Units of labor

38. A firm uses workers and seed to grow lettuce. Its output rises from 100 tons to 200 tons when the number of workers increases from 25 to 75. Its production process shows

1. decreasing returns to scale

2. diminishing returns to labor

3. increasing returns to scale

4. increasing returns to labor

5. increasing long-run average cost

39. If a production function exhibits diminishing marginal product, its slope

1. is linear (a straight line)

2. becomes steeper as the quantity of the input increases

3. could be any of these answers

4. becomes flatter as the quantity of the input increases

5. no true answer

40. In the long-run, some firms will exit the market if the price of the good offered for sale is less than

1. marginal revenue

2. marginal cost

3. average total cost

4. average revenue

5. average variable cost

41. If a production function exhibits diminishing marginal product, the slope of the corresponding total-cost curve

1. is linear (a straight line)

2. could be any of these answers

3. becomes steeper as the quantity of output increases

4. becomes flatter as the quantity of output increases

5. no true answer

42. The production process described below exhibits

Number of Workers	Output
0	0
1	23
2	40
3	50

1. constant marginal product of labour

2. diminishing marginal product of labour

3. increasing returns to scale

4. increasing marginal product of labour

5. decreasing returns to scale

43. Which of the following is a variable cost in the short run?

1. rent on the factory

2. wages paid to factory labour

3. interest payments on borrowed financial capital

4. payment on the lease for factory equipment

5. salaries paid to upper management

44. The efficient scale of production is the quantity of output that minimizes

1. average fixed cost

2. average total cost

3. average variable cost

4. marginal cost

5. B and C are true

45. If marginal costs equal average total costs

1. average total costs are falling

2. average total costs are rising

3. average total costs are maximized

4. average total costs are minimized

5. average variable costs are minimized

Section 2. Free response questions.

You will have a total of 60 minutes for this section of the exam. It is strongly recommended that you spend the first 10 minutes reading the exam carefully, and the next 50 minutes working on the questions.

Please, start your answer for each question on a separate page.

1. (25 points)

Alfred consumes only two goods - donuts and ice-cream. Let us assume that donuts and ice-cream are perfectly divisible (it is possible to buy and consume them in fractions). Alfred’s preferences with respect to donuts and ice-cream are as follows: he generally likes both goods, and is always ready to exchange 1 ice-cream cone for 1 donut.

There is, however, an important trait in his preferences: if the quantity of some good in a consumption bundle is too small, Alfred just doesn’t care about that good. This means that Alfred doesn’t care about the exact quantity of donuts in a consumption bundle, if there is less than 1 donut. He also doesn’t care about the exact quantity of ice-cream in a consumption bundle, if there is less than 1 cone.

A) Draw a map of Alfred’s indifference curves.

B) Suppose Alfred’s daily income is $10, a donut costs $1 and a cone of ice-cream costs $2. Draw Alfred’s budget line, and indicate his optimal consumption bundle.

C) Suppose that the price of donuts rose to $2,50. On a separate graph, illustrate the consequences of this price change for Alfred’s optimal choice.

D) Indicate the substitution and income effects on the graph that illustrates solution to the question C.

Solution and marking scheme

A) (10 points total)

There are three important elements in this graph:

• the student must show that |MRS_ID| = 1 whenever I, D1.

• the student must show that all bundles with I, D < 1 belong to the same indifference curve

• the student must show that whenever I < 1, D 1, indifference curves are parallel to “Ice” axis, and whenever D < 1, I1, indifference curves are parallel to “Donuts” axis.

3 points - if his graph shows any one of these three traits, 7 points – if it shows any two traits, 10 points if all three traits are shown correctly.

