CFA Level 1 - Economics Session 4 - Reading 13 (Notes, Practice Questions, Sample Questions) 1. An internal combustion engine is best described as a(n): A)intermediate good. B)finished good.C)factor of production Explanation — A: Engines are most likely to be consideredintermediate goods because they are used in the productionof such finished goods as motor vehicles. They areunlikely to be considered finished goods, even thoughconsumers might occasionally purchase them, because theirprimary use is in the production of other goods that aredriven by engines 2. A supply function for leather shoes is most likely to include: A)Average hourly wage for leather workers. B)Average income for all workers.C)Price of plastic shoes Explanation — A: A supply function will depend on theprice of inputs to production of leather shoes, such aswages for leather workers. A demand function for leathershoes will likely depend on, among other factors, theprice of plastic shoes (a substitute) and average incomeof all workers (who would be consumers of shoes)
3. The most likely cause for a shift in the supply curve for coffee is a change in the: A)price of coffee. B)wages of coffee harvesters. C)price of tea Explanation — B: The supply curve shifts in response to achange in the cost of inputs, such as the wages for coffeeharvesters. A change in the price of the product is amovement along the supply curve, not a shift in the curve.A change in the price of a substitute would more likelyinfluence the demand curve, not the supply curve 4. A columnist is discussing how the efficient quantity of output for a good or service is determined. These twostatements appear in his column: Statement 1: The equilibrium quantity of production for agood or service can be considered efficient as long as themarginal social benefit of that quantity is greater thanits marginal social cost.Statement 2: Subsidies and quotas typically result inproduction of a good or service in quantities at which themarginal social cost exceeds the marginal social benefit. With respect to these statements: A)both are correct.B)only one is correct. C)both are incorrect. Explanation — C: Statement 1 is incorrect. The efficientquantity of output is the quantity at which the marginalsocial benefit (demand) is equal to the marginal social
cost (supply). Statement 2 is also incorrect. Subsidiestypically lead to overproduction, where the marginalsocial cost at the quantity produced is greater than themarginal social benefit. Quotas, however, typically limitproduction to a level below equilibrium, such that themarginal social benefit at the quantity produced isgreater than the marginal social cost 5. If a change in consumer tastes causes a permanent downward shift in demand for hats, but there are nochanges in the cost of inputs to production of hats, themost likely market response would be: A)a short-run shift in the supply curve, causing a declinein the price of hats.B)no change in the price of hats because the costs ofproduction have not changed. C)a short-term movement along the supply curve to a lowerequilibrium price, and a long-run shift in supply. Explanation — C: If the costs of production do not change,the supply curve for hats will not shift in the short runin response to a decrease in demand. Instead, there willbe a movement along the supply curve to a new, lower,equilibrium price, followed by a long-run shift in thesupply curve as producers exit the business 6. A stable market equilibrium is best described as one in which: A)excess supply drives prices lower and excess demanddrives prices higher. B)the current market price equals the equilibrium price.C)the supply curve is less steeply sloped than the demandcurve.
