Economics 53 Introductory Microeconomics

Practice Midterm 2

NAME:________________________Answer all the questions. Allocate your time according to the points that each question is worth. There are 100 points in the exam. You should plan on spending 100 minutes to complete the exam.

Part I Multiple Choice (24 Points, 1.5 Points each question)Please write the letter corresponding to the correct answer in the box below.

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16

D C A D D B B C D D A D A A * C

*Error in Q15 all choices were true.Figure 1

1. Refer to Figure 1. Which of the curves is most likely to represent average fixed cost?

A) A C) CB) B D) D

2. Refer to Figure 1. Which of the curves is most likely to represent average variable cost?A) A C) CB) B D) D

3. For Firm A, when four units of output are produced, the total cost is $175 and the average variable cost is $33.75. What would the average fixed cost be if ten units were produced?A) $4B) $10C) $40D) $135

4. In the long run for Firm A, total cost is $105 when output is 3 units and $120 when

output is 4 units. Does Firm A exhibit economies or diseconomies of scale?A) Diseconomies of scale, since total cost is rising as output rises.B) Diseconomies of scale, since average total cost is falling as output rises.C) Economies of scale, since total cost is rising as output rises.D) Economies of scale, since average total cost is falling as output rises

5. For a perfectly competitive firm in the long run equilibrium, A) MC = PB) ATC=PC) Economic profits are zeroD) All of the above are correct

6. For a perfectly competitive industry choose the statement THAT IS FALSE:A) The profit maximizing output is where marginal revenue is equal to marginal cost.B) If the at the profit maximizing output level, price is less than average variable cost the firm should continue to operate in the short run, but shut down in the long run.C) At the profit maximizing output profits can be negative.D) An increase in output above the profit maximizing point would cause a decrease in profits.

7. Consider a firm producing ice cream. The firm is currently using 10 workers, who produce 50 gallons of ice cream per day. The wage per worker is $35 per day. You work in human resources and have to decide whether to lay-off one worker or not (all the other inputs being fixed). Under which of the following should you lay-off the tenth worker:A) The marginal product of the 10th worker is 8 gallons of ice cream. The price of one gallon of ice cream is $6. B) The marginal product of the 10th worker is 5 gallons of ice cream. The price of one gallon of ice cream is $6. C) The marginal product of the 10th worker is 5 gallons of ice cream. The price of one gallon of ice cream is $8.D) The marginal product of the 10th worker is 8 gallons of ice cream. The price of one gallon of ice cream is $8.

8. Which of the following is an example of social capital?A) A $10 billB) A college educationC) Interstate Highway 5 D) Worker training programs

9. The demand curve for an input will slope downward because ofA) the factor substitution effect.

B) the output effect.C) decreasing returns to scale. D) Both A and B

10. A fund that takes household savings and puts them into high -risk ventures in exchange for ashare of the profits if the new business succeeds is a(n)A) money market fund. B) mutual fund.C) exchange traded fund. D) venture capital fund.

11. Technological breakthroughs revolutionized the calculator industry during the 1970s.Studying the impact on these technological changes in the calculator industry alone would bean example ofA) partial equilibrium analysis. B) general equilibrium analysis.C) market equilibrium analysis. D) efficiency analysis.

12. A monopoly will choose their level of output whereA) marginal cost and demand curves intersectB) average total cost and demand curves intersectC) revenue and average total cost curves intersectD) marginal revenue and marginal cost curves intersectFigure 2

13. Refer to Figure 2. What is the consumer surplus associated with this monopoly?A) $422.50 B) $845 C) $1690 D) None of the above

14. Refer to Figure 2. What is the deadweight loss associated with this monopoly?A) $422.50 B) $845 C) $1690 D) None of the above

15. Which of the following statements regarding perfect price discrimination is FALSE?A) Perfect price discrimination is charging different prices to different buyers.B) Perfect price discrimination is an attempt by monopolists to capture consumer surplus asprofit.

