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You are on page 1of 24

UNIVERSITY OF LONDON

279 0028 ZA

BSc degrees and Diplomas for Graduates in Economics, Management, Finance and the

Social Sciences, the Diploma in Economics and Access Route for Students in the

External Programme

Managerial Economics

Thursday, 14th May 2009 : 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 stongly 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.

UL09/0183

D01

Page 1 of 4

SECTION A

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

1.

2.

Olga is indifferent between 50 for sure and a lottery which gives her 100 with

probability 0.7 and zero with probability 0.3.

(a)

Is Olga risk loving, risk neutral or risk averse? Explain your answer.

(b)

Consider the following game in normal form. Find all Nash-equilibria (i.e. mixed as

well as pure).

PLAYER 1

3.

4.

U

UM

DM

D

L

(2,0)

(1,4)

(3,-1)

(2,2)

PLAYER 2

LM

RM

(2,1)

(1,0)

(1,2)

(0,0)

(1,0)

(-1,-1)

(1,3)

(2,2)

Consider a second price sealed bid private value auction where bidders have valuations

which are independently and uniformly distributed on [6,15].

(a)

(b)

(c)

A consumer with income m = 10 chooses the optimal consumption bundle (x1, x2) of

two consumption goods. His utility function is given by U(x1, x2) = (x1 x2)2 and the

prices for good 1 and good 2 are p1 =1 and p2 =2. What is (x1, x2)?

UL09/0183

D01

R

(3,0)

(2,2)

(4,1)

(2,2)

Page 2 of 4

SECTION B

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

5.

6.

An employer needs to hire 10 workers. There are equal numbers of good and bad

workers in the population and the employer cannot distinguish between these two types.

Good workers produce 10 widgets per hour whereas bad workers produce 5 widgets per

hour. The employer has a profit margin of P per widget. Good workers have better

outside opportunities than bad workers: the alternative wages available are wg and wb

for good and bad workers respectively (wg > wb). The employer is considering two

possible payment schemes: a fixed wage of S per hour or a smaller fixed wage SL plus a

piece rate equal to 15% of the profit margin (P) per widget.

(a)

In the fixed wage scheme all workers get S per hour. What are the payments for

good and bad workers under the piece rate scheme?

(b)

Under the fixed wage scheme, what is the minimum salary the employer needs to

pay if he wants to attract good workers? If he offers this salary, how many good

workers does he expect to hire?

(c)

(d)

If the employer does not aim to hire good workers, what is the minimum salary he

has to pay in the fixed salary scheme?

(e)

(f)

Assuming the fixed salary scheme is used, find the condition under which it

doesnt pay to attract good workers.

(g)

Now consider the piece rate scheme. For which values of SL will good workers

apply? For which values of SL will bad workers apply?

(h)

workers will apply?

(i)

For the parameter values in (h), determine the profit maximising payment scheme.

A duopoly faces market demand Q = 100 - P. The marginal cost for each firm is 40 and

fixed costs are zero.

(a)

(b)

Suppose Firm 1 is the incumbent and can commit to an output level before Firm 2

makes an entry decision. Find the optimal quantities Firm 1 and, if it enters, Firm

2, will produce. Calculate optimal profits.

(c)

Suppose the incumbent (Firm 1) can commit to lowering its marginal cost from 40

to 4 by incurring a fixed cost of 1,804. Suppose the rival (Firm 2) incurs a fixed

cost of 100 to enter. Determine whether the incumbent will make the

commitment.

UL09/0183

D01

Page 3 of 4

7.

Suppose Bill, a buyer, and Sally, a seller, are bargaining over the price at which Sally

will perform a service for Bill. It is common knowledge that the maximum price Bill

will pay is 300 and the minimum price Sally will accept is 200 (you should interpret

these values as reservation prices). Bill and Sally bargain over the price in the following

manner: Bill offers a price to Sally who can either accept or reject it. If she accepts

Bills offer, the game ends and they exchange at the offered price. If Sally rejects the

offer, then Bill offers another price which Sally can again accept or reject, and so on.

Both players discount future income by 50% per period. Sally accepts an offer if she is

indifferent between accepting it and rejecting it.

(a)

Draw the game tree assuming they bargain for only two rounds, i.e. if Sally rejects

Bills second offer, then they do not trade and each receives a payoff of 0.

(b)

(c)

Determine perfect equilibrium strategies for the infinite horizon version of this

game.

(d)

Now assume that neither player discounts the future at all and the rules of the

game change as follows. In each round a fair coin is flipped to decide who makes

the offer in that round. If the coin comes up heads Bill gets to make an offer

which Sally can accept or reject, if the coin comes up tails then Sally gets to make

an offer which Bill can accept or reject. Draw the game tree assuming bargaining

stops after two rounds.

(e)

Assume that it is common knowledge that both players have the following utility

function over final payoffs: U(x) = x1/2. Find perfect equilibrium strategies for the

game in (d).

8.

Explain what is meant by price discrimination and discuss the various forms of price

discrimination a monopolist can use. Is it possible for consumer surplus to be larger

under price discrimination than with a uniform price? Illustrate your answers with

examples.

9.

Setco uses one input to produce widgets. It is a monopsonist in the input market and a

monopolist in the widget market. Explain how Setco decides on the amount of input to

use.

10.

