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# Chapter 9 Chapter 9: The Analysis of Competitive Markets 1 Which of the following concepts is used by economists to measure the welfare

effects of
government policies on consumers? Correct Answer: Consumer surplus. .

## 2. When will a maximum price result in a loss of consumer surplus?

Your Answer: Never. Maximum prices are imposed in order to protect consumers. Correct Answer: When demand is sufficiently inelastic. Incorrect. The elasticity of demand is an important factor in determining the impact of the price ceiling.

3.
If both supply and demand are highly inelastic, the imposition of a maximum price will have: Your Answer: double deadweight loss. Correct Answer: a small deadweight loss. Incorrect. The idea of doubling the deadweight losses is not considered here.

4.
Suppose the demand for natural gas can be expressed as Q = 30 6P and the supply can be expressed as Q = 10 + 4P where Q is measured in billion mcf and price is measured in \$/mcf. What is the deadweight loss to society if government sets a price ceiling of \$1/mcf? Your Answer: \$6.67 billion Correct Answer: \$3.33 billion Incorrect. First, solve for equilibrium by setting 10 + 4P = 30 6P. This yields 10P = 20 or P =2. At this price, equilibrium quantity equals 10 + 4(2) = 18. At a price ceiling of \$1, quantity supplied equals 10 + 4(1) = 14. The value consumers place on the 14th unit is found by solving 14 = 30 6P, or P = 2.67. The deadweight loss is the value to consumers of the unsold 4 units over and above the cost to produce them. This equals the area of the triangle [(2.67 1) * (18-14)]/2 = \$3.33 billion.

5.
Suppose the demand for natural gas can be expressed as Q = 30 6P and the supply can be expressed as Q = 10 + 4P where Q is measured in billion mcf and price is

measured in \$/mcf. What is the net change in consumer surplus if government sets a price ceiling of \$1/mcf? Your Answer: Consumers gain \$14 billion. Correct Answer: Consumers gain \$12.67 billion. Incorrect. First, solve for equilibrium by setting 10 + 4P = 30 6P. This yields 10P = 20 or P =2. At this price, equilibrium quantity equals 10 + 4(2) = 18. At a price ceiling of \$1, quantity supplied equals 10 + 4(1) = 14. Consumers gain \$1 per unit on the 14 they buy at \$1 instead of \$2 for a gain of \$14 billion. The value consumers place on the 14th unit is found by solving 14 = 30 6P, or P = 2.67. The loss of consumer surplus is the value to consumers of the unsold 4 units over the old price of \$1. This equals the area of the triangle [(2.67 2) * (18-14)]/2 = \$1.33 billion. The net gain in consumer surplus equals \$14 billion minus 1.33 billion equals \$12.67 billion.

6.
Suppose the demand for natural gas can be expressed as Q = 30 1P and the supply can be expressed as Q = 10 + 4P where Q is measured in billion mcf and price is measured in \$/mcf. Do consumers benefit if government sets a price ceiling of \$1/mcf? Your Answer: Yes, because consumers will pay a lower price for natural gas. Correct Answer: No, because consumer surplus decreases. Incorrect. First, solve for equilibrium by setting 30 1P = 10 + 4P. This yields 20 = 5P or P =4. At this price, equilibrium quantity equals 10 + 4(4) = 26. At a price ceiling of \$1, 14 units are supplied. The value of the 14th unit can be solved as 14 = 30 1P or P = 16. Consumers gain \$42 billion by buying these 14 units at \$1 instead of \$4. However, this gain is offset by the lost consumer surplus of the 12 units not produced. This equals the area of the triangle [(16-4) * (26-14)]/2 = \$72 billion. On net, consumers are worse off because consumer surplus falls by (72 42) = \$30 billion.

7.
Suppose the demand for natural gas can be expressed as Q = 30 1P and the supply can be expressed as Q = 10 + 4P where Q is measured in billion mcf and price is measured in \$/mcf. What is the net loss in producer surplus if government sets a price ceiling of \$1/mcf? Your Answer: \$42 billion Correct Answer: \$60 billion Incorrect. First, solve for equilibrium by setting 30 1P = 10 + 4P. This yields 20 = 5P or P =4. At this price, equilibrium quantity equals 10 + 4(4) = 26. At a price ceiling of \$1, 14 units are supplied. The value of the 14th unit can be solved as 14 = 30 1P or P = 16.

