ANSWERS TO SECOND HOUR EXAM

Economics 102

November 14, 2002

Test Form A

PART A: Multiple choice. (20 questions ´ 3 points each = 60 points) Correct answers are marked in red.

1. Marginal cost

(a) is the increase in total cost resulting from producing one more unit.

(b) always equals average cost.

(c) equals the increase in AVC resulting from producing one more unit.

(d) is the average cost of production divided by output.

2. Phil's Eraser Head Company is a perfectly competitive firm producing 5000 replacement pencil erasers per day. At this output level, price exceeds this firm's marginal cost. It follows that producing one more eraser will cause this firm's

(a) total cost to decrease.

(b) profits to remain unchanged.

(c) profits to decrease.

(d) profits to increase.

3. For a normal good like dog breath mints, the income and substitution effect of a price decrease

(a) work in the same direction to increase the quantity demanded of the good.

(b) work in the opposite direction at low prices, but the same direction at high prices.

(c) work in the same direction at low prices, but opposite directions at high prices.

(d) work in opposite directions to increase or decrease the quantity demanded of the good.

4. A firm in a perfectly competitive market has no control over price because

(a) the government imposes price ceilings on the products produced in perfectly competitive industries.

(b) the market demand for products produced in perfectly competitive industries is perfectly elastic.

(c) every firm's product is a perfect substitute for every other firm's product.

(d) there is free entry and exit from the industry.

5. In the long run,

(a) a firm can shut down, but it cannot exit the industry.

(b) a firm can vary all inputs, but it cannot change the mix of inputs it uses.

(c) there are no fixed factors of production.

(d) all firms must make economic profits.

6. Society will produce the allocatively efficient mix of output if all firms equate

(a) price and marginal cost.

(b) price and marginal revenue.

(c) marginal cost and average total cost.

(d) price and average total cost.

7. If the output obtained from the last dollar spent on labor is less than the output obtained from the last dollar spent on capital, then the firm

(a) is minimizing costs.

(b) should increase the price paid to labor and decrease the price paid to capital to minimize costs.

(c) should use less labor and more capital to minimize costs.

(d) should use more labor and less capital to minimize costs.

8. In perfect competition, the marginal revenue curve

(a) and the demand curve facing the firm are identical.

(b) is always above the demand curve facing the firm.

(c) is always below the demand curve facing the firm.

(d) intersects the demand curve when marginal revenue is minimized.

9. If the total product of two workers is 100 and the total product of 3 workers is 120, then the average product of the third worker is _____ and the marginal product of the third worker is _______.

(a) 40; 20

(b) 20; 40

(c) 13.33; 6.67

(d) 120; 100

10. Profit-maximizing firms want to maximize the difference between

(a) total revenue and marginal cost.

(b) total revenue and total cost.

(c) marginal revenue and marginal cost.

(d) marginal revenue and average cost.

11. When an increase in the scale of production leads to higher average costs, the industry is characterized by

(a) diminishing returns.

(b) increasing returns to scale.

(c) diseconomies of scale.

(d) constant returns to scale.

12. You own a building which has four possible uses: a bomb shelter, a massage parlor, a fireworks warehouse, and a hamster obedience school. The value of the building in each use is $2,000; $3,000; $4,000; and $5,000, respectively. You decide to open a fireworks warehouse. The opportunity cost of using this building for a fireworks warehouse is

(a) $2,000, the value if the building is used as a bomb shelter.

(b) $3,000, the value if the building is used as a massage parlor.

(c) $3,333, the average of the values if the buildings is used for either a bomb shelter, a massage parlor, or a hamster obedience school.

(d) $5,000, the value if the building is used for a hamster obedience school.

13. Diminishing marginal returns implies

(a) decreasing average variable costs.

(b) decreasing marginal costs.

(c) increasing marginal costs.

(d) decreasing average fixed costs.

14. Dubya can buy either pizzas or Fat Darrells. If the prices of pizza and Fat Darrells double and so does Dubya's money income, we can deduce that Dubya's budget constraint will

(a) shift in but remain parallel to the old one.

(b) shift out but remain parallel to the old one.

(c) swivel in so that the slope of the budget constraint is doubled.

(d) remain unchanged.

15. Which of the following will shift the short-run industry supply curve of a perfectly competitive industry?

(a) a decrease in the price of an input.

(b) an increase in consumer income.

(c) an increase in the price of the product produced by the industry.

(d) an increase in demand for the product of the industry.

16. Which of the following is a correct statement about the relationship between average product (AP) and marginal product (MP)?

(a) If AP exceeds MP, then AP is falling.

(b) If AP = MP, then total product is at a maximum.

(c) If TP is declining then AP is negative.

(d) If AP is at a maximum, then MP is also.

17. As long as indifference curves are bowed toward the origin, utility maximization will take place

(a) where the consumer spends all of his income on one good.

(b) where the consumer spends half of his income on each good.

(c) where the budget constraint intersects the indifference curve.

(d) at the point at which the indifference curve is just tangent to the budget constraint.

18. A firm will shut down in the short run if

(a) it is suffering a loss.

(b) fixed costs exceed revenues.

(c) variable costs exceed revenues.

(d) total costs exceed revenues.

19. Pareto efficiency is the condition in which

(a) the distribution of income is equal.

(b) no change is possible that will make some members of society better off without making some other members of society worse off.

(c) firms are forced to internalize the effects of all externalities.

(d) it is possible to make one person better off without making someone else worse off.

20. The short-run industry supply curve for a perfectly competitive industry is the

(a) horizontal sum of the individual firms' marginal cost curves above AVC.

(b) vertical sum of the individual firms' marginal cost curves above AVC.

(c) horizontal sum of the individual firms' marginal cost curves above ATC.

(d) vertical sum of the individual firms' marginal cost curves above ATC.

PART B: Answer BOTH questions in this part.

1. (25 points) The graph below depicts the average and marginal cost curves of a perfectly competitive firm. When this industry expands or contracts, input prices paid by the firms in the industry do not change. The current market price for the good produced by the industry is $30.

a) Label each of the four cost functions (abbreviations will do).

b) Draw average revenue and marginal revenue functions for the firm on the graph.

c) Label on the graph the short-run profit-maximizing output of the firm.

d) Indicate on the graph the level of economic profits or losses earned by the firm.

e) Label on the graph the long-run industry equilibrium price (assuming that all firms have cost functions indentical to those of this firm).

f) Label on the graph the output this firm will produce when the industry is in long-run equilibrium.

g) What will be the value of its economic profits in that circumstance? Explain.

Economic profit must be zero for the industry to be in long-run equilibrium. If economic profit is positive, then new firms will be attracted to the industry. If economic profit is negative, then some incumbent firms will be forced to exit from the industry.

2. (15 points) The diagram shows three budget lines and three indifference curves for a person who consumes only fenugreek and cardamom. The consumer's income is $120 per week. The price of cardamom is $2.

a. Determine three (price, quantity) pairs on the consumer's demand curve for fenugreek. Enter their coordinates in the table below.

Price	Quantity
6	4
3	24
2	46

b. Suppose that the price of fenugreek is the lowest of the three prices entered in your table. When this price prevails, is fenugreek a normal good or an inferior good? Using a straightedge, draw carefully in your diagram additional budget line(s) to support your claim. Explain briefly.

Fenugreek is a normal good. The red budget line corresponds to a lower income than the $120 income represented by the outermost black budget line, to which it is parallel. At the lower income, the quantity demanded of fenugreek is approximately 34, while at the higher income, the quantity demanded of fenugreek is 46. Since an increase in income raises consumption, holding prices constant, fenugreek is a normal good.