Midterm examination paper in microeconomics (second year of studies, example).

Answer two of the following four questions - question 1 and any ONE of the others.

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

(a) Provided that consumer’s preferences are standard and both schemes yield the same effect on "real income" under Hicks, a lump sum tax on the consumption of X will bring greater tax revenue to the budget than taxing the consumption of X on a per-unit basis.

(b) The demand curve for a normal good can never be upward-sloping.

(c) Whenever marginal returns to a factor are diminishing average returns to a factor are diminishing too.

(d) In the world of two goods an individual with standard preferences chooses to consume 60 units of Y and 40 units of X when the price of X is equal to the price of Y and equals 5. When the price of X falls to 2, the substitution effect under Hicks will lead the individual to choose the bundle of 40 units of Y and 60 units of X. If the government reduced this individual’s income by 150, he will be as well off as before the change in the price of X.

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

(f) In the world of two goods you observe a consumer in two market situations:

(i) spending his money income on 6 units of X at the price of $10 each and 6 units of Y at the price of $10 each;

(ii) still spending his money income on 6 units of X and 6 units of Y when this income falls by $12, the price of X falls to $6 and the price of Y increases to $12.

Such choice means that the consumer behaves rationally.

(g) If a consumer is making choice in the space of 2 goods and one of them is a luxury, the other should be a necessity.

(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.

2. Mr. Petrov, has become a new Russian and decided to provide his two grown-up children – a son and a daughter – with a proper annuity, equivalent to the money value of "basic" bundle consisting of 2 goods – fast automobile drives(X) and fashionable clothes(Y). According to Mr. Petrov’s opinion, there should be more of good X than of good Y in the structure of the son’s "basic" bundle, while for the daughter – the opposite should be true.

а) Let us assume that the father’s provision is the only source of his children’s income and that the initial amount of their income is the same for both. Supposing that, contrary to Mr. Petrov’s idea, the children’s tastes turn out to be the same, graph and subscribe the initial budget line for each of the children and show the initial optimal choice of each.

b) Analyze the impact of the fall in the price of good X on the son’s and daughter’s welfare.

c) Could X be a Giffen good for both children? Graph the compensated and Marshallian demand curves for each of them.

d) Could X and Y be gross complements, with X being an inferior good for the son? Assuming that X and Y are gross complements, will the price elasticity of demand for X be smaller than unity?

e) Could X and Y be gross complements, with X being an inferior good for the daughter? Assuming that X and Y are gross complements, will the price elasticity of demand for X be smaller than unity?

3. 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 that a consumer faces. 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?

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