Prof. Dr.

Anna Gumpert
Chair of International Economics and European Integration
School of Business and Economics
Faculty of Economics and Social Sciences
University of Tübingen

Advanced Microeconomics I

Mock Exam

Student ID: . . . . . . . . . . . . . . . . . . . . . . . . .

Student name: . . . . . . . . . . . . . . . . . . . . . . .

Instructions

• This exam consists of 15 pages. Please make sure that you have all the pages, otherwise,
ask for a new exam copy.

• The maximum number of credits is 120. The available time is 120 minutes. It is recom-
mended to allocate time accordingly.

• The exam consist of four problems of 30 credits each.

• Many subquestions can be solved independently of the others.

• Please use the allocated space below questions for your answers. It is also indicative of
the length of answers expected. If you need more space, you can write on the back of the
pages. Please clearly mark where answers belong.

• This is a closed book exam, but you are allowed to take 1 DIN A 4 sheet of paper with
notes on both sides.

• You are allowed to use a non-programmable calculator.

• Please write your answers legibly in English.

Problem 1: Consumer demand [30 Credits]
Sophie chooses how to allocate her free time. Her options are eating at a restaurant, r, or going
to the theater, t. Her utility function takes the following form:

u(r, t) = ln(r) + ln(t)

a) Is the utility function strongly monotone? Support your answer mathematically. [2

credits]

In the following, assume Sophie’s income equals w > 0 and the unit prices of dining at the
restaurant and going to the theater are pr > 0 and pt > 0, respectively.

b) State the utility maximization problem, set up the Lagrangian function and derive the
necessary first-order conditions. [8 credits]

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c) Will Sophie ever choose not to eat at the restaurant or not to go the theater, i.e., can the
optimal solution ever be the corner solution r = 0 or t = 0? Why/ why not? [4 credits]

d) Use the first-order conditions of the Lagrangian function to derive the demand for going the
theater relative to the demand for eating in the restaurant as a function of relative prices.
Interpret your result for pr = 2 and pt = 6. [4 credits]

e) Derive the demand function. [2 credits]

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 In the following, assume that disposable income is w = 10 and prices are pr = 2 and pt = 4.
The associated budget constraint and the optimal consumption bundle (r = 2.5, t = 1.25) are
illustrated in the following diagram:

5
Bpr ,pt
4 x(pr , pt )

t 3

0
0 1 2 3 4 5
r

Consider a drop of the price of going to the theater, with the new price being p′t = 2.
f) How does wealth change if this price change is compensated? [2 credits]

g) Compute the new optimal consumption bundle. Draw the new budget line in the figure
using a dashed line and mark the new optimal consumption bundle with a circle. [4
credits].
Hint: Use the demand function you derived in question e). If you did not get a solution,
use the following function: (r, t) = ( w−1.75p
2pr
, 2pt ). If you did get a solution, please note
r w+1.75pt

that this is not the correct solution.

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h) Do Sophie’s preferences satisfy the compensated law of demand and the weak axiom of
revealed preferences? Justify your answer with the help of your graph. [4 credits]

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Problem 2: Production [30 credits]
Consider a single-product firm that produces output q from capital K and labor L using the
following production technology:

q = f (K, L) = K α Lβ

where α + β ≤ 1. Rent r is the market price for capital and wages w is the market price for
labor. The firm takes these prices as given.

a) Does the production technology exhibit increasing, decreasing or constant returns to scale?
Support your answer with a mathematical argument! [4 credits]

b) Set up the Lagrangian for the firm’s cost minimization problem and derive the necessary
first-order conditions for an optimum. Use the first-order conditions to derive the condi-
tional factor demand L(w, r, q) and K(w, r, q). [10 credits]

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c) Show that the conditional factor demands L(w, r, q) and K(w, r, q) are homogeneous of
degree zero in factor prices (w, r). Give an economic intuition for this finding. [4 credits]
Hint: If you did not obtain a solution in the previous question, you can work with
 1−α  α
αw (1 − α)r
K=q L=q
(1 − α)r αw
If you obtained a solution in the previous question, please note that this hint is not the
correct solution.

