University of Toronto ECO101: Principles of Microeconomics

Department of Economics Robert Gazzale, PhD

Term Test 1: Form Code: X1: 2018

Solutions: Full
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General Instructions
1. 105 minutes. 106 marks. Allocate your time wisely!
2. OTHER test booklet: 53 Multiple choice marks.
3. THIS test booklet: 53 short-answer and calculation marks.
4. Aids allowed: a non-graphing, non-programmable calculator; a straight edge (i.e., ruler).
5. For True, False or Uncertain questions, all marks are earned for the explanation.
6. Show your work. No work, no partial marks.
7. When explanations are needed, be clear, accurate, and concise.
Avoid the temptation to write too much.
8. The final page is blank. If you need to continue an answer on this page, you must write
“Continued on final page” in the question’s answer space.
9. Unless otherwise stated, assume quantities need not be integers.

20180528X1 Term Test 1: Solutions: Full

 I. [20 Marks] TFU means “True, False or Uncertain?”. All marks are earned for the explanation.

(1) [5 Marks] Assume the TTC has a fixed number of advertising spaces, and sells all available
spaces at the price where quantity demanded equals spaces available. The Plan: The province
would require the TTC to give away, for free, 5% of available advertisement spaces for public
service announcements. TFU: The plan will lower TTC advertisement revenues.
Solution: Uncertain. The statement is true if the increase in price does not compensate for
fewer spaces sold. If demand is inelastic, this false (increase in price more than compensates) as
the percent increase in price will be greater than 5% . If demand is elastic, this is true (increase
in price does not fully compensate for quantity reduction) as the percent increase in price will
be less than 5%.
(2) [5 Marks] Assume each 1-mark improvement in your ECO101 final grade is worth $100. No
matter how many hours you study, your final marks will be higher if you purchase The Method
than if you do not purchase the method. TFU: If you purchase the method, you rationally study
fewer hours.
Solution: Uncertain. We need to know about marginal benefits. Assume that without the
method, you study for 20 hours. If the method decreases the marginal benefit of the 20th hour
(because the first hours were so pruductive), then you study less. If the method increases the
marginal benefit of the 20th hour, you continue to study.
For example, assume a constant marginal cost of studying, where you study any day giving you
a 5-mark or higher improvement in your final mark. Assume the table shows ECO101 mark as
a function of the number of days studying.
Days 0 1 2 3
Mark: No Method 60 70 76 78
Mark: Method I 60 80 83 85
Mark: Method II 60 71 80 88
Row 1 shows without The Method. You stop studying after 2 days. If studying productivity
with The Method is given by row 2, you stop studying after 1 day. If productivity with The
Method is given by o row 3, you study (at least) 3 days.
(3) [5 Marks] At a per-ride price of $2, Victoria takes 50 public transportation rides per month.
She then realizes that she can buy a monthly pass enabling her to take as many rides as she
wants in a month without paying any extra money. TFU: If the price of the monthly pass is
$125, Victoria should not purchase a monthly pass.
Solution: Uncertain. If she purchases the monthly pass, this reduces her marginal cost to zero.
She will thus take more rides (all those rides where the benefit is positive but less than $2.) If
the sum of the benefits from these extra rides is $25 or more, she should purchase the monthly
pass. If the sum of the benefits from these extra rides is less than $25, she should not purchase
the monthly pass.
(4) [5 Marks] Assume no external costs nor benefits. King Bob has correctly calculated that 1000
is the efficient quantity of new cars. The Plan:
• Have 1000 new cars produced at the lowest total cost.
• Anyone who who wants a new car can pay $100 to enter the new-car lottery.
• 1000 people who entered the new-car lottery are chosen at random to get a new car!

20180528X1 Term Test 1: Solutions: Full

 TFU: Assuming car quality is the same in both a competitive market and The Plan, a com-
petitive market and The Plan have the same total surplus.
Solution: False. Total surplus is societal benefit minus societal cost. By assumption, both
the market and The Plan have the same societal cost of car building. The Plan will have
lower total surplus because the competitive market maximizes societal benefit because cars go
to the 1000 highest marginal societal benefits (i.e., private benefits or MWTP). Because The
Plan allocates cars via lottery, those getting cars will almost certainly not be the 1000 highest
benefits.

II. [10 Marks] Assume a perfectly competitive market for landscaping in Borianastan, where the Bori
is the official currency. In 2028, 100 units were transacted at a price of 100 Boris. In 2029, the hourly
wage landscaping firms pay their workers increases.

(1) [4 Marks] Use the graph below, clearly identify producer surplus in 2028 and 2029. (Yes, you
will need to draw additional “curves”.)

Solution: Just for grins, I have drawn one graph with elastic demand and one In both graphs,
the triangle ABC is producer surplus in 2028, while the triangle DEF is producer surplus in
2029.

20180528X1 Term Test 1: Solutions: Full

 Figure 1: Elastic demand on left, inelastic demand on right.
(2) [6 Marks] Given the increase in the hourly wage landscaping firms pay their workers, will 2029
producer surplus be higher if, at relevant prices, own-price elasticity of landscaping demand is
elastic or or if it is inelastic? Explain.
Solution: Inelastic demand. The increase in wage puts upward pressure on the price of
landscaping. With elastic demand, this causes a large decrease in quantity demanded, while
with inelastic demand, this causes a relatively small decrease in quantity.
This leads to two effect on producer surplus. (See Figure 1.) First the more inelastic the demand,
the larger the increase in market price (i.e., the more of this wage increase you can pass on to
consumers). Second, the more inelastic the demand, the smaller the decrease in quantity (i.e.,
units on which you earn surplus decreases).
The full-mark answer discusses both aspects: larger increase in price and smaller increase in
quantity.

