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Department of Economics ECO 204 Microeconomic Theory for Commerce 2012 2013 Ajaz Hussain
Test 2 Solutions

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Exam details:
Duration: 1 hour and 50 minutes
Total number of questions: 4
Total number of pages: 26
Total number of points: 100

Please answer all questions. To earn credit you must show all calculations. Please see last page of this exam for the allocation of points
across questions.

Exam aids:
This is a closed note and closed book exam.
You may use a non-programmable calculator. Sharing is not allowed.

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Question 1 [25 POINTS]
Consider an agent in an economy with a single good (corn) and where all agents live for exactly two periods At
the beginning of each period, the agent is endowed with real incomes

and

(in units of corn). Let

and

denote the amounts of corn consumed in and respectively. Assume that the inter-temporal consumption
set is {(

) }
At agents can save or borrow corn at the real interest rate . Agents do not save to bequeath savings to
future generations because in this economy theres no romance and no possibility of amorous encounters between
agents as such, agents do not have children.
(1.1) [3 POINTS] Suppose an agent tells you that she must consume positive amounts of corn in both periods and that she
perceives

and

as imperfect substitutes with diminishing marginal rate of substitution. Write down the equation
of a utility function that represents this agents preferences and show why this utility function represents the agents
preferences. Show all calculations and state all assumptions.
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(1.2) [7 POINTS] State and solve this agents inter-temporal Utility Maximization Problem (UMP) with a real (Future
Value) inter-temporal budget constraint. To earn credit you must use the appropriate constrained optimization method,
solve for all variables, and interpret any Lagrange multipliers. Show all calculations. Hint: If applicable, use a
convenient positive monotonic transformation of the utility function in part (1.1).
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(1.3) [5 POINTS] Suppose the agent is given the opportunity of having either one more unit of corn income at or one
more unit of corn income at . True or false: the agent will prefer to have one more unit of corn income at ?
Show all calculations.




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(1.4) [3 POINTS] Use your answer to part (1.2) to calculate that value of the real interest at which the agent is
indifferent between saving and borrowing at . Show all calculations.











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(1.5) [4 POINTS] Suppose the current real interest rate is the value calculated in part (1.4). If the government levies a
small flat income tax (in units of corn) on

will the agent become a saver or a borrower at ? Show all calculations.

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(1.6) [3 POINTS] Use your answer to part (1.2) to answer this question. True or false: a small flat income tax (in units of
corn) on

has a larger impact on consumption at than consumption at ? Show all calculations.

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Question 2 [30 POINTS]

(2.1) [3 POINTS] The following table contains the monthly closing price and monthly dividend yields on Sunoco and JP
Morgan stocks for the last 6 months of 2011:
Date Sunoco Price Sunoco Dividend Yield JP Morgan Price JP Morgan Dividend Yield
7/29/2011 40.65 0 40.45 0.006107
8/31/2011 38.14 0.00369 37.56 0
9/30/2011 31.01 0 30.12 0
10/31/2011 37.23 0 34.76 0.008301
11/30/2011 38.81 0.004029 30.97 0
12/30/2011 41.02 0 33.25 0
Source: CRSP through U of Ts CHASS system

If the last digit of your ID # ends in 0, 2, 4, 6, 8 Calculate Sunocos monthly capital gains and monthly dividend
issued and enter these values below. Give a brief explanation on how to calculate capital gains and dividends.
If the last digit of your ID # ends in 1, 3, 5, 7, 9 Calculate JP Morgans monthly capital gains and monthly dividend
issued and enter these values below. Give a brief explanation on how to calculate capital gains and dividends.
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(2.2) [3 POINTS] On December 1
st
, 2011, the monthly interest rate on 3-month US T-Bills and reported on an annualized
basis was 0.01%. Calculate the monthly interest out of 100 on a de-annualized basis. Hint: You were asked to do this in
Excel Project #1. Only if you are unable to calculate this number here should you use the value 0.00002 below for the
risk free rate (note this is NOT the correct value and you will get a zero in all parts below if you calculate the correct
value here but use 0.00002 below instead).



