Guide to the Answers to Midterm 2 Fall 2010 FormA This was put together quickly and may have typos You should really think of it as an unofficial guide that might be of some use 1 Hopefully you got this question right After all there is only one choice for your answer 2 When trade is based on comparative advantage trading partners must be different in terms of their PPF because otherwise they will have the same opportunity costs and that means even If they trade they will just do as good as they would if they produced themselves The answer is B 3 Right away seeing quotas should tip you off to the domestic producers Quotas are used to limit foreign imports and the whole point of importing is because the good is cheaper abroad So the consumers in the US definitely do not want a quota and that also means that foreign producers will not want a quota since they can t sell as much under a quota D is false since we ve seen that quotas create a dead weight loss that lowers total surplus A quota is then probably the result of lobbying from US producers of sugar The answer is B 4 Here you should find the point 16 pizzas 4 sodas on the graph right away You will see that it is conveniently on an indifference curve After that finding the answer just becomes a game of finding what point lies on the same line which should be a fun one So you should get that the only consumption bundle on the same indifference curve is 8 pizzas and 8 sodas The answer is E 5 We need to graph Sparty s budget constraint We can do so by figuring out how many pizzas he can afford if he uses all his money on pizza and how much soda he can afford if he spends all his money on soda We find that the answer to those questions can be found by just dividing Sparty s income by the price of pizza and soda respectively We get the points 8 0 and 0 16 on the graph since Sparty can afford 8 pizzas or 16 soda if he spent all his money on either Connect the two points to get the budget constraint Then the opportunity cost of one more slice of pizza is just the absolute value of the slope of the budget curve which you can find using the rise over run method The answer is D 6 The optimal consumption bundle is simply where the budget curve intersects the indifference curve at exactly one point This is why bringing your ruler was a great idea You should see that the optimal consumption bundle is 4 pizza and 8 soda so the answer is A 7 Now the price of pizza drops to 2 meaning the budget constraint is going to change Now if Sparty spent all his money on Pizza he can get 32 of them This means you should now draw the new budget constraint which connects the points 32 0 with 0 16 This new budget line should conveniently intersect an indifference curve at exactly one point That point is your new optimal consumption bundle and it happens to be 16 pizzas and 8 sodas So we went from 4 pizzas to 16 pizzas which is an increase of 12 pizzas The answer is E 8 9 10 11 12 13 To find the substitution effect we want to shift the new budget constraint back to the old indifference curve such that the shifted budget constraint intersects the old indifference curve at exactly one point remember to keep the shifted budget constraint parallel to the new budget constraint The shifted budget constraint should intersect the old indifference curve at exactly one point and the increase in quantity from the amount of pizza from the original consumption bundle of 4 pizzas and 8 sodas to the consumption bundle where the shifted budget constraint intersects with the same indifference curve of 8 pizza and 4 soda an increase of 4 pizzas means the substitution effect increased demand for pizza by 4 units Note even though this question doesn t ask this the income effect is just the remaining increase in quantity of pizza demanded in this case it s 8 pizzas since the optimal bundle after the price drop of pizza is 16 pizzas and 8 sodas The answer is A If income doubled you can find that the new budget line connects 16 0 and 0 32 corresponding to 16 pizzas and 32 sodas that Sparty can afford if he spends all his income on either We see that the quantity demanded in the optimal consumption bundle at the point where the budget intersects with the indifference curve at exactly one point of 8 pizzas and 16 sodas Then we see that the demand for both pizzas and sodas increased from the original optimal consumption bundle of 4 pizzas and 8 sodas and thus we see that both pizzas and sodas are normal goods since the quantity demanded increased with income Thus the answer is D When the price of any goods falls we see that through the substitution effect consumers will buy more of that good since the price of it is lower relative to the other good However the characteristic of an inferior good is such that when income increases the quantity demanded of it decreases and so the income effect will have a negative effect on quantity demanded of the good Thus the answer is B The next few questions may seem scary at first since you probably never seen a question put this way before but the fact is these are just questions about tax and externalities If both countries agree to each cut consumption in half and each country sets a tax on oil to do it for the poor country to cut consumption from 8 to 4 we simply use the wedge method and draw a wedge at Q 4 for the poor country We see that the length of this wedge is the amount of tax that is needed to reduce consumption to 4 Since the wedge connects the points 4 2 and 4 6 we see that the length of the wedge is 4 and the tax must be 4 The answer is D Doing the same thing as the last question we use the wedge method to find that the size of the tax is 8 to decrease consumption from 16 to 8 The answer is A The total surplus before the tax is the giant triangle that corresponds to consumer surplus We see that the area of this triangle is 128 1 2 16 16 Note that you actually don t need to know this to answer this problem I just have it on here in case you were curious The surplus that s lost from the tax is the triangle with vertices 8 2 8 10 and 16 2 which has an area of 32 Thus the change is minus 32 which is E 14 Here what I did …