MSU EC 201 Problem Sets, Exams, Key concepts
MSU EC 201 Problem Sets, Exams, Key concepts EC 201
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Professor C.L. Ballard Fall Semester, 2015 ECONOMICS 201 KEY CONCEPTS FROM THE MIDDLE PART OF THE COURSE I. Elasticity A. The ownprice elasticity of demand is our measure of the responsiveness of quantity demanded for a good to changes in the current price of the good. An analogous measure is used for the elasticity of supply. The own price elasticity of demand is defined as the proportionate change in quantity demanded, divided by the proportionate change in price. We get the same results if we define the ownprice elasticity of demand as the percentage change in quantity demanded, divided by the percentage change in price. In this course, our convention is to drop the minus sign, so that the demand elasticity is positive when the Law of Demand is obeyed. Another convention is to use the average, or midpoint, of the beginning and ending prices as our measure of the reference level of price, and to use the average or midpoint quantity demanded as our measure of the reference level of quantity demanded. B. A vertical demand curve is perfectly inelastic, and has elasticity of zero. A horizontal demand curve is perfectly elastic, and has elasticity of infinity. Along a downwardsloping, straightline demand curve, the elasticity decreases as we go down from left to right. C. In an elastic portion of a demand curve, the elasticity exceeds one. Total revenue for the sellers of a good is equal to the price received by the sellers, multiplied by quantity: TR = (P)(Q). If demand is elastic, total revenue for the sellers will increase as price decreases. This is because, when the price falls and demand is elastic, the increase in quantity demanded is sufficiently large that it will outweigh the price decrease. Similarly, if demand is elastic, total revenue will fall when price rises. D. In an inelastic portion of a demand curve, the elasticity is less than one. If demand is inelastic, total revenue for the sellers will fall as price falls. This is because, when the price falls and demand is inelastic, the increase in quantity demanded is relatively small, and is not large enough to outweigh the price decrease. Similarly, if demand is inelastic, total revenue will increase when price increases. E. When demand is unit elastic, the elasticity is exactly one, and total revenue will not change when price changes. This is because, when the elasticity is one, the percentage change in price is exactly equal to the percentage change in quantity demanded. Thus, any change in price is exactly offset by a change in quantity demanded, and the total revenue will remain unchanged. F. All else equal, demand tends to be more elastic (i.e., the ownprice elasticity of demand tends to be larger) if it is easy to substitute away from a good when its price changes. Also, all else equal, demand tends to be more elastic if consumers are given a longer period of time over which to adjust to changes in price. Finally, all else equal, demand tends to be more elastic if the item is a relatively large share of the consumer’s expenditure. G. The income elasticity of demand measures the responsiveness of demand to changes in the incomes of buyers. Whereas the ownprice elasticity of demand refers to movements along an existing demand curve, the income elasticity of demand refers to shifts in the demand curve caused by changes in income. The income elasticity is the percentage change in demand, divided by the percentage change in income. The income elasticity is positive for normal goods and negative for inferior goods. 1 H. The crossprice elasticity of demand measures the responsiveness of demand for one good to changes in the price of a different good. Whereas the ownprice elasticity of demand refers to movements along an existing demand curve, the crossprice elasticity of demand refers to shifts in the demand curve caused by changes in the prices of other goods. The crossprice elasticity is the percentage change in demand for one good, divided by the percentage change in the price of another good. The crossprice elasticity is negative for complements and positive for substitutes. When the crossprice elasticity of demand is zero, we say that the two goods are “independent in demand”. I. The (ownprice) elasticity of supply is the percentage change in quantity supplied, divided by the percentage change in the price. When the Law of Supply is obeyed, the supply elasticity will be a positive number. However, the Law of Supply is not always obeyed. In the case of something that cannot be reproduced (such as a rare painting), the supply curve is vertical. In this case, the supply elasticity is zero, and we say that supply is perfectly inelastic. If the supply curve is horizontal, supply is perfect elastic. For many goods, the supply elasticity will be larger when sellers are given a longer time period over which to adjust their behavior. In other words, as we give suppliers more time to adjust, they may be able to respond more to a change in price. II. Consumer Behavior A. On several occasions in this part of the course, we will use certain relationships between marginal, average, and total quantities or values. Two important examples of marginal values are marginal revenue and marginal cost. Marginal revenue is the extra amount of money that the firm receives, when it sells one additional unit of output. Marginal cost is the extra amount of cost the first incurs, when it produces one additional unit of output. For any quantity or value, when marginal is greater than average, average will increase. When marginal is equal to average, average will stay the same. When marginal is less than average, average will decrease. For any quantity or value, total is what we get when we add up all of the marginals. If we reverse this, we find that marginal is the change in total from adding one additional unit. B. Total utility is the maximum amount that a consumer is willing to pay for a particular quantity of some item. Marginal utility is the extra amount of money that the individual is willing to pay, in order to consume one additional unit. Thus marginal utility is the change in total utility, when quantity increases by one unit. We assume that consumers have diminishing marginal utility, which means that their marginal