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Chapter 12/The Design of the Tax System ✦ 69 Chapter 13 The Costs of Production Which of the following is an implicit cost? a salaries paid to owners who work for the firm b interest on money borrowed to finance equipment purchases c cash payments for raw materials d foregone rent on office space owned and used by the firm ANSWER: d foregone rent on office space owned and used by the firm SECTION: 1 OBJECTIVE: 1 Samantha has been working for a law firm and earning an annual salary of $90,000. She decides to open her own practice. Her annual expenses will include $15,000 for office rent, $3,000 for equipment rental, $1,000 for supplies, $1,200 for utilities, and a $35,000 salary for a secretary/bookkeeper. Samantha will cover her startup expenses by cashing in a $20,000 certificate of deposit on which she was earning annual interest of $1,000. Assuming that there are no additional expenses, Samantha’s annual implicit costs will equal a $55,200 b $221,400 c $91,000 d $146,200 ANSWER: a $55,200 SECTION: 1 OBJECTIVE: 1 Economists assume that the goal of the firm is to maximize a total revenue b profits c costs d All of the above are correct ANSWER: b maximize profits SECTION: 1 OBJECTIVE: 1 The difference between accounting profit and economic profit relates to a the manner in which revenues are defined b how total revenue is calculated c the manner in which costs are defined d the price of the good in the market ANSWER: c the manner in which costs are defined SECTION: 1 OBJECTIVE: 1 In this diagram, the shift in the total product curve represents an increase in the firm’s a costs of production b productivity c diseconomies d market share ANSWER: b productivity SECTION: 2 OBJECTIVE: 2 70 ✦ Chapter 12/The Design of the Tax System Which of the following could explain why the total product curve shifted in this diagram? a A reduction in capital equipment available to the firm b Labor skills have become rusty and outdated in the firm c The firm has developed new technology in their production facility d The firm is now receiving a higher price for its product ANSWER: c The firm has developed new technology in their production facility SECTION: 2 OBJECTIVE: 2 As Al’s Radiator Co. continues to add workers, while keeping the same amount of machinery, some workers may be underutilized because they have little work to do while waiting in line to use the machinery. When this occurs, Al’s Radiator Co. encounters a economies of scale b diseconomies of scale c increasing marginal returns d diminishing marginal returns ANSWER: d diminishing marginal returns SECTION: 2 OBJECTIVE: 2 Which of the following costs of publishing a book is a fixed cost? a author royalties of 5% per book b costs of paper and binding c shipping and postage d composition, typesetting, and jacket design ANSWER: d composition, typesetting, and jacket design SECTION: 3 OBJECTIVE: 2 Which of the following is the best example of a variable cost? a monthly payments for hired labor b property tax payments c monthly rent payments for a warehouse d pension payments to retired workers ANSWER: a monthly payments for hired labor SECTION: 3 OBJECTIVE: 3 Chapter 12/The Design of the Tax System ✦ 71 10 Smith Tire Co. has total fixed costs of $100,000 per year. The firm’s average variable cost is $80 for 10,000 tires. At that level of output, the firm’s average total costs equal a $90 b $100 c $110 d $120 ANSWER: a $90 SECTION: 3 OBJECTIVE: 3 11 Miller Technologies has average variable costs of $6 and average total costs of $10 when it produces 1,000 units of output. The firm’s total fixed costs equal a $2,000 b $3,000 c $4,000 d $5,000 ANSWER: c $4,000 SECTION: 3 OBJECTIVE: 3 12 At a firm’s current output level of 200 units per week, it has 10 employees at a weekly wage of $500 each. Raw materials, which are ordered and delivered daily, cost $1,000 per week. The weekly cost of the firm’s capital is $1,250. Which of the following statements is correct? Total Variable Cost Total Fixed Cost Total Cost a $5,000 $2,250 $7,250 b $6,000 $1,250 $7,250 c $1,250 $6,000 $7,250 d $2,250 $ 500 $2,750 ANSWER: b $6000 $1,250 $7,250 SECTION: 3 OBJECTIVE: 3 13 If marginal cost is greater than average total cost then a profits are increasing b economies of scale are becoming greater c average total cost remains constant d average total cost is increasing ANSWER: d average total cost is increasing SECTION: 3 OBJECTIVE: 3 14 The minimum points of the average variable cost and average total cost curves occur where a the marginal cost curve lies below the average variable cost and average total cost curves b the marginal cost curve intersects those curves c wages are the lowest d the slope of total cost is the smallest ANSWER: b the marginal cost curve intersects those curves SECTION: 3 OBJECTIVE: 3 72 ✦ Chapter 12/The Design of the Tax System th If Franco’s Pizza Parlor knows that the marginal cost of the 500 pizza is $3.00 and that the average total cost of making 499 pizzas is $3.30, then a average costs are rising at Q = 500 b average costs are falling at Q = 500 c total costs are falling at Q = 500 d average variable costs must be falling ANSWER: b average costs are falling at Q = 500 SECTION: 3 OBJECTIVE: 3 15 16 When the marginal product of labor falls, the marginal cost of output a falls, then rises b becomes negative c rises d remains constant ANSWER: c rises SECTION: 3 OBJECTIVE: 4 17 