TA: David Simpson Principles of Economics UN1105 10/26/2017

Midterm Solutions

1. Definitions: (20 points total) Define the following terms very briefly. (Not
more than two sentences per definition.)

(a) Omitted Variable - Something that has been left out of a study that,
if included would explain why two variables that are in the study are
correlated.
(b) Perfectly Elastic Demand Curve - a very small increase in price causes
consumers to stop using goods that have perfectly elastic demand
(c) Willingness to Pay - is the highest price that a buyer is willing to pay
for an extra unit of a good.
(d) Excess Supply - when the market price is above the competitive equilib-
rium price, quantity supplied exceeds quantity demanded, creating excess
supply.
(e) Fixed Factor of Production - is an input that cannot be changed in
the short run.

Rubric: 4 points awarded per definition.

2. Elasticity: (8 points) A slump in the energy industry leads residents of Hous-

ton to experience a 10% drop in incomes. The income elasticity of demand for
housing is estimated to be 0.5. By how much will the quantity of housing de-
manded in Houston change? Is housing a normal or inferior good? Explain
your reasoning.
Rubric:

4 points - Correct calculation of change in quantity demanded:

%∆qd
εincome =
%∆income
%∆qd
0.5 =
−10%
%∆qd = −10 × 0.5 = −5%
Therefore there is a 5% decline in the quantity demanded for housing.
2 points - Housing is a normal good:
Inferior Goods: εincome < 0 
Normal 1 > εincome > 0
Superior Goods: εincome > 0 where
Luxury εincome > 1

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TA: David Simpson Principles of Economics UN1105 10/26/2017

2 points - for correct explanation of the above two concepts.

3. Sunk Costs: (12 points) A dairy farming cooperative upstate produces 1,000
gallons of milk per day. In recent years, all the milk has been sold locally for $4
per gallon. A new cooperative member suggests that the milk should, instead,
be transported to New York City, where it would sell for $7 per gallon. The
cooperative already owns a tanker for local transportation, and the additional
cost of sending it to the City would be $500 each day.
The farmers decide to try the NYC strategy. Alas, on the first day of driving
to the City, a freak lightning storm overturns the tanker. The farmers are
thankful that neither the driver nor the tanker suffered any damage, but they
are dismayed that all the milk leaked onto the highway, and they had to pay
$3,300 for a crane to turn the tanker right side up. Some of them argue that
they should return to selling
Rubric:

4. points - Correct calculation of profits:

π = TR − TC

Local New York City

T RL = p · q = $4, 000 T RN Y C = p · q = $7, 000
T CL = Cproduction T CN Y C = Cproduction + $500
πL = $4, 000 − C πN Y C = $6, 500 − C
πN Y C − πL = $2, 500 > 0
8. points - Correct Explanation: The payment of $3,300 is a one time sunk
cost. Although it is true that for one week the farmers make a loss relative
selling local without a spill, this loss only occurs once. They should expect
to make more money by selling in NYC for all subsequent weeks, therefore
they should continue to sell in NYC. So, you should tell the farmers, “Don’t
cry over spilt milk.”

4. Complements: (21 points) Using two supply/demand diagrams analyze the

effect of especially good weather for the growing of peanuts on the price and
quantity sold of jelly. Explain the logic clearly and label the diagrams carefully.
Would the results differ if the good weather had been accurately forecast months
in advance? Using your graphs (or a new one) illustrate a possible outcome if
the weather is forecast.
Rubric:

2 points - Correctly identifying the goods as complements

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3 points- Correct reasoning about why they are complements. Peanut but-
ter and jelly are consumed together. A price fall of one good causes an
increase in demand for the other good. The cross-price elasticity of de-
%∆qjelly
mand for jelly is given by ε = %∆ppeanuts < 0. Since the increase in peanut
supply causes a decrease in the price of peanuts, we should expect to see
an increase in the quantity demanded for jelly.
5 points - Correct explanation and graph of the impact on the market for
peanuts. Good weather will cause an increase in the supply of peanuts.
See below figure 1(a). 1 point for labeled graphs, 1 point for supply shift
to the right, 1 point for demand curve stable, 1 point for decline in price
and 1 point for increase in quantity demanded.
5 points - Correct explanation and graph of the impact on the market for
jelly. Jelly is a complementary good to peanuts. Since the price of peanuts
falls, this will cause an increase in demand for jelly. See below figure 1(b).
1 point for labeled graph, 1 point for demand shift to the right, 1 point for
supply curve stable, 1 point for price increase, and 1 point for increase in
quantity demanded.

