Microeconomics–Final.

October 8, 2010

Answer any five of six questions. Each questions carries 20 marks. The marks for each
subpart is indicated in brackets after the statement of the question.

1. A monopolist has a cost function given by c(q) = q 2 and faces a demand curve given by
p(q) = 120 − q.

(a) What is his profit -maximizing output level? What price will the monopolist charge?
What is the monopolist’s profit and what is consumer surplus? (5)
(b) If a lump-sum tax of 100 were imposed on this monopolist, what would be its profit
maximizing output level? What is the monopolist’s profit and what is consumer surplus?
Do you notice any change between (a) and (b)? Explain the change. (Hint: Lump sum
tax just adds a constant amount to the producer’s cost).(5)
(c) If you wanted to choose a price ceiling for this monopolist so as to maximize consumer
plus producer surplus, what price ceiling should you choose? How much outputs will the
monopolist produce at this price ceiling? (There is no lump sum tax in this question).(5)
(d) Suppose that you put a specific tax on the monopolist of 20 per unit of output. What
would its profit–maximizing level of output be? (5)

2. You are selling two goods, 1 and 2, to a market consisting of three consumers with reservation
prices as follows:
Consumer Good 1 Good 2
A 20 100
B 60 60
C 100 20
The unit cost of production of each product is 30.

(a) Suppose you can engage in perfect price discrimination. What prices will you charge
each consumer for the two goods? What is your profit from this scheme? (7)
(b) Suppose you cannot price discriminate and must charge each consumer the same price.
What price will you charge for the two goods if you sell them separately? (6)

1
 (c) Now suppose you bundle the two goods and sell them as a pair. What price will you
charge for the bundle? What is your profit?(7)

3. Suppose two individuals decide to work together on a project. Both of them have the option
to either work hard on the project or shirk. If both of them work hard, the value of the
finished project is worth 7 to each of them. However, if only one of them works hard while
the other shirks, the value of the finished project is worth only 4 each. If both of them shirk,
the finished project is of a very poor quality and worth only 1 to each. The effort cost of
working hard is 5 while the cost of shirking is 1.

(a) Interpret the above story as a simultaneous move game and write its payoff matrix.
(Hint: payoff=benefit−cost). (6)
(b) From the social point of view, which outcome is the best. (3)
(c) What is the Nash equilibrium of the game? Is is also the dominant strategy equilibrium?
(5)
(d) Does the finished project qualify as a public good for the two players? Use your answer
to (b) and (c) to explain why it is difficult to provide a public good through individual
initiative. Explain how this difficulty may be resolved through repeated interaction
between the two players. (6)

4. Consider the market for baseball caps. You are the CEO of a company, which is the only
producer of baseball caps. Initially, you had been maximizing profits by producing quantity
Q = 90. However, a new firm is considering entering the baseball cap market to get a share
of the positive economic profits being earned. The following decisions must be made: you
must decide whether to continue producing quantity Q = 90 (the profit maximizing level of
production for a monopoly) or to produce Q = 150 (you would produce 150 baseball caps
in an effort drive market price down so low that the new firm would rather not enter the
cap making industry); the new firm must decide whether to enter the market and produce
Q = 50 or not enter the market and produce nothing (Q = 0). We are therefore assuming
that you can produce Q = 90 or Q = 150 and the new firm can produce Q = 0 or Q = 50.
This situation is depicted using a payoff matrix. For parts (a) - (c), assume you and the new
firm must decide how much to produce simultaneously.
 
QY = 90 QY = 150
 QN F = 0 0, 8000 0, 4500 ,
 

QN F = 50 500, 3600 −2500, −3000

where QN F denotes the new firm’s output and QY denotes your output. The numbers in the
matrix denote profits.

(a) Do you have a dominant strategy? If so, what is it? Justify your answer.(4)

2
 (b) Does the new firm have a dominant strategy? If so, what is it? Justify your answer.(4)
(c) Find the Nash Equilibrium for this game. (5)
(d) Now suppose your firm (being more established and trusted by the consumer) is the
dominant firm in the industry such that you decide how much to produce first and the
new firm decides how much to produce second. Find the Stackelberg Equilibrium for
this game. State how much you and the new firm produce. (7)

5. Consider a labour market with two types of workers. Suppose the high type (H-type) produces
an output of 200 while the low type (L-type) produces 100. The proportion of H-type workers
1
in the market is 3 and that of L-type is 23 .

(a) Suppose the labour market is competitive. If an employer has full information about an
worker’s type, what wage will be offered to each type of worker? If the employer has no
information on the worker’s type, what will be the wage offered? (4)
(b) Now consider the situation where a worker can signal capability by using the level of
education acquired. Let w be wage and e be education. Suppose the utility function of
a H-type worker is UH (e, w) = w − e2 and that of a L-type worker is UL (e, w) = w − 2e2 .
Explain why the coefficient of the e term is higher in the L-type’s utility function; i.e.
why is the coefficient 2 in UL (e, w) and 1 in UH (e, w). (8)
(c) Let e∗H and e∗L be the education levels acquired by the H-type and the L-type respectively
in a separating equilibrium. Find e∗H and e∗L . What are the wages earned by the two
types in that separating equilibrium. (Hint: Low type’s utility from acquiring e∗H and
getting the H-type wage must be equal to utility obtained by acquiring e∗L and getting
the L-type wage). (8)

6. Suppose the owner of a firm is contemplating hiring a worker to run the firm. The worker
operates the firm by exerting effort e. An additional unit of effort increases output by an
additional 100 by 6%. The cost of effort for the worker is C(e) = e2 .

(a) What is the optimal level of effort that the worker should exert? (5)
(b) Suppose the owner hires the worker on a fixed wage contract. What will be the effort
level of the worker? Give the intuition behind your answer in terms of marginal benefit
and marginal cost. (5)
(c) Suppose now the owner hires the worker on the basis of a fixed-cum-variable pay contract.
What is the variable pay component of this contract that will induce optimal effort from
the worker? What is the fixed pay component that will maximize profit for the owner.
If the fixed pay component is a negative number, interpret the negative number. (Hint:
fixed pay component determined by making worker’s net benefit zero). (10)