This Paper Is Not To Be Removed From The Examination Halls

This paper is not to be removed from the Examination Halls
UNIVERSITY OF LONDON EC2066 ZA

(279 0066)
BSc degrees and Diplomas for Graduates in Economics, Management, Finance and the
Social Sciences, the Diplomas in Economics and Social Sciences and Access Route
Microeconomics
Wednesday, 16 May 2012 : 10.00am to 1.00pm
Candidates should answer ELEVEN of the following SIXTEEN questions: EIGHT from
Section A (5 marks each) and THREE from Section B (20 marks each). Candidates are
strongly advised to divide their time accordingly.
A calculator may be used when answering questions on this paper and it must comply in all
respects with the specification given with your Admission Notice. The make and type of
machine must be clearly stated on the front cover of the answer book.
© University of London 2012

UL12/0035 PLEASE TURN OVER
D01 Page 1 of 8
SECTION A
Answer eight questions from this section (5 marks each).
1. A monopolist practices third degree price discrimination across two markets, A

and B. The marginal cost of the monopolist is increasing in output. If demand
increases in market A, the monopolist charges a higher price to customers in
market B. Is this true or false? Explain your answer.
2. Compensated demand (Hicksian demand) is always less elastic than ordinary

demand (Marshallian demand). Is this true or false? Explain your answer.
3. There is a competitive market for a good. The government announces a per unit
subsidy to be paid to producers of the good. Using a diagram, explain why this
policy creates a deadweight loss.
4. There are 50 firms in a competitive industry. Each firm has the production func-
tion q = ln L, where q denotes firm output and L denotes the quantity of labour
employed by the firm. The wage rate is w = 2 and each firm can sell its output
at price p = 10. What is the total labour employment in the industry?
5. Pip derives all of his utility from consuming only chocolate bars. He spends his
entire weekly allowance of 10 on chocolate bars. Suppose the price of chocolate
bars rises from 1 to 2. Compute Pip’s Compensating Variation (the amount of
extra income needed after the price change to return Pip to the original utility
level) and Equivalent Variation (the maximum amount of money that Pip would
pay to prevent the price increase).
6. Leo consumes only two goods A and B. Consuming more of any of the two
goods raises Leo’s utility (in other words, Leo’s preferences satisfy the “more is
better” condition). Both goods cannot be inferior goods for Leo. Is this true or
false? Explain your answer.
7. Suppose firms in a competitive market produce output using a technology fea-

turing constant returns to scale, and face constant input prices. It follows that
for each firm, the average cost is constant in the short run. Is this true or false?
Explain your answer using a diagram.
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8. An economy consists of a farmer and a tailor. The farmer has 10 units of bread
(B) but no clothing (C). The tailor has 30 units of clothing but no bread. The
farmer and the tailor have the same utility function:
u( Bi , Ci ) = Bi Ci ,
where i is either F (for the farmer) or T (for the tailor). Suppose the farmer and
the tailor can trade. The price of clothing is 1, and the price of bread is 3. Can
the economy be at a competitive equilibrium at these prices? Explain.
9. You don’t know your neighbour, but you can see his garden from your living
room window. Your neighbour enjoys gardening and you enjoy the view of
his garden. It follows that your neighbour is working too little on the garden
compared to the social optimum. Is this true or false? Explain your answer.
10. Suppose that in the market for paper, the inverse demand curve is given by
P = 100 − Q
The private marginal cost is
MCP = 10 + Q
Pollution generated during the production process creates external marginal

harm equal to
MCE = Q
Under this scenario, calculate the deadweight loss from monopoly.
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SECTION B
Answer three questions from this section (20 marks each).
11. (a) Lyra derives utility from consumption of a composite good C and from
leisure L. The price of C is normalized to 1. She faces the budget constraint
C = wH + I0
where w is the hourly wage, H is hours worked, and I0 is non-labour in-

come (e.g. interest income, gifts etc). She also faces the time constraint
H = 24 − L
Suppose we observe that if I0 increases, Lyra’s consumption of C always

increases by more than the rise in I0 .
i. Is leisure a normal good or an inferior good for Lyra? Explain.
[5 marks]
ii. If w increases, Lyra works more (H increases). Is this true or false?
Explain. [5 marks]
Suppose Will faces the same budget constraint and time constraint as Lyra.
We observe that Will’s optimal H does not change when w changes.
iii. Is leisure a normal good or an inferior good for Will? Explain.

[5 marks]
(b) Estella spends her income on fuel for heating her house and other goods
(“other goods” represents a composite of all other goods). The price of
the composite of other goods is 1, and the price of heating fuel is p. The
local council wants to help Estella with her heating bill. It could subsi-
dize the price of heating fuel at the rate of s per unit, so that the effective
price becomes (1 − s) p. This allows Estella to attain a higher level of utility.
Alternatively, the council could directly provide extra income to Estella al-
lowing her to make exactly the same utility gain. Which scheme is cheaper
for the council? Explain. [5 marks]
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12. Individuals differ in their state of health: half the population is healthy and
the other half is unhealthy. Initial wealth for all individuals is 100. Any in-
dividual (regardless of health) becomes sick with probability 0.4. The state of
health affects the cost of getting sick: medical expenses for healthy people, if
they become sick, amount to 19 (reducing wealth to 81); medical expenses for
unhealthy people, if they become sick, are 36 (reducing wealth to 64). The Ini-
tial wealth of 100 remains unchanged if an individual does not get sick. Each
individual’s utility function is
U (Y ) = Y1/2
where Y denotes wealth. Suppose an insurance company is available to provide

insurance.
(a) What is the maximum premium that a healthy individual would be willing
to pay for full insurance? [5 marks]
For the next three parts, assume that while each individual knows whether he
or she is healthy, the insurance company does not have this information.
(b) Suppose everyone is required by law to purchase insurance from the same
insurance company. The insurance company provides full insurance to all
individuals and charges an average premium. What premium must the
insurance company charge to break even? [5 marks]
(c) If restrictions are lifted so that individuals may opt out of insurance, does
the insurance company need to charge a different price compared to part
(b) to break even? Explain. [5 marks]
(d) Is the insurance market in part (c) efficient? If your answer is yes, explain
why the market is efficient. If the answer is no, explain the problem that
prevents the market from being efficient. [5 marks]

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13. The inverse demand function for the product of a perfectly competitive industry
is given by
Q
P = 160 −
2
where P is the price per unit and Q is the total quantity. The short-run total cost
function of each firm is given by
C = 50 + 10q + 50q2
where q denotes the output of the representative firm. There are 100 firms in the
industry.
(a) Derive the short-run supply curve of a firm. [5 marks]

(b) Derive the equilibrium price in the market. [5 marks]
A tax of 30 per unit sold is now imposed on every unit sold.
(c) Calculate the tax revenue raised. [5 marks]

(d) Calculate the deadweight loss from the tax. [5 marks]
14. Suppose there are two identical firms in an industry. The output of firm 1 is
denoted by q1 and that of firm 2 is denoted by q2 . Let Q = q1 + q2 . The total
cost of production for firm 1 is 2 + q1 and that for firm 2 is 2 + q2 . The inverse
demand curve in the market is given by
P = 10 − Q
(a) Find the Cournot-Nash equilibrium quantity produced by each firm and
the market price. [5 marks]
(b) Calculate the deadweight loss arising from the Cournot-Nash equilibrium.
[5 marks]
(c) Under what conditions can the firms successfully engage in collusive be-
haviour? Explain informally but carefully. [5 marks]
(d) What would be the quantities produced by each firm and market price
under Stackelberg duopoly if firm 1 moves first? [5 marks]
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15. Suppose that Acme and Zoom are the only two firms that can produce a new
type of high-definition television. If both enter the market, there is a price war so
that each firm makes a loss. If only one firm enters, it makes a profit and sources
some parts from the other firm, so that the other firm also makes a profit. The
payoffs (in millions of dollars) from the various combinations of entry decisions
are shown in the following payoff matrix, where E denotes “enter” and NE
denotes “not enter.”
Zoom
E NE
Acme E -4,-4 5,1
NE 1,5 0,0
(a) Find all pure-strategy Nash Equilibria of this game, assuming the firms
make entry decisions simultaneously. [5 marks]
(b) Suppose now the game is played sequentially, with Acme moving first.
Find the credible Nash equilibria now. [5 marks]
(c) Now assume again that the firms make entry decisions simultaneously.
Find the mixed-strategy Nash equilibrium of this game. [5 marks]
(d) Again assume that the firms make entry decisions simultaneously. How-
ever, before the game starts, Zoom enters into a contract with a supplier
of stands for the new televisions. The contract is reported in the newspa-
pers so that everyone is aware of the contract. The contract promises the
supplier of stands a payout of 6 million from Zoom if Zoom decides not to
enter the market.
Find all pure-strategy Nash equilibria of the game in this case. [5 marks]

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16. (a) Consider a labour market with two types of workers: high ability and low
ability. The ability of a worker is known only to the worker himself. Ex-
plain the conditions necessary for education to be a credible signal of abil-
ity even when education does not enhance ability. [12 marks]
(b) An employer has two types of jobs available: high difficulty and low dif-
ficulty. There are two types of workers: high ability and low ability. The
ability is known only to the worker himself.
The utility of a worker is w − c where w denotes salary and c denotes the
cost of doing the job. The salary is w H for the high difficulty job and w L
for the low difficulty job. Further, c varies across worker types and jobs, so
that the utilities are as follows:
Utility from Utility from

High Difficulty Job Low Difficulty Job
High Ability Worker w H − 100 w L − 50
Low Ability Worker w H − 150 w L − 100
Suppose w L = 100.
Since the employer cannot observe the ability level of a worker directly,
how should he set w H so that the low ability workers take only the low
difficulty jobs and high ability workers take only the high difficulty jobs?
[8 marks]
END OF PAPER
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This paper is not to be removed from the Examination Halls
UNIVERSITY OF LONDON EC2066 ZB

