Economics 1110
Practice Prelim 1 with Answers
1. Tom borrowed $100,000 from his parents to buy a house, and repaid the loan in full, plus $5000 interest,
one year later when he received his royalty check from his recording contract.
His parents have $1 million
in the bank at 10 percent interest.
The fact that they charged Tom five percent interest for his loan is
a. unfair to Tom's sister, because she ends up subsidizing Tom's loan out of her inheritance.
b. unfair to Tom, because parents shouldn't charge their children interest.
c. inefficient, because it encouraged Tom to buy too large a house.
d. all of the above are correct.
e. a and c are correct.
Answer: e.
Had Tom’s father not made the loan at 5% interest, his account would have earned $10,000.
The loan is unfair to Tom’s sister in the sense that it will reduce the value of her inheritance by half of the
$5000 shortfall.
The loan is also inefficient because it causes Tom to choose a house on the basis of a cost
that is less than the true opportunity cost of the house.
2. You are planning a 300 mile round trip to Washington.
Except for the cost, you are completely
indifferent between driving and taking the bus.
You don't know how much it would cost to drive your car,
so you call Hertz for an estimate.
The person you speak with tells you that for your make of car the costs
of a typical 10,000 mile driving year are as follows:
Insurance
$1000
Interest
3000
2000
Maintenance
1000
Total
$7000
At what round-trip busfare will you be indifferent between driving and taking the bus?
a. $210.
b. $120.
c. $90.
d. $60.
e. None of the above is correct.
Answer: c.
The only costs that will change if you drive are the fuel & oil and maintenance costs, which
come to $0.30 per mile.
For the 300 mile trip by car, the cost will therefore be $90.
3. As the wage rate per hour increases, the opportunity cost of leisure (i.e., time spent not working)
a. remains constant.
b. decreases, since the individual can now afford to take more time off.
c. increases, since the cost of forgoing one hour's worth of wages increases.
d. may increase or decrease, depending on the individual's preferences.
e. decreases, since leisure is unpaid.
Answer: c.
The opportunity cost of taking an extra hour of leisure includes the wage that could have been
earned by working instead.
4. Jane had already bought a $50 ticket to a concert when she was invited out to dinner by a friend.
The
ticket cannot be resold.
Had she known about the dinner invitation in advance, she would not have bought
a ticket to the concert.
If she is a rational person, she
a. should attend the dinner anyway, because the concert ticket is a sunk cost.
b. should attend the dinner anyway, if that’s the alternative she likes best.