Test 3 Essays – Sections 11, 12, 13 & 14
Section 11
3. Use the graphs below of a perfectly competitive market to answer this set of questions.
a. Suppose in the short run the industry supply curve is given by S1. Identify the shortrun equilibrium market price and quantity, and the quantity produced by the
representative firm, and decide whether the firm is making positive, negative, or zero
economic profit. Holding everything else constant, what will happen in the long run
in this industry? In your answer to this question, identify the long-run equilibrium
price and quantity in the industry, the quantity produced by the firm in the long run,
and the level of profit for the firm in the long run.
b. Suppose in the short run the industry supply cure is given by S4. Identify the shortrun equilibrium market price and quantity and the quantity produced by the
representative firm, and decide whether the firm is making positive, negative, or zero
economic profit. Do you know with certainty what this firm’s profit equals in the
short run? Holding everything else constant, what will happen in the long run in this
industry? In your answer to this question, identify the long-run equilibrium price and
quantity in the industry, the quantity produced by the firm in the long run, and the
level of profit for the firm in the long run.
c. You are told that this representative firm is currently making negative economic
profit in the short run but that it is covering all of its variable costs of production and
some of its fixed costs. Given the price choices in the above graph, what is the
current price for this good? In the long run, will there e entry of new firms into the
industry or will existing firms exit the industry? Explain your answer.
1
3.a. The equilibrium price is P1 and the equilibrium quantity is Q1 in the market. The
representative firm produces the quantity at which MR = MC, or P1 = MC, because for
a perfectly competitive firm, MR = P. The representative firm produces Q1. The firm
earns positive economic profit because P1 > ATC for q1 units of output. In the long
run, new firms will enter the industry because the existence of positive economic profit
creates an incentive for more competition. As firms enter the industry, the industry
supply curve will shift to the right from S1 to S2, which will result in a decrease in the
market price from P1 to P2. The equilibrium output in the industry will increase to Q2
while the representative firm will decrease its production to Q2. Economic profit will
equal zero in the long run for each firm.
b. The equilibrium price is P4 and the equilibrium quantity is Q4 in the market. The
representative firm finds that the market price goes through its shutdown price at P4
(the minimum point of the AVC curve), and therefore the firm needs to decide whether
or not it wants to produce in the short run. With either choice, the firm will earn
negative economic profit equal to the negative of their fixed costs. The firm will
produce q4 units because MR = MC at this level of output. In the long run, firms will
exit the industry causing the industry supply curve to shift to the left to S2. This will
cause the market price to increase to P2, the market quantity to decrease to Q2, and the
level of production for each firm remaining in the industry to increase to Q2.
Economic profit will equal zero in the long run for each firm.
c. P4 corresponds to the price that goes through the shut-down price, which implies
that the firm covers all of its variable cost but none of its fixed cost. At P1, he firm
earns a positive economic profit and thus its revenues are greater than the sum of its
fixed and variable costs. P2 corresponds to the price that goes through the break-even
price: the firms total revenue is exactly equal to its total cost, and therefore the firm is
covering all of its variable costs and all of its fixed costs. That leaves P3, and from the
graph we see that P3 is a price that lies between the break-even price and the shut-down
price: the firm will receive enough revenue to cover all of its variable cost and some of
its fixed cost. In the long run, firms will exit this industry until the supply curve shifts
left from S3 to S2. The remaining firms in the industry will earn zero economic profit
in the long run.
5. Suppose the following table contains the market demand schedule for a monopoly.
Price ($) Quantity demanded (units)
1,000
0
800
400
600
800
400
1,200
200
1,600
0
2,000
2
a. Draw a graph of this market demand schedule for the monopoly.
Price
Quantity
b. Compute the firm’s total revenue and marginal revenue figures for the table
below. For the marginal revenue figures, use the midpoint method.
