Econ 98 (CHIU) Midterm 1 Review: Part A Fall 2004

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1 Disclaimer: The review may help you prepare for the exam. The review is not comprehensive and the selected topics may not be representative of the exam. In fact, we do not know what will be on the exam. We try to make our answers complete, but we cannot guarantee their correctness. Use at your own risk and use good judgment. William Chiu s Selected Topics 1. The beauty of Supply and Demand 2. Different flavors of elasticity 3. erfect Competition without taxes 4. erfect Competition with taxes SUGGESTED SOLUTIONS William s Chiu s uick Notes Intro to Basic Economic Ideas and Assumptions eople are rational consistent decision-making Scarcity trade-offs Cost-Benefit Analysis (MB MC) Opportunity Cost Economics surplus = benefits minus costs Ignore sunk costs Demand and Supply Downward-sloping Demand Upward-sloping Supply Assumes that the curves reflect all benefits and costs (no externalities) Market equilibrium ( d = s ; d = s ; Demand=Supply) Market adjustment mechanisms Excess and shortage Movements along the curves Shifts of the curves Substitutes/Complements; Income; opulation; Social Norms Normal and Inferior goods Input prices; Technology; Weather/Natural disaster age 1 of 7

2 Firm Supply & erfect Competition Market supply is the horizontal summation of each firm s marginal cost curves that is above the minimum of the AVC roducer Surplus Assumptions for perfect competition: (1) many buyers and sellers (2) homogeneity (3) perfect information (4) free entry-and-exit Total Cost, fixed cost, variable cost, average total cost, average variable cost, marginal cost rofit-maximizing firms (MC=MR) Social Optimum (=MC) Short-run profits and losses Long-run zero economic profits Efficiency and Exchange/Invisible Hand Accounting versus Economic profits rice floors rice ceilings Deadweight loss Farm Subsidies age 2 of 7

3 THE BEAUTY OF SULY AND DEMAND 1. True, false, or uncertain. An increase in demand always increases the market equilibrium price and quantity. False. If market supply were perfectly elastic (i.e. horizontal), then an increase in market demand would not change the equilibrium price. Draw a graph to convince yourself. 2. True, false, or uncertain. A per-unit tax in a perfectly competitive market with no externalities always causes a deadweight loss. False. If market demand were perfectly inelastic (i.e. vertical), then a perunit tax on producers would not create a DWL. Notice that there is only one quantity that is produced and sold when demand is perfectly inelastic. Draw a graph to convince yourself. 3. The following market for water bottles is initially in equilibrium at $4. What if the price of water bottles was $6? Will there be excess demand (shortage) or excess supply (surplus) in the long-run? Explain S In the long-run, the market adjusts to the market equilibrium price and quantity. No shortage and no surplus because d=s. 4 0 d 12 s D 20 If =6, then s>d which is a temporary excess supply. roducers and consumers bid prices down until d=s. age 3 of 7

4 4. The government imposes a price-ceiling at $6. How many water bottles are being produced and how many are being sold? Is there a dead weight loss? A price ceiling is a maximum price. It is only effective if c<*. In our question, c>*, hence it is ineffective. Remember that one of the characteristics of equilibrium is that producers and consumers have no incentive to bid prices up or down. *=12=Number of bottles sold=number of bottles produced No DWL because equilibrium price and quantity were not affected by an ineffective price ceiling. 5. The government flip-flops and imposes a price-floor at $6. How many water bottles are being produced and how many are being sold? Is there a dead weight loss? A price floor is not the same thing as a price support. Lets assume that the government does not buy back any of the excess water bottles. A price floor is a minimum price. It is only effective if f>*. In our question, f>*, hence it is effective. There is excess supply (s>d). Supply: =(1/3)s s=18=number of bottles produced Demand: =(-1/2)d+10 d=8=number of bottles sold There is a DWL=A+B. An alarm should go off in your brain if the number of bottles produced does not equal the number of bottles sold. 10 S 6 4 A B f 0 d 12 s D 20 age 4 of 7

5 DIFFERENT FLAVORS OF ELASTICITY 1. True, false, or uncertain. If the percentage change in the price of good X exceeds the percentage change in the quantity supplied of good Y, then the price elasticity of supply is considered elastic. False. The price elasticity of supply is the percentage change in quantity supplied (of good Y) when price (of good Y) increases by 1%. rice elasticity of supply is also the percentage change in quantity supplied divided by the percentage change in price. rice elasticity of supply is considered elastic if the percentage change in quantity supplied exceeds the percentage change in price. The percentage change in the price of good X tells us nothing about price elasticity of supply of good Y. 2. True, false, or uncertain. If a positive percentage change in income causes a positive percentage change in the quantity demand of good X, then good X is considered an inferior good. False. The income elasticity of good X is the percentage change in quantity demanded when income increases by 1%. Income elasticity is also the percentage change in quantity demanded divided by the percentage change in income. If a positive percentage change in income causes a positive percentage change in the quantity demanded of good X, then good X is considered a normal good. For example: You demand more steak when you get a pay raise. 3. The cross price elasticity between good X and good Y is positive. The price of good X increases. Show graphically what happens to the market for good Y. Label 1 and 1 as your initial market equilibrium. Label 2 and 2 as your new market equilibrium. If the cross price elasticity between good X and good Y is positive, then X and Y are substitutes for each other. If the price of X increases, then it is more expensive to buy X. Hence consumers demand more Y. Mkt for good Y S D D2 age 5 of 7

6 ERFECT COMETITION WITHOUT TAXES 1. True, false, or uncertain. If MC intersects ATC at ATC s minimum, then MC does not necessarily intersect AVC at AVC s minimum. True. If MC<AVC, then AVC is falling. If MC>AVC, then AVC is rising. Therefore, if MC intersects ATC at min ATC, then MC must necessarily intersect AVC at min AVC. It might help you to think about your GA and your grade in Econ 1. If your GA is a 3.0, then getting a C in Econ 1 would lower your GA. If your GA is a 3.0, then getting an A in Econ 1 would increase your GA. 2. There are 500 firms in the perfectly competitive market for rice. Each firm produces q 1 at the market equilibrium price 1. The market equilibrium quantity is 1. The market is currently in long run equilibrium. Draw and clearly label the rice market and a representative firm s graphs. lease include in your graphs: market demand (D 1 ), market supply curve (S 1 ), firm s demand curve (d 1 ), marginal revenue curve (MR 1 ), marginal cost curve (MC 1 ), and average total cost curve (ATC 1 ). There should only be two graphs: market and firm. Market S1 Individual Firm MC1 S3 ATC1 2 1 d1=mr D1 D2 3. A new Berkeley study shows that eating servings of rice per day increases your life span. Show graphically what happens to the short-run price (2), market quantity (2), and firm quantity (q2). Is the firm making a profit in the short run? Assume that there is no entryor-exit in the short-run. up, up, q up, profits up 4. Fast forward to the long-run. Is the firm making a profit in the long run? How many firms are in the rice market in the long-run? Label the long-run price (3), market quantity (3), and firm quantity (q3). Firms enter in the long-run (supply shifts right). 1=3, 2<3, q1=q3. Firms make zero profits. Number of firms is greater than 500. age 6 of 7 q1 q2 q

7 ERFECT COMETITION WITH TAXES 1. There are 500 firms in the perfectly competitive market for rice. Each firm produces q 1 at the market equilibrium price 1. The market equilibrium quantity is 1. The market is currently in long run equilibrium. Draw and clearly label the rice market and a representative firm s graphs. lease include in your graphs: market demand (D 1 ), market supply curve (S 1 ), firm s demand curve (d 1 ), marginal revenue curve (MR 1 ), marginal cost curve (MC 1 ), and average total cost curve (ATC 1 ). There should only be two graphs: market and firm. Market Individual Firm S3 S1 ATC2 MC1 ATC1 3 1 d1=mr The government places a lump-sum tax on all rice producers. How does the lump-sum tax affect the firm s marginal cost and average cost curves? A lump sum tax is a one time tax that the firm must pay regardless of the amount of output it sells or produces. Show graphically what happens to the short-run price (2), market quantity (2), and firm quantity (q2). Is the firm making a profit in the short run? Assume that there is no entry-or-exit in the short-run. A lump-sum tax is an increase in fix costs. MC does not shift. Supply does not shift in the short-run. ATC shifts up. 1=2, 1=2, and q1=q2. The firm makes a loss in the short-run. 3. Fast forward to the long-run. Is the firm making a profit in the long run? How many firms are in the rice market in the long-run? Label the long-run price (3), market quantity (3), and firm quantity (q3). Firms exit in the long-run (supply shifts left). Number of firms is less than >1, 3<1, and q3>q1. 4. Show the dead weight loss in the market in the long-run after the tax. DWL=Red Triangle D1 q1 q3 age 7 of 7