Midterm and Final Exams

1

Rice BE 500

MIDTERM AND FINAL EXAMS

INSTRUCTIONS:

Answer all questions. It is essential that you explain the reasoning behind your answers rather than just give the answers themselves. Be as brief, but as rigorous, as possible. Be sure to use graphical explanations where appropriate. The exam has a total of X points, with points for each question in parentheses.

My name is ______

(Print)

I have neither given nor received inappropriate aid on this work. Nor have I observed any academic misconduct on the part of others pertaining to this work.

______

(Signed at the end of the exam)

I. (10 points) Recent tire safety problems have caused the small state of Rhode Island, sandwiched along the east coast of the U.S. between Massachusetts and Connecticut, to consider taking action. In particular it is considering requiring a State agency to inspect all new cars sold in the state to make sure their tires are safe and properly inflated. The inspections will cost $30 per car, and will be charged to the Rhode Island auto dealership selling the car.

A)Will the inspections raise the price of cars in Rhode Island?

B)Will the inspections cause the number of cars sold in Rhode Island to decline?

Consumer groups have presented evidence that even if the $30 were passed along to consumers in car prices, the effect on sales would be small. Looking at Alaska, a state with a population not much different from Rhode Island, they show that a $30 increase in new car prices reduced the quantity sold by only 0.1%.

C)If the average car price is about $15,000, can you use this evidence to approximate the price elasticity of demand for cars in Alaska? If not, why not? If so, what is your estimate?

D)Do you expect the price elasticity of demand for cars in Rhode Island to be greater than, less than, or the same as the price elasticity of demand in Alaska? Why?

III. (13 points) Assume that the tavern industry in the state of Washington is perfectly competitive. Also assume the industry is in long run competitive equilibrium. There are currently 200 taverns serving 40,000 alcoholic beverages per year per tavern, and the price of an alcoholic beverage in the taverns is $4. Assume that alcoholic beverages are the only tavern output, and that the Washington tavern industry does not significantly impact the price of any of its inputs.

The costs that a tavern incurs are affected by the government in two ways. First, there is a liquor excise tax that amounts to $1 per beverage sold (and is paid by the tavern, and thus is not in addition to the $4 price). Also, taverns must pay a license fee to the government that amounts to $40,000 per year per tavern, regardless of how many beverages are sold.

A new bill proposed in the State Legislature, the Tavern Tax Adjustment Act (TTAA), will permanently change the liquor excise tax to $1.50 per beverage sold in taverns, but will also permanently decrease the tavern license fee to $20,000 per year. The bill would go into effect in January of 2001 when each tavern must renew its license.

A)How would TTAA affect the Average Cost curve for the typical tavern in the Short Run?

B)How would TTAA affect the Marginal Cost curve for the typical tavern in the Short Run? (Use graphs to answer A and B.)

C)How, if at all, would the TTAA affect the Short Run price of beverages in taverns and the total quantity sold?

D)How would the TTAA affect the profits earned by a typical tavern in the Short Run?

E)Describe how the Long Run industry situation would differ from (1) the original situation in the tavern industry, and (2) the short run situation after the passage of the bill. Address the likely changes in

1. The number of taverns

2. The price of alcoholic beverages in taverns

3. The quantity sold by taverns

4. Profits of tavern owners

5. Revenue to the government from taxes paid by taverns

6. The number of alcoholic beverages sold per tavern

IV. (3 points) Recently the United States Government decided to sell some oil that is currently being stored in the Strategic Petroleum Reserve. They plan to sell it over the next couple of months, but to buy back at least the same amount of oil for future storage after the winter is over. One commentator argues that this policy will not be effective in reducing the price of heating oil and gasoline. She says, “The problem with the policy is that the government oil will be sold to oil companies for refining. But since the oil companies are currently making large profits from the high prices of heating oil and gasoline, they have little incentive to lower their prices when receiving the oil.” Critically evaluate this argument.

SPECIAL MULTIPLE CHOICE INSTRUCTIONS: The following questions are multiple choice-- circle all correct answers. Note that any number of answers may be correct, from zero to all.

No explanation is necessary for full credit. You may give explanations if you wish, but you may lose as well as gain points from them. In any event, the explanations should be no longer than two sentences.

V. (3 points) Consider two dry cleaning firms, A and B that are similar in almost every respect. That is, they are located in similarly affluent areas of town, they have similar production processes, they have similar quality of output, face similar input prices, etc. The only difference between them is that A owns the building it inhabits (with a fully paid off mortgage) while B rents its building. Then we can expect

A)B will charge a higher price than A.

