Correct Answers Are Noted with *

ECON 101 Spring 2004 Principles of Microeconomics Gundersen

Answers to the Practice Final Exam (correct answers are noted with *)

1. The term “market failure” refers to the idea that a. a surplus or shortage has remained in a particular market due to its failure to reach equilibrium b. the perfectly competitive market has failed to produce enough output to meet the demand of all consumers *c. the perfectly competitive market has failed to produce the socially optimal output level d. the stock market ended the current day lower than the previous five

2. An externality exists when a. the government interferes with perfectly competitive markets b. markets are not able to reach equilibrium c. a firm sells its product in a foreign market *d. one person’s (or firm’s) actions affect the well-being of another person

3. Markets are not socially optimal when negative production externalities are present because a. marginal utility exceeds marginal social costs at the unregulated equilibrium output level b. externalities can never be corrected without government regulation *c. marginal social costs exceed marginal utility at the unregulated equilibrium output level d. a deadweight loss occurs

4. In a market with a downward-sloping demand curve that is affected by a negative production externality, the socially optimal level of output is ______the unregulated equilibrium level of output and the socially optimal price is ______the unregulated equilibrium price. a. greater than, less than b. greater than, greater than c. less than, less than *d. less than, greater than

5. Internalizing a negative production externality will cause a(n) ______in the quantity supplied to the market and a(n) ______in the price of the good. a. decrease, decrease *b. decrease, increase c. increase, decrease d. increase, increase 6. Suppose that a steel factory emits a certain amount of air pollution and that this pollution constitutes a negative externality. If this market is not required to internalize this externality, a. the quantity of steel produced will be socially optimal. b. consumers will be required to pay a higher price for steel. *c. the quantity of steel produced will be profit-maximizing for the firm. d. producers will produce less steel than they otherwise would.

7. The statement that “professors are paid less than lawyers and doctors, but have similar amounts of education” is likely to reflect market conditions such that a. education is completely unrelated to wages b. doctors and lawyers have higher nonmonetary job satisfaction than professors *c. professors’ wages may have been adjusted by a compensating wage differential d. all of the above

8. Liberal arts majors are typically told that a liberal arts degree does not restrict one’s ability to find successful employment in business-related fields. This statement is likely to reflect a philosophy that a liberal arts degree is *a. a signal of high ability b. linked to the accumulation of specific human capital c. an indication of how education can directly increase marginal productivity d. all of the above

9. Taxicab drivers in large cities are likely to earn more than taxi cab drivers in rural areas. One reason for this wage differential could be that a. driving in large cities is more fun than driving in rural areas. b. driving in a large city is easier than driving in a rural area. c. it is unlikely that a taxi cab driver in a large city will be involved in a traffic accident that involves farm animals. *d. driving a taxi in a large city is more dangerous than driving in a rural area.

10. When workers that work the night shift are paid more than those that do identical work on the day shift it is referred to as a. wage inequality. b. inefficient labor markets. *c. a compensating differential. d. discriminatory wage practice.

11. Empirical analysis of wages differences have found evidence that *a. a portion of the wage gap between African American workers and white workers cannot be explained by differences in their job-related characteristics. b. men and women with the same number of years in the labor market have nearly equal wages. c. African American workers and white workers with similar educational levels have nearly equal wages. d. None of the above. 12. When employers sort employment applications into high-ability and low-ability people based solely on the attainment of a college degree (irrespective of major), they are likely to be adhering to the a. human capital theory of education. b. principle that education enhances marginal productivity. *c. signaling theory of education. d. principle that most business owners are more interested in discriminating against a particular group than in maximizing profits.

13. One characteristic of an oligopoly market structure is: a. Firms in the industry are typically characterized by very diverse product lines. b. Products typically sell at a price that reflects their marginal cost of production. *c. The actions of one seller can have a large impact on the profitability of other sellers. d. Since markets are typically large, the actions of one seller largely go unnoticed by its competitors.

