STUDENTID: Please write your name in small print on the inside portion of the last page of this exam

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1 STUDENTID: Please write your name in small print on the inside portion of the last page of this exam Instructions: You will have 60 minutes to complete the exam. The exam will be comprised of three parts and will be worth a total of 60 points. Please write all of your answers NEATLY on this exam sheet. If I cannot read your writing, I certainly won t be able to grade it. I. Part I will consist of two essay questions, each worth 10 points. You should answer BOTH of these questions. II. Part II will consist of two essay questions, each worth 20 points. You should answer BOTH of these questions. 1

2 PART I: Each of these questions are worth 10 points 1. This question consists of two parts. a. (6 points) Economists like to use math and in some cases it is confusing. However, in this case, the use of mathematics illustrates an economic concept perfectly. Explain what the following expression means (make believe you re trying to describe it to your parents). A utility maximizing bundle of peanuts and hot dogs has been selected MU MU Peanuts HotDogs when =. P P Peanuts HotDogs The LHS of the equation tells us how much satisfaction a consumer gets from spending an additional $1 on peanuts. The RHS tells us how much satisfaction a consumer gets from spending an additional $1 on hot dogs. Therefore, in order to maximizing her happiness, our consumer must be choosing a bundle (peanuts, hot dogs) such that the happiness she gets from spending an additional dollar on either food is the same. b. (4 points) Suppose you know that at our consumer s current consumption bundle, MU Peanuts /P Peanuts = 2 and MU Hot Dogs /P Hot Dogs = 4. What should our consumer do to make herself happier? At the current bundle the last dollar (or next) she spent on peanuts provided her with 2 units of happiness while the last dollar (or next) she spent on hot dogs provided her with 4 units of happiness. Therefore, it must be the case that she can rearrange her consumption bundle while keeping her total expenditures the same and make herself happier. Since she gets less satisfaction from eating the last dollar s worth of peanuts than she did the dollar s worth of hot dogs, she should consume fewer peanuts and more hot dogs. How much more? We can t say. However, what we can say is that when spending one less dollar on peanuts, she loses 2 units of happiness. By spending one more dollar on hot dogs she increases her happiness by 4 units. Therefore, by substituting a dollar s worth of hot dogs for a dollar s worth of peanuts, she will increase her happiness by 2 units and she would have spent the same amount as before. 2. (10 points) Allie goes to a small college in the Northeast. The meal plan at the college works as follows: the first 60 meals consumed are priced at $6 per meal. All additional meals after that are priced at $4 per meal. A picture of Allie s total meal bill at the college for the semester is below. 2

3 $ / semester Total Meal Bill at Small College First 60 meals cost $6, each additional is $4 $360 $4 0 $ # meals / semester Allie has to eat a total of 130 meals during the course of a semester and pays his food bill after the term ends. Like many college students, Allie is more likely to eat a dinner at Cracker Barrel in September than he is in December (suppose he enjoys a meal at Cracker Barrel equally in both months; further, he always orders the same meal when he goes there). Is Allie s behavior rational? Justify your answer. Remember how we like to assess whether someone s decision making skills are rational a rational decision is one that considers the marginal benefits and the marginal costs. No, this behavior is irrational. It is irrational because the marginal cost of eating a meal at Cracker Barrel is the SAME in both September and December. I assert that the marginal benefits of the meal are the same. Therefore if the marginal benefits and marginal costs are the same when you face two decisions, you should make the SAME decision each time. Some people think that it costs less to eat out in September than in December because the price of the first 60 meals at the college is $6.00 (so this is how much you save by eating out) while the price of the 61 st, 62 nd, 63 rd, etc. meal is only $4.00 (so you save less by eating out), but this thinking is not a proper accounting of marginal costs. Whether I eat a meal at Cracker Barrel in September or December, I still have to consume 129 more meals at the college. Therefore, I am saving $4.00 from my dining services bill whether I eat out in September or December. The marginal cost of any future action is the change in my total costs from taking that action. PART II: Each of these questions is worth 20 points 3. Bill Samuels Jr. is the CEO of Maker s Mark, a very high-quality bourbon company located in Loretto, KY. He recently appeared before the legislature in Frankfort arguing that the suggested increased tax on liquor would force him to 3

4 reconsider plans for a $35 million expansion to his distillery. a. (5 points) Why do you think he launched this complaint? He launched his complaint because he thinks that an increase in taxes will lead to an increase in the cost of bourbon to customers, which would decrease the quantity demanded at any initial bourbon price. In other words, he thinks he ll be able to sell less bourbon which will reduce his profits. b. (15 points) Suppose that the demand for bourbon is extremely inelastic over any reasonable range of prices (i.e. Rizzo s gotta have his Saturday evening glass ). Suppose further that liquor stores carry only two types of bourbon, Maker s (which is of very high quality) and Old Grand Dad s (which is not very good quality). Try to convince me that Bill Samuels should have been doing just the opposite he should have been lobbying in support of the tax increase! Mr. Samuels does not fully understand the law of demand. People make decisions at the margin on RELATIVE PRICES. Maker s Mark bourbon, being of very high quality, sells for a high price. Let s assume that a 750ml bottle sells for $40. Old Grand Dad s, being of very low quality, sells for a low price. Let s assume that a 750ml bottle sells for $10. Before the tax increase, the relative price of a bottle of Maker s Mark is 4 bottles of Old Grand Dad s. In other words, for each bottle of Maker s I drink, I give up the opportunity to drink 4 bottles of Old Grand Dad s. Let s suppose that the tax will take the form of a $20 per bottle sales tax. Now, each bottle of Maker s Mark will cost bourbon drinkers $60 while each bottle of the bad stuff costs each drinker $30. Now, what is the relative price of Maker s Mark? It is two bottles of Old Grand Dad. In other words, for each bottle of Maker s that I drink, I now only give up the opportunity to drink 2 bottles of Old Grand Dad. Since we know that the demand for bourbon is inelastic over a range of prices, the total quantity of bourbon demanded is not likely to fall very much. Therefore, at the lower relative price, it seems likely that the tax would induce buyers to substitute Maker s Mark for Old Grand Dad. 4. Dana has two friends, Sally and Hillary. Dana currently has 30 hours per week of leisure time to spend as she wishes on various activities but she does not like to spend her time alone. Sally is more of a homebody she loves to spend time at home watching 2 movies at a time (each is a 1.5 hour long movie on average). Hillary loves the outdoors her idea of a good time is a grueling hike followed up with a bicycle ride to cool down. Each activity with Sally (S) lasts for 3 hours. Each activity with Hillary (H) lasts for 5 hours. 4

5 a. (3 points) Write down an expression for, and draw, Dana s budget constraint and tell me the price of an activity with Sally and the price of an activity with Hillary. Her budget constraint can be written as 3S + 5H = 30. The price of an activity with Sally is 3 hours. The price of an activity with Hillary is 5 hours. Here is what her budget constraint looks like: with Sally Dana's Budget Constraint "Price" of Sally = 3 hours, "Price" of Hillary = 5 hours, "Income" = 30 hours with Hillary b. (4 points) What is the marginal cost of spending an additional activity with Hillary? We know that the budget constraint tells us what the marginal opportunity costs of an activity is. In the case of an activity with Hillary, the marginal cost is the amount of hours that Dana cannot spend with Sally for every hour that she spends with Hillary. This, as you know, is the ratio of the prices which is equal to the absolute value of the slope of the budget line in this case equal to 1.67 hours. c. (4 points) If at her current consumption level, the total level of satisfaction Dana gets from spending time with Sally is the same as the total level of satisfaction that she gets from spending time with Hillary, can you say if she is maximizing her happiness? Explain. No. She MAY be maximizing her satisfaction, but we cannot determine this from knowing only that the level of satisfaction provided by each activity is the same. In order to be maximizing her satisfaction, it MUST be the case that the sum of her satisfaction from both activities is as large as possible, and 5

6 this happens when the marginal benefits from spending time with Hillary are equal to the marginal costs of spending time with Hillary. d. (3 points) Dana used to get to Sally s house by taking her car (assume that taking the car took no time at all for simplicity s sake). However, her car was stolen last night and now in order for Dana to hang out with Sally she must take the bus. Busing to Sally s house takes 2 hours and bus rides are free. However, Dana s parents are compassionate, so to make up for Dana s loss of the use of her car they relieve her of 10 hours worth of work she used to do around the house. Dana s time with Hillary is unchanged, as they take their bicycles together to get wherever they are going. Write down an expression for, and draw, Dana s new budget constraint and tell me the price of an activity with Sally and the price of an activity with Hillary. Her budget constraint can be written as 5S + 5H = 40. The price of an activity with Sally is 5 hours. The price of an activity with Hillary is 5 hours. She now has a total of 40 hours for leisure because she no longer has to do housework. Here is what her budget constraint looks like: with Sally Dana's New Budget Constraint "Price" of Sally = 5 hours, "Price" of Hillary = 5 hours, "Income" = 40 hours with Hillary 6

7 e. (6 points) Suppose that after the change, Dana chooses to spend 3 activities with Hillary and 5 activities with Sally. Has the change made Dana better or worse off? How do you know? The change has made Dana WORSE off, she would prefer the initial situation. How do we know this? Let s assume that Dana s preferences have not been altered by the stolen car and chores changes. First, since I did not say that activities with Hillary and activities with Sally are perfect complements, we know that Dana would not have chosen bundle A before the changes took place. Why? Because to be maximizing her satisfaction, we know that the marginal benefits of spending an additional activity with Hillary should equal the marginal costs of spending an additional activity with Hillary. In both cases, the marginal benefits are the same, since I did not say otherwise. However, at point A, the marginal costs of spending time with Hillary are LOWER after the changes than they are before the changes. Therefore, if the marginal benefits equal the marginal costs after the changes (equals one), then we know it must be the case that at point A, the marginal benefits are LESS than the marginal costs before the changes. When the marginal costs of doing an activity exceed the marginal benefits, we know that we should we doing LESS of that activity. Therefore, it must be the case that before the change, Dana was spending more than activities with Sally and less than three activities with Hillary. She must have located at a point like point B. Furthermore, we know that Dana s initial indifference curve (IC 0 ) must lie above point A under the initial situation. This says nothing more than that she prefers point B to point A before the change otherwise she would have chosen point A. I tell you that after the change Dana ends up at point A, so to maximize happiness, we know that she will move to the highest possible indifference curve that still is tangent to her new budget line, and you can see that it MUST be below the initial indifference curve. The economics is clear, at point B, the marginal benefit of spending an additional activity with Hillary must be 1.67 which equals the marginal cost. When the marginal cost falls of spending more time with Hillary (or when the marginal cost of spending time with Sally increases), we see that Dana should spend more time with Hillary and less with Sally but she would not have preferred to do this initially. 7

8 with Sally Dana's New Budget Constraint "Price" of Sally = 5 hours, "Price" of Hillary = 5 hours, "Income" = 40 hours 10 B 5 A IC 0 after changes with Hillary