Page 1 of 12

Department of Economics Prof. Gustavo Indart

University of Toronto December 5, 2012




ECO 100Y
INTRODUCTION TO ECONOMICS
Term Test # 2



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, non-programmable calculator.
3. Use pen instead of pencil.
4. Please write legibly. If I cant read your handwriting, I cant award you any
marks!


DO NOT WRITE IN THIS SPACE


Part I 1. /10


2. /10


3. /10


4 /10


5. /15


6. /15
Part II /30












Total /100


SOLUTIONS

Page 2 of 12
PART I (70 marks)

Instructions: Answer all questions in the space provided.

1. (10 marks) Pascal spends all his income on good X and good Y. He is currently maximizing
his utility by consuming 40 units of X and 60 units of Y. The government raises the tax on
good X, thereby raising the price of X. But the government also lowers the income tax,
thereby increasing Pascals disposable income. This increase in disposable income is just
sufficient to allow Pascal to afford the 40 units of X and 60 units of Y he was consuming
before the increase in the price of good X.
Statement: Cedric concludes that Pascal will be better off now than in his initial equilibrium.
Cedric also predicts that, in the new equilibrium, Pascal will consume more than 40 units of
good X but fewer than 60 units of good Y.
Position: Do you agree with Cedrics conclusion? Use a proper diagram to analyze this
situation and indicate, with reasons, whether you agree or disagree with Cedrics conclusion.

No, I do not agree with Cedrics conclusion.
As shown in the diagram below, Pascal is initially maximizing his utility by consuming at point A, i.e.,
consuming 40 units of good X and 60 units of good Y. As the price of good X increases, his budget
line changes from BL
1
to BL
2
and now he can no longer afford bundle A. However, with the increase
in income his budget line shifts up (from BL
2
to BL
3
) just enough to allow him now to afford bundle A
again. But although he can now afford bundle A, Pascal will not be maximizing his utility by
consuming that bundle. Indeed, at point A the slope of indifference curve I
1
is flatter than the slope of
the new budget line BL
3
(i.e., MRS = MU
X
/MU
Y
< P
X
/P
Y
). Therefore, he must substitute good Y for
good X in order to maximize his utility, i.e., he must move up along his budget line BL
3
. Indeed, by
doing so his MU
Y
will fall while her MU
X
will increase until MU
X
/MU
Y
= P
X
/P
Y
. As shown in the
diagram, by moving up along her new budget line BL
3
Pascal can reach higher indifference curves
until he maximizes his utility (i.e., he reaches the highest possible indifference curve) when
consuming bundle B.





















A
B
60
X
BL
1

I
2

BL
2

BL
3

Y
40
I
1

Y
B
X
B

Page 3 of 12
2. (10 marks) Jessica likes to attend both rock concerts (RC) and basketball games (BG). The
price of attending a rock concert is one-half the price of attending a basketball game. For
her current monthly consumption of rock concerts and basketball games, Jessica values
attending one more concert as much as she values attending one more basketball game
i.e., her marginal utility of rock concerts (MU
RC
) is equal to her marginal utility of basketball
games (MU
BG
).
Placing rock concert on the horizontal axis, use an indifference curve diagram to indicate
Jessicas current consumption bundle. Can Jessica increase her present level of utility or
satisfaction by changing her current consumption choice? If so, how? Briefly explain your
answer with the help of your diagram.

Jessica is not presently maximizing her utility since at her current consumption bundle her MRS is greater
than the relative prices of the two goods she consumes, that is, presently the last dollar she spends on
rock concerts (RC) increases her total utility by more than the last dollar she spends on basketball games
(BG) increases it.
Indeed, the MRS = MU
RC
/MU
BG
= 1 and P
RC
/P
BG
= 0.5 and thus MU
RC
/MU
BG
> P
RC
/P
BG
. To maximize her
utility she must decrease MU
RC
/MU
BG
until it equals 0.5. She will do so by increasing the quantity of RC
(which decreases the MU
RC
) and decreasing the quantity of BG (which increases the MU
BG
).
This can also be shown graphically in the diagram below. At the present consumption bundle (point A),
Jessicas MRS (i.e., the absolute value of the slope of indifference curve I
1
) is greater than the relative
prices of the two goods (i.e., the absolute value of the slope of her budget line).
Jessica can increase her level of utility (i.e., reach a higher indifference curve) by increasing her
consumption of RC and decreasing her consumption of BG. And she will be maximizing her utility when
the last dollar she spends on RC and the last dollar she spends on BG both increase her total utility by
the same amount i.e., when MRS = P
RC
/P
BG
. This is shown graphically in the diagram below by
increasing the quantity of RC and decreasing the quantity of BG (i.e., moving down along her budget
line), Jessica increases her utility (i.e., reaches higher indifferences curves) until she maximizes her utility
(i.e., reaches the highest possible indifference curve) at point B (where MRS = P
RC
/P
BG
).























