16 December 2021 Dr. David Mushinski ECONOMICS 306 FINAL EXAMINATION ANSWERS (1) Suppose that a firm produces coffee and operates in a perfectly competitive market. Suppose that the wage rate (per hour) is 10 and the rental rate of capital (per hour cost of capital) is 5. Suppose that the firm's short run total cost function (assume that capital is fixed) is C= 0.2)+Q'+ 120+Q aw where O represents kilograms of coffee produced by the firm per hour. The marginal cost function for this total cost function is MC = 1 + (0.4)°Q. The market price of a pound of coffee is 7. (A) [2% points] What is the firm’s level of capital? Answer Since capital is fixed the fixed costs in equation (1) are capital costs. The 120 represents fixed costs. Fixed costs=reK. So, 120=5*K — K =24, (B) (2% points] Identify the firm's profit function. Answer ‘The firm’s profit function equals Total Revenues minus Total costs, or T1(Q) = 7-Q-[(0.2)-Q?+ 120+ Q] (O[S points] Identify the firm's optimal level of output. Answer The firm identifies its optimal level of output (Q*) by finding the level of output where MC = p. So, 1+(0.4Q=7 + 0.4)Q=6 + Q*=15.(D){5 points] Should the firm produce that level of output? Answer ‘The firm should produce that level of output if average variable costs at Q = 15 are greater than or equal to price. AVC = ((0.2)Q?+ QUQ = (0.2)Q+ 1 AVC(15) = (0.215 +1=4. Since p [=7] > AVC [= 4]. the firm should produce 15 units per hour. (E) (2% points] What is the firm's producer surplus? Answer A student may answer this question in one of two ways: () The firm’s producer surplus equals Total Revenues minus Variable Costs at Q= 15, + PS = 715 ~(0.2)15*-15= 45, (ii) The firm’s producer surplus equals Fixed costs plus Economic Profits. Fixed costs = 120, Economic Profits = 7*15 —(0.2)+15? ~ 120 ~ 15 = 105-180 = -75. Fixed Costs plus Economic profits = 120 ~ 75 = 45.2) {5 points] Hue is a monopolist in the Llama hair brush market. The market demand function for the brushes is O= 60—(1/3)P where Q is the number of brushes purchased in a day and P is the price of a brush. Suppose that the marginal cost of producing a brush is 30. How many brushes will she produce and what price will she charge for a brush? Answer [B points] She determines her profit maximizing level of output (Qu) by finding the level of ‘output where Marginal Revenue (MR) = Marginal Cost (MC). We calculate the MR function (MR(Q)) by finding the inverse demand function (P(Q)). We know that the MR function is twice as steep as P(Q). P(Q)= 180 - 3*Q. So, MR(Q)= 180 - 6*Q MR(Q)=MC — 180 - 6°Q=30 > Qu=25. [2 points] She determines her price (Pm) by inserting Qu into the inverse demand function; i.e., Pa = 180 - 3°25 = 105.(3) [5 points] Consider a duopoly with Firm 1 and Firm 2. ‘Suppose that the market demand curve for the good which the firms produce is_ Q = 50—(14)*P, where P is the market price of the good and Q is the sum of the quantity produced by Firm 1 and the quantity produced by firm 2, Suppose that the both firms’ marginal costs of producing a unit of output equals 10. Suppose that the firms compete by deciding which price to charge for their good (their strategies dare the price they charge) and that they choose their price without knowing the price charged by the other firm. Let pi be the price chosen by Firm I and p2 be the price chosen by firm 2. (Assume that if both firms charge the same price they “split the market”; ie., each produces one half of the quantity demanded at that price.) Explain whether each of the following combinations of price is or is not a Nash Equilibrium. Answer ‘The (i) combination of prices is not a Nash Equilibrium because Firm 1 would want to change its strategy. Given that firm 2 is charging a price of 20, firm 1 would prefer to charge a slightly ower price (like 19 or 19.99). At that price, firm 1 would be making positive economic profits instead of making zero economic profits. ‘The (ii) combination of prices is not a Nash Equilibrium because both firms would want to change their strategy. Given that Firm 2 is charging a price = 20 (and splitting the market with Firm 1), Firm 1 would prefer to charge a slightly lower price (¢.g.. Q= 19 or Q= 19.99) and produce for the whole market (thereby increasing its profits). The same is true for Firm 2.