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Econ 100A Midterm 2

Review Session
Hemaxi Desai, Emmanuel Lee, Chen Meng, Aoyi Shan
Student Learning Center Econ Program
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Topics
1. Hicksian Compensation, Slutsky Compensation, CV, EV
2. Addiction & Uncertainty
3. Production and Cost Curves
4. Firms and Market Supply
5. Welfare -- Tax
T/ F Questions
1. Slutsky compensation is bigger than Hicksian
compensation for both normal and inferior goods.
T/ F Questions
Slutsky compensation is bigger than Hicksian compensation
for both normal and inferior goods.

Answer: True!

Type of good does not matter because you can always end
up on a higher indifference curve than the Slutsky
compensation.
Slutsky Compensation & Hicksian Compensation
Slutsky -- New price,
old bundle

Hicksian -- New price,


old utility
T/ F Questions
2. The elasticity of compensated demand is negative for a
giffen good.
T/ F Questions
2. The elasticity of compensated demand is negative for a
giffen good.

Answer: True!

Substitution effect is the same for all types of goods.


Downward sloping demand curve. (Giffen is a type of inferior
good, which is income dependent, not price)
T/ F Questions
3. The elasticity of uncompensated demand is negative for a
giffen good.
T/ F Questions
3. The elasticity of uncompensated demand is negative for a
giffen good.

Answer: False!

Giffen good has upward sloping Marshallian demand.


T/ F Questions
4.Theta for a giffen good in the Slutsky equation must be
small.
Slutsky Equation
Marshallian = Hicksian + (-)

Marshallian is the elasticity of


uncompensated/Marshallian demand
Hicksian is the elasticity of compensated/Hicksian
demand
is the share of budget to that good
is the elasticity of income
T/ F Questions
4.Theta for a giffen good in the slutsky equation must be
small.

Answer: False! Marshallian = Hicksian + (-)

As we know, for a Giffen good, Marshallian is positive, Hicksian is


negative, and the income elasticity is negative because it is
an inferior good theta must be large in order to have the net
sign (marshallian demand) be positive.
T/ F Questions
5. A risk neutral person has a constant marginal utility.
T/ F Questions
A risk neutral person has a constant marginal utility.

Answer: True! Utility function is a straight line.


T/ F Questions
6. The expected value of a fair bet for a risk seeking
individual is greater than zero.
T/ F Questions
The expected value of a fair bet for a risk seeking individual is
greater than zero. True or False?

Answer: False!

Explanation: the expected value of a fair bet is zero. When the expected value of a
bet is greater than zero, it is defined as a more than fair bet.

To clarify, the expected value of a bet does not depend on whether an individual
is risk averse, neutral or seeking.
T/ F Questions
7. If wages permanently increase, the isocost becomes
steeper.
T/ F Questions
If wages permanently increase, the isocost becomes steeper.

Answer: True!

Slope of isocost is -w/r if w is increasing, slope is steeper.


T/ F Questions
8. If MC is greater than AC everywhere, then the firm has
decreasing returns to scale.
T/ F Questions
If MC is greater than AC everywhere, then the firm has
decreasing returns to scale.

Answer: True!
T/ F Questions
9. In the short run, a lump-sum tax will change both profits
and the quantity supplied in a competitive market.
T/ F Questions
In the short run, a lump-sum tax will change both profits and
the quantity supplied in a competitive market.

FALSE! The tax will change profits by increasing firms total


costs. However, it does not affect the marginal cost curves,
which determine the quantity supplied in a competitive
market.
T/F Questions
10. The isoquant represents all combinations of outputs that
are equally profitable.
T/F Questions
The isoquant represents all combinations of outputs that are
equally profitable.

False!

Isoquant represents all the combination of inputs that will


result in the same quantity of output. In order to gauge a
firms profitability, we need to first decide how much quantity
of goods a firm should produce.
T/F Questions
11) If a firm chooses inputs such that w/r = MRTS, then it is
profit maximizing.
T/F Questions
If a firm chooses inputs such that w/r = MRTS, then it is profit
maximizing.

