Economics 110
March 3rd, 2005
1st Midterm Exam
STUDENTID:
•
Please write your name in small print on the inside portion of the last page of this
exam
Instructions: You will have 60 minutes to complete the exam. The exam will be
comprised of five short essay questions and will be worth a total of 50 points. Please
write all of your answers NEATLY on this exam sheet. If I cannot read your writing, I
certainly won’t be able to grade it.
1
Economics 110
March 3rd, 2005
1st Midterm Exam
1. There are two parts to this question.
a. (5 points) “Rizzo and his wife cannot possibly be wealthy, they only have
$10,000 in the bank.” Comment.
To an economist, wealth is whatever people value and want, and these lie in
the eyes of the chooser. Therefore the above comment makes no sense to the
true economist. If Mike and Rachel value spending time together, then we
might be considered extremely wealthy. If we value having a large piece of
property so that we can enjoy watching the wildlife, then we are wealthy. If
the only thing we valued is having a bank account full of green pieces of
paper, then we would not be considered wealthy.
b. (5 points) Economists generally agree that there are 4 objectives of any
economic policy. These are efficiency, equity, growth and stability. What
do we mean when we say that a market outcome is efficient?
A market outcome is efficient when the goods that people WANT are
produced at the LEAST POSSIBLE COST.
2. (10 points) Susan can pick 4 pounds of coffee in an hour or 2 pounds of nuts.
Tom can pick 2 pounds of coffee in an hour or 4 pounds of nuts. Each works 6
hours per day.
a. What is the maximum number of pounds of coffee the two can pick in a
day?
If each devotes 6 hours to coffee picking, Susan can pick 24 pounds in 6 hours
while Tom can pick 12 pounds in 6 hours, for a total of 36 pounds.
b. What is the maximum number of pounds of nuts the two can pick in a day.
If each devotes 6 hours to harvesting nuts, Susan can pick 12 pounds of nuts
in 6 hours while Tom can pick 24 pounds of nuts in 6 hours, for a total of 36
pounds.
c. If Susan and Tom were picking the maximum number of pounds of coffee
when they decided that they would like to begin picking 4 pounds of nuts
per day, who would pick the nuts, and how many pounds of coffee would
they still be able to produce?
2
Economics 110
March 3rd, 2005
1st Midterm Exam
To make themselves as well off as possible, they should specialize in the
activity that each of them has a comparative advantage in. To do this, we
need to find out who has the lowest opportunity cost of picking each product.
For Susan, each pound of coffee she picks costs her ½ pound of nuts picked.
For Susan, each pound of nuts she picks costs her 2 pounds of coffee.
For Tom, each pound of coffee picked costs him 2 pounds of nuts while each
pound of nuts picked costs him ½ pound of coffee. Since the opportunity cost
of nut picking is smaller for Tom (½) than it is for Susan (2), Tom should pick
all of the nuts (i.e. he should specialize in producing the goods he is “better”
at producing – the good he has a comparative advantage in producing over
Susan).
Tom can produce the desired 4 pounds of nuts in 1 hour, so he could devote
his remaining 5 hours to picking 10 pounds of coffee. Susan will still devote
all of her time to picking coffee and produce 24 pounds. The total amount of
coffee produced will now be 34 pounds.
d. Now suppose that Susan and Tom were picking the maximum number of
pounds of nuts when they decided that they would like to begin picking 8
pounds of coffee per day. Who would pick the coffee and how many
pounds of nuts would they still be able to produce?
Again, to decide who should pick the coffee, they should find the person with
the comparative advantage in coffee picking. Since Susan faces a lower
opportunity cost for producing coffee than Tom, she should spend two hours
of her day picking 8 pounds of coffee. She will still have four more hours for
which to produce an additional 8 pounds of nuts. Tom will continue to devote
all of his time to nut picking and produce 24 pounds of nuts. The total amount
of nuts produced will now be 32 pounds.
e. Would it be possible for Susan and Tom to pick a total of 26 pounds of
nuts and 20 pounds of coffee each day? If so, how much of each good
should each person pick?
