Download Answers to Second Midterm

Economics 101
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Summer 2008
Day and Time of Discussion Section _______
Answers to Second Midterm
Student ID Number _____________________
6/12/08
Version 1
DO NOT BEGIN WORKING UNTIL THE INSTRUCTOR TELLS YOU TO DO SO.
READ THESE INSTRUCTIONS FIRST.
You have 90 minutes to complete the exam. The exam consists of three parts: Part I is 10 Binary
Choice Questions worth 1.5 points each for a total of 15 points; Part II is 18 Multiple Choice Questions
worth 2.5 points each for a total of 45 points; and Part III is 3 Problems worth 10 points each for a total
of 30 points. The total point value of the exam is 90 points. Parts I and II should be answered on the
scantron sheet that we will provide. Please answer all questions on the scantron sheet with a #2 pencil.
No cell phones, calculators, or formula sheets are allowed.
PICK THE BEST ANSWER FOR EACH QUESTION IN PARTS I AND II.
How to fill in the scantron sheet:
1. Print your last name, first name, and middle initial in the spaces marked "Last Name," "First Name," -,
and "MI." Fill in the corresponding bubbles below.
2. Print your student ID number in the space marked "Identification Number." Fill in the bubbles.
3. Write the number of the discussion section you are enrolled in under "Special Codes" spaces ABC, and
fill in the bubbles. You can find the discussion numbers below on this page.
4. Write the version number of your exam booklet under "Special Codes" space D, and fill in the bubble.
The version number is on the top of this page.
5. If there is an error on the exam or you do not understand something, make a note on your exam booklet
and the issue will be addressed AFTER the examination is complete. No questions regarding the exam
can be addressed while the exam is being administered.
6. When you are finished, please get up quietly and bring your scantron sheet and this exam booklet to
the place indicated by the instructors.
Discussion sections are as follows:
Discussion Section 301
Discussion Section 302
Discussion Section 303
11:30 – 12:45 Wednesday
4:25 – 5:40 Thursday
11:30 – 12:45 Thursday
I. Binary Choice Questions: (Worth 1.5 points each)
1. The CPI using 1985 as the base year is equal to 250 for 2006 and 400 for 2007.
Suppose we want to use 2007 as the base year. What is the value of the CPI in 2006 using
2007 as the base year?
a. 62.5
b. 160
2. Suppose Joe’s income doubles and the price of doughnuts and coffee, the two goods
Joe purchases with his income, also double. Then
a. Joe will now consume more coffee and doughnuts given his indifference curve map.
b. Joe will not change his current consumption of coffee and doughnuts given his
indifference curve map.
3. Suppose Mary’s income is currently $50 a week and that the price of bus tickets (B) is
$2 per ticket and the price of fast food lunches (L) are $2.50 per lunch. If these are the
only two goods that Mary buys, then Mary’s budget constraint is
a. B = 25 – 1.25L
b. B = 20 - .4L
4. Suppose the marginal cost curve is increasing as output increases. Then
a. Average fixed cost must be decreasing.
b. Average variable cost must be decreasing.
5. Suppose that marginal revenue is greater than marginal cost for a firm. Then to profit
maximize this firm should produce a
a. Higher level of output.
b. Lower level of output.
6. Suppose that the average total cost of producing the fifth unit of output is equal to $6
and the average total cost of producing the sixth unit of output is equal to $5.50. Then the
marginal cost of producing the sixth unit is
a. Greater than or equal to $6.
b. Less than or equal to $5.50.
7. Consider a constant cost perfectly competitive industry. Currently a representative firm
finds that in short run equilibrium, its average total cost of production is greater than its
marginal revenue. Holding everything else constant, in the long run there will be
a. Entry of new firms into this industry.
b. Exit of firms from this industry.
8. Suppose a monopolist’s demand curve is linear and can be written as Q = 40 - .8P.
Furthermore, suppose the marginal cost for this firm is equal to MC = 5Q + 5. This firm
will profit maximize by producing
a. 7.2 units of the good.
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b. 6 units of the good.
9. For a monopoly to exist
a. There must be some kind of effective barrier to entry.
b. The government must have passed a law creating the monopoly.
