Guide to the Answers to Midterm 2, Fall 2010 (FormA) (This was put together quickly and may have

typos. You should really think of it as an unofficial guide that might be of some use.)

1. Hopefullyyougotthisquestionright.Afterall,thereisonlyonechoiceforyouranswer! 2. Whentradeisbasedoncomparativeadvantage,tradingpartnersmustbedifferentintermsof theirPPFbecauseotherwise,theywillhavethesameopportunitycosts,andthatmeansevenIf theytradetheywilljustdoasgoodastheywouldiftheyproducedthemselves.TheanswerisB. 3. Rightaway,seeingquotasshouldtipyouofftothedomesticproducers.Quotasareusedtolimit foreignimports,andthewholepointofimportingisbecausethegoodischeaperabroad.Sothe consumersintheUSdefinitelydonotwantaquota,andthatalsomeansthatforeignproducers willnotwantaquotasincetheycantsellasmuchunderaquota.Disfalsesinceweveseen thatquotascreateadeadweightlossthatlowerstotalsurplus.Aquotaisthenprobablythe resultoflobbyingfromUSproducersofsugar.TheanswerisB. 4. Here,youshouldfindthepoint(16pizzas,4sodas)onthegraphrightaway.Youwillseethatit isconvenientlyonanindifferencecurve.Afterthat,findingtheanswerjustbecomesagameof findingwhatpointliesonthesameline,whichshouldbeafunone.So,youshouldgetthat theonlyconsumptionbundleonthesameindifferencecurveis8pizzasand8sodas.Theanswer isE. 5. WeneedtographSpartysbudgetconstraint.Wecandosobyfiguringouthowmanypizzashe canaffordifheusesallhismoneyonpizzaandhowmuchsodahecanaffordifhespendsallhis moneyonsoda.Wefindthattheanswertothosequestionscanbefoundbyjustdividing Spartysincomebythepriceofpizzaandsoda,respectively.Wegetthepoints(8,0)and(0,16) onthegraph,sinceSpartycanafford8pizzasor16sodaifhespentallhismoneyoneither. Connectthetwopointstogetthebudgetconstraint.Then,theopportunitycostofonemore sliceofpizzaisjusttheabsolutevalueoftheslopeofthebudgetcurve,whichyoucanfindusing theriseoverrunmethod.TheanswerisD. 6. Theoptimalconsumptionbundleissimplywherethebudgetcurveintersectstheindifference curveatexactlyonepoint.Thisiswhybringingyourrulerwasagreatidea.Youshouldseethat theoptimalconsumptionbundleis4pizzaand8soda,sotheanswerisA. 7. Now,thepriceofpizzadropsto$2,meaningthebudgetconstraintisgoingtochange.Now,if SpartyspentallhismoneyonPizza,hecanget32ofthem.Thismeansyoushouldnowdrawthe newbudgetconstraintwhichconnectsthepoints(32,0)with(0,16).Thisnewbudgetlineshould