B)A will have lower average cost than B.

C)A will have lower marginal cost than B.

D)If there is an industry downturn that causes profit to fall, B is likely to exit the industry sooner than A.

VI. (3 points) Short run price elasticity of supply is almost sure to be higher than usual (e.g., higher than the short run elasticity in long run competitive equilibrium) when

A) Prices have recently increased, and many firms are operating near their short run capacity.

B) Prices have recently decreased, and many firms are operating very close to their shut down point.

C) Technology in the industry is rapidly changing.

D) The industry demand curve increases in elasticity.

IV. (4 points) Because of labor union contracts in the auto industry, it is often very difficult for firms to fire or lay off workers. That is, the contracts severely limit the conditions under which workers can be fired or laid off. Also, even if workers are fired or laid off, the auto firms must pay large amounts for severance packages, job retraining, and other benefits. The effect of these contractual provisions, compared to a situation where firing and lay offs are less restrictive and less expensive, is to

A) Increase the fixed costs of auto firms.

B) Increase the shutdown price for the auto firms.

C) Increase the price elasticity of supply for autos at prices below the current market price.

D) Increase the price elasticity of supply for autos at prices above the current market price.

E) Reduce the price of automobiles more than usual during periods when demand falls substantially.

V. (3 points) If new, superior production or distribution technology becomes available in a competitive industry, it will result in

E)Increased economies of scale.

F)Reduced price in the short run.

G)Reduced price in the long run.

H)Higher long run firm economic profit.

II. (5 points) Major League Baseball has seen a large increase in players’ salaries over the past 20 years, and also a large increase in ticket prices to games. Assuming the individual teams (such as the Seattle Mariners) are profit maximizing, do you think the players’ increased salary demands caused ticket prices to be higher? Be clear and complete.

III. (4 points) Wages for barbers have increased fairly steadily in real terms (even after adjusting for inflation) over the past forty years. This has occurred despite there being no new barbering technology and no change in the kind of skills required to be a barber. Why then have barber’s wages increased?

I. (10 points) The advent of auction markets on the Internet has made it easier for buyers and sellers to find each other, especially in markets for previously hard–to-find collectibles such as original editions of old, out-of-print books. Now there are several websites devoted to these “antiquarian” books. Here, potential buyers can easily find books that previously required extensive search through specialty bookstores. Also, owners of such antiquarian books can easily reach a much larger pool of potential buyers than they previously could, by listing their books for sale at the sites.

A) Do you expect that the introduction of Internet auction markets caused an increase or a decrease in the price of antiquarian books? How does your answer depend on your guess as to, before the Internet, whether the majority of the search costs in the market were paid by buyers or sellers?

B) What effect should the Internet have on the number of antiquarian books traded?

C) Some books sold on antiquarian sites are “relatively” rare, but there may be many (say 200) existing copies of the books in existence somewhere. Other books are very expensive one-of-a-kind items, such as the original handwritten draft of a famous novel. Is there any reason to suspect a difference in the effect of the Internet on the average price of one-of-a-kind books compared to the somewhat rare, multiple copy books? If so, with which kind of book is the Internet likely to have a more positive effect on price (i.e., increase price more, decrease price less, or increase price instead of decrease it).

II. (6 points) You have done a study of the demand curve for soft drinks and concluded that the price elasticity of demand is between –0.5 and –0.8 at current prices. Agnes, a coworker, has seen the preliminary results of your study and argued that your conclusion about elasticity is unreasonable. She argues, “If demand has an elasticity in this range, then raising price would raise total revenue. Raising price would also lower quantity sold and therefore lower cost. An industry would never price in a region where elasticity was between 0 and –1, therefore, because it would be more profitable charging customers more.”

Evaluate each part of Agnes’s argument. In particular, is Agnes correct in saying:

A)If elasticity is between –0.5 and –0.8, price increases will raise Total Revenue.

T / F – Circle one

B)Price increases lower quantity and therefore lower Total Cost.

T / F – Circle one

C)Industry profit will increase if price were a little higher, given this elasticity.

T / F – Circle one

D)We would therefore never find an industry setting a price where elasticity is in this range.

T / F – Circle one

Explain the key logic in your overall evaluation of her argument.

III. (6 points) Critically evaluate the following statement. State whether the argument is true, false, or uncertain. If the argument is false or uncertain, indicate precisely where and why the argument breaks down. In any event, be sure to explain your reasoning completely.

