Exam 1 W23 answers

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Page 2 of 7 Multiple Choice, 12 questions. Choose the best answer. Each correct answer is worth two points. 1. Economic models ______ omit potentially relevant factors because there is a trade-off between the _____ of the model and how realistic the model is. a. always; simplicity b. always; fairness c. never; correctness d. never; rationality Economic models are simplifications; they must omit variables that aren’t of immediate interest to the application at hand (think about the ceteris paribus “all else equal” assumption discussed in lecture). As we add factors/variables to a model, the model becomes both more realistic and less simple, creating a trade-off. 2. Elena owns a townhouse that includes a small storefront on the first floor. In this store, she operates her homemade candle business. She brings in $3500 in revenue from candle sales monthly. Candle supplies cost $250/month, and hiring a staff member costs $1500/month. If she weren’t operating the candle business, she could rent out the storefront for $2000/month. The accounting profit of Elena’s business is __________ ; the economic profit of Elena’s business is _________. a. $250; $3750 b. $1750; $3750 c. $1750; -$250 d. $-250; $1750 Accounting profits are explicit benefits minus explicit costs. Here, the explicit benefit is the revenue Elena collects from her candle business ($3500). Her explicit costs are supplies ($250) and labor ($1500). Therefore, accounting profits = 3500-250-1500=1750. Economic profits account for not just explicit costs but also implicit opportunity costs. Here, Elena is missing out on $2000/month by using the storefront as her own shop rather than renting it out. This is another (implicit) cost. Her economic profits are 3500-250-1500-2000=-250. 3. Miguel is considering two college options: the University of Michigan and (the) Ohio State University. After graduating from Michigan, Miguel would get a job that pays $74,000/year. After graduating from Ohio State, Miguel would get a job that pays $52,000 /year. To attend the University of Michigan, Miguel would need to take out student loans. Repaying his student loans would cost him $6,000/year after he graduates. Ohio State offered Miguel a full ride scholarship, meaning that he would not need to take out any student loans to attend Ohio State. What is the opportunity cost of attending the University of Michigan for Miguel? a. $80,000 per year b. $58,000 per year c. $52,000 per year d. $46,000 per year Miguel’s opportunity cost of attending the University of Michigan is the value of his next best alternative, which here is Ohio State. Attending Ohio State has two benefits: it provides a $52,000 annual salary and saves him $6000 in annual debt obligations. Therefore, the value of this next-best alternative totals $52,000 + $6,000 = $58,000/year after graduation.

Page 3 of 7 4. Which of the following statements is FALSE about general properties of indifference curves? a. Indifference curves slope downwards. b. Indifference curves are convex, that is, they are bowed in. c. Indifference curves can never cross a budget line. d. Indifference curves that are shifted up and to the right represent higher levels of utility. Indifference curves must not cross one another but they can cross a budget line. 5. Ethan eats burritos and burgers for lunch. His utility of eating each is described in the table to the right. Which of the following statements is TRUE about Ethan’s preferences? a. Ethan’s preferences of consuming burritos and burgers always obey the “more is better” law. b. Ethan’s preferences of consuming burritos and burgers always obey the law of diminishing marginal utility. c. Ethan’s preferences of consuming burritos always obeys the law of diminishing marginal utility, while Ethan’s preferences of consuming burgers always obeys the “more is better” law. d. Ethan’s preferences of consuming burritos always obeys the “more is better” law, while Ethan’s preferences of consuming burgers always obeys the law of diminishing marginal utility. Ethan’s preferences of consuming burritos do not obey the law of diminishing marginal utility because the marginal utility does not get smaller starting at the 5 th burrito. Ethan’s preferences of consuming burgers do not obey the “more is better” law because the marginal utility of consuming the 5 th burger is zero and of consuming the 6 th burger is negative. 6. The graph to the right describes Brandon’s budget constraint. Which of the following statements about the points on the graph to the right are FALSE ? a. There is no money left over to consume pineapples if he chooses to consume Point A. b. He can consume both more avocados and more pineapples if he chooses to consume Point B. c. We can be sure that Point C is the optimal consumption bundle for Brandon. d. He cannot afford to consume Point D. Quantity consumed Marginal utility of… burrito burger 0 - - 1 85 25 2 80 20 3 73 10 4 70 5 5 70 0 6 70 -3

