Marginal Cost

Report
EC 100 Mock Exam
(Micro)
Mock Exam Class Discussion
- This week: Discuss the Mock Exam.
- Mock Exam is structured very similar to typical
final examinations.
Section A: Question 1
• Consider a perfectly competitive market with a
downward sloping demand curve and an upward
sloping supply curve and the price at the marketclearing level. Now suppose the government
introduces a tax on the sale of the good which is paid
by the buyer.
– On a diagram where the vertical axis is the price received
by sellers, and the horizontal axis is the quantity, show
how the tax affects the demand and supply curves? [3
marks]
– What happens to the quantity traded in the market? [3
marks]
– What happens to the price received by sellers? [2 marks]
– And what happens to the price paid by buyers? [2 marks]
Section A: Question 1
• See board
Section A: Question 2
1. An economy consists of two workers, A and B. The amounts of bread and butter they
can produce in a day if they spend all their time on bread or butter production is shown
in the following table
Bread
Butter
Worker A
4 loaves
500g
Worker B
2 loaves
100g
a. Which worker has an absolute advantage in the production of bread? Which has an
absolute advantage in the production of butter? [3 marks]
b. Who has a comparative advantage in the production of bread? Do they also have a
comparative advantage in the production of butter? [3 marks]
c. If A and B are allowed to trade what good will A sell to B? [you can assume that the
production of bread and butter is proportional to the amount of time they spend on
it] [4 marks]
Section A: Question 2 a
• First, define absolute advantage. A
country/individual has an absolute advantage
if they are more productive in producing a
good (ignoring all other goods).
– Equivalently, they are the lowest cost producer.
Worker A
Worker B
Bread
4 loaves
2 loaves
• Who has absolute advantage here?
Butter
500g
100g
Section A: Question 2 b
• Define comparative advantage. A country/individual has
comparative advantage if they are relatively/comparatively
more productive (i.e. relative to other goods).
– Key point: have comparative advantage if you have the lowest
opportunity cost.
• Comparative Advantage:
– worker A’s trade off: 1 loave = 125 g butter.
– Worker B’s trade off: 1 loave = 50 g butter.
• So Worker B has a comparative advantage in producing
bread. Has lower opportunity cost.
• A has a comparative advantage in butter. (Can check
opportunity costs of butter).
Section A: Question 2 c
• Remember law of comparative advantage:
countries should specialize in production of the
good(s) for which they have a comparative
advantage.
• So B specialises in bread, A specializes in
butter.
• B sells bread to A
• A sells butter to B
Section A: Question 3
• Suppose the price of energy rises.
– What will be the income and substitution effect of this
change on the demand for energy by consumers?
Show the income and substitution effect on a graph.
[4 marks]
– Suppose the alternative to keeping warm by heating
your house is to wear lots of clothes. What will be the
income and substitution effect of the change in the
price of energy on the demand for clothing? Explain
your answer [3 marks]
– Who do you think is most hurt by rising energy prices?
Give reasons for your answer. [3 marks]
Section A: Question 3 a
First, write some explanation of income and substitution effects.
Will be marks for it, and will help you if you get the diagrams wrong.
– If energy becomes more expensive, consumers will substitute away from it
and demand less energy. This is the substitution effect.
– However, as energy becomes more expensive, consumer’s are poorer. This
induces them to change their consumption of energy further. This is the
income effect. The direction of the income effect depends on whether the
good is an inferior good or a normal good.
– Could add: if the good is an inferior good, a drop in income induces consumers
to consume more of that good. This income effect may even offset the
substitution effect; we call such goods “Giffen goods”.
– The total effect on consumption is the sum of income and substitution effects.
Both Effects together
All other goods
Old Budget Constraint
Energy
Highlighting Substitution / Income
Effect
All other goods
Old Budget Constraint
IE
SE
Energy
Section A: Question 3 b
– Clothes are a substitute for (domestic) energy.
– As price of energy rises, people substitute into
buying more clothes.
