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# BPUB 250: Fall 2010

2
nd
Midterm
Instructions
1 Work on each question in a separate Bluebook: clearly indicate the
question number on the Bluebook cover
2 Read over the whole exam, and do the easier questions first.
3 Show your work. No credit will be given if work is not shown.
4 Make clear which subsection of the exam you are answering!
5 Write legibly!
6 Write your name and student I.D. number on every Bluebook and on
the first and last page of this exam

Your
Name:_____________________________________________________
Your
I.D. # _______________________________________________________________

Section number:_____________________________________________

DO NOT START UNTIL 6:00 PM

EACH QUESTION IN A SEPARATE
BLUEBOOK!

Question 1 (20 points)

Steve Employments, the CEO of Pineapple Inc., is developing a new product: a black
turtleneck sweater that incorporates a microphone, ear buds, 4G coverage, an MP3
player, GPS, and a health monitoring system. The productcodenamed IHotis ready
to go into production. Unfortunately, Steve knows that his suppliers will eventually share
the production technology with a competitor: Swansong. Swansong is already developing
marketing materials for their copy-cat product: the MeSweats.

Fortunately for Steve, Pineapple is widely recognized as the leader in new consumer tech
products. Steve will make a decision as to how many IHots to produce first and thinks
that Swansong will just accept its secondary position upon entering the industry.

Since the product is outsourced to identical foreign suppliers, the marginal cost of
production will be the same for Pineapple and Swansong: \$20 per unit. Assume that fixed
costs are zero.

Steve estimates that the overall demand for the indistinguishable IHots and MeSweats
follows the function:
1
300
2
P Q = .

a) (10 points) What should be the production target of Pineapple?

b) (3 points) What will be the likely retail price of the IHot?

Steve realizes that, rather than outsourcing the production of IHot, he could be producing
it in his Mugertino plants, at an estimated marginal cost of \$150 per unit. The advantage
of in-house production is that it would not allow any competitors access to the IHot
technology, and Pineapple would be the sole producer in this market.

c) (7 points) Should Steve outsource production or produce the IHot in-house?
Briefly discuss.

Question 2 (20 points)

Brianna is an iPhone user, whose individual demand for hours of iPhone use is given by q
= 40 P, while her opportunity cost of time can be represented by P = 10 + 2q. In this
market, q represents Briannas hours of iPhone use, and P represents the amount of
money she would spend for the right to use her phone for an hour or the opportunity cost
of her time.

Briannas iPhone use affects the people around her on Penns campus: the more she uses
her iPhone, the more each hour of texting while walking, talking loudly, game-playing,
etc., annoys people around her. These additional costs can be written as MEC(q) = 3q.

a) (3 points) Compute the efficient quantity of Briannas iPhone use.

b) (5 points) Compute Briannas preferred quantity of iPhone use and the total

c) (5 points) Suppose Penns administration recognizes the problem in this
market and charges each user a constant fee of \$100 to register her phone
and consequently be permitted to use her phone on campus. How does this
affect your answers to (b)? Would Brianna pay the fee? Provide appropriate
calculations.

d) (5 points) Now suppose that instead of the policy in (c), Penn assesses each
user a per-hour fee of \$3. How does this affect your answers to (b)? How
much revenue would Penn collect from Brianna? Provide appropriate
calculations.

e) (2 points) Describe a policy that yields the efficient quantity of iPhone hours
and generates revenue for Penn. Calculate the revenue Penn collects from
Brianna.

Question 3 (20 points)

You own a small company with only two workers: Eloi and Morlock. Eloi is hard-
working and highly motivated. His utility function is therefore independent of effort and
contingent on his wages:
E
U W = . Morlock, on the other hand, tends to display
inordinate narcissist tendencies and loathes working hard. If Morlock does not work hard,
his utility function is identical to Eloiss:
M
U (shirking) W = ; however, if Morlock must
work hard, he feels as if his wage were reduced by \$5,000, and his utility function
therefore becomes ( )
M
U (working) W 5,000 = .

