Answer all the following questions:
Question 1
A. Suppose it requires 3 labor hours for the country Technoland to produce 1 apple, and 3
labor hours to produce 1 banana. Country Farmville can produce 1 apple using 5 labor
hours and 1 banana using 1 labor hours. Technoland has 1200 units of labor available and
Farmville has 800 units of labor. Draw the PPF for country Technoland? What is the
opportunity cost of producing apples in Technoland? What is the opportunity cost of
producing bananas in Farmville? Which country has a comparative advantage in apple
production? Give a price at which the country explained above would like to trade apples.
Show your work. [7 points]
[Answer]
First note that Technoland spent all its time on 1 good, then it can produce 400 apples or
400 bananas. Likewise, Farmville can produce the 160 apples or 800 bananas. The PPFs for
Technoland is given below. [3 pts. Take off one point if axes are not labeled. Take off one point
if the intercepts are wrong. Take off 1 point if PPF is not straight. Note that the scale will
probably be off for most students, and that’s okay so long as axes are labeled]
For Technoland,
•
•
the opportunity cost of apples is 400/400 = 1 banana per apple [1 pt for correct number. 0.5pt for not including units]
the opportunity cost of bananas is 400/400 = 1 apple per computer [not asked for but
useful]
For Farmville
•
•
the opportunity cost of apples is 800/160 = 5 bananas per apple [not asked for but useful]
the opportunity cost of bananas is 160/800 = 0.2 apples per banana [1 pt for correct
number -0.5 pt for not including units]
Technoland has a comparative advantage in apples. [1 pt. Either right or wrong]
Any price between 1 banana per apple and 5 bananas per apple is acceptable. [1 pt. Must actually
give a price. -0.5 points for just saying that it needs to be between opportunity costs]
B. Indicate whether the following statement is true or false and justify your answer:
“If wages for accountants rose, then accountants’ leisure time would have a lower opportunity
cost.”. [4 points]
[Answer] False. Opportunity costs is measured in terms of what you are not doing (or in what
you are giving up). By taking leisure, this means that you are giving up time spent working. The
increase in wage tells us that the time spent working is more valuable, thus are opportunity cost
of leisure would be higher.
[1 pts for saying False. 3 Pts explanation: 2pts for saying that the opportunity cost of leisure is
the wage. 1 pt for saying if wage increases, the opportunity cost increases.]
C. What three principles does the Production possibility frontier explain? What will be the
likely impact of large-scale outflow of foreign capital on the PPC of the economy, and
why? [4 points]
[Ans:]
I can imagine there being quite a few different answers to this question. Here is a list that I think
can be argued:
• choice
• tradeoffs
• scarcity
o feasible and infeasible allocations
• efficiency
• opportunity costs
o increasing opportunity costs
• trade as the only way to attain outside the PPF
[1.5 pts, 0.5 for each reasons listed]
With a large-scale outflow of capital, we would expect the PPC to shift inwards because we
would have less an input to produce goods, which means that we cannot produce as much. The
PPF represents the maximum that we could produce if using all of our inputs efficiently, so if we
have fewer inputs, then the max amount that we could produce would be smaller.
[2.5 pt total,
1 pt for identifying shift inwards, and
1.5 pt for explanation.
1 pt for recognizing that capital is an input to the production process.
0.5 pt for saying a decrease in capital reduces the max output
note a drawing is sufficient for the first part (i.e. with arrows showing an inward
shift), but does not suffice as an explanation. ]
Question 2
A. The supply and demand for solar panels are given by QS = 5P – 5,000 and
QD = 15,000 – 5P, where P is the price per solar panel and Q measures the quantity of solar
panels. Calculate the equilibrium price and quantity of Solar panels. At what price will
there be 20 units of surplus? [6 points]
Q_d = Q_s
15000 – 5P = 5P -5000
20000 = 10 P
P = 2000
Plug into either supply or demand
Q_d = 15000 – 5(2000) = 5000
Q_s = 5(2000) – 5000 = 5000
Surplus occurs when Q_s > Q_d
Q_s – Q_d = 20
5P – 5000 – (15000 – 5P) = 20
10 P – 20000 = 20
10 P = 20020
P = 2002
At price of 2002 dollars per unit, there will be a surplus of 20 units
[1 pt for Q_s = Q_d]
[1 pt for P =2000]
[1 pt for Q = 5000]
[2 pt for Q_s - Q_d = 20, can give 1 point partial credit if they say a surplus means
Q_s > Q_d or that P must be higher than 2000]
[1 pt for P=2002]
B. Indicate whether the following statement is true or false and justify your answer:
Over the last two decades, tuition fees at Johns Hopkins University have increased by
20%. At the same time, the number of students enrolled has increased from 20,000 to
over 30,000. This example demonstrates that the Law of Demand is false. [4 points]
False. If there was an increase in the demand for college education (for example, the
expectation on the return to college increased in the last two decades), this would mean that
price (the tuition) and the quantity (number of college students) both increase. If you draw it
out, you still have two demand curves that are downward-sloping, which means that they both
do not violate the Law of Demand while still explaining the fact. Graph below.
[1 pt for False. 3 pts for explanation.
