Economics 1 - Fall 1998

- Midterm 1 (Professor Wright) -

Suggested Answers

October 15, 1998.

 


PART I (5 Points each)

  1. Income Elasticity:


    2. The responsiveness of quantity demanded to a change in income, other things held constant. The formula is
     


    h I = (% ?Q)/(% ?I).

     
  2. Scarcity:


    3. The state in which the resources available are insufficient to satisfy people’s needs.

  3. Consumer’s Surplus:


    4. The value that the consumer gets from each unit of a good minus the price paid for it. Graphically, the CS is depicted by the area between the demand curve and the price.

    [Graph]
     

  4. Positive Economics:


    5. The subset of economics which deals with testable hypotheses that can be proven right or wrong without reference to value judgements. Positive Economics is the study of "What is?" rather than "What ought to be?".

  5. Excess Supply:


    6. The state of the market that prevails whenever QD < QS, and the excess supply is given by the difference between the quantity supplied(QD) and quantity demanded(QS). This is usually caused by the price being higher than the equilibrium level.

    [Graph]
     

  6. Opportunity Cost:
The opportunity cost of an action is the highest – valued alternative foregone.
 
  PART II (6 points each)
  1. Answer:


    2. There are two possible explanations for this question –

    Explanation A:

    This good is a Giffen good. A Giffen good is a special type of inferior good in which the negative income effect dominates the substitution effect. As a result when the price rises, the quantity demanded also rises. Under this scenario, we are moving along the same demand line.

    [Graph]

    Explanation B:

    Demand increased in that it shifted outward. Meanwhile, Supple curve may have increased, decreased, or stayed the same, but as long as the change in Demand dominates the change in Supply, the new equilibrium point is to the north-east of the old equilibrium point.

    [Graph]
     

  2. Answer:


    3. There are many possible causes for an increase in worker’s productivity. Here are two examples. First, any improvement in technology that is beneficial to production can increase productivity. Second, workers’ specialization can also increase productivity if they specialize in those tasks in which they enjoy a comparative/absolute advantages.

  3. Answer:


    4. Using the well-known formula for demand elasticity,
     


    h D = (% ?Q)/(% ?P) = 10%/20% = ½ = 0.5

     
  4. Answer:


    5. This is a true statement. Giffen goods are, by definition, inferior goods (goods with a negative income effect, i.e., when real income goes up, quantity purchased declines). However, Giffen goods are inferior goods for which the negative income effect is larger than the positive substitution effect, and hence goods whose demand goes up when the price goes up (upward sloping demand curve). Not all inferior goods are Giffen goods, and for most of them, substitution effect > income effect so Law of Demand still applies.

  5. Answer:
Adam Smith was referring to the fact that markets work to ensure that when we each make decisions that are in our own best interests, we end up achieving the best outcome for everyone, even though that wasn’t the individuals’ intentions. We are led to the "efficient" outcome, as though by an "invisible hand". The market system we studied so far is the Demand-Supply-Price system, i.e., without any regulation/interference, the market can guide all the self-interest fulfilling buyers and sellers to equilibrium, the most efficient allocation of resources.

[Graph]


PART III (20 points each)

  1. Answer:


    2. A minimum wage law imposes a price floor on wages. If the minimum wage is set below the equilibrium price, then the minimum wage will have no effect. If the wage is set above the equilibrium price, the net result will be a shortage of jobs (unemployment, denoted by QD - QS.) This result is due to the combination of two factors. First, the quantity of labor supplies goes up because the higher wage will compensate for the higher marginal costs of supplying more labor (working more). Second, the quantity of labor demanded will go down because the higher wage will exceed the marginal benefit, and hence quantity demanded will fall until marginal benefit equals the minimum wage. This means that compared to the equilibrium point, there is a shortage of jobs because the supply of workers willing to work exceeds the demand for workers. This is unemployment. The textbook explains further, that this leads some people to spend time, money, etc., searching for a job because the minimum wage exceeds the minimum wage they are willing to work for given the level of demand. Refer to Figure III 1. above for more information, especially the Dead-weight Loss caused by this price regulation.
     
     

  2. Answer:
The assumption of Perfect Competition means that everyone involved is a price taker and, hence, can’t affect the price. This is true because there are many, many similar "small" producers and buyers in the market. So when the producers consider how much to produce, regardless of the quantity they choose to produce, they will not affect the market price.

The assumption of Increasing Marginal Costs means that as the quantity produced of any goods increases, the cost of producing an additional unit (marginal cost) increases. This assumption is true, for reasons such as scarcity of resources, decreasing returns to inputs and technology, etc. In order to produce (supply) one more unit of a good, the price you receive for that unit must exceed the marginal cost. Hence, you will only produce greater quantities of a good when the price is higher (in order to compensate for the increasing marginal costs). In fact, for price-taking producers, the optimal(profit maximizing) quantity to produce at a given price is the Q level such that P = MC(Q). Hence for an individual producer in a competitive market, his MC curve is also his supply curve. In other words, when the price of a good is higher, the quantity supplies is higher (The Law of Supply).
 
 



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