ECO 100Y INTRODUCTION TO ECONOMICS Midterm Test # 1 … - Solution to Test 1... · Page 2 of 16...

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Department of Economics Prof. Gustavo Indart University of Toronto October 22, 2010

ECO 100Y INTRODUCTION TO ECONOMICS

Midterm Test # 1

LAST NAME

FIRST NAME

STUDENT NUMBER

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 1. /10

2. /8 3. /12 4. /10

5. /12 6. /12 Part II /36

TOTAL /100

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PART I (64 marks)

Instructions: Answer all questions in the space provided.

1. (10 marks) Determine the amount of consumer or producer surplus generated in each of the

following situations. Briefly explain how you get to this amount.

a) Aneseh goes to the CD store to buy Lady Gaga’s latest CD. She is willing to pay up to $15 for the CD and finds that its price tag is exactly $15. At the cash register she is told that Lady Gaga’s CD is on sale today for $12. (2 marks) Aneseh’s consumer surplus is the difference between the value she assigns to the CD — i.e., the maximum price she is willing to pay for it — and the price she actually pays for the CD. Aneseh was willing to pay up to $15 for the CD but she got it for only $12, and thus her consumer surplus is $3.

b) Galina is willing to pay up to $20 for a used copy of the last of Harry Potter’s books. She goes to the bookstore and finds one copy selling for $20. (2 marks) Galina’s consumer surplus is the difference between the value she assigns to the Harry Potter’s book — i.e., the maximum price she is willing to pay for it — and the price she actually pays for the book. Galina was willing to pay up to $20 for the book and this is exactly what she paid for it, and thus her consumer surplus is $0.

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c) Bowen has just finished a soccer practice at the Athletic Centre. She wants to purchase a bottle of mineral water for up to $2. The Centre’s vending machine sells mineral water for $2.50. (2 marks) Bowen’s consumer surplus is the difference between the value she assigns to a bottle of mineral water — i.e., the maximum price she is willing to pay for it — and the price she actually pays for it. However, since Bowen is willing to pay a maximum of $2 for a bottle of mineral water and the price is $2.50, she will not buy any bottle (and thus there will not be any consumer surplus to calculate).

d) Fatima advertises her car for sale in the Varsity for $2,000. She is, however, willing to sell her car for any price above $1,800. A classmate buys her car for $2,000. (2 marks) Fatima’s producer surplus is the difference between the minimum price she is willing to accept for her car and the price she actually gets for it. Fatima was willing to accept a minimum price of $1,800 for her car but she got $2,000 for it, and thus her producer surplus is $200.

e) Lady Gaga’s concert is sold out. Allison got a ticket for the concert for $50. She lists her ticket on eBay thinking of selling it for at least $75. To her surprise, after two days of bidding she sells the ticket for $150. (2 marks) Allison’s producer surplus is the difference between the minimum price she is willing to accept for her ticket to Lady Gaga’s concert and the price she actually gets for it. Allison was willing to accept a minimum price of $75 for her ticket but she got $150 for it, and thus her producer surplus is $75.

Note as well that the minimum price of $75 she is willing to accept for the ticket represents the value she assigns to it, and thus her consumer surplus when she bought the ticket for $50 was $25.

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2. (8 marks) What can you conclude about the price elasticity of demand in each of the following statements? Briefly explain with the help of an appropriate demand curve diagram.

a) My economics professor has chosen to use the Ragan/Lipsey textbook. I have no choice but to buy this book. (2 marks)

Recall that η = % ∆Q / % ∆P and that we can also express this relationship as:

η = (∆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 (η = 0) and thus my demand curve for this textbook is vertical at Q = 1.

b) The photocopy business is very competitive. I would lose half of my sales when I raised the

price by as little as 10 percent. (2 marks)

Recall that η = % ∆Q / % ∆P.

Since when price increases by 10 percent the quantity demanded for my photocopies decreases by 50 percent, I’m 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:

η = % ∆Q / % ∆P = − 50% / 10% = − 5 (or 5 in absolute value).

1

D

P

η > 1

Q

P D

Q

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c) I don’t get it! I’m spending more on coffee even though the price of coffee fell from $8 to $5 a pound. (2 marks) Recall that η = % ∆Q / % ∆P.

