Download SI exam review 3 ANSWER KEY

SI exam review 3 ANSWER KEY
IMPORTANT NOTE: On the sheet that I handed out in the review sessions, the first part of
question 1, question 4, and question 7 asked for an explanation of why certain cost curves looked
the way that they do. Many students found these questions very hard, so I checked with Kate and
found out that questions like these WILL NOT be on the test – you need to know the shape of
marginal cost, average cost, marginal revenue, ect., but you don’t need to know why they are
shaped that way. I apologize for any unnecessary pain and agony I may have caused by including
these questions.
1. A variable input can be changed in the short run, while a fixed input can only be changed
in the long run. To use the example from class, some inputs for producing restaurant food
are the hours of labor of the cooks, as well as the grills that the cooks use. The restaurant
can easily and quickly increase the number of hours worked by the cooks by paying them
overtime, so the cooks’ labor is a variable input. The restaurant can’t install more grills in
its kitchen quickly, but can if it has more time – therefore it is a fixed input.
2.
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A firm will always produce where marginal cost=marginal benefit to maximize profit;
in the case of perfect competition, the marginal benefit is simply the market price because
the demand curve is perfectly flat. Therefore, a perfectly competitive firm will always
produce where the marginal cost curve intersects with price – regardless of whether or
not the market is in long-run equilibrium.
So how do we know where the long-run equilibrium is? We can know it is at the
minimum of average cost by thinking about all of the firms in the market: If firms are
selling at a price above the average cost to produce, they will be experiencing economic
profit and new firms will enter, driving price down. If price is below average cost, firms
will be losing money – firms will exit and because of this price will rise. This graph is in
your notes as well as on WebCT.
3. We say that perfectly competitive markets are efficient because there is no deadweight
loss – all trades which make everyone better off have taken place. We also say that
perfectly competitive markets are efficient because they produce at the lowest possible
average cost. This means that consumers pay the lowest price possible.
4. This is in the notes as well as in the textbook – it will be extremely useful to know these
characteristics because on the test you will be asked to categorize industries and then
justify your answer. For example, if the market for apples on the test you could
categorize it as perfectly competitive and argue that apples from different farms are
perfect substitutes and that there are low barriers to entering this market.
5. The firm is trying to make its demand curve steeper. To use the example from class, if
people think that Pepsi and Coke are identical, then if Coke or Pepsi raises its price by 1
cent, everyone will buy the cheaper brand – in this case we have perfectly flat (perfectly
elastic) demand for Pepsi as well as Coke. However, if people think that Coke and Pepsi
are different, some will prefer one over the other. In this case, if Coke raises its price by 1
cent, some people might switch to Pepsi but others will pay the higher price because they
like Coke better.
6. Remember that the rule for finding the point where any firm produces is:
marginal cost=marginal benefit. In the cast of an imperfectly competitive firm, the
marginal benefit is the marginal revenue. If you find the point where the marginal cost
curve crosses the marginal revenue curve, this will be the point where the firm produces.
To find deadweight loss, we want to find the area of a triangle. The left side of the
triangle will be a vertical line drawn at the quantity being produced. The other sides of
the triangle are formed by the demand curve and the marginal cost curve – average cost
can be ignored.
To find the area of profit, look at the vertical distance between the average cost curve and
the demand curve at the quantity being produced – the marginal cost curve can be
ignored.
7. If you look at a graph of a firm in imperfect competition, you can see that average cost
falls as quantity increases – a firm trying to enter the market and produce a small quantity
will face higher average costs relative to the big, established firm that is producing a large
quantity.
8. In a simultaneous game, both players pick a strategy without knowing what the other
player is choosing, as in rock-paper-scissors. In a sequential game, players take turns
choosing strategies/making moves, as in checkers or chess.
9. A Nash Equilibrium is an outcome where neither player has an incentive to change
strategy, assuming that the other player doesn’t change theirs (in the prisoner’s dilemma
game, there are four outcomes represented by the four cells).
A Dominant Strategy is a strategy that will always lead to a higher payoff, regardless of
what the other player chooses (in the prisoner’s dilemma game, there are two strategies,
cooperate or defect).
There can be Nash equilibrium and no dominant strategy! (For example, in the pick a
number game).
10. Backward induction is the process of starting at the end of a sequential game and
eliminating strategies and outcomes until the beginning of the game is reached – there is
a good example of this on the old exam.
11. Your answers should look like the graphs posted on WebCT as
‘FourExternalitiesGraphs.’ Study these and practice drawing them until you feel
comfortable doing it on your own.