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Foundations of Economic Analysis
Fall 2006 Test 02 in-class
Stratton
Name _______Key____________
Description: This is the in-class portion of the test. It is divided into three (3) sections:
definitions, short answer, and problems. Your ability to demonstrate understanding, insight and/or
the ability to use the material is the primary purpose of the assessment. Thus full credit will only
be earned if you follow the directions carefully and provide the explanation, description, thought
process as directed. Note the slight difference in the weight of the questions in each section and
allocate your time accordingly. You do NOT have to begin at the beginning; just make sure you
label your answers clearly!
Instructions: All answers are to be in the booklet provided. While you may want to use the test
page as scratch paper, only the responses in the booklet will be graded. Please be sure to write
legibly, identify the question being answered, and clearly mark any information you want
ignored.
Definitions(Q1 – 5) (10 points total – 1 point each for definition, 1 point each for significance):
For each term, write a short definition in your own words and explain the significance of the
term. The significance should explain at least one use of the concept (term) in economics.
1.
Short-run production function
– A function showing the relationship between
inputs and outputs, when at least one input is fixed (constant). From this relationship a
firm can construct its short-run cost functions. It is important in the understanding of
management decision-making.
2.
Sunk costs
– Costs that have already been incurred or Historic
costs. They are irrelevant for deciding on the optimal course of action (production level),
but do help to determine the level of benefit (profit) derived from the action.
3.
Minimum efficient scale (MES)
– the smallest operating unit (plant size) at which the
long rum average total cost of production is minimized. Firms operating at scales smaller
than MES will face a cost disadvantage in the market.
4.
Cartel
– An organization of firms that agree to coordinate
their pricing and output decisions in order to meet organizational goals (usually to
maximize profits for the organization). Cartels arise in oligopoly markets as a strategy for
increasing profits. In the US they are illegal.
5.
Pure public good
– A commodity (good or service) which is
characterized by non-rival consumption (consumption of the good by one person does not
affect its consumption by another) and for which there are very high costs of exclusion (it
is very costly to deny the commodity to one person if the commodity is available to
anyone. Private markets do not provide such commodities efficiently, if at all. Some
alternative arrangements for their provision are necessary.
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Short Answer Questions(Q6 – 17) (36 points total – 1 point each for the answer, 2 points each
for explanation or reasoning): Answer each question in the booklet provided. Please indicate
any assumptions you make; explain your thinking; and show all work to receive full credit.
6.
Assume a firm is currently producing 100,000 pairs of shoes per year. Its total cost (TC)
is $1 million per year and its average variable cost (AVC) is $9. Find the firm’s total
fixed cost (TFC), average total cost (ATC), and average fixed cost (AFC).
TFC = TC – TVC thus TC = $1 million, TVC = AVC * Q = $9 * 100,000 = $900,000.
Thus TFC = $1,000,000 - $900,000 = $100,000 per year.
ATC = TC / Q = $1,000,000 / 100,000 = $10 per unit.
AFC = ATC – AVC = $10 - $9 = $1 per unit.
Or AFC = TFC / Q = $1,000,000 / 100,000 = $1 per unit.
7.
As more labor is used (other things held constant) output (TP) at first increases, reaches a
maximum and then declines. What is the value of marginal product of labor (MPL) at the
point that TP is at its maximum?
MPL = 0. If MPL > 0, then TP is increasing; If MPL < 0, then TP is decreasing; since TP
first increases (MPL>0) and then decreases (MPL<0) MPL must = 0 at TP maximum.
8.
As more labor is used (other things held constant) output (TP) at first increases, reaches a
maximum and then declines. Assuming labor is the only variable input, what do we know
about the AVC and MC at the level of output at which the marginal product of labor
(MPL) equals the average product (AP)?
AVC is minimum and MC = AVC. If AP = MP, then AP is at its maximum. That means
that the firm is getting the maximum output per unit of variable input (labor). With
wages constant, maximum AP implies minimum AVC. If MC < AVC, then AVC is
decreasing; If MC > AVC, then AVC is increasing; since AVC first decreases (MC <
AVC) and then increases (MC > AVC). MC = AVC at AVC minimum. Thus we also
know that MC = AVC at this level of output.
9.
In a monopolistically competitive market will a firm earning zero economic profit shut
down in the long run? Why or why not?
No. Earning zero economic profit means they are earning a profit comparable to
alternative uses of the resources. Thus there are no other opportunities to use the
resources more productively and no reason to shut down. In fact, if they do shut down,
those resources will be used in other endeavors and be able to earn zero profit, at most.
