Industrial Organization
Midterm#1 (100pts)
Name:
1. (10 pts) Cost function of producing umbrellas is given by C  Q   60  Q  Q2 .
a) Is it a short run or a long run cost function? How do you know?
1. Short run b/c there is a fixed cost
b) What is the fixed and variable cost?
3. FC(Q)=60
5. VC(Q)= Q  Q 2
c) At what quantity average cost is minimized?
7.
Q  60
2. (5 pts) There are two retail technologies, call them “Walmart” and “Grocery store”. Their corresponding costs are
given by CWM  Q   200  Q and CGS  Q   10  2Q .
a) Calculate the quantity at which the two technologies have the same average cost
9. 190
200
10
1   2
Q
Q
200 10
  2 1
Q
Q
b) Draw and label two short run AC ruves and the long run AC curve
11.Q
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3. (25pts) Market demand is given by Q  110  5 P . The cost function of is given by C  Q   16  2Q  Q2
a) Derive firm’s short run supply function
13. Q=0.5P-1, for P>2 and 0 otherwise
b) Derive short run supply of 10 firms. 15. Q(10)=5P-10, for P>2 and 0 otherwise
c) Derive long run supply of 10 firms 17. Q(10)=5P-10, for P>10 and 0 otherwise
Grading comment: some credit was subtracted18.
from incorrect specification of the price inequalities because they represent
a crucial part of the supply.
d) Calculate short run market equilibrium price when there are 10 firms in the market
20. P=12
e) Calculate short run market equilibrium quantity when there are 10 firms in the market22. Q=50
f) What is each firm’s marginal revenue?24. MR=P=12
Grading comment: 3 points were subtracted for incorrect answer to this question because MR=P is a fundamental
characteristic of a perfectly competitive market
g) Calculate each firm’s total revenue 26. TR=60
h) Calculate each firm’s profit
i)
28. Profit=9
Show the relation between firm and market price and quantity on the graph below.
30. Firm
Market
P=MC=2+2Q
SR supply Q=0.5P-1
minAC=AC=MC -> 16/Q+2+Q=2+2Q -> Q=4 => P=2+2x4=10
5P-10=110-5P => 120=10P => P=12 => Q=110-5x12=50
Profit=TR-C=12x5-16-2x5-25=9
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4. (4pts)Hair gel can be produced using one of the two technologies: technology A and technology B. Their respective
cost functions are given by CA  Q   25  Q2 and CB  Q   18  1.5Q2 , which technology will prevail in the long
run competitive equilibrium? Explain why by showing your calculations.BB
33. B
The technology with the lowest AC. To answer this question we need to find both minAC points using minAC=MC
A: 25/Q+Q=2Q
Q=5 P=minAC=10
B: 18/Q+Q=3Q
Q=3 P=minAC=9
Since technology B has lower minAC once the market price falls below 10 all technology A will cease to be used
Grading comments: in many cases correct reasoning did not result in correct conclusion due to arithmetical mistakes.
Substantial partial credit was awarded in those cases
5. (10pts)Market demand is given by Q  80  P  I , where I  20 is the income. The cost function is
C  Q   25  Q2 .
a) Calculate long run output per firm
35. Q=5
b) Calculate the long run price in this market 37. PLR=10
c) How many firms would operate in this market in the long run equilibrium?
39. N=18
minAC=MC 25/Q+Q=2Q Q=5
Market quantity=80+20-10=90
N=90/5=18
P=10
6. (5pts) Starting with your answer to the previous question, assume that the economy goes into a recession and the
income decreases by 50%. What will happen to the profits of the existing firms?
a) Derive the short run supply (don’t forget the shut down condition)41. Q=9P, if P>0
b) Calculate the change in firm’s profits.
43. Profits decrease from ____0_____ to __-4.75______
MC=2Q
Q=P/2
Q(18)=18xP/2=9P
Demand becomes: Q=90-P
Market price becomes: 90-P=9P
P=90/10=9
Market quantity becomes: 90-9=81
Quantity per firm become 81/18=4.5
Profit becomes: 4.5x9-25-4.5x4.5=-4.75
Grading comment: there was substantial deduction for not identifying “ …. from ___0 ____” because to know that profits
are zero in LR equilibrium did not require any calculations and is a fundamental characteristic of a LR competitive
equilibrium
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7. (20 pts)Market demand is given by Q  12  P . Monopoly’s cost is given by C  Q   2  2Q
a) Find marginal revenue
45. MR=12-2Q
b) Find marginal cost
47. MC=2
c) Calculate monopoly quantity49. QM=5
d) Calculate monopoly price
51. PM=7
e) Calculate monopoly profit
53.   23
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f) Demonstrate the above situation on the graph below. Label the demand, MC, AC, MR, equilibrium quantities,
profit.
