Business And Economics: Course Manual 2012

1.2 International Business

Economics and Business1

Course manual (EBC1009-2012-13)

18 October 2012

1No part of this publication may be reproduced or distributed in any form or by any means, or stored

in a database or retrieval system without any prior written permission of the authors.

(c) by J. Philipp Reiss and Jan Vandekerckhove

Contents

1 Introduction 2

2 Course Contents and Literature 2

2.1 Literature . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2

2.1.1 Compulsory Literature . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2

2.1.2 Deficiencies in Mathematics . . . . . . . . . . . . . . . . . . . . . . . . . . . 2

2.1.3 Supplementary Literature . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3

2.2 Contents . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3

3 Course Organization 4

3.1 Lectures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4

3.2 Group Tutorials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4

3.3 eleUM Quizzes and Required Readings . . . . . . . . . . . . . . . . . . . . . . . . 5

3.4 Determination of Final Grade . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5

3.5 WARNING: Consequences of Not Passing Participation . . . . . . . . . . . . . . . 8

3.6 Repeat Students . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8

3.7 Study Switchers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9

3.8 The Planning Group . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9

4 Tasks 11

5 Exam Examples 23

1

1 Introduction

The undergraduate course Economics and Business introduces economic principles and concepts.

The following topics are addressed in lectures and tutorials: supply and demand, perfect com-

petition, monopoly, game theory, oligopoly, auction markets, agency theory, and elements of

macroeconomics. Due to time limitations, the lectures cannot cover every single aspect of the

course that is dealt with, but rather focus on the most important and complex content.

Since Economics and Business is a first-year class, the presentation avoids the use of advanced

mathematical concepts. However, knowledge of basic mathematical concepts such as solving

equations, reading and working with graphs, manipulating inequalities or elementary calculus

is an indispensable prerequisite.

In addition to economic contents, the course Economics and Business mediates Academic Writ-

ing Skills. For that, the Language Center offers a separate series of lectures and group tutorials

during course period 1.2. For details on the organization and contents of the academic writing

skills part, please see the separate course manual for the Introduction to Academic Writing that is

provided on the eleUM website in the folder ”Academic Writing”.

2 Course Contents and Literature

2.1 Literature

2.1.1 Compulsory Literature

The compulsory textbook for this class is:

! McDowell, M., Thom, R., Frank, R., Pastine, I. & Bernanke, B. (2012). Principles of Eco-

nomics, 3rd European edition. Maidenhead, UK: McGraw-Hill.

In general, you are free to use any textbook and any edition, but the course assumes that you

work with the 3rd edition of the compulsory textbook for this class implying that you are

responsible for any friction that arises from using another one (including using the first or

second edition.)

2.1.2 Deficiencies in Mathematics

If you feel that you have deficiencies in mathematics, here are two splendid textbooks:

! Chiang, A.C., & Wainwright, K. (2005). Fundamental Methods in Mathematical Economics,

4th ed. New York, NY: McGraw-Hill/Irwin.

2

! Sydsaeter, K., & Hammond, P. (2008). Essential Mathematics for Economic Analysis, 3rd ed.

FT Prentice-Hall.

2.1.3 Supplementary Literature

If you are interested in the economic history of Western economies, here is a short and non-

technical book:

! Heilbronner, R.L., & Milberg, W. (2006). The Making of Economic Society, 12th ed. Pearson

Prentice-Hall.

If you want to get to know exciting applications of Economics, consider the following enter-

taining book:

! Levitt, S.D., & Dubner, S.J. (2006). Freakonomics, Penguin Books.

For more information about eBay auctions, try:

! Steiglitz, Ken (2007). Snipers, Shills, and Sharks: eBay and Human Behavior, Princeton Uni-

versity Press.

2.2 Contents

Table 1 provides economic course contents for each week together with the relevant textbook

chapters of McDowell et al. (2012).

Week Topic Required reading

week 1The Economic View of Human Behavior

Game Theory

chs. 1 (incl. appendix),

16, and 9

week 2Demand and Supply

Elasticitieschs. 2 and 3

week 3 Optimal Choice ch. 4

week 4Perfect Competition

Welfare Analysischs. 5, 6, and 7

week 5

Market Structures

Monopoly

Oligopoly

chs. 8 and 10

week 6Optimal Search

Agency Theorychs. 11 and 12

week 7 Elements of Macroeconomicschs. 17, 18, 22, and

pp. 599-602, 615f., and 695f.

Table 1: Contents and required readings by week

3

3 Course Organization

There are four building blocks of the economics part of this course: lectures, group tutorials,

required readings, and eleUM quizzes. In each lecture week, the required readings introduce

the basic material and should have been read before enjoying the lecture; at least this is what

the lecture assumes. The lecture elaborates on that material, extends it, and demonstrates its

fruitful application. The purpose of the group tutorials is to deepen the understanding of that

material and to apply it to alternative contexts. Since mastering required readings is of eminent

importance to be able to adequately follow the lecture and productively participate in group

tutorials, there are weekly, compulsory multiple-choice quizzes on eleUM that allow every

student to monitor if the textbook material is sufficiently mastered.

3.1 Lectures

There are seven lectures, each given on Thursdays in the Lecture Hall in Tongersestraat 53. The

first lecture (November 1, 2012) is scheduled from 13:30 till 15:00. The six other lectures are

scheduled from 11:00 till 13:00. The lectures are given by the course coordinator.

