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Department of Economics Prof. Gustavo Indart

University of Toronto June 17, 2010



ECO 100Y
INTRODUCTION TO ECONOMICS
Midterm Test # 1



LAST NAME


FIRST NAME


STUDENT NUMBER


Check your section of the course: L0201 (T/R from 2:00 to 4:00 PM)
L5101 (T/R from 6:00 to 8:00 PM)


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 /30
Part II 1. /10
2. /15
3. /10
4. /10
5. /10
6. /15

TOTAL /100
SOLUTIONS

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PART I (30 marks)
Instructions: Enter your answer to each question in the table below. Only the answers
recorded in the table will be marked. Table cells left blank will receive a zero mark for that
question. Each question is worth 3 marks. No deductions will be made for incorrect answers.

1 2 3 4 5 6 7 8 9 10
C E E C E B B A C B


1. Which one of the following will cause the demand for bacon to decrease?
A) The price of ham (a substitute) increases.
B) Disposable income decreases and bacon is an inferior good.
C) The price of eggs (a complement) increases.
D) The price of bacon decreases.
E) A storm in Southern Ontario kills 30 percent of the provinces pigs.


2. Which one of the following circumstances would cause the supply curve of goat cheese to
shift down?
A) The price of labour increases in the goat cheese industry.
B) The government imposes a quota on the goat cheese industrys output.
C) The government introduces a specific unit-tax on the goat cheese industry.
D) Energy prices increase for each firm in the goat cheese industry.
E) The price of goat milk decreases.


3. At a garage sale, Heba purchases a used bicycle for $60 when she was willing to pay $100.
After buying it she realizes that the bicycle needs repair at a cost of $15. If the bicycle costs
$200 new, Hebas consumer surplus is
A) $140.
B) $115.
C) $100.
D) $40.
E) $25.


4. If per capita income increases by 10 percent and household expenditures on fur coats
decrease by 10 percent, one can conclude that the income elasticity of demand for fur
coats is
A) unity.
B) elastic.
C) negative.
D) inelastic.
E) not determinable from the information given.



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Diagram 1: Production Possibility Curve




Quantity
of good Y


PPC
1
PPC
2


Quantity of good X

5. In Diagram 1, the shift of the production possibility curve from PPC
1
to PPC
2
might be the
result of
A) an increase in the quantity of resources available for production combined with
technological improvement throughout the economy.
B) a decrease in the quantity of resources used by the Y industry and an increase in
quantity of resources used by the X industry.
C) an increase in the quantity of resources used by the X industry.
D) technological improvement throughout the economy with no change in the quantity of
resources.
E) a decrease in the quantity of resources throughout the economy and technological
improvement in the X industry.


6. Because hamburgers and French fries are often eaten together, they are complements. We
observe that both the equilibrium price of hamburgers and the equilibrium quantity of
French fries have risen. What could be responsible for this pattern?
A) An increase in the price of potatoes.
B) A fall in the price of potatoes.
C) A fall in the price of beef.
D) An increase in the price of beef.
E) A decrease in the price of hot dogs, a close substitute for hamburgers.


7. When the price of milk used to produce cheese rises, the consumer surplus associated with
the consumption of cheese
A) will definitely increase.
B) will definitely decrease.
C) will increase if cheese is a normal good.
D) will decrease if cheese is an inferior good.
E) None of the above is true.


8. Producers will bear a larger burden of a unit-tax if
A) demand is relatively elastic and supply is relatively inelastic.
B) the tax is imposed on firms rather than on consumers.
C) both demand and supply are relatively elastic.
D) demand is relatively inelastic and supply is relatively elastic.
E) both demand and supply are relatively inelastic.


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Diagram 2: Price Elasticity of Demand



B A

Price

D
1


D
2


Quantity

9. In Diagram 2, the D
1
and D
2
curves are parallel. The price elasticity of demand
A) at point A is greater than at point B.
B) is equal at points A and B.
C) at point A is less than at point B.
D) at point A cannot be compared to that at point B.
E) is not determinable from the information given.


10. Sandys demand schedule for soccer games is given in Table 1 below.
TABLE 1






The price of a ticket is $5 and Sandy is planning to buy three tickets. However, the game is
sold out and now Sandy cannot buy tickets except from a scalper. The scalper offers her a
package of three tickets at $25. If Sandy accepts this offer, what is the value of her
consumer surplus?
A) $0.
B) $5.
C) $10.
D) $15.
E) $25.
F) None of the above is correct.

