# University of Toronto February 10, 2006 ECO 100Y L0101 INTRODUCTION TO ECONOMICS. Midterm Test #3

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1 Department of Economics Prof. Gustavo Indart University of Toronto February 10, 2006 SOLUTION ECO 100Y L0101 INTRODUCTION TO ECONOMICS Midterm Test #3 LAST NAME FIRST NAME STUDENT NUMBER INSTRUCTIONS: 1. The total time for this test is 50 minutes. 2. Answer all questions in the space provided (if space is not sufficient, continue on the back of the previous page). 3. Aids allowed: a simple, non-programmable calculator. 4. Use pen instead of pencil. DO NOT WRITE IN THIS SPACE 1. /8 4. /12 2. /8 5. /9 3. /8 6. /5 TOTAL /50 Page 1 of 9

2 Question 1 (8 marks) Assume that a perfectly competitive industry, with n identical firms, is initially in long-run equilibrium. The industry has a constant cost long-run supply curve. The product is a normal good. Disposable income increases as a result of a tax cut. Statement: In the new long-run equilibrium, the industry price will increase; the industry output will also increase; each firm will produce a larger output; and the number of firms in the industry will remain unchanged. Position: Do you agree with the statement? Draw the proper diagram to explain your answer. P \$ S SRMC SRAC LRAC S LRS D D Q 1 Q 2 Q 3 Q q 1 q 2 q In the initial long-run equilibrium, price is, industry output is Q 1, and each of the n 1 firms in the industry is producing output q 1 (and thus Q 1 = n 1 q 1 ). Note that since the industry is in long-run equilibrium, firms economic profits are zero. Since the product this industry produces is a normal good, the increase in disposable income increases the demand for this good. The demand curve shifts to D and equilibrium price increases to and industry output increases to Q 2 in the short-run. At this new price, each firm produces an output q 2 in the short-run (and thus Q 2 = n 1 q 2 ). Firms make now positive economic profits since is greater than average cost at the level of output q 2. The firm s profit is shown by the blue area in the right-hand side diagram. The economic profits firms are making attract more firms into the industry in the long-run. As more firms enter the industry, the short-run supply curve starts shifting to the right, price starts to fall, and economic profits start to decrease. This process continues until the price level falls back to and all firms make normal profits once again (i.e., a new long-run equilibrium is reached). Industry output increases to Q3, but each firm is producing the same output as before (i.e., Q 3 = n 2 q 1 ) Therefore, I disagree with the statement: price doesn t change in the long-run; industry output does increase; each firm produces the same output as before; and the number of firms increases. Page 2 of 9

3 Question 2 (8 marks) A perfectly competitive industry is initially in long-run equilibrium with a constant cost long-run supply curve. The government imposes a tax of \$2.00 per unit of output on this industry. Statement: As a result, the long-run industry price will increase by \$2.00; industry output will fall; and the number of firms will remain unchanged but each firm will produce a lower output. Position: Do you agree with the statement? Draw the proper diagram to explain your answer. P \$ SRMC 2 SRAC 2 LRAC 2 S S S SRAC 1 SRMC 1 LRAC 1 P 3 LRS P 3 D LRS Q 3 Q 2 Q 1 Q q 2 q 1 q In the initial long-run equilibrium, price is, industry output is Q 1, and each of the n 1 firms in the industry is producing output q 1 (and thus Q 1 = n 1 q 1 ). Note that since the industry is in long-run equilibrium, firms economic profits are zero. The imposition of the tax of \$2 per unit of output shifts the SRAC curve, the SRMC curve, and the LRAC curve all up by exactly \$2 at each level of output. The short-run supply curve thus also shifts up by exactly \$2 to S. The decrease in supply causes price to rise to and industry output to fall to Q 2 in the short-run. At this lower price, each firm in the industry decreases output to q 2 (where Q 2 = n 1 q 2 ). Each firm is now making economic losses in the short-run since P is less than average cost at the level of output q 2 (loss is shown by the orange area in the diagram). Since firms are making economic losses, some firms will exit the industry in the long-run. As the number of firms decreases, the short-run supply curve starts shifting to the left and price starts to rise. This process continues until the price increases to P 3 and all firms are just making normal profits once again (i.e., a new long-run equilibrium is achieved). Note that industry output decreases to Q 3 in the new long-run equilibrium but each firm is producing output q 1 as before (i.e., Q 3 = n 2 q 1 ). Therefore, I disagree with the statement: price does increase by \$2 and industry output falls in the long-run, but the number of firms decreases and each firm produces the same output as before. Page 3 of 9

