# COMM 295 MIDTERM REVIEW SESSION BY WENDY ZHANG

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1 COMM 295 MIDTERM REVIEW SESSION BY WENDY ZHANG

2 TABLE OF CONTENT I. Introduction, Supply and Demand, Elasticity II. Estimation III. Profit Maximization IV. Competition, Consumer and Producer Surpluses V. Monopoly VI. Price Discrimination VII. Game Theory

3 INTRODUCTION, SUPPLY AND DEMAND, ELASTICITY Positive (Descriptive) Statement A statement made based on facts Could be tested or proved Could be true or false does not necessarily have to be a true fact! Normative (Prescriptive) Statement A statement made based on subjective opinion Debatable and persuasive Market Equilibrium is the point where the demand curve intersects with the supply curve; this point is also called the market-clearing pricing. The price elasticity of demand Arc Elasticity Point Elasticity 1. Identify the following statements as either positive or normative. Justify. a. Trump is going to be the best president for the Americans. Normative; this is an assertion of subjective opinion that cannot be tested by facts b. More people buy from Walmart because its merchandises are relative cheaper. Positive; this is a statement that could be proven or disproven by tests c. Samsung will go out of business by the time Apple releases iphone 7. Positive; this can be tested whether it be true or not, it could be proven or disproven by the outcome when the time comes

4 2. The demand function for the elementary band concert ticket is Q d=4p-10, where Q d is the number of tickets and P is the price per ticket. The supply is represented by Q S=7P-40, where Q s is the number of tickets supplied. What is the price and quantity of tickets sold at equilibrium? i. Since equilibrium is where Q d=q s, equate the two functions 4P-10 and 7P-40 and solve for P 4P-10=7P-40 30=3P P=\$10 ii. Given P, plug the value in and solve for Q d or Q s Q d=4(\$10)-10 Q d=30 tickets 3. Weekly demand for NuNunemon leggings is expressed as P=50-Q. Determine the price elasticity of demand at a price of \$25 per pair of leggings. i. Use point elasticity equation ii. Assume change of P to be from \$25 to \$0, then change of P is \$25-\$0=\$25 Plug in P=\$25 and P=\$0 into the demand function P=50-Q, so we get two Q s of 25 pairs of leggings with P=\$25 and 50 pairs of leggings when P = \$0; change of Q is therefore 25-50=-25 pairs of leggings Given change of P=\$25, change of Q=-\$25, P=\$25 and Q=50-\$25=\$25, plug in using the equation E P=(-25/\$25) x (\$25/25)= -1

5 ESTIMATION Ordinary Least Squares draws a line across all data points such that the sum of squared residuals is as small as possible. Goodness of Fit (R 2 ) suggests how well the relationship is explained by the function. 1. The regression for kale chips estimates a demand of Qd=24-8P. The regression model has R 2 statistic of You find out that one of the data points used to derive the demand function was incorrect. The actual price is \$3.29 rather than \$2.19 so the residual of that point should actually be smaller. What happens to R 2? If residual is smaller, that means variation is smaller. Smaller variation means greater accuracy in the prediction of the relationship and since R 2 is the test of how well the relationship is explained by the regression function, R 2 becomes larger. 2. The demand function for diamond ring is Qd=9000-8P where P is the price of the diamond ring. The standard error is Given that P is \$900, find the t-statistic for the price coefficient and interpret your t-statistic. i. Use formula t statistic = Price coefficient Standard error ii. Given price coefficient of \$900 and standard error of 24.6, plug in the numbers iii. t-statistic=\$900/24.6= The number of thunderstorms in a week is positively correlated with midterm class average. It s tempting to conclude that higher midterm class average is caused by more thunderstorms in a week, but it s incorrect! What explains the relationship here? Third factor problem more thunderstorms are correlated with higher midterm class average because students are more likely to stay home and study more for the midterm

