Problem 1

The Island Economy of Nabapur

Nabapur is an island economy. In year 0, almost everyone works in agriculture. The economy produces
grain, which is also used as a measure of real income. Later, firms emerge, manufacturing expands, fossil-
fuel technology is adopted, and inequality rises.

Economists have collected the following information.

In the agricultural sector, output is produced according to:

𝑌𝐴 = 𝐴√𝐿𝐴

where 𝑌𝐴 is grain output in kg, 𝐿𝐴 is the number of agricultural workers, and 𝐴is the level of agricultural
technology.

The subsistence income is:

𝑠 = 500 kg of grain per person.

Population rises when average product of labour is above subsistence, falls when it is below subsistence,
and remains constant when average product equals subsistence.

Initially:

𝐴 = 20,000.

After an agricultural technology improvement:

𝐴 = 24,000.

Later, capitalist firms emerge. They hire workers and produce manufactured goods measured in grain-
equivalent units. If 600 workers move from agriculture into factories, each factory worker produces
1,000 grain-equivalent units under coal-based technology. The coal technology causes environmental
damage equal to 200 grain-equivalent units per factory worker.

A renewable technology is also available. It produces only 900 grain-equivalent units per factory worker
but causes environmental damage of only 45 grain-equivalent units per factory worker.
Two countries, Equalia and Unequalia, each have 1,000 people and the same GDP per capita of 1,000.
In Equalia, every person earns 1,000. In Unequalia, 900 people earn 800 each, while 100 people earn
2,800 each. Assume the wellbeing index is:

𝑊 = average of √income.

Natural resource depletion reduces true income by 150 per person in both countries.

Finally, Nabapur’s historians compare two formerly similar districts. Both had income per capita of 500
before colonial land reforms. After the reforms, landlord-controlled districts have income per capita of
560, while village-controlled districts have income per capita of 700.

Questions

(a) Measurement, GDP per capita, and welfare. [12]

Calculate GDP per capita in Equalia and Unequalia. Then calculate 𝑊for both countries. Explain why
GDP per capita alone gives an incomplete ranking of living standards.

(b) Environmental depletion and adjusted living standards. [8]

After subtracting natural resource depletion of 150 per person, calculate adjusted income per capita in
both countries. Then calculate the adjusted wellbeing index for Equalia and Unequalia. Explain what
this shows about GDP and planetary limits.

(c) Production function and diminishing average product. [12]

For Nabapur’s original agricultural technology 𝐴 = 20,000, calculate total output and average product
of labour when:

𝐿𝐴 = 800, 𝐿𝐴 = 1,600, 𝐿𝐴 = 2,400.

Show whether the average product of labour is diminishing. Explain why this happens in the
Malthusian model.

(d) Malthusian equilibrium. [12]

Find the Malthusian equilibrium population under the original technology 𝐴 = 20,000. Then find the
new equilibrium population after technology improves to 𝐴 = 24,000. Explain why the technological
improvement raises total output but not long-run income per person in this model.

(e) Structural transformation: from farm to firm. [12]

After the technology improvement, suppose population is at the new Malthusian equilibrium. Then 600
workers move into capitalist firms, leaving the rest in agriculture. Calculate agricultural output, factory
output, total GDP, and GDP per capita under coal-based technology before accounting for
environmental damage.

(f ) Planetary limits and technological choice. [12]

Compare coal technology and renewable technology after accounting for environmental damage.
Which technology gives higher measured GDP? Which gives higher environmentally adjusted income?
Explain why private firms may choose the socially inferior technology unless government policy changes
incentives.

(g) Carbon pricing. [8]

Suppose the government taxes each unit of environmental damage at rate 𝜏. Find the minimum value of
𝜏that makes firms prefer renewable technology to coal technology.

(h) Institutions of capitalism. [8]

Explain whether the new manufacturing sector in Nabapur is capitalist. Your answer must refer to
private property, markets, and firms.

(i) Causality and natural experiments. [10]

Using the district data, estimate the effect of landlord-controlled colonial institutions on later income
per capita using a difference-in-differences logic. Explain why this is stronger than simply comparing the
two districts after the reform, and state one limitation.
Problem 2

The Cottonabad Industrial Transition

Cottonabad is a textile-producing economy. It begins as a small agricultural and handloom economy,

but later develops capitalist textile firms using workers, coal, machines, and imported raw cotton. The
government is trying to understand why firms adopt new technologies, why specialization raises
productivity, why coal-based growth creates environmental damage, and whether Cottonabad’s
experience resembles the Industrial Revolution.

A textile entrepreneur, Amina, is considering whether to adopt a new coal-powered production method.
The economy has two goods: cloth and grain. It has two producers, Rina and Karim. It also has five
available technologies for producing 100 metres of cloth.

The technologies are:

A: 2 workers and 8 tons of coal.

B: 5 workers and 3 tons of coal.
C: 4 workers and 9 tons of coal.
D: 6 workers and 5 tons of coal.
E: 12 workers and 1 ton of coal.

Initially, the wage is 𝑤 = 10, and the coal price is 𝑝 = 20. Later, because labour becomes expensive and
coal becomes cheap, the wage becomes 𝑤 = 20, and the coal price becomes 𝑝 = 5.

The market price of 100 metres of cloth is initially 130. Each firm produces 4,000 metres of cloth if it
adopts the new technology.

Burning coal creates environmental damage worth 8 per ton of coal. The government can impose a coal
tax 𝑡per ton.

In addition, historians believe that imported sugar and cotton matter. With cheap imported food and
cotton, raw material cost is 15 per 100 metres of cloth. Without those imports, raw material cost rises to
45, and the wage rises from 20 to 30 because food becomes more expensive.

Questions

(a) Opportunity cost, economic cost, and economic rent. [10]

Amina can either attend a machine-operation training course or continue in her current job.

If she attends training, the expected lifetime benefit is 80,000. The direct monetary cost is 20,000, and
the effort cost is 10,000. Her next best option is continuing in her current job, which gives a net benefit
of 35,000.
Calculate:

1. the net benefit of training,

2. the opportunity cost of training,

3. the economic cost of training,

4. the economic rent from training,

5. whether Amina should train.

(b) Comparative advantage and specialization. [12]

Rina and Karim can each spend all their time producing either cloth or grain.

Rina can produce either 80 units of cloth or 40 units of grain.

Karim can produce either 60 units of cloth or 15 units of grain.

Before trade, Rina consumes 20 cloth and 30 grain. Karim consumes 30 cloth and 7.5 grain.

1. Who has absolute advantage in each good?

2. Who has comparative advantage in cloth? Who has comparative advantage in grain?

3. Show that if Rina specializes in grain and Karim specializes in cloth, and Rina sells 9 grain to
Karim at a price of 3 cloth per grain, both can be better off.

(c) Fixed-proportions technologies and dominated technologies. [10]

Using the five technologies A–E:

1. Identify which technologies are dominated.

2. Explain why dominated technologies will not be chosen by profit-maximizing firms.

3. Identify the non-dominated technologies.

(d) Isocost lines and least-cost technology. [12]

At the initial prices 𝑤 = 10, 𝑝 = 20:

1. Calculate the cost of each technology A–E.

2. Which technology minimizes cost?

3. Write the equation of the isocost line with total cost 110. Put workers 𝑁on the horizontal axis
and coal 𝑅on the vertical axis.
 4. Calculate the slope and interpret it.

(e) Relative prices and technological change. [12]

At the later prices 𝑤 = 20, 𝑝 = 5:

1. Calculate the cost of each technology A–E.

2. Which technology now minimizes cost?

3. Explain why a rise in 𝑤/𝑝encourages labour-saving, coal-intensive technology.

4. Derive the threshold value of 𝑤/𝑝above which technology A is cheaper than technology B.

5. Derive the threshold value of 𝑤/𝑝below which technology E is cheaper than technology B.

(f ) Innovation rents and creative destruction. [10]

At the later prices 𝑤 = 20, 𝑝 = 5, suppose firms were originally using technology B. Amina is the first
entrepreneur to adopt technology A.

1. Calculate the cost saving from switching from B to A per 100 metres.

2. Calculate the increase in profit per 100 metres, assuming the cloth price remains 130.

3. Calculate total innovation rent if Amina produces 4,000 metres.

4. Suppose competition later lowers the cloth price to 90. Calculate profit per 100 metres for firms
using A and firms still using B.

5. Explain the meaning of creative destruction in this case.

(g) Carbon damage and a coal tax. [10]

At the later prices 𝑤 = 20, 𝑝 = 5, compare the private and social costs of technologies A, B, and E.
Environmental damage is 8 per ton of coal.

1. Calculate private cost for A, B, and E.

2. Calculate social cost for A, B, and E after including environmental damage.

3. Which technology does the private firm choose? Which technology is socially better?

4. Find the minimum coal tax 𝑡that makes B at least as cheap as A for the firm.

5. Explain why this is a technology-and-incentives problem, not just an environmental problem.

(h) Imported cotton, sugar, and the colonial counterfactual. [8]

Assume Amina uses technology A.

With cheap imported food and cotton: wage 𝑤 = 20, coal price 𝑝 = 5, raw material cost = 15, price
of cloth = 130.

Without imported food and cotton: wage 𝑤 = 30, coal price 𝑝 = 5, raw material cost = 45, price of
cloth = 130.

1. Calculate profit per 100 metres with cheap imported food and cotton.

2. Calculate profit per 100 metres without those imports.

3. Explain why higher food and raw cotton costs could slow industrialization.

(i) Escaping the Malthusian trap and distribution of productivity gains. [10]

Before mechanization, Cottonabad has population 100 and total output 50,000. After mechanization,
total output rises to 90,000 and population rises to 130.

1. Calculate output per person before and after mechanization.

2. Did productivity grow faster than population?

3. Suppose the real wage initially rises only from 500 to 520. Calculate the worker’s share of output
per worker after mechanization.

4. Later, after labour-market regulation, trade unions, and voting rights, the real wage rises to 650.
Calculate the worker’s share then.

5. Explain why real wages may rise later than productivity.

Problem 3

The Working-Time Choice of Maya, Her Household, and Her Country

Maya is a young worker in a high-income city. She chooses how many hours per day to work. She cares
about two goods: free time 𝑡, measured in hours per day, and consumption 𝑐, measured in dollars per
day. Free time includes sleep, meals, commuting, family care, rest, study, leisure, and all other non-paid-
work time.

Maya cannot borrow, so her daily consumption cannot exceed her wage income. If she works ℎhours per
day at wage 𝑤, then:

𝑐 = 𝑤ℎ

Since a day has 24 hours:

ℎ = 24 − 𝑡

so her budget constraint is:

𝑐 = 𝑤(24 − 𝑡)

Assume Maya cannot work more than 16 hours per day, so:

8 ≤ 𝑡 ≤ 24

Her preferences are represented by the utility function:

𝑢(𝑡, 𝑐) = (𝑡 − 6)2 (𝑐 − 45)

where 𝑡 > 6and 𝑐 > 45.

where Karim’s utility is written as 𝑢 = (𝑡 − 6)2 (𝑐 − 45), and where the budget constraint is 𝑐 =
𝑤(24 − 𝑡).

Questions

(a) Scarcity, feasible set, and opportunity cost. [8]

Suppose Maya’s wage is:

𝑤 = 30.
 1. Write her budget constraint.

2. Find maximum consumption if she takes 𝑡 = 8, 𝑡 = 16, and 𝑡 = 24hours of free time.

3. Is the point (𝑡, 𝑐) = (16,250)feasible? Is (18, 150)feasible?

4. What is the opportunity cost of one extra hour of free time?

5. Explain why both free time and consumption are scarce goods.

(b) Preferences, utility, indifference curves, and MRS. [12]

Using:

𝑢(𝑡, 𝑐) = (𝑡 − 6)2 (𝑐 − 45)

1. Calculate Maya’s utility at (17, 210).

2. Derive the equation of an indifference curve for utility level 𝑢0 , solving for 𝑐as a function of 𝑡.

3. Derive the marginal rate of substitution:

𝑀𝑈𝑡
𝑀𝑅𝑆 =
𝑀𝑈𝑐

4. Calculate the MRS at (12, 360), (17, 210), and (21.9, 63).

5. Interpret why MRS falls as free time rises and consumption falls.

(c) Utility maximization at the original wage. [12]

At wage 𝑤 = 30:

1. Use the budget constraint to write utility as a function of 𝑡alone.

2. Find Maya’s utility-maximizing free time 𝑡 ∗ , working time ℎ∗ , and consumption 𝑐 ∗ .

3. Verify that the optimum satisfies 𝑀𝑅𝑆 = 𝑀𝑅𝑇.

4. Explain intuitively why a point with 𝑀𝑅𝑆 > 𝑀𝑅𝑇cannot be optimal, and why a point with
𝑀𝑅𝑆 < 𝑀𝑅𝑇cannot be optimal.

(d) Technological progress and a higher wage. [10]

Technological progress raises labour productivity, and Maya’s wage rises from:
 𝑤 = 30

to:

𝑤 = 45.

1. Write the new budget constraint.

2. Find the new utility-maximizing 𝑡 ∗ , ℎ∗ , 𝑐 ∗ .

3. Compare the old and new choices.

4. Explain why higher wages can lead to both more consumption and more free time.

(e) Wage rise, income effect, and substitution effect. [12]

Now consider Maya as a student choosing how many days of a 70-day summer break to work. Let 𝑡be
free days and 𝑐be consumption during the break. Her utility is:

𝑢(𝑡, 𝑐) = 𝑡(𝑐 + 600)

and her budget constraint is:

𝑐 = 𝑤(70 − 𝑡) + 𝐼

where 𝑤is the daily wage and 𝐼is unearned income.

1. Derive the optimal choice:

𝐼 + 600
𝑡 ∗ = 35 +
2𝑤

and

𝐼 − 600
𝑐 ∗ = 35𝑤 + .
2

2. Initially 𝑤 = 96, 𝐼 = 0. Find 𝑡𝐴 , 𝑐𝐴 .

3. The wage rises to 𝑤 = 150, 𝐼 = 0. Find 𝑡𝐷 , 𝑐𝐷 .

4. Calculate the total effect of the wage rise on free time.

 5. Find the equivalent unearned income 𝐽at the old wage 𝑤 = 96that gives the same utility as the
new wage. Use it to decompose the wage effect into income and substitution effects.

(f ) Unearned income and pure income effect. [8]

Return to the summer-break model:

𝑢(𝑡, 𝑐) = 𝑡(𝑐 + 600), 𝑐 = 𝑤(70 − 𝑡) + 𝐼.

Let 𝑤 = 96. Suppose Maya receives a scholarship grant of:

𝐼 = 960.

1. Find the new optimal 𝑡 ∗ , 𝑐 ∗ .

2. Compare it with the original case 𝑤 = 96, 𝐼 = 0.

3. Explain why unearned income creates an income effect but no substitution effect.

(g) Inequality, Veblen effects, and changed preferences. [10]

Return to the daily model with 𝑤 = 30. Maya initially chooses:

(𝑡, 𝑐) = (17,210)

where 𝑀𝑅𝑆 = 𝑀𝑅𝑇 = 30.

Now suppose social media exposes Maya to luxury consumption by very rich households. She starts
valuing consumption more relative to free time. Model this as follows: at every bundle, her new MRS is
only 75% of her old MRS.

1. What is Maya’s new MRS at the old choice (17, 210)?

2. Is the old choice still optimal?

3. Find the new optimum on the same budget constraint.

4. Calculate the change in free time and working hours.

5. Explain how this captures the Veblen-effect logic.

(h) Gender, wage discrimination, and unpaid work inside the household. [14]

Maya’s friends Ana and Luis are parents. Together they have 48 hours per day. They require 14 hours of
unpaid domestic work per day, including cooking, cleaning, and childcare. Their household
consumption is the sum of their paid earnings. Their household non-working time is the total time not
spent in paid work or domestic work.

First suppose both earn:

𝑤𝐴 = 𝑤𝐿 = 30.

Their preferred choice is 22 hours of household non-working time and consumption of 360.

Then suppose Ana faces labour-market discrimination and can earn only:

𝑤𝐴 = 17,

while Luis earns:

𝑤𝐿 = 30.

Luis cannot do more than 8 hours of paid work per day.

1. In the equal-wage case, calculate total paid work, total unpaid domestic work, household non-
working time, and household consumption.

2. In the equal-wage case, if they share total work equally, how many hours of paid work and
domestic work does each do?

3. With discrimination, derive the kinked household budget constraint: why is the first slope −30,
and why does the later slope become −17?

4. If the household now chooses point 𝐷 = (24,274), calculate Ana’s paid work, Luis’s paid work,
Ana’s domestic work, Luis’s domestic work, and each person’s consumption.

5. Explain why a gender wage gap can reduce women’s paid work and increase their unpaid
domestic work, but why the wage gap alone cannot explain the whole gender division of labour.

