test2_solns - Department of Economics University of Toronto...

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Page 1 of 13 Department of Economics Prof. Gustavo Indart University of Toronto July 19, 2007 ECO 100Y INTRODUCTION TO ECONOMICS Midterm Test # 2 LAST NAME FIRST NAME STUDENT NUMBER SECTION (“Morning” or “Evening”): INSTRUCTIONS : 1. The total time for this test is 1 hour and 45 minutes. 2. This exam consists of three parts. 4. Aids allowed: a simple calculator. 5. Write with pen instead of pencil. DO NOT WRITE IN THIS SPACE Part I 1. /6 2. /6 3. /6 4. /6 5. /6 Part II 1. /12 2. /10 2. /8 Part III /20 TOTAL /80 SOLUTION
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PART I (30 marks) Instructions : Indicate your position regarding the following statements and explain your answers in the space provided (if space is not sufficient, continue on the back of the previous page). Each question is worth 6 (six) marks. 1. Statement: Anastasia argues that the cost of a monopoly to society arises because of the excess profits earned by the monopolist. She believes that if the government imposed a lump-sum tax to eliminate these profits, then a monopoly would impose no cost to society. Position: Do you agree with Anastasia’s view? Use a proper diagram to analyze this situation and indicate, with reasons, whether you agree or disagree with Anastasia’s view. No, I don’t agree with Anastasia’s view. Taxing the monopolist profits away eliminates only one of the costs the monopolist imposes on society. The monopolist imposes two costs to society. First, the monopolist generally makes economic profits, which means that it appropriates some of the consumer surplus – thus making consumers worse off. Second, the monopolist does not produce the level of output at which P = MC and thus it doesn’t achieve allocative efficiency – it produces an output below the socially optimum. The latter means that the total surplus – i.e., the summation of the consumer and the producer surpluses – is not being maximized (like in perfect competition). Therefore, the elimination of the monopolist profits through taxation will not eliminate the allocative inefficiency. The monopolist will make zero profits but still produce the same inefficient level of output. The allocative efficient level of output is achieved when the social marginal cost of producing the last unit of output is equal to the social marginal benefit of this last unit and, in the absence of externalities, this is achieved when P = MC. This is shown in the diagram below. Taxing away the profits increases the fixed cost of the monopolist, and thus the AC curve shifts up. However, the MC curve is not affected and thus the monopolist will continue producing the same output as before. That is, the deadweight loss (welfare loss) to society continues as before as shown in the diagram. Deadweight Loss
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test2_solns - Department of Economics University of Toronto...

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