UNIVERSITY OF NORTH CAROLINA ECONOMICS 101h: HONORS INTRODUCTORY ECONOMICS PRACTICE MIDTERM EXAMINATION # 2

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1 UNIVERSITY OF NORTH CAROLINA ECONOMICS 101h: HONORS INTRODUCTORY ECONOMICS PRACTICE MIDTERM EXAMINATION # 2 Prof. B. Turchi Nov 9, 2006 GENERAL INSTRUCTIONS: There are six (6) questions on this examination; please answer them all. Sign the honor code pledge on your blue book. Please write legibly and remember, quality and precision beat quantity every time. 1. Last year the U.S. economy was operating at full employment, very close to the nation s production possibilities frontier. Then, the stock market began a rapid descent. Show how this would affect the conumer demand in the economy. 2. Following the massacre of Sept. 11, 2001 surveys showed that consumer confidence has fallen sharply. Show how this decline would affect the consumption function for the economy. 3. The automotive parts manufacturer, Delphi Corporation, filed for bankruptcy protection on Saturday, Oct. 8th, 2005, thereby becoming the largest corporate bankruptcy in the history of the U.S. automobile industry. Delphi had suffered net losses of $4.8 billion in 2004, and its situation has continued to deteriorate this year. Bankruptcy allows Delphi to continue operations while seeking ways to become profitable. According to the Wall Street Journal, [CEO Robert S. Miller] said General Motors and other customers could count on Delphi to continue to operate smoothly as the company moves through the bankruptcy process. (Assume Delphi is a perfectly competitive firm operating in the short run.) (a)write an essay using graphics in which you illustrate the conditions under which a company losing $4.8 billion per year could continue to operate smoothly in spite of such huge losses. Under what conditions would it be forced to stop production? Be specific in your answers. (a) During bankruptcy Delphi will seek to reduce union wages from an average of $65.00 per hour to about $25.00 per hour. Assuming that Delphi uses capital and labor to produce its products, show graphically and explain how this wage cut, if achieved, would affect Delphi s use of capital and labor to produce a given level of output. Show what would happen to capital and labor inputs and to the total cost of producing a given level of output. 4. On Tuesday, October 18th, General Motors Corp. announced that it had reached an agreement with the United Auto Workers union to reduce retirees health benefit liabilities by about $15 billion out of a total liability of $77.5 billion. According to the Wall Street Journal, this reduction in liabilities will result in an annual saving of about $3 billion. Since GM s third quarter net loss was $1.63 billion, this is a sizable reduction in costs. (Assume that GM is operating as a perfect competitor in the short run as you answer the questions below.) 5. (a) What impact will this reduction in retiree health benefits have on GM s profit maximizing (or loss minimizing) optimal output level? What impact will it have on GM s profit (or loss)? Use graphs and explain your answer. (b) GM is also negotiating with the UAW to reduce the health benefits of current GM employees. Show what effect, if any, this reduction would have on GM s profit maximizing (or loss minimizing) level of output. What impact will it have on GM s profit (or loss)? (Assuming no change in retiree health benefits) Use graphs and explain your answer.

2 6. National Public Radio s Morning Edition ran a feature recently on the situation of farmers in China who are facing low prices for their products and fear even lower prices when China becomes a member of the World Trade Organization (WTO) and must eliminate its tariffs and quotas on agricultural products. (a) Assuming that the world trades two goods, agricultural products and machinery, and assuming that China s productivity is lower than the rest of the world in both goods, describe the conditions under which China would become either an importer or exporter of agricultural products when the economy is opened up to free trade. How would the changing welfare of Chinese farmers affect your assessment of whether freer trade is beneficial to China? Why? Use graphics and explain your answer. (b) Show what will happen to agricultural prices in China under both situations --(1) China becomes an agricultural importer, (2) China becomes an agricultural exporter -- once free trade is achieved under the WTO. Use graphics and explain your answer.

