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Fall 2010, Econ 002, Section 001 Study Guide for the Final 1. The final is comprehensive. Most weight (16 points out of 40) will be put on material covered after exam 2 (units 9,10,11,12). 2. You will have 45 minutes for Part 1 and 2 hours for Part 2. 3. Make sure that you go over all homework answer keys and compare them with your submissions. Spot the points you got wrong. If you feel that you do not understand the right answer, consult your instructor for clarification. 4. Study the practice questions posted. 5. Make sure you know how to solve the following types of questions. Note that these are not the only questions that can come up but they cover the basic concepts thought in this class. i. Given demand curve and marginal cost, find the profit maximizing price and quantity for a monopolist, as well as the profit level. ii. Finding the price a monopolist would charge using a diagram of demand, marginal revenue and marginal cost. iii. Calculating the deadweight loss created by a monopolist and by an excise tax iv. Finding comparative advantage using the production levels of two countries for two goods. v. Given supply and demand curves, find equilibrium price and quantity. vi. Identify whether dominant strategies exist in payoff matrix of a simultaneous game. vii. Finding max-min strategies in a payoff matrix. viii. Transforming a simultaneous game to a sequential game by drawing and labeling a game tree. ix. Identify efficient, inefficient, feasible and infeasible points in a diagram of the PPF. x. Calculate the HHI given information on market shares of firms in an industry. xi. Calculate price elasticity of demand using two points on the demand curve. 6. Here are some typical questions from past quizzes and their answers. given a level of marginal cost and a demand curve, how to find the quantity produced by a competitive curve: we know that P=MC for a competitive firm, use this in the demand curve, P = a – b*Q => insert P, solve for Q. characteristics of a perfectly competitive market: There are many firms, each too small to influence the market price. Firms produce identical (homogeneous) products. Households have perfect information about qualities and prices in the market. Firms have perfect information about technologies and input costs. There are no barriers to entry. the concept of being a ‘price taker’: the firm's demand curve is horizontal at the competitive price, the firm sees a price in the market that it cannot affect. If the firm charges a price slightly above that market price, it will not sell any product. identifying the graph of a demand curve faced by a price taker: in the figure below, this is depicted by graph 2. The demand faced by this firm is perfectly elastic. the market demand curve in a perfectly competitive industry is downward sloping: note the difference between the demand curve faced by a firm vs. the market demand curve under perfect competition. The latter is downward sloping, the former is flat. A perfectly competitive firm produce a positive quantity if at the market price, marginal cost curve is above the average variable cost curve. For instance, in the graph below, if P=4, a competitive firm produces 8 units (although MC < ATC. Note that ATC matters for the long-run. In the short-run, the firm will produce as long as P=MC > AVC). If P=1, it does not produce since P=MC < AVC there. In the figure below, the left hand side graph represents a perfectly competitive industry and the right hand side graph represents a perfectly competitive firm. Note that at the equilibrium price (P=5), the firm is making zero economic profits (because P=ATC). Reading marginal revenue from price & quantity table. Suppose a monopolist faces the following demand curve: What is the marginal revenue of the 5th unit of output? Price Quanity $90 0 $80 1 $70 2 $60 3 $50 4 $40 5 $30 6 $20 7 In this question, first find total revenues for the 4th and 5th units: for 4 units, total revenue is $50*4 = $200. For 5 units, it is $40*5 = $200. For both 4 and 5 units, the firms earns $200. So, the 5th unit does not bring in additional revenue, its marginal revenue is zero! The concept of Pareto efficiency: If in a situation, some economic agent can be made better off without making any other economic agent worse off, that situation is NOT Pareto efficient. Consider splitting $100 between two people. Any division that does not leave any money in the table is Pareto efficient (why?). Any division where there is money left on the table, is NOT Pareto efficient. Marginal revenue product of labor (MRPL) is the additional revenue contributed by the last worker employed. As more and more labor is added, MRPL falls (because of diminishing returns) The firm hires labor until MRPL = wage. Reading marginal product, marginal revenue product, and marginal profit from a table: Effects