(i) Cross-country working hours and preferences. [8]

Consider the following country observations:

US: wage 31.04, free time per day 19.16, consumption per day 150.28.
Netherlands: wage 27.88, free time per day 20.17, consumption per day 106.85.
South Korea: wage 14.05, free time per day 18.77, consumption per day 73.42.
Slovak Republic: wage 13.85, free time per day 19.69, consumption per day 59.63.
1. Compare South Korea and the Slovak Republic. Why are wage differences alone insufficient to
explain their free-time choices?

2. Compare the US and the Netherlands. What does the difference suggest about preferences?

3. Explain why indifference curves for representative workers in two countries may cross, even
though one individual’s indifference curves cannot cross.
Problem 4

The River Delta: Crops, Pesticides, Irrigation, Bargaining, Software, and Climate

Two farmers, Anil and Bala, live in the River Delta. Their decisions affect not only their own incomes
but also each other’s income, the village irrigation system, and the wider climate. The village council
hires you as an economic analyst.

Unless otherwise stated, pay-offs are monetary-equivalent utility points. In every two-player matrix
below, pay-offs are written as:

(Anil’s payoff, Bala’s payoff)

or, in later games, as:

(row player’s payoff, column player’s payoff).

Answer all parts.

Questions

(a) Identifying the game and the strategic interaction. [8]

Anil and Bala simultaneously choose whether to grow Rice or Cassava. Their pay-offs are:

Bala: Rice Bala: Cassava

Anil: Rice (4, 4) (6, 3)
Anil: Cassava (6, 6) (5, 2)

1. Identify the players, strategies, information, order of play, and pay-offs.

2. Explain why this is a strategic interaction.

3. Explain why this is a simultaneous one-shot game.

(b) Best responses, Nash equilibrium, and invisible hand logic. [10]

Using the crop-choice game in part (a):

1. Find Anil’s best response to each of Bala’s possible strategies.

2. Find Bala’s best response to each of Anil’s possible strategies.

3. Find the Nash equilibrium.

 4. Is the Nash equilibrium Pareto efficient?

5. Explain why this game can be called an “invisible hand” game.

(c) Pest control, dominant strategies, and prisoners’ dilemma. [12]

Now the farmers decide whether to use Integrated Pest Control, denoted 𝐼, or a toxic pesticide, denoted
𝑇. Their pay-offs are:

Bala: I Bala: T
Anil: I (3, 3) (1, 4)
Anil: T (4, 1) (2, 2)

1. Find each player’s dominant strategy.

2. Find the dominant-strategy equilibrium.

3. Find all Pareto-efficient outcomes.

4. Which outcome Pareto-dominates the equilibrium?

5. Explain why this is a prisoners’ dilemma.

(d) Public good game and free-riding. [12]

Four farmers must decide whether to contribute $10 each to repair the village irrigation canal. Each $10
contribution increases every farmer’s crop yield by $8.

Let Kim be one of the farmers.

1. If two other farmers contribute, calculate Kim’s payoff if she contributes and if she does not
contribute.

2. Show generally that “Do Not Contribute” is Kim’s dominant strategy if she is purely self-
interested.

3. What is the dominant-strategy equilibrium if all four farmers are purely self-interested?

4. What is each farmer’s payoff if all four contribute?

5. Explain why the irrigation project is a public good game and a social dilemma.

(e) Altruism and social preferences. [8]

Return to the four-farmer irrigation game. Suppose Kim’s utility is:

𝑈𝐾 = Kim’s own monetary payoff + 𝛼(sum of the other three farmers’ monetary payoffs)
where 𝛼 ≥ 0measures altruism.

Assume Kim is deciding whether to contribute while the other three farmers’ actions are fixed.

1. Calculate the change in Kim’s own monetary payoff from contributing rather than not
contributing.

2. Calculate the change in the other three farmers’ total payoff from Kim’s contribution.

3. Find the minimum value of 𝛼such that Kim is willing to contribute.

4. Interpret the result.

(f ) Repeated interaction and cooperation. [8]

Suppose the pest-control game from part (c) is repeated every season forever. Both farmers use this rule:

“Use 𝐼as long as both used 𝐼in the previous season; if anyone ever uses 𝑇, use 𝑇forever after.”

Let 𝛿be the discount factor, where future pay-offs are multiplied by 𝛿each season.

1. Calculate the present value of always cooperating with 𝐼.

2. Calculate the present value of deviating once to 𝑇, then being punished forever by 𝑇, 𝑇.

3. Find the minimum 𝛿needed to sustain cooperation.

4. Explain the economic intuition.

(g) Peer punishment and changing the rules of the game. [8]

In a laboratory public good game, each participant receives $20. Each dollar contributed to a common
pool gives $0.40 to every member of a four-person group, including the contributor.

Suppose the other three group members each contribute $10.

1. Calculate your payoff if you contribute $10.

2. Calculate your payoff if you contribute nothing.

3. Now suppose that if you contribute nothing while the others contribute $10, each of the three
others punishes you with probability 𝑝. Each punishment costs you $3. Find the minimum
𝑝such that contributing $10 is at least as good as contributing nothing.

4. Explain how peer punishment changes incentives.

(h) Experiments, field evidence, and crowding out. [8]

A daycare centre wants parents to arrive on time. Before any policy, parents may be on time because they
feel a social responsibility not to inconvenience staff. The centre introduces a fine for late pickup. After
the fine, late pickups increase.

1. Explain how to design a treatment-control field experiment to test the effect of the fine.

2. Why does random assignment matter?

3. Why might a fine increase lateness?

4. Explain the idea of “crowding out” social preferences.

(i) Ultimatum game, fairness, and minimum acceptable offers. [10]

A proposer must divide $100 with a responder. The proposer offers 𝑦to the responder and keeps 100 −
𝑦. If the responder rejects, both receive zero.

Suppose the fairness norm is a 50–50 split. If the offer is below $50, the responder gets satisfaction from
rejecting the offer equal to:

𝑅(50 − 𝑦)

where 𝑅 ≥ 0measures reciprocity or anger at unfairness.

1. Derive the responder’s minimum acceptable offer.

2. Calculate it when 𝑅 = 1and when 𝑅 = 4.

3. Suppose a proposer faces these acceptance probabilities, based on local experimental evidence:

𝑃(accept 50) = 1, 𝑃(accept 40) = 0.96, 𝑃(accept 30) = 0.52.

Calculate the proposer’s expected payoff from offering 50, 40, and 30.
4. Which offer maximizes expected payoff ?
5. Explain why ultimatum-game behaviour is inconsistent with purely self-interested Homo
economicus.

(j) Coordination game with conflict of interest. [10]

Two software engineers, Astrid and Bettina, must choose whether to write a project in Java or C++.
They choose simultaneously. Their pay-offs are:

Bettina: Java Bettina: C++

Astrid: Java (4, 3) (2, 2)
Astrid: C++ (0, 0) (3, 6)
 1. Find the Nash equilibria.

2. Explain why this is a coordination game.

3. Explain the conflict of interest.

4. Which equilibrium has the higher total payoff ?

5. Suppose they can choose C++ and Bettina can transfer 𝑥to Astrid. Find the range of 𝑥that
makes both weakly prefer C++ to the Java equilibrium.

(k) Climate change as a hawk–dove game. [10]

Two large countries, North and South, choose either Restrict emissions 𝑅, or continue Business as Usual
𝐵. Their pay-offs are:

South: R South: B
North: R (4, 4) (1, 5)
North: B (5, 1) (0, 0)

1. Find each country’s best response to each action of the other.

2. Find the Nash equilibria.

3. Is (𝑅 , 𝑅)a Nash equilibrium?

4. Is (𝑅 , 𝑅)Pareto efficient? Does it maximize joint payoffs?

5. Suppose clean-technology policy raises the payoff from choosing 𝑅by 2 for each country, no
matter what the other country does. Find the new Nash equilibrium.
Problem 5

The Estate of Grainland: Power, Fairness, Contracts, Inequality, and Pollution

Grainland is a farming economy. Angela is a farmer. Bruno owns the land. Angela produces grain. The
amount of grain depends on how much free time she has. A day has 24 hours. If Angela has more free
time, she works less and produces less grain.

The production technology has the following important points:

At A, Angela has 16 hours of free time, works 8 hours, and produces 46 bushels.
At M, Angela has 19.5 hours of free time, works 4.5 hours, and produces 35 bushels.
At 24 hours of free time, she works zero hours and produces zero bushels.

