Midterm 1 -- Answer Key

Midterm 1 -- Answer Key - Evans School of Public Affairs...

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Evans School of Public Affairs PBAF 516, Autumn 2012 Midterm 1 – Answer Key October 18, 2012 1. The Arroyo family only consumes heating oil and beef. Heating oil is a Giffen good for the Arroyo family. Beef is a normal good for the Arroyo family. Suppose the price of heating oil doubles and the price of beef also doubles. a. Fill-in the following table with one of the following signs: + or – or ? (3 points). Heating Oil Beef Income Effect + - Substitution Effect 0 0 Total Effect + - b. Explain the signs you gave for the substitution effects (1 point). Since the price ratio is unchanged, neither good becomes relatively more or less expensive. Thus, there is no reason to substitute one for the other. c. Explain the signs you gave for the income effects (1 point). With higher prices, the Arroyo’s cannot afford their original bundle. They will buy less of all normal goods (beef) and more of all inferior goods (heating oil – note: all Giffen goods are inferior goods). d. Explain the signs you gave for the total effects (1 point). Since there is no substitution effect, the total effects are equivalent to the income effects. 2. Presidential candidate Spano makes a speech where she argues that credit card companies should be limited to charging no more than a 15% interest rate for borrowers (banks currently charge 18% interest to borrowers). Spano claims that by lowering the borrowing rate of interest, it will increase the current consumption of citizens who are “borrowers” (i.e., those who consume more now than their current endowment). In response, banks complain that such a policy would lower the interest rate that they could
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