C) Perfect price discrimination can eliminate the deadweight loss to society of a monopoly.D) Perfect price discrimination yields the same market price and output result as perfectcompetition.

16. The first major piece of anti-trust legislation was theA) Clayton Act B) Taft-Hartley ActC) Sherman ActD) Smoot-Hawley Act

Section II: Short Essay Questions (21 Points Total)Answer three (3) questions from Questions (1) through (4). Do NOT answer all four questions. Each question is worth 7 points.

Question 1: List the characteristics that define a perfectly competitive market. Explain why a perfectly competitive firm that is earning above normal-economic profits in the short-run will earn zero economic profits in the long-run.

(a) Perfectly competitive industry will have (1) many small firms, each firm is so small they are price takers, (2) each firm produces identical product, (3) there are no barriers to entry.

(b) If a perfectly competitive firm is earning above normal profits in the short-run this will cause new firms to enter the industry and existing firms to produce more output. The net result would be an increase in market supply (the industry supply curve will shift downward to the right). This will continue until above normal economic profits are eliminated and the industry returns to zero economic profits.

Question 2: From an economic standpoint, patents reduce efficiency because they serve as a barrier to entry and thus limit market competition. Are there any positive economic benefits of patents? Explain. Points)

Yes. Patents provide an incentive for invention and innovation. Research requires resources that have opportunity costs. If research did not lead to expanded profits, little research would be done. Thus, if patents were not available to protect a firm's profits from competition, we would have less innovation.

Question 3: Comment on the following statement: "The output effect and the factor substitution effect work in opposite directions, so it is possible that a decrease in the wage rate can lead to a decrease in the amount of labor hired."

The statement is false. The output effect and the factor substitution effect work in the same direction. In either case, a drop in wage will lead to an increase in the amount of labor hired.

Question #4: What is a barrier to entry? Briefly discuss three sources of barriers to entry that allow a monopoly to remain the sole seller in a market.

A barrier to entry is anything that restricts new firms from entering an industry. There a several sources of barriers to entry

(1) Economies to scale: It could be that the minimum efficient scale is very large. If one firm reaches the MES first, it can effectively prevent other firms from entering since it will have the lowest average total costs. Any new firms who try to enter will have much higher costs and thus will not be able to compete with the monopolist.

(2) Patents: Government may issue patents which gives a single firm the exclusive right to produce and sell the good.

(3) A key resource could be owned by a single firm, thus only that firm can produce the good.

(4) Government may set itself up as a monopoly and legally bar anyone else from entering. Example are state lotteries.

(5) Network effects: The usefulness of a product increases with the number of users. If an established firm has a large number of users, a new firm trying to enter the market will be at a severe disadvantage since only a few people are using the product.

Part III Quantitative/Graphical Section (50 Points Total)You must show your work to receive full or partial credit.

Question #5: General Equilibrium Theory (14 Points)

Suppose that the economy has only two sectors, A and B. Assume that both are initially in long-run competitive equilibrium. The government releases a report indicating that the consumption of good A increases an individual's health. Use graphs (both showing the industry and a representative firm for each sector) to show the impact of the government report on both sectors of the economy in the short-run and long-run.

Consumer preferences will shift which will increase the demand for Good A. As the demand curve shifts to the right, the equilibrium market price will increase. The representative firm will see that if their costs remain the same, that they will now earn positive economic profits. In the long-run, the presence of these profits, will encourage other firms to enter the industry which will cause the supply curve to shift to the right. This will continue until the price returns to its original level and long-run equilibrium is again 0. If consumers demand more of Good A, by necessity they will demand less of all other goods (including Good B). This shifts the demand curve of Good B to the left and results in a lower equilibrium price. As the price falls, existing firms will suffer economic losses. In the long-run, existing firms will decrease production, and eventually leave the industry. This will shift the supply curve upward to the left. This will continue until the price returns to its original level and long-run equilibrium is again 0.

