(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 corn. 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). Price S 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. Price Supply A B C D E F World Price G H I Demand 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 price. 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 shortages. 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 Supply P* Price Ceiling Demand 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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