BEFORE YOU BEGIN: On the front page of the answer book, (1) PRINT YOUR NAME; (2) SIGN YOUR NAME; (3) Print your SOCIAL SECURITY NUMBER. The exam has 100 points, indicated in parentheses after each question. You have 50 minutes.
 
 

1. Dave can wash a car in 15 minutes or sweep the floor in 3 minutes. Tom can wash a car in 12 minutes or sweep the floor in 2 minutes. Who has a comparative advantage in washing a car? In sweeping the floor? (4)

Dave has a comparative advantage in washing a car; Tom has a comparative advantage in sweeping the floor.

2 Read the following news headlines and interpret them in terms of supply and demand:

(a) "Digital Camera Prices Fall as More People Buy, Contradicting Law of Supply and Demand" (2)

(b) "Crude Oil, Petroleum Product prices Rise after Explosion at Large Shell Refinery..." (2)

(a) supply increases

(b) supply decreases

3. What happens to the demand for a good if the price of a complement for it rises? (2)

it decreases

4. If a 20 percent rise in the price of Frisbees reduces the quantity of Frisbees demanded by 10 percent, what is the elasticity of demand for Frisbees? (2)

the elasticity equals 1/2.

5. Your company's marketing department estimates that the elasticity of demand for your company's product is 1/2. What happens to the quantity sold and total revenue if you raise the price by 5%? (2)

The quantity sold falls by 2.5%, and total revenue rises.

6. Suppose the government raises its budget deficit by cutting taxes by $100 per person without reducing spending. Suppose people use all their extra money from the tax cut to buy computers. What are the effects on

(a) The interest rate? (2)

(b) Borrowing by the private sector? (2)

(c) How would your answer change if people saved all the money they received from the tax cut? (2)

(a) and (b) The demand for loans increases as the government increases borrowing to compensate for the tax revenue it loses. The demand curve shifts rightward by the amount of the tax cut. Therefore the interest rate rises, and borrowing by the private sector falls (in the graph above, it falls from 200 to 125).

(c) If people save all the extra money they get from the tax cut, the supply of loans would increase as in the graph. The supply of loans would shift rightward by the amount of the tax cut. Because the demand and supply of loans increase by the same amount, the interest rate remains unchanged, as in the graph. The equilibrium quantity of loans rises by $100 per person, but the government borrows this much, so borrowing by the private sector remains constant.
 
 

7. Suppose that a good that was formerly illegal to buy becomes legal, and the expected-punishment price falls by $100. Draw a graph to show how this affects the money price of the good and its quantity sold. (4)

 If the expected-punishment price falls by $100, the demand curve shifts upward by $100. When the expected-punishment price is $100, the demand curve is D1. When the expected-punishment price falls to zero, the demand curve rises to D2. As a result, the money price of the good rises by less than $100 and the quantity sold increases.
 
 

8. (a) What is selection bias? (4)

(b) Explain how selection bias applies to the following claim made by a financial consulting firm: "Our stock analysts can help you pick the winners and avoid the losers, and our track record proves it." (4)

(c) Explain the logic behind the claim that stock prices follow a random walk. (4)

(a) Selection bias occurs when people use data that are not typical, but selected in a way that biases results.

(b) This firm may simply have been lucky -- and that's why it's still in business. After all, if they have the skills to pick the winners, why don't they get rich by following their own advice, rather than selling this advice to others? The fact that they were successful in the past does not prove that they have the skills to pick the winners. As the book explains, in an example of selection bias: Suppose you want to study the investment advice of stock analysts. You gather data on the results of investment advice given by all stock analysts who have been in business in your city for the last ten years. Did the analysts give good advice to their customers? You might find that the advice was good, on average: People who listened to these stock analysts may have earned more money on their investments (on average) than other people earned. Does this imply that stock analysts give good advice, on average? Not necessarily. The problem is selection bias: You probably lack data on stock analysts who went out of business because they gave less successful advice. Therefore, you would commit a fallacy if you draw conclusions about the average performance of investment advisors from your study.

(c) Stock prices follow a random walk because, in equilibrium, the expected future price of a stock approximately equals its current price. If the current price of a stock were below its expected future price, people would buy more of that stock (to try to profit), driving up the price now. The opposite would happen if the current price of a stock were above its expected future price: people would sell the stock (and some would sell it short, borrowing it to sell). In other words, the future price might be higher or lower than the current price, but on average it will be the current price.
 
 

9. Snow in Florida reduces the number of oranges that will be available in the future. Comment on the following statement: "The price of orange juice may rise in the future, but the current price does not change because the weather in Florida does not change the amount of orange juice already in stores." (8)

False. The decrease in the expected future supply of oranges -- and therefore the future supply of orange juice -- raises the current price of orange juice by increasing the amount of orange juice currently put into storage for future sale. The graph below shows what happens -- the decrease in future supply leads speculators to put more oranges go into storage today, driving up today's price.

