MICROECONOMIC PRINCIPLES
SPRING 2001
MIDTERM ONE -- Answers
February 16, 2001
Multiple Choice. (2 points each) Circle the correct response and write one or two sentences to
explain your choice. Use graphs as appropriate.
Table One
Labor Hours Needed to Make 1 Pounds Produced in 20 Hours
Pound of
Meat Potatoes Meat Potatoes
Farmer 10 5 2 4
Rancher 4 1 5 20
Questions 1 & 2 refer to Table One
1. The farmer has an absolute advantage in _________ and the rancher has the absolute
advantage in _____________.
a. meat, potatoes
b. potatoes, meat
c. meat, meat
d. both goods, neither good
e. neither good, both goods
e. The rancher can produce more meat and more potatoes with 20 hours of time than can the
farmer. The rancher has the absolute advantage the production of both.
2. Refer to the table shown. The Farmer has the comparative advantage in _____________ and
the Rancher has the comparative advantage in __________________.
a. meat, potatoes
b. potatoes, meat
c. meat, meat
d. both goods, neither good
e. neither good, both goods
b. The opportunity cost of potatoes in terms of meat in Table Two.
Table Two
Opportunity Cost Opportunity cost
of 1 lb of of 1 lb of meat
potatoes
lbs of Meat lbs of Potatoes
Farmer 1/2 2
Rancher 1/4 4
The opportunity cost of potatoes is lower for the rancher than for the farmer. The rancher has
the comparative advantage in potatoes; the farmer, meat.
Another way to think about this is to focus on the joint consumption possibility frontier. Suppose
the farmer specializes in potatoes and the rancher in meat and they each work 20 hours. They
would jointly have 5 lbs of meat and 4 lbs of potatoes. However, if the farmer focused on meat
and the rancher produced both meat and potatoes, they could have 5 lbs of meat and 8 lbs of
potatoes (the rancher devotes 8 hours to potato production) or 6 lbs of meat 4 lbs of potatoes
(the rancher devotes 4 hours to potato production) or 5.5 lbs of meat and 6 lbs of potatoes (the
rancher devotes 6 hours to potato production). Clearly, they can have more of both goods when
the farmer specializes in meat and the rancher produces some potatoes.
3. A technological advancement
a. will shift the demand curve to the right and decrease the market price.
b. will shift the demand curve to the left and increase the market price.
c. will shift the supply curve to the right and increase the market price.
d. will shift the supply curve to the left and increase the market price.
e. will shift the supply curve the right and decrease the market price
e. A technological advancement reduces the cost of production. This shifts supply to the right.
The increase in supply leads to a reduction in the market price (a movement down along the
demand curve) and an increase in output.
16
Original Supply
14
New Supply
12
Demand
10
New P
0
0 1 2
Old Q New Q 3 4 5 6
Quantity
4. Suppose that the incomes of buyers in a particular market for a normal good declines and there
is also a reduction in input prices. What would we expect to occur in this market?
a. The equilibrium price would increase, but the impact on the amount sold in the market would
be ambiguous.
b. The equilibrium price would decrease, but the impact on the amount sold in the market would
be ambiguous.
c. Both equilibrium price and equilibrium quantity would increase.
d. Both equilibrium price an d equilibrium quantity would decrease.
e. Equilibrium quantity would increase, but the impact on equilibrium price would be
ambiguous.
b. The reduction of buyers' income will reduce demand. The demand curve shifts down to the
left. The reduction in input prices will shift supply out to the right. The decreased demand
would lead to a lower price and output. The increased supply decreases price, but increases
output. Hence, the combined effect is a decrease in price, but an ambiguous effect on output.
In this graph, the increase in Q resulting from the shift in supply is offset by the decrease in Q
caused by the decreased demand so Q is unchanged.
Original
16
Original Supply
14
New Supply
12
10
Original Price
6
New Price
4
2 Original Demand
New Demand
0 Original Quantity
0 1 2 3 4 5 6
5. A higher price for batteries would tend to
a. increase the demand for flashlights.
b. decrease the demand for electricity.
c. increase the demand for electricity.
d. increase the demand for batteries.
e. increase the price of flashlights.
c. Batteries and electricity are substitutes (not perfect substitutes, but substitutes nonetheless).
A higher price for batteries would increase the demand for electricity.
(Flashlights are generally not sold with batteries. To receive credit for choosing (e), you must
have a clear statement that batteries are an input into flashlights from the supplier's perspective
and that a higher price of batteries would shift the supply of flashlights up to the right. The
decreased supply results in a higher price. )
6. Alice says that she would buy one banana split a day regardless of the price. If she is telling
the truth,
a. Alice's demand for banana splits is perfectly inelastic.
b. Alice's price elasticity of demand for banana splits is 1.
c. Alice's price elasticity of demand is infinite.
d. Alice's income elasticity of demand for banana splits is negative.
e. None of the above answers are correct.
a. Alice's consumption does not vary as the price varies so for any % in Price, her % in
Quantity is zero. Hence, her elasticity of demand is 0 -- perfectly inelastic. Graphically, her
demand is a vertical line at Q=1.
Perfectly Inelastic Demand
10
0
0 2 4
7. How does total revenue change as one moves down a linear demand curve?
a. It increases.
b. It decreases.
c. It first increases, then decreases.
d. It first decreases, then increases.
e. It is unaffected by a movement along the demand curve.
c. The elasticity of demand changes as one moves down a linear demand curve. Initially,
demand is elastic. An X% decrease in price increases quantity by more than X% so total revenue
(Price times Quantity) increases. At the point of unitary elasticity, an X% decrease in price
increases quantity by X% so total revenue is unchanged. Beyond that point, demand is inelastic.
An X% decrease in price increases quantity by less than X% so total revenue decreases.
8. A binding price ceiling in the computer market will cause
a. an increase in the quantity supplied of commuters.
b. a surplus of computers.
c. a shortage of computers.
d. quantity demanded of computers to be equal to quantity supplied.
e. an increase in the demand for computers.
c. A binding price ceiling sets price below the market clearing price where Qd=Qs. This lower
price increases Qd and decreases Qs so now Qd>Qs. This gap between Qd and Qs implies a
shortage.
16
14
12
10
Demand
8 Supply
Price Ceiling
0
0 1 QS 2 3 QD 4 5 6
Quantity Demanded Exceeds Quantity Supplied. Quantity
9. The burden of a tax on Good X is borne entirely by suppliers of Good X when
a. the demand for Good X is perfectly inelastic
b. the supply of Good X is perfectly inelastic
c. the supply of Good X is perfectly elastic
d. the supply of Good X is relatively inelastic and the demand for Good X is relatively elastic.
e. the supply of Good X is relatively elastic and the demand for Good X is relatively inelastic.
b. The burden of the tax will be borne entirely by suppliers when supply is perfectly inelastic.
In this case, if suppliers try to pass the tax to consumers by increasing P above the market
clearing price, quantity demanded will fall and there will be a surplus of the good. Competition
will drive the price consumers pay back to its original level. Producers will have to pay the tax
out of revenues.
(Suppliers bear a bigger burden than consumers when supply is relatively inelastic and demand
relatively elastic, but the burden is still shared. )
Free Response
1. (24 pts) Suppose we are analyzing the market for hot chocolate. What will be the impact on
the equilibrium price and quantity of each of the following events affecting the hot chocolate
market? (Use graphs to illustrate.)
a. the price of coffee falls
Coffee and hot chocolate are substitutes. When the price of a substitute falls, demand decreases
(Shifts down). Price and quantity fall.
16
14
New Supply
12
10
Original P
6
New P
Original Demand
2 New Demand
0
0 1 New Q 2Original Q 3 4 5 6
Quantity
b. the price of whipped cream falls
Whipped cream is a complement for hot chocolate. When the price of a complement falls,
demand increases. If we re-label the graph above, price and quantity increase from (New Q,
New P) to (Original Q, Original P)
If you decided that whipped cream is an input, then you would increase supply. The price falls
and quantity increases.
16
Original Supply
14
12
New Supply
10
Original Price
New Price
4
Demand
0
New Quantity
0 1 Original Quantity
2 3 4 5 6
Quantity
c. the price of cocoa beans increases
This is the reverse of the supply shift depicted above. Cocoa beans are an input into production
of hot chocolate. An increase in price of cocoa beans will decrease supply (shift up). With
decrease in supply price increases (from New Price to Original Price) and quantity decreases
(From New Quantity to Original Quantity)
d. consumer income falls because of a recession
Demand will shift in to right. (See graph for a.) Price and quantity decrease.
e. the Surgeon General of the U.S. announces that hot chocolate cures acne
Demand will shift out to left. Reverse figure in part a. Price will increase from New Price to
Original Price. Quantity will increase from New Quantity to Original Price.
f. a better method of harvesting cocoa beans is introduced
See figure for part b (whipped cream as input). Price will decrease; quantity will increase.
