Exam solutions 2015, semester 1 (courtesy of Reshad Ahsan), edited.

Intermediate Microeconomics
Semester 1, 2015
Final Examination: Solutions
Section A: There are TEN multiple-choice questions in this section. Answer
all questions using the computer response sheet. The response sheet should
be inserted in the back of the examination script book at the end of the ex-
amination. [20 marks]

Question A1:

[2 marks] Suppose a consumer considers two goods (X1 and X2 ) to be perfect comple-
ments. Her indifference curve for these two goods are L-shaped, as illustrated above.
Consider the horizontal segment of the indifference curve, BC. We know that in this
horizontal segment, it is the case that

a) the M RS of X1 for X2 is undefined.

b) the M RS of X1 for X2 is infinity.
c) the M RS of X1 for X2 is zero.
d) the M RS of X1 for X2 is 1.
e) none of the above are true.

Solution: In the segment BC, the consumer does not gain any utility from increasing
only her X1 consumption. As a result, she will not substitute any X2 to get more X1 . As
a result, her M RS on this horizontal segment is zero.

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Question A2: question is removed

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Question A3:

[2 marks] A firm uses two factors of production. Irrespective of how much of each factor
is used, both factors always have positive marginal products. Which of the following
statements are necessarily true?

a) isoquants are relevant only in the long run.

b) isoquants have negative slope.
c) isoquants are convex.
d) isoquants are vertical.
e) none of the above.

Solution: We can dismiss (a) and (d). As for (c), positive marginal products do not
imply convexity. For instance, the production function q = v1 + v2 where vi is an input
yields positive marginal products but the isoquant is not convex. On the other hand, (b)
must be true as the slope of the isoquant is −M RT S, where M RT S = M P1 /M P2 and
M P1 and M P2 are the marginal products of the two inputs respectively. If both marginal
products are always positive, then −M RT S must always be negative. This means that
the isoquant must have a negative slope.

Question A4:

[2 marks] Suppose that a semiconductor chip factory uses only labour to produce output.
Consider the following statements when answering this question.

I. A semiconductor chip factory uses a technology where the average product of

labour is constant for all employment levels. This technology obeys the law of
diminishing returns.

II. A semiconductor chip factory uses a technology where the marginal product
of labour rises, then is constant and finally falls as employment increases. This
technology obeys the law of diminishing returns for some levels of labour.

a) I is true and II is false.

b) I is false and II is true.
c) Both I and II are true.
d) Both I and II are false.
e) more information is needed to answer this question.

Solution: Consider the following production function: q = 2L. Here average product is
constant at 2 but there isn’t diminishing returns as marginal product is also constant at

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2. Thus, I is false. II is clearly true because the marginal product, by definition, is falling
for some levels of labour.

Question A5:

[2 marks] A plant uses machinery and waste water to produce steel with steel production
being an increasing function of each input. The owner of the plant wants to maintain
an output of 10,000 tons a day, even though the government has just imposed a $100
per gallon tax on using waste water. Suppose that the rental rate of machinery remains
unchanged. For this cost minimizing plant, the reduction in the amount of waste water
use that results from the imposition of this tax depends on

a) the ratio of the marginal product of waste water to the marginal product of
machinery.
b) the waste water price before the tax was put in place.
c) the rental rate of machinery.
d) all of the above.
e) none of the above.

Solution: With an increase in the price of waste water, the firm’s isocost line will become
steeper (with waste water on the horizontal axis). It also means that its cost of production
for 10,000 units must increase. Notice that both axis intercepts of the isocost line will
change since the cost of production has increased. To keep producing 10,000 units, the
firm must change its technique to a more machinery intensive one. The difference in
waste water use in the two equilibrium points will depend on the slope of the isoquant,
which is the ratio of the two marginal products. The extent of the change of the slope of
the isocost line will also depend on the initial slope of the isocost line. This is the ratio
of pre-tax waste water price and rental rate of machinery. Hence the answer here is (d).

Question A6:

[2 marks] Consider a perfectly competitive firm in the short run. Let this firm’s marginal
cost (M C) have the property that M C = 0 if output is zero. If this firm’s marginal
cost always increases with output, then at the profit maximizing output level, producer
surplus is

a) zero because marginal costs equal marginal revenue.

b) zero because price equals marginal costs.
c) positive because price exceeds average variable costs.
d) positive because price exceeds average total costs.
e) positive because revenues are increasing faster than variable costs.

