ECON3400H – Assignment 2 Final Exam

Subject: Economics / General Economics
ECON3400H – Managerial Economics
Winter Semester, 2017
Assignment #2
Final Exam on April ,2017
This assignment has 6 questions worth a total of 100 marks, and is worth 15% of the course grade.
The marks for each question are as indicated, and are evenly divided among the components of a
question. Answers to the assignment must be legible, concise and submitted in hard copy at the
beginning of the exam. While students may work together on the assignment, they must develop,
write up and submit answers independently.
1. (15 marks) Consider pricing with market power:
a. Briefly define price discrimination and state the four conditions for it to be viable.
b. A monopolist is considering a choice between two alternative pricing strategies: (i)
perfect price discrimination and (ii) two-part pricing. Assume both strategies are
feasible and the demand side of the market comprises identical consumers.
Determine which of the two strategies will earn the monopolist the greater amount
of profit. For each strategy, determine the share of consumer surplus the monopoly
is able to extract as profit.
c. A cable utility is considering various pricing strategies over the provision of internet
and TV services. The table below summarizes the reservations prices ($/month) for
these services by type of customer:
Traditional Internet
$50 TV
$70 Bundle
$120 The utility cannot observe customer type and the marginal cost of serving an
additional consumer with either service is zero. From the utility’s perspective, rank
the following pricing strategies by determining the associated revenue-maximizing
prices: (i) separate pricing, (ii) pure bundling and (iii) mixed bundling. 2. (15 marks) Consider an oligopolistic market with identical firms. Inverse market demand
is given by = ? where and are market price and output, respectively. Total cost
for each firm is given by = where is firm-level output.
a. Verify that marginal revenue is given by = ? (2 + ? ? ), where is
output of firm and ? ? is the sum of all other firms’ output ?.
b. Recognizing the symmetric nature of the equilibrium, derive the expression for the
Cournot equilibrium output for firm as a function of the model’s parameters ,
, and .
c. Verify that the Cournot equilibrium market output approaches the competitive
level ? as the number of firms grows without bound.
3. (20 marks) Consider a town of homes for which annual fire loss is independently and
identically distributed according to a probability distribution where the expected value is percent of the home’s value. Each homeowner is risk-averse and has a risk premium of percent of his or her home’s value in respect of the risk of fire. Recognizing this, the
homeowners decide to pool their risk by forming a non-profit mutual insurance cooperative
to which each homeowner contributes an annual insurance premium (measured in
dollars) in exchange for full fire insurance, according to the value of his or her home. For
simplicity, assume the cooperative has no explicit costs other than insurance claims.
a. Briefly define the term “risk premium”.
b. Since the cooperative comprises risk-averse members, it too is risk-averse. For each
home, the cooperative has a risk premium of percent of the home’s value, which is
an implicit cost. Based on the Law of Large Numbers, briefly argue that < and
that ? 0 as ? ?. That is, argue that the cooperative faces less risk than an
individual member, and that this risk approaches zero as the number of members
grows without bound.
c. For a homeowner with a home valued at (measured in dollars), express the annual
insurance premium as function of , , and . Is this an actuarially fair premium?
d. Supposing = 0.20% and = 0.05%, determine the value of paid by a
homeowner with a home worth = $600,000.
4. (15 marks) Consider the problems arising from asymmetric information:
a. Define the following terms: (i) adverse selection, (ii) moral hazard, (iii) screening,
(iv) signaling, (v) principal-agent problem and (vi) efficient contract.
b. Consider government-provided health insurance, such as OHIP in Ontario, and
government-mandated insurance, such as Obamacare in the United States. Are such
programs intended to combat adverse selection or moral hazard? Briefly
characterize the tradeoff between adverse selection and moral hazard in respect of
health insurance public policy. c. Auto insurance policies often require deductibles and health insurance policies
often require copayments. Briefly explain whether and how deductibles and
copayments are intended to combat adverse selection or moral hazard.
5. (25 marks) Consider a utility providing water service as a natural monopoly to residents of
a city. The market (as defined by the city’s boundaries) comprises 100,000 identical
households, each of which has an inverse demand function = 23,000 ? 80,000 where is the number of megalitres (ML) of water demanded annually and is the price per
megalitre (1 ML = 1,000m3). Letting denote total production (i.e. total output in the
market) in megalitres, the annual total cost to the utility of providing water is () =
81,900,000 + 5,000 + 0.1 2. Thus, average cost and marginal cost are, respectively,
given by () = 81,900,000/ + 5,000 + 0.1 and () = 5,000 + 0.2.
a. Briefly explain why water service (treatment, transmission and distribution) is a
natural monopoly within the city.
b. Show that inverse market demand is given by = 23,000 ? 0.8 and that the
efficient price, consumption level and output level are ? = $8,600, ? = 0.18 and ? = 18,000, respectively.
c. Calculate the deficit incurred by the utility if it charges ?. Illustrate the efficient
outcome and the deficit in an appropriate diagram.
d. Verify that marginal revenue is = 23,000 ? 1.6. Show hat the equilibrium
price, consumption level and output level are = $15,000, = 0.1 and = 10,000, respectively, in the absence of regulation. Calculate the profit earned
by the utility in equilibrium. Illustrate the equilibrium outcome and profit in an
appropriate diagram.
e. The total replacement value of the utility’s infrastructure is $1,000,000,000. The
infrastructure requires capital replacement at a rate of $11,900,000 per annum due
to physician depreciation and is financed by shareholders whom earn a return on
investment (ROI). Depreciation and the required ROI are the only fixed costs to the
utility; all other costs are assumed to be variable. Determine the equilibrium rates
of depreciation and ROI (in percentage terms), and decompose ROI into its required
(i.e. investment opportunity cost) and economic rent components.
6. (10 marks) Use an appropriate table to define the following terms: (i) private good, (ii) club
good, (iii) common good and (iv) public good. Identify the term commonly used to refer to
the externality associated with public goods.

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