Microeconomics, Module 1: Supply, Demand, and Equilibrium. Illustrative Test Questions. (The attached PDF file has better formatting.

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1 Microeconomics, Module 1: Supply, Demand, and Equilibrium Illustrative Test Questions (The attached PDF file has better formatting.) Updated: December 21, 2006 Question 1.1: Elastic (Horizontal) Demand Curve (Adapted from question 3 of the May 2000 Course 2 exam) Suppose the demand curve for books purchased on the Internet is horizontal (i.e., demand is perfectly elastic). If the government imposes a sales tax on books purchased this way, which of the following is most likely? A. The equilibrium quantity and pre-tax price both decline. The sellers and buyers each pay a portion of the tax. B. The equilibrium quantity will decline, and the equilibrium pre-tax price will rise. The sellers pay the tax. C. The equilibrium quantity will decline, and the equilibrium pre-tax price falls by the amount of the tax. The sellers pay the tax. D. The equilibrium quantity will not be affected, and the equilibrium pre-tax price will rise. The buyers pay the tax. E. The equilibrium quantity will decline, and the equilibrium pre-tax price will rise. The buyers pay the tax. Answer 1.1: C A perfectly elastic demand curve is horizontal. A sales tax is paid directly by consumers to the government, so the demand curve moves down by the amount of the tax. The equilibrium quantity decreases, and the equilibrium price decreases by the amount of the tax. The seller is worse off by exactly the amount of the tax. The economic incidence is entirely on the seller. Question 1.2: Cameras and Film, Part 1 Assume the markets for cameras and film have one type of camera and one type of film. A decline in the price of cameras causes A. An increase in the demand for film. B. An increase in the quantity demanded for film. C. A decrease in the demand for film. D. A decrease in the quantity demanded for film.

2 E. No change in the quantity demanded for film. Answer 1.2: A The demand for film is the demand curve (the relation between price and quantity demanded); the quantity demanded is one point on the curve. When the price of cameras declines, consumers buy more cameras, and they want more film even at the same price for film. This is an increase in the entire demand curve for film. Question 1.3: Cameras and Film, Part 2 A decline in the price of cameras causes A. An increase in the supply of film. B. An increase in the quantity supplied of film. C. A decrease in the supply of film. D. A decrease in the quantity supplied of film. E. No change in the quantity supplied of film. Answer 1.3: B [NEAS: Since the demand for film increases, their price increases. Consumers pay more for film, so the quantity supplied of film increases. The marginal cost of producing film does not change, so the supply of film does not change. But consumer are willing to pay more for film, so the quantity supplied increases.] Question 1.4: Plane or Bus Suppose consumers can travel by plane or bus from Boston to Chicago. The plane takes 2 hours; the bus takes two days. If they must travel because of an emergency, the air fare does not much affect their decisions to fly instead of going by bus. In this scenario A. The equilibrium price of air travel is high. B. The demand curve for air travel is upward sloping. C. The supply curve for air travel is downward sloping. D. The demand curve for air travel is relatively flat. E. The demand curve for air travel is relatively steep. Answer 1.4: E Consumers have a demand curve; the producers (the airlines) have a supply curve. If the price does not affect how much consumers buy of the good (air travel), the demand curve is steep.

3 Jacob: If consumers must travel because of an emergency, won t the equilibrium price be high? Rachel: If the marginal cost (supply curve) is low, the point of intersection has a low price. Changing the slope of the demand curve does not necessarily change the intersection. For long-run competitive equilibrium, the equilibrium price depends on the suppliers costs, no the slope of the demand curve. Only if the suppliers have a monopoly does the slope of the demand curve affect the equilibrium price. Question 1.5: Bidding Up and Down The market price of a loaf of bread in Boston is $1.49, consumers want to buy 12,000 loaves, and stores want to sell 20,000 loaves. In this scenario A. Consumers will bid up the market price. B. Sellers will bid down the market price. C. Demand will rise to bring the market to equilibrium. D. Supply will fall to bring the market to equilibrium. E. None of A, B, C, or D is true. Answer 1.5: B If the price remains $1.49, consumer buy 12,000 loaves of bread and stores have 8,000 loaves unsold and getting stale on the shelves. So store bid down the price, until consumers want to buy the number of loaves that stores want to sell. Question 1.6: Market Price and Equilibrium Price If the market price of a loaf of bread in Boston is $1.49 and the equilibrium price is $1.75 A. Suppliers can sell all they produce but consumers can not buy all they demand. B. Suppliers can not sell all they produce but consumers can buy all they demand. C. Suppliers can sell all they produce and consumers can buy all they demand. D. Suppliers can not sell all they produce but consumers can not buy all they demand. E. By definition, suppliers and consumers sell and buy exactly what they demand. Answer 1.6: A If the market price of a loaf of bread were $1.75, consumers would want to buy the same quantity that suppliers want to sell. Since the market price is lower, consumers want to buy more (law of demand) and suppliers want to sell less (law of supply). Question 1.7: Supply and Demand for Afghan Poppy

