ECOM056 Foundations of Microeconomics

Question 1

Consider Helen who can spend her income of £200 on two products: Food (F) andLuxuries (L). Helen’s tastes are represented by the following utility function: Food sells for £2 per unit and luxuries sell for £5 per unit. (a) Write down the equation for Helen’s budget constraint and show it in a diagram.

(b)Knowing that marginal utilities for respectively, compute the amounts of each good in Helen’s optimal consumption basket. Show it in your diagram.

(c) Suppose that the government adds a tax of £1 to the price of luxury goods. How does this affect Helen’s consumption choice?

(d)Calculate the Slutsky substitution and income effects for luxury goods associated with this tax.

Question 2

Consider a perfectly competitive market for fizzy drinks. The market demand is given byand market supply is given by . (a) Calculate the equilibrium price and quantity. Show your answer in a diagram.

(b)Suppose the government imposes a quantity tax of � = 2 per unit. What is the effect of the tax on the equilibrium quantity and price? Show that the consumers bear a larger share of the tax burden and explain why this is the case. Illustrate your answer in a diagram.

(c) Suppose that instead of the tax, the government launched a campaign informing the citizens of the adverse health effects of drinking fizzy drinks. Explain how this alternative course of action may influence the market outcome. Why might the government want to use this policy instead of taxation?

Question 3

(a) Explain why a firm in a perfectly competitive market faces a horizontal demand curve. What does this imply in terms of the firm’s pricing decision?

(b)Consider following the production function:  Show that this production function exhibits increasing returns to scale. Is it possible for this same production function to also exhibit diminishing marginal product to  Explain.

(c) Explain why in the short run a perfectly competitive firm should shut down production only if its variable costs exceed its revenues.

(d)Explain why the marginal cost (MC) curve and the average cost (AC) curve intersect at the minimum of the AC curve.

Question 4

Discuss the proposition that a perfectly competitive firm can make positive economic profits in the short-run while in the long-run economic profits are driven to zero. Use diagrams to complement your answer.

Question 5

Conelec is the only supplier of electricity in the market. The market demand for electricity is given as: . Electricity is produced in coal-powered plants at a constant unit cost: is the price of coal and it is equal to 20. Conelec needs one unit of coal to produce each unit of electricity.

(a) What is Conelec’s marginal revenue? Explain how you obtain it. For a monopolist, is marginal revenue higher or smaller than price? Why?

(b)What is the output level that maximises the Conelec’s profits? If welfare is measured as the sum of profits and consumer surplus, what is the corresponding level of welfare? Compare this to the welfare generated in a perfectly competitive market. Briefly comment on the different amount of welfare in both market structures.

(c) In order to reduce the use of coal, which pollutes the atmosphere, the government introduces a unit tax of = 5 on production. What is the new level of output that maximises Conelec’s profits? Has the price increased by more or less than ?