of an increase in labor supply: An increase in labor supply will result in lower wages, more people will be hired. In the input markets, a perfectly competitive firm using multiple inputs maximizes profit by hiring inputs until the marginal product per dollar is the same for all inputs. Then all inputs contribute the same at the margin. If this was not correct (one input generates more revenue at the margin) the firm could increase profits by using more of that input, and less of some other inputs. An example for the above: You own a bagel shop that uses capital and labor in its production process. You recently realized that your marginal product per dollar for capital is larger than your marginal product per dollar for labor. What should you do to increase profit? A. B. C. D. You should increase the amount of capital you are using You should increase the amount of labor you are using You are already maximizing profit so you should not make any changes You should hire more capital and more labor to increase profit The right answer is (A). You are using too little capital compared to labor. Because of diminishing marginal returns, as you use more of an input, its marginal product revenue decreases. If you realize that the MRP of an input X is below the MRP of another input Y, this only happens because you have not used enough of input X. Another similar question: Your bagel shop uses both capital and labor in the production of bagels. In this production process capital and labor are substitutes. If you install a new oven and the marginal product of capital (MPK) increases, you will A. B. C. D. reduce the number of workers you employ increase the number of workers you employ reduce the amount of capital you are using not make any changes since you are already maximizing profit You will reduce the number of workers. This way MPL will increase (more labor reduces MPL, less labor increases MPL). You will fire workers until the value of MPL equals the value of MPK. The difference between accounting and economic profits: you can have positive accounting profit and zero economic profit at the same time. The first one is simply revenue minus direct expenses. The latter takes into account the opportunities you could have exploited with your time and capital. Price elasticity of demand: when you look at the demand curve at (P,Q) graph, elasticity is about the slope of the line. If it is steep, it is inelastic. If it is flat, it is elastic (remember, horizontal line is perfectly or infinitely elastic). In the below figure, (A) is the least elastic, and (C) is the most elastic demand curve: Compared to a perfectly competitive firm, the demand curve facing a monopolistically competitive firm is A. B. C. D. is more elastic. less elastic. perfectly elastic. perfectly inelastic. The correct answer is B. For a competitive firm, demand is infinitely elastic. In a monopolistically competitive industry, in long run equilibrium A.firms produce at minimum average total cost and make zero economic profit. B.firms produce at minimum average total cost and make positive economic profit. C.firms produce at greater than minimum average total cost and make positive economic profit. D.firms produce at greater than minimum average total cost and make zero economic profit. Correct answer is D. In the long run, the monopolistically competitive firm produces at a level where demand curve is tangent to the ATC curve. At that point, price is greater than minimum average total cost. Entry eliminates economic profits. For a monopolistically competitive firm, A. price is equal to marginal revenue. B. price is greater than marginal revenue. C. price is less than marginal revenue. D. price can be greater than or less than marginal revenue. Correct answer is B. Note that this does NOT mean that MR is not equal to MC. This condition still holds. However, price is greater than MC. In long run equilibrium, a monopolistically competitive firm will produce a quantity A. B. C. D. where average total cost is at a minimum. that is less than the quantity where average total cost is at a minimum. that is more than the quantity where average total cost is at a minimum. where marginal cost intersects average total cost. Correct answer is B. Suppose a monopolistically competitive firm in the short run is selling 100 units of output at $10 each. At that level of output, MR = MC and marginal cost is rising. Also, ATC = $15, AVC = $12 and AFC = $3. This firm should A. continue to produce 100 units of output since MR = MC. B. increase output to the point where price equals marginal cost. C. decrease output to the point where marginal cost equals average total cost. D. shut down and produce 0 units of output. Correct answer is B. Since MC is increasing, and price is already less than ATC, if the firm increases production, MR will fall short of MC and the firm will make negative profits.