ECON 002 - Principles of Microeconomics Drake University, Spring 2024 William M. Boal

Version A

I. Multiple choice

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

II. Problems

(1) [Calculating elasticities: 2 pts]

• -0.5 = -1/2, using arc-elasticity formula: (ΔQ/Qavg) / (ΔP/Pavg) .

(2) [Cross-price elasticity of demand: 4 pts]

1. complements, because an increase in the price of one good caused a decrease in the quantity demanded of the other good.
2. -2/5 = -0.4, using formula: percent change quantity / percent change other price.

(3) [Income elasticity of demand: 4 pts]

1. inferior good, because an increase in income causes a decrease in the quantity demanded.
2. -1/5=-0.2, using formula: percent change quantity / percent change income.

(4) [Income elasticity of demand: 4 pts] Recall that by definition, necessary goods occupy a larger share of the budgets of low-income people than high-income people and have income elasticities between zero and one. Luxury (or superior) goods occupy a smaller share of the budgets of low-income people than high-income people and have income elasticities greater than one.

1. necessary good, income elasticity less than one.
2. luxury good, income elasticity greater than one.

(5) [Using price elasticity of demand: 10 pts]

1. elastic, because price elasticity is greater than one in absolute value.
2. decrease.
3. 6 percent, using definition: elasticity = percent change quantity divided by percent change price.
4. decrease, because the increase in price is less than the decrease in quantity.
5. 1 percent, using approximation formula: percent change in revenue = percent change in price + percent change in quantity.

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

1. \$7.
2. import, because quantity supplied is now less than quantity demanded.
3. 4 million = quantity demanded minus quantity supplied.
4. increase, because price fell.
5. \$14 million = area of trapezoid bounded by new and old prices and demand curve.
6. decrease, because price fell.
7. \$10 million = area of trapezoid bounded by new and old prices and supply curve.
8. increase, because consumers gain more than producers lose.
9. \$4 million = increase in consumer surplus minus decrease in producer surplus. Note that consumer's gain is greater than producers' loss, so international trade passes the compensation test.

(7) [Welfare analysis of market controls: 18 pts] Price ceiling = \$3.

1. \$5.
2. 5 million. That is all that suppliers are willing to sell.
3. excess demand, because quantity demanded is greater than quantity supplied at \$3.
4. 6 million, equal to quantity demanded minus quantity supplied at \$3.
5. decrease, because price fell.
6. \$14 million = area of trapezoid bounded by horizontal lines at new and old prices, and supply curve.
7. increase.
8. \$2 million = \$10 million - \$8 million. Consumers enjoy an increase due to a lower price (rectangle bounded by horizontal lines at new and old prices, and vertical line at new quantity, 10 million) but a decrease due to fewer units purchased (triangle between demand curve, horizontal line at \$5, and vertical line at new quantity, 5 million).
9. \$12 million = decrease in producer surplus minus increase in consumer surplus = area of triangle. Note that producer's loss is greater than consumers' gain, so this price ceiling does not pass the compensation test.

(8) [Welfare analysis of tax or subsidy: 18 pts] Tax = \$15. Under this tax, PD = PS + \$15, so at the new equilibrium quantity, the demand curve must be higher than the supply curve by \$15. Both consumers and producers lose from a tax, but government gains tax revenue.

1. 4 thousand.
2. \$20 per baseball bat, on supply curve.
3. \$35 per baseball bat, on demand curve.
4. decrease, because sellers' price fell.
5. \$25 thousand = area of trapezoid bounded by new and old prices for sellers and supply curve.
6. decrease, because buyers' price rose.
7. \$50 thousand = area of trapezoid bounded by new and old prices for buyers and demand curve.
8. \$60 thousand = new quantity times tax rate (\$15).
9. \$15 thousand = area of deadweight-loss triangle.

III. Critical thinking [4 pts]

(1) a. The study indicates that marijuana and tobacco cigarettes are complements for young people because the quantity of marijuana consumed is negatively related to the price of tobacco cigarettes.
b. The cross-price elasticity is defined as the percent change in quantity demanded of one good divided by the percent change in the price of the other good. Therefore the cross-price elasticity is -12/10 = -1.2 for young people, according to this study. Complements always have a negative cross-price elasticity.

