Intermediate Micro FINAL

A consumer's utility function is given by: U(x,y) = 4x^.5y^.5 + 100 The consumer's income is I, and the price of good y is P(y). Derive the consumer's demand function for good x. You must show your work.

*In parenthesis means subscript* This problem is similar to other problems you have seen. With the consumer's utility function given by: U(x,y) = 4x^.5y^.5 + 100 we know: MU(x) = 2x^-.5y^.5 MU(y) = 2x^.5y^-.5 Using the fact that the MRS equals the price ratio at optimal bundles, you can use basic algebra to find: y = (P(y)/P(y))x Using the above equation, along with the budget constraint (I = P(x)x + P(y)y) to solve for x yields: x = I/(2P(x))

A competitive firm's total costs for a year are: TC = 16 + Q + Q2 B) Suppose there is unlimited potential entry and exit of firms in the market. Also suppose that all firms, including potential entrants, have costs identical to those given above. What will the market price be in the long run? How much will each firm produce?

AC = TC/Q = 16Q-1 + 1 + Q So dAC/dQ = -16Q-2 + 1 Solve the first-order condition to find the minimum point on AC: -16Q-2 + 1 = 0 => Q = 4 At Q=4, AC = 9 (& MC=9), so in the long run P=9.

A competitive firm's total costs for a year are: TC = 16 + 8Q + Q2 C) Again suppose there is unlimited potential entry and exit of identical firms in the market. If the government imposed a tax of $6 per unit, what would the market price be in the long run? How much will each firm produce?

AC = TC/Q = 16Q-1 + 14 + Q So dAC/dQ = -16Q-2 + 1 Solve the first-order condition to find the minimum point on AC: -16Q-2 + 1 = 0 => Q = 4 At Q=4, AC = 22, so in the long run P=22.

A competitive firm's total costs for a year are: TC = 16 + 4Q + Q2 B) Suppose there is unlimited potential entry and exit of firms in the market. Also suppose that all firms, including potential entrants, have costs identical to those given above. What will the market price be in the long run? How much will each firm produce?

AC = TC/Q = 16Q-1 + 4 + Q So dAC/dQ = -16Q-2 + 1 Solve the first-order condition to find the minimum point on AC: -16Q-2 + 1 = 0 => Q = 4 At Q=4, AC = 12 (& MC=12), so in the long run P=12.

A competitive firm's total costs for a year are: TC = 16 + 6Q + Q2 B) Suppose there is unlimited potential entry and exit of firms in the market. Also suppose that all firms, including potential entrants, have costs identical to those given above. What will the market price be in the long run? How much will each firm produce?

AC = TC/Q = 16Q-1 + 6 + Q So dAC/dQ = -16Q-2 + 1 Solve the first-order condition to find the minimum point on AC: -16Q-2 + 1 = 0 => Q = 4 At Q=4, AC = 14 (& MC=14), so in the long run P=14.

A competitive firm's total costs for a year are: TC = 16 + 8Q + Q2 B) Suppose there is unlimited potential entry and exit of firms in the market. Also suppose that all firms, including potential entrants, have costs identical to those given above. What will the market price be in the long run? How much will each firm produce?

AC = TC/Q = 16Q-1 + 8 + Q So dAC/dQ = -16Q-2 + 1 Solve the first-order condition to find the minimum point on AC: -16Q-2 + 1 = 0 => Q = 4 At Q=4, AC = 16 (& MC=16), so in the long run P=16

The Gabba Gabba Hay Company is a price-taking form with total costs for a year described by: TC=32 + 10Q + 2Q^2 where Q us the quantity of hay. Suppose there is unlimited entry and exit of firms in the hay market. Also suppose that all firms, including potential entrants, have costs identical to those given above. A) What will the market price be in the long run? How much hay will the Gabba Gabba Hay Company be producing in the long run?

AC = TC/Q = 32Q^-1 + 10 + 2Q So dAC/dQ = -32Q^-2 + 2 Solve the first-order condition to find the minimum point on AC: -32Q^-2 + 2 = 0 —-> Q = 4 At Q = 4, AC = 26 (& MC = 26), so in the long run P = 26.

You have been hired to advise a country about economics. The country previously obtained advice from the consulting firm of Noah, Little, & Cheatem. The leaders of the country know that the advice they got from Noah, Little, & Cheatem is not entirely correct, but they do not understand why. Your job is to explain what is wrong with each of the quotations below. Be clear and precise about the fundamental flaws. "After a huge hurricane struck our island, the price gasoline increased, as did the price of transportation that relies on gasoline (e.g., taxi fares increased, the price of shipping goods by truck increased). Imposing a price ceiling on gasoline will surely help decrease the price of transportation that relies on gasoline."

An obvious preliminary point is that, because the price ceiling reduces the quantity 7 of gasoline supplied and increases the quantity of gasoline demanded, there will be a shortage of gasoline.(That is a basic supply-and-demand result.)Turning to the key part of the question (the effect on the price of transportation services), most of the class gave a good answer along the following lines: For those who drive vehicles (including trucks and taxis), the opportunity cost of obtaining gasoline could increase due to the increased effort necessary to find gasoline for sale or due to the increased time spent waiting in line; this would cause a leftward shift in the supply curve for transportation and, hence, a price increase for transportation services. The clearest way to answer this is probably to explain and illustrate a decrease (i.e., leftward shift) in the supply of transportation services. One additional item worth noting here is that the price of transportation services need not increase. If, say, the effect of the price ceiling is that transportation firms pay substantially less money for gasoline, yet only have minor costs of waiting in line(perhaps because non-commercial buyers of gasoline are the ones who account for most of the demanders who would like to buy, but do not get, gasoline at the regulated price), then the supply of transportation services (e.g., taxi rides)could shift to the right, causing a reduction in the price of transportation services.

You have been hired to advise a country about economics. The country previously obtained advice from the consulting firm of Noah, Little, & Cheatem. The leaders of the country know that the advice they got from Noah, Little, & Cheatem is not entirely correct, but they do not understand why. Your job is to explain what is wrong with each of the quotations below. Be clear and precise about the fundamental flaws. A. "Suppose you see two people come out of a store. Also suppose you notice that Person A has a lot of apples and a few bananas, while Person B has a lot of bananas and a few apples. It must be that Person A has a high marginal utility of apples and a low marginal utility of bananas at his bundle, while Person B has a high marginal utility of bananas and a low marginal utility of apples at her bundle."

Because consumers face the same prices (as a result of shopping at the same store) and each buys some of each good, it must be true that MU(apples)/MU(bananas) = P(apples)/P(bananas) for each consumer at his or her optimal bundle. Consequently, the quotation must involve some inconsistency. For example, if Person A has a high marginal utility of apples and a low marginal utility of bananas at his bundle, then it must be that the price of apples is greater than the price of bananas. And, if the price of apples is greater than the price of bananas, then it cannot be true that Person B has a high marginal utility of bananas and a low marginal utility of apples at her bundle.

You have been hired to advise a country about economics. The country previously obtained advice from the consulting firm of Weir, High, & Spacey. The leaders of the country know that the advice they got from Weir, High, & Spacey is not entirely correct, but they do not understand why. Your job is to explain what is wrong with each of the quotations below. Be clear and precise about the fundamental flaws. Suppose you see two people come out of a store. Also suppose you notice that Person 1 has a lot of books and a few pizzas, while Person 2 has a lot of pizzas and a few books. It must be that Person 1 is a bookworm and, therefore, has a high marginal utility of books and a low marginal utility of pizza at her bundle, while person 2 has a high marginal utility of pizza and a low marginal utility of books at her bundle.

Because consumers face the same prices (as a result of shopping at the same store) and each buys some of each good, it must be true that MUpizza/MUbooks = Ppizza/Pbooks for each consumer at his or her optimal bundle. Consequently, the quotation must involve some inconsistency. For example, if Person 1 has a higher marginal utility of books and a low marginal utility of pizza at her bundle, then it must be that the price of books is greater than the price of pizza. And, if the price of books is greater than the price of pizza, then it cannot be true that Person 2 has a high marginal utility of pizza and a low marginal utility of books at her bundle.

