Microeconomics Re-exam 2015-01-26 Page 1 of 12

Microeconomics Re-exam
2015-01-26
Answers
Multiple choice section

Question 1-1

One reason the EU governments might subsidize research of an alternative to crude-oil based
gasoline?

A. More substitutes will reduce the price of crude-oil based gasoline for the EU.
B. More substitutes will increase the EUs demand elasticity of crude-oil based gasoline.
C. More substitutes will reduce the impact of supply shocks on the price of crude-oil based
gasoline in the EU.
D. Any or all of the above.

Answer: D. Developing substitutes are likely to both flatten the demand curve (B) and shift
demand down (A), and, as a consequence of B, also reduce any supply shocks or shifts in the
supply curve (C).

Question 1-2

If the supply curve for orange juice is estimated to be Q = 40 + 2p, then, at a price of p=2, the price
elasticity of supply is

A. 0,01
B. 0,09
C. 1
D. 11
2
Answer: B. = =2 = 0,09.
40+22

Question 1-3

A perfect price discriminator

A. charges each buyer their reservation price.

B. charges different prices to each customer based upon different costs of delivery.
C. generates a deadweight loss to society.
D. charges lower prices to customers who buy greater quantities.

Answer: A. That is the definition of perfect price discrimination.

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Question 1-4

All else held constant, as the variance of a payoff increases, the

A. expected value of the payoff increases.

B. risk of the payoff increases.
C. risk of the payoff decreases.
D. expected value of the payoff decreases.

Answer: B. Risk measures the variability in payoff. Higher variability means higher risk.

Question 1-5

The figure shows Bobby's indifference map for soda and juice. 1 indicates his original budget line
and 1 his original indifference curve. 2 indicates his budget line and 2 the indifference curve he
can now reach, resulting from a decrease in the price of soda. What change in quantity best
represents his substitution effect?

A. 10
B. 18
C. 28
D. 54

Answer: B. The substitution effect arises from a change in the relative prices of soda and juice (a
shift in the slope of the budget line), causing a move along the original indifference line I1 from
point e1 to the middle point in the figure (from 36 to 54 on the horizontal axis). The income effect
then arises from the fact the subsequent outward shift of the budget line reflecting that the drop in
the soda price allows him to buy more soda and juice (to point e2).

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Question 1-6

Electricity accounts for almost 20% of the cost of making steel. A 10% increase in electricity prices
results in steel firms decreasing production and thereby demanding 5% less electricity. Over many
years, technological innovations can change the way steel firms make steel and reduce the
industry's energy requirements. This suggests that the steel industry's short-run elasticity of
demand for electricity is probably

A. less than its long-run elasticity of demand for electricity.

B. less than one in absolute terms in the short run.
C. Both A and B above.
D. Neither A nor B above.

Answer: C. The long elasticity of demand is higher since steel industry will have more alternatives
available. The short-run elasticity is 5%/10%=0,5 which is less than 1. Hence the answer is C.

Question 1-7

Suppose the demand curve for a good is downward sloping and the supply curve is upward
sloping. At the market equilibrium, if demand is more elastic than supply in absolute value, a 1
specific tax will raise the price to consumers by

A. 0,50 .
B. 1 .
C. more than 0,50 .
D. less than 0,50 .

Answer: D. The largest share of the tax falls on the side of the market with the lowest elasticity.
Given that neither supply nor demand is completely inelastic or infinitely elastic, they will both pay
some of the tax, with the supply side paying more than half, so consumers will pay less than half.

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Question 1-8

Airline B
Enter Dont enter

-20 0
Enter
10 50
Airline A
40 0
Dont
enter
0 0

The above figure shows the payoff to two airlines, A and B, of serving a particular route. If the two
airlines must decide simultaneously, which one of the following statements is true?

A. The outcome of the game is unpredictable.

B. Neither firm entering is a Nash equilibrium.
C. Airline B has a dominant strategy.
D. Airline A has a dominant strategy.

Answer: D. Regardless of what B does, it is always better for A to enter. If A does not enter it gets
0 whether or not B enters. If A enters it gets 10 if B also enters and 50 if B does not both better
than 0. B does not have a dominant strategy since it is best for B not to enter if A does (0 vs. -20),
whereas it is best for B to enter if A does not (40 vs. 0). This rules out C. If neither firm enters,
either of them would be better of to change their strategy and enter, so this cannot be a Nash
equilibrium. This rules out B. Since A has a dominant strategy, it will always enter, which means B
is better off not, so the top left cell is the predicted outcome of the (non-cooperative) game, which
rules out A.

