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University of Ottawa
David Gray

Name: SOLUTIONS Student number: ______________ ECO1104B INTRODUCTION TO MICROECONOMICS MIDTERM EXAMINATION Professor: David Gray Fall 2010 INSTRUCTIONS a) The allotted time is one hour and twenty minutes. There are a total of 80 points, or one point per minute. b) Turn off all cellular telephones. c) You may notconsult with anywritten materials whatsoever, including other students' papers, and no conversation is permitted while the examination is in progress. You may not use palm pilots. The only electronic devices that are permittnon-programmable calculatorsand dictionaries for students whose native tongue is not English. Any ravention of these ruleswill be treated as an infraction to the honour code of the university. d) Good luck. I anticipate that some of you will be pressed for time. Please pace yourself accordingly, and respond carefully. DO NOT SPEND TOO MUCH TIME ON ANY ONE QUESTION. e) All of the questions which follow are verstraightforward, and can be answered in a few sentences. The responses that I hope to elicit have been repeated by me several times in class. Please take a minute to concentrate on the que stion being asked, as opposed to writing down everything which comes to your mind about a certain topic. I have tried to pose the questions in such a way that you focus correctly. 1 PART I – SHORT ANSWER, CONCEPTUAL QUESTIONS 1) (4 points; 2-3 sentences) Identify and give thesignificance of the price elasticity of demand. In other words, what is its purpose? In still other words, why do we bother studying it? Do not give details concerning the price elasticity of demand, such as the formula that we use to calculate it. What I am looking for here is a brief discussion of how it fits in with supply and analysis. IT INDICATES THE RESPONSIVENESS OF QUANTITY DEMANDED TO CHANGES IN PRICE. THE LAW OF DEMAND SAYS TH AT THERE IS ALWAYS A NEGATIVE, INVERSE RELATIONSHIP BETWEEN PR ICE AND QUANTITY DEMANDED. THE PRICE ELASTICITY OF DEMAND IS A T OOL THAT MEASURES THE DEGREE OF RESPONSIVENESS BY GIVING IT A PRECISE MAGNITUDE. 2) (4 points; 2 sentences) How does the model of supply and demand relate to the first central coordination task that faces any economy - snd services should be produced, and in what quantities? Do not draw the graph, as this is strictly a verbal question. THE EQUILIBRIUM QUANTITY THAT ISGENERATED ON THE QUANTITY AXIS BY THE FORCES OF SUPPLY AND DEMAND S HOWS HOW MUCH OF A GOOD WILL BE PRODUCED IN A FREE MARKET ECONOMY. 