Economics 100.15
November 2003
Please note that this document is also posted without the answers. These questions will be of most benefit to you if you try to answer them on your own, and try to find out how to answer them by referring to your notes or the text book and associated materials. When you have done your best to answer them on your own, you can check your answers by consulting this guide.
1. Theatre Antigonish wishes to increase its revenues. It is contemplating raising its ticket price from $11 to $13. The manager anticipates that the number of people attending will fall from 225 to 175 as a result of the change. What is the elasticity of demand for plays at Theatre Antigonish? Will the increase in ticket price have the desired result?
Formula: Percentage change in quantity divided by the percentage change in price.
Change in quantity = 225 – 175 = 50
Average quantity = (225 + 175)/ 2 = 200 Ratio equals 50/200 = 1/4 = .25
Change in price = $11- $13 = $ 2 (ignore the sign)
Average price = ($11 + $13)/2 = $12 2/12 = 1/6 = .167
Answer .25/.167 = 1.5
By fractions: 1/4 divided by 1/6 = 1/4 times 6/1 = 6/4 = 1.5
The demand is elastic, so the price increase will decrease total revenues. This can be checked by calculating the TR in each case. When the price is $11, sales are 225 and TR is $2475. When the price is $13, sales are 175 and TR is $2275. The price increase will not have the desired result.
2. Answer the following three questions:
- Bus travel in Nova Scotia is an inferior good. It's income elasticity is more likely to be +2, +1, or -.5? (Circle one.)
-.5. Demand for an inferior good decreases when income rises, so that the coefficient of income elasticity will be negative.
- If the long-run supply elasticity for a commodity is +1 is the Short-run supply elasticity more likely to be +1.25 or +.5? (Circle one.)
+.5. Supply elasticity is always lower in the short-run than the long run. Therefore the coefficient of short-run elasticity will be smaller than the coefficient of long-run supply elasticity.
- Some people always mistrust government intervention in the market, while others always mistrust profit maximising firms and urge the government to intervene in the market. Discuss the circumstances in which resources will not be used efficiently when markets are completely unregulated.
You should right a thoughtful paragraph or two about this. The general argument is that markets will be inefficient if there are external costs such as pollution. External benefits, so as the pleasure others receive from your Christmas lights also could cause inefficiency. Many people argue that education has external benefits. Markets must be competitive to be efficient as well. If firms can’t enter the industry, then price won’t be driven down to minimum average cost. Too few firms will produce where costs are higher than necessary. They will make profits, at the expense of the consumer. You should Illustrate your argument with a diagram showing the competitive firm in long-run equilibrium. You should also be able to show the supply and demand curves and the maximizing of consumer and producer surplus. See the diagrams in your notes and in the text.
- Assume that the Nova Scotia Symphony is running a deficit and needs to increase its revenues. They hire you as an economic advisor to determine whether they should increase or decrease ticket prices. Explain how the concept of demand elasticity can help to determine the correct action. Would knowing the price of theatre tickets help in determining the action to take? (People who like the symphony tend to like theatre as well.) Why?
If demand is elastic, and they increase ticket prices, revenue will fall, not rise. The bigger an impact ticket prices have on income, the more likely the demand is to be elastic. Theatre is a close substitute for the symphony, so if the price of the symphony rises significantly relative to a theatre ticket, the demand may become more elastic.
- a. Draw the demand curve and the average and marginal cost curves of a firm which produces lumber in a perfectly competitive industry, showing that the firm is earning a profit. Show the profit maximising price and output and indicate the firm’s profits on the diagram. (You may omit the AFC curve.)
(Note the shapes and intersection points of the curves. Note also the little gap between the profit box and the ATC curve. ATC are above the minimum at the profit maximizing output.)
b. Explain the changes which will occur in this industry and to this firm as the industry moves into long-run equilibrium.
In the long-run, firms will enter the industry shifting out the industry supply curve and driving down the price. The industry will reach equilibrium, and firms will neither enter nor leave, when the price equals the minimum ATC.
6. The government of Metropolis wishes to reduce the deficit of its transit company by increasing the revenue from riders. Their economic advisor has calculated that if the fares are increased from $.90 to $1.10 the number of riders will fall from 12,000 to 8,000. Calculate the elasticity of demand. How can Metropolis increase the revenue earned by its transit system? Explain your answer.
The correct answer is 2. (See above for method.) Total revenues would rise if the transit company decreased its fare.
7. Suppose an economist makes the following statement: ‘An increase in the tax on tobacco will reduce the amount of smoking. Such a tax increase will be beneficial to Canadians.’ Discuss the parts of the statement which are positive and the parts which are normative. Explain why they are different.
The statement that increasing the tax will reduce the amount of smoking is positive. It can be tested and proved or disproved. The statement that such a tax will be beneficial is normative. The concept of a benefit is a normative concept. Note, if the economist stated that the tax would improve health, that would be a positive statement, although outside the economists area of expertise. Not also that the statement that the tax and reduced smoking would reduce health would also be a positive statement, even though it is likely untrue.
8. In Canada, milk production is regulated through milk marketing boards. Using the appropriate diagram, show the impact the quotas imposed by such boards have on the equilibrium price and quantity of milk produced. Use the concept of elasticity to explain why a milk marketing board regulates the industry through quotas, but a pork marketing board might reject such a policy.
NOT REQUIRED ON CHRISTMAS EXAM.
9. Assume the National Energy Board has set a goal of reducing oil consumption from 62 to 58 million barrels a year. Its economic advisors recommend raising the price per barrel from $28 to $32 in order to achieve this goal. However the advisors state that if income rises sharply in Canada the price rise would have to be larger to achieve the goal. Calculate the elasticity coefficient which the economic advisors assume applies to the demand for oil and use the concept of income elasticity of demand to explain why rising incomes would require a larger price increase to achieve the goal of reduced oil consumption.
