Download Econ 106 * SI review questions for exam 2

Econ 106 – SI review questions for exam 2 (with brief answers in italics)
Hint: These questions are all based on class notes. Try to answer them on your own but refer to your
notes if you get stuck or if my question is not clear. This is a good way to study on your own – turn
everything you have been taught into a question, and then see if you can write a good answer. If you
can, no need to study that concept anymore. If you can’t, re-read your notes on that concept or look it
up in the book.
1. For any type of elasticity, there is a change, and a response to that change. Draw this as a
fraction. Here, I just wanted you to write: response/change
2. The answer to question 1 is what you will use to construct the three types of elasticity that we
discuss – what are these three types and how are they represented as fractions? The three types
are price elasticity of demand (%changeQ/%changeP), income elasticity (%changeQ/%change
income), and cross price elasticity (%changeQ/%changeQ of other good).
3. When is elasticity positive? Negative? Greater than one? Between 1 and 0? Hint: draw the
response/change fraction, and then compare how the numerator and denominator are
increasing/decreasing. Elasticity is positive if the response and change move in the same
direction – it is negative when they move in different directions. Greater than 1 implies that
response was greater than change (elastic), because a fraction with a large number on top and a
small number on the bottom will be greater than 1. Between 1 and zero implies that the change
was bigger than the response (inelastic), because a fraction with a small number on top and a
big number on the bottom will be less than 1.
4. Why would a firm care about elasticity? Draw a graph to show your answer visually. Hint: Think
about total revenue. If demand is inelastic, a firm can raise total revenue by charging a higher
price. Conversely, if demand is elastic, a firm can raise total revenue by charging a lower price.
5. Draw a price/quantity graph showing supply, demand, and equilibrium. Now indicate the areas
of producer as well as consumer surplus.
6. Now shift the supply curve to the left – show the area of lost trades, or a loss in efficiency.
Graphs of the above questions are in your notes.
7. What is the definition of a luxury good? A normal good? An inferior good? Income elasticity is
positive for both normal and luxury goods. However, luxury goods are elastic while normal goods
are inelastic. Inferior goods have negative income elasticity.
8. What do economists mean when they use the word ‘utility?’ I think of utility as “awesomeness,”
it’s the benefit to you of a thing or activity.
9. What is the difference between total utility and marginal utility? What does diminishing
marginal utility mean? Total utility is the utility you get from everything you have, marginal
utility is only the utility of the next thing you add or subtract. In other words, total utility is the
total benefit of all of the Reese’s you’ve eaten, while marginal utility is the utility of a single
Reese’s. Marginal utility changes as you eat more – each piece of candy is less enjoyable than
the last: this is what we mean by diminishing marginal utility.
10. Write the formula for the rational spending rule. Write what this means in your own words. Why
is diminishing marginal utility important for this rule to be true? MU/p=MU/p for all goods. If
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this ‘rule’ is being violated, then you are not getting enough “bang per buck” for one of your
goods. As you consume more of this good and less of another, your marginal utility for this good
decreases by less than the marginal utility of the other good increases because of diminishing
marginal returns. (Check your notes and the book for a more complete explanation).
Draw a graph with utility on the y-axis and quantity on the x-axis. Now draw two curves: one for
total utility and another for marginal utility. Refer to your notes on this one.
What is a reservation price, and how does it relate to supply and demand curves? Refer to the
reservation price lab.
Draw a bowed-out production possibilities curve (PPC) (we always draw them this way in class)
with two goods (such as peanuts and cotton, but hopefully something more interesting…). Now,
draw the supply curve for one of the goods. How does the shape of the PPC determine the
shape of the supply curve? Hint: think about how the opportunity cost of a good changes as you
make more or less of it. A bowed-out curve implies that the opportunity cost of one good
increases as you produce more of it, it is this increasing cost that drives the upward slope of the
supply curve.
Does a firm exist to minimize cost? To maximize revenue? To maximize profit? Maximize profit,
which is total revenue – total cost.
What are the conditions which make a market perfectly competitive? Check notes for this and
the next one.
Draw a supply and demand graph for an entire perfectly competitive market, and then draw the
supply and demand graph for an individual firm.
Why should a firm facing a perfectly competitive market follow the rule of producing a good up
until the point that marginal cost equals marginal benefit (MC=MB)? If a firm is producing less
where marginal cost is less than marginal benefit, then there is an incentive to produce more to
maximize total benefit – a more complete explanation is in the notes (the bathtub analogy).