EC201 Microeconomic Principles 1

Collective Feedback
Summer 2019

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Common errors that students made were:

• Failing to read the question properly. There are details below. It may help you to make brief
notes of what the question tells you and exactly what you are told to find. If you do not use
some of the information in a question you have probably made a mistake.

• Failure to explain what you are doing. An explanation for what you are doing is always required.

• Poor diagrams, either too small or to messy to follow. This can be a major difficulty, especially
if coupled up with bad handwriting.

• Getting timing wrong and the missing entire questions or major parts of questions. If you find
yourself getting into difficulties, for example with algebra, stop, leave yourself space in your
answer book to come back to the question, and move on to another question. You may find that
when you come back to the question which caused you problems you see how to do it. If you
do a question and get a silly answer, e.g. a negative price, point out your error, but do not try to
correct it unless you have time at the end of the exam.

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 Section A
(Answer all SIX questions. Each question carries 25 marks.)

Question 1
(a) Define the total cost function. What happens to the total cost function if the prices of all inputs
decrease by 20%? Use a diagram to explain your answer. [10 marks]

Feedback : [10 marks]

The total cost function c(v, w, q) is the minimum cost of producing output q using capital
K and labour L with prices v and w.
If the prices of all inputs decrease by 20% the total cost function decreases by 20%. This
is one of the key properties of the cost function. However, simply stating that the cost
function is homogeneous of degree one in input prices would not have been enough.
The diagram required can be found in the lecture notes and simply shows the tangency
between the isocost and isoquant. Students should have pointed out that the optimal input
bundle is not changing because both prices went down by the same percentage and hence
the only thing changing is the cost needed to afford the bundle (now lower). The slope of
the isocost line is −w/v . If w and v both increase by 20% the ratio doesn’t change, so the
tangency point doesn’t change, so conditional factor demand L(v, w, q) and K (v, w, q)
don’t change. However the cost of K and L decreases by 20% so the total cost function
decreases by 20%.
A common mistake was to show shifts in the isoquant and isocost lines. The isoquant
does not change because the quantity produced does not change. The tangency point is
determined by the isoquant and the slope ? w/v of the isocost line, which does not change
because both prices increase by the same percentage.

(b) Define an entry-and-exit equilibrium for a perfectly competitive industry. Suppose that an indus-
try is perfectly competitive and that all firms in the industry, including potential entrants, have
the same total cost function. What profits do the firms make if the industry is in entry-and-exit
equilibrium? [8 marks]

Feedback : [8 marks]
In entry and exit equilibrium in a perfectly competitive industry:
•Each firm supplies a profit maximizing level of output given input and output prices.
•The market clears, that is supply = demand.
•The number of firms in the industry and industry price are at a level where, no firms in
the market make losses, and no firm outside the market could enter and make positive
profits.
Here all firms, including potential entrants, have the same cost function, so in entry and exit
equilibrium all firms make zero profits.
Here most students wrote something but forgot at least one of the conditions needed.

(c) Suppose that the industry starts in an entry-and-exit equilibrium, and then input prices decrease
by 20%. The industry adjusts until it is again in entry-and-exit equilibrium. What happens to the
industry price? What happens to the output of an individual firm? Does the number of firms in
the industry change? [7 marks]

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 Feedback : [7 marks]
Here there are two ways of answering the question, one assuming U-shaped average cost
curves and one assuming constant returns to scale. In the first case when input prices in-
crease and the industry adjusts to the new entry and exit equilibrium the firm still produces
at the same zero profit level of output at which AC has a minimum and MC = AC. However
AC, MC and the industry price decrease by 20%. This implies that demand increases, so
industry output increases. As firms produce the same quantity as before the number of
firms in the industry must increase.
The alternative is constant returns to scale with a horizontal MC = AC curve. In this situation
both the output of an individual firm, and the number of firms in the industry are indeter-
minate. One firm could expand production now that costs are lower so that the number of
firms in the industry doesn’t change.
The effects on price and quantity are the same regardless of the assumptions made on the
cost curve: price decreases and quantity sold increases.
Some people referred to firms setting prices. In perfect competition firms take prices as
given. This does not imply that prices do not change, but it does imply that nothing that a
firm can do changes the price. Some people thought that if input prices decrease the firms
will produce more. This is correct if the price at which the firms sell does not change, but
this is not what happens. The price at which the firms sell also falls by 20%. This output q
at which price = MC = AC does not change, p, MC and AC all decrease by 20%. Thus firm
output does not change. However at the lower price consumers demand more, so industry
output has to increase. As each firm produce the same q the number of firms in the industry
has to increase.

Question 2
This question asks you to work with a greatly simplified model of the state of the UK debate on leaving
the European Union in February 2019.

• There are two groups of politicians, leavers and remainers.

• Each group has to make a proposal, either leave with a deal, or delay leaving.

• If they make the same proposal this determines the outcome.

• If they make different proposals the UK leaves the European Union with no deal.

• For leavers leaving with no deal is the best result. For remainers leaving with no deal is the worst
result.

The payoffs are described by the following matrix which you should analyse as a game. In each cell
the number on the left is the payoff of the leavers and the number on the right is the payoff of the
remainers.

Remainer
Leave with deal Delay
Leaver Leave with deal 2, 1 3, -1
Delay 3, -1 1, 2

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(a) Explain the distinction between an equilibrium in pure strategies and an equilibrium in mixed
strategies. Does the game have an equilibrium in pure strategies? [10 marks]

Feedback : [10 marks]

Here there was a lot of confusion between pure strategy equilibria and dominant strategy.
In general a Nash equilibrium arises where both players are maximizing their payoff given
what the other(s) are doing and cannot individually deviate to improve his/her situation.

A player plays a pure strategy if she does not randomize. In a mixed strategy the players
randomize between strategies.
There is no equilibrium in pure strategies here. As the leavers want no deal, their best
response to whatever the remainers do is to do the opposite. This rules out an equilibrium
in pure strategies on the diagonal. As the remainers hate no deal their best response to
whatever the leavers do is to do the same. This rules out an equilibrium in pure strategies
off the diagonal. There is no equilibrium in pure strategies.

With the numbers:

•Deal/deal is not an equilibrium in pure strategies because the leavers’ best response
to deal is delay as 3 > 2.
•Delay/delay is not an equilibrium in pure strategies because the leavers’ best response
to delay is deal as 3 > 1.
•Delay/deal is not an equilibrium in pure strategies because the remainers’ best re-
sponse to delay is delay as 2 > -1.
•Deal/delay is not an equilibrium in pure strategies because the remainers’ best re-
sponse to deal is deal as 1 > -1.

(b) Does the game have an equilibrium in mixed strategies? [10 marks]

Feedback : [10 marks]

In an equilibrium in mixed strategies each player must be indifferent between the two pure
strategies given the probability with which the other player randomizes; otherwise he will
not be willing to randomize.

If the leavers play deal with probability p and delay with probability 1 − p the remainers are
indifferent if

p − (1 − p) = −p + 2 (1 − p)

so p = 3/5. If the remainers play deal with probability q and delay with probability 1 − q
the leavers are indifferent if

2q + 3 (1 − q) = 3q + (1 − q)

so q = 2/3. Thus is the equilibrium in mixed strategies leavers propose deal with proba-
bility 3/5 and remainers propose deal with probability 2/3.

(c) Recall that the outcome is leave with no deal if the remainers and leavers make different pro-
posals. What is the probability of leaving with no deal? [5 marks]

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 Feedback : [5 marks]
The probability of leaving with no deal is the probability of the off diagonal cells, i.e.

2 2 3 1 7
(1 − p) q + p (1 − q) = ∗ + ∗ = .
5 3 5 3 15
Some students considered the probability of leaving to be 1-Pr(deal,deal). This is incorrect
as it also considers the case where they both agree to delay the decision.

Question 3
There are 100 people in an economy and their incomes are as follows: 25 have income of £2, 50 have
income of £4 and 25 have income of £8.

(a) What is the average income in the economy? [3 marks]

Feedback : [3 marks]

(25 × 2) + (50 × 4) + (25 × 8)

= 4.5
100

(b) Draw the Lorenz curve for this economy. [10 marks]

Feedback : [10 marks]

This is a standard Lorenz curve, like the one seen in the lecture. This is drawn in the at-
tached figure. Here the perfect answer would have started with an explanation of what
a Lorenz curve is and what calculations are needed, i.e. the share of income against the
share of people. Many students left too much the examiners’ imaginations simply record-
ing numbers without explaining where these were coming from.
A lot of students failed to draw an accurate Lorenz curve and only showed a piece-wise
upward sloping line or curve. Here we get three segments (all linear), one for each group
of people. Note that the Lorenz curve shows shares of income/people on the axes so no
number should have been greater than 1.

(c) Suppose that the incomes of some people fall and some increase so that the income distribu-
tion is: 75 have income of £2 and 25 have income of £8. Draw the new Lorenz curve. Can you
say whether inequality has increased or decreased from part b) by looking at the Lorenz curve?
[12 marks]

Feedback : [12 marks]

Here again students should start by explaining the construction of the Lorenz curve. This
in the attached figure.
As drawn, the Lorenz curves cross and so thus does not tell us automatically that the Gini
coefficient is higher. The students who exploited the fact that the Lorenz curve is based on
shares and hence both curves could have been plotted in the same graph found this much

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 easier to explain. Most of the others took a guess without explaining what determines
whether inequality is higher or lower. Only some pointed out that the new Lorenz curve
identifies a higher Gini coefficient and hence represents a more unequal society.

Question 4
Suppose that the Bean Counter cafe is deciding what kind of wage structure to use for employing
its baristas who work in their coffee shop making coffee and serving customers. The Bean Counter
owners aims to sell as many cups of coffee as possible each day, but if the baristas are slow some
customers may leave before getting their cup of coffee because they are put off by long queues.

(a) Under what assumptions does this kind of employment relationship constitute a moral hazard
problem? [10 marks]

Feedback : [10 marks]

Here there are three key points that students should have pointed out: (i) effort has to be
unobserved (ii) effort has to be costly and (iii) benefits from effort accrue to Bean Counter
rather than the employee. A lot of students here just mention "asymmetric information",
with no explanation, which would not have been specific enough in this question.

(b) What kind of incentive compatible contract might the Bean Counter offer to baristas to limit
moral hazard? [10 marks]

Feedback : [10 marks]

As in the lectures, most students discussed output incentives based on rate of production
(paying baristas more for each coffee cup sold).
For a really good answer, students could have referred to the model from the lecture. They
could also refer to whether the outside option is binding. In general students should have
pointed out that the contract should be incentive compatible and the meaning of this con-
cept in the current context for the baristas to exert more effort.

(c) Are there alternatives to using monetary incentives which might also improve the rate of cus-
tomer service? [5 marks]

Feedback : [5 marks]
The lectures introduced the idea of intrinsic motivation, which most students highlighted
here.
The students who got full marks here are those who made an effort to think about how to
increase intrinsic motivation, or why they think this is not a feasible solution in this con-
text. There was quite a lot of discussion of tournament incentives here which is not strictly
relevant.

Question 5

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Consider a two-good economy with 20 consumers all of whom have an income of £10. Both goods
have a price of £1. Suppose that 10 consumers have experience utility of x1 + 2x2 and decision utility
of 2x1 + x2 . The the other 10 consumers have experience utility of 2x1 + x2 and decision utility of
x1 + 2x2 .

(a) Explain what is meant by “decision utility” and “experience utility”. [5 marks]

Feedback : [5 marks]
The definition that we gave in the lecture was utility before the decision and after the deci-
sion, i.e. at the point of final consumption. Most students got this right.

(b) What consumption decisions do we expect each group of consumers to make according to their
decision utility? [7 marks]

Feedback : [7 marks]
Students should observe that the perfect substitutes gives a corner solution so that they
must compare

20 with 10

which implies that the first group of consumers choose x1 = 10 and the second group
choose x2 = 10. A large amount of students tried to set this up as the utility maximization
we’ve seen in general equilibrium.
This wouldn’t work as the first order condition only gives a number. Note that utility maxi-
mization with perfect substitutes was covered in the Michaelmas term and has a worked
example online.
Failure to identify these goods as perfect substitutes was they key reason why some stu-
dents got stuck. Many students got the right answer but with a poor explanation of the
reasoning and hence lost marks.