(2.3) [3 POINTS] The following table shows the average monthly returns and risk of Sunoco and JP Morgan stocks as well
the covariance of Sunoco and JP Morgan monthly returns over the period May 1969 to December 2011:

Sunoco JP Morgan
Average Monthly
Return
0.0106 0.0114
Risk 0.0863 0.0917
Covariance 0.0016

Briefly explain: how to calculate the risk of a stock why JP Morgan stocks offer higher returns (on average) than
Sunoco stocks.
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(2.4) [4 POINTS] Write down an investors mean-variance utility function (be sure to use the correct notation for the
utility function parameter(s)). True or false: as the asset becomes riskier, the investor demands higher returns but at a
decreasing rate? Show all calculations

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(2.4) [5 POINTS] For the month of January 2012, an investor wishes to construct a portfolio consisting of:
If the last digit of your ID # ends in 0, 2, 4, 6, 8 Sunoco stocks and 3-month US T-Bills.
If the last digit of your ID # ends in 1, 3, 5, 7, 9 JP Morgan stocks and 3-month US T-Bills.
Using the risk free rate calculated in part (2.2), calculate that value of the mean-variance utility function parameter
at which the investor will allocate 100% of portfolio funds in the risky asset. You are expected to solve the appropriate
UMP. Show all calculations to 4 decimal places.
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(2.5) [2 POINTS] For the month of January 2012, construct a portfolio consisting of:
If the last digit of your ID # ends in 0, 2, 4, 6, 8 Sunoco stocks and 3-month US T-Bills by using the risk free rate
calculated in part (2.2) and 1.05 times the value of the mean-variance utility function parameter calculated in part
(2.4). What fraction of the portfolio is in the risky asset, what is expected return and risk of this portfolio? Is the investor
leveraging her portfolio and if so, indicate how she does this.
If the last digit of your ID # ends in 1, 3, 5, 7, 9 JP Morgan stocks and 3-month US T-Bills by using the risk free rate
calculated in part (2.2) and 0.8 times the value of the mean-variance utility function parameter calculated in part (2.4).
What fraction of the portfolio is in the risky asset, what is expected return and risk of this portfolio? Is the investor
leveraging her portfolio and if so, indicate how she does this.
Show all calculations to 4 decimal places.



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(2.6) [4 POINTS] For the month of January 2012, an investor wants to create a synthetic risky asset consisting of Sunoco
stocks and JP Morgan stocks. What fraction of the synthetic risky asset is in each risky asset and what is expected return
and risk of this synthetic risky asset? Use the risk free interest rate calculated in part (2.2), and if relevant, feel free to
use the utility parameter value from part (2.5) and the formula below. Show all calculations.

(

Proctors are NOT allowed to tell you anything about this formula. Please indicate which stocks are A and B and
show all calculations to 4 decimal places.
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(2.7) [3 POINTS] For the month of January 2012, construct a portfolio consisting of:
If the last digit of your ID # ends in 0, 2, 4, 6, 8 3-month US T-Bills and the synthetic risky asset from part (2.6). Use
the risk free rate calculated in part (2.2) and use 0.9 times the value of the mean-variance utility function parameter
calculated in part (2.4). What fraction of the portfolio is in the risky asset, what is expected return and risk of this
portfolio? Is the investor leveraging her portfolio and if so, indicate how she does this.
If the last digit of your ID # ends in 1, 3, 5, 7, 9 3-month US T-Bills and the synthetic risky asset from part (2.6). Use
the risk free rate calculated in part (2.2) and use 1.1 times the value of the mean-variance utility function parameter
calculated in part (2.4). What fraction of the portfolio is in the risky asset, what is expected return and risk of this
portfolio? Is the investor leveraging her portfolio and if so, indicate how she does this.
Show all calculations.


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(2.8) [3 POINTS] Use your answer to part (2.7) to answer this question. An investor has $5,000 to invest. Fill the entries in
the following table and show all calculations.
If the last digit of your ID # ends in 0, 2, 4, 6, 8 An investor has $5,000 to invest. Fill the entries in the following table
and show all calculations below:

