This is the solution guide compiled by your instructors of Econ 1101. This is a guide for exam 2 form A. If you had form B, you can still figure from this guide what the answers to your questions are. If you have any questions, ple ase contact your TAs or instructors. 1. This is form A, so the answer is A. 2. From Buckeye’s indifference curves, (8 pizzas, 16 sodas) is on the second highest indifference curve (IC) from the above graph and the only bundle from choices on the same indifference curve is (32 pizzas, 4 sodas), which I also show in red point in the graph. The answer is D. 3. I show the budget constraint (BC) in blue line, and the opportunity cost of one more pizza is just the slope of BC, 32/8=4 sodas. The answer is E. 4. The tangent point on both BC and IC, where marginal rate of substitution equals price ratio is just the optimal consumption bundle, shown as black point on the graph, (4 pizza, 16 sodas). 5. The new BC is shown in green, and the new optimal consumption bundle is (8 pizza, 16 sodas), so consumption of pizza increased by 4 units. The answer is B. 6. To identify the income effect, we draw a yellow line parallel to the new budget constraint, and tangent to the original indifference curve, and the tangent point is (6 pizza, 11 sodas), so the income effect on demand of pizza is the increment on pizza from this point to the new optimal consumption bundle, 8‐6=2 pizzas. The answer is C. 7. As income decreases, the budget constraint shifts inward in a parallel fashion (because neither the price of pizza nor the price of soda changed). The new budget constraint now intersects the pizza‐axis at Q=8 (because income/price = $8/$1=8) and the soda‐axis at Q=16 (because income/price = $8/$0.5 = 16). Buckeye’s new optimal consumption bundle is (pizza=4, soda=8). Now consider the three statements: (a) TRUE. When Buckeye’s income was $16, he used to spend 50% of his income on pizza ($1*8=$8). Now Buckeye’s income is $8, he is still spending 50% of his income on pizza ($1*4=$4). (b) FALSE. Consumption of both pizza and soda decreases as income decreases. This meets the definition of a normal good. If either item were an inferior good instead (e.g. ramen, spam), its consumption would increase instead of decrease, when income decreases. (c) FALSE. Income elasticity = (Δ%Q)/ (Δ%Income). Since both the numerator and the denominator are negative in this case, the overall fraction is positive. Income elasticity is positive. Thus the correct answer is A. 0246810121416182022242628303202468101214161820222426283032pizzasoda 8. A person has an absolute advantage in producing apples if he requires the least amount of resources per unit produced. Robinson requires 1 hr/apple while Friday requires 0.125hr/apple (= 8 apples/hr). Thus Friday has an absolute advantage in producing apples. A person has a comparative advantage in producing apples if he requires the least opportunity cost (expressed in terms of number of oranges forgone) per apple. Opportunity cost of producing an apple is given by the slope of the person’s budget constraint. Robinson’s budget constraint has slope = 4, i.e. he has to sacrifice 4 oranges per apple produced, i.e. his opportunity cost of producing each apple is 4 oranges. Friday’s budget constraint has slope = 0.25, i.e. he has to sacrifice 0.25 oranges per apple produced, i.e. his opportunity cost of producing each apple is 0.25 oranges. Friday has a comparative advantage in producing apples. Thus the answer is A. 9. Optimal consumption bundles are defined as the point where the highest indifference curve is tangent to the budget constraint. They are illustrated in the above diagrams. Robinson’s optimal consumption bundle is (5 apples, 20 oranges). The answer is E. 10. When trade is possible, each person will specialize in the good in which he has comparative advantage in. Robinson has comparative advantage in oranges, while Friday has comparative advantage in apples. Thus Robinson produces (0 apples, 40 oranges), while Friday produces (40 apples, 0 oranges). Their common budget constraint under trade is (40 apples, 40 oranges), which is illustrated above in blue. Both will consume the bun dle (20 apples, 20 oranges), which is the point where the highest indifference curve is tangent to the new budget constraint under trade. The answer is C. 0510152025303540450 5 10 15 20 25 30 35 40 45ApplesOrangesU1U2U30510152025303540450 5 10 15 20 25 30 35 40 45ApplesOrangesU1U2U3Friday Robinson11. Let’s consider each statement individually: (i) FALSE. MC is not required to be less than ATC at all quantities. At any quantity where MC<ATC, quantity produced for each firm will simply be zero in the firm’s LR supply curve. In an industry LR equilibrium, each firm can choose to produce at its profit‐maximizing quantity, which is where ATC is at minimum. This is also where ATC intersects MC. (ii) FALSE. The shape of the demand curve has no effect on the shape of the supply curve. (iii) TRUE. This is to ensure that all firms have the same cost curves. (I.e., a firm is more costly when it has worse technology.) This is necessary because all firms will then have the same profit‐maximizing price (the minimum ATC), which gives the price of the LR supply curve. (iv) TRUE. There cannot be barriers to entry because in the LR, the industry’s supply adjusts to changing demand by changing the number of firms, not changing the amount of production within each firm. (v) TRUE. This is similar to (iii). This ensures that cost curves of fir ms do not change as the number of firms in the industry increases. Thus the answer is C. The following chart is for questions 12‐18. 12. Fixed cost equals 36. The correct answer is e. To find the fixed co st note that AFC=ATC‐AVC and FC=Q*AFC. For example, at a quantity of 6 ATC is 12 and AVC is 6, so AFC is 6. This means that fixed cost is Q*AFC=6*6 or 36. A similar calculation could be performed at other quantities (where it is easy to see the value of AVC and ATC) to get the same answer. The answer is E. 13. If the price equals 4, in the short run the firm will produce. The resulting maximum profit e quals ‐32. A profit maximizing competitive firm sets price equal to marginal cost to determine the quantity 012345678910111213141516171819202122232425260 1 2 3 4 5 6 7 8 9 10 11 12MCATCAVCq$012345678910111213141516171819202122232425260 300 600 900 1200 1500