Erasmus University Rotterdam International Program in Business Administration BAP 68 - MICROECONOMICS AND MARKETS Final Exam, Version 1 March

2009

Instructions: Check right now that you have got 50 questions in this exam. Of these, the last 16 questions are clustered in 4 groups, each one containing 4 questions that refer to a single problem. Read the questions carefully and provide your answers by filling in the answer form. The answer you provide should make the statement true, unless otherwise indicated. As a general rule, and unless stated otherwise in the question, Q refers to quantity, P refers to price, M to income, C to total cost, K refers to capital, L to labor, w is the cost of a unit of labor, r is the cost of a unit of capital. Graphical calculators are not allowed. All 50 questions carry equal weight. The answer key of the exam will be published on BlackBoard shortly after the exam. Good luck! 1. Consider two firms (A and B) competing to sell a homogeneous product by setting price. If firms charge the same price then they share the market equally. The inverse demand curve is given by P = 6 Q, where Q is the total quantity. Each firms' cost function is C(Qi)= 6 + 2Qi, i=A,B. How many units of output will each firm produce, and how much profit will each firm make? a) b) c) d) 4 units; profits of $6 2 units; profits of $2 4 units; losses of $2 2 units; losses of $6

Key: Bertrand, so P=MC. MC = 2 => P = 2, so market demand is Q = 4, and firms produce 2 units each. Profits of each firm = TR(2)-TC(2) = 2*2-(6+2*2) = -6 2. Consider two firms competing in a Cournot Duopoly. An increase in firm 2's marginal cost will cause: a) A downward shift in firm 1's reaction function resulting in a new Cournot equilibrium where firm 1 is producing a lower quantity and firm 2 is producing a higher quantity An upward shift in firm 1's reaction function resulting in a new Cournot equilibrium where firm 1 is producing a higher quantity and firm 2 is producing a lower quantity A downward shift is firm 2's reaction function resulting in a new Cournot equilibrium where firm 1 is producing a higher quantity and firm 2 is producing a lower quantity An upward shift in firm 2's reaction function resulting in a new Cournot equilibrium where firm 1 is producing a lower quantity and firm 2 is producing a higher quantity

b)

c)

d)

Key: An increase in the MC of firm implies that for any fixed output of firm 1, firm 2 wants to supply less output. So firm 2s reaction function shifts downward. Firm 1 produces more and firm 2 less.

3. Consider the following entry game. Firm B is an existing firm in the market, and firm A is a potential entrant. Firm A must decide whether to enter the market (play "enter") or stay out of the market (play "not enter"). If firm A decides to enter the market, firm B must decide whether to engage in a price war (play "hard"), or not (play "soft"). By playing "hard", firm B ensures that firm A makes a loss of $1 million, but firm B only makes $1 million in profits. On the other hand, if firm B plays "soft", the new entrant takes half of the market, and each firm earns profits of $5 million. If firm A stays out, it earns zero while firm B earns $10 million. Which of the following are subgame perfect equilibrium strategies? a) b) c) d) (Enter, soft) (Not enter, soft) (Enter, hard) Not enter, hard)

Key: This is a version of the entry deterrence game. The only Nash equilibrium which does not involve use of non credible threats is (Enter, soft). 4. Which of the following is true? a) b) c) d) A Nash equilibrium is always a subgame perfect equilibrium A subgame perfect equilibrium is always a Nash Equilibrium A Nash equilibrium is always subgame perfect in a game with sequential moves Subgame perfect equilibrium and Nash equilibrium are the same concept but with different names

Key: Subgame perfection rules out non credible threats 5. Jane prefers Snickers to Mars Bars, Mars Bars to Milkyway, and Milkyway to Snickers. Which property about preferences does Janes preference violate? a) b) c) d) Completeness More-is-Better Diminishing Marginal Rate of Substitution Transitivity

Key: By transitivity Snickers should be preferred to Milkyway 6. The value of the firm is the: a) b) c) d) Current value of profits Present discounted value of all future profits Average value of all future profits Total value of all future profits

Key: Definition

7. Trade will take place: a) b) c) d) If the maximum that a consumer is willing and able to pay is less than the minimum price the producer is willing and able to accept for a good If the maximum that a consumer is willing and able to pay is greater than the minimum price the producer is willing and able to accept for a good Only if the maximum that a consumer is willing and able to pay is equal to the minimum price the producer is willing and able to accept for a good None of the above

Key: Whenever the consumers valuation is greater than the producers cost of providing the good, both have the correct incentives to trade the good.
d

8. Suppose the demand for good X is given by Q = 10 + P + P + M. From

X X X Y Y M

the law of demand we know that will be:

X

a) b) c) d)

Less than zero Greater than zero Zero None of the above

Key: By the law of demand as the own-price increases the smaller the quantity demanded

9. For a steel factory, a decrease in the cost of electricity to the plant will cause the supply curve to: a) b) c) d) Become flatter Shift to the left Shift to the right Become parallel to the price axis

Key: For a steel company electricity is a variable cost. Since the marginal cost of production has gone down, at any given price the firm is now willing to supply a larger quantity.
d S

10. Suppose market demand and supply are given by Q = 100 - 2P and Q = 5 + 3P. The equilibrium price is: a) b) c) d) $15 $17 $19 $20
d S

Key: Setting Q = Q => P =19

11. If steak is a normal good, what do you suppose would happen to price and quantity during an economic recession? a) b) c) d) Price would increase and quantity decrease Price and quantity would both increase Price and quantity would both decrease Price would decrease and quantity increase

Key: Income is a demand shifter. Demand would shift down, and at new equilibrium trade would take place at a lower price and quantity.

12. Consider the following game with simultaneous moves: Firm 2 L T Firm 1 B 6, 2 8, 6 10, 6 3, 13 M 4, 10 R 7,5

Which strategy profiles remain after iterative elimination of strictly dominated strategies? a) b) c) d) (B, L), (B, M), (B, R) (B, M), (B, R) (B, R) none of the above

Key: For Firm 1 B strictly dominates T. After eliminating T, L is now strictly dominated (actually by both M and R) for firm 2.

13. Consider a market characterized by the following inverse demand and supply functions: P = 10 - 2Q and P = 2 + 2Q. Compute the surplus received in equilibrium by consumers and producers respectively: a) b) c) d) consumer surplus = 24, producer surplus = 24 consumer surplus = 4, producer surplus = 4 consumer surplus = 2, producer surplus = 6 consumer surplus = 6, producer surplus = 2

Key: Setting supply equal to demand: 10 2q = 2+2q => q = 2 => P = 6. CS is area under demand above price: CS = (10-6)*2*1/2 = 4. PS is area above supply below price: PS = (6-2)*2*1/2 = 4.

14. An own-price elasticity of zero corresponds to a demand curve that is: a) b) c) d) Horizontal Downward sloping with a slope always equal to 1 Vertical Either vertical or horizontal

Key: Own-price elasticity: (dQ/Q)/(dP/P) = 0 => Quantity demanded independent of price.

15. You are the manager of a popular shoe company. You know that the advertising elasticity of demand for your product is 0.15. How much will you have to increase advertising in order to increase demand by 10%? a) b) c) d) 0.02% 38.6% 66.7% 4.3%

Key: (dQ/Q)/(dA/A) = .15, to get 10% increase: .1/(dA/A) = .15

d 0.5 X 0.25 0.12

16. Suppose the demand function for a good X is given by Q = 8P

X

The demand for good X is: a) b) c) d) Inelastic Unitary elastic Elastic Perfectly elastic
d

Key: Taking logs own price elasticity is coefficient in front of PX : ln(Q )= ln(8) +.5
X

ln(P )+ ...
X

17. Under a buy-one, get-one free offer, compared to a situation where no such offer is in place, the a) b) c) d) Budget line rotates counter-clockwise Price is reduced by 50% Budget set expands Indifference curves change

Key: After first unit budget set expands by an additional unit of the good.

18. Suppose a worker is offered a wage of $8 per hour, plus a fixed payment of $100 per day, and he can use 24 hours per day. What is the equation for the worker's opportunity set? (E is total earnings and L is leisure) a) E = 100 - 8L b) E = 192 - 8L c) E = 292 - 8L d) none of the above Key: E = 100 + 8(24-L)

19. Consider a two good world, with commodities X and Y. If Y is an inferior good, then an increase in consumer income cannot a) b) c) d) Decrease the demand for Y Decrease the demand for X Increase the demand for X Make the consumer better off

Key: Both goods cannot be inferior, so X must be normal, and therefore as income increases demand increases.

20. If a firm's production function is Leontief and the wage rate goes up the a) b) c) d) Firm uses more labor in order to minimize the cost of producing a given level of output Firm uses more capital in order to minimize the cost of producing a given level of output Firm uses less labor in order to minimize the cost of producing a given level of output Cost minimizing combination of capital and labor does not change for a given level of output

Key: If Production is Leontief there is no substitution between inputs.

