Page 1 of 14

Department of Economics Prof. Gustavo Indart

University of Toronto June 26, 2009



ECO 100Y
INTRODUCTION TO ECONOMICS
Midterm Test # 2



LAST NAME


FIRST NAME


STUDENT NUMBER



Check your section of the course: L0201 (T/R from 2:00 to 4:00 PM)
L5101 (T/R from 6:00 to 8:00 PM)


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 /40
Part II 1. /10
2. /10
3. /8
4. /12
5. /10
6. /10

TOTAL /100
SOLUTIONS

Page 2 of 14
PART I (40 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 you class section on the SCANTRON sheet either L0201 or L5101 where it says
DO NOT WRITE IN THIS SPACE.
Each question is worth 2.5 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
C E B E A D E B
9 10 11 12 13 14 15 16
E D C B A D B C

1. Diminishing marginal utility means that if more of a good is consumed
A) total benefit or utility derived from the good decreases.
B) total benefit or utility derived from the good decreases as the price of the good falls.
C) the benefit or utility of an additional unit decreases.
D) the benefit or utility of an additional unit increases less as the price of the good falls.
E) the benefit or utility of an additional unit decreases as the price of the good falls.

2. If an individual derives utility or satisfaction from the consumption of only two goods, she will
maximize her utility or satisfaction when
A) the ratio of the marginal utilities of these two goods is equal to one.
B) the ratio of the marginal utilities of these two goods is greater than one.
C) the ratio of the marginal utilities of these two goods is greater than the price ratio.
D) the ratio of the marginal utilities of these two goods is less than the price ratio.
E) the ratio of the marginal utilities of these two goods is equal to the price ratio.

3. Willy likes candy bars and popcorn. Candy bars sell for 50 cents and popcorn sells for $1
per bag. Willy is maximizing his utility at his present level of consumption of candy bars and
popcorn. Now the price of candy bars jumps to $1 per bar. Which of the following
statements is true in Willys new consumer equilibrium?
A) The marginal utility of popcorn will increase.
B) The marginal utility of candy will be equal to the marginal utility of popcorn.
C) Marginal utility per dollar spent will be equal to 2.
D) Total utility will be higher.
E) The marginal utility of candy will decrease.


Page 3 of 14
4. A utility-maximizing individual is consuming 4 slices of pizza and one cup of coffee a day.
The price of a slice of pizza is $4, and the price of a cup of coffee is $3. Given the above,
which one of the following statements is true?
A) The marginal utility of a slice of pizza is smaller than the marginal utility of a cup of
coffee.
B) The marginal utility of a slice of pizza is negative.
C) The marginal utility of a slice of pizza is equal to the marginal utility of a cup of
coffee.
D) The marginal utility of a cup of coffee is one-half the marginal utility of a slice of
pizza.
E) None of the above is true.

5. A firms fixed costs are $100. If total costs are $200 for one unit of output, $310 for two units,
and $415 for three units, which one of the following statements is true?
A) In this output-range, marginal cost is first increasing and then decreasing.
B) The marginal cost of the second unit is $210.
C) In this output-range, marginal cost is increasing.
D) In this output-range, marginal cost is decreasing
E) The marginal cost of the first unit is $200.

6. If we know that capital is fixed and a basket-producing firm can produce 40 baskets per day
with 5 workers and 51 baskets per day with 6 workers, which one of the following
statements is true?
A) The marginal product of the sixth worker is 8.5.
B) The average product of the sixth worker is 11.
C) In this range, average product is decreasing.
D) In this range, the marginal product is above the average product.
E) The firm has passed the point of diminishing marginal productivity.

7. Consider a perfectly competitive firm in the following position: output = 4000 units, market
price = $2, fixed costs = $10,000, variable costs = $1000, and marginal cost = $1.10. To
maximize profits in the short term, the firm should
A) shut down.
B) increase the market price.
C) not change output.
D) reduce output.
E) expand output.

8. A perfectly competitive industry is in short-run equilibrium with n identical firms and each
firm is earning zero economic profits (i.e., earning normal profits). Assume that firms ATC,
AVC, and MC curves have the traditional U-shape. Under these circumstances, which one
of the following statements is correct in the short run?
A) With a decrease in fixed costs, each firm would suffer losses and firms would exit the
industry.
B) With an increase in variable costs, each firm would make economic losses.
C) With a decrease in industry demand, each firm would make economic losses and
would produce a higher output.
D) With a decrease in variable costs, each firm would make economic profits and would
produce a lower output.
E) With an increase in industry demand, each firm would make economic profits and
would produce a smaller output.


