Econ 100AMidterm 2 Practice Exam Friday, March 16, 2012.

Name:

SID:

GSI:

The exam is 80 minutes long. There are a total of 80 points. Do not open exam until instructed. Pages are printed front and back. Label and box your answers. Show all your work. Do not turn in your scratch paper. If you nish after 9:15 pm, do not leave early.

True/False

(2 questions, 10 points total)

Answer true or false and explain your answer. Your answer must t in the space provided. T/F 1. (5 points) A rm with increasing returns to scale will maximize prots by producing the quantity of output at which its marginal cost is equal to the price of its output.

T/F 2. (5 points) If demand is inelastic, a rm with no competition can increase revenue by raising its price, but a perfectly competitive rm cannot.

Short Answer

(2 questions, 20 points total)

Your answer must t in the space provided. SA 1. (10 points) Explain why, if rms in an industry have access to inputs of dierent qualities, a tax will decrease producer surplus in the long run.

SA 2. (10 points) If some prices go up more than others from one year to the next, explain why giving retirees a cost of living adjustment that allows them to continue to purchase the same basket of goods makes them better o than before prices went up.

Problem Solving

(2 problems, 50 points total)

Problem 1. (20 points total) The city council of a city is thinking about imposing a tax on guests at hotels in the city. (This is a very common way for cities to raise revenue.) There are two types of people who stay in hotels in the city: tourists, and business travelers. The weekly demand for hotel-room rental is Xd = 10,000 for tourists, and Xd = 10,000,000 for business travelers. p p2 (A rental means one room for one night.) The long-run inverse supply curve of the hotel industry is horizontal at p = 100. The council is trying to decide whether to impose the tax on tourists or on business travelers. We will assume there is no after-market trade. In other words, if a toursit rents a room for a night, they cannot then re-rent it to a business traveller, and vice versa. We will also assume that hotels can perfectly identify who is a tourist and who is a business traveler. (a) (4 points) Compute the pre-tax equilibrium price and number of rentals each week, rst for tourists, and then for business travelers.

(b) (8 points) Now lets gure out what happens under a tax. (i) Suppose the council levies a tax of $21 per night on tourists. What will be the aftertax equilibrium number of rentals by tourists, the price paid by tourists, and the price received by hotels? (ii) Suppose the council levies the same size tax on business travelers. What will be the after-tax equilibrium number of rentals by travelers, the price paid by travelers, and the price received by hotels? (iii) Graph the inverse supply curve and the two inverse demand curves, and mark the pre-tax and after-tax equilibria on your graph.

(c) (8 points) Now lets consider the dierences between the two taxes. (i) Which tax (on tourists or on business travelers) will generate the most tax revenue? (ii) Which tax will create the most deadweight loss? (iii) Compute the elasticity of demand for tourists and for business travelers and explain your answers to (c)i and (c)ii above. (Make sure to fully explain the economic concepts involved, not just the math or the geometry of your graph.)

Problem 2. (30 points total) Consider a rm that has a production function of y = K 2 L 2 . Assume the wage and the rental rate of capital are w = r = 2. (a) (12 points) Lets start with cost minimization. (i) Compute the rms conditional demand for capital and labor as funtions of output. (ii) Compute the rms cost function. (iii) Compute the rms marginal cost curve and graph it. (iv) Compute the rms cost-minimizing capital and labor for producing output of y0 = 100, and the cost of producing at this level. (v) Graph the rms isoquant and isocost, and the cost-minimizing solution you just computed.

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(b) (12 points) Now lets consider what happens when the rm decides to increase output to y1 = 200 in the short run. (Here we are dening short run as the timescale in which the rm can adjust labor, but not capital. Thus, the rm must continue to use the quantity of capital you solved for in part (a) above.) (i) What is the rms short-run production function at this level of capital? (ii) What is the rms short-run demand for labor as a function of output? [In other words, how much labor will the rm use to produce any given quantity of output in the short run, given that it cant adjust capital?] (iii) Compute the rms short-run cost function. [Make sure to include all of the costs of production.] (iv) Compute the rms short-run marginal cost curve, and add it to your marginal-cost graph. (v) Compute the amount of labor the rm will use to produce y1 = 200 units of output in the short run, and the cost of producing at that level in the short-run, and add them to your isoquant graph. [Make sure to include the new isocost.]

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(c) (6 points) Now lets consider the long run, the time in which the rm can adjust both labor and capital. Lets assume that the rm continues to produce y1 = 200 units of output. (i) What will be the long-run cost-minimizing capital and labor, and the long-run cost, for producing y1 = 200 units of output? (ii) Add this new long-run cost-minimizing solution, and the rms new isocost, to your isoquant graph. (iii) Explain the dierence between the rms short-run and long-run marginal cost curves, and use the insights from your isoquant graph to explain the economic reason for this dierence.

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