Universidad Carlos III de Madrid May 2018

Microeconomics

Name: Group:

1 2 3 4 5 Grade

You have 2 hours and 45 minutes to answer all the questions.

1. Multiple Choice Questions. (Mark your choice with an “x.” You get 2 points if your answer is
correct, -0.66 points if it is incorrect, and zero points if you do not answer.)

1.1. The lexicographic preferences %L over consumption bundles in R2+ are de…ned as (x; y) %L
(x0 ; y 0 ) if x > x0 ; or if x = x0 and y y 0 . Hence, %L

does not satisfy axiom A:1 (completeness)

does not satisfy axiomA:2 (transitivity)
does not satisfy axiom A:3 (monotonicity)
satis…es axioms A:1; A:2 and A:3.

1.2. A consumer with monetary income I = 4 is considering buying the consumption bundle (0; 2)
at prices (px ; py ) = (3; 2): If RM S(0; 2) = 2, then

buy less good x and more good y buy more of both goods
buy more good x and less good y the bundle (0; 2) is optimal.

1.3. The prices were (px ; py ) = (1; 1) in 2017, and are (p0x ; p0y ) = (1; 2) in 2018. Therefore the true
consumer price index (CPI) for a consumer with income I = 3; and preferences are represented by
the utility function u(x; y) = minf2x; yg is

4 3 5
1 ,
3 2 3

1.4. and his Laspeyres CPI is

4 3 5
1 .
3 2 3

1
 p
1.5. An individual with preferences represented by the Bernoulli utility function u(x) = x, where x
is his salary, has two job o¤ers (X and Y ) with wages that depend on whether the economy falls into
a recession (R), maintains the current situation (M ), or stars a booming cycle (B), which occurs
with probabilities pR = 1=4; pM = 1=2 and pB = 1=4: Job o¤er X pays (xR ; xM ; xB ) = (16; 25; 36)
and job o¤er Y pays (yR ; yM ; yB ) = (0; 16; 100). Hence, the expected utility and certainty equivalent
of his preferred job o¤er, (Eu ; CE ); are

(Eu ; CE ) = (4; 16) (Eu ; CE ) = (5; 20)

(Eu ; CE ) = (5; 25) (Eu ; CE ) = (6; 36);

1.6. and the maximum amount the individual is willing to pay in order to know with certainty the
state of the economy, M; satis…es

M =0 M 2 (5; 10)
M 5 M 10:

1.7. The production function of Lolita, the competitive cow of Holstein that produces milk using
p
oats (x) and barley (y) which she buys at prices px = 8 and py = 4, is F (x; y) = x2 y. In the
short run the amount of oats is …xed to x = 2 units. There in the short run Lolita has

economies of scale diseconomies of scale

constant returns to scale increasing average variable cost,

1.8. and her competitive supply of milk S(p) at prices p = 2 and p = 6 is

S(2) = 0; S(6) = 3 S(2) = 4; S(6) = 6

S(2) = 0; S(6) = 12 S(2) = 4; S(6) = 12.

1.9. The Lerner index of a monopoly that produces the good with costs C(Q) = 20 + Q2 if the
demand is D(P ) = maxf12 P; 0g is
1 1 1 2
,
4 3 2 3

1.10. and its pro…t with …rst degree price discrimination is

2 4 6 8.

2
2. The preferences of a consumer over food (x) and cloths (y) are represented by the utility function
u(x; y) = 4x + ln y.
(a) (10 points) Calculate the consumer’s demand of food and cloths, x(px ; py ; I) and y(px ; py ; I).
(Check the possibility of corner solutions to the consumer’s problem.) Graph his budget set and
calculate his optimal consumption bundle and utility level for (px ; py ; I) = (4; 1; 5).
Since
4
M RS(x; y) = 1 = 4y;
y
an interior solution to the consumer’s problem solves the system

px
4y =
py
px x + px y = I:
The solution to this system is
I 1 px
x(px ; py ; I) = ; y(px ; py ; I) = :
px 4 4py
When I > px =4; these values are positive and are the solution to the consumer’s problem. When
I px =4; the solution to the consumer’s problem is (x; y) = (0; I=py ).
For (px ; py ; I) = (4; 1; 5) the budget constrain is
4x + y = 5;
and the optimal consumption bundle is
5 1 4
(x ; y ) = ( ; ) = (1; 1):
4 4 4 (1)
Hence the consumer’s utility is
u(1; 1) = 4(1) + ln 1 = 4:
The following graph illustrates these results.
y

