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Department of Economics Prof. Gustavo Indart

University of Toronto July 22, 2011




ECO 100Y
INTRODUCTION TO ECONOMICS
Midterm Test # 2




LAST NAME


FIRST NAME


STUDENT NUMBER



Check your section of the course: L0101 (M/W from 2:00 to 4:00 PM)
L0201 (T/R from 2:00 to 4:00 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 /50


TOTAL /100
Part II 1. /18
2. /16
3. /16
SOLUTIONS

Page 2 of 12
PART I (50 marks)
Instructions:
Multiple choice questions 1 to 20 are to be answered using a black pencil or a black or blue
ball-point pen on the separate SCANTRON form being supplied.
Be sure to fill in your name and student number on the SCANTRON form!
Write the version of your paper either A A or B B on the SCANTRON form where it says
DO NOT WRITE IN THIS SPACE.
Each question is worth 2.5 marks. No deductions will be made for incorrect answers.
Write your answers to the multiple choice questions 1 to 20 ALSO in the table below. You
may use this question booklet for rough work, and then transfer your answers to each
multiple choice question to the table AND onto the separate SCANTRON sheet. Your
answers must be on the SCANTRON sheet. In case of a disagreement, the answer to be
marked is the one on the SCANTRON sheet.


1 2 3 4 5 6 7 8 9 10
B B C B B D D E C E
11 12 13 14 15 16 17 18 19 20
E A C C B E A D A B


1. (From May/2005 exam) If the average product curve is rising, then the marginal product
curve
A) must lie above the average product curve over this range and must also be rising.
B) must lie above the average product curve over this range.
C) can be either above or below the average product curve, although it must be rising
over the entire range.
D) must lie below the average product curve over this range.
E) must be falling.

2. (From May/2006 exam) When one additional unit of labour is hired, total product increases
from 100 to 110 units of output per unit of time. Marginal product must therefore be
A) increasing.
B) positive.
C) decreasing.
D) constant.
E) zero.

3. (From May/2006 exam) The average product for six workers is 15. If the marginal product
for the seventh worker is 18,
A) marginal product is rising.
B) marginal product is falling.
C) average product is rising.
D) average product is falling.
E) marginal product is rising and average product is falling.

Page 3 of 12

4. (From May/2006 exam) Suppose fixed costs are $100 and average variable costs are
constant regardless of output. Which one of the following statements is then true?
A) Marginal cost will equal average total cost.
B) Average total cost will decrease when output is increased.
C) Marginal cost will be less than average variable cost.
D) Average total cost will be constant.
E) None of the above is true.


5. (From May/2005 exam) Suppose that in a perfectly competitive industry, the market price of
the product is $12. Firm A is producing the output level at which average total cost equals
marginal cost, both of which are $10. To maximize its profits, Firm A should
A) reduce output.
B) expand output.
C) leave output unchanged.
D) increase its advertising.
E) change the price of its product.


6. (From May/2005 exam) In the short run, an increase in a perfectly competitive firms fixed
costs should lead to
A) a decrease in output.
B) a decrease in the number of sellers.
C) a decrease in the units of fixed factor that the firm uses.
D) a decrease in profits.
E) all of the above.


7. A perfectly competitive firm is currently producing an output level where price is $12;
average total cost is $16; average fixed cost is $3 and marginal cost is $12. In the short-run,
in order to maximize profits this firm should
A) not change output.
B) decrease its output.
C) increase its output.
D) shut down.
E) increase its market price.


8. (From May/2006 exam) A decreasing-cost, perfectly competitive industry is initially in long-
run equilibrium. Suppose now that the industry demand decreases. As a result, which one of
the following statements is correct for the long run?
A) Newer, more efficient firms will enter the industry and earn normal profits.
B) Existing firms will modernize plant and equipment in order to increase efficiency.
C) Some firms will exit the industry while others will expand output to increase revenues
and eliminate economic losses.
D) The industry output will fall and the industry price will also fall.
E) The industry output will fall while the industry price will rise.


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9. From May/2007 exam) If a perfectly competitive firm is faced with average revenue below
average variable cost it will shut down so as to reduce its
A) costs to below its revenue.
B) costs to zero.
C) losses to the amount of its fixed costs.
D) losses to the amount of its variable costs.
E) losses to the amount of its marginal costs.