• May expect substitution effect to be strong because
substitutes (clothes) are readily available. Consumers
will cut back their consumption of energy significantly.
– Income effect: income has fallen, so demand for
clothes depend on whether they are normal or
inferior. If normal, clothes consumption will fall.
Section A: Question 3 c
– Who do you think is most hurt by rising energy prices? Give reasons
for your answer. [3 marks]
– Energy demand is a classical example of a commodity whose demand
is very inelastic; i.e. consumers find it very hard to substitute away
from consuming energy.
– This implies that there will be only a small change in quantity.
– If the quantity demanded does not change a lot, high energy cost
means that consumers have less money to spend on other goods.
– Hence, consumers have to start cutting back on other expenditures
just to keep warm.
– Clearly, the hardest hid individuals are ones whose expenditure shares
on energy in their current budget is very high.
– This applies especially to low income households and the elderly.
– High energy prices have strong redistributive effects, the poor are hit a
lot harder than the rich.
Section A: Question 4
• If a technology has increasing returns to scale
how do
– Marginal and average costs vary with the level of
output [3 marks]
– Marginal and average costs compare [3 marks]
– Why is an industry with increasing returns to scale
unlikely to be perfectly competitive? [2 marks]
– Explain why a mobile phone system is likely to
have increasing returns to scale. [2 marks]
Section A: Question 4 a
• If a technology has increasing returns to scale
how do Marginal and average costs vary with
the level of output [3 marks]
– Give definitions from lectures.
– A Firm Has Increasing Returns to Scale if a 1%
increase in output leads to less than a 1% increase
in total costs
– Falling AC means IRS
– So MC below AC, both falling
Section A: Question 4 a
• If a technology has increasing returns to scale how do Marginal and
average costs vary with the level of output [3 marks]
• Increasing returns to scale means that increasing all inputs by, say,
1% increases output by more than 1%.
• This implies that, with given input prices, the cost of each additional
unit of output decreases. So the marginal cost curve is downward
sloping.
• The average cost is the total cost divided by quantity.
• Since the cost of producing the marginal unit is decreasing, the
average cost per unit will also decrease. However, the average cost
curve will lie above the marginal cost curve, since the first unit was
more expensive to produce than the 10th unit.
• Only for the first unit is the average cost = marginal cost.
Section A: Question 4 a / b
• If a technology has increasing returns to scale how do Marginal and
average costs vary with the level of output [3 marks]
• Graphically:
Average and
Marginal Costs
Average Cost
Marginal Cost
Output
Section A: Question 4 c / d
Why is an industry with increasing returns to scale unlikely to
be perfectly competitive? [2 marks]
-
Larger firms will always be able to outbid their competitors by
offering a lower price
Case of natural monopoly
Explain why a mobile phone system is likely to have IRS
[2 marks]
-
-
Network industries usually have IRS because the fixed
costs are very high (building antennas etc.) and marginal
costs very low.
The more dense a phone network, the higher is the value
of adding one additional phone mast to the network
Section A: Question 5
• Explain why free healthcare paid for by a tax
on income is likely to be a redistribution from
rich to poor. What is the Gini coefficient and
what is it used for? Show, using a graph, how
you would expect the effect of the
introduction of free health care to affect the
Lorenz curve. What will be the effect on the
Gini coefficient?
Section A: Question 5
• Explain why free healthcare paid for by a tax
on income is likely to be a redistribution from
rich to poor.
– The rich have higher income (by definition). So a
40% tax on the rich contributes more money than
a 40% tax on the poor.
– So the rich pay more, yet everyone gets the same
good (free healthcare).
Section A: Question 5
• What is the Gini coefficient and what is it used
for?
– Gini coefficient is a common measure of
inequality.
– It ranges between 0 (complete equality) and 1
(complete inequality)
– It is calculated using the Lorenz curve (next slide).
