For each multiple choice question, select the best answer and provide a brief explanation of why your answer is the best response. Each multiple choice question is worth 4 points (2 for the correct answer and 2 for the explanation). No graphs are required for full credit on this section, but a graph may help you formulate your explanation. Show calculations where applicable.
1) Suppose that the competitive market for rice in Japan was suddenly monopolized. The effect of such a change would be:
A) to decrease the price of rice to the Japanese people.
- B) to decrease the consumer surplus of Japanese rice consumers.
- C) to decrease the producer surplus of Japanese rice producers.
- D) a welfare gain for the Japanese people.
If a competitive market becomes suddenly a monopoly market it would reduce output to increase the price where MC = MR (marginal costs = marginal revenue) Then this would lead to a decrease in consumer surplus as the prices of rice would be higher for everyone and the producer surplus would be increased because there would have more profit on every unit. The answer is B.
2) Which of the following is true for both perfect and monopolistic competition?
- A) Firms produce a differentiated product.
- B) Firms face a downward sloping demand curve.
- C) Firms produce a homogeneous product.
- D) There is freedom of entry and exit in the long run.
In order to survive in any market structure a firm has to make at least normal profits in the long run (= zero economic profits) : the freedom of entry and exit in the long run ensures normal profits earnings in the long run. The answer is D.
3) The authors explain that the international copper cartel (CIPEC) has been largely ineffective in raising the price of copper in world markets, and the reason is mainly due to the relatively elastic demand for copper. Suppose the cartel recognized that there are multiple uses for copper, and some of the uses have few substitute products (e.g., copper electrical wire) while others have several close substitutes (e.g., copper water pipes). If cartel attempted to raise the price of copper in one of these sub-markets, which market should the cartel choose?
- A) Market with several close substitutes because demand is more elastic.
- B) Market with several close substitutes because demand is more inelastic.
- C) Market with few close substitutes because demand is more elastic.
- D) Market with few close substitutes because demand is more inelastic.
The more that close substitutes are available, the higher the elasticity is likely to be : if the market has few close substitutes the demand is more inelastic (= less elastic) and in an inelastic market a change in price would not significantly affect the demand, which is more interesting for the cartel to select the most inelastic market to increase the prices. The answer is D.
4) Engineers at Jalopy Automotive have discovered a safety flaw in their new model car. It would cost $500 per car to fix the flaw, and 10,000 cars have been sold. The company works out the following possible scenarios for what might happen if the car is not fixed, and assigns probabilities to those events:
Scenario Probability Cost
- No one discovers flaw 0.15 $0
- Government fines firm 0.40 $10 million
III. Resulting lawsuits are lost 0.30 $12 million
(no government fine)
- Resulting lawsuits are won 0.15 $2 million
(no government fine)
Which of the following statements is true?
- A) The expected cost of not fixing the car is less than the cost of fixing it.
- B) The expected cost of not fixing the car is greater than the cost of fixing it.
- C) It is not possible to tell whether the expected cost of fixing the car is less than the cost of fixing it, because the probabilities are subjective.
- D) It is not possible to tell whether the expected cost of fixing the car is less than the cost of fixing it, because the probabilities are not equal.
The expected cost is determined by the costs times their respective probabilities : 0.15*$0 + 0.40*$10+0.30*$12+0.15*$2 = $7.90 million and this is for 10,000 cars : the expected cost per car is $7.90 million/10000 = $790, which is greater than the cost of fixing it ($500). The answer is B.
5) A firm should hire more labor when the marginal revenue product of labor
- A) equals the wage rate.
- B) exceeds the wage rate.
- C) is less than the wage rate.
- D) Any of these can be true.
A profit maximizing firm would hire more workers till their marginal revenue product equals the wage rate because it is not efficient to pay the workers more than their earnings from their labor. Therefore their earning, then the marginal revenue product of labor, has to be greater than the wage rate to be able to hire more employees : the answer is B.
6) The industry demand curve for labor is the
- A) horizontal sum of individual firm labor demand curves.
- B) vertical sum of individual firm demand curves.
- C) representative firmʹs demand curve multiplied by the number of firms.
- D) none of the above
For each wage rate obtained from the vertical axis each firm has a specific demand for labor : in order to obtain the curve of firm demand labor we can join all the points (quantity of labor units in demand, wage rate). The summation of these curves for all the firms in the market is then the market demand curve. The answer is A
7) If a firm can earn a profit stream of $50,000 per year for 10 years, that profit stream is worth
- A) more than $500,000 today.
- B) $500,000 today
- C) less than $500,000 today, but a positive amount.
- E) some amount, but whether it is more, less or the same as $500,000 cannot be determined.