Imagine a small town in which only two residents, Tony and Jill, own wells that produce water for safe drinking. Each Saturday, Tony and Jill work together to decide how many gallons of water to pump, bring the water to town, and sell it at whatever price the market will bear. To keep things simple, suppose that Tony and Jill can pump as much water as they want without cost; therefore, the marginal cost of water equals zero.

The weekly town demand schedule and total revenue schedule for water is reflected in the table below.

Weekly Weekly Quantity Total Revenue (in gallons) Price (and Total Profit) 0 $12 $ 0 10 11 110 20 10 200 30 9 270 40 8 320 50 7 350 60 6 360 70 5 350 80 4 320 90 3 270 100 2 200 110 1 110 120 0 0 14. Suppose the town currently has antitrust laws that prohibit Tony and Jill from operating as a monopolist. What will the price of water be once the Nash equilibrium is reached? a. $6 b. $5 *c. $4 d. $3

15. If Tony and Jill could form a cartel, what price would they choose to charge? a. $8 b. $7 *c. $6 d. $4

16. Consider two cigarette companies, PM Inc. and Brown Inc. If neither company advertises, the two companies split the market. If they both advertise, they again split the market, but profits are lower, since each company must bear the cost of advertising. Yet if one company advertises while the other does not, the one that advertises attracts customers from the other and receives higher profits. Based on this information, the Nash equilibrium for this game is *a. Both companies will advertise. b. Neither company will advertise. c. PM Inc. will advertise, but Brown Inc. will not. d. Brown Inc. will advertise, but PM Inc. will not.

17. If a firm in a monopolistically competitive market uses advertising to decrease elasticity of demand for its product (encourage brand-loyalty), a. it will not be effective because the firm is a price-taker. *b. it will be able to increase its mark-up over marginal cost. c. it will increase the well-being of society. d. it will reduce average total cost.

18. A downward-sloping demand curve a. is common to all monopolistically competitive firms. b. is common to all monopoly firms. c. causes price to exceed marginal revenue. *d. all of the above.

19. When firms have agreements among themselves on the quantity to produce and the price to sell output they are organized as a. a Nash arrangement. b. competitive scale firms. c. competitive oligopolists. *d. a cartel. 20. Equilibrium prices in markets characterized by oligopoly are *a. lower than in monopoly markets and higher than in perfectly competitive markets. b. lower than in monopoly markets and lower than in perfectly competitive markets. c. higher than in monopoly markets and higher than in perfectly competitive markets. d. higher than in monopoly markets and lower than in perfectly competitive markets.

21. Some companies have competitors but do not face much competition; in this case they are not price takers. Economists call this situation *a. imperfect competition. b. an oligopoly. c. a duopoly. d. monopolistic competition.

22. As the number of firms in an oligopoly grows larger, an oligopolistic market looks more and more like a. a monopoly. b. a duopoly. *c. a perfectly competitive market. d. none of the above.

Two discount superstores (Ultimate Saver and SuperDuper Saver) are considering expanding the size of their store and parking lot to accommodate potential growth in their customer base. The following game depicts the strategic outcomes that result from the game. Growth related profits of the two discount superstores under two scenarios are reflected in the table below.

Super Duper

 size Don’t  size

 size Super Duper = $50 Super Duper = $25 Ultimate Saver = $65 Ultimate Saver = $275 Ultimate Saver

Super Duper = $250 Super Duper = $85 Don’t Ultimate Saver = $35 Ultimate Saver = $135  size

23. If both firms follow their dominant strategy, then the Nash equilibrium will be *a. SuperDuper Saver $50; Ultimate Saver $65 b. SuperDuper Saver $25; Ultimate Saver $275 c. SuperDuper Saver $250; Ultimate Saver $35 d. SuperDuper Saver $85; Ultimate Saver $135 24. If a few of New York's prominent drug smugglers were to form a cartel, the arrangement would most likely limit (i) the total amount of drugs sold in New York. (ii) the total amount each member of the cartel is allowed to sell in New York. (iii) competition among the drug smugglers. a. (i) and (ii). b. (ii) and (iii). c. (i) and (iii). *d. all of the above.

