Examiners’ commentaries 2008

Examiners’ commentary 2008

66 Microeconomics

Specific comments on questions Zone B

Reading advice
Reading on which candidates could have based their answers to the
questions is to be found in the following recommended textbooks:
Eaton, B. Curtis, D.F. Eaton and D.W. Allen Microeconomics. (Toronto:
Prentice Hall/Pearson, 2002) fifth edition [ISBN 9780130330116].
Katz, M.L. and H.S. Rosen Microeconomics. (Boston, Mass:
Irwin/McGraw-Hill, 1998) third edition [ISBN 9780256171761].
Estrin, S. and D. Laidler Microeconomics. (Pearson, 2008) fifth edition
[ISBN 9780273646273].
Pindyck, R.S. and D.L. Rubinfeld Microeconomics. (Upper Saddle River,
New Jersey: Prentice Hall/Pearson, 2008) seventh edition [ISBN
9780132080231].
For the sake of brevity, each of the answers below will indicate reading
references by the page(s) in the Microeconomics subject guide where
the relevant chapters, and sections of chapters, are to be found.
Question 1
Two markets, A and B, are monopolistically competitive. Assume that, in
both markets, firms’ marginal costs are constant and identical and that fixed
costs are also identical. In Market A, consumers are sensitive to price
differences when they choose among existing sellers. By contrast, in Market
B, consumers are less sensitive to price differences. Then, if the total number
of units bought in long-run equilibrium is the same in Market A as in Market
B, explain what, if any, differences there will be between Markets A and B in
the following:
(a) the margin between price and marginal cost,
(b) the number of firms,
(c) profit per firm.
Reading: p. 33.
Using diagrams, candidates should have described the assumptions of
the model of monopolistic competition and explained the nature of the
predicted long-run equilibrium. In monopolistic competition, there is a
large number of competing firms, free entry and exit, and the products
of firms are symmetric and the competition between them is
generalised in the sense that each product competes with every other
in the product group. Thus, a new entrant into the market captures
n/(n+1) of the quantity produced by the established firms in the
market, receiving almost the same profit as firms currently in the
market and so, in long-run equilibrium, profits must be zero.
Diagramatically, each firm’s downward-sloping, perceived-demand

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66 Microeconomics

curve (showing the quantity demanded of its product as its price

changes, holding the prices of all other products in the product group
(market) constant) is brought into tangency with its average cost
curve, while its marginal revenue curve is equal to its marginal cost.
The less sensitive (less elastic) consumers are to price differences, the
steeper is the perceived-demand curve, so the greater is the margin
between price and marginal cost ( P − MC = P / η , where η is the
absolute value of the elasticity of demand). Also, the less sensitive
consumers are to price differences, the smaller the output produced by
each firm. Given this analysis, candidates should have drawn the
following conclusions:
(a) The margin between price and marginal cost will be higher in
Market B than in Market A (that is, with the same marginal costs,
prices will be higher in Market B than in Market A).
(b) The number of firms will be greater in Market B than in Market A
(because the market quantities are similar but every firm in Market
B produces less than every firm in Market A).
(c) The profit per firm is the same in Market B as in Market A (that is,
zero).
Question 2
Farm A raises cattle, and the cattle occasionally stray onto the land of a
neighbouring farm, Farm B, thereby damaging the crops grown on Farm B.
The owner of either farm can build a fence on the boundary between the two
farms to prevent the cattle from roaming onto Farm B. Assume that it is
costless for the parties to bargain. Demonstate the validity of the Coase
Theorem:
(a) when the cost of the fence is $20,000 and the cost of damage is $10,000;
(b) when the cost of the fence is $20,000 and the cost of damage is $30,000.
Reading: p. 57.
Firstly, candidates needed to give a clear statement of the Coase
Theorem. The Coase Theorem states that, regardless of how property
rights are assigned, the allocation of resources will be efficient when
the parties to an externality situation can costlessly bargain with each
other. Then, candidates should used the theorem as the basis of the
following sort of analysis.
(a) Suppose the property rights are assigned to A. B can either pay for
the fence costing $20,000, or live with the damage of $10,000. B
therefore does not find it worthwhile to pay for the fence, and the
cattle will roam. B receives no compensation for the damages of
$10,000.
Suppose the property rights are assigned to B. A can either spend
$20,000 to build a fence to prevent damage or build no fence and
pay $10,000 to B to compensate for damage. A does not find it
worthwhile to pay for a fence, and the cattle will roam. The
damage to B is $10,000, but A will compensate B.

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 Examiners’ commentaries 2008

With either property rights assignment, the outcome is the same:

the cattle will roam. It is economically efficient to build no fence
because it costs more than the damage from roaming cattle.
(b) Using a similar approach, it can be shown that, again, the outcome
is the same whoever is assigned the property rights but that, now,
the cattle will not roam. In this case, it is economically efficient to
pay for the fence because the fence costs less than the damages
that would have occurred from roaming cattle.
Question 3
An industry consists of two firms selling a homogeneous product with a
market demand curve given by P = 18 − Q1 − Q2, where Q1 is Firm 1’s output
and Q2 is Firm 2’s output. Both firms have a constant marginal and average
cost of 6.
(a) Find the Stackelberg equilibrium in which Firm 1 acts as the leader and
Firm 2 acts as the follower. How much profit does each firm make? What
is the profit of the industry?
Reading: p. 29 and p. 30.
Candidates needed to derive the following results.
(a) As a follower, Firm 2 maximises its output given the output set by
Firm 1. Then, as Firm 2’s residual demand curve is P = 18 − Q1 −
Q2, its marginal revenue is MR2 = 18 − Q1 − 2Q2 . Setting
MR2 = MC 2 and rearranging terms, Firm 2’s profit-maximising
output is given by Q2 = 6 − 12 Q1 .

