ECON 002 - Principles of Microeconomics Drake University, Fall 2018 William M. Boal

EXAM 3 ANSWER KEY

### Version A

I. Multiple choice

(1)f. (2)a. (3)c. (4)a. (5)a. (6)c. (7)d. (8)a. (9)c. (10)d.

II. Problems

(1) [Budget line: 12 pts]

1. Not affordable.
2. Affordable with money left over.
3. Exactly affordable.
4. 2 gallons of gasoline.
5. \$6.
6. \$3.

(1) [Consumer choice and demand: 16 pts]

1. 5 pizzas and 3 ice cream cones.
2. 7 pizzas and 3 ice cream cones.
3. Budget line A is a straight line with intercepts at 10 ice cream cones and at 15 pizzas.
4. 9 pizzas.
5. Budget line B is a straight line with intercepts at 10 ice cream cones and 10 pizzas.
6. 7 pizzas.
7. (P,Q) = (\$6,7), (\$4,9).

(3) [Rational choice: 10 pts]

1. MC = Δ TC / Δ miles = \$25 thousand, \$20 thousand, \$20 thousand, \$25 thousand.
2. MB = Δ TB / Δ miles = \$100 thousand, \$50 thousand, \$25 thousand, \$10 thousand.
3. 6 miles, where MB = MC.

(4) [Business revenue and cost--definitions: 3 pts]

1. marginal cost.
2. total revenue.
3. marginal cost.

(5) [Discounting: 4 pts]

1. \$243.
2. \$40 million.

(6) [Short-run cost curves and supply: 20 pts]

1. \$16 thousand (= 2000 × SATC).
2. \$12 thousand (= 2000 × SAVC).
3. \$4 thousand (= STC - SVC).
4. \$2 (= SMC).
5. \$6 (= minimum SATC).
6. \$3 (= minimum SAVC).
7. 1600 parts, using the rule P=MC.
8. profit, because P is greater than breakeven price.
9. 1300 parts, using the rule P=MC.
10. loss, because price is less than breakeven price.

(6) [Long-run competitive equilibrium: 24 pts]

1. \$3.
2. 5 million pairs.
3. \$3, because price = AC in long-run equilibrium.
4. \$9.
5. 11 million pairs.
6. profits, because above long-run supply curve.
7. new firms enter, seeking profits.
8. \$3.
9. 14 million.
10. \$3, because price = AC in long-run equilibrium.
11. increased, because of entry of firms seeking profits.
12. constant-cost industry, because long-run supply curve is horizontal.

III. Critical thinking [3 pts]

(1) One should disagree with this statement. To maximize profit, produce output up to the point where marginal cost equals price, provided price is greater than or equal to average cost. If price is less than average cost, shut down. In almost all cases, this rule implies producing an output level different from the minimum point on the average cost curve. (Full credit requires a graph showing the firm's average cost and marginal cost curves, and dotted lines demonstrating how to choose output using the rule "price = marginal cost.")

[The above answer assumes a long-run time horizon for the firm and uses long-run cost concepts. You could instead answer the question using a short-run time horizon, using short-run cost concepts, as follows.]

To maximize profit in the short run, produce output up to the point where short-run marginal cost equals price, provided price is greater than or equal to short-run average variable cost (SAVC). If price is less than SAVC, shut down. In almost all cases, this rule implies producing an output level different the minimum point on the SAVC curve, and different from the minimum point on the short-run total cost (SATC) curve. (Full credit requires a graph showing the firm's SAVC, SATC, and SMC curves, and dotted lines demonstrating how to choose output using the rule "price = SMC.")

(2) You should not switch to Vendor B's system. You should stay with Vendor A's system. The \$100,000 you paid to install Vendor A's system is a sunk cost because the money cannot be recovered. It must be paid whether or not you switch. So you should compare the other costs. Excluding sunk costs, Vendor A's system will cost only \$50,000, which is less than the \$75,000 total you must pay for Vendor B's system. Therefore you should stay with Vendor A's system.

### Version B

I. Multiple choice

(1)a. (2)b. (3)d. (4)b. (5)b. (6)a. (7)b. (8)a. (9)a. (10)b.

II. Problems

(1) [Budget line: 12 pts]

1. Exactly affordable.
2. Not affordable.
3. Affordable with money left over.
4. 3 gallons of gasoline.
5. \$6.
6. \$2.

(1) [Consumer choice and demand: 16 pts]

1. 4 burritos and 5 nachos.
2. 7 burritos and 7 nachos.
3. Budget line A is a straight line with intercepts at 10 burritos and at 15 nachos.
4. 6 burritos.
5. Budget line B is a straight line with intercepts at 6 burritos and 15 nachos.
6. 4 pizzas.
7. (P,Q) = (\$6,6), (\$10,4).

(3) [Rational choice: 10 pts]

1. MC = Δ TC / Δ miles = \$20 thousand, \$25 thousand, \$30 thousand, \$40 thousand.
2. MB = Δ TB / Δ miles = \$90 thousand, \$50 thousand, \$20 thousand, \$10 thousand.
3. 4 miles, where MB = MC.

(4) [Business revenue and cost--definitions: 3 pts]

1. marginal revenue.
2. marginal cost.
3. average cost.

(5) [Discounting: 4 pts]

1. \$17.
2. \$20 million.

(6) [Short-run cost curves and supply: 20 pts]

1. \$9 thousand (= 1500 × SATC).
2. \$6 thousand (= 1500 × SAVC).
3. \$3 thousand (= STC - SVC).
4. \$2 (= SMC).
5. \$6 (= minimum SATC).
6. \$4 (= minimum SAVC).
7. 1800 parts, using the rule P=MC.
8. profit, because P is greater than breakeven price.
9. zero parts, because P is less than the shutdown price.
10. loss, because price is less than breakeven price. (The loss is equal to the short-run fixed cost, which must be paid even when the firm is shut down.)

(6) [Long-run competitive equilibrium: 24 pts]

1. \$8.
2. 12 million pairs.
3. \$8, because price = AC in long-run equilibrium.
4. \$2.
5. 6 million pairs.
6. losses, because below long-run supply curve.
7. existing firms exit, avoiding losses.
8. \$6.
9. 4 million.
10. \$6, because price = AC in long-run equilibrium.
11. decreased, because of exit of firms avoiding losses.
12. increasing-cost industry, because long-run supply curve slopes up.

III. Critical thinking [3 pts]

(Same as version A.)

[end of answer key]