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[Exam Tutorial] ECO206 Term Test 2 Full Study Package

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University of Toronto St. George

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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