25. At Lincoln High School, Mr. Burns teaches history to the senior class. Mr. Burns takes medication that makes him drowsy. After he distributes an exam to the class he always falls asleep at his desk. As a result, many of the students cheat on the exams in Mr. Burns' class. The students have never been caught cheating and to make things simple, assume that they never will. Mr. Burns also believes in competition among the students, and therefore he grades exams on a relative scale. In other words, students have the incentive to score better than their classmates, and scoring worse than their classmates will always lead to an inferior grade. Even though Sam is an honest young man, he decides to cheat on the exam because he feels he is a victim of the prisoners' dilemma. Which of the following statements would support Sam's decision to cheat?

a. If any of the other students cheat, Sam will do worse on the test if he doesn't cheat as well. b. If the other students do not cheat, Sam can boost his score by cheating. c. Cheating is Sam's dominant strategy. *d. All of the above.

26. Which of the following is a consequence of oligopolist hot-dog vendors on the beach failing to cooperate with one another on the quantity of hot-dogs they should sell? (i) The quantity supplied to the market will be closer to the socially optimal level. (ii) The invisible hand of the market will help to allocate resources more efficiently. (iii) Markets will become less competitive. *a. (i) and (ii) b. (ii) and (iii) c. (i) and (iii) d. (iii) only

27. When a firm's demand curve is tangent to its average total cost curve, a. the firm must be operating in a monopolistically competitive market. *b. economic profits are zero. c. the firm must be earning economic profits. d. the firm must be incurring economic losses. 28. The graph above depicts the demand, marginal revenue, marginal cost, and average cost curves for a monopolistically competitive firm. At the profit maximum, price will be at point ____ and output will be at point ____. a. D; A b. P; B *c. E; A d. P; A e. E; B

29. When a profit-maximizing firm in a monopolistically competitive market is in long-run equilibrium, a. the demand curve will be perfectly elastic. b. marginal cost is falling. *c. price exceeds marginal cost. d. marginal revenue exceeds marginal cost.

30. When a firm operates at excess capacity, *a. there are consumers who are willing to pay more than the marginal cost of producing more units. b. additional production would increase the deadweight loss to society. c. fixed costs are always higher than variable costs. d. it must be operating in a monopolistically competitive market.

31. Monopolistically competitive markets differ from perfectly competitive markets because of (i) the number of sellers. (ii) product differentiation among the sellers. (iii) barriers to entry. a. (i) and (ii) b. (i) and (iii) c. (i) only *d. (ii) only Short-answer questions to do at home:

1. In 2003, the average black worker’s wages were nearly 20% lower than the average white worker’s wages. Is this evidence of labor market discrimination? Why or why not? Use a graph to illustrate the method economists use to statistically measure the portion of this wage gap that can be attributed to discrimination. Explain your graph thoroughly.

Oaxaca Decomposition Method:

How much of the total wage gap is due to differences in productivity characteristics and how much is due to discrimination? Need to break down the total wage gap into two parts: – Explained portion • Due to differences in productivity characteristics – Unexplained portion • Due to discrimination • Wage gap that still exists when comparing workers with same productivity characteristics

For illustration purposes, let’s focus only on education Statistics show on average – Black workers have fewer years of education than white workers – For each additional year of education, white wages increase by more than black wages Wages will be different based only on this – Does this mean that white and black workers with the same education receive same wages? – If not, some portion of wage gap still exists

For white and black workers with same education, need to measure difference between wage black workers would receive with no discrimination (wB*) and the wage actually received (wB)

Basic idea is as follows: Wages White wage function

WB* Black wage function

EB EW Years of Education

Slope of wage functions measures change in wage that comes from a 1-unit change in education (return to education) – We know that this is larger for whites

WW = wage white workers receive with EW WB = wage black workers receive with EB WB* = wage black workers would receive if returns to education were equal

Total observed wage gap = WW - WB This equals (WW - WB*) + (WB* - WB)