Page 4 of 7 We cannot determine an optimal consumption bundle just by looking at the budget constraint. We need more information – that is, an indifference curve that describes his preferences over consuming the goods. It’s possible that Point A is optimal, it’s possible that Point C is optimal, it’s possible that any of the other points on the BC are optimal. We can’t be sure that Point C is the best, given what we know. 7. The table to the right contains the production functions of phones (P) and tablets (T). Which of the following statements is TRUE ? a. The Marginal Product of Labor (MPL) of both goods is downward sloping. b. The Marginal Product of Labor (MPL) is increasing for only one of the goods. c. The Marginal Product of Labor (MPL) is decreasing for only one of the goods. d. The Production Function for Tablets is horizontal. The MPL is decreasing for one of the goods (phones). The production function for tablets is an upward sloping straight line, which means that the MPL for tables is flat, since each additional worker hired always produces an additional two units of tablets. 8. Consider Anna's initial and new budget constraints in the graph to the right. Anna splits her income between sandwiches and chicken wings. What would make her initial budget constraint change to become the new budget constraint? a. When Anna’s income rises, and all else remains equal. b. When both prices of sandwiches and chicken wings rise, and all else remains equal. c. When Anna’s utilities of consuming both sandwiches and chicken wings increase, and all else remains equal. d. When the costs of producing sandwiches and chicken rise, and all else remains equal. When Anna’s income rises, she can afford more sandwiches and chicken wings. Therefore, her budget constraint will shift to the right. Budget constraints do not come from utility, nor do they come from production costs. Number of Workers (L) Quantity of phones (P) Quantity of tablets (T) 1 10 2 2 18 4 3 24 6 4 29 8 5 33 10 6 36 12 7 38 14 8 39 16

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Page 5 of 7 9. The table to the right describes the production function of computers. The firm has $200 of fixed costs and the wage per worker is $50. Workers are the only variable input. Calculate the Marginal Cost of producing a computer as the firm increases the quantity of computers produced from 70 to 80 units. a. $3.84 b. $5 c. $6.25 d. $8 It takes 5 workers to produce 80 computers, so w*L = 5*$50 = $250 is the firm’s variable cost. It also has $200 on fixed costs and so the total cost is equal to 250 + 200 = 450. Since producing 70 computers costs a total of 200 + 4*50 = 400, the increment in total costs is ∆TC = 50. Therefore the marginal cost per computer is ∆TC/∆Q = 50/10 = $5 per computer. 10. Which of the following situations would lead to a rise in Average Variable Cost (AVC) as output rises? a. Fixed costs are decreasing with quantity. b. Wages are decreasing as more workers are hired. c. A horizontal Marginal Cost curve. d. A decreasing Marginal Product of Labor as more workers are hired. The correct answer is a decreasing MPL as more workers are hired since, in case wages were constant, it would lead to increasing AVC function as seen in lecture.. Fixed costs are both separate from variable costs, and “fixed costs are decreasing” is a contradiction in terms. Since all marginal costs come from variable costs, if MC is constant that would result in a constant AVC as well, it would be flat rather than rising. 11. Which of the following statements about profit maximization in a competitive environment is TRUE ? a. A firm maximizes profits by choosing to set the price where (P - ATC)*Q is maximized. b. A firm maximizes profits by choosing to produce the quantity where MR = MC. c. A firm maximizes profits by choosing to set the price where P = MC. d. A firm maximizes profits by choosing to produce the quantity where ATC = MC. The firm cannot choose the price in a competitive environment since it is a price taker, so we rule those options out. Firms want to maximize profits, and that always happens where MR=MC. ATC=MC only occurs at the lowest possible cost; firms don’t want to minimize cost, they want to maximize profit. Number of Workers (L) Quantity of computers (C) 1 25 2 42 3 57 4 70 5 80 6 88