Firm 1’s residual demand curve is then given by:

P = 18 − Q1 − (6 − 12 Q1 ) = 12 − 12 Q1 and MR1 = 12 − Q1 . Setting
MR1 = MC1 and rearranging terms, Firm 1’s profit-maximising
output is given by Q1 = 6 . So Q2 = 6 − 12 (6) = 3 and P= 18 − 6−
3 = 9. Thus, π 1 = 6(9 − 6) = 18 , π 2 = 3(9 − 6) = 9 and
π 1 + π 2 = 18 + 9 = 27 .
(b) Suppose, instead, that both firms act as Cournot competitors. Compare
the profit outcomes with your answer to (a).
(b) If both firms act as Cournot competitors, Firm 1’s best-response
function will be symmetrical to that derived for Firm 2 in part (a).
So Firm 1’s profit-maximising output given Firm 2’s expected
choice of output is given by Q1 = 6 − 12 Q2 . Thus, in equilibrium,
Q1 = 6 − 12 (6 − 12 Q1 ) = 3 + 14 Q1 = ( 43 )3 = 4 and Q2 = 6 − 12 (4) = 4 .
Thus, P = 18 − 4 − 4 = 10 , π 1 = π 2 = 4(10 − 6) = 16 and
π 1 + π 2 = 16 + 16 = 32 .
Finally, candidates needed to compare profit outcomes. If both act as
Cournot competitors, both firms earn the same profits. In
Stackelberg equilibrium, Firm 1 earns more profits than in Cournot
equilibrium, Firm 2 earns less, and industry profit is also less.

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66 Microeconomics

Question 4
Reading: p. 37.
Suppose that a monopsonist in the labour market has a production function
given by Q = K + 2L, where Q is output, K is capital, and L is labour. Let the
supply of labour be W = 4L, where W is the wage rate. The monopsonist
sells its output in a perfectly competitive market at a price of P = $8.
(a) Find the monopsony equilibrium wage and employment of labour.
Given the production function Q = K + 2L, the marginal physical
dQ
product of labour is MPL = = 2 and, given also that the output
dL
price is 8, the marginal revenue product of labour is
MRPL = P × MPL = 8(2) = 16 . Given that W=4L, WL= 4L2 and the
d (WL)
marginal cost of employing labour is MFC L = = 8 L . To
dL
maximise its profits, the monopsonist (the sole buyer in the labour
*
market) determines optimal employment ( L ) where
MFC L = MRPL ; that is, where 8L=16 so that L* = 2 . To attract this
quantity of labour the monopsonist must pay a wage rate determined
by its labour supply function: W
*
= 4(2) = 8 . This result is illustrated
below:

W MFCL
SL

16 MRPL
A

O 2 4 L
(b) Find the deadweight loss of monopsony.
The deadweight loss – that is, the net loss of maximum possible total
surplus (here, entirely made up of a loss of producer surplus) – is
measured by area A = 12 (16 − 8)(4 − 2) = 8 .

Question 5
Reading: p. 25.
Consider a market with 100 individuals each with the demand schedule for
electricity of P = 10 − Q . They are served by an electric utility with a
constant marginal and average cost of 2.
(a) i. Assuming zero costs of implementation, what is the two-part tariff that
a profit-maximising utility will set?
ii. What is the total profit?
iii. What is the total surplus in this market?

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 Examiners’ commentaries 2008

A good answer would have included the following analyses.

(a) i. By implication, the electric utility has a monopoly in the supply of
electricity in this market. It can maximise its profits by setting a
price per unit equal to marginal cost and setting a fixed charge to
each individual equal to what would otherwise be the individual’s
consumer surplus. Thus, the price per unit will be P = MC = 2 and
the fixed charge will be F = 12 (10 − 2)(8 − 0) = 32 .

(a) ii. Total profit is the profit earned per customer (since total costs
are covered by the charge per unit this is equal to the fixed charge)
multiplied by the number of customers – that is, (32)(100)=3200.
(a) iii. Total surplus is the sum of consumers’ and producers’ surpluses
which is also 3200 because, in this case, the electric utility is able
to capture all of the consumers’ surplus as monopoly profit.
(b) What is the total profit and total surplus if, instead of a two-part tariff,
the utility had to sell all its electricity at a single price per unit (with no
other prices or charges)?
Now the monopoly will set output where MR = MC. As the inverse
market demand curve is P = 10 − 100
1
Q , MR = 10 − 501 Q (where Q,
here, is market quantity). Thus, the profit-maximising output is given
by 10 − 501 Q = 2 , that is, Q = 400. So, price per unit will
be P = 10 − 100
1
(400) = 6 and total profit will be
π = 400(6 − 2) = 1600 . This is half the total profit earned by
implementing a two-part tariff. Consumers’ surplus is given by
2 (10 − 6)( 400 − 0) = 800
1 so total surplus is now 1600 + 800 = 2400.
This is only three-quarters of the (maximum) total surplus earned with
the two-part tariff because the monopoly sets a single price above
marginal cost, causing a deadweight loss of 12 (6 − 2)(800 − 400) = 800 .

Good candidates used a diagram to help demonstrate the results.

Question 6
‘Taken together, the completeness and transitivity assumptions guarantee
that an individual can consistently rank any set of consumption bundles but,
even if these assumptions underlie every individual's ranking of consumption
bundles, collective choices made on the basis of a majority-voting rule need
not be consistent.’ True, false, or uncertain? Explain your answer.
Reading: p. 5 and p. 61.
Candidates needed to answer ‘true’ and to explain why this is so for
both parts of the statement. To rank consistently any set of
consumption bundles, an individual must be able to compare any two
bundles A and B and to make preference statements – that is, to decide
whether he or she prefers A to B, prefers B to A, or is indifferent
between A and B (the axiom of completeness). Also, he or she must
not make inconsistent preference statements – that is, if an individual
prefers A to B, and also prefers B to C, he or she must prefer A to C,
and a person who is indifferent between A and B, and also indifferent
between B and C, must be indifferent between A and C (the axiom of
transitivity).

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66 Microeconomics

To show that the second part of the statement is true candidates

should have used a simple example. Suppose a society consists of three
people who face three choices over the size of a public project: small,
medium or large. Jack prefers S to M and M to L, while Katherine
prefers M to L and L to S, and Lois prefers L to S and S to M. Assume
each person also has transitive preferences so that John prefers S to L,
Katherine prefers M to S, and Lois prefers L to M.