Wal-Mart, brought on behalf of past and present female employees who claim the

retailer is biased in favour of men in pay.

(a)

Explain why it could be profit-maximising for Wal-Mart to pay women less than

men.

(b)

Assuming Wal-Mart is a monopsonist which has been paying women less and is

forced to pay equal wages to male and female employees, what will happen to

male and female wages and employment? Could the new wage be as low as the

previous female wage or as high as the previous male wage?

END OF PAPER

UL09/0183

D01

Page 4 of 4

UNIVERSITY OF LONDON

279 0028 ZB

BSc degrees and Diplomas for Graduates in Economics, Management, Finance and the Social

Sciences, the Diploma in Economics and Access Route for Students in the External

Programme

Managerial Economics

Thursday, 14th May 2009 : 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 stongly 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.

UL09/0184

D01

Page 1 of 4

SECTION A

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

1.

2.

will receive some monetary compensation. Potential participants are invited to submit a bid

for the amount of monetary compensation they require to take part in the study. Successful

bidders will be those who bid the lowest amounts and each subject will be paid the amount of

compensation demanded by the lowest unsuccessful bidder.

(a)

(b)

Suppose the researchers use a first price sealed bid auction format instead (i.e. the

winners are the lowest bidders and they get paid what they bid). Would this increase the

researchers recruitment expenses? Explain your answer.

Find all perfect (pure strategy) equilibria for the game below.

U

(1,2)

(2,3)

(3,2)

(2,1)

(1,1)

(0,2)

2

T

B

2

3.

Toms utility of money function is given by U(x) = x2 (x 0). Is Tom risk averse, risk neutral

or risk loving? Explain your answer.

4.

In a three stage alternating offers bargaining game, player 1 demands a fraction x of $100. If

this is accepted by player 2, the $100 is split between the players with outcome

($100x, $100(1 - x)). Otherwise, at stage 2, player 2 makes a demand for a fraction y. If this is

accepted by player 1, the $100 is divided accordingly but otherwise player 1 can make

another offer and demand a fraction z. If that offer is rejected by player 2, the outcome is

(0,0). Both players have a discount factor of .

(a)

(b)

UL09/0184

D01

Page 2 of 4

SECTION B

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

5.

6.

An oligopolistic industry has market demand Q = 100 - p. All firms in the industry have zero

fixed cost and marginal cost of 10.

(a)

Assume there are 2 firms in the industry. Find the Cournot equilibrium quantities and

profits.

(b)

Assume there are n firms in the industry. Find the Cournot equilibrium quantities and

profits.

(c)

With n firms in the industry, assume firm 1 maximises revenue (rather than profit)

whereas all the other firms maximise profit. Find the Nash equilibrium quantities and

profits.

(d)

Comparing (c) to (b), does firm 1s profit increase? Do the other firms profits increase?

The demand for detergent in Luxland is characterised by the following demand function:

p(q)= 100 - 10q. Firm A supplies detergent and has a cost function given by CA (qA) = 10qA2.

(a)

quantity and price?

(b)

Now assume that firm A can produce for two different countries, Luxland and Povland.

Demand in Povland is given by p(q) = 50 - 20q. Assuming firm A is a monopolist for

both markets, what is the optimal price and quantity for each market under third-degree

price discrimination?

(c)

Now assume that firm A is only active in Luxland where it competes with firm B. Firm

Bs cost function is CB(qB) = 40qB. Suppose that both compete in quantities (Cournot

competition). What are the equilibrium quantities? What is the price?

(d)

Now assume that firm A is competing with firm B in Luxland (as before, in quantities)

but is a monopolist in Povland. Again, firm A can set a price in Povland independently

of the price that arises in Luxland. What are the firms optimal production quantities

and what are the prices in Luxland and Povland?

UL09/0184

D01

Page 3 of 4

7.

A monopoly manufacturer has cost function C(Q) = 100 + 0.05 Q2. It sells its products

through two retailers who have identical cost functions ci(qi) = 10 + 2 qi , i = 1,2. Market

demand is given by Q =1000 - 10p.

(a)

Assume the retailers act as Cournot duopolists, taking the wholesale price, pw, as given.

Find their equilibrium sales as functions of the wholesale price.

(b)

(c)

Now assume that the two retailers have exclusive territories of identical size i.e. they

both behave as monopolists with respect to half the market demand. Calculate optimal

prices, quantities and profits for the retailers and the manufacturer.

(d)

8.

Explain how you would calculate the expected return and standard deviation of the return of a

portfolio from the distributions of returns for each individual asset in the portfolio. Explain

the benefits of diversification.

9.

(a)

(b)

Why is adverse selection potentially a problem? How can this problem be overcome?

(c)

i.

ii.

employment.

10.

Singapore is famous for the high salaries it offers politicians and civil servants. The Prime

Ministers salary is over $2million. Outline the efficiency wage explanation and other

possible explanations for these comparatively high public sector salaries.

END OF PAPER

UL09/0184

D01

Page 4 of 4

28 Managerial economics

Specific comments on questions Zone A

Section A

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

Question 1

Olga is indifferent between 50 for sure and a lottery which gives her 100 with

probability 0.7 and zero with probability 0.3.

(a) Is Olga risk loving, risk neutral or risk averse? Explain your answer.

