Intermediate Microeconomics

Semester 1, 2018
Final Examination: Solutions

Section A: There are TEN multiple-choice questions in this section. Answer

all questions using the response sheet. The response sheet should be inserted
in the back of the examination script book at the end of the examination. [20
marks]

Question A1:

[2 marks] Suppose that a consumer has preferences over two goods: X1 and X2 . Let the
price of X1 be P1 , the price of X2 be P2 , and let this consumer’s income be I. Her budget
line is illustrated by the line B1 above. Now suppose that the prices of both goods remain
unchanged and her income changes to kI, where k > 1 is a constant. What effect will
this have on the budget line B1 above?

(a) the budget line will shift out with no change in the slope.

(b) the budget line will shift in with no change in the slope.

(c) the budget line will shift in and the slope will decrease.

(d) the budget line will shift out and the slope will decrease.

(e) the budget line will remain unchanged.

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Solution: Given that prices have not changed, we know that the slope of the budget line
will also not change. Thus, we can rule out options (c) and (d). With k > 1, we know
that this consumer’s income has increased. This means that the consumer’s budget line
will shift out. It follows that the correct answer here is (a).

Question A2:

[2 marks] Suppose that a consumer has preferences over two goods: X1 and X2 . Let
the price of X1 be P1 , the price of X2 be P2 , and let this consumer’s income be I. This
consumer’s budget constraint is

P1 X 1 + P 2 X 2 = I

Suppose that this consumer chooses to devote her entire income to the consumption of
X2 . What is the maximum amount of X2 she can consume?

(a) I/P1 .

(b) I/X1 .

(c) P2 /P1 .

(d) I/P2 .

(e) I/X2 .

Solution: If this consumer devotes her entire income to X2 , we know that it will be the
case that X1 = 0. Substituting this in to the budget constraint above yields

P2 X 2 = I

or
I
X2 =
P2
Thus, the correct answer here is (d).

Question A3:

[2 marks] Suppose that an individual is considering an investment in which there are

three possible outcomes. Outcome 1 yields a payoff of $100 and has a 30% chance of
occurring. Outcome 2 yields a payoff of $50 and has a 50% chance of occurring. Finally,
outcome 3 yields a payoff of −$150 and has a 20% chance of occurring. What is the
expected payoff of this investment?

(a) −150.

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(b) 100.

(c) 25.

(d) 50.

(e) 0.

Solution: The expected payoff of this investment is

(0.3 × 100) + (0.5 × 50) + (0.2 × −150) = 25

Thus, the correct answer here is (c).

Question A4:

[2 marks] Consider an individual with a utility function

√
u(w) = w

where w represents the individual’s monetary payoff. Suppose that this individual has
the option of buying a lottery ticket that provides $400 with probability 0.1 and $100
otherwise. What is this individual’s expected utility if she chooses to purchase the lottery
ticket?

(a) 11.

(b) 20.

(c) 30.

(d) 150.

(e) 120.

Solution: If the lottery ticket provides $400 with probability 0.1 then it must provide
$100 with probability 1 - 0.1 = 0.9. This means that the expected utility of purchasing
this lottery ticket is
√ √
(0.1 × 400) + (0.9 × 100)

which is equal to
(0.1 × 20) + (0.9 × 10) = 11

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Thus, the correct answer here is (a).

Question A5:

[2 marks] Consider a firm that produces output q using labour, L, and capital, K. Its
production function is
q = Lα K β

where α > 0 and β > 0 are constants. Which of the following statements must be true
for this production function to exhibit constant returns to scale?

(a) α + β < 1.

(b) α + β = 1.

(c) α + β > 1.

(d) α = 0.5 and β = 0.25.

(e) none of the above.

Solution: If the production function above were to exhibit constant returns to scale, then
it must be the case that for any constant t,

(tL)α (tK)β = tq

The above will only be true if α + β = 1. Thus, (b) is the correct answer.

Question A6:

[2 marks] Consider a firm that produces output using labour and capital and a production
function that exhibits increasing returns to scale. If the wage and rental rate of capital
are constant, this firm can expect its

(a) long-run total cost to double as output doubles.

(b) long-run total cost to more than double as output doubles.

(c) long-run total cost to go up less than double as output doubles.

(d) long-run total cost to decline as output doubles.

(e) none of the above.

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Solution: A characteristic of a production function that exhibits increasing returns to
scale is that inputs do not have to double for their to be a doubling of output. Because
input use increases less than proportionally compared to output, it must be the case that
the long-run total cost also increases less than proportionally than output. This statement
requires that both the wage and the rental rate of capital are constant.

