Massachusetts Institute of Technology

Department of Economics

14.01 Principles of Microeconomics

Exam 2

Tuesday, December 20th, 2011

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1. True/False/Uncertain Questions (25 points)
In this section, write whether each statement is True, False or Uncertain. You should fully
explain your answer, including diagrams where appropriate. Points will be given based on
your explanation.

(a) (5 points) In country A, each worker can produce either 3 apples or 1 orange. In country
B, however, each worker can produce either 6 apples or 2 oranges. Opening up to trade
between A and B will lead to greater welfare for both countries.

False, even though country B has an absolute advantage in both sectors, countries A
and B have no comparative advantage in either sector, hence, there is no benefits from
country A and country B opening to trade.

(b) (5 points) Consider a tax which is imposed in a market with a downward sloping demand
curve and a totally inelastic supply curve. Suppliers bear the entire tax burden and there
is no deadweight loss.

TRUE: Perfectly inelastic supply means that suppliers will provide the same amount of
product regardless of the price. If a tax is imposed, the supplier will still provide the same
amount of product, but in order to sell that amount to consumers, then it must charge
the same pre-tax price to consumers. Hence, suppliers will pay the entire tax.

(c) (5 points) Given that cigarette smoking creates negative externalities, the efficient gov-
ernment policy response is to impose a corrective tax equal to size of the externality.

FALSE: answering TRUE and explaining how corrective taxes would work will give half
credit. The best answer is FALSE because government could also take into account be-
havioral issues like time inconsistency by banning smoking or providing commitment tool
via taxes.

(d) (5 points) There are two types of workers in an economy, type A and type B. Type A
workers consider leisure a normal good, while for type B workers leisure is an inferior
good. In this economy, aggregate labor supply will be backward-bending.

UNCERTAIN: aggregate labor supply can be backward bending, but it doesn’t have to
be so. i) If income effect dominates in workers A, then workers A will have backward-
bending labor supplies. Now, the aggregate supply shape will depend on several things,
like the proportion of workers A to workers B, and the relative elasticities of workers A
vs. workers B supply functions.

(e) (5 points) There are three firms in the plain yogurt industry, and these firms compete
with each other on quantity. Kimchi flavored yogurt is only produced by a South Korean
firm. The price mark-up charged by the Korean firm will be greater than that of the three
plain yogurt oligopolists. UNCERTAIN: this depends on the elasticities of the demand
functions for both market. For instance, one could have a monopoly with a highly elastic
demand function, in which case the mark-up will be very low.

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2. Short Answer (20 points)
(a) (5 points) A Latin American columnist once made this statement: “The fight on eradi-
cating drug crops in Colombia has been unsuccessful: the price of cocaine keeps rising,
showing that black markets have been successful in making drugs more attractive to
consumers”. Why is this statement wrong?

Eradicating drug crops has the expected effect of increasing prices of cocaine. Destroying
drug crops implies increasing input costs for coca leaf growers, this creates an inward
shift in supply, which translates into higher cocaine prices and lower quantity trans-
acted/consumed.

(b) (5 points) Jenn maximizes her utility which is dependent on effort (e) and consumption
(c), explicitly U (c, e) = c e2 . Jenn receives 10% of all Disney profits, and Disney has
the following profit function ⇡(e) = e. How much effort would Jenn put in?

Jenn recieves 10% of profits therefore:

U (c, e) = max 0.1e e2

e
⇤
0.1 = 2e
e⇤ = 0.05

(c) (10 points) There are only two firms in the market for good X and the market demand
is Q = 15 p. Firm 1’s cost function is C1 (q1 ) = q1 and firm 2’s cost function is
C2 (q2 ) = 2q2 .

