Microeconomic Principles � Test #1 by ZRZ5Mezo


									   (Honors) Principles of Economics, Microeconomics – Test #3

Charles L. Baum II                                                            Spring 2002

Instructions: Answer all four questions, which are equally weighted. You may write on
the backs of these pages when necessary. There is no time limit on this test. No
cheating: sign an honor pledge upon completion of the exam.

1. For each of the following pairs of goods, state which good would you expect to have
   more elastic demand and explain why.
a) required textbooks or mystery novels.

b) Beethoven recordings or classical music recordings in general.

c) Heating oil during the next six months or heating oil during the next five years.

d) Root beer or water
2. In a recent attempt to lower the price of energy in California, Senator Barbara Boxer
   suggested that the Bush Administration impose a price ceiling. When the
   administration did not respond affirmatively, Boxer commented that she was appalled
   that Bush did not consider price caps. She went on to note that Bush and Cheney are
   former oil company executives. Vice President Cheney later responded that capping
   energy prices would not increase the supply of energy or reduce demand.

   a) In a carefully labeled supply and demand diagram, indicate the equilibrium price
      and quantity for energy assuming the market initially clears.
   b) Then, impose a binding price ceiling. Note the quantity supplied and demanded
      at the price cap.
   c) According to your diagram, what benefits do price caps provide, if any?
   d) What are the drawbacks of price controls, if any?
   e) Cheney suggested that increasing the supply of energy would reduce market
      prices. Is this true?
   f) What are the four factors that affect the supply curve?
3.     Consider the market for Tennessee corn. Assume that in the graph below, “S”
represents the supply of Tennessee corn and “D” represents the national demand for
Tennessee corn. Let P* and Q* be the market-clearing price and quantity for Tennessee

   a) According to the following diagram, characterize the demand curve’s elasticity.
   b) Why would the demand curve for Tennessee corn have this elasticity? (Give an
      intuitive answer to this question using the appropriate “factors affecting elasticity”
      discussed in class).



       P*                                                               D

                                              Q*             Quantity

        Suppose that the state of Tennessee decides to raise extra tax revenue by taxing
the production of corn grown in Tennessee. That is, let the statutory incidence of a tax
fall on Tennessee corn producers.

   c) Graphically, show how the corn tax affects the graph above.
   d) Clearly indicate the new market price and quantity for Tennessee corn.
   e) Who bears the burden of this tax? Answer this question by indicating (i) the
      portion of the tax burden borne by Tennessee corn farmers and (ii) the portion
      borne by consumers of Tennessee corn.
   f) We rarely see state taxes on farmers in the real world. Using your answers to
      parts a) – e) above, explain why.
   4. On March 6, 2002, President Bush announced that he was willing to impose
   sweeping tariffs and quotas on steel imports. The trade restrictions were to be in
   place for 3 years. The Wall Street Journal Article, “Imposing Steel Tariffs, Bush
   Buys Some Time for Troubled Industry,” by Robert G. Matthews and Neil King, Jr.,
   discusses the particulars: Bush will impose an initial tariff of 30% on steel, and this
   tariff will decrease to 24% in the second year and to 18% in the third.

   a) According to the Wall Street Journal Article, what response can the United States
      expect from other countries? Give a specific example.
   b) According to the article, who is helped by the trade restrictions?
   c) According to the article, give some examples of they types of people who are hurt
      by these trade restrictions.
   d) For this part of the question, refer to the following diagram. Assume the world
      price of steel before the Bush trade restrictions is given by the horizontal, dotted
      line below. Also, assume that the Bush trade restrictions completely eliminate
      trade. What is the no trade equilibrium price level? Indicate this price on the
      graph below.
   e) How do the trade restrictions affect consumer surplus? Give the letters that
      represent the change in surplus for consumers.
   f) How do the trade restrictions affect producer surplus? Give the letters that
      represent the change in surplus for producers.
   g) Do trade restrictions create any dead weight loss? If so, identify the dead weight
      loss caused by the trade restrictions, if any.
   h) Give a brief intuitive explanation for why countries are better (or worse) off as a
      result of free trade.



                      A        B

                      C        D     E     F
World Price
                      G        H               I

                            QS        Q*             QD             Steel
Answer to question 2.
   a)     At a market-clearing equilibrium, the market price is p* and the market
          quantity is q*.
   b)     Now, impose a price ceiling. A Price Ceiling is a legal maximum at which a
          good can be sold. Let Boxer’s price ceiling be given by the horizontal, dotted
          line below. At the price cap, the quantity supplied is QS and the quantity
          demanded is QD.
   c)     The benefit of the price regulation is that the price of energy cannot legally
          rise above the price ceiling. Those who can buy energy get to do so at a lower
   d)     The drawback is a shortage of QD – QS. As a result, some people who would
          have been willing to pay p* for energy are unable to make such a purchase,
          which means that many Californians would be without electricity
   e)     Yes. If the supply curve shifts to the right, then the market-clearing price will
          go down and the market-clearing quantity will increase. There will be no
   f)     The factors that affect the supply curve are (i) the price, (ii) the cost of inputs,
          (iii) technology, and (iv) the number of firms.




Price Ceiling

                              QS        Q*             QD California Energy
Answer to question 4:

a) The United States can expect retaliation from other countries. For example,
   Moscow (Russia) is expected to retaliate, as is the European Union, with tariffs
   and trade restrictions of their own.
b) The steel industry is helped.
c) Consumers are hurt, as are companies that use steel as an input in production.
   This includes the auto industry and, in particular, smaller companies who
   purchase steel on the spot market. (The article notes that a $20,000 car contains
   $700 in steel on average).
d) The no trade price level is where the market supply and demand curves intersect
   one another.
e) Consumer surplus decreases by C+D+E+F
f) Producer surplus increases by C+D.
g) Dead weight loss of E+F is created.
h) Free trade is welfare enhancing because it provides natural incentives for each
   country to produce (more of) what it is best at. In this context, if the United
   States is unable to produce steel as cheaply as other countries, then other countries
   should produce steel and the United States should use its resources to produce
   those things for which it has a comparative advantage.

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