INDIAN INSTITUTE OF MANAGEMENT KOZHIKODE

Post Graduate Programme in Management

Name______________________________________ ________________Section______
Roll No. PGP/20/_______________
MIDTERM EXAMINATION
Course Title Microeconomics
Duration 120
Maximum marks 50
Term & Year I 2016
Instructions
 Please PRINT your name, section and roll number.
 Answer all questions.
 Each multiple-choice question has one best answer. Each multiple-choice question carries one mark.
Choose the one alternative that best completes the statement or answers the question. Circle the right
answer on the question paper itself.
 The point value of each short-answer question and its parts is mentioned in parentheses on the
right margin. There may not be any partial award of part points.
 Clearly show your reasoning and calculations for all short-answer questions.
 In the answer book, any part of any question must start from the left margin. Anything not started
from the left margin shall not be graded.
 This is a closed-book examination. C a l c u l a t o r s a r e O K . B u t n o notes and no
neighbours.
 Good luck!

1) Firms face trade-offs in production, including decisions related to:

A) the best way to produce a given amount of output.
B) which products to produce.
C) how much of a particular product to produce.
D) all of the above

2) Arbitraging price differences between two markets is generally not possible if:
A) there are positive costs of transporting the products from one market to the other.
B) the transportation costs are larger than the difference in prices.
C) the government has prohibited exchange between the two markets.
D) A and C above
E) B and C above

3) If a competitive firm has a U-shaped marginal cost curve then

A) the profit maximizing output is found where MC = MR and MC is increasing.
B) the profit maximizing output is found where MC = MR and MC is constant.
C) the profit maximizing output will always generate positive economic profit.
D) the profit maximizing output will always generate positive producer surplus.
E) the profit maximizing output is found where MC = MR and MC is decreasing.
4) When the price faced by a competitive firm was $5, the firm produced nothing in the short run. However, when
the price rose to $10, the firm produced 100 tons of output. From this we can infer that
A) the firm's total cost of producing 100 tons is less than $1000.
B) the firm's marginal cost curve must be flat.
C) the firm's average cost of production was less than $10.
D) the firm's marginal costs of production never fall below $5.
E) the minimum value of the firm's average variable cost lies between $5 and $10.

5) The price of good A goes up. As a result, the demand for good B shifts to the left. From this we can infer that:
A) goods A and B are substitutes.
B) good B is used to produce good A.
C) goods A and B are complements.
D) good A is used to produce good B.
E) none of the above

6) Suppose there is currently a surplus of wheat on the world market. The problem of excess supply may be
removed from the market by:
A) lowering the market price. B) shifting the supply curve leftward.
C) shifting the demand curve leftward. D) Both A and B are plausible actions.

7) The price elasticity of demand for a demand curve that has a zero slope is
A) zero.
B) one.
C) infinity.
D) negative but approaches zero as consumption increases.

8) For Indian consumers, the income elasticity of demand for fruit juice is 1.1. If the economy enters a recession
next year and consumer income declines by 2.5%, what is the expected change in the quantity of fruit juice
demanded next year?
A) +27.5% B) +2.75% C) -2.75% D) -27.5%

9) Jim left his previous job as a sales manager and started his own sales consulting business. He previously earned
$70,000 per year, but he now pays himself $25,000 per year while he is building the new business. What is the
economic cost of the time he contributes to the new business?
A) $45,000 per year B) $25,000 per year
C) zero D) $70,000 per year

10) In a short-run production process, the marginal cost is rising and the average total cost is falling as output is
increased. Thus, marginal cost is
A) below average fixed cost.
B) between the average variable and average total cost curves.
C) above average total cost.
D) below average total cost.

11) In the short run, suppose average total cost is a straight line and marginal cost is positive and constant. Then,
we know that fixed costs must:
A) be declining with output.
B) equal zero.
C) be positive.
D) We do not have enough information to answer this question.
12) Which of the following is NOT an expression for the cost minimizing combination of inputs?
A) MPL/w = MPK/r
B) MPL/MPK = w/r
C) MRTS = MPL /MPK
D) MRTS = w/r
E) none of the above

13) If indifference curves are concave to the origin, which assumption on preferences is violated?
A) Transitivity of preferences
B) Diminishing marginal rates of substitution
C) More is preferred to less
D) Completeness

14) Consider the following three market baskets:

Cheese Crackers
A 5 8
B 15 6
C 10 7

If baskets A and B are on the same indifference curve and if indifference curves exhibit diminishing MRS:
A) C is on the same indifference curve as A and B.
B) A and B are both preferred to C.
C) C is preferred to both A and B.
D) There is not enough information to determine preferences for C relative to the other goods.

15) The price of lemonade is $0.50; the price of popcorn is $1.00. If Fred has maximized his utility by purchasing
lemonade and popcorn, his marginal rate of substitution will be:
A) 2 lemonades for each popcorn.
B) 1/2 lemonade for each popcorn.
C) 1 lemonades for each popcorn.
D) indeterminate unless more information on Fred's marginal utilities is provided.

