Economics Exam - Fall 2011

This document contains a comprehensive economics exam from Fall 2011, designed to assess students' understanding of various economic principles. The exam includes questions on market structures, elasticity of demand, cost analysis, market equilibrium, monopoly pricing, and game theory. It provides detailed scenarios and requires students to apply their knowledge to solve problems and make informed decisions. The exam also includes a section on strategic decision-making using game theory concepts. The questions are designed to test both theoretical understanding and practical application of economic concepts.

Directions:
Download the examination between 12:00 am December 18 and 8:00 pm December 31, 2011.
This is an open book exam. Please print your name clearly below and on each page of your
answer sheets. Once downloaded, you are allowed to complete the examination in four hours
-- three hours in total to focus on the examination, and one hour to allow for
downloading/uploading technology-related logistical snafus. It would be best if you take the
examination all in one setting. However, the examination and answers must be uploaded back
within 24 hours of it being downloaded (download and upload times will be time stamped). No
examinations will be accepted after midnight, December 31, 2011.
Answer all questions as clearly and legibly as possible. The exam has a total of 180 points. The
number of points and a suggested amount of time is indicated for each question. In order to
obtain full credit for your answers, you need to show your work. If you believe a question is
ambiguous, in your answer state clearly any assumptions you are making.
Please read and sign below:

1. (18 points, 18 minutes). Decide whether each of the following statements is True, False or
Uncertain, and give a brief but clear explanation supporting your answer. Most of the credit
will be given for your explanation.
a. Both in perfect competition and in monopolistic competition, in long run equilibrium
economic profits are zero.
b. If the quantity demanded for your product varies greatly with changes in customer
per capita incomes, this implies you face an elastic (flat) demand curve.
c. The Commonwealth of Massachusetts taxes each bottle of alcohol sold. Assume the
price elasticity of demand for wine is -5, the price elasticity for hard liquor is -2, and
that the price elasticity of supply is the same for both types of alcohol at +2.
True/False/Uncertain: A larger fraction of the alcohol tax will be passed on to hard
liquor consumers than the fraction passed on to wine consumers.
d. With sequential Bertrand competition in a market for two slightly differentiated
products, it is generally preferable to be the player who prices second rather than
the one who goes first.
e. The average annual probability of a five year old dog having a urinary tract infection
is 20%; the average annual cost of treating a five year old dog’s urinary tract
infection is $150. Therefore, an animal health insurer offering an insurance policy
covering urinary tract infections for five year old dogs that charges an annual
premium of $30 can be expected on average to break even.

2. (18 points, 18 minutes). An econometric analysis of gasoline sales and price data provided
the following gasoline demand equation estimates (ln refers to the natural logarithm):
ln Qt = 3.5 – 0.16 ln PGt + 0.20 ln INCt + 0.8 ln Qt-1
where Qt and Qt-1 are current time period and one time period-lagged quantities of gasoline (in
hundreds of gallons), respectively, PGt is the current period price of gasoline in dollars, and INCt
is per capita income in dollars.
a. What is the short-run price elasticity of demand for gasoline? What does this mean
in words?
b. What is the long-run price elasticity of demand for gasoline? Does it make sense in
this case that the long-run elasticity is different from the short-run elasticity? Why
or why not?
c. What does this imply for the volatility of gasoline prices in the short-run vs. the long
run in response to oil price shocks that shift the supply curve for gasoline? Why?

3. (15 minutes, 15 points) Toyondai is a growing toy manufacturing company. Toyondai’s
manufacturing facility has limited capacity, and the company is examining options to expand.
Currently, Toyondai has several options from which to choose:
(1) Purchase a new facility
(2) Rent a new facility
(3) Do not expand
- The revenue from the additional capacity is expected to be $4,000,000. Cost of goods
produced is expected to be $3,000,000. Assume that the funds are realized at the end of
a year.
- The new facility’s market value is $6,000,000 and with the secondary market for
commercial real estate in decline, its market value is expected to decline by 2.5% per
year.
- Renting the new facility will cost $750,000 per year, payable at the end of the year.
- Toyondai’s cost of capital is 15%.
For all parts of this question below, consider only the first year.
a. What is Toyondai’s User Cost of Capital (UCC) for the new facility as an owner? As a
renter?
b. What would you recommend to Toyondai—should they choose (1) (2) or (3)?
c. What if the market value of the facility were expected to increase in value by 5% per
year?

4. (32 points, 32 minutes) The market for regular gasoline in Cambridge, Massachusetts is
perfectly competitive. The supply and demand equations are given by:
Qd = 4 – (1/3)*P and Qs = -1 + P
where Qd and Qs are the quantities of regular gasoline demanded and supplied, respectively, in
thousands of gallons per day, and P is the price per gallon of regular gasoline in dollars.
a. Calculate the market equilibrium price and quantity
b. Draw the supply and demand curves on a figure, with axes labeled
c. Calculate the consumer surplus and producer surplus at the equilibrium
d. Now suppose that the government subsidizes regular gasoline by paying retailers $1
for each gallon of regular gasoline sold. What will be the new equilibrium price paid
by consumers and the quantity purchased? Calculate the deadweight loss, if any.