Angela values both grain and free time. Bruno values only grain. Angela’s indifference curves are quasi-
linear: for any given amount of free time, her MRS does not depend on how much grain she has. At 𝑡 =
16, the efficient condition 𝑀𝑅𝑆 = 𝑀𝑅𝑇holds. At 𝑡 = 19.5, 𝑀𝑅𝑆 < 𝑀𝑅𝑇.

The government may choose different institutions. These institutions determine who has power, what
choices are available, and how grain is divided.

Questions

(a) Pirate economics, institutions, incentives, and power. [8]

A pirate ship has written articles. The crew votes on decisions. The captain and quartermaster receive
two shares of captured treasure; ordinary crew members receive one share. The lookout who first spots a
target ship receives a special reward. Injured crew members receive compensation.

1. Identify three institutions in this pirate economy.

2. Identify one incentive.

3. Explain why these rules affect “who gets what.”

4. Explain the difference between structural power and bargaining power.

5. Why might pirates have used written rules even though they were criminals?

(b) Baseline: Angela as an independent farmer. [8]

Suppose Angela owns the land herself.

1. Who decides how many hours Angela works?

2. What allocation does Angela choose?

 3. How much grain does Angela consume?

4. Is there any income distribution problem between Angela and Bruno?

5. Explain why the condition 𝑀𝑅𝑆 = 𝑀𝑅𝑇matters here.

(c) Case 1: Forced labour. [10]

Now Bruno owns the land and can use force. He can order Angela to work and decide how much grain
she receives. But he must give Angela at least enough utility to prevent starvation, escape, or revolt.
Bruno chooses:

𝐷 = (𝑡 = 16, Angela’s grain = 15)

At this point total output is 46 bushels.

1. How many hours does Angela work?

2. How much grain does Bruno keep?

3. Calculate Angela’s and Bruno’s shares of total output.

4. Is this allocation Pareto efficient?

5. Is it procedurally fair? Explain.

(d) Case 2: Take-it-or-leave-it contract. [10]

Now the government protects Angela from violence and enforces contracts. Bruno owns the land, but
Angela can reject Bruno’s offer and seek work elsewhere. Bruno offers a take-it-or-leave-it employment
contract:

𝐿 = (𝑡 = 16, Angela’s grain = 23)

Total output remains 46 bushels.

1. How much grain does Bruno keep?

2. How does Angela’s reservation option differ from Case 1?

3. Why does Bruno still capture the whole surplus above Angela’s reservation utility?

4. Is the outcome Pareto efficient?

5. Is it necessarily fair? Explain using procedural and substantive fairness.

(e) Case 3: Democracy, legislation, and bargaining. [14]

Angela and other workers now have voting rights. They successfully demand a law limiting work to 4.5
hours per day and requiring at least 23 bushels of pay. Bruno therefore offers:

𝑁 = (𝑡 = 19.5, Angela’s grain = 23)

At this point total output is 35 bushels, so Bruno receives 12 bushels.

But 𝑁is not Pareto efficient because 𝑀𝑅𝑆 < 𝑀𝑅𝑇. If Angela works 8 hours instead, total output
becomes 46. To keep Angela just as well off as at 𝑁, she must receive 30 bushels at 𝑡 = 16. This point is
called 𝑃. If Bruno is kept just as well off as at 𝑁, Angela can receive at most 34 bushels at 𝑡 = 16. This
point is called 𝑅.

1. Calculate Angela’s and Bruno’s payoffs at 𝑁.

2. Why is 𝑁not Pareto efficient?

3. Calculate the bargaining range for Angela’s grain at 𝑡 = 16.

4. Suppose they agree on 𝑄 = (𝑡 = 16, Angela’s grain = 32). Calculate Bruno’s grain.

5. Show that 𝑄is a Pareto improvement over 𝑁.

6. Explain why legislation alone may improve fairness but reduce efficiency, while legislation plus
bargaining may improve both.

(f ) Comparing the four institutional outcomes. [10]

Compare these outcomes:

Case 1 forced labour: Angela 15, Bruno 31, 𝑡 = 16, total output 46.
Case 2 take-it-or-leave-it contract: Angela 23, Bruno 23, 𝑡 = 16, total output 46.
Case 3 legislation before bargaining: Angela 23, Bruno 12, 𝑡 = 19.5, total output 35.
Case 3 after bargaining: Angela 32, Bruno 14, 𝑡 = 16, total output 46.

1. Which outcomes are Pareto efficient?

2. Which outcome gives Angela the highest income?

3. Which outcome gives Bruno the highest income?

4. Which outcome has the highest total output?

5. What is the central lesson about institutions?

(g) Measuring inequality with the Gini coefficient. [10]

A small village has one landowner and three sharecroppers.

Before reform, each sharecropper produces 0.5 units of grain and gives half to the landowner. The
landowner also produces 1 unit on his own land. Therefore incomes are:

(1.75, 0.25, 0.25, 0.25)

After reform, each sharecropper keeps 75% of output and works harder, producing 0.75 units. The
landowner receives 25% from each sharecropper and still produces 1 unit himself. Therefore incomes
are:

(1.5625, 0.5625, 0.5625, 0.5625)

For a four-person society, use:

1 average absolute income difference across all unordered pairs

𝐺𝑖𝑛𝑖 = ×
2 mean income

1. Calculate total income before and after reform.

2. Calculate the Gini before reform.

3. Calculate the Gini after reform.

4. Did reform increase efficiency?

5. Did reform reduce inequality?

6. Was it a Pareto improvement?

(h) Endowments, human capital, and income distribution. [8]

Three people live in Grainland.

Ella has skills as a medical technician and earns 875 hours × 30 plus a child grant of 2,000.
Kamal owns a business that generates 480,000 in profit after paying all costs, and he also has managerial
human capital worth 120,000.
Angela owns no land and has only her labour capacity unless institutions give her stronger rights.

1. Calculate Ella’s income.

2. Calculate Kamal’s income.

 3. Identify two endowments of Ella.

4. Identify two endowments of Kamal.

5. Explain how institutions and technology affect the income value of endowments.

(i) Environmental conflict, reservation options, and bargaining. [12]

A factory town faces a conflict between workers/citizens and a firm. Citizens care about wage 𝑤and
environmental quality 𝐸. Their utility is:

𝑈 = 𝑤 + 10√𝐸

The firm’s cost per worker is:

𝐶 =𝑤+𝐸

The firm can operate only if:

𝐶 ≤ 70

This is the firm’s shutdown condition.

Initially, citizens’ reservation utility is:

𝑈 ≥ 80

Later, after political organization, their reservation utility rises to:

𝑈 ≥ 90

1. When citizens’ reservation utility is 80, find the cost-minimizing package (𝑤 , 𝐸)that the firm
offers.

2. Calculate the firm’s surplus relative to the shutdown condition.

3. When citizens’ reservation utility rises to 90, find the new cost-minimizing package.

4. Calculate the firm’s surplus then.

5. If citizens and the firm bargain after the reservation utility rises, what is the maximum citizen
utility possible under the shutdown condition?
6. Explain how this models conflicts over wages, pollution, and jobs.
Problem 6

LingoLab: Wages, Effort, Rents, Power, Unemployment, and Cooperatives

LingoLab is a private language school in Dhaka. It hires young graduates to teach short courses in
English, Bangla, and French. The owners decide strategy. Managers assign classes, observe performance,
and recommend dismissal or promotion. Teachers prepare lessons and teach students, but their effort is
difficult to verify perfectly.

The school earns revenue of:

𝑦 = 800

per tutor per week.

The school’s potential tutors differ in their reservation wages. If the school wants to employ 𝑁tutors, the
reservation wage of the marginal tutor is:

𝑤𝑟 (𝑁) = 550 + 2.5𝑁.

To make tutors work hard, the school must pay more than the reservation wage. Under ordinary
monitoring and morale conditions, the weekly wage needed to recruit, retain, and discipline 𝑁tutors is:

𝑊(𝑁) = 𝑤𝑟 (𝑁) + 60 = 610 + 2.5𝑁.

The school’s weekly profit is:

Π = (𝑦 − 𝑤)𝑁.

Questions

(a) The firm as an organization, not a black box. [8]

1. Identify the owners, managers, and workers in LingoLab.

2. Who are the residual claimants?

3. Explain why owners, managers, and workers have both common interests and conflicting
interests.

4. Explain why the firm is different from an ordinary market transaction.

5. Relate the Firestone tyre case to the idea that what happens inside the firm matters.
(b) Job matching, turnover, and reservation wages. [10]

The school’s reservation wage curve is:

𝑤𝑟 (𝑁) = 550 + 2.5𝑁.

