This paper is not to be removed from the Examination Halls

UNIVERSITY OF LONDON

279 0028 ZA

BSc degrees and Diplomas for Graduates in Economics, Management, Finance and the
Social Sciences, the Diplomas in Economics and Social Sciences and Access Route for
External Students

Managerial Economics

Monday, 16 May 2011 : 10.00am to 1.00pm

Candidates should answer SIX of the following TEN questions: FOUR from Section A (12.5
marks each) and TWO from Section B (25 marks each). Candidates are strongly advised to
divide their time accordingly.
A calculator may be used when answering questions on this paper and it must comply in all
respects with the specification given with your Admission Notice. The make and type of
machine must be clearly stated on the front cover of the answer book.

University of London 2011

UL11/0194
D01

PLEASE TURN OVER

Page 1 of 4

SECTION A
Answer all four questions from this section (12.5 marks each).

1.

n identical firms supply a market with demand function p=1-Q where Q is the total quantity
supplied, i.e. the sum of quantities supplied by the n firms (Q = q 1 + q2 ++ qn). The firms have
constant marginal cost c (0 < c < 1).
(a)

Find the Cournot equilibrium.

(b)

Show that a merger of two firms is not in the interest of the merging firms.

2.

Consider a profit maximising firm in a perfectly competitive industry. Its production function is
given by q = ALK1-. Show that = wL/(pq) where w is the per unit cost of Labour (L) and p is
the per unit output price.

3.

Alex is considering auction formats to sell an antique. There are 3 potential buyers, Ben, Charlie
and David who have valuations 2, 5 and 8 respectively. The 3 bidders know their own valuation
but not the other bidders although they and the seller know that valuations are drawn from a
uniform distribution on [0,10].

4.

(a)

What is Alexs revenue if he uses an English auction? Who wins the auction?

(b)

What is Alexs revenue if he uses a second price sealed bid auction? Who wins the
auction?

(c)

Determine the bidders equilibrium strategies in a first price sealed bid auction. What is
Alexs revenue if he uses this type of auction?

Richards utility function is given by U(x1, x2) = x1 x23. His budget is m and the per unit prices
of the goods are p1 and p2.
(a)

Find Richards optimal consumption bundle.

(b)

Suppose m = 100. What is the change in consumption of good 2 if its price changes from 1
to 3?

UL11/0194
D01

Page 2 of 4

SECTION B
Answer two questions from this section (25 marks each).
5.

Consider the game in normal form below.

Player1\Player2
T
B

6.

L
(1,1)
(2,0)

(a)

Assume x = y. For which values of x do both players have a dominant strategy? What are
their dominant strategies?

(b)

Assume x = y. For which values of x is this game a prisoners dilemma?

(c)

Now assume x > 0 > y. Find the Nash equilibrium in pure strategies.

(d)

Are there any values of x and y for which this game does not have an equilibrium in pure
strategies? Explain your answer.

Alice and Benny are bargaining over the division of 100. Both have discount factor
(0 < < 1).
(a)

Consider a two period bargaining game. In the first period Alice makes an offer. If Benny
rejects this offer, he can make a counteroffer in the second period. If Alice rejects that
offer they both end up with zero. What are Alices and Bennys shares of the 100 in
equilibrium?

(b)

Now consider a three period game where the sequence of offers is Alice, then Benny, then
Alice again. If Benny rejects the offer made by Alice in the third period they both get zero.
What are Alices and Bennys shares of the 100 in equilibrium?

(c)

Now suppose that Alice is impatient (i.e. her < 1) whereas Benny is not (i.e. his = 1).
Now what are the shares in equilibrium for the three period game in (b)? Has Bennys
share increased or decreased?

UL11/0194
D01

R
(0,2)
(x,y)

Page 3 of 4

7.

In Russian roulette a player spins a revolvers 6 round cylinder, places the muzzle against his
head and pulls the trigger. If the revolver contains x bullets then the chance of being killed is x/6.
(a)

Alexey is going to play Russian roulette. There are 5 bullets in the revolver. He could pay
an amount of money p1 to reduce the number of bullets to 4. Draw his decision tree.
[Hint: the outcomes are dead, alive with wealth W, alive with wealth W-p1.]

(b)

Suppose Alexey starts out with 1 bullet in the revolver and if he pays p 2 that bullet is
removed. Draw his decision tree.

(c)

Using Alexeys utility function, write down the equation indicating indifference between
the two decisions in (a).

(d)

Using Alexeys utility function, write down the equation indicating indifference between
the two decisions in (b).

(e)

Use your answers to (c) and (d) to derive the conclusion that Alexey is prepared to pay
more to reduce the number of bullets from 5 to 4 than to reduce the number of bullets from
1 to zero.

8.

Explain what is meant by first degree, second degree and third degree price discrimination and
give examples of each. Illustrate your answer with numerical examples.

9.

Explain what is meant by asymmetric information, adverse selection and moral hazard.
Explain why asymmetric information can be problematic and discuss signalling and screening as
ways to overcome asymmetric information problems. Illustrate your answer with examples.

10.

Explain the perfect competition model. Discuss in detail, using graphs and equations, how
market supply is determined.

