Dominick Salvatore Schaums Outline of Microeconomics, 4th edition Schaums Outline Series 2006

182 MIDTERM EXAMINATION
(b)
AC ¼ AVC þ AFC. Since AFC declines continuously as output expands, the AC curve reaches its lowest point at
a higher level of output than the AVC curve. The MC curve crosses the AVC and AC curves at their lowest point.
The reason for this is that for the AVC and the AC to fall, the MC must be lower, and for the AVC and AC to rise,
the MC must be higher. Thus, MC ¼ AVC and MC ¼ AC at the lowest AVC and AC. See Fig. M-4.
(c)
See Fig. M-5.
Fig. M-4
Fig. M-5
5.
In the top panel of Fig. M-6, real income is kept constant according to Hicks by shifting budget line 2 down and parallel
to itself (budget line 3) until it is tangent to the original indifference curve I at point C. The movement from A to C (Q 1
Q 2 ) is the Hicksian substitution effect shown on the Hicksian demand curve in the bottom panel. Q 2 Q 4 is then the
Hicksian income effect. In the top panel, real income is kept constant according to Slutsky by rotating budget line
1 through point A until it is parallel to budget line 2. This gives budget line 4, which is tangent to indifference
curve III at point D. The movement from A to D (Q 1 Q 3 ) is the Slutsky substitution effect shown on the Slutsky
demand curve in the bottom panel. Q 3 Q 4 is then the Slutsky income effect. The Slutsky method is a better
measure of the substitution effect because, as with the income effect, it puts the consumer on a higher indifference
curve and because it can be obtained from observed prices and quantities without the need to know the exact shape
of the indifference curve.
6. (a) Q ¼ AL a K b , where Q ¼ output, and L and K ¼ inputs. A, a, and b are positive parameters determined in each
case by the data. The greater the value of A, the more advanced is the technology. a and b measure the
output elasticity of L and K, respectively. There are constant, increasing, or decreasing returns to scale to the
extent that a þ b ¼ 1, a þ b . 1, or a þ b , 1, respectively.
(b) See Fig. M-7. The TP L ,AP L , and MP L refer only to stage II of production (i.e., the Cobb-Douglas production
function is not defined for stage I or III of L and K).
(c) In Fig. M-8, doubling the inputs of L and K quadruples output. e subst. LK ¼ 1 for a Cobb-Douglas.