Thursday Nov. 01 Nov. 08 Nov. 15 Nov. 22 Nov. 29 Dec. 06 Dec. 13

13:30-15:30 11:00-13:00 11:00-13:00 11:00-13:00 11:00-13:00 11:00-13:00 11:00-13:00

All lecture slides will be available at eleUM before the lecture. This allows you to download

and print them before attending a lecture which substantially eases note-taking during lectures

leaving more time to concentrate on the content.

3.2 Group Tutorials

There are nine group tutorials scheduled for the dates as follows:

Wednesday Oct. 31 Nov. 07 Nov. 14 Nov. 21 Nov. 28 Dec. 05 Dec. 12

Friday Nov. 30 Dec. 14

The weekly group tutorials employ the teaching method problem-based-learning. Therefore,

each meeting is composed of the pre- and post-discussion of scheduled tasks. All tasks for this

course are listed in chapter 4 of the course manual, see p. 11ff.

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Guidelines for attending a group tutorial

1. Prepare thoroughly and be on time.

2. Participate actively.

3. When it is your turn, take the role of the discussion leader seriously.

4. Be open towards new ideas and towards others

3.3 eleUM Quizzes and Required Readings

In order to ensure that everyone is sufficiently prepared to participate in a productive post-

discussion of tasks during group tutorials, a necessary requirement to pass the course is to

pass 5 out of 7 multiple choice quizzes. These quizzes are administered through eleUM during

lecture weeks 1-7. There is one quiz in every lecture week. Every quiz is composed of multiple-

choice questions about the required readings for that week during which the quiz is conducted.

All questions are randomly drawn from a large database of questions. Therefore, every quiz

given to any student is unique. We expect that you first study the required readings and sub-

sequently take the quiz. If you did not pass the first time, you should study the chapters again

and afterwards retake it. However, you cannot retake it more than once. We recommend you

not to wait until the last minute since experiences of the previous years show that most ”tech-

nical problems” occur just before the deadline. In order to pass a quiz, you need solve at least

12 problems correctly. In the exam week, you get one extra and final opportunity to retake each

quiz. Taking eleUM quizzes seriously is a good preparation for the final exam since 40% of the

written exam consists of questions from the same database as that for the eleUM quizzes.

3.4 Determination of Final Grade

There are three necessary requirements for passing the course Economics and Business:

1. Passing the final exam;

2. Passing the participation requirement (or passing the course assignment as published at

the eleUM site of the course);

3. Passing the skills training Introduction to Academic Writing.

You must pass each of these items separately in order to pass the entire course.

1. Passing the final exam

The final exam consists of two parts, a multiple-choice part (60%) and an open-book part

(40%). Both parts are based on the material that is covered in the lecture, the lecture

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notes, the required readings, and the tasks.

The multiple-choice part is a closed book exam that consists of 60 multiple choice ques-

tions. 40 multiple choice questions are drawn from the database that is used for the

eleUM quizzes.

The open-book part consists of problem-type questions. Note that you can bring anything

with you for the open-book part of the exam (except for, of course, items that are pro-

hibited in the exam regulations such as mobile phones). There are 60 minutes available

for the open-book part. It is designed such that students with excellent command of ma-

terial covered during the course period have sufficient time to adequately address the

entire open-book part of the exam. This implies that students with an average level of

knowledge or even a good level of knowledge presumably run out of time on this part. A

time-saving practice is to continuously work during the course period with the textbook

and notes used on the final exam so that valuable final exam time does not have to be

wasted on locating relevant material in the set of resources. Needless to mention that

reading is time-consuming, too.

The final grade of the final exam, which is also your final grade for the entire course,

is determined by the sum of points that you score on the multiple-choice part and the

open-book part.

2. Passing the participation requirement (or passing the course assignment as published

at the eleUM site of the course)

This part of the examination actually contains two requirements that you both have to

satisfy in order to be exempted from doing and passing the course assignment: (a) the

usual 75% requirement for the weekly group tutorials, and (b) the weekly eleUM quizzes.

(a) The 75% attendance requirement boils down to attending 7 out of 9 weekly tutorials.

Attending a tutorial means more than just physical presence: you are expected to

prepare the relevant literature, to participate actively in the discussions and to take

responsibilities, like being discussion leader, seriously. If you fail to do so, your tutor

is entitled to deny your “cross” to you, even when your physical presence is beyond

dispute.

(b) Passing 5 out of 7 weekly eleUM quizzes during weeks 1-7. To stimulate you to read

the relevant literature in time, to help you identify remaining gaps in your knowl-

edge after this reading process, or boost your self-confidence by establishing that

such gaps don’t exist, you are expected to do a weekly quiz which will be presented

to you through eleUM. Each week’s quiz consists of 20 multiple choice questions,

drawn from a large database and corresponding to that week’s required readings.

6

For example, week 2’s quiz corresponds to chs. 2 and 3 in McDowell et al. (2012),

see table 1 on p. 3 of this course manual. The selection from the database is ran-

dom and therefore different for individual students, but the degree of difficulty is

the same. To pass a quiz, you need to solve at least 12 questions correctly. Addition-

ally, you have to complete the quiz within 40 minutes, and before Monday, 18:00, of

the week following the lecture week in question. If you fail to pass for the first time,

then do not panic: for each quiz, you can have a second shot in that same week (but

within the following Monday 18:00 limit). To avoid misunderstanding, we stress

that the quiz questions are, on average, easier than the questions you will encounter

in the multiple-choice part of the final exam. Further, if you passed a quiz in your

first attempt, you can do the second attempt without endangering your original re-

sult. Similarly if you passed a quiz either on the first or second attempt, you can

do the third attempt during the final exam week without endangering your original

result, too. This allows you to take resit quizzes as a preparation for the final exam.

