The following 10 questions cover some of the material that is relevant for the third exam. While these exact questions will not be on the exam, questions that are similar to (at least) some of them will be. Therefore, seeing these questions will help you prepare for the exam.
Answers and explanations for all 10 questions are found at the bottom of this page. The link after each question takes you to the relevant answer. Please note that while checking the answer to question 3 (for example), you may also be able to see the answer to question 4. If you prefer not to see an answer before you've read the corresponding question, you may wish to look over all 10 questions before checking any answers.
Please note that studying for the third exam should entail more than merely reviewing these 10 questions. The exam itself will have 30 questions, and there are topics covered on the exam that do not appear in the sample questions. Also note that you do not receive any direct credit for accessing this page, nor is the page set up to report a score based on your answers.
The questions and answers on this page are also available (on paper) at the Reserve Desk of the main library.
Each of the accompanying tables describes one set of payoffs the firms could receive. The lower, left-hand number in each box represents Firm 1's payoff; the upper, right-hand number represents Firm 2's payoff (a higher number is better for a firm than is a lower number). [Assume the firms interact just one time, that the firms choose their actions simultaneously, and that the firms can't sign binding contracts.]
(I apologize for the rather goofy looking table, but it's the best I'm going to do now.)
| Game I | . | Game II | ||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| Firm 2 | Firm 2 | |||||||||||||||
| price high | price low | price high | price low | |||||||||||||
| Firm 1 | price high | . | . | 20 | . | . | 25 | Firm 1 | price high | . | . | 20 | . | . | 25 | |
| . | . | . | . | . | . | . | . | . | . | . | . | |||||
| 20 | . | . | 15 | . | . | 20 | . | . | 10 | . | . | |||||
| price low | . | . | 15 | . | . | 10 | price low | . | . | 10 | . | . | 15 | |||
| . | . | . | . | . | . | . | . | . | . | . | . | |||||
| 25 | . | . | 10 | . | . | 25 | . | . | 15 | . | . | |||||
Based on the payoffs described in the charts, which of
the statements below accurately describes the situation facing
Firm 1?
answer and explanation
| Workers | Output |
|---|---|
| 1 | 60 |
| 2 | 110 |
| 3 | 150 |
| 4 | 180 |
| 5 | 200 |
| 6 | 210 |
Question 1 answer is:
c. In Game I, neither always choosing "price high" nor always choosing "price low" is a dominant strategy for Firm 1. In Game II, Firm 1 has a dominant strategy -- always choose "price low."Explanation: One of the actions available to a player is a "dominant strategy" if it always gives that player a higher payoff (or at least as high a payoff) than does any of his other possible strategies regardless of what the other player chooses to do.
In the simple situation described in the question (game played just one time, each firm chooses its action before observing what the other firm does), Firm 1 has only two possible strategies -- charge a "low price" or charge a "high price." One of these actions will be a dominant strategy if it always gives a higher payoff than does the other action (holding constant the action of the other firm).
The way to check this is to first assume that Firm 2 chooses a "high" price, and then see which price offers Firm 1 the highest payoff. After this is done, then assume that Firm 2 chooses a "low" price, and again see which price offers a Firm 1 the highest payoff. If the same choice is optimal for Firm 1 in both situations, then that choice must be Firm 1's dominant strategy.
For Game I, begin by assuming that Firm 2 chooses "high;" in this case, Firm 1 does best by choosing "low" ("low" gives Firm 1 a payoff of 25, while "high" would give Firm 1 only 20). Now assume that Firm 2 chooses "low;" in this case, Firm 1 does best by choosing "high;" ("high" gives Firm 1 a payoff of 15, while "low" would give Firm 1 only 10).
Our conclusion in that Firm 1 has no dominant strategy in Game I -- Firm 1's payoff-maximizing choice differs depending on what Firm 2 does, so no single choice is dominant for Firm 1.
For Game II, follow the same procedure. Assuming that Firm 2 chooses "high," Firm 1 does best by choosing "low" (Firm 1 gets 25 rather than the 20 it would get it if it picked "high"). Assuming that Firm 2 chooses "low," Firm 1 again does best by choosing "low" (Firm 1 gets 15 rather than 10). In this game, therefore, we conclude that Firm 1 does have a dominant strategy -- Firm 1's payoff-maximizing choice is always to set a "low" price, no matter what action Firm 2 picks.