(2) One should disagree with this statement. As the tax rate rises, the tax revenue collected by the government typically first rises and then falls. As the tax rate rises, it drives a wedge between demand and supply, causing the number of units sold to fall. At a high enough tax rate, the number of units sold may fall faster than the tax rate rises, and the tax revenue collected will then also fall. (A curve relating the tax rate to the tax revenue collected is called a "Laffer curve.") [Full credit requires a supply-and-demand graph showing for a given tax rate, the quantity traded and the rectangle representing tax revenue collected.]

Version B

I. Multiple choice

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

II. Problems

(1) [Calculating elasticities: 2 pts]

• -4, using arc-elasticity formula: (ΔQ/Qavg) / (ΔP/Pavg) .

(2) [Cross-price elasticity of demand: 4 pts]

1. substitutes, because an increase in the price of one good caused an increase in the quantity demanded of the other good.
2. 1/5 = 0.2, using formula: percent change quantity / percent change other price.

(3) [Income elasticity of demand: 4 pts]

1. luxury (or superior) good, because the percent change in quantity is greater than the percent change in income.
2. 2/3 = 1.5, using formula: percent change quantity / percent change income.

(4) [Income elasticity of demand: 4 pts] Recall that by definition, necessary goods occupy a larger share of the budgets of low-income people than high-income people and have income elasticities between zero and one. Luxury (or superior) goods occupy a smaller share of the budgets of low-income people than high-income people and have income elasticities greater than one.

1. luxury good, income elasticity greater than one.
2. necessary good, income elasticity less than one.

(5) [Using price elasticity of demand: 10 pts]

1. inelastic, because price elasticity is less than one in absolute value.
2. decrease.
3. 3 percent, using definition: elasticity = percent change quantity divided by percent change price.
4. increase, because the increase in price is greater than the decrease in quantity.
5. 2 percent, using approximation formula: percent change in revenue = percent change in price + percent change in quantity.

(6) [Welfare analysis of international trade: 18 pts] International price = \$10.

1. \$8.
2. export, because quantity supplied is now greater than quantity demanded.
3. 4 million = quantity supplied minus quantity demanded.
4. decrease, because price rose.
5. \$12 million = area of trapezoid bounded by new and old prices and demand curve.
6. increase, because price rose.
7. \$16 million = area of trapezoid bounded by new and old prices and supply curve.
8. increase, because producers gain more than consumers lose.
9. \$4 million = increase in producer surplus minus decrease in consumer surplus. Note that producer's gain is greater than consumers' loss, so international trade passes the compensation test.

(7) [Welfare analysis of market controls: 18 pts] Price floor = \$6.

1. \$5.
2. 7 million. That is all that demanders are willing to buy.
3. excess supply, because quantity demanded is less than quantity supplied at \$7.
4. 6 million, equal to quantity supplied minus quantity demanded at \$7.
5. increase.
6. \$13 million = \$14 million - \$1 million. Producers enjoy an increase due to a higher price (rectangle bounded by horizontal lines at new and old prices, and vertical line at new quantity, 7 million) but a decrease due to fewer units sold (small triangle between supply curve, horizontal line at \$5, and vertical line at new quantity, 7 million).
7. decrease, because the price rose.
8. \$16 million = area of trapezoid bounded by horizontal lines at new and old prices, and demand curve.
9. \$3 million = increase in producer surplus minus decrease in consumer surplus = area of triangle. Note that producer's gain is less than consumers' loss, so this price ceiling does not pass the compensation test.

(8) [Welfare analysis of tax or subsidy: 18 pts] Subsidy = \$3. Under this subsidy, PD + 3 = PS, so at the new equilibrium quantity, the supply curve must be higher than the demand curve by \$3. Both consumers and producers gain from a subsidy, but government pays.

1. 8 thousand, where supply curve is higher than demand curve by \$3.
2. \$30 per baseball bat, on the supply curve.
3. \$15 per baseball bat, on the demand curve.
4. increase, because the sellers' price rose.
5. \$35 thousand = area of trapezoid bounded by new and old prices for sellers, and supply curve.
6. increase, because the buyers' price fell.
7. \$70 thousand = area of trapezoid bounded by new and old prices for buyers, and demand curve.
8. \$120 thousand = new quantity times subsidy rate (\$15).
9. \$15 thousand = area of deadweight-loss triangle.

III. Critical thinking [4 pts]

Same as Version A.