2012-Managerial Economics Main EQP and Commentaries

This paper is not to be removed from the Examination Halls
UNIVERSITY OF LONDON
MN3028 ZA
(279 0028)
BSc degrees and Diplomas for Graduates in Economics, Management, Finance and the
Social Sciences, the Diplomas in Economics and Social Sciences and Access Route
Managerial Economics
Tuesday, 15 May 2012 : 10.00am to 1.00pm
Candidates should answer SIX of the following TEN questions: FOUR from Section A (12.5
marks each) and TWO from Section B (25 marks each). Candidates are strongly advised to
divide their time accordingly.
A calculator may be used when answering questions on this paper and it must comply in all
respects with the specification given with your Admission Notice. The make and type of
machine must be clearly stated on the front cover of the answer book.
University of London 2012

UL12/0139
D01
PLEASE TURN OVER

Page 1 of 3
SECTION A
Answer FOUR questions from this section (12 marks each).
1.
Consider a game with n players. Each player chooses L or H. If a player chooses H, he gets 1 if
everyone else also chooses H, 0 if not everyone else chooses H. If a player chooses L, he gets x where
0 < x < 1. What are the two pure strategy Nash equilibria? Explain your answer.
2.
A monopolist has a cost function C(q) = q2/2. Market demand is given by p = 1-q.
(a)
Find the monopolists profit maximizing price.
(b)
Now assume there are n firms with identical cost function as above. These firms behave as price
takers. What is the equilibrium price?
3.
A firm has production function q = K1/2 L1/2, where K is capital and L is labour. The unit input prices
are r and w for capital and labour respectively. Derive the firms cost function.
4.
Consider the two period consumption model. Income equals M1 in period 1 and M2 in period 2. The
(borrowing and saving) interest rate is r so that any income x not consumed in period 1 increases the
budget in period 2 by (1+r)x. U(C1 , C2 ) is the utility of consumption in period 1 and period 2.
(a)
Write down the budget constraint and draw it.
(b)
Show graphically that saving can increase if r decreases.
SECTION B
Answer TWO questions from this section (25 marks each).
5.
A monopolist sells his product for 2 periods. Consumers buy at most 1 unit. Consumer willingness to
pay is given by Q = 100 p. Any consumer who buys in period 1 leaves the market and will not buy
in period 2. Consumers are myopic, i.e. if the price in the first period is below their willingness to pay,
they buy in the first period. The monopolist has constant marginal cost of c1 =10 in period 1. In
period 2, due to learning, the marginal cost is lower the higher the output in period 1 and equals c2 =
10-Q1/10.
(a)
Draw the demand curve in period 1 and indicate how many units are sold at price p1.
(b)
Draw the demand curve in period 2 assuming a price p1 was charged in period 1.
(c)
Find the optimal second period price, p2, given p1.
(d)
Find the optimal first period price.
UL12/0139
D01
Page 2 of 3
6.
7.
Each sale generated by a salesman gives a payoff of $4,000 to the firm. The probability of a sale
depends on the effort (e) exerted by the salesman. Effort equals 0 or 1. Salesmen who work hard (e
=1) make a sale with probability 0.8 whereas lazy salesmen (e = 0) make a sale with probability 0.2.
The utility of a salesman is given by U(w,e) = w1/2 10e, where w is the payment to the salesman.
Salesmen have reservation utility u = 30.
(a)
If effort is observable, what payment will the firm offer to hard working and to lazy salesmen
respectively? Will the firm care whether salesmen are hard working or lazy?
(b)
If effort is not observable, the firm can choose to pay either (i) a constant wage to all salesmen,
or (ii) pay a sales commission to the salesman for a sale. Show that no salesman will work hard
if a constant payment is offered.
(c)
What level of commission does the firm have to offer to induce salesmen to work hard?
(d)
Should the firm offer a constant wage or a commission contract?
An individual has wealth W and utility of money function U(m). He suffers a loss, x, with probability
p (and no loss with probability 1-p).
(a)
Consider a full insurance contract with premium R. Write down the equation identifying the
premium R* for which the individual is indifferent between the full insurance contract and no
insurance.
(b)
Normalising the utility function so that U(W-x) = 0 and U(W) = 1, show that U(W-R*) = 1-p.
(c)
Now consider a probabilistic insurance contract with premium R/2. This insurance pays through
a lottery if there is a loss: with probability the full loss is covered provided the policy holder
pays an additional R/2 and with probability there is no coverage and the premium R/2 initially
paid is reimbursed. Write down the expected utility of this partial insurance policy if R=R*.
(d)
Show that probabilistic insurance is preferred to full insurance (where R=R*) if U(W-R*/2) > 1p/2.
(e)
Show that the inequality in (d) is satisfied if U(m) is concave. Risk averse individuals prefer
probabilistic insurance to full insurance!
8.
Explain, using a numerical example, what happens to price and profits when there is a merger in an
industry with Cournot competition. Assume all firms produce the same product and have the same
costs. Are the merged firms more profitable after the merger? Are the non-merged firms more
profitable after the merger?
9.
The government runs a sealed bid auction for the right to build a motorway and charge a toll. The
winner is the company which charges the lowest toll. Suppose everyone knows the costs of all
potential bidders and the demand function for the motorway. Discuss how companies should decide
whether and how to bid in this auction. You do not need to explicitly calculate any bids.
10.
Explain the efficiency wage model including the minimum cost implementation problem.
END OF PAPER
UL12/0139
D01
Page 3 of 3
This paper is not to be removed from the Examination Halls
UNIVERSITY OF LONDON
MN3028 ZB
(279 0028)
BSc degrees and Diplomas for Graduates in Economics, Management, Finance and the
Social Sciences, the Diplomas in Economics and Social Sciences and Access Route
Managerial Economics
Tuesday, 15 May 2012 : 10.00am to 1.00pm
Candidates should answer SIX of the following TEN questions: FOUR from Section A (12.5
marks each) and TWO from Section B (25 marks each). Candidates are strongly advised to
divide their time accordingly.
A calculator may be used when answering questions on this paper and it must comply in all
respects with the specification given with your Admission Notice. The make and type of
machine must be clearly stated on the front cover of the answer book.
University of London 2012

