Introductory
Microeconomics - EC155A and B
October
14, 2002
SOLUTIONS TO FIRST EXAMINATION
I. Thinking like an economist (25 points)
A. Tiger Woods is arguably the world’s best known athlete. Because of his popularity, Woods is often offered ‘appearance fees’ of $2,000,000 by organizers of golf tournaments. Even if he plays very poorly in such tournaments, Woods is guaranteed a paycheck of $2,000,000 just by ‘appearing’ for four days.
Yet Woods often turns down such lucrative invitations. Use the concepts of opportunity cost and of marginal utility to explain Wood’s decision to not accept such an invitation.
·
The opportunity cost of his time must be worth more
than $2 million. Perhaps because of a
more lucrative tournament, he is preparing for another (more lucrative)
tournament, or he REALLY wants to spend time with family and friends.
· As Tiger gets, richer the Marginal Utility of Income goes down. [What’s another $2 million to someone who earns $70 million a year!]
B. The production possibilities frontier below shows the amounts of ice cream and frozen yogurt that Ben & Jerry’s can produce. On the graph, carefully illustrate how the imposition of a price floor for milk products in Vermont will affect this frontier. Defend your answer.
Ice cream
There is NO change. The PPF is ‘a curve measuring the maximum combinations of outputs that can be obtained from a given number of inputs’ (Colander, p. 34.)
C. Over the last five years, the tuition at Middlebury College has increased. Each year, has the new tuition been an ‘equilibrium’ price? Defend your answer.
The tuition is not an equilibrium price, since the forces of scarcity of places at Middlebury College are not converted into market forces. The admission office decides who is admitted, not a market.
D. The Otter Creek Brewery announces that it will increase the wages of all of its factory workers by $4 per hour. On the two graphs, carefully illustrate how this announcement will affect the supply curve for: (a) factory workers at Otter Creek; and (b) self-employed carpenters in Middlebury. Defend your answers.
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Factory workers
at Otter Creek Wage Quantity of workers |
Self-employed
carpenters Quantity of carpenters |
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There is no change of the first curve: there is only a movement up the curve. The second curve would shift in, as the opportunity cost of the time of carpenters has gone up. (This is just like the firewood example that we discussed.)
E. The data below are based on the reported willingness to pay for beans among families in West Virginia. When these families earn $15,000 per year, is demand elastic or inelastic? Among these families, are beans a normal good or an inferior good? Defend your answers.
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Price |
Quantity demanded (income = $15,000) |
Quantity demanded (income = $30,000) |
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$
0.25 |
10,000 |
15,000 |
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$
0.75 |
6,000 |
9,000 |
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$
1.25 |
2,000 |
3,000 |
Ed = | change in percentage Q /
change in percentage P | =
| (2-10)/6 /(125 - 25)/75 | = | -8/6 /100/75 | = | -4/3 /4/3 | = 1.
So it is unitary elasticity. [I also accepted calculations across the
smaller ranges: from 10 to 6, and from 6 to 2].
Beans are a normal good, since they are buying more of them as their income goes up.
F. A family in Bolivia is trying to maximize their utility as they purchase food (f), clothes (c), and medicine (m). If the prices of clothes and of medicine suddenly fall so that MUf/Pf < MUc/Pc = MUm/Pm, will the family then buy more or less food? Defend your answer.
They might eat more or less. I accepted any reasonably argued answer that showed knowledge of the basic MU.P concepts.
II. Using supply and demand (25 points)
Many Vermonters claim that the lack of affordable housing in Vermont is the state’s most pressing economic and social problem. In the past three years, the average price of a house in Addison County has gone up by 35 percent --- while incomes have barely increased. (According to the Center for Rural Studies at UVM, the median per household income in Addison County in 2000 was $43,000.)
- In a small mountainous community in Addison County, the demand and supply for housing in 2001 were as follows:
· Qs = 20
· Qd = 25 – 0.0001 P
What were the equilibrium price and quantity in the housing market for this community in 2001?
Qs = Qd
20 = 25 – 0.0001 P
P = $50,000, Q = 20.
- In the beginning of 2002, those demand and supply schedules still hold. Then, after the preservation of more wilderness area in the Green Mountain National Forest in the surrounding mountains, demand for houses in this community shifts further out. Specifically, five different Middlebury College alums (persons A – E) call the town’s real estate agent in the middle of 2002 and announce that they are each interested in buying one house in this community. The five Midd alums conclude their phone calls with the following statements.
· (Person A) ‘I will pay up to $200,000 for any one house in this community.
· (Person B) ‘I will pay up to $175,000 for any one house in this community.
· (Person C) ‘I will pay up to $150,000 for any one house in this community.
· (Person D) ‘I will pay up to $125,000 for any one house in this community.
· (Person E) ‘I will pay up to $100,000 for any one house in this community.
Using the grid below, plot the demand schedule for each of these Midd alums in 2002, and then plot the total market demand schedule for the five Midd alums.
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200 |
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175 |
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150 |
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125 |
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100 |
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75 |
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50 |
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25 |
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0 |
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Five individual demand curves
- By the end of 2002, a price of $100,000 is clearing the market in this town. At this price, what is the total number of houses that have been sold in this community. At this price, how many of the five Midd alums will have bought a house in this town? Among those Midd alum who did buy, what was each of their consumer surpluses?
