Unformatted text preview: Final Exam KEY 120 minutes Econ 1101: Principles of Microeconomics Thomas Holmes December 18, 2006 Name: _______________________________________________ TA’s Name: __________________________________________ Section Number: ______________________________________
(TA’s Name and Section Number are worth 4 points, not bonus.) Points are allocated on a 200 point scale. Clearly highlight/circle solutions. If you need more space, use the back of the page. Clearly state where your work/answer are. Calculators are NOT allowed. You may leave answers as fractions. Fully label all graphs. Read each question carefully and be sure to answer all parts of every question. There should be 12 pages including the cover sheet. 1 Question 1 (6 points). State the First Welfare Theorem of Economics
The First Welfare Theorem of Economics states that in the absence of externalities and monopoly, the competitive market will achieve the (Pareto) efficient outcome. Question 2 (10 points). Reservation Prices and Costs in Econland Name of D Person Reservation price Cost to make one Name of for one widget ($) widget ($) S Person D1 9 1 S1 D2 8 2 S2 D3 7 3 S3 D4 6 4 S4 D5 5 5 S5 D6 4 6 S6 D7 3 7 S7 D8 2 8 S8 D9 1 9 S9 D10 0 10 S10 None of the allocations below are Pareto efficient. In each case, propose a Pareto improvment. (a) An allocation where S8 produces a widget but S3 does not.
S3 produces a widget, gives it to S8. S8 gives S3 $5. (Any price between $3 and $8 will work.) (b) An allocation where D1 and D7 consume widgets but D3 and D10 do not.
D7 gives D3 his widget. D3 gives D7 $5. (Any price between $3 and $7 will work.) (D1 still consumes widget. D10 still does not consume.) (c) An allocation where S1 produces a widget and gives it to D1 and no other widgets are produced and consumed.
S2, S3, S4, S5 produce widgets. D2, D3, D4, D5 consume widgets. Each D person gives each S person $5. 2 Question 3 (44 points). This question asks you do determine the impact of various government policies in Econland. The policies are (i) a price floor of $7 with efficient rationing and (ii) a tradeable production quota policy (also called supply management) with a total quota of 3, with S4, S5, S6 each allocated one quota unit each. (a) Complete the table below. (In the case of tradable production quotas PS is the price the seller receives subtracting out whatever the seller has to pay to buy quota. Producer surplus does not include revenues obtained on sales of quota.)
Free Market Q PD PS Consumer Surplus Producer Surplus Gov't Surplus Quota owner surplus Total Surplus 5 5 5 12.5 12.5 0 0 25 (i) $7 price floor (efficient rationing)
3 7 7 4.5 16.5 0 0 21 (ii) Supply Mgmt Quota=3 allocated to S4,S5,S6 quota is tradable
3 7 3 4.5 4.5 0 12 21 (b) On Graph 1 below illustrate CS and PS in case (i), a $7 price floor with efficient rationing. 10 9 8 7 $6 5 4 3 2 1 0
Quantity S D
0 1 2 3 4 5 6 7 8 9 10 Graph 1: CS and PS with $7 price floor 3 (c) Both government policies have lower total surplus than the free market for the same reason. What efficiency condition do they both violate?
Efficient Quantity (Condition 3) (d) For policy (i) above, a $7 price floor, we assumed rationing is efficient. Suppose instead that the rationing was inefficient. Specifically, suppose the high cost producers get the sales. Consumer surplus
9 4.5 would then be ________, producer surplus would be _______, and total surplus would be __________. 4.5 What two efficiency conditions are violated with this allocation?
Efficient Quantity (Condition 3) Efficient Production (Condition 2) (e) For policy (ii) above, tradable production quota, the equilibrium price of quota would be _________. Note that in this allocation, S6 is initially allocated one quota unit. Explain why S6 likes the quota system more than the free market, while S1 prefers the free market to the quota system.