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Solution: Given the properties of the marginal cost above, we know that producer sur-
plus will be positive. Since producer surplus is total revenue minus total variable cost or
P Q − V C(Q), it follows that a positive producer surplus means P Q > V C(Q). Dividing
both sides by Q yields P > AV C(Q).

Question A7:

[2 marks] Consider a consumer choosing between two goods X1 and X2 where her indif-
ference curve for both goods is convex. Further, assume that P1 and P2 are the prices
of X1 and X2 respectively and I is her income. Suppose that with P1 = 1, P2 = 2, and
I = 10, she chooses an optimal basket, A, with (X1A , X2A ) = (2, 4). Now consider a second
basket, B, with (X1B , X2B ) = (3, 3.5). Which of the following statements is necessarily
true?

a) basket A cannot be an optimal choice at the prices and income stated above.
b) the consumer prefers A to B.
c) the consumer prefers B to A.
d) the consumer is indifferent between the two baskets.
e) we need more information to rank A and B.

Solution: The income needed to afford basket B is P1 X1B + P2 X2B = 3 + (2 × 3.5) = 10.
This means that the consumer could have afforded B when she chose A. This means that
A is revealed preferred to B.

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Question A8:

[2 marks] A perfectly competitive hardware manufacturer has total revenue of $85 mil-
lion, total variable costs of $45 million, and fixed costs of $10 million. What is the firm’s
producer surplus?

a) $85 million
b) $70 million
c) $40 million
d) $30 million
e) $50 million

Solution: Producer surplus is total revenue minus total variable cost. In this case, it is
equal to $40 million.

Question A9:

[2 marks] Consider the following statements when answering this question.

I. With convex isoquants, a firm’s expansion path cannot be negatively sloped.

II. If a firm uses only two factors of production, one of whose marginal product
becomes negative when its use exceeds a certain level, then a cost-minimizing firm’s
expansion path will have vertical or horizontal segments.

a) I is true and II is false.

b) I is false and II is true.
c) Both I and II are true.
d) Both I and II are false.
e) more information is needed to answer this question.

Solution:
For I, it is similar to the case of an inferior good in the consumer theory. To produce higher
output, the firm might use more of one input and less of the other, thus, resulting in the
negatively-sloping expansion path. This is possible even if isoquants are convex.

For II, suppose the marginal product of labour becomes negative for sufficiently high levels
of labour. If this is the case, then the firm has no incentive to use any more labour as
doing so will incur a cost equal to the wage and actually lower output. Thus, once this
threshold labour usage is reached, the firm will expand output further by only expanding
capital. In other words, the expansion path will become vertical.

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Question A10:

[2 marks] Consider the figure above that depicts two budget lines, I1 and I2, along with
four possible consumption baskets. Suppose that a consumer chooses A on budget line
I1 and B on budget line I2. Which of the following rankings describes the consumer’s
preferences (first is highest ranked and last is lowest ranked)?

a) A-B-C-D
b) A-D-B-C
c) A-B-D-C
d) We do not have enough information to rank all four baskets.
e) D-A-B-C

Solution: From the information above we know that A is preferred to B, which is pre-
ferred to C. However, we cannot rank D relative to the other three baskets given the
information we have. As a result, the answer is (d).

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Section B: There are TWO short-answer questions in this section each worth
20 marks. Answer ALL questions using the script book provided. [40 marks]

Question B1:

Consider an individual with preferences defined over two goods, X1 and X2 . This indi-
vidual has preferences that can be represented by the following utility function:

u(X1 , X2 ) = X1 + X20.5

Let P1 = 4 and P2 = 2. In addition, suppose this individual has an income of $120.

(a) [3 marks] Write down the expression for this consumer’s marginal rate of substitution
of X1 for X2 (M RS12 ). Identify the distinguishing feature of this particular M RS12 .

Solution: Given the utility function above, this consumer’s MRS of X1 for X2 is:
M U1
M RS12 =
M U2
1
=
0.5X2−0.5
p
= 2 X2

Notice that the M RS in this case is independent of X1 . This means that for a given
X2 , M RS12 is constant.