Which of the following factors is most likely to shift IBM’s total cost and marginal cost curves downward? a a technological advance resulting in increased productivity b higher property taxes charged by the municipal government c increased wages to attract additional computer operators d a reduction in subsidies from the state government ANSWER: a a technological advance resulting in increased productivity SECTION: 3 OBJECTIVE: 4 18 Given the cost curve described in the diagrams below, the efficient scale of production occurs at point a A b B c C d D ANSWER: c C SECTION: 3 OBJECTIVE: 4 Chapter 12/The Design of the Tax System ✦ 73 19 Economies of scale a requires a change in the size of operations and therefore is a longrun consideration b requires a more intensive use of existing plant and therefore is a shortrun consideration c means that a doubling of plant size will double output d requires a change in the size of plant and therefore is a shortrun consideration ANSWER: a requires a change in the size of operations and therefore is a longrun consideration SECTION: 4 OBJECTIVE: 4 20 Since the 1980s, WalMart stores have appeared in almost every community in America. WalMart buys their goods in large quantities and therefore at cheaper prices. WalMart also locates its stores where land prices are low, usually outside of the community business district. Many customers shop at WalMart because of low prices and free parking. Local retailers, like the neighborhood drug store, often go out of business because they lose customers. This story demonstrates that a consumers are boycotting local retailers whose prices are relatively higher b there are diseconomies of scale in retail sales c there are economies of scale in retail sales d there are diminishing returns to producing and selling retail goods ANSWER: c there are economies of scale in retail sales SECTION: 4 OBJECTIVE: 5 21 Some reasons that firms may experience diseconomies of scale include that a the firm is too small to take advantage of specialization b large management structures may be bureaucratic and inefficient c if there are too many employees, the work place becomes crowded and people become less productive d average fixed costs begin to rise again ANSWER: b large management structures may be bureaucratic and inefficient SECTION: 4 OBJECTIVE: 5 74 ✦ Chapter 12/The Design of the Tax System 22 A local bagel company plans to keep and maintain its bagel factory, which is estimated to last 25 years. All cost decisions it makes during the 25year period a are shortrun decisions b are longrun decisions c involve only maintenance of the factory d are zero, since the cost decisions were made at the beginning of the business ANSWER: a are shortrun decisions SECTION: 4 OBJECTIVE: 5 23 If a firm experiences constant returns to scale at all output levels, then its longrun average total cost curve would a slope downward b be horizontal c slope upward d slope downward for low output levels and upward for high output levels ANSWER: b be horizontal SECTION: 4 OBJECTIVE: 5 24 Which of the following explains why longrun average cost at first decreases as output increases? a diseconomies of scale b lessefficient use of inputs c fixed costs becoming spread out over more units of output d gains from specialization of inputs ANSWER: d gains from specialization of inputs SECTION: 4 OBJECTIVE: 5 25 The total cost to the firm of producing zero units of output is a zero in both the short run and the long run b its fixed cost in the short run, zero in the long run c its fixed cost in both the short run and the long run d its variable cost in both the short run and the long run ANSWER: b its fixed cost in the short run, zero in the long run SECTION: 4 OBJECTIVE: 5 Chapter 14 Firms in Competitive Markets One of the defining characteristics of a perfectly competitive market is a a small number of sellers b a large number of buyers and a small number of sellers c a standardized product d significant advertising by firms to promote their products ANSWER: c a standardized product SECTION: 1 OBJECTIVE: 1 Chapter 12/The Design of the Tax System ✦ 75 Which of the following firms is the closest to being a perfectly competitive firm? a a hot dog vendor in New York b Microsoft Corporation c Ford Motor Company d the campus bookstore ANSWER: a a hot dog vendor in New York SECTION: 1 OBJECTIVE: 1 Java Joe sells 200 cups of coffee each day in a perfectly competitive market at the market price of $1.00 per cup. If Java Joe independently decreased its price per cup to $0.75, a its sales would rise to 250 cups b its revenues would decrease c its revenues would remain constant at $200 d the market price would fall to $0.75 as other sellers match Java Joe’s price ANSWER: b its revenues would decrease SECTION: 1 OBJECTIVE: 1 If the market elasticity of demand for potatoes is –.3, then the individual farmer’s elasticity of demand a is also –.3 b depends on how large a crop she produces c will range between –.3 and –1.0 d will be infinite ANSWER: d will be infinite SECTION: 1 OBJECTIVE: 1 Perfect competition may be defined as competition a among pricetaking sellers b among buyers with perfect information about the market c among sellers of highquality products d in a market where prices adjust quickly to the longrun equilibrium ANSWER: a competition among pricetaking sellers SECTION: 1 OBJECTIVE: 1 Free entry means that a there are no costs of entering into an