Economics I Mid-term exam

2023-11-13
1. [20 points] Pam has made her best affordable choice of cookies and granola
bars. She spends all of her weekly income on 30 cookies at $1 each and 5
granola bars at $2 each. Next week, she expects the price of a cookie to fall
to 50¢ and the price of a granola bar to rise to $5.
a. Will Pam be able to buy and want to buy 30 cookies and 5 granola bars
next week? [5 points]
Pam can still buy 30 cookies and 5 granola bars. When Pam buys 30 cookies at $1
each and 5 granola bars at $2 each, she spends $40 a week. Now that the price of a
cookie is 50 cents and the price of a granola bar is $5, 30 cookies and 5 granola bars
will cost $40. So Pam can still buy 30 cookies and 5 granola bars. But Pam will not
want to buy 30 cookies and 5 granola bars because the marginal rate of substitution
does not equal the relative price of the goods. Pam will move to a point on the
highest indifference curve possible where the marginal rate of substitution equals the
relative price.

b. Which situation does Pam prefer: cookies at $1 and granola bars at $2

or cookies at 50¢ and granola bars at $5? [5 points]
Pam prefers cookies at 50 cents each and granola bars at $5 each because she can
get onto a higher indifference curve than when cookies are $1 each and granola bars
are $2 each. To see why Pam can move to a higher indifference curve, note that the
new budget line and the old budget line both pass through the point 30 cookies and 5
granola bars. If granola bars are plotted on the x-axis, the marginal rate of
substitution at this point on Pam’s indifference curve is equal to the relative price of a
granola bar at the original prices, which is 2. The new relative price of a granola bar
is $5/50 cents, which is 10. That is, the budget line is steeper than the indifference
curve at 30 cookies and 5 granola bars. Pam’s new equilibrium combination of
cookies and granola bars must be on an indifference curve at a point steeper than
the initial indifference curve. Because the new budget line is steeper and passes
through the initial equilibrium combination, the new best affordable point must lie
above the initial equilibrium point so it must be on a higher indifference curve.

c. If Pam changes how she spends her weekly income, will she buy more
or fewer cookies and more or fewer granola bars? [5 points]
Pam will buy more cookies and fewer granola bars. The new budget line and the old
budget line pass through the point at 30 cookies and 5 granola bars. If granola bars
are plotted on the x-axis, the marginal rate of substitution at this point on Pam’s
indifference curve is equal to the relative price of a granola bar at the original prices,
which is 2. The new relative price of a granola bar is $5/50 cents, which is 10. That is,
the budget line is steeper than the indifference curve at 30 cookies and 5 granola
bars. Pam will buy more cookies and fewer granola bars.
 d. When the prices change next week, will there be an income effect, a
substitution effect, or both at work? [5 points]
There will be a substitution effect and an income effect. A substitution effect arises
when the relative price changes and the consumer moves along the same
indifference curve to a new point where the marginal rate of substitution equals the
new relative price. An income effect arises when the consumer moves from one
indifference curve to another, keeping the relative price constant.

2. [10 points] Saudi Arabia cut its price by 10 percent today in retaliation for
Russia’s refusal to join in the large production cut last month by the
Organization of the Petroleum Exporting Countries. Falling prices are a huge
problem for Saudi Arabia because they erode petroleum revenues.
Source: [Link], March 8, 2020
a. How can you use the information in the news clip to determine whether
the demand for Saudi Arabian oil is elastic or inelastic?
The total revenue test reveals that the demand for oil from Saudi Arabia
is inelastic. The total revenue test concludes that if the demand is
inelastic and the price falls, then the total revenue decreases, which is
exactly what the article says occurs.

b. Does the news clip tell us whether the supply of Saudi Arabian oil is
elastic or inelastic? Explain.
The article does not allow us to determine the price elasticity of supply
because it does not suggest that the demand for oil changed.
Consequently, we do not have information about how the quantity
supplied changed when the price changed.

