Introductory Microeconomics - EC155A and B

October 17, 2001

ANSWERS TO FIRST EXAMINATION

I. Thinking like an economist

ANSWER FIVE OUT OF THE SIX QUESTIONS IN THIS SECTION: (AMONG QUESTIONS 1A – 1F) THERE IS NO EXTRA CREDIT FOR ANSWERING ALL SIX)

A. On October 12^th, 2001, BBC Radio reported on “Queue for You,” a new business in London that will stand in line for you! For example, if you need to renew your driver’s license, a “Queue for You” employee will go to the Department of Motor Vehicles and stand in line. The employee will call you when he is almost at the front of the line so that you can then replace him in line, get your photo taken, and sign for your new license!

Explain how “Queue for You” is taking advantage of the concept of opportunity cost. What decision rule would a potential client follow as she decides whether to pay for the services of “Queue for You”?

For some people, the opportunity cost – the benefit foregone of the next best alternative – of standing in line is higher than others. For example, a lawyer who earns $350 per hour gives up more by being in line for tow hours than does a retiree on a fixed income.

“Queue for You” takes advantage of this by offering a service to people for whom the opportunity cost is high. A potential client will pay for this service if the marginal cost -- the amount that she pays to “Queue for You” -- is less than or equal to the marginal benefit – the wages foregone (or more generally, her the value of the time foregone.)

B. Over Family Weekend for Middlebury College, how do you think that the demand for pizza changes in downtown Middlebury? If you sold pizza in Middlebury, how would you react to this change in order to maximize your revenues over Family Weekend? Justify your answers.

It depends. You could argue that demand shifts in, since a lot of parents are taking their kids out to restaurants, so that there are less students eating pizza on Friday and Saturday nights. In this case, you might offer coupons to students in order to sell pizza at the lower equilibrium price.

By contrast, demand could shift out because there is a lot of late night carousing over the family weekend. In this case, their will be a higher equilibrium price: some pizza seller might stay open later (a movement up the supply curve) to sell more pizzas .. or not allow discount pizzas over this weekend.

C. As a pro-consumer lobbyist in Washington, you are trying to make consumers better off in the energy market. You could push for one of two policy changes: switch the current gasoline tax on consumers to a similarly-sized gasoline tax on producers; or remove tariffs on oil from overseas producers (so that more foreign oil would be sold in the United States). For consumers of gasoline, which of these two possible changes would be better? Justify your answer.

The first change would not make a difference in terms of the size of the consumer surplus, as we discussed in class: it doesn’t matter whom you tax. By contrast, removing tariffs would shift out supply, lower prices, and thereby increase the consumer surplus (since consumer surplus is defined as the difference between demand – which wouldn’t change in this case – and the price that consumers pay.)

D. On October 5^th, 2001, the Associate Press reported that teen-agers are now less likely to become cigarette smokers. Since 1997, the number of new teen smokers has decreased by a third – and the average price of a pack of cigarettes has gone from $1.85 to $2.92. Would it be correct for a researcher to use this data to calculate the own-price elasticity of demand for cigarettes among young smokers? Justify your answer.

No, this would not be correct. It is quite possible that there has also been a shift in of the demand curve among teenagers (based, say, on public anti-smoking campaigns). Since there is no way to determine this with these data, on cannot use them to estimate the elasticity along a demand curve.

E. Two drivers -- Ben and Jerry -- each drive up to a full-service gas station. Before looking at the price, each places an order. Ben says, “I’ll take 10 gallons of gasoline.” Jerry says, “I’ll take $10 worth of gasoline.” What is each driver’s own-price elasticity of demand for gasoline?

Ben’s elasticity of demand must be 0 (perfectly inelastic), since he will buy 10 gallons, no matter what the price.

Ben’s elasticity of demand must be 1 (unitary elasticity), since he will pay the same amount, no matter what the price. (Remember, his total payment is the revenue for the service station, and revenues are constant when the own price elasticity is 1: as you all showed with the non-linear demand curve in the second problem set.)

F. The following data are from a student in an economics class who was asked about their willingness to pay for CDs and DVDs under two different scenarios (A and B).