Union rules force you to pay your workers 50% of the companys gross profits, divided
equally between your workers (25% to Eloi, 25% to Morlock). Eloi will always work
hard, and so the chance of experiencing higher profits depends solely on Morlocks
attitude. The following table illustrates the probabilities of attaining high gross profits
(\$100,000) or low gross profits (\$60,000) as a function of Morlocks effort:

Probability of Obtaining High
Gross Profits (\$100,000)
Probability of Obtaining Low
Gross Profits (\$60,000)
Morlock Shirks 0.1 0.9
Morlock Works Hard 0.7 0.3

a) (2 points) What is the expected wage for each worker if Morlock shirks?

b) (2 points) What is the expected utility of working hard for Morlock, given
that he obtains wages equal to 25% of profits?

c) (2 points) What is the expected utility of shirking for Morlock?

d) (3 points) What average net profits (after wages) should you expect?

The local union boss, Joe Breccabonni, has realized that you are risk-neutral and only
care about your expected profits whereas workers are risk-averse. He offers you a deal:
you can now pay one or both of your workers a fixed salary if you want to; however, you
have to make sure that the worker would agree to the fixed payment in lieu of his current
situation (25% profit sharing).

e) (5 points) What is the fixed minimum payment that Eloi will accept in lieu of
his share in the companys profit?

f) (6 points) How should you structure your wage payments now? What is your
expected net profit (after all wage disbursements)?

Question 4 (20 points)

Hana and Dave play the following simultaneous game:

a) (5 points) Find all Nash equilibria of this game

b) (2 points) Suppose this game is repeated 55 times, what would the Nash
equilibrium or equilibria be? Why?
Now suppose that Hana and Dave have altruistic preferences. Specifically, Hanas and
Daves new utilities are given by

v
H
(s
H
,s
D
)=u
H
(s
H
,s
D
) + yu
D
(s
H
,s
D
), and

v
D
(s
H
,s
D
)=u
D
(s
H
,s
D
) + yu
H
(s
H
,s
D
),

respectively, where y is a constant and s
H
, s
D
represent each players strategy.
For example, u
H
(Confess, Confess) = 1, u
D
(Confess, Confess) = 1, so Hanas utility from
playing (Confess, Confess) will be v
H
(Confess, Confess) = 1+ y.

c) (3 points) Draw a payoff matrix that represents this new game.

d) (5 points) Find the range for values of y such that the Nash equilibrium or
equilibria of this new game are the same as that or those found in (a).

e) (5 points) If y lies outside the range found in (d), find all possible Nash
equilibria.

Player D: Dave
Not Confess Confess
Player H:
Hana
Not Confess (3,3) (0,5)
Confess (5,0) (1,1)
Question 5 (20 points)

Comment on the article snippet from Bloomberg.com below. You can use any argument
relevant to BPUB 250, but start by focusing on the game-theoretic aspects that underlie
the confidence problem that the government of Portugal is facing with investors in the
credit markets. What is the role of the European Central Bank (ECB) in this game?

evaluated in terms of breadth and quality. Write clearly.

Greek, Portuguese Debt Climbs Amid
Speculation ECB Bought Region's Bonds
By Paul Dobson - Dec 3, 2010 7:47 AM ET
Irish, Greek and Portuguese bonds rose, narrowing the yield difference with
benchmark German bunds, amid speculation the European Central Bank bought
more assets of high-deficit nations to stem the debt crisis.
Bonds from so-called peripheral nations rallied yesterday as traders said that the
ECB increased purchases of their government bonds. The central bank bought
Portuguese debt as well as Irish bonds today, said two people with knowledge of the
deals who declined to be identified because the transactions are confidential.
The ECB may increase purchases of government bonds to ensure the sovereign debt
crisis abates, according to Dirk Schumacher, an economist at Goldman Sachs Group
Inc. in Frankfurt.
We remain convinced that the political will among policy makers, including the
ECB, to prevent any systemic event is unquestionable, he wrote in a research report
dated yesterday. We could easily see the ECB stepping up its bond purchases
aggressively if things do not start to normalize.

Question 1 (20 points)

a) What should be the production target of Pineapple?

