ECONOMICS 108 FINAL EXAM Fall, 1995

ECONOMICS 108 FINAL EXAM Fall, 1998

There are 120 points on this exam, allocated as marked in parentheses after each problem. You have 3 hours.

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PART I. Write "true" or "false" after each of the following statements. Note: No explanation is required. A correct answer is worth one point, no answer at all is zero points, and an incorrect answer is MINUS one point. Therefore, you should guess only if you are reasonably confident in your answer; otherwise, it is better not to answer.

1. Recent news articles reported on a new scientific study showing that people who use suntan lotion are more likely to develop skin cancer. It is reasonable to conclude from this fact that people should try to avoid using suntan lotion.

False

2. A minimum wage reduces employment, so a maximum legal wage would raise employment.

False

3. Demand for a good is more inelastic when close substitutes for it are available to buyers.

False

4. If the demand for a firm’s product is inelastic, an increase in the price increase definitely raises the firm's profit.

True

5. If the demand for a firm’s product is elastic, an increase in the price increase definitely lowers the firm's profit.

False

6. When the Federal Reserve lowered the interest rate recently, it did so by reducing the money supply.

False

7. A firm in a perfectly competitive industry chooses a quantity to produce so that marginal cost equals the price.

True

8. An increase in the sales tax on a product usually reduces the price (net of tax) that sellers receive, lowering sellers' profits; however, a monopoly seller will raise its price to prevent this loss.

False

9. An increase in the rate of inflation tends to raise the nominal interest rate.

True

10. The more inelastic the supply of labor, the greater is the rise in the wage when the demand for labor increases.

True

11. Sellers of products would increase their profits if they would make their products fall apart or go out of style sooner (that is, if they have greater "planned obsolescence").

False

12. If Furbies and Beanie Babies are substitutes, then a tax on sales of Beanie Babies machines would reduce the price of Furbies.

False

13. A 50-cent increase in the tax on cigarettes would raise the equilibrium price of cigarettes by 50 cents.

False

14. Suppose that land in Idaho can grow 6 bushels of corn per acre or 12 pounds of potatoes per acre, while land in Nebraska can grow 7 bushels of corn per acre or 16 pounds of potatoes per acre. Then Idaho has a comparative advantage in corn and Nebraska has a comparative advantage in potatoes.

True

15. The Internet is an example of a common resource.

True

16. Schools are examples of public goods.

False

17. If the rate of inflation rises, and people learn to expect this higher inflation, then the real interest rate will fall and the nominal interest rate will remain constant.

False

18. The government can raise long-run economic growth by policies that encourage consumer spending.

False

19. Because y = c+i+g+nex, an increase in consumption spending, or an increase in government spending, raises GDP.

False

20. A rise in the nominal interest rate reduces the velocity of money.

False

PART II. Answer the questions.

21. (10) Answer each part with numbers:

(a) Suppose the money supply is $5,000, the velocity of money is 2 per year, the nominal interest rate is 5% per year, and real GDP is 2000 goods per year. What is the equilibrium price level?

$5 per good

(b) Suppose the nominal money supply rises from $5,000 to $6,000. What happens to the equilibrium price level in the long run?

It rises to $6 per good

(c) Suppose the nominal money supply remains at $5,000, but velocity falls from 2 per year to 1 per year. What happens to the equilibrium price level in the long run?

It falls to $2.50 per good

(d) Suppose, in part (c), that the price level is sticky in the short run. What happens to real GDP in the short run?

It falls, in the short run, from 2000 goods per year to 1000 goods per year.

(e) Suppose, in part (d), that the government wanted to change the money supply to bring real GDP back to its original level. How would the government change the money supply?

It could raise the money supply from $5000 to $10,000.

22. (2) Suppose the growth rate of the money supply is 4 per cent per year, velocity is constant over time, the nominal interest rate is 6 percent per year, and the growth rate of real GDP is 2 per cent per year. What is the rate of inflation? (Answer with a number.)

2 percent per year.

23. What is (2 points each)

(a) selection bias?

Selection bias is a statistical fallacy that occurs when people use data that are not typical, but are selected in a way that biases the results.

(b) the marginal benefit of doing something?

Your marginal benefit of doing something is the increase in your total benefit from doing that thing a little more.

