Eco100Pesando_PT2solutions - © Prep101...

Info iconThis preview shows page 1. Sign up to view the full content.

View Full Document Right Arrow Icon
This is the end of the preview. Sign up to access the rest of the document.

Unformatted text preview: © Prep101 Student Last Name: ________________ Student First Name: ________________ Student Number: __________________ Economics 100 (Pesando) Solutions to Practice Test 2 Students Must Answer All Questions in the Space Provided. No Aids Allowed. I. (18 points) Suppose that banana farming is a perfectly competitive industry in long-run equilibrium, and the industry has a constant cost long-run supply curve. 1. Using appropriate diagrams, characterize the situation of the industry and a representative firm. Solution: MC P ATC P SRS P0 LRS D q0 Q Q0 Firm Industry Page 1 of 13 Q © Prep101 2. Suppose there is an increase in the price of tractors, causing an increase in the fixed costs of the representative firm. In the short run, what happens to the following variables? a) Firm price and output b) Market price and output c) Industry supply curve d) Economic profit of a representative firm Solution: a) The firm’s price and output stay the same, since the change in the price of tractors represents a fixed cost change, leaving MC unaffected b) Market price and output would stay the same (in the short-run) c) In the short-run, the industry supply curve stays the same d) In the short-run, firms bear an economic loss ATC1 MC P ATC0 P0 P S LOSS D q0 Q Q0 Firm Industry Page 2 of 13 Q © Prep101 3. Suppose we return to the market described in question 1, where the market is in long run equilibrium. Then, all of a sudden, poor weather conditions call for an increase in the use of fertilizer. This causes the average variable cost curve for each firm to increase by $1.50 at all output levels. a) What happens to market price in the short-run? Ensure your explanation includes a properly labeled diagram. Solution: In the short-run, the AVC, ATC and MC curves shift up, as the increase in fertilizer requirement increases costs. The increase in production costs also cause a decrease in supply at both the firm (production) and market (supply) levels. Assuming that demand is not perfectly inelastic, nor supply perfectly elastic, the change in price (in the shortrun) is less than the $1.50 – price moves from P0 to P1. Note: consider how things would differ if demand was perfectly inelastic, or supply perfectly elastic. MC1 MC0 P S2 P S1 S0 ATC0 P2 P1 P0 ATC1 LOSS $1.50 $1.50 D q1 q0 q Q2 Q1 Q0 Q Industry Firm b) What happens to market price in the long-run? Ensure your explanation includes a properly labeled diagram. Solution (see previous diagram): In the long run, since it’s a constant cost industry, the market price increases to absorb the full $1.50 shock (price eventually settles at P2). The process by which this happens is that in the short run, after the change in production costs, firms suffer an economic loss. In the long run some firms exit, which allows a small increase in production for the remaining firms, but not enough to replace the loss in market supply (caused by competitor exit). The full drop in supply causes the market price increases by the full $1.50. Page 3 of 13 © Prep101 II. (20 points) An unregulated monopoly is in long run equilibrium, earning economic profits. 1. Using a diagram, show the monopolist’s profit-maximizing output and price. On the same diagram, show the price and output that would occur under perfect competition P MC PM PPC P=MRPC D QM QPC Q MRM 2. If a price ceiling is imposed at the allocative-efficient level (that which would prevail in a perfectly competitive industry), would the monopoly reduce its production? Solution: No Monopolies maximize their profits where MC = MR. The advantage unregulated monopolies have is that they can “freely” set that price/MR. However, under a price ceiling, the marginal revenue is the price established by the ceiling. From the diagram below, we can see that the monopolist will increase its production/output. P MC P0 P1 MR1 (Price Ceiling) D Q0 Q1 MR0 Q Page 4 of 13 © Prep101 3. A monopoly is bad for the economy because of the excess economic profits accrued by that monopoly. If the government imposed a tax that took these profits from the monopoly, would there still be a cost/burden on society as a result of the monopoly? Assume that governments hold all tax revenues. Solution: YES there is still a social burden after the tax The burden bestowed by monopolies (on society) can be categorized into 2 parts: • Income distortion – monopolists make economic profits at the expense of consumers • Allocative distortion/inefficiency (market price is above marginal costs) – if the entire economy was controlled by a single benevolent planner s/he would spend the profits earned by the monopoly on some other good, to better share these gains. Because these profits are not shared in a monopoly regime, there is a sub-optimal allocation of resources, thus allocative inefficiency A government tax on profits would shift the ATC and MC curves upwards (the monopoly would now incur the new tax cost on top of its old costs). This could be done to the point that the monopoly earns no economic profits, thus overcoming the income distortion. This would occur where P = ATC. Note: because the MC curve shifts, so too does the monopoly’s production point (QM0 QM1). In the face of increased MC (not only this type of tax, any increase in MC), a monopoly would decrease its output. The tax in this question would absorb the producer surplus based on this new output level. Since we assume governments hold all