The first step is to find the reaction function of the follower (Swansong) with respect
to the leaders decision. Swansongs revenue function is

[ ]
2
1 1 1 1
Re 300 300 300
2 2 2 2
S S S P S S S P S S
v P Q Q Q Q Q Q Q Q Q Q
| | | |
= = = + =
| |
\ \
,
and therefore marginal revenue:
1
300
2
S P S
MR Q Q = . At the optimal quantity,
MR
S
=MC, and so
1
300 20
2
P S
Q Q = and the reaction function of Swansong will be:
1
280
2
S P
Q Q = .
Now, Pineapple should use the anticipated reaction function to make decisions.
Pineapples revenues are:
[ ]
1 1
Re 300 300
2 2
P P P P S P
v P Q Q Q Q Q Q
| | | |
= = = +
| |
\ \
, into which we substitute
Swansongs reaction function:
2
1 1 1
Re 300 280 160
2 2 4
P P P P P P
v Q Q Q Q Q
| | (
= + =
|
(
\
.
And
1
160
2
P P
MR Q = , which is equated to MC=20 and yields:
1
20 160
2
P
Q = and
280
P
Q = , which is the answer.

b) What will be the likely retail price of the IHot?

We need to find the total production in the market and plug into the demand function to
find the price that the market will bear. From the reaction function of Swansong, we
know they will produce:
1 1
280 280 280 140
2 2
S P
Q Q = = = . This implies
[ ] [ ]
1 1
300 300 280 140 90
2 2
P S
P Q Q
| |
= + = + =
|
\
.

c) Should Steve outsource production or produce the IHot in-house? Briefly
discuss.

The trade-off is as follows. If you produce in-house you will have a monopoly, but the
costs of production are higher. If you outsource, your secrets will be revealed to a third
party, but your costs of production will be lower, and you will remain the market leader.
We first need to calculate Pineapples profits under the Stackelberg duopoly.
90 280 20 280 19, 600
Stackelberg
P
REV TC = = =
Now if Pineapple were a monopolist, revenues would be
2
1 1
Re 300 300
2 2
v P Q Q Q Q Q
| |
= = =
|
\
, and so 300 MR Q = .
Equating to the new marginal cost of 150, we obtain Q=150.
Now the monopolist price of the IHot is (from demand function):
1 150
300 300 225
2 2
Mon
P Q
| |
= = =
|
\
and total profits are
225 150 150 150 11, 250
Stackelberg
P
REV TC = = = .

It pays off to outsource even if this means that the IHot technology will eventually be
transferred: producing at home is too costly.

Question 2 (20 points)

(a) Efficient consumption of iPhones occurs when MSC=MSB.
MSC=MSB
10+2q+3q=40-q
6q=30
q
eff
=5

(b) Brianna will use her phone until MB=MC. (This is not a monopoly, so its total
surplus we are maximizing, not something akin to profits)
40-q=10+2q
3q=30
q*=10

DWL=(1/2)MEC(Q*)(Q*-Qeff)=(1/2)(30)(5)=\$75.

(c) Briannas total surplus is (1/2)(40-10)(10)=\$150, so she will pay any amount under
\$150 for the right to use her phone. This does not affect the DWL calculation, as the
quantity of iPhone use does not change.

(d) 40-q=10+2q+3
q*=9
This is better, but its still not efficient:
DWL=(1/2)(MSC(9)-MSB(9))(9-5)=\$48.
Tax revenue=9*3=27.

(e) A per-unit tax equal to the MEC at the efficient quantity will do the trick. TR=
q
eff
*(3q
eff
)=75.

Question 3 (20 points)

Morlock Hazard.
Probability of Obtaining High
Gross Profits (\$100,000)
Probability of Obtaining Low
Gross Profits (\$60,000)
Morlock Shirks 0.1 0.9
Morlock Works Hard 0.7 0.3

a. (2 points) What is the expected wage for each worker if Morlock shirks?

W 0.25 (0.1 100,000 0.9 60,000) 0.25 64,000 16,000 = + = =

b. (2 points) What is the expected utility of working hard for Morlock, given
that he obtains wages equal to 25% of profits?

( ) ( )
M
EU (working) 0.7 0.25 100,000 5,000 0.3 0.25 60,000 5,000 = +
M
EU (working) 0.7 25,000 5,000 0.3 15,000 5,000 = +
M
EU (working) 0.7 141.42 0.3 100 98.994 30 128.994 = + = + =

c. (2 points) What is the expected utility of shirking for Morlock?