(b) What is Olgas risk premium for this lottery?

(a) This is a very straightforward question since all that is required is that you know the definitions

of risk loving, risk neutral and risk averse. A risk averse decision makers certainty equivalent of

a lottery is less than the expected value of the lottery. Therefore, Olga is risk averse since her

certainty equivalent of the lottery is 50 which is less than the expected value of the lottery

(70).

(b) What is required here is that you know what a risk premium is and how to calculate it. The risk

premium is the difference between the expected value of the lottery and its certainty equivalent.

Hence, Olgas risk premium is 70 50 = 20.

Question 2

Consider the following game in normal form. Find all Nash-equilibria (i.e. mixed as

well as pure).

Player 1

U

UM

DM

D

L

(2,0)

(1,4)

(3,-1)

(2,2)

Player 2

LM

RM

(2,1)

(1,0)

(1,2)

(0,0

(1,0)

(-1,-1)

(1,3)

(2,2)

R

(3,0)

(2,2)

(4,1)

(2,2)

This question was generally answered well, at least in terms of candidates realising they could

use iterated strict dominance to eliminate strategies. Most answers, however, conveyed that

candidates did not really grasp what they were doing in calculating mixed strategy equilibria. It

is no good memorising procedures. You must know why you are doing a certain calculation.

To find the Nash equilibria, we first eliminate all dominated strategies. For player 1, UM is

dominated by U. When we eliminate row UM, we see that for player 2, L and RM are dominated

by LM. After elimination of these two columns (L and RM), we see that for player 1, D is

dominated by U.

This leaves us with the following 2 X 2 payoff matrix:

28 Managerial economics

Player 1

U

DM

Player 2

R

LM

(2,1)

(3,0)

(1,0)

(4,1)

There are 2 pure strategy Nash equilibria: (U, LM) and (DM, R).

To find the mixed strategy Nash equilibrium, assume player 1 plays U with probability x (and

DM with probability 1 x) and player 2 plays LM with probability y (and R with probability

1 y).

Given x, the expected payoff of player 2 equals:

2 = xy + (1 x)(1 y).

Player 2 wants to choose y to maximise this expected payoff. The derivative of 2 with respect

to y equals 2x 1 which is positive for x > 1/2, negative for x < 1/2 and equal to zero for

x = 1/2. Hence player 2 will set y = 1 if x > 1/2 and set y = 0 if x > 1/2. Any value of y is

optimal against x = 1/2.

Given y, the expected payoff of player 1 equals:

1 = 2xy + 3x(1 y) + (1 x)y + 4(1 x)(1 y).

Player 1 wants to choose x to maximise this expected payoff. The derivative of 1 with respect

to x equals 2y 1 which is positive for y > 1/2, negative for y < 1/2 and equal to zero for

y = 1/2. Hence player 1 will set x = 1 if y > 1/2 and set x = 0 if y > 1/2. Any value of x is

optimal against y = 1/2.

The players optimal response functions intersect at 3 points, namely (0, 0), (1, 1) (the two pure

strategy equilibria identified earlier) and (1/2, 1/2), the mixed strategy Nash equilibrium.

Question 3

Consider a second price sealed bid private value auction where bidders have

valuations which are independently and uniformly distributed on [6, 15].

(a) How should you bid in this auction?

(b) What is the sellers expected revenue if there are 2 bidders?

(c) What is the sellers expected revenue if there are n bidders?

(a) The dominant strategy in a second price sealed bid private value auction is to bid your true

valuation.

(b) The expected revenue for the seller is the expected second highest valuation. Since the valuations

are uniformly distributed on [6, 15], the expected value of the second highest valuation for two

bidders is 9.

Most candidates did not know how to calculate this the formula for the expected second

highest of n numbers drawn from a uniform distribution on [x, y] is:

x + (y x)

(n 1)

.

(n + 1)

(c) The sellers expected revenue is still the expected value of the second highest valuation which, for

n bidders, equals:

(n 1)

.

6+9

(n + 1)

Question 4

A consumer with income m = 10 chooses the optimal consumption bundle (x1 , x2 )

of two consumption goods. His utility function is given by U (x1 , x2 ) = (x1 x2 )2 and

the prices for good 1 and good 2 are p1 = 1 and p2 = 2. What is (x1 , x1 )?

This is a standard question on consumption. At the optimal consumption bundle, the ratio of

marginal utilities equals the price ratio:

1

2x1 x22

M U1

= ,

=

M U2

2x2 x21

2

so that x1 = 2x2 .

Substituting into the budget constraint gives x1 + 2x2 = 4x2 = 10 or x2 = 2.5 and x1 = 5.

Section B

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

Question 5

An employer needs to hire 10 workers. There are equal numbers of good and bad

workers in the population and the employer cannot distinguish between these two

types. Good workers produce 10 widgets per hour whereas bad workers produce 5

widgets per hour. The employer has a profit margin of P per widget. Good workers

have better outside opportunities than bad workers: the alternative wages available

are wg and wb for good and bad workers respectively (wg > wb ). The employer is

considering two possible payment schemes: a fixed wage of S per hour or a smaller

fixed wage SL plus a piece rate equal to 15% of the profit margin (P ) per widget.

(a) In the fixed wage scheme all workers get S per hour. What are the payments for

good and bad workers under the piece rate scheme?

