ECON 002 - Principles of Microeconomics Drake University, Fall 2019 William M. Boal

### Version A

I. Multiple choice

(1)a. (2)a. (3)b. (4)d. (5)b. (6)b. (7)a. (8)b. (9)b. (10)a. (11)b. (12)b. (13)f. (14)b. (15)b. (16)c. (17)b. (18)d. (19)b. (20)b. (21)b. (22)a. (23)c. (24)b. (25)a. (26)b.

II. Problems

(1) [Production functions: 4 pts]

1. Average product = total output / total input: 6, 4, 3.
2. Marginal product = Δ output / Δ input: 6, 2, 1.
3. Diminishing returns? YES because MP is decreasing.

1. 1 scooter.
2. 1/2 scooters.
3. 1 table.
4. 2 tables.
5. Country Y, because it has lower opportunity cost of producing tables.
6. Country X, because it has lower opportunity cost of producing scooters.
7. Both countries can consume combinations of products outside their individual production possibility curves if Country Y exports three tables to Country X, which exports 2 scooters in return.
8. Plot should show each country's production before trade, and consumption after trade.

(3) [Shifts in demand and supply: 15 pts] Full credit requires accurate graphs.

1. right, unchanged, increase, increase.
2. unchanged, right, decrease, increase.
3. left, right, decrease, cannot be determined.

(4) [Welfare effects of tax or subsidy: 18 pts] Subsidy = \$3. Under this subsidy, PD + 3 = PS, so in equilibrium, the supply curve must be higher than the demand curve by \$3. Both consumers and producers gain from a subsidy, but government must pay.

1. 12 thousand.
2. \$7 per shovel.
3. \$4 per shovel.
4. increase.
5. \$11 thousand.
6. increase.
7. \$22 thousand.
8. \$36 thousand.
9. \$3 thousand.

(5) [Consumer choice and demand: 14 pts]

1. 8 cupcakes and 10 lattes.
2. 5 cupcakes and 4 lattes.
3. Budget line A is a straight line with intercepts at 15 lattes and at 5 cupcakes.
4. 3 cupcakes.
5. Budget line B is a straight line with intercepts at 15 lattes and at 10 cupcakes.
6. 4 cupcakes.
7. (P,Q) = (\$6,3), (\$3,4).

(6) [Using income elasticities: 10 pts]

1. necessary good.
2. increase.
3. 3 percent.
4. decrease.
5. 1 percent.

(7) [Rational choice: 10 pts]

1. MC = Δ TC / Δ stations = \$4 million, \$3 million, \$2 million, \$2 million.
2. MB = Δ TB / Δ stations = \$10 million, \$4 million, \$3 million, \$1 million.
3. 6 stations, where MB drops below MC.

(8) [Business revenue and cost--definitions: 3 pts]

1. marginal cost.
2. total reveue.
3. marginal cost.

(9) [Economy-wide efficiency: 14 pts]

1. 1/3 units of clothing.
2. 3 units of food.
3. \$2, because in competitive equilibrium, prices reflect opportunity costs for the economy as a whole: if the opportunity cost of a unit of food is 1/3 units of clothing, then the price of a unit of food must be 1/3 times the price of a unit of clothing.
4. Alan's budget line should have intercepts at 30/2=15 units of food and 30/6=5 units of clothing.
5. 1/3 units of clothing, same as PP curve.
6. 3 units of food, same as PP curve.
7. -1/3, because at a tangency the slope of his indifference curve must equal the slope of his budget line.

(10) [Monopoly price discrimination: 4 pts]

1. \$12 = MC / (1 + (1/ε)), where ε = elasticity for children.
2. \$20, using same formula, where ε = elasticity for adults.

(11) [Competition versus collusion: 16 pts]

1. 9 million.
2. \$3 = marginal cost = height of supply curve.
3. \$3.
4. Since demand curve is linear, MR curve must have same intercept and twice the slope. So MR curve should have intercept at \$12 on price axis, and slope = -2/1 million.
5. 5 million, where MR = MC.
6. \$2 = marginal cost = height of supply curve.
7. \$7, on demand curve.
8. \$10 million, the area of a triangle

(12) [Externalities: 12 pts]

1. \$4, at intersection of demand and supply.
2. 6 million, at intersection of demand and supply.
3. 12 million, at intersection of marginal social benefit and supply.
4. \$12 million, the area of the triangle between marginal social benefit, supply, and a vertical line at 6 million. Deadweight loss is the gap between the benefit to society and the cost to sellers of all those units that should have been produced.
5. subsidy, to increase the quantity to the social optimum.
6. \$3 per vaccination, which equals the vertical gap between demand and supply and the socially-optimal quantity.

(13) [Regulating pollution: 20 pts]

1. Factories A, B, D, E.
2. \$80.
3. Each factory's willingness-to-pay for a permit equals its annual cost of cleanup. Graph should show six downward-sloping stairsteps.
4. Factories C, F.
5. \$40.
6. \$80.
7. \$40.
8. \$80.