industry b no legal barriers prevent a firm from entering an industry c a firm’s marginal cost is zero d a firm has no fixed costs in the short run ANSWER: b no legal barriers prevent a firm from entering an industry SECTION: 1 OBJECTIVE: 1 This table describes the relationship between output, marginal revenue, and marginal cost. If the firm is currently producing 14 units, what would you advise them to do? a decrease quantity to 13 b increase quantity to 15 c remain at 14 units d increase quantity to 16 units ANSWER: d increase quantity to 16 units SECTION: 2 OBJECTIVE: 2 76 ✦ Chapter 12/The Design of the Tax System Unit Marginal Marginal Quantity Cost Revenue 12 $5.00 $9.00 13 $6.00 $9.00 14 $7.00 $9.00 15 $8.00 $9.00 16 $9.00 $9.00 17 $10.00 $9.00 This table describes the relationship between output, marginal revenue, and marginal cost. If the firm is maximizing profit, how much profit is it earning? a b $1.00 c $16.00 d There is not sufficient data to determine firm profitability ANSWER: d There is not sufficient data to determine firm profitability SECTION: 2 OBJECTIVE: 2 Cold Duck Airlines flies between Tacoma and Portland. The company leases planes on a yearlong contract at a cost that averages $600 per flight. Other costs (fuel, flight attendants, etc.) amount to $550 per flight. Currently, Cold Duck’s revenues are $1,000 per flight. All prices and costs are expected to continue at their present levels. If it wants to maximize profit, Cold Duck Airlines should a drop the flight immediately b continue the flight c continue flying until the lease expires and then drop the run d drop the flight now but renew the lease if conditions improve ANSWER: c continue flying until the lease expires and then drop the run SECTION: 2 OBJECTIVE: 2 10 Raiman’s Shoe Repair also produces custommade shoes. When Mr. Raiman produces 12 pairs a week, the MC of the twelfth pair is $84, and the MR of that unit is $70. What would you advise Mr. Raiman to do? a shut down b produce more custommade shoes c decrease the price d produce fewer custommade shoes ANSWER: d produce fewer custommade shoes SECTION: 2 OBJECTIVE: 2 11 Carla’s Candy Store is maximizing profits by producing 1,000 pounds of candy per day. If Carla’s fixed costs unexpectedly increase and the market price remains constant, then the profit maximizing level of output a is less than 1,000 pounds b is still 1,000 pounds c is more than 1,000 pounds d becomes zero ANSWER: b is still 1,000 pounds SECTION: 2 OBJECTIVE: 2 Chapter 12/The Design of the Tax System ✦ 77 12 The firm will make the most profits if it produces that quantity of output for which a marginal cost equals average cost b profit per unit is greatest c marginal revenue equals total revenue d marginal revenue equals marginal cost ANSWER: d marginal revenue equals marginal cost SECTION: 2 OBJECTIVE: 2 13 This table shows the total revenue and total cost data for a perfectly competitive firm. The profit earned at the profitmaximizing output level is a $80 b $10 c $0 d $15 ANSWER: d $15 SECTION: 2 OBJECTIVE: 2 Total Output Revenue Cost $ 20 40 60 80 100 120 Total $ 40 60 70 80 85 110 14 Joe’s Garage operates in a perfectly competitive market. At the point where marginal cost equals marginal revenue, ATC = $20, AVC = $15, and the price per unit is $10. In this situation, a Joe’s Garage will break even b Joe’s Garage will shut down immediately c Joe’s will lose money in the short run, but stay in business d the market price will fall in the short run ANSWER: b Joe’s Garage will shut down immediately SECTION: 2 OBJECTIVE: 3 15 If there is an increase in market demand in a perfectly competitive market, then in the short run a there will be no change in the demand curves faced by individual firms in the market b the demand curves for firms will shift downward c the demand curves for firms will become more elastic d profits will rise ANSWER: d profits will rise SECTION: 2 OBJECTIVE: 3 16 A sunk cost is one that a changes as the level of output changes in the short run b was paid in the past and will not change regardless of the present decision c should determine the rational course of action in the future d has the most impact on profitmaking decisions ANSWER: b was paid in the past and will not change regardless of the present decision SECTION: 2 OBJECTIVE: 4 78 ✦ Chapter 12/The Design of the Tax System 17 A corporation has been steadily losing money on one of its product lines. The factory used to produce that brand cost $20 million to build 10 years ago. The firm now is considering an offer to buy that factory for $15 million. Which of the following statements about the decision to sell or not to sell is correct? a The firm should turn down the purchase offer because the factory cost more than $15 million to build b The $20 million spent on the factory is a sunk cost that should not affect the decision c The $20 million spent on the factory is an implicit cost, which should be included in the decision d The firm should sell the factory only if it can reduce its costs elsewhere by $5 million ANSWER: b The $20 million spent on the factory is a sunk cost that should not affect the decision SECTION: 2 OBJECTIVE: 4 18 The shortrun market supply curve in a perfectly competitive industry a shows the total quantity supplied by all firms at each possible price b is perfectly inelastic at the market price c is perfectly elastic at the market price d is usually downwardsloping ANSWER: a shows the total quantity supplied by all firms at each possible price SECTION: 3 OBJECTIVE: 5 19 Tommy’s Tires operates in a perfectly competitive market. If tires sell for $50 each and ATC = $40 per tire at the profitmaximizing output level, then in the long run a more firms will enter the market b some firms will exit from the market c the equilibrium price per tire will rise d average total costs will fall ANSWER: a more firms will enter the market SECTION: 3 OBJECTIVE: 5 20 If all firms have the same costs of production, then in longrun equilibrium, a price exceeds all firms’ average cost b price exceeds all firms’ marginal cost c some firms have positive profits d all firms have zero profits and just cover their opportunity costs ANSWER: d all firms have zero profits and just cover their opportunity costs SECTION: 3 OBJECTIVE: 5 21 When market conditions in a competitive industry are such that firms cannot cover their production costs, then a the firms will suffer longrun economic losses b the firms will suffer shortrun economic losses that will be exactly offset by longrun economic profits c some firms will go out of business, causing prices to rise until the remaining firms can cover their production costs d all firms will go out of business, since consumers will not pay prices that enable firms to cover their production costs ANSWER: c some firms will go out of business, causing prices to rise until the remaining firms can cover their production costs SECTION: 3 OBJECTIVE: 5 110 ✦ Chapter 12/The Design of the Tax System Chapter 21 The Theory of Consumer Choice Budget constraints exist for consumers because a their utility from consuming goods eventually reaches a maximum level b even with unlimited incomes they have to pay for each good they consume c they have to pay for goods and they have limited incomes d prices and incomes are inversely related ANSWER: c they have to pay for goods and they have limited incomes SECTION: 1 OBJECTIVE: 1 A family on a trip budgets $800 for restaurant meals and fast food. If the price of a fast food meal for the family is $20, how many such meals can the family buy if they do not eat at restaurants? a b 15 c 20 d 40 ANSWER: d 40 SECTION: 1 OBJECTIVE: 1 A family on a trip budgets $800 for restaurant meals and fast food. If the price of a fast food meal is $20 and if the family can afford 16 restaurant meals if they don’t buy any fast food, how many fast food meals would the family gain if they gave up one restaurant meal? a b .4 c d 2.5 ANSWER: d 2.5 SECTION: 1 OBJECTIVE: 1 If the price of bread is zero, a budget line between bread (on the vertical axis) and cheese (on the horizontal axis) would a be vertical b coincide with the vertical axis c coincide with the horizontal axis d be horizontal ANSWER: a be vertical SECTION: 1 OBJECTIVE: 1 Chapter 12/The Design of the Tax System ✦ 111 Suppose the price of pizza is $8, the price of cola is $2, and the consumer’s income is $16. The consumer’s budget line measures pizza on the horizontal axis and cola on the vertical axis Given the information above, if the price of cola doubles to $4, then the a budget line intersects the vertical axis at 16 colas b slope of the budget line rises to –1/2 c budget line intersects the vertical axis at 4 colas d budget line shifts inward in a parallel fashion ANSWER: c budget line intersects the vertical axis at 4 colas SECTION: 1 OBJECTIVE: 1 Given the information above, if the consumer’s income rises to $32, then the budget line for pizza and cola would a now intersect the horizontal axis at 4 pizzas and the vertical axis at 16 colas b not change c now intersect the horizontal axis at 1/4 pizza and the vertical axis at 1/16 cola d rotate outward with an increased quantity of cola consumed ANSWER: a now intersect the horizontal axis at 4 pizzas and the vertical axis at 16 colas SECTION: 1 OBJECTIVE: 1 If John’s marginal benefit derived from the consumption of another candy bar is greater than the price of the candy bar, then a John will not purchase any more candy bars b John will increase his total satisfaction by purchasing the candy bar c the opportunity cost of the candy bar is lower than the price d John will decrease his total satisfaction if he purchases the candy bar ANSWER: b John will increase his total satisfaction by purchasing the candy bar SECTION: 2 OBJECTIVE: 2 Each of the following are characteristics of an indifference map except a moving northeast to a new indifference curve will increase utility b points on the same indifference curve yield equal utility c the axes represent levels of utility for each of the goods d indifference curves cannot cross ANSWER: c the axes represent levels of utility for each of the goods SECTION: 2 OBJECTIVE: 2 As more hours of Internet access are purchased, everything else equal, marginal satisfaction from consuming additional hours will tend to a decrease at the same rate for all consumers b decrease but at different rates for different people c increase at the same rate for all consumers d increase but at a decreasing rate for all consumers ANSWER: b decrease but at different rates for different people SECTION: 2 OBJECTIVE: 2 112 ✦ Chapter 12/The Design of the Tax System 10 Suppose Rich always uses two packets of sugar with his coffee. Rich’s indifference curves for sugar and coffee are a bowed inward b bowed outward c straight lines d L shaped ANSWER: d L shaped SECTION: 2 OBJECTIVE: 2 11 Indifference