UNIVERSITYOFTORONTO

FacultyofArtsandSciences
AprilMayExaminations2009
ECO204Y1Y

Duration:3hoursTotalPoints:200points
ExaminationAid:OnlyRegularCalculators.
Instructions:
Thistestconsistsof12questionsin30pages,singlesided.
Thelastpageisaworksheet
Writeanswersonlyinthespaceprovidedforthatquestion

LastName:____________________FirstName:______________
StudentNumber:_______________________________

Question(Points)
1.20points
3.25points
5.15points
7.25points
9.5points
11.20points

Score

Question(Points)
2. 10points
4. 10points
6. 20points
8. 30points
10. 5points
12. 15 points
TOTAL (200Points)

Score

Question1(20points)
Almaspreferencesovergoods1and2aregivenbytheutilityfunction:

U=Q1Q2

whereQ1andQ2areunitsofgoods1and2respectively.Suppose+=1.DenoteAlmasweekly
incomebyY.Denotethepriceofgood1byP1andthepriceofgood2byP2.

(a)(5points)DeriveAlmasdemandfunctionsforgoods1and2.Showyourcalculations.

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(b)(5points)Trueorfalse:foracompanysellinggood1toAlma,anypricewillmaximizerevenues.
Showyourreasoning.

(c)(5points)[This part can be answered without answering parts (a) & (b)].Trueorfalse:a
10%increaseinallpricesandAlmasincomewillnotchangeheroptimalconsumptionofgoods1
and2.Brieflyexplainyourreasoning.

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(d)(5points)Suppose=0.25and=0.75.Evaluatethestatement:a100%increaseinAlmas
incomeleadstoa25%increaseintheconsumptionofgood1anda75%increaseinthe
consumptionofgood2.

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Question2(10points)
Yourutilityisafunctionofthreegoods:

U=min(Q1,Q2,Q3)

DenoteincomebyYandthepriceofgood1byP1,thepriceofgood2byP2andthepriceofgood3
byP3.

(a)(5points)Derivethedemandequationsforgoods1,2and3.Explainyourreasoningandshow
allcalculations.

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(b)(5points)Whatistheincomeelasticityforgood1?Showyourcalculations.

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Question3(25points)
JennInc.isaperfectlycompetitivefirmwithacapacityof100units.Sheuseslabor(L)andcapital
(K)asvariableinputstoproduceoutput(q).Jennsproductionfunctionisgivenby:q=K1/2L1/2

Supposethepriceoflaboris$160/workerandthepriceofcapitalis$10/machine.Denotetheprice
ofoutputbyP.

(a)(5points)DoesJennstechnologyhaveincreasing,constant,ordecreasingreturnstoscale?
Proveyouranswer.

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(b)(5points)DeriveJennscostfunctionandshowthatitexhibitsthereturnstoscalefromyour
answerinpart(a).Showyourcalculations.

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(c)(5points)IfJennisarationalproducer,whatistheequationofhersupplycurve?Showall
calculationsandgraphthesupplycurvebelow:

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(d)(5points)EttoreInc.isarationalproducerandhasthesametechnologyasJenn(i.e.q=K1/2
L1/2).EttoreproposesamergerwithJennarguingthatthemergerwillbenefitfromeconomiesof
scope.IsEttorecorrect?

(e)(5points)[This part can be answered without answering parts (a) - (c)].AssumeJennisan

irrationalproducer.Graphhersupplycurvebelowandbrieflyexplainyourreasoning.

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Question4(10points)
FuelledbyeasyaccesstodrugsfromtheUSA(UnitedStatesofAddicts)thecitizensoftheCanadian
townCrackotoaarefastbecomingdrugaddicts.ThemayorofCrackotoa,Ms.CindyBong,has
startedadrugtreatmentprogramwhichusespoliceofficers(P)anddrugcounselors(D)as
complementaryinputsin1:1ratiototreatdrugaddicts(A)astheoutput.

(a)(5points)Theprogramcurrentlyhas1,000policeofficersand1,000drugcounselors.IfCracko
toasgovernmentdoublesthebudgetforthedrugtreatmentprogram,howmanymorepolice
officersanddrugcounselorsshouldMs.CindyBonghire?Assumethepriceofpoliceofficersand
drugcounselorsisconstant.

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(b)(5points)Repeatpart(a)forthecasewherethepriceofpoliceofficersanddrugcounselors
alsodoubles.

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Question5(15points)
TheTablebelowreproducesTableBfromtheDHLcase:

InternationalAirExpressMarketSharesby$Revenues(1988)
Company
MarketShare
DHL
44%
Fedex
7%
TNT
18%
UPS
4%
Others
27%
Source:TableBinDHLcase.

