Economics 310 Price Theory

Economics 310Price Theory First Exam-Spring 2001 Department of Economics College of Business and Economics California State University-Northridge Professor Kenneth Ng Friday, January 3, 2020

Wash Clothes Cook Dinner John 1 hours 2 hours Betty 15 minutes 1 hour Question 1 • (40 points). John and Betty recently began living together. The number of hours required to complete two household tasks for each person are given in the table below. • Betty suggests that a fair way of dividing the household chores is to take turns. One week she will wash the clothes and John will cook dinner. The next week she will cook dinner and John will do the laundry. Is this a good way of dividing up the household chores. Explain using economic principles and terminology. • Numerically demonstrate your answer. • Suppose John took a cooking course at the local community college where he learned how to cook a meal in 15 minutes. Explain using economic principles and demonstrate numerically what effect this would have on John and Betty.

Wash Clothes Cook Dinner John 1/2 2 Betty 1/4 4 Question 1 A • Betty suggests that a fair way of dividing the household chores is to take turns. One week she will wash the clothes and John will cook dinner. The next week she will cook dinner and John will do the laundry. Is this a good way of dividing up the household chores. Explain using economic principles and terminology. Betty’s plan is a bad way of dividing the chores. It would be better for each person to specialize in the production of the good in which they have a comparative advantage and exchange for the good in which they have a comparative disadvantage. Betty has a comparative advantage in washing clothes and John has a comparative advantage in cooking dinner. If they did this they could collectively and individually enrich themselves.

Question 1B • John has the comparative advantage in cooking dinner. Betty has the comparative advantage in washing clothes. • Start with the situation where each is washing their own clothes and cooking their own meals: • John is cooking 7 dinners (14 hours) and doing 4 loads of laundry (4 hours) per week-18 hours doing chores. • Betty is cooking 7 dinners (7 hours) and doing 4 loads of laundry (1 hour) per week-8 hours doing chores. • They should now specialize in the production of the good in which they have a comparative advantage. • Suppose Betty does 3 loads of John’s laundry in exchange for 1 dinners. Now John is cooking 8 dinners and doing 1 load of laundry (17 hours) and Betty is doing 7 loads of laundry and cooking 6 dinners (7.75 hours). • John is saving one hour and Betty is saving .25 hours. Numerically demonstrate your answer. Computing opportunity cost yields the following

Wash Clothes Cook Dinner John 4 dinners 1/4 loads of laundry Betty ¼ dinner 4 loads of laundry Question 1C Suppose John took a cooking course at the local community college where he learned how to cook a meal in 15 minutes. Explain using economic principles and demonstrate numerically what effect this would have on John and Betty. • John still has the comparative advantage cooking dinner but the difference in opportunity costs between John and Betty is now greater. Since they are now more different the gain to specialization and exchange will be larger. • Use the same example from the previous slide where each is washing their own clothes and cooking their own meals: • John is cooking 7 dinners (3.75 hours) and doing 4 loads of laundry (4 hours) per week-7.75 hours doing chores. • Betty is cooking 7 dinners (7 hours) and doing 4 loads of laundry (1 hour) per week-8 hours doing chores. • If they specialize as before: • Betty does 3 loads of John’s laundry in exchange for 1 dinners. Now John is cooking 8 dinners and doing 1 load of laundry (3 hours) and Betty is doing 7 loads of laundry and cooking 6 dinners (7.75 hours). • John is saving 4.75 hour and Betty is saving .25 hours.

Question 2 • Consider a person who works 2000 hours a year, makes $15/hr, and spends $500 per month on rent. • 1. Draw budget lines and indifference curves depicting this individual. Label full both axes. • 2. Suppose the individual received a raise to $20 per hour. Show how this would affect his expenditures on housing if housing were an inferior good. Show the substitution and income effect of the increase in his wage. • 3.Suppose the individual now got married and had a child. What effect would this have? Explain using relative price and marginal rates of substitution. Depict the change on your graph.

$40,000 Income $30,000 $40,000 $30,000 $6,000 Draw budget lines and indifference curves depicting this individual. Label full both axes. Suppose the individual received a raise to $20 per hour. Show how this would affect his expenditures on housing if housing were an inferior good. Show the substitution and income effect of the increase in his wage. Since the slope of the BL hasn’t changed, there is no substitution effect. Because housing is an inferior good, the amount of housing chosen falls as his income increases. $15/hour B New optimum I2 Income effect Initial optimum A $20/hour I1 0 Housing Income effect

Income Suppose the individual now got married and had a child. What effect would this have? Explain using relative price and marginal rates of substitution. Depict the change on your graph. Having children will make housing more valuable relative to other goods. This will cause the MRS between housing and income to increase and the IC curve through a point to become steeper (purple to red). B New optimum I2 $20/hour I1 0 Housing

Question 3 • Suppose that each month Lillian gets a $500 allowance from her parents for clothing and entertainment. In March, she spends $300 on clothing and $200 on entertainment. In April, she gets another $500 from her parents and spends $200 on clothing and $300 on entertainment. • If Lillian's preferences haven't changed what has happened to the relative price of clothing? Use the axes below to depict and explain what has happened on an indifference curve and budget line graph. • Does the change from part A create a substitution and income effect. Show and explain on your graph. • Suppose the relative price of clothing changed from 2 to 1. Show the change on an indifference curve/budget line graph. Indicate on the graph the income and substitution effect of the change in relative price. Assume that clothing is an inferior good. • In June, Lillian’s father decides its’ time “to learn the value of hard work,” so orders her to get a job rather than just live off her allowance. Lillian gets an offer to work as a sales clerk at her favorite stores--Fred Segal’s on Rodeo Drive. The job pays $6/hour, she works 15 hours per week and she works 4 weeks each month. In addition, she gets 50% off clothing she buys in the store. Depict the change in her budget line if she accepts the offer and her father cuts her allowance from $500 to $250 per month. • Suppose Lillian’s father eliminates her allowance altogether. Is it possible that Lillian will do something to get fired from her job so that she can go back to being unemployed and collect a $500 allowance from her father? Use budget lines and indifference curves to show and explain.

Entertainment 5 3 A B 10 5 4 3 2 Suppose that each month Lillian gets a $500 allowance from her parents for clothing and entertainment. In March, she spends $300 on clothing and $200 on entertainment. In April, she gets another $500 from her parents and spends $200 on clothing and $300 on entertainment. If Lillian's preferences haven't changed what has happened to the relative price of clothing? Use the axes below to depict and explain what has happened on an indifference curve and budget line graph At point A, the price of clothing is $100 and the price of entertainment is $50. If the price of entertainment increased to $100, the BL would shift to the purple dotted line. 0 Clothing

Entertainment 5 3 A B 10 5 2.5 C Suppose the relative price of clothing changed from 2 to 1. Show the change on an indifference curve/budget line graph. Indicate on the graph the income and substitution effect of the change in relative price. Assume that clothing is an inferior good. The S-effect is shown from A to C. The I-effect is shown from C to B. Since clothing is an inferior good, the decrease in income causes clothing consumption to increase. 0 Clothing

Entertainment 5 3.6 5 10 6.1 In June, Lillian’s father decides its’ time “to learn the value of hard work,” so orders her to get a job rather than just live off her allowance. Lillian gets an offer to work as a sales clerk at her favorite stores--Fred Segal’s on Rodeo Drive. The job pays $6/hour, she works 15 hours per week and she works 4 weeks each month. In addition, she gets 50% off clothing she buys in the store. Depict the change in her budget line if she accepts the offer and her father cuts her allowance from $500 to $250 per month. Entertainment costs $100. Clothing costs $100. If she earns $360/month and gets a 50% discount on clothing, she can buy 3.6 units of entertainment or 10 units of clothing. If she still gets $250 in monthly allowance she can buy 6.1 units of entertainment or 12.5 units of clothing. 0 Clothing

Entertainment 5 3.6 5 10 6.1 Suppose Lillian’s father eliminates her allowance altogether. Is it possible that Lillian will do something to get fired from her job so that she can go back to being unemployed and collect a $500 allowance from her father? Use budget lines and indifference curves to show and explain. If her father completely takes away her allowance she will be forced onto the solid blue budget line. The purple IC’s show her preferences when she would prefer to get the $500 allowance and not work. The green budget lines show her preferences if she continues to work even if she could not work and get her $500 allowance. 0 Clothing

Summary Statistics

Mandatory one week cooling off period.Questions regarding the exam will be handled only in office hours beginning next Tuesday.BB4262, TTH 12:30-1:30 PM, T 9:30-10:30 AM

Economics 310 Price Theory