(c) Show that these decisions are sub-optimal according to experience utility. [7 marks]

Feedback : [7 marks]
Students should show that the optimal bundle under experience utility is at the opposite
corner to the one chosen in part a. Simply stating that the decision is suboptimal wouldn’t
be enough here. Students who got full marks showed that the bundle resulting from the
decisions made in the first part would have led to lower utility than the optimal bundle
under experience utility.

(d) Could a tax on consumption of one of the goods correct the sub-optimal outcome? Explain.
[6 marks]

Feedback : [6 marks]
The main point is that a tax will not help since consumers make mistakes in both directions.
Students could also show that the tax has to be above 2 to affect either consumer’s decision
or discuss other ways of influencing behaviour.
A lot of students tried to show that the tax was Pareto improving by fixing the bundle that
one of the two consumers picks. This is correct only if the tax is above 2 (which many
students didn’t mention) as it allows one group to be better off and the other is unaffected.

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 However, this doesn’t generate any tax revenue for the government as the good taxes is not
sold. This was not strictly the focus of the question but was awarded partial marks.

Question 6
Suppose that two consumers A and B have utility functions defined over two goods, x1 and x2 , given
by
q
xJ1 xJ2
U J (xJ1 , xJ2 ) =
2
where J= A, B. Individual A has an endowment of 3 units of good 1 and 1 unit of good 2 and individual
B has 3 units of good 2 and 1 unit of good 1.

(a) Draw an Edgeworth box for this economy. [5 marks]

Feedback : [5 marks]
Here students should draw the Edgeworth box, show the endowment point and the lengths.
(See the attached Figures). Ideally this should be square given the endowments, but clear
labelling the axes to show that each has a length of 4 would have been enough. Most
students simply drew a rectangle here without any labelling, which wasn’t enough to answer
the question. In general, we did not penalize students for drawing a rectangle rather than
a square but poor explanation of what was meant to be on the axes and why was an issue
for many students.

(b) Draw the indifference curve that each individual is on if they consume their endowment.
[8 marks]

Feedback : [8 marks]
This means clearly finding the point in the box and then drawing it so that the indifference
curves cross through this point. To check that the curves cross students could have eval-
uated the marginal rate of substitution for each consumer at the endowment point and
noted that they different. Students who failed to calculate the MRS did badly on this ques-
tion. Here MRS for A is 1/3 and MRS for B is 3. As the MRS?s are different the indifference
curves at the endowment point are not tangent to each other. They cross. Assuming that
the origin for A is at the bottom left hand corner of the box as MRS A < MRS B at the en-
dowment point indifference curve for A is flatter than the indifference curve for B at the
endowment point.
Some students identified two endowment points. This is wrong. The main usefulness of the
Edgeworth box is to represent the entire economy in one space so that each point identifies
the endowment or allocation of both consumers. Many answers also lacked an explanation
of why they had put the endowment point where it was meant to be.

(c) Draw the allocation with x1 = x2 = 2. [2 marks]

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 Feedback : [2 marks]
Students need to find this point in the box and explain that this is what they doing to get
full marks. Again there should be only one point in the box and students can check that the
indifference curves are tangent at this allocation by either noting that they were starting
from the same endowment and have the same preferences or checking that the marginal
rates of substitution are equal. Both A and B have the same MRS(=1) so the indifference
curves are tangent to each other.

Note that not explaining your diagram by calculating the MRS?s and using them to deduce
whether the indifference curves are tangent or cross at these points is a serious mistake
even if you draw the diagram correctly. This is because you are failing to explain what you
are doing and might be getting it right by chance.

(d) Is the allocation with x1 = x2 = 2 Pareto optimal? Explain. [5 marks]

