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October 8, 2010

1. (a) Since p(q) = 120 − q, total revenue is T R(q) = (120 − q)q = 120q − q 2 . Hence marginal

revenue is M R(q) = 120 − 2q. Marginal cost is M C(q) = 2q. Profit maximizing output

is given by M R(q) = M C(q) which implies q ∗ = 30. The price charged is p(q ∗ ) = 90.

The monopolist’s profit is T R(q ∗ ) − T C(q ∗ ) = 1800. Consumer surplus is 30×30

2 = 450

(the area of the triangle formed by the demand curve and the price).

(b) Since there is no fixed cost, producer surplus is equal to profit. In order to maximize

the sum of consumer surplus and producer surplus, the price must be set so that p(q) =

M C(q). Solving this equation, we get q̂ = 40 and p(q̂) = 80. At this price and quantity,

40×40

profit is 1600 and consumer surplus is 2 = 800. Hence, the sum of consumer and

producer surplus is 2400. Note that this is higher than in (a) where the sum is 2250.

(c) If the lump sum tax is added, it simply adds 100 to the monopolist’s total cost. Hence,

c(q) = 100 + q 2 . The marginal cost function is not affected by the lump tax. Since

marginal revenue is also not affected, profit maximizing output and price remains the

same. Hence, consumer surplus also remains the same. The only difference is that the

monopolist’s profit goes down by 100 to 1700. Apart from the reduction in profit by the

amount of the lump sum tax, nothing else changes because the two relevant marginal

quantities do not change.

(d) With the specific tax of 20 per unit of output, c(q) = 20q + q 2 . Hence, M C(q) = 20 + 2q.

So, M R(q) = M C(q) gives qs = 25 and p(qs ) = 95.

2. (a) If the producer is able to practice perfect price discrimination, then he would sell both

goods to consumer B at a price of 60 each. To consumer A, only good 2 is sold at a price

of 100. Good 1 is not sold to A since even at the maximum possible price that can be

extracted from that consumer, the producer makes a loss (20 − 10). For a similar reason,

only good 1 is sold to consumer C at a price of 100. Total revenue is 100+120+100 = 320.

Total cost is 30 × 4 = 120. Hence, profit is 200.

(b) If all consumers are to be charged the same price for any particular good, then monopolist

charges a price of 100 for each good. Selling at 20 is a loss making proposition. If the

monopolist sells at 60,he is able to sell two units of good 1 (consumers B and C) and

1

two units of good 2 (consumers A and B). With two units of each good sold at 60 per

unit, total revenue is 240. Total cost is 30 × 4 = 120. So, profit is 120.

If, however, the price is 100, then only 1 unit of each good is sold (good 2 to consumer

A and good 1 to consumer C). Total revenue is 200. But cost is only 30 × 2 = 60. So,

profit is 140. Hence, profit is maximized at a price of 100.

(c) If the two goods can be bundled, then the monopolist can charge 120 for the bundle.

All three consumers will be willing to pay that price since it is equal to their sum of

valuations. Hence, total revenue is 120 × 3 = 360 and total cost is 30 × 6 = 180. So

profit is 180.

Work Hard Shirk Work Hard Shirk

Work Hard 7 − 5, 7 − 5 4 − 5, 4 − 1 = Work Hard 2, 2 −1, 3 .

Shirk 4 − 1, 4 − 5 1 − 1, 1 − 1 Shirk 3, −1 0, 0

(b) Note that this is the prisoner’s dilemna. The socially optimal outcome is (Work Hard,

Work Hard).

(c) The Nash equilibrium is (Shirk, Shirk). Since “Shirk” is the dominant strategy for both

players, it is also the dominant strategy equilibrium.

(d) The finished project is a public good for the two players. Once it is finished, both

players benefit from the value of the project equally, without reducing the value for the

other. Hence, it is non-rival. Neither player can exclude the other player from benefiting

from the value of the project. Hence, it is non-excludable. It is difficult to provide the

public good because both players find it optimal to shirk irrespective of the other player

is doing. As a result, they get trapped in the sub-optimal outcome where both shirk

leading to a very low quality public good.