4 Suppose the price of Afghan poppy declines, and the quantity of Afghan poppy sold on the black market declines as well. We may infer that A. Afghan poppy does not have a demand curve since it does not trade in a free market. B. The supply of Afghan poppy must have fallen. C. The demand for Afghan poppy must have fallen. D. The supply of Afghan poppy must have risen. E. The demand for Afghan poppy must have risen. Answer 1.7: C Know the four scenarios for the final exam:! If the demand for Afghan poppy falls, consumers buy less and pay less.! If the demand for Afghan poppy rises, consumers buy more and pay more.! If the supply of Afghan poppy rises, suppliers produce more and sell for less.! If the supply of Afghan poppy falls, suppliers produce less and sell for more. We put these scenarios into a two by two matrix: Price Increases Price Falls Quantity Increases Demand Rises Supply Rises Quantity Falls Supply Falls Demand Falls These scenarios assume that all else is equal. When we say demand falls, we mean that supply stays the same, the quality of the good stays the same, and so forth. Question 1.8: Supply and Demand of Wine If the demand for wine increases and the supply of wine decreases A. The quantity of wine traded decreases; the price may increase or decrease. B. The quantity of wine traded increases; the price may increase or decrease C. The price of wine increases; the quantity may increase or decrease. D. The price of wine increases and quantity decreases. E. By definition, a rise in demand can not occur along with a fall in supply. Answer 1.8: C Know the four scenarios for the final exam:! If demand rises and supply rises, quantity increases but price may rise or fall.! If demand falls and supply falls, quantity decreases but price may rise or fall.! If demand rises and supply falls, price increases but quantity may rise or fall.! If demand falls and supply rises, price decreases but quantity may rise or fall.

5 We put these scenarios into a two by two matrix: Demand Rises Demand Falls Supply Rises Quantity Increases Price Decreases Supply Falls Price Increases Quantity Decreases Question 1.9: Sales Tax vs Excise Tax Suppose that Boston consumers pay a $2.00 tax per pound of tea. For tax relief, the Boston city council reduces the sales tax to $1.00 per pound of tea. To maintain the same tax revenues, a $1.00 excise tax per pound of tea is levied on suppliers. What is the net economic effect of the tax changes on buyers and sellers? A. If supply curve is steeper than the demand curve, consumer lose and suppliers gain. B. If supply curve is steeper than the demand curve, consumer gain and suppliers lose. C. If demand curve is steeper than the supply curve, consumer lose and suppliers gain. D. If demand curve is steeper than the supply curve, consumer gain and suppliers lose. E. Neither consumers nor suppliers of tea are gain or lose. Answer 1.9: E The choice of an excise tax vs a sales tax does not affect the economic incidence of the tax. Question 1.10: Economic Incidence vs Legal Incidence What does Landsburg mean by the economic incidence of a tax is independent of its legal incidence? A. The economic incidence and legal incidence of a tax are the same. B. The economic incidence of a tax is the same no matter who bears the legal incidence of the tax. C. Consumers and suppliers equally share the economic burden of the tax, regardless of the legal incidence. D. Since suppliers can pass on a tax to consumers, the economic incidence of a tax falls on consumers. E. In a competitive market, suppliers bear the cost of the tax, not consumers. Answer 1.10: B The burden of the tax is not necessarily equal between suppliers and consumers; the relative burdens depend on the slopes of the supply and demand curves.

6 Microeconomics, Module 1: Supply, Demand, and Equilibrium Illustrative Test Questions (The attached PDF file has better formatting.) Updated: May 23, 2005 Question 1.1: Law of Demand All but which of the following are true regarding the law of demand? A. The law of demand says that when price rises, the quantity demanded falls. B. The law of demand implies that demand curves slope downward. C. A change in the price of wine leads to a change in the demand for wine. D. The law of demand implies that goods have decreasing marginal utility. E. All of A, B, C, and D are true. Answer 1.1: C A change in the price of wine leads to a change in the quantity demanded of wine; the demand for wine that is, the demand curve for wine stays the same. Jacob: Choice E in many of these questions is all of A, B, C, and D are true or none of A, B, C, or D is true. Is this the type of question we should expect on the final exam? Rachel: The final exam gives five distinct choices; the exam questions do not say all of the above or none of the above. Question 1.2: Laws of Supply and Demand All but which of the following are true regarding supply and demand? A. If demand falls, the demand curve shifts downwards. B. A sales tax is paid by the seller (supplier, producer) to the government. C. The law of supply says that as price rises, producers supply more of the good. D. The law of supply implies that supply curves are upward sloping. E. All of A, B, C, and D are true. Answer 1.2: B In Landsburg s textbook, a sales tax is paid by the consumer to the government. Question 1.3: Sales and Excise Taxes

7 All but which of the following are true regarding sales and excise taxes? A. An excise tax is paid to the government by sellers. B. The economic incidence of a sales tax is usually shared between the buyers and the sellers. C. If the demand curve is vertical, the economic incidence of an sales tax is completely on the consumers. D. If the demand curve is vertical, the economic incidence of an excise tax is completely on the sellers. E. All of A, B, C, and D are true. Answer 1.3: D