A public good is a good or service that is (a) nonrival (when someone consumes the good, the quantity remaining for other people does not fall), and (b) nonexcludable (it is prohibitively costly to provide the good only to people who pay for it (and to prevent non-payers from obtaining it).

(d) adverse selection?

Adverse selection refers to a situation in which sellers (or buyers) have some relevant information -- that buyers (or sellers) lack -- about some aspect of product quality.

(e) moral hazard?

Moral hazard refers to a situation in which an agent lacks an incentive to promote the best interests of a principal, and the principal cannot observe the actions of the agent.

(f) the velocity of money?

The velocity of money is the average number of times per year that money is spent -- flowing all the way around the circular flow (see pages 582-583).

(g) nominal GDP?

Nominal GDP (Gross Domestic Product) is the money value (in dollars, yen, etc.) of a country's total production of final market goods and services.

(h) real GDP?

Real GDP (Gross Domestic Product) is the real (inflation-adjusted) value of a country's total production of final market goods and services -- generally measured in constant (base-year) dollars.

(i) the connection between the nominal interest rate and the real interest rate?

nominal interest rate = real interest rate plus (expected) rate of inflation

NOTE TO GRADERS: GIVE FULL CREDIT EVEN IF THEY NEGLECT THE WORD "expected.:

24. (3) Why is inflation like a tax? What is it a tax on? Who collects the tax revenue?

It is like a tax on money, because it reduces the value of each person's money. The government collects the tax revenue, because it has the newly printed money to spend.

25. (2) Suppose members of the International Olympic Committee take bribes to determine the site of the next Olympic Games. What determines the equilibrium size of the winning bribe?

The equilibrium bribe equals the discounted present value of the profits that the bribe-makers could collect if they won the Olympics for their city.

26. (3) What are the formulas for

(a) the discounted present value of $50 paid one year from now?

$50/(1+r) where r is the interest rate

(b) the discounted present value of $50 paid two years from now?

$50/(1+r)² where r is the interest rate

$50/r where r is the interest rate

27. (3) Consider the data in the following table:

Hours of Work Required for:	Robin	Little John
Making one crossbow	11 hours	12 hours
Making one arrow	2 hours	2 hours

(a) Who has the comparative advantage at making arrows?

Robin

(b) What is Robin's opportunity cost of making a crossbow?

5-1/2 arrows

6 arrows

28. Explain the argument that the social security system reduces savings in the U.S. (4)

The social security system is mainly a pay-as-you go system. The government takes the money that people pay in social security taxes and gives it to current beneficiaries. The people who pay these social security taxes reduce their saving, because "social security is saving for them." Because social-security tax revenues are mainly paid to current beneficiaries rather than saved, no one raises saving to compensate for the fall in saving by people paying into social security. As a result, the system reduces total savings in the U.S.

29. Explain: "Stock prices follow a random walk." (3)

See the discussion on page 174, and on pages 849-52.

30. (5) Draw a graph to show the effects of an income tax on

(a) wages paid by employers (firms) including taxes;

(b) wages received by employees (workers) net of taxes;

(d) government revenue from the tax;

(e) the deadweight social loss from the tax.

Draw graph similar to Figure 12 on page 222. The figure will show that:

(a) wages paid by employers (firms) including taxes rise (as from P1 to PB in Figure 12);

(b) wages received by employees net of taxes fall (as from P1 to PS in Figure 12);

(c) employment falls (as from Q1 to Q2 in Figure 12);

(d) government revenue from the tax appears like area B+D in Figure 12;

(e) the deadweight social loss from the tax appears like area C+E in Figure 12.

31. Suppose the demand curve for a product is xd = 10,000 - 6p where xd is the quantity demanded and p is the price. Suppose the supply curve for the product, with xs representing the quantity supplied, is xs = 4p - 1000.

(a) Find the equilibrium price and quantity. (2)

p=$1,100 and x=3,400

(b) Suppose a per-unit tax of $100 is placed on the product. Find the new equilibrium quantity, the price the buyer pays including, the price sellers receive net of tax, and the deadweight social loss. (3)

10,000 - 6(ps+100) = 4ps - 1000

10,400 = 10ps

ps=$1,040, pb=$1,140, and x=3,160

deadweight social loss = (1/2)(240)(100) = $12,000

(c) Suppose a per-unit tax of $100 is placed on the product. Find the new equilibrium quantity, the price the buyer pays including, the price sellers receive net of tax, and the deadweight social loss. (3)

NOTE TO GRADERS: THIS QUESTION REPEATS THE PREVIOUS ONE (BY MY MISTAKE). GIVE EVERYONE 3 POINTS FOR THIS PART, REGARDLESS OF HOW WELL THEY DID ON PART (b).

