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Department of Economics Prof. Gustavo Indart

University of Toronto December 3, 2010




ECO 100Y
INTRODUCTION TO ECONOMICS
Midterm Test # 2



LAST NAME
FIRST NAME
STUDENT NUMBER



INSTRUCTIONS:

1. The total time for this test is 1 hour and 50 minutes.
2. Aids allowed: a simple calculator.
3. Write with pen instead of pencil.


DO NOT WRITE IN THIS SPACE


Part I 1. /8


2. /8


3. /8


4. /8


5. /12


6. /12



Part II /24




TOTAL /80
SOLUTIONS

Page 2 of 12
PART I (56 marks)


Instructions: Answer all six questions in the space provided.


1. (8 marks) Vanessa spends her income on gas for her car and food. She is currently
maximizing her utility by consuming 20 units of gas and 50 units of food. The government
raises the tax on gas, thereby raising the price of gas. But the government also lowers the
income tax, thereby increasing Vanessas disposable income. This increase in disposable
income is just sufficient to allow Vanessa to afford the 20 units of gas and 50 units of food she
was consuming before the increase in the price of gas.
Statement: Jaclyn, Vanessas friend, concludes that Vanessa will now maximize her utility by
still consuming 20 units of gas and 50 units of food as before.
Position: Do you agree with Jaclyns conclusion? Use a proper diagram to analyze this
situation and indicate, with reasons, whether you agree or disagree with Jaclyns conclusion.

No, I do not agree with Jaclyns conclusion.
As shown in the diagram below, Vanessa is initially maximizing her utility by consuming at point
A, i.e., consuming 20 units of gas (G) and 50 units of food (F). As the price of gas increases,
her budget line changes from BL
1
to BL
2
and now she can no longer afford bundle A. However,
with the increase in income her budget line shifts up (from BL
2
to BL
3
) just enough to allow her
now to afford bundle A again. But although she can now afford bundle A, Vanessa will not be
maximizing her utility by consuming that bundle. Indeed, at point A the slope of indifference
curve I
1
is now steeper than the slope of the new budget line BL
3
(i.e., MRS = MU
F
/MU
G
>
P
F
/P
G
). Therefore, she must substitute food for gas in order to maximize her utility, i.e., she
must move down along her budget line BL
3
. Indeed, by doing so her MU
F
will fall while her MU
G

will increase until MU
F
/MU
G
= P
F
/P
G
. As shown in the diagram, by moving down along her new
budget line BL
3
Vanessa can reach higher indifference curves until she maximizes her utility
(i.e., she reaches the highest possible indifference curve) when consuming bundle B.






















A
B
20
F
BL
1

I
2

BL
2

BL
3

G
50
I
1


Page 3 of 12
2. (8 marks) Florencia likes to attend both rock concerts and basketball games. The cost of
attending a rock concert is twice as expensive as attending a basketball game. For her current
monthly consumption of rock concerts and basketball games, Florencia values attending one
more concert as much as she values attending one more basketball game i.e., her marginal
utility of rock concerts (MU
RC
) is equal to her marginal utility of basketball games (MU
BG
).
Placing rock concert on the horizontal axis, use an indifference curve diagram to indicate
Florencias current consumption bundle. Can Florencia increase her present level of utility or
satisfaction by changing her current consumption choice? Briefly explain your answer with the
help of your diagram.