10. Draw diagrams to show the effects of an increase in the expected future demand for a product next year on today’s (a) price of the good, (b) quantity produced, and (c) quantity consumed. Also show the amount of the good (d) produced next year and (e) consumed next year, along with (f) the price next year. (12)

An increase in expected future demand from D1 to D2 raises the expected future price. This creates an incentive for speculators to store more product for future resale. (a) This increased demand raises the price of the good today from $20 to $21 in the graph. (b) Output today rises from 13 to 14. (c) Consumption falls today from 7 to 4. (d) Expected future output rises from 7 to 8. (e) Expected future consumption rises from 13 to 18. f) The expected future price and the current price both rise (by the same amount, from $20 to $21).
 
 

11. Suppose a new law prevents Americans from borrowing from foreign countries. Draw supply-demand graphs to show the effects of this law on the U.S. interest rate and equilibrium borrowing by Americans. (8)

International trade in LOANS works like international trade in any other good. The supply of loans represents lending; the demand for loans represents borrowing. Use the analysis of international trade, with "lending" instead of "production" and "borrowing" instead of "consumption." In the graph below, the new law would raise the U.S. interest rate from 6% to 7% and reduce borrowing by Americans from 900 to the quantity at which the U.S. supply and demand curves intersect.

12. Draw a graph to show the effect of a tax on sales of a product. Show the effect of the tax on (a) the price paid by buyers, (b) the price received by sellers, (c) the equilibrium quantity, (d) government tax revenue. (6)

13. (a) At a well-known prep school, freshmen who buy candy from machines in the dorms are "required" to give part of their candy bars to seniors. Why do seniors require freshmen to give only part of each candy bar instead of the whole thing? (2)

(b) How is the question in part (a) related to government revenue from taxes? (2)

(a) If freshmen were required to give their entire candy bars to the seniors, they would not buy any candy bars. In other words, if the tax on candy (levied by seniors, rather than the government) were 100%, the equilibrium quantity of candy purchased would be zero. Seniors can maximize their "revenue" from this "candy tax," by requiring freshmen to give less than 100% of their candy to seniors.

(b) If the government sets tax rates that are particularly high, the tax base may fall enough that tax revenue decreases.
 
 

14. Draw graphs to show:

(a) how a maximum legal price below the equilibrium price would affect equilibrium output. (3)

It would decrease output, as in the following graph:

(b) how a minimum legal price above the equilibrium price would affect equilibrium output. (3)

It would decrease output, as in the following graph:

(c) how a maximum legal price on fabric would affect the price of clothes. (3)

 It would raise the price, as in the following graph (which applies to peanuts and peanut butter rather than fabric and clothes, but the idea is the same):

15. Suppose that the tax law changes so that buyers, rather than sellers, must remit sales tax payments to the government. Would sellers benefit from this change? Explain. (6)

No. The number of dollars that buyers pay at stores would go down by the amount of the tax (buyers would pay the prices on price tags rather than having sales tax added on at the cash register). But the total price that buyers pay would remain unchanged, because buyers would remit the tax to the government. Therefore, the total price that buyers pay remains unchanged (they pay less at the store, but they have to send tax money to the government). The price that sellers receive net of tax also remains unchanged (sellers collect less money at the store, but they don't have to send any tax money to the government). So sellers do not benefit from the change.
 
 

16. (a) (5 points) Suppose the demand curve for tickets to a rock concert is

QD = 2000 - 8P

and the supply curve is

QS = 1600 + 2P

where QD is the quantity demanded, QS is the quantity supplied, and P is the price in dollars. Find the equilibrium price and quantity.

Set QD = QS, so P=40. Therefore Q= 1680.
 
 

(b) (6 points) Suppose the government puts a $20 per ticket tax on sales of these tickets. Find the equilibrium price paid by buyers, price received by sellers, quantity, and government revenue from the tax.

Note that pb=ps+20. You can use that fact to substitute out for either pb or ps. Let's substitute for ps. Then, letting QD=QS, we have 2000-8pb = 1600+2(pb-20), or 2000-8pb = 1560+2pb, or 440=10pb.

So buyers pay pb=44 and sellers receive ps=24.

Now plug pb into the demand equation to find the quantity, and you get q=2000-(8)(44)=2000-352=1648. Alternatively, plug qs into the supply equation to solve for the quantity, and you get q=1600+48 =1648.

Government tax revenue equals the per-unit tax of $20 multiplied by the quantity sold, which gives 1648*20 = 3296.