Explanation — A: Stable market equilibria are defined asthose in which excess supply tends to drive prices lowerand excess demand tends to drive prices higher. Unstableequilibria are characterized by a downward sloping supplycurve that is less steeply sloped than the demand curve,so that excess supply tends to drive prices up and excessdemand tends to drive prices down (further away from theequilibrium value). The current market price and theequilibrium price can be equal in either stable orunstable equilibria 7. The market for radios consists of 100 consumers, each of whom has the demand function:QDradio = 4 − 0.4 Pradio + 0.0025 Income + 0.25 Pnewspaper − 0.005 Pbatteries At current average prices, a radio costs £10, a newspapercosts £1, and batteries cost £2. Average income is £1,000.The market demand curve for radios is most accuratelydescribed as: A)16.85 − 0.025 QDradio. B)400 − 40 Pradio + 0.25 Income + 25 Pnewspaper − 0.5 Pbatteries.C)674 − 40 Pradio Explanation — A: Aggregating the individual demandfunctions into the market demand function we get:QDradio = 100(4 − 0.4 Pradio + 0.0025 Income + 0.25 Pnewspaper − 0.005 Pbatteries) QDradio = 400 − 40 Pradio + 0.25 Income + 25 Pnewspaper − 0.5 PbatteriesSubstituting average values for all variables except pricewe get:QDradio = 400 − 40 Pradio + 0.25(1,000) + 25(1) − 0.5(2) QDradio = 400 − 40 Pradio + 250 + 25 − 1
QDradio = 674 − 40 Pradio 40 Pradio = 674 − QDradio Solving for price gives us the demand curve:Pradio = 16.85 − 0.025 QDradio 8. The demand function for textbooks is given by 100 − 2P, and the supply function is given by 2P − 10. At a price of 30, the market: A)has excess demand of 10. B)has excess supply of 10. C)is in equilibrium with quantity supplied and demandedequal to 45. Explanation — B: At a price of 30, quantity demanded = 100 − 2(30) = 40, and quantity supplied = 2(30) − 10 = 50. Excess supply = 50 − 40 = 10. 9. Which of the following statements best describes the principal difference between a Vickrey auction and othertypes of sealed bid auctions? A)A Vickrey auction does not use sealed bids. B)In a Vickrey auction, the winner pays the price bid bythe second-highest bidder. C)In a Vickrey auction, the winner pays the reservationprice. Explanation — B: A Vickrey auction is a second-pricesealed bid auction, in which the winner pays the price bidby the second highest bidder. The reservation price is thehighest price that a bidder is willing to pay. In a secondprice sealed bid auction, a bidder’s optimal strategy isto bid his reservation price. Because he pays the second
highest bid, the winner pays less than his reservationprice 10. Which of the following most accurately describes society's allocation of resources to the production ofgoods with external costs or external benefits,respectively? A)Under-allocation; over-allocation. B)Over-allocation; under allocation. C)Over-allocation; over-allocation Explanation — B: External costs are costs associated withthe production of goods which are not entirely borne byproducers. The industrial pollution of fishing watersdecreases the yield to the fishing industry. However, thelost revenue to the fishing industry is not considered acost to the firms generating the pollution. The result isan over-allocation of resources to the production of goodsmade by the firms generating the pollution.External benefits refer to benefits received by thoseother than the buyers of a good. Scenic gardens andfountains built by private enterprises for their owninterests are examples of goods with external benefits.Since the marginal benefit to society is greater than thatof the marginal cost to the producer, less than theefficient quantity is produced 11. Which of the following is least likely to be an obstacle to the efficient allocation of resources? A)Common resources.B)Price controls. C)Technological advancement
Explanation — C: As opposed to being an obstacle toallocative efficiency, technological advancement requiresa constant reallocation of an economy’s resources to moreefficient uses 12. Which of the following is least accurate regarding obstacles to the efficient allocation of resources in acompetitive market? A)Subsidies lead to production of more than the efficientquantity of the good.B)Quotas result in production of less than the efficientquantity of the good. C)Public goods, such as national defense, tend to beoverproduced because they can be consumed by everyonewhether they pay for the goods or not. Explanation — C: Public goods can be consumed by everymember of a society, regardless of whether they paid forthem or not. In a competitive market for public goods,fewer goods than the efficient quantity would be producedbecause it is not in each person’s interest to pay theirshare of the cost 13. Which of the following relationships most accurately describes the inefficiency resulting from governmentimposed production quotas? A)Marginal cost exceeds marginal benefit leading tounderproduction.B)Marginal benefit exceeds marginal cost leading tooverproduction. C)Marginal benefit exceeds marginal cost leading tounderproduction.