“Increased firm investment in plant and equipment normally lowers the marginal cost curve for the firm. This lower marginal cost will shift the supply curve out. The result of more firm investment in fixed assets is then lower prices and greater quantities of goods for consumers. Thus, legal requirements forcing firms in an industry to invest more, will tend to lower prices in that industry.”

(Be sure to distinguish in your answer between long run and the short run effects.)

V. (8 points) Video-on-Demand (VOD) has just begun to make inroads into cable television systems in certain areas of the country. These systems enable consumers to watch a variety of movies and other video content at any time over cable television systems. Furthermore, the customers, when watching the video content, will have access to special functions usually found on a video recorder or a DVD player – stop, pause, review, scan forward (and back), slow motion, freeze frame, etc. There is considerable uncertainty, however, about whether the VOD technology will ultimately be very successful with consumers.

A)What effect do you expect the introduction of VOD technology to have on the demand for videocassette movie rentals (from stores like Blockbuster)?

B)Suppose that the initial VOD offerings show that, quite unexpectedly, VOD is enormously popular with consumers. Assuming the videocassette rental market is perfectly competitive, how would you expect the price and quantity of videocassette rentals to change over the next three years in areas where VOD will not be introduced until December of 2003?

I. (6 points) Webvan, an online grocery delivery firm, recently filed for bankruptcy and ceased operation. But it still had a liability for leases of warehouse space that the firm planned to use for storage of its products. When operations ceased, Webvan began searching for another firm that could use the warehouse space it was leasing. One large warehouse was in Carol Stream, Illinois just south of Chicago. The warehouse was equipped with cooling units and other specialized to its purposes.

Assume that Webvan leased the Carol Stream plant for $150,000 per month, or $1.8 million per year. Also assume that Webvan closed its operations shortly after renewing the lease for 12 months. It took two months for Webvan to find someone to sublease the space once they ceased operations. The sublease was to a furniture company for $85,000 per month to cover the remaining 10 months of the lease. Assume the time it took to search for the new lessee, and the approximate price that Webvan received in the sublease were all very predictable.

A) If we considered one year as the short run time period of interest in determining our cost curves, how would you characterize the $1.8 million cost of the lease? That is, was it

--- entirely a fixed cost in the economic sense?

--- not a fixed cost at all in the economic sense?

--- partially a fixed cost and partially not fixed?

If you pick the last alternative, state the exact amount that was fixed and the exact amount that was not fixed. In any case, completely justify the reasoning for your answer.

B) Do you think that the likelihood of the cost being fixed, or the part of the cost that was fixed, would have been larger or smaller if the space that Webvan was leasing was generic space instead of specialized to the food industry? Why?

II. (I4 points) You work for Burgerhouse Inc. (BHI), a chain of fast food hamburger restaurants. BHI is considering the purchase of a new type of broiler machine to make its hamburgers. Its current machines, called Assemblemasters, not only broil the hamburgers, but also toast the buns and assemble the hamburgers and condiments on the bun. The new machines being considered, Broilmasters, would only broil the hamburgers and toast the buns, but would not do any assembly. (The current Assemblemasters are aged and now are virtually completely worn out.) Broilmasters are similar to Assemblemasters in that they produce burgers at the same rate of output, last for about ten years, involve little or no maintenance, and never break down. BHI, however, would have to hire extra labor to assemble burgers if they buy the Broilmasters. The reason that BHI is considering the switch is because Broilmasters cost much less to purchase than Assemblemasters.

Let Q0 be the current rate of output in each of the BHI stores. Assume that you have conclusively determined that if your stores continue to produce Q0, total economic costs would be lower with the Broilmasters -- even after fully accounting for increased labor costs. Assume BHI will change neither price nor quantity if it keeps the Assemblemasters. Further assume that each BHI restaurant faces a downward sloping demand curve for its burgers, due to some amount of location monopoly power.

A) How would the installation of Broilmasters in BHI's restaurants affect the short run marginal cost curve (MC) for hamburgers?

B) How would the installation of Broilmasters affect the short run average cost curve (AC) for hamburgers? (You may draw sample curves for A and B to illustrate this.)

C) In order to maximize profit, should BHI change its price (and therefore its quantity sold) in a given restaurant if it switches to Broilmasters? If so, how will its price and quantity change?

D) Would you advise BHI to make the switch to Broilmasters in its current restaurants? Why or why not?