You have been hired to provide objective advice to the leaders of an island nation. The country has one beer producer, and the leaders plan to adopt one of two policy proposals. Proposal A would make the beer producer pay a tax of $1 per beer to the government. Proposal B would make the beer producer pay a license fee of $1 million dollars per year to the government. Neither proposal would put the company out of business. A) One politician tells you that she wants to reduce beer consumption. She fears that "either proposal might just encourage the beer producer to increase output in order to cover increased costs. Which proposal would you recommend to her? Explain why - I am looking for a careful answer.

Because the firm is a monopoly, an increase in fixed costs (such as the $1 million dollar per year license fee) will not change the quantity or price of beer as long as the firm remains in business (and the question tells you the firm will stay in business). The $1 per beer tax will, however, increase price and decrease the quantity of beer consumed; to see why, consider the $1 per beer tax as an increase in MC. Good graphs here were very helpful. The politician in Part A would favor the $1 per beer tax. That policy would decrease beer consumption. Neither policy would increase beer consumption.

Alphonso also attends a pancake breakfast. He buys 10 pancakes and 60 sausages. The prices he pays are different from those paid by Frank, because Alphonso lives in a more expensive country: $8 per pancake and $2 per sausage. B) Draw the budget constraint for Alphonso. Label his optimal consumption bundle and show a plausible indifference curve passing through that bundle. Can you determine MU(pancake)/MU(sausage) (i.e., the marginal rate of substitution) for Alphonso at his chosen consumption bundle?

Because you know the price ratio Alphonso faced, you know that: MU(pancake)/MU(sausage) = 4 Again, the figure is quite generic, but be sure to label things correctly: The bundle (as stated in the question) has 10 pancakes and 60 sausages; the budget constraint intercepts are 25 on the pancake axis and 100 on the sausage axis.

Chenille also attends a pancake breakfast. She buys 5 pancakes and 60 sausages. The prices she pays are the same as those paid by Frank: $4 per pancake and $1 per sausage. B) Draw the budget constraint for Chenille. Label her optimal consumption bundle and show a plausible indifference curve passing through that bundle. Can you determine MU(pancake)/MU(sausage) (i.e., the marginal rate of substitution) for Chenille at her chosen consumption bundle?

Because you know the price ratio Chenille faced, you know that: MU(pancake)/MU(sausage) = 4 Again, the figure is quite generic, but be sure to label things correctly: The bundle (as stated in the question) has 5 pancakes and 60 sausages; the budget constraint intercepts are 20 on the pancake axis and 80 on the sausage axis.

Frank attends a pancake breakfast, where he buys 20 pancakes and 40 sausages. The prices he pays are: $4 per pancake and $1 per sausage. A) Draw the budget constraint for Frank. Label his optimal consumption bundle and show a plausible indifference curve passing through that bundle. Can you determine MU(pancake)/MU(sausage) (i.e., the marginal rate of substitution) for Frank at his chosen consumption bundle?

Because you know the price ratio Frank faced, you know that: MU(pancake)/MU(sausage) = 4 The figure is quite generic, but be sure to label things correctly: The bundle (as stated in the question) has 20 pancakes and 40 sausages; the budget constraint intercepts are 30 on the pancake axis and 120 on the sausage axis.

Frank attends a pancake breakfast, where he buys 20 pancakes and 40 sausages. The prices he pays are: $4 per pancake and $1 per sausage. A) Draw the budget constraint for Frank. Label his optimal consumption bundle and show a plausible indifference curve passing through that bundle. Can you determine MU(pancake)/MU(sausage) (i.e., the marginal rate of substitution) for Frank at his chosen consumption bundle?

Because you know the price ratio Frank faced, you know that: MUpancake/MUsausage = 4 The figure is quite generic, but be sure to label things correctly: The bundle (as stated in the question) has 20 pancakes and 40 sausages; the budget constraint intercepts are 30 on the pancake axis and 120 on the sausage axis.

Some basic background: You own a firm in a competitive industry. All firms in your industry are identical, and there are an unlimited number of potential entrants that, if they entered, would have the same costs as the firms in the industry. Firms may also exit; if they do, this will not change the cost curves for the remaining firms. Now suppose that the government is considering one of two policies: Policy I A subsidy of $1000 per firm per year. This would apply to all firms in the industry, including your firm, and including entrants. Policy II A subsidy of $500 per firm per year. This would apply to all firms in the industry (including entrants) except your firm: Your firm would receive a subsidy of $1100 per year (because your aunt is a politician and gets you special treatment). A) Which policy would you prefer? Consider only long run effects, and explain carefully and precisely how you arrive at your answer. If you can determine dollar amounts for how much these policies affect you, provide the dollar amounts.

Considering only long run effects, Policy I would be worth nothing to you (nor would it do you any harm), while Policy II will be worth $600 per year to you. One key point to see is that *Policy I will cause entry*. *More specifically, Policy I will cause the amount of entry that* *decreases the price to the point where you will be indifferent between remaining in business and* *exiting - in other words, leaving you no better or worse off than you were before the subsidy was* *put in place. The other key point to see is that Policy II also causes entry and,* *thus, decreases the* *price of your output. More specifically, Policy II will cause entry to the point* *where firms* *receiving the $500 subsidy will be indifferent between remaining in business* *and exiting;* because you will receive an $1100 subsidy, Policy II will generate for you a benefit of $600. Note: The important comparison for evaluating the desirability of Policy II is the following: With Policy II, you would be $600 per year better off than you would be in the absence of Policy II. That, rather than the mere fact that Policy II treats other firms in a less favorable manner than it treats you, is why you would want Policy II. This is a very important point. Put another way: Some policies (or other things) could do more harm to other firms than to you, but that need not imply that you desire such a policy.

Some basic background: You own a firm in a competitive industry. All firms in your industry are identical, and there are an unlimited number of potential entrants that, if they entered, would have the same costs as the firms in the industry. Firms may also exit; if they do, this will not change the cost curves for the remaining firms. Now suppose that the government is considering one of two policies: Policy I A subsidy of $500 per firm per year. This would apply to all firms in the industry, including your firm, and including entrants. Policy II A tax of $500 per firm per year. This would apply to all firms in the industry except your firm: Your firm would pay a tax of $200 per year (because your aunt is a politician and gets you special treatment). A) Which policy would you prefer? Consider only long run effects, and explain carefully and precisely how you arrive at your answer. If you can determine dollar amounts for how much these policies affect you, provide the dollar amounts.

Considering only long run effects, Policy I would have no effect on you, while Policy II will be worth $300 per year to you. One key point to see is that Policy I causes entry and Policy II causes exit. More specifically, Policy I will cause the amount of entry that decreases the price to the point where you will be indifferent between remaining in business and exiting - in other words, leaving you at zero profits and no better off than you were before the subsidy was put in place. Policy II causes exit and, thus, increases the price of your output. More specifically, Policy II will cause exit to the point where firms paying the $500 tax will be indifferent between remaining in business and exiting (i.e., at zero profits). Because you will pay a smaller tax (compared to the other, zero-profit firms), the policy will leave you better off (than you would be without Policy II) by $300 per year.

The Gabba Gabba Hay Company is a price-taking form with total costs for a year described by: TC=32 + 10Q + 2Q^2 where Q us the quantity of hay. Suppose there is unlimited entry and exit of firms in the hay market. Also suppose that all firms, including potential entrants, have costs identical to those given above. C) Considering only long run effects, how much will the policy in Part B matter to hay producers? Explain how you know.

Considering only long run effects, the policy in Part B does not matter to firms. Profits will be zero in the long run, with or without the subsidy. Because the question assumes identical firms, with new entrants having the same costs as the original firms, rents to inputs will also be unaffected. Note that the answer here is consistent with a simple supply and demand analysis of a per unit subsidy in a market with perfectly elastic supply.

