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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
SOLUTION

Page 2 of 14
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. 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.
1 2 3 4 5 6 7 8 9 10 11 12

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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.
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.


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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.









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 firms average total cost curve.
e) Both the firm in perfect competition and the monopolist must produce where average
total cost equals industry price.


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6. Suppose that a commoditys 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.










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.

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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 dont 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 dont really keep close tabs on total profits, but I dont 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.
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 Walmarts warehouse.
e) Both c) and d).






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

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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.






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.

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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.

Page 9 of 14
PART II (39 marks)

Instructions: Answer all questions in the space provided.

Question 1 (14 marks)
1. Suppose that the perfectly competitive peanut butter industry is in short-run equilibrium. The
industrys 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)

To find the market equilibrium price and quantity we must equate the market demand and
market supply: D = S
15 0.25Q = 0.25Q 0.5Q = 15 Q* = 15/0.5 = 30
and P* = 15 0.25Q* = 15 0.25 (30) = 7.5

If P* = 7.5 and profit-maximizing firms will produce where P = MC, then:
7.5 = 25q q* = 7.5/25 = 0.3














ATC
$
Quantity in millions of jars per year
0.3

Representative Firm Industry
Quantity in millions of jars per year
30

60
10
15
5
15

10

7.5
0.6 0.4

40

P
Additional economic profits when
cheating on the agreement
S
D
MR
5
7.5
20

0.2
MC
Economic profits when
complying with agreement

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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)
Since P = ATC at the equilibrium level of output (i.e., at q = 0.3), then each firm is just breaking
even (i.e., making zero economic profits).

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)

The cartel will behave like a monopoly and produce where MR = MC, where the competitive
supply curve is the MC curve of the cartel as a whole. The MR curve has the same vertical
intercept as the demand curve but its quite as steep, i.e., MR = 15 0.5Q. Therefore,
MR = MC 15 0.5Q = 0.25Q 0.75Q = 15 Q* = 15/0.75 = 20
and P* = 15 0.25Q* = 15 0.25 (20) = 10

Since the total industry output must be reduced by one-third i.e., from 30 to 20 million jars per
year each firm will have to reduce its output also by one-third i.e., from 0.3 to 0.2 million
jars per year. Note that this is the level of output at which the MC of the firm is equal to the MR
of the cartel (i.e., the last unit produce by each firm will have the same MC).






d) In the diagrams above, show the cartels 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)

Each firm is contributing to maximize the profits of the cartel but not their individual profits.
There is a strong incentive for a firm to cheat on the agreement and produce where its own MR
= MC.
If a firm takes the cartels price of $10 as given, then its MR = 10 since its behavior cannot by
itself affect the market price. Therefore, a cheater would produce the profit-maximizing level
output where MR = MC = 10. Therefore,
MR = MC 10 = 25q q* = 10/25 = 0.4





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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. Annies 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)
She will produce the level of output at which MR = MC. The MR curve has the same vertical
intercept as the demand curve but its quite as steep, i.e., MR = 1.50 0.02Q. Each additional
unit of output (cup of fruit) increases total cost by the cost of the fruit (40 cents) plus the cost of
the paper cup (10 cents), i.e., MC = 0.50.
Therefore, MR = MC 1.50 0.02Q = 0.50 Q* = 50
and P* = 1.50 0.01Q* = 1.50 0.50 = 1.00
Her profits will be equal to the difference between her daily Total Revenues and her daily Total
Cost. Therefore, since TR = P*Q = 1.00*50 = 50 and TC = TVC + TFC = 0.50*50 + 10 = 35,
then her profits are = TR TC = 50 35 = 15

1.00
75
0.50
1.50
150 100 50
MC = AVC

MR
D
P
Q
Deadweight loss

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b) In the diagram above, draw Annies 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)

The equilibrium of part a) is not allocative efficient because the marginal benefit of the last unit
bought and sold (i.e., the price) is greater than its marginal cost. Therefore, the quantity
transacted in the market is below the social optimum.
Allocative efficiency is achieved at the quantity at which P = MC. Therefore,
P = MC 1.5 0.01Q = 0.5 0.01Q = 1.0 Q* = 100.




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)

The local government should impose a price ceiling equal to the constant MC, i.e., $0.50. At this
price, Annie will sell:
P = 1.5 0.1Q 0.5 = 1.5 = 0.1Q 0.1Q = 1.0 Q* = 100
Her profits will be = TR TC, where
TR = P*Q = 0.5*100 = 50 and
TC = TVC + TFC = 0.5*100 + 10 = 60
and thus = TR TC = 50 60 = 10



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

The outcome of part c) would not be sustainable because Annie would be making economic
losses. To make it sustainable, the local government could give Annie a lump-sum subsidy of
$10 to allow her to make normal profits (i.e., to break even). For example, the local government
could forfeit the $10 daily rental fee for Annies stand.

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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 markets 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 years 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)
To find the market equilibrium price and quantity we must equate the market demand and
market supply: D = S
1000 0.2Q = 0.3Q 0.5Q = 1000 Q* = 1000/0.5 = 2000
and P* = 1000 0.2Q* = 1000 0.2 (2000) = 1000 400 = 600.
Therefore, 3000 2000 = 1000 youth do not receive any high-school education in this town.


P
C
= 400
750
250
P
4000 2000 1000
S = MC
P
= MC
S
3000
MB
S
500
D = MB
P
Deadweight loss
P
P
= 900
600
Q
S
u
b
s
i
d
y

p
e
r

s
t
u
d
e
n
t


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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 mayors 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 (MB
S
) curve for high-school education in Low Literacy town? What is the socially
optimum number of high-school students in this town? (2 marks)

The MB
S
is equal to the summation of the MB
P
(i.e., the market demand curve) and the
externality of $500 per student. That is,
MB
S
= 1000 0.2Q + 500 = 1500 0.2Q.
The social optimum is achieved at the quantity at which MB
S
= MC
S
, where the S = MC
S
= MC
P

since there are no negative externalities. Therefore,
1500 0.2Q = 0.3Q 0.5Q = 1500 Q* = 1500/0.5 = 3000

d) In the diagram above, draw the MB
S
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)

The local government should give a subsidy equal to the value of the externality (i.e., $500 per
student) either to each student or to the schools. In theory, the outcome would be exactly the
same whether the subsidy is given to the students or to the schools. For simplicity, I will assume
here that the subsidy is given directly to each student and thus the MB
P
would shift up and
coincide with the MB
S
.
In this way the socially optimum number of students will attend high-school, i.e., 3000 students.
Given the supply function, the schools will receive a monthly tuition fee (P
P
) equal to
P
P
= 0.3Q = 0.3 (3000) = 900.
Students will pay a tuition fee (P
C
) equal to P
P
minus the subsidy, i.e.,
P
C
= P
P
500 = 900 500 = 400.
Note that P
C
can also be obtained by plugging q = 3000 in the demand curve, i.e.,
P
C
= 1000 0.2 (3000) = 400.