Microeconomics Final Exam Review Questions 1. Suppose you have two goods, ice cream and Kraft Macaroni and cheese (an inferior good to most people). Show graphically what happens when 1) the price of the ice cream decreases and 2) your income increases. 2. A gardener states that for only $1 in seeds, she s been able to grow over $20 in produce an enormous profit. Do you agree or disagree with her? Explain. 3 a) Filene s Basement, a local Boston discount department store, sells a wide selection of household goods and clothing. The manager of household linens is facing an oversupply of queen size sheets and must decide whether or not to put them on sale during the month of November. While reading the Boston Globe over coffee this past Sunday, she saw that Mattress Discounters, a local mattress shop located down the street from Filenes, is having a gigantic sale on its queen size mattresses starting this weekend and continuing throughout the month. Explain in words what effect, if any, this should have on her decision about a sale on sheets. 3b) We know that the cross price elasticity of mattress prices on sheet demand is 1.5. According to the advertisement for the mattress sale, the store is reducing the price on its queen size mattress from $400 to $360. A quick phone call to the manager of Mattress Discounters reveals that last week they sold 50 mattresses at $400 per mattress. Filene s currently sells 100 sets of queen size sheets per week at a price of $40 per set. How might the Filene s household linens manager estimate what effect this sale will have on the demand for queen size sheets? Based on your calculations, what will be the effect on the quantity of sheets sold? You should assume that it is possible to buy fractions of sheets or mattresses. 3c) We also know that the price elasticity of supply for sheets is 2.5. Given your answer in part 1b), what will be the new price for queen size sheets sold at Filenes? Use a diagram to help explain your answer. 4a) Senator John Kerry lost the recent presidential election to President George Bush, continuing an era of utter stupidity and dangerous Cowboyism in the highest and most powerful elected office of the United States. Shamed by his inability to win and saddened at the prospect of another four years under this moronic president, Kerry has retreated to Boston. More specifically, he has decided to drink and eat his worries away at the Legal Seafood restaurant located in Kendall Square. Kerry s utility is defined by the following utility function: U(SA, CC) = 10 LN(SA) + 2 LN(CC)
Where SA = pints of Samuel Adams Beer and CC = bowls of Legal Seafood s famous clam chowder. Surveying the remainder of his campaign war chest, Kerry has found that his income for the next week is $100. According to the prices of the Legal Seafood menu, a pint of Samuel Adams Beer costs $4 and a bowl of clam chowder costs $5 (forget about tax and tip). What mixture of pints of Sam Adams beer and bowls of clam chowder will maximize Kerry s utility over the next week, allowing him to forget about his misfortunes (assume he can buy fractions of both pints of beer and bowls of clam chowder)? Illustrate Kerry s utility maximizing consumption decision in a diagram. 4b) The Boston Globe has reported that the brew master at Samuel Adams has resigned his position and moved to Canada to protest the reelection of Bush. Unfortunately for Kerry, this has resulted in a decrease in supply of Samuel Adams beer and a resulting increase in price. Now each pint that he buys at Legal Seafood costs him $8 instead of $4. Calculate his new utility maximizing consumption decision. Using a diagram, show how this change in events modifies the utility maximizing consumption choice of Kerry, assuming that the price of clam chowder and his income has not changed. 5. Rice, which is an important agricultural products for both the US and other countries, has different demand and supply curves in different areas because of the difference of technology, location, weather, etc. Now assuming that the supply and demand curves in the US rice industry are: Supply of Rice in the US (Unit: 10 6 pounds) Qs = 0.3* P Demand of Rice in the US (Unit: 10 6 pounds) Qd = 2 0.5P As we can calculate from these two curves, the equilibrium price in domestic market of the US will be $2.5/pound. 5a). In 2003, the price of the world rice market is $1.5. Assuming that there is no tariff, show the equilibrium of rice market in the US. a. Draw the supply and demand curve in the US domestic rice market. b. Calculate the consumer surplus and producer surplus in the market above. 5b). In Jan. 2004, the US government got through a federal law issuing a tariff of rice of $0.5/pound. a. Draw the new supply and demand curve in the graph you have drawn in 1). Recalculate the consumer surplus and producer surplus. Compare the sum of CS and PS here with that in 1), explain why there is some difference between them, if any. 6. Beans are the main agricultural product of Sarasota, a small city in Florida, and the planting bean is very common in this city. For a typical bean farm, the minimized average cost can be realized at the production of 400 pounds at the price of $1.6. 1). Draw the graphs of both the individual firm and the whole industry for bean in Sarasota.