Florencia is not presently maximizing her utility since at her current consumption bundle her
MRS is smaller than the relative prices of the two goods she consumes, that is, presently the
last dollar she spends on rock concerts (RC) increases her total utility by less than the last
dollar she spends on basketball games (BG) increases it.
Indeed, the MRS = MU
RC
/ MU
BG
= 1 and P
RC
/P
BG
= 2 and thus MU
RC
/MU
BG
< P
RC
/P
BG
. To
maximize her utility she must increase MU
RC
/ MU
BG
until it equals 2. She will do so by reducing
the quantity of RC (which increases the MU
RC
) and increasing the quantity of BG (which
reduces the MU
BG
).
This can also be shown graphically in the diagram below. At the present consumption bundle
(point A), Florencias MRS (i.e., the absolute value of the slope of indifference curve I
1
) is
greater than the relative prices of the two goods (i.e., the absolute value of the slope of her
budget line).
Florencia can increase her level of utility (i.e., reach a higher indifference curve) by decreasing
her consumption of RC and increasing her consumption of BG. And she will be maximizing her
utility when the last dollar she spends on RC and the last dollar she spends on BG both
increase her total utility by the same amount i.e., when MRS = P
RC
/P
BG
. This is shown
graphically in the diagram below by decreasing the quantity of RC and increasing the
quantity of BG (i.e., moving up along her budget line), Florencia increases her utility (i.e.,
reaches higher indifferences curves) until she maximizes her utility (i.e., reaches the highest
possible indifference curve) at point B (where MRS = P
RC
/P
BG
).






















A
B
BG
RC
I
1

I
2

Slope = 2

Page 4 of 12
3. (8 marks) Anni consumes only two goods, good X and good Y. Anni has negative income
elasticity for good X and her income effect for good X is stronger than her substitution effect.
Statement: Timothy, Annis friend, believes that when the price good X falls Anni will maximize
her level of consumer satisfaction by purchasing a smaller quantity of good X and therefore
Annis demand curve for good X has a positive slope.
Position: Do you agree with Timothys view? Use a proper diagram to analyze this situation
and indicate, with reasons, whether you agree or disagree with Timothys view.
Yes, I agree with Timothys views.
Since Anni has a negative income elasticity for good X, good X is an inferior good for her.
Moreover, since her income effect for good X is stronger than her substitution effect, good X is
a particular type of an inferior good for Anni good X is a Giffen-good for her. This is shown in
the diagram below.
Initially Anni is maximizing his utility consuming bundle A. As the price of good X decreases her
budget line shifts from BL
1
to BL
2
. She will now consume a different bundle on this new budget
line and will increase her level of satisfaction since the highest indifference curve she will be
able to reach now is higher than indifference curve I
1
. Her real income has thus increased. Lets
examine the substitution and the income effect of this fall in the price of good X.
To measure the substitution effect we must consider the change in the quantity demanded as a
result of the change in relative prices while assuming no change in real income (i.e., while
assuming that Anni remains on the same indifference curve I
1
). This is illustrated by the
movement from point A to point B, and the quantity demanded increases from X
A
to X
B
.
Now we measure the income effect by allowing real income to rise while keeping relative prices
constant at the new level. In this way, Anni moves to a higher indifference curve. Since good X
is an inferior good for Anni, as her income increases her quantity demanded of good X
decreases. And since her income effect is greater than her substitution effect, Anni ends up
maximizing her utility by consuming a quantity of good X smaller than the quantity she was
consuming before the decrease in its price. This is illustrated below by the movement from
point B to point C, and the quantity demanded decreases from X
B
to X
C
.
Therefore, since total effect (i.e., the summation of the substitution and income effects) is a
decrease in the quantity demanded as a result of the decrease in price, Annis demand curve
for good X has a positive slope.














Y

E/P
X
BL
1
BL
2
I
1
I
2
A

B
C

X
A
X
B
X
C
X E/P
X

E/P
Y
i.e.
s.e.

Page 5 of 12
4. (8 marks) Zenah is the proud owner of a small firm in a perfectly competitive market. Zenahs
total revenue is $1200, her total fixed cost is $400, and her output is 100 units. Her firm also
generates the following short-run information: the average total cost is $14 and the marginal
cost is $18.
Statement: Aseef a friend of Zenahs and an economics student from another university
advises Zenah to shut down production to minimize her economic losses.
Position: Do you agree with Aseefs advice? Use a proper diagram to analyze this situation
and indicate, with reasons, whether you agree or disagree with Aseefs advice.

