1

EC201 2012 - 13
Margaret Bray

Notes on exam questions for class 9

Definitions are in the lecture notes. Most calculations are covered
in notes or worked examples.



Questions 1 5 are each worth 6 marks


1. (a) (2 marks) Define compensated demand and the expenditure function.

See notes.



(b) (3 marks) If all prices increase by 50% how do compensated demand
and the expenditure function change? Use an indifference curve
diagram to explain your answer.

Compensated demand does not change, the expenditure function
increases by 50%. See notes for explanations.

(c) (1 mark) Find compensated demand if the expenditure function is
u
p p
p p
) (
2 1
2 1

.


From Shephards lemma

u
p p
p
p
u p p E
u p p h
u
p p
p
p
u p p E
u p p h
2
2 1
2
1
2
2 1
2 1 2
2
2 1
2
2
1
2 1
2 1 1
) (
) , , (
) , , (
) (
) , , (
) , , (

2



2. ( 6 marks) Consider the two period model of consumption and savings.
Does a cut in the interest rate always increases current consumption by
households that are saving? Explain your answer using a diagram.

No, the slides below from lecture notes explains this.











3




3. Consider an industry with 400 consumers. Demand by each consumer as a
function of the price p of the good is 0.25(10 p). There are many firms in
the industry. The cost to a firm of producing output q

is 2q.

(a) (3 marks) If there is free entry and exit into the industry and many
firms in the industry what is the price?

2 because the firm is a price taker with a constant average cost of 2.

See notes for an explanation.


How would you measure the gain to an individual consumer of being
able to buy the good at that price?

Consumer surplus, see notes.

Illustrate the measure in a diagram and finds its numerical value.

consumer surplus = 1/2*2* (10 2) = 8.

(b) (3 marks) Now suppose that there is one firm in the industry. This firm
makes each consumer a take it or leave it offer, either pay an amount
x to get q* units of the good or do not get any units of the good.

What values of x and q* maximize the firms profits? How much profit
does the firm make?

Is there any deadweight loss due to monopoly in this situation?

See notes on perfect price discrimination.

X = 12, q = 2 profits are = 3200.
There is no deadweight loss.

0 2 4 6 8 10
0
2
4
6
8
10
q
p
individual demand q =0.25 (10 p)
4




4. Consider an industry in which demand for the output Q of the industry is
given by Q = 5 p where p is the price.

Each firm in the industry has a cost function c(q) = q + 3 where q is the
output of the firm.

(a) (4 marks) Assume that there are n firms in the industry and the
industry operates as a cartel. What output does the industry produce?
What is the industry price? What are the total profits of the industry?

What is the maximum number of firms that can operate profitably in
the industry if it is a cartel?

See notes on cartels.
A cartel chooses Q to maximize industry profits 5Q Q
2
Q 3n.
Industry output = 2, price = 3, industry profits 4 3n. Maximum
number of firms = 1 because if n > 1 the 4 3n < 0, the
industry makes losses so at least one firm makes losses.





(b) (2 marks) Can the industry operate profitably as a two firm Cournot
duopoly?

A cartel maximizes industry profits so as a 2 firm cartel cannot operate
profitably a Cournot-Nash duopoly cannot operate profitably.



5


5.

In the game below each player is choosing whether to put down a coin with
the head side upmost (H) or the tail side upmost (T).

The row player likes situations where the players put down the coins in
different ways.

The column player likes situations where the players puts the coins down in
the same way.

In the matrix -3, 1 means that if both play H the row player gets -3 and the
column player gets 1.

column player
H T
Row player

H -3, 1 2, -4
T 2, -1 -1, 1

(a)

(1 mark) Define a Nash equilibrium.

See notes

(b) (5 marks) Explain the distinction between a Nash equilibrium in pure
strategies and a Nash equilibrium in mixed strategies.
Find a Nash equilibrium of this game.

See the notes for an explanation of the distinction and an example
(the enforcement game) showing how to calculate probabilities for an
equilibarium

There is no equilibrium in pure strategies
There is an equilibrium in mixed strategies in which the column player
plays H with probability 3/8 and the row player plays H with probability
2/7.



6


Questions 6 and 7 are each worth 18 marks

Note the long questions are now worth 26 marks, so are longer, but in
the same style as these questions

6. (a) (3 marks) What is an isoquant? What is the marginal rate of
technical substitution? Given a production function f(L,K) how
would you find the marginal rate of technical substitution? What
is the marginal rate of technical substitution for the production
function f(L,K) = (K
1/2
+ L
1/2
)
2
?

See notes for definitions.

