LAST YEARS FINAL EXAM

EC 701 Michael Manove Final Examination

Microeconomics 18 December 2003

Instructions: Answer either Problem 1A or Problem 1B (not both). Then answer Problems 2, 3 and 4. Think before you write. Do not spend too much time on any one problem. If you have to leave the room for any reason, please give the instructor your examination on the way out. You will have 150 minutes to complete a 120-minute exam. I suggest that you do not exceed the recommended times for each question until you have answered all questions. The you can use the extra time to improve your answers. If you nish before 2:45 pm, you may leave, but be extremely quiet!

Problem 1A. (20 minutes) Consider the space of lotteries over money. a) Use the concept of expected utility to dene of rst-order stochastic dominance (as in lottery L1 rst-order stochastically dominates lottery L2 ). b) State a proposition that gives necessary and sucient conditions for rst-order stochastic dominance in terms of the distribution functions of the lotteries. c) Use the concept of expected utility to dene second-order stochastic dominance (as in lottery L1 second-order stochastically dominates lottery L2 ). d) State a proposition that gives necessary and sucient conditions for second-order stochastic domination in terms of the distribution functions of the lotteries.

OR

Problem 1B. (20 minutes) A social planner from Mainland China (PRC) believes that the bundle of goods consumed by Ching-to Ma is extremely decadent. The planner would like Ma to consume the vector of goods x instead, where x 0. Mas utility function is continuous, monotonic and strictly quasiconcave. Prove that the planner can nd a set of prices p and a level of wealth w that would induce Ma to demand the planners preferred bundle, x.

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Problem 2. (30 minutes) An exchange economy has two consumers, A and B, and two goods x1 and x2 . Consumers utility is given by UA (x1 , x2 ) 2x1 + x2 UB (x1 , x2 ) x1 + 2x2 and initial endowments are A = (2, 4) B = (2, 2) .

a) Find the set of all Pareto optimal allocations for this economy. Show your work. b) Let p denote the price of Good 1, and assume that the price of Good 2 is normalized to 1. Given the initial endowments specied above, nd the supply and demand functions (or excess demand functions, if you prefer) of each consumer and then compute the market supply and demand. c) Find a competitive equilibrium (price and allocation) that is consistent with the specied initial allocation. Show your work.

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Problem 3. (25 minutes) Li and Zakirova each owns a textile company that produces the same silk cloth. Lis company (Firm A) has a technology that uses only labor (L) as an input. His production function is QA (L) L.

Zakirovas company (Firm B) has a technology that uses both capital (K) and labor (L). Her production function is QB (K, L) 2 KL. Let r and w represent the capital rental rate and the wage rate, and assume that both companies are price-takers in the input markets. Suppose that the market demand for silk cloth is given by Q = 120 P where P is the prevailing market price of cloth. Both rms are prot maximizers. The two rms set the prices of their cloth (PA and PB ) simultaneously, where PA and PB can take any integer value between 0 and 120 (no fractional prices are permitted). If PA 6= PB , consumers buy only from the lower-price rm; if PA = PB they divided their purchases equally between the two rms. a) Now nd Nash equilibrium prices when w = 10 and r = 40. Show your work. b) Is the above equilibrium unique? Explain. A formal proof is not required.

Problem 4. (45 minutes) Li and Zakirova (see Problem 3) decide that it is time to exploit the bourgeois masses of the United States, and they merge their two rms into a monopoly called LZ Corp. LZ is free to divide their labor between the two technologies A and B (corresponding to the production functions of their old rms); of course capital is used only by technology B. a) Show that LZs production function is given by L + K for K L Q (K, L) . 2 KL for K > L [Suggestion: Go on to parts b)-d) and leave this part for last.] b) Let r and w denote input prices as before. Use the production function given in part a) (even if you have not yet answered that part) in order to nd the derived demands for K and L conditional on the level of output Q. c) Compute the cost function C (r, w, Q). Find the marginal cost of producing the output. d) Assume that market demand is given by Q = 120 P as in the previous problem. Find LZs prot-maximizing price Pm and output level Qm as a function of r and w. For this problem, price can take any value, not only integer values. Find monopoly prots and the dead-weight loss as a function of r and w.