A
B
BG
A
RC
I
1

I
2

Slope = 0.5
BG
BG
B
RC
A
RC
B

Page 4 of 12
3. (10 marks) Addison consumes only two goods, good X and good Y. Addison has negative
income elasticity for good X and her income effect for good X is stronger than her
substitution effect.
Statement: Katherine believes that when the price good X falls Addison will maximize her
level of consumer satisfaction by purchasing a smaller quantity of good X and therefore
Addisons demand curve for good X has a positive slope.
Position: Do you agree with Katherines view? Use a proper diagram to analyze this
situation and indicate, with reasons, whether you agree or disagree with Katherines view.













If Addisons income elasticity for good X is negative, then good X is an inferior good for heri.e., a
decrease in income will prompt her to increase her consumption of good X. Since good X is an inferior
good for her, the substitution and the income effects move in opposite directions. Therefore, as the price
of good X decreases, her quantity demanded of good X increases as a result of the change in relative
prices while keeping real income constant (i.e., while remaining on the same indifference curve). At the
same time, when real income is allowed to increase (i.e., moving to a higher indifference curve) while
keeping relative prices constant at the new level, Addisons quantity demanded of good X decreases. But
we are told that the income effect is greater than the substitution effect (i.e., good X is a Giffen good for
Addison) and thus the total effect of the decrease in the price of good X is a decrease in Addisons
quantity demanded of good Xwhich means that her demand curve for good X has a positive slope.
This is shown in the diagram above. Initially, when the price of good X is P
X
1
, Addison is maximizing her
utility by consuming bundle A which includes a quantity X
A
of good X. When the price of good X
decreases to P
X
2
, her budget line changes from curve BL
1
to curve BL
2
and now she maximizes utility at
point B on a higher indifference curve (i.e., her real income has increased). Her quantity demanded of
good X has increased from X
A
to X
B
. Lets split this total effect into the substitution and income effects.
If we allow relative prices to change while keeping real income constant, we must find a point on
Addisons original indifference curve where its slope is equal to that of the new budget line. This is point C
in the diagram. Therefore, her quantity demanded of good X increases from X
A
to X
C
as a result of the
substitution effect. Now we let real income increase (i.e., move to a higher indifference curve I
2
) while
keeping relative prices constant at the new level (P
X
2
/ P
Y
). Therefore, as shown in the diagram, Addison's
quantity demanded of good X decreases from X
C
to X
B
, reflecting the fact that good X is an inferior good
for her. The total effectthe summation of the substitution and income effectsis negative since the
income effect is greater than the substitution effect by assumption. Therefore, her quantity demanded of
good X decreases from X
A
to X
B
when the price of good X falls from P
X
1
to P
X
2
, and her demand curve for
good X has a positive slope as shown on the right-hand side diagram.
Therefore, I agree with Katherines view.
A
D
Y
E/P
X
1
E/P
X
2
P
X
1
P
X
2
E/P
Y

X
A
X
I
1
X
B

X
B

X
A
X
C

P
X
I
2
BL
1
BL
2
s.e.
i.e.
X
C
B

Page 5 of 12
4. (10 marks) Alanna owns a small firm in a perfectly competitive market. Her firm generates
the following short-run information: current level of output is 100 units; total revenue is
$3,500; total cost is $5,000; marginal cost is $35; and total fixed cost is $2,000.
Statement: Liang believes Alannas firm is making economic losses and should, therefore,
shut down production. Elena disagrees and advises Alanna not to shut down but to lay off
some workers to decrease production.
Position: Do you agree with Liangs or Elenas advice? Use a proper diagram to analyze
this situation and indicate, with reasons, whether you agree or disagree with their advice.





















Since Q = 100 and TR = $3500, then P = TR/Q = $35.
Since Q = 100 and TC = $5000, then AC = TC/Q = $50.
Since TC = $5000 and TFC = $2000, then TVC = $3000 and AVC = $30 when Q = 100.
The firm is making economic losses since P = $35 < AC = $50, and these economic losses account to
(AC P) Q = ($50 - $35) 100 = $1500. These losses are shown by the shaded area in the diagram. So
Liang is correct on this point. But Alanna should not shut down production since P = $35 > AVC = $30. In
addition, Alanna is minimizing these economic losses since she is producing the level of output at which
P = MC = $35. Indeed, her economic losses would be greater if she were to shut down, i.e., equal to TFC
= $2000.
Therefore, Elena is correct in that Alanna should not shut down production, but she is wrong suggesting
that she should reduce output since she is producing where P = MC. Therefore, I disagree with both
Liang and Elena.