convenientlyintersectanindifferencecurveatexactlyonepoint.Thatpointisyournewoptimal consumptionbundle,andithappenstobe16pizzasand8sodas.Sowewentfrom4pizzasto16 pizzas,whichisanincreaseof12pizzas.TheanswerisE. 8. To findthesubstitutioneffect,wewanttoshiftthenewbudgetconstraintbacktotheold indifferencecurvesuchthattheshiftedbudgetconstraintintersectstheoldindifferencecurve atexactlyonepoint(remembertokeeptheshiftedbudgetconstraintparalleltothenewbudget constraint).Theshiftedbudgetconstraintshouldintersecttheoldindifferencecurveatexactly onepoint,andtheincreaseinquantityfromtheamountofpizzafromtheoriginalconsumption bundleof4pizzasand8sodastotheconsumptionbundlewheretheshiftedbudgetconstraint intersectswiththesameindifferencecurveof8pizzaand4soda(anincreaseof4pizzas)means thesubstitutioneffectincreaseddemandforpizzaby4units.Note,eventhoughthisquestion doesntaskthis,theincomeeffectisjusttheremainingincreaseinquantityofpizzademanded, inthiscaseits8pizzas(sincetheoptimalbundleafterthepricedropofpizzais16pizzasand8 sodas).TheanswerisA. Ifincomedoubled,youcanfindthatthenewbudgetlineconnects(16,0)and(0,32), correspondingto16pizzasand32sodasthatSpartycanaffordifhespendsallhisincomeon either.Weseethatthequantitydemandedintheoptimalconsumptionbundleatthepoint wherethebudgetintersectswiththeindifferencecurveatexactlyonepointof8pizzasand16 sodas.Then,weseethatthedemandforbothpizzasandsodasincreasedfromtheoriginal optimalconsumptionbundleof4pizzasand8sodas,andthusweseethatbothpizzasandsodas arenormalgoods,sincethequantitydemandedincreasedwithincome.Thus,theanswerisD. Whenthepriceofanygoodsfalls,weseethatthroughthesubstitutioneffectconsumerswill buymoreofthatgood(sincethepriceofitislowerrelativetotheothergood).However,the characteristicofaninferiorgoodissuchthatwhenincomeincreases,thequantitydemandedof itdecreasesandsotheincomeeffectwillhaveanegativeeffectonquantitydemandedofthe good.Thus,theanswerisB. Thenextfewquestionsmayseemscaryatfirstsinceyouprobablyneverseenaquestionput thiswaybefore,butthefactisthesearejustquestionsabouttaxandexternalities.Ifboth countriesagreetoeachcutconsumptioninhalfandeachcountrysetsataxonoiltodoit,for thepoorcountrytocutconsumptionfrom8to4wesimplyusethewedgemethodanddrawa wedgeatQ=4forthepoorcountry.Weseethatthelengthofthiswedgeistheamountoftax thatisneededtoreduceconsumptionto4.Sincethewedgeconnectsthepoints(4,2)and(4,6), weseethatthelengthofthewedgeis4andthetaxmustbe$4.TheanswerisD. Doingthesamethingasthelastquestion,weusethewedgemethodtofindthatthesizeofthe taxis$8todecreaseconsumptionfrom16to8.TheanswerisA. Thetotalsurplusbeforethetaxisthegianttrianglethatcorrespondstoconsumersurplus.We seethattheareaofthistriangleis128((1/2)*16*16).(Notethatyouactuallydontneedto knowthistoanswerthisproblem.Ijusthaveitonhereincaseyouwerecurious.)Thesurplus thatslostfromthetaxisthetrianglewithvertices(8,2),(8,10),and(16,2)whichhasanareaof 32.Thus,thechangeisminus32,whichisE.