(279 0066)
BSc degrees and Diplomas for Graduates in Economics, Management, Finance and the
Social Sciences, the Diplomas in Economics and Social Sciences and Access Route
Microeconomics
Wednesday, 16 May 2012 : 10.00am to 1.00pm
Candidates should answer ELEVEN of the following SIXTEEN questions: EIGHT from
Section A (5 marks each) and THREE from Section B (20 marks each). Candidates are
strongly advised to divide their time accordingly.
A calculator may be used when answering questions on this paper and it must comply in all
respects with the specification given with your Admission Notice. The make and type of
machine must be clearly stated on the front cover of the answer book.
© University of London 2012

UL12/0036 PLEASE TURN OVER
D01 Page 1 of 7
SECTION A
1. Two indifference curves of an individual cannot cross. Is this true or false? Ex-
plain your answer.
2. Compensated demand (Hicksian demand) is always less elastic than ordinary

demand (Marshallian demand). Is this true or false? Explain your answer.
3. There is a competitive market for a good. The government announces a per unit
subsidy to be paid to producers of the good. Using a diagram, explain why this
policy creates a deadweight loss.
4. There are 50 firms in a competitive industry. Each firm has the production func-
tion q = ln L, where q denotes firm output and L denotes the quantity of labour
employed by the firm. The wage rate is w = 2 and each firm can sell its output
at price p = 10. What is the total labour employment in the industry?
5. In a perfectly competitive industry with constant input prices and constant re-
turns to scale, the burden of any tax will fall only on the consumers in the long
run. Is this true or false? Explain your answer.
6. Rachel has a weekly allowance of 10 from her father which she spends on
milkshakes and other goods (“other goods” represents a composite of all other
goods). The price of milkshakes is 1 and the price of other goods is also 1.
Rachel’s father wants to spend some more money on her allowance through
one of two options. In addition to giving her 10, he could pay half of Rachel’s
milkshake bill, so that the subsidized price of milkshakes for Rachel is 1/2. In
this case Rachel would choose to buy 8 milkshakes per week, and her father
would spend an additional amount of 4 per week. Alternatively, Rachel’s father
could just raise her weekly allowance by 4. Which option does Rachel prefer?
Explain.
7. Consumers drink both tea and coffee. Suppose that as the price of coffee rises,
consumers drink less tea. Hence the income elasticity of demand for tea is neg-
ative. Is this true or false? Explain your answer.
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8. Consider the two-period model of inter-temporal choice. If consumption in
both periods is a normal good, it is possible that a borrower will borrow less
if the interest rate falls. Is this true or false? Explain your answer.
9. You don’t know your neighbour, but you can see his garden from your living
room window. Your neighbour enjoys gardening and you enjoy the view of
his garden. It follows that your neighbour is working too little on the garden
compared to the social optimum. Is this true or false? Explain your answer.
10. Suppose that in the market for paper, the inverse demand curve is given by
P = 100 − Q
MCP = 10 + Q
Pollution generated during the production process creates external marginal

harm equal to
MCE = Q
UL12/0036
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SECTION B
11. Consider the following exchange economy. There are two goods (b and c), and
two consumers (1 and 2). Let bi and ci denote the consumption of goods b and c
respectively by consumer i, i ∈ {1, 2}.
Consumer 1 has utility function
U1 (b1 , c1 ) = b11/3 c2/3

1
U2 (b2 , c2 ) = b21/2 c1/2

2
Consumer 1 is endowed with 10 units of b and 20 units of c. Consumer 2 is

endowed with 20 units of b and 10 units of c. Suppose the price of good c is 1,
and let p denote the price of good b.
(a) Derive the demand functions of the two consumers for b and c.
[10 marks]
(b) Derive the competitive equilibrium price of b in this economy, and the equi-
librium quantities of the two goods consumed by each consumer.
[10 marks]
12. (a) Using either the contingent commodities model or the expected utility model,
explain why a risk averse individual would choose full insurance under
fair odds. [5 marks]
(b) Rai has wealth 81, but if she becomes ill, she will have to pay medical bills,
reducing her wealth to 36. The probability that Rai will fall ill is 13 . Rai’s
utility function is given by
√
u(W ) = W
where W denotes wealth. Rai has the option of buying insurance coverage
for illness from an insurance company.
i. What is the maximum premium that Rai is willing to pay for full in-
surance? [5 marks]
ii. What is the minimum premium that the insurance company would
accept to provide full insurance? [5 marks]
iii. Suppose Rai can buy X units of cover by paying a premium of X3 (i.e.
the insurance company pays X to Rai if she falls ill, and Rai pays the
insurance company X3 whether she is ill or not ill). What is the optimal
choice of X by Rai? [5 marks]
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13. A competitive firm produces according to the following production function:
Q = 2L1/2 K1/2
where Q denotes the firm’s output, K denotes capital and L denotes labour. The
price of labour is 4 and the price of capital is 16. Let P be the price at which the
firm can sell its output. In the short-run, capital is fixed at some level K. In the
long run both labour and capital are variable.
(a) Write down the total short run cost of the firm as a function of the output
Q and the fixed level K. [5 marks]
(b) What is the minimum average cost in the short run? [5 marks]
(c) What is the short-run supply curve of the firm? In answering this question,
be careful to check whether there is a P below which the firm would shut
down in the short run (so that supply would be zero for such prices).
[5 marks]
(d) Now consider the long-run scenario in which both labour and capital are
variable inputs. Derive and explain the shapes of the long-run marginal
and average cost curves of the firm. [5 marks]
14. Suppose there are two identical firms in an industry. The output of firm 1 is
denoted by q1 and that of firm 2 is denoted by q2 . Let Q = q1 + q2 . The total
cost of production for firm 1 is 2 + q1 and that for firm 2 is 2 + q2 . The inverse
demand curve in the market is given by
P = 10 − Q
(a) Find the Cournot-Nash equilibrium quantity produced by each firm and
the market price. [5 marks]
[5 marks]
(c) Under what conditions can the firms successfully engage in collusive be-
haviour? Explain informally but carefully. [5 marks]
(d) What would be the quantities produced by each firm and market price
under Stackelberg duopoly if firm 1 moves first? [5 marks]
UL12/0036
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15. Suppose that Acme and Zoom are the only two firms that can produce a new
type of high-definition television. If both enter the market, there is a price war so
that each firm makes a loss. If only one firm enters, it makes a profit and sources
some parts from the other firm, so that the other firm also makes a profit. The
payoffs (in millions of dollars) from the various combinations of entry decisions
are shown in the following payoff matrix, where E denotes “enter” and NE
denotes “not enter.”
Zoom
E NE
Acme E -4,-4 5,1
NE 1,5 0,0
(a) Find all pure-strategy Nash Equilibria of this game, assuming the firms
make entry decisions simultaneously. [5 marks]
(b) Suppose now the game is played sequentially, with Acme moving first.
Find the credible Nash equilibria now. [5 marks]
(c) Now assume again that the firms make entry decisions simultaneously.
Find the mixed-strategy Nash equilibrium of this game. [5 marks]
(d) Again assume that the firms make entry decisions simultaneously. How-
ever, before the game starts, Zoom enters into a contract with a supplier
of stands for the new televisions. The contract is reported in the newspa-
pers so that everyone is aware of the contract. The contract promises the
supplier of stands a payout of 6 million from Zoom if Zoom decides not to
enter the market.
Find all pure-strategy Nash equilibria of the game in this case. [5 marks]
UL12/0036
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16. (a) Consider a labour market with two types of workers: high ability and low
ability. The ability of a worker is known only to the worker himself. Ex-
plain the conditions necessary for education to be a credible signal of abil-
ity even when education does not enhance ability. [12 marks]
(b) An employer has two types of jobs available: high difficulty and low dif-
ficulty. There are two types of workers: high ability and low ability. The
ability is known only to the worker himself.
The utility of a worker is w − c where w denotes salary and c denotes the
cost of doing the job. The salary is w H for the high difficulty job and w L
for the low difficulty job. Further, c varies across worker types and jobs, so
that the utilities are as follows:

High Difficulty Job Low Difficulty Job
Suppose w L = 100.
Since the employer cannot observe the ability level of a worker directly,
how should he set w H so that the low ability workers take only the low
difficulty jobs and high ability workers take only the high difficulty jobs?
[8 marks]
END OF PAPER
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Examiners’ commentaries 2012

EC2066 Microeconomics
Important note
This commentary reflects the examination and assessment arrangements for this course in the
academic year 2011–12. The format and structure of the examination may change in future years,
and any such changes will be publicised on the virtual learning environment (VLE).
Information about the subject guide
Unless otherwise stated, all cross-references will be to the latest version of the subject guide (2011).
General remarks
Learning outcomes
By the end of this course, and having completed the Essential reading and activities, you should:
• be able to define and describe:

• the determinants of consumer choices, including inter-temporal choices and those
involving risk
• firms’ behaviour
• how firms’ behaviour differs in different market structures and may help to determine
those structures
• how firms and households determine factor prices.
• be able to analyse and assess:

• efficiency and welfare optimality of perfectly and imperfectly competitive markets
• the effects of externalities and public goods on efficiency
• government policies aimed at improving welfare.
• be prepared for further courses which require a knowledge of microeconomics.
Time management
Section A comprises ten questions of which eight must be answered (accounting for 40 per cent of
the total marks). Section B comprises six questions of which three must be answered (accounting
for 60 per cent of the total marks). Candidates are strongly advised to divide their time accordingly.
On average, only nine minutes should be allocated to any individual Section A question. On
average, only 36 minutes should be allocated to any individual Section B question.
1
Key steps to improvement

