UNIVERSITY OF TORONTO

ECO200– Term Test Three

Instructor: Professor Khazra

• You have 90 minutes to answer the questions.

• This exam contains 13 pages (including this cover page) and 6 questions. Total of points is
100.

• You should show your work for ALL questions. Correct final answers with inconsistent,
missing or wrong solutions receive no marks.

• For optimization questions, you can use either Lagrangian or the graphical approach unless
it is specified to use Lagrangian.

Distribution of Marks
Question: 1 2 3 4 5 6 Total
Points: 18 20 25 15 17 5 100
Score:

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ECO200 Term Test Three

1. (18 points) Consider the following Prisoner’s Dilemma game, where in (x, y) x refers to player
1’s payoff and y to player 2’s payoff. The row player is player 1. D is deviate and C is cooperate.

C D
C (2,2) (0,3)
D (3,0) (1,1)

(a) Prove that (D,D) is the only equilibrium in the game with no more than 2 sentences.
(b) Is (D,D) Pareto efficient? (Yes/No) explain why in one sentence only.
(c) Now suppose the game is played for infinite times. Players discount future payoffs at rate
d = 0.8. What is each player’s discounted payoff if they always cooperate (C)?
(d) With d = 0.8, suppose each player’s strategy is to play C forever, and play grim trigger
strategy if the other player plays D, that is, play D forever if the other player cheats. What
is the discounted payoff for player 2 if he/she cheats in the first period?
(e) Is both players always cooperating an equilibrium? Explain in no more than 2 sen-
tences. Anything after the second line/sentence will not be graded.

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2. (20 points) In the land of Westeros, House Lannister (Country 2) has occupied the Iron Islands,
and House Stark (Country 1) is contemplating whether to launch an attack to claim the territory
or to bow down to their rule. If House Stark decides to go to war, then both Houses will
engage in a simultaneous battle of wits, choosing between a bloody battle (Fight) or a peaceful
compromise (Accommodate). The game is depicted below in its extensive form.

(a) Show the simultaneous part of the game in normal form (draw the payoff matrix). Put
Country 1 as the row player. Solve for all Nash Equilibria including mixed strategies.
(b) Show the simplified tree(s). What is the outcome of the entire game? If there are multiple
outcomes, please list all of them. (Hint: use backward induction)

Use the following for part (a):

( , ) ( , )

( , ) ( , )

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3. (25 points) Imagine we have a monopoly product market and a monopsony labor market with
the following profit function:
π = T R(Q(L)) − T C(L) =⇒ π = T R(Q(L)) − w(L) × L

(a) Maximize the above profit function with respect to labor and derive the profit maximizing
equation involving the MRPL.
(b) Interpret your MRPL equation; what does MRPL mean? Why should the equation that
you found in the previous part hold for the firm to maximize profit? What is the meaning
of this equality?
Now let’s put this model to
√ work. A-S Glass is a monopoly producing glass bottles. The
production function is Q = KL, where capital is fixed at 100 and the rental rate of capital is
3. The company faces demand curve Q = 1000 − 50P .
(c) Calculate the marginal revenue product of labor.
(d) If the wage is 18 and the labor market is competitive, how many workers the firm will
hire?
√
(e) Going back to monopsony if the marginal expenditure is M E = L − 2, what is the
profit maximizing number of labor to hire?

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4. (15 points) Taxi Driver (A) and Truck Driver (B) are two occupations that closely substitute
each other, though not perfect substitutes. Labor supply for taxi driver is LA = 6WA − 4WB −
100, where WA is wage for the taxi drivers and WB is the wage for truck drivers. Labor supply
for truck driver is LB = 3WB − WA − 60. The demand for taxi drivers is LA = 620 − 2WA , and
the demand for truck drivers is LB = 270 − WB .
(a) What are the equilibrium employment and wage for both occupations?
(b) Suppose the government imposes a minimum wage of $130 for truck drivers. How are taxi
driver’s employment and wage affected?
(c) There is a negative demand shock to taxi drivers due to more public transportation. The
taxi company would like to know how it influences the equilibrium employment of taxi
drivers. Would partial equilibrium analysis over-estimate or under-estimate the effects
compared to general equilibrium analysis? (No need for calculus; explain in no more than
4 sentences)

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2 1
5. (17 points) Larry and Matthew like scarves and gloves. Larry’s utility is UL = 5S 3 G 3 , where
S and G denote consumption of scarves and gloves separately. Scarves and gloves are perfect
substitutes for Matthew, and his utility can be represented by UM = 4S + 2G. There are 8
scarves and 8 pairs of gloves in total.
(a) Derive the Consumption Contract Curve and show it in an Edgeworth box where Larry is
in the lower left corner.
(b) What is the efficient price ratio between scarves and gloves to achieve Pareto Optimal?
(c) Write down the Rawlsian social welfare function. What does the function imply?
(d) Assume that utilities have the same scale and are additive. If we are using a Rawlsian
social welfare function, explain how we want scarves and gloves be allocated between them?
Explain how can we use the second welfare theorem to reach this goal. Write no more than
4 sentences.

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6. (5 points) In the code below, we have two players (1 and 2) and two strategies (A and B).
Interpret the equilibria; what do the last three lines of outcome mean? What are the equilibria
in this game? You answer should not be more than 4 sentences.

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