Microeconomics for MSc in Finance

WINTER EXAM

Section A [48 points total].

Pick a single correct answer to each question. Each correct answer is worth 4 points.

1) If a reallocation of resources from Jack to Jill increases Jill's utility twofold and decreases Jack's utility by
25%...

a. This reallocation creates a Pareto improvement to the initial allocation

b. This reallocation creates a Pareto improvement only if Jill's initial utility is greater than 25% of Jack's initial
utility.
c. This reallocation does not create a Pareto improvement to the initial one
d. This reallocation creates a Pareto improvement to the initial allocation only if Jill's maximum willingness to
pay for it to happen is bigger than Jack's maximum willingness to pay to avoid it

2) A worker with standard preferences allocated one-third of her time to leisure. Assuming that leisure and
consumption are normal goods, a 10% tax on labour income would:

a. Make her work more;

b. Make her work less;
c. Make her spend less money on consumption;
d. Make her spend more money on consumption.

3) A risk-averse investor with zero wealth said that he would be indifferent between getting $140 for sure and
receiving a share of stock that would be worth $200 with a probability of 1/4 and $X with a probability of 3/4.
Which of the following is a possible value for X?

a. $90;
b. $50;
c. $130;
d. $120;
e. Not enough information to answer

4) Alexander and Yuri’s preferences are described by von Neumann-Morgenstern’s expected utility functions
with utility-of-wealth function vA(xA) = 2ln(xA) for Alexander and vY(xY) = 25xY + 2 for Yuri. Each of them has a
wealth of $1000 and may lose 20% of it with a probability of p∈ (0, 1). They can buy insurance at a price of γ
per unit of insurance coverage. If Alexander bought $150 of insurance, how much insurance did Yuri buy?

a. 0;
b. $30;
c. $150;
d. $200;
e. Not enough information to answer.

5) Consider a firm, which is a price-taker on both input and output markets. Suppose that it currently hires 400
units of labor. If the price of output equals 100, the wage rate equals 2 and her production function is 𝑓(𝐾, 𝐿) =
√𝐾 + √𝐿, then it should...

a. Increase the amount of labor hired

b. Decrease the amount of labor hired
c. Maintain the amount of labor hired at its current level
d. Change the amount of labor hired only if MPL/w  MPK/r

6) Consider a firm whose production function exhibits increasing returns to scale for all output levels. Assuming
that input prices are constant (so there are no non-technological causes for economies or diseconomies of scale),
which of the following would correctly characterize its cost curves?
a. Total cost curve is convex (c”(q) > 0) at any level of output
b. Both short-run and long-run average cost curves are U-shaped
c. Long-run marginal costs are smaller than long-run average costs at any positive level of output
d. All of the above

7) Consider a perfectly competitive, constant-cost industry. In the long run, a lump-sum subsidy paid to
producers in this industry would lead to…

a. An increase in the industry's output and social welfare

b. An increase in industry's output, but no change in individual firm's output or social welfare
c. An increase in industry's output, but a decrease in individual firm's output and social welfare
d. An increase in industry's output, individual firm's output and social welfare

8) A monopoly with a cost function c(Q) = 10 000 + 10Q (Q is the total quantity of output produced) serves
1000 customers with identical individual demand functions given by qDi(p) = 100 – p. It considers using a two-
part tariff (p, F) where p is the unit price of output and F is a fixed fee each consumer would be asked to pay. The
values of p and F that would maximize its profit would be …

a. p = 55, F = 0
b. p = 0, F = 5000
c. p = 10, F = 4050
d. p = 45, F = 55
e. None of the above

9) Consider a market with demand described by PD(Q) = 800 – 2Q, served by two identical firms that compete by
simultaneously choosing quantities. The firms’ cost functions are c1(Q1) = 100Q1 and c2(Q2) = 100Q2,
respectively.

a. If firm 2 produced 100, firm 1’s best response would be to sell 250;
b. If firm 2 produced 150, firm 1’s best response would be to sell 100;
c. If firm 2 produced 200, firm 1’s best response would be to sell 200;
d. If firm 2 produced 300, firm 1’s best response would be to sell 100
e. None of the options above are correct