5. (30 points, 30 minutes) A monopolist must decide how to price its product in two markets
that are separated geographically by a national border. Demand in the two markets is:
Q1 = 40 – P1 Q2 = 80 – P2
where prices are in dollars and quantities are in number of units sold. The monopolist’s total
costs are
TC = 32 (Q1 + Q2)
where TC is in dollars. What are the profit maximizing prices charged, total product shipped to
each market, and total profits across both markets under the following two assumptions:
a. The border is open to free trade, arbitrage is possible, so that the monopolist must
charge the same price in both markets
b. The markets are separated, arbitrage is not possible, so that the monopolist can
maintain separate prices in the two markets
c. Regarding (b) above, without doing any mathematical calculations, do you think that
at the equilibrium prices, demand for Q1 is more or less price elastic than demand
for Q2? Why (what is the intuition)?

6. (20 points, 20 minutes) Your company produces children’s Halloween costumes. You have a
workshop in Quincy, Massachusetts that produces costumes with the following cost
considerations:
Variable Costs = 0.5Q2, where Q is the number of crates produced.
You know that your customers have the following demand curve for Halloween costumes:
Q = 220 – 2P
The workshop cost $2000 to build 30 years ago, but it is worthless today (market value = $0.)
a. What are the fixed costs, average costs, and marginal costs for any given Q?
b. How many Halloween costumes should you produce for the upcoming holiday season?
c. Now suppose you have the option of renting capacity from another plant in nearby
Weymouth, Massachusetts. This plant would have variable costs = 0.25Q2. Assuming
this plant will have no fixed costs other than building costs, how much would you be
willing to pay to rent capacity from the facility?
d. Does the amount you will produce in the Quincy plant change once the Weymouth plant
comes online? Briefly explain why or why not.

7. (32 points, 32 minutes) Suppose the airline industry consisted of only two firms: American (A)
and Texas Air Corp (T). Let the two firms have identical cost functions
Total CostsA = 42QA Total CostsT = 42QT
Assume the demand curve for the industry is given by P=240-Q, where Q = QA + QT, and that
each firm expects the other to behave as a Cournot competitor.
a. Calculate the Cournot-Nash equilibrium quantity for each firm, assuming that
each chooses the output level that maximizes its profits when taking its rival’s
output as given. What are the profits at each firm?
b. Without doing any mathematical calculations, describe how the Cournot-Nash
equilibrium quantities for both airlines would change if Texas Air had constant
marginal and average costs of 36 and American had constant marginal and
average costs of 42? Why?
c. Assuming equal costs at American and Texas Air Corp as in part (a) above, and
that American now has the opportunity to announce its output quantity before
Texas Air can, in what direction would the quantities at American and Texas Air
Corp change? Why?

8. (10 points, 10 minutes) An established, incumbent software company (I) offers a product that
allows companies to manage their marketing campaigns. A serial entrepreneur (E) has a new
low cost solution and is considering whether to enter this market with a low price. The
incumbent can choose to either price low or price high. The entrepreneur can choose whether
or not to enter the market. The payoff matrix for each party is described below. Values are
shown as follows: Incumbent’s Payoff, Entrant’s Payoff.
Entrant
Enter with Price = 100 Don’t Enter
Incumbent Set Price = 100 -15, -5 -5, 0
Set Price = 200 -10, 20 0, 0
a. Does either party have a dominant strategy? Explain.
b. Is there a Nash equilibrium? If so, what is it?
c. Given your answer to (b), what decision would you recommend the entrepreneur make?
d. Now assume that before the entrepreneur decides whether or not to enter, the incumbent
announces a guarantee that it will match any competitor’s prices. This guarantee is included in
all customer contracts and is legally binding. How does this guarantee affect the decision that
the entrepreneur should make? Does the price match guarantee benefit the customers in the
market?

9. (5 points, 5 minutes) Assume a company has recently discovered that a batch of laptop
batteries that they produced is defective. This only affects 10 customers. The company is going
to issue a recall and refund the customers for their purchases. However, both the company and
the customers affected have a decision to make about whether to publicize the incident. The
payoff matrix for both parties is shown below. Values are shown as follows: Customer’s Payoff,
Company’s Payoff.
Company
Don’t share Share
Customer Don’t share -2, 0 -1, -5
Share 3, -100 -2, -10
a. Does either party have a dominant strategy? If so, what is it?
b. Is there a Nash equilibrium? If so, what is it?
c. Is there any reason the company might not pursue its Nash equilibrium strategy in this case?
Why or why not?