tax revenues, the profits taken away from the monopoly effectively disappear from the economy. Thus this tax policy does not overcome the allocative inefficiency cost. Graphically, this occurs where price > MC. MC1 P MC0 AC1 Consumer surplus AC0 PM PPC Producer surplus = tax revenue DWL D QM1 QM0 Q QPC Page 5 of 13 MR © Prep101 III. (7 points) Is the following statement TRUE or FALSE? Illustrate your answer with a(n) appropriate diagram(s). For many years, the TTC had a monopoly on public transit in Toronto and charged seniors, children and students lower fares than adults. The TTC did this out of a benevolent concern for these customers, and offered these discounted fares even though it reduced profits. Solution: FALSE – this is an example of price discrimination, and is done to exploit differences in consumer’s elasticity of demand, not out of benevolence. In charging these customers a lower price, the TTC is price discriminating between the two groups to maximize their profits. Seniors, children and students have more elastic demands than adult travelers. That is, in the face of adult prices, these “special” groups may forego public transit (in favour of substitutes [i.e. bicycle]), whereas adult consumers are typically forced to travel and they typically have larger discretionary incomes. It is in pursuit of revenues from these “special” groups, that the TTC offers discounted fares. If they did not, the TTC would risk losing this clientele altogether. Adult Customers (A) “Special” Customers (S) P P PA PS MCS MCA D QA MCA DS Q QS Page 6 of 13 MCS Q © Prep101 IV. (20 points) For a very long time, Bell Canada had a monopoly on local telephone services in Toronto. Assume for now that Bell Canada is still a monopoly, in long run equilibrium with normal cost curves. 1. Draw a diagram that depicts this market (as it was when Bell Canada was a Monopoly), making sure to label the Producer Surplus (PS), Consumer Surplus (CS), Deadweight Loss (DWL), and price and quantity sold (Hint: instead of labeling the diagram by colouring in regions, label points [i.e. point A, B, etc.] on the diagram and describe regions such as “CS = P0EP2” Solution (in a Monopoly): Price – P3 Quantity – q1 Producer Surplus – P3AGP0 Consumer Surplus – P3AP4 Dead Weight Loss – AGB P P4 MC P3 P2 P1 A E F B G D P0 C q1 q0 Q MR Page 7 of 13 © Prep101 3. Now suppose that the market is opened to competition. Explain how the market will evolve from a monopoly to a perfectly competitive market (even though the Canadian local telephone service is not one). Make sure to identify the new PS, CS and DWL. (Hint: use the diagram from the previous diagram, and again identify regions using the form “CS = P0EP2”). Solution: • Initially Bell Canada is earning economic profits, which attracts new firms to enter the market • As firms enter, the industry supply increases, causing a drop in the market price • This process continues until the allocative efficient equilibrium is reached (where P = ATC) • At this equilibrium economic profits are zero, and firms stop entering the industry as it is no longer “profitable” to do so Producer Surplus – P2BP0 Consumer Surplus – P2BP4 Dead Weight Loss – in tax-free perfect competition, there is no DWL 4. One measure of social welfare is PS + CS + tax revenue. That is, the gain to producers, consumers and Government. Using your responses to the previous 2 questions, complete the table. Consider the change in social welfare when moving from a monopoly and perfect competition. What do you find? Is this surprising? Solution: PS CS Tax Rev. Social Welfare Monopoly P3AGP0 P3AP4 N/A Perfect Competition P2BP0 P2BP4 N/A P4AGP0 P4BP0 Social welfare is greater under perfect competition, bolstering the idea that monopolies are inefficient. The difference in welfare is AGB. Page 8 of 13 © Prep101 V. (35 points) P P4 MC P3 P2 P1 A E F B G D C P0 QM QPC MR Q 1. Consider this diagram. Which section outlines the loss in consumer surplus by moving from perfect competition to monopoly? a. P4BP2 b. AGB c. QMABQPC d. P3ABP2 Solution: D Perfectly competitive equilibrium is at point B where supply (MC for monopolist) equals demand. CS at this equilibrium is P4BP2. Monopolist equilibrium price is P3, which corresponds to QM which is where MR=MC. This gives a CS of P4AP3. The decrease is CS is given by P3ABP2. 2. If there is a successful collusive agreement among oligopolistic firms to maximize profit a. Industry price will equal the marginal cost of production b. Industry price will equal the average cost of production c. Price will be the same as the competitive price d. Price will be the monopoly price e. Industry marginal revenue will equal industry average cost of production Solution: D When oligopolists collude, they restrict the output and produce the monopolist output, charging the monopolist price. Without colluding, they compete against each other and decrease prices, leading to increased output. Page 9 of 13 © Prep101 3. Compare two firms – a firm in perfect competition and a monopoly firm – which are both in long run equilibrium. Which of the following statements is correct about long run equilibrium? a. Price equals marginal cost for both firms b. Price equals marginal cost for the perfectly competitive firm and price exceeds marginal cost for the monopoly c. Both firms will produce at the lowest point of their average total cost curve d. Price and marginal cost equal average total cost for the perfectly competitive firm but price may be less than average total cost for the monopoly e. None of the above Solution: B For a perfectly competitive firm, P=MR. Since profit maximization is where MC=MR, for a competitive firm P=MR=MC. In a monopolist equilibrium, MR=MC is the profit maximization criterion, and the monopolist price is found on the demand curve. But the MR curve always lies below the demand curve, so monopolist price will ALWAYS be above MC (for a given quantity). 