Test02_fin_a.docFoundations of Economic AnalysisStratton

Fall 2005 Test 02Name ______Key______

Description: This test is divided into three (3) sections: definitions, short answer, and problems. Your ability to demonstrate understanding, insight and/or the ability to use the material is the primary purpose of the assessment. Thus full credit will only be earned if you follow the directions carefully and provide the explanation, description, thought process as directed. Note the slight difference in the weight of the questions in each section and allocate your time accordingly.

Instructions: All answers are to be in the booklet provided. While you may want to use the test page as scratch paper, only the responses in the booklet will be graded. Please be sure to write legibly, identify the question being answered, and clearly mark any information you want ignored.

Definitions(Q1 – 5) (10 points total – 1 point each for definition, 1 point each for significance):For each term, write a short definition in your own words and explain the significance of the term. The significance should indicate why this term is important in the study of economics.

  1. Diminishing returns to labor – A proposition that states that at some level of labor usage, the output gained by using one additional unit of labor (MP of labor) will decline as more units of labor are employed while holding other input usage constant. It is the reason for upward-sloping MC curves.
  2. Best practices (Economic efficiency) – Production techniques that creates the highest levels of productivity. Using inputs to produce the most output at the least cost. This depends on the relative costs and productivity of the inputs. An essential concept to understand optimal mix of input to minimize production costs.
  3. Industry concentration – measures the output distribution of firms in an industry. High concentration implies that few firms control a large percentage of the total market (industry) output. It is important for both categorizing markets (competitive to monopolistic) and in application of anti-trust laws.
  4. Barriers to entry – Costs which make entry into a market difficult. These might be caused by economies of scale, critical input ownership or control, government rules, or other conditions. They help define market structure and firm behavior.
  5. Non-rival consumption – Consumption of the good by one person does not affect its consumption by another. Thus once it is provided, everyone can consume it simultaneously. The MC of supplying other consumers is zero. An important implication is that for such goods, the efficient price (MC=MB) should be zero also and no private person has an incentive to produce the product.

Short Answer Questions(Q6 – 24) (57 points total – 1 point each for the answer, 2 points each for explanation or reasoning):Answer each question in the booklet provided. Please indicate any assumptions you make, explain your thinking and show all work to receive full credit.