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14. Here,whatIdidwasjusttrytheanswersout.Itriedfirsta$6tax(sinceitsthefirstchoice)and seewherethatgotme.Witha$6tax,thepoorcountrywillconsume2gallonsofoilandtherich countrywillconsume10gallonsofoil.Heylook,thatswhatwewant.Theanswerthenisthat thesametaxhastobe$6,sincethatbringsaboutthewantedreductioninoilconsumption.The answeristhenA. 15. Itmayhelptodrawthewedgeagaintoindicatequotas.Theonefortherichcountrywillbeat Q=8andtheoneforthepoorcountrywillbeatQ=4.Then,weseethatintherichcountry,the quotapriceis$8(thelengthofthewedge)andinthepoorcountry,thequotapriceis$4.Tosee whattheworldpricewillbeforoneunitofquota,weneedtofirstseethatthepriceofaquota inthepoorcountryis$4andthepriceofaquotaintherichcountryis$8.Then,itmakessense thattherichcountrywillwanttobuycheaperquotasfromthepoorcountry,untilwearriveat anequilibriumpricethatwillbetheworldprice.Todoso,iftherichcountrybuystwounitsof quotafromthepoorcountry(sothepoorcountrysellstwounitsofquotatotherichcountry), thenifyoudrawinthenewwedgescorrespondingtothistrade(awedgefortherichcountryat Q=10andawedgeforthepoorcountryatQ=2),thenthepricesofquotainbothcountriesare equalat$6(thelengthofbothwedgesare6).Thus,theanswerisD. 16. Thiscouldhavebeengottenfrommyexplanationaboveofquestion15,thepoorcountrywill selltwoallowancestotherichcountry.TheanswerisC. 17. Heylook,aquestiontakendirectlyfromthepracticemidterm.Refertothatguideifyouare confusedaboutthis.TheanswerisD. 18. Thisistakenfromtheworksheetonsupply,thethreeassumptionsthatyouneedforaperfectly elasticlongrunsupplycurvearethefirmshavingthesametechnology,nobarrierstoentry,and inputpricesdonotchangeastheindustryexpands.Thesearebasicassumptionsaboutperfectly competitivefirmsthatneedstoholdforourresultstobetruefromanalyzingthesefirms.The answerisC. 19. Tofindfixedcostwecanjustlookforaconvenientpoint(refertosamplemidterm2guideifyou dontknowwhatImean),whichq=3appearstobeone.So,knowingthatATC=AFC+AVC,wecan findthatAFC=ATCAVC=63=3.SinceAFC=FC/Q,weseethatFC=Q*AFCor3*3=9.Sofixedcostis 9.TheanswerisE. 20. Ifshortrunpriceis2,thenweseethatsinceprice=marginalrevenueinaperfectlycompetitive firm,thefirmwillproducewhereMR=MC,orinthiscasewhereP=MC,andmorespecifically theywillproducewhereMCis$2.Thishappensataquantityof1.So,theprofitisrevenue cost,inthiscaserevenueistheamountofunitstheyareselling(1)timestheprice($2),which meanstherevenueis$2.Thecostwecanfindfromtheaveragetotalcost,whichatq=1isequal to$10.Sosincetotalcost=averagetotalcost*quantity,wehavetotalcost=$10*1=$10.So thecostis$10.Now,profitisrevenuecost,so$2$10=$8.TheanswerisE. 21. Thelongrunpriceisalwaysgoingtobewherefirmshavezeroprofit,whichmeanswhere MC=minATChappens.Thishappensatapriceof$6,sothatsyourlongrunprice.Theansweris C. 22. LongrunoutputperfirmhappensalsoatthepointwhereMC=minATC,exceptnowinsteadof lookingatpriceyouarelookingatquantity.Weseethatinthelongrun,thereare3units producedineachfirmTheanswerisA.

