UBC

Managerial Economics: Commerce/ FRE 295

October 26, 2017

PART I. MULTIPLE CHOICE ANSWERS (Use letters A, B, C, or D.)

1. ____C____ 11. ___A_____

2. ____B____ 12. ___C_____
3. ____A____ 13. ___B_____
4. ____C____ 14. ___D_____
5. ____D____ 15. ___C_____
6. ____D____ 16. ___C_____
7. ____D____ 17. ___B_____
8. ____C___ 18. ___A_____
9. ____B____ 19. ___B_____
10. ___A___ 20. ___D_____

Total Multiple Choice Marks: ______ / 40

1
 PART I

MULTIPLE CHOICE QUESTIONS

1. In economics a “positive statement” is

A. A correct statement
B. A statement that incorporates value judgments.
C. A testable assertion of fact.
D. None of the above.

2. Assuming that demand curves slope down and supply curve slope up, which of the
following events would increase both the equilibrium quantity and price of a normal good
or service?

A. An increase in the cost of inputs to production.

B. An increase in the price of a substitute good.
C. A decrease in income.
D. None of the above.

3. The following diagram illustrates supply and demand shifts in the U.S. corn market. Before
the shifts, the market equilibrium is at e1. After the shifts, the new equilibrium is at e3.
Choose the statement that is most consistent with this diagram.

A. Supply has shifted out, putting upward pressure on quantity, but the shift in
demand has more than offset that effect and quantity has fallen.
B. Supply has shifted out, putting upward pressure on the price of corn, but the shift in
demand has more than offset that effect and price has fallen.
C. The supply shift and the demand shift reinforce each other (work in the same
direction) for both price and quantity.
D. None of the above.

2
4. A firm’s production function is given by q = K + L0.5.

A. This firm has increasing returns to scale in production.

B. For any positive values of L and K, the marginal product of labor and average product
of labor are equal.
C. This firm has diminishing marginal productivity of labor.
D. This firm’s average product of capital is constant and is equal to 1.

5. ABC Furniture purchased custom equipment two years ago for $100,000. The equipment
has no value to anyone else except for one other firm that has made a one-time-only offer
of $40,000 for the equipment. ABC is considering whether to accept this offer. Which of
the following statements is correct?

A. The sunk cost associated with the equipment is $40,000.

B. The opportunity cost of continuing to use the equipment is $60,000.
C. The opportunity cost exceeds the sunk cost in this case.
D. None of the above.

6. The following diagram shows an estimated cost function. What inference can we draw
from this estimation?

A. The implied average cost curve is U-shaped.

B. Marginal cost is well-approximated by a quadratic function.
C. In the underlying data, factors other than quantity have little effect on cost.
D. All of the above.

7. In the Portland Fish Exchange example from the textbook the estimated inverse demand
function is P = 1.96 – 0.15Q where P is dollars per pound and Q is thousands of pounds.

A. Increasing quantity from Q = 1 to Q = 2 decreases price by 0.15 percent.

B. Total sales revenue, R = PQ, is positive for all positive values of Q.
C. Demand is inelastic when Q = 5
D. Demand is elastic when Q = 5.

3
8. Kim wishes to test whether student height affects grades achieved in COMM 295. She
collects data and estimates Y = a + bX + e where Y is the student’s grade, X is the
student’s height, and e is a random error. Her estimate of b is -0.134 with a t statistic
of -0.457, and the R2 statistic is 0.014.

A. Student height has a statistically significant negative impact on grades.

B. About 99 percent of the variation in grades can be explained by student height.
C. Kim cannot reject the hypothesis that height has no effect on COMM 295
grades.
D. The estimated value of a is approximately equal to the average height of the
students.

9. Which of the following statements is true?

A. In order to become incorporated, a closely-held firm must make an initial public

offering (IPO) of its shares on an organized stock exchange.
B. Public sector enterprises do not have publicly traded stock.
C. One advantage of an initial public offering (IPO) is that it allows a firm to obtain the
benefits of limited liability.
D. A publicly traded firm cannot become closely-held or private.