Producers lose \$42 billion by selling these 14 units at \$1 instead of \$4. Additionally, producers lose the surplus of the 12 units not produced. This equals the area of the triangle [(4-1) * (26-14)]/2 = \$18 billion. In total, producers lose \$60 billion.

8.
When the sum of producer surplus and consumer surplus is maximized, we say that: Your Answer: the market is efficient and price signals are properly transmitted. Correct. Economic efficiency is the maximization of aggregate consumer and producer surplus.

9.
When will a minimum price benefit producers? Your Answer: When producers move along the supply curve to a higher quantity supplied associated with the minimum price. Correct Answer: When quantity supplied equals quantity demanded at the minimum price. Incorrect. In this case, producers increase quantity supplied but some of it will go unsold, which will make them worse off.

10.
Fill in the blank. If the objective of price supports is to give farmers additional income, then price supports are ________ desirable than simply giving money directly to farmers. Your Answer: less Correct. Since farmers do not have the incentive to produce unnecessary output, direct payments are preferable to price supports. Read section 9.4 in the textbook: "Price Supports and Production Quotas" for a thorough explanation.

11.
Suppose that statewide the demand for milk can be expressed as Q = 100 20P and supply can be expressed as Q = 30P where Q is measured as millions of gallons per week and P is measured as \$/gallon. If the state's dairy board establishes a \$3 per gallon price floor, and producers produce only enough milk to meet demand, what is the resulting deadweight loss to society? Your Answer: \$83.33 million Correct Answer: \$16.67 million

Incorrect. First, solve for equilibrium by setting 100 20P = 30P or 100 = 50P or P =2. At this price, equilibrium quantity equals 30(2) = 60. At P =3, quantity demanded equals 100 20(3) = 40. The price that sellers require for 40 units can be found by solving 40 = 30P or 1.33 = P. The area of the deadweight loss triangle equals [(3-1.33)*(60-40)]/2 = \$16.67 million.

12.
Suppose that statewide the demand for milk can be expressed as Q = 100 20P and supply can be expressed as Q = 30P where Q is measured as millions of gallons per week and P is measured as \$/gallon. By how much are producers better off if the state's dairy board establishes a \$3 per gallon price floor and producers stay on the supply curve? Your Answer: \$40 million Correct Answer: \$33.33 million Incorrect. First, solve for equilibrium by setting 100 20P = 30P or 100 = 50P or P =2. At this price, equilibrium quantity equals 30(2) = 60. At P =3, quantity demanded equals 100 20(3) = 40. Producers receive an extra \$1 for these 40 units as a result of the floor. Producers gain \$40 million. The price that producers require for 40 units can be found by solving 40 = 30P or 1.33 = P. The lost producer surplus equals [(2-1.33)*(60-40)]/2 = \$6.67 million. On net, producers are better of by \$33.33.

13.
Suppose that statewide the demand for milk can be expressed as Q = 100 20P and supply can be expressed as Q = 30P where Q is measured as millions of gallons per week and P is measured as \$/gallon. If the state's dairy board establishes a price support of \$3 per gallon, how much milk must the state purchase? Your Answer: 30 million gallons per week Correct Answer: 50 million gallons per week Incorrect. At a price of \$3, quantity demanded equals 100 20(3) = 40. Quantity supplied equals 30(3) equals 90. To maintain the price support, government must purchase 50 million gallons of milk per week.

14.
Suppose that statewide the demand for milk can be expressed as Q = 100 20P and supply can be expressed as Q = 30P where Q is measured as millions of gallons per week and P is measured as \$/gallon. If the state's dairy board establishes a price support of \$3 per gallon, how large is the decrease in consumer surplus? Your Answer: \$10 million Correct Answer: \$50 million Incorrect. First, solve for equilibrium by setting 100 20P = 30P or 100 = 50P or P =2. At this price, equilibrium quantity equals 30(2) = 60. At P =3, quantity demanded equals 100

20(3) = 40. Consumers pay an extra \$1 for the 40 units they buy for a loss of \$40 million. Additionally, the lost surplus on the units not purchased equals [(60-40)* (3-2)]/2 = \$10 million for a total loss of \$50 million in consumer surplus.

