Principles of Microeconomics
David C. Broadstock
December 25, 2013
The following questions are to be completed by hand and submitted during the final class on December 23rd.
Final homework questions
Question 1
Suppose the book printing industry is competitive and begins in a long run
equilibrium.
Part a
Draw a diagram describing the typical firm in the industry.
Part b
Hi-Tech printing company invents a new process that sharply reduces the
cost of printing books. What happens to Hi-Tech’s profits and the price of
books in the short-run when Hi-Tech’s patent prevents other firms from using
the new technology?
Part c
What happens in the long run when the patent expires and other firms are
free to use the technology?
Question 1: Solution
Part a
Figure 7 shows the the typical firm in the industry, with average total cost
AT C1 , marginal cost MC1 and price P1 .
1
Figure 7
Part b
The new process reduces Hi-Tech’s marginal cost to MC2 nad its average
total cost to AT C2 , but the price remains at P1 since other firms cannot use
the new process. Thus Hi-Tech earns positive profits.
Part c
When the patent expires and other firms are free to use the technology, all
firms’ average total cost curves decline to AT C2 , so the market price falls to
P3 and firms earn no profits.
Question 2
Suppose the U.S. textiles industry is competitive, and there is no international trade in textiles. In long-run equilibrium, the price per unit of cloth
is $30.
part a
Describe the equilibrium using graphs for the entire market and for the individual producer.
part b
Now suppose that textile producers in other countries are willing to sell large
quantities of cloth in the united states for only $25 per unit.
Assuming that U.S. textile producers have large fixed costs, what is the
short run effect of these imports on the quantity produced by an individual
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Figure 9
producer? What is the short run effect on profits? Illustrate your answer
with a graph.
Part c
What is the long run effect on the number of U.S. firms in the industry?
Question 2: Solution
part a
Figure 9 illustrates the situation in the U.S. textile industry. With no international trade, the market is in long run equilibrium. Supply intersects
demand at quantity Q1 and price $30, with a typical firm producing output
q1 .
part b
The effect of imports at $25 is that the market supply curve follows the old
supply curve up to a price of $25, then becomes horizontal at that price. As
a result, demand exceeds domestic supply, so the country imports textiles
from other countries. The typical domestic firm now reduces its output from
q1 to q2 , incurring losses , since the large fixed costs imply that average total
cost will be much higher than the price.
Part c
In the long run, domestic firms will be unable to compete with foreign firms
because their costs are too high. All the domestic firms will exit the industry
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and other countries will supply enough to satisfy the entire domestic demand.
Question 3
A publisher faces the following demand schedule for the next novel of one of
its popular authors;
P
Q
$100
0
90
100
80
200
70
300
60
400
50
500
40
600
30
700
20
800
10
900
0
1,000
The author is paid $2 million to write the book, and the marginal cost of
producing the book as a constant $10 per book.
Part a
Compute total revenue, total cost, and profit at each quantity. What quantity
would a profit maximising publisher choose? What price would it charge?
Part b
Compute marginal revenue. (Recall that MR =
revenue compare to the price? Explain.
∆T R
.)
∆Q
How does marginal
Part c
Graph the marginal revenue, marginal cost, and demand curves. At what
quantity do the marginal revenue and marginal cost curves cross? What does
this signify?
Part d
In your graph, shade in the deadweight loss. Explain in words what this
means.
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Part e
If the author were paid $3 million instead of $2 million to write the book,
how would this affect the publisher’s decision regarding the price to charge?
Explain.
Part f
Suppose the publisher was not profit maximising but was concerned with
maximising economic efficiency. What price would it charge for the book?
How much profit would it make at this price?
Question 3: Solution
The following table shows revenue, costs and profits, where quantities are in
thousands, and total revenue, total cost, and profit are in millions of dollars.
P
Q
TR MR TC π
$100
0
$0
—
$2 $-2
90
100
9
$9
3
6
80
200
16
7
4
12
70
300
21
5
5
16
60
400
24
3
6
18
50
500
25
1
7
18
40
600
24
-1
8
16
30
700
21
-3
9
12
20
800
16
-5
10
6
10
900
9
-7
11 -2
0
1,000 0
-9
12 -12
Part a
A profit-maximising publisher would choose a quantity of 400,000 at a price
of $60 or a quantity of 500,000 at a price of $50; both combinations would
lead to profits of $18 million.
Part b
Marginal revenue is always less than price. Price falls when quantity rises
because the demand curve slopes downward, but marginal revenue falls even
more than price because the firm loses revenue on all the units of the good
sold when it lowers the price.
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Part c
Figure 2
Figure 2 shows the marginal revenue, marginal cost, and demand curves.
The marginal revenue and marginal cost curves cross between quantities of
400,000 and 500,000. This signifies that the firm maximises profits in that
region.
Part d
The area of deadweight loss is marked DW L in the figure. Deadweight loss
means that the total surplus in the economy is less than it would be if the
market were competitive, since the monopolist produces less than the socially
efficient level of output.
Part e
If the author were paid $3 million instead of $2 million, the publisher wouldn’t
change the price, since there would be no change in marginal cost or marginal
revenue. The only thing that would be affected would be the firm’s profit,
which would fall.
Part f
To maximise economic efficiency, the publisher would set the price at $10 per
book, since that’s the marginal cost of the book. At that price, the publisher
would have negative profits equal to the amount paid to the author.
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Question 4
Johnny Rockabilly has just finished recording his latest CD. His record company’s marketing department determines that the demand for the CD is as
follows:
P
24
22
20
18
16
14
Q
10,000
20,000
30,000
40,000
50,000
60,000
The company can produce the CD with no fixed cost and a variable cost
of $5 per CD.
Part a
Find total revenue for quantity equal to 10,000, 20,000, and so on. What is
the marginal revenue for each 10,000 increase in the quantity sold?
Part b
What quantity of CD’s would maximise profit? What would the price be?
What would the profit be?
Part c
If you were Johnny’s agent, what recording fee would you advise Johnny to
demand from the record company? Why?
Question 4: Solution
Part a
The following table shows total revenue and marginal revenue for each price
and quantity sold:
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P
24
22
20
18
16
14
Q
TR
MR
10,000 $240,000 —
20,000 440,000 $20
30,000 600,000
16
40,000 720,000
12
50,000 800,000
8
60,000 840,000
4
TC
π
$50,000 $190,000
100,000 340,000
150,000 450,000
200,000 520,000
250,000 550,000
300,000 540,000
Part b
Profits are maximised at a price of $16 and quantity of 50,000. At that point
profit is $550,000.
Part c
As Johnny’s agent, you should recommend that he demand $550,000 from
them, so he instead of the record company receives all of the profit.
Question 5
A company is considering building a bridge across a river. The bridge would
cost $2 million to build and nothing to maintain. The following table shows
the company’s anticipated demand over the lifetime of the bridge:
P
$8
7
6
5
4
3
2
1
0
Q
0
100
200
300
400
500
600
700
800
Part a
If the company were to build the bridge, what would be its profit maximising
price? Would that be the efficient level of output? Why or why not?
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Part b
If the company is interested in maximising profit, should it build the bridge?
What would be its profit or loss?
Part c
If the government were to build the bridge, what price should it charge?
Part d
Should the government build the bridge? Explain.
Question 5: Solution
Part a
The table below shows total revenue and marginal revenue for the bridge.
The profit maximising price would be where revenue is maximised, which
will occur where marginal revenue equals zero, since marginal cost equals
zero. This occurs at a price of $4 and quantity of 400. The efficient level of
output is 800, since that’s where price equals marginal cost equals zero. The
profit maximising quantity is lower than the efficient quantity because the
firm is a monopolist.
P
$8
7
6
5
4
3
2
1
0
Q
0
100
200
300
400
500
600
700
800
TR MR
$0
—
700
$7
1,200
5
1,500
3
1,600
1
1,500 -1
1,200 -3
700
-5
0
-7
Part b
The company should not build the bridge because its profits are negative.
The most revenue it can earn is $1,600,000 and the cost is $2,000,000, so it
would lose $400,000.
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Part c
If the government were to build the bridge, it should set price equal to
marginal cost to be efficient. But marginal cost is zero, so the government
should not charge people to use the bridge.
Part d
Yes, the government should build the bridge, because it would increase society’s total surplus. As shown in Figure 7, total surplus has area 1/2 × 8 ×
800, 000 = $3, 200, 000, which exceeds the cost of building the bridge.