Price (dollars) Quantity
Total Revenue Marginal Revenue
Demanded (units) (dollars)
(dollars per unit)
1,000
0
800
400
600
800
400
1,200
200
1,600
0
2,000
c. Draw the monopolist’s marginal revenue curve on the graph you drew in part (a)
of this problem.
d. If the firm’s marginal cost is constant at $200, what is this monopolist’s profitmaximizing level of output and what price will the monopolist charge for the
good? Label this quantity and price on your graph.
e. On the graph you drew in part (a), shade in the area that corresponds to the
consumer surplus and label it clearly. On this same graph, shade in the area that
corresponds to producer surplus and label it clearly. Shade in the area that
corresponds to deadweight loss and label it clearly.
3
f. Calculate the value of consumer surplus, producer surplus, and deadweight loss
for this monopoly.
5. a.
b.
Price (dollars)
1,000
800
600
400
200
0
Quantity
Total revenue Marginal Revenue
Demanded (units)
(dollars)
(dollars per unit)
0
0
800
400
320,000
400
800
480,000
0
1,200
480,000
-400
1,600
320,000
-800
2,000
0
c. See the graph in part (a).
d.The monopolist profit maximizes by producing the level of output at which MR = MC
and then moving up to the demand curve to charge the price associated with this level
of output. Thus, if MC = 200 and MR = 1,000 – Q, then the profit-maximizing quantity
is 800 units. To find the monopolist’s price, substitute 800 for Q in the demand
equation: the monopolist’s price is $600.
4
e.See the graph in part (a).
f.Consumer Surplus – (1/2)($400) per unit (800 units) = $160,000; producer surplus =
($400 per unit)(800 units) - $320,000; deadweight loss = (1/2($400 per unit)(800 units)
= $160,000.
6. The graph below represents a monopolist’s cost curves and the demand curve for the
monopolist’s product. Use this graph to answer this set of questions.
a. On the above graph, identify the monopolist’s profit maximizing level of output
and label this amount Qm. (Hint: Don’t forget that you will need to first find the
monopolist’s MR curve to answer this question.) On the graph, label the price the
monopolist will charge for the good as Pm.
b. Does this monopolist make positive, negative, or zero economic profit in the short
run? Identify the area that represents profit in the above graph if the firm earns
positive or negative profit.
c. What do you expect will happen to the monopolist in the long run? In your
answer, be sure to identify what happens to the firm’s profit, level of production,
and price.
5
6.
a. See the above graph
b. This monopolist earns positive economic profit because the price it receives on
each unit (Pm) is greater than its average total cost (ATC) of production (ATCm
on the graph).
c. This monopolist will continue to earn positive economic profit because there is
an effective barrier to entry to this industry that prevents the firm from having
to compete with other producers. The firm’s profit will continue at the level
given in the graph, and the firm’s price and quantity decision will remain
unchanged.
Section 12
6. Suppose the existing firms in the fast-food restaurant business are currently earning
positive economic profit in the short run.
a. Draw a graph representing a monopolistically competitive firm in this situation.
Identify the price of the good, the output the firm produces in the short run, and
the area that represents this firm’s profit.
b. What do you anticipate will happen in the long run in this industry? How will the
industry price and quantity change in the long run? How will each firm’s profit
change in the long run?
6
c. Draw a graph representing a monopolistically competitive firm in the long-run
equilibrium. Identify the price of the good and the quantity the firm sells in the
long run. What is the relationship between price and marginal cost for this firm in
the long run? What is the relationship between price and average total cost for
this firm in the long run?
6. a.
b. In the long run, new firms will enter this industry because the short-run positive
economic profit acts as a signal for firms to enter the industry. As firms enter the
industry, each existing firm in the industry will see the demand for its product shift to
the left as some of its customers stop buying its product and start buying the new firm’s
product. As the demand cure shifts to the left, this will also cause the MR curve to shift
to the left. This process will continue until the firm earns zero economic profit in the
long run. The firm will sell its product at a lower price and produce a smaller quantity
of the good because of the entry of the new firms into the industry.
c.In the long run, the monopolistically competitive firm will continue to charge a price
that is greater than its marginal cost. In the long run, the price of the product will
equal the average total cost of producing the product, but the price will not equal the
minimum point of the ATC curve. The figure below illustrates the long-run
equilibrium for a monopolistically competitive firm.
