1.

2 International Business

Economics and Business1

Course manual (EBC1009-2012-13) 18 October 2012

1 No part of this publication may be reproduced or distributed in any form or by any means, or stored

in a database or retrieval system without any prior written permission of the authors. (c) by J. Philipp Reiss and Jan Vandekerckhove

Contents
1 2 Introduction Course Contents and Literature 2.1 Literature . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.1.1 2.1.2 2.1.3 2.2 3 Compulsory Literature . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Deciencies in Mathematics . . . . . . . . . . . . . . . . . . . . . . . . . . . Supplementary Literature . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 2 2 2 2 3 3 4 4 4 5 5 8 8 9 9 11 23

Contents . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Course Organization 3.1 3.2 3.3 3.4 3.5 3.6 3.7 3.8 Lectures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Group Tutorials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . eleUM Quizzes and Required Readings . . . . . . . . . . . . . . . . . . . . . . . . Determination of Final Grade . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . WARNING: Consequences of Not Passing Participation . . . . . . . . . . . . . . . Repeat Students . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Study Switchers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . The Planning Group . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

4 5

Tasks Exam Examples

Introduction

The undergraduate course Economics and Business introduces economic principles and concepts. The following topics are addressed in lectures and tutorials: supply and demand, perfect competition, monopoly, game theory, oligopoly, auction markets, agency theory, and elements of macroeconomics. Due to time limitations, the lectures cannot cover every single aspect of the course that is dealt with, but rather focus on the most important and complex content. Since Economics and Business is a rst-year class, the presentation avoids the use of advanced mathematical concepts. However, knowledge of basic mathematical concepts such as solving equations, reading and working with graphs, manipulating inequalities or elementary calculus is an indispensable prerequisite. In addition to economic contents, the course Economics and Business mediates Academic Writing Skills. For that, the Language Center offers a separate series of lectures and group tutorials during course period 1.2. For details on the organization and contents of the academic writing skills part, please see the separate course manual for the Introduction to Academic Writing that is provided on the eleUM website in the folder Academic Writing.

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2.1

Course Contents and Literature

Literature
Compulsory Literature

2.1.1

The compulsory textbook for this class is:

! McDowell, M., Thom, R., Frank, R., Pastine, I. & Bernanke, B. (2012). Principles of Economics, 3rd European edition. Maidenhead, UK: McGraw-Hill. In general, you are free to use any textbook and any edition, but the course assumes that you work with the 3rd edition of the compulsory textbook for this class implying that you are responsible for any friction that arises from using another one (including using the rst or second edition.) 2.1.2 Deciencies in Mathematics

If you feel that you have deciencies in mathematics, here are two splendid textbooks:

! Chiang, A.C., & Wainwright, K. (2005). Fundamental Methods in Mathematical Economics,

4th ed. New York, NY: McGraw-Hill/Irwin.

! Sydsaeter, K., & Hammond, P. (2008). Essential Mathematics for Economic Analysis, 3rd ed.
FT Prentice-Hall. 2.1.3 Supplementary Literature

If you are interested in the economic history of Western economies, here is a short and nontechnical book:

! Heilbronner, R.L., & Milberg, W. (2006). The Making of Economic Society, 12th ed. Pearson
Prentice-Hall. If you want to get to know exciting applications of Economics, consider the following entertaining book:

! Levitt, S.D., & Dubner, S.J. (2006). Freakonomics, Penguin Books.

For more information about eBay auctions, try:

! Steiglitz, Ken (2007). Snipers, Shills, and Sharks: eBay and Human Behavior, Princeton University Press.

2.2

Contents

Table 1 provides economic course contents for each week together with the relevant textbook chapters of McDowell et al. (2012).
Week week 1 week 2 week 3 week 4 Topic The Economic View of Human Behavior Game Theory Demand and Supply Elasticities Optimal Choice Perfect Competition Welfare Analysis Market Structures week 5 Monopoly Oligopoly week 6 week 7 Optimal Search Agency Theory Elements of Macroeconomics chs. 11 and 12 chs. 17, 18, 22, and pp. 599-602, 615f., and 695f. chs. 8 and 10 Required reading chs. 1 (incl. appendix), 16, and 9 chs. 2 and 3 ch. 4 chs. 5, 6, and 7

Table 1: Contents and required readings by week 3

Course Organization

There are four building blocks of the economics part of this course: lectures, group tutorials, required readings, and eleUM quizzes. In each lecture week, the required readings introduce the basic material and should have been read before enjoying the lecture; at least this is what the lecture assumes. The lecture elaborates on that material, extends it, and demonstrates its fruitful application. The purpose of the group tutorials is to deepen the understanding of that material and to apply it to alternative contexts. Since mastering required readings is of eminent importance to be able to adequately follow the lecture and productively participate in group tutorials, there are weekly, compulsory multiple-choice quizzes on eleUM that allow every student to monitor if the textbook material is sufciently mastered.

3.1

Lectures

There are seven lectures, each given on Thursdays in the Lecture Hall in Tongersestraat 53. The rst lecture (November 1, 2012) is scheduled from 13:30 till 15:00. The six other lectures are scheduled from 11:00 till 13:00. The lectures are given by the course coordinator. Thursday Nov. 01 13:30-15:30 Nov. 08 11:00-13:00 Nov. 15 11:00-13:00 Nov. 22 11:00-13:00 Nov. 29 11:00-13:00 Dec. 06 11:00-13:00 Dec. 13 11:00-13:00

All lecture slides will be available at eleUM before the lecture. This allows you to download and print them before attending a lecture which substantially eases note-taking during lectures leaving more time to concentrate on the content.

