This paper is not to be removed from the Examination Halls

UNIVERSITY OF LONDON

279 0028 ZA

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

Managerial Economics
Thursday, 15th May 2008 : 10.00am to 1.00pm

Candidates should answer SIX of the following TEN questions: FOUR from Section A (12.5
marks each) and TWO from Section B (25 marks each). Candidates are stongly 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 2008

UL08/039
D02

PLEASE TURN OVER

Page 1 of 3

SECTION A
Answer all four questions from this section (12.5 marks each).

1.

Consider a private value auction with two bidders whose valuations are drawn
independently from a uniform distribution on [0,1]. Show that each bidder bidding half
his valuation is a Nash equilibrium.

2.

A price-taking firm has production function q = mK1/2 where K is the amount of capital
employed. The unit cost of capital equals r.
(a)
(b)
(c)

3.

Two players each have to pick a number from {1,2,3} simultaneously. The player who
picks the lowest number wins 1 as long as the other player picks a different number. If
both players pick the same number, both get zero.
(a)
(b)

4.

Determine the firms conditional demand for capital.

Determine the firms cost function.
Determine the optimal output level and profit.

Write down the payoff matrix for this game.

Determine all pure strategy Nash equilibria.

A buyer with a valuation of v = 12 would like to buy an object from a seller with a
valuation (cost) of c = 5 for that object. They bargain over the price and play the
following alternating offers bargaining game. First the buyer proposes a price. This
price can either be accepted by the seller (and then the game ends and trade happens at
the accepted price) or rejected. In the latter case, the seller proposes a price which then
can be accepted or rejected by the buyer. If the price is accepted the game ends with
trade at the proposed price; if it is rejected, the buyer can again propose a price. If the
seller accepts this price then trade takes place at this price; if it is rejected, no trade takes
place. The discount factor for both players is with 0< <1 and payoffs are discounted
after each rejection. Draw the game tree for this game and find its perfect equilibrium.

SECTION B
Answer two questions from this section (25 marks each).
5.

A risk neutral firm has to decide on its production level for a perishable product. If the
production level exceeds demand, the excess supply is worthless. The firm is a price
taker and the price per unit of output equals p. The firm has constant marginal costs, c.
Demand is uncertain but the firm knows that it is uniformly distributed on [0,100].
(a)
(b)
(c)

(d)

Determine the output level which maximises expected profit.

Calculate the optimal expected profit.
Suppose the firm could eliminate the demand uncertainty i.e. it would know
demand for sure before deciding on its output level. What would its expected
profit be?
What is the expected value of perfect information?

UL08/039
D02

Page 2 of 3

6.

An entrepreneur needs a bank loan of x to start his business. The business will be a
success and generate a profit of 1 with probability p(e) where e is the effort the
entrepreneur puts into his project (0 < e < 1) . Assume p(e)=e. With probability 1 p(e)
the business will go bankrupt. In this case the loan will not be repaid. If the business is a
success, the bank will demand a repayment of D. The entrepreneurs cost of effort
equals C(e) = e2/2.

(a)
(b)
(c)
(d)

7.

Determine the entrepreneurs optimal effort level as a function of D (assuming

risk neutrality).
Show that the banks expected payoff is increasing and then decreasing in D.
Find the D which maximises the banks expected payoff and the corresponding
optimal expected payoff.
Now assume that the entrepreneur is risk averse and has utility of money function
U(m) = m1/2. Answer (a) to (c) under this assumption.

Demand for a good produced by a duopoly is given by p = 150 Q. Both firms have
constant marginal costs c = 10 and zero fixed costs.
(a)
(b)

(c)
(d)

Determine the Cournot equilibrium quantities and profits.

Now suppose the managers of Firm 1 maximise revenue rather than profit (while
the managers of Firm 2 maximise profit). Determine the equilibrium quantities
and profits.
Suppose both firms maximise revenue (rather than profits). Determine the
equilibrium quantities and profits.
The owners of the two firms simultaneously choose incentive schemes for their
firms managers so that they can make sure that managers maximise either sales
or profit. What are the owners equilibrium choices?

8.

Explain what is meant by compensating variation and equivalent variation. Use

graphs and examples.

9.

