Econ 1302 Midterm 1 Practice Problems PDF

Econ 1302: Midterm I Practice Problems: Solutions This is a set of practice problems to help in preparation for the coming exam. Work through each question carefully, and make note of any difficulties or misunderstandings you have. We will be reviewing these questions in the class prior to the exam...

Econ 1302: Midterm I Practice Problems: Solutions This is a set of practice problems to help in preparation for the coming exam. Work through each question carefully, and make note of any difficulties or misunderstandings you have. We will be reviewing these questions in the class prior to the exam date. Please come with questions so that you and your fellow students can best prepare. Supply & Demand 1. In a few words, explain why demand is downward sloping and supply is upward sloping. Demand slopes downward because we assume that as price of a good decreases, con- sumers will buy more of the good. This produces a negative relationship between price and quantity demanded. More fundamentally, when the price of a good decreases, con- sumers decide to forego more of other goods in order to purchase that good which has become relatively less expensive. Supply slopes upward, as we assume that higher prices 1) incentivize existing suppliers to produce more, and 2) cause more suppliers to enter the market. The result is a positive relationship between price and quantity supplied. 2. Explain the di↵erence between concepts of demand vs. quantity demanded and supply vs. quantity supplied. Quantity demanded (supplied) refers to a single quantity demanded (supplied), given a price. Demand and supply refer to the entire relationship between quantity demanded (supplied) and price. 3. What are some factors that cause shifts in demand? Supply? Demand: preferences, income, expectations, price of substitutes, price of complements Supply: prices of inputs, returns from alternative investment, technology, natural events, number of sellers 4. Given the following demand and supply schedules: QD P 3 5 4 3 5 1 QS P 6 5 4 3 2 1 (a) Plot both demand and supply curves in a single graph (make sure to put price on the y axis). 13 P S 5 - - -... - - Y ↑ 1 i -... 3 - - S ↑ ↑ ↑ & ↑ - ↑ ↑ I... - ↑ : iii Q 23 45 6 (b) What is the equilibrium price and quantity in this market? Equilibrium price: P = 3. Equilibrium quantity: Q = 4. (c) Suppose price is above equilibrium. What situation does this produce? Sketch on the graph. How is this situation resolved? When price is above equilibrium, the situation produced is known as a surplus (QD < QS ). Surpluses are resolved by a combination of decreased quantity sup- plied (existing suppliers deciding to produce less, or even leaving the market all together), and increased quantity demanded in response to increasing discounts (as suppliers compete to o✏oad inventory, they begin slashing prices). The result is a decrease in QS , increase in QD , and a decrease in P. (d) Suppose now price is below equilibrium. What situation does this produce? Sketch on the graph. How is this situation resolved? When price is below equilibrium, the situation produced is known as a shortage (QD > QS ). Shortages are resolved by a combination of increased quantity supplied (existing suppliers deciding to produce more, new suppliers entering the market), and decreased quantity demanded (through bidding up of the price, thereby pricing out some consumers). The result is an increase in QS , decrease in QD , and an increase in P. 5. Consider the market for oranges. (a) Sketch the market in equilibrium. P so M S P,X - - - - ----- i P* --------i I -- ⑮ j I I I I I I i i B Q * * Q Q. (b) Suppose a frost hits Florida (where most US oranges are grown). What will be the impact on the market? Sketch on the graph drawn in part a). This will impact the supply of oranges, specifically a leftward shift of the supply curve. The result will be a decrease in equilibrium quantity and an increase in price. (c) Suppose now it is a year later, and the Florida crop has returned to normal. In addition, there is a groundbreaking study released in the scientific journal Nature detailing the various health benefits of fresh citrus. Sketch these changes in the market from the point reached in part b). What can you say for certain about the change in quantity of oranges? Price of oranges? so P 11 S P ----- ---- i " ↑ ⑮ I I I I i Da I 7 I I I I I B Q I Q, * * Q  Supply has increased (rightward shift) and demand has increased (rightward shift). The result will be an increase in equilibrium quantity of oranges. The impact on price is undetermined, depends on magnitude of shifts. 6. Explain the concept of (own) price elasticity of demand. Why is this the preferred method for measuring sensitivity of quantity demanded to price? Own price elasticity demand (") is measured as the percentage change in quantity demanded of a good in response to a 1% increase in price of that good. " = %% QPD. This is a useful metric because it allows for the comparison of demand sensitivity to price across di↵erent types of goods. 