14.

01 Principles of Microeconomics: Exam 2

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First Name: _____________
Kerberos ID: _____________

Instructions (please read carefully)

This exam has a total of 90 points. You have two hours to finish the exam. Answers should be as concise as possible.

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This is a closed book exam. You are not allowed to use notes, equation sheets, books, or any other aids. You are
allowed to use calculators, but only for the purpose of arithmetic calculations. You must answer each section in

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a separate blue book (Section I, II, III, IV) so you will submit a total of 4 blue books along with your exam

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question sheet. Submit your exam sheet and all other blue books inside your first (Section I) blue book. Be sure
to write your full name and Kerberous ID on EACH of your blue books. This exam is 5 pages long including

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this initial page.
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Circle Your Section/Recitation:
Please circle the section or recitation that you are attending below. The marked exam will be returned to you in
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the section or recitation that you indicate.

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1. R01 (F10, Roman)

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2. R02 (F11, Roman)

3. R03 (F12, David)
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4. R04 (F1, David)

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5. R05 (F11, David)

6. R07 (MWF10, Josh)
7. R08 (MWF1, Arianna)
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8. R09 (MWF2, Mahvish)

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DO NOT GO TO THE NEXT PAGE UNLESS THE PROCTORS INSTRUCT YOU TO DO SO

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 Section I [18 points total]
Question 1 [6 points]
A bank is trying to decide on how to compensate one of their loan officers (employees who decide what businesses
the bank should loan money to). They are considering two different compensation schemes. Scheme A pays the
loan officer 10,000 for every loan he gives out. Scheme B pays the loan officer 20,000 for every loan he gives out
that does not default and fines him 20,000 for every loan that defaults while he is overseeing it. Suppose that for
every loan that does not default the bank gets 40,000 and when the loan defaults the bank loses 40,000. Further,
suppose at the end of the year the loan officer is leaving to pursue his passion for music at which point his loans
will become another officer’s responsibility. Consider the following hypothetical scenario:
The loan officer is approached by a business with a business that has a 75% chance of default within a year.
Under the two different payment schemes, does the bank want him to give the loan? What does the officer do under
the different compensation schemes? Explain your reasoning.
Under Scheme A the bank’s expected profits are (1/4)40,000-(3/4)(40,000)-10,000= -40,000 and they
don’t want him to give the loan. The officer makes 10,000 from giving out the loan so he does anyway.
Under Scheme B, the bank’s expected profits are (1/4)(40,000-20,000)+(3/4)(20,00-40,000)= -10,000

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so they still don’t want him to give the loan. The officer’s expected earnings are (1/4)(20,000)+(3/4)(-

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20,000)= -15,000 so he does what the bank wants and doesn’t give the loan.

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Question 2 [12 points]

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Jim is a farmer who produces organic tomatoes and conventional corn. The direct growing costs of organic tomatoes

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and traditional corn are given by PO Q2O and PC Q2C . In order to have his tomatoes certified as organic, the US
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Department of Agriculture requires that Jim plant a “buffer zone” (such as a line of trees or grass) between the
organic tomatoes and the corn to ensure no pesticides from the cornfields accidentally contaminate the organic
tomatoes. Thus in addition to the direct costs of growing the crops mentioned above, Jim must pay PB · (QO × QC )
in buffer construction costs.
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1. Write Jim’s total cost function as a function of QO , QC , PC , PO , PB [3 Points]

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C(QO, QC ) = pO Q2O + pC Q2C + pB (QO × QC )

2. Does this cost function exhibit economies of scope or diseconomies of scope? Show mathematically and explain
your intuition. [5 Points]
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The cost function exhibits diseconomies of slope. C(QO , 0) + C(0, QC ) < C(QO , QC ) because his
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buffer zone costs are increasing in the product of the two quantities. That is because his costs of
creating buffers depends on the product of the number of organic tomatoes and conventional ears of
corn, diversifying his crops increases his costs.
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3. Suppose that Jim is producing a positive number of both organic tomatoes and conventional ears of corn when
the demand for organic tomatoes increases after Oprah talks about how much better organic tomatoes taste
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than regular tomatoes. How does this affect the quantities of tomatoes and corn Jim chooses to produce? [4
Points]

An increase in demand for organic tomatoes causes the price of tomatoes to rise and thus because
MC is increasing in quantity of tomatoes produced, Jim chooses to produce more tomatoes. Holding
demand for corn constant, he will decrease the amount of corn he chooses to produce because the
MC of corn is increasing in the quantity of tomatoes due to the need to build buffer zones.

