Homework 1 ECON 351

ECON 351x - Microeconomics for Business - Kendall
Homework 1 - Fall 2016
[This version: Aug/24/2016]
• You do not have to turn in this homework. It will not be graded. The answer
key is at the end of this pdf file, but you will get much more out of the exercises
if you attempt them all before checking your answers.
• The objective of this homework is to complement the material from class. This
is not an exhaustive list of the topics or types of questions that will appear on
the exams. You should carefully read and study the book, the slides, and your
class notes. In particular, study all the examples, exercises, and graphs from
class.
Lecture 3 - The Basics of Supply and Demand
[1] Along any downward sloping straight-line demand curve:

A) both the price elasticity and slope vary.
B) the price elasticity varies, but the slope is constant.
C) the slope varies, but the price elasticity is constant.
D) both the price elasticity and slope are constant.
[2] The market for good Q features a linear downward sloping demand curve. For
this market, the shape of the total revenue curve (with revenue on the vertical axis
and Q on the horizontal axis) will be
A) Horizontal B) Vertical C) U-shaped D) Inverted u-shaped E)W-shaped
[3] Which of the following would cause a shift to the right of the supply curve for
gasoline?
I. A large increase in the price of public transportation.
II. A large decrease in the price of automobiles.
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III. A large reduction in the costs of producing gasoline.
A) I only B) II only C) III only D) II and III only
[4] Which of the following would cause a rightward shift in the demand curve for
gasoline?
I. A large increase in the price of public transportation (assume public transportation
uses natural gas).
II. A large decrease in the price of automobiles.
III. A large reduction in the costs of producing gasoline.
A) I only
B) II only
C) I and II only
D) II and III only
E) I, II, and III
Consider the following scenario to answer the next 6 questions:

The demand for books is: QD = 120 − P
The supply of books is QS = 5P
[5] What is the equilibrium price of books?

A) 5 B) 10 C) 15 D) 20 E) none of the above
[6] What is the equilibrium quantity of books sold?

A) 25 B) 50 C) 75 D) 100 E) none of the above
[7] If P = $15, which of the following is true?

A) There is a surplus equal to 30.
B) There is a shortage equal to 30.
C) There is a surplus, but it is impossible to determine how large.
D) There is a shortage, but it is impossible to determine how large.
[8] If P = $25, which of the following is true?

A) There is a surplus equal to 30.
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B) There is a shortage equal to 30.
C) There is a shortage, but it is impossible to determine how large.
D) There is a surplus, but it is impossible to determine how large.
[9] Which of the following would cause an unambiguous decrease in the price of DVD
players?
A) A shift to the right in the supply curve for DVD players and a shift to the right
in the demand curve for DVD players.
B) A shift to the right in the supply curve for DVD players and a shift to the left in
the demand curve for DVD players.
C) A shift to the left in the supply curve for DVD players and a shift to the right in
D) A shift to the left in the supply curve for DVD players and a shift to the left in
[10] From 1970 to 1993, the real price of a college education increased, and total
enrollment increased. Which of the following could have caused this increase in price
and enrollment?
A) A shift to the right in the supply curve for college education and a shift to the left
in the demand curve for college education.
B) A shift to the left in the supply curve for college education and a shift to the right
C) A shift to the left in the supply curve for college education and a shift to the left
D) A shift to the right in the supply curve for college education and a shift to the
right in the demand curve for college education.
E) Either B or D.
[11] The daily demand for hotel rooms on Manhattan Island in New York is given by
the equation QD = 250, 000 − 375P. The daily supply of hotel rooms on Manhattan
Island is given by the equation QS = 15, 000 + 212.5P . Diagram these demand and
supply curves in price and quantity space (quantity should be on the horizontal axis).
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What is the equilibrium price and quantity of hotel rooms on Manhattan Island?
[12] The monthly supply of desktop personal computers is given by the equation
QS = 15, 000 + 43.75P . At a price of $800, what is the price elasticity of supply? At
this price, is supply elastic?
[13] The market for gravel has been estimated to have these supply and demand
relationships:
Supply QS = −1, 000 + 100P
Demand QD = 10, 000 − 100P
where P represents price per unit in dollars, and Q represents sales per week in tons.
a) Determine the equilibrium price and quantity.
b) Determine the amount of shortage or surplus that would develop at P = $40/ton.
Lecture 4 - Consumer Choice
[14] The assumption of transitive preferences implies that indifference curves must:
A) not cross one another.
B) have a positive slope.
C) be L-shaped.
D) be convex to the origin.
E) all of the above
[15] An upward sloping indifference curve defined over two goods violates which of
the following assumptions from the theory of consumer behavior?
A) transitivity.
B) preferences are complete.
C) more is preferred to less.
D) all of the above
E) none of the above
[16] The slope of an indifference curve reveals:

A) that preferences are complete.
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B) the marginal rate of substitution of one good for another good.
C) the ratio of market prices.
D) that preferences are transitive.
[17] Indifference curves are convex to the origin because of:

A) transitivity of consumer preferences.
B) the assumption of a diminishing marginal rate of substitution.
C) the assumption that more is preferred to less.
D) the assumption of completeness.
[18] Consider the following three market baskets:

Food Clothing
A 15 18
B 13 19
C 14 17
If baskets B and C are on the same indifference curve, and if preferences satisfy all
four of the basic assumptions, then:
A) A is preferred to C.
B) A is preferred to B.
C) There is not enough information to determine preferences for A relative to B.
D) Both A and B answer choices are correct.
E) Both A and C answer choices are correct.

Food Clothing
A 5 15
B 10 10
C 15 5
If baskets A and C are on the same indifference curve, and if preferences satisfy all
four of the basic assumptions, then:
A) A is preferred to C.
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B) B is preferred to C.
C) There is not enough information to determine preferences for A relative to B.
D) Both A and B answer choices are correct.
E) Both A and C answer choices are correct.
[20] Mikey is very picky and insists that his mom make his breakfast with equal
parts of cereal and apple juice — any other combination and it ends up on the floor.
Cereal costs 4 cents per tablespoon and apple juice costs 6 cents per tablespoon. If
Mikey’s mom budgets $8 per month for Mikey’s breakfast, how much cereal and juice
does she buy?
A) 40 tablespoons each of cereal and juice
B) 80 tablespoons each of cereal and juice
C) 40 tablespoons of cereal and 75 tablespoons of juice
D) 100 tablespoons of cereal and 67 tablespoons of juice
[21] Antonio is very picky and insists that his mom make his breakfast with two
parts of cereal for each part of milk; any other combination and it ends up on the
floor. Cereal costs 5 cents per tablespoon and milk costs 10 cents per tablespoon. If
Antonio’s mom budgets $1 for Antonio’s breakfast, how many tablespoons of cereal
does she buy?
A) 0 B) 5 C) 10 D) 13.33 E) 20
[22] The magnitude of the slope of an indifference curve is:

A) called the marginal rate of substitution.
B) equal to the ratio of the total utility of the goods.
C) always equal to the ratio of the prices of the goods.
D) all of the above
E) A and C only
[23] If a consumer is always indifferent between an additional one grapefruit or an

additional two oranges, then when oranges are on the horizontal axis the indifference
curves:
A) will be straight lines with a slope of -1/2.
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B) will be straight lines with a slope of -1.
C) will be straight lines with a slope of +1/2.
D) will be right angles whose corners occur on a ray from the origin with a slope of
+2.

Cheese Crackers
A 5 8
B 15 6
C 10 7
If baskets A and B are on the same indifference curve and if indifference curves exhibit
diminishing MRS:
A) C is preferred to both A and B.
B) A and B are both preferred to C.
C) C is on the same indifference curve as A and B.
D) There is not enough information to determine preferences for C relative to the
other goods.
[25] If Jill’s MRS of popcorn for candy is 2 (popcorn is on the horizontal axis), Jill
would willingly give up:
A) 2, but no more than 2, units of popcorn for an additional unit of candy.
B) 2, but no more than 2, units of candy for an additional unit of popcorn.
C) 1, but no more than 1, unit of candy for an additional 2 units of popcorn.
D) 2, but no more than 2, units of popcorn for an additional 2 units of candy.
[26] A consumer has $100 per day to spend on product A, which has a unit price
of $7, and product B, which has a unit price of $15. What is the slope of the budget
line if good A is on the horizontal axis and good B is on the vertical axis?
A) -7/15 B) -7/100 C) -15/7 D) 7/15 E)15/7
[27] Suppose that the prices of good A and good B were to suddenly double. If good
A is plotted along the horizontal axis,
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A) the budget line will become steeper.
B) the budget line will become flatter.
C) the slope of the budget line will not change.
D) the slope of the budget line will change, but in an indeterminate way.
[28] If the quantity of good A (QA ) is plotted along the horizontal axis, the quantity
of good B (QB ) is plotted along the vertical axis, the price of good A is PA , the price
of good B is PB and the consumer’s income is I, then the slope of the consumer’s
budget constraint is
A) −QA /QB B) −QB /QA C) −PA /PB D) −PB /PA E) I/PA or I/PB
[29] The endpoints (horizontal and vertical intercepts) of the budget line:
A) measure its slope.
B) measure the rate at which one good can be substituted for another.
C) measure the rate at which a consumer is willing to trade one good for another.
D) represent the quantity of each good that could be purchased if all of the budget
were allocated to that good.
E) indicate the highest level of satisfaction the consumer can achieve.
[30] An increase in income, holding prices constant, can be represented as:

A) a change in the slope of the budget line.
B) a parallel outward shift in the budget line.
C) an outward shift in the budget line with its slope becoming flatter.
D) a parallel inward shift in the budget line.
[31] Assume that food is measured on the horizontal axis and clothing on the vertical
axis. If the price of food falls relative to that of clothing, the budget line will:
A) become flatter.
B) become steeper.
C) shift outward (parallel shift).
D) shift inward (parallel shift).
E) become steeper or flatter depending on the relationship between prices and income.
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[32] A consumer maximizes satisfaction at the point where his valuation of good X,
measured as the amount of good Y he would willingly give up to obtain an additional
unit of X, equals:
A) the magnitude of the slope of the indifference curve through that point.
B) one over the magnitude of the slope of the indifference curve through that point.
C) PX /PY
D) PY /PX
[33] Apples sell for 20 cents and oranges sell for 30 cents. Arthur has preferences
that can be represented by a Cobb-Douglas utility function. He is currently using all
his income to buy 20 apples and 30 oranges. With this consumption bundle, his MRS
of apples for oranges is 1. Which of the following is true?
A) Arthur could increase his utility by buying more apples and fewer oranges.
B) Arthur could increase his utility by buying more oranges and fewer apples.
C) Arthur is maximizing his utility.
D) Arthur should choose a corner solution.
E) We need more information about Arthur’s preferences.
[34] The fact that Alice spends no money on travel:

A) implies that she does not derive any satisfaction from travel.
B) implies that she is at a corner solution.
C) implies that her MRS does not equal the price ratio.
D) any of the above are possible.
[35] The price of lemonade is $0.50; the price of popcorn is $1.00. Arthur has
preferences that can be represented by a Cobb-Douglas utility function, and he is
currently consuming a bundle that maximizes his utility. Therefore, Arthur’s marginal
rate of substitution is:
A) 2 lemonades for each popcorn.
B) 1 lemonades for each popcorn.
C) 1/2 lemonade for each popcorn.
D) indeterminate unless more information on Arthur’s marginal utilities is provided.
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E) indeterminate unless we know Arthur’s income.
[36] When Joe maximizes utility, he finds that his MRS of X for Y is greater than
Px/Py. It is most likely that:
A) Joe’s preferences are incomplete.
B) Joe’s preferences are irrational.
C) Joe is not consuming good X.
D) Joe is not consuming good Y.
E) Joe has Cobb-Douglas preferences.
[37] Denise is shopping for lobsters and eclairs. When she faces budget line b1,
baskets A and B are affordable, and she chooses basket A over B. When she faces
budget line b2, market baskets B and C are affordable, and she chooses basket B
over basket C. Which assumption of consumer theory helps us determine Denise’s
preference ordering over basket A and basket C?
A) Completeness
B) More is better than less
C) Transitivity
D) Convexity
[38] If a consumer must spend her entire income on some combination of two com-
modities and chooses to spend it all on just one of the commodities then:
A) the other commodity is an economic bad.
B) the other commodity must have zero marginal utility.
C) the other commodity generates less marginal utility per dollar spent on the good.
D) the two commodities must be perfect substitutes.
[39] Marginal utility measures:

A) the slope of the indifference curve.
B) the additional satisfaction from consuming one more unit of a good.
C) the slope of the budget line.
D) the marginal rate of substitution.
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[40] Monica consumes only goods A and B. Suppose that her marginal utility from
consuming good A is equal to 1/QA , and her marginal utility from consuming good
B is 1/QB . If the price of A is $0.50, the price of B is $4.00, and the Monica’s income
is $120.00, how much of good A will she purchase?
A) 0 B) 12 C) 24 D) 48 E) 120
[41] Alfred derives utility from consuming iced tea and lemonade. For the bundle
he currently consumes, the marginal utility he receives from iced tea is 16 utils, and
the marginal utility he receives from lemonade is 8 utils. Instead of consuming this
bundle, Alfred should:
A) buy more iced tea and less lemonade.
B) buy more lemonade and less iced tea.
C) buy more iced tea and lemonade.
D) buy less iced tea and lemonade.
E) none of the above is necessarily correct.
[42] Bill currently uses his entire budget to purchase 5 cans of Pepsi and 3 hamburgers
per week. The price of Pepsi is $1 per can, the price of a hamburger is $2, Bill’s
marginal utility from Pepsi is 4, and his marginal utility from hamburgers is 6. Bill
could increase his utility by:
A) increasing Pepsi consumption and reducing hamburger consumption.
B) increasing hamburger consumption and reducing Pepsi consumption.
C) maintaining his current consumption choices.
D) We do not have enough information to answer this question.
[43] Lalas has the following utility function for goods X and Y:
u(X, Y ) = 10X 0.6 Y 0.4
Compute the marginal utility of Lalas with respect to X. When Lalas consumes X=10
and Y=57, his marginal utility with respect to X is approximately:
A)M UX = 12 B)M UX = 20 C)M UX = 120 D)M UX = 200 E)M UX = 220.
[44] A market has three consumers. Each consumer has, respectively, the following
utility function and income:
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Consumer A: uA (X, Y ) = X .8 Y .2 , IA = $300
Consumer B: uB (X, Y ) = X .7 Y .3 , IB = $200
Consumer C: uC (X, Y ) = X .6 Y .4 , IC = $100
Market prices are Px = $5 and Py = $10. In equilibrium, when each individual
consumes his preferred market bundle,
A) Consumer A has the highest M RSX,Y
B) Consumer B has the highest M RSX,Y
C) Consumer C has the highest M RSX,Y
D) All consumers have the same M RSX,Y
E) We need more information to answer this question
[45] There are two goods, apples and bananas. The price of apples is PA = $2,
and the price of bananas is PB = $3. A consumer has $120 to spend, and his utility
function is U (A, B) = 2A2 B 3 .
a) Write the expression that represents the consumer’s budget constraint. Graph the
budget constraint, and label it “BC” (apples should be on the horizontal axis). What
is the slope of the budget constraint?
b) Find the consumption basket that maximizes the consumer’s utility. Plot this
point on the graph, and label it as “Point X”. Draw the indifference curve that goes
through Point X, and label it “IC” (the indifference curve can be an approximation,
it does not have to be exact). What is the slope of the indifference curve at Point X?
[46] There are two goods, apples and bananas. The price of apples is PA = $2,
and the price of bananas is PB = $3. A consumer has $120 to spend, and his utility
function is U (A, B) = 5A + 6B.
budget constraint. Graph the budget constraint, and label it “BC” (apples should be
on the horizontal axis). What is the slope of the budget constraint?
b) Find the consumption basket that maximizes the consumer’s utility. Plot this
point on the graph, and label it as “Point X”. Draw the indifference curve that goes
through Point X, and label it “IC” (the indifference curve has to be exact). What is
the slope of the indifference curve at Point X?
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Lecture 5 - Individual and Market Demand
[47] The inverse demand curve for product X is given by:
PX = 25 − 0.005QD + 0.15PY ,
where PX represents price in dollars per unit, Q represents rate of sales of X in pounds
per week, and PY represents selling price of another product Y in dollars per unit.
The inverse supply curve of product X is given by: PX = 5 + 0.004QS .
a. Determine whether X and Y are substitutes or complements.
b. Let PY = $10. Determine the equilibrium price and sales of X.
[48] The price of good A goes up. As a result, the demand for good B shifts to the
left. From this we can infer that:
A) good B is a normal good.
B) goods A and B are independent.
C) goods A and B are substitutes.
D) goods A and B are complements.
E) good B is an inferior good.
[49] The cross-price elasticity of demand for peanut butter with respect to the price
of jelly is -0.3. If we expect the price of jelly to decline by 15%, what is the expected
change in the quantity demanded for peanut butter?
A) +15% B) +45% C) +4.5% D) -4.5%
[50] The cross-price elasticity of demand between two complementary goods is

A) positive.
B) negative.
C) zero.
D) positive or zero depending upon the strength of the relationship.
E) negative or zero depending upon the strength of the relationship.
[51] If goods X and Y are substitutes, then their cross-price elasticity is

A) positive.
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B) negative.
C) zero.
D) +1 if they are perfect substitutes.
E) −1 if they are perfect substitutes.
[52] The change in the price of one good has no effect on the quantity demanded of
another good. These goods are:
A) complements.
B) substitutes.
C) both inferior.
D) both Giffen goods.
[53] The price of good A goes up. As a result the demand for good B shifts to the
left. From this we can infer that:
A) good A is a normal good.
B) good B is an inferior good.
C) goods A and B are substitutes.
D) goods A and B are complements.
[54] If an Engel curve has a positive slope

A) both goods are normal.
B) the good on the horizontal axis is normal
C) as the price of the good on the horizontal axis increases, more of both goods in
consumed.
D) as the price of the good on the vertical axis increases, more of the good on the
horizontal axis is consumed.
[55] Use the following two statements in answering this question:

I. All Giffen goods are inferior goods.
II. All inferior goods are Giffen goods.
A) I and II are true.
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B) I is true, and II is false.
C) I is false, and II true.
D) I and II are false.
[56] For an inferior good, the income and substitution effects

A) work together.
B) work against each other.
C) can work together or in opposition to each other depending upon their relative
magnitudes.
D) always exactly cancel each other.
[57] Which of the following is true concerning the income effect of a decrease in
price?
A) It will lead to an increase in consumption only for a normal good.
B) It always will lead to an increase in consumption.
C) It will lead to an increase in consumption only for an inferior good.
D) It will lead to an increase in consumption only for a Giffen good.
[58] Assume that beer is a normal good. If the price of beer rises, then the sub-
stitution effect results in the person buying of the good and the income effect
results in the person buying of the good.
A) more, more B) more, less C) less, more D) less, less
[59] When a good has a unitary price elasticity, consumer expenditures for the good
A) change in the same direction as a price change.
B) change in the opposite direction to a price change, but not necessarily by the same
percentage as the price change.
C) do not change when the price of the good decreases.
D) change in the opposite direction and by the same percentage as any price change.
The demand for erasers (Qe ) is given as follows:

Qe = 240 − 4Pe + 2I + Pb + A
where
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Pe is the price of erasers.
I is the level of income.
Pb is the price of another good.
A is the level of advertising.
Suppose that Pe = 10, Pb = 10, I = 14, and A = 2.
[60] Erasers are:

A) a normal good.
B) an inferior good.
C) neither normal nor inferior.
D) complements.
E) necessities.
[61] Erasers and good b are:

A) substitutes.
B) complements.
C) completely unrelated.
D) normal.
E) inferior.
Lecture 6 - Expected Utility
[62] You are considering buying a scratch-and-win lottery ticket. It costs $2 to

buy and pays $10 with probability 1/10, $100 with probability 1/1000, and nothing
otherwise. What is the expected value of this lottery ticket? Would a risk-neutral
person buy this ticket?
[63] A person with a diminishing marginal utility of income

A) will be risk averse.
B) will be risk neutral.
C) will be risk loving.
D) cannot decide without more information.
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[64] An individual with a constant marginal utility of income will be
A) risk averse.
B) risk neutral.
C) risk loving.
D) insufficient information for a decision
[65] A consumer with a increasing marginal utility of income will be

A) risk averse.
B) risk neutral.
C) risk loving.
D) insufficient information for a decision
[66] The concept of a risk premium applies to a person that is

