Emporia State University

School of Business
Fall 2017
BC 807 A
Wednesday, November 1, 2017 Solution for Exam 2 Total Points = 50

1. (10 points)

Y
I2
C

D B

AB is the budget line and CD is one indifference curve showing one level of utility (all other
indifference curves are parallel to CD).
(a) What type of goods are X and Y? Please explain.

Goods X and Y are prefect substitutes. Since the indifference curve is a straight line, the actual
quantity of X and Y does not matter, you can get the same amount of utility from more X and
less Y, and also from more Y and less X.

(b) Given the budget line AB and the shape of the indifference curves, where does this consumer
maximize her utility? Please explain.

The consumer will maximize utility on the highest indifference curve which can be reached, given
the budget constraint (income level) of the consumer. The budget line is AB. The highest
indifference curve that can be reached is I2, and the only point of I2 that can be reached is point B.
This is the utility maximization point.

The intersection of AB and CD is not the utility maximization point, since the consumer’s budget
will allow her to reach a higher indifference curve than CD.
2. (10 points) Assume that the demand for cosmetic or plastic surgery is price inelastic. Are the
following statements true or false? You must give an explanation in each case.
(a) When the price of plastic surgery increases, the number of operations decreases.
When price increases quantity demanded will always decrease. This follows from the law of
demand and is always true, no matter what the elasticity of demand is.

(b) The percentage change in the price of plastic surgery is less than the percentage change
in quantity demanded,
Since demand is price inelastic, this means that the percent change in quantity demanded is
less than the percent change in price.
𝑝𝑒𝑟𝑐𝑒𝑛𝑡 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑
𝑝𝑟𝑖𝑐𝑒 𝑒𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦 𝑜𝑓 𝑑𝑒𝑚𝑎𝑛𝑑 = <1
𝑝𝑒𝑟𝑐𝑒𝑛𝑡 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒
𝑝𝑒𝑟𝑐𝑒𝑛𝑡 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑 < 𝑝𝑒𝑟𝑐𝑒𝑛𝑡 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒

(c) Changes in the price of plastic surgery do not affect the number of operations.
This would be true if demand were perfectly inelastic. If it is just inelastic, then quantity
demanded does change when price changes, but not by very much, and the statement would
be false.

(d) Quantity demanded is quite responsive to changes in price.

This statement is false, as inelastic demand means that quantity demanded is not very
responsive to changes in price.

(e) If more plastic surgery is performed, expenditures on plastic surgery will decrease.
An increase in demand for plastic surgery will occur if price falls. Since demand is price
inelastic, the percent decrease in price is greater than the percent increase in quantity, and there
will be a decrease in total revenue (total expenditure).

3. (5 points) The demand function for a good is Q = 100 – 2P. What is the point elasticity of
demand when P = 10? Please show your calculations
∆𝑄 𝑃
𝑃𝑟𝑖𝑐𝑒 𝑒𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦 𝑜𝑓 𝑑𝑒𝑚𝑎𝑛𝑑 = ×
∆𝑃 𝑄

∆𝑄
= 𝑠𝑙𝑜𝑝𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑑𝑒𝑚𝑎𝑛𝑑 𝑒𝑞𝑢𝑎𝑡𝑖𝑜𝑛 = −2
∆𝑃

P = 10, Q = 100 – 2P
= 100 – 2(10)
= 80
10
𝑃𝑟𝑖𝑐𝑒 𝑒𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦 𝑜𝑓 𝑑𝑒𝑚𝑎𝑛𝑑 = −2 = −0.25
80
4. (5 points) Assume that the Marginal Product of labor in the U.S. is 75 and the Marginal
Product of labor in Mexico is 20, Price of labor in the U.S. is $40 and the price of labor in
Mexico is $20. Explain, using the theory of marginal productivity (discussed in chapter 7), why a
firm might want to produce in the U.S. even though Mexican wages are half the U.S. wages. You
must give an explanation.

Look at the ratio of MP of labor to price of labor in each country.

𝑀𝑃𝐿 75
(𝑈𝑆) = = 1.875
𝑃𝐿 40
𝑀𝑃𝐿 20
(𝑀𝑒𝑥𝑖𝑐𝑜) = =1
𝑃𝐿 20
𝑀𝑃 𝑀𝑃
Since 𝐿 (𝑈𝑆) = 1.875 𝑖𝑠 𝑔𝑟𝑒𝑎𝑡𝑒𝑟 𝑡ℎ𝑎𝑛 𝐿 (𝑀𝑒𝑥𝑖𝑐𝑜) = 1, this means that one additional
𝑃𝐿 𝑃𝐿
dollar being spent on labor in the US will result in additional output of 1.875 units, but one
additional dollar being spent on labor in Mexico will result in additional output of 1 unit. The
returns from hiring additional workers in the US is higher than the returns from hiring additional
workers in Mexico, even though US wages are higher than Mexican wages, because the
productivity of US workers is higher than the productivity of Mexican workers. The additional
productivity of the US workers outweighs the higher wages in the US, and the returns from
hiring more workers in higher in the US than in Mexico.