I do not agree with Aseefs advice.
1) Since TR = P*q = $1200 and q = 100, then P = TR/q = $12.
2) Since TFC = $400 and q = 100, then AFC = $4.
3) Since ATC = AFC + AVC, then AVC = ATC AFC = $14 $4 = $10.
But Zenah is not currently maximizing profits because she is not producing the level of output
at which P = MC. Indeed, MC > P and thus she is producing too large an output. She should
reduce output and produce where P = MC. This is shown in the diagram below.
Indeed, Zenah should produce output q
1
to maximize profits (or minimize losses). As shown by
the pink-shaded area in the diagram, at q = 100 she is making economic losses equal to (P
ATC) q = ($12 $10) 100 = $200. At q
1
, Zenah will still be making economic losses (yellow-
shaded area in the diagram) because ATC > P but these losses are smaller than at q = 100.
Moreover, since P > AVC she should not shut down in the short run. If she were to shut down,
her losses would increase to TFC = $400.



























MC
AVC
$
q
2

100
18
ATC
10
Economic losses at
q = 100
12
14
q
Economic losses at
q = q
1

Increase in
economic losses if
shutting down

Page 6 of 12
5. (12 marks) Peter consumes only two goods, good X and good Y. His income is $500 per
month, the price of good X is $1.00 and the price of good Y is also $1.00. The diagram below
shows two of Peters indifference curves.




























a) What is the expression for Peters budget line? (1 mark) In the diagram above, sketch
Peters budget line clearly indicating the values of the vertical and horizontal intercepts.
Indicate Peters utility-maximizing combination of good X and good Y (point A). (1 mark)


The general expression for a budget line is E = P
X
X + P
Y
Y and thus the expression for
Peters budget line is:

500 = X + Y or Y = 500 X





b) Suppose now that the price of good X increases to $2.00. What is the expression for
Peters new budget line? (1 mark) In the diagram above, draw Peters new budget line
clearly indicating the values of the vertical and horizontal intercepts. Indicate Peters new
utility-maximizing combination of good X and good Y (point B). (1 mark)

The expression for Peters new budget line is:

500 = 2 X + Y or Y = 500 2 X

100
200
300
X
1
0
0

2
0
0
3
0
0

4
0
0

5
0
0

400
B
500
2
7
5
325
225
1
5
0
2
5
0
Y
C
s.e.
A
i.e.

Page 7 of 12
$1
$2
275 150
D
c) Clearly show in your diagram the substitution and the income effects. (1 mark) Measured in
units of good X, how much are the substitution effect and the income effect? (2 marks)
The movement from point A to point C represents the substitution effect, i.e., the change in
the quantity demanded as a result of the change in relative prices while keeping real
income constant. Measured in units of X the substitution effect represents a decrease of 75
units (from 275 units at point A to 200 units at point C).
The movement from point C to point B represents the income effect, i.e., the change in the
quantity demanded as a result of the change in real income while keeping relative prices
constant at the new level. Measured in units of X the income effect represents a decrease
of 50 units (from 200 units at point C to 150 units at point B).

d) Given the new (higher) price of good X, by how much should Peters money income
increase to allow him to reach the same level of utility as before the increase in the price of
good X? Show all your work. (3 marks)

In order to consume 200 units of X and 325 units of Y as before the increase in the price of
X, Peters income (E) should increase to:
E = $2 (200) + $1 (325) = $725
Therefore, his money income should increase by $225.









e) Given your answers to parts a) and b) above, draw Peters demand curve for good X in the
diagram below. Clearly indicate all relevant points. (2 marks)























P
X
X

Page 8 of 12
6. (12 marks) Suppose Pear Co. produces 10,000 pocket calculators a day using only two factors
of production: capital (K) and labour (L). The price of labour is $100 a day and the price of
capital is also $100 a day, and the total daily cost of producing 10,000 calculators a day is
$60,000.



















