Economics for Everyone

Problem Set 2
Due February 20th 2019, 1:30pm CT

Instructions: Students are encouraged to turn in this problem set in groups. Please turn in one
problem set per group with all group members listed. Students whose names are not listed on the
problem set will not receive credit. Remember that as per the course policy, two points will be
deducted from your grade for each member in your group. Be sure to submit your assignments in
hard copies before the beginning of the class.

50 points total

Part I - Short Answer [15 points]

Select every answer that applies and write a short (1-2 line) explanation justifying your response.

1. Present bias can explain which of the following education-related behaviors [2 point]
a) Students place more weight on tuition fee than on living expenditure in deciding which
school to attend
b) An immediate reward has a greater impact on student performance than a delayed reward
c) An incentive framed as a loss has a greater impact on student performance than an equal-
sized incentive framed as gain
d) Students drop out of school even when the return to additional years of schooling are higher

2. An investigator is studying the relation between the physical and intellectual growth of primary
schoolchildren (grades 1-6). At each grade level, she notes that the correlation between the height
of children and the size of their vocabulary is zero. For all students in the school, the correlation is
likely to be: [2 points]
a) Positive
b) Negative
c) About zero
d) Cannot tell

3. Suppose Countries A and B use only labor as an input and produce only cloth and wheat. In A,
a worker in a day could produce 2 units of cloth or 4 units of wheat. In B, a worker in a day could
produce 3 units of cloth or 9 units of wheat. Suppose trade opens up. Which of the following
statements is true? [1 point]

a) Country A will export cloth to B, and import wheat from B, and each country will be able
to consume more of both products than before.
b) Country A will export wheat to B, and import cloth from B, and each country will be able
to consume more of both products than before.
c) Country A will export cloth to B, and import wheat from B, but only country B will gain
from the trade.
d) Country A will export wheat to B, and import cloth from B, but only country B will gain
from the trade.
4. In class, when talking about behavioral economics and we discussed a number of common
behavioral biases. Discuss how a particular behavioral bias might contribute to the following
scenarios. Note: you must use a different behavioral bias for each of the four scenarios! [4 points]

a) Mattress companies offer a “try our mattress risk-free for 90 days” promotion.
b) Your doctor tells you that you’re getting a treatment that saves 200 of 600 lives (rather than a
treatment that kills 400 of 600 people).
c) Fitness centers require new members to commit to a year-long contract but count on members
not working out regularly.
d) Studies have shown that people spend more money when paying with a credit card rather than
cash.

5. What price and quantity changes (if any) do you expect in each of the following scenarios? How
do demand/supply curves move? Drawings/schematics are encouraged but not required. Discuss
any assumptions needed as well
as the implications of those assumptions. [6 points]

(a) Recent years have seen an improved technology for developing alternative energy sources,
such as solar panels for homes. At the same time, the price of electricity is going up. [2
points]
(b) In recent years, more people have decided to take up a vegan lifestyle, not consuming any
animal products in any facet of life. Meanwhile, the price of leather jackets has remained
constant. [2 points]
(c) Remember from part (b) that lately more people have become vegan. Recent discoveries in
soy processing have made it much cheaper to create tofu. [2 points]

Part 2 - Long Answer [35 points]

1. Demand and Supply [15 points]

The following table provides the quantity demanded and supplied of bread (in pounds) for several
bread price levels ($ per pound).

Price Q demanded Q supplied

$9 5 80
$8 20 70
$6 50 50
$4 80 30
$2 110 10

a. By just looking at the table, determine the equilibrium price and quantity of this market
for bread. What feature of the competitive market equilibrium have you relied to answer
this question? [1 point]

b. Instead of the above table, we can parsimoniously express demand for and supply of bread
with two equations. Demand curve is given by: Q B = 140 − 15PB and supply curve is
given by: Q B = 10PB − 10 where Q B denotes quantity of bread and PB price of bread.
Algebraically, solve for the equilibrium price and quantity. Confirm that your answers are
identical to those from part a. (Hint: Solve the system of equations jointly using the
 feature of the competitive equilibrium you described in part a.) [2 points]