M
EU (shirking) 0.1 25,000 0.9 15,000 = +
M
EU (shirking) 0.1 158.11 0.9 122.47 126.038 = + =

d. (3 points) What average net profits (after wages) should you expect?

The profit-sharing nature of wages makes
M M
EU (working) EU (shirking) > , and so
Morlock will work. We will obtain 50% of expected profits:
E(Net ) 0.5 (0.7 100,000 0.3 60,000) 44,000 = + =

e. (5 points) What is the fixed minimum payment that Eloi will accept in lieu of
his share in the companys profit?

Since Morlock will work: ( ) ( )
E
EU 0.7 0.25 100,000 0.3 0.25 60,000 = +
E
EU 0.7 25,000 0.3 15,000 0.7 158.11 0.3 122.47 147.4221 = + = + =
Elois certainty equivalent is the minimum he is willing to accept in lieu of profit sharing:
( )
2
E
CE 147.4221 21,733.27 = =

f. (6 points) How should you structure your wage payments now? What is your
expected net profit (after all wage disbursements)?

Note that you will not want to pay a fixed amount X to Morlock, because in that case
he will certainly shirk:
M M
U (shirking) X U (working) X 5,000 = > = . Therefore
you will offer a fixed wage to Eloi of 21,733.27 to take advantage of his risk aversion
but keep Morlock incentivized by paying the 25% profit share. Your expected net
profit is:
E(Net ) 0.75 (0.7 100,000 0.3 60,000) 21,733.276 44,266.724 = + = ,
which represents an improvement for you.

Question 4 (20 points)

1. Hana and Dave play the following simultaneous game:

1) Find all Nash equilibria of this game
(Confess, Confess) is the only Nash equilibrium. Given Dave playing Confess,
Hanas best response is to play Confess and given Hana playing Confess,
Daves best response is to play Confess as well.
2) Suppose this game is repeated 55 times, what would the Nash equilibrium or
equilibria be? Why?
Hana and Dave will play (Confess, Confess) in the last period. Thus the fact that
the game is played 55 times does not change the Nash equilibrium in each round
of the game (despite the possibility of reciprocation). Suppose the two players
attempted to collude and both play Not Confess in each period. In the last
period, each player would have incentive to cheat, and so get 5 instead of 3. So
the Nash equilibrium will be played in the last period. This would then be the case
for the 54
th
period, and so on back. So the Nash equilibrium is for Hana to
Confess and Dave to Confess in each round of the game.

Now suppose that Hana and Dave have altruistic preferences. Specifically, Hanas
and Daves new utilities are given by
v
H
(s
H
,s
D
)=u
H
(s
H
,s
D
) + yu
D
(s
H
,s
D
) and
v
D
(s
H
,s
D
)=u
D
(s
H
,s
D
) + yu
H
(s
H
,s
D
),
respectively, where y is a constant and s
H
, s
D
represent each players strategy.
For example, u
H
(Confess, Confess)=1, u
D
(Confess, Confess)=1, so Hanas utility
from playing (Confess, Confess) will be v
H
(Confess, Confess)=1+ y.
3) Draw a payoff matrix that represents this new game.

4) Find the range for values of y such that the Nash equilibrium or equilibria of
this new game are the same as that or those found in (a).
If the Nash equilibrium of this new game is (Confess, Confess), we need y to be
1+y>5y and 3+3y<5. Thus y<1/4.
5) If y lies outside the range found in (d), find all Nash equilibria.
If 3+3y>5 and 1+y<5y, that is y>2/3, then the only Nash equilibrium will be (Not
Confess, Not Confess). If 1/4<y<2/3, then the Nash equilibria are (Not Confess,
Player D: Dave
Not Confess Confess
Player H:
Hana
Not Confess (3,3) (0,5)
Confess (5,0) (1,1)
Player D: Dave
Not Confess Confess
Player H:
Hana
Not Confess (3+3y, 3+3y) (5y, 5)
Confess (5, 5y) (1+y, 1+y)
Confess), (Confess, Not Confess). If y=1/4, then the Nash equilibria are (Not
Confess, Confess), (Confess, Not Confess), (Confess, Confess). If y=2/3, then the
Nash equilibria are (Not Confess, Confess), (Confess, Not Confess), (Not
Confess, Not Confess).