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’.

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
2	18
3	24
4	28
5	30

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.

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
Firm B	11	24	39	56	75	96	119

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.

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.

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

P

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.

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.

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)?

Output per worker

(in cases)

Output

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.

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.

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.

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.

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
$ 8,000	5,000
$ 7,000	6,000
$ 6,000	7,000
$ 5,000	8,000
$ 4,000	9,000
$ 3,000	10,000
$ 2,000	11,000
$ 1,000	12,000

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

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

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?

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

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

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.

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.

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.

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.

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.