7
9. Use the graph below of a monopolistically competitive firm to answer the next set of
questions.
a. Label the profit maximizing level of output and price for this firm in the short run.
b. Identify any profit the firm is making in the short run, and decide whether these
profits are positive or negative.
c. Draw the long-run equilibrium situation on this graph. Identify the long-run
profit-maximizing quantity and the long-run price. What will this firm’s profits
equal in the long-run?
d. Did entry or exiting of firms occur in the long run in this problem? Explain your
answer.
8
9. a-c.
The firm earns negative economic profit in the short run because price is less than the
average total cost at the short-run profit maximizing quantity.
In the long run, this firm earns zero economic profit because price is equal to ATC
at the long run profit maximizing quantity.
d. Exiting of firms occurred in the long run because there were too many firms initially
serving this monopolistically competitive industry. Firms exited because they were
earning negative economic profit; exiting continued until the remaining firms were
able to break even.
Section 13
3. Sarah operates a coffeehouse, and her production function per week is given in the
table below. The current equilibrium weekly wage in the perfectly competitive labor
market is $400 per week, and Sarah sells each cup of coffee for $3 at her coffeehouse.
Quantity of Labor Quantity of coffee
Workers
(number of cups)
0
0
1
300
2
450
3
550
4
600
9
a. Find the marginal product of labor for each worker and the value of the marginal
product of each worker. Put your findings in the table below.
Quantity of Labor Marginal product of Value of the marginal
(workers)
Labor (cups of coffee
Product of labor
Per worker)
(dollars per worker)
0
----1
2
3
4
b. How many workers should Sarah hire?
c. Suppose the equilibrium wage rate fell to $300 per week. How would this change
in the equilibrium wage rate affect Sarah’s hiring decision? Describe how Sarah
would determine how much labor she should hire?
3. a.
Quantity of Labor Marginal product of Value of the marginal
(workers)
Labor (cups of coffee
Product of labor
Per worker)
(dollars per worker)
0
----1
300
900
2
150
450
3
100
300
4
50
150
b. Sarah should continue to hire workers, provided that the value of the marginal
product of the additional worker is greater than or equal to the cost of hiring an
additional worker. When Sarah hires the first worker, the cost of hiring that worker is
$400 per week, but the value of the marginal product of the first worker is $900 per
week. Sarah will want to hire the first worker. When she considers hiring the second
worker, the cost of hiring that worker is $400 per week, but the value of the marginal
product of the second worker is $450 per week. She will want to hire the second
worker. But, when she considers the third worker, she finds that the marginal cost of
hiring the third worker ($400 per week) is greater than the value of the marginal
product from this third worker ($300). She will not want to hire this third worker.
c. Sarah would decide how much labor to hire by comparing the additional cost of
hiring the labor to the additional revenue from hiring the labor. Sarah would continue
to hire labor provided that the value of the marginal product of the last unit of labor
hired is greater than or equal to the marginal factor cost of hiring the last unit of
labor. When the equilibrium wage rate falls to $300 per week, Sarah will find that the
profit-maximizing amount of labor to hire is three workers.
10
4. Mike operates a sandwich shop, and his production function is given in the table
below. Suppose that the equilibrium weekly wage in the perfectly competitive labor
market is $300 a week and that Mike sells his sandwiches for $5 each.
Quantity of labor Quantity of sandwiches
(workers)
(number of sandwiches)
0
0
1
100
2
180
3
240
4
290
a. Using the above information, fill in the following table:
Quantity of labor
Marginal Product
Value of the marginal
(workers)
Of labor (sandwiches
Product of labor
Per worker)
(dollars per worker)
0
----1
2
3
4
b. Draw the value of the marginal product of labor curve for Mike’s sandwich shop.
Use this graph to determine how many workers Mike should hire.
Value of the
Marginal product
of labor
Quantity of
Labor
c. Suppose that the price of sandwiches falls to $4 a sandwich. Draw a new graph
illustrating Mike’s value of the marginal product of labor. How will this price
change affect the amount of labor Mike chooses to hire?