3. [17 points]
 Price Quantity supplied
(dollars (rides per week)
per Rick Sam Tom
ride)
10.00 0 0 0
12.50 5 0 0
15.00 10 5 0
17.50 15 10 5
20.00 20 15 10

The table gives the supply schedules for jet-ski rides by the only suppliers:
Rick, Sam, and Tom.
a. What is each owner’s minimum supply-price of 10 rides a day? [6 points]
Rick’s minimum supply- price for 10 rides is $15.00, Sam’s minimum
supply-price is $17.50, and Tom’s minimum supply-price is $20.00.

b. Which owner has the largest producer surplus when the price of a ride is
$17.50? Explain. [5 points]
Rick has the largest producer surplus when the price is $17.50. Rick’s
producer surplus is largest because he produces the largest quantity and
his costs are lower than those of the other producers. More formally, each
supplier’s producer surplus is equal to the area under the price and above
that producer’s supply curve. Calculating these areas of producer surplus,
Rick’s producer surplus is $56.25, Sam’s producer surplus is $25.00, and
Tom’s producer surplus is $6.25.

c. What is the marginal social cost of 45 rides a day? [3 points]

45 rides are produced when the price is $20.00, so the marginal social
cost of producing 45 rides a day is $20.00.

d. Construct the market supply schedule of jet-ski rides. [3 points]

When the price is $10.00, the quantity of rides supplied is 0; when the
price is $12.50, the quantity supplied is 5 rides; when the price is $15.00,
the quantity supplied is 15; when the price is $17.50, the quantity
supplied is 30; and, when the price is $20, the quantity supplied is 45.
4. [10 points] The government wants to discourage the consumption of sugary
drinks and proposes introducing a 20 percent tax on them. A survey shows
that the demand for sugary drinks is perfectly elastic and people are equally
happy to stop consuming those drinks and switch to healthier alternatives.
Producers of sugary drinks complain and say they will increase their prices
 by 20 percent. Explain, and illustrate with a graph, why sugary drinks
producers are wrong.
Sugary drink producers are wrong because the demand is perfectly elastic.
Consequently, consumers are not willing to pay a price that is higher than the
price at which the demand is elastic. Figure 6.5 illustrates this situation. The
initial price of a drink is $1.00 and the demand for drinks is perfectly elastic
at this price. Once the tax is imposed, the supply curve shifts upward by the
amount of the tax, 20 percent of the price without the tax, to the supply
curve labeled S + tax. The new equilibrium price demanders pay is the same
as the price they paid without the tax: $1.00 per drink. Not only can the
producers not mark up the price by 20 percent, but they also cannot mark it
up by anything at all! In this case, the entire incidence of the tax falls on the
sellers.

5. [18 points] Cindy has $70 a month to spend, and she can spend as much
time as she likes playing golf and tennis. The price of an hour of golf is $10,
and the price of an hour of tennis is $5. The table shows Cindy’s marginal
utility from each sport.
 Hours Marginal Marginal
per utility utility
month from golf from
tennis
1 80 40
2 60 36
3 40 30
4 30 10
5 20 5
6 10 2
7 6 1

a. Make a table that shows Cindy’s affordable combinations of hours

playing golf and tennis. If Cindy increases her expenditure to $100, describe
how her consumption possibilities change. [5 points]
The table showing Cindy’s affordable combinations of hours playing golf and
tennis is to the right. If Cindy increases her expenditure, then for each entry
of tennis hours in the table, her hours of playing golf increase by 3 hours.
Alternatively, for each entry of golf hours in the table her hours of playing
tennis increase by 6. In terms of a diagram, Cindy’s budget line shifts to the
right and its slope does not change.
Hours Hours
playing playing
golf tennis
7 0
6 2
5 4
4 6
3 8
2 10
1 12
0 14

b. How many hours of golf and how many hours of tennis does she play
to maximize her utility? [4 points]
Cindy plays golf for 5 hours and tennis for 4 hours to maximize her utility.
This combination allocates (spends) all her income and sets the marginal
utility per dollar from golf equal to the marginal utility per dollar from tennis.