A) risk averse.
B) risk neutral.
C) risk loving.
D) all of the above
[67] Amos Long’s marginal utility of income function is given as: M U (I) = I 1.5 ,
where I represents income. From this you would say that he is
A) risk averse.
B) risk loving.
C) risk neutral.
D) none of the above
[68] Smith just bought a house for $250,000. Earthquake insurance, which would pay
$250,000 in the event of a major earthquake, is available for $25,000. Smith estimates
that the probability of a major earthquake in the coming year is 10 percent, and that
in the event of such a quake, the property would be worth nothing. The utility (U)
that Smith gets from income (I) is given as follows:
U (I) = I 0.5 .
Should Smith buy the insurance?
A) Yes.
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B) No.
C) Smith is indifferent.
D) We need more information on Smith’s attitude toward risk.
[69] Using the information from the previous question, what is the maximum amount
Smith is willing to pay for the insurance?
A) $25,000
B) $32,500
C) $47,500
D) Smith would never buy insurance
E) We need more information on Smith’s attitude toward risk.
[70] Connie’s utility depends upon her income. Her utility function is U = I 1/2 . She
has received a prize that depends on the roll of a pair of dice. If she rolls a 3, 4, 6 or
8, she will receive $400. Otherwise she will receive $100.
a) What is the expected payoff from this prize? [Hint: The probability of rolling a 3
is 1/18, the probability of rolling a 4 is 3/36, the probability of rolling a 6 is 5/36,
and the probability of rolling an 8 is 5/36]
b) What is the expected utility from this prize?
c) Connie is offered an alternate prize of $169 (no dice roll is required). Will she
accept the alternate prize or roll the dice?
d) What is the minimum payment that Connie will accept to forego the roll of the
dice?
[71] Describe Larry, Judy and Carol’s risk preferences. Their utility as a function of
income is given as follows
√
Larry: UL (I) = 10 I.
Judy: UJ (I) = 3I 2 .
Carol: UC (I) = 20I.
√
[72] Sam’s utility of wealth function is U (w) = 15 w. Sam owns and operates a
farm. He is concerned that a flood may wipe out his crops. If there is no flood, Sam’s
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wealth is $360,000. The probability of a flood is 1/15. If a flood does occur, Sam’s
wealth will fall to $160,000. Calculate Sam’s risk premium.
[73] Jim has $100 to invest today, and he will need the money back in 30 days. He
is considering 3 investment options. First, he could buy shares of ACME Inc. The
current market price of this stock is $10 per share. After some research, Jim believes
that in 30 days there is a 50% chance that this price will go up to $14 per share;
a 25% chance that the price will stay at $10 per share; and a 25% chance that the
price will go down to $5 per share. The second investment option is to buy shares
of Tabajara Inc. This stock currently trades at $5 per share. Jim believes that in 30
days there is a 50% chance that this price will go up to $9 per share; a 25% chance
that the price will stay at $5 per share; and a 25% chance that the price will go down
to $0.50 per share. Finally, Jim can choose a safe investment and open a USC Credit
Union savings account. This savings account pays 1% per month interest on deposits.
√
Jim’s utility from income is given by u(I) = I, and he has to invest all his money
in only one of the three investment options.
a) Compute the expected payoff from each investment option.
b) Compute the expected utility from each investment option. Find the best (and
worse) investment option for Jim.
[74] Joe’s utility from income is given by

√
u(I) = 8 I
He has a house in LA County. With probability 1/4, the rain will cause a mudslide
and damage his house, decreasing its value to $250,000. With probability 3/4, no
mudslide occurs and the house retains its original $1,000,000 value. AAA offers to
fully insure the house for a price P . What is the maximum insurance premium P
that Joe is willing to pay? What is the associated risk premium?
Lecture 7 - Asymmetric Information I
[75] The problem of adverse selection in insurance results in a situation in which

A) people choose inappropriate or inadequate coverage because they do not under-
stand the complex information in the policies.
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B) people choose too much coverage because they do not understand the complex
information in the policies.
C) people choose too little coverage because they do not understand the complex
information in the policies.
D) unhealthy people become more likely to buy insurance than healthy people, which
drives premiums up, which drives even more healthy people away from the market.
E) healthy people become more likely to buy insurance than unhealthy people, which
drives premiums up, which drives even more unhealthy people away from the market
even though they are the ones who need it most.
[76] When sellers have more information about products than buyers do, we would
expect
A) sellers to get higher prices for their goods than they could otherwise.
B) buyers to pay lower prices for goods than they would otherwise.
C) high-quality goods to drive low-quality goods out of the market.
D) low-quality goods to drive high-quality goods out of the market.
[77] Which of the following represent examples of adverse selection?

A) Unhealthy people are more likely to want health insurance.
B) Unskilled drivers purchasing extra auto insurance.
C) Risk averse individuals choosing to buy extra insurance.
D) all of the above
E) A and B only
[78] Assume that a particular state has decided to outlaw the sharing of individuals’
credit histories as an illegal invasion of privacy. As a result of this action we would
expect the
A) cost of borrowing money to rise.
B) number of loans to unworthy credit risks to rise.
C) problems of asymmetric information to become more severe.
D) all of the above
20
[79] When firms participate in group health insurance for all employees, it
A) raises rates for everyone, because it brings unhealthy people into the pool.
B) raises rates for unhealthy people.
C) may lower rates for all people to the extent that it keeps healthy people in the
pool.
D) prevents unhealthy people from selecting out, to the detriment of healthy people.
E) increases the amount of information available to insurers about the population.
[80] When asymmetric information problems drive high quality products from a
market, we refer to this situation as:
A) adverse selection.
B) moral hazard.
C) a lemons problem.
D) A and C are correct.
E) B and C are correct.
[81] Asymmetric information in financial markets results in:

A) higher bid prices at which you can buy a stock than ask prices at which you sell
B) higher bid prices at which you can sell a stock than ask prices at which you buy
C) lower bid prices at which you can buy a stock than ask prices at which you sell
D) lower bid prices at which you can sell a stock than ask prices at which you buy
E) equal bid and ask prices
[82] Prior to a firm’s quarterly earnings announcement:

A) the bid-ask spread widens because informed traders are more likely
B) the bid-ask spread narrows because informed traders are more likely
C) the bid-ask spread widens because informed traders are less likely
D) the bid-ask spread narrows because informed traders are less likely
E) the bid-ask spread should be unchanged
[83] If an approaching earnings announcement causes the probability of an informed

trader to double and the potential up and down movements in the stock to double,
the bid-ask spread:
21
A) is unchanged
B) doubles
C) increases by 4 times
D) is cut in half
E) decreases by 4 times
Lecture 8 - Asymmetric Information II

Use the following information to answer questions 84 to 87:
For Group A (high-productivity) the cost of attaining an educational level y is
CA (y) = $6, 000y
and for Group B (low-productivity) the cost of attaining that level is
CB (y) = $10, 000y.
Employees will be offered $50,000 if they have y < y ∗ , where y ∗ is an education
threshold determined by the employer. They will be offered $130,000 if they have
y > y∗.
[84] The highest level of y ∗ that can be set and still have the high-productivity
people choose to meet it is
A) 16. B) 13 1/3. C) 13. D) 8. E) 0.
[85] The lowest level of y ∗ that can be set and still have only the high-productivity
people meet it is
A) 16. B) 13 1/3. C) 13. D) 8. E) 0.
[86] If the threshold educational level y ∗ is set at 10,

A) only individuals in Group A will attain it.
B) only individuals in Group B will attain it.
C) individuals in both groups will attain it.
D) no individuals will attain it.
E) some fraction of individuals in each group will attain it.
[87] An employer who only wants to hire individuals who find learning less costly
can do so by choosing y ∗ to be anywhere between
22
A) 7 and 14.
B) 8 and 13 1/3.
C) 10 and 16.
D) 13 1/3 and 20.
E) 14 and 20.

For Group K (high-productivity) the cost of attaining an educational level y is
CK (y) = $2, 000y
and for Group M (low-productivity) the cost of attaining that level is
CM (y) = $4, 000y.
Employees will be offered $30,000 if they have y < y ∗ , where y ∗ is an education thresh-
old determined by the employer. They will be offered $90,000 if they have y > y ∗ .
[88] The highest level of y ∗ that can be set and still have the high-productivity
people choose to meet it is
A) 90. B) 60. C) 30. D) 22.5. E) 15.
[89] The lowest level of y ∗ that can be set and still have only the high-productivity
people meet it is
A) 90. B) 60. C) 30. D) 22.5. E) 15.
[90] An employer who only wants to hire those people who find learning less costly
can do so by choosing y ∗ to be anywhere between
A) 15 and 45.
B) 15 and 30.
C) 13 1/3 and 30.
D) 8 and 20.
[91] In the insurance market, moral hazard refers to the problem that
A) insurers can’t tell high-risk customers from low-risk customers.
23
B) high-risk customers have an incentive to give false signals to make themselves look
like low-risk customers.
C) companies may unfairly lump individuals together by race, sex, age or other char-
acteristics in an attempt to use demographic data to pinpoint high-risk populations.
D) individuals are willing and able to pay different amounts for insurance, but must
all be charged the same amount.
E) individuals may change their behavior after the insurance is bought, so that they
behave in a more high-risk manner than they did before.

The probability of a fire in a factory without a fire prevention program is 0.01. The
probability of a fire in a factory with a fire protection program is 0.001. If a fire
occurred, the value of the loss would be $300,000. A fire prevention program would
cost $80 to run.
[92] If the fire protection program were in place, the company could insure the
warehouse for a premium equal to
A) the loss from the fire, $300,000.
B) the expected loss from the fire, $300.
C) the expected loss from the fire, $3,000.
D) the cost of the fire protection program, $80.
E) 0.
[93] If the fire protection program were not in place, the insurer would not be willing
to ensure the warehouse for any amount less than
A) $80. B) $300. C) $3,000. D) $6,000. E) $300,000.
[94] Moral hazard arises in this situation because once the firm
A) pays the premium that is based on the 0.001 probability, it has no incentive to
spend the additional $80 for the fire protection program, so the true probability of
loss is no longer 0.001.
B) pays the premium that is based on the 0.01 probability, it has no incentive to
24
spend the additional $80 for the fire protection program, so the true probability of
loss is no longer 0.01.
C) puts the fire protection program in place, it has less incentive to spend $300 for a
premium, leaving the firm underinsured.
D) puts the fire protection program in place, it has less incentive to spend $6,000 for
a premium, leaving the firm underinsured.
E) puts the fire protection program in place, it will consider that a substitute for
insurance and not be able to deal with the loss from a fire should it occur.
[95] Over the past several years, the federal government has rescued a few financially
distressed banks and other large private companies, and the key reasons for these ac-
tions is to stabilize financial markets and to prevent additional business failures that
may arise from the original problem. However, critics of these interventions argue
that these actions generate a moral hazard problem. Why?
A) Government oversight of rescued firms is typically based on limited information,
so the outcome is economically inefficient.
B) Rescued firms will have a difficult time buying insurance in private markets, so
the government will also have to insure the firm against losses from fire, theft, etc.
C) Managers have more information about the financial strength of their firm than
government officials, so the rescue attempts may be unnecessary.
D) Managers may be more likely to invest in risky projects if they believe the gov-
ernment will save the firm in case of failure.
E) Both A and C are correct.
[96] The principal-agent problem in corporations exists because the managers of a

firm
A) may pursue their own goals even when the result is lower profit for owners.
B) may know how to operate the business better than absentee owners do, and yet
not be allowed to.
C) are generally unable to do the monitoring that would result in the firm’s avoiding
moral hazard problems.
D) are generally unable to do the monitoring that would result in the firm’s avoiding
25
adverse selection.
E) are generally unable to monitor consumers.
[97] In the economic literature on principal-agent problems, the is the person