11
Value of the
Marginal product
of labor
Quantity of
Labor
4.a.
Quantity of labor
Marginal Product
Value of the marginal
(workers)
Of labor (sandwiches
Product of labor
Per worker)
(dollars per worker)
0
----1
100
$500
2
80
$400
3
60
$300
4
50
$250
b.
12
Mike should hire three workers, given his production function and the above
information.
c.When the price of sandwiches decreases from $5 per sandwich to $4 per sandwich,
this changes Mike’s value of the marginal product of labor curve. The new values are
given in the table below:
Quantity of labor
Marginal product
Value of the marginal
(workers)
Of labor (sandwiches
Product of labor
Per worker)
(dollars per worker)
0
----1
100
$400
2
80
$320
3
60
$240
4
50
$200
This price change causes the VMP curve to shift to the left: at every wage rate, Mike
will demand fewer units of labor. The figure below gives the new VMP curve.
Mike will choose to hire less labor when the price of sandwiches falls to $4; if he has
to hire whole units of labor, he will choose to hire two workers when the price of his
product decreases to $4 per unit.
13
9. Suppose that Mark is willing to work 40 hours a week when his wage rate is $10 per
hour, but when the wage rate increases to $15 an hour, he is willing to work only 36
hours a week.
a. If you were to draw Mark’s labor supply curve given this information, what
would it look like? In the graph below, measure wage rate per hour on the
vertical axis and quantity of labor hours per week on the horizontal axis.
Wage rate
Per hour
Hours of labor
Per week
b. Given this information, what do you know about the income effect relative to the
substitution effect of this change in wage rates for Mark?
c. What happens to the opportunity cost of an hour of leisure when mark’s wage rate
increases from $10 an hour to $15 an hour?
d. Describe the income effect of this wage increase.
9. a. As Mark’s wage rate is bid up, the number of hours of labor he supplies
decreases. This implies that Mark’s labor supply curve is downward sloping because
the wage rate and the number of hours worked are inversely related to each other over
this range of wages. This figure below illustrates Mark’s supply of labor curve.
14
b. The income effect is stronger than the substitution effect over this range of wages.
As Mark’s wage is bid up, he chooses to consume more leisure and less work. The
substitution effect of a higher wage makes an hour of leisure relatively more expensive
and would tend to encourage Mark to work more and take fewer hours of leisure, but
the income effect of a higher wage is that he can earn more income working the same
number of hours. Because Mark chooses to work fewer hours, it must be the case that
the income effect is dominant over the substitution effect in this case.
c. The opportunity cost of an hour of leisure increases when the wage rate increases.
For each additional hour of leisure Mark consumes, he is now giving up $15 in lost
wages instead of $10. Leisure has gotten relatively more expensive.
d. The income effect of this wage increase is that Mark can earn the same amount of
income as he did initially while working fewer hours. For instance, if he works 40
hours a week for $10 an hour he will earn $400, but if his wage increases to $15 an
hour he can earn $400 a week by working only 26.67 hours a week. In Mark’s case, he
chooses to consume a bit more income (36 hours at $15 an hour gives him $540 a week
in income) plus 4 more hours of leisure.
Section 14
1.Classify each of the following situations as positive or negative externalities, then
identify whether the externality occurs on the demand/consumption side of the model or
on the supply/production side of the model.
a. A manufacturing plant spews toxic gas into the environment as a by-product of its
production of furniture.
15
b. A group of teenagers gather on Saturday to play loud music and congregate in a
downtown park, making it difficult for other people in the town to enjoy the park.
c. A property owner fills his front yard with trash and old tires.
d. A company develops a new technology for producing its product, and the new
technology can potentially help other companies produce more efficiently.
e. School-age children in a community do not get immunized prior to attending
school.
f. A neighbor decorates the outside of her house with a tasteful holiday display.
g. A neighbor keeps his barking dog outside his house all day and all night.
h. Commercial fishermen catch too many fish and deplete the stock of fish.
