Download Eco 301 Name_______________________________ Test 2 9

Eco 301
Test 2
Name_______________________________
9 November 2007
100 points. Each question is worth 20 points. Please write all answers in ink. You may use
pencil and a straight edge to draw graphs. Use the economic way of thinking. Allocate your
time efficiently.
Part I: For the following, please answer "True" or "False" and explain why.
1. Your company makes copper pipes. Over the years, you have collected a large inventory of
raw copper. The production process involves melting the copper and shaping it into pipes. You
also have a large stockpile of pennies. Suppose the price of copper rises so much that the copper
in the penny becomes worth more than one cent. Should you melt down your pennies?
This problem appeared as a puzzle in the Journal of Economic Perspectives (Winter, 1988). It is
true (in this problem) that the pennies when melted currently have a value greater than one cent.
Yet, the price of copper can fluctuate. If the price of copper stays high, it does not matter if you
melt pennies or not. However, if the price of copper falls so that the value of the copper in the
penny falls below one cent, your unmelted pennies are still worth one cent. Your melted pennies
would be worth less than one cent. Thus, as long as you have some other source of copper, you are
better off melting that copper and not the pennies.
2. In the long-run firms in a competitive market make zero economic profit. This induces most
firms to leave the industry.
False. Those firms cannot make themselves better off by moving their resources into another
industry because they cover all opportunity costs. Most importantly, a zero economic profit means
that firms earn the normal rate of return.
Part II. Short Answer
3. If entry is limited due to a limited input, firms in that market earn long run economic profit.
Provide an example of a limited input that prevents entry.
False. The price of the limited input will be bid up until zero economic profits result in the market
that uses the input. Owners of the limited input earn economic rent. Examples include real estate
in prime locations, taxi medallions, liquor licenses, tobacco acreage allotments (recently eliminated?)
to name a few.
Part III. Economic Analysis
4. Suppose anyone with a driver's license is capable of supplying one trip from the airport to the
downtown business center on any given day. The long-run supply curve of such trips is
horizontal at p = $50, which is the average cost of such trips. Suppose daily demand is Q = 1000
- 10p. Calculate the change in consumer surplus, producer surplus and social welfare if the city
government requires those people supplying such trips to possess a special license, and the
government will issue only 300 licenses.
5. The above figure shows the demand and supply curves in the market for milk. Currently the
market is in equilibrium. If the government establishes a $4 per gallon price support, estimate the
change in p, Q, and social welfare.
Price rises to $4 per gallon. Consumers purchase only 500 gallons of milk. The government
purchases 1,000 gallons of milk to support the price at $4. Thus, a total of 1,500 gallons is
produced. The loss in social welfare equals 1,000 gallons of milk at $4/gallon (equals $4,000)
less the producer surplus above the old demand curve up to a price of $4 (which is $500). The
loss in social welfare is $3,500.
Eco 301
Test 2
Name_______________________________
9 November 2007
100 points. Each question is worth 20 points. Please write all answers in ink. You may use
pencil and a straight edge to draw graphs. Use the economic way of thinking. Allocate your
time efficiently.
Part I: For the following, please answer "True" or "False" and explain why.
1. Even though fixed costs do not affect the output decision, an increase in fixed costs results in
a wider range of prices for which the firm operates at a loss.
True. An increase in fixed costs will shift AC upward but leave AVC unchanged. The gap
between AVC and AC represents prices at which the firm will operate at a loss.
2. If a firm cannot earn profits in the short run, it will shut down.
False. A firm will operate at a loss if the loss incurred from production is less than the loss
incurred from shutting down. Even if the firm shuts down, it still must pay its fixed costs
because, in the short-run, going out of business is not an option.
Part II. Short Answer
3. Even if two competitive firms in the same market have different production technologies,
they will each earn long-run zero profits. Why?
The firm that has more productive resources will have the cost of those resources bid up by the
marketplace. The more productive the resource, the more expensive it will be. This price is bid
up until the firm's profits are zero. The firm with less productive resources will also have zero
profits because it is not paying as much for its resources. There is no such thing as a free lunch or
a free productivity gain.
Part III. Economic Analysis
4. Suppose an industry trade group has convinced legislators that a price floor should be used so
that producer surplus is maximized in the market for milk. The group argues that such a policy
would save the "family farm." Assuming a downward-sloping linear demand curve and a
horizontal long-run supply curve, determine the resulting price, output and social welfare from
such a policy. Compare this result to the competitive equilibrium.
5. The above figure shows the demand and supply curves in the market for milk. Currently the
market is in equilibrium. If the government establishes a $2 per gallon price ceiling to ensure that
children are nourished, estimate the change in p, Q, and social welfare.
At a price of $2, only 500 gallons are produced. The deadweight loss equals [(1000 - 500) * (4 2)]/2 = $500.