3.2

Group Tutorials

There are nine group tutorials scheduled for the dates as follows: Wednesday Friday Oct. 31 Nov. 07 Nov. 14 Nov. 21 Nov. 28 Nov. 30 Dec. 05 Dec. 12 Dec. 14

The weekly group tutorials employ the teaching method problem-based-learning. Therefore, each meeting is composed of the pre- and post-discussion of scheduled tasks. All tasks for this course are listed in chapter 4 of the course manual, see p. 11ff.

Guidelines for attending a group tutorial 1. Prepare thoroughly and be on time. 2. Participate actively. 3. When it is your turn, take the role of the discussion leader seriously. 4. Be open towards new ideas and towards others

3.3

eleUM Quizzes and Required Readings

In order to ensure that everyone is sufciently prepared to participate in a productive postdiscussion of tasks during group tutorials, a necessary requirement to pass the course is to pass 5 out of 7 multiple choice quizzes. These quizzes are administered through eleUM during lecture weeks 1-7. There is one quiz in every lecture week. Every quiz is composed of multiplechoice questions about the required readings for that week during which the quiz is conducted. All questions are randomly drawn from a large database of questions. Therefore, every quiz given to any student is unique. We expect that you rst study the required readings and subsequently take the quiz. If you did not pass the rst time, you should study the chapters again and afterwards retake it. However, you cannot retake it more than once. We recommend you not to wait until the last minute since experiences of the previous years show that most technical problems occur just before the deadline. In order to pass a quiz, you need solve at least 12 problems correctly. In the exam week, you get one extra and nal opportunity to retake each quiz. Taking eleUM quizzes seriously is a good preparation for the nal exam since 40% of the written exam consists of questions from the same database as that for the eleUM quizzes.

3.4

Determination of Final Grade

There are three necessary requirements for passing the course Economics and Business: 1. Passing the nal exam; 2. Passing the participation requirement (or passing the course assignment as published at the eleUM site of the course); 3. Passing the skills training Introduction to Academic Writing. You must pass each of these items separately in order to pass the entire course. 1. Passing the nal exam The nal exam consists of two parts, a multiple-choice part (60%) and an open-book part (40%). Both parts are based on the material that is covered in the lecture, the lecture 5

notes, the required readings, and the tasks. The multiple-choice part is a closed book exam that consists of 60 multiple choice questions. 40 multiple choice questions are drawn from the database that is used for the eleUM quizzes. The open-book part consists of problem-type questions. Note that you can bring anything with you for the open-book part of the exam (except for, of course, items that are prohibited in the exam regulations such as mobile phones). There are 60 minutes available for the open-book part. It is designed such that students with excellent command of material covered during the course period have sufcient time to adequately address the entire open-book part of the exam. This implies that students with an average level of knowledge or even a good level of knowledge presumably run out of time on this part. A time-saving practice is to continuously work during the course period with the textbook and notes used on the nal exam so that valuable nal exam time does not have to be wasted on locating relevant material in the set of resources. Needless to mention that reading is time-consuming, too. The nal grade of the nal exam, which is also your nal grade for the entire course, is determined by the sum of points that you score on the multiple-choice part and the open-book part. 2. Passing the participation requirement (or passing the course assignment as published at the eleUM site of the course) This part of the examination actually contains two requirements that you both have to satisfy in order to be exempted from doing and passing the course assignment: (a) the usual 75% requirement for the weekly group tutorials, and (b) the weekly eleUM quizzes. (a) The 75% attendance requirement boils down to attending 7 out of 9 weekly tutorials. Attending a tutorial means more than just physical presence: you are expected to prepare the relevant literature, to participate actively in the discussions and to take responsibilities, like being discussion leader, seriously. If you fail to do so, your tutor is entitled to deny your cross to you, even when your physical presence is beyond dispute. (b) Passing 5 out of 7 weekly eleUM quizzes during weeks 1-7. To stimulate you to read the relevant literature in time, to help you identify remaining gaps in your knowledge after this reading process, or boost your self-condence by establishing that such gaps dont exist, you are expected to do a weekly quiz which will be presented to you through eleUM. Each weeks quiz consists of 20 multiple choice questions, drawn from a large database and corresponding to that weeks required readings. 6