FALSE!
It is the cost minimizing combination of inputs. In order to be
profit maximizing, it has to produce at P = MC.
T/ F Questions
12. A lump-sum tax has no impact on a firms production in
the LR.
T/ F Questions
A lump-sum tax has no impact on a firms production in the
LR.

FALSE! Lump-sum tax shifts up the AC curve and LR supply


curve is where MC = AC (i.e the minimum of AC) because in
the LR firms will make normal profits. Hence it affects a firms
production in the LR.
T/ F Questions
13. When welfare is maximized, consumer surplus equals
producer surplus.
T/ F Questions
When welfare is maximized, consumer surplus equals
producer surplus.

FALSE!
When we maximize welfare, we only care about the
aggregate welfare, not the distribution of welfare.
T/ F Questions
14. Tax incidence is the same regardless of which side of the
market is being taxed.
T/ F Questions
Tax incidence is the same regardless of which side of the
market is being taxed.

TRUE! Tax incidence depends on the relative elasticity of


demand and supply, not which party is taxed.
PART 1: Compensation, Income Elasticity, CV, EV
Compensating Variation & Equivalent Variation
CV: Old Utility, New Price

EV: New Utility, Old Price

Graph CV and EV when


we have a increase in
price X.
Short Answer
Consider Melissas preference over goods X and Y which can be modeled by the
following utility function: U(X,Y) = X(1+Y). Her income is 11 and the price of X and
Y are $1. What is the Hicksian and Slutsky compensation required to keep Melissa
as well off before the price change as she was after the price change if the price of
X increases to $2?
Short Answer Solutions
Step 1: Use Lagrange or MUx/MUy = Px/Py to find the original optimal bundle.

X = Py(1+ Y)/Px

I = Px*X + Py*Y

Y = (I-Py)/2Py

Plug in I = 11, Px = Py = 1

(6,5)
Short Answer Solutions
Step 2: Hicksian compensation uses the new optimal bundle on the old IC at new
prices (substitution bundle).
MRS = (1 + Y)/X = Px/Py and the original level of utility is U = 6(1+5) = 36.
Solve for the substitution bundle by substituting X=Py(1+Y)/Px into the utility
function to get
U = [Py(1 + Y)/Px](1 + Y)
U = 1/2(1 + Y)2= 36
Y = 7.5, X = 4.2

Income needed for the substitution bundle = 7.5 x 1$ + 4.2 x 2$ = 15.9

So this is the income required and subtracting from the original income of 11 we
get 4.90 as the hicksian compensation
Short Answer Solutions
Step 3: Slutsky takes the original bundle and approximates the budget constraint
through the new prices.

Income required for the Slutsky bundle = 6 x $2 + 5 x $1 = $17

Subtracting from original income of 11 we get $6 as the slutsky compensation.


Short Answer
If the share of your income spent on beer is 0.25, and the elasticity of Marshallian
and Hicksian demand is -0.5 and -0.75 respectively, what is the income elasticity
of beer? Is this a normal, inferior, or giffen good?
Short Answer Solutions
=0.25, Marshallian = -0.5, Hicksian =

-0.75

Marshallian = Hicksian + (-)

-0.5 = -0.75 +(-0.25)

0.25 = -0.25 Income elasticity recap:


Normal Good: + , Inferior Good: -
= -1 inferior good
Luxury good, >1; Necessity <1
Long Answer
James, Pierres twin, consumes coffee and cigarettes, which he regards as imperfect substitutes.
One day he wakes up to the terrible news that the government imposed a 200% tax on cigarettes
and that drought conditions in South America lead to the price of his favorite coffee to double.
a. Draw James initial consumption bundle, and his budget constraint after the price
changes. You may choose the axis.
b. James parents hear about his hardships and decide to increase his stipend so he can
purchase the same bundle he purchased before. Add this budget constraint to your
graph.
c. Given the new prices and his additional stipend, will James consume more or less
coffee than his initial bundle? (HINT: he has to maximize utility)
d. Pierre complains to his parents that the stipend they gave James is too high and claims
that if they gave him a Hicksian compensation they will save money AND James will
also smoke less than he did before the price changes. Is the Hicksian compensation
going to save money to James and Pierres parents? Is James going to smoke less that
he did before the price changes? Explain your answer.
Long Answer Solution
A. Draw James initial consumption bundle, and his budget constraint after the price changes.
You may choose the axis.
Long Answer Solution
B. James parents hear about his hardships and decide to
increase his stipend so he can purchase the same bundle he
purchased before. Add this budget constraint to your graph.
Long Answer Solution
B. James parents hear about his hardships
and decide to increase his stipend so he
can purchase the same bundle he
purchased before. Add this budget
constraint to your graph.