END OF PAPER

UL11/0194
D01

Page 4 of 4

This paper is not to be removed from the Examination Halls

UNIVERSITY OF LONDON

279 0028 ZB

BSc degrees and Diplomas for Graduates in Economics, Management, Finance and the
Social Sciences, the Diplomas in Economics and Social Sciences and Access Route for
External Students

Managerial Economics

Monday, 16 May 2011 : 10.00am to 1.00pm

Candidates should answer SIX of the following TEN questions: FOUR from Section A (12.5
marks each) and TWO from Section B (25 marks each). Candidates are strongly advised to
divide their time accordingly.
A calculator may be used when answering questions on this paper and it must comply in all
respects with the specification given with your Admission Notice. The make and type of
machine must be clearly stated on the front cover of the answer book.

University of London 2011

UL11/0195
D01

PLEASE TURN OVER

Page 1 of 4

SECTION A
Answer all four questions from this section (12.5 marks each).

1.

Two players are playing an alternating offers bargaining game. They start out with a given
amount of money. Whenever an offer is rejected, the available sum of money is discounted
(discount factor ). Player 1 makes the first move and offers to keep a fraction x 1. If this offer is
rejected by Player 2, the latter offers to keep a fraction y1. If this is rejected by Player 1, the
latter offers to keep a fraction x2. At this stage, if Player 2 rejects the offer, both players get zero.
Find the subgame perfect Nash equilibrium. Does Player 1 have a first mover advantage in this
game?

2.

Diane always has tea with two sugars and coffee without sugar.
(a)

Draw her indifference curves for tea and sugar and write down her utility function for tea
and sugar.

(b)

Draw her indifference curves for coffee and sugar and write down her utility function for
coffee and sugar.

3.

Teds utility of money function is given by U(x) = x1/2, x 0. Find Teds Certainty Equivalent
of a gamble with a fifty-fifty chance of 100 and zero. Explain your answer.

4.

Consider a second price sealed bid auction with 5 bidders whose (private) valuations are
independently drawn from a uniform distribution on [100, 160].
(a)

How should each bidder bid?

(b)

What is the sellers expected revenue?

UL11/0195
D01

Page 2 of 4

SECTION B
Answer two questions from this section (25 marks each).
5.

6.

7.

Consider a duopoly with market demand Q = 100 p. Each firm has constant marginal cost,
MC = 1.
(a)

Find the Cournot output levels, price and profits.

(b)

Find the Stackelberg output levels, price and profits.

(c)

Suppose the two firms form a cartel. Find the profit maximising output level, price and
profit.

(d)

In (c), how will production be divided between the two firms?

A company has two plants with different production technologies to produce the same good.
Plant A has production function Q = min(3L, 2K) and plant B has production function
Q = L0.5 K0.5. Unit costs of labour (L) and capital (K) are w and r respectively.
(a)

Find the cost function for plant A.

(b)

Find the cost function for plant B.

(c)

For w = r = 10, how should production be divided between the two plants if the company
wants to produce 100 units?

(d)

Assuming r = 10, what is the maximum value for w so that plant B will be used?

The demand for an e-book is given by Q = 100 5p.

(a)

Under the wholesale pricing model, Amazon decides on the retail price, p r, and the
publisher decides on the price it charges Amazon, the wholesale price, p w. Find the profit
maximizing prices and the resulting quantity and profits.

(b)

Under the Apple model, the publisher decides on the retail price and Amazon gets 30%
of the sales revenue. Find the profit maximizing retail price and the resulting quantity and
profits.

(c)

Which of the two pricing schemes is best for Amazon? For the publisher? For consumers?

(d)

Can you think of any reasons why Amazon might want to set the retail price below the
profit maximizing price?

UL11/0195
D01

Page 3 of 4

8.

What is meant by pure bundling and mixed bundling? Explain how bundling can increase
profits. Give a numerical example.

9.

It is very common for lawyers to bill their clients by the hour. Explain how this creates moral
hazard problems. Suggest a different billing structure which avoids these problems and discuss
its advantages and disadvantages.

10.

In 2010 some members of the Pakistan cricket team were accused of conniving with
bookmakers, if not to lose matches, then at least to instigate specific events in the game. Does
efficiency wage theory explain why such scandals are more likely to arise for relatively low-paid
sports people? What can be done to reduce corruption in sports?

END OF PAPER

UL11/0195
D01

Page 4 of 4

Examiners commentaries 2011

Examiners commentaries 2011

28 Managerial economics
Important note
This commentary reflects the examination and assessment arrangements for this course in the
academic year 201011. The format and structure of the examination may change in future years,
and any such changes will be publicised on the virtual learning environment (VLE).

General remarks
Learning outcomes
At the end of this course and having completed the Essential reading and Learning activities, you
should be able to:
be prepared for Marketing and Strategy courses through an understanding of consumer
behaviour and markets in general
analyse business practices with respect to pricing and competition
understand and be able to apply key concepts in decision analysis and game theory.