• You need to be able to apply relevant microeconomic theory to questions that you may not
have encountered before. To prepare for this, you need not only to gain a thorough
understanding of microeconomic models but also (and importantly) to practise using
relevant models to answer specific questions. Practice is the key, not the learning of specific
answers.
• You should spend time planning your answers and make sure that you respond to all parts
of a question and to key words like define, explain and compare. Precise and concise
answers are to be preferred to vague and long-winded answers.
• You should be aware that, for most answers, diagrams and/or mathematical analysis are
essential. These should be correct and diagrams should be well-labelled. In addition, you
should always accompany them with appropriate explanations. Again, ‘practice makes
perfect’.
Essential reading: important information
The subject guide refers to Morgan, Katz and Rosen as the principal text. In addition to this, you
should practise questions from other texts. Two ‘auxiliary’ texts that are good sources for practice
questions are listed below. Further, the auxiliary texts often develop applications not covered in the
principal text. You should study these to broaden, as well as deepen, your understanding. In some
cases, reading several treatments of the same topic might help to clarify the basic idea. You should
use the auxiliary texts for this purpose as well.
The coverage of game theory is often inadequate in texts. You should make sure that you
understand the key ideas covered in some detail in the subject guide.
Essential reading
• Morgan, W., M.L. Katz and H.S. Rosen Microeconomics. (Boston, Mass.:
Irwin/McGraw-Hill, 2009) second edition [ISBN 9780077121778].
Further reading
• Perloff, J.M. Microeconomics with Calculus. (Pearson Education, 2011) second edition
[ISBN 9781408264324].
• Pindyck, R.S. and D.L. Rubinfeld Microeconomics. (Upper Saddle River, New Jersey:
Prentice Hall/Pearson, 2012) eighth edition [ISBN 9780133041705].
2
Question spotting
Many candidates are disappointed to find that their examination performance is poorer
than they expected. This can be due to a number of different reasons and the Examiners’
commentaries suggest ways of addressing common problems and improving your perfor-
mance. We want to draw your attention to one particular failing – ‘question spotting’, that is,
confining your examination preparation to a few question topics which have come up in past
papers for the course. This can have very serious consequences.
We recognise that candidates may not cover all topics in the syllabus in the same depth, but
you need to be aware that Examiners are free to set questions on any aspect of the syllabus.
This means that you need to study enough of the syllabus to enable you to answer the required
number of examination questions.
The syllabus can be found in the ‘Course information sheet’ in the section of the VLE dedi-
cated to this course. You should read the syllabus very carefully and ensure that you cover
sufficient material in preparation for the examination.
Examiners will vary the topics and questions from year to year and may well set questions
that have not appeared in past papers – every topic on the syllabus is a legitimate examination
target. So although past papers can be helpful in revision, you cannot assume that topics or
specific questions that have come up in past examinations will occur again.
If you rely on a question spotting strategy, it is likely you will find yourself in difficulties
when you sit the examination paper. We strongly advise you not to adopt this strategy.
3

Important note
Comments on specific questions – Zone A
Candidates should answer ELEVEN of the following SIXTEEN questions: EIGHT from Section A
(5 marks each) and THREE from Section B (20 marks each).
We use the following abbreviations:
• M,K&R – Morgan, W., M.L. Katz and H.S. Rosen Microeconomics. (Boston, Mass.:
• Perloff – Perloff, J.M. Microeconomics with Calculus. (Pearson Education, 2011) second
edition [ISBN 9781408264324]. (Note that the first edition of this text had the slightly
different title Microeconomics: Theory and Applications with Calculus.)
For each question, we point out the relevant sections from the main text (M,K&R) as well as the
subject guide. Additional references from Perloff are provided for a few questions.
Section A
Question 1
A monopolist practices third degree price discrimination across two markets, A and B. The
marginal cost of the monopolist is increasing in output. If demand increases in market A, the
monopolist charges a higher price to customers in market B. Is this true or false? Explain your
answer.
Reading for this question
M,K&R, Chapter 13.
Subject guide, pp.59–60.
4
Approaching the question
This is true. The optimality condition is MR A ( Q A ) = MR B ( Q B ) = MC ( Q A + Q B ). To find the

optimal prices, first take the horizontal sum of MR A and MR B . Call this MR T .
It is very important that you understand that the horizontal sum MR T is not MR A + MR B . You
would lose most of the points if you make this mistake. MR A + MR B is the vertical sum which
is the total marginal revenue across the two markets at any given quantity. This has no use in
our calculations here.
The horizontal sum MR T gives the total quantity at any given level of marginal revenue m in
each market (i.e. given any m where MR A = MR B = m). The intersection of MR T with MC
gives the required m for which m = MR A ( Q A ) = MR B ( Q B ) = MC ( Q A + Q B ). The optimal
prices are then found from the demand curves as PA ( Q A ) and PB ( Q B ). If the demand schedule
PA ( Q) rises, so does the schedule MR A ( Q) and so does the horizontal sum MR T . Since MC is
rising, the new intersection between MR T and MC is at a level m0 > m. A higher level of
marginal revenue corresponds to lower quantities Q0A < Q A and Q0B < Q B . Thus prices rise in
both A and B markets. You can also see this from the picture.
Price
P1
MC
P
2
MR1= MR2= MC (Q + Q2 )
1 D2= AR 2
MR
T
MR 1 D1 = AR1 MR2
Q1 Q2 Q
Third degree price discrimination.

In equilibrium, MR1 (Q 1 )= MR 2 (Q 2 )= MC (Q 1+Q2)
Question 2
Compensated demand (Hicksian demand) is always less elastic than ordinary demand
(Marshallian demand). Is this true or false? Explain your answer.
M,K&R, Chapter 4.
5
This is false. You should understand that compensated demand is obtained from ordinary
demand by removing the income effect, and therefore compensated demand shows only the
substitution effect. So the question is, is the substitution effect always smaller than the total price
effect, which is the sum of the substitution effect and the income effect? This is, of course, not
always true. This is true only when the income effect goes in the same direction as the
substitution effect. In other words, this is true for a normal good. However, for an inferior good,
the income effect goes in the opposite direction compared to the substitution effect, making the
substitution effect larger than the total price effect. Therefore, compensated demand for an
inferior good is more elastic compared to ordinary demand.
Question 3
There is a competitive market for a good. The government announces a per unit subsidy to be
paid to producers of the good. Using a diagram, explain why this policy creates a deadweight
loss.
M,K&R, Chapter 11.
Subject guide, p.58.
For a better coverage of deadweight loss arising from a variety of policies, see Chapter 9 of
Perloff.
This is an easy question. If you are struggling with this, your preparation is unlikely to be
adequate. Note that without the subsidy, the competitive market equilibrium is efficient. A
subsidy then shifts the supply curve out, which in turn implies that output is now too high
relative to the social optimum. Be careful when drawing the picture. Many candidates correctly
draw the supply curve shift, but then do not correctly identify the triangular area that shows the
deadweight loss.
Price
Supply
Deadweight
Loss
P
0
Supply after subsidy
P1
Demand
P -S
0
Q0 Q1 Q
Deadweight loss from subsidy.

6
Question 4
There are 50 firms in a competitive industry. Each firm has the production function q = ln L,
where q denotes firm output and L denotes the quantity of labour employed by the firm. The
the wage rate is w = 2 and each firm can sell its output at price p = 10. What is the total
labour employment in the industry?
M,K&R, Chapter 10.
Subject guide, Chapter 7 covers the theory of optimisation by the firm. The chapter does not
mention factor demand specifically.
For a better coverage, see Perloff, Chapter 15.1.
Each firm optimally sets MRPL = w, which implies p/L = w. So each firm employs L = p/w
units of labour. Therefore the total employment is 50L = 50p/w. For w = 2 and p = 10, total
employment is 250.
Question 5
Pip derives all of his utility from consuming only chocolate bars. He spends his entire
weekly allowance of 10 on chocolate bars. Suppose the price of chocolate bars rises from 1 to
2. Compute Pip’s Compensating Variation (the amount of extra income needed after the price
change to return Pip to the original utility level) and Equivalent Variation (the maximum
amount of money that Pip would pay to prevent the price increase).
M,K&R, Chapter 4.
CV is the amount of money needed to return Pip to his original level of utility. He initially
consumes 10 bars per week. The only way to make Pip as happy as before after the price rises is
to give him enough income so that he can still consume 10 bars. Thus we would need to raise his
income from 10 to 20. It follows that CV = 10.
EV is the maximum amount Pip would pay to prevent the price increase. To compute this, notice
that Pip consumes 10/2 = 5 bars after the price increase. Before the price rise, the maximum
amount he would be willing to pay is 5 of his income to prevent the price change leaving him to
consume 5 bars. Thus EV=5.
Question 6
Leo consumes only two goods A and B. Consuming more of any of the two goods raises Leo’s
utility (in other words, Leo’s preferences satisfy the ‘more is better’ condition). Both goods
cannot be inferior goods for Leo. Is this true or false? Explain your answer.
M,K&R, Chapter 4.
7
See also Perloff, Chapter 4.2 for a direct discussion of the issue.
This is true. If both goods are inferior, as income goes up Leo would buy less of each. In that
case, Leo would spend less than his income. But since he gets a higher utility from consuming
more (of any of the goods), not spending all of his income is suboptimal.
Question 7
Suppose firms in a competitive market produce output using a technology featuring constant
returns to scale, and face constant input prices. It follows that for each firm, the average cost
is constant in the short run. Is this true or false? Explain your answer using a diagram.
M,K&R, Chapter 9.
Subject guide, pp. 55–58.
See Perloff, Chapter 7.2 for a clearer exposition of short-run cost curves.
This is false. In the short run, capital is typically fixed, giving rise to an average fixed cost that is
decreasing. Further, diminishing returns from labour ensures that the average variable cost is
increasing. So the overall average cost curve has a U-shape in the short run. You should draw a
picture showing the average fixed cost curve, average variable cost curve and the sum of the
two, which is the short run average cost curve.
Question 8
An economy consists of a farmer and a tailor. The farmer has 10 units of bread (B) but no
clothing (C). The tailor has 30 units of clothing but no bread. The farmer and the tailor have
the same utility function:
u( Bi , Ci ) = Bi Ci ,
where i is either F (for the farmer) or T (for the tailor). Suppose the farmer and the tailor can
trade. The price of clothing is 1, and the price of bread is 3. Can the economy be at a
competitive equilibrium at these prices? Explain.
M,K&R, Chapter 12.
At the given prices, the farmer’s budget line is