Q
g) What is the maximum amount that this monopoly would be willing to spend on R&D to lower marginal cost by
50%?
5.25
With MC=1, monopoly quantity becomes 12-2Q=1
Q=5.5
Price becomes 7.5
Profit becomes 5.5*6.5-2-5.5=28.25
This profit is higher than the previous profit by 28.25-23=5.25
8. (2 pts) Explain why a perfectly competitive equilibrium does not exist in industries with constant marginal cost.
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9. (5pts) Jared owns a gas station. Jared’s gas station is a monopoly in a small town with demand that is given by
Q  13  P . His fixed cost is 10, his average variable cost is constant and is equal 1 per unit. Jared buys gasoline
from a refinery at PR  2
57. P=8
a) What price does Jared charge?
59. PNEW=9
b) If the refinery price increases to 4, what will happen to the price of gasoline? (calculate)
c) What will happen to the profit? (calculate)61. Profit will go from __15___ to __6_____
MR=13-2Q=MC=1+2=3
Q=5 P=8
Profit=5x8-10-3x5=15
MR=13-2Q=MC=1+4=5
Q=4 P=9
Profit=4x9-10-5x4=6
10. (2pts) The market demand for corn is given by Q  55  P . Productivity in agriculture depends on the quality of
land. Five farms are located on good land and can produce corn using a technology for which min AC1  5  5 all
other farms (if any) do not have access to the better land of the five farms and can produce corn using a technology
for which min AC1  5  10 . Find the long run price in this market.
63. PLR=10
Note: AC  5 denotes the average cost of 5 units. Feel free to use a graph to show your answer.
At price of 5 farms with the better technology can produce 5 x 5=25 units of output.
But at the price of 5 market quantity is 55-5=50
This means that some of the corn will be produced on bad lands where the minAC=10 and the price will be 10
11. (2 pt)Other than the number of firms, what is the difference between monopoly and perfect competition?
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12. (3pts) Some industries compete on quality. How is the difference in the evolution of industrial structure (i.e. number
of firms) on newspapers and restaurants is driven by the effect of quality on cost?
Increasing quality in newspaper business increases fixed costs and leads to a decrease in the number of firms.
Increasing quality in the restaurant business increases variable cost and leads to an increase in the number of firms
13. (3pts) Perfectly competitive model applies in the strict sense only to a handful of very regulated markets (stock
market, commodities market, foreign exchange market). Many other markets however resemble perfectly competitive
markets and can be analyzed using the perfectly competitive model. Please give one example (from the class
discussion) of a market or an industry that resembles perfectly competitive market structure and describe the
similarities.
14. (1ps) What is the relationship between price elasticity of demand and the price.
65. Monopolies charge higher markups in the markets where the absolute price elasticity is ___low___ (high/low)
15. (3pts) A monopoly pharmaceutical company is selling a drug in two countries with different incomes. The demand
for drug in both countries is given by Q  100  P  I , where I is the income. The income of the Cowbonia is 20 and
the income of Ramsia is 10. The constant marginal cost is the same in both markets and is equal to 1. The fixed cost is
sunk. Which country has higher absolute price elasticity at the market price? Ramsia
Explain or show calculations or show a graphical answer (Hint: you do not need to perform any calculations to answer
this question)
The country with lower income would have lower demand and thus lower price. Since marginal cost is the same, the
markup over the marginal cost is also lower. According to the previous question, the lower markup happens when the
absolute price elasticity is higher. So, the country with the lower price (the low income Ramsia), has lower price to
cost ratio, and thus has higher elasticity. It also makes sense intuitively, lower income consumers are more sensitive to
the price (higher elasticity)
16. (3 pts) Which predictions of the perfectly competitive model are observed in the TV set industry? (name at least two)
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17. (2 pts)How can a government create a monopoly? (name more than one way)
18. (1 pt) What does rent-seeking do to the dead weight loss from monopoly?
68. DWL increases/decreases
19. (3 pts) What are three main barriers to entry according to Bain
20. (2 pts) What do consumer and producer surplus measure?
Welfare.
21. (2 pts) What is the relation between market demand elasticity, firm demand elasticity, and the number of firms
22. (2 pts) How did USPS prevent entry?
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