(a)(5points)CalculatetheCR4intheinternationalairexpressmarket.Stateanyassumptions.

(b)(5points)EstimatetheHHIfromthedataintheTableabove.Briefexplainwhethertheestimate
overstatesorunderstatesthetrueHHI.

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(c)(5points)IfFedexandUPSmergewhatisthechangeintheglobalHHI?Showyourreasoning.

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Question6(20points)
ThefollowingtablereproducesportionsofExhibit11fromtheDHLcase.

Exhibit11RevenueandCostLaneExamples:DOXandWPX
U.K.toUnitedStates(1990)
DOX
WPX
Revenue
$5,723,000
$2,342,000
OutboundCost
2,392,915
667,712
HubCost
596,608
490,436
LineHaul 1
1,121,882
647,915
Delivery
1,376,953
386,049
GrossMargin
234,642
149,888
GrossMargin%
4.1
6.4
Shipments
231,139
68,580
Revenue/Shipment
$24.76
$34.15
Note:Pleaseseefootnoteatthebottomofthispage.

(a)(10points)SupposeDHLsheadquartersinBrusselssetspricestomaximizeprofits.IfBrussels
raisesthepriceofadocumentfrom$24.76to$25.01howmanydocumentswillbesentfromthe
U.K.totheU.Sonthislane?Stateanyassumptions.

Linehaulreferstotheairsegmentoftheshipment

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(b)(5points)ComputethepriceelasticityoftheWPXsegment.Showyourcalculations.

(c)(5points)SupposeDHLlowersthecostofshippingpackagesthroughlearningbydoing.
Assumingtheelasticityinpart(b)isconstant,whatmusttheMCofpackagesbeinorderforthe
priceofadocumenttobeequaltothepriceofapackageontheU.K.toU.S.lane?Showall
calculations.

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Question7(25points)
ProctorandGrumble(P&G),ariskneutraldecisionmaker,mustdecidewhethertodevelopand
releaseanewshampooShineonyoutargetedatbaldmen.IfP&Gdoesnotdevelopthe
shampootheoutcomeis$0m.IfP&Gdevelopstheshampoo,R&Dcostswillbe$100mandwhen
releasedintothemarketitwillbeasuccess(S)withprobability0.6orafailure(F)withprobability
0.4.

Iftheshampooisasuccess,grossrevenues(beforeR&Dcosts)areestimatedtobe$500m.Onthe
otherhand,iftheshampooisafailure,grossrevenues(beforeR&Dcosts)areestimatetobe$0m.

(a)(5points)DrawP&Gsdecisiontreeandindicatewhethertheshampooshouldbedeveloped.

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(b)(5points)P&Gsstatisticsconsultantthinkstheprobabilityofsuccessmaynotbeaccurate:i.e.
thereisamarginoferrorintheprobabilityofsuccess.Theconsultantworriesthatwithinthe
marginoferror,thedecisioninpart(a)maybechange.Forwhatrangeoftheprobabilityofsuccess
willP&Gmakethedecisioninpart(a)?

(c)(5points)[This part can be answered without answering parts (a) - (b)].Supposea

marketingcompanyhasdevelopedaperfect(100%accurate)testfornewproducts.Thetest
resultscanbepositive(+)ornegative().Fillintheentriesinthetwowayclassificationtablebelow.

S
F
Total
+

Total

100

Brieflyexplainyouranswerbelow.

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(d)(5points)DrawP&Gsdecisiontreeifitmakesthedecisionwiththeperfecttestinpart(c).
WhatisP&Gsdecisionwiththeperfecttest?

(e)(5points)Whatisthevalueofaperfecttest?Showyourcalculations.

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Question8(30points)
LeeHao,aprivateinvestor,hasatT=0purchasedaperpetualannuity(bond)issuedbytheBMO
(BankofManyOdors).Thepurchasepriceis$500andtheannuitywill,startingatT=0,payan
annualcouponpaymentof$100forever.

(a)(5points)CalculatetheyieldtomaturityoftheBMObond.WhatcanyousayaboutLeeHaos
opportunitycostofcapital?Incaseyouneedit,thesumofaninfiniteseries[1+x+x2+x3+..]is
1/(1x).

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LeeHaoisariskaverseinvestorwithutilityfunctionU=X.Therecenteconomicdownturnhasled
LeeHaotobelievethatthereisachanceBMOwilldefaultonthebond:heexpectstheannual
couponpaymenttobe$40.

(b)(5points)WhatdoesLeeHaothinktheprobabilityofBMOdefaultingis?Showyourreasoning.

(c)(5points)WhatisLeeHaosexpectedutilityfromfacingtheuncertaintythatBMOmight
default?

