Practice Midterm V3 SOLUTIONS

March 8 Name__________________________ Practice Midterm SOLUTIONS • You have 75 minutes to complete this test. • No outside paper/materials are allowed except a non-graphing calculator. • You can tear off the last two pages of the test to use as scratch paper. • Good luck!

Part 1: True/False • For each question in this section determine whether the statement is True or False. • Clearly write “True” or “False” on the line next to the question number. • Below each question, write a short (one sentence or less) explanation of your answer. • Answers without explanation will be worth no credit. ____ F _____ Question 1.1: If all the prices a consumer faces fall by 50%, their real income decreases by 50%. No, real income would double ____ F _____ Question 1.2: Economic models of household consumption are invalid in situations where households don’t actually calculate their MRS/MRT when making consumption decisions. No, economic models make simplifications to abstractly describe the complex way humans make decisions to find tractable solutions, often using things like MRS to tractably describe an agent’s optimal decision. ____ F _____ Question 1.3: In some situations, output maximization and cost minimization may lead to different optimal input mixes for the firm. Correctly defined output maximization and cost minimization always result in the same optimal input mix ____ F _____ Question 1.4: A firm produces with two inputs, capital and labor. It must pay r for each unit of capital and w for each unit of labor. For a given output level q, the cost minimizing mix of capital and labor will be such that MRTS = !"# $ MRTS = ! # (or % ! depending on how MRTS is defined)

____ F _____ Question 1.11: When you pay for a haircut you’re purchasing a service not a good because the hairdresser doesn’t provide you with a physical object. Goods can be physical things (products) or intangible things like a haircut (services) _____ F ____ Question 1.12: Indifference curves may cross if one of the goods is inferior. Indifference curves can never cross. This is inconsistent with the preference axioms we assume all preferences obey. _____ T ____ Question 1.13: Predictions based on economic theory tend to get less accurate the more outside factors that change at once. Because economics requires making ceteris paribus arguments, if many things change at once, our ability to predict outcomes quickly diminishes. _____ T ____ Question 1.14: The marginal cost curve crosses the average total cost curve at it’s minimum value. Due to the way averages work, adding an element that is larger (smaller) than the average of a set of elements will always increase (decrease) the average of the enlarged set. _____ F ____ Question 1.15: A demand curve tells us how much of a good an agent would choose to consume at different income levels. A demand curve tells us how much a good an agent would choose to consume at different price levels of that good.

Part 2: Multiple Choice • In this section you must determine which of the corresponding lettered options best answers each question. • Clearly write the letter of the most correct answer on the line next to the question number. • Only what’s written on the line next to each question number will be graded! ____ A _____ Question 2.1: Sarah budgets to spend $300 a month on beer and coffee. Beer at her favorite pub is $8 and coffee at her favorite coffee shop is $5. At her current consumption level her MRS of coffee with respect to beer is 2. Based on this information we can conclude: A. Sarah would be better off consuming more beer and less coffee B. Sarah would be better off consuming less beer and more coffee C. Sarah is optimally consuming beer and coffee D. We don’t have enough information to say any of the above _____ B ____ Question 2.2: Tom is facing the decision of how of much goods x and y to buy. The price of good x is $3 and the price of good y is $5. At his current consumption level his MRS of good y with respect to good x is 0.5. Based on this information we can conclude: A. Tom would be better off consuming more of good x and less of good y B. Tom would be better off consuming less of good x and more of good y C. Tom is optimally consuming goods x and y D. We don’t have enough information to say any of the above ____ B _____ Question 2.3: The following constrained optimization problem corresponds to which economic model? min &,( ࠵?࠵? + ࠵?࠵? ࠵?. ࠵?. ࠵?(࠵?, ࠵?) ≥ ࠵? A. Optimal savings decision of households B. Cost minimization of optimal input mix C. Output maximization of optimal input mix D. Optimal household consumption E. Profit maximization of a price-taking firm F. Profit maximization of a non-price-taking firm G. None of the above

