Managerial Economics

Indian School of Business

Term 1, 2017-18

HOMEWORK 1 SOLUTIONS

Problem 1
Arnav is a risk-averse decision maker whose utility function is given by U ( I )  I , where I
denotes Arnav’s monetary payoff from an investment. Arnav is considering an investment in
machine tools factory with a payoff of Rs. 10,00,000 with probability 0.6, and Rs. 250,000 with
probability 0.4. If the cost of the investment is Rs. 6,00,000, should Arnav invest in this factory?

Expected utility (investment) =

0.6 * 1000000  0.4 * 250000  600000  0.6 *1000  0.4 * 500  775  25
which is positive. Therefore, invest.

Problem 2
Consider two farmers and two pieces of land.1 We want to know what the effect is of each farmer
working his own piece of land versus the farmers cooperating and jointly working on the two
pieces of land. To simplify the exposition, we will denote these as ‘independent farmers’ and
‘cooperative farmers’ respectively.

Assume that each farmer (whether independent or cooperative) can decide on his own how much
time to spend on farming. Let farmer i’s weekly time spent on farming be denoted hi (in hours per
week; so h1 for farmer 1 and h2 for farmer 2). The farmer’s productivity (expressed in bushels of
grain) is directly proportional to the time he spends on farming. In particular, an independent
farmer produces (80*hi) bushels of grain if he works hi hours per week. Farmers in a cooperative
are more productive since they can specialize: a cooperative farmer produces (90* hi) bushels of
grain if he works hi hours per week. Collective farmers share the output of their farm equally. Let
bi be the bushels of grain that farmer i can take home at the end of the year, then bi = 80hi for an
independent farmer, while bi = (90h1 + 90h2)/2 for a cooperative farmer.

Farmers dislike working and more so as they work more. In particular, farmer i’s utility is

Ui = bi – (hi2/2)

We assume that a farmer i will choose hi to maximize his utility Ui.

1
This question is from Berndt, Chapman, Doyle and Stoker’s course at MIT Sloan
(a) Write out the utility functions of an independent farmer and a cooperative farmer completely
in terms of h1 and h2.

The utility of an independent farmer is

Ui = 80hi – (hi2/2)

while that of a collective farmer is

Ui = 90(h1+ h2)/2 – (hi2/2)

(b) How many hours will an independent farmer work (assuming that farmers choose hi to
maximize their utility)? What is his utility?

Taking the derivative of the independent farmer’s utility with respect to hours of work and
setting it equal to zero yields:
80 – hi = 0
=> hi = 80

The utility of an independent farmer is 3200.

(c) How many hours will a collective farmer work? What is his utility?

Consider farmer 1, with utility: u1 = 45(h1+h2)-h12/2

Taking the derivative of his utility with respect to his hours of work and setting it equal to zero
yields 45=h1. u1 = 45(45+45)-2025/2 = 3037.5

By symmetry, the same result holds for farmer 2.

(d) What is the problem with a collective farm? What would happen (qualitatively) if 100 farmers
worked jointly in a collective farm? How could the farmers solve that problem?

The problem of the collective farm is that the output is common property, so farmers get only
part of the output they produce. The incentives to work change from MR=MC to a fraction of
MR = MC. Compare, in particular, independent and collective farmers who consider the gain
from putting in one more hour after they have already worked 45 hours. The cost to each of
working the 46th hour is 462/2 – 452/2 = 45.5

The gain for an independent worker is 80, which outweighs the cost of 45.5. For a cooperative
worker, the gain is only 45 (since half of his output goes to the other farmer), so working the
extra hour is not worth it. Note that farmer 1 putting in more hours does not change how many
hours farmer 2 works. This problem is magnified with more farmers, as the share of the
marginal bundle kept by the farmer (1/no. of farmers) decreases with the number of farmers.
 Of the number of hours that someone works is observable, the farmers could write a contract
that exploits the gains from specialization and maximizes utility. (The optimal number of hours
for each farmer is 90 per week in the cooperative and farmers would get utility of 4050.) If
effort is not observable, we would have to explore incentive schemes or screening mechanisms
to align incentives.

Problem 3
An annuity provides insurance against out-living one’s financial resources. LEICO, a life
insurance company, takes a deposit from customers at age 60 years, and returns an annual payment
of Rs. 5000 till their death.

(a) Calculate the break-even deposit for LEICO if average population-wide life expectancy is 80
years. Assume a 5% interest rate.

Rs. 62311 is the deposit.

(b) If potential customers have a sense of their life expectancy, based on factors such as the
longevity of their parents, who will purchase the annuity with the deposit you have calculated
above?

Customers who expect to live for a long time, in particular, for those whose life expectancy is
greater than 80 years.

(c) If life expectancy is uniformly distributed in the population (up to a maximum of 100 years),
what is the deposit that that LEICO will ultimately end up charging? Who will finally buy this
annuity?