utility will decrease when the quantity of their consumption of a good increases. C. For now, we assume that the individual consumer is too small to affect the market price. Therefore, the individual consumer takes the market price as given. (Later in the course, we will consider the case in which buyers have some ability to manipulate the price to their advantage.) The consumer will maximize satisfaction by choosing the quantity at which marginal utility is equal to price. In this case, the individual demand curve is given by the marginal utility curve. D. Total expenditure is the total amount that buyers pay for a particular quantity of some item. Total expenditure is equal to the price paid by the buyers, multiplied by the quantity: TE = (P)(Q). If there are no taxes, the buyers’ price will be the same as the sellers’ price, so that total revenue for the sellers is equal to total expenditure by the buyers. If there are taxes, total expenditure by the buyers will be larger than the total revenue of the sellers. 2 E. Another way to describe the consumer’s optimal purchase decision is to say that the consumer maximizes the difference between (i) the total amount that he/she is willing to pay, and (ii) the total amount that he/she actually has to pay. In other words, when the consumer chooses to buy and consume the quantity at which marginal utility is equal to price, this is the same as the quantity at which (total utility minus total expenditure) is greatest. Consumer surplus is the difference between (i) the maximum amount that the consumer is willing to pay, and (ii) the amount actually paid. In other word, consumer surplus is the difference between total utility and total expenditure. Thus we now have three ways to characterize the consumer’s optimal choice: (a) it is the quantity at which consumer surplus is maximized, and (b) it is the quantity at which the difference between total utility and total expenditure is maximized, and (c) it is the quantity at which marginal utility is equal to price. F. Graphically, consumer surplus is the area under the demand curve but above the price line. If price rises (for example, because of a leftward shift in the supply curve, or because of a government price control, or an import quota, or a tariff), consumer surplus will decrease. If price falls, consumer surplus will increase. The change in consumer surplus is our dollar measure of the harm to consumers from a price increase, or the benefit to consumers from a price decrease. III. Production, Cost, and Profit Maximization A. As the level of output changes, fixed inputs remain the same. Fixed costs are the costs associated with fixed inputs. Thus, the total amount of fixed cost is constant, regardless of the level of output. In particular, the firm’s fixed costs are the same when output is zero as when any positive amount of output is produced. Variable inputs are the inputs that must be increased, in order to increase the level of output. Variable costs are the costs associated with variable inputs. The short run is a period of time that is short enough that at least one input is fixed. In the long run, all inputs are variable. B. The law of diminishing returns or the law of diminishing marginal product states that, if we increase one variable input while holding all other inputs constant, the additional increases in output will eventually get smaller. C. Total cost is equal to the sum of total fixed cost and total variable cost: TC = TFC + TVC. D. Average variable cost (i.e., variable cost per unit) is equal to total variable cost divided by the quantity of output: AVC = TVC/Q. Average fixed cost (i.e., fixed cost per unit) is equal to total fixed cost divided by the quantity of output: AFC = TFC/Q. Average fixed cost always decreases as the quantity increases. Average total cost (i.e., total cost per unit) is equal to total cost divided by the quantity of output: ATC = TC/Q. Another way to calculate average total cost is to add average variable cost and average fixed cost: ATC = AVC + AFC. E. We often observe Ushaped shortrun averagetotalcost curves. The downwardsloping portion of the averagetotalcost curve results from the fact that the fixed costs are spread over an increasingly large output. (In other words, AFC is decreasing.) However, average total costs eventually rise, as the production process encounters coordination difficulties and diminishing marginal product sets in. In the short run, when there is at least one fixed input, marginal cost eventually has to increase, as the production process is constrained by the fixed input. 3 F. When average total cost is decreasing, marginal cost is below average total cost. To put it in another way, if marginal cost is less than average total cost, it will pull average total cost down to a lower level. When average total cost is increasing, marginal cost is above average total cost. And, when average total cost is at its minimum, marginal cost is equal to average total cost. Also, when average variable cost is at its minimum, marginal cost is equal to average variable cost. G. In the long run, all inputs are variable. If we increase all inputs by the same percentage, and output increases by that same percentage, we say that the production process is characterized by constant returns to scale. If we increase all inputs by the same percentage, and output increases by more than that percentage, we say that the production process is characterized by increasing returns to scale (also called economies of scale). If we increase all inputs by the same percentage, and output increases by less than that percentage, we say that the production process is characterized by decreasing returns to scale (also called diseconomies of scale). H. The longrun averagetotalcost curve is constructed by putting together the shortrun ATC curves, for various scales of operations. In the case of constant returns to scale, the longrun averagetotalcost curve is horizontal. For increasing returns to scale, the longrun averagetotalcost curve is downward sloping (i.e., longrun average costs are decreasing). In the case of decreasing returns to scale, the longrun averagetotal cost curve is upward sloping (i.e., longrun average total costs are increasing). I. We define economic profits to be net of the opportunity cost of being in business, which includes the "normal" rate of return on