2. ( 8 pts) Using a demand-supply diagram, show how OPEC raising oil prices in the 1970s
combined with a government imposed price ceiling on gasoline created a shortage of gasoline.
Initially the price ceiling on gasoline was not binding. Equilibrium price was below the price
ceiling. OPEC raised oil prices in the 1970s. Oil is an input into gasoline. An increase in oil
prices caused supply of gasoline to contract. Shift shifted up to the left. As a result, the
equilibrium price increased. With the new equilibrium price the price constraint became binding.
With a binding price ceiling, quantity demand will exceed quantity demanded. There is a
shortage of gasoline.
25
Supply After OPEC
20
15
Original Supply
10
Price Ceiling
P before OPEC
5
Shortage
Demand
0
Qs Qd Q before OPEC
0 1 2 3 4 5 6
3. (16 pts) Draw a supply-demand diagram for chocolate. On the diagram, show the equilibrium
before and after the imposition of a tax. Now identify areas corresponding to each of the
following.
a. consumer surplus before the tax: ∆ACJ
b. producer surplus before the tax: ∆JCH
c. total surplus before the tax: ∆ACH
d. consumer surplus after the tax: ∆AKB
e. producer surplus after the tax:∆GFH
f. total surplus after the tax: ∆AKB+:∆GFH+ KBFG
g. tax revenue: KBFG
h. deadweight loss: ∆ BCF
14
Supply after tax
12
10
Supply
K B
6
D
J C
4
G F
Demand
H0
Q after tax
0 2 4 6 8 10 12
Original Q
Quantity
4. (8 pts) Suppose you are the manager of a theater. You currently charge the same admission
price to all customers, regardless of age. You hire an economist to determine the price elasticity
of demand for admissions by age, and he tells you that at the current price, demand by adults is
inelastic and demand by children is elastic. If you want to increase your total revenue by
adjusting admission prices, how should they be adjusted?
Since adults have inelastic demand, the theater can increase revenues by increasing the price for
adults. An X% increase in price will reduce quantity demanded by less than X% and increase
total revenue. The theater can charge a lower price for children. Since they have elastic
demand, an X% decrease in price will increase quantity demanded by more than X% and hence,
increase total revenue.
5. (10 pts) How does elasticity affect the burden of a tax? Justify your answer using supply-
demand diagrams.
If supply is relatively inelastic, the supplier bears the larger burden. If demand is relatively
inelastic, the consumers bear the larger burden. In these graphs, the elasticity of supply
changes. It was also acceptable to change elasticity of demand.
25
Elasticity of Demand and Supply Nearly Same, Burden Shared
Equally Between Consumers and Producers
20
TAX
15
Supply
10
Demand
0 Q Before Tax
0 10 20 30 Q After Tax
40 50 60 70 80
Quantity
25
Where Supply is Relatively Inelastic, Producer Bears Larger Burden of Tax
20
Tax
Supply
15
10
PRODUCER BURDEN
5
Demand
0
0 10 20 30 40 50 60 70 80
Quantity
6. ( 16 pts) Some policy makers believe that a minimum wage has negligible effects on
employment and will increase incomes of low skilled workers. Others believe that it will hurt
the workers that it is designed to help. What the economic arguments employed to support these
opposing views?
Points for Essay to Cover
• Illustrate that a minimum wage, a price floor, leads to unemployment of workers.
(ESSENTIAL)
• Discuss that the reduction in employment resulting from the minimum wage will depend on
the elasticity of demand for labor. (ESSENTIAL)
• Cite arguments that minimum wage might not create unemployment because (a) worker
productivity increases or (b) employers have market power
• Cite empirical studies or estimates of impact of minimum wage on employment.
• Discuss how an increase in the minimum wage might increase incomes of low skill workers
and their families.
• Acknowledge that not all minimum wage workers live in poor families.
• Cite impact of minimum wage on small businesses
