ECON 002 - Principles of Microeconomics Drake University, Fall 2017 William M. Boal

EXAM 2 ANSWER KEY

### Version A

I. Multiple choice

(1)a. (2)a. (3)d. (4)a. (5)b. (6)d. (7)a. (8)b. (9)c. (10)b. (11)b. (12)a. (13)a. (14)b. (15)c. (16)c.

II. Problems

(1) [Computing price elasticity of demand: 6 pts]

1. -0.8 (using arc-elasticity formula: (ΔQ/Qavg) / (ΔP/Pavg) ).
2. inelastic.
3. -0.8 (value of elasticity does not depend on units of measure).

(2) [Price elasticity of demand: 10 pts]

1. elastic.
2. decrease.
3. 6 percent.
4. decrease.
5. 1 percent.

(3) [Income elasticity of demand: 10 pts]

1. luxury or superior good.
2. increase.
3. 7 percent.
4. increase.
5. 2 percent.

(4) [Welfare effects of international trade: 18 pts] International price = \$8.

1. \$6.
2. export.
3. 6 million.
4. decrease.
5. \$18 million.
6. increase.
7. \$24 million.
8. increase.
9. \$6 million.

(5) [Welfare effects of market controls: 18 pts] Price floor = \$7.

1. \$5.
2. 80 thousand pounds.
3. excess supply.
4. 60 thousand pounds.
5. increase.
6. \$150 thousand.
7. decrease.
8. \$180 thousand.
9. \$30 thousand.

(6) [Welfare effects of tax or subsidy: 18 pts] Subsidy = \$3. Since PS = PD + 3, in equilibrium, the supply curve must be higher than the demand curve by \$3. Both consumers and producers gain from the subsidy, but government loses.

1. 14 million tee-shirts.
2. \$8 per tee-shirt.
3. \$5 per tee-shirt.
4. increase.
5. \$13 million.
6. increase.
7. \$26 million.
8. \$42 million.
9. \$3 million.

III. Critical thinking [4 pts]

(1) If the elasticity of demand is -1.5, then percent changes in quantity are greater (in absolute value) than percent changes in price by a factor of 1.5. So an increase in price would cause an even larger decrease in quantity demanded, resulting in a decrease in revenue. So Marketing Consultant A is incorrect. By the same reasoning, a decrease in price would cause an even larger increase in quantity demanded, resulting in an increase in revenue. So Marketing Consultant B is correct. If you want to increase revenue, you must lower price, because demand is elastic.

(2) One should disagree with this statement. If America trades with a country whose price is lower than ours, the increase in consumer surplus exceeds the decrease in producer surplus. So, although American producers lose from international trade in this case, the country as a whole enjoys an increase in social welfare. (Full credit requires a supply-and-demand graph showing the welfare gain from the price fall.)

### Version B

I. Multiple choice

(1)b. (2)b. (3)b. (4)b. (5)c. (6)b. (7)b. (8)d. (9)a. (10)c. (11)c. (12)b. (13)b. (14)a. (15)d. (16)a.

II. Problems

(1) [Computing price elasticity of demand: 6 pts]

1. -1.2 (using arc-elasticity formula: (ΔQ/Qavg) / (ΔP/Pavg) ).
2. elastic.
3. -1.2 (value of elasticity does not depend on units of measure).

(2) [Price elasticity of demand: 10 pts]

1. inelastic.
2. increase.
3. 4 percent.
4. decrease.
5. 6 percent.

(3) [Income elasticity of demand: 10 pts]

1. necessary good.
2. increase.
3. 4 percent.
4. decrease.
5. 1 percent.

(4) [Welfare effects of international trade: 18 pts] International price = \$5.

1. \$6.
2. import.
3. 3 million.
4. increase.
5. \$10.5 million.
6. decrease.
7. \$9 million.
8. increase.
9. \$1.5 million.

(5) [Welfare effects of market controls: 18 pts] Price ceiling = \$4.

1. \$5.
2. 80 thousand pounds.
3. excess demand.
4. 30 thousand pounds.
5. decrease.
6. \$90 thousand.
7. increase.
8. \$60 thousand.
9. \$30 thousand.

(6) [Welfare effects of tax or subsidy: 18 pts] Tax = \$3. Since PD = PS + 3, in equilibrium, the demand curve must be higher than the supply curve by \$3. Both consumers and producers lose from the tax, but government gains tax revenue.

1. 10 million tee-shirts.
2. \$6 per tee-shirt.
3. \$9 per tee-shirt.
4. decrease.
5. \$11 million.
6. decrease.
7. \$22 million.
8. \$30 million.
9. \$3 million.

III. Critical thinking

Same as Version A.

[end of answer key]