Exam 1 W20 answers

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University of Michigan *

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Economics

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Feb 20, 2024

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Page 2 of 10 is worth two points. 1. If a firm is currently making 0 economic profit, then we can be sure that: a. It is earning no revenue. b. The explicit costs of the firm are equal to its revenues. c. The firm's resources could not be better used in another endeavor. d. The firm's accounting profit is also 0. Explanation: An economic profit of 0 means that, including the opportunity cost, the firm would make the same profit if it was using its resources to pursue the next best alternative to its current operations. This implies that they could not use their resources to make more economic profit elsewhere. 2. The Gotham City Police Department is investing $50,000 to recruit and train additional officers to help thwart Joker's evil plans. If they make this investment, they prevent $100,000 worth of damage to the city. Alternatively, Gotham PD could invest $40,000 to capture Penguin, saving the city $75,000 worth of damage. What is the opportunity cost of investing resources to thwart the Joker? a. $85,000 b. $75,000 c. $50,000 d. $10,000 Explanation: The OC of targeting Joker is targeting Penguin. This would have a value of 75,000 in saved damages, cost 40,000 in resources, and save the 50,000 in spending from targeting Joker. This means the OC is equal to 75,000-40,000+50,000=85,000. 3. You have a part-time tutoring job, and you are deciding how many hours to work this week. You should keep working until the marginal benefit of working one more hour ______ the marginal cost. If the marginal benefit of working one more hour ________ the marginal cost, you should work more. a. is greater than; equals b. equals; is greater than c. is less than; is greater than d. equals; is less than Explanation: When we use the marginal principle to make optimal decisions, we keep going until the marginal benefit is equal to the marginal cost. Hours of TV Utility Marginal

Page 3 of 10 4. Do the TV watching preferences described in the table to the right always obey the law of diminishing marginal utility? Do they always follow the law of preferences that “more is better”? a. They follow both laws. b. They do not follow either law. c. They follow the “more is better” law, but not the law of diminishing marginal utility. d. They follow the law of diminishing marginal utility, but not the “more is better” law. Explanation: It follows the law of diminishing marginal utility, because marginal utility gets smaller as you watch more TV. It does not follow the “more is better law” because the marginal utility of the 5 th hour of TV is 0, indicating it has no benefit. 5. You buy 5 apples and 2 bananas. The price of apples is $3. Your income is $30 and you spend your entire budget on applies and bananas. What is the price of bananas? a. $3 b. $5 c. $7.50 d. $9.50 Explanation: The budget line is Pa*Qa+Pb*Qb = 30 (with equality, because the question says that you spend your entire budget), We’re given Pa= 3, Qa = 5, and Qb = 2 so 3*5+2*Pb = 30  2Pb = 15  Pb = 7.5 6. When you have two goods, what does the slope of the indifference curve mean? a. When the quantity of X increases by one unit, how many units of Y must we give up to remain equally happy? b. When the quantity of X increases by one unit, how can we make the quantity of Y increase by the same amount? c. When the price of X increases by one, what is the change in the price of good Y? d. When the price of X increases by one, how many units of X do we optimally give up? Explanation: definitional 7. Suppose a firm has exactly two inputs to production: pencils and computers. Which of the following CANNOT be true? a. In the short run, the firm can adjust pencils but not computers. b. In the short run, the firm can adjust computers but not pencils. c. In the long run, the firm can adjust both computers and pencils. d. In the short run, the firm can adjust both computers and pencils. Explanation: definitional. In the long run, by definition, ALL inputs can be changed. In the short run, by definition NOT watched utility 0 0 - 1 8 8 2 14 6 3 18 4 4 20 2 5 20 0

