Question A1 Abbey plans to start a coffee shop. Her rental costs are
$450 per day but these costs have been paid for the month and are
non-recoverable. Based on market research, she is expected to sell the
following number of cups of coffee (see table below) if a cup of coffee
is priced at $4. Courtney’s best alternative use of time is to work at
the local convenience store which pays her $22 per hour. Assume that
there are no other costs associated with selling coffee. How many hours
should she run the coffee shop for Number of hours Total coffee
sold (cups) 0 0 1 20 2 35 3 45 4 50 5 52 (a) 0. (b) 1. (c) 2. (d) 3.
(e) 4. Answer: D Question A2 The markets
for strawberries and blueberries are perfectly competitive. Strawberries
and blueberries are complements. Suppose that adverse weather destroys
30% of the domestic strawberry crop. Which of the following statements
is correct (a) The price of strawberries will rise and the
quantity of blueberries will fall. (b) The price of strawberries will
rise and the quantity of strawberries will rise. (c) The price of
blueberries will rise and the quantity of blueberries will rise. (d) The
price of blueberries will rise and the quantity of blueberries will
fall. (e) None of the above. Answer: A Question
A3 Bob runs a book-binding business, and the production of bound books
requires two inputs: the binding machine and labour. The production
function exhibits diminishing returns to labour. Which of the following
statement is incorrect in the short run (a) The production function
is concave in the labour input. (b) Average total cost is increasing in
output. (c) Short-run total cost is convex in output. (d) Variable cost
is convex in output. (e) Marginal cost is increasing in output. Answer: B Question
A4 The local animal shelter sets the adoption price for kittens, cats,
and dogs who are rescued from the surrounding area. Over time, they
have experimented with their adoption prices. The table below shows the
percentage change in quantity demanded of kittens, cats, and dogs from a
one-percent increase in each adoption price (holding all other prices
constant): Effect on quantity of: Change in adoption price of:
Kittens Cats Dogs Kittens -0.8 -0.1 0 Cats -0.5 -3 0.5 Dogs 0 0.1 -0.5
Which of the following statements is true (a) The quantity demanded
for Kittens and Dogs are inelastic. Cats and Kittens are substitutes.
(b) The quantity demanded for Cats is elastic. Cats and Kittens are
complements. (c) The quantity demanded for Kittens and Dogs are
inelastic. Dogs and Cats are complements. (d) The quantity demanded for
Kittens and Dogs are elastic. Dogs and Cats are complements. (e) The
quantity demanded for Kittens and Dogs are elastic. Cats and Kittens
are substitutes. Answer: B Question
A5 When the government imposes a per unit tax on producers in a
perfectly competitive constant-cost industry, in the long run the
incidence of the tax: (a) Will fall mostly on producers. (b) Will be
split between consumers and producers. (c) Will fall exclusively on
consumers. (d) Will fall exclusively on producers. (e) Cannot be
determined without further information. Answer: C Question
A6 Lionotica is a biotech firm who has discovered a drug that reduces
the symptoms of Covid-19 and is considering switching from its current
policy to setting a single uniform price for all consumers to a
third-degree price discrimination strategy based on geographic region.
If Region A is more price elastic than Region B at the current single
uniform price and Lionotica is a monopoly, what would we expect would
happen when third-degree price discrimination is introduced (a) The
price of Lionotica’s drug to rise in Region A and rise in Region B. (b)
The price of Lionotica’s drug to fall in Region A and fall in Region B.
(c) The price of Lionotica’s drug to rise in Region A and fall in Region
B. (d) The price of Lionotica’s drug to fall in Region A and rise in
Region B. (e) No change in prices for either region. Answer: D Question
A7 A profit-maximising monopolist firm facing a downward sloping
demand will not select an output where: (a) Demand is elastic. (b)
Marginal revenue is falling. (c) Average total cost is rising. (d)
Average revenue is equal to marginal cost. (e) Marginal cost is rising.