	Scenario A	Scenario B
	DVD price = $20	DVD price = $30
Price of a Compact Disk	Number of compact disks demanded	Number of compact disks demanded
$ 20	10	15
$ 18	12	18
$ 16	14	21
$ 14	16	24
$ 12	18	27

Based on these results, what is the cross price elasticity of demand for CDs with respect to DVDs for this student when the price of a CD is $14? Based on the logic of consumer choice (and assuming that this student always tries to be as happy as possible), in which of the two cells in this row (16 and 24, respectively) is the marginal rate of substitution (MU_CD /MU_DVD) higher? Justify your answer.

Cross price elasticity = (percentage change of quantity ) / (percentage change of other price), using the midpoint convention.

So, E = (24 – 16)/(24+16)/2 / (30 – 20)/(30+20)/2

= (8/20)/(10/25)

= (2/5)/(2/5)

= 1

If she is trying to maximize her happiness, MU_CD /MU_DVD = P_CD /P_DVD at each point.

In the first cell, P_CD /P_DVD = 14/20 = 7/10 = 0.7

In the second cell, P_CD /P_DVD = 14/30 = 7/15 = 0.47

So it is higher in the first cell. This makes sense intuitively: when the relative price of CD’s is higher --in the first cell – one will not buy as many CDs. With less CDs, the marginal utility of the last CD purchased will be higher (following the law of diminishing marginal utility); whereas with more DVDs, the marginal utility of the last DVD purchased will be lower (again, following the law of diminishing marginal utility).

II. Using supply and demand

The commodity markets for some goods (like wheat) often have the following characteristics: supply shifts frequently; prices fluctuate wildly and frequently; the quantity sold per year doesn’t change much; and the per capita consumption of the good increases – but not by much -- as (most) countries grows economically.

A. Is the own-price elasticity of demand for such a commodity likely to be relatively elastic or inelastic? Justify your answer.

If supply shifts frequently; prices fluctuate wildly and frequently; and the quantity sold per year doesn’t change much, this is consistent with an inelastic demand curve. Buyers are not very sensitive to price -- they need their wheat products – so don’t change their quantity demanded much as the prices varies a lot with a large supply shift.

P

	Supply shift

B. Is the elasticity of supply for such a commodity likely to be relatively elastic or inelastic? Justify your answer.

Supply could be relatively elastic or inelastic – a shift will change prices dramatically along the demand curve. (Even in the case of a perfectly elastic supply curve, it could move up or down – a change, as we will see, in marginal cost.)

C. Is such a commodity likely to be an inferior good, a normal good, and/or a luxury good? Justify your answer.

Since the per capita consumption of the good increases – but not by much -- as (most) countries grows economically, it is likely to be a normal good, but not a luxury good (so it is a necessity.) This corresponds to a demand shift as income increases, but one for whom the income elasticity is less than one.

D. Under these conditions, why would established suppliers of such a commodity try to persuade their governments to impose a price floor on the commodity and/or to restrict imports of the commodity?

A price floor or an import restriction would raise prices – through the seeting of a price above the market equilibrium or by shifting in supply. Since demand is inelastic, this would mean higher revenues – since producers would be producing less (the equilibrium quantiy would of course fall, following the law of demand), their cost would fall too. Accordingly, with higher revenues and lower costs, profits would be higher.

E. If you were a lobbyist for a company that was trying to establish a price floor, how would you argue that society would not be very hurt by such a policy? Under what conditions would society be more hurt by the imposition of a price floor?

You would argue that since the demand is inelastic, the deadweight loss would be relatively small (you can show this graphically). If demand was elastic, by contrast, the deadweight loss would be greater.

III. The logic of consumer choice

In Kenya, a family with two children in primary school has $24 to spend on two goods: textbooks and clothing for the school year. The price of each textbook is $3; the price of each school uniform is $4.

A. Using the axes below, plot the relevant income constraint for this family, with textbooks on the vertical axis and uniforms on the horizontal axis. What is the slope of this line?

The slope is -4/3, since, using our formula, the budget constraint can be expressed as Q_t = - (P_u/P_t)*Q_u+ I/P_t

10

8

Uniforms

4 5 6

B. The government orders that all uniforms must be bought from a single, state- owned supplier -- who will now charge $6. On the same graph above, show what this does to the income constraint. What is the slope of this new line?

The new slope is -6/3 = - 2: a steeper line.

C. Soon after the government declares this policy, the woman in this household finds new income-generating activities, supported by a small loan from a local development agency. The family is soon able to afford spending $30 on textbooks and clothing. On the same graph above, show what this does to the income constraint. What is the slope of this new line?

The slope is still - 2, since the prices have not changed.