  1. Assume a firm is currently producing 100,000 pairs of shoes per year. Its ATC is $10 per pair and its total FC is $100,000 per year. Find the firm’s TC and TVC. TC = ATC*Q = $10*100,000 = $1 million per year. TVC = (TC – FC) = $1,000,000 - $100,000 = $900,000 per year.
  2. As more labor is used (other things held constant) output (TP) at first increases, reaches a maximum and then declines. What is the value of marginal product of labor (MPL) at the point that TP is at its maximum? MPL = 0. If MPL > 0, then TP is increasing;If MPL< 0, then TP is decreasing; since TP first increases (MPL>0) and then decreases (MPL<0) MPL must = 0 at TP maximum.
  3. As more labor is used (other things held constant) output (TP) at first increases, reaches a maximum and then declines. Assuming labor is the only variable input, what do we know about the AVC and MC at the level of output at which the marginal product of labor (MPL) equals the average product (AP)? AVC is minimum and MC = AVC. If AP = MP, then AP is at its maximum. That means that the firm is getting the maximum output per unit of variable input (labor). With wages constant, maximum AP implies minimum AVC. If MC < AVC, then AVC is decreasing; If MC > AVC, then AVC is increasing;since AVC first decreases (MC < AVC) and then increases (MC > AVC). MC = AVC at AVC minimum. Thus we also know that MC = AVC at this level of output.
  4. Assume an industry is characterized by many medium firms, but no small or large firms.Draw a representative LRAC and industry demand for the industry. Explain how your drawing is consistent with the industry description. Assume there are n firms; the MES will occur about output level 1/n. The LRAC will have a relatively steep gradient.
  5. In a perfectly competitive market will a firm earning zero economic profit shut down in the long run? Why or why not?No. Earning zero economic profit means they are earning a profit comparable to alternative uses of the resources. Thus there are no other opportunities to use the resources more productively and no reason to shut down. In fact, if they do shut down, those resources will be used in other endeavors and be able to earn zero profit, at most.
  6. Briefly explain why typical firms in a monopolistically competitive market earn zero economic profits in the long run.One characteristic of monopolistic competition is low barriers to entry. If firms in the market (industry) are making an economic profit (more than their can earn in alternative pursuits) than other entrepreneurs will be attracted to the market and firms will enter. More firms in the market will increase the supply, there will also be less differentiation between products so the elasticity of demand facing each firm will increase. This combination forces the equilibrium price down. Firms will continue to be attracted to the market as long as profits are positive. [Firms will exit if profits are negative and the process is reversed.] Thus in the long run, firms will typically earn zero economic profits.
  7. Is it possible for a monopolistic firm to earn zero economic profit in the short run?Yes. In the short run demand for the product might fall sufficiently to eliminate all economic profits.
  8. In a perfectly competitive industry, the market price is $12. One firm in the industry is producing 10,000 units per month, its average total cost is $15 per unit, its average variable cost is $8 per unit and its marginal cost is $8 per unit. Is the firm maximizing its profits? If not, should the firm increase or decrease output to maximize profits? Please explain.The firm is not maximizing profits, since Price > MC. Thus MR > MC and the firm should increase production until P = MC.
  9. In a perfectly competitive industry, the market price is $12. One firm in the industry is producing 10,000 units per month, its average total cost is $15 per unit, its average variable cost is $8 per unit and its marginal cost is $8 per unit. Is the firm minimizing its average total cost?If not, should the firm increase or decrease output to minimize average total cost? Please explain.No the firm is not minimizing ATC, since minimum ATC occurs where ATC = MC. Since ATC > MC the firm should increase production until ATC = MC to minimize ATC.
  10. In a perfectly competitive industry, the market price is $15. One firm in the industry is producing 10,000 units per month, its average total cost is $12 per unit, its average variable cost is $10 per unit and its marginal cost is $12 per unit. Is the firm maximizing its profits? If not, should the firm increase or decrease output to maximize profits? Please explain. The firm is not maximizing profits, since Price > MC. Thus MR > MC and the firm should increase production until P = MC.
  11. In a perfectly competitive industry, the market price is $15. One firm in the industry is producing 10,000 units per month, its average total cost is $12 per unit, its average variable cost is $10 per unit and its marginal cost is $12 per unit. Is the firm minimizing its average total cost?If not, should the firm increase or decrease output to minimize average total cost? Please explain. Yes the firm is minimizing ATC, since minimum ATC occurs where ATC = MC.While the firm is minimizing ATC, it is not maximizing profits. To maximize profits it must increase output until MC = P.
  12. In a perfectly competitive industry, the market price is $15. One firm in the industry is producing 10,000 units per month, its average total cost is $12 per unit, its average variable cost is $10 per unit and its marginal cost is $12 per unit. If this firm is typical of the industry, what do you expect to happen in this market in the long run? Please explain. First, while the firm is not maximizing profits it is earning a profit (P>ATC). So I would expect it to increase output until MC = P. Second, since the firm is typical in the market and is making an economic profit, I would expect other firms to be attracted to the market. The long run equilibrium (assuming costs remain the same) would be for the market price to fall to $12 per unit.
  13. If monopolies reduce economic efficiency as compared to perfect competition, as we have argued, why do governments try to protect particular sellers against the competition that additional entrants would create? – For a variety of reasons. 1) to accommodate political interests, 2) to allow economic profits as a reward for innovation, 3) to stimulate research, 4) to prevent the loss of economies of scale – to name a few.
  14. How might government restrictions on advertising benefit producers? – If advertising is self-canceling – that is my advertising offsets your advertising – and market shares are not permanently affected, then firms could lower costs (FC) by reducing advertising. But no one firm has that incentive, so they do not do it on their own. However, if government mandated it (or enforced an agreement to reduce it) then the firms could benefit by reduced fixed costs and increased profits.
  15. Some purposes of advertising are to differentiate a product, build brand loyal and increase market power. To the extent that the advertising is successful, one could argue that it increases inefficiency. What economic benefits does advertising provide that, at least partially, offset these inefficiencies? – The primary positive aspect of advertising is that it provides information. If this information is relevant to consumer choice, that is a benefit.
  16. Explain what is meant by “non-price competition” and why it is used. – Non-price competition is the act of using non-price characteristics of a product to differentiate it from rival (substitute) products to increase consumer demand for the product. It includes style, size, features, location, branding, etc. It is used to differentiate one’s product and to capture market share.
  17. One approach to reducing pollution is to tax polluters. Consider two tax proposals: 1) Each firm is taxed $100,000 per year; 2) Each firm is taxed 1% of its sales. Assume the industry is perfectly competitive. Compare and contrast the impact of each proposal on a typical firm’s profit maximizing output level and short run profit.Proposal 1 increases FC and thus TC but not MC. Thus it will reduce the firm’s profits, but not change its profit maximizing output. Proposal 2 increases VC and thus TC and MC. Thus it will reduce the firm’s profit maximizing output level as well as its profits.
  18. Successful advertising campaigns tend to increase the firm’s market share and customer loyalty. Carefully describe how such a successful advertising campaign would affect the demand faced by the firm.- If the advertising campaign increased market share, the firm’s demand curve would shift to the right. If the advertising campaign increased consumer loyalty, it would mean fewer customers would switch if the price increased (demand becomes more inelastic or less elastic). This should translate into the firm facing a less elastic demand to the right of current demand and allow increased price and maybe output (in SR).
  19. Advertising campaigns often try to change the firm’s revenue functions by increasing the firm’s market share and customer loyalty. However, advertising campaigns also change the firm’s cost functions. How would an economically knowledgeable manager judge the success of this campaign? – The rule it that the marginal cost of the campaign is less than the marginal benefit. Therefore for the campaign to be successful, the additional cost of the campaign must be less than the additional revenue generated by the increased market share and increased loyalty.