6 PROFIT MAXIMIZATION Profit is maximized at the point where MR=MC MR is the derivative of the revenue function; MC is the derivative of the cost function 1. The short-run total cost function of Susie s furniture shop is C=800+6Q-4Q 2 +5Q 3 +Q 4. Rewrite the function to reflect average cost, average variable cost, average fixed cost and marginal cost. Average cost = (800+6Q-4Q 2 +5Q 3 +Q 4 )/Q Average variable cost = (6Q-4Q 2 +5Q 3 +Q 4 )/Q Average fixed cost = 800/Q Marginal cost (derivative of the function) = 6-8Q+15Q 2 +4Q 3 2. Mike s donut shop has a price function of P=702-7Q and a cost function of C=35+2Q. What is the profit maximizing quantity? Given that the average variable cost function is AVC=Q/25 and an average fixed cost of \$1600, should Mike shut down the shop in a short run? How about in a long run? Mike should shut down the shop in a short run if MR<AVC when profit is maximized i. To find point of profit maximization, set MR=MC Revenue (R)= P x Q = (702-7Q) x Q = 702Q 7Q 2 Marginal revenue (MR) = derivative of R function = Q Marginal cost (MC) = derivative of C function = Q = 2 14Q = 700 Q = 50 P = 702 7(50) = \$352 Profit is maximized when P=\$354 and Q=50 ii. Plug profit-maximizing quantity Q=50 into MR function MR = (50) =\$2 iii. AVC = \$2 when Q=50 iv. Since MR = AVC, Mike should not shut down in the short run Mike should shut down in a long run only if MR<AC when profit is maximized i. AC = AVC + AFC = Q/ ii. AC = \$1602 when Q=50 iii. Since MR is \$2, MR < AC, Mike should shut down in the long run

7 COMPETITION, CONSUMER AND PRODUCER SURPLUS Perfect Competition Firms are price takers price of good is determined by the market; cannot set price themselves There are many sellers and buyers Products are identical; no differentiation Buyers and sellers have full information of products Easy entry and exit in the long run Low transaction costs Consumer surplus is the area under the demand curve but above the market price; it is the difference between what consumers are willing to pay for relative to the market price. Producer surplus is the area under the market price and above the supply curve; it is the difference between the market price and the minimum amount that induces producers to produce. 1. The market demand for muffin tin is Qd=84-6P. There are currently 20 firms in the market, each with a supply function of Qs=2P-4. a. If the minimum average cost is \$8, explain using a graph whether the firms will enter or exit the market in a short run. i. Set Qd=Qs to get equilibrium quantity and price 84 6P = 2P 4 88 = 8P P = \$11; since MR = P in perfect competition, MR = \$11 Q = 18 ii. Only shut down in the short run if MR < AVC and in the long run if MR < AC, but since MR>AC, the firms should not exit the market

8 b. Derive a long run market supply curve. 2. A steel market has a demand of Qd=110-3P. If price is \$20 for each unit of steel, what is the consumer surplus? Consumer surplus is the area under demand curve and above MC (or P) curve Qd = 110 3(\$20) = 50 CS = [(110-20) x (50-0)]/2 CS = The demand for the aluminum market is Qd=400-3P. Market equilibrium is at Q=40. Suppose the government has placed a price ceiling at \$150. What is the loss in consumer surplus? Show calculation and explain with a graph. i. Price ceiling raises price and reduces market demand for aluminum (a shift along the demand curve). The reduce in demand induces all producers to decrease supply (a shift of supply curve toward the left). ii. The new equilibrium shifts from Q = 40 and P = \$120 to Q = 10 and P = \$130 iii. Old CS = [( ) x 40]/2 = 5600 iv. New CS = [( ) x 10]/2 = 1350 v. Change in CS = = \$4250 (loss in consumer surplus is \$4250 as a result of price ceiling)

