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ECON 1001
Tutorial 8
Q1)Smith is a corn farmer earning economic
profits and Wesson is a wheat farmer receiving
a normal profit. Wesson has an incentive to
become a corn farmer because
A)
B)
C)
D)
E)
His accounting profits are negative.
He is not currently covering his opportunity costs.
He could earn more than his next best alternative.
His accounting profits are zero.
He dislikes Smith and wants to undermine Smith’s
profit.
Ans: C
• Economic π = Total Revenue – Total Cost
• When we calculate the economic profit, the cost we use
is the opportunity cost of factors of production.
• In particular, the OC of whatever (may it be physical or
psychological efforts) the farmer contributes to the
production process is included
• All rational farmers of course will choose the alternative
that yields the highest economic profit.
• Thus, Wesson will be attracted to corn farming. (C)
Q2) One difference between the long run
and the short run in a perfectly
competitive industry is that
A) πLR > πSR at all times.
B) πSR > πLR at all times.
C) Firms necessarily produce Q that minimises
ATC only in the LR.
D) MR = P only in the LR
E) π are maximised when MR = MC only in LR
Ans:C
• Options A and B are wrong.
• A counter-example is enough to illustrate that they are
both wrong, i.e., the strict inequalities do not hold in
some situations.
• The example: If in the short run the market price is at the
minimum ATC of the perfectly competitive firms, the firms
will choose to produce Q where P=MC=min ATC,
earning zero profit. Note that in the LR, firms will always
produce at P=MC=min ATC.
• In this case, πLR = πSR , not strict inequality as claimed in
A and B.
• Option D is wrong because perfect competitive firms
take price as given and hence P=MR in both SR and LR.
A graphical illustration for the
previous slide
P, MC, ATC
MC
ATC
PSR = PLR
QSR=QLR
Q
• Option E is also obviously not true. In
both SR and LR (at all times), the profit
maximising condition is MR = MC.
• Option C is the right answer.
• In the LR in perfectly competitive market,
entry and exit are free. Positive economic
profits attract entry. Negative economic
profits force firm to exit. Thus, in the LR, a
perfect competition firm must earn zero
economic profit, hence must be producing
at Q that minimises ATC.
Q3) What is the sequence of changes
resulted from how a perfectly
competitive industry responds to a
sudden increase in popularity of the
product? The mkt D shifts to the right
causing the market…
C) Price to ↑. ↑π attracts new firms to
enter, shifting supply to the left.
LR
market equilibrium will be at a higher
quantity but same price as
before.
• Some features of a perfectly competitive
industry:
– Identical firms: all firms face the same cost
curves.
– Free entry and exit. New firms can enter and
existing firms can leave freely.
– Homogeneous products.
Demand increases – SR in Perfect Competition
P, MC,
ATC
P
D’
S
D
MC
P2
ATC
P1
Q
When there is an increase in demand
(D shifts to the right), price increases.
Note that entry and exit cannot happen
in the short run.
q1 q2
q
The only response will come from
individual firms expanding the output
(along the firms’ MC or supply curve).
Demand increases – SR in Perfect Competition
P, MC,
ATC
P
D’
D
P2
S
Profit
MC
ATC
P1
q1 q2
q
Q
Suppose the market was originally at LR equilibrium so that each firm is earning
zero economic profit and producing at the output corresponding to min ATC. As
price has increased, the new price must be above ATC. Hence, all current firms are
earning positive economic profits.
LR Adjustment – Supply Increases and Price Drops
P, MC,
ATC
P
D’
S
D
S’
MC
ATC
P2
P1
Q
q1 q2
q
• In LR, the positive economic profit will
attract new comers to enter the market. It
is because a positive profit means they
can make more earnings than elsewhere.
• As new firms enter the market, the
quantity supplied at all prices rises.
• This shifts the Supply Curve to the right.
• As all firms are identical, their min ATC
points are all the same.
• New firms will continue to enter the market
until the price is exactly = min ATC.
• Therefore, the price returns to the original
level. But since more firms are now in
operation, the new MARKET quantity
supplied is higher than the original level.
(C) (Note: Individual firm produce q1 in the
LR!)
Q4) Assume that the market is currently as
shown in the graph on the left (i.e.
current price is $8). In the LR
equilibrium in this market under free
entry and exit,
A)
B)
C)
D)
E)
P=$5, 20 firms producing.
P=$5, 10 firms producing.
P=$8, 20 firms producing.
P=$5, Total Q=500, no. of firms unknown.
P=$2, Total Q=700, 70 firms producing 10
units each.
Ans:A
• At the current price of $8, each existing
firm is earning a positive economic profit.
• This is because P > ATC at the level of
production.
• A positive profit will attract new comers to
join the industry.
• As more firms are producing, the market
supply shifts to the right.
Market
Price
Profit attracts new firms,
causing market supply to
increase.
Supply
Individual Firm
$ / unit
S’
MC
8
ATC
5
Demand
Q
10
25
30
q
• By how much will the market supply curve
shifts rightwards?
• As supply increases, market price drops
and quantity transacted increases.
• As all firms have identical cost functions,
price will drop all the way to the breakeven point – min ATC. The new eq. price
will be $5.
• Let’s look at the Market Demand schedule.
• At P=$5, Qd = 500.
• That means in the LR, the eq. P = $5 and
eq. Q = 500.
• Each firm produces 25 units at P=$5.
• Hence, there will be 20 firms producing. (A)
Q5) Economic profits are earned by ?
while economic rents are earned
by ? .
A)
B)
C)
D)
E)
Firms in perfect competition; landlords.
All inputs to production; only land and buildings.
Firms; unique inputs to production.
Workers; entrepreneurs buildings.
Firms in the long run; firms in the short run.