Solution: Slutsky compensation budget


constraint is BC2, which goes through
bundle A because it is a stipend from his
parents to consume his original bundle
before the price increases.
Long Answer Solution
C. Given the new prices and his additional stipend, will James
consume more or less coffee than his initial bundle? (HINT:
he has to maximize utility)
Long Answer Solution
C. Given the new prices and his additional stipend, will James consume more or
less coffee than his initial bundle? (HINT: he has to maximize utility)

Solution: To maximize the utility, he will consume more of the cheaper goods.
Since the relative price of coffee is cheaper after the price change, he will
consume more coffee and less cigarettes
Long Answer Solution
D. Pierre complains to his parents that the stipend they gave James is too high
and claims that if they gave him a Hicksian compensation they will save money
AND James will also smoke less than he did before the price changes. Is the
Hicksian compensation going to save money to James and Pierres parents? Is
James going to smoke less that he did before the price changes? Explain your
answer.
Long Answer Solution
Solution: Hicksian
compensation is point C. Pierre
is right that his parents will save
money if they use this
compensation since Hicksian
compensation is always less
than Slutsky. Relative to the
original bundle, James will
consume less cigarettes and
more coffee.
Part 2: Addiction, Uncertainty
Time consistency vs Time Inconsistency
Time Consistency

Time Inconsistency --- additional discounting to values in the near future


Short Answer
Explain the concept of a commitment mechanism and when it
might make a difference in behavior.
Short Answer
Explain the the concept of a commitment mechanism and
when it might make a difference in behavior.
Answer: without commitment mechanisms, making a decision today about what you are going to do in the
future has an uncertain outcome. The decision might seem favorable to you today, but seem less
favorable when you actually have to follow through with it. In that case, putting a commitment mechanism
in place ensures that you act on your initial decision.

This problem occurs frequently with people who are time -inconsistent discounters (and suffer from
present biased preferences), since the impact of a decision is discounted based on when they have to go
through with it -now or later. Eventually, the later becomes the now, and their evaluation of the
decisions impacts will ultimately change.
Short Answer
Annibal has homework to do. Instead She goes out with
friends and gets a D on the homework. Does this imply that
Annibal is time-inconsistent?
Short Answer
Annibal has homework to do. Instead he goes out with friends and gets a D on the
homework. Does this imply that Annibal is time-inconsistent?

Answer: No! The fact that Annibal did not do the homework does not imply time
inconsistency. She may just be very impatient (high discounting ) or may value
hanging out with friends more than the net benefit from going to school.
Long Answer
After her 100A final exam this semester, Sophia must drive from UC Berkeley to
her home near Los Angeles. She has two possible routes for her trip: US 101 or
Interstate 5. Sophia is a compulsive speeder who consistently drives above the
speed limit. Her only concern in choosing her route is the probability that she will
receive a speeding ticket and the amount of the fine on a given route. Prior to the
trip, Sophias wealth is $400. Sophias utility of wealth function is U (w) = w .
There is a 20% probability of receiving a $200 ticket if she travels via US 101 and
a 40% probability of receiving a $100 ticket if she takes I-5.
Long Answer
a. Using the Arrow-Pratt measure of risk aversion, determine if Sophia is a risk
averse, risk neutral or risk seeking individual.
Long Answer
a. Using the Arrow-Pratt measure of risk aversion, determine if Sophia is a risk
averse, risk neutral or risk seeking individual.

Answer:

Since Sophias utility of wealth function is given by U(w) = w0.5, the coefficient of
absolute risk aversion is:

A(w) = -U''(w) / U'(w) = - (-0.25w-1.5 / 0.5w-0.5) = 1 / (2w).

