Microeconomics Honors Exam

The Tale of Cookie Monster, Harvard Class of 2013

Solutions
NOTE: Each question is worth 25 points and can be completed without
completing the other three questions.
1. Cookie Monster gets a job as an analyst at Goldman Sachs. He used to like
cookies, but now Cookie Monster only likes coffee and leisure. His utility
function is

u ( c , l )=c1 /2 l 1/ 4

where c is cups of coffee and l is hours of

leisure. Coffee costs $4 a cup. Cookie Monster has H hours to allocate

between work and leisure, and he earns $40 for each hour he works.
a. (5 points) Express Cookie Monsters maximization problem, including
budget constraint.
Cookie monster must solve
1

max c 2 l 4
s .t . 4 c=40( Hl)
The amount of coffee he consumes must be equal to his income.
b. (10 points) Solve for the optimal consumption of coffee and leisure as a
function of hours H.
Substituting in the budget constraint gives
1
2

max (10 ( Hl )) l

1
4

Solving gives

1
l= H
3

Cookie monster works for

Working

20
H
3

2
H
3

2
H
3

and consumes

gives him income

cups of coffee.

80
H
3

1
H
3

as leisure.

which allows him to afford

c. (5 points) Suppose Cookie Monster suddenly realizes he no longer

needs sleep and H increases. What happens to his consumption of
coffee? (Assume that the change in the need for sleep and any change
in consumption of coffee are unrelated except through the change in
H.) Is coffee a normal good, an inferior good, or neither?
Since Cookie Monster consumes

20
H
3

cups of coffee, his coffee

consumption will increase as H increases. Thus, coffee is a normal

good.
d. (5 points) Are coffee and leisure complements, substitutes, or neither?
Explain.
Neither. A change in the price of leisure or coffee has no effect on the
allocation of hours between work and leisure.
2. Cookie Monster decides to celebrate his Saturday night off by taking his
girlfriend, Pie Monster, out for dessert. They can either go out for cookies or
for pie. While Cookie Monster and Pie Monster are debating on the phone
whether to meet at the cookie store or the pie store, Cookie Monsters cell
phone battery dies. Thus, both must decide where to go without having
agreed on where to meet. Both Cookie and Pie Monster know that the utility
for each from each option
is as follows:

Cookie
Monster

Cookies
Pie

Pie Monster
Cookies
Pie
4,2
0,0
0,0
2,4

a. (5 points) Find all pure strategy Nash equilibria of this game.

There are two pure strategy NE: (cookies, cookies) and (pie, pie).
b. (5 points) Are there any mixed strategy Nash equilibria? If so, find
them. What is the expected payoff to each player in each mixed
strategy Nash equilibrium (if there are any)?
There is one mixed strategy Nash equilibrium. Each player will mix to
make the other indifferent between his or her two strategies. Let p be
the probability that Cookie Monster picks cookies and q the probability
that Pie Monster picks cookies. Then we must have

2 p=4 (1 p)

4 q=2(1q)
The equilibrium is for Cookie Monster to choose cookie with probability

2
3

1
3 . The

and for Pie Monster to choose cookie with probability

payoff to each of Pie Monster and Cookie Monster is

4
3

c. (10 points) Cookie Monster and Pie Monster both remember an

agreement they made long ago: if they got in a fight that they could
not resolve, Cookie Monster would win if the lights on top of 30
Rockefeller Plaza are blue, and Pie Monster would win if they are red.
Both decide independently that if the lights are blue, they will go to the
cookie store and if the lights are red they will go to the pie store.
Before they look at 30 Rock, they know that the probability of the lights
being blue is and the probability of red is . What is the expected
payoff of this coordination strategy?
They will pick (cookie, cookie) with probability half and (pie, pie) with
probability half. The expected payoff is (3, 3). Given that the other
player is playing this coordinated equilibrium, each player has no
incentive to deviate.
d. (5 points) If a mixed strategy equilibrium exists, is the payoff in c)
larger, smaller, or the same as the payoff in b)? Provide intuition why.
It is larger. The coordination device (the lights) eliminates the outcome
that Pie Monster and Cookie Monster end up going to different places.
3. Cookie Monster decides he no longer wants to work in investment banking, so
he gets a job as the assistant to the CEO of a private equity firm. The CEO is
a very busy person with a lot of money. She has 5 hours of leisure per week
and $5000 to spend on consumption. Cookie Monster, on the other hand, has
no money and lots of leisure time. He is endowed with $10 and 20 hours of
leisure per week. The utility function of the CEO is
and the utility of Cookie Monster is now

U CEO ( c ,l ) =( l5 )
2/5

U CM ( c ,l ) =8 l c

hours of leisure per week and c is consumption.

