ECON 101: Principles of Microeconomics – Discussion Section Week 10

TA: Kanit Kuevibulvanich

Important Concepts:
• Income and Substitution Effect
• Production and Cost

Problems
1. A consumer has income of $3,000. Wine costs $3 per glass, and cheese costs $6 per pound.
a. Draw the consumer’s budget constraint (put cheese on the horizontal axis). What is the
slope of this budget constraint?
b. Suppose his income increases from $3,000 to $4,000. Show what happens if both wine
and cheese are normal goods.
c. Now show what happens if cheese is an inferior good.
d. The price of cheese rises from $6 to $10 per pound, while the price of wine remains $3
per glass. For a consumer with constant income of $3,000, show what happens to
consumption of wine and cheese. Decompose the change into income and substitution
effects.
e. Can an increase in the price of cheese possibly induce a consumer to buy more cheese?
Explain.

2. A chocolate factory has total production cost (TC) given by the equation TC = 300 + 15Q
where Q is the number of bars of chocolate produced.
a. What is the total fixed cost and what is the total variable cost?
b. Write the equations of average total cost (ATC), average variable cost (AVC) and average
fixed cost (AFC) and draw the ATC, AVC and AFC curves
c. What is the marginal cost (MC) for this factory?
d. If the factory produces 50 bars of chocolate, find its total fixed cost, total variable cost
and marginal cost.
e. Ignoring the existence of fixed cost and based on the ATC curve, does this firm have
increasing, constant or decreasing return to scale?

3. Kate Smith provides catered meals, and the catered meals industry is perfectly competitive.
Kate’s machinery cost $100 per day and is the only fixed input. Her variable cost consists of
the wages paid to the cooks and the food ingredients. The variable cost per day associated
with each level of output is given in the table. Find total cost, average variable cost, average
total cost and marginal cost. At what quantity or range of quantities does the minimum of
ATC occurs?
Q TVC TC AVC ATC MC

0 $0

10 $200

20 $300

30 $480

40 $700

50 $1,000

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 ECON 101: Principles of Microeconomics – Discussion Section Week 10
TA: Kanit Kuevibulvanich
Practice Midterm Questions (Midterm 2, Fall 2012 Afternoon)
4. Suppose that in the long run, if a firm increases its output from 50 to 80 units, this causes its
total cost to increase from $1200 to $1500. Given this information and holding everything
else constant, this firm exhibits:
a. Decreasing returns to scale
b. Increasing returns to scale
c. Constant returns to scale
d. Decreasing marginal product of labor

5. Suppose the marginal cost curve is increasing. If at a quantity q* the marginal cost curve is
above the average total cost curve, we can conclude that:
a. q* is larger than the quantity at which the average total cost curve achieves its minimum.
b. q* is smaller than the quantity at which the average total cost curve achieves its
minimum.
c. At q* the average total cost curve has a negative slope.
d. At q* the marginal cost curve has a negative slope.

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 ECON 101: Principles of Microeconomics – Discussion Section Week 10
TA: Kanit Kuevibulvanich
Solutions:
Question 1
a. Figure 1 shows the consumer's budget constraint. The intercept on the horizontal axis shows
how much cheese the consumer could buy if she bought only cheese with income of $3,000
and the price of cheese $6 per pound, she could buy 500 pounds of cheese. The intercept on
the vertical axis shows how much wine the consumer could buy if she bought only wine;
with income of $3,000 and the price of wine $3 per glass, she could buy 1,000 glasses of
wine. With cheese on the horizontal axis and wine on the vertical axis, the budget constraint
has a slope of – 1000/500 = – 2.

Figure 1

b. See Figure 2
c. See Figure 3

Figure 2 Figure 3

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 ECON 101: Principles of Microeconomics – Discussion Section Week 10
TA: Kanit Kuevibulvanich
Figure 2 shows the effect of an increase in income. The rise in income shifts the budget
constraint out from BC1 to BC2. If both wine and cheese are normal goods, consumption of
both will increase. If cheese is an inferior good, the increase in income causes the
consumption of cheese to decline, as shown in Figure 3.

d. A rise in the price of cheese from $6 to $10 per pound makes the horizontal intercept of the
budget line decline from 500 to 300, as shown in Figure 6. The consumer's budget constraint
shifts from BC1 to BC2 and her optimal choice changes from point A (c1 cheese, w1 wine) to
point B (c2 cheese, w2 wine). To decompose this change into income and substitution effects,
we draw the budget constraint BC3, which is parallel to BC2 but tangent to the
consumer's initial indifference curve at point C. The movement from point A to C
represents the substitution effect. Because cheese became more expensive, the consumer
substitutes wine for cheese as she moves from point A to C. The movement from point C to
B represents an income effect. The rise in the price of cheese results in an effective decline in
income.

Figure 4

e. An increase in the price of cheese could induce a consumer to buy more cheese if cheese is a
Giffen good. In that case, the income effect of the rise in the price of cheese induces the
consumer to buy more cheese because cheese is an inferior good. If the income effect is
bigger than the substitution effect (which induces the consumer to buy less cheese), the
consumer will buy more cheese.

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 ECON 101: Principles of Microeconomics – Discussion Section Week 10
TA: Kanit Kuevibulvanich
Question 2
a. TFC = 300, TVC = 15Q
b. ATC = (300+15Q)/Q = 15 + 300/Q, AVC = 15, AFC = 300/Q
c. MC = AVC = 15
d. If Q = 50, fixed cost is 300, total variable cost is 750, marginal cost is 15
e. As ATC is decreasing as Q increases, this is an example of increasing return to scale
Graph of b. looks like this:

Vertical distance between ATC and AFC is constant as AVC is constant.

Question 3

Q Total Cost Average VC Average TC Marginal cost

0 100 - - -
10 300
ffqQ 20 30 (300-100)/10 = 20
20 400 15 20 (400-300)/10 = 10
30 580 16 19.33 (580-400)/10 = 18
40 800 17.5 20 (800-580)/10 = 22
50 1100 20 22 (1100-800)/10 = 30

Minimum of ATC occurs between Q = 20 and Q = 40.

Question 4 b.

Question 5 a.

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