ECON10004 2020 S1 Final Exam B-3 PDF

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The University of Melbourne Department of Economics Semester 1 Final Exam, 2020 ECON10004 Introductory Microeconomics Reading Time: 30 Minutes Writing and File Upload Time: 3 Hours This Exam paper has 13 pages (including the cover sheet). Authorized Materials   

This exam is open book and open notes. You may use any dictionary or software that translates English to a foreign language. You may use a calculator of any type.

Instructions to Students     

The final exam contributes 60 percent to the assessment in ECON10004. The total score for the exam is 100. The number of marks is clearly indicated next to each part of every question. Answer the questions to the test on the answer sheet. Do not resize the boxes or adjust the pages on this answer sheet. If you need extra room, use the overflow page at the end of the answer sheet. Communication with anyone during this test is not allowed.

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Question A1 Abbey plans to start a coffee shop. Her rental costs are $450 per day but these costs have been paid for the month and are non-recoverable. Based on market research, she is expected to sell the following number of cups of coffee (see table below) if a cup of coffee is priced at $4. Courtney’s best alternative use of time is to work at the local convenience store which pays her $18 per hour. Assume that there are no other costs associated with selling coffee. How many hours should she run the coffee shop for? Number of hours 0 1 2 3 4 5 (a) (b) (c) (d) (e)

Total coffee sold (cups) 0 20 35 45 50 52

0. 1. 2. 3. 4.

Question A2 The markets for strawberries and blueberries are perfectly competitive. Strawberries and blueberries are substitutes. Suppose that adverse weather destroys 30% of the domestic strawberry crop. Which of the following statements is correct? (a) The price of strawberries will rise and the quantity of blueberries will fall. (b) The price of strawberries will rise and the quantity of strawberries will rise. (c) The price of blueberries will rise and the quantity of blueberries will rise. (d) The price of blueberries will rise and the quantity of blueberries will fall. (e) None of the above.

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Question A3 Bob runs a book-binding business, and the production of bound books requires two inputs: the binding machine and labour. The production function exhibits diminishing returns to labour. Which of the following statement is incorrect in the short run? (a) The production function is concave in the labour input. (b) Average total cost is U-shaped. (c) Short-run total cost is convex in output. (d) Variable cost is concave in labour input. (e) Marginal cost is increasing in output.

Question A4 The local animal shelter sets the adoption price for kittens, cats, and dogs who are rescued from the surrounding area. Over time, they have experimented with their adoption prices. The table below shows the percentage change in quantity demanded of kittens, cats, and dogs from a one-percent increase in each adoption price (holding all other prices constant):

Change in Kittens adoption Cats price of: Dogs

Kittens -0.8 -0.5 0

Effect on quantity of: Cats Dogs -0.1 0 -3 0.5 0.1 -0.5

Which of the following statements is true? (a) The quantity demanded for Kittens and Dogs are inelastic. Cats and Kittens are complements. (b) The quantity demanded for Cats is elastic. Cats and Kittens are substitutes. (c) The quantity demanded for Kittens and Dogs are inelastic. Dogs and Cats are complements. (d) The quantity demanded for Kittens and Dogs are elastic. Dogs and Cats are complements. (e) The quantity demanded for Kittens and Dogs are elastic. Cats and Kittens are substitutes.

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Question A5 When the government imposes a per unit tax on producers in a perfectly competitive constant-cost industry, in the long run: (a) Producers will be better off. (b) Consumers will be better off. (c) Producers will be worse off. (d) Consumers will be worse off. (e) Cannot be determined without further information.

Question A6 Lionotica is a biotech firm who has discovered a drug that reduces the symptoms of Covid-19 and is considering switching from its current policy of setting a single uniform price for all consumers to a third-degree price discrimination strategy based on geographic region. If Region A is less price elastic than region B at the current single uniform price and Lionotica is a monopoly, what would we expect would happen when third-degree price discrimination is introduced? (a) The price of Lionotica’s drug will rise in Region A and rise in Region B. (b) The price of Lionotica’s drug will fall in Region A and fall in Region B. (c) The price of Lionotica’s drug will rise in Region A and fall in Region B. (d) The price of Lionotica’s drug will fall in Region A and rise in Region B. (e) We would not expect a price change in either region.

