Question

1. Which statements about the short-run are true?

I. Marginal cost intersects the minimum of average variable cost.
II. Average fixed cost is always declining as the quantity increases.
III. Marginal cost intersects the average fixed cost at the maximum of the average fixed cost.

a. only III is true

b. only I is true

c. None of the other answers is correct

d. only II and III are true

e. only I and II are true

2. Coffee and tea are two substitute products that are both sold in competitive markets. Coffee beans are an essential ingredient in the production of coffee; tea leaves are an input into making tea. We observe a price increase in both the coffee and tea markets, and that the amount of coffee traded in the market goes down while the amount of tea traded in the market increases.
Which of the following scenarios is consistent with the observation in the two markets outlined above?

a. Improvements in tea leaves picking technology allow for cheaper production of tea.

b. Drought conditions reduced the supply of coffee beans.

c. None of the other answers is correct.

d. Insects killed half of the tea plants.

e. New research revealed the benefits of consuming tea.

Answer 1

1. The correct answer is that (e) statement I and II are correct.

This is because according to the properties of the marginal cost and average variable cost, the marginal cost will cut the average variable cost at its lowest point. This is shown in the attached diagram as well.

The shape of average fixed cost is also shown in the diagram. It will keep on decreasing as the quantity decreases.

The third statement is not true because the maximum point of average fixed cost does not necessarily intersect the marginal cost.

2. The correct answer is (e) new benefits of consuming tea revealed by research. This is because due to this factor, people will continue consuming tea even if its price has reduced. And this perfectly explains why the demand for coffee went down due to rise in prices and demand for tea did not.

The other options are incorrect because improvement in tea picking technology would have led to decline in prices of tea which did not happen in this case.

Drought conditions reducing supply of coffee cannot explain the consistent demand for tea even after rise in its price levels.

If insects kills tea plants, its price would rise furthur due to reduction in supply. This does not explain why people kept on buying tea even after higher prices.