10. Is it possible for a monopolistic firm to earn zero economic profit in the short run?
Yes. In the short run demand for the product might fall sufficiently to eliminate all
economic profits.
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Use this information for the next 2 questions. In a perfectly competitive industry, the market
price is $12. One representative firm in the industry is producing 10,000 units per month, its
average total cost is $15 per unit, its average variable cost is $8 per unit and its marginal cost
is $8 per unit.
11. Is the firm maximizing its profits? If not, should the firm increase or decrease output to
maximize profits? Please explain.
The firm is not maximizing profits, since Price > MC. Thus MR > MC and the firm
should increase production until P = MC.
12. Is the firm minimizing its average total cost? If not, should the firm increase or decrease
output to minimize average total cost? Please explain.
No the firm is not minimizing ATC, since minimum ATC occurs where ATC = MC.
Since ATC > MC the firm should increase production until ATC = MC to minimize
ATC.
Use this information for the next 3 questions. In a perfectly competitive industry, the market
price is $15. One representative firm in the industry is producing 10,000 units per month, its
average total cost is $12 per unit, its average variable cost is $10 per unit and its marginal
cost is $12 per unit.
13. Is the firm maximizing its profits? If not, should the firm increase or decrease output to
maximize profits? Please explain.
The firm is not maximizing profits, since Price > MC. Thus MR > MC and the firm
should increase production until P = MC.
14. Is the firm minimizing its average total cost? If not, should the firm increase or decrease
output to minimize average total cost? Please explain.
Yes the firm is minimizing ATC, since minimum ATC occurs where ATC = MC. While
the firm is minimizing ATC, it is not maximizing profits. To maximize profits it must
increase output until MC = P.
15. If this firm is typical of the industry, what do you expect to happen in this market in the
long run? Please explain.
First, while the firm is not maximizing profits it is earning a profit (P>ATC). So I would
expect it to increase output until MC = P. Second, since the firm is typical in the market
and is making an economic profit, I would expect other firms to be attracted to the
market. The long run equilibrium (assuming costs remain the same) would be for the
market price to fall to $12 per unit.
16. Explain what is meant by “non-price competition” and why it is used.
Non-price competition is the act of using non-price characteristics of a product to
differentiate it from rival (substitute) products to increase consumer demand for the
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product. It includes style, size, features, location, branding, etc. It is used to differentiate
one’s product and to capture market share.
17. Advertising campaigns often try to change the firm’s revenue functions by increasing the
firm’s market share and customer loyalty. However, advertising campaigns also change
the firm’s cost functions. How would an economically knowledgeable manager judge the
success of this campaign?
The rule it that the marginal cost of the campaign is less than the marginal benefit.
Therefore for the campaign to be successful, the additional cost of the campaign must be
less than the additional revenue generated by the increased market share and increased
loyalty.
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Problems(Q 18 – 24) (28 points total – 2 points each for the answer, 2 points each for
explanation or reasoning): Answer each question in the booklet provided. Please indicate any
assumptions you make, explain your thinking and show all work to receive full credit.
Figure 1: Presents the relevant cost information for AlphaOmega Company. Output is measured
in units per week and price in dollars per unit.
Firm Costs
MC
$40
ATC
$35
AVC
Price
$30
$25
$20
$15
0
10
20
30
40
50
60
70
80
90
100
110
120
Quantity
18. If AlphaOmega Company operates in a perfectly competitive market and the market price
is $35 per unit, what is the profit maximizing output level?
Profit max occurs at MC=P. In this case MC = $35. Profit maximization occurs at just
under 70 units per week.
19. If AlphaOmega Company operates in a perfectly competitive market. Below what market
price will this firm cease operations (shut down)?
The firm will operate as long as P >= minimum AVC. Thus at a price below $20 per unit
the firm will cease operations.
20. If AlphaOmega Company operates in a perfectly competitive market and the market price
is $30 per unit, what is the maximum amount of profit the firm can earn?
Profit max occurs at MC=P. In this case MC = $30. That occurs at about 60 units per
week. Profit = (AR – ATC)*Q or ($30 - $26) * 60 = $240 per week.
21. If AlphaOmega Company operates in a perfectly competitive market and its costs are
typical of firms in the market, what will be the market price at long run equilibrium?
At long run equilibrium competitive firms earn no profits. That will occur at a market
price of $25 per unit.
