This paper is not to be removed from the Examination Halls

UNIVERSITY OF LONDON

279 0066 ZB

BSc degrees and Diplomas for Graduates in Economics, Management, Finance and the
Social Sciences, the Diplomas in Economics and Social Sciences and Access Route for
External Students

Microeconomics

Monday, 16 May 2011 : 2.30pm to 5.30pm

Candidates should answer ELEVEN of the following SIXTEEN questions: EIGHT from
Section A (5 marks each) and THREE from Section B (20 marks each). Candidates are
strongly advised to divide their time accordingly.
A calculator may be used when answering questions on this paper and it must comply in all
respects with the specification given with your Admission Notice. The make and type of
machine must be clearly stated on the front cover of the answer book.

University of London 2011

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SECTION A
Answer eight questions from this section (5 marks each).
1. Consider an economy with two goods, Bread (B) and Milk (M). Jo likes both
goods and her marginal rate of substitution between the two goods is diminishing. The price of M is 3 and the price of B is 1. At the current consumption
basket, her marginal rate of substitution of Milk for Bread (MRS M,B ) is 2. Is Jo
currently at her optimum consumption? If your answer is yes, show why. If
your answer is no, clarify how her consumption basket should change to reach
her optimum.
2. Suppose that the government subsidizes housing expenditures of low-income
consumers by providing a dollar-for-dollar subsidy to a consumers housing expenditure - i.e. if a consumer spends x of his own on housing, the government
gives him x, making total housing expenditure 2x. Ariel qualies for this subsidy and spends a total of 500 per month on housing: he spends 250 of his own
and receives a government subsidy of 250. Recently, a new policy has been proposed that would provide each low income consumer with a lump sum transfer
of 250 which can be used for housing or other goods. Using a graph, demonstrate whether Ariel would prefer the current program, the proposed program,
or would be indifferent between the two.
3. There are two rms in an industry. The output of rm 1 is denoted by q1 and
that of rm 2 is denoted by q2 . Let
Q = q1 + q2
The total cost of production for rm 1 is 30q1 and that for rm 2 is 20q2 . The
demand curve is given by
Q = 100 P
(a) Find the Cournot-Nash equilibrium quantity produced by each rm and
the market price.
(b) If the two rms interact repeatedly, is the outcome likely to be different?
Explain informally but carefully.
4. A perfectly competitive market implies a perfectly elastic demand curve, which
then implies that such a market produces no consumer surplus. Is this true or
false? Explain carefully.
5. In the long-run equilibrium under monopolistic competition, rms earn a zero
prot. This is similar to the prot of rms in the long-run equilibrium under
perfect competition. It follows that there is no loss of efciency in the longrun equilibrium under monopolistic competition. Is this true or false? Explain
carefully.

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6. For each of the following statements, state whether the statement is true or false,
and explain your answer.
(a) If average product is increasing, marginal product must be less than average product.
(b) If total product is increasing, marginal product must be increasing.
7. It is very expensive to rent a at in Metropolis. The government of Metropolis
wants to use some of its tax receipts to deliver lower rents for its poorer citizens,
and decides to subsidize rents for citizens below a certain level of income. The
poorer citizens mostly live in rented housing in the Eastern part of Metropolis.
We also know that the supply of rental housing is very inelastic in the Eastern
part due to restrictions on construction. Evaluate this choice of policy. Is there
any other policy that the government of Metropolis could adopt which would
deliver lower rents for its poorer citizens?
8. Data from a competitive market shows periods in which price is high, sales
tend to be high, and periods in which price is low, sales tend to be low. This
implies that demand is relatively stable, and the pattern of uctuations in price
and quantity is mostly due to uctuations in the marginal cost of production of
sellers. Is this true or false? Explain carefully.
9. Consider the production function
Q = LK
where K is the quantity of capital and L is the quantity of labour. Let w denote
the wage rate and r denote the price of capital, where
r = 4w
Derive the demand functions for labour and capital as functions of output (Q).
10. Two rms (1 and 2) must decide simultaneously whether to produce a low output (L), a medium output (M) or a high output (H). The payoffs from the different output combinations are given by the payoffs in the following game. In
each box, the rst number is the payoff of player 1, and the second number is
the payoff of player 2.

L
1 M
H

L
4,4
4,2
5,1

2
M
2,4
3,3
2,0

H
1,5
0,2
0,0

Find the Nash equilibria of the game.

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SECTION B
Answer three questions from this section (20 marks each).

