Page 1 of 12

Department of Economics Prof. Gustavo Indart

University of Toronto October 26, 2012




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


/30



Part II 1. /15
2. /15
3. /10


TOTAL /80

Page 2 of 12
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. Note that no marks will be given for explanations to wrong answers.


Diagram 1: Indifference Curve













1. Victoria consumes only two goods: good X and good Y. Diagram 1 depicts one of Victorias
indifference curves. If she was initially consuming bundle A and now she chooses to
consume bundle B, which one of the following would be correct? [Note: MU
X
denotes
marginal utility of good X and MU
Y
denotes marginal utility of good Y.]
A) Her utility at point B will be greater than at point A.
B) Her MU
X
equals her MU
Y
at both points A and B.
C) Both her MU
X
and MU
Y
remain constant along the same indifference curve.
D) Her MU
X
increases and her MU
Y
decreases as she moves from point A to point B.
E) Her
G
o
o
d

Y

Good X
A
B
I
1
1 2 3 4 5 6 7 8 9 10
MU
X
decreases and her MU
Y
increases as she moves from point A to point B.


Page 3 of 12
2. If you always spend one-third of your income on food, then your price elasticity for food is
A) inelastic and equal to 1/3.
B) equal to 1.
C) inelastic.
D) elastic.
E) not determinable with the information provided.






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

Explanation:






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




S
CC

P
CC
Q
CC
S
CC

D
B

P
B
Q
B
D
B
S
B
D
CC

Page 4 of 12
4. A museum increases its admission price by 10 percent. As a result, total revenues increase
by 10 percent. This implies that, ignoring the sign, the price elasticity of demand for
admission is
A) zero.
B) less than one.
C) greater than one.
D) one.
E) not determinable with the information provided.

Explanation:

If both total revenue and the admission price increase in the same proportion, then the quantity
of admissions does not change as price changes. Therefore, the percentage change in the
quantity demanded is zero.
Since the price elasticity of demand () is defined as = %Q
D
/ %P, then the price elasticity
of demand for admission to the museum is zero.
[Note that all this implies that the demand curve for admission to the museum is vertical.]






5. Jeff often has pizza for lunch. His weekly demand for pizza is given by the following
schedule:
Price ($) 6 5 4 3 2
Quantity (slices) 1 2 3 4 5
If the price of a slice of pizza is $3, what is Jeffs weekly consumer surplus?
A) $0.
B) $3.
C) $6.
D) $12.
E) None of the above.

Explanation:

If P = $3, then Jeff will purchase 4 slices of pizza a week. The consumer surplus is the
difference between the maximum price the consumer is willing to pay for a particular unit of the
good (as indicated by the demand curve) and the price he actually pays (the market price).
For the first slice of pizza Jeff is willing to pay up to $6, but he pays only $3 and thus his
consumer surplus from consuming the first slice is $3.
For the second slice he is willing to pay up to $5, but he pays only $3 and thus his consumer
surplus from consuming the second slice is $2.
For the third slice he is willing to pay up to $4, but he pays only $3 and thus his consumer
surplus from consuming the third slice is $1.
And for the fourth slice he is willing to pay up to $3 and, since he actually pays $3, his consumer
surplus from consuming the fourth slice is $0.
Therefore, Jeffs weekly total consumer surplus of consuming 4 slices of pizza is:
CS = $3 + $2 +$1 + $0 = $6.

Page 5 of 12
6. Rachel found a nice one-bedroom apartment close to St. George campus. Last years
tenant paid $1,000 a month for this apartment. The landlord was now asking $1,100 for the
apartment but Rachel was not willing to pay more than $950 a month. To Rachels delight,
the landlord agreed to rent it to her for $950 a month. What is Rachels monthly consumer
surplus of renting this apartment?
A) $950.
B) $150.
C) $100.
D) $50.
E) None of the above.

Explanation:

Rachels consumer surplus is the difference between the maximum price she is willing to pay for
the apartment and the actual price she pays for it. Since the maximum price she is willing to pay
($950) is equal to the price she ends up paying, her consumer surplus is zero.
Therefore, E) is the correct answer.











7. Suppose that the Consumer Price Index was 150 last year. If there has been a 2 percent
price inflation this year, which one of the following is correct?
A) The current Consumer Price Index is 152.0.
B) The current Consumer Price Index is 153.0.
C) The current Consumer Price Index is 150.02.
D) The current Consumer Price Index shows that the price of each and every good and
service has increased by 2 percent.
E) Both A) and D) are true.

