Queen’s School of Business

Managerial Economics (COMM 172)

Winter 2012

Professor Olena Ivus

MIDTERM EXAM

February 14, 2012

NAME:

STUDENT NUMBER:

Instructions: Please make sure your name and student number are written above. The exam
consists of two parts: Part A and Part B. Part A consists of 20 multiple choice questions and
5 true-false-explain questions. Answer all of these questions. Part B consists of 4 numerical
problems, of which you are required to choose and answer 3. For all parts, provide your answers
in the space provided.

This is a closed-book exam. You are not allowed to use books or notes. You may use a non-
graphing calculator.

GOOD LUCK!

MARKS:

Multiple-choice questions / 20

True-false-explain questions / 20

Numerical problems (answer 3 out of 4):

1 / 20
2 / 20
3 / 20
4 / 20

TOTAL / 100

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PART A
Multiple-choice questions:
Please circle the correct answer.

1. Which elasticity measures the responsiveness of the quantity of one good demanded to an
increase in the price of another good?

(a) price elasticity.

(b) income elasticity.
(c) cross price elasticity.
(d) cross substitution elasticity.

2. When the average product is decreasing, marginal product

(a) equals average product.

(b) is increasing.
(c) exceeds average product.
(d) is decreasing.
(e) is less than average product.

3. The law of diminishing returns refers to diminishing

(a) total returns.

(b) marginal returns.
(c) average returns.
(d) all of these.

4. The law of diminishing returns applies to

(a) the short run only.

(b) the long run only.
(c) both the short and the long run.
(d) all inputs, with no reference to the time period.

5. If the isoquants are straight lines, then

(a) inputs have fixed costs at all use rates.

(b) the marginal rate of technical substitution of inputs is constant.
(c) only one combination of inputs is possible.
(d) there are constant returns to scale.

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6. You operate a car detailing business with a fixed amount of machinery (capital), but you
have recently altered the number of workers that you employ per hour. Three employees
can generate an average product of 4 cars per person per hour, and five employees can
generate an average product of 3 cars per person per hour. What is the marginal product
of labor as you increase the labor from three to five employees?

(a) MP = 3 cars.
(b) MP = 1.5 cars.
(c) MP = 15 cars.
(d) MP = -1 cars.

7. When the demand curve is downward sloping, marginal revenue is

(a) equal to price.

(b) equal to average revenue.
(c) less than price.
(d) more than price.

8. 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 curve 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 the price that prevailed before the change in income.

9. If input prices are constant, a firm with increasing returns to scale can expect

(a) costs to double as output doubles.

(b) costs to more than double as output doubles.
(c) costs to go up less than double as output doubles.
(d) to hire more and more labor for a given amount of capital, since marginal product
increases.

10. Which of the following statements is true regarding the differences between economic and
accounting costs?

(a) Accounting costs include all implicit and explicit costs.

(b) Economic costs include implied costs only.
(c) Accountants consider only implicit costs when calculating costs.
(d) Accounting costs include only explicit costs.

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11. A firm employs 100 workers at a wage rate of $10 per hour, and 50 units of capital at a
rate of $21 per hour. The marginal product of labor is 3, and the marginal product of
capital is 5. The firm

(a) is producing its current output level at the minimum cost.

(b) could reduce the cost of producing its current output level by employing more capital
and less labor.
(c) could reduce the cost of producing its current output level by employing more labor
and less capital.
(d) could increase its output at no extra cost by employing more capital and less labor.
(e) Both (b) and (d) are true.

12. To model the input decisions for a production system, we plot labor on the horizontal axis
and capital on the vertical axis. In the short run, labor is a variable input and capital is
fixed. The short-run expansion path for this production system is

(a) a vertical line.

(b) a horizontal line.
(c) equal to the 45-degree line from the origin.
(d) not defined.

13. If current output is less than the profit-maximizing output, which must be true?

(a) Average revenue is less than average cost.

(b) Average revenue is greater than average cost.
(c) Marginal revenue is less than marginal cost.
(d) Marginal revenue is greater than marginal cost.

14. A firm never operates

(a) at the minimum of its ATC curve.

(b) at the minimum of its AVC curve.
(c) on the downward-sloping portion of its ATC curve.
(d) on the downward-sloping portion of its AVC curve.

15. Producer surplus in a perfectly competitive industry is

(a) the difference between profit at the profit-maximizing output and profit at the profit-
minimizing output.
(b) the difference between revenue and total cost.
(c) the difference between revenue and variable cost.
(d) the difference between revenue and fixed cost.

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16. Two soft-drink firms, Fizzle and Sizzle, operate on a river. Fizzle is farther upstream, and
gets cleaner water, so its cost of purifying water for use in the soft drinks is lower than
Sizzle’s by $500,000 yearly. Fizzle and Sizzle

(a) would be perfectly competitive if their purification costs were equal; otherwise, not.
(b) would be perfectly competitive if it costs Fizzle $500,000 more per year to keep the
upstream land, relative to Sizzle’s downstream land.
(c) may or may not be perfect competitors, but their position on the river has nothing
to do with it.
(d) cannot be perfect competitors because they are not identical firms.

17. Suppose Orange Inc sells MP3 players and initially has monopoly power because there
are only a few close substitutes available to consumers. As more types of MP3 players are
introduced into the market, the demand facing Orange becomes elastic and the
Lerner index achieved by the firm in this market .

(a) less, declines

(b) less, increases
(c) more, declines
(d) more, increases

18. A third-degree price discriminating monopolist can sell its output either in the local market
or on an Internet auction site (or both). After selling all of its output, the firm discovers
that the marginal revenue earned in the local market was $20 while its marginal revenue
on the Internet auction site was $30. To maximize profits the firm should

(a) have sold more output in the local market and less at the Internet auction site.
(b) do nothing until it acquires more information on costs.
(c) have sold less output in the local market and more on the Internet auction site.
(d) sell less in both markets until marginal revenue is zero.
(e) sell more in both markets until marginal cost is zero.