4 Question 3 (8 marks) An unregulated monopolist is in long-run equilibrium and making positive economic profits. The minimum of the monopolist s total average cost (AC) curve lies below the average revenue curve. The government implements average-cost pricing policy with the aim of eliminating the monopolist s economic profits. Statement: As a result of the government intervention, the monopolist s price will fall; the monopolist s output will increase; the monopolist will make normal profits (i.e., zero economic profits); and allocative efficiency will be achieved (i.e., the deadweight loss will be eliminated). Position: Do you agree with the statement? Draw the proper diagram to explain your answer. P MC AC AC 2 AR Q 1 Q 3 Q 2 MR Q Before the imposition of average cost pricing, the monopolist is maximizing profits by producing an output Q 1 (where MR = MC) and charging a price. The monopolist is making economic profits since is greater than average cost at the level of output Q 1. The government now imposes a price ceiling at the level where the AC curve intersects the demand curve (or AR curve), i.e., a price. The objective of the government is to eliminate the monopolist s economic profits by making P = AC. But although the monopolist will not be able to charge a price higher than, it will not have to produce a quantity Q 2. As a matter of fact, the monopolist will not produce an output Q 2. The monopolist will produce the quantity that will allow it to maximize profits, and this means the quantity where MR = MC. And the imposition of this price ceiling has changed the monopolist s MR curve. Since the monopolist will receive the same price for any level of output lower than Q 2 it might decide to produce, the monopolist MR curve is now horizontal at up to the level of output Q 2 (and then it continues as before for Q greater than Q 2 ). The monopolist, therefore, will produce an Q 3. At the level of output Q3, the monopolist is making economic profits since P2 is greater than AC at this level of output. The economic profits are shown by the blue area in the diagram above. Therefore, although economic profits have been reduced, they have not been eliminated. In addition, allocative efficiency is not achieved either since P MC (in the diagram above, the green area indicates the economic inefficiency of the monopolist) the level of allocative inefficiency has been reduced but not eliminated. Page 4 of 9

5 Question 4 (12 marks) The local movie theatre in Littletown serves two kinds of adult customers: seniors and non-seniors. There are 100 seniors and 400 non-seniors in Littletown. Each senior s willingness to pay for a movie ticket is \$5. Each non-senior s willingness to pay for a movie ticket is \$10. Each will buy at most one ticket. The movie theatre s marginal cost per ticket is constant at \$3, and there is no fixed cost. [Note: You do not need to draw any graphs to answer this question.] a) Suppose the movie theatre cannot price-discriminate and needs to charge both seniors and non-seniors the same price per ticket. If the movie theatre charges \$5, who will buy movie tickets, and what will the movie theatre s profit be? (3 marks) How large is the consumer surplus? (1 marks) If the movie theatre charges a price of \$5 per ticket, both seniors and non-seniors will buy tickets. The total number of tickets sold will be 500, for a total revenue of \$2,500 (i.e., 500 x \$5). The total cost will be \$1,500, i.e., 500 x \$3 = \$1,500. Therefore, the total profits will be \$1,000. On the one hand, seniors will not have any consumer surplus since they will be charged the maximum price they are willing to pay. Non-seniors, on the other hand, will have a consumer surplus equal to the difference between the maximum price they are willing to pay (i.e., \$10) and the price they are actually paying (i.e., \$5), that is, a consumer surplus of \$5 per ticket. The total consumer surplus is, therefore, \$2,000 (i.e., \$5 x 400). b) If the movie theatre charges a price of \$10, who will buy the movie tickets, and what will the movie theatre s profit be? (3 marks) How large is the consumer surplus? (1 marks) If the movie theatre charges a price of \$10 per ticket, only non-seniors will buy tickets. The total number of tickets sold will be 400, for a total revenue of \$4,000 (i.e., 400 x \$10). The total cost will be \$1,200, i.e., 400 x \$3 = \$1,200. Therefore, the total profits will be \$2,800. Since seniors are not purchasing tickets and non-seniors are being charged the maximum price they are willing to pay, then there will be no consumer surplus. Page 5 of 9