investment. In other words, economic costs are defined to include not only explicit, outofpocket costs, but also the opportunity cost of being in business. These opportunity costs include the opportunity cost of the business manager’s time (he/she could do something else) as well as the opportunity cost of the business manager’s money invested in the firm (he/she could invest in something else.) Thus, economic costs are greater than accounting costs, and economic profits are less than accounting profits. J. We assume that the firm seeks to maximize profits. Profits are given by the difference between total revenue and total cost: Profit = TR TC. Profits will be maximized when this difference is greatest, which will occur when marginal revenue is equal to marginal cost. The quantity at which MR = MC will be the quantity at which profits are maximized. This is true for any profitmaximizing firm, regardless of its market structure. Earlier, we saw that there are three ways to characterize the consumer’s optimal choice. Now we see that there are also three ways to characterized the business firm’s optimal choice: (a) The firm chooses to produce and sell the quantity at which profit is maximized, and (b) the firm chooses to produce and sell the quantity at which the difference between total revenue and total cost is maximized, and (c) the firm chooses to produce and sell the quantity at which marginal revenue is equal to marginal cost. IV. Perfect Competition A. Perfect competition is characterized by the presence of many sellers, each of which is small relative to the market, and each of which produces a homogeneous, undifferentiated product. As a result, the sellers behave as price takers; i.e., the perfectly competitive firm takes the market price as given. This means that the firm faces a perfectly elastic demand curve for its product (that is, a horizontal demand curve), where price = average revenue = marginal revenue. Free entry into the industry and free exit from the industry are also characteristics of perfectly competitive markets. B. Some of the best examples of perfect competition are in agriculture. Many agricultural markets have a very 4 large number of farmers. In many agricultural markets, the output of one farmer is virtually identical to the output of another farmer. And many agricultural markets also have free entry and exit. C. All firms maximize profits by producing the quantity at which marginal revenue is equal to marginal cost. Since price is equal to marginal revenue for the perfectly competitive firm, the profitmaximizing level of output for a perfectly competitive firm will also be the quantity at which price is equal to marginal cost. This means that the supply curve of a perfectly competitive firm is the same as the firm’s marginalcost curve, as long as the firm produces anything at all. Below, we will discuss the conditions under which the firm will go out of business, and produce a quantity of zero. D. Profit per unit is equal to revenue per unit minus cost per unit. (In other words, Profit/Q = TR/Q – TC/Q.) Revenue per unit is TR/Q, but TR = (P)(Q). Thus revenue per unit, or average revenue, is equal to (P)(Q)/Q, which means that average revenue is equal to price. Cost per unit (TC/Q) is called average total cost. Therefore, profit per unit, or average profit, is equal to price minus average total cost. E. Profit is equal to profit per unit, multiplied by the number of units. Therefore, since profit per unit is equal to (P – ATC), profit is equal to (P ATC)(Q). Thus, profit is positive when price is greater than average total cost. Profit is zero when price is equal to average total cost. Profit is negative when price is less than average total cost. F. If, at the profitmaximizing level of output, price is greater than average total cost, the firm will be making positive economic profit. Because there is free entry into a perfectly competitive market, new firms will enter the industry when the existing firms are earning positive economic profits. The new firms will increase the market supply. As a result of the increased supply, the market price will fall until the economic profits are eliminated. G. If the firm is suffering economic losses in the short run, it will not necessarily go out of business immediately. This is because, if the firm shuts down, it must still pay its fixed costs. In other words, the fixed costs cannot be avoided, even by shutting down. Thus fixed costs are not relevant to the decision about whether to shut down. It turns out that the firm should shut down in the short run if total revenue is less than total variable cost: Shut down if TR<TVC. If we divide both sides of this inequality by the quantity of output, we have TR/Q < TVC/Q. We have seen that TR/Q = P, and TVC/Q = AVC. Thus another way to characterize the firm’s shortrun shutdown decision is that the firm should shut down in the short run if price is less than average variable cost: Shut down if P<AVC. If the firm cannot even cover its variable costs (let alone its fixed costs), it should shut down. H. Thus, the firm's shortrun supply curve in a perfectly competitive industry will be its marginalcost curve for prices that are equal to or greater than average variable cost (AVC). For prices below AVC, the firm's quantity supplied will be zero. The market supply curve is derived by summing horizontally the supply curves of the individual perfectly competitive firms. I. As pointed out above, firms that are suffering economic losses may not go out of business immediately. However, if the profit picture does not improve, some firms will eventually shut down. When firms go out of business, the market supply will be decreased. As a result of the decrease in supply, the market price will rise until the firms are once again earning zero economic profits. Thus, regardless of whether we begin with positive economic profits or negative economic profits, the tendency of a perfectly competitive market is toward 5 zero economic profit. When the firms are maximizing profit and earning zero economic profit, P=MC=ATC, implying that average total costs are minimized. In the long run, the same competitive forces will lead firms to minimize longrun average total cost, as well as shortrun average total cost. V. Monopoly A. A monopolistic market has only a single firm. (We also consider "near monopolies", in which there are