PracticeExamEco204Y1YSolution

ANSWERTOTHEFIRSTQUESTIONISEXTENSIVE.ITINCLUDESALLTHESTEPSOFWORKINGOUTTHESOLUTIONANDA
COMPLETEFINALANSWER.
1.

(50POINTS)TrueorFalse?Ifaconsumerspends$40on4pizzaseverymonththenthe
consumerisindifferentbetweenapricereductionof$2perpizzaforthedurationofa
monthandan$8onetimediscount.

INTUITION:Ofcourse,theconsumerisindifferent:Athiscurrentconsumptionbundle,thesavings
of$2perpizzaequal$8forthismonthwhichisexactlytheonetimediscountoffered.Setit
aside.
CONCEPT:OptimalconsumptionBundle
REPRESENTINGINFORMATION:
OtherGoods

B2

B1
B3

Pizzas

LetssayI istheconsumersoriginalbudget.InthegraphitisdepictedasB1.
Wewanttocomparetwooptions:Adecreaseintheprizeofpizzaby$2andaonetime
discountin$8.ThefirstchangeresultsinapivotingoutofthebudgetlinebudgetlineB2.The
secondchangeresultsinanoutwardshiftofthebudgetlinebudgetlineB3.
Iftheconsumermaintainshiscurrentconsumptionofpizza,thentheconsumerwouldhavethe
sameamountofmoneylefttospendonothergoodsunderbothscenarios:
I 4x$8=I +$8 4x$10.
ANALYSIS:WewanttodeterminewhethertheconsumerhasapreferencebetweenbudgetB2
andB3orwhethertheconsumerisindifferent.

LetsseecouldtheconsumerpreferB3(thepricechange)?Yes.Seethegraphontheleft.
CouldtheconsumerpreferB2(theonetimediscount)?Yes.Seethegraphontheright.
OtherGoods

OtherGoods

B2

B2

B1

B1

B3
B3
Pizzas

Pizzas

ANSWER:FALSE.(Inthesenseofnotnecessarilytrue.)
Theconsumermightpreferoneortheotheroptionasshowninthediagram.Ineithercase,
theconsumerhasapreferenceandisnotindifferent.
REFLECT:Couldtheconsumerbeindifferentbetweenbothoptions?(Maybeifweknewforsure
thatthepreferencesarehomogenous..?)Inthiscase,bothoptionswouldhavetoyieldthe
samehappiness.Solikethis:
OtherGoods
B2

B1
B3

Pizzas

Sogood.Answercouldreverse.
Next,letscheckwhethertheanswerfoundisreasonable:Ontheleft,asthepriceofpizza
decreases,consumerpurchasesmorepizzaandfewerothergoods.Reasonableenough.
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Ontheleft,asincomeincreases,consumerpurchasesfewerpizzaandmoreothergoods.Hm.If
thatisthecase,pizzawouldhavetobeaninferiorgoods(quantitydecreasesasincome
increases).Unlikely.
Letsfollowthatthought:Boththeonetimediscountandthepricedecreaseincreasethe
consumers(perceived)income.Ifweassumethatpizzaisanormalgood,thenthequantityof
pizzayouconsumeshouldincrease.Inotherwords,underbothoptionstheconsumershould
consumemorethan4pizzas.Iftheconsumerpurchasesmorethan4pizzas,thentheconsumer
strictlyprefersthechangeinpriceoverthechangeinincome.

FINALANSWER:FALSE.(Inthesenseofnotnecessarilytrue.)
Ifpizzaisanormalgood,thentheconsumerwillstrictlypreferthechangeinprice:Boththe
onetimediscountandthepricedecreaseincreasetheconsumers(perceived)income.So
underbothoptionstheconsumershouldconsumemorethan4pizzas.Iftheconsumer
purchasesmorethan4pizzas,thentheconsumerstrictlyprefersthechangeinpriceoverthe
changeinincome,becausethecostsavingsfrombuying5ormorepizzasat$8apiecerather
than$10exceeds$8.
Evenifpizzaisaninferiorgood,theconsumermightpreferoneortheotheroptionasshown
intheabovediagram.Ineithercase,theconsumerhasapreferenceandisnotindifferent.

