Eco 201
Final Exam
Name______________________________
2 July 2009
Please write answers in ink. You may use a pencil to draw graphs.
Allocate your time efficiently. Good Luck.
1. Why did airlines that once were regulated by the government generally fail to earn an
economic profit, even on routes with relatively high fares?
When fare reductions were prevented by regulators, airlines competed with one another by
offering additional, costly services in order to differentiate themselves from competitors. Since
economic profit is the difference between total revenue and total cost, high fares were often
outweighed by even higher costs.
2. The city of New Orleans has 200 advertising companies, 199 of which employ designers
of normal ability at a salary of $100,000 a year. Paying this salary, each of the 199 firms
makes a normal profit on $500,000 in revenue. However, the 200th company employs Janus
Jacobs, an unusually talented designer. This company collects $1,000,000 in revenues because
of Jacobs's talent.
a. How much will Jacobs earn? What proportion of his annual salary will be economic
rent?
Jacobs will earn $600,000 per year. This equals the normal salary for a designer, $100,000, plus
the economic rent he collects for his special talent, $500,000. 5/6 of his salary is thus economic
rent.
b. Why won't the advertising company for which Jacobs works be able to earn an
economic profit?
If Jacobs’s employer withholds some of the additional revenue it takes in as a result of hiring
him, some other advertising company will offer him a higher salary and still manage to earn an
economic profit. Bidding for Jacobs will continue until firms are indifferent between paying him
$600,000 and hiring any other designer for $100,000.
3. Explain carefully why, in the absence of a patent, a technical innovation invented and
pioneered in one tofu factory will cause the supply curve for the entire tofu industry to shift
to the right. What will finally halt the rightward shift?
Suppose that the tofu industry is initially in a long-run equilibrium in which each tofu firm earns
zero economic profit. The innovation will cause one tofu factory’s costs to fall, and the firm that
owns the factory will earn an economic profit in the short run because the market price of tofu
will not immediately change. As other firms that are already in the industry adopt the innovation,
they too will make an economic profit. These economic profits will attract new firms into the
industry and this will shift the supply curve for tofu to the right, causing the market price of tofu
to fall. The decline in price will continue as more firms enter, until finally there is no more
economic profit to be made. The industry will then be in a new long-run equilibrium in which
each tofu firm earns zero economic profit.
4. The government of the Republic of Self-Reliance has decided to limit imports of machine
tools, to encourage development of locally made machine tools. To do so, the government
offers to sell a small number of machine-tool import licenses. To operate a machine-tool
import business costs $30,000, excluding the cost of the import license. An importer of
machine tools can expect to earn $50,000 per year. If the annual interest rate is 10 percent,
for how much will the government be able to auction the import licenses? Will the owner of a
license earn an economic profit?
If the import licenses were free and could not be transferred, owners of each license would make
an economic profit of $20,000 per year. When the annual interest rate is 10 percent, the most a
buyer will be willing to pay for a stream of economic profits of $20,000 per year is the amount of
money she would have to put into a savings account to earn that much interest each year.
$20,000
Applying the present-value formula, PV =
= $200,000 . Thus, if the import licenses are
0.10
auctioned, they will sell for this $200,000 and the government will earn an economic rent of
$200,000 per license. The buyers of the licenses will make no economic profit.
5. Serena is a single-price, profit-maximizing monopolist in the sale of her own patented
perfume, whose demand and marginal cost curves are as shown. Relative to the consumer
surplus that would result at the socially optimal quantity and price, how much consumer
surplus is lost from her selling at the monopolist's profit-maximizing quantity and price?
See graph below. The profit-maximizing quantity is 8, the quantity for which MR=MC. The
socially optimal quantity in this market is 12, the quantity for which MC = demand. The
increase in consumer economic surplus that results when Q increases from 8 to 12 is the area of
the blue-shaded trapezoid, or $100 per day.
6. TotsPoses, Inc., a profit-maximizing business, is the only photography business in town that
specializes in portraits of small children. George, who owns and runs TotsPoses, expects to
encounter an average of eight customers per day, each with a reservation price shown in the
following table.
a. If the total cost of each photo portrait is $12, how much should George charge if he must
charge a single price to all customers? At this price, how many portraits will George produce
each day? What will be his economic profit?
To answer this question, we need a table of George’s total and marginal revenue:
Customer
A
B
C
D
E
F
G
H
Reservation price
50
46
42
38
34
30
26
22
Total revenue
50
92
126
152
170
180
182
176
Marginal revenue
50
42
34
26
18
10
2
-6
Since marginal cost = $12, George will set a price consistent with serving only the first five
customers. That price is the reservation price of the fifth customer, $34. His profit will be $170 $60, or $110 per day.
b. How much consumer surplus is generated each day at this price?
Consumer surplus = $(50 + 46 + 42 + 38 + 34) - $170, or $40 per day.
c. What is the socially efficient number of portraits?
The socially efficient number is 8, since each customer has a reservation price that exceeds the
marginal cost of production.
d. George is very experienced in the business and knows the reservation price of each of his
customers. If he is allowed to charge any price he likes to any consumer, how many portraits
will he produce each day and what will his economic profit be?
George will produce 8 portraits, and his economic profit will be $(50 + 46 + 42 + 38 + 34) - $96,
or $192 per day.
e. In this case, how much consumer surplus is generated each day?
No consumer surplus will be generated since each customer is paying a price equal to their
reservation price.
f. Suppose George is permitted to charge two prices. He knows that customers with a
reservation price above $30 never bother with coupons, whereas those with a reservation price of
$30 or less always use them. At what level should George set the list price of a portrait? At what
level should he set the discount price? How many photo portraits will he sell at each price?
The ability to offer a rebate coupon allows George to divide his market into two sub-markets.
The table of total and marginal revenue for the list-price sub-market is as follows:
Customer
A
B
C
D
E
Reservation price
50
46
42
38
34
Total revenue
50
92
126
152
170
Marginal revenue
50
42
34
26
18
George should set the price at $34 and sell 5 photos per day in this market. In the discount-price
sub-market, the table of total and marginal revenue is as follows:
Customer
F
G
H
Reservation price
30
26
22
Total revenue
30
52
66
Marginal revenue
30
22
14
The discount price should be $22; George should sell three photos in this market.
g. In this case, what is George's economic profit and how much consumer surplus is generated
each day?
George’s economic profit is now $34(5) + $22(3) - $96, or $140. Consumer surplus is
$(50+46+42+38+34) - $170, plus $(30+26+22) - $66, or $52.