Please, start your answer for each question on a separate page.

EXAM IN MICROECONOMICS

(October, 2009)

SOLUTIONS

Section 2. Free response questions.

You will have a total of 60 minutes for this section of the exam. It is strongly recommended that you spend the first 10 minutes reading the exam carefully, and the next 50 minutes working on the questions.

Please, start your answer for each question on a separate page.

1. (30 points) Country Greatland produces only agricultural and military goods. The agricultural goods are produced using a labour intensive technology, while military goods production is capital intensive.

1. Draw country Greatland’s production possibilities frontier (PPF), assuming that the law of diminishing returns holds.

Answer: See one of the pictures below, say, in part B.

For parts B through D, consider each of the suggested changes separately.

1. Show what would happen to the PPF if there was a large inflow of immigrants into Greatland.

Answer: See graph.

1. Plot the effect of technological improvement in the production of military goods only on the Greatland’s PPF.

Answer: See graph.

1. What would happen to the PPF of Greatland and its decision of how much agricultural and military goods to produce if a neighboring country threatened to attack it? Illustrate your answer with a graph.

Answer: See graph below.

1. (25 points) Sarah is a big movie fan and only consumes two goods: movie and Coke. She has an income of $100 per month. The price of movie ticket is $2 and the price of one Coke is $1. Sarah chooses to see 20 movies and drink 60 Cokes every month to maximize her utility.

1. Is the above consumption bundle affordable for Sarah? Does it exhaust Sarah’s income? Draw Sarah’s budget line, with Coke on the horizontal axis, and draw a typical convex and downward sloping indifference curve through her chosen consumption bundle.

Answer: Yes, it’s affordable, and it also exhausts her income. See figure below for BL1 and IC1.

One research shows that Coke is not so healthy. The government wants to encourage people to buy less Cokes, by imposing a 100% tax on the price of Coke; thus, the price of Coke is $2 now. The price of movies doesn’t change.

1. A government economist makes the following comment on this tax policy: “Since $1 tax is collected from every unit of Coke consumed and Sarah buys 60 Cokes, the government can collect a tax revenue of $60(=1*60) every month from every consumer just like Sarah”. Is the comment true? Why?

Answer: No, it’s not true. When the tax is imposed, Sarah will adjust her consumption. Since the price of coke increases, she will consume less coke and will no longer consume 60 units as she did before.

1. Will the budget line change? How? If it changes, draw the new budget line.

Answer: Yes, the budget line will shift inward, pivoting around the same y-intercept point. BL2 will intercept the horizontal axis at 50. See the figure above for BL2.

Suppose the bundle of 10 movies and 40 Cokes maximizes Sarah’s utility under the new prices.

1. Draw a typical convex and downward sloping indifference curve through the new chosen bundle.

Answer: see the figure above for IC2.

1. In this stage, think about the tax revenue from Sarah again. How much is it?

Answer: the tax revenue is $40 (=$1*40).

1. (45 points) Rice is the main agricultural product in the country of Riceland, and rice production is a constant average cost perfectly competitive industry. For a typical rice farm, the minimized long run average cost can be realized at the production of 100 kg at the price of $2 per kg. The demand for rice is given by the function .

1. What are the equilibrium price and output of the industry? How many farms is the industry composed of? (Here and in other parts of the question you may round the number of farms to the nearest integer.)

Answer: P*=$2, Q*=5000. Number of farms = 50.

1. Draw the graphs of both the individual farm and the whole rice industry in Riceland in the short run and in the long run. Include both short run and long run cost curves.

Answer: see below. Note that increase in output over the current minimum efficient scale is more costly in the short run than in the long run, since the firm cannot increase all of its factors to the optimal level in the short run. A decrease in output, however, can be achieved at a lower marginal cost in the short run.

Suppose there has been an improving in technology, such that the minimum efficient scale is now achieved at 200 kg instead of 100 kg, and at the cost of $1 instead of $2.

1. At the industry level, use your graph to show the new short run and long run equilibrium in this market. Mark the equilibrium price and quantity in the long run. How many farms would there be in the new long run equilibrium?

Answer: See graph below. The number of farms is 25.

1. Analyze in details, as much as you can, whether or not this technology will make the farmers better off or worse off in both the short run and long run, and also explain the reason for your conclusion. You may (but do not have to) use a graph to illustrate your answer.

Answer: In the short run, the farmers can make some positive profit. The graph below illustrates the point: in the short run, not all factors can be adjusted (for example, farmers could be locked in land-lease contracts), so the short run cost curves shift to SMC’ and SATC’ (in purple). The equilibrium price falls by less than $1, allowing farmers to make a profit.