16) A firm's marginal product of labor is 4 and its marginal product of capital is 5. If the firm adds one unit of
labor, but does not want its output quantity to change, the firm should
A) use five fewer units of capital. B) use 0.8 fewer units of capital.
C) add 1.25 units of capital. D) use 1.25 fewer units of capital.
Figure 1

17) Refer to Figure 1. The situation pictured is one of

A) increasing returns to scale, because doubling inputs results in more than double the amount of output.
B) decreasing returns to scale, because the isoquants are convex.
C) increasing returns to scale, because the isoquants are convex.
D) constant returns to scale, because the line through the origin is linear.
E) decreasing returns to scale, because doubling inputs results in less than double the amount of output.

18) A farmer uses M units of machinery and L hours of labor to produce C tons of corn, with the following
production function This production function exhibits
A) increasing returns to scale for all output levels.
B) decreasing returns to scale for all output levels.
C) no clear pattern of returns to scale.
D) constant returns to scale for all output levels.

19) Which of the following production functions exhibits constant returns to scale?
A) q = KL0.5 B) q = K + L C) q = KL D) q = log(KL)

20) Which of the following is NOT a necessary condition for long-run equilibrium under perfect competition?
A) No firm has an incentive to enter the market.
B) No firm has an incentive to exit the market.
C) Each firm is maximizing profit.
D) Each firm earns zero economic profit.
E) Prices are relatively low.

21) If a factory has a short-run capacity constraint (e.g., an auto plant can only produce 800 cars per day at
maximum capacity), the marginal cost of production becomes __________ at the capacity constraint.
A) highly elastic B) zero
C) less than the average variable cost D) infinite

22) Use the following two statements to answer this question:

I. Increasing returns to scale cause economies of scale.
II. Economies of scale cause increasing returns to scale.
A) Both I and II are true. B) I is false, and II is true.
C) I is true, and II is false. D) Both I and II are false.

23) At the current level of output, long-run marginal cost is $50 and long-run average cost is $75. This implies
that:
A) there are economies of scale.
B) there are neither economies nor diseconomies of scale.
C) there are diseconomies of scale.
D) the cost-output elasticity is greater than one.

24) Which of the following are examples of situations in which the standard model of the consumer may not be
realistic?
A) Impulse purchases
B) Addictions or other strong habits in consumption
C) Following fads and fashions instead of one's own preferences
D) all of the above

25) Assume that beer is a normal good. If the price of beer rises, then the substitution effect results in the person
buying __________ of the good and the income effect results in the person buying __________ of the good.
A) more, more B) more, less C) less, less D) less, more

Please answer all questions. Write your answer in the space provided.
Answers:

26) The market for study desks is characterized by perfect competition. Firms and consumers are price-takers and
in the long run there is free entry and exit of firms in this industry. All firms are identical in terms of their
technological capabilities. Thus the cost function as given below for a representative firm can be assumed to be
the cost function faced by each firm in the industry. The total cost (in the short run as well as long run, like poetic
freedom this is called teacher’s freedom) for the representative firm is given by the following equation:

TC = 2q2 + 5q + 50
Suppose that the market demand is given by:
P = 1025 - 2Q
[Note: Q represents market values and q represents firm values. The two are different.]
a. What is the long run equilibrium price in this market?
Answer: q = 5; P = 25.
b. When this industry is in long run equilibrium, how many firms are in the industry?
Answer: Q = 500; N = 100.
c. Now suppose that the number of students increases such that the market demand curve for study desks
shifts out and is given by P = 1525 – 2Q. In the short run will a representative firm in this industry
earn negative economic profits, positive economic profits, or zero economic profits?
Answer: positive economic profits.

d. In the long run will a representative firm in this industry earn negative economic profits, positive
economic profits, or zero economic profits?
 Answer: zero profits.

e. What will be the new long run equilibrium price in this industry?
Answer: P = 25.

f. At the new long run equilibrium, what will be the output of each representative firm in the industry?
Answer: q = 5.

g. At the new long run equilibrium, how many firms will be in the industry?
Answer: At P = 25, Q = 750; N = 150.

Now, consider another scenario where technology advancement changes the cost functions of each representative
firm. The market demand is still the original one (before the increase in the number of students). The new cost
function (in the short run as well as long run) is:

TC = q2 + 5q + 36.

h. What will be the new long run equilibrium price?

Answer: q = 6; P = 17.

i. In the long run, given this technological advancement, how many firms will there be in the industry?
Answer: At P = 17, Q = 504; N = 84.
[1.25 + 0.5 + 0.5 + 0.25 + 0.25 + 0.25 + 1 + 1 + 1 = 6]

27) In 1998, Americans smoked 470 billion cigarettes, or 23.5 billion packs of cigarettes. The average retail price
was $2 per pack. Statistical studies have shown that the price elasticity of demand is –0.4, and the price elasticity
of supply is 0.5. Using this information, derive linear demand and supply curves for the cigarette market.
[3]

28) Study the table below and answer the question clearly with proper reasoning.

a. Using the table above, calculate the value of the marginal cost of the 3rd unit of output.

