Econ 112: Review for final exam

These short answer questions are taken from previous semesters exams. The exam itself will
consist of multiple choice and short answer/essay questions. Remember to also review
homework, lecture notes and examples, quizzes, and the study guide. Since the final exam is
cumulative, you should also review past exams and past exam reviews. However, the final exam
will focus heavily on material covered since the last exam.
1. The coffee market has many sellers. Further, coffee sellers often sell coffee at different
prices. For instance, at Dunkin Donuts an 8 ounce cup of coffee sells for $1. At Starbucks,
an 8 ounce cup of coffee sells for $1.50. At McDonalds, an 8 ounce cup of coffee sells for
$0.75.
a. Given these facts, would you characterize the coffee market as competitive, monopolistic,
oligopolistic, or monopolistically competitive and why? Name at least two
characteristics that justify your answer. The coffee market is monopolistically
competitive. There is free entry and exit, many sellers, firms sell differentiated products,
and firms have market power (firms are not price takers as evidenced by firms abilities
to charge different prices in the market).

b. Starbucks has reported large economic profits. Starbucks has hired you to analyze the
future of the coffee market and Starbucks future profitability. Is the market in long run
equilibrium? Why or why not? What do you expect to happen to Starbucks economic
profits in the long run and why? The market is not in long run equilibrium because
Starbucks is making profits. In long run equilibrium, Starbucks (and all firms) will earn
zero profits. Since firms are making positive profits, new firms will enter. Starbucks
demand will shift to the left, bringing profits to zero.
c. Upon hearing your profits prediction, Starbucks asks Are these the shadows of the
things that will be, or are they shadows of things that may be, only? How do you reply?
Name at least two ways in which Starbucks can influence its profitability in the future.
There is no indication of when the market will reach long run equilibrium. In the meantime,
there are things that Starbucks can do to influence its profitability:
(1) Advertise (or establish better brand loyalty): this will shift the demand for Starbucks
to the right
(2) Create new products: this will create new products for Starbucks
(3) Lower production costs (Starbucks has already experimented this by standardizing the
production process in some cafes as well as experimenting with having employees specialize
in particular tasks).

Econ 112

2. You are a restaurant manager that has expanded into the take-out business. The take-out
meals industry is a monopolistically competitive market. You have graphed the demand (D),
marginal revenue (MR), marginal cost (MC), and average total cost (ATC) curves for your
meals below.
P
($/meal)

MC

ATC

30
27

20
18
17
15
12

PROFIT

D
MR
5

8 10 16 18

Q (# meals)

a) What is the profit maximizing number of meals that you will sell? Firms profit maximize
when MR = MC. This occurs at Q = 8 meals.
b) What is the profit maximizing price at which you should sell your meals? Look at the
demand curve to determine the price that leads to Q = 8 meals sold. This occurs at P = 27.
c) Calculate your profits. Profits = (P ATC) Q = (27 18) 8 = $72. Profits are the area
shaded above.
d) Shade in the area of deadweight loss associated with the profit maximizing price, if any.
The socially optimal number of bottles is located where the demand curve and the marginal
cost curve intersect, or at Qc = 16. The deadweight loss is shaded in yellow above.
e) Is the take-out meals industry in long-run equilibrium? Explain. If it is not in long-run
equilibrium, do you expect the price of your meals to rise or fall in the long run (assuming
no changes in your costs)? No, long-run equilibrium occurs when all firms earn zero
profits. Since you are making positive profits, the industry cannot be in long run
equilibrium. As the industry approaches long run equilibrium, new firms will enter and
demand for your meals will fall. This will lower the price for your meals.
f) Will the firm produce the socially optimal number of meals in long-run equilibrium? No, in
long-run equilibrium all firms earn zero profits and the new demand curve will be tangent
to the average total cost curve. However, the new profit-maximizing price will NOT
correspond to the new socially optimal number of meals (where the new demand curve
intersects the marginal cost curve).
g) Will the firm produce at the minimum of its ATC curve in long-run equilibrium? No,
although firms earn zero profits in long-run equilibrium, they will still have excess capacity
(not produce at min ATC curve).