You have been asked by a judge to testify as an expert witness on the effects of tax policy. Your job is to provide objective analysis. Sue Fordeau owns Chateau Fordeau Vineyards, an old family business that makes wine, which is just like all the other wine produced by thousands of other similar firms. Sue recently discovered that her grandparents had a contract with the government guaranteeing that all wine produced by their vineyard would be untaxed. Last year the tax on wine production was $1 per bottle, and Chateau Fordeau produced 10,000 bottles of wine. The government has agreed to refund $10,000 to Sue. A group of consumers who bought Sue's wine is lobbying for some of the $10,000 refund. The group claims that part of the tax was paid by consumers of Sue's wine. In contrast, Sue claims that $10,000 is not enough to compensate her for the amount she was made worse off due to taxation last year. Use your knowledge of economic theory to evaluate these claims.

First consider why it matters that Sue makes wine that is just like all the other wine produced by thousands of other similar firms. That means Sue is a price taker. Therefore, she can assume that consumers will pay the same amount for her wine regardless of how much she produces and regardless of whether or not she is required to pay taxes. This tells you that Sue was made worse off by at least $10,000 last year. (Note that because Sue's tax exemption does not eliminate the tax for other producers, you cannot legitimately do your analysis by assuming the tax is eliminated from the entire market.) Why would Sue have been made worse off by more than $10,000? To answer that, consider the following question: If Sue had known in advance that she would be exempt from taxes, how many bottles of wine would she have produced last year? With a standard, upward- sloping MC curve, the answer is more than 10,000 bottles (because 10,000 bottles will be less than the profit maximizing quantity). Hence, the benefits of the tax exemption to Sue are the $10,000 in taxes not paid plus the additional gain she will obtain on the additional bottles that she will produce due to the tax exemption. What do you know about whether Sue's exemption would leave consumers better off? First, it is clear consumers will pay the same price for Sue's wine as for other wine. So, it would not be reasonable to argue that it was the particular consumers who bought Sue's wine that bore the burden of the tax on Sue's wine. Second, if the market supply of wine is perfectly elastic, then consumers would bear the full burden of the tax on the entire market, but they will gain none of the long run benefits of Sue's tax exemption because the after-tax market price paid by consumers will be the untaxed price (determined by the minimum point on firms' AC curves) plus the tax. Third, if the market supply is upward sloping, then whatever reduction occurred in the market price (resulting from Sue's long run increased output) would benefit all wine consumers (not just those who buy Sue's wine), and it would benefit them through only a very, very small amount per bottle.

The Gabba Gabba Hay Company is a price-taking form with total costs for a year described by: TC=32 + 10Q + 2Q^2 where Q us the quantity of hay. Suppose there is unlimited entry and exit of firms in the hay market. Also suppose that all firms, including potential entrants, have costs identical to those given above. D) A policy analyst makes this following statement: The policy discussed in Part B won't do much good for producers because it reduces marginal cost, and we all know that marginal equals price for competitive firms. Therefore, to help hay producers we should just pay a fixed number of dollars to each producer that has output greater than zero. If, for example, we pay each producer $10 per year, then they will each benefit $10 per year. Explain precisely what is wrong with the logic in that statement.

Focusing on long run effects, it is true that the policy in Part B will not do much good for firms: The policy will induce an amount of entry sufficient to cause the price to fall so that firms earn zero profits. The quotation is incorrect, however, because it ignores the fact that paying firms $10 per year (or some other amount) will also cause entry until economic profits return to zero. It is true that the payment will leave MC unaffected and that firms produce a quantity such that P=MC, but price falls because the reduction in average cost induces entry. As some students noted, if the government made a $10 payment to just some (but not all) of the firms in the market, the payment would indeed be worth $10 to those firms that received it.

In the United States and other countries, there has been much public discussion of implementing programs that guarantee a minimum income. (The Swiss voters considered a quite large program.) On that theme, consider the following. B) Assuming leisure is a normal good and using your graph from Part A, how would you expect hours worked to be affected by the policy described in Part A? (That is: Would you expect an increase or a decrease in hours worked?) Explain carefully. (Hint: Income and substitution effects are highly relevant.)

For Part B, the logic is identical to that on the handout: Both the income effect and the substitution effect work in the direction of more leisure (equivalently: less work); use your graph to explain why.

Some basic background: You own a firm in a competitive industry. All firms in your industry are identical, and there are an unlimited number of potential entrants that, if they entered, would have the same costs as the firms in the industry. Firms may also exit; if they do, this will not change the cost curves for the remaining firms. Now suppose that the government is considering one of two policies: Policy I A subsidy of $500 per firm per year. This would apply to all firms in the industry, including your firm, and including entrants. Policy II A tax of $500 per firm per year. This would apply to all firms in the industry except your firm: Your firm would pay a tax of $200 per year (because your aunt is a politician and gets you special treatment). C) If instead of the conditions described above, Policy I applied only to incumbent firms (i.e., new entrants are not eligible for the subsidy), which policy would you prefer: Policy I applied to incumbent firms or Policy II? Explain. Again, if you can determine dollar amounts for the difference in how much these policies affect you, provide the dollar amounts. (You can assume market demand does not shift.)

For this question, Policy I is equivalent to a reduction in fixed costs with no entry (because entrants would not receive the subsidy). That implies that the policy causes no change in P or Q. You gain $500 with Policy I, compared to $300 with Policy II. Hence, you prefer Policy I to Policy II (by an amount $200 per year).

Can you determine whether Frank would have greater or lesser utility at Chenille's bundle than at his own bundle? Explain.

Frank prefers his bundle to Chenille's bundle. If you look at Frank's budget constraint, you'll see that Chenille's bundle is located inside Frank's budget constraint. Frank must therefore prefer his own bundle because he could have bought, but did not buy, Chenille's bundle instead of his own bundle (and after buying Chenille's bundle, Frank would have had $20 leftover to buy more pancakes and sausage). Similarly, and be sure that you understand this (otherwise you may miss the logic of Part D), you can see that the indifference curve Frank reaches at his bundle cannot pass below his budget constraint and, therefore, cannot pass below Chenille's bundle.

You have been hired to advise a country about economics. The country previously obtained advice from the consulting firm of Weir, High, & Spacey. The leaders of the country know that the advice they got from Weir, High, & Spacey is not entirely correct, but they do not understand why. Your job is to explain what is wrong with each of the quotations below. Be clear and precise about the fundamental flaws. Suppose you have a friend who consumes only pizza and books. Also suppose that you know that he would buy more pizza and fewer books if you gave him more money per month. If you want to make your friend happier, but you don't want to reduce his book consumption, the solution is simple: just give him a few books each month.

From the information about what your friend would do if you gave him more money, you can determine that pizza is a normal good and books are an inferior good. Unless you prohibited your friend from selling the books you gave him and you gave your friend a sufficient number of books that he would want to sell them if he could, giving your friend a few books will cause a pure income effect and, therefore, increase consumption of normal goods (pizza) and decrease consumption of inferior goods (books). Not that the key point of this question is not whether your friend can sell the books you give him. Suppose your friend is buying 10 books per month initially, then you undertake a policy of each month giving him 5 books that he cannot sell. Your policy will decrease the number of books he buys by more than 5 books if books are inferior.

This summer you visit some countries that have recently implemented policies to tax and/or regulate firms that sell food. B) Country B has many firms that produce organic broccoli. After realizing that eating nothing but organic broccoli could lead to poor health, the president implemented a new policy that requires each organic broccoli producer to pay an annual license fee in order to remain in business. How would you expect this policy to affect the price that consumers pay for organic broccoli and the quantity of broccoli purchased? Would this policy lead to larger or smaller firms (i.e., a greater or smaller quantity of organic broccoli per firm) in the organic broccoli industry? Explain how you arrive at your answers.

In contrast to the case of monopoly in Part A, imposing a license fee in a competitive market will cause P to increase: an increase in FC will cause the profits of at least some firms to become negative, causing some firms to exit; this exit will shift short run supply left and increase prices, continuing until profits return to zero. Firms will be larger because P increases and MC does not shift. Note that consumers will bear at least some of the burden of a license fee in a competitive market, but consumers may not bear the full burden: if long run S is upward sloping, rents to producers (more specifically, the owners of inputs) will fall as a result of the license fee.

