UBC

Managerial Economics: Commerce/ FRE 295

October 27, 2016 – Marking Guide

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

your answers here. Multiple choice answers placed elsewhere will not be marked.

1. ____D___ 11. ___C____

2. ____B___ 12. ___D____
3. ____C___ 13. ___A____
4. ____D___ 14. ___C____
5. ____B___ 15. ___A____
6. ____D___ 16. ___D___
7. ____A___ 17. ___C____
8. ____A___ 18. ___D____
9. ____C___ 19. ___A____
10. ___B____ 20. ___C____

Total Multiple Choice Marks: ______ / 40

PART II. Marks for Longer Questions. DO NOT fill in the box below. It is for use by
markers. Put your answers in the indicated place on each page.

Question 1. ________ THIS BOX IS FOR USE BY MARKERS ONLY

Question 2. ________
Question 3. ________
Question 4. ________
Question 5. ________
Question 6. ________
Question 7. ________

Total Longer Question Marks: ________ / 60

Overall Mark: ____________/ 100

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 PART I

MULTIPLE CHOICE QUESTIONS

1. Economic theories normally (but not always) assume that all decision markers attempt to
maximize their well-being subject to constraints created by scarcity. When individuals make
decisions subject to such constraints,

A. Their marginal cost is higher than their marginal benefit.

B. They are forced to ignore opportunity costs.
C. They fail to make rational decisions.
D. They face trade-offs.

2. Suppose the price of peanuts (the major input for peanut butter) increases. In addition, a new
study showing negative health effects of peanut butter is published. The equilibrium market price of
peanut butter falls. In explaining this price change, which of the following statements about the
peanut butter market is correct? (Note: “outward” means “shift to the right” and “inward” means
“shift to the left”.)

A. The outward shift of the demand curve more than offsets the inward shift of the supply curve.
B. The inward shift of the demand curve more than offsets the inward shift of the supply
curve.
C. The outward shift of the supply curve more than offsets the inward shift of the demand curve.
D. The movements of the supply and demand curves both put downward pressure on price.

3. Suppose that consumers suddenly develop stronger preferences for apples. The price of apples
will not change if

A. The price elasticity of demand is zero.

B. The demand curve has unitary price elasticity.
C. The supply curve is perfectly elastic.
D. None of the above.

4. Suppose you use a linear regression to estimate the relationship between the monthly quantity of
snow shovels sold in Canada (dependent variable) and the monthly number of Canadians who travel
to Hawaii (explanatory variable). You discover that the relationship is positive and statistically
significant, and the R2 value is 0.46. It is reasonable to conclude that:

A. Travelers to Hawaii tend to take snow shovels with them.

B. People often use purchased snow shovels to earn extra money to pay for trips to Hawaii.
C. Reverse causality is confirmed because R2 < 0.5.
D. A third (omitted) variable that has a positive effect on travel to Hawaii is positively
correlated with the explanatory variable.

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5. The estimated coefficient of each explanatory variable in a linear regression has a standard error.
The standard error is a measure of:

A. The fraction of variation in the dependent variable that is explained by variation in the
explanatory variable.
B. How much the estimated coefficient would vary when estimating the relationship with
repeated samples from the same population.
C. The inverse of the t-statistic for the estimated coefficient.
D. All of the above.

6. The average variable cost of producing windows is given by AVC = 5 + 0.04q. The total cost of
producing 100 windows is 1275.

A. Marginal cost is given by MC = 5 + 0.08q.

B. Fixed costs equal 375.
C. The total cost of producing 50 window is 725.
D. All of the above.

7. The table below shows the number of solar panels that GreenGo Inc. produces each day using
various combinations of labour (L) and capital (K). The underlying production function has both:

K=1 K = 1.5 K=2

L=1 5 10 14
L = 1.5 10 14 17
L=2 14 17 19

A. Diminishing marginal returns to labour and increasing returns to scale.

B. Constant marginal returns to labour and increasing returns to scale.
C. Diminishing marginal returns to labour and decreasing returns to scale.
D. Constant marginal returns to labour and decreasing returns to scale.

