Example of Midterm

A. Multiple Choice Questions - 50 points

Each question is worth 5 points. Write the question number with the corresponding letter in
the answer book.
1. Marginal utility
a. Has to decrease if indifferent curves are convex.
b. Is the rate at which total utility changes as the level of consumption rises.
c. Is equal to the products price.
d. Tells us nothing; were only concerned with total utility.

2. If two goods are perfect substitutes, then

a. The marginal rate of substitution is constant.
b. The indifference curves are straight lines.
c. The indifference curves are L-shaped.
d. Both a) and b) are true.

3. The budget line

a. Represents the set of all baskets the consumer can afford.

b. Represents the set of all baskets the consumer can afford while spending all available
income.
c. Represents the set of all baskets that give the consumer the same level of utility while
holding spending constant.
d. Represents the set of all baskets in which the consumer purchases only one of the goods.

4. Identify the statement that is true. Assume that the price of good x increases.
a. If x is an inferior good, the substitution effect has a positive impact on its consumption.
b. If x is a normal good, the substitution effect has a positive impact on its consumption.
c. If x is an inferior good, the income effect has a positive impact on its consumption.
d. If x is an inferior good, the income effect has a negative impact on its consumption.

5. Demand functions are "homogeneous of degree zero in all prices and income." This
means
a. a proportional increase in all prices and income will leave quantities demanded unchanged.
b. a doubling of all prices will not alter consumption decisions.
c. prices directly enter individuals utility functions.
d. an increase in income will cause all quantities demanded to increase proportionately.

6. Identify the truthfulness of the following statements.

1. When the marginal product is falling, the average product is falling as well.
2. When the marginal product is higher than the average product, then average product is
rising.
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a. Both I and II are true.

b. Both I and II are false.
c. I is true; II is false.
d. I is false; II is true.

7. An isoquant represents
a. All combinations of inputs that produce a given level of output at the same cost.
b. All combinations of inputs that produce a given level of output.
c. All combinations of output that require the same levels of inputs.
d. All combinations of inputs that cost the same amount.

8. Opportunity cost is
a. Costs that involve a direct monetary outlay.
b. The sum of the firms economic explicit costs and implicit costs.
c. The total of explicit costs that have been incurred in the past.
d. The value of the next best alternative that is forgone.

9 Identify the truthfulness of the following statements.

I. A profit-maximizing firm will not produce if P is smaller than the minimum AVC.
II. A profit-maximizing firm will not produce if P is smaller than the minimum AC.
a. Both I and II are true.
a. Both I and II are false.

a. I is true; II is false.
a. I is false; II is true.

10 In a perfectly competitive, increasing-cost industry in the long run, economic profit for
the marginal firm (

) and economic rent of other firms (

).

a. Can be positive; can be positive.

b. Can be positive; equals zero.
c. Equals zero; can be positive.
d. Equals zero; equals zero.

B. Analytical Questions - 50 points

Give your answers with all the intermediate steps in the answer book.
1 - (25 points) An individual has utility defined over two goods U (x, y) = xy. The budget
line is is described by px x + py y = I
a. (5 points) Calculate the demand for the two goods (Find the optimal x as a function of
prices and income).
b. (4 points) Calculate the indirect utility function by plugging the two demand functions
found in [a] in the utility function (U becomes V).
c. (4 points) Calculate the expenditure function inverting the indirect utility function and
solving for the expenditure (I becomes E and V becomes U).
d. (4 points) Assuming that (px = 1, py = 1, I = 4), calculate the indirect utility associated
with these prices and income.
e. (4 points) Assuming now that (p0x = 4, py = 1, I = 4), i.e. the price of x increases.
Recalculate the indirect utility associated with these prices and income.
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f. (4 points) The government wants to compensate the individual for this loss of utility with
a lump sum transfer. Using the expenditure function calculate the amount of money the
individual needs in order to achieve the same level of utility as in [d], having the prices as
in [e]. Find the Compensating Differential (CV), which is the transfer of the government.

2 - (25 points) A firm is characterised by the following production function: q = k 1/4 l1/2 .
The rental price of capital is v = 1 and wages are w = 1 per unit. Each firm has to pay each
year an entry fee of 1 in order to operate. The firm sells the output at a price p.
a. (5 points) Find the RTS for this firm (M Pl over M Pk ).
b. Assuming that in the short run the firm is stuck with k0 = 1, find the short run contingent
demand for labor and the short run cost function (Using the production function, and
imposing the short run restriction, solve for labor. In this problem the cost function
includes the cost of capital, labor and the entry fee).
c. (5 points) Find the short run supply function for this firm (q(p)). Remember that a price
taker firms sets p = M C.
d. (3 points) Assume that there are 100 firms in the market and that the total demand for
the good is Q = 100 50p. Find the equilibrium price (Remember that the aggregate
supply function is the sum of the individual supply functions, i.e. Q(p) = 100q(p)).
e. (3 points) At the equilibrium price, compute the quantity produced by each firm and its
profit.
f. (3 points) We are now in the long run. The prices of inputs are the same. Compute the
contingent demand for capital and labor. You can do it by setting RTS=w/v and then
plugging this equation in the production function.
g. (3 points) Compute the long run cost function (remember the entry fee). Compute also
the long run marginal and average cost.