11. (a) Oscars utility depends upon his wealth W. His utility function is

u(W ) = W
Oscars current wealth is 100, but he faces the risk of losing 60 with probability 13 .
An insurance company makes him the following offer: for every dollar that
Oscar pays as premium, the insurance company will pay him 3 if the loss
occurs.
i. How much insurance will Oscar buy?
[5 marks]
ii. Oscars friend John has the same current wealth as Oscar and faces
exactly the same risk. However, his utility function is
v(W ) = ln W
If the insurance company makes the same offer to John, how much
insurance will he buy?
[5 marks]
(b) Consider an exchange economy with two goods (X and Y) and two consumers (A and B). There are 10 units available of each of the two goods.
Consumer A is endowed with 5 units of good X and 5 units of Y. Consumer B is also endowed with 5 units of good X and 5 units of Y. The
preferences of the two consumers are as follows. Consumer A has utility
function

U A (X, Y ) = X
and consumer B has utility function
UB (X, Y ) = Y
i. Draw an Edgeworth box and draw the contract curve in this economy.
[5 marks]
ii. In the Edgeworth box, show the area of mutually benecial trades between the two consumers.
[5 marks]

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12. Consider a market for used cars. There are 10 low quality cars and 10 high
quality cars. There are 20 potential sellers with a car each, and 20 buyers. A
seller values a high quality car at 8000 and a low quality car at 4000. A buyer
values a high quality car at 10,000 and a low quality car at 5000. All agents are
risk-neutral.
(a) Suppose quality is unknown to both buyers and sellers. However, both
buyers and sellers expect a car to be of high quality with probability 1/2.
How many cars of each quality would be sold? Write down the interval(s)
of possible equilibrium prices.
[5 marks]
(b) Suppose quality is observable to sellers but not to buyers. Buyers only
know that out of the 20 sellers, 10 offer high quality cars and 10 offer low
quality cars. How many cars of each quality would be sold? Write down
the interval(s) of possible prices.
[10 marks]
(c) Is the market outcome in part (b) efcient? If you answer yes, explain why.
If you answer no, suggest (informally) a way to reduce the inefciency.
[5 marks]

13. A competitive market is made up of 100 identical rms. The short-run total cost
function of each rm is given by
C = 5q +

q2
+ 100
4

where q denotes the output of the representative rm.

(a) Determine the short-run market supply curve.
(b) Calculate the price at which market supply is 2000.

[10 marks]
[5 marks]

(c) Do you expect the long run equilibrium price in the market to be higher,
lower or the same as the price you calculated in part (b)? Explain.[5 marks]

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14. Consider a competitive industry with several identical rms. The market demand is given by
Q D = 10 P
where P is the market price. The suppliers have a constant marginal cost of
production of 5, and no xed costs.
(a) Find the equilibrium market price and quantity.

[5 marks]

(b) The government grants a subsidy of 1 per unit to the suppliers. Calculate
the new equilibrium price and quantity in the market.
[5 marks]
(c) Show that the government expenditure used to pay for the subsidy program exceeds the sum of the changes in producer and consumer surplus.
[10 marks]

15. Alice and her brother Bill support their elderly parents. There is a single good
(call it money). All consumptions are measured in units of money. Alice cares
about the number of units she consumes directly (denoted by y A ) and the number of units her parents consume (denoted by x). Her utility function is
1

u A ( x, y A ) = x 3 y A
Similarly, Bills utility function is
1

uB ( x, y B ) = x 3 y B
where y B is his direct consumption. The parents consumption x is simply the
sum of the support contributions from Alice (x A ) and Bill (x B ), i.e.
x = x A + xB
Alice and Bill have an income of 42 each.
(a) Suppose Alice is unable to contribute anything toward the parents support, so that Bill must provide for both his own consumption y B , and his
parents consumption x. Determine Bills optimal choice of x and y B .
[5 marks]
(b) Now suppose Alice is also going to contribute toward the parents support.
Given any level of contribution from Bill, Alice chooses her optimal contribution. Similarly, for any level of contribution by Alice, Bill chooses his
optimal contribution. What are their equilibrium contributions to support
their parents?
[10 marks]
(c) Does the equilibrium contributions in part (b) add up to the Pareto optimal
level of support? Explain informally (you do not need to derive the Pareto
optimal level of support).
[5 marks]

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16. (a) Explain the problem of externalities and discuss how this problem affects
the conditions for economic efciency.
[8 marks]
(b) In each of the following situations, identify the externality and explain
whether or not the Coase theorem would provide a basis for dealing with
the externality. You must dene all relevant economic concepts clearly.
i. The Ganges river in India receives industrial efuents from hundreds
of tanneries that operate along its banks. Further, millions of litres
of raw sewage are spilled into the river from hundreds of towns and
villages.
[6 marks]
ii. Your neighbour has an electrical device that is costly to run, but kills
insects very effectively. The longer he keeps the device on, the fewer
insects appear in your garden.
[6 marks]

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