(i). Determine the Cournot equilibrium price and quantities.

q1 = 5 and q2 = 4. Eqm price is p = 15 q1 q2 = 15 5 4 = 6.
(ii). Suppose that the two firms merge and produce using the most efficient technology.
Compute the new equilibrium price and quantity and discuss the pros and cons of
merger in terms of social surplus (i.e. the sum of consumer surplus and producer
surplus).
When the two firms merge and produce using the most efficient technology they
produce the monopoly quantity. This is the quantity such that MR=MC. Assuming
the most efficient technology is adopted we have M C = 1. Thus M R = 15 2Q =
1 ! Q = 7 and the eqm price is p = 8. A merger between two firms in a duopoly
generates a monopoly. This increases the DWL. However the improvement in terms
of production efficiency can more than offset the increase in DWL caused by the
monopoly. In this particular case the social surplus decreases after the merger.

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3. Stipend Savings (35 points)
Annalisa works as a TA for 14.01, and she earns $10 in the fall semester. She plans to retire
from teaching at the end of the semester, so she earns no income in the spring. She therefore
must decide how much of her income to consume in the fall (c1 ), and how much to save so
that she can consume c2 in the spring.
Her preferences for consumption between the two semesters are given by
p p
U (c1 , c2 ) = c1 + c2

She can freely borrow and save at interest rate r.

(a) (5 points) Solve for Annalisa’s optimal consumption in period 1 (c1 ) in terms of r.

Setting intertemporal MRS=MRT, we have

p
c2
p = 1 + r ) c2 = (1 + r)2 c1
c1

Plugging into the intertemporal budget constraint yields:

10
10 = c1 + (1 + r)c1 ) c1 =
2+r

(b) (3 points) How much does Annalisa save in period 1? How much does she consume in
period 2?

Annalisa saves whatever she doesn’t consume in period 1, i.e. s = 10 c1 . This gives us
✓ ◆ ✓ ◆
10 1 1+r
s = 10 = 10 1 = 10
2+r 2+r 2+r

She consumes c2 = (1 + r)s.

(c) (5 points) Suppose that there are 29 other graduate students (so 30 total) who are
identical to Annalisa in terms of their incomes and consumption preferences. Find the
total capital supply function for these graduate students as a function of the interest
rate.
⇣ ⌘
The individual capital supply function is s = 10 1+r
2+r , so overall savings is given by
✓ ◆
1+r
Ks = 30s = 300
2+r

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(d) (7 points) Now supppose that the MIT Federal Credit Union is the only place that these
graduate students can put their savings. The credit union uses the money that these 30
students save to invest in various projects. Currently there are three potential projects
that the credit union can invest in:
Project A: $100 investment, 200% return
Project B: $100 investment, 150% return
Project C: $100 investment, 50% return

The returns accrue in the spring semester, so project A requires a $100 investment at
the end of the fall and pays out $300 at the beginning of the spring, or a 200% return
on the capital invested.
Write down the credit union’s demand for capital as a function of the interest rate. (You
can assume that it behaves like a competitive firm, i.e. it does not behave as if it has
any control over the interest rate. It’s also possible to invest in more than one project if
the credit union has enough capital to fully fund multiple projects.)

The credit union will invest in all three projects if the interest rate is below 50% (i.e.
r  .5), only A and B if it is between 50 and 150% and only A if it is between 150 and
200%. The demand function is:
8
>
<300 r 2 (0, 0.5)
KD (r) = 200 r 2 (0.5, 1.5)
>
:
100 r 2 (1.5, 2)

(e) (5 points) Draw the supply and demand functions for capital in this economy. What is
the equilibrium interest rate r?

The intersection between the two curves occurs at r = 1, K = 200. The demand curve
is composed of four vertical segments at 0, $100, $200, and $300, and the supply curve
intersects the $200 segment at an interest rate of 1.
(f) (5 points) Does the credit union fund project C? Why or why not? Is this efficient?