The present value (PV) and the futurevalue (FV) are linked with the following equation :
PV = FV/(1+i)^t where i is the annual interest rate. The future value is FV = $50,000 * 10 = $500,000 and we have 1+i > 1 so (1+i)^t > 1 and FV/PV > 1 : therefore FV > PV. The present value is less than $500,000 but a positive amount. The answer is C.
8) Dry cleaning of clothing produces air pollutants. Therefore, in the market for dry cleaning services, the equilibrium price
- A) and output are too low to be optimal.
- B) and output are too high to be optimal.
- C) is too low to be optimal, and equilibrium quantity is too high.
- D) is too high to be optimal, and equilibrium quantity is too low.
If air pollutants are produced by dry cleaning of clothing this means there is no pollutant treatment that could increase the cost of the service : then the equilibrium price is too low to be optimal. According to Suong Jian & Liu Yan, MGMT Panel , Guangdong University of Finance : the monthly demand and supply relations for dry cleaning are : Qd = 500,000- 50,000P and Qs = -100,000 + 100,000P so the equilibrium price is Pe = $4 and the equilibrium quantity : Qe = 300,000 which is a too high value. The answer is C.
9) Over the past several years, the federal government has rescued a few financially distressed banks and other large private companies, and the key reasons for these actions is to stabilize financial markets and to prevent additional business failures that may arise from the original problem. However, critics of these interventions argue that these actions generate a moral hazard problem. Why?
- A) Government oversight of rescued firms is typically based on limited information, so the outcome is economically inefficient.
- B) Rescued firms will have a difficult time buying insurance in private markets, so the government will also have to insure the firm against losses from fire, theft, etc.
- C) Managers have more information about the financial strength of their firm than government officials, so the rescue attempts may be unnecessary.
- D) Managers may be more likely to invest in risky projects if they believe the government will save the firm in case of failure.
A moral hazard is when a party will tend to take risks knowing that the costs that could incur will not be felt by this party : then if a manager knows that the government will rescue the firm if something wrong happen, the costs would not be paid by the firm so he would be more likely to take risky investments in order to earn more money : in case of failure the government will save the firm and the firm would lose nothing. The answer is D.
10) If households pay a fixed annual fee for trash disposal,
- A) households will all tend to produce the same amount of garbage.
- B) households have no incentive to cut back on the amount of garbage they generate.
- C) that fee will provide households with an incentive to cut back on the amount of garbage they generate.
- D) that fee will discourage households from throwing out reusable materials.
The pay-as-you-throw fees allow households to reduce the quantity of garbage they generate : if the fee would be fixed, whatever the quantity of garbage, the households would not try to reduce the garbage they produce : they would have no incentive to cut back on the amount of garbage. The answer is B.
11) When there are externalities, economic efficiency can be achieved without government intervention
- A) at no time.
- B) when the externality affects many people and property rights are well defined.
- C) when the externality affects only a few parties and property rights are not well defined.
- D) when the externality affects only a few parties and property rights are well defined.
Externalities are usually compensated by the government. However if only a few people are affected by this externality a private solution to the inefficiency would be better. In this case it is necessary to define perfectly the property rights of each parties. The answer is D.
12) In which of these situations would the Coase theorem be MOST likely to work?
- A) A thousand firms use a lake, there are no other users, all their costs could be reduced somewhat by polluting, but all would have lower water intake costs if the lake were clean.
- B) A group of nine firms use a lake, there are no other users, all their costs could be reduced somewhat by polluting, but all would have lower water intake costs if the lake were clean.
- C) Worldwide deep sea fishing rights need to be negotiated among thousands of fishermen from different countries.
- D) One hundred and fifty nations need to come to an accord about CFC generation to combat ozone depletion.
In the second example each firm that use the lake pollutes, so there is for each other 8 companies a negative externality because the pollution affects the water of the other companies that have to pay intake costs to clean the water. Then even if polluting lowers the costs of the firms, the removal of all externalities (here the pollution) would lead to a marginal cost close to 0 (the water intake costs would be close to 0 as no water treatment would be necessary to use the water) : this is an example of the use of the Coarse Theorem. The answer is B.
13) The provision of an education in public school is
- A) exclusive and rival.
- B) exclusive and non-rival.
- C) nonexclusive and non-rival.
- D) a public good, regardless of exclusivity and rivalness.
Education has some characteristics of public goods but are more classified as quasi-public goods because excludability is possible : it is possible to prevent people who have not paid for it from having access to it. This is a rival good as it can be consumed simultaneously by other consumers (here students). So the education in public school is exclusive and rival. The answer is A.
14) According to the economic reasoning presented in the textbook, the government provides public education because
- A) public education is a public good.
