FHCE 3150 Final Exam

Externalities and Property Rights: Failure of Free Market According to negative externality (a third party harmed by a transaction) and positive externality (a third party benefits from a transaction), which of the following is an example of an externality?

1. All of the above

Moral hazard occurs when incentives that lead people to file fraudulent claims or to be negligent in their care of goods insured against theft or damage. On the other hand, adverse selection is the process by which:

1. the undesirable members of a particular market are more likely to participate in exchange.

The income-consumption curve shows us:

1. whether we spend more or less on a commodity when income changes.

Which of the following are most likely to have indifference curves that are L-shaped?

1. your textbook and its study guide

For two goods which are perfect complements, the substitution effect of a price decrease is:

1. zero

Suppose that you are deciding between seeing a movie and going to a concert on a particular Saturday evening. You are willing to pay $20 to see the movie and the movie ticket costs $5. You are willing to pay $80 for the concert and the concert ticket costs $50. The opportunity cost of going to the movie is:

2. $30

Holding the composite good Y constant, after the price of a normal good rises we've seen the income and substitution effects result in the consumption decrease of that good. What will be the result in the case of a price decrease of that normal good?

2. The income effect and the substitution effect will both increase consumption of the good.

Indifference curves that intersect will be illogical because:

2. of the consistency (transitivity) property of indifference theory

From the diagram below, which of the following price-quantity data would be part of the demand curve derived?

2. price=5, quantity=23

The Kahneman-Tversky value function is:

2. steeper in losses than in gains.

Let the demand curve be P=10-Q, let the supply be given by P=Q. What is the equilibrium price?

3. 5

If a person earns M1 this year and M2 next year and the interest rate is denoted by the letter i, what is the formula for the present value of both incomes?:

3. M1 + M2/(1 + i)

The graph of the budget line below has dollars on the vertical axis and food on the horizontal axis. Which statement is false?

3. The distance OA shows the amount of money spent on OD amount of food

Consumer's weekly budget for coffee and doughnuts is $10. A cup of coffee and a doughnut cost costs $1 each. The line B1 in the figure below shows the consumer's budget constraint. Explain what changes in the parameters of the model would shift the budget line to position B2:

3. The shift might be caused by a combination of both the consumer income dropped to $5 per week and the prices of both goods doubled so that the collective purchasing power dropped by a half

Which statement is true within the framework of rational choice economics?

3. When the relative prices change a rational consumer's preference will not be altered.

Expected return/value is defined as ________:

3. the summed value of each possible rate of return weighted by its probability.

Which of the following gambles of flipping a fair coin should be considered more attractive?

4. If heads, you win $9; if tails, you lose $6.

Which of the following is most likely an inferior good?

4. The cheapest low-quality foods e.g., fast-food

In the textbook, income elasticity of demand is defined as the percentage change in the quantity of a good demanded that results from a 1 percent change in income. If = 0.50, what will be the quantity of a good when your income increases to $50,000 from $40,000?

4. The quantity demanded is likely increasing by 12.5%.

The income-leisure model of work is based on the assumption that:

4. the worker is able to choose how many hours to work.

Your favorite movie has just been released on video. If you were offered the choice of buying the tape for $20 with a $3 rebate, or the choice of simply paying $17 for the tape with no rebate, which offer would you choose if you acted: a. according to the rational choice model? b. according to the Kahneman-Tversky value function?

If you were rational, you would rather pay $17 for the tape since this would require less sales tax and you would not have to wait for the rebate. If you behaved according to the K-T value function the loss of the extra three dollars is more than offset by the $3 gain so you would be more inclined to opt for the rebate offer which will make you feel better off

In your own words, properly explain the Welfare Effect from Rising Housing Prices on Homeowners depicted in the scenario below: You have just purchased a house for $200,000. The very next day, the prices of all houses, including the one you just bought, double. (2-3 sentences)

When looking at the graph, the original budget constraint was B1. After the value of your home doubled, your budget is not B2. When the price of housing doubles, you will only be able to purchase 1.5 units of housing as opposed to before, when you could have purchased 2. On B2, the optimal bundle is C, which contains H1<1 units of housing and O2>200,000 units worth of other goods. Bundle C is located higher on the indifference curve than bundle A, which was the original optimal bundle, you were actually better of before the price increase.

