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Economics 510:   This exam covers the material in Chapters 12-16 as well as Rationality and Uncertainty, and the accompanying outside readings

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Economics 510:

 

This exam covers the material in Chapters 12-16 as well as Rationality and Uncertainty, and the accompanying outside readings.  This is an economics class.  One tenet of economics is that people are rational in their allocation of resources amongst competing ends.  Your resources are the readings and time.  Since this is a take-home exam, you have access to all necessary information.  I will expect you to utilize all the information, since, as rational agents, you know that if you do not, then someone else will, and that person will get the better grade.

 

 

The exam is worth 100 points.  Each question is weighted as given.  Parts of a question, 1a, 1b, 1c, etc for instance, are all part of ONE question.

 

One final hint.  I am NEVER asking for your opinion.  The answer to any “True, False, Explain” questions comes from the course material, not what you already believe or think.

 

 

 

 

 

1)            Monopolies are thought of as bad.  One reason is that they produce less of an item at a higher price than

                would be produced under perfect competition.

 

Let Market Supply for a product be                                P=$20+.50QS

 

Let Market Demand for the product be          P=$170-.75QD

 

 

a)            Using the D and S equations from above, show the validity of the above statement by finding the output

                level and price for both a perfectly competitive industry and a monopoly.  Carefully explain how you know

                this.  [You should put both points on the same graph, but do it carefully.]

 

b)            Monopolies can charge whatever they want.  True, False, Carefully explain.

 

(a) Under perfect competition, the equilibrium condition is Demand = Supply

=> 20 + 0.50Q = 170 - 0.75Q

=> 1.25Q = 150

=> Q = 150 / 1.25 = 120

P = 20 + 0.50(120) = $80

Under Monopoly, the equilibrium condition is MR = MC

Total Revenue = P * Q = 170Q - 0.75Q²

MR = 170 - 1.5Q

Here, MC is the supply curve

MR = MC

170 - 1.5Q = 20 + 0.50Q

=> 2Q = 150

=> Q = 150 / 2 = 75

P = 170 - 0.75(75) = $113.75

 

 

(b) False.

Although monopolists is the sole producer of the product, it does not mean they can charge any price they want. They charge the price that will allow them to maximize profit. And the profit is maximized when MR = MC.

 

 

 

2)            Verizon recently instituted a price rise in its phone service.  Shortly thereafter, Verizon recently rescinded its decision.  Verizon is one of the nation’s 6-8 largest cellular phone companies. 

 

Read “Smell of Success: Suave Copies Hot Scents to Boost Sales”, “American Airlines Cuts Select Business Fares” and “Verizon Fee Rescinded” to stimulate your thinking.  [Articles on Jupiter site].

 

Answer the following question:  [Do NOT use previously held knowledge or beliefs.  Use relevant articles for guidance.]

 

a)            What sort of competitor is Verizon, i.e. what sort of market is Verizon in (Perfect Competition, Monopoly,

                Monopolistic Competition, Oligopoly)? 

b)            What is Verizon’s apparent strategy, and what does that tell you

                about its perception of its market power? 

c)             Is Verizon correct in their perception of market power?

 

1. Verizon is in a monopolistic competition wherein there are several competitors for the goods which are close substitutes for one another.
2. Verizon’s market strategy included strategic price rise in order to increase the market revenue and also portray itself as a superior brand which has a higher benchmark price. What this move tells us is that Verizon underestimated the power of its competitors in the market and also placed its own position higher. The company had a miscalculated move based on its belief that it can influence the market rates and that its market power was large enough to sustain the existing customers and bring in further revenue.
3. Verizon was clearly not correct in their perception as it had to rescind its decision. It now has to take into account the presence of extremely strong competitors such as AT&T and Sprint.

 

 

3)            Let there be a dilemma facing your company.  Your company can either collude or cheat with a rival

                over some issue of importance to both.  Payoffs are as follows.

 

 

Your Company

Their Company

Cheat

Cheat

Collude

Collude

$0

$-1.0

$+2.0

$+4.5

$0

$+4.5

$-1.0

$+2.0

Payoffs in Millions of Dollars

 

 

a)            Identify the Nash equilibrium, it one exists.  Explain your reasoning.

b)            Identify the equilibrium that would obtain if the game was played repeatedly.  Explain reasoning, and how

                it may come to pass.  Is there a difference?  Why or why not?

a. The nash equilibrium of this game is (cheat, cheat). In this equilibrium both the players are playing their dominant strategy, cheat. The dominant strategy of both these players is to cheat as the get a higher pay-off when they decide to cheat, no matter what the other player is doing.
b. When the players repeated game, then the equilibrium will be (collude, collude). This is because in repeated games, both players know what the other player played in previous game. If the player knows that a player had cheated , the other player will cheat. Thus, there is a credible threat. It is in the interest of both the players to collude. Therefore, (collude, collude) will be the equilibrium in this scenario.

4)            Two soap producers, the Fortnum Company and the Maison Company, can focus on either newspapers or magazines in their forthcoming advertisement campaigns. The payoff matrix is as follows:

 

 

Maison

Fortnum

Newspapers

Newspapers

Magazines

Magazines

$9.0

$9.0

$8.0

$8.0

$7.0

$10.0

$12.0

$7.0

Payoffs in Millions of Dollars

 

 

Where payoffs are (Fortnum Profits, Maison Profits).

 

1. Is there a dominant strategy for each firm? If so, what is it?
2. What will be the profit of each firm?
3. Is this game an example of the prisoner’s dilemma? (Nash equilibrium that is inferior to collusion).  Why or why not?

1. There is no dominant strategy for Maison. However, the dominant strategy of Fortnum is to focus on the newspaper. This is the dominant strategy because this allows the firm to get higher pay-off, no matter what Maison is doing.
2. 2. The nash equilibrium of this game is (9,8). Thus, fortnum gets $9M and Maison gets $8M.
3. 3. This is not an example of prisoner;s dillema because even if they both decide to cooperate or collude, there wont be any situation when both the firms will get a higher pay-off.

 

5)            Firm 1 operating in an imperfectly competitive industry knows: price elasticity of demand is -1.8.

                Firm 2 operating in an imperfectly competitive industry knows: price elasticity of demand is -2.3. 

a)            Find the optimal price for each firm if MC = $25, $100, and $200.  

b)            What can you conclude about the market power, thinking of the Lerner Index, of each firm?  Why?

Lerner Index (LI) = - 1 / Price elasticity of demand

For Firm 1, LI = - 1 / - 1.8 = 0.56

For Firm 2, LI = - 1 / - 2.3 = 0.43

Again, LI = (P - MC) / P

(a)

(1) For Firm 1:

(i) MC = 25

0.56 = (P - 25) / P

0.56P = P - 25

0.44P = 25

P = $56.82

(ii) MC = 100

0.56 = (P - 100) / P

0.56P = P - 100

0.44P = 100

P = $227.27

(iii) MC = 200

0.56 = (P - 200) / P

0.56P = P - 200

0.44P = 200

P = $454.54

(2) For Firm 2:

(i) MC = 25

0.43 = (P - 25) / P

0.43P = P - 25

0.57P = 25

P = $43.86

(ii) MC = 100

0.43 = (P - 100) / P

0.43P = P - 100

0.57P = 100

P = $175.44

(i) MC = 200

0.43 = (P - 200) / P

0.43P = P - 200

0.57P = 200

P = $350.88

(b)

In general, the higher the Lerner Index, the higher the market power of the firm. Since firm 1 has a higher Lerner Index, firm 1 has higher market power than firm 2.

 

 

6)            A pharmaceutical company wants to charge rich customers more for a product and poor customers

                less for the same product.  This is legal to do.  Neither group is a protected class. 

 

a)            What type of economic issue does this example illustrate? 

b)            Why, from an economic perspective would the company want to do this? 

c)             Give an example calculating and showing that the firm obtains its goals by doing this pricing practice.

d)            Someone suggests that this is a bad thing to do…that everyone ought to pay the same price. 

                Show/calculate how this may be mistaken.

a) This type of pricing is called price discrimination where in a company charges different prices from different consumer groups.

b) The company would do this in order to maximize their profits by increasing their revenue. I.e. it is a profit maximizing initiative by the company.

c) For example, for product x, let the company charge $10 from one segment of the economy(rich) and $2 from the other (poor). Lets say the total no. of rich people buying it is 5, and the total number of poor people buying it is 5.

The total revenue of the company would be 10*5+2*5= 50+10=$60.

d) If this company prices all the drugs at any equal price of say $5. I.e. irrespective of being rich or poor, the price would be equal for all customers. The total number of people purchasing it remaining same as in the above example (10), the total revenue earned by the company would be

= 10*5=$50.

This shows that by having price discrimination as its strategy the company can maximize the revenue it earns from the market also fulfilling a social objective of charging low from the poor segment of the society. Thus, this pricing discrimination has dual objectives and both satisfied in a socially optimal fashion.

7a)          I prefer $1,000 for certain over a gamble where I earn an expected value of $1,000. 

Draw this state of affairs.

b)            Determine (estimate/guess) from the graph you draw the value I’d be indifferent between taking for certain

                compared to the $1,000 from the gamble.  [I’d prefer to get that amount of money for sure and avoid the

                gamble]. 

                Draw this state of affairs.

c)             Am I risk averse, risk neutral or risk loving?  Explain.

d)            Armed with information from a) and b), determine my Certainty Equivalent Adjustment Factor.

e)             How might this sort of information be useful to a company?  Discuss using an appropriate example.

f)             Thinking more deeply, from the general concept of expected value and risk (σ), how closely ought you

                follow this, or any notion of risk analysis?  Discuss in depth.

[In this question, there is no indifference curve to calculate.  Simply draw/estimate].