Employees typically have wage profiles which rise with age whereas the self-employed
tend to have flatter earnings profiles. Discuss possible explanations for this pattern.

10.

Goods are sometimes bundled so that the price of the bundle is less than the sum of the
prices of the goods in the bundle bought separately. Explain, using examples, how this
practice of bundling can increase profits.

END OF PAPER

UL08/039
D02

Page 3 of 3

This paper is not to be removed from the Examination Halls

UNIVERSITY OF LONDON

279 0028 ZB

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

Managerial Economics
Thursday, 15th May 2008 : 10.00am to 1.00pm
Candidates should answer SIX of the following TEN questions: FOUR from Section A (12.5
marks each) and TWO from Section B (25 marks each). Candidates are stongly 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 2008

UL08/040
D02

Page 1 of 3

PLEASE TURN OVER

SECTION A
Answer all four questions from this section (12.5 marks each).
1.

Explain the difference between private value and common value auctions. What is
meant by the winners curse? In which type of auctions can the winners curse be
observed?

2.

A price taking firm has production function q = mK1/2 where K is the amount of capital
employed. The cost of capital is r per unit.
(a)
(b)
(c)

3.

Write down the firms profit function (as a function of K).

What is the optimal level of K?
Determine the ratio of optimal profit over optimal K.

Consider the following payoff matrix.

1
2
(a)
(b)

4.

1
(0.0)
(0,1)

2
(1,0)
(0,0)

Determine all the perfect equilibria if the row player moves first.
Assuming players make simultaneous choices, find all pure strategy Nash
equilibria.

A buyer with a valuation of v = 12 would like to buy an object from a seller with a
valuation (cost) of c = 5 for that object. They bargain over the price and play the
following alternating offers bargaining game. First the buyer proposes a price. This
price can either be accepted by the seller (and then the game ends and trade happens at
the accepted price) or rejected. In the latter case, the seller proposes a price which then
can be accepted or rejected by the buyer. If the price is accepted, the game ends with
trade at the proposed price; if it is rejected, no trade takes place. The discount factor for
both players is with 0< <1 and payoffs are discounted after each rejection. Draw the
game tree for this game and find its perfect equilibrium.

SECTION B
Answer two questions from this section (25 marks each).
5.

(a)
(b)
(c)

(d)

Explain what is meant by risk-loving, risk-neutral and risk-averse decision

makers.
Explain what is meant by the expected value of perfect information (EVPI).
Consider the payoff table below with two possible decisions, D1 and D2, and two
equally likely states of the world, s1 and s2. What is the optimal decision for a
risk- neutral decision maker? Calculate the EVPI for a risk neutral decision
maker.
s1
s2
50
150
D1
100
0
D2
Assume a risk-loving decision maker with utility function U(x) = x2 faces the
problem decribed in (c) above. What is his optimal decision? Calculate his EVPI.

UL08/040
D02

Page 2 of 3

6.

A duopolistic industry has market demand p = 100 Q. The two firms have identical
cost functions C i (qi ) = 10 qi and zero fixed costs.
(a)
(b)

(c)
(d)

7.

Determine the Cournot quantities and profits.

Suppose there are two managers in each firm and one of them wants to maximise
output whereas the other wants to maximise profit. They compromise and the
result is that both firms maximise profit times (own) quantity. Find the
equilibrium output levels and profits.
Now suppose that only firm 1 has the setup in (b) i.e. it maximises its proft times
its quantity whereas firm 2 maximises its profit. Find the equilibrium output levels
and quantities.
The owners of the two firms simultaneously decide on the firms objective
functions (through their choice of incentive scheme for the managers), i.e. they
can choose profit maximisation or maximisation of the product of profit and
output. Which choices do they make in equilibrium?

Poor households have a weekly income of $100. Their utility function is given by
U(x,y) = xy where x is the amount of money spent on food and y is remaining income.
(a)
(b)
(c)

Draw the budget constraint, find the optimal level of spending on food and sketch
the indifference curve corresponding to this optimum.
The government allocates food stamps worth $20 a week to each poor household.
Draw the new budget constraint, find the optimal level of spending on food and
sketch the indifference curve corresponding to this optimum.
At a price of $50, each poor household can buy $70 worth of food vouchers. Draw
the new budget constraint, find the optimal level of spending on food and sketch
the indifference curve corresponding to this optimum.

