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Department of Economics Prof. Gustavo Indart

University of Toronto December 7, 2011




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 calculator.
3. Write with pen instead of pencil.



DO NOT WRITE IN THIS SPACE


Part I /4
/24



Part II 1. /11
2. /12
3. /9


TOTAL /60
SOLUTION

Page 2 of 12
PART I (28 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-half (0.5) mark for a maximum of four (4) 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 twenty-four
(24) additional marks. Note that no marks will be given for explanations to wrong answers.

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

Refer to Table 1 to answer questions 1 to 3. Table 1 shows the marginal cost, average variable
cost, and average total cost of producing various quantities of a commodity by a firm in a
perfectly competitive industry.
Table 1
Output (units) 4 5 8 10 20
Marginal Cost $10 $12 $18 $22 $42
Average Variable Cost $12.25 $12 $13.125 $14.5 $23.25
Average Total Cost $31 $27 $22.5 $22 $27

1. Refer to Table 1 above. What are the Total Fixed Costs of the firm?
A) $36.
B) $75.
C) $84.
D) $96.
E) None of the above.

Explanation:

TC = TFC + TVC and thus ATC = AFC + AVC.
Therefore, at any level of output AFC = ATC AVC.
At Q = 5, for instance, Table 1 shows that ATC(5) = 27 and AVC(5) = 12 and thus
AFC(5) = 27 12 = 15.
Since AFC = TFC / Q, then TFC = AFC * Q and at Q = 5, TFC = 15 * 5 = 75.



Page 3 of 12
2. Refer to Table 1 above. What are the Economic Profits of the firm when the firm is in
equilibrium at a price of $18?
A) -$25.
B) $36.
C) $39.
D) $45
E) None of the above.

Explanation:

Since a profit-maximizing firm will produce the level of output at which P = MC, when QP = $18
the firm will produce 8 units of output.
Economic profit () is the difference between total revenue (TR) and total cost (TC), where TR =
P * Q. Therefore, at Q = 8, (8) = TR(8) TC(8).
Since TR(8) = ($18 * 8) = $144 and TC(8) = ATC(8) * 8 = $180, then (8) = $144 $180 =
$36.
Therefore, the economic profits are $36, i.e., the firms is making economic losses and none of
the above is correct.






3. Refer to Table 1 above. What is the level of output at which the Economic Losses of the
firm are equal to Total Fixed Cost?
A) 4.
B) 5.
C) 8.
D) 10.
E) None of the above.

Explanation:

The economic losses of the firm are equal to total fixed cost when price is equal to the minimum
of the AVC curve since at this level of output TR = TVC. In turn, the firms AVC reaches a
minimum at the level of output at which MC = AVC.
Table 1 indicates that when Q = 5, MC = AVC = $12. Therefore, economic losses are equal to
TFC = $75 when Q = 5.





Page 4 of 12
4. Which of the following is true for an increasing ATC curve?
A) The increase in AVC is less than the decrease in AFC.
B) The increase in AVC is less than the increase in AFC.
C) The increase in AVC is greater than the decrease in AFC.
D) The increase in AVC is greater than the increase in AFC.
E) None of the above is true.

Explanation:

ATC = AFC + AVC.
AFC = TFC/Q is a continuously decreasing function of Q.
AVC = TVC/Q first falls as Q increases, at some level of Q it reaches a minimum, and then rises
as Q continues to increase. Note that AVC first falls because the AP of labour is increasing, and
then rises when the AP of labour decreases. Of course, when AVC reaches a minimum, AP
reaches a maximum.
Therefore, ATC first decreases as Q increases because both AFC and AVC are falling. At some
level of output ATC reaches a minimum, and then starts to increase as Q continues to increase.
Note that ATC will increase despite the fact that AFC continues to fall as Q increases, which
means that the increase in AVC must be greater than the decrease in AFC for ATC to rise.





5. Suppose that 5 workers produce 260 units of output, 6 workers produce 300 units of output
and 7 workers produce 336 units of output. Which of the following is true?
A) Marginal Product is rising.
B) Average Product is rising.
C) Marginal Product is less than Average Product.
D) Marginal Cost is less than Average Variable Cost.
E) Marginal Cost is falling.

