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Department of Economics Prof. Gustavo Indart University of Toronto February 17, 2012

ECO 100Y INTRODUCTION TO ECONOMICS

Term Test # 3

LAST NAME

FIRST NAME

STUDENT NUMBER 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 /6

/30

Part II 1. /14

2. /14

3. /11

TOTAL /75

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PART I (36 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 six (6) 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 two and one-half (2.5) 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.

1 2 3 4 5 6 7 8 9 10 11 12

1. Consider a perfectly competitive, decreasing cost industry. If there is a permanent decrease

in demand, which one of the following statements will be true in the long run? a) Price will definitely decrease but the number of firms could increase, decrease or

remain constant. b) Price will definitely increase but the number of firms could increase, decrease or

remain constant. c) Price will definitely increase and the number of firms will also definitely increase. d) Price will definitely decrease and the number of firms will also definitely decrease. e) Price will definitely increase and the number of firms will definitely decrease.

Explanation:

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2. For a perfect price-discriminating monopoly, which one of the following statements is false? a) The firm sets prices. b) The firm captures the entire consumer surplus. c) Allocative efficiency is worse than with single-price monopoly. d) The firm can distinguish between buyers. e) Buyers cannot resell the product.

Explanation:

3. Comparing the short-run and long-run profit-maximizing positions of a perfectly competitive

firm, which one of the following statements is true? a) Price will equal marginal cost in the short-run, but not necessarily in the long-run. b) Economic profit may exist in the short-run and in the long-run. c) The firm will produce at minimum average cost in both the short- and long-run. d) Price should equal average cost in the long-run, but not necessarily in the short-run. e) The firm may have unexploited economies of scale in both the short-run and the

long-run.

Explanation:

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4. Assume that the following information applied to a firm in the short run at its current output: the industry price was $20; marginal revenue was $10; average total cost was $22; marginal cost was $10; average fixed costs were $6. On the basis of this information, which one of the following statements is correct in the short run?

a) The firm is not in perfect competition and is at a profit maximizing output. b) The firm is in perfect competition and should produce a greater output. c) The firm is not in perfect competition and should shut down. d) The firm is in perfect competition and is at a profit maximizing output. e) The firm is not in perfect competition and should produce a greater output.

Explanation: 5. When the long-run equilibrium solutions are examined between a firm in perfect competition

and a single-price unregulated monopolist, which one of the following statements is correct? a) Both the firm in perfect competition and the monopolist could make economic profits. b) Both the firm in perfect competition and the monopolist would produce where price

equalled marginal cost. c) Both the firm in perfect competition and the monopolist would produce where

marginal revenue equaled marginal cost. d) Both the firm in perfect competition and the monopolist would produce an output

associated with the minimum point of the firm’s average total cost curve. e) Both the firm in perfect competition and the monopolist must produce where average

total cost equals industry price.

Explanation:

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6. Suppose that a commodity’s demand function is P = 280 – 0.02Q. What is marginal revenue when P = $100?

a) -$80. b) -$40. c) $40. d) $80. e) None of the above is correct.

Explanation: 7. Suppose a monopolist can sell 10 units of output per day for a price of $10 each, and 11 units of

output per day for $9.80 each. The marginal revenue for the 11th unit sold is equal to a) $9.80. b) $5.80. c) $7.80. d) -$0.20. e) none of the above.

Explanation:

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8. Four monopolists were overheard talking at an expensive restaurant. Which one of their statements below contains a correct strategy for maximizing profits?

a) “In my company, we don’t increase output unless we know that the larger output will raise total revenue.”

b) “I think cost minimization is the key to maximizing profits.” c) “We try to make the most of our equipment by producing at maximum capacity.” d) “I don’t really keep close tabs on total profits, but I don’t approve any business deal

unless it increases my revenue more than it increases my costs.” e) “I always produce a level of output where my revenues are maximized.”

Explanation: 9. Which one of the following is NOT considered an investment item when calculating GDP?

a) Construction of a new school. b) Purchase of a new canning machine by Campbell Soup Co. c) Purchase of 20 shares of Bell Canada stock. d) Increase in unsold goods in Walmart’s warehouse. e) Both c) and d).

Explanation:

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Use the data in Table 1 to answer questions 10 and 11.

Table 1 Consumption 270 Corporate income taxes 10 Depreciation (capital consumption allowance) 45 Exports 55 Government expenditure on goods and services 55 Gross investment 80 Interest on the government debt 0 Imports 70 Indirect taxes minus subsidies 35 Personal income taxes 60 Transfer payments to households 80 Undistributed corporate profits 15

10. Refer to data in Table 1 above. What is the value of Gross Domestic Product?

a) 345. b) 390. c) 405. d) 445. e) None of the above is correct.

Explanation: 11. Refer to data in Table 1 above. What is the value of Net Domestic Income?

a) 345. b) 390. c) 405. d) 445. e) None of the above is correct.