2 points for saying an increase in demand explains the result
1 point for explaining how the Law of Demand is not violated in the counterexample ]
C. In the summer of 69, the price of oil increased (input for gasoline), and at the same
time, the price of gasoline increased tremendously while the quantity of gasoline
consumed also increased. Using a supply and demand diagram of the market for
gasoline, explain what could have caused this outcome. [5 points]
[Answer: The price of oil shifts decreases supply, which means higher prices and lower
quantity. However, there is increased quantity, so this must mean that demand must of
increased during this time (for example, an buyers of gasoline due to Baby Boomers
becoming legal driving age could have increased the demand) enough such that the quantity
increased. See graph below ]
[1 pt for saying demand increased so much that it outweighed the Supply effect on Q]
[1 pt for giving a reason why demand might have increased]
[1 pt for labelling Supply/Demand Graph]
[1 pt for have a supply shift to the left]
[1 pt for having demand shift to the right such that equilibrium quantity increased]
Q3
A. Please refer to the following figure. In the market for asparagus, the original equilibrium Price is $4, and the Equilibrium quantity is 3000, as shown in the figure. Suppose
the consumer income rises by 10%, leading to the new demand curve: QD = −0.5P + 6.5.
What is the income elasticity of demand between the old and new equilibrium prices? (6
points)
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Answers
We can read from the graph that: Q s = P − 1.
Solve for the new equilibrium price and quantity by equating Q s = Qd
Solve −0.5P + 6.5 = P − 1, we get Pnew = 5 and Qnew = 4
The income elasticity =
(Qnew −Qold )/Qold
(incomenew −incomeold )/incomeold
= 10/3
solving for the new equilibrium, 3 points; correct computation of income elasticity,
3 points. Setting up equilibrium condition and correctly write out the income elasticity
definition, each worth 2. Correct number of equilibrium/elasticity, 1 for each. If students
use middle point to compute the percentage change in Q, also considered as correct.
B. Indicate whether the following statement is true or false and justify your answer:
“The elasticity of demand is the same as the slope of the demand curve.” (4 points)
Answers
False.
Given a demand curve: Q = a − bP, the formula for price elasticity of demand is:
Price Elasticity of Demand
∆Q
Q
= ∆P
P
∆Q P
∆P Q
P
=b × ,
Q
=
(1)
It is obvious that slope b is just one component of the elasticity.
Students can also use the example of linear demand curve from the textbook.
Linear demand curve has a constant slope but does not have constant elasticity, because ratio of changes in two variables is different from ratio of percentage changes in two
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variables.
1 point for saying False; 3 for explanation. If students can point out slope is only part
of the formula, or can use the linear demand curve example, then get full credit.
C. Explain the Price effect and Quantity effect at different points along the linear demand curve. How do these two effects influence the total revenue? (5 points)
Answers
Use the graph from the textbook:
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As price increases from 0, at first the elasticity is smaller than 1, then price effect dominates the quantity effect: revenue will increase as price increases. After some threshold,
elasticity becomes larger than 1, then quantity effect dominates the price effect and revenue
decreases as price increases.
Key point is that with elasticity smaller or larger than 1, revenue increases or decreases
with price. As long as this key point is mentioned, then should get full credit; if omitting
the condition for price effect to be larger/smaller than quantity effect in affecting revenue,
but generally discusses those two effects, then 3 points at most.
Q4
A. The city council of a small college town decides to regulate rents in order to reduce student living expenses. Suppose the average annual market-clearing rent for a two4
bedroom apartment had been $700 per month, and rents were expected to increase to $900
within a year. The city council limits rents to their current $700-per-month level. Draw a
supply and demand graph to illustrate what will happen to the rental price of an apartment
after the imposition of rent controls. Do you think this policy will benefit all students?
Why or why not? What will happen to the city council policy if they dont change it in a
few years?(6 points)
Answers
The rental price will remain at $700 since the new pricing ceiling is binding. There
will be a shortage as shown in the graph. Some students now can’t find apartments to
live with the price ceiling, they definitely get hurt. And in the rationing process, longer
waiting time or discrimination may happen. If this policy keeps working, landlords won’t
have incentives to improve the property or to respond to concerns of tenants.
Graph with good labels of axises, demand/supply curves, and a shortage get 2 points,
if incomplete, then lose 1; Students can also draw a perfectly inelastic supply curve as
in the textbook; 2 points for answering that not all students benefit from this policy and
offering at least one plausible reason; 2 points for pointing out what will happen in the
long run.
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B. In 1991, a sales tax was imposed for the first time in California on “junk foods.”
This was the so-called “snack tax.” It imposed a sales tax on goods like pretzels. Would
the incidence of this sales tax be mostly on the buyers of these foods, or would it be mostly
on the stores that sell them? Explain why.(5 points)
Answers
The side that has a lower elasticity will have a higher burden of the tax. The firm that
produces the snack can easily shift their sales to other states but Californian residents buy
snacks locally, so it is easier for the producers to make adjustment. An educated guess
would be that buyers have a higher burden of the tax.
If students say that consumers can also quickly shift to a different type of food so the
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elasticity of demand is higher and consumers face a lower burden, then they also get full
credit. This is an empirical question, though the educated guess in the answers may be
more plausible. As long as the answer specifies that the side with a lower elasticity faces a
higher burden, and gives a plausible reason why the side they choose has a lower elasticity,
then get full credit. Any guess of incidence without reason gets at most 1; any guess of
elasticity but without a reason gets at most 3.
C. Indicate whether the following statement is true or false and justify your answer: “A
tax always raises the price the buyers pay, lowers the price the sellers receive, and reduces
the quantity sold.” (4 points)
Answers
False. For example, if the supply is perfectly inelastic (a vertical line), then tax burden
is all on firms and quantity won’t change.
False is worth 1 point; explanation is 3. Any counterexample to refute the statement
works. For example, a perfectly elastic demand curve.
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