Exam Solutions: The multiple choice answers (for Version A) are given in boldfaced print and the short answer question answers are given below each question.

Part 1. Multiple Choice Questions (2 pts. per question).
1. Which of the following is a source of market failure:
a. situations where equilibrium prices are too high, no matter the reason
b. situations where equilibrium output is too low, no matter the reason
c. situations where at least some unemployment exists
d. free riding, which affects the provision of public goods

2. Opportunity cost is defined as:
a. the monetary cost of taking certain actions
b. the cost of foregone alternatives
c. the effect of one event on another variables
d. the cost associated with having different opportunities

3. The assumption of ceteris paribus states:
a. hold all "other things" constant
b. quantity demanded will always decrease as price rises
c. higher quality leads to higher prices
d. consumers will always spend something each period

4. The assumption of ceteris paribus is vital to economic analysis because:
a. holding other things constant allows us to examine the specific relationship between two variables
b. when quantity demanded decreases with higher prices, the demand curve has a negative slope
c. higher quality leading to higher prices helps us realize that the Consumer Price Index (CPI) may not accurately reflect price changes for consumers
d. when consumers spend at least $1, we can ignore savings and focus only on consumption

5. Points located outside a production possibilities curve (PPC) represent:
a. efficient production points
b. inefficient production points
c. points where consumption is possible, but after utilizing our comparative advantage
d. points where consumption is possible, but after unemployment decreases

6. Points located at the corner of a PPC (where the PPC meets the axis, and only one good is produced) represent:
a. efficient production points
b. points involving some unemployment for both goods
c. points involving unemployment only for one of the goods
d. inefficient production points

7. How does a PPC embody the concept of opportunity cost?
a. by showing that it is possible to move inside the curve or that shifts may occur
b. by showing the maximum amount that can (currently) be produced
c. by the fact that the PPC has a negative slope
d. by working with only two goods on each graph, rather than three or more different goods

22. If your income is $35,000, then in which city (above) do you have the most purchasing power?
a. San Francisco
b. Houston
c. New York
d. Los Angeles
e. Detroit

23. Suppose your nominal income in June (1999) in New York was $40,000. In the base year (1984) it was also $40,000. By how much has your real income changed between the base year and June, 1999?
a. decreased by about $17,000
b. decreased by about $29,000
c. there was no change in my real income
d. unable to calculate, since we don't know the base year CPI

24. If you're offered $40,000 in Philadelphia, then which of the following alternative offers provide you with greater purchasing power (if any):
a. $40,000 in New York
b. $36,000 in Houston
c. $39,000 in San Francisco
d. $35,000 in Los Angeles
e. none of the above

25. What do quantities purchased (for each good) reflect in the CPI?
a. quantities are used to more easily calculate the CPI inflation rate
b. quantities help us see whether there are increases in quality over different years
c. the quantity purchased tells us whether consumer prices are constant in different years
d. quantities serve as "weights", telling us the relative importance of each good in the CPI

26. What is disinflation?
a. an increase in the price level
b. a decrease in the price level
c. a decrease in the inflation rate
d. an increase in the inflation rate
e. a very high inflation rate (i.e. greater than 1000% per year)

27. How do you calculate the national income accounting measure called National Income?
a. Gross Domestic Product (GDP) minus Depreciation
b. Net Domestic Product minus Depreciation
c. Net Domestic Product minus Indirect Business Taxes
d. Personal Income minus Indirect Business Taxes

28. Rising real GDP is not good to use as the sole measure of social welfare (i.e. whether we, as a society, are "better off") for each of the following reasons except:
a. real GDP increases when we replace infrastructure that has been destroyed in a natural disaster, which is not consistent with the idea that we're all better off
b. higher real GDP is typically accompanied by a higher level of pollution, and if the increase in pollution is large, then we may not be better off at all
c. real GDP is an overall measure of income, so we don't know if every person is better off
d. higher real GDP is always accompanied by increases in the price level, and not everyone benefits from greater inflation

29. Given the data on the CPI handout from class, what general item (below) in the CPI has decreased in price (on average) since the base year?
a. education-related goods
b. communication-related goods
c. transportation-related goods
d. medical care
e. housing

30. In terms of each good's relative importance within the CPI, which general item (below) is given the greatest weight:
a. education-related goods
b. communication-related goods
c. transportation-related goods
d. medical care
e. housing

31. When the government measures unemployment how do they define it?
a. persons who are not employed, but are actively seeking employment
b. persons who do not have full-time employment (i.e. work 40 hrs. per week)
c. persons who are not employed
d. persons without full-time employment, but are actively seeking full-time employment

32. When people become part of the official category called "discouraged workers":
a. the unemployment rate does not change
b. the unemployment rate increases
c. the unemployment rate decreases
d. the unemployment rate may increase or decrease, depending upon the participation rate

33. Which of the following go directly into the calculation of this year's GDP
a. the expenditure I make on paint when preparing to paint my room (myself)
b. the expenditure I make buying raw materials that go into the production of something else
c. the expenditure I make buying used goods at the consignment shop (used clothing store)
d. the expenditure I make buying illegal drugs for my parents

34. What problem is avoided by counting only final goods and services in GDP, rather than total sales of all goods and services
a. the low demand problem
b. the inflationary change problem
c. the ceteris paribus problem
d. the double counting problem

35. When do we expect to see increases in cyclical unemployment?
a. after technological change causes workers to become unemployed
b. after (increased) minimum wage legislation is passed
c. after workers begin to quit existing employment voluntarily
d. after the business cycle reaches a peak

The table below corresponds with Questions #36-38.