Page 6 of 7 12. Which of the following is NOT a characteristic of a perfectly competitive market? a. Firms can set the price of the good they produce. b. Firms are free to enter and exit the market. c. There is no product differentiation. d. There are many firms. Answer choices b, c, and d are characteristics of perfectly competitive markets, as discussed in Lecture 8. Firms in competitive markets are price-takers—they do not have control over the price of the good they produce, but rather take the market price as given. If they tried to charge a higher price, they would have no customers. If they tried to charge a lower price, they would be operating at a loss (economic profits < 0).

Page 2 of 5 Name: _________________________________________ Short Answer, 26 points. Answer each question in the space given (and ONLY the space given). 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. (11 points total) Lena likes to consume carrot cupcakes or vanilla cupcakes after her dinner. She has a budget of $20 to spend in total and can only consume both goods in whole units (unit: cup). a. (1 pt) If she chooses to consume only one or the other of the cupcake types, Lena can afford either at most 5 carrot cupcakes at one extreme, or 4 vanilla cupcakes at the other. Write the equation for her budget line by using the letter “C” to denote the quantity of carrot cupcakes and “V” to denote the quantity of vanilla cupcakes. Since Lena can consume 5 carrot cupcakes if she spends all her budget on carrot cupcakes, the price of carrot cupcakes must be $4 per cupcake. Also, since Lena can consume 4 vanilla cupcakes if she spends all her budget on vanilla cupcakes, the price of vanilla cupcakes must be $5 per cupcake. Therefore, the budget line can be written as: 4*C + 5*V = 20 b. (3 pts) A grocery store has a special event that offers a discount price for carrot cupcakes at $2 per cupcake. Vanilla cupcakes are the same price as before (as in part (a)) (i) Write down the equation for the new budget line AND (ii) Draw Lena’s initial and new budget lines together in the same graph, using the axes given below. Put carrot cupcakes on the vertical axis and vanilla cupcakes on the horizontal axis. Clearly label all axes, intercepts, and graphs for full credit. The new budget line is 2*C + 5*V = 20

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Page 3 of 5 Name: _________________________________________ c. (2 pts) Using the new (part (b)) price for carrot cupcakes, fill in the blanks of the table below Carrot cupcakes (price: $2 per cup) Vanilla cupcakes (price: $5 per cup) Quantity Total Utility Marginal Utility (MU) MU/P Quantity Total Utility Marginal Utility (MU) MU/P 1 24 24 12 1 50 50 10 2 46 22 11 2 90 40 8 3 58 12 6 3 105 15 3 4 68 10 5 4 115 10 2 5 76 8 4 5 120 5 1 d. (2 pts) Given the information and numbers you filled in the table, what is Lena’s optimal consumption bundle that maximizes her total utility? Calculate the total utility that Lena gets at optimum. Show the work that illustrates how you figured out her optimal choice! The optimal consumption bundle is 5 carrot cupcakes and 2 vanilla cupcakes. - The first two carrot cupcakes give her higher marginal utility per dollar (MU/P) than the first vanilla cupcake, so she would buy two carrot cupcakes first by spending $2*2 = $4 - Then she would buy the first two vanilla cupcake by spending $10 becuase MU/P of the first two vanilla cupcakes are higher than that of the 3rd carrot cupcake. This leaves her $20 – ($2 * 2 carrot cupcakes) – ($5 * 2 vanilla cupcake) = $6. - Finally, she would buy the rest of the carrot cupcakes, since MU/P of the 3 rd , 4 th , and 5 th carrot cupcakes are greater than the 3 rd cupcake. - Therefore, she would buy 5 carrot cupcakes, and 2 vanilla cupcakes, and the total cost is $20. And the total utility at optimum is 76 + 90 = 166 e. (3 pts) Using the given axes below, draw (i) the new budget line you obtained in part (b) above AND (ii) the indifference curve that represents the utility-maximizing choice you found in part (d) above. (iii) Be sure to label clearly label all axes, intercepts, curves, and optimal quantities.