a) What is the equation for the isocost curve corresponding to a total cost of $60,000 a day? (1
mark) Draw this isocost curve (IC
1
) in the diagram above and indicate all relevant points. (1
mark) Add a convex isoquant tangent to the isocost curve at 200 units of labour per day
(point A). How many units of capital per day are employed? (1 mark)

TC = P
L
L + P
K
K 60,000 = 100 L + 100 K or K = 600 L
If L = 200, then K = 600 200 = 400

b) Explain why the point of tangency between the isocost and the isoquant described in part a)
is a long-run equilibrium. (1 mark)

The point of tangency is a long-run equilibrium because the firm is using K and L in the
combination that allows it to minimize total cost, that is, the firm cannot choose any other
combination of K and L and produce the level of output Q = 10,000 at a cost lower than
$60,000.


K
L
600
300
200
600
L
B
K
B

IC
2
A
B
400
Q = 10,000

IC
3

IC
1

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c) What is the value of the MRTS at the point of tangency in part a) above? (1 mark) What
happens to the value of the MRTS as we move down along the isoquant? (1 mark) What
happens to the values of the marginal product of labour (MP
L
) and the marginal product of
capital (MP
K
) as we move down along the isoquant? (1 mark)

The MRTS is equal to the absolute value of the slope of the isoquant at that point, and the
slope of the isoquant at that point is equal to the slope of the isocost. Therefore, the MRTS
= 1.
As we move down along the isoquant (i.e., as L increases and K decreases), the MRTS
decreases (since the isoquant becomes flatter).
The MRTS is equal to MP
L
/MP
K
, and the value of the MP
L
decreases as we move down
along the isoquant due to the principle of diminishing returns, i.e., as L increases the MP
L

decreases. Similarly, since not only does L increase but K also decreases as we move
down along the isoquant, the MP
K
increases as K decreases.


d) Suppose now that the price of capital rises to $200 a day while the price of labour continues
at $100 a day. Draw the new isocost curve (IC
2
) corresponding to TC = $60,000 in the
same diagram. (1 mark)
e) Further suppose that Pear Co. chooses to produce the same daily output as before. Draw
the new isocost curve (IC
3
) in the same diagram and show Pears new long run equilibrium
(point B). (1 mark) Has the combination of capital and labour changed? If it has, explain
why. (1 mark)
As the price of K rises, the family of isocost curves becomes flatter. Therefore, the point of
tangency of an isocost with the isoquant representing output Q = 10,000 will be to the right
of the initial equilibrium.
In the new equilibrium the firm will use more L and less K than before, i.e., it will use less of
the factor of production that has become relatively more expensive and more of the other
factor (which has become relatively less expensive) to produce the same level of output as
before.


f) If at point B the MP
L
is equal to 4, what is the value of the MP
K
at this point? (2 marks)
At point B, MRTS = P
L
/P
K
= $100/$200 = 0.5. And since MRTS = MP
L
/MP
K
MP
L
/MP
K
=
0.5 MP
K
= MP
L
/0.5 = 4/0.5 = 8.

Page 10 of 12
PART II (24 marks)
Instructions:
Multiple choice questions are to be answered using a black pencil or a black or blue ball-point
pen on the separate SCANTRON sheet being supplied.
Be sure to fill in your name and student number on the SCANTRON sheet!
Write the version of your paper either A A or B B on the SCANTRON sheet where it says DO
NOT WRITE IN THIS SPACE.
Each question is worth 2 marks. No deductions will be made for incorrect answers.
Write your answers to the multiple choice questions ALSO in the table below. You may use this
question booklet for rough work, and then transfer your answers to each multiple choice
question to the table AND onto the separate SCANTRON sheet. Your answers must be on the
SCANTRON sheet. In case of a disagreement, the answer to be marked is the one on the
SCANTRON sheet.

