1
Summer Economics 2007
University of California, Berkeley
Midterm Exam #2
August 6, 2007
10:10-11:00 AM
Midterm #2
Please do not open the exam until you are told to do so. EXPLAIN each
one of your answers. A correct but unexplained answer will not receive
full credit.
Your Name___Suggested Solutions_______
Your SID____________________________
Your GSIs Name_____________________
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Economics 1
Summer 2007
University of California, Berkeley
Midterm Exam #2
August 6, 2007
10:10-11:00 AM
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Economics 1
Summer 2007
University of California, Berkeley
1.
Midterm Exam #2
August 6, 2007
10:10-11:00 AM
(10 Points) The supply and demand curves for cigarettes are shown below. In an effort to
reduce smoking, the government imposes a tax on stores that sell cigarettes.
S+T
P
S
Incidence on consumer
T
Incidence on producer
D
Q2 Q1
Q
a. (5 Points) Show the incidence of the tax on producers and consumers. Who pays the
majority of the tax? No Explanation necessary.
The consumers pay the majority of the tax.
b. (5 Points) Is the tax an effective way for the government to reduce smoking? Why or
why not?
The tax is NOT an effective way of reducing smoking. The quantity consumed is not
reduced by much (Q1 to Q2). The demand for cigarettes is highly inelastic, which
means that large changes in price (or a large tax) do not effect the quantity consumed
by much. In order to reduce the quantity of cigarettes consumed, the demand curve
would have to change. This advocates demand-side policies on the part of the
government (education programs, etc.)
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Economics 1
Summer 2007
University of California, Berkeley
Midterm Exam #2
August 6, 2007
10:10-11:00 AM
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Page 4 of 15
Economics 1
Summer 2007
University of California, Berkeley
Midterm Exam #2
August 6, 2007
10:10-11:00 AM
2. (6 Points) Two firms, a Huge Firm and a Tiny Firm, are the only producers of Frisbees in
Elkton, Maryland. They each choose which price to charge, a low price (L)or a high price
(H). Their profits for each combination of prices is shown in the matrix below.
Tiny Firm
L
Huge Firm
L
H
H
Huge Firm's Profit=50
Tiny Firm's Profit= 10
Huge Firm's Profit=200
Tiny Firm's Profit=15
Huge Firm's Profit=60
Tiny Firm's Profit= 5
Huge Firm's Profit=210
Tiny Firm's Profit=20
Does the Huge Firm have a dominant strategy? What is it? How about the Tiny Firm?
No explanation necessary.
The Huge
Firms dominant strategy is to charge a high price.
The Tiny Firm has no dominant strategy.
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Economics 1
Summer 2007
University of California, Berkeley
Midterm Exam #2
August 6, 2007
10:10-11:00 AM
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Page 6 of 15
Economics 1
Summer 2007
University of California, Berkeley
Midterm Exam #2
August 6, 2007
10:10-11:00 AM
3. (15 points) Show the effects of the following on the money market. Be sure to show the
change in the interest rate. No explanation necessary.
a. (5 points) The fed lowers the required reserve ratio.
MS
r
r1
r2
MS2
MD
M
b. (5 points) GDP increases
MS
r
r2
r1
MD
M
c. (5 points) The Fed sells T-Bills on the open market.
MS
r
r2
r1
MD
M
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Economics 1
Summer 2007
University of California, Berkeley
Midterm Exam #2
August 6, 2007
10:10-11:00 AM
This page is blank.
Page 8 of 15
Economics 1
Summer 2007
University of California, Berkeley
Midterm Exam #2
August 6, 2007
10:10-11:00 AM
4. (10 Points) Mr. Bellman is a monopolistic producer of Running Shoes in Newark, Delaware.
His cost curves and the demand curve that he faces are shown below.
P
MSC
MC
ATC
PM
MDC
MR
QM=QSO
D
Q
a. (4 Points)Show Mr. Bellmans profit-maximizing quantity, QM and price, PM.
b. (6 Points)Research shows that there is a negative externality that accompanies the
production of Mr. Bellmans running shoes. Coincidentally, the profit-maximizing
quantity happens to be the same as the socially-optimal quantity (QM=QSO). Draw the
marginal damage cost (MDC) and marginal social cost (MSC) curves.
5. (7 Points) Argue that the usage of highways is excludable and non-rival.
EXCLUDABLE: Toll booths can be put on highways, which keep non-payers out.
NON-RIVAL: Many commuters can use a highway without affecting the commute of
the others using the highway.