B) (5 points total)

2 points for a clear intuitive explanation of optimal choice, without proper graphic illustration

1 point if at least the budget line is drawn and labeled correctly

If the graph is correct, 1-2 points may be deducted for some important curves or points not labeled properly

C) (4 points total)

2 points for a clear intuitive explanation of optimal choice, without proper graphic illustration

1 point if at least the budget line is drawn and labeled correctly

If the graph is correct, 1-2 points may be deducted for some important curves or points not labeled properly

D) (6 points total)

A completeanswer to this question would clearly indicateboththesignandmagnitudeof income and substitution effects forany one of twogoods (ideally, both). Positive marks were only given if the student was able to find pointsB, B’andCcorrectly. If so:

1 point was given for showing the proper sign, and

2 points – for showing the proper magnitude of the substitution effect.

1 point was given for showing the proper sign, and

2 points – for showing the proper magnitude of the income effect.

2. (30 points)

A) Assume that a profit-maximizing firm in a perfectly competitive industry is earning economic profits. For a given market price, draw a correctly labeled graph and show each of the following for a typical firm in this perfectly competitive industry.

(i) Marginal revenue

(ii) Output

(iii) Economic profits

B) Using the information in (a), draw correctly labeled side-by-side graphs for the industry and a typical firm.

(i) Given the existence of economic profits of the typical firm, show on the graphs how the industry adjusts in the long run and explain the process that leads to the long-run equilibrium.

(ii) Show on the graphs each of the following for the industry and for the typical firm in long-run equilibrium.

• Price

• Output

C) Now assume that the government sets a price that is less than the equilibrium price but greater than average variable cost. Indicate how each of the following will change for the typical firm and explain why the change occurs.

(i) Marginal revenue

(ii) Level of output

(iii) Short-run total cost

(iv) Short-run total revenue

Solution and marking scheme

The firm has a perfectly elastic (or horizontal) marginal revenue curve that is equal to the market price. The firm produces the output level where marginal revenue equals marginal cost. The economic profit of the firm is the area bounded by the quantity produced and the difference between price and average total cost (P-ATC) at that output level.

With economic profits, new firms will enter the industry. The market supply will shift outward with the entry of firms, and market price will fall. The process continues until a long-run equilibrium is established. At this equilibrium, the market price is equal to the minimum of the long-run average cost of the typical firm. Each firm produces where P=MR=MC, which is the level of output that corresponds to the minimum of the long-run average cost. The firm makes zero economic profits.

A price control below the long-run equilibrium price but above the firm's average variable cost will affect equilibrium of the firm in short-run. Since the price has fallen, the firm's marginal revenue falls. The firm's output level, where MR=MC, will also decrease. Since the firm is producing less output, total costs go down. Since both the firm's price and quantity have fallen, total revenue falls.

(a) 3 points

A correctly labeled graph of the firm's situation is sufficient for full credit on part (a). An explanation is not necessary. The breakdown is as follows:

(i) 3 point A horizontal MR shown.

(ii) 3 point Show (and indicate) that output should be where MR = MC.

(iii) 3 point Show the area of profit as the rectangle whose width is the distance between 0 and the equilibrium quantity and whose height is the distance between the P(AR) and АТС at that quantity.

(b) (9 points total)

(i) 6 points The breakdown is as follows:

3 point showing correctly drawn side-by-side graphs of the firm and the market, with both graphs correctly labeled.

2 point showing a market supply curve shifting out and a market price decreasing, with this price being used in the firm graph.

1 point explaining that with economic profits, more firms enter the market.

(ii) 3 points The breakdown is as follows:

1 point showing the industry equilibrium price and quantity.

2 point showing the long-run equilibrium price and quantity for the firm at the minimum АТС.

(c) 12 points A graph is not necessary to answer this question. The point breakdown is as follows:

(i) 3 point For indicating that marginal revenue has fallen because P has been lowered.

(ii) 3 point For indicating that output has fallen because MR = MC is at a lower q.

(iii) 3 point For indicating that total costs fell because output fell.

(iv) 3 point For indicating that price and quantity fell. It is not sufficient to state that merely one of the two fell: either both are explicitly stated, or else the student clearly shows on the graph that the new equilibrium has a lower P and Q and that because of this, total revenue falls.

1Test was cancelled due to a mistake in the conditions of the problem.

2Test was cancelled due to possible multiplicity of fitting answers.

3Test was cancelled due to misprint in an answer.

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