10. A market that is characterized as a natural monopoly is one in which
a. A single firm can provide the good at lower average cost than can two or more firms.
b. As output increases the marginal cost curve lies beneath the average cost curve as long
as the average cost is decreasing.
II. Multiple Choice Questions: (Worth 2.5 points each)
11. Suppose the CPI in 2006 is equal to 125 and the CPI in 2007 is equal to 150. The
nominal price of textbooks increases from 2006 to 2007. Which of the following
statements is true?
a. Since the CPI and the nominal price both increased, the real price of textbooks
increased between 2006 and 2007.
b. Although the CPI and the nominal price of textbooks increased, it is possible that the
real price of textbooks increased, decreased, or remained the same.
c. Since there was inflation in the economy this implies that the real price of textbooks
must have risen during this time period.
d. None of the above statements is true.
12. The nominal wage in 2006 is equal to $30 an hour and the real wage in 2006 is equal
to $20 an hour. The CPI in 2006 is equal to 150 and the CPI in 2007 is equal to 300. If
the real wage stays constant between 2006 and 2007, what is the nominal wage equal to
in 2007?
a. $15 an hour
b. $30 an hour
c. $6 an hour
d. $60 an hour
13. The graph below depicts Mario’s budget line with respect to subway tickets and hot
dogs. Assume that Mario only purchases subway tickets and hot dogs and that he does
not save any of his income.
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Suppose Mario’s initial budget line is BL2 and then his budget line changes to BL1.
Furthermore, you know that Mario’s income elasticity of demand for both hot dogs and
subway tickets is positive. Which of the following statements must be true given the shift
in Mario’s budget line from BL2 to BL1?
a. The price of hot dogs increases and Mario will consume fewer hot dogs.
b. The price of hot dogs increases and Mario will consume fewer hot dogs and fewer
subway tickets.
c. The price of hot dogs decreases and Mario will consume fewer hot dogs.
d. The price of hot dogs increases and Mario will consume more hot dogs.
Use the following information to answer the next three questions.
Marissa currently has $100 in income per month that she spends on CDs and books. The
current price of a book is $4 and the current price of a CD is $2. With this income, the
prices of the two goods and her normal shaped indifference curve map, Marissa chooses
to consume 10 books and 30 CDs each month. The local government decides that they
would like to encourage reading and so the government enacts a book subsidy that
reduces the price of books to $2 while the price of CDs is unaffected. Given these new
prices Marissa chooses to consume 25 books and 25 CDs each month. If Marissa’s
income was adjusted so that she faced the new prices but was constrained to stay on her
original indifference curve she would choose to consume 20 books and 20 CDs a month.
14. What is Marissa’s compensated level of income if her income is adjusted so that she
has the same level of utility that she had initially but with the new subsidized prices?
a. $100
b. $180
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c. $80
d. $140
15. What is the substitution effect with respect to books for Marissa? The substitution
effect is
a. An increase of 10 books
b. An increase of 5 books
c. An increase of 15 books
d. A decrease of 5 books
16. What is the income effect with respect to books for Marissa? The income effect is
a. An increase of 10 books
b. An increase of 5 books
c. An increase of 15 books
d. A decrease of 15 books
Use the following information to answer the next three questions.
You are given the following information about a perfectly competitive constant cost
industry comprised of 60 identical firms. The industry demand curve is given by
D: P = 20 – (1/50)Q
where Q is the market quantity demanded. In addition, you know that a representative
firm in this industry has a total cost function and a marginal cost function that can be
represented by the equations
TC = 25 + 4q + q2
MC = 4 + 2q
where q is the quantity produced by the firm.
17. At the long run equilibrium the total quantity produced in this market is equal to
________ and the equilibrium price is equal to ________.
a. 1500 units; $10
b. 500 units; $10
c. 300 units; $14
d. 750 units; $5
18. Suppose that tastes and preferences for this good increase so that at every price in the
market the quantity demanded by consumers increases by 400 units. Holding everything
else constant, what is the short run equilibrium price and the short run level of production
for the representative firm?
a. $14; 7.5 units
b. $14; 5 units
c. $19; 7.5 units
d. $10; 5 units
19. Given the changes described in question (18) and the initial information, what do you
expect will happen in this market to the price and the number of firms in the long run?
