UNIVERSITY OF TORONTO

DEPARTMENT OF ECONOMICS
INTRODUCTION TO ECONOMICS
ECO100Y (LEC0501)
MICHAEL HO
TEST 2 SOLUTIONS
NOVEMBER 27TH, 2013

Name: ID#:
(Print Full Name Clearly)

Tutorial #: TUT0500
IMPORTANT:

Do not use red-coloured pen (this colour is reserved for the markers) and you cannot appeal any part
of your answer if it is done in pencil (except the graphs).
You must show the step-by-step calculations in every part of Question 1 or a zero will be given.
You must relate your explanation in Question 2 to your graph for full marks.
Only put your answers in the designated page(s) or space.
Do not separate any page from this test or a 10-mark penalty will be imposed.

Questions
Question 1 Question 2 Total
3 to 7

Marks 45 30 25 100

Score 45 30 25 100

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1. Suppose there is only one female beauty spa in a small town serving two different groups of
females with being the price and being the number of treatments for each group of females.
The first group (market segment) includes females who need treatment urgently (no time to book
an appointment) and their demand can be written as . The second group
includes females who only visit the spa with appointment and their demand can be written as
. The cost of serving these two groups of females is assumed to be constant
regardless of how many treatments are being provided.

1. (a) Show the step-by-step derivations of the profit-maximizing quantity and price ,
profits , consumer surplus , and deadweight loss in the market segment for
the first group of females. (15 marks)

For the first group, total revenue ( ) and marginal revenue

. The Golden Rule of profit maximization is to produce a quantity
where . For the first group, ,
, and profits ( ) ( ) . When , quantity
.
( ) ( )

( )( ) ( )( )

1. (b) Show the step-by-step derivations of the profit-maximizing quantity and price ,
profits , consumer surplus , and deadweight loss in the market segment for
the second group of females. (15 marks)

For the second group, total revenue ( ) and marginal revenue

. The Golden Rule of profit maximization is to produce a quantity
where . For the second group, ,
, and profits ( ) ( ) . When , quantity
.
( ) ( )

( )( ) ( )( )

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1. (c) Use the point elasticity formula to determine the demand elasticities ( and ) of these
two groups of females at and . Use these point elasticities to help you explain the
economic intuition why these females are charged different prices? (10 marks)

The formula for point elasticity

| | | | | | | | and | |

From the demand equations

| | |( )( )| and | | |( )( )|
Females in the first group pay a higher price than those in the second group when their demand
is less elastic . Females in the first group need the treatment urgently (less flexible) and hence
less bargaining power relative to those females in the second group. As a result, the female beauty spa
can exercise more monopoly power over the females in the first group and charge them a higher price.

1. (d) Plot all your results in a properly labeled graph. (5 marks)

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2. Explain the economic intuition behind the Golden Rule of a firms profit-maximizing output
decision. Then, use the graph provided below to help you explain the step-by-step derivation of
the short-run supply curve of a typical firm from its cost curves in a perfectly competitive
market. Answer this question according to lecture discussion.
Graphs: 6 marks; Explanation: 24 marks

Marginal revenue refers to the additional

revenue that an extra unit could bring in for the firm
while marginal cost MC refers to the additional cost
that an extra unit would cost the firm to produce. A
firm will maximize its profit when it produces an
output where . When , this
implies an extra unit could bring in more revenue
than the cost that the firm has to pay in order to
produce it, which results in a positive contribution to
the firms profit and hence the firm will produce that
extra unit of output. When , this implies
cutting the production of the last unit could save the
firm more cost than the revenue that the firm
would lose without the production of the last unit , which improves the firms profit by the cutting
loss from the last unit of output. The profit has not yet been maximized whenever there is a possibility
to improve the firms profitability by changing its output. Therefore, a firm maximizes its profit only
when .

Every competitive firm is a are price-taker with when the demand for its product is perfectly
elastic. Maximizing profit requires the firm to produce where . Suppose the market
equilibrium price is , the firm takes as given and maximizes its profit by producing where
(the grey shaded area, ( ) , which is the profit margin per unit multiplied by the
number of units). When the market equilibrium price falls to , the firm takes as given and
maximizes its profit by producing where . Since , the firm has zero profit
(this is called the breakeven point).

As the market equilibrium price falls below to , the firm takes as given and maximizes its profit
by producing where . Since , the firm is losing money (the blue shaded
area). Should the firm shut down? If the firm shuts down, then it would lose its fixed cost , which is
the cost the firm has to pay in the short run whether it produces or not. Since (
is the vertical distance between and ) and , when the firm shuts down, it would
not only lose the blue shaded area (the loss when it produces ), but it would also lose the blue diagonal
patent area. Therefore, the firm could minimize its loss by staying in production at because it could
recover part of its fixed cost (the blue diagonal patent area) when .

When the market equilibrium price drops further to , the firm takes as given and maximizes its
profit by producing where . The firm would now be indifferent between producing or
shut down because either way the firm would lose all the fixed cost when (this is called the
shutdown point). If the market equilibrium price falls below the shutdown point to , then the firm
should not produce where when ,
which means the firm could not generate enough revenue to pay the variable cost (labour cost) and
hence no worker would go to work such that the firm has to shut down involuntarily. Otherwise, the
firm would lose more than just the fixed cost if it produces .

In fact, the firms short-run supply curve is simply its marginal cost curve starting at the shutdown point
and above.
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Questions 3 to 7 (5 marks each)

3. As a consumer moves along an indifference curve

(A) the combination of goods he prefers will be unchanged, but the level of satisfaction will vary.
(B) the combination of goods and the consumer's income level will remain constant.
(C) his level of utility will vary as the combinations of goods varies.
(D) the combination of goods will vary, but the level of money income remains constant.
(E) the combination of goods will vary but the level of utility remains constant.
Answer:

4. Which of the following factors of production is most likely to be variable in the short run?
(A) Technology.
(B) Land.
(C) Entrepreneurship.
(D) Capital equipment.
(E) Labour.
Answer:

5. The creation of a new product is called

(A) creative destruction.
(B) process innovation.
(C) product innovation.
(D) a rise in productivity.
(E) investment.
Answer:

6. A perfectly competitive firm's demand curve coincides with

(A) both its marginal and total-revenue curves.
(B) its total-revenue curve.
(C) the market demand curve.
(D) its average-revenue curve and total-revenue curve.
(E) both its marginal and average-revenue curves.
Answer:

7. If a monopolist is practicing perfect price discrimination, then

(A) demand must be perfectly elastic.
(B) consumer surplus is zero.
(C) the producer surplus is zero.
(D) the monopolist is not profit maximizing.
(E) costs are lower than for the non-price-discriminating monopolist.
Answer:

End of Test 2 Total = 100 marks

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