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Microeconomics and Policy Analysis

Midterm Exam – Due October 30, 2022

1.    (55 points) Suppose that in 2021 the demand for electricity in Ukraine was QD  = 133 _  P and the supply of electricity was QS  = 66P, where quantity is measured in billions of kilowatt hour per year, and price is measured in hryvnia (UAH) per kilowatt hour.

a.   (7 points) Illustrate the Ukrainian demand and supply of electricity on a graph where you place quantity on the horizontal axis and price on the vertical axis.  Make sure to label the axes and   indicate the relevant intercepts of the demand and supply functions.

b.   (7 points) Find the equilibrium price and quantity, and illustrate your answer on the graph that you drew in part a.

The Russian invasion has led to significant damage to the power stations across Ukraine. It has been   estimated that, holding the price constant, the supply of electricity in Ukraine in 2022 has fallen by 30 (billions of kilowatt hour).

c.   (8 points) Illustrate the effects of this shock on the graph of part a, and illustrate the resulting change in consumer surplus.

d.   (6 points) Why would the equilibrium quantity of electricity fall by less than 30 (billions of kilowatt hour)? Explain.

e.   (6 points) Why does the price elasticity of demand affect the extent of the change in equilibrium price even if the demand does not shift? Explain.

In order to alleviate the effects of the contraction in electricity supply on consumers, the Ukrainian          government is considering eliminating a per-unit tax that was levied on the production of electricity. (We did not consider the role of the tax in the previous parts).

f.    (5 points) Why would the elimination of a tax on production benefit consumers? Clearly explain.

g.   (6 points) Given the elasticity of demand and supply that are implicit from the two equations     above, who do you expect to gain the most, consumers or producers, from the elimination of the tax? Clearly explain.

h.   (5 points) Would the elimination of the tax attain Pareto efficiency despite the fact that this will hurt the government? Carefully explain.

i.    (5 points) Suppose that Ukrainian consumers and producers compensate the government for its loss in tax revenue. Would then the elimination of the tax be a Pareto improvement? Carefully explain.

2.    [45 points] Vika is a Ukrainian person who has 4,000 hryvnia (UAH) per week to spend on firewood and other goods during the winter of 2023. Suppose that the price of one cubic foot of firewood is 200 UAH and the price of one unit of other goods is 1 UAH. Hence, the quantity of other goods that she    purchases is equal to her expenditure on other goods.

a.   (5 points) Illustrate Vika’s budget constraint (make it really large) by placing firewood on the x- axis and other goods on the y-axis. Include the numerical value of the maximum amount of        firewood and expenditure on other goods that Vika can afford.

b.   (5 points) What is the opportunity cost of firewood in terms of other goods in words? How do we measure this opportunity cost numerically?

c.   (5 points) If Vika purchased 10 cubic feet of firewood, how many units of other goods could she afford?

d.   (5 points) Could Vika find it optimal to purchase i) 10 cubic feet of firewood and ii) spend 1,000 UAH on other goods? Clearly explain.

e.   (5 points) If the numerical value of Vika’s MRSFirewood,Other Goods at the basket of part c. were equal to 200, would Vika optimally choose to consume this bundle? Explain why or why not, and          illustrate Vika’s choice on the graph of part a.  Make sure to include Vika’s indifference curve.

It turns out that Vika is not allowed to purchase more than 5 cubic feet of firewood per week because the Ukrainian government has rationed the consumption of firewood.

f.    (5 points) Illustrate Vika’s constraint and Vika’s choice under the rationing scenario on the graph that you used in part a.  Make sure to include her new indifference curve. Will the rationing make Vika better off or worse off? Explain.

The government is considering discontinuing the rationing of 5 cubic feet of firewood per week by letting consumers purchase un unrestricted amount of firewood at a higher equilibrium price.

g.   (5 points) Could the elimination of the rationing make Vika better off even if the price of firewood increased? Explain and illustrate your answer on the graph of part a.

Oleg is a low-income individual who earns 1,000 UAH per week and chooses to purchase 3 cubic feet of firewood per week when the price of firewood is 200 UAH.

h.   (5 points) Would the elimination of the firewood rationing of 5 cubic feet per week (and resulting increase in the firewood price) make Oleg better off or worse off? Explain.

i.    (5 points) Under what circumstances (except for having a different income) would Oleg respond to the resulting increase in the firewood price by increasing their consumption of firewood? Clearly    explain.