Econ 100a

Second Midterm 1997

Costs (15 points):

1. Initially, a firm uses L* units of labor and K* units of capital to produce q* units of output. The firm has the usual smooth-shaped isoquants (labor and capital are imperfect substitutes). To encourage additional employment, the government starts paying 25% of the firm's wage payments (the rate offered by the U. S. government in the late 1970s under the New Jobs Tax Credit program).

A. If the firm continues to produce q* units, show in a graph how its choice of inputs changes. (6 pts)

B. Does the government program achieve its objective of increasing employment? (3 pts)

C. In a graph, show the firm's original output-expansion path and its new path. (6 pts)

Competition (17 points): Answer only 3 of the 4 questions in this section:

2. A firm produces candles. The market for candles is highly competitive, with candles currently selling for $10. The firm's short-run total cost function is C = 200 + 0.2q², so its marginal cost is MC = 0.4q.

A. What is the firm's profit-maximizing quantity? (5 pts)

B. Is the firm earning a profit? (6 pts)

C. What is the short-run shutdown price? (6 pts)

3. In the short run, will a competitive firm ever produce in A) the downward-sloping section of its average cost curve, B) in the downward-sloping section of its average variable cost curve? Why (17 pts)?

4. The domestic supply of orange juice is upward-sloping and the demand slopes down in the country of Econica. The rest of the world will supply it with an unlimited amount of orange juice at the world price of p*.

A. In a diagram, show the free-trade equilibrium price and quantity in Econica. (3 pts)

B. Now suppose that other countries subsidize the production of orange juice by s per unit. How does this change affect the Econica equilibrium (4 pts), domestic consumer surplus (3 pts), domestic producer surplus (4 pts), and domestic welfare (3 pts)?

5. What is the effect of a lump-sum tax, $L, assessed on each competitive firm in a market on the equilibrium (5 pts), consumer surplus (4 pts), producer surplus (4 pts), and welfare (4 pts)?

Monopoly, Dominant Firm (17 points): Answer only 2 of the 3 questions in this section:

6. A firm has a U-shaped average cost curve. The market demand is a downward-sloping straight line.

A. Can this firm ever be a natural monopoly? If not, why not? If so, what conditions must be met for it to be a natural monopoly? (10 pts)

B. Show the equilibrium price, quantity, and profit for this monopoly equilibrium. (7 pts)

7. Firm 1 is initially a monopoly. Then, a competitive fringe enters the market. The fringe supply is horizontal at p* (a price that is above Firm 1's minimum average cost). Show that the dominant firm-competitive fringe equilibrium price, p*, is less than the original monopoly equilibrium price, p (10 pts). Also show how much the dominant produces, Q_d, and how much the fringe produces, Q_f, in the new equilibrium (7 pts).

8. A monopoly produces a life-saving medicine at a constant cost of $10 per dose. The demand for this medicine is perfectly inelastic so long as price is less than the $100 (per day) income of the 100 patients who need to take this drug once a day.

A. Show the equilibrium price and quantity and the consumer and producer surplus in a graph. (8 pts)

B. The government imposes a price ceiling of $30. Show the new equilibrium. What is the change in consumer and producer surplus? What is the deadweight loss (if any) from this price control? (9 pts)

Optional bonus problem (10 bonus pts):

9. What is the effect of a tax of t dollars per hour on labor in one sector of the economy (the covered sector) on the equilibrium wage, total employment, and employment in the covered and uncovered sectors? [You may ignore any possible effects on demand in the two sectors.]