ECON 002 - Principles of Microeconomics Drake University, Fall 2023 William M. Boal

### Version A

I. Multiple choice

(1)c. (2)b. (3)a. (4)c. (5)b. (6)c. (7)b. (8)a. (9)b. (10)b.
(11)a. (12)b. (13)a. (14)f. (15)f. (16)c. (17)a. (18)b. (19)b. (20)d.
(21)c. (22)c. (23)b. (24)d. (25)b. (26)a. (27)c. (28)b. (29)a. (30)c.

II. Problems

(1) [Using price elasticity of demand: 10 pts]

1. inelastic, because price elasticity is less than one in absolute value.
2. decrease.
3. 2 percent, using definition: elasticity = percent change quantity divided by percent change price.
4. increase, because the increase in price is greater than the decrease in quantity.
5. 3 percent, using approximation formula: percent change in revenue = percent change in price + percent change in quantity.

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

(3) [Market equilibrium: 12 pts] First, use the graph to draw demand and supply curves. The curves should have stairsteps, similar to those for the trading activity we did in class.

1. excess demand, because quantity demanded is 7 and quantity supplied is 4.
2. \$10.
3. 4 units.
4. \$40 (= price × quantity).
5. \$42. (Compute the surplus of each buyer and each seller and add them up. Or count the boxes between the demand and supply curves.)
6. sellers.

(4) [Welfare analysis of tax or subsidy: 18 pts] Tax = \$6. Under this tax, PD = PS + \$3, so at the new equilibrium quantity, the demand curve must be higher than the supply curve by \$3. Both consumers and producers lose from a tax, but government gains tax revenue.

1. 6 thousand.
2. \$5 per rake, on supply curve.
3. \$8 per rake, on demand curve.
4. decrease, because sellers' price fell.
5. \$7 thousand = area of trapezoid bounded by new and old prices for sellers and supply curve.
6. decrease, because buyers' price rose.
7. \$14 thousand = area of trapezoid bounded by new and old prices for buyers and demand curve.
8. \$18 thousand = new quantity times tax rate (\$3).
9. \$3 thousand = area of deadweight-loss triangle.

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

1. 2 hamburgers and 6 gallons of gasoline.
2. 5 hamburgers and 6 gallons of gasoline.
3. Budget line A is a straight line with intercepts at 10 hamburgers and at 15 gallons of gasoline.
4. 9 gallons of gasoline (at the tangency point).
5. Budget line B is a straight line with intercepts at 10 hamburgers and at 5 gallons of gasoline.
6. 4 gallons of gasoline (at the tangency point).
7. (P,Q) = (\$2,9), (\$6,4).

(6) [Short-run cost curves and supply: 20 pts]

1. \$22 thousand (= 2000 × SATC).
2. \$16 thousand (= 2000 × SAVC).
3. \$6 thousand (= STC - SVC).
4. \$2 (= SMC).
5. \$8 (= minimum SATC).
6. \$3 (= minimum SAVC).
7. 0 parts, because price is less than the shutdown price.
8. loss, because price is less than breakeven price (profit = -SFC).
9. 1400 parts, using the rule P=MC.
10. profit, because P is greater than breakeven price.

(7) [Economy-wide efficiency: 16 pts]

1. 2 units of clothing.
2. 1/2 units of food.
3. \$5, because in competitive equilibrium, prices reflect opportunity costs for the economy as a whole: if the opportunity cost of a unit of clothing is 1/2 units of food, then the price of a unit of clothing must be 1/2 times the price of a unit of food.
4. Caitlin's budget line should have intercepts at 50/10=5 units of food and 50/5=10 units of clothing.
5. 2 units of clothing, same as country's PP curve.
6. 1/2 units of food, same as country's PP curve.
7. 3 units of food, at tangency between budget line and highest indifference curve that Caitlin can reach.
8. 2, because at the tangency, the |slope| of her indifference curve (MRS) must equal the slope of her budget line.