S6: In free market S6 does not produce or sell. S6's welfare = 0. With quota, S6 sells quota for $4; now S6's welfare is $4. S6's welfare increases by $4 with the quota. $4 S1: In free market S1 receives $5 for widget, which costs her $1 to produce. S1's welfare is $4. With quota, S1 gets $7 for selling a widget, but needs to pay $4 for the quota in order to produce. She still incurs $1 cost of production. After quota, S1's welfare is just 7-4-1=$2. S1's welfare is $2 lower after quota, compared to free trade. (f) In the above analysis we have assumed no externalities. Assume for the remaining parts of this question that there is a negative externality of $4 per widget consumed. The socially efficient quantity of
3 widgets is then __________. At this quantity, the social marginal cost of one more unit of output equals 7 _______ and the social marginal benefit equals __________. 7 (g) Suppose for policy (iv), the production quota that are allocated to S4, S5, S6 are not tradeable. Explain why this would reduce total surplus compared to the policy where quota are tradable.
If quota are not tradeable, then S4,S5,S6 will produce widgets. S4,S5,S6 have higher production costs than S1,S2,S3. Thus, total surplus will decrease due to inefficient production. 4 Question 4 (14 points). Let’s put Econland in the the world economy. Suppose the world price of widgets is $2. Suppose Econland is small relative to the world market so that its trade policy has no effect on the world price.
2 (a) Suppose there is a $2 tariff on widgets. Then the quantity of widgets imported is _________. Illustrate and label in graph 2 below (i) the government revenue collected by the tariff and (ii) the loss in total Econland surplus from the tariff compared to no tariff. (b) What are the two reasons total Econland surplus declines with the tariff compared to no tariff?
Inefficient production (producers in Econland with higher production costs than those abroad are now producing due to tariff). Inefficient consumption (fewer consumers can consume good after tariff). (c) Suppose instead of a tariff, there is a quota limiting imports to two units. Illusrate in graph 3 below the total loss in Econland surplus compared to no quota. 10 9 8 7 $6 5 4 3 2 1 0
Quantity S D
0 1 2 3 4 5 6 7 8 9 10 10 9 8 7 $6 5 4 3 2 1 0
Quantity S D
0 1 2 3 4 5 6 7 8 9 10
Graph 3: Econland ΔTS from quota Graph 2: ΔGS and Econland ΔTS from $2 tariff (d) Suppose two countries were identical so there are no differences in comparative advantage. Explain why there still might be gains from trade.
There could still be gains from trade resulting from increasing returns to scale. As countries produce more of one good (specialize in production) they produce more efficiently (at lower average cost). It is then possible for both countries to consume more. 5 Question 5 (20 points). Tom consumes widgets and smigets in fixed proportions, two widgets for every one smiget. His income is $24. The price of widgets is pwidget = $4. The price of smigets is psmiget = $4 (a) In the graph below, draw in Tom’s budget contraint and label it BC1. Put widgets on the horizonal 1 (opp. cost is abs. axis. The opportunity cost of one more widget in terms of smigets is _____________. value slope of BC)
2 (b) Tom’s optimal consumption bundle is Qwidget = _______ and Qsmiget = _________.
A bundle of two widgets, one smidget costs $12. Tom can afford two such bundles. 4 (c) Illustate Tom’s optimal consumption bundle from (b) in the graph and label this point A. Draw Tom’s indifference curve through A. Label it IC1. Draw in a second indifference curve through a point that Tom likes less than point A. Label this IC0. (d) Suppose the price of widgets falls to pwidget = $1, everything else the same. Draw the new budget constraint and label it BC2. Illustrate the new optimal consumption bundle and label it point C.