(b) Under the fixed wage scheme, what is the minimum salary the employer needs to

pay if he wants to attract good workers? If he offers this salary, how many good

workers does he expect to hire?

(c) What is the employers expected net profit in (b)?

(d) If the employer does not aim to hire good workers, what is the minimum salary he

has to pay in the fixed salary scheme?

(e) What is the employers expected net profit in (d)?

(f ) Assuming the fixed salary scheme is used, find the condition under which it doesnt

pay to attract good workers.

(g) Now consider the piece rate scheme. For which values of SL will good workers

apply? For which values of SL will bad workers apply?

(h) Assume wg = 4, wb = 3 and P = 2. Is it possible to set SL so that only good

workers will apply?

(i) For the parameter values in (h), determine the profit maximising payment scheme.

(a) Very few candidates attempted this question but those who did gave excellent answers. The

question relates to the Asymmetric Information material in the subject guide but, in fact, can be

solved from first principles.

In the fixed wage scheme, good and bad workers get S per hour. In the piece rate scheme, good

workers get:

SL + 0.15P (10) = SL + 1.5P

28 Managerial economics

SL + 0.15P (5) = SL + 0.75P

per hour.

(b) The minimum fixed salary the employer needs to pay to attract good workers is the latters

alternative wage, wg . Since half of the workers in the population are good, the employer expects

to hire 5 good workers.

(c) Good workers produce 10 widgets per hour and bad workers produce 5 widgets per hour. On

average a worker therefore produces 7.5 widgets per hour. The employers net profit (for 10

workers) equals 75P 10wg .

(d) If the employer is happy to just hire bad workers, he only needs to pay a fixed salary of wb .

(e) Now all 10 workers are bad and produce 5 widgets per hour so that the employers profit equals

50P 10wb .

(f) It doesnt pay to attract good workers if 75P 10wg < 50P 10wb or wg wb > 2.5P .

(g) Good workers will apply if SL + 1.5P wg and bad workers will apply if SL + 0.75P wb .

(h) If we want only good workers to apply then we need SL + 1.5P wg and SL + 0.75P < wb . For

the given parameter values this means SL + 1.5(2) 4 and SL + 0.75(2) < 3. As long as the

employer sets SL between 1 and 1.5, only good workers will apply.

(i)

i. First consider the fixed wage scheme.According to (f) it doesnt pay to attract good

workers if wg wb > 2.5P . For the given parameter values this condition is not satisfied.

Therefore if the employer uses the fixed wage scheme he should attract good workers. This

means he has to pay 4 per hour and his profit (given average output of 7.5 widgets per

hour) equals 75(2) 40 = 110 per hour.

ii. Now consider the piece rate scheme. Assuming the employer wants to attract only good

workers, we know from (h) that he should set SL = 1. In this scenario, his profit equals

10(10)(2) 10(1 + 10(0.15)(2)) = 200 40 = 160

per hour. If the employer wants to attract both good and bad workers he would set

SL = 1.5 and assuming he gets 5 good and 5 bad workers, his profit would be:

5(5)(2) 5(1.5 + 5(0.15)(2)) + 5(10)(2) 5(1.5 + 10(0.15)(2))

= 50 15 + 100 22.5

= 112.5

per hour.

So, the best (profit-maximising) scheme is the piece rate scheme with SL = 1.

Question 6

A duopoly faces market demand Q = 100 P . The marginal cost for each firm is 40

and fixed costs are zero.

(a) Find the Cournot equilibrium quantities and profits.

(b) Suppose Firm 1 is the incumbent and can commit to an output level before Firm 2

makes an entry decision. Find the optimal quantities Firm 1 and, if it enters, Firm

2, will produce. Calculate optimal profits.

(c) Suppose the incumbent (Firm 1) can commit to lowering its marginal cost from 40

to 4 by incurring a fixed cost of 1,804. Suppose the rival (Firm 2) incurs a fixed cost

of 100 to enter. Determine whether the incumbent will make the commitment.

(a) Profit for Firm 1 is given by 1 = (100 q1 q2 40) q1 . Given q2 , the optimal quantity for

Firm 1 is found from the first order condition:

1

= 60 2q1 q2 = 0.

q1

(6.1)

Since the two firms are identical, we may assume that q2 = q1 = q which reduces ( 6.1) to

60 3q = 0 or q = 20.

From the market demand we find the price P = 60 and both profits equal (60 40)20 = 400.

(b) The most common mistake here was that candidates did not recognise that we are dealing with a

Stackelberg situation in this part of the question. Some got the same answer as for (a) which

should have alerted them to the fact that they did something wrong. The phrasing of the

question clearly indicates that a sequential structure is required.

From the response function of Firm 2 (the equivalent of ( 6.1) above) we know that

q1 = (60 q1 )/2 so that Firm 2s profit equals:

q1 2

60 q1

60 q1

= 30

,

2 = 60 q1

2

2

2

which is positive as long as q1 < 60.

Assuming Firm 2 enters, Firm 1s profit equals:

60 q1

q1

1 = 60 q1

q1 = 30

q1 .

2

2

The optimal quantity for Firm 1 is found from the first order condition:

1

= 30 q1 = 0,

q1

so that q1 = 30 and q2 = 15.

