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1 The following is the first sample problem set for your final examination. I will also post here more problem sets (with questions mostly needing calculations), as well as a previous final exam (all multiple choice questions) with answers coming soon. I hope that all these will help you Regards, Dr. Salmasi PRACTICE QUESTIONS FOR THE FINAL EXAM (Part 1) 1. Why would a firm that incurs losses choose to produce rather than shut down? Losses occur when revenues do not cover total costs. Revenues could be greater than variable costs, but not total costs, in which case the firm is better off producing in the short run rather than shutting down, even though they are incurring a loss. The firm should compare the level of loss with no production to the level of loss with positive production, and pick the option, which results in the smallest loss. In the short run, losses will be minimized as long as the firm covers its variable costs. In the long run, all costs are variable, and thus, all costs must be covered if the firm is to remain in business. 2. What is the difference between economic profit and producer surplus? While economic profit is the difference between total revenue and total cost, producer surplus is the difference between total revenue and total variable cost. The difference between economic profit and producer surplus is the fixed cost of production. 3. Why do firms enter an industry when they know that in the long run economic profit will be zero? Firms enter an industry when they expect to earn economic profit. These short-run profits are enough to encourage entry. Zero economic profits in the long run imply normal returns to the factors of production, including the labour and capital of the owners of firms. For example, the owner of a small business might experience positive accounting profits before the foregone wages from running the business are subtracted from these profits. If the revenue minus other costs is just equal to what could be earned elsewhere, then the owner is indifferent to staying in business or exiting. Practice questions for the final exam, Part One (Dr. Salmasi s sections) 1

2 4. At the beginning of the twentieth century, there were many small American automobile manufacturers. At the end of the century, there are only three large ones. Suppose that this situation is not the result of lax federal enforcement of antimonopoly laws. How do you explain the decrease in the number of manufacturers? (Hint: What is the inherent cost structure of the automobile industry?) Automobile plants are highly capital-intensive. Assuming there have been no impediments to competition, increasing returns to scale can reduce the number of firms in the long run. As firms grow, their costs decrease with increasing returns to scale. Larger firms are able to sell their product for a lower price and push out smaller firms in the long run. Increasing returns may cease at some level of output, leaving more than one firm in the industry. 5. Industry X is characterized by perfect competition, so every firm in the industry is earning zero economic profit. If the product price falls, no firms can survive. Do you agree or disagree? Discuss. Disagree. As the market price falls, firms cut their production. If price falls below average total cost, firms continue to produce in the short run and cease production in the long run. If price falls below average variable costs, firms cease production in the short run. Therefore, with a small decrease in price, i.e., less than the difference between the price and average variable cost, the firm can survive. With larger price decrease, i.e., greater than the difference between price and minimum average cost, the firm cannot survive. In general, we would expect that some firms will survive and that just enough firms will leave to bring profit back up to zero. 6. An increase in the demand for video films also increases the salaries of actors and actresses. Is the long-run supply curve for films likely to be horizontal or upward sloping? Explain. The long-run supply curve depends on the cost structure of the industry. If there is a fixed supply of actors and actresses, as more films are produced, higher salaries must be offered. Therefore, the industry experiences increasing costs. In an increasing-cost industry, the long-run supply curve is upward sloping. Thus, the supply curve for videos would be upward sloping. 7. True or false: A firm should always produce at an output at which long-run average cost is minimized. Explain. False. In the long run, under perfect competition, firms should produce where average costs are minimized. The long-run average cost curve is formed by determining the minimum cost at every level of output. In the short run, however, the firm might not be producing the optimal long-run Practice questions for the final exam, Part One (Dr. Salmasi s sections) 2

3 output. Thus, if there are any fixed factors of production, the firm does not always produce where long-run average cost is minimized. 8. The government passes a law that allows a substantial subsidy for every acre of land used to grow tobacco. How does this program affect the long-run supply curve for tobacco? A subsidy on tobacco production decreases the firm s costs of production. These cost decreases encourage other firms to enter tobacco production, and the supply curve for the industry shifts out to the right. 9. From the data in the following table, show what happens to the firm s output choice and profit if the price of the product falls from $40 to $35. The table below shows the firm s revenue and cost information when the price falls to $35. Q P TR TC MC MR TR P = 35 MR P = 35 P = At a price of $40, the firm should produce eight units of output to maximize profit because this is the point closest to where price equals marginal cost without having marginal cost exceed price. At a price of $35, the firm should produce seven units to maximize profit. When price falls from $40 to $35, profit falls from $60 to $ A sales tax of $1 per unit of output is placed on one firm whose product sells for $5 in a competitive industry. a. How will this tax affect the cost curves for the firm? Practice questions for the final exam, Part One (Dr. Salmasi s sections) 3