Page 4 of 14
9. In the short run, a decrease in a perfectly competitive firms fixed costs should lead to
A) a decrease in price.
B) an increase in output and a decrease in price.
C) an increase in output and no change in price.
D) lower marginal costs.
E) none of the above.

10. A firm is producing 100 units of output with total revenue of $5,500; total cost is $9,000; total
fixed cost is $3,000; and marginal cost is $55. Which of the following represents the firms
best profit strategy in the short run?
A) The firm should maintain output at its present level.
B) The firm should decrease output until marginal cost equals minimum average
variable cost.
C) The firm should increase output until marginal cost equals the minimum point of
average total costs.
D) The firm should shut down.
E) None of the above is correct.

11. Suppose fixed costs are $100 and average variable costs are constant regardless of output.
Which of the following is then true?
A) Marginal cost will be less than average variable cost.
B) Marginal cost will equal average total cost.
C) Average total cost will decrease when output is increased.
D) Average total costs will be constant.
E) None of the above.

12. A perfectly competitive industry with n identical firms is in short run equilibrium. Each firm
has a total fixed cost of $80,000 and is initially making economic profits of $50,000 per year.
Now, each firm faces an increase in property taxes of $80,000 per year. As a result of this
shock, which one of the following statements is correct?
A) All firms will shut down.
B) Each firm will produce an unchanged output.
C) Each firm will produce an increased output and make economic losses of $30,000.
D) Each firm will produce a lower output and make zero economic profits.
E) None of the above is correct.

13. If a profit-maximizing firm in perfect competition is making economic losses, then it must be
producing a level of output where
A) average total cost is greater than marginal cost.
B) price is greater than marginal cost.
C) price is greater than marginal revenue.
D) marginal cost is greater than marginal revenue.
E) price is greater than variable cost.

14. For a certain perfectly competitive firm, total cost is $22 at 5 units of output, $24 at 6 units of
output, and $27 at 7 units of output. In this range of output, marginal cost is
A) greater than average total cost and increasing.
B) greater than average total cost and decreasing.
C) less than average total cost and decreasing.
D) less than average total cost and increasing.
E) not determinable with the information provided.


Page 5 of 14
15. Suppose that in a perfectly competitive industry, the industry price equals the minimum
value of average variable cost, then
A) total revenue equals total fixed cost and the loss equals total variable cost.
B) total revenue equals total variable cost and the loss equals total fixed cost.
C) total variable cost equals total fixed cost.
D) total cost equals total variable cost.
E) none of the above are correct.

16. Suppose a typical competitive firm has the following data in the short run: price = $10;
output = 100 units; ATC = $12; AVC = $7. Which of the following statements is correct?
A) Price will fall in the long run.
B) In the long run the industry will expand because of economic profits.
C) In the long run the industry will contract because firms are suffering losses.
D) The size of the industry will remain the same in the long run.
E) There is not enough information to formulate an answer.


Page 6 of 14
PART II (60 marks)

Instructions: Answer all questions in the space provided.

Question 1 (10 marks)
Mike has a monthly income of $100 which he totally spends on gas for his car and food. Gas is
an income-independent good for Mike. The price of gas is $1.00 per litre and the price of food is
also $1.25 per unit.





























a) Write the expression for Mikes budget line. Sketch Mikes budget line in the diagram above,
placing food (F) on the vertical axis and gas (G) on the horizontal axis. Clearly indicate the
values of the vertical and horizontal intercepts of his budget line. (2 marks)
E = P
F
*F + P
G
*G F = E/P
F
(P
G
/P
F
) G
100 = 1.25 F + 1.00 G F = 100/1.25 (1.00/1.25) G = 80 0.8 G

F
o
o
d

(
u
n
i
t
s

p
e
r

m
o
n
t
h
)

Gas (litres per month)
50 100 35
B
80
40
20
60
25
C
A
75
10
65 40

Page 7 of 14
b) At the utility maximizing combination of food and gas, Mike consumes 50 litres of gas per
month. How many units of food does Mike consume when maximizing his utility? Show
below how you obtained this value. Without drawing any indifference curve, show this
utility-maximizing equilibrium in your diagram (label it point A). (1 mark)
Since F = 80 0.8 G, if G = 50 then F = 80 0.8 (50) = 80 40 = 40