8 Microeconomics, Module 2, Prices, Cost, and Trade Illustrative Test Questions (The attached PDF file has better formatting.) Updated: May 25, 2005 Question 2.1: Absolute and Relative Prices In an economy with only two goods, bread and wine, the absolute price of bread is $1.50 per loaf and the absolute price of wine is $6.00 per flask. The relative price of wine is A. $4.50 per flask. B. $6.00 per flask. C. 4 loaves of bread per flask. D. 1½ loaves of bread per flask. E. ¼ loaf of bread per flask. Answer 2.1: C One can trade four loaves of bread for one flask of wine. Question 2.2: Relative Prices An economy has only two goods, bread and wine. If the price of a flask of wine is 5 loaves of bread, the price of a loaf of bread is A. 0.2 flasks of wine B. 2½ flasks of wine C. 5 flasks of wine D. higher if bread and wine are substitutes than if they are complements. E. lower if bread and wine are substitutes than if they are complements. Answer 2.2: A If we can trade a flask of wine for 5 loaves of bread, we can trade a loaf of bread for 0.2 flasks of wine. We deal with substitutes and complements in a later module; they are not relevant to this question. Question 2.3: Relative Prices An economy has only two goods, bread and wine. If the relative price of bread rises, the relative price of wine

9 A. also rises. B. falls. C. is not affected. D. falls if bread and wine are substitutes and rises if bread and wine are complements. E. rises if bread and wine are substitutes and falls if bread and wine are complements. Answer 2.3: B If the relative price of bread rises, we must trade more flasks of wine for each loaf of bread; this implies that we must trade fewer loaves of bread for each flask of wine. Question 2.4: Economic Terms When Landsburg says the price of bread is $1.50 per loaf A. The dollars represent a collection of goods in the economy. B. He assumes the price has been adjusted for inflation. C. He is referring to the absolute price of the commodity. D. He means that a consumer must spend $1.50 to buy one loaf of bread. E. Dollars are a proxy for loaves of bread. Answer 2.4: A Dollars are a measure of value; they represent all other goods in the economy. Question 2.5: Inflation and Relative Prices If inflation caused the absolute prices of all goods to rise, the relative price of any good A. Also rises. B. Remains unchanged. C. Falls. D. Could rise, fall, or remain unchanged. E. Rises or remains unchanged, but does not fall Answer 2.5: D Whether the relative price rises or falls depends on the effects of inflation on all the goods in the economy. Suppose a loaf of bread costs $2.00 and a flask of wine costs $8.00.! If bread rises to $2.10 and wine rises to $9.00, the relative price of bread falls.! If bread rises to $2.25 and wine rises to $8.50, the relative price of bread rises. Question 2.6: Inflation and Relative Prices

10 Suppose only bread and wine are produced in an economy, and consumers spend half their income on each. If the inflation rate is 10% and the relative price of bread rises 5%, the relative price of wine A. Rises 15%. B. Rises 10%. C. Rises 5%. D. Does not change. E. Falls 5%. Answer 2.6: E If the relative price of bread rises by 5%, the relative price of wine falls by 5%. The monetary inflation is not relevant. One can quibble about the exact amount; instead of falls 1 by 5% one should say Our focus in this course is the economic reasoning, not the arithmetic. Question 2.7: Transportation Costs Strawberries and raspberries are grown in California and shipped to Chicago. In California, strawberries cost $2.50 a pound and raspberries cost $1.50 a pound. Transportation costs of 50 a pound added to the prices in Chicago. Which city has a lower price of strawberries (relative to raspberries), and which city has a lower relative price of raspberries? A. The relative prices of strawberries and raspberries are lower in California, because consumers do not have to pay for transportation costs. B. The relative prices of strawberries and raspberries are lower in Chicago, because transportation costs lower relative prices. C. California has the lower relative price of raspberries, and Chicago has the lower relative price of strawberries. D. Chicago has the lower relative price of raspberries, and California has the lower relative price of strawberries. E. The relative prices are the same in California and Chicago. Answer 2.7: C! California: relative prices of strawberries and raspberries are $2.50 to $1.50 or 62.5% to 37.5%.! Chicago: relative prices of strawberries and raspberries are $3.00 to $2.00 or 60% to 40%. The relative price of strawberries is lower in Chicago (60%) and the relative price of raspberries is lower in California (37.5%). Question 2.8: Quality

11 Oranges are grown in Florida and shipped to New York. Is the average quality of oranges higher in New York or Florida? A. In Florida, because it has the comparative advantage in orange growing. B. In Florida, because the costs of bringing oranges to market is lower than in New York. C. In New York, because it cannot produce enough oranges to meet its demand. D. In New York, because the price of high-quality oranges relative to low-quality oranges is lower than in Florida. E. The average quality of oranges is the same in the two markets. Answer 2.8: D Suppose that growing oranges in Florida costs 25 for low quality and 50 for high quality. Consumers are willing to pay up to twice these costs for oranges. Shipping costs to New York are 30 for each orange. The cost of oranges in New York is 55 for low quality and 80 for high quality. The cost for low quality oranges is more than consumers are willing to pay, so low quality oranges will not be shipped to New York. Only high quality oranges are shipped to New York. Jacob: This seems counter-intuitive. We often hear that oranges are higher quality in Florida and strawberries and raspberries are higher quality in California. Rachel: Landsburg assumes that the fruit does not deteriorate en route to other cities. Since it takes a few days for fruit to be transported across the country, the quality is lower at the end of the journey than at the beginning. Question 2.9: Opportunity Costs A farmer owns land which can grow either wheat or barely. Which of the following best describes the opportunity cost of growing wheat on the land? A. The barley that could have been grown on the land instead of wheat. B. The value of the seed, fertilizer, labor, and other resources needed to grow the wheat. C. The deterioration in soil quality caused by growing wheat. D. There is no opportunity cost because the farmer owns the land. E. The market price of the land used to grow the wheat. Answer 2.9: A The cost if the value of the next best opportunity. Brealey and Myers use the same definition when calculating the net present value of a series of cash flows (corporate finance course). Question 2.10: Economic Costs

