ECO2003F: Intermediate Microeconomics

Supplementary Examination
January 2010
TIME: 3 hours
TOTAL MARKS: 235

This exam comprises FOUR sections and 8 pages.

Please answer each section in a separate booklet.

Section A (80 marks)

1. Mr. Mouse has a utility function described as U ( x, y ) = x1 / 4 y 3 / 4 , with prices
associated with goods

and

and

respectively, with a total monthly income of m.

a. Find the optimal quantities of

and .

[25 marks]
b. If the price of is 10, the price of is 7, and Mr. Mouses total income is R350, what
is the level of utility associated with his optimal consumption bundle?
[5 marks]
c. What type of good is ? Why?
[5 marks]
2. Please explain the Hicks Decomposition below (you are not required to reproduce this
diagram), being sure to note the direction and sizes of the income, substitution and total
effects as well as the direction of the price change.

[15 marks]

3. Schooling
The South African government is considering two possible interventions in the education market in
South Africa. Prior to any policy being proposed, schooling is initially at s1, and the two proposals
under consideration are outlined below. For the representative individual, (i) illustrates the
impact of option 1, and (ii) the impact of option 2 on schooling.
Option 1 allows you an amount (s2) of free schooling tenable at public schools
Option 2 provides you with schooling free up to an amount s2 which can be redeemed at any school.
The first panel shows you the effects of each policy superimposed on one another, while the bottom
panel illustrates the effect of each policy separately.

a. Describe the type of policy being employed and optimal schooling in (i)
b. Describe the type of policy being employed and optimal schooling in (ii)

[5 marks]
[5 marks]
c. Please relate the final consumption of education in (i) to (ii). Why might the observed
difference in optimal schooling differ between the policies? Do you expect to see this
pattern for all individuals? How do the level of funding and individual preferences
matter?
[20 marks]
3

Section B (75 marks) Show all your workings.

1. Your utility function is M . Your current level of wealth is R400 000. There is a 0.0001
probability that your legal liability in a car accident would reduce your wealth to R0. What
is the most that you would be willing to pay for insurance to cover this risk?
[10 marks]
2. Ingrid spends all her income on 2 goods, X and Y. The prices she paid and the quantities she
consumed last year are as follows: PX = 10, X=50, PY = 20 and Y=25. This year, PX and PY
are both 10. This year her income is R750. Assuming that her tastes have not changed, in
which year was she better off? Use a graphical representation to explain your answer.
[25 marks]

3. A daily production function for widgets is Q = 12L1/2 + 8K1/2 (where L is units of labour and
K is units of capital).
a. What is the marginal product equation for capital?

(3)

b. What is the marginal product equation for labour?

(3)

c. How many widgets are produced when labour is 9 and capital is 16?

(3)

d. What is the slope of the isoquant at the point of production in answer (c) above?

(3)

e. If capital is fixed at 16 in the short-run, are there diminishing returns to labour when
a 9th worker is hired?
(3)
[15 marks]

4. Suppose that production processes A and B give rise to the following average and marginal
total cost curves:
MCA = 12 QA
ATCA = 16/QA + 6 QA
B
B
ATCB = 240/QB + 2QB
MC = 4Q
What is the lowest cost of producing 32 units of output?

[15 marks]

5. A firms total revenue curve is given by TR = aQ 2Q2. Is this a perfectly competitive firm?
Explain why or why not.

[10 marks]

Section C (40 marks)

Questions 1 to 5 are MCQs, each worth 5 marks. Negative marking applies (-1 mark per incorrect
answer). There are no penalties for omitting a question. Write the answers CLEARLY in your
answer book, i.e. no MCQ sheet has been provided. Only write the number of the question and the
LETTER corresponding to the correct answer.
Q1. The strategic form or normal form representation of a game comprises:
i. A list of participants (the players)
ii. A list of strategies for each player
iii. A list of payoffs for each player, associated with each strategy profile (i.e. each combination of
strategies of each player)

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

Q2. The prediction that a player (say, player 1 in a two-player game) will not choose a strictly
dominated strategy requires:
a) Only that player 1 is rational
b) That both players are rational
c) That player 1 is irrational
d) That both players are rational and each players knows the other is rational
e) That both players are rational; each players knows the other is rational; and each player
knows that the other knows that he/she is rational

Q3. The Nash equilibrium/equilibria of the following two-person game is/are:

(5,3)

(0,4) (3,5)

m (4,0) (5,5)
d

(4,0)

(3,5) (0,4) (5,6)

a) There is only one Nash equilibrium and it is (u,r)

b) There is only one Nash equilibrium and it is (m,m)
c) There is only one Nash equilibrium and it is (d,r)
d) There are two Nash equilibria, (m,m) and (d,r)
e) None of the above

Q4. Consider an industry with two firms, all producing the same good. Each firm chooses a price,
and produces enough output to satisfy the demand it faces, given the other firms prices. If firms
set different prices, then all consumers buy from the firm with the lowest. If two or more firms set
the lowest price, these firms receive an equal share of the market demand at that price. Any firm
choosing a price above the lowest price receives no demand and produces no output. Let pi denote
the price of firm i, and c the marginal cost, assumed equal for all firms and constant.
Suppose

pi > c , p j > c and pi p j . Then:

a) The firm with the lowest price will make negative profit
b) Firm j captures all demand but makes zero profit
c) Firm i can increase its profit by raising its price
d) Firm i can increase its profit by reducing its price to just below its rivals p j .
e) The price pair ( pi , p j ) is the unique Nash equilibrium


Q5. In an N-person strategic form game, an action (or strategy) profile a * = (a1 ,..., a N
) is a Nash

equilibrium if:
a) Each strategy in the profile

a * is a strictly dominated strategy

b) Each strategy in the profile

a * is a strictly dominant strategy

c) For every player i = 1,..., N , ui (ai , a i ) ui (ai , a i ) , for every action a i in Ai .

d) For player i only, ui (ai , a i ) ui (ai , a i ) , for every action a i in Ai .
e) Both b) and c) are correct.

Q6. Suppose the demand function faced by firm i, in a symmetric two-firm industry, is given by

qi = 90 2 pi + p j , where i = 1,2. Marginal cost is constant, and equal to 5 for each firm. Find
the Nash Equilibrium prices.

[15 marks]

Section D (40 marks)

The following diagram presents a production possibility frontier (PP) and the community
indifference curve (CC) that is tangent to relative prices (TT) at point A. Assume initially that there
is no international trade. Point A is at the intersection of PP, TT and CC.

Food

C
P

C
P

Cloth

1. Briefly explain the producer, consumer and product mix conditions for general equilibrium.
[10]
2. Explain why consumption and production at point A is not in general equilibrium.

[5]

3. Describe and illustrate with the aid of diagrams the adjustment process towards equilibrium.
Make sure you discuss how changes in prices alter consumption and production decisions to reach
an equilibrium outcome.
[10]
Assume that the country has a comparative advantage in the production of food and it opens up to
international trade.
4. Discuss how this affects the production, consumption and product mix conditions for general
equilibrium.
[5]
5. Illustrate using a production possibility frontier diagram similar to that above how opening up
to international trade can increase national welfare.
[10]