3 Answers to Practice Exam Last year the U.S. economy was operating at full employment, very close to the nation s production possibilities frontier. Then, the stock market began a rapid descent. 1. (10 points) Assuming that the economy on the aggregate demand side was in equilibrium, explain how equilibrium aggregate demand would have been affected by the stock market decline. Be specific about which component(s) of aggregate demand would have been affected and use graphics to explain your answer. This question asks the student to discuss the impact of declining stock market values on the portfolio value of wealth held by households. We know that consumption spending is affected by nominal (and real) wealth. In this case nominal wealth has declined, causing the consumpton function to shift down (since "W" is part of "a" autonomous consumption). Graphically the story looks like this: Expenditures 45 C+I+G C+I C C'+I+G C'+I C' Y** Y* Y where the decline in wealth causes the consumption function to shift from C to C', with the other two expenditure lines following. Equilibrium aggregate demand declines from Y* to Y**. 2. (10 points) Following the massacre of Sept. 11, 2001 surveys showed that consumer confidence has fallen sharply. Show how this decline would affect the aggregate demand situation you described in the previous question. Be specific about which components of aggregate demand will have been affected. Use graphics to illustrate your answer. Consumer confidence is also a determinant of consumer spending; therefore, its decline causes the consumption function to fall even further. And that causes equilibrium aggregate demand to decline yet again. Now it falls from Y** to Y***: 45 C+I+G C+I C Expenditures C'+I+G C'+I C' C''+I+G C''+I C'' Y*** Y** Y* Y 3. The automotive parts manufacturer, Delphi Corporation, filed for bankruptcy protection on Saturday, Oct. 8th, 2005, thereby becoming the largest corporate bankruptcy in the history of the U.S. automobile industry. Delphi had suffered net losses of $4.8 billion in 2004, and its situation has continued to deteriorate this year. Bankruptcy allows Delphi to continue operations while seeking ways to become profitable. According to the Wall Street Journal, [CEO Robert S. Miller] said General Motors and other customers could count on Delphi to continue to operate smoothly as the company moves through the bankruptcy process. (Assume Delphi is a perfectly competitive firm operating in the short run.)

4 (a) (5 points) Write an essay using graphics in which you illustrate the conditions under which a company losing $4.8 billion per year could continue to operate smoothly in spite of such huge losses. Under what conditions would it be forced to stop production? Be specific in your answers. This is a question about the conditions under which a firm making losses can continue to operate in the short run. Although Delphi s losses seem to be huge, it could continue to operate if it were producing at a level that allowed it to cover its variable costs. In the graph below, Delphi is making losses, but it still covering its Average Variable Costs per unit of output. As long as its creditors agree, and the bankruptcy laws virtually force them to do so, Delphi can continue to operate indefinitely under these conditions. MC,, etc. MC Loss On the other hand if the price of its product(s) falls low enough that Delphi cannot even recover its variable costs (see graph below) then Delphi would minimize its losses by shutting down immediately. So when price falls to minimum (at output level Qsd) the firm should shut down MC,, etc. MC Loss Qsd (b) (5 points) During bankruptcy Delphi will seek to reduce union wages from an average of $65.00 per hour to about $25.00 per hour. Assuming that Delphi uses capital and labor to produce its products, show graphically and explain how this wage cut, if achieved, would affect Delphi s use of capital and labor to produce a given level of output. Show what would happen to capital and labor inputs and to the total cost of producing a given level of output. This is a question about how to use inputs to minimize the cost of producing a given level of output. By cutting wages so sharply (assuming that capital prices remain unchanged) Delphi can reduce the cost of producing the given level of output. Also, if there is any substitutability between inputs, it may pay Delphi to move toward a relatively more labor intensive production process to take advantage of the relatively cheaper labor. In the graph below, Delphi is producing units with capital/labor combination A. The decline in labor price (wage) causes the iso-expenditure line to pivot out (assuming no change in capital costs). Then, to produce units we can reduce total expenditure to the dashed iso-expenditure line, ending up with cost reductions as indicated on the graph and a labor/capital ratio at B.

