Econ 98 (CHIU) Midterm 1 Review: Part A Fall 2004

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1 Disclaimer: The review may help you prepare for the exam. The review is not comprehensive and the selected topics may not be representative of the exam. In fact, we do not know what will be on the exam. We try to make our answers complete, but we cannot guarantee their correctness. Use at your own risk and use good judgment. William Chiu s Selected Topics 1. The beauty of Supply and Demand 2. Different flavors of elasticity 3. Perfect Competition without taxes 4. Perfect Competition with taxes William s Chiu s Quick Notes Intro to Basic Economic Ideas and Assumptions People are rational consistent decision-making Scarcity trade-offs Cost-Benefit Analysis (MB MC) Opportunity Cost Economics surplus = benefits minus costs Ignore sunk costs Demand and Supply Downward-sloping Demand Upward-sloping Supply Assumes that the curves reflect all benefits and costs (no externalities) Market equilibrium (Q d =Q s ; P d =P s ; Demand=Supply) Market adjustment mechanisms Excess and shortage Movements along the curves Shifts of the curves Substitutes/Complements; Income; Population; Social Norms Normal and Inferior goods Input prices; Technology; Weather/Natural disaster Page 1 of 7

2 Firm Supply & Perfect Competition Market supply is the horizontal summation of each firm s marginal cost curves that is above the minimum of the AVC Producer Surplus Assumptions for perfect competition: (1) many buyers and sellers (2) homogeneity (3) perfect information (4) free entry-and-exit Total Cost, fixed cost, variable cost, average total cost, average variable cost, marginal cost Profit-maximizing firms (MC=MR) Social Optimum (P=MC) Short-run profits and losses Long-run zero economic profits Efficiency and Exchange/Invisible Hand Accounting versus Economic profits Price floors Price ceilings Deadweight loss Farm Subsidies Page 2 of 7

3 THE BEAUTY OF SUPPLY AND DEMAND 1. True, false, or uncertain. An increase in demand always increases the market equilibrium price and quantity. 2. True, false, or uncertain. A per-unit tax in a perfectly competitive market with no externalities always causes a deadweight loss. 3. The following market for water bottles is initially in equilibrium at $4. What if the price of water bottles was $6? Will there be excess demand (shortage) or excess supply (surplus) in the long-run? Explain. P 10 S D 20 Q Page 3 of 7

4 4. The government imposes a price-ceiling at $6. How many water bottles are being produced and how many are being sold? Is there a dead weight loss? 5. The government flip-flops and imposes a price-floor at $6. How many water bottles are being produced and how many are being sold? Is there a dead weight loss? Page 4 of 7

5 DIFFERENT FLAVORS OF ELASTICITY 1. True, false, or uncertain. If the percentage change in the price of good X exceeds the percentage change in the quantity supplied of good Y, then the price elasticity of supply is considered elastic. 2. True, false, or uncertain. If a positive percentage change in income causes a positive percentage change in the quantity demand of good X, then good X is considered an inferior good. 3. The cross price elasticity between good X and good Y is positive. The price of good X increases. Show graphically what happens to the market for good Y. Label P1 and Q1 as your initial market equilibrium. Label P2 and Q2 as your new market equilibrium. Page 5 of 7

6 PERFECT COMPETITION WITHOUT TAXES 1. True, false, or uncertain. If MC intersects ATC at ATC s minimum, then MC does not necessarily intersect AVC at AVC s minimum. 2. There are 500 firms in the perfectly competitive market for rice. Each firm produces q 1 at the market equilibrium price P 1. The market equilibrium quantity is Q 1. The market is currently in long run equilibrium. Draw and clearly label the rice market and a representative firm s graphs. Please include in your graphs: market demand (D 1 ), market supply curve (S 1 ), firm s demand curve (d 1 ), marginal revenue curve (MR 1 ), marginal cost curve (MC 1 ), and average total cost curve (ATC 1 ). There should only be two graphs: market and firm. 3. A new Berkeley study shows that eating servings of rice per day increases your life span. Show graphically what happens to the short-run price (P2), market quantity (Q2), and firm quantity (q2). Is the firm making a profit in the short run? Assume that there is no entryor-exit in the short-run. 4. Fast forward to the long-run. Is the firm making a profit in the long run? How many firms are in the rice market in the long-run? Label the long-run price (P3), market quantity (Q3), and firm quantity (q3). Page 6 of 7

7 PERFECT COMPETITION WITH TAXES 1. There are 500 firms in the perfectly competitive market for rice. Each firm produces q 1 at the market equilibrium price P 1. The market equilibrium quantity is Q 1. The market is currently in long run equilibrium. Draw and clearly label the rice market and a representative firm s graphs. Please include in your graphs: market demand (D 1 ), market supply curve (S 1 ), firm s demand curve (d 1 ), marginal revenue curve (MR 1 ), marginal cost curve (MC 1 ), and average total cost curve (ATC 1 ). There should only be two graphs: market and firm. 2. The government places a lump-sum tax on all rice producers. How does the lump-sum tax affect the firm s marginal cost and average cost curves. A lump sum tax is a one time tax that the firm must pay regardless of the amount of output it sells or produces. Show graphically what happens to the short-run price (P2), market quantity (Q2), and firm quantity (q2). Is the firm making a profit in the short run? Assume that there is no entry-or-exit in the short-run. 3. Fast forward to the long-run. Is the firm making a profit in the long run? How many firms are in the rice market in the long-run? Label the long-run price (P3), market quantity (Q3), and firm quantity (q3). 4. Show the dead weight loss in the market in the long-run after the tax. Page 7 of 7