10. A monopolist with a constant marginal cost of production of 10 maximizes its profit by
choosing to produce where the price elasticity of demand is –3.
(Recall that MR = p(1 + 1/ε) where MR is marginal revenue, p is price and ε is the point
price elasticity of demand.)

A. If price is decreased (from its profit maximizing level) by a small amount,

revenue of the monopolist will increase.
B. If the monopolist’s fixed cost increases, its profit maximizing price also increases.
C. The price set by the monopolist is equal to 30.
D. Since marginal cost is constant, both profit-maximizing and revenue-maximizing
quantities are equal.

11. Suppose there are 30 identical, perfectly competitive firms. In the short-run competitive
equilibrium, each firm is earning $500 in revenue, has variable costs equal to $400 and
fixed costs equal to $200. How many firms will there be in this industry in the long run?

A. Less than 30
B. 30 (the same amount)
C. More than 30
D. There is insufficient information to determine the answer.

4
12. A short-run competitive equilibrium is considered efficient because

A. Firms are earning positive profits

B. Consumer surplus is maximized
C. There does not exist an additional transaction that would make both a buyer
and seller better off.
D. All of the above

13. A computer hardware firm sells both laptop computers and printers. It has a large
inventory of laptops and printers that it wants to sell, so it has no variable production
cost. Assume that it has 3 customers and that these customers’ reservation prices are as
follows:

Laptop Printer Bundle

Helen $800 $100 $900
Isobel $1,000 $50 $1,050
James $600 $150 $750

A. The reservation prices are positively correlated.

B. The maximum profit from pure bundling exceeds the maximum profit from
separate (stand-alone) pricing by more than $200.
C. The maximum profit from pure bundling exceeds the maximum profit from separate
(stand-alone) pricing, but by less than $200.
D. Pure bundling provides no advantage over separate (stand-alone) pricing in this
case.

14. The following diagram shows demand and marginal cost for a monopoly firm. There are
no fixed costs.

A. Under perfect price discrimination, profit is A + B + D.

B. Under (imperfect) individual price discrimination, profit must exceed A + B + D.
C. If the firm could subdivide the market into two groups and price discriminate
between those groups, there would be no deadweight loss.
D. None of the above.

5
15. A buyer has an inverse demand function given by p = 90 – Q. In the following diagram,
panel (a) shows the consequences of nonlinear price discrimination (quantity
discrimination) if the firm charges $70 each for the first 20 units and $50 for any
additional units. Panel (b) illustrates profit-maximizing uniform monopoly pricing.
Marginal cost is constant at 30. There are no fixed costs. Identify the correct statement
(for this case) from the alternatives below

A. The buyer would prefer the nonlinear pricing structure to uniform monopoly pricing
in this case.
B. Nonlinear price discrimination is efficient in that total surplus is maximized.
C. Under profit-maximizing two part pricing, profit would exceed $1600.
D. Deadweight loss is higher under nonlinear price discrimination than under uniform
pricing.

16. Consider the Bertrand model with two firms producing identical products. Firm 1 has
constant marginal cost equal to $5 and Firm 2 has constant marginal cost equal to $10.
Which of the following statements is true?

A. The Bertrand-Nash equilibrium price is $10.

B. The Bertrand-Nash equilibrium price is $5.
C. In the Bertand-Nash equilibrium, Firm 1 will earn positive profits.
D. In the Bertand-Nash equilibrium, neither firm will earn positive profits.

17. In the model of monopolistic competition with symmetric firms, which of the following
statements is true?

A. Firms earn positive above-normal profits in the long-run

B. P > MC
C. There are significant barriers to entry in the long run.
D. None of the above.

6
18. Suppose a two-player static game has one pure strategy Nash equilibrium.

