**Unformatted text preview: **Economics 3010
Fall 2008 Professor Daniel Benjamin
Cornell University EXAM #1, PRACTICE You have 75 minutes for this exam. No calculators are allowed. There are 65 points on the exam, and you should plan to spend approximately as many minutes per question as they are worth in points. This should leave you five minutes at the beginning to read over the test and five minutes at the end to check your answers. Please do all of the questions on this exam. Use a separate blue book for each part of the exam (I, II, and III), three in total. On the cover of each blue book, please write your name, your TA’s name, your section time, and the part of the exam answered in that book. Read over the whole test before starting. To keep the test as fair as possible, we will not answer any questions during the test. Some advice: Complete answers will include definitions of relevant terms and verbal intuition (in addition to graphs or formulas, if those are appropriate). Do not get hung up on calculations when answering a question. If you get the formulas and explanation correct, little credit will be deducted for mistakes in calculation. The questions vary in difficulty, so try to keep moving through the exam; if you are having trouble with something, it is probably a good idea to skip it and come back later. Good luck! I. True / False / Uncertain Your grade on these questions will depend on the generality, completeness, and persuasiveness of your explanation, not simply on whether the “true” or “false” is correct. The objective here is to provide an answer that convinces; not merely an answer that is “not wrong.” At the very least, make sure that you give clear definitions for the relevant economic terms used in the question. Please use a separate blue book for this section. (5 points) 1) When economists say that Policy A is better for society than Policy B, they are engaged in positive economics. (5 points) 2) Production is efficient if it occurs on the frontier of the production possibilities set. (5 points) 3) Rather than facing an ad valorem tax, a consumer is always better off facing a lump‐
sum tax that raises the same amount of revenue. (5 points) 4) When the wage is high enough, an individual’s labor supply may be decreasing in the wage. (5 points) 5) If both supply and demand for a good are highly inelastic, then the deadweight loss from a tax will be small. 1 II. Brief Problem (5 points) When New York corn is “in‐season,” corn is relatively cheaper than when it is out‐of‐
season, and in‐season relatively greater quantities are sold. When vacations to Club Med Martinique are in‐season, greater quantities of them are also sold, but in‐season rates are relatively higher than out‐
of‐season rates. Explain this seemingly paradoxical situation. Draw relevant diagrams to illustrate your point. III. Multi‐Part Problem Note: This question is designed so that if you skip part of the question, you still have enough information (stated explicitly earlier in the question) to answer later parts of the question. Please answer as many parts as you can. (4 points) (a) The following Engel curve plots household income on the x‐axis and expenditure on alcohol consumed outside the home as a percentage of income on the y‐axis: Explain why this data justifies writing a representative consumer’s utility function for alcohol consumption (x) and all other goods (y) as (approximately) U(x, y) = 0.01 ln(x) + 0.99 ln(y). (5 points) (b) The representative consumer’s budget constraint is Px + y ≤ M. Show that the consumer’s demand function for alcohol is x*(P, m) = 0.01 M/P. (5 points) (c) What is the representative consumer’s income elasticity of demand? Show that alcohol consumption is a normal good for the representative consumer. 2 (5 points) (d) Suppose the demand side of the market for alcohol is composed of 10,000 consumers, each of whom has the preferences given above. Let the (base 10) log of price be denoted by p = log10(P), let the (base 10) log of (the representative consumer’s) income be m = log10(M), and let the (base 10) log of market demand for alcohol be denoted by xd = log10(Xd). Explain why the (log of) market demand for alcohol is xd(p) = 2 + m – p. Show that the price elasticity of demand for alcohol consumption in this market equals ‐1. (5 points) (e) Suppose the (log of) market supply for alcohol is xs(p) = 1 + p. Show that the equilibrium (log) price, p, is equal to (1+m)/2, and the equilibrium (log) quantity, x, is equal to (3+m)/2. (7 points) (f) Between 1920 and 1933, Prohibition was a (largely failed) attempt by the U.S. government to prohibit the sale, manufacture, and transportation of alcohol. Suppose that instead of making it illegal to produce alcohol, the law had prohibited consuming alcohol. If the chance of being caught and punished is proportional to the amount of alcohol consumed, explain why it now makes sense to write the representative consumer’s budget constraint as (P+t)x + y ≤ M. Explain how we can predict (without doing any calculations), using our knowledge that alcohol is a normal good, that these laws would both reduce the equilibrium quantity of alcohol consumed and reduce the equilibrium price of alcohol. Show on an indifference curve/budget constraint diagram the change from before the law to after the law. (4 points) (g) Relative to the above‐mentioned illegalization, explain why imposing a monetary tax of t per unit of alcohol consumption is a potentially Pareto improving way to reduce alcohol consumption by exactly the same amount. 3 ...

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