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Department of Economics
University of Toronto
SOLUTION
Prof. Gustavo Indart
July 27, 2006
ECO 100Y – L0201
INTRODUCTION TO ECONOMICS
Midterm Test # 2
LAST NAME
FIRST NAME
STUDENT NUMBER
INSTRUCTIONS:
1.
4.
5.
The total time for this test is 1 hour and 50 minutes.
Aids allowed: a simple calculator.
Write with pen instead of pencil.
DO NOT WRITE IN THIS SPACE
Part I
/30
Part II 1.
/5
2.
/5
3.
/5
Part III 1.
/30
2.
/25
TOTAL
/100
Page 1 of 11
PART I
(30 marks)
Instructions: Enter your answer to each question in the table. Only the answer recorded in
the table will be marked. Table cells left blank will receive a zero mark for that question. Each
question is worth 3 (three) marks. No deductions will be made for incorrect answers.
1
2
3
4
5
6
7
8
9
10
B
E
B
D
C
A
E
C
B
B
1. Consider a perfectly competitive firm in the following position: output = 4000 units, market
price = $2, fixed costs = $10,000, variable costs = $1000, and marginal cost = $1.10. To
maximize profits in the short-run, the firm should
A) reduce output
B) expand output
C) shut down
D) increase the market price
E) not change output
2. In the short-run, a decrease in a perfectly competitive firm’s fixed costs should lead to
A) a decrease in output
B) a decrease in the number of sellers
C) an increase in price
D) lower variable costs
E) none of the above
3. Suppose a typical competitive firm has the following data in the short-run: price = $10;
output = 100 units; ATC = $12; AVC = $7.
A) in the long-run the industry will expand because of economic profits
B) in the long-run the industry will contract because firms are suffering losses
C) the size of the industry will remain the same in the long-run
D) price will fall in the long-run
E) there is not enough information to formulate an answer
4. Assume that a perfectly competitive industry has a perfectly inelastic supply curve. The
government introduces a specific commodity tax of $2.50 per unit of output. As a result,
which one of the following statements would be correct?
A) the consumer price would increase by $2.50
B) the consumer price would fall by $2.50
C) the burden of the tax would fall completely on consumers
D) the price received by the producer would decrease by $2.50
E) none of the above
Page 2 of 11
5. Suppose all of the firms in a perfectly competitive industry form a cartel and agree to restrict
output, thereby raising the price of the product. Individual firm A will gain the most from the
existence of the cartel if
A) all firms, including A, cooperate and restrict output
B) firm A restricts output, while the other firms do not
C) all firms, except A, cooperate and restrict output
D) no firms restrict output
E) all firms revert back to their competitive outputs
6. A perfectly competitive industry is in long run equilibrium. Under these conditions, which
one of the following statements is correct?
A) marginal revenue, marginal cost, average revenue and average cost are equal
B) marginal revenue equal marginal cost but not average revenue and average cost
C) marginal revenue equals average revenue but marginal cost and average total cost
D) marginal revenue equals average total but not marginal cost and average revenue
E) none of the above
7. An unregulated monopolist is in short-run equilibrium with economic profits. Which one of
the following statements is correct?
A) an increase in rent will cause an increase in the monopoly price and a decrease in
the monopolist’s output
B) an increase in rent will cause an increase in the monopoly price and an increase in
the monopolist’s output
C) the monopolist’s price will equal its marginal cost at the equilibrium output
D) the monopolist’s marginal revenue will equal its average revenue at the equilibrium
output
E) none of the above
8. A monopolist is currently producing an output level where P = $4, AVC = $2, ATC = $8, and
MC = $4. In order to maximize profits, this monopolist should
A) shut down
B) increase production
C) decrease production
D) not change the level of output, because the monopolist is maximizing profits
E) not enough information to answer
9. Suppose we compare two monopolists with identical cost and demand conditions.
Monopolist A charges a single price. Monopolist B engages in price discrimination. Which
one of the following statements is correct?
A) B will produce less than A, resulting in a deadweight loss
B) B will produce more than A, resulting in less deadweight loss
C) A will produce less than B, resulting in smaller deadweight loss
D) A will produce more than B, resulting in larger deadweight loss
E) A and B will both produce the same amount
10. Which of the following is included in the calculations of current GDP?
A) the purchase of a second hand automobile
B) pizza purchased by college students for dinner
C) volunteer work undertaken by Mary Smith
D) the purchase of a 1939 painting
E) welfare payments
Page 3 of 11
PART II
(15 marks)
Instructions: Answer true or false to the following statements and explain your answers in the
space provided (if space is not sufficient, continue on the back of the previous page). Draw the
appropriate diagram or diagrams to assist your answer. Each question is worth 5 (five) marks.
