Also, big thank you to fellow TA Enoch Hill for edits and some additions to the guide.

Transcription

1 Hello class, once again, here s an unofficial guide to the sample midterm. Please use this with caution, since 1) I am prone to error so incorrect explanations are entirely possible and 2) you should do the midterm yourself first before looking at this guide. Working out problems while looking at solutions will cause you to miss out on the most effective way of learning, which is to struggle through problems by thinking about them. Also, I m not sure about the coverage for this exam. There may be questions here that are not covered this year. I would check with the lecture notes before the midterm as to what the exam coverage will be before freaking out. And even if something you thought you ve never seen before has actually been covered in class, don t freak out either. There s still time to learn it! Hope this helps. Also, big thank you to fellow TA Enoch Hill for edits and some additions to the guide. Kelvin, like the temperature 1) We are given Bucky s indifferent curves, and right away you should make a note that because the indifference curves are right angles, that soda and pizza are perfect compliments. A better way to think about perfect compliments is with the example of right and left shoes. You won t get more utility out of having 2 right shoes and 1 left shoe as if you had 1 left shoe and 1 right shoe, since right and left shoes are perfect compliments. Similarly, in this example, you are told that pizza and soda are perfect compliments (from the graph). Notice that Bucky does not consume at a 1 1 ratio (as you would left shoes and right shoes, assuming you have one left foot and one right foot, of course), but at a 2 pizza for every 6 soda ratio. That means that if Bucky only had 2 pizzas, it does not matter how many soda he has, he will still be as happy as if he had 2 pizzas and 6 sodas (because he is indifferent between any consumption bundles on the indifference curve). So that s what this question is asking, what is a consumption bundle that Bucky is indifferent to having 10 pizzas and 12 sodas? Well, let s look at what choices we are given lie on the same indifference curve. Right after checking A, you should realize that indeed, 4 pizza and 30 soda lie on the same indifference curve. And since anything on the same indifference curve is, well, indifferent to each other in terms of happiness to Bucky, we see that A is the correct answer. 2) First of all, draw Bucky s budget constraint. You can do this by asking yourself, How much soda can Bucky buy if he spent all his income on soda? and also How much pizza can Bucky buy if he spent all his income on pizza? you should get from the answer to these two questions 8 pizzas (Bucky has $24, meaning he can afford 8 pizzas at a price of $3 per pizza) and 24 sodas. So, you have two points on the graph, namely (0,24) and (8,0). Connect these two dots and you should get a line that intersects the corner of the second indifference curve (the second from the origin, that is). Now, we are asked what the opportunity cost of one more slice of pizza equals, this is basically the same question as asking What s the absolute value of the slope of the budget curve? Remember what the slopes are telling you the slope of the budget curve is giving you

2 the opportunity cost of the good on the x axis in terms of the good on the y axis, and the slope of the indifference curve is telling you what the marginal rate of substitution is. Anyway, using the rise over run formula for calculating slope, and since we already have two points on the budget curve, we can calculate the slope to be 24/ 8 = 3 =3. Thus, the answer is C. 3) The optimal consumption bundle is the amount of both soda and pizza that Bucky can afford and brings him the highest utility, or happiness. This means we want the indifference curve that s farthest away from the origin, yet within or on the budget curve. We seee when we drew our budget constraint, it intersected the second indifference curve at exactly one point (the corner point), and that point is our optimal consumption bundle ( 4 pizza, 12 sodas). Thus, the answer is B. 4) We now draw a new budget line by recalculating how much pizza Bucky can get if he spent all his money on pizzas. We know that since the price off sodas did not change, the new budget constraint will still have the point (0,24). We find thatt at $1, Bucky can now buy 24 pizzas. So connect those two dots and we see thatt once again, we have the budget constraint intersecting an indifferencee curve at exactly one point. The change in the quantity demanded, or the optimal quantity of pizza for Bucky, went from 4 when the price was $3 to 6 when the price is $1. Thus, the quantity of pizza went up by 2. The answer is D. 5) So we saw that the price of pizza going from $3 to $11 caused a change in the optimal consumption for Bucky. We see that the quantity of pizzas went up by 2. Now, we want to separate this increase into the income effect and thee substitution effect. To do so, we go to our new budget constraint and shift it down to the original bundle. By shifting, I mean keeping it parallel and moving it back to intersect the indifference curve of the first bundle at exactly one point. Why didd we do this? Well, it s very difficult to separate out the substitution effect from the income effect when there is an increase in demand. The way we can do this though is by assuming that income didn t change, and seeing what the substitution effect is first, and then we can see the income effect. So when you shift the budget constraint back to the original bundle, like this: New bundle (6 pizzas, 18 sodas) Pizza Original bundle (4 pizzas, 12 sodas)