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Economics 1
Summer 2007
University of California, Berkeley
Midterm Exam #2
August 6, 2007
10:10-11:00 page AM
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Economics 1
Summer 2007
University of California, Berkeley
Midterm Exam #2
August 6, 2007
10:10-11:00 AM
6. True/False, Explain (20 points, 5 points each): Decide whether the following statements
are true or false, and explain your answers. Correct but unexplained answers will receive
very little credit. You may draw a graph if it aids in your explanation.
a. (5 Points) The consumer price index (CPI) somewhat over-states changes in the cost
of living.
True. The CPI uses a fixed-weight procedure to compute inflation. By fixing a basket
of consumer goods and services one month and calculating the price of the same
basket the next month, the CPI implicitly assumes that consumers do not substitute
towards now relatively cheaper goods, which mitigates increases in the cost of living.
b. (5 Points) Monopolistically competitive firms can earn positive economic profits in
the long run.
False. Free entry allows others to enter the industry, shifting the firms demand curve
to the left until they can earn no more than zero profit.
c. (5 Points) Because there are no barriers to entry in monopolistically competitive
industries, firms are forced to produce at the minimum of their average total cost
curves in the long run.
False. MC firms earn zero profit in the long run. MC firms face downward-sloping
demand curves. Therefore, MC firms produce in the downward-sloping portion of
their cost curves. Therefore, MC firms do NOT produce at the minimum of their ATC
curves.
d. (5 Points) Due to the discouraged-worker effect, the unemployment rate during
recessionary periods can be artificially high.
False. Discouraged workers want to work but are not counted as part of the labor
force. This makes the number of those counted in the labor force artificially low and
the unemployment rate artificially low.
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Economics 1
Summer 2007
University of California, Berkeley
Midterm Exam #2
August 6, 2007
10:10-11:00 AM
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Page 12 of 15
Economics 1
Summer 2007
University of California, Berkeley
Midterm Exam #2
August 6, 2007
10:10-11:00 AM
7. (10 points) The city of San Francisco is considering building a new park in the North of
Panhandle neighborhood. The cost of the proposed park is $100. There are 5 people who will
be affected by the construction of the park. The table below shows eachs willingness to pay
for the park. Will a popular vote to evenly split the cost among the 5 citizens result in the
efficient decision? Explain.
Name
Luda
Trae
Lauren
Brittany
Katherine
Willingness to Pay
50
10
30
15
15
No. The cost will be $20/person. Therefore, Luda and Lauren will vote yes, and Trae,
Brittany and Katherine will vote no, and the resolution will not pass. However, the
efficient outcome would be for the park to be built.
(WTP=50+10+30+15+15=120>100=cost).
8. (5 Points) Bulgarias government increased spending by $50 billion dollars. As a result,
equilibrium output rose by $150 billion dollars. What is the marginal propensity to consume
in Bulgaria? Show or explain how you got your answer.
Y = multiplier G =
1
G
1 mpc
1
50b
1 mpc
1
3=
1 mpc
2
mpc =
3
150b =
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Economics 1
Summer 2007
University of California, Berkeley
Midterm Exam #2
August 6, 2007
10:10-11:00 AM
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Page 14 of 15
Economics 1
Summer 2007
University of California, Berkeley
Midterm Exam #2
August 6, 2007
10:10-11:00 AM
9. (17 Points) The equations below characterize the economy of Uzbekistan. Assume that
interest rates and prices are fixed.
AE = C + I + G
C = 100 +
3
(Y T )
4
I = 50
G = 300
T = 200
a. (3 Points) What is Uzbekistans marginal propensity to consume (MPC)? No explanation
necessary.
3/4
b. (7 Points) Calculate Uzbekistans equilibrium level of output (Yeq) and consumption (Ceq).
Y eq = C + I + G
3
Y eq = 100 + (Y EQ 200) + 50 + 300
4
eq
Y
= 100 150 + 50 + 300 = 300
4
Y EQ = 1200
C eq = Y eq I G = 1200 50 300 = 850
c. (7 Points) Now, rather than setting the total amount of net taxes directly, Uzbekistan sets net
taxes as a fraction of income. Specifically, net taxes are 1/3 of aggregate income, or T=Y/3.
Find the new equilibrium level of output, Yeq. (all other variables remain as above).
Y
eq
Y eq
3
Y EQ
EQ
= 100 + (Y
) + 50 + 300
4
3
3 2Y EQ
Y EQ
= 450 +
= 450 +
4
3
2
Y EQ
= 450
2
Y eq = 900
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