Figure 1: Complements - (a) Peanuts (b) Jelly

6 points Correct explanation or use of graph. A good forecast months in

advance should ultimately cause jelly producers to increase the supply of
jelly. Observe:
(1) Increase in supply of peanuts ⇒ lower equilibrium price of peanuts
and higher equilibrium quantity
(2) Jelly and Peanuts are complements. Lower price of peanuts ⇒ increase
in demand for jelly
(3) Increased demand for jelly ⇒ increase of equilibrium price and quan-
tity of jelly

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TA: David Simpson Principles of Economics UN1105 10/26/2017

(4) Increased price in the jelly market causes jelly producers to enter the
market and increase supply. The new equilibrium quantity in the jelly
market is larger and the new equilibrium price is ambiguous

Figure 2: Complements - Forecast

5 The Budget Set: 24 points Nigel is a single parent with two children. Nigel
currently chooses to work 30 hours a week (out of 50 possible hours). Nigel
receives a wage rate of $5 per hour.
(a) On the graph below, show Nigels budget line and indicate the budget set.
(b) This week, Nigel applied to receive benefits from a welfare program that
provides $50 per week for single working parents who can show they are work-
ing at least 10 hours per week. On the same graph, show Nigels new budget
constraint if his application is approved. What will happen to the number of
hours he works?
(c) While Nigel is waiting for his application to be approved, he learns that the
welfare program will be phased out and replaced by a wage-support program
that would increase his hourly wage rate. Explain how the new wage-support
program will affect Nigels work decision. Under which program is Nigel likely
to work more hours? Explain carefully - no graphing is necessary.
Rubric:
4 points (a) See back budget constraint (line)
3 points (a) See blue budget set
8 points (b) See red piece-wise budget constraint (line)
1 points (b) Correct discussion about hours.
Before the new policy Nigel was already choosing to work at least 30 hours.
We should expect that he is unaffected by the 10 hour work threshold;
however, if we assume that leisure is a normal good we might expect Nigel
to slightly decrease hours worked and consume more leisure.

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TA: David Simpson Principles of Economics UN1105 10/26/2017

6 points (c) See green budget constraint

1 points (c) The new green budget constraint rotates outward around the 50
hours point, and intersects the y-axis somewhere above $250. This policy
increases the return to hours worked. Therefore, we would expect both the
income effect and substitution effect impact Nigel’s work decision. His new
labor-leisure decision will depend on his preferences and the magnitude of
the wage-support payment.
1 points (c) The policy in part (b) induces a pure income effect for individu-
als who work more than 10 hours. However, the policy in part (c) changes
the price of labor. There will be both a substitution and income effect.

Figure 3: Budget Constraints - (a) Black (b) Red (c) Green

6. Firm’s Problem (24 points) Senior daycare centers provide care and com-
panionship for older adults who need assistance or supervision during the day.
The table below shows the daily variable costs faced by Longevity, one of many
senior daycare centers in this perfectly competitive industry. Longevity incurs
a daily fixed cost of $500 in renting wheelchair-accessible space.
(a) The market price of daycare is $138 per senior per day. How many seniors
will Longevity serve each day? Explain your reasoning carefully.
(b) Is this market in long run equilibrium? Explain your reasoning.
(c) With the Baby Boomer generation beginning to turn seventy, rapid popula-
tion aging is expected to increase the demand for senior daycare. Assuming no
other changes, explain how this population aging will affect Longevity and the
adult daycare center industry in the short run. What will happen in the long
run? Explain carefully and draw a graph.
Rubric:

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TA: David Simpson Principles of Economics UN1105 10/26/2017

6 points - The firm will continue to increase the number of individuals it

serves as long as M R ≥ M C. Therefore, the firm will serve six individuals.
Six individuals is the last number where M R ≥ M C.

Figure 4: Firm’s Cost Chart

6 points - Yes, the market is in long run equilibrium. We are assuming

perfect competition; therefore, all firms in the market are identical and we
have that this firm is operating where M R = M C = AT C. The firm is
making zero profits. No firm has an incentive to enter or leave the market.
6 points - Short run: Demand increases, so the demand curve shifts to the
right. It will intersect the supply curve at a new higher equilibrium price
and higher equilibrium quantity. The new price will intersect the marginal
cost curve above the average total cost curve. Therefore, the firm will
make profits in the short term.
- See the Figure 5 -
6 points - Long run: Since the firm is making profits, other firms have an
incentive to enter the market as well. This will cause the supply curve to
shift out. It will shift out until price falls to the original level at a new
higher equilibrium quantity. The firm will make no profits in the long run.
- See the below Figure 5 -

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TA: David Simpson Principles of Economics UN1105 10/26/2017

Figure 5: Firm’s Cost Chart