Repeated interaction may help resolve this problem. The players may employ a strategy

where they both start by working hard; but with the implicit agreement that shirking by

any one of them will lead to the Nash equilibrium for the indefinite future. The possibility

of being punished in the future with the low value outcome deters any momentary

temptation to shirk in the present. Of couse, this strategy can only work if players are

sufficiently patient, i.e. they care about future payoffs.

4. (a) The existing firm’s dominant strategy is QY = 90. Irrespective of what the new firm

does, the existing firm always gets a higher payoff with QY = 90.

(b) The new firm does not have a dominant strategy. If QY = 90, the new firm’s best

response is QN F = 50 and if QY = 150, the new firm’s best response is QN F = 0. So the

new firm’s best response depends upon the action of the existing firm. Hence, it does

not have a dominant strategy.

2

(c) The Nash equilibrium is (QN F = 50, QY = 90).

(d) The Stackelberg equilibrium is (QN F = 0, QY = 150).

5. (a) With full information, the H-type gets a wage of 200 and the L-type gets 100. Without

full information, the employer pays the expected output as wage to both types. The

1 2

expected value is 3 × 200 + 3 × 100 = 133.333.

(b) Suppose the utility function of type i is Ui (e, w) = w − ai e2 . The marginal rate of

substitution between e and w is

M Ue −2ai e

MRSew = − =− = 2ai e.

M Uw 1

the utility function. Higher is ai , the greater is the slope of the indifference curve. (Note

that because education is a “bad” and wage is a “good”, indifference curves are positively

sloped. Hence, the positive MRS). The low type’s indifference curve has higher slope.

For the same change in wage, the L-type, due to greater effort cost of education, requires

a higher wage as compensation than the H-type. Hence, the coefficient of the e variable

in the L-type’s utility function is higher.

(c) In a separating equilibrium, the L-type acquires education level eL = 0 and gets wage

wL = 100. Hence, it’s utility is UL (eL , wL ) = 100. The H-type’s wage is wH = 200. The

H-type acquires the minimum possible education level eH that would prevent the L-type

from pretending to be the H-type to earn the higher wage level wH = 200. Hence, eH has

to be such that UL (eL , wL ) = UL (eH , wH ). If this equation is satisfied, the L-type will

have no incentive to pretend to be the H-type. Since UL (eL , wL ) = 100 and wH = 200,

we require

100 = 200 − 2e2H ,

√

which implies eH = 50 = 7.07107.

6

B(e) = 100 e = 6e.

100

Since the cost function is C(e) = q 2 , the worker should maximize B(e) − C(e) which

gives e∗ = 3. Hence, the worker should exert 3 units of effort.

(b) With a fixed wage F , the worker exerts zero effort. This is because since wage is fixed,

marginal benefit for the worker from additional effort is zero. Since marginal cost of

effort is 2e, equating marginal benefit with marginal cost gives effort level ê = 0.

(c) Suppose the owner now hires the worker on a fixed-cum-variable pay scheme. To induce

the worker to generate optima effort of 3, the owner must provide the worker with the

3

full benefits of additional effort. Hence, if the worker, through additional effort generates

an additional profit of 100, he keeps the entire profit for himself. With this, the worker’s

wage as a function of effort will be

6

W (e) = F + 100 e = F + 6e,

100

where F is the fixed element in the compensation scheme. With this scheme, the worker’s

marginal benefit of effort is 6. Equating that with marginal cost 2e, we get e∗ = 3. The

worker therefore exerts optimal effort.

The owner now needs to fix F . To maximize profit, the owner makes the worker’s benefit

at e∗ = 3 equal to the cost of exerting that effort. Since c(e∗ ) = 9, we have

which gives F = −9. The interpretation of this negative number is that the worker needs

to pay the owner the fixed cost of 9 to work in the firm. This may be interpreted as the

rent or the commission the worker pays to the owner for “renting” the firm. The worker

then gets to keep all the profits of the firm after paying the “rent”.

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