Format of the examination

The examination is three hours long and comprises two sections. You have to answer all four
questions in Section A (12.5 marks each) and two questions in Section B (25 marks each).
Planning your time in the examination
The marks for each question correspond roughly to the proportion of time you are expected to spend
on it. Try not to spend too much time on any one question. You can always go back to it later if you
have time left.
When you select which questions to answer in Section B, take time to read all the questions (and all
parts of each question). Often candidates select a question on the basis of the topic of the question
only to realise that they are able to answer at most the first part of the question.
If you end up doing terribly complicated calculations taking up several pages it is highly likely that
you have misinterpreted the question or made a mistake go back and check the question and your
answer. The same applies, of course, if you find negative prices or quantities, or probabilities greater
than one or less than zero.
Write down clearly what you are doing as we award marks for correct logic and development even if
there are numerical mistakes.
What are the Examiners looking for?
We are looking for evidence that you have truly understood the material and can apply this
knowledge. Memorising answers to past questions will not get you very far. You should have the

28 Managerial economics

confidence to tackle the questions from first principles. Of course, you will only have this confidence
if you have worked consistently throughout the year to familiarise yourself with the way of thinking
that this subject requires.
How to do well in the examination
A key success factor is obviously the time spent preparing and, as mentioned before, an early start is
definitely required. It is impossible to acquire the thinking skills you need in the last few weeks
before the examination.
It is not good enough to simply repeat the material from the subject guide. You must understand it!
A good way to check whether you really understand the material is to try to explain it to a friend.
You also have to spend a lot of time thinking about questions/problems/exercises. Never look at
answers or solutions until you have spent at least an hour or two trying to figure out the solution
yourself. Obviously during the examination you will not have that much time, but the more time
you spend thinking about how to solve problems during the year, the easier your revision and the
examination will be.
Especially for the essay questions, do not write down everything you know about a topic which is
vaguely related to the question. Answer the question! We do not expect polished essays with nicely
constructed sentences, and the use of bulleted lists is acceptable where appropriate. The main thing
is to show that you have understood the material. You can give evidence of your understanding
through clear exposition, including models and numerical and verbal examples (preferably your
own). Diagrams should be clear. It is not important that the axes are drawn as straight lines, etc.
but diagrams have to be neat enough to illustrate the point you are making.
Amazingly, we often find that candidates have not read the subject guide properly. You do not need
to read anything else to do well in this course, so make sure you read and understand the subject
guide.

Question spotting
Many candidates are disappointed to find that their examination performance is poorer
than they expected. This can be due to a number of different reasons and the Examiners
commentaries suggest ways of addressing common problems and improving your performance.
We want to draw your attention to one particular failing question spotting, that is,
confining your examination preparation to a few question topics which have come up in past
papers for the course. This can have very serious consequences.
We recognise that candidates may not cover all topics in the syllabus in the same depth, but
you need to be aware that Examiners are free to set questions on any aspect of the syllabus.
This means that you need to study enough of the syllabus to enable you to answer the required
number of examination questions.
The syllabus can be found in the Course information sheet in the section of the VLE dedicated
to this course. You should read the syllabus very carefully and ensure that you cover sufficient
material in preparation for the examination.
Examiners will vary the topics and questions from year to year and may well set questions that
have not appeared in past papers every topic on the syllabus is a legitimate examination
target. So although past papers can be helpful in revision, you cannot assume that topics or
specific questions that have come up in past examinations will occur again.
If you rely on a question spotting strategy, it is likely you will find yourself in
difficulties when you sit the examination paper. We strongly advise you not to
adopt this strategy.

Examiners commentaries 2011

Examiners commentaries 2011

28 Managerial economics
Important note
This commentary reflects the examination and assessment arrangements for this course in the
academic year 201011. The format and structure of the examination may change in future years,
and any such changes will be publicised on the virtual learning environment (VLE).

Specific comments on questions Zone A

SECTION A
Answer all four questions from this section (12.5 marks each).
Question 1
n identical firms supply a market with demand function p = 1 Q where Q is the
total quantity supplied, i.e. the sum of quantities supplied by the n firms
(Q = q1 + q2 + . . . + qn ). The firms have constant marginal cost c (0 < c < 1).
The background reading for this question is in Chapter 11 of the subject guide (Oligopoly).
Very few candidates got full marks for this question.

a) Find the Cournot equilibrium.

This is a standard question on oligopoly with n firms. To find the Cournot equilibrium,
write down the profit function of firm i:
i = (1 q1 q2 . . . qi . . . qn c)qi .
Take the derivative with respect to qi and set it equal to zero:
1 q1 q2 . . . 2qi . . . qn c = 0.

(.1)

Since all firms are assumed to be identical, we may assume that at the Cournot equilibrium
all quantities will be identical, i.e. q1 = q2 = . . . = qi = . . . = qn = q. Substituting into (.1)
gives
1 (n + 1)q c = 0,
or
q=

1c
.
n+1

b) Show that a merger of two firms is not in the interest of the merging firms.
There were no fully correct answers to this part of the question. Most candidates did not
seem to know how to formulate the question algebraically to enable them to answer the
question.

28 Managerial economics

To answer this question we need to know the firms pre-merger and post-merger profits.
Using the answer to a), we find the pre-merger profit of each firm to be


1 n(1c)

c
(1 c)  1 c 2
n+1
.
=
n+1
n+1
Post-merger, the number of firms has reduced has reduced to n 1 and at the Cournot
equilibrium each firm will now produce q = (1 c)/n and make profits of [(1 c)/n]2 .
It is easy to see that the non-merged firms now make higher profits. However, the merged
firms initially made joint profits of 2[(1 c)/(n + 1)]2 and now make joint profits of
[(1 c)/n]2 . The former is greater than the latter if 2n2 > (n + 1)2 or n2 2n 1 > 0. This
last inequality is satisfied for n > 1 + 20.5 or n > 2. So, if there are at least three firms in the
industry a merger between two firms will make the merging firms worse off.