Problems(Q 25 – 34)(40 points total – 2 points each for the answer, 2 points each for explanation or reasoning):Answer each question in the booklet provided. Please indicate any assumptions you make, explain your thinking and show all work to receive full credit.

Figure 1:Presents the relevant cost information for AlphaOmega Company. Output is measured in units per week and price in dollars per unit.

  1. If AlphaOmega Company operates in a perfectly competitive market and the market price is $35 per unit, what is the profit maximizing output level? Profit max occurs at MC=P. In this case MC = $35. Profit maximization occurs at just under70 units per week.
  2. If AlphaOmega Company operates in a perfectly competitive market. Below what market price will this firm cease operations (shut down)? The firm will operate as long as P >= minimum AVC. Thus at a price below $20 per unit the firm will cease operations.
  3. If AlphaOmega Company operates in a perfectly competitive market and the market price is $30 per unit, what is the maximum amount of profit the firm can earn? Profit max occurs at MC=P. In this case MC = $30. That occurs at about 60 units per week. Profit = (AR – ATC)*Q or ($30 - $26) * 60 = $240 per week.
  4. If AlphaOmega Company operates in a perfectly competitive market and its costs are typical of firms in the market, what will be the market price at long run equilibrium?At long run equilibrium competitive firms earn no profits. That will occur at a market price of $25 per unit.
  5. If AlphaOmega Company operates in a monopolistically competitive market and its costs are typical of firms in the market, what will be the long run equilibrium output and price for this firm?At long run equilibrium monopolistically competitive firms earn no profits. However, they face a downward sloping demand for their differentiated product. So, the long run output level for this firm will be less than 50 unit per week and it will charge a price greater than $25 per unit.

Figure 2: Cost and revenue information for BetaGamma Company. Output is measure in units per month. These questions are related; a small error at the beginning can be very costly. So be careful and show all of your reasoning and calculations.

  1. What is the profit maximizing output levelfor the BetaGamma Company? Profit max occurs at MC=MR. In this case MC = MR at 75 units of outputper week.
  2. What is the profit maximizing price the BetaGamma Company should charge? Profit max occurs at MC=MR. In this case MC = MR at 75 units of outputper week. The maximum price BetaGamma can charge and sell all 75 units per week is $25 per unit.
  3. Estimate the maximum profit (or minimum loss) the BetaGamma Companycan earn. Be sure to show all work to get full credit.At a price of $25 per unit and selling 75 units of outputper week BetaGamma’s TR = $25 * 75 = $1875 per week. Their TC for 75 units per week is about $22 * 75 units = $1650 per week. Thus profit is $225 per week. [Alternatively, profit = (AR – ATC)*Q = ($25 - $22)*75 = $3*75 = $225 per week.
  4. Estimate the Lerner Index (price-cost margin)for this profit maximizing firm. – Lerner index (the price-cost margin) is one measure of the extent of concentration (market power). It is calculated as (P – MC)/P. In this case ($25 - $10)/$25 = 0.6. This is comparable to the concentration in breakfast cereals (0.672 p. 203).
  5. Describe the market structure in which the BetaGAmma Company operates.Be sure to clearly indicate the differentiating characteristics that allowed you to identify the market structure.BetaGamma has some market power, since it faces a downward sloping demand. We cannot know more for sure without knowing the number of competitors it faces. If there are many competitors, it would be operating in a monopolistically competitive market. If there are no close competitors, it is a monopoly. If there are only a few competitors, it would be operating in an oligopolistic market. However, this is least likely since the demand facing it would depend on the actions of its rivals. The Lerner index of 0.60 indicates a relatively concentrated market.

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