Econ 10: Midterm (Dr. Stein)
October 23, 2007
Instructions:
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This is a 90-minute examination.
Write all answers in blue books. Show all work. Use diagrams where
appropriate and label all diagrams carefully.
Do not overwrite! Use the guidelines and suggestions in each question.
This exam is given under the rules of Penn's Honor system.
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No calculators allowed.
The Exam has 2 parts. Make sure you answer both parts.
Use blue book #1 for Part I.
Use blue book #2 for Part II.
Write your name and your TA’s name on both blue books NOW.
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Part I
Warm up. (3 points each).
Choose the correct answer and write it in your blue book. Do not explain.
If you think the question is ambiguous, you may state any additional assumptions
you are making.
1. Daniel spent 5 hours selling old toys at a flea market and got $100 for them. The
cost of renting space to sell his toys was $35. From this information we can
conclude that:
a.
b.
c.
d.
Daniel made a profit of $65.
Daniel made a loss of $65.
Daniel made at least $65 profit.
Daniel made at most $65 profit.
2. Economic growth is depicted by
a.
b.
c.
d.
a shift in the production possibilities frontier outward.
a movement from inside the curve toward the curve.
a shift in the production possibilities frontier inward.
a movement along a production possibilities frontier toward capital goods.
3. If the unemployment rate decreases from 10 percent to 8 percent, the economy
will
a.
b.
c.
d.
move closer to the ppf.
move away from the ppf toward the origin.
remain on the ppf.
remain on the origin.
4. A change in the price of a good leads to a ________, which leads to a _______.
a.
b.
c.
d.
change in its demand; movement along its demand curve.
change in its quantity demanded; movement along its demand curve.
change in its demand; shift in its demand curve.
change in its quantity demanded; shift in its demand curve.
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5. Suppose lettuce and endives are substitutes. Suppose 15% of the endive crop was
destroyed by flooding. This would have caused the equilibrium price of lettuce to
______ and the equilibrium quantity of lettuce to _______.
a.
b.
c.
d.
decrease; decrease
decrease; increase
increase; increase
increase; decrease
6. The price of a magazine increases by 10% and quantity demanded of magazines
falls by 10%. The demand for magazine is
a.
b.
c.
d.
perfectly elastic.
unitarily elastic.
elastic.
inelastic.
7. Price and total revenue are inversely related when demand is
a.
b.
c.
d.
elastic.
inelastic.
unitarily elastic.
perfectly inelastic.
Answers:
1. d
2. a
3. a
4. b
5. c
6. b
7. a
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Q1. (15 points)
John, Forbes, and Nash are three brothers living on a farm where they can only produce
bananas and apples. The table below shows the amount of apples and bananas that these
guys can produce per day:
Brother
John
Forbes
Nash
Apple (pounds/day)
10
6
5
Banana (pounds/day)
5
6
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a. What is the opportunity cost of producing 1 pound of apples for each of the three
brothers?
Answer: (1 point each, must include units)
John: ½ lb bananas
Forbes: 1 lb banana
Nash: 2 lbs. bananas.
b. Draw the daily joint PPF for John and Nash with apples on the horizontal axis
(i.e., John and Nash collaborate). Label important points and show your work.
Answer:
PPF with one kink (1 point)
Points at: (0,15) (10, 10) (15,0) (1/2 point each)
c. Now draw the daily joint PPF for all three brothers with apples on the horizontal
axis (i.e., now all three brothers, John, Forbes, and Nash collaborate). Label
important points and show your work.
Answer:
PPF with 2 kinks (1.5 point)
Points at: (0,21) (10, 16) (16,10), (21,0) (1/2 point each)
d. If they (all three of the guys together) want to produce 12 pounds of apples
efficiently, who is producing what and how much of it?
Answer:
Efficiency requires production of 12 lbs apples and 14 lbs bananas. (1 point)
Apples will be produced by John (10 lbs) & Forbes (2 lbs). (1/2 point)
Bananas will be produced by Nash (10 lbs) & Forbes (4 lbs). (1/2 point)
e. If they are producing 5 pounds of apples and 18 pounds of bananas, are they
working efficiently?
Answer: (2 point, must include either a numeric or a graphically accurate
explanation).
No. This is a point inside the PPF.
