Boston College - EC 201   Ivan Ivanhoe, president of Ivan’s Ink, Inc

Boston College - EC 201

1. Ivan Ivanhoe, president of Ivan’s Ink, Inc., one of only four producers of ink in the U.S., wants you to tell him whether or not he should increase his production of ink. 
   1.  If his goal is to maximize revenue, what information do you need to know in order to answer Ivan’s question (whether he should increase production)?  Explain.  Support your answer with an appropriate graph.
   2. Would you need to know different information to answer Ivan’s question if his goal is to maximize profits?  Why?  Support your answer on the same graph.

2. Why are some industries such as auto and steel made up of a few large firms, while other industries such as retail trade are made up of a large number of small firms?

3. Assuming all firms are faced with identical cost curves, compare and explain the long-run equilibrium result of a perfectly competitive firm with that of a monopolistically competitive firm.  Illustrate with graphs.

4. The graph below shows the demand, marginal revenue, and marginal costs for Firm M, a monopolist.  Use it to answer the following questions:

1. 1. What is the effect of Firm M's behavior on consumer surplus?  That is, compare consumer surplus with Firm M to what it would be if the industry instead was a competitive industry.  Use the graph to supplement your answer.

1. 2. Economists often discuss the reallocation of resources due to monopoly markets.  What are they talking about?  Use the graph to illustrate your answer with a concrete example.

1. 3. What is the deadweight loss resulting from Firm M's pricing and output decisions?  Describe what deadweight loss is and illustrate it on the graph.

1. 4. Who would benefit from this regulated price and quantity?  Why?

5. Chocolate candy production in the U.S. is concentrated among a few firms.  The top four firms (Hershey, Peter Paul, Russell Stover, and Fanny Farmer) produce 80% of all domestic chocolate candy, with Hershey producing over 50%.  Briefly describe a model of oligopoly market behavior that would explain why virtually all domestic chocolate candy bars are priced at $0.85.

6. Two firms are Cournot duopolists in the market for Superfan t-shirts. The Market demand curve is: P=110-2Q, where Q=q₁ + q₂. The two firms have different marginal costs. Firm 1’s marginal cost is MC₁= $20. Firm 2’s marginal cost is MC₂= $10.
   1. Determine the profit maximizing quantity for each firm, the Cournot equilibrium price, and the amount of profit earned by each firm.

b. A third firm enters the market for Superfan t-shirts. Would you expect consumers surplus to rise, fall, or remain the same as it was in part a. Briefly explain why.

7. In most models of firm behavior, quantities are determined by setting MR=MC. One exception is the cartel model. In the cartel model, MR=MC holds at the level of the industry as a whole, but for each individual firm MR is not equal to MC under the cartel agreement.

1. Why would we expect MR=MC at the level of the industry as a whole under a cartel agreement?

2. Explain how the failure of the MR=MC condition to hold at the level of the individual firm is related to the likelihood that the industry will be able to sustain the cartel agreement.

8. Suppose the hospital industry is monopolistically competitive and is in equilibrium.  The government, concerned about high health care costs, decides to impose price controls on hospitals, setting the price of hospital services below the existing monopolistically competitive price.

1. In the short-run, do profits per hospital rise, fall, or remain the same?  Why? 

8. In the long-run, do profits per hospital rise, fall, or remain the same?  Why? 

9. The market for sprockets follows the price leadership model.  Assume for this problem that the dominant firm does not produce at a point where the price would be BELOW that which is necessary to keep the fringe out of the market (they might produce at the point exactly where the fringe exits). For each of the following, state whether it would or would not affect market price in the short run.  Assume that even if the fringe firms are not producing initially, that they could start production if they wish even in the short run. Explain what would happen to the short-run equilibrium price as a result of each of the following:

1. A drop in the dominant firm marginal cost.
2. A drop in the marginal cost for the fringe firms.
3. An increase in the dominant firm fixed costs.

10. Manning and colleagues estimated the external costs of smoking to be the equivalent of 33 cents per pack for a new smoker evaluated in 1995 dollars. This implies that:

1. 1. A tax of 33 cents should be levied on new smokers to impose the full societal costs
   2. Without a tax, cigarettes would be too cheap, leading to over-consumption
   3. The government needed tax revenue from cigarettes
   4. Answers (a) and (b) are correct

11. The output effect of a change in the wage rate on a firm’s demand for labor input will be greater;

1. The larger the share of labor costs in total costs and the greater the price elasticity of demand for output
2. The larger the share of labor costs in total costs and the smaller the price elasticity of demand for output
3. The larger the share of labor costs in total costs and the higher the quantity demanded
4. The smaller the possibilities of substituting capital for labor

12. The fact that more women have chosen to work as real wages rise is evidence that, for them

1. leisure is an inferior good
2. income and substitution effects of higher real wages work in the same direction
3. income and substitution effects of higher real wages may work in opposite directions
4. income and substitution effects may work in opposite directions but that the substitution effect is stronger

13. Which of the following “externalities” does not distort the allocation of resources?

       I.         An individual’s unwillingness to cut his or her own lawn in an otherwise                      immaculately kept neighborhood.