(4) Consider a game with two firms: firm 1 and firm 2. Firm 2 is the only firm which produces craft beer ina town. It is considering whether to expand iis production. Thus, its strategies are Expand and Not Expand. Firm 1 is considering opening a micro-brewery in the fown. is strategies are Open and Not Open. The firms’ payoffs from associated with different combinations of strategies are If firm 1 chooses Not Open and firm 2 chooses Expand, firm 1's profits equal zero and firm 2's profits equal 10, Iffirm 1 chooses Not Open and firm 2 chooses Not Expand, firm 1's profits equal zero and firm 2's profits equal 6. Iffirm 1 chooses Open and firm 2 chooses Expand, firm 1s profits equal -1 and firm 2's profits equal 3 iffirm 1 chooses Open and firm 2 chooses Not Expand, then firm I's profits equal 2 and firm 2's profits equal 4. (A) [5 points] Suppose shat both firms choose their strategy without knowing the strategy chosen by the other firm. Identify all (pure strategy) Nash equilibria of the game. Answer [On Separate Written Page] (B) [5 points] Suppose that firm I makes its decision to open first and then firm Il, after observing the decision of firm 1, decides whether to expand. What is the backward induction outcome of the game? Answer [On Separate Written Page] (8) Consider an economy in which two goods (x1 and x2) are produced. Suppose that there are ‘hwo consumers: Bao and Wei. Suppose that they have Cobb-Douglas types of utility functions. (A)[5 points] Suppose that the initial allocation of the two goods is () Bao has 30 x; and 15 x2, and (ii) Wei has zero x; and zero x2. Define the “core” and identify the core for this allocation of the goods. Answer [2% points] The “core” is the set of Pareto Efficient allocations of x1 and x2 associated with an initial allocation of resources. Students should lose 1 point if they do not mention the underlined condition. [2 % points] In this example the core is the initial allocation of resources. If the initial allocation is Pareto Efficient any reallocation would necessarily make one person worse off. The initial allocation is Pareto Efficient because there is no other allocation which would make Wei better off without making Bao worse off.(B) [5 points] Suppose that the present level of production in the economy is x; ~ 30 and x2 = 15 and that at that level of production the (absolute value of the) Marginal Rate of Substitution of x1 for x2 (MRSi2) of consumers (assume that they all have the same MRS;2) equals 2 while the (absolute value of the) Marginal Rate of Product Transformation of x1 for x2 (MRPT12) equals 5. Assume that society seeks to produce efficient amounts of the two goods and that x1 and x2 are produced in perfectly competitive markets. Will the market prices of x1 and x2 change? If not, explain why not. Ifso, explain what will happen to them. Answer Students can answer this referring to the conditions for efficiency or graphically. Ihave attached a written page with the graphical analysis. Analysis using conditions for efficiency: Since the MRPTi2 > MRS12, society is willing to give up less of x2 for another x: than the amount of x2 which is given up for another xi . So, society should produce less x1 and more x3. In this case, the MRPT;2 will decrease and the MRS12 will inerease. They will end up equal and somewhere between 2 and 5, Since the price ratio pi/po will equal the slope of the common tangeney of MRPTi2 and MRS, we know that prices will adjust to equal that slope. ‘Note: | asked students what will happen to the prices. Don’t worry about their answer in this regard (i.e, if prices will increase or decrease). Students should get full credit if they simply note that prices will adjust to equal the MRPT2 and MRSi2. (O22 4 points] Suppose that in the above example the MRPT12 is constant (suppose that MRPT;2= 4) for all levels of production of x1 and x2, and continue to assume that society seeks to produce efficient amounts of the two goods. Will the market prices of x1 and x2 change? If not, explain why not. Ifso, explain what will happen to them. Answer Note: In retrospect, this is not a good question because of uncertainty about the initial prices. So, GIVE ALL STUDENTS FULL CREDIT (2 % points) for this question. You do not have to grade this question.(Yt) Find EAD —- LOT GHP AwD < 7 Powis Fer GRnreereg OR Aw ws sors) PART R ——— 2 Pets FR Cher Ls. 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