Price Theory Problems

Foundations of Economics

  • According to Edward Lazear, what three themes have become fundamental in economics? Briefly describe what each of these themes means.

  • Describe the four basic tasks that must be performed by any economic system.

  • Describe the difference between exchange and production.

  • Consider the in-class discussion of supermarket lines, freeway lanes, and the stock market. The argument underlying the predicted outcomes in each case could be summarized as "the outcome has a particular pattern because if it did not, it would be in the interest of people to change their behavior in a way that would push the outcome closer to fitting the pattern." Provide another real-world example to which this argument could be applied.

  • According to F.A. Hayek, what is the economic problem of society? Briefly describe how a price-coordinated economy solves this problem.

Basics of Supply and Demand

  • Suppose the price of gasoline increases because the supply of oil decreases. Explain why the demand for gasoline will be more elastic in the long run than in the short run.

  • You decide to compare the inflation-adjusted price of gas 5 years ago to the price of gas today and notice that both its price and the quantity bought and sold have increased. True or false: you can be certain that demand increased by more than supply. Use a supply and demand diagram to support your answer.

  • Suppose that the supply of cattle was perfectly inelastic, i.e., the supply curve is vertical. Would a decrease in the demand for red meat affect the prices of the other products supplied by cattle? You may assume that the cross-price elasticity between red meat and those other products is zero, i.e., they’re neither complements nor substitutes.

  • According to the Energy Information Administration, a barrel of crude oil jointly supplies gasoline, diesel, heating oil, jet fuel, lubricating oils, asphalt, and many other products. Suppose that the invention of electric vehicles reduces the demand for gasoline but has no effect on the demand for the other products jointly supplied by a barrel of oil. Assuming the supply of oil is upward-sloping, what effect will this invention have on the price of the other products jointly supplied by a barrel of oil? Use a supply and demand diagram to support your answer.

  • Suppose that cotton or wool as substitutes. Suppose further that while the supply of cotton is upward sloping, the supply of wool is flat, i.e., perfectly elastic. A new production technique increases the supply of cotton. True or false: The quantity of wool supplied will fall, but there will be no change in the price of wool and, thus, no change in the demand for cotton. Support your answer with two supply and demand diagrams that reflect the markets for cotton and wool. You may assume that demand for both goods is downward sloping.

  • Briefly describe why, according to Armen Alchian, the forms and kinds of property rights sanctioned in a society define or identify the kinds of competition, discrimination, or behavior characteristic of that society.

Consumer Theory

  • Briefly explain why, according to Gary Becker, scarcity alone is sufficient to guarantee negatively-inclined market demand curves but not sufficient to guarantee negatively-inclined individual demand curves.

  • Bryan loves steak, hates chicken, and is indifferent to vegetables. Draw his indifference curves between (a) steak and chicken, (b) steak and vegetables, and (c) chicken and vegetables, and indicate the direction of preference in each case. Graph each scenario on a separate diagram.

  • True or false: A doubling of all prices in the economy would not affect consumer behavior. Explain your answer using either the mathematical expression for the budget constraint or a graphical illustration of the budget constraint.

  • A student of economics went one night to a bar where beer and whisky both cost $5 and drank six beers and four whiskies. The next night, this student went out to another bar where beers cost $2.50, and whiskies cost $7.50 and drank two beers and six whiskies. True or false: this student’s behavior is inconsistent. Defend your answer using a diagram that illustrates the budget constraints the student faced each night and the consumption baskets the student chose.

  • Consider two means of helping the poor. One option is giving people some quantity of goods that people consider “necessities,” like food. The other option is giving these same people the cash equivalent of these goods. For example, instead of giving them $100 worth of food, we just give them $100 in cash and let the recipients choose how to spend it. One criticism of the cash-transfer program is that recipients will use the money to purchase other goods, including those that taxpayers may find objectionable, like drugs. The underlying assumption of this criticism is that giving people some quantity of “necessary” goods like food will not affect their demand for all other goods, including those goods that taxpayers presumably do not want the recipients of welfare purchasing. (1) What does this assumption imply about people’s income elasticity of demand for food? (2) Do you think this implied income elasticity of demand for food is reasonable? If yes, why? If not, why not? (3) Assuming that your goal is to maximize the well-being of the poor as they understand it, which of the two assistance programs is guaranteed to do so, irrespective of the particular preferences of the recipients? (4) Suppose people can costlessly resell the food (or other provided items). Will there be any difference between the two programs regarding their effect on recipients’ behavior?

  • In class, we discussed two types of demand curves. The first type includes both income and substitution effects. The second includes only substitution effects. True or False: The first type of demand curve will be more elastic than the second type when the good is normal but less elastic than the second type when the goal is inferior. Explain your answer.

  • True or False: A rise in interest rate increases the opportunity cost of current consumption. Both borrowers and lenders will, in consequence, tend to reduce their current consumption. (Assume saving and borrowing are in the form of bank deposits and loans, the capital value of which does not change with the interest rate).

