Final Exam Practice Questions

Final Exam, 2024

1 True, False, or Uncertain (20 points)

1. (4 points) Sean is from the US and he is thinking about placing a bet that the
US will win the most number of gold medals during the 2024 Summer Olympics,
but his bet has a negative expected value. He will not place the bet.

2. (4 points) Only negative externalities can lead to an inefficient allocation, while

positive externalities will always result in efficient outcomes.

3. (4 points) Assume there are two firms A and B, which both produce the same
good. Assume also that Firm A has lower production costs than firm B. Firm
B will never enter market.

4. (4 points) A profit-maximizing monopolist chooses a price based by plugging

their first-order condition into the demand curve. A monopsonist, however,
chooses a price by plugging their first-order condition into the supply curve.

5. (4 points) A firm faces the cost function C(q) = 5q 2 + 10q. In a perfectly com-
petitive market, it always will choose to produce in the short run.

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 2 PRODUCTION THEORY AND COMPETITION (33 POINTS)

2 Production Theory and Competition (33 points)

Suppose you own an airline (we will call this a type 1 airline), with cost functions
given below:

SRT C 1 (q) = 10q 2 − 5q + 2 (1)

LRT C 1 (q) = 5q 2 + 5 (2)

The market demand for seats on flights is described by QD (P ) = 100 − P .

1. (11 points) It is the 1930’s, and there are only 5 firms (all type 1 firms) in the
market, including your firm. Consider production in the short run.

(a) (4 points) What is the short run market supply curve?

(b) (4 points) What is the short run equilibrium market price and quantity?
(c) (3 points) Do you make profits and why? If so, how much?

2. (8 points) It is the late 1970’s, and new firms (type 2) enter the market. Suppose
that the new firms entering the market are much more efficient. Their long-run
cost functions are given by:

LRT C 2 (q) = 4q 2 + 1 (3)

(a) (4 points) What is the long run supply curve for a single type 2 firm?
(b) (4 points) What is the long-run equilibrium price and quantity? How many
firms of each type are in the market in the long run? What happens to
your firm?

3. (8 points) You go out of business and your brother opens a new firm. His long
run cost curve is as follows (we will call this a type 3 firm):

LRT C 3 (q) = 2q 2 + 1 (4)

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 2 PRODUCTION THEORY AND COMPETITION (33 POINTS)

Assume that this is the only type 3 firm. All other firms are type 2 and have
costless entry and exit.

(a) (5 points) What is the market equilibrium price and quantity? What
quantity does the type 3 firm supply the market? How many type 2 firms
remain in the market, and what quantity do they supply?
(b) (3 points) Does any firm make a profit π in this market? If so, who, and
how much?

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 2 PRODUCTION THEORY AND COMPETITION (33 POINTS)

4. (6 points) There is now a global pandemic. Demand for air travel falls to
′
QD (P ) = 20 − 6P and is expected to remain at that level for a long time
(consider this a permanent change). Again, assume that there is only one type
3 firm in the long run. What is the new long-run market price and quantity?
What is notable about this? Explain what is happening intuitively.

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 3 INPUT FACTORS AND INTERNATIONAL TRADE

3 Input factors and international trade

Suppose that there are only two products, automobiles (A) and bananas (B). Auto-
mobiles are more capital-intensive (require relatively more capital) and are produced
according to the production function

FA (KA , LA ) = (KA )2/3 (LA )1/3

Bananas are more labor intensive (require relatively more labor) and are produced
according to the function

FB (KB , LB ) = (KB )1/3 (LB )2/3

Suppose that both labor and capital are perfectly mobile across the two industries.
That is, workers and capital can switch fluidly from producing automobiles to pro-
ducing bananas and vice versa. For this problem, assume everything is in perfect
competition.

1. If labor and capital are perfectly mobile across the two industries, what must be
true about wages and the price of capital in the two industries? That is, if wA
and wB are the wages per unit of labor paid to workers in the automobile and
banana industries respectively, what can we say about wA and wB ? Likewise,
if rA and rB are the price of capital in the two industries, what must be true
about rA and rB ?

2. For given values of w, r, find the number of units of capital per unit of labor
employed in each industry Which industry employs more capital per worker?
Explain mathematically and intuitively.

3. Calculate the marginal product of labor in each industry. Write it as a function

only of K
L
for both industries.

4. Firms choose their labor so that w = pA MPLA = pB MPLB . Using this condition
and your previous results, find the ratio of input prices wr as a function only of
A
the ratio of output prices ppB .

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 3 INPUT FACTORS AND INTERNATIONAL TRADE

pA
5. Is w
r
increasing or decreasing with respect to pB
?

6. Suppose that there are two countries, the US and Mexico. They both have
the same production technologies and the same preferences, but the US has an
abundant endowment of capital relative to labor, while Mexico has abundant
labor relative to capital. If both countries are in autarky, how do you think the
A
price ratio ppB in the US will compare to that in Mexico? Answer explaining the
intuition behind it, no math required.

7. Using your previous results, what can you say about income of workers relative
to capital-owners in the US and Mexico?