WW - WB* = explained portion of wage gap WB* - WB = unexplained portion – This portion is said to be due to discrimination 2. Consider two steel plants that face different costs of cutting back on their emissions of SO2, as follows:

Reduction in Plant A Plant B Emissions Marginal Cost Marginal Cost 0 $0 $0 1 1 0.5 2 2 1 3 3 1.5 4 4 2 5 5 2.5 6 6 3

Suppose a system of marketable permits is implemented and each firm is given 3 permits. Each permit allows the firm to release one unit of emissions (so each firm must reduce its emissions from 6 units to 3 units). Which firm would sell permits? How many permits would be sold? At what price would the permits be sold? Why? (explain thoroughly).

Plant A will find it advantageous to purchase a permit from Plant B. By only cutting back by 2 units instead of 3, Plant A can reduce its costs by $3 (the marginal cost of eliminating the third unit of emissions). Plant B, having sold a permit to Plant A, must cut its emissions back further, from a reduction of 3 units to a reduction of 4 units. This raises its cost by $2 (the marginal cost of eliminating the fourth unit of emissions). As long as the price of a permit is between $2 and $3, both firms gain.

3. Suppose that instead of permits, a system of emissions taxes is implemented to reduce emissions. Show graphically and discuss the effects of imposing a tax on polluting firms. Include discussions of social and marginal costs and benefits, following the discussion in Figure 21.3 of the textbook.

4. Review problem sets 6 and 7 (answers are posted on course web page).

5. From chapter 21, do review questions 1, 2, 3, 4 and problems 2, 3, 4. These problems are for studying purposes only - they will not be collected or graded.

Review Questions:

1. Externalities, imperfect competition, and information problems are all market failures. Under these circumstances, markets lead to a misallocation of resources, so governments may be able to improve overall welfare by intervening to correct the market failure. 2. Markets will produce too many goods that have negative externalities because firms do not pay all of the costs of their activity. This means these goods are artificially cheap. Likewise, markets will underproduce goods that have positive externalities because buyers do not receive all the benefits.

3. The advantages of assigning externalities property rights are that it does not matter to who is assigned the rights from society's point of view. Limitations are the normative question of who should get the rights and sometimes the rights are difficult to define.

4. Permits raise revenue and can be resold to companies that value them more highly. They can also have a built-in mechanism for the gradual reduction of pollution. Subsidies for pollution abatement do not discourage pollution-related production while taxes do.

Problems:

2. If the social cost of the glop is ignored, the equilibrium price is $21 and the equilibrium quantity is 600; this is where the quantity supplied equals the quantity demanded. If the social cost were considered, the equilibrium price would be $23 and the equilibrium quantity 540. The social marginal cost curve is $3,000 higher than the private marginal cost curve which we have learned is the firm's supply curve. The government could charge a $3,000 per unit tax. With subsidies, the government could pay for $3,000 per unit worth of pollution abatement, but market quantity would remain above the social optimum. Economists prefer taxes since the activity that generates the negative externality is curtailed. Equilibrium P = $21,000 and Q = 600. New price is $23,000 and quantity is 540 trucks.

3. A tax on fishing that raised the supply curve would achieve the efficient outcome, as the activity would now internalize the external cost. A single owner would "own" the benefits from future fish, so his costs would reflect the true social costs. Unlimited public fishing would result in overfishing.

4. If smoking is allowed each smoker benefits by $1, while the cost to each nonsmoker is only $.50. Everyone is better off. If nonsmokers are given the property rights to clean air, the smokers could pay the nonsmokers for the privilege. Since they value the right more so than do nonsmokers, there are gains from the trade until the efficient solution is reached. That is, the price of such a right would fall between $1 and $.50 and both parties would be better off. As the Coase theorem holds, the efficient solution will be reached no matter who is given the initial rights to the air. If each nonsmoker is given a veto over the deal, there might be a problem since each one would attempt to amass all the gains for herself by blocking the agreement. Hence no agreement would be reached.