who takes some action, and the is the person whom the action affects.
A) agent, principal
B) principal, agent
C) Both statements describe the agent.
D) Both statements describe the principal.
[98] In this problem, a labor market exists where employers hire and pay workers
according to how much formal education workers possess. Education is a proxy for the
level of productivity that employers can expect from workers. Therefore, employers
follow a strategy in which they hire workers and pay salaries according to the following
conditions:
Degrees Above the Values of Post High School
High School Level Education During Working Life, B(y)
None (y = 0 years) 0
Associate’s Degree(y = 2 years) $30,000
Bachelor’s Degree (y = 4 years) $51,000
Master’s Degree (y = 6 years) $58,000
Assume that there are only two types of worker abilities, those who are less pro-
ductive (type L) and those who are highly productive (type H). The less productive
workers have to study harder than highly productive workers in order to earn any de-
gree. Consequently, the costs (including the psychic costs of study effort) of attaining
various levels of education for these two types of employees are different.
For less productive workers: CL (y) = $13, 000y
For highly productive workers: CH (y) = $10, 000y.
Discuss what level of education each type of worker should obtain.
[99] Assume that the owners of a firm know that the firm’s profits will depend upon
two parameters: (1) how hard the managers work, and (2) the state of the economy.
26
For simplicity, assume that the managers can exert either maximum or minimum
effort and that the economy can be either favorable or unfavorable. The profits under
various situations are represented by the matrix below.
Favorable Unfavorable
Economy Economy
Maximum Effort 700,000 400,000
Minimum Effort 400,000 200,000
The firm considers there to be an equal probability of either state of the economy.
The manager considers the cost of effort to be C = 55, 000x, where x = 1 for maximum
effort, 0 for minimum effort. The firm is considering the pay scheme described below.
Evaluate each alternative in terms of their incentive effects for the manager and their
effect on the firm’s profitability.
a) a flat salary of $30,000 that is not tied to the firm’s performance
b) a bonus of 0 if profit equals 200,000 or 400,000 and a bonus of 120,000 if profit
equals 700,000.
Lecture 9 - Game Theory I
[100] A dominant strategy can best be described as

A) a strategy taken by a dominant firm.
B) the strategy taken by a firm in order to dominate its rivals.
C) a strategy that is optimal for a player no matter what an opponent does.
D) a strategy that leaves every player in a game better off.
E) all of the above
Game 101:
27
[101] Which of the following is true about game 101?
A) ABC’s dominant strategy is to offer a rebate.
B) ABC’s dominant strategy is not offer a rebate.
C) XYZ’s dominant strategy is to offer a rebate.
D) XYZ’s dominant strategy is not offer a rebate.
E) Both ABC and XYZ have offer a rebate as a dominant strategy.
[102] In game 101, the equilibrium strategies

A) are for both firms to offer rebates.
B) is for ABC to offer a rebate, and XYZ not to offer a rebate.
C) is for XYZ to offer a rebate, and ABC not to offer a rebate.
D) are for both firms to offer no rebate.
E) are not pure strategies.
Game 103:
[103] Which of the following is true for game 103?

A) Moto’s dominant strategy is the CD changer.
B) Moto’s dominant strategy is the free maintenance.
C) Zport’s dominant strategy is the low-profile tires.
D) Zport’s dominant strategy is the sun roof.
E) Neither company has a dominant strategy.
[104] In game 103, the equilibrium outcome:

A) is for Moto to offer a CD changer and Zport to offer low-profile tires.
28
B) is for Moto to offer a CD changer and Zport to offer a sun roof.
C) is for Moto to offer free maintenance and Zport to offer low-profile tires.
D) is for Moto to offer free maintenance and Zport to offer a sunroof.
E) does not exist in pure strategies.
Game 105:
[105] Which of the following is TRUE for game 105?

A) NRG’s dominant strategy is to sponsor the marathon.
B) NRG’s dominant strategy is to sponsor the TV show.
C) Vita’s dominant strategy is to sponsor the marathon.
D) Vita’s dominant strategy is to sponsor the TV show.
E) Neither company has a dominant strategy.
[106] In game 105, the equilibrium outcome:

A) is for both NRG and Vita to sponsor the marathon.
B) is for both NRG and Vita to sponsor the TV show.
C) is for NRG to sponsor the marathon and Vita to sponsor the TV show.
D) is for NRG to sponsor the TV show and Vita to sponsor the marathon.
E) does not exist in pure strategies.
Game 107:
29
[107] In game 107,
A) there is one equilibrium: for both to expand West.
B) there is one equilibrium: for both to expand South.
C) there are two pure strategy equilibria: one expands in the West, and the other
expands in the South.
D) there is only a mixed strategies equilibrium.
E) all four outcomes are equilibria.
[108] Use the following statements to answer this question:

I. A player must have at least one dominant strategy in a game.
II. If neither player in a game has a dominant strategy in a game, then there is no
equilibrium outcome for the game.
A) I and II are true.
B) I is true and II is false.
C) II is true and I is false.
D) I and II are false.
Consider the Matching Pennies game for questions 109 to 111:

Player B - heads Player B - tails
Player A - heads 1, -1 -1, 1
Player A - tails -1, 1 1, -1
[109] Suppose Player B always uses a pure strategy that selects heads. What is
Player A’s optimal response to this pure strategy?
A) Always select heads.
B) Always select tails.
C) Mixed strategy with probability 1/2 on heads and 1/2 on tails
D) There is no optimal pure or mixed strategy for this situation.
[110] Suppose Player B always uses a mixed strategy with probability of 3/4 for
head and 1/4 for tails. Which of the following strategies for Player A provides the
highest expected payoff?
30
A) Mixed strategy with probability 1/4 on heads and 3/4 on tails
B) Mixed strategy with probability 1/2 on heads and 1/2 on tails
C) Mixed strategy with probability 3/4 on heads and 1/4 on tails
D) Pure strategy in which Player A always selects heads
E) Pure strategy in which Player A always selects tails
[111] What is the unique Nash equilibrium of the Matching Pennies game?
Lecture 10 - Game Theory II
Game 112:
[112] Game 112 represents a simplified Cournot game in which firms simultaneously
choose production quantities. You will study these games after the midterm. What
is true in this game?
A) In equilibrium, both firms choose Q = 50.
B) In equilibrium, both firms choose Q = 100.
C) There are two equilibria, at Q = 50 and at Q = 100.
D) The only equilibrium is in mixed strategies.
E) The two equilibria are those associated with the (40,30) outcome and the (30,40)
outcome.
[113] If player R moves first in Game 112, the equilibrium will

A) not be different from what it is in the simultaneous-move scenario.
B) be to R’s detriment because it will not be able to react to C’s choice.
C) be one in which R chooses 50 and C chooses 150.
D) be one in which R chooses 100 and C chooses 50.
E) be one in which R chooses 150 and C chooses 50.
31
Game 114:
[114] Refer game 114. If the firms must choose their actions simultaneously,
A) both firms will buy gelato.
B) both firms will buy yogurt.
C) two pure strategy equilibria exist: one in which Gooi buys a gelato machine and
Ici buys a Yogurt machine; one in which Ici buys a gelato machine and Gooi buys a
Yogurt machine.
D) the game has no pure strategy equilibrium.
E) the game has no mixed strategy equilibrium.
[115] Refer to game 114. If Gooi moves first, the payoff in equilibrium will be
A) $150, $0.
B) $150, $300.
C) $400, $150.
D) $50, $50.
E) $650, $450.
[116] Refer to game 114. If Gooi can move first, and Ici threatens to buy yogurt
machines, no matter what Gooi does,
A) Gooi will have to buy gelato machines, so Ici will get its highest possible profit.
B) Gooi will buy yogurt machines, which it otherwise wouldn’t have, in order to
retaliate.
C) the equilibrium payoff of ($50,$50) will be enforced.
D) Gooi will not change its behavior, because Ici’s threat is not credible.
32
[117] La Tortilla is the only producer of tortillas in Santa Teresa. The firm produces
10,000 tortillas each day and has the capacity to increase production to 100,000
tortillas each day. La Tortilla has made a large profit for years, but no other firm has
chosen to compete in the Santa Teresa tortilla market. La Tortilla has been able to
deter entry because if other firms were to enter the market it would greatly step-up
production and reduce price.
A) La Tortilla’s behavior is inconsistent with economic theory.
B) La Tortilla has been successful because of its credible threat.
C) La Tortilla behaves like a Stackelberg firm.
D) La Tortilla must have other barriers to entry to protect its monopoly power.
Consider the entry-deterrence game 118 below. The potential entrant moves first,
and would have to spend some amount in sunk costs to enter the market.
[118] In game 118, Incumbent Monopoly has

A) an incentive to threaten accommodation, which would be credible.
B) an incentive to threaten war, which would be credible.
C) an incentive to threaten accommodation, which wouldn’t be credible.
D) an incentive to threaten war, which wouldn’t be credible.
E) no incentive to make a threat.
[119] If game 118 were to be infinitely repeated, waging a price war might be a
rational strategy
A) because there would be no short-term losses.
B) because the short-term losses might be outweighed by long-term gains from pre-
venting entry.
C) if the potential entrant were irrational.
D) if the monopolist had excess capacity.
33
E) if there were no sunk costs to the potential entrant.
Game 120: Two firms are situated next to a lake, and it costs each firm $1,500
per period to use filters that avoid polluting the lake. However, each firm must use
the lake’s water in production, so it is also costly to have a polluted lake. The cost
to each firm of dealing with water from a polluted lake is $1,000 times the number of
polluting firms.
[120] Refer to game 120. What kind of game is being played by Lago and Nessie?
A) Battle of the Sexes.
B) Prisoner’s Dilemma.
C) Beach Location.
D) Stackelberg Output Choice.
E) Cournot Output Choice.
[121] Refer to game 120. The equilibrium of this game, if played only once, is that
A) both firms pollute.
B) only Lago pollutes.
C) only Nessie pollutes.
D) neither firm pollutes.
E) the firms choose a mixed strategy.
[122] What can happen if Game 120 is repeated over an infinite horizon? What if
the game is repeated over a known finite number of periods?
[123] Suppose Game 120 is repeated over an infinite horizon. Consider the following
simple agreement: both firms play “Don’t Pollute” as long as no firm has deviated. If
some firm deviates, then both firms play “Pollute” forever. Firms discount the future
34
1
using the discount rate δ. Show that if δ ≥ 2
then cooperation under this agreement
is possible.
Lecture 11 - Behavioral Economics
[124] Consider the following two pairs of choices:

I: $1000 for sure OR II: 89% chance of $1000, 1% chance of $0, and 10% chance of
$5000
III: 89% of $0 and 11% chance of $1000 OR IV: 90% chance of $0 and 10% chance of
$5000
If we observe an individual choose I over II and IV over III, then this individual is:
A) risk-neutral
B) risk-seeking
C) risk-averse
D) not an expected utility maximizer
E) we don’t have enough information to answer
[125] Consider the following two pairs of choices:

I: $1000 for sure OR II: 60% chance of $2000 and 40% chance of $0
III: -$1000 for sure OR IV: 60% chance of -$2000 and 40% chance of $0
If we observe an individual choose I over II and IV over III, then this individual is:
A) risk-neutral
B) risk-seeking
C) risk-averse
D) not an expected utility maximizer
E) we don’t have enough information to answer
[126] Prospect theory can explain the choices in Question 125 by allowing the person
to:
A) be risk-averse over gains and risk-seeking over losses
35
B) be risk-averse over losses and risk-seeking over gains
C) have a reference point of $0
D) A and C
E) B and C
[127] Consider a risk-neutral individual and consider the following two pairs of
choices:
I: $100 today OR II: $110 tomorrow
III: $100 today OR IV: $150 two days from now
If we observe an individual choose I over II and IV over III, then this individual:
A) may be discounting the future in a standard way
B) must be present-biased
C) must be time-inconsistent
D) must be reference-dependent
E) B and C
[128] Consider a risk-neutral individual and consider the following two pairs of
choices:
I: $100 today OR II: $110 tomorrow
III: $100 tomorrow OR IV: $110 two days from now
If we observe an individual choose I over II and IV over III, then this individual:
A) may be discounting the future in a standard way
B) must be present-biased
C) must be time-inconsistent
D) must be reference-dependent
E) B and C
36
ANSWERS:
Lecture 3
[1] B.
[2] D.
[3] C. Options I and II imply a change in the demand for gasoline, not its supply.
[4] C. If public transportation is more expensive, then more consumer will choose to
drive their own cars, increasing the demand for gasoline. If cars are cheaper, then
more consumers will buy cars, increasing the demand for gasoline. A change in the
cost affects the supply curve, not the demand curve (Note that a change in the supply
curve changes the equilibrium price and quantity, but not the demand curve itself).
[5] D. In equilibrium, QD = QS , that is, 120 − P = 5P and P ∗ = 20.
[6] D. Since P ∗ = 20 and QD = QS , we can use supply to find Q∗ = 5 × 20 = 100.
[7] B. When P = 15, we have QD = 120 − 15 = 105 and QS = 5 × 15 = 75. Note
that QD > QS (there is a shortage), and QD − QS = 105 − 75 = 30.
[8] A. When P = 25, we have QD = 120 − 25 = 95 and QS = 5 × 25 = 125. Note
that QD < QS (there is a surplus), and QS − QD = 125 − 95 = 30.
[9] B. To answer this question, think about the individual effects of the changes in
demand and supply, and verify which effects move in the same direction. If the two
effects move in the same direction, the net change is unambiguous. If they move in
opposite directions, then the net change is ambiguous (you need to know which effect
dominates).
When the supply moves to the right, we have a higher supply: This moves us in the
direction of lower prices and higher quantity.
When the supply moves to the left, we have a lower supply: This moves us in the
direction of higher prices and lower quantity.
When the demand moves to the right, we have a higher demand: This moves us in
the direction of higher prices and higher quantity.
When the demand moves to the left, we have a lower demand: This moves us in the
direction of lower prices and lower quantity.
37
In this particular question, we have:
Option A: Higher supply (lower price, higher quantity) and higher demand (higher
price and higher quantity). Equilibrium net effect: the quantity will go up, but we
do not know what happens with the price.
Option B: Higher supply (lower price, higher quantity) and lower demand (lower price
and lower quantity). Equilibrium net effect: the price will go down, but we do not
know what happens with the quantity.
Option C: Lower supply (higher price, lower quantity) and higher demand (higher
price and higher quantity). Equilibrium net effect: the price will go up, but we do
not know what happens with the quantity.
Option D: Lower supply (higher price, lower quantity) and lower demand (lower price
and lower quantity). Equilibrium net effect: the quantity will go down, but we do
not know what happens with the price.
[10] E. Use the same logic as question [9]. Which options can result in a higher price
and higher quantity?
Option A: Higher supply (lower price, higher quantity) and lower demand (lower price
and lower quantity). Net effect: lower price, higher or lower quantity.
Option B: Lower supply (higher price, lower quantity) and higher demand (higher
price and higher quantity). Net effect: higher price, higher or lower quantity.
Option C: Lower supply (higher price, lower quantity) and lower demand (lower price
and lower quantity). Net effect: higher or lower price, lower quantity.
Option D: Higher supply (lower price, higher quantity) and higher demand (higher
price and higher quantity). Net effect: lower or higher price, higher quantity.
Note that B gives a higher price and possibly a higher quantity; D gives a higher
quantity and possibly a higher price. Therefore, both options are consistent with
higher price and higher quantity.
38
[11] First find the equilibrium:
QD = QS
250, 000 − 375P = 15, 000 + 212.5P
235, 000 = 587.5P
P ∗ = 400
Therefore Q∗ = 15, 000 + 212.5 × 400 = 100, 000.

To draw the demand curve, find the two corners: when P = 0, we have QD = 250, 000;
when QD = 0, we have P = 250, 000/375 = 666.7. So draw a straight line connecting
these two points.
To draw the supply, note that there is only one corner: when P = 0, we have
QS = 15, 000. The supply curve has a positive slope, and QS keeps increasing as
P increases. So we have one point for the supply curve (P = 0, QS = 15, 000),
but we need two points to draw a straight line. What is the second point? The
equilibrium point (P ∗ = 400, Q∗ = 100, 000). The supply is a straight line starting at
(P = 0, QS = 15, 000) and going through (P ∗ = 400, Q∗ = 100, 000) — note that the
supply does not stop at the second point.
P
800
S
600
400
200
D
Q
0 50 000 100 000 150 000 200 000 250 000 300 000
[12] At a price P = 800, supply is QS = 15, 000 + 43.75 × 800 = 50, 000. The
P ∆QS
slope of the supply function is +43.75. Price elasticity of supply is ES = QS ∆P
=
800
50,000
(43.75) = 0.7. At this price, supply is inelastic, |0.7| < 1.
39
[13] a) In equilibrium
QD = QS
10, 000 − 100P = −1, 000 + 100P
11, 000 = 200P
P ∗ = 55
Therefore Q∗ = −1, 000 + 100 × 55 = 4, 500.

b) When P = 40, we have QD = 10, 000 − 100 × 40 = 6, 000 and QS = −1, 000 +
100 × 40 = 3, 000. Because QD > QS , there is a shortage of QD − QS = 3, 000.
Lecture 4
[14] A
[15] C
[16] B
[17] B
[18] D. A is preferred to C because A has more of both products (more is better than
less). Note that we cannot directly compare baskets A and B, because B has more
clothing but less food. However, the problem states that B and C are on the same
indifference curve. Therefore, using transitivity, A is better than C and C gives the
same level of satisfaction as B, implying that A is better than B.
[19] B. In this question we are assuming the fourth basic property: diminishing
marginal rate of substitution (indifference curves are strictly convex). You must
realize that bundle B is on a straight line connecting bundles A and C (if you cannot
see it directly from the numbers, draw the graph). Therefore, since A and C are on
the same indifference curve, B is on the straight line connecting these points, and
DMRS (indifference curves are strictly convex), it must be the case that B is better
than both A and C. This is exactly the convexity property that we discussed in class.
[20] B. In this question, cereal and apple juice are perfect complements, and Mikey
consumes them in equal parts. Therefore, it must be the case that QC = QA . Using
40
this relationship together with the budget constraint:
PC QC + PA QA = I
0.04QC + 0.06QA = 8.00
0.04(QA ) + 0.06QA = 8.00
0.10QA = 8.00
Q∗A = 80
Q∗C = 80.
[extra] Note that Mikey’s utility function can be represented by u(QC , QA ) = min{QC , QA }.
[21] C. In this question, cereal and milk are perfect complements: The optimal pro-
portion is two parts of cereal for each part of milk, that is, C = 2M (NOTE: This may
be backwards from what you think it should be. The easiest way to see this is correct
is to try an example. If you have 1 part milk (M=1), this gives two parts of cereal
C
(C=2) which is what we want. We can also write it as 2
= M ). Use this information
together with the budget constraint 5C + 10M = 100 to get 5C + 10 C2 = 100, that
is, C = 10 and M = 5.
[extra] Note that Antonio’s utility function can be represented by either u(C, M ) =
min{C, 2M } or u(C, M ) = min{ 12 C, M }.
[22] A
[23] A. If oranges are on the horizontal axis, then the slope of the indifference curve
∆QG
is slope = ∆QO
= − 12 .
[24] A. Bundles A and B are on the same indifference curve, and bundle C is on
the straight line that connects these two points. Because we are assuming DMRS
(indifference curves are strictly convex), bundle C is preferred to both A and B. See
explanation of question 19.
[25] B
[26] A. Since product A is on the horizontal axis, its price goes on top of the price
ratio (do not forget the negative sign of the slope): slope = − PPBA = − 15
7
.
[27] C. The slope of the budget line does not change because the price ratio does not
change.
41
[28] C
[29] D
[30] B
[31] A. If food becomes cheaper, then the budget line will cross the horizontal axis
at a higher number (the consumer can afford to buy more food). The budget line
rotates outward and becomes flatter. See the figure in the Lecture 4 slides on budget
sets.
[32] C. The question asks which consumption bundle maximizes utility. Note that
a consumer’s “valuation of good X, measured as the amount of good Y he would
willingly give up to obtain an additional unit of X” is by definition the M RSXY ,
that is, it is always the magnitude of the slope of the indifference curve at each point
along the indifference curve, even the points that do not maximize utility. Only when
M RSXY equals the price ratio we get the optimal utility.
[33] A. Arthur has a Cobb-Douglas utility function, therefore we must look for a
PA
consumption bundle such that M RSA,O = PO
. Recall that this will be an interior
solution, not a corner solution. The question states that M RSA,O = 1, and the price
PA 0.20 PA
ratio is PO
= 0.30
= 32 . Therefore, M RSA,O > PO
and Arthur could increase his utility
by buying more apples and fewer oranges.
[34] D
PL 0.50
[35] A. The price ratio is PP
= 1.00
= 12 . Arthur has a Cobb-Douglas utility func-
tion, therefore he maximizes his utility by choosing a consumption bundle such that
PL 1
M RSL,P = PP
. Therefore, M RSL,P = 2
and Arthur is willing to give up 1/2 popcorn
PP 1.00
for each lemonade. This is the same as saying M RSP,L = PL
= 0.50
= 2, that is, he
is willing to give up 2 lemonades for each popcorn. Note that M RSP,L is the inverse
of M RSL,P .
PX
[36] D. If Joe is maximizing his utility at a point where M RSX,Y > PY
, then it is
most likely that he is at a corner solution, consuming only good X. See our notes on
perfect substitutes.
[37] C
[38] C. Note that answer D is not correct because the goods could be perfect substi-
tutes, but they do not have to be perfect substitutes. For example, Fig. 5.15 shows a
42
corner solution with indifference curves that are not perfect substitutes (they are not
straight lines). Read also Section 5.5 to understand the concept of marginal utility
per dollar.
[39] B
[40] E. By definition M RSA,B = M UA /M UB = 1/QA ÷ 1/QB = QB /QA . In equilib-
rium,
PA
M RSA,B =
PB
QB 0.5
=
QA 4
0.5
QB = QA .
4
Use the budget constraint
PA QA + PB QB = I
0.5QA + 4QB = 120