To sum up, in Game II, picking "low"' always gives Firm 1 a higher payoff than does picking "high," no matter what price Firm 2 sets. Thus, setting a "low price" is a dominant strategy for Firm 1 in Game II.
Question 2 answer is:
b. A "prisoners' dilemma" game has both characteristics; a "chicken" game has only characteristic I.Explanation: Characteristic I talks about an outcome in which both players are worse off than they are in some other outcome. In other words, it refers to an outcome that is mutually-harmful for both players. This sort of outcome arises in both games.
In a "prisoners' dilemma" game, a player chooses between "cooperate" and "cheat", and the payoffs are such that both players are worse off in the "cheat"-"cheat" outcome than they are in the "cooperate"-"cooperate" outcome.
In a "chicken" game, a player chooses between "swerve" and "not swerve", and the payoffs are such that both players are worse off in the "not swerve"-"not swerve" outcome than they are in the "swerve"-"swerve" outcome.
Characteristic II talks about a player having an action that always gives him a higher individual payoff, no matter what action the other player chooses. Characteristic II, by the way, is really the definition of a "dominant strategy."
In a "prisoners' dilemma" game, a player does have a dominant strategy. If the other player chooses "cooperate," you do better individually by choosing "cheat" rather than choosing "cooperate." If the other player chooses "cheat," you still do better individually by choosing "cheat" rather than "cooperate." Thus there is indeed one action (in particular, that action is "cheat") that gives you a higher payoff than does your other possible action (which is choosing "cooperate") no matter what action the other player chooses.
[By the way, Game II in Question 1 is a game in which the payoffs have the pattern of a prisoner's dilemma. In this case, to "price low" is to "cheat." Given the action chosen by Firm 2, Firm 1 can always increase its own payoff by choosing "low" (and the same is true for Firm 2). When both firms choose "low," however, they both end up worse off than if both had picked "high."]
In a "chicken" game, in contrast, a player does not have a dominant strategy. If the other player chooses "not swerve," you do better individually by choosing "swerve" rather than choosing "not." But, if the other player chooses "swerve," you do better individually by choosing "not swerve" rather than "swerve." Thus the action that is most beneficial for you varies depending on what action the other player has picked. In a "chicken" game, in other words, it is not true that there is one action that always gives you a higher individual payoff than does your other possible action, no matter what choice the other player has made.
Question 3 answer is:
b. positive ; negativeExplanation: Remember that the definition of a "public good" implies the following. If one unit of a public good is available to the members of a community, then each member of the community can fully "consume" (and fully benefit from) that unit. [While it doesn't really matter in this question, this is true regardless of whether or not a person pays for the good.] For example, if one unit of a public good is provided to a two-person community, then each person in the community benefits from one whole unit of the good (so that the unit is not "divided up," in which case each person would benefit from only one-half unit).
In the first part of this question, each person in the (two-person) community gets a benefit valued at $12 from one unit of the good. In this case, making one unit of the good available to the community produces $24 worth of benefit to the community. Since the good costs only $20 to purchase, there is a positive net benefit since the benefit exceeds the cost.
When each person gets a benefit valued at $8 from one unit of the good, making one unit of the good available to the community produces only $16 worth of benefit. Since the good costs $20 to buy, there will be a negative net benefit since the cost exceeds the benefit.
Note that this question asks only about whether or not purchasing the good would create a positive or negative net benefit. It does not ask whether or not the good actually will be purchased. That question depends (in part) on how the purchase would be financed. If the people in this example compared only private benefits and private costs, neither person would find it personally beneficial to privately pay for a unit of the good.
Question 4 answer is:
a. more than ; less thanExplanation: When the production of a good creates a "external cost," firms do not bear the whole cost of producing the good (nor do consumers). This is because part of the cost of producing the good is external, in the sense that it affects parties other the producers and consumers of the good.