6a). In September 2004, a professor in the Department of Agricultural Sciences at Florida University announced that he found a technology which can lower the minimized average cost to $1.3 at the production of 1300 pounds. Assume that all the farmers planting beans will accept this technology. a. In the long run, analyze in details, as much as you can, whether or not this technology will make the farmers better off or worse off, and also explain the reason for your conclusion. b. Now assume that the price elasticity of the demand curve of bean in the local market is 4, which is very inelastic; re-think your answer to a. Will your answer be the same? Explain why. 7. According to the Mayor of one of the largest cities in the East, the market demand for heroin is highly inelastic. The heroin supply is believed to be controlled by one Mafia family, which like all Mafia families, is interested in maximizing profits. Does this make economic sense? Why or why not? 8. One firm has the entire market for Halloween masks that look like Richard Nixon. It produces at average and marginal costs of AC=MC=10. Originally, the firm faces a market demand curve of Q= 60-P. a) Calculate the profit-maximizing price and quantity combination for the firm. What are the firm s profits? b) Assume that the market demand curve becomes steeper and is given by Q= 45 -.5P. What is the firm s profit-maximizing price and quantity now? What are the firm s profits? c) Say the market demand curve becomes flatter and is given by Q =100-2P. What is the firm s profit-maximizing price-quantity now? d) Graph the three different situations and explain why there is no supply curve for a monopoly. 9. The XYZ drug company is considering investing in research that would lead to a cost-saving innovation in its production of a special rabies vaccine. Assuming the firm can keep this innovation solely for its own use, will the increased profits from the lower marginal costs be greater if the firm is in a competitive market or if it is a monopoly? Explain your answer in a graph (ignore AC curves) and with words.
ANSWERS 1. Inferior Good Price of other good decreases Income increases Inferior Good 2. The gardener is not taking into account the opportunity costs that go into growing the produce. She needs to take into account her our time even though she is not being paid a wage. 3a) Because queen size mattresses and queen size sheets are complement goods and the mattress seller is having a sale (which will result in an increased quantity of mattresses purchased), the household linens manager should expect to sell more sheets holding her price constant. Therefore, she may be able to reduce her stock of sheets without reducing the price. 3b) Answer Cross Price Elasticy of P M on D S = -1.5 Sheets
Cross Price Elasticy of P M on D S = -1.5 = [(Q2 100) / 100] / [(360 400) / 400] -1.5 = [(Q2 100) / 100] / [-0.1] 0.15 = [(Q2 100) / 100] 15 = (Q2 100) 115 = Q2 Therefore, the quantity of queen size sheets sold will increase from 100 sets to 115 sets. 3c) Answer: Price elasticity of supply for sheets = 2.5 = [(115 100) / 100] / [(P2 40) / 40] 2.5 = [1.5] / [(P2 40) / 40] [(2.5P2 100) / 40] = 1.5 (2.5P2 100) = 60 2.5P2 = 160 P2 = 64 P2 P1 Q1 Q2 As the above diagram of the demand and supply of queen size sheets at Filene s shows, the sale on mattresses caused an increase in demand for sheets (these goods are complements). From part 1b), we know that the quantity demanded increased from 100 (Q1) sets to 115 (Q2) sets. Using the price elasticity of supply for sheets, we calculated that the price of a set of sheets increased from $40 (P1) to $64 (P2). 4a) Answer: Solve for MU SA and MU CC : du/dsa = 10/SA du/dcc = 2/CC Slope of utility function = -(10/SA) / (2/CC) Budget Constraint: 100 = 5(CC) + 4(SA) Slope of budget constraint = -P SA /P CC = -4/5
