Answer: The government spends PF (QS - QD).

MOCK EXAM IN MICROECONOMICS

(27 March 2010)

ANSWERS

Section 2. Free response questions.

You will have a total of 60 minutes for this section of the exam. It is strongly recommended that you spend the first 10 minutes reading the exam carefully, and the next 50 minutes working on the questions.

Please, start your answer for each question on a separate page.

1. (30 points) Consider the market for corn. The demand and supply curves are linear and have usual slopes. Suppose the corn farmers complain to the government that the price of corn is too low and does not allow them to sustain a decent living standard. To support the farmers, the government imposes a support price (price floor) above the equilibrium price. The government also guarantees farmers that it would purchase any quantity of their crops at the support price.

Show graphically the initial equilibrium in this market and the consequences of introducing a price floor for

A. (6 points) Price of corn and quantity of output sold to the consumers. Explain your answer.

Answer: See graph below.

Before the price floor (PF) is imposed, the equilibrium price is P* and the equilibrium quantity is Q*. With price floor, farmers supply QS and consumers demand QD. The quantity sold in this market is thus QD.

B. (8 points) Consumer and producer surpluses. Illustrate your answer with a graph.

Answer: See graph above. Consumer surplus without the price floor is the area bEP*, with the price floor it is the area bxPF. Producer surplus without the price floor is the area P*Ea, with the price floor it is PFza.

C. (8 points) How much does the government spend on this policy? Show this amount on your graph.

Answer: The government spends PF (QS - QD).

D. (8 points) Since the consumers ultimately pay taxes to finance government spending on this policy, is the total welfare higher or lower with the price floor policy? Explain your answer.

Answer: The total welfare is lower. The gain to producers from the policy (the area xzE on the graph) is more than offset by losses to consumers in surplus and increased government spending.

2. (40 points) Mike consumes two goods: leisure and all other goods, which we will call consumption goods. His leisure is measured in hours, and he can have at most 24 hours of leisure per day. The consumption goods are measured in monetary terms.

Mike can earn an hourly wage of W for every hour of leisure he foregoes. If he does not work at all, he receives no income and cannot consume any goods.

1. (10 points) What is the opportunity cost in terms of consumption of an extra hour of leisure? Draw Mike’s budget constraint. What is the value of the slope?

Answer: See graph below: