Econ 211
Problem Set 3
Spring 2000

1. Suppose that a young chef opened his own restaurant. To do so, he quit his job, which was paying $28,000 per year; cashed in a $5,000 certificate of deposit that was yielding 5% (to purchase equipment); and took over a building owned by his wife which had been rented out for $1,000 per month. His expenses for the first year amounted to $50,000 for food, $40,000 for extra help, and $4,000 for utilities. The chef is trying to figure out whether he would have been better off not being in business last year. He knows how to calculate his revenues, but he needs help with the cost side of the picture. What were the chef's total economic costs?

2. A business executive claims a company should never hire another worker if the new person causes diminishing returns. Explain why this person is wrong.

3. "My overhead (fixed cost) at this car dealership is $2,000 per day. So I figure that the best way to make the most money is to sell as many cars as possible, thereby spreading out the overhead so it is only a small part of the cost on each car sold." What is wrong with the reasoning of this person?

4. You are the adviser to President Wilson of Marietta College. A wealthy alumnus buys, then gives a plot of land to the university for use as an athletic field. The president says that, as far as the land is concerned, it does not cost the college anything to use the land as an athletic field. What do you say?

5. Several years ago, Congress authorized development of the Z-13 bomber, based on a cost estimate of $10 billion and a benefit estimate of $15 billion. The benefit estimate appears to be correct, but costs to date total $20 billion, and the plane still is not ready. The cost of completing the project, X, is uncertain. Congressman Jones wants to stop now: "Whatever the value of X, it is clear that the Z-13 will yield negative net benefits." Congresswoman Smith wants to continue: "If we stop now, we will have wasted $20 billion." Comment. How should the decision depend on the value of X?

6. The following table shows some of the long-run costs for the American Production Company. Fill in the missing values.

7. What determines the shape of the short run MC curve? Explain.

8. The Preservation Embalming Company's cost data have been partially entered in the table below. Following the sudden and unexpected death of the company's accountant, you are called on to fill in the missing entries.

9. Draw a diagram showing a competitive firm operating at a loss in the short run. Identify the loss. Identify the loss the firm would incur if it shut down and explain why the firm continues to operate.

10. Suppose that you own a house that you are planning to be away from for one year. In a typical month when the house is occupied, you pay $400 in utility bills and $300 in taxes. If the house is vacant, the utility bills fall to $150, but the tax bill remains the same. Somebody wants to rent your house from you while you are away. What is the minimum rent she would have to pay before you would agree?

11. A competitive firm is maximizing profits by producing 250 units of output at the current market price of $1000 per unit. The firm has AFC of $300 and total costs of $300,000 at this output level.
a) Draw a graph showing all the relevant cost and demand curves. That is, include the MR, MC, AVC, and ATC curves.
b) Calculate FC, VC, ATC, AVC, MC, TR, and MR.
c) Calculate and indicate the area of profits on your graph.
d) In light of your answer above, does it make sense that this firm is "maximizing profits"? Explain precisely.

12. Your coffee mug company is currently producing at an output level of 200 units per month. Fixed costs are $500 per month. At the current output level, you know that marginal cost is $10 and equal to average total cost. At an output level of 150, you have determined that marginal cost would be $6 and equal to average variable cost. The market price for your coffee mugs is $8. If your goal is profit maximization, should you continue at q = 200, increase q above 200, or reduce q below 200? Would you do better to shut down? (Hint: It might be useful to sketch the cost curves and demand curve for this firm.)

13. Perfectly Competitive Firm:

a) Complete the table.
b) What is the p -maximizing price and output level? How does MR compare with MC at this output level?
c) Using your favorite spreadsheet, plot the following graphs:
Graph 1: TR, TC, VC, FC versus q
Graph 2: MR, MC, ATC, AVC versus q
Graph 3: p versus q
d) Suppose the market price fell to $3.00 per unit. What would the new p -maximizing output level be? Why?

14. Differentiate between the factors that give the short-run average cost curve and the long-run average cost curves their shapes.

15. What three conditions must be satisfied for a competitive industry to be in long-run equilibrium? Why is each condition necessary?

16. In the 1960s, hula-hoops were a popular toy, but in a short while, their novelty wore off and prices fell. However, after a few months, they were higher than ever. Given this description, trace out on a graph the fluctuations in supply and demand. What kind of long-run cost industry is this?

17. "Economists are silly to say that profits are competed away in the long run. No firm would operate unless it made profits." Explain.

18. Assume that the domestic beer industry is a constant cost industry. Let society's demand for beer increase. Explain precisely (using graphs and words) the chain of events that must happen for society to have more beer at the same price. (Hint: That is, derive the long run supply curve for a constant cost industry while discussing the market supply and demand curves and the individual firm's decision process assuming we start from a point of zero economic profit.)

19. "Monopoly is good for producers but bad for consumers. The gains of the former offset the losses of the latter. On balance, there is no reason to think that monopoly is bad for the economy." Evaluate.

20. Is price discrimination harmful to the US economy? Explain why or why not. What three conditions are necessary for successful price discrimination?

21. A price discriminating seller will charge a higher price to those market segments which have the relatively more inelastic demand. For each of the markets below, indicate which segment you think will be charged the higher price. Explain why you think that segment has a lower elasticity of demand.
a) sales of new boats to those who presently own a boat, or those who do not own a boat.
b) sales of movie tickets to children or adults.
c) sales of airline tickets to business travelers or a couple on vacation.
d) sales of cosmetic surgery to the poor or the rich.

22. It has been argued that the development of the railroad in the middle of the nineteenth century substantially reduced the market power of many American manufacturing firms. Explain.

23. If an organization like the Mafia effectively monopolized illegal activity, would you expect to observe less crime than under competitive free entry into this "industry"?

24. A price searcher produces output at a constant marginal cost of $5 per unit and has no fixed costs. The demand schedule facing the price searcher is below:

a) What is the p -maximizing output, price, and profit?
b) Sketch a diagram of the firm's demand curve, MR curve and MC curve. Indicate the optimal output and price.

25. How are some firms able to earn economic profits year after year after year? Why doesn't the competitive process force economic profits to zero?

26. A monopolist produces 100 units of output where MR = MC and charges a price of $20. The average cost of 100 units is $12. Draw this situation on a graph.
a) What is total revenue, total cost, and economic profit at this output level?
b) Suppose the government imposes a lump-sum tax of $300 on the monopolist. How does the monopolist respond to this in terms of price and output? Illustrate graphically. What are its profits now?

27. A monopolist is producing at a point where its marginal cost exceeds its marginal revenue. How should it adjust its output level to increase its profit?

28. Monopolistic Firm:

a) Complete the table.
b) What is the p -maximizing output and price?
c) Using your favorite spreadsheet, plot the following graphs:
Graph 1: TR, TC, VC, FC versus Q
Graph 2: P, MR, MC, AC, AVC versus Q
Graph 3: p versus Q
d) What is the lowest price at which the monopolist would be willing to operate at in the short run?

29. The following table indicates the prices various buyers are willing to pay for a Miata sports car:

The cost of producing the cars includes $50,000 of fixed costs and a constant marginal cost of $10,000.
a) Graph the demand, marginal revenue, and marginal cost curves.
b) What is the profit-maximizing output and price for a monopolist? How much profit does the monopolist make?
c) If the monopolist can practice first-degree price discrimination, how many cars will she sell? How much profit will she make?
d) What techniques could the monopolist use to employ price discrimination?