c. The above competitive equilibrium can also be found graphically. Graph the demand and
supply curves (with PB on the Y-axis and Q B on the X-axis), and clearly label the
equilibrium price and equilibrium quantity of bread. Make sure you label all axes and
intercepts if applicable. [2 points]

d. A naïve leader of the bakers’ union convinced the government to fix the per pound price
of bread at $8. Is this a price floor or price ceiling? Explain your answer. On the same
graph from part c., depict this situation and describe what will happen to the bread market.
[3 points]

e. Suppose a new technology is developed that allows bakers to produce bread more cheaply.
How will this innovation affect (i) the demand curve, (ii) the supply curve, (iii)
equilibrium price and (iv) equilibrium quantity? [3 points]

f. Although controversial, new scientific research has shown additional health benefits of
consuming bread, with the consequent effect of increasing demand by 50% for all price
levels. Replicate the graph from part c., and show how the demand curve is affected.
Algebraically, calculate the new equilibrium price and quantity. [4 points]

2. Supply and demand and tax policy [10 points]

Consider the market for good X and suppose it is at its equilibrium.

a. Suppose the government imposes on the sellers a per unit tax of t on the consumption of
good X. On a clearly labeled figure show the change in equilibrium after the imposition
of the tax. Clearly show the consumer surplus, producer surplus and tax revenue of the
government on your figure. Is there any of the old total surplus that is lost (i.e., goes to
none of the consumers, producers, or government)? We call this loss of total surplus
“deadweight loss.” (Hint: think above the effect of the per unit tax on the demand and/or
supply curve/s). [3 points]

b. Now, suppose good Y is a substitute for good X. What effect does the tax on X have on
the equilibrium price and quantity of Y. [1 point]

c. Suppose there are two parallel worlds: in world #1, there are only two goods: X and Y,
and they are perfect substitutes. In world #2, there are also only two goods: X and Z, and
they are perfect complements. Consider the market of good X – in both worlds, the
equilibrium price and quantity of X are the same. In which world is the demand curve for
X more elastic? Fully justify your answer. [2 point]

d. If the government’s goal is to maximize tax revenue from taxing X, which world should it
choose? In which world is consumer surplus greater? In which world is producer surplus
greater? Fully justify your answer. (Hint: Use your answer from part c. Does the elasticity
of demand affect the size of tax revenue, consumer surplus, and producer surplus?) [4
points]
3. Externalities [10 points]

Three roommates: Homer, Marge, and Bart share a house in Springfield. They are considering
turning up the thermostat by 1, 2, 3, or 4 degrees. Each time they raise the temperature in the
apartment by 1 degree their heating bill will rise by $6. Suppose they split the heating bill evenly
(each person pays $2 per 1 degree increase). Their individual marginal benefits (not including costs)
from making it warmer are as follows:

Bart Marge Homer

1 degree $7 $4 $1
2 degrees $6 $3 $0
3 degrees $5 $2 $-1
4 degrees $3 $0 $-2

a. What is the marginal social benefit from making it 1, 2, 3, or 4 degrees warmer? [1 points]

b. By how many degrees should they turn up the temperature to achieve the social optimum?
[2 points]

c. You’ll notice that Homer prefers the house at colder temperatures. Suppose Homer has the
legal rights to the thermostat. Suppose he doesn’t value Bart or Marge’s private benefits and
suppose they cannot pay him to raise the temperature: by how much would he change the
temperature, if at all? What would he base his decision on? [2 points]

d. Now suppose Marge and Bart can compensate Homer. How much would they have to pay
Homer to raise the temperature to achieve the social optimum? [3 points]

e. What is the gain in total consumer surplus achieved by allowing Marge and Bart to pay
Homer to increase the temperature? (Hint: it is the marginal social benefit of each degree
change minus the marginal cost, summed over each degree change.) [2 point]