Question 2
Consider a profit-maximising firm in a perfectly competitive industry. Its
production function is given by q = AL K 1 . Show that = wL/pq, where w is the
per-unit cost of labour (L) and p is the per-unit output price.
The background reading for this question is in Chapter 7 of the subject guide (Production, factor
demands and costs).
Most candidates knew that a perfectly competitive firm will equate marginal cost to price. This
insight is not directly helpful to answer this question though. We can get the answer from first
principles by looking at the firms optimisation problem.
The firms profit is given by
= pAL K 1 wL rK.
The first-order condition for the optimal amount of labour is

= pAL1 K 1 w = 0.
L
We can rewrite this as

pq
= w,
L

and simple rearranging gives the result.

Question 3
Alex is considering auction formats to sell an antique. There are 3 potential buyers,
Ben, Charlie and David, who have valuations 2, 5 and 8 respectively. The 3 bidders
know their own valuation but not the other bidders although they and the seller
know that valuations are drawn from a uniform distribution on [0, 10].
The background reading for this question is in Chapter 5 of the subject guide (Auction and
bidding).
a) What is Alexs revenue if he uses an English auction? Who wins the auction?
Many candidates thought that revenue equals the highest valuation (8) but, of course, in an
English auction the bidder with the highest valuation gets the item at the second-highest
valuation.
In an English auction bidders bid up to their valuation. This implies that Ben and Charlie
drop out when the bidding reaches 2 and 5 respectively. David wins the auction and Alexs
revenue is 5.

Examiners commentaries 2011

b) What is Alexs revenue if he uses a second price sealed bid auction? Who
wins the auction?
Many candidates thought they had to calculate the expected second highest valuation which
would be correct if, for example, valuations were uniformly distributed. In this question,
however, we are given the exact valuations and so no calculation is necessary.
In a second price sealed bid auction, bidders bid their true valuation. Hence, David wins but
since he pays the second highest bid, Alexs revenue is 5.
c) Determine the bidders equilibrium strategies in a first price sealed bid
auction. What is Alexs revenue if he uses this type of auction?
Very few candidates managed this part although the derivation is in the subject guide.
In a first price sealed bid auction with n bidders and uniform valuations on [0, 10], a bidders
expected payoff if he has valuation v and bids b equals
(v b)P (win)

(.2)

where
P (win) = P (all n 1 other bids are below b).
Suppose all bidders bid a fraction f of their valuation. Then

P (win) = P (all n 1 other f v below b) = P

b
all other v below
f

b
=
10f

n1
.

Substituting into (.2) gives an expected payoff of


(v b)

b
10f

n1
.

Setting the first derivative with respect to b equal to zero gives


(v b)(n 1)

b
10f

n2 

 
n1
1
b

= 0,
10f
10f

or

(n 1)v
.
n
Clearly David will win as he has the highest valuation. According to (.3) he will bid
2 8/3 = 16/3 which will be Alexs revenue.
b=

(.3)

Question 4
Richards utility function is given by U (x1 , x2 ) = x1 x32 . His budget is m and the
per-unit prices of the goods are p1 and p2 .
The background reading for this question is in Chapter 6 of the subject guide (Topics in
consumer theory).

a) Find Richards optimal consumption bundle.

Most candidates realised that calculation of marginal utilities is required and that the ratio
of marginal utilities should equal the price ratio. Many failed to execute the calculation
correctly.
For the optimal consumption bundle, the ratio of marginal utilities equals the price ratio:
U/x1
x32
p1
=
= ,
2
U/x2
3x1 x2
p2

28 Managerial economics

or

x2
p1
= ,
3x1
p2

so that

3p1 x1
.
p2
Substituting this into the budget constraint gives


3p1 x1
p1 x1 + p2
= m.
p2
x2 =

Therefore,
x1 =

m
4p1

3p1
and

x2 =

m
4p1

p2

3m
.
4p2

b) Suppose m = 100. What is the change in consumption of good 2 if its price

changes from 1 to 3?
For m = 100 and p2 = 1, x2 = 300/4 = 75 and for p2 = 3, x2 = 300/12 = 25.

SECTION B
Answer two questions from this section (25 marks each).
Question 5
Consider the game in normal form below.
Player 1/Player 2
T
B

L
(1,1)
(2,0)

R
(0,2)
(x, y)

The background reading for this question is in Chapter 2 of the subject guide (Game theory).
This question turned out to be rather easy and typically candidates answered all but part b)
correctly.
a) Assume x = y. For which values of x do both players have a dominant
strategy? What are their dominant strategies?
For Player 1 only B can be a dominant strategy since his payoff for B is higher than his
payoff for T if Player 2 picks L. Hence Player 1 has a dominant strategy (B) if x > 0. Since
the game is symmetrical, this means that Player 2 has a dominant strategy (R) if y > 0.
b) Assume x = y. For which values of x is this game a prisoners dilemma?
Answering this part of the question correctly requires knowledge of the abstract structure of
a prisoners dilemma.
In a prisoners dilemma, the dominant strategy equilibrium is inefficient. From a) we know
that (B, R) is the dominant strategy equilibrium if x > 0. This equilibrium is inefficient
(Pareto dominated) if x < 1. Hence for 0 < x < 1, this game is a prisoners dilemma.
c) Now assume x > 0 > y. Find the Nash equilibrium in pure strategies.
(T, L) cannot be an equilibrium (since both players would want to change strategy).
(B, L) is an equilibrium for 0 y.
(T, R) cannot be an equilibrium if x > 0.
(B, R) cannot be an equilibrium for y < 0.
Hence (B, L) is the unique Nash equilibrium for x > 0 > y.