5 Cost Reduction Labor B A units Capital 4. On Tuesday, October 18th, General Motors Corp. announced that it had reached an agreement with the United Auto Workers union to reduce retirees health benefit liabilities by about $15 billion out of a total liability of $77.5 billion. According to the Wall Street Journal, this reduction in liabilities will result in an annual saving of about $3 billion. Since GM s third quarter net loss was $1.63 billion, this is a sizable reduction in costs. (Assume that GM is operating as a perfect competitor in the short run as you answer the questions below.) 5. (5 points) What impact will this reduction in retiree health benefits have on GM s profit maximizing (or loss minimizing) optimal output level? What impact will it have on GM s profit (or loss)? Use graphs and explain your answer. Retiree health benefits are fixed costs. Therefore, they do not change as GM raises or lowers output level. Since profit maximization (or loss minimization) depends upon equating marginal cost and marginal revenue, GM s behavior will not change as a consequence of this reduction in retiree health benefits, since they are fixed costs. As the graph below shows, the reduction in retiree health benefits will result in a reduction in fixed costs and a rise in profits; however, optimal output () will not change as a result of the change in fixed costs. On

6 the other hand, GM s profits will rise (as shown) or its losses will decline, even though optimal output () does not change. TC-TR Total Cost-before Total Revenue Total Cost-after Profit Profit-after Profit-before (b) (5 points) GM is also negotiating with the UAW to reduce the health benefits of current GM employees. Show what effect, if any, this reduction would have on GM s profit maximizing (or loss minimizing) level of output. What impact will it have on GM s profit (or loss)? (Assuming no change in retiree health benefits) Use graphs and explain your answer. Changing current employee health costs reduces Variable Costs. This has the effect of changing both the level of profits (or losses) and in raising the optimal level of output. The graph below shows the change in optimal output from to * and it shows the change in profits that results from the reduction in current employee health costs. There is another way to graph this. The bottom graph shows the average and marginal cost curves for the firm. The reduction in health benefits shifts the average ( and ) and marginal cost curves. The decline in health benifits for current workers causes variable costs to decline.

7 TC-TR Total Cost-before Total Revenue Total Cost-after * Profit Profit-after Profit-before * MC,, etc. ' MC MC' ' Loss Loss *

8 6. (20 points) National Public Radio s Morning Edition ran a feature recently on the situation of farmers in China who are facing low prices for their products and fear even lower prices when China becomes a member of the World Trade Organization (WTO) and must eliminate its tariffs and quotas on agricultural products. (a) Assuming that the world trades two goods, agricultural products and machinery, and assuming that China s productivity is lower than the rest of the world in both goods, describe the conditions under which China would become either an importer or exporter of agricultural products when the economy is opened up to free trade. How would the changing welfare of Chinese farmers affect your assessment of whether freer trade is beneficial to China? Why? Use graphics and explain your answer. This is a question about comparative advantage. If the Chinese are relatively more productive in agricultural production (i.e., their opportunity cost is lower [see relative PPFs below]) then they will become exporters of agricultural products. On the other hand, if they re relatively less efficient, they ll be importers of agricultural products. Even if the farmers suffer from imports, the country as a whole will benefit because of the gains from free trade (see the CPF). The Chinese government might want to consider giving adjustment assistance to those farmers hurt by low-priced imports. Agriculture PPF: Rest of World Even though China has an absolute disadvantage in both goods, it has a comparative advantage in agriculture and will specialize in agriculture on the world market. CPF:Rest of World PPF: China CPF: China Machinery (b) Show what will happen to agricultural prices in China under both situations --(1) China becomes an agricultural importer, (2) China becomes an agricultural exporter -- once free trade is achieved under the WTO. Use graphics and explain your answer. If China becomes an exporter of agricultural products, its agricultural prices will rise in order to develop a sufficient excess supply to export (left-hand panel of graph below). On the other hand, if China becomes an importer of agricultural products, then, indeed, its agricultural prices will fall to meet the international price, P1. S S Po P1 Po P1 D Qbefore D of Wheat Qbefore of Wheat China becomes exporter and agricultural prices rise China becomes importer and agricultural prices fall