Download Principles of Microeconomics Test 1 Dr. Hossain Note: This is short

Principles of Microeconomics
Test 1
Dr. Hossain
Note:
1. This is short answer part of the test. It includes 50 points equally distributed to each question.
2. The MCQ part of the test must be taken at the EzTestOnline between Wednesday 9 am and Friday
midnight.
3. Be precise and to the point. Unnecessary discussion can reduce your score.
4. Show your work to get full credit.
5. Graphs must be labeled properly.
Question Number 1
a. Define economics. How is it related to the scarcity of resources?
Economics is a discipline in social science concerned with allocation of society’s scarce resource to
achieve competing objectives.
The discipline is concerned with allocation of
b. What is meant by rational self interest? Explain marginal analysis using an example.
Rational self interest means individual are rational in their behavior. Individuals look for and
pursue opportunities to increase their satisfaction or pleasure through consumption of a good or
service. They allocate their time, energy, and money to maximize their satisfaction.
Marginal analysis means that individual compares of marginal benefits and marginal costs in
making optimal choice that maximize their rational self interest.
c. Define opportunity cost. Drawing PPC, explain how it is different from the law of increasing
opportunity cost.
Opportunity cost of any action is precisely the other actions that you must give up in order to
pursue that action. O.C. suggests that more of one thing necessarily means less of something else.
This generates a negative slope for all PPC. This is true all three graphs below:
A
A
A
B
Fig 1
B
Fig 2
B
Fig 3
All three PPC shows O.C., in which more of B means less of A. However, in figure 1, the O.C. is
constant (give up equal amount A and each B), in figure 2, the O.C. is decreasing (give up less and
less amount A and each B) and in figure 3, the O.C. is increasing (give up less and less amount A
and each B). The law of increasing O.C. suggests the when society wants to produce more and
more of one product (B), the cost of next B in term of A will be more than the cost of previous unit
of B produced.
Question Number 2
Assume your budget for CDs and DVDs is $200. The price of a CD is $10 and a DVD is $25.
a. Draw your budget line for these two goods. Call it BL1. Compute the slope of BL1.
DVD
8
6
BL3
10
BL2
15
BL1
20
CD
b. If your income falls to 150. Draw your new budget line and call in BL2. Compute the slope of BL2.
How is this slope different from the slope of BL1?
Slope of BL1 = Rise/Run = - 8/20 = - 2/5
Slope of BL2 = Rise/Run = - 6/15 = - 2/5
c. If your income does not change (stays at $200), but the price a CD becomes $20, draw your new
budget line and call it BL3. Compute the slope of BL3. How is this slope different from the slope of
BL1?
Slope of BL3 = Rise/Run = - 8/10 = - 4/5
d. Based on your answers to a, b and c, what can you say about the slope of budget line and price
ratio.
Slope of budget line is equal to the price ratio. For BL1 and BL2 price ratio was 10/25 or 2/5. For
BL2, the price ratio was 20/25 or 4/5. Therefore, change in income never affects the slope of the
budget line. However, a change in price does.
Question Number 3
a. What is the difference between positive and normative economics? Give an example of each.
Positive economics deals with factual, scientific economic statements that can be proved or disproved by
collecting data.
Example: Unemployment rate in the month of January was 8.7%
Normative economics deals with value judgment or opinions of someone.
Example: Government should pass pay roll tax to stimulate the economy and reduce unemployment rate.
b. What is the difference between change in demand and change in quantity demanded? Explain
using appropriately labeled graphs.
Change in demand is increase or decrease in demand usually expressed as a shift of demand curve to the
right or left. This happens whenever ceteris paribus assumption is relaxed (changed income, tastes and
preference, number of buyers, price of substitutes and complements, future price expectation and others.)
Change in quantity demanded is a movement along a same demand curve usually happens when price of
the product changes. This happens due to the law of demand.
Price
From D0 to D1 is a change in demand.
D0
D1
Quantity
Price
A
B
Movement from point A to B is a change in quantity demanded.
D
Quantity
c. What is meant by the law of demand? Define income effect and substitution effect. How do these
two effects justify the law of demand?
When price of a produce increases, the quantity demanded falls and vice versa.
Income effect: when price rises (or falls), consumers’ real income falls (or rises), this leads to lower (higher)
quantity demanded by the consumer.
Substitution effect: when price rises (or falls) for product A, consumers substitute (away from) good A for its
substitute good B causing quantity demanded for A to fall (rise)
Thesre two effects explain the law of demand or why price and quantity demanded has a negative
relationship.
Question Number 4
a. Equilibrium price is stable in the sense that whenever prices are at disequilibrium consequent
shortage or surplus force the price move towards the equilibrium price. Explain how. [hint: use
appropriately labeled graphs for shortage and surplus to make your point]
Equilibrium price is stable because markets tend to move toward the equilibrium whenever it is at
disequilibrium (shortage or surplus).
In case of a shortage, consumers bid the price up allowing quantity demanded to fall and quantity supplied
to rise. This leads the price to move to the equilibrium price. At the equilibrium, market clears and upward
pressure on price goes away. This is shown in the graph below:
Price
S
At P1, quantity demanded is larger than quantity
supplied
P1
D
Quantity
In case of a surplus, suppliers end up lowering the price allowing quantity demanded to rise and quantity
supplied to fall. This leads the price to move to the equilibrium price. At the equilibrium, market clears and
downward pressure on price goes away. This is shown in the graph below:
Price
S
P2
D
Quantity
At P2, quantity supplied is larger than quantity demanded
b. The demand for led TV has increased in recent years in the U.S. due to consumer preference for
light weight TV with sharper resolution. At the same time, supply of these TVs has increased here
due to improved technology and mass production in China, South Korea, Philippines and
Singapore. As an economics reporter at the consumer electronics, draw all possible scenarios (graphs)
about future change in market price (equilibrium price or P*) and quantity (equilibrium quantity or
Q*) that will be bought and sold in the U.S. [hint: one of them will change invariably in certain direction
and the other will be indeterminate]
The following answer is taken right off the handout posted in the course website about simultaneous shifts
of demand and supply.
Case 1: Demand increases and Supply increases
P
S1
S2
p*
D1
q1*
q2*
D2
Q*
Scenario 1: This is scenario number 1 of case 1. In this scenario, demand and supply both increases.
However, as a consequence of this simultaneous change in demand and supply only equilibrium quantity
increases (q1* to q2*) but equilibrium price remains the same (p*).
P
S1
S2
p2*
p1*
D1
q1*
D2
q2*
Q*
Scenario 2: This is scenario number 2 of case 1, where demand and supply both increases. In this scenario,
both equilibrium price and quantity change in this scenario. Specifically, equilibrium quantity increases (q1*
to q2*) and equilibrium price also increases from (p1* to p2*) after the shift.
P
S1
S2
p1*
p2*
D1
q1*
q2*
D2
Q*
Scenario 3: This is scenario number 3 of case 1, where demand and supply both increases. In this scenario,
both equilibrium price and quantity change in this scenario. Specifically, equilibrium quantity increases (q1*
to q2*) and equilibrium price decreases from (p1* to p2*) after the shift.
Final prediction about case 1: If demand and supply both increases, equilibrium quantity (q*) will
invariably increase. However, nothing can be said about the equilibrium price (p*). Because equilibrium
price may go up, down or stay the same depending upon the relative magnitude of shifts of demand and
supply.