You are exempted from the course assignment if you simultaneously satisfy requirements 2(a)

and 2(b). Students who fail one or both of them have to do the course assignment. This assign-

ment will be published on eleUM, involves a considerable workload, and is graded explicitly.

Note that, apart from the course assignment, there is no resit for requirements 2(a) and 2(b)!

3. Passing the skills training ”Introduction to Academic Writing”

The exam requirements related to the parallel skills training Introduction to Academic Writ-

ing are spelled out at length in the corresponding manual on our eleUM site, under the

“Academic Writing” button in the menu column on the left of the screen. Briefly, they

boil down to:

(a) Sufficient presence and participation in the group tutorials organized by the Lan-

guage Center, including the writing of one short paper that is peer-reviewed.

(b) Writing the main paper. The subject of this paper is related to the contents of the Eco-

nomics and Business course. The use of the English language will be assessed by your

language tutor. The economic content will be assessed by your Economics and Busi-

ness tutor. The paper has to be submitted in two ways: (1) electronically via eleUM

(deadline: Monday 10 December 2012, 18:00); AND (2) as a hardcopy to your Eco-

nomics and Business tutor in the tutorial on Wednesday 12 December 2012. (If you

are a repeat student and do not participate in a tutorial group, hand in the hard copy

to the pigeonhole of Jan Vandekerckhove in room A1.06 by the same deadline.) Both

the electronic and the hard copy must be the same. Please make sure that the name

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of your language tutor and that of your Economics and Business tutor appear on the

cover of the paper. In case you happen to be a repeat student, please indicate this

information next to your name on the cover of the paper - this considerably eases

the organizational process of grade provision.

Note: The paper will be checked extensively for plagiarism and copying. Any

paper found to be plagiarized or copied will receive a score of zero, and the per-

petrator will be subject to the disciplinary authority of the Exams Committee.

Note: The procedure for "Introduction to Academic Writing" is strict. Not follow-

ing the procedure might result in serious consequences.

3.5 WARNING: Consequences of Not Passing Participation

Please note that the consequences you face if not passing participation in the tutorial groups,

eleUM quizzes and in the academic writing tutorials (or not compensating it by passing the

relevant course assignments) are serious! Not passing participation means that you have to

register for the entire course in the future again and to pass participation then. Since there

is a maximum number of courses that you can take in any course period, re-taking EBC1009

Economics and Business in future implies that you will be prevented from taking other

courses in the second or third year that you certainly will prefer to take at that time!

3.6 Repeat Students

repeat student = a second-year student who continues to study in the same program as in the

first year, but did not pass the course Economics and Business in the first year.

All partial exam results from last year remain valid, i.e. final exam, participation require-

ment, and both elements of academic writing skills (participation and main paper). You do

not have to redo whichever of these items you passed last year. Notice that for the final exam,

only your overall grade remains intact, the individual components (multiple-choice part and

open-book part) are not carried over; analogously only your overall participation result re-

mains intact implying that if you have either failed the eleUM quizzes or the 75% attendance

requirement, you have to redo both elements in this year. The same principle applies to the

main paper: you have to pass both on content and on language; partial success in one of these

components cannot be carried over. Of course, you can do the eleUM quizzes in this course

period voluntarily again to benefit from the feedback and prepare for the exam.

The following remarks concern registration:

� If you have to redo Economics and Business participation or the writing participation, or

both, then you have to formally register for the entire course again.

8

� If you have to redo the final exam, but already passed the Economics and Business partici-

pation, then you do not need to formally register for the entire course again. It is sufficient

to register for the exam.

� If you have to redo the main paper but already passed writing participation, then you

do not need to register for the entire course again. However, you have to sign up for the

main paper by sending an email to [email protected] before

Wednesday 31 October 2012. Moreover, you have to formally enroll again in the SAP

system. You do so by registering at MY UM for the course Economics and Business and

you need to indicate only exam. This is really important in order to make sure the grade

of your paper counts.

If there remain any doubts about the precise requirements that you have to satisfy, please

contact the course coordinator by email at [email protected] as

soon as possible.

3.7 Study Switchers

study switcher = a student who switched from one study program to another one.

In general there are no exemptions! However, there is one exception to this rule: If you

have already passed the Introduction to Academic Writing as an element of another course, e.g.

Microeconomics in the Economics program, then you do not have to redo the participation

requirement of the academic writing part. However, you still have to write the main paper.

You have to submit a request by email to [email protected] before

Wednesday 31 Ocotber 2012.

If there remain any doubts about the precise requirements that you have to satisfy, please

contact the course coordinator by email at [email protected] as

soon as possible.

3.8 The Planning Group

This course has been designed by a planning group consisting of the following persons:

� Dr. Jan Vandekerckhove (course coordinator, email: [email protected])

� Dr. Kyle Hyndman

� Dr. Kaj Thommson

9

The current design of the course has been developed by Philipp Reiss, updated by Jan

Vandekerckhove and benefited from helpful comments by Jeannette Hommes, Christian Ker-

ckhoffs, Bart Rienties, Ronald Peeters, and Bob Wilkinson.

The course coordinator is the person to contact in case of questions about the Economics

and Business part of this course by emailing to [email protected].

For the Academic Writing Skills part, please contact Mr. Wilkinson or Mrs Struijke at the email

address [email protected].

