Introductory Microeconomics - EC155A and B

November 24th, 2001

 

SOLUTIONS TO SECOND EXAMINATION

 

I.              Thinking like an economist

 

 

1.        According to a recent article in The Campus (October 24, 2001), the couple that owns the Storm Café in Middlebury has recently decided to ‘downsize and reorganize their business.’  Specifically, they are no longer open for seated dinners at night (although they still sell carry-out dinners from 4:00 to 6:00 PM).   The owners explained that with the birth of a baby boy, they have decided to reduce their time running the restaurant ‘in favor of family necessities.’

Assume that the couple was making zero economic profits before the birth of their child.  Explain how the birth of their child has changed the calculation of their economic profits, and therefore led them to ‘downsize and reorganize’.

Economic profits = (Explicit revenues  + Implicit revenues) – (Explicit costs - implicit costs).  If they were earning zero economic profits prior to the birth of their son, this could now be less than zero since the opportunity cost of their time has gone up – leading to a higher implicit cost.  Presumably, they are cutting back until the MB of their revenues = the MC of working, including the hours lost.

2.        A fisherwoman who works by herself has noticed the following relationship between hours spent fishing and the quantity of fish caught.

Hours

Quantity of fish

MP

0

0

 

1

10

10

2

18

8

3

24

6

4

28

4

5

30

2

 

What is her marginal product for each hour spent fishing?  What additional information would you need in order to advise her about the profit-maximizing level of fishing effort?  Justify your answers.

See above.  You would need information about the price of fish, her explicit and implicit costs (including the opportunity cost of her time) and (this wasn’t required) the nature of the market (monopoly, say, vs. perfect competition)

3.        Consider the following table of long-run total cost for two different firms.

 

Quantity

 

1

2

3

4

5

6

7

Firm A

60

70

80

90

100

110

120

 

60.00

35.00

26.67

22.50

20.00

18.33

17.14

Firm B

11

24

39

56

75

96

119

 

11

12

13

14

15

16

17

 

If you were Warren Buffet, which one of these firms would you invest in so that it could increase its output?  Which one of these firms should employ a personnel specialist in order to build company morale?  Justify your answers.

Buffet should invest in firm A, since it is experience economies of scale (see calculations above) : the more it produces, the lower is the cost of each good.  A personnel specialist would help the firm B, since it is experiencing diseconomies of scale – which, we saw, can come from low ‘team spirit’ among a firm.

4.        Next semester, you and your roommate plant to run a Ben and Jerry’s delivery service on campus.  Will you be operating under conditions of perfect competition, monopoly, monopolistic competition, or oligopoly?  How will you decide what prices to charge?  Justify your answers.

It depends.  Not perfect competition, but you can make an argument for each of the other three.  The best answer is probably monopolistic competition, but I accepted any well-reasoned answer.  NOTE: if you made the case for monopoly, you had to make the case why there would be complete barriers to entry – a tough case to make!

5.        The graph below shows the demand and marginal costs faced by a monopolist who has no fixed costs.

 

 Profit (a)

P                                                                                     Profit (b)

 

 

 

 


                                                                       

                                                        Q

On the graph, label (a) the profits of a monopolist that can only charge one price (the standard model); and (b) the profits of a price discriminating monopolist that can charge a different price to every consumer.  Explain your answers.

(a)     See above.  The rectangle is the profit: total revenues less total cost.

(b)     See above:  The triangle is the profit, since they could charge each consumer what they were willing to pay.

6.        What aspects of the global market for oil resemble the pure ‘Cartel Model’?  What aspects of the global market for oil resemble the ‘Contestable Markets Model’?  Justify your answers.  

See the discussion in Colander.  It is mostly the Cartel Model, but one can argue that there are elements of the contestable markets model, since the barriers to entry are large ad other producers (Russia, Norway, Mexico) are always willing to jump in an provide that residual amount that is demanded on the open market: this may force OPEC to keep its prices lower than it otherwise would as a pure cartel. 

II:            The relationship between productivity and costs.

