Economics 384 A1. Intermediate Microeconomics II. Review Questions 1. S Landon Fall 2007

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1 Economics 384 A1 Intermediate Microeconomics II Review Questions 1 S Landon Fall 2007 The following questions are intended to help you review the course material as well as to give you some rough idea of the types of questions I may ask on the mid-term exam and the final exam. While some of these questions are more complicated than I would expect you to be able to answer during a time constrained exam, the concepts behind all the questions are potentially relevant for the exams. These examples are not intended to be comprehensive. The exams may include questions that do not appear here or that relate to topics that are not covered here. In thinking about answers to these questions, try to employ the methods and concepts that have been covered in class. The type of answer expected will vary depending on the question. Some answers will involve words only, some will involve words and diagrams, and others may involve simple calculations or algebraic manipulation. Answers should not be overly long and should be to the point. These questions cover sections 1 through 3 of the reading list. I am happy to discuss any of the questions with you, but I would like you to attempt the questions on your own before coming to see me. Notes: a) P&R is an abbreviation for the textbook by Pindyck and Rubinfeld. b) You may not want to spend a huge amount of time working out all the calculations in the questions below, but you should be sure that you understand the concepts and processes involved in solving the questions. Intertemporal Choice 1. P&R, page 574, questions 2, 4, 5 and P&R, page 575, exercises 1, 6a, 6b, 6c and 6e. 3. If the utility of an individual depends on consumption today and consumption in the future, show that the marginal rate of substitution between consumption in these two periods depends on the rate of time preference. 4. An arena takes two years to build at a cost of $1 million in the first year and $500,000 in the second year. It then earns $300,000 a year for each of the next four years after which it is sold for $400,000. If the interest rate is 8 percent, what is the net prevent value of the arena? How would you calculate the internal rate of return of the arena? 5. Using words and a diagram, explain how a change in the market interest rate alters the intertemporal budget constraint. 1

2 6. Using words and a diagram, explain how an increase in the rate of time preference alters an individual s indifference curves. 7. Using the standard two period intertemporal model, illustrate one possible optimal choice for a borrower. Identify consumption in the two periods, borrowing and debt repayments. 8. Using the standard two period intertemporal model, illustrate one possible optimal choice for a lender. Identify consumption in the two periods, lending and repayment of lending. 9. For a lender, what happens to consumption in each of the two periods, as well as lending, when there is an increase in the first period endowment? Explain using words and a diagram. What happens in response to an increase in the second period endowment of income? An increase in the market rate of interest? An increase in the rate of time preference? Be sure to identify the income and substitution effects if these are relevant. 10. The demand curve for loans has a negative slope, while the supply curve has a positive slope. True, false or uncertain. Explain using words and a diagram. 11. Does a tax on interest earnings increase or decrease the supply of loans? Explain using words and a diagram. 12. Explain why an actuarially fair pension will not affect the level of consumption in either period or the level of total saving. When, and how, might the introduction of a pension plan lead to a change in consumption and saving? 13. Suppose an individual can sacrifice (invest) some of their current endowment to expand their income in the future. Using words and a diagram, show how this possibility can alter their current and future consumption and their utility. If the person is a borrower, what impact does an increase in the market rate of interest have on the level of investment as well as the level of current consumption? Explain using words and a diagram. Can it be the case that the ability to invest does not have any impact on the individual s utility? Explain. 14. What is the separation theorem and why is it significant? General Equilibrium and Welfare Economics 15. P&R, page 610, questions 1, 4, 5, 6, 7 and Suppose the government imposes a tax on one type of good. Using words and diagrams, explain why, if markets are interdependent, partial equilibrium analysis may give an inaccurate impression of the impact of the tax on the quantity of the good consumed. 17. Explain the basic form of the standard Edgeworth box diagram for an exchange economy. Define the contract curve and show how to derive it. Explain why points off the contract curve are not efficient. 2

3 18. If an allocation is not efficient, a movement to an efficient allocation will make everyone better off. Explain whether this statement is true, false or uncertain. 19. What do we know about the willingness of individuals to trade one good for another at an inefficient consumption equilibrium versus an efficient equilibrium? Explain. 20. Suppose an individual has an endowment of goods X and Y. Write down the budget constraint of the individual, illustrate it in a diagram, and show how the budget constraint moves when there is a change in each of the two prices. 21. Using an Edgeworth box diagram, explain how a competitive market yields the consumption efficient allocation of goods. 22. Using an Edgeworth box, show that a competitive equilibrium may be efficient, but it may also lead to a very unequal distribution of utility across individuals. 23. Define a lump sum tax. 24. What is the Second Theorem of Welfare Economics and why might it be significant? 25. Show how to derive the Utility Possibilities Curve and relate it to the contract curve. 26. Define a social welfare function and illustrate a set of social indifference curves. Explain the difference between the indifference curves illustrated and the indifference curves associated with Utilitarian and Rawlsian social welfare functions. What comparison does a social welfare function make that Pareto efficiency does not require. Why might a social welfare function be useful? 27. Using a social welfare function, show why society may prefer an inefficient allocation to an efficient allocation. 28. Using words and a diagram, illustrate and explain the equity-efficiency trade off. 29. Explain Walras Law, why it holds and why it is important. 30. Define the marginal rate of technical substitution (MRTS) and relate it to the marginal products of capital and labour. 31. Draw an Edgeworth Production box and explain its form. Use this box to explain what we mean by production efficiency. Is every point in the Edgeworth production box efficient? Explain in words with reference to the box and the MRTS. 32 Explain why a competitive market for inputs will yield production efficiency. 33. Using words and diagrams relate the production possibilities frontier (PPF) to the Edgeworth Production box. Explain why a point to the interior of the PPF must not be on the production contract curve. 3

4 34. Define the marginal rate of transformation (MRT) and relate it to the marginal products of inputs. 35. What is the condition for output efficiency (allocative efficiency)? Explain in words and perhaps with a diagram. Explain why perfectly competitive markets will yield output efficiency. 36. Write down the three central efficiency conditions. Explain which of these conditions are violated if there is a monopoly in an output market and why this violation occurs. Illustrate and explain the violation in a diagram. Externalities and Public Goods 37. P&R, page 672, questions 4 and P&R, page 673, exercises 3, 6 and P&R, page 674, exercise Define a pure public good and explain all the terms used in your definition. 41. Graphically illustrate and explain in words how to determine the efficient quantity of a public good. 42. Explain why the private sector is not likely to provide the efficient quantity of a public good. 43. Why might the government not provide the efficient quantity of a public good? 44. Is it a contradiction to suggest that the marginal cost of an additional user of a pure public good is zero, but the marginal cost of the public good is positive? 45. Why might a user fee for a public good be inefficient? When might a user fee be preferred? 46. a) Using words and diagrams, illustrate and explain the competitive market equilibrium level of output and the efficient level of output for the following cases: i) a positive production externality, ii) a negative production externality, iii) a positive consumption externality, iv) a negative consumption externality. b) For each case, illustrate the deadweight loss of the externality. c) For each case indicate how a tax or subsidy could be used to eliminate the inefficiency. 4

5 d) Does the tax or subsidy eliminate the externality completely? Explain. Illustrate the cost or benefit of the externality (after imposing a tax or subsidy), if there still exists a cost or benefit. 47. The current oil boom has pushed up wages for all firms as firms compete for workers. If the labour market is competitive and there are only two firms (an oil industry firm and a non-oil industry firm), show how the increase in oil prices has affected the wages paid by non-oil industry firms. Is this effect consistent with the usual definition of an externality and, in this case, what is the efficient level of employment of workers by each of the two firms? 48. What methods, other than a tax, can be used to counter the inefficiency of a negative externality? 49. Using the case of a negative externality, explain how the assignment of property rights can potentially eliminate the inefficiency associated with a negative externality and why it does not matter who gets the property rights in terms of efficiency, but does matter in terms of the distribution of utility. What are some of the problems associated with the assignment of property rights as a solution to the externality problem? 50. Other than better access to parking, why might big box stores be more likely to locate in malls than on streets such as Whyte Avenue? 5