The price is determined by the market demand as P = 55 which gives profits of

(55 40)30 = 450 and (55 40)15 = 225 for Firm 1 and Firm 2 respectively.

We should check whether Firm 1 can be better off by keeping Firm 2 out of the market, i.e. by

setting q1 = 60. Its profit would then equal (40 40)60 = 0 so clearly this is not better.

(c) Many candidates did not get this far on this question. Those who did often ignored the

possibility of Firm 1 driving Firm 2 out.

Firm 2s response is still given by q2 = (60 q1 )/2. If Firm 1 commits to lowering its marginal

cost, its profit equals:

60 q1

q1

1 = 96 q1

q1 1804 = 66

q1 1804,

(6.2)

2

2

assuming Firm 2 enters. However, optimising ( 6.2) gives q1 = 66 and Firm 2 may now not enter.

To check this, write Firm 2s profit function as:

q 1 2

60 q1

60 q1

100 = 30

100.

2 = 60 q1

2

2

2

This is only positive as long as q1 < 40.

So lets calculate Firm 1s optimal profit as a monopoly:

1 = (96 q1 ) q1 1804,

1

= 96 2q1 = 0,

q1

so that q1 = 48 and 1 = 482 1804 = 500.

28 Managerial economics

This profit level is higher than the no-commitment solution in (b) but perhaps we can do even

better. Firm 2 now doesnt enter if q1 40. If Firm 1 decides not to lower its marginal cost, its

profit (as a monopoly) equals:

1 = (60 q1 ) q1 .

The optimal quantity for Firm 1 would be q1 = 30 but it needs to set q1 = 40 if it wants to

remain a monopoly. For q1 = 40, Firm 1s profit equals (60 40)(40) = 800. Therefore, the best

decision for Firm 1 is not to commit to lowering its marginal cost and set its quantity just high

enough to keep Firm 2 out of the market.

Question 7

Suppose Bill, a buyer, and Sally, a seller, are bargaining over the price at which

Sally will perform a service for Bill. It is common knowledge that the maximum

price Bill will pay is 300 and the minimum price Sally will accept is 200 (you

should interpret these values as reservation prices). Bill and Sally bargain over the

price in the following manner: Bill offers a price to Sally who can either accept or

reject it. If she accepts Bills offer, the game ends and they exchange at the offered

price. If Sally rejects the offer, then Bill offers another price which Sally can again

accept or reject, and so on. Both players discount future income by 50% per period.

Sally accepts an offer if she is indifferent between accepting it and rejecting it.

(a) Draw the game tree assuming they bargain for only two rounds, i.e. if Sally rejects

Bills second offer, then they do not trade and each receives a payoff of 0.

(b) Determine perfect equilibrium strategies for the game in (a).

(c) Determine perfect equilibrium strategies for the infinite horizon version of this

game.

(d) Now assume that neither player discounts the future at all and the rules of the game

change as follows. In each round a fair coin is flipped to decide who makes the offer

in that round. If the coin comes up heads Bill gets to make an offer which Sally can

accept or reject, if the coin comes up tails then Sally gets to make an offer which

Bill can accept or reject. Draw the game tree assuming bargaining stops after two

rounds.

(e) Assume that it is common knowledge that both players have the following utility

function over final payoffs: U (x) = x1/2 . Find perfect equilibrium strategies for the

game in (d).

(a) See Figure 1.

Many candidates were able to draw the game tree but some did not manage to get the payoffs

right or did not take into account that only one party is making offers. You have to read the

question carefully!

(b) Sally will reject Bills second offer if P2 < 200. Hence Bill will set P2 = 200. This would give

him a payoff of 0.5(300 200) = 50 if his first offer is rejected. Since Sally expects a zero

payoff in the second round, she will accept Bills first offer if P1 200. Hence Bill will set

P1 = 200.

(c) In the infinite version, if Sally accepts the first offer P she gets P 200. If she rejects the first

offer, the game is exactly the same as the initial game. Sally can never get a positive payoff. So,

at the perfect equilibrium, Bill offers 200 initially and Sally will accept.

accept

a

heads

S

r

(1)

heads

reject

a

tails

B

r

a

tails

heads

(2)

S

r

reject

accept

a

tails

B

r

Remember that in decision trees and game trees, moves by nature are indicated as circles and

decision points as squares.

(e) Many mistakes were made in this part, including getting the payoffs wrong, ignoring the utility

function, etc.

In the second round Bill will accept any P 300 and Sally will accept any P 200. This

implies that in the second round Bill (if he gets to make a decision) will offer 200 and Sally (if

she gets to make a decision) will ask for 300. At the start of the second round Bill will get

utility (300 200)1/2 = 10 if he gets to make the decision and Sally will get (300 200)1/2 = 10

if she gets to make the decision. For both of them the payoff is zero if the other one gets to make

the decision. Therefore, at the second coin toss both have expected utility 5. So, at node (1)

Sally will accept any P which gives her at least 5 in utility, i.e. (P 200)1/2 5 or P 225.

Similarly, at node (2) Bill will accept any P which gives him at least 5 in utility, i.e.

(300 P )1/2 5 or P 275. Hence, in the first round Bill will offer 225 if he gets to decide

and Sally will ask for 275 if she gets to decide. In both cases the first offer will be accepted.

