Microeconomics Final Exam Review

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Nash equilibrium

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is a solution concept of a game involving two or more players, in which each player is assumed to know the equilibrium strategies of the other players, and no player has anything to gain by changing only his or her own strategy unilaterally. If each player has chosen a strategy and no player can benefit by changing his or her strategy while the other players keep theirs unchanged, then the current set of strategy choices and the corresponding payoffs constitute a Nash equilibrium.

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Prisoner's Dilemma

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If we assume that each player cares only about minimizing his own time in jail, then the prisoner's dilemma forms a non-zero-sum game in which two players may each cooperate with or defect from (betray) the other player. In this game, as in all game theory, the only concern of each individual player (prisoner) is maximizing his own payoff, without any concern for the other player's payoff. The unique equilibrium for this game is a Pareto-suboptimal solution, that is, rational choice leads the two players to both play defect, even though each player's individual reward would be greater if they both played cooperatively.

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zero-sum

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a situation in which a participant's gain or loss is exactly balanced by the losses or gains of the other participant(s).

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non-zero-sum

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a situation in which the interacting parties' aggregate gains and losses is either less than or more than zero. Zero sum games are also called strictly competitive.

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Pareto efficiency or Pareto optimality

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situations in which any change to make any person better off would make someone else worse off.

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Indifference curves

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a. are nonintersecting.
b. are contour lines of a utility function.

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For an individual who consumes only two goods, X and Y, the opportunity cost of consuming one unit of X in terms of how much Y must be given up is reflected in

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the slope of the individual’s budget constraint.

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. Suppose an individual’s MRS (of steak for beer) is 2:1. That is, at the current consumption choices he or she is willing to give up 2 beers to get an extra steak. Suppose also that the price of a steak is $1 and a beer is 25¢. Then in order to increase utility the individual should

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buy more beer and less steak.

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Suppose that at current consumption levels an individual’s marginal utility of consuming an extra hot dog is 10 whereas the marginal utility of consuming an extra soft drink is 2. Then the MRS (of soft drinks for hot dogs)—that is, the number of hot dogs the individual is willing to give up to get one more soft drink is

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1/5

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The point of tangency between a consumer’s budget constraint and his or her indifference curve represents

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constrained utility maximization for the consumer.

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An increase in an individual’s income without changing relative prices will

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shift the budget constraint outward in a parallel way.

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If the price of X falls, the budget constraint

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rotates outward about the Y-intercept.

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Suppose a new healthcare initiative for the working poor will be paid for with a reduction to the earned income tax credit. Suppose the average working poor family has income of $12,000 from work and an additional $4000 from the EITC. If there are two goods, H (healthcare) and C (all other consumption), the equation for a budget line with the EITC

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C = $16,000 - H

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Suppose a little girl likes peanut butter and jelly sandwiches with exactly 2T of jelly and 1T of peanut butter. Suppose further that her mom agrees to make sandwiches to those exact specifications and the price of peanut butter is $.25/T and the price of jelly is $.10/T. If she has $1.8 to spend on peanut butter and jelly ingredients (ignore the bread) in a week, how many sandwiches will she make?

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4

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Assume that Eri-san can consume only Royal Milk Tea or garbage. Draw a few of Eri’s indifference curves. Explain why they have the slope that they do.

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Garbage is a “bad”. We don’t want it, and more makes us feel worse. We are willing to give up some of what we like (Royal Milk Tea) to have less garbage. The indifference curves slope up.

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Explain why the tangency between the indifference curve and the budget constraint is the best possible point for the consumer.

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Any higher indifference curve does not come into contact with the budget constraint and hence is not affordable, so anything better is not possible.
Any other affordable point is on a lower indifference curve (we get to the tangent indifference curve by adding one good or the other), so any other affordable point is not as good.

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North Korea appears to be headed for another famine. The United States wants to help, but it does not want any of the aid to go into North Korea’s nuclear weapons program. It therefore gives North Korea $1 billion, but does not permit North Korea to spend the aid on anything but food. Assuming there are only two goods in the word – food and nuclear weapons – will this aid program achieve its goal?

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Giving North Korea $1 billion in aid shifts out its budget constraint (to the red line). Because North Korea is not allowed to spend any of its aid on nuclear arms, the constraint ends at the old level of expenditure (dotted line). Unfortunately, North Korea can use the aid to buy food and shift its own money toward arms, thus increasing its military expenditure, as seen by the move from indifference curve 1 to indifference curve 2.

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. Suppose a person’s utility is only a function of their consumption of diet soda and they do not care which brand, Diet Coke (DC) or Diet Pepsi (DP) they consume. Suppose further that PDC < PDP. If PDC rises but it remains less than PDP then the consumption of DC

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Falls from a positive amount to another positive amount.