- B) private education is rival and exclusive.
- C) public education combats the negative externalities of private education.
- D) public education provides positive externalities.
Public education provides positive externalities as education increases civic engagement and contributes to a democratic and stable society. Furthermore the educated workforce is necessary for the creation and the application of new technologies. The answer is D.
15) A team of researchers has conducted a study of the well being of the citizens of the island nation of Zarasa. Using a scale from 1 (least happy) to 10 (most happy), the researchers find that citizens who earn 100 Zarutas per year have a mean happiness of 2.0, those who earn 200 Zarutas per year have a mean happiness of 6.0, and those who earn 300 Zarutas per year have a mean happiness of 7.0. The researchers should make which of the following conclusions?
- A) The utility of Zarasians increases with income.
- B) The marginal utility of Zarasians increases with income.
- C) The marginal utility of Zarasians decreases with income.
- D) both A and C
As the utility (here the happiness of the citizens) increases from 2.0 to 7.0 when the income increases from 100 Zarutas to 300 Zarutas we can conclude that the utility of Zarasians increases with income. In addition we can see that from 100 to 200 Zarutas the utility increases by 4 and from 200 to 300 it only increases by 1 : this means that the marginal utility decreases as the income is higher. The answer is D.
________________________end of multiple choice section ____________________________
Respond to the following 4 multi-part short answer questions.
1) You have been hired by an attorney to perform an economic analysis of lost wages in a wrongful death suit. The case involves an insurance agent, John Doe, who was killed in an auto accident the day after his 59th birthday. Mr. Doe could have expected to earn $75,000 this year. Data suggest that the income of insurance agents has risen an average of 6% over the past 20 years. Mr. Doeʹs expected retirement age was 65, i.e., on his 65th birthday.
Available data provide the survival rates given below for individuals of Mr. Doeʹs sex and occupation at various ages.
Ten percent (10%) appears to be the appropriate discount rate.
Age Survival Rate (Probability of surviving the prior year)
Question 1, continued
- (6 points) Calculate the present discounted value of Mr. Doeʹs expected earnings stream. (For simplicity, assume he receives all of his earnings for the preceding year on his birthday.)
The present value is expressed as follow :
Where y = $75,000 r = 6% and n = number of years
On his 65th birthday Mr Doe would have earned $554,537.82 more.
- (2 points) The attorney has asked your advice regarding a minimum figure that should be accepted as an out-of-court settlement. What guidance can you give the attorney? Would additional information allow you to give the attorney a more precise estimate of the figure that should be accepted? Give an example of how more information would help.
It is necessary to make into account the mortality rate which is increasing : indeed after 62 years the survival rate goes below 0.90, therefore the attorney will have more risky behavior by pursuing his investment as the survival rate decreases. It is then more appropriate to accept a smaller settlement, the quantity depending on the probability of winning the case considering the full settlement, the offer would be the probability of winning the case times the estimated loss : 0.9 x $347,782 = $313,004 : as the probability of winning decreases the out-of-court settlement also decreases.
- (2 points) You must be prepared for cross-examination by the defendantʹs attorney. Where would you expect the opposing attorney to attack your testimony?
The defendant’s attorney could be expected so as to attack the validity of the assumptions that have been chosen in preparing the estimated loss income. If we assume the survival rate figures come from objective sources, we should make assumptions for both Mr Doe’s growth in earnings and for the interest rate. The defendant would argue for a lower growth in earnings ans a higher discount rate.
2) The probability of a fire in a factory without a fire prevention program is 0.01. The probability of a fire in a factory with a fire protection program is 0.001. If a fire occurred, the value of the loss would be $300,000. A fire prevention program would cost $80 to run.
- A) (2 points) If there is a fire protection program in place and the company has no insurance coverage, what is the expected loss from fire for this company?
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The expected loss is :
- B) (2 points) If there is no insurance and no fire protection program in place, what is the expected loss from fire for this company?
The expected loss is :
- C) (2 points) If the fire protection program were not in place, what is the minimum premium amount for which the insurer would be willing to insure the warehouse?
The minimum premium amount would be the expected loss in case there is no fire protection program, i.e. $3,000.
- D) (2 points) Why does moral hazard arise in the situation where the company pays a three hundred dollar ($300) premium for insurance?
The choice to pay $300 of insurance is a moral hazard as the company tends to take risks and not to take the full consequences and responsibilities of its actions : if there is a fire accident the insurance will cover the company.
- E) (2 points) What is a step that could be taken to address or reduce the moral hazard problem in this situation?
In order to reduce the moral hazard problem a fire protection program should be established by the company to take the responsibility of its employees and not only to rely on an insurance covering.