more than one firm, but in which one firm has a very dominant position. Thus, Microsoft Corporation is not literally the only firm in the market for personalcomputer operating systems, but Microsoft controls such a large portion of the market that it is appropriate to analyze Microsoft as if it were a monopoly.) If the firm is able to earn positive economic profits, this situation can only be sustained if there are barriers to entry. These include legal restrictions, such as patents or exclusive franchise arrangements. Cost advantages can also be a barrier to entry: If average total costs are continually decreasing, then a single firm can produce at lower average total cost than could any combination of two or more firms. In this case, we say that the industry is a natural monopoly. However, in reality, natural monopolies are probably rare. B. Another characteristic of monopolistic markets is that the monopolist’s output cannot have close substitutes. Thus, for example, Kellogg's is the only producer of a product known as Kellogg's Corn Flakes, but many other products are fairly close substitutes for Kellogg's Corn Flakes. Thus, it wouldn't be appropriate to think of Kellogg's as a monopolist in the market for Kellogg's Corn Flakes. Instead, it is better to think of Kellogg's as one of several firms in the market for breakfast cereal. C. Here are some examples of monopoly: Patents give monopoly power, which is especially important for pharmaceutical companies. (Of course, the monopoly power of a pharmaceutical company can be eroded if other companies produce drugs that are similar.) Most professional sports franchises have local monopolies. Electricpower utilities are often set up as local monopolies, although there is controversy about whether these companies are natural monopolies. D. Since the monopolist is the only firm in the market, it "owns" the downwardsloping market demand curve. This means that the monopolist is not a price taker. Instead, we say that the monopolist is a price maker—the firm will manipulate the price in order to increase its profits. Another way to say this is that the firm has market power. Since the demand curve for the firm’s output is downward sloping, and since the demand curve is the same as the averagerevenue curve, we have a downwardsloping averagerevenue curve. By the usual relationships between marginal values and average values, a downwardsloping averagerevenue curve means that the marginalrevenue curve is below the averagerevenue curve. In the case of a downwardsloping demand curve that is a straight line, the marginalrevenue curve will be exactly twice as steep as the demand curve. E. When demand is elastic, marginal revenue is positive. When demand is inelastic, marginal revenue is negative. When demand is unit elastic, marginal revenue is zero. F. To maximize profit, the monopolist chooses the quantity at which MR = MC, and then charges the price given by the demand curve at the profitmaximizing quantity. Since MC is positive, it must be that MR is also positive at the profitmaximizing quantity. Marginal revenue is positive when demand is elastic. Therefore, the profitmaximizing monopoly firm will always produce a quantity that is in the elastic region of its demand curve. (In the inelastic region of the demand curve facing a monopolist, the firm can always increase its profits 6 by reducing quantity and increasing price. If the firm can increase its profits by changing its quantity, then the firm is not maximizing profits at its current quantity.) G. Because of barriers to entry, the monopoly may be able to make positive economic profits for a long time. This is different from the situation in a perfectly competitive industry, where positive economic profits will lead to the entry of new firms, and the economic profits will be competed away. H. The price charged by a monopoly will be greater than marginal cost. In a perfectly competitive market, P=MC and P=MU, which implies that MU=MC, which is a condition for efficiency for society as a whole. This will not occur in a monopolistic setting. The monopolist will usually make positive economic profits, and may not produce at minimum average total cost. Consumers will have less consumer surplus with a monopoly than they would have if the industry were perfectly competitive. The loss of consumer surplus is greater than the monopoly profit. The difference between the consumers' loss and the monopoly profit is called the deadweight loss of monopoly. The deadweight loss is the amount by which society is worse off, when an industry is organized as a monopoly instead of in a competitive fashion. I. For a monopolist, the relationship between price and quantity supplied will depend on the shape of the demand curve and the MR curve. Thus, the monopolist does not have a unique, welldefined supply curve. VI. Price Discrimination A. Price discrimination involves charging different prices to different customers for the same good or service. Monopolies may practice price discrimination. Other firms may do so, as well, including firms in industries that are monopolistically competitive or oligopolistic. However, by definition, perfectly competitive firms may not practice price discrimination, since they have no control over price. B. One example of price discrimination is the practice by which passenger airlines charge more to a customer who does not stay over a Saturday night than to a passenger who does stay over a Saturday night. Other examples include store coupons and discounts for Senior citizens. C. Price discrimination will increase the firm's profits if it involves higher prices for customers with less elastic demand, and lower prices for customers with more elastic demand. Thus, to engage in price discrimination in a way that increases profits, firms must have some mechanism for distinguishing customers with less elastic demand from customers with more elastic demand. D. Finally, price discrimination requires that it must be difficult or impossible for buyers to resell the product to other buyers. VII. Monopolistic Competition A. Monopolistically competitive markets have many sellers, each of which is small relative to the market. Monopolistically competitive markets are also characterized by free entry and exit. Thus, if we only consider these two characteristics, monopolistic competition is the same as perfect competition. B. The