Since firms do not bear the external cost, they will have a tendency to ignore that cost. In other words, production levels will depend on the costs directly paid by the producers and consumers -- the quantity produced will be the quantity at which the market demand and market supply curves cross. This output level is inefficiently large -- since firms ignore part of the cost of their action, they will engage in more than the efficient level of production.
Put another way, firms are willing to produce more of their output as long as the price that consumers will pay is enough to cover the firms' private costs of production. This is a problem, since the external cost implies that the social cost of production exceeds the private cost of production. From an efficiency point-of-view, production should stop when the price that consumers will pay for a unit equals the social cost of producing that unit. Since marginal social cost exceeds marginal private cost, demand hits MSC at a lower quantity than it hits MPC.
A good has the characteristics of a "public good," if (a) any unit of the good can be simultaneously "consumed" by all people, and (b) it is "impossible" (or very difficult) to prevent a person who didn't pay for the good from consuming it. These two characteristics imply that a person who contributes very little (or nothing) toward the purchase of a public good can still benefit from the purchases funded by the contributions of others.
Therefore, a person who could potentially contribute to helping to pay for a "public good" good will have an incentive to "free ride." In other words, the person may be able to gain (individually) by holding back on paying for the good herself, while still planning to consume the amounts of the good that are purchased using other peoples' contributions.
Since all people who could contribute to buying the public good will feel the incentive to "free ride," voluntary (unregulated) private decisions will lead to less than the efficient level of good being produced.
Question 5 answer is:
a. lower than ; a comparativeExplanation: Remember that a country has a comparative advantage over another country in producing a good if its opportunity cost of producing that good is lower than is the opportunity cost in some other country. Opportunity cost is measured in terms of a trade off -- producing more of one good entails giving up some of another. In contrast, a country has an absolute advantage over another country if it is able to produce more units of a certain good than is another country.
This question gives us information about opportunity costs, but not about total output. Therefore, it can tell us only about comparative advantage. The information in the question cannot tell us anything about absolute advantage.
In particular, the question tells us that England has a lower opportunity cost of producing a bicycle than does Portugal. We know this because we are told that producing one more bike in England entails giving up 1 unit of cloth. Producing one more bike in Portugal entails giving up 2 units of cloth. Thus the opportunity cost of making bikes is lower in England than it is in Portugal (a lower opportunity cost means that the production of Good A entails giving up less of Good B).We therefore state that England has a comparative advantage over Portugal in the production of bicycles.
To be able to make any statement about absolute advantage, we'd have to have information about the total amounts of bicycles and cloth that England and Portugal can produce. Since the question does not supply any information about total production, we know nothing about absolute advantage.
Question 6 answer is:
d. Both (a) -- Upland's Production Possibilities Curve intersects the axes a larger values for cloth and bread than does Downland's PPC -- and (c) -- Residents of Upland will have a higher standard of living (a higher level of consumption) than will residents of Downland -- are correct.Explanation: A country with an "absolute advantage" in the production of a particular good is capable of producing more units of that good than can a country with an absolute disadvantage. Answer (a) is thus correct -- a country with an absolute advantage in both goods will have a PPC that is farther out from the origin (and thus hits the axes at larger values) to reflect its greater amounts of possible production.
Answer (c) is also correct, since a country with an absolute advantage in both goods is more productive, and thus will be able to consume more of both goods, than will the other country. [This last statement is true regardless of whether or not there is trade between the two countries.]
Answer (b), however, is not correct. Remember that the concept of "absolute advantage" relates to the number of units of output a country can produce, while the concept of "comparative advantage" relates to the opportunity cost of producing a good.
For example, suppose that for a country to be able to produce more units of Good X, it must reduce its production of Good Y. Measure the cost of producing one more unit of X by determining the drop in production of Y that must occur to make this possible. Say that Country A would have to cut its production of Y by 1 unit in order to produce 1 more unit of X, while Country B would have to cut its production of Y by 2 units in order to produce 1 more unit of X. In this case, the opportunity cost of producing X in lower in Country A than it is in Country B, so we would say that Country A has a comparative advantage over Country B is producing good X.