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10 MONOPOLY Monopoly Price setter company sets the price at which to sell the product Only one firm in the market with no other substitutes 1. A monopolistic electricity provider faces a market demand curve of Qd=40-2P. The cost of generating the electricity is expressed by C=890+8Q. At what price and quantity should the firm produce to maximize profit? Set MR = MC P = (40 Q)/2 = 20 Q/2 Revenue (R)= P x Q = (20 Q/2) x Q = 20 Q Q 2 /2 Marginal revenue (MR) = derivative of R function = 20 Q Marginal cost (MC) = derivative of C function = 8 MR = MC = 20 Q = 8 Q = 12 P = 20 12/2 = \$14 2. Given that P=500-2Q and that C=40Q. At what quantity will a monopoly produce? What is the deadweight loss as a result? i. Set MR = MC Revenue (R)= P x Q = (500 2Q) x Q = 500Q 2Q 2 Marginal revenue (MR) = derivative of R function = 500 4Q Marginal cost (MC) = derivative of C function = 40 MR = MC 500 4Q = 40 4Q = 460 Q = 115 P = 500 2(115) = \$270 ii. Deadweight loss is the difference between the total surplus at perfect competition where no deadweight loss occurs and the total surplus of the monopoly where there is a deadweight loss In perfect competition, P = MC, so P = \$40 At P = \$40, Q = 230 TS at perfect competition = [(500 40) x 230]/2 = TS at monopoly = [( ) x 115]/2 = 13225

11 TS (perfect competition) TS (monopoly) = = Deadweight loss is Ginger Ltd. used to be a perfectly competitive firm in a large market. It has a demand curve of Qd=220-2P. The market cost function is C=2Q. One day, a thunderstorm destroyed all its competitors and all of a sudden, Ginger Ltd. becomes the monopoly. How much consumer surplus gets transferred to the producer? i. Find profit-maximizing Q and P under perfect competition; P = MC Qd=220-2P 2P = 220 Qd P = 110 Qd/2 MC = derivative of C function = 2 P = MC 110 Qd/2 = = Qd/2 Qd = 216; P = /2 = \$2 CS (perfect competition) = [(110 2) x 216]/2 = ii. iii. Find profit-maximizing Q and P under monopoly; MR = MC Revenue (R)= P x Q = (110 Qd/2) x Q = 110Q Q 2 /2 Marginal revenue (MR) = derivative of R function = 110 Q Marginal cost (MC) = derivative of C function = 2 MR = MC 110 Q = 2 Q = 108; P = /2 = \$56 CS (monopoly) = [(110 56) x 108]/2 = 2916 Calculate change in consumer surplus = CS (perfect competition) CS (monopoly) = 8748 consumer surplus got transferred to Ginger Ltd. (producer) Price Discrimination 1. A monopoly firm has a demand function of Qd=900-6P and cost function of C=60+20Q. What is the profit under perfect price discrimination? i. Find profit-maximizing Q and P MR = MC 6P = 900 Q P = 150 Q/6 Revenue (R)= P x Q = (900 Q/6) x Q = 150Q Q 2 /6 Marginal revenue (MR) = derivative of R function = 150 Q/3 Marginal cost (MC) = derivative of C function = 20 MR = MC 150 Q/3 = 20 Q = 390; P = /6 = \$85 ii. Find producer surplus to determine profit PS = [(150 85) x 390]/2 = 12675

12 2. Magical Produce Co. is a monopoly undergoing uniform pricing. It has a price function of P=140-2Q and cost function of C=68+6Q. a. If you are the manager trying to maximize profitability, will you practice perfect price discrimination? How profitable is perfect price discrimination? Explain and justify your answer. Under uniform monopoly pricing: MR = MC Revenue (R)= P x Q = (140 2Q) x Q = 140Q 2Q 2 Marginal revenue (MR) = derivative of R function = 140 4Q Marginal cost (MC) = derivative of C function = 6 MR = MC 140 4Q = 6 Q = 33.5; P = 140 2(33.5) = \$73 Profit = PS = [(140 73) x 33.5]/2 = Under perfect price discrimination: P = MC 140 2Q = 6 2Q = 136 Q = 68; P = 140 2(68) = \$4 Profit = PS = [(140 4) x 68]/2 = = Perfect price discrimination is \$ more profitable than uniform pricing b. From the social standpoint, should Magical Produce Co. switch to perfect price discrimination? Explain and justify your answer. Yes, under perfect price discrimination, there is zero deadweight loss because the quantity being supplied by Magical Produce Co. is equal to a quantity that would be supplied by a perfectly competitive firm such that total surplus is maximized c. Assume that now Magical Produce Co. decides to go with perfect price discrimination. It has a new marginal cost function of MC=30+7Q. How much consumer surplus gets transferred to the producer? Under uniform monopoly pricing: MR = 140 4Q MR = MC 140 4Q = Q Q = 10; P = 140 2(10) = \$120 CS = [( ) x10] = \$200