8. If the US and Mexico decide to trade freely, the equilibrium international price
A∗ A A
ratio ppB will be somewhere in between ppB in the US and ppB in Mexico. What
happens to the income of workers relative to capital-owners in the US and
Mexico when they open up to trade? Who might oppose free trade in the US
and who in Mexico?

9. Before trade, suppose that prices for product B were 1 in both countries, while
prices for product A were 1 for the US and 2 for Mexico. After deciding to trade
freely, prices for B remained at 1 while prices for A were set at 1.5. Calculate
the relative cost of labor ( wr ) in autarky for both countries before and after
trade. Assume that workers and capital cannot switch countries. Who is better
off and worst off with trade in each country?

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 4 TRADE AND WELFARE

4 Trade and Welfare

Supply and demand of potatoes of producers and consumers in the EU are equal
to p = 400 + 10qs and p = 1000 − 2qd respectively (where prices are in dollars and
quantities in tons).

1. Assume that under free trade, the global price is $800 and European consumers
can import any amount of potatoes at that price per ton. Does Europe import
or export potatoes at this price? How much does the EU import or export?

Suppose that the EU authorities decide that they have to decrease their de-
pendence on foreign potatoes, so they want to decrease imports of potatoes to
55 tons. We will consider different policies that can achieve this objective.

2. Suppose that the EU sets an import tariff of t dollars per ton of potatoes.

(a) What will be the price of potatoes in the EU with this tariff?

(b) What tariff t should the EU set in order to reduce imports to 55 tons?

(c) Calculate the deadweight loss generated by this policy. Who is better off
with this policy? Who is worse off? What are the sources of deadweight
loss?

3. Suppose instead that the EU will impose a tax on domestic consumption of

potatoes. In particular, European consumers must pay a tax of x dollars per
ton of potatoes that they buy.

(a) What is the price paid by European consumers and what is the price re-
ceived by European producers with this policy?

(b) What tax x should the EU set in order to reduce imports to 55 tons?

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 4 TRADE AND WELFARE

(c) Calculate the deadweight loss generated by this policy. Who is better off
with this policy? Who is worse off? What is the source of deadweight loss?

4. Which of these two policies generates a smaller deadweight loss? Can you pro-
vide an intuition for this result?

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 5 INTERTEMPORAL CHOICE (32 POINTS)

5 Intertemporal Choice (32 points)

A household has to decide how much to consume during their working age and how
much to save for retirement. We will model this as if there were two periods: period
1 is the working age, while period 2 is retirement. Suppose that we can represent the
preferences of this household with the utility function

c1−σ
1 c1−σ
U (c1 , c2 ) = + 2
1−σ 1−σ

where c1 is consumption in period 1, and c2 is consumption in period 2 and σ > 0,

σ ̸= 1. Buying 1 unit of consumption costs $1 in both periods. Income in period 1
is W dollars from employment, and w dollars during retirement. The household can
save and borrow at the market interest rate r. Assume that the household gets no
utility from leaving any money behind after death.

1. What is the opportunity cost (in terms of consumption today) of one unit of
consumption during retirement? Why?

2. Write an expression for the household’s budget constraint in terms of today’s

value of consumption and income.

3. How much of its income will the household consume and how much will it save
or borrow given the interest rate r? Show that the household will save a strictly
positive amount if and only if

w
W > 1 (5)
(1 + r) σ

For the rest of this problem, assume that there is no income in retirement,
w = 0.

4. Does the household save a positive amount? How much does it save?

5. Consider the case when σ = 21 . Does increasing interest rates increase or de-
crease savings?

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 5 INTERTEMPORAL CHOICE (32 POINTS)

6. Consider the case when σ = 2. Does increasing interest rates increase or de-
crease savings?

7. Explain intuitively why interest rates increases have different impacts on savings
depending on whether σ = 12 or σ = 2. Hint: the per-period utility function
1−σ
u(c) = c1−σ is called Constant Relative Risk Aversion (CRRA) utility, and σ
is called the coefficient of relative risk aversion. A higher sigma corresponds
to higher risk aversion, or equivalently, to a more concave utility function. In
a multi-period consumption allocation decision like in this problem, with per-
period utility u, a higher concavity of u (i.e. a higher risk aversion) will increase
the willingness of the consumer to smooth consumption, that is, to make the
consumption in each period as similar as possible. Think about what this means
for the substitutability of c1 and c2 for different values of σ.

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 6 RENTING OR BUYING (60 POINTS)

6 Renting or Buying (60 points)

You just graduated from MIT and found a job in a lovely city. You are trying to
decide whether to rent or to own a house. Let’s assume that you will live forever, and
stay in the house for the rest of your life.