3BF + CF = 30.
His budget line is tangent to an indifference curve when
MUB C
= F = 3.
MUC BF
8
Substituting yields 6BF = 30 or BF = 5 and CF = 15. The tailor’s budget line is exactly the same:
3BT + CT = 30.
Since the preferences are the same, we have BT = 5 and CT = 15. Thus both markets clear.
Therefore the economy can indeed be at a competitive equilibrium at the given prices.
Question 9
You don’t know your neighbour, but you can see his garden from your living room window.
Your neighbour enjoys gardening and you enjoy the view of his garden. It follows that your
neighbour is working too little on the garden compared to the social optimum. Is this true or
M,K&R, Chapter18.
This is true. The neighbour’s gardening generates a positive externality. Since the gardener
presumably does not take his neighbour’s enjoyment into account when deciding how much
effort to spend on his garden, the effort expended is socially suboptimal.
Question 10
Suppose that in the market for paper, the inverse demand curve is given by
P = 100 − Q
MCP = 10 + Q
Pollution generated during the production process creates external marginal harm equal to
MCE = Q
M,K&R, Chapters 13 and 18.
Subject guide, pp.58–59 (monopoly) and pp.101–104 (externalities).
First, the socially optimal quantity of paper is found by setting MCP + MCE = P or
10 + Q + Q = 100 − Q. Rearranging yields Q = 30. Under monopoly, the firm sets MCP equal to
marginal revenue, which is given by 100 − 2Q. From MCP = 100 − 2Q we get Q = 30. It follows
that the output under monopoly is socially optimal, and therefore monopoly creates no
deadweight loss.
(This is not required for the answer, but note that the competitive output is found by setting
MCP = P or 10 + Q = 100 − Q. Rearranging yields Q = 45. The deadweight loss of those
additional units equals (45 − 30) × 45/2 = 337.50. It follows that social welfare is greater under
monopoly.)
9
Section B
Question 11
(a) Lyra derives utility from consumption of a composite good C and from leisure L. The
price of C is normalized to 1. She faces the budget constraint
C = wH + I0
where w is the hourly wage, H is hours worked, and I0 is non-labour income (e.g.
interest income, gifts etc). She also faces the time constraint
H = 24 − L
Suppose we observe that if I0 increases, Lyra’s consumption of C always increases by

more than the rise in I0 .
M,K&R, Chapter 4.
i. Is leisure a normal good or an inferior good for Lyra? Explain.

[5 marks]
Consumption of C rises by more than the rise in I0 . This means when I0 rises, Lyra must
increase her hours worked. This implies that the income elasticity of leisure must be
negative, making leisure an inferior good.
ii. If w increases, Lyra works more (H increases). Is this true or false? Explain.
[5 marks]
This is true. When w rises, the substitution effect implies a higher H. Since leisure is
inferior, the income effect on H is also positive. Therefore as w rises, H unambiguously
rises.
Suppose Will faces the same budget constraint and time constraint as Lyra. We observe
that Will’s optimal H does not change when w changes.
iii. Is leisure a normal good or an inferior good for Will? Explain.
[5 marks]
Will’s optimal H does not change when w changes. When w rises, the substitution effect
would imply lower leisure, so the income effect must cancel out this effect. This implies
that the income effect must be positive, making leisure a normal good.
(b) Estella spends her income on fuel for heating her house and other goods (‘other
goods’ represents a composite of all other goods). The price of the composite of other
goods is 1, and the price of heating fuel is p. The local council wants to help Estella with
her heating bill. It could subsidise the price of heating fuel at the rate of s per unit, so
that the effective price becomes (1 − s) p. This allows Estella to attain a higher level of
utility. Alternatively, the council could directly provide extra income to Estella allowing
her to make exactly the same utility gain. Which scheme is cheaper for the council?
Explain.
[5 marks]
M,K&R, Chapter 4.
10

The answer to this becomes clear once you draw the picture correctly. This is the standard
result about EV being smaller than expenditure on a subsidy, which is explained in some
detail in the text. You should study this carefully. The intuition is that relative to the income
transfer, the subsidy distorts choice in favour of the subsidised good through an additional
substitution effect.
Other
Goods
A D
Budget line
after
subsidy
Budget line
before E
subsidy
Heating
Price subsidy versus an equivalent variation in income. Estella’s consumption is initially at
A, and moves to B after the subsidy. Since the composite good has a price of 1, the vertical
distance between the budget lines (segment BE) shows the extent of the expenditure on
subsidy. An equivalent variation in income would move Estella’s consumption to C. It
follows that DE is the equivalent variation in income, which is smaller than the expenditure
on the subsidy.
Question 12
Individuals differ in their state of health: half the population is healthy and the other half is
unhealthy. Initial wealth for all individuals is 100. Any individual (regardless of health)
becomes sick with probability 0.4. The state of health affects the cost of getting sick: medical
expenses for healthy people, if they become sick, amount to 19 (reducing wealth to 81);
medical expenses for unhealthy people, if they become sick, are 36 (reducing wealth to 64).
The Initial wealth of 100 remains unchanged if an individual does not get sick. Each
individual’s utility function is
U (Y ) = Y 1/2
where Y denotes wealth. Suppose an insurance company is available to provide insurance.
The question requires you to calculate insurance premiums in different cases, and also to relate
to the idea of adverse selection. For the insurance part, see M,K&R, Chapter 6.
11
For a better coverage of this issue, see Chapter 17 of Perloff.
For adverse selection, see M,K&R, Chapter 17 and subject guide, pp.94–97.
(a) What is the maximum premium that a healthy individual would be willing to pay for
full insurance?
[5 marks]
Expected utility of a healthy person is
√ √
EU = 0.6 100 + 0.4 81 = 6 + 3.6 = 9.6.
√
Therefore the certainty equivalent is CE = 9.6, or CE = 92.16. Therefore the maximum
premium is 100 − 92.16 = 7.84.
For the next three parts, assume that while each individual knows whether he or she is
healthy, the insurance company does not have this information.
(b) Suppose everyone is required by law to purchase insurance from the same insurance
company. The insurance company provides full insurance to all individuals and charges
an average premium. What premium must the insurance company charge to break even?
[5 marks]
Fair premia for the healthy and the unhealthy correspond to their respective expected
medical expenses. Fair premium for the healthy is 0.4 × 19 = 7.6, and fair premium for the
unhealthy is 0.4 × 36 = 14.4. The insurance company must charge the average premium
14.4+7.6
2 = 11.
(c) If restrictions are lifted so that individuals may opt out of insurance, does the
insurance company need to charge a different price compared to part (b) to break even?
Explain.
[5 marks]
Healthy people will not want to purchase insurance, since 11 > 7.84.
One can also check this (unnecessarily) as follows. Expected utilities with and without
insurance are respectively:
EU without insurance = 0.61001/2 + 0.4811/2 = 9.6.
EU with insurance = (100 − 11)1/2 = 9.43.
Therefore, the insurance company only has unhealthy people as clients, and therefore must
increase the premium to 14.4 to break even.
(d) Is the insurance market in part (c) efficient? If your answer is yes, explain why the
market is efficient. If the answer is no, explain the problem that prevents the market
from being efficient.
[5 marks]
The insurance company is willing to provide insurance at any premium at or above 7.6, and
healthy people are willing to pay a maximum of 7.84. There are clearly gains from trade
12
that cannot be exploited. Hence the market is inefficient. The problem arises from the fact
that an individual’s health is private information. Your answer should clarify this problem
of adverse selection.
Question 13
The inverse demand function for the product of a perfectly competitive industry is given by
Q
P = 160 −
2
where P is the price per unit and Q is the total quantity. The short-run total cost function of
each firm is given by
C = 50 + 10q + 50q2
where q denotes the output of the representative firm. There are 100 firms in the industry.
M,K&R, Chapter 9.
For a better discussion of this issue, see Chapter 8.3 of Perloff.
(a) Derive the short-run supply curve of a firm.

[5 marks]
The short-run supply curve of a firm is given by P = MC, so long as MC > AVC. Here,
MC = 10 + 100q, and AVC = 10 + 50q. Therefore MC always exceeds AVC. Therefore
short-run supply curve is P = MC, which is P = 10 + 100q, or
P 1
q= − .
100 10
(b) Derive the equilibrium price in the market.

[5 marks]
The industry supply is Q = 100q, which is Q = P − 10, so P = 10 + Q. Equating demand
and supply,
Q
10 + Q = 160 −
2
we get Q = 100 which implies P = 110.
A tax of 30 per unit sold is now imposed on every unit sold.
(c) Calculate the tax revenue raised.

[5 marks]
Q
The new supply function is P = 40 + Q. 40 + Q = 160 − 2 implies Q = 80. So the tax
revenue is 80 × 30 = 2400.
13
(d) Calculate the deadweight loss from the tax.

[5 marks]
Approaching the question The deadweight loss, as shown in the picture, is
(100−80)×30
2 = 300.
Price
P = 40+Q
160
P = 10+Q
30
C
A
110 E
B
D
40
P = 160 - Q/2
10
80 100 Quantity
Calculating the tax revenue and deadweight loss from tax. The rectangular area ABCD is
the tax revenue, and the shaded triangle CDE is the deadweight loss from the tax.
Question 14
Suppose there are two identical firms in an industry. The output of firm 1 is denoted by q1
and that of firm 2 is denoted by q2 . Let Q = q1 + q2 . The total cost of production for firm 1 is
2 + q1 and that for firm 2 is 2 + q2 . The inverse demand curve in the market is given by
P = 10 − Q
For Cournot equilibrium, see M,K&R, Chapter 15 and subject guide, pp.77–78.
For tacit collusion in a repeated game, see M,K&R, pp.600–603 and subject guide, pp.79–80.
(a) Find the Cournot-Nash equilibrium quantity produced by each firm and the market
price.
[5 marks]
To calculate the Cournot quantities, first derive the reaction functions. Firm 1 chooses q1 to
maximise (10 − q1 − q2 )q1 − 2 − q1 . The first order condition (best-response function of firm
14
1 or reaction function of firm 1) is given by
9 − q2
q1 = .
2
Similarly, the reaction function of firm 2 is given by
9 − q1
q2 = .
2
Either solve by imposing symmetry at this point (easier), or solve directly. Solving, we get
q1 = q2 = 3. Therefore the equilibrium quantity produced by each firm is 3, and the market
price is 10 − 6 = 4.
[5 marks]
Approaching the question The efficient quantity in the market can be found by setting
P = MC. Here MC is 1. So we have 10 − Q = 1, or Q∗ = 9. The total Cournot quantity is 6,
and the price is 4. Therefore the loss is
(4 − 1)(9 − 6)
DW L = = 4.5.
2
Price
10
Q D = 10 - P
Deadweight Loss
4
6 9 Quantity
Calculating the deadweight loss from Cournot equilibrium.