10

4 Tasks

Regular tasks that require the approach of problem-based-learning as well as exam examples

are discussed in tutorial group settings. The purpose of the exam examples is to illustrate the

style of problems that can be expected for the open-part of the final exam. Indeed, the majority

of these problems was used as exams questions before. Please notice that the given examples

are not exhaustive in any sense since there are many, many more problems (in terms of variation

and topic) that can be expected to be on the exam. Some more problems are provided at the

eleUM site of the course. Table 2 details the allocation of tasks and exams examples to group

tutorial meetings.

Meeting Post-discussion Pre-discussion Exam example

1: Oct. 31

WED / wk 1introduction tasks 1 and 2

2: Nov. 07

WED / wk 2tasks 1 and 2 tasks 3, 4, and 5 X1

3: Nov. 14

WED / wk 3tasks 3, 4, and 5 tasks 6 and 7 X2

4: Nov. 21

WED / wk 4tasks 6 and 7 tasks 8, 9, and 10 X3

5: Nov. 28

WED / wk 5tasks 8, 9, and 10 tasks 11, 12, and 13

6: Nov. 30

FR / wk 5tasks 11, 12, and 13 tasks 14 and 15 X4

7: Dec. 05

WED / wk 6tasks 14 and 15 tasks 16 and 17 X5

8: Dec. 12

WED / wk 7

tasks 16 and 17,

hand in papertasks 18, 19, and 20 X6

9: Dec. 14

FR / wk 7tasks 18, 19, and 20 X7

Table 2: Allocation of tasks

11

Task 1 Advertising on the Internet

Consider the online business news market, particularly the online editions of the Financial

Times, ft.com, and the Wall Street Journal, wsj.com. Suppose that both sites compete for clients

in online advertising by setting either a high price or a low price for a web banner. If both firms

set a high price, each of them earns 100. If both firms set a low price, each of them earns 50. If

one of them sets a high price while the other one sets a low price, the one setting the high price

earns 0 while the one setting the low price earns 150.

Task 2 Applied Game Theory: some little games

1. Appealing to the Theory of Games, try to solve the following decision problem using the

solution concept known as Nash equilibrium:

Imagine that visitors are distributed evenly along a long and straight beach. That is, the

distance between each pair of guests is the same. Furthermore, everybody wants to have

exactly one cup of ice cream. Suddenly, two sellers of ice cream turn up who want to

sell as many cups as possible. Both charge the same price and sell the same quantity and

quality of ice cream (regard ice cream as a homogenous good). Let’s consider the rules

of the seller’s game: Since ice cream melts in the sun, every guest buys from the seller

closest to him. If the distance to both happens to be the same, each seller is chosen with

probability 0.5 If both sellers choose the same location each sells to 50% of the guests.

Once a seller has decided about his location, he can’t move to another place for the rest

of the day.

The problem of both sellers is to choose a particular location on the beach independently

of each other and simultaneously, that is, each of them wants to determine his optimal

strategy. What is the unique Nash equilibrium in (pure) strategies? [This setting was

introduced in a paper by Hotelling in 1929 and is commonly referred to as Hotelling’s

beach.]

2. Find all Nash equilibria in the following game. The first entry in each cell is the payoff

to player 1, the second entry is the one to player 2. Is there a dominant strategy for any

player? Predict the outcome of this game.

player 2

left right

player 1 up 5,1 1,0

bottom 3,1 2,2

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3. Consider the game in the preceding strategic form. Suppose player 1 moves first and

player 2 moves after observing player 1’s choice. Find the extensive form of this game

and solve it by backward induction. Predict the outcome of this game and compare your

prediction to the one you made for the simultaneous version of this game.

4. Find all Nash equilibria in the following game. The first entry in each cell is the payoff

to player 1, the second entry is the one to player 2. Is there a dominant strategy for any

player? Predict the outcome of this game.

player 2

left right

player 1 up 5,1 1,0

bottom 8,2 2,1

Task 3 Supply and Demand

The following figure depicts a time series for the oil price since 1970. As can be seen from

the figure, the price level fluctuates over time. E.g., in 1973/74 and 1979/80 the price-level

sharply skyrocketed. Economists typically rely on the model of supply and demand to explain

such price changes. Below the figure, there is a list of events that certainly affected supply and

demand plans which triggered supply-driven or demand-driven (or both) changes of the price

level.

$­

$10

$20

$30

$40

$50

$60

$70

$80

$90

1970

1972

1974

1976

1978

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

2006C

onst

ant $

2005

 per

 bar

rel

Oil prices 1970-2006; Source: US Energy Information Administration

1. Oil embargo of OPEC (production cut) begins on Oct. 19-20, 1973 (first oil crisis).

2. 1979/1980: revolution in Iran and first Gulf war Iran-Iraq (second oil crisis).

3. Early 1980s: Combined Non-OPEC and OPEC oil production increase.

13

4. Iraq invades Kuwait on Aug. 2, 1990, Operation Desert Storm begins shortly thereafter,

end of war in 1991.

5. September 11, 2001: Terrorist attacks on the US leading to increased fears of sharp eco-

nomic downturn.

6. Early 2002: Oil production cuts by Non-OPEC and OPEC plus unrest in the Middle East.

More details may be found at, e.g., the website of the US Energy Information Administra-

tion at http://www.eia.doe.gov/emeu/cabs/AOMC/Overview.html.

Task 4 Market Equilibrium

Consider the demand for mathematical textbooks in Micromania. There are separate estimates

of the demand schedules for the northern and the southern part of the country that both depend

on the price level P � 0:

QDN(P) = 100� 2P

QDS (P) = 50� 5P

The supply of textbooks for the whole country is given by

QS(P) = 3P.

What is the market equilibrium in Micromania as a whole? How does the market equilibrium

qualitatively adjust if there is a unification of Micromania and some other country?

Task 5 Elasticities

The publishing company ReadIt publishes its magazine Survive Economics in the internet. In

order to access it, readers have to purchase an annual subscription that is currently priced

at P1 = 100 EUR. At this price, the company recorded Q1 = 600 subscriptions. The cost of

providing the magazine online is independent of the number of subscriptions. Unsurprisingly,

the management’s goal is to increase the subscription revenue as much as possible. Recently

an analysis of the demand for Survive Economics lead to the trustworthy information that the

firm sells Q2 = 800 subscriptions if it sets the price at P2 = 50 EUR and that it sells Q3 = 200

subscriptions if it charges P3 = 200 EUR. The management knows that there is an ambiguous

effect on subscription revenue if it increases or decreases the subscription price that is somehow

related to the economic concept of a price elasticity of demand. In order to figure out up to what

level it should increase or decrease its price or even leave it unchanged, it decided to employ

the management consultancy Clever&Smart.

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Task 6 Optimal Choice

A powerful tool for analyzing and predicting the behavior of homo sapiens (but also for capuchin

monkeys1) is indifference curve analysis that incorporates the rational choice rule. This analysis

strictly separates considerations concerning tastes from budgetary considerations. Preferences

(=tastes) are represented by indifference curves. Affordable consumption bundles are repre-

sented by the budget set where its frontier is the budget constraint. Indifference curve analysis

assumes that an individual selects that particular consumption bundle in the budget set that

lies on the highest indifference curve. If preferences are well behaved, the selection of the op-

timal consumption bundle satisfies an equivalent restatement of the rational choice rule where

the marginal rate of substitution is equal to the relative price. Essentially, indifference curve

analysis operationalizes the behavioral assumption that an individual chooses his/her mostly

preferred consumption bundle that it can afford. Apart from the traditional application to typ-

ical consumption goods, a broader interpretation of a good allows its applications to scenarios

such as the allocation of time between labor and leisure, intertemporal consumption decisions,

or trade-offs between monetary income and personal integrity of sales representatives.

Assume that there are two goods in the world: apples and bananas. Say that Eefje has a

utility function for these goods of the following type, where xB denotes the quantity of bananas

and xA the quantity of apples

U(xA, xB) = xA + xB.

Julie’s utility function is

U(xA, xB) = xA + 2xB

and Natalie’s utility function is given by

U(xA, xB) = xA � xB.

For each individual do the following:

a) Draw the indifference curves that are defined by the utility function (2-3 curves). In the

case of Natalie, make sure to include an indifference curve that is defined by a utility level

of 2,500.

b) What is the marginal rate of substitution when Eefje/Julie/Natalie consumes 50 bananas

and 50 apples? What is the marginal rate of substitution between these two goods when

Eefje/Julie/Natalie consumes 100 bananas and 50 apples? What do the answers to these

questions imply about the type of goods the apples and the bananas are for them?

1See Chen, Lakshminarayanan, & Santos. (2006). How basic are behavioral biases? Evidence from capuchin

monkey trading behavior. Journal of Political Economy 114, 517-537.

15

c) If the price of bananas is 1 EUR per banana, the price of apples is 1 EUR per apple, and

Eefje/Julie/Natalie has 100 EUR to spend, what bundle of bananas and apples would she

buy? Would the marginal rate of substitution be equal to the ratio of the prices of these

goods in the optimal bundle? If not, why not?

d) If the unit prices of the bananas and the apples are 4 EUR and 3 EUR, respectively,

what bundle of bananas and apples would Eefje/Julie/Natalie buy with her income of

100 EUR?

Task 7 Optimal Choice at ReadIt

The publishing company ReadIt employs many writers that have similar preferences being

characterized by diminishing marginal rates of substitution. The company’s cafeteria offers

two categories of food: junk food and salad. To simplify, suppose these categories to be two

different goods. (We could make it more realistic by allowing for more goods, but this only

complicates things while offering no additional insight.) The cafeteria price of one unit of junk

food is pJ , the price of one unit of salad is pS. The representative employee spends an amount

of m on food.

ReadIt is a very special company. One of the things that make it special is its monitoring of

food consumption behavior in the cafeteria. As it happens, its employees spend 75% of their

budget on junk food although prices and portions of both goods are the same. In an attempt

to provide an incentive for healthy food consumption, the management of ReadIt orders its

cafeteria to double the price of junk food. Preferences are such that the expected consumption

decrease of junk food realizes, but - unfortunately and unexpectedly - the consumption of salad

decreased, too.

Task 8 Supply under perfect competition

Due to extreme weak demand for washing machines in Atlantis, every firm in the industry

appears to make losses. This development comes as a surprise to many market observers since

the number of suppliers and their supply plans did not change as compared to the previous

quarter where each firm made some economic profit. In Atlantis, washing machines produced

by different firms are essentially identical, so that consumers view them as homogeneous prod-

ucts. The current market price for washing machines is p =A$750.

WashingRobots is one of the producers of washing machines and its management is con-

cerned with its future in the face of its present losses. In order to make a rational decision, it

ordered a management consultancy to provide it with advice. As a first step, the consultancy

inquired into the cost processes of the firm that are representative for the industry. The firm’s

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total cost of production depending on the number y of washing machines that it supplies are

estimated to be:

C(y) = 5, 000+ 50y2.

