Page 1 of 14

Department of Economics Prof. Gustavo Indart

University of Toronto October 28, 2011




ECO 100Y
INTRODUCTION TO ECONOMICS
Term Test # 1




LAST NAME


FIRST NAME


STUDENT NUMBER




INSTRUCTIONS:
1. The total time for this test is 1 hour and 40 minutes.
2. Aids allowed: a simple calculator.
3. Write with pen instead of pencil.



DO NOT WRITE IN THIS SPACE


Part I /10
/30



Part II 1. /10
2. /13
3. /12


TOTAL /75
SOLUTION

Page 2 of 14
PART I (40 marks)
Instructions:
Enter your answer to each question in the table below. Table cells left blank will receive a
zero mark for that question.
Each question is worth one (1) mark for a maximum of ten (10) possible marks. No
deductions will be made for incorrect answers.
In addition to recording your answers in the table below, briefly explain your answers in the
space provided. Use graphs to help your explanation whenever appropriate. Up to three (3)
additional marks will be awarded for each correct explanation for a maximum of thirty (30)
additional marks.

1 2 3 4 5 6 7 8 9 10
C D B C D B C A D A

1. Sean has accepted a $15,000 sports grant to start training full time for the London Olympics.
Sean therefore has to give up his full time job in which he earns $35,000 per year. In
addition, Sean must spend $2,000 in sports equipment and live in a residence which costs
$10,000 per year. Sean is presently living with his parents, to whom he pays $6,000 per
year for room and board. What is Seans yearly opportunity cost of training full time for the
Olympics?
A) $37,000
B) $32,000
C) $26,000
D) $3,000.
E) None of the above is correct.

Explanation:

To calculate Seans opportunity cost of training full time we must take into account all he has to
give up. This includes, of course, the out-of-pocket expenses (explicit costs) since these
represent monies he could have spent on other things but also other things hes forced to
give up such as his labour income (implicit costs). The explicit costs include $2,000 in
equipment and $4,000 in additional room and board expenses (i.e., the difference between
$10,000 in residence cost minus the $6,000 he currently pays at home). The implicit costs are
the $20,000 loss in annual income (i.e., the difference between his yearly income of $35,000
and the $15,000 sports grant). Therefore, his opportunity cost of training full time is $26,000.






Page 3 of 14
Diagram 1: Production Possibility Curves















2. A countrys production possibility curve has changed from PPC
1
to PPC
2
as shown in
Diagram 1. Which one of the following may explain this change in this countrys PPC?
A) Technological improvement in both industries.
B) A transfer of resources from food industry towards the clothing industry.
C) A transfer of resources from clothing industry towards the food industry.
D) A reduction in the quantity of resource and technological improvement in the clothing
industry.
E) None of the above.

Explanation:

While a reduction in the quantity of resources leaves opportunity costs (i.e., the slope of the
PPC) unchanged, it causes the PPC to shift inwards to PPC
3
(as shown in the diagram). A
subsequent technological improvement in the clothing industry decreases the opportunity cost
of clothing and increases the opportunity cost of food (i.e., the slope of the PPC gets steeper),
and thus the PPC shifts to PPC
2
(as shown in the diagram).

U
n
i
t
s

o
f

C
l
o
t
h
i
n
g

Units of Food
PPC
2

PPC
3

PPC
1


Page 4 of 14
3. Suppose the demand curve for good X is downward-sloping and the price of an input used
to produce good X falls. Given the above, which of the following statements would be true in
the market for good X?
A) The consumer surplus would not be affected.
B) The consumer surplus would increase.
C) The price of good X would increase.
D) The quantity bought and sold of good X would decrease.
E) None of the above would be true.

Explanation:

The decrease in the price of an input shifts the supply curve down
and to the right, and thus the equilibrium price falls. Since
consumer surplus is measured by the area below the demand
curve and above the price line, the consumer surplus increases
when the price line falls. This increase in consumer surplus is
shown by the shaded area in the diagram on the left.








4. Suppose the demand curve for good X is negatively sloped and the supply curve for good X
is positively sloped. If the government removes a $1 sales tax on each unit (paid by the
seller), which one of the following statements is true in the short run?
A) The market price of good X will decrease by $1.
B) The quantity of good X bought and sold will decrease.
C) The market price of good X will decrease by less than $1.
D) Consumer surplus will fall.
E) None of the above is true.

