ECON 500 – Spring 2007 Name: _A. Key______________________ Exam 1 Multiple Choice: (circle the letter of the best response; 4 points each) 1. The _______________ states that: “Although we have unlimited needs and wants, the resources available to us are limited. So having more of one good thing usually means having less of another.” b. Scarcity Principle 2. A price ceiling a. is a maximum allowable price, set by law. 3. A “Buyer’s Reservation Price” is b. the largest dollar amount a buyer is willing to pay for a good. 4. _______________ is the study of individual choice under scarcity and its implications for the behavior of prices and quantities in individual markets. a. Microeconomics 5. Suppose the income elasticity of demand for eggs is 0.44. Based upon this value d. eggs are a normal good. 6. Which of the following would NOT likely lead to an increase in market Supply: c. an increase in consumer income. 7. If the “Law of Demand” is satisfied: d. All of the above answers are correct. For questions 8 through 10, consider a market in which demand is given by the linear function illustrated below: $ 16.00 Q 20,000 8. At a price of $12.00 per unit, demand is b. elastic (1 < ε < ∞ ). 9. If price were increased from $4.50 to $6.25, then “Total Firm Revenue” (or equivalently “Total Consumer Expenditures”) a. would increase. 10. “Total Firm Revenue” (or equivalently “Total Consumer Expenditures”) e. More than one, but not all, of the above answers is correct. 11. Apples are a normal good. In 2006 the equilibrium price of apples was $1.29 per pound and 12,500 pounds of apples were traded. Suppose consumer income is higher in 2007 than in 2006 (with all other factors fixed). From this information it must be that: e. More than one of the above answers is correct. For questions 12 and 13, consider a society with the Production Possibilities Curve illustrated below: Revolvers A D B C Velvet 12. Based upon the graph above: b. (A), (B), and (C) are attainable; (D) is unattainable. 13. The Opportunity Cost of Velvet a. is higher at (C) than at (A). For questions 14 and 15, consider a market with supply and demand as illustrated below: price Supply 12.80 7.00 4.10 Demand quantity 1,350 2,100 2,800 14. The level of trade which maximizes “Total Social Surplus” in this market (that is, the “socially optimal quantity of trade”) c. is 2,100. 15. Imposing a price floor of p f = 12.80 would b. give rise to excess supply. “Short Answer” Questions: 1. Axl and Slash devote each workday to producing guns and roses. On any given day Axl can produce 30 guns or 90 roses, while Slash can produce 20 guns or 10 roses. a. Which individual has an absolute advantage in the production of guns? Clearly explain. (4 points) The determination of “Absolute Advantage” requires a comparison of maximum levels of output (of guns) per day. Axl possess an Absolute Advantage in the production of guns, since his maximum level of output (30 guns) exceeds Slash’s maximum level of output (20 guns). b. Which individual has a comparative advantage in the production of guns? Clearly explain. (4 points) The determination of “Comparative Advantage” requires a comparison of opportunity costs (for producing guns) across workers. From the given Axl 90 Slash 10 1 information we have OC guns = 30 = 3 and OC guns = 20 = 2 . That is, in order for Axl to produce one more gun, he must decrease his production of roses by three units. Similarly, in order for Slash to produce one more gun, he must decrease his production of roses by half a unit. Therefore, it is comparatively Slash 1 Axl less expensive for Slash to produce a gun ( OCguns = 2 < 3 = OCguns ) – Slash possesses a comparative advantage in the production of guns. c. Which individual should produce “the first gun” for this society? Clearly explain. (4 points) The “first gun” should be produced by the worker with the lower opportunity cost of producing guns (that is, by the worker who can produce a gun with the smaller decrease in output of roses). From part (b) above we know Slash 1 Axl OC guns = 2 < 3 = OC guns . This implies that Slash should produce the first gun (if he does so, output of roses will decrease by only half a unit – if instead Axl were to produce the first gun, output of roses would decrease by three units). 