8.

Show how an insurance company can separate high and low risk clients by offering a
menu of insurance contracts with different premiums and amounts of cover such that
high risk clients self-select into a policy with high cover.

9.

Explain the concept of second degree price discrimination. Show how a monopolist
optimally sets prices in this scenario when there are two types of customers. Compare
this with the situation where price discrimination is not allowed. Discuss whether price
discrimination of this type always leads to lower welfare.

10.

Explain how market concentration is measured and which factors determine how many
firms there are in an industry.

END OF PAPER

UL08/040
D02

Page 3 of 3

Examiners commentaries 2008

Examiners commentary 2008

28 Managerial economics
General remarks
Learning outcomes
At the end of this unit and having completed the essential reading and
activities you should be able to:

be prepared for Marketing and Strategy units through an

understanding of consumer behaviour and markets in general

analyse business practices with respect to pricing and competition

understand and be able to apply key concepts in decision analysis and

game theory.

Format of the examination

The examination is three hours long and comprises two sections. You have
to answer all four questions in Section A (12.5 marks each) and two
questions in Section B (25 marks each).

Planning your time in the examination

The marks for each question correspond roughly to the proportion of time
you are expected to spend on it. Try not to spend too much time on any
one question. You can always go back to it later if you have time left.
When you select which questions to answer in Section B, take time to read
all the questions (and all parts of each question). Often students select a
question on the basis of the topic of the question only to realise that they
are able to answer at most the first part of the question.
If you end up doing terribly complicated calculations taking up several
pages it is highly likely that you have misinterpreted the question or made
a mistake go back and check the question and your answer. The same
applies of course if you find negative prices or quantities or probabilities
greater than one or less than zero.
Write down clearly what you are doing, we give marks for correct logic
and development even if there are numerical mistakes.

What are the examiners looking for?

We are looking for evidence that you have truly understood the material
and can apply this knowledge. Memorising answers to past questions will
not get you very far. You should have the confidence to tackle the
questions from first principles. Of course you will only have this confidence

28 Managerial economics

if you have worked consistently throughout the year to familiarise yourself

with the way of thinking this subject requires.

How to do well in the examination

A key success factor is obviously the time spent preparing and, as
mentioned before, an early start is definitely required. It is impossible to
acquire the thinking skills you need in the last few weeks before the exam.
It is not good enough to be able to repeat the material in the subject guide.
You must understand it! A good way to check whether you really
understand the material is to try to explain it to a friend.
You also have to spend a lot of time thinking about questions/problems/
exercises. Never look at answers or solutions until you have spent at least
an hour or two trying to figure out the solution yourself. Obviously during
the examination you will not have that much time, but the more time you
spend thinking about how to solve problems during the year, the easier
your revision and the examination will be.
Especially for the essay questions, do not write down everything you
know about a topic which is vaguely related to the question. Answer the
question! We dont expect polished essays with nicely constructed
sentences, and the use of bullet points lists are acceptable where
appropriate. The main thing is to show that you have understood the
material. You can give evidence of your understanding through clear
exposition, including models and numerical and verbal examples
(preferably your own). Diagrams should be clear. It is not important that
the axes are drawn as straight lines etc but diagrams have to be neat
enough to illustrate the point you are making.
Amazingly, we often find that students have not read the subject guide
properly. You do not need to read anything else to do well in this unit so
make sure you read and understand the subject guide.

Examiners commentaries 2008

Examiners commentary 2008

28 Managerial economics
Specific comments on questions Zone A
Question 1
Consider a private value auction with two bidders whose valuations are drawn
independently from a uniform distribution on [0,1]. Show that each bidder
bidding half his valuation is a Nash equilibrium.
The derivation which is required here can be found in Chapter 5 of the
subject guide in the section Private value standard sealed bid auctions.
Note that the question asks you to show that this pair of strategies is a
Nash equilibrium. Writing down a formula which you memorised is not a
good answer.
Question 2
A price-taking firm has production function q = mK1/2 where K is the amount of
capital employed. The unit cost of capital equals r.
(a) Determine the firms conditional demand for capital.
The production function is given by q = m K . To determine the
conditional demand for capital, invert this to find K = (

q 2
) .
m

(b) Determine the firms cost function.