Page 4 of 5 Name: _________________________________________ 2. (8 points total) A profit-maximizing shoe store has the cost curves shown in the graph to the right. The graph represents the quantity of pairs of shoes in the horizontal axis (Q). The market price of a pair of shoes is $35. a. (2 pts) What is the quantity of shoe pairs that the store will choose in order to maximize profits? Explain in a sentence or two what profit- maximizing rule the store follows. The firm follows the optimal strategy to equalize Marginal Revenue (Price) and Marginal Cost. Since the firm takes a price of $35 as given, P = MR = $35. The firm will choose to produce 110 pairs of shoes since it is the quantity where MC=MR. b. (1 pt) Given its production choice in part (a), what is the firm’s profit? Profits are calculated by the equation 𝜋𝜋 = (P-ATC)*Q. They take the price P=$35 as given, and part (a) shows that Q = 110. At Q=110, ATC = 21 in the graph above. The firm will get 𝜋𝜋 = (35-21)*110 = $1,540 of profits. c. (2 pts) At which price will the shoe store get exactly 0 profit? And how many pairs of shoes will the store produce at that point? The store gets zero profit when (P-ATC)*Q = 0, so when P = ATC (when Q = 0, it will have fixed costs and therefore negative profits). That is when the MC line intersects with the ATC. Price = $20 gives the store 0 profit. At that point the store will choose to produce 100 pairs. d. (1 pt) What is the optimal quantity of shoes for the store to produce if the price falls to $12? How much profit will it make? If the price is $12 the firm will choose to produce 80 pairs of shoes. The profits at that point will be (12-21)*80 = $- 720. e. (2 pts) Is the firm willing to stay open in the situation described in part (d)? What is the range of prices where the firm is willing to remain open at a loss? Yes, the firm is willing to produce that quantity. That price puts the firm right at the place where MC=AVC, the shutdown price. At that price, the firm is indifferent to staying open or closing. They are willing to stay open, just as they are willing to shut down. $20 is the price at which profits switch from positive to negative – the minimum of the ATC curve. Above, profits are positive, below negative. Any price below $20 incurs a loss, but any price above $12 means the firm is willing to stay open. So the range of prices is from $12-$20. $

Page 5 of 5 Name: _________________________________________ 3. (7 points total) The table to the right presents supply and demand schedules for ice cream in Ann Arbor: a. (3 pts) Plot the supply and demand curves for ice cream in a graph with quantity of ice cream on the horizontal axis and the price of ice cream on the vertical axis. Be sure to clearly label your graph. b. (1 pt) What is the equilibrium price and quantity of ice cream in this example? How do you know? The equilibrium price is $4 and the equilibrium quantity is 60,000 pints of ice cream. The table and graph both illustrate that this is where quantity demanded is equal to quantity supplied. c. (1 pt) Suppose the city of Ann Arbor decides that ice cream should be only $3, and prohibits firms from charging any more than $3 for a pint of ice cream. How many pints of ice cream will be sold under this policy? At a price of $3, there will be 80,000 units demanded but only 30,000 units supplied. Only 30,000 units will be sold— firms will not be willing to produce any more. d. (2 pts) Under the $3 maximum price, will there be excess supply or excess demand in the market for ice cream? Calculate how large of an excess, and illustrate this quantity in the graph you drew for part (a). There is an excess demand of 80,000-30,000=50,000 units. Price (per pint) Quantity of pints demanded Quantity of pints supplied $2 100,000 0 $3 80,000 30,000 $4 60,000 60,000 $5 40,000 90,000 $6 20,000 120,000 $7 0 150,000

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