Econ 112

3. Two teenagers in souped-up cars drive toward each other at great speed. The first one to
swerve out of the road is chicken. The best thing that can happen is that the other guy
swerves and you dont. Then you are the hero with a payoff of 3, and the other guy is
chicken with a payoff of 1. If you swerve and the other guy doesnt, you are the chicken
with a payoff of 1 while the other guy is the hero with a payoff of 3. If you both swerve, you
are both chickens and each receives a payoff of 2. If neither swerves, you both end up in the
hospital and each receives a payoff of 0. Assume the game is played only once.
d. Using the information above, fill in the normal form game below.
Your friend
Swerve
Do not swerve
Your payoff = 2
Your payoff = 1
Swerve
Friends payoff = 2
Friends payoff = 3
You
Do not Your payoff = 3
Your payoff = 0
swerve Friends payoff = 1
Friends payoff = 0
e. Does either player have a dominant strategy? If so, name all dominant strategies.
Neither has a dominant strategy.
Your strategies:
If your friend swerves, you should not swerve.
If your friend does not swerve, you should swerve.
Since your strategy depends on what your friend does, you do not have a dominant
strategy.
Your friends strategies:
If you swerve, your friend should not swerve.
If you do not swerve, your friend should swerve.
Since your friends strategy depends on what you do, your friend does not have a
dominant strategy.
f. List all possible Nash equilibrium if any exist.
A Nash equilibrium occurs wherever neither player has an incentive to change the
strategy s/he is currently using. There are two Nash equilibria: (1) you swerve while your
friend does not and (2) your friend swerves while you do not swerve.

Econ 112

4. The following graphs show three firms. The first graph is of a representative firm in a
competitive industry. The second graph is a monopoly. The third graph is of a
representative firm in a monopolistically competitive industry. For each graph indicate the
profit maximizing price and quantity and shade in the area of profits (if any). Then shift, if
necessary, the appropriate curves to show what a representative firm looks like in a long-run
equilibrium.
Competitive
Firm

MC

ATC
P*

Monopoly
Firm

ATC

P*
PROFIT

PROFIT

MC

D
MR

Q*
Monopolistic
Competitive
Firm

Q*

MC
ATC

P*
PROFIT

MR
MR
Q*

Econ 112

D
Q

The competitive firm produces where P =

MC. Since it is currently making profits,
new firms will enter shifting market supply
to the right. This will decrease market price
so the firms demand curve falls. All
competitive firms earn zero profits in long
run equilibrium. This occurs at the
minimum of the ATC curve.
Monopoly firms profit maximize where
MR = MC. In this case, the firm is making
profits and since monopolies have barriers
to entry, nothing changes in the long run.
Monopolistically competitive firms profit
maximize where MR = MC. In this case,
the firm is making profits. New firms will
enter, causing the demand curve for
existing firms to shift to the left. All firms
earn zero profits in long run equilibrium.
Note that the profit maximizing price and
quantity will fall in long run equilibrium
(assuming no changes in costs).

5. The graph describes a typical demand and supply graph in the market for crude oil where
quantity is measured in the number of barrels per person per year.
Price
($/barrel)
140
120
100
PB
80
P0
PS =60

U.S.
Supply

DWL

U.S.
Demand

40
20
20

40

60

80

100

120

140

160

Quantity (barrels)

a. What is the equilibrium price and quantity of crude oil? P* = $70/barrel and Q* = 120
barrels.
b. Suppose that the government wishes to lower oil consumption in the U.S. to 80 barrels.
What is the size of tax that the government should impose? If the government wishes to
lower oil consumption to 80 barrels, the size of the tax should be $30/barrel.
c. How much will this generate in tax revenues? Tax revenues = (size of the tax)
(quantity sold with the tax) = 3080 = $2400. Deadweight loss (DWL) is shaded above.
d. If the government imposes the tax size you found in (5b), what is the buyers tax burden?
What is the sellers tax burden? The size of the tax burden on buyers is measured by the
vertical distance between the demand curve and the original equilibrium price (without
tax) at the quantity sold with the tax (PB P0). Thus the buyers tax burden is $20 per
bottle. The size of the tax burden on sellers is measured by the vertical distance between
the original equilibrium price (without tax) and the supply curve at the quantity sold with
the tax (P0 PS). Thus the sellers tax burden is $10 per bottle.
e. Do buyers or sellers have the larger tax burden? Does this seem reasonable? Why or
why not? Explain using the concept of elasticity. The tax burden was heavier on the
buyer. The relative elasticity of the supply and demand curves determines the size of the
tax burden. The demand curve is less elastic because consumers cannot easily substitute
away from purchasing gasoline, especially in the short run.

