Department of Economics Prof. Gustavo Indart University of Toronto February 6, 2009 SOLUTIONS ECO 100Y INTRODUCTION TO ECONOMICS Midterm Test # 3 LAST NAME FIRST NAME STUDENT NUMBER INSTRUCTIONS: 1. The total time for this test is 1 hour and 50 minutes. 2. Aids allowed: a simple calculator. 5. Write with pen instead of pencil. DO NOT WRITE IN THIS SPACE Part I 1. /14 Part II /50 2. /12 3. /12 4. /12 TOTAL /100 Page 1 of 11
PART I (50 marks) Instructions: Answer all questions in the space provided. 1. Long-Run Competitive Equilibrium (14 marks) Consider the hot dog street vendor industry in Piriapolis, a small city with the world s greatest consumption of hot dogs per capita. The city s hot dog street vendor industry is a perfectly competitive, constant cost industry. The industry consists of 100 identical street vendors. The diagrams below provide information about the industry short-run supply (S) and demand (D) curves and about a representative street vendor short-run marginal cost (SRMC), shortrun average total cost (SRAC), and long-run average cost (LRAC). Price (dollars) 5.0 3.5 3.0 2.5 S S S LRS LRS Price (dollars) 5.0 3.5 3.0 2.5 SRAC SRMC SRMC SRAC LRAC LRAC D 8 10 Hot dogs/day (thousands) 90 100 Hot dogs/day a) What are the industry short-run equilibrium price and quantity? (1 mark) How many hot dogs does each vendor sell in this short-run equilibrium? Briefly explain. (1 mark) Is each vendor making economic profits or economic losses in this short-run equilibrium? Briefly explain. (1 mark) P = $ 2.5 Industry quantity = 10,000 Vendor s quantity = 100 Since the industry output is 10,000 hot dogs/day and there are 100 identical street vendors, then each street vendor will sell 10,000/100 = 100 hot dogs per day. Each street vendor is making the normal profits, i.e., zero economic profits, since P = SRAC at the equilibrium level of output. Page 2 of 11
b) Is the industry in long-run equilibrium? Briefly explain. (1 mark) Draw the industry long-run supply (LRS) curve in the diagram above. (1 mark) Yes, the industry is in long-run equilibrium because every firm is making zero economic profits and producing with the optimum scale of production (i.e., at the minimum of the LRAC curve). c) Suppose now that the government introduces a specific tax of $1 per hot dog to be paid by the street vendors. In the diagram above, show the short-run impact of this specific tax by carefully re-drawing the affected curves. (2 marks) d) What are the new industry short-run equilibrium price and quantity? How many hot dogs does each vendor sell in this short-run equilibrium? (2 marks) Is each vendor making economic profits or losses in this short-run equilibrium? Briefly explain. (1 mark) P = $ 3.00 Industry quantity = 9,000 Vendor s quantity = 90 Each street vendor is making economic losses, since P < SRAC at the equilibrium level of output. e) In the diagram above, carefully draw the new long-run industry supply curve. (1 mark) What are the new industry long-run equilibrium price and quantity? How many hot dogs does each vendor sell in this new long-run equilibrium? (2 marks) How many vendors are there in the new long-run equilibrium? Briefly explain. (1 mark) P = $ 3.50 Industry quantity = 8,000 Vendor s quantity = 100 Since the industry output is 8,000 hot dogs/day and each vendor is selling 100 hot dogs per day, the number of vendors is 8,000/100 = 80. Page 3 of 11
2. Regulated Monopoly (12 marks) Consider the monopoly firm providing cable services in your neighbourhood. The diagram below shows the demand curve (D) for basic cable services, the firm s marginal cost curve (MC), and the firm s average total cost curve (AC). Price of basic cable services (dollars/month) 150 110 100 90 80 50 Economic profits of unregulated monopolist Deadweight loss MC AC AC D 10 14 20 30 Quantity of households/month (thousands) a) If the government does not regulate this monopolist, which price will it charge? Show the monopolist s price and quantity in the diagram above. (2 marks) What economic profits or losses will the monopolist make? Shade the area of economic profits or losses in the diagram above. (2 marks) Illustrate the allocative inefficiency this creates by shading the deadweight loss from monopoly. (2 marks) P M = $ 110 Profits (losses) = $ 300,000 b) Suppose now that the government decides to regulate this monopolist in order to achieve allocative efficiency, what price ceiling should the government impose? (1 mark) What economic profits or losses will the monopolist make? Show your work. (2 marks) P C = $ 90 Profits (losses) = $ 140,000 Economic profits = (P C AC) Q = (90 80) 14 = 140 thousand. Page 4 of 11
