This is the exam solution guide for Form A of Exam 2. 1) The answer to this question is A, since this is Form A. 2) We are trying to find which consumption bundle Wolverine is indifferent to compared with 8 pizzas and 8 sodas. Remember that an indifference curve tells us exactly that: any points on the same indifferent curve are such that the utility gotten from that bundle is the same. Therefore, what we are looking for is just another point on the same indifference curve as the indifference curve that the bundle 8 pizzas, 8 sodas is on. This is the second indifference curve from the bottom. We see that the bundle of 4 pizzas and 16 sodas lies on that same indifference curve. The answer is E. 3) We first draw Wolverine’s budget constraint by asking ourselves two simple questions. If he spends all of his income ($40) on soda, how many can he buy? Since the price of soda is $2, this means he can afford 20 soda if he were to spend all his income on it. The second question we ask is how many pizzas Wolverine can afford if he were to spend all his money there. Since the price of pizza is also $2, he can buy 20 pizzas. We now have two points of the budget constraint, and since the budget constraint is linear, we can simply connect the two points. The opportunity cost of one more slice of pizza in terms of soda is then simply the slope of the budget constraint. Since we already have two points on the budget constraint 0246810121416182022242628303202468101214161820222426283032pizzasoda(0,20) and (20,0), we can use the “rise over run” formula to find the slope. The rise here is -20, and the run is 20, meaning the slope of the budget constraint is -1. This means that for every unit of pizza Wolverine buys, he must give up 1 soda. Hence, the opportunity cost of one slice of pizza is 1 soda, and the answer is B. 4) Remember the optimal consumption bundle is the point at which Wolverine is the happiest given his budget constraint. This point occurs where the budget constraint touches the indifference curve at exactly one point (or in other words, the budget constraint is tangent to the indifference curve at the optimal consumption bundle). From the above diagram, the blue budget constraint touches the black indifference curve exactly at the point 10 pizzas and 10 sodas. This is the optimal consumption bundle for Wolverine at that given income and prices. The answer is C. 5) When income increases, the budget constraint shifts upwards. We can figure out the new budget constraint by once again asking two simple questions: “How many pizzas can Wolverine buy if he spent all of his money on pizzas?” and “How many sodas can Wolverine buy if he spent all of his money on sodas?” We see that the answer to both of these questions is 32, since the price of both are still at $2. We denote the new budget constraint below, with a green line. The new optimal consumption bundle happens at 16 pizzas and 16 sodas. Therefore, we see that Wolverine now demands 6 more pizzas than he did before (since he demanded 10 pizzas at the old budget constraint). The answer is D. 0246810121416182022242628303202468101214161820222426283032pizzasoda6) If both income and prices double, then we see that nothing will happen to the picture we had above. We can see this by asking ourselves once again the two simple questions that helps us find the budget constraint. Wolverine now has $80 but the prices of both goods are now $4, meaning that he can still get 20 of each good. Therefore, the blue budget constraint will still be the budget constraint we will look at, and the optimal consumption bundle is exactly the same as it was when income was $40 and prices of both pizza and soda were $2. The answer is C. 7) First, we figure out what the budget constraint will be if Wolverine has $32 with the price of pizza being $4 and the price of soda being $2. We have the following budget constraint (the blue one) and optimal consumption bundle (which is labeled as point A). Thus, we see that originally, Wolverine will consume 4 pizzas. Now, the price of pizza falls to $1, and we draw his new budget constraint in the above diagram, represented by the green line. The optimal consumption bundle at this price is labeled point C. To find the substitution, effect, we need to shift the new budget constraint (the green line) back to the original indifference curve (the one where point A is). Doing so will tell us what Wolverine’s consumption bundle is if we kept him equally as happy as before but changed the opportunity cost to reflect that of the new prices. This is precisely the substitution effect. We therefore get the red budget constraint above that is parallel to the green budget constraint and also touches the old indifference curve at exactly one point. We call that point “Point B”. Now, the substitution effect is simply going from A to 0246810121416182022242628303202468101214161820222426283032pizzasodaA C B B, and the income effect is going from B to C. We see that at A, 4 pizzas are demanded, and at B, 8. Therefore, the substitution effect is 4 pizzas, and the answer is D. 8) We see from the diagram also that the income effect is also positive, since from point B to point C, we went from 8 to 16 pizzas. Therefore, both the substitution and income effect on the demand for pizza go in the same direction. The answer is A. 9) We have two effects that go in opposite directions here. The negative externality is pushing the social efficient quantity to the left of the market equilibrium quantity (T); at the same time, we also have the positive externality, so for each unit consumed we have an external benefit, so the socially efficient quantity will be pushed to the right of T. Overall, we find the socially efficient quantity looking at the intersection of Social Marginal Benefit and Social Marginal Cost, which happens at quantity T. Notice that this is the same as the free market equilibrium, given by the intersection of private marginal cost and private marginal benefit (supply and demand): the two effects just end up cancelling each other. The answer is D. 10) Taxes and subsidies might in general improve social surplus when we have an externality; the reason is that when we have externalities the market equilibrium allocation might not be the one that maximizes social surplus. Then, the target of imposing a tax or a subsidy is to achieve the socially efficient quantity. In this case, we notice that even if we