19. Deadweight loss from monopoly power is expressed on a graph as the area between the

(a) competitive price and the average revenue curve bounded by the quantities produced
by the competitive and monopoly markets.
(b) competitive price line and the marginal cost curve bounded by the quantities pro-
duced by competitive and monopoly markets.
(c) competitive price line and the monopoly price line bounded by zero output and the
output chosen by the monopolist.
(d) average revenue curve and the marginal cost curve bounded by the quantities pro-
duced by competitive and monopoly markets.

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20. When a monopolist engages in perfect price discrimination,

(a) the marginal revenue curve lies below the demand curve.
(b) the demand curve and the marginal revenue curve are identical.
(c) marginal cost becomes zero.
(d) the marginal revenue curve becomes horizontal.

True-false-explain questions:
Please state whether the statement is true or false and explain in the space pro-
vided.

1. Bundling raises higher revenues than selling the goods separately when the goods are
complementary in nature.

2. It is possible to have diminishing returns to a single factor of production and constant

returns to scale at the same time.

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3. If you are an employer seeking to fill a vacant position on an assembly line, you should be
concerned with the average product of labor. If you observe that your average product is
just beginning to decline, you should not hire any additional workers.

4. A firm will not find it optimal to sell quantity at which the marginal cost of production
is declining.

5. For a single-price monopolist, an increase in output will always increase revenue by less
than the price of the output.

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PART B

This part consists of 4 numerical problems. Please choose 3 out of 4 problems to answer.

1. Markets and Government Intervention

In 2007, Americans smoked 19.2 billion packs of cigarettes. The average retail price was
$4.50 per pack.

(a) Statistical studies have shown that the price elasticity of demand is -0.4, and the
price elasticity of supply is 0.5. Using this information, derive linear demand and
supply curves for the cigarette market.

(b) Cigarettes are subject to a federal tax, which was about 40 cents per pack in 2007.
How does this tax affect the market-clearing price and quantity?

(c) What share of the federal tax will consumers pay? What share will producers pay?

(d) Illustrate your answer to part (c) with a diagram.

(e) Suppose the price elasticity of demand is instead -0.15. Will consumer burden be
higher or lower? Explain. No calculations are required here.

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2. Production and Costs

You manage a plant that mass-produces engines by teams of workers using assembly
machines. The technology is summarized by the production function q = 5KL, where q
is the number of engines per week, K is the number of assembly machines, and L is the
number of labour teams. Each assembly machine rents for PK = $10,000 per week, and
each team costs PL = $5000 per week. Engine costs are given by the cost of labour teams
and machines, plus $2000 per engine for raw materials. Your plant has a fixed installation
of 5 assembly machines as part of its design.

(a) What is the short-run production function? Is the marginal product of labour teams
increasing, constant, or decreasing as more labour teams are used?

(b) What is the short-run cost function for your plant – namely, how much would it cost
to produce q engines? What is the marginal cost of producing q engines? What is
the average cost? How does the average cost vary with output?

(c) In the short run, how many teams are required to produce 250 engines?

(d) Does the production exhibit increasing, constant, or decreasing returns to scale?

(e) You are asked to make recommendations for the design of a new production facility.
What capital/labor (K/L) ratio should the new plant accommodate if it wants to
minimize the total cost of producing at any level of output q?

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3. Perfect Competition

The market demand for a type of carpet has been estimated as P = 75 − 1.5Q, where P
is price ($/yard), and Q is output per time period (thousands of yards per month). The
market supply is expressed as P = 25 + 0.50Q. A typical competitive firm that markets
this type of carpet has a total cost of production of T C = 2.5q + 5q 2 and a fixed cost of
zero.

(a) Determine the market equilibrium price and quantity for this type of carpet.

(b) How much will the typical firm produce per month at the equilibrium price.

(c) If all firms have the same cost structure, how many firms will compete in the market?

(d) What is the producer surplus of the typical firm? What is the profit of the typical
firm?

(e) What is the lowest price at which each firm would sell its output in the short run?
What is the lowest price at which each firm would sell its output in the long run?

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4. Pricing with Market Power

Laughlin and Sons is a company that provides estate planning services to 100 wealthy
clients. Although the clients have different wealth levels, their demands for the hourly
estate planning services are identical. The aggregate annual demand for estate planning
services facing Laughlin and Sons is Q = 20000 − 200P , where Q is the total hours of
estate planning services and P is the hourly rate charged for the services, and the firm’s
total cost of providing the estate planning services is T C = 80Q. The firm wants to
establish a two-part tariff scheme for charging the clients, and the fees include an annual
fixed retainer (entry fee) plus an hourly rate (usage fee).

(a) What is the firm’s marginal cost of providing estate planning services? What is the
demand curve for a representative client?

(b) What are the profit maximizing levels for the retainer and hourly rate? What is the
firm’s aggregate annual profit under the two-part tariff scheme?

(c) Suppose Laughlin and Sons has a local monopoly on estate planning services. What
are the profit maximizing hourly rate (price) and quantity under a single-price
monopoly?

(d) How does the profit earned under the single-price monopoly compare to the profit
earned under the two-part tariff scheme? How does the consumer surplus under the
single-price monopoly compare to the consumer surplus earned under the two-part
tariff scheme?

(e) Suppose Laughlin and Sons decide to implement a first-degree price discrimination
strategy. What is the firm’s aggregate annual profit under this strategy? What is
the consumer surplus?

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