12 Which of the following best describes the cost of growing wheat? A. The time and raw materials used to grow wheat. B. The alternative uses of the time and raw materials used to grow wheat. C. The monetary value of the time and raw materials used to grow wheat. D. The market price of wheat. E. All of the above represent different types of cost used by economists. Answer 2.10: B Question 2.11: Efficient Suppliers When are you considered to be the most efficient at producing food? A. When your absolute cost of producing food is less than that of producing other goods. B. When your relative cost of producing food is less than that of producing other goods. C. When your absolute cost of producing food is less than others cost of producing food. D. When your relative cost of producing food is less than others cost of producing food. E. When the market price of the food you produce is lower than the market price of the food that others produce. Answer 2.11: D This question discusses relative efficiency. The cost of the resources is their alternative use. Think of the cost of producing food as the amount of clothing (or other products) that could be produced with the same time and resources. See the question below about food and clothing in Asia and America. Question 2.12: Benefits of Trade When do people benefit from trade? A. When they have different abilities. B. When they have different tastes. C. When they have different abilities or different tastes. D. When they have different abilities and different tastes. E. It is always beneficial to trade. Answer 2.12: C Illustration: Jacob excels at growing grapes and making wine; Rachel excels at baking bread. Jacob likes bread, and Rachel likes wine. Both Jacob and Rachel gain in Jacob makes wine, Rachel bakes bread, and they trade. Table for the following illustrative test questions:

13 The table below shows the labor needed in Asia and America to produce food and clothing. Question 2.13: Relative Costs in Asia The cost of producing food in Asia is A. 6 hours of labor B. 3 bushels of food per suit of clothing C. a bushel of food per suit of clothing D. 3 suits of clothing per bushel of food E. a suit of clothing per bushel of food Answer 2.13: D Asia America One bushel of food 6 hours 8 hours One suit of clothing 2 hours 4 hours A suit of clothing takes 2 labor hours to make; a bushel of food takes 6 labor hours to grow. A bushel of food can be traded for 3 suits of clothing. Question 2.14: Relative Costs in America The cost of producing clothing in America is A. 2 bushels of food per suit of clothing. B. ½ bushel of food per suit of clothing. C. 2 suits of clothing per bushel of food. D. ½ suit of clothing per bushel of food. E. Four hours of labor. Answer 2.14: B A suit of clothing takes 4 labor hours to make; a bushel of food takes 8 labor hours to grow. A bushel of food can be traded for 2 suits of clothing, so a suit of clothing can be traded for half a bushel of food. Question 2.15: Production Efficiency Which continent is more efficient in producing food and which continent is more efficient in producing clothing? A. Asia is the more efficient producer of both food and clothing. B. America is the more efficient producer of both food and clothing. C. Asia is the more efficient producer of food, and America is the more efficient producer of clothing.

14 D. America is the more efficient producer of food, and Asia is the more efficient producer of clothing. E. Both countries are equally efficient producers of food and clothing. Answer 2.15: D One bushel of food is 3 suits of clothing for Asia but only 2 suits of clothing for America, so America is better at producing food and Asia is better at producing clothing. Jacob: Newspapers and magazines say that America is more efficient at producing all goods than many developing countries; even the Wall Street Journal says this. Rachel: Economists speak of relative efficiency; journalists speak of absolute efficiency. Question 2.16: Benefits of Trade When can trade benefit both Asia and America? A. When Asia specializes in food production, and America specializes in clothing. B. When Asia specializes in clothing production, and America specializes in food. C. The countries can not gain from trade, because Asia has the lower costs of production for both food and clothing. D. The countries can not gain from trade, because America has a comparative advantage in the production of both goods. E. Trade benefits both countries regardless of who produces what. Answer 2.16: B Asia is better at producing clothing and America is better at producing food; they can trade to get the goods that they want to consume. Final Exam: Expect a question on comparative advantages on the final exam, comparing countries, states, or individuals. See also the practice problems and the homework assignments for additional examples of what you can expect on the final exam. Jacob: Would economists say that trade between the U.S. and India helps both nations, even though one country has much lower wages than the other? Rachel: Yes; despite the disparity between the two nations, they are relatively efficient in different products, and they both gain from trade. Jacob: So why is out-sourcing such a volatile issue if everyone gains?

15 Rachel: Out-sourcing causes some temporary problems, as nations adjust. It is a volatile political issue; very few economists say that out-sourcing is bad. Those who do say it is bad are often writing politically motivated pieces to criticize business.

16 Microeconomics, Module 3, Consumers Behavior Illustrative Test Questions (The attached PDF file has better formatting.) Updated: December 21, 2006 Question 3.1: Indifference Curves Which of the following is the same for all points on an indifference curve? A. The level of satisfaction obtained from consumption. B. The prices faced by consumers. C. The consumer s income. D. Level of satisfaction and prices, but not income. E. Level of satisfaction, prices, and income. Answer 3.1: A An indifference curve means the consumer is indifferent between any two points on the curve. Items B and C: The product prices and the consumer s income affect the budget line, not the indifference curve. Question 3.2: Properties of Indifference Curves Which of the following is not a property of indifference curves representing a consumer s tastes between bread and wine? A. Every combination of bread and wine is on one and only one indifference curve. B. No two indifference curves cross. C. The indifference curves are downward sloping. D. The indifference curves are concave. E. The indifference curves reflect the marginal utility of goods. Answer 3.2: D The indifference curves for bread and wine are convex, since both goods provide utility to the consumer. Indifference curves are concave only if one of the axes is an economic bad, not an economic good. Jacob: If we use the terms concave upward and concave downward, which is convex?

