If food is an inferior good, then

The correct answer: its Engel curve will be negatively sloped.

This is only true for a Giffen good.

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Suppose that the quantity of food is measured on the horizontal axis and the quantity of clothing is measured on the vertical axis. When the price of food changes, the substitution effect can be found by comparing the equilibrium quantities of food purchased

The correct answer: on the old budget line and a line parallel to the new budget line tangent to the old indifference curve.

This comparison evaluates the change in quantity demanded allowing real income to change.

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Suppose that the quantity of food is measured on the horizontal axis and the quantity of clothing is measured on the vertical axis. When the price of food changes, the income effect can found by comparing the equilibrium quantities of food purchased

The correct answer: on the new budget line and a line parallel to the new budget line tangent to the old indifference curve.

The income effect is found by comparing the quantity demanded when facing the new price but the old level of real income with the quantity demanded when facing the new price and the new level of real income.

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Suppose that the quantity of food is measured on the horizontal axis and the quantity of clothing is measured on the vertical axis. In the case of convex indifference curves for the two goods, it is always true that

The correct answer: when the price of food declines, the substitution effect leads to an increase in the quantity of food demanded.

The shape of the income consumption path is dependent upon the specific utility function. With convex indifference curves, one can have a positively or negatively sloped income consumption path.

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Suppose that the substitution effect of a decline in the price of food is the same for both Harry and Sally. However, Harry feels that food is an inferior good while Sally feels that food is a normal good. As a result,

The correct answer: Harry's demand curve for food will be steeper than Sally's.

For a given price decrease, both Harry and Sally experience an increase in real income. Since food is an inferior good for Harry, he will not increase his quantity demanded of food as much as Sally will increase hers. Thus, Harry's demand curve is steeper because the income effect is less for Harry than for Sally.

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Edward and Larry have identical preferences; however, due to differences in income, Edward spends a larger share of his income on caviar than Larry does. Which of the following statements is true regarding a decrease in the price of caviar?

The correct answer: Since the budget share of caviar is greater for Edward than for Larry, the income effect will be greater for Edward than for Larry.

The income effect of a price change is weighted by the budget share of the good for which the price has changed. Therefore, the income effect is greater for Edward than for Larry.

________________________________________

When the price of food increases, Jimmy spends more on food than he did before. It must be true that Jimmy's demand for food

The correct answer: is relatively inelastic.

Total expenditure on a good will increase when the price of a good increases if demand is relatively inelastic.

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The price of grapes is different each week at the supermarket. Yet, Marge spends exactly $10 on grapes each week. It must be true that Marge's demand for grapes

The correct answer: is unit elastic.

Total expenditure on a good will not change when the price of a good changes if demand is unit elastic.

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Martha's demand for spring water has a price elasticity of –3.0. A recent tax that caused the price of spring water to increase by 20% will cause Martha to decrease her quantity demanded for spring water by

The correct answer: 60%.

Since price elasticity of demand is the percent change in quantity divided by the percent change in price, % change in Q /20% = -3. Rearranging yields % change in Q = -60%.

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Greg, Bobby, and Peter are the only consumers of camera film in a certain small town. Greg's demand is Q = 100 – 2P. Bobby's demand is Q = 25 – P. Peter's demand is Q = 75 – 7P. The market demand for film in that town is

The correct answer: Q = 200 – 10P.

QMARKET = QGREG + QBOBBY + QPETER = (100 – 2P) + (25 –P) + (75 – 7P) = 200 – 10P

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The market demand for photo film in a given town is Q = 500 – 10P where Q is measured as rolls of film consumed per week and P is measured as $/roll. If the price of film is $5 per roll, how much is the consumer surplus in the market for film?

The correct answer: $10,125

At that price, 450 rolls will be purchased. The demand intersects the vertical axis at a reservation price of $50. Consumer surplus is the area [($50 - $5) * 450] / 2 = $10,125.

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Sam is willing to part with his old car for no less than $5,000. Bob likes the car and would pay as much as $8,000 for it. After lengthy negotiations, they agree on a price of $7,000. As a result of the deal, Bob will enjoy a consumer surplus equal to

The correct answer: $1,000.