7. Give an example of a good with elastic demand. Explain your reasoning. Do the same for a good with inelastic demand. Again, explain your reasoning. An example of a good with elastic demand is a car. The demand for cars is somewhat responsive to changes in price because cars are durable goods, and consumers have options. If the price of a car rises significantly, buyers may delay their purchase, choose a cheaper model, or opt for a used car instead. This flexibility makes the demand for cars more elastic compared to necessities. An example of a good with inelastic demand is gasoline for cars. Most people rely on gasoline to commute and go about their daily activities, and there are few immediate substitutes. Even if the price of gasoline rises, people still need to buy it in roughly the same quantities, making its demand relatively inelastic. Consumer Theory 8. What are the four assumptions of consumer preferences we make? (a) Completeness - Consumer always knows whether they prefer one bundle of goods to another, or whether they are indi↵erent (no uncertainty) (b) Transitivity - If a consumer prefers bundle A to bundle B, and bundle B to bundle C, then they must prefer bundle A to bundle C. (c) Nonsatiation (“more-the-better”) - A consumer always prefers to have more of a good than less of a good. In other words, they don’t get negative utility from having more of something. (d) Diminishing marginal utility - As a consumer consumes increasingly more of a good, the added utility they gain from each additional unit declines. For example, going from 0 ! 1 slice of pizza generates more utility than going from 1 ! 2. 9. What is utility? What is marginal utility? What is diminishing marginal utility? Utility=“happiness”. Marginal utility is the additional utility brought on by consum- ing one more unit of a good. Diminishing marginal utility is the idea that the more you have of a good, the less additional utility it brings. 10. In a few words, explain what an indi↵erence curve represents. What does it mean for two points to be on an indi↵erence curve? Graphically, an indi↵erence curve is a contour line on the utility function. A contour line is simply a line representing all the points at a single elevation. In the case of utility, this is a line representing all the di↵erent combinations of goods that produce the same level of utility. This was illustrated in class by placing a section of dental floss on the play-doh utility mountain such that it was entirely level. Indi↵erence curves thus represent the set of points for which the individual is “indi↵erent” between. In other words, if two points are on the same indi↵erence curve, the individual is ambivalent or indi↵erent between which of the two they prefer. 11. What are the four properties of “normal” indi↵erence curves? Where do each of these properties come from? (a) Indi↵erence curves further from the origin in the northeast direction are preferred to indi↵erence curves closer to the origin (southwest direction). This follows from the non-satiation (more-the-better) assumption, as more of both goods is always preferred to less of both goods. (b) Indi↵erence curves always slope downward. This also follows from the non- satiation (more-the-better) assumption: an upward sloping indi↵erence curve implies the consumer is indi↵erent between more of both goods and less of both goods. (c) Indi↵erence curves cannot cross. This follows from the assumption of transitivity (A B and B C ) A C). If indi↵erence curves cross, this assumption is violated. (d) Indi↵erence curves are convex. This follows from the assumption of diminishing marginal utility. When the consumer is rich in one good but poor in the other, they are willing to trade a lot of the good they are rich in for a little of the good they are poor in (in order to stay at the same level of utility). The reason for this is because the consumer experiences diminishing marginal utility, so an additional unit of the good they are rich in does not bring them much more utility. 12. Suppose goods x and y are both “goods” (as opposed to things that are “bad”). Under the assumptions of a rational consumer, sketch two indi↵erence curves representing two di↵erent levels of utility. Be sure to label which curve corresponds to each level of utility. Y u = 6 V= 4 X 13. For each of the indi↵erence curves in Figure 1, describe what is wrong with the curve (perhaps multiple things), and why each is a “bad” indi↵erence curve. A Indi↵erence curve is concave. This means that the consumer experiences increas- ing marginal utility when consuming y and x. See solution to question 11c. B Indi↵erence curve is upward sloping. This violates the non-satiation (more-the- better) assumption. See solution to question 11b. C Indi↵erence curves cross. This violates the transitive property. See solution to question 11c. D Two problems: indi↵erence curves are concave, violating assumption of diminish- ing marginal utility (see solution to question 11c.) and indi↵erence curve closer to the origin represents higher utility (see solution to question 11a), violating non-satiation (more-the-better) principle (see solution to question 11a). 14. Starting with the budget constraint in Figure 2, sketch the following: (a) Increase in the price of x (b) Decrease in the price of y (c) Increase in income I Note: you do not have to draw indi↵erence curves for this question. 15. Define a normal good. Define an inferior good. Give an example of each. A normal good is a good for which quantity demand increases as consumer income rises, and vice versa. In other words, when people have higher incomes, they tend to buy more of this good. An example of a normal good is organic food. As people’s incomes increase, they often choose higher-quality products like organic fruits and vegetables over conventional alternatives. An inferior good is a good for which quantity demand decreases as consumer income rises, and vice versa. When people earn more, they tend to buy less of this good and opt for better alternatives. An example of an inferior good is instant noodles. As incomes rise, consumers tend to buy fewer instant noodles and instead purchase more expensive, fresh food options. Figures Figure 1: Some bad indi↵erence curves Affordable Set Figure 2: A budget constraint Increase in Price of X : in * 1 Py results a of affordable reduction Set I PX Figure 2: A budget constraint  Decrease in Price of Y : F M *y Py results in expension. set of affordable Figure 2: A budget constraint  Increase in income : I * ↑I results in increase 1 Py of affordable Set. > Ex Figure 2: A budget constraint