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Question 1-9

The above figure shows the cost curves for a competitive firm. If the firm is to earn economic profit,
price must exceed

A. 0
B. 5
C. 10
D. 11

Answer: C. Economic profits is revenue (quantity times price) less total cost. Dividing this by
quantity we get that per-unit economic profit is price less average (total) cost. In order for this to be
positive, price must exceed the minimum average cost, or 10.

Question 1-10

In the automobile insurance market, adverse selection occurs when

A. insured drivers drive recklessly.

B. drivers with greater risks buy a policy with a large deductible (selvrisiko).
C. drivers with greater risks buy a policy with no deductible (selvrisiko).
D. uninsured drivers drive recklessly.

Answer: C. Adverse selection arises when insurance companies cannot distinguish risky from less
risky drivers. Drivers who drive recklessly are likely to purchase insurance policies with no
deductible (since they are likely to have more accidents and know this to be the case.) This makes
these policies disproportionately more expensive for drivers who drive carefully.

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Question 1-11

At Joey's Lawncutting Service, a lawn mower cannot cut grass without a laborer. A laborer cannot
cut grass without a lawn mower. Which graph in the above figure best represents the isoquants for
Joey's Lawncutting Service when capital per day is on the vertical axis and labor per day is on the
horizontal axis?

A. Graph A
B. Graph B
C. Graph C
D. Graph D

Answer: A. A laborer and the lawn mower are perfect complements, which is represented in Graph
A. Graph C represents the case of perfect substitutes. Graph D is not possible since isoquants
are never outward bending like shown. Graph B represents the usual case of less than perfect
substitutes.

Question 1-12

In the case of a good that has no exclusion and no rivalry, private markets fail because

A. of free-ridership
B. profit is driven down to zero.
C. the quantity produced will exceed the social optimum.
D. this is a natural monopoly.

Answer: A. A non-exclusive, non-rival good is also known as a public good. Because providers of
the good cannot prevent people from using it, people will use it without paying for it (free ride), so
there is too little incentive for firms to provide the good compared to the social benefit it provides,
leading to under-supply of the good.

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Question 1-13

Which of the following is least likely to be considered a capital input?

A. A computer.
B. A tractor.
C. A sewing machine
D. A ten euro bill.

Answer: D. Capital inputs means use of production capital such as machines, equipment,
infrastructure, etc., not financial capital such as money.

Question 1-14

If you place 100 in a bank account that pays 6% at the end of each year, and you leave your 100
and all your interest in the bank, how much will you have in the bank at the end of 7 years with
annual compounding?

A. 7 106
B. 1067
C. 100 1,607
D. 100 1,067

Answer: D

Question 1-15

A firm should shut down production if its revenue is

A. less than its avoidable costs.

B. less than its average fixed costs.
C. declining.
D. less than its total costs.

Answer: A.

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Analytical section
Assume that the housing market in Copenhagen can be characterized by the following supply and
demand curves:

= 1.000 10,

= 10 200.

The curves have been drawn in the diagram below, with the demand curve in blue and the supply
curve in red. In the following, you may use equations or refer to the diagram (explain using the
labels A, B, etc.) to make your calculations. Please provide numerical answers to all questions.

Question 2-1

What is the competitive equilibrium quantity and price of in the absence of regulation.

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Answer: Competitive equilibrium is where the demand and supply curves cross, i.e., =
1.000 10 = 10 200 1.200 = 20 = 60 and = = 1.000 10 60 = 400.

This can also be read off the figure as point H.

Question 2-2

Now suppose that the government imposes rent control, in the form of a maximum price of housing
of = 50 (the purple line in the figure). What is the quantity demanded and supplied at this price.
What is the excess demand?

Answer: The price is now = 50, so the quantity demanded is = 1.000 10 50 = 500 and the
quantity supplied is = 10 50 200 = 300. Hence the excess demand is 500 300 = 200.
These numbers could also be found as the points K and M in the figure.

Question 2-3

What is consumer surplus and the producer surplus in the competitive equilibrium without rent
control?

Answer: The consumer surplus is the area below the demand curve and above the price, up to the
quantity purchased, i.e., the triangle AFH, which has area 400 (100 60)2 = 8.000. The
producer surplus is the area below the price and above the supply curve, or the triangle DFH,
which has area 400 (60 20)2 = 8.000.

Question 2-4

What is the consumer surplus and the producer surplus in the market with rent control?

Answer: The consumer surplus is the area below the demand curve and above the price, up to the
quantity purchased, i.e., the figure ACKJ, which has area ((100 50) + (70 50)) 3002 =
10.500. The producer surplus surplus is the area below the price and above the supply curve up to
the quantity sold, i.e., the triangle DJK, which has area (50 20) 3002 = 4.500.

Question 2-5

What is the deadweight loss (the loss in total surplus generated by the market) as a result of the
regulation?