Question 8

Explain what is meant by price discrimination and discuss the various forms of

price discrimination a monopolist can use. Is it possible for consumer surplus to be

larger under price discrimination than with a uniform price? Illustrate your answers

with examples.

Definitions of the various forms of price discrimination can be found in the subject guide

(Chapter 10). It is important that you show the Examiner that you have not just memorised the

material but that you actually understand it!

It is possible for consumer surplus to be larger under price discrimination. For example, some

groups of consumers may not be served at all if the seller is not allowed to use third degree price

discrimination. In such a scenario, assuming constant marginal costs, it is easy to show that

consumer surplus increases if the seller is allowed to use third degree price discrimination.

Question 9

Setco uses one input to produce widgets. It is a monopsonist in the input market

28 Managerial economics

and a monopolist in the widget market. Explain how Setco decides on the amount

of input to use.

The analysis of factor demand in the most general setting (monopoly monopsony) can be found

in the subject guide (Chapter 7). Very few candidates attempted this question although it is

straightforward and merely requires understanding of the subject guide material.

Question 10

The biggest sex-discrimination case in American history is a class-action lawsuit

against Wal-Mart, brought on behalf of past and present female employees who

claim the retailer is biased in favour of men in pay.

(a) Explain why it could be profit-maximising for Wal-Mart to pay women less than

men.

(b) Assuming Wal-Mart is a monopsonist which has been paying women less and is

forced to pay equal wages to male and female employees, what will happen to male

and female wages and employment? Could the new wage be as low as the previous

female wage or as high as the previous male wage?

(a) Very few candidates attempted this question. What is required here is an exposition of the

monopsonist employer model with two (male and female) labour supply curves.

(b) This requires an analysis of the monopsonist employer model where the two labour supply curves

are summed horizontally. The analysis is similar to that of third degree price discrimination.

28 Managerial economics

Specific comments on questions Zone B

Section A

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

Question 1

A team of researchers is looking for subjects to participate in an experiment. Each

participant will receive some monetary compensation. Potential participants are

invited to submit a bid for the amount of monetary compensation they require to

take part in the study. Successful bidders will be those who bid the lowest amounts

and each subject will be paid the amount of compensation demanded by the lowest

unsuccessful bidder.

(a) How should a potential subject bid? Why?

(b) Suppose the researchers use a first price sealed bid auction format instead (i.e. the

winners are the lowest bidders and they get paid what they bid). Would this

increase the researchers recruitment expenses? Explain your answer.

(a) Potential subjects should bid their true reservation level, i.e. the amount of money which makes

them indifferent between participating (and receiving the payment) and not participating since

this is an n-th price sealed bid auction. The reasoning is the same as for a second price sealed

bid auction: if you bid higher than your true valuation and you are successful then you would

have been successful if you had bid your true valuation, but if you are not successful then you

might have won if you had bid your true valuation. If you bid less than your true valuation then

you might win but you could end up being worse off than when you had not won.

(b) It would not increase (or decrease) the researchers expenses (although potential subjects would

bid higher amounts) because of the Revenue Equivalence Theorem.

Question 2

Find all perfect (pure strategy) equilibria for the game below (see Figure 3 on page

2).

At the top node, player 2 chooses D. At the middle node, player 2 chooses U. At the bottom

node, player 2 chooses D. Anticipating this strategy by player 2, player 1 chooses M. Hence the

perfect equilibrium is (M, (D,U,D)).

Answers to this easy question were far from satisfactory. Many candidates tried to write the

game in strategic form which is not helpful for identifying subgame perfect equilibria. Another

common mistake occurs in writing down Nash equilibria remember that an equilibrium is a

combination of strategies and strategies must indicate actions for each possible decision point.

28 Managerial economics

(1, 2)

(2, 3)

(3, 2)

(2, 1)

(1, 1)

(0, 2)

B

2

Question 3

Toms utility of money function is given by U (x) = x2 (x 0). Is Tom risk averse,

risk neutral or risk loving? Explain your answer.

Tom is risk loving. The utility of money function is convex. Obviously, the way to show this is to

show that the second derivative of the utility of money function is positive. Good answers

include a discussion of how EMV and CE compare for risk loving individuals.

Question 4

In a three stage alternating offers bargaining game, player 1 demands a fraction x of

$100. If this is accepted by player 2, the $100 is split between the players with

outcome ($100x, $100(1 x)). Otherwise, at stage 2, player 2 makes a demand for a

fraction y. If this is accepted by player 1, the $100 is divided accordingly but

otherwise player 1 can make another offer and demand a fraction z. If that offer is

rejected by player 2, the outcome is (0,0). Both players have a discount factor of

1/2.

(a) This question was answered well. The most common mistakes were algebraic errors make sure

you double check your calculations.

accept

$100 z4 , $100 1z

4

y

2

accept

accept

x

1

y

$100 1y

2 , $100 2

z

1

reject

(0, 0)

Figure 4: Game tree for question 4.

At the last node, player 2 will accept any z for which $100(1 z)/4 0. Hence, at the

penultimate node, player 1, if he chooses to reject player 2s offer, will set z = 1 which gives him

$25. At the same node, player 1 can get $100(1 y)/2. Hence, player 1 will accept player 2s offer

if $100(1 y)/2 $25 or y 1/2. At the second node, player 2, if he rejects player 1s offer, sets

y = 1/2 which gives him $25. So, player 2 will accept player 1s first offer if $100(1 x) $25 or

x 3/4. At the start node, player 1 will set x = 3/4 and this offer will be accepted by player 2.