A. The Nash equilibrium might also be a dominant strategy equilibrium.

B. Because there is just one Nash equilibrium, there can be no dominant strategy
equilibrium.
C. The Nash equilibrium might involve a player choosing a strategy that is not a best
response to the other player’s strategy.
D. A dominant strategy equilibrium must be a prisoners’ dilemma outcome.

19. In the following payoff matrix, Coke and Pepsi have two choices available to them
regarding their advertising budgets. In each cell the number on the left is the profit of
Coke and the number on the right is the profit of Pepsi. Which of the following
statements is true?

Pepsi
Low High Advertising
Advertising
Low Advertising 100, 50 90, 55
Coke High Advertising 90, 40 95, 45

A. The unique Nash equilibrium is for both firms to use Low Advertising.
B. The unique Nash equilibrium is for both firms to use High Advertising.
C. There is more than one pure strategy Nash equilibrium in this game.
D. None of the above.

20. The payoff matrix below shows the payoffs for a Rock-Paper-Scissors game between
players Angela and Betty.

Angela
Rock Paper Scissors
Rock
0 0 -1 1 1 -1
Paper 1 -1 0 0 -1 1
Betty
Scissors -1 1 1 -1 0 0

A. There is no Nash equilibrium in this game.

B. There are multiple Nash equilibria in this game.
C. There is no maximin solution in this game.
D. There is a mixed strategy Nash equilibrium in this game.

7
PART II: Longer Questions

1. a) Supply and Demand: Suppose that the demand function for haircuts in a small town is
is Qd =500 – 30p, where Qd is quantity demanded per month and p is the price haircuts. The
supply function is given by Qs = 100 + 20p – 5w, where Qs is the quantity supplied and w is the
hourly wage of barbers. If the current equilibrium price is p = $9, calculate the prevailing
market wage rate of barbers. Illustrate in the diagram how an increase in the wage rate of
barbers affects the equilibrium price and quantity and state in words the direction of these
changes.

At equilibrium,
Qd = Qs
500 – 30p = 100 + 20p – 5w (1 pt. for using Supply= Demand)
50p = 400 + 5w
p = 8 + 0.1w (1 pt. for working)
If p = $9, then w = $10 (1 pt. for answer)

$
S (w2 > w1)

S(w1)
p1

p0

Q1 Q0 Quantity of haircut (Q)

Graph 2 pts:
(1 point for shifting supply curve to the left. 1 point for a statement in words. There are three things
to say: “the supply curves shifts inward”, “price increases” and “quantity decreases”. To get the
point the answer must contain two of those statements.

1(b) Cost curves:

A computer chip manufacturer has a short-run cost function that is given by C = 100 + 10q. For
this firm

𝜕𝐶
Marginal cost (MC) = = 10 (1 pt)
𝜕𝑞
Average variable cost (AVC) = 10q/q = 10 (1 pt)
𝐶 100+10𝑞 100
Average (total) cost (AC) =
𝑞
= 𝑞
= 𝑞
+ 10 (1 pt)

Draw these curves in the following diagram.

8
 $

ATC

10 MC = AVC

Graph 2 points:
1 pt for correct MC and AVC (horizontal line at 10). 1 pt for correct AC curve. It must slope down as
shown and approach the horizontal line as q gets very large.

9
2. Regression

a) Suppose the data in the four scatterplots below is used to estimate the following linear
regression: Y = a + bX + e where Y is CEO salary and X is one of four explanatory variables.

A CEO Salary ('000s $) B CEO Salary ('000s $)

XA XB

C CEO Salary ('000s $) D

CEO Salary ('000s $)

XD
XC

Use a √ (check mark) to identify which regression (A, B, C or D) is expected to:

Make one choice per row.

(i) Have the highest R2 A□ B□ C□ D

(ii) Have an estimate of b that is closest to zero A□ B□ C D□

(iii) Should be estimated with a quadratic, Y = a + bX + cX2 + e A□ B C□ D□

(iv) Have a negative value for the estimated intercept, a. A B□ C□ D□

(v) Which of the four scatterplots is most likely to have a very large standard error for the

estimate of b? (Either A or B is acceptable.) A  B C □ D □

1 pt for each correct response.

