EC155e mid term of March 5, 2014 SOLUTIONS

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1 EC155e mid term of March 5, 2014 SOLUTIONS Question 1 Define four of the following terms. (No extra credit for answering all five.) See the definitions in our textbook. A few additional notes here: 1) Substitutes and complements You had to say something about the relationship between price and quantity. E.g., if when the price good A goes up then quantity demanded for good B goes up, they are substitutes. 2) Comparative advantage You had to say something about opportunity cost 3) The law of supply 4) Positive and normative economics 5) Income elasticity of demand You had to show an understanding of the ratio: as income goes up, quantity demanded changes... Question 2 Two cities can produce the following goods, as follows: In New York, it takes 20 minutes to produce 3 pants and 30 minutes to produce 2 shirts In Barcelona, it takes 40 minutes to produce 3 pants and 60 minutes to produce 2 shirts 1) Who has the absolute advantage in pants? In shirts? Under these circumstances, can these cities both gain from trade? Why or why not? You wanted to set up a table like this:

2 Production/two hours Pants Shirts NY 18 8 Barc. 9 4 NY clearly has the absolute advantage in both (18 > 9, 8 > 4). Since the opportunity costs are the same in each city 18/8 = 9/4 neither has a comparative advantage. 2) Now imagine that a new technology is imported into Spain; workers in Barcelona can now double their shirt production per unit of time. Under these new circumstances, who has the comparative advantage in pants? In shirts? Justify your answers. You now should have a table that looks like this Production/two hours Pants Shirts NY 18 8 Barc. 9 8 Barcelona intuitively must have the c.a. in shirts, as they can no produce more per unit of time and nothing else has changed in either city. The opportunity costs confirm this: Opportunity costs (in fractions of the other good) Pants Shirts NY 4/9 9/4 Barc. 8/9 9/8 SInce 4/9 < 8/9, NY has the c.a. in pants; since 9/8 < 9/4, Barc. has the c.a. in shirts. 3) Using the PPF model, show the gains from trade under these new circumstances. Illustrate carefully on your graphs who exports and imports each of the two goods. Remember as we saw in Chapter 3 that since the o.c. s here are constant (see above), the PPFs in cases like this are straight. Many of you drew concave PPFs,

3 which is only true when the o.c. s change, as they did in our biking typing exercise. So for this question, you need to pick a trading price that is between the opportunity costs that s how we get gains from trade, as we saw in Chapter 3 and then create two diagrams. So let s set a price of 1.5 trading 1.5 pants for every one shirt, a fraction that is between 9/8 and 9/4. Then let s say that the cities agree to exchange 6 pants for 4 shirts.

4 4) After trade, can we say exactly how much each city will consume of each good? Why or why not? No, because we do not know what price in the range between the two opportunity costs will be the equilibrium. As many of you pointed out, this will depend on the demand in each country (which will in turn determine relative prices) Question 3 Production and consumption of maple syrup a delicious sweetener that comes from the sap of maple trees are very common in Vermont. It is produced in the early spring ( mud season ) from full grown trees and consumed year round. a) Imagine that the demand and supply for pints of syrup among three suppliers and three consumers are as follows: Consumer A Consumer B Consumer C $ $

5 $ $ $ $ $ $ Producer X Producer Y Producer Z $ $ $ $ $ $ $ $ Based on these data, what is the market demand schedule for maple syrup? What is the market supply schedule? For this problem you just need to add up the three demand and supply schedules, respectively, to get the market demand and supply. Just about all of you got this. b) Using our supply and demand graphical model, plot supply and demand based on the data above. Carefully label the market equilibrium and explain why it is the market equilibrium. Plotting this data showed the equilibrium of (40, $25). Again, most of you got this. c) In January 2014, researchers at the Proctor Maple Research Center at the University of Vermont announced the discovery of a new technique that extracts the sap out of maple saplings. According to recent press coverage, the new technique would allow more maple syrup to be produced on less land. Using a graphical model, show how this discovery is likely to affect the supply of maple syrup. Show demand and supply in a clear graph, with supply then shifting out because of better technology

6 d) Timothy Perkins, the Director of the Proctor Center, recently stated that he doesn't expect the new technique to reduce the price of maple syrup in the short run. Under what circumstances would he be right? How is the price of maple syrup likely to change in the long run as a result of this new technique? Is this change likely to increase revenues for producers? Justify your answers. The price of syrup may not go down in the short run: the suppy curve does not shift out a lot (it will take time to benefit from the technology; the saplings still must grow); and/or the demand for syrup is very elastic (e.g., close to a zero slope line in the relevant range; this would be true, by the way, if consumers have many substitutes for maple syrup.) In the long run, the price is likely to go down, for all the reasons we have discussed. Revenues: as is so often true, it depends on the elasticities! Question 4 a) On a Saturday night, Juan says that he will spend $20 on pizza, no matter what the price per slice. Cheryl says she will buy three slices, no matter what the price per slice. What is each of their elasticities of demand for pizza slices? Justify and illustrate your answers. Juan has unitary elasticity: p * q always equals 1 (see Mankiw, p. 93, Figure 1 for the graph.) Cheryl s demand is perfectly inelastic: three no matter what the price, a perfectly vertical line. Few of you got the first; most f you got the second. b) When the price of a good is raised from $90 to $110, the quantity demanded of the good declines by 5%. If the producer of this good wants to increase revenues, should she raise prices, lower prices, or do nothing or is it not certain? Using the elasticity formula (Mankiw, p. 92), you can show that the elasticity of demand is 0.25, which is < 1. So since demand is relatively inealstic, she should raise prices (Mankiw, p. 95.) c) Imagine that demand and supply for a good are neither perfectly elastic not perfectly inelastic. Before the imposition of a tax, the equilibrium price for the good is $ After the imposition of a $2.00 per unit tax, will the new equilibrium price for consumers be greater than, equal to, or less than $12.00 or is it not certain? You can show that each side consumer and producer will bear some of the burden of the tax and that the new price will be less than $12 (with a diagram like Figures 6. 7, and 8 in Mankiw, Chapter 6.)

7 d) Explain and illustrate why the relative burden of a tax on producers and consumers, respectively, will depend on the relative elasticities of the supply and demand curves, respectively. A good explanation of the material in pp in Mankiw, as reviewed in class.

The total exam is worth 20 points. Each question is worth 2 points, and each sub question is worth an equal share of the two points.

Exam One PPA 723, Fall 2010 Professor John McPeak Name: The total exam is worth 20 points. Each question is worth 2 points, and each sub question is worth an equal share of the two points. 1) The demand