This is the guide to Fall 2014, Midterm 1, Form A. If you have another form, the answers will be different, but the solution will be the same. Please consult your TA or instructor if you think there is an error in the guide – it is not guaranteed to be mistake free. 1) Your answer to this question is what form of the exam you had. The answer is A if you have form A. The answer is B if you have form B etc. 2) The price of corn decreases and corn is an input into the production of ethanol. Decrease in the price of an input shifts the supply curve down and to the right. Therefore, the equilibrium quantity of ethanol increases and the equilibrium price of ethanol decreases. The answer is C. 3) The price of crude oil decreases. Crude oil is a substitute for ethanol. A decrease in the price of a substitute shifts demand down and to the left. Therefore the equilibrium quantity of ethanol decreases and the equilibrium price of ethanol decreases. The answer is D. 4) From the two questions above we know that the supply curve will shift down and to the right and the demand curve will shift down and to the left. We do not, however, know the magnitude of these shifts. Since both shifts cause the equilibrium price of ethanol to decrease we know that the equilibrium price will decrease when both curves shift. However, since the two shifts move the equilibrium quantity in opposite directions we do not know the effect on equilibrium quantity of ethanol. The answer is D. 5) We are told that the price of a complement increases. Therefore, the demand curve moves down and to the left. We are told that the price of a widget decreases but the quantity remains unchanged. If we had a standard supply curve with a positive slope we would expect the equilibrium quantity to decrease and the equilibrium price to decrease. Therefore, it must be that the supply curve is a vertical line so that the equilibrium quantity remains unchanged. The supply curve must be inelastic. The answer is D. 6) We are told demand is unit elastic, this means that the following an increase in prices of 1%, demand decreases 1%. Similarly, supply is unit elastic, i.e. an increase in prices of 1% will increase supply by 1%. Also we know that in order for consumers to bear the whole tax burden, demand should be perfectly inelastic (the more inelastic part of the market bears the burden), which is not the case. If producers were to bear 100% of the tax burden, supply should be perfectly inelastic, which is not true either. If we draw the curves, we can see how both consumers and producers are losing surplus following the introduction of the tax: consumers end up paying a higher price, producers receive a lower one compared to before, and total quantity is reduced.Hence, since they are all unit elastic, it has to be that both consumers and producers share the tax burden. The answer is C. 7) First realize this is a violation or Principle 2: efficient production. S2 has a lower cost, so should produce before S9 does. Thus, it is not Pareto Efficient. In order for S2 to produce he needs to break even, so at least needs to make $2 to cover the cost of production. This rules out b) and c) as answers, because S2 wouldn’t be better off by producing, since he would be losing money. S9 also has to make less of a loss by paying S2 to produce and don’t make a widget, compared to the initial situation when he is producing with a cost of 9. In answer a) he would have to pay $10 to S2 so that’s even worse than producing at a cost of $9. We can see that if S9 pays $2.01 to S2, S2 would be better off (in particular $0.01 better off) compared to not producing, and S9 would only have to pay $2.01 to get that unit instead of producing it Both would be better off compared to the initial situation, which is a Pareto improvement. Then, the right answer is D. 8) From the First Welfare Theorem we know what the market will ensure the equilibrium allocation is Pareto Efficient under three principles: P1. Efficiency in consumption. Consumers with high reservation values should consume first. D1 is the consumer with the highest valuation, D2 the second one and so on. Since D1-D5 consume and they are ranked from highest to lowest reservation values , this principle is satisfied.P2. Efficiency in production: producers with lowest costs should produce and sell first. We see that S1-S5 are ranked from lowest to highest costs and they all sell, so this principle is satisfied too. P3. Efficient quantity: marginal reservation value of the last buyer should be equal to marginal cost of last seller. Last buyer is D5 with a reservation value of 5. Last seller is S5 with cost 5. Since both are equal, the quantity is efficient. Hence the allocation is Pareto Efficient. Since none of the answers recognize that there is Pareto efficiency in the allocation, the answer is E. 9) The best way to see this is with an example. Suppose demand is unit elastic and supply is perfectly inelastic. There are no externalities and the market is perfectly competitive, so the assumptions for 1st welfare theorem are satisfied, hence the market equilibrium (P=5,Q=5) is Pareto Efficient. However, we see that the share of surplus that consumers and producers will receive depends on the elasticity of their curves. CS= 0.5*5*5=12.5 and producer surplus is 25. Hence we see the allocation is Pareto Efficient, but consumer surplus is different than producer surplus. The answer to the question is false, and is B. 10) In the unregulated market, the equilibrium price is such that QD=QS , hence Excess Demand = QD – QS = 0. The answer is A. 11) In the unregulated market consumer surplus is the area under the demand curve and above the equilibrium price line. In this case the equilibrium price line is the horizontal line at PEQ = 5. Thatarea is a triangle and we use the formula for the area of a triangle to calculate the consumer surplus. In this case CS= (10-5)x5/2 = 12.5. The answer is C 12) Recall that a government tax or subsidy puts a wedge between the price that the consumers pay and the price that the producers get. PD = Tax + PS. In this case we have a subsidy of $6 hence Tax = -$6. This implies that the equilibrium quantity is where PD = -6+ PS. This happens when Q=8, because in this case PD = 2 and PS = 8. Hence the equilibrium quantity is 8. The answer is D 13) In the previous question we found that when there is a $6 subsidy, there is a production of 8