2 / 1
2 / 1
2 / 1 2 / 1 2 / 1
2 / 1 2 / 1 2 / 1
) (
) (
L
K
K L K
L L K
K
f
L
f
MRTS

(b) (5 marks) What conditions on the production function make it
possible to find the cost minimizing of inputs needed to produce
a particular level of output by equating the marginal rate of
technical substitution to the input price ratio? Are these
conditions satisfied by the production function f(L,K) = (L
1/2
+
K
1/2
)
2
?

See notes.

Output must be increasing in inputs and that the isoquant
considered as function of L be convex.

Here
0 ) (
0 ) (
2 / 1 2 / 1 2 / 1
2 / 1 2 / 1 2 / 1

K L K
K
f
L L K
L
f

so output is increasing in both inputs.

7

0
2
1
1 ) (
) (
2 / 3 2 / 1
2
2
2 / 1 2 / 1 2 / 1 2 / 1 2 / 1
2 2 / 1 2 / 1

L q
L
K
so
L q L L q
L
K
L q K

so the isoquant is convex function of L.


Illustrate in a diagram a situation in which one of these
conditions is not satisfied and there is a point at which the
marginal rate of technical substitution is equal to the input price
ratio but cost is not minimized.






(c) (6 marks) Explain the distinction between long and short run cost
functions. What variables do these functions depend upon?

See notes.
K
0 L
A
Here convexity is not
satisfied, A is a tangency
but B gives lower costs.
B
K
0 L
f(L,K) =q
A
B
Here decreasing both
inputs from A increases
output, A is a tangency but
B gives lower costs.
8


Find the short run cost function associated with the production
function f(L,K) = (K
1/2
+ L
1/2
)
2
where K and L are the quantities of
labour and capital.

See notes.
vK K q w vK wL SRC
2 2 / 1 2 / 1
) (


.

Could the short run cost function ever be less than the long run
cost function?

No, see notes

(d) (4 marks) What are the uses and limitations of the theory of long
run and short run costs in understanding real world economies?

There was some discussion of this in lectures. This is an
example of a question that is looking for your ability to say
sensible things about the relationship between a model and the
real world. Markers are looking for a sensible discussion. There
is no single right answer.





7 An industry consists of a large number of small firms; each of the firms
is a price taker. Demand for the output Q of the industry is given by
Q = 1200 100p where p is the industry price. The cost to each firm
of producing output q is c(q) = 0.5 q
2
+ 50.

(a) (3 marks) Find marginal and average cost for the total cost
function c(q) = 0.5 q
2
+50. Draw a graph showing the
marginal and average cost curves derived from the total cost
function.

9


Marginal cost is q, average cost is 0.5q + 50/q.




(b) (3 marks) If there are 200 price taking firms in the industry and
there is no possibility of entry and exit what is the industry price,
how much does each firm produce, how much does the industry
produce and how much profit or loss does each firm make?

See notes.
Price p = 4. Each firm produces q = 4.
Industry production is 800.
Each firm makes profits - 42, i.e. a loss of 42.


(c) (3 marks) Define an entry and exit equilibrium in an industry with
price taking firms. If the industry is in entry and exit equilibrium
what is the industry price, how much does each firm produce,
how much profit does each firm make, and how many firms are
there in the market?

See notes.
Industry price p = 10
Firm quantity q = 10
No of firms n = 20
Industry production Q = 20*10 = 200.
Firm profits = 0.
0 10 20 30 40
0
10
20
30
40
MC
AC
q
10






(d) ( 5 marks) Now suppose that an innovative piece of software
reduces the total cost of a firm that uses it from 0.5 q
2
+50 to 0.5
q
2
+2.

The software is available only from the company Magic201. The
company charges a license fee x so each firms costs are now
0.5 q
2
+ 2 + x
.
The costs of developing the software are sunk.
The marginal cost of supplying the software is zero.

Continue to assume that there is free entry and exit into the
industry.

There is a debate within the company as to what the level of the
license fee should be.

One proposal is that the license fee should be set at the
maximum level at which firms will buy the software rather than go
without it.

The other proposal is that the fee should be set at a level at
which there are 200 firms in the industry.

Which of these proposals gives Magic201 higher income from
fees?


The highest fee the firm can charge is that which leaves the firm
just indifferent between buying the software in which case the
firms cost is 0.5 q
2
+ 2 + x and not buying the software in which
case the firms cost is 0.5 q
2
+ 50 as in part c, so the fee is 48
and there are 20 firms in the industry. Fee income is 20* 48 =
960.

With 200 firms in the industry the situation is as described in part
b, price is 4, profits are 8 fixed cost, so the maximum license
fee is 6.

Fee income is 6*200 = 1200 > 960 so this gives higher fee

11

income..


(e) (4 marks) Comment on the proposition that those who gain most
from the introduction of new business software that reduces fixed
costs are the customers of the industry.

This asks you to think about a model that you have not seen
before. There is no single right answer to this question. Markers
were told to give generous credit for anything sensible that
comes from this model and to give some credit for any economic
insight.