Since wealth is always positive, A(w) = 1 /(2w) > 0 and hence Sophia is a risk
averse individual.
Long Answer
b. What are Sophia's (1) expected fine, (2) expected wealth and (3) expected
utility if she takes the US101 route?
Long Answer
b. What are Sophia's (1) expected fine, (2) expected wealth and (3) expected
utility if she takes the US101 route?

Answer:

Expected fine: 0.2*200 = $40

Expected wealth: 0.2*(400-200) + 0.8(400 - 0) = 360

Expected Utility: 0.2*2000.5+0.8*4000.5 = 18.83


Long Answer
c. What are Sophia's (1) expected fine, (2) expected wealth and (3) expected
utility if she takes the I5 route?
Long Answer
c. What are Sophia's (1) expected fine, (2) expected wealth and (3) expected
utility if she takes the I5 route?

Answer:

Expected fine: 0.4*100 = $40

Expected wealth: 0.4*(400-100) + 0.6(400 - 0) = 360

Expected Utility: 0.4*3000.5+0.6*4000.5 = 18.93


Long Answer
d. Which route will she take? Illustrate
using a diagram.

She will take the I5. This is because the


expected value of the gamble is the
same so the difference in utility
depends on the smaller variance
involved in taking the I5.
Long Answer
e. What is Sophias risk premium for the route you chose in part (d)? Show this on
your graph. Now if she could eliminate the possibility of getting a ticket, what is the
maximum amount she will pay to do so?
Long Answer
e. What is Sophias risk premium for the route you chose in part (d)? Show this on
your graph. Now if she could eliminate the possibility of getting a ticket, what is the
maximum amount she will pay to do so?

Risk premium is the difference between expected value of a bet and the amount that will yield the
expected utility of the same bet. U(EV - RP) = EU

Hence, 18.93 = (360 - p)0.5. Hence, p = $1.66

Full insurance premium is the fair insurance premium (expected loss b/c an insurance premium that is fair
covers dollar for dollar) + risk premium:
(400 - -EV) + $1.66 = $41.66
Long Answer
2. Julio is a farmer and his utility is given by U= I, where I is the income in dollars.
a. Draw a graph for this function.
b. Julios annual income depends on the weather. Weather can either be good
or bad for farming with a probability of 50%. If the weather is good Julio gets
an income of $90,000 and if the weather is bad he only gets an income of
$40,000. What is the expected income and expected utility of Julio? Show the
results using the graph from part a.
c. Compute the value of utility at the expected income. Is Julio risk averse?
d. What certain income can give the same expected utility to Julio? How do you
relate this to the concept of risk aversion? Compute the risk premium? Show
these results in the graph.
Long Answer
a. Draw a graph for this function
Long Answer
2 Julios annual income depends on the weather. Weather can either be good or bad for farming with a
probability of 50%. If the weather is good Julio gets an income of $90,000 and if the weather is bad he
only gets an income of $40,000. What is the expected income and expected utility of Julio? Show the
results using the graph from part a.
Long Answer
2 Julios annual income depends on the weather. Weather can either be good or bad for farming with a
probability of 50%. If the weather is good Julio gets an income of $90,000 and if the weather is bad he
only gets an income of $40,000. What is the expected income and expected utility of Julio? Show the
results using the graph from part a.
Long Answer
3. Compute the value of utility at the expected income. Is Julio risk averse?
Long Answer
3. Compute the value of utility at the expected income. Is Julio risk averse?
Long Answer
4 What certain income can give the same expected utility to Julio? How do you relate this to the concept
of risk aversion? Compute the risk premium? Show these results in the graph.
Long Answer
4 What certain income can give the same expected utility to Julio? How do you relate this to the concept
of risk aversion? Compute the risk premium? Show these results in the graph.

If we want U(Income) = 250, the certain income should be 250^2 = 62,500, which is less than the
expected value 65,000$. Therefore, this individual is risk averse.

