ECON 1001

Midterm #1 Revision

Q1) After paying the movie distributor and meeting all other non-interest expenses, the owner expects to net $2.00 per ticket sold. Construction costs are $1,000,000 per screen. How many screens should be built if the real interest rate is 7% ?

A) 1

B) 2

C) 3

D) 4

E) 5

Ans: B

Num ber of Tota l num berScreens of patrons

1 50,0002 90,0003 120,0004 140,0005 150,000

Installing the ↑ in patrons ↑ in revenue (MB)

1st 50000 $100000

2nd 40000 $80000

3rd 30000 $60000

4th 20000 $40000

5th 10000 $20000

•We should use a ‘cost-benefit’ analysis

•In particular, ‘Marginal Benefit vs Marginal Cost’ of installing ONE MORE screen.

•MB of installing ONE MORE screen=(increase in patrons)∙$2

Installing the n-th screen

Interest income forgone (MC)

1 $70000

2 $70000

3 $70000

4 $70000

5 $70000

•How about the MC of installing ONE MORE screen?

•Cost of constructing ONE screen = $1,000,000

•If you save the money in a bank instead of investing it in the cinema, how much do you get? (r=7% per annum)

•So MC of installing ONE MORE screen = $1m∙0.07

Should you install the first screen? YES! Because MB>MC

How about the second one? The third one?

How many screens would you install in total?

Installing the ↑ in revenue (MB)

Interest income forgone (MC)

1st $100000 $70000

2nd $80000 $70000

3rd $60000 $70000

4th $40000 $70000

5th $20000 $70000

Q2)Mike gives a non-refundable $100 to ACE adventure to reserve a raft for a group rafting trip in the New River. The raft has room for 5 people. He can only sell 3 tickets at $25 each for a total of $75. Should Mike cancel the trip?

A) Yes, because he will lost $100.

B) No, because he is making $75.

C) Yes if Mike values going on the trip at less than $25.

D) No, because losing $25 is better than losing $100.

E) Yes, because he will lost $25 on the venture.

Ans: D

• This is a question about opportunity cost.

• If Mike cancels the trip, he loses $100 and gets nothing. Hence, the net loss is $100.

• If the trip goes as planned, Mike loses $100, and gets $75 back. The net loss is $25.

• In other words, if he cancels, he loses $100; if he goes, he loses $25 only.

• As a rational economic agent, what would Mike choose?

• NOT to cancel the trip!

• Because losing $25 is better than losing $100 (D).

• The key word in the question is ‘non-refundable’. That means the $100 is already sunk. Mike would endeavour to recover as much money as possible from the venture.

Q3) How many hours should IBM employ Pam to maximise its benefit from her employment?

A) 1 hour.

B) 2 hours.

C) 3 hours.

D) 4 hours.

E) 5 hours.

Ans: D

• This is a slightly tricky question. However, all we have to do is to apply the usual π-max principle: MR=MC.

• To summarise the information provided:– Cost of all hardware needed to assemble a computer

is $600

No. of Hours No. of Computers

1 1

2 4

3 8

4 10

5 11

• To apply the MR=MC principle, first, we need to find out that Marginal Increment in No. of Computers in each hour.

No. of Hours

No. of Computers

Additional Computers from the n-th hour

1 1 1

2 4 3

3 8 4

4 10 2

5 11 1

• Then, we can find out the extra Revenue brought along by the computers in each hour. (MR of hour)

• To calculate the MRhour, multiply the price ($620) by Additional computers Computers.

No. of Hours

No. of Computers

Additional Computers from the n-th hour MRhour ($)

1 1 1 620

2 4 3 1860

3 8 4 2480

4 10 2 1240

5 11 1 620

• We then compute the MC of each working hour. (MChour)

• MChour is the sum of Pam’s wage and all hardware costs ($600 each computer).

No. of Hours

No. of Computers

Additional Computers from the n-th hour MChour ($)

1 1 1 640

2 4 3 1840

3 8 4 2440

4 10 2 1240

5 11 1 640

• To find the No. of hours that maximises IBM’s profit, find where MRhour = MChour.

• So the answer is 4 hours (D).

No. of Hours MChour ($) MRhour ($)

1 640 620

2 1840 1860

3 2440 2480

4 1240 1240

5 640 620

• Just to show that profit has been maximised...