Some basic background: You own a firm in a competitive industry. All firms in your industry are identical, and there are an unlimited number of potential entrants that, if they entered, would have the same costs as the firms in the industry. Firms may also exit; if they do, this will not change the cost curves for the remaining firms. Now suppose that the government is considering one of two policies: Policy I A subsidy of $1000 per firm per year. This would apply to all firms in the industry, including your firm, and including entrants. Policy II A subsidy of $500 per firm per year. This would apply to all firms in the industry (including entrants) except your firm: Your firm would receive a subsidy of $1100 per year (because your aunt is a politician and gets you special treatment). C) If instead of the conditions described above, Policy I applied only to incumbent firms (i.e., new entrants are not eligible for the subsidy), which policy would you prefer: Policy I applied to incumbent firms or Policy II as originally specified? Explain. Again, if you can determine dollar amounts for the difference in how much these policies affect you, provide the dollar amounts. (You can assume market demand does not shift.)

In the absence of entry, you will prefer Policy I to Policy II. Because Policy I does not shift MC curves, the market output (and firm-level output) will not change, thus keeping the price the same as without any policy. With the price the same and MC not shifting, Policy I will be worth $1000 for each incumbent firm, including your firm.

You have been hired to advise a country about economics. The country previously obtained advice from the consulting firm of Noah, Little, & Cheatem. The leaders of the country know that the advice they got from Noah, Little, & Cheatem is not entirely correct, but they do not understand why. Your job is to explain what is wrong with each of the quotations below. Be clear and precise about the fundamental flaws. "Consider the standard model of a consumer who buys two goods: good x and good y. If reducing the price of good x has no effect on the amount of y consumed, then it must be that giving the consumer cash would also have no effect on the amount of y consumed. You know that because reducing the price of x makes the consumer better off and thus creates an income effect, yet the consumer does not buy more y when the price of x falls."

In the standard two-good case described, if the price of x does not affect the quantity of y consumed, then good y has a zero cross-price elasticity with good x (i.e., the elasticity relating the price of x to the quantity of y is zero), but good y has a positive income elasticity(i.e., good y is a normal good). How do you know that good y has a positive income elasticity? When the price of x falls, that creates a substitution effect toward less consumption of y. Since the net effect is no change in the quantity of y, the income effect must be in the direction of more y consumed in order to exactly offset the substitution effect. That direction of the income effect indicates a positive income elasticity; in other words, an increase in income would increase the amount of y consumed.

Evaluate the reasoning in the following statement: Consider a competitive market with identical firms and unlimited entry and exit (i.e., a generic constant cost industry). If the government establishes a combination policy that (i) charges firms for an annual license fee and (ii) pays firms a per unit subsidy for the good they produce, it may turn out that the government collects just as much in license fees as it spends on the subsidy. If so, the policy simply doesn't matter for anyone. Give a precise answer here. For full credit, a good graph is highly recommended.

It is true that the combination policy may have no effect on government revenue (i.e., the license fee revenue may exactly offset the per unit subsidy), but if this is the case, consumers will be made worse off, because the price they pay will increase. To see why, note that the license fee will push the price up, while the per unit subsidy will push the price down. First consider a preliminary point related to the question you had seen earlier. (I will discuss this here because many students looked at the question this way, yet some students went astray when doing so.) If the effects of the two policies on prices were to offset each other exactly from the consumer's perspective, the combination policy would cost the government money, even though neither consumers nor producers would benefit. The reason for this is that the combination policy will cause firms to be inefficiently too large. (The per unit subsidy pushes MC and AC down, and the license fee pushes AC up.) At the firm's new level of output, the true cost of production (i.e., resources used) higher that it was at the old level of output. Because the firm earns zero profit and has higher costs per unit, it must be that the government is paying the AC-P. In other words, the license fee does not raise enough revenue to fund the per unit subsidy. Now consider the question on this exam. Following the same style of analysis described above, if the government's license fee revenue exactly offsets the government expenditure on the per unit subsidy, the government is not paying enough to keep the price unchanged: Thus, the consumers will pay a higher price with the combo policy than with no policy. Again, recall that the DWL comes about because firms are operating at a Q above the efficient scale (that it, at a Q above where the original AC curve bottoms out).

A competitive firm's total costs for a year are: TC = 16 + Q + Q2 A) If the market price were $11, what quantity would this firm produce? How much would the firm's profits be?

MC = 1 + 2Q Setting MC = P yields: 1 + 2Q = 11 => Q = 5 & Profit = 9

A competitive firm's total costs for a year are: TC = 16 + 4Q + Q2 A) If the market price were $14, what quantity would this firm produce? How much would the firm's profits be?

MC = 4 + 2Q Setting MC = P yields: 4 + 2Q = 14 => Q = 5 & Profit = 9

A competitive firm's total costs for a year are: TC = 16 + 6Q + Q2 A) If the market price were $16, what quantity would this firm produce? How much would the firm's profits be?

MC = 6 + 2Q Setting MC = P yields: 6 + 2Q = 16 => Q = 5 & Profit = 9

A competitive firm's total costs for a year are: TC = 16 + 8Q + Q2 A) If the market price were $18, what quantity would this firm produce? How much would the firm's profits be?

MC = 8 + 2Q Setting MC = P yields: 8 + 2Q = 18 => Q = 5 & Profit = 9

This summer you visit a country where burritos are produced by many price-taking firms in a constant cost industry. You notice the following: To add 2 tablespoons of guacamole to a burrito, the customers must pay an extra dollar. (There is nothing complicated here: The customer-pays the regular price of the no—guacamole burrito plus a dollar.) Given this pricing structure, 25% of burritos are purchased with 2 tablespoons of guacamole added, and the other 75% are purchased without guacamole. You meet a politician who is "mad as hell that guacamole costs extra" — and he tells you that he is proposing a law that will stop "abusive pricing practices" in the burrito industry. More specifically, he tells you the following: I am proposing a "Guacamole Mandate" that will require all burrito sellers to provide tablespoons of guacamole — free of additional charge — to any burrito-buying customer who requests guacamole on his or her burrito. Given my calculations, this will increase the price of a burrito by 25 cents over the current no-guacamole price, because guacamole costs $1 and only 25% of burritos are currently sold with guacamole. Evaluate the politician's economic analysis. Do you believe his prediction about the effects of the Guacamole Mandate on burrito prices? Explain carefully why or why not. Also, do you expect the Guacamole Mandate will cause a deadwaight loss? Again, explain why or why not.

My real-world inspiration for this question comes from various type of regulafions, including the "Contraceptive Mandate" recently in the news. You had some flexibility in how you answered this, but some simple analytical tools (namely, supply and demand) could get you full credit. Here are some key points. First, recall that the assumptions in the question imply zero profits for firms — and, moreover, that the industry is constant cost. Thus, the new price of a burrito will necessary be higher than the old non—guacamole burrito (otherwise profits would be negative). And if some consumers choose non-guacamole burritos even when the Guacamole Mandate is in effect, the new price of a burrito will be less than the old with-guacamole burrito price. Among consumers who previously did not buy burritos or previously bought non guacamole burritos, some will choose under the Mandate to buy burritos with guacamole, and no one who previously bought a burrito with guacamole will be leaving the market. Thus, it is clear that with the Mandate in effect, more than 25% of burritos will have guacamole. This, in turn, implies that the new price will be morethan 25 cents higher than the old non-guacamole burrito price. There is more than one factor leading to a DWL here. One factor is that some people will be consuming guacamole even though their willingness-to-pay is less than the MC ($1) for guacamole. Another is that some people who are willing to pay more than the MC of a non—guacamole burrito, (i.e. more than the old price) will not consume burritos, because of the price increase.