Explanation:

Two percent of 150 is 3, and thus the current CPI is 153.
Alternatively. Lets call X the current CPI. Therefore, CPI = X 150.
And the %CPI = (X 150) / 150, where %CPI = 0.02. Therefore,
(X 150) / 150 = 0.02
X 150 = 0.02 (150)
X 150 = 3
X = 153


Page 6 of 12
8. John spends all his income in a fitness club membership and tickets to Blue Jays baseball
games. If a 12-month membership in the fitness club costs as much as tickets for 24 Blue
Jays baseball games, the opportunity cost of one-month membership in the fitness club is
A) 1/2 baseball game.
B) 1 baseball game.
C) 2 baseball games.
D) 12 baseball games.
E) 24 baseball games.

Explanation:

The opportunity cost of one-month membership in the fitness club is equal to quantity of Blue
Jays baseball games John has to forgo in order to pay for that one-month membership.
Since the cost of a 12-month membership is the same as the cost of 24 baseball games, then
the opportunity cost of a 12-month membership is 24 baseball games.
Therefore, the opportunity cost of one-month membership will be one-twelfth of the opportunity
cost of a 12-month membership, i.e., the opportunity cost of a one-month membership is 2 Blue
Jays baseball games.





9. An effective price ceiling for a particular good is in place. Now the demand for this good
increases. All else equal, which one of the following statements best describes the most
likely outcome?
A) The quantity exchanged in the market will remain unchanged.
B) The quantity exchanged in the market will increase.
C) The quantity exchanged in the market will decrease.
D) The excess supply will decrease.
E) The excess supply will increase.

Explanation:

If there is an effective price ceiling in place, then there is an excess
demand in the market. Indeed, as shown in the diagram on the left,
at the price ceiling P
C
the quantity demanded is Q
D
while the
quantity supplied is Q
S
and thus the excess demand is Q
D
Q
S
.
The quantity bought and sold in the market is thus determined by
the lesser of these two quantities, i.e., by Q
S
.
An increase in demand causes the demand curve to shift up to D,
and thus the quantity demanded increases to Q
D
at the price level
P
C
. Therefore, the excess demand increases to Q
D
Q
S
. The
quantity exchanged in the market continues to be determined by
Q
S
and thus it will remain unchanged.







S P
P
C
D
D
Q Q
D Q
S
Q
D


Page 7 of 12
Diagram 2: Price Elasticity of Demand














10. In Diagram 2, the demand curves D
1
and D
2
have different slopes and intersect at point A.
Given the above, which one of the following statements is correct?
A) Both demand curves have the same price elasticity at point A.
B) Demand curve D
1
is more elastic than demand curve D
2
at point A.
C) Demand curve D
1
is less elastic than demand curve D
2
at point A.
D) Both demand curves are inelastic at point A.
E) Demand curve D
1
is elastic and demand curve D
2
is inelastic at point A.

Explanation:

The price elasticity of demand indicates the responsiveness of the quantity demanded to a
change in the price of the good. And the price elasticity of demand is measured as follows:
= %Q
D
/ %P = (P
1
/Q
1
) / (P / Q
D
) where P / Q
D
is the slope of the demand curve at the
point (Q
1
, P
1
).
Since the slope of the D
1
demand curve is greater than the slope of the D
2
demand curve, then
demand curve D
1
has a lower elasticity (i.e., its more inelastic) than the demand curve D
2
at
point A.
P
r
i
c
e
Quantity
A
D
2
D
1
Q
1
P
1

Page 8 of 12
PART II (40 marks)

Instructions: Answer all questions in the space provided.

