ECON 201 - Colgate University



ECON 201

Midterm #2

Spring 2000

1. Studded snow tires cause damage to highways, thus leading states to consider banning them.

a. Use the model of demand and supply to show the equilibrium price and output of such tires.

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The equilibrium price is P1 and the equilibrium quantity is Q1.

b. Assuming tires manufacturers and users don’t have to pay the costs of this damage, what can you say about the efficiency of the quantity of studded snow tires produced?

Too many snow tires are produced because the producers and consumers do not take into account the negative externality associated with the tires. Producers and consumers only consider their private interests, which leads to a quantity of snow tires sold and used that is higher than the optimal or most efficient amount. In the graph above, the efficient amount is Q2 while the market quantity is Q1.

c. Show the area of deadweight loss imposed by this external cost.

[pic]

The dotted area represents the deadweight loss.

d. Using your graph, explain whether or not such snow tires should be banned or whether their use should be restricted.

Snow tires should be restricted, not banned, according to the graph shown above. They should be restricted in order to reduce the quantity to the efficient amount. This could be done through taxing snow tires or by issuing permits for their use. The government could also restrict their use to those people who would benefit most. Perhaps, this would be people in rural areas in northern states in the winter. Snow tires should not be banned because they do provide a benefit to some people. Since the optimal level of production is not zero, a ban would also lead to an inefficient amount of production.

2. Consider that Joe’s carpet cleaning business has the following variable costs and total costs :

|Number of carpets cleaned |Variable cost |Total cost |Marginal Cost |

|0 |$0 |$30 | |

|1 |$10 |$40 |10 |

|2 |$25 |$55 |15 |

|3 |$45 |$75 |20 |

|4 |$70 |$100 |25 |

|5 |$100 |$130 |30 |

|6 |$135 |$165 |35 |

a. What is the value of Joe’s fixed cost? Give at least three examples of what his fixed costs might include.

Joe’s fixed cost is $30. This includes all costs which do not vary with output. Labor and intermediate inputs are variable costs since they do vary with output levels. If Joe did not produce anything, he would not hire any cleaners and would not buy any carpet shampoo. Fixed costs include such items as ongoing leases on machines, the payment on his truck, administrative costs such as his accountant fees, rent that he pays on his store, etc.

b. Calculate marginal cost for each quantity and enter the value in the table above.

See above.

c. Suppose the carpet cleaning industry is perfectly competitive and the equilibrium price for a cleaning is $29. How many carpets will Joe clean? Explain why.

Joe will clean 4 carpets. Profit is maximized if Joe cleans carpets as long as marginal revenue exceeds marginal cost. At 5 carpets, marginal cost is greater than marginal revenue, so it does not make sense for Joe to clean that 5th carpet.

d. At this price, would we expect firms to be entering or leaving the carpet cleaning business (or do we need more information)? Explain you answer.

From the information we have been given, we would expect firms to be entering the market, because it is profitable. Joe makes a profit of $16 at the profit maximizing point. However, these are accounting profits, and what we really need in order to make this decision are economic profits. We need to know what the opportunity cost is. If potential entrants could be making $20 by working in the window cleaning business, then they will not enter the carpet cleaning business.

3. The Pfizer Drug Company holds a patent on Viagra, thereby creating a monopoly.

a. Using a model of supply and demand, show the profit maximizing price and quantity of Viagra for the monopolist.

[pic]

The profit maximizing price is P* and the profit maximizing quantity is Q*.

b. What is the deadweight loss associated with the monopolist’s price?

The deadweight loss is the dotted area in the graph.

c. Why is the government willing to allow Pfizer to have monopoly position in the market for this drug? Discuss in terms of costs and benefits to society of a patent system.

The government is willing to allow Pfizer to have a monopoly even thought they do not produce at the socially efficient point because it wants to encourage innovation in the drug market. If firms could not patent their discoveries, there would be little incentive to invest in R&D. Without a patent system, other firms would copy new technologies and enter the market without having to pay the research and development costs, essentially becoming free riders. This would lead to a level of technological innovation which is lower than optimal. The drawbacks of the patent system are that consumers pay too high of a price and that the quantity which is produced is inefficient. The government has considered these tradeoffs and decided that the benefits of encouraging innovation outweigh the costs of inefficiency which occur while the patent is in place.

4. College professors are highly skilled (or at least highly educated) laborers. Yet their wages are not very high. Explain this in terms of the various factors which affect wage differentials.

Several factors influence wages in the economy. Prime among them are the skills and other attributes of the worker and the nature of the job. College professors are highly skilled. They have many years of education and continue to research in order to refine their skills further. This should lead them to have high wages. They also have very desirable jobs. Hours are flexible, the job is generally enjoyable, they can choose areas of research which appeal to them, and there are no major drawbacks such as health risks or unpleasant working conditions. This increases the supply of workers willing and eager to take such a job, decreasing wages.

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