Given that cotton is an essential input for making cotton t-shirts, the imposition of a generic price ceiling in the cotton market will necessarily lead to a reduction in the price of cotton t-shirts." [A graph is highly recommended here.]

Note that this question involves the same concept illustrated in the old exam question about a price ceiling on hot fudge. One good answer (given by most of the class): Because the price ceiling reduces the quantity of cotton supplied, there will be less cotton for making cotton t-shirts and, hence, fewer cotton t-shirts produced. With fewer cotton t-shirts produced, the price of cotton t-shirts must rise (due to movement along the demand curve). Many students also explained that, for t-shirt manufacturers, the opportunity cost of obtaining cotton could increase due to the increased effort necessary to find cotton for sale or time spent waiting in line; this would cause a leftward shift in the supply curve for cotton t-shirts and, hence, a price increase for cotton t-shirts. The clearest way to answer this is probably to explain and illustrate a decrease (i.e., leftward shift) in the supply of cotton t-shirts. One additional item worth noting here is that the price of cotton t-shirts need not increase. If, say, the effect of the price ceiling is that cotton t-shirt manufacturers pay substantially less money for cotton, yet only have to wait in a short line (perhaps because non-commercial buyers of cotton are the ones who account for most of the demanders who would like to buy, but do not get, cotton at the regulated price), then the supply of cotton t-shirts could shift to the right, causing a reduction in the price of cotton t-shirts.

Some basic background: You own a pizza parlor in a competitive industry. All firms in your industry are identical, and there are an unlimited number of potential entrants that, if they entered, would have the same costs as the firms in the industry. Firms may also exit; if they do, this will not change the cost curves for the remaining firms. Now suppose that the government is considering one of two policies: Policy I A subsidy of $1000 per firm per year. This would apply to all firms in the industry, including your firm, and including entrants. Policy II A subsidy of $500 per firm per year. This would apply to all firms in the industry (including entrants) except your firm: Your firm would receive a subsidy of $800 per year (because your aunt is a politician and gets you special treatment). D. If the policy were to create increase pizza consumption, which policy (Policy I or II) would be more effective? (Again, consider the long run.) Explain how you know.

Once again, a good graph illustrates this very well. Indeed, all you need is movement along the demand curve when the long run market supply shifts. Policy I leads to a lower price (than would Policy II), which in turn leads to a higher quantity demanded (than would Policy II). Hence, Policy I is more effective for increasing pizza consumption.

You have been hired to advise the leaders of a country. The leaders previously obtained various kinds of economic advice from the consulting firm of Weir, High, and Spacey. The leaders of the country know that the advice they got from Weir, High, and Spacey is not entirely correct, but they do not understand why. Your job is to explain what is wrong with each of the quotations below. Be clear and precise about the fundamental flaws. B. "Suppose you observe that new technology (e.g., better machinery) increases crop yields on farms. If the widespread adoption of that new technology causes a reduction in the price of crops and an increase in the price of farmland, that means that the technology will negatively affect farmers."

One key factor to consider is that the price of land increased; almost all students mentioned why that mattered. Note that if the new technology causes, say, higher yields with less labor, the adoption of the technology could generate an increase in rents to farmland (consistent with the price of farmland increasing) and increase overall market output (reducing crop prices). As many students pointed out, if the price of farmland increases, that allows farmers who own land to exit with more wealth than if the price of farmland had not increased. Thus, farmers who exit will benefit from the technological advances. In addition to that point, it is worth noting that, even for those who do not exit, the higher price of farmland indicates higher rents (e.g., think along the lines of revenue from crops minus costs of labor); that makes owning land more valuable and explains why buyers are willing to pay more for the land.

Can you determine whether Chenille would have greater or lesser utility at Frank's bundle than at her own bundle? Explain.

Preliminary note: The most common way to go astray in this question (also in Part C, but more so here) was to skip the process of applying consumer theory. Many students did not bother to use indifference curves and budget constraints, and almost all those students came to the wrong conclusion.From the information in the question, you cannot determine whether Chenille would prefer her bundle to Frank's bundle. (A good answer will prove that.) To see why, try drawing two possible indifference curves tangent to Chenille's budget constraint at her chosen bundle: draw one curve so that it passes above Frank's bundle, and draw the other curve so it passes below Frank's bundle. You can do this with standard indifference curves.The most common error: Not addressing the question of whether Chenille would prefer Frank's bundle, but instead stating that Chenille would prefer Frank's budget constraint (which she would, of course).

Suppose that a wealthy graduate of an engineering school has decided to donate some of her wealth to build a new high-tech ice cream stand on campus. The high-tech ice cream stand will cost $1,000,000 to build, but after it's built, the marginal cost and the average cost of ice cream cones will be 25 cents. The donor will be paying for building the stand, but she does not want to pay for the ice cream. She is considering two different pricing systems for ice cream. One option is to sell ice cream club cards, which entitle the buyer of the card to all-you-can-eat ice cream for one month; she has determined that if she offers those cards for $25, every student will choose to but a card each month and eat 100 ice cream cones each month. The other option is to sell ice cream cones for 25 cents each. If the donor's goal is to maximize students' consumer surplus, which of the two options would you advise her to choose? Explain why. A good graph will probably be very useful.

Selling cones at 25 cents each will maximize consumer surplus. With either pricing scheme, consumers get all the surplus, so it makes sense that maximizing total surplus (i.e., selling the efficient quality) will maximize consumer surplus, while creating a deadweight loss graphically, draw a generic demand curve hitting the quantity axis at Q=100, then draw a horizontal price line at 25 cents, with generic consumer surplus for the standard pricing scheme of 25 cents. Now, by how much would consumer surplus fall if the standard 25 sent price were replaced by the club cards: by the amount of the deadweight loss created. To see why, notice that because students would pay $25 for the club cards, the deadweight loss triangle is equal to the extra amount students would pay in total for cones minus the value of the extra cones they would eat.

A competitive firm's total costs for a year are: TC = 16 + 4Q + Q2 D) Again suppose there is unlimited potential entry and exit of identical firms in the market. If the government passed a law that required each firm to pay a tax of $4 per unit (instead of the license fee in Part C), what would the market price be in the long run? How much will each firm produce?

Solving as above: Q = 4, P = 16

TC = 16 + 6Q + Q2 D) Again suppose there is unlimited potential entry and exit of identical firms in the market. If the government passed a law that required each firm to pay a tax of $10 per unit (instead of the license fee in Part C), what would the market price be in the long run? How much will each firm produce?

Solving as above: Q = 4, P = 24

TC = 16 + 6Q + Q2 C) Again suppose there is unlimited potential entry and exit of identical firms in the market. If the government passed a law that required each firm to buy an annual license for $9, what would the market price be in the long run? How much will each firm produce?

TC = 25 + 6Q + Q2 AC = TC/Q = 25Q-1 + 6 + Q So dAC/dQ = -25Q-2 + 1 Solve the first-order condition to find the minimum point on AC: -25Q-2 + 1 = 0 => Q = 5 At Q=5, AC = 16 (& MC=16), so in the long run P=16.

A competitive firm's total costs for a year are: TC = 16 + Q + Q2 C) Again suppose there is unlimited potential entry and exit of identical firms in the market. If the government passed a law that required each firm to buy an annual license for $9, what would the market price be in the long run? How much will each firm produce?

TC = 25 + Q + Q2 AC = TC/Q = 25Q-1 + 1 + Q So dAC/dQ = -25Q-2 + 1 Solve the first-order condition to find the minimum point on AC: -25Q-2 + 1 = 0 => Q = 5 At Q=5, AC = 11 (& MC=1), so in the long run P=11

A competitive firm's total costs for a year are: TC = 16 + 4Q + Q2 C) Again suppose there is unlimited potential entry and exit of identical firms in the market. If the government passed a law that required each firm to buy an annual license for $20, what would the market price be in the long run? How much will each firm produce?

TC = 36 + 4Q + Q2 AC = TC/Q = 36Q-1 + 4 + Q So dAC/dQ = -36Q-2 + 1 Solve the first-order condition to find the minimum point on AC: -36Q-2 + 1 = 0 => Q = 6 At Q=6, AC = 16 (& MC=16), so in the long run P=16.