The cost function gives cost as a function of output, i.e.

q
C (q ) = rK (q) = r ( ) 2 .
m
(c) Determine the optimal output level and profit.
The firm is a price-taker and will set its output level so that marginal cost
equals price, or

pm 2
2rq
=
p
,
which
gives
optimal
output
level
q
=
.
m2
2r

Profit equals

pq ( p ) C (q( p)) =

p2m2
pm 2 2 p 2 m 2 p 2 m 2 p 2 m 2
r(
=
.
) =
2r
2r
4r
4r

Question 3
Two players each have to pick a number from {1,2,3} simultaneously. The player
who picks the lowest number wins 1 as long as the other player picks a
different number. If both players pick the same number, both get zero.

28 Managerial economics

(a) Write down the payoff matrix for this game.

1

(0,0)

(1,0)

(1,0)

(0,1)

(0,0)

(1,0)

(0,1)

(0,1)

(0,0)

(b) Determine all pure strategy Nash equilibria.

The pure strategy Nash equilibria are (1,1), (1,2), (1,3), (2,1), (3,1).
Question 4
A buyer with a valuation of v = 12 would like to buy an object from a seller A
buyer with a valuation of v = 12 would like to buy an object from a seller with a
valuation (cost) of c = 5 for that object. They bargain over the price and play the
following alternating offers bargaining game. First the buyer proposes a price.
This price can either be accepted by the seller (and then the game ends and trade
happens at the accepted price) or rejected. In the latter case, the seller proposes
a price which then can be accepted or rejected by the buyer. If the price is
accepted the game ends with trade at the proposed price; if it is rejected, the
buyer can again propose a price. If the seller accepts this price then trade takes
place at this price; if it is rejected, no trade takes place. The discount factor for
both players is with
0 < <1 and payoffs are discounted after each rejection. Draw the game tree
for this game and find its perfect equilibrium.

B
(6)

(12 - p, p - 5 )

accept

(5)

reject, ask for p = 12 7

(4)

accept

(3)

( (12 p ), ( p 5))

reject, offer p = 5
( 2)

(1)

accept
reject

( 2 (12 p ), 2 ( p 5))

Examiners commentaries 2008

At (1) S will accept any p 5. Hence, at (2), p = 5. At (3) B will accept if

(12 p) (12 5) or 12 p 7 or p 12 7.
Hence at (4) p = 12 7.
At (5) S will accept if p 5 (12 7 5) or p 7 (1 ) + 5.
At (6) B will offer p = 7 (1 ) + 5.

SECTION B
Question 5
A risk neutral firm has to decide on its production level for a perishable product.
If the production level exceeds demand, the excess supply is worthless. The firm
is a price taker and the price per unit of output equals p. The firm has constant
marginal costs, c. Demand is uncertain but the firm knows that it is uniformly
distributed on [0,100].
(a) Determine the output level which maximises expected profit.
Let s denote the firms production level and x the demand level. If x > s, a
quantity s gets sold. For x s, the quantity sold is x.
The firms expected profit equals:
s

p.s Prob (x > s) + p

x
100 s
100 dx cs = p.s (
)+

100

ps 2
cs (1)
200

(b) Calculate the optimal expected profit.

The first order condition for maximising (1) is given by

ps

+
100

100 s ps
p
c = 0
+
100 100

Solving this for s gives s =

100( p c)
.
p

Substituting into (1) gives optimal expected profit

50( p c) 2
.
p

(c) Suppose the firm could eliminate the demand uncertainty i.e. it would know
demand for sure before deciding on its output level. What would its expected
profit be?
If the firm knows demand equals x it would set s = x and therefore its
expected profits would be
100

(pc)

x
dx = 50(p c).
100

28 Managerial economics

(d) What is the expected value of perfect information?