Suppose the demand for cigarettes was P= 120- 7Q, and the supply for cigarettes was P=5Q. The market equilibrium quantity in this market would be:

1. 10

The market demand for a gallon of liquefied petroleum gas (LPG) is 5P=50-0.25Q. What price should be charged and quantity should be sold when the LPG producers want to produce where the elasticity of demand is negative unity?

1. 100 gallons at $5

The marginal utility of a good is the:

2. the rate at which total utility changes with the consumption of the good

Suppose your business decides to increase parking fees in order to deal with the shortage of parking spaces. However, the manager of your business convinces the board to pay back the amount spent on higher parking fees to its users in the form of a rebate at the end of the calendar year. As a result, the increase in parking fees will:

1. Can reduce the demand for parking and hence alleviate the parking shortage.

There are two individual demand curves representing the entire market for a commodity. (1) P=60-10Q(2) P=60-15Q Find the market demand curve for this commodity and compute the value of its price elasticity of demand at P = $30?

1. P=60-6Q and the demand is unit elastic.

When the price of a good changes, we call the change in consumption that leaves the consumer indifferent, the:

1. Substitution effect

Given that the good is normal (or inferior), the effect of the rise (or fall) in income will tell the direction of the relationship between income and the quantity demanded of that good.

1. True

Theory of rational consumer choice carries the assumption that the consumers will enter the market place to obtain a bundle of goods and services with well-defined preferences:

1. True

With a normal good, the income and substitution effects:

1. always work together and both tend to make the demand curve downward sloping.

When given an opportunity to deposit 10% of income to the retirement saving account with an equal employer matching contribution, many employees decline the offer. However, when given the same opportunity in the form of future commitment, i.e., the employee's and the employer's contributions would start next year, many of the employees who declined the first offer would now accept. This illustrates the concept of _________.

1. hyperbolic discounting

A risk-averse individual ________:

1. prefers a sure return to an uncertain prospect generating the same expected return

The slope of an indifference curve in a two-good model can be interpreted as:

1. the amount of one goof that the consumer is willing to give up to acquire the equally satisfying unit of the other good

The reservation price of good X is:

1. the price at which one would be indifferent between good X and simply keeping the money

One determinant of price elasticity of demand that can characterize the share of total expenditures on a product such that can describe the income effect of a price change in the market is:

1. the share of consumer budget.

If the consumer's weekly budget for frozen yogurt and ice cream is given by 0.5C+Y=5, where C is the quantity of ice cream and Y is the quantity of frozen yogurt, how much ice cream can she buy if she already purchased 3 units of frozen yogurt this week?

2. 4

Refer to the graph below. Assume that the initial equilibrium in the market for bus rides is point A (30 rides per week). The price of bus rides increases and the equilibrium changes to point B (20 rides per week). The substitution effect of the change in consumer behavior is:

2. 4

The cross-price elasticity of demand is the percentage change in the quantity of one good demanded that results from a tenth percent change in the price of the other good, and its positive value indicates the types of goods are substitutes.

2. False

From the concepts of Consumer Surplus and Two-Part Pricing, the graphical representation of consumer surplus that sellers seek to get from consumers is:

2. The area under the demand curve above the price that is charged.

A decrease in the price of one good will cause:

2. an outward rotation of the budget curve

The income effect of the price increase:

2. depends on whether the good in normal or inferior

When comparing T-bills and stocks, a risk-averse investor may choose to invest in T-bills although stocks give higher average returns because ________:

2. investing in stocks involves a higher degree of risk

The consumer price index overestimates inflation because it:

2. measures the cost of a market basket in the second year that has too many units of the most inflated items (i.e., consumers switched to relatively less expensive goods).