10
b) There are four X axis variables associated with the four scatterplots in part (a):
CEO Age (ranging from 30 to 75) Number of Employees in CEO’s Firm
Number of Cousins that CEO has Last Year’s Salary for the CEO

Your task is to choose the best match of these four explanatory variables with the four graphs
based on what we might expect to see in the real world.
Make one choice per row.

(i) Best match for CEO Age (ranging from 30 to 75) A□ B C□ □

D

(ii) Best match for Number of Employees in CEO’s Firm A B□ C□ D□

(iii) Best match for Number of Cousins that CEO has A□ B□ C D□

(iv) Best match for Last year’s salary for the CEO A□ B□ C□ D

Based on the information provided in both parts of this question, indicate the multivariate
regression equation that you would propose using to estimate the determinants of CEO
salaries.

The answers to the questions above imply that the estimated coefficient on the “Number of
Cousins” variable is not statistically different from zero. This is equivalent to concluding that
“Number of Cousins” does not have a causal effect on CEO salary. For this reason the “Number of
Cousins” variable should not be included in the regression.

It should also be clear that the “CEO Age” variable should enter the regression as a quadratic
since the salary scale flattens out for older CEOs.

The multivariate regression equation should therefore be

Y = a + b1XA + b2XB + b3XB2 + b4XD + e where: XA is “Number of Employees”, XB is CEO age and XD is
last year’s salary of the CEO.

To receive a mark of 1 the regression equation must not include the number-of-cousins
variable and must include a squared CEO age variable.

11
3. a) Monopoly. Assume that Christy owns a factory that produces a specialty on-line service
in a small town. The inverse market demand function for her product is given by p = 240 – 4Q.
The cost function is C = 40Q + Q2. Calculate Christy’s profit-maximizing price and quantity.
Illustrate your results in a well-labeled diagram. Also calculate Christy’s profits. (You do not
need to illustrate the amount of profit on the diagram.)

MC =40 +2Q
p = 240 – 4Q
MR = 240 – 8Q

A monopoly maximizes profits where

MR = MC
240 – 8Q = 40 + 2Q (1 pt.)
Q = 20 and (1 pt)
p = 240 – 4*20 = $160

Profits = 160*20 – (40*20 + 202) = $2,000 (1 pt.)

240

MC
p=160

40
MR D

Q =20 30 60 # of bikes (Q)

Graph 2 points:
There several important features for the graph:
i) the demand curve should be a downward sloping line with a vertical intercept of 240.
ii) the MR curve should be a downward sloping line with a vertical intercept of 240 and be twice as
steep as the demand curve.
iii) the MC curve should be an upward sloping line with a vertical intercept of 40.
iv) the solution of Q = 20 occurs directly under the intersection of MC and MR.
v) the solution of p = 160 is, as shown, obtained from the point on the demand curve directly above the
point where MC = MR.
vi) the graph should indicate that the solution values are 160 for price and 20 for quantity.

To get one point, three of these elements must be present and correct.
To get two points all major elements should be present.
12
b) Managerial Objectives. Now assume that Christy hires Paul to manage her firm. Upon
Paul’s insistence, Christy agrees to pay Paul 25% of the firm’s revenue. Assuming that Paul
maximizes his own income, calculate the quantity he decides to produce. What is Paul’s
compensation under this scheme? If Christy wants to use a profit-sharing contract (instead of
revenue sharing), what percentage of profits must she offer Paul so that he is at least as well
off under profit-sharing as under revenue-sharing?

Paul maximizes 25% of revenue which occurs at the same level of Q as with maximizing revenue.
Revenue is maximized where
MR = 0
240 – 8Q = 0 (1 pt. for setting MR = 0.)
Q = 30 (1 pt. for Q = 30)
R = (240 - 4Q)Q = (240 – 4*30)30 = $3,600
Paul’s income/compensation = 25% of 3600 = $900. (1 pt. for compensation = 900)

Assume Paul gets fraction x of profits under profit sharing. Then for Paul to be as well off as with
revenue sharing share x of profits must equal at least 900: xπ = 900. If Paul get a share of profit he
will choose output to maximize profit so profit will be 2000.

