# Exam 1 Version A A = 4; A- = 3.7; B+ = 3.3; B = 3.0; B- = 2.7; C+ = 2.3; C = 2.0; C- = 1.7; D+ = 1.3; D = 1.0; F = 0

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2 Question 1. Consider the following price and consumption information for the typical Vietnamese consumer to determine which year is preferred: Answer to Question 1: Which year is preferred? Price of Computers 4 8 Price of Food 2 4 Price of Movies 1 2 Consumption of Computers 1 2 Consumption of Food 2 2 Consumption of Movies 8 1

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4 Question 2: Measure the value to you and your spouse of having kids by the amount you would be willing to pay each year to raise them. And suppose the cost or raising kids is \$1,500 per kid. Would it be efficient if the government offered a child tax credit of \$1,000 per kid? Value of Kids Per year Value of Kid #1 \$5,000 Value of Kid #2 \$4,000 Value of Kid #3 \$2,000 Value of Kid #4 \$1,000 Answer to Question 2:

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6 Question 3. Consider the following linear production possibilities from Tom, Jeffery, and Hank. To be useful, an ad must be both composed and televised. Ads Composed Ads Televised Tom 2 composed 2 televised Jeffery 1 composed 2 televised Hank 3 composed 4 televised A) How many ads can be completed if Tom, Jeffery, and Hank work separately? That is, each composes and televises his own ads. (As usual, fractions are allowed.) B) Show how the market can organize production efficiently. Specifically, suppose the market price per unit for televising ads is \$100. Find the price P C per unit for composing ads so that, when the output of completed ads is maximized, then Tom, Jeffery and Hank are each choosing the work that maximizes their income. Answer to Question 3:

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8 Question 4. According to the New York Times (November 18, 2006), the number of car producers in China is increasing rapidly. The newspaper reports that China has more car brands now than the United States.... But while car sales have climbed 38 percent in the first three quarters of this year, automakers have increased their output even faster, causing fierce competition and a slow erosion in prices. At the same time, Chinese consumers incomes have risen. Assume that cars are a normal good. Use a diagram of the supply and demand curves for cars in China to explain what has happened in the Chinese car market. Answer to Question 4:

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10 Question 5: Consider the following demand curves for a Good X by women Abby, Betty, Carla and by men Doug, Ernest, Frank: Potential buyers of Good X Willingness to pay Abby \$7 Doug \$6 Betty \$5 Ernest \$4 Carla \$2 Frank \$1 And consider supply curves for the same Good X by women Gail, Heidi, Ingrid and by men Jim, Kyle, Leo: Potential sellers of Good X Cost to sell Gail \$1 Jim \$2 Heidi \$3 Kyle \$4 Ingrid \$5 Leo \$6 a. Compute the competitive equilibrium price and quantity. Compute consumer surplus and producer surplus. b. By considering Good X to be education at Pepperdine University, show the consumer surplus losses from affirmative action programs designed to help women. Specifically, suppose affirmative action programs cause Pepperdine University to accept Carla and reject Doug. c. By considering Good X to be teachers hired by the state of California, show the producer surplus losses if affirmative action causes California to hire Ingrid and reject Jim. d. By considering Good X to be patients accepted treated by Kaiser Permanente, show the lost total surplus if a US program of Universal Health Care forces Leo to treat Carla. Answer to Question 5:

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12 Question 6: Consider the following demand curves for labor by Abby, Betty, Carla, Doug, Ernest, Frank: Potential buyers of labor Willingness to pay Abby \$12 Betty \$10 Carla \$9 Doug \$8 Ernest \$5 Frank \$2 And consider supply curves for labor by Gail, Heidi, Ingrid, Jim, Kyle, and Leo: Potential sellers of labor Cost to sell Gail \$2 Heidi \$4 Ingrid \$6 Jim \$8 Kyle \$10 Leo \$12 a. Compute the competitive equilibrium wage and employment. Compute consumer surplus and producer surplus (that is worker surplus). Now consider a minimum wage of \$11 designed to help workers. b. Show the lost producer surplus from the inefficient allocation of employment. Specifically, suppose Kyle successfully competes to sell labor instead of Heidi. c. Show the lost total surplus as minimum wages reduce employment. d. Show the wasted resources from potential workers competing for employment. Specifically, suppose potential workers compete for jobs by waiting in line. Answer to Question 6:

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14 Question 7. Draw a linear demand curve where the range of prices for which demand is elastic and inelastic is labeled. In each of the following scenarios, the supply curve shifts. Show along which portion of the demand curve (that is, the elastic or the inelastic portion) the supply curve must have shifted in order to generate the event described. In each case, show on the diagram the quantity effect and the price effect. a. Recent attempts by the Colombian army to stop the flow of illegal drugs into the United States have actually benefited drug dealers. b. New construction increased the number of seats in the football stadium and resulted in greater total revenue from box-office ticket sales. c. A fall in input prices has led to higher output of Porsches. But total revenue for the Porsche Company has declined as a result. Answer to Question 7:

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16 Question 8. In 1990, the United States began to levy a tax on sales of luxury cars. For simplicity, assume that the tax was an excise tax of \$6,000 per car. The accompanying figure shows hypothetical demand and supply curves for luxury cars. a. Under the tax, what is the price paid by consumers? What is the price received by producers? What is the government tax revenue from the excise tax? Over time, the tax on luxury automobiles was slowly phased out (and completely eliminated in 2002). Suppose that the excise tax falls from \$6,000 per car to \$4,500 per car. b. After the reduction in the excise tax from \$6,000 to \$4,500 per car, what is the price paid by consumers? What is the price received by producers? What is tax revenue now? c. Compare the tax revenue created by the taxes in parts a and b. What accounts for the change in tax revenue from the reduction in the excise tax? Answer to Question 8:

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21 composing and televising, spending the fraction c composing and the fraction 1 c televising and, thereby, composing 3c and televising 4(1 c). You need not compute that fraction c to answer the question. When the output of completed ads is maximized, Hank spends part of his day composing and part of his day televising, so his daily income must equal from the two jobs, 3P C = 400, or P C = 400/3 = And Tom specializes in composing, so at P C = his daily incomes from composing must higher than from televising, > 200. And Jeffery specializes in televising, so at P C = his daily incomes from composing must lower than from televising, < 200. So, at the price P C = per unit for composing ads, when the output of completed ads is maximized, then Tom, Jeffery and Hank are each choosing the work that maximizes their income. Answer to Question 4: As Chinese consumers incomes rise, the demand curve for cars shifts to the right, from D 1 to D 2, because cars are a normal good. If this were the only shift, then price would rise. But there is a report of a slow erosion in prices (prices fall). So there must be another shift. As more automakers enter the Chinese market, the supply curve shifts to the right, from S 1 to S 2. As a result, the equilibrium moves from its initial position at E 1 to the new equilibrium at E 2, and the quantity of cars bought and sold increases from Q 1 to Q 2. This accounts for the 38 percent increase in sales. Since the newspaper reports a slow erosion in prices, from P 1 to P 2, the rightward shift of the supply curve must have been greater than the rightward shift of the demand curve.

22 Answer to Question 5: a. At price \$4, Abby, Doug, Betty and Ernest buy from Gail, Jim, Heidi, and Kyle. In particular, competitive equilibrium price is \$4 and quantity is 4 (or 3 in case Ernest does not buy and Kyle does not sell). Consumer surplus from Abby, Doug and Betty is the difference between their willingness to pay and \$4, which is \$3 = \$7-\$4, \$2 = \$6-\$4, and \$1 = \$5-\$4, making aggregate consumer surplus \$6 = \$3+\$2+\$1. Producer surplus from Gail, Jim and Heidi is the difference between their \$4 and their cost to sell, which is \$3 = \$4-\$1, \$2 = \$4-\$2, and \$1 = \$4-\$3, making aggregate producer surplus \$6 = \$3+\$2+\$1. (There is a technical simplification we make to work with integers when we assume someone will buy or someone will sell even when they get surplus 0. Make the same simplification on your homework and exams.) b. By considering Good X to be education at Pepperdine University, show the consumer surplus losses from affirmative action programs designed to help women. Specifically, suppose affirmative action programs cause Pepperdine University to accept Carla and reject Doug. Carla values the good at \$2 and Doug at \$6, so there is \$4 lost consumer surplus from Carla consuming rather than Doug. c. By considering Good X to be teachers hired by the state of California, show the producer surplus losses if affirmative action causes California to hire Ingrid and reject Jim. Ingrid s cost to sell is \$5 and Jim s is \$2, so there is \$3 lost producer surplus from Ingrid selling rather than Jim. d. By considering Good X to be patients accepted treated by Kaiser Permanente, show the lost total surplus if Universal Health Care forces Leo to treat Carla. Carla values the good at \$2 and Leo s cost to sell is \$6, so there is \$4 lost total surplus from Leo treating Carla. Answer to Question 6: a. At price \$8, Abby, Betty, Carla, and Doug buy labor from Gail, Heidi, Ingrid, and Jim. In particular, competitive equilibrium wage is \$8 and employment is 4. Consumer surplus from Abby, Betty, Carla, and Doug is the difference between their willingness to pay and \$8, which

23 is \$4 = \$12-\$8, \$2 = \$10-\$8, \$1 = \$9-\$8, and \$0 = \$8-\$8, making aggregate consumer surplus \$7 = \$4+\$2+\$1+\$0. Producer surplus from Gail, Heidi, Ingrid, Jim, and Kyle is the difference between \$8 and their cost to sell, which is \$6 = \$8-\$2, \$4 = \$8-\$4, \$2 = \$8-\$6, and \$0 = \$8-\$8, making aggregate producer surplus \$12 = \$6+\$4+\$2+\$0. (There is a technical simplification we make to work with integers when we assume someone will buy or someone will sell even when they get surplus 0. Make the same simplification on your homework and exams.) Now consider a minimum wage of \$11 designed to help workers. b. Show the lost producer surplus from the inefficient allocation of employment. Specifically, suppose Kyle successfully competes to sell labor instead of Heidi. Kyle s cost to sell is \$10 and Heidi s is \$4, so there is \$6 lost producer surplus from Kyle selling rather than Heidi. c. Show the lost total surplus as minimum wages reduce employment. Betty, Carla, and Doug no longer employ labor and, if only the least cost workers get jobs, Heidi, Ingrid, and Jim are no longer employed. Betty, Carla, and Doug value labor at \$10 and \$9 and \$8 and Heidi s, Ingrid s, and Jim s cost to sell are \$4 and \$6 and \$8, so there is \$9 = (\$10+\$9+\$8)-(\$4+\$6+\$8) lost total surplus from reduced employment. d. Show the wasted resources from potential workers competing for employment. Specifically, suppose potential workers compete for jobs by waiting in line. Since only the first potential worker will be employed, only Gail will work since she has the most to gain from employment. She has to wait in line long enough so that the cost of the line makes unemployment unattractive to Heidi and the rest of the potential sellers of labor. For Heidi to find work unattractive, her net wage must be below her cost of \$4 to sell, so the line must reduce wages from the minimum of \$11 down to just below \$4. That is, \$7 is wasted in line by Heidi as she competes for employment. Answer to Question 7: a. Attempts to stop the flow of drugs into the United States shift the

24 supply curve leftward, raising the price of drugs and reducing the quantity demanded. If this benefits drug dealers, their total revenue must have increased. That is, we must be on the inelastic portion of the demand curve, where a rise in price results in an increase in revenue (the price effect outweighs the quantity effect). In the accompanying diagram, as supply shifts from S 1 to S 2, revenue decreases by area B but increases by area A. b. An increase in the number of seats shifts the supply curve rightward, reducing the price of stadium seats and increasing the quantity demanded. If this increases total revenue, we must be on the elastic portion of the demand curve, where a fall in price results in an increase in total revenue from box-office sales (the quantity effect outweighs the price effect). In the accompanying diagram, as supply shifts from S 1 to S 2, total revenue decreases by area A but increases by area B. (The supply curve is a vertical line because the supply of seats is perfectly inelastic: whatever the price, the supply of seats is just how many seats there are in the stadium.) c. Increasing production shifts the supply curve rightward, lowering the price of Porsches and increasing the quantity demanded. If this reduces total revenue, we must be on the inelastic portion of the demand curve, where a fall in price results in a fall in total revenue (the price effect

25 outweighs the quantity effect). In the accompanying diagram, as supply shifts from S 1 to S 2, total revenue decreases by area A but increases only by area B. Answer to Question 8: a. The price paid by consumers is \$54,000. The price received by producers is \$48,000. The government s tax revenue is \$6,000 per car 40,000 cars = \$240 million. b. The price paid by consumers is now \$53,000. The price received by producers is \$48,500. The government s tax revenue is \$4,500 per car 60,000 cars = \$270 million. c. The government tax revenue rose as a result of the reduction in the excise tax. This occurs because the supply of and the demand for luxury automobiles are both highly elastic: a fall in the price paid by consumers leads to a large increase in the quantity demanded; and a rise in the price received by producers leads to a large increase in the quantity supplied. As a result, reducing the tax leads to a large increase in the quantity of luxury automobiles bought and sold so large, in fact, that the increase in the quantity bought and sold more than makes up for the decrease in the tax per car.

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