Feedback : [5 marks]
Here, students should point out that the indifference curves are tangent and hence that the
allocation that they have drawn is on the contract curve.
Some students expected to get marks for just saying what Pareto optimality is rather than
trying to locate the Pareto optimal point in a specific context. Some students tried to argue
that the allocation is Pareto optimal because both consumers have the same utility. This is
not accurate. Two people trading with different preferences/endowments may end up with
different utility but that doesn’t imply that the allocation is not efficient. In the same way
two people may have the same utility but not be at an efficient point.
The position is a competitive equilibrium, but many people failed to give a good explanation.
Some people argued that because the allocation it is Pareto efficient it must be a general
competitive equilibrium. This is wrong. A competitive equilibrium is Pareto efficient under
the assumptions of the First Welfare Theorem, which also implies that if a point is NOT
Pareto efficient it cannot be a general equilibrium. However, it does NOT imply that all
Pareto efficient points are a general equilibrium. Given the endowment, here there is only
one competitive equilibrium, whereas all points on the straight line joining the two origins
are Pareto efficient. At the tangency the MRS = 1, so if this is a competitive equilibrium the
prices of the two goods must be the same. You need to calculate demand at these prices
and find whether both A and B demand 2 units of each good.

(e) Is the allocation with x1 = x2 = 2 a competitive equilibrium? Explain. [5 marks]

Feedback : [5 marks]
Yes. Supply equals demand and the price line is tangent to the two indifference curves.
Students should draw the supporting budget line which is tangent to the two indifference
curve to represent the price line. Again, everything needs to be explained. it is not enough
to draw the two curves without any explanation.

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 Section B
(Answer all THREE questions. Each question carries 50 marks.)

Question 7
(a) Define economies of scale. Under what conditions do firms have economies of scale? If a firm
has a total cost function c (q) = 20 + 6q does it have economies of scale? [6 marks]

Feedback : [6 marks]
A firm has economies of scale if average cost decreases with output. A firm has economies
of scale if it has a production function with increasing returns to scale. A firm also has
economies of scale if it has a fixed cost and then a constant marginal cost, e.g. if the fixed
cost is research and development. For the cost function c (q) = 20 + 6q , AC = 20/q + 6

so
dAC 20
=− 2 <0
dq q
so AC is decreasing so the firm has economies of scale.
Many students tried to check that the marginal cost curve is decreasing to prove economies
of scale. That is a mistake, we only care about a decreasing average cost curve in this
context.

(b) Is perfect competition possible if all the firms in an industry have economies of scale?
[12 marks]

Feedback : [12 marks]

No. Perfect competition implies price taking behaviour. There are two possibilities: ei-
ther the firm is a price taker with economies of scale for all levels of output or there are
economies of scale at low levels of output, and then diseconomies of scale, i.e. a u-shaped
average cost curve.
In the first case either the price is less than average cost at all levels of output in which case
the firm makes losses at every level of output so shuts down or the price is greater than or
equal to average cost at some level of output. In that case, as average cost is decreasing
the price is above average cost at higher levels of output. Decreasing average cost implies
that marginal cost<average cost, so the price is above marginal cost at higher levels of
output, in which case a price taking firm can always increase profits by increasing output.
At some point its output will be so large it is no longer a price taker.
The second possibility is that there are economies of scale at low levels of output, and then
diseconomies of scale, i.e. a u-shaped average cost curve. A good answer shows the re-
lationship between MC, AC and the demand curve and points out that supply is 0 unless
p > or = min AC in which case AC is increasing so there are diseconomies of scale. Most
students were able to discuss one of the reasons but not both and with often confusing
explanations.

(c) What is a cartel? There are two firms in an industry. The inverse demand curve is given by
p = 24 − 3Q where p is price and Q is industry output. Firm 1 produces output q1 with a total
cost of c (q1 ) = 20 + 6q1 . Firm 2 produces output q2 with a total cost of c (q2 ) = 20 + 6q2 . Can
a two firm cartel operate profitably in the industry? [12 marks]

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 Feedback : [12 marks]
If firms form a cartel the firms have an agreement to restrict industry output to the level
that maximizes industry profits.
Here industry cost is c (Q) = 40 +6Q where Q = q1 + q2 . As price = p = 24− 3Q industry
profits

π (Q) = pQ − c (Q) = (24 − 3Q) Q − 6Q − 40

= 18Q − 3Q2 − 40

As this is a quadratic in Q with a negative coefficient on Q2 the foc give a maximum. These
are
dπ
= 18 − 6Q = 0
dQ
so Q = 3.
Alternatively students can do this by setting MR = MC and explain why this is enough to
guarantee a maximum.
Revenue is pQ = (24 − 3Q) Q so M R = 24 − 6Q and M C = 6 so MR = MC when Q = 3.

