EXAM IN MICROECONOMICS

(October, 2008)

VARIANT 2

SOLUTIONS

Section 1. Multiple choice questions

You have 60 minutes to do this part of the exam.

Marking scheme: 1 point for a correct answer, -0.25 for a wrong answer, 0 if the answer has not been given.

1. Suppose that Country A can produce either 6 million tons of wheat or 3 million tons of meat per year (or any linear combination of those). Country B can produce either 2 million tons of meat or 6 million tons of wheat (or any linear combination of those). In this setup:

   1. Country A should specialize in wheat and trade with B

   2. Country B should specialize in wheat and trade with A

   3. Countries should trade, but not necessarily specialize in any good

   4. Countries should not trade

   5. Can not determine from the information given

The correct answer is (b), due to the principle of comparative advantage.

2. Which of the following statements is/are normative, rather than positive?

   1. «Firms should always maximize their profits»

   2. «Given equal prices, a utility-maximizing individual should increase the consumption of goods for which marginal utility is higher»

   3. «Considering the current economic situation, the government should back up the banking system with additional financial aid»

   4. More than one of the above

   5. None of the above

The correct answer is (d), as both (a) and (c) are normative (they express opinions rather than logical conclusions).

3. Consider the following PPF:

Which of the following does this shape of PPF NOT satisfy?

1. Principle of scarcity

2. Principle of increasing opportunity costs

3. Both (a) and (b)

4. None of the above

The correct answer is (b), since the opportunity costs are constant for a linear PPF.

4. When economic agents with linear PPF's decide to engage in trade according to the principle of comparative advantage, their aggregate PPF after trade is:

   1. A horizontal sum of the individual PPF's

   2. A vertical sum of the individual PPF's

   3. The frontier of the set representing the intersection of individual production possibility sets

   4. The frontier of the set representing the union of individual production possibility sets

   5. A line obtained by combining individual PPF's in the order of increasing (in absolute values) slopes left to right

The correct answer is (e), by construction.

5. Suppose that you prefer cinema to playing computer games and you prefer playing computer games to studying microeconomics before the exam. However, you choose to study microeconomics for some reason. Your opportunity costs in this case are:

   1. The utility of going to cinema

   2. The utility of playing computer games

   3. The utility of going to cinema minus the utility of playing computer games

   4. The utility of going to cinema minus the utility of studying microeconomics

   5. The utility of playing computer games minus the utility of studying microeconomics

The correct answer is (a), which corresponds to the best alternative foregone. Note that the definition of opportunity costs does not yet embrace individual rationality.

6. Vasya Pupkin studies microeconomics. He makes three statements:

1. A good is defined to be inferior if price and quantity demanded of the good move in the same direction.

2. Higher consumer incomes always benefit producers.

3. An inferior good is less durable¹ than a luxury good

Which statements are correct?

1. I only

2. II only

3. III only

4. II and III only

5. All statements are wrong

The correct answer is (e). (I) is wrong because that is definition of Giffen good. (II) is wrong when the good is inferior. (III) is wrong because less durability doesn’t necessarily imply inferiority.

7. If the absolute value of income elasticity for a good is greater than 1, it must be:

1. A Giffen good

2. An inferior good

3. A luxury good

4. A normal good

5. No true answer

The correct answer is (e). The income elasticity of the good in question can be both <-1 or >1, since we are talking about the absolute value, and none of these goods match this description. However, since luxury goods satisfy this partially by having income elasticity >1, this answer will also be accepted.

8. The competitive market for gasoline is currently in equilibrium. Which of the following would most likely increase the price of gasoline?

1. A decrease in household income

2. Improvement in gasoline production technology

3. A decrease in the price of subway tickets and other public transportation

4. An increase in the price of crude oil

5. An increase in the price of car insurance

The correct answer is (d), since crude oil is an input is gasoline production.

9. A consequence of a binding price floor is:

1. A persistent shortage of the good

2. An increase in total welfare

3. A persistent surplus of the good

4. Elimination of deadweight loss

5. An increase in quantity demanded and a decrease in quantity supplied

The correct answer is (c), since producers would want to supply more of the good than the buyers would be willing to purchase at the price that is above the equilibrium price.

