BA 210 Dr. Jon Burke Exam 1 Version A

This is a 100-minute exam (1hr. 40 min.). There are 8 questions (12.5 minutes per question). The exam begins exactly at the normal time that class starts. To avoid the temptation to cheat, you cannot take this exam if you arrive more than 10 minutes late, and you cannot (without permission) leave the room and re-enter during the exam. Exam Grading Each individual question on the following exam is graded on this 4-point scale: 4 points if all is explained and is correct --- or there is only a small error. 3 points for missing or doing wrong part of a problem, but the rest is correct. 2 points for a reasonable and substanative attempt. 1 point if there is at least something of value in the attempt.

After all individual questions are graded, I sum the individual scores, then compute that total as a percentage of the total of all points possible.

I then apply a standard grading scale to determine your letter grade:

90-100% A; 80-89% B; 70-79% C; 60-70% D; 0-59% F

Finally, curving points may be added to letter grades for the entire class (at my discretion), and the resulting curved letter grade will be recorded on a standard 4-point numerical scale:

A = 4; A- = 3.7; B+ = 3.3; B = 3.0; B- = 2.7; C+ = 2.3; C = 2.0; C- = 1.7; D+ = 1.3; D = 1.0; F = 0

Tip: You must show your work and explain each answer for full credit.

Tip: Pace yourself. When there is only ½ hour left, spend at least 5 minutes outlining an answer to each remaining question.

Question 1. Consider the following price and consumption information for the typical Vietnamese consumer to determine which year is preferred:

Answer to Question 1:

1980 2010

Price of Computers 4 ₫ 8 ₫Price of Food 2 ₫ 4 ₫

Price of Movies 1 ₫ 2 ₫Consumption of Computers 1 2

Consumption of Food 2 2Consumption of Movies 8 1

Which year is preferred?

Question 2: Measure the value to you and your spouse of having kids by the amount you would be willing to pay each year to raise them. And suppose the cost or raising kids is $1,500 per kid. Would it be efficient if the government offered a child tax credit of $1,000 per kid?

Per year

Value of Kid #1 $5,000Value of Kid #2 $4,000Value of Kid #3 $2,000Value of Kid #4 $1,000

Value of Kids

Answer to Question 2:

Question 3. Consider the following linear production possibilities from Tom, Jeffery, and Hank. To be useful, an ad must be both composed and televised. A) How many ads can be completed if Tom, Jeffery, and Hank work

separately? That is, each composes and televises his own ads. (As usual, fractions are allowed.)

B) Show how the market can organize production efficiently. Specifically, suppose the market price per unit for televising ads is $100. Find the price PC per unit for composing ads so that, when the output of completed ads is maximized, then Tom, Jeffery and Hank are each choosing the work that maximizes their income.

Answer to Question 3:

AdsComposed

AdsTelevised

Tom 2 composed 2 televised

Jeffery 1 composed 2 televised

Hank 3 composed 4 televised

Question 4. According to the New York Times (November 18, 2006), the number of car producers in China is increasing rapidly. The newspaper reports that “China has more car brands now than the United States. . . . But while car sales have climbed 38 percent in the first three quarters of this year, automakers have increased their output even faster, causing fierce competition and a slow erosion in prices.” At the same time, Chinese consumers’ incomes have risen. Assume that cars are a normal good. Use a diagram of the supply and demand curves for cars in China to explain what has happened in the Chinese car market. Answer to Question 4:

Question 5: Consider the following demand curves for a Good X by women Abby, Betty, Carla and by men Doug, Ernest, Frank:

Potential buyers of Good X Willingness to pay Abby $7 Doug $6 Betty $5 Ernest $4 Carla $2 Frank $1 And consider supply curves for the same Good X by women Gail, Heidi, Ingrid and by men Jim, Kyle, Leo:

Potential sellers of Good X Cost to sell Gail $1 Jim $2 Heidi $3 Kyle $4 Ingrid $5 Leo $6

a. Compute the competitive equilibrium price and quantity. Compute consumer surplus and producer surplus.

b. By considering Good X to be education at Pepperdine University, show the consumer surplus losses from affirmative action programs designed to help women. Specifically, suppose affirmative action programs cause Pepperdine University to accept Carla and reject Doug.

c. By considering Good X to be teachers hired by the state of California, show the producer surplus losses if affirmative action causes California to hire Ingrid and reject Jim.

d. By considering Good X to be patients accepted treated by Kaiser Permanente, show the lost total surplus if a US program of Universal Health Care forces Leo to treat Carla.

