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Economics 003 Answers to First Exam Behzad Diba

Fall 2015

Please check your copy of the exam to make sure that you have questions 1 through 17.G. A. Multiple Choice (3 points each): each question has only one correct answer. 1.

To establish that allocation X is Pareto efficient, we need to show that

Answer: for every other feasible allocation Y, there is at least one person who prefers X to Y. 2.

We say two goods are “complements,” whenever their cross price elasticities of demand

Answer: are negative. 3.

Suppose bad news about the economic outlook makes buyers and sellers in the US stock market worried that stock prices may fall in the near future. In the aftermath of the news, the volume of trade (the number of shares bought and sold)

Answer: may rise or fall, but stock prices are likely to fall immediately. 4.

If firms in a competitive industry incur losses in the short run,

Answer: some firms will exit the industry over time, and the market price will rise. 5.

According to the theoretical model of a perfectly competitive industry,

Answer: none of the above is necessarily true. 6.

According to the theoretical model of a perfectly competitive industry,

Answer: an individual firm faces a perfectly elastic demand curve. 7.

Consider a competitive industry that uses raw materials to produce its output. Suppose an increase in the cost of raw materials leads to a 10% increase in the equilibrium price of the industry’s output. The corresponding effect on the quantity of output will be larger if

Answer: the demand curve is highly elastic. 8.

Suppose we have CPI data with base year 1929 for a hypothetical country, and the CPI figure for 1933 is 80. We can infer that from 1929 to 1933, this country had

Answer: 20% deflation.

9.

The value added of corporations includes

Answer: wages and salaries paid by corporations as well as corporate profits. 10.

In the National Income and Product Accounts, productive non-market activities

Answer: are often not included in GDP, although in theory they should be. 11.

The NIPA data on Business Fixed Investment include

Answer: neither intended nor unintended inventory accumulation. B. Multiple Choice (4 points each): each question has only one correct answer. 12.

For an economy that produces only two goods X and Y, “production efficiency” implies that

Answer: to produce more X, the economy has to reduce its production of Y. 13.

Consider our basic trade model with two goods (Good 1 and Good 2) and two countries (A and B). If Country A has both absolute and comparative advantage in producing Good 1, we can infer

Answer: that Country B has comparative advantage in producing Good 2. 14.

If US firms had produced more goods (than they actually did) in December 2008, kept these goods in inventory, and sold them in January 2009, then (compared to the actual figures) the GDP of 2008 would be

Answer: larger, but the GDP of 2009 would be the same. 15.

The vertical distance between average total cost and average variable cost curves decreases as output increases if, and only if,

Answer: fixed costs are positive. C. Short Answers (You can get full credit without spending time on detailed explanations). 16. Briefly explain (in one or two sentences) why each of the following statements is TRUE or FALSE. A. (4 points) In an efficient equilibrium, any two individuals consuming the same good must have the same marginal utility for that good.

Answer: False. They should have the same marginal benefits. We cannot compare utility across individuals. B.

(4 points) In an efficient equilibrium, any two firms producing the same good must have the same marginal cost of producing that good.

Answer: True. Otherwise, we could reduce the costs of production by having the firm with lower marginal cost produce another unit, and the firm with higher marginal cost produce one unit less. C.

(4 points) The basic argument for Pareto efficiency of a competitive equilibrium is that consumers and firms are price takers, and they all face the same market prices.

Answer: True. All consumers and firms equate their marginal benefits and marginal costs to the same price. So, the efficiency condition (marginal benefit = marginal cost) is satisfied. D. (4 points) A competitive firm’s marginal revenue equals the market price. Answer: True. When a competitive firm increases it’s output by one unit, the market price is not affected; so, the revenue gain from selling the extra output equals the market price. 17. Suppose the market demand and supply curves for gasoline fit the following linear equations. The demand curve satisfies

where P denotes the price in cents, and Qd denotes the quantity demanded in gallons; A and b are positive constants. The supply curve satisfies

where Qs denotes the quantity supplied in gallons, C and d are positive constants, and we have A > C. A. (4 points) What are the equilibrium values of price and quantity in this market? Answer: The equilibrium quantity satisfies A - bQ = C + dQ which gives

Substituting this in the supply or demand equation, we get

B. (4 points) Use a graph to mark the areas that measure consumer and producer surplus with linear supply and demand curves. [Note: you don’t need the correct answer to Part A for answering Part B]. Answer: Middle diagram of Figure 4 in Chapter 7 of the textbook. C. (4 points) Calculate the producer and consumer surplus in the equilibrium of Part A, in terms of the parameters of the supply and demand curves. [Note: as you probably recall, the area of a triangle is its base times its height divided by two.] Answer: Consumer surplus (CS) is the area of a triangle with base Q and height A - P. So, we get

[Note: the answer without the last step (which simplifies the algebra) is enough to get full credit.] Producer surplus (PS) is the area of a triangle with base Q and height P - C. So, we get

[Note: the answer without the last step (simplifying the algebra) is enough to get full credit.] D. (6 points) Suppose the government imposes a tax of T cents per gallon sold on suppliers (sellers have to pay this tax to the government). Calculate the equilibrium price and quantity after the tax is imposed. Answer: The supply curve shifts to the left and now satisfies

The equilibrium quantity now satisfies A - bQ = T + C + dQ which gives

and

(assuming the tax is small enough to satisfy A > T +C). E. (6 points) Use a graph to show the shift(s) of supply and / or demand resulting from a tax imposed on sellers. Mark the areas that measure consumer and producer surplus after the tax is imposed. [Note: you don’t need the correct answer to Part D for answering Part E; it is sufficient to reproduce the relevant graph in the textbook.] Answer: Figure 9 in Chapter 7 of the textbook. F. (6 points) Calculate the producer and consumer surplus in the equilibrium of Part D (after the tax is imposed), in terms of the parameters of the supply and demand curves. Answer: Consumer surplus (CS) is the area of a triangle with base Q and height A - P. So, we get

[Note: the answer above is enough to get full credit, but we can simplify it to

or get this answer using the slope of the demand curve to relate the height of the surplus triangle to its base.] Producer surplus (PS) is the area of a triangle with base Q and height P - C - T (noting that the vertical intercept of the supply curve is now C + T). So, we get

[Note: the answer above is enough to get full credit, but we can simplify it to

to make some optional calculations below.] G. (5 points) Calculate the deadweight loss to society from taxation, in terms of the parameters of the supply and demand curves. Answer: The government’s tax revenue is TQ

The deadweight loss is DL = CS + PS - CS* - PS* - TR [Note: the answer above is enough to get full credit, but we can simplify it as follows. We have

and

So

is the deadweight loss from taxation.]...