8. A start-up firm calculates that it is profitable to invest $70 million in specialized equipment and
begin production only if the expected future price of oil is $100 per barrel or higher. After the
investment is made, the firm has operating costs of the form C = F + cQ. Both the fixed cost (F) and
variable cost are avoidable if the firm shuts down. The firm calculates that, once it starts operating,
it will shut down only if the price of oil drops below $50 per barrel. This situation likely means:

A. A significant fraction of the $70 million investment was a sunk cost.

B. The firm is ignoring economic profit and is basing its shut-down decision on accounting profit.
C. Average variable cost must be above $50 per barrel at the output that maximizes profit.
D. Average avoidable fixed cost (F/Q) equals 50 at the profit-maximizing output.

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9. Which of the following changes in a firm’s situation would necessarily imply that the firm moved
from having unlimited liability to having limited liability?

A. Changing from non-profit status to profitable status.

B. Undertaking an initial public offering.
C. Changing from a sole proprietorship to a corporation.
D. Moving from the public sector to the private sector.

10. You use regression analysis to estimate a firm’s revenue function as R = 20q – 2q2 and you have
determined that MC is constant at 10. Donald, the CEO of the company, receives compensation
equal to 10% of total revenue and therefore chooses output to maximize his compensation. The
shareholders would prefer to maximize profit.

A. Donald and the shareholders have consistent (aligned) objectives.

B. Donald chooses twice as much output as the shareholders would like.
C. The demand function is quadratic.
D. None of the above.

11. Lelu runs a perfectly competitive firm that grows almonds. Her short-run cost function is given
by C(q) = 144 + 25q + q2, where q is measured in tons of almonds. Fixed costs are unavoidable in
the short run.

A. If the market price is $75 per ton, Lelu will sell 30 tons.
B. If price equals 30, profits are zero.
C. If price is 27, she should continue to produce in the short-run.
D. If price is 45, she should continue to produce in the long-run.

12. How much profit will a monopolist whose cost and demand curves are shown below earn at
output Q1? (Note, ATC is the same as AC and AR stands for average revenue.)

A. 0CDQ1
B. ACDF
C. 0BEQ1
D. BCDE

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13. You work as a marketing analyst for a pharmaceutical firm. A competing firm has a patent on a
popular medication that currently sells for $20 per dose. Your firm is considering acquiring this
rival and wants to determine whether the rival’s profitability can be increased by changing the price.
You estimate the rival's current price elasticity of demand as -0.8 and believe that its demand curve
is approximately linear. You also believe that its marginal cost is about 10. What conclusion should
you draw?

A. Profit could be increased by raising the price.

B. Profit could be increased by lowering price.
C. The rival is maximizing profit.
D. Profits can be increased only if costs can be reduced.

14. A consumer has a demand curve 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 sold. Panel (b) illustrates
profit-maximizing uniform monopoly pricing. Marginal cost is constant at 30. Identify the correct
statement (for this case) from the alternatives below.

A. Uniform monopoly pricing generates less consumer surplus than nonlinear price discrimination.
B. Profits are higher under uniform pricing.
C. Under nonlinear price discrimination the deadweight loss is $200.
D. Deadweight loss is less under uniform pricing.

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15. The following diagram is related to two-part pricing.

Assume that consumers are identical and that each consumer has the demand curve shown in each
panel above. Which of the following statements is true?

A. The panel on the left illustrates that charging a per-unit price of 10 and an access fee of
$2,450 maximizes profit of the firm.
B. The panel on the right illustrates that charging a per-unit price of 20 and an access fee of $1800
maximizes profit for the firm.
C. Perfect price discrimination would generate the same profit as implied by the panel on the right.
D. The two panels together illustrate the point that there are many different combinations of an
access fee and per unit price that would maximize profit.

16. Consider a Bertrand duopoly with two firms selling identical goods. Firm 1 has a constant
marginal cost equal to $10 and Firm 2 has a constant marginal cost equal to $7. There are no fixed
costs. Assume there are 100 consumers who will each purchase one unit from the firm offering the
lower price. Each firm’s price must be a whole dollar number ($7 or $8 or $9, etc.) If the firms
offer the same price, then they will split the demand equally. Which statement below best describes
the Nash-Bertrand equilibrium of this game?

