Instructions:

This part of the written comprehensive exam in Economics is divided into two parts, macro and micro, which are given equal weight in your final Economics comprehensive grade.

Answer the Macro exam in a bluebook. Be sure to put your identification number on each bluebook. Answer the Micro exam in the spaces provided in the Micro handout. Be sure to put your identification number on the Micro exam.

Your answers should include appropriate verbal, graphical, and mathematical reasoning. Please number each answer in your bluebook and write coherently and legibly.

Remember, the Macro and Micro sections are equally weighted, so you should allocate your time efficiently. Do NOT spend too much time on one part of the exam or on one question. If you can’t get it, MOVE ON!

Use the 30 minute reading period to read the entire exam carefully, underlining important information.

You have until 12:00 PM to complete the exam. Good luck.

During the past several years economic observers have noted the following "events" or "shocks":

Now suppose the economy is populated by imperfectly competitive firms that set prices by marking up on unit labor cost (the labor cost per unit of output). Further suppose that labor suppliers have rational expectations of prices and base their supply on the expected real wage. A significant portion of wages are set by multiyear, staggered contracts. In addition, given the expected inflation rate, the growth rate of the average wage rate is inversely related to the spread between the actual unemployment rate and the natural rate of unemployment.

During the past few years there has been strong growth in aggregate demand but the inflation rate has been modest. Over the past four years real, labor productivity has increased; GDP has grown around 3.2% per year; while the inflation rate (based on the GDP deflator) decreased from 2.6%/year in 1993 to 1.9%/year in 1997, and with the diminished actual inflation, expected inflation fell; at the same time the unemployment rate has systematically declined.

"Air travel between North America and Europe is a very big business, as reflected by the fact that about 12 percent of all international air passengers travel between these two continents. The North Atlantic market is marked by at least two noteworthy characteristics. First, the bulk of the travellers are non-business travellers. About 46% of all passengers are vacation travellers, 34 percent are visiting relatives and friends, and the rest are business travellers. Second, there is considerable seasonable variation in the demand for air travel in this market, the peak season being the summer. About 37% of all traffic in this market occurs in the third quarter of the year.

Many major international airlines, such as American, Delta, British Airways, Lufthansa, Air France, and SAS fly between Europe and North America. They, as well as a host of industry and government analysts, are vitally interested in the demand for air travel in this market. In particular, they are interested in the price and income elasticities of demand for such air travel. J.M. Cigliano of the Lockheed-California Company has published the results of a study in which he estimated these elasticities. His findings have been used in a variety of contexts, as we shall see below. Table 1 shows the estimated elasticities of demand for air travel between the United States and Europe, as well as between Canada and Europe.

Table 1: Price and Income Elasticities of Demand for Air Travel in the North Atlantic Market

In the questions below, assume that Cigliano’s estimates are correct.

For the Canada-Europe route, the income elasticity (1.8) is about the same as between the United States and Europe, but the price elasticity (.8) is much lower in absolute value. In part, this may reflect a different mix of air travellers. Compared to the U.S.-Europe route, a relatively large proportion of the travelers between Canada and Europe may be business travellers whose travel plans are relatively insensitive to the price of air travel. Whatever the reasons for the difference between the Canada-Europe and the U.S.-Europe routes in the price elasticity of demand, this difference is of considerable interest to the airlines.

Table 2 shows the estimated elasticities of demand for each of three fare categories of air travel between the United States and Europe.

Table 2: Price and Income Elasticities of Demand for Air Travel between the

United States and Europe

Question 6 (5 pts): Suppose that Northwest Airlines has a monopoly on the Indy-Detroit route. What must the marginal cost per passenger be in order for the facts given above to make sense? We’ll repeat them for you: "the linear demand curve for flights between Indianapolis and Detroit is Q = 337.5 - 0.75 P, where P is price in dollars and Q is hundreds of passengers. The observed price is $250 and average daily volume is 150."

Airline costs typically include categories for food, marketing (airline advertising), maintenance, inflight service (cost of crews), ticketing, administrative expenses, fuel, and interest on debt. Some of these are sensitive to the number of flights, some are sensitive to the number of passengers, and some are fixed. Thus, what costs are variable depends on whether the flight schedule has been set.

Your explanation:

Northwest Airlines and its 148 flight kitchen employees Wednesday signed a new four-year labor contract.

The workers, represented by the International Association of Machinists, will earn a 14-percent wage increase over the life of the contract. They also will receive a lump sum check equal to 3.5 percent of their wages for 29 months from Aug. 1, 1996.

The new contract guarantees no layoffs and 50 percent increase in pension benefits.

Northwest still must resolve contract issues with its two largest unions representing the mechanics and flight attendants.

Suppose for the sake of simplicity that it takes only two inputs to produce a flight from Indy to Detroit: labor (L) and planes (P). The production function is Q = 1,000 * min{20P, L}, where L is labor in person-hours, P is number of plane-hours, and Q measures passenger-miles. The cost of labor is initially $50 and the cost of the plane is $1000 per hour.

The airline industry was deregulated during the Carter administration with the Airline Deregulation Act of 1978. The fundamental assumption underlying the policy change was that the market was "contestable" -- that is, that potential competition would be so vigorous because of low barriers to entry into or exit from the industry that there would be little opportunity to exploit monopoly power before a new entrant would move in to compete away those rents. Unsuccessful entrants would be able to dispose of their expensive capital equipment easily by selling or leasing to rival companies or to freight or mail transport services. In addition, it was assumed that large established airlines had no inherent advantage over small start-up airlines, i.e., that customers viewed the services of both types of competitors as perfectly substitutable.

Others disagree, claiming that factors such as limited landing slots constitute barriers to entry. Some demand studies purport to show that consumers, other things equal, prefer to fly established carriers. In addition, some studies suggest that large established airlines use techniques such as frequent flyer miles and travel agent commissions in order to maintain a market advantage over small entrants. If this were true, then potential competition would not be effective as a restraining force and large airlines would profitably dominate the market.

The contestability hypothesis has been tested in several papers on the airline industry. Morrison and Winston estimated a regression using pooled time-series cross-section data from 1978 to 1988. Their results have been adapted and reproduced below, with standard errors in parentheses.

ln (FARE) = .501• ln (DIST) - .201*ln (NEC) - .0014*ln (POT)

( .003) (.005) (.0004)

where: ln indicates the natural log

FARE = round trip fare in dollars

DIST = distance in miles of the particular route

NEC = number of competitors who also serve that route

POT = potential competition, as measured by carriers that serve at least one of the airports in a particular city-pair but who do not serve that particular

route

[For example, if there are three carriers that fly found-trip between Detroit and Indy, NEC is 3. If there are 10 carriers that that operate out of either Detroit or Indy but who don’t fly between them POT = 10.]

  .

It is convenient to live near a major airport, but one of the drawbacks is the amount of noise generated by incoming and outgoing flight traffic. In other words, noise is a negative production externality.

All major airports have noise limits or restrictions that are usually non-tradable and allocated across airlines according to each firm’s share of passenger traffic. Some airports have taken the step of imposing noise surcharges on carriers that exceed their specified limits.. For example, the schedule for the Dresden airport’s surcharges are shown below. Type I Aircraft cause less noise than Type II aircraft, which in turn cause less noise than Type III aircraft. The amount of noise is greater for heavier aircraft.

NOISE SURCHARGE

Rate (German marks per ton)

International Flights Domestic Flights

Type I Aircraft 16.75 16.75

Type II Aircraft 18.75 18.75

Type III Aircraft 29.20 29.20