The industry price is p = 24 − 3Q = 15. Industry profits are

π (Q) = pQ − 6Q − 40 = 15 ∗ 3 − 6 ∗ 3 − 40 = 27 − 40 = −13

so the cartel is not profitable.

(d) What is a Cournot-Nash equilibrium? Can the two firms operate profitably in a Cournot-Nash
equilibrium? [12 marks]

Feedback : [12 marks]

In the Cournot-Nash equilibrium the outputs q1 and q2 are at at level where given q2 firm 1
sets q1 at a level that maximizes its profits. Similarly given q1 firm 2 sets its output at a
level that maximizes its profits.
Students observing that, as the cartel output maximizes industry profits, industry profits
in a Cournot-Nash equilibrium cannot be greater than in a cartel and as the industry make
losses in a cartel the firms must make losses in the Cournot Nash equilibrium got full marks.
Alternatively students can observe that the industry price is p = 24 − 3 (q1 + q2 ) so profits
for firm 1 are

π1 = pq1 − 6q1 − 20 = (24 − 3 (q1 + q2 )) q1 − 6q1 − 20

= 18q1 − 3q12 − 3q1 q2 − 20.

This is a quadratic in q1 with a negative coefficient of q12 so the first order condition gives a
maximum. This is
∂π1
= 18 − 6q1 − 3q2 = 0.
∂q1
Similarly as the two firms have the same cost function firm 20 s profits are maximized when

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 ∂π2
= 18 − 6q2 − 3q1 = 0.
∂q2
Solving simultaneously

18 − 6q1 − 3q2 = 0
18 − 3q1 − 6q2 = 0.

gives q1 = q2 = 2 and p = 24 − 3 (q1 + q2 ) = 24 − 12 = 12. Profits for firm 1 are

π1 = pq1 − 6q1 − 20 = 12 ∗ 2 − 6 ∗ 2 − 20 = 12 − 20 = −8 < 0.

As firm 2 is identical these are also the profits of firm 2. Both firms make losses.

(e) How many firms will there be in the industry? [8 marks]

Feedback : [8 marks]
There can be at most one firm in the industry, as it is impossible for two firms, and thus for
more than two firms, to operate profitably even if they form a cartel. Thus the only possible
market structure is monopoly.
However it is important to check that the monopoly can operate profitably. Both the cartel
and a monopoly choose Q to maximize industry profits so produce the same Q, that is
Q = 3, so the price p = 24 − 3Q = 15 and revenue is 3p = 45. Total cost for the
monopoly is 20 + 6Q = 38. Thus monopoly profits are 45 − 38 = 7 so the industry will be
a monopoly.

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Question 8
q
Consider an economy with 100 consumers, each with utility function U J (xJ1 , xJ2 )= xJ1
+ 2 xJ2 . The
economy comprises 100 consumers. All 100 consumers supply a fixed amount of labour. 90 con-
sumers can produce 1 unit of good 1 each and 10 can produce 2.5 units of good 2 each. For the rest
of the question you can focus on interior solutions.

(a) Derive the demand functions for goods 1 and 2. What is the equilibrium price ratio?
[10 marks]

Feedback : [10 marks]

This is exactly the same function we used in class repeatedly. Many students recognized
this and use the methods that they had seen repeatedly. It was clear that the students who
had completed the class exercises and paid attention in class had a significant advantage.
Students should lay out what they are doing to get full marks. The budget constraint is

m = p 1 x1 + p 2 x2

where m = p1 for one group of consumers and m = p2 for the other group. Then for good
2
 
m − p 2 x2 √ 1
x2 = max + 2 x2 =
p1 (p2 )2
which implies that
1
m− p2
x1 = .
p1
(It is fine to normalize p1 = 1 justifying why it can be done)
Students should explain how to derive the equilibrium price ratio before computing it. Nor-
malize p1 = 1 (although this is not strictly necessary), then set p2 to clear the market for
good two
1
100 = 2.5 ∗ 10
(p2 )2
implying p2 = 2

(b) From now on suppose that a new technology is discovered which dramatically increases the
productivity of good 2 producers who can now produce 10 units of good 2 for the same fixed
labour supply. Give a real world example of a dramatic technological improvement like this.
[2 marks]

Feedback : [2 marks]
No correct answer but needs to be plausible. Many students used the introduction of ma-
chines after the Industrial revolution, which is a good example.