15
(c) Under what conditions can the firms successfully engage in collusive behaviour?
Explain informally but carefully.
[5 marks]
From past answers, it seems that many candidates think collusion is somehow connected
with price competition only, and that repeated interaction makes no difference if the firms
are competing in quantities. As previous Examiners’ commentaries have pointed out, this is
entirely incorrect. Infinitely repeated games allow firms to collude whether they compete in
prices or quantities (so long as the firms are patient enough, i.e. they have high enough
discount factors).
Further, as previous Examiners’ commentaries have pointed out, whether the firms have the
same cost or different costs makes no difference to the possibility of collusion.
The important point to make in your answer is that repeated interaction allows firms to
choose a collusive quantity (smaller than the total Cournot quantity) and increase total
profit so long as the firms are patient enough (their discount factor is high enough).
While the points noted in the paragraph above are enough for answering the question, let
us go a bit further here and point out how collusion works in this case in a more formal
manner. Suppose each firm has a discount factor δ, where 0 < δ < 1.
Let Q M denote the total collusive quantity (you can work out the exact figure by
maximising joint profit). Suppose each firm produces half of this under collusion. Now,
suppose each firm adopts the following ‘trigger’ strategy. Start by producing Q M /2 at
t = 0. In any subsequent period t > 1, do as follows:
• If in period t − 1 each firm produced Q M /2, produce Q M /2 in period t.
• If in period t − 1 any single firm deviated, produce the Cournot quantity 3 in period t
and in all future periods.
Such a strategy is called a ‘trigger’ strategy since a deviation by any single firm triggers
non-cooperation in all future periods.
Now, the best possible deviation by a firm is to produce the one-period best response to
Q M /2. Let us call this Q D . Again, you can easily work out the precise figure. Let πi ( x )
denote the profit of firm i from producing quantity x.
If firm i deviates in any period, it gets πi ( Q D ) that period, but subsequently, each firm
produces the Cournot quantity so that the payoff in each subsequent period is πi (3). So the
total payoff starting from the deviation period is:
δ
πi ( Q D ) + δπi (3) + δ2 πi (3) + δ3 πi (3) + . . . = πi ( Q D ) + π (3).
1−δ i
If firm i had not deviated, its payoff over the same periods would be
1
πi ( Q M /2) + δπi ( Q M /2) + δ2 πi ( Q M /2) + . . . = π ( Q M /2).
1−δ i
Therefore, for deviation to be unprofitable, we need
1 δ
π ( Q M /2) > πi ( Q D ) + π (3).
1−δ i 1−δ i
Simplifying,
πi ( Q M /2) > (1 − δ)πi ( Q D ) + δπi (3)
which gives us
πi ( Q D ) − πi ( Q M /2)
δ> .
π i ( Q D ) − π i (3)
Since πi ( Q M /2) > πi (3) (the payoff of each firm under collusion is necessarily higher than
that under Cournot competition), the expression on the right hand side is less than 1.
Therefore, for δ high enough (close enough to 1), the above inequality is satisfied for all i,
and for such values of δ, collusion can be sustained.
16
(d) What would be the quantities produced by each firm and market price under
Stackelberg duopoly if firm 1 moves first?
[5 marks]
Firm 1 now chooses a quantity given 2’s reaction function q2 = (9 − q1 )/2. So firm 1’s profit
is
(9 − q1 )

10 − q1 − q1 − 2 − q1 .
2
Maximising with respect to q1 , we get
q1 = 4.5.
Therefore q2 = 2.25. The market price is P = 10 − 6.75 = 3.25.
Question 15
Suppose that Acme and Zoom are the only two firms that can produce a new type of
high-definition television. If both enter the market, there is a price war so that each firm
makes a loss. If only one firm enters, it makes a profit and sources some parts from the other
firm, so that the other firm also makes a profit. The payoffs (in millions of dollars) from the
various combinations of entry decisions are shown in the following payoff matrix, where E
denotes ‘enter’ and NE denotes ‘not enter’.
Zoom
E NE
Acme E -4,-4 5,1
NE 1,5 0,0
The coverage of game theory in M,K&R, Chapter 16 is not ideal.
See Chapter 9 of the subject guide for a detailed discussion.
(a) Find all pure-strategy Nash Equilibria of this game, assuming the firms make entry
decisions simultaneously.
[5 marks]
This is just testing that you know what a Nash equilibrium is. If you know this, it is
straightforward to see that the Nash equilibria in this game are ( NE, E) and ( E, NE).
(b) Suppose now the game is played sequentially, with Acme moving first. Find the
credible Nash equilibria now.
[5 marks]
The credible Nash equilibrium is ( E, NE). The answer should mention why the other pure
Nash equilibrium is not credible. Essentially, the threat by Zoom to enter if Acme enters is
not credible.
In previous years, the concept of subgame-perfect Nash equilibrium had not been included
in the syllabus. However, the new subject guide discusses the notion of a strategy in a
dynamic game, and clarifies the concept of subgame-perfect Nash equilibrium. In future,
questions might ask you to calculate the subgame-perfect Nash equilibrium rather than ask
you to employ the informal notion of credible Nash equilibrium used here. The difference
between the two lies in the specification of strategies. A strategy in a dynamic game with
17
sequential moves (also called an extensive-form game) is a complete plan of actions, and
therefore you need to specify an action for the second mover after every action of the first
mover.
A subgame perfect Nash equilibrium (which is a formalisation of the notion of credibility)

is a Nash equilibrium of the whole game that also induces Nash equilibrium play in every
subgame. For games of perfect information, we can obtain the subgame perfect equilibrium
using backward induction. (In more complicated games where a player does not have
perfect information about moves of previous players, backward induction may not work,
but such games are outside the scope of this course.)
The dynamic or extensive-form game being analysed here is as follows.
Acme
E NE
Zoom Zoom
E NE E NE
(-4,-4) (5,1) (1,5) (0,0)
Let us use backward induction to derive the subgame perfect Nash equilibrium of this
game. In the subgame after Acme plays E, the optimal choice by Zoom is NE. Further, in
the subgame after Acme plays NE, the optimal choice by Zoom is E. Given these choices of
Zoom, Acme prefers E. Therefore the subgame perfect Nash equilibrium is as follows:
Acme’s strategy is to play E, Zoom’s strategy is to play NE if Acme chooses E and to play E
if Acme chooses NE.
Of course, given these equilibrium strategies, the players will end up playing E by Acme
and NE by Zoom, with the resulting payoff profile (5, 1).
(c) Now assume again that the firms make entry decisions simultaneously. Find the
mixed-strategy Nash equilibrium of this game.
[5 marks]
Acme plays E with probability p and NE with (1 − p), and Zoom plays E with probability q
and NE with (1 − q). The probability p must be such that Zoom is indifferent between E
and NE, so
−4p + 5(1 − p) = p
which implies that p = 21 . The probability q must be such that Acme is indifferent between
E and NE. The game is symmetric, so q = 21 as well.
You can also see all Nash equilibria by drawing the best response functions of the two
players, as shown in the picture.
18
Zoom’s best
response function
1
C
1/2
B
Acme’s
best
response
function
A
0 1
1/2
p
A and C are pure strategy Nash equilibria and B is the mixed strategy Nash equilibrium.
Many candidates answer this correctly. Some candidates use a slightly different method:
first write down the expected payoff of each player given that each plays a mixed strategy.
Let Eπ A denote the expected payoff of Acme. Now differentiate this with respect to p and
set this equal to zero. What does this do? Well, this should give us the value of q for which
Eπ A does not depend on p (i.e. the derivative of Eπ A with respect to p is zero, so that the
expected payoff of Acme does not change when p changes). This is precisely the value of q
for which Acme would be indifferent between E and NE. For all other values of q, the
derivative is either positive or negative, so that the optimal choice of p is either 1 (when the
derivative is positive) or 0 (when the derivative is negative). Similarly we can find the p for
which Zoom is indifferent.
However, note that when you set dEπ A
dp = 0, this is not a maximisation exercise (i.e. this is
not a first order condition). If you say you are maximising with respect to p, this tells the
Examiners that you have not understood the exercise you are carrying out, and you are
unlikely to get any credit for your answer. In general, the Examiners would encourage you
to adopt the first method discussed above for deriving mixed strategy Nash equilibria. That
method is the simplest, makes the underlying intuition clear and minimises the chance of
making a mistake.
(d) Again assume that the firms make entry decisions simultaneously. However, before
the game starts, Zoom enters into a contract with a supplier of stands for the new
televisions. The contract is reported in the newspapers so that everyone is aware of the
contract. The contract promises the supplier of stands a payout of 6 million from Zoom if
Zoom decides not to enter the market.
Find all pure-strategy Nash equilibria of the game in this case.
[5 marks]
Now the payoffs are as follows.
19
Zoom
E NE
Acme E -4,-4 5,-5
NE 1,5 0,-6
Given these changed payoffs, E is the dominant strategy for Zoom. The only NE is ( NE, E).
Question 16
M,K&R, Chapter 17.
(a) Consider a labour market with two types of workers: high ability and low ability.
The ability of a worker is known only to the worker himself. Explain the conditions
necessary for education to be a credible signal of ability even when education does not
enhance ability.
[12 marks]
The question asks you to explain the basic model of signalling in a job market. Suppose the
cost of acquiring education is higher for low ability workers compared to high ability
workers. Then there could be a threshold number of years of education such that the
employers can successfully discriminate among workers based on acquiring the threshold
level of education. A worker who acquires the threshold level is identified as high ability
and paid the appropriate high wage, while others are paid the low wage associated with
low ability. This works if the wage differential and the cost differential are such that it is
incentive compatible for high ability workers to acquire the threshold level, but not for the
low ability workers who therefore do not acquire education.
(b) An employer has two types of jobs available: high difficulty and low difficulty. There
are two types of workers: high ability and low ability. The ability is known only to the
worker himself.
The utility of a worker is w − c where w denotes salary and c denotes the cost of doing
the job. The salary is w H for the high difficulty job and wL for the low difficulty job.
Further, c varies across worker types and jobs, so that the utilities are as follows:

High Difficulty Job Low Difficulty Job
Suppose wL = 100.
Since the employer cannot observe the ability level of a worker directly, how should he
set w H so that the low ability workers take only the low difficulty jobs and high ability
workers take only the high difficulty jobs?
[8 marks]
A high ability worker will take the job with high difficulty if
w H − 100 > w L − 50.
Setting w L = 100, this implies w H > 150.
20
A low ability worker will take the low difficulty job if
w L − 100 > w H − 150
which implies w H 6 150.

