Intermediate Microeconomic Theory

Econ 3101
Spring 2016
Problem Set 4

This problem set is due on Thursday July 28 at the beginning of class. The maximum score is 110 points (10 bonus
points). Be sure to review the syllabus for details about homework assignments and their grading. Feel free to
contact me or your TA via e-mail if you have specific questions about the assignment. Note that some exercises
have several parts and each part may conceal more than one task for you. Be sure to answer every question
thoroughly for full credit.
Present all final answers neatly on these provided pages. Show any relevant calculations neatly. Please do your
scratch work somewhere else. Please remember to attribute help received and collaboration.
Name: _______________________________________________
Section Number: ____________

Names of classmates you worked with:

1.) In the 1960s, the Soviet Union began moving missiles and military hardware into Cuba. In response to
the aggressive maneuver in the United States backyard, the US Navy began blockading Cuba and would
intercept Soviet freighters carrying military hardware and missiles bound for Cuba. The growing tension
had the Soviet Union on the brink of retaliation against the United States.
If the Soviet Union does not move missiles into Cuba, then the US and the Soviet Union receive a payoff
of 0. If the Soviet Union does move missiles into Cuba, then the United States has the opportunity to
respond. If the US does not blockade Cuba and intercept the Soviet Unions freighters, then the Soviet
Union is allowed to establish a dangerous military presence in Cuba leading to a payoff of 5 for Cuba and
-5 for the US. If the US does blockade the Soviet Union, the Soviet Union can choose to escalate the
conflict and declare war against the US. Since the war would end via mutually assured destruction, the
US and the Soviets would receive negative infinity as their payoff. If the Soviet Union does not
escalate and allows its ships to be blockaded, then the US calls the Soviet bluff and the US receives a
payoff of 10 while the Soviets receive a payoff of -10.
a.) Model the sequential interactions as an extensive form game. Moreover, define the action space for
each player. (5 points)

b.) Solve the game by backwards induction. What is the SPNE of the game? (10 points)

c.) Bonus: Set up the extensive form game as a normal form game (simultaneous move). Does it yield a
different set of Nash Equilibria? If the sets are different, how does this relate to the notion of empty
threats and the refinement of Nash equilibria? (10 points)

2.) Consider a monopolist that faces a linear inverse demand of

P(q) = 200 2q
The firm has the cost function
C(q) = 3q2 + 6q + 100
a.) What are the monopoly market price, the monopoly market quantity and the monopolists profits?
Please show your derivatives neatly in your work. (10 points)
PM =

QM=

M=

b.) What is the welfare loss generated by the monopolist compared to perfect competition? (10 points)

3.) Suppose you are the CEO of a textbook company which is a monopolist in the world market for
textbooks. Your companys cost function is c(Q) = Q2 + 5000. There are two major groups of consumers:
the US/Europe and Asia. The demand curve for the US/Europe is QUS/EU(p) = 300 .1p and the demand
curve for Asia is QA(p) = 600 .8p.
a.) What type of price discrimination could you engage? What are potential problems you could face in
trying to price discriminate? (5 points)

b.) Suppose the firm decides to engage in price discrimination. How much is sold in each market and
what is the total quantity solid? What are the prices in each market? What is the profit for the monopolist?
(10 points)

QUS/EU=

QA=

PUS/EU =

PA=

M=

c.) In equilibrium, what is the monopolists elasticity of demand in each of the two markets? (5 points)
US/EU =

EA =

d.) Suppose the monopolist cannot price discriminate. What is the change in welfare from the scenario
when the monopolist could price discriminate? (10 points)

4.) Consider a Cournot duopoly with both firms producing a homogenous good and facing linear demand
of the form: P(Q) = 150- 15Q where Q = q1 + q2. Assume both firms have the same costs C(q) = 5q.

a.) For each firm, derive the best response function below. Show all work. (10 points)

b.) Graph the best response functions for both firms. As in class, q1 should be on the y-axis and q2 should
be on the x-axis. (5 points)

c.) Solve for the Nash Equilibrium output for each firm. (5 points)

q1*=

q2*=

d.) Solve for the equilibrium market price and the equilibrium profits for each firm (Note: the firms are
symmetric so we only have to solve for one firms profits). (5 points)

P* =

5.) Suppose an individual wants to purchase insurance. The individual has utility U(w) = ln(w) and has a
deterministic income w = $20000. If the individual gets sick, they must incur health care costs of $10000.
Insurance is $.07 per dollar of insurance purchased.

a.) Set up the maximization problem that the consumer faces. (5 points)

b.) What is the amount of insurance that the consumer purchases? Is it full insurance? (5 points)