3 /5

where

1 /2

1/2

is

a. (5 points) Suppose Cookie Monster gets paid wage w. Solve for the
CEOs demand for hours of labor from Cookie Monster as a function of
w.
Let h be the hours of labor demanded from Cookie Monster by the CEO.
The CEO solves

max ( l5 )1 /2 c 1/ 2
s.t.

c=5000h w

l=5+h
Substituting in gives

max ( h )1 /2 (5000h w)1/ 2

h=

5000
2w

b. (5 points) Solve for the supply of hours of labor by Cookie Monster as a

function of w.
Let s be the hours of labor supplied by Cookie Monster. Cookie Monster
solves
2

max 8 l 5 c 5
s.t.

c=10+ s w

l=20s
Substituting in gives
2

max 8 ( 20s ) 5 ( 10+ s w )5

s=12

4
w

c. (5 points) Solve for the equilibrium wage rate by equating Cookie

Monsters supply function with the CEOs demand. How many hours
will Cookie Monster supply to the CEO at this wage? How much money
will Cookie Monster earn?
Setting supply and demand equal gives the condition

4 5000
12 =
w 2w

626
3

Plugging this in to the supply function gives

s=h=12

4
12
=12
=11.98 hours
626
626
3

11.98

hours626
=$ 2504
3

d. (5 points) Sketch an Edgeworth box in consumption-leisure space.

Indicate the initial endowments (1 point) and the competitive solution
(1 point). Sketch indifference curves for both the CEO and Cookie
Monster through the initial endowments (1 point each) and shade the
region in which there are gains from trade (1 point).
Leisure

25
Initial

Competitive

5010

Consumption
e. (5 points) After beginning work for the CEO, Cookie Monster discovers
that the CEOs mood is also a function of the performance of her
investment portfolio. Her utility is given by

U CEO ( c ,l ) =( l5 )1 /2 c 1/2 +

s p
1000

where s&p is the S&P 500 at the start of

business. How does this change the answers to sections a through d?

This will have no effect on the supply or demand of labor and thus no
effect on the answers in a) through d).
4. In his newly-found free time, Cookie Monster decides to start a business
making caffeinated cookies to sell to his friends who work at Goldman Sachs.

The total cost of making q cookies is

caffeinated cookies is

TC=50+0.5 q

. The demand for

p=100q

a. (5 points) Graph the demand curve for caffeinated cookies. Label both
axes.
b. (5 points) Compute the equilibrium price, quantity, and Cookie
Monsters profits.
Find the equilibrium quantity by setting marginal revenue equal to

q
100 q

marginal cost. Total revenue is given by

revenue is

q=

1002 q . Marginal cost is q. Setting these equal gives

100
3 . The equilibrium price is

profits are

and marginal

p=

200
3 . Cookie monsters

TRTC =100 q501.5 q2=100

100
100 2
501.5
=$ 1,616.67
3
3

c. (5 points) Cookie Monster finds cheaper caffeine powder to use in his

cookies. His total cost function is now

TC=50+0.25 q2 . Re-do b) with

this new cost function. How is Cookie Monsters profit affected by this
change in costs?
Total revenue and marginal revenue are unchanged. Marginal cost is
now .5 q. Setting these equal gives

p=

q=

200
5 . The equilibrium price is

100
5 . Cookie monsters profits are

TRTC=100 q501.25 q2=100

200
200 2
501.25
=$ 1,950.
5
5

Cookie

Monsters profits increase.

d. (10 points) To improve public health, Mayor Michael Bloomberg
imposes a $25 tax on each caffeinated cookie sold in New York City.
Solve for the new equilibrium price and quantity of cookies using the
cost function from parts a) and b). How does this tax affect Cookie

Monsters profits? What is the tax revenue for the city from Cookie
Monsters cookie business? What is the deadweight loss from the tax?
The tax implies that the price paid by consumers is not equal to the
amount received by cookie monster. Let p be the amount received by
Cookie Monster for each cookie and p=p+25 be the price faced by the
consumer. Then demand is given by

p=75q

Costs are unaffected. Total revenue is given by

marginal revenue is
equal gives

q
75 q

and

752 q . Marginal cost is q. Setting these

q=25 . The equilibrium price is

p=50 . Cookie

monsters profits are

TRTC=75 q501.5 q2=75( 25)501.5 ( 25 )2=$ 887.50 .

Cookie

monster loses $729.16 in profits. The city gets tax revenue of 25*

25=$ 625 . The loss in consumer surplus is $243.06. The deadweight

loss is $347.22.