Therefore x(2000) = 900 so x = 900/2000 = .45 = 45%.

1 pt for recognizing that xπ = 900 and 1 pt for the correct answer.

13
4. Perfect Competition

Assume that the concentrated orange juice industry is perfectly competitive. There are 50
identical firms. Each firm has the following total cost function in the short run and the long
run: C (q) = 36+11q+q2 where q is quantity measured in tons of concentrated orange juice. Do
your working in the blank area after each part of the question: 1 mark for each entry.

i) The marginal cost function for each firm is ____MC = dC/dq = 11+2q_________________. It

follows that the equation for the firm’s supply function is

We start by getting the inverse supply function by replacing MC with p in the above equation to

obtain p = 11 + 2q. The we solve for q to get the supply function: _q = -5.5 + 0.5p (p=11+2q_is ok,

although that is the inverse supply function), provided price exceeds average variable cost.

(Hint: The supply function shows q as a function of P).

ii) The average variable cost function for each firm is ____AVC = 11+q__________________. It

follows that firms will shut down in the short-run if the market price is less than

$____11____________. (If you draw AVC and MC on a diagram you will see that p > AVC for any p >

11. If p < AVC the firm cannot cover variable costs as p < AVC for any quantity.

iii) The average (total) cost function for each firm is ____AC = 36/q + 11 + q______________. It

follows that the each firm will exit the industry in the long run if the market price is less than

$___23__________ . (Solve for this using the long run equilibrium condition that MC = AC under

perfect competition. The firm’s quantity must be 6 and MC = AC = 23 at that point. If price was

less then firms would not operate in the long run. )

iv) Suppose that market demand is given by Q = 445 –5P. The long run industry equilibrium

quantity is ____330___________ and the price is ______23___________. (In the long run price = min AC,

which is where MC = AC = 23. Therefore Q = 445 – 5(23) = 330

v). In the long run there are ___55______ firms and each firm produces quantity ____6_____.

As q = 6 (see above) it follows that n = 330/6 = 55. (At first – in the short run – there are 50 firms
but that must change in the long run.)

14
5. Pricing With Market Power

a) Jason’s sandwich shop is trying to come up with a strategy to price the two items it sells for
lunch: soup and sandwiches. The table below shows the willingness to pay (reservation
prices) for four consumers that buy lunch at Jason’s. Assume costs are zero.

Consumer Soup Sandwich Bundle

Aphrodite 2 9 11
Apollo 9 2 11
Athena 7 8 15
Artemis 8 1 9

Fill in the bundle column showing each person’s maximum willingness to pay for the bundle,

Jason’s maximum profit if he uses separate (stand-alone) pricing is ____37_________ and he sells

____3_______ bowls of soup and ______2________ sandwiches.

Jason’s maximum profit if he uses pure bundling is ____36_______ and he sells ____4_____ bundles.

CORRECT ANSWER:

If Jason uses mixed bundling, he earns ____40________ by charging ______8____ for soup, ___9_____

for sandwiches and _____15______ for the bundle.

Marking:

1 pt for filling in the bundle values in the table correctly. All four values must be correct.
1 pt for correct profit under stand-alone pricing (37).
1 pt for get BOTH quantities for stand-along price (3 and 2).
1 pt for the profit AND quantity for pure bundling (36 and 4)
1 pt for getting profit and all three prices for mixed bundling (40, 8,9, and 15).

15
 b.) Squamish White Water (SWW) sells white water canoeing adventures. Daily inverse
demand in the summer is given by p = 160 – q. In the winter, daily inverse demand is given by
p = 100 – 2q. Marginal cost is 20 in both seasons and there are no fixed costs. SWW has 60
canoes (one person per canoe) so its daily capacity is 60.

