Econ 10: Midterm (Dr. Stein) October 27, 2008 Answer Key Instructions: This is a 90-minute examination. Write all answers in blue books. Show all work. Use diagrams where appropriate and label all diagrams carefully. Do not overwrite! Use the guidelines and suggestions in each question. This exam is given under the rules of Penn's Honor system. No calculators allowed. The Exam has 2 parts. Make sure you answer both parts. Use blue book #1 for Part I. Use blue book #2 for Part II. Write your name and your TA s name on both blue books NOW. 1
Part I Warm up. (4 points each). State whether each statement is True or False. Briefly explain your answer. Do not write a novel: a quick graph or a sentence or two will do! 1. The concept of Opportunity Cost helps us understand why applications to graduate school programs (e.g., MBA & Law programs) are higher this year than in recent years. True. With a poor economy, job prospects and salaries are lower so less is sacrificed by going to school. The OC is lower. Points: 2 for relating slow economy to lower wages 2 for lower O.C. 2. A recession is defined as a prolonged period of economic contraction. Joe says As long as technology is not deteriorating and population is not shrinking we will never have a recession because the production possibilities frontier will not shift in. False. PPF only says what is possible, not what is actually produced. In a recession the US will be producing at a point inside the PPF. Points: Need to explain that a recession is being inside the PPF. 3. The demand for Lattes has a peculiar shape: below $3 a cup it is perfectly inelastic, but above that price it is elastic. In this case, an increase in the price of coffee beans (an input in Lattes) in this market will not effect coffee consumption. False. Coffee beans are, presumably, a variable input so an increase in their price would cause a shift in of the supply and increase in P. If P increases to <$3 then quantity will not change. Otherwise, increase in P will cause a change in Q along the demand curve. 2
For students who clearly assume Coffee Beans are a fixed input and thus explain that the supply will not change full credit. Points: 2 for understanding the shift in of the supply curve. 2 for relating this to change in quantity iff the shift in the supply is large enough. 4. Au Bon Pain sells its bakery product at a half price one hour before it closes. From this we can infer information on the elasticity of demand for its products. Presuming revenue maximization is profit maximization (since goods already baked and cannot be sold in future) then dropping price to increase revenues is consistent with elastic demand. Points: 2 for understanding that we are looking at changes in revenue. 2 for relating this to elastic demand. 3
Q1. (17 points) Aisha and Shalom spend their days working. They can split their time between two tasks: writing software or baking cookies as follows: Software (lines per day) Cookies (per day) Aisha 40 4 Shalom 60 15 a. Draw the separate daily PPFs for Aisha and Shalom with Cookies on the horizontal axis. Label important points. A: Linear PPF (0,40), (4,0) S: Linear PPF (0,60), (15,0) Points: 4 2 for each PPF: 1 for linear, ½ for each intersect. b. Assume there is no trade. Aisha always likes exactly 2 cookies a day. Add her consumption point to your graph above. How many software lines will she write in a day? A spends ½ her time on cookies, so she can make ½*40=20 units software. (2,20) Points: 3 1 for answer, 1 for explanation. 1 for adding on PPF. c. Assume there is no trade. Shalom always likes exactly 20 software lines a day. Add his consumption point to your graph above. How many cookies will he make in a day? (10,20) Points: 3 1 for answer, 1 for explanation. 1 for adding on PPF. d. Aisha suggests to Shalom that they trade among themselves. Shalom says: there is no point in my trading with you because I am better at making both cookies & software. Who is the better economics student? Explain. Aisha is a better economics student as she distinguishes between absolute & comparative advantage. Shalom has an abs adv in both but a comp adv only in C. It is beneficial to Shalom to be able trade cookies for software, so long as the price of cookies is higher than his OC. Points: 3 4
Use of terminology/comparative Advantage etc: 2 Benefits of trade exist: 1 e. To solve their conflict they hire you as a consultant. You suggest a fair price for trading. Show that Aisha can be better off without Shalom being worse off. Assume that Aisha still likes exactly 2 cookies a day. Explain your solution and show Aisha s & Shalom s new consumption points on your graph above. Be careful to show your work! Any price between would be fair. But choose Pc=4 software to make Aisha better off w/o making Shalom worse off. Aisha makes only software and trades 8 software for 2 cookies, leaving her with 32 Software>20 Software from part c. Shalom is no worse off as he makes 12 cookies and 12 software and trades 2 Cookies for 8 Software leaving him at his original consumption point (10,20). Points:4 Choice of price: 2 Aisha s new consumption point: 1 (1 for correct explanation or correct graph) Shalom s new consumption point: 1 (as above) 5