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. Suppose two goods coffee and creamer provide the consumer with utility but only if they are consumed in fixed proportions. An increase in the price of coffee will yield

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an income effect but no substitution effect.

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If a good is normal and its price increases,

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income effect will be negative and the substitution effect will be negative.

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If the prices of all goods increase by the same proportion as income, the quantity demanded of good X will

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remain unchanged.

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. An increase in quantity demanded is represented by

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a movement along the demand curve in a southeasterly direction in response to a decline in the good’s price.

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. Suppose demand can be written as P = 5. The elasticity of demand is (the absolute value of %ChangeQ/%ChangeP,

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constant regardless of prices and perfectly elastic.

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If the income elasticity of demand is 1/2, the good is

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a normal good (but not a luxury).

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. If the cross price elasticity of demand equals -1, then the two goods are

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complements to one another.

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In Homogenia everyone is the same. Demand for apples is P = A - BQ for all 1 million citizens. Market demand for apples in Homogenia is given by the equation

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P=A-1,000,000BQ

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If the demand for a product is elastic, then a rise in price will

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cause total spending on the good to decrease.

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Miki can consume only two goods: sushi and ice cream. Suppose the price of sushi falls and that Miki responds by consuming more ice cream. Is this proof that Miki regards ice cream as an inferior good? Explain your answer.

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If the price of sushi falls, the substitution effect says buy less ice cream. The lower price of sushi increases Miki’s purchasing power. The income effect says buy more ice cream if ice cream is a normal good. It says buy less ice cream if ice cream is an inferior good. Because Miki buys more ice cream, it must be a normal good.

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. The Marginal Utility of cleaner air is given by MU=100*1/ppm
Where utility is expressed in yen, and PPM is the amount of pollution (expressed in parts per million of the pollutant) that has been removed from the air.
Draw the Marginal Utility curve of cleaner air.

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Using the same Marginal Utility of Clean Air...
Sketch the Total Utility curve.

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We know that added cleanliness adds to utility but that it adds less and less as the air becomes cleaner. Total Utility thus looks like this:

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c) Suppose the cost of reducing pollution by 1 PPM is always 10 yen. What is the optimal amount of pollution? Why doesn’t this economy want completely clean air?

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As long as the addition to happiness from cleaner air exceeds the cost, we will want to make the air a little cleaner. If the addition to happiness is less than the cost, the air is “too clean.” The optimal amount of cleanliness is where the marginal utility equals the added cost, or:
x/1000 = 10 This occurs at 100ppm.

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If production is given by Q = KL, doubling both inputs

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more than doubles output.

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Suppose electricity (E) can be produced with coal (C) or gas (G) to operate steam turbines (T). Suppose gas is more efficiently burned than coal but that they are otherwise perfect substitutes. The isoquants are

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downward sloping lines.

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On an isoquant-isocost two-input model you can tell that a nonoptimal short-run production decision is being made because

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the rate of technical substitution is not equal to the ratio of the input prices

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The marginal productivity of labor is defined as

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the extra output produced by employing one more unit of labor while holding other
inputs constant.

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. If more and more labor is employed while keeping all other inputs constant, the marginal productivity of labor

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will eventually decrease.

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Graphically, the average productivity of labor would be illustrated by

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the slope of the chord connecting the origin with the relevant point on the total output
curve.

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A firm’s isoquant shows

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the various combinations of capital and labor that will produce a given amount of
output.

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. Let FC = fixed cost, Q = quantity of output, MC = marginal cost, TC = total cost, and VC = variable cost. Using this notation, average cost equals

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(FC + VC)/Q

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A technical innovation in the production of automobiles by Ford Motor Company’s for 1 million cars per year would necessarily

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shift the “1 million car” isoquant toward the origin.

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A firm increases the number of hours its workers are employed from 7,500 to 8,500, and output increases from 170,000 bushels to 190,000 bushels. The marginal product of an extra hour is

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20

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To the right is a graph of the cost curves for some firm. Total Cost for this firm if it produces 20 units of output is:

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d. 300

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. If the firm whose costs curves are graphed to the right produces 50 units of output its Total Variable Cost will be:

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c. 900

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. If the firm whose costs curves are graphed to the right produces 50 units of output its Total Fixed Cost will be

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d. 100

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. If the firm whose costs curves are graphed to the right produces 50 units of output its Total Fixed Cost will be

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d. 100

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Consider a manufacturing firm which uses natural gas to generate its own electricity. The electricity is used to run its manufacturing equipment. If the price of natural gas rises this would lead to:

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d. a shift up in the marginal cost, average variable cost, and average total cost curves.

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Suppose a manufacturing firm learns that its annual property tax payments will decrease. We would depict this by:

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e. shifting the average total, and the average fixed cost curves downward.

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Suppose pigs (P) can be fed corn-based feed (C) or soybean-based feed (S) such that the production function is P = 2C + 5S. If the price of corn feed is $4 and the price of soybean feed is $5, what is the cost minimizing combination of producing P = 200?

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S = 40

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The firm’s expansion path records

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cost-minimizing input choices for all possible output levels for a fixed set of input prices.

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. Technical progress will

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shift a firm’s production function and its related cost curves.

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1. Suppose the doughnut industry is perfectly competitive that, all else equal, the entry of new firms causes the price of sugar and flour to fall. This causes the

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b. Long run supply curve of doughnuts to be downward sloping

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2. Insulin is a medicine with few substitutes. If the government puts a ¥100 sales tax on it

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b. The price of insulin rises by about ¥100 and there is a very small deadweight loss

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3. Consuming a bottle of Royal Milk tea brings Miyuki ¥100 of happiness. If the price is

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b. She will definitely not buy a bottle

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4. Suppose the equilibrium price of ramen is ¥200. A price ceiling of ¥150

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c. Reduces social well-being because producer surplus falls more than consumer surplus rises

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Suppose there are 200 firms each with a short run total cost of STC = q2 + q + 2, so that marginal cost is MC = 2q +1. The supply curve for each firm is

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P = 2q + 1

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. Suppose there are 200 firms each with a short run total cost of STC = q2 + q + 2, so that marginal cost is MC = 2q +1. The market supply curve is

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QS = -100 + 100P

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Suppose there are 200 firms each with a short run total cost of STC = q2 + q + 2, so that marginal cost is MC = 2q +1. If market demand is given by QD = 800 - 80P, what is the equilibrium price?

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5

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Suppose there are 200 firms each with a short run total cost of STC = q2 + q + 2, so that marginal cost is MC = 2q +1. If market demand is given by QD = 800 - 80P, how much will be produced in the market?

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400

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Suppose there are 200 firms each with a short run total cost of STC = q2 + q + 2, so that marginal cost is MC = 2q +1. If market demand is given by QD = 800 - 80P, how much will the individual firm produce?

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2

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Suppose there are 200 firms each with a short run total cost of STC = q2 + q + 2, so that marginal cost is MC = 2q +1. If market demand is given by QD = 800 - 80P, total revenue to the firm will be

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10

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Suppose there are 200 firms each with a short run total cost of STC = q2 + q + 2, so that marginal cost is MC = 2q +1. If market demand is given by QD = 800 - 80P, total cost to the firm will be

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8

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Suppose there are 200 firms each with a short run total cost of STC = q2 + q + 2, so that marginal cost is MC = 2q +1. If market demand is given by QD = 800 - 80P, profit to the firm will be

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2

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. Suppose there are 200 firms each with a short run total cost of STC = q2 + q + 2, so that marginal cost is MC = 2q +1. If market demand is given by QD = 800 - 80P, in the long run the number of firms will

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rise

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The Prisoners’ Dilemma is not a constant sum game because

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some outcomes are better than others for both players.

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The Nash equilibrium in a Bertrand game of price setting where all firms have the same marginal cost is

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efficient because all mutually beneficial transactions will occur.

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The game theory approach assumes that oligopolists:

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act strategically.

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Game theory focuses on:

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strategic behavior among rivals.

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Economists would be most likely to apply game theory to the market structure of:

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oligopoly

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A strategy combination where each player is playing a best response to other players' current strategies, and thus has no incentive to change strategies in a repeating game is called:

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a Nash equilibrium.

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Softbank and AU engage in aggressive and expensive advertising for cell-phones. One reason for this advertising might be:

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(a) attempts to increase market share.
(b) predatorily drive other firms from the market.
(c) to increase the use of cell phones.
(d) to deter entry by potential new competitors.
(e) All of the above are possibilities.

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(True/False) A Nash Equilibrium occurs where a player maximizes their payoff given what they anticipate their opponent is doing

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True

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Which of the following is an example of an institution that enforces cooperative behavior in a Prisoner's Dilemma - type game?

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World Trade Organization

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A Nash equilibrium occurs when

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. each player plays her best strategy given that the other does, too.

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The consideration of strategic behavior plays no role in which of the following types of economic models?

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competitive, monopolistic

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Please define what the dominant strategy is. You can use any example and/or payoff matrix.

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A dominant strategy is one where a player maximizes their payoff irrespective of what their opponent is doing.