Price
Per Ticket
Quantity
Demanded
$1 4
$5 3
$10 2
$15 1

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This consumer will not buy Jonas Brothers CD
even when the price is zero. Therefore, her
demand curve is totally insensitive to changes
in the price at any price the quantity
demanded is always zero. Therefore, the
demand curve is vertical at Q = 0 (i.e., it
coincides with the vertical axis).
PART II (70 marks)

Instructions: Answer all questions in the space provided.

Question 1 (10 marks)
Sketch the demand curve and briefly explain the demand relationship in each of the following
statements.

a) I would never buy a Jonas Brothers CD! I wouldnt even take one for nothing.




















b) I usually buy more coffee as the price falls. But when the price falls to $3 a pound, I buy out
the entire stock of the supermarket.

















P
P
Q
This consumers demand curve for coffee has
two distinct segments. For prices greater than
$3, his demand curve has the usual negative
slope. At P = 3, however, he buys any quantity
being supplied at his local supermarket (i.e., this
segment of his demand curve is horizontal at P
= 3).

D
D
$3

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c) Although I buy less coffee as the price rises, I will never go without my morning coffee.
























d) After an increase in tuition fees, students eat more often at the school cafeteria and less
often at restaurants even though prices at the cafeteria have risen too. [To explain this
statement, you need to draw both the demand and the supply curves for cafeteria meals.]














P
1
Q
P
Q
1
The graph shows the market for school
cafeteria meals. The initial equilibrium price (P
1
)
and quantity (Q
1
) is determined by the supply
curve (S) and the initial demand curve (D).
When tuition fees increase, students
disposable income decreases (i.e., the money
available to spend on everything else after
paying their tuition fees decreases). Therefore,
students adjust their consumption pattern. They
reduce their demand for normal goods and
increase their demand for inferior goods. Here,
restaurants meals are said to be normal goods
for these students and cafeteria meals are said
to be inferior goods for them. Therefore, their
demand for cafeteria meals increases to D and,
as a result, P increases to P
2
and Q increases
to Q
2
.
P
D

1
S
D

D
Q Q
2
P
1
P
2
This consumers daily demand curve for coffee
also has two distinct segments. As the price of
coffee increases he buys less coffee to a
minimum of just one coffee a day (when the
price reaches level P
1
, as shown in the graph).
Therefore, for prices less than P
1
, his demand
curve has the usual negative slope. However,
for prices greater than P
1
, he will always buy
one coffee a day (i.e., his demand curve
becomes vertical at Q = 1 for P > P
1
).

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Question 2 (15 marks)
Suppose that government regulation does not allow Canadian salmon to be exported to other
countries. Further suppose that the yearly supply and domestic demand schedules of Canadian
salmon are as follows:
Price (per pound) $15 $12 $9 $6 $3
Quantity demanded (thousands of pounds) 200
400
600 800 1000
Quantity supplied (thousands of pounds) 800 700 600 500 400

a) Draw the supply (S) and domestic demand (D) curves in the diagram below and clearly
show the market equilibrium (point A). (2 mark)





























b) Now suppose that Canadian salmon can also be sold in the U.S. and that the American
yearly demand schedule for Canadian salmon is as follows:
Price (per pound) $15 $12 $9 $6 $3
Quantity demanded (thousands of pounds) 200 300 400 500 600
Fill in the blanks in the box below to express the yearly demand schedule for Canadian
Salmon now that Americans are also buying it. (2 mark)
Price (per pound) $15 $12 $9 $6 $3
Quantity demanded (thousands of pounds) 400 700 1000 1300 1600
4
0
0

2000 1500
5
15
10
Q
D
1000
12
3
500
6
0
0

7
0
0

P
D
S
A
B
9
S

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c) In the diagram above, draw the new demand curve (D) for Canadian salmon now that
American consumers can also buy it and clearly show the new market equilibrium (point B).
What happens to the price paid by Canadian consumers? What happens to the quantity
purchased by Canadian consumers? Briefly explain. (3 marks)
To get the new market demand curve (D) we must add the quantities demanded at each
price level by both Canadian and American consumers. The corresponding increase in
demand for Canadian salmon results into an increase in the equilibrium price from $9 to $12
and an increase in the quantity demanded from 600 to 700 thousand pounds. Therefore,
Canadian consumers are now paying $3 more per unit than before and, as a result, they are
buying a smaller quantity400 instead of 600 thousand pounds.