Order of
Choice First Second Third
Voter

Jack S M L

Katherine M L S

Lois L S M

In pairwise, majority voting, S is preferred to M, M is preferred to L,

and L is preferred to S. Hence, under majority voting, social
preferences are intransitive even though individual preferences are
transitive: there is no agreed ranking.
Question 7
(a) Consider the following two forms of the production function –
Q = min(α L, β K ) and Q = Lα K β , where Q is the quantity of output per
period of time, L and K are inputs of labour and capital services per period
of time and α and β are positive constants.
i. With reference to each of the production functions, explain and
distinguish between the concepts of returns to scale and returns to a
factor.
ii. With both factor inputs variable and with constant factor prices, will a
cost-minimising firm with either of these production functions alter its
capital-to-labour ratio as it expands output? Will average costs change?
Reading: p.16 and p.18.
(a) i. Candidates should have provided clear definitions of the relevant
concepts and then explained the characteristics of the two forms of
production function using algebra (and perhaps diagrams). If all inputs
are changed in the same proportion (by a factor of λ ) this is referred
to as a change in the scale of production. For a given proportionate
increase in all inputs there are increasing, constant, or decreasing
returns to scale if, correspondingly, output increases by more than the
proportionate increase in inputs, by the same proportion, or by less
than the proportionate increase in inputs. Returns to a factor refers to

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 Examiners’ commentaries 2008

the effect on output of varying one factor while keeping the other
factor fixed. The hypothesis of diminishing returns states that if
increasing quantities of a variable factor are applied to a given quantity
of a fixed factor, the marginal product and average product of the
variable factor will eventually decrease.
Given Q = min(α L, β K ), min(αλ L, βλ K ) = λ min(α L,β K ) = λQ .
Thus, this production function exhibits constant returns to scale. With
this production function returns to a factor are constant if additional
units of the other factor are superfluous and zero if the other factor is
the binding constraint in the production process. For example, if
α L < β K then Q = α L : labour is the binding constraint in this case
and MPK = 0 while MPL = α .

Given the Cobb-Douglas production function Q = Lα K β ,

(λL)α (λK )β = λα +β Lα K β = λα + β Q . Thus, this production function
exhibits increasing, constant, or decreasing returns to scale as
α + β > 1, α + β = 1, or α + β < 1. If labour is varied while capital
∂Q ⎛Q
is kept constant, MPL = = α Lα −1 K β = α ⎝ ⎞⎠ > 0 and
∂L L
∂ MPL ∂ 2 Q
= 2 = (α − 1)αLα −2 K β . Thus, there are diminishing
∂L ∂L
returns to labour only if α < 1 . Similarly, it can be shown that there
are diminishing returns to capital only if β < 1. There are constant or
increasing returns to labour (or capital) if α (or β ) equals or is greater
than one.
(a) ii. Candidates needed to explain that the answer to the first
question is ‘No’. With both factors variable and constant factor prices, a
cost-minimising firm with either of these production functions will not
alter its capital-labour ratio.

K α
slope, =
L β

X3 X3
β X2
X1
O X3 L
α
Given Q = min (αL, β K ) and positive prices of inputs, then, whatever
the ratio of factor prices, the cost-minimising factor combination for

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66 Microeconomics

producing any given level of output is at the vertex of the

corresponding production isoquant; that is, where the capital-labour
ratio is α / β .
α β
Given Q = L K , the cost-minimising capital-labour ratio is
determined by the slope of the ray from the origin which passes
through the points of tangency between the isocost lines and isoquants,
w MPL α (Q / L) α K
that is, where = MRTS LK = = = . Thus,
r MPK β (Q / K ) β L
K wβ
= and so the capital-labour ratio is higher the greater the
L r α
ratio of the price of labour (w) to the price of capital (r), but is
constant at different output levels if the prices of labour and capital are
constant.

K wβ
slope, =
L r α

X3
X1 X2
O L

Candidates should have explained that the answer to the second

question depends on the form of the production function. Average
costs will reflect the scale characteristics of the production function.
Given Q = min(α L, β K ), returns to scale are constant so there are
constant average costs as output is increased.
α β
Given Q = L K , average costs are decreasing, constant, or increasing
depending on whether returns to scale are increasing, constant, or
decreasing (i.e. α + β > 1, α + β = 1, or α + β < 1).
α β
(b) If Q = L K , where α = β = 12 , and one factor is fixed, explain the
shape of the average total cost curve when factor prices are constant.
Candidates should have demonstrated that the average total cost curve
is U-shaped. At low rates of output, the decline in average fixed costs
( AFC ), as output increases, outweighs the rise in average variable
costs ( AVC ) so that average total costs ( ATC = AFC + AVC ) fall.
However, as the AFC curve is a rectangular hyperbola, while the
AVC curve has a constant and proportional slope, at high rates of
output, the ATC curve will rise because the rise in AVC will
outweigh the decline in AFC .

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 Examiners’ commentaries 2008

Thus, suppose that capital is the fixed factor. Then, AFC = r K /Q

2
1 1 ⎛ Q ⎞ Q2
and AVC = wL / Q . Given that Q = L2 K 2 , L = ⎜ 1 ⎟ = .
⎝ K2 ⎠ K
Q2 / K wQ rK wQ
Thus, AVC = w = . ATC = + . The minimum
Q K Q K
r
point of this U-shaped curve is Q = K (found by differentiating
w
ATC and setting the result equal to zero). The second derivative of
2rK
ATC is equal to 3 which is positive indicating that this is indeed a
Q
minimum.
Question 8
Reading: pp. 51–54.
(a) Examine the consequences of asymmetrically held information for the
efficiency of the operation of insurance markets.
Fully defining all terms, candidates needed to distinguish carefully
between the problem of adverse selection arising from the hidden
characteristics (e.g. driving ability) and the problem of moral hazard
arising from the hidden actions (e.g. driving care) of people wanting to
buy insurance. They needed to show that, in market equilibrium, good
risks are likely to be underinsured (or not insured) as a result of
adverse selection and lose utility compared to a (hypothetical)
situation in which they are distinguished costlessly from bad risks.
They also needed to show that moral hazard will cause insured people
to take less care to reduce expected damage than would be the case
were care taken up to the level where the marginal social costs of
taking care are equal to the marginal social benefits (that is, the
reduction in the expected value of damage resulting from an additional
unit of care). Insurance policy holders lose utility compared to a
(hypothetical) situation in which their actions can be costlessly
observed because they lose more from paying higher premiums to
cover the higher expected costs of damage (assuming for the moment
that they remain fully insured) than they gain from lower costs
associated with reduced care.
(b) Indicate how buyers and sellers of insurance might reduce these problems
and determine what limits the extent to which they are able to reduce
them.
Again, candidates needed to distinguish carefully between those
responses of buyers and sellers of insurance that may reduce the
problem of adverse selection and those responses that may reduce the
problem of moral hazard. Insurance companies may alleviate adverse
selection problems (but not eliminate them) by offering group
insurance plans whereby employees of particular employers are all
insured rather than being left to make their insurance decisions
individually. Insurance companies may also use indirect (and
imperfect) measures of risk (e.g. sex, age) on which to base premiums.
They may also use screening devices (e.g. medical tests) for setting

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66 Microeconomics

premiums. The substantial costs and inaccuracies that may be

associated with the latter may limit the extent to which buyers and
sellers find it beneficial to make use of them. The moral hazard
problem may be reduced if insurance companies require policy holders
to bear some of the costs of claims by means of coinsurance and
deductibles (‘excess’ charges). However, the moral hazard problem is
not fully solved in these ways as long as the person buys some
insurance. And moral hazard is only reduced by reducing the benefits
to insured persons of shedding their risks.
Good answers used carefully drawn and labelled diagrams to support a
full analysis of these points.
Question 9
Reading: pp. 45–48 and p.59.
(a) Explain the concept of Pareto efficiency and examine how markets may
achieve a Pareto-efficient allocation of resources.
Pareto efficiency refers to a situation where no feasible change in the
allocation of resources will make some person better off without
making someone else worse off. Candidates needed to explain that,
given well-behaved preferences and production functions (and, for
simplicity, assuming an economy in which there are two goods, X and
Y, two factor inputs, L and K, in fixed supply, and two individuals, A
and B), three conditions are necessary for Pareto efficiency: efficiency
in consumption (or exchange); efficiency (in the use of inputs) in
production; and efficiency in product mix (or output allocation).
Algebraically, these conditions are expressed as MRSXY = MRSXY ,
A B

MRTSLK X
= MRTSYLK , and MRT XY = MRSXY A
= MRSXY B
, respectively.
These conditions need to be described and explained using Edgeworth-
box diagrams and, for the third condition, a production possibilities
frontier (or transformation curve) as well. Good candidates will
demonstrate that, if one of the conditions is not met, it is possible to
make some change (e.g. reallocate consumption goods between
individuals) so that at least one individual is made better off and the
other is no worse off.
Candidates also needed to explain the first (fundamental) theorem of
welfare economics which states that, if there is a market for every
commodity, optimising behaviour on the part of individuals and firms
under perfect competition leads to a Pareto-efficient social outcome.
That is, an economy in competitive equilibrium will be efficient in
consumption, production and product mix. In competitive equilibrium
every consumer faces the same prices ( PX and PY ) for goods and
each consumer chooses a consumption bundle at which
MRSXY = PX / PY . Thus, there is efficiency in consumption because
A B
MRSXY = PX / PY = MRSXY . Similarly, there is also efficiency in
production because the desire of every producer to minimise costs
X Y
ensures that MRTSLK = W / R = MRTSLK , where W is the price of a
unit of labour services and R is the price of a unit of capital services.
For efficiency in product mix we need to show that:
MRT XY = PX / PY = MRS XY . In competition, firms will be
producing output levels such that the marginal cost of a good is equal

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 Examiners’ commentaries 2008

X Y
to its price. Thus, W / MPL = PX and W / MPL = PY , where
X Y
MPL and MPL are the marginal products of labour ( L ) in the
production of X and Y respectively. Combining these equations,
Y X X Y
MPL / MPL = P / P . Thus, the marginal rate of transformation
Y X
between X and Y , MRT XY = MPL / MPL , is equal to the ratio of
their prices. This ratio, in turn, is equal to each person’s marginal rate
of substitution in consumption, as shown above, so there is efficiency
in product mix. Hence the utility-and-profit-maximising signals
inherent in the price system lead competitive markets to a Pareto-
efficient allocation of resources.
(b) With reference to the conditions for Pareto efficiency show the
implications of:
i. a monopoly,
ii. a public good.
(b) i. Candidates should have explained that a monopoly restricts the
supply of the monopolised good and causes inefficiency in the product
mix. Thus, suppose that good X is produced by a monopoly while Y
is produced by a competitive industry. Then, to maximise its profit, the
monopolist will restrict output of X to the level where MRX = MCX ,
which implies that PX > MCX . In the competitive industry,
PY = MCY . Thus, MCX / MCY < P X / PY . Given that
MRT XY ≡ MCX / MCY and that consumers balance their
A B
consumption so that PX / PY = MRS XY (and PX / PY = MRS XY ),
A B
this implies that MRT XY < MRSXY (and MRT XY < MRSXY ). This
means that, at the margin, consumers are more willing to give up Y
for an additional unit of X than it costs in terms of reducing
production of Y in order to produce an additional unit of X . Thus,
too little X (and too much of Y ) is being produced. In other words,
efficiency in the product mix is not achieved because it would be
possible to make someone better off without making someone else
worse off by producing more X and less Y .
ii. Candidates should have explained that a public good is non-
rivalrous; that is, consumption by any one person does not reduce the
amount available for others. The difference between (ordinary)
rivalrous goods (that are used exclusively) and public goods (that can
be used concurrently by many people) makes for a change in the
efficiency conditions. In a simple 2 x 2 x 2 general equilibrium model if
X is a public good, then the efficiency condition is:
MRT XY = MRSXY
A
+ MRSXY
B

[not, as when X is a private good, MRT XY = MRSXY = MRSXY ]

A B

where MRT and MRS magnitudes are defined in terms of the

amount of private good Y given up.
This condition could be achieved by means of market transactions if
each consumer could be charged a price equal to his marginal
willingness to pay for a public good. However, it is not always easy
(cheap) to exclude nonpayers. That is, a good may be non-excludable.

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66 Microeconomics

If a public good is non-excludable, some of the public good might be

supplied by self-interested individuals for their own benefit, but the
amount will be lower than the Pareto-efficient level because no one is
eager to incur private costs in producing the public good but, rather
everyone wants to let others pay. Moreover, even if exclusion is
possible, the system of prices that would ensure efficiency is likely to
require price discrimination (as marginal willingness to pay is likely to
vary from person to person) and so could not be achieved under
competition. A competitive industry would tend to undersupply a
public good because of the inability to discriminate; a monopolist
would tend to undersupply in order to exploit its monopoly power.
Question 10
Reading: p. 23.
Assuming competitive markets, analyse the following:
(a) Suppose the government wants to lower the price that consumers pay for
commodity X . With respect to their welfare effects on consumers,
producers, and society as a whole, compare a price ceiling with a subsidy
per unit paid to producers that lowers the price paid by consumers to the
same extent.
A good answer would have included the following analyses.
(a)

P2 A
E Ss
B C
P0 K
F G H J
P1

D
O Q1 Q0 Q2 Q
P2 = P1 + s , where s is the subsidy per unit. P2 is the effective price
received by producers (i.e. including the subsidy they receive). P1 is the
price consumers pay (i.e. the producers’ price minus the subsidy per
unit). The quantity bought and sold increases from Q0 to Q2. As a result
of setting a price ceiling at P1, the quantity traded decreases from Q0 to
Q1.
Comparing the two schemes’ effects on welfare we have:

Subsidy Price ceiling

Change in consumers' surplus F+G+H+J F−A−C

Change in producers' surplus B+C+E −F−G

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 Examiners’ commentaries 2008

Cost to government (taxpayer) −B−C−E−F−G−H−J−K 0

Welfare loss −K −A−C−G

Both consumers and producers are better off in the case of the subsidy.
Compared to the initial equilibrium, producers are worse off when a
price ceiling is imposed; consumers may be better off if F > ( A + C)
but, even so, they are less well off than in the case of the subsidy (by
− B − C − E − F − G and − A − C − G − H − J , respectively). With a
demand curve that is relatively less elastic compared to supply (as
shown), the net welfare cost to society is larger in the case of the price
ceiling. The reverse would be true if demand were relatively elastic
compared to supply.
(b) Suppose the government wants to raise the price that producers receive
for commodity Y . Identify and compare the welfare effects of a
production quota with a scheme in which the government buys as much
output as necessary to drive the price up to the level that would be
achieved by the production quota.
Consider the Figure below. SS o is the initial short-run industry supply
curve and D is the market demand curve.

PY
S0

P1
A B C
P0 E F

G H

D
O X2 X 0 X1 QX

Under the first scheme, output must be restricted by enforcing a

production quota at X2 if price is to be raised from P0 to P1. (Assume
that the cost of operating the production quota is zero.) Under the
second scheme, to ensure that consumers will pay P1, the government
buys X 1 − X 2 output and stocks it indefinitely or destroys it. (Assume
that both these actions are costless.) Price is driven up from P0 to P1
and production increases from X0 to X1.
Comparing the two schemes’ effects on welfare we have:

Production quota Government purchase

Change in consumers' surplus −A−B −A−B

Change in producers' surplus A−E A+B+C

Cost to government (taxpayer) 0 −B − C − E − F − G − H

13
66 Microeconomics

Welfare loss −B−E −B − E − F − G − H

Thus, the reduction in consumer surplus is the same, the increase in

producer surplus is larger under the government purchase scheme
(under the production quota, producer surplus may even fall if E > A),
and the cost to the government and the overall welfare loss are greater
under the government purchase scheme.
(c) Suppose that the government wants to raise the price of a commodity on
the domestic market by reducing imports. Assume that the importing
country is a price taker in world markets. Compare the welfare effects of
an import tariff with an import quota.

P
Sd Dd

Pd

A B C D
Pw

O Q1 Q2 Q3 Q4

S d and Dd are the domestic supply and demand schedules and Pw is

the world price. When a tariff is imposed the domestic price rises (from
Pw to Pd ). Domestic production increases (from Q1 to Q2 ), domestic
consumption decreases (from Q 4 to Q3 ) and imports fall (from
Q4 − Q1 to Q3 − Q2 ). Consumer surplus falls by −A−B−C−D,
producer surplus rises by A, and government revenue rises by C.
Summing these amounts, total welfare falls by −B−D.
An import quota can have similar price, production and consumption
effects as a tariff (if the quota is equal to Q3 − Q2 ) but now the total
loss to the importing country is greater ( − B − C − D ) because,
assuming quota allotments are simply assigned to foreign suppliers,
there is a loss to foreign suppliers of −C (that is, there is no
government revenue).
Question 11
Reading: p. 39 and p. 40.
(a) Defining all relevant terms, use a simple two-period model to analyse the
optimising consumption, investment, and borrowing or lending decisions
of an individual who can borrow or lend at the market rate of interest.
Candidates should have defined terms clearly and used accurately
labelled diagrams to explain decisions involving the intertemporal
allocation of resources. In particular, the following concepts –
endowment position, interest rate (r), and rate of time preference ( ρ )
– should have been defined and used to explain the position and slope

14
 Examiners’ commentaries 2008

of the intertemporal budget line, the slopes of indifference curves and

the condition for a consumption optimum ( ρ = r ) . Candidates should
have allowed for investment opportunities by explaining the concept of
the production opportunities curve (representing how current
consumption can be transformed into future consumption by
investment). Assuming that available investment opportunities are
independent of one another and may be taken up in any order, the
production opportunities curve can be drawn concave to the origin to
show that additional investment opportunities yield declining
increments to output. The absolute slope of the production
opportunities curve is equal to one plus the marginal rate of return on
investment (R) so, with access to a perfect capital market, the wealth-
maximising investment-production plan is where R= r. A figure
describing indifference curves, production opportunities curve, and
market opportunities line(s) should have been used to explain the
optimal investment and consumption decisions (represented by the
tangencies of a market opportunities line with the production
opportunities curve and an indifference curve, respectively).
(b) Given the model described in (a), explain whether and, if so how, the
individual's investment decision is dependent on:
i. the interest rate,
ii. the productivity of investment,
iii. her rate of time preference proper,
iv. the present value of her endowed income streams (assume a constant
interest rate).
Again using diagrams, candidates should have demonstrated that:
i. Investment is inversely related to the interest rate. For example, at
a higher interest rate, fewer investments offer a marginal return
that exceeds the opportunity cost of investment (as represented by
the interest rate) so that investment will be restricted to a lower
level at which the last pound of investment returns one pound plus
a marginal rate of return on investment (R) where R = r.
Diagramatically, a steeper market opportunities line is tangential to
the production opportunities curve at a lower level of investment.
ii. Investment is positively related to the productivity of investment.
Representing the productivity of investment by the marginal rate of
return, an individual will invest more the higher the marginal
return is on investment because more investments will satisfy the
condition that R ≥ r . Diagramatically, a steeper production
possibilities curve is tangential to a higher market opportunities
line at a higher level of investment.
iii. Investment is independent of her rate of time preference proper.
The latter is the additional amount of future consumption she
would be willing to give up in return for having an additional unit
of current consumption when her consumption levels are equal in
each period. If the rate of time preference proper is positive she is
said to be ‘impatient’; if negative, she is said to be ‘patient’.
Depending on her degree of impatience/patience, her utility-
maximising consumption choice may be at any point along her

15
66 Microeconomics

wealth-maximising market opportunities line but, regardless of the

consumption point chosen, the wealth-maximising investment
decision is unaffected. The so-called ‘separation theorem’ holds.
Good candidates should contrast this situation with one in which,
say, the individual has to pay a higher interest rate if she borrows
than she can earn if she lends. If she has a sufficiently high rate of
time preference proper that she is a borrower she will invest less
than if she has a sufficiently low rate of time preference proper so
that she is a lender.
iv. Together with her investment-production opportunities and the
market rate of interest, an individual’s wealth depends also on the
present value of her endowed income streams. Her investment
decision, however, is independent of her endowed income streams.
Diagramatically, the endowment position affects the position of her
production possibilities curve but not the point along it of her
optimal investment decision.
(c) Given the model described in (a), explain whether and, if so how, the
individual’s consumption decision is dependent on:
i. her wealth (assume a constant interest rate),
ii. the pattern of her income flows (assume a constant interest rate and a
constant level of wealth).
Diagrams should also have been used to help explain that:
i. Assuming that consumption in each period is normal with respect
to wealth, the higher is her wealth the higher is her consumption in
both the current and future periods.
ii. An individual’s consumption decision depends on the interest rate
and her level of wealth (or the present value of her income flows)
but does not depend on the pattern of her income flows (which are
determined by her initial endowment and her investment returns).
Question 12
Reading: p. 11 and p. 13.
(a) Explain and compare the responses of a risk-averse person and a risk-
neutral person to the offer of:
i. a gamble with favourable odds,
ii. insurance with a premium that is higher than an actuarially fair one.
Good answers would have included correct definitions of all relevant
terms and clear explanations to accompany diagrams, such as those
that follow.
i. A risk averse person is one who prefers a certainty with a particular
expected value to an uncertain prospect with the same expected
value. This implies that his preferences over contingent
commodities are represented by indifference curves that are convex
to the origin and that cross the certainty line with an absolute slope
equal to the fair odds [the ratio of the probability of a loss to the
probability of a win, p /(1 − p ) ]. A risk neutral person is one who
is indifferent between a certainty with a particular expected value
and an uncertain prospect with the same expected value. Her
indifference curves are straight lines with an absolute slope equal

16
 Examiners’ commentaries 2008

to the fair odds. Candidates need to show that both individuals will
accept the gamble if the gamble is actuarially favourable to the
individuals (expected value of the gamble is positive) and the
individuals are allowed to choose their respective stakes. A risk-
neutral person will stake all his money on the gamble in these
circumstances. A risk-averse person will stake at least some money
on the gamble. In the diagram below, an actuarially favourable
gamble is represented by points along line ad . From the
endowment position, a , a risk-averse person moves to b and a
risk-neutral person moves to d. [If the individuals are required to
make a sufficiently large stake to place them between c and d on
the budget line ad , a risk-averse person will reject the gamble (as
he will be on a lower indifference curve than û 0 if he accepts – to
him, the greater risk outweighs the greater expected gain) while
the risk-neutral person will accept the gamble.]

Cw certainty line

c p
b slope = −
1− p

a
uˆ1
uˆ0

u0 u1
O Cl

ii. A risk-averse person may choose to partially insure against the risk
of a loss if he is strongly risk averse and the insurance terms are
not too unfavourable. Budget line ab represents the budget line
when insurance is actuarially fair, allowing an individual to
exchange an uncertain situation at a for a less risky situation with
the same expected value of consumption. Lines ac and ad
represent budget lines when the insurance premium is higher than
the actuarially fair one. Along budget line ac , he chooses to
partially insure (moving onto a higher indifference curve û1 ) but,
along budget line ad , representing even more unfavourable
insurance terms, he remains at a (on indifference curve û 0 ). A
risk-neutral person will not buy actuarially unfavourable insurance
as, by doing so, she will be placed on a lower indifference curve
than u1 .

17
66 Microeconomics

Cnl certainty line

p
slope = −
1− p
a

c uˆ1 uˆ2
u0 u1
uˆ0
d

O Cl

In answer to parts (b) and (c), candidates needed to derive and explain
briefly the following results.
1
(b) John has the utility function U = W 2 and initial wealth W = $2,500 .
He faces the risk of a loss of $1,600 with probability 12 .
i. What is John's expected utility?
ii. What is the actuarially fair price for full insurance?
iii. Will John buy full insurance if it is actuarially fair?
iv. What is the maximum John is prepared to pay for full insurance?
i. John’s expected utility=
1
2 2500 + 12 2500 − 1600 = 1
2
(50) + 12 (30) = 40 .
ii. Actuarially fair insurance is when the premium charged (R) equals
the probability of loss (p) multiplied by the loss (L). Thus,
R = pL = 12 (1600) = 800 .
iii. John can consume with certainty wealth of 2500–800=1700. John’s
utility from this wealth is U (W ) = 1700 = 41.23 > 40 so John
will insure fully.
iv. The most that John would pay for full insurance would be an
amount (x) that, when it is subtracted from his initial wealth,
leaves him with a level of wealth which, if it is certain, provides the
same utility as when he is uninsured. That amount is given by
2500 − x = 40 2 so x = 900.

18
 Examiners’ commentaries 2008

(c) Three possible investment projects A, B, and C yield the following

payoffs in ‘bad times’, ‘normal times’, and ‘good times’. The probabilities
of each of these states of the world are given as well:

Probability 0.6 0.2 0.2

State of the
world Bad times Normal times Good times
Project

A 0 0 20

B 4 4 4

C 0 9 16

As a result of making an investment, an investor obtains utility that equals

the payoff.
i. Which investment does the investor prefer?
ii. Assume that, by waiting, before making the decision, the investor can
obtain full information about the state of the world. Using a decision tree,
calculate and explain the value of perfect (complete) information for the
investor. Would the investor do better by waiting than investing
immediately if the cost of waiting is zero?
i.
EU(A)=EV(A)=0.6(0)+0.2(0)+0.2(20)=4
EU(B)=EV(B)=0.6(4)+0.2(4)+0.2(4)=4
EU(C)=EV(C)=0.6(0)+0.2(9)+0.2(16)=5
Hence Project C is preferred with EU(C)=5(>4).

19
66 Microeconomics

ii.

B
N EU=4
G
B
N EU=4
A G
B
B N EU=5
G
C

A U(0)
Wait B
C U(4)
U(0)
B

A U(0)
N B EU( Wait ) = 0.6(4)+0.2(9)
U(4)
C +0.2(20)
G U(9) = 4+1.8+2.4
= 8.2
A U(20)
B U(4)
C
U(16)

The decision tree represents the choice of investing immediately in

project A, B, or C on the top three branches (after which the state of
the world is determined) or waiting for the state of the world to be
determined on the bottom branch, after which the investment decision
is made. In the case of investing immediately, the payoffs in utility
terms are the payoffs calculated in part i. The expected utility of
waiting is the sum of the probabilities of each state of the world
multiplied by the utility of the best investment choice given that state
of the world (8.2). The value of perfect information is the increase in a
decisionmaker’s expected payoff when the decision maker can – at no
cost – conduct a test that will reveal the outcome of a risky event.
Thus, the value of perfect information is 8.2 − 5 = 3.2. If the cost of
waiting (the ‘test’) is zero, then the investor will wait because the net
benefit of waiting (3.2 − 0 = 3.2) is positive.
Question 13
Reading: pp. 5–8.
Answer three of the following:
(a) Distinguishing between a corner solution and an interior solution, explain
the condition for the optimum of a consumer.
Using diagrams and defining relevant terms, candidates should have
explained that the optimum of the consumer is the point on the budget
line that touches the highest attainable indifference curve. With convex
indifference curves, the optimum can be an interior solution where

20
 Examiners’ commentaries 2008

amounts of both commodities are bought. When indifference curves

are smooth and the budget constraint is a straight line, the utility
maximising bundle of X and Y is on the budget line at the point where
the ratio of the price of X to the price of Y is equal to the marginal rate
of substitution of X for Y – that is, PX Q X + PY QY ≡ M and
PX
MRS XY = . Alternatively, the optimum can be a corner solution:
PY
the budget line reaches the highest attainable indifference curve along
an axis, so that one of the commodities is not bought at all. If, at the
point where the budget line intersects the Y axis, the budget line is
steeper than the indifference curve that touches it, the consumer buys
PX
only Y – that is, MRS XY < at Q X = 0 . If, at the point where the
PY
budget line intersects the X axis, the budget line is flatter than the
indifference curve that touches it, the consumer buys only X – that is,
PX
MRS XY > at QY = 0 .
PY
(b) Using the Slutsky method, explain what is meant by a Giffen good. Why is
a Giffen good considered to be a remote possibility?
dX ∂X s ∂X M
The Slutsky equation can be written as = − X1 . This
dPX ∂PX ∂M
describes what happens when the demand for good X changes in
response to a change in its price in terms of a substitution effect
(the change in quantity demanded when the level of utility is fixed)
and an income effect (the change in quantity demanded with the
level of utility changing but the relative price of good unchanged).
The substitution effect must be negative as it represents a movement
along the indifference curve. If the relative price of good X goes up the
quantity of X demanded goes down ( ∂X s / ∂PX < 0 ). The income
effect is the product of two terms. The first is the number of dollars by
which money income decreases as a consequence of an increase in the
price of X. The second is the change in quantity demanded per dollar
decrease in income. To obtain the first term of the product, suppose
the consumption of X is X1 units, then the change in income induced by
a dollar increase in price is simply −X1. (The minus sign is there
because the effect of the increase in price is to reduce income.) Turning
now to the second term in the income effect, we denote the change in
quantity demanded per dollar increase in income as ∂X M / ∂M . This
term is positive if the good is normal and negative if the good is
inferior. Thus, it can be deduced that, for the overall effect of a price
increase on the quantity demanded to be positive and therefore a
Giffen good, the good must be inferior so that the income effect is
positive and the income effect must be larger in absolute value than
the substitution effect.
A Giffen good is usually considered to be a remote possibility because a
good not only has to be inferior but also form a large part of a
consumer’s budget for it to have a large (positive) income effect.

21
66 Microeconomics

(c) Is it possible for a consumer to be worse off when his income increases by
more than the rise in his Paasche price index? Explain your answer.
The answer is ‘Yes’. Candidates needed to demonstrate that it is
possible for a consumer to be worse off when his income increases by
more than the rise in his Paasche price index because the Paasche price
index understates the increase in the true cost of living. The Paasche
price index (PPI) is the ratio of the sum of given-year prices weighted
by given-year quantities to the sum of the base year prices weighted by
given-year quantities. The PPI tends to understate increases in the true
cost of living; that is, the increase in money income that is necessary
for the consumer to achieve the same level of utility in the given year
as in the base year. It is a minimum estimate of the increase in the true
cost of living since it assumes, erroneously, that, had the consumer
received, in the base year, an amount of income equal to the sum of
the base-year prices weighted by given-year quantities he would have
bought the given-year quantities. In fact, the consumer would have
tended to buy relatively more of the commodities which became (in
the given year) relatively expensive. This implies that an individual
whose income rises relatively as much as his PPI and therefore could
have purchased the same bundle of goods in the base year as he does
in the given year will be worse off in the given year. Further, this
implies that if an individual’s income increases by more than his PPI,
but only slightly more, he may become worse off in the given year.
(This analysis assumes, quite reasonably, that relative prices change
and the consumer responds by substituting between commodities over
the period in question.)
n

∑P Q i1 i1
The PPI is given by PPI = i =1 , where the i ' s represent the
n

∑P Q
i =1
i0 i1

commodities (total number equal to n) and the subscripts 0 and 1

represent the base year and the given year, respectively. The argument
can be illustrated diagrammatically in the two-commodity case. Denote
expenditures (actual and hypothetical) on two commodities X and Y as
follows: PX 0 Q X 0 + PY 0 Q X 0 = M 0a , PX 1Q X 1 + PY 1Q X 1 = M 1a ,
M 1a M 1a M 1a
PX 0 Q X 1 + PY 0 Q X 1 = M . Then, PPI = h . So, if
h
0 = ,
M0 M 0a M 0h
M 0h = M 0a .

22
 Examiners’ commentaries 2008

QY
M1a
PY 1
M0a M0h
= a
PY 0 PY 0 B1
M0a M0h
< a
PY 0 PY 0 B0
M0a
PY 1 uH

uL
a
O M0a M1a M0a M0h M0 M0h QX
< =
PX 1 PX1 PX 0 PX 0 PX 0 P X0
The base-year budget line is tangential to u H at B0a . Prices of X and Y
increase in the given year with the price of X increasing relatively more
than Y so that, in the absence of a change in income, the budget line
would move in towards the origin and become steeper (the lowest
budget line shown). With an increase in income in the given year,
however, the new budget line is tangential to u L at B1a . If
M 1a M 1a
M 0a = M 0h , so that = , it is clear that the consumer is
M 0a M 0h
a
worse off in the given year ( B1 is on a lower indifference curve than
M 1a M 1a
B ). Even if M < M , so that
a
0
a
0
h
0 > , it is possible that the
M 0a M 0h
consumer is worse off in the given year (the broken line lies above a
segment of indifference curve u L indicating that, in this case too, the
consumer could be at a preferred consumption bundle in the base year
– that is, on a higher indifference curve – than in the given year).
(d) Explain why, as long as indifference curves have the usual shape, any
subsidy that changes relative prices is inefficient in the sense that the
value to the recipient is less than the cost to the government.
Candidates should have explained the statement by using a diagram
like the following:

23
66 Microeconomics

A
e
e1 e2
u2
u1 b
a
C D E
O X
The horizontal axis measures the quantity of good X and the vertical
axis measures the quantity of a composite commodity Y which has a
price per unit of £1. Assume that the government provides a subsidy on
consumption of X at a percentage rate s, so that a consumer faces a
price of (1 − s )PX . The consumer’s budget line swings out from AC
toAE so that the consumer’s optimum moves from e1 to e2 . The
money cost of the subsidy is measured by the distance ae2 (good
candidates explained why). To place a money value on the increase in
the consumer’s welfare when he moves from u1 to u 2 we need to find
an amount of income that could be given to the consumer to produce
an equivalent welfare gain – that is, we need to find the equivalent
variation. To do this we shift the original budget line outwards in
parallel fashion until it is tangential to indifference curve u 2 (at e ).
The equivalent variation is then measured by the distance AB = ab .
ab < ae2 which demonstrates the validity of the statement.
Question 14
Reading: pp.29–30 and p.32.
(a) Consider the following market. There is a single incumbent and a single
potential entrant. Each firm has constant marginal cost of $C per unit
and the product is undifferentiated. To enter the market, the new firm
would have to incur a one-time cost of $X million. Resolve the following
paradox:
If the post-entry game is a Bertrand duopoly, then neither firm will make
profits, whereas under a Cournot duopoly they would. The incumbent,
however, would prefer to be in a situation where the post-entry
interaction is Bertrand rather than Cournot.
Candidates should have explained that the paradox can be resolved by
assuming that market demand conditions and costs yield profits for
both the incumbent and the entrant (even after allowing for its one-
time entry cost) in Cournot duopoly but a zero profit for the incumbent
and a loss for the entrant (again, after allowing for its one-time entry
cost) in Bertrand duopoly. Clearly, if entry occurs, the incumbent
prefers Cournot interaction to Bertrand. However, assuming that the
potential entrant can anticipate the type of post-entry interaction that

24
 Examiners’ commentaries 2008

will occur if it enters, it will not enter if it expects Bertrand interaction

as it will incur a loss. If entry does not occur the incumbent can earn a
monopoly profit, which is greater than it would earn in Cournot
duopoly, so the incumbent would prefer to be in a situation where the
post-entry interaction is Bertrand rather than Cournot. Good
candidates used algebraic methods or a numerical example to explain
their answer.
(b) i. Suppose that an incumbent monopolist ( I ) faces a potential entrant
( E ). E has to decide whether to enter or stay out. Contingent on the
action taken by E , I has to decide whether to charge a low price or a
high price. The possible outcomes of these decisions are described in the
following pay-off matrix ( E ’s profits before the commas):
Incumbent
Low price High price
Enter –1,5 6,6
Potential
Entrant
Stay
out 0,8 0,7

If I threatens to set a low price if E should enter, will E believe the

threat? Construct a game tree to help explain your answer.
ii. Now, suppose that I can build a larger plant prior to E ‘s decision
whether to enter or stay out. As a result the pay-off matrix is now:
Incumbent
Low price High price
Enter –2,4 5,3
Potential
Entrant
Stay
out 0,5 0,4

If I built the large plant, would its threat to set a low price if E should
enter be credible? What is the outcome of this game? Explain your
answers.
(b) i. The small-plant branch of the game tree below should have been
used by candidates to argue that, if I threatens a low price if E should
enter, E should not believe it. Looking at the incumbent’s payoffs, it
can then be seen that the incumbent will choose a high price if the
potential entrant enters (6>5) and a low price if the potential entrant
stays out (8>7). Knowing this, the potential entrant will enter (6>0).

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66 Microeconomics

–1,5

Incumbent Low price

High price
Entrant Enter 6,6
Stay out 0,8
Low price
Small plant Incumbent High price
Incumbent
0,7
–2,4
Large plant Incumbent Low price
High price
Enter 5,3
Entrant Stay out 0,5
Low price
Incumbent High price
0,4
ii. The large-plant branch of the game tree below should have been
used by candidates to argue that it is feasible for the incumbent to
deter entry. Looking at the incumbent’s payoffs, it can be seen now
that the incumbent will choose a low price if the potential entrant
enters (4>3) and a low price if the potential entrant stays out (5>4).
Knowing this, the potential entrant will stay out (0>–2).
To determine the prior decision of the incumbent whether to build a
small plant or a large plant, we need to compare the incumbent’s
anticipated payoffs. If it builds a small plant, the potential entrant will
enter and the incumbent will choose a high price, so that the
incumbent’s anticipated payoff is 6. If it builds a large plant, the
potential entrant will stay out and the incumbent will choose a low
price, so that the incumbent’s anticipated payoff is 5. Thus, the
incumbent will build the small plant (6>5).
Thus, although it is feasible to deter entry by building a large plant the
incumbent will not build a large plant because it is more profitable to
build a small plant. The equilibrium is perfect because, at each stage,
not only is there a Nash equilibrium (entry is the best response to a
small plant and a small plant is the best response to entry; a high price
is the best response to entry and entry is the best response to a high
price); but also strategies satisfy the credibility condition that, at each
stage of the game, ‘players’ act in their own self-interest (that is,
threats are only effective if they are credible). The incumbent would
receive the highest payoff if the entrant stays out and the incumbent
chooses a low price. However, the strategy pair ‘potential entrant stays
out; incumbent chooses a low price (no matter what the potential
entrant does)’ is a Nash equilibrium but does not satisfy the credibility

26
 Examiners’ commentaries 2008

condition because, if the potential entrant entered it would be in the

self-interest of the incumbent to choose a high price.

27