13 Under perfect price discrimination: All consumer surplus (\$200) gets transferred to producer 3. Carcinogen Electricity Co. is a monopoly that decides to target two segments of consumer: Gen X and Gen Y. Gen X has a demand given by P=150-2Q while Gen Y has a demand given by P=60-Q/2. Cost function is 4Q. How should the company charge its customers to maximize profit? This is a group price discrimination problem; Carcinogen Electricity Co. should charge the two groups of consumer different prices For Gen X: MR = MC 150 4Q = 4 4Q = 146 Q = 36.5; P = 150 2(36.5) = \$77 should charge group Gen X \$77 For Gen Y: MR = MC 60 Q = 4 Q = 56; P = 60 56/2 = \$32 should charge group Gen Y \$32 4. Wow Ltd. has a monopolistic demand of P=100-3Q and cost of AC=MC=10. The CEO of Wow Ltd. cannot decide on which pricing proposal to adopt for conference room rental (see table below). Proposal A \$70/hr for the first 10 hours \$55/hr for the first 15 hours \$40/hr for the first 20 hours Proposal B \$55/hr a. If you are the manager, demonstrate to your CEO which pricing strategy is superior. Compare profits of the two proposals (area of producer surplus) Proposal A: PS = (70 10) x 10 + (55 10) x (15 10) + (40 10) x (20 15) = 975 Proposal B: Q = (100 55)/3 = 15 PS = (55 10) x 15 = > 675 proposal A generates a greater profit, hence is better

14 b. Explain from the consumer s perspective, which pricing is better overall? Compare consumer surpluses of the two proposals (area of consumer surplus) Proposal A: CS = [(100 70) x 10]/2 + [(70 55) x (15 10)]/2 + [(55 40) x (20 15)]/2 = 225 Proposal B: CS = [(100 55) x 15]/2 = > 225 proposal B generates greater consumer benefits, hence is better c. Explain from the social standpoint, which pricing is better overall? Compare deadweight loss generated by the two proposals (area of deadweight loss) Proposal A: DL = [(40 10) x (30 20)]/2 = 150 Proposal B: DL = [(55 10) x (30 15)]/2 = < proposal A generates smaller deadweight loss, hence is better STATIC GAME Dominant strategy is a strategy that is the best response to all possible strategic choices of the rival; there can only be one dominant strategy in a game. Nash equilibrium is a set of strategies where each player is making its best response to the other player s strategy; there can be multiple Nash equilibria in a single game. Prisoners Dilemma game always has a dominant strategy and will never arrive at the best outcome (highest joint profits) for both firms. 1. The software market is dominated by Company X and Company Y. Both companies are deciding whether to launch their software updates. If rival company launches, it will harm the host company by capturing the entire market. If both companies do not launch, firms do not incur the launching costs and things remain the same as they have always been. Company X

15 Launch Not launch Launch 1 0 Company Y 1 3 Not launch a. What is the dominant strategy? Dominant strategy is for both Company X and Company Y to launch b. What is the Nash equilibrium? Nash equilibrium is where both companies launch and each company gains 1 2. Both companies are deciding whether or not to pay for the improvement in supply chain. If one of them pays for the improvement, the improvement will benefit both companies but the company that pays will incur a cost while the rival company free rides. Pay Company X Not pay Pay 2 3 Company Y 2 5 Not pay a. What is the Nash equilibrium in this game? There is no Nash equilibrium in this game b. What is the best response of each firm?

16 The best response for Company X is to pay when Company Y does not pay, and not pay if Company Y pays The best response for Company Y is to pay when Company X does not pay, and not pay if Company X pays 3. Alice and Alex are deciding where to go for dinner. Both of them like pizza and sushi, but both prefer pizza over sushi. Pizza Alex Sushi Sushi -1 3 Alice -1 3 Pizza a. What is the Nash equilibrium in this game? The Nash equilibria are where Alex and Alice both have sushi together, and where Alex and Alice both have pizza together b. What should Alice and Alex do? There is a Pareto criterion in this coordination game. Alice and Alex should do a precommunication before picking their decisions to ensure they both arrive at the 5/5 outcome that maximizes collective benefits

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