curves tend to be bowed inward because of diminishing a marginal rates of substitution b demand for the good as prices rise c income d supply of the good being consumed ANSWER: a marginal rates of substitution SECTION: 2 OBJECTIVE: 2 12 The marginal rate of substitution between two goods equals the a marginal satisfaction of one divided by the marginal satisfaction of the other b marginal satisfaction of one times the marginal satisfaction of the other c marginal cost of one times the marginal cost of the other d price of one good divided by the price of the other ANSWER: a marginal satisfaction of one divided by the marginal satisfaction of the other SECTION: 2 OBJECTIVE: 2 13 Jeffrey spends all of his income on warmup suits and running shoes, and the price of a warmup suit is four times as large as the price of a pair of shoes. Then, in order to maximize total utility, Jeffrey should a buy four times as many warmup suits as pairs of running shoes b buy four times as many pairs of running shoes as warmup suits c divide his income equally between warmup suits and running shoes d buy both items until the marginal satisfaction of a warmup suit is four times the marginal satisfaction of a pair of running shoes ANSWER: d buy both items until the marginal satisfaction of a warmup suit is four times the marginal satisfaction of a pair of running shoes SECTION: 3 OBJECTIVE: 3 14 For dessert, Mac has the choice between cheesecake and apple pie. The cheesecake has a marginal satisfaction of 50 and a price of $5, and the apple pie has a marginal utility of 30 and a price of $3. Given this information, Mac should buy a the cheesecake b the apple pie c two servings of the apple pie and no cheesecake d either the apple pie or the cheesecake, it makes no difference to Mac at this point ANSWER: d either the apple pie or the cheesecake, it makes no difference to Mac at this point SECTION: 3 OBJECTIVE: 3 Chapter 12/The Design of the Tax System ✦ 113 15 TsaiFen is maximizing total utility while consuming food and clothing. Her marginal satisfaction from food and clothing are 50 utils and 25 utils, respectively. If clothing is priced at $10 per unit, the price of food must a be rising b be falling c equal $10 as well d equal $20 ANSWER: d equal $20 SECTION: 3 OBJECTIVE: 3 16 Higher education is a normal good. If its price falls a the quantity demanded of higher education will fall b the substitution and income effects work in opposite directions c the income effect is negative d higher education will satisfy the law of demand ANSWER: d higher education will satisfy the law of demand SECTION: 3 OBJECTIVE: 4 17 If the price of hamburgers increases, the substitution effect works to a decrease the quantity of hamburgers supplied b increase the number of hamburger buns demanded c decrease the quantity of hamburgers demanded d increase the number of hamburger buns supplied ANSWER: c decrease the quantity of hamburgers demanded SECTION: 3 OBJECTIVE: 4 18 If the substitution effect of a lowered price is partly or fully offset by the income effect, we know that the good in question is a(n) a complementary good b inferior good c luxury good d normal good ANSWER: b inferior good SECTION: 3 OBJECTIVE: 5 19 Suppose that for Edwin, DVDs and trips to the movie theater are perfect substitutes. If the price of DVDs doubles, the substitution effect will be a two times the income effect b half the income effect c zero d dependent upon Edwin’s income ANSWER: c zero SECTION: 3 OBJECTIVE: 5 20 An individual’s demand curve for a good is derived by a varying the income level and observing the resulting total utility derived from both goods b varying the price of one good and observing the resulting quantities of the other good c shifting the budget line to the left and calculating the loss in total utility d varying the price of one good and observing the resulting quantities demanded of that good ANSWER: d varying the price of one good and observing the resulting quantities demanded of that good SECTION: 3 OBJECTIVE: 5 114 ✦ Chapter 12/The Design of the Tax System 21. If a good is a Giffen good, then a the supply curve slopes down b the demand curve slopes up c the demand curve is horizontal d there is no optimal level of consumption for the consumer ANSWER: b the demand curve slopes up SECTION: 4 OBJECTIVE: 6 22 Suppose that Annette gets an increase in her wage and she decides to work fewer hours. For her, the substitution effect of the wage change is a greater than the income effect b less than the income effect c exactly offset by the income effect d zero ANSWER: b less than the income effect SECTION: 4 OBJECTIVE: 6 23 In the upwardsloping portion of the individual labor supply curve, the substitution effect is the income effect a greater than b less than c equal to d exactly offset by ANSWER: b less than SECTION: 4 OBJECTIVE: 6 24 The opportunity cost of current household consumption is the a wage rate b market interest rate c price of the goods consumed d explicit cost of consumption ANSWER: b market interest rate SECTION: 4 OBJECTIVE: 6 25 Last week, the Federal Reserve took steps to lower the Federal Funds rate by onehalf point. This means that a the opportunity cost of current consumption has fallen b the opportunity cost of future consumption has fallen c the cost of borrowing has risen d households will save more money to make up for lost interest earnings ANSWER: a the opportunity cost of current