As a second step it provides the firm with a profit maximizing supply plan and indicates mar-

ket price intervals where the firm makes an economic profit and economic losses. Since the

management of WashingRobots is interested in the long-run behavior of the industry, the con-

sultancy analyzed likely long-term developments: ”Due to huge losses of some of your com-

petitors, we have strong reasons to believe that many of them are in the process of exiting the

market. We expect that the current market situation of extreme weak demand is an exception.

Over the medium-run, market demand stabilizes at a somewhat higher level where you can

expect economic profits if you follow our suggested supply plan. Note that these economic

profits will fade away over time when the industry reaches its long-run equilibrium. We do

not recommend you to shut-down your production in this quarter as some of your competitors

did if you want to minimize your loss.”

Task 9 Government intervention in competitive markets

For Paradise Island, the demand and supply functions in the market for bread have been

estimated as

D(p) = 600� 10p,

S(p) = 40p.

Since in the currently prevailing unregulated market equilibrium the price of a single unit of

bread is rather high, the government plans to prevent excessively high prices of bread by im-

posing a price ceiling. After a lengthy discussion about which price ceilings affect the market

price and which do not, the government implements a law prohibiting the sale of a unit of

bread at a price above PI-$6. The government is extremely proud of its courageous regulation

policy and decides to ask a research agency to quantify the change of the economic surplus. At

the same time the government wonders why it receives plenty of complaints of consumers that

are ready to buy bread at $6 but find themselves unable to do so. As a response to the result

of the ordered research report and continuing consumer complaints, the government abolishes

the price ceiling.

Task 10 Taxation

The notorious government of Paradise Island plans to raise its tax revenue by introducing a

quantity tax into the pizza market. It defends its policy by arguing that junk food is unhealthy

and less pizza should be consumed. According to the implemented tax law, every single pizza

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seller has to pay PI-$5 to the government for each pizza sold. Since 20.000 pizzas were sold in

the absence of taxation, the government estimates the tax revenue to equal T = $100.000. In

the press and on TV, there is much lobbyism against the proposed taxation scheme on the basis

that the government tax leads the pizza price to double. The demand and supply schedules

have been estimated as

D(p) = 30, 000� 2, 000p

S(pn) = 4000pn

where p is the market price that a buyer pays for a pizza and pn is the net price that the seller

receives after subtracting any taxes. After the government introduced the tax, it wonders that

its revenue is somewhat lower than expected. In addition, economists claim that there is a

hidden cost of taxation due to price distortions that the government completely ignored.

Task 11 Monopoly: Appetizer

Consider the industry underwater housing. Since the construction of apartments in the sea

is quite involved, there is only a single supplier with the necessary technical expertise in the

market: FishyApartments. The cost function of the firm is given by (in Mio. EUR)

C(y) = 3y2 + 10y

and the firm faces the demand function

y(p) = 25� 0.5p

where the price level p is measured in Mio. EUR. The firm’s CEO boldly claims at the latest

Stockholder Meeting: ”Economics is not useless in running a business. All I ever learnt is to

simply equate the market price to marginal cost. If I did that, our company made a loss. In

contrast, I am proud of the profit FishyApartments enjoys which results from my personal rea-

soning to equate marginal cost to the price plus a mark-up that amounts to 800% of price (hint:

p + 8p). I fully deserve my bonus.” Then he adds, ”I always try to ensure that the company

operates at a point on the demand curve that is inelastic.” At the end of the meeting the CEO

wondered why the majority of stockholders forced him out of office.

Task 12 Monopoly: Welfare Loss

Suppose that the high-risk start-up ArtificialOrgans has been successful in the development

of artificial hearts that can perfectly substitute human ones. Since ArtificialOrgans patented

some of the key production processes and no other production technologies are yet available,

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it is a monopolist in this innovative market. The firm’s total cost function of daily production

is given by

C(y) = 8y

where y is the output of the firm and total costs is measured in 1’000s. The daily demand for

artificial hearts is assumed to be

D(p) = 20� p

where p is the price level that is measured in 1’000s.

There is a fierce fight on the company’s management board: some members prefer to choose

the welfare maximizing production level due to ethical reason, others prefer to choose the

profit-maximizing solution in order to recover R&D costs of investors that are sunk at this

point in time. They argue that only profits ensure that there is a continuing inflow of R&D

investment in future.

Task 13 Applied Game Theory: Strategic behavior of OPEC

In the face of the oil price evolution during September and October 2006, the organization

of oil producing countries (OPEC) announced on Oct. 20, 2006, that it decreases its production

”by an amount of 1.2 million barrel per day”. This joint decision to cut production requires that

each oil producing country that is part of the OPEC substantially decreases its daily produc-

tion level. Experts have mixed opinions about the production level that the OPEC is expected

to implement. Some of them believe that the trust between OPEC-members is sufficient to im-

plement this agreement. Others believe that each member faces a dilemma due to available

free-riding options that reflect in dominant strategies.

Task 14 Bertrand Oligopoly

There are two firms without capacity constraints in the market for diving eyeglasses in

Atlantis. Customers in this market consider the products of these firms to be homogeneous. As

it happens, the production cost for each eyeglass is independent of the number of produced

eyeglasses, the same for both firms, and given by Atlantis-$15. Buyers prefer to buy from the

firm that charges the lowest price. In case of equal prices, buyers flip a fair coin to decide where

to buy. Does this scenario constitute a game? What is the market price in Atlantis? How many

Nash equilibria are there? Does the outcome differ from that in a Cournot Duopoly?

For experts only: If you are up to a challenge, consider a market analogously to the one described

but with three identical firms. How many Nash equilibria exist? Characterize all of them, including the

prevailing market price!