Examiners commentaries 2011

d) Are there any values of x and y for which this game does not have an
equilibrium in pure strategies? Explain your answer.
We already know that (T, L) cannot be an equilibrium.
(B, L) is an equilibrium if 0 y.
(T, R) is an equilibrium if 0 x.
(B, R) is an equilibrium if x 0 and y 0.
Therefore, there are no values for x and y for which there is no equilibrium in pure strategies.

Question 6
Alice and Benny are bargaining over the division of 100. Both have discount factor
(0 < < 1).
The background reading for this question is in Chapter 3 of the subject guide (Bargaining).
This question was generally answered well.

a) Consider a two period bargaining game. In the first period Alice makes an
offer. If Benny rejects this offer, he can make a counteroffer in the second
period. If Alice rejects that offer they both end up with zero. What are Alices
and Bennys shares of the 100 in equilibrium?
First we draw the game tree.

(100

Accept
Offer to keep fraction

Reject
Offer to keep fraction

, (1

Accept
B

)100)

((1

)100,

100)

A
Reject

(0,0)

In the second round Alice accepts if (1 xB )100 0, or xB 1. So, Benny will set xB = 1
and will accept Alices offer if 100(1 xA ) 100 or xA 1 .
So, Alice will offer to keep a share of xA = 1 and this offer will be accepted. At the
equilibrium Alice ends up with a share 1 and Benny with a share .

b) Now consider a three period game where the sequence of offers is Alice, then
Benny, then Alice again. If Benny rejects the offer made by Alice in the third
period they both get zero. What are Alices and Bennys shares of the 100 in
equilibrium?
Now the game tree looks like this:
(Ignore the second pairs of payoffs in some places, they are only relevant for the next part of
the question.)

28 Managerial economics

(100

Accept
Offer to keep fraction

Reject
Offer to keep fraction

, (1

Accept
B

((1

((1

Reject
Accept

(1002
(1002

)100)

)100,

100)

)100,

100)

(0,0)

, 1002(1 A))
, 100(1 A))
A

In period 3, Benny accepts if yA 1. So Alice sets yA = 1.

In period 2, Alice accepts if (1 xB )100 100 2 , or xB 1 . So Benny sets xB = 1 .
In period 1, Benny accepts if 100(1 xA ) 100(1 ), or xA 1 (1 ).
At the start, Alice will set xA = 1 (1 ) since 100(1 (1 )) 100 2 .
Therefore, Alice ends up with a share 1 (1 ) and Benny ends up with a share (1 ).

c) Now suppose that Alice is impatient (i.e. her < 1) whereas Benny is not
(i.e. his = 1). Now what are the shares in equilibrium for the three period
game in b) ? Has Bennys share increased or decreased?
The game tree obviously remains the same. Only the payoffs change in a couple of places.
The new sets of payoffs are written under the payoffs for part b) in the game tree.
In period 3, Benny accepts if yA 1 so Alice sets yA = 1.
In period 2, Alice accepts if (1 xB )100 100 2 or xB 1 . So Benny sets xB = 1 .
In period 1, Benny accepts if 100(1 xA ) 100(1 ) or xA .
At the start Alice sets xA = . So Alice ends up with a share and Benny with a share 1 .
Since 1 (1 ) > for < 1, Alices share has decreased and Bennys share has increased.

Question 7
In Russian roulette a player spins a revolvers 6 round cylinder, places the muzzle
against his head and pulls the trigger. If the revolver contains x bullets then the
chance of being killed is x/6.
The background reading for this question is in Chapter 1 of the subject guide (Decision analysis).
This question was rather unpopular. Most candidates who attempted it were capable of drawing
the decision tree (which is, of course, the easy part) but did not get further than that.

Examiners commentaries 2011

a) Alexey is going to play Russian roulette. There are 5 bullets in the revolver.
He could pay an amount of money p1 to reduce the number of bullets to 4.
Draw his decision tree. [Hint: the outcomes are dead, alive with wealth W ,
alive with wealth W p1 .]

4
6

Dead

2
6

Alive, W p1

5
6

Dead

Pay

Dont pay

1
6

Alive, W

b) Suppose Alexey starts out with 1 bullet in the revolver and if he pays p2 that
bullet is removed. Draw his decision tree.