Question #6: Present value (10 Points)

As the president of your firm, you are considering the purchase of a new piece of machinery. The machine is expected to generate revenues of $5,000 per year for five years. After that, the machine will have no value. If the machine costs $22,000 today and the interest rate is 5 percent, should your firm purchase the machine? Explain. (Note: To receive full or partial credit you must show your calculations in how you derived your answer.)

No. The present value of the income stream is ($5,000/1.05) + ($5,000/1.1025) + ($5,000/1.157625) + ($5,000/1.2155063) + ($5,000/1.2762816) = $4,761.90 + $4,535.15 + $4,319.19 + $4,113.51 + $3,917.63 = $21,647.38. Since the cost of the machine is greater than the present value of the income stream, the machine should not be purchased.

Question #7: Graphical Analysis of a Monopoly (6 Points)In this question, you will analyze features of a monopolized market. Figure 2 shows the market for computer operating systems. Assume there is only firm that supplies this market.Figure 2

(a) Clearly indicate on the diagram the profit-maximizing output and price for a monopolist. Label the profit maximizing output as (qm) and the price charged as (pm). (2 Points)

(b) Is the firm earning a positive or a negative profit? Clearly show the firm's profit (or loss) on the graph. (4 Points)

Question #8: Production Costs under Perfect Competition (14 Points)

Dona Ana’s Tortilla Factory produces large wheat tortillas. Assume that the tortilla industry is perfectly competitive. The total cost function for Dona Ana Factory is given below:

TC=1000+0 . 1Q+0 .00045Q2

Where Q = number of wheat tortillas produced.

If Q = 600. Calculate the following

(a) Total Fixed Costs (TFC) (2 Points)Total fixed cost does not depend on output production. To find total fixed costs see what total costs are when Q = 0. In this case,

TFC = 1000

(b) Average Variable Costs (AVC) (2 Points)

AVC = TVC/QFrom above we know that TVC = 0.1Q + 0.00045Q2 thus AVC = 0.1 + 0.00045QAVC = 0.1 + 0.00045(600) = 0.37

(c) Average Total Costs (ATC) (2 Points)ATC = TC/Q Find what TC is if Q = 600TC = 1222ATC = 1222/600 = 2.04

Assume that you also know the following information:

The marginal cost function is MC=0 . 1+0 . 0009Q

While the market price of a tortilla is $1 each.

(d) How many tortillas should Dona Ana Factory produce in order to maximize profits? (2 Points)Under perfect competition P=MR=$1MR = MC$1 = 0.1 + 0.0009QSolving for QQ = 1000

(e) Given your answer in Part (d), calculate the profit or loss for this factory. (2 Points)TR = P x Q = $1 x 1000 = $1000TC = 1000 + 0.1(1000) + 0.00045(1000)2 = $1550Profit = TR – TC = -$550

(f) Given your answer in Part (e) would Dona Ana Factory immediately shut down their operation? Explain your answer. (4 Points)Even though Dona Ana is suffering a loss, you need to compare the price with the AVC at Q = 1000. We know that AVC = 0.1 + 0.00045Q; so if Q = 1000 AVC = 0.1 + 0.00045(1000) or AVC = 0.55. Since P =$1 is greater than AVC = 0.55, the factory should remain in operation in the short-run. Although in the long-run, if nothing else changes, it should probably shut down.