Bob actually pays $7,000 and is willing to pay $8,000. The difference is $1,000.

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Suppose the demand for bridge crossings at a certain remote site is P = 100 – 2Q where Q is measured as crossings per year and P is measured as $ per crossing. What is the value to consumers of building a bridge at that site?

The correct answer: $2,500

The total value to consumers is the area under the demand curve. The demand intersects the horizontal axis at a quantity of 50. Thus the area under the demand curve is (100 * 50) / 2 = $2,500.

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Evidence of the presence of network externalities in the market for electronic fax machines wouldbe that

The correct answer: an increase in the number of fax machines sold increase the individual consumer's benefit of owning a fax machine.

This is true for any good. A network externality exists if a consumer's utility from a good increases as more of other consumers purchase the good.

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Joe can finally afford his dream car – the MBA2000. He has called around to all of the auto service centers within a 250-mile radius of his home. None of them will service the car. It seems that since there are not too many MBA2000's out on the road, no mechanic has taken the time to learn how to service this vehicle. Joe decides to purchase a more conventional automobile. His behavior can best be explained by

The correct answer: a network externality.

A network externality increases the benefit of owning a product when more and more people own it. A snob effect decreases the benefit of owning a product when more and more people own it.

Chapter 5

Multiple-choice test

1.			The probability for all possible events  Your Answer: is a measure of the likelihood that a given outcome will occur, and the sum of the probability of all possible outcomes must add to 100. Correct Answer: is a measure of the likelihood that a given outcome will occur, and the sum of the probability of all possible outcomes must add to 1.
		Incorrect. The sum of the probability of the possible outcomes must add to 1.
2.			Objective probability is  Your Answer: attached to a likely outcome based upon a person's judgment or experience, and is not based on actual outcomes observed. Correct Answer: attached to a likely outcome based upon the frequency with which the event tends to occur.
		Incorrect. This is the definition for subjective probability.
3.			The expected value  Your Answer: measures the probability weighted average payoff or value that is expected from all possible outcomes.
		Correct.
4.			If the probability of outcome 1 is 0.75 with an expected payoff of $5000, and the probability of outcome 2 is 0.25 with an expected payoff of $20,000, then the expected value of the outcome is  Your Answer: (0.75x$5000 + 0.25x$20,000)/2 = $4,375. Correct Answer: (0.75x$5000) + (0.25x$20,000) = $9,375.
		Incorrect. The expected value is the sum of the probability of success times the expected payoff for each possibility.
5.			Variability is defined as  Your Answer: the difference between the expected value and the actual value of the outcome. Correct Answer: the extent to which the possible payoffs vary in their actual outcomes.
		Incorrect. Variability is measured using the sum of the squared differences between the expected and possible outcomes, weighted by their probability, or the Standard Deviation.
6.			The standard deviation is calculated as  Your Answer: the sum of the differences between each of the expected value and possible payoffs or outcomes. Correct Answer: the sum of the squared differences between the expected and possible outcomes, weighted by their probabilities, taken to the square root.
		Incorrect. The standard deviation is the square root of the weighted average of the sum of the squared differences between the expected and possible payoffs or outcomes.
7.			A risk adverse individual can be defined as someone who  Your Answer: prefers a more certain income with a low standard deviation of possible outcomes to a higher income with a higher standard deviation of possible outcomes. Correct Answer: Both 1 and 2.
		Incorrect. This answer is correct, but number 1 is also correct.
8.			A risk loving individual can be defined as someone who  Your Answer: prefers a less certain, higher income with a high standard deviation of possible outcomes to a lower income with a lower standard deviation of possible outcomes.
		Correct. More is always preferred to less, especially for a risk loving person who can tolerate a higher standard deviation in the outcomes.
9.			John is evaluating two investment opportunities, one with an expected outcome of a 5% return on investment (standard deviation of 1 percentage point) and one with an expected outcome of 7.5% return on investment (standard deviation of 5 percentage points). John will decide to invest in  Your Answer: the 5% project if he is risk averse, in that he expects to earn a 5% return with little variability.
		Correct.