Only those who live for 100 years will end up buying the annuity. LEICO will charge then
85795 which is the break even value for those customers.

Problem 4
The business district of Bombay2, Hariman’s Joint, sits on an island.3 Most of the people who work
in this district commute from the mainland. Specifically, 400,000 people make this commute.
Bombayites are in love with their cars, so each of the 400,000 people drives to and from work in
a private car; there is no carpooling.

There are two routes from the mainland into (and out of) the business district, the Borli Bridge
(B)4 and the Tycoon’s Tunnel (T). The times it takes to commute across the bridge and through
the tunnel depend on the number of individuals nB and nT who take the bridge and the tunnel,

2
Any resemblance to an actual city is purely coincidental.
3
This problem is adapted from Kreps’ Microeconomics for Managers.
4
The local press grandly calls this a “sealink”.
respectively. Specifically, if nB people come via the bridge, the commute time via the bridge is
30+ nB/20000 minutes, and if nT people come via the tunnel, the commute time via the tunnel is
40+ nT/5000 minutes.

(a) Suppose each of the 400,000 people who make this commute takes either the bridge or the
tunnel; that is, nB+nT =400,000. People choose whether to take the bridge or the tunnel
depending on which takes less time, so in equilibrium, the numbers nB and nT are chosen so
that the two commute times are equal. What are nB and nT?

Equate commute times,

40 + nT/5000 = 30 + nB/20000

We also know that nB + nT = 400,000

Solve as nT = 40000 and nB =360,000

(b) We define the total commute time as nB times the commute time via the bridge plus nT times
the commute time via the tunnel. In your answer to part a, what is the total commute time?

This gives a commute time of 48 minutes for both routes, and hence total commute time of
19.2 million minutes.

(c) Suppose Bombay’s mayor could control the number of people who come via the bridge and
via the tunnel. She chooses these numbers to minimize the total commute time. How should
she allocate the 400,000 commuters between the bridge and the tunnel to minimize total
commute time?

We want to minimize (30 + nB/20000)nB + (40+ nT/5000)nT subject to nB + nT = 400000.

One way to solve is to substitute 400000-nB for nT, take the derivative and set it equal to zero.

We get nB = 60,000 and nT = 340,000

The optimal commute time is 47 minutes by bridge and 52 minutes by tunnel.

(d) Except for the congestion on the bridge and tunnel, there is a 0 marginal cost of getting
commuters across the bridge and the tunnel. For this reason, transit across the bridge and
through the tunnel has been kept free. But the mayor is considering whether to impose a toll
on one or the other. If a toll of tB is imposed on the bridge and tT on the tunnel, consumers will
rearrange their commute so that (10tB+commute time through the bridge in minutes) equals
(10tT +commute time through the tunnel in minutes). In other words, 10 minutes of commute
 time is worth Rs. 1 to commuters. Find values for tB and tT, where one is 0, so that, facing these
tolls, commuters arrange their commute in the manner that minimizes total commute time.

You can read the answer right off of the last line of part c. To get commuters to divide 60000
via tunnel and 340000 via the bridge, the toll has to be set to overcome the 5 minute difference
in commute times, in favor of the bridge. So set a toll of Rs. 0.50 for the bridge.

Problem 5
Awbrey Butte is an exclusive neighborhood of big, modern houses surrounded by native pines in
the Oregon mountains (see attached article). Resident Susan Taylor likes to use a clothesline to
dry her laundry, and thus saves $80 on average in annual energy costs (apart from the obvious
environmental benefits). Neighborhood manager Carol Haworth is concerned that seeing laundry
outside might give potential home-buyers the idea that residents are too poor to afford dryers, and
that will drive down property values. Suppose the decline in property values is proportional to the
number of weeks a year Susan dries her laundry outside.

Number of weeks Total benefits to Susan Total annualized loss to

clothesline is used Taylor Carol Hayworth

0 0 0

10 $16 $10

20 $32 $25

30 $48 $45

40 $64 $70

50 $80 $100

(a) In the absence of bargaining, how many weeks would Susan dry her laundry if she has a right
to do so?

50 weeks

(b) In the absence of bargaining, how many weeks would Susan dry her laundry if Carol has a
right to protect her property value?

0 weeks

(c) What is the socially optimal number of weeks (from the six points in the table above) the
clothesline should be used?
 20 weeks

(d) With bargaining, how many weeks would Susan dry her laundry if she has a right to do so?
What is the minimum Carol will pay Susan?

20 weeks. Carol will pay Susan $48. Susan’s payoff is preserved ($80). Carol will be better off
because her cost is $25 + $48 = $73 <$100.

(e) With bargaining, how many weeks would Susan dry her laundry if Carol has a right to protect
her property value? What is the minimum Susan pay Carol?

20 weeks. Susan will pay Carol $25. Carol’s payoff is preserved ($0). Susan will be better off
because her cost is $32 - $25 = $7>$0.