15.
Suppose that statewide the demand for milk can be expressed as Q = 100 20P and supply can be expressed as Q = 30P where Q is measured as millions of gallons per week and P is measured as \$/gallon. What is the total cost to society of the state's dairy board's policy to establish a price support of \$3 per gallon? Your Answer: \$125 million Correct. First, solve for equilibrium by setting 100 20P = 30P or 100 = 50P or P =2. At this price, equilibrium quantity equals 30(2) = 60. At P =3, quantity demanded equals 100 20(3) = 40. At P=3, quantity supplied equals 30(3) =90. Government must buy 50 units at a price of \$3 for a total of \$150. This is offset by the producer on those 50 units which equals [(90-40)*(3-2)]/2 =25. The net loss to society of the price support program is \$125 million.

16.
Suppose that statewide the demand for milk can be expressed as Q = 100 20P and supply can be expressed as Q = 30P where Q is measured as millions of gallons per week and P is measured as \$/gallon. To maintain a price of \$3 per gallon, the government will pay dairy farmers to limit output to 40 million gallons per week. How much must the government pay the dairy farmers? Your Answer: \$16.67 million Correct Answer: \$41.67 million Incorrect. First, solve for equilibrium by setting 100 20P = 30P or 100 = 50P or P =2. At this price, equilibrium quantity equals 30(2) = 60. At P =3, quantity demanded equals 100 20(3) = 40, the government's production target. At P=3, quantity supplied equals 30(3) =90. The supply price for 40 units is found by solving 40 = 30P or P =1.33. The lost producer surplus equals [(3-1.33)*(90-40)]/2 = 41.67.

17.
Which of the following barriers to trade generates larger government revenue? Your Answer: Import quotas. Correct Answer: Tariffs. Incorrect. Tariffs are taxes on imports, which represent government revenue. Quotas generate revenue for foreign producers, not for the domestic government.

18.

Suppose that the domestic demand for cotton towels can be expressed as Q = 200 4P and the domestic supply can be expressed as Q = 16P. If the world price is \$5 per towel, what must be the per unit tariff on towels to completely eliminate all imports? Your Answer: \$2.50 towel Correct Answer: \$5 per towel Incorrect. Find the equilibrium price by setting 200 4P = 16P or 200 = 20P or P =10. Since the world price is \$5, a \$5 tariff raises the price of imports to \$10. At that price, there is no excess demand.

19.
Suppose that the domestic demand for cotton towels can be expressed as Q = 200 4P and the domestic supply can be expressed as Q = 16P. If the world price is \$5 per towel, what is the net change in social welfare resulting from a \$3 per unit tariff on towels? Your Answer: \$240 Correct Answer: \$90 Incorrect. Without a tariff, quantity demanded equals 200 4(5) = 180. Quantity supplied equals 16(5) = 80. With a \$3 tariff, the domestic price becomes \$8. At that price, quantity demanded equals 200 4(8) = 168 and quantity supplied equals 16(8) = 128. The loss equals the areas [(8-5)*(128-80)]/2 + [(8-5)*(180-168)]/2 = \$90.

20.
Fill in the blanks. The burden of a tax will fall mostly on buyers when demand is relatively ___________ and supply is relatively __________. Your Answer: None of the above. Correct Answer: inelastic...elastic.

## Chapter 10: Market Power: Monopoly and Monopsony

1.
The XYZ Company is a monopolist in the market for a new IQ-enhancing pill. The demand for the pill is Q = 2000 (1/2)P. XYZ's marginal revenue function is Your Answer: MR = 4000 4Q. Correct. First, solve for P as a function of Q. Q = 2000 (1/2)P, then P =4000 2Q.Total Revenue, TR = (4000 2Q)*Q = 4000Q 2Q2. MR = 4000 4Q.

