Midterm I. 1 Multiple-choice Questions (30 points) Economics 110 Spring 2005 Tanya Rosenblat. Name: Section:

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1 Economics 110 Spring 2005 Tanya Rosenblat Name: Section: Before you proceed, write down your name and section number above. Please read all questions carefully. You will get full credit only if you provide complete answers. The total number of points on this exam is 100. Plan your time accordingly. This exam is subject to the policies outlined by the Wesleyan Honor Code. Honor Code pledge: Signature: Midterm I 1 Multiple-choice Questions (30 points) Instructions: Select the best and/or the most complete choice among the five offered by circling the corresponding letter. When you are done, fill in the table above. 1. You are a computer wiz considering coming to Wesleyan. Wesleyan is ranked among top 10 most expensive colleges this year by the Chronicle of Higher Education with an annual tuition of $31,650 per year. Imagine that you got an amazing financial aid package and you only have to pay $10,000 per year. Your acceptance letter points out that you will pay less than half of the true cost of your education. (a) you know that this is not true because unless you major in economics you will not get a high-paying job after graduating from Wesleyan. (b) you know that this is not true because you could have earned at least $35,000 a year with a new internet startup (*). (c) you know that this is not true because in addition to paying tuition you will need to eat. (d) you know that this is true and you gladly accept. 1

2 2. Recent hurricanes wreak havoc on the orange harvest in Florida. The effect on market equilibrium will be: (a) quantity of orange juice rises, quantity of apple juice rises (b) quantity of orange juice falls, price of apple juice falls (c) price of orange juice rises, price of apple juice rises (*) (d) price of orange juice rises, quantity of apple juice falls 3. Demand for digital cameras is given by Q d camera = ap camera + bp memory + cp cellphone where P camera is the market price of digital cameras, P memory is the price of memory sticks used in the digital cameras and P cellphone is the price of cell phones with cameras. The signs of coefficients a, b, c are (a) positive, positive, positive (b) positive, positive, negative (c) negative, positive, positive (d) negative, negative, positive (*) (e) negative, negative, zero 4. Which statement is normative? (a) Organ transplant laws that make the sale of organs illegal should be repealed because they will increase the number of murders.(*) (b) Legalizing the sale of organs will increase the number of organ donors. (c) Legalizing the sale of organs is likely to help rich patients more. (d) Legalizing the sale of organs will create a price ceiling. 5. Which statement best describes the incentive-equality trade-off in which equality is preferred to incentives. (a) In a math tournament with 900 participants, a person who can solve the most problems gets a large financial reward. (b) In a company that employs 10 workers, each worker gets paid based on his or her contribution to the production process. (c) Unemployment benefits in United States are given only to people actively looking for jobs, usually cover 47% of salary prior to job loss and last on average 4 months. (d) Subjects recruited for experiments by the psychology department are paid a flat participation fee of $10. (*) 6. A shortage that persists in a market is likely due to (a) price ceilings above equilibrium price. (b) price ceilings below equilibrium price (*). 2

3 (c) price floors above equilibrium price. (d) price floors below equilibrium price 7. The elasticity of demand for bus fares is estimated to be 1.5 (a) 10% increase in bus fares will increase the revenues of a bus company. (b) 10% increase in bus fares will decrease the revenues of a bus company (*) (c) 10% increase in bus fares will decrease quantity demanded by less than 10%. (d) (a) and (c) (e) None of the above 8. Suppose that demand for labor is given by L d = 12 w, where w is hourly wage rate and L is the number of workers employed. Supply of labor is given by L s = 2w. (a) minimum wage of $6 per hour creates unemployment. (*) (b) minimum wage of $4 per hour creates unemployment. (c) minimum wage of $2 per hour creates unemployment. (d) given supply and demand schedules,there cannot be unemployment in this economy. (e) None of the above 9. In China, rice is a Giffen good. If new technology were introduced that doubled the rice yields thereby reducing the market price of rice, you would expect that individual consumers would: (a) buy more rice and less meat (b) experience a positive substitution effect that dominates the negative income effect (c) experience a negative substitution effect that dominates the positive income effect (d) experience a positive income effect that dominates the negative substitution effect (e) experience a negative income effect that dominates the positive substitution effect (*) 10. Suppose Connecticut introduces a new 25 tax per pack of cigarettes and the price of cigarettes rises by the full 25. This change alone would induce Peter Puffer, who has been smoking 50 packs per month, to reduce his smoking to only 25 packs per month. Suppose that at the same time, for reasons unrelated to the tax, Puffer finds that his income rises by $12.50 per month. As a result of the tax and the income change combined, (a) Puffer will choose fewer than 25 packs of cigarettes per month and is worse off in comparison (b) Puffer will choose exactly 25 packs of cigarettes per month and is better off in comparison (c) Puffer will choose between 25 and 50 packs of cigarettes per month and is better off in comparison (*) 3