c) Suppose now that the government raises the tax on gas, thereby raising the price of gas to
$2.50 a litre. Draw Mikes new budget line in the diagram above. If at the new utility
maximizing combination of food and gas Mike consumes now 10 units of food per month,
wow many litres of gas does Mike consume per month? Show below how you obtained this
value. Without drawing any indifference curve, show this utility-maximizing equilibrium in
your diagram (label it point B). (2 marks)
Budget line: F = E/P
F
(P
G
/P
F
) G F = 100/1.25 (2.50/1.25) G = 80 2 G
Since F = 80 2 G, if F = 10 then
10 = 80 2 G 2G = 70 G = 35





d) After the increase in the tax on gas, the government lowers the income tax, thereby
increasing Mikes disposable income from $100 to $162.50. Suppose that the increase in
Mikes disposable income is just enough to allow him to reach the same indifference curve
as the one he was on before the price of gas rose. Keeping in mind that gas is an income-
independent good for Mike, how many units of food does Mike consume now per month?
Show below how you obtained this value. Without drawing any indifference curve, show
this utility-maximizing equilibrium in your diagram (label it point C). (3 marks)
Budget line: F = E/P
F
(P
G
/P
F
) G F = 162.50/1.25 (2.50/1.25) G = 130 2 G
Since G is an income-independent good, G = 35 when income increases from $100 to $162.50.
Therefore, F = 130 2 (35) = 130 70 = 60





e) Assuming smooth and convex indifference curves, now draw in the diagram above Mikes
initial indifference curve (i.e., the one he was on before the increase in the price of gas) and
the one he reached after the increase in the price of gas but before the decrease in the
income tax. (2 mark)

Page 8 of 14
Question 2 (10 marks)
Pawel consumes only two goods: good X and good Y. Pawels demand curve for product X is
perfectly inelastic.
Statement: Evangeline, a friend of Pawels, concludes that good X must be an income-
independent good for Pawel.
Position: Do you agree with Evangelines conclusion? Use a proper diagram to analyze this
situation and indicate, with reasons, whether you agree or disagree with Evangelines view.
No, I dont agree with Evangelines conclusion since income-independent goods also have
negatively-sloped demand curves. Rather, good X is a particular type of an inferior good for
Pawel one where the substitution effect and the income effect are of different sign but of
equal absolute value. This is shown in the diagram below.
Initially Pawel is maximizing his utility
consuming bundle A. As the price of good X
increases his budget line shifts from BL
1
to
BL
2
. He will now consume a different bundle
on this new budget line and will reduce his
level of satisfaction since the highest
indifference curve he will be able to reach is
lower than indifference curve I
1
. His real
income has thus decreased. Lets examine the
substitution and the income effect of this
increase 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 Pawel remains on the
same indifference curve). This is illustrated by
the movement from point A to point B, and the
quantity demanded decreases from X
A
to X
B
.
Now we measure the income effect by allowing
real income to fall while keeping relative prices
constant. In this way, Pawel moves to a lower
indifference curve. Since good X is an inferior
good for Pawel, as his income decreases his
quantity demanded of good X increases. And
since after the increase in price he continues
consuming the same quantity as before, the
increase in quantity as a result of the income
effect is equal to the decrease in quantity
resulting from the substitution effect so he
ends up consuming a quantity X
C
equal to X
A
.
His demand curve for good X is thus perfectly
inelastic i.e., vertical at X
A
.


P
Y
X
X
D
A
B
C
X
A
= X
C

X
A

X
B

BL
2

BL
1

I
1

I
2

P
1

P
2


Page 9 of 14
Question 3 (8 marks)
Sweet Treats is a small company specializing in customized wedding cakes. This company has
a fixed cost of $200 per day. Each worker is paid $40 per day. The cost of flour, sugar, and
other ingredients is $10 per cake. Sweet Treats daily production function is shown in table
below:
Quantity of workers 0 1 2 3 4
Quantity of cakes 0 3 7 10 12
Marginal product --- 3 4 3 2
Total cost 200 270 350 420 480
Marginal cost --- 23.3 20.0 23.3 30.0
Average variable cost --- 23.3 21.4 22.0 23.3

a) In the table above, fill in the marginal product (MP
L
) of each additional worker. Briefly show
how you obtained these figures. (2 marks)

MP
L
= Q/L, therefore:
MP
L
of the first worker is: MP
L
= Q/L = 3/1 = 3
MP
L
of the second worker is: MP
L
= Q/L = 4/1 = 4
MP
L
of the third worker is: MP
L
= Q/L = 3/1 = 3
MP
L
of the fourth worker is: MP
L
= Q/L = 2/1 = 2



b) In the table above, fill in the total cost (TC) of producing 0, 3, 7, 10, and 12 cakes per day.
Briefly show how you obtained these figures. (2 marks)