Pay

Alive, W p2

Dont pay

1
6
5
6

Dead

Alive, W

c) Using Alexeys utility function, write down the equation indicating

indifference between the two decisions in a).
4
2
5
1
U (dead) + U (alive, W p1 ) = U (dead) + U (alive, W ).
6
6
6
6

(.4)

d) Using Alexeys utility function, write down the equation indicating

indifference between the two decisions in b).
U (alive, W p2 ) =

1
5
U (dead) + U (alive, W ).
6
6

(.5)

e) Use your answers to c) and d) to derive the conclusion that Alexey is

prepared to pay more to reduce the number of bullets from 5 to 4 than to
reduce the number of bullets from 1 to zero.
The amounts of money p1 and p2 which satisfy (.4) and (.5) respectively are clearly the
maximum amounts of money Alexey is willing to pay.
(.4) can be rewritten as
U (dead) + U (alive, W ) = 2U (alive, W p1 ).

(.6)

28 Managerial economics

(.5) can be rewritten as

U (dead) + 5U (alive, W ) = 6U (alive, W p2 ).

(.7)

Combining (.6) and (.7) we find

U (dead) = U (alive, W ) 2U (alive, W p1 ) = 5U (alive, W ) 6U (alive, W p2 ).
Hence,
4U (alive, W ) = 6U (alive, W p2 ) 2U (alive, W p1 ).
Lets drop the alive bit to simplify notation now. So,
4U (W ) = 4U (W p2 ) + 2 [U (W p2 ) U (W p1 )] .
Since the first term on the right-hand side is less than the left-hand side, the expression in
brackets has to be positive, i.e. W p2 > W p1 , or p2 < p1 .

Question 8
Explain what is meant by first degree, second degree and third degree price
discrimination and give examples of each. Illustrate your answer with numerical
examples.
The outline of a good answer can be found in the subject guide (Chapter 10, Monopolistic
pricing practices).
Not many candidates attempted this question. Only a few candidates provided a clear exposition
of the concepts and illustrated their answers with numerical examples. Obviously, if the question
asks you specifically to provide examples and you do not, you lose marks!

Question 9
Explain what is meant by asymmetric information, adverse selection and moral
hazard. Explain why asymmetric information can be problematic and discuss
signalling and screening as ways to overcome asymmetric information problems.
Illustrate your answer with examples.
The outline of a good answer can be found in the subject guide (Chapter 4, Asymmetric
information).
This is a standard question and it was very popular. Again, not many candidates provided
examples.

Question 10
Explain the perfect competition model. Discuss in detail, using graphs and
equations, how market supply is determined.
The outline of a good answer can be found in the subject guide (Chapter 9, Market structure).
Surprisingly few candidates attempted this question. Again, it is very important to answer all
parts of the question. Many answers did not provide an explanation of market supply.

Examiners commentaries 2011

Examiners commentaries 2011

28 Managerial economics
Important note
This commentary reflects the examination and assessment arrangements for this course in the
academic year 201011. The format and structure of the examination may change in future years,
and any such changes will be publicised on the virtual learning environment (VLE).

Specific comments on questions Zone B

SECTION A
Answer all four questions from this section (12.5 marks each).
Question 1
Two players are playing an alternating offers bargaining game. They start out with
a given amount of money. Whenever an offer is rejected, the available sum of money
is discounted (discount factor ). Player 1 makes the first move and offers to keep a
fraction x1 . If this offer is rejected by Player 2, the latter offers to keep a fraction y1 .
If this is rejected by Player 1, the latter offers to keep a fraction x2 . At this stage, if
Player 2 rejects the offer, both players get zero. Find the subgame perfect Nash
equilibrium. Does Player 1 have a first-mover advantage in this game?
The background reading for this question is in Chapter 3 of the subject guide (Bargaining).
This is a standard alternating offers bargaining question. Not many candidates were able to
explain that Player 1 has a first-mover advantage.

1
Offer to keep fraction

Accept

,1

2
Reject
Offer to keep fraction

1
Reject
Offer to keep fraction

(2

, 2(1

((1

Accept

Reject

))

),

(0,0)

2
Accept

At the last node, Player 2 accepts any x2 1. Hence Player 1 sets x2 = 1.

At the next to last node, Player 1 accepts if (1 y1 ) 2 or 1 y1 or y1 1 . Player 2
will therefore set y1 = 1 .
Player 2 accepts the first offer if 1 x1 (1 ) or x1 1 (1 ).
At the start, Player 1 sets x1 = 1 (1 ) since acceptance of this offer by Player 2 gives a
better result than rejection (the latter gives Player 1 2 ).

28 Managerial economics

Hence, at the subgame perfect equilibrium, Player 1 gets 1 (1 ) = 1 + 2 and Player 2

gets (1 ) = 2 .
The payoff to Player 1 is greater than the payoff to Player 2:
1 + 2 2 ,
since 1 2 + 2 2 0, as the left-hand side equals (1 )2 + 2 . So Player 1 has a first-mover
advantage.

Question 2
Diane always has tea with two sugars and coffee without sugar.
The background reading for this question is in Chapter 6 of the subject guide (Topics in
consumer theory).
a) Draw her indifference curves for tea and sugar and write down her utility
function for tea and sugar.
The majority of candidates were able to draw the indifference curves but not many correctly
specified the utility function.

Sugar
4
2

2
Tea

If she has 1 tea then having more than 2 sugars does not increase her utility and similarly if
she has 2 sugars then having more tea does not increase her utility. Hence the indifference
curves are L-shaped.
Her utility function is given by U = min(tea, sugar/2).
b) Draw her indifference curves for coffee and sugar and write down her utility
function for coffee and sugar.
The majority of candidates were able to draw the indifference curves but not many correctly
specified the utility function.