c) Suppose that in addition to achieving allocative efficiency the government also wants this monopolist to make normal profits (i.e., zero economic profits). What type of tax or subsidy should the government introduce? Briefly explain. (1 mark) What is the size of this tax or subsidy? (1 mark) In the diagram above, show the impact of this tax or subsidy by carefully drawing all the necessary new curves. (1 mark) The government should introduce a lump-sum tax in order to increase AC without affecting MC. The size of the lump-sum tax should be $140,000, so AC would increase by $10 at the level of output (14,000) at which allocative efficiency is achieved and then P = AC = 90. 3. Negative Externalities (12 marks) Empirical studies show a causal relationship between cigarette consumption and the incidence of lung cancer among smokers and also among those exposed to second-hand smoke. Therefore, cigarette consumption imposes costs also on people who do not smoke not only is the health of those exposed to second-hand smoke affected but also society as a whole has to cover the additional medical cost of treating all those affected by the consumption of tobacco. The diagram below illustrates the market supply and market demand curves for cigarettes. 15 Deadweight loss MC S Price (dollars) 10 Tax = $4 S = MC P P C = $9 7 A P P = $5 D = MB P = MB S 100 120 180 200 300 Cigarette (thousand packs/month) Page 5 of 11
a) What are the market equilibrium price and market equilibrium quantity of cigarette packs? Indicate this equilibrium in the diagram above (point A). (2 marks) P = $ 7 Quantity = 180 packs/month b) In the diagram above, draw the social marginal cost (MC S ) curve assuming that the consumption of each pack of cigarettes imposes and additional cost of $4 to society. (2 marks) What is the allocatively efficient quantity of cigarette packs? (1 mark) Efficient quantity = 120 packs/month c) In your diagram, shade the area corresponding to the net cost imposed on society ( deadweight loss ) by the allocatively inefficient quantity of cigarette packs of part a). (2 marks) d) Explain the options open to the government to achieve the allocative efficient quantity of cigarette packs. (3 marks) The government should impose a unit tax equal to the negative externality (i.e., $4 per pack) in order to increase the private marginal cost to the level of the social marginal cost. In this way the supply curve would shift up and coincide with the MC S curve. e) If allocative efficiency is achieved by following the above option, what price will consumers pay per pack of cigarettes? What price will producers receive per pack of cigarettes? Show these outcomes in the diagram above. (2 marks) P C = $ 9 P P = $ 5 Page 6 of 11
4. Calculation of National Accounts (12 marks) (From Study Guide, Chapter 20) Below are data from the national accounts of a hypothetical country. Assume that all relevant items you need to answer the questions have been provided. Wages and salaries 800 Depreciation 60 Indirect taxes minus subsidies 40 Undistributed corporate profits 80 Corporate profits before taxes 300 Corporate profits taxes 170 Imports 140 Exports 130 Net unincorporated business income 50 Consumption 920 Investment 200 Interest and rental income 200 Use the above data to answer the following questions: a) What is the value of net domestic income? (3 marks) [Note: Show all your work.] NDI = wages (800) + corporate profits (300) + interest and rental income (200) + net unincorporated business income (50) = 1350 b) What is the value of gross domestic product? (2 marks) [Note: Show all your work.] GDP = NDI (1350) + depreciation (60) + indirect taxes minus subsidies (40) = 1450 c) What is the value of government expenditure on goods and services? (3 marks) [Note: Show all your work.] G = GDP (1450) consumption (920) investment (200) exports (130) + imports (140) = 340 d) What is the value of net investment? (2 marks) [Note: Show all your work.] Net investment = gross investment (200) depreciation (60) = 140 e) What is the value of dividends? (2 marks) [Note: Show all your work.] Dividends = corporate profits (300) undistributed profits (80) corporate taxes (170) = 50 Page 7 of 11
