ECON 102 Brown Exam 2 Practice Exam Solutions

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1 ECON 102 Brown Exam 2 Practice Exam Solutions 1. C You know this is an inferior good because the income elasticity of demand is negative. E Q,I = % ΔQd % ΔI = 30% 10% = C You know the goods are substitutes because the cross price elasticity of demand is positive. 3. C 4. C 5. C E Qx, PY = % ΔQd for Strawberry D % ΔP for Sour D = 30% 40% = D You get less value from spending a second day at theme park than you do from the first day you spent at the theme park 7. A 8. C For this problem you need to use the equation the following equation to solve for the marginal utility of ice cream. (MU of good A) (Price of good A) = (MU of good B) (Price of good B) 10 $2 = MU ice cream $3 MU ice cream = 15 1

2 9. B 10. A 11. D 12. D 13. B Bang for the buck X = 10 / $5 = 2 utils per dollar Band for the buck Y = 8 / $2 = 4 utils per dollar Bang for the buck X = 4 / $10 = 0.4 utils per dollar spent Bang for the buck Y = 5 / $25 = 0.2 utils per dollar spent Bang for the buck X = 150 / $75 = 2 utils per dollar Bang for the buck Y = 250 / $125 = 2 utils per dollar Q = 10(7) + 2(4) + 20(40) = 878 units 14. C Total product increases because we get 10 additional units from one more unit of labor. APL decreases because 10 is less than 12 so it will bring the average down. 15. D Total product increases because we get 14 additional units from one more unit of labor. APL increases because 14 is greater than 8 so it will bring the average up. 16. C In this class we assume that each unit of labor will cost the same, but each unit of labor does not produce the same number of units of output. 17. B 18. A 19. D 20. A If fixed costs increase, total costs will also increase. 21. B This will increase total costs, but revenue will stay the same so profit will decrease. 22. C Since rent is a fixed cost, variable costs will not be affected. 23. D We can change the number of workers we have in the short run, but in the short run capital is fixed. A production facility would be considered capital. Since the company is adding a production facility this is a long run decision. 2

3 24. B The minimum efficient scale is the first point where costs are minimized. 25. D The capacity quantity is the highest level of production where costs are still minimized. 26. A 27. D 28. A You know the goods are complements because the cross price elasticity of demand is negative. 29. C 30. A 31. B 32. A 33. D 34. A E Qx, PY = % ΔQd for OJ = 10% = % ΔP for Champagne 15% 0.67 Average variable costs = $1,200 / 4 = $ A 36. B 37. D If your demand decreases when your income increases, the income elasticity of demand will be negative. Since that elasticity of demand is negative, you also know that this good is an inferior good. 38. B 39. D 40. C 41. A 42. A 43. C 3

4 44. B 45. A 46. B Demand is inelastic when you increase price and revenue increases. 47. B Consumers are not sensitive to price changes when no substitutes are available. 48. A Consumers will be more sensitive to price changes as they are given more time to adjust. 49. B Business focus on maximizing profit, not revenue. 50. C Adverse selection means that the last people you want to buy your product will be the first people to buy it. Typically the last people that you want to buy your product are your highest cost customers. Sick people are the highest cost customers for insurance companies. 51. C Firms FIRST choose their level of production and THEN minimize costs. 52. B Diminishing marginal product makes short run cost curves U-shaped because at least one of the inputs is fixed. In the long-run none of the inputs are fixed so economies of scale cause the long run curves to be U-shaped. It is important to understand the distinction because questions on this topic regularly appear on the exam! 53. C All of the other factors are variable in the short-run; however, the number of factories to build is a long-run decision for firms. 54. C This is the point where the MC curve intersects the ATC curve. 55. A Make sure that you know the abbreviation MES for minimum efficient scale is fair game for your professor to use on the exam. 56. E Both A and D. Answer A is true because consumers with inelastic demand are not as sensitive to changes in price as consumers with elastic demand. Answer D is true because the elastic demand curve has a steeper slope than the elastic demand curve. 57. B Increasing price would cause no change in quantity demanded. 58. A They are substitutes because cross-price elasticity is positive. 59. D Additional because marginal relates to the additional cost or benefit of consuming an additional unit. 60. B The value you place on things is dependent upon your personal tastes and preferences. 61. D Marginal utility is negative because purchasing this product leaves you less happy than you were before your purchased the product. Total utility will decrease when marginal utility is negative. 4

