UNIVERSITY OF CALIFORNIA

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1 UNIVERSITY OF CALIFORNIA IAS 106 FALL SEMESTER, 2003 Campus: Berkeley INTERNATIONAL AREA STUDIES PROGRAM Intermediate Microeconomic Theory Maximilian Auffhammer The Final Exam (Time: 180 Minutes) Instructions This exam starts at 12:30 pm and ends precisely at 3:30 pm. No extensions will be granted. For the true/false questions in part A, there is only one correct answer per question. Please circle the answer you think is correct. You will receive no credit for questions with multiple markings. Before you hand in the exam, make sure your name is marked clearly, as well as your student ID number. By taking this exam, you acknowledge that the use of outside materials, apart from pens and pencils, is not permitted during the exam. Before you start working, read the questions carefully. If you have any questions, ask! You can use either pencil or pen. If you would like me to your course grade to you by the end of the weekend, please initial here: Initials: Section A: or (2 points each) Circle the preferred choice. 1. The monopolistically competitive firm earns positive profit in the long run. 2. The monopolistically competitive firm can charge a large markup because there no close substitutes for its product.

2 2 IAS The monopolist will never operate on the inelastic section of the demand curve. 4. All monopolists earn a positive profit by setting MR = MC. 5. The Second Theorem of Welfare Economics states that any Competitive Equilibrium can be obtained given the proper redistribution of endowments 6. A risk averse person will refuse any gamble. 7. Monopolists, oligopolists, competitive and monopolistically competitive firms maximize profits by setting MR = MC. 8. Imposing a specific tax on a product produced by a monopolist will increase the deadweight loss. 9. The amount of market power exercised by firms in a market only depends on the elasticity of the demand curve. 10. A country has absolute advantage in the production of a good when its opportunity cost of producing that good is lower than for the other country. 11. If Cournot Duopolists can cooperate they will jointly produce monopoly output and get higher profits than if they could not cooperate.

3 3 IAS If a monopolist faces an inverse market demand curve P (Q) = 100 Q, his Marginal Revenue curve is MR(Q) = 50 2Q. 13. A risk neutral person will choose the outcome with the highest expected value. 14. International Trade may allow countries to consume outside their production possibilities frontier. 15. If in a pure exchange economy (no prices) at the endowment MRS Max > MRS Lori, we know that Max and Lori will trade to a point on the contract curve. 16. Economics is not as boring as I previously thought. (1 bonus point for honest answer)

4 4 IAS 106 Section B: Short Answer Questions (5 points each) Please answer these questions using no more than three or four sentences and/or a graph where required. 1. Name three sources of market failure. Public Goods, Externalities, Asymmetric Information, Market Power. 2. Explain why collusion (cartel behavior) is more likely in repeated games? Ability to signal and punish. 3. What do economists mean when they talk about market power? Define and briefly explain the concept. The ability to charge a price above Marginal Cost. 4. Give two examples of government created monopolies. Almost anything goes here. Anything where a patent or copyright law is used.

5 Section C: Longer Problems (50 points total) Use the given space for your calculations and short answers. 5 IAS Suppose there are two Cournot duopolists (firm 1 and 2) producing an identical type of processed cheese ( American ) and they are the only two firms in a well protected market. The inverse market demand curve they face is P (Q) = 200 Q, where Q is market output implying that Q = Q 1 + Q 2. The two firms are identical and have marginal costs of $40 (MC 1 = MC 2 = $40). Suppose you are a management consultant working for firm 1 and you know that if it believes that firm 2 won t produce anything, it will maximize profits producing 80 units of output. If it believes that firm 2 produces 160 units of output, its profit maximizing output should be 0 units. You also know that the other firm is identical to yours. Draw the two firms best response functions. Q 1 40? ? Q 2 What would be the profit maximizing output of each firm if you can cooperate? (Show graphically and give numbers). (40,40) (c) What would be the price taking outcome? (Show on the graph and give numbers). (80,80) (d) Show the non-cooperative Cournot outcome on your graph. See graph (?,?) (e) Which equilibrium is characterized by the largest amount of market power. Briefly explain The cartel outcome (40,40). They jointly produce the monopoly outcome, which has the largest markup given a specific demand curve.

6 6 IAS For the plastic garden chair industry, the greater the output, the more air pollution is produced (and hence the greater the social harm from pollution). [Hint: Assume that the private and external marginal cost curves are linear, upward sloping and start at the origin. You can also assume that the market demand curve is linear and downward sloping] On a graph, show the private and the social optimal outcome. MC s= MC p + MC e private P*=Price Floor P τ MC p MC e Q * Q private Q,G On a separate graph show how large τ, the specific tax rate, has to be to get producers of plastic chairs to produce the socially optimal amount. τ on graph above. (c) In a separate graph use a price floor to get a perfectly competitive market to produce the socially optimal amount of output. Price Floor on graph above.

7 7 IAS Jane, who works for Jane magazine, is spending her vacation in Hollywood. She hears a rumor that Brad Pitt may be attending the fancy nightclub chic that same night. Jane has $49 in her wallet. The cover charge to get into the club is $24. Her utility function is U = I, where I = wealth. If Brad Pitt shows up, Jane can sell a photo of him to her magazine for $32 and they will reimburse her for the $24 it took to get into the club. If he does not show up, she will have lost the cover charge. Is Jane risk loving, risk averse or risk neutral? Jane is risk averse since her utility function is concave. How high does the probability of Brad Pitt attending have to be for her to attend the club? Jane s Utility of the $49 with certainty is 49 = 7/ She will only accept a gamble if E(U) 7. She will get $82 if Brad shows up and $25 if he doesn t. E(U) = α 81 + (1 α) 25 gives us α 2. (c) What is the expected payoff (expected value) of the gamble from part? EV = 0.5 $ $25 = 53 (d) What is Jane s risk premium? $53 - $49 = $4

8 8 IAS 106 Section D: Bonus Question worth 10 Midterm Points. No partial credit is given. 1. Utility-maximizing prep school student Jonathan with smooth, convex indifference curves spent his entire allowance on Reeses (R) and M&Ms (M) last month. This month, the per-unit price of Reeses doubles and the per-unit price of M&Ms triples. Poor Jonathan complains to his parents, and as a result they immediately increase his allowance so that, if desired, he could purchase the same bundle this month as he did in the last. Are the following statements true, false, or uncertain? (Use a graph to illustrate your answers and explain your answers.) He eats more M&Ms and fewer Reeses than last month. Jonathan clearly paid diligent attention during his intermediate microeconomics class and his parents did not. He understands that price increases have a substitution and income effect. Since both prices increase he now faces a steeper budget constraint and a smaller opportunity set. By compensating Jonathan, he can now afford the original bundle. He will, however, substitute away from the original consumption bundle and make himself better off by consuming a few more Reeses and fewer M&Ms than before. Reeses a Compensated Consumption Point a/2 Price Effect Original Consumption Point Parent Effect I1 I2 b/3 b M&Ms He is just as well off as he was last month. He is better off than before, as shown in the picture above Happy Holidays! Thank you for making my first semester teaching here such a pleasant experience.