Econ 1 Quiz 2 Free Response Questions Suggested Answers

Prompt: Allie spends all of her income on two goods: gas and books. The price of gas is $4 per gallon and the
price of books is $20 per book. At her current consumption levels, her marginal utility for gas is 60 utils per
gallon. Suppose Allie understands utility maximization and has decided to spend more on books and less on gas.
What must be true of her marginal utility of a book right now? (For example, you might write, "MU of a book
must be > 50" , or "MU of a book must be < 50.") Explain your reasoning. Answer in 2 sentences.

Suggested Answer: When MU per $ is not equal across goods, consumers increase their utility by allocating their
spending towards the good with higher MU/P (more “bang-for-the-buck”). In this case, if she is buying more
books, it must be the case that MUb/Pb > MUg/Pg, or MUb/20 > 60/4, or MUb > 300 (=1200/4).

Grading notes: Partial credit was granted if the student demonstrated understanding of the rational spending rule
(i.e. to maximize utility MUx/Px=MUy/Py).

(Note: This question tested understanding of the concept applied in Problem Set 2 #4. )

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Prompt: Preston owns two premium pretzel stands. Store A is in a busy downtown with many other premium
snack stands. Store B is in the small local airport where Preston is the only snack seller. Preston initially charges
$4 per pretzel at both locations. Preston would like to increase revenue and decides to increase price at one of his
stands. In which location (A: downtown, or B: airport) should he consider raising the price? Defend your answer
in 3 sentences. Be sure to name the economic concept relevant to the question, and how it relates specifically to
Preston's decision.

Suggested Answer: Preston should consider raising the price at Store B at the airport. Demand is likely to be more
inelastic (less price elastic) at the airport than downtown due to the lack of substitute snack sellers at the airport.
The total revenue effect tells us that when demand is inelastic, an increase in price increases revenue, because the
decrease in quantity demanded in response to a price increase is relatively small.

Grading notes:

You get -0.5 if you're missing a small part of the explanation - For example, if you have not explained why the
demand is inelastic or what the impact of inelasticity on quantity demanded/revenue is. Some of you have said
that there will be no change in quantity demanded in case of inelasticity and that demand will remain constant no
matter what the price - you've lost 0.5 for that too.

You get -1 if you're missing a major part of the explanation, where you have not referred to the concept of
elasticity or total revenue effect and simply stated that the price should be increased in the airport shop because
there is less competition there and that the shop is a monopoly.

You get -1.5 if you have correctly answered that Preston should increase revenue in the airport shop (B), but
either you have not provided any explanation or provided an explanation that is inadequate/incomplete/based on
incorrect principles. Some of you have based your answer on the assumption that Store A is in perfect
competition, even though the question offers no evidence to imply that Store A meets all the conditions of being
in a perfectly competitive market. You've lost points for that too.

(Note: This question tested understanding of the same concept applied in Section Exercise W4_S1 #1.)