ECON 3710: Microeconomic Theory
Study Guide for Midterm 2
Major Topics:
1. Price Elasticity
i.
How to calculate it using the percentage formula and point-slope method
ii.
How it changes along linear demand curve
iii.
Relationship with revenue (expenditures)
iv.
Determinants of elasticity
2. Consumer Surplus
1. What it is
2. How to calculate it from a demand curve.
3. The relationship between consumer surplus and price elasticity.
4. Study by Layson on Consumer Surplus associated with a city owned complex.
3. Choice Under Uncertainty
1. Probability and expected value.
2. Expected value vs. Expected utility
i. Determining Risk Behavior
1. Risk averse, loving, neutral
3. Study by Kahneman and Deaton, “Does Money Buy Happiness?”
4. Willingness to Pay for Insurance / Take Gambles
i. Reservation prices
ii. Moral hazard
iii. Adverse selection
4. Kahneman and Tversky
i. Differences with classical model
ii. Value function
1. Interesting insights
2. Risk behavior in gains vs. losses
iii. Judgment biases
1. Framing
2. Anchoring and adjustment
3. Availability bias
4. Irrelevant alternatives
5. Production
1. Short-run vs. long-run
2. Production functions
i. Marginal vs. average productivity
1. Law of diminishing marginal returns
2. Finding marginal and average productivity
3. Efficient allocation of inputs across plants
4. Isoquants
i. Marginal rate of technical substitution
ii. Perfect substitutes and perfect complements
5. Increasing, constant, and decreasing returns to scale
i. Determining RTS mathematically and graphically
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Practice Problems. Please remember this is not an exhaustive study guide (meaning you should
also review your notes, the book, your assignment, etc.). Enjoy the questions!!
1. The price of TVs decreases from $400 to $300 and quantity demanded increases from 6,000 to
7,000. Calculate the price elasticity of demand for TVs using the basic percentage formula. Are
TVs inelastic, elastic or unit-elastic?
2. Draw a linear demand curve and label where demand is elastic, inelastic, and unit elastic.
3. Determine whether demand for the following goods are elastic, inelastic, or unit elastic:
a.) Price increases by 10% and revenue increases by 10%
b.) Price increases by $10 and revenue decreases by 12%
c.) Price increases by 10% and quantity demanded decreases 10 units
d.) Price decreases by 10% and revenue doesn’t change
e.) Price decreases by 10% and revenues increase from $400 to $500
f.) The demand for tennis balls is given by P=20 – 0.01Q and the price is currently $8.
g.) The demand for a furnace manufacturer is given by P=4,000 – 0.5Q and revenue is
currently $80,000.
4. The demand for candy bars is given by P = 5 - 0.01Q, where P is measured in dollars and Q
in candy bars.
a. How much revenue is collected at $3?
b. What is the price elasticity of demand at $3?
c. At what point is total expenditures maximized?
5. Suppose demand is given by P = 50 – 0.10Q.
a) What is the consumer surplus at P=$25?
b) What happens to consumer surplus if price rises to $26?
c) If this represents an individual’s demand for a product, what is the maximum amount the
individual would be willing to pay to be allowed to purchase this product?
6. A demand curve has the following characteristics: When price is $50 the quantity demand is
1,000 and the price elasticity of demand is -1.5.
Calculate the new quantity demanded at a price $52.
What is the change in consumer surplus?
What is the change in total expenditures?
7. Suppose you have $100 to invest or store in a safe deposit box. Your only alternative to storing
is a stock which sells for $100. The stock is an initial public offering for a company with a
risky idea that is projected to double in value in a year if the idea works. The history of such
ventures is that 50% of the time they fail and you lose your money. The other half of the time
they double your money in a year.
a. What is the expected value of each option at the end of the year?
b. Which option would you take if your utility function for money is u(M) = M2?
c. Which option would you take if your utility function for money is u(M) = M1/2?
8. Your utility function is U = M½, and your current wealth is $400,000. There is a .00001
probability that your legal liability in an automobile accident will reduce your wealth to $0.
a.) What is the actuarially fair premium?
b.) What is the most you would pay for insurance to cover the risk?