.6 .4

21. The production function is Q = K L . The marginal rate of technical substitution is:
-1

a) b) c) d)

2/3 K L
-1 -1 -1

K L 2/3 K L
.4 -.6

K L

Key: MRTS = MPL/MPK = 2/3 K/L

22. For the cost function C(Q) = 1000 + 14Q + 9Q + 3Q , what is the marginal cost of producing the fourth unit of output? a) b) c) d) $42 $295 $230 $116
2

Key: MC(Q) = dC(Q)/dQ = 14 + 18Q + 9Q . MC(4) = 14 + 18*4 + 9*42

.5 .5

23. The production function is Q = 5K L . The cost of a unit of labor is w=20 and the cost of a unit of capital is r=50. The input combination compatible with cost minimization is: a) b) c) d) 4 units of labor and 16 units of capital 10 units of labor and 4 units of capital 10 units of labor and 10 units of capital 12 units of labor and 30 units of capital

Key: MRTS = MPL/MPK = w/r => K/L = 20/50, so cost minimization requires: 50K = 20L 24. You are the manager of a monopoly that faces a demand curve described by P = 230 - 20Q. Your costs are C(Q) = 5 + 30Q. Your firm's maximum profits are: a) b) c) d) 495 475 480 415

Key: Setting MC = MR => 30 = 230 40Q => Q* = 5. Inserting in demand function => P* =130. Profits = TR TC = 650 155.

25. A monopolist faces a demand curve described by P = 230 - 20Q. Total costs are C(Q) = 5 + 30Q. When the monopolist sets the optimal monopoly price, the size of the deadweight loss is: a) b) c) d) 30 130 250 none of the above

Key: From above we know that P* =130, Q*=5. Since MC is constant at 30 we can determine DWL once we know the perfectly competitive supply. Setting P = MC in demand gives: Q(perfect comp) = 10. DWL = *5*100

26. In the long-run, monopolistically competitive firms: a) b) c) d) Charge prices equal to marginal cost Have excess capacity Produce at the minimum of average total cost Have excess capacity and produce at the minimum of average total cost

Key: In the long run firm will produce where AC touches demand curve. Since a monopolistically competitive firm has a downward sloping demand this occurs before minimum average total cost.

27. Suppose that initially the price is $50 in a perfectly competitive market. At this price firms are making zero economic profits. Then the market demand shrinks permanently and some firms leave the industry and the industry returns back to a long-run equilibrium. What will be the new equilibrium price, assuming cost conditions in the industry remain constant? a) b) c) d) $50 $45 Lower than $50 but exact value cannot be known without more information Not sufficient information to determine

Key: Technology is fixed so in the new equilibrium firms will continue to produce at minimum AC = 50.

28. You are a manager in a perfectly competitive market. The price in your market is
2

$14. Your total cost curve is C(Q) = 10 + 4Q + 0.5Q . What will happen in the longrun if there is no change in demand? a) b) c) d) Some firms will eventually exit the market Some firms will eventually enter the market There will be neither entry nor exit none of the above
.5

Key: In the long run price equals min LAC, which is at least as small as short run min ATC. ATC = 10/Q + 4 + .5Q, and min ATC => d(ATC(Q))/dQ = 0 => Q = 20 =>
.5

ATC (Q = 20 ) < P = 14, so firms are earning excess profits and entry will occur.

29. Suppose a perfectly competitive market is characterized by the following inverse demand and inverse supply functions: P = 100 - 5Q and P = 10 + 5Q. Then, the demand curve facing an individual firm operating in this market is a) b) c) d) P = 100 - 5Q A horizontal line at $9 A horizontal line at $55 P/N = (100 - 5Q)/N, where N is the total number of firms in the competitive market

Key: Under perfect competition firm cannot affect price. Thus firms demand is perfectly elastic at the equilibrium price. Setting supply equal to demand gives Q=9, inserting yields P = 100 5*9 = 55.

30. Suppose a monopolist knows the own-price elasticity of demand for its product is -3 and that its marginal cost of production is constant MC(Q) = 10. To maximize its profit, the monopolist should set price equal to: a) b) c) d) $6.67 per unit $10 per unit $15 per unit $30 per unit

Key: Optimal Markup for Monopolist: P = MC*(elast/(1+elast)) = 10*(-3/(1+-3)) 31. Suppose that KPNWireless (a telephone company) has hired you as a consultant to determine what price it should set for calling services. Suppose that an individuals' inverse demand for wireless services in the Randstad area is estimated to be P = 100 33Q and the marginal cost of providing wireless services to the area is $1 per minute. What is the optimal two-part price that you would suggest to KPN? a) b) c) d) Charge a fixed fee = $95.5 and a usage fee of $1 per minute Charge a fixed fee = $3 and a usage fee of $0.33 per minute Charge a fixed fee = $148.50 and a usage fee of $1 per minute Charge a fixed fee = $3 and a usage fee of $3 per minute