Sugar
4
2

2
Coffee

Examiners commentaries 2011

She does not use sugar so any amount of sugar for a given amount of coffee does not change
her utility.
Her utility function is given by U = coffee.

Question 3
Teds utility of money function is given by U (x) = x1/2 , x 0. Find Teds certainty
equivalent of a gamble with a fifty-fifty chance of 100 and zero. Explain your answer.
The background reading for this question is in Chapter 1 of the subject guide (Decision analysis).
This question tests candidates understanding of expected utility theory. A common mistake is
failure to realise that the utility function implies risk aversion and hence there is no point in
calculating the expected value of the lottery. Another common mistake is failure to grasp the
concept of certainty equivalent.
Teds expected utility of the lottery equals
0.5U (100) + 0.5U (0) = 0.5(10) + 0.5(0) = 5.
The certainty equivalent is the amount of money such that Ted is indifferent between it and the
lottery. In other words, Teds utility of the certainty equivalent (CE) equals that of the lottery:
U (CE) = 5.
Hence CE1/2 = 5 and so CE = 25. Note that CE < EV as Ted is risk averse.

Question 4
Consider a second price sealed bid auction with 5 bidders whose (private) valuations
are independently drawn from a uniform distribution on [100, 160].
The background reading for this question is in Chapter 5 of the subject guide (Auction and
bidding).

a) How should each bidder bid?

In a private valuations second price auction, bidding your true valuation is a dominant
strategy.
The question does not ask you to prove why bidding your true valuation is optimal, but if
you do want to explain it make sure you get it right!
b) What is the sellers expected revenue?
A common mistake here is that students have memorised a formula without really
understanding what it means. The risk is, of course, that you do not remember it correctly.
A better strategy is to make sure you understand the reasoning so you will be able to think
of any formulae you need from first principles.
The sellers expected revenue is the expected value of the second highest valuation. For a
uniform distribution on [100, 160] with 5 bidders, the expected value of the lowest valuation
is 110, that of the second lowest valuation is 120 and so on. The expected value of the
second highest valuation is 140, which is the sellers expected revenue.

28 Managerial economics

SECTION B
Answer two questions from this section (25 marks each).
Question 5
Consider a duopoly with market demand Q = 100 p. Each firm has constant
marginal cost, MC = 1.
The background reading for this question is in Chapter 11 of the subject guide (Oligopoly).
A large majority of candidates attempted this question and did well, at least in the first two
parts.

a) Find the Cournot output levels, price and profits.

Firm 1s profit is given by
1 = (100 q1 q2 1)q1 .
Optimising with respect to q1 gives
1
= 100 2q1 q2 1 = 0.
q1

(.1)

Since the two firms are identical, we may assume q1 = q2 = q and from (.1) we find q = 33 so
that p = 34 and 1 = 2 = 332 = 1089.
b) Find the Stackelberg output levels, price and profits.
Lets assume Firm 1 is the follower. Then for given q2 , (.1) is Firm 1s optimal response, i.e.
q1 = (99 q2 )/2.
The leader, Firm 2, anticipates this response and therefore maximises


99 q2
(99 q2 )q2
2 = 100
q2 1 q2 =
.
2
2
Optimising with respect to q2 gives q2 = 99/2 and hence q1 = 99/4.
p = 100 99/4 99/2 = 103/4.
1 = (103/4 1)(99/4) = 612.6 and 2 = (103/4 1)(99/2) = 1225.1.
c) Suppose the two firms form a cartel. Find the profit-maximising output
level, price and profit.
The most common mistake here was failing to recognise that you have to solve a monopoly
problem.
If the firms form a cartel, they maximise joint profits
= (100 Q 1)Q.
Hence Q = 99/2, p = 100 99/2 = 101/2 and = (101/2 1)(99/2) = 2450.2.
d) In c), how will production be divided between the two firms?
Very few candidates answered this part correctly. Most candidates suggested that output
has to be divided equally.
Since there are no fixed costs and marginal costs are constant and the same in both firms, it
does not matter how output is divided, any division is optimal.

Examiners commentaries 2011

Question 6
A company has two plants with different production technologies to produce the
same good. Plant A has production function Q = min(3L, 2K) and plant B has
production function Q = L0.5 K 0.5 . Unit costs of labour (L) and capital (K) are w and
r respectively.
The background reading for this question is in Chapter 7 of the subject guide (Production, factor
demand and costs).
The first two parts of this question are fairly routine, but the last two parts are a bit more
challenging and require problem-solving skills.

a) Find the cost function for plant A.

Clearly, you cannot use calculus to derive the cost function for the given production function.
For plant A, cost minimisation implies Q = 3L = 2K so that the conditional input demands
are L = Q/3 and K = Q/2. The cost function is therefore
CA (Q) = w

Q
Q
+r .
3
2

b) Find the cost function for plant B.