17 Rachel: The term concave means concave downward; the phrase concave upward means convex. Jacob: What an example of a downward sloping, convex curve? Rachel: For most numerical problems, we use curves like X * Y = K, where K is a constant, and X and Y are the quantities of the two goods. 2! A downward sloping curve has a negative first derivative: Y = K/X Y/ X = K/X ! A convex curve has a positive second derivative: Y/ X = +2K/X. Jacob: Why must the curve be convex? Rachel: Let the two goods be bread and wine, for which an indifference curve is B W = 16. The following points all lie on this indifference curve: Bread Wine Wine Utility ! If the consumer has only 1 loaf of bread, he is hungry, and he is willing to give up 8 flasks of wine to get a second loaf of bread.! If the consumer has 7 loaves of bread, he has as much bread as he can eat, but only 2 flasks of wine. To get another loaf of bread, he willing to give up only 0.29 flasks of wine. The convex indifference curve is the same concept as decreasing marginal utility. Question 3.3: Marginal Values If the marginal value of a loaf of bread is half a flask of wine, then A. Half a flask of wine makes the consumer better off than one loaf of bread.

18 B. The consumer is indifferent about trading one loaf of bread for half a flask of wine. C. Wine provides half as much satisfaction to the consumer as does bread. D. The consumer s optimum contains twice as much bread as wine. E. The market price of bread is half the market price of wine. Answer 3.3: B Jacob: From the previous question, it seems that the marginal utility of a good depends on how much of the good the consumer now has. Rachel: Correct; the marginal utility depends on two items: (i) the tastes of the consumer and (ii) how much of the good the consumer now has. Illustration: Suppose Jacob likes bread but doesn t care much for wine, and Rachel likes wine but doesn t care much for bread. One is tempted to say that Jacob s marginal utility of bread in terms of wine is greater than Rachel s. Yet if Jacob now has 10 loaves of bread and only a few drops of wine, and Rachel has 10 flasks of wine but only a few crumbs of bread, Jacob may be willing to exchange more bread for a cup of wine that Rachel. Jacob: That s a nice illustration, but I don t presume it is realistic. If someone likes bread more than wine, he or she would generally exchange less bread for a cup of wine. Rachel: If consumers are at their optimal consumption points, their indifference curve is tangent to their budget line. The slope of the budget line depends on the market prices of the two goods, which does not differ by consumer, so the slopes of their indifference curves at their equilibrium points does not differ. The upshot is that all consumers have the same marginal utility of bread in terms of wine if they are all at their optimal consumption points. Question 3.4: Constant Marginal Value If the consumer s marginal value is constant, then A. There is no optimum purchase for the consumer. B. The consumer s indifference curves are concave instead of convex. C. The consumer s indifference curves are straight lines. D. The possibility of corner solutions is eliminated. E. Utility maximization occurs anywhere along the budget line. Answer 3.4: C The marginal value is the slope of the indifference curve; if the marginal value is constant, the indifference curve is a straight line. Jacob: We said above that indifference curves are convex; how can they be straight lines?

19 Rachel: In practice, indifference curves are not straight lines; this question is heuristic only. If the marginal value of a flask of wine is four loaves of bread and the consumer has $100:! If the price is $2 for a loaf of bread and $10 for a flask of wine, the consumer buys 50 loaves of bread and no wine (corner solution).! If the price is $2 for a loaf of bread and $5 for a flask of wine, the consumer buys 20 flasks of wine and no bread (corner solution).! If the price is $2 for a loaf of bread and $8 for a flask of wine, any combination of bread and wine gives the same utility (statement E). Question 3.5: Slope of the Budget Line Good X is on the horizontal axis and good Y is on the vertical axis in the consumer-choice diagram. P X denotes the price of good X, P Y denotes the price of good Y, and I is the consumer s income. The slope of the budget line is A. P X / P B. P X / PY C. P Y / PX D. I / P X E. I / P Y Y Answer 3.5: A Jacob: How do we choose which good is on the vertical axis and which is on the horizontal axis? Rachel: In practice, the good in question is on the horizontal axis and the vertical axis is a basket of all other goods. The final exam questions use two goods, such as bread and wine, and they explicit say which one is on the vertical axis. Question 3.6: Steepness of Budget Line Good X is on the horizontal axis and good Y is on the vertical axis in the consumer-choice diagram. Which of the following can make the budget line steeper? A. A rise in the consumer s income. B. A rise in the consumer s marginal value of X in terms of Y. C. A rise in the consumer s marginal value of Y in terms of X. D. A rise in the price of good X. E. A rise in the price of good Y. Answer 3.6: D