THEFOLLOWINGANSWERSAREBRIEFGIVINGYOUASENSEOFWHETHERYOUAREONTHERIGHTTRACK.ASFINAL
ANSWERSTHEYARENOTNECESSARILYCOMPLETE.
2.

(50POINTS)TrueorFalse?Acompanythatprofitablyproducesandsells10,000items
eachyearshouldproduceandsellmoreitems.

CONCEPT:Decisionsaremadeatthemargin.Equimarginalprinciple
ANSWER:FALSE.(Notnecessarilytrue.)Recallthataccordingtotheequimarginalprincipleifa
profitmaximizingfirmproducesatall,itoptimallyproducesuptothepointwheremarginal
revenueequalsmarginalcost.
Forexample,consideramonopolistproducingwidgetsataconstantmarginalcostof$10.Let
thedemandcurvethatthemonopolistfacesbeQ=30,0001,000P.SolvingMR=MC,the
monopolistoptimallyproduces10,000units[aligningthemodelwithinformationgiven],
charging$20,andgeneratingaprofitof$100,000.Producinganadditionalunitdecreasesthe
monopolistsprofitby1/500.

3.

(50POINTS)TrueorFalse?IftheConsumerPriceIndex(CPI)reportsaninflationrateof

0%,thenapersonwithafixedincomewillbeneitherbetteroffnorworseoff.
CONCEPT:ConsumerPriceIndices.OptimalConsumptionBundle.
ANSWER:FALSE.(Notnecessarilytrue.)Recallthatinflationmeasuresthechangeinthecostof
affordingaparticular(representative)bundle.Aninflationrateofzeromeansthatthecostof
purchasingthesameconsumptionbundleinthefirstandsecondperiodisthesameatboth
times.
Forexample,say,thebundleconsistsof1unitofconsumerelectronics,1unitoffood,and
otherconsumptiongoods.Assumethatthepricesinperiod1and2areasfollows

Consumerelectronics Food
Othergoods
Priceinperiod1
$200
$100
$1,500
Priceinperiod2
$100
$200
$1,500

Theninperiod1,thetotalcostofthebundleis$1,800asitisinperiod2.Inflationis0%,
[aligningthemodelwithinformationgiven].

Assumetheconsumerunderconsiderationhasanincomeof$1,500anddoesnotpurchase
consumerelectronics.Inperiod1,theconsumermayconsume5unitsoffood(morethanthe
representativebasket)and2/3unitsofothergoods(lessthantherepresentativebasket).Then
4

inperiod2,theconsumercannolongeraffordhispreviousbundle.Thegoodstheconsumer
purchasedhaveincreasedinprice(orstayedthesame).Theconsumerisworseoff.
(Couldtheconsumeralsobebetteroff?)
(Doublecheck:Theanswerdependsontheconsumernotconsumingtherepresentative
bundle.Wouldtheanswerswitchifitwasguaranteedthattheconsumerdidconsumethe
representativebundle?)

4.

(50POINTS)TrueorFalse?IfGeneralMotorscouldrequireallGMcarownerstobuyallof
theirreplacementpartsdirectlyfromGM,itwouldchargemonopolypricesforthose
replacementparts.

CONCEPT:BackwardInduction.Twoparttariff.
ANSWER:FALSE.Consumerswouldtakethecostofreplacementpartsintoaccountwhenmaking
acarpurchase.GMwouldbebetteroff,chargingthecompetitiveprice(=MC)ofthe
replacementpartsandaddingtheamountofthethusgeneratedconsumersurplustotheprice
ofthecarinthespiritofatwoparttariff.

5.

(50POINTS)TrueorFalse?Ifsafercarsreduceadriver'schanceofdyinginanaccident,

thentherewillbefewerdriverfatalities.
CONCEPT:IncomeandSubstitutionEffect.
ANSWER:FALSE.(Notnecessarilytrue.)

Withoutasafercart,thedriverisatAand
withasafercarthedriverisatB.Assuming
speedandsafetyarenormal,Bisaboveand
totherightofC.Bygeometry,Cisabove
andtotheleftofA.ThusBmustbeaboveA
(peoplecertainlydrivefaster).ButBcould
beeitherleftorrightofA(eithermoreor
fewerlivesmightbesaved).

6.

(50POINTS)TrueorFalse?Arationalsocietywilluseitsmostfertilelandforagriculture.