d) Suppose that as a result of overfishing after the increase in demand of part c), the stock of
Canadian salmon is seriously depleted. In order to allow salmon stock to recover, the
government introduces a quota limiting the quantity of Canadian salmon caught to 400
thousand pounds per year. What happens to the price paid by consumers? What happens
to the quantity purchased by Canadian consumers? What happens to the quantity
purchased by American consumers? Briefly explain. (4 marks)
The introduction of a quota of 400 thousand pounds per year creates a situation of excess
demand at the initial equilibrium price of $12. Therefore, price increases to $15 (i.e.,
consumers demand a quantity of 400 thousand pounds per year when the price is $15). At
this price, Canadian consumers buy only 200 thousand pounds as indicated by the
Canadian demand curve. The Americans, therefore, buy the restanother 200 thousand
poundsas indicated by the American demand schedule.


e) The government finds that the quota is difficult to administer and decides to impose instead
a unit-tax on producers to reduce the quantity of Canadian salmon caught to 400 thousand
pounds per year. In the diagram above, draw the new supply curve (S) of Canadian salmon.
What is the amount of the tax per pound? Briefly explain. What price do consumers pay?
What price do producers receive net of the tax? Briefly explain. (4 marks)
The imposition of the unit-tax on producers increases the cost of production of the fishing
industry. Therefore, the industry supply curve shifts up by exactly the size of the unit-tax.
Note that this is a parallel shift, i.e., the minimum price that producers are willing to accept
for each additional unit of output increases by the size of the unit-tax. The supply curve thus
shifts up to S, i.e., just enough to intersect the market demand curve (D) at the price level
of $15. As shown in the diagram, the unit-tax is thus equal to $12the difference between
the price consumers pay ($15) and the minimum price producers are willing to accept in
order to produce the 400 thousandth pound ($3).



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Question 3 (10 marks)
What can you conclude about the price elasticity of demand in each of the following
statements?
a) Although the price of orange juice fluctuates widely from year to year, Julia spends the same
amount of money on orange juice every year.
Recall that = % Q / % P.

We are told that Julia always spends the same
amount of money on orange juice although the
price of orange juice changes. That is, P might
increase and thus Q decrease, but her total
expenditure (TE) doesnt change TE = P*Q
is constant.
A constant TE means that Q changes in the
same proportion as P but in the opposite
direction. In other words, in absolute value,
% Q = % P
and thus = 1.





b) My economics professor has chosen to use the Ragan/Lipsey textbook. I have no choice but
to buy this book.
Recall that = % Q / % P and that we can
also express this relationship as:
= (Q / Q) (P / P).
Since I must buy a textbook and the
Ragan/Lipsey is the only textbook I can use for
my course, I have no choice but to buy it. This
means that I must get a copy of the textbook
independently of its price. In other words, my
price elasticity of demand for Ragan/Lipsey
textbook is zero ( = 0) and thus my demand
curve for this textbook is vertical at Q = 1.







Q
1
Q
2
P
2
1
P
P
1
D
P
1
* Q
1
= P
2
* Q
2
P
Q
D
Q

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c) The photocopy business is very competitive. I would lose half of my customers when I raised
the price by as little as 10 percent.
Recall that = % Q / % P.
Assuming that loosing half of my customers is the same as losing half of my sales, then
when price increases by 10 percent the quantity demanded for my photocopies decreases
by 50 percent. In other words, Im operating in the elastic segment of my demand curve, i.e.,
in the segment where demand elasticity is greater than one. More precisely, the price (arc)
elasticity of demand is:
= % Q / % P = 50% / 10% = 5 (or 5 in absolute value).














d) I dont get it! Im spending more on coffee even though the price of coffee fell from $8 to $5
a pound.
Recall that = % Q / % P.
If my total expenditure on coffee increases
when the price of coffee decreases, then Im
operating in the elastic segment of my
demand curve. Indeed, if elasticity is greater
than one then the percentage increase in the
quantity demanded is greater than the
percentage decrease in price and thus my
total expenditure increases. This can be
observed in the diagram on the right.
We are operating in the segment where >
1, i.e., in the segment of the demand curve
between the vertical intercept and the mid-
point. As the price falls from $8 to $5, total
expenditure (i.e., price times quantity)
increases by the difference between areas
(a) and (b).