They could produce 5 apples (by John) and this would leave them with 18.5
bananas (by Nash, 10, Forbes, 6 & John, 2.5)
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f. The three brothers are considering trade with other farms. John claims that they
will gain from trade whatever the going price ratio is. Do you agree? Explain
carefully.
Answer: (2 points. Explanation is crucial!)
At any price ratio there will be at least 2 brothers who have an opportunity cost
that differs from the world price so that the CPF must lie outside the PPF for at
least part of the range and there will be gains from trade.
Note that theoretically it is possible that their preferences are such that they
choose not to move from their consumption point. If students add this that is
fine, but I am looking for the understanding that the CPF lies above the PPF at
least for part of the range.
Q2. (14 points)
In this question, consider the market for flip-flops. Suppose that the supply of flip-flops is
upward sloping and that the demand is downward sloping.
a. Graph supply and demand in this market. Make sure to point out the equilibrium
price, the equilibrium quantity, the consumer surplus, and the producer surplus.
Answer:
Standard graph expected.
Axis: 1 point
Q* & P*: ½ point each
P.S. & C.S.: 1 point each
b. Now suppose the U.S. government imposes a per-unit tax on flip-flops. Draw a
new graph with the new equilibrium.
Answer:
Shift up supply curve by t: 1 point
New Q** & P**: 1 point each
c. In your graph for part b, does the sum of consumer surplus, producer surplus, and
government revenue equal the sum of the original consumer and producer
surpluses? Explain carefully.
Answer:
No. There is Dead Weight Loss. Explanation can be:
1. Graphical. Showing D.W.L. on the graph
Or
2. Showing that at the new Q, MB(Q**)>MC(Q**). Since MC=MB is our criteria
for efficiency an inequality implies inefficiency.
3 points. Must have explanation.
d. How would you answer to part c change if the supply curve for this market is
perfectly elastic? Explain graphically.
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Answer:
In this case too there is D.W.L.
Points: 1 for drawing the correct case (perfectly elastic supply)
1 point for showing D.W.L.
e. Redo the same exercise as in part d, but now suppose instead that the supply curve
is perfectly inelastic.
Answer:
In this case there is no D.W.L.
Points: 1 for drawing the correct case (perfectly inelastic supply)
1 point for showing no D.W.L. or no change in quantity.
End of Part I
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Part II
Use blue book #2 for this part.
Stretch & relax. (3 points each).
Choose the correct answer and write it in your bluebook. Do not explain.
If you think the question is ambiguous, you may state any additional assumptions
you are making.
1. The marginal cost curve
a. first rises, then declines.
b. intersects the average variable cost and average total cost curves from
below at their minimum points.
c. increases when the average total cost curve lies above the average variable
cost curve.
d. falls when the point of diminishing marginal returns is reached.
2. The vertical distance between the ATC and AVC curve represents
a.
b.
c.
d.
marginal cost.
average fixed cost.
total fixed cost.
total variable cost.
3. Choose the statement that is FALSE:
a. The perfectly competitive firm’s supply curve (in the short run) is the
portion of its marginal cost curve that lies above its average variable cost
curve.
b. At the profit-maximizing output profits can be negative.
c. The marginal cost curve cuts both the average variable cost and average
total cost curves at their minimum points.
d. An increase in output above the profit-maximizing point would cause
negative profits.
Answers:
1. b
2. b
3. d
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Q3. (3 points)
Suppose that the marginal cost curve of a firm in a competitive market and the market
price P* are as follows:
Now, a student, recalling that his or her RI said that the maximum-profit condition is
given by “Price = Marginal Cost,” argues that both Q1 and Q2 are profit-maximizing. Is
the student correct? Support your claim.
Answer:
The student is incorrect. The area between the P* & MC represents extra profits
(revenue minus variable costs) that can be acquired if the firm produces Q2 vs.
Q1. Therefore Q1 cannot be the profit maximizing output.
Q4. (3 points each)
If a perfectly competitive firm has chosen an output level that maximizes profits, state for
each of the following statements whether true or false. There is no need to explain unless
you need to make a clarification.
I.
II.
III.
Average total cost is minimized. False.
The difference between average revenue and average total cost is maximized.
False.
The difference between total revenue and total variable cost is maximized.
True.