u(x,y)=4

0
0 1 2 3x

3
 (b) (10 points) At prices and income (px ; py ; I) = (4; 1; 5); calculate the income and substitution
e¤ects over the demand of cloths y of an increase of its price to p0y = 2.
At prices and income (px ; p0y ; I) = (4; 2; 5) the demand for food and cloths are

5 1 4 1
( ; ) = (1; ):
4 4 4 (2) 2

Thus, the total e¤ ect on the demand of y is

1 1
T E = y(4; 1; 5) y(4; 2; 5) = 1= :
2 2

To calculate the substitution e¤ ect we solve the system

4x + ln y = 4
4
4y = :
2
Solving for y we get
1
y= :
2
Hence the substitution e¤ ect is
1
SE = y y(4; 1; 5) = ;
2
and the income e¤ ect is
1 1
IE = T E SE = = 0:
2 2

4
3. Alberto’s preferences over leisure (h; measured in hours) and consumption (c; measured in euros)
are represented by the utility function u(h; c) = h2 c: Alberto has a monetary income of M = 36
euros, and 24 hours available for leisure and labor. (Denote the wage as w; and observe that since
consumption is measured in euros, pc = 1.)
(a) (10 points) Calculate and graph Alberto’s labor supply.

Alberto’s marginal rate of substitution for leisure-consumption is M RS(h; c) = 2c=h. Hence,

an interior solution to Alberto’s problem solves the system
2c
= w
h
c + wh = 24w + 36;

whoso solution is
24
h(w) = 16 + ; c(w) = 12 + 8w:
w
For ! 3 this is the solution to Alberto’s problem. For w < 3, we get h(w) > 24; and hence the
solution to Alberto’s problem is (h; c) = (24; 36).
Alberto’s labor supply is

0 if w < 3
l(w) = 24 h(w) =
8 24=w if w 3:

The graph of this function is given below.

8 l

5
(b) (10 points) Assuming that w = 8 euros/hour, calculate the equivalent variation of a 25% tax
on labor income, and show that it is greater than the tax revenue.

With the tax on labor income, if the wage is w = 8, then the e¤ ective wage is w = (1 0:25)8 = 6.
The optimal leisure-consumption bundle is (h ; c ) = (20; 60) and Alberto’s utility is

u = (20)2 60 = 24000:

Thus, Alberto’s labor supply is l(6) = 4, and the 25% labor tax rises a revenue of

(0:25) (8) 4 = 8:

To obtain the equivalent variation we solve the system

2c
h2 c = 24000; = 8;
h
which solution is
p3
c~ = 4 6000
p
~
h =
3
6000 = 18:171:

~ that allows Alberto paying for this leisure-consumption bundle satis…es

The monetary income M
the budget constrain
p p
~ = c~
M (24 ~ ) (8) = 4 3 6000
h 24
3
6000 8 = 26:054:

Therefore the equivalent variation is

M ~ = 36
M 26; 054 = 9; 946 > 8:

6
4. A …rm produces a good using labor (L) and capital (K) that buys in p competitive markets at
4
prices are w and r; respectively. Its production function is F (L; K) = L (K 4): The market
demand is D (P ) = maxf0; 12 P=2g:

(a) (5 points) Calculate the …rm’s conditional input demand functions.

Since
K 4
M RT S(L; K) = ;
L
for Q > 0 the conditional input demands solve the system
K 4 w
=
p L r
4
L(K 4) = Q;

which solution is r r
r 2 w 2
L = Q ; K = Q + 4:
w r
For Q = 0; cost is minimized at K = L = 0: Hence the condition input demands are
r
r 2
L(w; r; Q) = Q ;
w
0 if Q = 0
K(w; r; Q) = pw 2
r Q + 4 if Q > 0:

7
 (b) (10 points) Assuming that input prices are (w; r) = (1; 4), calculate the …rm’s total, mar-
ginal, and average cost functions. If the …rm was competitive, what would be its supply function?

