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pracmt2f07solutions - Department of Economics Amherst...

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Department of Economics Amherst College Economics 11 Spring 2007 Midterm 2 Answers Each question is worth 10 points. Carefully explain your answers. The exam is 6 pages. 1. The market for T-shirts is perfectly competitive. The diagrams below illustrate the cost curves for a typical firm and the market demand and supply curves. a) Is the market currently in LR equilibrium? At the current equilibrium, each firm produces at q* since that level of production maximizes profits (MR = MC at q*). At q*, each firm is earning zero profits as the price (average revenue) is equal to the ATC at q*. This implies that there is no incentive for entry and exit and the current equilibrium is a LR equilibrium. 1 D MC $/unit P S Q ATC q Panel A: Market Panel B: Typical Firm P cons P 0 P prod q** q* Q** Q* MR MR’
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The government decides to impose a $1 sales tax on each T-shirt sold. b) Illustrate the short-run impact of the tax on the diagrams above. In particular, label the resulting short-run equilibrium market quantity, price paid by consumers and firm quantity. Are economic profits negative following the imposition of the tax? The sales tax drives a wedge between the price that consumers pay for the product (Pcons) versus the price that the producers receive (Pprod). The overall market quantity reduces from Q* to Q**. The price paid by consumers rises from P 0 to Pcons. The price received by producers declines from P 0 to Pprod, the MR (shown as MR’) for firms following the imposition of the tax. Each firm now produces at q** where MC equals MR’. Economic profits are negative at q**, because ATC exceeds Pprod (average revenue). c) Do the consumers and producers share the burden of the tax in the short-run? How about in the long-run? As illustrated on the graph for part (b), in the short-run, the price that consumers pay increases and the price that producers receive decreases. This implies that in the short-run, both consumers and producers share the burden of the tax. In the long-run, however, consumers bear the whole burden of the tax. Negative profits in the short-run lead to an exit of firms which shifts the market supply curve to the left and increases price. This process will bring the price that producers receive (Pprod) back up to P 0 in the new long fun equilibrium. At that price firms earn zero profits. Because the price paid by consumers (Pcons) equals P 0 + $1 in the new long run equilibrium, consumers bear the whole burden of the tax.
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