For example, week 2s quiz corresponds to chs. 2 and 3 in McDowell et al. (2012), see table 1 on p. 3 of this course manual. The selection from the database is random and therefore different for individual students, but the degree of difculty is the same. To pass a quiz, you need to solve at least 12 questions correctly. Additionally, you have to complete the quiz within 40 minutes, and before Monday, 18:00, of the week following the lecture week in question. If you fail to pass for the rst time, then do not panic: for each quiz, you can have a second shot in that same week (but within the following Monday 18:00 limit). To avoid misunderstanding, we stress that the quiz questions are, on average, easier than the questions you will encounter in the multiple-choice part of the nal exam. Further, if you passed a quiz in your rst attempt, you can do the second attempt without endangering your original result. Similarly if you passed a quiz either on the rst or second attempt, you can do the third attempt during the nal exam week without endangering your original result, too. This allows you to take resit quizzes as a preparation for the nal exam. You are exempted from the course assignment if you simultaneously satisfy requirements 2(a) and 2(b). Students who fail one or both of them have to do the course assignment. This assignment will be published on eleUM, involves a considerable workload, and is graded explicitly. Note that, apart from the course assignment, there is no resit for requirements 2(a) and 2(b)! 3. Passing the skills training Introduction to Academic Writing The exam requirements related to the parallel skills training Introduction to Academic Writing are spelled out at length in the corresponding manual on our eleUM site, under the Academic Writing button in the menu column on the left of the screen. Briey, they boil down to: (a) Sufcient presence and participation in the group tutorials organized by the Language Center, including the writing of one short paper that is peer-reviewed. (b) Writing the main paper. The subject of this paper is related to the contents of the Economics and Business course. The use of the English language will be assessed by your language tutor. The economic content will be assessed by your Economics and Business tutor. The paper has to be submitted in two ways: (1) electronically via eleUM (deadline: Monday 10 December 2012, 18:00); AND (2) as a hardcopy to your Economics and Business tutor in the tutorial on Wednesday 12 December 2012. (If you are a repeat student and do not participate in a tutorial group, hand in the hard copy to the pigeonhole of Jan Vandekerckhove in room A1.06 by the same deadline.) Both the electronic and the hard copy must be the same. Please make sure that the name 7

of your language tutor and that of your Economics and Business tutor appear on the cover of the paper. In case you happen to be a repeat student, please indicate this information next to your name on the cover of the paper - this considerably eases the organizational process of grade provision. Note: The paper will be checked extensively for plagiarism and copying. Any paper found to be plagiarized or copied will receive a score of zero, and the perpetrator will be subject to the disciplinary authority of the Exams Committee. Note: The procedure for "Introduction to Academic Writing" is strict. Not following the procedure might result in serious consequences.

3.5

WARNING: Consequences of Not Passing Participation

Please note that the consequences you face if not passing participation in the tutorial groups, eleUM quizzes and in the academic writing tutorials (or not compensating it by passing the relevant course assignments) are serious! Not passing participation means that you have to register for the entire course in the future again and to pass participation then. Since there is a maximum number of courses that you can take in any course period, re-taking EBC1009 Economics and Business in future implies that you will be prevented from taking other courses in the second or third year that you certainly will prefer to take at that time!

3.6

Repeat Students

repeat student = a second-year student who continues to study in the same program as in the rst year, but did not pass the course Economics and Business in the rst year. All partial exam results from last year remain valid, i.e. nal exam, participation requirement, and both elements of academic writing skills (participation and main paper). You do not have to redo whichever of these items you passed last year. Notice that for the nal exam, only your overall grade remains intact, the individual components (multiple-choice part and open-book part) are not carried over; analogously only your overall participation result remains intact implying that if you have either failed the eleUM quizzes or the 75% attendance requirement, you have to redo both elements in this year. The same principle applies to the main paper: you have to pass both on content and on language; partial success in one of these components cannot be carried over. Of course, you can do the eleUM quizzes in this course period voluntarily again to benet from the feedback and prepare for the exam. The following remarks concern registration: If you have to redo Economics and Business participation or the writing participation, or both, then you have to formally register for the entire course again. 8

If you have to redo the nal exam, but already passed the Economics and Business participation, then you do not need to formally register for the entire course again. It is sufcient to register for the exam. If you have to redo the main paper but already passed writing participation, then you do not need to register for the entire course again. However, you have to sign up for the main paper by sending an email to AW-EBC1009-SBE@MaastrichtUniversity.nl before Wednesday 31 October 2012. Moreover, you have to formally enroll again in the SAP system. You do so by registering at MY UM for the course Economics and Business and you need to indicate only exam. This is really important in order to make sure the grade of your paper counts. If there remain any doubts about the precise requirements that you have to satisfy, please contact the course coordinator by email at j.vandekerckhove@MaastrichtUniversity.nl as soon as possible.

3.7

Study Switchers

study switcher = a student who switched from one study program to another one. In general there are no exemptions! However, there is one exception to this rule: If you have already passed the Introduction to Academic Writing as an element of another course, e.g. Microeconomics in the Economics program, then you do not have to redo the participation requirement of the academic writing part. However, you still have to write the main paper. You have to submit a request by email to AW-EBC1009-SBE@MaastrichtUniversity.nl before Wednesday 31 Ocotber 2012. If there remain any doubts about the precise requirements that you have to satisfy, please contact the course coordinator by email at j.vandekerckhove@MaastrichtUniversity.nl as soon as possible.

3.8

The Planning Group

This course has been designed by a planning group consisting of the following persons: Dr. Jan Vandekerckhove (course coordinator, email: j.vandekerckhove@maastrichtuniversity.nl) Dr. Kyle Hyndman Dr. Kaj Thommson

The current design of the course has been developed by Philipp Reiss, updated by Jan Vandekerckhove and beneted from helpful comments by Jeannette Hommes, Christian Kerckhoffs, Bart Rienties, Ronald Peeters, and Bob Wilkinson. The course coordinator is the person to contact in case of questions about the Economics and Business part of this course by emailing to j.vandekerckhove@MaastrichtUniversity.nl. For the Academic Writing Skills part, please contact Mr. Wilkinson or Mrs Struijke at the email address AW-EBC1009-SBE@MaastrichtUniversity.nl.