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Section II [12 points total]

Juan has just started a taco restaurant. In order to enter the business he had to pay a sunk cost of 2, that is the
total value of the time he spent learning tacos recipes. In addition he needs to pay for labor and capital. The wage
rate he has to pay is 41 , and the rental rate of each unit of capital is 1. Juan knows that his production function is
given by q = K 1/3 L1/3 .
1. In the short run the units of capital that Juan has are fixed and equal to 3. Find the short run total cost
function. [6 points]
Solution:
We know that in the short run K = K = 3. From the production function we have that

1/3 q3
q=K L1/3 ⇐⇒ L =

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K

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The total cost function is given by:

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1 1 q3 q3
T C = 2 + rK + wL = 2 + 3 + L = 5 + =5+

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4 4 3 12

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2. Now, let’s consider a time horizon long enough such that producers like Juan can adjust the level of capital,
although they still have to pay the sunk cost of 2 in order to learn the recipes. Assuming that they face the
same price for labor (w = 41 ) and for the rental rate of capital (r = 1), find the long run total cost production
function in this market. [6 points]
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Solution:
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In this case the problem that they face can be written as:
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1 1 1
min 2 + L + K subject to q = L 3 K 3
K,L 4

From the fact that the marginal rate of substitution has to be equal to the marginal rate of transformation
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in this market we know that:

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1 K 3

1
1 3 L2 K
= 1 =
4 1 L 3

L
3 K2

which implies that in the optimal bundle of labor and capital we should have that:
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L = 4K
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then we have that: 3

√
3 2 q2
q= 4K 3 ⇐⇒ K =
2
3
and we have that L = 2q 2 . So, we have that:
3
TC = 2 + q2

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Section III. Hot Dogs [30 Points total]

You make very tasty hot dogs. You can do hot dog business in two potential monopoly markets: one inside
Fenway Park, Boston’s baseball stadium, and one inside TD Garden, the home arena for Boston’s ice hockey
team, the Bruins, and basketball team, the Celtics. The demand for hot dogs in each game in Fenway Park is
QF enway = 100 − 5p and the demand for hot dogs per game in TD Garden is QT D = 50 − 5p. You need to pay 100
dollars per game for renting the space in each market. The cost of making a hot dog is 2 dollars. Assume that you
can sell fraction of hot dogs.
(a) What will the price of hot dogs in each market be if you enter both markets? [4 points]
Revenue at Fenway Park is q ∗(20− 51 q), so M RF enway = 20− 52 q. Since M C = 2, qF enway = 45
and pF enway = 11. Similarly, M RT D = 10 − 25 q and so qT D = 20 and pT D = 6.
(b) You are choosing which market(s) to enter. What will your decision be? [3 points]

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Your total revenue is 45∗11 = 495 at Fenway Park and your total cost is 100+2∗45 = 190 < 495,

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so you will enter the Fenway Park market. In TD Garden, your total revenue is 120 but your

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total cost is 140, so you won’t enter.
(c) Calculate consumer surplus in the market(s) you enter. [2 points]

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CSF enway = 12 (20 − 11) ∗ 45 = 202.5.
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Now suppose that Fenway Park has space for another potential hot dog seller, who can make the same hot dogs
with the same marginal cost as you and has to pay the same amount of rent. Customers will always buy from the
cheaper seller, but when the price is the same, they are indifferent and buy randomly (that is, each seller gets half
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of the customers). In (d)∼(f) below, hot dog sellers are competing over price.
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(d) If you and the other hot dog seller agree to charge the same price that maximizes each’s profit, what will
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this price be? What will your profit be? [6 points]

The price will be the monopoly price found in (a), which is 11 dollars, because this gives you
and the other supplier the largest total profit possible in this market and therefore splitting this
maximum profit equally gives you the largest possible profit when sharing half of the market
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with someone else. Your profit is 12 (100 − 5 ∗ 11) ∗ 11 − 100 − 2 ∗ 22.5 = 102.5. [When grading
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(d)~(e), note that we did not have “hot dog sellers are competing over price” in the regular exam.
Therefore, if someone did Cournot competition and did everything right, please give necessary
points. Let Donghee know if this complicates the situation too much!]
(e) Given that the other seller agrees to charge the price in (d), do you want to keep your promise? If not,
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how much will your hot dog be (assume that you can set the price down to cents)? What will your profit
be? And what will the profit of the other seller be? [6 points]
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You will want to deviate to a price that is arbitrarily close to 11 but smaller than it so that
you can take over the entire market and earn almost the monopoly profit, which is 305. In
reality, you will charge 10.99 because the smallest price reduction is a cent. This gives you
45.05 ∗ (10.99 − 2) − 100 = 304.9995. The other seller will have no customer and incur a loss,
which is worth of the rent.
(f) Suppose both of you are operating in the market. Find the price of hot dogs such that if you and the
other seller have no agreement on what price to charge, both of you act in your own best interest. Show
that given that the other seller sells hot dogs at this price, your best response is to charge the same price.
What will the profit for each of you be? [6 points]

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 The market price will be 2 dollars for each hot dog because if one seller sells at a price higher
than this, the other seller can undercut it and capture the whole market. Given that the other
seller charges 2 dollars, selling your hot dogs for over 2 dollars gives you no sale, which is
strictly domniated by selling them for 2 dollars. Also selling below your marginal cost does not
make any sense since you lose money by doing this. Therefore, your best response is to match
the other seller’s price when he sells it for 2 dollars and the profit will be -100 for both of you.
(g) Will a seller enter if you are already in the market (assume that you are the only one in the market)? [3
points]
No, if he enters then he knows that you will not credibly collude with him because your profit in
(e) (not colluding) is greater than your profit in (d) (colluding). So if he enters, the market will
eventually end up in the situation as in (f), where both of you lose money.

