EC 202-Principles of MicroeconomicsNAME_______________________________________________________________________ 1. The theory of consumer choice provides the foundation for understanding which curve in the Supply & Demand situation? Answer (1): Indifference curves Explanation: The theory of consumer choice states that given a limited amount of income (budget constraint), a consumer would develop preferences with respect to consumption i.e., make trade-offs to maximize his utility. Such preferences can be depicted through an indifference curve. . 2. A consumer a. b. c. d. Is equally satisfied with any indifference curve. Prefers indifference curves with positive slopes. Prefers higher indifference curves to lower indifference curves. Prefers indifference curves that are straight lines to indifference curves that are right angles.. Answer (2) (C) Prefers higher indifference curves to lower indifference curves Explanation: The indifference curve approach assumes that a rational consumer would seek to attain a position of equilibrium by maximizing the satisfaction i.e., prefer more goods over less. Therefore, a higher combination of goods/services (higher indifference curve) will be more preferable as it adds to the utility. 3.the theory of consumer choice illustrates that people face tradeoffs, which is one of the Ten Principles of Economics. (TRUE/FALSE) Answer (3): True Explanation: Scarcity of resources is one of the fundamental propositions of economics. The theory of consumer choice examines the trade-offs a typical consumer will make and provides basis to understand why a demand curve Given limited means (resources).slopes downward. a rational consumer would certainly make trade-offs to maximize utility. . e. if this consumer’s income goes down as a result of a recession. a consumer is more likely to cut his spending on CD’s and movies because in accordance with the budget constraint. Demand for some goods such as necessities are not much affected by the decrease in income. Therefore. real income. Recession hurts GDP. but the market will also adjust itself i.. demand and consumption for both CD’s and movies will fall. the price of CD’s and movies will also decline and achieve equilibrium. If a consumer's income is spent on CDs and movies. Not only the consumer’s income goes down. therefore.4. . However. employment and production. what would happen to the budget constraint for CDs and movies? Draw a graph demonstrating your answer with CDs on the Y-axis (2 points) Answer (4) Recession involves significant decline in economic activity. the CD’s and Movies are both entertainment goods (not necessity). Figures for Question 4 below 4a.Which of the graphs in the figure reflects a decrease in the price of good X only? Answer (4a): Graph (B) Explanation: The decrease in the price of good X would cause the demand to increase. Therefore. the consumer will buy more of good B. quantity demanded will increase as shown by graph B . As a result. 4b.Which of the graphs in the figure could reflect a decrease in the prices of both goods? Answer (4c): Graph (D) Explanation: Decrease in the price of both goods would increase the consumer’s purchasing power and allow him to buy more. 5. Using the graph shown. the increase in the price of good Y would cause the demand to decrease. The quantity demanded will increase for both goods which is ideally depicted by graph D. 4c. (Hint: of the four letters on the indifference curve.Which of the graphs in the figure reflects an increase in the price of good Y only? Answer (4b): Graph (C) Explanation: Consistent with the demand and supply principle. consumer’s quantity demanded for Y will decrease. only two translates into the demand curve). Consequently. construct a demand curve for M&M's given an income of $10. (2 points) Answer: . . e. (TRUE/FALSE) Answer (6): TRUE Explanation: Accountants only include explicit costs into the cost analysis whereas economists include both explicit and implicit costs. What are opportunity costs? How do explicit and implicit costs relate to opportunity costs? (2 points) Opportunity costs refer to the benefit foregone in order to acquire the next best alternative. he would have to forego another alternative i. the 5% benefit foregone will become the opportunity cost of investing in stock market. This is one of the reasons why economic profits are usually lower than accounting profits.. Opportunity costs essentially comprise of both explicit and implicit costs. assume that an investor can either invest in the stock market and earn 15% return or take a bank’s fixed term deposit offering 5% interest. For instance. Economists and accountants usually differ on the inclusion of implicit costs into the cost analysis of a firm. 7.6. Therefore. . interest on fixed deposit. If a consumer opts to invest in stock market. (3 points per column for a total of 21 possible points) Quantity of Silk Ties 1 2 3 4 5 6 7 8 Fixed Cost Variable Cost 25 25 25 25 25 25 25 25 Total Cost 13 28 45 64 85 108 133 160 38 53 70 89 110 133 158 185 Average Fixed Cost Average Variable Cost Average Total Cost Marginal Cost 25 13 8 6 5 4 4 3 13 14 15 16 17 18 19 20 38 27 23 22 22 22 23 23 15 17 19 21 23 25 27 Working Note: Fixed cost = $38 – $13 = $25 Variable cost (Where applicable) = Total cost – fixed cost Total cost (Where applicable) = Fixed cost + variable cost Average fixed cost = Fixed cost / Quantity Average variable cost = Variable cost / quantity Average total cost = Avg. the rest of table can be completed by calculating the missing figures as balancing amounts. fixed Marginal cost = Change in total cost / change in quantity The fixed cost will remain same within the relevant range regardless of the number of units produced. Complete the Table Below. .8. Putting a fixed amount of $25 in the respective column. variable + Avg. . Hence. List and describe the 3 characteristics of a perfectly competitive market. (3 points) Three key characteristics of a perfectly competitive market are as follows.. individual firm cannot alter or influence the market price because their output accounts for only a small proportion of total output and of the total demand.e.e.9. No barriers to entry – There is no restriction on entry and exit of new buyers and sellers and costs of entry and exit are not substantial i. . Homogeneous products – One of the key characteristics of a perfectly competitive market is that the commodity produced by the firm should be identical or standardized i. prices tend to be same regardless of the changes in output or demand. Large number of buyers and sellers – Perfect market is essentially characterized by a large number of buyers and sellers having perfect knowledge of market prices. when a firm make losses. Therefore. it will leave the market which would shift the industry’s supply curve to the left. This will raise price and the market will achieve equilibrium. the products are a perfect substitutes for one another and the elasticity of demand for individual firm is infinite. and when should the firm lower production? (3 Points) The profit maximization level would be the point where Marginal Cost (MC) is equal to Marginal revenue (MR) i. firms under competitive market may earn super normal profits.. Sketch a graph to demonstrate the circumstances that would prevail in a competitive market where firms are earning economic profits (hint: Where does the ATC curve go?).10. MC = MR. (4 points) In the short-term. Therefore. As a result. 