4 (e) The total effect on the quantity of widgets demanded from the price decrease is ________ widgets. 4 This can be broken down into a substitution effect of 0 widgets plus an income effect of _________ widgets. (f) Let’s see why the substution effect is zero here. Pivot the budget constraint around point A in the appropriate way and illustrate this in the figure. Label it “BC Pivot.” True or False (circle one). Point A remains the optimal point even after we pivot the budget contraint around point A. S m i g e
t s 10 9 8 7 6 5 4 3 2 1 0 IC0 IC1 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 Widgets
For BC Pivot: the first 4 widgets cost $4, a total of $16. Tom has $8 left. After first 4 widgets, widgets cost $1. Tom can buy 8 more widgets at this price. In total Tom can buy 12 widgets. The highest IC that BC Pivot is tangent to is still IC1. There is no change in consumption do to the substitution effect. 6 Question 6 (26 points). A monopolist faces the demand curve illustrated below. (a) Draw in the marginal revenue curve and label it. (b) Why is marginal revenue less than price for a monopolist?
Since a monopolist charges everyone the same price, as it reduces its price, all consumers pay less than they did before so the additional revenue is less than the price. (c) Suppose the marginal cost (MC) and average variable cost (AVC) both equal 2 for all quantity levels, MC = AVC = 2. Draw the MC curve in the figure and label it.
6 8 (d) The profit maximizing monopoly quantity is ______ and price is _______. Label these on your graph.
4 (e) Suppose the fixed cost is 16. At Q = 4, average fixed cost (AFC) is ____, average variable cost (AVC) 6 4 is 2 and average total cost (ATC) is _____. At Q = 8, AFC = _______, AVC = 2, and ATC = ________. 2 1 3 At Q = 16, AFC = ______, AVC = 2, and ATC = _______. Graph ATC below at Q = 4, Q = 8, and Q = 16. Connect the points and label the curve the ATC curve.
16 (f) The monopoly profit is __________________. Illustrate the monopoly profit in the figure below.
(6-4)*8 $ 10
9 D 8 7 6 5 4 ATC 3 MC=AVC 2 1 MR 0 -1 0 1 2 3 4 5 6 7 8 9 1011121314151617181920 -2 Q QMONOP -3
7 PMONOP Profit Question 7 (14 points). $
P2 $ S1 P1 D1 Q1 Q
Q2 P1 D1 Q1
Q2 Q (a) In the graph on the left, shift up demand up and to the right . Label this D2. Label the new equilibrium price and quantity P2 and Q2. Because of the shift in demand: Price: increases / decreases / stays same (circle one) Quantity: increases / decreases / stays same (circle one) (b) One reason demand could shift up and to the right is income increases and the good is normal. What are two other reasons demand could shift up and to the right?
Any two of the following are fine: * Tastes & preferences * More consumers * Price complement good falls * Price substitute good increases (c) Suppose supply shifts to to the right. Suppose demand also shifts and the new equilibrium price increases. Think about how demand must shift in order for this to happen. On the graph on the right, illustrate a right-ward shift in supply to S2 and a shift in demand to D2 such that the new equilibrium price P2 is higher than P1. (d) Relate the analysis in part (c) to what has happened to the skill premium in the past two decades. Specifically, for the market for skilled labor, specify factors that have shifted supply and demand over this period.
Over the past 20 years supply of skilled labor has increased since more people are going to college. Demand for skilled labor has increased due to new technology (capital) that requires skilled labor (capital-skill complementarity). (Due to trade, demand of skilled labor relative to unskilled labor has increased.) Demand has increased more than supply, increasing price of labor (wages). 8 Question 8 (32 points). Cindy works 5 hours a day. She can make 4 apples an hour or 8 oranges an hour. George works 20 hours day. He can make 2 apples a hour and 1 orange an hour. The figures below show the indifference curves for Cindy and George. OR (a) Illustrate Cindy’s and George’s production possibility frontiers (ppf) in the graphs in the next page. (Cindy on the left, George on the right). Label the ppf curves. (b) Circle the correct answer: Who has an absolute advantage in making apples? Cindy or George Who has a comparative advantage in making apples? Cindy or George Cindy can produce more apples an hour than George, Cindy has absolute advantage in making apples. (c) Suppose trade is impossible so each is in autarky. So for each, production equals consumption. Determine the utility maximizing choice for Cindy and label it point A. At this choice Cindy produces and consumes 10 __________ apples and ________ oranges. 20 Cindy's OC of apples is 2 oranges. George's OC of apples is 1/2 an orange. George has a lower OC of producing apples, thus George has comparative advantage in producing apples. Determine the utility maximizing choice for George and label it point X. At this choice George produces and consumes 20 __________ apples and ________ oranges. 10 (d) Suppose trade is costless. Suppose in world markets, the price of one apple in terms of oranges is one orange. Suppose that each individual specializes in production according to his or her comparative advantage. Draw and label the budget constraint of each individual in this case.