difference between monopolistic competition and perfect competition is that monopolistically competitive firms have some market power, because of product differentiation. Consequently, each firm faces a 7 downwardsloping demand curve for its product. However, it is unlikely that the individual monopolistically competitive firm will have a large amount of market power. This is because the other firms in the market will produce goods that are fairly close substitutes. Thus, it will not usually be possible for one firm's prices to be dramatically higher than the prices of its competitors. Although the monopolistically competitive firm will not lose all of its customers if it raises its prices, the demand for the output of the individual firm is still likely to be quite elastic. C. Some of the best examples of monopolistic competition are in retailing, where product differentiation arises because of differences in location, perceived quality of product, or perceived quality of service. D. Because of free entry into the industry, the tendency of a monopolistically competitive market is toward zero economic profit. Thus, in this respect, monopolistic competition and perfect competition are the same: In either of these market structures, there is free entry and exit. In any industry that has free entry and exit, the tendency will be toward zero economic profit. E. Monopolistically competitive firms will not produce at minimum average total cost. This is sometimes called excess capacity. The industry will have too many small firms, relative to the level that would minimize average total cost. However, the firms will usually not produce at an ATC that is much greater than the minimum ATC. Moreover, even though the firms may be small, they provide a lot of variety, which is valuable to society. VIII. Oligopoly A. Oligopolistic industries have a small number of sellers, each of which acts strategically, because it knows that it is large enough relative to the market to have an effect on the market price. (In other words, oligopolistic firms have market power. In some cases, they have a substantial amount of market power.) B. Many of the best examples of oligopoly are in manufacturing. These include the automobile industry, the commercialaircraft manufacturing industry, the breakfastcereal industry, and many others. C. Oligopolists sometimes try to form into cartels, which are collusive arrangements under which the firms cooperate with each other, instead of competing with each other. If a cartel is to succeed in boosting the profits of the firms, it will restrict the quantity of output in the industry, and increase price. The ultimate goal of the firms in a cartel is to behave as a “shared monopoly”. In a shared monopoly, the firms will produce the monopoly profit, sell at the monopoly price, and divide the profits among themselves. D. Fortunately for consumers, but unfortunately for oligopolists, cartels are often unstable. This is because it is in each firm's interest to try to sell more by secretly offering price reductions. Also, cartels are illegal in the United States and in Europe. E. Game theory has been used to analyze the interactions among oligopolistic firms. In an oligopolistic setting, the players in a game are the oligopoly firms. In the case of oligopoly, a game is a description of the rules faced by the firms, the strategies undertaken by the firms, and the payoffs (profits or losses) received by the firms. A payoff matrix shows the relationship between strategies and payoffs. 8 F. A wellknown game is the "Prisoners' Dilemma". In the original context that gives the Prisoners’ Dilemma its name, there are circumstances under which both prisoners will confess to the crime. In its application to oligopoly, the outcome of the Prisoners' Dilemma game is that there are circumstances under which both firms will cheat on their cartel agreement, and the cartel will break down. IX. The Michigan Economy A. In the middle decades of the 20 century, the manufacturing sector was booming. This was very good for Michigan’s economy, which was heavily concentrated in manufacturing. However, manufacturing’s share of the economy has been decreasing for half a century or more. In Michigan, the percentage of the economy in manufacturing decreased from about 49 percent in 1965 to about 19 percent in 2014. This has created a long period of very difficult adjustment for Michigan. The first decade of the 21 century was especially difficult. From its peak in the spring of 2000 until it bottomed out in early 2010, total employment in Michigan decreased by about 18 percent, and manufacturing employment was cut in half. Employment increased in 2010 and in every year since then, but it is still below its level in 2000 by more than 400,000 jobs. B. Despite these troubles, and despite the fact that there are poor people in Michigan, the overall Michigan economy is not poor. Personal income is about $40,000 per person, which is twice as large as in the mid1960s, and seven times as high as at the depths of the Great Depression, even after we adjust for inflation. C. The distribution of income has become much more unequal since about 1975. In particular, the earnings of collegeeducated workers have grown, while the earnings of those with only a highschool diploma and high school dropouts have been stagnant or even falling. As a result, the bottom half of the income distribution in Michigan has had very little income growth since the mid1970s, while the upper part of the income distribution has seen very substantial income growth. This trend has also occurred in most other states. D. Michigan lags behind the national average in the percentage of the labor force with a college education. Partly as a result of this, during this period when collegeeducated workers have done relatively well, percapita incomes in Michigan have fallen relative to the national average. In the 1950s, 1960s, and 1970s, average incomes in Michigan were usually above the national average. Since then, however, average incomes in Michigan have been below the national average in most years. In recent years, average incomes in Michigan have been about 12 or 13 percent below the national average. E. Despite the growing importance of education, the Michigan legislature has chosen to make large cuts to education funding, especially highereducation funding. As a