4 With the imposition of a $1 tax on a single firm, all its cost curves shift up by $1. b. What will happen to the firm s price, output, and profit? Since the firm is a price-taker in a competitive market, the imposition of the tax on only one firm does not change the market price. Since the firm s short-run supply curve is its marginal cost curve above average variable cost and that marginal cost curve has shifted up (inward), the firm supplies less to the market at every price. Profits are lower at every quantity. c. Will there be entry or exit? If the tax is placed on a single firm, that firm will go out of business. In the long run, price in the market will be below the minimum average cost point of this firm. 11. How does a car salesperson practice price discrimination? How does the ability to discriminate correctly affect his or her earnings? The relevant range of the demand curve facing the car salesperson is bounded above by the manufacturer s suggested retail price plus the dealer s mark-up and bounded below by the dealer s price plus administrative and inventory overhead. By sizing up the customer, the salesperson determines the customer s reservation price. Through a process of bargaining, a sales price is determined. If the salesperson has misjudged the reservation price of the customer, either the sale is lost because the customer s reservation price is lower than the salesperson s guess or profit is lost because the customer s reservation price is higher than the salesperson s guess. Thus, the salesperson s commission is positively correlated to his or her ability to determine the reservation price of each customer. 12. Why did Loews bundle Gone with the Wind and Getting Gertie s Garter? What characteristic of demands is needed for bundling to increase profits? Loews bundled its film Gone with the Wind and Getting Gertie s Garter to maximize revenues. Because Loews could not price discriminate by charging a different price to each customer according to the customer s price elasticity, it chose to bundle the two films and charge theatres for showing both films. The price would have been the combined reservation prices of the last theatre that Loews wanted to attract. Of course, this tactic would only maximize revenues if demands for the two films were negatively correlated. 13. How does tying differ from bundling? Why might a firm want to practice tying? Tying involves the sale of two or more goods or services that must be used as complements. Bundling can involve complements or substitutes. Tying Practice questions for the final exam, Part One (Dr. Salmasi s sections) 4

5 allows the firm to monitor customer demand and more effectively determine profit-maximizing prices for the tied products. For example, a microcomputer firm might sell its computer, the tying product, with minimum memory and a unique architecture, then sell extra memory, the tied product, above marginal cost. 14. How can a firm check that its advertising-to-sales ratio is not too high or too low? What information does it need? The firm can check whether its advertising-to-sales ratio is profit maximizing by comparing it with the negative of the ratio of the advertising elasticity of demand to the price elasticity of demand. The firm must know both the advertising elasticity of demand and the price elasticity of demand. 15. Many retail video stores offer two alternative plans for renting films: A two-part tariff: Pay an annual membership fee (e.g., $40) and then pay a small fee for the daily rental of each film (e.g., $2 per film per day). A straight rental fee: Pay no membership fee, but pay a higher daily rental fee (e.g., $4 per film per day). What is the logic behind the two-part tariff in this case? Why offer the customer a choice of two plans rather than simply a two-part tariff? By employing this strategy, the firm allows consumers to sort themselves into two groups, or markets (assuming that subscribers do not rent to non-subscribers): high-volume consumers who rent many movies per year (here, more than 20) and low-volume consumers who rent only a few movies per year (less than 20). If only a two-part tariff is offered, the firm has the problem of determining the profit-maximizing entry and rental fees with many different consumers. A high entry fee with a low rental fee discourages low-volume consumers from subscribing. A low entry fee with a high rental fee encourages membership, but discourages high-volume customers from renting. Instead of forcing customers to pay both an entry and rental fee, the firm effectively charges two different prices to two types of customers. 16. Why does price leadership sometimes evolve in oligopolistic markets? Explain how the price leader determines a profit-maximizing price. Since firms cannot explicitly coordinate on setting price, they use implicit means. One form of implicit collusion is to follow a price leader. The price leader, often the dominant firm in the industry, determines its profit-maximizing price by calculating the demand curve it faces: it subtracts the quantity supplied at each price by all other firms from the market demand, and the residual is its demand curve. The leader chooses the quantity that equates its marginal revenue with marginal cost. The market price is the price at which the leader s profit-maximizing quantity sells in the market. At that price, the followers supply the remainder of the market. Practice questions for the final exam, Part One (Dr. Salmasi s sections) 5

6 17. Explain the meaning of a Nash equilibrium. How does it differ from equilibrium in dominant strategies? A Nash equilibrium is an outcome where both players correctly believe that they are doing the best they can, given the action of the other player. A game is in equilibrium if neither player has an incentive to change his or her choice, unless there is a change by the other player. The key feature that distinguishes a Nash equilibrium from an equilibrium in dominant strategies is the dependence on the opponent s behaviour. An equilibrium in dominant strategies results if each player has a best choice, regardless of the other player s choice. Every dominant strategy equilibrium is a Nash equilibrium but the reverse does not hold. 18. Two firms are in the chocolate market. Each can choose to go for the high end of the market (high quality) or the low end (low quality). Resulting profits are given by the following payoff matrix: Low Firm 2 High Firm 1 Low -20, , 600 High 100, , 50 a. What outcomes, if any, are Nash equilibria? A Nash equilibrium exists when neither party has an incentive to alter its strategy, taking the other s strategy as given. If Firm 2 chooses Low and Firm 1 chooses High, neither will have an incentive to change (100 > -20 for Firm 1 and 800 > 50 for Firm 2). If Firm 2 chooses High and Firm 1 chooses Low, neither will have an incentive to change (900 > 50 for Firm 1 and 600 > -30 for Firm 2). Both outcomes are Nash equilibria. Both firms choosing low is not a Nash equilibrium because, for example, if Firm 1 chooses low then firm 2 is better off by switching to high since 600 is greater than -30. b. What is the cooperative outcome? The cooperative outcome would maximize joint payoffs. This would occur if Firm 1 goes for the low end of the market and Firm 2 goes for the high end of the market. The joint payoff is 1,500 (Firm 1 gets 900 and Firm 2 gets 600). c. Which firm benefits most from the cooperative outcome? How much would that firm need to offer the other to persuade it to collude? Practice questions for the final exam, Part One (Dr. Salmasi s sections) 6

7 Firm 1 benefits most from cooperation. The difference between its best payoff under cooperation and the next best payoff is = 800. To persuade Firm 2 to choose Firm 1 s best option, Firm 1 must offer at least the difference between Firm 2 s payoff under cooperation, 600, and its best payoff, 800, i.e., 200. However, Firm 2 realizes that Firm 1 benefits much more from cooperation and should try to extract as much as it can from Firm 1 (up to 800). Practice questions for the final exam, Part One (Dr. Salmasi s sections) 7