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Economics 313 – Fall 2007 – PRELIM 2 - J. Wissink – Tuesday November 6
Directions: ANSWER ALL THE QUESTIONS. Write legibly, concisely, and coherently. Be sure to
label all axes, functions, and variables you use. READ QUESTIONS CAREFULLY. Draw pictures
whenever possible. Show all your work! Total time for the test is 75 minutes. Total points on test = 100.
TURN IN THESE EXAM QUESTIONS WITH ANSWERS.
USE SEPARATE EXAM BOOKLETS FOR EACH SECTION: PART I and Part II.
Please print your name here: _____________________________________________________________
Part I: START A NEW ANSWER BOOKLET & LABEL IT PARI I and PUT YOUR NAME ON IT
1. (15pts)Suppose you currently have $202,500 in income. Suppose there are two states of the world: good
and bad. In the good state of the world your income is $250,000. In the bad state of the world your
income is $90,000. The good state occurs with probably .25 and the bad state occurs with probably .75.
Suppose your utility function is: u = y1/2 where y = money.
a. What would a basic “income insurance” contract with only a premium and benefit look like if it took
away all your income risk and left you ex ante indifferent between buying the insurance and taking the
income gamble?
b. Ex ante, how much expected profit would this contract have for the insurance seller?
c. In a sentence or two, briefly give one rationale for seeing deductibles added to basic insurance contracts.
Identify the role of the deductible when added to the basic insurance contract.
2. (16pts)Wilfred uses Tea and Honey (T and H) measured in ounces to make lip balm, x, which is measured
in sticks. He does this magically, with no labor. Part of his isoquant map is illustrated.
a. Write down Wilfred’s production function.
b. Does the technology exhibit increasing,
constant or decreasing returns to scale and,
briefly, why?
c. In general, i.e., for any per unit prices for tea
and honey, PT and PH, what is the equation for
Wilfred’s long run total cost function?
d. Suppose the quantity of tea is taken as a
FIXED FACTOR of production at T=12,
putting Wilfred in the short run. What is the
equation for Wilfred’s short run total cost
function?
Helping Line
Tea
x=24
12
x=12
6
2
4
Honey
3. (12pts)The graph represents long run
and short run average total cost
information for Guy’s Gadgets.
$
Assume there are only 2 factors of
production, L and K, with unit prices,
$w and $r.
Assume Guy’s technology is the
following: g = f(L, K) and is very
nicely behaved.
Illustrate the points A, B, C, and D in a
very carefully detailed total cost
function diagram.
sratc 0
$15
8
B
sratc 1
$10
$9
A
D
lratc
C
$7
g=300
g=700
gadgets
Part II: START A NEW ANSWER BOOKLET & LABEL IT PARI II and PUT YOUR NAME ON IT
4. (18pts)Assume that the apple industry in New York State is a perfectly competitive industry with typical
market demand and supply curves. Assume a “closed apple state” meaning New York does not import OR
export apples out of state. Consider Ackles Apples of Cortland. Suppose Ackles Apples has typical “text
book curvy” short run cost curves and is currently maximizing short run profits by selling a* = 5,000
bushels of apples. The current market price for apples is P*. Suppose Ackles Apples is experiencing
positive economic profit at the current equilibrium.
a. Using “THE GRAPH” illustrate the current situation for Ackles Apples.
Now suppose that Governor Spitzer and the New York State legislature pass a bill requiring that each apple
farm in New York State immediately pay the State $500 for a license to sell apples.
b. Show, carefully, how the apple license law will impact the cost curves you just drew for Ackles Apples.
c. In the short run, do you predict any change in the equilibrium quantity and/or price of apples in New
York State? Why or why not?
d. How would your answers above change, if, instead, the apple law was written to be a per bushel tax on
apples collected from apple farmers?
5. (24pts)Suppose all firms in the widget industry, which is perfectly competitive, have the following
production function:
x= √K√L
a. Long-run total costs are defined as: lrtc = rK*(x) + wL*(x), where r is the price of kapital and w is the
wage rate for labor. Assume that r = $2 and w = $2. Find and graph (on separate graphs) the following
(assuming plant managers know how to cost minimize):
i) the firm’s long-run total cost function. SHOW SOME WORK.
ii) the firm’s long-run average total cost function. SHOW SOME WORK.
b. Now assume that each firm is in the short run with K for each firm fixed at 36 units. Assume that
there are exactly 120 identical firms in this market and that market demand for widgets is as follows:
XD =6,600 - 20P. Note: Still assume that r = $2 and w = $2. Find and graph (on the appropriate
graphs) the following (SHOW SOME WORK for answers below):
i) the typical firm’s short-run variable cost curve.
ii) the typical firm’s short-run supply curve.
iii) the market short-run supply curve.
iv) the short-run market equilibrium price P* and quantity X*
v) the typical firm’s profit at the short run equilibrium.
6. (15pts)You are advising a firm named ZicroSoft that makes and sells recordable CDs. ZicroSoft operates in
a perfectly competitive market and wants to maximize profits (or minimize loss) by selling the right number
of CD's but is not at all sure that it is currently doing the right thing, so they have hired you to help.
ZicroSoft's chief-executive-officer gives you the following information. (He's helpful, but not all that
helpful.) He tells you (correctly) that ZicroSoft's cost curves are all well behaved and very “textbook”
typically shaped. He also gives you a table (see below) with current revenue and cost values. Based on this
information:
a. What must be ZicroSoft's current level of output?
b. What price must ZicroSoft currently be getting for the CDs it sells?
c. Given its current situation, would you advise this firm to increase output, decrease output, not change
output, or shutdown entirely? Justify your answer.
d. Illustrate ZicroSoft's current position in a diagram that includes ZicroSoft's marginal revenue, marginal
cost, average total cost and average variable cost.
CURRENT INFORMATION for ZicroSoft
Total revenue: $2,000,000
Fixed cost: $150,000
Variable cost: $1,500,000
Average variable cost: $50
Average total cost: $55
Marginal cost: $55