The EVPI is the difference between optimal expected profit with the
information (in (c)) and optimal expected profit without the information
(in (b)) i.e. EVPI = 50(p c)

50( p c) 2
50( p c)c
=
.
p
p

Question 6
An entrepreneur needs a bank loan of x to start his business. The business will
be a success and generate a profit of 1 with probability p (e) where e is the effort
the entrepreneur puts into his project. Assume p (e) =e. With probability 1p(e)
the business will go bankrupt. In this case the loan will not be repaid. If the
business is a success, the bank will demand a repayment of D. The entrepreneurs

e2
cost of effort equals C (e) =
.
e
(a) Determine the entrepreneurs optimal effort level as a function of D
(assuming risk neutrality).

p(e)=e

1 D

e2
2

1-p(e) = 1-e
0

e2
2

The expected payoff to the entrepreneur equals

e(1 D

e2
e2
e2
) + (1 e)( ) = e(1 D)
2
2
2

(1)

The first order condition for maximising (1) is given by

(1 D) e = 0 so that the optimal effort level equals e = 1 D.
(b) Show that the banks expected payoff is increasing and then decreasing in D.
The bank will get D back but only when the project succeeds. Its expected
payoff is therefore D(p(e)) x = De x = D(1D) x which is a
quadratic function in D, initially increasing and then decreasing.

Examiners commentaries 2008

(c) Find the D which maximises the banks expected payoff and the corresponding
optimal expected payoff.
The optimal D is D = and the banks optimal expected payoff
equals x.
(d) Now assume that the entrepreneur is risk averse and has utility of money
function U(m) = m1/2. Answer (a) to (c) under this assumption.
2

The risk averse entrepreneur has expected utility e 1 D e .

2
His optimal effort level equals e = 1 D .
The banks expected payoff equals D 1 D x
1
F.O.C. D2 (1 D ) 2 +

1 D = 0

(The second derivative is negative.)

Solving for D gives D =

( 23 )

1
3

2
and the banks optimal expected payoff equals
3

x.

Question 7
Demand for a good produced by a duopoly is given by p = 150 Q. Both firms
have constant marginal costs c = 10 and zero fixed costs.
(a) Determine the Cournot equilibrium quantities and profits.

1 = (150 q1 q2 )q1 10q1

150 2q1 q2 10 = 0
q1 = q 2 = q

q=

140
3

1 = (150 2(
2

140 140 1400 19600

=
2178
)) (
)
3
3
9
3

(b) Now suppose the managers of Firm 1 maximise revenue rather than profit
(while the managers of Firm 2 maximise profit). Determine the equilibrium
quantities and profits.
The managers of firm 1 maximise revenue

R1 = (150 q1 q2 )q1
150 2q1 q 2 = 0
q1 =

(1)

150 q 2
2

28 Managerial economics

The managers of firm 2 maximise profit

2 = (150 q1 q2 )q2 10q2

150 q1 2q2 10 = 0
q2 =

(2)

140 q1
2

Solving (1) and (2) for q1 and q2 gives

1=
2

(150

q1 =

160
130
and q 2 =
3
3

160 130 160

160
160 130
)(
) 10(
)=(
)(
) 2311

3
3
3
3
3
3

(150

160 130 130

130
130 2
)(
) 10(
)=(
) 1878

3
3
3
3
3

(c) Suppose both firms maximise revenue (rather than profits). Determine the
equilibrium quantities and profits.
Using (1) and setting

q1 = q2 = q gives q = 50.

1 = 2 = (50)(50) 10(50) = 2000

(d) The owners of the two firms simultaneously choose incentive schemes for
their firms managers so that they can make sure that managers maximise either
sales or profit. What are the owners equilibrium choices?
Both sets of owners have two strategies: sales maximisation (S) or profit
maximisation (P). From the answers to (a) (c) we can construct the
payoff matrix below:
Firm 2
Firm 1

2000, 2000

2311, 1878

1878, 2311

2178, 2178

(S, S) is the unique Nash equilibrium.

Question 8
Explain what is meant by compensating variation and equivalent variation. Use
graphs and examples.
This questions was not answered well at all, although the answer can be
found in Chapter 6 of the subject guide in the section Consumer welfare
effects of a price change.
Question 9
Employees typically have wage profiles which rise with age whereas the selfemployed tend to have flatter earnings profiles. Discuss possible explanations for
this pattern.
A good start here would be to explain why employees typically have rising
wage profiles. This would point towards possible explanations for flatter

Examiners commentaries 2008

self-employed wage profiles. The efficiency wage theory of rising wage

profiles for employees, for example, clearly does not apply in a selfemployed setting.
Question 10
Goods are sometimes bundled so that the price of the bundle is less than the sum
of the prices of the goods in the bundle bought separately. Explain, using
examples, how this practice of bundling can increase profits.
This question was not answered well although the section on commodity
bundling in Chapter 10 of the subject guide contains most of the elements
that the Examiners would expect in a good answer.