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Question A7 A profit-maximising monopolist firm facing a downward sloping demand will not select an output where: (a) Demand is inelastic. (b) Marginal revenue is falling. (c) Average total cost is rising. (d) Average revenue is greater than marginal revenue. (e) Marginal cost is rising.

Question A8 Aaron and Bob run mattress shops across the street from each other. At the start of each month, they independently and simultaneous choose prices for their mattresses, which will result in profits as depicted below:

Aaron

Low price Medium price High price

Low price $200, $800 $500, $900 $400, $1000

Bob Medium price $400, $200 $200, $600 $700, $200

High price $800, $700 $200, $400 $100, $800

Which of the following statements is correct? (a) There are two pure strategy Nash equilibria. (b) Aaron has a dominant strategy of playing “high price”. (c) There exists a pure strategy Nash equilibrium in which Aaron earns higher profits than Bob. (d) Aaron playing “medium price” cannot be part of a pure strategy Nash equilibrium. (e) Bob has a dominant strategy of playing “low price”.

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Question A9 Adam’s Jewelry Store and Brian’s Cafe are located next to each other at a local mall. They are considering whether to hire security guards for their business. Their choices and profits are depicted below:

Adam’s Jewelry Store

Don’t Hire Hire

Brian’s Cafe Don’t Hire Hire -$200, $0 $-100, $50 $400, $100 $600, $0

Which of the following statements is correct if both firms hire workers simultaneously? (a) In equilibrium, Brian will be a free rider. (b) In equilibrium, the socially efficient number of security guards will be hired. (c) In equilibrium, no security guards will be hired. (d) There are two pure strategy equilibria. In each equilibrium exactly one security guard will be hired. (e) There is no pure strategy Nash equilibrium in this game.

Question A10 You are working at a solar panel installation company. Your manager announces that the company is starting a new incentive program to increase the number of potential customers, or leads, for salespeople to contact. For every lead submitted by an employee, the employee will receive $100 in their next paycheck. After a week, the sales manager realizes that her staff is simply submitting lists of names of everyone they know for $100 a name, resulting in a net loss to the company because most of the leads are useless. Which of the following strategies is likely to have the biggest impact in mitigating moral hazard and improving the quality of submitted leads: (a) Instead of offering $100 a name, offer $200 instead. (b) Instead of offering $100 a name, offer $10 instead. (c) Cap the number of leads that can be submitted by an employee at 5. (d) Instead of paying $100 for each lead, offer to pay employees a percentage of revenue earned from a lead they submit. (e) Open the incentive program up to non-employees who might have a different set of potential contacts.

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Question B1 [10 points] When producing steel, a small amount of pollution is emitted into the atmosphere that has a negative impact on the health of people in the surrounding area. The government has calculated that the private and social marginal benefits of steel are given by: PMB = SMB = 110 – Q While the private marginal cost and social marginal costs are PMC = 10 + Q SMC = 50 + Q Answer the following questions: B1.1: In the absence of regulation, what level of output will the economy produce? (2 points) B1.2: What is the efficient (welfare-maximizing) level of output? (2 points) B1.3: What is the dollar value of the net gain to society from `correcting’ the externality? (4 points) B1.4: Suppose the government wishes to correct the market failure using a tax. What size of the tax should the government choose if it wishes to induce the efficient (welfare-maximizing) level of effort? (2 points)