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Task 15 Cournot Oligopoly: Theory and Experiment

Huck, Müller and Normann (2001) investigate the explanatory power of the Cournot model

of oligopoly and compare its theoretical prediction to experimental data. They study a model

with two firms that face the linear inverse demand function p(Q) = maxf30� Q, 0g where

industry output is the sum of individual firm output, Q = q1 + q2. Firm i’s cost function is

linear and given by Ci(qi) = 6qi where i = 1, 2.

The experimental evidence also sheds light on the stability of collusive behavior of firms

(’cartels’). Furthermore, the paper investigates the Stackelberg oligopoly in the same theoretical

setting.

The reference of the paper is Huck, Müller and Normann (2001): ”Stackelberg beats Cournot:

On Collusion and Efficiency in Experimental Markets”, Economic Journal 111(Oct.), 749-765.

Task 16 Decision Making under Uncertainty

Eefje Boonen sells apartments and she has to choose between two job offers.

� FishyApartments pays her according to sales performance: To keep things simple, suppose

that Eefje faces just three annual income possibilities. In a good year, she sells many

apartments and receives 400,000 EUR. In a bad year, she earns nothing. In any other year,

she receives 200,000 EUR. Each outcome is as likely as any other.

� SunshinePlaces pays her a flat wage of 200,000 EUR independent of her sales performance.

Eefje seeks to maximize the expected value of her income. Which job offer does she accept?

What is the role of risk aversion in this setting?

Task 17 Agency Theory

The company ElectionPrediction sells predictions about upcoming elections to the media.

For that, it relies on calling center agents that randomly call individuals by phone in order to

assemble a sample of intended votes. Focus on a representative agent. Suppose the company is

paid an amount of p for each intended vote in the sample. Each phone call leads to an intended

vote such that x is the number of phone calls that the agent places and the number of intended

votes generated by the agent. The more phone calls the agent places, the more disutility he

suffers. His utility function is given by u(w, x) = w � x2 where w indicates his wage. The

company offers the agent a contract. A contract fw, xg consists of the agent’s wage and the

number of calls that he has to place. Due to time restrictions, the agent cannot place more than

x̄ phone calls.

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� Scenario 1: The company is perfectly informed about the number of phone calls that the

agent places. The agent is a slave and has no choice but to follow the contract fw, xg. In

particular, the agent cannot opt out. Use an indifference curve analysis in contract space

to indicate the profit-maximizing contract that the company ElectionPrediction offers the

agent.

� Scenario 2: The company is perfectly informed about the number of phone calls that the

agent places. The agent is no slave and does not accept a contract that leads to a utility

index smaller than 0. In other words, the agent does not accept contracts leading to neg-

ative utility. Conduct an indifference curve analysis and identify the profit-maximizing

contract.

� Scenario 3: The company is not informed about the number of phone calls that the agent

places. For that it has to rely on the agent. Not every phone call is successful. In order

to ease the introduction of uncertainty, assume that for each given number of phone calls

x, nature chooses the share s of them that lead to an intended vote with equal probability

(density), 0 � s � 1. What happens if a utility-maximizing agent receives a flat wage?

What could be a fruitful alternative to the inefficient outcome if a flat-wage contract is

chosen?

Task 18 Macro Concepts

You hear about terms like nominal GDP, real GDP, inflation, consumer spending, and un-

employment on a daily basis in the news. However, many people only have a rather vague

idea about these concepts and how they are measured.

Task 19 The Keynesian Cross

The following statement relates to the benefits of fiscal policy: ”Everyone seems to agree

that government spending must increase in order to pull the economy from the grip of the

deepest economic downturn since the Great Depression. Especially spending on infrastruc-

ture, health care, scientific research and clean energy development could be very helpful in the

short-run to keep existing jobs, create new jobs and replace lost spending of consumers and

businesses in the current economic environment.”

One famous example of a recent measure taken in, e.g., the UK and Germany, is the vehicle

discount scheme (or ’scrappage scheme’) that applies to the subsidized purchase of a new car in

return for scrapping a very old car.

The Keynesian Cross is a simple macroeconomic model that allows to study the effects of

fiscal policy. There are multipliers. To fix ideas suppose that in an economy with no interna-

tional trade, the aggregate consumption function is linear and depends on disposable income

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where autonomous consumption is Caut > 0 and the marginal propensity to consume is c with

0 < c < 1. Further, I is fixed and the government selects G and T.

(Numerical example: Caut = 200, s = 0.25, I = G = T = 100.)

Task 20 Quantity Theory

In our all-round economy, the village Atlantis being at the moment a 7-good-economy, the

following transaction information was collected for 2009:

goods price [$] number of sold units

cornflakes 1 20,000

orange juice 2 100,000

chocolate 3 350,000

digital organizers 200 2,000

mobile phones 100 1,000

tobacco 2 200,000

sandwiches 4 160,000

� The monetary supply in that economy consists of 123,500 $1-notes. How many times did

a typical dollar change hands in 2008? Find nominal GDP for 2008 and use it to calculate

the velocity of money.

� If an economy’s growth rate is -1%, its money stock growth equals 1.5%, and the income

velocity of money decreases by 0.5% over time, what is its rate of inflation using the

quantity theory as a theory of inflation? If nominal interest is 5% what is the real rate of

interest.