(b) Yes, there is a first mover advantage since player 1 ends up with $75 and player 2 gets $25.

Section B

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

Question 5

An oligopolistic industry has market demand Q = 100 p. All firms in the industry

have zero fixed cost and marginal cost of 10.

(a) Assume there are 2 firms in the industry. Find the Cournot equilibrium quantities

and profits.

(b) Assume there are n firms in the industry. Find the Cournot equilibrium quantities

and profits.

(c) With n firms in the industry, assume Firm 1 maximises revenue (rather than profit)

whereas all the other firms maximise profit. Find the Nash equilibrium quantities

and profits.

(d) Comparing (c) to (b), does Firm 1s profit increase? Do the other firms profits

increase?

Many candidates attempted this question, but very few got it completely right. Most candidates

gave the correct answer to (a) and probably thought they could do this question because it looked

familiar. Make sure you read all parts of the questions before deciding which ones to attempt!

(a) To find the Cournot equilibrium, write down Firm 1s payoff:

1 = ((100 q1 q2 ) 10) q1 .

Taking q2 as given, optimising this with respect to q1 gives:

(90 2q1 q2 ) = 0.

28 Managerial economics

Since the two firms are identical we can now use q1 = q2 = q= 30. Substitution in the profit

function gives profits of 900 for both firms.

(b) To find the Cournot equilibrium for n firms, write down Firm 1s payoff:

1 = ((100 q1 q2 . . . qn ) 10) q1 .

Taking qi (i = 2, . . . n) as given, optimising this with respect to q1 gives:

(90 2q1 q2 . . . qn ) = 0.

Since all firms are identical we can now use:

90

.

n+1

2

90

for all firms.

Substitution in the profit function gives profits of

n+1

(c) Firm 1 now maximises revenue, hence its objective function equals:

q 1 = q2 = . . . = qn = q =

R1 = (100 q1 q2 . . . qn ) q1 .

Maximising with respect to q1 gives:

(100 2q1 q2 . . . qn ) = 0.

Or:

100 q2 . . . qn

.

(5.1)

2

All other firms still maximise profit so that the payoff function for Firm i (i = 2, . . . , n) is given

by:

i = ((100 q1 q2 . . . qn ) 10) qi .

q1 =

(90 q1 q2 . . . 2qi . . . qn ) = 0.

Since all firms (apart from Firm 1) are identical we can now use q2 = q3 . . . = qn = q so that:

(90 q1 nq) = 0,

(5.2)

q1 =

100 (n 1) q

.

2

q1 = 90

n

n+1

80,

80

.

n+1

Substituting these quantities in the demand function gives:

n

80

80

p = 100 90

80 (n 1)

= 10 +

.

n+1

n+1

n+1

and q =

n

80

90

80 ,

1 =

n+1

n+1

and

i =

80

n+1

2

i = 2, . . . , n.

(5.3)

(d) Comparing these profits to the profits in (b), it is immediately obvious that profits of Firms

2, . . . , n have decreased.

The profit of Firm 1 can be rewritten as:

1 =

80 (90 + 10n)

(n + 1)

Question 6

The demand for detergent in Luxland is characterised by the following demand

function:

p(q) = 100 10q.

Firm A supplies detergent and has a cost function given by:

2

CA (qA ) = 10qA

.

quantity and price?

(b) Now assume that firm A can produce for two different countries, Luxland and

Povland. Demand in Povland is given by:

p(q) = 50 20q.

Assuming firm A is a monopolist for both markets, what is the optimal price and

quantity for each market under third-degree price discrimination?

(c) Now assume that firm A is only active in Luxland where it competes with firm B.

Firm Bs cost function is:

CB (qB ) = 40qB .

Suppose that both compete in quantities (Cournot competition). What are the

equilibrium quantities? What is the price?

(d) Now assume that firm A is competing with firm B in Luxland (as before, in

quantities) but is a monopolist in Povland. Again, firm A can set a price in Povland

independently of the price that arises in Luxland. What are the firms optimal

production quantities and what are the prices in Luxland and Povland?

(a) Most candidates got this part of the question right.

Firm A will produce the quantity for which marginal revenue (M R) equals marginal cost (M C):

M R = 100 20q = M C = 20q,

so that the profit maximising quantity equals q = 2.5. Substitution in the demand function gives

p = 100 10(2.5) = 75.

(b) A common mistake here was to ignore the fact that quantities affect marginal costs. Of course

this makes the question harder and you have to think more carefully about what you are doing

rather than blindly apply some method you have memorised!

Assuming firm A sells in both markets, it will set quantities such that marginal revenue is equal

in both countries and equal to marginal cost:

M RL = 100 20qL = M RP = 50 40qP = M C = 20(qL + qP ).

This gives:

qL = 2.5,

qP = 0,

M RL = 50,

M RP = 50,

M C = 50.

The optimal price in Luxland is therefore still 75 and given that firm A will not supply in

Povland, the optimal price in Povland is any price greater than or equal to 50.

28 Managerial economics

(c) Most candidates got at least partial credit for this part of the question. A common mistake was

to assume symmetry read the question properly!