0.5
0.5QA + 4 QA = 120
4
Q∗A = 120.
[41] E. From the question we know Alfred’s marginal rate of substitution, M RSIT,L =
M UIT 16
M UL
= 8
= 2. However, we do not have information about relative prices.
M UP 4 2 PP 1
[42] A. From the question, M RSP,H = M UH
= 6
= 3
, and PH
= 2
. Therefore,
PP
M RSP,H > PH
and Bill should increase Pepsi consumption and reduce hamburger
consumption.
[43] A. Use the definition of marginal utility from Lecture 4:
0.4
∂u(X, Y ) Y
M UX = = 0.6 × 10X −0.4 Y 0.4 = 6 .
∂X X
Plug in the values of X and Y
0.4
57
M UX = 6 ≈ 6 × 2 = 12.
10
[44] D. All consumers have a Cobb-Douglas utility and are choosing X ∗ and Y ∗ such
PX
that M RSX,Y = PY
. Since all consumers face the same price ratio, they all have the
43
same M RSX,Y in equilibrium.
[45] a) The budget constraint is PA A + PB B = I, that is, 2A + 3B = 120. With
apples on the horizontal axis, we could also rewrite it as B = 40 − 32 A. The budget
I I
line crosses the vertical axis at PB
= 40, and the horizontal axis at PA
= 60. Its slope
is − PPBA = − 23 .
b) First compute:
M UA 2 ∗ 2AB 3 2B
M RSA,B = = 2 2
= .
M UB 3 ∗ 2A B 3A
This is a Cobb-Douglas utility, therefore we must look for the basket such that
PA 2B
M RSA,B = PB
, that is, 3A
= 32 . Consequently, the optimal proportion is A = B.
Plug this information into the budget constraint 2A+3B = 120 to get 2A+3A = 120,
that is, A = 24 and B = 24. At Point X, the slope of the indifference curve and the
slope of the budget constraint are the same, − 23 .
Optimal Consumption
Bananas
60
50
40
Point X H24,24L
30
20
IC
10
BC
Apples
0 10 20 30 40 50 60
[46] a) The budget constraint is the same as question 45.

b) First compute:
M UA 5
M RSA,B = = .
M UB 6
PA
These goods are perfect substitutes, therefore we must compare M RSA,B and PB
. In
5 PA PA
this question, M RSA,B = 6
and PB
= 23 , therefore M RSA,B > PB
. The consumer
I 120
will use all his income to purchase apples (A = PA
= 2
= 60), and will not consume
bananas (B = 0). At Point X, the slope of the indifference curve is −M RSA,B = − 56 ,
while the slope of the budget constraint is − 23 . The indifference curve that goes
through Point X is a straight line. We already know where this straight line crosses
the horizontal axis (at A = 60), but we must find where it crosses the vertical axis. At
Point X, the consumer buys A = 60 and B = 0, receiving utility U = 5∗60+6∗0 = 300.
44
Find the amount B of bananas that gives the same utility U = 300 when the consumer
does not buy apples (A = 0):
U (A, B) = 5 ∗ A + 6 ∗ B
300 = 5 ∗ 0 + 6 ∗ B
B = 50.
In other words, both bundles (A = 60, B = 0) and (A = 0, B = 50) yield the same
level of utility (U = 300), therefore they belong to the same indifference curve. (When
answering this questions, you need to be precise. You need to clearly label that the
IC crosses the vertical axis at B = 50 and the horizontal axis at A = 60)
Optimal Consumption
Bananas
60
50 IC
40
30 BC
20
Point X H60,0L
10
Apples
0 20 40 60 80
Lecture 5
[47] a) Rewrite the inverse demand functions to get the demand function:
PX = 25 − 0.005QD + 0.15PY
⇒ 0.005QD = 25 − PX + 0.15PY
⇒ QD = 5000 − 200PX + 30PY .
Note that if price PY goes up, the demand QD for X also goes up (there is a positive
sign before PY ). Therefore, Y and X are substitutes (see the definition of substitutes).
b) Rewrite the inverse supply function to get the supply function:
PX = 5 + 0.004QS
⇒ 0.004QS = −5 + PX
⇒ QS = −1250 + 250PX .
45
In equilibrium, and using PY = 10,
QD = QS
5000 − 200PX + 30PY = −1250 + 250PX
5000 − 200PX + 30 × 10 = −1250 + 250PX
6550 = 450PX
PX∗ = 14.56
In equilibrium, QD = QS and we can use supply to find Q∗ = −1250 + 250 × 14.56 =

2, 388.89.
[48] D. If the demand for B shifts to the left, then consumers are less willing to
buy B (demand for B goes down). Price of A goes up and demand for B goes down,
therefore they are complements.
[49] C. The cross-price elasticity is −0.3, which means that peanut butter and jelly
are complements. When the price of jelly goes down by 1%, the demand for peanut
butter goes up by 0.3% (price and quantity move in opposite directions). In this case,
the price of jelly goes down by 15%, therefore peanut butter demand must go up by
15 × 0.3% = 4.5%
[50] B. If goods X and Y are complements, it means that when the price of X goes up,
the demand for Y goes down (and vice-versa). That is, the price of X and the demand
for Y move in opposite directions. Therefore, when two goods are complements, the
cross-price elasticity of demand is negative. See also Section 4.4.
[51] A. If goods X and Y are substitutes, then it means that when the price of X goes
up, the demand for Y also goes up (and vice-versa). That is, the price of X and the
demand for Y move in the same direction. Therefore, when two goods are substitutes,
the cross-price elasticity of demand is positive. See also Section 4.4. Note that if X
and Y are perfect substitutes, then the cross-price elasticity of demand could be +1,
but it does not need to be +1.
[52] E. The goods are independent.
[53] D. The demand for good B shifts to the left, that is, it goes down. Therefore,
PA goes up and QB goes down: The goods are complements.
[54] B. Note the in the graph of an Engel curve, one good is on the horizontal axis,
46
and income is on the vertical axis. If the Engel curve has a positive slope, then as
income increases, the consumption of the good on the horizontal axis also increases
(the graph describes one good, not two).
[55] B
[56] B. To understand why, suppose good X is an inferior good. If the price of X
goes down then the consumer can buy more goods, that is, it increases the con-
sumer’s purchasing power. When we isolate the income effect from the price effect,
this higher purchasing power works “as if” the consumer became richer. Since good
X is an inferior good, an increase in income results in a lower demand for X. How-
ever, when isolating the price effect, the lower price of X results in a higher demand
for X. Therefore, in the case of an inferior good, the income and substitution effect
work against each other: when the price of X goes down, the income effect decreases
demand, while the price effect increases demand. Similarly, if the price of an inferior
good X goes up (reducing purchasing power), the income effect increases demand,
while the price effect decreases demand. Which effect dominates depends on the ac-
tual consumer’s preference.
[57] A. A price decrease increases purchasing power (the consumer can buy more
goods). When we isolate the income effect from the price effect, this higher purchas-
ing power works “as if” the consumer became richer. A higher income leads to higher
consumption of normal goods, and a lower consumption of inferior goods (which in-
cludes Giffen goods).
[58] D. A higher price decreases purchasing power (the consumer can buy less goods).
When we isolate the income effect from the price effect, this lower purchasing power
works “as if” the consumer became poorer. Since beer is a normal good, a decrease
in income results in a lower demand for X. Isolating the substitution effect, a more
expensive beer results in a lower demand for X. Note that since beer is a normal
good, the income and substitution effects work together (in the same direction).
[59] C. If the price elasticity of demand is one, then as price increases by 1%, de-
mand decreases by 1%. Consequently, expenditure (price times quantity demanded)
remains the same.
[60] A. Income has a positive effect (+2) on demand Qe .
47
[61] A. The price of good b (Pb ) has a positive effect (+1) on the demand Qe for
erasers. That is, increasing the price of good b increases the demand for erasers.
Therefore, they are substitutes.
Lecture 6
[62] The expected value of the ticket is given by the weighted sum of the payouts.
1 1
EV = 10
10 + 1000
100 = 1.1 Because its expected value is less than its cost, a risk-
neutral person would not buy this ticket.
[63] A
[64] B
[65] C
[66] A
[67] B
√ √
[68] A. Expected utility from not buying insurance: E[uN I ] = 0.9 250, 000+0.1 0 =
√
450. Expected utility from buying insurance: E[uI ] = 250, 000 − 25, 000 = 474.3.
Since E[uN I ] < E[uI ], Smith should buy insurance.
[69] C. Find insurance premium P such that E[uN I ] = E[uI ]. Using the information
from the previous question,
E[uN I ] = E[uI ]
p
450 = 250, 000 − P
202, 500 = 250, 000 − P
P = 47, 500.
[70] a) The probability of winning (rolling 3, 4, 6, or 8) and receiving $400 is

1 3 5 5
P r(winning) = + + +
18 36 36 36
5
P r(winning) = .
12
The probability of losing (not rolling 3, 4, 6, or 8) and receiving $100 is
P r(losing) = 1 − P r(winning)
7
P r(losing) = .
12
48
5 7
Connie’s expected payoff is then 12
∗ 400 + 12
∗ 100 = $225.
b) The expected utility from this gamble is
√ √
E[ug ] = P r(winning) ∗ 400 + P r(losing) ∗ 100
5 √ 7 √
E[ug ] = ∗ 400 + ∗ 100
12 12
85
E[ug ] = ≈ 14.16
6
√
c) The utility from having $169 for sure is 169 = 13, which is less than the expected
utility from the gamble (14.16).Therefore, Connie will roll the dice.
d) Find the payment P such the the utility from the payment equals the expected
utility from the gamble:
√
P = E[ug ]
√ 85
P =
6
2
85
P =
6
7225
P = ≈ $200
36
[71] Larry is risk-averse; Judy is risk-lover; Carol is risk-neutral