Setting the slopes equal: -4/5 = -(10/SA) / (2/CC) -8/CC = -50/SA -8(SA) = -50(CC) SA = (50/8)CC SA = 6.25CC Substituting into the budget constraint equation: 100 = 5(CC) + 4(6.25CC) 100 = 5(CC) + 25(CC) 100 = 30CC 3.33 = CC 100 = 5(3.33) + 4(SA) 100 = 16.67 + 4(SA) 83.33 = 4(SA) 20.83 = SA CC 20 3.33 20.83 25 SA 4 b) Answer: New slope of budget constraint = -(8/5) Setting the slope of the budget constraint and the indifference curve equal: -(8/5) = -[(10/SA) / (2/CC)] -(16/CC) = -(50/SA) -16SA = -50CC SA = 3.13CC Substituting into the budget constraint:
100 = 8(3.13CC) + 5(CC) 100 = 29CC 3.45 = CC 100 = 8SA + 5(3.45) 100 = 8SA + 17.24 82.76 = 8SA 10.34 = SA CC 20 5. 1) 3.45 10.34 12.5 SA P CS = 0.5*2.5*1.25 = 1.56 2.5 1.5 Q PS = 0.5*1.5*0.45 = 0.34 Note: Green line stands for the supply curve, while the read stands for demand.
2) P CS = 0.5*2*1 = 1 2 1.5 Tariff DWL Q PS = 0.5*2*0.6 = 0.6 In 1), CS + PS = 1.90 In 2), CS + PS = 1.60 Loss = -0.3 Tariff Revenue = 0.4* 0.5 = 0.2 So DWL = -0.3+0.2 = - 0.1, which is the area sum of the two little triangles shown in the graph above. P 6. 1). 1.6 400 Q Q* Q
2). The better-off aspect for the farmers: in the short run, they can make some economic profit; however, in the long run, the economic profit will be 0 again. The worse-off aspect: to realize the new equilibrium, each farmer needs to produce 500 pounds more, which, most probably, cannot be absorbed by the demand of the industrial market, thus pushing a lot of farmers out of this market. When assuming E(d) = -4, meaning with 18.75% decrease on price, the demand will increase by 75%; however, to realize the lower price, each farmer need to produce 125% more (from 400 to 900). Thus, there will some farmers quit this market. My answer in a) will be the same. 7. No, because a profit-maximizing monopoly would never produce on the inelastic portion of the demand curve. 8. Answer: a) MR = 60-2Q; set MR=MC; 10= 60 2Q; Q = 25; P = 35; Profits are equal to Total Revenues Total Costs = 25*35 25*10 = 625 b) MR = 90 4Q; MC = MR, 10= 90 4Q; Q = 20, P = 50; Profits equal 20* 50 20*10 = 800. c) MR = 50-Q; 10= 50-Q, Q=40, P=30; profits = 40*30 40*10 = 800 Graphs (see page 579 of the text book): Explanation: The supply curve for a monopoly is the single point on the demand curve that corresponds to profit maximization. Any attempt to connect equilibrium points on the market demand curve has little meaning and creates a strange shape because as the demand curve shifts, its elasticity (and it s MR curve) often changes. 9. Answer: If one draws MC curves pre and post innovation as well as the Marginal Revenue line for a monopoly and the MR in a competitive situation (where MR = P), one can see that in the competitive situation, the potential profits are greater for the firm(see page 581 of the textbook). This suggests that in a competitive market, firms are more likely to adopt innovative techniques, which is a classic argument against monopolies..