sample-midt-solutions-1 - Model Solutions Econ 115b Midterm...

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Model Solutions Econ 115b Midterm (2001) Section I 1. Variable Cost (2 points): A cost that varies with output, rising as more output is produced and falling as less output is produced. Note: Partial credit answers --- ‘Variable Cost = Total Cost – Fixed Cost’ with no definition of fixed cost 2. Inferior Good (2 points): A good for which quantity demanded falls as income rises. Its income elasticity is negative. 3. Income elasticity of demand (2 points): A measure of responsiveness of Quantity demanded to a change in income. Specifically, % change in quantity demanded divided by % change in income Note: Answers with ‘correct’ definition of price elasticity of demand gets partial credit of one point. 4. Increasing returns to scale (2 points): Either: Output increases more than in proportion to inputs as the scale of production increases. Equivalently, f( λ L, λ K) > λ f(L, K) where λ >1 Or (full credit): IRTS is ‘correctly’ explained in terms of Decreasing Average Cost 5. Consumer Surplus: The difference between the total value (willingness to pay) of all units consumed of a good and the total paid for those units. Area between demand curve and price charged for the good, out to total quantity exchanged. Extra Credit: Even though the answer is ‘yes’, no extra credit point will be given if no name, no TA name, and indecipherable signature.
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Section II Question 1 (a) Foobars W i d g e t s (b) The production possibilities frontier (PPF) needs to have a negative slope, given fixed resources (inputs used in production) and the fact that the country of Whim is producing efficiently (not wasting any resources). Production of one more unit of widgets can only be achieved by cutting down the production of foobars and vice versa. This implies a negative slope for the PPF. The PPF also needs to be bowed out from the origin, to exhibit diminishing marginal returns (as required by section a above). Diminishing marginal returns (DMR) implies increasing opportunity cost in terms of the other good as more of this good is produced. For example, as widget production increases for each additional widget the amount of foobars that needs to be sacrificed increases. This shows up in the figure above by an increasing absolute value of the slope of the PPF as we move right. [Note: one point was deducted for not mentioning fixed resources, mentioning a tradeoff in production is not enough. Similarly one point was deducted if DMR was not mentioned or if DMR was explained in a sufficiently innovative (wrong) way. ] (c) As shown in the figure below if Whim was producing at A and nation 2 was producing at B before trade, then Whim will have a comparative advantage in widgets and nation 2 will have a comparative advantage in foobars. We can see this by the fact that at A the slope of Whim’s PPF is lower in absolute value (or flatter) than the slope of nation 2’s PPF at B. This implies that the opportunity cost of widgets or the number of foobars that needs to be given up to produce one more widget is lower in Whim than in
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sample-midt-solutions-1 - Model Solutions Econ 115b Midterm...

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