Econ501aMidans06

# Econ501aMidans06 - The Ohio State University Department of...

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The Ohio State University Department of Economics Econ 501.02 Winter 2006 Prof. James Peck Midterm Questions and Answers Part I: Short Answer. 1. (10 points) Suppose good x is high quality navel oranges and good y is medium quality navel oranges. Call the prices in California (where the oranges are grown) p x and p y , and assume that the high quality oranges are more expensive than the medium quality oranges, p x >p y . Also assume that the prices in New York re f ect the shipping cost, s , so the price of high quality oranges is p x + s and the price of medium quality oranges is p y + s . Based on the substitution e f ect, explain why the typical New York consumer chooses a higher ratio of high quality oranges to medium quality oranges than the typical California consumer. Answer: The substitution e f ect is the change in demand due to a price change, holding utility constant. For this problem, we can see how a consumer’s choices change when we move from the California prices to the New York prices. The shipping cost serves to bring the price ratio closer to one, so that the relative price of higher quality oranges to medium quality oranges has gone down. Simple algebra shows that p x y implies p x p y > p x + s p y + s (try plugging in numbers). According to the substitution e f ect, the consumer should substitute towards the good whose price has gone down, so the New York consumer would increase the ratio of high quality oranges to medium quality oranges. Note: The problem is complicated by the fact that there are other goods besides oranges. Thus, it is not surprising that the New York consumer would buy fewer of both types of oranges. However, the ratio of higher quality oranges to medium quality oranges should still be higher in New York, at least due to the substitution e

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Econ501aMidans06 - The Ohio State University Department of...

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