ECO2003F: Intermediate Microeconomics Examination

May 2009

TOTAL MARKS: 240

This exam comprises TWO sections and 16 pages.

SECTION A and B each count 50% of the examination mark.
SECTION A: MULTIPLE CHOICE
This section comprises 30 MULTIPLE CHOICE questions.

Please make sure you record your student number in pencil on your MCQ sheet.
Negative marking applies. Each question counts 4 marks. 1 mark will be deducted for each
wrong answer.
Selecting more than one answer for the same question incurs a 1 mark penalty too.
If you leave a question blank, you will not be penalised.
Only use pencil to fill in your MCQ sheet, and erase all unwanted marks thoroughly.
SECTION B: PROBLEM SET

Please answer each question of the problem set in a separate booklet

Note question 4 requires only one option A or B to be submitted.

TIME: 3 hours
The duration of this examination paper includes appropriate reading time.

Section A (120 marks):

ANSWER SECTION A ON THE MCQ SHEET USING PENCIL.
1. Bryan likes Pete Philly, a hip-hop artist, whose CDs (X) are only available on import, but whose
music can be downloaded in lower quality mp3 format (Z) for a price strictly above zero. For
Bryan:
A)
B)
C)

Pete Philly CD tracks and mp3s are perfect substitutes

Pete Philly CD tracks and mp3s are perfect complements
/
= / < 0

D)

E)

The own price elasticity of mp3 format tracks is

>0

2. Consider the graphs below.

In relation to the two scenarios shown in A) and B) above, which of the following statements apply:
(i)
(ii)
(iii)
(iv)
(v)
A)
B)
C)
D)
E)

Good X increases in price if the critical threshold, X is exceeded

Good X decreases in price if the critical threshold, X is exceeded
Assuming X is exceeded, the new price is applied to the entire consumption bundle in
scenario A
Assuming X is exceeded, the new price is applied to the entire consumption bundle in
scenario B
The price of Y changes beyond X in scenario A
(i) & (v) only
(i) & (iii) only
(ii) & (iii) only
(ii) & (iv)only
(iv) & (v) only

3. The solution to a Lagrangian optimisation problem yields the following demand equation for

Good X: = where m is income, p1 is the price of Good X and p2 is the price of Good Y.
1 2

Which of the following statements accord with the preceding demand equation?
(i)
(ii)
(iii)
(iv)
(v)
A)
B)
C)
D)
E)

X & Y are complements

X & Y are substitutes
The demand for Good X is unrelated to the demand for Good Y
X is a normal good
X is an inferior good
(i) & (iv) only
(ii) & (iv) only
(iii) & (v) only
(i) & (v) only
(iii) & (iv) only

4 . Which of the graphs below match the same type of good as Good X in the preceding question?

A)
B)
C)
D)
E)

Graph A
Graph B
Graph C
Graph D
None of the above

Consider the decomposition below for questions 5 & 6.

5. If the initial budget constraint is CL in the preceding decomposition, which of the following
statements apply
(i)
(ii)
(iii)
(iv)
(v)

The total change in demand for Y is the distance from F to E

The substitution effect reduces the demand for Y from D to F
The total change in demand for X is from H to I
The substitution effect reduces the demand for X from H to G
The income effect reduces the demand for X from I to G
A)
B)
C)
D)
E)

(i) & (iii) only

(i), (iii) & (iv)
(i), (iii) & (v)
(ii) & (iv) only
(ii), (iv) & (v)

6. The preceding graph shows

A) that good Y is an inferior good, X is a normal good and decomposes the total effect of a price
increase of good Y
B) that good Y is a Giffen good, X is a normal good and decomposes the total effect of a price
decrease of good Y
C) that good Y is an inferior good, X is a normal good and decomposes the total effect of a price
decrease of good Y
D) that good X is an inferior good, Y is a normal good and decomposes the total effect of a price
increase of good X
E) that good X is an inferior good, Y is a normal good and decomposes the total effect of a price
decrease of good X