AVC
MC
$
Q 100
50
35
30
AC
Economic losses of $1500

Page 6 of 12
5. (15 marks) Consider the perfectly competitive market for potatoes of a small country. The
potato market of this country is in long-run equilibrium. There are 1,000 identical farms
producing potatoes in this country, each farm producing 50 tons of potatoes annually. The cost
curves of farms have the usual U-shape. Each farm has an annual fixed cost of $10,000 and the
market price of a ton of potatoes is $800.
























a) What is the equation for the isocost line corresponding to a total cost of $50,000 a day?
(1 mark) Draw this isocost line (IC
1
) in the diagram above and indicate all relevant
points. (1 mark) Add a convex isoquant curve tangent to the isocost line at 200 units of
labour per day (point A). How many units of capital per day does Aramark employ? (1
mark)

Firm is in long-run equilibrium and thus P = AC
q=50
= $800.
AC = AFC + AVC AVC = AC AFC
TFC = $10,000 and thus AFC
q=50
= $10,000/50 = $200.
Therefore, AVC
q=50
= AC
q=50
AFC
q=50
= $800 $200 = $600
$
q (tons/year)
AFC = $200
50
600
AC
840
q*
AVC
800
AC
MC
Economic losses of $2000
P*

Page 7 of 12
b) The government now imposes a land tax of $2,000 to all farms. What will be the short-
run impact of this land tax? Briefly explain its impact on the market price (P), the market
quantity (Q), the farms output (q), the farms profits (), and the number of farms (n) in
the potato market? (5 marks) Show the impact of this land tax in the diagram above. (1
mark)

The land tax represents a fixed cost since it does not depend on the level of output, i.e., as Q changes
the land tax remains constant at $2,000. Therefore, the imposition of this land tax represents an increase
in TFC of $2,000. Therefore, TC will increase by $2,000 and the AC curve will shift up to AC and the
vertical shift of the AC curve is equal to AFC (which decreases as Q rises).
The AVC and MC curves do not change. And since MC doesnt change, then the market supply curve
does not change in the short run either. Therefore, the firms supply curves do not change and thus the
market supply curve also remains unchanged. If the market supply doesnt change, then P and Q remain
as before; and since P doesnt change, then q also remains unchanged at 50 units.
Since TR remains unchanged at TR = $800 x 50 = $40,000 while TC increase to $12,000, each farm will
now make economic losses equal to $2,000 (i.e., equal to the land tax).
Since K remains constant in the short run (and thus the number of firms also remains constant in the
short run), firms will continue producing 50 units of output and making economic losses of $2,000 in the
short run. The will not shut off production in the short run since otherwise their losses would increase to
TFC = $12,000.






c) What will be the long-run impact of this land tax? Briefly explain its impact on the market
price (P), the market quantity (Q), the farms output (q), the farms profits (), and the
number of farms (n) in the potato market. (5 marks)

In the long run farms can enter or exit the potato business. Therefore, since farms are making economic
losses, some farms will start exiting the industry in the long run (i.e., when the time comes to replace the
fixed capital).
As the number of firms decreases, then the market supply also decreases (i.e., the market supply curve
shifts to the left). Therefore, Q decreases and P increases.
As P increases, then q also increases (since farms will produce where P = MC).
In turn, as P increases the economic losses of the farms will be reduced.
And this process will continue as long as farms are making economic losses and continue exiting the
industry.
In the new long-run equilibrium, therefore, P will be higher than $800 (but less than $840) and equal to P*
in the diagram, Q will be lower, q will be higher than 50 and equal to q* in the diagram, every farm will be
making normal profits (i.e., zero economic profits), and the number of potato farms will be lower.