Key: Optimal Two part pricing: Set P = MC, and charge fee equal to consumer surplus when P = MC. P = MC = 1. At P = 1, 3 units are demanded => fee = *(1001)*3

32. A risk neutral apple farmer, named Joe, must decide how many apples to harvest for the world apple market. He knows that there is a one-third probability that the world price will be $1, a one-third probability that it will be $1.5, and a one-third
2

probability that it will be $2. His cost function is C(Q) = .01Q . The expected profit maximizing quantity is: a) b) c) d) 0 75 90 150

Key: Expected price = 1/3*1 + 1/3*1.5 + 1/3*2 = 3/2. Since Joe is risk neutral and he cannot affect world market prices he sets expected price = MC: 3/2 = .02Q. 33. The optimal strategy for a risk neutral bidder in a second-price, sealed-bid auction with independent private values is to bid a) b) c) d) Slightly less than his or her valuation Slightly higher than his or her valuation His or her true valuation none of the above

Key: Bidding less than valuation, risk not winning the object, but same price since second price. Bidding more than valuation, risk winning the object and paying more than own valuation

34. Suppose that sellers value a good quality car at $10,500 and a bad quality car at $5,500. Quality is not observed by the buyers. 60 percent of the cars are good. What is the highest price that a risk-neutral buyer will offer for a used car if she ignores adverse selection? a) b) c) d) $8,000 $5,500 $10,500 $8,500

Key: Buyer is risk neutral so willing to pay expected value of car. Expected value = .6*10,500 + .4*5,500.

Problem 1 (A Pricing Game): Refer to the following game for questions 35-38: Firm 2 C A Firm 1 B 100, 500-y 50, 50 50, 50 D 500-x, 200

35. For which value(s) of y is strategy D strictly dominant for Firm 2? a) b) c) d) y > 450 y < 450 y = 450 y < 50

Key: Strict dominance requires: 200 > 50 and 50 > 500 y. 36. For which value(s) of x is strategy A strictly dominant for Firm 1? a) b) c) d) x > 450 x < 450 x = 450 none of the above

Key: Strict dominance of A requires: 50 > 100 and 500-x > 50. Cant be satisfied. 37. For which value(s) of x and y is strategy (B, D) the only Nash equilibrium of the game? a) b) c) d) x > 450 and y < 450 x < 450 and y > 450 x > 450 and y > 450 none of the above

Key: If (B,D) is Nash then B must be Best response to D for Firm 1 and D must be Best response to B for Firm 2. Firm 1: B BR D requires: 50 500 - x => x 450 Firm 2: D BR B requires: 50 500 - y => y 450 Now check at x = 450 and y = 450 to see if only Nash. At x = 450 and y = 450 also (B,C) and (A,D) are Nash equilibria. So to make (B,D) unique Nash we require that x > 450 (rules out (A,D) as Nash) and y > 450 (rules out (B,C) as Nash).

38. Set x=500 and y =300. Suppose the game is repeated 2 times. In any subgame perfect equilibrium of the game in every period the following outcome occurs: a) b) c) d) (B, D) (B, C) (A, D) answer depends on the discount factor

Key: At x = 500, y = 300, B strictly dominates A for firm 1, so we can eliminate A. Given that 1 plays B and y = 300, C is strictly dominant for firm 2. Implication: (B,C) is unique Nash equilibrium. Game is repeated 2 times, so finite repeated game. Using backwards induction in period 2 players must play (B,C) independent of history. Therefore in period 1 play will also be (B,C).

Problem 2 (Stackelberg Duopoly): For questions 39-42 consider a Stackelberg duopoly. Firm L is the leader and firm F is the follower. The inverse demand function is given by: P = 100 2(QL + QF). Firms have identical marginal cost given by MCi(Qi) = 2, i=L,F. 39. The Stackelberg followers marginal revenue function is given by: a) b) c) d) MRF(QL,QF) = 100 - 2QL - 4QF MRF(QL,QF) = 100 - 4QL - 2QF MRF(QL,QF) = 100 - 2QL - QF MRF(QL,QF) = 100 - QL - 2QF

Key: TR follower = (100 2(QL + QF))QF, MR = d(TR)/dQF 40. The Stackelberg follower's (F) reaction function is given by: a) b) c) d) QF = 24.5 - 0.25QL QF = 49 - 0.25QF QF = 24.5 - 0.5QL QF = 24.5 - QL

Key: Setting MR follower = MC follower yields BR: 100 - 2QL - 4QF = 2, solving yields QL = 98/4 2/4QL 41. The Stackelberg leader's (L) reaction function is given by: a) b) c) d) QL = 24.5 - 0.5QF QL = 50 - 0.5QF QL = 49 - 0.5QF none of the above

Key: The leader does not have a reaction function since she is the first to set quantity. 42. The profits that firms L and F earn in equilibrium is given by: a) b) c) d) (Profit L, Profit F) = (450.5, 225.25) (Profit L, Profit F) = (600.25, 300.125) (Profit L, Profit F) = (230.25, 100.5) (Profit L, Profit F) = (200.75, 325.375)

Key: Profit of L: TR TC = (100 2(QL + QF))QL 2QL. Substituting followers reaction function: Profit L = (100 2(QL + 49/2-1/2QL))QL 2QL and taking FOC yields: QL = 49/2. Inserting into followers reaction function: QF = 49/4. Market price is then given by: 53/2. Using equilibrium price and quantity yields result.

Problem 3 (Perfect Competition): For questions 43-46 consider the perfectly competitive market for microchips. Twenty (20) firms are currently operating in this market. The market demand (in thousands of microchips) is given by: P = 3000 25Q, where Q = q1 + q2 + + q20 is the total quantity supplied by all firms operating in the market. All firms have identical production technologies, summarized by the following equation for average total cost: ATC(qi) = 100 + 25qi + 100/qi 43. Firm is supply curve is given by: a) b) c) d) P = 400+5qi P = 100+50qi P = 25qi none of the above

Key: Under perfect competition supply of a firm MC-curve above AVC. TC = 100q +25q2 + 100, So AVC = 100 + 25q, and MC = 100 + 50q. Since MC > AVC for every q, supply is given by: P = MC = 100 + 50q 44. The market supply curve when the twenty identical firms are operating in the market is given by: a) b) c) d) P = 100+2.5Q P = 20+.25Q P = 25Q P = 100-3Q

Key: To get market supply from individual supply sum total firm supply for every price. Individual supply: qi = P/50 2, so total supply: Q = 20*(P/50 2) = 2/5P 40. Rewriting: Q = 2/5P 40 => P = 100 + (5/2)Q Suppose that in the long run the average cost for firm i is also characterised by AC(qi) = 100 + 25qi + 100/qi. All firms are identical. 45. In the long run a firm operating in the market produces: a) b) c) d) 0 units of output (in thousands) 1 unit of output (in thousands) 2 units of output (in thousands) 4 units of output (in thousands)

Key: In the long run P = min ATC = min AC. d(AC)/dq = 25 100/q2 = 0 => q2 = 4 => q =2

46. In long run equilibrium the number of firms active in the market is given by: a) b) c) d) 33 firms 56 firms 66 firms none of the above

Key: We know in the long run P = min AC. Substituting q = 2 in average cost function yields: ATC(q=2) = 100 + 25*2 + 100/2 = 200 = P. At P = 200 quantity demand is equal to: 200 = 3000 25Q => Q = 2800/25 = 112 units. Since each firm produces 2 units in the long run industry accommodates 112/2 = 56 firms.

Problem 4 (Bundling): Use the following information to answer questions 47-50. Three different types of consumers want to buy a new car. Each type has the following valuations for dealer options:

The total population of consumers is 1,000 (one thousand). Consumer One types make up 40% of the population, Consumer Two types and Three types each make up 30% of the population. 47. By setting a separate price optimally for an Air Conditioner how much profit can the dealer make? a) b) c) d) 400,000 560,000 600,000 620,000

Key: When setting a price of 800 the dealer sells to segments One (40%) and Two (30%). Earnings are 560,000. 48. The optimal separate price for Power Brakes is: a) b) c) d) 250 300 500 800

Key: By setting a price of 500 the dealer sells to segments One and Three. Earnings are 350,000. 49. The maximum total profit when charging separate prices is given by: a) b) c) d) 720,000 910,000 1,040,000 none of the above

Key: Summing up from above: 560,000 + 350,000 = 910,000.

50. When the dealer offers only the optimal bundle, she: a) b) c) d) makes higher profit than when she offers two separate prices makes less profit than when she offers two separate prices makes the same profit under bundling as under separate pricing not sufficient enough information provided

Key: Consumer valuations for the bundles: 1500, 1100 and 900. If selling at 900 she makes 900,000. If setting at 1100 she makes 770,000. If selling at 1500 she makes 600,000. So optimal bundle is to sell to all segments at 900. Making profits of 900,000 which is less than the 910,000 from separate pricing.