Your Name: SOLUTIONS UM ID Number. Ford School of Public Policy 555: Microeconomics A Fall 2010 Exam 1 October 6, 2010 Professor Kevin Stange

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1 Ford School of Public Policy 555: Microeconomics A Fall 2010 Exam 1 October 6, 2010 Professor Kevin Stange This exam has 8 questions and spans the topics we have covered so far in the course. Please explain your answers when asked and show your work. It is in your best interest to show each of your steps clearly in order to receive partial credit and so that you are not penalized in later parts for math mistakes in earlier ones. You have 80 minutes to complete the exam. Each question indicates the points each question is worth you should use this as a guide to the number of minutes you can spend on each question. The points sum to 85, so 5 points are bonus. Good luck! Short Answer 1. [3] True or False: The income effect associated with a price increase of a good will cause consumption of that good to always decrease. Briefly explain your answer. False. The income effect of a price increase will cause a decrease in consumption only if the good is a normal good. It will have the opposite effect if the good is an inferior good. 2. [3] True or False: The substitution effect associated with a price increase of a good will cause consumption of that good to always decrease. Briefly explain your answer. True. The substitution effect associated with a price increase (the change in consumption associated with the relative price change holding utility constant) will always cause people to shift away from the good that has become relatively more expensive. 3. [3] Fill in the blank: The income elasticity of demand is the percent change in quantity demanded associated with a one percent increase in income. 1

2 4. [3] Ann Arbor is considering levying a $.10 tax on each bottle of soda. Each year, 20,000 bottles of soda are purchased in the city. Given this information, the City Health Department projects that the city will take in $2,000 of revenue annually from this tax. Do you agree with this analysis? Why or why not? No. The calculation doesn t take account of the behavioral response of consumers to the tax. By making soda relatively more expensive, the tax will cause the amount of soda purchased to decrease (assuming soda is not a Giffen good). The revenue raised will thus be less than $ [3] Atur only consumes two goods: Coffee and Antacid. Given his current level of consumption of these two goods, his marginal utility for Coffee is 20 and his marginal utility for Antacid is 5. The price of Coffee is $4.00 and price of Antacid is $2.00. Is Atur consuming the optimal amount of each good? If no, then how, in words and not math, could he adjust his consumption to reach optimality? Assume that Atur has diminishing marginal utility for all goods. C A Atur is not consuming the optimal bundle. At the optimum, but given the current PC PA C 20 A 5 bundle 5 and 2.5. Since these are not equal, we know that Atur is PC 4 PA 2 not at the optimal. What should he do? He can be made better off by shifting to a bundle with more coffee and less antacid. This would decrease C while increasing A, given the assumption of diminishing marginal utility for all goods. Note that you do not need to know Atur s income to answer this question. 6. [5] Consolidation in the airline industry has lowered airlines labor costs. At the same time, the closing of several major rail routes has increased the price of long distance train tickets. Together, what will these changes do to the quantity and price of airline flights in equilibrium? Circle all that apply and illustrate with a graph. a. Increase quantity definitely P b. Increase or decrease quantity c. Decrease quantity definitely d. Increase price definitely e. Increase or decrease price P1* f. Decrease price definitely P2* S1 S2 D1 D2 Q1* Q2* Q 2

3 7. Supply & Demand. This question asks you to use supply and demand analysis to study the market for human organs. Suppose that without any regulation of the market, the supply of kidneys available for transplant would be given by Q S = 20+3P and the demand for kidneys would be given by Q D = 100 P. There are obviously many important ethical and legal aspects to organ transplant and donation ignore these for now and focus on the economics. a. [5] Draw the supply and demand curves in the space below. Label all intercepts and slopes. Be sure to indicate which line is the supply curve and which line is the demand curve. Your graph does not need to be to scale. P 100 Slope= 1/3 S P* Slope= 1 D 20 Q* 100 Q b. [5] What is the equilibrium price and quantity of kidneys? Label these P* and Q* on your graph. QS QD 20 3P 100 P 4P 80 P* 20 Q* 80 c. [5] At this equilibrium price and quantity level, what is the price elasticity of demand? Interpret this price elasticity (describe in words what it means). QP 20 D ( 1).25 PQ 80 This means that a one percent increase in the price of kidneys is associated with a 0.25 percent decrease in demand. Demand is thus relatively inelastic to price. 3

4 d. [5] Which is more price elastic, supply or demand? What does this mean? QP 20 s (3) 0.75 PQ 80 Supply is more elastic (responsive to prices) than demand. This means that when there is a price change, supply will adjust much more than demand. A one percent increase in the price of kidneys is associated with a 0.75 percent increase in supply. Notice that your answer to this question will not depend on the price and quantity chosen. Supply is three times as elastic as demand at any price/quantity. e. [5] In response to ethical and other concerns, most governments have banned the sale of kidneys and rely exclusively on organ donations. Given the above demand and supply equations, how many kidneys would be donated if selling them were outlawed, forcing the price to zero? [Assume no illegal market for kidneys arises]. Banning the sale of kidneys effectively pushes their price to zero. At a price of zero, supply is equal to 20 ( QS 20 3(0) 20 ), so 20 kidneys would be donated. f. [10] Relative to the completely unregulated situation (parts a d), describe qualitatively the consumer and producer welfare (surplus) effects from this policy? Again, ignore noneconomic factors and focus on the issues we ve discussed in class. You can use graphs if that would help you explain your answer, but a precise written answer is fine too. There are four main groups affected by the policy: 1. Consumers (people who need kidneys) that are able to get one of the donated kidneys under the new policy are better off. Previously they paid $20, now they (or their insurer) pay nothing. 2. Consumers who previously were able to buy a kidney but can t now get one because they are in short supply are worse off. These consumers have been rationed out of the market. 3. Producers (people who donate/sell kidneys) who still donate even when the price is zero are worse off because they used to receive $20, but now receive nothing. 4. Producers who previously sold their kidney at a price of $20 but now choose not to participate in the market when the price is fixed at zero are also made worse off. You could have also answered this question by indicating the changes in consumer and producer surplus on the graph, but you didn t need to. 4

5 8. Consumer Choice. Individuals must choose between two goods: health care visits (H) and all other goods (AOG). Initially the price of health care services is P H = $2 and the price of all other goods is normalized to P AOG = $1. Each person s income is $100. a. [5] On the graph below, draw the budget constraint, labeling the intercepts, kink points (if applicable), and slopes. Healthcare is on the x axis. Label this BC 0. b. [10] Megan has a utility function over health care visits (H) and other goods (AOG), described by U(H,AOG) = 15(H) 2 (AOG) 3. How many units of H will she buy? 3 H 30 H( AOG) 2( AOG) MRS 2 2 AOG 45 H ( AOG) 3H PH at optimum: MRS PAOG 2( AOG) PH 2 3H PAOG 1 AOG 3H Substituting this expression into the budget constraint: 100 ( AOG)(1) H (2) 100 (3 H)(1) H(2) 100 5H H* 20, AOG* 60 c. [5] Now suppose health care reformers desired a policy with two goals: i. Get people who don t typically go see the doctor at all (H=0) to get at least one checkup annually (H 1). ii. Allow people who currently spend all of their income on health care (who presumably need more care and would purchase more if they could), to be able to afford more. To do this, they proposed a policy where the first doctor s visit is free, the next ten visits cost $4 each, and any visits beyond eleven cost $1 each. Draw the new budget constraint on the graph below, labeling all intercepts, kink points (if applicable), and slopes. Label this BC 1. AOG 100 Slope=0 (1,100) BC 1 : Slope= 4 (11,60) PH BC 0 : Slope 2 P AOG Slope= H 5

6 d. [5] Does the new policy achieve these two goals? Explain. Yes. Now anyone who would previously have chosen H=0 will obtain at least one unit of H. Since there is no cost to receiving at least one unit of H, the more is better assumption about preferences implies that nobody would choose H=0 under the new policy. Also, people previously in the corner solution at H=50 will see an expansion of their budget constraint and are now able to afford more health care. e. [5] Would you say that people previously choosing a moderate amount of health care (e.g visits) are generally better off, worse off, or unaffected by the policy? Explain. Generally worse off. The budget constraint has shifted dramatically inward (due to the increased price) over this range of H, so they have most likely been made worse off. It is possible that some people previously choosing H=10 will now choose H=1 (for free) and be better off than they were before the policy, but most will probably be on a lower indifference curve as a consequence of the policy. Useful Formulas n m The partial derivative of a function U( X, Y) ax Y with respect to X is where a, n, and m are numbers. U X Y X (, ) n 1 m anx Y 6