BEFORE YOU BEGIN: On the front page of the answer book,
There are 50 points on this
exam (one per minute). The number of points appears in parentheses after
each question -- (3) means "3 points."
The exam is long - just do your best and don't worry.
1. What happens to the demand
for a good if the price of a substitute for it rises? (1)
It increases.
2. Dave and Tom are having a big party. Dave can fill a glass with lemonade and ice in 12 seconds or ice a cupcake in 2 seconds. Tom can fill a glass with lemonade and ice in 15 seconds or ice a cupcake in 3 seconds. Who has a comparative advantage in filling glasses? in icing cupcakes? (2)
Dave has a comparative advantage in icing cupcakes, and Tom has a comparative advantage in filling glasses.
EXPLANATION: It takes Dave 6 times as long to fill a glass as it take him to ice a cupcake. It takes Tom only 5 times as long to fill a glass as it takes him to ice a cupcake. So Tom is relatively better filling glasses. Dave has the comparative advantage at icing cupcakes, and Tom has the comparative advantage at filling glasses.
ANOTHER EXPLANATION: In 1 minute, Dave could fill 5 glasses (60 seconds divided by 12 seconds per glass) or ice 30 cupcakes. In 1 minute, Tom could fill 4 glasses or ice 20 cupcakes. So Dave can produce 6 times as many cupcakes as filled glasses in one minute. But Tom can produce only 5 times as many cupcakes as filled glasses in one minute. So Dave has the comparative advantage at icing cupcakes, and Tom has the comparative advantage at filling glasses.
YET ANOTHER EXPLANATION: Every time Dave fills a glass, we sacrifice
6 (=12 seconds / 2 seconds) iced cupcakes. Every time Tom fills
a glass, we sacrifice only 5 (=15 seconds / 3 seconds) iced cupcakes.
So Tom has relatively lower costs of filling glasses, therefore he has
a comparative advantage in filling glasses. And Dave has the comparative
advantage at icing cupcakes.
3. Comment on this quotation
from a newspaper story: "Increased demand for Tickle-Me Elmo dolls caused
their prices to skyrocket [increase]… these higher prices contributed to
reduced demand for the popular toy." (2)
This confuses increases in demand with increases
in the quantity demanded. An increase in demand for Tickle-Me Elmo dolls
may have caused and increase in the price, but that higher price did not
lead to decreased demand.
4. Discuss: "They're building too many hotels in this city. They think this town will become a big convention city. If they're wrong, there will be too many hotels, and loads of empty rooms. It will cost more to spend a night in a hotel here, because the hotels will charge more to make up for all the empty rooms." (2)
False. An increase in the supply of hotel rooms lowers
their price. Hotel owners lose money, but that's life.
5. What can you do to try to profit if the futures price of eggs differs from the spot price of eggs that you expect next month? (2)
If the futures price is less than the spot
price that you expect next month, you can profit by buying eggs on the
futures market and then planning to sell them next month on the spot market.
If the futures price is greater than the spot price that you expect
next month, you can profit by selling eggs on the futures market and then
planning to buy them next month on the spot market (to cover your sales).
6. Your boss gives you responsibility for setting the price of your company's main product. Your marketing department estimates that the elasticity of demand for your company's product is 2. What happens to your firm's quantity sold and total revenue (dollar value of sales) if you raise the price by 5%? (2)
If you raise the price by 5% then your quantity demanded
will fall by 10% and your total revenue will fall by 5% (since you're selling
10% less but at a 5% higher price).
7. Explain why the equilibrium price differential between two locations cannot exceed the per-unit cost of arbitrage. (3)
Because if it did, additional arbitrage would
be profitable, so there would be an incentive for people to increase the
amount that they arbitrage (or for other people to begin arbitraging).
An equilibrium is a situation without a tendency to change unless underlying
conditions change, so this cannot be an equilibrium. Therefore the price
differential cannot exceed the per-unit cost of arbitrage in equilibrium.
8. Suppose that a good that was formerly legal to buy becomes illegal, and the expected-punishment price rises to $100. Show (on a graph) how this change affects the money price of the good and its quantity sold. (3)
Buyers care about the total price of what they buy -- the money price plus any expected punishment price. So when the expected-punishment price rises by $100, the demand curve shifts downward by $100. In other words, the quantity demanded would stay the same if the money price fell by $100 to make up for the $100 increase in the expected punishment price. Because the demand curve shifts downward by $100, the money price falls typically by less than $100, and the quantity sold decreases.
FOR THE ANSWER TO THE OPPOSITE CASE, (AN ILLEGAL GOOD BECOMES LEGAL), SEE PROBLEM 6.17 HERE.
9. What is the government budget deficit? Use a graph to help discuss the effects of an increase in the government budget deficit, caused by a tax cut, on the interest rate. (Assume that people spend the money from the tax cut to go on vacations.) (3)
The government budget deficit is the amount of money that the government borrows each year when it spends more than it collects in taxes. An increase in the government budget deficit raises government borrowing, which raises the demand for loans, raising the equilibrium interest rate.
The demand for loans shows the behavior of borrowers. Higher
interest rate => people want to borrow less.
