ECON 1001

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ECON 1001

• Midterm 1 Revision

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• 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

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• 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 ? in patrons ? in revenue (MB)
1st 50000 100000
2nd 40000 80000
3rd 30000 60000
4th 20000 40000
5th 10000 20000
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• 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?
  (r7 per annum)
• So MC of installing ONE MORE screen 1m0.07

Installing the n-th screen Interest income forgone (MC)
1 70000
2 70000
3 70000
4 70000
5 70000
5
Should you install the first screen? ? YES!
Because MBgtMCHow 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
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• 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?
• Yes, because he will lost 100.
• No, because he is making 75.
• Yes if Mike values going on the trip at less than
  25.
• No, because losing 25 is better than losing
  100.
• Yes, because he will lost 25 on the venture.
• Ans D

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• 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.

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• 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.

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• Q3) How many hours should IBM employ Pam to
  maximise its benefit from her employment?
• 1 hour.
• 2 hours.
• 3 hours.
• 4 hours.
• 5 hours.
• Ans D

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• This is a slightly tricky question. However, all
  we have to do is to apply the usual p-max
  principle MRMC.
• 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
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• To apply the MRMC 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
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• 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
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• We then compute the MC of each working hour.
  (MChour)
• MChour is the sum of Pams 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
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• To find the No. of hours that maximises IBMs
  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
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• Just to show that profit has been maximised...
• At 4th hour, Marginal Profit 0 (feature of
  p-max)

No. of Hours MChour () MRhour () Mphour ()
1 640 620 -20
2 1840 1860 20
3 2440 2480 40
4 1240 1240 0
5 640 620 -20
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• Q4) How many hours should IBM employ Pam to
  maximise its benefit from her employment if
  output price is 640?
• 1 hour.
• 2 hours.
• 3 hours.
• 4 hours.
• 5 hours.
• Ans E

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• We use the same technique as in Q3.
• However, the selling price of computers has
  changed to 640.
• This may affect Pams number of working hours.
• Is MC affected by the price change? How about
  MR?
• MC no change. MR different now. (recalculate)

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• 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
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• To find the No. of hours that maximises IBMs
  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.
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• Just to show that profit has been maximised...
• At 5th hour, Marginal Profit 0 (feature of
  p-max)

No. of Hours MChour () MRhour () Mphour ()
1 640 640 0
2 1840 1920 80
3 2440 2560 120
4 1240 1280 40
5 640 640 0
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• 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?
• 1 is the equilibrium price for potatoes.
• AT 0.90, there is excess demand for potatoes.
• 1.10 is more than Chriss customers reservation
  prices.
• Price elasticity of demand is unitary at 1.00.
• Both A and D must be true.
• Ans D

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• (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.

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• e 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 lt ?P.
• When demand is price elastic, raising the price
  would mean losing many customers, since they are
  all very sensitive to price changes (?Qd gt ?P)

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• 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
Elastic
Unitarily Elastic
1
Inelastic
Q
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• 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
• Be irrational.
• Value spending time with the children by more
  than 25,000.
• Value spending time with the children by more
  than 12,000.
• Value spending time with the children by more
  than 13,000.
• Value spending time with the children more than
  Chris does.
• Ans D

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• 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 gt 13000

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• 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 shortage equal to 1.8 of the market eq.
  quantity.
• A shortage equal to 0.6 of the market eq.
  quantity.
• A shortage equal to 18 of the market eq.
  quantity.
• A shortage equal to 6 of the market eq.
  quantity.
• Ans C

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• Price Ceiling diagrammatic approach

Note that the price ceiling has impact on
quantity demanded AND quantity supplied.
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Finding The New Qs

P
S
PC
Q
Qe
QS
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Finding The New Qd

P
D
PC
Q
Qe
Qd
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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).

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• 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
• Becomes less elastic at every price.
• Becomes less elastic at the price that prevailed
  before the change in income.
• Becomes more elastic at every price.
• Becomes more elastic at price that prevailed
  before the change in income.
• Both A and B are both correct.
• Ans C

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• 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. (???e)

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• 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.

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• Q9) Other things being equal, the increase in
  rents that occur AFTER abolishing rent control is
  smaller when
• The own price elasticity of demand is inelastic.
• The own price elasticity of demand is elastic.
• The own price elasticity of demand is unitarily
  elastic.
• Rented homes and owned homes are substitutes.
• Rented homes and owned homes are complements.
• Ans B

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• Rent control is a form of PRICE CEILING.
• Price Ceiling is set at a price LOWER than the
  market equilibrium price.

P
D
S
Trading Loci
Pe
Price Ceiling
Q
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• When Rent Control is imposed, Qd gt 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

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Relative inelastic
P
D
S
Pe
Price Ceiling
Relative elastic
Q
Hence, the increase in rents that occur AFTER
abolishing rent control is smaller when (B) The
own price elasticity of demand is elastic.
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• Q10) What might cause a supply function to shift
  to the LEFT?
• An increase in the products own price.
• An expectation that the products own price will
  fall in the future.
• Endorsement of the product by a popular
  celebrity.
• An expectation that the products own price will
  rise in the future.
• A decrease in the price of one of the inputs to
  making the product.
• Ans D

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• 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.

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• (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.

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• (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.

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• 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.

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• 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.