Each of the Four Questions Is Worth Five Points for a Total of 20 Points

EnvEcon 1 / Econ 3 P. Berck Quiz 1 – Solutions Fall 2006

Each of the four questions is worth five points for a total of 20 points.

1. Define: a. Substitute goods

If an increase in the price of one good causes consumers to buy more of another good, then the two goods are said to be substitutes. Alternatively, we could define goods as substitutes when an increase in the price of one good causes an outward shirt in the demand curve of another good.

b. Externality

Externalities are costs or benefits arising from an economic activity that affect individuals other than those people directly engaged in the economic activity.

c. Indifference Curves

Indifference curves represent the set of bundles that give the same utility.

d. Public Good

Most simply, public goods are not goods not diminished by consumption.

Some economists define public goods as goods that are both non-rival and non-excludable. “Non-rival” means that one individual’s consumption does not prevent another person’s consumption. “Non-excludable” means that if one individual can consume the good, it is impossible to stop another person consuming it.

e. Demand and Quantity demanded

“Demand” describes the quantity demanded as a function of price (and other things); that is, demand describes the consumer’s willingness to pay for different possible quantities of a good. “Quantity demanded” describes the actual amount that is consumed at a given price. Demand includes all possible quantities at all the various prices and quantity demanded occurs at a single price. EnvEcon 1 / Econ 3 P. Berck Quiz 1 – Solutions Fall 2006

2. Assume the market supply and demand equations for wine are

QD =100 - 4 P

QS =6 P - 40 a. Graph the two equations and determine (graphically and algebraically) the equilibrium price and quantity.

In equilibrium, quantity demanded (QD) will equal quantity supplied (QS). To find the equilibrium, we solve:

QD = QS 100-4P=6P-40 price 10P = 140 P = $14 25

supply QD = QS = 100 - 4(14) = 44

demand

44 100 quantity

b. Now, the government wants to impose $2 specific tax on wine. Use algebra to find the new equilibrium prices (price consumers pay and the price producers receive), quantity and government tax revenue.

We know that the tax drives a wedge between producer and consumer prices PC - PS=2 But quantity demanded will still equal quantity supplied in the market. QD = QS 100 - 4PC = 6PS – 40 Since PC = PS + 2, we can substitute into our equilibrium condition to get 100 – 4(PS + 2) = 6PS – 40 100 - 4PS – 8 = 6PS – 40 10PS = 132 PS = $13.20 PC = PS + 2=$13.20 + $2 = $15.20

C QD = 100 - 4P =100 - 4($15.20) = 39.2 S QS = 6P - 40 = 6($13.20) - 40= 39.2 EnvEcon 1 / Econ 3 P. Berck Quiz 1 – Solutions Fall 2006

3. Draw a diagram and use it to explain the “loan program” agricultural price support program. Be sure to show quantities produced and consumed and government purchases.

The “loan rate” is essentially the price at which government will purchase a program crop (e.g. wheat, corn). In practice, the government loans the farmer money using the crop as collateral. In the event that the loan rate exceeds the market price (which always happens, since the program was designed to subsidize farmers), the farmer can default on the loan and the government gets the crop.

loan supply rate

cost to the government demand

quantity quantity quantity demanded supplied

surplus EnvEcon 1 / Econ 3 P. Berck Quiz 1 – Solutions Fall 2006

4. Assume that the price of the good on the vertical axis is TWO. Note that the vertical axis does not go all the way down to zero! The good on the horizontal axis is electricity. Look at the diagram below;

1 0 1 0 0

1 0 0 0 0

9 9 0 0

9 8 0 0

9 7 0 0

9 6 0 0

9 5 0 0 0 1 2 3 4 5 6 7 8 9 1 0

. What are the prices of electricity on each of the two budget constraints?

If the price of the other good is 2 and the consumer can buy at most 10,000 units of the good, then their total income must be: 2 x 10,000 = 20,000. But note that the vertical axis does not go to zero at the origin—so the consumer has only 500 x 2 = 1,000 worth of discretionary income to spend on electricity and the other good.

If the consumer’s discretionary budget is 1,000 and they can buy at most 5 units of electricity, then the price of electricity must be: 1,000/5 = 200

If the consumer’s discretionary budget is 1,000 and they can buy at most 10 units of electricity, then the price of electricity must be: 1,000/10 = 100

a. How much electricity is purchased at each of these two prices?

By examining the indifference curves and budget constraints of the consumer, we can see that they will buy approximately 2 units of electricity when the price is 200 and approximately 3 units of electricity when the price is 100. EnvEcon 1 / Econ 3 P. Berck Quiz 1 – Solutions Fall 2006 b. Assume that the consumer originally faced a high price for electricity and the diagram shows the results of lowering that price. How many dollars would this change in price be worth to the consumer? Find your answer by drawing one more line on the diagram. Explain what you have done. (Slight extra credit for identifying whether you have used CV or EV.)

Say we asked: “How much does the consumer need to be compensated after the price change to keep her utility equal to the level before the price change?” We would draw the following diagram and calculate the required change in income as: (10,000-9,900) x 2 = 200 This is compensating variation.

1 0 1 0 0

1 0 0 0 0

9 9 0 0

9 8 0 0

9 7 0 0

9 6 0 0

9 5 0 0 0 1 2 3 4 5 6 7 8 9 1 0

Or, say we asked: “By how much should consumer’s income be changed before the price change to make her utility equal to the level after the price change?” We would draw the following diagram and calculate the required change in income as: (10,100-10,000) x 2 = 200 This is equivalent variation.

1 0 1 0 0

1 0 0 0 0

9 9 0 0

9 8 0 0

9 7 0 0

9 6 0 0

9 5 0 0 0 1 2 3 4 5 6 7 8 9 1 0