Therefore we must have w H = 150 to satisfy both constraints.
21

Important note
Comments on specific questions – Zone B
Candidates should answer ELEVEN of the following SIXTEEN questions: EIGHT from Section A
(5 marks each) and THREE from Section B (20 marks each).
We use the following abbreviations:
• M,K&R – Morgan, W., M.L. Katz and H.S. Rosen Microeconomics. (Boston, Mass.:
• Perloff – Perloff, J.M. Microeconomics with Calculus. (Pearson Education, 2011) second
edition [ISBN 9781408264324]. (Note that the first edition of this text had the slightly
different title Microeconomics: Theory and Applications with Calculus.)
For each question, we point out the relevant sections from the main text (M,K&R) as well as the
subject guide. Additional references from Perloff are provided for a few questions.
Section A
Question 1
Two indifference curves of an individual cannot cross. Is this true or false? Explain your
answer.
M,K&R, Chapter 2.
This is an easy question that tests your basic knowledge of representation of preferences using
an indifference map. The statement is true, since intersecting indifference curves violate
22
transitivity. You should draw a picture of two intersecting indifference curves and explain how
this violation arises.
Question 2
Compensated demand (Hicksian demand) is always less elastic than ordinary demand
(Marshallian demand). Is this true or false? Explain your answer.
M,K&R, Chapter 4.
This is false. You should understand that compensated demand is obtained from ordinary
demand by removing the income effect, and therefore compensated demand shows only the
substitution effect. So the question is, is the substitution effect always smaller than the total price
effect, which is the sum of the substitution effect and the income effect? This is, of course, not
always true. This is true only when the income effect goes in the same direction as the
substitution effect. In other words, this is true for a normal good. However, for an inferior good,
the income effect goes in the opposite direction compared to the substitution effect, making the
substitution effect larger than the total price effect. Therefore, compensated demand for an
inferior good is more elastic compared to ordinary demand.
Question 3
There is a competitive market for a good. The government announces a per unit subsidy to be
paid to producers of the good. Using a diagram, explain why this policy creates a deadweight
loss.
M,K& R, Chapter 11.
For a better coverage of deadweight loss arising from a variety of policies, see Chapter 9 of
Perloff.
This is an easy question. If you are struggling with this, your preparation is unlikely to be
adequate. Note that without the subsidy, the competitive market equilibrium is efficient. A
subsidy then shifts the supply curve out, which in turn implies that output is now too high
relative to the social optimum. Be careful when drawing the picture. Many candidates correctly
draw the supply curve shift, but then do not correctly identify the triangular area that shows the
deadweight loss.
23
Price
Supply
Deadweight
Loss
P
0
Supply after subsidy
P1
Demand
P -S
0
Q0 Q1 Q
Deadweight loss from subsidy.
Question 4
There are 50 firms in a competitive industry. Each firm has the production function q = ln L,
where q denotes firm output and L denotes the quantity of labour employed by the firm. The
the wage rate is w = 2 and each firm can sell its output at price p = 10. What is the total
labour employment in the industry?
M,K&R, Chapter 10.
Subject guide, Chapter 7 covers the theory of optimisation by the firm. The chapter does not
mention factor demand specifically.
For a better coverage, see Perloff, Chapter 15.1.
Each firm optimally sets MRPL = w, which implies p/L = w. So each firm employs L = p/w
units of labour. Therefore the total employment is 50L = 50p/w. For w = 2 and p = 10, total
employment is 250.
Question 5
In a perfectly competitive industry with constant input prices and constant returns to scale,
the burden of any tax will fall only on the consumers in the long run. Is this true or false?
Explain your answer.
M,K&R, Chapter 10.
24
For a better exposition of this issue, see Perloff, Chapter 8.4.
This is true. You should realise that under the conditions specified in the question, the long run
industry supply curve is horizontal. Once you realise this, the answer is immediate as a
horizontal supply curve implies that price rises by the full extent of a tax, as shown in the
picture.
Price
Long-Run Supply
P0 + t
after tax of t per unit
t
P Long-Run Supply
0
Demand
Q Q
1 0 Quantity
With a flat long-run supply curve, price rises by the full amount of any tax.
Question 6
Rachel has a weekly allowance of 10 from her father which she spends on milkshakes and
other goods (‘other goods’ represents a composite of all other goods). The price of milkshakes
is 1 and the price of other goods is also 1. Rachel’s father wants to spend some more money
on her allowance through one of two options. In addition to giving her 10, he could pay half
of Rachel’s milkshake bill, so that the subsidised price of milkshakes for Rachel is 1/2. In this
case Rachel would choose to buy 8 milkshakes per week, and her father would spend an
additional amount of 4 per week. Alternatively, Rachel’s father could just raise her weekly
allowance by 4. Which option does Rachel prefer? Explain.
M,K&R, Chapter 4.
25
The answer to this question becomes clear if you draw the right picture. The crucial thing to
understand is that the optimal consumption point with the subsidy is also available under the
income transfer, and as you can see from the picture, the income transfer of 4 makes Rachel
better off.
After a price subsidy, Rachel consumes at point A in the figure (8 milkshakes and 6 of other
goods). The income transfer of 4 makes her income 14, which also allows her to consume at A.
But she can clearly move to a higher indifference curve in this case.
Budget constraint
Other with income grant
goods
10
B
Budget constraint
with price subsidy
Original A
budget
constraint
8 10
Milkshakes
Comparing a price subsidy with an income grant.
You could also answer this by pointing out the more general result that for Rachel’s father, EV is
smaller than the expenditure on a subsidy – i.e. he would need to give Rachel less than 4 as
direct income transfer to make her as well off as after the price subsidy. Therefore an income
transfer of 4 makes Rachel better off.
Question 7
Consumers drink both tea and coffee. Suppose that as the price of coffee rises, consumers
drink less tea. Hence the income elasticity of demand for tea is negative. Is this true or false?
Explain your answer.
M,K&R, Chapter 4.
26
This is false. As the price of coffee rises, the substitution effect will increase the demand for tea.
If consumers drink less tea after the rise in price for coffee, this must then be due to the income
effect (which overcomes the substitution effect). As the price of coffee rises, real income falls and
this reduces demand for tea only if it is a normal good. Therefore, for consumers to drink less
tea, the income elasticity of demand for tea must be positive.
Many candidates attempt to answer this question by drawing a picture to start with. Note that a
picture is not very helpful here. What you need to do is to work through the logic of income and
substitution effects. In fact, the best strategy for answering questions of this sort is as follows.
Start by writing down the ‘substitution effect’. Try to argue for the relevant price change, which
direction the relevant demand changes. Here, for example, price of coffee rises, so that the
substitution effect implies a greater demand for tea. Next, write down the ‘income effect’ and
clarify the direction of this effect. The answer should be apparent from the two effects you have
just identified.
Question 8
Consider the two-period model of inter-temporal choice. If consumption in both periods is a

normal good, it is possible that a borrower will borrow less if the interest rate falls. Is this
true or false? Explain your answer.
M,K&R, Chapter 4.
Subject guide, p.22 as well as pp.32–36.
For some questions, drawing a picture is essential. However, as noted in discussing the
approach to the previous question, this is not true for every question. This is another example
where just drawing a picture will not give you the answer. You need to know the logic of the
answer first, and then you can show this in a picture to clarify your own understanding, but you
cannot simply draw a picture and try to guess the answer from that.
Let us try the method identified in discussing the approach to the previous question. A fall in
the interest rate has two effects.
• Substitution effect: The price of current consumption, C0 , has fallen relative to future
consumption, C1 , so a borrower will choose a higher C0 . This implies that a borrower will
borrow more.
• Income effect: Since consumption in both periods are normal goods, the income effect
implies the borrower will choose a higher C0 which implies higher borrowing.
From the above, we see that both income and substitution effects imply higher borrowing. It
follows that the statement is false.
Question 9
You don’t know your neighbour, but you can see his garden from your living room window.
Your neighbour enjoys gardening and you enjoy the view of his garden. It follows that your
neighbour is working too little on the garden compared to the social optimum. Is this true or
27
M,K&R, Chapter 18.
This is true. The neighbour’s gardening generates a positive externality. Since the gardener
presumably does not take his neighbour’s enjoyment into account when deciding how much
effort to spend on his garden, the effort expended is socially suboptimal.
Question 10
Suppose that in the market for paper, the inverse demand curve is given by
P = 100 − Q
MCP = 10 + Q
Pollution generated during the production process creates external marginal harm equal to
MCE = Q
Subject guide, pp.58–59 (monopoly) and pp.101–104 (externalities).
First, the socially optimal quantity of paper is found by setting MCP + MCE = P or
10 + Q + Q = 100 − Q. Rearranging yields Q = 30. Under monopoly, the firm sets MCP equal to
marginal revenue, which is given by 100 − 2Q. From MCP = 100 − 2Q we get Q = 30. It follows
that the output under monopoly is socially optimal, and therefore monopoly creates no
deadweight loss.
(This is not required for the answer, but note that the competitive output is found by setting
MCP = P or 10 + Q = 100 − Q. Rearranging yields Q = 45. The deadweight loss of those
additional units equals (45 − 30) × 45/2 = 337.50. It follows that social welfare is greater under
monopoly.)
28
Section B
Question 11
Consider the following exchange economy. There are two goods (b and c), and two consumers
(1 and 2). Let bi and ci denote the consumption of goods b and c respectively by consumer i,
i ∈ {1, 2}.
U1 (b1 , c1 ) = b1/3
1 c1
2/3
U2 (b2 , c2 ) = b1/2
2 c2
1/2
Consumer 1 is endowed with 10 units of b and 20 units of c. Consumer 2 is endowed with 20

units of b and 10 units of c.
Suppose the price of good c is 1, and let p denote the price of good b.
M,K&R, Chapter 12.
(a) Derive the demand functions of the two consumers for b and c.
[10 marks]
At the optimum, for each consumer,
MUb
MRSbc = = p.
MUc
c1
For 1, this implies 2b
1
= p, and for 2, this implies bc22 = p. Consumer 1’s budget constraint is
pb1 + c1 = 10p + 20. This implies 3pb1 = 10p + 20, or
10p + 20
b1 = .
3p
Similarly,
2(10p + 20)
c1 = .
3
Consumer 2’s budget constraint is pb2 + c2 = 20p + 10. Therefore,
20p + 10
b2 =
2p
and
20p + 10
c2 = .
2
(b) Derive the competitive equilibrium price of b in this economy, and the equilibrium
quantities of the two goods consumed by each consumer.
[10 marks]
29