Explanation:

Since AP = TP/L, then AP(5) = 260/5 = 52, AP(6) = 300/6 = 50, and AP(7) = 336/7 = 48.
Therefore, AP is decreasing as L increases, which means that MP < AP.
The information above also allows us to see that MP < AP.
When L = 5, AP = 52. The 6
th
worker contributes to increase TP from 260 to 300 units, and thus
the MP of the 6
th
worker is 40 units. Therefore, MP = 40 in less than AP = 52. And it is as a
result of employing this 6
th
worker whose MP = 40 is less than AP = 52, AP decreases from 52
to 50.




Page 5 of 12
6. Consider a perfectly competitive firm in the following position: Output = 4000 units, Total
Revenue = $4000, Total Fixed Costs = $2000, Total Variable Costs = $3000, and Marginal
Cost = $1.10. In the short run, this firm should
A) shut down.
B) expand output.
C) increase the market price.
D) reduce output.
E) not change output.

Explanation:

A perfectly competitive, profit-maximizing firm will produce the level of output at which P = MC
as long as P is greater than the minimum AVC.
Since output is 4000 units and TR is $4000, then P = $1. Therefore, P < MC = $1.10 and the
firm is not maximizing profits. In turn, since TVC = $3000, AVC = $3000/4000 = $0.75.
Therefore, since P > AVC the firm should produce a positive output. But the firm should produce
the level of output at which P = MC and thus it should reduce output until the MC of the last unit
being produce is equal to P.







7. Rachel consumes only books (Y-axis) and CDs (X-axis). Books and CDs are both normal
goods for Rachel. If the price of CDs increases, which of the following statements is
correct?
A) Her budget line becomes flatter.
B) Her quantity demanded of books increases as a result of the income effect.
C) Her quantity demanded of books decreases as a result of the substitution effect.
D) At her new optimal consumption bundle her marginal rate of substitution of CDs for
books will be greater than before.
E) None of the above is correct.

Explanation:

Rachels equilibrium as a consumer is attained when she consumes a combination of books (B)
and CDs that 1) she can afford (i.e., a point on her budget line), and 2) gives her the maximum
level of satisfaction or utility. Here she is maximizing her utility, which means that shes reaching
the highest possible indifference curve.
At this utility-maximizing consumption bundle, her budget line is tangent to an indifference curve
which means that the slope of the budget line and the slope of the indifference curve are
equal at this point.
The absolute value of the indifference curve is the MRS, and the absolute value of the budget
line is the relative price of the good measured on the horizontal axis (P
CD
/P
B
).
Therefore, since in equilibrium MRS = P
CD
/P
B
, if P
CD
increases, then in the new equilibrium
P
CD
/P
B
will also increase.


Page 6 of 12
8. 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 in the short-run?
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.

Explanation:

Since the market is in short-run equilibrium, then each firm is maximizing profits and thus
producing the level of output at which P = MC. At this profit-maximizing level of output each firm
is making economic profits of $50,000 in the short run.
Property taxes are part of the fixed costs of the firm, i.e., property taxes do not change as the
level of output changes. Therefore, the increase in property taxes does not affect the MC of the
firm and thus the firm will continue producing the same profit-maximizing level of output as
before as long as P > AVC.
Of course, instead of an economic profit of $50,000 the firm will be making now an economic
loss of $30,000. But since the firm would be making economic losses equal to total fixed cost
(i.e., $160,000) if it were to shut down, the firm will continue producing the same level of output
as before.







Page 7 of 12
PART II (32 marks)

Instructions: Answer all questions in the space provided.

Question 1 (11 marks)
Mario has a monthly income of $80 which he spends only on sports videos (SV) and visits to the
gym (GV). The price of sports videos is $5 and the price of each gym visit is also $5.




























a) What is the expression for Marios budget line? Suppose that, subject to his budget
constraint, he maximizes his utility when he visits the gym 5 times per month. How many
video games does he buy when maximizing his utility? Briefly show how you got this
answer. (2 marks)
Marios budget line is:
80 = 5 GV + 5 VG VG = 16 GM
If GV = 5, then the number of video games he buys is:
VG = 16 5 = 11.


