,000 + 4,000P = QS P* = $1.50 Q* = 3,000 d) (3 marks) In the case where international trade is allowed (still at the price of 50 cents per kilogram of bananas) is there any effect on the equilibrium price of bananas? What about on the total quantity demanded by Australian consumers, and total quantity supplied by Australian suppliers? With international trade the equilibrium price will remain equal to the world price. P* = $0.50 Qty bought by Australian consumers = 9,000 Qty supplied by Australian suppliers = 0 (QS = -3,000+4,000(0.5)) Imports = 9,000-0 = 9,000 e) (3 marks) Will the effect of the cyclone on the well-being of Australian consumers be worse where there is international trade or no international trade? What about the effect on the overall well-being of society in Australia?

Price

Supply post-cyclone Supply pre-cyclone A B C

$1.50

$1

D E F wp G Demand

50c

Quantity

No International trade: Before cyclone A+B+C D+E+G A+B+C+D+E+G After cyclone A B+D A+B+D Change -B-C B-E-G -C-E-G

CS PS Total surplus

With international trade: Before cyclone A+B+C+D+E+F G A+B+C+D+E+F+G After cyclone A+B+C+D+E+F Zero A+B+C+D+E+F Change Zero -G -G

CS PS Total surplus

Hence the reduction in total surplus is larger with no international trade than with international trade (by the amount C+E).

Question C2 (20% of total marks) Part A (10 marks) Many Victorian private schools will raise their fees by more than four times the rate of inflation with principals claiming that a boost to government teacher salaries has forced independent schools to play catch-up [with their own teachers salaries]. The average fee increase at private schools was about 5 per cent, compared to 8 per cent last year, with the impact of the economic downturn tempering fee rises. Teacher pay blamed for private school fees hike, The Age, January 7 2010, page 3. Use the model of a profit-maximising firm with market power to explain why private schools would want to increase school fees in response to an increase in teacher salaries. Teacher salaries should be considered a cost to private schools of supplying education. School fees are the price that a private school charges for supplying education. Hence this question is asking how an increase in costs affects the price that a profit-maximising firm with market power will set. Suppose that we consider teacher salary costs as a variable cost The idea here is that teaching extra students requires extra labour time from teachers. An increase in teacher salaries will therefore cause increases in VC, SRMC and SRTC. The effect on the profit-maximising price of the change in SRMC and SRATC can then be represented as:

SRMC2 SRMC1 SRATC2 SRATC1

qty

$ SRMC2 P*2 P*1 SRMC1

MR

qty Q*2 Q*1

The profit-maximising quantity is determined at the intersection of the SRMC and MR curves, and then the profit-maximising price is found by reading up to the demand curve at that quantity. Because SRMC shifts up, the intersection of the new SRMC curve with the MR curve will be at a higher point on the MR curve than the intersection of the old SRMC with the MR curve. Hence the profit-maximising quantity supplied will decrease, and, from reading up to the demand curve, the profit-maximising price increases. Hence this demonstrates how an increase in teacher salaries would cause a profit-maximising school to increase its price. [Note: To get full marks it is not necessary to go into this amount of detail. It is enough to show that if SRMC is increased, then the profit-maximising price will increase. Of course, if a student was to make the argument that teacher salaries are a FC, then there would be no effect on SRMC, and hence no effect on the profit-maximising price This would be OK as an answer.] Part B (10 marks) Stanley has begun planning for selling hamburgers at the 2012 Grand Final. He thinks that there are two types of consumers, StKilda fans who are willing to pay $5 for a hamburger, and Collingwood fans who are willing to pay $3. The MC of making a hamburger is $2. At the same time, Theonie, who is planning to sell Pepsi and chips at the Grand Final, suggests to Stanley that they should form a partnership. Preferences of StKilda and Collingwood fans for these items are described in the table below. There are 200 StKilda fans and 50 Collingwood fans who are potential customers. Pepsi costs $1 for Theonie to obtain, and hot chips cost her $1 to make. StKilda fans Collingwood fans Hamburger $5 $3 Pepsi $3 $2 Hot chips $2 $3

