XLRI - Xavier School of Management

Solution
Managerial Economics (MGEG20-1)

Multiple Choice Questions

1. When there are more substitutes for a product, the · · · · · · for the product is · · · · · · .
(a) demand; less price elastic
(b) demand; more price elastic
(c) income elasticity; greater
(d)income elasticity; smaller.

2. The income elasticity of demand for education is 3.5. Thus, a 4% increase in income
will
(a) decrease the quantity of education demanded by 3.5%.
(b) decrease the quantity of education demanded by 14%.
(c) increase the quantity of education demanded by 4%.
(d) increase the quantity of education demanded by 14%.

3. The cross-price elasticity of demand between good X and good Y is −3. Given this
information, which of the following statements is TRUE?
(a) The demand for goods X and Y is elastic.
(b) Goods X and Y are substitutes.
(c) Goods X and Y are complements.
(d) The demand for goods X and Y is income elastic.

4. When the price of Rs. 4, quantity supplied is 100; and when the price increased to
Rs. 6, quantity supplied is 120. The price elasticity of supply is · · · · · · and supply is
······.
(a) 0.1; inelastic
(b) 0.40; inelastic
(c) 2.2; elastic
(d) 10; elastic?

5. Suppose that a budget equation is given by p1 x1 + p2 x2 = m. The government decides

to impose a lump-sum tax of u, a quantity tax on good 1 of t and a quantity subsidy
on good 2 of s. What is the formula for the new budget line?

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 (a) (p1 + t)x1 + (p2 − s)x2 = m − u.
(b)(p1 + t)x1 + (p2 − s)x2 = m
(c) p1 x1 + (p2 − s)x2 = m − u
(d) p1 x1 + (p2 − s)x2 = m

6. A college football coach says that given any two linemen A and B, he always prefers
the one who is bigger and faster. This preference relation is · · · · · · · · ·
(a) complete and transitive
(b) complete
(c) transitive
(d) insufficient information

7. If S1 (p) = p − 10 and S2 (p) = p − 15 be the supply functions of firm 1 and 2, then at

what price does the industry supply curve have a kink in it?
(a) 10
(b) 15
(c) 20
(d) 12

8. If a household’s income falls by 10%, its budget constraint will

(a) shift out parallel to the old one.
(b) pivot at the Y −intercept.
(c) shift in parallel to the old one.
(d) be unaffected.

9. Michael can buy either pizzas or submarine sandwiches. If the prices of pizza and
submarine sandwiches double and so does Michael’s money income, we can deduce
that Michael’s budget constraint will
(a) shift in but remain parallel to the old one.
(b) shift out but remain parallel to the old one.
(c) swivel in so that the slope of the budget constraint is doubled.
(d) remain unchanged.

10. Marginal utility is the · · · · · · satisfaction gained by consuming · · · · · · of a good.

(a) total; all units
(b) total; one more unit
(c) additional; all units
(d) additional; one more unit

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11. Hari is consuming X and Y so that he is spending his entire income and M Ux /Px = 6
and M Uy /Py = 10. To maximize utility, he should
(a) continue to consume the same amount of X and Y since he is already maximizing utility.
(b) consume less of both X and Y .
(c) consume more X and less Y .
(d) consume less X and more Y .

12. Roshni is maximizing her utility. Her M Ux /Px = 10 and M Uy = 40. Then the price
of Y must be
(a) Rs. 10
(b) Rs. 4
(c) Rs. 40.
(d) Rs. 20

13. Assume Sally is initially in equilibrium and that X and Y are normal goods for her.
Then the price of X rises. For Sally to move to a new equilibrium point her consumption
of
(a) X must remain constant, but her consumption of Y must increase.
(b) X must decrease.
(c) X must increase.
(d) both X and Y must increase

14. You own a building that has four possible uses: a cafe, a craft store, a hardware
store, and a bookstore. The building’s value in each use is RS 200 thousands; Rs. 300
thousands; Rs 400 thousands; and Rs. 500 thousands, respectively. You decide to open
a hardware store. The opportunity cost of using this building for a hardware store is
(a) Rs. 200 thousands, the value if the building is used as a cafe.
(b) Rs. 300 thousands, the value if the building is used as a craft store.
(c) Rs 1 million, the sum of the values if the building is used for a cafe,
a craft store, or a bookstore.
(d) Rs. 100 thousands, the difference in value if the building were used as a bookstore
and its actual use.

SCENARIO 1: You own and are the only employee of a company that writes computer
software that gamblers use to collect sports data. Last year your total revenue was
$90,000. Your costs for equipment, rent, and supplies were $50,000. To start this
business you invested an amount of your own capital that could pay you a $40,000 a
year return.