1. How many tutors can the school recruit at a wage of 650?

2. How many tutors can it recruit at a wage of 700?

3. What wage is required to recruit 50 tutors?

4. Why does the reservation wage curve slope upward?

5. Explain why long-term employment relationships are usually better than day-labour-style
transactions for this kind of school.

(c) Employment rent: the cost of losing a job. [10]

A tutor, Sima, is paid:

𝑤 = 705

per week. Providing the required effort costs her the equivalent of:

𝑐 = 25

per week. Her planning horizon is 52 weeks.

If she keeps the job and works hard, her weekly net utility is:

𝑤 − 𝑐.

If she loses the job, she expects to spend 10 weeks unemployed with weekly utility 500, and then 42
weeks in another job with weekly net utility 650.

1. Calculate Sima’s total value from keeping the job.

2. Calculate the total value of her next best alternative.

3. Calculate her employment rent.

4. Calculate her average weekly employment rent.

5. Explain why this rent helps the employer exercise power.

(d) Incomplete contracts and the no-shirking wage. [12]

Suppose a tutor’s reservation wage is:

𝑤𝑟 = 645.

The weekly cost of effort is:

𝑐 = 25.

The planning horizon is:

ℎ = 52.

If the tutor shirks, the school catches and fires the tutor after 𝑠weeks on average.

A sample labour-discipline model gives the no-shirking wage:

𝑠
𝑤 = 𝑤𝑟 + 𝑐 + ( ) 𝑐.
ℎ−𝑠

1. Explain why the employment contract is incomplete.

2. Calculate the no-shirking wage if 𝑠 = 13.

3. Calculate the no-shirking wage if 𝑠 = 39.

4. Calculate the no-shirking wage if 𝑠 = 0.

5. Explain how better monitoring affects the required wage.

6. Explain why this is a principal–agent problem.

(e) Profit maximization with a no-shirking wage curve. [14]

The school must choose 𝑁and 𝑤, subject to the no-shirking wage curve:

𝑤 = 𝑊(𝑁) = 610 + 2.5𝑁.

Each tutor generates revenue:

𝑦 = 800.
 1. Write profit as a function of 𝑁alone.

2. Find the profit-maximizing employment level 𝑁 ∗ .

3. Find the wage 𝑤 ∗ .

4. Calculate total profit.

5. Find the reservation wage of the marginal worker at 𝑁 ∗ .

6. Calculate the marginal worker’s weekly employment rent after effort cost.

7. Explain why the firm does not hire more workers even though each tutor still generates revenue
greater than wage.

(f ) Morale, monitoring, and competition. [12]

Starting from the baseline no-shirking wage curve:

𝑊(𝑁) = 610 + 2.5𝑁,

consider three separate changes.

Case 1: morale falls after management imposes longer hours. The cost of motivating effort rises by 30,
so:

𝑊1 (𝑁) = 640 + 2.5𝑁.

Case 2: monitoring improves, so the required wage premium falls by 20, giving:

𝑊2 (𝑁) = 590 + 2.5𝑁.

Case 3: competing schools expand and attract similar tutors, raising outside opportunities. This shifts
the school’s no-shirking wage curve to:

𝑊3 (𝑁) = 640 + 2.5𝑁.

For each case:

1. Calculate the profit-maximizing employment level.

2. Calculate the wage.

3. Calculate profit.
 4. Explain the economic mechanism.

(g) Involuntary unemployment. [10]

Use the baseline optimum from part (e):

𝑁 ∗ = 38, 𝑤 ∗ = 705.

The reservation wage curve remains:

𝑤𝑟 (𝑁) = 550 + 2.5𝑁.

Assume there are 80 potential tutors.

1. How many tutors would be willing to work at wage 705?

2. How many tutors are actually employed?

3. How many are involuntarily unemployed in this local labour market?

4. Why are these workers involuntarily unemployed rather than simply unwilling to work?

(h) Employer power and the minimum wage. [10]

The government introduces a legal minimum wage of:

𝑤ˉ = 720.

The school must pay at least 720. It can hire workers only if the wage is high enough to satisfy the no-
shirking condition:

720 ≥ 610 + 2.5𝑁.

1. What is the maximum number of tutors the school can employ without violating the no-
shirking condition?

2. If it pays 720, how many tutors will it hire to maximize profit?

3. Calculate profit.

4. Compare employment, wage, and profit with the baseline.

 5. Explain why a minimum wage can raise employment when employers have labour-market
power.

6. Explain why a very high minimum wage could still reduce employment.

(i) Separation of ownership and control. [7]

A manager proposes a policy that lowers weekly wages to 690 and raises employment to 40, but teacher
morale falls and student complaints reduce revenue per tutor from 800 to 760. The manager also
receives perks worth 1,000 per week from this policy. Owners receive the firm’s residual profit.

1. Calculate owners’ profit under this policy.

2. Compare it with baseline profit.

3. Explain why the manager may still prefer the policy.

4. Explain how this illustrates the separation of ownership and control.

(j) Worker-owned cooperative. [7]

Suppose the tutors buy the school and turn it into a worker-owned cooperative. They employ 38 tutors
and keep revenue per tutor at 800. They set aside 1,520 per week for investment and maintenance. The
rest is divided equally among the 38 worker-owners.

1. Calculate total weekly revenue.

2. Calculate weekly income per worker-owner.

3. Compare this with the capitalist-firm wage of 705.

4. Explain why worker-owned cooperatives may need fewer supervisors.

5. Explain one possible weakness or difficulty of worker-owned cooperatives.

Problem 7

NutriBite: Branding, Demand, Profit, Market Power, and Competition Policy

NutriBite is a cereal producer. It sells a differentiated breakfast cereal called NutriBite Plus. Consumers
see it as different from ordinary cereals because of its taste, packaging, health claims, and brand
reputation.

The firm faces the inverse demand curve:

𝑃 = 140 − 𝑄

where 𝑃is the price per box and 𝑄is the number of thousand boxes sold per week.

NutriBite’s total cost function is:

1
𝐶(𝑄) = 500 + 20𝑄 + 𝑄 2
2

1
where 500 is fixed cost, 20𝑄 + 2 𝑄 2 is variable cost, and all values are measured in thousand taka.

Questions

(a) Differentiated product, market power, and economic profit. [8]

1. Explain why NutriBite Plus is a differentiated product.

2. Explain why product differentiation gives NutriBite some market power.

3. Define total revenue, total cost, economic profit, and profit margin in this context.

4. Explain why economic profit differs from accounting profit.

5. Identify two decisions other than price that may affect NutriBite’s profit.

(b) Cost function, average cost, marginal cost, and scale. [10]

Using:

1
𝐶(𝑄) = 500 + 20𝑄 + 𝑄 2
2

1. Derive 𝐴𝐶(𝑄).

2. Derive 𝑀𝐶(𝑄).
 3. Find the output level at which average cost is minimized.

4. Show whether 𝑀𝐶 < 𝐴𝐶, 𝑀𝐶 = 𝐴𝐶, or 𝑀𝐶 > 𝐴𝐶at 𝑄 = 20, 𝑄 = 31.62, 𝑄 = 50.

5. Explain the economic meaning of the fixed cost of 500.

6. Explain briefly how economies and diseconomies of scale may arise in a real cereal firm.

(c) Demand, willingness to pay, revenue, and elasticity. [10]

1. Write total revenue as a function of 𝑄.

2. Derive marginal revenue.

3. Write the direct demand function 𝑄 = 𝑔(𝑃).

4. Calculate price elasticity of demand at 𝑄 = 40.

5. Interpret the elasticity.

6. Explain why a firm facing more competition would usually have a more elastic demand curve.

(d) Profit-maximizing price and quantity. [12]

1. Write NutriBite’s profit as a function of 𝑄.

2. Find the profit-maximizing quantity using 𝑀𝑅 = 𝑀𝐶.

3. Find the corresponding price.

4. Calculate total revenue, total cost, and economic profit.

5. Calculate the markup (𝑃 − 𝑀𝐶)/𝑃.

6. Verify the markup rule:

𝑃 − 𝑀𝐶 1
=
𝑃 𝜀

(e) Isoprofit curves and fixed costs. [8]

1. Write the equation of an isoprofit curve for profit level Π0 .

2. For Π0 = 1900, write 𝑃as a function of 𝑄.

3. Explain why isoprofit curves slope downward when 𝑃 > 𝑀𝐶.

4. Suppose fixed cost rises from 500 to 900 but marginal cost is unchanged. Does the profit-
maximizing 𝑄and 𝑃change?
 5. What happens to profit?

