Solutions for Econ 290 Sample Midterm One Please take note that the solution provided below is for your own reference. They are not completed answers; you can explain more using all the concepts and theories we have learned in this class. Section I: Multiple Choice Questions 1. Government goods and services are usually: a. not rationed by prices. b. sold in markets. c. made available to persons according to their willingness and ability to pay. d. financed by revenue obtained from sales. 2. Taxes: a. are prices paid for the right to consume government goods and services. b. are compulsory payments not directly related to the benefits received from government goods and services. c. never affect economic incentives. d. are used by private firms to raise revenue. 3. If the economy is currently operating on a point on the production possibility curve for government goods and services versus private goods and services, a. an annual increase in government goods and services can be obtained without any sacrifice of annual private goods and services. b. it will be impossible to increase annual output of government goods and services. c. a decrease in the annual output of government goods and services will have no effect on the annual output of private goods and services. d. a decrease in the annual output of government goods and services will allow an increase in annual output of private goods and services. 4. If the marginal social benefit of a good exceeds the marginal social cost at the current monthly output, then: a. it will be possible to make buyers of the good better off without harming sellers of the good. 1 b. it will be possible to make sellers of the good better off without harming buyers of the good. c. either (a) or (b) d. a reduction in monthly output will be required for efficiency. 5. The marginal social cost of bread exceeds the marginal social benefit at the current weekly output. Therefore, a. the marginal net benefit of bread is positive. b. the output of bread is efficient. c. a reduction in weekly output of bread is necessary to achieve efficiency. d. an increase in weekly output of bread is necessary to achieve efficiency. 6. Diamonds are sold by a monopoly firm that maximizes profits. Then it follows that: a. the marginal social benefit of diamonds exceeds its marginal social cost. b. the marginal social cost of diamonds exceeds its marginal social benefit. c. the price of diamonds equals its marginal social cost. d. the price of diamonds exceeds its marginal social benefit. 7. Which of the following is true about command-and-control regulation that allows businesses to emit pollutants up to a certain point and bans emissions after that limit is reached? a. They are equivalent to emissions charges. b. They make firms pay the marginal cost of the damages done by their emissions, no matter what the level. c. They allow firms to emit some pollutants at zero charge. d. They are likely to minimize the cost of achieving any given reduction in emissions. 8. Assuming a product can be manufactured competitively without any externalities at an efficient quantity of 1,000 units and an efficient price of $100.00 per unit, what efficient quantity-price combination would be consistent with a negative externality? a. 1,000 units, $95.00 per unit price. b. 950 units, $102.00 per unit price. c. 900 units, $90.00 per unit price. d. 1,100 units, $105 per unit price. 2 9. The effect of a negative externality is similar to: a. A supply curve (marginal social cost) shifting to the left. b. A supply curve (marginal social benefit) shifting to the right. c. A demand curve (marginal social cost) shifting to the left. d. A demand curve (marginal social benefit) shifting to the right. Section II: True or False Questions. Please indicate whether the following statements are true or false. For the incorrect statements, please explain why. (You need to put down “true” or “false” before your explanation or you will lose one point) 1. Pollution rights can be used to price the right to emit pollutants and to provide incentives to reduce emissions by profit-maximizing firms. (T) 2. Emissions standards allow businesses to emit waste at zero cost until the limits set by the standards are reached. (T) 3. If the marginal social cost of beer production exceeds its marginal social benefit, then more than the efficient about of beer is being produced. (T) 4. Efficient outcomes are often viewed as inequitable. (T) 5. Points lying below a utility possibility curve are efficient. (F) Solution: Points lying below a utility possibility curve are inefficient. Points lying on a utility curve are efficient. Section III: Short Answer Questions. 1. Demand for labor is L = 45 - w, labor supply is L = 4w, where w is hourly wage and L is labor measured in thousands of labor-hours per year. (a) Find equilibrium employment and wage. Solution: In this question, you need to rewrite the labour demand/supply functions to inverse labour demand/supply functions first for your own convenience. L = 45 – w è w = 45 – L L = 4w è w = 0.25L Equate Ls = Ld, we get W* = $9 and L* = 36 3 (b) Suppose government introduces minimum wage at Wmin = 15 dollars. Calculate and show on diagram number of jobs destroyed and resulting unemployment, calculate welfare loss. Solution: W 45 # of unemployed Ls 15 Wmin 9 Ld 30 36 45 60 L # of jobs destroyed At Wmin = $15: # of jobs destroyed = 36 – 30 = 6 # of unemployed people = 60 – 30 = 30 (c) Explain shortly why this policy results in inefficient outcome. Solution: the minimum wage policy changes employers’ real cost of hiring and at the same time distorts employees’ incentive to work. With the minimum wage, the equilibrium employment is less than the employment in a perfectly competitive market. The MSB of the equilibrium employment is higher than the MSC and thus creates DWL (the loss in efficiency). At the same time, it creates unemployment in the economy, those unemployed people will claim for EI benefits from the government. The government will use its tax revenue which is collected from other markets to finance the EI, in other words, someone in the economy has to pay for it. 2. Mary lives in small town and keeps bees. Demand for Mary's honey is given by P = 30 – 0.2Q, where Q is amount of honey in kilograms. Mary's supply curve for honey is P = 5+0.5Q. When collecting the honey, bees pollinate in her neighbor's orchard, the value of pollination created is 0.2 per kilogram of honey. (a) Draw the demand and supply curves, find market equilibrium, label the equilibrium on the 4 diagram. Draw marginal social cost and benefit curves, find efficient quantity. Solution: P 30 S = MSC 23 22.86 E D’ = MSB 5 D = MPB 35.71 36 Q 150 Equate S = D or MPB = MSC, you can get the P* = $22.86 and Q* = 35.71 With the positive externality, MSB = MPB + MEB = 30.2 – 0.2Q Equate MSB = MSC, we find the efficient P = $23 and efficient Q = 36 (b) Please explain why the unregulated market will fail to achieve the efficient outcome and what policy can correct this market failure. Shortly explain why efficiency is achieved after the policy is implemented. Solution: if the market is unregulated, the market price ($22.86) cannot reflect the external benefits that Mary’s bee keeping spills to the third party and thus result in an output where MSB exceeds MSC. To internalize this positive externality, the government can subsidize Mary for her bee keeping at $0.2 per kilogram. With this subsidy, it provides Mary incentive to keep more bee and thus result in an output where MSB = MSC. (c) What does the Coase Theorem sates about this situation: is government intervention necessary to achieve efficiency? Explain fully. 5 Solution: The theorem states that with the presence of externalities, it is possible for the two parties to bargain and it will lead to an efficient outcome regardless of the initial allocation of property rights if there is no transaction cost or minimal transaction cost. In practice, obstacles to bargaining or poorly defined property rights can prevent the negotiation to achieve efficiency. According to this theory, government intervention is not necessary if property rights are well defined. 6