PART II (50 marks) Instructions: Multiple choice questions are to be answered using a black pencil or a black or blue ballpoint pen on the separate SCANTRON sheet being supplied. Be sure to fill in your name and student number on the SCANTRON sheet! Each question is worth 2.5 marks. No deductions will be made for incorrect answers. Write your answers to the multiple choice questions ALSO in the table below. You may use this question booklet for rough work, and then transfer your answers to each multiple choice question onto the separate SCANTRON sheet. Your answers must be on the SCANTRON sheet. In case of a disagreement, the answer to be marked is the one on the SCANTRON sheet. 1 2 3 4 5 6 7 8 9 10 D C A E D B B C B D 11 12 13 14 15 16 17 18 19 20 B A D C D C B E A B 1. (From May/2005 exam) A perfectly competitive industry is in long-run equilibrium with a constant cost industry supply curve. The government imposes a specific commodity tax of $2.00 per unit of output. As a result, which one of the following statements is correct in the long run? A) Consumer price would increase, but not by $2.00, and industry output would fall. B) Industry output would increase and consumer price would be unchanged. C) Industry output would decrease and consumer price would decrease. D) Consumer price will increase by $2.00 and industry output would fall. E) None of the above is correct. 2. (From May/2005 exam) Suppose all of the firms in a perfectly competitive industry form a cartel and agree to restrict output, thereby raising the price of the product. Individual firm A will gain the most from the existence of the cartel if A) all firms, including A, cooperate and restrict output. B) firm A restricts output, while the other firms do not. C) all firms, except A, cooperate and restrict output. D) no firms restrict output. E) all firms revert back to their competitive outputs. 3. (From May/2005 exam) A perfectly competitive industry is in long-run equilibrium. Under these conditions, which one of the following statements is correct for a typical firm? A) Marginal revenue, marginal cost, average revenue and average cost are equal. B) Marginal revenue equal marginal cost but not average revenue and average cost. C) Marginal revenue equals average revenue but not marginal cost and average total cost. D) Marginal revenue equals average total cost but not marginal cost and average revenue. E) None of the above is correct. Page 8 of 11
4. (From May/2006 exam) Suppose a competitive industry is initially in long-run equilibrium. If this industry faces a decrease in demand for its product, the theory of perfect competition predicts that in the long run A) newer, more efficient firms will enter the industry and earn normal profits. B) existing firms will modernize plant and equipment in order to increase efficiency. C) existing firms will expand output as a means of recovering losses. D) the industry will raise its price to earn higher revenue. E) capacity in the industry will gradually shrink. 5. (From May/2006 exam) Comparing the short-run and long-run profit-maximizing positions of a perfectly competitive firm, which one of the following statements is true? A) Price will equal marginal cost in the short run, but not necessarily in the long run. B) Economic profits may exist in the short run and in the long run. C) In order to profit maximize, the firm must always produce at the minimum of average total cost in the short run and in the long run. D) The price must equal average total cost in the long run, but not necessarily in the short run. E) None of the above is true. 6. (From May/2006 exam) Suppose a typical competitive firm has the following data in the short-run equilibrium: price = $10; output = 100 units; ATC = $12; AVC = $7. Which of the following statements is correct? A) In the long run the industry will expand because of economic profits. B) In the long run the industry will contract because firms are suffering losses. C) The size of the industry will remain the same in the long run. D) Price will fall in the long run. E) There is not enough information to formulate an answer about the long run. 7. (From May/2004 exam) A perfectly competitive industry is in short run equilibrium. Each firm is initially making economic profits of $100,000 per year. Now, each firm faces an increase in property taxes of $40,000 per year. As a result of this shock, which one of the following statements is correct? A) Each firm would shut down. B) Each firm would produce an unchanged output and make economic profits of $60,000. C) Each firm would produce an increased output and make economic profits of more than $60,000 but less than $100,000. D) Each firm would produce a lower output and make economic profits of more than $60,000 but less than $100,000. E) None of the above is correct. 8. (From May/2007 exam) Suppose a firm is maximizing profits where price is $10 and marginal revenue is $8. Given the above, which of the following we do NOT know with certainty? A) Price elasticity is greater than one. B) The firm is not perfectly competitive. C) The firm is making a profit. D) Total revenue is increasing (as output increases). E) Price exceeds marginal cost. Page 9 of 11