4 (d) Puffer will choose exactly 50 packs of cigarettes per month and is equally well off in comparison (e) Puffer will choose more than 50 packs of cigarettes per month and is worse off in comparison If cigarettes are measured on the horizontal axis and other goods are measured on the vertical axis, the higher price of cigarettes causes the budget line to become steeper, pivoting through the intercept on the vertical axis. Puffer s higher income causes the new, steeper budget line to shift outward. The new budget line reflecting both of these changes will pass through Puffer s original bundle (the one that included 50 packs per month), but will be steeper than the original budget line. It goes through the original bundle because the extra $12.50 of income will exactly cover the additional 25 tax on 50 packs of cigarettes, leaving just enough income to buy the original bundle of goods at the original prices. The budget line is steeper because the tax has increased the price of cigarettes. While his original bundle is feasible, it will not be chosen given the tax and income changes. Puffer s marginal rate of substitution for that bundle equals the old, lower price ratio and is, therefore, less than the new price ratio including the cigarette tax. He can make himself better off by choosing fewer than 50 packs of cigarettes and more other goods. Because cigarettes are a normal good and he would choose 25 packs with the higher price but no income change, the income change induces him to choose more than 25 packs. Therefore, as a result of the tax and income change combined, Puffer will choose between 25 and 50 packs of cigarettes per month and will be better off than he was with his original bundle before either change. Utility Theory (30 points) Gabrielle divides her income between health insurance (H) and other goods (Y). Her preferences can be described by the utility function: U = HY Gabrielle has $1575 to spend on health insurance and other goods. Health insurance costs $50 per unit and other goods are measured in units that cost $1 each. 1. (5 points) What is the marginal rate of substitution? 2. (10 points) Calculate the amounts of health insurance and other goods that Gabrielle will purchase each month if her goal is to make herself as well off as possible. 4

5 3. (15 points) Now suppose that the state passes a law requiring that individuals purchase at least 30 units of health insurance (you might think of this as mandatory coverage for mental illness, substance abuse, long-term care, etc.). At the same time, by mandating this coverage the price per unit of health insurance falls to $40 per unit (because prior to the mandated benefits, only people likely to need benefits were buying large amounts of coverage This is the problem of adverse selection noted by several economists. You dont need to know anything about this now, but you ll learn about it in Econ 301). Sketch Gabrielles new budget constraint, and solve for her new optimal bundle of health insurance and other goods. Be sure that the grader can follow your work and can understand how you know that the bundle you have identified is the optimum. Budget Constraint: 50H + Y = 1575 MRS Y H = P H /P Y Y/H = 50/1 = 50 Solving these equations simultaneously: H = 15.75; Y = Under the new state law, Gabrielle can now buy health insurance at $40 per unit. This change causes her budget constraint to pivot outward from the Y-intercept if she purchases only other goods, the maximum amount she can buy has not changed, but now for each unit of other goods given up, she can purchase more health insurance than before. However, the state mandate requires that Gabrielle purchase at least 30 units of health insurance, so only the portion of the new budget constraint corresponding to 30 or more units of health insurance is relevant, shown by the darkly shaded portion of the new budget constraint in the diagram below. To find Gabrielles new optional bundle, start by solving for the bundle she would choose at the lower price of health insurance in the absence of the minimum coverage mandate. Budget Constraint: 40H + Y = 1575 MRS Y H = P H /P Y : Y/H = 40/1 = 40 Solving these equations simultaneously: H = 19.69; Y = This bundle is not feasible because it includes fewer than 30 units of health insurance. We know that there can be no other tangency along this budget constraint (because of diminishing MRS), so Gabrielles new optimum will be the corner solution at which she purchases 30 units of health insurance and 375 units of other goods (she is left with $375 after purchasing 30 units of health insurance at $40 each). We can verify that this is her optimal bundle by noting that at this corner solution, her marginal rate of substitution is 12.5, which is less than the price ratio, implying that she would prefer to choose less health insurance and more other goods. 5

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