CB2 April 2022

[Greg Raine]

Hi,

I've gone over this exam paper and the examiners report, and am unsure on my understanding regarding Q12 and Q17, which both give answers of C.

For Q12, my understanding was that the dominant strategy was an individual firm's best response. Given both firms get profit of 60 when pricing high, how come this isn't the best response for each firm (my answer was B)?

For Q17, I thought the formula for the multiplier was 1/(1-MPC) where MPC is marginal propensity to consume. I've done 1/(1-0.8) = 5 so answered B, but appreciate that this may be ignoring the income tax stated in the question. Could some please explain what this would equal if income tax was included, and the rationale behind the solution in the examiner's report?

Many thanks,
Greg

 

[Gresham Arnold]

For Q12, my understanding was that the dominant strategy was an individual firm's best response. Given both firms get profit of 60 when pricing high, how come this isn't the best response for each firm (my answer was B)?

Hi Greg

Broadly speaking, a dominant strategy for a firm is one which is the best response, no matter what its rivals do. So, if we think about things from Firm A's perspective, we go through all of Firm B's strategies, and for each one, work out the best thing for Firm A to do. If they are all the same, this is a dominant strategy. So from Firm A's perspective:

Suppose Firm B goes high. If Firm A:

• goes high, it will get a payoff of 60
• goes low, it will get a payoff of 90.

So Firm A should go low.

Suppose Firm B goes low. If Firm A:

• goes high, it will get a payoff of 20
• goes low, it will get a payoff of 40.

So Firm A should go low.

Since Firm A should go low no matter what Firm B does, low is a dominant strategy for Firm A. This rules out Options A and B.

We can then look at things from firm B's perspective. In summary, Firm B should also go low, no matter what Firm A does. Hence Option C is the correct answer.

I hope that helps
Gresham

 

[Gresham Arnold]

For Q17, I thought the formula for the multiplier was 1/(1-MPC) where MPC is marginal propensity to consume. I've done 1/(1-0.8) = 5 so answered B, but appreciate that this may be ignoring the income tax stated in the question. Could some please explain what this would equal if income tax was included, and the rationale behind the solution in the examiner's report?

Hi Greg

This is a challenging question. I tackled it this way:

We are told in the question that the marginal propensity to consume goods and services (mpc) is 0.8. We need the marginal propensity to consume domestically produced goods and services (mpcd) to calculate a multiplier.

In A and B we are interested in the closed economy multiplier, ie the multiplier if there is no international trade. If the economy is closed, all goods and services must be domestically produced, so mpcd = mpc.

In A we need a multiplier ignoring taxes, so the multiplier (k) = 1/(1-0.8) = 5. So A is false and so is not the correct answer

As you say, in B we need a multiplier including taxes. We are told that mpc = 0.8 and that tax rate on all income is 25%, so this implies strongly that the mpc we have been given is based on income after tax (because if the 0.8 was based on pre-tax income and the tax rate is 25%, then 0.8+0.25 = 1.05, which is > 1 which seems weird). When calculating the multiplier, we really want mpcd based on pre-tax income. So mpcd (in this closed economy), allowing for tax = 0.8 x (1-0.25) = 0.6. So k = 1/(1-0.6) = 2.5. So B is false and is not the correct answer

We’ve just calculated a multiplier allowing for taxes of 2.5. So, let’s use this to test option C

An increase in G of £10m would lead to an increase in national income of 10 x 2.5 = £25m. So it looks like C is true and is the correct answer.

Option D implies the multiplier is 1. This looks false and so D is not the correct answer.

I hope that helps
Gresham