Econ 10: Midterm (Dr. Stein) Answer KeyOctober 27, 2009

PART 1:

Name_______________________

TA _________________________

Instructions:

This is a 90-minute examination. Write all answers in blue books. Show all work. Use diagrams where

appropriate and label all diagrams carefully. Do not overwrite! Use the guidelines and suggestions in each question. This exam is given under the rules of Penn's Honor system.

No calculators allowed.

The Exam has 3 parts. Make sure you answer all 3 parts.

Write your name and your TA’s name on all three parts NOW.

Bonus point: use multiple colors in your graphs to get an additional point!

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Part IMultiple Choice questions: circle the correct answer.You do NOT need to explain unless you want to add a clarification.

1.1 (3 points) Adam bought 10 tickets to a raffle for $1 each. It was his lucky day and he won a ticket to a Phillies playoff game. Unfortunately, the game is scheduled for the same evening as Penn Soccer Teams game. Adam can see the Soccer team for free and values it at $20. The resale value of the Philly ticket is $40 and he values that game at $40. What is the opportunity cost of going to the Philly’s game?

a. $90b. $80c. $70d. $60e. $50f. $40g. Zero.

Answer: d

1.2 (3 points) The table below shows the production of Apples & Bananas per hour for George & Frank.

Apples BananasGeorge 6/hr 12/hrFrank 4/hr 6/hr

According this information, which of the following statements is true?a. George has the absolute advantage in apples, Frank has the absolute advantage in

bananas.b. George has the absolute advantage in apples, Frank has the comparative

advantage in bananas.c. George has the absolute advantage in apples, Frank has the comparative

advantage in applesd. George has the comparative advantage in apples, Frank has the comparative

advantage in bananas

Answer: c

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1.3 (20 points)This question asks you to use our concepts of Production Possibilities Frontier to analyze the decisions of Serena, a Wharton Freshman. Please start with one LARGE graph and add to it well labeled modifications for subsequent parts.

Each part refers back to PART A.

If you need to make additional assumptions, please do so clearly.

Serena wants to be a good economist and tennis player at the same time. Because of the time constraint that she has, the possible amounts of economic knowledge and tennis skill that she can get are limited.

Out of 24 hours per day, she spends 14 hours for laundry, eating, dish washing, dorm cleaning, sleeping etc. Therefore she has total 10 hours that she can devote to her economics studying and tennis practice.

a. Draw Serena’s PPF with Economics Knowledge on the X axis. Assume that the Opportunity Cost of Economics Knowledge is increasing. Explain briefly why this assumption makes sense?

Answer: Bowed out PPF. It makes sense that we have diminishing Marginal Productivity for both learning tennis and studying economics.

Points:5Axis:1Bowed out: 2Explanation:2 (1 for intuition, 1 for terminology)

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b. Suppose that Serena could have worked out hard at Pottruck Center before the semester started. In that case what would be her new PPF? Add it to the graph above and label “b”.

Answer: See above. Training before the semester began would make her better at tennis bit not improve her economics learning ability.

Points: 2Increase in tennis: 1 No increase in economics:1

c. If Serena hires a tutor to work with her on economics every weekend, what will happen to her PPF? Label “c”. Explain briefly the assumptions you are making.

Answer: See above. A Tutor would increase productivity in learning only.

Points: 3No increase in tennis: 1 Increase in economics:1Consistent explanation: 1

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d. Serene has been given a robot housekeeper that does all her households tasks so that she doesn’t need to spend time on laundry, dish washing or dorm cleaning. Add and label “d” her new PPF.

Answer: See above. With more hours a day to spend on the two tasks she can increase output in both.

Points: 2Increase in tennis: 1 Increase in economics:1

e. If Serena got the swine flu during the semester, then what would happen to her PPF?Add and label “e” her new PPF.

Answer: See above. Not being able to work out or study her PPF shifts in. Points: 2Decrease in tennis: 1 Decrease in economics:1

f. Suppose, instead of working hard during weekdays, Serena decides to stay in her dorm room watching YouTube video clips. Then what can we say about her choice?

Answer: It is inefficient. She is inside her PPF.