Page 8 of 12
6. (15 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 $200 per day, and the total daily cost of producing 10,000 calculators a
day is $50,000.



















a) What is the equation for the isocost curve corresponding to a total cost of $50,000 a
day? (1 mark) Draw this isocost curve (IC
1
) in the diagram above and indicate all
relevant points. (1 mark) Add a convex isoquant tangent to the isocost curve at 200
units of labour per day (point A). How many units of capital per day does Aramark
employ? (1 mark)
TC = w*L + r*K 50,000 = 100 L + 200 K 200 K = 50,000 100 L K = 250 0.5 L
If L = 200, then K = 250 0.5 (200) = 250 100 = 150


b) Explain why the point of tangency between the isocost line and the isoquant curve
described in part a) is a long-run equilibrium. (2 mark)
Any combination of K and L on the isoquant corresponding to 10,000 units of output allows the firm to
produce this output efficiently from a technical point of view, i.e., without wasting any resources. The firm,
however, will choose the technically efficient combination of K and L that allows it to produce this output
at the minimum cost. In other words, the firm will try to reach the lowest possible isocost line while still be
able to produce 10,000 units of output. That combination is given by point A in the diagram, i.e., the point
of tangency between the isoquant and an isocost line. Any other point on the isoquant will also lie on a
higher isocost line, and thus it will represent a greater cost. The firm cannot now substitute one factor of
production for the other in order to reduce its cost of producing this output, and thus the firm has achieved
a long-run equilibrium.
K
L
Q=10,000
500 200
150
B
IC
2
250
250
A
L
B

K
B

IC
3
TC
3
/ 200
IC
1
TC
3
/ 200

Page 9 of 12
c) What is the value of the MRTS at the point of tangency in a) above? (1 mark) What
happens to the value of the MRTS as we move down along the isoquant curve? (1
mark) What happens to the values of the marginal product of labour (MP
L
) and the
marginal product of capital (MP
K
) as we move down along the isoquant curve? (1 mark)

The MRTS is equal to the absolute value of the slope of the isoquant and at point A the slope of the
isoquant is equal to the slope of the isocost line. Since the absolute value of the slope of the isocost line
is the relative price of L (i.e., P
L
/ P
K
= $100 / $200 = 0.5), then at point A the MRTS is 0.5.
As we move down along the (convex) isoquant, its slope becomes flatter. Therefore, the MRTS
decreases as we move down along the isoquant.
The MRTS can be expressed as the ratio of the marginal product of the factors of production, i.e., MRTS
= MP
L
/ MP
K
. Therefore, as we move down the isoquant, MP
L
/ MP
K
decreases. Lets recall that as we
move down along an isoquant, the quantity of L increases while the quantity of K decreases. And, given
the assumption of diminishing marginal return to a factor of production, MP
L
decreases as L increases
and MP
K
decreases as K increases. Therefore, as we move down the isoquant, the ratio MP
L
/ MP
K

decreases because MP
L
falls (as L increases) and MP
K
rises (as K decreases).

d) Suppose now that the price of labour rises to $200 a day while the price of capital
continues at $200 a day. What is the equation for the new isocost line corresponding to
a total cost of $50,000 a day? (1 mark) Draw this new isocost line (IC
2
) in the diagram
above and indicate all relevant points. (1 mark)
TC = w*L + r*K 50,000 = 200 L + 200 K 200K = 50,000 200 L K = 250 L

e) Further suppose that Aramark Co. chooses to produce the same daily output as before.
Draw the new isocost line (IC
3
) in the same diagram and show Aramarks new long-run
equilibrium (point B). (1 mark) Has the combination of capital and labour changed? If it
has, explain why. (1 mark) Has Aramarks total cost changed? If it has, briefly explain
why and how. (1 mark)
Given the assumption of convex isoquants (i.e., K and L are not perfect substitutes), as the relative price
of the factors of production changes the firm will use more of the relatively less expensive factor and less
of the relatively more expensive one. Therefore, the firm will substitute K for L, i.e., as the price of L
increases the firm will use more K and less L to produce 10,000 units of output. Indeed, as the slope of
the family of isocost lines becomes steeper, the firm will choose a combination of K and L where the
MRTS is equal to the new (higher) relative price of the factors of production. This occurs at point B in the
diagram.
The total cost of producing 10,000 units of output has increased (i.e., point B lies on a higher isocost line).
Indeed, with a total outlay of $50,000 a day the firm will not be able to produce this output (isocost line IC
2

lies below the isoquant corresponding to 10,000 units of output). Isocost line TC
3
does represent an
outlay greater than $50,000 (but smaller than $70,000 the cost of bundle A at the new price of L).


f) If at point B the MP
L
is equal to 4, what is the value of the MP
K
at this point? (2 marks)
If the MRTS at point B is equal to 1 and MRTS = MP
L
/ MP
K
, then MP
K
= 4 when MP
L
= 4.

Page 10 of 12
PART II (30 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 correct answer is worth 3 marks. No deductions will be made for incorrect answers.