consumption has fallen SECTION: 4 OBJECTIVE: 6 Chapter 12/The Design of the Tax System ✦ 115 Chapter 22 Frontiers in Microeconomics Moral hazard occurs when a the principal monitors an agent b two people might trade with each other and one person has relevant information about some aspect of the product’s quality that the other person lacks c an agent lacks an incentive to promote the best interests of the principal, and the principal cannot observe the actions of the agent d an agent monitors the principal ANSWER: c an agent lacks an incentive to promote the best interests of the principal, and the principal cannot observe the actions of the agent SECTION: OBJECTIVE: Carlos, who knew nothing about construction, paid Joe to remodel a room in his house. Two years later, the wall of the new room crumbled because Joe used poorquality materials. This is an example of a adverse selection b screening c moral hazard d signaling ANSWER: c moral hazard SECTION: OBJECTIVE: Monitoring an agent means a reducing asymmetric information the agent possesses b obtaining information about the agent’s actions c increasing the costs of moral hazard d reducing the costs of adverse selection ANSWER: b obtaining information about the agent’s actions SECTION: OBJECTIVE: The fact that someone with a high risk of medical problems is more likely to buy a lot of health insurance is an example of a adverse selection b monitoring c moral hazard. d irrational behavior ANSWER: a adverse selection SECTION: OBJECTIVE: 116 ✦ Chapter 12/The Design of the Tax System Adverse selection occurs when a people are not as careful after they buy insurance b owners take better care of their homes than do renters c good cars are underpriced in the usedcar market d there is separation of ownership and control ANSWER: c good cars are underpriced in the usedcar market SECTION: OBJECTIVE: What would be the equilibrium price of used cars if 4/5 of them were faulty and worth $1000 while 1/5 of them were good quality and worth $2000? a $1000 b $1200 c $1800 d $2000 ANSWER: b $1200 SECTION: OBJECTIVE: Guarantees may not completely eliminate adverse selection problems because a no one guarantees a product 100% b getting the firm to honor a guarantee is too much work c a firm that makes lowquality products may issue guarantees and then go out of business d a firm offering guarantees subjects itself to lawsuits concerning their obligations ANSWER: c a firm that makes lowquality products may issue guarantees and then go out of business SECTION: OBJECTIVE: Which of the following is an example of a principalagent relationship? a buyerseller b clientaccountant c parentnanny d Both B and C are correct ANSWER: d Both B and C are correct SECTION: OBJECTIVE: The principalagent problem arises because of a the firm’s motive for profit maximization b the salary differential between management and laborers c the structure of the market in which the firm operates d conflicting interests between a principal and an agent ANSWER: d conflicting interests between a principal and an agent SECTION: OBJECTIVE: 10 Suppose that the Boston Red Sox hire Homer Jones as a first baseman. One day, the manager tells Homer not to swing at a pitch so that he can get a walk and help the team win the game. Homer, however, wants to hit a home run so that he can improve his value on the free agent market, so he swings at the next pitch and misses the ball. This is an example of a moral hazard b adverse selection c signaling d the principalagent problem ANSWER: d the principalagent problem SECTION: OBJECTIVE: Chapter 12/The Design of the Tax System ✦ 117 11 The principalagent problem is more serious in large firms than in small firms because a monitoring employee activity in large firms is generally more difficult b employees in large firms have less information c profits increase with the size of the firm d customers expect better treatment from small firms and they usually get it ANSWER: a monitoring employee activity in large firms is generally more difficult SECTION: OBJECTIVE: 12 The voter is the voter whose views on a policy issue are in the middle of the spectrum, with half of the other voters on one side of this voter’s view and half on the other side a average b mean c Arrow d median ANSWER: d median SECTION: OBJECTIVE: 13 If voter A would like the government to spend $10,000 on a project, voter B prefers $5000, voter C prefers $3000, voter D prefers $2000, and voter E prefers $0, how much spending would a politician seeking as many votes as possible select when running against one opponent? a $1000 b $2000 c $3000 d $7000 ANSWER: b $2000 SECTION: OBJECTIVE: 14 The medianvoter theorem explains why a politicians take extreme stands on issues b voters are attracted to political outsiders c two opposing politicians tend to take opposite sides of each issues d politicians tend to take middleoftheroad positions ANSWER: d why politicians tend to take middleoftheroad positions SECTION: OBJECTIVE: 15 The Arrow impossibility theorem states that a there is no tendency for a change unless some underlying condition changes b the equilibrium government policy is the one favored by the median voter c people’s votes are generally irrelevant d the results of voting can be inconsistent even if all voters make consistent choices ANSWER: d the results of voting can be inconsistent even if all voters make consistent choices SECTION: OBJECTIVE: 118 ✦ Chapter 12/The Design