In the lead article in this week’s Addison Independent (November 12, 2001), Lawrence Miller of Otter Creek Brewery discusses the rising cost of health insurance in Addison County.  He noted that the employer’s share of health insurance for each of his employees has gone up by 30% over the last two years, which is forcing him to make some changes in the way he runs his company.  He further noted that this increase of insurance costs also seems to be happening to most of his competitors in the microbrew market in New England.

1.        Assume that in the short run, all inputs to production at Otter Creek Brewery are fixed except for labor and the goods that are used to make beer (water, hops, malt, etc).  In the space below, plot the likely marginal product and average product curves for Otter Creek Brewery --  and justify the relative location and shape of your curves.  What point on your graph corresponds to the minimum of the short run average total cost curve (SRATC)?

 

Minimum of SRATC
 

MP
 
Output per worker

 (in cases)

 

 

 

 

 

 

 

 

 


                                                                                                                        Output

SEE GRAPH ABOVE

2.        How will the change in insurance costs shift either of the curves in your graph in (1) above, if at all?  How will the change in insurance costs change the point on your graph that corresponds to the minimum of the SRATC, if at all?  Justify your answers.

It will not change the production relationship at all, since this production relationship is shows what workers can produce in the presence of other fixed inputs (equipment, machinery, etc).  In the long run, they could change because those fixed inputs could change, thereby affecting the marginal product of each worker.

3.        In the short run, how will this will the change in insurance costs affect Lawrence Miller’s: (a) average fixed costs; (b) average variable costs; (c) average total costs; and (d) marginal costs?  Justify your answers.

(a)     average fixed costs would not change, if we assume that all FC are machinery and equipment related;

(b)     average variable costs will increase, since the cost of hiring an additional worker has increased;

(c)     average total costs will also increase, since AVC has gone up ;

(d)     and marginal costs go up, since the cost of hiring an additional worker has increased.

4.        Assume that Otter Creek operates under the long-run conditions of monopolistic competition.  Based on the comments of Lawrence Miller that are summarized above, how will the change in insurance rates affect prices in the microbrew market in New England?  Justify your answer. 

Miller noted that this increase of insurance costs is also affecting his competitors.  This means that while his MC (and ATC) has shifted up, so has the MAC (and ATC) of the others in this industry.  When MC shifts up, this means that  MC = MR at a lower optimal quantity – remember, the demand schedule hasn’t changed – which would mean a higher equilibrium price.

5.        Assume still that Otter Creek operates under the long-run conditions of monopolistic competition.  How will the change in insurance rates affect Lawrence Miller’s long-run profits?  Justify your answer.

Since ATC has shifted up, price must now be below ATC (if Otter Creek had been earning zero profits, which is consistent with operating under the long-run conditions of monopolistic competition.  This means that for the short – run , they will be earning negative economic profits.  What happens in the long-run depends on whether other microbreweries drop out first (as they have to replace capital equipment and machinery, so that in the long run ATC becomes AVC), so he gets a larger share of the market (demand shifting out) .

III:           Firm behavior in different market structures

A large share of the world’s supply of diamonds comes from Russia and South Africa.  Suppose that the marginal cost of mining diamonds is $2000 per diamond, and the demand for diamonds is described by the following schedule.

Price

Quantity

TR

MR

 

 

 

 

$8,000

5,000

$40,000,000

--

 

 

 

 

$7,000

6,000

$42,000,000

$2,000,000

 

 

 

 

$6,000

7,000

$42,000,000

$0

 

 

 

 

$5,000

8,000

$40,000,000

-$2,000,000

 

 

 

 

$4,000

9,000

$36,000,000

-$4,000,000

 

 

 

 

$3,000

10,000

$30,000,000

-$6,000,000

 

 

 

 

$2,000

11,000

$22,000,000

-$8,000,000

 

 

 

 

$1,000

12,000

$12,000,000

-$10,000,000

 

 

 

 

 

 

1.        If there were many suppliers of diamonds, what would be the equilibrium price and quantity for diamonds?

If the MC = $2000, then the perfectly competitive outcome would be where the MC (supply) curve and the demand curve intersect, which is a P = $2000 and Q = 11,000.