The demand elasticity coefficient is .5. See above for the method. Oil consumption is a normal good, and may will have a relatively high income elasticity. Therefore if income rises, ceteris paribus, the demand for oil would increase. If income rises while the price increases, the impact of rising income would offset the impact of the rising price. Price would have to rise more to get the same reduction in consumption.
10. The following table shows the costs of a firm in a perfectly competitive market.
OUTPUT / TOTAL COST / AVC / MC0 / 300
=100/1=100
1 / 400 / =100/1=100
=50/1=50
2 / 450 / =150/2=75
=60/1=60
3 / 510 / =210/3 =70
=80/1=80
4 / 590 / =290/4=75
=110/1=110
5 / 700 / =400/5=80
=140/1=140
6 / 840 / =540/6=90
=180/1=180
7 / 1020 / =720*7=103
a. Fixed costs of this firm are _300_.
Minimum average variable costs of this firm are _70_____.
Diminishing marginal returns begin when output = _2______.
b. Complete Table B using information from Table A to determine the profit maximising output.
TABLE B
Price / Output / Profit (loss) = TR-TC$50 / ___0__ / -300 a loss / Price is less than min AVC. Loss is least with zero output. Lose only the fixed costs.
80 / __4___ / =(4*80)-590=-270 (a loss) / The loss if it operates where p = mc is less than the fixed costs.
140 / __6___ / =(6*140)-840 = 0 / The firm just breaks even.
11. Draw a diagram showing the cost and demand curves of a firm in a perfectly competitive industry which is in long-run equilibrium. Explain the process which results in such an industry achieving productive and allocative efficiency.
In the short run the firm achieves allocative efficiency because production expands until P = MC. The price represents the MB or what people are willing to give up. The MC curve shows what people have to give up. In the long-run, if price is greater than min ATC the firm makes a profit. As a result, firms enter the industry, and they shift the industry supply curve (the sum of the MC curves) to the right, and the equilibrium price falls. If price is less than min ATC the firm makes a loss. As a result, firms leave the industry, and they shift the industry supply curve (the sum of the MC curves) to the left, and the equilibrium price rises. Firms stop entering or leaving the industry only when price = minATC. At that point output is being produced at the lowest possible cost, so that the economy is achieving productive efficiency.
12. Complete the following table.
Labour0
1
2
3
4
5 / Output
0
10
22
30
36
40 / Marginal
Product
_10_
_12_
_8__
_6__
__4_
____ / Average
Product
__10
__11
__10
___9
___8
____
a. Where do diminishing marginal returns begin? When MP begins to fall, at 2 units of labour.
b. Discuss the implications of the law of diminishing marginal returns for the limits to the growth of production in the world as a whole.
The planet Earth is a fixed factor. As a result, for the globe as a whole, if we try to expand output by applying more and more labour and capital to the fixed factor of the earth, the addition to output of an additional input will eventually fall. Given our technology, we cannot indefinitely double inputs and double output. As a result, growth in output per person is expected to fall eventually. Improvements in technology can offset diminishing returns by shifting up the total product curve. For example, improved technology means that output per person of food is greater now than in the past, in spite of a great increase in world population.
- a. Complete the following table of the costs of a curve in a perfectly competitive industry:
OUTPUT / TOTAL COST / MC / ATC / AVC
0 / 25
=30/10=3
10 / 55 / =55/10=5.5 / =(55-25)=30; 30/10=3
=20/10=2
20 / 75 / =75/20=3.75 / =(75-25)=50; 50/20=2.5
=10/10=1
30 / 85 / =85/30=2.83 / =(85-25)=60; 60/30=2
=20/10=2
40 / 105 / =105/40=2.63 / =(105-25)=80; 80/40=2
=30/10=3
50 / 135 / =135/50=2.7 / =(135-25)=110; 10/50=2.2
=40/10=4
60 / 175 / =175/60=2.9 / =(175-25)=150; 150/60=2.5
=50/10=5
70 / 225 / =225/70=3.2 / =(225-25)=200; 200/70=2.86
=60/10=6
80 / 285 / =285/80=3.5 / =(285-25)=260; 260/80=3.25
b. Fixed costs of this firm are __25______.
c. Complete the following table showing the profit maximising output at each price:
price / Output / profit (loss)$1.50 / 0 / $-25 loses fixed costs / Price < minAVC; don’t produce
$2.50 / 40 / =(2.50-2.63)*40=$-5, a loss / TR = (P minus ATC)*output
$3.00 / 50 / =(3.00-2.70)*50=$15 profit / TR = (P minus ATC)*output
$4.00 / 60 / =(4.00-2.90)*60=$66 profit / TR = (P minus ATC)*output
d. The price at which this firm will shut down is ___$2_or less______.
e. In long-run industry equilibrium, the price in this industry will be _$2.63 (min ATC______output will be ___40____ and profits will be _zero_____.
Note: We don’t have the data for output between 30 and 40. When the price is $2.50, the loss will be smallest at best output that can be produced: 40 units. If output of 30 or 50 were produced the loss would be greater than $5. If the firm can choose to produce between 30 and 40 units, it might be able to reduce its loss a wee bit more. In the long-run price must equal minATC so that given the data we have, the best price that can be predicted is $2.63.
- Draw the short-run average cost curves of a firm in a perfectly competitive industry. Explain how the firm determines its profit maximising output. What is the supply curve of a firm in a perfectly competitive industry? Explain your answer.