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Microeconomics–Final Solution.

September 30, 2009

1. (a) Given the demand and supply curves, equilibrium is given by 10 − P = 5 which implies
P ∗ = 5 and Q∗ = 5. Both consumer surplus and producer surplus are 5×5
2 = 12.5.
(b) With import, equilibrium price is 3. From the demand curve, domestic consumption at
a price of 3 is 7. Domestic supply at a price of 3 is 3. Import = 7 − 3 = 4
7×7 3×3
(c) With import, consumer surplus is 2 = 24.5. Producer surplus is 2 = 4.5. Clearly,
consumers gain and producers lose. Aggregate surplus is 24.5 + 4.5 = 29 which is higher
than the surplus in (a).
(d) With a per unit import tariff of 1, domestic price is 4. Domestic consumption is 6 and
6×6
domestic production is 4. Import is 2. Consumer surplus is 2 = 18 and producer
4×4
surplus is 2 = 8. Government revenue is Import × per unit tariff = 2 × 1 = 2. Total
surplus is 18 + 8 + 2 = 28. Total surplus is lower compared to (c).

2. (a) Combining the two markets, we obtain the aggregate demand curve Q = Q1 + Q2 =
dT R(Q)
150−2P or P = 75− Q2 . The marginal revenue function is therefore M R(Q) = dQ =
dP (Q)Q dT C(Q)
dQ = 75 − Q. The marginal cost curve is M C(Q) = dQ = 10. Equating
M R(Q) = M C(Q), we obtain Q∗ = 65 and P∗ = 42.5. Profit = P Q − 10Q∗
∗ ∗ = 2112.5.
(b) The monopolist now prices the high quality version by considering the demand for that
version by group 1 consumers. For the low quality version, he considers the demand for
that version by group 2 consumers.
Hence, to price the high quality version, he considers the demand curve Q1 = 100 − P .
The marginal revenue is M R(Q1 ) = 100 − 2Q1 and the marginal cost is M C(Q1 ) = 10.
From M R(Q1 ) = M C(Q1 ), the equilibrium quantity is Q∗1 = 45 and the equilibrium
price is 55. Profit from the high quality version is therefore π1 = 55×45−10×45 = 2025.
To price the low quality version, the monopolist considers the demand curve Q2 = 40−P .
Note that the cost of producing the low quality version is 12Q. M R(Q2 ) = M C(Q2 )
implies 40 − 2Q2 = 12 which implies Q∗2 = 14. The equilibrium price is 26. Profit from
the low quality version is therefore π2 = 26 × 14 − 12 × 14 = 196.
Total profit is therefore π1 + π2 = 2025 + 196 = 2221. Clearly, profit from the damaged
goods strategy is higher.

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3. (a) i. For both players, strategy H is a dominant strategy. Hence, both players will engage
is high level of advertising.
ii. The predicted outcome is (H, H). Clearly, this is not socially optimal since (L,L)
provides higher payoff to both players.
(b) i. The two Nash equilibria are (L1, L2) and (L2, L1).
ii. The equilibrium (L1, L2) is preferred by firm 1. Hence, it launches an advertising
campaign to in favour of L1 to signal its commitment to L1. Seeing firm 1 committed
thus, Firm 2 is forced to play its best response which is L2.

4. (a) In a perfectly competitive market, P = M C. Hence, 30 − Q = 10 which implies Q = 20


20×20
and P = 10. Consumer surplus is 2 = 400. The profit of any firm is zero since
P = AC = 10.
(b) Two firms engage in quantity competition. Consider firm 1’s profit function

π1 = (30 − Q1 − Q2 )Q1 − 10Q1 .

Maximizing this function, we obtain firm 1’s best response as a function of Q2 .

20 − Q2
BR1 (Q2 ) = . (1)
2

By a similar procedure, we obtain firm 2’s best response function.

20 − Q1
BR2 (Q1 ) = . (2)
2

In a Cournot-Nash equilibrium, we have Q1 = BR1 (Q2 ) and Q2 = BR2 (Q1 ). Solving


these two equations, we obtain Q1 = Q2 = 6.6667. Total output is therefore 13.3333
and price is 16.6667.
13.3333×13.3333
The profits of the two firms are π1 = π2 = 44.4447. Consumer surplus is 2 =
88.8884.
(c) Firm 1 is the leader and therefore can anticipate firm 2’s reaction. Firm 1 knows that
20−Q1
Q2 = BR2 (Q1 ) = 2 . Hence,
 
20 − Q1
π1 = 30 − Q1 − Q1 − 10Q1 .
2

This function is maximized at Q1 = 10. Hence, firm 1 produces Q1 = 10. Firm 2’s output
is given by its best response function. So, Q2 = BR2 (Q1 ) = 5. Since total output is 15,
15×15
price is 15. Therefore, π1 = 50 and π2 = 25. Consumer surplus is 2 = 112.5.
(d) We need to find the aggregate surplus in each of the three parts. In part (a), AS =
CS = 200. In (b), AS = CS + π1 + π2 = 177.778. In (c), AS = CS + π1 + π2 = 187.5.
Hence, (a) is best and (b) worst.

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5. (a) For coverage C, the premium charged from the low-risk consumers would be πL (C) =
pL C. The premium charged from the high-risk consumers would be πH (C) = pH C.
(b) Suppose the probability of loss is pi . If coverage is C, the utility after insurance is

(1 − pi )u(W − pi C) + pi u(W − L − pi C + C).

Since individuals opt for full coverage, C = L. Hence, utility after insurance is u(W −
pi L). So, for low risk borrowers, utility after insurance is u(W − pL L) and for high risk
borrowers, utility is u(W − pH L).
(c) Suppose the insurer provides full insurance at premiums given by (a). Then, if a high
risk borrower pretends to be a low risk one, he pays a premium of pL L and his utility is

(1 − pH )u(W − pL L) + pH u(W − L − pL L + L = u(W − pL L).

On the other hand, if he tells the truth, he pays premium pH L and his utility is u(W −
pH L). Since W − pL L > W − pH L, u(W − pL L) > u(W − pH L). Hence, the utility from
lying is greater. So, a high risk individual would have the incentive to lie and pretend
to be a low risk one.
(d) The whole problem emerges because low risk individuals are also being full coverage. A
solution to the problem would be to reduce the coverage of low risk individuals. This
would reduce their utility and therefore reduce the incentive of the risk individuals to lie.
The question is by what should be the coverage of the low risk individuals. It should be
such that high risk individuals do not have the incentive to lie. If high risk individuals
get full coverage, their utility would be u(W − pH L). On the other hand, if low risk
individuals get coverage CL , their utility is

(1 − pL ) u (W − pL CL ) + pL u (W − L − pL CL + CL ) .

If the two are equal, then the high risk individuals would not have any incentive to lie.
So, CL is determined by

(1 − pL ) u (W − pL CL ) + pL u (W − L − pL CL + CL ) = u(W − pH L).

6. (a) The optimal number of cows is obtained by maximizing the net benefit function

N B(x) = 200 x − 5x.

This function is maximized at x = 400. Hence, the optimum number of cows is 400.
(b) Suppose the villagers reach an agreement to graze 400 cows. If a villager now breaks the
agreement and introduces one more cow, the output from that additional cow would be

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200 401
401 = 9.98752. But the cost of the additional cow is only 5. Hence, it pays for any
villager to add an additional cow to the common ground. Since every villager faces the
same incentive, the agreement to graze 400 cows breaks down.
(c) The actual number of cows that would be grazed is given by

200 x
= 5,
x

which implies x = 1600.