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

1. Alexander spends all his income on only two goods, coffee (X-axis good) and donuts (Y-
axis good). The price of coffee is $2 a cup and the price of donuts is $1 a piece, and
Alexanders indifference curves are smooth and convex to the origin. If at his present
consumption bundle Alexanders marginal rate of substitution is 3, which one of the
following statements will be correct?
A) Alexander is presently maximizing his utility.
B) Alexander should consume more coffee and less donuts to maximize his utility.
C) Alexander should consume more donuts and less coffee to maximize his utility.
D) Alexander should consume more coffee and more donuts to maximize his utility.
E) Alexander should increase the price of coffee to maximize his utility.

2. Consider a constant cost, perfectly competitive industry with n identical firms. The industry
is currently in long run equilibrium. If the industry demand decreased, which one of the
following statements would be correct in the long run?
A) Price would decrease; industry output would decrease; and each firm would produce
an unchanged output.
B) Price would remain unchanged; industry output would increase; and each firm would
produce a larger output.
C) Price would increase; industry output would decrease; and each firm would produce
an unchanged output.
D) Price would decrease; industry output would decrease; and each firm would produce
a smaller output.
E) Price would remain unchanged; industry output would decrease; and each firm would
produce an unchanged output.


Use this space for rough work.


Page 11 of 12
3. A perfectly competitive industry is in short-run equilibrium and each firm is initially making
normal profits. If material costs were to increase, which one of the following statements
would be correct in the short run?
A) Each firm would produce less and make economic losses.
B) Each firm would produce more and make economic losses.
C) Each firm would produce an unchanged output and make economic losses.
D) Each firm would produce an unchanged output and make economic profits.
E) Firms would leave the industry.

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

5. Suppose that 100 workers produce 1000 units, 101 workers produce 1015 units, and 102
workers produce 1028 units of output for a firm. Given the above, which one of the following
is true?
A) The firms marginal cost is decreasing and its average variable cost is decreasing.
B) The firms marginal cost is decreasing and its average variable cost is increasing.
C) The firms marginal cost is increasing and its average variable cost is decreasing.
D) The firms marginal cost is increasing and its average variable cost is increasing.
E) None of the above is true.

6. Consider a constant cost, perfectly competitive industry with n identical firms. The industry
is currently in long-run equilibrium. If the government gives producers a permanent subsidy
of $10 per unit of output, which one of the following statements would be correct in the long
run?
A) Price would decrease by $10; industry output would increase; and each firm would
produce a larger output.
B) Price would decrease by $10; industry output would remain unchanged; and each
firm would produce an unchanged output.
C) Price would decrease by less than $10; industry output would increase; and each
firm would produce a larger output.
D) Price would decrease by $10; industry output would increase; and each firm would
produce an unchanged output.
E) Price would decrease by less than $10; industry output would increase; and each
firm would produce an unchanged output.


Use this space for rough work.



Page 12 of 12
7. Suppose that in a perfectly competitive industry, the market price of the product is $6. A firm
is currently producing 100 units of output per week with a weekly total cost of $900 and total
fixed cost of $200. The firms marginal cost is $6. What should this firm do to maximize its
profits?
A) The firm should change the price of the product.
B) The firm should reduce its output.
C) The firm should expand its output.
D) The firm should leave its output unchanged.
E) The firm should shut down.

8. A perfectly competitive industry is in short-run equilibrium and each firm is initially making
normal profits. The price of a substitute good falls. As a result, which one of the following
statements is correct in the short run?
A) Price would decrease; industry output would decrease; each firm would produce a
smaller output; and each firm would make economic losses.
B) Price would increase; industry output would increase; each firm would produce a
smaller output; and each firm would make economic losses.
C) Price would increase; industry output would increase; each firm would produce a
larger output; and each firm would make economic profits.
D) Price would decrease; industry output would decrease; each firm would produce a
larger output; and each firm would make economic profits.
E) None of the above is correct.

9. Suppose that the average return in the economy on a $1 million investment is $50,000 per
year. What is the economic profit of a firm that earns a return of $280,000/year on a capital
of $3 million after payment of expenses and rent?
A) $0.
B) $100,000.
C) $130,000.
D) $150,000.
E) $280,000.

10. Suppose that average variable cost is $4, marginal cost is $6, price is $6, and average total
cost is $7 at an output of 10,000 for a perfectly competitive firm. Which of the following is
true at this output?
A) Total variable cost is $60,000 and the economic profit is $0.
B) Producers surplus is $20,000 and fixed costs are $30,000.
C) Fixed costs are $20,000 and total revenue is $70,000.
D) Fixed costs are $10,000 and total revenue is $60,000.
E) None of the above is true.


Use this space for rough work.