7. If goods X & Y
(i)
(ii)
(iii)
(iv)
(v)

are perfect complements, they must be consumed in fixed proportions

are easily substitutable we expect a large income effect in response to price changes
are easily substitutable and x becomes more expensive than y, we expect a large substitution
effect
cost the same one would consume equal amounts of both
are salt and sugar, we would expect both the income effect and substitution effect to be
small if either of their prices changed
A)
B)
C)
D)
E)

(i) & (ii) only

(i) & (v) only
(ii) & (v) only
(i), (iii) & (v)
(iii), (iv) & (v)

8. Regarding Giffen and inferior goods, which of the following statements hold
(i)
(ii)
(iii)
(iv)
(v)

A)
B)
C)
D)
E)

With inferior goods if price increases the quantity demanded of that good increases
With Giffen goods if price increases the quantity demanded of that good increases
With both inferior goods and Giffen goods the income effect increases demand for that good
if the price rises
If a good is an inferior good but not a Giffen good the substitution effect is always smaller
than the income effect
If a good is an inferior good but not a Giffen good the substitution effect is always larger
than the income effect

(i), (ii) & (iii)

(ii) & (iii) only
(i) & (iv) only
(ii), (iii) & (iv)
(ii), (iii) & (v)

9. Which of the following statements are true?

(i)
(ii)
(iii)
(iv)
(v)
A)
B)
C)
D)
E)

It is possible that a consumer will pick the same market basket when faced with a choice
of a cash grant or a single product subsidy of equal value
Cash grants shift part of the budget line to the right but single product cash subsidies shift
the entire budget line to the right
A cash grant always allows the consumer fewer choices than a subsidized price of equal
value for one commodity
A cash grant always allows the consumer more choices than a subsidized price of equal
value for one commodity
The government should not provide cash grants because the consumption of food does not
rise as people make poor decisions about how they should spend unconditional grants

(i) & (iv) only

(ii) & (iv) only
(ii), (iii) & (v)
(i), (iii) & (v)
(i), (iv) & (v)

10. Which of the following statements apply in relation to the bias in typical CPI calculations?
(i)
(ii)
(iii)
(iv)
(v)
A)
B)
C)
D)
E)

CPI tends to overstate increases in the cost of living

CPI tends to understate increases in the cost of living
CPI bias arises because of the income effect
CPI bias arises as a result of a failure to account for the substitution effect
CPI bias is larger the more substitutable consumption items are

(i) & (iv) only

(ii) & (iii) only
(ii) & (iv) only
(i), (iv) & (v)
(ii), (iii) & (v)

11. Conspicuous consumption as an ability signal is

A)
B)
C)
D)
E)

Completely different to the prisoners dilemma

Stronger if the nature of positional goods causes everyone to consume more extravagantly
Likely to continue even if it is wasteful for all concerned
Characterized by lower levels of consumption
Directly proportional to the amount of other information available about the person.

12. The Lemons argument helps to explain why:

A) Physical depreciation is the only reason for the sharp price differential between new and used
cars
B) Physical depreciation is an insufficient reason for the sharp price differential between new and
used cars
C) Used cars fail to satisfy consumer demands for transportation
D) It is irrational to buy a new car
E) New and used cars sell for more than their intrinsic value would suggest
13. Toms utility function is given by U = M1/2. Tom has a choice: take R100 in cash or take a
gamble based on the flip of a (fair) coin. If Tom takes the gamble, the outcomes are as follows:
heads, he wins R225; tails, he wins R49. Tom will
(i)
(ii)
(iii)
(iv)
(v)
A)
B)
C)
D)
E)

Take the R100 in cash

Take the gamble
Be indifferent between the cash and the gamble
We cannot say as we do not know Toms initial value of M
Tom is risk averse and will never accept a gamble

(i) and (v)

(iv) only
(ii) only
(iii) only
(v) only

14. The Kahneman-Tversky value function is

A)
B)
C)
D)
E)