Question A7:

[2 marks] Consider a firm with output q that has the following average cost (AC) and
marginal cost (M C) functions:

722 q q
AC(q) = + and M C(q) =
q 200 100
This firm operates in a perfectly competitive industry in which it takes the market
price as given. What is the lowest price at which the firm will provide positive output?

(a) 3.8.

(b) 5.

(c) 3.61.

(d) 4.61.

(e) 1.

Solution: Recall that the lowest price at which this firm will provide positive output is
the price at which it earns zero economic profits. That is, it is the price, P , at which
P = min(AC). The minimum of the AC function will be where AC = M C, or
722 q q
+ =
q 200 100
or
q 2 = (722 × 200)
and
q ∗ = 380

The average cost at this output is

722 380
AC(380) = + = 3.8
380 200

It follows that the long-run competitive equilibrium price for this firm is P = 3.8,
which is option (a).

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Question A8:

[2 marks] Which of the following is NOT a necessary condition for a long-run equilibrium
under perfect competition?

(a) No firm has an incentive to enter the market.

(b) No firm has an incentive to exit the market.

(c) Prices are relatively low.

(d) Each firm earns zero economic profit.

(e) Each firm is maximizing profit.

Solution: The long-run competitive equilibrium price is one that ensures that firms earn
zero economic profit. However, it does not ensure that prices are “relatively low”. So the
correction answer is option (c).

Question A9:

[2 marks] Consider a monopolist that has a constant marginal cost of 10. The demand
for its product is given by
Q = 100 − P

where Q is the quantity demanded and P is the price. What is this monopolist’s profit
maximizing price?

(a) 45.

(b) 55.

(c) 50.

(d) 100.

(e) 10.

Solution: A monopolist’s profit maximizing price is one where M R = M C. To derive

it’s marginal revenue, we need to recognize that this firm’s total revenue is P (Q)Q =
Q × (100 − Q). It follows that
M R = 100 − 2QM
Thus, at the profit maximizing point

100 − 2QM = M C = 10

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or
QM = 45

Next, by substituting this quantity in to the demand function, we know that PM =

100 − 45 = 55, which is option (b) above.

Question A10:

[2 marks] Consider again the monopolist in question A9. Suppose that the demand
function is as given above and let the the marginal cost again be constant at 10. Now
suppose that the firm’s average cost (AC) is given by

900
AC = + 10
Q
What is the monopolist’s profit at its profit-maximizing price?

(a) 30.

(b) 100.

(c) 1,125.

(d) 2,500.

(e) 1,450.

Solution: From above, at its profit-maximizing price, we know that this firm produces
QM = 45. Its average cost at this output is.

900
AC(45) = + 10 = 30
45
It follows that the monopolist’s equilibrium profits are

ΠM = QM × (PM − AC(QM )) = 45 × (55 − 30) = 1, 125

This is option (c) above.

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Section B: There are TWO short-answer questions in this section each worth
20 marks. Answer ALL questions using the script book provided. [40 marks]

Question B1:

Consider an individual with preferences over two goods, X1 and X2 . Her preferences can
be represented by the following utility function:

u(X1 , X2 ) = X12 X2

Let P1 = 1 be the price of X1 and P2 = 4 be the price of X2 . In addition, suppose

this individual has an income of I = 24.

(a) [12 marks] Calculate the optimal consumption of X1 and X2 and the total utility
at this optimal basket. Fully illustrate the optimal basket in a diagram with X1 on the
horizontal axis.

Solution: Given the utility function above, this consumer’s MRS is:

M U1 2X1 X2 2X2
M RS12 = = 2
=
M U2 X1 X1
Thus, the tangency condition implies:

2X2 P1 1
= =
X1 P2 4
or
X1 = 8X2

Substituting this expression into the budget constraint yields:

P1 [8X2 ] + P2 X2 = 24
or
8X2 + 4X2 = 24
and
X2∗ = 2 and X1∗ = 16

Total utility at this optimal basket is u1 = 162 × 2 = 512. This equilibrium is depicted
below.

(b) [3 marks] Suppose that P1 now increases to 3. Let P2 and I remain unchanged. Cal-
culate the new optimal basket. Fully illustrate this new optimal basket in your diagram

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in part (a).

Solution: Let the new price of X1 be P10 . Then the tangency condition will now become:

2X2 P0 3
= 1 =
X1 P2 4
or
3X1 = 8X2

Substituting this expression into the budget constraint yields:

8X2
3 + 4X2 = 24
3
or
16
X2∗ = 2 and X1∗ =
3
Total utility at this optimal basket is u1 = (16/3)2 × 2 = 56.89. This equilibrium is
depicted above.

