Prof. Jennifer Olmsted
Practice questions Exam 2 answers

1. a. Using the data provided above, graph a perfectly competitive market for computers. See graph outside my office.
b. Calculate total revenue, consumer and producer surplus. CS = 1/2 (80-40) * 200 = 4000, PS = 1/2 (40-0) * 200 = 4000, TR = 40*200= 8000
c. Suppose all firms go out of business except one and that firm decides to raise the price to 60. How many computers will be supplied and demanded at this price? Q = 100
d. Using economic terminology, discuss whether it seems realistic for a computer company to raise its price in such a way. (Hint - what factors other than being a sole producer, determine whether a firm will have market power?) The demand for computers is probably fairly inelastic, so that might mean that a firm can raise its price. But it seems unlikely that all other computer firms will go out of business. Still, computers may be fairly heterogenous products, so an individual firm might be able to raise its price somewhat.
e. Calculate the new consumer surplus. CS = 1/2 (80-60) * 100 = 1000
f. Show graphically and explain verbally what the new producer surplus will be. Producers lose a small triangle to DWL, but gain more overall surplus by capturing some of the consumers' surplus. See graph outside my office.
g. Show the impact of this change in the market for computers on the computer workers' wages. A reduction in production will lead to a reduction in the demand for workers, so the number of workers hired will drop and their wages will as well. See graph outside my office.

2. a. Draw a graph showing the impact of a price ceiling on consumer and producer surplus. A price ceiling (below equilibrium) has the opposite effect that a monopolist has. Some producer surplus is tranferred to consumers, and a DWL is created.
b. Explain the impact of this policy on efficiency. Since a DWL is created, the solution must be ineffecient. (Note in the case where a monopoly already exists, the price ceiling actually reduces DWL.

3. a. Explain the difference between fixed and variable costs. Fixed costs do not vary with changes in the quantity of goods (Q) produced. Examples - marketing costs, rent on a building, etc. Variable costs increase as Q rises. Rubber and leather used in shoes are variable costs, since the more shoes you make, the more rubber and leather you need.
b. How do firms use information about fixed and variable costs in making their production decisions? The decision on whether to stay in the market in the short run is a function primarily of variable costs. If a firm can cover all variable costs, it will keep producing in the short run. But when contracts expire (labor, rental, loans, etc.) the firm must decide whether to sign another set of contracts, and so fixed costs become relevant.

4. a. What rule do both perfectly competitive and monopolistic firms use to determine Q? MC=MR
b. How does the monopoly decision differ from the perfectly competitive firm's decision? In the case of perfect competition, the firm has no power to change the price, and so takes p as given. If the price is given, that means that the marginal revenue is the price. Given MR=p the firm simply sets p=MC, to determine Q. In the case of the monopoly, MR varies, because if the firm increases or decreases Q the price wil change. The monopoly uses MR=MC to determine the profit maximizing Q, and then figures out what to charge by reading the p off the demand curve, given the Q they have decided to produce.

5. A politician makes the following campaign promise: “I plan to impose a tobacco tax, in order to cut smoking rates by 50%.”
a. Given what you know about cigarettes, does this sound like a realistic plan? Cigarette demand is relatively inelastic, so it seems unlikely that this politician will be able to cut smoking rates in 1/2, unless (s)he raises taxes a lot!
b. Does it sound like an equitable plan? Cigarette taxes are regressive, since poor people spend a higher portion of their income on cigarettes. So this plan will hurt the poor more than the rich.
c. If the elasticity of demand for cigarettes is -0.25, how much will the price have to rise in order to achieve this goal. Explain why this is the case. The price would need to rise by 200% since 50/200 = .25!

6. How do economists view taxes? Why do policy makers levy taxes and what are the economic and social consequences of taxes? Discuss the case of the tobacco tax. Be sure to discuss in your answer to discuss issues of equity and efficiency.
Taxes are seen as necessary to raise revenues. Taxes may also be seen as useful because they reduce consumption of certain goods and/or as a way of redistributing income from one group in society to another. Unfortunately when a tax is effective in reducing consumption, it is not effective for raising revenues! For example, a cigarette tax is an effective way of raising revenues, since cigarette demand in inelastic, but a tax may not be that effective in reducing the amount that people smoke. In some cases taxes are inefficient, although in the case of cigarettes, this is not the case, since cigarette smoking involves second hand smoke! Cigarette taxes are also regressive, since the poor end up paying a higher portion of their income on cigarettes.