Mid-term exam

The International College of Economics and Finance

MICROECONOMICS (second year of studies) – 2006 (corrected).

Mid-term exam

Sample Marking Scheme (with brief sample answers)

(1 hour 30 minutes). Answer two of the following four questions - question 1 and any ONE of the others.

General structure of marking: 50% (or 50 marks) at maximum can be given for question 1, same - for any ONE of the others. Within question 1, each of the three sub-questions chosen can be given 16,(6)% (or 16,(6) marks), which can be “rounded” to at maximum 17% (or 17 marks).

(“Rounding” is an extra, though very small, bonus, for an exceedingly good answer to the particular question. It “works” only if the student’s answer to the remaining 2 (or 1 of the 2) sub-questions included in question 1 is marked below16,(6)%).

1. Answer three of the following 8 questions. True or false, explain.

1.(c) [ 16,(6) or, max., 17% (marks) ]

Whenever marginal returns to a factor are diminishing average returns to a factor are diminishing too. True or false, explain.

(1) [ 1% (marks) ] – definitions of marginal and average returns to a factor as properties of the short-run production function.

(2) [ 8 % (marks) ] – explaining the concepts of marginal and average returns to a variable factor and the relationship between them on the basis of two diagrams – the one presenting the short-run production function curve and the one presenting the marginal and average returns to factor curves.

(3) [ 4 % (marks) ] – discussing the relationship between marginal and average returns in terms of the law of diminishing marginal returns and technically efficient range of production.

(4) [ 3 % (marks) ] – rigorous (formalized) explanation of the relationship between marginal and average returns to a variable factor, showing why the MPL curve always passes through the maximal point of the APL curve.

(5) [ 0,(6) % (marks) ] – for the summarizing conclusion that the statement turns out to be FALSE.

1. (e). [ 16,(6) or, max., 17% (marks) ]

If price elasticity of demand is -3, it means that the fall in price will decrease consumer’s spending.

True or false, explain.

(1) [ 2% (marks) ] – explaining the concept of the price elasticity of demand, its sign for ordinary goods and its value ranges along a linear demand curve.

(2) [ 6% (marks) ] – explaining the relationship between a good’s price change and the total expenditure on this good’s change for elastic range of demand using the diagram (see Pic.1).

Рic. 1. The relationship between the price elasticity of demand and consumers’ total expenditure on X in the elastic range of demand.

(3) [ 6% (marks) ] – rigorous (formalized) explanation of the relationship between the good’s price change and the change of total expenditure on this good, deriving the formula:

(4) [ 2% (marks) ] – applying this formula to give an extra counterexample: for the demand with constant price elasticity total expenditure on the good is constant.

(5) [ 0,(6) % (marks) ] – for the summarizing conclusion that the statement turns out to be FALSE.

1.(h). The income effect under Slutsky's definition of real income always exceeds the one under Hicksian definition of real income when the price of the good increases. True or false, explain.

(1) [ 16% (marks) ] – comparing the absolute values of these effects for income in cash situations; of these:

8% (marks) – on thebasis of the graph for X- normal, explaining that under these circumstances the statement is true, as substitution effect under Slutsky's definition of real income is smaller than the one under Hicksian definition of real income and substitution and income effects works in the same direction;

8% (marks) – on thebasis of the graph for X- inferior, explaining that under these circumstances the statement is also true, as substitution effect under Slutsky's definition of real income is greater than the one under Hicksian definition of real income and substitution and income effects work in opposite directions.

(2) [ 0,(6) or, at max., 1 % (marks) ] – for the summarizing conclusion that the statement is TRUE for the situations when income is in cash.

3. [ 50% (marks) ] A record company wishes to entice the public by offering Club arrangements whereby consumers get a set of compact disks for a fixed sum (B). In return, members are committed to buy a given number of compact disks at catalogue price (which is higher than market price). Any further purchase will be at market price.

(a) Describe, in the same diagram, the two possible budget constraints facing a consumer. Distinguish between those consumers who would join the club and those who would not.

(b) Assuming that those who join will not purchase more than they are committed to buy how would an increase in the market price of compact disks affect the quantity demanded? Is the price elasticity of demand more likely to be greater or less than unity?

c) One of the company’s advisors argued that if the Club offer did not require a commitment to purchase a further number of compact disks, the company would have confronted an upward-sloping demand Is this at all possible without concluding that compact disks must be an inferior good for all consumers?

(a) [ 16% (marks ) ] - discussing the three possible types of choices under the scheme. Of these:

[ 8% (marks ) ] – for the diagram presenting the two budget constraints facing a consumer, correspondingly, before and after the scheme’s introduction, with subscribed intercepts, accounting for the fact that once an individual joins the Club, he will get (N+M) CDs and his income will become (Io –B – PcM), where Pc is the catalogue price of CDs (see Pic. (4a)).

Pic.4 (a)). Comparing the budget lines and possible optima for consumers joining and not joining the Club.

[ 8% (marks ) ] – for distinguishing between those consumers who would join the club and those who would not in terms of their initial and final optima. The initial optimum (say, point A) of those who would not join the club is above the horizontal part of the budget constraint for those who would and coincides with their final optimum. The initial optimum (say, point B) of those who would join the club is below the horizontal part of their budget constraint and there are two types of their final optima: - the “corner” optimum (B’) in which they consume exactly (N+M) and the “interior” optimum (B’’) in which they consume more than (N+M) CDs. In both cases the utility level reached increases.

(b) [ 16% (marks ) ] – assuming that most individuals will end up in the “corner” optimum B’, for discussing their reaction to the increase of the market price of CDs. This includes distinguishing between two possibilities: - (1) when this increase does not affect the catalogue price Pc;

- (2) when Pc increases too. Of these:

[ 8% (marks ) ] - analyzing the changes in the budget constraints (a fall in the X-axis intercepts for both) and final optima in case (1), explaining that those who would not join the club now move to the lower budget constraint consuming less CDs while the Club members remain in B’, hence, an increase in the catalogue price will not influence much the overall quantity purchased.

[ 8% (marks ) ] - analyzing the changes in the budget constraints (a fall in the X-axis intercepts for both and also a fall of the Club members budget constraint’s Y-axis intercept) and final optima in case (2), explaining that now the Club members will not remain in B’, moving downward vertically to a new “corner” optimum (say, C’) (see Pic.4 (b)).

Pic.4 (b). The impact of the market price of CDs increase upon the consumer choice of the Club members and non-members in the absence of the catalogue price increase and with such increase.

(c) [18 % (marks ) ] – discussing (on the basis of diagrams) the implications of abolishing the commitment for the Club members to purchase a number of compact disks at the catalogue price Pc. Of these:

[ 6% (marks ) ] – discussing the change in the budget constraint (now becoming higher in its horizontal part) for the Club members;

[ 8% (marks ) ] – explaining, that with the increase in the price of X (CDs) the Club members will still purchase N CDs while those who didn’t want to join the Club before might now want to do it, moving to B’ as this might increase their utility reached; hence, sales increase.

[ 4% (marks ) ] – explaining that, if this happens, (CDs), not being an inferior good, will demonstrate the upward–sloping demand.

Pic.4(c). Budget lines and the impact of the market price of CDs increase upon the consumer choice of the Club members and non-members in the case when they are not obliged to purchase M compact disks at the catalogue price.

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