(f ) Gains from trade, surplus, and deadweight loss. [14]

Use the profit-maximizing outcome from part (d).

1. Calculate consumer surplus.

2. Calculate producer surplus.

3. Calculate economic profit.

4. Find the Pareto-efficient output level where 𝑃 = 𝑀𝐶.

5. Calculate total surplus at the monopoly outcome and at the efficient output.

6. Calculate deadweight loss.

7. Explain why the profit-maximizing outcome is not Pareto efficient.

(g) Price discrimination. [8]

Suppose NutriBite can perfectly price discriminate: it can charge each buyer exactly their willingness to
pay, while producing all units for which willingness to pay exceeds marginal cost.

1. What output does it choose?

2. What is consumer surplus?

3. What is producer surplus?

4. What is economic profit?

5. Is the allocation Pareto efficient?

6. Explain the fairness concern.

(h) Product differentiation, advertising, and innovation. [8]

NutriBite can spend 600 on advertising and product redesign. This changes demand to:

𝑃 = 160 − 𝑄

but does not change the cost function except for the advertising/design cost of 600.

1. Find the new profit-maximizing 𝑄and 𝑃, before subtracting advertising cost.

2. Calculate gross economic profit before advertising cost.

 3. Calculate net economic profit after advertising cost.

4. Should NutriBite invest in advertising and redesign?

5. Explain how this reflects product differentiation.

(i) Strategic price setting with few firms. [10]

NutriBite competes with one rival, CrunchCo. Each firm can set a High price 𝐻or Low price 𝐿.

When consumers are loyal to brands, the profit matrix is:

CrunchCo: H CrunchCo: L
NutriBite: H (520, 520) (338, 470)
NutriBite: L (470, 338) (300, 300)

When consumers become more price-sensitive, the profit matrix is:

CrunchCo: H CrunchCo: L
NutriBite: H (520, 520) (182, 530)
NutriBite: L ,
(530 182) (300, 300)

1. Find the Nash equilibrium in the loyal-consumer case.

2. Find the Nash equilibrium in the price-sensitive case.

3. Explain why the price-sensitive case is a prisoners’ dilemma.

4. Explain how elasticity and market power are connected here.

(j) Decreasing long-run average cost and natural monopoly. [8]

Now consider a different product: a breakfast-delivery app. It has high platform development cost and
low marginal cost:

𝐶(𝑄) = 2000 + 10𝑄

and market demand is:

𝑃 = 90 − 0.1𝑄.

1. Derive 𝐴𝐶(𝑄)and 𝑀𝐶(𝑄).

2. Explain why average cost decreases as 𝑄rises.

 3. Find the monopoly output and price.

4. Find the efficient output where 𝑃 = 𝑀𝐶.

5. Explain why marginal-cost pricing may require a subsidy.

(k) Competition policy and market power. [8]

Suppose NutriBite tries to increase market power in three ways:

1. It buys exclusive shelf space in major supermarkets.

2. It acquires CrunchCo.

3. It designs its cereal bowl, spoon, and app so that they work best only with NutriBite products.

For each action:

1. Explain how it may reduce competition or make demand less elastic.

2. Explain why competition authorities may investigate.

3. Explain one possible efficiency defence NutriBite might offer.

4. State the policy objective of competition or antitrust law.

Problem 8

The Shonarhat Rice Market: Prices, Competition, Surplus, Shocks, Taxes, Information, and Controls

Shonarhat is a large rice market. Thousands of consumers buy the same standard-quality rice, and many
small rice mills sell it. Rice is homogeneous enough that buyers care mostly about price. All prices are
measured in taka per kg, and quantities are measured in thousand kg per day.

The inverse market demand curve is:

𝑃𝐷 = 120 − 𝑄

The short-run inverse market supply curve is:

𝑃𝑆 = 20 + 𝑄

There are initially 50 identical small mills. Each mill has cost function:

𝐶(𝑞) = 25 + 20𝑞 + 25𝑞 2

where 𝑞is the output of one mill. Therefore:

𝑀𝐶(𝑞) = 20 + 50𝑞

Questions

(a) Demand, supply, WTP, WTA, and market clearing. [10]

1. Interpret the demand curve using willingness to pay.

2. Interpret the supply curve using willingness to accept or marginal cost.

3. Find the market-clearing price and quantity.

4. At 𝑃 = 60, calculate quantity demanded, quantity supplied, and excess demand or excess
supply.

5. At 𝑃 = 80, calculate quantity demanded, quantity supplied, and excess demand or excess
supply.

6. Explain why prices tend to move toward the market-clearing price.

(b) Competitive equilibrium and price-taking. [8]

 1. Define competitive equilibrium in this market.

2. Explain why each buyer is a price-taker.

3. Explain why each rice mill is a price-taker.

4. Explain the Law of One Price.

5. State four conditions under which the supply-and-demand competitive-equilibrium model is a

good approximation.

(c) Firm supply and market supply. [10]

Each rice mill has:

𝐶(𝑞) = 25 + 20𝑞 + 25𝑞 2

1. Derive the individual mill’s marginal cost.

2. At market price 𝑃 = 70, find the output of each mill.

3. Calculate the profit of each mill at 𝑃 = 70.

4. Derive the individual mill’s short-run supply function.

5. Derive the market supply curve when there are 50 mills.

6. Verify that this market supply curve is the same as 𝑃𝑆 = 20 + 𝑄.

(d) Gains from trade, surplus, and Pareto efficiency. [12]

Using the competitive equilibrium from part (a):

1. Calculate consumer surplus.

2. Calculate producer surplus.

3. Calculate total surplus.

4. Explain why the competitive equilibrium maximizes total surplus.

5. Explain why it is Pareto efficient only under specific conditions.

6. Explain why Pareto efficiency does not automatically imply fairness.

(e) Demand shock and short-run/long-run equilibrium. [12]

Suppose urban consumers suddenly increase demand for Shonarhat rice. The new demand curve
becomes:

𝑃𝐷′ = 150 − 𝑄

The short-run supply curve remains:

𝑃𝑆 = 20 + 𝑄

1. Find the new short-run equilibrium price and quantity.

2. At the old price 𝑃 = 70, calculate excess demand under the new demand curve.

3. Explain the disequilibrium rents that push price upward.

4. Find the minimum average cost of a rice mill.

5. Find the long-run price if entry is free and all remaining firms make normal profit.

6. Find long-run quantity demanded at that price.

7. How many mills operate in the long run if each produces at minimum average cost?

8. Explain why supply is usually more elastic in the long run.

(f ) Supply shock and market dynamics. [8]

Now return to the original demand curve:

𝑃𝐷 = 120 − 𝑄

Suppose a fertilizer and fuel shock raises every mill’s marginal cost by 20. The new supply curve
becomes:

𝑃𝑆′ = 40 + 𝑄

1. Find the new equilibrium price and quantity.

2. Compare this with the original equilibrium.

3. Explain the effect on consumers and producers.

4. Explain why oil-market shocks often create large short-run price movements.

(g) Per-unit tax and tax incidence. [12]

Return again to the original market:

𝑃𝐷 = 120 − 𝑄, 𝑃𝑆 = 20 + 𝑄

The government imposes a tax of 30 taka per kg on sellers.

1. Find the new equilibrium quantity.

2. Find the price paid by consumers.

3. Find the price received by sellers net of tax.

4. Calculate government revenue.

5. Calculate consumer surplus after tax.

6. Calculate producer surplus after tax.

7. Calculate total surplus including government revenue.

8. Calculate deadweight loss.

9. Explain tax incidence in this case.

(h) Price ceiling after a demand shock. [10]

Use the post-shock demand curve:

𝑃𝐷′ = 150 − 𝑄

and the original short-run supply curve:

𝑃𝑆 = 20 + 𝑄

The market-clearing price would be 85, but the government imposes a maximum legal price:

𝑃 = 70

1. Calculate quantity demanded at the ceiling.

2. Calculate quantity supplied at the ceiling.

3. Calculate excess demand.

4. What quantity is actually traded?

 5. Assuming rice goes to the highest-WTP consumers, calculate consumer surplus.

6. Calculate producer surplus.

7. Calculate total surplus.

8. Calculate deadweight loss relative to the uncontrolled post-shock equilibrium.

9. Explain one fairness argument for the price ceiling and one efficiency problem.

(i) Information, local price differences, and the Law of One Price. [8]

Fishermen near Shonarhat sell hilsa in three landing markets. Before mobile phones, fishermen do not
know which market has excess demand. On one day:

Market A has excess supply and the fish price falls to 0.

Market B clears at 6 taka per kg.
Market C has excess demand and the fish price rises to 10 taka per kg.

