Practice Free Response Questions
1) Assume that a profit-maximizing firm in a monopolistically competitive
industry is in long-run equilibrium.
(a) Draw a correctly labeled graph that shows the profit-maximizing
firm’s price and output.
i.
Difference between a competitive output, price & profit
MC
P
P1
ATC
A
Price
MC
B
-----------Q1
Perfectly Competitive Firm
ATC
B
P = MC
P = MR
(demand
curve)
D
0
MR
Qty
Quantity produced =
Efficient scale
Quantity
(b)
The city eliminates the business license fee (a fixed cost) for all firms
in this industry. How does the elimination of the license fee affect:
i. Output
ii. Profit iii. Modify Graph
MC
P
P1
ATC
A
i) Output/Price does NOT change
WHY: a ∆ in fixed costs
D
Q1
MR
Qty
does not ∆ marginal costs or
marginal revenue.
(c)
continued
i. Output ii. Profit iii. Modify Graph
P
ii) As fixed costs ↓ ATC
MC
ATC
(from zero to shaded Area)
A
P
ATC1
Economic
Profits
Q
Shifts downward => profits ↑
c) In long run this would
MR
attract more competition
D
-Demand would shift left
-Profit would = ZERO
Q -Quantity would fall
Demand Curve & Elasticity
Unit Elastic
Elastic range
Inelastic Range
-----------------
●
D
MR
1) Firms Operate in Elastic Portion of Demand
2) Elasticity = 1 when MR = 0
Practice Free Response Question #2
Watsonia
PRICE/COST
Marginal Cost
P6
P5
P4
P3
Average Total Cost
P2
P1
Demand
0
Q1
Q2 Q3 Q4
Q5
Q6
Q7 ATTENDANCE
Marginal Revenue
1. There is one art museum on the island of Watsonia. The
museum’s demand and cost curves are shown in the
graph above. The museum currently relies on an
admission charge for some of its funding. Its directors
are debating about how to set the admission charge.
PRICE/COST
Marginal Cost
P6
P5
P4
P3
Average Total Cost
P2
P1
Demand
0
Q1
Q2 Q3 Q4
Q5
Q6
Q7 ATTENDANCE
Marginal Revenue
a) Identify the price and quantity associated:
i) The museum maximizes its profit.
P5 Q2
PRICE/COST
Marginal Cost
P6
P5
P4
P3
Average Total Cost
P2
P1
Demand
0
Q1
Q2 Q3 Q4
Q5
Q6
Q7 ATTENDANCE
Marginal Revenue
ii) The museum maximizes its total revenue
P3
Q4
PRICE/COST
Marginal Cost
P6
P5
P4
P3
Average Total Cost
P2
P1
Demand
0
Q1
Q2 Q3 Q4
Q5
Q6
Q7 ATTENDANCE
Marginal Revenue
iii) The museum maximizes the sum of consumer and
producer surplus (total welfare)
P4
Q3
PRICE/COST
Marginal Cost
P6
P5
P4
P3
Average Total Cost
P2
P1
Demand
0
Q1
Q2 Q3 Q4
Q5
Q6
Q7 ATTENDANCE
Marginal Revenue
iv) The museum maximizes its attendance, as long as
it breaks even.
P2
Q5
PRICE/COST
Elastic
Marginal Cost
P6
P5
P4
P3
Average Total Cost
P2
Inelastic
P1
Demand
0
Q1
Q2 Q3 Q4
Q5
Q6
Q7 ATTENDANCE
Marginal Revenue
b) When the attendance is Q1, is the demand price elastic,
inelastic, or unit elastic? Explain.
Demand is elastic at Q1.
MR is greater than zero; Q1 is left of the mid-point
or in the upper half of the demand.
PRICE/COST
Marginal Cost
P6
P5
P4
P3
Average Total Cost
P2
P1
Demand
0
Q1
Q2 Q3 Q4
Q5
Q6
Q7 ATTENDANCE
Marginal Revenue
c) Assume that the price is set at P2. Assuming the
existence of an opportunity cost, indicate whether the
museum’s accounting profits would be positive,
negative, or zero. Explain why.
Accounting profits are positive.
PRICE/COST
Marginal Cost
P6
P5
P4
P3
Average Total Cost
P2
P1
Demand
0
Q1
Q2 Q3 Q4
Q5
Q6
Q7 ATTENDANCE
Marginal Revenue
c) Assume that the price is set at P2. Assuming the
existence of an opportunity cost, indicate whether the
museum’s accounting profits would be positive,
negative, or zero. Explain why.
Economic profit is zero and opportunity costs exist.
PRICE/COST
Marginal Cost
P6
P5
P4
P3
Average Total Cost
P2
P1
Demand
0
Q1
Q2 Q3 Q4
Q5
Q6
Q7 ATTENDANCE
Marginal Revenue
c) Assume that the price is set at P2. Assuming the
existence of an opportunity cost, indicate whether the
museum’s accounting profits would be positive,
negative, or zero. Explain why. Or-Economic profit is zero and ATC includes opportunity costs.
PRICE/COST
Marginal Cost
P6
P5
P4
P3
Average Total Cost
P2
P1
Demand
0
Q1
Q2 Q3 Q4
Q5
Q6
Q7 ATTENDANCE
Marginal Revenue
d) Assume that the government decides the museum should
charge no admission and agrees to subsidize the
museum for any losses.
i)
Using the labeling in the graph, identify the museum’s attendance under
that circumstance.
Q7
Innovation in Schools
http://www.youtube.com/watch?v=azNo8ttSCiY
PRICE/COST
Marginal Cost
P6
P5
P4
P3
Average Total Cost
P2
P1
Demand
0
Q1
Q2 Q3 Q4
Q5
Q6
Q7 ATTENDANCE
Marginal Revenue
d) Assume that the government decides the museum should
charge no admission and agrees to subsidize the
museum for any losses.
ii) Would the outcome be allocatively efficient? Explain.
Outcome is NOT allocatively efficient.
PRICE/COST
Marginal Cost
P6
P5
P4
P3
Average Total Cost
P2
is
greater
than
P1
Demand
0
Q1
Q2 Q3 Q4
Q5
Q6
Q7 ATTENDANCE
Marginal Revenue
d) Assume that the government decides the museum should
charge no admission and agrees to subsidize the
museum for any losses.
ii) Would the outcome be allocatively efficient? Explain.
MC > P or MSC > MSB