1. You have the option to rent a house for $10 a year, with payments starting
immediately today. Suppose the annual discount rate is r. What is the net
present value of the rent payments you will have to make, N P Vrent
∞
? (2 points)

2. Suppose that you have a large amount of savings, currently invested at a 5%

interest rate in a savings account. What is the NPV of rent payments under
these circumstances? (2 points)

3. You want to compare two options: renting, or buying a home.

Renting has:

• a benefit: the value of living in the home, V H

• and a cost: the net present value of rent payments N P Vrent
∞

So the net utility of renting, V R , is:

∞
V R = V H − N P Vrent

For each individual i, home-ownership, on the other hand, has:

• a benefit: the value of living in a similar home, V H

• a "non-monetary" benefit from living in their own home for individual i,
µi
• and cost: the price of the house P H

The net utility of owning for person i, ViO , is thus:

ViO = V H + µi − P H

For what values of µi would the person prefer owning to renting? Explain why.
(4 points)

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 6 RENTING OR BUYING (60 POINTS)

4. Assume that µi is random, and distributed uniformly in the population in the

interval [−220, −200], so that the fraction of people with µi less than x is:

x−a
P(µi < x) =
b−a

Using the value of N P Vrent

∞
found in the first question, what share of the pop-
ulation, as a function only of P H , prefers to own? If there are 80 people in the
population, each of them willing to buy or to rent exactly one house, write the
total demand for owner-occupied housing as a function only of P H .

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 7 PORTFOLIO DIVERSIFICATION (25 POINTS)

7 Portfolio diversification (25 points)

Jon has $1,000 that he wants to invest. He can either invest in:

• A bond, which yields a 10% return

• The stock market, which consists of two firms, Amazon and Toyota.

Each firm’s stock costs $100 today, and will be worth $400 in one year with probabil-
ity 12 or will drop to $0 with probability 21 . Assume that the evolution of both stocks
is independent (that is, whether Amazon’s stock increases or falls doesn’t depend on
how Toyota is performing, and vice versa).

Finally, assume that Jon only consumes next year, and his utility function is U (w) =
√
w.

1. (5 points) Suppose that Jon needs to make a choice between investing only
in bonds, or only in Amazon. He cannot buy Toyota stocks, and he cannot
buy both Amazon stocks and bonds. What is Jon’s expected utility of buy-
ing bonds? What is his expected utility of investing only in Amazon’s stock?
Which does he prefer?

2. (5 points) Now, suppose that if Jon decides to invest in the stock market, he
can choose how much he wants to invest in each company. Let x denote the
fraction of his wealth that Jon puts into Amazon and 1 − x denote the fraction
of his wealth Jon puts into Toyota. If Jon invests fully in the stock market and
maximizes his expected utility, at what level should he set x? Please mathe-
matically justify your answer.

3. (5 points) What is Jon’s expected utility if he invests in the stock market (dis-
tributing his investment across Amazon and Toyota in the optimal proportion
x that you found in the last question)? Does Jon prefer to use this strategy or

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 7 PORTFOLIO DIVERSIFICATION (25 POINTS)

invest in bonds? Does your answer change relative to question 1? Why or why
not?

4. (6 points) Suppose now that Toyota has gone bankrupt, so Jon can no longer
invest in it. However, Jon can now invest in a third company, Walmart, whose
stock today is worth $100. Interestingly, the values of the stocks for Amazon
and Walmart are negatively correlated, so that with probability 1/2 Amazon
goes bankrupt and Walmart’s stocks are worth $400, and with probability 1/2
the opposite happens. What is Jon’s optimal investment, again assuming that
he can only invest in stocks or bonds? What is his expected utility in this case?
Why does the stock correlation make Jon better or worse off relative to the case
where he was splitting his investment between Toyota and Amazon?

5. (4 points) Suppose Jon works for Amazon and he is investing for his retirement.
Is the investment decision you found in last question still optimal? Why or
why not? (You don’t need to do any calculations; an intuitive explanation is
sufficient.)

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 8 TAXES AND REDISTRIBUTION (20 POINTS)

8 Taxes and Redistribution (20 points)

Consider an economy with two individuals, one of them skilled and the other one
unskilled. The only difference between the two is that the skilled individual has a
higher wage ws = 2 than the unskilled, wu = 1. Suppose that each individual has a
utility function over consumption (c) and labor (L) of the following form:

1
U (c, L) = c − L2
2
Suppose that the government charges as income tax a τ fraction of an individual’s
labor income. The government also gives a fixed transfer of T dollars to each indi-
vidual.

1. (2 points) Write down each individual’s budget constraint in terms of consump-

tion and labor.

2. (5 points) Find the optimal consumption and labor for each type of worker (as
a function of τ, T ). How is labor supply affected by the tax? Explain.

3. (3 points) Suppose that all the revenue that the government obtains from the
labor income tax is used to fund the fixed transfer T . Use this condition to
express T as a function of τ . Calculate the difference between the taxes paid
and the transfer received by each individual and explain the intuition.

4. The social welfare function is

SW F = Uskilled + (1 + α) Uunskilled

where α ≥ 0 can be interpreted as how much society cares about the unskilled
relative to the skilled workers.

(a) (5 points) Suppose first that α = 0. Using your previous results, express
social welfare as a function of τ , and then find the optimal tax τ . Explain

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 8 TAXES AND REDISTRIBUTION (20 POINTS)

the intuition.

(b) (5 points) Suppose now that α = 1. Express social welfare as a function of

τ , and then find the optimal tax τ . Why is it different from in the previous
case? Explain the intuition.

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