AP Economics:
Theory of the Firm FRQs
April 29, 2015
Theory of the Firm FRQs
1. Assume that a profit-maximizing firm in a monopolistically competitive industry is in longrun equilibrium.
(a) Draw a correctly labeled graph that shows the profit-maximizing firm’s price and
output.
Correct labels; MR curve below D curve, both downward sloping; Q where
MR=MC; P sliding up vertical Q line at intersection with D; ATC curve tangent
to D at P
(b) Assume that the city in which this industry operates eliminates the business
license fee (a fixed cost) for all the firms in the industry. How does the
elimination of the license fee affect each of the following for the individual firm
in the short run? Explain your answers.
(i) Output Does not change. License fee is a fixed cost and does not change
MC.
(ii) economic profits Increases in short run. No effect on P or Q but ATC
decreases.
2. Market structures differ from one another in many respects. Consider two profitmaximizing firms that earn short-run economic profits. One is a perfectly competitive firm
and the other is a monopoly.
(a) For each firm, draw a correctly labeled graph showing the following:
(i) price
(ii) quantity of output
(iii) area of economic profits
Perfectly Competitive firm: Correct labels, horizontal D=P=MR curve, upward
sloping “swoosh” MC curve intersecting both D=P=MR line above u-shaped ATC
curve at its minimum; Q where MR=MC; economic profits shaded as Q * (P –
ATC)
Monopoly: Correct labels, downward sloping D curve, MR curve curve below D
curve with steeper slope; upward sloping “swoosh” MC curve; Q where
MR=MC, P following vertical Q line to its intersection with D curve; profits in
the area Q * (P – ATC)
(b) For each firm, explain the relationship between price and marginal revenue.
For the Perfectly Competitive firm, P = MR. For the Monopoly, P lies along the
demand curve, which is always above MR.
(c) For each firm, explain how economic profits would most likely change in the long
run. If a Perfectly Competitive firm earns economic profits in the short run,
new competitors enter the industry, increasing supply and eliminating
economic profits. Monopolies have barriers to entry so, absent government
regulation, economic profits can exist in the long run.
(d) Label the area that represents the deadweight loss on the graph for the
monopoly firm drawn in (a). Explain what deadweight loss represents.
Deadweight loss represents the consumer surplus and producer surplus lost
due to the monopoly producing less than the efficient quantity (where P = MC)
(more on next page)
3. In the country of Lola, sugar had always been produced in a perfectly competitive industry
until a dictator seized power and monopolized the production of sugar.
(a) Draw a graph that shows the output and price a monopolist would choose to
maximize profits.
Correct labels, downward sloping D curve, MR curve curve below D curve with
steeper slope; upward sloping “swoosh” MC curve; Q where MR=MC, P
following vertical Q line to its intersection with D curve; profits in the area Q *
(P – ATC)
The people of Lola revolt, imprison the dictator, and repeal the law restricting the number of
sellers of sugar.
(b) Explain two conditions that might lead to an increase in the number of sugar
sellers after the repeal of the law. Presence of economic profits will attract new
competitors to the sugar industry, increasing supply and decreasing prices. The
reduced prices will increase demand which might require more producers.
(c) Describe how an individual seller would determine the profit-maximizing output
level of sugar if the sugar industry were perfectly competitive. Optimal output
will be where their MC = Price. In a perfectly competitive industry P = MR.
(d) Given your answers in parts (a) and (c), is the repeal of the law likely to make the
sugar industry more efficient? Why? In your explanation, be sure to include an
explanation of economic efficiency. Yes. Monopolies do not produce at an
allocatively efficient level, where P = MC. The repeal of the law will encourage
new entrants, which will increase supply and decrease P until it P = MC. The
increase is S will also push P down to the minimum of ATC, a productively
efficient level.
4. Two airline companies, Airtouch and Windward, operate a route from City X to City Y,
transporting a mix of passengers and freight. They must file their schedules with the National
Transportation Board each year and cannot alter them during that year. Those schedules are
revealed only after both companies have filed. Each airline must choose between a morning
and an evening departure. The relevant payoff matrix appears below, with the first entry in
each cell indicating Airtouch's daily profit and the second entry in each cell indicating
Windward's daily profit.
(a) In which market structure do these firms operate? Explain. Oligopoly. There
are only two firms, and they are interdependent.
(b) If Windward chooses an evening departure, which departure time is better for
Airtouch? Evening. Their profit would be $900, versus $700 for morning
departure.
(c) Identify the dominant strategy for Windward. Morning
(d) Is choosing an evening departure a dominant strategy for Airtouch? Explain. No.
If Windward chooses Morning, Airtouch would also choose Morning ($1000 vs.
$750)
(e) If both firms know all of the information in the payoff matrix but do not
cooperate, what will be Windward's daily profit? $700. Windward will choose
its dominant strategy, Morning, then Airtouch will also choose Morning.