EC 202-Principles of Microeconomics

NAME_______________________________________________________________________
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

slopes downward. Given limited means (resources), a rational consumer

would certainly make trade-offs to maximize utility.

4. If a consumer's income is spent on CDs and movies, if this

consumers income goes down as a result of a recession, 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. Recession hurts
GDP, real income, employment and production. Not only the consumers
income goes down, but the market will also adjust itself i.e., the price of CDs
and movies will also decline and achieve equilibrium.
Demand for some goods such as necessities are not much affected by the
decrease in income. However, the CDs and Movies are both entertainment
goods (not necessity), therefore, a consumer is more likely to cut his
spending on CDs and movies because in accordance with the budget
constraint. Therefore, demand and consumption for both CDs and movies
will fall.

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. As a result, the consumer will buy more of good B. Therefore,
quantity demanded will increase as shown by graph B

4b.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, the increase
in the price of good Y would cause the demand to decrease. Consequently,
consumers quantity demanded for Y will decrease.
4c.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
consumers purchasing power and allow him to buy more. The quantity
demanded will increase for both goods which is ideally depicted by graph D.
5.

Using the graph shown, construct a demand curve for M&M's

given an income of $10. (Hint: of the four letters on the
indifference curve, only two translates into the demand curve).
(2 points)

Answer:

6. Economists and accountants usually differ on the inclusion of

implicit costs into the cost analysis of a firm. (TRUE/FALSE)
Answer (6): TRUE
Explanation: Accountants only include explicit costs into the cost analysis
whereas economists include both explicit and implicit costs. This is one
of the reasons why economic profits are usually lower than accounting
profits.

7. 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. For instance, assume that an investor can either invest in
the stock market and earn 15% return or take a banks fixed term deposit
offering 5% interest. If a consumer opts to invest in stock market, he would
have to forego another alternative i.e., interest on fixed deposit. Therefore,
the 5% benefit foregone will become the opportunity cost of investing in
stock market.
Opportunity costs essentially comprise of both explicit and implicit costs.

8. Complete the Table Below. (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. variable + Avg. 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. Putting a fixed amount of $25 in the respective
column, the rest of table can be completed by calculating the missing figures
as balancing amounts.

9. List and describe the 3 characteristics of a perfectly competitive

market. (3 points)
Three key characteristics of a perfectly competitive market are as follows;
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. Therefore, 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. Hence, prices tend to
be same regardless of the changes in output or demand.
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.e., the products are a perfect substitutes for
one another and the elasticity of demand for individual firm is infinite.
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.e.,
when a firm make losses, it will leave the market which would shift the
industrys supply curve to the left. This will raise price and the market will
achieve equilibrium.

10. Explain how a firm in a competitive market identifies the profitmaximizing level of production. When should the firm raise
production, 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.e., MC = MR. Therefore, the firm can only
raise production as long as incremental revenues outweighs or are equal to
the marginal costs. Conversely, the production needs to be lowered when
cost of producing a marginal unit is more than the benefits derived.
11. 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?). What happens to this
scenario in the long run? Carefully explain your answer. (4 points)
In the short-term, firms under competitive market may earn super normal
profits. This will attract new firms to enter the market. Entry of additional
firms increases the output. As a result, the quantity of goods supplied will
increase, price will come down and so the profits of overall industry.

12. Use the information for a competitive firm in the table below to
answer the following questions. (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.

b. Using the information (data) from the table, sketch the graph of
the firms Marginal Cost, Marginal Revenue & Average Total Cost
and label point of the firms Profit Maximizing location as point P.
[Important: Dont forget to calculate the firms average total
costs before you draw your graph.] (4 points)

The profit maximization point will be where MR and MC curves intersect each
other i.e. point P on the above paragraph.

13. A fundamental source of monopoly market power arises from

a. perfectly elastic demand.
b. perfectly inelastic demand.
c. barriers to entry.
d. availability of "free" natural resources, such as water or air.
Answer:
One of the common characteristics of monopoly is to create entry barriers
and limit the entry of new firms in the market. This is specifically done to
control the price i.e., when there are more producers, the price is likely to be
driven by market forces of demand and supply. Monopoly hurts production,
GDP and creates artificial inflationary bubbles in the economy.
14. A monopoly creates a deadweight loss to society because it
produces less output than the socially efficient level.
(TRUE/FALSE)
Answer: TRUE
Deadweight losses from monopoly can have significant implications for GDP, NI and economys
overall economic and social development. Monopolies restrict entry of new firms so as to
manipulate price and sell less for more. This will hurt standard of living and certainly creates
inefficiencies which impede consumers social efficiency in the long-run.

15. 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, a monopolist will produce Qo units of and sells at price Po. In this case,
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.

PART B: EXTRA CREDIT (15 POINTS TOTAL).

EC1. According to the mathematical laws that govern the
relationship between average total cost and marginal cost, 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, fixed costs are absorbed into the
units of production. Consequently, average total cost will decline for every
additional unit produced. The marginal cost will therefore meet the average
total cost curve when average total cost becomes closely equal to the
marginal cost.

EC.2 Assume that a person consumes two goods, Coke and Snickers.
Use a graph to demonstrate how the consumer adjusts his/her
optimal consumption bundle when the price of Coke decreases.
Carefully label all curves and axes. 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, the decrease in the price of Coke will increase the quantity demanded. As a result, the
consumer will have move units of Coke. However, the effect of decrease in price on demand and
consumption depends primarily upon the type of good i.e., If coke is a normal good of necessity, the
consumption will increase. If it is inferior, the substitution effect will prevail. If it is inferior good, the
income effect prevails and the consumption will decline.

b. 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. What possible good might Coke be if the
income effect dominates for coke as an inferior good? (Hint: Its rare
for this to happen in the world) (4 points)
Answer:
If coke is considered as inferior good by consumer, demand and consumption
would decrease when income effect dominates because a consumer would
spend less money on it. However, when substitution effect dominates, a
consumer would most likely substitute more of cokes for other similar
substitutes.
However, 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.

EC3. At its current level of production a profit-maximizing firm in a

competitive market receives $12.50 for each unit it produces and
faces an average total cost of $10. At the market price of $12.50 per
unit, the firm's marginal cost curve crosses the marginal revenue
curve at an output level of 1,000 units. What is the firm's current
profit? What is likely to occur in this market and why? (3 Points)
Answer:
Profit = ($12.50 price $10.00 total cost) * 1,000 units (output) = $2,500
(Profit).

The firm is said to have been maximizing its profits in this market. i.e., the
marginal revenue is more than the marginal cost.