20 Jacob: Does a rise in the price of X mean that inflation causes the price of X to be $11 instead of $10? Rachel: Inflation is a monetary phenomenon; it affects the purchasing power of the dollar (or other currency unit, such as Yen or Euro), not the prices of goods. Prices are in real terms, or the price of X in terms of units of Y. Suppose X costs $10 in 20X7 and $11 in 20X8.! If the dollar price of Y rises from $5 to $6.00, the price of X has decreased.! If the dollar price of Y rises from $5 to $5.25, the price of X has increased. For this question, a decline in the (relative) price of Y means the same as a rise in the (relative) price of X. Question 3.7: Optimizing Welfare Suppose the consumer spends all of his or her income. If P X/ P Yis larger than the marginal value of X in terms of Y, the consumer A. Will be better off if he purchases more X and less Y. B. Will be better off if he purchases more Y and less X. C. Will be better off if he purchases more of both goods. D. Cannot make himself better with any change in his purchases. E. Has an incentive to work more and buy more of goods X and Y. Answer 3.7: B P X / P Y is the negative of the slope of the budget line; the marginal value of X in terms of Y is the negative of the slope of the indifference curve. At the equilibrium point, the slope of the budget line equals the slope of the indifference curve, since the two curves are tangent. Since the slopes are not equal here, the consumer is not at the optimal point (the equilibrium point). To see if the consumer should buy more of X or more of Y, let s use a numerical example. Suppose the price of a loaf of bread is $2 and the price of a flask of wine is $1, and the consumer would exchange one loaf of bread for one flask of wine. The consumer can buy one less loaf of bread and one more flask of wine and have the same overall utility. But the consumer has gained a dollar, since the one less loaf of bread saves $2 and the one more flask of wine costs $1. With the extra dollar, the consumer can buy another flask of wine and have more total utility. Jacob: Does this only work for consumers who are indifferent between bread and wine, or for consumers who prefer wine to bread? What about consumers who much prefer bread to wine?

21 Rachel: The consumer s preference depend on how much bread and wine he now has. Even a consumer who much prefers bread to wine may be indifferent between them if he already has 10 loaves of bread and only 1 flask of wine. We should not speak about absolute preferences, for two reasons:! The preference for wine in terms of bread depends on how much wine and bread the consumer now has.! Units of wine and bread are not comparable. A consumer may prefer a large loaf of bread to a small flask of wine but a large flask of wine to a small loaf of bread. For most economic relations, we use elasticities, which are unit-less; we discuss these later. Question 3.8: Marginal Value If Jacob s marginal value of bread is 50 per loaf, then A. Jacob places a value of 50 on his last loaf of bread. B. Jacob will not buy any bread unless the price is lower than 50 per loaf. C. Jacob is willing to pay an average of 50 per loaf of bread. D. Jacob is willing to trade away all his bread in exchange for 50 per loaf. E. Jacob s utility increases by 50 when he buys a loaf of bread. Answer 3.8: A The marginal value is the value of the last unit, the last loaf of bread. By decreasing marginal utility, if the last loaf of bread is worth 50, each previous loaf is worth more than 50. Question 3.9: Corner Solutions Suppose bread is on the horizontal axis and wine is on the vertical axis. Consider a corner solution in which the consumer buys only wine and no bread. At this optimum, the relative price of bread in terms of wine A. Is strictly less than the marginal value of bread in terms of wine. B. Is less than or equal to the marginal value of bread in terms of wine. C. Is equal to the marginal value of bread in terms of wine. D. Is greater than or equal to the marginal value of bread in terms of wine. E. Is strictly greater than the marginal value of bread in terms of wine. Answer 3.9: D The budget line can be steeper than the indifference curve at a corner solution. If the price of bread in terms of wine were less than the marginal value of bread in terms of wine, the

22 consumer would exchange some of the wine for bread. Jacob: Are corner solutions common? Rachel: Suppose Leah doesn t drink alcohol; she spends all her income on bread. Question 3.10: Indifference curves and Consumer s Optimum A consumer s indifference curves are downward sloping, but they are concave (bowed away from the origin) instead of convex, because the two goods are economic bads (they are harmful, like pollution or taxes). What can be said about the consumer s optimum? A. The consumer s optimum is always a corner solution in this situation. B. The consumer s optimum does not exist, because there is no tangency in this situation. C. The consumer s optimum is at the tangency between the indifference curve and the budget line, and the indifference curve lies below the budget line. D. The consumer s optimum is at the tangency between the indifference curve and the budget line, and the indifference curve lies above the budget line. E. The consumer has two optima: one at the tangency and one at a corner solution. Answer 3.10: C Jacob: We said that indifference curves are convex, not concave; what s happening here? Rachel: The indifference curve is downward sloping and convex if the two goods are desired by the consumer; it is downward sloping and concave if neither good is desired. Suppose the two items on the indifference curve are air pollution and water pollution, which are measured by number of particles per cubic meter of air or water. Small amounts of pollution are hardly noticeable; moderate amounts are tolerable; large amounts ruin the quality of life. A consumer may be indifferent among may be indifferent among the following baskets: Air Pollution Water Pollution