(b) [6 marks] Calculate the optimal basket of X1 and X2 and fully illustrate this optimal
choice in a diagram with X1 on the horizontal axis.

Solution: The tangency condition for this consumer implies:

p P1
2 X2 = =2
P2
or
X2∗ = 1

Substituting this expression into the budget constraint yields:

4X1 + 2(1) = 120

4X1 = 118

or
X1∗ = 29.5

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 This equilibrium is illustrated above.

(c) [4 marks] Suppose the government introduces a $2 tax on the consumption of each
unit of X2 but X1 remains tax-free. Calculate the new optimal basket of X1 and X2 .
Illustrate this new optimal choice in your diagram above.

Solution: The tangency condition now becomes:

p
2 X2 = 1
or
1
X2∗ =
4
Substituting this expression into the budget constraint yields:
4X1 + 4(0.25) = 120
4X1 = 119
or
X1∗ = 29.75

This new equilibrium is illustrated above.

(d) [7 marks] Calculate the compensating variation needed to return this consumer to
her original utility level.

Solution: The compensating variation is a lump-sum transfer that will allow this con-
sumer to return to her original utility level. In this case, the compensating variation will

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shift the budget constraint such that it is tangent to the original indifference curve. At
this point, the utility will be restored to the original level. Note that the original utility
level is: √
u1 = 29.5 + 1 = 30.5

At the new equilibrium point, the ratio of prices is P1 /P2 = 1 and thus the following
tangency condition will hold:
p
2 X2 = 1
or
1
X2∗ =
4
In addition, we know that, at the equilibrium point, total utility is u1 = 30.5. Or,

X1 + X20.5 = 30.5
0.5
X1 + (0.25) = 30.5

Thus,
X1∗ = 30

The income needed to afford the basket at this new equilibrium is:

I 0 = (4 × 30) + (4 × 0.25)
= 121

Given that this consumer’s actual income is 120, it follows that her compensating
variation (CV ) is:

CV = 121 - 120 = 1

Question B2:

Consider a firm that uses capital (K) and labour (L) to produce output (q) according to
the following long-run production function:
√ √
q= L+ K

(a) [4 marks] Use the tangency condition to derive an expression for this firm’s expansion
path.

Solution: We know that the tangency condition implies

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 M PL w
M RT S = =
M PK r
where  
∂q 1
M PL = = √
∂L 2 L
and  
∂q 1
M PK = = √
∂K 2 K
Substituting these expressions back into the tangency condition yields:
√
 
M PL 1
= √ × K
M PK L
r
K
=
L
w
=
r
Rearranging the above gives us the expansion path as follows
K  w 2
=
L r
or   
w 2
K= L
r

(b) [8 marks] Let the price of each unit of labour be w and the (rental) price for each unit
of capital be r = 1. Determine the cost-minimizing labour input and the cost-minimizing
capital input for an output of q0 . (Hint: you should not assume a particular value for w)

Solution: With r = 1, the expansion path becomes

  
w 2
K= L
1
or
K = w2 L
Substituting this expression into the production function yields
√ √
q = L + w2 L
√
= (1 + w) L

Thus, the cost-minimizing labour input is

 2
q
L(q) = (1)
1+w

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and the cost-minimizing capital input is
 2
2 ∗ 2 q
K(q) = w L = w (2)
1+w

(c) [2 marks] Find this firm’s long-run total cost function.

Solution: With K = w2 L and r = 1, the long-run total cost function is

C(q) = wL∗ + rK ∗
= (w + w2 )L∗
 2
q
= w(1 + w) (3)
1+w
2 
wq

= (4)
1+w

(d) [6 marks] Suppose instead that this firm’s long-run production function is
 
1
q = min L, K
3
Assume that wages and rental rates are w and 1 respectively. Derive the long-run
total cost function for an output of q0 in this case.