1 2 3 4 5 6 7 8 9 10 11 12
E B D E B D E D C C C D


1. Ahmed consumes only two goods, good X and good Y, and he is currently maximizing his
utility. The price of good X now doubles. In order to maximize his utility, his quantity of good X
consumed must now
a) rise until the marginal utility of X has doubled.
b) fall to one-half its previous level.
c) fall until the marginal utility of X has doubled.
d) fall until the marginal utility of X falls to one-half its previous level.
e) None of the above is correct.

2. Happy Meals Co. recently won a bid to provide meals at Robarts cafeteria. An unhappy
competitor described Happy Meals proposed prices as being well below cost. If the
competitors assessment was correct, then we could conclude that Happy Meals most likely
a) was prepared to lose money to help students with tight incomes.
b) bid at a price that was below its ATC but above its AVC to ensure a successful bid.
c) bid at a price that was below its AVC but above its AFC to ensure the bid would not go
to a competitor.
d) bid a price just high enough to cover its AFC.
e) The information is insufficient to allow reaching a conclusion.

3. Consider a perfectly competitive firm in the following position: output = 4000 units, total revenue
= $4000, fixed costs = $2000, variable costs = $3000, and marginal cost = $1.10. In the short
run, this firm should
a) shut down.
b) expand output.
c) increase the market price.
d) reduce output.
e) not change output.


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4. A perfectly competitive industry is in short-run equilibrium and each firm is initially making
normal profits. Which one of the following statements is correct in the short run if the price of
material inputs were to increase?
a) Each firm would produce an unchanged output and make economic losses.
b) Each firm would produce an unchanged output and make economic profits.
c) Firms would leave the industry.
d) Each firm would produce more and make economic losses.
e) Each firm would produce less and make economic losses.

Table 1
Units of labour per period 0 1 2 3 4 5
Units of output per period 0 10 30 90 132 150

5. Refer to Table 1 above. If the fixed cost of capital is $100 and the wage per unit of labour is
$25, then the marginal cost for the 20th units of output is approximately
a) $0.80.
b) $1.25.
c) $1.00.
d) $1.50.
e) None of the above is correct.

6. Refer to Table 1 above. If the fixed cost of capital is $100 and the price per unit of labour is
$25, then the average total cost of producing 30 units of output is
a) $1.67.
b) $4.16.
c) $3.33.
d) $5.00.
e) None of the above is correct.

7. Consider a perfectly competitive industry. In the short-run, a decrease in the price of capital
should lead to
a) a decrease in firms and industrys output.
b) a decrease in the number of firms.
c) an increase in price.
d) higher marginal costs.
e) none of the above.

8. If a profit-maximizing firm in perfect competition is earning economic losses in the short run,
then it must be producing a level of output where
a) price is greater than marginal cost.
b) price is greater than marginal revenue.
c) marginal cost is greater than marginal revenue.
d) average total cost is greater than marginal cost.
e) average variable cost is greater than price.

9. For a certain firm, total cost is $15 at 5 units of output and $17 for 6 units. In that range of
output, marginal cost is
a) decreasing.
b) equal to average total cost.
c) less than average total cost.
d) greater than average total cost.
e) Insufficient information given for an answer.


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10. Consider a perfectly competitive industry in long-run equilibrium. In the short run, an increase in
the price of capital will lead to
a) a decrease in the firms output.
b) an increase in the market price.
c) a decrease in the firms profits.
d) a decrease in the industrys output.
e) all of the above.

11. In the short run, if average total cost is increasing as output rises, then
a) average fixed costs must be increasing.
b) average total cost is no longer equal to the sum of average variable cost and average
fixed cost.
c) average variable cost must be increasing.
d) marginal cost must be below average total cost.
e) none of the above is correct.

12. A local factory pays $20 per unit of labour and finds that the average product of labour is 5
units of output when 8 units of labour are employed. Therefore, when 8 units of labour are
hired, average variable cost is
a) $10.
b) $5.
c) $8.
d) $4.
e) None of the above.