It is area A divided by area (A+B)
Share of income
100%
A
B
45o
100% Share of population
Section A: Question 5
• Because free health care reduces inequality,
the Lorenz curve moves towards the 45
degree line
– (Being on 45 degree line is complete equality)
• This reduces the Gini coefficient
Section A: Question 6
• Why is monopoly bad –make sure your answer
uses some relevant graphs? What are the
reasons why monopolies might occur?
• Reasons for monopoly. Recall (and explain!) 3
reasons for monopoly given in lectures:
– Natural monopoly (IRS)
– Firms actions (buying other firms, cornering
market) e.g. ram man
– Government actions (create monopolies, give
patents)
Section A: Question 6
• Why is monopoly bad –make sure your answer uses some relevant
graphs? What are the reasons why monopolies might occur?
• Price is higher and quantity lower compared to perfect competition.
There is deadweight loss (DWL) relative to perfect competition.
– Some CS has been transferred to profits. The rest has gone.
– So overall welfare is lower.
– So board for diagram.
• Under perfect competition, the price paid by consumers equals
marginal cost. This is socially efficient (as long as no externalities).
–
–
–
–
Price is what people are willing to pay.
MC is the social cost of providing it.
Hence, socially optimal point is where P=MC.
If P>MC society benefits from producing more. Hence monopoly is not
socially efficient.
Section A: Question 6
Price, P
P*
Marginal
Revenue
Marginal Cost
Demand Curve
(Average Revenue)
Q*
Quantity, Q
Section A: Question 7
• Street lighting in many countries is provided
by government. Why do you think this is?
• Goods can be categorised in a simple matrix:
Section A: Question 7
• Most goods, e.g. ipads, guitars are rival and
excludable
• A competitive market does a good job at
providing these goods (it is Pareto efficient as
long as no externalities)
• Street lighting is non-rival and non-excludable. It
is a public good.
• The market will provide too little.
– It is very difficult to charge for using it (nonexcludable)
– Purchasing good would have positive externalities for
others (non-rival)
Section A: Question 7
• It is most likely that no private enterprise
would offer street lighting, since they can not
discriminate people into “paying customers”
and “non paying customers” due to the nonexcludability.
• Nobody would pay
Section A: Question 8
• What is moral hazard? Give an example of moral hazard from real
life. What could be done to reduce the extent of moral hazard in
your example?
• Moral Hazard arises in situations of asymmetric information. A
classical example is (health) insurance. In case you are insured, you
may take up some risky activities (such as skiing), that you would
otherwise not take up. Without insurance, you would have to pay
the cost that arise in case of accidents. Once you are insured, the
health care system pays your bills.
• Another example is unemployment insurance: knowing that you are
insured, you may shirk at work or work less hard.
• The extent of moral hazard can be reduced by providing adequate
incentives. In the health care example, insurers may want to charge
higher insurance premiums for consumers, who engage in risky
activities (smoking, skiing,…). They also charge an excess for claims
(so you have to pay something yourself).
Section B : Question 9
• Consider a firm that is a price-taker in both product and labour
markets and has a production function with diminishing returns to
labour:
– Explain why the demand for labour will be decreasing in the wage. [4
marks]
– Suppose that no workers want to work if the wage is below £250 per
week but everyone wants to work at a wage higher than that. Draw
this supply curve. [4 marks]
– Suppose the marginal product of labour when everyone is employed is
above £250 per week. Draw the equilibrium in this market. Identify
the producer and consumer surplus. [4 marks]
– Now suppose that immigration increases the supply of labour in the
economy. What happens to the wage and employment? What
happens to consumer and producer surplus? [4 marks]
– What does this analysis tell you about the groups likely to support and
oppose immigration? [4 marks]
Section B : Question 9 a
– Explain why the demand for labour will be decreasing in the wage. [4 marks]
Each additional worker increases the firm’s output by her marginal product
(MP). The additional revenue that this gives the firm is MRP = MP * p.
The cost of hiring an additional worker is the wage w.