The total cost function is

0 if Q = 0
C(w; r; Q) = wL(w; r; Q) + rK(w; r; Q) = p
2 wrQ 2 +4r0 if Q > 0:

For (w; r) = (1; 4) and Q > 0; this function is

C(Q) = 4Q2 + 16;

and the average and marginal cost function are

16
AC(Q) = 4Q + ; M C(Q) = 8Q:
Q

We calculate the …rm’s supply. The second order condition for pro…t maximization is satis…ed
since
dM C(Q)
= 8 > 0:
dQ
The closing down condition is given by

(Q) > (0) = C(0) = 0;

which requires checking the inequality

P AC(Q);
and implies that the …rm supplies zero units for prices below the minimum average cost, AC ; and
supplies Q solving the equation
P = M C(Q) () P = 8Q;
for larger prices. In order to calculate the minimum average cost we solve the equation

dAC(Q) 16
= 0 () 4 = 0;
dQ Q2

which solution, Q = 2; leads to an average cost of AC = AC(Q ) = 16: Therefore the competitive
…rm’s supply is 8
< 0 if P < 16
S(P ) = f0; 2g if P = 16
: P
8 if P > 16:

8
 (c) (5 points) Assuming that there is free entry, and that the given technology is the one available
to produce the good and can be freely adopted, calculate the price, total surplus and the number
of …rms in the long run competitive equilibrium.

In the long run competitive equilibrium the price equals the minimum average cost, that is
P = AC = 16, and therefore …rms’ output is Q 2 f0; 2g. To serve the demand at this price the
number of …rms that supply Q = 2 units, n ; satis…es the la equation
16
D(16) = 12 = 2n ;
2
which solution is n = 2.
Since …rms’ pro…ts are zero, the total surplus (TS) coincides with the consumer surplus (CS),
which we can calculate as the area of the triangle with vertices in the points (0; 24), (Q ; P ) =
(4; 16) and (0; 16): Hence the total surplus is
1
T S = CS = (24 16) 4 = 16:
2

9
(d) (10 points) Determine the price and output assuming that the market is monopolized by a
single …rm with the given technology. Calculate the loss in total surplus relative to the long run
competitive equilibrium.
The inverse demand function is
P (Q) = 24 2Q:
(We only consider output levels Q 12, since the demand is always below 12.) Thus, the
monopoly’s revenue function is

R(Q) = P (Q)Q = (24 2Q) Q:

and its marginal revenue function is

dR(Q)
M R(Q) = = 24 4Q:
dQ
In the monopoly equilibrium output solves the equation

M R(Q) = M C(Q) , 24 4Q = 8Q:

The solution to this equation is

QM = 2; PM = P (QM ) = 20:

In the monopoly equilibrium the total surplus (TS) is the sum of the consumer surplus and
producer surplus (i.e., the pro…ts of the monopoly). The consumer surplus is
1
CSM = (24 20) 2 = 4;
2
and the pro…t of the monopoly is

M = PM QM C(QM ) = 20 (2) 4 (2)2 + 16 = 8:

Hence the lost surplus relative to the long run competitive equilibrium is

TS (CSM + M) = 16 (4 + 8) = 4:

10
(e) (10 points) Determine the price and output if the government regulates optimally the price.
Calculate the loss in total surplus relative to the long run competitive equilibrium, and graph the
demand and the equilibrium of parts (c), (d), and (e).

The optimal regulated price is the solution to the equation

P (Q) = CMa (Q) , 24 2Q = 8Q;

which is
QR = 2:4; PR = P (QR ) = 19:2:
At this price the consumer surplus is
1
CSR = (24 19:2) 2:4 = 5:76;
2
and the monopoly pro…t is

R = PR QR C(QR ) = 19:2 (2:4) 4 (2:4)2 + 16 = 7:04:

Hence, the loss surplus relative to the long run competitive equilibrium is

TE (ECR + R) = 16 (5:76 + 7:04) = 3:2:

The graph below represents the equilibria calculated in parts (c), (d) and (e).

20 ..
(QM, PM )
(QR,PR )
.(Q*,P*)

10

0 Q
0 5 10

11