10) Suppose that the cost of operating a lobster boat in Ra Wai bay is $5 000 per month. Suppose that if X
lobster boats operate in the bay, the total monthly revenue from lobster boats in the bay is $1000(21X - X2). Let
X1 denote the number of boats in the long run perfectly competitive equilibrium, and let X2 denote the Pareto-
optimal number of boats.

a. X1 = 16 and X2 = 16.
b. X1 = 8 and X2 = 6
c. X1 = 16 and X2 = 8
d. X1 = 20 and X2 = 12
e. None of the options above are correct.

11) Anna and Daria rent an apartment together. Anna’s utility function is UA(XA, G) = 2XA + G and
Daria’s utility function is UD(XD, G) = XDG where G denotes their expenditures on the public goods they share in
their apartment and where XA and XD are their respective private consumption expenditures. The total amount
they have to spend on private goods and public goods is 36 000. They agree on a Pareto optimal pattern of
expenditures in which the amount that is spent on Anna's private consumption is 6 000. How much do they spend
on public goods?

a. 10 000
b. 20 000
c. 8 050
d. 5 000
e. There is not enough information here to be able to determine the answer.
12) There are 200 used cars for sale, half of them good and another half bad. Owners of bad cars are
willing to sell them for $300. Owners of good cars are willing to sell them for prices above $900 but will keep
them if the price is lower than $900. There is a large number of potential buyers who are willing to pay $500 for a
bad car and $1500 for a good one. Buyers can't tell good cars from bad, but original owners know.

a. There will be an equilibrium in which all used cars sell for 1000.
b. The only equilibrium is one in which all used cars on the market are bad and they sell for 500.
c. There will be an equilibrium in which bad cars sell for 300 and good cars sell for 900.
d. There will be an equilibrium in which all used cars sell for 600.
e. There will be an equilibrium in which bad cars sell for 500 and good cars sell for 1500.
Section B [52 points total]

Answer the questions below

1. A public transport operator with a cost function C(Q) = 4Q is a monopolist on a local market with demand function
𝐷(𝑃) = 16 − 𝑃. Due to noise and air pollution, its operations generate external costs for the local community. The
monetary value of these costs is equal to Q2, where Q is the amount of services provided by the transport company.
a) Set up the monopolist’s profit maximization problem and find the equilibrium output QM and price PM.
b) Find the socially efficient amount of transportation services QEFF, compare it with QM and compute the
monetary value of social losses (if any).
c) The government puts forward a “take-it-or-leave-it” proposal (𝑄 , 𝑇), where 𝑇 is a payment from the
government to the monopolist in return for changing output from QM to QEFF. Find the lowest T which will be
accepted by the monopolist.
d) There is another solution for inefficiency problem. Government can impose a per unit subsidy/tax. Find per
unit subsidy/tax, which leads to efficient output.
2. Two real estate development companies A and B submit applications for construction, to be approved by local
authorities. In these applications each company determines projected building area (qA and qB, respectively) in square
meters. These areas would be built and sold in a common market with demand function 𝑄 = 1200 − 2𝑃, where 𝑄 =
qA + qB, P is the price of a square meter. Company A’s marginal costs are constant and equal to $100. Company B’s
marginal costs are constant and equal to $200.
a) Find the Nash equilibrium when the companies submit their applications simultaneously and independently.
b) Suppose that on the night before applying for construction permits, company A’s president calls company B’s
president and offers him a bribe X for not applying (i.e., for setting qB = 0). What is the lowest possible value
of X that will be accepted? What is the highest possible value of X that will be offered?
c) Suppose that the bribing process described in (b) doesn’t happen, but the application procedure changes in the
following way:

(i) Company A submits its application, qA0

(ii) Then, company B observes A’s application qA and submits its own application, qB
(iii) After that, A observes B’s decision and has an opportunity to revoke its old application, qA0, and
submit a new (final) application qA1.
Find the values of qB and qA1 in the subgame perfect Nash equilibrium.