3) This semester, you read 4 economic articles assigned on the syllabus. For any one of the articles of your choice (you can also choose the Rothstein article “Good Principals or Good Peers?” if you want), answer the following four questions:
- A) (3 points) What hypothesis were the researchers trying to test? In other words, what research question were they trying to answer?
The researchers wants to find if the difference in health costs in hospitals could be explained by the desire of the doctor to perform the greatest tests possible to avoid medical malpractice litigation and to comply with the safe harbor bounds, or because they want to make profits by excessively increasing the mastercharges.
- B) (3 points) What conclusion did the authors reach?
They found that nonprofit hospitals generate more profit margins than for-profits hospitals in the US, and that the mastercharges are not the same in all hospitals, that lead to unequal financial costs which depend on the hospital and their willingness to make profits.
- C) (2 points) What is one implication of their conclusion for public policy or public management?
Their conclusion unveils an important health public issue as there is a significant difference in price according to the hospital which delivers the care : all the medical institutions should align their price to provide fair prices to their patients.
- D) (2 points) What is one limitation or questionable assumption of the study?
One questionable assumption would be the reproducibility of these results in large scale : indeed all these results were found in some specific hospitals in the country and as the sample is not that big it does not totally correspond to the global situation in the US. This study should be extended to much more nonprofit hospital all around the country in order to have a more suitable random sample.
4) Here is a citation and abstract for a research article relevant to public sector economics. Read the abstract and answer the questions below.
POWELL, L. M. and CHALOUPKA, F. J. (2009), Food Prices and Obesity: Evidence and Policy Implications for Taxes and Subsidies. Milbank Quarterly, 87: 229–257. doi:
Context: Pricing policies have been posited as potential policy instruments to address the increasing prevalence of obesity. This article examines whether altering the cost of unhealthy, energy-dense foods, compared with healthy, less-dense foods through the use of fiscal pricing (tax or subsidy) policy instruments would, in fact, change food consumption patterns and overall diet enough to significantly reduce individuals’ weight outcomes.
Methods: This article examined empirical evidence regarding the food and restaurant price sensitivity of weight outcomes based on a literature search to identify peer-reviewed English-language articles published between 1990 and 2008. Studies were identified from the Medline, PubMed, Econlit, and PAIS databases. The fifteen search combinations used the terms obesity, body mass index, and BMI each in combination with the terms price, prices, tax, taxation, and subsidy.
Findings: The studies reviewed showed that when statistically significant associations were found between food and restaurant prices (taxes) and weight outcomes, the effects were generally small in magnitude, although in some cases they were larger for low–socioeconomic status (SES) populations and for those at risk for overweight or obesity.
Conclusions: The limited existing evidence suggests that small taxes or subsidies are not likely to produce significant changes in BMI or obesity prevalence but that nontrivial pricing interventions may have some measurable effects on Americans’ weight outcomes, particularly for children and adolescents, low-SES populations, and those most at risk for overweight. Additional research is needed to be able to draw strong policy conclusions regarding the effectiveness of fiscal-pricing interventions aimed at reducing obesity.
Questions: Assume that your state is actively considering a food pricing policy. How might the following people make use of the article described in the abstract above? In 2-3 sentences that demonstrate an understanding of the abstract, outline the main point that would probably be emphasized by your choice of two of the following stakeholders (5 points each).
- The executive director of an industry group such as the National Restaurant Association
- The governor who is seeking additional sources of revenue
- An advocate for low-income clients at a community health clinic
This study underlines the potential interest of reducing overweight by increasing the prices of the products that contains unhealthy and dense energy foods in order to determine if an increase in the prices would lead to a change in behavior and to less consumption of unhealthy food, and to see if it would decrease the obesity rate in the country. Considering the few past studies on this topic, a small increase in prices would not significantly affect consumer behavior and that only a substantial increase in taxes would drastically affect the consumption of these products, especially in the population which is the most at risk for overweight.
In the case of the governor, this increase in prices by applying a new tax would generate additional sources of revenue, and a ready reason of this increase can be shown to the citizens : the fight against obesity. The governor would be then totally in favor of this kind of project as everyone would be highly taxed, from the low-SES populations to the Restaurants, in order to achieve significant results in decrease of overweight.
On the other hand the advocate who favors low-income clients, even if he is working in a community health clinic, would not totally agree with this project as low-income consumers would be financially penalized because of an increase in their average cost of living : although the obesity would decrease the power of consumption would also be affected and it would have a negative effect in the whole country economy. The advocate, who is protecting low-income clients, will favor the project that will not jeopardized his clients : therefore he will not agree with this project as it endangered his clients financial situation.