FINAL EXAMEcon 115a, 1996Instructions: No books, no notes. This exam is designed to take 2 hours, but you maytake three hours if necessary. If you finish early, you may leave if it is possible to do soquietly. Concise answers will be favored over long-winded ones. There are 120 points on theexam, so to complete the exam in two hours, you would take one minute per point.PART INAME:TA:(20 points). Define the following terms in one or two sentences in the space provided on thispage. 4 points each. Be sure to turn in this page and indicate your name and section leader.1. Reaction Function2. Statistical Discrimination3. Negative Externality4. Head Tax5. Monopsony1PART IIAnswer these question in a separate bluebook labeled “Part II”. Be sure to indicate yourname and your section number on the bluebook. 33 points total.1. (13 points) Suppose that the market (inverse) demand curve isp = a − bq,where a and b are constants. Suppose that marginal cost is constant and equal to c.(a) What is a monopolist’s price and quantity?(b) Compare this to the perfectly competitive price and quantity.(c) Graph the optimal price and indicate the area of the deadweight loss.(d) On the same graph, indicate the area of surplus transfered from consumers toproducers.2. (14 points) Consider a Cournot duopoly. Assume constant marginal costs.(a) Graph the reaction function of firm 2 as a function of the output of firm 1 (putq2on the vertical axis).(b) Give an economic interpretation to the intercepts on the q2and q1axes.(c) Now graph the Cournot equilibrium output.(d) Show how the equilibrium would change if the marginal cost of firm 2 declines.3. (6 points) Graph an average cost curve that implies a natural monopoly at some outputsbut not at others. On the same graph, add a demand curve such that the industry isa natural monopoly.2PART IIIAnswer these question in a separate bluebook labeled “Part III”. Be sure to indicate yourname and your section number on the bluebook. (34 points).1. (10 points) Explain the “prisoner’s dilemma” and how it relates to collusion.2. (4 points) Suppose that the interest rate is r. Give an equation for the present valueof an inve stment that returns $1000 this period, $2000 next period and $3000 in theperiod after that.3. (10 points) Consider a perfectly competitive labor market. Now suppose the gove rmentdecides to pay $5000 per year to every person who has no income. Use an indifferencecurve analysis to graph the effect of the payment on an individual’s labor supplydecision.4. (10 points) What is the optimal level of a pure public goo d? Illustrate your answerwith a graph.3PART IVAnswer these questions in a separate bluebook labelled “Part IV”. Be sure to indicate yourname and your section number on the bluebook. (33 points).1. (6 points) Consider pollution taxes.(a) What is the optimal level of a tax on pollution?(b) Would it be better to tax pollution directly or to tax the production of the pol-luting good? Why?2. (15 points) Consider the market for fire insurance.(a) Graph utility, as a function of income, in a way that indicates a risk-averse con-sumer.(b) Now graph the expected utility of the consumer with and without insurance.(c) Would this consumer buy fair fire insurance?3. (6 points) One argument against the North American Free Trade Agreement (NAFTA)was that US manufacturing jobs would go to Mexico and that no other jobs wouldreplace them.(a) Under perfect competition, what is the counter argument to this claim?(b) Give one criticism of NAFTA that is consistent with perfect c ompetition.4. (6 points) Consider a democracy in which the only political issue is the level of taxation.Say that there are only two political parties. What tax level will be