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9. Ms Fogg is planning an around-the-world trip on which she plans to spend $10,000. The
utility from the trip is a function of how much she actually spends on it (Y), given by U(Y) = ln Y
a. If there is a 25 percent probability that Ms. Fogg will lose $1000 of her cash on the trip, what
is the trip’s expected utility?
b. Suppose the Ms. Fogg can buy insurance against losing the $1000 (say by purchasing
traveler’s checks) at an “actuarially fair” premium of $250. Show that her expected utility is
higher is she purchases this insurance than if she faces the chance of losing the $1000 without
insurance.
10. According to the Kahneman-Tversky (hedonic framing model), which of the following
options would most people prefer to the other?
a.) Option 1: A gain of $5,000 or Option 2: a gain of $6,000 and a loss of $1,000?
b.) Option 1: A loss of $5,000 or Option 2: a loss of $4,000 and a loss of $1,000?
c.) Option 1: A 50% chance of winning $1,000 and a 50% chance of winning $0 or
Option 2: A sure gain of $500?
d.) Option 1: A 50% chance of losing $1,000 and a 50% chance of losing $0 or
Option 2: A sure loss of $500?
11. Margaret has decided to open a new savings account. There are two solvent S&Ls in her
neighborhood. One offers 6% interest and a free toaster oven with each new account. The other
S&L offers 6 1/2% interest but no free toaster. Suppose the 1/2 percent is just enough to offset the
price of the toaster oven after six months, and suppose she has no immediate need for the oven.
She plans to use it as a gift to her niece who plans to get married in six months. Which S&L will
she choose if she applies the principles of hedonic framing (Kahneman and Tversky)? What if she
uses the rational choice (the classical) model? Assume no sales tax complications and that the
toaster price stays constant.
12. Suppose a random group of people are asked to estimate the following: “How large is the
state of Oklahoma in square miles?”
Before answering, some are told that Alaska is 663,267 sq. miles, while others are told that Rhode
Island is 1545 sq. miles.
Explain how and why this information will influence each group’s estimates of the square
mileage of Oklahoma.
13. How is the anchoring index calculated?
14. Explain why the majority of people believe there are more murders than there are suicides in
big cities, even though the number of suicides is actually much higher.
15. Explain why salespeople often show customers an irrelevant alternative (or an option that is
inferior and more expensive than another option) even though they know that this product will
not be selected by the customer.
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16. Given the following information Where L is labor and Q is output. K is fixed in the short-run.
L
Q
O
O
1
10
2
25
3
50
4
70
5
85
6
95
7
100
8
103
9
105
10
104
a) Calculate the marginal product of labor and average product of labor for L=2, L=4, and L=7.
b) Diminishing returns is identifiable with the employment of what unit of labor?
17. If labor is currently set at 5 units for a short run production process, and the marginal
product of labor is currently 15, while the average product of labor is equal to 17, will the average
product of labor rise or fall if labor is increased to 6 units?
18. Suppose a firm can produce in two different facilities. The average productivity of labor
(APL) in facility 1is 70 and the APL in facility 2 is 80. If the firm wants to expand production by
hiring additional workers, which facility should they choose?
19.
A firm has production function Q=2 K2L0.5. The current amount of capital employed is 4
units and labor is 64 units.
a.) What is the average productivity of labor?
b.) What is the marginal productivity of labor?
c.) Is average productivity currently falling or rising? How do you know?
20. If the marginal product of labor is currently 10, and the marginal rate of technical
substitution is currently 20, what does the marginal product of capital equal?
21. By studying, Will can produce a higher grade, Gw, on an upcoming economics exam. His
production function depends on the number of hours spent studying production problems (P) and
the number of hours spent studying risk problems (R). Specifically, Gw=2.5R0.25P0.75
a. (4) What is the equation for Will’s marginal productivity of studying risk problems?
b. (4) Calculate the marginal rate of technical substitution for Will studying the two types of
problems. Interpret this at the point R=2, P=2.
22. Determine which of the following production functions exhibit decreasing returns to scale,
increasing returns to scale, or constant returns to scale.
a. Q=4K + 2L
b. Q = a KL ( +  = 1)
c. Q = a KL (( +  < 1)
23. What is the difference between diminishing returns and decreasing returns to scale?
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