CONCEPT:Opportunitycost.
ANSWER:FALSE.(Notnecessarilytrue.)Considersocietyhastwooptionsusinglandfor
agricultureandbuildingacity.Assumetherearetwolotsandthebenefitsfromtherespective
usageareasfollows

City
Agriculture
LandParcel1
200
150
LandParcel2
80
100

Themostfertilelandisparcel1.[linkingthemodeltoinformationgiven].Buttheopportunity
costofusingthatparcelforagricultureisnotusingitforacity.Thetotalbenefitfromusing
parcel1foragriculturewouldbe50.Incontrast,thetotalbenefitfromusingparcel2for
agricultureis20.
Saiddifferently,ifsocietyusesparcel1foragricultureandparcel2forbuildingacity,thetotal
benefitgeneratedis230.Butifsocietyusesparcel2foragricultureandparcel1forbuildinga
city,thetotalbenefitgeneratedis300.
Thus,arationali.e.,abenefitmaximizingsocietydoesnotnecessarilyuseitsmostfertile
landforagriculture.

7.

(50POINTS)Inmanyindustriesworkersarerequiredtobelongtoaunionandtopay
uniondues,eveniftheywouldprefernotto.TrueorFalse?Workerswouldbebetter
offifeachonecouldchoosewhethertobelongtotheunion.

CONCEPT:Freeridingandunderinvestmentinthepresenceofexternalbenefits.
ANSWER:FALSE.Workerswouldbenefitfromtheunionsbargainingeveniftheyarenotinthe
union.Itwouldthusbeindividuallyrationalforworkerstonotpayunionduesandfreerideon
theunion.Allworkersmakingthesamedecision,theunionwouldunravel,ceasetoexist,and
failtonegotiatethebenefitsfortheworkers.Giventhatworkerschosetoorganizeasaunion
inthefirstplace,thebenefitsfromtheunionmustexceedthecostofthedues.Soiftherewas
nounion,theworkerswouldbeworseoff.

8.

(50POINTS)Inclasswehaveshownthatifconsumersmaketheirpurchasesinorderto
maximizetheirutility,thentheresultingdemandcurvesaredownwardsloping.Inthe
realworldweobservedemandcurvestobedownwardsloping.TrueorFalse?Thisreal
worldobservationconfirmsthatconsumersonaverageindeedbehaveasutility
maximizers,evenifsomeindividualconsumersarenotconsciouslyawareofit.

CONCEPT:RandomDemandModel.
ANSWER:FALSE.Weshowedthatrationalbehaviorimpliesadownwardslopingdemandcurve.
Observingadownwardslopingdemanddoesnotvalidatetheassumption.(Whenitrains,the
streetiswet.Butfromobservingthewetstreetwecannotconcludethatitrained.)
Inparticular,thereareotherexplanationsthatalsoresultinadownwardslopingdemand
curve:Forexample,ifconsumersrandomlypickaconsumptionbundleontheirbudgetline,
thentheaggregatedemandcurveisdownwardsloping.(seequestion11onstudyguide12.)
9.

(50POINTS)Ifagreementsbetweenmanufacturersanddealerslimitthewayhowdealers

presentandsellthemanufacturersproduct,thensuchagreementscansustain
collusionamongdealers.TrueorFalse?Sincecollusionsarewelfaredecreasing,
agreementsbetweenmanufacturersanddealersshouldbelimitedbylawtothe
interactionbetweenthemanufactureranddealer(suchasthepricepaidbythedealer
tothemanufacturer);agreementsaboutinteractionsbetweenthedealerandthe
consumermarket(suchasthepricechargedbythedealer)shouldbeillegal.
CONCEPT:RetailPriceMaintenance.
ANSWER:FALSE.Ifthemanufacturer,forexample,imposesapriceflooritwouldconstrainthe
dealersinteractionwithconsumers.[linkingthemodelwithinformationgiven].Doingsomay
increasetheoverallwelfare(ifB>Cinthediagrambelow).
Retail

SocialGain

Demandforbikes,
soldw/oservice

W/oRPM

W/RPM

A+C

A+B

Demandforbikes,soldw/service

B
A

P
P

MCforbikes,soldw/service
1

MCforbikes,soldw/oservice

Quantity