Summer 2019 Exam

EC202
Microeconomic Principles, II

Suitable for 2018/19 syllabus only — not for resit candidates

Instructions to candidates

This paper contains 10 questions. Your answers to all 10 questions will count towards the final mark.
Answers should be justified by showing work.
Please write your answers in dark ink (black or blue) only.

Time Allowed Reading Time: 15 minutes

Writing Time: 3 hours

You are supplied with: No additional materials

You may also use: No additional materials

Calculators: Calculators are not allowed in this examination

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 Section A
(Answer all questions. 32 total marks, as indicated by question.)

Question 1
Two players play a game described by the following matrix:

1=2 L M R
A 20; 10 2; 9 5; 22
B 11; 22 18; 6 4; 9
C 11; 3 11; 8 1; 20
D 10; 12 2; 10 10; 10

They choose their strategies simultaneously and independently. [5 marks]

(a) Indicate which pure strategies are weakly dominated by other pure strategies. Indicate which
pure strategies are strictly dominated by other pure strategies. [2 marks]
(b) Which strategies survive iterated deletion of pure strategies? [2 marks]
(c) What is (are) the pure and mixed strategy Nash Equilibrium(s)? [1 mark]

Question 2
Ayla and Beth are offered the following deal. First, Ayla makes a contribution cA of between 0 and 10
pounds. Beth sees how much Ayla contributed, then makes a contribution of cB of between 0 and 10
pounds. Their contributions are taken away but a pot worth 23 (cA + cB ) is split equally between the
two. [5 marks]
(a) What are the pure strategies of Ayla and Beth? [2 marks]
(b) Find the subgame perfect equilibrium of the game. [2 marks]
(c) What contributions would maximize the sum of Ayla and Beth’s payouts? Relate this to your
answer from part (b) [1 mark]

Question 3
Two players play a simultaneous move game described by the following matrix twice:

1=2 C D E
C 4; 4 0; 6 1; 1
D 6; 0 3; 3 1; 1
E 1; 1 1; 1 0; 0

Their payoff is the sum of the payoffs from both repetitions ( = 1). [6 marks]
(a) What is (are) the pure strategy Nash equilibrium(s) of the stage game? [2 marks]
(b) Is there a subgame perfect equilibrium where both play C in the first period? If so, construct it
and verify that it is an equilibrium. If not, explain why not. [4 marks]

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Question 4
Consider a Principal-Agent problem. The agent has two possible effort levels: H or L. Her utility from
1
receiving a wage w is w 3 minus the effort cost, which is zero if effort is L and 1 otherwise. With
effort H , output equals 125 with probability 0:8 and otherwise equals 8. With effort L, output equals
125 with probability 0:2 and otherwise equals 8. The agent is resource constrained so the principal
cannot set a negative wage. [6 marks]
(a) Derive the optimal wage schedule set by the principal when both effort and output are observ-
able. [2 marks]
(b) Derive the optimal wage schedule set by the principal when only output is observable.
[4 marks]

Question 5
A worker’s type is t 2f g1; 2 . The probability that any worker is of type t = 2 is equal to 32 ; otherwise
she is type t = 1. A worker of type t produces f (t ) = 2t . Each worker chooses a level of education
e  j
0. The total cost of obtaining education level e is C (e t ) = (3 t )e . Firms compete a la Bertrand
to drive each worker’s wages up to her expected productivity. [5 marks]
(a) Characterize a pooling equilibrium where e = 0. [2 marks]
(b) Characterize a separating pooling equilibrium where type t = 1 workers obtain zero education.
[3 marks]

Question 6
Consider two players with  = 21 who play the following stage game for infinite repetitions:

1=2 H L
H 4; 4 1; 5
L 5; 1 0; 0

[5 marks]
(a) Describe a subgame perfect equilibrium strategy profile where both players take action H in
every period along the equilibrium path. [3 marks]
(b) Consider the following “Tit for Tat” strategy for each player. Play H in the first period. In each
subsequent period, play H only if the opponent played H in the previous period. Otherwise, play
L. Show these strategies do not constitute a subgame perfect equilibrium. [2 marks]

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 Section B
(Answer all questions. 68 total marks, 17 per question.)

Question 7
The Talent and The Face come together to produce widgets. The Face exerts effort eF
1 3
[0; 2) at2
a private cost 3 eF . The Face’s effort does not increase revenue, but instead decreases The Talent’s
cost. The Talent contributes effort eT 
0 and produces revenue of eT at a private cost of 14 (2

eF ) eT2 . To sum up, for a given pair of efforts (eF ; eT ) and payments (tF ; tT ), The Face gets utility
tF 1 3
3 eF and The Talent gets utility tT
1 2 
4 (2 eF ) eT ; the payments are feasible if tF + tT eT . 
[17 marks]
(a) Suppose that eF and eT are observable and contractible. What are the first best efforts that
maximize revenue minus total costs? [5 marks]
(b) Suppose The Talent and The Face split revenues equally and choose their efforts simultane-
ously. What efforts will they choose in the (pure) Nash equilibrium of the game? [4 marks]
(c) Find the revenue shares that maximize total utility when they choose their efforts simultane-
ously. What efforts will they choose in the (pure) Nash equilibrium of the game? [4 marks]
(d) The Face chooses her effort first, and the amount she chose is observed by The Talent before
she chooses her own effort. The revenue is shared equally between the two. How does this
change the incentives for The Face to exert effort relative to part (a) and (b)? (No need to find
an actual number but argue formally). [4 marks]

Question 8
A risk-neutral wholesaler wants to purchase from a new supplier, who may have either high costs
c H (q ) = 3q 2 or low costs c L (q ) = 2q 2 with equal probability. The wholesaler sells every unit of
the
 good at a price of 1 unit of currency and acts as a monopsonist: she offers a menu of contracts
(q H ; p H ); (q L ; p L ) , and if the supplier selects (q; p ), then she buys q units of the good from the
supplier in exchange for p units of currency. The supplier must accept one of the contracts or get a
payoff of zero. [17 marks]
(a) Suppose the wholesaler knows the costs of the supplier. What contract does she offer?
[4 marks]
(b) Consider a menu of contracts (q H ; p H ); (q L ; p L ) . Show that if the low cost supplier prefers


(q L ; p L ) to (q H ; p H ) and the high cost supplier is willing to participate if she accepts (q H ; p H ),

then the low cost supplier is also willing to participate. [4 marks]
(c) Find the profit-maximizing menu of contracts when the costs of the supplier are not known to
the wholesaler. [7 marks]
(d) Compare the “second-best” solution of part (c) with the “first-best” solution of part (a). How and
why does it agree? How and why does it differ? [2 marks]

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Question 9
A firm has a fixed cost F and marginal costs a + bq , where q is output and a; b; F are all positive
parameters. [17 marks]
(a) If the firm behaves as a price-taking profit maximiser, show that its optimal output is given by

p a if p > p
 b
 p a

q = b or 0 if p = p
if p < p

0

where
p
p := a + 2bF :

[5 marks]
(b) Suppose this firm is in fact a monopolist in a market with the inverse demand function p =
1
A 2 Bq , where A > a and B > 0. Show that the firm’s profit-maximising output and price
charged are given by

q  =
A a
;
b+B

p  =
1 1 Ab + Ba
A+ :
2 2 B+b
Draw a diagram of this solution, showing marginal and average cost, marginal and average
revenue. [6 marks]
(c) A government agency now introduces a price ceiling p on the monopolist of part (b) where p
is less than p  but greater than marginal cost at q  . Explain what will happen to the firm’s
optimal output. [6 marks]

Question 10
An agent has property worth W and risks losing some of this property through flood. The probability
of a flood is known to be  and the loss would be L < W . Insurance cover against flood is available
at a premium , where  > L and it is possible to take out partial cover on a pro-rata basis (so that
an amount tL of the loss can be covered at cost t where 0 < t < 1). [17 marks]
(a) Draw a diagram depicting the agent’s budget set. [4 marks]
(b) If the agent’s preferences are given by a standard von Neumann-Morgenstern utility function
will he/she take out full insurance? [6 marks]
(c) Suppose that the agent is risk averse and has decreasing absolute risk aversion. If the value of
the property W increases while L,  and  remain unchanged, will the agent take out more or
less insurance cover? Explain. [7 marks]

END OF PAPER

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