Review Session #1: Answers to Short Essay/Problems

Question 1: Basics of Supply and Demand

1a) Suppose that we are analyzing the market for hot chocolate. Sketch a basic supply and
demand diagram, and state the impact on the equilibrium price and quantity of each of
the following events affecting the hot chocolate market:

i. winter starts and the weather turns sharply colder: D shifts right, P & Q increase

ii. a better method of harvesting cocoa beans is introduced: S shifts right, P decreases, Q
increases

iii. the price of coffee falls: D shifts left, P and Q decreases

iv. the price of cocoa beans increases: S shifts left, P increases, Q decreases

v. the Surgeon General of the US announces that drinking a cup of hot chocolate each
day cures arthritis: D shifts right, P & Q increase

1b) The demand for books is: Qd = 120 - P

The supply of books is: Qs = 5P

i. What is the equilibrium price and quantity of books? Qd = 120 – P = Q s = 5P. P =20;
Q = 100

ii. What would happen in the market if the government were to set a price ceiling of P
= $15? Price ceiling = max price. We would see a shortage of 30 units. At p = $15.
Qd = 105; Qs = 75.

iii. What would happen in the market if the government were to set a price floor of P =
$15? Reverts back to market equilibrium as this minimum price would have no
effect on the market.

Question 2: Consumer Behavior

2a) The following combinations of goods X and Y represent various market baskets.
Consumption is measured in pounds per month.

Market Basket Units of X Units of Y

A 4 6
B 16 7
C 15 3
D 3 2

Explain which market basket(s) is (are) preferred to other(s), and if there is any uncertainty
over which is preferable, point this out as well.
Since more of each good is preferred to less, by assumption some comparisons can be
made. B is preferred to all others because more X and Y would be consumed in B than in any
other combination. A and C cannot be compared without additional information; however, A
and C are both preferred over D because they make available more of X and Y than does D.

2b) Jane lives in a dormitory that offers soft drinks and chips for sale in vending machines.
Her utility function is U = 3SC (where S is the number of soft drinks per week and C
the number of bags of chips per week), so her marginal utility of S if 3C and her
marginal utility of C is 3S. Soft drinks are priced at $0.50 each, chips $0.25 per bag.

i. Write an expression for Jane’s marginal rate of substitution between soft drinks and
chips.

MU s
MRS =
MU c

3C C
MRS = =
3S S

ii. Use the expression generated in part (a) to determine Jane’s optimal mix of soft
drinks and chips.

The optimal market basket is where

Ps
MRS =
Pc

C .5
This requires = =
S .25

C
= 2, C = 2S which tells us Jane should buy twice as many chips as soft
S
drinks.

iii. If Jane has $5.00 per week to spend on chips and soft drinks, how many of each
should she purchase per week?

Well, I = PsS + PcC, and recall the optimal mix is C = 2S

Thus, 5.00 = 0.5S + 0.25C. If C = 2S, this implies that 5.00 = 0.5S + (0.25)2S
S = 5; C = 10

2c) Draw a set of indifference curves for the following pairs of goods:

a. Hamburgers and carrots for a vegetarian who neither likes nor dislikes meat.
(vegetarians do not eat meat): H = vertical; C = horizontal: ICs are straight lines
(increasing utility to the right)
b. Peanut butter and jelly for an individual that will not eat peanut butter sandwiches or
jelly sandwiches, but loves peanut butter and jelly sandwiches made with two parts
peanut butter and one part jelly: L-shaped ICs (2 to 1; 4 to 2, etc.)

c. Tickets for Knott’s Berry Farm (KBF) and Universal Studios (US) for a tourist that
believes that KBF and US are perfect substitutes: ICs are straight lines

d. Ice cream and pie if these are goods that you like, but if you consume enough of
either, you get sick of them: Normal ICs: diminishing marginal rate of substitution

Question 3: Individual and Market Demand

3a) Suppose demand is given by Q = 100 – 4P. Graph this demand curve, and determine
the quantity demanded when the price = $10. What is the level of consumer surplus
when the price = $10, and how does this change if the price is raised to $20?

When Q = 0, P =25; when P = 0, Q = 100. When P = $10, Qd = 60. CS = ½(60)(15) = $450. If

P = $20, Qd = 20, and CS = ½(5)(20)=$50.

3b) Suppose you are the manager of a theater, and you currently charge the same
admission price to everyone, regardless of their age. An economist calculates the price
elasticity of demand, and tells you that at the current price, demand by adults is
inelastic and demand by children is elastic. If you want to increase your total revenue,
how should you adjust the admission price?

Increase price to adults; reduce price to children. Total revenue will increase.

3c) The president of Michigan State University is concerned about increasing operating
costs, and decides to raise tuition fees in an attempt to increase total revenue. Do you
think the rise in tuition fees will accomplish the president's goal?

Depends on the elasticity of demand: need to talk about the availability of substitutes.

3d) Suppose the Daily Newspaper estimates that if it raises the price of its newspaper
from $1.00 to $1.50, its subscribers will fall from 50,000 to 40,000. Using the arc
method, what is the price elasticity of demand for the Daily Newspaper? What does
this tell us about consumer responsiveness?

Ed = (40 – 50)/45 divided by (1.50 – 1)/1.25 = -0.222/0.4 = -0.556

3e) Briefly explain the substitution effect and the income effect when the price decreases
for a normal good.

Sub effect: as price decreases, Qd increases as increase consumption (sub away from other
goods).

Income effect: as price decreases, Qd increases if good is normal (increase in real

purchasing power)
Question 4: Production

4a) What is a production function? How does a long-run production function differ from a
short-run production function?

A production function represents how inputs are transformed into outputs. Given the
technology, the firm maximizes output using a combination of inputs (K, L, raw materials). I.e.
it shows what is technically feasible when the firm operates efficiently. In the short-run, can
only vary L (capital is fixed). But in the long-run, all inputs are variable.

4b) Explain what an isoquant is. How does the slope of an isoquant relate to the marginal
rate of technical substitution?

An isoquant shows all possible combinations of inputs that yield the same level of output. The
slope of the isoquant measures the rate at which two input can be exchanged and still keep
output constant, and this rate is called the MRTS. Along the typical isoquant, the MRTS
diminishes as you move down the isoquant.

4c) Complete the following table:

Quantity of Marginal Product of Average Product of

Total Output
Variable Input Variable Input Variable Input
0 0 ----- -----
1 100 100 100
2 190 90 95
3 270 80 90
4 330 60 82.5
5 360 30 72
6 380 20 63.3

4d) You manage a department in a large corporation. Two years ago, you had 20 workers
and produced 40,000 units. The company allocated 10 more workers to your
department, and output increased to 45,000. You just received a memo from your boss
indicating that he is very concerned about the department. Explain why and how might
you defend yourself?

APL = 40,000/20 = 2,000. As hire more workers, APL = 45,000/30, and MPL = 5,000/10 =
500. Thus, MPL < APL, so if you continue to hire more workers, this will pull down the APL
further. As a defense, I would argue that this is a short-run phenomenon. My department was
allocated more workers, but not more capital, so the law of diminishing marginal returns
holds. In all likelihood, the decline in average product is due to technical matters, and not
management problems. Perhaps the K/L ratio should be increased?