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Amherst College Department of Economics Economics 111 – Section 3 Fall 2012 Second Examination Solutions 1. (15 points) Consider the market for fast food hamburgers in a large city. There is a very large number of small profit maximizing fast food restaurants in the city, 1,000 fast food restaurants. The demand and curve for hamburgers and the typical firm’s marginal and average cost curves appear below: Market for Hamburgers P ($/hamburger) Typical Hamburger Firm ($/hamburger) S 5.00 MC 5.00 P* = 4.00 4.00 MR = 4.00 3.00 3.00 ATC 2.00 2.00 1.00 1.00 D 100 a. 200 300 400 500 (Thousands of Hamburgers) 600 Q 100 200 300 (Hamburgers) q Illustrate the equilibrium price and quantity by carefully and neatly drawing the appropriate curve(s) in the above diagram. 1) What is the equilibrium i) price? $4.00 i) quantity? 300 thousand 2) How many hamburgers does the typical firm produce? 300 Firms seek to maximum profits. To do so they produce the level of output at which marginal revenue (MR) equals marginal cost (MC). Since the industry is perfectly competitive marginal revenue (MR) equals the price, $4.00. The typical firm’s profit maximizing level of production is 300. b. Is the industry in long equilibrium? ___ Yes ___ X No Explain. The firm is producing 300 hamburgers. The price is $4.00 and the firm’s average total cost equals (approximately) $2.30. Since price exceeds average total cost, the firm is earning positive profit. Owners of hamburger firms are earning more income when operating their firms than they could earn elsewhere. Consequently, entry will occur in the long run. 2 c. In the long run, what happens to the 1) equilibrium quantity? ___ X Increase 2) equilibrium price? ___Increase ___ Decrease ___ X Decrease ____ Remain the same ____ Remain the same 3) number of hamburgers produced by the typical firm? ___Increase ___ X Decrease ____ Remain the same Carefully and neatly illustrate the effect on the above diagram by drawing the appropriate curve(s) on the above diagram. Explain. The market supply curve is the horizontal sum of each individual firm’s supply curve. Since firms enter in the long run, the market supply curve shifts to the right. Consequently, the equilibrium price decreases and the equilibrium quantity increases. The lower price causes the marginal revenue curve to shift down thereby reducing the firm’s profit maximizing level of output. Market for Hamburgers P ($/hamburger) S Typical Hamburger Firm ($/hamburger) S’ 5.00 MC 5.00 P* = 4.00 P** 3.00 4.00 MR = 4.00 P** 3.00 MR’ = P* ATC 2.00 2.00 1.00 1.00 D 100 200 300 400 500 (Thousands of Hamburgers) 600 Q 100 200 300 (Hamburgers) Note that the above diagram does not illustrate the long run equilibrium because the price still exceeds average total cost. Assuming that entry does not cause the cost curves to shift, a long run equilibrium would be established when the price equals minimum average total cost, $2.00. q 3 2. (15 points) There are only a handful of private corporations that deliver packages overnight: Federal Express, UPS, Document Handling Service, etc. Consider the following statements about this industry. Mr. A: “Since there are only a few firms, they are surely colluding to maximize their profits.” ____ Agree ___ X Disagree Explain. Even though there are only a few firms in the industry, collusion need not be occurring. Two conflicting interests could be at work. While it is in the collective interests of the firms to collude, act as a monopoly, and maximize their joint profit, it may be in the individual interest of a firm to cheat on the collusive agreement, produce more in order to increase its individual profit. Mr. B: "I couldn't agree more. Each firm has a great incentive to abide by the collusive agreement that maximizes the industry’s joint profit; if a firm would violate the agreement, its profit would fall." ____ Agree ___ X Disagree Explain. It will be in the individual interest of a firm to cheat on the collusive agreement and produce more whenever its competitors do not retaliate aggressively. In this case, the additional output produced by cheating firm would will increase the cheating firm’s individual profit (but reduce the joint profits of all firms in the industry). Mr. C: “The price the firms are charging exceeds average total cost which means that they are producing at an inefficiently low level of output." ____ Agree ___ X Disagree Explain. The relationship between price and average total cost tells us if a firm’s profit is positive, negative, or zero. If price is • greater than average total cost, profit is positive. • less than average total cost, profit is negative. • equal to average total cost, profit is zero. Efficiency depends on the relationship between price and marginal cost. If price is • greater than marginal cost, an inefficient low level of output results. • less than marginal cost, an inefficient high level of output results. • equal to marginal cost, an efficient level of output results. 3. (10 points) Demand is inelastic for overnight packages. 4 a. If the price of delivering overnight packages decreases, what happens to the 1) quantity demanded? ___ X Increase ___ Decrease ___ No change 2) total revenues firms in the industry collect? ___ Increase Explain. ___ X Decrease ___ No change Total revenue equals price times quantity: TR = P × Q When demand is inelastic, the quantity demanded is not very sensitive to the price. Consequently, when the price decreases the quantity demanded will increase, but not “by very much”: TR = P × Q ↓ ↑ Down Total revenue, the product of price and quantity, decreases. b. If the price of delivering overnight packages increases what happens to the 1) quantity demanded? ___ Increase ___ X Decrease ___ No change 2) total revenues firms in the industry collect? ___ X Increase Explain. ___ Decrease ___ No change When demand is inelastic, the quantity demanded is not very sensitive to the price. Consequently, when the price increases the quantity demanded will decrease, but not “by very much”: TR = P × Q ↑ ↓ Up Total revenue, the product of price and quantity, increases. Ms. D: "Since the demand for overnight deliveries is inelastic, the firms cannot be colluding to maximize their joint profits." ___ X Agree ____ Disagree Explain. Profit equals total revenue less total cost: Profit = TR × TC From part b we know that when demand is inelastic and the price rises: • Quantity decreases; hence, total cost decreases. • Total revenue increases. Profit = TR × TC Up ↑ ↓ A higher price and lower quantity could increase joint profits. Consequently when demand is inelastic the firms cannot be colluding to maximize their joint profits.