UL12/0140
D01
PLEASE TURN OVER

Page 1 of 4
SECTION A
Answer FOUR questions from this section (12 marks each).
1.
2.
3.
4.
There are 5 people in a group. Each individual has 20 tokens which have to be spent on a private good
or a public good. For each token invested in the private good the investor gets $2. For each token
invested in the public good, each of the 5 group members gets $1.
(a)
What are the 5 peoples investment decisions and payoffs at the Nash equilibrium?
(b)
Which investment decisions lead to the highest total payoff? What is each individuals payoff in
this scenario?
An investor has utility function U(r,) = r/, where r is expected return and is risk (standard
deviation of return).
(a)
Draw his indifference curves. (Put expected return on the x-axis and risk on the y-axis.)
(b)
There are two assets available. The investor can invest in a risky asset with expected return rR
and risk R and/or in a safe asset with expected return rS (< rR) and zero risk. Draw the set of
possible investment choices on your graph in (a).
(c)
What is the investors optimal portfolio choice?
Ted has an endowment (E) which he can invest. With probability p the investment works out well and
Ted ends up with E(1+r) but with probability 1-p Ted loses all of his money.
(a)
If Ted is risk neutral what is the lowest value of p for which Ted should invest?
(b)
Now assume Ted is risk averse with utility of money function U(m) = m1/2. What fraction, x, of
his endowment should Ted invest?
Market demand is given by Q = 100 p. There are two potential entrants in this market. An entrant
incurs an entry cost E. There are no production costs. If both firms enter, they compete according to
the Cournot model. For which values of E is there an equilibrium in which both enter?
UL12/0140
D01
Page 2 of 4
SECTION B
Answer TWO questions from this section (25 marks each).
5.
6.
Consider a large population of potential insurance buyers with initial wealth W and concave utility of
money function U(m). Each individual suffers a loss L with probability p. The potential loss is the
same for everyone but individuals differ in their p. Assume p is uniformly distributed on [0,1].
(a)
Suppose insurance companies can observe p and offer full insurance at a fair premium. What is
the fair premium? How does this premium vary with p?
(b)
Write down the equation from which an individuals maximum willingness to pay for full
insurance can be derived.
(c)
Now assume that insurance companies cannot observe p and therefore have to set the same
premium R for everyone. Write down the equation which identifies individuals who buy
insurance at premium R and find p* such that individuals with p > p* buy insurance.
(d)
Assume the insurance company sets the premium R such that its expected profit equals zero.
Using your answer to (c), write down the equation which would allow you to calculate R.
A monopolist sells his product for 2 periods. Consumers buy at most 1 unit. Consumer willingness to
pay is given by Q = 100 p. Any consumer who buys in period 1 leaves the market and will not buy
in period 2. Consumers are myopic, i.e. if the price in the first period is below their willingness to pay,
they buy in the first period. The monopolist has constant marginal cost of 10 in period 1 and 8 in
period 2.
(a)
Draw the demand curve in period 1 and indicate how many units are sold at price p1.
(b)
Draw the demand curve in period 2 assuming a price p1 was charged in period 1.
(c)
Find the optimal second period price, p2, given p1.
(d)
Find the optimal first period price.
UL12/0140
D01
Page 3 of 4
7.
Consider a private value first price sealed bid auction with n risk neutral bidders whose valuations vi
are independently and uniformly distributed on [0,1].
(a)
Show that each bidder bidding a fraction (n-1)/n of his valuation is a Nash equilibrium.
(b)
Now assume n=2 but the second highest bidder gets a prize P (paid by the seller). Show that
both bidders bidding bi = vi /2 - P (i=1,2) is a Nash equilibrium.
(c)
In (b) how does the expected revenue to the seller differ from the expected revenue in a standard
first price sealed bid auction?
(d)
A few years ago, the Israeli government offered a $12m prize to the second highest bidder in an
auction of oil-refinery facilities. In the light of your answer to (c), what could have been the
rationale for this?
8.
Explain why it might be optimal for a firm to destroy part of its output even if there is a market for this
output. How can it make sense to produce a good which is then destroyed? Give a numerical
example.
9.
Explain the perfect competition model and the derivation of the supply curve in a competitive
industry.
10.
Long term employment and wages rising over time are important features of managerial careers.
Explain why we are likely to observe both simultaneously, i.e. in the same firm.
END OF PAPER
UL12/0140
D01
Page 4 of 4
Examiners commentaries 2012

28 Managerial economics
Important note
This commentary reflects the examination and assessment arrangements
for this course in the academic year 201112. The format and structure
of the examination may change in future years, and any such changes
will be publicised on the virtual learning environment (VLE).
Information about the subject guide

Unless otherwise stated, all cross-references will be to the latest version
of the subject guide (2011).
General remarks
Learning outcomes
At the end of this course and having completed the Essential reading and
Learning activities, you should be able to:
prepare for Marketing and Strategy courses by being able to analyse
and discuss consumer behaviour and markets in general
analyse business practices with respect to pricing and competition
define and apply key concepts in decision analysis and game theory.
Format of the examination

The examination is three hours long and comprises two sections. You
have to answer all four questions in Section A (12.5 marks each) and two
questions in Section B (25 marks each).
Planning your time in the examination

The marks for each question correspond roughly to the proportion of time
you are expected to spend on it. Try not to spend too much time on any
one question. You can always go back to it later if you have time left.
When you select which questions to answer in Section B, take time to read
all the questions (and all parts of each question). Often candidates select a
question on the basis of the topic of the question only to realise that they
are able to answer at most the first part of the question.
If you end up doing terribly complicated calculations taking up several
pages it is highly likely that you have misinterpreted the question or made
a mistake go back and check the question and your answer. The same
applies, of course, if you find negative prices or quantities, or probabilities
greater than one or less than zero.
Write down clearly what you are doing as the Examiners award marks for
correct logic and development even if there are numerical mistakes.
What are the Examiners looking for?

We are looking for evidence that you have truly understood the material
and can apply this knowledge. Memorising answers to past questions
will not get you very far. You should have the confidence to tackle
the questions from first principles. Of course, you will only have this
confidence if you have worked consistently throughout the year to
familiarise yourself with the way of thinking that this subject requires.
How to do well in the examination

A key success factor is obviously the time spent preparing and, as
mentioned before, an early start is definitely required. It is impossible
to acquire the thinking skills you need in the last few weeks before the
examination.
It is not good enough to simply repeat the material from the subject
guide. You must understand it! A good way to check whether you really
understand the material is to try to explain it to a friend.
You also have to spend a lot of time thinking about questions/problems/
exercises. Never look at answers or solutions until you have spent at least
an hour or two trying to figure out the solution yourself. Obviously during
the examination you will not have that much time, but the more time you
spend thinking about how to solve problems during the year, the easier
your revision and the examination will be.
Especially for the essay questions, do not write down everything you
know about a topic which is vaguely related to the question. Answer
the question! We do not expect polished essays with nicely constructed
sentences, and the use of bulleted lists is acceptable where appropriate.
The main thing is to show that you have understood the material. You can
give evidence of your understanding through clear exposition, including
models and numerical and verbal examples (preferably your own).
Diagrams should be clear. It is not important that the axes are drawn as
straight lines, etc. but diagrams have to be neat enough to illustrate the
point you are making.
Amazingly, we often find that candidates have not read the subject guide
properly. You do not need to read anything else to do well in this course,
so make sure you read and understand the subject guide.
Question spotting
Many candidates are disappointed to find that their examination
performance is poorer than they expected. This can be due to a number
of different reasons and the Examiners commentaries suggest ways
of addressing common problems and improving your performance.
We want to draw your attention to one particular failing question
spotting, that is, confining your examination preparation to a few
question topics which have come up in past papers for the course. This
can have very serious consequences.
We recognise that candidates may not cover all topics in the syllabus in
the same depth, but you need to be aware that Examiners are free to
set questions on any aspect of the syllabus. This means that you need
to study enough of the syllabus to enable you to answer the required
number of examination questions.
The syllabus can be found in the Course information sheet in the

section of the VLE dedicated to this course. You should read the
syllabus very carefully and ensure that you cover sufficient material in
preparation for the examination.
Examiners will vary the topics and questions from year to year and
may well set questions that have not appeared in past papers every
topic on the syllabus is a legitimate examination target. So although
past papers can be helpful in revision, you cannot assume that topics
or specific questions that have come up in past examinations will occur
again.
If you rely on a question spotting strategy, it is likely
you will find yourself in difficulties when you sit the
examination paper. We strongly advise you not to adopt
this strategy.

28 Managerial economics Zone A
Important note

Comments on specific questions

Section A
Answer all four questions from this section (12.5 marks each).
Question 1
Consider a game with n players. Each player chooses L or H. If a player chooses
H, he gets 1 if everyone else also chooses H, 0 if not everyone else chooses H.
If a player chooses L, he gets x where 0 < x < 1. What are the two pure strategy
Nash equilibria? Explain your answer.
Reading for this question
The background reading for this question is in Chapter 2 of the subject
guide (Game theory).
Approaching the question
The two pure strategy Nash equilibria are everyone picking H and
everyone picking L. Without loss of generality, consider the position of
player 1 when everyone else chooses H. If player 1 chooses H he gets 1
and if he chooses L he gets x < 1. So, H is the optimal response. Now
consider player 1s situation when everyone else chooses L. If player 1
chooses H he gets 0, if he chooses L he gets x > 0, hence the optimal
response is to choose L.
This question was well answered. However, some candidates interpreted
the game as sequential and got confused.
Question 2
A monopolist has a cost function C(q) = q2/2. Market demand is given by p = 1 q.
guide (Market structure).
(a) Find the monopolists profit maximizing price.
Lets write the monopolists profit as a function of output:
4
= 1 q q
q2
.
2
Optimising with respect to q gives

1 2q q = 0
so that the optimal output level equals q = 1/3. Substituting in the
demand function gives the optimal price p = 1/3.
This is a standard question and was answered reasonably well by most
candidates.
(b) Now assume there are n firms with identical cost function as above. These
firms behave as price takers. What is the equilibrium price?
Each firm takes the price as given and therefore maximises
q2
= pq
Optimising with respect to output gives

pq=0.
Hence, each of the n firms produces q = p. Total market supply is
therefore np. Setting supply equal to market demand we find p = 1 np
or p = 1/(n + 1).
This second part of the question proved slightly more difficult for most
candidates and there were few correct answers.
Question 3
A firm has production function q = K1/2 L1/2, where K is capital and L is labour. The
unit input prices are r and w for capital and labour respectively. Derive the firms
cost function.
guide (Production, factor demands and costs).
To find the cost function, we first find the firms conditional input
demands. We can do this by setting the ratio of marginal products of
capital and labour equal to their price ratio:
1
2
1
2
1 / 2 1 / 2
1/ 2
1 / 2
r .
w
Simplifying this gives
L r ,
=
K w
or L = rK/w.
(1)
Substituting this into the production function yields
q=K
1/ 2
rK
1/ 2
r
= K
w
1/ 2
We can rearrange this to find the conditional demand for capital:

5
1/ 2
K (q ) = q
Substituting this into (1) gives the conditional demand for labour:
r
L (q ) = q
w
1/ 2
The cost function is then

C ( q ) = rK ( q ) + wL ( q ) = q ( wr )
1/ 2
Few candidates got this question completely right. Most had an idea
of how to approach the question in general, but a mixture of algebraic
mistakes and problems working with exponents led to most candidates
losing marks.
Question 4
Consider the two period consumption model. Income equals M1 in period 1 and
M2 in period 2. The (borrowing and saving) interest rate is r so that any income
x not consumed in period 1 increases the budget in period 2 by (1 + r)x. U(C1 , C2)
is the utility of consumption in period 1 and period 2.
guide (Topics in consumer theory).
(a) Write down the budget constraint and draw it.
The amount of cash available for consumption in period 2 equals
C2 = M
+ ( M 1 C 1 )(1 + r ) .
C2
M2
M1
C1
This part of the question was generally answered well although some
candidates did not specify the budget constraint correctly or did not have
the budget line go through (M1, M2).
(b) Show graphically that saving can increase if r decreases.
If the interest rate decreases, the budget line becomes flatter. The lower
interest rate scenario corresponds to budget line B below. The point where
lines A and B intersect is (C1, C2) = (M1, M2). In the figure below, after the
interest rate decrease, saving increases.
6
A
Before interest rate decrease
After interest
rate decrease
Part (b) was answered poorly. Most candidates did not explain that the
budget lines intersect at (M1, M2). Many drew indifference curves which
looked like they would intersect.
Section B
Answer two questions from this section (25 marks each).
Question 5
A monopolist sells his product for 2 periods. Consumers buy at most 1 unit.
Consumer willingness to pay is given by Q = 100 p. Any consumer who buys in
period 1 leaves the market and will not buy in period 2. Consumers are myopic,
i.e. if the price in the first period is below their willingness to pay, they buy in
the first period. The monopolist has constant marginal cost of c1 =10 in period 1.
In period 2, due to learning, the marginal cost is lower the higher the output in
period 1 and equals c2 = 10 Q1/10.
guide (Monopolistic pricing practices).
(a) Draw the demand curve in period 1 and indicate how many units are sold
at price p1.
p
100
A
p1
100 p1
100
(b) Draw the demand curve in period 2 assuming a price p1 was charged in
period 1.
In period 2, only consumers with willingness to pay below p1 are left in
the market. So, the period 2 demand curve is the portion of demand to the
right of point A in the figure above.
7
p
p1
p1
(c) Find the optimal second period price, p2, given p1.
Second period demand is given by Q = p1 p. Second period profit is
therefore
2 = ( p 1 p 2 ) p 2 10 +
100 p 1 .
10
Maximising with respect to p2 yields

p1 p 2 p2 + 10
100 p1
= 0
10
p2 = 0 . 55 p1 .
(d) Find the optimal first period price.
To find the optimal first period price we need to take into account the
effect of first period price on second period profits so lets write profit in
period 2 as a function of p1:
( )
2 p1 = 0. 45 p 1 0 . 55 p1 10 +
100 p1
10
We now need to maximise total profit (the sum of first and second period
profit) with respect to p1:
= (100 p1 )( p1 10 ) + 2 ( p1 ) .
The optimal first period price equals 69 and the optimal second period
price is 38.
There were not many good answers to this question. Some candidates
tried to solve this problem as a standard one period monopoly problem
which was incorrect.
Question 6
Each sale generated by a salesman gives a payoff of $4,000 to the firm. The
probability of a sale depends on the effort (e) exerted by the salesman. Effort
equals 0 or 1. Salesmen who work hard (e = 1) make a sale with probability
0.8 whereas lazy salesmen (e = 0) make a sale with probability 0.2. The utility
of a salesman is given by U(w,e) = w1/2 10e, where w is the payment to the
salesman. Salesmen have reservation utility u = 30.
guide (Asymmetric information).
8

(a) If effort is observable, what payment will the firm offer to hard working
and to lazy salesmen respectively? Will the firm care whether salesmen
are hard working or lazy?
Hard working salesmen have expected utility w1/2 10.
The firm needs to make sure that this is no lower than their reservation
utility of 30 and therefore needs to pay w = 1600.
Lazy salesmen have expected utility w1/2 and reservation utility of 30. The
firm therefore needs to pay them w = 900.
The expected payoff to the firm from a hard working salesman is then
4000(0.8) 1600 = 1600,
and the expected payoff to the firm from a lazy salesman is 4000(0.2)
900 = 100.
So, clearly the firm cares about whether salesmen are hardworking or lazy.
In fact, the firm will not want to employ lazy salesmen.
(b) If effort is not observable, the firm can choose to pay either (i) a constant
wage to all salesmen, or (ii) pay a sales commission s to the salesman for
a sale. Show that no salesman will work hard if a constant payment is
offered.
If a constant payment w is offered, no salesman will work hard as his
utility being lazy (w1/2) exceeds the utility from hard work (w1/2 10). We
already know from (a) that the firm cannot make a profit if salesmen are
lazy, so it will have to pay a sales commission.
(c) What level of commission does the firm have to offer to induce salesmen
to work hard?
If the firm wants salesmen to work hard it has to 1) make sure they get
at least their reservation utility by working hard, and 2) they get higher
expected utility from working hard than from being lazy, i.e.:
1)
(s(0.8))1/2 10 30
2)
(s(0.8))1/2 10 (s(0.2))1/2.
The first inequality reduces to s 2000 and the second one to s 500.
Hence, the firm has to offer at least 2000 as commission.
(d) Should the firm offer a constant wage or a commission contract?
The firm should offer a commission contract. It cannot make profits under
a constant wage contract.
Question 6 was not very popular and most of those who attempted it
struggled to get many marks.
Question 7
An individual has wealth W and utility of money function U(m). He suffers a loss,
x, with probability p (and no loss with probability 1 p).
guide (Decision analysis).
(a) Consider a full insurance contract with premium R. Write down the
equation identifying the premium R* for which the individual is
indifferent between the full insurance contract and no insurance.
9
If the individual does not have insurance he ends up with wealth W x

with probability p and W with probability 1 p. Under full insurance
wealth is always W R. Hence, we have indifference when U(W R) =
pU(W x) + (1 p)U(W).
(b) Normalising the utility function so that U(W x) = 0 and U(W) = 1, show
that U(W R*) = 1 p.
Substituting in the equation in (a), we have:
U(W R*) = p 0 + (1 p) 1 = 1 p.
(c) Now consider a probabilistic insurance contract with premium R/2. This
insurance pays through a lottery if there is a loss: with probability the
full loss is covered provided the policy holder pays an additional R/2 and
with probability there is no coverage and the premium R/2 initially paid
is reimbursed. Write down the expected utility of this partial insurance
policy if R = R*.
Under partial insurance, if there is no loss, wealth is W R/2. If there is
a loss, then with probability wealth equals W R and with probability
wealth equals W L. Hence the expected utility under probabilistic
insurance at premium R* equals
(1 p)U(W R*/2) + p/2 U(W R*) + p/2 U(W x).
(d) Show that probabilistic insurance is preferred to full insurance (where R =
R*) if U(W R*/2) > 1 p/2.
Combining the answers to (b) and (c), we know that probabilistic
insurance is preferred to full insurance if
(1 p)U(W R*/2) + p/2 U(W R*) + p/2 U(W x) > 1 p,
or (1 p)U(W R*/2) + p/2 (1 p) > 1 p,
or U(W R*/2) > 1 p/2.
(e) Show that the inequality in (d) is satisfied if U(m) is concave. Risk averse
individuals prefer probabilistic insurance to full insurance!
If U is concave then the following inequality holds:
U(W R*/2) > U(W) + U(W R*),
or U(W R*/2) > 1 + (1 p) = 1 p/2.
Very few candidates managed to do more than part (a) of this question.
This is a challenging question and is intended to reward those who take
the time to think about the material and understand it.
Question 8
Explain, using a numerical example, what happens to price and profits when
there is a merger in an industry with Cournot competition. Assume all firms
produce the same product and have the same costs. Are the merged firms more
profitable after the merger? Are the non-merged firms more profitable after the
merger?
The Cournot model is explained in detail in Chapter 11 of the subject
guide (Oligopoly). When there is a merger, price will rise. Profits of the
non-merged firms will go up but profits of the merged firms decreases.
Some candidates got full marks on this question. However, there were also
many answers which ignored the Cournot set-up and some candidates
started out with a duopoly which is not appropriate for this question as
there are no non-merged firms after the merger in that model!
10
Question 9
The government runs a sealed bid auction for the right to build a motorway and
charge a toll. The winner is the company which charges the lowest toll. Suppose
everyone knows the costs of all potential bidders and the demand function for
the motorway. Discuss how companies should decide whether and how to bid in
this auction. You do not need to explicitly calculate any bids.
guide (Auction and bidding).
The company with the lowest cost will be able to make a profit at the
lowest toll. It will bid the highest toll for which the company with the
second lowest cost cannot make a profit. This bidding strategy for the
lowest cost company and all other companies bidding, so that they would
not make a loss at their bids, is an equilibrium.
Many candidates discussed auctions in general and in particular the
winners curse. To gain marks in any question you have to answer the
actual question asked. Many candidates did not read the question properly
and ignored the fact that this is a reverse auction the winner is the
company charging the lowest toll.
Question 10
Explain the efficiency wage model including the minimum cost implementation
problem.
A full analysis of this question is presented in Chapter 8 of the subject
guide (Topics in labour economics).
This question was attempted by many candidates and most did fairly well
on it. That said, however, few received very high marks because they did
not explain the minimum cost implementation problem properly. Simply
writing down the formula without any explanatory words is not sufficient
for a good answer. You must show the Examiners that you understand the
models.
11

28 Managerial economics Zone B
Important note

Comments on specific questions

Section A
Answer all four questions from this section (12.5 marks each).
Question 1
There are 5 people in a group. Each individual has 20 tokens which have to be
spent on a private good or a public good. For each token invested in the private
good the investor gets $2. For each token invested in the public good, each of
the 5 group members gets $1.
guide (Game theory).
(a) What are the 5 peoples investment decisions and payoffs at the Nash
equilibrium?
Independent of what other individuals decide, it is always better to invest
all tokens in the private good since each token invested in the private
good gives you $2 whereas a token invested in the public good only gives
you $1. Hence, at the Nash equilibrium everyone invests all of their tokens
in the private good.
Some candidates treated this problem as a 2 X 2 game whereas it is clearly
stated in the question that it is a 5 person game and each player has 21
strategies (the amount of tokens to invest in the private good, i.e. 0, 1, ,
20).
Many candidates demonstrated they do not know what a Nash equilibrium
is.
(b) Which investment decisions lead to the highest total payoff? What is each
individuals payoff in this scenario?
Investing a token in the private good results in a $2 total payoff whereas
investing a token in the public good results in a $5 total payoff. Hence,
everyone investing all of their tokens in the public good gives the
maximum total payoff of 5 X 20 X $5 = $500 or $100 for each individual.
12
Quite a few candidates did not appreciate the difference with part (a)
and therefore demonstrated that they do not understand the difference
between equilibrium and efficiency.
Question 2
An investor has utility function U(r,) = r/, where r is expected return and is
risk (standard deviation of return).
guide (Topics in consumer theory).
(a) Draw his indifference curves. (Put expected return on the x-axis and risk
on the y-axis).
On an indifference curve utility is constant, i.e. r/ = k or = r/k. Hence,
the indifference curves are linear as drawn below. Obviously higher utility
corresponds to flatter indifference curves.
(b) There are two assets available. The investor can invest in a risky asset
with expected return rR and risk R and/or in a safe asset with expected
return rS (< rR) and zero risk. Draw the set of possible investment choices
on your graph in (a).
The risky asset is marked as R on the graph above. The safe asset is
marked as S. The possible investment choices are indicated by the line
connecting R and S.
(c) What is the investors optimal portfolio choice?
For the given utility function we can see from the graph that the optimal
choice is to invest in the safe asset only.
Although parts of this question were answered well, very few candidates
could locate the optimal portfolio choice. If you do not see why S is the
optimum you do not understand the model and need to go back and study
this section again.
Question 3
Ted has an endowment (E) which he can invest. With probability p the investment
works out well and Ted ends up with E(1 + r) but with probability 1 p Ted loses
all of his money.
13

guide (Decision analysis).
(a) If Ted is risk neutral what is the lowest value of p for which Ted should
invest?
If Ted invests, his expected payoff equals E(1+r)p whereas his payoff if he
does not invest is E. Hence, Ted will invest if p 1/(1+r).
This part was answered correctly by most candidates, although some did
not realise that the outcome in the bad state is zero (and not E).
(b) Now assume Ted is risk averse with utility of money function U(m) = m1/2.
What fraction, x, of his endowment should Ted invest?
If Ted invests a fraction, x, of his endowment, his expected utility equals
p U(xE(1+r) + (1 x)E) + (1 p) U((1 x)E).
Substituting the utility function and setting the derivative with respect to
x equal to zero (and checking that the second derivative with respect to x
is negative) results (after some rearranging) in
x =
( pr ) 2 (1 p ) 2
(1 p ) 2 r + ( pr ) 2
There were no fully correct answers for this part. While some candidates
got to the right expression for expected utility, they then failed to optimise
(i.e. differentiate with respect to x). Another common mistake was to take
x as an absolute amount whereas it says very clearly in the question that x
is a fraction of the endowment.
Question 4
Market demand is given by Q = 100 p. There are two potential entrants in this
market. An entrant incurs an entry cost E. There are no production costs. If both
firms enter, they compete according to the Cournot model. For which values of E
is there an equilibrium in which both enter?
guide (Oligopoly).
Suppose both firms enter and there is Cournot competition. Assuming
Firm 1 produces q1, the payoff to Firm 2 equals
2 = (100 q1 q 2 ) q 2 E .
Setting the first derivative with respect to q2 equal to zero gives
100 q1 2q2 = 0.
By symmetry we may assume q1 = q2 = q and therefore q = 100/3.
However, firms will only enter if their profits are non-negative. Profit
equals (100/3)2 E. So, there is an equilibrium where both firms enter if
E (100/3)2.
Solving the Cournot problem was straightforward for most candidates.
However, many had problems figuring out what exactly they are supposed
to do in determining the zero profit condition.
14
Section B
Answer two questions from this section (25 marks each).
Question 5
Consider a large population of potential insurance buyers with initial wealth W
and concave utility of money function U(m). Each individual suffers a loss L with
probability p. The potential loss is the same for everyone but individuals differ in
their p. Assume p is uniformly distributed on [0,1].
guide (Asymmetric information).
(a) Suppose insurance companies can observe p and offer full insurance at a
fair premium. What is the fair premium? How does this premium vary with
p?
The fair premium equals the expected claim, i.e. pL. Clearly the premium
increases in p.
(b) Write down the equation from which an individuals maximum willingness
to pay for full insurance can be derived.
We can find an individuals maximum willingness to pay for insurance by
equating their expected utility with and without insurance.
Expected utility without insurance equals
pU (W L ) + (1 p )U (W ) .
Expected utility from full insurance at premium R equals U(W R).
(c) Now assume that insurance companies cannot observe p and therefore
have to set the same premium R for everyone. Write down the equation
which identifies individuals who buy insurance at premium R and find p*
such that individuals with p > p* buy insurance.
Anyone whose expected utility from insurance exceeds their expected
utility without insurance will buy insurance, i.e. individuals for whom
pU (W L ) + (1 p ) U (W ) < U(W R) .
This inequality implies a lower bound, p*, on p where

p* =
U (W ) U (W R )
U (W ) U (W L )
(d) Assume the insurance company sets the premium R such that its expected
profit equals zero. Using your answer to (c), write down the equation
which would allow you to calculate R.
Since we know that only individuals with p > p* will buy insurance, the
average loss probability of insurance buyers is (1 + p*)/2. Hence R = (1
+ p*)L/2.
Few candidates managed to answer the last parts of the question correctly.
It is important that you understand the question and answer what has
been asked.
15
Question 6
A monopolist sells his product for 2 periods. Consumers buy at most 1 unit.
Consumer willingness to pay is given by Q = 100 p. Any consumer who buys in
period 1 leaves the market and will not buy in period 2. Consumers are myopic,
i.e. if the price in the first period is below their willingness to pay, they buy in
the first period. The monopolist has constant marginal cost of 10 in period 1 and
8 in period 2.
guide (Monopolistic pricing practices).
(a) Draw the demand curve in period 1 and indicate how many units are sold
at price p1.
p
100
p1
100 p1
100
The demand curve is linear. At price p1, 100 p1 units are sold in period 1.
The Examiners were surprised to find that quite a few candidates were
unable to draw a linear demand function.
(b) Draw the demand curve in period 2 assuming a price p1 was charged in
period 1.
p
p1
p1
If p1 is charged in period 1, all consumers with willingness to pay above p1

will have left the market by the start of period 2. The residual demand is
thus the portion of the demand curve in (a) to the right of 100 p1, or Q
= p1 p.
16
(c) Find the optimal second period price, p2, given p1.
The monopolist now faces the demand curve in (b). Hence, his profit
equals
2 = ( p2 8)( p1 p2 ) .
The FOC is
p2 + 8 + p1 p2 = 0
so that p2 = (8 + p1)/2.
(d) Find the optimal first period price.
To find the optimal first period price we write down total profit (period 1
plus period 2) taking into account the effect of first period price on second
period profit.
8 + p1
8 + p1
8 p 1

2
2
= ( p 1 10 )(100 p1) +
2
= ( p1 10)(100 p1 ) + ( p1 / 2 4 ) .
The FOC is
p1+10+100 p1+2(p1 /2 4)(1/2)=0
which yields p1 = 106(2/3) = 70.67 and therefore p2 = 39.3.
Although the question guides candidates to solve the problem by
backward induction and calculate the optimal second period price first,
many candidates tried to find the optimal first period price before the
second period price. This does not work.
Question 7
Consider a private value first price sealed bid auction with n risk neutral bidders
whose valuations vi are independently and uniformly distributed on [0,1].
This derivation can be found in Chapter 5 of the subject guide (Auction
and bidding).
(a) Show that each bidder bidding a fraction (n 1)/n of his valuation is a
Nash equilibrium.
This question was very popular and most candidates answered part (a)
correctly. There was however some evidence of memorised (rather than
understood) answers.
(b) Now assume n = 2 but the second highest bidder gets a prize P (paid by
the seller). Show that both bidders bidding bi = vi /2 P (I = 1,2) is a Nash
equilibrium.
The expected payoff to bidder 2 (given b1) equals
2 = (v2 b2 ) Pr ob (b2 > b1 ) + P Pr ob (b2< b1) .
Substituting b1 = v1 /2 P gives
2 = (v 2 b2 ) Pr ob (v1< 2 ( b2 + P)) + P Pr ob (v1> 2 ( b2 + P ))
= (v2 b2) 2(b2+P) + P (1 2(b2+P)) if 2(b2+P)<1
=v2 b2 if 2(b2+P)>1.
Lets first consider the case where 2(b2 + P) < 1. Maximising with respect
to b2 yields b2 = v2 /2 P which is what we wanted to prove. Expected
payoff to bidder 2 at this optimal bid equals
17
v 2
2 =
+P v2 + P (1 v2 ) =
v2
+ P (1).
2
2
Now assume 2(b2 + P) > 1. Then bidder 2s expected payoff is maximised

by setting b2 as low as possible, i.e. b2=1/2 P. Expected payoff to bidder
2 in this case equals v2 1/2 + P. Since this is always less than (1), the
optimal bidding strategy for bidder 2 is to set b2 = v2 /2 P.
Most candidates who attempted this question knew the analysis for the
case without a prize but failed to incorporate the prize element properly
and did not specify the expected payoff correctly.
(c) In (b) how does the expected revenue to the seller differ from the
expected revenue in a standard first price sealed bid auction?
Given the equilibrium bidding strategies as given above, the expected
revenue to the seller is half the expected value of the highest valuation
minus P and minus P again because the seller has to pay P to the loser.
The seller is therefore worse off by 2P compared to the standard first price
sealed bid auction.
Most candidates forgot about the second P the seller has to pay.
(d) A few years ago, the Israeli government offered a $12m prize to the
second highest bidder in an auction of oil-refinery facilities. In the light of
your answer to (c), what could have been the rationale for this?
The government might have wanted to increase participation in the
auction.
Many candidates mentioned encouragement of entry but quite a few
stated that the prize would encourage higher bids which is wrong.
Question 8
Explain why it might be optimal for a firm to destroy part of its output even
if there is a market for this output. How can it make sense to produce a good
which is then destroyed? Give a numerical example.
A full analysis of this problem is given in Chapter 10 of the subject guide
(Monopolistic pricing practices).
Profit maximising firms will destroy by-products if the quantity produced
exceeds the revenue maximising quantity. A minority of candidates gave
excellent answers to this question, they explained the joint product model
verbally and analytically and provided a worked out numerical example.
Question 9
Explain the perfect competition model and the derivation of the supply curve in
a competitive industry.
The analysis required here is given in Chapter 9 of the subject guide
(Market structure).
This question was answered poorly. Almost all answers ignored the
second part of the question and did not explain how the supply curve is
determined. You must read the questions properly and answer all parts of
a question.
18
Question 10
Long term employment and wages rising over time are important features of
managerial careers. Explain why we are likely to observe both simultaneously,
i.e. in the same firm.
Firms may offer rising wage profiles to encourage loyalty in their
workforce. Employees with rising wage profiles are typically paid below
the value of their marginal product initially but they are willing to take
these jobs if they plan to stay in the job long enough to benefit from the
higher wages later on.
Candidates who answered this question did reasonably well. However,
many candidates simply used this question as an opportunity to recite
everything they recalled from the labour economics chapter (Chapter 8),
which is of course penalised. You must answer the question! Good answers
made some attempt at linking the two phenomena rather than giving a
simple list.
19

2012-Managerial Economics Main EQP and Commentaries

Uploaded by

Document Information

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

2012-Managerial Economics Main EQP and Commentaries

Uploaded by

Copyright:

Available Formats

This paper is not to be removed from the Examination Halls

Tuesday, 15 May 2012 : 10.00am to 1.00pm

University of London 2012

PLEASE TURN OVER

Find the monopolists profit maximizing price.

Write down the budget constraint and draw it.

Show graphically that saving can increase if r decreases.

Find the optimal second period price, p2, given p1.

Find the optimal first period price.

Should the firm offer a constant wage or a commission contract?

This paper is not to be removed from the Examination Halls

Tuesday, 15 May 2012 : 10.00am to 1.00pm

University of London 2012

PLEASE TURN OVER

What is the investors optimal portfolio choice?

Find the optimal second period price, p2, given p1.

Find the optimal first period price.

Examiners commentaries 2012

Examiners commentaries 2012

Information about the subject guide

Format of the examination

Planning your time in the examination

What are the Examiners looking for?

How to do well in the examination

Examiners commentaries 2012

The syllabus can be found in the Course information sheet in the

Examiners commentaries 2012

Information about the subject guide

Comments on specific questions

Examiners commentaries 2012

Optimising with respect to q gives

Optimising with respect to output gives

Simplifying this gives

Substituting this into the production function yields

We can rearrange this to find the conditional demand for capital:

The cost function is then

Examiners commentaries 2012

Maximising with respect to p2 yields

Examiners commentaries 2012

Approaching the question

If the individual does not have insurance he ends up with wealth W x

Examiners commentaries 2012

Examiners commentaries 2012

Information about the subject guide

Comments on specific questions

Examiners commentaries 2012

Reading for this question

Examiners commentaries 2012

This inequality implies a lower bound, p*, on p where

If p1 is charged in period 1, all consumers with willingness to pay above p1

Examiners commentaries 2012

Now assume 2(b2 + P) > 1. Then bidder 2s expected payoff is maximised

Examiners commentaries 2012

You might also like