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Tasks

Regular tasks that require the approach of problem-based-learning as well as exam examples are discussed in tutorial group settings. The purpose of the exam examples is to illustrate the style of problems that can be expected for the open-part of the nal exam. Indeed, the majority of these problems was used as exams questions before. Please notice that the given examples are not exhaustive in any sense since there are many, many more problems (in terms of variation and topic) that can be expected to be on the exam. Some more problems are provided at the eleUM site of the course. Table 2 details the allocation of tasks and exams examples to group tutorial meetings.
Meeting 1: Oct. 31 WED / wk 1 2: Nov. 07 WED / wk 2 3: Nov. 14 WED / wk 3 4: Nov. 21 WED / wk 4 5: Nov. 28 WED / wk 5 6: Nov. 30 FR / wk 5 7: Dec. 05 WED / wk 6 8: Dec. 12 WED / wk 7 9: Dec. 14 FR / wk 7 Post-discussion introduction tasks 1 and 2 tasks 3, 4, and 5 tasks 6 and 7 tasks 8, 9, and 10 tasks 11, 12, and 13 tasks 14 and 15 tasks 16 and 17, hand in paper tasks 18, 19, and 20 Pre-discussion tasks 1 and 2 tasks 3, 4, and 5 tasks 6 and 7 tasks 8, 9, and 10 tasks 11, 12, and 13 tasks 14 and 15 tasks 16 and 17 tasks 18, 19, and 20 X4 X5 X6 X7 X1 X2 X3 Exam example

Table 2: Allocation of tasks

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Task 1 Advertising on the Internet Consider the online business news market, particularly the online editions of the Financial Times, ft.com, and the Wall Street Journal, wsj.com. Suppose that both sites compete for clients in online advertising by setting either a high price or a low price for a web banner. If both rms set a high price, each of them earns 100. If both rms set a low price, each of them earns 50. If one of them sets a high price while the other one sets a low price, the one setting the high price earns 0 while the one setting the low price earns 150. Task 2 Applied Game Theory: some little games 1. Appealing to the Theory of Games, try to solve the following decision problem using the solution concept known as Nash equilibrium: Imagine that visitors are distributed evenly along a long and straight beach. That is, the distance between each pair of guests is the same. Furthermore, everybody wants to have exactly one cup of ice cream. Suddenly, two sellers of ice cream turn up who want to sell as many cups as possible. Both charge the same price and sell the same quantity and quality of ice cream (regard ice cream as a homogenous good). Lets consider the rules of the sellers game: Since ice cream melts in the sun, every guest buys from the seller closest to him. If the distance to both happens to be the same, each seller is chosen with probability 0.5 If both sellers choose the same location each sells to 50% of the guests. Once a seller has decided about his location, he cant move to another place for the rest of the day. The problem of both sellers is to choose a particular location on the beach independently of each other and simultaneously, that is, each of them wants to determine his optimal strategy. What is the unique Nash equilibrium in (pure) strategies? [This setting was introduced in a paper by Hotelling in 1929 and is commonly referred to as Hotellings beach.] 2. Find all Nash equilibria in the following game. The rst entry in each cell is the payoff to player 1, the second entry is the one to player 2. Is there a dominant strategy for any player? Predict the outcome of this game. player 2 left player 1 up bottom 5,1 3,1 right 1,0 2,2

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3. Consider the game in the preceding strategic form. Suppose player 1 moves rst and player 2 moves after observing player 1s choice. Find the extensive form of this game and solve it by backward induction. Predict the outcome of this game and compare your prediction to the one you made for the simultaneous version of this game. 4. Find all Nash equilibria in the following game. The rst entry in each cell is the payoff to player 1, the second entry is the one to player 2. Is there a dominant strategy for any player? Predict the outcome of this game. player 2 left player 1 up bottom Task 3 Supply and Demand The following gure depicts a time series for the oil price since 1970. As can be seen from the gure, the price level uctuates over time. E.g., in 1973/74 and 1979/80 the price-level sharply skyrocketed. Economists typically rely on the model of supply and demand to explain such price changes. Below the gure, there is a list of events that certainly affected supply and demand plans which triggered supply-driven or demand-driven (or both) changes of the price level.
$90

right 1,0 2,1

5,1 8,2

$80

$70

Constant $2005 per barrel

$60

$50

$40

$30

$20

$10

$1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006

Oil prices 1970-2006; Source: US Energy Information Administration 1. Oil embargo of OPEC (production cut) begins on Oct. 19-20, 1973 (rst oil crisis). 2. 1979/1980: revolution in Iran and rst Gulf war Iran-Iraq (second oil crisis). 3. Early 1980s: Combined Non-OPEC and OPEC oil production increase. 13

4. Iraq invades Kuwait on Aug. 2, 1990, Operation Desert Storm begins shortly thereafter, end of war in 1991. 5. September 11, 2001: Terrorist attacks on the US leading to increased fears of sharp economic downturn. 6. Early 2002: Oil production cuts by Non-OPEC and OPEC plus unrest in the Middle East. More details may be found at, e.g., the website of the US Energy Information Administration at http://www.eia.doe.gov/emeu/cabs/AOMC/Overview.html.