Yes. Since Susan has a comparative advantage in picking coffee over Tom,
she should devote her first five hours of work to picking coffee, which would
allow her to produce 20 pounds of coffee. She will be able to produce 2
pounds of nuts with her remaining hour of time. Since Tom has a
comparative advantage in picking nuts over Susan, he should devote his time
(specialize) to picking nuts. If he spends his entire six hours picking nuts, he
is able to produce 24 pounds of nuts each day. Therefore, when Tom spends
ALL of his time picking nuts, and Susan spends 5 of her 6 hours picking
coffee, the two of them can produce a total of 26 pounds of nuts and 20
pounds of coffee per day.
3
Economics 110
March 3rd, 2005
1st Midterm Exam
3. There are two parts to this question.
a. (6 points) A simple way to think about the “law of demand” is to think
that (ceteris paribus) when something is more costly, people economize by
choosing to consume (or do) less of it. Explain why people behave this
way?
This question is akin to asking, “Why do demand curves slope downward?” It
would help to understand that demand curves represent the quantity of a good
that I would demand for every given price (I prefer to think of it as a marginal
benefit curve – the most I would be willing to pay for a unit of a good at
different levels of consumption of that good). One prominent reason is that
when a good or service becomes more costly, demanders look around for
substitutes – and we know that for even the most “needed” goods, substitutes
exist when costs rise too much. When we find the substitute, we tend to
consume more of the substitute good and less of the good in question.
Second, when the cost of consumption increases, in some sense consumers
have lost purchasing power. For example, if you have a $100 per week
allowance and you use it to buy $10 t-shirts and $20 CDs, and you currently
buy 6 t-shirts and 2 CDs, if the price of t-shirts doubles to $20, at most you
would only be able to buy 5 t-shirts – it’s as if you experienced a loss of
income. For normal goods, we will purchase less of them when our
purchasing power falls. Finally, since consumers experience diminishing
marginal satisfaction from each unit of a good that they consume, for every
given incremental fall in the cost of a good, we will want to purchase a
smaller incremental amount more. Remember, I really like eating that 1st slice
of pizza when I am hungry and I would be willing to pay a decent amount for
that pleasure. After I have eaten my 6th slice, I probably am full and would
not get much satisfaction from consuming a 7th slice, therefore I’d be willing
to pay a small amount to acquire that 7th slice.
b. (4 points) Can you tell me why my demand for Maker’s Mark bourbon is
much more sensitive to price changes than my demand for alcohol?
The more narrowly defined a good, the more elastic the demand for that good
tends to be. The reason for this is that the more narrowly we define a good,
the more likely it is that there are desirable substitutes for that good. With
regard to alcohol, when the price of all alcoholic beverages increase, I am
probably going to be upset, but I always have the option of consuming more
soda, water, ice cream floats and other non-alcoholic beverages. However,
when the price of Maker’s Mark increases, I will have many more
alternatives. For example, I may decide to purchase Blanton’s bourbon, or I
4
Economics 110
March 3rd, 2005
1st Midterm Exam
may decide to substitute vodka for bourbon, or beer for bourbon, or some
other alcoholic drink. I ALSO still have the option of substituting soda, milk,
water, etc. for bourbon so that I have many more options available to me when
I am deciding to buy Maker’s Mark bourbon that when I am deciding to buy
an alcoholic beverage.
4. This question has two parts.
a. (6 points) The law of supply says that (ceteris paribus) when producers are
able to fetch a higher price for their goods, they will want to produce more
of that good. Explain why producers behave this way?
Why do supply curves slope upward? The marginal opportunity costs of
production increase as producers make more of their goods and provide more
of their services. Therefore, in order to be induced to produce more, sellers
would need to be compensated by a higher price that would cover the
additional costs of making the next units or providing the additional services.
A great answer will include a mention of why the marginal opportunity costs
of production increase with the level of production. There are two main
reasons. First, to make more of a good, you must use more inputs. As you
demand more of an input, you need to bid away these resources away from
competing uses, which will tend to be more valuable the larger the level of
inputs you need. Second, there are diminishing returns to adding more inputs.
