# 5. A Positive Statement A. attempts to explain how the world actually is or how the world actually functions.

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2 14. Under the current U.S. Federal Income Tax, the Top 1% of wage earners pay B. about 39.38% of all taxes collected, an amount roughly equal to the 40.33% of all taxes collected paid by the bottom 95% of wage earners. 15. refers to the recognition that if a public good were supplied in the marketplace, the amount provided would be less than the efficient quantity (since many people would attempt to enjoy the benefits of units purchased by others, while not purchasing any units themselves). C. The Free Rider Problem 16. S-Mobile, a new entrant into the cell phone service market, offers potential consumers two pricing options for cell phone service. Under Plan A : a consumer must pay a flat fee of \$50 per month, but can then use their cell phone as much as they like without incurring any additional charges. Under Plan B : a consumer must pay a flat fee of only \$10 per month, the consumer can then use up to 30 minutes per month at no additional charge, but the consumer must pay 15 for each additional minute used. S-Mobile presents all potential consumers with both of these two options, and allows each consumer to choose the pricing option which they prefer. This pricing practice is an example of: B. Second Degree Price Discrimination or Menu Pricing. 17. Visually, the demand curve facing a firm operating in a perfectly competitive market is C. a horizontal line at the prevailing market price, since such a firm has no market power. 18. Kristin sells corn. Last year she had Revenues of \$120,000, incurred Explicit Costs of \$70,000, and incurred Implicit Costs of \$40,000. From these values, it follows that B. her Accounting Profit was \$50,000 last year. 19. If a firm is currently operating at a point where costs of production exhibit Diseconomies of Scale, then as the firm increases its level of output C. Average Total Costs of Production must increase. 20. In order to maximize profit, this firm should produce/sell units of output. A. 1, When choosing the level of output and setting the price which maximize profit, the profit of this firm is B. \$3, In the Long Run this firm should C. expect new firms to enter the market. 23. Nick argues that: We should impose an additional sales tax on children s clothing, and use the resulting revenue to fund pubic elementary schools. After all, this is only fair, since it would make it so that the parents who receive the benefits of being able to send their children to public schools are the ones who will ultimately pay the taxes to provide the service. This argument appears to be an argument B. based upon the Principle of taxation. 24. is a market structure in which there is one single seller of a unique good (with no close substitutes ) and in which there are barriers to entry which prevent rival firms from entering the market A. Monopoly 25. If a good is such that it is very difficult or very costly to prevent consumption by those who do not pay for the good, then the good in question is B. a Non-Excludable Good. 26. The is defined as a period of time sufficiently long so that the amount hired/used of every factor of production can be varied. D. Long Run

3 27. According to the Inverse Elasticity Pricing Rule, when maximizing profit a firm must be operating in a way such that 1 ε p P MC C.. P is equal to 28. Consider the three market structures of a Perfectly Competitive Market, a Monopolistically Competitive Market, and a Monopoly Market. A firm could possibly expect to earn a positive profit in the Long Run if they were operating in which of these market structures? C. A Monopoly Market. 29. One way to potentially correct for the market failure which would result if a public good were provided in a free market is to: A. have the government decide upon the quantity to be provided (presumably, a best guess of the optimal quantity ), and then tax people to cover the costs of providing the good. 30. At the market equilibrium outcome (with no government intervention in the market) C. 300 units would be traded, each at a price of \$ At the market equilibrium outcome (with no government intervention in the market) B. Total Consumers Surplus is equal to areas (a)+(b)+(c). 32. In comparison to the free market outcome, imposing a price ceiling of \$2.00 in this market would: D. More than one of the above answers is correct. 33. Suppose that this good is a normal good. If per capita income were to decrease, then the market equilibrium outcome (with no government intervention in the market) would change as follows: C. equilibrium price and equilibrium quantity trade would both decrease. 34. In the United States, Price Controls were imposed on a wide range of goods in an unsuccessful attempt to combat inflation by A. President Richard Nixon, in the early 1970 s. 35. says that in order for a tax to be fair, two individuals of equal economic capacity should have equal tax burdens. B. The notion of horizontal equity 36. In a simultaneous move game with two players, it must always be the case that A. there is at least one Nash Equilibrium (potentially in mixed strategies ). 37. Consider a firm in a perfectly competitive market with: output price of \$6.35 per unit; AVC min = \$3.80; and ATC min = \$5.40. In the short run, this firm should D. produce a positive quantity and earn a positive profit. 38. Suppose that demand for bubble-gum is elastic at all prices. If the price of bubble-gum decreased by 10%, then quantity demanded of bubble-gum would C. increase, but by more than 10%. 39. In 2009, government spending in the U.S. (combined, at all levels of government) as a percentage of GDP is B %, higher than the percentage in all but three previous years in the entire history of our country (with the exceptions being 1943, 1944, and 1945).

