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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 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.

University of London 2009


UL09/0183
D01

PLEASE TURN OVER


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)

What is Olgas risk premium for this lottery?

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)

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 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)

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 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.

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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)

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).

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.

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?

END OF PAPER

UL09/0183
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 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.

University of London 2009


UL09/0184
D01

PLEASE TURN OVER


Page 1 of 4

SECTION A
Answer all four questions from this section (12.5 marks each).
1.

2.

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.

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)

Find a perfect equilibrium for this game.

(b)

Is there a first-mover advantage?

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)

Assuming that firm A is a monopolist in Luxland, what is the profit-maximising


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)

Calculate the manufacturers optimal wholesale price and profit.

(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?

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)

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.
ii.

the insurance industry, and,


employment.

Give numerical examples for i. and ii.

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

Examiners commentaries 2009

Examiners commentaries 2009


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)

Examiners commentaries 2009

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

per hour and bad workers get:


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.

Examiners commentaries 2009

(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!

Figure 1: Game tree for question 7 part (a).


(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.

Examiners commentaries 2009

(d) See Figure 2.

accept

a
heads

S
r

(1)
heads

reject

a
tails

B
r
a

tails

heads
(2)

S
r

reject

accept

a
tails

B
r

Figure 2: Game tree for question 7 part (d).


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.

Examiners commentaries 2009

Examiners commentaries 2009


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

Figure 3: Game tree for question 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) Find a perfect equilibrium for this game.

(b) Is there a first-mover advantage?

(a) This question was answered well. The most common mistakes were algebraic errors make sure
you double check your calculations.

Examiners commentaries 2009

($100x, $100(1 x))


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 =

The first order condition is:


(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)

and we can rewrite ( 5.1) as:


q1 =

100 (n 1) q
.
2

Solving ( 5.2) and ( 5.3) for q1 and q gives:


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 =

So that the profits can be calculated as:




 

n
80
90
80 ,
1 =
n+1
n+1
and
i =

80
n+1

2

i = 2, . . . , n.

(5.3)

Examiners commentaries 2009

(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)

Which is greater than Firm 1s profits in (b)!

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
.

(a) Assuming that firm A is a monopolist in Luxland, what is the profit-maximising


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
.

Maximising with respect to qA gives:


100 20qA 10qB 20qA = 0.

(6.1)

Firm Bs payoff equals:


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.

The prices in Luxland and Povland respectively are:


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.

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.

Examiners commentaries 2009

(b) Calculate the manufacturers optimal wholesale price and profit.


(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

Since the retailers are identical we may assume:


q1 = q2 = q =

980 10pw
.
3

(b) The manufacturers profit equals:




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

m = pw (490 5pw ) 100 0.05 (490 5pw ) ,


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.