If my total expenditure on coffee increases when the price of coffee decreases, then I’m 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 η > 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 (B) and (A).

d) The price of coffee has oscillated between $0.75 and $1.50 a cup during the last two years. However, I always spend exactly $15 a week on coffee. (2 marks)

Recall that η = % ∆Q / % ∆P. We are told that I always spends the same amount of money ($15) on coffee although the price of coffee changes. That is, P might increase and thus Q decrease, but my total expenditure (TE) doesn’t 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 η = 1.

(A)

(B)

Q0 /2

$5

Q2

$8

Q1

P0 /2

P0

η > 1

Q0 Q

P

Q1 Q2

P2

P

P1

P1 * Q1 = P2 * Q2

D

Q

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100 15050

Y

X

50

200 250 300

150

100

PPC1

PPC2

PPC3

3. (12 marks) Consider a hypothetical country that has 250 units of resources and produces only two goods, good X and good Y. The table below shows different allocations of resources between these two industries and the corresponding maximum levels of output that can be produced of each of these two goods.

a) In the diagram below, draw this country’s production possibilities curve (PPC1). (2 marks)

b) What is the opportunity cost of producing 30 additional units of X if the economy is initially

producing 60 units of X and 60 units of Y? And, what is the opportunity cost of producing 30 additional units of X if the economy is initially producing 90 units of X and 45 units of Y? (2 marks)

When X = 60 and Y = 60, increasing the production of X by 30 units requires a transfer of resources from the Y industry which reduces de quantity produced of Y by 15 units (from 60 units to 45 units). Therefore, the opportunity cost of producing these 30 additional units of X is 15 units of Y. When X = 90 and Y = 45, increasing the production of X by 30 units requires a transfer of resources from the Y industry which reduces de quantity produced of Y by 25 units (from 45 units to 20 units). Therefore, the opportunity cost of producing these 30 additional units of X is 25 units of Y.

Quantity of resources used

in the Y industry

Annual production of Y


in the X industry

Annual production of X

0 0 250 130 50 20 200 120

100 45 150 90 150 60 100 60 200 70 50 35 250 75 0 0

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c) Given your answer in b), what can you conclude regarding the opportunity cost of X? What is the economic explanation of your conclusion? (2 marks) The answers to part b) show that the opportunity cost of producing X increases as more of X is produced.

The reason for this is that although additional resources allocated to the production of X increase the output of X, they do so at a decreasing rate. This means that the production of each additional unit of X requires the use of more resources than the previous one (and thus it becomes necessary to transfer more and more resources from the Y industry to produce additional units of X).

d) Suppose now that only the technology associated with producing good Y improves, so that the maximum level of Y that can be produced with any given quantity of resources increases by 100 percent. Fill in the table below with the annual production of Y and X corresponding to each resource allocation. Draw this country’s new production possibilities curve (PPC2) in your diagram above. (3 marks)

e) Go back to the situation of part a) above. Suppose now that the technology associated with producing both good X and good Y improves, so that the maximum level of X and the maximum level of Y that can be produced with any given quantity of resources increases by 100 percent. Fill in the table below with the annual production of Y and X corresponding to each resource allocation. Draw this country’s new production possibilities curve (PPC3) in your diagram above. (3 marks)


in the Y industry



in the X industry


0 0 250 130 50 40 200 120

100 90 150 90 150 120 100 60 200 140 50 35 250 150 0 0


in the Y industry



in the X industry


0 0 250 260 50 40 200 240

100 90 150 180 150 120 100 120 200 140 50 70 250 150 0 0

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4. (10 marks) Consider the market for milk in the small country of Las Piedras. This market demand and supply schedules are shown in the table below, where the price of milk is expressed in pesos per litre and the quantity of milk in millions of litres per month:

Price 10 9 8 7 6 5 4 3

Quantity demanded 2 4 6 8 10 12 14 16

Quantity supplied 11 10 9 8 7 6 5 4

a) Assuming there is no government intervention in this market, what are the equilibrium price and the equilibrium quantity? Briefly explain. (2 marks)

Equilibrium is established at the price level at which the quantity demanded is equal to the quantity supplied. Therefore, equilibrium is reached at P = $7 since at that price the quantity demanded and the quantity supplied are both equal to 8 millions of litres per month.

b) Now suppose the government of Las Piedras guarantees milk producers a price of 9 pesos per litre and promises to buy any amount of milk that the producers cannot sell. What are the quantities demanded and supplied at this guaranteed price? Briefly explain. (1 mark) How much milk would the government be buying (per month) with this price support program? Briefly explain. (1 mark)

If P = $9, the above schedule shows that the quantity demanded is 4 million while the quantity supplied is 10 million litres per month — i.e., there will be an excess supply equal to 6 million litres per month. Therefore, the government will have to buy 6 million litres per month with this price support system.