Econ 112

6. The graph below shows the demand and supply curves in the market for wine in
Massachusetts. To discourage drinking, Governor Patrick decides to place a tax on wine.
The effect of the tax is illustrated in the graph below.
Price
($/bottle) 14
PB = 12
P0 = 10
8

Supply

PS = 6

Demand

Demand
with tax

7 Quantity (hundreds
of bottles)
According to the graph, did Patrick place the tax on the buyers or the sellers?
Explain your answer. Since the demand shifts, this indicates a tax levied on the
buyers.
What was the size of the tax and how much tax revenues were generated? The
size of the tax is measured by the vertical distance between the demand curve and
the demand-with-tax curve (or PB PS). Thus the tax is $6 per bottle. The
quantity sold with the tax is 200 bottles. Therefore total tax revenues are $1200.
What was the size of the tax burden on the buyers? What was the size of the tax
burden on the sellers? The size of the tax burden on buyers is measured by the
vertical distance between the demand curve and the original equilibrium price
(without tax) at the quantity sold with the tax (PB P0). Thus the buyers tax
burden is $2 per bottle. The size of the tax burden on sellers is measured by the
vertical distance between the original equilibrium price (without tax) and the
supply curve at the quantity sold with the tax (P0 PS). Thus the sellers tax
burden is $4 per bottle.
Was the tax burden heavier on the buyers or the sellers? What economic
phenomenon determines the size of the tax burden? In this market, why would
you expect the tax to fall more heavily on this particular group (buyers or sellers)?
The tax burden was heavier on the seller. The relative elasticity of the supply and
demand curves determines the size of the tax burden. The demand curve is
relatively more elastic because consumers can easily substitute away from
purchasing wine (they could purchase beer or other spirits). This makes the
supply curve relatively more inelastic.
Over time, do you expect the tax will be more effective, less effective, or the same
effectiveness in reducing the number of wine drinkers? Over time, both the
supply and demand curves will become more elastic. Therefore the tax will be
more effective in reducing the number of wine drinkers (assuming the size of the
tax does not change).
1

a.

b.

c.

d.

e.

Econ 112

2 3 4

7. Suppose in the small country of Andorra, there are three firms that emit carbon dioxide (CO2)
each year. Each firm produces 2 metric tons of carbon dioxide emissions per year (for a total
of 6 metric tons per year). By upgrading its technology, Firm 1 could reduce its emissions
for $100 per metric ton. Firm 2 could reduce its emissions for $200 per metric ton. Firm 3
could reduce its emissions for $300 per metric ton. Andorra wishes to participate in the
Kyoto Protocol which requires it to emit no greater than 4 metric tons per year.
a. Draw the demand curve for pollution rights in Andorra. (4 points)
Price
($/metric 350
ton)
300
250
200
150
100
50
1

2 3 4

7 Quantity of CO2
(metric tons)

b. At what value should the government of Andorra set the pollution tax? Which, if
any, firms will emit pollution? $100/unit < tax < $200/unit. Since for firms 2 and 3
the cost of reduction is greater than the tax, Firms 2 and 3 will emit pollution.
c. How many tradable pollution permits should the Andorran government allocate
(where one permit allows for emissions of one metric ton of CO2.) Which, if any,
firms will emit pollution? Number of permits = 4 permits. Note that the equilibrium
price of the permits will settle somewhere between $100 and $200 per permit. Firms
2 and 3 will emit pollution.
d. Suppose now that a new firm builds a factory which also emits 2 tons of carbon
dioxide per year. Curbing emissions would cost the firm $350 per metric ton. If the
government leaves the pollution tax as you calculated in part (b) above, what would
happen to the amount of carbon dioxide emitted? Which, if any, firms will emit
pollution? Note that this is equivalent to a rightward shift in the demand for pollution
rights. Emissions will increase to 6 metric tons. Since the cost of reduction is greater
than the tax for firms 2, 3 and the new firm, Firms 2, 3, and the new firm will emit
carbon dioxide.
e. Again suppose that instead of only three firms emitting carbon dioxide, a new firm
builds a factory which emits 2 tons of carbon dioxide per year. Curbing emissions
would cost the firm $350 per metric ton. If the government had instead issued
permits as you calculated in part (c) above, what would happen to the amount of
carbon dioxide emitted? Which, if any, firms will emit pollution? Carbon dioxide
stays at 4 metric tons since only 4 permits were originally issued. The new
equilibrium price of the permits will now be between $200 and $300 per permit.
Firm 3 and the new firm will emit carbon dioxide.

