Econ 101, Final, Fall ANSWER KEY

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1 Econ 101, Final, Fall ANSWER KEY Prof. Guse, W & L University 1. [ 3 Points ] The bowed-out shape of the Production Possibility Frontier (PPF): (a) reflects the existence of opportunity cost. (b) ANSWER: reflects the existence of increasing marginal opportunity cost. (c) is due to technological inefficiency. (d) reflects economic inefficiency. EXPLANATION. The slope of a PPF is the marginal rate of transformation (MRT) between the two goods. If Guns are on horizontal axis and Butter in pounds is on the vertical, then the slope of the PPF at some point is the number of poinds of butter production which must be forgone to make more guns from that point on the PPF. Bowed out means that this slope gets steeper along the PPF as we move toward production possibilities involving more Guns and less Butter. In other words, the opportunity cost of making more guns - measured in forgone butter - increases as make more guns. 2. [ 3 Points ] Diminishing marginal product occurs whenever: (a) business is operating inefficiently, resulting in high per-unit costs. (b) business becomes so large that it is unwieldy to manage and productivity declines. (c) diseconomies of scale occur due to increasing marginal costs of production. (d) BEST ANSWER: additional workers add less to output than did the workers who came before. EXPLANATION: (d) is clearly the best answer. It is just a re-wording of Diminishing marginal product (of labor). (c) is not a terrible answer since increasing short run marginal cost and decreasing marginal product are essentially equivalent. However, the reference to scale in (c) screams long run. An argument could be made for (b) in the sence that (b) is 1

2 a suffient condition for the statement to hold. However whenever suggests that we are looking for a necessary and sufficient condition. (a) is a terrible answer. inefficient operation of a business is neither necessary nor sufficient for it to be experiencing diminishing MP of labor. Just the opposite in fact: If a firm is operating where MP of labor is increasing that would indicate inefficiency. 3. [ 3 Points ] A competitive firm with no fixed cost is producing where MR = $4.00 and MC = $2.00. This firm can increase profit by: (a) BEST ANSWER: expanding output. (b) 2nd BEST: reducing output to reduce costs and increase profit. (c) keep doing what it is doing its already making a profit. (d) raise price to increase total revenue. EXPLANATION Expanding output when MR MC means that the additional output will generate more revenue than cost, so profit will certainly increase. However if the firm is making a negative profit, than reducing output all the way to zero would increase profit to zero (long run) so (b) is not a bad answer if explained well. (c) is a terrible answer. The firm should either increase output or reduce it to zero as just explained. (d) is no good since we are told the firm is competetive. It is a price-taker by assumption. 4. [ 3 Points ] Which of the following would not increase the demand (shift the curve to the right) for beer? (a) A new health study concludes that beer cures colds and skin disorders. (b) ANSWER A price war results in beer selling for $.50 per bottle. (c) Bars begin to give away spicy snacks to their customers. (d) The price of a substitute, e.g. wine or malt liquor, rises. EXPLANATION: (b) is the only answer that represents a movement along the own-price demand curve for beer. Every other choice represents a positive shift: (a) positive change in preferences (c) decrease in the price of a complement (d) increase in the price of a substitute. 5. [ 3 Points ] Suppose that the demand for calculators rose even more than the supply had increased. The net effect of the two increases would be the following change in equilibrium price and quantity: (a) an increase in quantity but a slight decrease in price. 2

3 (b) ANSWER increases in both quantity and price. (c) decreases in both quantity and price. (d) an increase in price but a decrease in quantity. EXPLANATION. Increase in Supply is potentially ambiguous given our class discussion. The conventional interpretation here would be a shift in the supply curve down and to the right - meaning a shift representing a larger quantity supplied at every price. However, if one thinks of the supply curve as the marginal cost curve (vertical interpretation), then one might think of an increase as a shift up and to the left - higher marginal cost for each quantity supplied 1. Nevertheless, and increase in demand can ONLY mean shift in the demand curve up and to the right whether one interprets it as an increase in quantity demanded at every price or an increase in marginal willingness to pay at each quantity. Since the statement indicates that the demand shift dominates the supply shift (whatever it is), (b) is clearly the best answer. 6. [ 3 Points ] According to the principle of comparative advantage, (a) countries with a comparative advantage in the production of every good need not specialize. (b) countries should specialize in the production of goods which they enjoy consuming more than other countries. (c) 2nd Best countries should specialize in the production of goods for which they use fewer resources in production than their trading partners. (d) ANSWER countries should specialize in the production of goods for which they have a lower opportunity cost of production than their trading partners. EXPLANATION. (a) can be eliminated since it is mathematically impossible to have a comparative advantage in all goods. (b) is not inconsistent with the right answer under certain circumstances. Namely when transportation and transaction costs are very high, countries should trade less and produce more of what they to consumer (local demand). However, this is clearly not the best answer in the spirit of the principle of comparative advantage. Answers (c) and (d) actually say almost the exactly same thing. If we measure using fewer resources in dollars and lower opportunity cost in dollars and markets are sufficiently competetive, these two things mean exactly the same thing. 1 However, one would probably say an increase in marginal cost in this case. 3