11. Entry of additional firms increases the output. What happens to this scenario in the long run? Carefully explain your answer. Conversely. price will come down and so the profits of overall industry. . the production needs to be lowered when cost of producing a marginal unit is more than the benefits derived. When should the firm raise production. This will attract new firms to enter the market. the firm can only raise production as long as incremental revenues outweighs or are equal to the marginal costs.e. Explain how a firm in a competitive market identifies the profitmaximizing level of production. the quantity of goods supplied will increase. (6 points) Quantity 0 1 2 3 4 5 6 7 8 9 Total Revenue 9 18 27 36 45 54 63 72 81 Total Cost 10 14 19 25 32 40 49 59 70 82 Marginal Cost 4 5 6 7 8 9 10 11 12 Marginal Revenue 9 9 9 9 9 9 9 9 9 Average Total Costs 14 10 8 8 8 8 8 9 9 a. At which quantity of output does the firm maximize profits? (hint: You need to calculate MR & MC for each Quantity) (2 points) Answer: Profit maximizing quantity is 06 units where marginal revenue equals the marginal cost. Use the information for a competitive firm in the table below to answer the following questions. .12. Using the information (data) from the table. sketch the graph of the firm’s Marginal Cost. Marginal Revenue & Average Total Cost and label point of the firm’s Profit Maximizing location as point P.] (4 points) . [Important: Don’t forget to calculate the firm’s average total costs before you draw your graph.b. availability of "free" natural resources. perfectly inelastic demand. Monopolies restrict entry of new firms so as to manipulate price and sell less for more. barriers to entry.e. perfectly elastic demand. b. (TRUE/FALSE) Answer: TRUE Deadweight losses from monopoly can have significant implications for GDP. d.. 13. A fundamental source of monopoly market power arises from a.The profit maximization point will be where MR and MC curves intersect each other i.e. A monopoly creates a deadweight loss to society because it produces less output than the socially efficient level. point “P” on the above paragraph. Answer: One of the common characteristics of monopoly is to create entry barriers and limit the entry of new firms in the market. . Monopoly hurts production. 14. such as water or air. the price is likely to be driven by market forces of demand and supply. This will hurt standard of living and certainly creates inefficiencies which impede consumer’s social efficiency in the long-run. when there are more producers. This is specifically done to control the price i. NI and economy’s overall economic and social development. GDP and creates artificial inflationary bubbles in the economy. c. a monopolist will produce Qo units of and sells at price Po. marginal cost (MCo) can be viewed as similar to the deadweight loss of taxation when it forces a wedge between market price and marginal cost. Sketch a graph depicting the deadweight loss caused by a monopoly. . Explain in your own words how this is similar to the deadweight loss from taxation? (4 points) Answer: To maximize profits. In this case.15. EC1. Consequently.PART B: EXTRA CREDIT (15 POINTS TOTAL). average total cost will decline for every additional unit produced. where must these two curves intersect? (2 Points) Answer: The two curves will intersect at the point where average total cost is at minimum. As the production increase. The marginal cost will therefore meet the average total cost curve when average total cost becomes closely equal to the marginal cost. fixed costs are absorbed into the units of production. According to the mathematical laws that govern the relationship between average total cost and marginal cost. . However. Carefully label all curves and axes. If it is inferior. . If coke is a normal good of necessity. What will happen to consumption if Coke is a normal good? Sketch in your graph also what will happen to consumption if Coke is an inferior good? (6 points) Answer: Generally speaking.EC. the consumer will have move units of Coke. the consumption will increase.2 Assume that a person consumes two goods. the effect of decrease in price on demand and consumption depends primarily upon the type of good i. the decrease in the price of Coke will increase the quantity demanded.. the income effect prevails and the consumption will decline. Use a graph to demonstrate how the consumer adjusts his/her optimal consumption bundle when the price of Coke decreases. If it is inferior good. Coke and Snickers. the substitution effect will prevail.e. As a result. when substitution effect dominates.50 price – $10.500 (Profit).50 per unit.b. . What is the firm's current profit? What is likely to occur in this market and why? (3 Points) Answer: Profit = ($12.000 units (output) = $2. it is a rare phenomenon because a rational consumer would always aims to maximize his utility and consumes only a limited number of cokes if they are considered inferior. the firm's marginal cost curve crosses the marginal revenue curve at an output level of 1. EC3.000 units. a consumer would most likely substitute more of cokes for other similar substitutes. demand and consumption would decrease when income effect dominates because a consumer would spend less money on it.50 for each unit it produces and faces an average total cost of $10. At its current level of production a profit-maximizing firm in a competitive market receives $12. Explain in your own words the possible change when the income effect dominates and when the substitution effect dominates if coke is an INFERIOR GOOD. However.00 total cost) * 1. However. At the market price of $12. What possible good might Coke be if the income effect dominates for coke as an inferior good? (Hint: It’s rare for this to happen in the world) (4 points) Answer: If coke is considered as inferior good by consumer. The firm is said to have been maximizing its profits in this market. . i.e.. the marginal revenue is more than the marginal cost.