2. Consider the market for staplers. In 2004, equilibrium price was p04 = 4.56 and equilibrium quantity was q04 = 52,450 . In 2006, equilibrium price was p06 = 5.23 and equilibrium quantity was q06 = 61,075 . a. Could this observed change be a result of an increase in Supply with no change in Demand? Clearly explain why or why not. (4 points) If Supply increases with demand fixed, then equilibrium price must decrease and equilibrium quantity must increase (as illustrated below): price Supply 2004 Supply 2006 4.56 Demand 2004 quantity 52,450 That is, if Demand in 2004 is as illustrated by the curve above, then the new equilibrium (in 2006) must be along the “green shaded portion” of this curve. In comparison to the initial equilibrium price of $4.56 and initial equilibrium quantity of 52,450, all points along this “green shaded portion” are characterized by a lower price and higher quantity (as indicated on the shaded portion of each axis). Therefore, the new equilibrium price must lower and the new equilibrium quantity must be higher, results which are inconsistent with the observed increase in both price and quantity. b. Could this observed change be a result of a simultaneous increase in Demand and decrease in Supply? Clearly explain why or why not. (4 points) Yes, this observed increase in both price and quantity could be a result of a simultaneous increase in Demand and decrease in Supply (as illustrated below): price Supply Demand 2006 2004 5.23 Supply 2004 4.56 Demand 2006 quantity 52,450 61,075 3. Clearly explain why each of the following statements is either correct or incorrect. a. “When deciding how much to study for an exam, you should always increase your ‘study time’ if doing so increases your expected grade on the exam.” (4 points) This statement is not correct. It suggests increasing “study time” so long as MB > 0 . However, sound decision making should be based upon a comparison of MB and MC . A rational individual will want to study up to the point where MB = MC . If MC are always positive, this immediately implies that you will have MB > 0 beyond the time when you stop studying. b. “Gene and Mo spend their time mowing lawns and raking leaves. Gene is exceptionally good at yard work and therefore possesses a comparative advantage in performing both tasks.” (4 points) This statement cannot be correct. When two workers perform two tasks, a single worker can never have a comparative advantage in both tasks. To see why, assume that Gene has a comparative advantage in mowing lawns ML ML (that is, OCGene < OCMo ). However, for each worker i , the following must be ML 1 true: OCi = RL . It follows that if Gene has a comparative advantage in OCi 1 ML ML 1 mowing lawns, then RL = OCGene < OCMo = RL . This condition could OCGene OCMo RL RL be expressed as OCMo < OCGene , which implies that Mo posses a comparative advantage in raking leaves. 4. The following “Own-Price” and “Cross-Price” Elasticities of Demand have been estimated for three makes of automobiles: Price of Price of Price of Kia Rio Hyundai Accent Mercedes-Benz S600 Demand for Kia Rio 3.245 0.189 0.002 Demand for Hyundai Accent 0.157 3.794 0.000 Demand for Mercedes-Benz S600 0.003 0.001 2.014 Answer the following questions, making specific reference to the numerical values in the table above. a. Under current market conditions, is demand for the Mercedes-Benz S600 elastic, inelastic, or unit elastic? Clearly explain. (3 points) Elastic, since 2.014 > 1. b. Would an increase in the price of the Kia Rio increase or decrease total consumer expenditures on the Kia Rio? Clearly explain. (3 points) Since 3.245 > 1, we know that demand is elastic under current market conditions. Whenever demand is elastic, a slight increase in price will lead to a decrease in Total Consumer Expenditures on the product in question. c. How would an increase in the price of a Hyundai Accent affect the demand for a Kia Rio? Clearly explain. (3 points) The cross-price elasticity of demand for the Kia Rio with respect to the price of a Hyundai Accent is positive ( 0.189 > 0 ). This value implies that a Rio is a substitute for an Accent. As a result, an increase in the price of an Accent will lead to an increase in demand for the Rio. d. How would an increase in the price of a Mercedes-Benz S600 affect the demand for a Hyundai Accent? Clearly explain. (3 points) The cross-price elasticity of demand for the Hyundai Accent with respect to the price of a Merceds-Benz S600 is equal to zero ( 0.000 = 0 ). This value implies that changes in the price of the S600 will have no impact whatsoever on demand for the Accent. Extra Credit! (4 points) Annika is an avid golfer. The table below summarizes her “Total Benefit” from playing golf (measured in Swedish Kronors, denoted “SEK”) for different numbers of rounds played per week.