(a)
(b)
Q
0
/2
$5
Q
2
$8
Q
1
P
0
/2
P
0
> 1
Q
0
Q
P
P

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Question 4 (10 marks)
Caroline consumes only tuna [X-axis product] and lamb chops [Y-axis product]. The price of
tuna falls. In order to maximize her level of consumer satisfaction, Caroline chooses to purchase
the same quantity of tuna after the decrease in price.
Statement: Maia, an economics student, believes that tuna is an income-independent good for
Caroline.
Position: Do you agree with Maias view? Draw a consumer indifference curve diagram to
analyze this situation and indicate, with reasons, whether you agree or disagree with Maias
view.
















as long as we remain on the same indifference curve. Therefore, the movement from point A to
point B represents the increase in the quantity demanded as a result of the substitution effect.
Note that at point B the MRS is equal to the new relative price of tuna.
On the other hand, the income effect is the change in the quantity demanded as a result of the
change in real income while keeping relative prices constant at the new level. By definition,
then, a change in real income implies a change from one indifference curve to another. In our
diagram, the movement from point B to point C represents the decrease in the quantity
demanded as a result of the income effect.
Therefore, tuna is an inferior good for Caroline since as real income increases she consumes
less tuna. But tuna is neither a Giffen nor a non-Giffen inferior good for Caroline. Its an inferior
good where the change in the quantity demanded as a result of the substitution effect is equal
(but of the opposite sign) to the change in the quantity demanded as a result of the income
effect.
I thus disagree with Maias views.
LC

T
BL
1
BL
2
I
1
I
2
A

B

C

T
A
T
B
Caroline is initially maximizing utility by
consuming bundle A as shown in the diagram.
Her initial budget line is BL
1
and she is reaching
the highest indifference curve possible (I
1
).
When the price of tuna (T) drops, her new
budget line is BL
2
. Caroline now can consume
anywhere on this new budget line and she will
choose a new combination that will allow her to
maximize utility. She will choose bundle C as
shown in the diagram. This move from point A to
point C is the result of the substitution effect and
the income effect since, as a result of the fall in
the price of tuna, not only have relative prices
changed but also Carolines real income has
increased.
On the one hand, the substitution effect is the
change in the quantity demanded as a result of
the change in relative prices while keeping real
income constant at the previous level. Recall
that, by definition, real income remains constant

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Question 5 (10 marks)
Michelle consumes only two goods: books (X-axis good) and video games (Y-axis good). Her
indifference curves for books and video games have the usual convex shape. Michelle has an
income of $200 that she spends entirely on books and video games. The price of books is $10
and the price of video games is $5.
Suppose that Michelle buys 12 books and 16 video games. With this consumption bundle, her
marginal rate of substitution (MRS) of books for video games is 3.
Is Michelle maximizing her utility with this consumption bundle? If not, what should she do to
maximize her utility? Explain your answers with the help of a clearly labelled diagram.
























Michelle is not maximizing her utility at her present consumption combination of books (B) and
video games (VG) point A in the above diagram. Indeed, two conditions must be satisfied for
utility maximization 1) the bundle must lie on the consumers budget line; and 2) at that
bundle the MRS must be equal to the relative prices of the two goods, i.e., MRS = P
B
/ P
VG

and Michelles consumption bundle satisfies only the first of these two conditions.
The MRS is equal to the absolute value of the slope of the indifference curve, and at point A it is
equal to 3. The absolute value of the slope of the budget line is equal to the relative price of the
good measured on the horizontal axis: P
B
/ P
VG
= $10 / $5 = 2. Therefore, MRS > P
B
/ P
VG
at
point A and Anastasia must change the combination of B and VG in order to increase and
eventually maximize her utility.
We have seen that the MRS can be expressed as the ratio of the marginal utilities of the two
goods, i.e., MRS = MU
B
/ MU
VG
. We have also seen that MU decreases as the quantity
consumed of the good increases (and increases as the quantity of the good decreases).
Therefore, in order to increase her level of utility until its maximized, Michelle must substitute B
for VG. As B increases, the MU
B
falls while as VG decreases, the MU
VG
rises, and thus the MRS
decreases. This process of substitution of B for VG must continue until the MRS becomes equal
to the ratio of the relative prices of the two goods and utility is maximized i.e., until the
consumption bundle is point B in the diagram above.
12 20
16
I
1
40
VG
B
A
B
I
2

