Economics 272

Final Exam Answer Key

Name: _________________

1. Suppose that the government subsidizes a good: For each unit of the good sold, the government pays $3 to the buyer. Please provide a brief explanation for each of the questions below.

P1 P2 P3 J K

a) Please show using the figure the effect of the subsidy on the price paid by the demanders and the price received by the suppliers. (2 points) Price paid by the demanders: P3. Price paid by the suppliers: P1. b) Please use the letters in the figure to write out the consumer surplus and producer surplus after the subsidy. (2 points) CS after subsidy = A + B + E + F + G + J + K. PS after subsidy = B + C + E + I + J + K. c) Please use the letters in the figure to write out the total surplus after the government subsidy. (2 points) TS after subsidy = CS after subsidy + PS after subsidy Governtment PaidOut = A + B + E + I + J + K D H. d) Please show whether a subsidy leads to a deadweight loss. (2 points) Change in TS = TS after subsidy TS before subsidy = -(D + H). Therefore, Deadweight Loss is (D + H).

2. The Pristine River has two polluting firms on its banks. Came Industrial and Creative Chemicals each dump 100 tons of glop into the river each year. The cost of reducing glop emissions per ton equals $10 for Acme and $100 for Creative. The local government wants to reduce overall pollution from 200 tons to 50 tons. a) If the government knew the cost of reduction for each firm, what reductions would it impose to reach its overall goal? What would the cost to each firm and the total cost to the firms together? (2 points) If the government knew the cost of reduction at each firm, it would have Acme eliminate all its pollution (at a cost of $10 per ton times 100 tons = $1,000) and have Creative eliminate half of its pollution (at a cost of $100 per ton times 50 tons = $5,000). This minimizes the total cost ($6,000) of reducing the remaining pollution to 50 tons.

b) In a more typical situation, the government would not know the cost of pollution reduction at each firm. If the government decided to reach its overall goal by imposing uniform reductions on each firm, calculate the reduction made by each firm, the cost to each firm, and the total cost to the firms together? (2 points) If each firm had to reduce pollution to 25 tons (so each had to reduce pollution by 75 tons), the cost to Acme would be 75 x $10 = $750 and the cost to Creative would be 75 x $100 = $7,500. The total cost would be $8,250.

c) Compare the total cost of pollution reduction in parts (a) and (b). If the government does not know the cost of reduction for each firm, is there still some way for it to reduce pollution to 50 tons at the total cost you calculated in part (a)? Explain. (2 points) In part a, it costs $6,000 to reduce total pollution to 50 tons, but in part b it costs $8,250. So it is definitely less costly to have Acme reduce all of its pollution and have Creative cut its pollution in half. Even without knowing the costs of pollution reduction, the government could achieve the same result by auctioning off pollution permits that would allow only 50 tons of pollution. This would ensure that Acme reduced its pollution to zero (since Creative would outbid it for the permits) and Creative would then reduce its pollution to 50 tons.

3. Suppose there are 1,200 hot-pretzel stands operating in New York City. Each stand has the usual U-shaped average-total-cost curve. The market demand curve for pretzels slopes downward, and the market for pretzels is in long-run competitive equilibrium. a) Draw the current equilibrium, using graphs for the entire market and for an individual pretzel stand. (3 points)
Price, Costs MC ATC P* D P* LRS Price, Costs SRS

D Q* Q Individual Stand Industry Q* Q

b) Now the city decides to restrict the number of pretzel-stand licenses, reducing the number of stands to only 1000. What effect will this action have on the market and on an individual stand that is still operating? Use graphs to illustrate your answers. (4 points) If the city government restricts the number of pretzel stands to 1000, the industrysupply curve shifts to S2. The market price rises to P2, and individual firms produce output q2. Now the price exceeds average total cost, so each firm is making a positive profit. Without restrictions on the market, this would induce other firms to enter the market, but they cannot, since the government has limited the number of licenses.

c) Suppose that the city decides to charge a license fee for the 1000 licenses. How will this affect the number of pretzels sold by an individual stand, and the stands profit? The city wants to raise as much revenue as possible and also wants to ensure that 1000 pretzel stands remain in the city. By how much should the city increase the license fee? Show the answer on your graph. (4 points)

The city could charge a license fee for the licenses. Since it is a lump-sum fee for the license, not based on the quantity of sales, such a tax has no effect on marginal cost, so won't affect the firm's output. It will, however, reduce the firm's profits. As long as the firm is left with a zero or positive profit, it will continue to operate. So the license fee that brings the most money to the city is to charge each firm the amount (P2 ATC2)q2, the amount of the firm's profit.