result, tuition has increased very rapidly. F. Michigan has never been among the states with the highest levels of taxation. However, state and local taxes in Michigan were a slightly larger percentage of the state’s economy than the national average in the 1970s and 1980s. In recent years, however, the percentage of the economy that goes to state and local taxes in Michigan has been about the same as, or a bit lower than, the national average. And this has occurred at a time when the national average has fallen substantially. Thus the percentage of the economy that goes to state and local taxes has decreased very substantially in Michigan. Translated into dollar terms, the reduction is the equivalent of 9 about $8 billion per year. G. The shrinkage of tax revenue is only partly due to reductions in tax rates. Instead, the reduction in tax revenue is largely due to the fact that all of the major sources of tax revenue in Michigan have structural deficiencies. As a result of these, the percentage of the economy that is subject to tax has decreased over time. A major example of this is that the sales tax does not apply to most services and entertainments. Since services and entertainments have been growing more rapidly than the rest of the economy, this means that the sales tax applies to an evershrinking portion of the economy. 10 Professor C.L. Ballard Fall Semester, 2015 Economics 201 First Examination Answers and Discussion for FORM A 1. Currently, the quantity of zlatis demanded is greater than the quantity of zlatis supplied. This means that a. there is a shortage in the market for zlatis. b. there is a surplus in the market for zlatis. c. the market for zlatis is in equilibrium. d. there will be pressure for the price to decrease. e. (b) and (d). Answer: a. When the quantity demanded is greater than the quantity supplied, we say there is a shortage. This will create pressure for the price to increase. 2. There is an increase in the price of good L. Good L and good M are complements. What (if anything) will happen in the market for good M? a. The supply curve for good M will shift to the right. b. The supply curve for good M will shift to the left. c. The demand curve for good M will shift to the right. d. The demand curve for good M will shift to the left. e. None of the above: The increase in the price of good L will have no effect on good M. Answer: d. When we discussed complements in class, we used examples such as hot dogs and mustard, or peanut butter and jelly, or coffee and cream. These are goods that tend to be used together; we would say that the two goods complement each other. In any case, if two goods are complements, an increase in the price of one good will lead to a leftward shift in the demand curve for the other good. Similarly, if two goods are complements, a decrease in the price of one good will lead to a rightward shift in the demand curve for the other good. 3. Which of the following would push the productionpossibilities frontier inward? a. An increase in the amount of available resources that are wasted. b. A decrease in the size of the labor force, as a result of a plague. c. A deterioration in technology of production, when many factories are destroyed in an earthquake. d. All of the above: (a), (b), and (c) would all push the p.p.f. inward. e. Only (b) and (c) would push the p.p.f. inward. Answer: e. A decrease in the size of the labor force would truly reduce the productive capacity of the economy, and we would represent it as pushing the p.p.f. inward toward the origin. The 1 same can be said for a deterioration of technology. However, an increase in waste would not be represented as pushing the p.p.f. inward. An increase in waste is represented by a movement to a point below the frontier, or further below the frontier. 4. Janet and Margaret are both capable of producing good A and good B. Janet’s opportunity cost of one additional unit of good A is 3 units of good B. Margaret’s opportunity cost of one additional unit of good A is 1 unit of good B. Based on this information, which of the following statements is/are true? a. Janet has comparative advantage in production of good A. b. We have not been given enough information to determine comparative advantage. c. Margaret has comparative advantage in production of good A. d. Janet should specialize in production of good A, and Margaret should specialize in production of good B. e. (a) and (d). Answer: c. A person or a country has comparative advantage in a particular activity when it has lower opportunity cost. Margaret’s opportunity cost of one additional unit of good A is one unit of good B. (In other words, to get an extra unit of A, Margaret has to give up one unit of B.) Janet’s opportunity cost of one additional unit of A is three units of B. Thus Margaret has lower opportunity cost of A, which means that she has comparative advantage in A. This means that efficiency would be enhanced if Margaret were to specialize in production of A, and Janet were to specialize in production of B. 5. Which of the following characteristics does an import quota have in common with a voluntary export restraint? a. Both are direct restrictions on the quantity of internationally traded goods (whereas a tariff is a price mechanism). b. Both do harm to the producers in the exporting country. c. Both do harm to the producers in the importing country. d. Both bring in revenue for the government of the importing country. e. (a) and (b). Answer: a. Of the three restrictions on international trade that we discussed in class, the tariff is the only one that operates as a price mechanism. (A tariff raises the price of imports, and the quantity of imports adjusts to a different equilibrium.) An import quota and a VER are both direct restrictions on the quantity of trade. Thus choice (a) is correct. A quota harms the exporters, but a VER may help them, so that choices (b) and (e) are incorrect. Both help the producers in the importing country, so choice (c) is also incorrect. A tariff raises revenue for the government of the importing country, but neither a quota nor a VER raises government revenue, so choice (d) is also incorrect. 6. The elasticity of demand for zoozoos is 1.5. Due to a government price control, the price of zoozoos increases by 10%. What will happen to the quantity demanded? a. Quantity demanded will decrease by 1.5%. b. Quantity demanded will decrease by 6.667%. c. Quantity demanded will decrease by 10%. 2 d. Quantity demanded will decrease by 11.5%. e. Quantity demanded will decrease by 15%. Answer: e. The ownprice elasticity of demand is the percentage change in quantity demanded, divided by the percentage change in price: e = %∆Q /%∆P. dWe are given that e=1.5 and %∆P=10. If we insert these two pieces of information into the elasticity equation, we have 1.5 = %∆Q /10. If we multiply both sides of this equation by 10, we have (1.5)(10) = %∆Q . d d Thus %∆Q = d5: if the elasticity is 1.5 and if price increases by 10%, the quantity demanded will decrease by 15%. 7. The equilibrium price of plastic spoons is $2 per package. A priceceiling law says that it is illegal to buy or sell plastic spoons for more than $1 per package. Assuming that the law is enforced, what effect(s) will the price ceiling have? a. The price ceiling will lead to a shortage. b. The price ceiling will lead to a surplus. c. The price ceiling will have no effect. d. The quantity that is actually bought and sold will be less than it would have been if there had not been a price ceiling. e. (a) and (d). Answer: e. If the price ceiling were equal to or greater than the equilibrium price, the equilibrium would be legal, and the ceiling law would have no effect. In this question, however, the ceiling is below the equilibrium. Thus the equilibrium is illegal. Since the law is enforced, it will not be possible for the market to find its way to equilibrium. Buyers will move downward and to the right along their existing demand curve, and sellers will move downward and the left along their existing supply curve. Thus quantity demanded will be greater than quantity supplied, which means that we have a shortage, so that choice (a) is correct, and choices (b) and (c) are incorrect. Even though the quantity demanded is now larger than the equilibrium quantity, it does not follow that there has been an increase in the quantity that is actually bought and sold. To have a transaction, it is necessary to have both a buyer and a seller. In this case, the quantity that is actually bought and sold is given by the supply curve. The quantity supplied is less than the original equilibrium quantity, which means that the quantity bought and sold will be less than it would have been if there had not been a price ceiling. Thus choice (d) is correct. 8. The supply of hip waders increases (i.e., the supply curve for hip waders shifts to the right). As a result, what will happen to the equilibrium price and quantity of hip waders? a. The equilibrium price will rise; the equilibrium quantity will rise. b. The equilibrium price will rise; the equilibrium quantity will fall. c. The equilibrium price will fall; the equilibrium quantity will fall. d. The equilibrium price will fall; the equilibrium quantity will rise. e. All of the above!! Answer: d. An increase in supply will cause the market to move to a new equilibrium. As long as the Law of Demand is obeyed, buyers will move downward and to the right along their existing demand curve. The new equilibrium will have a large equilibrium quantity and a smaller equilibrium price. 3 9. It is useful to have a measure of the responsiveness of quantity demanded to changes in price. Why do economists use the elasticity of demand, instead of the slope of the demand curve? a. Elasticity is easier to calculate than slope. b. Elasticity is easier to pronounce than slope. c. Elasticity is a unitfree measure, whereas slope depends on the units of measurement. d. Elasticity and slope are identical; economists’ preference for elasticity is arbitrary. e. None of the above: There is a reason to prefer elasticity, but it is not listed here. Answer: c. 10. The supply of groolbahs is given by Q = 3P. sThe demand for groolbahs is given by Q d 60 P. What will be the equilibrium price and quantity of groolbahs? a. P = 30, Q = 30. b. P = 20, Q = 10. c. P = 15, Q = 45. d. P = 10, Q = 30. e. P = 60, Q = 15. Answer: c. At the equilibrium, quantity supplied will be equal to quantity demanded: Q = Q . If s d we insert the supply equation and the demand equation into the equilibrium equation, we have 3P = 60 – P. Adding P to both sides of the equation gives us 4P = 60. If we then divide both sides of the equation by 4, we have (4/4)P = 60/4. Thus P = 15. If we insert P = 15 into the supply equation, we have Q = 3(1s = 45. If we insert P = 15 into the demand equation, we have Q d 60 – P = 60 – 15 = 45. Thus quantity demanded and quantity supplied are the same, which confirms that we have found the equilibrium. 11. Which of the following would be expected to shift the supply curve for cellular phones to the right? a. A decrease in the prices of inputs used in production of cellular phones. b. An increase in the price of cellular phones. c. Discovery of a new technology that makes it possible to produce more cellular phones without using more inputs. d. All of the above. e. (a) and (c) only. Answer: e. A decrease in the price of an input leads to a rightward shift in the supply curve, so choice (a) is correct. An improved technology also leads to a rightward shift in the supply curve, so choice (c) is also correct. However, an increase in the price of cellular phones does not shift the supply curve for cellular phones. Instead, an increase in the price will cause a movement upward and to the right along the existing supply curve. 4 12. Which of the following would be included in a good definition of economics? a. Scarcity. b. Statistics on imports and exports. c. How to forecast the unemployment rate. d. How to make money in the stock market. e. How rats and pigeons respond to incentives. Answer: a. 13. There is a decrease in demand for leaky cauldrons. In other words, the demand curve for leaky cauldrons shifts to the left. What will happen to the equilibrium price and quantity of leaky cauldrons as a result? a. The equilibrium price will rise; the equilibrium quantity will rise. b. The equilibrium price will fall; the equilibrium quantity will fall. c. The equilibrium price will rise; the equilibrium quantity will fall. d. The equilibrium price will fall; the equilibrium quantity will rise. e. All of the above! Answer: b. When the demand curve shifts to the left, the market will go to a new equilibrium. As long as the Law of Supply is obeyed, sellers will move downward and to the left along their existing supply curve. The new equilibrium will have a smaller quantity and a lower price. 