Task 4 Market Equilibrium Consider the demand for mathematical textbooks in Micromania. There are separate estimates of the demand schedules for the northern and the southern part of the country that both depend on the price level P 0: Q D ( P) = 100 N
D QS ( P) = 50

2P 5P

The supply of textbooks for the whole country is given by QS ( P) = 3P. What is the market equilibrium in Micromania as a whole? How does the market equilibrium qualitatively adjust if there is a unication of Micromania and some other country? Task 5 Elasticities The publishing company ReadIt publishes its magazine Survive Economics in the internet. In order to access it, readers have to purchase an annual subscription that is currently priced at P1 = 100 EUR. At this price, the company recorded Q1 = 600 subscriptions. The cost of providing the magazine online is independent of the number of subscriptions. Unsurprisingly, the managements goal is to increase the subscription revenue as much as possible. Recently an analysis of the demand for Survive Economics lead to the trustworthy information that the rm sells Q2 = 800 subscriptions if it sets the price at P2 = 50 EUR and that it sells Q3 = 200 subscriptions if it charges P3 = 200 EUR. The management knows that there is an ambiguous effect on subscription revenue if it increases or decreases the subscription price that is somehow related to the economic concept of a price elasticity of demand. In order to gure out up to what level it should increase or decrease its price or even leave it unchanged, it decided to employ the management consultancy Clever&Smart. 14

Task 6 Optimal Choice A powerful tool for analyzing and predicting the behavior of homo sapiens (but also for capuchin monkeys1 ) is indifference curve analysis that incorporates the rational choice rule. This analysis strictly separates considerations concerning tastes from budgetary considerations. Preferences (=tastes) are represented by indifference curves. Affordable consumption bundles are represented by the budget set where its frontier is the budget constraint. Indifference curve analysis assumes that an individual selects that particular consumption bundle in the budget set that lies on the highest indifference curve. If preferences are well behaved, the selection of the optimal consumption bundle satises an equivalent restatement of the rational choice rule where the marginal rate of substitution is equal to the relative price. Essentially, indifference curve analysis operationalizes the behavioral assumption that an individual chooses his/her mostly preferred consumption bundle that it can afford. Apart from the traditional application to typical consumption goods, a broader interpretation of a good allows its applications to scenarios such as the allocation of time between labor and leisure, intertemporal consumption decisions, or trade-offs between monetary income and personal integrity of sales representatives. Assume that there are two goods in the world: apples and bananas. Say that Eefje has a utility function for these goods of the following type, where xB denotes the quantity of bananas and xA the quantity of apples U ( xA , xB ) = xA + xB . Julies utility function is U ( xA , xB ) = xA + 2xB and Natalies utility function is given by U ( xA , xB ) = xA xB . For each individual do the following: a) Draw the indifference curves that are dened by the utility function (2-3 curves). In the case of Natalie, make sure to include an indifference curve that is dened by a utility level of 2,500. b) What is the marginal rate of substitution when Eefje/Julie/Natalie consumes 50 bananas and 50 apples? What is the marginal rate of substitution between these two goods when Eefje/Julie/Natalie consumes 100 bananas and 50 apples? What do the answers to these questions imply about the type of goods the apples and the bananas are for them?
1 See

Chen, Lakshminarayanan, & Santos. (2006). How basic are behavioral biases? Evidence from capuchin

monkey trading behavior. Journal of Political Economy 114, 517-537.

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c) If the price of bananas is 1 EUR per banana, the price of apples is 1 EUR per apple, and Eefje/Julie/Natalie has 100 EUR to spend, what bundle of bananas and apples would she buy? Would the marginal rate of substitution be equal to the ratio of the prices of these goods in the optimal bundle? If not, why not? d) If the unit prices of the bananas and the apples are 4 EUR and 3 EUR, respectively, what bundle of bananas and apples would Eefje/Julie/Natalie buy with her income of 100 EUR? Task 7 Optimal Choice at ReadIt The publishing company ReadIt employs many writers that have similar preferences being characterized by diminishing marginal rates of substitution. The companys cafeteria offers two categories of food: junk food and salad. To simplify, suppose these categories to be two different goods. (We could make it more realistic by allowing for more goods, but this only complicates things while offering no additional insight.) The cafeteria price of one unit of junk food is p J , the price of one unit of salad is pS . The representative employee spends an amount of m on food. ReadIt is a very special company. One of the things that make it special is its monitoring of food consumption behavior in the cafeteria. As it happens, its employees spend 75% of their budget on junk food although prices and portions of both goods are the same. In an attempt to provide an incentive for healthy food consumption, the management of ReadIt orders its cafeteria to double the price of junk food. Preferences are such that the expected consumption decrease of junk food realizes, but - unfortunately and unexpectedly - the consumption of salad decreased, too. Task 8 Supply under perfect competition Due to extreme weak demand for washing machines in Atlantis, every rm in the industry appears to make losses. This development comes as a surprise to many market observers since the number of suppliers and their supply plans did not change as compared to the previous quarter where each rm made some economic prot. In Atlantis, washing machines produced by different rms are essentially identical, so that consumers view them as homogeneous products. The current market price for washing machines is p =A$750. WashingRobots is one of the producers of washing machines and its management is concerned with its future in the face of its present losses. In order to make a rational decision, it ordered a management consultancy to provide it with advice. As a rst step, the consultancy inquired into the cost processes of the rm that are representative for the industry. The rms