Market clearing implies c1 + c2 = 30, which implies
20p + 40 20p + 10
+ = 30.
3 2
Solving,
40p + 80 + 60p + 30 = 180
which implies p = 7/10. It follows that b1 = 90/7, c1 = 18, b2 = 120/7 and c2 = 12.
Question 12
M,K&R, Chapter 6.
For a good coverage of the expected utility model, as well as the derivation of risk premium for
a risk-averse individual, see Perloff, Chapter 17.2.
(a) Using either the contingent commodities model or the expected utility model, explain
why a risk averse individual would choose full insurance under fair odds.
[5 marks]
The recommended text explains this using a contingent commodities model. Essentially,
you need to explain that the indifference curves of a risk averse individual are convex (the
better-than set is convex) and they are tangent to the fair-odds line at the point of full
insurance. You should explain, following the text, why any other scenario leads to a
contradiction. It then follows that the decision of how much to gamble on a fair bet is the
same as deciding the best point on the fair odds line. But this is simply the endowment
point of full-insurance.
Consumption
if loss does
not occur
Full Insurance Line

(Certainty Line)
Fair-odds
line (slope = - p/(1-p))
Consumption if loss
occurs
Optimal choice under uncertainty by a risk-averse consumer who faces a loss with
probability p.
30
(b) Rai has wealth 81, but if she becomes ill, she will have to pay medical bills, reducing
1
her wealth to 36. The probability that Rai will fall ill is . Rai’s utility function is given
3
by √
u (W ) = W
where W denotes wealth. Rai has the option of buying insurance coverage for illness
from an insurance company.
i. What is the maximum premium that Rai is willing to pay for full insurance?
[5 marks]
Rai’s expected utility is
2√ 1√
EU = 81 + 36 = 6 + 2 = 8.
3 3
√
Therefore the certainty equivalent is CE = 8, or CE = 64. Therefore the maximum
premium is 81 − 64 = 17.
ii. What is the minimum premium that the insurance company would accept to provide
full insurance?
[5 marks]
The fair premium is equal to expected payout, which is 31 (81 − 36) = 45
3 = 15.
iii. Suppose Rai can buy X units of cover by paying a premium of X3 (i.e. the insurance
company pays X to Rai if she falls ill, and Rai pays the insurance company X3 whether
she is ill or not ill). What is the optimal choice of X by Rai?
[5 marks]
You should realise that this is just fair insurance. Once you understand this, it is
straightforward to conclude that Rai would buy full insurance, so that X = 45.
Question 13
A competitive firm produces according to the following production function:
Q = 2L1/2 K 1/2
where Q denotes the firm’s output, K denotes capital and L denotes labour. The price of
labour is 4 and the price of capital is 16. Let P be the price at which the firm can sell its
output. In the short-run, capital is fixed at some level K. In the long run both labour and
capital are variable.
Subject guide, p.48 and pp.56–58.
For a better discussion of these issues, see Chapters 7 and 8 of Perloff.
(a) Write down the total short run cost of the firm as a function of the output Q and the
fixed level K.
[5 marks]
31

Let K be fixed at K. From the production function,
Q2
L= .
4K
Therefore the total cost is
Q2
TC = 4L + 16K = + 16K.
K
(b) What is the minimum average cost in the short run?

[5 marks]
Equate AC and MC.
Q 16K 2Q
+ = .
K Q K
This implies Q = 4K. At this quantity, AC= 8.
(c) What is the short-run supply curve of the firm? In answering this question, be careful
to check whether there is a P below which the firm would shut down in the short run (so
that supply would be zero for such prices).
[5 marks]
The supply curve is given by P = MC above the AVC curve. Now
Q 2Q
AVC = < = MC.
K K
Therefore the firm continues operation at all positive prices, and the supply curve is given
simply by P = MC which is P = 2Q/K, or
PK
Q= .
2
(d) Now consider the long-run scenario in which both labour and capital are variable
inputs. Derive and explain the shapes of the long-run marginal and average cost curves
of the firm.
[5 marks]
Approaching the question Now,
MPL 4
= .
MPK 16
The left hand side is simply K/L. So we have
L = 4K.
It follows that
Q = 2K1/2 (4K )1/2 = 4K.
So K = Q/4 and therefore L = Q. Therefore total cost in the long run is
Q
C = 4Q + 16 = 8Q.
4
Therefore long-run AC and MC are both 8. In other words, the long-run AC (and MC) is
constant at 8. This arises from the fact that we have a CRS production function and the
32
factor costs are constant. The picture below shows the LRAC and LRMC with short-run AC
curves for K = .5 and K = 1 (and the associated MC curves).
SRAC1
SRAC2
8
LRAC=LRMC
2 4 6 8 10
LRAC and LRMC with short-run AC curves for K̄ = 0.5 (SRAC1) and K̄ = 1 (SRAC2), and
the associated MC curves (shown as dashed lines).
Question 14
Suppose there are two identical firms in an industry. The output of firm 1 is denoted by q1
and that of firm 2 is denoted by q2 . Let Q = q1 + q2 . The total cost of production for firm 1 is
2 + q1 and that for firm 2 is 2 + q2 . The inverse demand curve in the market is given by
P = 10 − Q
For Cournot equilibrium, see M,K&R, Chapter 15 and subject guide, pp.77–78.
For tacit collusion in a repeated game, see M,K&R, pp.600–603 and subject guide, pp.79–80.
(a) Find the Cournot-Nash equilibrium quantity produced by each firm and the market
price.
[5 marks]
To calculate the Cournot quantities, first derive the reaction functions. Firm 1 chooses q1 to
maximise (10 − q1 − q2 )q1 − 2 − q1 . The first order condition (best-response function of firm
1 or reaction function of firm 1) is given by
9 − q2
q1 = .
2
Similarly, the reaction function of firm 2 is given by
9 − q1
q2 = .
2
33
Either solve by imposing symmetry at this point (easier), or solve directly. Solving, we get
q1 = q2 = 3. Therefore the equilibrium quantity produced by each firm is 3, and the market
price is 10 − 6 = 4.
[5 marks]
The efficient quantity in the market can be found by setting P = MC. Here MC is 1. So we
have 10 − Q = 1, or Q∗ = 9. The total Cournot quantity is 6, and the price is 4. Therefore
the loss is
(4 − 1)(9 − 6)
DW L = = 4.5.
2
Price
10
Q D = 10 - P
Deadweight Loss
4
6 9 Quantity
Calculating the deadweight loss from Cournot equilibrium.
(c) Under what conditions can the firms successfully engage in collusive behaviour?
Explain informally but carefully.
[5 marks]
From past answers, it seems that many candidates think collusion is somehow connected
with price competition only, and that repeated interaction makes no difference if the firms
are competing in quantities. As previous Examiners’ commentaries have pointed out, this is
entirely incorrect. Infinitely repeated games allow firms to collude whether they compete in
prices or quantities (so long as the firms are patient enough, i.e. they have high enough
discount factors).
Further, as previous Examiners’ commentaries have pointed out, whether the firms have the
same cost or different costs makes no difference to the possibility of collusion.
The important point to make in your answer is that repeated interaction allows firms to
choose a collusive quantity (smaller than the total Cournot quantity) and increase total
profit so long as the firms are patient enough (their discount factor is high enough).
34
While the points noted in the paragraph above are enough for answering the question, let
us go a bit further here and point out how collusion works in this case in a more formal
manner. Suppose each firm has a discount factor δ, where 0 < δ < 1.
Let Q M denote the total collusive quantity (you can work out the exact figure by
maximising joint profit). Suppose each firm produces half of this under collusion. Now,
suppose each firm adopts the following ‘trigger’ strategy. Start by producing Q M /2 at
t = 0. In any subsequent period t > 1, do as follows:
• If in period t − 1 each firm produced Q M /2, produce Q M /2 in period t.
• If in period t − 1 any single firm deviated, produce the Cournot quantity 3 in period t
and in all future periods.
Such a strategy is called a ‘trigger’ strategy since a deviation by any single firm triggers
non-cooperation in all future periods.
Now, the best possible deviation by a firm is to produce the one-period best response to
Q M /2. Let us call this Q D . Again, you can easily work out the precise figure. Let πi ( x )
denote the profit of firm i from producing quantity x.
If firm i deviates in any period, it gets πi ( Q D ) that period, but subsequently, each firm
produces the Cournot quantity so that the payoff in each subsequent period is πi (3). So the
total payoff starting from the deviation period is:
δ
πi ( Q D ) + δπi (3) + δ2 πi (3) + δ3 πi (3) + . . . = πi ( Q D ) + π (3)
1−δ i
If firm i had not deviated, its payoff over the same periods would be
1
πi ( Q M /2) + δπi ( Q M /2) + δ2 πi ( Q M /2) + . . . = π ( Q M /2)
1−δ i
Therefore, for deviation to be unprofitable, we need
1 δ
π ( Q M /2) > πi ( Q D ) + π (3)
1−δ i 1−δ i
Simplifying,
πi ( Q M /2) > (1 − δ)πi ( Q D ) + δπi (3)
Which gives us
πi ( Q D ) − πi ( Q M /2)
δ>
π i ( Q D ) − π i (3)
Since πi ( Q M /2) > πi (3) (the payoff of each firm under collusion is necessarily higher than
that under Cournot competition), the expression on the right hand side is less than 1.
Therefore, for δ high enough (close enough to 1), the above inequality is satisfied for all i,
and for such values of δ, collusion can be sustained.
(d) What would be the quantities produced by each firm and market price under
Stackelberg duopoly if firm 1 moves first?
[5 marks]
Firm 1 now chooses a quantity given 2’s reaction function q2 = (9 − q1 )/2. So firm 1’s profit
is
(9 − q1 )