(8) [Competition versus collusion: 16 pts]

1. 12 million.
2. \$7 = marginal cost = height of supply curve.
3. \$7. Note that perfect competition yields marginal-cost pricing.
4. Since demand curve is linear, MR curve must also be linear and have same intercept and twice the slope as demand. So MR curve should have intercept = \$12 on price axis, and slope = -1/1 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 between demand curve, joint MC curve, and vertical line at cartel quantity (5 million).

(9) [Nonrival goods: 6 pts]

1. Zero kilometers because MC > MB for all positive values of Q.
2. MSB = 1000 (100-10Q) = 100,000 - 10,000 Q.
3. 4 kilometers (found by setting MSB = MC and solving for Q).

(10) [Common property resources: 6 pts]

1. 500 traps, where marginal private benefit equals zero.
2. 250 traps, where marginal social benefit equals zero.
3. \$25, the dollar equivalent of marginal private benefit (5 traps), at the socially optimal number of traps.

(11) [Externalities: 12 pts] Trees evidently provide an external benefit.

1. \$40, at intersection of demand and supply.
2. 80, at intersection of demand and supply.
3. 120, at intersection of marginal social benefit and supply.
4. \$600, the area of the triangle between marginal social benefit, supply, and a vertical line at 80, the unregulated quantity. Deadweight loss is the gap between the benefit to society and the cost of all those units that should have been produced.
5. subsidy, to increase the quantity to the socially-optimal quantity.
6. \$20, which equals the vertical gap between demand and supply and the socially-optimal quantity.

(12) [Regulating pollution: 20 pts]

1. Factories C, D, and E, the factories with the lowest clean-up costs.
2. \$60.
3. Each factory's willingness-to-pay for a permit equals its annual cost of cleanup. Graph should show five downward stairsteps.
4. Factories A and B, which have the highest clean-up cost and are therefore willing to pay the most for a permit.
5. \$30, between the price that Factory B is willing to pay and the next-highest willingness to pay (Factory C).
6. \$60.
7. \$30. Only Factories A and B would rather pay this fee than clean up.
8. \$60.

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 causes 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)a. (2)c. (3)c. (4)e. (5)a. (6)b. (7)a. (8)d. (9)c. (10)a.
(11)b. (12)a. (13)b. (14)c. (15)c. (16)b. (17)b. (18)d. (19)d. (20)e.
(21)b. (22)b. (23)d. (24)b. (25)b. (26)a. (27)c. (28)b. (29)a. (30)a.

II. Problems

(1) [Using price elasticity of demand: 10 pts]

1. elastic, because price elasticity is greater than one in absolute value.
2. decrease.
3. 6 percent, using definition: elasticity = percent change quantity divided by percent change price.
4. decrease, because the increase in price is less than the decrease in quantity.
5. 2 percent, using approximation formula: percent change in revenue = percent change in price + percent change in quantity.

1. 1/2 units of wheat.
2. 2 units of wheat.
3. 2 units of corn.
4. 1/2 units of corn.
5. Farmer A, because has lower opportunity cost of producing corn.
6. Farmer B, because has lower opportunity cost of producing wheat.
7. Both farmers can consume combinations of products outside their individual production possibility curves if Farmer B sends two units of wheat to Farmer A, who sends 2 units of corn in return.
8. Plot should show each farmer's production before trade, and consumption after trade.

(3) [Market equilibrium: 12 pts] First, use the graph to draw demand and supply curves. The curves should have stairsteps, similar to those for the trading activity we did in class.

1. excess supply, because quantity demanded is 5 and quantity supplied is 6.
2. \$4.
3. 5 units.
4. \$20 (= price × quantity).
5. \$47. (Compute the surplus of each buyer and each seller and add them up. Or count the boxes between the demand and supply curves.)