14. In the productionpossibilities frontier diagram below, point R is Good Y R S Good X a. attainable, but associated with inefficient use of the available resources. b. attainable, and associated with efficient use of the available resources. c. unattainable with the resources that are currently available. d. all of the above. e. none of the above. Answer: c. The production possibilities frontier is a graph of the combinations of outputs that can be produced, if the existing resources are used as efficiently as possible. Thus any point that is up and to the right from the frontier is a point representing a combination of outputs that 5 cannot be produced with the current resources and technology. (It may be possible to produce a combination such as R at some point in the future, if the frontier is pushed outward by improvements in technology, capital investment, or increases in the quantity and quality of the labor force.) 15. Refer to the same diagram that was used in the previous question. Point S is a. attainable, but associated with inefficient use of the available resources. b. attainable, and associated with efficient use of the available resources. c. unattainable with the resources that are currently available. d. All of the above. e. None of the above. Answer: a. As we saw above, the p.p.f. shows the combinations of outputs that can be produced, if the existing resources are used as efficiently as possible. A point like S, which is below and to the left of the frontier, has less of both goods than some points on the frontier. Thus a point like S is associated with inefficiency. 16. We observe an increase in the equilibrium price of paring knives, and a decrease in the equilibrium quantity of paring knives. Which of the following could have caused these changes? a. A rightward shift in the demand curve for paring knives. b. A leftward shift in the demand curve for paring knives. c. A rightward shift in the supply curve for paring knives. d. A leftward shift in the supply curve for paring knives. e. All of the above!!! Remarkably enough, an increase in the equilibrium price and a decrease in the equilibrium quantity are consistent with (a), (b), (c), and (d)!!! Answer: d. If the supply curve shifts to the left, the market will move to a new equilibrium. As long as the Law of Demand is obeyed, the new equilibrium will have a higher price and a lower quantity. 17. Which of the following is true for a tariff, and an import quota, and a voluntary export restraint? (In other words, for a choice to be a correct answer, it must apply to all three kinds of restriction on international trade.) a. The producers in the importing country are helped (i.e., made better off). b. The consumers in the importing country are harmed (i.e., made worse off). c. The producers in the exporting country are harmed (i.e., made worse off). d. All of the above. e. (a) and (b) only. Answer: e. All three types of interference with international trade are helpful to the producers in the importing country, so that choice (a) is correct. All three are harmful to the consumers in the importing country, so that choice (b) is also correct. A tariff and an import quota are both harmful to the exporters, but a VER may help them. Thus choice (c) is incorrect. 6 18. The elasticity of demand for yellow highlighters is 3. The quantity demanded goes down by 15%. Assume that a change in price was the only reason for this change in quantity demanded. What must have happened to the price, in order for quantity demanded to have changed in this way? a. Price was unchanged. b. Price went up by 5%. c. Price went up by 15%. d. Price went up by 18%. e. Price went up by 45%. Answer: b. The ownprice elasticity of demand is the percentage change in quantity demanded, divided by the percentage change in price: e = %∆Q /%∆P.d We are given that e=3 and %∆Q =1d. If we insert these two pieces of information into the elasticity equation, we have 3 = 15/%∆P. If we multiply both sides of the equation by %∆P, we have (3)(%∆P) = 15. If we then divide both sides of the equation by 3, we have %∆P = 15/3 = 5. If the elasticity is 3 and quantity demanded goes down by 15%, and if the decrease in quantity demanded is caused by a change in price, the price must have gone up by 5%. 19. The slope of the production possibilities frontier is a. zero. b. the opportunity cost of the good on the horizontal axis. c. the opportunity cost of the good on the vertical axis. d. the negative of the opportunity cost of the good on the horizontal axis. e. the negative of the opportunity cost of the good on the vertical axis. Answer: d. The slope of a line is the change in the vertical dimension, divided by the change in the horizontal dimension, as we move from left to right across the graph. This is sometimes expressed by saying that the slope is the rise divided by the run. In the case of a production possibilities frontier, the slope is the number of units by which the good on the vertical axis decreases, divided by the number of units by which the good on the horizontal axis increases. This will be a negative number. We have defined opportunity cost in such a way that it is always a positive number. The opportunity cost of the good on the horizontal axis is the number of units of the good on the vertical axis that are given up, in order to get an additional number of units of the good on the horizontal axis. Thus the slope of the p.p.f. is the negative of the opportunity cost of the good on the horizontal axis. 20. In the past few decades, the proportion of the U.S. economy that is accounted for by imports and exports has a. increased substantially. b. stayed remarkably constant. c. decreased substantially. 7 d. increased substantially, AND stayed remarkably constant, AND decreased substantially, all at the same time. e. not been measured. (Therefore, we do not have enough information to answer the question.) Answer: a. See Figure 5.1 and the discussion around it, on p. 108 of your textbook. 21. As a result of a hurricane, several refineries are damaged, and are temporarily unable to produce gasoline. Thus, it could be said that the technology of producing gasoline has deteriorated. This change could be characterized as a. ?
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