3 In shifting the thick red line (the new budget constraint) back to intersecting the original indifference curve (light red line), we have to be sure that the two (as in the new budget line in dark red and the shifted budget line in light red) are parallel to each other and that the light red line intersects the old indifference curve only at exactly one point. I put exactly one point in bold because you can try and shift the dark red line down (keeping the new line parallel to the dark red one) and have it intersect at more than one point. This is not what we want! To differentiate between the substitution effect and income effect we must have the shift in budget hit the original indifference curve at exactly one point, just like our original dark blue line did. It is only then that we can compare the budget lines correctly. This example may not be a particularly interesting example of this method, but try doing this on some indifference curves with decreasing marginal rate of substitution (refer to the consumer theory worksheet, example 3) and see whether you can use this same method to find substitution and income effect. Doing this separated out the income and substitution effect because now we can compare the blue line with the light red line first for the substitution effect and then the light red line to the dark red line for the income effect. We see that here, because pizza and soda are perfect complements, that the substitution effect did not change the quantity of pizza demanded, since both the blue line and the light red line intersect the indifference curve at the same point. (try other examples where they don t and you can see the substitution effect or look at the lecture notes posted on Moodle Lec 8(iii)) Thus, the substitution effect of price change increases demand for pizza by 0 units. Now, we can look at the income effect. That s basically the change in quantity that was brought forth from going to the light red line (when we held budget to be the same as the blue line) to the dark red line where we factored in the change in income (You may think there was no change in income but because the price of pizza decreased, it s essentially saying you can buy more, which is basically saying your income increased in this case, as reflected by the shift up of the budget curve). Now, we see that we go from the point where the light red line intersects the old indifference curve (at the original bundle) to the point at which the dark red line intersects the new indifference curve (our new bundle). Since we already calculated the change in quantity in question #4, we see that since the substitution effect affected demand for pizza by 0 units, the full change of 2 units of pizza must be caused by the income effect. The answer is D. 6) A cap and trade is not a kind of command and control policy. Cap and trade means having emission allowances traded in a market, such that firms are given incentive to cut down on emissions so they can sell their allowances for a higher revenue, or for firms that can t cut down on emissions easily, they can buy allowances from firms that are selling allowances. A command and control policy is where the regulator comes in and tells the firms what they can emit or how they can be reducing emissions. One s based on a market, the other is based on having a regulator controlling emissions. The other options are true, as you may remember from class or in readings. The answer is A. 7) We know that fixed cost plus variable cost is total cost, and we are given a graph that gives us average total cost and average variable cost. That s enough information, since we can figure out the total cost and variable cost from the averages. Let s just pick an easy to read point, like at a quantity of 2. We see here that average variable cost is $1 and average total cost is $5. Since

4 average total cost is just total cost divided by quantity and average variable cost is just variable cost divided by quantity, and since we picked a quantity of 2, we see that the variable cost is $2 and the total cost is $10 at a quantity of 2. Since total cost = variable cost + fixed cost, or doing some algebra, total cost variable cost = fixed cost, we have that fixed cost = $10 $2=$8. Thus, the answer is E. 8) In the long run, remember that a perfectly competitive firm, which we are given since we are told there are no barriers to entry, has zero economic profit. Thus, this means that total cost = total revenue (since profit = total revenue total cost, and if profit = 0 then 0 = total revenue total cost, or total revenue = total cost). We know that firms are at 0 economic profits when price is equal to the minimum point on the average total cost curve (from lectures and from the text). Otherwise, if the price is higher (or lower), then it will exceed (or not be enough to cover) the cost of the good and there will be profits (or losses). This means firms will enter (or leave) the market (since there are no barriers to entry) and eventually drive profits down (or up) to zero (where the price equals the minimum of the ATC curve). The answer is A. 9) The long run output per firm is then 4, since we found out from the last problem that the equilibrium long run price is 4. Since the firm will produce where marginal revenue = marginal cost, and in the case of a perfectly competitive firm marginal revenue = price, we have that the price = marginal cost when the horizontal line corresponding to $4 intersects the marginal cost curve, and this happens at an output of 4 units. Thus, the answer is E. 10) Since the long run price is $4, then you can see that at $4, D1 is equal to 800. (If you draw a horizontal line from the left graph to the right graph where p=$4, you see that the horizontal line intersects D1 at a quantity of 800 on the graph on the right.) Thus, long run industry quantity is 800. The answer is B. 11) Now, since we found that each firm produces 4 units in the long run, and that the industry quantity is 800, and that each firm has the same technology (this was given in the introduction to the problem), then we know that each firm will produce exactly the same amount and thus we can just take the total quantity in the industry, which is 800, and divide that by the quantity each firm makes, which is 4, to get the total number of firms, which is 200. Thus, the answer is A. 12) Now, we can plot the supply curve on the graph on the right side. We know that there are 200 firms, and we know the marginal cost curve of each firm. So we can just multiply the quantities of each firm by 200 to get the supply curve for the whole industry. After doing that, you see if the demand dropped to D2, that the new intersection with the supply curve is at a price of $2 where the industry quantity is 400. Note that in the short run, producers can t shut down their businesses so there will be losses (negative profits), as you will see in the next question. So, the answer is A. 13) Here, since there are still 200 firms (since it s the short run and firms have not had time to shut down their businesses due to negative profits), we see that each firm is producing 2 units (since the industry quantity decreased to 400, as we saw in the last question, and dividing by 200 firms means each firm produces 2 units). So to find each firm s profit, we need to find both their total revenue and total cost. Total revenue is just quantity sold times price, which in this case is 2 units times $2, which is $4. We can get total cost from the average total cost, which at a

5 quantity of 2 is $5. Since the average total cost is the total cost divided by quantity, if we multiply average total cost by quantity we can get total cost. So $5 times 2 = $10, which is our total cost. Since profit is just total revenue minus total cost, we have $4 $10 which is $6, and thus the answer is A. 14) The market equilibrium, as we have seen so many times now in class, is just where supply equals demand. This takes place at a quantity of T. The socially efficient quantity is S, because that s where the social marginal cost equals the social marginal benefit (which in this case, is the same as the private marginal benefit curve since there are no positive externalities). (Also note that the private marginal benefit curve is the same curve as the demand curve) So, this intersection happens at a quantity of S. Thus, the answer is C. 15) How much tax do we have to charge to get the society to be producing at quantity S instead of T? Well, this sure looks like one of those tax examples we saw a while ago. We can just draw a wedge between C and L and we find that a tax CL will cost society to produce less of the good, moving the quantity from T to S. Thus, the answer is E. 16) Notice that before we had externalities, a tax has dead weight loss and is inefficient. Here, the tax still carries with it a dead weight loss. But it s offset by the gain in surplus due to the negative externalities being reduced. So, the dead weight loss is still the area CLH, but the gain from having less of the negative externalities is the parallelogram VCLH. So, the net gain in surplus is the area VCLH minus the area CLH, and that s the area CVH. The answer is C. 17) (Note: for these types of problem, make sure whether it s saying units/hour or hours/unit! They have very different interpretations! For example, it s better to make 5 cans of spam per hour than 2 cans of spam per hour but worse to make 1 can of spam every 5 hours than 1 can of spam every 2 hours.) It may be very helpful with these types of problem to set up a table first. One to list out what the problem already told you about Robinson and Friday and the other to calculate their opportunity costs of producing oranges and apples. Let me do that first: Apples Oranges Robinson 4 apples/hour 8 oranges/hour Friday 2 apples/hour 1 orange/hour Apples Oranges Robison 2 oranges ½ apples Friday ½ oranges 2 apple The first table is just what was given to us in the problem. The second table calculates their opportunity cost of producing apples or oranges. For example, for Robinson, producing ONE apple means he would need to spend ¼ of an hour, so how many oranges could he have produced had he used that ¼ of an hour to produce oranges? Well, since he can produce 8 oranges per hour, that means that he could have produces 2 oranges in ¼ of an hour. That s why we have 2 oranges listed in the first cell. Notice that his opportunity cost of producing oranges is just going to be the flipped amount of what his opportunity cost of producing apples was. So in this case, since his opportunity cost of producing apples is 2 oranges, the opportunity cost of producing oranges is ½ apples. We do the same thing for Friday and find that his opportunity