Hence: A firm will continue hiring workers whenever
MRP = MP * p > w, since this will increase profits.
The firm will stop hiring workers when MRP = w
Since there are decreasing returns to scale, the marginal product falls as the
firm increases workers. If w is higher, MRP also must be higher to satisfy the
equation MRP>w. And MRP is higher when there are less workers! So with
higher wages, the firm hires less workers. With lower wages, it hires more.
Section B : Question 9 b / c
– Suppose that no workers want to work if the wage is
below £250 per week but everyone wants to work at a
wage higher than that. Draw this supply curve. [4
marks]
This is an example of a perfectly inelastic supply
curve. No worker wants to work at wages below
250, and everybody works at wages above that.
(In the graph, the vertical part of supply curve is
at the total number of workers in the economy)
Section B : Question 9 b/c
Wage
W=250
Supply
Curve
Demand
Curve
Workers
Section B : Question 9 b/c
Wage
Labour
supply
CS
w*
w=250
PS
Labour
Demand
Workers
The worker is the producer (supplier) and the firm is the consumer (demander of the
good, which is labour)
Section B : Question 9 d/e
– Now suppose that immigration increases the
supply of labour in the economy. What happens to
the wage and employment? What happens to
consumer and producer surplus? [4 marks]
– What does this analysis tell you about the groups
likely to support and oppose immigration? [4
marks]
Section B : Question 9 d/e
– Continue to assume that workers work only if wage >= 250. Influx of
migrants shifts the supply curve to the right.
Wage
w*
w=250
Labour
Demand
Workers
Section B : Question 9 d/e
– We see that the equilibrium wage falls. We see that
the consumer surplus increases, while the producer
surplus of initial residents falls [for this one uses the
old labour supply curve].
– Native workers are worse off, since their wages have
fallen.
– So existing workers are likely to oppose immigration
and firms support it.
– Does this ring some bells considering the current
political debate about Bulgarians/ Romanians in the
EU?
Section B : Question 10
• The government imposes a tax on cigarettes. Using
graphs as well as text:
– What is likely to happen to the demand for cigarettes? [5
marks]
– Explain how it is possible that an increase in the tax on
cigarettes can lead to a fall in total tax revenue for the
government. [5 marks]
– How does the price elasticity of demand for cigarettes
affect the impact of the tax on total tax revenue? [5 marks]
– Suppose the government thinks that cigarettes are so bad
that they ban them completely. Do you think this a good
idea? [5 marks]
Section B : Question 10 a
What is likely to happen to the demand for
cigarettes? [5 marks]
– Standard tax diagram
– See class
• Demand curve shifts down
• OR can shift supply curve up
– Don’t move both
• Quantity falls
Section B : Question 10 b
Explain how it is possible that an increase in the
tax on cigarettes can lead to a fall in total tax
revenue for the government. [5 marks]
• The tax revenue is given as TR = t x Q
• An increase in taxes increases t but reduces Q
(see diagram in a)
• If the fall in Q is large enough, tax revenues may
actually fall.
Section B : Question 10 c
How does the price elasticity of demand for cigarettes affect the impact of the tax on total tax
revenue? [5 marks]
•
First, define price elasticity of demand: % change in demand for a good divided by % change
in price of the good.
– i.e. by what % does demand change if price changes by 1%
– If demand is very inelastic, quantity does not change much when prices increase
– If demand is perfectly inelastic, quantity does not change at all
– If demand is perfectly elastic, quantity collapses to 0
•
Always consider the extreme cases first.
•
If demand is perfectly inelastic (vertical demand curve), the quantity demanded does not
change if taxes go up. So tax revenues increase.
•
If demand is perfectly elastic (horizontal demand curve), an increase in prices leads to a
collapse in the market (quantity demand = 0), so tax revenue falls (to zero).
•
In reality, it is somewhere in between, but at the more inelastic side. The quantity reaction is
there, but it is small. So tax revenues are likely to increase if the tax rate goes up.
•
Should draw diagram too.