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

1. 10 thousand, where supply curve is higher than demand curve by \$3.
2. \$7 per rake, on the supply curve.
3. \$4 per rake, on the demand curve.
4. increase, because the sellers' price rose.
5. \$9 thousand = area of trapezoid bounded by new and old prices for sellers, and supply curve.
6. increase, because the buyers' price fell.
7. \$18 thousand = area of trapezoid bounded by new and old prices for buyers, and demand curve.
8. \$30 thousand = new quantity times subsidy rate (\$3).
9. \$3 thousand = area of deadweight-loss triangle.

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

1. 4 hamburgers and 9 gallons of gasoline.
2. 5 hamburgers and 10 gallons of gasoline.
3. Budget line A is a straight line with intercepts at 10 hamburgers and at 10 gallons of gasoline.
4. 4 hamburgers, the tangency point.
5. Budget line B is a straight line with intercepts at 5 hamburgers and at 10 gallons of gasoline.
6. 3 hamburgers, the tangency point.
7. (P,Q) = (\$4,4), (\$8,3).

(6) [Short-run cost curves and supply: 20 pts]

1. \$7 thousand (= 500 × SATC).
2. \$3 thousand (= 500 × SAVC).
3. \$4 thousand (= STC - SVC).
4. \$10 (= SMC).
5. \$7 (= minimum SATC).
6. \$4 (= minimum SAVC).
7. 1300 parts, using the rule P=MC.
8. loss (because price is less than breakeven price).
9. zero parts (because price is less than shutdown price).
10. loss (profit = -SFC, because firm has shut down).

(7) [Economy-wide efficiency: 16 pts]

1. 1/3 units of clothing.
2. 3 units of food.
3. \$6, because in competitive equilibrium, prices reflect opportunity costs for the economy as a whole: if the opportunity cost of a unit of clothing is 3 units of food, then the price of a unit of clothing must be 3 times the price of a unit of food.
4. Caitlin's budget line should have intercepts at 30/2=10 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. 3 units of food, at tangency between budget line and highest indifference curve that Caitlin can reach.
8. 1/3, because at the tangency, the |slope| of her indifference curve (MRS) must equal the slope of her budget line.

(8) [Competition versus collusion: 16 pts]

1. 9 million.
2. \$5 = marginal cost = height of supply curve.
3. \$5. Note that perfect competition yields marginal-cost pricing.
4. Since demand curve is linear, MR curve must also be linear and have same intercept and twice the slope as demand. So MR curve should have intercept = \$14 on price axis, and slope = -2/1 million.
5. 5 million, where MR = MC.
6. \$5 = marginal cost = height of supply curve.
7. \$9, on demand curve.
8. \$10 million, the area of a triangle between demand curve, joint MC curve, and vertical line at cartel quantity (5 million).

(9) [Nonrival goods: 6 pts]

1. Zero kilometers because MC > MB for all positive values of Q.
2. MSB = 1000 (80-10Q) = 80,000 - 10,000 Q.
3. 3 kilometers (found by setting MSB = MC and solving for Q).

(10) [Common property resources: 6 pts]

1. 400 traps, where marginal private benefit equals zero.
2. 200 traps, where marginal social benefit equals zero.
3. \$20, the dollar equivalent of marginal private benefit (4 traps), at the socially optimal number of traps.

(11) [Externalities: 12 pts] The chemical evidently creates an external cost.

1. \$4, at intersection of demand and supply.
2. 12 million liters, at intersection of demand and supply.
3. 8 million liters, 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 10 million, the unregulated quantity. 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.

(12) [Regulating pollution: 20 pts]

1. Factories D and E, the factories with the lowest clean-up costs.
2. \$40.
3. Each factory's willingness-to-pay for a permit equals its annual cost of cleanup. Graph should show five downward stairsteps.
4. Factories A, B, and C which have the highest clean-up cost and are therefore willing to pay the most for a permit.
5. \$30, between the price that Factory C is willing to pay and the next-highest willingness to pay (Factory D).
6. \$40.
7. \$30. Only Factories A, B, and C would rather pay this fee than clean up.
8. \$40.

III. Critical thinking

Same as Version A.