Download Exercise questions

Exercise questions
1. Suppose that you win two free tickets to a concert by calling into a radio show. Each ticket has a
face value of $30 and originally sold for $30, but now the concert is sold out. People with tickets are
currently asking $50 each for tickets to the concert. What is the opportunity cost of taking your
boyfriend/girlfriend to the concert? Explain.
The opportunity cost of a good is the value of the next best alternative use of the good. In
this case, the opportunity cost of taking a friend to the concert is the value that could be
obtained by selling the tickets. In this case the opportunity cost is 2 * $50 = $100. The
face value of the ticket or the fact that they were obtained without cost are not important
in calculating the opportunity cost.
2. The following are the assumed supply and demand schedules for hamburgers in Collegetown:
Quantity
Quantity
Price
Demanded
Supplied
$2.00
6,000
15,000
1.75
8,000
14,000
1.50
10,000
13,000
1.25
12,000
12,000
1.00
14,000
11,000
0.75
16,000
10,000
i) Plot the supply and demand curves and determine the equilibrium price and quantity.
2.0
0
1.7
5
1.5
0
1.2
5
1.0
0
0.7
5
0.5
0
0.2
5
Supply
Demand
2
4
6
8
10
12
14
16
ii) What effect would a decrease in the price of beef (a factor of production) have on the
equilibrium price and quantity of hamburgers, ceterus paribus? Explain referring to the graph.
A decrease in the price of an input shifts the supply curve to the right.
iii) What effect would an increase in the price of pizza (a substitute commodity) have on the
equilibrium price and quantity of hamburgers, again ceterus paribus? Explain referring to the
graph.
A rise in the price of a substitute good increases the demand. This shifts the demand
curve to the right.
3. Use small, well labelled, graphs to show the likely effect of the following events:
i) What is the effect of an increase in the price of popcorn on the number of movie tickets sold at
Cinemaxx?
Popcorn and movie tickets are complement
goods. When the price of a complement
good increases, the demand for a good
decreases. In the new equilibrium, the price
and quantity are both lower.
P
S
D
’
ii) What is the effect of an increase of crude oil prices on gasoline prices ?
P
Oil is an input into producing gasoline.
When the price of an input increases, then
the supply decreases. This causes the
equilibrium price to rise and the quantity to
fall.
D
Q
S’
S
D
Q
iii) What is the effect of increasing income levels on the use of mini (dolmus) buses?
The use of a mini bus is probably an inferior
good. As income rises, people will likely
buy their own cars, or take taxis. Rising
income reduces the demand for inferior
good. In equilibrium, both price and
quantity of dolmus rides will likely fal l.
P
S
D
’
D
Q
iv) What is the expected effect of an increase of coffee prices on the market for tea?
Coffee and tea are substitute goods.
When the price of coffee increases, the
demand for tea increases. In equilibrium,
both the price and quantity of tea increase.
P
S
D
D
’
Q
4. Explain why the demand for cigarettes is more inelastic in the short run than in the long run.
The demand for most goods is more inelastic in the short run than in the long run. This can be
explained by habits and the ability to change behavior quickly. With cigarettes, smokers get used to
smoking a certain quantity per day or per week. It is difficult to quickly change the quantity
demanded in response to a change of price. Over time, people can adjust their behavior however.
5. When the price of Widgets went from $0.80 to $0.90, the quantity of Gadgets demanded went
from 140 to 155.
i) What is the (arc) cross-price elasticity between Widgets and Gadgets?
GW
Q

