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Test #1 Answers

Multiple Choice:
1=c; 2=a; 3=d; 4=a; 5=b; 6=c; 7=a; 8=d; 9=a; 10=b; 11=c; 12=d; 13=d; 14=b;
15=c; 16=b; 17=a; 18=c; 19=b; 20=d.
Question 1: Basics of Supply and Demand
1a)

Suppose we are analyzing the market for potatoes. Sketch a quick supply and demand
diagram to show which curve will shift and state the resulting impact on the equilibrium
price and quantity of each of the following events affecting the potato market (6 points):
i.

Potatoes are now considered by doctors to be the most healthy vegetable to eat: D
shifts right, P increases, Q increases

ii.

There is a decline in the amount of land dedicated to growing potatoes: S shifts left,
P increases, Q decreases

iii.

The price of rice falls: Rice is a substitute; D shifts left, P decreases, Q decreases

iv.

Scientists discover a new method of growing potatoes which dramatically increases


farmers productivity: S shifts right, P decreases, Q increases

1b)

Suppose a new discovery in computer manufacturing has made production cheaper. In


addition, the popularity and usefulness of computers continues to grow. Use supply
and demand analysis to predict how these shocks will affect equilibrium price and
quantity of computers. Is there enough information to determine if market prices will
rise or fall? Explain why or why not (4 points).
$
D1

S0
S1

D0
P0

P1

Q
q0

q1

The increase in demand will cause P and Q to rise; the increase in supply will cause P to fall
while Q increases. Thus, the two effects on price work in opposite directions. If the supply
effect dominates the demand effect, then prices fall (as shown here). If the demand effect
dominates, prices will rise. We dont know which effect dominates, given the current
information, so cant perfectly predict the change in price.

1c)

The market for gravel has been estimated to have these supply and demand
relationships, where P = $ price per ton, and Q = sales per week in tons:
Supply
Demand
i.

P = 10 + 0.01Q
P = 100 0.01Q

Determine the equilibrium price and quantity (2 points)

10 + 0.01Q = 100 0.01Q. Thus, 0.02Q = 90


Q = 4,500 tons/week; P = 10 + 0.01(4,500) = $55/ton.
ii.

Determine the amount of shortage or surplus that would develop at P = $40/ton


(2 points).

At P = $40/ton, Qd = 40 = 100 0.01Q or Qd = 6,000 tons/week. Qs = 40 = 10 + 0.01Q or Qs


= 3,000 tons/week. The shortage is 3,000 tons/week.
iii.

What would be the impact on the market if the government set a price floor of
$70 per ton of gravel? (1 point)

The price floor is binding as it is above the equilibrium price. There would be excess supply of
3000 tons of gravel. Qd = 3000 tons; Qs = 6000 tons.
Question 2: Consumer Behavior
2a) An island economy produces only two goods: coconuts and pineapples. Four people (A,
B, C, and D) live on the island. Given the following preferences, construct a representative
indifference curve for each of the individuals with pineapples on the vertical axis and
coconuts on the horizontal axis. Discuss the shape of the indifference curves and relate them
to the MRS. (8 points)
A has a strong preference for pineapples.
B has a strong preference for coconuts.
C has a life-threatening allergy to pineapples so assigns no value to them.
D will only consume pineapples and coconuts in the fixed proportion of one P to one C.

Pineapples

A
B
Coconuts

Pineapple
s

D
W
Coconuts

The MRS measures the incremental number of pineapples the consumer will forego to get a
one unit increase in coconuts. A has relatively flat ICs (needs lots of C to compensate for the
loss of P) so As MRS is low. B has relatively steep ICs (needs few C to compensate for the
loss of P) so Bs MRS is high. Cs MRS is infinite (as utility is not affected by P, he will give up
all P (infinite) to increase C). Ds MRS is infinite when Q p>Qc, zero when Qc>Qp.
2b) George has $50 to spend on clothing, C, and food, F, where C costs $10 per unit and F
costs $5 per unit. Putting F on the horizontal axis, draw Georges budget line and an
indifference curve such that he buys 2F. Assuming Martha has the same income and faces
the same prices, but buys 6F, draw her indifference curve on the same diagram. In
equilibrium, what is the MRS of F for C for George? And for Martha? (3 points)

C
Y

UG

Umm
Mm

mG

In equilibrium, both Georges and Marthas MRS = Pf/Pc = 5/10 = .


2c) Peter consumes goods X and Y and spends $25 per week. The per unit price of X = $3;
the per unit price of Y = $2. Peters utility function can be written as U(X,Y) = 0.5XY. This
implies that the MUX = 0.5Y, and the MUY = 0.5X.

Write the expression for Peters marginal rate of substitution between X and Y. (1 point):
MRS = MUX/ MUY= 0.5Y/0.5X = Y/X

Write the expression for the budget line. (1 point): 25 = 3X + 2Y

Determine the values of X and Y that will maximize utility. (2 points)

In equilibrium: MUX/Px = MUY/Py. Thus, 0.5Y/3 = 0.5X/2, giving Y = 3/2X.