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Question 6 (15 marks)
Anastasia is the proud owner of a small basket-producing firm. Her firm can produce 60 baskets
per day with 4 units of labour and 70 baskets per day with 5 units of labour. The price of one
unit of labour is $100 per day and her total fixed cost is $200 per day.
a) Is Anastasias firm exhibiting increasing or decreasing average productivity? Briefly explain
(marks will be given entirely for the explanation). (3 marks)
Since 4 units of labour can produce 60 baskets a day, the average product of the first 4 units
of labour is:
AP = TP / L = 60 / 4 = 15.
Similarly, since 5 units of labour can produce 70 baskets a day, the average product of the
first 5 units of labour is:
AP = TP / L = 70 / 5 = 14.
Therefore, the firm is exhibiting decreasing marginal productivity.

Alternatively, we could also answer this question as follows:
We know that the 5
th
unit of labour contributes to increase output by 10 baskets a
day, i.e., the marginal product (MP) of the 5
th
unit of labour is 10. Therefore, since the
hiring of the 5
th
unit of labour causes output to increase by less than the average (i.e.,
by less than 15), then the average product must be falling. That is, the firm is
exhibiting decreasing marginal productivity.

b) Is Anastasias firm exhibiting increasing or decreasing marginal productivity? Briefly explain
(marks will be given entirely for the explanation). (3 marks)












The 5
th
unit of labour contributes to increase
output by 10 baskets a day, i.e., the marginal
product (MP) of the 5
th
unit of labour is 10.
We also know that the AP of the first 5 units
of labour is 14.
Therefore, MP < AP at L = 5, i.e., the MP
curve has already intersected the AP curve
from above and thus MP is decreasing. This
is shown in the diagram on the left.
AP
AP
MP
MP
14
10
L 5

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c) What is the average variable cost (AVC) when her firm produces 60 baskets per day? Briefly
explain and show all your work. (3 marks)
The average variable cost is equal to the total variable cost per unit of output, i.e.,
AVC = TVC / Q
But, what is the TVC when Q = 60? The TVC is the cost of the quantity of labour required to
produce 60 baskets a day, i.e., the cost of hiring 4 units of labour. Since the price of 1 unit of
labour is $100 a day, then
TVC (60) = w L = $100 * 4 = $400
Therefore, the AVC of producing 60 baskets a day is:
AVC (60) = $400 / 60 = $6.67

d) What is the average total cost (ATC) when her firm produces 70 baskets per day? Briefly
explain and show all your work. (3 marks)
The average total cost is equal to the total cost per unit of output, i.e.,
ATC = TC / Q
What is the total cost of producing any level of output? The TC is the summation of the total
fixed cost (TFC) i.e., the cost of the quantity of the fixed factor of production (i.e., the cost
of capital) plus the cost of the quantity of labour required to produce that particular level
of output, i.e.,
TC = TFC + TVC
TFC is equal to $200 a day. The TVC is the cost of the quantity of labour required to
produce 70 baskets a day, i.e., the cost of hiring 5 units of labour. Since the price of 1 unit of
labour is $100 a day, then
TVC (70) = w L = $100 * 5 = $500
Therefore, TC (70) = TFC + TVC (70) = $200 + $500 = $700, and the ATC of producing 70
baskets a day is:
ATC (70) = $700 / 70 = $10.

e) Given your answer in part b) above, what can you say about the marginal cost (MC) of the
firm? At the level of output of 70 baskets a day, is MC increasing or decreasing? Briefly
explain (marks will be given entirely for the explanation). (3 marks)
Marginal cost is defined as the increase in TC given an increase in Q, and this increase in
TC is the result of having to hire more labour to produce more output, i.e., TC = TVC.
That is, MC = TVC / Q.
TVC, in turn, is equal to the cost of the quantity of labour required to produce a given level of
output, i.e., TVC = w L. Therefore, TVC = w L.
Given the above, MC = TVC / Q = w L / Q = w / (Q / L).
And since MP = Q / L, then MC = w / MP.
Therefore, since MP is decreasing, then MC is increasing.