Figure 7
Question 6
Larry, Curly, and Moe run the only saloon in town. Larry wants to sell
as many drinks as possible without losing money. Curly wants the saloon to
bring in as much revenue as possible. Moe wants to make the largest possible
profits. Using a single diagram of the saloon’s demand curve and it’s cost
curves, show the price and quantity combinations favoured by each of the
three partners. Explain.
Question 6: Solution
Larry wants to sell as many drinks as possible without losing money, so he
wants to set quantity where price (demand) equals average cost, which occurs
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at quantity QL and price PL in Figure 10. Curly wants to bring in as much
revenue as possible, which occurs where marginal revenue equals zero, at
quantity QC and price PC . Moe wants to maximise profits, which occurs
where marginal cost equals marginal revenue, at quantity QM and price PM .
Figure 10
Question 7
Explain why a monopolist will always produce a quantity at which the demand curve is elastic. (Hint: If demand is inelastic and the firm raises its
price, what happens to total revenue and total costs?)
Question 7: Solution
A monopolist always produces a quantity at which the demand curve is elastic. If the firm produced at a quantity for which the demand curve were
inelastic, then if the firm raised its price, quantity would fall by a smaller
percentage than the rise in price, so revenue would increase. Since costs
would decrease at a lower quantity, the firm would have higher revenue and
lower costs, so profit would be higher. Thus the firm should keep raising its
price until profits are maximised, which must happen on an elastic portion
of the demand curve.
Another way to see this is to note that on an elastic portion of the
demand curve, marginal revenue is negative. Increasing quantity requires
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a greater percentage reduction in price, so revenue declines. Since a firm
maximises profit where marginal cost equals marginal revenue, and marginal
cost is never negative, the profit maximising quantity can never occur where
marginal revenue is negative, so can never be on an inelastic portion of the
demand curve.
Question 8
The New York Times (Nov. 30, 1993) reported that “the inability of OPEC to
agree last week to cut production has sent the oil market into turmoil...[leading
to] the lowest price for domestic crude oil since June 1990.”
Part a
Why were the members of OPEC trying to agree to cut production?
Part b
Why do you suppose that OPEC was unable to agree on cutting production?
Why did the oil market go into “turmoil” as a result?
Part c
The newspaper also noted OPEC’s view “that producing nations outside
the organisation, like Norway and Britain, should do their share and cut
production.” What does the phrase “do their share” suggest about OPEC’s
desired relationship with Norway and Britain?
Question 8: Solution
Part a
OPEC members were trying to reach an agreement to cut production so they
could raise the price.
Part b
They were unable to agree on cutting production because each country has
an incentive to cheat on any agreement. The turmoil is a decline in the price
of oil because of increased production.
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Part c
OPEC would like Norway and Britain to join their cartel so they could act
like a monopoly.
Question 9
A large share of the world supply of diamonds comes from Russia and South
Africa. Suppose that the marginal cost of mining diamonds is constant at
$1,000 per diamond, and the demand for diamonds is described by the following schedule:
Price Quantity
$8,000
5,000
7,000
6,000
6,000
7,000
5,000
8,000
4,000
9,000
3,000
10,000
2,000
11,000
1,000
12,000
part a
If there were many suppliers of diamonds, what would be the price and
quantity?
part b
If there were only one supplier of diamonds, what would be the price and
quantity?
Part c
If Russia and South Africa formed a cartel, what would be the price and
quantity? If the countries split the market evenly, what would be South
Africa’s production and profit? What would happen to South Africa’s profit
if it increased its production by 1,000 while Russia stuck to the cartel agreement?
Part d
Use your answer to part (c) to explain why cartel agreements are often not
successful.
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Question 9: Solution
part a
If there were many suppliers of diamonds, price would equal marginal cost
($1,000), so the quantity would be 12,000.
part b
With only one supplier of diamonds, quantity would be set where marginal
cost equals marginal revenue. The following table derives marginal revenue:
Price Quantity Total revenue Marginal Revenue
$8,000
5,000
40
—
7,000
6,000
42
2
6,000
7,000
42
0
5,000
8,000
40
-2
4,000
9,000
36
-4
3,000
10,000
30
-6
2,000
11,000
22
-8
1,000
12,000
12
-10
With marginal cost of $1,000 per diamond, or $1,000,000 per thousand diamonds, the monopoly will maximize profits at a price of $7,000 and a quantity
of 6,000. Additional production beyond this point would lead to a situation
where marginal revenue is lower than marginal cost.