For example, if you work in an ice cream shop, adding a 2nd worker will likely
result in a lot more cones being scooped. However, while adding the 3rd
worker will certainly enable more cones to be produced, she might not add as
many cones as the 2nd worker did – because there is only so much space
behind the counter to maneuver and only so much ice cream equipment to go
around.
b. (4 points) Both you and your friend place an equal value on going to the
U of L basketball game tonight. You have season tickets to the games in
Freedom Hall and you paid for these at the beginning of the season. Your
friend plans to buy a ticket at the window when you get there. You just
found out that you have an Economics test tomorrow. If both you and
your friend are rational, is one of you more likely to attend the game than
the other?
YOU would be more likely to attend the game because the cost of your ticket
is a sunk cost. Your decision to attend the game should depend only on the
benefits to you of seeing the game and the opportunity cost of the study time
given up. For your friend, the opportunity cost of going to the game is
HIGHER than it is for you, since she has yet to purchase a ticket. Therefore,
she would be less likely to go than you would.
5
Economics 110
March 3rd, 2005
1st Midterm Exam
5. This question has 3 parts.
a. (2 points) How would an increase in the number of mosquitoes carrying
West Nile Virus affect the equilibrium price and quantity in the market for
early summer fishing vacations in Maine?
This will change the behavior of buyers in the market for fishing vacations –
for any given price of a fishing vacation, the trips are now less desirable. So
we know that demand will fall. For those that like pictures, the demand curve
will shift to the left. When demand falls, we know that the equilibrium price
of fishing trips and the equilibrium quantity of fishing trips will fall.
b. (4 points) What will happen to the equilibrium price and quantity of corn
if the price of butter increases and the price of fertilizer increases? It
might help to think of what the relationship is between butter and corn.
This will change the behavior of BOTH buyers and sellers. For buyers, butter
is a complementary good to corn, so that when the price of butter increases, at
every current price of corn, corn will be less desirable – fewer people will
want to buy it, so demand will fall. In other words, the demand curve will
shift in to the left. For farmers, an increase in the price of fertilizer raises the
marginal opportunity cost of producing every unit of corn. Therefore, in order
to continue to produce the same amount of corn as before they would have to
receive a higher price for it. In other words, for every given level of the price
of corn, sellers are not willing to produce as much corn. Therefore, supply
will also fall. For those that like pictures, the supply curve will shift up and to
the left. Since both demanders desire less of the corn and suppliers want to
produce less corn, we know the new equilibrium quantity of corn will fall.
However, we cannot say for sure what will happen to the equilibrium price of
corn. The fall in demand would tend to depress prices (if supply were
unchanged) but corresponding fall in supply would tend to increase prices
(had demand been unchanged). Whether the price rises depends on how much
each curve will shift in. It might seem plausible that an increase in butter
prices have only a small negative impact on demand (but I don’t explicitly tell
you this), in which case the new equilibrium price would be higher.
c. (4 points) “Cornell really did Rizzo a favor by keeping ticket prices to his
beloved Big Red hockey team’s games low ($8). If the University acted
like a greedy capitalist, the tickets would have been sold for about $30 –
so Cornell reduced his costs by $22 per ticket.” Provide a brief comment
(agree, disagree, true, false, explain, etc.).
Rather than allowing the price system to ration the very scarce resources (in
which case tickets would go to people that would be willing to pay the most
6
Economics 110
March 3rd, 2005
1st Midterm Exam
for money them), Cornell uses a “first-come first-serve” mechanism. Let’s
ignore the potential benefits to Cornell of doing this (which is largely why
they do this) and focus on my quote. While Cornell may have reduced the
money price of a ticket to Rizzo, they have done little to lower the real
economic costs to me. Recall that economic costs are all marginal
opportunity costs. If Rizzo waited in line for 3 days to get tickets, he
sacrificed three days worth of labor or leisure that could very well have been
worth over $22 per ticket (but the tickets were worth that to me!!!). If he
didn’t wait in line, since he valued the tickets so much, he could have paid
someone else to secure the tickets for him, or purchased them from a scalper
to get the tickets. The lesson here is, that regardless of the rationing
mechanism, consumers will compete with each other in order to acquire the
goods that are most valued by them – and this competition will tend to
increase the economic cost of acquiring the good. By rationing on a queue,
Cornell is simply making it less transparent for an outside observer to see that
true economic costs of the tickets.
7