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15. Refer to Scenario 1. During the year your economic costs were
(a) $40,000.
(b) $60,000.
(c) $90,000.
(d) $100,000

16. Refer to Scenario 1. A yearly normal rate of return for your computer software firm
would be
(a) $20,000.
(b) $40,000.
(c) $60,000.
(d) $100,000.

17. Refer to Scenario 1. Your accounting profit last year was

(a) $10,000.
(b) $30,000.
(c) $40,000.
(d) $60,000.

18. Refer to Scenario 1. Your economic profit last year was

(a) -$40,000.
(b) -$10,000.
(c) $0.
(d) $10,000

19. A firm is operating such that the marginal product of labor is 10 and the marginal
product of capital is 40. The firm is minimizing its costs only if
(a) the wage is one fourth the rental rate.
(b) the rental rate is one fourth the wage.
(c) since capital is more productive than labor, the firm must be minimizing cost.
(d) Given this information the firm can’t be minimizing cost under any circumstances

20. When the marginal product of labor equals the average product of labor, then
(a) the average product is maximized.
(b) the marginal product is maximized.
(c) the marginal product is still increasing.
(d) the average product is still increasing

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 Computational Questions

21. Suppose the utility function of a consumer is given by U = x0.5 y 0.5 . Her income is 100.
Initially the prices of x and y are (px , py ) = (1, 1). Then the price of x increased to
p0x = 4.

(a) What are optimal consumption of x and y before price change?

Solution:

M Ux px y
= ⇒ =1 ⇒ y=x
M Uy py x
x + y = 100 2x = 100 ⇒ x∗ = 50, y ∗ = 50

Optimal consumtion: x∗ = 50, y ∗ = 50

(b) What are optimal consumption of x and y after price change?
Solution:

M Ux p0 y
= x ⇒ =4 ⇒ y = 4x
M Uy py x
100 25
4x + y = 100 8x = 100 ⇒ x∗ = = , y ∗ = 50
8 2

Optimal consumtion: x∗ = 12.5 = 25

2
, y ∗ = 50
(c) What are the substitution and income effect when price changes?
Solution:
We know the initial and final consumtion, let us calculate the intermediate con-
sumtion bundle at new budget line BLd to remain at U1 .
√ √
U1 = xy = 50 × 50 = 50

M Ux p0 y
= x ⇒ = 4 ⇒ y = 4x
M Uy py x
√ √
50 = xy ⇒ 50 = 4x2 = 2x, x∗d = 25, yy∗ = 100

Substitution effect: 25 − 50 = −25, Income effect: 12.5 − 25 = −12.5

(d) What are the compensating variation and equivalent variation?
Solution:

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 CV: Money needed for the consumer when price x has increased from 1 to 4 to
be enjoying the old utility level: md = 25 × 4 + 100 × 1 = 200.

CV=100
EV: Money needed for the consumer to be enjoying the new utility level at old
prices: md = 25 × 1 + 25 × 1 = 50.

EV=50

22. Mr. Micro’s utility function is given by u = min{x, 3y}. Mr. Micro has Rs. 140 and
price of x is 2 and y is 1. What are the optimal consumption of x and y?
Solution:

x = 3y This comes from the utility function

2x + y = 140 Budget line
140
7y = 140 y ∗ = = 20, x∗ = 20 × 3 = 60
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Optimal consumtion: x∗ = 60, y ∗ = 20

23. A firm has the production function Q = (K 1/2 + L1/2 )2 . The price of capital is r = 1
and the price of labor is w = 1. What are optimal levels of capital and labour to
produce a output of 16?
Solution:

√
M PL w K √ √
= ⇒ √ =1 ⇒ K= L
M PK r L
16 = (K + L ) = 4L ⇒ L∗ = 4,
1/2 1/2 2
K∗ = 4

Optimal levels of capital and labour: L∗ = 4, K ∗ = 4

24. A firm has a production function Q = LK. If the minimum cost of production at
w = r = 1 is equal to 4, what is Q equal to?
Solution:

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 First derive the cost function:
M PL w K
= ⇒ =1 ⇒ K=L
M PK r L
p p
Q = KL ⇒ L∗ = Q, K ∗ = Q
p p
1 × L∗ + 1 × K ∗ = C ⇒ 1 × Q + 1 × Q = 4 Isocostline
Q=4

25. Suppose the production function is Q = L2/3 + 1/3L, and the price of Q is P = 6.
Assume L ≥ 1.

(a) Find the marginal product of labour M P (L) and average product AP (L).
Solution:

2 1
M P (L) = L−1/3 +
3 3
Q 1
AP (L) = = L−1/3 +
L 3

(b) What is the firm’s value of marginal product V M P (L).

Solution:

 
2 −1/3 1
V M P (L) = p × M PL = 6 × L + = 4L−1/3 + 2
3 3

(c) How many labours firm’s will employ if w = 4?

Solution:

V M P (L) = w ⇒ 4L−1/3 + 2 = 4
L∗ = 8