Midterm Quiz 7 February 2008 SOLUTIONS

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1 MBA, P1 Jan Feb 2008 Prices & Markets Timothy Van Zandt Midterm Quiz 7 February 2008 SOLUTIONS The grade marked on your quiz is the number of points off; subtract from 27 to get your score. Mean grade was about 22.1 (i.e., 4.9). That was nice because the quiz was more conceptual (hence harder) than last year, yet the average score (82%) was the same. Most grades were between 19 and 25 ( 8 and 2). A grade below this range indicates a need to reinforce your understanding of the first half of the course (or possibly just getting used to taking quizes/exams again).

2 Prices & Markets Midterm Quiz SOLUTIONS 1 Part I Multiple choices without explanations Instructions: For each of these 6 problems, any number of the statements may be correct (including none or all). Circle any that are correct. (Thus, each question is really a group of true-false questions.) Provide no explanations. Problem 1. [3 points] Which of the following hold (in equilibrium) for an individual firm in the model of perfect competition? a. Its marginal revenue is less than the market price. Commentary: In perfect competition, for the individual firm MR = P. b. It never earns an economic profit. Commentary: We saw many examples in which a firm earns economic profit; e.g., heterogeneous firms in which some have comparative (i.e., competitive) advantage. This was the main point of the entrepreneurship example in Session 2 and the Bagels case in Session 7. See also discussion on FPM page 113. c. Its marginal cost equals its marginal revenue. Commentary: This the profit-maximizing condition whethera firm is a price-taker or has market power. What differs is whether MR = P or MR <P. Problem 2. [3 points] Which of the following statements about own-price elasticity of demand are valid? a. For linear demand, elasticity is higher at higher prices. Commentary: See FPM Figure 3.4; this graph was also reviewed in class. b. For log-linear demand, elasticity is higher at higher prices. Commentary: Log-linear means constant elasticity. Elasticity is the same at all prices. c. For a linear demand function, an increase in the price of a substitute good causes own-price elasticity to go down. Commentary: It causes the demand curve to shift to the left (or up) the opposite of Figure 3.2. This raises the choke price and hence reduces elasticity at any price.

3 Prices & Markets Midterm Quiz SOLUTIONS 2 Problem 3. [3 points] Which statements about the inefficiency of the decisions of a firm with market power are true, in the models we have studied in class? a. The firm has no incentive to reduce its cost of production. Commentary: In the market power model, When a firm s cost goes down, its profit goes up. b. The firm will produce too much in order to take over market share. Commentary: The firm produces too little, because MR <P. c. The firm may forgo projects that have positive net social value. Commentary: This is one of the main points of FPM Section 8.5; I also discussed it in class in the context of the trade-off in the design of a patent system and the role of government in funding basic research. Problem 4. [4 points] Which of the following are inappropriate treatments of longrun fixed costs? a. Raising prices to make up for sunk R&D expenses that were unexpectedly high. Commentary: LR fixed costs don t affect pricing whether they become sunk or not. b. Raising prices because on-going R&D expenses are unexpectedly high. Commentary: LR fixed costs don t affect pricing whether they become sunk or not. c. Forecasting R&D costs in order to decide whether to enter a market. Commentary: E.g., FPM Section 8.5., or the business plan in Session 8. d. Continuing to operate even though you are not covering your incurred R&D expenses. Commentary: OK, since these costs have now become sunk and hence cannot be recovered by exiting the market.

4 Prices & Markets Midterm Quiz SOLUTIONS 3 Problem 5. [3 points] Suppose you are trying to estimate a manufacturing rival s long-run marginal cost. Which of the following costs from the current income statement should you include? Commentary: In other words, which of the following are neither sunk nor long-run fixed costs? a. Retirement obligations to past employees. Commentary: Sunk. b. Health insurance that varies with the number of assembly workers. Commentary: Remember this is long run: if the firm ramps up output then it will hire more assembly workers and hence have higher health insurance costs. c. The salaries of its sales managers. Commentary: Remember this is long run: if the firm ramps up output then it will hire more sales managers. Problem 6. [3 points] Which of the following are reasons that the supply curve may slope upward in the model of perfect competition? a. Firms in the market have increasing marginal cost. Commentary: With a fixed number of firms in the market, each firm s supply curve is the marginal cost curve. b. Potential entrants have heterogeneous break-even prices. Commentary: E.g., illustrated in the model of entrepreneurship in Session 2. Also emphasized in FPM Section 5.4 and when we studied exit/entry with heterogeneous firms in Session 7. c. Firms exert market power. Commentary: Wrong model; the question is about perfect competition.

5 Prices & Markets Midterm Quiz SOLUTIONS 4 Part II Short answer Problem 7. [2 points] The figure below shows a demand and supply curve for a good. The government has imposed a per-unit tax on the good. You don t know the size of this tax, but you do know that the amount being transacted in the market (after the tax) is 20. Illustrate graphically (a) the size of the tax; (b) the deadweight loss. In neither case should you calculate a number. P d(p ) deadweight loss tax { s(p ) Q Commentary: Some people interpreted amount transacted as the market price; a correct answer based on this interpretation received full credit. Problem 8. [1 points] For the demand curve in Problem 7, what is the elasticity of demand when P = 80? Commentary: E = 4 P P P.Since P = 100,atP = 80 we have E = 80 =

6 Prices & Markets Midterm Quiz SOLUTIONS 5 Problem 9. [4 points] A perfectly competitive market has free entry. All potential firms have the same increasing MC curve and the same long-run FC = 1,850. The table below shows equilibrium values in the market given that N firms have entered, for N from 1 to 25. P is the price. Q i is output per firm. VΠ i is per-firm variable profit not taking into account the fixed cost. Equilibrium as function of N N P Qi V i , , , , , , , , , , , , , , , , , , , , , , , , , What is the equilibrium number of firms in the market? (No explanation required.) Commentary: As practiced in Session Answer the following about the AC curve of each firm in this market: What is approximately the quantity Q u that minimizes the average cost? Between 147 and 153. Commentary: This was meant to be hard. You have to remember that the Q u is the approximate production per firm in equilibrium in the free-entry model.

7 Prices & Markets Midterm Quiz SOLUTIONS Suppose the government imposes a license fee of 400 per firm, which is independent of the firm s output. Consider the short or medium run, in which entry and exit are not possible, so that there are still the same number of firms in the market as you found before. What happens in this time horizon to the market price? Specifically, is it higher than, lower than, or the same as before the license fee? Circle one: HIGHER LOWER SAME Commentary: A license fee is a fixed cost. Thus it drives exit/entry decisions, not the output level. Thus, until exit occurs, there is no effect on supply. E.g., when we studied entry/exit in Session 7, we first noted that the fixed cost did not affect the equilibrium price when the number of firms in the market was fixed. We also reviewed this in the review session. Problem 10. [1 points] Your consulting team does an analysis of the worldwide market for all flat-panel displays. It estimates that, at the wholesale level, the elasticity of demand is 0.7. One of your co-workers, remembering the mantra set price in the elastic portion of the demand curve, wants to advise LG to raise its price. In one simple sentence, state the flaw in your co-worker s argument. 0.7 is the elasticity of the market demand curve, not LG s demand curve. Commentary: This was meant to be hard, even though the basic point was made several times in the course: (a) discussion of elasticity on Slide 12 of Topic 3; (b) distinction between market demand and the demand of an individual firm made in the initial slides of Session 8; (c) the numerical example in the optional Demand Exercise.