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.