Section B : Question 10 d
•
Suppose the government thinks that cigarettes are so bad that they ban them
completely. Do you think this a good idea? [5 marks]
Here you need to argue beyond the constraints of the question and argue along
normative dimensions, using positive arguments in the background.
Partly depends on whether consumers are “rational” or make wrong choices
•
Good idea:
– Positive: smoking has negative externalities on non-smokers due to passive
smoking; this has very high social costs that can’t be paid for by the smokers for
any price.
– Normative: should protect the smokers from harm they are inflicting on
themselves.
•
Bad idea:
– Positive: consumers are rational and so banning cigarettes makes them worse
off.
• But smoking has negative externalitites (e.g. second-hand smoke) so there
is still a case for reducing smoking
– Normative: could trigger smuggeling crime, etc…
Section B : Question 11
• Suppose that there is a monopoly supplier of electricity.
– What is the optimal price that the monopolist should
charge to maximize its profits? [4 marks]
– On a diagram compare the price the monopolist will
charge with the price that would prevail if the market was
perfectly competitive. [4 marks]
– Explain why the monopoly outcome is inefficient? [4
marks]
– Suppose the government caps the price that the
monopolist can charge? What will be the effect on the
quantity of electricity consumed? Explain your answer. [4
marks]
– Should the government impose a price cap on the
monopolist? If so, what price? [4 marks]
Section B : Question 11 a
What is the optimal price that the monopolist should
charge to maximize its profits? [4 marks]
1. Chooses quantity by setting MR = MC (why?)
2. Uses demand curve to find price at that
quantity
Draw diagram and explain
Section B : Question 11 a
Price, P
Pm
Marginal
Revenue
Marginal Cost
P*
Demand Curve
(Average Revenue)
Qm
Q*
Quantity, Q
Section B : Question 11 b
On a diagram compare the price the monopolist will
charge with the price that would prevail if the market
was perfectly competitive. [4 marks]
• In perfect competition, each firm sets P=MC to maximise profits
• So for the industry, the MC curve is the supply curve
• As always in perfect competition, equilibrium is where
Demand = Supply
D=S
Hence under PC, price is lower and quantity is
higher compared to monopoly
Section B : Question 11 b
Price, P
Pm
Marginal
Revenue
Marginal Cost
= S curve under
perfect
competition
P*
Demand Curve
(Average Revenue)
Qm
Q* (perfect competition)
Quantity, Q
Section B : Question 11 c
• Quantity is lower. There is deadweight loss (DWL) relative to perfect
competition.
– Some CS has been transferred to profits. The rest has gone.
– Show this on a graph.
– So overall welfare is lower.
• Under perfect competition, the price paid by consumers equals
marginal cost. This is socially efficient (as long as no externalities).
–
–
–
–
Price is what people are willing to pay.
MC is the social cost of providing it.
If P>MC society benefits from producing more.
since the price reflects the valuation of consumers and the marginal
costs reflects the social costs of providing electricity.
• As a monopolist charges prices above marginal cost, there is a
welfare loss as too little electricity is being produced.
Section B : Question 11 d
Suppose the government caps the price that
the monopolist can charge? What will be the
effect on the quantity of electricity consumed?
Explain your answer. [4 marks]
The monopolist still sets MR=MC to get Q.
But the MR curve has changed. It is flat at the price
ceiling, then downward sloping.
Easiest to draw diagram using upward sloping MC curve.
Quantity of electricity may fall as a result of the price
cap. But price will be lower.
Section B : Question 11 e
(e) Should the government impose a price cap on the monopolist? If so, what price? [4
marks]
If the government sets pcap = p*, then the efficient outcome can be achieved.
The problem with markets with a natural monopoly is, that we will never know what p* would
be, since it will never be observed.
Hence regulators tend to study a monopolists cost structure with a lot of caution, because the
monopolists marginal cost MC tells us what p* should be.
If the price cap is too low, the quantity will fall.