6 cost of producing apples is ½ oranges, and flipping ½ we get 2, so the opportunity cost of Friday producing oranges is 2 apples. Now it s plain to see that Robinson has the absolute advantage (we look at the first table for this one, since Robinson can produce more per hour than Friday can for apples. You may see that he can produce more of oranges than Friday can too, so Robinson actually has absolute advantage in both oranges and apples) and Friday has the comparative advantage in apples (we look at the second table for this one, since Friday s opportunity cost is lower than Robison in producing apples. Look at it as Friday not having to give up as much to produce one unit of apple compared to Robinson). Thus, the answer is D. 18) If trade was impossible, then that means Robinson will consume where he can afford to that brings him the highest utility. This happens to be the point where the budget constraint intersected with the second indifference curve (note that while the budget constraint intersected with the first indifference curve, Robinson can do better by consuming more because he can afford to, i.e. it is attainable but not efficient. Then note that if there was no trade, he could not afford to consume anything on the highest indifference curve, i.e. that it s unattainable). Looking at the graph, this point is 10 apples and 20 oranges, so the answer is E. 19) Now, suppose trade is possible. Then we see that Robinson and Friday will both specialize in what they have comparative advantage in. Since Robinson has the comparative advantage in oranges (see the comparative advantage table above) and Friday has the comparative advantage in apples, Robinson will produce 0 apples and 40 oranges and Friday will produce 40 apples and 0 oranges (The question doesn t ask for what Friday produces, but it will come in handy for the next question). Thus, the answer is C. 20) With trade, we see that if Robinson produces 40 oranges and no apples and Friday produces 40 apples and no oranges, then it s basically saying that the budget constraint has changed. You should draw this new budget constraint for Robinson. Now the budget constraint, instead of starting from (0, 40) and going to (20,0), goes from (0, 40) (this doesn t change since we are looking at Robinson, who specialized in oranges in trade) to (40,0) (since Friday produces all apples and thus no oranges). Notice that when there was no trade, Robinson s world could not have 40 apples, since even if he spent all his time making apples, he could only have made 20. In other words, it was unattainable to him without trade. Now that there is trade, Robinson s world could have 40 apples (that point is now attainable), since maybe he could trade all of his oranges for all of Friday s apples (he wouldn t though because of the shape of his indifference curve, but at least it s attainable now). So, connecting the two points (0,40) and (40,0) we get the new budget constraint. Notice that it intersects one of Robinson s indifference curve at exactly one point again. That s his optimal consumption, and thus he will consume 20 apples and 20 oranges (The answer is D). 21) We saw that there are gains from trade in this example, since Robinson s optimal bundle went from 10 apples and 20 oranges without trade to 20 apples and 20 oranges with trade. You can try this for Friday and you will see that he also gains from trade. We never exploited any increasing returns here, and the gains from trade are purely from specialization. Thus, the gains from trade are based on differences in comparative advantage (B).

7 22) At a price equal to $8 (draw a horizontal line at $8), we see that we can calculate the profit of the firm exactly as we would the profit of any firms total revenue minus total cost. Since we are given that this firm is a competitive firm, we know that the marginal revenue is the same as the price, and in this question it s $8. Since a firm will produce where marginal cost equals marginal revenue, that takes place at a quantity of 8 (that s where the horizontal price line, which is also the marginal revenue line, intersects the marginal cost curve). Now, total revenue is just quantity times price, which in this case is 8 times $8 or $64. Notice that $64 corresponds to the area of the square with length 8 as its side (the square that starts at the origin and has sides up the y axis and to the left on the x axis with length 8). Information about total cost can be obtained from the graph as well. At a quantity of 8, the average total cost is $5. Since the average total cost is equal to the total cost divided by the quantity, we can just multiply the average total cost by quantity and we will get the total cost. So, $5 times 8 = $40, and thus $40 is our total cost. Notice that on the graph, the $40 total cost is the area corresponding to the rectangle with length 8 (going from 0 to 8 on the x axis) and height 5 (going from 0 to 5 on the y axis). If you don t see why this makes sense, look at the graph and shade in the square you got from finding revenue and then shade in the rectangle you got from finding total cost. It may help you see why these areas correspond to revenue and cost. Now, the area that s left over is just the profit, since profit = total revenue total cost. This area is the rectangle represented by ACGD, and has an area of 24 (corresponding to a $24 profit). Thus, the answer is D. 23) A, B, and C make sense as to ways to stop people from overusing a common resource. If you privatize it, that will give firms incentive to regulate the good so they can make profits. Taxing will obviously decrease consumption, and regulating will once again help with the resource being overused. However, what does not solve anything is to ask individuals to voluntarily reduce their use of the resource. People respond to incentives, and if there is gain to be made by using a common resource, people will continue to overuse it because it doesn t cost them anything. 24) This is just the definition of a public good. A public good cannot be a rival good because if one person s use prevents someone else from using that good, or reduces its availability for others to use, then it can t be a public good. It also needs to be nonexcludable since no one should be excluded from being able to use the good. Thus, the answer is A. 25) Here, everything but the siren is not a public good. The table on the next page from Wikipedia may help you in understanding the difference between excludable and rival goods.

8 Rivalrous Non rivalrous Excludable Private goods food, clothing, cars, personal electronics Club goods cinemas, private parks, satellite television Non excludable Common goods (Common pool resources) fish stocks, timber, coal, national health service Public goods free to air television, air, national defense Then, a pair of Vikings game ticket is either a private good or a club good, cable television is a club good, and fish stocks is a common good. This means that A, B, and D are either excludable, rivalrous, or both. The only one that s nonrivalrous and nonexcludable is a tornado siren. Thus, the answer is C. 26) When a country is importing, then that means that the goods are cheaper overseas than they are at home. Thus, the consumers benefit because they can now buy cheaper goods. The domestic producers suffer because they are selling less, since everyone is buying from overseas. Thus, the answer is C. 27) This is just from your reading or lecture, the answer is A.