MC(3) = 4.

b. Using the table above, calculate the value of the average cost at 2 units of output.

AC(2) = 24.

c. Using the table above, calculate the marginal cost of the 8th unit of output.
 MC(8) = 29.
[3]

29) The demand for tickets to the Daytona 500 NASCAR event is given by the equation
The supply of tickets to the event is given by the capacity of the Daytona track, which is 150,000. What is the
equilibrium price of tickets to the event? What is the price elasticity of demand at the equilibrium price? What
is the price elasticity of supply at the equilibrium price?
[2]

30) Acme Container Corporation produces egg cartons that are sold to egg distributors. Acme has estimated this
production function for its egg carton division:
Q = 25L0.6K0.4,
where Q is output measured in one thousand carton lots, L is labor measured in person hours, and K is capital
measured in dollars. Acme currently pays a wage of $10 per hour and considers the relevant rental price for
capital to be $25 per hour. Determine the optimal capital-labor ratio that Acme should use in the egg carton
division.
[2]

31) Complete the following table:

[2]

32) Draw a set of indifference curves for the following pairs of goods:

a. Hamburgers and carrots for a vegetarian who neither likes nor dislikes meat. (Vegetarians do not eat meat.)
b. Peanut butter and jelly for an individual that will not eat peanut butter sandwiches or jelly sandwiches, but
loves peanut butter and jelly sandwiches made with two parts peanut butter and one part jelly.
c. Tickets for Knott's Berry Farm (KBF) and Universal Studios (US) for a tourist that believes that KBF and
US are perfect substitutes.
d. Ice cream and pie if these are goods that you like, but if you consume enough of either, you get sick of
them. If you are sick of a good, consuming more of it lowers your utility.
[0.5 x 4 = 2]

33) Jane lives in a dormitory that offers soft drinks and chips for sale in vending machines. Her utility function
is (where S is the number of soft drinks per week and C the number of bags of chips per week), so her
marginal utility of S is 3C and her marginal utility of C is 3S. Soft drinks are priced at $0.50 each, chips $0.25
per bag.
a. Write an expression for Jane's marginal rate of substitution between soft drinks and chips.
b. Use the expression generated in part (a) to determine Jane's optimal mix of soft drinks and chips.
c. If Jane has $5.00 per week to spend on chips and soft drinks, how many of each should she purchase per
week?
[1 + 1 + 1 = 3]
34) The following data pertain to products A and B, both of which are purchased by Madame X. Initially, the
prices of the products and quantities consumed are:
= $10, = 3, = $10, = 7.
Madame X has $100 to spend per time period. After a reduction in price of B, the prices and quantities
consumed are:
= $10, = 2.5, = $5, = 15.
Assume that Madame X maximizes utility under both price conditions above. Also, note that if after the price
reduction enough income were taken away from Madame X to put her back on the original indifference curve,
she would consume this combination of A and B:
= 1.5, =9
a. Determine the change in consumption rate of good B due to (1) the substitution effect and (2) the income
effect.
b. Determine if product B is a normal, inferior, or Giffen good. Explain.
[1 + 1 = 2]
29) Consumers are willing to pay The price elasticity of demand at $250 is

The price elasticity of supply is

30) = .6 = 15

= .4 = 10

MRTS =

MRTS = = 1.5 ∙

MRTS = 1.5

Equate MRTS to .

1.5 =

1.5 = 0.4
1.5K = 0.4L; K=0.266L

31)

32) a.
b.

c.

d.
33) a.

MRS =

MRS = =

b.
The optimal market basket is where

MRS =

Requires = =

= 2, C = 2S
Jane should buy twice as many chips as soft drinks.

c.
Jane must satisfy her budget constraint as well as optimal mix.
Her budget constraint is:
I = P S S + P CC
where I = income
5.00 = .5S + .25C
But she must also satisfy the optimal mix. Substitute 2S for C into budget constraint
5.00 = .5S + .25(2S)
5 = .5S + .5S
5=S
Buy 5 soft drinks.
Substitute into either expression to obtain C
C = 2S
C = 2(5)
C = 10
Jane should spend her $5.00 to buy 5 soft drinks and 10 bags of chips.
34) a.
The total effect of the price change is the difference in the quantities before and after the price change, or 15 - 7
= 8. This change of 8 includes the income and substitution effects. The reduction in consumption that resulted
from the reduction in income to put Madame X back on the original indifference curve represents the income
effect. 15 - 9 = 6 is the substitution effect and income effect is 8 - 6 = 2.
b.
Since the two effects are additive and both are positive, we have a normal good, i.e.,

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