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Figure 2: Cost and revenue information for BetaGamma Company. Output is measure in units
per month. These questions are related; a small error at the beginning can be very costly. So be
careful and show all of your reasoning and calculations.
MC
$40
$35
$30
ATC
Dollars
$25
AVC
$20
$15
$10
$5
MR
AR
$0
0
25
50
75
100
125
150
175
200
225
250
Units per month
22. What is the profit maximizing output level for the BetaGamma Company?
Profit max occurs at MC=MR. In this case MC = MR at 75 units of output per week.
23. What is the profit maximizing price the BetaGamma Company should charge?
Profit max occurs at MC=MR. In this case MC = MR at 75 units of output per week.
The maximum price BetaGamma can charge and sell all 75 units per week is $25 per
unit.
24. Estimate the maximum profit (or minimum loss) the BetaGamma Company can earn. Be
sure to show all work to get full credit.
At a price of $25 per unit and selling 75 units of output per week BetaGamma’s TR =
$25 * 75 = $1875 per week. Their TC for 75 units per week is about $22 * 75 units =
$1650 per week. Thus profit is $225 per week. [Alternatively, profit = (AR – ATC)*Q =
($25 - $22)*75 = $3*75 = $225 per week.
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Foundations of Economic Analysis
Fall 2006 Test 02 take-home
Stratton
Name ________Key____________
Description: This is the take-home portion of the test. It is divided into two (2) sections:
problems and applications. Your ability to demonstrate understanding, insight and/or the ability to
use the material is the primary purpose of the assessment. Thus full credit will only be earned if
you follow the directions carefully and provide the explanation, description, and thought process
as directed. Note the slight difference in the weight of the questions in each section and allocate
your time accordingly. You do NOT have to begin at the beginning, just make sure you label your
answers clearly!
Instructions: All answers are to be typed or written on separate paper. While you may want to
use the test page as scratch paper, only the responses separate pages will be graded. Please be
sure to identify the question being answered. If you write out your answers, write legibly and
clearly mark any information you want ignored.
Short Answer Questions(Q1 – 7) (21 points total – 1 point each for the answer, 2 points each
for explanation or reasoning): Answer each question. Please indicate any assumptions you
make; explain your thinking; and show all work to receive full credit.
1.
One approach to reducing pollution is to tax polluters. Consider two tax proposals: 1)
Each firm is taxed $100,000 per year; 2) Each firm is taxed 1% of its sales. Assume the
industry is perfectly competitive. Compare and contrast the impact of each proposal on a
typical firm’s profit maximizing output level and short run profit.
Proposal 1 increases FC and thus TC but not MC. Thus it will reduce the firm’s profits, but not
change its profit maximizing output. Proposal 2 increases VC and thus TC and MC. Thus it will
reduce the firm’s profit maximizing output level as well as its profits.
2.
Successful advertising campaigns tend to increase the firm’s market share and customer
loyalty. Carefully describe how such a successful advertising campaign would affect the
demand faced by the firm.
If the advertising campaign increased market share, the firm’s demand curve would shift to the
right. If the advertising campaign increased consumer loyalty, it would mean fewer customers
would switch if the price increased (demand becomes more inelastic or less elastic). This should
translate into the firm facing a less elastic demand to the right of current demand and allow
increased price and maybe output (in SR).
3.
If monopolies reduce economic efficiency as compared to perfect competition, as we
have argued, why do governments try to protect particular sellers against the competition
that additional entrants would create?
For a variety of reasons. 1) to accommodate political interests, 2) to allow economic profits as a
reward for innovation, 3) to stimulate research, 4) to prevent the loss of economies of scale – to
name a few.
4.
How might government restrictions on advertising benefit producers?
If advertising is self-canceling – that is my advertising offsets your advertising – and market
shares are not permanently affected, then firms could lower costs (FC) by reducing advertising.
But no one firm has that incentive, so they do not do it on their own. However, if government
mandated it (or enforced an agreement to reduce it) then the firms could benefit by reduced fixed
costs and increased profits.
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Foundations of Economic Analysis
Stratton
Some purposes of advertising are to differentiate a product, build brand loyalty and
increase market power. To the extent that the advertising is successful, one could argue
that it increases inefficiency. What economic benefits does advertising provide that, at
least partially, offset these inefficiencies?
The primary positive aspect of advertising is that it provides information. If this information is
relevant to consumer choice, that is a benefit.
6.
Assume an industry is characterized by many medium firms, but no small or large firms.
Draw a representative LRAC and industry demand for the industry. Explain how your
drawing is consistent with the industry description.