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Question B2 [10 points] Huntingon’s disease (HD) is an inherited disorder that has symptoms that develop when individuals are between 30 and 50 years of age. You are the owner of a nonprofit startup that has discovered a treatment for the disease. The marginal cost for offering the treatment is $100,000 and many individuals who may be at risk to the condition are interested in purchasing an insurance contract that will cover the treatment. Question B2.1: Currently, all individuals can take a free genetic test that can identify whether they are at risk of HD. If an individual receives a positive test result, they have a 45% chance of getting sick while an individual who receives a negative test result has a 0% chance of getting sick. How much would you expect to pay on average if everyone who tests positive purchases the insurance you offer? (2 points) Question B2.2: Suppose that a biotech firm called Lionotica has discovered a new testing procedure that can give an individual better information about their risk. In particular, the test can place individuals into five “groups” that differ in the probability of getting sick. An individual who has tested positive to the initial test is equally likely to fall into each of the five groups shown in the table below. Test Result Probability of Getting Sick “Group 1” 10% “Group 2” 25% “Group 3” 35% “Group 4” 70% “Group 5” 80% Suppose that you charge the expected payment that you calculated in part B2.1 and that all individuals who are considering the insurance are risk neutral. Which groups would take up the original insurance offer? What are your expected losses per individual who buys the insurance if they can take the test privately and do not have to disclose it to you? (4 points) Question B2.3: Suppose that you need to cover the expected cost of treatment with the premium that you charge. If all individuals have access to Lionotica’s test and can keep the results private, what price will you charge for insurance? Who will continue to buy it? (4 points)

Question B3 [10 points] For this question, refer to the figure below, which shows the average total cost curve of a firm that faces demand curve D. We have marked the point on the demand curve where the elasticity of demand is equal to 1. As done in class, you may assume that the ATC includes both variable costs and fixed costs but does not include sunk costs.

Question B3.1: Would we ever observe a profit maximizing monopolist produce a quantity of QA and charging price PA? If not, explain why (2 points) Question B3.2: Would we ever observe a profit maximizing monopolist produce a quantity of QB and charging price PB? If not, explain why (2 points) Question B3.3: Would we ever observe a profit maximizing monopolist produce a quantity of QC and charging price PC? If not, explain why (2 points) Question B3.4: Would we ever observe a profit maximizing monopolist produce a quantity of Q D and charging price PD? If not, explain why (2 points) Question B3.5: Based on the graph, what can we say about the marginal cost curve of the firm? Where does it intersect the average total cost curve? (2 points)

Question C1 [20 marks] To produce honey, beekeepers raise bees in hive boxes that are specifically designed to allow for easy access to honey. Hives can be co-located near apple orchards or near orange groves:  

When beekeepers keep their hives near apple orchards, their bees will pollinate the apples, increasing the output of the orchard. When beekeepers keep their hives in orange groves, the sticky nectar in orange blossoms helps the bees to produce more honey.

Question C1.1: Suppose that the beekeepers have property rights over their beehives but can only place their beehives next to an apple orchard or an orange grove if they are granted permission to the land. Beeswax Beehives has already been paid to locate its bees at Amy’s Apple Orchard when it is contacted by Groovy Groves who is willing to allow Beeswax to move its bees to its orange grove instead. Beeswax is negotiating with Amy’s Apples to break its current contract. The two companies have determined that their economic profit for staying in the Apple Orchard and or moving to the Orange Grove are:

Bees Stay at Amy’s Apple Orchard Bees Move to Groovy Groves Orange Grove

Beeswax Beehives Profit $400

Amy’s Apples Profit

$900

$100

$300

Assume that there are no transaction costs for bargaining. Based on the Coase Theorem, would you predict that the bees stay or move? Let P be the price paid by Beeswax Beehives to Amy’s Apple Orchard to break its contract. What is the lowest possible P that would lead to this outcome? What is the highest possible P that would lead to this outcome? [4 marks] Question C1.2: In the last 10 years, there has been a dramatic fall in bee populations due to the spread of Varroa mites, which infect and kill the larvae of bees and can cause bee colonies to collapse. Beeswax Beehives and its competitor Candlewax operate hives in the same area and must decide on whether to transport their bees to different spots in the orchard in the season or to keep them stationary. Transporting bees can be privately lucrative but potentially exposes both operators to the mite. Based on the actions of both parties, the payoffs are as follows:

Beeswax Beehives Profit

Candlewax Profit Keep Stationary

Transport

Keep Stationary

600, 700

250, 500

Transport

500, 250

700, 400

Suppose that the two companies simultaneously choose whether to transport their bees or not transport their bees. What are the pure strategy Nash Equilibrium of this game? [4 marks] Question C1.3: Suppose that instead of the game being played simultaneously, Beeswax Beehives can commit to an action before or after Candlewax. 



If it commits to acting before Candlewax, the game is played sequentially with Beeswax Beehives choosing its action, Candlewax observing this action, and then choosing its own action. If it commits to acting after Candlewax, the game is played sequentially with Candlewax choosing its action, Beeswax Beehives observing this action, and then Beeswax Beehives choosing its own action.

Write down the strategies of both players in the sequential game that would arise if Beehives chooses to act before Candlewax. Write down the strategies of both players in the sequential game that would arise if Beehives chooses to act after Candlewax. Should Beeswax Beehives commit to acting before or after Candlewax? [6 points] Question C1.4: Groovy Groves has written into its contract that it has the right to prevent bee owners from transporting their bees in the orchard. However, it cannot force the owners to transport bees if they do not wish to. Assume that there are no transaction costs for bargaining and that without an agreement, Beeswax’s preferred outcome from question C1.3 will occur. Based on the Coase Theorem, would you predict that the bees will be allowed to be transported? Let P be the price paid by Candlewax to Groovy Groves to prevent owners from transporting bees in the orchard. What is the lowest possible P that would lead to this outcome? What is the highest possible P that would lead to this outcome? [6 marks]

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Question C2 [20 marks] The Australian Competition and Consumer Commission (ACCC) has opened an investigation regarding collusion between the two major firms producing fire protection gear for bush firefighters. The firms – Azure Associates and Blue Guard – contend that they are quantity competitors and that the prices they are charging are a result of an increase in price by their suppliers. As part of the case, the ACCC has noted that the Australian firefighters typically purchase their own protective gear and are thus price takers in the market. Both the ACCC and the two firms under investigation agree that the market demand can be described by the inverse demand function: PD (Q )  240  Q , where Q is the total quantity provided by the two firms (i.e., Q  qA  qB , where qA is the amount produced by Azure Associates and qB is the amount produced by Blue Guard). All parties also agree that the two firms have identical production technologies and that the two firms have the same constant marginal cost of production of c. In court, however, the firms argue that their marginal costs are high while the ACCC argues that they are low. Question C2.1 Azure Associates and Blue Guard contend that the two firms are competing as an oligopoly and that they compete by simultaneously choosing quantity. They argue that their marginal costs of production are equal to c = 75. Based on this marginal cost, the two firms have the following profit functions:

 A ( qA , qB )  (240  qA  qB ) qA  75 qA  B ( qA, qB )  (240  qA  qB ) qB  75 qB Using these profit functions, find the best-response function for each firm based on the other firm’s quantity choice. Use these best-response functions to calculate the equilibrium price and quantity that would arise in the market. (8 points)

Question C2.1 The ACCC maintains that the two firms are acting in a collusive agreement and that the marginal cost of production is 10. Using these assumptions, calculate the predicted market price and the total quantity offered if the two firms collude and act as a monopolist. If the two firms agree to split the surplus evenly, how much profit does each firm earn? (6 points) Question C2.3 Suppose that the court hearing the case cannot tell whether the assertion made by the ACCC or the firms is correct. However, it notes that in 2019, the Australian government offered a subsidy of $120 to all firefighters who purchased gear during the peak of the fire season. Thus, the demand in this time period was: PD (Q )  360  Q . Explain how this information might be used to Identify whether the ACCC or the firms are co...