2.        If there were only one supplier of diamonds, what would be the equilibrium price and quantity for diamonds?  

In this case, you have to calculate the marginal revenue for an monopolist, as noted in the fourth column.  So since a monopolist sets MR = MC, the equilibrium quantity would be 6,000, and the price would be $7,000

3.        If Russia and South Africa formed a cartel, what would be the equilibrium price and quantity for diamonds?  If the countries split the market evenly and each had a fixed cost of $5,000,000, what would be South Africa’s level of production and profit?  

In a cartel, the (non-cheating) players act as a monopolist, so the equilibrium quantity would again be 6,000, and the price would be $7,000.

If they each split the market, they would each produce 3,000.  So South Africa’s profits would be calculated as follows:

Profits = TR – TC = PQ – (FC + VC) = PQ – (FC + AVC*Q) = PQ – (FC + Q*MC) = (P-MC)Q – FC = ($7,000 - $2,000)*3,000 – $5,000,000 =

$5,000*3,000 - $5,000,000 = $15,000,000 - $5,000,000 = $10,000,000

(Note that we know that AVC = MC here, since MC is constant. )

4.        If South Africa increased its production to by 1000 while Russia stuck to the cartel agreement, what would be South Africa’s profit?

Since an additional 1000 would be on the market (3000 from Russia and 4000 from SA), the equilibrium price would fall to $6,000.  Now, there profit would be calculated as

Profits = (P-MC)Q – FC = ($6,000 - $2,000)*4,000 – $5,000,000 =

$4,000*4,000 - $5,000,000 = $16,000,000 - $5,000,000 = $11,000,000

5.        Use your answers above to explain why cartel agreements are often not successful.   

As we discussed, everybody has an incentive to cheat.

 

IV:          Strategic consulting in Addison County

Over the last few weeks, as part of your participation in the group project in this course, you each have begun to learn about firms, social service agencies, or public agencies within a certain sector  that operate in Addison County (for example clothing or elderly services.)  Each of these firms or agencies, is some way, provides economic goods or services to people who live or travel through this area.  To answer the following set of questions, please choose one of the firms or agencies that you have been studying (for example, Forth and Goal or Project Independence.)

1.        Briefly describe the firm or agency.  List some of the fixed costs for the firm or agency, and described why they are fixed.  List some of the variable costs for the firm or agency, and described why they are variable.  Justify your answers. 

Group-specific answer

2.        How would you characterize the current demand for the economic goods or services that your  firm or agency provides: relatively elastic or inelastic?;  shifting in or shifting out?  Justify your answers.

Group-specific answer

3.        In the market in which it operates is your firm or agency ever a ‘price maker’?  Is it ever a ‘price taker’?  Justify your answers.

Group-specific answer

4.        What are the current constraints that your firm faces in trying to increase its profits -- or what are the current constraints that that your agency faces in trying to increase the services that it provides for the community?  Justify your answers.  

Group-specific answer

5.        Describe and illustrate how participation in a group project in a course can be analogous to “The Prisoner’s Dilemma” (or, equivalently, “The Clothing Shop Game” which we did in class).  What mechanisms are available to  participants in a group project to assure that they attain the ‘Group Optimum’ equilibrium as opposed to the ‘Nash’ equilibrium?  Justify your answers.

Set up a 2 x 2 game theory model to show that everybody has the incentive to free ride. 

So as noted below, let’s say that students value ‘time for fun’ – time freed up because they are slackers on their group project! – by more than one increment of a grade (for example, they value fun time more than a change from B+ to A-,.  Then, as the game below illustrates, everybody has an incentive to slack under group project conditions where everybody gets a common grade, based on their collective input.  Under these conditions, social norms might prevent people from slacking.

The group project game

 

Player 2

 

 

Slack

Work hard

PLAYER 1

Slack

P1 gets B and time for fun

P1 gets B+ and time for fun

 

P2 gets B and time for fun

P2 gets B+ but no time for fun

Work hard

P1 gets B+ but no time for fun

P1 gets A- but no time for fun

 

P2 gets B+ and time for fun

P2 gets A- but no time for fun