(c) How does the price ratio change after the introduction of the technology described in (b)? Ex-
plain. [8 marks]

Feedback : [8 marks]
Again, students should lay out the reasoning. Demands are the same as earlier, but for

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 good 2 producers we now have m = 10p2 . Clearing the market for good 2 we get:

1 2
100( ) = 10 ∗ 10
p2
implying p2 = 1 This makes sense intuitively because the overall supply of good 2 has
increased so its relative price has dropped.

(d) Compute the utilities of the consumers before and after the introduction of the technology dis-
cussed in (c) to show how much each group benefits from the new technology. Explain your
finding intuitively. [8 marks]

Feedback : [8 marks]
They should compute the utilities of each type ofqproducer before and after. For producers
√
q
of good 1 utility used to be: U J (xJ1 , xJ2 )= xJ1 + 2 xJ2 = m − p2 x2 + 2 x2 = 12 + 2 1
4 = 32 .
√ √
Now it is m − p2 x2 + 2 x2 =2 1 = 2 so utility has increased by 12 . Similarly for producers
√
q q
9 1
of good 2 utility used to be U J (xJ1 , xJ2 )= xJ1 + 2 xJ2 = m − p2 x2 + 2 x2 = 2 +2 4 =
11
√
2 and is now 9 + 2 1 = 11 so their utility has doubled and total utility increased byto 13.
Hence the innovation has made both groups better off. For good 1 producers this happens
because the price of good 2 is now lower. For good 2 producers the increase in productivity
is enough to offset the decrease in the price of the good they sell (and because of this they
can buy more of good 1). Many students went wrong with the algebra and then attempted
to explain their wrong results here. It would have been better to focus on why both might
be better off and explain it intuitively.

(e) Contrast your answer in (d) with the benefits of this new technology discussed in (b) if prices
did not change in response and use this calculation to explain why it is important to look at the
introduction of new technologies in general equilibrium? [8 marks]

Feedback : [8 marks]
Students should compute the utilities of both groups now that p2 = 2. For good 1 producers
√
nothing has changed from part (a) so utility remains m − p2 x2 + 2 x2 = 23 . For good 2
√
q
producers: m − p2 x2 + 2 x2 = 39 1 41
2 + 2 4 = 2 . In this case only the producers of good 2
gain (twice). They now have a higher income to spend on good 1 because of the increased
productivity and they receive a higher price than what the market would pay if agents were
allowed to trade. Students could also note that at these prices the market no longer clears.

(f) Suppose that the new technology requires an investment of 54 which would need to be funded
through a lump-sum tax on the good 1 producers (i.e. each of them would pay 0.6). Does a
Utilitarian welfare criterion support the introduction of the new technology discussed in (c)?
[8 marks]

Feedback : [8 marks]
We can look at the overall gains from the introduction of the technology and see if the costs
are lower. The total gains are: 90 ∗ 12 + 10 ∗ 13
5.5==175
100. This is higher than the cost of 45
so funding the innovation is worth it under a Utilitarian criterion. We can also look at who

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 wins and loses. Good 2 producers are still gaining from this as they are not paying for the
innovation but benefit from it as argued in (c). Good 1 producers now have the utility in (c)
but have to pay 0.6. As their gain from the technology is only 12 = 0.5 paying 0.6 makes them
worse off than they were before the introduction of the new technology. In this setting the
introduction of this technology is no longer a Pareto improvement because 90 people lose
from it.

(g) Use the framework developed here to discuss the consequences of different ways of financing
technological change. [6 marks]

Feedback : [6 marks]
Clearly the good 1 producers would not be willing to pay the tax if it was up to them. Stu-
dents could note that because this group is much larger the tax would not pass if decided
through a majority vote. But aggregate utility would increase with the new technology and
group 2 producers would be happy to pay even more than 0.6 each because they stand to
gain much more from the innovation. Students could also note that if group 2 producers
tried to compensate group 1 producers so that they pay from innovation there would be
free-riding incentives from group 2 producers so private provision also cannot solve the
issue easily. Overall the point is that the new technology is creating gains for society but
whether it would be a Pareto improvement to have it and/or whether it would pass a vote
depends on how the government proposes to fund it.

