practice final problems - ECO 2302 Principles of...

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Unformatted text preview: ECO 2302 Principles of Microeconomics Dr. Susan Williams McElroy University of Texas at Dallas Solutions to Practice Problems for Final Exam Notes from Dr. McElroy: 1) I strongly encourage you to work these problems as practice for the final exam. The solutions are available on WebCT. 2) Do not interpret these practice problems as an indicator of all of the topics or types of problems that will be included in the final exam. For a list of the chapters and topics to be covered on the exam, consult the list provided by Dr. McElroy (posted on WebCT). 3) The final exam will consist of the following types of problems: \/ Multiple choice \/ Fill in the blanks \/ Short—answer questions \/ Problems (with emphasis on material covered since the midterm exam) Part 1: Problems 1. (12 points total) What happens to the equilibrium price of ice cream in response to each of the following? For each question, draw a supply and demand diagram of the ice cream market as part of your answer. Be sure to label your axes and explain what each of your diagrams shows. a. (4 points) Concerns arise about the fat content of ice cream. Answer: The demand curve for ice cream shifts to the left. The new equilibrium price is lower than the old one, and the new equilibrium quantity is lower than the old one. b. (4 points) The price of sugar (an ingredient used to produce ice cream) increases. Answer: The supply curve for ice cream shifts to the left. The new equilibrium price is higher than the old one, and the new equilibrium quantity is lower than the old one. The old equilibrium point is A, and the new equilibrium point is B. c. (4 points) The price of frozen yogurt (a substitute for ice cream) increases. Answer: The demand curve for ice cream shifts to the right. the new equilibrium price is higher than the old one, and the new equilibrium quantity greater (or larger) than the old one. The old equilibrium point is A, and the new equilibrium point is B. 2. (10 points) Matilda receives $8 per day to purchase lunch. She spends all of her lunch money on bagels (which cost $1 each) and soda (which costs $1 per bottle). Draw Matilda's budget constraint. If the price of a bagel falls to $0.75, what will happen to Matilda's budget constraint? Draw Matilda's new budget constraint on the same graph. Answer: Let the quantity of bagels be measured on the x-axis, and let the quantity of soda be measured on the y—axis. A simple way to plot the budget constraint is to find the two anchor points of the budget constraint and connect them. If Matilda ’s income is $8 per day and the price of a bagel is $1.00, then we can divide the income by the price of one bagel to determine the anchor point of the budget constraint on the x-axis. Similarly, the anchor point for soda is the number of sodas Matilda can purchase if she spends all her income on soda. The budget constraint is shown as the solid line connecting points A and B. After the price of a bagel falls, the budget constraint will swing out to the right and become flatter. This is because with the same amount of income, Matilda can now purchase more bagels, so the anchor point of the budget constraint on the x~axis moves to the right of the ”old ” anchor point on the x—axis. Notice that the anchor point on the y-axis (soda) has not changed because the price of sodas did not change. The “new” budget constraint is shown as the dotted line connecting points A and C. Note that the algebraic equation of the budget constraint is I = PxX + PyY where I = income Px = price of good x (which in this case is bagels) X = number of bagels consumed Py = price of good Y (which in this case is soda) Y = number of sodas consumed Coordinates of point A = (0, 8) $8. 00/$l .00 = 8 income/price of soda Coordinates of point B = (8, 0) $8.00/$].00 = 8 income/old price of bagels Coordinates of point C = ( l 0. 66, 0) $8.00/$0. 75 = 10. 66 income/new price of bagels * See next page for drawing of Matilda ’5 budget constraint. Matilda ’s Budget Constraint 3. (l 0 points total) The price of cabbage rises fiom $0.20 per pound to $0.30 per pound. The quantity of cabbage demanded falls from 800 pounds per week to 600 pounds per week. a. (6 points) Calculate the price elasticity of demand for cabbage. Answer: Price elasticity of demand is defined as Ep = % change in Quantity demanded % change in price % change in quantity demanded = [600 — 800] 800 = —200/800 = — .25 % change in price = [$0.30 - $0.20]/$0.20 = $0.10/$0.20 = .5 Therefore, price elasticity of demand = [ —.25]/[ 0. 5] = —0.5. b. (4 points) Is the demand for cabbage elastic, inelastic, or unit elastic? Answer: Since the absolute value of the price elasticity of demand is less than one, the demand is inelastic. Why take the absolute value of the elasticity? —- because in the case of elasticity, it is the magnitude of the percentage changes that we care about. In other words, we want to know how much quantity demanded changes in response to a change in price, so by taking the absolute value, we can clearly see the magnitude of the ejj’ects. 4. (18 points total) When Frank's income rises from $29,000 to $34,000 per year, he increases his purchases of tomatoes from 20 pounds to 28 pounds per year. a. (6 points) Write down the formula for income elasticity of demand. Answer: Income elasticity of demand is defined as E p = % change in Quantifl demanded Note: Income elasticity of demand tells us how responsive quantity demanded is to a change in income. b. (6 points) What is Frank's income elasticity of demand for tomatoes? Use the midpoint formula to calculate income elasticity of demand. Answer: Income elasticity of demand is defined as E1: A change in Quantity demanded % change in income % change in quantity demanded = (28—20)/24 = 8/24 = 33.3 percentage change in income = ($34, 000 — $29, 000)/$3I,500 = 5, 000/31,500 = 15.9 Therefore, income elasticity of demand = (333/135. 9) = 2.1 % change in income 0. (6 points) According to Frank, are tomatoes an inferior or normal good? Answer: Because Frank increased his demand for tomatoes when his income increased, he VieWS tomatoes as a normal good. Therefore, his income elasticity of demand for tomatoes is positive. 5. (18 points total) Laura's Cookie Company faces the following cost schedule for making cookies by the dozen: q TFC TVC TC AFC AVC ATC MC 0 0 J 1 10 1 10 1 11 1 .1 W 2 10 13 6.50 3 17 3.33 5.67 4 4 10 13 3.25 5 31 2 6.20 a. (10 points) Write down the definitions of each of the cost measures (for example TFC and TVC) in the above table. Answer: T F C = Total fixed costs = Costs that do not depend on the quantity (or level) of output produced. Fixed costs must be paid even if output is zero. T VC = Total variable costs = costs that vary with the level of output TC = T F C + TVC = the total economic cost of all the inputs used by a firm in production AFC =T F C/Q, where Q is the quantity of output produced = variable costs per unit of output AVC =TVC/Q, where Q is the quantity of output produced AT C =TC/Q = Average total costs = AFC + A VC MC = Marginal costs = the increase in total cost that results from producing ] additional unit of output MC = A TC/A Q MC = A TVC/A Q Hint: remember that since fixed costs do not vary with the quantity of output produced, marginal cost is the change in total variable cost when one additional unit of output is produced. Hence, in steps we can write the following: 1. Start with the definition of total cost TC : TFC + T VC 2. Now rewrite this equation in terms of change in output ( that is, make everything a A). A TC/A Q = A TFC/A Q + A TVC/A Q 3. Sofinally we can write A T C/A Q = A TVC/A Q (note that ATF C /A Q = 0 by definition) M = = A T VC/A Q (MC = A TC/A Q by definition) and M = = A T C/A Q b. (8 points) Fill in the blanks above. q TFC TVC TC AFC AVC ATC MC 0 10 0 10 --—- -——- —-—~ ~—-— 1 10 1 11 10 1 11 1 2 10 3 13 5 1.50 6.50 2 3 10 7 17 3.33 2.33 5.67 4 4 10 13 23 2.50 3.25 5.75 6 5 10 21 31 2 4.20 6.20 8 6. (10 points) Kamika lives in Chicago but goes to school in Tucson, Arizona. For the last 2 years, she has made four trips home each year. During the year 2001, the price of a round trip ticket from Chicago to Tucson increased from $350 to $600. As a result, Kamika bought five fewer compact discs (CD8) that year and decided not to drive to Phoenix with friends for an expensive rock concert. Explain how Kamika’s demand for CDs and concert tickets can be affected by an increase in air travel prices. Answer: Kamika ’s demand for CD5 and Concert tickets are afiected by an increase in air travel prices, as she has a limited budget. An increase in air travel prices means that she has now less left to spend on other goods (CDs and Concert tickets). She can no longer afford the same combination of items that she purchased last year. Something has to give —— her budget constraint has changed. So, she has to cut back on some things, and her preferences dictate that she buy fewer CDs. 7. (6 points) The demand, marginal cost, and marginal revenue curves for Jay's Company are shown below. Jay has decided that his firm should produce 40 units per day. Is this the profit—maximizing level of output? Explain. MC 2o 30 40 Quantity MR Answer: No, the firm is not maximizing profit at an output level of 40 units. This is not where the firm’s marginal revenue is equal to marginal cost. For each of the units between 30 and 40, the marginal cost exceeds the marginal revenue. Therefore, producing these units would lower profit. The profit—maximizing level of output is 30. Part 2: Fill in the Blanks (10 points total e— 1 point per blank) 8. Market equilibrium occurs when guantifl demanded equals Quantity supplied. 9. Oligopoly can be described as a market structure in which the industry is dominated by a few large firms. 10. Market power refers to the ability firms may have to control the price in a particular market. 11. Price elasticity of demand is the ratio of percentage change in Quantity demanded to percentage change in price. 12. The process that transforms scarce resources into useful goods and services 'is called production. 13. The best alternative that we give up, or forgo, when we make a choice or decision is the opportunity cost of that choice or decision. 14. The officially established income level that distinguish the poor from the nonpoor is called the poverty threshold or poverty line. 15. Goods that are nonrival in consumption are called public goods. Part 3: Short-answer Questions 16. (3 points) Why is the demand curve for the product produced by a perfectly competitive firm perfectly elastic? Include a diagram as part of your answer. Answer: The demand curve faced by a firm in a perfectly competitive market is perfectly elastic because the firm is a price—taker. Because each firm ’s production is very small relative to the entire market, the firm can sell as much output as it would like at the market price. However, if the firm tries to raise its price, it will sell no output. This occurs because the firm’s product has many identical substitutes (products produced by other firms in the industry). If on the other hand, the firm tries to sell its product for lower than the market price, it will sujfer losses and eventually have to go out of business (shut down). See graph below which shows the demand curve the perfect competitor faces for its products. Demand curve perfect competitor faces for its products $2 5 '00 -.,...........‘............,.,._,...WNW...“._....w._._..r...___....................--.....W.-.“-m.c,cic........i.,r.._._r_._._._.................s...§ ; $20.00 H—O—O—Q—O—wH—H—HwH—O—O—H—O—E $15.00 Price $10.00 _ W7, , ,,,,,, ,i we ,. . .__, fistsifisi" $500 WWW—V—"qw—isficiiwn W w,” w ., . . "W . ”in, , ,, $0.00 i . i 17. (3 points) Explain the following statement using economic reasoning: “Products provided for ‘free’ to an individual are not free for society.” Answer: Products provided for rfree ’ to an individual are not free for society because of the required use of scarce resources to produce them. ...
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