Problem Set # 2

Alice Chiao-En Ip

PPD 501A: Economics for Policy, Planning, and Development Gary Painter True/False/Uncertain Explain: (The explanation is the most important part of the question) 1) A firm should shut down in the short run if it is not making positive profit. o Uncertain. If the price is still above the firm's average variable cost, but less than the average total cost, then the firm should still produce. Doing so will still make some revenue to cover the firm's costs, since the fixed costs are already sunk. If the price is less than average variable cost and less than average total cost, the firm should not produce as doing so would increase losses. 2) Regulating a polluter will lead to an outcome which is Pareto superior. o False. Pollution is a negative externality which probably is not a significant factor in consumer's indifference curves. If regulation results in reduced supply, then consumers would be consuming less or paying more, a situation that would not be Pareto superior. . 3) Consumers are more likely to pay more of a gas tax than a tax on beer. o True. Demand for gas is probably more price inelastic than that of beer so consumers will probably pay a larger portion of the tax. How much consumers pay versus suppliers, however, depends on the relative price elasticities of supply and demand for a particular product. 4) Firms in competitive markets make profits by producing where the marginal revenue is greater than the marginal cost. o False. They should produce when MR=MC. If MR>MC they are making money, but they should be selling more quantity, until MR=MC in order to maximize profit. 5) The supply curve is upward sloping because of decreasing returns to scale. o False. The supply curve is upward sloping because as prices increase, suppliers are willing to supply more quantity. Decreasing returns to scale are reflected in the convexity of the marginal cost curve. 6) A production isoquant describes the different combinations of output levels possible as capital inputs change. 1

Alice Chiao-En Ip o False. An isoquant shows different combinations of production inputs that yield the exact same output.

Discussion Questions: 1) Explain the difference between Pareto superior and Pareto efficient outcomes (use a graph if you want to). Why is Pareto efficiency such a difficult standard for public policy? Suggest an alternative standard that we can use to evaluate policy proposals. o Pareto efficient outcomes occur at a point when one party cannot be made better off without making their counterparty worse off. These outcomes occur at points of tangency between the indifference curves of trading partners. Pareto superior outcomes result in increased satisfaction for both parties, but not necessarily at a Pareto efficient point. Pareto efficiency is a very difficult standard because it is very to difficult make changes that are maximally mutually beneficial. It is hard to know at exactly which point someone will be made worse off by additional trade. Furthermore, policy problems involve many stakeholders. A given change will likely have a negative impact on some group of stakeholders. Therefore, Pareto superior policy outcomes are much more feasible. 2) Demonstrate graphically how a farm subsidy leads to inefficiency (deadweight loss). What economic rational can be given for such a policy that causes inefficiency?

Alice Chiao-En Ip

DWL

D Q1 Q2

o Government will provide farm subsidies in order to account for the risk and uncertainty of the farming industry. Farming involves many capital inputs, land, equipment, etc., and if farmers were to overproduce (w/o a subsidy) in a given season, it could come at a great loss. The unpredictable nature of the weather, also affects farming so governments provide subsidies so that farmers are better able to plan their production and have more stable revenues. 3) Describe how the terms diminishing marginal productivity of labor and decreasing returns to scale are related and how they are different. o Diminishing marginal productivity of labor contributes to decreasing returns to scale. Decreasing returns to scale occur when doubling inputs does increases output by less than double. Diminishing marginal productivity of labor describes the principle that as more and more workers are added, total output increases by less and less after a certain point. Decreasing returns to scale describes the process by which as total inputs increase, total outputs increase by a lesser proportion. Diminishing marginal productivity of labor describes only the labor input, but decreasing returns to scale incorporates all inputs (capital and labor). Problems 1) Complete the following table: 3

Alice Chiao-En Ip

Quantity of Labor 0 1 2 3 4 5 6

Total Output 0 100 190 270 330 360 380

Average Product of Labor 0 100 95 90 82.5 72 63 1/3

Marginal Product of Labor 0 100 90 80 60 30 20

2) A firm has the following cost data: Output 1 2 3 Total Cost 70 74 79 Variable Cost 30 34 39

a. What are the Average total cost, average fixed cost, average variable cost, and marginal cost for these output levels? o output level 1: ATC=70; AFC=70; AVC=30, MC=30 o output level 2: ATC=37, AFC=35; AVC=17, MC=4 o output level 3: ATC=26 1/3; AFC=23 1/3; AVC=13, MC=5 b. Graph these four curves for these output levels.

3) Suppose that the market for spark plugs is characterized by many small firms who have no impact on the final price of spark plugs. The market demand for spark plugs has been estimated to be 4

Q = 28 2P
D

Alice Chiao-En Ip

where P is the price and Q is the quantity of carpet. The market supply curve is QS = 4 + 4P a. Determine the market equilibrium and output. 28-2P=4+4p 24=6P P=4 QD = 28 2(4) QD= 20 QS = 4 + 4(4) QS = 20 Equilibrium price is $4, and quantity is 20. b. Suppose that a tax is placed on the market to raise revenue. It is a $3/unit tax. What is the new market equilibrium and output? Pd - Ps = 3.00 Pd = 3.00 + Ps 28-2Pd = 4 + 4Ps ' 28-2(3.00 + Ps) = 4 + 4Ps 28-6-2Ps = 4 + 4Ps 18=6Ps Ps = 3 Pd = 6 QD=28-2(6) QD=16 New quantity = 16 c. Do the consumers or the producers pay more of this tax? Why? Consumers pay $2 of the tax and suppliers pay $1 of the tax. Consumers pay more because their demand is more price inelastic while supply is more price elastic. 4) The cost of gas in 1995 was $1.22/gallon, and was $4.12/gallon in 2008. What is the cost of gas in constant 2000 dollars for each year? price of gas 1995 gas in 2000 dollars = (172.2/152.4)*1.22 =$1.38 price of 2008 gas in 2000 dollars = (172.2/219.1)*4.12 =$3.24 5

Alice Chiao-En Ip Use these CPI numbers from the BLS (www.bls.gov) for your answer

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 152.4 156.9 160.5 163 205.1 208.5 219.1 166.6 172.2 177.1 179.9 184 188.9 195.3

Why is inflation harmful for the economy? Inflation is harmful mainly due to the risk and uncertainty it brings. Consumers and suppliers both do not know how prices will change, but usually anticipate some sort of increase in prices. There are significant "menu costs" of inflation, where firms waste resources in order to adapt to constantly changing prices (changing price tags, limiting offerings in order to accommodate price changes). Also, firms and households are unable to plan for the future, which is detrimental to long term growth, investment, and innovation. Households will not save money, because they fear that their money will lose its worth if it's not spent. Furthermore, lending becomes impaired. Lenders will not want to lend out money because the money they are paid back will be worth much less. Without financing, firms will not be able to make capital investments. Therefore, inflation is harmful because it results in losses to firms and inhibits economic growth.