The price consumption curve shows us:

2. none of the above

When the size of the potential loss is small, most people will

2. self-insure because they can afford it and the expected loss is less than the insurance premium.

If a budget line with good Y on the vertical axis and good X on the horizontal axis is linear with a negative slope we know that:

2. the price of good X and the price of good Y are constant no matter what the consumer's market basket mix between the two goods is.

If there is a shortage in the market:

2. the price will likely go up

If the consumer is willing to give up 3 units of food (vertical axis) in exchange for one unit of shelter (horizontal axis) and food is priced at 10 and shelter at 20, then the consumer is purchasing:

2. too much shelter for utility maximization

From the diagram shown below, when a price of gasoline rose from $2/gal to $3/gal, the loss in consumer surplus was the shaded area DCEF, i.e. $7.50/week. By how much would consumer surplus shrink if the price of gasoline increased further from $3/gal to $4/gal?

3. $6.50/week

Suppose Microsoft stock will provide either a return of 10 or 20 percent over the next year and that the probability of the former outcome is 0.25 while the probability of the latter is 0.75. The expected return on Microsoft stock over the next year is thus ________%.

3. 17.5

If two goods are perfect substitutes, then their .......................... Given the good Y on the vertical axis what will be the sum of the substitution effect and the income effect? (The diagram can used for analysis: The starting point is at A, and the end point is at D.):

3. Indifference curves are negatively sloped straight lines. .... The sum of two effects results from (X*,0) to (0,Y*).

What is the most likely cross-price elasticity between beef and vegetables for a strict vegan when the prices of vegetables have increased?

3. Zero

Refer to the graph below. Assume that the initial equilibrium in the market for bus rides is point A (30 rides per week). The price of bus rides increases and the equilibrium changes to point B (20 rides per week). The diagram suggest that bus travel is a type of:

3. a normal good

Your utility function is given by U = M2 . You are (Graphically draw this equation, exam it in the first quadrant.)

3. a risk seeker / risk lover

In a model of present vs. future consumption, an increase in the interest rate will, assuming that consumption in both periods is a normal good, ...

3. decrease current consumption.

According to the Life-cycle hypothesis, if a person received a payment roughly equal to her current income, her consumption would:

3. increase, but not by as much as the increase in income.

In this chapter, we encounter several theories explaining financial and consumption decision behaviors. What would Precautionary Saving theory imply?

3. individuals save more when they are uncertain about their future income

The substitution effect of a price decrease:

3. is a movement on the indifference curve to consume more of the lower priced good and less of the higher priced good

A risk-neutral consumer:

3. is indifferent between accepting and refusing a fair gamble.

The cross-price elasticity of demand for iPhones and Android phones is most likely:

3. positive

The income effect of a price change

3. reinforces the substitution effect in the normal good case.

In a two-goods model of consumer behavior, if the price of both goods doubles:

3. the budget curve will move towards the origin and will be parallel to the original line

If the surgeon general announces that Cola causes cancer ,then we would expect

3. the demand for Cola will shift left

Excluding corner solutions, in consumer equilibrium, which of the following is true?

3. the marginal rate of substitution equals the slope of the budget constraint

When a tax on gasoline and an income tax rebate program of equal amount is implemented (like the one we discussed in class), then:

3. the tax restricts gas usage and the rebate program encourages usage, but the net effect is a decrease in consumption.

Conspicuous consumption as an ability signal:

3. will likely continue even if it is wasteful for all involved.

How does the income effect from the decrease in the price of a good differ from the income?

3. with the price change, the consumer is on a higher indifference curve, but on a lower slope relative to the increase in income.