If the last digit of your ID # ends in 1, 3, 5, 7, 9 An investor has $8,000 to invest. Fill the entries in the following table
and show all calculations below:
US 3-Month T-Bills Synthetic Asset Sunoco JP Morgan
Fraction of Portfolio in:
Dollars in:
US 3-Month T-Bills Synthetic Asset Sunoco JP Morgan
Fraction of Portfolio in:
Dollars in:
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Question 3 [30 POINTS]
Phew! You passed ECO 204 and cruised through your third and fourth year courses. But youre one course shy of
graduation. In desperation, you look for a bird course (like ECO 204) and after consulting your brainy friends you settle
on RSM 000 The Business of Nothingness (nope, its not a marketing course). The trouble is that this course is full (after
all, its a bird course) and you must choose one of the following options:
Either offer the RSM 000 professor a $200 bribe to let you in. With a chance ( ) the professor accepts the
bribe (tsk tsk) and immediately enrolls you in the course, for which youll have to pay $4,000 in tuition. On the
other hand, with a chance the professor is offended that you tried to bribe him and reports you for academic
violation (life sucks). The school confiscates your bribe, kicks you out, and fines you $2,000.
Or dont bribe the RSM 000 professor and wait to see if you get into the course. With probability you do
get into RSM 000 in which case your total cost will be $4,000 in tuition and an opportunity cost of $500. On the
other hand, with probability ( ) you dont get into RSM 000 in which case you will have to take a
course at Ryerson University which costs you $3,000 in tuition and an opportunity cost of $500.
(3.1) [7 POINTS] Assuming you are risk neutral, should you bribe the RSM 000 professor to let you into his course? Show
all calculations and be sure to interpret your calculations. Hint: It is strongly recommended that you draw a decision
tree.
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(3.2) [5 POINTS] Assume that the probability the professor will not take the bribe and report you for academic violations
is . Will you try to bribe the professor and what is the expected value of your decision? Show all calculations.
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(3.3) [10 POINTS] Assume the probability that the professor will not take the bribe and report you for academic violations
is Now suppose a friend of yours, as well as the professors, tells you that he will for a fee test the professors
integrity and honesty. Perhaps your friend will bring up the subject of bribes and get a feel for whether the professor will
take the bribe. You need to decide whether to make the decision of whether to bribe or not bribe the professor on the
basis of no test information (as you did in part (3.2)) or on the basis of test information. Since your friend has done this
sort of stuff in the past you ask him for a breakdown of test results and what actually happened. Heres what your friend
gives you:
Professor Took Bribe Professor Did not Take Bribe Total
Positive (evidence that professor is corrupt) 15 5 20
Negative (evidence that professor is not corrupt) 5 75 80
Total 20 80 100

Based on the information in this table, should you make the decision to bribe versus not bribe the professor by hiring
your friend to do tests on the professor? Draw the decision tree below, show all calculations, and indicate what you
will do if the test comes back positive or negative.
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ECO 204, 2012 - 2013, Test 2
This test is copyright material and cannot be used for commercial purposes or posted anywhere without prior permission. Report violations to eco.204@utoronto.ca
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(3.4) [4 POINTS] [THIS IS INDEPENDENT OF PARTS (3.2) AND (3.3)] Recall that you are risk neutral. From the information above,
derive the equation of your utility function and compute the utilities of the four outcomes in your decision problem.
Show all calculations and briefly explain the steps used to derive the utility function.






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(3.5) [4 POINTS] [THIS IS INDEPENDENT OF PARTS (3.2) AND (3.3)] Use your answer to part (3.4) to compute the certainty
equivalence to the uncertainty arising from bribing the professor not bribing the professor.


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Question 4 [15 POINTS]
[ALL PARTS ARE INDEPENDENT OF EACH OTHER] The original formula and production process for manufacturing Coca-Cola did
not permit the use of any other sweetener besides sugar.
(4.1) [5 POINTS] Assuming sugar is the only input for producing Coca-Cola, write down the equation of the long run
production function, plot an iso-quant with sugar on the x-axis and fructose on the y-axis, and characterize the returns
to scale.






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(4.2) [5 POINTS] Assuming sugar, capital and labor are the only complementary inputs for producing Coca-Cola (where
each machine requires 3 units of sugar and 2 workers) write down the equation of the long run production function, plot
an iso-quant with sugar on the x-axis and labor on the y-axis, and characterize the returns to scale.
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(4.3) [5 POINTS] Eventually Coke was able to reformulate Coca-Colas formula and manufacturing process to allow the use
of sugar and/or fructose as imperfect substitutes (with diminishing technical rate of substation) and permitting the use
of no sugar or no fructose. Write down the equation of a long run production function that describes this production
process, plot an iso-quant with sugar on the x-axis and fructose on the y-axis, and characterize the returns to scale.

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