SWW uses profit-maximizing peak load pricing. The diagram below illustrates this situation.
Calculate the intercepts where the dashed lines reach the axes and put them on the diagram
and label the lines on the figure.

DW = demand in winter
MRW = MR in winter
MC
DS = demand in summer
MRS = MR in summer

2 pts for diagram. One point for all 100

intercepts (100, 60, 20, and 60) and
one point for correct labels for MC
and for demand and MR curves. 60
DW
DS
MRS

MRW

20 60

Now SWW’s canoe supplier offers SWW a special arrangement. It will give additional canoes
to SWW if SWW pays the supplier $5 for each canoe ride taken in one of those additional
canoes. Therefore, MC = 20 + 5 = 25 for these additional canoes. Do not change the above
diagram but state in words how this would affect the diagram and state how many additional
canoes SWW would want to take on this basis.

The two main changes to the diagram would be:

i)__The vertical line representing the capacity constraint would disappear (1 pt)

ii)__At q = 60 the MC curve would jump up to 25 and continue horizontally from there. (1 pt)

SWW would take ___7.5__(1 pt) (7 or 8 is ok)_ additional canoes on this basis from the supplier.

Show your working below. For q > 60, MC is now 25. For summer, setting MR = MC = 25 yields
160 – 2q = 25 so q = 67.5. Therefore, SWW would want 7.5 more canoes.

16
6. Duopoly

Consider a market for a homogenous product with linear demand and two identical Cournot
duopoly firms, Firm 1 and Firm 2. The marginal cost of production for each firm is constant
and is equal to $20. Market demand is given by inverse demand function P = 200 – 2Q where P
is the market price and Q is total production by the two firms (i.e., Q = q1 + q2).

a. Find the best response functions of the two firms and illustrate them in an appropriate
diagram. Label the Cournot-Nash Equilibrium quantities on your diagram. Put Q1 on the
horizontal axis, put numbers for intercepts on the axes and indicate which best response
function applies to each firm.

For Firm 1, revenue is given by R=PQ1=(200-2q1-2q2)q1. This implies

MR1=200-2q2-4q1. (1pt)

Set MR equal to MC and solve for q1 to get Firm 1’s best response function: 200-2q2-4q1 = 20.
q1=45-0.5q2. (1 pt)

As Firm 2 is symmetric to Firm 1, Firm 2’s best response function is given by q2=45-0.5q1.
Solving simultaneously we get the Nash-Cournot equilibrium quantities: q1 =q2=30. (1 pt)

The diagram is worth 2 pts. The required elements are:

i) the best response functions should be straight lines as shown.
ii) the best response functions should be correctly identified (the steeper one is for Firm 1)
iii) the intercepts (45 and 90) should be correctly shown.
iv) the Cournot equilibrium should be identified and the solution values (30, 30) should be
shown.

Give 1 pt if any two items are correct and give 2 pts is all 4 are correct. If solution values are
incorrect and those incorrect values are on the diagram they still get points for the diagram.

17
b. Calculate the level of output for each firm if they decide to collude to produce the monopoly
quantity. Assume that each firm produces exactly half of this output. Mark this point on your
diagram above and explain below why this point is not a Cournot-Nash Equilibrium. (5 pts)

A cartel faces inverse demand equal to P=200-2Q. This implies R=(200-2Q)Q and MR=200-
4Q. Setting MR=MC we get Q=45 which implies q1=q2=22.5. (1 pt for answer and 1 pt for
method.) If this point is correctly shown on the diagram that is 1 pt. The explanation is worth 2
pts. The main idea is that each firm has incentive to cheat (1 pt) by producing more output if
they are at the cartel output levels. Any comment about an incentive to cheat gets this point. A
more complete answer such as saying that we know firms have an incentive to cheat because
they are not on their best response curves is needed for the second point.