Q2. (17 points) Housing prices have increased significantly this last decade. This question asks you to analyze why this may have happened and forecast if we should have expected this trend to continue. a. Some analysts assume that the supply of land is completely inelastic. Graph the supply and demand in this case. Point out the equilibrium price, the equilibrium quantity, the consumer surplus, and the producer surplus in this case. Vertical supply, downward sloping demand. P, Q, CS, PS as usual. Points: 5 Vertical supply:2 P & Q: 1 (together) CS:1 PS: 1 b. How would population growth affect the market in this case? In particular, what will happen to the equilibrium price & the equilibrium quantity? What happens to producer surplus? Show graphically. Population growth would likely shift out demand causing an increase in price and no change in quantity. PS increases as Q unchanged and P is higher. Points: 4 Shift out of demand: 1 points Q unchanged: 1 point P higher: 1 point PS bigger: 1 point c. Robert Shiller, a Yale economist who specializes in housing markets, says that housing prices have not, over the long run, increased significantly with population growth. What assumption in your graph above must be wrong? The supply is probably not perfectly inelastic (though it could also be that population growth and demand are unrelated though this is unlikely). Points: 2 Elastic supply: 2 points d. Using your answers to parts a & c, how would you evaluate a housing tax in terms of equity & efficiency. Use graphs to explain your answer. 6
Under the assumption of perfectly inelastic demand, a housing tax would lead to a shift in of the demand curve (with producer price on the vertical) and a decrease in the price to producers. Consumers pay the same but producers receive less and pay the entire tax. Efficient because no DWL (MC=MB) but inequitable as producers bear entire burden. If supply is upward sloping, then there would be a DWL created with a tax, but the consumers and producers would divide the tax more equitably. Points: 6 For each case: 1 point for graph, 1 point for efficiency answer, 1 point for reasonable equity analysis. 7
Part II Use blue book #2 for this part. Stretch & relax. (4 points each). State whether each statement is True or False. Briefly explain your answer. Do not write a novel: a quick graph or a sentence or two will do! 1. A rice farmer in a perfectly competitive industry is facing higher land rent and thus higher costs of production. As a result he will reduce the production of rice to achieve profit maximization. False. If rent is a FC then the point where MR=MC is unchanged and the farmer will produce the same quantity in the SR. In the LR the quantity will stay the same as long as indeed he continues to produce in LR. Points: 2 for shift of correct shift of cost curve. Students need to explain WHY they shifted MC if they did so as rent is usually assumed to be a fixed input. 2 for output change (or not) Note: No need for LR & SR discussion to get full credit. One of them is sufficient. 2. Since in the long run, both perfectly competitive market and monopolistic competition make zero profit, they are both efficient. False. Efficiency where MC=MB. Monopoly produces where MR=MC. If MR is below demand then MR<MB and MC<MB, so it is inefficient. Points: Students need to relate definition of efficiency with monopolistically competitive firm s long run output. Acceptable answers include not producing where MC=MB, having dead weight loss and not producing a minimum ATC/having excess capacity. Definition of efficiency: 2 points Relating to this case: 2 3. A gym is a (pure) Public Good. False. A pure public good is both non excludable and non rival. Though a gym is likely to be non-rival, presuming that it is not so crowded that there are not wait times for the machines, it is excludable (through, for example, memberships). Points: For full credit need to give the definition of pure public good using both properties (2 points) and relate to this good (1 point each). 8
4. Mobileye, a world leader in artificial vision capabilities, has developed a camera based system for collision warning, lane departure & headway monitoring. This system is likely to reduce collisions and as such benefits not just the installer of the system but other drivers as well. In this case we expect the market system to provide too little of this good. True. There is a positive externality from the camera. Therefore, SMB>PMB and the market system will provide where PMB=PMC<SMB, an under-provision relative to the efficient quantity. Points: positive externality: 2 points. Explanation that we get under provision: 2 points. An explanation(and/or graph) is necessary for full credit. Q3. (17 points) We are hearing in the news that the credit crunch on Wall Street is sure to affect Main Street. This question asks you to use your knowledge of firms cost and output decisions to explore one area of interaction between the financial and the commercial sectors of the economy. The following graph shows the costs facing Mama P, a typical pizza manufacturer on Main Street: a. The MR curve is the demand curve facing Mama P. What is the elasticity of demand this seller is facing? Why does this suggest that the market is in perfect competition? Completely elastic demand (infinite elasticity). Price taker suggests PC. Points: 3 Completely elastic: 2 9
