epartment of Economics Prof. Gustavo Indart University of Toronto October 26, 2007 ECO 100Y L0201 INTROUCTION TO ECONOMICS SOLUTIONS Midterm Test #1 LAST NAME FIRST NAME INSTRUCTIONS: STUENT NUMBER 1. The total time for this test is 50 minutes. 2. This question booklet has 9 (nine) pages. 3. Answer all questions in the space provided. 4. Aids allowed: a simple, non-programmable calculator only. 5. Use pen instead of pencil. O NOT WRITE IN THIS SPACE Part I 1. /12 4. /12 2. /12 5. /12 3. /12 Part II /20 TOTAL /80 Page 1 of 9
PART I (60 marks) uestion 1 (12 marks) The table below represents the supply and demand for Mexican papaya in thousands of pounds. [Note: Use the space provided in this table to work your answers to parts b) to d).] uantity Supplied uantity emanded Price ($/pound) S 0 S 1 S 2 0 1 0 0 0 4 20 30 10 6 4 8 16 24 20 12 8 12 12 18 30 18 12 16 8 12 40 24 16 20 4 6 50 30 20 24 0 0 a) Graph both the supply (S 0 ) and demand ( 0 ) curves in the diagram below. What is the current equilibrium price? Label that point A. (2 marks) Equilibrium price = 20 $ S 1 S 2 S 0 40 C 26 30 B 25 A 20 0 1 10 12 14.4 20 Page 2 of 9
b) Assume that Mexico is hit by a hurricane, and the supply of papaya is reduced by onethird. raw the new supply curve (S 1 ). What will be the new equilibrium price in the market? Label that point B. (3 marks) Equilibrium price = 25 At each price level the quantity supplied is one-third less than before. c) Now assume that President s Choice introduces a new papaya drink, and this increases the demand for Mexican papaya by 50%. raw the new demand curve ( 1 ). What will be the new equilibrium price keeping in mind that the supply curve is S 1? Label this new equilibrium point C. (3 marks) Equilibrium price = 30 At each price level the quantity demanded is one-half more than before. d) The government of Mexico wants to increase the country s production of papaya and to that end introduces a unit-subsidy paid to producers of $10 per pound. raw the new supply curve (S 2 ). What will be the new equilibrium price keeping in mind that the demand curve is 1? Label this new equilibrium point. (4 marks) Equilibrium price = 26 Papaya producers now require a minimum price $10 lower than before to produce any particular unit of output. Therefore, the supply curve shifts down by exactly $10 at each level of output. Page 3 of 9
uestion 2 (12 marks) a) In the past, rental car companies used to charge more for an SUV or a luxury car than for a compact car. However, in 2006 rental car companies often charged more to rent a compact car than an SUV or a luxury vehicle. Why do you think rental companies changed their normal pricing structure? Briefly explain. (6 marks) The price of gasoline increased significantly in 2006 and thus drivers preferred to drive more gas efficient compact cars rather than gas inefficient SUVs and luxury cars. The increase in the demand for compact cars resulted in an increase in its rental price, while the decrease in the demand for SUVs and luxury cars resulted in a drop in its rental price. P Compact cars SUVs and luxury cars b) Why is the demand for gasoline relatively inelastic, while the demand for Petro-Canada s gasoline relatively elastic? Briefly explain. (6 marks) This is due to the degree of substitutability. On the one hand, there are no close substitutes for gasoline, and thus a general increase in the price of gasoline will have a small impact on its quantity demanded i.e., the demand for gasoline is relatively inelastic. On the other hand, there are very close substitutes for Petro-Canada s gasoline e.g., Shell s gasoline, Texaco s gasoline, etc. Therefore, if only the price of Petro-Canada s gasoline increases, drivers will buy more gasoline from other competitors and the quantity demanded for Petro-Canada s gasoline will fall significantly i.e., the demand for Petro- Canada s gasoline is relatively elastic. Page 4 of 9
uestion 3 (12 marks) Statement: Marina believes that one major rationale for farm price supports (e.g., subsidies) is that demand is inelastic and that rapidly improving technology, improved fertilizer, and better farming methods increased supply so significantly that farm incomes were severely depressed. Position: o you agree with Marina s position? With the help of a proper diagram analyze this situation and indicate, with reasons, whether you agree or disagree with Marina. I agree with Marina. The price elasticity of demand is defined as the ratio of the percentage change in the quantity demanded over the percentage change in the price of the commodity. The demand is said to be inelastic if elasticity is less than one (in absolute value), i.e., if the percentage change in the price of the commodity is greater than the percentage change in its quantity demanded. As shown in the diagram below, an increase in the supply of agricultural products from S 0 to S 1 as a result of technological improvement, better fertilizers, or better farming methods will cause the price of agricultural products to fall from P 0 to. The drop in prices will, in turn, increase the quantities demanded from 0 to 1. This is the law of demand in action a movement down along the demand curve. Now, if elasticity is less than one i.e., the demand is inelastic then the percentage drop in prices will be greater than the percentage increase in quantities demanded and farm incomes (revenues) will fall. Indeed, total revenue is equal to the product of price and quantity demanded and a percentage fall in prices greater than a percentage increase in quantities demanded results in a decrease in revenues. The imposition of a subsidy will help to increase farm incomes. The subsidy will reduce farmers cost of production and thus the supply curve will shift down to S 2. Therefore, the quantity transacted in the market will increase to 2 and the price paid by consumers will drop to. Producers, however, will now receive a price higher than before, a price P P i.e., the price paid by consumers plus the subsidy received from the government. P S 0 S 1 S 2 P 0 P P Subsidy 0 1 2 Page 5 of 9
uestion 4 (12 marks) Consider that the government wished to reduce the quantity of consumer purchases for a product and imposed a specific commodity (per-unit tax) in the industry to be paid by producers. Statement: Ameena believes that the intended impact of the tax would be more successful if the product had a relatively inelastic demand curve. Position: o you agree with Ameena s position? Use a proper diagram to analyze this situation and indicate, with reasons, whether you agree or disagree with Ameena. I disagree with Ameena s position. The imposition of the per-unit tax will increase the cost of production of this commodity and shift the supply curve up to the left (i.e., it will cause a decrease in supply). Therefore, the market price (i.e., the price paid by consumers) increases and the quantity bought and sold in the market decreases as the government intended. This is shown in the diagram below. The initial equilibrium before the imposition of the unit-tax is at point A price and quantity bought and sold 1. The imposition of the unit-tax causes the supply curve to shift up exactly by the size of the tax (t). As a result, consumers end up paying a price in the new equilibrium and buying a quantity 2. Note that producers now receive a price P 3 equal to t. P S t S P 3 2 1 Now let s examine whether the reduction in the quantity consumed will be greater if this product has a relatively inelastic demand curve or a relatively elastic one. That is, what we want to determine is in which case relatively inelastic or relatively elastic demand curve the reduction in the quantity consumed will be greater after the imposition of this unit-tax. The price elasticity of demand is defined as the ratio between the percentage change in quantity demanded and the percentage change in price. If (in absolute value) this ratio is greater than one, then at that point or segment the demand for this product is elastic; if the ratio is less than one, then at that point or segment the demand for this product is inelastic. A relatively elastic demand curve means that the % > % P and, therefore, for a given % P the quantity demanded decreases by more in this case. Ameena is thus not correct. Page 6 of 9
uestion 5 (12 marks) Constantine only purchases product X and product Y. Constantine s demand curve for product X is downward-sloping. Statement: Bianca, a friend of Constantine s, concludes that product X must be a normal good for Constantine. Position: o you agree with Bianca s conclusion? Use a proper diagram to analyze this situation and indicate, with reasons, whether you agree or disagree with Bianca s view. No, I don t agree with Bianca s conclusion since income-independent goods and inferior non- Giffen goods also have negatively-sloped demand curves. Let s consider the case of an inferior non-giffen good for Constantine. Initially Constantine is maximizing his utility consuming bundle A. As the price of good X increases his budget line shifts from BL 1 to Y BL 2. He will now consume a different bundle on this new budget line and will reduce his B level of satisfaction since the highest indifference curve he will be able to reach is lower than indifference curve I 1. His real BL 2 income has thus decreased. Let s examine the A substitution and the income effect of this increase in the price of books. I 1 To measure the substitution effect we must consider the change in the quantity demanded C as a result of the change in relative prices while assuming no change in real income (i.e., BL 1 while assuming that Constantine remains on I the same indifference curve). This is illustrated 2 by the movement from point A to point B, and X B X C X A X the quantity demanded decreases from X A to X B. Now we measure the income effect by allowing real income to fall while keeping relative prices constant. In this way, Constantine moves to a P lower indifference curve. Since good X is an inferior good for Constantine, as his income decreases his quantity demanded of good X increases so he will end up consuming a quantity greater than X B. But good X is an inferior non-giffen good for Constantine and thus the substitution effect is greater than the income effect and he will end up consuming more than X B but less than X A he will consume a quantity X C as shown in the diagram. X C X A X His demand curve for good X thus has a negative slope as indicated in the diagram on the left. Page 7 of 9
PART II (20 marks) Instructions: Enter your answer to each question in the table below. Only the answers recorded in the table will be marked. Table cells left blank will receive a zero mark for that question. Each question is worth 4 marks. No deductions will be made for incorrect answers. 1 2 3 4 5 A A 1. Let the supply curve for oranges be upward sloping. Suppose that bad weather conditions adversely affect this year s crop of oranges. However, it is discovered that orange producers have a higher level of total revenue. Given this information, which of the following statements is true? a) The supply curve for oranges is elastic. b) The supply curve for oranges is inelastic. c) The demand curve for oranges has unitary elasticity. d) The demand curve for oranges is inelastic. e) The demand curve for oranges is elastic. 2. Suppose the supply curve for breakfast cereals is upward sloping. Suppose also that as average household income decreases we observe a fall in the price of breakfast cereal. We can conclude that breakfast cereal is a) a luxury good. b) a substitute good. c) an inferior good. d) a normal good. e) a necessity good. 3. Suppose the government decides to cancel an effective price ceiling that it had previously imposed on a particular good. It can be expected that a) the price would increase, the quantity demanded would decrease and the quantity supplied would increase. b) the price would increase, the quantity demanded would increase and the quantity supplied would decrease. c) the price would decrease, the quantity demanded would decrease and the quantity supplied would increase. d) the price would decrease, the quantity demanded would increase and the quantity supplied would decrease. e) no changes would take place. Page 8 of 9
4. Suppose there are only three things you can do rather than attend a community social event (which you value at $12): read a novel (you value this at $5), go to work (you could earn an extra $7), or watch videos with some friends (you value this at $10). The opportunity cost of attending the community social event is a) $10, because this is the highest valued alternative forfeited. b) $5, because this is the lowest valued alternative forfeited. c) $7, because going to work is the only alternative involving a genuine monetary payment. d) $22, because this is the total dollar amount of the three alternatives. e) $12, because you value the community social event higher than any other alternative. 5. When the price of apples is $1.00 a piece, Yvonne doesn t buy any. However, as the price of apples gradually drops she buys one apple a day when the price is $0.80 a piece, and two apples a day when the price is $0.50 a piece. What is the money value of Yvonne s consumer surplus when the price of apples is $0.50 a piece? a) $0.80. b) $0.70. c) $0.50. d) $0.30. e) None of the above. Page 9 of 9