mid I 2012 Solutions_v2

Midterm I Solutions
Fall 2012
Midterm I
1. Give a short definition of:
a. Externality (1 point) Non pecuniary effect on a third party not involved in
the transaction
b. Pareto preferred (1 point) The allocation of goods that result after
voluntary trade is pareto preferred to the allocation before. That is, the
allocation of goods is pareto preferred to the initial allocation if everyone
is at least as well or better off but nobody is worse off .
c. Normal good (1 point) A good such that when income increases demand
for it increases(demand curve shifts out/right).
d. Open access (1 point) A resource where anybody, without restriction can
enter. Open access resources are rival and non excludable. Example:
e. Indifference curve (1 point) The set of all bundles that produce the same
utility—level of satisfaction or well being---as any other point on the
2. a. Draw a diagram with two budget constraints that differ only in the price of the
good on the horizontal axis. Call this good on the horizontal axis bread. Label
your axes. You may assume that the price of the good on the vertical axis (wine)
is one. Now draw two indifference curves that allow you to find the consumer’s
chosen bundles for each of the two prices. Mark these bundles. (3 points)
1 point for drawing the two budget constaints
2 points for showing the chosen bundles
Figure 1
The chosen bundles are A for budget constraint I. When there is an increase in the price
of bread the new budget constraint is II. The chosen bundle under the lower price is
bundle A, which consists of 5 units of bread and 10 of wine; this is given by the point of
tangency of the indifference curve U0 and budget constraint I. The chosen bundle under
the higher price is bundle B, which consists of 3 units of bread and 10 of wine.
b. Draw one more line on your diagram and use it to carefully explain that is the
compensating variation for the price change described above. (2 points)
For compensating variation we compensate consumers by giving them enough
income such that they are as happy as before even with the price change.
For a price increase CV is shown in figure 1; it is given by the vertical distance
between budget constraint I and III, which is the budget constraint with a high
price for bread and tangent to the old indifference curve.
3. Assume that the inverse demand curve for a product slopes down, but is not
a. Now draw an inverse supply curve and use it to explain the case where a
specific tax would be wholly incident upon the producer. (1 point)
1 point for identifying that the incidence will fall fully on the producer is when the
supply curve is vertical. .
Consumer incidence is given by Pd-P*. Producer incidence is given by
P*-Ps. In this case Pd-P*=0 and P*-Ps is the vertical distance shown in
the graph below
b. Explain the role of any curves you draw in addition to your inverse supply
and inverse demand curves. Also, show on your graph the price paid by
consumers and the price received by producers.(2 points)
1 point for explaining the D-t graph. ½ point for showing the price paid by
producers. ½ point for showing the price paid by consumers.
The D-t graph is the demand curve shifted down by the amount of the tax;
the vertical distance between D and D-t is t. Ps and Pd are shown on the
graph above.
c. Now draw a second diagram that shows the case where a specific tax
would be wholly incident upon the consumer. Though you must label
your diagram, you need not explain anything. (2 points)
1 point for showing that it is when supply is horizontal when the full
burden of the tax will fall on the consumer. ½ a point for showing
consumer and producer price. ½ point for showing incidence
4. Six people with identical tastes go to dinner together and agree to evenly split the
bill for dinner. Each person prefers the hamburger dinner for $6 to the steak
dinner for $10. However, all six people choose the steak dinner.
a. Explain how this choice is individually rational (2 points).
The choice is individually rational if for a person the steak is worth at least $6.67.
This is because when the bill is split evenly, a single person’s expenditure for the
steak is (10/6+other people’s expenditure/6), and for the hamburger is (6/6+other
people’s expenditure/6). Therefore, the price difference between the hamburger
and the steak is (10-6)/6=0.67.
b. If one of these people went to dinner alone and had a choice between the
hamburger for $6 and the steak for $6.50, can you tell which the diner
would choose? What about steak for $7.50? (2 points)
1 point for each question
If the steak is $6.5 this person will buy it since we know from (a) that she values it
at least at $6.67. At a price of 7.5 we do not know whether this person will chose
it since from (a) we only know that she values it at least at 6.67 but don’t know
whether she values it at more than that.
c. Give another example where the wrong choice is made because people
share the consequences of their choice, rather than bear all the costs
individually. (1 point)
Examples where there are free riders, fisheries/bathroom are acceptable.