EEP1/Econ3
Midterm 2 2015
1. (5pts) Give a definition:
a. Option Value: The value of preserving access to the potential future uses of
something; the willingness to pay for retaining the option to use something later.
i. Explain that it is the value of actually retaining the option itself (1 point)
ii. Definitions that used ``value of the right, but not the obligation to do
something" were acceptable.
b. Cost Function: The least amount of money/minimum cost needed to produce
output Q.
i. The least (-.5 points without least) amount of money to produce some Q (1
point)
c. Stated Preference: The values that people say they place on goods.
Theoretically captures both use value and non-use value (suffers from
hypothetical bias/``warm glow").
i. Explain that it is generated from questions about someone's
valuation/willingness to pay (1 point).
d. Grandfathering: Allowing already-existing firms to postpone compliance with
new environmental regulations.
i. Doesn't affect old firms/pollution (1/2 point)
ii. Affects entering firms (1/2 point)
e. Hedonic Method: Examining the value of a good's attributes, which are not
directly priced in the market.
i. Explain that this is a method for valuing attributes indirectly (or that the
model can use differences between attributes to explain the difference in
price between two almost identical goods) (1 point)
Answers that differ slightly from these definitions may still be correct, and additional
context/examples provided in the answer will be taken into account. However, answers with
additional incorrect information may have partial credit taken off.
2. (7pts)Draw a diagram using isocost lines and isoquants and use it to explain why a
tax on a polluting input is more expensive to a firm than a requirement to use less of
the input. Assume that requirement and the tax both lead to the same technique
and the same output. Follow these steps:
a. (1pt) Draw a diagram with an isoquant curve, an isocost line and a chosen
input bundle (technique).
An example might look like this – if it was not labeled (the isocost, isoquant, and bundle) or was
not clear from your following answers, only partial credit was awarded. (1/3 point for each)
b. (1pt) Why is the technique you marked chosen?
i. State that you chose the tangency point as shown in part A (1/2 point)
ii. Explain that this minimizes cost to the firm at that isoquant (or maximizes
profits) (1/2 point)
c. (1pt) Assume the input on the horizontal axis causes pollution and the
government restricts its use. Use your diagram to show what happens,
output held constant. Label your result.
i. Identify the new point which uses less of the polluting good on the graph,
stays on the same isoquant (1/2 point)
ii. Shift out the isocost line in parallel to intersect the new point (1/2 point)
d. (2pts) Now show how a tax can lead to the same result. Explain.
i. Isocost line slope shifts, making the taxed good more expensive (1/2
point)
ii. New tangency at the same point from part C (1/2 point)
iii. Indicate and explain that the tax has increased the cost to the firm for that
input, changing the slope of the isocost and resulting in that tangent point
being the new cheapest bundle (1 point, answers may vary slightly in
wording)
e. (2pts) Use your diagram to show which method costs the firm more. Explain.
i. Indicate that the taxed bundle costs more (1 point)
ii. Explain that the tax increases the cost of all units of the polluting good the
firm is buying, so even if they produce at the same point as in B, they are
being charged more (1 point, answers may vary slightly in wording)
1. Was not sufficient to simply state “the taxed bundle costs more.”
3. (4pts) Consider a price taking firm and explain:
a. What is the supply curve for a single competitive firm? Explain why this is
true.
The supply curve for a single competitive firm is the firm’s marginal cost curve above the point
where MC=AVC. This is because the firm’s profit is maximized when P=MC, and the firm is
losing profit per unit if it operates below where MC=AVC (shut down rule).
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Supply is marginal cost curve (1/2 pt)
Above where MC=AVC (1/2 pt)
b. Draw a diagram that shows long run competitive equilibrium, with four
firms producing at the equilibrium point. Include in your diagram the firm's
AC, AVC, and MC, the industry short run supply curve, the industry
demand curve, and the industry long run supply curve. Explain each
element in your diagram and explain how your diagram shows long run
competitive equilibrium.
The short run supply curve is found by horizontal addition; multiply each quantity along the
individual supply curve by four if there are four identical firms. The slope of the short run supply
curve will be less steep than the slope of the individual supply curve, and the short run supply
curve will not exist when P < an individual firm’s AVC.
The long run supply curve is a horizontal line beginning at the minimum of an individual firm’s
AC curve.
The demand curve intersects the long run supply (and in this case also the short run supply) at a
point where there are four firms producing.
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
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MC, AC, AVC (1 pt)
LRS (1 pt)
SRS (1/2 pt)
Demand curve, equilibrium (1/2 pt)
If the graph was correct and there was explanation, you received full credit. If the graph seemed
incorrect, I looked to the explanation for possible redemption. This question was not especially
clear about whether the four firms restriction was in the short run or the long run, so I gave credit
for showing either.
4. (4pts)This problem is about finding a recreation demand curve for an imaginary
park, Jellybear. See the other side of this exam the relevant information.
a. Find the total number of visitors when the entrance fee is $2. Explain ALL
the steps.
Step 1: find the relevant cost to plug into the visits/capital equation, by town. (1/2 pt)
Eg: Alabaster: cost= one-way cost + admission fee= $1*1 mile + $2= $3
Step 2: find visits/capita using the equation given. (1/2 pt)
Eg: Alabaster: Visits/Capita = 1-0.15*(3)=0.55
Step 3: find visits from each town by multiplying by each town’s population (1/2 pt)
Need to recognize that negative visits/capita means 0 visits (1/2 pt)
Eg: Alabaster: visits = 0.55*100=550
Step 4: Sum total number of visits
City of Origin Population
Alabaster
1000
Distance
1
Cost
3
Visits/Capita
0.55
Visits
550
Beautiful
3000
Cornucopia
5000
Delight
7000
Total visits = 550+750=1300
3
5
7
5
7
9
0.25
0
0
750
0
0
b. Instead assume that you were a researcher and you did not know the relation
between visits per capita and costs. How would you find that relationship
using a revealed preference method? (Your answer does not need to include
the details of methods to fit lines to data points.)
Your answer should contain:



Valid revealed preference method (1/2 pt)
Data-gathering method (1/2 pt)
What data you need
o Data for cost: distance traveled, cost of traveling that distance (1/2 pt)
o Data for visit rate: each person’s town/city, population of that city (1/2 pt)
No points were given if you listed a stated preference method.
Note: using revealed preference methods other than the travel cost method is tricky because you
still need information on cost of a visit and visits per capita in order to answer the question. If
you explain how your revealed preference method could find this information, you received
partial to full credit.
Eg answer: To find the relationship between visits per capita and costs, I would use the travel
cost method. I would survey a random sample of those entering the park, on random days
throughout the year, making sure to include weekends and holidays as well as weekdays. To find
cost information, I would ask each individual where they were coming from and perhaps even
the make and model of their car. Knowing where each person lives would also help me calculate
visits/capita. Finally, I would ask other demographic information that might be relevant if I
thought the visit rate would vary by demographic group. I would calculate each person’s distance
traveled and combine this with data on local gas prices and car mileage to estimate the average
cost of travel. I would combine each person’s hometown with data on town populations to
calculate the visits/capita of each town. I would then run a regression to estimate the relationship
between visits/capita and cost of a visit.
2. The following table gives information on visitors to Jellybear Park:
City of
Origin
Population
Distance
Alabaster
1000
1
Beautiful
3000
3
Cornucopia
5000
5
Delight
7000
7
The travel cost per mile (one way) is $1.
Visits/Capita= 1 – 0.15*(One-Way Cost + admission fee).