EEP 100 Spring 2010
Final Answers
May 14, 2010
1.(9 points) With the end of the Cold War the U.S. government decided
to °downsize± the military.
Along with a pink slip, the government o/ered
exmilitary personnel their choice of $8,000 a year for 30 years or a lump sum
payment of $50,000 immediately. The lumpsum option was chosen by 92% of
enlisted personnel and 51% of o¢ cers (Warner and Pleeter, 2001). Assuming
that all these individuals expect to live at least 30 years, what is the breakeven
personal discount rate at which someone would be indi/erent between the two
options? What can you conclude about the relative size of the personal discount
rates of the enlisted personnel and of the o¢ cers? (Hint: You may treat 30 years
as being essentially °forever.±)
Answer:
(a). Suppose the breakeven personal discount rate is r*, then we have:
30
X
t
=1
8000
(1 +
r
°
)
t
= 50000
Using the hint, we can write the lefthandside as:
1
X
t
=1
8000
(1 +
r
°
)
t
= 8000
1
X
t
=1
1
(1 +
r
°
)
t
= 8000
1
r
°
Therefore we have:
8000
1
r
°
= 50000
)
r
°
=
8000
50000
= 0
:
16 = 16%
i.e. the breakeven personal discount rate is 16%.
(b).
From the present value formula, we can see that one²s present value
of the ³rst option will be smaller than $50,000 if one²s personal discount rate
is greater than r*. Since the lumpsum option was chosen by 92% of enlisted
personnel but only 51% of o¢ cers, therefore 92% of enlisted personnel and 51%
of o¢ cers should have personal discount rates greater than 16%.
1
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2.(9 points) A monopoly has a marginal cost of zero and faces two groups
of consumers. At ³rst, the monopoly could not prevent resales between groups,
so it maximized its pro³t by charging everyone the same price, p = $5. No one
from the ³rst group chose to purchase. Now the monopoly can prevent resales,
so it decides to price discriminate. Will total output expand? Why or why not?
What happens to pro³t and consumer surplus?
Answer:
When the monopoly could not prevent resales, since no one from the ³rst
group (denoted by group 1 afterwards) chose to purchase at p = $5, then there
is no resales from group 2 to group 1 because the price is higher than the choke
price of the demand (or the greatest willingnesstopay) of group 1.
Now when the monopoly can prevent resales, it will use multimarket price
discrimination. Since the marginal cost is zero, then the equilibrium price and
quantity of group 2 won²t change after the price discrimination. Since now there
will be another price (lower than $5) for group 1, the new equilibrium quantity
of group 1 will be positive.
Therefore, the total output will expand after the price discrimination. More
over, after the price discrimination, since the cost curves, demand functions, or
equilibrium price and quantity won²t change, and the new equilibrium quantity
of group 1 will be positive, therefore the monopoly²s pro³t will increase and
consumer surplus will also increase due to the additional quantity purchased by
group 1.
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 Spring '10
 PERLOFF
 Economics, Monopoly, Supply And Demand, evil ink inc.

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