A. Both firms will set their price equal to $10.

B. Both firms will earn zero profits.
C. Firm 1 will set its price equal to $10 and Firm 2 will set its price equal to $7.
D. Firm 2 will earn $200 in profit.

17. The most important reason cartels are illegal is probably that

A. A successful cartel makes more profit than a monopoly firm.

B. Cooperative agreements among firms are difficult to enforce.
C. Reduced competition among firms is often harmful to consumers.
D. The government does not like businesses to earn too much profit.

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18. The following diagram is related to monopolistic competition with symmetric firms.

A. This diagram shows a firm-specific demand curve and industry marginal cost curve.
B. This diagram shows the industry demand curve and the firm’s short run marginal cost curve.
C. This diagram implies that MR would be positive at the quantity that minimizes average cost.
D. None of the above.

19. A Nash Equilibrium is characterized by

A. A set of strategies, one for each player, such that no one player can improve its payoff
holding constant the strategies of the other players.
B. A set of strategies, one for each player, such that combined payoffs are maximized.
C. An outcome such that no other possible outcome is better for all players.
D. All of the above

20. Consider the following game where William and Kate must decide simultaneously, and without
observing each other’s choices, where to go on Friday evening.

Kate
Polo Opera
Polo 2,1 0,0
William
Opera 0,0 1,4

In this case there are two Nash Equilibrium. Which of the following statements is true?

A. William and Kate can maximize their expected payoffs by choosing mixed strategies.
B. According to the Pareto Principle, William and Kate will coordinate on the outcome that
maximizes the sum of their payoffs; in this case, going to the Opera
C. If William can send a message to Kate before the game then they can coordinate their
actions on a single location.
D. All of the above.

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 Part II

LONGER QUESTIONS

Choose 6 questions out of 7. If you do all 7 questions the last question will not be marked. Each
question is worth 10 marks. Show your working and provide (brief) explanations where appropriate.
Confine your answers to the space provided in the question. In all diagrams label the axes and put
numbers for intercepts and solution values on the diagram.

1. Supply and Demand

a) The demand function for avocados is Q = 200 - 40P. The supply function Q = 50 + 10P - 20Pf
where Pf is the price of fertilizer. How much do the price and quantity change if the price of
fertilizer rises from $2.50 to $4.00? Illustrate this change in the diagram. (Your diagram does
not need to be precisely drawn, but show the equilibrium prices and quantities on the axes.) (5
pts)

When Pf = 2.50, supply function Q = 50+10P - 20*2.5 = 10P

At equilibrium with Pf =2.5,

200 – 40P = 10P $
P = $4.0
Q = 10*4 = 40 5.0
S (Pf =4)
When Pf = 4, Q = 50 +10P – 20*4 = - 30 +10P

At equilibrium with Pf = 4,
200 – 40P = - 30 + 10P 4.6 S (Pf =2.5)
P =$4.6
Q = - 30+10*4.6 =16 4.0

(Some students may derive: P = 3+0.4Pf and D

Q = 80 – 16Pf and then substitute the values of Pf
to calculate P and Q)
16 40 Avocado (Q)

b) Derive an algebraic expression for price of avocados as a function of the price of fertilizer. Does
the point price elasticity of demand for avocados change when the price of fertilizer changes.
Explain briefly. (Hint: use the definition of elasticity, ε = (dQ/dP)(P/Q) in your answer.) (5 pts)

In equilibrium, Qd = Qs
200 - 40P = 50 + 10P - 20Pf
P = 3+0.4Pf
Q = 80 – 16 Pf

ε = (dQ/dP)(P/Q). For a linear demand curve, as in this case, dQ/dP is constant. Therefore, if
P/Q changes then ε changes. In this case, P/Q = (3+0.4Pf)/(80 – 16 Pf) which changes as Pf
changes.

