Answers: Economics Final Exam

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ECS2220 EXAM PAPER MAY 2011 ANSWERS PART 1 Question 1 a) If the monopolist is not regulated, the price will be set at P2. It is the point where marginal cost equals marginal revenue and the resulting optimum quantity is replaced into the demand function. b) The price will be P4. This is the point where the marginal cost equals the average revenue, which in a perfectly competitive industry is also the marginal revenue of the firm. c) The minimum feasible price is P3. The firm will not produce below its average total cost.

Question 2 a) A perspective. Body Shop was founded with a strong ethical view of how a business should be conducted (the “perspective”). Its staff and its customers strongly relate to that perspective. The takeover of Body Shop by a company having a completely different perspective could undermine the motivation of staff and put off customers if both groups believe Body Shop's values would not be respected. As a result, the takeover could lead to a loss for L'Oréal. b) L'Oréal's strategy is by external expansion by takeover. External expansion happens when a firm engages with another either by merger or strategic alliance.

Question 3: Consider the following diagram where a perfectly competitive firm faces a price of $40.

a) The profit-maximizing output is 67 because this is the point where the price equals the marginal cost. b) The average total cost is equal to $31 and the average variable cost is equal to around $26.

c) The total revenue is equal to PxQ, TR=$40x67=$2680, and the total profit is TRTC=$40x67-$31x67=$2680-$2077=$603 Question 4

a) In a noncooperative game the players do not formally communicate in an effort to coordinate their actions. They are aware of one another’s existence, and typically know each other’s payoffs, but they act independently. The primary difference between a cooperative and a noncooperative game is that binding contracts, i.e., agreements between the players to which both parties must adhere, is possible in the former, but not in the latter. An example of a cooperative game would be a formal cartel agreement, such as OPEC, or a joint venture. A noncooperative game example would be a research and development race to obtain a patent. b) A Nash equilibrium is an outcome where both players correctly believe that they are doing the best they can, given the action of the other player. A game is in equilibrium if neither player has an incentive to change his or her choice, unless there is a change by the other player. The key feature that distinguishes a Nash equilibrium from an equilibrium in dominant strategies is the dependence on the opponent’s behavior. An equilibrium in dominant strategies results if each player has a best choice, regardless of the other player’s choice. Every dominant strategy equilibrium is a Nash equilibrium but the reverse does not hold. c) A maximin strategy is one in which a player determines the worst outcome that can occur for each of his or her possible actions. The player then chooses the action that maximizes the minimum gain that can be earned. If both players use maximin strategies, the result is a maximin solution to the game rather than a Nash equilibrium. Unlike the Nash equilibrium, the maximin solution does not require players to react to an opponent’s choice. Using a maximin strategy is conservative and usually is not profit maximizing, but it can be a good choice if a player thinks his or her opponent may not behave rationally. The maximin solution is more likely than the Nash solution in cases where there is a higher probability of irrational (non-optimizing) behaviour. Question 5 The curve is backward bending because it reflects the main trade-off between work and leisure at different levels of wages. The more hours worked, ie, the more leisure is given up in favour of work, the higher the income. So the worker substitutes leisure for work, up to the level of wage W1. This is called the substitution effect. When the...
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