1.a. This is a negative production externality
b. This is a negative consumption externality
c.This is a negative consumption externality
d.This is a positive production externality
e.This is a negative consumption externality
f.This is a positive consumption externality
g.This is a negative consumption externality
h.This is a negative production externality
7. Jimmy and Beth are the only residents of Smalltown. They both think the community
would benefit from more parks, but neither Jimmy or Beth is willing to contribute money
to buy land to turn into parks because they both realize that once a park is provided, they
can enjoy the park even though they have not paid for it.
a. Describe Jimmy and Beth’s behavior and why it represents a problem when trying
to provide parks in their community.
b. Suppose Jimmy reveals that his marginal benefit from one park is $50 per park,
his marginal benefit from two parks is $25 per park, and his marginal benefit from
three parks is $0 per park. Beth reveals that her marginal benefit from one part is
16
$60 per park, her marginal benefit from two parks is $40 per park, and her
marginal benefit from three parks to $20 per park. What is the marginal social
benefit of two parks in their community? Explain how you found this answer.
c. Suppose the information in part (b) is still true. Jimmy and Beth analyze the cost
of providing parks in their community and they find that the marginal social cost
of providing parks is constant at $55. What is the socially optimal number of
parks for this community? Explain how you got this answer.
d. If Jimmy and Beth are both willing to reveal their preferences with regard to parks
(that is, they will tell the truth about the marginal private benefit they receive
from the parks), will they both contribute to getting the socially optimal amount
of parks for their community?
7. a. Both Jimmy and Beth are free riding on this issue of park provision. They both
realize that once the parks are provided, they can enjoy the park even if they have not
contributed to its creation. When people free ride, too little or none of the good gets
produced. In this case, if neither Jimmy nor Beth are willing to contribute, then the
community will end up with no new parks.
b. The marginal social benefit of two parks is equal to the sum of Jimmy’s and Beth’s
marginal benefits from two parks. Jimmy’s marginal social benefit from two parks is
$25 per park while Beth’s marginal social benefit from two parks is $40 per park, for a
total marginal social benefit of $65 per park.
c. Because the marginal cost of providing parks is constant at $55 per park, parks
should be provided as long as the marginal social benefit from the park is greater than
or equal to the marginal cost of providing the park. In this case, two parks will be
provided because the marginal social benefit of two parks is $65 per park while the
marginal cost of providing two parks is $55 per park. Three parks will not be provided
because the marginal social benefit of three parks is only $20 per park while the
marginal social cost of three parks is $55 per park.
d. Yes, if both Jimmy and Beth reveal their preferences, they will each contribute
because they each assign a positive marginal benefit to two parks. Jimmy will likely
contribute less than Beth because the marginal benefit he receives from two parks is
less than the marginal benefit that Beth receives from two parks.
9. Big sports is a television company that has won the rights to broadcast next season’s
football games in the Big Group college football conference. To watch these televised
games, viewers need to subscribe to the Super Cable package that costs an additional $15
per month.
17
a. Does Big Sports and its televised games represent a public good, a common
resource or an artificially scarce good? Explain your answer and why you have
classified Big Sports in this manner.
b. What is the efficient price for consumers to pay for watching these football
games? Explain your answer.
c. Does Big Sports produce the socially optimal, or efficient level of televised
football games for the Big Group college football conference? Explain your
answer.
9.a. Because the televised games are available only if the consumer pays for the cable
package, these games are an excludable good. But the televised games are nonrival in
consumption because one individual’s viewing of the game does not diminish the
ability of another viewer to watch the game. Thus, Big Sports and its televised games
represent an artificially scarce good because these goods are excludable but nonrival in
consumption.
b. The efficient price for consumers would be zero because the marginal cost of
delivering the televised games to another consumer is zero. At a price of zero, however,
Big Sports has no incentive to provide the games. Big Sports will provide the games
only if they can charge consumers a positive price.
c.Big Sports does not produce the optimal amount of the good because the price they
charge ($15 per month) is greater than the marginal cost of allowing another viewer
for the televised game ($0). Because price is greater than marginal cost, this indicates
that too little of the good is being produced; the value consumers place on the last unit
produced is greater than the cost of producing the last unit.
18