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test2_solns

# test2_solns - Department of Economics University of Toronto...

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Page 1 of 8 Department of Economics Prof. Gustavo Indart University of Toronto December 7, 2007 ECO 100Y – L0201 INTRODUCTION TO ECONOMICS Midterm Test #2 LAST NAME FIRST NAME STUDENT NUMBER INSTRUCTIONS : 1. The total time for this test is 50 minutes. 2. This question booklet has 8 (eight) pages. 3. Answer all questions in the space provided. If space is not sufficient, continue on the back of the page. 4. Aids allowed: a simple, non-programmable calculator only. 5. Use pen instead of pencil . DO NOT WRITE IN THIS SPACE Part I 1. /10 4. /15 2. /10 5. /15 3. /10 TOTAL /60 SOLUTION

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Page 2 of 8 Question 1 (10 marks) Tasfia is the proud owner of a small firm in a perfectly competitive market. Her firm generates the following short-run information: the market price is \$9; the average total cost is \$12; the marginal cost is \$9; and the average fixed cost is \$5. Statement: Kinlam — a friend of Tasfia’s and an economics student from another university — advises Tasfia to shut down production to minimize her economic losses. Position: Do you agree with Kinlam’s advice? Use a proper diagram to analyze this situation and indicate, with reasons, whether you agree or disagree with Kinlam’s advice. The diagram above depicts the described situation. The firm is in short-run equilibrium producing the level of output at which P = MC. The firm is making economic losses since ATC > P. Since ATC = \$12 at q 1 , the average economic loss per unit of output is ATC – P = \$12 – \$9 = \$3; therefore, total economic losses are equal to the shaded pink area shown in the diagram. Although the firm is making economic losses, Tasfia should not shut down production since economic losses would otherwise increase. Indeed, as long as P > AVC, the firm should continue producing in order to minimize economic losses. And since ATC = AFC + AVC and AFC = \$5, AVC = \$12 – \$5 = \$7 and thus AVC < P. If Tasfia were to shut down production, economic losses would increase and be equal to TFC. As shown in the above diagram, the average economic loss per unit of output would be equal to the AFC = \$5 (i.e., equal to the distance between the ATC and the AVC curves) and the total economic losses would be equal to the shaded pink area plus the shaded blue area. Therefore, I disagree with Kinlam’s advice for the reasons stated above. MC ATC AVC \$ q q 1 12 9 7 Current economic losses Additional economic losses if shutting down
Page 3 of 8 Question 2 (10 marks) Consider the situation described in the previous question, but suppose now that Tasfia’s landlord wins the lottery and decides to reduce Tasfia’s rent. As a result, her average fixed cost falls from \$5 to \$1 at the level of output described in the previous question.

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test2_solns - Department of Economics University of Toronto...

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