Unformatted text preview: © Prep101 http://www.prep101.com/freestuff 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.
• 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 http://www.prep101.com/freestuff 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.
• 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
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 http://www.prep101.com/freestuff 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.
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 http://www.prep101.com/freestuff (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 http://www.prep101.com/freestuff 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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