Explanation:

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12. Assume a dealership in Toronto bought 40 brand new cars from the Ford Motor Company in Oakville, Ontario at a cost of $15,000 per car in July of 2011. By the end of 2011 it sold 20 of these cars at a price of $20,000 each. The remaining cars were sold in January 2012 at a price of $18,000 each. In these transactions, what was the contribution of the dealership to GDP in the year 2011?

a) $760,000. b) $600,000. c) $400,000. d) $160,000. e) None of the above is correct.

Explanation:

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PART II (39 marks)

Instructions: Answer all questions in the space provided.

Question 1 (14 marks) Suppose that the perfectly competitive peanut butter industry is in short-run equilibrium. The industry’s demand curve is P = 15 – 0.25Q and the short-run supply is P = 0.25Q. There are 100 identical firms in the industry and the short-run Marginal Cost of each firm is MC = 25q. Note that price is measured in dollars and quantity in millions of jars per year.

a) What are the short-run equilibrium price and quantity in this market? What is the equilibrium

output of an individual firm? Show how you obtained these figures. (3 marks)

ATC

$

Quantity in millions of jars per year

Representative Firm Industry

Quantity in millions of jars per year60

15

5

10

0.60.4 40

P

5

20 0.2

10

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b) In the diagrams above, draw the market demand and supply curves and the MC curve of the representative firm and show the equilibrium of part a) above. What are the profits of the representative firm? Briefly explain. (3 marks)

c) Suppose that all the firms in this industry decide now to form a cartel and operate as a monopoly. What price and output will maximize the profits of the cartel? What output must each firm produce to establish the maximum cartel profits? Show how you obtained these figures. (3 marks)

d) In the diagrams above, show the cartel’s price and output as well as the output and

economic profits of the representative firm. (2 marks) e) In the situation in part c) above, is the representative firm maximizing its individual profits?

Why or why not? If not, what output should the firm produce to maximize its profits? Show how you obtained this figure. In the diagram above, show the increase in economic profits of the cheating firm. (3 marks)

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Question 2 (14 marks) Annie is the owner of the only stand selling fresh fruit juice in Lomita Beach. Her daily demand curve for juice is P = 1.50 – 0.01Q, where P is in cents and Q is in cups. Annie’s only variable costs are the fruit to make the juice and the paper cups in which she sells the juice. The cost of fruit per cup of juice is constant at $0.40 and the cost of paper cups is also constant at $0.10 apiece. Her only fixed cost is the rent of the stand at $10 a day, which she pays to the government of Lomita Beach.

a) How many cups of juice will Annie sell a day if she is a profit-maximizer producer? What

price will she charge? What economic profits will she make a day? Show all your work. (5 marks)

1.00

0.50

1.50

15010050

P

Q

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b) In the diagram above, draw Annie’s daily demand curve, marginal revenue curve, and marginal cost curve. (1 mark) Why the equilibrium of part a) is not allocative efficient? Briefly explain. What would be the allocative efficient level of output? In the diagram above, show the deadweight loss measuring the degree of allocative inefficiency of the equilibrium of part a). (3 marks)

c) Suppose that the local government of Lomita Beach imposes a price ceiling to eliminate allocative inefficiency in the fruit juice market. What would be the level of this price ceiling? How many cups of juice will Annie sell a day? What economic profits will she make a day? Show all your work. (3 marks)

d) Would the outcome of part c) above be sustainable? Why or why not? Briefly explain. If it’s not, what could the government of Lomita Beach do to make it sustainable? (2 marks)

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Question 3 (11 marks) In Low Literacy town all high-schools are private and none are public. The market for private high-school education is perfectly competitive and all schools are currently making zero economic profits. This market’s demand and supply curves are, respectively, P = 1000 – 0.2Q and P = 0.3Q, where P is the monthly tuition fee in dollars and Q is the number of high-school students. This year’s census indicated that the total high-school-age population in Low Literacy town was 3,000.

a) What are the equilibrium price and quantity in this market? How many high-school-age youth do not attend school in Low Literacy town? Show how you obtained these figures. (3 marks)

750

250

Q 400020001000 3000

500

P

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b) In the diagram above, draw the market demand and supply curves for high-school education in Low Literacy town and show the equilibrium of part a) above. (1 mark)

c) Studies indicate that educational services produce a positive externality by raising productivity, decreasing unemployment, and reducing criminality rates. The mayor’s office estimates that these additional benefits to the people of Low Literacy town are equivalent to $500 per student/month. Given this externality, what is the equation for the social marginal benefit (MBS) curve for high-school education in Low Literacy town? What is the socially optimum number of high-school students in this town? (2 marks)

d) In the diagram above, draw the MBS curve for high-school education in Low Literacy town and show the allocative inefficiency (deadweight loss) of the market outcome of part a) above. (2 marks)

e) What should the local government do to increase the number of high-school students to the optimum level of part c) above? What monthly tuition fee would students pay out-of-pocket? What monthly tuition fee would schools receive per student? How many students would now attend high-school in Low Literacy town? (3 marks)