Please, start your answer for each question on a separate set of pages.

EXAM IN MICROECONOMICS

(October, 2014)

Solutions and Marking Scheme

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 set of pages.

1.(40 points) For each of the following scenarios, use a supply and demand diagram to illustrate the effect of the given shock on the equilibrium price and quantity in the specified competitive market. Explain whether there is a shift in the demand curve, the supply curve, or neither.

A. (6 points) An unexpected temporary heat wave hits Moscow. Show the effect in the ice cream market in Moscow.

Answer: Demand for ice cream increases (shift to the right and up). Equilibrium price and quantity increase.

B. (6 points) The government introduces a tax on ice cream which is paid by producers. What is the effect in the ice cream market?

Answer: Supply decreases (shift to the left and up). Equilibrium price increases, equilibrium quantity declines.

C. (6 points) China and Mexico are major producers of textiles. Workers in Mexico decide to go on strike. Show the effect on the market for Mexican textiles.

Answer: Supply in the market for Mexican textiles decreases (shift to the left and up). Equilibrium price increases, equilibrium quantity declines.

D. (6 points) Show the effect of the situation described in (C) on the market for Chinese textiles.

Answer: Chinese and Mexican textiles are substitutes. Thus, demand for Chinese textiles increases (shift to the right and up). Equilibrium price and quantity increase.

E. (6 points) Suppose the government imposes a price cap on bottled water. Show the effect in the bottled water market.

Answer:If the price cap is above current equilibrium price – no effect. If it is below equilibrium price (binding), then the observed price in the market is equal to the price cap, the observed quantity is lower than the equilibrium quantity and is equal to the quantity supplied at the price cap, and there is a deficit. The deficit is equal to the difference between quantity demanded and quantity supplied at the price cap.

F. (10 points) Suppose the government subsidizes rents for the apartments. Show the effect on the market for rental apartments. Is there any effect on the housing-ownership market? If so, describe the effect.

Answer:

Rental apartments. Demand increases (if subsidy is paid to the renters) OR supply increases (if subsidy is paid to the landlords). Observed price (which includes the subsidy) and quantity increase.

Housing-ownership market. On one hand, rental housing is a substitute for own housing. Thus, demand for own housing can decrease, resulting in lower price and quantity in the own housing market. On the other hand, demand for own housing may increase due to better rental opportunities – people may purchase housing in order to rent it out. Thus, price and quantity may increase. Total outcome depends on the relative strength of these to effects.

2.(40 points) Robinson works 5 hours a day. He can make 8 apples per hour or 2 oranges per hour.

Friday works 10 hours a day. He can make 1 apple per hour or 4 oranges per hour. The figures below show the indifference curves for Robinson and Friday.

A. (10 points) Write down the expression for Robinson’s production possibility frontier (PPF) and for Friday’s PPF. (Note: drawing them in the graphs above may help you find the answer, but there is no need to turn in the pictures with your solution).

Answer:

B. (10 points) Does either of them have an absolute advantage in making apples? If so, who? What about comparative advantage in making apples?

Answer:Robinson has both absolute and comparative advantages in making apples.

C. (10 points) Suppose trade is impossible, so each is in autarky. For each, production equals consumption. How much does Robinson produce and consume at the utility maximizing choice?

Answer: See picture above. His optimal choice is where his PPF is tangent to the highest indifference curve he can obtain with it. It is 20 apples and 5 oranges.

D. (10 points) Suppose trade is possible and that the price of one apple in terms of oranges equals one orange. In this case, how many apples does Robinson produce and consume?

(Hint: Draw a new constraint for Robinson in the graph above to obtain your answer. Again, there is no need to turn in the graph.)

Answer:See the green line in the picture above. Robinson’s optimal choice is 20 apples and 20 oranges. He produces 40 apples and sells 20 of them to Friday in exchange for 20 oranges.

3.(20 points) Answer the following questions based on the information below for the economy of a country in a given year. All numbers are in millions.

A. (10 points) If this economy is producing at point C what is the opportunity cost of moving to point B? What is it per unit of the good gained?

Answer: The economy would lose 3 million tons of grain (from 7 to 4) and gain 2 million computers (from 12 to 14) per year. Thus, the opportunity cost of 1 computer is 1.5 tons of grain when move from C to B.

B. (10 points) Suppose this economy is currently producing 5 million computers and 10 million tons of grain, would this be efficient?

Answer: No. Point E is feasible: it has the same number of computer, but 2 more million tons of grain.