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2. Regression Analysis

The law of diminishing marginal returns implies that as more and more fertilizer is applied to a plot
of land the yield of an irrigated crop will increase but at a diminishing rate. You are interested in
testing this theory so you run an experiment and estimate a quadratic production function of the
form Q = a + bX + cX2 + e where Q is crop yield, X is the amount of fertilizer applied and e is a
random error term. You obtain the following results.

a b c
Estimate 10.41 0.627 -0.034 R2 = 0.820
t-statistic 14.556 2.491 -1.631

a) Notice that b takes on a positive value and c takes on a negative value. Are these signs in
agreement with the law of diminishing marginal returns? [Circle one: YES / NO]. Explain briefly.
(3 pts)

Yes. (1 pt) The marginal product of fertilizer application is given by dQ/dX = b + 2cX. (1 pt).
A negative value for c indicates that this marginal product gets smaller as X gets bigger (1 pt),
as is consistent with the law of diminishing marginal returns. .

b) Do you have enough statistical evidence to conclude that the law of diminishing marginal returns
holds for this particular case? [Circle one: YES / NO]. Explain briefly. (3 pts)

No. (1 pt) The estimate of the c coefficient is not statistically significant since the absolute t
value of 1.631 is well below the level (approximately 2) that is required for statistical
significance. (1 pt). Therefore c = 0 is a significant possibility in which case the production
function would be linear and therefore not subject to the law of diminishing marginal returns
for X.

c) Your friend says that it is better to estimate a linear production function, Q = a + bX + e, in order
to test for the law of diminishing marginal returns. Your friend is [circle one: CORRECT /
INCORRECT]. Explain briefly. (2 pts)

Incorrect. ( 1pt). Even though your estimate of c is statistically insignificant, estimating a

linear production function (i.e., omitting cX2) does not allow you to test for diminishing
returns since you are forcing the production relationship to be linear. (1 pt)

d) Another friend tells you that your results have little value because over 80% of the variation of
crop yield in your data is probably explained by random events such as disease, rainfall, insect
damage and frost. This friend is [circle one: CORRECT / INCORRECT]. Explain briefly. (2 pts)

Incorrect. (1 pt) The R2 measure of 0.82 (82%) means that 82 percent of the variation in Q
can be explained by variation in X and X2. Therefore, other factors, such as those listed,
account for only about 1 - R2 = 18 percent. (1 pt)

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3. Perfect Competition

The canola oil industry is perfectly competitive. There are 100 firms. Each firm has the following
total cost function: C (q) = 0.5q2 + 2q + 5, where q is quantity measured in tons of canola oil.

a) (3 pts) The marginal cost function for each firm is ___MC = q + 2 _(1 pt). It follows that the

equation for the firm’s supply function is _q = P – 2, (2 pts) provided price exceeds average

variable cost. (The supply function shows q as a function of P).

(1 pt if the answer is P = q + 2. Or 1 pt for working that indicates that the supply function is

the same as the marginal cost curve for a perfectly competitive firm.)

b) Suppose that market demand for canola oil is given by: Q = 550 – 25P. Find the equilibrium
price and quantity. (3 pts) (Recall that there are 100 firms.)

Because there are 100 firms, QS = 100q = -200 + 100P. (1pt)

Set supply equal to demand: -200 + 100P = 550 – 25P. (1 pt)
Therefore the solution is P = 6 and Q = 400. (1 pt)

c) How much does each firm produce? (2 pts)

q = Q/100 = 4 OR q = 6 – 2 = 4. (1 pt for the method and 1 pt for the answer.)

d) This industry [circle one IS / IS NOT] in long run equilibrium. Explain briefly. (2 pts)

The industry IS NOT in long run equilibrium. (1 pt) The reason is that profits are positive:

Profit = (p - AC) q where AC = .5q + 2 = 3. Therefore Profit = (4 – 3)2 = 2. (Or could calculate

profit = R – C.) (1 pt for any answer the correctly determines that profit = 2 or that P > AC.

