1. (40 total points, 40 minutes, 5 points for each ques
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1. (40 total points, 40 minutes, 5 points for each question) Decide whether each of thefollowing statements isTrue,FalseorUncertain, and give abrief but clear explanationsupporting your answer. Most of the credit will be given for your explanation.A.If a firm having market power charges a price for its output that is less than itsmarginal cost, it should shut down and cease production.5 points. False/Uncertain. A firm having market power and maximizing profitsshould set output quantity at a level where MR = MC. If at that output level, P <AVC, it should shut down and cease production. However, if the costs of shuttingdown and then restarting are significant, or there is reason to believe demand willincrease in the near future putting upward pressure on P, then it may continueproducing, even if on a current basis P < AVC.B.Dominique is planning to bid on an antique piece of fine jewelry in a second pricesealed bid auction. Dominique’s private value for the antique jewelry is $10,000.Dominique should bid no more than $10,000 for the antique jewelry.5 points. True. Were Dominique to bid more than $10,000 and the second highestbid is also greater than $10,000 (but less than Dominique’s bid), then Dominiquewould pay more than her/his private reservation price, thereby not maximizing her/his payoff. By bidding at most $10,000, Dominique is ensured of not paying morethan her/his reservation price.C.Greater diversity among suppliers makes collusion more likely to emerge, sincethere is more likely to be something for everyone in the market.5 points. False, according to Porter, greater diversity among supplies hinderscooperation and collusion, since the diversity in cultures and language makes itmore difficult to interpret others’ behavior and communications.D.A monopolist’s long-run supply curve is that portion of its long-run marginal costcurve above its long-run average total cost curve.5 points. False. A monopolist does not have a supply curve, it is a price makerrather than a price taker, and the monopolist’s price depends on both demand(marginal revenue) and cost curves. However, for a firm in a perfectly competitiveindustry, its long-run supply curve is that portion of its long-run marginal cost curveabove its long-run average total cost curve. (Students might draw cost curves toportray their answer visually.)
E.The demand for refrigerators is characterized by a partial adjustment process(inertia). Suppose a $250 tax is imposed on new refrigerators. The share of theburden of this tax borne by consumers (as opposed to producers) will rise.5 points. False/Uncertain. Since refrigerators are a durable rather than non-durablegood, their demand is characterized by a stock adjustment rather than partialadjustment process. In the stock adjustment process, short-run price and incomeelasticities are larger (in absolute value) than the corresponding long-run price andincome elasticities. Since with stock adjustment as time passes price elasticitiesdecline (in absolute value), and become less elastic (more inelastic), the burden ofthe tax is increasingly borne by the increasingly less flexible consumer. However, ifrefrigerator suppliers also become more price inelastic as time passes, then theshare of the burden borne by consumers vs. producers will depend on who is themost price inelastic – consumers or producers.F.Deductibles and cost sharing copayments are tools used by insurers to mitigate orcounter the effects of consumers’ adverse selection into health care insurance plans.5 points. True/False/Uncertain. While deductibles and cost sharing copayments aretools insurers use to counter the effects of moral hazard, they might also discouragevery sick and ill people from signing up for the health insurance, i.e. discourageadverse selection. Tools more commonly used to affect adverse selection areexcluding those with pre-existing conditions and those with poor health behavior(e.g., smokers and those with substance abuse histories).G.Consider a Cournot game in which a Prisoners’ Dilemma-like payoff matrix isrepeated a known finite number of times. In such a case, a tit-for-tat strategy isoptimal.5 points. False/Uncertain. In general, the logic of backward induction suggests thatwhen a Cournot game is being played repeatedly but for a known finite number oftime periods, the Nash equilibrium will be the non-cooperative outcome even in thefirst round the game is being played. Tit for tat strategies appear to be particularlyattractive when the number of times the game is being played is infinite or at leastvery large (and unknown).H.Whenever a firm has market power and can set its own output prices, deadweightloss will occur. Therefore, any firm having market power reduces economicefficiency compared to a perfectly competitive market outcome.5 points. False. A firm having market power and practicing first degree (perfect)price discrimination transforms its demand curve into a marginal revenue curve, andwill produce the same quantity of output as would occur were the industry perfectly