Question #9: Input Demand in a Competitive Market (6 Points)

Affiliated Plastics Corporation sells bubble wrap for shipping in a competitive market. The price of the bubble wrap is $3 each. The factory is completely automated, and thus the only input necessary to produce bubble wrap are machines. Hourly output varies with the amount of machines rented as follows:

Number of Machines Rented (K)

Total Bubble Wrap Produced per hour (Q)

Marginal Product of Capital (MPK)

Marginal Revenue Product of Capital (MRPK)

0 0 N/A N/A

1 9 9 $27

2 16 7 $21

3 22 6 $18

4 27 5 $15

5 31 4 $12

(a) Fill in the columns in the table above for the marginal product of capital and the marginal revenue product of capital. (4 Points)

(b) If the rental price of capital was $16 per hour, how many machines would Affiliated Plastics rent? Briefly explain your answer. (2 Points)

The firm should hire 3 workers. The reason is that the 3rd worker hired would bring in $18 in revenue to the firm, while the firm would only have to pay him/her $16. The 4th worker on the other hand will only bring in $15 which is less than the going market wage. The 4th worker will not be hired.

Question #10: Social Costs of Monopoly (14 Points)

Kathmandu Bottled Water has a monopoly over spring water from Nepal. It has the following demand and marginal revenue curves:P = 12 – Q (demand curve)MR = 12 – 2Q (marginal revenue curve)

Additionally, the average total cost of producing the water is equal to the marginal cost and they are both fixed.

ATC=MC = $2

(a) Sketch the monopolist situation outlined above. (Hint: Find the X and Y intercepts for the demand and marginal revenue curve and connect the points to draw the curves). (2 Points)

(b) Calculate the profit maximizing level of output and price of a monopolist (1 Point)

MR = MC for a monopolist.12 – 2Q = $210 = 2QQ = 5

Since we know the monopolist will produce where Q = 5, plug this value into the demand equation to get the price.

P = 12-(5) = $7 The monopolist will produce 5 units, and charge $7 each.

(c) Calculate the consumer surplus, producer surplus (profits) and total surplus for the monopolist. (2 Points)

Consumer surplus is the area below the demand curve and the price consumers have to pay ($7).The area is equal to (1/2)($12-$7)(5) = $12.50

Producer surplus is equivalent to the profit in this case. The producer would be willing to sell the product for $2, but actually receives $7 for it. Thus each unit the monopolist sell will result in a surplus of $5. Thus the total profit is $25. You could have alternatively directly calculated the profit since TR = P x Q = $7 x 5 = $35TC = ATC x Q = $2 x 5 = $10Profit = $25

Total surplus is the sum of consumer and producer surplus or $12.50 + $25 = $37.50

(d) What would have been the level of output and price in the long run if this industry were perfectly competitive? (2 Points)

If the industry was perfectly competitive it would have produced where demand=price =marginal cost. Set the demand curve equal to the marginal cost and solve12-Q = 2Q = 10; P = $2

The perfectly competitive outcome would have been 10 units produced each selling for $2.

(e) Calculate the consumer surplus, producer surplus (profit), and total surplus if this industry were perfectly competitive (2 point)

Consumer surplus is the area below the demand curve and above the price paid ($2). It is found by the area = ½($12-$2)(10) = $50Note that producer surplus is now zero. Producers would be willing to accept $2 for their product which is exactly what they get in perfect competition, since there is no profit, there is no producer surplus. Total surplus will just equal consumer surplus which was $50

(f) Calculate the deadweight loss. (2 Points)

The difference in total surplus is the deadweight loss. Total surplus decreases by $12.50 (as we go from $50 to $37.50).

Alternatively, deadweight loss is found by calculating the loss to society of not producing the optimal amount. It is the triangle area between the monopoly outcome and perfectly competitive outcome. In this case the area is (1/2)($7-$2)(10-5) = $12.50

(g) If the monopolist was able to employ perfect price discrimination, what would be the level of deadweight loss to society? (3 Points)If the monopolist could perfectly price discriminate, the MR will equal the demand curve since they can charge each consumer exactly what he would be willing to pay. The monopolist will produce where MR=MC which in this case will be exactly where the perfectly competitive industry would have produced. Since the monopolist produces where the perfectly competitive optimal outcome would have been, there is no deadweight loss. However, there is no consumer surplus, as all consumer surplus got transferred to the monopolist in the form of profit.