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total cost of production depending on the number y of washing machines that it supplies are estimated to be: C (y) = 5, 000 + 50y2 . As a second step it provides the rm with a prot maximizing supply plan and indicates market price intervals where the rm makes an economic prot and economic losses. Since the management of WashingRobots is interested in the long-run behavior of the industry, the consultancy analyzed likely long-term developments: Due to huge losses of some of your competitors, we have strong reasons to believe that many of them are in the process of exiting the market. We expect that the current market situation of extreme weak demand is an exception. Over the medium-run, market demand stabilizes at a somewhat higher level where you can expect economic prots if you follow our suggested supply plan. Note that these economic prots will fade away over time when the industry reaches its long-run equilibrium. We do not recommend you to shut-down your production in this quarter as some of your competitors did if you want to minimize your loss. Task 9 Government intervention in competitive markets For Paradise Island, the demand and supply functions in the market for bread have been estimated as D ( p) = 600 S( p) = 40p. Since in the currently prevailing unregulated market equilibrium the price of a single unit of bread is rather high, the government plans to prevent excessively high prices of bread by imposing a price ceiling. After a lengthy discussion about which price ceilings affect the market price and which do not, the government implements a law prohibiting the sale of a unit of bread at a price above PI-$6. The government is extremely proud of its courageous regulation policy and decides to ask a research agency to quantify the change of the economic surplus. At the same time the government wonders why it receives plenty of complaints of consumers that are ready to buy bread at $6 but nd themselves unable to do so. As a response to the result of the ordered research report and continuing consumer complaints, the government abolishes the price ceiling. Task 10 Taxation The notorious government of Paradise Island plans to raise its tax revenue by introducing a quantity tax into the pizza market. It defends its policy by arguing that junk food is unhealthy and less pizza should be consumed. According to the implemented tax law, every single pizza 17 10p,

seller has to pay PI-$5 to the government for each pizza sold. Since 20.000 pizzas were sold in the absence of taxation, the government estimates the tax revenue to equal T = $100.000. In the press and on TV, there is much lobbyism against the proposed taxation scheme on the basis that the government tax leads the pizza price to double. The demand and supply schedules have been estimated as D ( p) = 30, 000 S( pn ) = 4000pn where p is the market price that a buyer pays for a pizza and pn is the net price that the seller receives after subtracting any taxes. After the government introduced the tax, it wonders that its revenue is somewhat lower than expected. In addition, economists claim that there is a hidden cost of taxation due to price distortions that the government completely ignored. Task 11 Monopoly: Appetizer Consider the industry underwater housing. Since the construction of apartments in the sea is quite involved, there is only a single supplier with the necessary technical expertise in the market: FishyApartments. The cost function of the rm is given by (in Mio. EUR) C (y) = 3y2 + 10y and the rm faces the demand function y( p) = 25 0.5p 2, 000p

where the price level p is measured in Mio. EUR. The rms CEO boldly claims at the latest Stockholder Meeting: Economics is not useless in running a business. All I ever learnt is to simply equate the market price to marginal cost. If I did that, our company made a loss. In contrast, I am proud of the prot FishyApartments enjoys which results from my personal reasoning to equate marginal cost to the price plus a mark-up that amounts to 800% of price (hint: p + 8p). I fully deserve my bonus. Then he adds, I always try to ensure that the company operates at a point on the demand curve that is inelastic. At the end of the meeting the CEO wondered why the majority of stockholders forced him out of ofce. Task 12 Monopoly: Welfare Loss Suppose that the high-risk start-up ArticialOrgans has been successful in the development of articial hearts that can perfectly substitute human ones. Since ArticialOrgans patented some of the key production processes and no other production technologies are yet available,

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it is a monopolist in this innovative market. The rms total cost function of daily production is given by C (y) = 8y where y is the output of the rm and total costs is measured in 1000s. The daily demand for articial hearts is assumed to be D ( p) = 20 where p is the price level that is measured in 1000s. There is a erce ght on the companys management board: some members prefer to choose the welfare maximizing production level due to ethical reason, others prefer to choose the prot-maximizing solution in order to recover R&D costs of investors that are sunk at this point in time. They argue that only prots ensure that there is a continuing inow of R&D investment in future. Task 13 Applied Game Theory: Strategic behavior of OPEC In the face of the oil price evolution during September and October 2006, the organization of oil producing countries (OPEC) announced on Oct. 20, 2006, that it decreases its production by an amount of 1.2 million barrel per day. This joint decision to cut production requires that each oil producing country that is part of the OPEC substantially decreases its daily production level. Experts have mixed opinions about the production level that the OPEC is expected to implement. Some of them believe that the trust between OPEC-members is sufcient to implement this agreement. Others believe that each member faces a dilemma due to available free-riding options that reect in dominant strategies. Task 14 Bertrand Oligopoly There are two rms without capacity constraints in the market for diving eyeglasses in Atlantis. Customers in this market consider the products of these rms to be homogeneous. As it happens, the production cost for each eyeglass is independent of the number of produced eyeglasses, the same for both rms, and given by Atlantis-$15. Buyers prefer to buy from the rm that charges the lowest price. In case of equal prices, buyers ip a fair coin to decide where to buy. Does this scenario constitute a game? What is the market price in Atlantis? How many Nash equilibria are there? Does the outcome differ from that in a Cournot Duopoly?
For experts only: If you are up to a challenge, consider a market analogously to the one described but with three identical rms. How many Nash equilibria exist? Characterize all of them, including the prevailing market price!