10. (From May/2005 exam) A perfectly competitive industry is in short-run equilibrium. Each
firm is making normal profits at this equilibrium. Now all landlords increase the rent each firm
pays by $2,000 per year. As a result, which one of the following statements is correct in the
short run?
A) The industry price and output would both increase.
B) The industry price and output would both decrease.
C) The industry price would increase and the industry output would fall.
D) The industry price would decrease and the industry output would fall.
E) None of the above is correct.


11. (From May/2007 exam) Consider a perfectly competitive firm in the following position:
output = 4000 units, market price = $1, total fixed cost = $2000, total variable cost = $2000
and marginal cost = $1. To maximize profits, the firm should
A) reduce output.
B) expand output.
C) shut down.
D) increase the market price.
E) not change output.


12. When the monopolist charges a price where the price elasticity of demand equals 1, which
of the following statements is correct?
A) Total revenues are at a maximum.
B) Total revenues are rising, although marginal revenue is falling.
C) Total revenues are falling.
D) Total revenues are at a minimum.
E) Total profits are at a maximum.


13. Suppose that a monopolist can sell 20 units of output per day for a price of $5 each and 21
units of output per day for $4.90 each. The marginal revenue for the 21
st
unit is
A) -$0.10.
B) $0.10.
C) $2.90.
D) $4.90.
E) uncertain, as not enough information is provided to compute marginal revenue.



Page 5 of 12
14. If an unregulated, single-price monopolists marginal revenue is MR = 100 4Q and its
marginal cost is MC = 20, then the monopolist will maximize profits when charging a price of
A) $50.
B) $80.
C) $60.
D) $40.
E) None of the above is correct.


15. In a cartel, the incentive to cheat is significant since
A) each individual member has the incentive to restrict its own output to maximize
profits.
B) each firm has the incentive to expand output to increase its profits.
C) the marginal cost is greater than the cartel price at the profit-maximizing output level.
D) each firm has the incentive to raise its price to reap monopoly rewards.
E) None of the above is true.


16. You have been renting a house for $1000 a month over the last four years. On July 1 of
2010 you purchased this house from your landlord for $250,000. As a result of this
transaction, GDP in 2010
A) increased by $250,000.
B) increased by $238,000.
C) decreased by $12,000.
D) decreased by $6,000.
E) did not change.


17. Which one of the following would NOT cause an increase in GDP?
A) Sean sold his old car, originally purchased in 2000, to Evan.
B) Simon started a new company which produced bicycles only for export.
C) Susan started selling a new drink to customers in her region.
D) Sterling produced 500 computers and sold 400 to local customers.
E) Seeley imported motor cycles and sold half of them for a profit to local customers.


18. Suppose that a country had new imports of 20 tractors at an import cost of $20,000 each
and that 10 of the tractors were sold to farmers at $30,000 each, 5 of the tractors were re-
exported at $25,000 each, and the remaining 5 tractors were in inventory at their imported
price at the end of the year. As a result of these transactions, by how much would the
countrys gross domestic product increase?
A) $400,000.
B) $425,000.
C) $300,000.
D) $125,000.
E) None of the above is correct.


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19. Which one of the following statements about investment is correct?
A) Net investment may be negative.
B) Net investment includes the total of all machinery and equipment produced during
the year.
C) Gross investment must equal net investment.
D) Gross investment plus depreciation equals net investment.
E) None of the above is correct.


Use the information in the table below to answer question 20.

Table 1
Investment expenditure $400
Indirect taxes $250
Corporate income taxes $50
Consumption expenditure $1300
Government transfer payments $150
Business profits $150
Depreciation $200
Government purchases $500
Net exports $90
Interest on the national debt $50

20. Refer to Table 1. What is the value of Net Domestic Income?
A) $2350.
B) $1840.
C) $2290.
D) $1950.
E) None of the above is correct.



Page 7 of 12
PART II (50 marks)

Instructions: Answer all questions in the space provided.