This summer you visit some countries that have recently implemented policies to tax and/or regulate firms that sell food. A) In Country A, the president recently rented a movie ("Supersize Me Yet Again") and came to the startling conclusion that his mom had actually been telling him the truth when she said that eating nothing but fast—food burgers and fries and drinking nothing but giant servings of cola could lead to poor health. The country has one fast food producer, and that firm sets the profit-maximizing monopoly price for fast food and has been earning $100 billion per year in profits. The new policy requires the company to pay the government $50 billion per year for ten years, regardless of how much fast food the company sells. How would you expect this policy to affect the price that consumers pay for fast food and the quantity of fast food purchased? Why?

The $50 billion pet year for ten years will not affect MC, and it will not cause the company to leave the. business. Hence, the Q at which MR=MC and, hence, profit—maximizing P & Q, will be unaffected by the policy. Because the price consumers pay for fast food will be unaffected, the quantity of fast food purchased will be unaffected.

You have been hired to advise a country about economics. The country previously obtained advice from the consulting firm of Weir, High, & Spacey. The leaders of the country know that the advice they got from Weir, High, & Spacey is not entirely correct, but they do not understand why. Your job is to explain what is wrong with each of the quotations below. Be clear and precise about the fundamental flaws. If in response to recent concern about the Middle East, the United States sought to reduce oil imports by 50%, the reduction could be accomplished with a quota or a tariff. The main difference is in the effects on consumers, because the burden of the tariff would (in comparison to the quota) have a greater effect on the price the consumers pay for gasoline and heating oil.

The 50% reduction could indeed be produced by either a quota or tariff. The easiest way to demonstrate this is with a generic tariff/quota diagram with domestic supply, domestic demand, and world price. This shows that the key distinction between a quota and a tariff is whether the government receives tariff revenue (in the case of a tariff) or if that area on the graph is quota rents instead (in the case of a quota).

Your friend Manny Bowles consumes 2 goods: ramen and eggs. Given his current budget, he eats 20 bowls of ramen per week. For Manny, ramen is an inferior good. With these facts in mind, answer the following question. Suppose that you decided to give Manny 10 bowls of ramen every week. What would that do to his ramen consumption? Illustrate using a carefully labeled graph with indifference curves and budget constraints.

The answer to this question is quite straightforward if you use basic consumer theory. A good starting point is to illustrate Manny's initial choice in a well-labeled graph: Draw a generic budget constraint with a tangent indifference curve at the optimal bundle, where the optimal bundle has 20 bowls of ramen and some unknown positive amount of eggs. Then show the effects of giving him 10 bowls of ramen, being careful to show that the budget constraint shifts out in a parallel manner. Because ramen is inferior, he consumption of ramen will necessarily fall (i.e., drop to below 20 bowls) as a result of the ramen gift.

Yesterday (i.e., September 20, 2016), I did a quick Google search for "price gouging" in the news, and I found lots of references to rules that nearby states (Georgia, North Carolina, and Tennessee) currently have in effect in an effort to prevent gasoline prices from rising in response to a gasoline pipeline leak. So I thought I should use this as the basis for an exam question. A) Suppose that in response to news of the gasoline pipeline leak, many motorists decide to fill up their cars' fuel tanks in expectation of a potential "shortage" caused by that leak.If supply and demand operated normally and there were no price controls, how would a bunch of motorists deciding to fill their fuel tanks affect gasoline prices? Would there be a shortage of gasoline? Provide an illustration (label your graph, of course).

The critical point is that there is no reason to expect a shortage. You had some flexibility in how you drew the graph, but you needed to show that the price will rise, and the market will clear, in the presence of one or both of the following: supply curve shifts left; demand curve shifts right.

You have been hired to advise the leaders of a country. The leaders previously obtained various kinds of economic advice from the consulting firm of Weir, High, and Spacey. The leaders of the country know that the advice they got from Weir, High, and Spacey is not entirely correct, but they do not understand why. Your job is to explain what is wrong with each of the quotations below. Be clear and precise about the fundamental flaws. B. "Suppose an accountant takes acting lessons and then finds that, as a result of taking those acting lessons, her economic profits from being an accountant have turned negative. That means that taking acting lessons was a big mistake.

The easy way to answer this is to use the basic logic of opportunity costs. If the accountant turns out to be a great actor, so that she can make a lot of money acting, that will make her economic profits from accounting negative - because being a great actor makes the opportunity cost of time spent doing accounting work very high. Thus, if acting lessons make the economic profits from accounting negative, that may indicate that acting lessons were a great thing to do.

Suppose that, following widespread legalization of recreational marijuana, a very intelligent friend of yours writes a research paper on the marijuana industry. She concludes that the industry will have many small firms (e.g., backyard growers). She also concludes that marijuana will likely be a decreasing cost industry (i.e., she thinks the long run market supply curve is downward sloping). Why might your friend expect the industry to be a decreasing cost industry? (Recall that your friend is very intelligent, so her argument will make logical sense, even if the conclusion is speculative.)

The industry could, at least in principle, be a decreasing cost industry. That is, the long run supply curve might be downward sloping. Why might that be so? One reason: If demand shifted out for marijuana, that might lead to both entry and technological advances (resulting, say, from R&D efforts among some of those new entrants). Those technological advances, if adopted by all firms (or, most importantly, by new entrants), would reduce AC curves and hence prices in the long run. In this manner, a shift out in demand could lead to a decrease in price.

Suppose you hear the following comment in conversation between two mayors: In your home city, you charge very little for liquor licenses, but in my home city we charge a lot for liquor licenses. I have visited both cities, and I noticed that the bars in my city are much larger than the bars in your city. Therefore, especially because our cities are otherwise almost identical, it is safe to conclude that my city's policy of charging a lot for liquor licenses is harmless to, and may even help, bar customers and bar owners. Evaluate the reasoning in that statement. Does the mayor have a good understanding of economics? Explain carefully. I strongly recommend using a graph or graphs to illustrate your answer.

The mayor does not understand much economics. Note that in a competitive market with entry and exit, an increase in fixed costs (such as caused by a liquor license) will cause exit, driving up the price. This increased price will lead to fewer (from exit) but larger firms, because an increase in P (with the MC curve unchanged) will, for each firm, lead to P=MC occurring at a higher Q. Thus, what the mayor describes is exactly what one would expect to see in a competitive market where the license fee harmed consumers. You did not need to mention this to get full credit, but also note that the license may harm firms as well as consumers - consider, for example, the owners of inputs (e.g., land & buildings in good places for bars) in the case of an increasing cost industry.

Evaluate the reasoning in the following statement: Consider a competitive market with identical firms and unlimited entry and exit (i.e., a generic constant cost industry). If the government establishes a combination policy that (i) pays each firm $1000 per year as a "small business development job creator award" as long as the firm produces some output and (ii) charges each firm a basic per unit fee (i.e., a per unit tax) on output, it may turn out that consumers are unaffected - if so, the policy will do nothing, and the policy simply will not matter for anyone. Give a careful, precise answer here. A graph is highly recommended.

The policies lead to firms operating at a Q below the efficient scale - and this means that, if the combo policy leaves consumers unaffected (i.e., the price paid by consumers remains unchanged), the combo policy cannot be revenue-neutral for the government. More specifically, the government will be paying out more dollars than it will be collecting. To see why, note that the per-firm payment would, on its own, lead to smaller firms and lower prices. The per unit fee would, on its own, lead to unchanged firm size and higher prices. At a smaller firm size (i.e., Q per firm below the efficient scale), more real resources are used per unit; so with firms at zero profits and the price paid by consumers remaining unchanged, the combo program will require the government to pay for the additional real resources used in production. Many students provided good graphs, and these graphs were very useful. In my view, the most straightforward approach to a graph is start with a generic AC & MC graph, then consider, first, the per firm payment's effect on AC (no shift in MC), then to that add the per unit fee (causing a shift in AC & MC) that will, as a combo policy, yield a long run price to the original no-policy price. That will show that the government pays each firm more than it collects from each firm.

