14.

01 Principles of Economics Fall 2018

True/False Question (20 minutes)

1. John has an income of $1,000. He spends $100 on potatoes and $900 on everything else.
The government is planning to assist low income people like John. In particular, they are
considering giving him either $200 in cash or giving him $200 in stamps that can only be
used to buy potatoes.

(a) (4 minutes) If potatoes are a normal good, then John will be strictly better off with $200
cash than with $200 in stamps.

(b) (4 minutes) If potatoes are an inferior good, then John will be strictly better off with
$200 cash than with $200 in stamps.

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2. (4 minutes) Mary consumes only two goods, x and y. When the price of x increases, she
consumes less of good y. Claim: y can’t be a Giffen good.

3. (4 minutes) Consider the market for cars. All firms have the same production technology,
and we know that the long-run average cost curve has a minimum at a cost of $10,000 per
car. Therefore, we can never observe a market equilibrium in which the equilibrium price is
below $10,000.

4. (4 minutes) Consider a firm that produces computers. Suppose that the market price of a
computer is p̄ (both in the short-run and in the long-run). If in the short-run this firm decides
to shut-down (i.e. produces q = 0), then it must be that in the long-run it decides to exit the
market.

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 Long Question: Consumer Theory (45 minutes)
For this question, it is okay to have non-integer answers
Rebecca likes eating bagels (b) and drinking coffee (c) for breakfast. Her preferences can be
represented by the function
U (c, b) = b2 c3

1. (3 minutes) Graph Rebecca’s indifference curve corresponding to utility level u = 64 (bagels

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2. Suppose that Rebecca budgets m dollars for breakfast every week, and the price of bagels
and coffee at the cafe are pb and pc respectively.

(a) (3 minutes) Write down Rebecca’s optimization problem when she is deciding how many
coffees and bagels to consume each week.

(b) (4 minutes) Solve for how many coffee and bagels Rebecca would consume as a function
of pb , pc , and m.

(c) (2 minutes) Are coffee and bagel normal goods or inferior goods? Why?

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3. Now suppose that Rebecca budgets 10 dollars for breakfast every day and only eats at Flour
Bakery, where the price of a bagel is 1 dollar and the price of a cup of coffee is 4 dollars.
However, because Rebecca is part of the loyalty program at the cafe, Rebecca receives a 50
percent discount on coffee.

(a) (3 minutes) Graph Rebecca’s budget set with bagels on the x-axis.

(b) (2 minutes) Find the number of bagels and cups of coffee that Rebecca chooses to buy.

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4. After a while, Flour Bakery realizes it is losing money because too many people are using its
loyalty program to buy coffee. Flour Bakery changes its loyalty program: now, a customer
only gets a 50 percent discount on the first three cups of coffee they buy in any given day.

(a) (3 minutes) Graph Rebecca’s new budget set (carefully label important points on the
graph)

(b) (4 minutes) What quantity of coffee and bagels would Rebecca choose to consume given
the new budget set? How does this answer compare with the previous result? Explain.

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5. Flour Bakery is still losing money. It decides to get rid of its loyalty program altogether so
that no one gets any discounts on coffee.

(a) (2 minutes) Find Rebecca’s consumption of coffee and bagels without any discounts.

(b) (4 minutes) Comparing your answer to the answer you got in part 3b: how much of the
change in Rebecca’s consumption of coffee is due to the substitution effect? How much
is due to the income effect? You do not need to solve for the actual numbers, drawing
the graph is enough.

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6. Disappointed that the loyalty program has been canceled, Rebecca goes searching for another
cafe and discovers that Tatte sells coffee for 2 dollars and bagels for 2 dollars. The quality of
coffee and bagels is the same between Tatte and Flour Bakery.

(a) (2 minutes) How many bagels and coffee does Rebecca buy at Tatte?

(b) (2 minutes) Rebecca only has time to go to one coffee shop before class. Which one does
she go to? Why?

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(c) (4 minutes) Now
√ suppose that Rebecca’s utility function for coffee and bagels is given
by U (c, b) = b + c. Which coffee shop does she go to and how much of each good does
she consume at that coffee shop? Why should your answer change compared to parts
a) and b)? (Hint: it is possible to arrive at the solution for this problem without doing
any math. If you do so, please explain the reasoning you used to arrive at your answer.)

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7. Now suppose that there are 30 consumers, all with utility for coffee and bagels U (c, b) = b2 c3 .
Suppose that ten of the consumers budget five dollars for breakfast, ten of the consumers
budget ten dollars for breakfast, and ten budget fifteen dollars for breakfast.

(a) (3 minutes) Find the aggregate demand curve for coffee.

(b) (4 minutes) Suppose that the supply curve for coffee is given by Qs (P ) = 5P . What is
the equilibrium price and quantity in the market for coffee?

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 Producer theory (40 minutes)
Suppose we are studying the market for clam chowder in the Boston area, which is perfectly
competitive and there is free entry. All the stores in the Boston area face the same long-run cost
function, C B (q) = 49 + 5q + q 2 . If they decide not to produce, the total cost is zero –i.e. C B (0) = 0.
Stores can sell the product at the same price p.

1. (4 minutes) Compute the marginal cost and the average total cost for one of the stores.

2. (4 minutes) Find this store’s supply function, expressing the quantity supplied by the store
as a function of the price.

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3. (5 minutes) Recall that all the clam chowder stores in the Boston area share the same cost
function above. Also, a study has shown that the demand for clam chowder takes the following
form, QD = 235 − 5p. What is the long-run market price and the long-run number of stores?
What is the quantity produced by each store? What are their profits?

4. Suppose that 15 out of the clam chowder stores that decided to operate in the long-run in the
previous question are in Cambridge –one of the cities in the Boston area. In addition, suppose
that Cambridge introduces a constant subsidy of $33 for each of these 15 clam chowder stores
if q > 0, that is, each of the 15 stores gets a $33 check from the city government if they decide
to produce a positive quantity of clam chowder.

(a) (2 minutes) What is the new cost function for one of Cambridge’s clam chowder stores
(denote it by C C (q))?

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(b) (6 minutes) Compute the marginal cost and average total cost for this store, as well as
the supply curve. Does the marginal cost change? Why or why not?

(c) (2 minutes) Solve for the new supply function for one of the Cambridge stores.

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5. Consider the market for Clam Chowder in the Boston area after the introduction of the
subsidy in Cambridge for those 15 stores (that is, other clam chowder stores that open in
Cambridge do not get the subsidy).

(a) (5 minutes) What is the long-run market price in the Boston area? And the number of
stores of each type? Explain the intuition.

(b) (6 minutes) How many clam chowder units does each subsidized store sell? What about
unsubsidized stores? What are the profits of each of the subsidized stores? And the
profits of the unsubsidized stores? Explain why.

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6. (6 minutes) Demand for clam chowder in the Boston area drops after the subsidy policy and
becomes QD = 207 − 5p. What is the long-run price and number of firms? How many stores
will there be in the Boston area and how many of them will be subsidized? How many clam
chowder units do subsidized stores sell? What about unsubsidized stores?

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14.01 Principles of Microeconomics

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