Explanation — C: Government imposed quotas restrictproduction to a level below that which would occur ifmarginal benefit equals marginal cost. This restrictedoutput quantity is less than the equilibrium quantity, somarginal benefit exceeds marginal cost 14. Which of the following statements regarding deadweight loss is least accurate? A)An overproduction of goods can lead to a reduction inconsumer surplus. B)Deadweight loss from underproduction leads to a loss ofproducer surplus but not consumer surplus. C)Deadweight loss occurs when the quantity supplied doesnot maximize the sum of consumer and producer surplus. Explanation — B: Deadweight loss is the reduction inconsumer and producer surplus due to underproduction oroverproduction 15. Which of the following is least likely to be considered an obstacle to the efficient allocation of aneconomy’s resources? A)Rent controls.B)Taxes. C)Changes in consumer tastes Explanation — C: Price controls and taxes are obstacles toallocative efficiency. Rent controls and minimum wages areexamples of price controls. As opposed to being obstaclesto the efficient allocation of resources, changes inconsumer tastes lead to the reallocation of society’sresources, producing a different mix of goods or servicesthat provide increased benefits
16. When a tax is imposed on the consumption of a good, which of the following terms refers to who bears theburden of the tax? A)The deadweight loss. B)The incidence of a tax. C)Consumer surplus Explanation — B: The incidence of a tax refers to how theburden of a tax is actually shared between buyers andsellers. The deadweight loss is the loss of the gains fromtrade from the lower equilibrium quantity that resultsfrom the tax. Consumer surplus is the gains from tradethat consumers accrue from the existence of the market 17. Which of the following statements is most accurate with respect to the effects of taxes imposed on goods andservices? A)The actual incidence will fall more heavily on theseller if the supply is less elastic relative to demand. B)The actual incidence will fall more heavily on the buyerif the demand is more elastic relative to supply.C)The statutory incidence will fall more heavily on thebuyer if the supply is less elastic relative to demand Explanation — A: When supply is relatively inelastic,changes in quantity are small for a given change in price,and a larger share of the tax burden—the taxincidence—will fall on the sellers
18. The decrease in production and trade as a result of a tax is called: A)total tax incidence.B)statutory incidence. C)deadweight loss Explanation — C: When the equilibrium quantity for aproduct or service is reduced as the result of a tax, thisis called the deadweight loss. This represents the loss,in terms of production and trade, that results from thepresence of the tax 19. When a tax on a good or service is imposed on the producers of the good or service, the: A)supply will decrease, but the incidence of the tax fallson the sellers only. B)supply will decrease, but the incidence of the tax fallson both buyers and sellers. C)demand will decrease, but the incidence of the tax fallson both buyers and sellers Explanation — B: When a tax is imposed on the producers ofa good or service, they will reduce supply at any givenlevel or market price, because they receive the marketprice minus the tax. However, the incidence of the tax,meaning how its cost is shared, falls on both the buyersand the sellers, depending upon the relative elasticitiesof supply and demand 20. The actual incidence of a tax imposed on buyers or sellers is most accurately defined as: A)the amount of tax times the equilibrium quantity.
B)the proportion of the tax burden borne by buyers andsellers. C)the party legally responsible for paying the tax Explanation — B: Tax revenue is the amount of a tax timesthe equilibrium quantity. Statutory tax incidence refersto who is legally responsible for paying a tax. Actual taxincidence represents the extent to which buyers bear thecost of the tax through a higher price paid and sellersbear the cost through a lower price received 21. Which of the following statements about a tax imposed on buyers or suppliers is most accurate? A)If demand is less elastic than supply, consumers willbear a lower proportion of the tax than suppliers.B)The proportion of the tax is borne equally by consumersand suppliers, regardless of supply and demand elasticity. C)If demand is less elastic than supply, consumers willbear a higher proportion of the tax than suppliers Explanation — C: If demand is less elastic than supply,consumers will bear a higher proportion of the tax thansuppliers. If supply is less elastic than demand,suppliers will bear a higher proportion of the tax thanconsumers 22. Which of the following is the most likely effect of a subsidy in the market for corn? A)The supply curve for corn will shift to the right. B)Marginal costs will be less than marginal benefit.C)The equilibrium quantity of corn will decrease
Explanation — A: A subsidy causes a shift rightward in thesupply curve (increase in supply at a given price level)by the amount of the subsidy. The equilibrium quantitywill increase and the price paid by buyers will decrease.Marginal cost will exceed marginal benefit and adeadweight loss will result from overproduction 23. An example of a price floor is: A)a minimum price for milk. B)a tax on ceramic tile.C)rent control. Explanation — A: A price floor is a minimum on the pricethat suppliers can charge. Such floors were once common inagricultural markets 24. Which of the following is the most likely effect of a quota on wheat? A)The supply curve will shift downward. B)Nothing if the quota is set above the equilibriumquantity. C)Marginal costs will be greater than marginal benefit Explanation — B: A quota does not cause the supply curveto shift. The equilibrium quantity will decrease to thequota amount. Marginal cost will be less than marginalbenefit, leading to a deadweight loss from underproduction 25. The imposition of a tax on producers but not on buyers in a market currently in equilibrium is most likely toincrease:
A)price paid by buyers and reduce quantity demanded. B)quantity supplied and price paid by buyers.C)actual tax incidence on producers but not on buyers Explanation — A: The imposition of a tax on producers islikely to result in an upward shift in the supply curve, areduction in the equilibrium quantity supplied anddemanded, an increase in equilibrium price, and anincrease in taxes paid by both suppliers and buyers.Actual tax incidence refers to taxes paid and notstatutory taxes, thus actual tax incidence is likely torise on both producers and buyers as market prices rise 26. Which of the following most accurately describes the impact of a price ceiling set below the equilibrium pricefor a good and a minimum wage set above the equilibriumwage, respectively? A)Shortage; increased unemployment. B)Shortage; decreased unemployment.C)Surplus; increased unemployment. Explanation — A: A ceiling that is below the equilibriumprice for a good will result in a shortage characterizedby a quantity demanded that is greater than the quantitysupplied. A minimum wage leads to increased unemploymentas firms tend to substitute capital for labor. Even thoughthere are often a large number of unemployed low-skilledworkers who may be willing to work at a wage lower thanthe minimum wage, firms cannot legally hire them 27. The effect of a price ceiling set above the equilibrium price is most accurately described by which ofthe following statements?
A)It will have no effect on equilibrium price andquantity. B)Quantity demanded will exceed quantity supplied.C)Quantity supplied will exceed quantity demanded Explanation — A: If a price ceiling is above theequilibrium price, it will have no effect on price orquantity 28. Which of the following is least likely to be the long-run effect of a price ceiling that is set below theequilibrium price? A)Consumers have to wait to make purchases. B)Sellers improve quality. C)Sellers take bribes Explanation — B: Under price ceilings, sellers may reducethe quality of goods to a level that reflects the imposedceiling price 29. If a price ceiling is above the equilibrium price in a given market, its effect will most likely be: A)nothing. B)a surplus.C)a shortage. Explanation — A: A ceiling is only effective if it isbelow the equilibrium price. If it is above theequilibrium price, then it should have no effect. If theceiling is below the equilibrium price, it will produce ashortage. In such a case, suppliers do not produce as muchas consumers wish to buy at the ceiling price
30. New legislation setting a price ceiling will most likely cause: A)a market surplus.B)a decrease in demand. C)a market shortage. Explanation — C: Price ceilings restrict the producer fromincreasing the selling price. The lower price willstimulate demand by consumers at this lower price.However, since producers will not be able to increaseprice there is little incentive for them to increasesupply. Hence, production and supply will be limited atthe price ceiling leading to a market shortage 31. Which of the following statements about price floors and the labor market is least accurate? A)In the long run, effective price floors lead toinefficiencies in production. B)If a price floor is set below the equilibrium price, thequantity demanded will exceed the quantity supplied. C)Setting a minimum wage above the equilibrium wage ratewill lead to an excess supply of labor. Explanation — B: If a price floor is set below theequilibrium price, it will have no effect on the quantitydemanded or supplied. However, a price floor (minimum wagein the labor market) above the equilibrium price (wagerate in the labor market) will cause a surplus at thefloor price. Inefficiencies result from a price floorbecause producers will divert resources to supply a largerquantity of the good, but consumers will demand a smallerquantity at the floor price
32. A minimum wage is an example of which of the following? A)A price floor. B)A price ceiling.C)Rent controls. Explanation — A: A minimum wage is an example of a pricefloor 33. A minimum wage set above the equilibrium minimum wage will most likely have which of the following effects? A)There will be a shortage of workers. B)Unemployment will rise. C)It will have no effects Explanation — B: Firms will not employ all the workers whowant to work at the imposed higher wage. Those who want towork at the higher wage but cannot find jobs will becounted as unemployed 34. Which of the following is least likely to be the result of a minimum wage? A)Labor will be substituted for capital. B)There will be an abundance of low-skilled workerswilling to work.C)On-the-job training will be cut back Explanation — A: Firms substitute capital for the“expensive” labor and use more than the economicallyefficient amount of capital
35. A price ceiling is only effective if it: A)is set above the equilibrium price.B)has been in effect in over a relatively short time. C)is set below the equilibrium price Explanation — C: A price ceiling is only effective if itis lower than the equilibrium price without the ceiling.This leads to a shortage as consumers wish to purchase aquantity of the good at the ceiling price which is greaterthan the quantity supplied at that price 36. The government imposes a tax on a good. The relative amounts of the tax that each economic actor in the marketplays is called the: A)tax incidence. B)statutory tax.C)deadweight loss Explanation — A: This is the definition of the incidenceof a tax. It is determined by the shape of the supply anddemand curves, not upon whom the tax is imposed legally(the statutory incidence of the tax) 37. If a good has elastic demand, a small price decrease will cause: A)a larger increase in quantity demanded. B)no change in the quantity demanded.C)a larger decrease in the quantity demanded.