9. (From May/2005 exam) If the monopolist operated in the inelastic range of his demand curve, A) he would be operating where his average revenue is negative. B) his marginal revenue would be negative. C) his marginal revenue would be negative although his total receipts would be at a maximum. D) he could raise his total revenue by lowering his price. E) he would be operating at his profit maximizing position. 10. (From May/2006 exam) When the monopolist charges a price where the price elasticity of demand equals 1, which of the following statement is correct? A) Total revenue is rising, although marginal revenue is falling. B) Total revenue is falling. C) Total profit is at a maximum. D) Total revenue is at a maximum. E) None of the above is correct. 11. (From May/2008 exam) The marginal revenue curve of an unregulated, single price monopolist lies below the demand curve because A) the demand curve is unit elastic. B) the monopolist must lower price on all units sold in order to sell additional units. C) the monopolist is a price taker. D) the marginal revenue curve coincides with the average revenue curve. E) the marginal revenue curve is linear. 12. (From Test 2 Summer 2008) If an unregulated profit-maximizing monopolist is producing an output at which marginal cost exceeds marginal revenue, it A) should raise price and reduce output. B) should lower price and raise output. C) is incurring losses. D) is maximizing profits. E) should lower price and output. 13. (From May/2008 exam) A monopolist can sell 50 units of output per day for a price of $20 each and 51 units for a price of $19 each. What is the marginal revenue of the 51 st unit sold? A) $0. B) $1. C) $19. D) -$31. E) $969. 14. (From Test 2 Summer 2008) If a perfectly competitive industry is characterized by constant costs in the long run, then a decrease in demand will, in the long run, lead to A) a decrease in quantity and a decrease in price. B) a decrease in quantity and an increase in price. C) a decrease in quantity and no change in price. D) no change in quantity and no change in price. E) an increase in quantity and no change in price. Page 10 of 11
15. (From Test 2 Summer 2008) Externalities are likely to lead to an inefficient allocation of resources because A) they create benefits or costs not borne by anyone. B) they are associated with monopolies. C) they involved fixed costs that are not a part of marginal cost. D) market demands and supplies do not reflect all the additional social benefits or costs. E) people behave selfishly. 16. (From Test 2 Summer 2008) Which of the following is NOT considered an investment item when measuring GDP? A) Increase in inventories of unsold goods at a warehouse owned by The Bay. B) Purchase of new bottling equipment by a Niagara winery. C) Purchase of 2000 shares of Sears Canada by a mutual fund company. D) Construction of a new condo apartment tower. E) Purchase of a new limousine for the transportation of the President of the Raptors. 17. (From Test 2 Summer 2008) How much would the production of a kayak add to GDP in Canada if the kayak was purchased in the United States for $250, painted in Canada for $20, and sold by a dealer in Canada to his customer for $800? A) $800. B) $550. C) $530. D) $20. E) $270. 18. (From May/2004 exam) In July 2003, a dealership in Toronto bought 40 brand new cars from the Ford Motor Company at a cost of $15,000 per car. Before the end of the year this dealership was able to sell 20 of these cars at a price of $20,000 each. The remaining cars were sold in January 2004 at a price of $18,000 each. In these transactions, what is the contribution of this dealership to GDP in the year 2003? A) 760,000 B) 600,000 C) 400,000 D) 160,000 E) 100,000 19. (From August/2005 exam) Which one of the following statements about investment is correct? A) Net investment may be negative. B) Net investment includes the total of all machinery and equipment produced during the year. C) Gross investment must equal net investment. D) Gross investment plus depreciation equals net investment. E) None of the above is correct. 20. (From May/2005 exam) Suppose that in 1999, ABC Corporation produced $18 million worth of natural gas pipes but was able to sell only $16 million worth. Is the remaining $2 million increase in inventories part of GDP for 1999? A) Yes, since changes in inventories are part of consumption expenditures. B) Yes, since they are part of the economy s output in 1999. C) No, since changes in inventories are part of actual investment. D) No, since they are part of the economy s output only when sold. E) None of the above. Page 11 of 11