Name Eco200: Practice Test 2 Covering Chapters 10 through 15

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1 Name Eco200: Practice Test 2 Covering Chapters 10 through Four roommates are planning to spend the weekend in their dorm room watching old movies, and they are debating how many to watch. Here is their willingness to pay for each film: Orson Alfred Woody Ingmar First film $7 $5 $3 $2 Second film Third film Fourth film Fifth film a. Within the dorm room is the showing of a movie a public good? Why or why not? b. If it costs $ to rent a video, how many videos should the roommates rent to maximize total surplus? c. If they choose the optimal number from part (b) and then split the cost of renting the videos equally, how much surplus does each person obtain from watching the movies? d. Is there any way to split the cost to ensure that everyone benefits? What practical problems does this solution raise? e. Suppose they agree in advance to choose the efficient number and to split the cost of the videos equally. When Orson is asked his willingness to pay, will he have an incentive to tell the truth? If so, why? If not, what will he be tempted to say? f. What does this example teach you about the optimal provision of public goods? Solution: A Chapter 11 problem a. Within the dorm room, the showing of a movie is a public good. None of the roommates can be excluded from viewing the movie. Because one roommate s viewing does not affect the ability of another roommate to view the movie, the good is also nonrival in consumption. b. The roommates should rent three movies because the value of the fourth film ($6) would be less than the cost ($8). c. The total cost would be $8 3 = $24. If the cost were divided evenly among the roommates, each would pay $6. Orson values three movies at $18 so his surplus would be $12. Alfred values three movies at $12 so his surplus would be $6. Woody values three movies at $6, so his surplus would be $0. Ingmar values three movies at $3 so his surplus is -$3. Total surplus among the three roommates would be $15. d. The costs could be divided up by the roommates based on the benefits they receive. Because Orson values the movies the most, he would pay the greatest share. The problem is that this gives each roommate an incentive to understate the value of the movies to him. e. Because they are going to pay equal shares, Orson has an incentive to tell the truth about the value he places on movies to ensure that the group rents three movies. He values each of the movies more than his cost per movie ($2). f. The optimal provision of public goods will occur if individuals do not have an incentive to hide their valuation of a good. This means that each individual s cost cannot be related to his valuation.

2 2. Each of the following expenditures is a deduction fro the purposes of calculating a person s federal income tax liability: a. Mortgage interest b. State and local taxes c. Charitable contributions If the income tax base were broadened by eliminating these deductions, tax rates could be lowered, while raising the same amount of tax revenue. For each of these deductions, what would you expect the likely effect on taxpayer behavior to be? Discuss the pros and cons of each deduction from the standpoint of efficiency, vertical equity, and horizontal equity. Would you keep or eliminate the deduction? Solution: Chap 12 problem a. If the deduction for mortgage interest were eliminated, fewer people would desire to hold mortgages or purchase homes. This would impact housing markets and housing values. The removal of this deduction will likely improve vertical equity because higher income households tend to hold larger mortgages and thus currently get larger deductions. It would also improve horizontal equity because homeowners would be treated equally. Efficiency would improve for two reasons: less distortion in incentives and a smaller amount of paperwork in filing taxes. b. Omit part b c. If the deduction for charitable contributions were eliminated, fewer dollars would be donated to charities. This would reduce the provision of some public goods (such as public television). Vertical equity would be improved, assuming that charitable contributions are positively related to income. Horizontal equity would also be improved because individuals in similar circumstances would pay the same level of taxes, whether or not they donated to charities.

3 3. You live in a town with 300 adults and 200 children, and you are thinking about putting on a play to entertain your neighbors and make some money. A play has a fixed cost of $2,00, but selling an extra ticket has zero marginal cost. Here are the demand schedules for your two types of customer: Price Adults Children $ a. To maximize profit, what price would you charge for an adult ticket? For a children s ticket? How much profit do you make? b. The city council passes a law prohibiting you from charging different prices to different customers. What price do you set for a ticket now? How much profit do you make? c. Who is worse off because of the law prohibiting price discrimination? Who is better off? (if you can, quantify the changes in welfare.) Solution: Chap 15 problem a. The marginal revenue from selling to each type of consumer is shown in the following tables: Price Quantity of Adult Total Revenue from Sale of Adult Revenue from Sale of Adult

4 Price Quantity of Child Total Revenue from Sale of Child Revenue from Sale of Child a. To maximize profit, you should charge adults $7 and sell 300 tickets. You should charge children $4 and sell 200 tickets. Total revenue will be $2,100 + $800 = $2,900. Because total cost is $2,000, profit will be $900. b. If price discrimination were not allowed, you would want to set a price of $7 for the tickets. You would sell 300 tickets and profit would be $100. c. The children who were willing to pay $4 but will not see the show now that the price is $7 will be worse off. The producer is worse off because profit is lower. There is no one that is better off.