For β = 1 − α, the minimum cost function is given by

 r α  w 1−α
c(w, r, q) = q · ·
α 1−α
d) Show that the cost function is increasing and concave in wages w. Give an economic
intuition for these characteristics of the cost function. [6 credits]

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 The firm maximizes its profits on the output market, taking as given the market price for
output p. For α = β = 0.25, the profit function is given by

1 p2
π(p, w, r) = √
8 wr

e) Use Hotelling’s Lemma to derive the firm’s optimal output. Explain how changes of the
output price p affect the optimal output according to the law of supply. Does the law of
supply only hold for compensated price changes? Why/why not? [6 credits]

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Problem 3: General Equilibrium [30 credits]
Consider an island economy with two resources 1 and 2. The total endowment of each resource
equals ω1 = ω2 = 10. Assume that there are only two individuals differing only in their
initial endowments. Individual 1 is endowed with ω11 = 5.8 and ω21 = 8 units of resources 1
and 2, respectively. Individual 2 is endowed with the remaining resources. Assume that both
individuals’ utility function takes the same form, namely

ui (x1i , x2i ) = x1i + ln(x2i ),

where xji denotes consumption of resource j by individual i. Prices for the two resources are
given by p1 , p2 . There are no production capabilities.

a) Verbally state and explain the conditions that need to hold for equilibrium in this economy!
How does your answer change if production is admissible? [6 credits]

b) State the wealth w1 , w2 of individuals 1 and 2. Is it exogenous? Why/why not? [4 credits]

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c) The individuals maximize their utility. Their optimal consumption of resource 2 is given
by
p1
x2i =
p2
Use this information together with the individuals’ budget constraints to derive the indi-
viduals’ offer curves as a function of relative prices p = pp12 ! [4 credits]

The following Edgeworth-Box displays the indifference curves for each individual given their
initial endowments.
x12
10 8 6 4 2 0
10 0

8 2

6 4
x21

x22

4 6

2 8

0 10
0 2 4 6 8 10
x11

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d) Agent 1 is endowed with a higher amount of both resources than agent 2. Is trade going
to occur in equilibrium? Justify your answer verbally with help of the graph. [4 credits]

e) Use your results from question c) and derive the equilibrium price ratio. Derive the asso-
ciated resource allocation (i.e. the consumption bundle for each individual at equilibrium
price level) and mark the equilibrium point in the graph above. [6 credits]
Hint: Use the following demand functions for each individual in case you could not solve
question c):
xi = (ω1i + ω2i · p − 2, 2/p)
If you did find a solution, note that this is not the correct solution. Do not forget to label
your marking in the graph appropriately!

f) Is the market equilibrium Pareto optimal? Justify verbally. [2 credits]

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g) Assume that a social planner would like to implement an alternative Pareto optimal alloca-
tion, where x11 = x12 = 5 and x21 = x22 = 5. Can this allocation be achieved as Walrasian
equilibrium? Why/why not? If it is achievable, briefly explain what the social planner
would have to do. [4 credits]

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Problem 4: Game theory and market power [30 credits]
Consider a market in which two firms i and j produce a homogeneous good at the same unit
costs c > 0. Firms decide about the quantity that they would like to offer. They make this
decision simultaneously.
Part 1: Assume that both firms have two possible options: offering a high quantity q H or
offering a low quantity q L . Firm profits are given by the following matrix:
Firm j
H
q qL
qH
128, 128 162, 108
Firm i
qL 108, 162 144, 144

a) Find the strictly dominant strategies for firms i and j and determine the Nash equilibrium
of the game! [4 credits]

b) Provide an extensive-form representation of the game! Can you solve the game via backward
induction? How/why not? [6 credits]

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c) Now assume that the two firms compete in the same market repeatedly for an infinite
number of periods. They play a trigger strategy, i.e., both firms choose quantity q L as long
as the respective other firm chooses q L and q H otherwise. Firms discount future profits
with the discount factor δ = 0.5. Mathematically show whether firms can sustain the
equilibrium (q L , q L ). P [5 credits]
∞
Hint: Remember that τ =0 δ = 1−δ .
τ 1

Part 2: Assume that both firms can choose any positive quantity qi , qj > 0. The inverse
demand function is given by
p(Q) = a − bQ
where p denotes the good’s price, aggregate output is Q = qi + qj , a > c and b > 0.

d) Compute the best-response functions for both firms and determine firms’ output levels in
the Nash equilibrium of this game! [6 credits]

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e) Determine the market price in Nash equilibrium. How does the price compare to the perfect
competition outcome? [5 credits]
Note: If you did not obtain a solution in the previous question, please work with the
quantity q̃j = q̃i = a−c 4b
. If you obtained a solution in the previous question, please note
that q̃j , q̃i is not the correct solution.

f) Now assume that firm j is more efficient than firm i. Specifically, firm j’s marginal costs
are cj = 0.8c and firm i’s marginal costs are ci = 1.2c. Determine the optimal level of
output for firm j! [4 credits]

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