• At 4th hour, Marginal Profit = 0 (feature of π-max)

No. of Hours MChour ($) MRhour ($) Mπhour ($)

1 640 620 -20

2 1840 1860 20

3 2440 2480 40

4 1240 1240 0

5 640 620 -20

Q4) How many hours should IBM employ Pam to maximise its benefit from her employment if output price is 640?

A) 1 hour.

B) 2 hours.

C) 3 hours.

D) 4 hours.

E) 5 hours.

Ans: E

• We use the same technique as in Q3.

• However, the selling price of computers has changed to $640.

• This may affect Pam’s number of working hours.

• Is MC affected by the price change? How about MR?

• MC – no change. MR – different now. (recalculate)

• To calculate the new MRhour schedule, multiply $640 by ∆Computers for each hour.

No. of Hours

No. of Computers

Additional Computers from the n-th hour MRhour ($)

1 1 1 640

2 4 3 1920

3 8 4 2560

4 10 2 1280

5 11 1 640

• To find the No. of hours that maximises IBM’s profit, find where MRhour = MChour.

• So the answer is 5 hours (E).

No. of Hours MChour ($) MRhour ($)

1 640 640

2 1840 1920

3 2440 2560

4 1240 1280

5 640 640

Note: When there is an increase in output price, the suppliers are likely to increase their output, and hence employment.

• Just to show that profit has been maximised...

• At 5th hour, Marginal Profit = 0 (feature of π-max)

No. of Hours MChour ($) MRhour ($) Mπhour ($)

1 640 640 0

2 1840 1920 80

3 2440 2560 120

4 1240 1280 40

5 640 640 0

Q5)Chris has been charging $1 for a pound of potatoes. Suppose Chris faces a linear demand curve. When P↓ to $0.90, TR drops. When P↑ to $1.10, TR also drops. Why?

A) $1 is the equilibrium price for potatoes.

B) AT $0.90, there is excess demand for potatoes.

C) $1.10 is more than Chris’s customers’ reservation prices.

D) Price elasticity of demand is unitary at $1.00.

E) Both A and D must be true.

Ans: D

• (A) claims that $1 is the equilibrium price.• There is no basis for that.

• To determine the equilibrium price, we need to have BOTH the demand and supply schedules. Without this information, we cannot tell what equilibrium price is.

• Therefore, both (A) and (E) are wrong.

• Note that (B) and (C) also require additional supply and demand information. Therefore, they cannot be correct.

• ε must be unitary at $1 according to what happened.

• When demand is price inelastic, reducing the price would lead to a drop in TR. That is because %↑Qd < %↓P.

• When demand is price elastic, raising the price would mean losing many customers, since they are all very sensitive to price changes (%↓Qd > %↑P)

• Since TR decreases whenever there is a deviation from P = $1.00, $1.00 must be the separation point between the price elastic part of the demand curve, and the price inelastic part of the demand curve.

• Therefore, (D) is the correct answer.

P

Q

$1

Unitarily Elastic

Elastic

Inelastic

Price

To

tal r

even

ue

1 1.10 0.9

Q6) Pat earns $25,000 per year. Her partner, Chris, earns $35,000 per year. They have 2 children. Childcare for their children is $12,000 per year. Pat has decided to be a stay-home mum. Pat must…

A) Be irrational.B) Value spending time with the children by more than $25,000.C) Value spending time with the children by more than $12,000.D) Value spending time with the children by more than $13,000.E) Value spending time with the children more than Chris does.

Ans: D

Pat has to choose between two alternatives.

• Net gain from alternative “go work and pay for childcare” = 25000-12000 + 0 (value of quality time with her

children)= $13000

• Net gain from alternative “Take care of children herself” = 0 – 0 + value of quality time with her children= value of quality time with her children

• Pat chose Choice II (stay-home mum), it must be the case that – value of quality time with her children >= $13000

Q7)Suppose at the market eq. price of natural gas, price elasticity of demand is -1.2, and price elasticity of supply is 0.6. What will result from a price ceiling that is 10% below the mkt eq. price?

A) A shortage equal to 1.8% of the market eq. quantity.

B) A shortage equal to 0.6% of the market eq. quantity.

C) A shortage equal to 18% of the market eq. quantity.

D) A shortage equal to 6% of the market eq. quantity.

Ans: C

Price Ceiling – diagrammatic approachPrice

Quantity

Demand Supply

Pe

Qe

PcPrice Ceiling

Qs Qd

Shortage

Note that the price ceiling has impact on quantity demanded AND quantity supplied.

