Correct Answer and Standards for 1998 Micro Free Response

1.    I.    Correct answer

As a result of the favorable wheat harvest, the supply of wheat shifts to the right (outward or downward).  With an unchanged demand curve, the equilibrium price falls and teh equilibrium output increases.  Since the demand is price inelastic, the total revenues of producers (farmers) fall.  the percentage reduction in price is of a greater magnitude than the percentage increase in quantity.

The increased cost of fertilizer, an input to wheat production, leads to a leftward (inward or upward) shift in the supply of wheat.  The government's announcement of the health benefits of wheat consumption leads to a rightward (outward) shift in the demand for wheat.  As a result of the simultaneous changes in demand and supply, the equilibrium price of wheat increases; the change in equilibrium output is indeterminate.  [The demand change would lead to an increase in output; the supply change would lead to a a decrease in output.  The relative magnitudes of these changes determine the effect on output.]

To be effective,  a price floor must be set above the equilibrium price.  At that price there is an excess quantity supplied.  The area of consumer surplus falls since the price paid by consumers increases and the quantity consumed falls.  At the original equilibrium there was allocative efficiency, as MSB (price from the demand curve) equaled MSC (price from the supply curve).  With the price floor, MSB no longer equals MSC.  Assuming that production occurs where P=MC on the supply curve, MSC>MSB at the quantity produced.  There is an over-allocation of resources to wheat production. From the perspective of the consumer, the price floor restricts the output consumed (below the optimal level), and the price paid by consumers (the marginal social benefit) exceeds the marginal social cost.

II.    Grading Rubric for #1:  9 points

Part (a)  3 points

• 1 point for a "properly" drawn graph (with outward shift in supply)
• 1/2 point for price (down)
• 1/2 point for quantity (up)
• 1 point for stating that with inelastic demand, a price decrease leads to a decrease in total revenues (% change in P> % change in Q)

Part (b) 3 points

• 1 point for the graph (must include an outward shift in demand and an inward shift in supply)
• 1 point for price increase (changes in both S and D must be shown or referenced)
• 1 point for indeterminate quantity change (i.e., may not state that " quantity does not change" or "stays the same")

Part (c): 3 points

• 1 point for an effective price floor (drawn above the equilibrium price)
• 1 point for showing that the area of consumer surplus falls (may not just state that consumer surplus falls)
• 1 point for showing that there is now allocative inefficiency: ideally that MSC>MSB at the output produced and that too many resources are being allocated to wheat or that MSC<MSB at the level of output actually consumed when the price floor is in effect.  [Some use of marginal analysis should be included in the answer.  simply saying that there is a surplus is not sufficient.  Reference to P>MC merits the point,  if and only if there is explicit reference to the quantity of wheat actually consumed when the price floor is in effect.]

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2.    I.    Correct Answer

Diminishing marginal returns implies that the marginal product of additional units of a variable input (labor), when combined with a fixed amount of another factor (capital), will eventually diminish.  Diminishing returns occur because the additional units of the variable input have less of the fixed factor with which to work.

Marginal product is maximized with the fifth worker, whose marginal product is 400 units of output.  With this labor utilization, diminishing marginal returns begin.

When the average product of labor is rising, the marginal product of labor exceeds the average product of labor.  When the average product of labor is at its maximum, the marginal and average products are equal.  When the average product of labor is falling, the marginal product of labor is below the average product.

The average variable cost (AVC) typically falls as output initially increases.  After reaching a minimum, the average variable cost begins to increase with the level of output.  When the AVC is falling, the average product of the labor being used is rising.  When the AVC is at its minimum, the average product of the labor being used is at a  maximum.  When the AVC is rising, the labor used has a falling average product of labor.

II.    Grading Rubric for #2:  5 Points

Part (a) and (b) 2 points

• As more of a variable input is combined with a fixed input (or inputs), output increases, but eventually at a diminishing rate.
• Diminishing returns occurs because each unit of the variable input has less of the fixed input with which to work.

For full credit, the following three elements should be found in the answer:
i.    The variable/fixed distinction MUST be made.
ii.    There must be a sense that marginal product is decreasing, not total product.
iii.    Also, there must be a sense that the variable input (usually labor) is being "crowded" by the fixed resource.

Part (c): 1 point

After 5 workers, or with the 6th worker, or when the use of the variable input leads to the marginal product of labor falling from 400 to 300 units.

Part (d): 1 point

• When marginal product is greater than the average product, average product is increasing.  
• When marginal product is less than average product, average product is decreasing.  This relationship may be described or graphed.  

[The correct answer must show a comparison of AP and MP over a range of points.
 It is NOT sufficient to state that when MP=AP, AP is at a minimum.]

Part (e): 1 point

Average product and average variable cost are inversely related.  The student may also state that when AP is at a maximum, AVC is at a minimum.  This may be graphed or described.

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3.    I.    Correct Answer

The firm is able to separate its consumers into two distinct markets.  In the market in which demand is less elastic, the firm will charge a higher price.  In each market the profit-maximizing firm will set quantity where marginal revenue equals marginal cost; price will then be found on the demand curve.  In comparing the two markets, the price will be higher where demand is less elastic.  [Since marginal revenue will be positive in each market, demand will never be inelastic.  Recall, the monopolist (or any firm) will never produce where demand is inelastic, as MR would be negative.]

Price discrimination with two markets is contingent on the firm having market power and being able to separate its consumers into different markets.  Also, for price differentials to prevail between the two markets, resale of the output should not be possible.

II.    Grading Rubric for #3:  5 Points

Part (a): 1 point

• 1 point for stating that when demand is less elastic, the firm will charge a higher price (or vice-versa).  A mere definition of elasticity is not a sufficient answer.

Part (b): 2 points

• 1 point for showing that profit-maximization occurs where MR=MC and price is then taken from the downward sloping demand curve.
• 1 point for a side-by-side comparison of the two different markets showing that price is higher where demand is less elastic.  [If a side-by-side comparison is not used, it is necessary to state convincingly that the less elastic demand has a higher price and/or the more elastic demand has a lower price.]

Part (c): 2 points

1 point for each of the following (up to a 2 point maximum):

• The firm must have market power.
• The firm must be able to separate consumers into different markets.
• There must not be resale of the product.