20 house will be sold, since 15 = 25 – 0.0001 * $100,000, and the 5 Midd alum will also want to buy.
Their surpluses are 100K, 75K, 50K, 25K, and 0, respectively.
- Based on the information provided here, are wilderness and mountain houses compliments or substitutes? Defend you answer.
Wilderness and mountain houses are compliments: with more wilderness, people were willing to pay more for mountain homes. [I accepted any reasonably argued answer here, since the question was not clear – many of you thought it concerned wilderness houses and mountain houses.]
- If the trend that began in 2002 continues --- more Midd alums wanting to buy more houses in Addison County -- what is the likely effect on the housing rental market? Given all of the information presented here, should the State of Vermont establish rent control? Should the State of Vermont establish a ‘living wage’? Defend your answers.
The rental price would go up, since the stock of housing has remained the
same and more people want to live in VT. Rent control would create a housing
shortage, which doesn’t seem like a good idea.
A living wage has its advantages, but it might lead to unemployment.
III. Taxation and the logic of consumer choice (25 points)
Let’s say that the state of Rhode Island has recently increased the sales tax on a pack of cigarettes by $2.50, so that a pack of cigarettes in which used to sell for $2.00 in Providence, Rhode Island now sells for $4.00. The primary goal of this policy is to further reduce smoking among all Rhode Islanders, particularly among high school students.
- Explain why the price of a pack of cigarettes in Providence only increased by $2.00 if the tax was $2.50? Defend you answer.
The producer bore some of the tax incidence – since the price went down by $0.50. A graph was very helpful to show this.
- The map of Rhode Island below shows the location of Providence and Block Island. (Connecticut is to the east of Rhode Island, and Massachusetts is to the north and west of Rhode Island). After the tax, do you think that the price of cigarettes was higher in Providence or Block Island? Defend you answer.
Higher in Block Island, because demand is more inelastic (and, as many of you noted, there might also be more transportation costs.)
BLOCK ISLAND PROVIDENCE
- The graph below illustrates the family of indifference curves for a young smoker in Providence, Rhode Island who also likes pizza. It also shows the budget constraint for the smoker before the imposition of the tax.
With the information that you have been given, carefully draw and label on the graph below: (a) this smoker’s new budget constraint (if any) after the imposition of the tax, and (b) this smoker’s new family of indifference curves (if any) after the imposition of the tax.
Pizza Cigarettes
The budget constraint would rotate in: it would intersect at 2 cigarettes. There is no change in the family of indifference curves: these represent tastes and preferences, which haven’t changed.
- This Rhode Islander has a sister who is severely allergic to cigarette smoke. On the graph above, carefully label two indifference curves for the sister. Which of the four axioms about preferences are not true in her case, if any? Defend your answer.
The indifference curves must be perfectly horizontal,
since their slope is MUc/MUp, and gets no utility from
cigarettes. [They could also
be negative.] The intuition is that she
would prefer 4 pizzas and 0 cigarettes to 3 ½ pizzas and 10,000 cigarettes!
The axioms of convexity and monotonicity are not true. [I accepted etiher one.]
- A year after the imposition of the tax, the tax commissioner calls the Governor of Rhode Island and declares: “This tax has been a huge success! We have increased our revenues from cigarette sales from $20 million to $38 million. I now propose that we increase the sales tax on pizza by $2.50 per pizza so that we can dramatically increase our revenues from the sale of pizza.”
Do you agree with the commissioner that the tax on cigarettes has been a success? Do you agree with the commissioner that the sales tax on pizza should be increased? Defend your answers.
·
Not really, because smoking has only gone down a
little (though, as many of you mentioned, the revenues could possibly be used
for anti-smoking campaigns.)
· No, because as we talked about in class, the demand for pizza is very elastic.
IV. Putting microeconomic reasoning to work (25 points)
In the beginning of The Invisible Heart, Laura Silver makes it clear that she has a very different view of the role of government than does Sam Roberts. (And this difference seems to run in the family, as Sam discovers over dinner!) Laura’s main concern seems to be that market outcomes are not fair, so that an active government should oversee markets and correct them for fairness.
On the issue of school vouchers, Sam would certainly agree with The Black Alliance for Educational Options (BAEO), an organization of African-American families who are “working to increase quality educational options and to empower families to meet their children's needs.” This group has been very successful in promoting the increased use of ‘school vouchers,’ which are a public policy for transforming the forces of education scarcity into market forces.
The way a school voucher program works is simple. The family of each grade school child in a large (typically urban) education district gets a ‘voucher’ in April. They can then ‘cash in’ the voucher at any public or private school in the district. When they ‘cash in’ the voucher, say, at the Benjamin Banneker School, the family gets the right to send their child to the school in the following September; the Banneker school then submits the voucher to the state and receives $8000 (the estimated average cost of educating a child in this district).
Advocates of vouchers claim that this method dramatically increases the quality of education in municipal school districts, since all schools have the incentive to improve in order to attract and retain students. Opponents of vouchers attack them as unfair: some students will be in better schools than others, and less successful schools in some neighborhoods may close, forcing students to commute further to find alternative schools. These opponents believe that highly-trained education superintendents can assure the long-term improvement of all schools in a district.
Do you think that vouchers are a good public policy for improving the overall quality of education? Is a voucher system fair? Carefully defend your answers with clear, analytical reasoning.
I was looking for well-argued, well-presented arguments.