III. [13 Marks] Short Answer. Be concise, but your use of ECO101 words must be clear to
someone who has not yet taken ECO101!

(1) [5 Marks] You are producing a movie. Here is the plan as of April 1:
April $30 million in filming expenses.
May $30 million in filming expenses.
June $10 million in marketing expenses.
July $100 million in revenues.
In order to get the revenue, you need two months of filming plus $10 million in marketing.
On April 30, your assistant says April filming expenses were actually $70 million. He also tells
you that May filming expenses will be $X with certainty. Assume no change in either marketing
expenses or revenues. As of April 30:
• What are your sunk costs?
• At what value of $X do you choose to cancel the movie? Explain.

20180528X1 Term Test 1: Solutions: Full

 Solution: Your sunk costs are the costs you cannot recover: $70 million. Nothing you can do
about that. If you proceed, in June and July, you get $100-$10=$90 million. Thus, if May’s
filming costs are $90 million or less, you should proceed, but if they are more than $90 million,
you should cancel.
(2) [4 Marks] Short-run elasticity of demand for automobiles has been estimated at 1.5. Long-run
elasticity of automobiles has been estimated at 0.2. Explain why this makes sense. (And no,
Prof. Gazzale did not make a mistake.)
Solution: In this case, demand is more elastic in the short run than in the long run! For
many people, the best substitute for purchasing a car is keeping the current car. This is a good
substitute in the short run, but in the long run, this is a less good substitute as the current car
gets crappier and crappier.
(Another way to frame this would be the distinction between luxury and necessity. Buying a
new car when your current car is fine is somewhat of a luxury. Buying a new car when your
current car dies in the long run is a necessity.)
(3) [4 Marks] Short-run elasticity of demand for automobiles has been estimated at 1.5. Is the
short-run elasticity of demand for automobiles made by the Ford Motor Company (a.k.a. Ford)
less than, equal to, or greater than 1.5? Explain.
Solution: Almost certainly greater than 1.5 (i.e., more elastic). Let’s say you have your eye
on a new Ford. The substitutes included keeping your current car or purchasing a car made
by another manufacturer (e.g., Toyota). If the price of all cars (including the Ford) increases,
only substitute which does not increase in price is keeping your current car. If only the price of
Ford automobiles increases, the the cars made by other manufacturers are going to look relatively
more attractive. In fact, elasticity for a particular brand of automobiles (e.g., Fords) is estimated
to be twice as large as the elasticity for automobiles in general.
IV. [10 Marks] Assume our standard model of gains from trade.

One Scarf One Hat

Ajaz 20 minutes 30 minutes
Bob 5 minutes 10 minutes

Table 1: Knitting productivity for two boys.

(1) [5 Marks] Table 1 shows for each individual the number of minutes to complete each of two
tasks. Fill in the blanks. For full marks you must show your work.

In a mutually beneficial trade, sends scarves and receive hats. He

only agrees to trades where he gets at least hat for each scarf.

In a mutually beneficial trade, will send hats and receive scarves.

He only agrees to trades where he gets at least scarves for each hat.
Solution: In a mutually beneficial trade, Bob sends scarves and receives hats. He only agrees
to trades where he gets at least 21 hats for each scarf.

20180528X1 Term Test 1: Solutions: Full

 In a mutually beneficial trade, Ajaz will send hats and receives scarves. He only agrees to trades
where he gets at least 32 scarves for each hat.
scarf scarf minutes
To see how we got here, let’s calculate OChat = hat = minutes hat for each individual.
1
Ajaz OChat = 20 × 30 3
1 = 2
Bob OChat = 51 × 10
1 =2
With the lower opportunity cost, Ajaz will send hats to Bob. For each hat Ajaz sends to Bob,
he had to give up 32 of a hat, so will only trade if he gets at least 32 of hat for each scarf.
Bob thus has the lower opportunity cost for scarves (inverting, we have 12 versus 32 ). For each
scarf Bob sends to Ajaz, he has to give up 21 of a hat, so will only trade if he gets at least 12 hats
per scarf.
One Scarf One Hat
Ajaz 20 minutes 30 minutes
Bob 5 minutes 10 minutes
(2) [5 Marks] Ajaz and Bob each have 10 hours, and you get to determine how they spend their
time. If they are efficiently producing 50 hats in total, how many scarves are they producing.
For full marks, you must briefly explain how you arrived at your answer.
Solution: 60 scarves.
Okay, we have to produce some hats. The first person we put on the task is the person with the
2hat
lowest opportunity cost, Ajaz. With 10 hours, he produces 10 hours × hour = 20 hats.
We need 30 more hats. Bob can knit 6 hats per hour, so he needs 5 hours. He knits scarves with
his 5 remaining hours. He produces 12 scarves per hour, so he can produce 5 × 12 = 60 scarves.

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ANSWER TO A QUESTION REFERS US TO THIS PAGE.

20180528X1 Term Test 1: Solutions: Full

 INTENTIONALLY LEFT BLANK. WE WILL LOOK AT THIS PAGE ONLY IF YOUR
ANSWER TO A QUESTION REFERS US TO THIS PAGE.

20180528X1 Term Test 1: Solutions: Full