            II.        Smoke produced by a new firm in an area that raises the costs of other                                firms.

            III.       A new firm’s bidding up skilled wages in an area, thus raising costs of                                other firms

            IV.       An individual’s unwillingness to obtain job training, thereby lowering the                           total GNP

1. I, III, and IV.
2. III and IV
3. III only
4. IV only
5. I and IV

14. As is the case with most positive externalities, the private market system fails to produce enough immunizations. The Commonwealth of Massachusetts has one of the lowest early childhood (before age 2) immunization rates in the US. Because some of the diseases being immunized against are very contagious and can have serious long-term health effects, the state wants to improve its standing and is considering a variety of solutions.

1. 1. Given what you know about the economics of externalities what is one policy recommendation you would make and why? A graph might be useful

b. Economic advisors to the Governor point out that the parents of these small children will always prefer a cash subsidy to an in-kind subsidy. Explain in economic terms why this is true?

1. 3. Given the statement in (b) why is it likely that the state would prefer to give in-kind subsidies rather than cash?

15. Suppose there are only two people in society. The demand curve for person A for mosquito control is given by Q_a = 100 – P and the demand curve for person B is given by Q_b = 200 – P

1. 1. Suppose mosquito control is a non-exclusive good – that is once produced everyone benefits from it. What would be the optimal level of this activity if it could be produced at a constant marginal cost of $50 per unit?

b. If mosquito control were left to the private market, how much might be produced? Does your answer depend on what each person assumes the other will do?

1. 3. If the government were to produce the optimal amount of mosquito control, how much would this cost? How should the tax bill for this amount be allocated between the individuals if they are to share it in proportion to benefits received from mosquito control?

16. The size of the reduction in quantity of labor hired by a firm due to an increase in the wage rate depends upon all of the following except
    1. what percentage of total costs are made up of labor costs.
    2. how much quantity demanded in the output market will be reduced by a higher price.
    3. the capital to labor ratio before the wage increase.
    4. how easily other inputs can be substituted for labor.

17. If the wage rate rises, labor’s share in the total costs of a production process
    1. will increase.
    2. will decrease.
    3. may increase or decrease depending on the elasticity of demand for the product.
    4. may increase or decrease depending on the ease of substitution of other inputs for labor.

18. If an individual’s supply of labor curve is positively sloped throughout, then

1. the substitution effect always dominates the income effect.
2. the income effect always dominates the substitution effect.
3. the substitution effect dominates at low real wage levels and the income effect dominates at high real wage levels.
4. the income effect dominates at low real wage levels and the substitution effect dominates at high real wage levels.

19. In the figure above, the pharmaceutical firm will:
    1. charge higher prices in the U.S. but sell larger quantities in Mexico than in the U.S.
    2. charge higher prices in the U.S. and sell larger quantities in the U.S than in Mexico.
    3. charge lower prices in the U.S. but sell larger quantities in Mexico than in the U.S.
    4. charge lower prices in the U.S. and sell lower quantities in Mexico than in the U.S.

20. An example of an externality would be…

1. Jack outbids Jill for her dream house that is for sale.
2. The BCPD arrest underage students at parties.
3. An EC201 student takes extra care (healthy diet and exercise) to avoid getting the flu.
4. An HMO enters the local market, increasing competition and driving down prices.

21. How would you maximize social surplus if you had the information about social and private marginal costs in the figure below but no other information (i.e. no information about demand or prices)?

1. Cap quantity at 100.
2. Distribute tradeable permits summing to 100 units.
3. Impose a constant per unit tax of $0.50.
4. Impose a per unit tax of 0.5*q (so the tax would be $0.50 for the 1^st unit, $1.00 for the 2^nd, etc).

22. Public goods are subject to market failures because:

1. they have increasing returns to scale in production.
2. consumers do not have incentive to pay much, even if they value the goods.
3. there is not enough competition between producers.
4. some people do not value these goods very much.

23. As part of its usual fundraising drive, National Public Radio is badgering its listeners incessantly to make donations…

Suppose there are three types of people in the station's listening area:

50% of people never listen to the station (group A)

40% occasionally listen (group B)

10% frequently listen (group C)

(a) What is the local population's demand curve (in mathematical terms)? (hint: for values of q above 25, you should count group B's marginal benefit as zero rather than a negative number).

