Gianmarco OttavianoLondon School of EconomicsEC102 - Economics B – MTMicroeconomics

Moodle Test 1 (Lectures 1 & 2)

Question 1:

• “Saudi Arabia can pump all the oil it needs. Therefore, consumption of oil is free in Saudi Arabia”. This statement is:

a) Trueb) False

Explanation:

Oil consumption has an opportunity cost for Saudi Arabia. It is the goods and services Saudi Arabia could have received by selling, rather than consuming, the oil.

Question 2:

• Suppose the crisis has reduced the extra money high-skill jobs pay relative to low-skill ones. Accordingly:

a) More people attend school b) People quit education earlierc) People quit education later

Explanation:

The reduction of the skill premium reduces the marginal benefit of education (MB) leaving its marginal cost (MC) unaffected. Graphically, that implies a downward shift of the marginal benefit curve MB to MB’ as shown in the following figure.

Question 3:

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• If bread and butter must be consumed together, an increase in the price of butter:a) Increases the price of bread b) Increases the number of loaves consumedc) Has no impact on the price of bread and the number of loaves consumedd) Decreases the price of bread and the number of loaves consumed

Explanation:

As shown in the following figure, the increase in the price of butter (a complement) induces a downward shift in the demand for bread. The price and quantity both fall, as determined by the intersection of D′ and S.

Question 4:

• Sue can choose between 10 memory sticks and 5 software manuals, or 9 memory sticks and 20 software manuals. If her tastes are complete, transitive and non-satiated:

a) We can predict she will choose the first option b) We can predict she will choose the second optionc) We can predict she will be indifferent between the two optionsd) We cannot predict her choice

Explanation:

We cannot predict which bundle Sue will choose for the following reasons. The assumption of completeness requires only that she has a preference (or expresses indifference). Non-satiation is not violated by the selection of either bundle in this example.

Question 5:

• Louise is purchasing 150 Russian novels and 30 comic books. She would be willing to give up 3 Russian novels for 2 more comic books. Her marginal rate of substitution of Russian novels for comic books is:

a) 1

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b) 0.5c) 1.5d) 5

Explanation:

Louise’s marginal rate of substitution of Russian novels for comic books is 3 Russian novels to 2 comic books, so it equals 1.5. The initial levels of consumption of the two types of book does not matter in this example.

Question 6:

• The marginal rate of substitution of 20-cent coins for 50-cent coins is: a) 1 b) 0.4c) 2.5d) 5

Explanation:

The consumer is indifferent between holding (a multiple of) two 50p coins or (the same multiple of) five 20p coins or any possible combination between. This fungible property is a key feature of a currency and applies also to different currencies if they are convertible. For example, if the consumer were indifferent between holding two 1£ bills and five 1$ bills, 2.5 would be the exchange rate of pounds for dollars.

Question 7:

• A university had initially allocated £500k to lectureships and scholarships, each of which costs £50k and £10k respectively. Its trustees have later reduced the overall budget to £300k. Hence, the opportunity cost of a scholarship has:

a) Fallen b) Increasedc) Remained unchanged

Explanation:

The opportunity cost of a scholarship is 0.2 lectureships (£10k/£50k) no matter how large the overall budget is.

To consolidate this point, it is useful to discuss the budget constraint of the university in detail.

The university’s budget constraint is 500,000 = 50,000 × f + 10,000 × s, where f is the number of lecturing positions and s is the number of scholarships offered. As reported above, the opportunity cost of a scholarship is 0.2 lectureships. Graphically, the budget constraint is represented by line B0

in the following figure where the slope captures the opportunity cost of a scholarship.

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When the budget is reduced to £300k, the university’s budget constraint shifts in from B0 to B1 maintaining the same slope:

The slope of the budget constraint is only affected by changes in the relative costs of scholarships to lectureships. For example, with a constant budget of £500k, if the cost of lectureships drops to £25k, the opportunity cost of a scholarship rises to 0.4 lectureships. The university’s budget constraint pivots to B2, which marks off a larger feasible set than B0.

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