U(EV - Risk Premium) = EU

U(65,000 - RP) = 250

RP = 2,500
Long Answer
Consider an individual with self-control problems, named Arnold. Arnold is deciding how much to exercise.
The quantity of exercise is given by e, with e > 0. The utility derived from exercising U(e) = e. In other
words, the benefit from exercising is directly proportional to how much Arnold exercises. This benefit from
exercising is received one period after the exercise. The cost of effort of exercising is given by C(e) = c.
Long Answer
Consider an individual with self-control problems, named Arnold. Arnold is deciding how much to exercise.
The quantity of exercise is given by e, with e > 0. The utility derived from exercising U(e) = e. In other
words, the benefit from exercising is directly proportional to how much Arnold exercises. This benefit from
exercising is received one period after the exercise. The cost of effort of exercising is given by C(e) = c.

a. At the moment when Arnold is deciding whether to exercise or not, what is the discounted utility
function that Arnold is trying to maximise? Explain your answer qualitatively. Hint: recall that the cost of exercising is
in the present (e.g going to the gym, time etc) while the benefit from exercising is in the future.
Long Answer
a. At the moment when Arnold is deciding whether to exercise or not, what is the discounted utility
function that Arnold is trying to maximize? Explain your answer qualitatively. Hint: recall that the cost of exercising is
in the present (e.g going to the gym, time etc) while the benefit from exercising is in the future.
Long Answer
b. Consider the following scenario. In Day 0, Arnold purchases a gym membership to a nearby gym in his
neighborhood thinking that he will go to the gym. However, in Day 1, when he decides whether or not to
go to the gym, he decides not to go to the gym. Explain how this scenario highlights the fact that Arnold is
a Naive consumer who is unaware of his self control problems? If possible, show this mathematically.
Assume that delta = 1 for this problem.
Long Answer
b. Consider the following scenario. In Day 0, Arnold purchases a gym membership to a nearby gym in his
neighborhood thinking that he will go to the gym. However, in Day 1, when he decides whether or not to
go to the gym, he decides not to go to the gym. Explain how this scenario highlights the fact that Arnold is
a Naive consumer who is unaware of his self control problems? If possible, show this mathematically.
Assume that delta = 1 for this problem.

Answer: When Arnold is purchasing the gym membership, both the cost of going to the gym and the
benefit of exercising are both in the future. We assume that e > c since Arnold decides to purchase the
Gym membership. However, just before making the decision of going to the gym in Day 1, Arnold
succumbs to his present biased preferences which discounts the future benefit of exercising. Thus, we
can say that c > be. Since Arnold is unaware of his present biased preferences when purchasing the gym
membership, he fails to develop a commitment device to go to the gym and ends up not going - a sign of
Naivete.
Part 3: Production and Costs
MPL & APL
Cost Minimization
w/r = MPL/MPK

Slope of isocost =

Slope of isoquant
Isoquant and Isocost
Expansion Path
An expansion path is a curve in a
graph with quantities of two inputs,
typically capital and labor, plotted
on the axes. The path connects
optimal input combinations as
the scale of production expands.
It is the line which reflects the least
cost method of producing different
levels of output, when factor prices
remain constant (same isocost
slope).
Returns to Scale
Cost Curves
MC, AVC
LR Costs
Long Answer
Let Q = KL1/3

a. Does this production function have increasing, decreasing, or constant


returns to scale? Show your answer mathematically.
Long Answer
Answer: IRTS

Two approaches:

A. Add exponents: 1 + > 1


B. Q(2K, 2L) > 2Q
Long Answer
b) Now let K=4, w=4, r=20. Find total costs in the short-run.
Long Answer
K = 4, w = 4, r = 20

TC = wL + rK
= 4L + (20*4)

Q = KL1/3
= 4L1/3 L = Q3/64

TC = 4(Q3/64) + 80 = Q3/16 + 80
Long Answer
c) Let market price be $9. Find the profit maximizing quantity.
Will the firm produce at this price? Why or why not?
Long Answer
MC = MR TC = P

3Q2/16 = 9
Q* = 48.5 =~ 7

Yes, because MC > AVC everywhere 3Q2/16 > Q2/16


Long Answer
d) Based on the quantity you found in (c), how many units of
labor are hired?
Long Answer
We get Q = 481/2 from part c

What is the question looking for? L* = ?