Question 1 (18 marks)
Assume that the pub business (in Toronto) is a constant-cost, perfectly competitive industry. As
depicted in the diagram below, the pub industry is currently in long-run equilibrium. The shut
down price of the representative firm is $1.00. The output of this industry can be expressed in
pints of beer per week.






















a) In the diagram above, draw the industry long-run supply curve (LRS). In this initial long-run
equilibrium, how many firms are in the pub industry? Briefly explain. (2 marks)
Since each firms is producing 100 pints of beer per week and the industry output is 10,000
pints, the number of firms is n = 10,000/100 = 100.




b) Recent medical studies suggest that drinking beer reduces ones life expectancy. This leads
to a large decrease in the demand by individuals to drink beer in pubs. Carefully draw in
your diagram the new demand curve (D) assuming that the quantity demanded of beer
decreases by 4 (thousand) pints at each price level. (2 marks) Show in your diagram the
new short-run equilibrium for the industry (point B) and the representative firm (point B). (2
marks)
3.25
5.00
D
2.50
SRS
100
P
r
i
c
e

(
d
o
l
l
a
r
s
)

P
r
i
c
e

(
d
o
l
l
a
r
s
)

Beer (pints) Beer (thousands of pints)
80
SRMC
LRAC
SRAC
5.00
3.00
2.50
SRS
A
D
2.00
Industry
Representative Firm
3.00
10 6 8
2.00
LRS
B
C
C
B
Economic
Losses
A

Page 8 of 12
c) What are the numerical values of industry price, industry output, and firm output in the new
short-run equilibrium? (3 marks) By shading the corresponding area, show in your diagram
the economic profits or losses of the representative firm. (2 marks)

As shown in the diagram, P = $2.00, Q = 8,000, and q = 80.





d) What will happen in the long run? Briefly explain. Show in your diagram the new long-run
equilibrium for both the industry (point C) and the representative firm (point C). (2 marks)

Since all firms are now making economic losses, some firms will exit the industry in the long
run and thus the short-run supply curve will shift gradually to the left. Therefore, market price
will gradually increase and the economic losses of the remaining firms will gradually
decrease. This process will continue until all remaining firms are breaking even, i.e., making
normal profits.




e) What are the numerical values of industry price, industry output, and firm output in the new
long-run equilibrium? (3 marks) In this new long-run equilibrium, how many firms are in the
pub industry? (2 marks)

As shown in the diagram, P = $3.00, Q = 6,000, and q = 100.

Since each firms is producing 100 pints of beer per week and the industry output is 6,000
pints, the number of firms is n = 6,000/100 = 60.

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Question 2 (16 marks)
Julie is the only provider of medical services in Farawayville, a small rural community. The
following is the weekly demand schedule for medical services in this community:
Price per office visit ($) 300 250 200 150 100 50 0
Number of office visits per week 0 50 100 150 200 250 300
Julies marginal cost of seeing a patient is a constant $100 per patient. Her total fixed costs are
$4000 per week.


























a) In the diagram above, neatly draw Julies demand curve (D), marginal revenue curve (MR),
and marginal cost curve (MC). (3 marks)
b) If Julie charges the same price per visit to all patients, how many patients will she see each
week? What price will she charge? Show this equilibrium in the diagram above. (2 marks)
What economic profits will she make per week? Briefly explain how you obtained this figure.
(2 marks)
Julie will maximize profits producing the level of output (i.e. office visits) at which MR = MC,
i.e., producing at Q = 100. At this level of output, Julie will charge a price of $200 per visit.
Her weekly profit is equal to the difference between her total revenue per week and her total
cost per week. Since her weekly production is Q = 100, her weekly revenue is: TR = P*Q =
$200*100 = $20,000.
Her weekly total cost is the summation of her weekly total fixed cost and her weekly total
variable cost. Her TFC is $4,000 per week. Since her MC is constant at $100, her AVC =
MC. Therefore, her TVC = $100*100 = $10,000 and her TC = $14,000.
Her weekly profit is, therefore, $6,000.
200
100
Q
P
200
300
300
400 100
Deadweight
Loss
MC = AVC
MR
D

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c) Show in the diagram above the deadweight loss measuring the degree of allocative
inefficiency in the market for medical services in Farawayville. (2 marks)
d) If Julie could perfectly price-discriminate, how many patients would she see each week?
Briefly explain how you obtained this figure. (2 marks) What is the degree of allocative
inefficiency in this case? Briefly explain how you obtained this figure. (1 mark)
If she could perfectly discriminate, then her demand curve would become also her MR
curve. Therefore, since a profit-maximizer will always produce the level of output at which
MR = MC, she would see 200 patients a week.
At Q = 200, the total surplus is maximized and allocative efficiency is achieved. Indeed, at
this level of output, the MB and the MC of the last unit (patients visit) are equal.