S
p
o
r
t
s

V
i
d
e
o
s

(
u
n
i
t
s

p
e
r

m
o
n
t
h
)

Gym (visits per month)
20
10
A
12
5
15
15 10 5
B
BL
1
BL
2
I
1
I
2

Page 8 of 12
b) In the diagram above, draw Marios budget line and an indifference curve indicating his
equilibrium (point A). Assume that indifference curves have the usual shape, i.e., have
negative slope and are convex to the origin. (1 mark)
c) Suppose now that the gym offers all members the possibility of joining a program where
they would be paying a monthly fee of $20 plus an additional $1 per visit. What is the
expression for Marios budget line if he joins this program? In the diagram above, draw
Marios budget line if he joins this program. [Hint: How much money will Mario have
available to spend on VG and GV after paying the gym fee?] (3 marks)
After paying the gym fee, Mario has only $60 available to spend on VG and GV, i.e., his
income is reduced to $60. His budget line thus becomes:
60 = 5 VG + GV VG = 12 0.2 GV



d) Will Mario join this program and pay a monthly fee of $20? Why or why not? Briefly explain
with the help of your diagram. (3 marks)
With $60 still available to spend on VG and GM after paying the gym fee of $20 and at the
new price of $1 per gym visit, Mario is able to afford the previous utility-maximizing
consumption bundle of VG = 11 and GV = 5. That is, the previous utility-maximizing bundle
is one point on Marios new budget line (as shown in the diagram).
But Mario will not choose to consume this bundle. He can now reach a higher indifference
curve by consuming more GV and less VG. As shown in the diagram, he will now maximize
his utility by consuming at point B which implies more GV and less VG than before.
Therefore, Mario will join the program since, by doing so, his utility will increase.




e) If Mario were to join the program, what would be his MRS at point A? Briefly explain. (2
mark)
His MRS at point A is equal to the absolute value of the slope of his indifference curve
tangent to his original budget line at that point, that is, MRS = 1.
[Note that at point A now MRS > P
GV
/ P
VG
, which explains why he will increase GV and
decrease VG.]

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Question 2 (12 marks)
Rachel provides childcare services in a small town. The following table shows her daily total
cost (TC) of providing these services:
Number of children 0 1 2 3 4 5 6 7 8 9 10
Total Cost (TC) 80 110 135 155 170 190 215 245 280 320 365
a) What is Rachels total fixed cost (TFC)? Briefly explain how you got this answer. (2 marks)
Since TC = TFC + TVC and TVC = 0 when Q = 0, then TC = TFC when Q = 0 and thus TFC
= 80.




b) What is her average variable cost (AVC) when she cares for 5 children? Briefly explain how
you got this answer. (2 marks)
AVC = TVC/Q and TVC = TC TFC
TVC(5) = TC(5) TFC = 190 80 = 110
AVC(5) = TVC(5) / 5 = 110/5 = 22




c) Fill in the table below with Rachels MC of caring for each additional child. (2 marks)
Number of children 0 1 2 3 4 5 6 7 8 9 10
Marginal Cost -- 30 25 20 15 20 25 30 35 40 45

d) If the market price is $38 per child/day, how many children will Rachel care for? What
economic profits or losses will she make? Briefly show how you got these answers. (2
marks)
Rachel will care for more children as long as MR > MC and MR = P = 38. Therefore, Rachel
will take the 8
th
child since her MC = 35 < 38 but not the 9
th
child since her MC = 40 > 38
and thus she will care for 8 children.
When Q = 8, her economic profits will be as follows:
(8) = TR(8) TC(8) = 38*8 280 = 304 280 = 24.
That is, she will make economic profits of $24.