Answer to Question 5:

Question 6: Consider the following demand curves for labor by Abby, Betty, Carla, Doug, Ernest, Frank:

Potential buyers of labor Willingness to pay Abby $12 Betty $10 Carla $9 Doug $8 Ernest $5 Frank $2 And consider supply curves for labor by Gail, Heidi, Ingrid, Jim, Kyle, and Leo:

Potential sellers of labor Cost to sell Gail $2 Heidi $4 Ingrid $6 Jim $8 Kyle $10 Leo $12

a. Compute the competitive equilibrium wage and employment. Compute consumer surplus and producer surplus (that is worker surplus).

Now consider a minimum wage of $11 designed to help workers.

b. Show the lost producer surplus from the inefficient allocation of employment. Specifically, suppose Kyle successfully competes to sell labor instead of Heidi.

c. Show the lost total surplus as minimum wages reduce employment.

d. Show the wasted resources from potential workers competing for employment. Specifically, suppose potential workers compete for jobs by waiting in line.

Answer to Question 6:

Question 7. Draw a linear demand curve where the range of prices for which demand is elastic and inelastic is labeled. In each of the following scenarios, the supply curve shifts. Show along which portion of the demand curve (that is, the elastic or the inelastic portion) the supply curve must have shifted in order to generate the event described. In each case, show on the diagram the quantity effect and the price effect. a. Recent attempts by the Colombian army to stop the flow of illegal drugs into the United States have actually benefited drug dealers. b. New construction increased the number of seats in the football stadium and resulted in greater total revenue from box-office ticket sales. c. A fall in input prices has led to higher output of Porsches. But total revenue for the Porsche Company has declined as a result. Answer to Question 7:

Question 8. In 1990, the United States began to levy a tax on sales of luxury cars. For simplicity, assume that the tax was an excise tax of $6,000 per car. The accompanying figure shows hypothetical demand and supply curves for luxury cars.

a. Under the tax, what is the price paid by consumers? What is the price received by producers? What is the government tax revenue from the excise tax? Over time, the tax on luxury automobiles was slowly phased out (and completely eliminated in 2002). Suppose that the excise tax falls from $6,000 per car to $4,500 per car. b. After the reduction in the excise tax from $6,000 to $4,500 per car, what is the price paid by consumers? What is the price received by producers? What is tax revenue now? c. Compare the tax revenue created by the taxes in parts a and b. What accounts for the change in tax revenue from the reduction in the excise tax? Answer to Question 8:

Answers to Exam 1 Version A (remember to try each problem before looking at these answers)

Answer to Question 1: Step 1: Compare consumptions. Here, the two year’s consumptions, (1, 2, 9) and (2, 2, 2), are incomparable: the former has less of good 1; the latter, less of good 3. Hence, continue the analysis. Step 2: Ask whether 1980’s consumption, (1, 2, 8), was affordable in 2010? Answer: In 2010 you had income determined by the budget equation, y = p1x1 + p2x2 + p3x3 = 2 × 2 + 2 × 2 + 2 × 1 = 11 while the cost of 1980’s consumption would have been p1x1 + p2x2 + p3x3 = 2 × 1 + 2 × 2 + 2 × 8 = 22 Thus you could not have had 1980’s consumption in 2010. Hence: Continue the analysis. Step 3: Ask whether 2010’s consumption, (2, 2, 1), was affordable in 1980? Answer: In 1980 you had income determined by the budget equation, y = p1x1 + p2x2 + p3x3 = 4 × 1 + 2 × 2 + 1 × 8 = 16 while the cost of 1980’s consumption would have been p1x1 + p2x2 + p3x3 = 4 × 2 + 2 × 2 + 1 × 1 = 13 Thus you could have had 2010’s consumption in 1980. Conclusion: 1980 is preferred to 2010. Answer to Question 2: Step 1: Use the economic principle that markets, without taxes or subsidies or any other government intervention, lead to efficiency, meaning all opportunities to make some people better off without making other people worse off are taken. In the present case, the market for the goods needed to raise kids drives the price equal to the $1,500 cost of raising kids. At that market price, you would choose to have Kids #1 and #2 and #3.