TC (Q) = TFC + TVC (Q) where TFC = 200 and TVC (Q) = 40 L + 10 Q
TC (0) = 200 + 40 (0) + 10 (0) = 200
TC (3) = 200 + 40 (1) + 10 (3) = 270
TC (7) = 200 + 40 (2) + 10 (7) = 350
TC (10) = 200 + 40 (3) + 10 (10) = 420
TC (12) = 200 + 40 (4) + 10 (12) = 480



Page 10 of 14
c) In the table above, fill in the marginal cost (MC) of producing each cake, assuming that MC
is constant for cakes produced by the same worker. Briefly show how you obtained these
figures. (2 marks)

MC (Q) = TC/Q, therefore:
MC of 1
st
to 3
rd
cake is: MC = TC/Q = 70/3 = 23.3
MC of 4
th
to 7
th
cake is: MC = TC/Q = 80/4 = 20.0
MC of 8
th
to 10
th
cake is: MC = TC/Q = 70/3 = 23.3
MC of 11
th
to 12
th
cake is: MC = TC/Q = 60/2 = 30.0







d) In the table above, fill in the average variable cost (AVC) of producing 3, 7, 10, and 12 cakes
per day. Briefly show how you obtained these figures. (2 marks)

TVC (Q) = 40 L + 10 Q, therefore:
TVC (0) = 40 (0) + 10 (0) = 0
TVC (3) = 40 (1) + 10 (3) = 70
TVC (7) = 40 (2) + 10 (7) = 150
TVC (10) = 40 (3) + 10 (10) = 220
TVC (12) = 40 (4) + 10 (12) = 280

And AVC (Q) = TVC (Q) / Q, therefore:
AVC (3) = 70 / 3 = 23.3
AVC (7) = 150 / 7 = 21.4
AVC (10) = 220 / 10 = 22.0
AVC (12) = 280 / 12 = 23.3

Page 11 of 14
Question 4 (12 marks)
Suppose Aramark 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.





























a) If Aramark is currently producing 10,000 pocket calculators a day using 250 units of labour
and 150 units of capital, what is its total cost? Briefly show how you obtain this figure. (1
mark) What is the expression for the corresponding isocost line? (1 mark) Draw this isocost
line in the diagram above and identify the cost-minimizing combination of capital and labour
(point A) that produces 10,000 pocket calculators a day. (1 mark)

TC = w L + r K, where L is the quantity of labour, K is the quantity of capital, w is the price of
labour, and r is the price of capital.
Total cost: TC = $100 (250) + $100 (150) = $40,000
Isocost line: 40,000 = 100 L + 100 K 100 K = 40,000 100 L K = 400 L





300 200
150
400
200
Q
u
a
n
t
i
t
y

o
f

C
a
p
i
t
a
l

100
300
400
500
Quantity of Labour
100
250
B
150
A

Page 12 of 14
b) If the marginal product of the 250
th
unit of labour is 10 pocket calculators, what is the
marginal product of the 150
th
unit of capital? (2 marks)

At the cost-minimizing combination (L*, K*) = (250, 150), MRTS = w/r (where w is the price of
labour, r is the price of capital, the MRTS is the absolute value of the slope of the isoquant
curve, and w/r is the absolute value of the isocost line). Since w = $100 and r = $100, then w/r =
1. Since MRTS = MP
L
/MP
K
, MRTS = 1, and MP
L
= 10, then MP
K
= 10.




c) Suppose now that the price of labour increases to $200 a day while the price of capital
continues at $100 a day. Will Aramark continue producing 10,000 pocket calculators a day
using the same combination of capital and labour of part a) above? Why or why not? Briefly
explain. (2 marks)

Since now w/r = $200/$100 = 2, then at (L, K) = (250, 150) the MRTS = 1 is less than w/r = 2.
That is, MP
L
/MP
K
< 2 and thus Aramark is not minimizing the cost of producing 10,000 pocket
calculators. To minimize the cost of producing 10,000 pockets calculators, Aramark must
substitute capital for labour, i.e., it must use more of the now relatively less expensive factor of
production (K), and less of the now relatively more expensive factor of production (L). Indeed,
as the quantity of K increases, the MP
K
falls; and as the quantity of L decreases, the MP
L
rises.
This process should continue until the MRTS is equal to w/r = 2.





d) If the price of labour is $200 a day and the price of capital is $100 a day, what is the
expression for the isocost line that corresponds to the same total cost as in part a) above?
Draw this isocost line in the diagram above. (1 mark)