No – project C is not worth doing if the interest rate is above 0.5. Even though project C
yields a positive return, the return is not high enough to convince the graduate students
to save enough to finance the project. This is efficient because the graduate students
value consumption now more than they would value the additional consumption in the
spring generated by the project.
(g) (5 points) Suppose that the government tries to stimulate private investment by capping
the interest rate at 0%. What would happen to aggregate savings? Which projects will
be funded?

The usual intuition for a price ceiling holds. The credit union would want to do all three
projects, but the graduate students wouldn’t save enough to finance all three. In fact, if
r = 05 then the students will save 300(1/2)=150, which is only enough to fund the first
project.

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4. Cars and Competition (30 points)
p p
Assume all U.S. car producers have the following production function F (K, L) = K 1+ L
and w = r = 2. Suppose that the p U.S. is open to trade. The supply from foreign producers
p is
perfectly elastic at a price p = 2 and the demand function in the U.S. is Q = 10 2 p.

(a) (7 points) Determine the long-run U.S. equilibrium. How many cars do U.S. consumers
buy? Determine the equilibrium quantity produced by each U.S. firm and the quantity
imported.

The cost function for a US firm is C(q) = 2 + q 2 . Thus AC(q) = 2q + q and minq AC =
p
2 2. Thus US firms do not produce at all, because the price on the market is below the
minimum of thepaveragep cost.pThe demand is entirely satisfied by foreign firms and it’s
equal to Q = 10 2 2 = 9 2.

(b) (3 points) Compute consumer surplus.

p p p p
The equilibrium price is 2 and the eqm quantity is 9 2. Thus CS = 0.5(9 2)(9 2) =
81.

(c) (5 points) Suppose the U.S. government bans imports. Assume firms operate in a per-
fectly competitive market, there is free entry and the input prices are fixed. Determine
the long-run supply function of a single firm and the long-run supply function of the
industry.

If the government bans imports US firms operate in the p

market at the minimun of the
AC. Thus the industry supply pfunction is flat at p = 2 2. The supply function of a
single firm is q = p/2 for p 2 2 and q = 0 otherwise.

(d) (5 points) Determine the total quantity, the quantity produced by each firm and the
number of firms in equilibrium.
p p p
The eqm price is p = 2 2 and the eqm quantity is Q = 8 2. Each firm produces q = 2
and the eqm number of firms is N = 8.

(e) (5 points) Compute consumer surplus and compare it to what you found in part (b).
Explain.
p
CS = 0.5(8 2)2 = 64. CS decreases after the government bans imports because the price
is now higher and the quantity supplied in the market is lower. This is because US firms
produce less efficiently than the rest of the world.

(f) (5 points) Suppose now that the government can introduce an ad valorem tax on imports.
How big should the tax be in order to keep U.S. firms in the market?

The ad valorem tax should be 100%.

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5. The Price of Canvas (30 points)
Nidhi is a shoe supplier to Macy’s. Macy’s will purchase shoes at a fixed price of $2 per pair
of shoes, but Nidhi has to commit to the number of shoes she will sell prior to knowing the
price of canvas. Nidhi knows the price of canvas will either be $1.50 or $ 73 per meter with
equal probability. Further she needs one meter of canvas to produce one pair of shoes and her
factory has a maximum capacity of 100 pairs of shoes.

(a) (5 points) Assuming Nidhi is an expected profit maximizing entreprenuer, how many
pairs of shoes would she commit to sell? What are her expected profits?

Nidhi would commit to selling one hundred pairs of shoes, since 2-0.5*1.5-0.5*7/3>0.
1
E(⇡) = 100 ⇤ 12 = 100
12

(b) (3 points) If Nidhi could increase the capacity of her factory by 50 pairs of shoes for a
fixed cost of $10, should she do it? Explain.
1
No, since the expected increase in profits (excluding fixed costs) is 12 ⇤ 50 which is less
than 10

(c) (8 points) Now assume Nidhi is risk averse, and in particular her utility function is
U = ln(w + ⇡) where w is her initial wealth and ⇡ is her profits. How many pairs of
shoes would Nidhi commit to sell if her w = $100? What is her expected utility and
profits? Does Nidhi change her willingness to supply? Explain.