Step 2: With the child tax credit of $1,000 per kid, determine which kids you would choose to have. That is, the price of kids falls from $1,500 per kid to $500 per kid. So, you would increase from Kids #1 and #2 and #3 by adding Kid #4.

Step 3: Conclude that since the child tax credit leads to a different number kids than at the efficient market prices, the child tax credit is not efficient. Specifically, it costs the government $1,000 when you have Kid #4 but you only get surplus $500, so there is a gain of $500 that can be split between you and the government if you agree not to have Kid #4. That gain makes you and the government (representing tax payers) better off without making other people worse off.

Answer to Question 3: Answer to Part A: First consider Tom. On one hand, if he spent all day composing, he would compose 2 ads and televise 0 ads and, thereby, complete 0 ads. On the other hand, if he spent all day trying to televise, he would compose 0 ads and try to televise 2 ads and, thereby, complete 0 ads. Obviously, to complete the maximum number of ads he would split his day evenly: spending half his day composing and the other half his day televising, he would compose 1 ad and televise 1 ad and, thereby, complete 1 ad. Next consider Jeffery. Like Tom, to complete the maximum number of ads he splits his day between composing and televising. Let’s find that split with algebra. Let c be the fraction of his day spent composing; that leaves the fraction 1−c for televising. Spending c of his day composing and 1−c of his day televising, he would compose c letters and televise 2(1−c) letters. If c < 2(1−c), then some televising exceeds composing, which is wasted effort. Likewise, c > 2(1−c) has some composing exceeding televising, which is also wasted effort. Therefore, to complete the maximum number of ads he would set c = 2(1 − c), which implies 3c = 2 and c = 2/3. That is, Jeffery spends 2/3 of his day composing and 1/3 of his day televising and, thereby, composes, televises, and completes 2/3 ads, which is approximately .66 ads.

Finally consider Hank. Let c be the fraction of his day spent composing; that leaves the fraction 1−c for televising. Spending c of his day composing and 1−c of his day televising, he would compose 3c letters and televise 4(1−c) letters. To complete the maximum number of ads he would set 3c = 4(1 − c), which implies 7c = 4 and c = 4/7. That is, Jeffery spends 4/7 of his day composing and 3/7 of his day televising and, thereby, composes, televises, and completes 12/7 ads. Altogether, the three complete 1+2/3+12/7 = 3.37 ads when working separately. Answer to Part B: To find efficient production, compute the opportunity cost of televising ads. For Larry, each ad televised takes 1/2 of a day (since in one day he can televise 2 letters), and in that 1/2 of a day he could have composed 1 letter (since in one day he can compose 2 ads). Hence, Tom’s opportunity cost of televising a letter is 1 composed letter. For Jeffery, each ad televised takes 1/2 of a day, and in that 1/2 of a day he could have composed 1/2 letter. Hence, Jeffery’s opportunity cost of televising a letter is 1/2 composed letter. Likewise, Hence, Hank’s opportunity cost of televising a letter is 3/4 composed letter (the ratio of maximum composing output to maximum televising output). Jeffery has the comparative advantage in televising (he gives up the fewest composed letters), so consider this trial solution: Jeffery spends all day televising and, thereby, televises 2 ads. Both Tom and Hank spend all day composing and, thereby, compose 5 letters. Since the number televised is less than the number composed, we need another televiser and, so, must consider another trial solution: After Jeffery, Hank has the comparative advantage in televising, so consider this trial solution: Jeffery and Hank spend all day televising and, thereby, televise 6 ads. Tom spends all day composing and, thereby, composes 2 ads. Since the number televised is greater than the number composed, we went too far. Hence, Hank splits his time between