40,000 = 200 L + 100 K 100 K = 40,000 200 L K = 400 2 L

e) Suppose now that, when the price of labour is $200 a day and the price of capital is $100 a
day, Aramark chooses to produce the same daily output as before using 150 units of labour
and 300 units of capital. What is the daily total cost of producing 10,000 pocket calculators
now? Briefly show how you obtain this figure. (1 mark) What is the expression for the
corresponding isocost line? (1 mark) Draw this isocost line in the diagram above and
identify the cost-minimizing combination of capital and labour (point B) that produces 10,000
pocket calculators a day. (1 mark)

Total cost: TC = $200 (150) + $100 (300) = $60,000
Isocost line: 60,000 = 200 L + 100 K 100 K = 60,000 200 L K = 600 2 L



f) Considering all the information above, draw in the above diagram the isoquant curve
corresponding to an output of 10,000 pocket calculators a day. (1 mark)

Page 13 of 14
Question 5 (10 marks)
Liat is the proud owner of a small firm in a perfectly competitive market. Her firm generates the
following short-run information: output is 100; the average fixed cost is $7; the average total cost
is $15; the marginal cost is $12; and total revenue is $1000.
Statement: Kinlam an economic consultant working for General Motors advises Liat to
shut down production to minimize her economic losses.
Position: Do you agree with Kinlams advice? If not, what advice would you give Liat? Use a
proper diagram to analyze this situation and explain your position.
Since TR = P*q, TR = $1000 and q = 100, then P = TR/q = $1000/100 = $10.
Since at q = 100, AC = $15 is greater than P = $10, Esmeralda is making economic losses
equal to = (P AC) q = ($10 $15) 100 = $500.
However, since AC = $15 and AFC = $7, AVC = AC AFC = $15 $7 = $8, which is less than
P = $10. Therefore, Esmeralda should not shut down as advised by Kinlam. If she were to shut
down, economic losses would be equal to TFC = AFC*q = $7 (100) = $700.
Therefore, Kinlams advice is wrong. But, although Esmeralda should continue producing a
positive output, she should reduce output and produce where P = MC (i.e., output q
1
as shown
in the diagram below).


























MC
AVC
$
q
q
1

15
10
8
Current economic
losses
Additional economic
losses if shutting down


100
AC
12

Page 14 of 14
Question 6 (10 marks)
A perfectly competitive industry is in long-run equilibrium with a constant cost industry supply
curve. The government then provides a permanent subsidy to every firm of $10 per unit of
output.
Statement: The long-run impact of the permanent per-unit subsidy will be as follows: price will
decrease but by less than $10, industry output will rise, the number of firms will increase, each
firm will produce a larger output, and all firms will make positive economic profits.
Position: Do you agree with the statement? Use a proper set of diagrams to analyze this
situation and explain your position.
If the industry is in long-run equilibrium, then each firm is making zero economic profits and
producing at the minimum of the LRAC curve. Since this is a constant cost industry, the LRS is
horizontal at the level of the minimum of the LRAC curve. Therefore, as the diagram below
shows, the initial long-run equilibrium price is P
1
, each firm is producing an output q
1
, and the
total output of the industry is Q
1
(where Q
1
= n*q
1
).
The subsidy of $10 per unit of output will reduce LRAC by exactly $10 at each level of output;
most particularly, it will reduce the minimum of the LRAC curve by exactly $10. Therefore, the
level of output at which each firm reaches the minimum efficient scale of production will remain
unchanged, and thus each firm will continue producing the same level of output (q
1
) in the new
long-run equilibrium. Therefore, the LRS curve will shift down by exactly $10, and thus the new
long-run equilibrium price will be P
2
= P
1
$10. However, the new total industry output will be
larger than before (i.e., Q
2
> Q
1
). This is so because as variable cost decreases, existing firms
will make economic profits in the short run, which will prompt new firms to enter the industry in
the long run. Therefore, the number of firms in the new long-run equilibrium will be greater than
before (i.e., n
2
> n
1
). Note that Q
2
= n
2
*q
1
>.
Therefore, the statement is false. It is correct that in the long run the industry price will decrease
but it will do so by exactly $10. It is also correct that the industry output will expand and that
more firms will enter the industry in the long run. However, each firm will continue producing the
same output as before and each firm will make just normal profits (i.e., zero economic profits) in
the long run.




















$ $
Industry Representative Firm
P
1
Q
2
q
LRAC
LRS
D
P
2
Q
LRS
q
1
P
1
P
2
Q
1
LRAC
$10
P = $10
Q