(b) Assume that the supply curve (marginal cost of producing q) is constant, with each unit of q costing $100.  What is the socially optimal production of q, and how much would it cost in total?

c) Suppose that you find out that everyone else in the community is contributing a total of $12,000.  In this circumstance, assuming you only care about your own utility (you selfish person, you), how much would you contribute if you were a type C person? Use numbers and a brief description in words to explain your answers to part c.

If everyone else is contributing $12,000, that means that $12,000/$100 = 120 units are being produced.  If 120 units are being produced, then as a type C person your marginal benefit is: p = 200 – 120 = $80. So would be willing to pay up to $80 for an additional unit of q.

24. In a Cournot equilibrium each firm chooses an output level that

1. maximizes joint profits.
2. maximizes joint revenue.
3. maximizes profits given what the other firm produces.
4. maximizes revenue given what the other firm produces.

25. In a cartel model each firm chooses an output level that

1. maximizes joint profits.
2. maximizes joint revenue.
3. maximizes profits given what the other firm produces.
4. maximizes revenue given what the other firm produces.

26. Suppose that a firm serves two markets with demand and marginal revenue curves given by

                                                P₁ = 100 – Q₁              MR₁ = 100 – 2Q₁

                                                P₂ = 130 – 2Q₂            MR₂ = 130 – 4Q₂

27. What is the present discounted value of $100

• 5 years in the future?
• 100 years in the future?
• 1000 years in the future?

[In other words, how much money now would be equivalent to $100 at some time in the future?  Use a discount rate of three percent (d = .03) and ignore inflation.]

28. Consider the market demand and supply for labor, given the market wage W.

1. What is the equilibrium market wage?  What is the equilibrium employment level?

b. Calculate the equilibrium market wage and employment level if the workers negotiate a benefit worth $1 that costs the employers $2.

c. Calculate the equilibrium market wage and employment level if the workers negotiate a benefit worth $2 that costs the employers $1.

Using either method, you should set the two curves equal to each other:

29. Non-identical 11-year old twins Jack and Jill have a rich uncle who promises to pay them each $10,000 upon their 21^st birthday.  Jack’s discount rate is 10%, while Jill’s discount rate is 5%. Write an expression for the present-discounted value of $10,000 to Jack.

30. a. What is a “market failure” according to basic economic theory (i.e., how we defined it in class)?  Limit your answer to 2-3 sentences. (7 points)

b. How can the consumption of alcohol lead to a market failure?

31. Dr. Spok is at it again…now he has designed an exciting new health education intervention.  In this intervention, people go to a website and complete a fun and informative game in which they learn about risk factors for cardiovascular health and strategies for reducing one’s risk.  Randomized trials of this program indicate that it is effective in increasing people’s knowledge about cardiovascular health.

Now that the program has proven to be effective in increasing knowledge, Dr. Spok is interested in commercializing it and making a profit.  He brings you on as his business advisor.

a) You estimate that the total market demand curve for this program is:

b) If people who complete the program often share some of the information with other people, how might the social demand curve for the program be different than the private demand curve? Show this in the graph.

(5 points)

There are two potential answers here, and both could receive full credit with the proper amount of explanation.

32. After graduating you climb the ranks quickly and soon find yourself as President of the American Cancer Society.  As one of your first tasks, you want to get a sense of whether the level of cancer research in the U.S. is anywhere close to where it should be. 

a) What is the total demand curve for cancer studies?  (8 points)

b) What is the socially efficient number of cancer studies? (6 points)

c) Explain the free rider problem briefly (3-4 sentences max).  Refer to specific numbers from this problem to help make your point. (6 points)

33. Suppose teen A and teen B are smitten with each other but neither knows of the other’s feelings. Suppose the teachers at their school organize a dance. The “payoff” is based on whether their advances are rebuffed or accepted. If they both “declare” they get positive utility but if they are rebuffed they face humiliation (significantly negative payoff). As teens are, they mildly enjoy humiliating others.

1. Is there a dominant strategy for either teen?

2. Find the pure-strategy Nash equilibrium or equilibria.

3. Suppose social convention requires teen A to go first.  Write the game in extensive form and find the optimal strategies for the two teens by backwards induction.

34. Suppose a teacher tells students that a final will be curved such that the top half of students will get an A and the bottom half an F (regardless of how well or poorly they do on the final.) Suppose that there are two groups, the Brainiacs and the Numbskulls and if they both study, or they both party, the Brainiacs will get the As but if the Brainiacs party and the numskulls study, the Numskulls will get the As. Suppose further that they both dislike studying and both like good grades such that their payoff matrix is below.  Find the Nash equilibrium.