composing and televising, spending the fraction c composing and the fraction 1−c televising and, thereby, composing 3c and televising 4(1−c). You need not compute that fraction c to answer the question. When the output of completed ads is maximized, Hank spends part of his day composing and part of his day televising, so his daily income must equal from the two jobs, 3PC = 400, or PC = 400/3 = 133.33. And Tom specializes in composing, so at PC = 133.33 his daily incomes from composing must higher than from televising, 266.66 > 200. And Jeffery specializes in televising, so at PC = 133.33 his daily incomes from composing must lower than from televising, 133.33 < 200. So, at the price PC = 133.33 per unit for composing ads, when the output of completed ads is maximized, then Tom, Jeffery and Hank are each choosing the work that maximizes their income. Answer to Question 4: As Chinese consumers’ incomes rise, the demand curve for cars shifts to the right, from D1 to D2, because cars are a normal good. If this were the only shift, then price would rise. But there is a report of a slow erosion in prices (prices fall). So there must be another shift. As more automakers enter the Chinese market, the supply curve shifts to the right, from S1 to S2. As a result, the equilibrium moves from its initial position at E1 to the new equilibrium at E2, and the quantity of cars bought and sold increases from Q1 to Q2. This accounts for the 38 percent increase in sales. Since the newspaper reports a slow “erosion in prices,” from P1 to P2, the rightward shift of the supply curve must have been greater than the rightward shift of the demand curve.

Answer to Question 5:

a. At price $4, Abby, Doug, Betty and Ernest buy from Gail, Jim, Heidi, and Kyle. In particular, competitive equilibrium price is $4 and quantity is 4 (or 3 in case Ernest does not buy and Kyle does not sell). Consumer surplus from Abby, Doug and Betty is the difference between their willingness to pay and $4, which is $3 = $7-$4, $2 = $6-$4, and $1 = $5-$4, making aggregate consumer surplus $6 = $3+$2+$1. Producer surplus from Gail, Jim and Heidi is the difference between their $4 and their cost to sell, which is $3 = $4-$1, $2 = $4-$2, and $1 = $4-$3, making aggregate producer surplus $6 = $3+$2+$1. (There is a technical simplification we make to work with integers when we assume someone will buy or someone will sell even when they get surplus 0. Make the same simplification on your homework and exams.)

b. By considering Good X to be education at Pepperdine University, show the consumer surplus losses from affirmative action programs designed to help women. Specifically, suppose affirmative action programs cause Pepperdine University to accept Carla and reject Doug. Carla values the good at $2 and Doug at $6, so there is $4 lost consumer surplus from Carla consuming rather than Doug.

c. By considering Good X to be teachers hired by the state of California, show the producer surplus losses if affirmative action causes California to hire Ingrid and reject Jim. Ingrid’s cost to sell is $5 and Jim’s is $2, so there is $3 lost producer surplus from Ingrid selling rather than Jim.

d. By considering Good X to be patients accepted treated by Kaiser Permanente, show the lost total surplus if Universal Health Care forces Leo to treat Carla. Carla values the good at $2 and Leo’s cost to sell is $6, so there is $4 lost total surplus from Leo treating Carla.