32. (7) Draw the basic supply-demand diagram with a negative externality. Show:

(a) the marginal private and social costs of the good; (b) the marginal private and social benefits of the good; (c) the marginal cost to others from the good; (d) the economically efficient amount of output of the good; (e) the perfect-competition equilibrium amount of output; (f) the deadweight social loss from the externality.

Draw graph like Figure 2 on page 470.

33. (10) Explain the point of Professor Lucas's story of creating a recession in Kennywood Park.

NOTE TO GRADERS - BE FAIRLY LENIENT. (Lucas's story is on pages 572-5.)

34. (5) Discuss, using graphs: "News reports say that crude oil prices rose 7 percent as soon as the U.S. began bombing Iraq on Wednesday evening. I could understand oil prices rising if a long war reduced oil supplies -- but the price increased without any change in oil supplies, violating the so-called laws of supply and demand."

This claim ignores speculation. If people expected a fall in the future supply of crude oil due to the bombing, then speculators will buy the product today to store for the future, raising the current price.

(DRAW A GRAPH OF A FALL IN FUTURE SUPPLY WITH SPECULATION -- a fall in future supply would raise the future price, leading speculators to store the good for future resale. This raises the current price.)

35. (5) Suppose the demand for a good is xd = 1,000 - p where xd is the quantity demanded and p is the price, and its supply is xs = p where xs is the quantity supplied. The government places a maximum legal price on this good, of $200, reducing the equilibrium quantity sold from 500 units to 200 units, and creating a shortage. Suppose the government rations the good by requiring people to use coupons to buy the good. It prints and distributes 200 coupons. A person with a coupon is allowed to buy the good for $200 (giving the coupon to the store along with the $200), and people without coupons are not allowed to buy the good. However, the government lets people buy and sell these coupons. Find the equilibrium price of coupons.

Without any maximum legal price the equilibrium price is $500 and the equilibrium quantity is 500 units. With a maximum legal price of $200, the quantity supplied is only 200 units. The height of the demand curve, at the quantity 200 units, which is $800, shows the highest total price that any buyer is willing to pay for the 200th unit -- that price consists of $200 at the store plus the cost of the rationing coupon. Therefore the equilibrium price of rationing coupons will be $600 (=$800 - $200).

SOME ADDITIONAL EXPLANATION: Notice that when rationing coupons sell for $600, anyone willing to pay $800 or more for thegood buys it, and anyone with a reservation price below $800 does not buy it. Buyers pay a total price of $800 for the good. (A buyer who recieves a coupon free from the government pays a $600 opportunity cost of not selling it, plus a $200 money price at the store.) At the total price of $800, the quantity demanded is 200 units, which equals the quantity supplied.

36. (12) Refer to the accompanying table to answer the following questions:

		United States		Other Countries			World
Price	Quantity Demanded		Quantity Supplied		Quantity Demanded	Quantity Supplied	Quantity Demanded	Quantity Supplied
12	2		13		5	25
11	4		12		6	22
10	6		11		7	19
9	10		10		8	17
8	11		9		9	15
7	12		8		10	14
6	14		6		11	13
5	16		0		12	12
4	18		0		13	9
3	20		0		14	0
2	22		0		15	0

Assuming these countries engage in international trade, find the equilibrium (a) world price; (b) quantity produced in the United States; (c) quantity consumed in the United States; (d) quantity produced in other countries; (e) quantity consumed in other countries.

At the world equilibrium price of $7, the U.S. produces 8 and consumes 12, while other countries produce 14 and consume 10.
Now suppose that the one of these countries prohibits trade with the other. Find: (a) the U.S. price; (b) the equilibrium quantity in the United States; (c) the price in other countries; (d) the equilibrium quantity in other countries.

Without international trade, the U.S. price is $9 and the U.S. equilibrium quantity is 10 units; the foreign price is $5 and the foreign equilibrium quantity is 12 units.

What is the deadweight social loss from a law prohibiting international trade? (Answer with a number.)

$8

because (1/2)($2)(4) in the U.S. + (1/2)($2)(4) in other countries = $8 in the world.