Finding The New Qs

%

% S

Qs

P

% %SQs P

0.6 ( 0.1)

0.06

0.94 eQs Q

P

Q

S

Qe

PC

QS

Finding The New Qd

%

% D

Qd

P

% %DQd P

1.2 ( 0.1)

0.12

1.12 eQd Q

P

Q

D

Qe

PC

Qd

Calculating the Shortage

• To calculate the shortage, simply find the difference between Quantity Demanded and Quantity Supplied.

• Both Qd and Qs have been expressed in terms of Qe.

• Qd-Qs = 0.18Qe

• Therefore, the shortage is 18% of the original eq. quantity. Hence, (C).

Q8)Suppose the demand for gourmet coffee can be represented by a linear demand curve. At the prevailing market price, the INCOME ELASTICITY of demand for gourmet coffee is 2. When income rises, the demand for gourmet coffee:

A) Becomes less elastic at every price.B) Becomes less elastic at the price that prevailed before

the change in income.C) Becomes more elastic at every price.D) Becomes more elastic at price that prevailed before

the change in income.E) Both A and B are both correct.

Ans: C

• The first elasticity mentioned in the question is INCOME ELASTICITY.

• Income elasticity measures the responsiveness of quantity demanded to changes in income.

• A positive figure means the product is a normal good. A negative figure denotes inferior good.

• The second elasticity, the elasticity mentioned in the 5 options, refers to price elasticity of demand for gourmet coffee.

• What affects the price elasticity of demand?

• Many factors, among which, the proportion of expenditure on the item. (↑%→↑ε)

• The INCOME ELASTICITY is 2.

• Suppose income now rises by 10% and price does not change.

• Quantity demanded will rise by 20%.

• Consumers are now spending a HIGHER PROPORTION of their income on gourmet coffee.

• Therefore, the PRICE ELASTICITY of demand should now be MORE ELASTIC at all prices than in the past (before income increases).

• Hence C.

Q9)Other things being equal, the increase in rents that occur AFTER abolishing rent control is smaller when…

A) The own price elasticity of demand is inelastic.

B) The own price elasticity of demand is elastic.

C) The own price elasticity of demand is unitarily elastic.

D) Rented homes and owned homes are substitutes.

E) Rented homes and owned homes are complements.

Ans: B

• Rent control is a form of PRICE CEILING.

• Price Ceiling is set at a price LOWER than the market equilibrium price.

P

Q

D S

Pe

Price Ceiling

Trading Loci

• When Rent Control is imposed, Qd > Qs.

• Equilibrium is not reached.

• And when the Price Ceiling is lifted, the market equilibrium quantity and price should be restored eventually.

• Price (rent) should increase.

• Because supply is upward sloping,

↑P → ↑ TR

P

Q

D S

Pe

Price Ceiling

Relative inelastic

Relative elastic

Hence, the increase in rents that occur AFTER abolishing rent control is smaller when(B) The own price elasticity of demand is elastic.

Q10) What might cause a supply function to shift to the LEFT?

A) An increase in the product’s own price.

B) An expectation that the product’s own price will fall in the future.

C) Endorsement of the product by a popular celebrity.

D) An expectation that the product’s own price will rise in the future.

E) A decrease in the price of one of the inputs to making the product.

Ans: D

• When Supply shifts to the LEFT, is Supply increasing or decreasing?– Decreasing.

• When Supply shifts to the left, quantity supplied at all prices drops.

• The shifting of the Supply schedule can be caused by anything but a change in the current own price.

• A change in the current own price of the product leads to a change in Qs only. Hence (A) is wrong.

• (C) is also obviously wrong.

• When a product is publicly embraced by celebrities, DEMAND is affected (demand will shift to the right).

• The celebrity factor does not affect the Supply side.

• Hence, (C) can be eliminated.

• (E) is a sound reason for changes in Supply.

• A drop in the cost of production, esp. variable costs, can shift the Supply curve.

• However, the Supply should shift to the right instead of shifting to the left.

• Therefore, (E) is not the correct answer.

• That leaves us with options (B) and (D).

• Both are related to expectations of the future price.

• Expectations on the future price can shift the supply curve.

• Note: not talking about current price.

• If a supplier expects price will be higher in the future…

• Current stock should be held back as any unit sold in the future earns more revenue than that at present.

• As a result, (D) is the correct answer.