5 4. You are thinking about setting up a lemonade stand. The stand itself costs $200. The ingredients for each cup of lemonade cot $0.50. a. What is your fixed cost of doing business? What is your variable cost per cup? b. Construct a table showing your total cost, average total cost, and marginal cost for output levels varying from 0 to 10 gallons. (Hint: There are 16 cups in a gallon.) Draw the three cost curves. Solution: This problem is straight from the text, p. 286, Q7 (4 th Edition). a. The fixed cost of setting up the lemonade stand is $200. The variable cost per cup is $ Costs Total Cost Average Total Cost Cost Quantity of Lemonade Figure 9 a. The following table shows total cost, average total cost, and marginal cost. These are plotted in Figure 9. Quantity (gallons) Total Cost Average Total Cost 0 $ $208 $ Cost

6 5. Are the following statements true or false? Also, explain why the statements are true or false. a. For a competitive firm, marginal revenue equals the price of the good it sells. (Hint: Use graph or table to explain why this is true of false.) b. In the short run, if the price a firm receives for a good is above its average variable cost but below its average total costs of production, the firm will exit the market. c. In the long run, perfectly competitive firms earn small but positive economic profits. (Hint: You can use a graph to explain why this is true of false.) d. A firm maximized profit when it produces output up to the point where marginal cost equals marginal revenue. Solution: All these questions refer to Chapter 14, firms in competitive markets a. True: P = MR for all competitive firms. The price times the quantity sold (P x Q). Thus, as you sell more quantity the total revenue increases proportional, which means MR will be the same throughout any increase in quantity. Note: If you divide Revenue by 100, which is the number of units, you ll get exact P=MR. Quantity Price Total Revenue (P x Q) Revenue (ΔTR/ΔQ) 100 $ b. False: If the price a firm receives for a good is above its average variable cost but below its average total costs of production, the firm will temporarily shut down. c. False: If there were the opportunity for profit, more companies would enter the market shifting from S 1 to S 2, thus driving down the price of the good. (In the second set of graphs the Demand Curve should be the same as the first group of graphs, sorry Microsoft Word isn t the best as a drawing program). Profit MC ATC S Long-Run Supply D S 1 S 2 d. True: Whether monopoly or competitive firm, either of these markets must set MR = MC to get the maximum profit.

7 6. Two firms, A and B, each currently dump 50 tons of chemicals into the local river. The government has decided to reduce the pollution and from now on will require a pollution permit for each ton of pollution dumped into the river. The government gives each firm 20 pollution permits, which it can either use or sell to the other firm. It costs Firm A $100 for each ton of pollution that it eliminates before it reaches the river, and it costs Firm B $50 for each ton of pollution that it eliminates before it reaches the river. a. Which firm will buy and which company will sell its permit? b. After the two firms buy or sell pollution permits from each other, how much will Firm A dump into the river? c. What is the total cost of reducing pollution if the firms are allowed to buy and sell permits from each other? (Hint: Do not include the cost of obtaining the permit.) d. Government officials are not sure whether to allow the firms to buy or sell the pollution permits to each other. What is the total cost of reducing pollution if firms are not allowed to buy and sell pollution permits from each other? (Hint: Do not include the cost of obtaining the permit.) Solution: Chapter 10, tradable permits a. Firm A will buy all of Firm B's pollution permits with each one costing between $50 and $100. b. Firm A started with dumping 50 tons of chemicals into the local river, but will buy all 20 permits from Firms B, which will leave 10 tons of chemicals. Firm A will then pollute 10 fewer tons of pollution into the river, and Firm B will dump 50 fewer tons of pollution into the river. c. Firm A reducing 10 tons at $100 per ton. 10 x $100 = $1,000 Firm B reducing 50 tons at $50 per ton. 50 x $50 = $2,500 $3,500 d. If the government reduced uniformly, then each company will reduce 30 units each Firm A reducing 30 tons at $100 per ton. 30 x $100 = $3,000 Firm B reducing 30 tons at $50 per ton. 30 x $50 = $1,500 $4,500