Eco100Carr_PT1solutions - © Prep101...

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Unformatted text preview: © Prep101 ECONOMICS 100 (Carr) Practice Term Test 1 SECTION I (30 marks) Answer the following questions TRUE, FALSE or UNCERTAIN. Give a brief explanation of your answer. Marks will be given entirely for your explanation. 1. Suppose a reduction in the interest rate inspires an increase in the demand for homes (mortgages become relatively cheaper). This, accompanied by an increase in the supply of homes for sale, will result in increased house prices. UNCERTAIN • The drop in interest rates causes an increase in demand for homes. The demand curve shifts to the right from D0 to D1 • Given: there is an increase in supply of homes for sale. The supply curve also shifts to the right from S0 to S1. • These 2 shifts necessarily result in an increase in the quantity of homes sold. Consumers want more homes, and suppliers are willing to sell more, therefore more homes are sold • The effect of these shifts on price depends on the relative magnitude of the shifts of supply and demand. For this to make sense first consider the ratio of demanders to suppliers. Initially suppose the ratio is 1:1. o If the shift in demand is greater than supply, the ratio changes so that the number of consumers > the number of sellers. So now more people want to buy homes than homes are available for sale. This conflict is resolved by a bidding up of prices. If the demand shift is larger than the supply shift, prices increase. o If the supply shift is larger than the demand shift, then the ratio tips so that there is relatively more supply than demand. So there are sellers struggling to find a buyer, and to make their home more attractive they reduce their prices. If the supply shift is larger than the demand shift, prices decrease. o If demand and supply shift by the same amount, then the initial ratio is preserved, and so prices stay the same. © Prep101 2. Unexpectedly good weather causes an increase in the supply of a particular agricultural good. This will necessarily result in higher revenues for this industry. FALSE • The good weather causes an increase in supply, a move from S0 to S1. This constitutes a movement along the demand curve to a new equilibrium with lower prices and relatively more quantity sold. The question is whether the gain in quantity more than compensates for the decrease in sales price. • The question concerns itself with the price elasticity of demand for this good o If demand is elastic: (% decrease in price) < (% increase in quantity) TR increases o If demand is inelastic: (% decrease in P) > (% increase in Q) TR decreases • This question is tricky, because the real answer is “it depends”, and so it disqualifies any suggestion of certainty (i.e. “necessarily”) © Prep101 3. Rising oil prices have inspired, among other things, a call for price controls. Such a policy will ensure an abundant supply of affordable oil. FALSE A price control (i.e. a price ceiling) confines prices below, above or within a specified price range, in this case the government sets a maximum price suppliers can charge consumers. This new price is below the equilibrium value, and so even though the new price is more affordable, fewer sellers are willing to sell at this new reduced price. With this price ceiling the quantity demanded exceeds quantity supplied. The result is oil shortage. © Prep101 Section II (20 marks) 1. The Canadian government frequently increases taxes on cigarettes to lower the consumption of cigarettes, but also to generate tax revenues. Focusing on the Government’s desire to maximize tax revenues, why would the government tax cigarettes and not orange juice? (Hint: assume equilibrium price and quantities are identical for these 2 products) The demand for cigarettes is relatively more inelastic than orange juice, with respect to price. That is, for cigarettes the quantity demanded is less responsive to changes in price than is the demand for orange juice. In the case of OJ, increased prices are likely to inspire a switch to a product substitute (i.e. apple juice), resulting in a large decrease in the quantity demanded. For example, consider a per-unit tax on suppliers, which causes a decrease in supply. Note in the diagram below, both sets of supply curves have identical slopes, and assume the original equilibrium (pre-tax) occurs at the same quantity. If the government taxed orange juice, consumers would switch to a substitute, say apple juice. Conversely, consumers are willing to stick with cigarettes despite the price increase caused by the tax. Consequently, the government is likely to earn higher tax revenue on cigarettes than on OJ. © Prep101 2. What is meant by the term marginal utility per dollar spent? How can this term be used to define the utility maximization in an economy with only 2-goods? Marginal utility per dollar spent refers to the additional utility a consumer gets from spending one extra dollar on the given product. Mathematically this is found by dividing the marginal utility offered by the additional unit divided by the price of that good (marginal utility/price = marginal utility/$1). This should be seen in contrast to the general term marginal utility, which refers to the extra utility offered by the consumption of one more unit of the given product. Unless the price of this product is $1, these 2 terms are not equivalent, thus it is important to know when to use which term. Suppose you live in a 2-good economy, where you spend your entire income on only goods X and Y. To maximize your utility, you should spend your income so that the marginal utilities per dollar spent from the last unit of consumption of each good are equal (MUX/PX = MUY/PY). This is sensible because if for a given bundle of the 2 goods; one good offers more utility per dollar spent, than the other, you’d be better off spending your dollar on the item rendering the higher utility. This process would continue until your entire income is spent, and the marginal utility per dollar spent is equal between the 2 goods – point A. ...
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