[72] Expected utility without insurance:
√ √
E(uN I ) = 14
15
1
∗ 15 360, 000 + 15 ∗ 15 160, 000 = 8, 800.
√
Expected utility with insurance: E(uI ) = 15 ∗ 360, 000 − P .
Find P such that E(uN I ) = E(uI ),
14 p 1 p p
∗ 15 360, 000 + ∗ 15 160, 000 = 15 ∗ 360, 000 − P
15 15 p
8, 800 = 15 ∗ 360, 000 − P
2
8, 800
= 360, 000 − P
15
142, 400
P = ≈ $15, 822.22
9
Sam is willing to pay $15,822.22 for insurance. The fair insurance premium is
1
equal to the expected loss, $13,333.33 (= 15 200, 000: with probability 1/15 Sam losses
200,000). Therefore, the risk premium is the difference between the insurance
49
premium Sam is willing to pay and the fair insurance premium, RiskP remium =
15, 822.22 − 13, 333.33 = 2, 488.89.
Equivalently, we can compute the risk premium from the difference in expected
14 1
payouts. The expected payout without insurance is 15
360, 000+ 15 160, 000 = 346, 666.67,
and the expected payout with the maximum insurance premium Sam is willing to
pay is 360, 000 − 15, 822.22 = 344, 177.78. The risk premium is then the difference,
346, 666.67 − 344, 177.78 = 2, 488.89
[73] a) If Jim uses all his money to buy shares of ACME, he buys 10 shares (= 100/10).
If the price goes up to $14, he can sell his shares and receive $140 (= 10 ∗ 14); if the
price stays at $10, he sells his shares and receives $100 (= 10 ∗ 10); if the price goes
down to $5 he receives $50 (= 10 ∗ 5). Given the probabilities, investment option 1
has an expected payoff = 0.50 ∗ 140 + 0.25 ∗ 100 + 0.25 ∗ 50 = $107.5. That is, an
expected 7.5% return on the investment.
If Jim uses all his money to buy shares of Tabajara, he buys 20 shares (= 100/5).
If the price goes up to $9 he receives $180 (= 20 ∗ 9); if the price stays at $5
he receives $100 (= 20 ∗ 5); if the price goes down to $0.50 he receives $10 (=
20 ∗ 0.50). Given the probabilities, investment option 2 has an expected payoff
= 0.50 ∗ 180 + 0.25 ∗ 100 + 0.25 ∗ 10 = $117.5. That is, an expected 17.5% re-
turn on the investment.
If Jim invests all his money on the savings account that has a 1% return, his expected
payoff is $101.
In summary, investment option 2 has the highest expected payoff, while investment
option 3 has the lowest.
b) Use the information above to compute the expected utility from each investment
option:
√ √ √
E[u1 ] = 0.50 ∗ 140 + 0.25 ∗ 100 + 0.25 ∗ 50 ≈ 10.18
√ √ √
E[u2 ] = 0.50 ∗ 180 + 0.25 ∗ 100 + 0.25 ∗ 10 ≈ 10.00
√
E[u3 ] = 101 ≈ 10.05
Note that, although Jim is risk averse, the best option is not the safe investment (op-
50
tion 3). Investment option 1 (ACME) is the best option for Jim, since it yields the
highest expected utility (in this case, the higher expected payoff more than compen-
sates for the risk). Although investment option 2 (Tabajara) has the highest expected
payoff, it is the worse investment option because it yields the lowest expected utility
(this option is too risky for Jim).
[74] First find the expected utility without insurance E[uN I ] and the expected
utility with insurance E[uI ] at price P .
3 p 1 p
E[uN I ] = 8 1, 000, 000 + 8 250, 000 = 7, 000
4p 4
E[uI ] = 8 1, 000, 000 − P
Then find P such that E[uN I ] = E[uI ].
E[uN I ] = E[uI ]
p
7, 000 = 8 1, 000, 000 − P
P = 234, 375
Joe is willing to pay at most $234,375 for insurance. The fair insurance premium is the
expected loss: with probability 1/4 Joe losses the difference 1, 000, 000 − 250, 000 =
750, 000, therefore the expected loss is 41 (750, 000) = 187, 500. The risk premium is
the difference RP = 234, 375 − 187, 500 = 46, 875.
Lecture 7
[75] D
[76] D. This is the classic lemons problem. If sellers know whether they have a high
quality or a low quality product, but buyers cannot observe that, then the result of
this asymmetric information is that low-quality goods can drive high-quality goods
out of the market.
[77] E. Note that risk aversion does not create an adverse selection problem for the
insurance company. Risk aversion simply implies that an individual dislikes risk; it
does not imply that a risk averse individual is more likely to become sick (in the case
of health insurance) or more likely to crash his car (in the case of car insurance).
[78] D. Credit history and credit scores allow lenders to partially distinguish high-
51
quality (low risk of default) from low-quality (high risk of default) borrowers. Conse-
quently, high-quality borrowers are able to pay less for a loan (that is, a lower interest
rate), while low-quality borrowers have to pay more for a loan (higher interest rate).
Sometimes the lender even denies credit to a low-quality (high risk) borrower. If
lenders cannot have access to credit history, then the lemons problem becomes more
severe, as it becomes harder to distinguish between the types of borrowers. So we
expect more low-quality borrowers to look for a loan, including those borrowers who
would not be able to borrow given their very bad credit history. Therefore, lending
money becomes riskier (higher average risk of default), and lenders must then charge
a higher price (increase the interest rate). To make things worse, because of the much
higher interest rate some high-quality (low risk of default) borrowers will choose to
stop borrowing money.
[79] C. See the slides from class on the Health Care Reform. Without the group
health insurance, the adverse selection problem may result in the insurance company
charging a very high price, and only unhealthy people buying insurance (the price is
high for every potential consumer, so healthy people do no buy insurance). In a group
health insurance where all employees of a company (or all students in a university)
are automatically added to the health care plan, the group will be a mix of healthy
and unhealthy consumers (no adverse selection, since everyone must participate).
Therefore, the “average” consumer is not as unhealthy as before, and the insurance
company can charge a lower price. Read also the section “Market for Insurance,”
pages 662 and 663 from your book.
[80] D
[81] D. The ask price is the price the dealer is ’asking’ for, so you can buy at this
price. The bid is what the dealer is willing to pay, so you can sell at this price. Due
to asymmetric information, the ask is higher than the bid.
[82] A. Just before an earning’s announcement, inforrmed traders are more likely:
there may be people related to the company that have some idea of whether the
earnings are good or bad. In this case, from the simple model we saw in class, the
bid-ask spread widens.
[83] C. From the model we looked at in class, the spread=2qc where q is the proba-
52
bility of an informed trader and c is the potential change in the stock price. If both
q and c double, then the spread increases by 4 times.
Lecture 8
[84] B. If the education threshold is y ∗ , then each individual either (a) chooses the
minimum education necessary to receive the wage increase, that is, chooses y = y ∗ ; or
(b) chooses no education, y = 0. For an individual in Group A (high-productivity),
the value of education y ∗ is 130, 000 − 6, 000y ∗ ; the value of not going to school is
50, 000 − 6, 000 ∗ 0. Therefore, this individual will choose education if
130, 000 − 6, 000y ∗ > 50, 000
80, 000 > 6, 000y ∗
13.33 > y ∗
[85] D. For an individual in Group B (low-productivity), the value of education y ∗ is

130, 000 − 10, 000y ∗ ; the value of not going to school is 50, 000 − 10, 000 ∗ 0. Therefore,
this individual will choose not to go to school if
130, 000 − 10, 000y ∗ < 50, 000
80, 000 < 10, 000y ∗
8 < y∗
[86] A. If y ∗ = 10, then it is in the range 8 < y ∗ < 13.33. Therefore, individuals from
Group A prefer to go to school, while individuals from Group B prefer not to go to
school.
[87] B. See previous questions.
[88] C. If the education threshold is y ∗ , then each individual either (a) chooses the
minimum education necessary to receive the wage increase, that is, chooses y = y ∗ ; or
(b) chooses no education, y = 0. For an individual in Group K (high-productivity),
the value of education y ∗ is 90, 000 − 2, 000y ∗ ; the value of not going to school is
30, 000 − 2, 000 ∗ 0. Therefore, this individual will choose education if
90, 000 − 2, 000y ∗ > 30, 000
60, 000 > 2, 000y ∗
30 > y ∗
53
[89] E. For an individual in Group M (low-productivity), the value of education y ∗ is
90, 000 − 4, 000y ∗ ; the value of not going to school is 30, 000 − 4, 000 ∗ 0. Therefore,
this individual will choose not to go to school if
90, 000 − 4, 000y ∗ < 30, 000
60, 000 < 4, 000y ∗
15 < y ∗
[90] B. See previous question.

[91] E
[92] B. If the fire protection program is in place, the probability of a fire is 0.001.
The fair insurance premium is the expected loss, that is, 0.001 ∗ 300, 000 = 300.
[93] C. If the fire protection program is not in place, the probability of a fire is 0.01.
The fair insurance premium is the expected loss, that is, 0.01 ∗ 300, 000 = 3, 000
[94] A. Answer (A) correctly describes the moral hazard problem. The other answers
are either false, or do not describe the moral hazard problem.
[95] D. Note that options A and C refer to an asymmetric information problem, not
moral hazard. If you want to see Hollywood’s take on this issue, watch ’Wall Street:
Money Never Sleeps’.
[96] A
[97] A
[98] Compute the net value (benefit minus cost) of each level of education for low-
productivity and high-productivity workers:
Education Net Value (low-productivity) Net Value (high-productivity)

y=0 0 0
y=2 30, 000 − 13, 000 ∗ 2 = 4, 000 30, 000 − 10, 000 ∗ 2 = 10, 000
y=4 51, 000 − 13, 000 ∗ 4 = −1, 000 51, 000 − 10, 000 ∗ 4 = 11, 000
y=6 58, 000 − 13, 000 ∗ 6 = −20, 000 58, 000 − 10, 000 ∗ 6 = −2, 000
The low type should earn an associate’s degree (y = 2) and the high type should
earn a bachelor’s degree (y = 4).
54
[99] a) Manager’s net value:
Maximum effort: 30, 000 − 55, 000 ∗ (1) = −25, 000
Minimum effort: 30, 000 − 55, 000 ∗ (0) = 30, 000.
No incentive (minimum effort). Firm’s expected profit = .5(400, 000) + .5(200, 000) −
30, 000 = 270, 000. Notice that the firm always pays 30,000.
b) Manager’s net value:
With maximum effort, there is a 50% chance that the profit will be 700,000, in which
case the manager receives the 120,000 bonus. With probability 50%, the economy
will be unfavorable and the manager will not receive the bonus, even though he had
maximum effort.
Maximum effort: 0.5 ∗ 120, 000 + 0.5 ∗ (0) − 55, 000 ∗ (1) = 5, 000
With minimum effort, the profit will never be 700,000, so the manager never receives
the bonus.
Minimum effort: 0 − 55, 000 ∗ (0) = 0.
Effective (maximum effort). Firm’s expected profit = .5(400, 000) + .5(700, 000 −
120, 000) = 490, 000. Notice that the firm only pays 120,000 if profits are 700,000.
In this example, the bonus payment scheme (b) yields a higher expected profit,
when compared to the flat wage scheme (a).
Lecture 9
[100] C
[101] E. If ABC plays “Offer Rebate”, then the best response of XYZ is to play “Offer
Rebate” (because 20 is better than 12). If ABC plays “No Rebate”, then the best
response of XYZ is to play “Offer Rebate” (because 30 is better than 20). Therefore,
“Offer Rebate” is a dominant strategy for XYZ. Similar argument implies that “Offer
Rebate” is a dominant strategy for ABC. Consequently, the Nash equilibrium of this
game is for both firms to offer rebates. Notice that this Nash equilibrium is also an
equilibrium in dominant strategies.
[102] A
[103] C. If Zport plays “Tires”, then the best response of Moto is to play “CD
Changer” (because 40 is better than 0). If Zport plays “Sunroof”, then the best
55
response of Moto is to play “Free Maintenance” (because 160 is better than 100).
Therefore, Moto does not have a dominant strategy.
[104] A
[105] E
[106] E. Game 105 does not have an equilibrium in pure strategies, but it has one
equilibrium in mixed strategies. In this mixed strategy equilibrium, NRG Bars
plays “Sponsor Marathon” with some probability P1 , and Vita Bars plays “Spon-
sor Marathon” with some probability P2 . In a more advanced Econ class, you would
actually learn how to compute these exact probabilities. For ECON 351, it is enough
to know that there exists such mixed strategies equilibrium.
[107] C
[108] D. Consider, for example, Game 107. In this game, neither player has a dom-
inant strategy (therefore I is false), but there are two equilibria in pure strategies
(therefore II is also false).
[109] A. Note that if player B choose a pure strategy (always plays heads), then
player A can choose a best response that guarantees that player A wins with proba-
bility one. Hence, we cannot have an equilibrium in pure strategies for this game.
[110] D. Player B chooses heads with probability 75%. Therefore, every time Player
A chooses heads, he wins with probability 75%; every time player A chooses tails, he
wins with probability 25%. Consequently, Player A should always play heads.
[111] Note from question [109] that we cannot have an equilibrium in pure strategies.
The only equilibrium is in mixed strategies: each players randomizes between heads
and tails with equal probability, that is, each player chooses heads with probability
50%, and tails with probability 50%. In this equilibrium, each player wins the game
with probability 50%. Note from question [110] that a player will not play in equilib-
rium heads (or tails) with probability greater than 50%, otherwise the other player
will win with probability greater than 50%.
Lecture 10
[112] B
[113] E. If R plays QR = 50, then the best response of C is QC = 100, and R’s payoff
56
would be 30. If R plays QR = 100, then the best response of C is QC = 100, and R’s
payoff would be 32. If R plays QR = 150, then the best response of C is QC = 50, and
R’s payoff would be 35. Therefore, R will play QR = 150 and C will play QC = 50.
[114] C
[115] C. If Gooi plays “Gelato”, then the best response of Ici is “Yogurt” (because
300 is better than 0), and Gooi’s payoff would be $150. If Gooi plays “Yogurt”, then
the best response of Ici is “Gelato” (because 150 is better than 50), and Gooi’s payoff
would be $400. Therefore, Gooi should play “Yogurt” and Ici “Gelato”.
[116] D. If Gooi plays “Yogurt”, then the best response of Ici is “Gelato”(because
150 is better than 50). Therefore, this is an empty threat.
[117] B
[118] D. If the Entrant plays “Enter”, then Incumbent’s best response is accommo-
date: Incumbent receives $300, and the Entrant -$60. If the Entrant plays “Out”,
then Incumbent’s best response is accommodate: Incumbent receives $600, and the
Entrant $0. Therefore, the Entrant will enter the market.
The Incumbent would like to commit to “War” if the Entrant decides to enter. In
this case, the Entrant would receive -$60 and would prefer to stay out of the market;
the Incumbent would then receive $600. However, this is an empty threat because if
the Entrant actually enters, it is in the Incumbent’s best interest to Accomodate.
[119] B. If the incumbent engages in a price war after a potential entrant enters the
market, then the incumbent has a short-term loss. However, if by engaging in a price
war today the incumbent is able to keep potential entrants out of the market in the
future (note that entrants lose money in a price war), then this long-run gain (no
future entrants) might outweigh the shot-run loss of a price war.
[120] B
[121] A
[122] When firms value the future, cooperation might be possible (neither firm pol-
lutes) in the infinitely repeated game. Cooperation is not possible if the game is
finite.
[123] The present value of cooperating is P V (Cooperate) = − 1,500
1−δ
. The present
57
value of deviating is P V (Deviate) = −1, 000 − δ 2,000
1−δ
. Firms will cooperate if
P V (Cooperate) ≥ P V (Deviate)
1, 500 2, 000
− ≥ −1, 000 − δ
1−δ 1−δ
2, 000δ − 1, 500
≥ −1000
1−δ
1
δ ≥ .
2
Notice that if δ = 12 , then firms are indifferent between cooperating or not.
Lecture 11
[124] D. Assume a utility function, u(x). We can write the expected utility of each
gamble as:
I: u(1000)
II: 0.89u(1000) + 0.01u(0) + 0.1u(5000)
III: 0.89u(0) + 0.11u(1000)
IV: 0.9u(0) + 0.1u(5000)
The choice of I over II means that u(1000) > 0.89u(1000) + 0.01u(0) + 0.1u(5000)
which is the same as 0.11u(1000) > 0.01u(0) + 0.1u(5000). The choice of IV over III
means that 0.9u(0) + 0.1u(5000) > 0.89u(0) + 0.11u(1000) or 0.01u(0) + 0.1u(5000) >
0.11u(1000). Comparing the two inequalities resulting from the two choices, we see
that we have a contradiction: no function u(x) can simultaneously satisfy both.
Therefore, this individual can not be an expected utility maximizer. This set of
choices was originally considered by Maurice Allais in 1953 and is known as the Al-
lais paradox.
[125] D. Assume a utility function, u(x). We can write the expected utility of each
gamble as:
I: u(1000)
II: 0.6u(2000) + 0.4u(0)
III: u(−1000)
IV: 0.6u(−2000) + 0.4u(0)
58
The choice of I over II means that u(1000) > 0.6u(2000) + 0.4u(0) implying that this
person must be risk-averse (they turned down a gamble which has a higher expected
payoff of $1200). The choice of IV over III means that u(−1000) < 0.6u(−2000) +
0.4u(0) implying that this person must be risk-seeking (they took a gamble which
has a lower expected payoff of -$1200). So, the person cannot be an expected utility
maximizer because they cannot be both risk-averse and risk-seeking.
[126] D. Referring to the answer for Question 125, this person is risk-averse over
gains and risk-seeking over losses if we take their reference point to be $0. So, if the
person has a reference point of $0 and an S-shaped utility function, prospect theory
can explain their choices.
[127] A. We want to see whether or not these choices are consistent with the standard
discounting model. Let’s call the discount rate, r. Can we find a value of r such that
100 > 110r and 100 < 150r2 ? (Note that because the person is risk-neutral, we can
assume u(x)=x.) For the first inequality to be true, we require r < 10/11 = 0.91.
p
For the second inequality to be true, we require r > 10/15 = 0.81. So, we see
that there are in fact many values of r such that this person’s choices are consis-
tent with the standard discounting model. The person may be present-biased and/or
time-inconsistent but we have no way of knowing because these violations of the stan-
dard discounting model require us to observe choices over two future periods. Also,
reference-dependence is not related to time preference.
[128] E. We want to see whether or not these choices are consistent with the standard
discounting model. Let’s call the discount rate, r. Can we find a value of r such that
100 > 110r and 100r < 110r2 ? (Note that because the person is risk-neutral, we
can assume u(x)=x.) Clearly the answer is no because we can divide both sides of
the second inequality by r which results in the opposite of the first inequality. So,
the person can’t be discounting the future in the standard way. In fact, they are
more heavily discounting between today and tomorrow than between tomorrow and
the next day, so they are present-biased. As we saw in class, present-bias leads to
59
time inconsistencies so the answer is both B and C. Also, reference-dependence is not
related to time preference.
60

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ECON 351x - Microeconomics for Business - Kendall

Homework 1 - Fall 2016

[This version: Aug/24/2016]

Lecture 3 - The Basics of Supply and Demand

[1] Along any downward sloping straight-line demand curve:

Consider the following scenario to answer the next 6 questions:

[5] What is the equilibrium price of books?

[6] What is the equilibrium quantity of books sold?

[7] If P = $15, which of the following is true?

[8] If P = $25, which of the following is true?

Lecture 4 - Consumer Choice

[16] The slope of an indifference curve reveals:

[17] Indifference curves are convex to the origin because of:

[18] Consider the following three market baskets:

[19] Consider the following three market baskets:

[22] The magnitude of the slope of an indifference curve is:

[23] If a consumer is always indifferent between an additional one grapefruit or an

[24] Consider the following three market baskets:

[30] An increase in income, holding prices constant, can be represented as:

[34] The fact that Alice spends no money on travel:

[39] Marginal utility measures:

u(X, Y ) = 10X 0.6 Y 0.4

[47] The inverse demand curve for product X is given by:

[50] The cross-price elasticity of demand between two complementary goods is

[51] If goods X and Y are substitutes, then their cross-price elasticity is

[54] If an Engel curve has a positive slope

[55] Use the following two statements in answering this question:

[56] For an inferior good, the income and substitution effects

The demand for erasers (Qe ) is given as follows:

[60] Erasers are:

[61] Erasers and good b are:

Lecture 6 - Expected Utility

[62] You are considering buying a scratch-and-win lottery ticket. It costs $2 to

[63] A person with a diminishing marginal utility of income

[65] A consumer with a increasing marginal utility of income will be

[66] The concept of a risk premium applies to a person that is

[74] Joe’s utility from income is given by

Lecture 7 - Asymmetric Information I

[75] The problem of adverse selection in insurance results in a situation in which

[77] Which of the following represent examples of adverse selection?

[81] Asymmetric information in financial markets results in:

[82] Prior to a firm’s quarterly earnings announcement:

[83] If an approaching earnings announcement causes the probability of an informed

Lecture 8 - Asymmetric Information II

[86] If the threshold educational level y ∗ is set at 10,

Use the following information to answer questions 88 to 90:

Use the following information to answer questions 92 to 94:

[96] The principal-agent problem in corporations exists because the managers of a

[97] In the economic literature on principal-agent problems, the is the person

Lecture 9 - Game Theory I

[100] A dominant strategy can best be described as

[102] In game 101, the equilibrium strategies

[103] Which of the following is true for game 103?

[104] In game 103, the equilibrium outcome:

[105] Which of the following is TRUE for game 105?

[106] In game 105, the equilibrium outcome:

[108] Use the following statements to answer this question:

Consider the Matching Pennies game for questions 109 to 111:

Lecture 10 - Game Theory II

[113] If player R moves first in Game 112, the equilibrium will

[118] In game 118, Incumbent Monopoly has

Lecture 11 - Behavioral Economics

[124] Consider the following two pairs of choices: