IB9T90

University of Warwick January 2022

Question 1: (20 points) Is the following statement correct? Either prove it or provide a counter
example. [Your answer should not exceed half a page].

If the average product of labour is increasing, then the marginal product of labour must be
increasing.

Answer: The statement is incorrect. If the average product of labour is increasing, the marginal
product of labour must be greater than the average but not necessarily increasing. See below: while
moving towards C from the left, the average product increases and the marginal decreases. For a
numerical example, note that for 𝑄 = 3𝐿 − 𝐿 , 𝐴𝑃 = 3𝐿 − 𝐿 increases in the interval [1,1.5]
while 𝑀𝑃 = 6𝐿 − 3𝐿 decreases there.

Q
C

O L
c
APL

MPL

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Question 2: (20 points) Provide an example to demonstrate how people who are both risk averse
with respect to gains and risk loving with respect to losses may be framed, by choosing separately, to
make suboptimal decisions. In other words, show that by jointly considering choices framed as gains
and losses, people can improve the quality of their decisions. [Your answer should not exceed half a
page].

Answer: Given the choice between (A) – a sure gain of $240 and (B) – a 25% chance to gain $1,000
and a 75% chance to gain nothing, most people prefer (A). Similarly, given the choice between (C) –
a sure loss of $750 and (D) – a 75% chance to lose $1,000 and a 25% chance to lose nothing, most
people choose (D). However, the chosen options (A)+(D) yield together a 75% chance to lose $760
and a 25% chance to gain $240, while the unchosen options (B)+(C) yield together a stochastically
dominating result: a 75% chance to lose $750 and a 25% chance to gain $250.

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Question 3: (20 points) Jenny’s utility function is given by 𝑈(𝑋, 𝑌) = 𝑋𝑌 + 5(𝑋 + 𝑌). Her income is
80 and the price of Y is 20.

a. (6 points) Find Jenny’s optimal basket for 𝑃 = 5. Show your work and explain your answer.

Answer: The marginal utilities are MUx = Y + 5 and MUy = X + 5. Equalizing MRS and the
ratio of the prices, we obtain

= = = =

This implies 𝑋 + 5 = 4𝑌 + 20, hence 𝑋 = 4𝑌 + 15 .

Substituting this expression into the budget line 5𝑋 + 20𝑌 = 80, we obtain

5(4𝑌 + 15) + 20𝑌 = 80

which implies 𝑌 = = 0.125 and 𝑋 = 0.5 + 15 = 15.5.

b. (7 points) Find Jenny’s optimal basket for 𝑃 = 2. Show your work and explain your answer.

Answer: Equalizing MRS and the price ratio, we obtain

= = = =

This implies 𝑋 + 5 = 10𝑌 + 50, hence 𝑋 = 10𝑌 + 45 .

Substituting this expression into the budget line 2𝑋 + 20𝑌 = 80, we obtain

2(10𝑌 + 45) + 20𝑌 = 80

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which implies 𝑌 = = −2.5 < 0. Hence, the solution is either A = (40,0) or B = (0,4).
Since 𝑈(40,0) = 0 + 5(40 + 0) = 200 > 20 = 0 + 5(0 + 4) = 𝑈(0,4), her optimal basket
is A.

c. (7 points) Find Jenny’s demand curve for X. Show your work and explain your answer.

𝑌+5
Answer: Equalizing MRS and the price ratio gives 𝑋 5
= 𝑥
. This implies 𝑃𝑥 𝑋 + 5𝑃𝑥 =
20𝑌 + 100, hence 𝑃𝑥 𝑋 = 20𝑌 + 100 − 5𝑃𝑥 .

Substituting into the budget line 𝑃 𝑋 + 20𝑌 = 80, we obtain

20𝑌 + 100 − 5𝑃 + 20𝑌 = 80

which implies 𝑌 = = . As in part b, for 𝑃 < 4 the optimal point is A = (80/𝑃 ,0)
and the demand curve for X is 𝑋(𝑃 ) = . Otherwise, we have

.
𝑋(𝑃 ) = = − 2.5 . However, as this expression needs to be non-
negative, 𝑃 cannot be greater than 36.

Therefore,

𝑋(𝑃 ) = 0 for 𝑃 > 36

𝑋(𝑃 ) = for 𝑃 <4

𝑋(𝑃 ) = − 2.5 otherwise

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Question 4: (20 marks) Assume there are 20 identical consumers in the market, each of them has
the demand curve 𝑄(𝑃) = 40 − 𝑃 for 𝑃 < 160, and 𝑄(𝑃) = 0 otherwise.

a. (5 marks) Find the aggregate market demand curve 𝐷(𝑃).

b. (5 marks) A monopolist whose total cost curve is 𝑇𝐶(𝑄) = 24𝑄 + 2𝑄 operates in the
market. Find the quantity produced and the price charged by the monopolist.
Answer: The inverse demand is 𝑃(𝑄) = 160 − 𝑄, hence 𝑀𝑅(𝑄) = 160 − 𝑄 and the
optimal Q solves 160 − 𝑄 = 24 + 4𝑄 (= MC). Therefore, 𝑄 = 30.9 and 𝑃 = 153.8 .

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c. (5 marks) Next assume that a change in input prices reduced the total cost curve to
𝑇𝐶 ∗ (𝑄) = 2𝑄 . Find the new quantity and the new price.
Answer: Solving 𝑀𝑅(𝑄) = 160 − 𝑄 = 4𝑄 = 𝑀𝐶 ∗ (𝑄) yields 𝑄 = 36.4 and 𝑃 = 152.7 .

d. (5 marks) How many identical consumers should join or leave the market in order to restore
the quantity calculated in part b?
Answer: With n identical consumers the demand is 𝐷(𝑃) = 40𝑛 − 𝑃, with inverse demand
𝑃(𝑄) = 160 − 𝑄 and 𝑀𝑅(𝑄) = 160 − 𝑄. Solving 𝑀𝑅(30.9) = 160 − ∙ 30.9 =
123.6 = 𝑀𝐶 ∗ (30.9) implies n = 247.2/36.4 = 6.8. Therefore, 13.2 (or 13) consumers need to
leave the market.

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Question 5: (20 marks) Two firms, A and B, compete in an oligopolistic market, where the market
demand is 𝑄(𝑃) = 440 − 𝑃. Firm A’s and firm B’s total cost curves are 𝑇𝐶 (𝑄 ) = 140𝑄 and
𝑇𝐶 (𝑄 ) = 140𝑄 , respectively (where 𝑄 is the quantity produced by A and 𝑄 is the quantity
produced by B).

a. (4 marks) For a given 𝑄 , find the residual demand and the residual marginal revenue of
firm B.
Answer: The residual demand is 𝑄 (𝑃) = 440 − 𝑄 − 𝑃, the residual inverse demand is
𝑃(𝑄 ) = 440 − 𝑄 − 𝑄 and hence B’s residual MR is 𝑀𝑅 (𝑄 ) = 440 − 𝑄 − 2𝑄 .

b. (4 marks) Similarly, for a given 𝑄 , find the residual demand and the residual marginal
revenue of firm A.
Answer: 𝑄 (𝑃) = 440 − 𝑄 − 𝑃, 𝑃(𝑄 ) = 440 − 𝑄 − 𝑄 and 𝑀𝑅 (𝑄 ) = 440 −
𝑄 − 2𝑄 .

c. (6 marks) Calculate the best response functions of both firms. Explain your work.
Answer: Setting 𝑀𝑅 (𝑄 ) = 440 − 𝑄 − 2𝑄 = 140 = 𝑀𝐶 (𝑄 ) yields the best
response for firm A: 𝑄 (𝑄 ) = 150 − 𝑄 . Similarly, the best response of firm B is
𝑄 (𝑄 ) = 150 − 𝑄 .

d. (6 marks) Determine the Nash-Cournot equilibrium of this market. Show your work and
explain why its outcome is stable.
Answer: Solving the two equations 𝑄 = 150 − 𝑄 and 𝑄 = 150 − 𝑄 yields the
unique equilibrium 𝑄 = 𝑄 = 100.

End of Paper

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