This is a standard cost function derivation.
For plant B, cost minimisation implies that the ratio of marginal products equals the ratio
of input prices:
K
0.5L0.5 K 0.5
w
Q/L
=
=
= .
0.5
0.5
Q/K
0.5L K
L
r
Hence K = wL/r. Substituting this into the production function gives
Q = L0.5

wL
r

The conditional input demands are

 r 0.5
L=Q
w

0.5
=

and

 w 0.5
r

K=Q

L.

 w 0.5
r

so that the cost function is given by

 r 0.5
 w 0.5
CB (Q) = w Q
+rQ
= 2(wr)0.5 Q.
w
r
c) For w = r = 10, how should production be divided between the two plants if
the company wants to produce 100 units?
A common mistake here was comparing total cost rather than marginal cost.
For w = r = 10, CA (Q) = (25/3)Q and CB (Q) = 20Q. It is always cheaper to produce in
plant A, so all units should be produced in plant A.
d) Assuming r = 10, what is the maximum value for w so that plant B will be
used?
Most candidates did not get this far into this question. Partial credit was awarded for a
correct start towards an answer.
Using plant B is optimal if 2(wr)0.5 w/3 + r/2. Squaring both sides gives
4wr

 w 2
3

 r 2
2

wr
.
3

28 Managerial economics

Substituting r = 10, we get

40w

w2
10w
+ 25 +
9
3

or

w2
110w

+ 25 0.
9
3

This last inequality is satisfied for w 0.683 and for w 329. Hence plant B will be used
only for very small and for very large values of w.

Question 7
The demand for an e-book is given by Q = 100 5p.
a) Under the wholesale pricing model, Amazon decides on the retail price, pr ,
and the publisher decides on the price it charges Amazon, the wholesale price,
pw . Find the profit-maximising prices and the resulting quantity and profits.
The background reading for this question is in Chapter 11 of the subject guide (Oligopoly).
The most common mistake here was failing to realise that this is a sequential problem and
you need to start by finding the retail price (as a function of the wholesale price).
Amazon maximises
(pr pw )(100 5pr ).
The first-order condition is
5pr + 5pw + 100 5pr = 0,
hence
pr =

pw
100 + 5pw
= 10 +
.
10
2

Retail demand at this price equals


pw 
5pw
Q = 100 5 10 +
= 50
.
2
2
The publisher therefore maximises

pw
The first-order condition is

5pw
50
2


.

5pw
5pw
+ 50
= 0,
2
2

hence pw = 10.
The retail price is then pr = 10 + 10/2 = 15 and the quantity sold equals Q = 25.
Amazons profit equals A = (15 10)25 = 125 and the publishers profit equals P = 250.
b) Under the Apple model, the publisher decides on the retail price and
Amazon gets 30% of the sales revenue. Find the profit-maximising retail price
and the resulting quantity and profits.
Now the publisher maximises
0.7pr (100 5pr ).
So he will set pr = 10. Quantity sold then equals Q = 50 and the profits are
A = (0.3)10(100 50) = 150

and

P = (0.7)10(100 50) = 350.

c) Which of the two pricing schemes is best for Amazon? For the publisher?
For consumers?
Both Amazon and the publisher are better off under the Apple model. Since the retail price
is lower under the Apple model, consumers are also better off.

Examiners commentaries 2011

d) Can you think of any reasons why Amazon might want to set the retail price
below the profit-maximising price?
Amazon might want to set a lower price for e-books to encourage purchases of e-book
readers (Kindle).

Question 8
What is meant bu pure bundling and mixed bundling ? Explain how bundling can
increase profits. Give a numerical example.
The outline of a good answer can be found in the subject guide (Chapter 10, Monopolistic
pricing practices).
Not many candidates attempted this question. Very few answered the question fully, including a
numerical demonstration of how bundling can increase profits.

Question 9
It is very common for lawyers to bill their clients by the hour. Explain how this
creates moral hazard problems. Suggest a different billing structure which avoids
these problems and discuss its advantages and disadvantages.
The background reading for this question is in Chapter 4 of the subject guide (Asymmetric
information).
Most candidates recognised why there is a moral hazard problem in this context. The proposed
solutions, however, often lacked plausibility.
A good answer discussed the misalignment of lawyer and client interests under the hourly billing
system. When lawyers are paid per hour, they have no incentive to speed up proceedings. They
also have no incentive to advise clients to accept a settlement. In practice, of course, these
problems may be somewhat mitigated by lawyers concern about their reputation.
An alternative billing system (which is indeed used in some cases, e.g. personal injury) involves
making the lawyers pay depend on the outcome of the case, cf. no win, no fee. The advantage
of such a system is that interests are aligned. Also, the risk is shared whereas in the standard
scheme the client bears all the risk. A downside is that it may be difficult to find a lawyer willing
to take on certain types of cases.

Question 10
In 2010, some members of the Pakistan cricket team were accused of conniving with
bookmakers, if not to lose matches, then at least to instigate specific events in the
game. Does efficiency wage theory explain why such scandals are more likely to
arise for relatively low-paid sports people? What can be done to reduce corruption
in sports?
The background reading for this question is in Chapter 8 of the subject guide (Topics in labour
economics).
The answers to this question were generally poor. This was often due to lack of knowledge of the
efficiency wage model.
A good answer would give an outline of the efficiency wage model and explained the effect of
wage on the decision to cheat.

28 Managerial economics

A number of measures could be taken to reduce corruption, e.g. paying more, increasing the
punishment when caught, increasing the probability of being caught etc. Another solution would
be to ban betting, or at least betting on anything other than the final outcome of a game.