Marks will be given entirely for the explanation.
1. Scooters are produced in a constant cost industry with two factors of production: capital [K]
and labour [L]. If the price of labour [the wage rate] increases by 5% and, at the same time,
the price of capital [rental fee] increases by 2%, then both the marginal product of labour
and the marginal product of capital will increase in this industry in the long-run.
False
Although the prices of both K and L have increased, the price of L has increased relatively
more, which means that the relative price of labour has increased. Therefore, in the long-run a
profit maximizing firm will produce any given output using more of the relatively less expensive
factor of production and less of the relatively more expensive factor of production. In this case,
therefore, the firm will substitute capital for labour (i.e., it will adopt a more capital-intensive
method of production). This is represented by a movement up along the isoquant representing
the level of output being produced.
K
K2
K1
Q1
L2
L1
L
Given the assumption of diminishing marginal productivity of factors of production, as the
quantity of K increases, the MPK decreases; in turn, as the quantity of L decreases, the MPL
increases. [Note that this outcome is reinforced by the fact the MP of a factor of production also
increases when the quantity of another factor of production increases.]
The firm will minimize the cost of producing any particular level of output by choosing a
combination of K and L given by the point of tangency between the isoquant and an isocost
line. At this point the slopes of the isoquant and the slope of the isocost are equal, i.e., the
MRTS is equal to the relative price of labour (w/r).
Initially, MRTS = w/r where MRTS = MPL/MPK. This equilibrium is altered when w/r increases to
w’/r’. Indeed, now MPL/MPK < w’/r’. To restore equilibrium, then, MPL must increase (through a
decrease in L) and MPK must decrease (through an increase in K).
Page 4 of 11
2. A constant cost, perfectly competitive industry is initially in long-run equilibrium with “n1“
identical firms. A technological innovation causes the average variable cost curve for each
firm to decrease by exactly $2.50 per unit of output. In the new long-run equilibrium, the
industry price will decrease by exactly $2.50; industry output will increase; each firm will
produce a larger output, and more firms will enter the industry.
False
If the industry is in long-run equilibrium, then each firm is making zero economic profits and
producing at the minimum of the LRAC curve. Since this is a constant cost industry, the LRS is
horizontal at the level of the minimum of the LRAC curve. Therefore, as the diagram below
shows, the initial long-run equilibrium price is P1, each firm is producing an output q1, and the
total output of the industry is Q1 (where Q1 = n*q1).
The decrease in AVC of $2.50 per unit of output will reduce LRAC by exactly $2.50 at each
level of output; most particularly, it will reduce the minimum of the LRAC curve by exactly
$2.50. Therefore, the level of output at which each firm reaches the minimum efficient scale of
production will remain unchanged, and thus each firm will continue producing the same level of
output (q1) in the new long-run equilibrium. Therefore, the LRS curve will shift down by exactly
$2.50, and thus the new equilibrium price will be P2 = P1 – $2.50. However, the new total
industry output will be larger than before (i.e., Q2 > Q1). This is so because as variable cost
decreases, existing firms make economic profits, which prompts new firms to enter the industry
in the long-run. Therefore, the number of firms in the new long-run equilibrium is greater than
before (i.e., n2 > n1). Note that Q2 = n2*q1>.
Therefore, the statement is false. It is correct that the industry price will decrease by exactly
$2.50, industry output will increase, and more firms will enter the industry; but each firm will
produce the same output as before and not a larger output.
$
$
Industry
Representative Firm
LRAC
LRAC’
P1
LRS
P1
LRS’
P2
$2.50
∆P = $2.50
P2
D
Q1
Q2
Q
q1
q
Page 5 of 11
3. In the short-run, a firm generates the following information at its current level of output: the
industry price is $15; the marginal revenue is $9; the average total cost is $18; the marginal
cost is $9 and average fixed cost is $5. Therefore, the firm is not in perfect competition and
should shut down to minimize its economic losses.
False
Independently of the nature of the market structure, any profit maximizing firm should produce
a level of out where MR = MC. This firm is indeed maximizing profits since its producing at the
level where MR = MC = $9.
But at this profit-maximizing level of output, price is greater than MR. This indicates that this
market structure is not perfect competition, but rather a monopoly market. Indeed in an
unregulated monopoly market, P is always greater than MR.
The information also indicates that P = $15 < ATC = $18, and thus the firm is making economic
losses in the short-run. However, the firm should not shut down since it’s covering AVC = $13
(since ATC = AVC + AFC). Therefore, the losses that the firm is making are less than the
losses it would make if it were to shut down. In the latter case, economic losses would be equal
to TFC. Continuing producing the firm minimizes losses (i.e., maximizes profits).