10. Suppose good X is inferior (but not Giffen). If consumers’ incomes rise, and technology for producing good X improves, then, given the usual shape of the supply and demand curves:

1. Price of good X will increase

2. Price of good X will decrease

3. Equilibrium quantity of good X will increase

4. Equilibrium quantity of good X will decrease

5. Nothing can be said for sure

The correct answer is (b), the equilibrium price will decline in response to lower demand and higher supply.

11. When the price of popsicles rose from $10 to $11, consumer expenditures on them dropped by 10%, indicating that:

1. Demand for popsicles had a price elasticity of -1

2. Demand for popsicles was price-elastic

3. Popsicles are a normal good

4. Popsicles are an inferior good

5. More than one answer is correct

The correct answer is (b). The price elasticity is greater than 1 (in absolute value) because the expenditures (price*quantity) drop by the same percentage amount as the percentage increase in price. For that too be the case, the quantity demanded should decrease by more than 10%.

12. At a price of $10, Jane would buy 8 CDs. At a price of $12, Jane would buy 6 CDs. Her price elasticity of demand would then be:

1. -1/2

2. -11/7

3. -5/4

4. -5/8

5. -4/5

The correct answer is (c).

13. Wayne’s cross-price elasticity of demand for peanuts with respect to the price of bananas is -0,44. This means that, for Wayne, peanuts and bananas are ______________ and that a reduction in supply of bananas would cause ______________ his peanut demand curve.

1. Complements; a rightward shift of

2. Complements; a movement along

3. Complements; a leftward shift of

4. Substitutes; a rightward shift of

5. Substitutes; a leftward shift of

The correct answer is (c).

14. If the price of watches falls by 3% and the quantity demanded of clocks increases by 2%, cross-price elasticity of clock demand with respect to the price of watches is _______ and clocks are _______________.

1. -1,5; substitute to watches

2. -2/3; complement to watches

3. 1,5; complement to watches

4. 2/3; substitute to watches

5. No right answer

The correct answer is (b). The cross-price elasticity is -2/3, and the clocks are complements to watches.

15. An extraordinary draught destroyed much of the coffee crops in Africa. The most likely consequence of this event for the instant coffee market would be:

    1. a deficit of instant coffee

    2. an increase in consumer surplus

    3. a decrease in demand

    4. an increase in supply

    5. a decrease in supply

The correct answer is (e).

16. If demand for silver coins increases by 5 at each price when income increases by 5% then the income elasticity of demand at quantity 100:

    1. 2

    2. 1/3

    3. 2/5

    4. 1

The correct answer is (d): (5%)/(5%)=1.

17. If total revenue rises when price falls, the demand curve is:

1. elastic

2. unit-elastic

3. inelastic

4. the answer cannot be determined 

The correct answer is (a).

18. Demand for a good is likely to be more elastic:

    1. the smaller the fraction of consumer income absorbed by the good

    2. in the short run than in the long run

    3. the more broadly defined the good

    4. the greater the number of available substitutes for the good

The correct answer is (d). The greater the number of substitutes - if the price rises, you can easily buy something else

19. When the price of cigars was $2, consumers bought 1 000 000 of them. After the government introduced an excise tax on cigars, the price of cigars has increased by $1, and the sales dropped to 800 000 cigars. We can tell that consumer surplus:

1. decreased by $900 000

2. decreased by $1 000 000

3. decreased by $800 000

4. decreased by $1 400 000

5. didn’t change

The correct answer is (a): 1*800 000 + (1/2)*1*(1 000 000 – 800 000)=900 000.

20. Given the usual shape of demand and supply curves, if the demand curve is steeper than the supply curve, the greater tax burden will fall on:

1. producers

2. consumers

3. the tax burden will be distributed equally

4. not enough information – we have to know their price elasticities

5. not enough information – we have to know the size of the tax that is imposed

The correct answer is (b).