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(d)(5points)ExpressLeeHaosutilityfromfacingtheuncertaintyofadefaultasanequivalentrisk
offacingtheuncertaintyofreceivingeither$10,000or$0.Showyourcalculations.

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(e)(5points)HowcanLeeHaousecreditdefaultswapstohedgeagainsttheriskofBMO
defaulting?Pleasedescribehowthecreditdefaultswapcontractwillbestructuredandhowthe
counterpartyexpectstoprofitfromtheswap.

(f)(5points)[This part can be answered without answering parts (a) - (e)].Whyhavecredit

defaultswapsbecomeaproblemrecently?

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Question9(5points)
AsyouwalkthroughTorontosPearsonairporttocatchaflighttoParis,youseeaboothselling
flightinsurancefor$12.Ifyoudieontheflight,theinsurancecompanywillpayyourfamily
$200,000.Asof2009theprobabilityofdyingflyingwas1in1.1million.Shouldyoubuythepolicy?
Stateanyassumptions.Hint:Whatisthepriceperdollarofinsurance?

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Question10(5points)
WhenbookingaonewayflightonAirCanada,youhavetheoptionofpurchasingatravelinsurance
policyOnMyWayfor$25.HereisthedescriptiononAirCanadaswebsite:

Getextraprotectionincaseofflightdelaysordisruptionsthatarebeyondtheairline's
responsibilityorcontrol.OnMyWayoffersaroundtheclockpriorityrebookingservice,
ahotelifneeded,andmuchmoreforonlyasmallfee.

Underactuariallyfairinsurance,whatisthebenefitoftheOnMyWaytravelinsuranceprogram
forapassengertravelingonewayfromTorontotoNYC?AccordingtoFlightstats.com,86%of
flightsfromTorontotoNYCareontime.

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Question11(20points)
Lb.CakeCorporationisacakefranchisor.Underthetermsofthecurrentcontractwitharestaurant
ontheUTorontocampus,Lb.Caketakesafractionoftherestaurantsrevenues(R)andincursa
fractionoftherestaurantstotalcost(C).

Lb.CakesuppliesingredientstotherestaurantwithamarkupoverAC:assumeACisconstantand
therestauranthasnoothercostsbesidesthecostofingredients.

Supposetherestauranthasacapacityof700cakesaday.Dailydemandisgivenbytheequation:

P=10010Q

PisindollarspercakeandQisinhundredsofcakes.

Suppose=0.2,=0.25,AC=$8perhundredcakes,and,Lb.Cakechargestherestauranta100%
markupoverAC.

(a)(10points)IfLb.CakechoosesthepriceandquantityattheUTlocation,solvefortheoptimalP
andQ.Showallcalculations.

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(b)(10points)Lb.Cakehasanopportunitytorenegotiatethecontract:itcanchangeeitherby
0.1orby0.1orthemarkupby10%.(i.e.Lb.Cakecanonlychangeoneofthese).Whatdoyou
thinktheyshoulddo?Showyourreasoningbelow.

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Question12(15points)
CapitalNone,acreditcardcompany,hastodecidetoday(T=0)whethertomakeacreditcard
offertoaparticularconsumer.Thereisnocostofmakingthisunsolicitedoffer.IfCapitalNone
doesnotmakeanoffer,thevalueofthisdecisionis$0.Ifitmakesanoffer,assumetheconsumer
alwaysaccepts.

ThetermsoftheCapitalNonecreditcardare:

Issuedfortwoperiodsonly(T=1,2)
Maximumlimitof$1,000ineachperiod 2 (The2hereisafootnote,notsquared).
LetidenotetheinterestratechargedbyCapitalNoneontheendingbalanceineachperiod.

Inanyperiodtheconsumerhasthecreditcard,shealwaysmaxesoutitout:i.e.,shechargesthe
maximumlimitof$1,000.

Inanyperiod,theconsumercandefaultonthecreditcardwithprobabilityp.Iftheconsumer
defaultsinT=1,CapitalNoneswallowsthelossandcancelshercreditcardinT=2.Ifthe
consumerdefaultsinT=2,CapitalNoneagainswallowstheloss.

Inanyperiod,iftheconsumerdoesnotdefaultCapitalNoneprofitsfrominterestratechargeson
thebalance:i*(balance).Denotetheopportunitycostofcapitalbyr.

ShowthatforCapitalNonetomakeacreditcardoffertothisconsumer,theinterestrateonthe
balancemustbeatleasttheoddsofdefault:i.e.ip/(1p).Hint:discountallfigurestoT=0.

Thatis,$1,000limitinT=1and$1,000limitinT=2.

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WORKSHEET

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