Answer: From the previous two questions, we see that the total welfare (consumer plus producer
surplus) falls by (8.000 + 8.000) (10.500 + 4.500) = 1.000. This can also be seen as the the
triangle CHK, which has area (70 50) 1002 = 1.000.

Question 2-6

Sometimes when there is excess demand in a market due to regulation, a black market may form.
In fact this happens in real rent-controlled housing markets, including Copenhagen, where
suppliers of housing receive under-hand payments from consumers in various ways. What is the
highest price that could form in such a black market? (Hint: assume the black market does not
lead to any increases in supply. What price would buyers be willing to pay?)

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Answer: If there is no increase in supply as a result of black-market prices, the amount supplied
will remain what it was before, i.e. = 300 (point K in the figure). This output corresponds to point
C on the demand curve, i.e., buyers could potentially bid black-market prices up to this point, i.e.
= 70.

Question 2-7

What might be reasons that black-market prices ends up being less than your answer to the
previous question?

Answer: First, given that such black market practices are illegal, it is unlikely that all consumers
would be willing to pay that much due to the risk of being caught and the resulting sanctions,
including losing their apartment. Second, a black market might induce an increase in supply as
suppliers receive a higher effective price for their housing. It may also involve renting out rooms
that are not legally fit for living such as attics, basements, or garages. This would cause a
rightward movement along the demand curve, lowering black-market prices somewhat.

Alice is going on vacation and is bringning a suitcase that is worth 1.000 DKK. She knows that
there is 20% chance that the suitcase will be lost or stolen on the trip. She is considering buying
an insurance policy for the suitcase.

The figure above shows Alices utility function. Values of the function are also provided in the table
below the figure.

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Question 2-8

What is Alices expected value if she does not buy insurance?

Answer: 0 0,2 + 1.000 0,8 = 800.

Question 2-9

What is Alices expected utility if she does not buy insurance?

Answer: (0) 0,2 + (1.000) 0,8 = 0 0,2 + 100 0,8 = 80.

Question 2-10

What is the fair price of an insurance policy for the suitcase (the one that a risk neutral insurance
company would be willing to provide).

Answer: The expected cost to the insurance company is 0,2 1.000 + 0,8 0 = 200, so the fair
prise is 200.

Question 2-11

How much is Alice willing to pay for the insurance?.

To find this, we need to find out what amount of certain value that would have the same expected
utility as the case without insurance that we considered above, i.e., the value for which () =
80. We see that (700) = 80, so this would be = 700. So she would be willing to pay 1.000
700 = 300 for the insurance policy.

Discussion section
Question 3-1

Over the years, Greece has accumulated an enormous amount of debt to other EU countries and
in 2010 it became clear that the government would not be able to service its debt. In order to
prevent the country from going bankrupt, a troika consisting of the International Monetary Fund,
the European Central Bank, and the Eurozone countries, provided several bail-out packages,
loaning Greece extra money. However, they also forced forced Greece to accept an austerity
program with strict limits on public sector spending, higher taxes, and lower wages, and less
attractive pensions for public-sector employees. These measures are immensely unpopular
among regular Greeks and have led to wide hostility towards the EU financial sector. The leading
candidate in the coming elections, Alexis Tsipras, has threatened to default on the debt and leave
the Eurozone altogether. He and others have called for the EU to forgive Greeces debt so that the
country can get a chance to get out if the current depression.

EU financial policy makers are strongly against the idea of debt relief because it creates a Moral
Hazard problem. Explain the logic of this argument.

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Answer: A moral hazard arises when an action of one party results in a situation where the other
party has an incentive to change their behavior after the action has been taken. In this case, if the
the EU forgives the debt, both Greece and other countries potentially in the same situation, such
as Spain, would have an incentive to engage in reckless economic behavior (excessive public
spending etc.) because they know that the EU will eventually come to their rescue and forgive the
debt.

Question 3-2

Economists frequently make simplifying assumptions about the behavior of consumers and firms.
For instance, they assume that consumers maxize their utility and act rationally when making
their purchasing decisions, and that firms maximize the profits. Models based on these
assumptions are then used to generate testable propositions about prices, quantities, etc.

Yet empirical studies also show that the assumptions are frequently not correct: Consumer
decisions are affected by biases and errors and firms do not necessarily maximize profits. Does
this mean that economic models based on these assumptions are wrong and should not be
used? Discuss this question and the role of models in economics.

Answer: No. Models are inevitably simplifications of the real world and therefore by their nature
always wrong in some sense. The relevant question is whether they can generate predictions
that are better than the alternative, and whether these predictions can be tested with actual data so
that one may improve the models over time to generate more accurate predictions for policy
making.

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