Test 3 16 December 2009

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1 Eco 301 Name Test 3 16 December points. Please write all answers in ink. Please use pencil and a straight edge to draw graphs. Allocate your time efficiently. 1. The New York Times, a profit-maximizing newspaper, faces a downward-sloping demand schedule for advertisements. When advertising for itself in its own pages (for example, an ad saying "Read Maureen Dowd in the Sunday Times"), is the opportunity cost of a given-size ad simply the price it charges its outside advertisers? Explain. First look at how the Times prices its ads to outside advertisers, who have a downwardsloping demand curve for ad space. When the Times sets its price for outside ads, its rule is to equate marginal revenue to marginal cost. Marginal cost is simply the cost of expanding the paper to accommodate the extra ad. When the paper maximizes profit, the price it charges outsiders for ads will thus be higher than the marginal cost of producing another ad. When the Times advertises for its own features, its rule should be to continue placing more ads until the marginal benefits (in terms of increased sales or higher prices) just equal the cost of producing an extra ad. The opportunity cost to the Times of running another ad is thus the marginal cost of producing the ad, which in general will be lower than the price it charges outside advertisers. 2. Suppose the government imposed a price ceiling on a monopolist (an upper bound on the price the monopolist can charge). Let P* denote the price ceiling, and suppose the monopolist incurs no costs in producing output. True or false: If the demand curve faced by the monopolist is inelastic at the price P*, then the monopolist would be no better off if the government removed the price ceiling. If demand is inelastic at the price ceiling, we know the monopolist could increase its profits by raising its price. So false. 3. Would you expect a firm that adopts cost-saving innovations faster than 80 percent of all firms in its industry to earn economic profits? If so, will there be any tendency for these profits to be bid away? Yes, in the short run, firms that innovate first will reap economic profit until other firms catch up and compete away the economic profit. Thus intensive innovation efforts are consistent with the perfect competition model.

2 4. The demand for gasoline is P = Q and the supply is P = Q, where P is in dollars and Q is in gallons. If a tax of $l/gal is placed on gasoline, what is the incidence of the tax? What is the lost consumer surplus? What is the lost producer surplus? (Hint: With tax, assume the supply curve shifts upward by 1 unit, which makes it: P= Q). Demand is given by P = Q, and supply is given by P= Q. In equilibrium, sale and purchase prices are equal. Thus, we get Q= Q, which solves for Q=800 and P=3.4. When we solve Q= Q, we get Q=1900/3 and P=56/15. This is the price paid by the consumer. The supplier gets P=41/15. The incidence of tax on the supplier is 2/3, and on the consumer it is 1/3. The consumer surplus before tax is [(5-3.4)x800]/2 = 640. The producer surplus before tax is [( )x800]/2 = The consumer surplus after tax is [(5-56/15)x1900/3]/2 = The producer surplus after tax is [(41/15-0.2)x1900/3]/2 = Lost consumer surplus is Lost producer surplus is True or false: Consumer surplus is the area between the demand curve and the price line. For a perfectly competitive firm the demand curve equals the price line, which makes it perfectly elastic. Thus a perfectly competitive industry produces no consumer surplus. Consumer surplus in a competitive industry is the area between the price line and the market demand curve, not the individual firm's demand curve. Since the market demand curve is downward sloping, there will in general be positive consumer surplus. Indeed, compared to other market structures, perfect competition creates the maximum consumer surplus. So false.

3 Eco 301 Name Test 3 17 December points. Please write all answers in ink. Please use pencil and a straight edge to draw graphs. Allocate your time efficiently. 1. How does the hurdle model of price discrimination mitigate both the efficiency and fairness problems associated with monopoly? The hurdle model gives the lower price only to those willing to jump the hurdle so the markets are more easily segregated. Deadweight losses are reduced. 2. Why does a profit-maximizing monopolist never produce on an inelastic portion of the demand curve? Would a revenue-maximizing monopolist ever produce on the inelastic portion of the demand curve? On the inelastic portion of the curve, raising price will always increase revenue and (since output will be lower) it also lowers costs. Therefore the firm should always move up the demand curve to where it is not inelastic if profit maximization is a goal. 3. The domestic supply and demand curves for Jolt coffee beans are given by P = 10 + Q and P = 100 2Q, respectively, where P is the price in dollars per bushel, and Q is the quantity in millions of bushels per year. The United States produces and consumes only a trivial fraction of world Jolt bean output, and the current world price of $30/bushel is unaffected by events in the U.S. market. Transportation costs are also negligible. a. How much will U.S. consumers pay for Jolt coffee beans, and how many bushels per year will they consume? At a world price of 30, domestic demand is 35 million bushels per year. Domestic producers supply the 20 million bushels of this total; foreign producers the remaining 15 million (left panel.) b. How will your answers to part (a) change if Congress enacts a tariff of $20/bushel, thereby raising the price of imported coffee beans to $50/bushel? With a tariff of $20/bu, the import price becomes $50/bu. Because the domestic market clears at $40/bu (center panel), this means that no beans will be imported. c. What total effect on domestic producer and consumer surplus will the tariff have? How much revenue will the tariff raise? Since no beans are imported, the tariff raises no revenue. Consumer surplus and producer surplus with the tariff is the area of triangle ABC (center panel), which equals $1350/yr.

4 Consumer surplus and producer surplus before the tariff-- the shaded area in the right panel-- was $1425/yr, which means that the tariff has reduced consumer and producer surplus by $75/yr. 4. What is the difference between economic profit and accounting profit, and how does this difference matter for actual business decisions? Economic profit includes all costs, while accounting profit looks only at cash flow. The firm should consider economic profit only. 5. A monopolist has a demand curve given by P = Q and a total cost curve given by TC = Q 2. Find the monopolist's profit-maximizing quantity and price. How much economic profit does the monopolist earn? The profit-maximizing level of output for a single-price monopolist occurs where MR = MC. The linear demand curve P = 100 Q has associated marginal revenue of MR = 100 2Q. Setting marginal revenue equal to marginal cost, MC = 8Q, we have 100 2Q = 8Q, which solves for Q = 10. The price charged for this quantity is read off the demand curve: P = 100 Q = = 90. The monopolist s price rises and quantity falls due to the increase in marginal costs. The monopolist earns lower profit than before: π = TR TC = 90Q (16 + 4Q 2 ) = = 484.

MULTIPLE CHOICE. Choose the one alternative that best completes the statement or answers the question.

MBA 640 Survey of Microeconomics Fall 2006, Quiz 6 Name MULTIPLE CHOICE. Choose the one alternative that best completes the statement or answers the question. 1) A monopoly is best defined as a firm that