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Midterm

# [Exam Tutorial] ECO206 Term Test 2 Full Study Package

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University of Toronto St. George

Economics

ECO206Y1

all

Fall

Description

ECO206 – Microeconomic Theory
1. Midterm II Structure
Based on analysis of past midterms, there are four main topics that are covered in the second midterm of
ECO206: Risk, cost minimization/profit maximization, competitive market equilibrium and short run and
long run decisions. The midterm is usually about 2 hours long and consists of 3 to 5 questions with 3 to 5
sub-questions per question. The total number of questions, including sub-questions, is roughly 12 to 15.
2. Midterm II Statistics
2011 2012 2013
Risk 0 1 1
Cost Minimization 1 1 1
Profit 1 0 0
Maximization
Competitive 1 0 1
Market
Equilibrium
Short Run and 0 1 1
Long Run Decisions
Total 3 3 4
Midterm II Statistics (2011-2013)
Short Run and
Long Run
Decisions Risk
20%
20%
Competitive
Market Cost
Equilibrium Minimization
20% 30%
Profit
Maximization
10%
Figure 1 - Midterm II Statistics Topic 1: Risk
Knowledge Summary:
Expected Utility Hypothesis: a decision framework that caters to the environment with
risk/probabilistic outcomes and analyzes the choices available.
For example, consider a simple game: flip a coin for a payoff. Payoffs are $2 if you get heads and
$0 if you get tails. Choices are: receive an amount $c with certainty or play the game. The amount
$c is known as the Reservation Price; i.e. it is the price that makes you indifferent between both
choices
Expected Wealth: EW = ∑ i.e. the payoff (i) times the probability of receiving
that payoff
Expected Utility: EU = ∑ where U(x) is the utility function of the individual
i
– Expected Utility determines the decision that will be made, not expected wealth.
Three types of individuals:
1. Risk Averse – likes to avoid risk and minimize risk (concave indifference curve)
2. Risk Neutral – is indifferent towards risk (linear indifference curve)
3. Risk Loving – gets greater utility from risky prospects than certain ones (e.g. casinos and
gamblers are risk loving and they have convex indifference curves)
To check what type an individual is, we have to compare the utility of the riskless prospect
(receiving a payoff with certainty), denote as P, to the expected utility of the gamble, denote as
C: If P>C then they are risk averse, if P = C they are risk neutral and if PC and A is expected wealth
From graph: level of wealth when U=E(U) is equal to the Certainty Equivalent (x )c an amount
with certainty that gives the same utility as the risky prospect (i.e. A). Maximum amount one is willing to pay to insure himself from risk is the difference between (x + δ) and x , or the
c
reservation price
Actuarially Fair Insurance: when the cost of the premium for insurance is equal to the expected
benefit of receiving insurance
When insurance is actuarially fair, the individual will insure themselves in full. When insurance
is actuarially unfair, the expected benefit from insurance will be less than the cost of insurance,
therefore the individual will consumes less than full coverage of insurance
Risk premium: graphically the difference between C and A. It is the amount of income a person is
willing to give up in order to avoid a risky situation (averse) or engage in one (loving)
We also have state dependent cases. Monetary payoffs are not all that matters to some
individuals. Therefore, they will not fully insure themselves if they are in a bad state (e.g. lose a
family member).
2 reasons why an individual would not fully insure themselves:
1. Insurance is actuarially unfair
2. State dependent preferences
Summary of Questions to be asked:
Calculating and illustrating expected wealth, expected utility, certainty equivalent and demand for
insurance
Identifying individuals as risk averse, risk loving and risk neutral
Calculating the risk premium
Identifying actuarially fair insurance, good vs. bad states and whether an individual will demand
full coverage or not
Related Past Test Questions:
2012 Midterm II Question 1 Topic 2: Cost Minimization and Profit Maximization
Knowledge Summary:
To find profit maximization level for a firm we need to find the isoprofit line and maximize the
production function of the firm with respect to the isoprofit line
To find cost minimization level for a firm we need to find the isocost line and minimize it with
respect to the production isoquant
Profit Maximization:
Production function: typically depends on labor (L) and capital (K)
Allows us to develop a relationship between inputs and output: Y=f(K,L) where Y is output and
inputs are K and L, represented by the production function f.
Finding isoprofit line: Profit: Π = TR – TC. Suppose we only have 1 input: labor (L) and we have
wage (w) and price per unit of output (p)
Π = p*Y – w*L
̅
Solving for Y we get: Y= and this is our isoprofit line, for a given level of profit we
choose: . Notice: wage changes the slope of the line and price changes the intercept and the
slope.

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