Explanation — A: If a good has elastic demand, a smallprice decrease will cause a larger increase in thequantity demanded 38. If quantity demanded increases 15% when the price drops 1%, demand for this good: A)perfectly elastic.B)inelastic, but not perfectly inelastic. C)elastic, but not perfectly elastic. Explanation — C: Whenever quantity demanded for a goodchanges by a greater percentage than price, the priceelasticity of demand will be greater than 1.0 and demandfor the product is considered to be elastic 39. For a linear demand curve, at the price where elasticity is -2.0, reducing prices will: A)increase total revenue and we are at the point ofmaximum total revenue. B)increase total revenue and we are not at the point ofmaximum total revenue. C)decrease total revenue and we are not at the point ofmaximum total revenue Explanation — B: If the price elasticity of demand is-2.0, this indicates that the percentage change inquantity demanded is twice the percentage change in price.Thus, a decrease in price will be more than offset by theincrease in quantity, and total revenue will increase. Weare not at the point of maximum total revenue which iswhere elasticity is -1.0—the point of unit elastic demand
40. Suppose the price of computers increases from $1,000 to $1,200. Assuming the original quantity demanded forcomputers was 50 million units, and the new quantitydemanded is 45 million computers, what is the priceelasticity of demand, and is the demand for computerselastic or inelastic? A)0.58, inelastic. B)-0.58, inelastic. C)-1.73, elastic Explanation — B: Price elasticity of demand is calculatedby dividing the percent change in quantity demanded by thepercent change in price, using the average value of thevariable in the computations. The percent change inquantity demanded is (45 − 50) / [(50 + 45) / 2] = − 5 / 47.5 = -0.105 or -10.5%. The percent change in price is =(1,200 − 1,000) / [(1,000 + 1,200) / 2] = 200 / 1,100 = 0.1818 or 18.2% . The price elasticity of demand is -10.5/ 18.2 = -0.58 41. If the price elasticity of demand is 1.5 and a change in the price of the product increases the quantitydemanded by 4%, then what is the percent change in price? A) − 2.667%. B)+2.667%.C)–0.375% Explanation — A: Price elasticity of demand is calculatedby dividing the percent change in quantity demanded by thepercent change in price. The percent change in price is,therefore, the percent change in quantity demanded dividedby the price elasticity of demand = 4 / 1.5 = 2.667.Because of the inverse relationship between quantitydemanded and price, the price elasticity is always going
to be negative although economists usually ignore thenegative sign and just use the absolute value. To properlypredict the price change a negative sign needs to be addedto the price elasticity before the calculation or to theanswer after the calculation.Using the latter case, the 2.667% will become -2.667%,showing that an increase in quantity demanded of 4% willcause a decrease in the price of 2.667% when the priceelasticity is 1.5 (-1.5) 42. When demand for a good is inelastic, a higher price will: A)fail to reduce the quantity demanded for the good.B)have no impact on the demand for the good. C)lead to an increase in total expenditures for the good Explanation — C: When demand is relatively inelastic,consumers do not reduce their quantity demanded very muchwhen the price increases. That is, a given percentageincrease in price results in a smaller percentagereduction in quantity demanded. Thus, total expenditureson the good increase. "Fail to reduce the quantitydemanded for the good" is inaccurate because that wouldonly be true if demand was perfectly inelastic 43. If the number of ice cream bars demanded increases from 19 to 21 when the price decreases from $1.50 to$0.50, the price elasticity of demand is: A) − 0.1. B) − 0.2. C) − 5.
