S. Klepper, Economics 73-100, Fall 2011

# Solutions to Exam III

1. A tax on a good can be justified economically when the consumption and/or production of the good adversely affects individuals other than those that consume and produce the good.  Statements two and four involve harm to others—in statement two drinking water is degraded, which harms consumers of drinking water, and in statement four, rivers are polluted, which harms users of the rivers.  The other three statements either do not involve harm (statements 1 and 3) or involve harm to workers involved in producing natural gas from shale, who will take this into account when deciding whether to work in the industry.

Based on this discussion, the answers to the individual questions, with points allotted to the questions, are:

[4] 1. False

[4] 2. True

[4] 3. False

[4] 4. True

[6] 5. False

2. If there were an equal number of buyers and sellers, say 30 of each, then the supply and demand schedules in round 1 would have been

 Price Quantity Supplied \$.23 30 .34 60 .51 90 .69 120 .90 150 1.20 180 1.65 210

 Price Quantity Demanded \$.86 30 .84 60 .79 90 .69 120 .51 150 .36 180 .28 210

The equilibrium price would have been \$.69 and each buyer and seller would have transacted four units of output.

In round 2, sellers were offered \$1.55 if they sold no output. Therefore, the cost schedules of sellers in round 2 would have been:

 Unit Total Cost Marginal Cost Average Total Cost 1 \$1.55 + .23 = 1.78 \$1.78 \$1.78 2 1.78 + .34 = 2.12 .34 1.06 3 2.12 + .51 = 2.63 .51 .877 4 2.63 + .69 = 3.32 .69 .83 5 3.32 + .90 = 4.22 .90 .844 6 4.22 + 1.20 = 5.42 1.20 .903 7 5.42 + 1.65 = 7.07 1.65 1.01

Average total cost reaches a minimum of \$0.83 at an output of four units, although marginal cost is less than average total cost at four units of output, which is a reflection of sellers being able to sell only whole units of output.  Sellers would only be willing to sell a positive level of output at prices greater than or equal to \$.83; at any lower price they would sell four or less units of output and earn less than \$1.55, the payment if they sold no output.  If they sold four units of output at a price of \$0.83, they would be indifferent between selling no output and selling four units of output, whereas if the price were \$0.84 they would want to sell four units of output.  They would not be willing to sell less than four units of output at a price of \$.84, as then they would earn less than \$1.55 and would have been better off selling no output in round 2.

The demand schedule in round 2 would have been the same as in round 1.  Therefore, at a price of \$.83 or \$.84, buyers would have each demanded two units of output.  With sellers each wanting to sell four units of output, only half the sellers would be able to sell output in round 2 and collectively the sellers would sell half as many units of output as in round 1.  All sellers would earn at least \$1.55 in profit in round 2 (if they sold four units of output at \$.84 each they would earn \$1.59 in profit), which exceeds the profit they earned in round 1 of \$.99 plus \$.20 in commission.  Note that in round 2 those sellers that sold four units of output would sell at a price, either \$.83 or \$.84, that exceeded the marginal cost of the last unit sold of \$.69.  This is a reflection of sellers only being able to sell whole units of output.

Based on this discussion, the answers to the individual questions, with the points allotted to them in brackets, are:

[3] 6. True

[3] 7. True

[5] 8. False

[5] 9. False

[6] 10. True

[6] 11. True

[6] 12. True

[7] 13. True

[7] 14. True

[3] 15. False

3. If the government supplies 10% as many new homes as were previously supplied, the quantity supplied at the market level will increase by 10%*Q0 at every price, where Q0 is the total market output before the government plan.  This is pictured in the graph below.  The shift in supply will cause the short-run equilibrium price to fall, which in turn will lead to builders of new homes supplying and selling less new homes.  If previously the industry was in long-run equilibrium, then the price was originally equal to minimum average total cost and now will be below minimum average total cost.  Consequently, new home builders will earn negative economic profits and in the long run some will exit the industry.  Total exit will have to be such that the quantity supplied by new home builders falls 10%*Q0.  This will be sufficient to cause the price to rise back to P0, the price prior to the government plan, which equals the minimum average cost of production before and after the government plan. Since all new home builders have the same cost curves and produce the same level of output, 10% of home builders will need to exit in the long run to cause the quantity supplied to decline by 10%*Q0.  After producers exit, the price of new homes will be the same as before the government program and thus the total quantity of new homes purchased by buyers will be the same as before the government program.

Based on this discussion, the answers to the individual questions, with points allotted in brackets, are:

[5] 16. True

[5] 17. True

[7] 18. True

[5] 19. False

[5] 20. False