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4. Monopoly

Suppose that you are the CEO of Bellco, a wireless communications company located in a city
surrounded by mountains from all sides. Only your company can provide cellular phone service for
local consumers. The daily inverse demand function for wireless service is given by: P = 22 – 5Q,
where P is the price per hour in dollars and Q is in hours. Marginal cost is constant at $2 per hour
and the firm has daily fixed costs equal to $10.

a. Calculate the profit maximizing price (per hour) and quantity and the resulting profit. (3 pts)

P = 22 – 5Q so MR = 22 – 10Q. Setting MR = MC yields 22 – 10Q = 2 so Q = 2 (1 pt)

P = 22 – (5 x 2) = 12 (1 pt)
Profit = R – C = (12)(2) – (10 + 2(2)) = 10. Or Profit is (P – AC)Q = (12 – 7)(2) = 10.

b. Show your answer (including price, quantity, and profit) in a clearly labelled diagram and
calculate the daily inefficiency (deadweight loss) associated with this monopoly relatively to perfect
competition. (4 pts)

30
28
26 Demand
24
MC
22
20 AC
18
16 MR
14 DWL = 10
Price = 12 12
10
8
6
Profit = (12-7)5 = 10 4
2
0
0 1 2 3 4 5
Quantity

Quantity = 2

c. Determine the daily profit and deadweight loss if Bellco is able to use perfect price
discrimination. (3 pts). Explain briefly.

If Bellco uses perfect price discrimination, the daily profit is the area of the triangle defined
by 22 on the vertical axis, 2 on the vertical axis, and quantity 4 (where P = MC) MINUS the
fixed cost of 10. This is (1/2)(20)(4) – 10 = 30. The deadweight loss is 0. In this case the firm
extract all surplus so consumers get nothing and there is no deadweight loss.

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5. Bundling

The following table provides willingness to pay information (i.e. reservation prices) for 3
consumers who are considering taking a holiday in the Okanagan. The consumers may book hotel
rooms and one possible activity is a wine-tasting tour. These are the only consumers and marginal
cost is zero for both products. A travel agency is considering whether to use stand-alone pricing
(selling the products separately), pure bundling, or mixed bundling.

Wine Hotel Bundle

Tour
Xavier 150 100 250
Yolanda 125 200 325
Zara 100 300 400

a. With stand-alone pricing, the profit-maximizing prices and profits are as follows. (3 pts)

Wine price = 100 ( 1 pt)

Hotel price = 200 (1 pt)
Profit for wine = 3 x 100 = 300, Profit for hotel = 2 x 200 = 400. (1 pt)
OR could say total profit is 700 for 1 pt.
If just Profit = 3 x 100 + 2 x 200 = 700 that is okay for 2 pts out of 3.

b. With pure bundling, the profit-maximizing price and associated profits are as follows. (3 pts)

Bundle price = 250 (1 pt), Profit = 3 x 250 = 750 (2 pts).

c. Consider a mixed bundling strategy with a price of $400 for the bundle, $125 for the wine tour,
and $200 for the hotel. Will this raise profits relative to pure bundling? (Circle one: YES / NO/
INDETERMINATE). Explain briefly. (2 pts) (1 pt for saying no, 1 pt for explanation that includes
statement that profit is 650.)

Xavier and Yolanda will buy a wine tour for $125 each. Zara will get a hotel room for 200.
Zara will NOT buy a bundle. If she does she gets no surplus. Instead she gets a hotel room for
$200 and gets a surplus of 100. She will not get a wine tour. The profit under mixed bundling
is (125 x 2) + (200 x 2) = 650, which is less than the pure bundling profit of 750

d. In this example, reservation prices are [circle one: POSITIVELY CORRELATED,

NEGATIVELY CORRELATED, NEITHER]. What does that mean? (2 pts) (Use words only. No
diagram is needed.) ( 1 pt for saying negatively correlated, 1 pt for explanation).

This means someone with a higher reservation price than another person for one good has a
lower reservation price for the other good. Higher reservation prices for one good are
associated with lower reservations for the other good.