3) (8 points) a) Explain why governments regulate thend quantities of certain commodities, particularly in the agricultural sector. FOR CERTAIN MARKETS, SOCIETY DECIDES (OR THE GOVERNMENT DECIDES) THAT THE MARKET PRICE (THAT IS GENERATED BY THE FORCES OF SUPPLY AND DEMAND) IS NOT SOCIALLY FAIR AND/OR EQUITABLE. SOCIETY DEEMS THAT EITHER THE DEMANDERS OR THE SUPPLIERS (BUT NEVER BOTH IN THE SAME MARKET) WOULD SUFFER GREAT HARDSHIP IF THE MARKET PRICE WERE TO PREVAIL. IN THE CASE OF AGRICULTURAL PRIOCE SUPPORTS, IT IS THE PRODUCERS WHO ARE DEEMED NEEDY. b) Explain why most economists tend to be very critical of interventions such as price floors and price ceilings. You do not need to give any graph. What I am looking for is an explanation of the economic behaviour the follows the imposition of these policies, and a description of the economic outcome. TAMPERING WITH PRICES DISTORTS THE CHOICES OF BOTH SUPPLIERS AND DEMANDERS. BOTH SIDES OF THE MARKET REACT TO PRICE CHANGES BY ALTERING THEIR BEHAVIOUR, AND THEY DO SO IN A WAY THAT WORKS AGAINST THE INITIAL OBJECTIVE OF MAKING ONE PARTY BETTER OFF. MARKET IMBALANCES IN THE FORM OF SURPLUSES OR SHORTAGES ALWAYS 2 ARISE. TRYING TO DEFY THE NATURAL FORCES OF SUPPLY AND DEMAND ALWAYS HAS UNINTENDED – BUT PREDICTABLE - CONSEQUENCES. c) What type of alternative policy instrument do economists recommend if the objective is to make a certain group of economic agents better off? THE NEEDY, DESERVING GROUP, WHETHER IT IS EITHER SUPPLIERS OR DEMANDERS, SHOULD BE GIVEN A SUM OF MONEY THAT SUFFICES TO MAKE THEM BETTER OFF. THIS SO-CALLED LUMP-SUM PAYMENT SHOULD BE INDEPENDENT OF THE PRICE RECEIVED OR THE QUANTITY BOUGHT OR THE QUANTITY PRODUCED. IT IS BETTER TO JUST GIVE THEM THE MONEY WITH NO STRINGS ATTACHED, WHICH MEANS THAT THEY CAN SPEND IT AS THEY PLEASE. THE KEY IS THAT THE LUMP-SUM PAYMENT SHOULD NOT AFFECT EITHER THE QUANTITY DEMANDED OR THE QUANTITY SUPPLIE 4. (3 points, 2-3 sentences) Explain briefly the nature of the difference between microeconomics and macroeconomics. THE PRIMARY DIFFERENCE LIES IN THE SCOPE. WHILE BOTH DISCIPOLINES DEAL WITH EQUILIBRIUM PRICES AND QUNATITIES, IN MICRO WE ANALYZE PRICES AND QUANTITIES AT THE LEVEL OF INDIVIDUAL FIRMS, CONSUMERS, WORJKERS, OR MARKET. IN MACRO, BY CONTRAST, WE ANALYZE PRICES AND QUANTITIES AT THE GLOBAL OR AGGREGATE LEVEL, CONCERNING OURSELVES WITH VARIABLES SUCH AS UNEMP LOYMENT, INFLKATION, AND GROSS DOMESTIC PRODUCT. 5. (3 points, 2 sentences) What is generally the role of models in economic analysis? In other words, what is their function? THEY ARE AN ANALYTICAL TOOL THAT IS USED TO EXPLAIN HOW THE ECONOMY FUNCTIONS. TYPICALLY THE CHANGES IN ONE ECONOMIC VARIABLE ARE RELATED TO CHANGES IN ONE OR SEVERAL OTHER ECONOMIC VARIABLES. THEY ARE OFTEN STATED IN HYPOTHESIS FORM – IF THERE IS A CHANGE IN ONE VARIABLE, ALL OTHER FACTORS HELP CONSTANT, WHAT IS THE CHANGE IN ANOTHER ECONOMIC VARIABLE? SEE PAGE 24 IN THE TEXT. 6. (7 points) These questions are easy. a) Explain why the production possibilities frontier has a concave shape. IT REFLECTS THE LAW OF INCREASING OPPORTUNITY COSTS. AS MORE AND MORE RESOURCES ARE ALLOCATED AWAY FROM THE PRODUCTION OF ONE GOOD TOWARD THE ALLOCATION OF THE OTHER GOOD, THE TRADEOFF BECOMES LESS AND LESS FAVOURABLE. THIS MEANS THAT IN ORDER TO PRODUCE ONE MORE UNIT OF GOOD A, WE HAVE TO GIVE UP MORE AND