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a. In the long run the equilibrium market price will increase and the number of firms in
the industry will increase.
b. In the long run the equilibrium market price will increase and the number of firms in
the industry will decrease.
c. In the long run the equilibrium market price will decrease and the number of firms in
the industry will increase.
d. In the long run the equilibrium market price will decrease and the number of firms in
the industry will decrease.
Use the graph below to answer the next two questions.
The graph provides information about a firm’s cost curves.
20. This firm’s fixed cost can be represented as
a. The distance from point M to point N.
b. The distance from point G to point M.
c. The area of rectangle AHIB.
d. The area of rectangle CMGO.
21. Which of the above statements about the above figure are true?
I. Marginal cost for this firm is equal to OB when the firm produces G units of
output.
II. Marginal cost for this firm is equal to LF when the firm produces F units of
output.
III. Average fixed cost is constant for this firm.
a. Statements I and II are true.
b. Statements I and III are true.
c. Statements II and III are true.
d. Statements I, II, and III are true.
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Answer the next two questions based upon the following information.
You are given the following information about a monopolist. The monopolist’s demand
curve for its product can be represented as
Q = 500 – 5P
The monopolist’s marginal cost of production is constant and equal to $20 per unit.
22. The monopolist will produce _______ units of the good and earn an economic profit
equal to __________ in the long run.
a. 200 units; $0
b. 200 units; $1200
c. 200 units; $8000
d. 400 units; $0
23. The deadweight loss associated with this monopoly is equal to
a. $300
b. $3000
c. $400
d. $4000
24. Compared to a perfectly competitive industry, a monopoly in the long run
a. Produces a smaller amount of the good and always earns positive economic profit.
b. Produces a smaller amount of the good and may earn a positive or negative economic
profit.
c. Produces a smaller amount of the good and may earn a positive or zero economic
profit.
d. Produces a smaller amount of the good and may earn a positive, negative or zero
economic profit.
25. Consider a constant cost perfectly competitive industry that is in long run
equilibrium. Suppose that the good produced by this industry is a normal good and that
people’s incomes decrease. In the short run this will result in
a. A decrease in the price of the good and the exiting of firms from the industry.
b. The level of production of a representative firm decreasing while the price remains at
its initial level.
c. The total level of output in the industry remaining at its initial level while the price
decreases.
d. Negative economic profits for a representative firm and a lower price to consumers.
Use the information below to answer the next two questions.
Utility, Inc. is a natural monopoly that provides electricity to the city of Gotham. Utility,
Inc. is currently producing 10,000 kilowatts of electricity at an average cost of $0.10 per
kilowatt. Assume the market demand curve for electricity is linear and downward
sloping.
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26. Which of the following statements is true given the above information?
I. If the market for electricity in Gotham is a natural monopoly than this market
can provide electricity at lower cost per unit if there are at least two providers of
electricity that compete with one another.
II. If the market for electricity in Gotham is a natural monopoly than Utility,
Inc.’s average cost per kilowatt has decreased as its level of production has
increased.
III. If the market for electricity in Gotham is a natural monopoly, when Utility,
Inc. produces that quantity where marginal revenue equals marginal cost it will
not be producing the socially optimal amount of the good.
a. Statement I is true.
b. Statement II is true.
c. Statement III is true.
d. Statements II and III are true.
27. Suppose the city of Gotham is debating regulating Utility, Inc. Which of the
following statements is true?
I. If the city of Gotham decides to regulate this firm using average cost regulation
it will result in the firm breaking even and the city getting the socially optimal
amount of electricity.
II. If the city of Gotham decides to regulate this firm using marginal cost
regulation it will result in residents paying the lowest price possible while the firm
will break even.
III. If the city of Gotham decides to regulate this firm using average cost
regulation the city will need to subsidize the firm since the price will be too low
for the firm to break even.
a. Statement I is true.
b. Statement II is true.
c. Statement III is true.
d. None of the above statements are true.
28. Consider a perfectly competitive industry in long run equilibrium. Which of the
following statements is true?