A boat has 100 kg of fish.

1. What does the boat earn if it lands in Market A?

2. What does it earn if it lands in Market C?

3. Why is the Law of One Price violated?

4. How do mobile phones change fishermen’s choices?

5. Explain how better price information can raise fishermen’s profits, lower consumer prices, and
reduce waste.

(j) Cartel, barriers to entry, and competition. [8]

Two rice wholesalers can choose High price 𝐻or Low price 𝐿. Production cost is 1 per unit.

If both charge 𝐻 = 4, total sales are 60 units, split equally.

If both charge 𝐿 = 2, total sales are 72 units, split equally.
If one charges 𝐿and the other charges 𝐻, the low-price firm gets the whole market of 72 units.

1. Calculate each firm’s profit in all four possible outcomes.

2. Find the Nash equilibrium or equilibria.

3. Explain why the high-price outcome may be sustained when there are only two firms and
barriers to entry.
 4. Now suppose a third firm enters. If all three charge high prices, each earns 60. If one firm cuts
price while the other two keep high prices, the low-price firm earns 72. Explain why competition
destroys the cartel.

5. Explain why this may be good for consumers even if firms earn lower profit.

(k) Model evaluation: when supply and demand works, and when it fails. [6]

For each case below, say whether the competitive supply-and-demand model is likely to work well,
imperfectly, or badly, and explain why:

1. Standard-quality paddy rice sold by thousands of farmers.

2. A patented diabetes medicine sold by one company.

3. Fish sold in isolated landing markets without price information.

4. Oil sold in a world market where a cartel restricts supply.

5. Housing rent under a legal rent ceiling.

6. A good whose production creates unpriced pollution.

Problem 9

The Chandra–Karim Credit Economy: Time, Wealth, Debt, Risk, Power, and Poverty Traps

In a small farming town, some people have money today and some only expect income later. Chandra is
a young borrower with no current income but guaranteed income later. Karim is a wealthy farmer with
money today and no income later unless he stores, lends, or invests. A local moneylender, Sardar, decides
whom to finance.

There are two periods: now and later. Consumption now is 𝑐1, and consumption later is 𝑐2 . Unless
otherwise stated, people have the utility function:

𝑢(𝑐1 , 𝑐2 ) = 𝑐1 𝑐2

The market uses real interest rates, with no inflation.

Questions

(a) Income, wealth, saving, depreciation, and debt. [8]

Nila owns cash worth 20, jewellery worth 40, and business equipment worth 100. She owes 50 to a
lender. During the year, she earns wages of 45, receives rent of 5, interest income of 4, and capital gains
of 6. Her equipment depreciates by 8. She consumes 40 during the year.

1. Calculate Nila’s material wealth at the start of the year.

2. Calculate her gross income.

3. Calculate her net income after depreciation.

4. Calculate her saving.

5. Calculate her end-of-year wealth.

6. Explain the difference between wealth and income.

(b) Borrowing and the feasible frontier. [8]

Chandra has no income now but will receive 120 later:

(𝑐1 , 𝑐2 ) = (0,120)

She can borrow at interest rate 𝑟.

1. Write Chandra’s feasible frontier when 𝑟 = 20%.

 2. Find her maximum possible current consumption.

3. Is (𝑐1 , 𝑐2 ) = (70,36)feasible?

4. Now suppose the interest rate is 78%. Write the new feasible frontier.

5. Find her maximum possible current consumption at 78%.

6. Explain why a higher interest rate shrinks a borrower’s feasible set.

(c) Consumption smoothing, MRS, and Chandra’s optimal borrowing. [10]

Assume:

𝑢(𝑐1 , 𝑐2 ) = 𝑐1 𝑐2

1. For 𝑟 = 20%, find Chandra’s optimal 𝑐1 , 𝑐2 .

2. How much does she borrow?

3. How much does she repay later?

4. For 𝑟 = 78%, find Chandra’s optimal 𝑐1 , 𝑐2 .

5. Explain situational impatience and intrinsic impatience using Chandra’s case.

(d) Storing, lending, investing, and borrowing after investment. [12]

Karim has 120 now and zero later:

(𝑐1 , 𝑐2 ) = (120,0)

He has four options.

Option 1: store grain, but 20% is lost before next period.

Option 2: lend money at 20%.
Option 3: invest grain at a 50%return.
Option 4: invest all 120 at a 50%return and also borrow against the future harvest at 20%.

Using 𝑢(𝑐1 , 𝑐2 ) = 𝑐1 𝑐2:

1. Find Karim’s optimal consumption under storage.

2. Find his optimal consumption under lending.

3. Find his optimal consumption under investment.

 4. Find his optimal consumption if he invests all 120 and then borrows against the future harvest.

5. Rank the four options by utility.

6. Explain why wealth expands Karim’s opportunity set.

(e) Discounting, external effects, and future generations. [8]

A climate policy costs 20 today and gives future generations a benefit of 100 exactly 100 years from now.

Use:

𝐹𝑉
𝑃𝑉 =
(1 + 𝑑)𝑛

1. Calculate the present value of the future benefit using 𝑑 = 1.4%.

2. Calculate the present value using 𝑑 = 4.3%.

3. Under each discount rate, should the policy be accepted by a strict cost–benefit rule?

4. Explain why discounting climate benefits is ethically different from Chandra discounting her
own future consumption.

(f ) Conflict between borrower and lender over interest rates. [8]

Suppose Chandra can borrow at either 20%or 78%. Karim can lend at either 20%or 78%. Their
preferences are identical:

𝑢(𝑐1 , 𝑐2 ) = 𝑐1 𝑐2

Chandra starts with (0, 120). Karim starts with (120, 0).

1. Calculate Chandra’s utility at 20%.

2. Calculate Chandra’s utility at 78%.

3. Calculate Karim’s utility at 20%.

4. Calculate Karim’s utility at 78%.

5. Explain why borrowers and lenders can both gain from credit markets but still have a conflict of
interest over the interest rate.

(g) Borrowing as a principal–agent problem. [14]

A borrower wants a loan of 100 to finance a business. The loan repayment due later is 120. The lender’s
opportunity cost of funds is 110.

The borrower can choose one of two projects after receiving the loan.

Safe project: success probability 0.9, output if successful 160, output if failed 0.
Risky project: success probability 0.5, output if successful 260, output if failed 0.

If the project succeeds, the borrower repays 120 and keeps the rest. If it fails, the borrower repays
nothing unless she has pledged collateral 𝐶, which is transferred to the lender.

1. With no collateral, calculate the borrower’s expected payoff from the safe project.

2. With no collateral, calculate the borrower’s expected payoff from the risky project.

3. Which project does the borrower choose?

4. With no collateral, calculate the lender’s expected repayment under the project the borrower
chooses.

5. Will the lender make the loan?

6. Find the minimum collateral 𝐶needed to make the borrower choose the safe project.

7. At that collateral level, will the lender be willing to lend?

8. Explain why poor borrowers may be credit constrained or credit excluded.

(h) Inequality among lenders, borrowers, and excluded borrowers. [10]

There is one lender and five potential borrowers. Each funded business generates net income 𝐼. The
lender receives share:
𝑟
𝑠=
𝑅

and each successful borrower receives:

1−𝑠

First assume all five borrowers receive loans.

1. If 𝑟 = 12%and 𝑅 = 20%, calculate 𝑠.

2. Use the following six-person formula:

 6𝑠 − 1
𝐺𝑖𝑛𝑖 =
5

to calculate inequality.
3. If 𝑟 = 15%and 𝑅 = 20%, calculate the new Gini.
4. Explain why a higher interest rate raises inequality.

Now suppose 𝑠 = 0.6, but only three of the five borrowers receive loans. The two excluded borrowers
receive zero income. Incomes measured in units of 𝐼are:

(1.8, 0.4, 0.4, 0.4, 0, 0)

where the first number is the lender’s income.

5. Calculate the mean income.

6. Calculate the average absolute difference across all 15 unordered pairs.

7. Calculate the Gini coefficient.

8. Explain why exclusion raises inequality beyond high interest rates alone.

(i) Wealth, risk aversion, and a poverty trap. [8]

Two people face the same investment choice.

Safe asset: return 5%for sure.

Risky asset: 50%chance of 60%return, and 50%chance of 20%loss.

Julia has wealth 20. Marco has wealth 200. Both need at least 18 next period to avoid a severe hardship.
Assume they judge any outcome below 18 as unacceptable.