c. Cindy’s tennis club raises its price of an hour of tennis from $5 to

$10, other things remaining the same. Please list the combinations of hours
 spent playing golf and tennis that Cindy can now afford and her marginal
utility per dollar from golf and from tennis. [5 points]
Hours Marginal Hours Marginal
playing utility playing utility
golf per dollar tennis per dollar
from golf from
tennis
7 0.6 0
6 1.0 1 4.0
5 2.0 2 3.6
4 3.0 3 3.0
3 4.0 4 1.0
2 6.0 5 0.5
1 8.0 6 0.2
0 7 0.1

d. How many hours does Cindy now spend playing golf and how many
hours does she spend playing tennis? [4 points]
Cindy now plays golf for 4 hours and plays tennis for 3 hours. This
combination allocates (spends) all her income and sets the marginal utility
per dollar from golf equal to the marginal utility per dollar from tennis.

6. [25 points] Sara’s income is $12 a week. The price of popcorn is $3 a bag,
and the price of cola is $1.50 a can. The Figure shows Sara’s preference
map for popcorn and cola.
a. What quantities of popcorn and cola does Sara buy? What is Sara’s
marginal rate of substitution at the point at which she consumes? [6
points]
Sara buys 6 cans of cola and 1 bag of popcorn. Sara’s budget line runs from 8 cans of
cola on the x-axis to 4 bags of popcorn on the y-axis and is tangent to indifference
curve I1 at 6 cans of cola and 1 bag of popcorn.
Sara’s marginal rate of substitution is ½. The marginal rate of substitution is the
magnitude of the slope of the indifference curve at Sara’s consumption point, which
equals the magnitude of the slope of the budget line. The slope of Sara’s budget line
is ½ bag of popcorn per can of cola so the marginal rate of substitution is ½ bag of
popcorn per can of cola.

b. Suppose that the price of cola rises from $1.50 to $3.00 a can while the
price of popcorn and Sara’s income remain the same. What quantities of
cola and popcorn does Sara now buy? What are two points on Sara’s
demand curve for cola? Draw Sara’s demand curve. [10 points]
Sara buys 2 cans of cola and 2 bags of
popcorn. Sara buys the quantities of cola
and popcorn that moves her onto the
highest indifference curve, given her
income and the (new) price of cola and
price of popcorn. The budget line is tangent
to indifference curve I0 at 2 cans of cola and
2 bags of popcorn.
Two points on Sara’s demand for cola are
the following: At $3 a can of cola, Sara buys
2 cans of cola. At $1.50 a can of cola, Sara
buys 6 cans. Her demand curve is
downward sloping and, as Figure 9.10
shows, goes through these two points.

c. Suppose that the price of cola rises

to $3.00 a can and the price of popcorn and Sara’s income remain the
same. What is the substitution effect of this price change and what is the
income effect of the price change? [6 points]
The substitution effect is 1 can of cola. To divide the price effect into a substitution
effect and an income effect, take enough income away from Sara and gradually move
her new budget line back toward the original indifference curve until it just touches
Sara’s first indifference curve I1. The point at which this budget line just touches
indifference curve I1 is 5 cans of cola. The substitution effect is the decrease in the
quantity of cola from 6 cans to 5 cans along the indifference curve I1. The substitution
effect is 1 can of cola.
The income effect is 3 cans of cola. The income effect is the change in the quantity of
cola from the price effect minus the change from the substitution effect. The price
effect is 4 cans of cola (2 cans minus the initial 6 cans). The substitution effect is a
decrease in the quantity of cola from 6 cans to 5 cans. So the income effect is 3 cans
of cola.

d. Is cola a normal good or an inferior good? Explain. [3 points]

Cola is a normal good for Sara because the income effect is positive.