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Endterm practise 18-19

Microeconomics, Institutions and Welfare (Universiteit Utrecht)

Studeersnel wordt niet gesponsord of ondersteund door een hogeschool of universiteit

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RECEIPT

(Please save this receipt carefully. It serves as proof of submission of your exam papers)

Name student: …………………………………..

Student registration number: …………………………………..

Exam: Microeconomics, Institutions and Welfare

Date: JANUARY 25, 2019, 1.30-4.30 PM.

Signature of proctor/instructor ...........................................................................................

Participation in this test is only allowed for students who are correctly registered for
the course and can present a valid proof of identity.

Have your ID ready to be checked !

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Microeconomics, Institutions and Welfare– Final exam

25th January 2019, 1:30 – 4:30 PM

Instructions & remarks

1. This examination (including the current front page) consists of 14 pages in total.
2. Don’t forget to enter your name and student registration number on each answer sheet, in
the indicated place!
3. Write your answer only on the answer sheets.
4. Answers that are not legible will not be graded!
5. Have your proof of identity ready to be checked.
6. Latecomers are allowed into the exam room until half an hour after the start.
7. Going to the toilet is allowed between 2 and 4 PM.
8. Cell phones or other communication devices are not admitted during the exam.
9. Use of programmable calculators and/or graphical calculators is not allowed during the exam.
10. It is not allowed to have any notes, memos etc. relating to the material to be studied for the exam
within arm’s reach (i.e. on your table, in an open bag, etc.).
11. You may bring a dictionary.
12. You are only allowed the scrap paper that is handed out by the examiners or one of the other
invigilators (upon request).
13. Always give your EXPLANATION of answers in FULL. Give the FULL DERIVATION of
your final answer if you need to do calculations and give a written explanation of all points and
lines that you draw in the figures.
14. The maximum number of credits that can be scored for this exam is 100. The results of this
examination will constitute 75% of your final result.
15. The results of the exam will be published in Osiris by Monday, February 11, 2019.
Date and location to inspect your exam are February 18, 2019, starting at 1 PM, in
Spinoza 106.
16. Information about the results of this exam will not be available over the telephone.
17. A photocopy of your exam can be requested at the student desk of the Utrecht School of
Economics. Four weeks after publication of the results of this exam, the original exam is available,
when a declaration is signed, stating that no appeal has been made or will be made.
18. Making an appeal against the result of this exam is possible in writing until four weeks after the
official announcement of the results. The appeal has to be directed to the “College van Beroep
voor Examens”, Heidelberglaan 8, 3584 CS Utrecht.

 2019 USE
All rights reserved. No part of this examination may be reproduced or transmitted in any form by any
electronic or mechanical means (including photocopying, recording or information storage and
retrieval) without the prior written permission of the Utrecht University School of Economics.

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Microeconomics, Institutions and Welfare– Final exam

25th January 2019, 1:30 – 4:30 PM

Family name: a b c d
First name:
Student number:

QUESTION 1 (4 + 1 + 4 + 4 points)

Consider a technology A that uses 1 kg of fertilizer (F) and 1 hour of labour (L) to produce 100kg of
wheat. Fertilizer costs 5 euro/kg and labour 10 euro/hour.

a) Indicate technology A and draw the isocost line that goes through it. Below, also specify the
expression of the isocost line (in a formula).
a)+b): Technology A is the green dot, B is the red dot. (see next page)
The isocost is 1*5+1*10=15.
The isocostline is 5F+10L=15 or L=3/2-1/2F
b)
a) Points: 1 for green dot, 1 for isocost line, 2 for expression
b) Points: 1 should be enough

b) A bio-engineer has invented a new technology B. This technology uses 0.5 kg of fertilizer and 1.5
hours of labour to produce 100kg of wheat. Add technology B to the diagram.

c) If you were an entrepreneur, would you switch to technology B? Use the expression “economic
rent” in your answer.
the isocost line through A is lower than through B – so at current prices technology A is cheaper. You
cannot earn an economic rent by switching to technology B, so as an entrepreneur you would not switch.

4 points. no points if there is no argumentation. -2 if term ‘economic rent’ is not or wrongly used

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Microeconomics, Institutions and Welfare– Final exam

25th January 2019, 1:30 – 4:30 PM

Now suppose that the price of fertilizer changes.

d) At what price for fertilizer would you be indifferent between technology A and B? What would be
the cost in that situation?

For you to be indifferent between A and B, they should be on the same isocost line. If you draw a line through
A and B, you can see it has a slope of -1/1=-1. So you would be indifferent at a relative price of 1 (Fertilizer to
Labour).

If Labour still costs 10, this means a price of 10 for fertilizer and an isocost of [tech A] 1*10+1*10 = 20 =
1.5*10+0.5*10 [tech B].

[see image for illustration – the equation would be L = 2 – F]

Points: 3 for first part, 1 for mentioning the correct cost.

If the wrong answer reads: pF=0 (and followed by correct calculation method), then only 2 points, since this
implies that pL should also be 0, but the question only mentions a change in pF.

Answer version: Picture with a-b:

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Microeconomics, Institutions and Welfare– Final exam

25th January 2019, 1:30 – 4:30 PM

a b c
Name:

QUESTION 2 (8 + 7 + 3 points)

George has the utility function U(x,y) = 6x1/2y1/3. The price of good x is €60, the price of good y is €2.
George’s available budget is €500.

a) Assuming utility maximisation, determine how much George will purchase of each of the two goods.
Use the Lagrange method.

L = 6x1/2y1/3 – [60x + 2y –500].

Next, formulate the partial derivatives and set them equal to zero:

(1) dL/dx = 3 x-1/2y1/3 – 60 = 0

(2) dL/dy = 2 x1/2y-2/3 – 2 = 0

(3) dL/d = -[60x + 2y –500] = 0

Dividing (1) over (2) gives 3y/2x = 30 , so y = 20x.
Substitute this into (3) gives: 60x + 2(20x) –500 = 0 ==> 100x = 500 ==> x = 5 ==> y = 100.

Points:
* 1 for mentioning the complete Lagrange expression
* 3x1 for setting up the three First order conditions (FOC) equal to zero.
* 2 for finding the correct ‘x-y ratio’
* 2 for substituting and finding the correct end answer

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Microeconomics, Institutions and Welfare– Final exam

25th January 2019, 1:30 – 4:30 PM

Suppose the optimal bundle of Mary can be represented by point A in the diagram below, with books
on the x-axis and magazines on the y-axis.

IC2

After a price change of books, the optimal bundle becomes point B.

b) In the figure, clearly indicate the Income effect and the Substitution effect, respectively. Use
arrows. Elaborate on your answer below, by explaining what the two effects mean for the
consumption of books.
See picture next page.
The price change is a price increase, since the budget line rotates inward.
The total price effect makes for a smaller consumption of books.
Books have become relatively more expensive than magazines, so due to the substitution effect you buy less
books.
The price increase has reduced your spending (purchasing) power, hence your real income declines. Due to
this decline, your income effect is negative as well. (in this case: the arrow of the IE points towards the
origin).

Points: 1 for drawing correct tangent line, 1 for IE and 1 for SE, 2x2 for correct description in words

c) Based on your drawing, briefly explain whether books are a normal good or an inferior good.
Due to the decline in (real) income, your IE is negative, you buy less books. This is the feature of a normal
good.

Points: 1 point for a correct answer, additional 2 points for a correct explanation.

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Microeconomics, Institutions and Welfare– Final exam

25th January 2019, 1:30 – 4:30 PM

Answer with b)

← ←
SE IE

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Microeconomics, Institutions and Welfare– Final exam

25th January 2019, 1:30 – 4:30 PM

Name:
a b c
QUESTION 3 (6 + 4 + 4 points)

The payoff matrix below shows profits for two profit-maximising airlines (Flywell and 4Air) for two
alternative pricing strategies. The airlines’ pricing strategies are to either hold rates the same or cut
rates. They decide simultaneously, while knowing all payoffs.
4Air
Hold rates Cut rates
Flywell Hold rates $400, $400 $200, $500
Cut rates $450, $350 $150, $250

a) Briefly describe what a Nash equilibrium is.

Next, determine whether one or more Nash equilibria in pure strategies exist in this game. If so,
indicate which one(s). Do Flywell and/or 4Air have a dominant strategy?
Nash = each player chooses the option (strategy) that leads to the highest payoff, given what the other player(s)
do(es).
Via mutual best responses, you can find that two Nash equilibria exist: the strategy combinations (200,500) and
(450,350).
Neither player has a dominant strategy, since their response differs per strategy chosen by the other player.

Points: 2 for description, 2 for no. of equilibria, 2 for question on dominant strategy.

Suppose one of the airlines causes a lot of noise nearby the airport where it lands, and that the local
authorities do nothing to reduce the noise pollution. Therefore, the local population living nearby the
airport can only try to reduce the noise caused by the airline via private and legally enforceable
negotiations. Obviously, noise reduction would imply a cost to the airline, while it would lead to a
higher level of wellbeing for the local population. The table below indicates the level of producer
surplus for the airline and consumer surplus for the local population, respectively, in the situation with
and without noise reduction by the airline.
Action airline
Reduces noise Does not reduce noise
Surplus of the airline € 1,000,000 € 1,300,000
Surplus for local population € 1,000,000 € 500,000

b) If the local population can negotiate with the airline without there being transaction costs, what
will be the outcome in terms of noise reduction? Indicate the minimum acceptable offer for the
airline and the maximum willingness to compensate for the local population.
For the airline, reducing the noise goes at a cost of 300,000.
For the population, reducing the noise is a gain of 500,000.
Hence, there is room for negotiation: the population can offer any amount between 300,000 and 500,000 to the
airline, as compensation for the noise reduction.

Points: 2x2

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Microeconomics, Institutions and Welfare– Final exam

25th January 2019, 1:30 – 4:30 PM

c) Is it likely in reality that successful negotiations will take place? Briefly elaborate on your answer,
by mentioning at least two aspects that play a role here.

a)
It is not quite likely that this outcome will come about.
For one, people living nearby must try to form one coherent negotiating party, which takes time (search
costs). They might want to hire an expert, which costs money. And many people may try to free ride on the
efforts & expenses of others. Knowing this in advance, the negotiations may not start at all.

Collective action
Missing information
Lack of enforcement
Liquidity constraints

2x2 points

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Microeconomics, Institutions and Welfare– Final exam

25th January 2019, 1:30 – 4:30 PM

a b c d
Name:

QUESTION 4 (4 + 6 + 6 + 6 points)

In the graph above we see the farmer Angela and the amount of grain she can produce per day,
depending on her amount of free time per day.
We also see her feasible frontier, her biological survival constraint and a few of her indifference
curves, among which her reservation indifference curve.

a) What does Angela’s reservation indifference curve represent?

A curve that indicates allocations (combinations) that are as highly valued as one’s reservation option.
With the latter we mean a person’s next best alternative among all options in a particular transaction.

2 points for mentioning what an indifference curve is (same valuation for different combinations of free
time and grain/different allocations)
2 points for mentioning that it refers to being indifferent between the combination of free time and grain
and the reservation option which is the value of the next best alternative.

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Microeconomics, Institutions and Welfare– Final exam

25th January 2019, 1:30 – 4:30 PM

b) Explain the logic of the concave shape of the feasible frontier: why is it more realistic than a linear
feasible frontier? Make use of the term ‘marginal rate of transformation’ (MRT).

MRT = the quantity of some good that must be sacrificed to acquire one additional unit of another good. At
any point, it is the slope of the feasible frontier.
Here, it shows that when subsequently hours of free time are transformed into working hours, this at first
contributes very much to extra production (from t=24 to t=18-20, the curve is very steep) since the farmer
has lots of energy. Thereafter, additional sacrifices of hours of free time contribute proportionally less to
extra production: the curve gets flatter, due to diminishing labour productivity.
This is more realistic than a linear curve, which would mean that every extra hour of free time turned into
working time, generates the same amount of extra production.

Points: 2 for explaining MRT, 3 for explaining concavity, 1 for briefly addressing linearity
NB: mentioning that MRT is (minus) the slope of the feasibile frontier is not enough. There needs to be some
explanation of the economic meaning of MRT and therefore the concavity of the feasible frontier.

Assume that Angela is a utility maximising independent farmer, who rents the land from landowner
Bruno.
Further assume that the rent Bruno receives in terms of bushels of grain is higher than the number of
bushels of grain Angela gets to keep for herself.
Angela is free to leave, but chooses to work on Bruno’s land.

c) Is this arrangement fair or unfair in a substantive sense and is it fair or unfair in a procedural
sense?

Several viewpoints/argumentation lines are correct.

Fair in a procedural sense, because they are ‘consenting adults’ who choose to trade like this: there is
agreement on the rules of the game.
Unfair in a substantive sense, because the division of the surplus is very skewed: the net gains for Angela
are smaller than for Bruno. NB: how this division comes about does not influence substantive fairness.
Or: unfair in the procedural sense. The book (page 189, section 5.3) gives 3 criteria for procedural fairness:
- Voluntary exchange of private property acquired by legitimate means
- Equal opportunity for economic advantage
- Deservingness
There is a voluntary exchange in this case, but you can argue whether there is an equal opportunity and if
we look at deservingness then it is clearly not fair in the procedural sense, because Angela is working but
Bruno gets more money.
Points: 2x3

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Microeconomics, Institutions and Welfare– Final exam

25th January 2019, 1:30 – 4:30 PM

Suppose instead that Bruno charges a rent that is equal to 25% of Angela’s daily production.

d) Angela and Bruno are together in a so-called principal-agent relationship. Briefly explain why their
(rental) contract could be characterised as incomplete. Mention two problems that may arise.

An incomplete contract does not specify, in an enforceable way, every aspect of the exchange that affects
the interests of parties to the exchange (or of others). Here, Bruno will not be sure whether Angela will be
honest about her daily productivity, this might be hard to check. Also, Angela could use the land in a
dentrimental way (exhausting it, for example), again without Bruno observing that.

(More things could be mentioned, such as the risks of a failed harvest: what does imply for the two parties?
To what degree can a contract be specified to take that into account? And how can Angela be sure that
Bruno will not cancel their relationship while she has not harvested yet?)

Points: 2x3 for mentioning two different problems and for briefly explaining what in the contract is it that
makes it incomplete.
NB: asymmetric information and imperfect knowledge about Angela’s effort and work are not problems
that arise. These are inherent characteristics of a principal-agent relationship and are the causes of the
problems.

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Microeconomics, Institutions and Welfare– Final exam

25th January 2019, 1:30 – 4:30 PM

a b c
Name:

QUESTION 5 (5 + 5 + 6 points )
The accounting firm Bill&Co offers services to a number of different customers. Assume that this
company has been given a concession to operate as the only supplier to all customers. With most of
these customers, Bill&Co therefore maintains a long-standing business relation.

The demand for the services of Bill&Co is: P = 1000 – 10Q, in which Q = 1 hour of services.
The marginal costs are: MC = 5Q.

a) Suppose that Bill&Co charges the same price for each hour of services to all its customers.
Which price should Bill&Co charge for one hour of services and how many hours of services
does it offer, given profit maximization?
Profit = TR – TC. profit max => MC=MR
AR = 1000 – 10Q, hence TR = 1000Q – 10Q2, hence MR = 1000 – 20Q
MC= 5Q, hence 1000 – 20Q = 5Q. So: Q = 40, hence P = 600.

Points: * MC = MR 1 point for mentioning this/applying it, 2 for correct MR expression, 2 for final answer
(1 for correct Q, 1 for correct P).

b) Now, suppose that Bill&Co is able to apply perfect first-degree price discrimination.
What is the meaning of first-degree price discrimination?
What will be the lowest price for one hour of services? And how many hours of services are
offered?

First-degree price discrimination implies that each customer pays his/her own reservation price,
hence the producer is able to capture the complete CS.
Lowest price with perfect first-degree price discrimination is where MC = AR = P.
So, 5Q = 1000 – 10Q, hence Q = 66 2/3 and P = 333 1/3.

Points: 2 for correct description, 1 for reasoning that this means P = MC, 2 for calculation (deduct 1 point
if incorrect P or Q). No points deducted if they round (so Q=67 is also accepted).

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Microeconomics, Institutions and Welfare– Final exam

25th January 2019, 1:30 – 4:30 PM

c) Because first-degree price discrimination is not possible in reality, Bill & Co produces at its
profit maximizing price and quantity. This implies that the Pareto-efficient outcome is not
achieved and there is a deadweight loss (DWL).
Draw a graph with the MC curve, MR curve and the demand curve, indicate the DWL, and
calculate its size. If you were not able to solve a) and/or b), you can earn points by correctly
sketching the required curves, including the correct intercepts, while clearly indicating the area
of DWL.

DWL = (600 - 200)*(66 2/3 - 40)*0.5=5333 1/3

Points: 1 for MC curve, 1 for MR curve, 1 for DWL indication (indications needed on the axes), 3 for
correct calculation (1 point if calculation is correct but wrong numbers are used).

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Microeconomics, Institutions and Welfare– Final exam

25th January 2019, 1:30 – 4:30 PM

a b c d
Name:

QUESTION 6 (4 + 4 + 5 + 4 points)

Assume that tomatoes are a homogenous product (i.e. undifferentiated).

The world price for tomatoes amounts to €40 per unit of 100 kilos.
The supply of tomatoes by a typical individual firm in the domestic market is: P = 30 + 10Qs,
where P is price in euros and Q is tomatoes in 100 kilos.
In the short run, this domestic producer can sell as many units as he likes against the world price.

a) How much does this firm in the domestic market supply?

Calculate elasticity of supply at the equilibrium output.
Firm’s supply: P = 30 + 10Qs
40 = 30 + 10Qs, thus Qs = 1 unit (of 100 kilos)

Rewriting gives Q = 0.1P -3. Elasticity of supply: E = dQ/dP * P/Q = 0.1 * 40/1 = 4

(PS this is a rather large value, which could be explained by the fact that tomatoes grow quickly and
the whole year around in green houses, so production can be adjusted rather easily)

Points: 1 for correct q, 1 for correct E formula, 2 for correct calculation of the E value
Note: Since €40 is the price (P = 40) for one unit of 100 kilos of tomatoes (Q = 1), it is incorrect to use the
values P=40 and Q=100 in calculating the elasticity.

b) In a graph, sketch the supply curve of the individual producer in the domestic market and calculate
domestic producer surplus.

Calculation: Producer surplus: Is the surface between the market price and the supply curve, hence:
PS = (40 – 30) * 1 * ½ = 5

Points: 2 for sketch, 2 for calculation

Note: Common mistakes included:

• A downward sloping demand curve rather than a horizontal line
• A supply curve that goes through the origin rather than through (0,30)
• Using Q=100 rather than Q=1 to calculate the producer surplus (and arriving at €500).
100 kg costs €40, and therefore 1 kg would cost €0,40. Thus, the producer surplus can also be
calculated as (€0,40 - €0,30)*100*½ = 5, but (€40 - €30)*100*1/2=500 is incorrect.

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Microeconomics, Institutions and Welfare– Final exam

25th January 2019, 1:30 – 4:30 PM

Now, suppose in an effort to boost domestic tomatoes production, the government pays producers a
subsidy of $5 per unit produced. Assume that this will not affect world prices.

c) Calculate the new output level and the new producer surplus. Briefly explain your answer. (You
may use the sketch in answer b.)
The subsidy will decrease production costs, so the supply line = MC line will shift downward with 5,
or the MR will shift up by 5.
(answer c continued if necessary)
Old supply was P = 30 + 10Qs
New supply becomes P = 30 − 5 + 10Qs = 25 + Qs

(Alternatively:
With a subsidy per unit of $5, the supply function becomes Q = 0.1 (P + 5) – 3 = 0.1P – 2.5.)

(In the sketch, the supply curve will make a parallel shift downwards with 5, and intersects the y-axis
at 25). At the given world market price, domestic supply increases to 1.5.
So, PS (new) = (40 – 25) * 1.5 * ½ = 11.25

Points: 2 for correct shift, 1 for new q and 2 for new PS

Note: if calculation is given but not explained 1 point is deducted.

d) Briefly discuss, whether this subsidy has increased or decreased social welfare (i.e., total gains from
trade).

The subsidy affects the three groups in the following way:

- Consumers: surplus does not change. [1 point]
- Producers: surplus increases by €11.25 - €5 = €6.25 [1 point]
- Government (i.e. transfer from consumer to producer): subsidy costs 1.5 * €5 = €7.50
[1 point]

Since the gain of producers is smaller than the size of the subsidy, and the subsidy is a transfer from
consumers to producers, total surplus/gains from trade/social welfare has decreased. [1 point]

Note: if calculations are not given but otherwise the answer is correct, full points are rewarded.

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