6 c) Now suppose that, if it chooses to, the movie theatre can price-discriminate between seniors and nonseniors by requiring seniors to show an identification card. If the movie theatre charges seniors \$5 and non-seniors \$10, how much profit will the movie theatre make? (3 marks) How large is the consumer surplus? (1 marks) If the movie theatre charges a price of \$5 per ticket seniors and a price of \$10 to non-seniors will buy tickets, total profits will be as follows. The total number of tickets sold to non-seniors will be 400, for a revenue of \$4,000 (i.e., 400 x \$10). The total number of tickets sold to seniors will be 100, for a revenue of \$500 (i.e., 100 x \$5). The total revenue will thus be \$4,500. In turn, the total cost will be \$1,500, i.e., 500 x \$3 = \$1,500. Therefore, the total profits will be \$3,000. The total consumer surplus will be zero since both seniors and non-seniors are being charged the maximum price they are willing to pay. That is, the entire consumer surplus is being appropriated by the movie theatre. Page 6 of 9

7 Question 5 (9 marks) The following entries are from the national accounts of a hypothetical country. Assume that all the relevant items that you need in order to answer the questions have been provided, and that the data are based on domestic production (GDP). Net Income of Unincorporated Businesses 8,000 Indirect Taxes 12,000 Undistributed Corporate Profits 3,000 Exports 21,000 Wages and Salaries 54,000 Capital Consumption Allowance (Depreciation) 10,000 Consumption 56,000 Interest Income 2,000 Corporate Profits before Taxes 9,000 Government Interest Payments on National Debt 1,000 Government Expenditure on Goods and Services 22,000 Imports 19,000 Corporate Taxes 4,000 Rental Income 2,000 Personal Taxes 15,000 Government Transfer Payments to Individuals 11,000 Use the above data to compute the following (show all your work): a) Net Domestic Income (3 marks) NDI = Wages & Sal. + Corp. Profits + Interest Income + Rental Inc. + Net Inc. of Unincorp. Businesses = 54, , , , ,000 = 75,000 Page 7 of 9

8 b) Gross Domestic Product (3 marks) GDP = NDI + Indirect Taxes + Depreciation = 75, , ,000 = 97,000 c) Personal Disposable Income (3 marks) PDI = NDI Corp. Profits + Dividends + Transfer Payments + Interest Payments Personal Taxes = 75,000 9, , , ,000 15,000 = 65,000 Since Dividends = Corp. Profits Corp. Taxes Undistributed Profits = 9,000 4,000 3,000 = 2,000 Page 8 of 9

9 Question 6 (5 marks) Consider the following data on Canadian GDP: Year Nominal GDP (in billions) GDP Deflator (base year a) What was the rate of growth of real GDP between 2004 and 2005? (3 marks) GDP Deflator = (Nominal GDP / Real GDP) * 100 Real GDP = (Nominal GDP / GDP Deflator) * 100 Real GDP in 2005 = (1260 / 105) * 100 = 1200 Real GDP in 2004 = (1200 / 102) * 100 = Rate growth of real GDP between 2004 and 2005 = ( ) / = or 2.0% b) What was the rate of inflation in 2005? (2 marks) Since the GDP deflator in 2005 was 105 and in 2004 was 102, the rate of inflation in 2005 was: π = ( ) / 102 = or 2.94% Page 9 of 9

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