SOLUTIONS ECO 100Y L0301 INTRODUCTION TO ECONOMICS. Midterm Test 2 LAST NAME FIRST NAME STUDENT NUMBER. University of Toronto January 23, 2004

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1 Department of Economics Prof. Gustavo Indart University of Toronto January 23, 2004 SOLUTIONS ECO 100Y L0301 INTRODUCTION TO ECONOMICS Midterm Test 2 LAST NAME FIRST NAME STUDENT NUMBER INSTRUCTIONS: 1. The total time for this test is 50 minutes. 2. This exam consists of two parts. 3. This question booklet has 8 (eight) pages. 4. Aids allowed: a simple calculator. 5. Use pen instead of pencil. DO NOT WRITE IN THIS SPACE Part I /25 Part II 1. /20 2. /15 TOTAL /60 Page 1 of 8

2 PART I (25 marks) Instructions: Circle the most appropriate answer. Each question is worth 2.5 (two and one-half) marks. No deductions will be made for incorrect answers. 1. When marginal product is at a maximum a) average product is falling b) total product is at a maximum c) marginal cost is at a maximum d) marginal cost is at a minimum 2. If a firm's fixed cost is $100, and its total cost is $200 to produce one unit and $310 to produce two units, the firm is a) already facing diminishing returns b) not yet facing diminishing returns c) facing constant returns d) already facing increasing returns 3. A competitive industry has two firms. Firm A produces 15 units of output at a marginal cost of $6 and an average cost of $5. Firm B produces 20 units of output at a marginal cost of $6 and an average variable cost of $7. What is the output supplied by this industry at $6? a) 15 units b) 20 units c) 35 units d) 40 units 4. A perfectly competitive industry is initially in long-run equilibrium. The industry has a constant cost long run supply curve. The government introduces a commodity tax of $1.50 per unit of output. This tax will cause which of the following in the long-run? a) there will be an increase in the consumer price by less than $1.50 b) there will be no change in industry output c) the full burden of the tax will be imposed upon consumers d) the tax revenue will be equal to the initial industry output times the tax 5. At the output where marginal revenue for a monopolist equals zero, a) monopoly profits are maximized b) efficiency loss is zero c) demand curve is unit elastic d) monopoly profits are zero 6. A perfectly competitive and constant cost industry is in long-run equilibrium. Which one of the following events would increase the quantity supplied by each firm and decrease the quantity supplied by the industry in the long-run? a) an increase in the price of a substitute good in consumption b) an increase in variable cost by exactly the same amount for each unit of output c) an increase in fixed costs d) a decrease in income for a normal good Page 2 of 8

3 7. A specific commodity tax of $2.00 per unit of output is imposed upon a perfectly competitive industry. Which one of the following statements is correct: a) the more inelastic the demand curve, the greater the amount of the tax revenue b) in the short run, the consumer price will rise by exactly $2.00 c) in the long run, where there is a perfectly elastic industry supply curve, the full burden of the tax will be imposed upon the producer d) the more elastic the demand curve, the smaller the reduction in industry output 8. A firm in a perfectly competitive industry is producing in the short run where industry price equals its short run marginal cost. In this position, each representative firm is producing 100 units of output with total revenue of $5,500; total short run costs [fixed plus variable] of $9,000 and total fixed costs of $3,000. The firm's best profit strategy in the short run is to: a) maintain output at its present level b) increase output until marginal cost equals minimum average variable cost c) increase output until marginal cost equals the minimum point of average total costs d) shut down 9. If the demand curve in an industry is perfectly elastic, then monopoly equilibrium occurs at a) Marginal Cost = Marginal Revenue b) Marginal Cost = Average Revenue c) Competitive equilibrium d) all of the above 10. If a monopolist's average cost curves intersects the demand curve at a point to the left of the minimum of the average cost curve, then average cost pricing implies that a) economic loss and efficiency loss are both zero b) economic loss is zero and efficiency loss is greater than zero c) economic loss is not zero and efficiency loss is zero d) economic loss and efficiency loss are both not zero Page 3 of 8

4 PART II Question 1 (50 marks) (20 marks) A perfectly competitive, constant cost industry with 100 identical firms is initially in short-run equilibrium at P = $10 and Q = 10,000 units per month (where Q is industry output), with each firm making $100 economic profit. If P were to drop to $8, then Q would be 8,000 units per month and each firm would be making just normal profits (i.e., neither economic profits nor economic losses). At P = $6, each firm would be indifferent between shutting down or producing 60 units of output per month, while making $180 in economic losses. Given the present cost schedule and demand conditions, the industry would be in long-run equilibrium at Q = 12,000. (4) (a) In the diagram below, sketch short-run marginal cost (SMC 1 ), short-run average total cost (SAC 1 ), average variable cost (AVC 1 ), short-run supply (SRS 1 ), and long-run average cost (LAC 1 ) curves for the representative firm consistent with the specific information above (assume that all curves have the usual shape). Shade the area representing the economic profit of the firm. Fully label the diagram Economic Profits SRS 1 SMC 1 SAC 1 LAC 1 Price 8 6 AVC Quantity (units per month) (4) (b) What is the total fixed cost (TFC 1 ) of a representative firm? What is the short-run total average cost at the equilibrium level of output? Briefly explain. At P = 6 and q = 60, the firm is just covering the total variable cost and still making an economic loss of $180. That is, the firm covers the variable cost but not the fixed cost. Therefore, the total fixed cost is equal to the economic loss of $180. Since at P = 10, q = 100 and each firm is making $100 in economic profit, firms are making an average of $1 in economic profit per unit of output. Since profit per unit of output is equal to P minus SAC, then SAC = 9. Page 4 of 8