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Task 15 Cournot Oligopoly: Theory and Experiment Huck, Mller and Normann (2001) investigate the explanatory power of the Cournot model of oligopoly and compare its theoretical prediction to experimental data. They study a model with two rms that face the linear inverse demand function p( Q) = maxf30 linear and given by Ci (qi ) = 6qi where i = 1, 2. The experimental evidence also sheds light on the stability of collusive behavior of rms (cartels). Furthermore, the paper investigates the Stackelberg oligopoly in the same theoretical setting. The reference of the paper is Huck, Mller and Normann (2001): Stackelberg beats Cournot: On Collusion and Efciency in Experimental Markets, Economic Journal 111(Oct.), 749-765. Task 16 Decision Making under Uncertainty Eefje Boonen sells apartments and she has to choose between two job offers. FishyApartments pays her according to sales performance: To keep things simple, suppose that Eefje faces just three annual income possibilities. In a good year, she sells many apartments and receives 400,000 EUR. In a bad year, she earns nothing. In any other year, she receives 200,000 EUR. Each outcome is as likely as any other. SunshinePlaces pays her a at wage of 200,000 EUR independent of her sales performance. Eefje seeks to maximize the expected value of her income. Which job offer does she accept? What is the role of risk aversion in this setting? Task 17 Agency Theory The company ElectionPrediction sells predictions about upcoming elections to the media. For that, it relies on calling center agents that randomly call individuals by phone in order to assemble a sample of intended votes. Focus on a representative agent. Suppose the company is paid an amount of p for each intended vote in the sample. Each phone call leads to an intended vote such that x is the number of phone calls that the agent places and the number of intended votes generated by the agent. The more phone calls the agent places, the more disutility he suffers. His utility function is given by u(w, x ) = w x2 where w indicates his wage. The company offers the agent a contract. A contract fw, x g consists of the agents wage and the number of calls that he has to place. Due to time restrictions, the agent cannot place more than x phone calls. industry output is the sum of individual rm output, Q = q1 + q2 . Firm is cost function is Q, 0g where

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Scenario 1: The company is perfectly informed about the number of phone calls that the agent places. The agent is a slave and has no choice but to follow the contract fw, x g. In particular, the agent cannot opt out. Use an indifference curve analysis in contract space to indicate the prot-maximizing contract that the company ElectionPrediction offers the agent. Scenario 2: The company is perfectly informed about the number of phone calls that the agent places. The agent is no slave and does not accept a contract that leads to a utility index smaller than 0. In other words, the agent does not accept contracts leading to negative utility. Conduct an indifference curve analysis and identify the prot-maximizing contract. Scenario 3: The company is not informed about the number of phone calls that the agent places. For that it has to rely on the agent. Not every phone call is successful. In order to ease the introduction of uncertainty, assume that for each given number of phone calls x, nature chooses the share s of them that lead to an intended vote with equal probability (density), 0 chosen? Task 18 Macro Concepts You hear about terms like nominal GDP, real GDP, ination, consumer spending, and unemployment on a daily basis in the news. However, many people only have a rather vague idea about these concepts and how they are measured. Task 19 The Keynesian Cross The following statement relates to the benets of scal policy: Everyone seems to agree that government spending must increase in order to pull the economy from the grip of the deepest economic downturn since the Great Depression. Especially spending on infrastructure, health care, scientic research and clean energy development could be very helpful in the short-run to keep existing jobs, create new jobs and replace lost spending of consumers and businesses in the current economic environment. One famous example of a recent measure taken in, e.g., the UK and Germany, is the vehicle discount scheme (or scrappage scheme) that applies to the subsidized purchase of a new car in return for scrapping a very old car. The Keynesian Cross is a simple macroeconomic model that allows to study the effects of scal policy. There are multipliers. To x ideas suppose that in an economy with no international trade, the aggregate consumption function is linear and depends on disposable income 21 s 1. What happens if a utility-maximizing agent receives a at wage? What could be a fruitful alternative to the inefcient outcome if a at-wage contract is

where autonomous consumption is Caut > 0 and the marginal propensity to consume is c with 0 < c < 1. Further, I is xed and the government selects G and T. (Numerical example: Caut = 200, s = 0.25, I = G = T = 100.) Task 20 Quantity Theory In our all-round economy, the village Atlantis being at the moment a 7-good-economy, the following transaction information was collected for 2009: goods cornakes orange juice chocolate digital organizers mobile phones tobacco sandwiches price [$] 1 2 3 200 100 2 4 number of sold units 20,000 100,000 350,000 2,000 1,000 200,000 160,000

The monetary supply in that economy consists of 123,500 $1-notes. How many times did a typical dollar change hands in 2008? Find nominal GDP for 2008 and use it to calculate the velocity of money. If an economys growth rate is -1%, its money stock growth equals 1.5%, and the income velocity of money decreases by 0.5% over time, what is its rate of ination using the quantity theory as a theory of ination? If nominal interest is 5% what is the real rate of interest.

