Ford School of Public Policy 555: Microeconomics A Fall 2010 Exam 3 December 13, 2010 Professor Kevin Stange

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1 Ford School of Public Policy 555: Microeconomics A Fall 2010 Exam 3 December 13, 2010 Professor Kevin Stange This exam has 7 questions [ 5 short, 1 medium length, 1 very long] and spans the topics we have covered in the third part of the course. Please explain your answers when asked and show your work. It is in your best interest to show each of your steps clearly in order to receive partial credit and so that you are not penalized in later parts for math mistakes in earlier ones. You have 80 minutes to complete the exam. Each question indicates the points each question is worth you should use this as a guide to the number of minutes you can spend on each question. The points sum to 85, so 5 points are bonus. Good luck! Short Answer [20] 1. [4] Suppose the market for internet service is in a competitive equilibrium at a price of $50/month for a standard plan and a quantity of 100 million users. True or False: All consumers are made better off by a policy that limits the price of internet service to $40/month. Briefly explain your answer. 2. [4] Michigan and Ohio are both considering implementing a business tax credit to build a green tech industry in their respective states. The payoffs to each state (in the matrix below) depend, in part, on whether the other state implements a similar credit. Assume that states decide simultaneously, act rationally, and have perfect information about the payoffs. True or false: As the advisor to Michigan s Governor Snyder, you should recommend that Michigan implement the tax credit. Explain. Ohio Implement Don t Michigan Implement 15, 15 50, 25 Don t 25, 30 40, 40 1

2 3. [4] Medicare is paid for by a 2.9% tax on payroll, half of which is deducted out of workers paychecks and the other half is paid directly by their employers. True or false: If the tax were eliminated, workers and employers would benefit equally. That is, the net wage paid by employers would decrease by the same amount that the wage workers receive would increase. Explain briefly. 4. [4] True or false: Regardless of whether firms in an oligopoly industry compete on price or quantity, if the product they sell is exactly the same, costs the same to produce, and if firms decisions are made simultaneously, equilibrium price will be pushed down to marginal cost. Explain briefly. 5. [4] The graph below plots the demand curve, marginal revenue curve, and marginal cost curve for a profit maximizing monopolist. Fill in the blanks with numbers: a. The firm will charge a price of. b. The firm will produce where marginal cost equals. c. If the firm were behaving competitively, it would set price equal to. d. If a price ceiling of $9 were implemented, the firm would set price equal to. $ per unit MC 8 6 Demand 4 2 MR q 2

3 6. [23] Taxing fake tans Assume that the indoor tanning industry is competitive, with demand function Q D = 140 2P and supply function is Q S = 40+3P. Q is the number of visits to tanning salons (in millions) and P is the price per visit. a. [2] On the graph below, draw the supply and demand curves. Label all intercepts. b. [3] What is the equilibrium price and quantity? Label these P* and Q* on the graph. Remember that quantity is in millions. One little known provision in the Patient Protection and Affordable Care Act of 2010 (also known as Health Reform ) is a tax on indoor tanning salons, which took effect this past summer. The tax aimed to both raise revenue and also to reduce the use of indoor tanning salons, which is believed to cause skin cancer. Assume that the government imposes a $5 tax on each tanning salon visit. c. [4] Find the new price that consumers pay for each tanning salon visit (net of the tax) and the price that salon owners receive for each visit (net of the tax). 3

4 d. [2] How many visits are sold now? (remember that quantity is in millions) e. [3] Show the effect of the tax on the supply and demand graphs you drew in part a. Be sure to label the price received by salon owners (P P ), price paid by consumers (P C ), and new quantity (Q TAX ). f. [2] How much revenue does the government raise? (remember that quantity is in millions) g. [3] Doe the subsidy generate deadweight loss? If so, calculate it and label it on your graph. h. [4] A spokesperson for the International Smart Tan Network (a Michigan based group representing tanning salons) said: The average cost of a tanning visit is going to rise by $5 and this will hurt the small business salon owners. Why is this statement contradictory? [Note: this does not depend on your answers to the above questions] 4

5 7. [42] Colleges Collude Prior to 1991, a large group of elite U.S. colleges met annually to coordinate how much financial aid they were going to provide to students accepted to multiple institutions. The U.S. Department of Justice pursued antitrust litigation against them, accusing the colleges of colluding to charge higher prices (tuition minus aid) to the smartest students. Throughout, assume that colleges act so as to maximize profits (as the Department of Justice assumed). [17] Part 1: Monopoly Pricing First assume that the group of colleges acts as a monopolist in the market for higher education for smart students. The aggregate demand function is given by Q = 100 2P where Q is the number of students attending the colleges and P is the net price. The group s total cost function is given by TC = Q +2Q 2. a. [2] What is the marginal revenue function? b. [1] What is the marginal cost function? c. [4] If the group maximized profits, what price will the colleges charge and how many students will attend? d. [2] What is the monopolist s total profit? 5

6 e. [4] What would price and quantity be if the colleges instead acted to maximize total surplus? (Note: you will need a calculator for this. If you do not have one, fractions are fine). f. [4] Briefly describe at least two policies (other than breaking up the monopoly) that would result in the efficient outcome calculated in part e and no deadweight loss. Be sure to explain briefly why each work. This should require minimal or no calculations. 6

7 [12] Part 2: Price Discrimination The college monopoly determines that there are two types of potential students rich kids and poor kids. The demand function for each is: Q Rich = 55 P Rich Q Poor = 45 P Poor Assume that the monopolist can perfectly distinguish between rich and poor students so is able to charge each group a different price (i.e. practice 3 rd degree price discrimination). g. [4] What price will it charge rich students? How many will attend the elite colleges? h. [4] What price will it charge poor students? How many will attend the elite colleges? i. [4] Explain what information the colleges would need to know about their potential students (and how they would need to use it) in order to turn all consumer surplus into profits. 7

8 [13] Part 3: Oligopoly Now suppose the DOJ succeeded in breaking up the monopoly so that each college now makes pricing decisions independently and simultaneously, but the number of schools is sufficiently small that the market is an oligopoly. Simplify things by assuming there are only two colleges (Yale and Harvard) and that the product offered by each is differentiated. The demand function faced by each is: Q Y = 40 P Y +P H Q H = 40 P H +P Y where Q Y and Q H and P Y and P H are the demand and prices for Yale and Harvard, respectively. Also assume that the cost function for these colleges is the same: TC Y = Q Y TC H = Q H j. [5] What is each college s reaction function? (Yale s profit maximizing price as a function of Harvard s and Harvard s profit maximizing price as a function of Yale s) k. [4] What is the equilibrium price and quantity for each college? l. [4] If the two colleges could collude and set prices to maximize their combined profits, what prices would they set? What would their profits be? Explain this result. 8