Answer: D Question A8 Aaron and Bob run
mattress shops across the street from each other. At the start of each
month, they independently and simultaneous choose prices for their
mattresses, which will result in profits as depicted below: Bob
Low price Medium price High price Aaron Low price $200, $300 $400, $200
$800, $700 Medium price $500, $900 $200, $600 $200, $400 High price
$400, $1000 $700, $200 $100, $800 Which of the following statements is
correct (a) There are two pure strategy Nash equilibria. (b) Both
players have a dominated strategy. (c) There is no pure strategy Nash
equilibrium that would result in Aaron having higher profits than Bob.
(d) Aaron playing “low price” cannot be part of a pure strategy Nash
equilibrium. (e) Bob has a dominant strategy of playing “low price”. Answer: A Question A9
Adam’s Jewelry Store and Brian’s Cafe are located next to each other at
a local mall. They are considering whether to hire security guards for
their business. Their choices and profits are depicted below: Brian’s Cafe Don’t Hire Hire Adam’s Jewelry Store Don’t Hire -$200, $0 $-100, $50 Hire $400, $100 $600, $0
Prior to making their decisions, Brian claims that he will hire a
security guard no matter what Adam does. Which of the following
statements is correct (a) In equilibrium, the socially efficient
number of security guards will be hired. (b) In equilibrium, no security
guards will be hired. (c) There are two pure strategy equilibria. In
each equilibrium exactly one security guard will be hired. (d) Brian’s
claim is not credible. (e) There is no pure strategy Nash equilibrium
in this game. Answer: D Question A10
Serge Koros, a high net worth individual, is approached one day at his
country club by Lenny Waldorf, hedge fund manager. After introducing
himself, Lenny tells Serge that he would be willing to manage some of
Serge’s wealth in exchange for a fixed fee of $1,000,000. Which of the
following strategies is likely to have the biggest impact in mitigating
moral hazard and improving Lenny’s management of Serge’s wealth (a)
Serge offers to pay Lenny a lower fee of $500,000. (b) Serge offers to
pay Lenny a higher fee of $2,000,000. (c) Instead of a fixed fee, Serge
offers to pay Lenny 20% of the profits that Lenny generates from
managing his wealth. (d) Serge offers to pay Lenny a fixed fee equal to
5% of the wealth he entrusts Lenny to manage. (e) Serge refuses Lenny’s
offer and asks him for stock tips instead. Answer: C Question
B1 [10 points] When producing steel, a small amount of pollution is
emitted into the atmosphere that has a negative impact on the health of
people in the surrounding area. The government has calculated that the
private and social marginal benefits of steel are given by: PMB = SMB =
110 – Q While the private marginal cost and social marginal costs are
PMC = 10 + Q SMC = 50 + Q Answer the following questions: B1.1: In
the absence of regulation, what level of output will the economy
produce (2 points) Solution: The market equilibrium is the point
where PMB=PMC or: 110-Q = 10 + Q Rearranging yields: Q* = 50, P* = 60
B1.2: What is the efficient (welfare-maximizing) level of output (2
points) Solution: The efficient outcome is the point where
SMB=SMC or: 110-Q = 50 + Q Rearranging yields: Q* = 30, P* = 80 B1.3:
What is the dollar value of the net gain to society from `correcting’
the externality (4 points) Solution: The deadweight loss due to the
externality is based on the two points found above and a third point at
{Q,P} = {Q = 50, P = 100}. The total DWL is thus equal to .5*(50 –
30)*(100-60) = 400 B1.4: Suppose the government wishes to correct the
market failure using a tax. What size of the tax should the government
choose if it wishes to induce the efficient (welfare-maximizing) level
of effort (2 points) Solution: A Pigouvian tax of $40 will lead to
the socially efficient level. Based on the equations: T = P_{D} –
P_{S} P_D = 110 – Q P_S = 10 + Q Thus, the equilibrium point will occur
when P_D = 110 – Q P_D = 10 + Q + T This coincides with the efficient
outcome when T = 40. Question B2 [10 points] Huntingon’s disease
(HD) is an inherited disorder that has symptoms that develop when
individuals are between 30 and 50 years of age. You are the owner of a