5 (2) (c) Sketch the industry demand (D 1 ), short-run supply (SRS 1 ), and long-run (LRS 1 ) curves in the diagram below. Fully label the diagram. 14 SRS 2 Price SRS 1 LRS 2 LRS 1 D Quantity (thousand units per month) (2) (d) How many firms there will be in the industry in the long-run? Briefly explain. In the long-run, P = 8, that is, all firms will make no economic profits (or losses). At P = 8, each firm will produce q = 80. Since the long-run industry output is 12,000, the number of firms will be 12,000 / 80 = 150 in the long-run. (3) (e) Go back to the initial short-run equilibrium situation. Suppose that material costs increase so that the average total cost curve increases by exactly $2.00 per unit of output. Alter only your industry diagram to incorporate this effect in the short- and long-run, clearly labelling any changed curves. Page 5 of 8

6 (3) (f) Will each firm produce more or less output in the short-run? Briefly explain. Will each firm continue making economic profits in the short-run? Briefly explain. The increase in material costs increases SMC by $2 at all levels of output. Therefore, in order to produce q = 100 as before, P should increase to 12. However, since the demand curve has a negative slope (i.e., it s not vertical), the upward shift of $2 by the SRS will result in an increase in P of less than $2. Therefore, each firm will supply a quantity somehow less than 100 units. Since P > 10, and the minimum of SAC is now at P = 10 and q = 80, each firm will continue making short-run economic profits (though less than before). (2) (g) How much output will each firm produce now in the long-run? Will the number of firms increase or decrease in the long-run? Briefly explain. In the long-run all firms will make neither economic profits nor economic losses and thus P will be equal to the new minimum SAC (and new minimum LAC) or $10. At this price each firm will produce 80 units of output. Since the existing firms will continue making short-run economic profits after the increase in material prices, new firms will be attracted to the industry and thus the number of firms will increase. Page 6 of 8

7 Question 2 (15 marks) Suppose that the peanut butter industry is a perfectly competitive, constant cost industry with demand defined by P = Q. Suppose that there are 100 identical firms in the industry and that the short-run Marginal Cost equation for each firm is MC = q. The minimum of the AVC of each firm is 10. Note that both Q and q are measured in millions of peanut butter jars per year. [Note: This problem is the same as Question 3 in Problem Set 9-10, which was solved in class. Only the quantities have been changed.] (4) (a) What are the short-run competitive equilibrium price and quantity in this market? First we must find the expression for the industry supply curve, which is the summation of the supply curves of all the firms in the industry. The supply curve of each firm is equal to their MC curve for P > 10. That is the representative firm s supply curve is given by the expression P = q. Since Q = 100q, that is, the industry quantity supplied is equal to the summation of the quantity supplied by each firm, the expression for the supply curve of the representative firm is more conveniently written as q = P. Therefore, the industry supply curve is expressed by Q = 100q = 100( P) = P. This expression can also be written as: P = Q. Market equilibrium is determined by the intersection of the industry demand and supply curves: Q = Q 0.5Q = 40 Q* = 40 / 0.5 = 80 and P* = Q* = (80) = 26 (2) (b) What is the short-run output of the individual firm in this market? At P = 26, each firm will supply q = (26) = = 0.8 (or 800,000 jars per year). Alternatively, q = Q/100 = 80/100 = 0.8 (or 800,000 jars per year). Page 7 of 8

8 (4) (c) Suppose now that the competitive firms wish to establish a cartel and operate as a monopoly. What price and output maximizes the short-run profit of the cartel? In order to maximize profits, a monopolist produces an output at the level where MC = MR (where MR P). We must first find the equation for MR. Given a straight line demand curve, we know that MR is also a straight line with the same vertical intercept but twice as steep. That is, MR = Q. Equilibrium, then, is determined by: MR = MC, but not the MC of one firm but the MC of the industry as whole, that is, the industry supply curve. Therefore, Q = Q 0.8Q = 40 Q* = 50 and going to the demand curve we find the monopoly price: P* = (Q*) = (50) = = 35. (2) (d) What output must each firm produce in the short-run to establish the maximum cartel profit? Since there are 100 identical firms and Q = 50, each firm must produce q = Q/100 = 50/100 = 0.5 (or 500,000 jars per year). (3) (e) What output would each firm produce in the short-run if they tried to maximize profit given the monopoly price with no concern for their effect on that price? While firms are maximizing collective profits when producing q = 0.5, they are not maximizing their individual profits. If A firms take P = 35 as given (i.e., firms behave as price-takers), then each firm would maximize profits by producing an output at the level where MC = P, that is, supplying q = (35) = = 1.25 (or 1.25 million jars of peanut butter). Page 8 of 8