In the original question, we are told that Upland can produce more cloth and more bread than can Downland, but we are given no information about the countries' opportunity costs of producing these goods. In other words, we are not given the information we need to be able to determine anything about comparative advantage.
Actually, if cloth and bread are the only two goods that Upland and Downland are capable of producing, then (b) is wrong for two reasons. As just explained, we are not given the info (opportunity cost) relevant to determine comparative advantage. Second, it is impossible for one country to have a comparative advantage over another in the production of every good. After all, comparative advantage (opportunity cost) is related to the slope of the Production Possibilities Curve, and it's impossible for one country's PPC to be both flatter and steeper than another's.
Question 7 answer is:
b. MRP = Marginal Product (measured as units of output produced for each unit of input used) × Price (of output).Explanation: The Marginal Revenue Product measures the additional revenue brought into a firm as a result of using one more unit of an input. An input produces revenue through a two-stage process.
First, the new unit of the input allows the firm to increase its production of output. Then, the firm can sell that output, and collect revenue as a result.
The Marginal Revenue Product that results from using a certain unit of an input is thus the product of two terms. The first term (which is called the "marginal product") is the increase in the number of physical units of the output that arises from using that one unit of the input. The second term is the price at which the output can be sold. Multiplying these two terms produces a number which tells us how much additional revenue was brought in as a result of using that particular unit of the input.
An example of how MRP is calculated follows. Suppose that using the 3rd unit of input (hiring the third worker, for example, or buying a third machine) allows a firm to increase its production of output by 10 units. Suppose that each of those units of output can be sold for $5. In this case, using the 3rd unit of input produced a revenue increase of $50 for the firm (10 new units of output that can be sold for $5 apiece means that revenue rises by 10 × $5 = $50).
Note that the per-unit price of the input itself is not used when computing Marginal Revenue Product. This is because MRP measures only the firm's benefit as a result of using an input -- and the benefit is the rise in the firm's revenue. The price of the input is irrelevant to this calculation.
The place where the price of the input becomes important is when the firm decides how much of the input it is profitable to use. For this decision, the firm must compare the revenue that it will collect if it uses a particular unit of the input (the input's MRP) with the cost of obtaining that input (the input's Price). If the MRP of the input exceeds its Price, then using that input will raise the firm's profit. The question of whether or not the firm wishes to buy the input is, however, a different issue than simply computing the input's Marginal Revenue Product, and the input's Price is not used to compute its MRP.
Question 8 answer is:
d. 4Explanation: One way (probably the best way) to answer this question is to convert the information you are given into "marginal revenue" and "marginal cost" terms. In this particular question, you are given Total Output, and you want to convert that into Marginal Revenue Product (the gain in revenue that results from using another unit of the input).
As described in the answer to Question 7, Marginal Revenue Product is found using a two-step procedure. First, find Marginal Product (the change in total output that results from using one more unit of the input). For example, when the firm hires a second worker, its output rises from 60 to 110. The Marginal Product of the second worker (the second unit of the input) thus equals 50.
Then, multiply the Marginal Product by the price at which the output can be sold, in order to find the gain in revenue that results from using that unit of the input. For example, hiring a 2nd worker increases output by 50 units, which can be sold for $4 apiece, so hiring the second worker allows the firm to collect an additional $200 (= 50 × $4). Conducting the same calculations for the other workers allows one to add two columns to the table.
| Workers | Output | Marg. Prod. | Marg. Rev, P. |
|---|---|---|---|
| 1 | 60 | 60 | $240 |
| 2 | 110 | 50 | 200 |
| 3 | 150 | 40 | 160 |
| 4 | 180 | 30 | 120 |
| 5 | 200 | 20 | 80 |
| 6 | 210 | 10 | 40 |
One can now compare the change in revenue from using more of the input (this is what MRP measures) to the change in cost (which is $110). Each of the first four workers increases revenue by more than he increases cost, and so hiring the first worker increases the firm's profit, as does hiring the second, and the third, and the fourth.
[Note that the rise in profit from hiring the fourth worker is smaller than the rise in profit from hiring the third worker (or the second or the first worker), but it is still a rise in profit since marginal revenue (MRP) exceeds marginal cost (input price).]
