Economics 8100

Final Exam

Spring 2000

Bruce A. Seaman

Name _______________________________ (1 point)

Instructions: This take-home exam is due on Tuesday, May 2 at 5:00 P.M. As always, your signature on the exam indicates that you have not collaborated with anyone else in completing the exam.

Part I. Indicate whether the following statements are true, false or uncertain, and coherently defend your answer using the appropriate economic analysis. Choose 6 of 10; each worth 9 points; 54 points total.

1. Assume that industry X is a constant cost competitive industry, with firms having Cobb-Douglas production functions yielding constant returns to scale. The elasticity of output with respect to the labor input is equal to that of the only other input, capital. Given this information, we can conclude that, if wage rates were to increase by 20%, the new long run equilibrium competitive price in the industry would increase by less than 8%.

2. If the government establishes a price support price for wheat above the original equilibrium price in that increasing cost competitive industry, the expected industry adjustment will involve shifts in the short run supply curves as well as a shift in the long run supply curve.

3. Price controls (below the equilibrium price) imposed in markets that behave like purely competitive industries will create a lower quantity supplied and excess quantity demanded and very likely a tendency for illegal black markets that lead to higher prices, but a price control that requires the price to be lowered in a market behaving like a monopoly can both increase output and lower price. Based essentially upon the same economic principles, a minimum wage above the equilibrium wage level imposed in a purely competitive labor market will tend to cause some reduction in employment (even if modest in magnitude), but a similar minimum wage if imposed in a labor market with employer monopsony power can increase both wage rates and employment.

4. If the nation's output can be approximated by a Cobb-Douglas production function, then increases in the real wage of labor due to increases in the available quantity of machinery per worker will not increase labo's share in national income.

5. Assume that a certain type of labor is employed in an industry in which the firms hiring those workers have market power in the product market in which they sell. This product market power will cause fewer workers to be hired and lower wage rates to be paid compared to the case in which the employing industry had no product market power. However, if those workers form a labor union and refuse to sell their labor unless a higher wage rate is paid, this "problem" for workers can be corrected.

6. Assume that a so-called "consumer welfare standard" focuses upon maximizing consumer surplus. Someone says at a local bar: "The argument that monopoly power is "bad" for the economy because it causes "static allocative inefficiency," i.e. generates an efficiency dead-weight welfare loss, is in reality fully consistent with the consumer welfare standard. That is, if we oppose a particular example of monopoly power using the consumer welfare standard, we would also oppose that monopoly power using the efficiency standard. And if we consider any offsetting "benefits" from monopoly (due to lower costs per unit of production) to be sufficiently large to outweigh the harm from monopoly, we should reach that same conclusion using either the efficiency or the consumer welfare standard." This person is clearly a well-informed economic analyst.

7. It is very unlikely that the insurance industry could survive as a private- for-profit industry if potential insurance buyers framed the decision to purchase insurance in the way that Kahneman and Tversky analyze peoples' decisions when dealing with uncertain options.

8. Dominant firm price leadership models differ from purely competitive models in that under price leadership, the entry of new firms into the relevant market has only a minimal effect on the price and output in the market, due to the market power of the dominant firm. By contrast, under pure competition this entry effect is always sufficient to drive profits back down to "normal" levels.

9. If all firms in a purely competitive industry have a short run total cost function TC = .8 q ² - 20 q + 280, an increase in the market price from $60 to $70 will increase short run industry output by about 14%, and induce entry into the industry until the price falls again to $60.

10. Assume that it is known that a person is willing to spend a maximum of $100 in an effort to eliminate his risk of being killed in a house fire, which has a probability without the expenditure of .0001. From this information, we can conclude that, regardless of his attitude toward risk, the implied value that he attributes to his life is $1 million.

Part II. Problems and Discussion Questions. Choose 3 of 5 questions. Each worth 15 points; 45 points total.

1. This is a problem regarding the interesting topic of "tying contracts" (part of the Microsoft case, for example, includes allegations about the use of tying contracts, which are sometimes, but definitely not always illegal or anticompetitive). Tying contracts are more likely to be viewed favorably by economists and antitrust authorities if they generate higher output compared to pricing schemes without tying contracts. There are various types of tying contracts. This problem exhibits principles related to a particular example of such contracts. Even though we have not discussed this topic in class, this problem uses familiar principles that you should be able to apply to this "new" issue. Follow the sequence of questions and "hints" in answering the questions below.

Assume that Peachtree Printing Press, Inc. manufacturers printing presses and leases them to local newspapers, who also require a specfic type of ink to print daily newspapers using those presses. Peachtree estimates that it costs it $1,000 per machine per time period to make the machines available for lease, and to maintain them in good condition during the lease period. There are 3 possible local customers: newspapers A, B and C. The specfic demands of A, B, and C for "newspaper printing services" is defined in terms of the amount of ink used per time period at different prices per unit of ink. The maximum value of renting printing presses from the perspective of the newspapers is, thus, determined by the amount of consumer surplus that results from their use of ink to generate "newspaper printing services." These specfic demands are:

A: Q = 150 - P

B: Q = 120 - P

C: Q = 100 - P

where in all cases Q is the amount of ink demanded per time period at different ink prices, P. Finally, assume that the ink can be supplied competitively at a price per unit of $10, so that if A, B, and C buy ink on the "open market," they pay only $10 per unit.