One thousand dollars given to you a year from now is worth __________ to you today if the relevant discount rate is 10%.:

4. $909.09

If food is on the vertical axis and shelter on the horizontal axis, the slope of the budget line is given by:

4. -Ps/Pf

A gamble in which you win D dollars if the coin comes up heads, but lose D dollars if the fair coin comes up tails has an expected value of:

4. 0

If the consumer's weekly budget for ice cream and frozen yogurt is given by C+2Y=10, where C is the quantity of ice cream and Y is the quantity of frozen yogurt, what is the opportunity cost of ice cream in terms of frozen yogurt:

4. 0.5

If the consumer's budget constraint is given by 10F+ 5S = 100 where F is food and S is shelter. How much food can he buy if he purchases 4 units of shelter?

4. 8

There has been much discussion on whether or not marijuana should be legalized. Likely legalizing it should lower the price of marijuana. Assume that if it becomes legal then the price will be cut by a half (or 50%). Given that an estimate of -1.0 of price elasticity of demand for marijuana, what would you expect to be the change in marijuana use?

4. It will increase by 50%

A risk-averse individual who owns a $200,000 house and faces the prospect that the house will burn down with the probability 0.05 in any given year will be willing to pay how much of an annual premium to fully insure against such as loss?

4. More than $10,000

What is the market demand curve for the two consumers who have the following demand functions? 1) P = 60 - 1.2Q 2) P = 60 - 2Q:

4. P = 60 - .75Q

In principle and practice, reference groups can show influence consumption, e.g. think of your group and friends' groups. By "Keeping Up with the Joneses", this metaphor is referred by ________.

4. Relative Income Hypothesis

Suppose the cross-price elasticity of demand for iPhones (i.e., X) and Android phones (e.g., Z) is 1.25. How much will the price of Android phones change after the quantity demanded for iPhones has increased from 8000 to 10000 units?

4. The price of Android phones will be likely to increase by 20%.

In a two goods model of consumer behavior, an increase in price in one good with no changes in income will cause:

4. an inward rotation of the budget curve

Recall Consumer Preferences (Chapter 3), the utility function framework is analogous to an indifference map framework in that both provide a complete description of the consumer's preferences. That is, the indifference curve framework allows ranking any two bundles by seeing which one lies on a higher indifference curve as the utility-function framework allows comparing any two bundles by seeing which one yields a greater number of utils. Thus, for each possible bundle of goods, a utility function is"

4. both a) and b).

The marginal benefit of a typical activity:

4. decreases as you do more of the activity

The substitution effect of the price increase:

4. is in the opposite direction to the price change.

If the government wishes to raise revenue by taxing cigarettes, it:

4. makes no difference whether the consumer or the producer actually transfers the money to the government since the market effects are the same

If an educational voucher system were adopted where parents could spend their share of education tax dollars at any school of their choice, then we could expect families to:

4. spend more on education

When a product that depicted on the horizontal axis of a typical indifference curve model of behavior is taxed, then:

4. the budget line becomes steeper

If income of buyers goes down:

4. the demand curve could either shift right or left

Equilibrium in the utility maximization model represents the most satisfying and affordable combination of goods that a consumer can purchase. It is given by:

4. the point of tangency between budget line and the highest indifference curve

The slope of a budget line in a two-goods model can be interpreted as:

4. the size of available budget (purchasing power)

The decomposition of total effect is:

4. the sum of the substitution and income effects.

The law of demand states:

4. when the price of a product falls, people will buy more of it

What is Consumer Surplus? How is a loss in consumer surplus defined? How is a gain in consumer surplus defined?

Consumer surplus is the difference between what the consumer is willing to pay and what they actually pay. It is also a dollar measure of the extent to which a consumer benefits from participating in a transaction. A loss in consumer surplus is defined when the price paid increases, and a gain in consumer surplus is when the price paid decreases.

