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. 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 so das 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. 9. 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 dema nded in the optimal consumption bun dle 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. 10. 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. 11. 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. 12. 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. 13. 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 was just try the answers out. I tried first a $6 tax (since it’s the first choice) and see …