(c) [5 marks] Calculate the compensating variation needed to return this consumer to her
original utility level.

Solution: The compensating variation is a monetary amount that will shift the con-
sumer’s new budget constraint out so that it is again tangent to the original indifference
curve. In the diagram above, this new budget line will allow this consumer to consume
the basket D. At D we know that the following tangency condition at the new prices will
hold:
3X1 = 8X2

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In addition, we know that at point D, total utility will be u1 = 512. These two
conditions imply that at D,
2
8X2
× X2 = 512
3

64
X23 = 512
9
1/3
4608
X2 =
64
This implies that X2 = 4.16. Further, using the tangency condition above, we know
that this implies that X1 = 2.67 × 4.16 = 11.09. The income needed to afford this basket
at the new prices is:
I 0 = (3 × 11.09) + (4 × 4.16)
= 49.19
It follows that the compensating variation is I − I 0 = 24 − 49.19 = −25.91.

Question B2:

Consider a firm that uses capital (K) and labour (L) to produce output (q) according to
the long-run production function:

q = L0.5 K 1.5

(a) [5 marks] Derive an expression for this firm’s expansion path.

Solution: To find this firm’s expansion path, we need to first determine its marginal
rate of technical substitution (M RT S), which is

M PL
M RT S =
M PK
where
∂q
M PL = = 0.5L−0.5 K 1.5
∂L
and
∂q
M PK = = 1.5L0.5 K 0.5
∂K
Substituting these expressions back into the M RT S yields:
M PL 0.5L−0.5 K 1.5
=
M PK 1.5L0.5 K 0.5
K 1.5 × K −0.5
=
3 × L0.5 L0.5
K
=
3L
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At this firm’s cost-minimizing choice of labour and capital, it must be the case that
the tangency condition applies. More formally, this means that

M PL w
M RT S = =
M PK r
or
K w
=
3L r
where w and r are the wage and rental rate of capital respectively. Rearranging the above
gives us the following expansion path

3w
K= L
r

(b) [6 marks] Let the wage paid to labour be w = 15 and the rental rate of capital be
r = 45. Determine the cost-minimizing labour input and the cost-minimizing capital
input needed to produce output q1 . Use an appropriate diagram to fully illustrate this
cost-minimizing choice.

Solution: With w = 15 and r = 45, the expansion path becomes

3 × 15
K= L
45
or
K=L
Substituting this expression into the production function yields
q1 = L0.5 × L1.5
= L2
Thus, the cost-minimizing labour input choice is
√
L1 = q1
and the cost-minimizing capital input choice is
√
K1 = L1 = q1

This cost-minimizing choice is illustrated in the diagram below.

(c) [2 marks] Find this firm’s long-run total cost function.

Solution: With K = L, the long-run total cost function is

C(q1 ) = wL1 + rK1
= (w + r)K1
√
= 60 q1

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(d) [7 marks] Now suppose that the wage paid by this firm increases to w1 = 22.5. You
can assume that the rental rate of capital remains unchanged. How does this increase in
the wage affect the firm’s optimal use of capital and labour to produce output q1 ? Fully
illustrate this new cost-minimizing choice in your diagram from part (b).

Solution: With w = 22.5 and r = 45, the expansion path becomes

3 × 22.5
K= L
45
or
K = 1.5L
Substituting this expression into the production function yields

q1 = L0.5 × 1.51.5 L1.5

= 1.51.5 L2

Thus, the cost-minimizing labour input choice is

r √
q1 q1
L2 = 1.5
= 0.75
1.5 1.5

and the cost-minimizing capital input choice is

√ √
q1
K2 = 1.5L2 = 1.5 × = 1.50.25 2
1.50.75
This new equilibrium is illustared above. Recall that the slope of the isocost line above
is −w/r. Thus, the higher wage will result in a steeper isocost line C2 , which results in a
new optimal technique that is more capital intensive than before.

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Section C: There are TWO short-answer questions in this section each worth
20 marks. Answer ALL questions using the script book provided. [40 marks]

Question C1:

Consider an individual that must decide how much to consume in a two-period model.
Suppose that her preferences for present consumption (c1 ) and future consumption (c2 )
can be characterized by the following utility function:

1/2
u(c1 , c2 ) = c1 + c2

Further assume that her income in both the present period (M1 ) and the future
period (M2 ) is equal to 100 each and the the nominal interest rate is i > 0. Let the price
index in the present period (p1 ) be 1 and the price index in the future period (p2 ) be 1.05.

(a) [10 marks] Solve for this individual’s optimal values of c1 and c2 respectively.