competitive (albeit at generally higher prices). Hence with first degree (perfect)price discrimination, there is no deadweight loss relative to a perfectly competitivemarket outcome.2. (30 total points, 30 minutes) Workers must travel from Residentsville to the Workplacecopper mine and return every day. On a monthly basis, the inverse demand for bus rides isgiven byP = 300 – 4Qwhere P is in cents per ride and Q is in thousands of rides. The marginal cost of each ride is 50cents (there are no economies of scale and no fixed costs).a.(8 points) Suppose that the transit business is perfectly competitive, and there are nobarriers to entry or exit. How many bus rides are sold, at what price are they sold, andwhat are the values of consumer and producer surplus?If the industry is perfectly competitive, then P = MC = 50 cents. Substituting P = 5- intothe inverse demand curve yields 50 = 300 – 4Q, or 4Q = 250 which implies Q = 62.5thousand rides. Consumer surplus is 0.5*(300-50)*62.5 = $78,125. Since there are noeconomies of scale and no fixed costs, the ATC curve is the same as the MC curve, and isperfectly flat at 50 cents. Hence there is no producer surplus.b.(10 points) Suppose that an exclusive license is obtained by Trailaway to provide transitservices between Residentsville and Workplace, so that Trailaway is a monopolyprovider of these bus rides. How many bus rides are sold, and at what price are theysold? What are Trailaway’s profits, and what is the deadweight loss relative to (a)above?Multiplying the inverse demand by Q gives us total revenue as PQ = 300Q – 4Q2. SinceMC = AC = 50Q, profits are (revenues minus costs) = 300Q – 4Q2– 50Q = 250Q – 4Q2.Maximizing profits by differentiating with respect to Q and setting the result to zeroyields 250 – 8Q = 0, or Q = 250/8 = 31.25 thousand rides. Substituting Q = 31.25 into theinverse demand equation yields P = 300 – 4*(31.25) = 300 – 125 = 175 cents, or $1.75per ride. Trailaways profits are (175 – 50)*31.25 = $39,062.50. Consumers’ surplus is0.5*(300 – 175)*31.25 = $19,531.25. Comparing the total surplus in part (a) above (=$78,125) with the sum of producers surplus here (profits are $39,062.50) plusconsumers’ surplus here ( = $19,531.25) gives a total surplus in this monopoly case of$58,593.75, which is a deadweight loss of $19,531.25, which is a 25% reduction in totalsurplus relative to case (a) above.
(12 points) Suppose that a government subsidy of 40 cents per ride is paid to theTrailaway monopoly. How many bus rides are sold, and at what price are they sold?What are Trailaway’s profits, what is the cost of the government subsidy program, andwhat is the dead weight loss relative to (a) above?In this case, profits to Trailaways are total revenues from bus riders minus costs plus thesubsidy, which turns out to be 300Q - 4Q2– 50Q + 40Q = 290Q - 4Q2. Maximizingprofits by differentiating with respect to Q and setting the result to zero yields 290 – 8Q= 0, or Q = 290/8 = 36.25 thousand rides. Substituting 36.25 into the inverse demandfunction yields P = 300 – 4*(36.25) = 300 – 145 = 155 cents, or $1.55 per ride. In thiscase Trailaway’s profits are revenues minus costs plus subsidy times quantity sold, or(155 – 50 + 40)* 36.25 = $52,562.50. The cost of the government subsidy program tothe government is 40*36.25, or $14,500. Consumers’ surplus is 0.5*(300 – 155)* 36.25,or $26,281.25. In this case total surplus is profits plus consumers’ surplus minus cost ofgovernment subsidy, or $52,562.50 + $26,281.25 - $14,500 = $64,343.75, which is$13,781.25 less than the total surplus in (a) above (=$78,125). Hence the deadweightloss relative to (a) is $13,781.25, or 17.6% of the surplus in (a).3. (20 points total, 20 minutes) Bob is deeply in debt, with over $60,000 owed on creditcards at an annual rate of 20%, and $80,000 owed on student loans at an annualinterest rate of 5%. Yet to maintain appearances, Bob must arrive at work in style. Hisonly options are: (i) to continue to drive his fancy BMW to work; or (ii) to sell his BMWand hire the Lightning Limousine Service to chauffer him to work. (Assume Bob gets thesame value from either alternative, and never has any reason to use his car other thanto go to work.) Lightning Limousine charges $18,000 per year (with payment for the fullyear due at the end of the year). Bob’s BMW can be sold now for $50,000, whereas ayear from now its resale price will only be $40,000.a.(10 points) What is the user cost of capital associated with owning the BMW for thenext year?The user cost of capital is the sum of the opportunity cost of capital plus economicdepreciation. His opportunity cost of capital given the 20% annual interest rate on theBMW’s current market value of $50,000 is therefore $10,000. If he keeps the car, itsvalue will decline to $40,000 a year from now, implying economic depreciation of$10,000 annually. Hence Bob’s user cost of capital for his BMS is $20,000 annually.b. (10 points) Should Bob sell his car and employ Lightning Limousine, or not? Why?