Price taker (or similar explanation): 1 b. With this demand curve how many pizzas will this firm sell? What are the firm s profits? 20 pizzas where MC=MR Profits= 20*3=60 Points: 4 Quantity: 2 Profits: 2 (1 for result, 1 for explanation) c. There is strong evidence that incomes are due to fall significantly in the next few years. Manufacturers of pizza believe this will cause the market price of pizza to fall. What assumption are they making about the demand for pizza? Draw the market for pizza to explain your answer. Draw regular S & D with equilibrium price of 10. If P falls with falling incomes this means a shift in of D (since S assumed to be unchanged) so Pizza is a normal good. Points: 3 Graph: 1 Normal good: 2 (need to mention that the assumption is that goods are normal) d. If the market price falls to $4 a pizza, how many pizzas will Mama P produce in the short run & the long run. Explain your answers and any assumptions you make graphically. If the firm produces pizzas in the SR they will produce where MC=4 which is 5 pizzas. But note that it is unlikely that P>=min AVC and the firm will likely not produce in the SR. Clearly at a price of $4 there are negative profits which implies q= 0 in LR. Points: 5 SR Q=5 as long as P>=min AVC: 3 (maximum of 1 point if omit condition as it is probably the case here that the firm will indeed choose to shut down and produce zero) LR=zero : 2 e. Mama P says: The economic downturn has cost me my economic profits. If the economy stayed strong so would have my profits. Do you agree with this statement? Explain. 10
In LR under PC economic profits are always zero due to free entry and exit. Points: 2 for understanding that profits would equal zero in either case in LR. Q4. (17 points) When Apple developed the i-phone they were the first and only company with a smartphone that supported web application in a convenient easy to use format. In this question you are asked to graph the cost curves and demand for i-phones. Use a full page for this graph and create it step by step as follows. a. Throughout this question, assume that the marginal cost of producing i-phone is increasing. Is this a reasonable assumption in this case? Explain your answer referring specifically to this product. Graph this MC curve. MC is increasing due to diminishing marginal returns. Jon P. believes that in this case, it seems like marginal cost would be closer to constant because it is just a matter of physical materials cost and assembly cost which we would not expect to be increasing. Andrew C. on the other hand believes that Apple faced significant capacity constraints in the SR and MC was increasing. Both answers are acceptable as long as explanation makes sense. Points: 3 Explanation needs to related MC shape to diminishing marginal returns: 2 points. Graph of MC increasing: 1 point b. Add to your graph a demand curve for i-phones. Why did you draw it the way you did? Downward sloping due to diminishing marginal benefit. Also acceptable: the firm is a price setter. Points: 3 (2 for downward sloping, 1 for explanation) c. Add to your graph the marginal revenue for i-phones. Why did you draw it the way you did? MR curve should be different than D curve (and drawn below D). For a monopolist and increase in Q implies a decrease in P for all units, so the MR is less than the price. Points: 3 (1 for downward sloping, 1 for below demand, 1 for explanation) d. The first i=phones were sold at $499. Show the profit maximizing output & price in your graph. 11
Q* is where MC=MR. P*=499 is the value of the demand at Q*. Points: 2 (1 for quantity marked, 1 for price marked). e. This product generated economic profits for Apple. Suppose the average profit was $100 per phone. Add an average total cost curve to your graph and show the profits generated. ATC should intersect MC at its minimum and this should be below the demand. Profits are the area from the rectangle generated by P*-ATC(Q*) on the vertical and Q* on the horizontal. Points: 4 ATC intersect MC at its minimum: 1 Below demand: 1 Showing profits correctly: 2 f. Recently Google has developed the Android web browsing software that will be used by T-mobile and other providers. This application has similar capabilities to the i-phone. How will this new product affect the graph you drew above? Specifically, state which curves will move and in what direction. No need to graph this. Demand for i-phones will change with the substitute good on the market, as will MR. In particular, Demand will move inward. Points: 2. D & MR shift in: 1 each. Loose 1 point for each shift of cost curves for a minimum grade of zero. End of Exam. Well done. 12