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ECOS2001

Microeconomics

Semester 1, 2014

Mid-semester Test

Wednesday 9 April 2014

Part A:  Multiple Choice (15 marks total)

1. If two bundles are on the same indifference curve, then

A) the consumer derives the same level of utility from each.

B) the consumer derives the same level of ordinal utility from each but not the same level of cardinal utility.

C) no comparison can be made between the two bundles since utility cannot really be measured.

D) the MRS between the two bundles equals one.

2. If the utility function (U) between food (F) and clothing (C) can be represented as

U =  , the marginal utility of food

A) is not positive.

B) does not diminish as food increases.

C) is not affected by the amount clothing.

D) increases as one obtains more clothing.

3. If the utility for two goods "x" and "y" can be measured as U = x, then it can be concluded that

A) "x" and "y" are perfect complements.

B) "y" is a "bad".

C) the indifference curves on the x,y graph are upward sloping where "x" is measured on the horizontal axis.

D) the indifference curves on the x,y graph are vertical where "x" is measured on the horizontal axis.

4. If the prices of both goods and income increase by the same percentage, what will happen to the budget line?

A) The budget line rotates inward from the intercept on the axis of the good that did not change in price.

B) The budget line rotates outward from the intercept on the axis of the good that did not change in price.

C) The budget line shifts outward without a change in slope.

D) Nothing.

5. Lisa maximizes her utility by eating both pizzas and burritos.  The price of a pizza is $10 and the price of a burrito is $5.  When Lisa's utility is maximized,

A) the marginal utility of pizza is larger than the marginal utility of burritos.

B) the marginal utility of a burrito is larger than the marginal utility of a pizza.

C) the marginal utility of both goods is the same.

D) the good with a larger marginal utility cannot be determined without more information.

6. Betty consumes good x and good y.  If the price of x = $2 and the price of y = $3, then

A) an extra unit of x costs 2/3 units of  y.

B) an extra unit of y costs 3/2 units of x.

C) an extra unit of x costs 3/2 units of y.

D) Both B and C.

7. If the substitution effect and the income effect move the consumption in the opposite directions, then the good is:

A) neither inferior nor normal.

B) a luxury.

C) income inferior.

D) income normal.

E) none of the above.

8. When the price of a good changes, the total effect of the price change on the quantities purchased can be found by comparing the quantities purchased

A) on the old budget line and the new budget line.

B) on the original indifference curve when faced with the original prices and when faced with the new prices.

C) on the new budget line and a hypothetical budget line that is a parallel shift back to the original indifference curve.  

D) on the new indifference curve.

9. When the price of a good changes, the substitution effect can be found by comparing the equilibrium quantities purchased

A) on the old budget line and the new budget line.

B) on the original indifference curve when faced with the original prices and when faced with the new prices.

C) on the new budget line and a hypothetical budget line that is a parallel shift back to the original indifference curve.  

D) on the new indifference curve.

10. In the case of a normal good

A) demand curves always slope downward.

B) the income effect and substitution effect are in the same direction.

C) the Engel curve slopes upward.

D) All of the above.

11. The nominal interest rate is 5% and the inflation rate is 6%. A rational consumer

A)  might save despite the negative real interest rate.

B)  will not save since the real interest rate is negative.

C)  will save less than 1% of her income.

D) will save the same amount regardless of inflation rate; only the nominal interest rate matters.

E) will necessarily save less if the inflation rate rises and the nominal interest rate does not change.

12. Peregrine consumes ($700,$800) and earns ($600,$990). If the interest rate is 10%, the present value of his endowment is

A)  $1,500.

B)  $1,580.

C)  $1,590.

D)  $3,150.

E)  $3,750.

13. A risk-averse individual would always

A)  take a 10% chance at $100 rather than a sure $10.

      B)  take a 50% chance at $4 and a 50% chance at $1 rather than a sure $1.

C)  take a sure $60 rather than a 50% chance at $100.

D)  take a sure $1 rather than a 50% chance at $4 and a 50% chance at losing $1.

E)  none of the above.

14. John Brown’s utility of income function is U = y², where y represents income.

A)  John Brown is risk neutral.

B)  John Brown is risk loving.

C)  John Brown is risk averse.

      D)  we need more information before we can determine John Brown’s preference for risk.

E)  none of the above.

15. Harley’s current wealth is $600, but there is a .5 probability that he will lose $100. Harley is risk neutral. He has an opportunity to buy insurance that would restore his $100 if he lost it.

A)  Harley would be willing to pay a bit more than $50 for this insurance.   

      B)  Harley would be willing to pay up to $50 for this insurance.   

      C)  Since Harley is risk neutral, he wouldn’t be willing to pay anything for this                insurance.   

      D)  Since Harley’s utility function is not specified, we can’t tell how much he would be willing to pay for this insurance.

E)  Harley would not be willing to pay more than $33.33 for this insurance.

Problem 1 (10 points)

 An investor has the option of investing one dollar in a project. The outcome of the project depends on the state of the world. There are eight states S = {1, 2 . . . 8} each of which are equally likely. In the even numbered states, the project will return 3 dollars while the return is zero in the odd numbered states.

(a) If the investor is risk neutral, will she invest in the project? Why? (3 marks)

(b) If the investor is risk averse, will she invest in the project? Why? (3 marks)

(c) Assume that prior to investing, the investor can consult a financial analyst for a ‘consultation fee’ of ‘F’ dollars. If the analyst knows the true state of the world, what is the maximum ‘F’ a risk neutral investor is willing to pay for consulting the analyst? (2 marks)

(d) Assume that the financial analyst does not know the true state of the world but only knows whether it is going to be in s₁=1,2,3,4 or s₂=5,6,7,8. In this case, what is the maximum ‘F’ a risk neutral investor is willing to pay for consulting the analyst? (2 marks)

Problem 2 (15 points)

Elina has income of M and can consume two possible goods, 1 and 2 priced at p1 and p2. Elina has well-behaved preferences.

(a) The government as part of its greenhouse-gas reduction policy implements a policy that taxes goods and services with high levels of greenhouse gas emissions. For Elina this means that good 1 is taxed and price of good 2 remains unchanged. (For example, good 1 is electricity and good 2 is a service with relatively few greenhouse gas emissions.) With the help of diagrams, analyse the change in the optimal consumption bundle for Elina following the introduction of the tax on good 1. For this change also derive the consumers demand curve for x₁. Explain your answer and diagrams - a good answer will include a discussion of the income and substitution effects. (7 marks)

(b) Is it possible that the introduction of the tax on good 1 is counterproductive in the sense that it increases Elina’s consumption of good 1? Carefully provide intuition for your answer. (4 marks)

 (c) The government, realising that the carbon-tax has a negative effect on Elina’s purchasing power also introduces an income transfer to her. The transfer is designed so that Elina can just afford her old consumption bundle before the tax on good 1 was introduced, even though she faces the new higher price of good 1. Analyse the effect of this income transfer (along with the tax on good 1). Is it possible for Elina to consume more of good 1 now than before the tax and income transfer were introduced? (4 marks)