Page 4 of 10 all inputs can be adjusted. We’re not told anything about capital and labor here, so it’s possible that either is possible to adjust in the short run, as long as the other is not. 8. The table to the right shows a pizza parlor’s costs of making pizza. The price of a pizza is $9. What is the marginal profit of the 10 th pizza? a. $10 b. $7 c. $6 d. $9 Explanation: price is marginal revenue: P = MR = $9 for all pizzas. The MC of the 10 th pizza is MC = ∆VC/∆Q = (25-10)/(10-5) = 15/5 = 3, so marginal profit is MR – MC = 9 – 3 = $6 9. A firm maximizes its profits and it earns a negative economic profit in the short run. Which of the following must be true? a. Marginal Revenue =Marginal Cost b. Price = Average Total Cost c. Price > Average Total Cost d. None of the above Explanation: a profit-maximizing firm always sets MC=MR; it is possible that maximum profit is negative. Profit is (P- ATC)*Q, so if profits are negative, (P – ATC)*Q < 0  P-ATC < 0  P < ATC. Both of the above options contradict this. 10. Average Total Cost is defined by: a. Total Cost + Average Variable Cost b. (Total Variable Cost)/Q + Average Fixed Cost c. Total Variable Cost + Average Fixed Cost d. (Total Cost)/Q +Total Variable Cost Explanation: ATC = TC/ Q = (TVC+FC)/Q = TVC/Q + FC/Q = (by definition) TVC/Q + AFC 11. Which of the following characteristics are associated with a perfectly competitive market? I. Consumers are price takers. II. Producers can affect the market price of the good. III. There are many firms with small market share. IV. Products are differentiated. a. I and III. b. I, II and III. c. II, III and IV. d. I, III and IV. Explanation: In a competitive market consumers and producers are price takers, so (I) is correct and (II) is incorrect. In Quantity of pizzas Variable cost Fixed cost 0 0 50 5 10 50 10 25 50 15 45 50 20 70 50

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Page 5 of 10 order for them not to be able to affect the prices we must have many small firms with small market share and the consumers must regard all the producers as equivalent which means that the goods are standardized, so (III) is correct and (IV) is incorrect. 12. Suppose we are in a competitive market and price is above the equilibrium price. Which of the following is true? a. There is a shortage, therefore producers will cut price and decrease the quantity produced until the price reaches the equilibrium level. b. There is a surplus, therefore producers will cut price and decrease the quantity produced until the price reaches the equilibrium level. c. There is a surplus, producers will increase the quantity produced and consumers will decrease the quantity demanded and prices will increase even more. d. There is a shortage, producers will increase the quantity produced and consumers will decrease the quantity demanded and prices will increase even more. Explanation: If the price is above the equilibrium price, there is excess supply (surplus) in the market. Therefore, the producers cannot find enough consumers to buy their products so they will cut prices and decrease the quantity produced until the quantity demanded meets the quantity supplied and the market price reaches its equilibrium level. Therefore, the only correct answer (a).

Page 7 of 10 Short Answer, 26 points. Answer each question in the space given (and ONLY the space given). Numerical numbers may be rounded to two decimal places. Show your work, and label your graphs! Please circle or highlight all of your final answers. 1. (7 points total) You have $10 to spend on chips and ice cream. Ice cream costs $4 a pint, and chips cost $2 a bag. You must consume ice cream and chips in whole units (no fractions of a good). a. (1 pt) If you only bought chips, how many bags of chips could you afford? 5 bags ($10 budget / $2 per bag of chips) b. (1 pt) If you only bought ice cream, how many pints of ice cream could you afford? 2 pints ($10 budget / $4 per pint of ice cream = 2.5, but can’t buy half a pint of ice cream) c. (2 pts) Fill in the table below. d. (2 pts) Use your completed table to determine how many pints of ice cream and bags of chips you should buy to maximize your total utility. How was this decision made? 2 pints of ice cream and 1 bag of chips. The first pint of ice cream gets you more “bank for your buck” (marginal utility / price) than the first bag of chips, so you should buy a pint of ice cream first. That leaves you $6 remaining to spend. The first bag of chips gets you more bang for your buck than the second pint of ice cream, so you should buy a bag of chips next. That leaves you $4 remaining to spend. The second pint of ice cream gets you more bang for your buck than the second bag of chips, so you should spend your last $4 on ice cream. e. (1 pt) What is total utility at optimum, given these prices, preferences, and income? Total utility can be calculated as the sum of the marginal utility of each good consumed. The first two units of ice cream give 24+12 = 36 utils. The first unit of chips gives 8 utils. 36 + 8 = 44 utils total. (For admin purposes – please leave blank) Question Score 1 2 3 4 Ice cream Chips Quantity Total Utility Marginal Utility (MU) MU/P Quantity Total utility Marginal Utility (MU) MU/P 1 24 24 6 1 8 8 4 2 36 12 3 2 12 4 2 3 44 8 2 3 14 2 1 4 48 4 1 4 15 1 0.5 5 50 2 0.5 5 16 1 0.5 Number of Cups of coffee