Assume there are n firms; the MES will occur about output level 1/n. The LRAC will have a
relatively steep gradient.
7.
Briefly explain why typical firms in a monopolistically competitive market earn zero
economic profits in the long run.
One characteristic of monopolistic competition is low barriers to entry. If firms in the market
(industry) are making an economic profit (more than their can earn in alternative pursuits) than
other entrepreneurs will be attracted to the market and firms will enter. More firms in the market
will increase the supply, there will also be less differentiation between products so the elasticity
of demand facing each firm will increase. This combination forces the equilibrium price down.
Firms will continue to be attracted to the market as long as profits are positive. [Firms will exit if
profits are negative and the process is reversed.] Thus in the long run, firms will typically earn
zero economic profits.
Problems(Q 8 – 10) (12 points total – 2 points each for the answer, 2 points each for
explanation or reasoning): Answer each question. Please indicate any assumptions you make,
explain your thinking and show all work to receive full credit.
Figure 1oc: Cost and revenue information for DeltaBeta Company. Output is measure in units
per month. These questions are related; a small error at the beginning can be very costly. So be
careful and show all of your reasoning and calculations.
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MC
$40
$35
$30
ATC
Dollars
$25
AVC
$20
$15
$10
D
$5
MR
$0
0
25
50
75
100
125
150
175
200
225
250
Units per month
8.
Estimate the Lerner Index (price-cost margin) for this profit maximizing firm. [Hint:
calculate the index using the profit maximizing price-quantity combination.]
Lerner index (the price-cost margin) is one measure of the extent of concentration
(market power). It is calculated as (P – MC)/P. In this case the profit maximizing price
is about $21 at an output level of 100 units. The MC at 100 units is about $13. So the
Lerner index is ($21 - $13)/$21 = 0.38. This is comparable to the concentration for all
food and tobacco products (0.3 p. 203).
9.
Describe the market structure in which the DeltaBeta Company operates. Be sure to
clearly indicate the differentiating characteristics that allowed you to identify the market
structure. [Do not assume market structure in #10 below!]
DeltaBeta has some market power, since it faces a downward sloping demand. We
cannot know more for sure without knowing the number of competitors it faces. If there
are many competitors, it would be operating in a monopolistically competitive market.
If there are no close competitors, it is a monopoly. If there are only a few competitors, it
would be operating in an oligopoly market. However, this is least likely since the
demand facing it would depend on the actions of its rivals. The Lerner index of 0.38
suggests a relatively competitive (unconcentrated) market, most likely monopolistic
competition.
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10. If DeltaBeta Company operates in a monopolistically competitive market and its costs are
typical of firms in the market, what will be the long run equilibrium output and price for
this firm?
At long run equilibrium monopolistically competitive firms earn no profits. However,
they face a downward sloping demand for their differentiated product. So, the long run
output level for this firm will be less than output at minimum ATC (125 units per week)
and it will charge a price greater it minimum ATC (greater than about $17 per unit).
Applications (Q11) (5 points total): Please indicate any assumptions you make and explain your
thinking to receive full credit.
Scenario 1oc:Your text indicates that the FTC opposed the proposed 1997 merger between
Office Depot and Staples, the two largest office supply superstores. FTC opposition hinged, in
part, on the definition of the market (p.233).
The opening case for chapter 8 discusses SBC’s fight with regulators over their practices to limit
competition in local telephone markets. One impression from that article is that the behavior of
the “Baby Bells” (including SBC) was anticompetitive. Yet recently the FTC allowed a $16
billion merger between SBC and AT&T and an $8 billion merger between Verizon and MCI, thus
further consolidating the communications markets. [Current news about the AT&T – Bell South
merger may be of some help.]
11. Assume you represent Quest Communications who opposed these merges. Construct an
argument in opposition to the SBC-AT&T merger using the Staples case as a guide.
The FTC guidelines focus on six major issues (p. 233). The FTC opposed the Staples –
Office Depot primarily on the grounds that it would harm competition in the “office
superstore market”. Thus the opposition depended on the limitation of the market
definition to office supply super stores, not the entire market for office supplies.
A similar argument to oppose the SBC – AT&T merger would focus on defining the
appropriate market to long-distance telephone services, rather than the entire
telecommunications market. Thus, I need to argue that wireless and cable phone services
are not direct competitors in the long-distance phone market. Opposition to the merger
would be supported by cross-price elasticity between long-distance phone services and these
other telecom services that show they are not close substitutes - small cross-price elasticity
coefficients.
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