non-profit startup that has discovered a treatment for the disease. The
marginal cost for offering the treatment is $100,000 and many
individuals who may be at risk to the condition are interested in
purchasing an insurance contract that will cover the treatment. Question
B2.1: Currently, all individuals can take a free genetic test that
can identify whether they are at risk of HD. If an individual receives a
positive test result, they have a 45% chance of getting sick while an
individual who receives a negative test result has a 0% chance of
getting sick. How much would you expect to pay on average if everyone
who tests positive purchases the insurance you offer (2 points)
Solution: This is a expected value calculation: .45*100000 = $45,000
Question B2.2: Suppose that a biotech firm called Lionotica has
discovered a new testing procedure that can give an individual better
information about their risk. In particular, the test can place
individuals into five “groups” that differ in the probability of getting
sick. An individual who has tested positive to the initial test is
equally likely to fall into each of the five groups shown in the table
below. Test Result Probability of Getting Sick “Group 1” 10% “Group 2”
25% “Group 3” 35% “Group 4” 70% “Group 5” 80% Suppose that you charge
the expected payment that you calculated in part B2.1 and that all
individuals who are considering the insurance are risk neutral. Which
groups would take up the original insurance offer What are your
expected losses per individual who buys the insurance if they can take
the test privately and do not have to disclose it to you (4 points)
Solution: The expected value of the contract of the five groups are
$10,000, $25,000, $35,000, $70,000, and $80,000. Thus, only individuals
in group 4 and group 5 will purchase the contract. The expected cost
is $.5*70,000 + .5*80,000 = $75,000. The expected loss per individual
is thus $45,000 – $75,000 = -$30,000. Question B2.3: Suppose
that you need to cover the expected cost of treatment with the premium
that you charge. If all individuals have access to Lionotica’s test
and can keep the results private, what price will you charge for
insurance Who will continue to buy it (4 points) Solution: At a
price of $75,000, only group 5 will purchase, thus the market will
unwind. The only price where this does not occur is $80,000. At this
price, only group 5 will purchase. Question B3 [10 points]
For this question, refer to the figure below, which shows the average
total cost curve of a firm that faces demand curve D. We have marked
the point on the demand curve where the elasticity of demand is equal to
1. As done in class, you may assume that the ATC includes both
variable costs and fixed costs but does not include sunk costs. Question
B3.1: Would we ever observe a profit maximizing monopolist produce a
quantity of QA and charging price PA If not, explain why (2 points)
Solution: No. The price here is below the average total cost curve.
Thus, the firm would be losing money on each unit offered and would shut
down. Question B3.2: Would we ever observe a profit
maximizing monopolist produce a quantity of QB and charging price PB
If not, explain why (2 points) Solution: Yes. Question
B3.3: Would we ever observe a profit maximizing monopolist produce a
quantity of QC and charging price PC If not, explain why (2 points)
Solution: No. Revenue is maximized at an elasticity of 1, but if this
was an equilibrium it would imply the marginal cost was zero. This
cannot be the case based on the drawn ATC curve. Question B3.4:
Would we ever observe a profit maximizing monopolist produce a
quantity of QD and charging price PD If not, explain why (2 points)
Solution: No. This is part of the inelastic portion of the demand
curve. Monopolists never produce here. Question B3.5: Based on
the graph, what can we say about the marginal cost curve of the firm
Where does it intersect the average total cost curve (2 points)
Solution: Based on the graph, the marginal cost curve must pass through
the minimum of the ATC curve and will be to the right of this point and
to the left of the rest of the ATC curve. Question C1 [20
marks] To produce honey, beekeepers raise bees in hive boxes that are
