I



Rice BE 500

Fall 2001

MIDTERM EXAM

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 35 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) 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. (12 points) Many politicians have proposed a Voucher System (VS) for K-12 education in the United States. Currently, households can send their children to government-run public schools for free, but must pay the full cost of tuition to send their children to private schools.

Under the VS proposal, each child would be granted a certificate (voucher) that could be used at the school of the household’s choice. The voucher would have a stated value – say $5000. This $5000 would be determined as the average cost paid to educate students in the public school. If the household chose to send their child to public school, they would go for free as under the current system. If, on the other hand, the household chose private school, the voucher could be used in place of up to $5000 of tuition. Thus, if tuition was $5000 or less, the child would go to school for free with government paying the school. But if private tuition were more than $5000, the government would pay $5000 and the household would have to pay the excess over $5000 from their own funds.

Suppose there are only two goods, quality of education (Qual) and other goods (OG). Assume throughout the question that the price of Qual is $1000 per unit and the price of other goods is $1 per unit. Assume also that public school offers 5 units of Qual.

A) With Qual on the x-axis and OG on the y-axis, draw the consumption opportunity (budget) set under the current system for a household with $10,000 of Income and 1 child. Label this set B0.

B) On the same graph as above, show the consumption opportunity (budget) set if VS is implemented. Label this set BV. Assume the household pays no taxes regardless of whether VS is implemented.

C) Is it possible that the household will choose a lower quality of education with VS? If so, under what conditions will this occur? If not, why can this not occur?

An alternative form of the Voucher System proposal (VS2) would change the rules of using the certificates. That is, under VS2, a household could use the voucher at a private school only if the voucher covered the entire private school tuition. Thus, if the tuition at the private school exceeded $5000, the household would have to pay the entire tuition.

D) As in parts A and B, draw the consumption opportunity (budget) set for our particular household if VS2 is implemented. Label this set B2.

E) Compare B2 with B0 and BV. Which plan is likely to result in the largest consumption of educational quality in the household being considered? Explain your reasoning thoroughly.

SPECIAL MULTIPLE CHOICE INSTRUCTIONS: The following two 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.

IV. (4 points) Shifty Winery is located in a region where wages for workers have recently declined. Shifty uses a very labor-intensive production process when it produces small amounts of wine. When it produces large amounts of wine, however, it uses small amounts of labor and intensive use of machinery. If the wage cuts in the region are permanent, then

A) Shifty’s Total Cost curve will fall at all positive output levels.

B) Shifty’s Average Cost curve will fall at all positive output levels.

C) Shifty’s Marginal Cost curve will fall at all positive output levels.

D) Shifty’s Marginal Cost curve will be steeper at all positive output levels.

E) Economies of Scale for Shifty will be weaker – that is, Economies of Scale are likely to predominate over a smaller range of output.

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.

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