Examiners commentaries 2008

Examiners commentary 2008

28 Managerial economics
Specific comments on questions Zone B
SECTION A
Question 1
Explain the difference between private value and common value auctions. What
is meant by the winners curse? In which type of auctions can the winners curse
be observed?
This is covered in the sections Private and common value auctions and
Common value first price sealed bid auctions in Chapter 5 of the subject
guide. But this question was answered very badly. No marks were given for
lengthy descriptions of auction formats which had no bearing on the
question.
The difference between private value and common value auctions is as
follows:

In a private value auction, each bidder has a separate private valuation

for the object. A bidders private valuation is exactly what the object is
worth to her. Therefore she knows the value of the object to herself,
but in general she does not know the value to other bidders.

In a common value auction, the object has the same value to all
bidders this is sometimes called its objective value but each bidder
has imperfect information about the object. That is, each bidder has an
estimate of the value which is prone to some random error, and (to
make the problem non-trivial) its normally assumed that there is a
separate randomly determined error term for each buyer. So if the
common value is, say, $1000, bidder 1 may have an estimate of
$1086, bidder 2 may have an estimate of $941, and so on. In formal
models, its normally assumed that the statistical process that
generates the estimates is common knowledge to all bidders, but each
bidder sees only her own estimate.

The winners curse may be observed in common value auctions. In a

common value auction, if all bidders are rational (and well assume riskneutral also to make the discussion simpler) then the winner will be the
bidder with the highest estimate. If she is bidding rationally she should
allow for the fact that, if she wins the auction, it means that her estimate is
the highest among all the bidders and therefore is likely to be greater than
the common value of the object (which we can regard as the true value).
Therefore, the maximum amount she should be prepared to bid is some
value below her estimate even in a second-price auction. The more the
number of bidders, the lower the maximum amount she should bid for a

28 Managerial economics

given estimate. The winners curse occurs when bidders do not allow for
this, so the winner of the auction is likely to pay more than the common
value.
Question 2
A price taking firm has production function q = mK1/2 where K is the amount of
capital employed. The cost of capital is r per unit.
(a) Write down the firms profit function (as a function of K).
The firm is a price taker, so its revenues are pq ( K ). There is only one
input, K, with a per unit cost of r, hence profit is given by
(1)

pm K - rK

(b) What is the optimal level of K?

Optimise (1) with respect to K:

pm
F.O.C.

2 k =r

pm
r
pm 2
K =(
)
2r

2 K=

(2)

(c) Determine the ratio of optimal profit over optimal K.

Substitute (2) into (1) to find optimal profit:

pm(

pm
pm 2 ( pm) 2
) r(
) =
2r
2r
4r

The ratio of optimal profit over optimal K is thus

2

( pm) (2r ) 2
=r.
4r ( pm) 2
Question 3
Consider the following payoff matrix.
1

(0.0)

(1,0)

(0,1)

(0,0)

(a) Determine all the perfect equilibria if the row player moves first.
The answers to this simple question were surprisingly bad. Given that you
are asked to find equilibria, you need to start by defining strategies. A
game, tree, as illustrated below, is also useful.

Examiners commentaries 2008

(0,0)
1

C
1
2
(1,0)

(0,1)
2

2
(0,0)

C has 4 strategies: (1,1), (1,2), (2,1), (2,2). R has 2 strategies: 1,2.

At a perfect equilibrium C will not play (1,2) or (2,2).
Against (1,1), R is indifferent between 1 and 2 so that (1, (1,1)) and (2,
(1,1)) are perfect equilibria.
Against (2,1), Rs best strategy is 1, so that (1, (2,1)) is a perfect
equilibrium.
(b) Assuming players make simultaneous choices, find all pure strategy Nash
equilibria.
(1,1), (1,2), (2,1).
Question 4
A buyer with a valuation of v = 12 would like to buy an object from a seller with
a valuation (cost) of c = 5 for that object. They bargain over the price and play
the following alternating offers bargaining game. First the buyer proposes a
price. This price can either be accepted by the seller (and then the game ends and
trade happens at the accepted price) or rejected. In the latter case, the seller
proposes a price which then can be accepted or rejected by the buyer. If the price
is accepted, the game ends with trade at the proposed price; if it is rejected, no
trade takes place. The discount factor for both players is with 0 < < 1 and
payoffs are discounted after each rejection. Draw the game tree for this game
and find its perfect equilibrium.