of the Tax System Three candidates, Fred, Betty, and Wilma, are running for office. There are three voters: Huey, Dewey, and Louie. Huey prefers Fred over Betty and Betty over Wilma. Dewey prefers Betty over Wilma and Wilma over Fred. Louie prefers Wilma over Fred and Fred over Betty. Use this information to answer the next four questions 16 If the voters were given a choice of Fred versus Betty first, then the winner was in a second election versus Wilma, who would win? a Fred b Betty c Wilma d There is not enough information to answer this question ANSWER: c Wilma SECTION: OBJECTIVE: 17 If the voters were given a choice of Betty versus Wilma first, then the winner was in a second election versus Fred, who would win? a Fred b Betty c Wilma d There is not enough information to answer this question ANSWER: a Fred SECTION: OBJECTIVE: 18 If the voters were given a choice of Fred versus Wilma first, then the winner was in a second election versus Betty, who would win? a Fred b Betty c Wilma d There is not enough information to answer this question ANSWER: b Betty SECTION: OBJECTIVE: 19 The outcome of the previous three questions is an illustration of a why people shouldn’t vote b a rationalexpectations equilibrium c the medianvoter theorem d the Arrow impossibility theorem ANSWER: d the Arrow impossibility theorem SECTION: OBJECTIVE: 20 Economic theory assumes that voters, politicians, and other political participants are largely motivated by a personal selfinterest b altruism c a desire to promote the general welfare d a desire to promote allocative economic efficiency ANSWER: a personal selfinterest SECTION: OBJECTIVE: Chapter 12/The Design of the Tax System ✦ 119 21 When economists assume that people are rational, they assume that a consumers maximize profits b firms maximize revenues c consumers maximize utility d firms maximize output ANSWER: c consumers maximize utility SECTION: OBJECTIVE: 22 Some of the systematic mistakes that people make include a they are overconfident b they place too much weight on events that are more vivid as compared to those with greater statistical probability c they are often unwilling to change their minds d All of the above are correct ANSWER: d All of the above are correct SECTION: OBJECTIVE: 23 The results of the ultimatum game illustrate the fact that a people’s behavior is often driven by an innate sense of fairness b homo economicus is a good description of people’s behavior c selfinterest brings out the most efficient economic outcome d Both b and c are correct ANSWER: a people’s behavior is often driven by an innate sense of fairness SECTION: OBJECTIVE: 24 Betty knows that she needs to save 20% of her annual income for retirement. However, she spends 90% of her income each year. This is an indication that Betty’s preferences are a irrational b inconsistent over time c satisficing rather than maximizing d undefined ANSWER: b inconsistent over time SECTION: OBJECTIVE: 25 Behavioral economics a integrates psychological insights into economic models b relies on the assumption that homo economicus describes economic decisionmaking c assumes that economic agents have full information about the conditions surrounding their decisions d All of the above are correct ANSWER: a integrates psychological insights into economic models SECTION: OBJECTIVE: 120 ✦ Chapter 12/The Design of the Tax System Chapter 12 The Design of the Tax System During what war did government spending rise dramatically in the United States, and then never again fall to its peacetime levels? a Civil War b World War I c World War II d Vietnam War ANSWER: c World War II SECTION: 1 OBJECTIVE: 1 Which type of tax is used to finance the Social Security program in the United States? a consumption tax b income tax c payroll tax d property tax ANSWER: c payroll tax SECTION: 1 OBJECTIVE: 1 All of the following are transfer payments except a Medicaid b unemployment compensation c personal income taxes d food stamps ANSWER: c personal income taxes SECTION: 1 OBJECTIVE: 1 If Nebraska imposed a tax on milk of 10 cents per gallon, a this is an excise tax b this is an income tax c tax revenue will fall d the supply of milk will rise ANSWER: a this is an excise tax SECTION: 1 OBJECTIVE: 1 If either supply or demand is perfectly inelastic, then the deadweight social loss from a tax is a infinite b large c small d zero ANSWER: d zero SECTION: 2 OBJECTIVE: 2 Chapter 12/The Design of the Tax System ✦ 121 The deadweight loss from a tax increases as supply becomes more or as demand becomes more a inelastic; inelastic b inelastic; elastic c elastic; elastic d elastic; inelastic ANSWER: c elastic; elastic SECTION: 2 OBJECTIVE: 2 Minimizing the total deadweight loss from taxes that raise a certain amount of revenue for the government is known as a an external benefit b optimal taxation c a lumpsum tax scheme d horizontal equity ANSWER: b optimal taxation SECTION: 2 OBJECTIVE: 2 In the short run, the imposition of a payroll tax of $1 per labor hour will have which of the following effects? a The quantity of labor exchanged will fall b The aftertax wage received by workers will fall c The quantity of labor traded will become inefficient d All of the above are correct ANSWER: d All of the above correct SECTION: 2 OBJECTIVE: 2 A person’s tax obligation divided by her income is called her a marginal social tax rate b marginal private tax rate c marginal tax rate d average tax rate ANSWER: d average