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c) What is, in pesos, the cost of this price support system (to the government)? Briefly explain. (1 mark) Who pays for the milk that the government buys? Who is helped and who is harmed by this policy? Briefly explain. (2 mark)

The cost of this price support system to the government is the cost of purchasing 6 million litres of milk per month, i.e., $9 X 6 (million) = $54 million per month.

The government will pay for this price support system from its general revenues, and thus it is taxpayers who end up paying for the milk that the government buys.

Milk producers are the clear and direct beneficiaries of this price support system (i.e. now they receive a higher price and produce a larger output, which means an increase in producer surplus), while milk consumers are those harmed by this policy (i.e., now they pay a higher price and purchase a lower output, which means a decrease in consumer surplus).

d) Suppose that the price of milk in Ontario is equal to the equilibrium price you determined for Las Piedras in part a) above, i.e., equal to the equilibrium price in Las Piedras before the intervention of the government. Further suppose that the government of Las Piedras exports to Ontario—at a price of 6 pesos per litre—the milk it purchased through the pricing system of part c) above. What is now, in pesos, the cost of this price support system (to the government of Las Piedras)? Briefly explain. (1 mark) Who is helped and who is harmed by this policy in Ontario? Briefly explain. (2 mark)

Since the government of Las Piedras now sells to Ontario the milk it purchases under the price support program, the cost per litre to the government of Las Piedras is the difference between the price it pays to producers ($9) and the price it receives from Ontarian importers ($6). Therefore, the total cost of this program to the government of Las Piedras is ($9 – $6) X 6 (million) = $18 million per month.

The milk imports from Las Piedras increases the supply of milk in Ontario (i.e., the supply curve shifts down to the right), and thus the price of milk falls in Ontario. Therefore, Ontarian milk consumers are the beneficiaries of this policy since they end up paying a lower price per litre of milk, while Ontarian milk producers are those harmed by this policy because now they end up receiving a lower price for their milk.

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5. (12 marks) Suppose that the hockey arena of a small town has a seating capacity of 6000. Hockey is the main sports activity in this town and every Saturday the local hockey team plays in this arena. The demand schedule for regular hockey games’ tickets is as follows:

a) What price would fill the arena without creating a shortage of seats at a regular Saturday hockey game? Briefly explain. (1 mark) At this price, what is the revenue generated at each hockey game? Show your work. (1 mark) Since the arena has a maximum seating capacity of 6000, a price of $8 per ticket would ensure a full house without creating any excess demand. At P = $8, the total revenue generated at each hockey game is TR = P*Q = $8 x 6000 = $48 thousand.

b) If the hockey team sets a price of $10 per ticket, will there be an excess demand or supply of tickets for a regular hockey game? Briefly explain. (1 mark) At this price, what is the revenue generated at each hockey game? Show your work. (1 mark) Considering the range of the demand curve for hockey games between P = $8 and P = $10, without doing any additional calculation what can you conclude about the price elasticity of demand? Is it elastic or inelastic? (2 marks)

When P = $10, the quantity demanded is 5000. Therefore, 1000 tickets will be left unsold — i.e., there will be an excess supply equal to 1000 tickets.

At P = $10, the total revenue generated at each hockey game is TR = P*Q = $10 x 5000 = $50 thousand.

Since TR rises as P increases from $8 to $10, we can conclude that demand is inelastic in this segment of the demand curve for hockey games. That is, η < 1 in this segment of the demand curve —which means that % ∆Q < % ∆P and thus ∆TR > 0.

Price $4 $6 $8 $10 $12 $14 Quantity demanded 8000 7000 6000 5000 4000 3000

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c) If the hockey team sets a price of $12 per ticket, what is the revenue generated at each hockey game? Show your work. (1 mark) Considering the range of the demand curve for hockey games between P = $10 and P = $12, without doing any additional calculation what can you conclude about the price elasticity of demand? Is it elastic or inelastic? (1 mark) When P = $12, the quantity demanded is 4000. Therefore, the total revenue generated at each hockey game is TR = P*Q = $12 x 4000 = $48 thousand.