L* = Q3/64 = (481/2)3/64 = 483/2/64


= (482/2)481/2/64 = 3(481/2)/4
Long Answer
e) Find the expression for the cost-minimizing quantity of
labor in the LR. Given 4 units of capital and input prices as
above, how much labor should the firm use? Why is this
answer different than the amount in (d)?
Long Answer
w/r = MPL/MPK

MPL = 4/3*L-; MPK = L1/3 MPL/MPK = 4/3L

w/r= 4/20 4/3L = 4/20 L* = 20/3

LR L* minimizes costs, while SR L* does not


Long Answer
A company produces hats using the following production
function: f(L,K) = K.25L.75. Let w = $8, r = $2.

a) Find MRTS in terms of K and L


Long Answer
Answer:

MRTS = 3K/L
Long Answer
b) The company currently has 16 machines. Find ATC, AVC,
and MC functions.
Long Answer
1) Q = K.25L.75 = 16.25L.75 = 2L.75 L = (Q/2)4/3

2) TC = 8(Q/2)4/3 + 2(16) = 3.174(Q)4/3 + 32

ATC = 3.174(Q) + 32/Q


AVC = 3.174(Q)
MC = 4.232(Q)
Long Answer
c) Assume that the firm is a price-taker and the market price
for hats is currently $12. Will the company produce in the
SR? If so, what quantity and profit?
Long Answer
MC = MR = P 4.232(Q) = 12
Q = 23.7

P > AVC to produce in SR


AVC = 3.174(Q) = 3.174(23.7) = 9.022 < 12 produce in
SR

Profit = TR - TC = 12(23.7) - (3.174(23.7)4/3 + 32) = $36.32


Long Answer
d) A new policy raises the minimum wage to $10. At the same
level of output, what will labor and capital be in the long-run?
What is profit at this allocation of resources?
Long Answer
MRTS = w/r 3K/L = 10/2 L = K

Q = 23.7 = K.25( K).75 = K().75 K = 34.8 L = 20.9

Profit = TR - TC = 12(23.7) - [(10)(20.9) + (2)(34.8)] = $5.80


Part 4: Firm and Market Supply
Firm and Market SR Supply Curve
Firm and Market LR Supply Curve
Short Answer Question
State the four conditions for perfect competition.
a. Explain why firms in a perfectly competitive market have
zero profits.
b. Explain why producers in competitive markets bear no tax
incidence in the long-run. Support your explanation with a
graph.
Solution
Four conditions for perfect competition

1) identical products
2) free entry and exit
3) perfect information
4) low transaction costs.
Solution
a. Explain why firms in a perfectly competitive market have
zero profits.

If firms make profit, then other firms will enter the market. If
firms incur losses, they will exit the market. In the long-run the
firms that remain make zero profits.
Solution
b. Explain why producers in competitive markets bear no tax
incidence in the long-run. Support your explanation with a
graph.

In the LR a competitive market producers make zero profits:


the market supply curve is flat, which means that all tax
burden is borne by consumers.
Solution:
Long Answer Question
The market for Indian restaurants in Berkeley is free to entry
and exit, has constant input prices, and identical costs.

a. On the left hand-side, draw the long-run AC & MC for a


single restaurant. On the right-hand side graph the market
supply. Add a demand curve to your market graph
Solution
Solution:
b. The city of Berkeley decides to limit the number of Indian
restaurants. On your market graph add a new supply curve
and mark the new equilibrium. Show on your graph the
change in consumer and producer surplus as well as DWL.
Solution:
(The new supply curve is in orange.)

Change in CS: -B-C


Change in PS: +B
DWL: - C
Solution:
c. Show the impact of the new equilibrium price on the
individual restaurants quantity and profit.
Solution
Quantity produced by
each firm will increase
and each firm will
make a profit.
Solution:
d. A politician running for office claims that a lump-sum
subsidy would be a more effective way to increase profits
without hurting consumers. Is he right? Explain your answer.

A lump-sum subsidy with free entry and exit will shift the LRS
down, but it will remain flat at minimum AC, so profits will
remain zero he is wrong!
Part 5: Welfare
Short Answer #1
Define the term efficiency. Show graphically and explain why the competitive
equilibrium is efficient.

Efficiency is achieved when when maximize the total welfare (consumer surplus +
producer surplus)
If produce more or less than Q*, there is DWL.
Solution
Short Answer #2
Show the area representing the deadweight loss if the government provides a per
unit subsidy.
Solution