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EEP1/ECON3
Fall 2010
Midterm 1: Solutions
1) (1 pt each) Give a short definition of
a) Public good: a good that is both non-rival and nonexcludable.
Non-rival in consumption means that the use by one person does not preclude the use by
another person. Non-excludable means that consumers cannot be prevented from using
the good.
b) Pareto preferred: the allocation of goods that results after a voluntary trade is Pareto
preferred to the allocation that existed before.
c) Externality: The non pecuniary effect of a transaction on a third party
d) Open access: a good that is rival but not excludable is a good for which there is open
access.
e) Complements: if two goods are complements then a decrease in the price of one good
leads to an increase in the quantity demanded for the other, at any given price for the
second good. In other words, the demand curve for the second good shifts to the right.
2) (4 pts) Draw two supply and demand diagrams and use them to explain: "When the
government subsidizes (puts a negative tax) on a good, the quantity of the good usually
increases."
Grading policy: 1 point for recognizing that demand shifts out, 2 points for drawing the
diagrams and 1 point for the explanation. You could also have drawn the diagram by shifting
the supply curve.
The key to solving this problem was to recognize that a subsidy is the opposite of a tax. A
tax causes an inward shift in demand so a subsidy causes an outward shift in demand. If
demand is downward sloping and supply upward sloping then a subsidy (a negative tax) will
lead to an increase in demand or an outward shift of demand. Quantity goes from Q1 to Q2
in figure 1. If demand is downward sloping and supply is fixed (vertical line) then although
demand shifts out, supply cannot adjust and will remain the same. Figure 2 shows this
situation. Because most of the time we have an upward sloping supply curve, when the
government subsidizes, the quantity of the good usually increases.
P
P
S
S
Ps
Ps
Pd
D2
Pd
D2
D1
Q
D1
Q1 Q2
Figure 1
Qfixed
Figure 2
1
Q
(1 pt) What would be the environmental consequences of the government subsidizing crop
production?
Think about the loan rate program. The price floor is a form of subsidy. The farmers are not
facing the market price but a higher, loan rate price. As we saw in class, this leads to over
production because consumers only demand Qd while farmers supply Qs. Thus, there is
excess supply, which can have negative environmental consequences due to land/ecosystem
conversion.
You could also have used figure 1 to argue that the quantity supplied as a result of a
subsidy usually increases, which will cause more land to be converted and have negative
environmental consequences.
3) (2 pts) Draw a budget constraint-indifference curve diagram when income is $50, the price of
good 2 is 2 and the price of good 1 is 4. What are the vertical and horizontal intercepts for
the budget constraint.
Grading policy: One point for drawing a reasonable diagram corresponding to the question.
One point for explaining why the price of good 1 and good 2 are consistent with your
diagram.
We know that the vertical intercept is equal to income/p2 so the vertical intercept is equal
to 50/2=25. Also, we know that the horizontal intercept is equal to income/p1 so the
horizontal intercept is equal to 50/4= 12.5. These are the quantities consumed if the
consumer spends all her income in only one good.
good 2
25
good 1
12.5
(1 pt) In your diagram, what is the chosen bundle (show on graph and clearly indicate the
quantity purchased of both goods.)
Grading policy: One point for explaining why the marked bundle is the bundle chosen as
opposed to some other consumption bundle and for showing the amount consumed of each good.
You didn’t have to indicate exact numbers to get the point.
good 2
25
A
15
5
BC1
12.5
good 1
2
The figure above is only one possibility that you could draw. You could have come up with any
chosen bundle that lies on the budget constraint. In the example shown above, the consumer
chooses bundle A (5 good 1, 15 good 2). The chosen bundle gives her the highest utility given her
budget constraint. Alternatively, you could argue that point A is the tangency point between the
budget constraint and an indifference curve. Make sure that 4x1+ 2x2=50, so in the example
above x1=5 and x2=15 is a possibility.
(1 pt) On the same graph show what happens when the price of good 1 decreases to 2. Again
clearly indicate the chosen bundle.
good 2
25
15
A
B
BC1
BC2 good 1
5
10 12.5
25
Grading policy: one point for showing that the budget constraint pivots out and that the
vertical intercept does not change. The chosen bundle has to be consistent.
Because the price of good 1 increased but the price of good 2 and income remained the
same, we know that the vertical intercept is the same and that only the horizontal intercept
changed. We know that the budget constraint pivoted out along the horizontal axis since
know the consumer can afford more of good 1. The new x intercept is equal to 50/2= 25. The
chosen bundle, B, could be x1=10 and x2=15 since this satisfies 2x2+2x1=50. This is only
one possibility.
(1 pt) How does this relate to a demand curve?
Grading policy: Here, you don’t have to draw the demand curve although it may help your
understanding. Your answer should be consistent with your diagram.
From our previous discussion, we know that when the price of good 1, p1 is equal to 4 then
the consumer consumes q1=12.5. When p1=2 then q1= 25. With these two points we can
draw the demand curve for good 1.
3
P
4
2
D
12.5
4)
25
Q
Consider a group of students who share a bathroom, and there are no janitorial services
provided. Some of the students prefer a clean bathroom; others have a high tolerance for
messiness.
(3 pts) a. Explain why, using concepts in chapter 3, there is a good chance that the
bathroom will end up a mess.
Grading policy: 1 point for recognizing that the bathroom is a public good, 1 point for the
realizing that there will be free riders in this situation , 1 point for explaining that the level of
cleanliness might be less than Pareto optimal.
The bathroom is nonrival and nonexcludible. A clean bathroom is thus a public good. In the
absence of social conventions or rules, each student will clean up only as long as the personal
benefit exceeds the personal cost and will ignore the benefits to others. The high-tolerance
students will clean very little. The low-tolerance students are likely not to clean all the messes
that others created. Messes will probably win.
(2 pts) b. Are there circumstances in which the mess is Pareto optimal? Are there
circumstances where the mess is a market failure?
Grading policy: 1 point for each situation
The mess is Pareto optimal if the low-tolerance students are not able to work out any
deals with the high-tolerance students over who does how much cleaning. The mess is a market
failure if, for instance, nobody knows who makes the messes, and any deals over the cleanliness
of the bathroom cannot be enforced.
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