Solution: Given the utility function above, this individual’s marginal rate of time pref-
erence (M RT P ) is

M U1 1 √
M RT P12 = = −0.5 = 2 c2
M U2 0.5 × c2
It follows that her tangency condition is

√ (1 + i)p1
2 c2 =
p2
or
√ 1+i
2 c2 =
1.05
and 2
1+i
c∗2 = (1)
2(1.05)

Notice that with the quasi-linear preferences above, the tangency condition only in-
volves c2 and not c1 . This means that we can use the tangency condition to directly solve
for c2 . Next, substituting (1) in to the intertemporal budget constraint yields
2
1+i
(1 + i)p1 c1 + p2 = (1 + i)M1 + M2
2(1.05)
or 2
1.05 1+i
(1 + i)c1 + = (2 + i)100
4 1.05

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The above further simplifies to

(1 + i)2
(1 + i)c1 + = (2 + i)100
4.2

It follows the optimal value of current consumption is

(2 + i)100 1 + i
c∗1 = − (2)
1+i 4.2

(b) [10 marks] Use your answer in (a) to write down this consumer’s savings function. Is
this consumer a saver or a borrower in the equilibrium above? Explain.

Solution: We know that this consumer’s savings function is

S = M1 − p1 c1

Substituting M1 = 100, p1 = 1, and (2) in to the above yields

(2 + i)100 1 + i
S = 100 − −
1+i 4.2

1+i 1+i−2−i
= + 100
4.2 1+i
1+i 100
= −
4.2 1+i

Savings in this case simply means that S > 0. This will happen if and only if
1+i 100
>
4.2 1+i
or
(1 + i)2 > 420
and √
i> 420 − 1 ≈ 19.5

Thus, this individual will be a saver for an interest rate above 1,950%. This means
that for any realistic nominal interest rate, this consumer will be a borrower.

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Question C2:

Consider a monopolist that faces the following demand for its product

Q = Pe

where Q is the quantity demanded, P is the price, and e < −1 is a constant.

(a) [4 marks] Show that the price elasticity of demand faced by the monopolist is equal
to the constant e regardless of the price charged.

Solution: We know that the expression for price elasticity of demand, Ed , is

dQ P
Ed = ×
dP Q
where
dQ
= eP e−1
dP
Substituting this back in to the expression for Ed yields

P eP e
Ed = eP e−1 × =
Q Q
We also know that Q = P e . This means that the price elasticity of demand is

eP e
Ed = e = e
P

(b) [6 marks] Let the monopolist’s total cost function be C(Q) = 10Q. Use this to
determine the profit-maximizing quantity and price for this firm. Fully illustrate this
monopoly equilibrium in a diagram.

Solution: Given the demand function above, the monopolist’s profit function is

Π1 = P (Q)Q − C(Q)
= Q Q1/e − 10Q

e+1
= Q e − 10Q

with marginal revenue (M R) equal to

e+1
MR = Q1/e
e

We know that the monopolist’s otpimal choice of output will be one where M R =
M C1 , where M C1 = 10 is the marginal cost. Thus, at an equilibrium

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e+1
Q1/e = 10
e
or

1/e e
Q = 10
e+1
and e
e
Q1 = 10
e+1
Next, from the demand function we know that the equilibrium price will be

1/e e
P1 = Q1 = 10
e+1

This monopoly equilibrium is illustrated below.

(c) [10 marks] Now suppose that the government places a tax of t on each unit that
the monopolist produces. What is the monopolist’s profit-maximizing quantity and price
now? Illustrate this new equilibrium in your diagram for part (b). Is the increase in price
paid by consumers less than, equal to, or greater than the tax itself?

Solution: A tax of t on each unit produced will change the monopolist’s profit function
to
e+1
Π2 = Q e − 10Q − tQ

In other words, the monopolist’s marginal revenue will remain unchanged while its
marginal cost will now be M C2 = 10 + t. Thus, at this post-tax equilibrium, M R = M C2

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implies that
e+1
Q1/e = 10 + t
e
or e
e
Q2 = (10 + t)
e+1

Next, from the demand function we know that the post-tax equilibrium price will be

e
P2 = (10 + t)
e+1

e
= P1 + t
e+1

The post-tax equilibrium is also illustrated in the diagram above. Note that the vertical
distance between the two marginal cost lines represents the size of the tax. This is clearly
smaller than the vertical distance between the two equilibrium prices. To demonstrate this
more generally, we can re-write the expression for P2 above as

e
P2 − P1 = t
e+1

With e < −1, the term in brackets on the right-hand-side, (e/e + 1), will always be
greater than 1. It follows that with e < −1, it will be the case that

P2 − P1 > t

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