10.			The risk premium is  Your Answer: the maximum income a person is willing to receive in order to avoid taking risk. Correct Answer: the maximum income a person is willing to forgo or the maximum amount of money a person is willing to pay to avoid taking risk.
		Incorrect. Persons who avoid taking risk forgo the opportunity for additional income.
11.			An investor is considering a $100,000 investment in a developing country that has the potential to return $75,000 with a 0.75 probability, but there is a 0.25 probability that a military coup, will result in a return $0. Purchasing political insurance for $18,750 will lead to an expected return of _____________________ with or without insurance, but reduces the standard deviation from _________ to ____________.  Your Answer: $75,000; $32,476; $0 Correct Answer: $56,250; $32,476; $0.
		Incorrect. The expected value is 0.75($75,000)+0.25(0)=$56,200 with a standard deviation of $32,476. The $18,750 insurance guarantees the $75,000 return in case of a coup but reduces the net return to $56,250, and variability is reduced to zero.
12.			The value of complete information is equal to  Your Answer: the difference between the expected value of a choice with complete information and the expected value of a choice with incomplete information.
		Correct.
13.			There is a 25% chance that a $100,000 investment will yield $25,000 and a 75% chance that the investment will yield $10,000. However, you are confident that if you purchase market research for $5000 you can with certainty invest the $100,000 and earn $20,000. In this case, the value of complete information is  Your Answer: $7,500, and so it is worth paying for the market research. Correct Answer: $6,250, and so it is worth paying the $5,000 for the market research.
		Incorrect. The expected value of yield on your investment is $13,750 without complete information, and $20,000 with it, so the value of complete information is $6,250.
14.			The actual rate of return on Treasury bills  Your Answer: Is usually more than the expected rate of return because Treasury bills are a low risk form of investment. Correct Answer: Is equal to the actual rate of return because the return on Treasury bills is risk-free.
		Incorrect. Treasury bills are a risk free form of investment and so the expected rate of return equals the actual rate of return.
15.			When analyzing the trade off between risk and return on investment, the slope of the budget line  Your Answer: is called the price of risk because it tells us how much extra risk an investor must incur to earn a higher expected rate of return on investments. Correct Answer: Numbers 1 and 3.
		Incorrect. This answer is correct, but so is no. 3.
16.			Indifference curves depicting an investor's trade-off between expected return on investment and risk are upward sloping because  Your Answer: a risk loving investor requires a higher expected rate of return as the level of risk increases. Correct Answer: a risk averse investor requires a higher expected rate of return as the level of risk increases.
		Incorrect. A risk averse investor requires a higher expected rate of return for each level of risk than risk neutral or risk loving investors.
17.			An indifference curves depicting a slightly risk averse investor's trade-off between expected return on investment and risk would have  Your Answer: a much steeper slope than that of a more risk averse investor due to the investor needing only a small increase in the expected return in exchange for a higher standard deviation of return. Correct Answer: a much flatter slope than that of a more risk averse investor due to the investor needing only a small increase in the expected return in exchange for a higher standard deviation of return.
		Incorrect. A small increase in the expected return for an increase in risk is illustrated by a flatter slope of the indifference curve.
18.			Loss aversion is defined as  Your Answer: an investor preferring a higher expected income despite a high degree of variability in the possible outcomes in order to compensate for past investment losses. Correct Answer: the tendency for individuals to prefer avoiding losses over acquiring gains.
		Incorrect. Loss aversion refers to a person wanting to avoid realizing a loss to acquiring gains.
19.			An example of loss aversion would include  Your Answer: an investor refuses to sell an asset below its purchase price even though the investor could use the capital loss to offset taxable capital gains income and invest the sales proceeds in income generating assets.
		Correct.
20.			"Rules of thumb" in economic decision making, such as "anchoring" and ignoring seemingly unimportant pieces of information,  Your Answer: introduce bias into people's buying decisions and result only in much inefficiency and waste. Correct Answer: can introduce bias into buying decisions but can also save time when making everyday economic decisions, thus offsetting some of the negative bias they introduce.
		Incorrect. The time saving effect of rule of thumb decision making may offset some of the negative bias.

Chapter 6 : Production

Multiple Choice