D. Is the family going to be better off, in terms of the utility that they derive from textbooks and uniforms, with the first income constraint and the first set of prices ($24, $3, and $4, as in question A) -- or with the second income constraint and the second set of prices ($30, $3, and $6, as in question C)? Justify your answer.

It depends. There are three possibilities.

1. As illustrated by the family of blue indifference curves above, they may have a general preference for textbooks. In this case, they would prefer the first scenario: where income is lower, but where the relative price of textbooks is quite low (compared to the price of uniforms), allowing them to buy more textbooks.

2. As illustrated by the family of green indifference curves above, they may, alternatively, have a general preference for uniforms. In this case, they would prefer the second scenario: where income is higher, and where the relative price of uniforms is quite low (compared to the price of textbooks), allowing them to buy more uniforms.

3. Alternatively, they may have no preference between the scenarios. This is the case of the red indifference curve -- the first of which, as drawn, is tangent to both of the budget lines.

E. Researchers at a development agency estimate that the own-price elasticity of demand for textbooks in Tanzania is about 0.1, the income elasticity for textbooks is about 2.0; and that only 20% of poor families regularly purchase textbooks. Based on these research results, which policy (or combination of policies) would you recommend to the government of Tanzania if its objective were to ensure that children of most poor families have access to textbooks in their homes?

· Lower prices of textbooks from $3.00 to $1.50.

· Rent the books for $3.00 – and give the family back it’s $3.00 at the end of the school year.

· Give away the books.

· Teach parents about the importance of textbooks for their children’s education.

Justify your answer.

A good answer here will show an understanding that lowering prices will do little, since demand is very inelastic. Giving away books, though, could introduce the problem of the books not being treated as an economic good (as we saw in the case of water). Renting the books is likely to be desirable, in combinations with an education program for parents about the importance of textbooks.

IV. Putting microeconomic reasoning to work

You are a member of the Town Council in Middlebury, which voted last year to increase the local tax on the sale of real estate by 10%. You and you colleagues are trying to decide how to use the new tax revenues. You could increase downtown parking (this would help local residents and businesses); expand the facilities at Project Independence (an elderly care program); or do a combination of both (some parking and some elderly facilities).

A. At the Middlebury Town Meeting, a voter gets up and declares: “This tax increase is really making us worse off: less houses are now being sold because of the tax, and these tax revenues represent money out of the pockets of buyers and sellers. In other words,” (it turns out that this guy is an economics teacher!) “our community has been made worse off in two ways: we are losing the ‘deadweight loss,’ and we are losing all of these tax revenues.” Is this voter’s logic correct? Justify your answer.

This guy is not right. The tax revenues are not lost to the community: they are used to fund public goods and other services that the community deems necessary and helpful.

B. Based on the material in our class, what ‘role of government’ would the Town Council be playing if it decided to increase downtown parking? What ‘role of government’ would the Town Council be playing if it decided to expand the facilities at Project Independence? Justify your answers.

Based on the Colander material and our discussion in class, this would include ‘providing public goods’ and ‘correcting for socially undesirable results.’

C. To help you and your colleagues to decide how to use these tax revenues, the town manager gives you the following production possibilities, based on his studies of local input prices and consultations with local contractors.

Resources devoted to parking lot construction	Square feet of parking lot	Resources devoted to elderly services expansion	Square feet of elderly services
100%	20,000	0%	0
80%	19,000	20%	2,000
60%	17,000	40%	3,600
40%	14,000	60%	4,800
20%	10,000	80%	5,600
0%	0	100%	6,000

Using the space below, plot the production possibilities frontier for these allocations.

Parking space

20,000

S

6,000

Elderly facilities

D. One of your colleagues states: “It’s obvious which one of these possibilities is best. If we allocate 80% of our resources to parking lot construction and 20% to elderly services, we get the most square feet: a total of 21,000. Since more is always better, this is what we should do.” Is your colleague right? Justify your answer.

No, the total amount makes no difference. What is important – in terms of the best choice for the community – is what the community prefers in terms of the balance of more parking space and more elderly facilities.

E. Based on our discussion of the logic of consumer choice, how can you relate the concepts of utility and indifference curves to this decision making process? Use your graph to illustrate your answer.

It is the community’s ‘social welfare function’ -- or social indifference curve -- which will guide the decision making process. The council members will try to determine which of these choices maximizes the collective utility of the community, as illustrated by the indifference curves on the graph.