Use the budget line: 25 = 3X + 3X gives X = 4.12 units so Y = 6.25 units.
Question 3: Individual and Market Demand
3a) The current price charged by a local movie theater is $8. The concession stand earns $5
in revenue for each ticket sold. At P1, the theater sells 300 tickets per movie. If the theater
raises prices to $9, 270 tickets are sold. What is the elasticity of demand? What happens to
ticket revenue if the theater increases its prices to $9? If the theater wants to maximize the
sum of ticket and concession revenue, should they raise their price to $9? (5 points)
P

30

The price elasticity of demand at $8 is E Q P 300 1 0.8 . Initial ticket revenue is



P*Q=$8(300) = $2,400. If prices are raised to $9, revenue = $9(270) = $2,430. Thus, if prices
are raised, revenue increases by $30.
At $8, the concession stand will average $1,500 per movie. At $9, the stand will average
$1,350. Thus, concession stand revenues fall by $150. If the theater wants to maximize the
sum of ticket and concession revenue, they should not raise ticket prices to $9.
8

3b) Suppose that at a price of $4 per bushel, the quantity supplied of corn is 25 million metric

tons. At a price of $6 per bushel, the quantity supplied is 30 million metric tons. Using the arc
method, what is the elasticity of supply for corn? Is supply elastic or inelastic (explain your
answer)? (2 points)
Q/Q = (30 25)/(27.5)
P/P = (6 4)/5
Es =0.182/0.4 = 0.455. Thus, supply is inelastic (<1) which means that firms are not too
responsive to changing prices.
3c) The San Francisco Chronicle reported that the toll on the Golden Gate Bridge was raised
from $2 (P1) to $3 (P2). Following the toll increase, traffic fell by 5%. Calculate the point
elasticity of demand. The chairman of the bridges finance committee warned that this toll
increase would cause toll revenues to decrease by $2.8 million per year. Is this statement
consistent with economic theory? Explain. (3 points)
Increasing the toll on the bridge from $2 to $3 is a 50% increase. Traffic is expected to
decrease by 5% as a result. Thus, the point price elasticity of demand is -5/50 or -0.1.
Demand is inelastic, which means that the chairmans statement is not consistent with
economic theory, as an increase in price will increase total toll revenue, not decrease it.
3d) The demand for bread is estimated as Q = 600 150P. Graph this demand curve (2
points). If the price were $1, how many loaves of bread would be purchased? What is
consumer surplus at this price? (2 points). Suppose that the price doubles. Calculate the
loss in consumer surplus. (1 point)
When Q = 0, p = 4; when p = 0; Q = 600. Draw the graph.
If p =$1, Qd = 450 loaves; CS = (450)(3) = 675
If P = $2; Qd = 300; CS = (300)(2) = 300. Thus, CS = $375
Question 4: Production
4a) Complete the following table and using a diagram, explain the relationship between the
MPL and the APL (4 points):
L
0
1
2
3
4
5
6

Q
0
50
80
90
96
100
96

MPL
----50
30
10
6
4
-4

APL
----50
40
30
24
20
16

As MPL decreases, it starts pulling down the APL. See Figure 6.2
4b) A bakery operating in the short-run found that when the level of employment in its baking
room was increased from 4 to 10 (one extra worker at a time), its total production of bread

rose as follows: 110, 115, 122, 127, 130, 132, 133. Calculate the marginal product of labor,
and explain whether this production function exhibits diminishing marginal productivity of
labor. (3 points)
L
4
5
6
7
8
9
10

TP
110
115
122
127
130
132
133

MPL
5
7
5
3
2
1

This production function does exhibit diminishing returns to labor. Labor inputs of 7 or more
yield diminishing marginal returns, because the MPL is decreasing in this input range.
4c) You are given the following table for a production process which has two variable inputs.
Sketch the isoquants corresponding to the following output levels: 70, 95, and 115. (4 points)
What can be said of the MRTS, and what does this imply? (2 points) What returns to scale
does this production function exhibit? (2 points)
Capital Investment
1
2
3
4
5

1
35
60
70
85
95

Labor Input
2
3
60
70
70
85
85
95
95
105
105
115

4
85
95
105
115
125

5
95
105
115
125
135

Sketch the isoquants with K on vertical, L on horizontal. Given these isoquants are linear,
MRTS is constant so K and L are perfect substitutes. Returns to scale can be determined by
examining main diagonal. As we move from 1L, 1K to 2L, 2K, output rises from 35 to 70,
which implies constant returns to scale. As we move from 2L, 2K to 3L, 3K, input was
increased 1 times, but output rises from 70 to 95 (1.36 proportional increase). From 2L, 2K
to 3L, 3K, the production function exhibits decreasing returns to scale, and does so for the
remaining input combinations.