18
7. Static Games

a) Each of two neighboring cities (Newtown and Oldtown) are simultaneously deciding
whether to allow a multinational firm to build a large casino on city-owned vacant land in
their city. The firm would be happy to build casinos in both cities if allowed to do so.

Newtown
Allow Casino Disallow Casino
Allow Casino X, Y 120, 85
Oldtown
Disallow Casino 85, 120 100, 100

Assume X = Y < 100. What is the minimum value for X (and Y) that make this game a
prisoners’ dilemma. Explain briefly.

The answer is X = Y > 85. (Give credit for saying “85” or “86” or “above 85”.) (1 pt)

If X = Y > 85 then “Allow Casino” is a dominant strategy for both cities. As X = Y < 100 the
dominant strategy solution (upper left corner) is worse for both cities than if they both disallow
the casino so both necessary conditions for a Prisoners’ dilemma are satisfied. (1 pt).

Now suppose Y = 80 (and X is no longer necessarily equal to Y or less than 100). What range
of non-negative values for X would lead to two pure strategy Nash equilibria? Explain briefly.

If Y = 80 and 0 < X < 85 then solving the game reveals that it has two pure strategy Nash
equilibrium: (1) Oldtown allowing the casino and Newtown not allowing the casino; and (2) vice
versa.

1 point for identifying 0 ≤ X ≤ 85 as the correct range of values (X < 85 is sufficient). 1 point for
solving the game and demonstrating that two Nash equilibria exist for X ≤ 85.

If both cities disallow the casino, each gets a payoff of 100. What do you think this value might
represent?

The 100 might represent the value of the vacant land in an alternative project (e.g., a new
community center). (1 pt). It is fine to say just “the opportunity cost” of the land.

19
 b) Once again suppose Oldtown and Newtown are simultaneously choosing whether or
not to allow a multinational firm to build a large casino in their city. The two cities face a
coordination problem because each city wants a casino but only if the other city does not
have a casino. If both cities have a casino then both will get lower benefits because of
insufficient demand. This situation is illustrated by following payoff matrix.

Newtown
Allow Casino Disallow Casino
Allow Casino 50, 70 120, 85
Oldtown
Disallow Casino 85, 130 100, 100

The Pareto criteria [DOES DOES NOT] (1 pt) (circle one) help us predict which of the two
cities will end up with the Casino because

There are two Nash equilibria in this game but neither one is preferred by both cities.
(1 pt)

Suppose that the two cities are able to engage in pre-play communication and suppose
further that it is possible to sign an agreement in which one city can pay compensation to
the other city for agreeing not to build a casino. Which city is likely to pay the
compensation (and then build the casino) and which city is likely to receive the
compensation (and not build the casino)?

CITY THAT BUILDS is (circle one): Oldtown Newtown (1 pt)

because if Newtown allows the casino and Oldtown does not allow the casino, then the
combined benefit is 85 + 130 = 215, which is more than in the reverse situation (120 + 85 =
205) or than in the other two possibilities. Therefore, there is more total surplus to divide
up in this case. (1 pt).

I would expect the amount of compensation paid under this agreement to be in the range
between _________ and ___________ . (See answer below)

because _________________________________________________________________________________________________

This is a hard question and any logical answer gets a point. The only requirement is that the
explanation be consistent with the numbers chosen. One possible answer is as follows. If
compensation is possible then the two cities are, in effect, just dividing up the total payoff. The
total payoff in this case is 130 + 85 = 215. As the two cities are nearly symmetric, it is plausible
that they might split the payoff. Then both players would get 107.5. That would require
compensation of 22.5 (as 85 + 22.5 = 107.5 and 130 – 22.5 = 107.5). A reasonable range might
be 20 to 25.

Compensation should never exceed 35. In the basic game, the best possible outcome for Oldtown
would be 120. If compensation equals 35 then Oldtown gets this amount and it gets a lot more
than Newtown (which gets 130 – 35 = 95). It is hard to see how reasonable bargaining could
result in a higher return to Oldtown. A range completely above 35 does not get a point.
20