Econ 112

8. Ringo values playing rock n roll music at high volume at $200. Luciano hates rock n roll
and loves opera. Luciano values listening to opera at $125. Unfortunately, they are nextdoor neighbors in an apartment building with paper-thin walls, and Luciano cannot listen to
opera music at the same time that Ringo plays his loud rock n roll music.
a) What is the externality here? The externality is noise pollution. Luciano is harmed by the
loud music and is not compensated for this harm.
b) What command-and-control policy might the landlord propose? Could such a policy lead to
an inefficient outcome? Note that since Ringo values playing his loud music more than
Luciano values listening to opera, the efficient outcome is for Ringo to play his loud music.
If the landlord actively enforces quiet at all times, Ringo will be unable to play his music
which will lead to an inefficient outcome.
c) Suppose the landlord lets the tenants do whatever they want. According to the Coase
theorem, how might Ringo and Luciano reach an efficient outcome on their own? What
might prevent them from reaching an efficient outcome? According to the Coase Theorem,
the efficient solution can be achieved through bargaining if there is a clear initial distribution
of rights. If Ringo has the right to play loud music, no bargaining will occur, Ringo will play
his music, and the efficient outcome will be achieved. If Luciano has the right to quiet (to
listen to his opera music), Ringo could offer Luciano anywhere between $125 and $200 to be
able to play his rock n roll loudly. (Luciano must be paid at least $125 to make him at least
as well off as without the loud rock n roll music; and Ringo is not willing to pay more than
$200 otherwise he would be worse off than without playing his loud music.) Therefore,
independent of the initial distribution of rights, the efficient outcome can be achieved with
bargaining. Its possible, however, that if Luciano and Ringo cannot agree on a price (each
tries to hold out for a better deal), there is no clear initial distribution of rights, or if other
transactions costs are involved (language barriers, the need for lawyers), then the efficient
outcome might not be achieved. Its also possible that even though Ringo values playing
music at $200, he may not have enough actual money to pay Lucianos valuation of quiet.

Econ 112

9. Is an open fireworks display considered a public good, a common resource, a club good, or a
private good? An open fireworks display is a public good. It is nonrival because one person
viewing fireworks does not reduce the amount available for other people to view. It is also
not excludable since it is open to the public (non-payers cannot be denied access to view the
fireworks.
10. Without government intervention, indicate the market and optimal allocation of fireworks
using social cost, social value, private cost, and private value curves. See the graph below.
Note that the market under-allocates the amount of fireworks since payers would not
internalize the external benefit of others abilities to enjoy the fireworks.
11. What can the government do to provide the efficient allocation of fireworks? The
government can subsidize someone to put on the display.
12. Is clean air considered a public good, a common resource, a club good or a private good?
Clean air is a common resource. It is rival because if someone pollutes, less clean air is
available for others to consume. It is not excludable because everyone has access to it.
13. Suppose a steel firm emits pollution. Without government intervention, indicate the market
and optimal allocation of steel using social cost, social value, private cost, and private value
curves. See graph below. Note that the market over-allocates the amount of steel produced
since steel firms do not internalize the external cost of pollution.
14. To obtain the efficient allocation of pollution, suppose the government taxes the firm for
each unit of steel it produces. On your graph, indicate the optimal size of the tax per unit of
steel. See graph below. The optimal size of the tax should equal the external cost of
pollution.
Price of
Fireworks

Fireworks

Price of
Steel

Steel
Social Cost
Tax

Private Cost
Private Cost

Social Value
Private Value
Private Value
Qmkt Qopt

Econ 112

Quantity of
Fireworks

Qopt Qmkt

Quantity of
Steel