4. A perfectly competitive firm is currently producing at an output level where price is $10.00, average variable cost is $6.00, average total cost is $12.00, and marginal cost is $8.00. In order to maximize profits, this firm should: a. Shut down b. Decrease output c. Increase output d. Increase the market price e. Not change output. This firm is at its profit maximizing position Solution: C P>MC, so an additional unit of production will bring more revenue to the producer (MR=P) than the cost of producing that additional unit (MC). So the firm should increase output to maximize profits. Page 10 of 13 © Prep101 5. In the short run production period, with labour as the only input, which one of the following statements is correct? a. With fixed factor prices, when average product per worker is at a maximum, average variable cost is at a minimum; b. When the marginal cost curve is increasing, then the average variable cost curve must also be increasing c. When there is an increase in fixed costs, there will also be an increase in marginal costs; d. The minimum point of the average total cost curve will occur at a lower output than the minimum point of the average variable cost curve e. None of the above Solution: A When average product per worker is at a maximum, it reaches the point of diminishing average return on the average product curve. At this point, given fixed factor prices, average variable cost begins to increase. b) is wrong because the marginal cost curve rises before the average variable cost curve rises. c) is wrong because average fixed costs fall over time while marginal costs first fall then rise. d) is wrong because the minimum point of the average total cost curve will occur at a higher output than the minimum point of the average variable cost curve. 6. The law of diminishing returns implies a. Upward-sloping short run supply curves b. Downward-sloping demand curves c. Downward-sloping long run supply curves d. Upward-sloping demand curves e. None of the above Solution: A The law of diminishing returns states that if increasing amounts of a variable factor are applied to a given quantity of a fixed factor, eventually a situation will be reached in which the marginal product of the variable factor declines. As marginal product falls, marginal cost rises and results in an upward sloping supply curve. Page 11 of 13 © Prep101 7. A monopolistically competitive firm and a monopoly firm are similar in which of the following ways? a. Each firm has a large number of insignificant competitors b. Both firms will earn zero profits in the long run c. Both firms always operate at their point of minimum average total cost d. Each firm can raise its price without losing all of its sales e. Both firms must behave strategically towards other firms in the industry Solution: D Since both monopoly and monopolistic competition firms faces downward sloping demand curves, if the price increases, even though the quantity demanded will decrease, there will still be some positive quantity. 8. Consider three firms: a perfectly competitive firm, a pure monopolist firm and a firm in monopolistic competition. Which one of the following statements is correct in the long run? a. Normal profits will be made by the firm in perfect competition, but economic profits will be made by the firms in the other two industries b. Price will exceed marginal cost in the cases of pure monopoly and pure competition; c. Normal profits will be made by the firm in perfect competition and by the firm in monopolistic competition; d. Price will equal marginal cost in the cases of perfect competition and monopolistic competition e. None of the above Solution: C In competitive markets, because there are no barriers to entry, firms will always make zero profits. This is true for perfect competition as well as monopolistic competition. Page 12 of 13 © Prep101 9. Which one of the following statements is correct for a pure monopolist? a. The monopolist can set both price and output b. The monopolist will maximize profits along the inelastic part of the average revenue curve c. If fixed costs increase, the monopolist will increase price and reduce output d. If fixed costs increase, the monopolist will reduce price and increase output e. If disposable incomes increase and the monopolist produces a normal good, the monopolist’s price and output will both increase Solution: E When demand that a monopolist faces increases, the demand and MR curves shift to the right. Monopolist adjusts the production decision by equating the MC curve to the new MR curve. At the new equilibrium market price is higher and so is market quantity, and monopolist is making a greater profit. 10. Suppose a monopolist can sell 5 units per day at a price of $3 each, and 6 units per day for $2.50 each. The marginal revenue for the last unit sold is: a. $2.50 b. $3.00 c. $0 d. $0.50 e. Uncertain, not enough info is given to compute the marginal revenue Solution: C The total revenue from selling the first 5 units of output is 5×$3=$15, and the total revenue from selling the 6 units of output is 6×$2.5=$15, so the marginal revenue for the 6th unit sold is $15-$15=0. Page 13 of 13 ...
View Full Document

This note was uploaded on 11/29/2011 for the course ECO 100 taught by Professor Indart during the Fall '08 term at University of Toronto.

Ask a homework question - tutors are online