Part c
If Russia and South Africa formed a cartel, they would set the price and
quantity like a monopolist, so the price would be $7,000 and the quantity
would be 6,000. If they split the market evenly, they would share total
revenue of $42 million and costs of $6 million, for a total profit of $36 million.
So each would produce 3,000 diamonds and get a profit of $18 million. If
Russia produced 3,000 diamonds and South Africa produced 4,000, the price
would decline to 6,000. South Africa’s revenue would rise to $24 million, costs
would be $4 million, so profits would be $20 million, which is an increase of
$2 million.
Part d
Cartel agreements are often not successful because one party has a strong
incentive to cheat to make more profit. In this case, each could increase profit
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by $2 million by producing an extra thousand diamonds. However, of both
countries did this profit would decline for both of them.
Question 10
What feature of the product being sold distinguishes the monopolistically
competitive firm from the monopolistic firm?
Question 10: Solution
A monopolistic firm produces a product for which there are no close substitutes, but a monopolistically competitive firm produces a product that is
only somewhat different from substitute goods. So the goods differ in terms
of the degree to which substitutes exist.
Question 11
Sparkle is one firm of many in the market for toothpaste, which is in long-run
equilibrium.
Part a
Draw a diagram showing Sparkle’s demand curve, marginal revenue curve,
average total cost curve, and marginal cost curve. Label Sparkle’s profit
maximising output and price.
Part b
What is sparkle’s profit? Explain.
Part c
On your diagram, show the consumer surplus derived from the purchase of
Sparkle toothpaste. Also show the deadweight loss relative to the efficient
level of output.
Part d
If the government forced Sparkle to produce the efficient level of output, what
would happen to the firm? What would happen to sparkles consumers?
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Question 11: Solution
Part a
Figure 4 illustrates the market for Sparkle toothpaste in long-run equilibrium.
The profit-maximising level of output is QM and the price is PM .
Figure 4
Part b
Sparkle’s profit is zero, since at quantity QM , Price equals average total cost.
Part c
The Consumer surplus from the purchase of Sparkle toothpaste is area A+B.
The efficient level of output occurs where the demand curve intersects the
marginal-cost curve, at QC . So the deadweight loss is area C, the area above
marginal cost and below demand, from QM to QC .
Part d
If the government forced Sparkle to produce the efficient level of output, the
firm would lose money because average total cost would exceed price, so the
firm would shut down. If that happened, Sparkle’s customers would earn no
consumer surplus.
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Question 12
Describe three commercials that you have seen on TV. In what ways, if any,
were each of these commercials socially useful? In what ways were they
socially wasteful? Did the commercials affect the likelihood of your buying
the product? Why or why not?
Question 12: Solution
Generally speaking, the commercials are socially useful to the extent that
they provide consumers with information about the product or demonstrate
from the existence of the commercial that the product is worth advertising,
and thus is not of low quality. Commercials are socially wasteful to the extent
that they manipulate people’s tastes and try to make products seem more
different than they really are.
Question 13
For each of the following pairs of firms, explain explain which firm would be
more likely to engage in advertising:
a A family owned farm or a family owned restaurant.
b A manufacturer of forklifts or a manufacturer of cars.
c A company that invented a very reliable watch or a company that invented
a less reliable watch that costs the same amount to make.
Question 13: Solution
Part a
A family owned restaurant would be more likely to advertise than a family
owned farm because the output of the farm is sold in a perfectly competitive
market, in which there is no reason to advertise, while the output of the
restaurant is sold in a monopolistically competitive market.
Part b
A manufacturer of cars is more likely to advertise than a manufacturer of
forklifts because there is little difference between different brands of industrial
products like forklifts, while there are greater perceived differences between
consumer products like cars. The possible return to advertising is greater in
the case of cars than in the case of forklifts.
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Part c
A company that invented a reliable watch is likely to advertise more than
a company that invented a less reliable watch that costs the same amount
to make because the company with the reliable watch will get many repeat
sales over time to cover the cost of the advertising, while the company with
the less reliable watch will not.
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