Explanation:

The removal of the $1 unit tax will allow producers to demand from
consumers a minimum price $1 lower for each unit of good X.
Therefore, the supply curve will shift vertically down exactly by $1
(as shown in the diagram on the left). Since the demand curve has
a negative slope, the market price will decrease but by less than
$1. (Note that the price would have decreased exactly by $1 only if
the demand curve had been perfectly inelastic.)







S
P
Q
D
S
S
P
$1
D
S
Q

Page 5 of 14
5. Which of the following could cause an increase in the price of Apple Juice in the short run?
A) A rise in the price of Orange Juice, a substitute for Apple Juice.
B) An increase in incomes, if Apple Juice is an inferior good.
C) A poor apple harvest due to an early frost.
D) Both a) and c).
E) All of the above.

Explanation:

An increase in the price of orange juice decreases the quantity
demanded of orange juice. This is the law of demand. Consumers
will now buy more of a (close) substitute for orange juice such as
apple juice. Therefore, the demand curve for apple juice increases
(i.e., it shifts up and to the right) and the price of apple juice rises
(as shown in the diagram on the left).




A poor apple harvest decreases the supply of apples and thus the
price of apples increases. Since apples are an input in the
production of apple juice, the supply of apple juice decreases (i.e.,
it shifts up and to the left as shown in the diagram on the left).
Therefore, the price of apple juice increases.




S
P
Q
D
S
P
Q
D
S
D

Page 6 of 14
6. Suppose that the income of buyers of good X declines and the price of an input used to
produce good X falls. If good X is a normal good, which of the following statements would be
true?
A) The equilibrium price of good X would definitely increase, but the equilibrium quantity
of good X could increase or decrease.
B) The equilibrium price of good X would definitely decrease, but the equilibrium
quantity of good X could increase or decrease.
C) Both the equilibrium quantity and the equilibrium price of good X would increase.
D) The equilibrium quantity of good X would definitely increase, but the equilibrium price
of good X could increase or decrease.
E) The equilibrium quantity of good X would definitely decrease, but the equilibrium
price of good X could increase or decrease.

Explanation:

Since good X is a normal good, a decrease in income decreases
its demand (i.e., its demand curve shifts down as shown in the
diagram). Therefore, the price of good X falls and the quantity
bought and sold decreases.
The decrease in the price of an input used in the production of
good X causes its supply curve to shift down and to the right (as
shown in the diagram). Therefore, the price of good X decreases
while the quantity bought and sold increases.
Taking these two impacts together, we can then conclude
unambiguously that the price of good X falls but the quantity
bought and sold can either decrease or increase depending on the
relative sizes of the demand and supply effects. (Note that in the
diagram we assume that the demand effect is relatively larger than
the supply effect, and thus quantity falls.)

7. A commodity has a perfectly elastic supply curve and an elastic (but not perfectly) demand
curve. A tax of $1.00 per unit of output (to be paid by the seller) will
A) increase market price by less than $1.00 and decrease quantity bought and sold.
B) increase market price by less than $1.00 and leave quantity bought and sold
unchanged.
C) increase market price by $1.00 and decrease quantity bought and sold.
D) increase market price by $1.00 and leave quantity bought and sold unchanged.
E) cause none of the above.

Explanation:

The imposition of a $1 unit tax on producers increases the costs of
production and thus producers will demand from consumers a
minimum price $1 higher for each unit of good X. Therefore, the
horizontal supply curve will shift vertically up by exactly $1 (as
shown in the diagram on the left) and the market price will increase
by $1. Since the demand curve has a negative slope, the quantity
bought and sold in the market decreases.



S
P
D
S
Q
D
S
P
$1
D
S
Q

Page 7 of 14
8. At a garage sale, Amina purchases a used bicycle for $75 when she was willing to pay up to
$120. Before paying for the bicycle she realizes that it needs repair at a cost of $15 but she
buys it anyway. If the bicycle costs $180 new, Aminas consumer surplus is
A) $30.
B) $60.
C) $90.
D) $105.
E) none of the above.

Explanation:

The consumer surplus is equal to the difference between the value Amina assigns to the bicycle
(i.e, the maximum price she is willing to pay for it) and the price she pays (i.e., the market price).
The value she assigns to the bicycle is $120, while the price she pays is $90 (the price of the
bicycle, $75, plus the cost of repairing it, $15). Note that the fact that Amina knew before she
paid that the bicycle needed repairs of $15 implies that the actual price of the bicycle to Amina
was $90.