A conventional utility function

Much steeper in losses than gains
Much steeper in gains than in losses
Not defined over changes in wealth
C) and D) are both correct

15. Adverse selection is the process by which

(i) "Undesirable" members of a particular market are more likely to participate in exchange
(ii) "Undesirable" members of a particular market are less likely to participate in exchange
(iii) Adversaries communicate negative messages
(iv) Full-disclosure becomes impossible
A)
B)
C)
D)
E)

(i)
(ii), (iii) and (iv)
(iii) and (iv)
(iv)
(i) and (iv)

16. Suppose that at a firm's current level of production the marginal product of capital is equal to
10 units, while the marginal rate of technical substitution between capital and labour is 2. Given
this, the marginal product of labour must be
A)
B)
C)
D)
E)

5
20
0.2
0.05
cannot be determined

17. Which of the following production functions exhibits increasing returns to scale?
A)
B)
C)
D)
E)

Q = K1/2L1/2
Q = K1/2L2/3
Q = K1/4L1/3
Q = K/L
None of the above

18. Output for a simple production process is given by Q = 2KL, where K denotes capital, and L
denotes labour. The price of capital is R25 per unit and capital is fixed at 8 units in the short run.
The price of labour is R5 per unit. What is the variable cost of producing 80 units of output?
A)
B)
C)
D)
E)

R200
R33
R25
R40
None of the above

19. Joe is self-employed in a shop that has a rental value of R500 a month which he pays. His
other expenses are R100 a month for maintenance. He makes R25,000 a year on net sales (total
revenue minus the wholesale cost of the product). If he quit his job and worked the same number
of hours elsewhere at a job he liked equally well, he estimates that he could make R20,000 a year.
No one else can be hired to work in the store. Suppose that Joe had a long term lease which
requires him to pay the rent even if he doesn't operate the store. What should Joe do?
A)
B)
C)
D)
E)

Quit immediately and take the alternative job

Keep his current job until circumstances change
Keep his current job until the lease expires
He is indifferent between his current job and the alternative job
It is impossible to say with the information given in the problem

20. Suppose an island has 1000 adults living on it. All are of working age (16-64). 600 people are
working. 200 people actively searched for work in the last week. 100 would like to work, but have
given up hope of ever finding a job so no longer bother to search. Which of the following
statements is/are correct?
(i)
(ii)
(iii)
(iv)
A)
B)
C)
D)
E)

The narrow (ILO) unemployment rate is 25% and the narrow (ILO) labour force
participation rate is 80%
The narrow (ILO) unemployment rate is 25% and the narrow (ILO) labour force
participation rate is 89%
The narrow (ILO) unemployment rate is 20%
The broad/expanded unemployment rate is 30%

(i) and (iv) are correct

(iii) and (iv) are correct
Only (i) is correct
Only (ii) is correct
(ii) and (iv) are correct

21. The strategic or normal form representation of a game comprises:

(i)
(ii)
(iii)

A list of participants (the players)

A list of strategies for each player
A list of payoffs for each player, associated with each strategy profile (i.e. each combination
of strategies of each player)

Which of the following combinations is true?

A) Only (i) is correct
B) Only (i) and (ii) are correct
C) Only (i) and (iii) are correct
D) (i), (ii) and (iii) are correct
E) Only (ii) and (iii) are correct

22. The prediction that a player (say, player 1 in a two-player game) will not choose a strictly
dominated strategy requires that:
A)
B)
C)
D)
E)

Player 1 is rational
Both players are rational
Player 1 is irrational
Both players are rational and each players knows the other is rational
Both players are rational; each players knows the other is rational; and each player knows that
the other knows that he/she is rational

23. Nash equilibrium as prediction of choices requires in a two-player game requires that:
A)
B)
C)
D)
E)

Player 1 is rational
Both players are rational
Player 1 is irrational
Both players are rational and each players knows the other is rational
Both players are rational; each players knows the other is rational; and each player knows that
the other knows that he/she is rational, etc i.e. rationality and common knowledge of
rationality