28 Managerial economics

offers
p

accept
(12-p, p-5)

B
(3)

(4)

reject, ask p

(1)

accept
( (12 p ), ( p 5))
reject

0,0
At (1) B will accept any p 12. At (2) S will set p = 12. At (3) S will
accept if p5 7, or p 7 +5. At (4) B offers p = 7 + 5.
SECTION B
Question 5
(a) Explain what is meant by risk-loving, risk-neutral and risk-averse decision
makers.
Most candidates attempting this question knew how to answer this part.
The definitions are in the section Attitude Towards Risk in Chapter 1 of
the subject guide. The key points are as follows:

A person is risk-loving if she prefers a lottery with an expected value of

X to a sure payment of X.

A person is risk-neutral if she is indifferent between a lottery with an

expected value of X and a sure payment of X.

A person is risk-averse if she prefers a sure payment of X to a lottery

with an expected value of X.

(b) Explain what is meant by the expected value of perfect information (EVPI).
The definition is in the section The expected value of perfect information
in Chapter 1 of the subject guide. It specifies the maximum amount that
the agent (i.e. the decision-maker) should be willing to pay for perfect
information.

Examiners commentaries 2008

(c) Consider the payoff table below with two possible decisions, D1 and D2, and
two equally likely states of the world, s1 and s2. What is the optimal decision for a
risk- neutral decision maker? Calculate the EVPI for a risk neutral decision maker.
s1

s2

D1

50

150

D2

100

D1 gives expected value 50(0.5) + 150(0.5) = 100

D2 gives expected value 100(0.5) + 0(0.5) = 50
The optimal decision is D1.
With perfect information, the optimal decision in s1 is D2 and in s2 is D1.
The EV corresponding to these optimal decisions is 100(0.5) + 150(0.5) =
125. For a risk-neutral decision-maker the EVPI equals the difference in EV
with and without the perfect information (i.e. 25).
(d) Assume a risk-loving decision maker with utility function

U(x) = x2 faces the problem described in (c) above. What is his optimal decision?
Calculate his EVPI.

EU ( D1 ) = 0.5(50) 2 + 0.5(150) 2 = 12,500

EU ( D2 ) = 0.5(100) 2 + 0.5(0) 2 = 5, 000
The optimal decision is D1.
The EVPI is the amount of money x such that if the decision maker pays
this amount when he has perfect information he is as well off as without
the perfect information, so 0.5(100 x ) + 0.5(150 x ) = 12,500
2

Solving for x gives

EVPI = 16 .

Question 6
A duopolistic industry has market demand p = 100 Q. The two firms have
identical cost functions Ci (qi ) = 10qi and zero fixed costs.
(a) Determine the Cournot quantities and profits.

1 = (100 - q1 - q2 )q1 - 10q1

100 - 2q1 - q2 - 10 = 0
q1 = q2 = q
q = 30
1 = 2 = (40)(30) - 10(30)= 900

28 Managerial economics

(b) Suppose there are two managers in each firm and one of them wants to
maximise output whereas the other wants to maximise profit. They compromise
and the result is that both firms maximise profit times (own) quantity. Find the
equilibrium output levels and profits.

Max 1q1 = (90 q1 q2 )q12

(90 q1 q2 )2q1 q12 = 0

(1)

q1 = q 2 = q
2(90 2q) q = 0
q = 36
(The second order condition is satisfied.)