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Section IV. Fixies [30 Points total]

Consider the market for fixies1 in Somerville. The supply side of the market is perfectly competitive and is composed
by fixies producers, who have a long run cost curve C(q) = 2q + 5q 2 . The demand side of the market is composed
by all the hipsters who live in Somerville (since they do not have fixies yet, their travel costs are really high so
they only buy their fixies in Somerville). Their demand is QD = 8.5 − 2p. Afraid that all commercial real estate
in Somerville is going to be taken over by fixies producers, the mayor of Somerville caps the maximum number of
firms to 25.
1. What is the long run equilibrium price in the market for fixies? What is the quantity produced by each firm?
What are the total quantities demanded and supplied? Is any of the firms making any profits? Note that you
can produce fractions of fixies in Somerville. [6 points]

The marginal cost curve is: M C(q) = 2 + 10q and the average cost curve is: AC(q) = 2 + 5q. The

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average cost is minimized when q = 0, which implies that the supply curve is q = (p − 2)/10 if p > 2

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and 0 otherwise (from p = M C = 2 + 10q). Since the number of firms in the market is fixed, the

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total quantity supplied is QS = N q = 25 ∗ (p − 2)/10. Setting this equal to demand gives p = 3 and

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QS = QD = 2.5. Each firm produces q = 1/10 and makes profits π = 0.10 ∗ 0.5 = 0.05.

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2. Elections in Somerville are coming up. The mayor decides to try and win some votes from hipsters. After

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hearing their complaints about how the price of fixies is too high, he introduces a price ceiling equal to 2.5
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(but he keeps the maximum number of licenses set at 25). What is the quantity produced by each firm? What
is the profit that each firm makes (if any)? What are the total quantities demanded and supplied (and what
is the equilibrium outcome)? [6 points]
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At pP C = 2.5, each firm produces q P C = 1/20. Profits are: π = 0.05∗(2.5−2−5∗0.05) = 0.0125. The
total quantity supplied is QP F
= 1.25, while total quantity demanded is QP C
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S D = 3.5. In disequilibrium
the constrained side determines the market outcome, which means that the actual quantity traded
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on the market is QP C = QP S
C
= 1.25.

3. Under a price ceiling equal to 2.5, what happens to consumer surplus? And to producer surplus? Show them
in a graph and compute their value. Is total welfare higher or lower than before? Can you give an intuition
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of why? [4 points]
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Consumer surplus is: CS = 1.25 ∗ (1.75 + 1.125) ∗ 0.5 = 1.797. Producer surplus is: P S =
25 ∗ 0.0125 = 1/2 ∗ (1.25 ∗ 0.5) = 0.3125. Total welfare is: W = CS + P S = 1.797 + 0.3125 = 2.1095.
Total welfare is lower than before [total welfare before is 2.81, we don’t deduct point if a student
calculated this number wrong, as long as he correctly say that it is lower than before]; introducing
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a price cap moves the market further away from the perfectly competitive benchmark, which implies
that total welfare is going to be lower.
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4. What happens if instead the mayor decides to increase the number of licenses for fixie producers to 70? What
is the quantity produced by each firm? What is the profit that each firm makes (if any)? What are the total
quantities demanded and supplied? [6 points]

The total quantity supplied is: QS = N q = 70 ∗ (p − 2)/10. Setting this equal to demand: 70 ∗ (p −
2)/10 = 8.5 − 2p, which gives pLR = 2.5. Each firm produces q = 0.05 and QS = QD = 3.5. Profits
are: π = 0.05 ∗ (2.5 − 2 − 5 ∗ 0.05) = 0.0125.
1 A fixed-gear bicycle (or fixed-wheel bicycle) is a bicycle that has no freewheel, meaning it cannot coast, because the pedals are

always moving when the bicycle is in motion. Hipsters like them.

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 5. What is consumer surplus under the new number of licenses for fixie producers? And producer surplus? Is
total welfare higher or lower than in the case where the number of firms is capped at 25 as in (1)? [4 points]

Consumer surplus is: CS = 3.5 ∗ 1.75 ∗ 0.5 = 3.0625. Producer surplus is: P S = 70 ∗ 0.0125 =
1/2 ∗ (3.5 ∗ 0.5) = 0.875. Total welfare is: W = CS + P S = 3.0625 + 0.875 = 3.9375. Total welfare
is higher in this case since we are moving closer to the perfectly competitive benchmark.

6. If the mayor only cares about hipsters (and does not care about fixies producers) which policy should he
implement between setting a price ceiling and increasing the number of licenses to 70? What if he only cares
about the single fixie producer? What should he do if he wanted to maximize social welfare (and he could
use any policies, not just the two mentioned)? [4 points]

If the mayor only cares about consumer he should increase the number of licenses to 70. If he only
cares about the well-being of the single fixie producer, he should keep the total number of licenses
fixed at 25 (since each producer is making higher profits in this case). If he wanted to maximize
social welfare he should not impose any restrictions in the market.

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 Graphs

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