I. The area of total surplus in this industry is at a maximum given the industry
demand and supply curves.
II. Long run equilibrium in perfect competition results in a deadweight loss to
society.
III. In the long run the exit and entry of firms into this perfectly competitive
industry insures that the level of economic profit for firms in this industry is equal
to zero.
a. Statements I, II and III are true.
b. Statements I and II are true.
c. Statements I and III are true.
d. Statements II and III are true.
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III. Problems (Worth 10 points each)
General Instructions: Please place a box around each of your answers so that your
answers are easier for the grader to find. Please work in a logical, orderly fashion.
1) The picture below describes Jim’s preferences and budget sets for his consumption of
brownies and sundaes per month.
a) (3 points) Assume that Jim’s income is $36 per month and that the cost of a brownie is
$4. Write the equations for BL1, BL2, and BL3, using B to represent the number of
brownies purchased per month and S to represent the number of sundaes purchased per
month.
We see that for BL1, if Jim spends all his income on sundaes, then he can get 9 per
month. This means that each sundae costs $36/9 = $4, so the equation for BL1 is given
by 36 = 4B + 4S. Using a similar approach, we find
BL2: 36 = 4B + 8S
BL3: 36 = 4B + 12S
b) (3 points) Find Jim’s marginal rate of substitution between sundaes and brownies at
points A, B, and C.
All of these points are optimal consumption bundles for Jim, so at each point the MRS
between brownies and sundaes is equal to the price ratio, specifically (price of sundaes) /
(price of brownies). Thus we have:
MRS (point A) = 4/4 = 1
MRS (point B) = 8/4 = 2
MRS (point C) = 12/4 = 3
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c) (4 points) Using the above graph, find the equation which describes Jim’s demand
curve for sundaes.
We can find points on Jim’s demand curve for sundaes by using the above graph to see
how many sundaes Jim optimally consumes at each price. From point A, we see that
when the price of sundaes is 4, Jim consumes 6 sundaes. When the price of sundaes is 8,
Jim consumes 4 sundaes, as illustrates by point B. Point C shows that when the price of
sundaes rises to $12, Jim consumes 2 sundaes. Thus, on a graph with P on the vertical
axis and Q on the horizontal axis, Jim’s demand curve runs through the points (6,4),
(4,8), and (2,12). Thus, the slope of the demand curve is given by (8-4)/(4-6) = -2, so the
y-intercept is given by
12 = -2(2) + b, so b = 16.
Thus, Jim’s demand curve for sundaes is given by P = 16 – 2Q.
2) The market for hammers features perfect competition among firms. Furthermore the
market is a constant cost industry. A representative firm has cost curves given by:
TC = 36 + 6q + 4q2
MC = 6 + 8q
where q is the number of hammers made by each firm.
The market demand curve for hammers is given by:
D: P = 180 – 2Q
where Q is the quantity demanded in the market.
a) (2 points) Find the long run equilibrium price of a hammer and the number of hammers
made by each firm in long run equilibrium.
In the long run, firms must make 0 economic profits, so the price must be equal to the
minimum of ATC. Since MC intersects ATC at the minimum of ATC, we can find the
minimum of ATC by finding this intersection. This yields
(36/q) + 6 + 4q = 6 + 8q, so (36/q) = 4q, so 9 = q2, implying q = 3.
Plugging this back into the MC equation gives us
MC = 6 + 8(3) = 30, so the price of a hammer is $30.
b) (2 points) Find the number of firms which exist in this market in the long run.
Since the price is $30, the total quantity demanded in this market can be found from the
demand equation. Thus, 30 = 180 – 2Q, so 2Q = 150, so Q = 75. Since each firm
supplies 3 units, this means that there must be 75/3 = 25 firms in this market in the long
run.
c) (2 points) The government decides to impose a $30 excise tax on consumers for each
hammer purchased. In the long run, will firms enter or exit this market? Justify your
answer.
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In the short run, the tax on consumers will shift demand down and lower the price
consumers are willing to pay for any given quantity of hammers, so firms will make
negative profits in the short run. As a result, firms will exit the market in the long run.
d) (2 points) Find the long run price which consumers will pay for hammers after the
imposition of the tax and the long run price sellers will receive per hammer sold after the
imposition of the tax.