This is shown in the diagram below.
The statement is, therefore, false – although the firm is certainly not in perfect competition, it
should not shut down in the short-run since variable costs are covered in excess (and thus
losses are being minimized).
$
MC
ATC
18
AVC
15
13
9
MR
Q1
D
Q
Page 6 of 11
PART III
(55 marks)
Instructions: Answer all questions in the space provided (if space is not sufficient, continue on
the back of the previous page).
Question 1
(30 marks)
Gadgets are produced in a constant cost, perfectly competitive industry by firms with traditional
U-shaped LRAC. Minimum LRAC is $50 and the efficient scale of production (where LRAC
reaches a minimum) is 25 gadgets per day. The demand for gadgets is given by the equation:
P = 125 – 0.1 Q, where P is price and Q is quantity per day.
a) Fill in the following table describing the initial long-run equilibrium. (6 marks) [Note: Show
all your work in the space below. If space is not sufficient, continue on the back of the
previous page.]
Firm Item
Firm’s quantity
Firm’s profits
Number of firms
Value
25
0
30
Industry Item
Price
Quantity
Consumer Surplus
Value
50
750
28,125
In a constant cost industry, the long-run equilibrium price is equal to the minimum of the LRAC,
i.e., $50. At this price, the total quantity transacted in the market is:
P = 125 – 0.1 Q Æ 50 = 125 – 0.1 Q Æ 0.1 Q = 125 – 50 Æ 0.1 Q = 75 Æ Q* = 750
Since each firms is producing at the minimum of the LRAC curve (i.e., 25 gadgets per day), the
total number of firms is n = 750/25 = 30.
Since the industry is in long-run equilibrium, each firm is making zero economic profits (i.e.,
they are producing at the minimum of the LRAC).
The consumer surplus is equal to the area below the demand curve and above the price line.
That is, the consumer surplus is equal to the area of the triangle with a height of 75 (i.e., 125 –
50) and base of 750: (75 x 750)/2 = 58,125.
Page 7 of 11
b) Show the initial long-run equilibrium for a representative firm and for the industry on the
diagram below. Include both short-run and long-run cost curves, and clearly show the
consumer surplus. (3 marks)
$
$
Industry
200
Representative Firm
200
150
150
SRMC
125
LRAC
100
60
LRAC’
SRAC
100
C.S.
LRS’
60
50
50
LRS
D
650
750
1000
1250
D’
1500
Quantity
50
25
Quantity
c) Suppose that the demand for gadgets increases and is now given by the equation:
P = 150 – 0.1 Q. Fill in the following table describing the new long-run equilibrium. (6
marks) Show the new long-run equilibrium for a representative firm and for the industry on
the diagram above, but do not show changes in short-run cost curves. (3 marks) [Note:
Show all your work in the space below. If space is not sufficient, continue on the back of the
previous page.]
Firm Item
Firm’s quantity
Firm’s profits
Number of firms
Value
25
0
40
Industry Item
Price
Quantity
Consumer Surplus
Value
50
1,000
50,000
In a constant cost industry, the long-run equilibrium price is equal to the minimum of the LRAC.
Since there has been no change in LRAC, then P remains unchanged at $50. At this price, the
total quantity transacted in the market is now:
P = 150 – 0.1 Q Æ 50 = 150 – 0.1 Q Æ 0.1 Q = 150 – 50 Æ 0.1 Q = 100 Æ Q* = 1,000
Since each firms is producing at the minimum of the LRAC curve (i.e., 25 gadgets per day), the
total number of firms is now n = 1,000/25 = 40.
Since the industry is in long-run equilibrium, each firm is making zero economic profits (i.e.,
they are producing at the minimum of the LRAC).
The consumer surplus is equal to the area below the demand curve and above the price line.
That is, the consumer surplus is equal to the area of the triangle with a height of 100 (i.e., 150 –
50) and base of 1,000: (100 x 1000)/2 = 50,000.
Page 8 of 11
d) Suppose new evidence shows that the industry is not constant cost, but increasing cost. If
the industry is increasing cost, the new long-run equilibrium after the increase in demand
will have the following attributes, compared to when the industry is constant cost. Circle the
correct answer. (3 marks) [Note: You don’t need to show this equilibrium on the diagram
above.]
Item
Price (P)
Industry Quantity (Q)
Each Firm’s Profits
Value
Same / Higher / Lower
Same / Higher / Lower
Same / Higher / Lower
e) Go back to the initial long-run equilibrium of a constant cost industry (i.e., before the
increase in demand). Suppose now that the government introduces an excise tax (i.e., a tax
per unit) of $10. Fill in the following table describing the new long-run equilibrium. (6 marks)
Show the new long-run equilibrium for a representative firm and for the industry on the
diagram above. (3 marks) [Note: Show all your work in the space below. If space is not
sufficient, continue on the back of the previous page.]