1. Calculate Julia’s next-period wealth under the safe asset.

2. Calculate Julia’s possible next-period wealth under the risky asset.

3. Which asset should Julia choose under the hardship constraint?

4. Calculate Marco’s next-period wealth under the safe asset.

5. Calculate Marco’s possible next-period wealth under the risky asset.

6. Which asset should Marco choose if he maximizes expected wealth?

7. Explain how this creates a poverty trap.

(j) Policies to reduce risk exposure. [8]

The government considers two policies.

Policy A: home-value insurance. A homeowner receives compensation when the citywide house-price
index falls, not when only her own house falls in value.

Policy B: income-contingent higher-education finance. Students pay no tuition now, but later pay a
graduate tax equal to a percentage of their income.

1. Explain why Policy A reduces risk for less wealthy homeowners.

2. Explain why basing the payout on a citywide index reduces moral hazard.

3. Explain why private insurers may fail to provide such insurance at sufficient scale.

4. Explain why private credit is weak for higher education.

5. Compare government-backed loans with income-contingent graduate taxation in terms of risk

and fairness.

(k) Model evaluation: what the unit’s model captures and misses. [6]

For each case, say whether the basic intertemporal-choice model works well, imperfectly, or badly, and
explain why.

1. A salaried worker saving for retirement through a simple savings account.

2. A poor household taking a payday loan with complex fees.

3. A student choosing a degree with uncertain future earnings.

4. A farmer borrowing to buy fertilizer under drought risk.

5. A wealthy household choosing between bonds and shares.

6. A person repeatedly saying “my diet starts tomorrow” and failing to save as planned.
Problem 10

The Meghna Agro-Industrial Economy: Pollution, Public Goods, Shared Resources, Hidden
Information, and the Limits of Markets

Meghna Valley is a coastal economy with banana plantations, fishermen, training firms, radio
broadcasters, insurers, banks, used-car sellers, and public services. Private decisions often affect people
who are not part of the original transaction.

A banana plantation sector sells bananas in the world market at a fixed price:

𝑃 = 100

The marginal private cost of banana production is:

𝑀𝑃𝐶 = 20 + 𝑄

where 𝑄is measured in thousand tons.

The pesticide used in banana production pollutes the river and damages fisheries. The marginal external
cost is:

𝑀𝐸𝐶 = 0.5𝑄

Therefore:

𝑀𝑆𝐶 = 𝑀𝑃𝐶 + 𝑀𝐸𝐶

Questions

(a) Diagnosis: private effects, social effects, and market failure. [8]

1. Define external effect.

2. Explain why pesticide pollution is a negative production externality.

3. Explain the difference between marginal private cost, marginal external cost, and marginal social
cost.

4. State the general condition for Pareto efficiency in this unit.

5. Explain why a competitive market can be efficient when only buyers and sellers are affected, but
inefficient when outsiders are affected.
(b) Pollution: private output, efficient output, and deadweight loss. [14]

Use:

𝑃 = 100, 𝑀𝑃𝐶 = 20 + 𝑄, 𝑀𝐸𝐶 = 0.5𝑄.

1. Write the marginal social cost curve.

2. Find the privately chosen competitive output.

3. Find the Pareto-efficient output.

4. Calculate plantation surplus at the privately chosen output.

5. Calculate total external damage at the privately chosen output.

6. Calculate net social surplus at the privately chosen output.

7. Calculate plantation surplus, total external damage, and net social surplus at the efficient output.

8. Calculate the deadweight loss from overproduction.

9. Explain why the market price sends the wrong message.

(c) Coasean bargaining and property rights. [12]

Suppose the law initially gives plantation owners the right to pollute. Without bargaining, they produce
the privately chosen output from part (b).

1. If output is reduced to the efficient level, how much plantation surplus is lost?

2. How much external damage is avoided?

3. What is the total net gain from bargaining?

4. What range of payments from fishermen to plantation owners would make both sides better
off ?

5. If they split the net gain equally, what payment should fishermen make?

6. Now suppose instead that the law gives fishermen the right to clean water, so banana output
would be zero without agreement. What range of payments from plantation owners to
fishermen would allow the efficient output?

7. Explain why the efficient output may be independent of the initial property right, but
distribution depends on the initial property right.
 8. Give two reasons bargaining may fail in practice.

(d) Regulation, Pigouvian taxation, compensation, and tradable permits. [10]

Use the pollution model from part (b).

1. What production quota would achieve the efficient outcome?

2. What Pigouvian tax per unit would achieve the efficient outcome?

3. Calculate tax revenue at the efficient output.

4. If firms must compensate fishermen for marginal damage, calculate total compensation at the
efficient output.

5. Compare the distributional effect of regulation, taxation, and compensation.

6. Explain why taxing the pesticide itself may be better than taxing banana output if cleaner
production methods exist.

7. Explain one informational difficulty faced by government.

(e) Positive externality: worker training. [8]

A firm can train workers. Training units are 𝑇.

The firm’s marginal private benefit from training is:

𝑀𝑃𝐵 = 80 − 𝑇

The marginal cost of training is:

𝑀𝐶 = 20 + 𝑇

Other firms benefit when trained workers later move jobs. The marginal external benefit is:

𝑀𝐸𝐵 = 20.

1. Find the privately chosen amount of training.

2. Write the marginal social benefit curve.

3. Find the Pareto-efficient amount of training.

4. Calculate deadweight loss from undertraining.

 5. What Pigouvian subsidy per unit would implement the efficient outcome?

6. Explain why positive externalities lead to too little activity.

(f ) Public good: community radio and free access. [10]

A radio programme has potential listeners. The willingness-to-pay curve is:

𝑃 = 15 − 0.0015𝑁

where 𝑁is the number of listeners. The fixed cost of producing and broadcasting the programme is:

𝐶 = 40,000.

The marginal cost of an additional listener is zero.

1. Why is the programme a public good?

2. Find the Pareto-efficient number of listeners.

3. Calculate total social benefit at the efficient number of listeners.

4. Calculate net social benefit if the programme is provided free.

5. If a private broadcaster charges 𝑃 = 6, how many people listen?

6. Calculate listener surplus, broadcaster revenue, broadcaster profit, and total net social benefit at
𝑃 = 6.

7. Calculate deadweight loss from charging 𝑃 = 6.

8. Explain why excludability does not solve the public-good problem.

(g) Open-access fishery and common-pool overuse. [8]

In an open-access fishery, 𝐵boats enter. The value of catch per boat is:

100 − 2𝐵

The cost per boat is:

40.

1. Find the open-access equilibrium number of boats.

 2. Calculate total surplus at the open-access equilibrium.

3. Find the socially efficient number of boats.

4. Calculate total surplus at the efficient number of boats.

5. Calculate the deadweight loss from open access.

6. Explain why open-access resources are overused.

7. Explain how community governance or permits could improve the outcome.

(h) Hidden action, moral hazard, and insurance. [10]

A house is worth 100. The homeowner can be careful or careless.

If careful, the probability of loss is 0.1, but care costs 4.

If careless, the probability of loss is 0.3, and care costs zero.

An insurance company cannot observe whether the homeowner is careful.

1. Without insurance, which action minimizes expected social cost?

2. Under full insurance, what action will the homeowner choose?

3. What premium must the insurer charge under full insurance if it expects careless behaviour?

4. Why is this a hidden-action problem?

5. Suppose insurance includes a deductible 𝐷. Find the minimum deductible that makes the
homeowner willing to be careful.

6. Explain why partial insurance can reduce moral hazard.

7. Explain how the same logic applies to credit markets.

(i) Hidden attributes, adverse selection, and missing markets. [8]

There are 100 used cars.

50 are high-quality cars. Each is worth 10,000 to buyers, but the seller will not sell for less than 8,000.
50 are low-quality cars. Each is worth 4,000 to buyers, but the seller will not sell for less than 2,000.

Sellers know their car quality. Buyers cannot observe quality.

1. If quality were observable, how many cars would be sold?

2. What total gains from trade would be realized under full information?
 3. If buyers cannot observe quality, what is the maximum price they would initially pay based on
average value?

4. Will high-quality sellers sell at that price?

5. What happens to the average quality of cars offered for sale?

6. What cars remain in the market?

7. Calculate total gains from trade under adverse selection.

8. Explain why adverse selection can create a missing market.

(j) Merit goods, repugnant markets, and the limits of markets. [6]

For each item below, state whether the main issue is market failure, merit good, repugnant market, or
ordinary private good. Give one sentence of reasoning.

1. Basic emergency healthcare.

2. Buying and selling human kidneys.

3. Standard rice sold in a competitive market.

4. Clean air.

5. Primary education.

6. A private shirt.