Nidhi maximizes the following function

1 1 1 1
U = max U (100 + s) + U (100 s)
s 2 2 2 3
dU 1 1
= 0 ! (100 + s) 1 = (100 s) 1
dS 2 3
! s = 50

1 250
U = [ln(125) + ln( )]
2 3
Nidhi reduces her wilingness to sell, since the more she sells the bigger her risk. This is
due to the potential losses stemming from the high cost of canvas.

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(d) (8 points) Suppose that Macy’s is willing to guarantee Nidhi a markup of x above the
cost of canvas. Write down the expression you would solve for x⇤ such that Nidhi is
indifferent between (i) accepting a price of $2 and (ii) a markup x⇤ above the cost of the
canvas. Assuming she accepts the markup x⇤ , would her expected profits be higher in
(i) or (ii)? How many units would she sell in each case? (no need to solve, simply stating
the intuition is sufficient)? Explain.

1 250
[ln(125) + ln( )] = ln(100 + 100x⇤ )
2 3
Firstly you must notice Nidhi will commit to 100 pairs of shoes, since she will always get
a positive profits from each sale.
Her expected profits would be lower if she accepted x⇤ , this is due to the fact we know
that there is zero risk in this markup; hence if she is indifferent between the two choices
and risk averse, her expected profits must be lower.

(e) (6 points) Go back to the situation in part (c), and (without doing any more mathemat-
ics) describe what would happen to the number of shoes she would be willing to sell in
each of the situations below. Explain.

(i). Assume Nidhi’s w rose to $200

She would sell more, this is because her income has risen, hence she would be willing
to take more risk, there s would rise
(ii). Assume the cost of canvas is $0.50 or $ 10
3 with equal probability

She would sell less shoes, since there is even more risk with respect to the price of
canvas.

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6. Gruberland (30 points)
Gruberland has two workers in its economy: worker A and worker B. Workers choose a com-
bination of leisure and consumption to maximize their utility. The individual utility functions
are as follows:

UA = C 7/8 Z 1/8
UB = C 1/2 + (30Z)1/2

where C stands for consumption, and Z stands for zzz... (sleeping the hours away). Any given
worker is constrained by a maximum of 24 hour of leisure, or a maximum of 24 hours spent
working for an hourly wage, w. One unit of consumption costs $1.

(a) (6 points) Find the expression for the individual labor supply functions for each worker
(as a function of wage, w). What is the aggregate labor supply function in this economy?

LA (w) = 21
✓ ◆
1
LB (w) = 24 1
w/30 + 1

(b) (6 points) On a single graph, depict the budget constraint and optimal leisure and
consumption choices for workers A and B. Carefully label the level of C, Z and L
(labor) that are chosen. Assume w = 10.

LA (w) = 21 ) ZA = 3; CA = 210
LB (w) = 6 ) ZB = 18; CB = 60

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(c) (12 points) The poverty line in this society is at Y = C = 66. A program is proposed
whereby a subsidy S = 66 Y is given to anyone whose Y is below 66. In order to
implement this, money is raised by having a marginal tax rate of 60% for incomes above
100. Calculate the utility levels before and after the program is implemented. Should
the government implement this subsidy program?

UA BEF ORE = 123.5

UB BEF ORE = 31.0
UA AF T ER = 88.8
UB AF T ER = 35.0

Deciding to implement the program will depend of the SWF function that is assumed. So
the answer is UNCERTAIN. If one assumes utilitarian SWF function, then the answer
is NO. If one assumes Rawlsian SWF function, then the answer is YES.

(d) (6 points) Show graphically what happens with aggregate labor supply after the subsidy
program is in place. Label if there is any DWL. Assume a downward sloping, linear
demand function that crosses the x-axis at a quantity 60.

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