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Exam Examples

Example X 1 Game Theory Airbus and Boeing consider offering super-jumbo jets. Each rm has to decide to either offer a long-distance jet of super size or not to introduce it. Expected prots depend on the entry decision by each rm and are summarized as follows: Boeing yes Airbus yes no -50, 25 60, 70 no 80, 90 70, 150

(payoffs: Airbus, Boeing)

a) Suppose the game is played simultaneously. Find all Nash equilibria; for each equilibrium show why it is a Nash equilibrium. b) Suppose the game is played sequentially such that Airbus moves rst. Draw the extensive form of this game. Consider the strategy combination such that Boeing matches Airbus behavior (i.e. Boeing enters if Airbus enters and Boeing does not enter if Airbus does not enter) and Airbus does not enter. Why is this strategy combination a Nash equilibrium? Is it a reasonable prediction for the outcome of the game? c) Consider the sequential game discussed in part (b). Briey explain backwards induction and use it to identify the path of play in the subgame-perfect Nash equilibrium and relate your result to your solution of part (b). Example X 2 Market Equilibrium Consider the market for ounders (a sort of sh). The demand function in the northern part of the country is given by DN ( p) = 4000 1000 25p while that in the southern part is DS ( p) = 25p. The supply function is S( p) = 50p and p is the Euro price per kg of ounders.

a) Find the joint demand curve for ounders and calculate the market equilibrium in terms of price and quantity and sketch it into a market diagram. b) Find the price elasticity of demand and supply in the market equilibrium. Interpret both numbers very briey. c) Suppose additional suppliers of ounders enter the market. What happens qualitatively to the market equilibrium? Provide a sketch of a new market diagram that illustrates market effects. 23

d) Suppose additional demanders of ounders enter the market along with additional suppliers. What happens qualitatively to the market equilibrium? Provide a sketch of a new market diagram that illustrates market effects. Example X 3 Optimal Choice Suppose that Ronald faces the budget constraint m
0.5 tion is given by u( x1 , x2 ) = 2x1 x2 .

p1 x1 + p2 x2 and that his utility func-

a) Sketch 2-3 indifference curves. Find the marginal rate of substitution between goods 1 and 2 and identify the utility-maximizing consumption bundle if p1 = 1, p2 = 2, and m = 15. Provide a sketch of the optimal consumption bundle. b) Suppose the price of good 2 drops by 50%. Find the new optimal consumption bundle and illustrate geometrically. Example X 4 Government Intervention Consider the market for designing websites. The demand function is D ( p) = 2500 where p is the price per webpage. The supply function is S( p) = 45p. a) Compute the market equilibrium in terms of price and quantity and indicate it in a market diagram. b) The government is crazy about protecting start-up businesses and introduces a price oor of 30 EUR, thereby banning the sale of webpages at any price smaller than 30 EUR. Compute the new market equilibrium under this form of regulation and nd the excess supply of webpages in the new equilibrium. c) Compute the deadweight loss due to the price oor and illustrate it in a new market diagram. d) Forget now about the price oor. Instead, the government imposes a quantity tax on sellers. For each webpage sold, sellers have to pay 5 EUR to the government. Compute the market equilibrium under taxation. Compute governments tax revenue and the welfare loss. Provide a geometric illustration of the market equilibrium under taxation where also the welfare loss is indicated. Example X 5 Monopoly Monopolist Milramia is faced with cost function C (q) = 40q2 where q is the level of production. The market demand is D ( p) = 300 p. 24 80p

a) Find the rms marginal cost and marginal revenue function. b) Calculate the prot-maximizing production level and the price that it charges in the prot maximum. Furthermore, nd the rms maximum prot and calculate economic surplus. c) What is the market equilibrium, ie. price and quantity, that a social planner chooses? d) Illustrate the welfare loss in the case of a monopoly geometrically and calculate it. Example X 6 Expected Value and Search for Bargain Prices Brian is risk-neutral and plans to buy a MP3-player. His reservation value for a wellfunctioning player is 80 EUR independently of the model. His reservation value for broken players is 0 EUR. a) Brian considers buying the MP3-player on the black market where no guarantee is given so that he cannot return the player if he nds out that it is broken. Three models are offered for sale differing in the probabilities of breaking down. With a probability of 80%, 70%, and 60% models A, B, and C work properly. They are priced at 70 EUR, 50 EUR, and 30 EUR respectively. Compute the expected value of either purchase and indicate Brians optimal consumption choice. What does a negative expected value mean in this context? b) Brian decided not to purchase on the black market. Instead he considers to buy at a store at High Street. Prices charged differ across stores. In particular the chance to nd an MP3-player priced at 40 EUR, 60 EUR, or 80 EUR is 25%, 50%, or 25%, respectively. Unfortunately nding out prices requires visiting the store which leads to a cost of 5 EUR per visited store. Suppose Brian already identied a store that charges 60 EUR. Should he continue searching for a price of 40 EUR? c) Suppose Brian is faced with the situation as given in part (b) of this problem. What is the search cost that makes him indifferent between continuing to search for a low price and stopping search if he only identied a seller charging a price of 80 EUR?

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Example X 7 Keynesian Cross Consider a closed economy that can be described by the Keynesian Cross. The marginal propensity to consume is 0.6, government spending is G = 200, and investment is I = 150. The consumption function of households is linear and depends on disposable income with taxes T = 0 and autonomous consumption equal to 250. a) Find households consumption function. Derive the marginal propensity to save and interpret it in a single sentence. b) Find aggregate demand and equilibrium output. Illustrate the equilibrium geometrically. c) Suppose the government increases spending by 100 ceteris paribus. Find the government spending multiplier and new equilibrium output.

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