24. In an Edgeworth box of the production sector, the contract curve in the interior of the box
shows:
A) Where marginal rates of technical substitution of the two producers are equal
B) The fair allocation of output
C) The unique allocation of output that is best for the economy
D) The initial endowment of inputs in the economy
E) The allocation where producers outputs are equal
25. In a two-person, two-good economy, mutual beneficial exchange will occur so long as:
A) the initial allocation of goods results in an uneven division of the two goods between the two
consumers
B) one person can be made off better than before
C) the two consumers are free to trade
D) one consumer has the total amount of one good and the other consumer has the total amount
of the second good
E) the marginal rates of substitution are not the same for both consumers
26. Use the following diagram of an Edgeworth exchange box to answer the following question:
OB

ICA

X
Apples

ICB

Y
V
Z

OA

Hot-Dogs

Which of the following are Pareto improving equilibrium positions given initial allocations Z?
A)
B)
C)
D)
E)

Any point on part OAV of the contract curve

any point on part VY of the contract curve
any point on entire contract curve OAOB
any point on part OBY of the contract curve
any point within the area enclosed by VXYZ

27. The diagram below presents a production possibility frontier, various relative price curves and
various community indifference curves for an open economy. Use the diagram to answer the
following question:
Cars
E
B
C
A

Cloth

Assume initial equilibrium is given by point A. Assume there is an increase in world demand for
cloth. The new consumer equilibrium is given by:
A)
B)
C)
D)
E)

A
B
C
D
E

28. Use the following diagram to answer the following question:

Px/Py=5

Y
A

B
IC

An economy finds itself at point A where the relative price (Px/Py) equals 5, the Marginal rate of
Transformation (slope of the Production possibility frontier) equals 1 and consumer equilibrium is
at B. Which of the following are correct?
(i)
The opportunity cost of producing X at A is lower than the relative price of X
(ii)
Production of X will decrease and production of Y will increase
(iii) At given relative prices (Px/Py = 5) and production at A, consumers will consume more
X and less Y
(iv) Production of X will increase and production of Y will decrease

A)
B)
C)
D)
E)

(i), (ii) and (iii)

(i), (iii) and (iv)
(iii) and (iv)
(i) and (iv)
(ii) and (iv)

Use the table below to answer questions 29 & 30:

Table: Ricardian production conditions in Country A and Country B
Countries

Wine

Cloth

Country A

1hr/bottle

2hr/metre

Country B

6hr/bottle

3hr/metre

29. The price of wine (Pw) relative to the price of cloth (Pc) in autarky is:
A)
B)
C)
D)
E)

Pw / Pc = in country A
Pw / Pc = 1 in country A
Pw / Pc = 1/6 in country A and B
Pw / Pc = 2/3 in country A and B
Pw / Pc = 1/2 in country B.

30. Which country has comparative advantage in which product?

A) Country A has a comparative advantage in cloth while Country B has a comparative
advantage in wine
B) Country A has a comparative advantage in wine while Country B has a comparative
advantage in cloth
C) Country A has a comparative advantage in both wine and cloth
D) Country B has a comparative advantage in both wine and cloth
E) Both countries have a comparative advantage in both goods

Section B. Long questions (120 marks).

REMINDER ~ please answer each question in a separate answer book and ensure that you write
the question number on the cover.
Question 1 (40 marks)
This question is comprised of parts A), B) and C). Parts A) and B) each compare two policy options
for a government looking to intervene in the education market.
Policies (i) & (ii) are each shown separately in the bottom panels, whereas A) & B) (top panels)
show the effects of policies (i) & (ii) superimposed on one another.
In both A) & B):
S1 shows the level of schooling prior to government intervention in the education market.
The price of the mandated amount of government education is pe
When asked to describe the type of policy being employed be sure to comment on how and why the
price of education changes, and the amount of education consumed as a result.
Part A