0 40 When the price of one apple is one orange, Cindy would produce _______ apples and _________ oranges. Label this point B in the graph. In the world market, she would sell/buy (circle one) _____________ 20
20 apples and she would sell/buy (circle one) _________ oranges. She would consume ________ apples and 20 20 _______ oranges. Label this point C in the graph.
45 40 35 30
45 40 35 30 O r 25 a 20 n g 15 e s 10
5 0 0 5 10 15 20 25 pples 35 A 30 U3 U2 U1 O r 25 a 20 n g 15 e s 10
5 0 U3 U2 U1 40 45 0 5 10 15 20 25 30 35 Apples 40 45 Cindy
9 George Question 9 (30 points). Each widget firm has the cost structure illustrated in the figure on the left below. Two different cases for industry demand are illustrated in the figure on the right. Please use the lines in the graph paper to determine the numbers you need to do the problem. . $10
9 8 7 6 5 4 3 2 1 0 0 1 2 3 4 5 6 7 8
Cost Structure of Firm $ 10
9 8 7 6 ATC 5 4 3 AVC q
9 2 1 0
0 200 400 600 800 1000 1200 1400 1600 1800 2000 2200 2400 D1
Industry Level Variables D2 Cost Structure of Firm Industry Level Variables (a) Draw in the longsupply curve on the rightside graph and label it SLR. Draw in the long-run supply curve on the right-hand side graph and label it SLR run hand (b) Two possibilities for demand are illustrated on the right, a low demand curve D1 and a high demand curve D2. Determine the long-run competitive equilibrium for each case by completing the table below: Demand Variable Definition PLR QLR qLR NLR Long-run Industry Price Long-run Industry Quantity
800 4 D1
4 D2 1800 Long-run output per firm Long-run number of firms 4 4 200 450 10 (d) Fill out the table below. The first column to be completed is the short-run supply for a firm in the industry for 4 different prices. The second column is the short-run industry supply when the number of firms is fixed at N = 200. Price 4 6 8 Firm Supply (Short-Run)
4 Industry Supply (Short-Run with N = 200 firms)
800 6 1200 8 1600 (e) Plot the short-run industry supply when N = 200 firms is fixed in the short run and label it
8 SSR(N=200). Suppose that the demand is given by D2. The short-run equilibrium price is ________. In 24 the short run, the profit of each firm is _____________. (8-5)*8 = 24 (f) Define Marginal Cost (MC).
Marginal Cost is the additional cost of producing an additional unit output. OR (g) Suppose at a particular quantity Q, MC is greater than ATC. What can we say about the ATC curve at that point?
At Q the ATC is increasing. 11 Bonus Points (8 points): 1. As explained by our guest lecturer, Turkey has comparative advantage in the production of which group of goods (circle one entire group): a. wine, cheese, crackers b. cars, boats, bikes c. raisins, hazel nuts, figs d. micro chips, TV's, DVD's 2. LIST TWO SPECIFIC reasons why Turkey has comparative advantage in the production of the goods given above. Reason 1:
Abundant low-wage (low-skilled) labor. Reason 2: Good land (soil) and climate.
OR Geographic location (surrounded by water) (good for transportation). 3. According to the special lecturer, one specific barrier to entry in the Mexican telephone market is: a. The Mexican government only allows one firm in this market b. Telmex controls the necessary infrastructure, the telephone network c. There are none d. Telmex has a patent on necessary technology e. All of the above 12 ...
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This note was uploaded on 02/24/2011 for the course ECON 1101 taught by Professor Someguy during the Fall '07 term at Minnesota.
- Fall '07