4 40. The Law of Demand states that B. all other factors fixed, the quantity demanded of a good will be greater when its price is lower. Short Answer Questions : 1. Justin and Erika devote each workday to producing pizza and watches. On any given day, Justin can produce either 30 pizzas or 60 watches, while Erika can produce either 20 pizzas or 20 watches. 1A. Which individual has an Absolute Advantage in the production of pizza? Clearly explain. (3 points) The worker who can produce more output in each day has the Absolute Advantage. Since Justin s maximum output of 30 pizzas per day is greater than Erika s maximum output of 20 pizzas per day, it follows that Justin has the Absolute Advantage in the production of pizza. 1B. Which individual has a Comparative Advantage in the production of pizza? Clearly explain. (3 points) The worker who has the lower Opportunity Cost for producing the good has the Comparative 60 = 30 Justin Advantage. Justin s Opportunity Cost for producing pizzas is OC = 2 (that is, in order to make one additional pizza, Justin would have to make two fewer watches). Erika s Erika 20 Opportunity Cost for producing pizzas is OC pizza = = 1 (that is, in order to make one 20 additional pizza, Erika would have to make one fewer watch). Since Erika Justin OC = 1 < 2 = OC, it follows that Erika has the Comparative Advantage in pizza pizza pizza production (since she can produce each pizza at a lower cost, measured in the number of watches which must be given up to make the pizza). 1C. Supposing that Justin and Erika can specialize in their production, graph the Production Possibilities Frontier for this two person society. Clearly label all relevant points, and state the value of the slope of the PPF at every point. (4 points) pizza Watches Erika (Slope of PPF) = OC = 1 Pizza 80 Justin (Slope of PPF) = OC = 2 Pizza 60 0 Pizzas

5 2. Consider a market for which there were 6 firms in 1998 and 2004 but only 5 firms in The market shares of the firms in each year are reported in the table below: Year Share of Share of 2 nd Share of 3 rd Share of 4 th Share of 5 th Share of 6 th The squared value of market share for each firm is as follows: Year Share of Share of 2 nd Share of 3 rd Share of 4 th Share of 5 th Share of 6 th ,296 1, , , A. Determine the numerical value of the Four Firm Concentration Ratio (C4) in this industry in each of these three years. (3 points) C4 is computed as the sum of the market shares of the four largest firms in the industry. Thus: C = = 87 C = = 85 C = = 96 2B. Determine the numerical value of the Herfindahl-Hirschman Index (HHI) in this industry in each of these three years. (3 points) HHI is computed as the sum of the squared value of market share over all the firms in the industry. Thus: HHI = 1, , , = HHI 2004 = 1, = 2,642 HHI = 1, , = 2C. Based upon the values of C4 determined in part (2A), in which year was this industry most competitive? Explain. (2 points) A smaller value of C4 corresponds to an industry which is more competitive. The values of C4 computed in part (2A) would suggest that the industry was most competitive in D. Based upon the values of HHI determined in part (2B), in which year was this industry most competitive? Explain. (2 points) A smaller value of HHI corresponds to an industry which is more competitive. The values of HHI computed in part (2B) would suggest that the industry was most competitive in 2009.

6 EXTRA CREDIT: EC. Consider a society consisting of six individuals (Amy, Ben, Claude, Dave, Emily, and Francis), deciding upon how many units to consume of a good that is non-rival in consumption and non-excludable. Suppose throughout that it costs \$1,200 to produce each unit of this good. No person has a positive benefit for any unit including or beyond the 6 th unit of the good. The marginal benefit for each person for each of the first five units is summarized in the table below. Amy s Ben s Claude s Dave s Emily s Francis Social 1 st Unit , ,850 2 nd Unit ,700 3 rd Unit ,700 4 th Unit th Unit Suppose someone proposed that the government should provide 4 units of the good and impose taxes of \$800 on each person in society (in order to cover the costs of providing these 4 units). EC 1. Is Total Social Surplus maximized under the proposed plan of government provision? Clearly explain why or why not. (2 points) Since this good is non-rival in consumption and non-excludable it fits the definition of a Public Good. Therefore, every individual in society is able to enjoy their entire benefits of every single unit provided. That is, for each unit the Social of the unit is equal to the sum of s over all individuals in society. The value of Social for each unit has been computed and is reported in the column which has been added at the far right of the table above. In order to maximize Total Social Welfare, society would have to provide all units (and only those units) for which Social is greater than Social Cost (which in this case is simply equal to the \$1,200 of production costs for each unit). It follows that Total Social Surplus is maximized if and only if 3 units of the good are provided. Thus, the proposed plan of government provision does not maximize Total Social Welfare (since under the proposed plan the optimal quantity of the good would not be provided). EC 2. Compared to the free market outcome, would the proposed plan of government provision make all individuals in this society better off? Clearly explain why or why not. (2 points) The free market outcome is such that zero units of the good would be provided (since no one individual has a for any unit which is greater than the \$1,200 Cost of producing each unit). Thus, at the free market outcome every individual in society realizes a surplus of \$0. However, the proposed plan of government provision is not preferred by every person. In particular, Emily is worse off under the proposed plan. To see this, note that if 4 units of the good are provided, Emily realizes a benefit of \$( ) = \$700 from these units. However, if she has to pay \$800 in taxes, Emily s surplus under the proposed plan is (\$700) (\$800) = \$( 100). Since this number is less than zero, it implies that Emily is worse off under the proposed plan than she would be under the free market outcome.

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