Page 8 of 10 2. (5 points total) The table to the right shows the total product curve for a coffee shop, whose only fixed input is espresso machines an whose only variable input is workers. a. (2 pts) Does this total product curve exhibit the property of diminishing marginal productivity? Explain, being sure to define what the property means as you do so. Diminishing marginal productivity means that for each additional unit of the input the firm employs, output rises but by a smaller amount than for the previous unit of input. Yes, the marginal product of each additional worker is decreasing (80 from 0 to 1, 60 from 1 to 2, 40 from 2 to 3, 20 from 3 to 4). b. (2 pts) Suppose each worker is paid $70 per day. What is the average variable cost of producing 180 cups of coffee in a day? From the table, it takes 3 workers to produce 180 cups of coffee. When each costs $70, total variable cost TVC = 3*70 = 210. AVC = TVC/Q = $210/180 = $1.17. c. (1 pt) The coffee shop adds one additional espresso machine, which doubles the productivity per worker relative to the table above. Draw a graph that illustrates how the marginal product of labor changes. (No calculations are necessary here.) The marginal product of labor will rise. Each unit of labor becomes more productive. workers per day 0 0 1 80 2 140 3 180 4 200 5 210 Price Quantity Quantity

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Page 9 of 10 3. (9 points total) Consider the market for yoga classes in Ann Arbor. The tables below show the demand and supply in this market. a. (3 pts) Plot the demand and supply curves using this schedule and indicate the equilibrium quantity and price in your graph. Be sure to clearly label your axes. b. (2 pts) The government declares that the price of all yoga classes in Ann Arbor must be exactly $20. Is there an excess demand or supply at this price? Calculate how large is the excess, and label it in your graph in part a At P = 20, Qd = 700 and Qs = 500. There is therefore excess demand of 700- 500 = 200. c. (2 pts) Now suppose the medical school publishes research showing that practicing yoga enhances academic performance. The new demand for yoga classes given by the table below, while supply is unchanged. How (be precise!) do equilibrium price and quantity change (relative to part (a)) as a result? Answer: The new equilibrium price is $40 and the new equilibrium quantity is 700. That means price rises by $10 and quantity rises by 100. Demanded Supplied $70 200 1000 $60 300 900 $50 400 800 $40 500 700 $30 600 600 $20 700 500 $10 800 400 $0 900 300 Price Quantity Demanded $70 400 $60 500 $50 600 $40 700 $30 800 $20 900 $10 1000 $0 1100

Page 10 of 10 (question 3, continued) d. (2 pts) By how much did the willingness-to-pay for the 400 th yoga class change when the demand curve moved from the old one to the new one? Explain. Demand directly describes willingness to pay. When Qd = 400, the previous price was $50, and the new price is $70. The willingness to pay for the 400 th class (and in fact all classes) rose by $20. 4. (5 points total) The table to the right gives the total cost for selling zero to ten widgets. Answer the following questions and SHOW YOUR WORK! a. (1 pt) Calculate Average Fixed Cost when Q = 5. We know that when Q = 0 that VC = 0, so TC = FC = 50. AFC = FC/Q, so at Q = 5, AFC = 50/ 5 = 10. b. (2 pts) Suppose widgets always sell for $25 apiece. How many widgets will a profit-maximizing firm sell? The firm should produce all units where MR≥MC. P = MR = $25. Calculating MC as to the right, MR≥MC holds for every unit up to the 8 th , but not for the 9 th . c. (2 pts) Given the price and quantity from part (b), what are the firm’s maximum profits? Profits can be stated TR – TC. The table gives TC, and we know from the previous item that optimal quantity is 8, so TC at optimum is 190. The firm is selling 8 units at $25 apiece, so TR = P*Q = 8*25 = 200. Profit = TR-TC = 200-190 = $10. Quantity produced Total cost MC 0 50 - 1 60 10 2 72 12 3 88 16 4 106 18 5 126 20 6 147 21 7 168 21 8 190 22 9 216 26 10 246 30

Exam 1 W20 answers

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