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Midterm Exam: Economics SOLUTIONS

1. One-Sentence Answers (15 points)

The following questions require one-sentence answers. Only the first sentence of your response will be graded, so do not submit anything longer (a supplementary graph is also allowed). Additionally, please keep your sentences short and to the point - long rambling sentences will be given lower grades. You will be graded on both accuracy and brevity.

a. Why does a supply curve shift downwards when there is a subsidy for producers? With a subsidy, producers are willing to sell a given number of units for a lower price per unit, since they also receive a per unit subsidy to defray production costs.

b. Explain the relationship between income and demand. Income is a non-price determinant of demand - higher income means greater demand for normal goods and less demand for inferior goods.

c. If a consumer is choosing between two products and has Cobb-Douglas preferences with equal weights on the two goods, will the consumer buy the same number of the two goods? No, the consumer divides his or her income equally between the two goods but if the prices of the two goods are different then the consumer buys different amounts of each.

2. True or False... and Explain! (15 points)

Please state whether the following statements are true or false, and provide a one-sentence explanation (a supplementary graph is also allowed). You will be graded on your explanation. Only the first sentence of your explanation will be graded. Each question is worth 3 points.

a. It is possible that for a single person, all goods are inferior goods. FALSE - if all goods were inferior, an income increase would lead to less spending on all goods, which wouldn't make sense because the money has to go somewhere! (Note: you might suggest that people would just 'save' the money... but then "savings" is your normal good!)

b. A greater elasticity of demand necessarily means a higher deadweight loss from a tax, regardless of the elasticity of supply. FALSE, because if supply is totally inelastic, there will be no DWL regardless of demand elasticity, but it is true in all other instances.

c. When the price of a substitute for good X changes, we would expect a movement along the demand curve for good X. FALSE, we would expect a shift of the demand curve, since we have a change in a non-price determinant here.

d. Demand for cars is more elastic that demand for Honda Civics. FALSE, it would be more inelastic for cars, since cars are a more broadly-defined good.

e. Producer surplus rises when there is an increase in supply, holding all else constant. TRUE, because when supply shifts to the right, the area representing producer surplus becomes a triangle with the same height but a larger base.

Or:

FALSE, because the price falls due to a movement along the demand curve if the shift is not constant at all quantities.

3. Short Problems

Below you will find two short problems, each worth 15 points. Points for each subsection of the problem are stated.

a. Cigarette Contradiction? (15 points)

Suppose the U.S. government administers only two programs that affect the market for cigarettes. Firstly, media campaigns and labeling requirements are aimed at making the public aware of the dangers of cigarette smoking. Secondly, the Department of Agriculture maintains a price support program for tobacco, which includes guaranteeing tobacco farmers a selling price that is above the equilibrium market price (including paying them for any excess supply).

Answer the following questions using appropriate graphs. Be specific about determinants of demand and supply affecting the outcomes.

i. What does the awareness campaign do in the cigarette market? (3 points)

The media campaign and labeling requirements are aimed at shifting the demand curve for cigarettes to the left (a decrease in demand). This shift will decrease the consumption of cigarettes, and drive down the price of cigarettes.

[pic]

ii. What does the price floor for tobacco do in the cigarette market? (5 points)

The Department of Agriculture program increases the price of tobacco. Since tobacco is an input in cigarette production, this will lead to a decrease in the supply of cigarettes. This too will decrease cigarette consumption, though it drives the price up.

[pic]

iii. Are these two programs at odds with each other with respect to the goal of reducing cigarette consumption? (3 points)

Both programs work towards the goal of reducing cigarette consumption – see combined graphs in part (iv).

iv. What is the combined effect of these two programs on the price of cigarettes? (4 points)

The first program leads to a lower price of cigarettes, and the second program leads to a higher price. Whether the combined effect of the two programs increases or decreases the price of cigarettes depends on the relative sizes of the two price changes.

The figure on the left shows the combined effect leading to an increase in price; the figure on the right shows the combined effect leading to a decrease in price.

[pic]

a. Low-Skill Labor (15 points)

Use the following graph to answer the next four questions. This question asks to explore a new application of the supply and demand model, to the question of the minimum wage. Note that the supply of labor in the graph below refers to workers, and the demand for labor in the graph below refers to firms hiring those workers.

[pic]For all questions related to the above graph, assume the market wage preceded the regulated wage.

i. How many more low-skill workers will seek jobs after the government establishes a minimum wage than did before the minimum wage? (4 points) 2 million more (used to be 6 million, now it's 8 million)

ii. Which of the following statements is true concerning the diagram presented above? Choose one and explain briefly. (5 points)

A. The government regulated price is a price ceiling and there will be 4 million low-skilled job seekers without jobs once the ceiling has been established

B. The government regulated price is a price ceiling and there will be 2 million low-skilled job seekers without jobs once the ceiling has been established

C. The government regulated price is a price floor and there will be 4 million low-skilled job seekers without jobs once the floor has been established

D. The government regulated price is a price floor and there will be 2 million low-skilled job seekers without jobs once the floor has been established

iii. Fill in the blanks (using the letters in the graph above, which represent areas of respective regions of the graph as shown): Once the regulated wage is established, the low-skilled laborers’ economic surplus will change from HK to HA. (4 points)

iv. Fill in the blank (using the letters in the graph above, which represent areas of respective regions of the graph as shown): According to the above diagram, the deadweight loss associated with the government establishing a minimum wage will be DK. (2 points)

4. Long Problem (40 points)

See below:

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