_____ B ____ Question 2.7: The elasticity rule tells us A. The amount a price setting firm will select to produce will be equal to the inverse of the income elasticity of demand they face B. A price setting firm will produce an amount of output such that the margin they charge will be equal to the inverse of the price elasticity of demand they face C. A firms may not choose to operate if the price they face isn’t high enough D. Elasticity is always measured as the percent change in price divided by the percent change in quantity E. The amount a price setting firm will select to produce will be equal to the inverse of the price elasticity of demand they face F. Firms will always increase their supply by their price elasticity of demand G. None of the above _____ D ____ Question 2.8: If good x is an inferior good (when compared to good y) and the price of good x increases, what do we know the consumption of good x? A. It increase B. It decrease C. It stay the same D. We don’t have enough information to say any of the above _____ E ____ Question 2.9: We define a good as A. Anything a firm uses to produce output B. Any physical product which can be bought or sold C. Any product or service which can be bought or sold D. Any product or service with differentiated units E. Any product or service with fungible units F. None of the above ____ B _____ Question 2.10: Transitivity is a property of preference relations that says A. Given any pair of options c 1 and c 2 , either c 1 ≻ c 2 or c 2 ≻ c 1 or c 1 ∼ c 2 B. Given any three options c 1 , c 2 , and c 3 , if c 1 ≻ c 2 and c 2 ≻ c 3 then c 1 ≻ c 3 C. If c 1 has more of every good than c 2 then c 1 ≻ c 2 D. None of the above

____ B _____ Question 2.11: In game theory a dominant strategy is: A. A strategy that is best for you if you know exactly what your opponent will do B. A strategy that is best for you regardless of what your opponent will do C. A strategy that will optimize your outcome regardless of the rules of the game you play D. A strategy that, if you have the right information, will always win the game for you E. None of the above _____ A ____ Question 2.12: The marginal principle is best described as: A. The level of a given economic activity should be increased if and only if the additional benefit exceeds the additional cost B. Economic agents will always optimize C. Firms must know the price elasticity of demand they face to set prices D. An agents decision will be impacted by the constraints they face E. Marginal cost is always less than average total cost F. None of the above ____ B _____ Question 2.13: As defined in class, the capitalist system refers to the combination of all of the following factors EXCEPT: A. Private property B. Incentives C. Firms D. All other options are aspects of the capitalist system as defined in class

Question 3.3: A firm as a fixed cost of $75 if they want to operate and can produce 1 unit of output with either 1 unit of capital or 1 unit of labor. They face a price of capital of $2 and a price of labor of $6. What is their ATC to produce 15 units of output? Capital and labor are perfect substitutes for the firm. Given this, firm would optimally choose to produce with capital not labor since it’s the cheaper input per unit of output. Total cost would be $75 + $2 x 15 = $105. Then ATC = $105/15 = $7 Now suppose the firm can produce 1 output with 4 units of capital or 1 unit of labor. What is their AVC to produce 15 units of output? In this case, the firm would optimally choose to produce with labor not capital since it’s the cheaper input per unit of output. AVC = price of labor = $6 Question 3.4: Table 1 below shows the demand for model school busses in the tourist stalls on the Brooklyn bridge. What is the price elasticity of demand when price increases price $3 to $4? Table 1: Price Quantity Sold $1 75 $2 60 $3 40 $4 30 $5 15 ࠵?࠵?࠵?࠵?࠵? ࠵?࠵?࠵?࠵?࠵?࠵?࠵?࠵?࠵?࠵? ࠵?࠵? ࠵?࠵?࠵?࠵?࠵?࠵? = ࠵?࠵?࠵?࠵?࠵?࠵?࠵? ࠵?ℎ࠵?࠵?࠵?࠵? ࠵?࠵? ࠵?࠵?࠵?࠵?࠵?࠵? ࠵?࠵?࠵?࠵?࠵?࠵?࠵? ࠵?ℎ࠵?࠵?࠵?࠵? ࠵?࠵? ࠵?࠵?࠵?࠵?࠵? = 30 − 40 40 4 − 3 3 = − 3 4

Question 3.5: Draw two sets of isoquant curves for a production function that takes two inputs: good x and good y. Draw one set that shows inputs which are perfect complements and one set that shows inputs which are perfect substitutes. Label each set of curves accordingly. Label each axis.

Question 3.7: What are two problems with using GDP per capita as a measure of economic welfare? There are lots of potential answers to this question. One problem with using GDP per capita is that prices in different regions may be very different, and so even though productivity is the save in the two regions, one region appears much more productive only because they have higher prices. Measuring GDP in terms of purchasing power parity (ppp) may partially address this issue Another problem is that GDP doesn’t capture any information about the income or wealth distribution with a region.