Econ 100a Midterm

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Econ 100A–Midterm 2 solutions. Thursday, March 22, 2012.

True/False

(2 questions, 10 points total)

Answer true or false and explain your answer. Your answer must fit in the space provided. T/F 1. (5 points) Suppose the government wants to place a tax on one of two goods, and suppose that supply is perfectly elastic for both goods. If the government wants to minimize the deadweight loss from a tax of a given size, it should put the tax on whichever good has worse substitutes.

False: If the supply curves are identical, the only factor that determines the amount of deadweight loss is the elasticity of demand. Placing the tax on the good that has the lower elasticity of demand will minimize the deadweight loss of the tax. It is true that, holding all else equal, a good without good substitutes will have more inelastic demand than a good with good substitutes. However, this is not the only factor that determines the elasticity of demand. The goods could also differ in terms of the income effect. If the good with worse substitutes happened to be strongly normal while the good with better substitutes was strongly inferior, then the income effects might overwhelm the substitution effects, causing the good with better substitutes to be more inelastic. T/F 2. (5 points) In a perfectly competitive market with no taxes, if the price consumers are willing to pay for the marginal unit is the same as the price at which producers are willing to produce the marginal unit, then there will be no way to make anyone in the market better off without making someone else worse off.

True. The price consumers are willing to pay for the marginal unit is the height of the inverse demand curve, and the price at which producers are willing to produce the marginal unit is the height of the inverse supply curve. Thus, when these prices are equal, it must be the case that supply is equal to demand, which is to say, the market is in equilibrium. If the quantity firms produce, and consumers consume, is more than the equilibrium quantity, then the firms’ cost of production will be greater than the consumers’ willingness to pay, and either consumers will have to pay more than the units are worth to them, making them worse off, or firms will have to receive less than the units cost them, making them worse off, or both. If the quantity is less than equilibrium, then there will be units not produced or consumed for which the cost of production would have been less than consumers’ willingness to pay, meaning that either firms have given up profitable units, or consumers have given up units that generated consumer surplus, or both. In any case, at least one side of the market will have been made worse off. Thus, from equilibrium there is no way that either firms or consumers can be made better off without someone being made worse off.

1

Short Answer

(2 questions, 20 points total)

Your answer must fit in the space provided.

SA 2. (10 points) Explain what we mean when we say that firms in long-run equilibrium are earning zero profit even though their owners and investors are making an adequate return on their labor and investments.

The statement refers to “economic profit”, which is the difference between revenue and opportunity cost. The opportunity cost of the labor of the owner of a firm is the wage the owner could have earned if he or she chose not to run the firm, but to get a job instead. The opportunity cost of the capital investors invest in a firm is the rate of return they could have earned by investing their capital in some other firm in some other industry. Thus, if the owner of the firm receives an amount just equal to the opportunity cost of their labor, and the investors receive an amount just equal to the opportunity cost of their capital, we do not include those amounts in economic profit, and the firm will be said to be earning zero economic profit, even though an accountant would say that both the owner and the investors are making an...
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