Short Answer (Must have explanation; geometric models helpful) (7 questions at 5 points each):

NOTE: these answers are more detailed than we expect in the limited space on the exam paper. Nevertheless, a better answer will be one that comes closer to the objectives outlined below.

1. On the November 3, 1998 ballot in California, Proposition 10 called for institution of a 50 cent per pack increase in cigarette taxes. Consider a simplified story where there are two "markets," one for teen smokers and one for all other smokers. These markets are likely to be characterized by different demands for cigarettes. Assume the supply in each market is identical. How is it that one new tax can simultaneously lead to big decreases in teen smoking and also raise huge revenues for anti-smoking campaigns? (Use carefully labelled diagram(s).)

Based on the models we have learned in class, you should have perceived that teens probably have much more elastic demand for cigarettes, if they have only started smoking, since they are probably not yet very addicted to nicotine. On the other hand, older smokers may have a much harder time decreasing their cigarette consumption if prices are raised, so their demands are much less elastic. In a market with very elastic demand, a $.50 tax will choke off a lot of demand, the burden of the tax would be borne relatively more by sellers and less by buyers (tax revenues will be limited by the fall-off in quantity demanded in the face of the tax). In a market with more less elastic demand, there will be little change in quantity sold in the face of a $.50 tax, so most of the tax would be shifted forward onto buyers (tax revenues would be high because there is little change in quantity sold as a result of the tax). Thus, we would expect that teens might indeed cut back a lot on smoking, even though adults probably won't. The adults, however, will end up paying more of the tax because they keep smoking. Since nicotine is addictive, there are likely to be substantial tax revenues.

In Economics 1, we have not considered how the diagrams above should be modified to reflect the fact that there cannot be two prices (one for teens and one for adults) in the market for cigarettes. If you are clever, you might realize that the total demand for cigarettes is the horizontal sum of demands by teens and adults, and there is but one supply curve. A single price for both "submarkets" is established in this pooled market, and passed back to the two separate markets we are considering here. In Econ 11, you will encounter models that provide further insights into problems like this one.

2. All other things equal, an increase in income will lead to an increase in the demand for electric edge-trimmers ("weed wackers") for lawns and gardens. True, False, Uncertain? Explain, using carefully labelled diagram(s).

If we are talking about a normal good, one for which quantity demanded increases as incomes increase, we might expect that the demand curve will shift out (leading to higher prices and greater quantities sold). However, if these devices are inferior goods, then the quantity demanded will decrease as incomes increase. The answer depends on whether this good is normal or inferior at current income levels of everybody in this market. As people get sufficiently wealthy, the opportunity costs of their time get high enough that they find it sensible to hire someone else to do their gardening and yard work (a professional gardener). They might not buy this equipment at all anymore. Heavy-duty versions might be sold to professional gardeners and used to work on the lawns and gardens of large numbers of households.

3. On vacation in Rome, you notice that unlike Americans, who like large sport utility vehicles, Europeans tend to prefer smaller cars. This is evidence that European tastes (utility functions) are vastly different than American tastes (utility functions). True, False, uncertain? Explain, using carefully labelled diagram(s).

Uncertain. It could be the case that preferences over different types of automobiles differ dramatically between the US and Europe. The diagram on the left depicts a situation where different choices are being made, despite identical constraints (same relative prices and incomes) as a result of fundamentally different families of indifference curves. In contrast, it could also be the case the preferences are virtually identical in the two regions, but dramatically lower gas prices in the US make a difference. The overall cost to the consumer of using a large car or SUV is much lower in the US than in Europe, where gas is much more expensive. This leads to a budget constraint that is much further out and of a flatter slope in the US. Despite the same preferences, you would see relatively more large vehicles and relatively fewer small vehicles in the US than in Europe.

4. A teaching assistants’ union at a large public university manages to negotiate a new higher minimum hourly wage . Using carefully labelled diagrams, discuss the likely consequences of this increased wage floor, both in the short run and in the long run. Identify subgroups of TAs that will be helped and hurt, in any way, by this change.