(14) [Nonrival goods: 4 pts]

1. MSB = 500 (8-Q) = 4,000 - 500 Q.
2. 6 movies (found by setting MSB = MC and solving for Q).

(15) [Common property resources: 6 pts]

1. 1200 cars, where marginal private benefit equals zero.
2. 600 cars, where marginal social benefit equals zero.
3. \$3, the dollar equivalent of marginal private benefit, at the socially optimal number of cars.

III. Critical thinking [4 pts]

(1) "Give an example of a government intervention that makes a market less efficient..." Any one of the following answers would be acceptable.

• A price floor makes a market less efficient because it reduces the quantity traded below the efficient quantity at the intersection of supply and demand. Although sellers want to sell more units, buyers want to buy fewer units at the higher controlled price. (Full credit requires a correct graph. Deadweight loss is the triangle bounded by the demand curve, the supply curve, and a vertical line at the reduced quantity.)
• A price ceiling makes a market less efficient because it reduces the quantity traded below the efficient quantity at the intersection of supply and demand. Although buyers want to buy more units, sellers want to sell fewer units at the lower controlled price. (Full credit requires a correct graph. Deadweight loss is the triangle bounded by the demand curve, the supply curve, and a vertical line at the reduced quantity.)
• A quota on sellers makes a market less efficient because it reduces the quantity traded below the efficient quantity at the intersection of supply and demand. (Full credit requires a correct graph. Deadweight loss is the triangle bounded by the demand curve, the supply curve, and a vertical line at the reduced quantity.)
• A quota on buyers makes a market less efficient because it reduces the quantity traded below the efficient quantity at the intersection of supply and demand. (Full credit requires a correct graph. Deadweight loss is the triangle bounded by the demand curve, the supply curve, and a vertical line at the reduced quantity.)
• An ordinary tax makes a market less efficient because it reduces the quantity traded below the efficient quantity at the intersection of supply and demand. With a tax, in equilibrium the demand curve must be higher than the supply curve by the amount of the tax rate. (Full credit requires a correct graph. Deadweight loss is the triangle bounded by the demand curve, the supply curve, and a vertical line at the reduced quantity.)
• An ordinary subsidy makes a market less efficient because it increases the quantity traded beyond the efficient quantity at the intersection of supply and demand. With a subsidy, in equilibrium the demand curve must be lower than the supply curve by the amount of the subsidy rate. (Full credit requires a correct graph. Deadweight loss is the triangle bounded by the demand curve, the supply curve, and a vertical line at the increased quantity.)

(2) "Give an example of a government intervention that makes a market more efficient..." Any one of the following answers would be acceptable.

• Breaking up a cartel through enforcement of antitrust laws makes a market more efficient because it promotes competition and increases the quantity traded. A cartel restricts output to increase price and profits, similar to a monopoly. Breaking up a cartel restores the market to the efficient quantity at the intersection of supply and demand. (Full credit requires a correct graph, similar to problem (11). Deadweight loss eliminated is the triangle bounded by the demand curve, the joint marginal cost or supply curve, and a vertical line at the cartel quantity.)
• A Pigou tax (also called a pollution tax) on a good that cause external costs (like coal) makes the market more efficient. A competitive market fails in this situation because the price reflects only marginal private cost born by the seller, not the marginal external cost born by everyone else, so too much is produced. A Pigou tax stands in for these external costs and reduces the quantity traded to its efficient level at the intersection of marginal social cost and demand. (Full credit requires a correct graph. Deadweight loss is the triangle bounded by the demand curve, the marginal social cost curve, and a vertical line at the competitive-market quantity.)
• A Pigou subsidy on a good that causes external benefits (like vaccines) makes the market more efficient. A competitive market fails in this situation because the price reflects only marginal private benefit enjoyed by the buyer, not the marginal external benefit enjoyed by everyone else, so too little is produced. A Pigou subsidy stands in for these external benefits and increases the quantity traded to its efficient level at the intersection of supply and marginal social benefit. (Full credit requires a correct graph. Deadweight loss is the triangle bounded by the supply curve, the marginal social benefit curve, and a vertical line at the competitive-market quantity.)

### Version B

I. Multiple choice

(1)b. (2)c. (3)a. (4)a. (5)b. (6)a. (7)b. (8)d. (9)a. (10)d. (11)a. (12)d. (13)f. (14)c. (15)d. (16)a. (17)e. (18)b. (19)b. (20)c. (21)a. (22)b. (23)a. (24)a. (25)b. (26)d.

II. Problems

(1) [Production functions: 4 pts]

1. Average product = total output / total input: 1, 2, 3.
2. Marginal product = Δ output / Δ input: 1, 3, 5.
3. Diminishing returns? NO because MP is increasing.