1 = 2 = (28 10)36 = 648

(c) Now suppose that only firm 1 has the setup in (b) i.e. it maximises its profit
times its quantity whereas firm 2 maximises its profit. Find the equilibrium
output levels and quantities.
We can use the F.O.C. in (1) for firm 1. From (a) we can deduce that firm
2s response function equals q2 =

90 q1
.
2

Substituting this into (1) gives q1 = 45 and hence q2 =

45
.
2

45
= 32.5
2
1 = (32.5 10)45 = 1012.5
p = 100 45

2 = (32.5 10)

45
= 506.25
2

(d) The owners of the two firms simultaneously decide on the firms objective
functions (through their choice of incentive scheme for the managers), i.e. they
can choose profit maximisation or maximisation of the product of profit and
output. Which choices do they make in equilibrium?
Both sets of owners have two strategies which are presented with payoffs
in the payoff matrix below.
Firm 2

Firm 1

Max 2

Max 2 q2

Max 1

(900, 900)

(506, 1012.5)

Max 1q1

(1012.5, 506)

(9648, 648)

At the unique Nash equilibrium, both firms will maximise profit times
quantity.

Examiners commentaries 2008

Question 7
Poor households have a weekly income of $100. Their utility function is given by
U(x,y) = xy where x is the amount of money spent on food and y is remaining
income.
(a) Draw the budget constraint, find the optimal level of spending on food and
sketch the indifference curve corresponding to this optimum.

y
$100

$100
Max xy s.t. x+y = 100

Max x (100 x ) x = 50
(b) The government allocates food stamps worth $20 a week to each poor
household. Draw the new budget constraint, find the optimal level of spending
on food and sketch the indifference curve corresponding to this optimum.
y
$100

$20

$120 x

x = 60
(c) At a price of $50, each poor household can buy $70 worth of food vouchers.
Draw the new budget constraint, find the optimal level of spending on food and
sketch the indifference curve corresponding to this optimum.

$100
$50
$70

$120

x = 70

28 Managerial economics

Question 8
Show how an insurance company can separate high and low risk clients by
offering a menu of insurance contracts with different premiums and amounts of
cover such that high risk clients self-select into a policy with high cover.
This question attracted a lot of answers which were completely beside the
point. The question asks very specifically how insurance companies can use
a menu of insurance contracts to separate high-risk and low-risk clients. No
marks are given for general discussions of moral hazard or adverse
selection. A good answer to this question is in the section An insurance
menu in Chapter 4 of the subject guide. Here are the key points of a
solution:

To make the analysis simple we will assume that all clients have the
same initial wealth, size of potential loss and utility function (and they
are all risk-averse). They differ only in their probabilities of making a
claim. They are either high-risk or low-risk. A clients knows his risk.
The insurance company knows the risk for a high-risk and for a lowrisk client but does no know which is which, and must offer the same
menu to all clients.

We assume that the insurance industry is perfectly competitive so that

each type of client will buy an actuarily fair insurance policy.

We cannot have a single policy for all clients. This is because if there is
one policy, then if the policy is actuarily fair for low-risk clients then
the company will make a positive expected loss on high-risk clients. If
the policy is actuarily fair for low risk clients then the company will
make a positive expected profit on high-risk clients.

So we need two policies: call them L and H. We require that low-risk

clients will select L in preference to H and that high risk clients will
select H in preference to L. We also require that L is actuarily fair to
low risk clients and that H is actuarily fair to high risk clients.

Now assume that high-risk customers are offered an actuarily fair

contract (for the higher risk) with no deductible (i.e. 100% cover).

Then assume that low-risk customers are offered an actuarily fair

contract (for the lower risk) with a positive deductible (i.e. only partial
cover).

We require that the high-risk customers should prefer the policy

designed for them to the policy designed for low-risk customers.

We require that the high-risk customers should prefer the policy

designed for them to the policy designed for low-risk customers.

This puts a minimum value on the deductible for low-risk customers.

In other words, low-risk customers can be offered only partial cover up
to some maximum level.

Examiners commentaries 2008

Question 9
Explain the concept of second degree price discrimination. Show how a
monopolist optimally sets prices in this scenario when there are two types of
customers. Compare this with the situation where price discrimination is not
allowed. Discuss whether price discrimination of this type always leads to lower
welfare.
A good answer to this question can be found in the section Second degree
price discrimination in Chapter 10 of the subject guide.
Question 10
Explain how market concentration is measured and which factors determine how
many firms there are in an industry.
A good answer to this question can be found in the sections Determinants
of market structure and Measures of market structure in Chapter 9 of the
subject guide.