a)(5 marks) Suppose Stanley and Theonie were to sell hamburgers, Pepsi and hot chips as separate items. What would be the profit maximising price to charge for each item? Hamburger: P = $5 => Profit = (200)(5-2) = $600. P = $3 => Profit = (250)(3-2) = $250. Hence prefer to choose $5. Pepsi: P = $3 => Profit = (200)(3-1) = $400. P = $2 => Profit = (250)(2-1) = $250. Hence prefer to choose $3. Hot chips: P = $3 => Profit = (50)(3-1) = $100. P = $2 => Profit = (250)(2-1) = $250. Hence prefer to choose $2. b) (5 marks) Could Stanley and Theonie choose to bundle just two items and make higher profits? What explains this result? There are a couple of possible answers: Stanley and Theonie could bundle Hamburger and Hot chips. They can then set a price P = $6 => Profits = 250(6-3) = $750. Or they could set a price P = $7 => Profits = 200(7-3) = $800. Hence they would prefer to set P = $7, and can then earn $800. This is greater than the sum of the profits by selling Hamburgers and Hot chips separately. By bundling these two goods, Stanley and Theonie can reduce the heterogeneity in the customers valuations. Or Stanley and Theonie could bundle Pepsi and Hot chips. They can then set a price P = $5 => Profits = 250(5-2) = $750. This is greater than the sum of the profits by selling Pepsi and Hot chips separately. By bundling these two goods, Stanley and Theonie can reduce the heterogeneity in the customers valuations. Question C3 (15% of total marks) Part A (7 marks) To spruik or not to spruik, that is the questionThe spruikers of Carltons Little Italy have long been considered a blight by many Melburnians, and recently the restaurant owners who employ them have come to think they might have a pointSo on Tuesday afternoon the owners of eight Italian restaurants on the eastern side of Lygon streetmet to discuss what to do about a practice that is both a tradition and a millstone. The informal gathering decided unanimously to put an end to spruiking. But by yesterday afternoon, one restaurant, Sale e Pepe, was back on the street, selling its own merits. (Lygon street hustle dances on for now, Karl Quinn, The Age, June 3 2010, page 3). [Note: A spruiker is a person who stands outside a restaurant and advertises for customers.] Suppose that there are two restaurants in Lygon Street. On each day they operate they must each make a choice between Spruik or Not spruik. Neither restaurant observes the choice made by the other restaurant prior to making its own choice.

a) (3 marks) Draw a game table showing this game including payoffs so that it is a strict dominant strategy for each restaurant to choose to Spruik. Restaurant 2 Spruik 5,5 0,10

Restaurant 1

Spruik Not spruik

Not spruik 10,0 8,8

[Note: The game table should have 2 players, each making a choice between Spruik and Not spruik. Obviously it is then OK to have any payoffs as long as they are chosen so that it is a strict DS to choose Spruik.] b) (2 marks) Suppose the restaurants planned to be in operation for two days. (So that they therefore need to play the game you have shown for part (a) twice.) Is it possible that this would lead to a different outcome on either day? If the restaurants are going to operate just for 2 days, playing this game on two occasions, then it will not result in a different outcome occurring on either day. On the second day it will just be like playing the game once (since there is no future), and therefore each restaurant will choose to Spruik. Then on the first day each restaurant will be able to predict that on the second day they will both always choose to Spruik. Hence there cannot be any credible threat to punish a player who cheats on an agreement to Not spruik on the first day. So both players will also choose to Not spruik on the first day. c) (2 marks) Suppose the restaurants think it is possible they will be operating indefinitely. Why might it be an equilibrium of the infinitely repeated version of this game that each restaurant would choose to Spruik on every day it operates? If the restaurants think it possible they will be operating indefinitely then they can think of there being a future in which each could punish the other for cheating on an agreement to choose Not spruik. For example, the restaurants could have an agreement to use a tit for tat strategy Each restaurant chooses Not spruik as long as the other restaurant chose Not spruik on the previous day; however if the other restaurant chose Spruik on the previous day, then the restaurant refuses to cooperate on every future day by always choosing Spruik. Now if a restaurant chooses Spruik is can gain a payoff of 2 on the current day (getting 10 rather than 8); but then will lose 3 on every future day (getting 5 instead of 8). So provided that each restaurant cares sufficiently about the future (and hence the punishment) it will stick to the agreement to Not spruik. Therefore, it is possible that the equilibrium will involve both restaurants choosing to Not spruik on every day. [For parts (b) and (c) I have gone into much more detail here than would be necessary to get full marks. To get full marks it is sufficient to just get right whether a different outcome would be possible, and one sentence of explanation.]

Part B (8 marks) In the Envelope game there are 2 players and 2 envelopes. One of the envelopes is marked player 1 and the other is marked player 2. At the beginning of the game, each envelope contains $1. The game has three stages. In the first stage player 1 must decide whether to Stop or Continue. If he chooses Stop then each player receives the money in their own envelope and the game stops. If he chooses Continue then the $1 is removed from his envelope, and $2 is added to player 2s envelope. In the second stage, player 2 must continue whether to Stop or Continue. If she chooses Stop then each player receives the money in their own envelope and the game stops. If she chooses Continue then $1 is removed from her envelope, and $2 is added to player 1s envelope. In the third stage, player 1 must again decide whether to Stop or Continue. If he chooses Stop then each player receives the money in their own envelope and the game stops. If he chooses Continue then $1 is removed from his envelope, and $2 is added to player 2s envelope. After this the game ends. a) (4 marks) Draw the game tree that represents the Envelope game.
1,1

stop 1

0,3 stop continue 2 2,2

continue 1

stop

continue

1,4

b) (4 marks) What is the rollback equilibrium of the game? RBE is:

1 stop 1,1 0,3 stop continue 2 2,2

continue 1

stop

continue 1,4

[Note: It is enough to get full marks to just draw the diagram once, and to indicate actions that are part of the RBE by drawing arrows in the game tree No need to write out the game tree a second time to answer part (b), or to write out all the actions.]