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Question 9
A community is deciding whether to fund a statue of Margaret Thatcher (the first female UK Prime
Minister). There are three groups of individuals: Rees-Moggers (R) who value the statue at £15,
Corbynistas (C) who value it at -£5 and Blairites (B ) who value it at £1. There are 100 of each. The
statue costs £600 to build.

(a) In what sense is building the statue a public good? [6 marks]

Feedback : [6 marks]
Students should note that a public good is non-excludable and non-depletable (and what
this means). They then need to explain how this applies to the statue: no one can be easily
excluded from seeing it and no one’s enjoyment of it decreases the enjoyment others have
of it. They could also note that it is a public bad for group C .

(b) Suppose that a group can choose to fund the statue with the cost distributed equally among
their group members. Which groups would be willing to fund the statue? [6 marks]

Feedback : [6 marks]
Students should be clear about their reasoning. Equations with no explanations are not
enough in this or other questions. Group R : Net Benefit= 100 ∗ 15 − 600 = 900 ; Group
C : Net Benefit= −500 − 600 = −1100; Group B : Net Benefit: 100 − 600 = −500. (All
of these could be stated per capita). Because of this only group R would be willing to fund
the statue.

(c) From now suppose that the government has the power to tax and divides the cost equally among
all citizens, i.e. each citizen has to pay £2 towards the cost. Is building the statue a Pareto
improvement? [5 marks]

Feedback : [5 marks]
No. As groups C and B lose. Again students should explain their reasoning for full marks.

(d) Will a Utilitarian government choose to build the statue? [5 marks]

Feedback : [5 marks]
Yes. Total benefit is 1500 − 500 + 100 = 1100 which is bigger than 600. Again, all steps in
the reasoning should be spelled out.

(e) Suppose that there is a majority vote over whether to build the statue where everyone pays £2
towards the cost. Will the statue be built? [5 marks]

Feedback : [5 marks]
No. Two thirds of the population would oppose if it they have to pay £2.

(f) Why do the voting outcome in (e) and Utilitarian welfare optimum in (d) diverge? [8 marks]

© LSE ST 2019/EC201 Page 17 of 18

 Feedback : [8 marks]
Taxes are levied on everyone not just those who benefit from what they will be spent on.
Also the Utilitarian calculation includes intensity of preference which is why group R carries
extra weight.

(g) Suppose that the statue is not built by government. Would you expect the statue to be built
without government intervention given the payoffs that you found in answers to part (b) of the
question? [8 marks]

Feedback : [8 marks]
Group R could use voluntary contributions but some may choose not to contribute. So
it depends, group R have to overcome their own free-rider problem. Most students here
took for granted that group R will act as one player, whereas they should have realised that
this is still a group of people, so they will also be subject to issues in trying to finance the
statue. It was necessary to note this to get full marks. In terms of solutions, perhaps social
punishments could be used as we discussed in the lecture or group R could develop its
own way of taxing its members.

(h) Suppose that the statue is not built by government. Use this example to comment on why private
provision of a public good (such as a statue) can be welfare superior to public provision/funding
of a statue. [7 marks]

Feedback : [7 marks]
This is quite open-ended and students could answer in a number of ways. It would be
good to point out that a Utilitarian government using uniform financing makes some citi-
zens worse off (especially group C ). So a successful private solution avoids this. But, as
discussed in the previous part, there may not be effective collective action among group
R. So then the statue may not be built. If the government had group specific taxes, then
it could use these to sove the issue and then government would definitely be better as it
would only bring about a Pareto improvement. But as discussed in one of the classes,
there could be other reasons to prefer uniform taxation as a means of financing public
goods even if they have selective benefits. A good answer will show an appreciation of the
trade-off between the form of public finance and the benefits of that as a form of coercive
finance against its downside in making those who do not benefit pay and the possibility of
free-rider problems causing difficulties.
A few students mentioned the possibility ways of compensating losers in getting a solu-
tion. Although it was an optional topic, credit was given for those who knew the link to the
Coase theorem showing that they had knowledge beyond the lecture material.

END OF PAPER

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