tax rate SECTION: 2 OBJECTIVE: 3 10 A person’s average tax rate equals her a tax obligation divided by her marginal tax rate b increase in taxes if her income were to rise by $1 c tax obligation divided by her income d increase in taxes if her marginal tax rate were to rise 1% ANSWER: c tax obligation divided by her income SECTION: 2 OBJECTIVE: 3 11 A person’s marginal tax rate equals a her tax obligation divided by her average tax rate b the increase in taxes she would pay as a percentage of the rise in her income c her tax obligation divided by her income d the increase in taxes if her average tax rate were to rise 1% ANSWER: b the increase in taxes she would pay as a percentage of the rise in her income SECTION: 2 OBJECTIVE: 3 122 ✦ Chapter 12/The Design of the Tax System 12 Pat figures that for every extra dollar she earns, she owes the government 33 cents. Her total income now is $35,000, on which she pays taxes of $7,000. Her average tax rate is and her marginal tax rate is a 33%; 20% b 20%; 33% c 20%; 20% d 33%; 33% ANSWER: b 20%; 33% SECTION: 2 OBJECTIVE: 3 13 Horizontal equity in taxation refers to the idea that people a in unequal conditions should be treated differently b in equal conditions should pay equal taxes c should be taxed according to their ability to pay d should receive government benefits according to how much they have been taxed ANSWER: b in equal conditions should pay equal taxes SECTION: 3 OBJECTIVE: 3 14 The idea that people in equal conditions should pay equal taxes is referred to as a horizontal equity b vertical equity c diagonal equity d linear equity ANSWER: a horizontal equity SECTION: 3 OBJECTIVE: 3 15 Vertical equity in taxation refers to the idea that people a in unequal conditions should be treated differently b in equal conditions should pay equal taxes c should be taxed according to their age and experience d should receive government benefits according to how much they have been taxed ANSWER: a in unequal conditions should be treated differently SECTION: 3 OBJECTIVE: 3 16 A tax that is higher for men than for women violates the criterion of a diagonal equity b linear equity c vertical equity d horizontal equity ANSWER: d horizontal equity SECTION: 3 OBJECTIVE: 3 17 The benefits principle of taxation is LEAST characteristic in a Social Security taxes b gasoline taxes c taxes on airline tickets d tolls used to finance the construction of a bridge ANSWER: Social Security taxes SECTION: 3 OBJECTIVE: 3 Chapter 12/The Design of the Tax System ✦ 123 18 A tax is if it takes a constant fraction of income as income rises a regressive b proportional c progressive d aggressive ANSWER: b proportional SECTION: 3 OBJECTIVE: 3 19 A tax is if it takes a smaller fraction of income as income rises a regressive b proportional c progressive d aggressive ANSWER: a regressive SECTION: 3 OBJECTIVE: 3 20 Most economists argue that when federal, state, and local taxes are combined, the overall effect is a proportional b progressive c regressive d unfair ANSWER: a proportional SECTION: 3 OBJECTIVE: 3 21 In its purest form, a system would eliminate the existing array of different tax rates on personal income and replace them with a single tax a valueadded tax b consumption tax c sales tax d flatrate income tax ANSWER: d flatrate income tax SECTION: 3 OBJECTIVE: 3 22 The main arguments in favor of a modified flatrate tax system (such as a proposal to place a 19% tax on all income over $20,000 with no deductions) are it would a raise more revenue than the current tax system, and it would be simpler b raise more revenue than the current tax system, and it would lower marginal tax rates c be simpler and it would lower average tax rates d be simpler and it would lower marginal tax rates ANSWER: d be simpler and it would lower marginal tax rates SECTION: 3 OBJECTIVE: 4 23 If the government imposed a $1,000 tax on every individual, a this would be an equitable tax b allocative efficiency would have to be sacrificed c this would be an efficient tax d this would be an income tax ANSWER: c this would be an efficient tax SECTION: 3 OBJECTIVE: 4 124 ✦ Chapter 12/The Design of the Tax System 24 In choosing the form of a tax, there is a tradeoff between a allocative and productive efficiency b profits and revenues c efficiency and fairness d fairness and profits ANSWER: c efficiency and fairness SECTION: 3 OBJECTIVE: 5 25 If society is interested in devising a tax that is fair to its citizens, a the tax will raise efficiency b none can be devised c the tax will create inefficiencies d it should choose a lumpsum tax ANSWER: c the tax will create inefficiencies SECTION: 3 OBJECTIVE: 5 ... Design of the Tax System The cigarette industry consists of large firms that compete vigorously by advertising heavily, which is directed at creating fantasy and image. Economists would characterize this industry as... “Tomatoes or no tomatoes. The choice of toppings on a burger can be important to a consumer these days when individualism is increasingly important to people.” SECTION: 1 OBJECTIVE: 3 16 The traditional view of monopolistic competition holds that this type of industrial structure is ... wastes resources because it creates an image without necessarily improving product quality b advertising lowers barriers to entry into an industry because new firms can more easily establish themselves as competitors c advertising increases competition by providing information about prices