  • Some policymakers support increasing excise taxes on gasoline to discourage people from driving. However, they also recognize that doing so would involve raising taxes on people whose incomes are well below the top of the income distribution in the U.S. To avoid getting accused of raising taxes on the poor and middle classes, many of these same policymakers support rebating the tax revenue to the taxpayers as a lump-sum payment. Use an indifference curve diagram with all other goods on the vertical axis and gasoline on the horizontal axis to determine whether this policy would leave consumers of gasoline at least as well off as they were before the tax. Assume that everyone receives a lump-sum transfer equal to the amount of the tax that they paid. Note that while the rebate plan does involve income and substitution effects, you do not need to illustrate these effects on your diagram to answer this question.

Exchange

  • According to Harold Demsetz, how do private property rights act to internalize externalities?

  • True or false: the slope of an indifference curve reflects the minimally acceptable trade. Explain your answer using an indifference curve diagram.

  • Use an Edgeworth Box to explain why it is not inconsistent to claim that (a) people’s preferences differ and (b) at their current consumption levels, their marginal rates of substitution are equal. Will the equality between marginal rates of substitution hold in the case of a bilateral monopoly? Why or why not?

The Firm

Production and Costs

  • George Stigler argues that, "[i]f one considers the full life of industries, the dominance of vertical distegration is surely to be expected." What reason does he offer to support this conjecture?

  • True or false: The larger the minimum efficient scale becomes relative to industry demand, the fewer firms there will be in the industry.

  • Assume that a firm employs positive quantities of both capital and labor. True or false: If the marginal productivity per dollar spent on capital exceeds the marginal productivity per dollar spent on labor, then the firm should either use more capital, less labor, or some combination thereof.

Competitive Industry

  • "A competitive firm with a constant returns to scale production function will produce either an unlimited amount of output, no output, or an indeterminate amount of output." Explain.

  • Consider a competitive, constant-cost industry in long-run equilibrium. Policymakers unexpectedly impose a per-unit tax on the output produced by the firms in this industry. Depict the effect of the tax on the representative firm’s cost curves. What will the effects of the tax be in the short run on industry output and price? Will the price increase by the full amount of the tax in the short run? What about in the long run? How would your answers to these questions change if the industry was characterized by increasing-cost instead?

  • Assume that the U.S. oil industry is competitive, characterized by constant cost, and is currently in a state of long-run equilibrium. In order to encourage the production of oil, the federal government gives firms in the oil industry a subsidy that is independent of the quantity of oil they produce (economists call this type of subsidy a lump-sum subsidy). Will the rate at which each oil-producing firm increase, decrease, or stay the same? How will the subsidy affect industry profits in the short run? What about the long run? How is consumer and producer surplus divided up in the long run? In other words, which group is the primary beneficiary of the subsidy?

  • Suppose a group of rental apartments has been subject to a binding rent control for some time. After seeing the negative consequences the rent control has wrought, government officials decide to repeal the rent control. Suppose further that the rental market is competitive and characterized by increasing-cost. True or false: The rental rate on the apartments previously affected by the rent control will increase by more in the short run than it will in the long run.

Monopoly

  • William Baumol argues that, "[t]he crucial feature of a contestable market is its vulnerability to hit-and-run entry." Briefly explain how hit-and-run entry may force firms with market power to behave as competitive firms.

  • Gary Becker argues that "monopoly and other imperfections are at least as important…in the political sector as in the market place." Briefly explain the implications this conjecture has for the desirability of government intervention aimed at correcting imperfections in the economy.

  • Suppose you lived in a town with only one hospital. The city council, responding to political pressure from their constituents who believe the hospital is a monopoly, imposes a price ceiling on the hospital. True or false: This policy will definitely increase the hospital’s output.

  • Most movie theaters offer lower-priced tickets for matinees than they do for evening screenings. True or false: This pricing strategy is definitely evidence of price discrimination.

Factor Demand

  • "If among many good-hearted employers there is one determined to exploit workers, the actions of the single employer may suffice to neutralize the good-heartedness of the rest. This is because if a single employer succeeds in paying lower wages, his fellow employers may have no alternative but to follow suit, or to see themselves undersold in the product market." Explain why this statement is wrong.

  • Some economists argue that taxing capital has the benefit of increasing employment and wages because such taxes increase the demand for labor. Use an isoquant/isocost diagram to illustrate that the validity of this claim requires that the substitution effect be larger than the scale effect brought about by the tax on capital.

  • True or false: An increase in demand for college economics courses has no effect on the productivity of economics professors and thus no effect on the demand for professors.

Factor Supply

  • According to Our World in Data, the number of annual hours worked in most developed countries has been steadily falling since 1870. At the same time, GDP per capita in these countries has been increasing. What does this evidence suggest about the relative strengths of the income and substitution effects between labor and leisure? What about the shape of the labor supply curve?

Externalities

  • According to Harold Demsetz, why may it be efficient for there to be some "inequalities (instead of equalities required for produced goods) among our marginal rates of substitution and marginal rates of transformation?"