5 62. D Her production function stayed the same; however, she increased the inputs, capital and labor. 63. E Both C and D. When output is zero total cost and total fixed cost will always be equal because there will be no variable cost when output is zero. 64. D Costs related to packing and shipping output will be variable costs. Total fixed costs stay the same as we produce more units. Total variable costs increase as we product more units. For each unit we sell, we are going to incur additional packing and shipping costs. 65. D No, Steve should have bought more Red Bull and less coffee. Coffee = 3 / $1.50 = 2 Red Bull = 10 / $2.50 = 4 Steve is getting more marginal utility per dollar spent on Red Bull than coffee. This is why he should buy more Red Bull and less coffee. 66. A 181 because we subtract the marginal utility of the 8 th and 9 th units from the total utility of the 9 th unit to find the total utility of the 7 th unit = A 5% because old people account for around 50% of the US health care costs. 68. C Most of the athlete s earnings come from economic rent. 69. D Workers are initially able to specialize as we hire more workers. However, we will eventually start to see less and less output per worker as we add more and more workers. The word initially was the key word in this problem. 70. A Negative $4,000 Economic profit = Revenue Explicit costs Implicit costs Economic profit = $20,000 $14,000 $10,000 Economic profit = $4,000 5

6 Short Answer 1. Charlie should be experiencing diminishing marginal utility as he consumes more and more pieces of pizza; however, his marginal utility is increasing as he eats more and more pizza until the 6 th piece when total utility drops to be negative which doesn t really make sense. The concept of diminishing marginal utility says that marginal utility should decrease as he eats more and more pizza. # of pieces of pizza Total utility Marginal utility Point elasticity = ( Q / P) * (P / Q) ( Q / P) = Coefficient on P Q = 32 4P Q = 32 4($6) = 8 Point elasticity = (-4)($6 / 8) = -3 6

7 3. -2 Ed = % ΔQd % ΔP New Qd Old Qd %ΔQd = Old Qd New P Old P %ΔP = Old P % Qd = (7 5) / 5 = 0.4 = 40% % P = ($8 - $10) / $10 = -0.2 = -20% Ed = 40% / -20% = -2 7

8 4. -3, inferior EI = % ΔQd % ΔI New Qd Old Qd %ΔQd = Old Qd New I Old I %ΔI = Old I %ΔQd = (16 40) / 40 = = -60% %ΔI = ($1,200 - $1,000) / $1,000 = 0.20 = 20% EI = -60% / 20% = -3 You know the good is an inferior good because the income elasticity of demand is less than Explicit costs = $21,000 + $9,000 + $7,000 = $37,000 Accounting profit = $230,000 - $37,000 = $193, Implicit costs = $18,000 + $6,000 = $24,000 Economic profit = $230,000 - $37,000 - $24,000 = $169,000 8

9 7. Q TC TVC TFC ATC AVC AFC MC When Q=2: TVC = TC TFC = = 30 TFC = 100 *TFC will be 100 in all rows because fixed costs stay constant by definition ATC = TC / Q = 130 / 2 = 65 AVC = TVC / Q = 30 / 2 = 15 AFC = TFC / Q = 100 / 2 = 50 MC = Change in TC = = 20 When Q=3: TC = TVC + TFC = = 160 TFC = 100 ATC = TC / Q = 160 / 3 = 53.3 AVC = TVC / Q = 60 / 3 = 20 AFC = TFC / Q = 100 / 3 = 33.3 MC = Change in TC = = 30 9

10 When Q=4: TVC = MC when Q=4 + TVC when Q=3 = = 120 TC = TVC + TFC = = 220 TFC = 100 ATC = TC / Q = 220 / 4 = 55 AVC = TVC / Q = 120 / 4 = 30 AFC = TFC / Q = 100 / 4 = 25 When Q=5: TVC = AVC x Q = 40 x 5 = 200 TC = TVC + TFC = = 300 TFC = 100 ATC = TC / Q = 300 / 5 = 60 AFC = TFC / Q = 100 / 5 = 20 MC = Change in TC = = 80 10

11 8. Use the demand function Q = P to create your graph. Find the horizontal intercept by finding Q when P = $0. Find the vertical intercept by finding P when Q = 0. Horizontal intercept: Q = ($0) Q = 500 Vertical intercept: 0 = P 0.8P = 500 P = $625 11