21. Consider a competitive market for tennis shoes, where the demand curve is linear and downward-sloping, and supply is perfectly elastic. There is a tax t on every pair of tennis shoes sold. If the government doubles that tax:

1. total DWL (dead-weight-loss) caused by the doubled tax will be exactly twice the original DWL

2. total DWL caused by the doubled tax will be more than twice the original DWL

3. total DWL caused by the doubled tax will be less than twice the original DWL

4. to know if total DWL caused by the doubled tax would be more or less than twice the original DWL, we would need to know the slope of the demand curve

5. None of the above

The correct answer is (b). Drawing graphs would help you to determine the answer.

22. The market for a good is characterized by downward sloping demand curve and a perfectly inelastic supply curve. Suppose the government imposes a price ceiling that is below the equilibrium price. As a result of this policy,

1. producer surplus must decrease

2. consumer surplus must increase

3. consumer surplus must decrease

4. producer surplus must decrease by the exact amount of the increase in consumer surplus

5. total surplus must decrease

6. More than one answer is correct

The correct answer is (f), since both (a), (b) and (d) are correct.

23. The country that produces 40% of the world's oil limits its oil exports in order to increase its income from sales abroad. Which of the following conditions would contribute the most to the success of this policy?

    1. inelastic demand by oil importers; inelastic supply by other oil producers

    2. inelastic demand by oil importers; elastic supply by other oil producers

    3. elastic demand by oil importers; inelastic supply by other oil producers

    4. elastic demand by oil importers; elastic supply by other oil producers

The correct answer is (a). Inelastic demand for oil means that lowering quantity would raise the price quite a lot, raising revenues as well. Inelastic supply by other oil-producing countries would mean that they cannot respond to the high price by substantially increasing their supply of oil.

24. Let a utility function be given as U(x, y)=min{2x, 2y}. Then:

    1. Goods x and y are substitutes

    2. Goods x and y are complements

    3. Income effect is zero for any price changes

    4. Both (b) and (c) are correct

The correct answer is (b), as the function perfect complements. Both goods are normal, and price effect is equal to income effect (substitution effect is zero).

24. Which of the following should always be true for indifference curves, given the usual assumptions?

    1. Indifference curves are strictly convex

    2. An indifference curve can be drawn through any point corresponding to a bundle of goods

    3. Indifference curves should approach axes asymptotically

    4. All of the above

    5. None of the above

The correct answer is (b), which corresponds to the axiom of completeness.

24. If indifference curves exhibit constant marginal rate of substitution at all points, they should be defined as:

    1. Symmetric hyperbolae

    2. Homothetic right angles

    3. Straight lines

    4. Circular arches

    5. None of the above

The correct answer is (c). The only functional form with a constant derivative is linear, and right angles do not fit due to MRS being undefined at the kink.

24. Suppose that a per-unit tax is levied on purchases of good X. Then:

    1. The budget line of a consumer will shift parallelly downwards

    2. The budget line of a consumer will rotate around a point on the Y-axis

    3. The budget line of a consumer will rotate around a point on the X-axis

    4. The budget set will expand

    5. The consumer will always consume less of X

The correct answer is (b). (e) does not hold for a strongly inferior X or for a corner solution with no X consumed.

24. Which of the following should always hold when utility is maximized?

    1. Marginal rate of substitution equals to the price ratio

    2. The indifference curve has only one point in common with the budget set

    3. The indifference curve has no points below the budget constraint

    4. More than one applies

    5. None applies

The correct answer is (c), which follows from nonsatiation of preferences (or a stronger assumption of “more is better”). A counterexample to (a) is a corner solution, and a counterexample to (b) is a solution with perfect substitutes (coincidence of the budget constraint with the indifference curve).

24. Which of the following should always be true about the substitution effect?

    1. It should be positive

    2. It should be negative

    3. It should be nonpositive

    4. It should be nonnegative

    5. None applies

The correct answer is (c). A decrease in the relative price of the good alone should lead to increase in its consumption (substitution effect can be zero, however, as in the case of perfect complements).

24. Suppose consumer’s preferences for X and Y are described by

.

Then MU (X) given Y=Y₀ is:

The correct answer is (d), which can be obtained by exponentiating and differentiating the equation with respect to X.

24. Suppose that a monetary subsidy is combined with an in-kind transfer in X (on the horizontal axis). Which of the following represents the change to the budget set?

    1. 

    2. 

    3. 

    4. 

    5. 

The correct answer is (e).