4. Please complete the following sentences. (6 points) a) The true cost of taking some action is its opportunity cost. b) Average total cost is falling when marginal cost is below it, and rising when marginal cost is above it. c) A cost that does not depend on the quantity produced is a fixed cost. d) In the ice-cream industry in the short run, variable cost includes the cost of cream and sugar, but not the cost of the factory. e) Profits equal total revenue less total cost. f) The cost of producing an extra unit of output is the marginal cost. 5. Please provide an answer and a brief explanation to the following questions. a) Please explain why, in general, marginal cost decreases first then increases as the quantity produced becomes higher. (2 points) As the company only has a few labors, hiring each additional labor can increase efficiency as each labor becomes specialized in his/her task. As company hires more labors, the labor becomes less and less efficient as the marginal product decreases. b) Please explain why firms are willing to produce at zero profit in the long run in a competitive industry? (2 points) The profit here refers to economics profit. The firms in competitive industry are still earning some accounting profit, which is the monetary compensation that could have been earned working at some other place. c) In general, what relationship can we say about marginal cost and average total cost? Please use a figure to show it. (2 points)
Costs MC ATC

Q*

1. ATC is decreasing when MC is less than ATC, and ATC is increasing when MC is more than ATC. 2. MC intersects the lowest point of ATC, which is the efficient scale of firm. d) Please explain why the average total cost is usually U-shaped. (2 points) ATC = AFC + AVC. Since fixed cost is constant, it decreases as more output is produced. AVC increases as the output increases. When output is low, AFC dominates, and when output is high, AVC dominates.

6. Nimbus, Inc., makes brooms and then sells them door-to-door. Here is the relationship between the number of workers and Nimbuss output in a given day: Workers Output Marginal Total Cost Average Marginal Product Total Cost Cost 0 0 200 1 20 20 300 15 5 2 50 30 400 8 3.33 3 90 40 500 5.56 2.5 4 120 30 600 5 3.33 5 140 20 700 5 5 6 150 10 800 5.33 10 7 155 5 900 5.81 20 a) Please complete the table. Complete point for each column is given only if the answers are all correct. A workers costs $100 a day, and the firm has fixed costs of $200. (5 points) b) Assume Nimbus is in a competitive broom industry. If the price of a broom is $2.50, what quantity will Nimbus choose to produce? Will Nimbus choose to operate in the short run? Will Nimbus choose to stay in the industry in the long run? Please show the derivation of your answers. (3 points) Nimbus will choose to produce the profit-maximizing quantity, 90, because this is where P = MC = $2.50. However, the firm will choose not to produce any for the following reasons. Nimbus will choose not to operate in the short run, because AVC is $300/90 = $3.33 when output is 90, and P<AVC. Nimbus will choose not to stay in the industry in the long run, because ATC is $500/90 = $5.55 when output is 90, and P<ATC. c) Assume again Nimbus is in a competitive broom industry. If the price of a broom is $10, what quantity will Nimbus choose to produce? Will Nimbus choose to operate in the short run? Will Nimbus choose to stay in the industry in the long run? Please show the derivation of your answers. (3 points) Nimbus will choose to produce the profit-maximizing quantity, 150, because this is where P = MC = $10. Nimbus will choose to operate in the short run, because AVC is $600/150 = $4 when output is 150, and P>AVC. Nimbus will choose not to stay in the industry in the long run, because ATC is $800/150 = $5.33 when output is 150, and P>ATC.