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Unformatted text preview: © Prep101 http://www.prep101.com/freestuff ECONOMICS 100 (Carr)
Practice Term Test 2 Answer the following questions TRUE, FALSE or UNCERTAIN. Give a brief
explanation of your answer. Marks will be given entirely for your explanation. All
questions are worth an equal share of the total mark.
1. If we know that a particular good’s income and substitution effect move in the same
direction, we know it is a Giffen good and that its demand curve is upward sloping.
• If the income and substitution effects move in the same direction, the item
would be a normal good
• A normal good has a downward sloping demand curve, which illustrates
decreasing quantity demanded as price increases
• A Giffen good is a special case of an inferior good
o It’s income and substitution effects move in opposite directions
o It’s income effect is larger than its substitution effect
A good is a Giffen good when quantity demanded increases as price of the
good increases. So, A Giffen good’s demand curve is upward sloping. Giffen
goods mostly exist in theory and there are no generally agreed upon
“examples” to give.
An inferior non-Giffen good endures income and substitution effects that also
move in opposite directions
o The income effect is NOT larger than the substitution effect
The demand curve for a non-Giffen good is downward sloping Page 1 of 5 © Prep101 http://www.prep101.com/freestuff 2. A firm in a perfectly competitive industry will inevitably enjoy economic profits in
long run equilibrium; otherwise there would be no incentive to stay in business.
Firms’ incentive to stay in business is accounting profits, which equals the
difference between accounting revenues and costs. Economic profits, in addition
to the explicit costs, factor implicit costs into the cost consideration. So when one
earns 0 economic profits, they are enjoying normal accounting profits.
If economic profits are being made in the short run, then new firms will enter the
market to enjoy these profits. As they join supply will increase and prices will
fall until economic profits are zero. At this point (of 0 economic profits) the
industry is in long run equilibrium. Graphically this occurs where ATC, MC and
market price intersect (at P1, Q1). Therefore, firms in a perfectly competitive
industry, in long run equilibrium enjoy zero economic profits. Page 2 of 5 © Prep101 http://www.prep101.com/freestuff 3. A monopoly is bad for the economy because of the excess economics profits earned by
that monopoly. If the government imposes a tax that took these profits away from the
monopoly, there would be no cost/burden on society as a result of the monopoly.
Assume that governments hold all tax revenues.
The burden bestowed by monopolies (on society) can be categorized into 2 parts:
• Income distortion – monopolists make economic profits at the expense of
• Allocative distortion/inefficiency (market price is above marginal costs) –
if the entire economy was controlled by a single benevolent planner s/he
would spend the profits (earned by the monopoly) on some other good(s), to
optimally share these gains. Because these profits are not shared in a
monopoly regime, there is a sub-optimal allocation of resources, thus
A government tax on profits would shift the ATC and MC curves upwards (the
monopoly would now incur the new tax cost on top of its old costs). This could be
done to the point that the monopoly earns no economic profits, thus overcoming the
income distortion. This would occur where P = ATC.
Note: because the MC curve shifts, so too does the monopoly’s production point
(QM0 QM1). In the face of increased MC (not only this type of tax, any increase
in MC), a monopoly would decrease its output. The tax in this question would
absorb the producer surplus based on this new output level.
Since we assume governments hold all tax revenues, the profits taken away from
the monopoly effectively disappear from the economy. Thus this tax policy does
not overcome the allocative inefficiency cost. Graphically, this occurs where price
MC1 P MC0
surplus AC0 PM
PPC Producer surplus
= tax revenue DWL D
QM1 QM0 Q QPC Page 3 of 5 MR © Prep101 http://www.prep101.com/freestuff 4. Airfare during the workweek is typically more expensive than over the weekend. This
pricing strategy demonstrates a social concern for non-business travelers with less
(Suppose that business travelers fly out and back within a workweek, and non-business
travelers travel for just the weekend.) FALSE
Airlines charge different prices to optimally exploit customers’ price elasticity.
This is an example of price discrimination.
Business travelers must travel to meet their business engagements. Consequently,
their demand for flights is relatively inelastic (insensitive to price changes).
Meaning they are more likely to bear higher flight costs.
Non-business travelers, or individuals traveling for pleasure, are relatively more
sensitive to price changes. That is, they have relatively elastic demands for flights.
Consequently, many “pleasure-travelers” would forego a weekend flight if faced
with higher workweek flight prices. And so, airlines offer a “discounted” price to
non-business consumers, not out of benevolence, but to maximize the
revenues/profits offered by this class of consumer. MCB = MCC = MR. Page 4 of 5 © Prep101 http://www.prep101.com/freestuff 5. Total costs are made up of fixed costs (i.e. plant and equipment, capital) and variable
costs (i.e. labour). If the price of a variable input increases, producers will increase
their production in the short-run to cover the additional costs.
Firms strive to maximize their profits, which occurs where MR = MC. An increase
in variable costs increases marginal cost (in the diagram: MCo MC1). From the
diagram below, we can see that honoring the MR = MC condition results in a
decrease in production – a move from qo to q1. . Page 5 of 5 ...
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This note was uploaded on 09/18/2010 for the course ECON 100 taught by Professor Carr during the Spring '10 term at University of Toronto- Toronto.
- Spring '10