4 7. [ 3 Points ] An increase in demand in a competitive industry leads to: (a) 2nd Best higher prices and profit in the short run only. (b) higher prices and profit in the long run only. (c) ANSWER higher prices and profit as long as demand remains high. (d) no change in either price or profit. EXPLANATION The best answer is (c) if you believe that long run supply curves as we have define them slope up even in competetive markets. So that even thought price increase will be greater in the short run since SR supply is less elastic, there will still be a permanent price increase due to the shift. One must remember here that supply curves - whether LR or SR - describe quantity supplied at every price holding everything else fixed including technology. Therefore a stories about a price going down in the long run after an increase in demand are often motivated by technology changes. Nevertheless one can also defend (a) as a good answer. The special case of perfectly elastic long run supply is often described in textbooks. The story usually going something like... In the long run price increases above above the zero profit point cannot be sustained because new firm will enter the market and drive price back down to the break-even point. This story, however, makes a lot of assumptions well beyond the set of assumptions we would normally describe as perfect competetiion. In particular, it assumes that besides free entry, the technology is easily exploitable to all potential entrants. Hence even there are no barriers to information about the technology, it is still conceivable (and likely) that new entrants will not have the necessary skills to exploit it. This bring up the more general point of true scarcity in factor markets. The supply curve for factors like entrepeneurial skill, land, and natural resources simply cannot be perfectly elastic in the long run. Therefore any growoing industry using these factors will eventually face higher price for them. Hence output prices must increase even in the long run. Furthermore, for firms already in posession of these scarce factors, it will feel an awful lot like higher profits as well. Though technically economists might refer to the profit as rent on the factors. That said, it is only rent if those scarce factors have the same value in other productive enterprises - which they may not. 8. [ 3 Points ] An excise tax (a tax per unit sold) on firms in a given industry: (a) will change the equilibrium price most when product demand is elastic. (b) ANSWER will change the equilibrium quantity least when product demand is in elastic. 4

5 (c) will impose the smallest share of the tax burden on consumers when product demand is inelastic. (d) ANSWER will bring in the greatest revenue for the government when product demand is inelastic. EXPLANATION. (b) and (d) amount to the same thing. Hold supply fixed, the equilibrium quantity will decrease the least the less elastic the demand curve is. For a given excise tax, this would mean greater government revenue. (a) is a little ambiguous. With a more elastic demand curve we expect to see a smaller increase in the buyers price with tax and a larger decrease in thye seller s price net of tax. If you thought the question was refering to the seller s price (a) is defensible. (c) is unambiguously wrong. It states the exact opposite of the principle of inverse elasticity rule of taxation: the less elastic side of the market will experience the greater price change and tax burden. 9. [ 3 Points ] A tax placed upon on polluting firms in a given industry would: (a) lower the price of the product. (b) increase the equilibrium output of the industry. (c) internalize the cost of the detrimental externality created by firms in the industry. (d) move the market away from its economically efficient equilibrium. 10. [ 3 Points ] If the price of a new car is $20,000, then consumers will continue to buy additional cars until the consumer surplus from the last car purchased is: (a) zero. (b) $20,000. (c) maximized. (d) minimized. 5

6 11. [ 15 Points ] WSX Toothpaste Corporation can hire labor for $10 per hour. They make toothpaste using labor and capital. In the short run, capital is fixed at 100. Figure 1 shows WSX s marginal and average product of labor curves for this fixed level of capital. Refer to this figure when answering the questions below. (a) [5] The price of their output, toothpaste, is $2 per tube. How much labor should WSX hire in the short run to maximize profit? (b) [5] What is the shutdown price? (c) [5] Suppose WSX wanted to maximize output instead of profit. How much labor should they hire in the short-run? MP Toothpaste / Hour labor 8 AP Average Product 5 Marginal Product Labor (Hours / day) Figure 1. 6

7 12. (5 Points) Suppose that an acre of land with mature orange trees on it will produce a steady harvest of 100 boxes of oranges per year forever. At current market prices of oranges of $5 per box and interest rate at 5%, what is V m, the value of an acre of mature trees to an orange grower? 13. (10 Points) Suppose the government sets a quota on the output of greenhouse gases. Assuming that the permits are transferable in each case, what is the difference between the government auctioning off the permits and giving them out to selected firms? 7

8 14. [20 points ] Mercury-runoff from gold-mining operations is thought to contribute significantly to merucry levels in the Amazon and it tributaries. This is bad for the local fishing industry as their catch becomes significantly less marketable. Suppose that demand for mercury among gold-miners in the Amazon is given by the following marginal willingness to pay schedule. MWTP = 2000 q while the cost to the fishing industry of mercury in the rivers is given by the following marginal cost function MC = 1 2 q where q is the quantity of mercury measured in flasks and MWTP and MC are both measured in $/per flask. Assume that every flask demanded by gold miners eventually ends up in the river and that gold-mining is the only source of mercury pollution. Assume also that, from the gold-miner s point of view, the supply of mercury is perfectly elastic at $500 / flask. Draw a diagram showing the demand, marginal private cost and marginal social cost of mercury in the Amazon. Indicate the following quantities on your diagram. (Calculations are not required.) (a) Quantity demanded for Mercury without any regulation, Q 0 D (b) The size of an efficient Mercury tax, τ eff (c) Demand for Mercury with the efficient tax, Q 1 D (d) Government revenue from an efficient tax. (e) Savings to the fishing industry from an efficient tax. 8

9 EXTRA SPACE. 9