36. According to the table above, how many people in Louisville were officially unemployed in June 1999 (if necessary, round to the nearest whole number)?
a. 12,135
b. 24,267
c. 137,569
d. 553,520
e. not enough information is given to answer this question

37. If the natural rate of unemployment in Owensboro is 5%, then - using the table above - how many people there were involuntarily unemployed in June 1999?
a. 465
b. 517
c. 2,581
d. 3,046
e. not enough information is given to answer this question

38. In 1999, between February and June, Bowling Green's unemployment rate decreased from 2.5% to 1.9%. Holding everything else constant, this decrease implies that more unemployed people became employed, but only if:
a. discouraged workers accepted jobs
b. the participation rate decreased
c. the participation rate did not change
d. part-time workers become full-time workers

39. The natural rate of unemployment in the U.S. is about 5%. How does the natural rate of unemployment compare with our current official unemployment rate?
a. the current unemployment rate is slightly below the natural rate of unemployment
b. the current unemployment rate is about triple the natural rate of unemployment
c. the current unemployment rate is about double the natural rate of unemployment
d. the current unemployment rate is definitely above the natural rate of unemployment, but not quite double the natural rate

40. Consider the total number of people who are not in the labor force. The handout from class revealed which of the following statements about this group (during 1997 and 1998):
a. a large majority of these people are officially classified as "discouraged" (over job prospects)
b. a large majority of these people are officially classified as "wanting a job"
c. a large majority of these people are officially classified as "not wanting a job"
d. a large majority of these people are officially classified as "wanting a job, but not having searched in the previous year"
e. all of the above

Part 2. Short Answer Questions (Points possible are given by each question)
Questions #1 and 2 consider the PPC relationship in Country A for tractors and automobiles.

Assume that you begin at a point involving full employment of all factors and resources.

1. Discuss the effect of each change (below) on Country A's PPC.
[note: you may use graphs as part of your explanation, but full credit is only possible by accurately and succinctly discussing the relevant issue(s) associated with each event]

[4 pts]
Event 1: there is a decrease in the demand for automobiles, but no change in the demand for tractors

For each of the three events, assume the following: the quantity of automobiles produced is located on the horizontal axis of the PPC graph, and the quantity of tractors produced is located on the vertical axis.

There is no shift in the curve, simply movement from point to point. The movement is from a point located on the curve to a new point inside the curve. Because demand decreases for one good (automobiles) and not for the other good (tractors), the moveme nt is directly to the left (i.e. parallel to the horizontal axis). On the graph below, this is illustrated by moving from pt. A to pt. C.

[4 pts]
Event 2: there is a decrease in the productivity of tractor workers (only), but no change in unemployment within either industry

There is an inward shift in the curve, but only for one good (tractors). The shift (decrease) shows lower levels of tractor production for every unit of automobiles produced, until you get to the point where only automobiles are produced. If we assume t hat no unemployment exists initially, then this economy is located at a point on the new curve. On the graph below, this is illustrated by moving from pt. A to pt. D.

[4 pts]
Event 3: technological change forces some workers in the automobile industry to become unemployed (no effect on the tractor industry)

There is an outward shift in the curve, but only for one good (automobiles). The shift (increase) shows higher levels of automobile production for every unit of tractors produced, until you get to the point where only tractors are produced. If we assume that no unemployment exists initially, but that this change creates some unemployment, then this economy is now located at a point between the old curve and the new curve. On the graph below, this is illustrated by moving from pt. A to pt. E.

[4 pts]
2. Country A is the least efficient automobile producer in the world (i.e. high opportunity cost), but consumers in Country A want at least some automobiles. How does the Law of Comparative Advantage make Country A increase their "consumption&quo t; of tractors without sacrificing their "consumption" of automobiles?

Country A has a comparative advantage in producing tractors if their opportunity cost of producing tractors is lower than that of other countries. According to the Law of Comparative Advantage, once Country A finds a country with a comparative advantage in producing automobiles, each country should specialize in producing the good where they have comparative advantage.

After specializing, both countries can trade amongst themselves. This allows each country to consume at a point located "outside" their PPC. Hence, by following the Law of Comparative Advantage, Country A can have more of at least one of these two goods , and no less of the other.

[4 pts]
3. Suppose you're the manager of some rural bank (the only bank in the area), and you know that inflation is coming. Would you want to raise your interest rates on savings accounts? Explain.

There are two possible answers to this question.

Answer 1. From the perspective of a savings account, the bank is a borrower, the customer is a lender (creditor). Borrowers are better off with inflation, because inflation erodes the value or purchasing power of the money to be repaid. As a bor rower, the bank has an incentive to keep interest rates the same because by doing so they (effectively) don't have to pay back as much money to customers when those customers retrieve their savings accounts.

Answer 2. Although banks may have an incentive to keep savings account interest rates from going up during inflation, banks also realize that customers know how inflation affects their savings. If the inflation rate exceeds the savings account in terest rate, then customers lose money by placing dollars in a savings account. To prevent customers from pulling money out of savings accounts, the bank may raise interest rates on savings.