Solution: Given the fixed-proportion production function, to produce one unit of output
this firm must use one unit of K and three units of L. Thus, in equilibrium, 0.33L = K.
It follows that the firm’s expansion path is
L = 3K

The cost minimizing input bundles will be located on the expansion path L = 3K.
Output is then determined by the production function, so output will be given by:
 
1
q0 = min (3K), K
3
= K
It follows that the cost-minimizing choice of K and L are

∗
K =q
and
∗ ∗
L = 3K = 3q
Thus, the long-run total cost function with r = 1 is

C(q) = wL∗ + rK ∗
= (1 + 3w)q

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Section C: There are TWO short-answer questions in this section each worth
20 marks. Answer ALL questions using the script book provided. [40 marks]

Question C1:

Consider a firm that is a monopolist in the market for good X. The demand for X is

Q = 200 − 2P

where P is the price of X and Q is the total quantity demanded. The monopolist’s total
cost function is

C = Q2 + 10Q

where C represents total costs.

(a) [7 marks] What is the monopolist’s profit maximizing output? What is the price at
this output? Fully illustrate this optimal output and price in an appropriate diagram.

Solution: The monopolist’s inverse demand function is P = 100 − Q/2. Thus, its profit
function is
 
Q
π = 100 − Q − Q2 − 10Q
2

Profit maximization implies dπ/dQ = 0 or,

100 − Q − 2Q − 10 = 0
90 − 3Q = 0

or
QM = 30
To find the price we can substitute Q∗ into the inverse demand function as follows
30
PM = 100 − = 85
2
This equilibrium is illustrated below.

(b) [7 marks] What output and price maximizes the sum of consumer surplus and pro-
ducer surplus? Explain your answer. Add this output and price to your diagram in part
(a).

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Solution: The sum of consumer surplus and producer surplus is maximized at the per-
fectly competitive price. This is the price at which the following condition holds: P = M C.
Or,
Q
100 − = 2Q + 10
2
Q
2Q + = 90
2
5Q
= 90
2
or
QC = 36
Next, using the inverse demand function we get
36
PC = 100 − = 82
2
This equilibrium is illustrated above.

(c) [6 marks] Suppose that the monopolist is able to charge the price in (a) rather than
the price in (b). What is the resulting difference in consumer surplus, producer surplus,
and total welfare?

Solution: To calculate the welfare changes we need to first identify the intersection
point of M C and M R. We know that Q = 30 at this point, so the M C at this point is
2 × 30 + 10 = 70. We know that the loss in consumer surplus (CS) is the sum of the area
of A and B. This is equal to
 
1
∆CS = −(3 × 30) − × 3 × 6 = −99
2

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 Similarly, the gain in producer surplus (P S) is the area of A minus the area of C.
This is equal to  
1
∆PS = (3 × 30) − 2 × 6 × 12 = 54

It follows that the net change in welfare (W EL) is

∆W EL = ∆CS + ∆P S = −45

Question C2:

Consider a risk-averse individual with an initial wealth of 100 and a utility function of
the form

u(W ) = W 0.5

where W represents the payoff from a particular outcome. Suppose that this individual
faces a loss of L with probability 0.5. To reduce her risk, she would like to purchase an
insurance policy that gives her a payment of B if she suffers the loss. Suppose that the
cost of the policy is equal to the the premium, M .

(a) [2 marks] Assuming that the insurance policy is actuarially fair, what is the premium
that insurance companies will charge?

Solution: We know that the actuarially fair insurance premium is equal to the expected
payment that will be made to the buyer. This means that this premium will be

M = 0.5B

(b) [2 marks] Use all of the information above to write down an expression for this indi-
vidual’s expected utility with the actuarially fair insurance.

Solution: This individual’s expected utility with the insurance is

EU = 0.5(100 − L + B − M )0.5 + 0.5(100 − M )0.5

= 0.5(100 − L + 0.5B)0.5 + 0.5(100 − 0.5B)0.5

where the second line uses the expression from part (a) above.

(c) [6 marks] Let the individual’s objective be to choose the optimal insurance payment,
B. What is the optimal B?

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Solution: The optimal B is one that allows the individual to be indifferent between
suffering a loss and not suffering a loss (full insurance). That is, it is the B that ensures
that the following equality holds:

100 − L + 0.5B = 100 − 0.5B (5)

It follows that
B=L
Thus, for this risk averse consumer, the optimal insurance benefit is one that provides
full coverage.That is, a benefit that equals the value of the loss.

(d) and (e) : Solution is not available

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