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5 Exam Examples

Example X 1 Game Theory

Airbus and Boeing consider offering super-jumbo jets. Each firm has to decide to either

offer a long-distance jet of super size or not to introduce it. Expected profits depend on the

entry decision by each firm and are summarized as follows:

Boeing

yes no

Airbus yes -50, 25 80, 90

no 60, 70 70, 150

(payoffs: Airbus, Boeing)

a) Suppose the game is played simultaneously. Find all Nash equilibria; for each equilib-

rium show why it is a Nash equilibrium.

b) Suppose the game is played sequentially such that Airbus moves first. Draw the extensive

form of this game. Consider the strategy combination such that Boeing matches Airbus

behavior (i.e. Boeing enters if Airbus enters and Boeing does not enter if Airbus does not

enter) and Airbus does not enter. Why is this strategy combination a Nash equilibrium?

Is it a reasonable prediction for the outcome of the game?

c) Consider the sequential game discussed in part (b). Briefly explain backwards induction

and use it to identify the path of play in the subgame-perfect Nash equilibrium and relate

your result to your solution of part (b).

Example X 2 Market Equilibrium

Consider the market for flounders (a sort of fish). The demand function in the northern

part of the country is given by DN(p) = 4000� 25p while that in the southern part is DS(p) =

1000� 25p. The supply function is S(p) = 50p and p is the Euro price per kg of flounders.

a) Find the joint demand curve for flounders and calculate the market equilibrium in terms

of price and quantity and sketch it into a market diagram.

b) Find the price elasticity of demand and supply in the market equilibrium. Interpret both

numbers very briefly.

c) Suppose additional suppliers of flounders enter the market. What happens qualitatively

to the market equilibrium? Provide a sketch of a new market diagram that illustrates

market effects.

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d) Suppose additional demanders of flounders enter the market along with additional sup-

pliers. What happens qualitatively to the market equilibrium? Provide a sketch of a new

market diagram that illustrates market effects.

Example X 3 Optimal Choice

Suppose that Ronald faces the budget constraint m � p1x1 + p2x2 and that his utility func-

tion is given by u(x1, x2) = 2x1 � x0.52 .

a) Sketch 2-3 indifference curves. Find the marginal rate of substitution between goods 1

and 2 and identify the utility-maximizing consumption bundle if p1 = 1, p2 = 2, and

m = 15. Provide a sketch of the optimal consumption bundle.

b) Suppose the price of good 2 drops by 50%. Find the new optimal consumption bundle

and illustrate geometrically.

Example X 4 Government Intervention

Consider the market for designing websites. The demand function is D(p) = 2500� 80p

where p is the price per webpage. The supply function is S(p) = 45p.

a) Compute the market equilibrium in terms of price and quantity and indicate it in a market

diagram.

b) The government is crazy about protecting start-up businesses and introduces a price floor

of 30 EUR, thereby banning the sale of webpages at any price smaller than 30 EUR. Com-

pute the new market equilibrium under this form of regulation and find the excess supply

of webpages in the new equilibrium.

c) Compute the deadweight loss due to the price floor and illustrate it in a new market

diagram.

d) Forget now about the price floor. Instead, the government imposes a quantity tax on sell-

ers. For each webpage sold, sellers have to pay 5 EUR to the government. Compute the

market equilibrium under taxation. Compute government’s tax revenue and the welfare

loss. Provide a geometric illustration of the market equilibrium under taxation where

also the welfare loss is indicated.

Example X 5 Monopoly

Monopolist Milramia is faced with cost function C(q) = 40q2 where q is the level of pro-

duction. The market demand is D(p) = 300� p.

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a) Find the firm’s marginal cost and marginal revenue function.

b) Calculate the profit-maximizing production level and the price that it charges in the profit

maximum. Furthermore, find the firm’s maximum profit and calculate economic surplus.

c) What is the market equilibrium, ie. price and quantity, that a social planner chooses?

d) Illustrate the welfare loss in the case of a monopoly geometrically and calculate it.

Example X 6 Expected Value and Search for Bargain Prices

Brian is risk-neutral and plans to buy a MP3-player. His reservation value for a well-

functioning player is 80 EUR independently of the model. His reservation value for broken

players is 0 EUR.

a) Brian considers buying the MP3-player on the black market where no guarantee is given

so that he cannot return the player if he finds out that it is broken. Three models are

offered for sale differing in the probabilities of breaking down. With a probability of 80%,

70%, and 60% models A, B, and C work properly. They are priced at 70 EUR, 50 EUR, and

30 EUR respectively. Compute the expected value of either purchase and indicate Brian’s

optimal consumption choice. What does a negative expected value mean in this context?

b) Brian decided not to purchase on the black market. Instead he considers to buy at a

store at High Street. Prices charged differ across stores. In particular the chance to find

an MP3-player priced at 40 EUR, 60 EUR, or 80 EUR is 25%, 50%, or 25%, respectively.

Unfortunately finding out prices requires visiting the store which leads to a cost of 5 EUR

per visited store. Suppose Brian already identified a store that charges 60 EUR. Should

he continue searching for a price of 40 EUR?

c) Suppose Brian is faced with the situation as given in part (b) of this problem. What is the

search cost that makes him indifferent between continuing to search for a low price and

stopping search if he only identified a seller charging a price of 80 EUR?

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Example X 7 Keynesian Cross

Consider a closed economy that can be described by the Keynesian Cross. The marginal

propensity to consume is 0.6, government spending is G = 200, and investment is I = 150. The

consumption function of households is linear and depends on disposable income with taxes

T = 0 and autonomous consumption equal to 250.

a) Find household’s consumption function. Derive the marginal propensity to save and

interpret it in a single sentence.

b) Find aggregate demand and equilibrium output. Illustrate the equilibrium geometrically.

c) Suppose the government increases spending by 100 ceteris paribus. Find the government

spending multiplier and new equilibrium output.

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