Points: 3Inefficient:2Inside PPF:1

g. Serena is frustrated that both economic knowledge and tennis skills cannot be easy traded. Use a graph (below) to explain why this is so annoying to her. Answer: Trading could allow Serena to consume outside her PPF.

Points: 31 for intuition.2 trading allows a point outside the PPF.

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Econ 10: Midterm (Dr. Stein)October 27, 2009

PART 2:

Name_______________________

TA _________________________ Briefly answer the following 2 questions. Do not write a novel: a quick graph or a sentence or two will do!Remember to use the terms we learnt in class.

2.1 (18 points)Based on an article from The New York Times business section, Wednesday, July 1, 2009.

The recession has had a positive impact on the quantity of pro bono (i.e., free) commercial time available on network TV for public service ads such as ads that promote drug-free lifestyles, encourage financial literacy or keep students from dropping out of high school. Let us use the typical supply and demand model to explain this phenomenon.

a. Draw a typical supply and demand for advertising time. Show the equilibrium price and quantity of advertising.Draw a large graph. You will need to add to it.

6Q

P

Supply (MC)

Demand (MB)

P

Q

Excess supply

Value of free ads

Answer:See graph above.

Points: 4Supply: 1Demand:1P*:1Q*:1

b. What will be the effect of the recession on the demand for advertising? Show graphically, above.

Answer: The demand will shift in.

Points: 2Demand shift: 1 in:1

c. Can the networks still generate the same revenues as before? Explain graphically.

Answer: They cannot as with a shift in demand both P & Q will fall so that Rev=P*Q will fall too. P1*Q1<P*Q.

Points: 2For explanation.

d. If the networks choose not to lower prices, what will be the excess demand or excess supply in this market? Show graphically.

Answer: Excess supply. See above.

Points: 3Excess supply:1Marked graphically: 2

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e. Instead of lowering the price networks choose to give free advertising time to public service advertising. The amount of free advertising is calculated by the price of advertising times the quantity of free advertising given. Show the value of free advertising on your graph.

Answer: See above.

Points: 3For correct graph.Only 1 point if graph is not used.

f. Could providing free advertising increase the revenues for the firms? What does this imply about the elasticity of demand in this market?

Answer: Free advertising could indeed increase revenues. By providing free advertising firms can avoid lowering the price. If demand is inelastic a higher price will increase revenue despite the lower quantity sold.

Points: 4Yes: 1Related to elasticity: 1Correct elasticity:2

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2.2 (20 points)

Consider the following graph for the firm.

a. What is the market structure in this industry? Explain your reasoning.

Answer: As the firm is a price taker this is probably a perfectly competitive market.

Points: 2Perfect Comp: 1Price taker/completely elastic demand: 1

b. In class you have seen that the firm will produce up to the point in which Marginal Costs (MC) equal the Price (P) of the good. In the graph above, there are two such quantities, A and B where P=MC. Nonetheless, your Recitation Instructor tells you that if the firm produces, it will produce at point B. Explain briefly why this is the case.

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Marginal Cost

$

Quantity

Price

A B

Answer:First note that at both point A & point B average revenue equals P. Further, at point A MC is decreasing and thus we know that it will be below ATC and ATC will still be decreasing. Thus it does not make sense to stop producing at A, but increasing production to B. Average revenue is the same at both points, while average costs decreases, which implies that average profits will be increasing. For those who like short answers: at point A profits are minimized, at point B they are maximized.

Points: 3Profits at B larger:1Relating to costs:1Full explanation relating to profits:1

c. Suppose the firm is producing at point B in the short run. Draw on the above graph Average Total Costs (ATC) and Average Variable Costs (AVC) schedules such that:

1. The firm makes negative profits;

2. The firm does not want to shutdown in the short run;

Answer:Need to draw typical AVC & ATC such that P is between the two.

Points: 4AVC cross MC at its minimum:1ATC cross MC at its minimum:1ATC>AVC: 1/2AVC & ATC get close together:1/2P between ATC & AVC: 1

d. Add to your graph the firm's Revenues, Total Costs & Profits.

Answer: At point B mark as usual.

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Points: 31 each.

e. Explain using your graph why the firm chooses not to shut down.

Answer:The firm will choose not to shut down because losses in operation are smaller than losses of shutting down, which are –FC. Show both current losses & FC on graph.

Points: 2Show FC:1State they are bigger than losses: 1

f. What will be the long run price in the industry? Show graphically.How will the market reach this price?

Answer:The long run price is at the minimum of ATC.The industry will reach the PLR through exit.

Points:3PLR=Min ATC:2Exit:1

g. How would your answer to (f) change if demand for this good increased? Explain.

Answer:No change in minATC so no change in PLR.

Points: 3For explanation.

Students should get full credit if they shifted demand before we each LR and stated that at P=minATC there will be no exit.

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Econ 10: Midterm (Dr. Stein)October 27, 2009

PART 3:

3.1 (18 points)This question asks to analyze the food truck market around the campus.

a. What are the characteristics of a monopolistically competitive market? Why may we analyze the food truck market using this model? Any reason why not?

Answer:Product differentiation and free entry & exit.All trucks serve different food- consistent with model..But, in the University area there is no free entry.

Points:41 each characteristic.1 each for consistent explanation.(e.g., Full credit even for stating that anyone can buy a truck and enter the market.)

b. We will look at this market from the perspective of Le Anh, the Asian noodle truck. Label the curves below.

Answer:Need to label MC, ATC & AVC.Points: 31 each.

c. Add a typical demand and the MR curve that Le Anh faces. Assume in your graph that Le Anh is making a profit.

Answer:Downward sloping demand & MR below it.

Points: 21 each.

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d. Using the graph above, mark the equilibrium price, quantity, and the profit for Le Anh’s food.

Answer:Q* at MR=MC.Up to D for Price.Mark Profits.

Points:41 each for P & Q2 for profit (loose one if loss).

e. Is this market in long run equilibrium? Why or why not? (One sentence!)

Answer: No. Profits will cause entry.

Points:32 if state profits>zero1 for entry.

f. List two distinct advantages of this market structure to society.

Answer:

1. Variety

2. Incentives to innovate.

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Points:2

1 each.

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3.2 (18 points)

The Cash For Clunkers Program was implemented by the White House to jump start (i.e.,

promote or advance) the automobile industry. This question asks you to analyze the

program and evaluate it using our model of supply & demand. Throughout the analysis,

assume that the market is competitive. Let us start with the typical graph where supply is

upward sloping and demand downward sloping.

a.Draw the typical supply & demand in this market. Let us suppose that the typical new car

in this market sells for $25,000 and that Q0 cars are sold. Mark clearly the equilibrium

price and quantity, consumer surplus & producer surplus.

Answer:

See graph for parts a through e.

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Price Consumer

25

Qo QuantQ*

D

S

Price Consumer after subsidy

P producer

5

Gains in Consumer Surplus

Gains in Producer Surplus Deadweight

Loss

Points:3

P & Q:1

C.S.:1

P.S.:1

One simple interpretation of the Cash for Clunkers program is as a subsidy of $5000 per

car. Use this approach when evaluating the program.

b.

What effect will this program have on the price of cars to consumers & producers? What

will be the impact on quantity of cars sold? Show graphically using your previous graph.

Specifically- state consumer and producer prices (in dollars) that are consistent with your

graph.

Points:6

2 points for set up of subsidy (e.g., shift S out)

25K>P(consumers)>20K:1.5

30K>P(producers)>25K:1.5

Q increased:1

Loose 1 point (for each price) if only mark P on graph w/o choosing a consistant

price as required.

c.

What will happen to producer surplus & consumer surplus? Show graphically using your

previous graph.

Points:2

C.S. increase:1 (on graph)

P.S. increase:1 (on graph)

d.

President Obama stated “this program will give an efficient jump start to the car

industry.” Is he correct? Explain using your graph.

Points:3

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Inefficient:1

Explanation/DWL:2 (if fail to show DWL on graph-loose 1 point)

e.

How would your answer to part d change if you were told that the subsidy is only given

to buyers of fuel efficient cars? Under what assumption would this program both enhance

production and be efficient?

Answer: If fuel efficient cars cause a positive eternality because, for example, they

reduce CO2 emissions that subsidizing them would be both efficient and increase

production.

Points: 4Positive externality:2Efficient:2

End of Exam. Well done.

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