Departures from Standard Rational Choice: First: Imagine you want to buy a ticket to a sold-out rock concert. Your only hope of seeing the concert is to buy a ticket from a scalper. There is a 40% chance that the ticket you buy will be a counterfeit. a. If going to the concert gives you a $200 worth of pleasure (payoff denoted as P), and the price for concert tickets is $175, what is your expected payoff if you buy a ticket from a scalper?b. Suppose you find out that you can buy legitimate tickets from an agency for $225. What variable would have to change in order for you to pay $225 for a ticket? Now: Suppose you decide to buy a ticket from the agency above (in Problem 1) for $225, and there is a 10% chance that the check you write to the agency will bounce and they will never recover what you owe them.a. What is the agency's expected payoff?b. Suppose it will cost the agency $25 in paperwork to ensure the validity of all checks. Should they pay for this option? (Hint: a. EV=E(P)=-55; b. what value must increase by at least $25?; a. EV=E(P)=$202.5; b. The net value/worth is $200, then this option would be attractive to them, or not?)

E(P)= 0.4 (175)+0.6(200-175)=70+120-105=-55 The payoff would increase by at least $25 E(P)=0.9(225)+0.1(0)=202.5 Net worth of the option: E(P)=225-25=200. Since 200 is less than the expected payoff of 202.5 without the option, the agency should not pay for this option.

From the concept of Two-Part Pricing, when would it be logical that sellers design this pricing strategy? When not?

It would be logical for a seller to have two part pricing when their is restricted usage/ a limited amount of something. An example of this would be tennis courts at a country club. Members would pay a fee to be a part of the country club and would also pay to use the tennis courts because the tennis courts are in high demand, yet there are only a few. It would not be logical to use two step pricing when you want the consumers to enjoy the experience they paid for with the initial price and supply is not a problem. An example of this would be Disney World. Once you pay the fee to get in, there is no additional fee to ride as many rides as you would like.

You have $50,000 of current income and $63,000 of future income. If the interest rate between the current and future period is 5 percent, what is the present value of your lifetime income? What is the maximum amount you could consume in the future? What is the equation describing your inter-temporal budget constraint?

The Present Value is $110,000. The Future Value is $115,500. The equation is C2= -1.05C1+ 115,500.

To extend further understanding of consumer surplus concept, let's analyze it in a whole market. Suppose in the market the demand and supply of hamburgers can be represented by the diagram below. Initial equilibrium price and quantity are at $2/unit and 300 units. What area and value are represented by consumer surplus at P=$2? then at P=$2.50? (You can choose to illustrate the solution with inserting your own graph.)

The area that was initially the consumer surplus was located under the demand curve, yet above the price paid (the triangle under the demand curve but above G). Now the consumer surplus is the area under the demand curve, yet above the now increased price (the triangle under the demand curve but above H). To find the area of consumer surplus for when the price is at $2 and $2.50, we use the formula 1/2BH. When the equilibrium is at $2, the base is 300 and the height is 1.5. We then multiply those two together and divide by 2 to get 225. When the price increases, the base is 200 and the height is 1. So we multiply 200 by 1 and divide by 2 to get 100. As we can see mathematically and graphically, the consumer surplus decreased when the price increased because the willingness to pay stayed the same. So the consumer surplus was 225, then it dropped down to 100, so the loss of consumer surplus is 125.

Given the four determinants of price elasticity of demand, explain the difference between a price consumption curve and an individual demand curve.

The difference between a price consumption curve and an individual demand curve is that the PCC for good X is the set of optimal consumption bundles traced on an indifference map as the price of good X increases or decreases.An individual demand curve shows the relationship between how much a consumer wants to purchase that good for at different prices.

Explain briefly the key characteristics of the Absolute Income Hypothesis. What difference in saving behavior between rich and poor consumers does this theory help explain?

The key characteristics of the absolute income hypothesis is consumption is determined by the absolute level of income. It also studies how a consumer divides his disposable income between consumption and savings. Poor consumers have a higher consumption to income ratio than rich consumer. This means poor consumers spend more and save less when compared to rich consumers, who save more and spend less when compared to poor consumers.