12 9. To find price when demand is unit elastic, divide the vertical intercept by 2. So in this problem, the price that makes demand unit elastic is $ ($625 / 2 = $312.50). To find quantity when demand is unit elastic, divide the horizontal intercept by 2. So in this problem, the quantity when demand is unit elastic is 250 (500 / 2 = 250). When is $ and quantity is 250, the elasticity of demand will be unit elastic (-1). You can check this by using the point elasticity formula. Point elasticity = (Coefficient on P) * (P / Q) Point elasticity = ( 0.8) * ($ / 250) = 1 You did not need to do the step above; however, doing this extra step allows you to check to make sure your calculations are correct. We know our calculations for this example are correct because the point elasticity is 1, which means it is unit elastic. All points along the demand curve with a price greater than $ will have elastic demand. All points along the demand curve with a price less than $ will have inelastic demand. Make sure you label this on your graph. 12

13 10. When P = $500: Q = P Q = ($500) Q = 100 Elasticity = -0.8 x ($500 / 100) Elasticity = -4 [Elastic] When P = $200: Q = P Q = ($200) Q = 340 Elasticity = -0.8 x ($200 / 340) Elasticity = [Inelastic] Demand is unit elastic at a price of $ Demand is elastic at any price above $ Demand is inelastic at any price below $ Elastic demand: $312.5 < P $625 Inelastic demand: $0 P < $

14 11. Demand elasticity is unit elastic at a price of $200 Find the vertical intercept: 0 = 2,000 5P 5P = 2,000 P = 400 Vertical intercept (a) = $400 Mid point price = a / 2 = $400 / 2 = $ Demand elasticity is unit elastic when quantity is 1,000 Find the horizontal intercept: Q = 2,000 5(0) Q = 2,000 Horizontal intercept (b) = 2,000 Mid point quantity = b / 2 = 2,000 / 2 = 1, The monopoly will be able to increase price to increase revenue anytime price is below $100 Increasing price will increase revenue when demand is inelastic. So the monopoly firm should raise price whenever the price is below the mid point price if it wants to increase revenue. Find vertical intercept: 0 = 6,000 30P 30P = 6,000 P = $200 Vertical intercept (a) = $200 Mid point price = a / 2 = $200 / 2 = $100 The monopoly should increase price anytime price is below $100 if it wants to increase revenue. 14

15 14. P = $2, Point elasticity = (Coefficient on P) * (P / Q) 2 = 0.25 * (P / Q) 8 = P / Q 8Q = P Q = 0.125P Q = 1, P 0.125P = 1, P 0.375P = 1,000 P = $2, Gatorade and 3 ice cream Bang for the buck of 1 st Gatorade = 40/4 = 10 Bang for the buck of 1 st ice cream = 60/2 = 30 Bang for the buck of 1 st Gatorade = 40/4 = 10 Bang for the buck of 2 nd ice cream = 40/2 = 20 Bang for the buck of 1 st Gatorade = 40/4 = 10 Bang for the buck of 3 rd ice cream = 24/2 = 12 Bang for the buck of 1 st Gatorade = 40/4 = 10 Bang for the buck of 4 th ice cream = 8/2 = 4 Bang for the buck of 2 nd Gatorade = 32/4 = 8 Bang for the buck of 4 th ice cream = 8/2 = 4 * Since Gatorade costs $4 and ice cream costs $2 we have used our full $14 budget at this point 16. MU = 15. For this problem you need to use the equation the following equation to solve for the marginal utility of ice cream. You know the two terms will be equal because the problem tells you that you want to have the optimum combination of Gatorade and ice cream. (MU of good A) (Price of good A) = (MU of good B) (Price of good B) 10 $2 = MU ice cream $3 MU ice cream = 15 15

16 17. Firms would be motivated to use capital if using capital is more productive and it is able to produce more output than labor. Capital can often be cheaper in the long run because you don t have to pay capital wages. Machines, a form of capital, are less likely to make mistakes than labor. 18. If a firm uses capital instead of labor, it could mean that people might lose their jobs. Politicians want to avoid losing jobs, even if it results in an increase in economic efficiency. 19. Moral hazard consumers are requesting unnecessary tests because they don t have to pay for them, and doctors are running the unnecessary tests because they are making a profit on them Adverse selection unhealthy people sign up for healthcare while healthy people do not The demand for healthcare is inelastic this allows health care providers to charge higher prices People tend to want the newest and most expensive health care available people generally don t want to cut corners when paying for major medical procedures An aging population the average age of the population is increasing, and older people spend more on health care People without insurance make expensive ER trips it is more expensive to go directly to the ER instead of having a primary care provider People without insurance often don t get preventative treatment they wait until larger, more expensive health issues arise An increase in unhealthy habits and activities Excessive sitting, overeating, and minimal exercise increase the cost of health care 16