Department of Economics Professor Kenneth Train

University of California, Berkeley Spring Semester 2004

ECONOMICS 1
FIRST MIDTERM EXAMINATION
In class, March 1

INSTRUCTIONS

1. Please fill in the information below:

SUGGESTED ANSWERS
Your Name: _____________________________________________________

Your SID #: _____________________________________________________

GSI’s Name: _____________________________________________________

Section Number (Days/Time): _____________________________________________

2. The exam ends at 10:55 a.m.

3. If you finish early, please remain in your seat so that you do not disturb others.

4. When time is called, stop writing and pass your exam to the aisle. Please stay in your
seat until all of the exams are collected.

5. There are a total of 100 points, 5 questions, and 6 pages (including this cover sheet).
Points for each question are in parentheses.

6. Answer the questions in the space provided. (NO BLUE BOOKS). If you need extra
room to answer questions, use the backs of the page.

7. Calculators are not permitted.

Do not turn the page until you are told to begin the exam.

1
 Question 1 – Cigarette Taxes (13 Points – 6 Minutes)

S2
$ S

P2 *
A
$1
P*
B

D
Cigarettes

Q2 * Q*

The graph above depicts the supply and demand for Cigarettes. The government is
thinking about placing an extra $1 excise tax on cigarettes as a way of collecting
money from cigarette producers to pay for rising health care costs.

Who will actually pay MOST of this new tax – producers or smokers? Show your answer
on the graph.

We can think of this new tax as shifting up the supply

curve by $1. (As we can see from the graph, price rises by
less than $1) The area labeled A shows consumer tax burden.
The area labeled B shows the producer tax burden. Clearly
the consumers are paying more of this burden.

This result was discussed in class. Here there is a steep demand curve and a less
steep supply curve. This means that producers can adjust more to changes than can
consumers. As we discussed, whoever can adjust more to changes will be hurt less
by them.

2
 Question 2 – Budget Constraint (8 Points – 4 Minutes)

Pizza

Soda
10

Molly has $10 to spend on pizza and soda. A slice of pizza costs $2. A can of soda
costs $1.

i) [4 points ] Draw Molly’s budget constraint in the graph provided above. Label the
axes and the points where the budget constraint intersects the axes. (Note: the budget
constraint was covered in the assigned reading). Can draw this with either
soda or pizza on the X-axis, just make sure the
intersection points are correct.

ii) [4 points ] If Molly is consuming 4 slices of pizza and 2 cans of soda, what is the
opportunity cost (in terms of slices of pizza) of consuming 1 more can of soda?

If Molly is consuming 4 slices of pizza and 2 cans of soda,

she is spending all of her $10. If she consumes one more
can of soda, she will be spending $3 on soda and have $7 to
pay for pizza, meaning she will be able to afford 3 and 1/2
slices of pizza now. So she has to give up 1/2 a slice.

So her opportunity cost for one more can of soda is:

1/2 slice of pizza

3
 Question 3. Competition (23 Points – 10 Minutes)

$ Individual Firm MC $ Market

S1
AC

P2 *
Negative profits
p1 * d1
P1 *

q Q
Q2* Q1*
q1 *

The above graphs depict the market for bead bracelets at a popular beach. You are
a consultant asked to study this market. Initially you know only that there are 100
bracelet vendors on the beach, that all the bracelet vendors face the same technology
and that the consumers on the beach do not distinguish between vendors.

i) [5 points ] Draw the demand curve for an individual firm (d1 ). Label the individual
firm’s initial (Stage I) price (p1 *) and quantity (q1 *).

You learn that given this initial situation all of the firms (bracelet vendors) are
making negative profits.

ii) [8 points ] Draw and label an AC curve for the individual firms such that this is true.

You learn that the firms (bracelet vendors) are free to enter and exit this market.

iii) [10 points] Label the Stage II equilibrium market price (P2 *) and quantity (Q2 *) given
the AC you have drawn.

Notice that the Stage II equilibrium price is at the

minimum of the average cost curve.

4
 Question 4. Monopoly (34 Points – 15 Minutes)

$ AC
Original MC
11 profits
10
ACnew
9
P* 8
7
6
5
Increase
in profit 4
from tax 3
change 2
D
1
MR
Widgets
0
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18
Q*

Firm A has a patent on Widgets and is the monopoly producer. The graph above
depicts the market for Widgets.

i) [3 points] The demand curve has been labeled in the graph. Label the other three
curves on the graph.
ii) [5 points] Label the equilibrium price (P*) and quantity (Q*) on the graph.
iii) [6 points ] Calculate Firm A’s equilibrium profit? (show the calculation)
Firm A’s profit = P*Q – AC*Q = 8*5 – 7*5 = 5

iv) [3 points ] Shade in a region on the graph showing Firm A’s profit.
v) [6 points ] Calculate the consumer surplus? (show the calculation)
Consumer surplus = (1/2)*(11-8)*5 = 15/2

vi) [11 points ] A government official plans to lower property taxes for the land on
which Firm A’s plant is built. The land is a fixed cost of production to Firm A. The
official argues that at least part of the lower costs to Firm A will be passed on to
consumers. Is the official right? Explain (using the graph as needed)

The official is wrong. Since land is a fixed cost of production,

lowering the cost of land (by lowering taxes) will simply shift the AC
curve down and to the left, but will not affect the marginal cost (MC).
The firm produces where MC = MR, which does not change. So, the amount
produced will stay the same, and thus given that demand has not
changed, so will the equilibrium price. So the consumers are no better
or worse off, but the firm makes higher profits.

5
 Question 5. Competition (22 Points – 10 Minutes)

$
MC S1
$
AC

P*new

P*

Dnew

D
Q
q
q*new Q* Q*new

The graphs above depict the market for sunglasses. The market for sunglasses is
perfectly competitive and is in Stage II equilibrium.

One day a movie star is seen wearing a pair of sunglasses in a popular movie,
causing the demand for sunglasses to rise.

Before any sunglasses firms can enter or exit the market, what happens to price, quantity
sold, and profit for each of the existing sunglasses firms? (Illustrate using the graphs
above).

Note that to illustrate this movement we need to draw in a

MC curve on the firm side. The sum of these MC curves then
is the Stage I market supply curve (S1). The shift out in
demand raises quantity demanded and price (before any firms
can enter). I have labeled the new price and demand on the
graphs. Initially each firm was making zero (economic)
profit – part of the definition of Stage II equilibrium.
Now they all make profits (the shaded region on the firm
graph). So price, quantity, and profit all rise.