5. (10 points) You are given the following production function

Q = 𝐴𝐿𝛼 𝐾𝛽 = 21.5𝐿0.85 𝐾 0.50
𝐾 0.5 𝐿0.85
MPL = 18.275 𝐿0.15 MPK = 10.75
𝐾 0.5
(a) Does this firm show diminishing returns to labor? Please show your calculations.
Diminishing returns to labor occurs when an increase in the quantity of labor results in a
𝐾0.5
decrease in the marginal product of labor. Since MPL = 18.275 0.15 an increase in L
𝐿
will lead to an increase in the denominator of the MPL equation, and therefore will lead to a
decrease in MPL.
𝐾 0.5 10.5
Or Assume that K = 1, L = 1, MPL = 18.275 𝐿0.15 = 18.275 10.15 = 18.275
𝐾 0.5 10.5 1
K = 1, L = 2, MPL = 18.275 = 18.275 = 18.275 = 16.46
𝐿0.15 20.15 1.11
When L increases, MPL decreases. This shows that there is diminishing returns to labor.

(b) Does this firm demonstrate increasing returns to scale (economies of scale), constant returns
to scale, or decreasing returns to scale (diseconomies of scale)? Please show your
calculations.

The sum of the exponents of the function is 0.85 + 0.5 = 1.35 >1. This denotes increasing returns
to scale.
6. (10 points) Given below are the regression results from a linear trend and growth trend
models for monthly data for stock prices (Dow Jones 30 index) from January 2000 to October
2017. The data includes two dummy variables, D1 and D2.
D1 is equal to 1 in all months of 2008 and 2009, and is equal to zero in all other months.
D2 is equal to 1 in May, June, July and August of each year, and is equal to 0 in all other months.

(a) Linear trend model for stock prices (Dow Jones 30 average) with two dummy variables D1
and D2 as described above.
SUMMARY OUTPUT
Regression Statistics
Multiple R 0.861737
R Square 0.74259
Adjusted R Square 0.738913
Standard Error 1785.466
Observations 214

ANOVA
Significance
df SS MS F F
Regression 3 1.93E+09 6.44E+08 201.9397 1.31E-61
Residual 210 6.69E+08 3187887
Total 213 2.6E+09

Standard Upper
Coefficients Error t Stat P-value Lower 95% 95%
Intercept 7990.706 262.5555 30.43435 6.2E-79 7473.123 8508.288
Time 46.26566 1.975888 23.41512 1.83E-60 42.37054 50.16078
D1 -2978.46 386.7981 -7.70029 5.26E-13 -3740.96 -2215.95
D2 71.92714 258.3319 0.278429 0.780957 -437.329 581.1832

(i) Write out the equation of the linear trend model.

St = 7990.71 + 46.27t – 2978.46D1 + 71.93D2

(ii) Are stock prices higher, lower, or not different in 2008 and 2009? Please explain.
Since the coefficient of D1 is negative and significant, we can say that the stock
prices in 2008 and 2009 were lower than in the other years.

(iii) Are stock prices higher, lower, or not different in May, June, July, and August of each
year? Please explain.
Since the coefficient of D2 in the regression is positive but insignificant, we can say
that stock prices in May, June, July, and August might be higher than in other
months, but this is not a significant relation and we cannot reach a definite
conclusion.
 (iv) If you were calculating a forecast for a future value of stock prices, would you
include the dummy variables in your forecasting equation? Please explain.

The dummy of 2008-09 refers to two years in the sample period. Even though the
coefficient is significant, if we are forecasting for the future, that will be for
November 2017 or later. Since 2008-09 is in the past, D1 will never equal to 1 for any
possible forecast period, and we will not include D1.

Since D2 is insignificant, it does not have a statistically significant impact on the

regression and the stock prices for May – August are not significantly different than
any other month. Therefore there is no reason to include D2 in any forecast either.

SUMMARY OUTPUT
Regression Statistics NATURAL LOGS (ln)
Multiple R 0.811823
R Square 0.659056
Adjusted R Square 0.657448
Standard Error 0.151518
Observations 214

ANOVA
df SS MS F Significance F
Regression 1 9.408142 9.408142 409.8028 1.95961E-51
Residual 212 4.867038 0.022958
Total 213 14.27518

Standard Upper
Coefficients Error t Stat P-value Lower 95% 95%
Intercept 9.046238 0.020788 435.1677 0 9.005260613 9.087216
Time 0.003394 0.000168 20.24359 1.96E-51 0.003063614 0.003725

SUMMARY OUTPUT
Regression Statistics
Multiple R 0.811823 COMMON LOGS (log)
R Square 0.659056
Adjusted R Square 0.657448
Standard Error 0.065803
Observations 214

ANOVA
df SS MS F Significance F
Regression 1 1.774486 1.774486 409.8028 1.95961E-51
 Residual 212 0.91798 0.00433
Total 213 2.692466

Standard Upper
Coefficients Error t Stat P-value Lower 95% 95%
Intercept 3.928731 0.009028 435.1677 0 3.910934993 3.946528
Time 0.001474 7.28E-05 20.24359 1.96E-51 0.001330511 0.001618

(b) Given above are the results from estimation of a growth trend model using both natural logs
and common logs. Please use one of these and NOT both.
Write out the equation of the growth trend model.

Natural Logs

LnSt = ln(S0) + tln(1+g)

Ln(S0) = 9.0462
S0 = antiln(9.0462) = e9.0462 = 8486.23
1+g = antiln(0.0034) = e0.0034 = 1.0034

Therefore, St = 8486.23(1.0034)t

Common Logs
LogSt = log(S0) + tlog(1+g)
Log(S0) = 3.9287
S0 = antilog(3.9287) = 103.9287 = 8485.94
1+g = antilog(0.0015) = 100.0015 = 1.0035

Therefore, St = 8485.94(1.0035)t