Since TR falls as P increases from $10 to $12, we can conclude that demand is elastic in this segment of the demand curve for hockey games. That is, η > 1 in this segment of the demand curve —which means that % ∆Q > % ∆P and thus ∆TR < 0.

d) Once a year, the Maple Leafs come to town to play a friendly game against the local team. If at each price the quantity demanded of tickets doubles when the Leafs play, what is the equilibrium price for a Leafs game? Briefly explain. (2 marks) The demand for Maple Leaf games is as shown in the following schedule:

Since the arena has a maximum seating capacity of 6000, a price of $14 per ticket will ensure a full house without creating any excess demand. Therefore, the equilibrium price is $14.

e) Go back to the situation of part a) above. Suppose now that, in order to promote hockey among children, the team decides to give local schools 1000 free tickets to every game. If the team also decides to charge a price to paying fans that will ensure every hockey game to be sold out without creating a shortage, what price will the team set? Briefly explain. (2 marks)

If the hockey team sets aside 1000 tickets for the local schools, then only 5000 tickets will be left available for regular hockey fans. Therefore, according to the demand schedule provided, for Q = 5000 the corresponding price is $10.

Price $4 $6 $8 $10 $12 $14 Quantity demanded 16000 14000 12000 10000 8000 6000

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6. (12 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). (1 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


Fill in the blanks in the box below to express the yearly demand schedule for Canadian Salmon now that Americans are also buying it. (1 mark)

Price (per pound) $15 $12 $9 $6 $3


400 2000 1500

5

15

10

Q

D

1000

12

3

500

600

700

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. (1 mark) What is the new equilibrium price and equilibrium quantity of Canadian salmon sold in the market? Clearly show the new market equilibrium (point B) in your diagram. (1 mark) What happens to the quantity purchased by Canadian consumers? Briefly explain. (2 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 quantity—400 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. (3 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 rest—another 200 thousand pounds—as 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. (3 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 $12—the 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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PART II (36 marks)

Instructions:

• Multiple choice questions are to be answered using a black pencil or a black or blue ball-point pen on the separate SCANTRON sheet being supplied.

• Be sure to fill in your name and student number on the SCANTRON sheet! • Write the version of your paper — either AA or BB — on the SCANTRON sheet where it says “DO

NOT WRITE IN THIS SPACE.” • Each question is worth 3 marks. No deductions will be made for incorrect answers. • Write your answers to the multiple choice questions 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 11 12

C E E B E B C D C B 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 province’s 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 industry’s 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.

Before paying for the bicycle she realizes that it needs repair at a cost of $15 but she buys it anyway. If the bicycle costs $200 new, Heba’s consumer surplus is

A) $140. B) $115. C) $100. D) $40. E) $25.

4. 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.

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Diagram 1: Production Possibility Curve Quantity of good Y PPC1 PPC2 Quantity of good X

5. In Diagram 1, the shift of the production possibility curve from PPC1 to PPC2 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. Consider a country that produces only two goods—good X and good Y. If the production of one unit of good X requires 10 units of resources and the production of one unit of good Y requires 20 units of resources, what is the opportunity cost of producing one unit of X in this country?

A) 2.5. B) 2.0. C) 0.5. D) 0.4. E) 20.

8. Because bagels and cream cheese are often eaten together, they are complements. We

observe that both the equilibrium price of cream cheese and the equilibrium quantity of bagels have risen. What could be responsible for this pattern?

A) An increase in the price of flour. B) A fall in the price of milk. C) An increase in the price of milk. D) A fall in the price of flour. E) A decrease in the price of muffins, a close substitute for bagels.

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Diagram 2: Price Elasticity of Demand

B A ● ● Price D1 D2

Quantity 9. In Diagram 2, the demand curves D1 and D2 are parallel. Therefore, we can conclude that 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. Sandy’s demand schedule for soccer games is given in the following table:

Price Per Ticket $1 $5 $10 $15 Quantity Demanded 4 3 2 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 sells tickets only in packages of three. 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) None of the above is correct.

11. If per capita income increases by 10 percent and household expenditures on fur coats

decrease by 15 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.

12. Suppose that the demand for CDs is very elastic and the supply is very inelastic. A sales tax on CDs would be paid:

A) equally by buyers and sellers. B) more heavily by sellers. C) more heavily by buyers. D) by neither buyers nor sellers. E) cannot be determined without more information.

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