Answer to Question 6:

a. At price $8, Abby, Betty, Carla, and Doug buy labor from Gail, Heidi, Ingrid, and Jim. In particular, competitive equilibrium wage is $8 and employment is 4. Consumer surplus from Abby, Betty, Carla, and Doug is the difference between their willingness to pay and $8, which

is $4 = $12-$8, $2 = $10-$8, $1 = $9-$8, and $0 = $8-$8, making aggregate consumer surplus $7 = $4+$2+$1+$0. Producer surplus from Gail, Heidi, Ingrid, Jim, and Kyle is the difference between $8 and their cost to sell, which is $6 = $8-$2, $4 = $8-$4, $2 = $8-$6, and $0 = $8-$8, making aggregate producer surplus $12 = $6+$4+$2+$0. (There is a technical simplification we make to work with integers when we assume someone will buy or someone will sell even when they get surplus 0. Make the same simplification on your homework and exams.)

Now consider a minimum wage of $11 designed to help workers.

b. Show the lost producer surplus from the inefficient allocation of employment. Specifically, suppose Kyle successfully competes to sell labor instead of Heidi. Kyle’s cost to sell is $10 and Heidi’s is $4, so there is $6 lost producer surplus from Kyle selling rather than Heidi.

c. Show the lost total surplus as minimum wages reduce employment. Betty, Carla, and Doug no longer employ labor and, if only the least cost workers get jobs, Heidi, Ingrid, and Jim are no longer employed. Betty, Carla, and Doug value labor at $10 and $9 and $8 and Heidi’s, Ingrid’s, and Jim’s cost to sell are $4 and $6 and $8, so there is $9 = ($10+$9+$8)-($4+$6+$8) lost total surplus from reduced employment.

d. Show the wasted resources from potential workers competing for employment. Specifically, suppose potential workers compete for jobs by waiting in line. Since only the first potential worker will be employed, only Gail will work since she has the most to gain from employment. She has to wait in line long enough so that the cost of the line makes unemployment unattractive to Heidi and the rest of the potential sellers of labor. For Heidi to find work unattractive, her net wage must be below her cost of $4 to sell, so the line must reduce wages from the minimum of $11 down to just below $4. That is, $7 is wasted in line by Heidi as she competes for employment.

Answer to Question 7: a. Attempts to stop the flow of drugs into the United States shift the

supply curve leftward, raising the price of drugs and reducing the quantity demanded. If this benefits drug dealers, their total revenue must have increased. That is, we must be on the inelastic portion of the demand curve, where a rise in price results in an increase in revenue (the price effect outweighs the quantity effect). In the accompanying diagram, as supply shifts from S1 to S2, revenue decreases by area B but increases by area A.

b. An increase in the number of seats shifts the supply curve rightward, reducing the price of stadium seats and increasing the quantity demanded. If this increases total revenue, we must be on the elastic portion of the demand curve, where a fall in price results in an increase in total revenue from box-office sales (the quantity effect outweighs the price effect). In the accompanying diagram, as supply shifts from S1 to S2, total revenue decreases by area A but increases by area B. (The supply curve is a vertical line because the supply of seats is perfectly inelastic: whatever the price, the supply of seats is just how many seats there are in the stadium.)

c. Increasing production shifts the supply curve rightward, lowering the price of Porsches and increasing the quantity demanded. If this reduces total revenue, we must be on the inelastic portion of the demand curve, where a fall in price results in a fall in total revenue (the price effect

outweighs the quantity effect). In the accompanying diagram, as supply shifts from S1 to S2, total revenue decreases by area A but increases only by area B.

Answer to Question 8: a. The price paid by consumers is $54,000. The price received by producers is $48,000. The government’s tax revenue is $6,000 per car × 40,000 cars = $240 million. b. The price paid by consumers is now $53,000. The price received by producers is $48,500. The government’s tax revenue is $4,500 per car × 60,000 cars = $270 million. c. The government tax revenue rose as a result of the reduction in the excise tax. This occurs because the supply of and the demand for luxury automobiles are both highly elastic: a fall in the price paid by consumers leads to a large increase in the quantity demanded; and a rise in the price received by producers leads to a large increase in the quantity supplied. As a result, reducing the tax leads to a large increase in the quantity of luxury automobiles bought and sold—so large, in fact, that the increase in the quantity bought and sold more than makes up for the decrease in the tax per car.