In your own words, properly explain the Welfare Effect from Falling Housing Prices on Homeowners depicted in the scenario below: You have just purchased a house for $200,000. The very next day, the prices of all houses, including the one you just bought, fall by half. (2-3 sentences)

The original budget was B1, and now your budget is B3 after the housing prices fell by half. Given the budget constraint of B3, the most optimal budget would now be D, which contains H3>1 units of housing and O3<200,000 units worth of other goods. Because housing is now cheaper to afford, you can purchase more units of housing and fewer units of other goods

Explain the gasoline tax and rebate policy diagram Textbook Figure 5.1

The policy being demonstrated here is gasoline tax and rebate policy. A 50 cent tax is imposed, raising the price of gasoline to $1.50. If the price increases to $1.50, and the income remains the same at $150, the budget line would then rotate inward and the consumer would consume less per week because it now costs more to consume gas. If the consumer receives a rebate, it acts as a change in income. They still consume less gas given a rebate.

Explain the current education system diagram Textbook figure 5.2

The policy being graphed here the current education system represented in terms of a family's budget. The family's pretax income is represented by Y, and the amount they pay in school taxes is represented by Pe. The family is entitled to 1 unit of tuition-free public education, but they may also chose a private school education at the cost of Pe per unit. The budget constraint, is therefore, A'BC. It is a corner solution because we are graphing the budget constraint of private and public school education on one graph. The optimal bundle is B, which contains one unit of public education.

With the PCC, the set of optimal bundles are traced out by the various budget lines. Recall that a change in the price of a good affects consumers' purchase decisions for 2 reasons. What are these two reasons? (You can choose explain it conceptually and/or with a graph as long as your explanation is consistent.)

The two reasons behind this would be the substitution effect and income effect. SE+IE= Total effect

Your bike is worth $50. There is a 50% chance that it will be stolen from the dining hall at lunch today. Your utility function for the bike is U=(bike value)2. (Show/explain these calculations when applicable.)1) Are you risk averse, a risk lover, or risk neutral?2) What is the expected value of your bike considering its vulnerability?3) The campus security has a bike check-in that will guard your bike for $5, so there would be no risk of loss. Do you take the campus security deal?4) What is the maximum you would pay security to check in your bike?

The utility function is convex implying that you have increasing marginal utility of wealth. You are a risk-seeker. The expected value is 25. It is calculated by multuplying (0.5)(50)+(0.5)(0)=25 The expected utility of taking the gamble is EU=(0.5)(50 squared) + (0.5) (0 squared)=1,250. Utility of paying for having your bike guarded is U= 45 squared= 2,025. Since U is greater than EU, you will pay $5 and check-in your bike to have it guarded To find the maximum you would pay which is x you solve for the utility of paying amount x is made equal to the utility of taking the gamble, example 1,250= (50-x) squared. Once the equation is solved, you get 14.64

Explain the diagram of the education system after the rebate is applied Textbook figure 5.3

This graph represents the policy of implementing school vouchers into our educational system. The voucher system would allow parents to provide small increases above 1 unit of education at the price of Pe per unit. The budget constraint changes from the graph above (A'BC) to A'BD. The family then choses bundle G, which is now more optimal for the family because it contains more than 1 unit of education. Switching to the voucher system would help the educational system because it will increase the level of spending on education and parents do not have to forfeit school taxes when they switch from public to private schools.

According to the a textbook (& PPT) example that illustrated how new homeowners could experience an increase in their well-being even if the price of the home that they just purchased reduced significantly one day after the purchase. Explain in your own words what two assumptions are needed to make this experience of still increasing in their welfare to hold true.

Your new budget constraint after the reduction in the value of the home must be at least as well off after the price change as before. The change in the relative price means your new budget constraint contains bundles beyond your original indifference curve. Because housing is now cheaper than before, you can respond by purchasing more units of housing and fewer units of other goods.