(i) Please describe the type of policy (oppq) being employed in (i)
(5 marks)
(ii) Please describe the type of policy (opr) being employed in (ii)
(5 marks)
(iii) Please relate the final consumption of education in (i) to (ii). Do you always expect to see
this pattern? How does the level of funding and individual preferences matter?
(10 marks)

Part B

(i) Please describe the type of policy being employed in (i) (uvvw)
(ii) Please describe the type of policy being employed in (ii) (uvw)

(4 marks)
(4 marks)

Part C
Please note (i)-(iv) require concise (one or two line) answers!
(i)
(ii)
(iii)
(iv)

If you consider both A) & B) to how would the size of voucher/fixed quantity subsidy/tax
rebate on educational expenditure affect the amount of schooling obtained?
(3 marks)
According to Hoxby, which conditions are necessary if a school choice programme is to
produce general improvements in educational quality?
(3 marks)
Why does the difference between transferable vouchers and forfeitable fixed-quantity
subsidies/rebates arise?
(4 marks)
Do transferable vouchers paid to students always result in the same or more education
being consumed than the provision of fixed quantity subsidies paid to schools? (2 marks)

Question 2 (40 marks).

Part A
The total cost function is TC = 10Q3- 50Q2+ 1000Q + 500.
(i) When does diminishing returns to production set in?

(5 marks)

(ii) At what output is AVC = MC?

(3 marks)

(iii) At what output does ATC reach its minimum?

(5 marks)

(iv) Explain in words why the AVC reaches its minimum before the ATC reaches its minimum.
(2 marks)
Part B
Sketch a perfectly competitive firm operating in short-run equilibrium but making economic
losses. Put in all the functions necessary to show that the firm should stay in business in the shortrun despite the losses. Shade in the area of loss.
(12 marks)
Part C
(i)
(ii)
(iii)

Explain what is meant by the term reservation wage.

(3 marks)
Explain how changing levels of education may affect the reservation wage in South Africa.
(4 marks)
Discuss the affect of social assistance grants on the reservation wage in South Africa.
(6 marks)

Question 3 (20 marks)

Assume Home is a two-good (Cloth and Machinery), two-factor (Capital and Labour) economy
characterised by constant returns to scale production technology, perfect competition and identical
consumers. Home has a comparative advantage in the production of Machinery.

(i)

Briefly discuss the consumption, production and product mix conditions required for the
economy to be in general equilibrium under free trade.
(10 marks)

(ii) Use the production possibility frontier diagram to show the effect on production,
consumption, trade flows and national welfare in the Home country if Foreign country
growth is biased towards machinery.
(10 marks)

Question 4 (20 marks)

ANSWER ONE OF THE FOLLOWING TWO QUESTIONS (4A OR 4B)
QUESTION 4 A (20 marks; 4 marks each)
(i) In the following game, find the only profile that survives the iterated elimination of strictly
dominated strategies.

L
A (4,6)
B (5,1)
C (6,0)

R
(5,2)
(8,3)
(6,3)

(ii) Find the unique Nash equilibrium of the following game:

A (1,10) (5,3)
B (2,7) (8,6)
(iii) Indicate whether the statement is true or false; and very briefly (one concise sentence,
maximum) explain why, or why not. In the basic Bertrand model (of price competition)
with an homogeneous good and no capacity constraints, the unique Nash equilibrium has
each firm setting price equal to marginal cost even if there are only two firms in the
market.
(iii) Indicate whether the following statement is true or false; and very briefly (one concise
sentence, maximum) explain why, or why not: An action (or strategy) ai is a best response for
player i to her opponents strategies a i if ui (ai , ai ) ui (ai ' , ai ) for all ai ' in Ai .

OR
QUESTION 4B (20 marks; 4 marks each)
Suppose the demand function faced by firm 1, in a two-firm industry, is given by
q1 160 2 p1 p2 . Its marginal cost is constant, and equal to 4.
(i) Write the firms profit function.
(ii) Write the marginal profit function for firm 1
(iii)Show that pricing decisions are strategic complements
(iv) Is the strategic effect of commitment positive or negative in this case? Comment.