You have been hired to provide objective advice to the leaders of an island nation. The country has one beer producer, and the leaders plan to adopt one of two policy proposals. Proposal A would make the beer producer pay a tax of $1 per beer to the government. Proposal B would make the beer producer pay a license fee of $1 million dollars per year to the government. Neither proposal would put the company out of business. B) Another politician says he wants to "punish the company for making the most foul beverage ever invented my humankind," but he does not want to "hurt consumers by increasing prices." He fears that either proposal will raise prices. Which proposal would you recommend him. Explain why - I am looking for a careful answer.

The politician in Part B would favor the $1 million dollar fee. That policy will not hurt consumers because prices will not change. The $1 per beer tax would raise prices for consumers, thus reducing consumer surplus. Either policy would "punish the company" in the sense of reducing its rents.

This summer you visit a country that is considering raising its minimum wage. You hear the following argument in a debate on the topic: From basic microeconomic theory, we can predict the following effects of increasing the minimum wage. First, because competitive firms are price takers, they cannot affect the price of their output. Therefore, in competitive industries that employ minimum wage workers, we should expect that firms cannot pass the costs of the minimum wage increase along to consumers by raising the price of the output produced by those firms. Second, for monopolies, we know the firms are already charging their profit-maximizing prices. Therefore, monopoly firms that employ minimum wage workers will not be able to pass the costs of the minimum wage increase along to consumers by raising prices. Evaluate that argument carefully. I would recommend using two good graphs.

The straightforward way to answer this is with generic graphs for competitive firms and monopolies. You should show that an increase in the minimum wage (which will increase MC & AC) will cause higher prices in both types of industries. In a competitive industry, the shift in MC and AC curves will cause exit, which in turn increases prices. In the case of monopoly, the shift in MC causes the intersection of MC with MR to occur at a lower Q, yielding a higher P.

Evaluate the reasoning in the following statement: "If you are entering the hotel business in a beach city with lots of hotels, you should buy a beachfront hotel with good views (rather than a hotel several blocks inland): The ocean views will yield higher economic profits for you."

There is no reason to believe that beachfront hotels would yield higher or lower economic profits than would non-beachfront hotels. The key point is that *the inputs will be* *priced such* *that expected economic profits are zero.* Thus, if tourists pay a higher price for beachfront hotel rooms than for inland hotel rooms, the price of buying a beachfront hotel (or beachfront land) should reflect the higher rents that go to the owners of beachfront hotels. In sum, expect zero profits when you enter the beachfront hotel business or the non-beachfront hotel business. For some additional intuition, you can think of this question in the following way. Suppose that economic profits were higher for beachfront hotels than for inland hotels. If so, one would expect owners of inland hotels to sell their inland hotels and buy beachfront hotels, because doing so would raise their profits. This would, in line with basic supply and demand, reduce the price for purchasing an inland hotel and increase the price for purchasing a beachfront hotel - the equilibrium outcome will have the hotels priced so that profits are zero for both locations.

"If we implement a tax reform that is revenue-neutral (meaning, the reform does not change how many dollars the government collects), that cannot do much good overall because it would only change who paid the taxes. The only way to benefit taxpayers is to collect fewer dollars in tax revenue." [A graph is highly recommended here.]

There were two common ways students answered this question (both correct). One was to use supply and demand to explain why two different tax rates (intuitively, a high rate and a low rate) can lead to the same amount of revenue for the government, with the low rate (for obvious reasons) leaving taxpayers (buyers and sellers both) better off. The other was to use a basic consumer model (indifference curves and budget constraints) to explain how replacing a per unit tax (or an income tax when leisure is one of the two goods in the graph) can be replaced by a lump sum tax that raises the same amount of tax revenue but leaves the taxpayer on a higher indifference curve. For either type of answer, a good graph was very useful.

How would your answer to Part A change if there were "price gouging" prohibitions, which in effect prohibit price increases? Provide an illustration (label your graph, of course).

There will be a shortage, and your graph should show that. The most common way students approached this was as follows: Show an original S & D outcome (with equilibrium P & Q labeled), then have D shift rightward (because motorists decide fill their tanks); with a price ceiling at the old P, there will be excess demand (i.e., quantity demanded at the old P on the new D curve minus quantity supplied at the old P on the original S curve). Some students also showed shifts in the S curve, and that works fine too.

Evaluate the reasoning in the following statement: "If the government provides a per unit subsidy for a good sold by a monopoly, that will not benefit consumers because the monopolist will simply keep all of the money that the government spends on the subsidy." (For full credit, provide a good graph.)

This is incorrect. The best way to answer this is with a simple graph, and the easiest way to do that is as follows: A subsidy will have the same effect as a decrease in MC (i.e., in your graph, shift the MC curve vertically downward), which increases the Q at which MC = MR. This yields a lower P for consumers.

A consumer's utility function is given by: U(x,y) = x^2 y+ 100 The consumer's income is I, and the price of good y is P(y). Derive the consumer's demand function for good x. You must show your work.

This problem is similar to other problems you have seen. With the consumer's utility function given by: U(x,y) = x^2 y + 100 we know: MU(x) = 2xy MU(y)= x^2 Using the fact that the MRS equals the price ratio at optimal bundles, you can use basic algebra to find: y = .5(P(x)/P(y))x Using the above equation, along with the budget constraint (I = P(x)x + P(y)y) to solve for x yields: x = (2/3)(I/P(x))

A consumer's utility function is given by: U(x,y) = .5x^2y^2 + 200 The consumer's income is I, and the price of good y is P(y). Derive the consumer's demand function for good x. You must show your work.

This problem is very similar to other problems you have seen. With the consumer's utility function given by: U(x,y) = .5x^2y^2 + 200 we know: MU(x)= xy^2 MU(y)= x^2 y Using the fact that the MRS equals the price ratio at optimal bundles, you can use basic algebra to find:y = (P(x)/P(y))x Using the above equation, along with the budget constraint (I = P(x)x + P(y)y) to solve for x yields: I = P(x)x + P(y)[(P(x)/P(y))x] I = P(x)x + P(x)x x = I/(2P(x))

"Because the environmental regulations in my hometown block the construction of new housing, we cannot build new apartments, despite a big increase in demand. Given these facts, a highly effective way to help renters would be for the government to send renters checks to cover, say, half of what they pay each month in rent."

This question can be addressed easily with supply and demand. The quotation describes building restrictions that would cause the supply curve to be highly inelastic. Having highly inelastic supply is good reason to expect that a subsidy (e.g., the government reimburses tenants for half of what the tenant pays in rent) will not be a highly effective way to help renters. To see why, draw a downward-sloping demand curve, then see how making the supply curve less elastic changes the way the subsidy affects the price paid and price received for a generic subsidy.As you will see, the more inelastic you make the supply curve, the greater the share of the subsidy that goes to the landlords. Note: Students who used supply and demand to analyze the incidence of a subsidy typically gave full-credit answers. A surprising number of students discussed rent control instead of addressing the question I asked.

Evaluate the reasoning in the following statements: "Suppose that space travel becomes more popular in the next several hundred years, and suppose that there will be many private firms operating shuttles to the moon. That's expensive to do, so you can be sure that the industry will be an increasing cost industry or constant cost industry." "If space travel gets cheaper over time, that implies that space travel is a decreasing cost industry." Give a careful, precise answer here. For full credit, provide a useful graph (or graphs) to illustrate your answers. (Hint: Increasing cost industries have upward sloping long run supply curves; decreasing cost industries have downward sloping long run supply curves.)

To address the first claim, note that the industry could be a decreasing cost industry. That is, the long run supply curve might be downward sloping. Why might that be so? One reason: If demand shifted out for shuttle flights, that might lead to both entry and technological advances. Those technological advances, if adopted by all firms (or, most importantly, by new entrants), would reduce AC curves and hence prices in the long run. In this manner, a shift out in demand could lead to a decrease in price. Note that prices falling over time need not imply that the industry is a decreasing cost industry. An increasing cost industry can have its supply curve (i.e., its upward sloping supply curve) shift due to technological advances, thus pushing price down. In a decreasing cost industry, it must be that an increase in demand would cause a decrease in price in the long run.