Firm Item
Firm’s quantity
Firm’s profits
Number of firms
Value
25
0
26
Industry Item
Price
Quantity
Consumer Surplus
Value
60
650
21,125
The imposition of the excise tax of $10 per unit will shift the LRAC curve up exactly by $10.
Since the long-run equilibrium price is equal to the minimum of the LRAC, the new long-run
equilibrium price will be now $60. At this price, the total quantity transacted in the market is
now:
P = 125 – 0.1 Q Æ 60 = 125 – 0.1 Q Æ 0.1 Q = 125 – 60 Æ 0.1 Q = 65 Æ Q* = 650
Since each firms is producing at the minimum of the LRAC curve (i.e., 25 gadgets per day), the
total number of firms is now n = 650/25 = 26.
Since the industry is in long-run equilibrium, each firm is making zero economic profits (i.e.,
they are producing at the minimum of the LRAC).
The consumer surplus is equal to the area below the demand curve and above the price line.
That is, the consumer surplus is equal to the area of the triangle with a height of 65 (i.e., 125 –
60) and base of 650: (65 x 650)/2 = $21,125.
Page 9 of 11
Question 2
(25 marks)
The Red Farm is the sole source of supply of raspberries in Yorkland. The marginal cost of
producing berries is constant at $20, and fixed costs are nil. The market demand schedule for
berries is P = 100 – 0.01 Q, where P is price and Q is quantity measured in buckets of berries
per day.
a) What is the profit maximizing level of output? What price will this monopolist charge for a
bucket of berries? What are the profits of the firm? (6 marks)
We must equate MC and MR in order to find the profit maximizing level of output of the
monopolist. The MR curve has the same intercept as the demand curve but it’s twice as steep,
i.e., the equation for the MR curve is MR = 100 – 0.02 Q. Therefore,
MR = MC Æ 100 – 0.02 Q = 20 Æ 0.02 Q = 100 – 20 Æ 0.02 Q = 80 Æ Q* = 4,000
The price that the monopolist will charge is:
P* = 100 – 0.01 Q* = 100 – 0.01 (4,000) = 100 – 40 = $60
Since marginal cost is constant at $20, then average variable cost is also constant at $20. And
since there are no fixed costs, average total cost is also constant at $20. Therefore, the
monopolist’s profits are (P – ATC) Q = ($60 − $20) (4,000) = $160,000.
b) Draw the profit maximizing solution in the diagram below. (2 marks) Clearly indicate the
consumer surplus, the producer surplus, and the deadweight loss, if any. (3 marks)
$
Consumer
Surplus
80
Producer
Surplus
60
Deadweight
Loss
40
MC
20
MR
4
5
D
8
10
12
Buckets of berries per day (in thousands)
Page 10 of 11
c) Suppose the owner of Red Farm has found a way (do not ask how!) to extract the highest
price any consumer is willing to pay each day for every bucket of berries. Now complete the
table below. (8 marks) [Note: Show all your work in the space below. If space is not
sufficient, continue on the back of the previous page.]
Item
Price *
Quantity
* of last unit sold
Value
20
8,000
Item
Total Profits
Consumer Surplus
Value
320,000
0
If the monopolist can perfectly discriminate, it will produce an output where the MC curve
intersects the demand curve, i.e., 8,000 gadgets per day. The last unit sold will have a price of
$20 (i.e., equal to MC). The monopolist will appropriate the entire consumer surplus, so CS =
$0.
[Note that the producer surplus will be now equal to the total surplus, i.e., equal to the area
below the demand curve and above the MC curve, so PC = $320,000.]
Since there are no fixed costs, the monopolist’s profits will be equal to the producer surplus,
i.e., $320,000.
d) Go back to monopoly market outcome when the monopolist did not price-discriminate.
Suppose now that the government attempts to regulate this monopoly by implementing a
marginal cost pricing policy. What price will the monopolist charge for a bucket of berries?
What will the profit maximizing level of output be? What will the profits of the firm be? (6
marks)
If the government implements a marginal cost pricing policy, then it will set a price ceiling at the
level where the MC curve intersects the demand curve. Therefore, the price ceiling will be
equal to $20.
Since P = MR = MC = ATC = $20 for Q < 8,000, the monopolist will be making the same profits
(i.e., zero economic profits) for any level of output up to 8,000 units.
Therefore, there is no unique profit-maximizing level of output – the monopolist will be
indifferent producing any level of output less than 8,000 units (including Q = 0).
Page 11 of 11