9. Because bagels and cream cheese are often eaten together, they are complements. We
observe that both the equilibrium price of cream cheese and the equilibrium quantity of
bagels have fallen. What could be responsible for this pattern?
A) A decrease in the price of flour (used to produce bagels).
B) A decrease in the price of milk (used to produce cream cheese).
C) An increase in the price of milk.
D) An increase in the price of flour.
E) An increase in the price of muffins, a close substitute for bagels.

Explanation:

An increase in the price of flour increases the cost of producing
bagels and the supply of bagels decreases (i.e., the supply of
bagels shifts up to the left). Therefore, as shown in the diagram on
the left, the price of bagels increases and the quantity bought and
sold of bagels decrease.





Since bagels and cream cheese are complements, the decrease in
the quantity bought and sold of bagels translate into a decrease in
the demand for cream cheese (i.e., the demand for cream cheese
shifts down to the left). Therefore, both the price and the quantity
bought and sold of cream cheese decrease.




S
B

P
B
Q
B
S
B

D
CC

P
CC
Q
CC
D
CC
S
CC
D
B

Page 8 of 14
Diagram 2: Price Elasticity of Demand













10. In Diagram 2, the demand curves D
1
and D
2
are parallel. Therefore, we can conclude that
the price elasticity of demand
A) at point A is greater than at point B.
B) is equal at points A and B.
C) at point A is less than at point B.
D) at point A cannot be compared to that at point B.
E) is not determinable from the information given.

Explanation:

At any point on the demand curve, the price elasticity of demand can be expressed as the ratio
of price over quantity divided by the slope of the demand curve, i.e., = (P
0
/ Q
0
) / (P / Q).
The slopes of the demand curves D
1
and D
2
are constant and equal, and P is also the same at
points A and B. Therefore, any difference between the elasticities at points A and B is
determined by the relative sizes of Q at these points i.e., the smaller Q the larger the
elasticity, and thus the price elasticity of demand is greater at point A than at point B.















P
r
i
c
e
Quantity
A B
D
2
D
1

Page 9 of 14
PART II (35 marks)

Instructions: Answer all questions in the space provided.

Question 1 (10 marks)
Suppose that the demand for Maple Leafs hockey game tickets is as follows:
Price ($) 110 100 90 80 70 60 50 40 30
Quantity demanded (thousands) 0 5 10 15 20 25 30 35 40
The Maple Leafs play all their home games at the ACC, which has a maximum capacity for 20
thousand spectators.
a) Assuming the price of Maple Leafs hockey game tickets is determined by market forces,
what is the equilibrium price and quantity of tickets? Briefly explain your answer. (1 mark)
Note that the quantity supplied is constant at 20 thousand since this is the capacity of the
arena. Equilibrium is determined at the price where the quantity demanded is equal to the
quantity supplied, and the quantity demanded is 20 thousand at P = $70. Therefore, P = $70
is the market equilibrium price.


b) Draw the demand curve and the supply curve for Maple Leafs tickets in the diagram below
and show the equilibrium (point A) of part a). (1 mark)



























10 30
50
150
100
A
20
P
Q
D
S
70
90
B
D

Page 10 of 14
c) Suppose now that in a blockbuster trade the Leafs general manager obtains the services of
Sidney Crosby, arguably the worlds best hockey player today. As a result, the demand for
Maple Leafs hockey game tickets increases by 10 thousand tickets at each price level.
Assuming the price of Maple Leafs hockey game tickets is determined by market forces,
what is the new equilibrium price and quantity of tickets? Briefly explain your answer. (2
marks)
The new market demand for Maple Leafs hockey game tickets is now:
A B C D E F G H I
Price ($) 110 100 90 80 70 60 50 40 30
Quantity demanded (thousands) 10 15 20 25 30 35 40 45 50
Therefore, since the quantity supplied is constant at 20 thousand, the quantity bought and
sold continues at Q = 20 but the equilibrium price is now $90.