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Q5. (15 points)
George Naylor is an Iowa corn farmer. Corn is a competitive market and is currently in a
long-run equilibrium.
a. Draw a graph depicting George Naylor's cost curves and his profits assuming that
the price of corn is currently $1.45/bushel.
Answer:
Typical cost curves:
MC increasing: ½ point
ATC intersect MC at minATC: ½ point
ATC above AVC: ½ point
AVC intersect MC at minAVC: ½ point
Distance between AVC & ATC decreases w/Q: ½ point
Q* at minATC: ½ point
P* marked as $1.45: ½ point
Profits=zero: ½ point
b. Draw a graph depicting the supply and demand in the corn market as a whole.
Make sure this graph is consistent with the one you drew in part a.
Answer:
Standard supply & demand with P=$1.45
Axis: ½ point
Upward supply & downward demand: ½ point each
P=1.45: 1½ point
A new hybrid of corn is expected to yield more bushels per acre. The new hybrid seed
costs only slightly more than the seed George is currently using. Suppose that George
decides not to use it, but that all other farmers do switch to the new corn.
c. Show the effects of the new seed on the market supply and demand graph that you
drew in part b. Explain why you shifted the curves that you shifted and clearly
mark what happens to the price of corn.
Answer:
Supply shifts out because the MC curves for each farmer (except George shifts
out). 1 point.
Market price of corn declines. 1 point.
d. What effect will the new hybrid have on George? Show these effects on the graph
that you drew in part a. Clearly explain why you shifted any curves that you
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shifted. What happens to George’s profits? Will George stay in the market in the
long run?
Answer:
George will now face a market price below $1.45 a bushel. : 1 point.
No other curves shift: 1 point.
George now has negative profits: 1 point (need to show this or explain carefully).
George will not stay in the market in the long run. 1 point.
e. George Naylor says that he will not adopt the new hybrid because any gains in
yield are offset by increases in costs. If this were the case, how would your
answers to parts c and d change?
Answer:
George is stating that the long run equilibrium will not change as any shifts out
of the MC curve due to improvements in productivity are off set by shifts in of
the MC due to the fact that the input price is higher.
In part c: there is not change in the equilibrium price. ½ point.
In part d: The answer is identical to part a. ½ point.
This is NOT the last page. Q6 is on the next page.
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Q6. (14 points)
ADM is the sole manufacturer of hybrid corn seed BSS 131. It faces a downwardsloping demand curve and chooses the quantity of corn seed it sells to maximize profits.
Assume that the marginal cost of making corn seed is constant.
a. Draw a graph showing ADM's costs, demand, and marginal revenue. Show
ADM's profit-maximizing output and price of corn seed.
Answer:
Standard monopoly graph with constant MC curve is expected.
MC constant: 1 point
Downward demand: 1 point
MR<D: 1 point
Qm (where MC=MR)= ½ point
Pm (off De curve)= ½ point
b. Is ADM providing the socially optimal output? Refer to the graph above when
answering.
Answer:
No. Two possible explanations are acceptable here:
At Qm there is Dead Weight Loss as shown in graph.
At Qm MB>MC.
3 points for either explanation.
c. The only way to use BSS 131 effectively is in combination with chemical
fertilizers. Unfortunately, these chemical fertilizers generate downstream
pollution. Suppose corn (not corn seed!) was sold in a competitive market.
Considering the fact that its production entails the use of these chemical
fertilizers, draw the private marginal cost, the social marginal cost, and the
demand for corn. Clearly mark the competitive outputs, the socially optimal
output, and any deadweight loss generated by this market.
Answer:
Standard S&D with negative externality is expected here.
S=MC upward sloping: ½ point
D=MB downward sloping: ½ point
SMC>MC: 1 point
Competitive output where S=D: ½ point
Socially optimal output: where SMC=MB(=D) ½ point
D.W.L.: 1 point
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d. Given the negative externality from the use of chemical fertilizers, is it
necessarily the case that ADM is creating deadweight loss by behaving as a
monopolist? Answer graphically.
Answer:
No. A monopoly under produces compared to the competitive equilibrium,
which means that less BSS 131 will be used than under perfect competition. But
as the use of BSS 131 causes a negative externality we want less than the
competitive amount used, so it may be the case that the monopoly is producing
closer to the efficient output than we would get under perfect competition.
3 points for explanation that shows understanding if the directions of the effect
on output & efficiency.
End of Exam. Well done.
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