1. 1/2 scooter.
2. 2 scooters.
3. 2 tables.
4. 1/2 table.
5. Country X, because it has lower opportunity cost of producing tables.
6. Country Y, because it has lower opportunity cost of producing scooters.
7. Both countries can consume combinations of products outside their individual production possibility curves if Country X exports two tables to Country Y, which exports 2 scooters in return (3 scooters also works).
8. Plot should show each country's production before trade, and consumption after trade.

(3) [Shifts in demand and supply: 15 pts] Full credit requires accurate graphs.

1. unchanged, right, decrease, increase.
2. right, unchanged, increase, increase.
3. right, right, cannot be determined, increase.

(4) [Welfare effects of tax or subsidy: 18 pts] Tax = \$6. Under this tax, PD = PS + 6, so in equilibrium, the demand curve must be higher than the supply curve by \$6. Both consumers and producers lose from a tax, but government gains tax revenue.

1. 6 thousand.
2. \$4 per shovel.
3. \$10 per shovel.
4. decrease.
5. \$16 thousand.
6. decrease.
7. \$32 thousand.
8. \$36 thousand.
9. \$12 thousand.

(5) [Consumer choice and demand: 14 pts]

1. 7 bagels and 10 smoothies.
2. 6 bagels and 9 smoothies.
3. Budget line A is a straight line with intercepts at 12 bagels and at 8 smoothies.
4. 6 smoothies.
5. Budget line B is a straight line with intercepts at 12 bagels and at 4 smoothies.
6. 3 smoothies.
7. (P,Q) = (\$6,3), (\$3,6).

(6) [Using income elasticities: 10 pts]

1. luxury (or superior) good.
2. increase.
3. 6 percent.
4. increase.
5. 2 percent.

(7) [Rational choice: 10 pts]

1. MC = Δ TC / Δ stations = \$5 million, \$4 million, \$3 million, \$2 million.
2. MB = Δ TB / Δ stations = \$7 million, \$5 million, \$2 million, \$0.5 million.
3. 4 stations, where MB drops below MC.

(8) [Business revenue and cost--definitions: 3 pts]

1. marginal cost.
2. average cost.
3. marginal revenue.

(9) [Economy-wide efficiency: 14 pts]

1. 1/2 units of clothing.
2. 2 units of food.
3. \$3, because in competitive equilibrium, prices reflect opportunity costs for the economy as a whole: if the opportunity cost of a unit of food is 1/2 units of clothing, then the price of a unit of food must be 1/2 times the price of a unit of clothing.
4. Alan's budget line should have intercepts at 30/3=10 units of food and 30/6=5 units of clothing.
5. 1/2 units of clothing, same as PP curve.
6. 2 units of food, same as PP curve.
7. -1/2, because at a tangency the slope of his indifference curve must equal the slope of his budget line.

(10) [Monopoly price discrimination: 4 pts]

1. \$10 = MC / (1 + (1/ε)), where ε = elasticity for children.
2. \$12, using same formula, where ε = elasticity for adults.

(11) [Competition versus collusion: 16 pts]

1. 12 million.
2. \$7 = marginal cost = height of supply curve.
3. \$7.
4. Since demand curve is linear, MR curve must have same intercept and twice the slope. So MR curve should have intercept at \$12 on price axis, and slope = -2/1 million.
5. 8 million, where MR = MC.
6. \$5 = marginal cost = height of supply curve.
7. \$9, on demand curve.
8. \$8 million, the area of a triangle

(12) [Externalities: 12 pts]

1. \$6, at intersection of demand and supply.
2. 12 million, at intersection of demand and supply.
3. 8 million, at intersection of marginal social cost and demand.
4. \$8 million, the area of the triangle between marginal social cost, demand, and a vertical line at 12 million. Deadweight loss is the gap between the benefit to consumers and the cost to society of all those units that should not have been produced.
5. tax, to decrease the quantity to the social optimum.
6. \$3 per liter, which equals the vertical gap between demand and supply and the socially-optimal quantity.

(13) [Regulating pollution: 20 pts]

1. Factories A, E.
2. \$25.
3. Each factory's willingness-to-pay for a permit equals its annual cost of cleanup. Graph should show six downward-sloping stairsteps.
4. Factories B, C, D, F.
5. \$20.
6. \$25.
7. \$20.
8. \$25.

(14) [Nonrival goods: 4 pts]

1. MSB = 500 (10-Q) = 5,000 - 500 Q.
2. 9 movies (found by setting MSB = MC and solving for Q).

(15) [Common property resources: 6 pts]

1. 800 cars, where marginal private benefit equals zero.
2. 400 cars, where marginal social benefit equals zero.
3. \$2, the dollar equivalent of marginal private benefit, at the socially optimal number of cars.

III. Critical thinking

Same as Version A.