Explanation — A: If the number of ice cream bars demandedchanges from 19 to 21 when the price changes from $1.50 to$0.50, the percentage change in quantity is (21 − 19) / [(21 + 19) / 2] = 10%, and the percentage change in priceis (0.50 − 1.50) / [(1.50 + 0.50) / 2] = − 100%. Thus, price elasticity = 10% / − 100% = − 0.1 44. If quantity demanded increases 20% when the price drops 2%, this good exhibits: A)inelastic, but not perfectly inelastic, demand.B)perfectly inelastic demand. C)elastic, but not perfectly elastic, demand. Explanation — C: If quantity demanded increases 20% whenthe price drops 2%, this good exhibits elastic demand.Whenever demand changes by a greater percentage thanprice, demand is considered to be elastic 45. The primary factors that influence the price elasticity of demand for a product are: A)changes in consumers' incomes, the time since the pricechange occurred, and the availability of substitute goods. B)the availability of substitute goods, the time that haselapsed since the price of the good changed, and theproportions of consumers' budgets spent on the product. C)the proportions of consumers' budgets spent on theproduct, the size of the shift in the demand curve for aproduct, and changes in consumers' price expectations Explanation — B: The three primary factors influencing theprice elasticity of demand for a good are the availabilityof substitute goods, the proportions of consumers' budgetsspent on the good, and the time since the price change. If
there are good substitutes, when the price of the goodgoes up, some customers will switch to substitute goods.For goods that represent a relatively small proportion ofconsumers' budgets, a change in price will have littleeffect on the quantity demanded. For most goods, the priceelasticity of demand is greater in the long run than inthe short run 46. If a good has elastic demand, a small percentage price increase will cause: A)a larger percentage decrease in the quantity demanded. B)a larger percentage increase in the quantity demanded.C)a smaller percentage increase in the quantity demanded Explanation — A: If a good has elastic demand, a smallprice increase will cause a larger decrease in thequantity demanded. Demand is elastic when the percentagechange in quantity demanded is larger than the percentagechange in price 47. The cross price elasticity of demand for a substitute good and the income elasticity for an inferior good are:Cross elasticity Income elasticity A) < 0 > 0 B) < 0 < 0C) > 0 < 0 Explanation — A: The cross price elasticity of substitutesis positive, and the income elasticity of an inferior goodis negative
48. Income elasticity is defined as the percentage change in: A)quantity demanded divided by the percentage change inincome. B)income divided by the percentage change in the quantitydemanded.C)quantity demanded divided by the percentage change inthe price of the product Explanation — A: Income elasticity is defined as thepercentage change in quantity demanded divided by thepercentage change in income. Normal goods have positivevalues for income elasticity, and inferior goods havenegative income elasticity 49. If the price elasticity of demand is − 2 and the price of the product decreases by 5%, the quantity demandedwill: A)increase 5%.B)decrease 2%. C)increase 10%. Explanation — C: If the price elasticity of demand is − 2, and the price of the product decreases by 5%, the quantitydemanded will increase 10%. The value, − 2, indicates that the percentage increase in the quantity demanded will betwice the percentage decrease in price 50. If the price elasticity of a linear demand curve is − 1 at the current price, an increase in price will lead to: A)no change in total revenue.B)an increase in total revenue.
C)a decrease in total revenue Explanation — C: On a linear demand curve, demand iselastic at prices above the point of unitary elasticity,so a price increase will decrease total revenue 51. A good is most likely to demonstrate higher price elasticity of demand: A)when there are few substitutes for the good, than whenthere are many good substitutes.B)if it represents a small portion of the consumer’sbudget, than if it represents a large portion. C)in the long run than the short run Explanation — C: A good is likely to show a high priceelasticity of demand when there are good substitutes, itrepresents a large proportion of consumer spending, and inthe long run as consumers make changes that take time toimplement in response to price changes for the good