The imposition of an excise tax does not change the cost curves of any of the firms in this
market. In the long run, firms must still make 0 economic profits, and so the price must
still be equal to the minimum of ATC. Since ATC is the same as in part a), the price
received by sellers must still be $30 so that they will make 0 economic profits.
Since the price received by sellers is $30, the entire burden of the tax must be bourn by
consumers. Thus, the price paid by consumers is $60.
e) (2 points) Find the total tax revenue raised by this tax.
Since consumers face a price of $60, we need to find the quantity of hammers demanded
after the imposition of the tax. We do this by plugging P = 60 into the demand curve to
find 60 = 180 – 2Q, so 120 = 2Q, so Q = 60.
Since 60 units are sold under a tax of $30 per unit, the total tax revenue raised is $1800.
3) In Myersville, flu vaccines are sold by a monopolist. The demand curve for flu
vaccines is given by:
D: P = 90 – 2Q.
For the monopolist, every vaccine costs $10 to manufacture. Also, in order to perform
the research and development necessary to create the vaccine each year, the monopolist
must pay $200 in fixed costs each year before beginning to produce the vaccine.
a) (2 points) Find the equilibrium price and quantity sold in this market.
We know that all firms maximize profits by setting MR = MC. For a monopolist, the firm
faces the market demand curve, so MR is given by MR: P = 90 – 4Q. Also, we know that
every vaccine costs $10 to make, so MC = $10. Setting MR = MC yields
90 – 4Q = 10, so 4Q = 80, so Q = 20.
To find the equilibrium price in this market, we plug Q = 20 into the market demand
curve to find
P = 90 – 2(20) = 90 – 40 = $50.
b) (2 points) Find the profit which this monopolist makes each year.
We first find the profit which the monopolist makes from its sales, then subtract off the
fixed research and development costs to get the total profit made per year.
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Profit from sales are the difference between the price per vaccine and the cost of
producing it times the total quantity sold, or ($50 – $10)(20) = ($40)(20) = $800. Since
the research and development costs are $200, this means that the monopolist earns $600
in profit per year.
c) (2 points) Find the level of consumer surplus under the monopoly.
Consumer surplus is the area under the demand curve and above the price paid by
consumers. Since the y-intercept of the demand curve is 90, we find the area of the
triangle as CS = (1/2)(90 – 50)(20) = (20)(20) = $400.
d) (2 points) Find the quantity of flu vaccines which would result in no deadweight loss
in this market.
We know that if the vaccines were supplied by perfectly competitive firms instead of a
monopolist, there would be no deadweight loss. To find the quantity which perfectly
competitive firms would produce, we simply find the intersection of MC and the demand
curve. Since MC = 10, we plug in P = 10 into the demand curve to find
10 = 90 – 2Q, so 2Q = 80, so Q = 40.
So if 40 vaccines are made, there will be no deadweight loss in this market.
e) (2 points) Consumers do not like the fact that deadweight loss is imposed on the
Myersville economy when the flu vaccines are produced by a monopolist. The CEO of
the monopolist firm replies that he would be happy to produce the efficient quantity of flu
vaccines and sell it at the corresponding market equilibrium price if only consumers (as a
group) would be willing to give his firm a payment of $1000. Will consumers be willing
to pay this price to get the higher level of production? Why or why not?
(Hint: think about your work in parts c and d.)
If consumers are going to give the monopolist a bribe to produce the efficient quantity,
then we can think of this payment as coming out of their consumer surplus. So we need
to determine whether the CS under the efficient equilibrium is large enough that
consumers can pay the $1000 bribe and still have more CS than they do under the
monopoly.
From part c), we know that under the monopoly, CS = $400.
Under the efficient equilibrium that we found in part d), we know that P = 10, Q = 80. At
this equilibrium, CS = (1/2)(90 – 10)(80) = (40)(80) = $3200.
So even if consumers pay the $1000 bribe, they still have $3200 - $1000 = $2200 worth
of CS, which is far more than the $400 they have under the monopoly. So consumers
would be very happy to pay this price to receive the higher level of production.
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