a. If A, B, and C can buy ink on the open market, what is the resulting consumer surplus that each obtains from the use of the printing presses in any given time period? That is, for the amount of ink demanded by each newspaper at the competitive ink price, how much consumer surplus is received by A, B, and C?

b. Given that the maximum lease price that can be charged by Peachtree to any newspaper is the value of these particular consumer surpluses, determine what the profit maximizing strategy would be in leasing the presses when A, B, and C are able to buy ink on the open market. Assume that it is not possible to charge different customers different rental prices (i.e. no explicit price discrimination is possible). Thus, you must determine whether it is more profitable for Peachtree to charge a rental price that is low enough to attract all three customers, or a price that allows Peachtree to rent the printing press to only two customers, or to only one customer. Show your analysis, and clarify the relevant costs to Peachtree in deriving these profits.

c. Now, assume that instead of allowing the newspapers to buy ink on the open market, Peachtree establishes a "tying contract" that requires anyone leasing its printing press to also buy the ink from Peachtree at a price per unit of $20, or $10 above the competitive open market price (which is also paid by Peachtree when it buys the ink to resell it to A,B, anc C.) What are the resulting consumer surpluses for A, B, and C under this pricing arrangement?

d. Again, recognizing that the maximum lease price for the printing press that Peachtree can charge any particular customer is the consumer surplus received by that customer from using the ink to generate "printing services," compare the following two cases in terms of the total profit that will result with the tying contracts:

1. Charge a lease price low enough to attract all three newspaper customers

2. Charge a lease price that attracts only two customers, A and B.

e. Given your analysis of profits in (d), does Peachtree's use of tying contracts in this particular example, when it charges an ink price of $20, succeed in increasing the number of customers it serves and the quantity of "newspaper printing services" that are generated, when compared to the case without tying contracts? Clarify.

2. A single firm has a patent that makes it the exclusive producer of product Y. It estimates that it can produce more Y at a constant long run average and marginal cost of $10. Over the last two years, the demand for product Y has fluctuated among the following specific demand functions:

Y = 60 - P; Y = 45 - .5P; and Y = 100 - 2P

Assuming that this firm behaves in a profit maximizing manner given any specific demand function, demonstrate that there is no well-defined supply function for this monopoly firm.

3. Ajax Inc. believes that it can separate two different consumer markets, i.e. customers located in Nevada and customers located in Georgia. The substantial distance makes resales of the product difficult. Ajax assumes that it can produce and sell to either group at a constant marginal and average cost of $35 per unit. The demands are estimated to be:

Georgia: Q = 250 - 2P

Nevada: Q = 160 - P

a. What are the profit maximizing prices and quantities that should be sold in each market if Ajax can successfully price discriminate? What are the resulting total revenues and total profits?

b. Now assume that shipping costs drop dramatically so that it is no longer possible to limit resales of the product across regions. What is the profit maximizing price and output that would maximize Ajax profits in this new situation? Explain. What are the new profits to Ajax in this new situation?

c. What is the intuitive explanation for why the profits to Ajax fell when shipping costs dropped? What exactly led to this reduction in profits?

d. How do economists view price discrimination from a social welfare perspective? Applying that standard, would price discrimination in this case have been a "good thing" when compared to the single price alternative? Clarify.

4. Suppose the demand curve for labor is given by: (L is the number of people hired at the real wage rate per hour, w)

L = - 50 w + 450,

and the supply of labor is given by

L = 100 w

a. What will be the equilibrium level for w and L in this market?

b. Suppose the government wishes to raise the equilibrium wage to $4 per hour by offering a subsidy to employers for each person hired. How much will this subsidy have to be? Explain. What will be the new equilibrium level of employment in that case? Explain. How much total subsidy will be paid by the government? Explain.

c. Suppose instead that the government passed a law establishing a legally required minimum wage of $4 per hour. How much labor would be demanded in this case? How much unemployment would result? Explain.

d. Discuss the relative pros and cons of these two policy options, stressing the social welfare comparisons that you think economists would emphasize in such a situation.

5. Alexander has a von Neumann-Morgenstern utility function u(c), where c is the dollar value of his consumption. He is confronted with a lottery that pays X with a probability of p, and Z with a probability of (1-p). He is indifferent between this lottery and receiving a certain amount T.

a. Write an equation that relates u(X), u(Z) and u(T)

b. Now, suppose that Alexander's friend Darius has a utility function a + b u(c), where a is any number, b is any positive number and u(c) is the same function as for Alexander. Will Darius and Alexander make the same or different decisions regarding whether to play the lottery? Explain.

c. Will they also make the same decision when confronted more generally with "can't lose" games vs. "can't win" games? Discuss

NOTE: YOU CAN ANSWER ONE ADDITIONAL QUESTION IN PART I AND ONE IN PART II FOR EXTRA CREDIT TO BE APPLIED TO YOUR FIRST EXAM GRADE ONLY. Therefore, it will not pay you in terms of your opportunity cost of time if your first exam grade was already "sufficiently high." CLEARLY IDENTIFY WHICH ANSWERS ARE EXTRA CREDIT.