To find the Cournot equilibrium, write down firm As payoff function as:

2

A = (100 10 (qA + qB )) qA 10qA

.

100 20qA 10qB 20qA = 0.

(6.1)

B = (100 10 (qA + qB )) qB 40qB .

Maximising with respect to qB gives:

100 10qA 20qB 40 = 0.

(6.2)

Solving ( 6.1) and ( 6.2) gives qA = 2, qB = 2. Substitution in the demand function gives

p = 100 10(2 + 2) = 60.

(d) As in part (b) of this question, many candidates ignored the fact that marginal costs are affected

by quantities.

L

P

L

Let qA

and qA

denote the quantities sold by firm A in Luxland and Povland respectively. Let qB

denote the quantity sold by firm B in Luxland. The payoff functions are now given by:

L

L

A = 100 10 qA

+ qB

and

L

P P

L

P

qA

+ (50 20qA

)qA 10 qA

+ qA

L

L

B = 100 10 qA

+ qB

2

L

L

qB

40qB

.

(6.3)

(6.4)

L

P

L

Optimising ( 6.3) with respect to qA

and qA

and ( 6.4) with respect to qB

gives the following

conditions:

L

L

P

100 40qA

10qB

20qA

= 0,

P

L

50 60qA

20qA

= 0,

L

L

60 10qA

20qB

= 0.

L

P

L

Solving these equations gives qA

= 1.882, qA

= 0.206 and qB

= 2.059.

pL = 100 10(1.882 + 2.059) = 60.59,

and

pP = 50 20(0.206) = 45.88.

Question 7

A monopoly manufacturer has cost function:

C(Q) = 100 + 0.05Q2 .

It sells its products through two retailers who have identical cost functions:

ci (qi ) = 10 + 2qi ,

i = 1, 2.

Q = 1000 10p.

(a) Assume the retailers act as Cournot duopolists, taking the wholesale price, pw , as

given. Find their equilibrium sales as functions of the wholesale price.

(c) Now assume that the two retailers have exclusive territories of identical size i.e.

they both behave as monopolists with respect to half the market demand. Calculate

optimal prices, quantities and profits for the retailers and the manufacturer.

(d) Which scenario, (a) or (c), is better for the manufacturer?

This question was a disaster for almost everyone who attempted it. The major problem was that

candidates did not seem to understand the concept of a wholesale price, i.e. the price at which

the manufacturer sells to the retailers. Failure to appreciate this unfortunately meant that

answers to all parts of this question were wrong.

(a) Since the demand function is p = 100 Q/10, Retailer 1s profit function is given by:

q2

q1

pw q1 10 2q1 .

1 = 100

10 10

Maximising with respect to q1 gives:

100 2

q1

q2

pw 2 = 0.

10 10

q1 = q2 = q =

980 10pw

.

3

2

2 (980 10pw )

980 10pw

100 0.05

.

m = 2pw

3

3

Maximising this with respect to pw gives pw = 61.25 and m = 11905.

(c) Each retailer now faces demand q = 500 5p or p = 100 q/5. Its profit is therefore:

q

r = 100 pw q 10 2q.

5

Optimising this gives q = 245 5pw /2.

The corresponding retail price equals p = 51 + pw /2.

The manufacturers profit function equals:

2

which gives an optimal wholesale price pw = 58.8 and optimal profit m = 9504.

The retail price in this scenario equals 80.4 and each retailer sells 98 units and makes a profit of

1910.8.

(d) The manufacturer makes higher profits in scenario (a).

Question 8

Explain how you would calculate the expected return and standard deviation of the

return of a portfolio from the distributions of returns for each individual asset in the

portfolio. Explain the benefits of diversification.

A good answer to this question can be found in the subject guide (Chapter 6, Risk and return

section).

It is important in answering questions of this type that you show the Examiners you understand

the material. A good answer provides graphs to illustrate how combining assets in a portfolio can

reduce risk.

28 Managerial economics

Question 9

(a) Explain what is meant by adverse selection.

(b) Why is adverse selection potentially a problem? How can this problem be overcome?

(c) Illustrate your answer in the contexts of:

i. the insurance industry, and,

ii. employment.

Give numerical examples for i. and ii.

(a) A good answer to this question can be found in the subject guide (Chapter 4, Asymmetric

information). It is important to give a good definition which shows that you understand the

concept of adverse selection. It is not sufficient to say that adverse selection may occur when one

party has private information.

(b) A good answer to this question can be found in the subject guide (Chapter 4, Asymmetric

information). The concept of screening should be mentioned and explained here.

(c) A good answer to this question can be found in the subject guide (Chapter 4, Asymmetric

information). The answers here were very poor, although some candidates showed that they had

understood the relevant concepts.

Question 10

Singapore is famous for the high salaries it offers politicians and civil servants. The

Prime Ministers salary is over $2 million. Outline the efficiency wage explanation

and other possible explanations for these comparatively high public sector salaries.

An exposition of efficiency wage theory is required here. Candidates should explain how this

theory could shed light on the phenomenon identified in the question. Creative and original

answers in terms of alternative explanations receive additional marks.

This question was answered satisfactorily by those who attempted it, although many candidates

diverged from the question. You should focus on answering the question and not regurgitate lots

of irrelevant material from the subject guide.

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