In the short run, there might be little or no change in the amount of TA hours required at this university, since courses will have been taught a particular way that dictated the use of a certain number of TA hours. In the short run, these methods would not change particularly, and the university would be stuck using the same numbers of TAs and paying the higher wages. In the longer term, however, it will be possible for the university to develop different ways of delivering its product (for example, on-line materials, computer tutorials, WWW exams, and distance learning in general). When the "long run" arrives, and these new technologies can be put in place, the university will substitute capital for labor and will be able to achieve lower costs than if they were to keep employing the same amount of TA services. The isoquant/isocost diagram on the left depicts the short-run situation of fixed capital and labor quantity L₁. With the new higher labor costs, the university would prefer to be at K₂ and L₂ which would cost less than K₁ and L₁ at the new price of TA time.

The figure on the right shows what happens as the university makes adjustments to its demand for labor under the new higher labor costs. TAs who still work (0-L₂) will be happy, since they will make higher wages and greater overall earnings as a group. TAs who are "laid off" consist of the group between L₂ and L₁. These people will be unhappy because they used to earn wage w₁ for these hours and they now earn nothing. The group between L₁ and L₃ was not interesting in working as a TA at all at the old wage, but now they think this would be a nice job to have--yet there is no demand for their services, so they are disappointed that they cannot get a job as a TA. Unemployment of TAs would be measured as the difference between L₃ and L₂.

5. A perfectly competitive firm is making zero economic profits, and its average total costs are greater than its marginal costs. Can the firm modify the number of units it is producing in order to achieve positive economic profits? If so, how? Explain, using carefully labelled diagram(s).

The firm must be producing at an output level like q₁. When it produces this quantity, it can sell it at price P, and its average total costs at this output level are exactly the same as the price, so its profits are zero. But since we know that marginal costs are less than ATC at this output level, the firm cannot be producing where P=MC, so it is not profit maximizing. By increasing its output to q*, it will maximize profits, and these profits will be given by the area of the "box" with height equal to (P-ATC(q*)) and width from 0 to q*.

6. Distinguish, in general, between "positive" and "normative" issues, and then identify the positive and the normative parts of this commentary:

Teenagers should not be taking up smoking, so we should help cut back the demand for cigarettes by teenagers by making cigarettes more expensive. Furthermore, a tax increase on cigarettes is the best way to discourage smoking because it will raise revenue for anti-smoking programs, which smokers should be paying for in the first place.

Positive issues are matters of fact, which can (potentially) be revealed to be correct or not by an appeal to the data. Normative issues are matters of opinion, frequently given away by words like "should" or "ought," and can be argued indefinitely without resolution. The quote from the LA Times article is "positive," whether or not it is actually true is a question of fact. The rest of the passage is mostly opinion. It is arguable whether we should interfere with teenagers decisions to smoke. It is also arguable whether another tax is the best way to discourage smoking, and whether smokers themselves are responsible for their plight and the costs that their behavior imposes on society. These normative issues were certainly at the fore in the debate over Proposition 10 in advance of the election. When the facts are not in doubt, interest groups often resort to normative arguments to persuade voters.

7. When we introduced the idea of a supply function, we asserted that quantities willingly supplied by firms will depend upon (1.) the price at which the good can be sold, (2.) the technology of production, and (3.) the prices of factors of production, among other things. Sketch a series of diagrams, indicating clearly where these components come into the derivation of the supply curve for a firm in a competitive industry.

The technology of production, in the short run, is captured in the short-run total product of labor curve, usually drawn with an S-shape. The prices of factors of production come into play as we convert the labor requirements curve to a total variable cost curve. First, the wage is used to multiply "labor required" to turn it into variable costs for each level of output. Then total costs are determined by adding in fixed costs, which are given by the price of capital times the amount of capital in place over the short run. The remaining component, the price at which the good can be sold, "comes in" from the larger market, where an equilibrium price is determined by the interactions of all buyers and sellers, and taken by the individual firm as a "given." The firm is a passive quantity adjuster that then decides on optimal quantity q* that maximizes profits under these conditions. The competitive firm's supply curve is then the portion of the marginal cost curve that lies above the minimum of the average variable cost curve.