Question 1 (15 marks)
Lady Gaga and Justin Bieber are both performing in Toronto. Isabel would like to attend both
concerts but, since they are both performing on the same night, she will have to settle for only
one of them. Isabel won a free ticket (which has no resale value) to attend the Lady Gagas
concert. On any given day, Isabel would be willing to pay up to $50 to attend a Justin Biebers
concert.
a) Assuming there are no other costs, what is Isabels opportunity cost of attending Lady
Gagas concert? Show all your work. (3 marks)
The opportunity cost of attending Lady Gagas concert is equal to what she has to forgo in
order to attend this concert.
Here she forgoes the possibility of attending Justin Biebers concert which she values at $50
(i.e., the maximum price she is willing to pay for a ticket to Justin Biebers concert).
Since she got a free ticket to Lady Gagas concert and this ticket has no resale value, she is
not forgoing any amount of money that she could spend elsewhere.
Therefore, Isabels opportunity cost of attending Lady Gagas concert is $50.






b) Based on the above information, can you calculate Isabels opportunity cost of attending
Justin Biebers concert? Explain. (3 marks)
The opportunity cost of attending Justin Biebers concert is equal to what she has to forgo in
order to attend this concert.
Here she forgoes the possibility of attending Lady Gagas concert and thus the satisfaction
or utility she would get by attending it (which is, in money terms, equal to the maximum price
she is willing to pay for a ticket to the concert).
She also forgoes the cost of the ticket to the Justin Biebers concert, i.e., the amount of
money that she could spend elsewhere.
Since we dont have this information, then we cannot calculate Isabels opportunity cost of
attending Justin Biebers concert.




Page 9 of 12
c) Suppose that, on any given day, Isabel would be willing to pay up to $30 to see Lady Gaga
in concert. Further suppose that tickets for the Justin Biebers concert cost $40. Based on all
the above information and assuming that there are no other costs, what is Isabels
opportunity cost of seeing Justin Bieber? Show all your work. (3 marks)
Now we have the information needed to calculate Isabels opportunity cost of attending
Justin Biebers concert.
She forgoes the possibility of attending Lady Gagas concert which she values at $30 (i.e.,
the maximum price she is willing to pay for a ticket to Lady Gagas concert).
She also forgoes the cost of the ticket to the Justin Biebers concert: $40 that she could
spend elsewhere.
Therefore, Isabels opportunity cost of attending Justin Biebers concert is $30 + $40 = $70.






d) Based on all the above information, which concert will Isabel attend? Explain. (3 marks)
Isabel will decide to attend the event with the lower opportunity cost. Therefore, since her
opportunity cost of attending Lady Gagas concert is $50 and her opportunity cost of
attending Justin Biebers concert is $70, Isabel will attend Lady Gagas concert.





e) Suppose now that Isabels free ticket to see Lady Gaga does have a resale value of $25.
What will be now Isabels opportunity cost of attending Lady Gagas concert? Show all your
work. Which concert will she decide to attend? Explain. (3 marks)
Since her ticket to see Lady Gagas concert now has a resale value of $25, by attending this
concert Isabel is now forgoing the possibility of spending this amount of money on
something else.
Therefore, the opportunity cost of attending Lady Gagas concert now must include the
resale value of her ticket in addition to the forgone satisfaction of attending Justin Bieber
concert.
Therefore, her opportunity cost of attending Lady Gagas concert is $50 + $25 = $75.
Since her opportunity cost of attending Lady Gagas concert ($75) is now greater than her
opportunity cost of attending Justin Biebers concert ($70), Isabel will decide now to attend
Justin Biebers concert.

Page 10 of 12
Question 2 (15 marks)
Consider the local market for high definition 40 TV sets. Suppose that the monthly demand
curve these TV sets is P = 1000 0.05 Q and the monthly supply curve is P = 100 + 0.05 Q.
a) What are the equilibrium price and quantity in this market? Show all your work. (4 marks)
D = S 1000 0.05 Q = 100 + 0.05 Q 0.1 Q = 900 Q* = 900 / 0.1 = 9000.
Plugging Q* in either the equation for D or S well find the equilibrium P:
P* = 1000 0.05 (9000) = 1000 450 = 550.
Or
P* = 100 + 0.05 (9000) = 100 + 450 = 550.









b) Suppose that the government intervenes in this market and imposes a price ceiling of $450
per set. What quantity will be bought and sold in the market? Will there be an excess
demand or supply in this market? If so, what will be the size of the excess demand or
supply? Show all your work. (4 marks)
At P = 450, the quantity demanded (Q
D
) will be:
450 = 1000 0.05 Q
D
0.05 Q
D
= 1000 450 0.05 Q
D
= 550 Q
D
= 550 / 0.05 =
11000.
At P = 450, the quantity supplied (Q
S
) will be:
450 = 100 + 0.05 Q
S
0.05 Q
S
= 450 100 0.05 Q
S
= 350 Q
S
= 350 / 0.05 = 7000.
Since Q
S
< Q
D
, the quantity bought and sold in the market will be determined by Q
S
and will
be, therefore, 7000 units.
Since Q
S
< Q
D
, there will be an excess demand equal to 11000 7000 = 4000 units.




