A little while back, I posted the first half and then the second half of the honors exam in economics that I administered at Oberlin College. Since then, I’ve slowly doled out a few answers, but I’m getting more and more requests for the complete set. Here, then, are the questions and answers for the first half; I warn you that some of these are pretty technical. I’ll post the second half soon.
Question 1. When the price of peanuts rises, Frieda reduces her root beer consumption. If Frieda’s income rises, will her root beer consumption go up or down?
Answer: When the price of peanuts rises, two things happen that might affect Frieda’s root beer consumption: First, the relative price of root beer has fallen, which makes her consume more root beer. (Economists call this the substitution effect.) Second, Frieda feels poorer, which could make her consume either more or less root beer. (Economists call this the income effect.) Since the substitution effect is positive (i.e. it leads to more root beer) and the sum of the two effects is negative, we can infer that the income effect is negative. In other words: Frieda’s root beer consumption moves in the same direction as her income. So if her income rises, her root beer consumption goes up.
The Most Common Wrong Answer: When the price of peanuts rises, Frieda feels poorer and consumes less root beer. Therefore her root beer consumption moves in the same direction as her income, so when her income rises she consumes more root beer.
This is wrong, because it assumes that when the price of peanuts rises, Frieda feels only an income effect. A correct answer must account for the substitution effect as well.
Question 2. Bananas cost $6 apiece, except for members of the banana club, who pay $2 apiece.
- Given full knowledge of Thomas’s preferences, explain how you’d compute his willingness to pay for a membership in the banana club.
- Given knowledge only of Thomas’s demand curve for bananas, explain how you’d estimate his willingness to pay for a membership in the banana club.
- Under what circumstances is your estimate an overestimate? Under what circumstances is it an underestimate?
Answer (this one is technical!):
- Given full knowledge of Thomas’s preferences, you can first predict how many bananas he buys (and how much money he has left over) at the current $6 price. Now identify another combination of bananas-plus-other-goods that satisifies two conditions: a) Thomas likes it exactly as much as he likes his current basket and b) If Thomas owned this basket and bananas were priced at $2 each, he’d neither want to buy or sell bananas. Finally, compute the amount of money you’d have to take from him so that if bananas were priced at $2 each, he could just afford this latter basket. Here is the (technical) diagram that illustrates this answer. (Click the picture for higher resolution):
- You can approximate Thomas’s willingness to pay as the area bounded by his demand curve, the $6 price, and the $2 price, i.e. the shaded area here:
- If bananas are a normal good, the area is an underestimate; if bananas are an inferior good (i.e one that Thomas consumes less of when his income increases), the area is an overestimate.
Question 3. Snidely Whiplash owns all the grocery stores and all the houses in the Yukon Territory. He charges a competitive price for groceries, and rents the houses at the highest price residents (who are all identical) are willing to pay. (If he charged any more, they’d all leave town). True or False: If Snidely raises the price of groceries, he’ll have to lower the price of housing, so he’ll be no better off than before.
Answer: I’ve answered this one here.
Question 4. Discuss the consequences for economic efficiency of giving your father a Barnes and Noble gift card, under various assumptions about how he uses (or doesn’t use) the card.
Answer: If he doesn’t use the card at all, or if he uses it to buy books he’d have bought anyway, then the transaction is perfectly efficient. (When he doesn’t use the card, wealth is transferred from you to Barnes and Noble; when he uses it to buy books he’d have bought anyway, wealth is transferred from you to your father; in neither case is any wealth destroyed.)
If he uses a $50 card to buy books he wouldn’t otherwise have bought (because, for example, they were worth only $30 to him) then the simplest answer is that the transaction is inefficient because $50 worth of resources have been devoted to giving your father $30 worth of pleasure. On the other hand, this is so only if you believe the $50 book price accurately reflects the costs of production; if publishers have some monopoly power, this might not be true.
Question 5. Rank these taxes in order of how much you’d dislike paying them:
- A tax on consumption
- A tax on wages
- A tax on income (including wages, interest and dividends)
Assume that the tax rates are adjusted so that your total tax bill is the same in each case.
Answer: I’ve answered this one here.