23. Drawahorizontallinefromwherewehaveourlongrunpriceontheleftgraphtotheright graph.Thisdenotesourlongrunsupplycurve.WeseethattheLRsupplycurveintersectsD1at Q=600.TheanswerisD. 24. Sincetheindustryquantityis600andeachfirmproduces3units,itmustmeanthatthereare 200firmsintheindustry.TheanswerisC. 25. Withthefactthatthereare200firmsintheindustry,wecannowconstructtheshortrunsupply curve.Wecandothisbyseeingthatsinceeachfirmproduces1unitat$2,2unitsat$4,3units at$6,andsoon,thatsinceallfirmsdothesamething,200firmswillproduce200unitsat$2, 400unitsat$4,andsoon.Thus,wecandrawinourindustryshortrunsupplycurveonthe graphontheright.TheshortrunsupplycurveshouldintersectD2atapointcorrespondingto P=$12andQ=1200.SotheanswerisE. 26. Thisisjustlikethequestionontheworksheet.Comparingtheshortrunsupplycurvewiththe longrunsupplycurve,whichyoushouldrememberisflat,weseethatthepriceinthelongrun doesnotchangeevenasthedemandgoesfromD1toD2,sincetheLRsupplycurveisperfectly elastic.WealsoseethattheintersectionoftheshortrunsupplycurvewithD2isatQ=1200, whereastheintersectionofthelongrunsupplycurvewithD2isat1800.So,wecanconclude thatintheshortrun,theeffectonpriceisbiggerandtheeffectonindustryquantityissmaller thaninthelongrun.TheanswerisC. 27. SincetheworldpriceofwidgetsisatR,weseethattheworldpriceislowerthanthedomestic priceofwidgets,whichisF(wheresupplyequalsdemand).So,withfreetrade(withtheworld), weseethatEconlandwillimportwidgetsfromtheworldat$1each.Weseethattheconsumer surplusatapriceofoneisthegianttriangleARY,with0producerssurplus.So,thetotalsurplus intheeconomyaftertradeisARY.NowsupposethereisaquotaofLNadded.Ifyouare confusedastowhatthismeans,thinkofitthiswayinfreetrade,thedemandforwidgetsisat pointYwhereasthedomesticsupplyisatpointR.Thedifference,YR,iswhatEconlandwill importfromtheworld(at$1).BysayingthattheresaquotathelengthofLN,wearesayingthat thereisaquotathatlimitstheamountofimportsintoEconland,soaquotaoflengthLNwould meanthemostEconlandcanimportisNL(i.e.theproducersareproducingatpointL,the consumersdemandingpointN,andsinceNisstillmorethanL,whateverisleftwillbeimported fromtheworld).Weseethatwiththisquota,theconsumersurplusisnowAKNandproducer alsonowhaveasurplusofKRL.Whichareaislost?TheareaRLNY.So,theanswerisC. 28. Basically,wearebeingaskedforthedeadweightloss.ThiscorrespondstotheareaRLVforthe producersandNXYfortheconsumers,sincethosearetheareasofsurplusthatarelostbecause themarketisnotfree.Thoseareasdontgotoanyone(notethattheareaLNVXdoesindeedgo tosomeone,soitsnotdeadweightloss,asyouwillseeinthenextquestion).Theansweris thenB. 29. WhatsleftistheareaLNVXthatsbeenunaccountedfor.Inthecaseofatariff,thatboxwould havegonetothegovernment.Butsincethisisaquota,itbecomesatransferofsurplusfrom Econlandtoforeignproducersallocatedwiththequota(i.e.thequotaowners),sotheansweris D. 30. False.Iftheworldpricefallsto0,weseethattheconsumersurpluswillbeagianttrianglewith cornersA,0andsomethingbeyondZ.However,underautarky,theconsumersurplusisAHFand

theproducersurplusisFHR,evenwhenyouaddthetwotogetherthetotalsurplusisnotnearly asmuchasthegianttriangle,whichdenotesthetotalsurplusifworldpricewas$0,since producersurplusiszerointhiscase(asdomesticproducerswontevenproduce,sincetheir supplycurvestartsatapriceofR).SotheanswerisB. 31. Thisanswer is D. 32. Thisanswer is A. 33. BandCshouldrightoffthebatringaIdontthinkthisisapublicgoodbell,sincetheyarenot nonrivalrousornonexcludable,whichiswhatweneedforapublicgood.Deerhuntingonpublic landsmayseemlikeacandidate,butitsdefinitelyrivalroussincemehuntingdeerwouldtake awayfromyourconsumptionofhuntingdeer.Thisisacommonresource,muchlikethefish stockexampleonthesamplemidterm.So,theanswerisA. 34. Whenacountrybecomesanimporterofagood,thatmeansthegoodisprobablycheaper abroadandsoitwillhurtthedomesticproducers,sincetheforeignproducerswillbasicallybe sellingthesamethingforacheaperpricetothedomesticconsumers.Thatalsomeansthat domesticconsumerswillgain,sincetheycannowbuystuffforcheaper.TheanswerisC. 35. The answer is D.