MORE UNITS OF PRODUCTION OF GOOD B. THE LAW OF INCREASING 3 OPPORTUNITY COSTS IN TURN IS DUE TO THE FACT THAT THE ECONOM’S RESOURCES ARE NOT EQUALLY WELL-SUITED TO TE PRODUCTION OF BOTH GOODS. b) What would be implied if the frontier has the form of a straight line? THERE WOULD BE CONSTANT OPPORT UNITY COSTS, SO THE TRADEOFF BETWEEN THE TWO GOODS IS EVEN. THISDOES NOT MEAN THAT THE TRADE OFF IS ONE-TO-ONE. THIS WOULDIMPLYS THAT THE ECONOMY’S RESOURCES ARE EQUALLY WELL SUITED FOR THE PRODUCTION OF BOTH GOODS. IT CERTAINLY DOES NOT MEAN THAT THE FRONTIER HAS A POSITIVE SLOPE. c) Explain why the production possibilities frontier has a negative slope. IT IS DUE TO SCARCITY. IF WE W ANT TO INCREASE PRODUCTION OF ONE GOOD, WE MUST SACRIFICE SOME OF THE OTHER GOOD. IN OTHER WORDS, THERE IS A TRADEOFF ONCE WE ARE ONTHE FRONTIER. IT HAS NOTHING TO DO WITH THE LAW OF INCREASING OPPORT UNITY COSTS. ITDOES MEAN THAT OPPORTUNITY COSTS EXIST. 7. (4 points) Explain the relationship between comaprative advantage, specialization, and the pattern of international trade (this means which country imports and/or exports which good). A COUNTRY SHOULD SPECIALIZE IN TH E PRODUCTION OF THE GOOD IN WHICH IT HAS A COMPARATIVE ADVANTAGE. IT SHOULD DEVOTE EITHER ALL OR MOST OF ITS RESOURCES TO THE PR ODUCTION OF THAT GOOD, AND LITTLE OR NONE OF ITS RESOURCES TO THE PR ODUCTION OF THE OTHER GOOD. IT SHOULD CONSUME SOME OF ITS PRODUCTION OF THE GOOD IN WHICH IT SPECIALIZES, AND IT SHOULD THEN EXPORT THE REST. IT CAN USE THE PROCEEDS FROM ITS EXPORT SALES TO PURCHASE IMPORTS FROM ITS TRADING PARTNER. IT IMPORTS THEGOOD IN WHICH IT HAS A COMPARATIVE DISADVANTAGE. SEE PAGES 57-58 OF THE TEXTBOOK. 8. (6 points) This question is drawn from th e assigned readings – the one-page document that I authored and posted on the website. a) Explain why most economists believe that free trade is beneficial from an economic point of view. SEE THE DOCUMENTS THAT I HAVE POSTED WITH THE LECTURE SLIDES FOR CHAPTER 3. IT LEADS TO A GR EATER VARIETY OF GOODS AVAILABLE TO CONSUMERS. IT LEADS TO LOWER PRIC ES FOR CONSUMERS. MOST OF THE POPULATION CAN EXPECT HIGHER LIVING STANDARDS STEMMING FROM THE LOWER PRICES. IT GIVES AN INCE NTIVE FOR DOMESTIC PRODUCERS TO BECOME MORE COST EFFICIENT, AND THE LEAST EFFICIENT FIRMS ARE 4 DRIVEN OUT OF BUSINESS. IT CAN ALSO OPEN UP NEW MARKETS FOR CANADIAN GOODS THROUGH EXPORTATION. b) Explain why anti-globalization types, such as those who were demonstrating in Toronto at the G20 summit this past summer, firmly believe the opposite. In other words, they HATE fee trade. Why? IN THE RICHER COUNTRY, CERATIN PRO DUCERS ARE DRIVEN OUT OF BUSINESS, WHICH CAUSES THEIR WORKERS TO BE DISP LACED. IN THERICHER COUNTRY, THERE IS INCREASED PRESSURE TOLOWER TAXES AND REDUCE REGULATION, WHICH COULD PUT STRAIN ON SOCI AL PROGRAMS AND SEVERELY DAMAGE THE SOCIAL AND ECONOMIC FABRIC OF THE RICHER COUNTRY. THE GOV
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