There are possibly better policies the government could use.
e.g. try to introduce competition, regulate both price and quantity, nationalise (?) etc
(see “public policies towards monopolies in lecture”)
Section B : Question 12
• Suppose the government has a welfare state that taxes some
people (those with high levels of market income) and provides
benefits to others (those with low levels of market income).
– Define the marginal and average tax rate [4 marks]
– Would you expect people with low incomes to have low or high
average tax rates? [4 marks]
– How do you think average and marginal tax rates affect the incentives
to work? [4 marks]
– Why are marginal tax rates often highest amongst the lowest earners?
[4 marks]
– Suppose the government is inefficient so that for every £1 it raises in
taxation it only manages to distribute 75p in benefits. Does this
inefficiency mean we should redistribute more or less? [4 marks]
Section B : Question 12
(a) Define the marginal and average tax rate [4 marks]
Intuition (not definition):
– Average tax rate is the tax rate you pay (on average) across
all your earnings…lost benefits included in this tax rate!
– Marginal tax rate is the tax rate you pay on an additional
dollar of earnings…lost benefits included in tax rate!
For definition, need to distinguish between final income and
market income.
final income = market income – tax + benefits
With no welfare state (no redistribution)
Final
income
45o
Market Income
With a welfare state….
Final
income
Market Income
Section B : Question 12 (a)
• Average Tax Rate
average tax rate 
market income  final income
market income
• Marginal Tax Rate
Change in final income
m arg inal tax rate = 1Change in market income
Section B : Question 12
(b) Would you expect people with low incomes to have
low or high average tax rates? [4 marks]
– People with low income tend to have low average tax
rates, since they often receive high benefits
• If final income > market income you have a negative average
tax rate
– People with high income tend to have high average
tax rates, since their final income < market income.
– However, marginal tax rates will be quite different.
– Low income individuals often have very high marginal
tax rates
(c) How do you think average and marginal tax rates
affect the incentives to work? [4 marks]
• Higher average tax rate reduces final income
• As leisure usually considered a normal good,
this reduces demand for leisure
• This means people want to work more
– Higher average tax rate increases work
Incentives to Work
• Higher marginal tax rate reduces payoff to an
extra hour of work
• The price of leisure effectively falls
• This increases demand for leisure and reduces
the demand for work
– Works like a substitution effect
• Hence a higher marginal tax rate reduces
incentives to work
(d) Why are marginal tax rates often highest amongst the
lowest earners? [4 marks]
Because (many) benefits are reduced as you begin to work
And low earners have low wages – so an extra hour of work
makes less difference to market income
… low pay and rapid withdrawal of benefits makes marginal
tax rates very high!
(So why do governments design welfare schemes in this
way?! See Iron Triangle discussion and previous class…)
Channel 4 programme “benefits
street”
Quite controversial, but huge viewing
figures
Fraser Nelson in The Spectator:
“The biggest scandal of Benefits Street…is that
Dee is behaving rationally in deciding not to
work…were she to earn, say, £90 a week as a
cleaner, then the system would reduce her
benefits by £70 – an effective [marginal] tax rate
of 78 per cent… this is nothing to do with
indolence. Which of us would work at a 91 per
cent tax rate?”
Section B : Question 12 (e)
Suppose the government is inefficient so that for every £1 it raises in
taxation it only manages to distribute 75p in benefits. Does this
inefficiency mean we should redistribute more or less? [4 marks]
– If the government is very inefficient, it “wastes” lots of the money
it gathers in tax
•
•
•
•
Spends this money on administration, or possibly on corrupt payments
Here, 25% of all taxes raised are wasted in this way
The more taxation, the higher the waste
Hence could argue for less redistribution
– Also, because of the waste, to achieve a given amount of
redistribution (e.g. to build a new school), the government will
have to raise taxes even further. This may further deteriorate
incentives to work.
– But perhaps the government could invent a better way to
redistribute
• E.g. by lowering the tax rate on charitable donations!

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