14.01 Principles of Economics Fall 2018 Midterm Exam Solutions 1 True/False Question (20 minutes) For each of the following statements, write whether it is True or False, and justify your answer. Points will be given based on your explanation. 1. John has an income of $1,000. He spends $100 on potatoes and $900 on everything else. The government is planning to assist low income people like John. In particular, they are considering giving him either $200 in cash or giving him $200 in stamps that can only be used to buy potatoes. (a) If potatoes are a normal good, then John will be strictly better off with $200 cash than with $200 in stamps. Solution: False, if John wants to spend more than $200 in potatoes when he receives a $200 cash transfer, then he can also buy that same bundle when he receives the $200 in stamps. Therefore, he could be indifferent between cash or stamps. (b) If potatoes are an inferior good, then John will be strictly better off with $200 cash than with $200 in stamps. Solution: True, since potatoes are an inferior good, we know that when he receives $200 in cash he will spend less than $100 in potatoes. However, that bundle is not affordable when he receives $200 in stamps, so he will have to choose another bundle on a lower indifference curve. 2. Mary consumes only two goods, x and y. When the price of x increases, she consumes less of good y. Claim: y can't be a Giffen good. Solution: True, when pr increases the substitution effect leads to more consumption of y, so the income effect must be negative if the total effect on y is negative. This implies that, y is a normal good, so it can't be Giffen (recall that Giffen goods have to be inferior). 3. Consider the market for cars. All firms have the same production technology, and we know that the long-run average cost curve has a minimum at a cost of $10,000 per car. Therefore, we can never observe a market equilibrium in which the equilibrium price is below $10,000. Solution: False, we could have a short-run equilibrium with a price below $10,000 because the firms may not want to shut down even if they are making negative profits as long as they can cover their variable costs. 4. Consider a firm that produces computers. Suppose that the market price of a computer is p (both in the short-run and in the long-run). If in the short-run this firm decides to shut-down (i.e. produces q =0), then it must be that in the long-run it decides to exit the market. Solution: False, it is possible that the firm shuts down in the short run, but if it were able to choose another level of capital it could produce more efficiently and stay in the market. 2 Long Question: Consumer Theory For this question, it is okay to have non-integer answers 3 Rebecca likes eating bagels