However, if the firm hired a fifth worker, the firm would bring in only an additional $80 in revenue, and it would cost the firm $110 to hire the worker. Thus, hiring the 5th worker would reduce the firm's profit. The firm would therefore maximize its profit by hiring 4 workers.
Question 9 answer is:
a. more ; a substitution ; less ; an incomeExplanation: Suppose that the wage that a person collects for an hour of work changes. That person may decide to respond by changing the number of hours that he works. However, economic theory alone does not allow us to predict how he will respond. We can't say for sure whether the number of hours that he wishes to work will increase or decrease. This is because the person is influenced in two ways by the higher hourly wage, and these two influences suggest different things about how his desired numbers of working hours will change.
One of these two influences is that as hour of work now offers a higher return (or, to put it another way, an hour spent not working now has a larger opportunity cost (in terms of lost income)). As a result of this change, the person feels an incentive to work more hours. This incentive is known as a substitution effect.
The name comes from the idea that the relative prices of "working" and "not working" have changed, and the person has an incentive to "substitute" away from the activity that that has gotten more expensive, which (in opportunity cost terms) is "not working." Thus, a higher hourly wage produces a substitution effect that tends to produce an increase in the number of hours spent working.
The other influence is that a higher hourly wage makes the person better off. This occurs because the higher wage increases the person's overall income. This effect creates an incentive opposite to that described above. The person's higher income tends to encourage that person to choose to "not work" more hours than he previously picked.
One way to understand this influence is to recognize that choosing to "not work" is like "consuming" the good "leisure." A rise in income allows a person to spend more money consuming enjoyable goods. In this case, the rise in income allows a person to consume more leisure (since he can now afford to do so) and thus creates an incentive to work less hours. Since this incentive arises from a change in the person's income, it is known as an "income effect."
Note that this is one of those cases in which a seemingly very simple question -- "will a rise in a person's wage lead that person to work more or fewer hours?" -- cannot be answered based on economic theory alone. [How a higher interest rate alters a person's desired amount of saving is another example.] The reason why there is not a clear answer to this question is because the change in the hourly wage creates two influences on the person's actions, and those two influences encourage opposite changes in behavior.
One perfectly logical result is for the person to react to a higher wage by working more hours, but a second perfectly logical result is for the person to react to a higher wage by working fewer hours. A given person may respond in either way. If we (as analysts) try to predict how that person will respond, we cannot be entirely certain of our prediction, since both possible changes in behavior (there is also a third possibility -- if the two influences just offset each other, the higher wage will produce no change in behavior) are perfectly rational ways to respond to a increased wage.
Question 10 answer is:
c. He would like either choice I or choice III the best (but we can't tell which), and choice II the least.Explanation: In this question, saying that a person prefers more money to less money is equivalent to saying that (other things equal) Barney prefers an outcome with a higher expected value to an outcome with a lower expected value. Of the three situations described above, choices I and II both have expected values equal to $500, while choice III has an expected value equal to $550.
Since Barney is also known to be risk averse, however, he cares about other things in addition to expected value. In particular, he cares about the amount of uncertainty in a situation. Other things equal, Barney prefers a situation with less risk over a situation with more risk.
Barney's two preferences (for higher expected value and against higher risk) may often conflict. In particular, there may be one situation that has a higher expected value but also has higher risk than some other situation. By saying that we don't know how risk averse Barney is, this question tells us that we don't know how Barney compares a high-expected-value-high-risk situation with a low-expected-value-low-risk situation.
Returning to the three specific situations described above, we can see that both choices I and III are preferred to choice II. Situation I and situation II have the same expected value, but choice I has less uncertainty. Situations II and III have equivalent amounts of uncertainty, but choice III has a higher expected value. Therefore, Barney ranks situation II last.
We can't definitely pick a winner between situations I (which is attractive because of its low risk), and situation III (which is attractive because of its high expected value). A person who was very risk averse would likely prefer situation I; a person who was only slightly risk averse would likely prefer situation III. Since we don't know into which category Barney falls, we can't decide whether he'd like situation I or situation III better.