Midterm Exam Solution Sketch

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1 University of California, Santa Cruz Economics 1 Winter 2002 Professor Kletzer The exam has a total of 63 points. Midterm Exam Solution Sketch Part I. True/False/Uncertain and Explain. 5 points each. (Your explanation will earn most of the points). 1. After a wildly successful marketing (advertising) campaign by the French champagne industry, many champagne executives felt giddy (tremendously excited) about the stratospheric (very high) champagne prices. But they also feared that such sharp price increases would cause demand to decline, which would then cause prices to plunge (drop). These executives need to take a course in introductory microeconomics (your true/false answer should address this last sentence). TRUE. Here s the graph: The advertising campaign shifts the demand curve to the right. Prices rise (to the stratosphere). These high prices will NOT cause demand to decline. Prices will stay high as long as the demand curve remains at D2. The only way prices will start to fall is if new entrants enter on the supply side, shifting the supply curve out to the right (say to S2). 2. Two drivers - George and Jeb - each (separately) drive up to a gas station in New Jersey. Before looking at the price, each places an order. George says, I d like 10 gallons of gas. Jeb says, I d like $10 of gas. George s price elasticity of demand for gasoline is unit elastic and Jeb s price elasticity of demand for gasoline is perfectly inelastic. FALSE. George s elasticity is perfectly inelastic. Without regard to the price, George wants 10 gallons. That s a vertical demand curve. Jeb wants $10 worth of gas, again without regard to price. That s a unit elastic demand, because as price changes, total expenditure (or total revenue to the gas station) remains constant. Here are the demand curves (not needed). 1

2 3. A binding minimum wage raises the quantity of labor supplied and reduces the quantity of labor demanded. TRUE. Here s the graph: A binding minimum wage, as a price floor, is set above the market equilibrium. At that legislated wage (w2), the quantity of labor supplied exceeds the quantity of labor demanded. The new quantity of labor supplied (LS2) is an increase from the level of labor supply at the unregulated market equilibrium (LS1), and the new quantity of labor demanded (LD2) represents a decrease in labor demand from the market equilibrium (LD1). 4. If the demand for a good falls when income falls, the good is called an inferior good. FALSE. For most goods, demand for the good falls as income falls. These goods are normal goods. For inferior goods, demand falls as income increases. 5. In the short run a perfectly competitive firm will always choose to shut down if product price is less than the lowest attainable average total cost. FALSE. In the short run, a competitive firm will shut down if price falls below the minimum of average variable cost. AVC lies below ATC, so if P>AVC but less than ATC, the firm operates at Q>0, and experiences losses (negative economic profit). Here s the (necessary) graph: 2

3 Part II. Short Answer 6. (10 points) Consider the market for mini-vans. Explain how each of the following events affects the mini-van market (use a supply and demand diagram in your explanation). a. People decide to have more children. The demand curve shifts to the right as people have more children. This causes the price of minivans to increase, and the quantity sold increases. b. A strike by steelworkers raises steel prices. A strike by steelworkers causes a reduction in the availability of steel (and/or an increase in the price of steel, an important input in the production of mini-vans). The supply curve shifts to the left, causing the price of mini-vans to increase. Quantity sold falls. c. Engineers develop new automated machinery for the production of mini-vans. This technological innovation shifts the supply curve to the right. The price of mini-vans falls, and the quantity sold increases. d. The price of station wagons rises. As the price of station wagons rise, the demand curve for its substitute, mini-vans, shifts to the right. The price of a mini-vans rise, and quantity sold rises. 3

4 e. A stock-market crash lowers people s wealth. With lower wealth, people want fewer mini-vans. The demand curve shifts to the left, the price falls, and the quantity sold falls. 7. A perfectly competitive firm s short-run cost curves are given by the following table: Q TC FC VC AVC ATC MC a. Complete the table. b. Graph AVC, ATC, and MC on the same graph (your graph can be rough). What is the relationship between the MC curve and ATC? MC intersects ATC at the min of ATC (approximately). c. Suppose that market price is $30. How much will the firm produce in the short run? What are At price=$30, quantity = 7. Profit: TR-TC = = -$30 (a loss) d. Suppose that market price is $50. How much will the firm produce in the short run? What are At price=$50, quantity = 9. Profit: TR-TC = = $120 (positive profit) 4

5 e. Suppose that market price is $10. How much will the firm produce in the short run? What are At price=$10, the firms shuts down (Q = 0), because $10 is less than AVC. Part III. Short Essay 8. (12 points) After economics class one day, your friend suggests that taxing food would be a good way to raise revenue because the demand for food is quite inelastic. In what sense is taxing food a good way to raise revenue? In what sense is it not a good way to raise revenue? It is true that a food tax raises revenue. The price elasticity of demand for food is very low; that is, food demand is price inelastic. At the minimum quantity of food/person required to survive, one might claim that the demand for food is perfectly inelastic. With inelastic demand, the imposition of a tax on food can raise considerable revenue. Here s the graph: Although raising tax revenue can be considered a good thing (conditional on how the revenue is spent), our judgment of goodness depends on several other factors. The fraction of income spent on food falls as income rises. This means that rich people spend a smaller fraction of their income on food than do poor people. A large share of lower-income earnings would be spent on this tax. In terms of a standard of living, the burden of a food tax would fall disproportionately on low-income people and families. 5

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