The demand for loans shows the behavior of lenders. Higher
interest rate => Lenders want to lend more.
In the following graph, the government budget deficit increases by $100. This raises the interest rate, raises TOTAL lending from 200 to 225 billion dollars, but DECREASES PRIVATE BORROWING (by people and businesses) by 75 (from 200 to 125).
10. People can reach the Island Restaurant only by boat. The round trip used to take one hour, but now it takes only 40 minutes. Draw a graph to show how this change affects the demand for meals at the Island Restaurant if all potential diners value their time at $12 per hour. (4)
Buyers
value the 20 minutes they save at $4, so the demand curve shifts upward
by $4. In other words, the highest price that buyers are willing
to pay for meals rises by $4 because buyers implicitly pay $4 less in a
time price when they go to the restaurant. The equilibrium moves
from point A to point B, so the price rises from P1 to P2. So the
price rises, but it rises by less than $4 (less than the upward shift in
the demand curve).
11. Comment on this claim, made by a well-known financial consulting firm, in their advertisement in a business magazine: "Our stock analysts can help you pick the winners and avoid the losers, and our track record over the last year proves it." Explain why stock prices follow a random walk. (4)
(1) Stock prices follow (approximately) a random walk, so it is very
unlikely that this consulting firm can help you pick winners and avoid
losers. Stock prices follow a random walk because, in equilibrium,
the expected future price of a stock approximately equals its current price.
In other words, the future price might be higher or lower than the current
price, but on average it will be the current price.
(2) If the consulting firm is confidant about its knowledge of winners
and losers, why don't the people who work that firm as advisors buy the
winners and avoid (or short-sell)
the losers? These people could get rich and wouldn't have to work
anymore as investment advisors. If they're so smart, why aren't they
rich?
(3) Past track records might only prove that the firm was lucky --
see the discussion and examples of selection
bias on pages 26-28 of the textbook.
12. Use a graph to show why producers have an incentive to save oil for the future if they expect a lower supplies or higher demands in the future. Also explain why producers also have an incentive to develop alternative energy sources in this case. (5)
An increase in expected future demand, OR decrease in expected future supply, raises the expected future price. This creates an incentive for speculators to store more of the good for future resale, which raises the current price. "Storing more of the good" is the same as "saving the good for the future."
Figure 7.9 on page 181 of the textbook graphs the case of an increase in expected future demand.
Because oil and alternative energy sources are substitutes, an increase
in the price of oil raise the price at which producers could sell energy
from alternative sources. This makes it more profitable to develop
those alternative sources.
13. Suppose a new law prevents Americans from importing foreign cars. Draw supply-demand graphs to show the effects of this law on prices, output, and consumption in each of two countries. Who gains and who loses from this law? (5)
Figure 7.1 from page 165 of the textbook, shows equilbrium with international
trade -- a world price of $5, U.S. output of 9, U.S. consumption
of 3, U.S. exports of 6, and foriegn output of 4, foreign consumption of
10, and foreign imports of 6. Replace the "United States" with Japan
in this graph, and replace "Other Countries" with the United States, and
this could show equilibrium with the U.S. importing of Japanese cars.
In that case, if the U.S. outlaws imports of Japanese cars, the U.S. equilibrium
goes to point B and Japanese equilibrium goes to point A. The price
of cars rises in the U.S. and falls in Japan. Output of cars also
rises in the U.S. and falls in Japan. Consumption of cars (car services)
goes the other way -- it falls in the U.S. and rises in Japan. U.S.
car producers gain and U.S. consumers lose from the law prohibiting imports.
Japanese car producers lose and Japanese consumers gain from this law.
14. According to the Fortune Magazine article, "How to Beat the Boomer Rush," what are some of the economic changes that are are likely to occur as the baby-boom generation ages, and how might people be able to profit from anticipating these changes? (4)
Briefly summarize the main points from this
article.
15. (Parts a and b are 3 points each; part c is 2 points.)
and the supply curve is
where QD is the quantity demanded, QS is the quantity supplied, and P is the price.
Find the equilibrium price and quantity.
Set QD
= QS, so 5000 - 40P = 4000, or 1000 = 40P,
or P=25.
QS= 4000, so Q=4000. (Alternatively,
QD = 5000 - 40P = 5000 - (40)(25) = 5000 - 1000 = 4000.)
(b) Do part (a) again assuming
that the demand curve for tickets is
where Y is the average income
of buyers. The supply curve is the same as before.
If average income of buyers
equals $500, what is the equilibrium price and quantity?
Set QD = QS, so 5000 - 40P + (2)(500)
= 4000, or 2000 = 40P, or P=50.
QS= 4000, so Q=4000. (Alternatively, QD =
5000 - (40)(50) + (2)(500) = 4000.)
(c) Do part (b) again assuming that average income of buyers is $300. Find the equilibrium price and quantity.
Set QD = QS, so 5000 - 40P + (2)(300)
= 4000, or 1600 = 40P, or P=40.
QS= 4000, so Q=4000. (Alternatively, QD =
5000 - (40)(40) + (2)(300) = 4000.)