d) Draw the new demand curve in the diagram above and show the equilibrium (point B) of part
c). (1 mark)
e) What is the slope of this new demand curve? What is the equation for this demand curve?
What is the (point) price elasticity of demand at the point of equilibrium of part c) above?
Show all your work. (3 marks)
The slope of the demand curve is equal to P / Q. Lets take P and Q between any two
points of the demand curve, e.g., between points D and E in the above schedule. Moving
from point D to point E, P = 10 and Q = + 5 and thus P / Q = 2.
Since the vertical intercept is now at P = 130 (as shown in the diagram), the equation for the
demand curve is: P = 130 2Q.
The price elasticity of demand can be expressed as the ratio of price over quantity divided
by the slope of the demand curve, i.e., = (P
0
/ Q
0
) / (P / Q). At the point of equilibrium
the absolute value of the price elasticity of demand is = (90 / 20) / 2 = 9 / 4 = 2.25.


f) Suppose now that ticket prices are not set by market forces but rather by Maple Leafs
management. Without doing any calculations, explain whether the Maple Leafs should
increase or decrease ticket prices in order to increase their game revenues. (2 marks)
On the one hand, since the demand is elastic (i.e., > 1) at the point of equilibrium, an
increase in P would cause revenues to decrease. Therefore, Maple Leafs management
should not increase P.
On the other hand, since Q cannot be increased beyond 20 thousand, a decrease in P
would also cause revenues to decrease. Therefore, Maple Leafs management should not
decrease P either.
Conclusion: The Maple Leafs are maximizing revenues at the market equilibrium price of
$90.

Page 11 of 14
Question 2 (13 marks)
In the labour market, firms are demanders (i.e., buyers) of labour and households (or workers)
are the suppliers (i.e., sellers) of labour. Suppose that in the labour market of a hypothetical
country the weekly demand and supply for labour are, respectively,
P = 15 0.2Q and P = 0.1Q,
where P is the price (in pesos, $) of an hour of labour (i.e., the wage rate) and Q is the quantity
of labour (in millions of hours).
a) What is the equilibrium price of labour? What is the equilibrium quantity of labour (i.e., the
level of employment)? What is the total income earned by workers in this equilibrium? Show
all your work. (3 marks)
We must equate demand and supply to calculate equilibrium P and Q:
15 0.2Q = 0.1Q 0.3Q = 15 Q = 50
Therefore, P = 0.1Q = 0.1 (50) = $5
The total income earned by workers is thus P*Q = $5*50 = $250 (millions)




b) Draw the demand curve and the supply curve for labour in the diagram below and show the
equilibrium (point A) of part a). (1 mark)


























25 75
5
15
10
Q
50
P
7
40 70
D
A
Excess Supply of 30,000
S
Decrease in
employment
of 10,000

Page 12 of 14
c) What is (in absolute value) the point-elasticity of demand for labour at this equilibrium?
Show all your work. Without doing any calculations, indicate with reasons whether an
increase in the wage rate will increase or decrease the total income earned by workers? (2
marks)
The price elasticity of demand can be expressed as the ratio of price over quantity divided
by the slope of the demand curve, i.e., = (P
0
/ Q
0
) / (P / Q). At the point of equilibrium
the absolute value of the price elasticity of demand is = (5 / 50) / 0.2 = 5 / 10 = 0.5.
Since the demand is inelastic (i.e., < 1) at the point of equilibrium, an increase in P would
cause the total income earned by workers to increase.


d) Suppose that the government decides that the equilibrium wage rate is not a living wage
and passes a law setting the minimum wage rate at $7/hour. What will be the decrease in
the level of employment as a result of the imposition of this minimum wage? What quantity
of unemployment (excess supply of labour) will arise in the market? What will be the total
income earned by workers at this minimum wage? Show all your work. (3 marks)
Since P = 15 0.2Q, then Q = 75 5P.
At P = 7, the level of employment is Q = 75 5 (7) = 40 and thus employment has
decreased by 10 million hours as a result of the imposition of this minimum wage.
At P = 7, the quantity supplied is 7 = 0.1Q Q = 7/0.1 = 70. Therefore, there is an excess
supply equal to 30 million hours of labour.
The total income earned by workers is thus P*Q = $7*40 = $280 (millions).


e) In the diagram above, show the decrease in the level of employment and the excess supply
of labour of part d). (1 mark)
f) Compering the outcome in part d) with the outcome in part a), are workers better off or
worse off as a result of the minimum wage law? How has the producer surplus (i.e., workers
surplus) changed as a result of the imposition of this minimum wage? Briefly explain. Show
the change in producer surplus in the diagram above. (3 marks)
The majority of workers will be definitely better off (i.e., those 40 thousand who remained
employed) while a minority might be worse off (i.e., those 10 thousand who lost their jobs).
Of course, there might be social programs in place to compensate the losers (e.g.,
employment insurance payments).
In order to determine how workers in general were affected by the minimum wage legislation
we could look at the changes workers total income and in the producer surplus (i.e., the
workers surplus).
On the one hand, workers total income increased from $250 million before the imposition of
the minimum wage to $280 million as a result of the minimum wage legislation. Therefore,
there was a significant increase in workers total income.
On the other hand, as shown in the diagram, at the initial equilibrium wage of $5 an hour the
producer surplus was equal to the blue area plus the red area. After the enaction of
minimum wage legislation and the wage increasing to $7 an hour, the producer surplus
became equal to the blue area plus the yellow area. Therefore, there was a significant
increase in workers surplus as a result of the minim wage legislation.

Page 13 of 14
Question 3 (12 marks)
Suppose that the demand for good X is perfectly elastic at P = 40 while the supply curve for
good X is P = 0.5Q, where P is the price (in dollars) and Q is the quantity in thousand of units
per week.
a) What is the equilibrium price and equilibrium quantity in the market for good X? Show all
your work. (2 marks)
Since the demand is perfectly elastic at P = $40, this means that consumers are willing to
purchase any quantity supplied at this price. Therefore, the quantity bought and sold in the
market will be determined by the quantity supplied at P = $40:
40 = 0.5Q Q = 40 / 0.5 = 80 (thousand).


b) Draw the demand curve and the supply curve for good X in the diagram below and show the
equilibrium of part a). (1 mark)



























c) What is the consumer surplus in this market? Explain. (2 marks)
The consumer surplus is the difference between the maximum price consumers are willing
to pay for each unit of the good and the price they are actually paying (i.e., the market price).
Consumers are willing to pay a maximum price of $40 for each unit of the good and the
marekt price is also $40, and thus the consumer surplus is zero.
25 75
25
75
50
Q
50
P
10
60
D
S
80
40
S
30

Page 14 of 14
d) Suppose now that the government introduces a $10 unit-tax to be paid by producers. What
is the equation for the new supply curve? What is the new equilibrium price and equilibrium
quantity in the market for good X? Show all your work. (2 marks)
The imposition of a $10 unit-tax on producers increases the costs of production and thus
producers will now demand from consumers a minimum price $10 higher for each unit of
good X. Therefore, the supply curve shifts vertically up by exactly $10 and becomes:
P = 10 + 0.5Q.
Since P is determined by demand and equal to $40, the quantity bought and sold in the
market is now:
40 = 10 + 0.5Q 0.5Q = 30 Q = 30 / 0.5 = 60 (thousand).

e) Show the equilibrium of part d) in your diagram above. What is the change in consumer
surplus? And the change in producer surplus? Explain your answer with the help of your
diagram. (3 marks)
Consumers continue paying the maximum price they are willing to pay for each unit of good
X, and thus consumer surplus continues to be zero (i.e., there is no change).
The producer surplus is the difference between the minimum price producers are willing to
accept for each additional unit of the good and the price they are actually receiving. Before
the introduction of the unit-tax producers were receiving $40 per unit of output, the same
price being paid by consumers. Therefore, the producer surplus was equal to the area below
the price line $40 and above the supply curve. This is shown in the diagram above as the
summations of the yellow, green and blue areas.
After the imposition of the $10 unit-tax, consumers continue paying a price of $40 but
producers only receive a price of $30 (the difference being the tax collected by the
government). Therefore, the producer surplus is reduced to the area below the price line
$30 and above the supply curve. This is shown in the diagram above by the blue area.
Therefore, after the imposition of the unit-tax, the producer surplus decreases and this
decrease is equal to the summation of the yellow and green areas (see diagram above).


f) Does a deadweight loss arise in the market for good X? Briefly explain. If it does, show the
deadweight in the diagram above. (2 marks)
The loss to society (i.e., the deadweight loss) is not equal to the loss in producer surplus
since part of this loss to producers represents a transfer to the government in the form of the
taxes collected by the latter (represented by the yellow area in the diagram above).
Therefore, the deadweight loss is equal only to the green area in the diagram above.