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e) Suppose the government imposes a licence fee of $50 per day. Will Rachel pay the licence
fee or will she prefer to shut down? If she decides to pay the fee and continue in her
business, how many children will Rachel care for now? What economic profits or losses will
she make? Briefly show how you got these answers. (2 marks)
The licence fee is a fixed cost and thus her marginal cost is not affected. Therefore, if she
remains in business she will continue taking care for 8 children.
Since TFC increases now to $130 and her TC(8) to $330) her economic profits will
decrease to:
(8) = TR(8) TC(8) = 38*8 330 = 304 330 = 26.
That is, she will make now economic losses of $26.
Since if she doesnt pay the fee she will have to shut down and make an economic loss of
$80 (i.e., her TFC), she will decide to pay the fee and continue in her business making a
lower economic loss of $26.






f) Suppose now that the licence fee is of $120 per day? Will Rachel pay the licence fee or will
she prefer to shut down? If she decides to pay the fee and continue in her business, how
many children will Rachel care for now? What economic profits or losses will she make?
Briefly show how you got these answers. (2 marks)
Since TFC increases now to $200 and her TC(8) to $400 her economic profits will
decrease to:
(8) = TR(8) TC(8) = 38*8 400 = 304 400 = 96.
That is, she will make now economic losses of $96.
Since if she doesnt pay the fee she will have to shut down and make an economic loss of
$80, she will prefer not to pay the fee and shut down since her economic losses will be
lower.


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Question 3 (9 marks)
Carlos owns a small photocopy business that reproduces course material for UofT students. His
total fixed cost (TFC) is the cost of his printer and rental space, while his total variable cost
(TVC) is the cost of labour plus the cost of paper and ink required for the reproduction of course
material. The table below shows Carloss cost of producing 10, 20 and 30 thousand copies per
day with different combination of his fixed and variable factors of production.

Quantity of
printers
Total Fixed
Cost
Total Variable Cost
10,000 copies 20,000 copies 30,000 copies
1 $300 $200 $500 $1,200
2 $500 $180 $280 $750
3 $700 $150 $160 $400

a) If Carlos has only one printer at the present time, what is his short-run average total cost
(ATC) of producing 10, 20, and 30 thousand copies per day? Show all your work. (3 marks)

TC(10,000) = TFC + TVC(10,000) = 300 + 200 = 500
ATC(10,000) = TC(10,000) / 10,000 = 500/10,000 = 0.05

TC(20,000) = TFC + TVC(20,000) = 300 + 500 = 800
ATC(20,000) = TC(20,000) / 20,000 = 800/20,000 = 0.04

TC(30,000) = TFC + TVC(30,000) = 300 + 1,200 = 1,500
ATC(30,000) = TC(30,000) / 30,000 = 1500/30,000 = 0.05


b) Carlos is currently producing 20 thousand copies per day and believes the demand for his
photocopy services will not increase in the foreseeable future. Nonetheless, he is
considering the possibility of buying one or two more printers. Should he buy more printers?
If so, how many more? Briefly explain (marks will be given entirely for your explanation). (3
marks)

Since all his factors of production are now variable, Carlos would like to have the quantity of
printers that will allow him to produce 20 thousand copies a day at the minimum cost. Lets
compare the total cost of producing 20 thousand copies a day with the three options of 1, 2,
and 3 printers:

1 printer TC(20,000) = TFC + TVC(20,000) = 300 + 500 = 800

2 printers TC(20,000) = TFC + TVC(20,000) = 500 + 280 = 780

3 printers TC(20,000) = TFC + TVC(20,000) = 700 + 160 = 860

Since the cost of producing 20 thousand copies a day is minimized when having 2 printers,
Carlos will buy one more printer.

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c) Suppose that Carlos is still producing 20 thousand copies per day with only one printer. He
learns now that a close by photocopy shop is about to shut down and he thus expects his
demand to increase to 30 thousand copies per day. Should he buy more printers? If so, how
many more? Briefly explain (marks will be given entirely for your explanation). (3 marks)

Lets compare the total cost of producing 30 thousand copies a day with the three options of
1, 2, and 3 printers:

1 printer TC(30,000) = TFC + TVC(30,000) = 300 + 1,200 = 1,500

2 printers TC(30,000) = TFC + TVC(30,000) = 500 + 750 = 1,250

3 printers TC(30,000) = TFC + TVC(30,000) = 700 + 400 = 1,100

Since the cost of producing 30 thousand copies a day is minimized when having 3 printers,
Carlos will buy two more printers.