G
2
W
P2


 Q1
G

W
P1
 P
 Q
W
2
G
2
 P1W
G
 Q1


155  140  0.90  0.80 
0.90  0.80  155  140 
 0.864
ii) Are these compliment or substitute goods? Explain.
Widgets and Gadgets are substitute goods because the cross-price elasticity is positive.
5. Briefly explain why most goods possess diminishing marginal utility. Also explain why this
means that a typical individual’s demand curve for a good is downward sloping.
Diminishing marginal utility of consumption is related to the idea of satiation. That is,
people tend to get satisfied with consuming a good. As more and more of the good is
consumed, consumers get more and more satisfied with that particular good, and they get
less benefit from consuming additional units of the good. Since the benefit is less, consumers
are also less willing to pay for more of the good. This is why the demand curve is typically
downward sloping.
6. Suppose that a consumer has selected a combination of goods X and Y such that she is spending
her entire income, but such that MU X  MU Y .
PX
PY
i) Show such a situation on an indifference curve graph.
Good Y
Y1
X1
Good X
ii) To increase the utility of consumption, should the consumer consume ( more less ) good X,
and ( more less ) good Y. Select the correct answers.
iii) What is true about the last dollar (or Lira) spent on each good at the optimal consumption
point?
The last dollar spent on each good should bring the consumer the same increase in
utility. If this were not true, then the consumer should spend a little less on the item
which gives less increase in utility and a little more on the good which gives more utility.
Note that MU X measures the additional utility for one dollar spent on good X.
PX
7. Why is an ounce of gold worth more than an ounce of water? Discuss using the concept of
marginal utility.
Although water is necessary for life and gold is not, gold has a higher value per unit of weight
because it is much more rare. The marginal value of water is relatively low because there is an
abundant amount consumed. The marginal utility of additional water is low. Gold is scarce. Since
there is so little gold, the marginal utility is high.
8. Consider the total cost and total revenue schedules of two firms:
Gulp and Devour
Shady Enterprise
Output
TC
TR
TC
TR
1
100
135
50
160
2
200
260
125
300
3
300
375
225
420
4
400
480
350
520
5
500
575
500
600
6
600
660
675
660
7
700
735
875
700
8
800
800
1100
720
(a) For each firm, and each level of output, calculate marginal cost, average cost, marginal
revenue, price, profit and marginal profit.
(b) On graph paper, plot all the variables in part (a).
(c) What is the profit maximizing output in each case? Show that three criteria are equivalent:
marginal cost equals marginal revenue, maximum profit, and marginal profit equals zero.
For G&D it is 4 and SE it is 3.
(d) For each firm, describe the relationship between marginal cost and average cost, and between
marginal revenue and price. How do you explain those relationships?
For G&D MC=AC because of constant returns to scale. As output increases, productivity doesn’t
decrease, so TC increases at a constant rate. MR decreases indicating that the firm is not a perfect
competitor. For SE MC and AC both are decreasing, but AC is less than MC since we never have
increasing productivity in this example. SE also is not a perfect competitor.
9. The graph below shows the cost curves for a perfectly competitive firm. Assume that this firm’s
cost curves are representative for all firms in the industry.
MC
P
40
ATC
30
3
0
AVC
CC
20
10
Q
i) What is the long run equilibrium price for this industry? Explain why.
The long run equilibrium price is $20 per unit. At this price the firm has zero profit. Zero profits
are required for long run equilibrium, only when the firm’s profits are zero, will there be no
incentive for firms to enter or exit the industry.
ii) What is the minimum price at which this firm will continue to operate in the short run? Briefly
explain why the firm would rather shutdown if the price falls below the minimum.
P < min AVC is the short run shut down condition for competitive firms. In this case the firm will
shut down if the price falls below $10. When P < min AVC the firm’s revenues do not even cover
its variable (labor) costs. The firm does better to let the workers go and save on this expense.
iii) Show graphically the equilibrium quantity that the firm will produce if the market price is 30.
Also show the region on the graph which shows the firm’s profit or loss at this price.
iv) At P = 30, over a period of time, there is likely to be entry of new firms into the market, exit of
existing firms from the market, or no change in the number of firms. State which of the above
statements is correct and clearly state why.
When P = 30, the typical firm is profiting. Profit means that the revenue exceeds the economic
cost. That is, the resources used in this industry get a better return than they could get if used in
any other way. Since the return is better than any other for resources used, more firms will enter
the market to enjoy that return.
10. Explain why the average cost of production is never higher in the long run than it is in the short
run.
In the short run some factors of production, such as capital equipment, may be fixed so the firm
cannot change the quantity of these inputs to achieve the best (cheapest) mix of inputs to attain a
given level of output. In the long run the firm can vary all inputs to achieve a lower cost.