A competitive firm's total costs for a year are: TC = 16 + Q + Q2 D) Suppose that the government passed the law to require $9 annual licenses, but stated that all firms in business when the law was passed would be exempt from the requirement. Also suppose that after the law was passed, the demand curve shifted out, causing new firms to enter. Would the owners of the old firms benefit or be hurt by this law? Considering only the long run, by how much would they benefit or be hurt?

We know that the new entrants must be earning zero profits, and that occurs at P=11 for them. This leaves the old firms (i.e., the incumbents) with profit = 9, as calculated above.

The Gabba Gabba Hay Company is a price-taking form with total costs for a year described by: TC=32 + 10Q + 2Q^2 where Q us the quantity of hay. Suppose there is unlimited entry and exit of firms in the hay market. Also suppose that all firms, including potential entrants, have costs identical to those given above. B) Suppose the government decides to pay hay producers $1 per unit of hay. Under this policy, what will the market price be in the long run? How much hay will each firm produce in the long run? Show your work or explain how you know.

With the new policy: TC = 32 + 9Q + 2Q^2 AC = TC/Q = 32Q^-1 + 9 + 2Q So dAC/dQ = -32Q^-2 + 2 Solve the first-order condition to find the minimum point on AC: -32Q^-2 + 2 = 0 ——> Q = 4 At Q = 4, AC = 25 (& MC = 25), so in the long run P = 25

In the United States and other countries, there has been much public discussion of implementing programs that guarantee a minimum income. (The Swiss voters considered a quite large program.) On that theme, consider the following. A) Draw a graph to illustrate the following. First, draw a generic budget constraint for a person who earns $5 per hour of work, has 24 hours in a day to allocate between leisure and earning money, and can choose the number of hours worked. Second, show what would happen to that person's budget constraint if the government implemented a policy that did two things: (i) gave the person $60 per day and (ii) took half of however much the person earned from work. (Be sure to label important points on your graph.)

You can answer this using with the same type of analysis presented in the handout on welfare programs and budget constraints. (The graph for Part A would be essentially the same as on the handout, with the numbers adjusted.)

Evaluate the logic of the following statement. Be sure to explain whether the quotation is accurate or not, and be sure to provide a useful graph. "If a price-taking firm can earn positive economic profits, it will generally choose to produce the quantity of output where average costs are the lowest. This way, the firm gets the highest markup possible; that is, the firm sells where the difference between price and average cost is maximized. This will maximize profits for the firm."

You can answer this with a generic graph for a profit-maximizing competitive firm earning positive profits. The key is to show that, when a firm can earn positive profits (that is, when price is above the minimum point on the AC curve), the firm will not produce the Q where AC is lowest. The firm produces the Q where MC=P, and that is a Q greater than the Q for which AC is lowest. Note: It is true that producing the quantity of output where average costs are the lowest would get the firm the highest markup possible in the sense that the firm would be selling where the difference between price and average cost would be maximized. That would not, however, maximize profits for the firm. Also note: If a firm that could earn positive profits decided for some reason (other than profit maximization, of course) to produce the quantity of output where AC is minimized, it would earn positive profits (not zero profits).

You have been hired to advise a country about economics. The country previously obtained advice from the consulting firm of Weir, High, & Spacey. The leaders of the country know that the advice they got from Weir, High, & Spacey is not entirely correct, but they do not understand why. Your job is to explain what is wrong with each of the quotations below. Be clear and precise about the fundamental flaws. B. "Suppose a good is sold in a market with price-taking firms and unrestricted entry. If you see the price fall over time, there can only be one possible explanation: The long run supply curve shifting to the right."

You want to debunk this claim (more specifically, say why the second sentence does not rest on good economics): "Suppose a good is sold in a market with price-taking firms and unrestricted entry. If you see the price fall over time, there can only be one possible explanation: The long run supply curve shifting to the right." The long run supply curve shifting to the right could indeed lead to a fall in price, but there are two easy ways to show that this part of the claim - "there can only be one possible explanation" - is wrong. One is that a leftward shift in demand (with upward-sloping long run supply) would lead to a decline in price; this is a very easy graph to draw. The other is that a rightward shift in demand could cause price to fall in the long run in a decreasing cost industry (i.e., in an industry where the long run supply curve slopes downward); this is also an easy graph to draw.

You have been hired to advise a country about economics. The country previously obtained advice from the consulting firm of Weir, High, & Spacey. The leaders of the country know that the advice they got from Weir, High, & Spacey is not entirely correct, but they do not understand why. Your job is to explain what is wrong with each of the quotations below. Be clear and precise about the fundamental flaws. A. "Suppose that you see families selling off their farmland and exiting farming because their profits from farming have turned negative. That clearly indicates unfortunate circumstances for those families."

You want to debunk this claim (more specifically, say why the second sentence does not rest on good economics): "Suppose that you see families selling off their farmland and exiting farming because their profits from farming have turned negative. That clearly indicates unfortunate circumstances for those families." Perhaps the easiest way to explain why that claim is wrong is to point out that very fortunate circumstances could also lead to "families selling off their farmland and exiting farming because their profits from farming have turned negative." The key point is that *negative profits may arise because the opportunity costs of the inputs increase*. For example, if a real estate developer offers $50,000,000 for a farm that produces crops worth $100,000 annually, a profit-maximizing family may sell the farm, exit farming, and be very happy about the outcome.

Some basic background: You own a firm in a competitive industry. All firms in your industry are identical, and there are an unlimited number of potential entrants that, if they entered, would have the same costs as the firms in the industry. Firms may also exit; if they do, this will not change the cost curves for the remaining firms. Now suppose that the government is considering one of two policies: Policy I A subsidy of $1000 per firm per year. This would apply to all firms in the industry, including your firm, and including entrants. Policy II A subsidy of $500 per firm per year. This would apply to all firms in the industry (including entrants) except your firm: Your firm would receive a subsidy of $1100 per year (because your aunt is a politician and gets you special treatment). B) Under which of the two policies would you produce more output? Explain precisely how you arrive at your answer (a graph is a good idea here).

You will sell more output under Policy II than under Policy I. Drawing a graph will show why: The price will be higher with Policy II than with Policy I, and your MC curve will be the same either way. That implies that your profit-maximizing quantity (i.e., the Q where P=MC) will be greater under Policy II than under Policy I.

Some basic background: You own a pizza parlor in a competitive industry. All firms in your industry are identical, and there are an unlimited number of potential entrants that, if they entered, would have the same costs as the firms in the industry. Firms may also exit; if they do, this will not change the cost curves for the remaining firms. Now suppose that the government is considering one of two policies: Policy I A subsidy of $1000 per firm per year. This would apply to all firms in the industry, including your firm, and including entrants. Policy II A subsidy of $500 per firm per year. This would apply to all firms in the industry (including entrants) except your firm: Your firm would receive a subsidy of $800 per year (because your aunt is a politician and gets you special treatment). Comparing Policy I to Policy II, under which policy would you sell more pizza? (Again, consider the long run.) Explain how you know.

You will sell more pizza under Policy II. Drawing a graph will show why: The price will be higher with Policy II than with Policy I, and your MC curve will be the same either way. That implies that your profit maximizing quantity (i.e., the Q where P=MC) will be greater under Policy II than under Policy I.

B) Under which of the two policies would you produce more output? Explain precisely how you arrive at your answer (a graph is a good idea here).

You would produce more with Policy II than with Policy I. The key point here is to see that (i) your MC curve will not shift, (ii) Policy I reduces the price of your output, and (iii) Policy II increases the price of your output. Thus, as a basic graph will show, your profit maximizing Q would decrease as a consequence of Policy I (relative to no policy) and increase as a consequence of Policy II (relative to no policy).