Intermediate Microeconomics

Spring 2009, Karl Storchmann

Exam No. 1
Instructions: Please read all the questions carefully. You have 80 minutes to complete
the exam. You must answer all questions. The value of each question is indicated in
parenthesis. The total maximum is 56 points. Answer each question as clearly and
concisely as possible. Show your work but be brief. Good luck!
Calculators allowed.

Real Price and Nominal Price (8 pts)

(1) The following Table provides you with the nominal price of watermelons from 1990
through 2007 (all in $/lb).
nominal price
CPI (1990=1)
CPI (2007=1)
real 2007 price

1990
0.35
1
0.833
0.42

1995
0.40
1.12
0.933
0.43

2000
0.42
1.16
0.967
0.43

2005
0.46
1.20
1.00
0.46

2007
0.50
1.20
1.00
0.50

Redefine the CPI (1990=1) as CPI (2007=1) and calculate the real price of watermelons
for each year in 2007 prices.

Elasticity (14 pts)

(2) The monthly supply of desktop computers is given by the equation
Qs = 15,000 + 43.75P. At a price of $800, what is the price elasticity of supply?
(6 pts)
Answer:
if P=800 Q=15,000+43.75*800 = 50,000
E = b*(P/Q) = 43.75*(800/50,000) = 0.7
(3) Correct or false? Do not explain! (3 pts)
(a) Substitutes have positive cross price elasticities. correct
(b) The income elasticity of demand is defined as (%Income / %Price)
wrong, it should be (%Quantity consumed/ %Income)
(4) The logic of elasticity
(a) Karl always spends 13% of his income on wine regardless of what the price is. What
is the income elasticity of his wine demand? (2 pts) EI=1

(b) The demand for Public Transit has a cross price elasticity of 0.03 with respect to
gasoline prices. What is the percentage impact on ridership when the gasoline price
increases by 10% (3 pts) if Pgas increases by 100%, transit ridership will increase by
0.03*100% or 3%. Thus, if Pgas increases by 10%, transit ridership will increase by
0.3%.

Consumer Behavior (22 pts)

(5) Assume you have a fixed budget of $100. Further assume that you spend your entire
budget. Both good x and good y cost $10 each. You are consuming both goods where
your MRS is equal to 0.8.
(a) Are you optimizing your utility? Why or why not? (2 pts)
(b) Draw a sketch and show the point of your consumption (3 pts)
(c) What should you do? (1 pt)

Answer:
You are at point A. Here you (1) spend your entire income because you are on the budget
line and (2) the MRS<Px/Py. That is, the value of x is lower than its price (all expressed
in terms of y). So, substitute y for x and move to point B.

U2

A
U1

Alternatively, a corner solution is possible as well (see graph below). Then you are at
point A. Again, you (1) spend your entire income because you are on the budget line and
(2) the MRS<Px/Py. That is, the value of x is lower than its price (all expressed in terms
of y). However, you already gave away all x and cannot get more y. This point is your
optimum.

U2

U1
x

(6) George receives utility from consuming x and y as given by U(x,y)=x+y

x costs $20 and y costs $10. Georges income is equal to $40. (This question is tricky).
(a) Draw a sketch and show his optimal consumption point (3 pts)
(b) What is his optimal consumption of x and y (3 pts)
Answer
MUx=1 and MUy=1 his MRS is constantly 1 (perfect substitutes)
Straight line with a slope of minus one.
The price ratio Px/Py is constantly 20/10=2.
Thus, Px/Py > MRS. This is a corner solution. He should only consume y, to be precise,
he should consume 4 y.
(7) Assume a utility function that is given by U(x,y) = xy+xy
Further assume a budget of $100 and the prices Px=1 and Py=2.
(a) What is the Lagrangian L(x,y,)? (4 pts)

MAX U = xy+xy = 2xy subject to

100 = 1x + 2y 0=x+2y-100
L(x,y,) = 2xy - (x+2y-100)
(b) Using the Lagrange method calculate the utility maximizing quantities of x and y. (6
pts).

(1)

L
2 y 0
x
L

(2) y 2 x 2 0
(3)

L
( x 2 y 100) x 2 y 100 0

(3a) x-2y+100=0 x=100-2y

(1a) = 2y
plus this into (2) and you will get
(2a) 2(100-2y) 2(2y) = 0
200-4y-4y=0
8y = 200
y =25
since x=100-2y x=50
U=2xy=2(50*25)=2500

Income and Substitution Effect (5 pts)

(8) C. Razy is the mayor of Bierland and wants people to drink more beer. His advisors
come up with a great plan: Impose a tax on beer and keep the revenue. In addition,
impose higher income taxes to raise even more revenue. Under what assumptions might
this plan boost the consumption of beer (if at all)? Explain. (5 pts)
Decompose everything into substitution (SE) and income effect (IE)
- The effect of the beer tax on quantity consumed is: SE -, IE (or IE + if it is an inferior
good, if it is a Giffen good |IE|>|SE|)
- The effect of the income tax: only IE (- for normal, + for inferior good).
quantity consumed may increase if the good is an inferior good (the two positive IEs
must more than offset one negative SE) and will certainly increase if it is a Giffen good.

Taxes and Burden (7 pts)

(9) Suppose the labor supply curve is given by Q=10 and the labor demand curve is given
my Q=10-P. If congress imposed a tax of $1 per unit on the supply of labor
(a) what is total tax revenue? (4 pts)
(b) who pays how much of this revenue? (3 pts)
Since Q is a vertical line, at the equilibrium before tax quantity is Q=10 and P=0.
Since Q is constant there will be a total tax revenue of 10, which is entirely borne by the
supplier. That means he will incur a loss of $1 per unit.
(Alternatively, since the price is zero and he has to pay the tax, you may assume that the
supplier shuts down. In this case tax revenue would be zero)