Page 11 of 12
c) Given the outcome of part c) above, do you think that a black market might be likely to
arise? Explain. If a black market arises, what would be the minimum price for TV sets in this
black market? Show all your work. (3 marks)
Since Q
S
< Q
D
, some potential buyers will not be able to purchase a TV set at P = $450 and
might be willing to offer higher prices to obtain one. Therefore, a black market will most likely
arise.
The demand curve shows that if the quantity available in the market is 7000 units, the
equilibrium price would be:
P* = 1000 0.05 (7000) = 1000 350 = 650.
Therefore, if any of the potential buyers unable to obtain a TV set at P = $450 were to be
willing to pay a maximum price of $650 or greater, then the minimum black market price
would be $650.









d) Lets go back to the initial situation depicted in part a) above. Suppose now that the
government decides to bring down the price of TV sets to $450 by giving instead a unit-
subsidy to all firms. What would be the size of the required unit-subsidy? Show all your
work. (4 marks)
Since at P = $450 the quantity demanded is 11000, then 11000 TV sets should be supplied
in the market. For this to happen, the supply curve indicates that producers must receive a
price net of the subsidy (P
P
) equal to:
P
P
= 100 + 0.05 (11000) = 100 + 550 = 650.
Therefore, the required subsidy i.e., the difference between P
P
and P would be:
P
P
P = $650 $450 = $200.

Page 12 of 12
Question 3 (10 marks)
The government would like to reduce the consumption of tobacco and thus is considering the
introduction of a unit-tax to increase the price of cigarettes. A pack of cigarettes currently sells
for $8 and, in absolute value, the price elasticity of demand for cigarettes is 0.5.
a) If the government wants to reduce the consumption of cigarettes by 20 percent, by how
much should the price of a pack of cigarettes increase? Show all your work. (Note: Your
answer must indicate the new price of a pack of cigarettes.) (4 marks)
The price elasticity of demand is defined as:
= %Q / %P 0.5 = 20 / %P %P = 20 / 0.5 = 40
Therefore, P should increase by 40%. What will be the new price of a pack of cigarettes?
If we consider the 40% increase to be on the initial price of $8 a pack, then a 40% increase
represents an additional $3.20 and the new price will be P
2
= $11.20 a pack. This answer
will be accepted as correct.
However, if you correctly calculate the 40% price increase as a percentage not of P
1
but of
the average price (P
ave
), then you will receive a bonus mark of 2 additional points.
%P = (P
2
P
1
) / P
ave
where P
ave
= (P
1
+ P
2
) / 2
Since %P = 40 and P
1
= 8, then:
(P
2
8) / [(8 + P
2
) / 2] = 0.4 P
2
8 = 0.2 (8 + P
2
) P
2
8 = 1.6 + 0.2 P
2
0.8 P
2
= 9.6
P
2
= 9.6 / 0.8 = 12.

b) If this increase in the price of cigarettes is permanent, will this policy have a larger impact
one year from now or five years from now? Explain. (3 marks)
This increase in the price of cigarettes, probably accompanied by a good educational
campaign, most likely will have a greater impact five years from now than a year later. As
time passes by, not only will more people try to kick the bad habit of smoking but also more
people will succeed at doing so. Many people will try more than once to kick the habit and
eventually most will succeed. In other words, if the price elasticity of demand for cigarettes is
0.5 in the short run, it most likely will be much higher in the long run.


c) Studies find that teenagers have a higher price elasticity than do adults. Why might this be
the case? Explain. (3 marks)
The size of the price elasticity of demand not only depends on the length of time that has
elapsed since the price change but also on the proportion of income spend on the good in
question i.e., the greater the proportion of income spend on this good the greater its
elasticity. Since the income of teenagers is usually lower than the income of adults, the cost
of a pack of cigarettes represents a larger proportion of the income of teenagers than that of
adults. Therefore, an increase in the price of cigarettes it is expected to have a greater
impact on the consumption pattern of teenagers and elicit a greater reduction in their
consumption of cigarettes.