specifically designed to allow for easy access to honey. Hives can be
co-located near apple orchards or near orange groves: When
beekeepers keep their hives near apple orchards, their bees will
pollinate the apples, increasing the output of the orchard. When
beekeepers keep their hives in orange groves, the sticky nectar in
orange blossoms helps the bees to produce more honey. Question
C1.1: Suppose that the beekeepers have property rights over their
beehives but can only place their beehives next to an apple orchard or
an orange grove if they are granted permission to the land. Beeswax
Beehives has already been paid to locate its bees at Amy’s Apple Orchard
when it is contacted by Groovy Groves who is willing to allow Beeswax
to move its bees to its orange grove instead. Beeswax is negotiating
with Amy’s Apples to break its current contract. The two companies have
determined that their economic profit for staying in the Apple
Orchard and or moving to the Orange Grove are: Beeswax Beehives Profit
Amy’s Apples Profit Bees Stay at Amy’s Apple Orchard $400 $300 Bees
Move to Groovy Groves Orange Grove $900 $100 Assume that there are no
transaction costs for bargaining. Based on the Coase Theorem, would you
predict that the bees stay or move Let P be the price paid by Beeswax
Beehives to Amy’s Apple Orchard to break its contract. What is the
lowest possible P that would lead to this outcome What is the highest
possible P that would lead to this outcome [4 marks] The beehives
should move to the orchard generating a total (additional) surplus of
$300. Under the status quo, Amy can force Beeswax bees to stay and
receive a profit of $300. Thus, to break the contract, it must receive
at least $200, the difference in economic profits between the two
actions. The maximum price that Beeswax will be willing to pay is $500.
Thus, P is between $200 and $500. Question C1.2: In the
last 10 years, there has been a dramatic fall in bee populations due to
the spread of Varroa mites, which infect and kill the larvae of bees and
can cause bee colonies to collapse. Beeswax Beehives and its
competitor Candlewax operate hives in the same area and must decide on
whether to transport their bees to different spots in the orchard in the
season or to keep them stationary. Transporting bees can be privately
lucrative but potentially exposes both operators to the mite. Based
on the actions of both parties, the payoffs are as follows: Candlewax
Profit Beeswax Beehives Profit Keep Stationary Transport Keep
Stationary 600, 700 250, 500 Transport 500, 250 700, 400 Suppose that
the two companies simultaneously choose whether to transport their bees
or not transport their bees. What are the pure strategy Nash
Equilibrium of this game [4 marks] The Two Nash Equilibria are {Keep,
Keep} and {Transport, Transport} Question C1.3: Suppose that
instead of the game being played simultaneously, Beeswax Beehives can
commit to an acting before or after Candlewax. If it
commits to acting before Candlewax, the game is played sequentially with
Beeswax Beehives choosing its action, Candlewax observing this action,
and then choosing its own action. If it commits to acting after
Candlewax, the game is played sequentially with Candlewax its action,
Beeswax Beehives observing this action, and then Beeswax Beehives
choosing its own action. Write down the strategies of both players in
the sequential game that would arise if Beehives chooses to act before
Candlewax. Write down the strategies of both players in the sequential
game that would arise if Beehives chooses to act after Candlewax.
Should Beeswax Beehives commit to acting before or after Candlewax [6
points] Beehive first: Beehive Strategy: [Transport],
Candlewax Strategy [Keep, Transport], where the first action is in the
case of Beehive choosing action “Keep” and the second action is the case
where Beehive chooses “Transport.” Candlewax first: Candlewax
Strategy: [Keep], Beehive Strategy [Keep, Transport], where the first
action is the case of Candlewax choosing “Keep” and the second action is
the case where Candlewax chooses “Transport.” Beeswax should commit to be the first mover. Question
C1.4: Groovy Groves has written into its contract that it has the
right to prevent bee owners from transporting their bees in the orchard.