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6. Peak Load Pricing

Glacier Bus Lines runs a tour bus that takes visitors on day trips around Glacier National Park,
including lunch. During the winter daily inverse demand is given by p = 100 – 2q and in the
summer daily inverse demand is p = 160 – q. Marginal cost is constant at 20 in both seasons. The
bus has 60 seats, which is its capacity. Glacier uses profit maximizing peak load pricing.

a. What is the price and quantity in winter? (2 pts)

p = 100 – 2q
MR = 100 – 4q = MC = 20
So q = 20 and p = 100 – 2q = 60. (1 pt for q = 20 and 1 pt for p = 60).

b. What is the price and quantity in summer? (2 pts)

p = 160 – q
MR = 160 – 2q = MC = 20 so q = 70
But 70 > the capacity of 60 (1 pt)
Therefore, the firm will sell up to capacity at the highest price: q = 60 and p = 160 – 60 = 100.
(1 pt for both q = 60 and p = 100.)

c. Illustrate this situation in a diagram. (3 pts)

MC
160 1 pt for D and MR curves. 1 pt
for MC curve including
vertical segment. 1 pt for
numbers. OK if one is missing.
100

60
D
D MR

MR

20 60

d. Glacier has the option of using a larger bus with a capacity of 80 but average and marginal cost
per person would be 24. Glacier can choose to use the larger bus in either season or in both seasons
if it wishes. Would Glacier use the larger bus in summer? In winter? (3 pts)

In summer: MR = 160 – 2q = MC = 24 so q = 68 and p = 160 – 68 = 92. Profit = (92 – 24)68 =

4624. This is less than the profit of (100 – 20)60 = 4800 that the firm earns with the small bus.
(1 pt for working). Therefore, the firm will NOT use the large bus in summer (1 pt). The firm
will also NOT use the large bus in winter (1 pt) because it is already unconstrained in winter
and using the large bus would just raise costs and increase the idle capacity.

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7. Duopoly

Consider a market for a homogenous product with linear demand and two Cournot duopoly firms
(Clinton Ltd. and Trump Enterprises). The marginal cost of production for Clinton is constant and is
equal to $12, and the marginal cost of production for Trump is constant and equal to $20. Market
demand is given by inverse demand function P = 180 – 2Q where P is the market price and Q is
total production by the two firms (i.e., Q = QC + QT).

a. Find the best response functions of the two firms and illustrate them in an appropriate diagram. (5
pts). Put QC on the horizontal axis, put numbers for intercepts on the axes and indicate which best
response function applies to each firm.

The revenue function for Clinton Ltd is given by

PQc = (180 – 2QC – 2QT)QC, hence marginal
revenue is given by MR = (180 – 2QT) – 4QC. (1 pt)

Setting marginal revenue equal to marginal cost

gives us Clinton Ltd’s best response
(180 – 2QT) – 4QC = 12  QC = 42 – 0.5QT. (1 pt)

Similarly, the revenue function for Trump Ent. is

given by PQT = (180 – 2QC – 2QT)QT, hence
marginal revenue is given by
MR = (180 – 2QC) – 4QT. Setting marginal revenue
equal to marginal cost gives us Trump Ent’s
best response (180 – 2QC) – 4QT = 20  QT = 40 – 0.5Qc. (1 pt) (It does not matter which best
response function is determined first. 1 pt for each best response function and one method for
a correct MR function for either firm.

In the diagram, 1 pt for any diagram with two downward sloping straight lines labelled as
best response functions. 1 additional point for correct vertical intercepts and correct labels on
best response curves.

b. Calculate the Cournot-Nash equilibrium quantity for each firm, the industry quantity, and the
industry price. Identify the equilibrium point in the diagram you drew in part a. (5 pts)

To calculate the Cournot-Nash equilibrium we solve the best response functions

simultaneously for QC and QT. One method is substitution.
QC = 42 – 0.5QT
QT = 40 – 0.5Qc = 40 – 0.5(42 – 0.5QT)
Therefore 0.75QT = 40 – 21 or QT = 19/0.75 = 25.33.
Similarly QC = 29.33 and Q = QC+QT ≈ 54.67 and the industry price is given by P = 180 – 2Q ≈
70.67.

1 pt for method. 1 pt for each quantity. 1 pt. for price. 1 pt for correct equilibrium numbers
shown on diagram.

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