e) Go back to the equilibrium of part b) above. Suppose now that the Mayor of Farawayville
decides to eliminate this allocative inefficiency in the market for medical services while
allowing Julie to continue making the same economic profits as in part b) above. What policy
or combination of policies should the Mayor implement in order to achieve these objectives?
[Note: Do NOT draw any curves to answer this question.] (4 marks)
In order to achieve allocative efficiency, P must be equal to MC, i.e., a price ceiling of $100
should be imposed.
At this price, however, Julies TR would not be enough to cover her TC and she would thus
be making economic losses. Indeed, TR = P*Q = $100*200 = $20,000 and TC = TFC + TVC
= $4,000 + $100*200 = $24,000.
Therefore, together with the imposition of a price ceiling at $100, the Mayor should give Julie
a lump-sum subsidy of $10,000 so she could continue making economic profits of $6,000
while seeing 200 patients a week.

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Question 3 (16 marks)
Consider the perfectly competitive market for car alarms in the town of Bella Vista. The following
table shows the yearly demand and supply schedule for car alarms in this town:
Price ($) 25 75 125 175 225 275 325 375
Quantity demanded 1500 1300 1100 900 700 500 300 100
Quantity supplied 0 300 600 900 1200 1500 1800 2100





























a) Draw the supply (S) and demand (D) curves for car alarms in the diagram above and clearly
show the market equilibrium (point A). (2 marks)
b) Suppose that each car alarm sold creates a negative externality (noise pollution) that
causes $100 in harm to the public. Carefully draw in the diagram above the corresponding
social marginal cost (MC
S
) curve. (2 marks)
c) Further suppose that each car alarm also creates a positive externality (reduced law
enforcement costs) that provides $225 in benefits to the public. Carefully draw in the
diagram the corresponding social marginal benefit (MB
S
) curve. (2 marks)
500 2000 1500
P
C
= 100
300
200
Q
P
1000
D = MB
P
B
S = MC
P

MB
S
MC
S

S
AA
1200
400
275
900
P
P
= 225
Deadweight
Loss
325
175
Subsidy
Subsidy

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d) Given the information of parts b) and c), the market equilibrium quantity of part a) is not
socially efficient. Why not? Briefly explain. What is the socially efficient quantity of car
alarms? Briefly explain. Clearly show in the diagram the socially efficient equilibrium (point
B). (2 marks)
Indeed, the market equilibrium of Q = 900 is not socially efficient since the MB
S
(= $400) of
the 900
th
unit is greater than the MC
S
(= $275).
The socially efficient quantity of car alarms is achieved when the MB
S
and the MC
S
of the
last unit are equal. Indeed, as long as MB
S
> MC
S
it will pay from the point of view of society
to increase the number of car alarms. The efficient quantity of car alarms is thus 1200.

e) By shading the corresponding area, clearly show in the diagram above the deadweight loss
that measures the degree of allocative inefficiency of the market outcome of part a). (2
marks)
f) Suppose now that the government gives a unit-subsidy to producers of car alarms in order
to achieve allocative efficiency in this market. What should be the size of this unit-subsidy?
Briefly explain. Show the impact of this subsidy in the diagram above. (2 marks)
The unit-subsidy must be enough to shift the supply curve downwards in order to intersect
the demand curve at Q = 1200. Therefore, producers should receive a unit-subsidy of $125.

g) After the introduction of the unit-subsidy, what price will consumers pay for car alarms?
What price will producers receive? Show these prices in the diagram above. (2 marks)
At Q = 200, consumers will pay a price of $100 and producers will receive a price of $225,
the difference being the subsidy given by the government.


h) Without drawing any curves, briefly explain the impact that this unit subsidy would have had
if it had be given directly to consumers instead of to producers. (2 marks)
A unit-subsidy given to producers or the same unit-subsidy given to consumers will have
exactly the same outcome with respect to quantity, price paid by consumers, and price
received by producers.
A unit-subsidy of $125 given to consumers would cause the D = MB
P
curve to shift up by
this amount and intersect the S = MC
P
at Q = 1200.