23 This curve is concave, not convex. The budget line is the price of curtailing pollution. The units of air pollution and water pollution are the units of pollution-reducing devices that we buy. For this illustrative test question, assume that each unit has the same effect. These units might be exhaust filters placed on cars or water filters placed in streams. For economic goods, we want to be on the highest indifference curve. For economic bads, we want to be on the lowest indifference curve. The optimal point is the point of tangency between the indifference curve and the budget line, but this budget line lies above the indifference curve. Jacob: Graphically, what are we doing? Rachel: When we shift from an economic good (like bread and wine) to an economic bad (like air and water pollution), we flip the indifference curve.! If the economic good or bad is along the vertical axis, we flip the indifference curve upside down.! If the economic good or bad is along the horizontal axis, we flip the indifference curve right to left. Flip a downward sloping, convex curve twice upside-down and right to left makes it downward sloping and concave. Jacob: What if we have one economic good and one economic bad? An example is amount of insurance along the horizontal axis (an economic good) and premium along the vertical axis (an economic bad). Rachel: We flip the indifference curve up-side down. Downward sloping and convex becomes upward sloping and concave. Jacob: Why is this important for actuaries? Rachel: You will use indifference curve analysis for later actuarial exams and perhaps at work. The horizontal axis is the amount of coverage, which is an economic good. The vertical axis is the premium for the policy, which is an economic bad. The intuition for indifference curve analysis is explained by Landsburg, but the slope and concavity of the lines change. Question 3.11: Changes in Relative Prices Recently, the price of bread has risen from $4 to $6 per loaf and the price of wine has fallen from $8 to $6 per flask, while Rachel s income has stayed fixed at $48 per week.

24 After the prices change, Rachel adjusts her buying habits and starts buying 4 loaves of bread and 4 flasks of wine weekly. We can conclude that A. Rachel is indifferent about the price changes. B. Rachel is worse off after the price changes. C. Rachel is better off after the price changes. D. Rachel may be worse off, better off, or indifferent after the price changes. E. Rachel may be better off or indifferent after the price changes, but not worse off. Answer 3.11: B Before the price change, Rachel could have bought 4 loaves of bread and 4 flasks of wine weekly, but she chose to buy some other combination. Her utility after the price change is lower than her utility before the price change. Jacob: The mathematics is not hard, but I don t see the intuition; what is happening here? Rachel: In an economy with two goods, a change in prices that is not the same for both goods causes a relative price increase for one good and a relative price decrease for the other good. Let B be the basket of goods bought before the price change and B be the basket of goods bought after the price change. One of three scenarios is true: the consumer can afford 1. both B and B before the price change but only B after the price change. 2. both B and B after the price change but only B before the price change. 3. only B before the price change and only B after the price change.! In scenario 1, the consumer is better off before the price change.! In scenario 2, the consumer is better off after the price change.! In scenario 3, we can t say if the consumer is better off or worse off. Question 3.12: Inflation Indices If an economist uses consumers 1980 purchases to track increases in the cost of living between 1980 and 2000, then increases in the cost of living will be A. Accurately measured. B. Overstated. C. Understated. D. Overstated if inflation is positive; otherwise understated. E. Overstated if inflation is negative; otherwise understated. Answer 3.12: B

25 The Laspeyres index overstates inflation, assuming consumers buy more a good when its relative price falls and less of a good when its relative price rises. Whether inflation is positive or negative depends on growth in the money supply and other macroeconomic factors, not the relative prices of goods. The final exam does not ask you to compute Laspeyres and Paasche indices, but you must know the qualitative aspects. Past Course 2 problems tested computation of the indices, since past editions of the Landsburg text and the current Wachtel text show the computation. You can expect a problem on computing these indices on the CAS transition exam. Jacob: The solution says that the Laspeyres index overstates inflation, assuming consumers buy more a good when its relative price falls and less of a good when its relative price rises. The Landsburg text does not have this qualification; why not? Rachel: The law of demand says that consumers buy more a good when its relative price falls and less of a good when its relative price rises. This statement should always be true. Question 3.13: Income Tax and Head Tax Consider a head tax and an income tax that generate the same tax bill for the consumer. Which tax causes the greater reduction in the consumer s welfare? A. The head tax. B. The income tax. C. The two taxes have the same effect on the consumer s well being. D. Either tax could cause the greater reduction in welfare, depending on the consumer s tastes for leisure and income. E. Either tax could cause the greater reduction in welfare, depending on the consumer s elasticities for leisure and income. Answer 3.13: B The income tax distorts the marginal value of leisure vs consumption; the head tax does not. Jacob: Is this saying that consumers prefer a head tax to an income tax? That is not true. A head tax (or poll tax) is the same for all citizens, whereas an income tax depends on earnings. If the total tax collected is the same, high income earners prefer the head tax and low income earners prefer the income tax. This is even more true if the income tax is progressive. Rachel: Both Landsburg and Barro discuss this topic, with the same conclusions. Questions on income taxes and head taxes may be asked on both final exams. (Barro does not use the term head tax, but he discusses this concept.) The comparison that Landsburg makes is as follows:

26 ! Determine the tax each person would pay under an income tax. Suppose the income tax is 60% of earnings. An physician providing cosmetic surgery and making $400,000 a year would pay $240,000 in tax; a cab driver making $20,000 a year would pay $12,000 in tax. Let us suppose that we can estimate the tax each person would pay.! Instead of the income tax, we say to the physician: You will pay $240,000 in tax this year, no matter how much you earn, and we say to the cab driver: You will pay $120,000 in tax this year, no matter how much you earn.! Suppose cosmetic surgery costs $10,000 and a cab ride costs $10. With the income tax, the physician kept $4,000 from every surgery. If an hour of leisure time was worth $1,000, the physician performed surgeries that took 4 hours or less. With the head tax, the physician keeps $10,000 from every surgery, and performs surgeries that take 10 hours or less.! Suppose a cab ride costs $10. With the income tax, the cab driver kept $4 from every cab ride. If an hour of leisure time was worth $10, the cab driver gave rides that took 20 minutes or less. With the head tax, the cab driver keeps $10 from every cab ride, and gives ride that take an hour or less. Both the physician and the cab driver are working more, earning more money, and are happier. Jacob: How do you know they are happier? They have less leisure time now. Rachel: The physician and the cab driver work only on those surgeries or cab rides that are worth more than the leisure time given up. We can also see this in the aggregate. Both the physician and the cab driver could work the same hours as before and earn the same income. Since they choose to work more, they must be happier working more. Jacob: The income tax in this illustration is not progressive; the tax rate is 60% for both the physician and the cab driver. What happens if we use a progressive income tax? Rachel: Nothing in the illustration depends on the tax rate so nothing changes. Jacob: Do we see this phenomenon in real life? Rachel: One sees this in a thousand ways, in ways that are so clear they are impossible to deny. But because governments are so dependent on more and more taxes every year, and because people want the benefits of government programs and hate to see others benefit from tax reductions, it is politically difficult to reduce tax rates. Jacob: What will happen? Rachel: No one can predict the future with certainty. What we see happening is that the economies of high tax rate countries (France, Germany, Switzerland) begin to fail, and the economies of low tax rate countries (Hong Kong, Singapore) perform better. High tax rate countries must either lower tax rates (Ireland, U.S.) or drift into oblivion.

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28 Microeconomics, Module 3: The Behavior of Consumers Illustrative Test Questions (The attached PDF file has better formatting.) Updated: May 31, 2005 Question 3.1: Indifference Curves All but which of the following are true regarding indifference curves? A. An indifference curve is a locus of points that are equally desirable to the consumer. B. Indifference curves for a single consumer cannot cross. C. Indifference curves for a single consumer are always parallel. D. A single consumer has an infinite number of indifference curves. E. Indifference curves for two goods are downward sloping. Answer 3.1: C Know the four attributes of indifference curves in A, B, D, and E, and know that indifference curves are not necessarily parallel. Question 3.2: Budget Lines All but which of the following are true regarding budget lines? A. Points to the left and below the budget line are within the consumer s budget. B. The slope of the budget line is the negative of the relative prices of the two goods. C. Budget lines for two economic goods slope downward. D. Each consumer has an infinite number of budget lines that cover the plane. E. All of A, B, C, and D are true. Answer 3.2: D Each consumer has a single budget line and an infinite number of indifference curves that cover the plane. Question 3.3: Budget lines and Inflation Suppose all prices and the consumer s income drop 10% because of deflation in the economy. How does the consumer s budget line change?

29 A. The budget line shifts upward. B. The budget line shifts downward. C. The budget line shifts to the right. D. The budget line shifts to the left. E. The budget line does not change. Answer 3.3: E The relative prices of the goods and the real income have not changed. Jacob: What are the rules for changes in the budget line and indifference curves? Rachel: If the relative prices of the goods do not change, the slope of the budget line does not change. The budget line moves outward (upward, rightward) if the income in real terms increases; it moves inward (downward, leftward) if the income in real terms decreases. Illustration: A loaf of bread costs $1.50, a flask of wine costs $6.00, and income is $24.! If a loaf of bread changes to $2.00 and a flask of wine changes to $8.00, the slope of the budget line does not change. If income increases to $30, real income decreases; the budget line moves inward. If income increases to $40, real income increases; the budget line moves outward. If the relative prices of the goods change, the slope of the budget line changes. If income increases or decreases for each of the goods in real terms, utility increases or decreases. Illustration: A loaf of bread costs $1.50, a flask of wine costs $6.00, and income is $24.! If a loaf of bread changes to $2.00 and a flask of wine changes to $9.00, wine becomes more expensive in terms of bread and the slope of the budget line changes. If income increases to less than $32, real income decreases, and the budget line moves inward. If income increases to more than $36, real income increases, and the budget line moves outward. If income increases to between $32 and $36, we cannot say if real income has increased or decreased, since the new budget line intersects the old budget line. Jacob: So we can t say if the consumer is better or worse off? Rachel: The consumer is either better off or worse off, but we need more information to say which occurs. On the final exam, you may be given the basket of goods the consumer buys before and after the price change. Suppose the consumer buys Basket A before the price change and Basket B after the price change.

30 ! If the consumer could have bought Basket B before the price change as well, but instead bought Basket A, the consumer is worse off after the price change.! If the consumer could have bought Basket A after the price change as well, but instead bought Basket B, the consumer is better off after the price change. Jacob: Is one of these two scenarios always possible? Rachel: No; often the consumer could buy Basket A but not Basket B before the price change and Basket B but not Basket A after the price change. To see if the consumer is better off, we must know the exact indifference curve. Exercise 3.4: Bread and Wine Budget Line The budget line shows the combinations of bread and wine a consumer can buy. A loaf of bread costs $2.00, a flask of wine costs $8.00, and the consumer s income is $120. A. The slope of the budget line is B. The slope of the budget line is C. The slope of the budget line is D. The slope of the budget line is E. None of A, B, C, or D is true. Answer 3.4: B (The slope is P / P.) x y Exercise 3.5: Bread and Wine Budget Line