Ans:C
• If price is above ATC, then there is a profit.
This profit is said to be earned by the firm.
• One way to interpret the economic rent
(not always right): If each factors of
production is earning an income higher
than the cost of producing this factor, then
it is said that they are enjoying an
economic rent. [E.g., the cost of producing
land is zero. The income to the this factor
is an economic rent.]
• Another way to interpret the economic rent:
(textbook: p 229)
e.g. As a talented cook, your customers
are willing to pay 50% more to dine in your
restaurant.
• Thus, your boss will be willing to pay, at
the most, 50% higher salary than a normal
cook.
• In this case, your economic rent (as the
‘unique’ cook in town) is the difference in
your wage minus the wage of a ‘normal’
cook.
• In this case, your boss is paying all the extra
revenue generated by you to you as a pay raise
(to keep your loyalty)
• Thus, how much is your boss’ economic profit?
ZERO in this case! (p. 228, textbook)
• Note: econ profit (earned by firm)
econ rent (earned by the specific factor)
• This question is about definitions and some
basic concepts of production. Please refer to
the lecture notes and the book for further details.
Q6) A new production technique that
reduces costs in a perfectly competitive
industry will result in
A) Widespread industry adoption and a lower
price to consumers.
B) Industry consolidation.
C) Sustained economic profits for the first firms
that adopt the technique.
D) A rightward shift in the demand curve.
E) Entry by new firms but a sustained economic
profits for the existing firms.
Ans:A
• One of the features of perfect competition
is perfect information.
• That means everyone knows everything
about production, demand and supply of
the products.
• A new technique in production invented
will be immediately known to all producers
in the industry.
P, MC,
ATC
MC
P1
ATC
ATC’
P2
q
• Therefore, this new technique will be
adopted by all firms.
• All firms’ ATC will shift down to the same
level and by the same extent.
• This drives down the market price
• As a result, (A) is the correct answer.
Background story for Questions 7 and 8:
•
Street vendors in Austin were making an
Revenue of $150,000 and Costs were
$85,000.
•
Now sellers need a permit to run their
businesses. Permits are issued to existing
vendors, but no new permits will ever be
issued.
•
These permits are freely transferable, with
no expiration date.
•
Interest rate = 10%
Q7) After regulation, street vendors who
own permits earn
A)
B)
C)
D)
E)
Economic profits of $65,000
Accounting profits of $65,000.
Economic losses of $585,000.
Economic profits of 0.
Accounting profits of 0.
Ans:D
• Before regulation, each vendor was
enjoying an economic profit of $65,000.
• With the regulation, permits are issued to
these existing vendors for free.
• At this point, we can still say that each
vendor is earning an econ π of $65,000.
• However, permits can be bought and sold
without restrictions.
• That means existing vendors now have
the option of quitting their businesses and
selling their permits to new vendors.
• The market price of the permit then
becomes an implicit cost of production.
• What is the market price of these permits?
• It would be the highest amount that new
vendors are willing to pay in order to join
the industry.
• This would be the before-regulation
economic profit.
• which is $65,000.
• With this extra $65,000 of implicit cost,
each street vendors will earn no economic
profits. (D)
Q8) Max, one of the current street vendors,
has gone from earning an economic
profit to earning a normal profit
because
A)
B)
C)
D)
E)
Fewer people come to shop.
His explicit costs have risen by $65,000.
His revenues have fallen by $65,000.
His implicit costs have risen by $65,000.
His implicit costs have risen by $650,000
Ans:D (see Q7 for explanation)
Q9)The efficient market hypothesis suggests
A)
Newsletters with stock tips and recommendations are
helpful to investors.
B) A significant lag exists between new info and changes
in stock price.
C) There is little incentive for insider trading.
D) Information in stock tip newsletters is too outdated to
be useful.
E) Some stock tip newsletters are helpful, others are
useless.
Ans: D
• What is the efficient market hypothesis?
• At any moment, the market price of a
firm’s stock reflects all currently available
information.
• All currently available information includes
any information about the present value of
the firm’s current and future accounting
profits.
• In other words, any information about
stock prices, any tips published in
newsletters, magazines and ‘hint-books’ is
already known and digested.
• The current stock price must have already
reflected those tips and information.
• Therefore, (D) is the answer.
Q10) Suppose a Ph.D. mathematician discovers
“the formula” for picking stocks, using wellknown statistical models and publicly
available data. One can predict that
A)
B)
C)
D)
E)
He will become the wealthiest man in the world.
He will always outperform the market.
Other investors will ignore his behaviour.
As his success becomes well known, other investors
will mimic his choices and thereby drive his return
down.
He can sustain his success forever.
Ans: D
• The approach of this PhD mathematician
can be successful only if the market is
inefficient, i.e., Efficient Market Hypothesis
is violated.
• That is, changes in accounting profits are
not correctly reflected in the stock prices.
• That means the PhD is exploiting the fact
that stock prices do not correctly reflect all
the market information – via a statistical
models and the use of publicly know
information.
• Note that news and information travels fast
in the world, especially in the financial
world.
• It will soon be known that this
mathematician is making a lot of money in
the stock market.
• Once known, everyone will be wanting to
discover his ‘secret’, to know how he
makes so much money.
• He may have protected his “formula” well, by
means of intellectual properties or simply trade
secret.
• However, it is not difficult to follow his decisions
(his buy and sell orders are observable), and we
can earn similar profit.
• These trades (that exploit the inefficiency in the
market of incorporating the market information
into stock prices) will help to make the stock
prices moving toward its “fundamental value”
(i.e., the price that will reflect all its accounting
profit).
• Once the market becomes more efficient,
the ability of the “secret formula” to beat
the market is lowered, and hence less
return will be earned.
• Hence (D) is the answer.