10 − q1 − q1 − 2 − q1 .
2
Maximising with respect to q1 , we get
q1 = 4.5.
Therefore q2 = 2.25. The market price is P = 10 − 6.75 = 3.25.
35
Question 15
Suppose that Acme and Zoom are the only two firms that can produce a new type of
high-definition television. If both enter the market, there is a price war so that each firm
makes a loss. If only one firm enters, it makes a profit and sources some parts from the other
firm, so that the other firm also makes a profit. The payoffs (in millions of dollars) from the
various combinations of entry decisions are shown in the following payoff matrix, where E
denotes ‘enter’ and NE denotes ‘not enter’.
Zoom
E NE
Acme E -4,-4 5,1
NE 1,5 0,0
The coverage of game theory in M,K&R, Chapter 16 is not ideal.
See Chapter 9 of the subject guide for a detailed discussion.
(a) Find all pure-strategy Nash Equilibria of this game, assuming the firms make entry
decisions simultaneously.
[5 marks]
This is just testing that you know what a Nash equilibrium is. If you know this, it is
straightforward to see that the Nash equilibria in this game are ( NE, E) and ( E, NE).
(b) Suppose now the game is played sequentially, with Acme moving first. Find the
credible Nash equilibria now.
[5 marks]
The credible Nash equilibrium is ( E, NE). The answer should mention why the other pure
Nash equilibrium is not credible. Essentially, the threat by Zoom to enter if Acme enters is
not credible.
In previous years, the concept of subgame-perfect Nash equilibrium had not been included
in the syllabus. However, the new subject guide discusses the notion of a strategy in a
dynamic game, and clarifies the concept of subgame-perfect Nash equilibrium. In future,
questions might ask you to calculate the subgame-perfect Nash equilibrium rather than ask
you to employ the informal notion of credible Nash equilibrium used here. The difference
between the two lies in the specification of strategies. A strategy in a dynamic game with
sequential moves (also called an extensive-form game) is a complete plan of actions, and
therefore you need to specify an action for the second mover after every action of the first
mover.
A subgame perfect Nash equilibrium (which is a formalisation of the notion of credibility)

is a Nash equilibrium of the whole game that also induces Nash equilibrium play in every
subgame. For games of perfect information, we can obtain the subgame perfect equilibrium
using backward induction. (In more complicated games where a player does not have
perfect information about moves of previous players, backward induction may not work,
but such games are outside the scope of this course.)
The dynamic or extensive-form game being analysed here is as follows.
36
Acme
E NE
Zoom Zoom
E NE E NE
(-4,-4) (5,1) (1,5) (0,0)
Let us use backward induction to derive the subgame perfect Nash equilibrium of this
game. In the subgame after Acme plays E, the optimal choice by Zoom is NE. Further, in
the subgame after Acme plays NE, the optimal choice by Zoom is E. Given these choices of
Zoom, Acme prefers E. Therefore the subgame perfect Nash equilibrium is as follows:
Acme’s strategy is to play E, Zoom’s strategy is to play NE if Acme chooses E and to play E
if Acme chooses NE.
Of course, given these equilibrium strategies, the players will end up playing E by Acme
and NE by Zoom, with the resulting payoff profile (5, 1).
(c) Now assume again that the firms make entry decisions simultaneously. Find the
mixed-strategy Nash equilibrium of this game.
[5 marks]
Acme plays E with probability p and NE with (1 − p), and Zoom plays E with probability q
and NE with (1 − q). The probability p must be such that Zoom is indifferent between E
and NE, so
−4p + 5(1 − p) = p
which implies that p = 21 . The probability q must be such that Acme is indifferent between
E and NE. The game is symmetric, so q = 21 as well.
You can also see all Nash equilibria by drawing the best response functions of the two
players, as shown in the picture.
37
Zoom’s best
response function
1
C
1/2
B
Acme’s
best
response
function
A
0 1
1/2
p
A and C are pure strategy Nash equilibria and B is the mixed strategy Nash equilibrium.
Many candidates answer this correctly. Some candidates use a slightly different method:
first write down the expected payoff of each player given that each plays a mixed strategy.
Let Eπ A denote the expected payoff of Acme. Now differentiate this with respect to p and
set this equal to zero. What does this do? Well, this should give us the value of q for which
Eπ A does not depend on p (i.e. the derivative of Eπ A with respect to p is zero, so that the
expected payoff of Acme does not change when p changes). This is precisely the value of q
for which Acme would be indifferent between E and NE. For all other values of q, the
derivative is either positive or negative, so that the optimal choice of p is either 1 (when the
derivative is positive) or 0 (when the derivative is negative). Similarly we can find the p for
which Zoom is indifferent.
However, note that when you set dEπ A
dp = 0, this is not a maximisation exercise (i.e. this is
not a first order condition). If you say you are maximising with respect to p, this tells the
Examiners that you have not understood the exercise you are carrying out, and you are
unlikely to get any credit for your answer. In general, the Examiners would encourage you
to adopt the first method discussed above for deriving mixed strategy Nash equilibria. That
method is the simplest, makes the underlying intuition clear and minimises the chance of
making a mistake.
(d) Again assume that the firms make entry decisions simultaneously. However, before
the game starts, Zoom enters into a contract with a supplier of stands for the new
televisions. The contract is reported in the newspapers so that everyone is aware of the
contract. The contract promises the supplier of stands a payout of 6 million from Zoom if
Zoom decides not to enter the market.
Find all pure-strategy Nash equilibria of the game in this case.
[5 marks]
Now the payoffs are as follows.
38
Zoom
E NE
Acme E -4,-4 5,-5
NE 1,5 0,-6
Given these changed payoffs, E is the dominant strategy for Zoom. The only NE is ( NE, E).
Question 16
M,K&R, Chapter 17.
(a) Consider a labour market with two types of workers: high ability and low ability.
The ability of a worker is known only to the worker himself. Explain the conditions
necessary for education to be a credible signal of ability even when education does not
enhance ability.
[12 marks]
The question asks you to explain the basic model of signalling in a job market. Suppose the
cost of acquiring education is higher for low ability workers compared to high ability
workers. Then there could be a threshold number of years of education such that the
employers can successfully discriminate among workers based on acquiring the threshold
level of education. A worker who acquires the threshold level is identified as high ability
and paid the appropriate high wage, while others are paid the low wage associated with
low ability. This works if the wage differential and the cost differential are such that it is
incentive compatible for high ability workers to acquire the threshold level, but not for the
low ability workers who therefore do not acquire education.
(b) An employer has two types of jobs available: high difficulty and low difficulty. There
are two types of workers: high ability and low ability. The ability is known only to the
worker himself.
The utility of a worker is w − c where w denotes salary and c denotes the cost of doing
the job. The salary is w H for the high difficulty job and wL for the low difficulty job.
Further, c varies across worker types and jobs, so that the utilities are as follows:

High Difficulty Job Low Difficulty Job
Suppose wL = 100.
Since the employer cannot observe the ability level of a worker directly, how should he
set w H so that the low ability workers take only the low difficulty jobs and high ability
workers take only the high difficulty jobs?
[8 marks]
A high ability worker will take the job with high difficulty if
w H − 100 > w L − 50.
Setting w L = 100, this implies w H > 150.
39
A low ability worker will take the low difficulty job if
w L − 100 > w H − 150
which implies w H 6 150.

Therefore we must have w H = 150 to satisfy both constraints.
40

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UNIVERSITY OF LONDON EC2066 ZA

Wednesday, 16 May 2012 : 10.00am to 1.00pm

© University of London 2012

Answer eight questions from this section (5 marks each).

1. A monopolist practices third degree price discrimination across two markets, A

2. Compensated demand (Hicksian demand) is always less elastic than ordinary

7. Suppose ﬁrms in a competitive market produce output using a technology fea-

The private marginal cost is

Pollution generated during the production process creates external marginal

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Answer three questions from this section (20 marks each).

where w is the hourly wage, H is hours worked, and I0 is non-labour in-

Suppose we observe that if I0 increases, Lyra’s consumption of C always

iii. Is leisure a normal good or an inferior good for Will? Explain.

where Y denotes wealth. Suppose an insurance company is available to provide

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(a) Derive the short-run supply curve of a ﬁrm. [5 marks]

A tax of 30 per unit sold is now imposed on every unit sold.

(c) Calculate the tax revenue raised. [5 marks]

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Utility from Utility from

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UNIVERSITY OF LONDON EC2066 ZB

Wednesday, 16 May 2012 : 10.00am to 1.00pm

© University of London 2012

Answer eight questions from this section (5 marks each).

2. Compensated demand (Hicksian demand) is always less elastic than ordinary

The private marginal cost is

Pollution generated during the production process creates external marginal

Answer three questions from this section (20 marks each).

U1 (b1 , c1 ) = b11/3 c2/3

Consumer 2 has utility function

U2 (b2 , c2 ) = b21/2 c1/2

Consumer 1 is endowed with 10 units of b and 20 units of c. Consumer 2 is

Utility from Utility from

Examiners’ commentaries 2012

Information about the subject guide

• be able to define and describe:

• be able to analyse and assess:

• be prepared for further courses which require a knowledge of microeconomics.

Key steps to improvement

Essential reading: important information

Examiners’ commentaries 2012

Information about the subject guide

Comments on specific questions – Zone A

We use the following abbreviations:

Answer eight questions from this section (5 marks each).

Reading for this question

M,K&R, Chapter 13.

Subject guide, pp.59–60.

Approaching the question

This is true. The optimality condition is MR A ( Q A ) = MR B ( Q B ) = MC ( Q A + Q B ). To find the

Third degree price discrimination.

Reading for this question

Subject guide, pp.18–22.

Approaching the question

Reading for this question

M,K&R, Chapter 11.