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Mgec HW4

Arnab has Rs. 6,00,625 and can either keep it or invest in a factory. If invested, there is a 60% chance of earning Rs. 10,00,000 and 40% chance of Rs. 250,000. His utility is maximized by investing since the expected utility is 800 versus 775 for not investing. LEICO offers annuities paying Rs. 5000 annually until death. The break-even deposit is Rs. 62,311. Those expecting to live longer than 80 years will buy. With varying life expectancies, the deposit is Rs. 57,102 and will be bought by those expecting 77 years or less. The Cournot equilibrium outputs are (2,

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124 views3 pages

Mgec HW4

Arnab has Rs. 6,00,625 and can either keep it or invest in a factory. If invested, there is a 60% chance of earning Rs. 10,00,000 and 40% chance of Rs. 250,000. His utility is maximized by investing since the expected utility is 800 versus 775 for not investing. LEICO offers annuities paying Rs. 5000 annually until death. The break-even deposit is Rs. 62,311. Those expecting to live longer than 80 years will buy. With varying life expectancies, the deposit is Rs. 57,102 and will be bought by those expecting 77 years or less. The Cournot equilibrium outputs are (2,

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Akash Yadav
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© © All Rights Reserved
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Problem 1:

Arnab is a risk-averse decision maker whose utility function is given by U(I) =


√I ,
where I denotes Arnab’s monetary payoff. Arnab has Rs. 6,00,625. He can either keep
this, or he can invest all this money in a machine tools factory. If he invests, then he
may end up with Rs. 10,00,000 with probability 0.6, or Rs. 250,000 with probability 0.4.
Should Arnab invest in this factory?

Solution -
The decision would be based on maximum utility.
Current Utility = 775
New Utility = 0.6*1000 +0.4*500 = 800

Since, Utility is more he should invest.

Problem 2: An annuity provides insurance against out-living one’s financial resources. LEICO, a
life insurance company, takes a deposit from customers at age 60 years, and returns an annual
payment of Rs. 5000 till their death.
(a) Calculate the break-even deposit for LEICO if average population-wide life expectancy is 80
years. Assume a 5% interest rate.
(b) If potential customers have a sense of their life expectancy, based on factors such as the
longevity of their parents, who will purchase the annuity with the deposit you have calculated
above?
(c) If life expectancy is uniformly distributed in the population (up to a maximum of 100 years)
and potential customers have a sense of their life expectancy, what is the deposit that LEICO
will ultimately end up charging? Who will finally buy this annuity?

Solution -
a) 62311 ( 5000/1.05 + 5000/1.05^2 + …..5000/1.05^20 )
b) People who expect to live more than 80 years
c) 57102.2 (People <=77 years of age)

Problem 3: Find the Cournot-Nash Equilibrium in a game with two French fry manufacturers,
Freddie’s Fries and Charlie’s Chips. There are five levels of production: produce 200, 300, 400,
500 or 600 thousands tons of output. The numbers in the table below represent as (FF,CC) the
profits for Freddie’s Fries and Charlie’s Chips corresponding to the quantities they produce. 200
300 400 500 600 200 63,-1 28,-1 -2,0 -2,45 -3,19 300 32,1 2,2 2,5 3,0 2,3 400 54,1 95,-1 0,2 4,-
1 0,4 500 1,-33 -3,43 -1,39 1,-12 -1,17 600 -22,0 1,-13 -1,88 -2,-57 -3,72
(a) What is the Nash Equilibrium output for this game assuming that the two firms choose their
production quantities simultaneously?
(b) What would be the equilibrium if Charlie’s Chips could choose its output first and Freddie’s
Fries chose second, taking Charlie’s decision as given.

Solution - a) (2,5) b) (54,1) or (32,1)


Problem 4: Consider a Cournot duopoly in which the two firms have different marginal costs. The inverse
demand in the market is P(Q) = 15 − Q. The costs of firm A and firm B are CA(qA) = 6qA and CB(qB) =
3qB, respectively.
(a) What is the best response (or reaction) function of firm A?
(b) What is the best response (or reaction) function of firm B?
(c) What are the equilibrium quantities produced by each firm?
(d) What is the market price?
(e) What are the profits of each firm?

Solution -
a) 15 - 2qa - qb = 6 → qa = (9 - qb)/2
b) 15 - qa - 2qb = 3 → qb = (12 -qa)/2
c) qb = 5 and qa =2. Q = 7
d) P = 8
e) (Profit)a = 16-12 = 4
(Profit)b = 40 - 15 = 25

Problem 5: (a) Firm A currently monopolizes its market and earns profits of $10 million1 . Firm B
is a potential entrant that is thinking about entering the market. If B does not enter the market, it
earns profits of $0, while A continues to earn profits of $10 million. If B enters, then A must
choose between accommodating entry, or fighting it. If A accommodates, then A earns $5
million and B earns $5 million. If A fights, then both firms lose $5 million. Draw the game
inextensive form and predict the outcome.

(b) Again, consider the above game. Now, suppose the decision of B to enter is reversible in the
following way. After B enters the market, and A has decided to either fight or accommodate, B
can choose to remain in the market or exit. All payoffs from the above game remain the same.
However, if B decides to exit the market, then B suffers a loss of $1 million, while A regains its
old profits of $10 million. Draw the game in extensive form and predict the outcome.

Solution -
a) If A can make a credible threat to B to fight its arrival then B will not enter the market
but with the given information, this threat can not be deemed credible. When B has
entered the market, A does not have any incentive to fight. So, the equilibrium is B
enters and then they split the market share

b) Stay. Because A has dominant strategy to not fight


Stay Exit

Fight -5, -5 5, -1

Not Fight 5,5 10, -1


Problem 6: The accompanying article presents a decision facing Robert Gates, the US Secretary of
Defense, who is trying to reduce costs for the US Air Force’s F-35 fighter program. The engines for the
plane are currently produced by Pratt and Whitney in Connecticut. Some lawmakers want to start a
second production line for the engines in Ohio, run by GE and Rolls Royce. Mr. Gates argues that a
single production line will save costs for the military, while Ohio lawmakers (who value the jobs the
second line will create) say that competition will lower engine prices and increase the welfare accruing to
the sole consumer – the US military. As a budget analyst at the Pentagon, you have been asked to analyze
two possible scenarios and advise Secretary Gates on production strategy. You determine that the
military’s demand curve for F-35 engines is given by P = 1000 − Q. The marginal cost of production
(revealed in Congressional filings) is $120 mm per plane for Pratt and Whitney (the original incumbent)
and $160 mm per plane for GE-Rolls Royce (the potential entrant).
(a) What is the quantity of engines produced if Pratt and Whitney is the monopolist supplier in
the market? What is the price that the government has to pay for the engines? What is the
consumer surplus for the military in this case?
(b) Now consider the duopoly case where Pratt and Whitney is the Stackelberg leader and GE-
Rolls Royce is the Stackelberg follower. What is the price that the government has to pay for the
engines? How many engines are produced and what is the consumer surplus for the military in
this case?
(c) Should Secretary Gates agree to the second production line? Explain briefly.

Solution -
a) MC = MR
120 = 1000 - 2Q
Q = 440
P = 560
Consumer Surplus = 0.5*440*440 = 96,800

b) 160 = 1000- q1 - 2q2


q2 = (840 - q1)/2

(Profit)1 = (1000 -q1/2 -420)*q1 - 120q1


→ 460 - q1 = 0
→ q1 = 460
→ q2 = 190
→ P = 350
Consumer Surplus = 0.5*650*650 = 2,11,250

c) Yes. 50% increase in number of planes with 8% reduction in total expenditure

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