However, it cannot force the owners to transport bees if they do not
wish to. Assume that there are no transaction costs for bargaining and
that without an agreement, Beeswax’s preferred outcome from question
C1.3 will occur. Based on the Coase Theorem, would you predict that the
bees will be allowed to be transported Let P be the price paid by
Candlewax to Groovy Groves to prevent owners from transporting bees in
the orchard. What is the lowest possible P that would lead to this
outcome What is the highest possible P that would lead to this
outcome [6 marks] The socially efficient outcome is for transportation
to be banned. Thus, this is the outcome we would expect to occur. The
lowest possible P that would be charged is $100. For lower prices,
Beeswax would be willing to counter-offer and pay to remove the
restriction from the contract. The highest possible P that could be
charged is $200. For any higher price, Beeswax would be happy to sign
its own agreement with Candlewax and ban the movement of bees. Question
C2 The Australian Competition and Consumer Commission (ACCC) has opened
an investigation regarding collusion between the two major firms
producing fire protection gear for bush firefighters. The firms – Azure
Associates and Blue Guard – contend that they are quantity competitors
and that the prices they are charging are a result of an increase
in price by their suppliers. As part of the case, the ACCC has noted
that the Australian firefighters typically purchase their own protective
gear and are thus price takers in the market. Both the ACCC and the
two firms under investigation agree that the market demand can be
described by the inverse demand function: ( ) 240 ,DP Q Q=
where Q is the total quantity provided by the two firms (i.e., A BQ q q=
+ , where Aq is the amount produced by Azure Associates and Bq is the
amount produced by Blue Guard). All parties also agree that the
two firms have identical production technologies and that the two firms
have the same constant marginal cost of production of c. In court,
however, the firms argue that their marginal costs are high while the
ACC argues that they are low. Question C2.1 Azure Associates
and Blue Guard contend that the two firms are competing as an oligopoly
and that they compete by simultaneously choosing quantity. They argue
that their marginal costs of production are equal to c = 75. Based on
this marginal cost, the two firms have the following profit functions:
( , ) (240 ) 75 ( , ) (240 ) 75 A A B A B A A B A B A B B B q q q q q q q q q q q q π π = =
Using these profit functions, find the best-response function for each
firm based on the other firm’s quantity choice. Use these
best-response functions to calculate the equilibrium price and quantity
that would arise in the market. (8 points) Solution: Taking the
first-order conditions of firm A, we have: (240 2 75) 0A Bq q = Rearranging this yields the reaction function: 75( ) 120 2 2 B A B qq q = By symmetry (or by solving for the other reaction function: 75( ) 120 2 2 A B A qq q = Noting that the problem Is symmetric, we can use one of the reaction functions to solve for each q: 75 2 75120 120 55 2 2 3 3 A A A qq q+ = → = = Thus, 55; 130.A Bq q P= = = Question
C2.2 The ACCC maintains that the two firms are acting in a collusive
agreement and that the marginal cost of production is 10. Using these
assumptions, calculate the predicted market price and the total quantity
offered if the two firms collude and act as a monopolist. If the two
firms agree to split the surplus evenly, how much profit does each firm
earn (6 points) Solution: If the two firms are colluding, they will
maximize: ( ) (240 ) (240 )DP Q Q cQ Q Q cQ Q c Qπ = = =
Taking the first order condition, the profit maximizing choice would
be: (240 2 ) 0 120 Q c Q c = = Thus, when c = 10, Q* = 115, P* = 125. Each firm would produce 57.5 and would receive a profit of (125-10)*57.5 = 6612.5. Question
C2.3 Suppose that the court hearing the case cannot tell whether the
assertion made by the ACCC or the firms is correct. However, it notes
that in 2019, the Australian government offered a subsidy of $120 to all
firefighters who purchased gear during the peak of the fire season.
Thus, the demand in this time period was: ( ) 360 .DP Q Q=
Explain how this information might be used to Identify whether the
ACCC or the firms are correct in their arguments. (6 points) Based on
the earlier analysis, the quantities under competition would be equal
to: 2 75180 95 3 3A q = = Thus, total quantity would be
190 and the equilibrium price would be 170. Under the monopoly problem,
we would have Q = 175. Thus, P* = 185. It follows that we would see
the colluding firms raise their prices by more than the competing firms.
Thus, we could use the response to the subsidy to identify whether the
ACCC or the firms were correct.