2.
The total cost function for a monopolist is TC = 100 + 4Q2. If the demand for the monopolist's output can be expressed as P = 50 Q, what level of output maximizes the monopolist's output? Your Answer: 10 units Correct Answer: 5 units Incorrect. MR = 50 2Q and MC = 8Q. Setting MR = MC yields 50-2Q=8Q or 50=10Q or Q = 5.

3.
The total cost function for a monopolist is TC = 100 + 4Q2. If the demand for the monopolist's output can be expressed as P = 50 Q, then maximum profit is equal to Your Answer: 25. Correct. MR = 50 2Q and MC = 8Q. Setting MR = MC yields 50-2Q=8Q or 50=10Q or Q = 5. At this level of output, the firm can charge a price of 50 5 = 45. Total revenue equals 45*5= 225. Total cost equals 100 +4(52) = 200. Profit equals 225-200=25.

4.
Assuming a stable demand curve, if a profit maximizing monopolist suddenly discovers that MR > MC, it will respond by Your Answer: increasing output and lowering price. Correct. If MR>MC, an increase in output would generate a greater increase in revenue than the increase in cost. The firm will, therefore, raise output. To sell this extra output, the firm needs to lower the price.

5.
The supply curve for a monopolist

Your Answer: is its marginal cost curve above average variable cost. Correct Answer: does not exist. Incorrect. By definition, a supply curve tells what level of output a firm would produce at a given price. Since a monopolist does not take price as given, it has no supply curve.

6.
The total cost function for a monopolist is TC = 100 + 4Q2. If the demand for the monopolist's output can be expressed as P = 120 2Q, the deadweight loss to society of this monopoly is equal to Your Answer: 2. Correct Answer: 4. Incorrect. First, in a competitive market, price would equal marginal cost, or 120-2Q=8Q. This yields Q=12 and P = 120-2(12) = 96. A monopolist would MR=MC. This yields 120-4Q = 8Q or Q =10 and P =120-2(10) =100. The deadweight loss equals the area [(100-96)*(1210)]/2 =4.

7.
The total cost function for a monopolist is TC = 100 + 4Q2. If the demand for the monopolist's output can be expressed as P = 120 2Q, rent-seeking expenditures to capture the monopoly would be Your Answer: 2. Correct Answer: 500. Incorrect. The monopolist could maximize profit by setting MR=MC or 120 4Q = 8Q.This yields Q =10. P = 120-2(10) =100. So, TR = 10*1000=1000. TC = 100 + 4(102)= 500. Profit equals 1000 500 =500.

8.
The amount of resources that firms devote toward rent-seeking activity is a function of Your Answer: the potential monopolist's profit. Correct. Rent-seeking expenditures are made to gain monopoly power. The size of the rentseeking expenditure is a function of the return to being a monopolist.

9.
The price elasticity of demand for a monopolist's output is 3. If the monopolist produces its output at a marginal cost of \$5 per unit, what price will it charge?

Your Answer: \$5 Correct Answer: \$7.50 Incorrect. (P-MC)/P = 1/-e or (P-5)/P = 1/3 or P-5 =P/3 or (2/3)P =5 or P =7.50.

10.
A monopolist retailer sets the price of its output simply by charging consumers twice what it paid. Such behavior is profit maximizing provided that the price elasticity of demand is Your Answer: -3. Correct Answer: -2. Incorrect. Let MC =a, then P = 2a. The Lerner Index equals (2a-a)/2a = 1/2. This implies a price elasticity of demand of 2.

11.
A monopolist operates 2 plants. At plant A, MC = QA, and at plant B, MC = 2QB. If the demand for the monopolist's output is P = 800 1Q, then how much is produced at each plant? Your Answer: 150 units at each plant. Correct Answer: 200 units at plant A and 100 units at plant B. Incorrect. First, find the firm's MC by horizontally summing the individual plant MC curves. QA =MC and QB=MC/2, then QA +QB =Qtotal =(3/2)MC or MC =(2/3)Qtotal. Maximize profit by setting MR=MC yields 800 2Q = (2/3)Q or 800 = (8/3)Q or Q =300. Thus, QA + QB = 300. Setting MC equal at the 2 plants means that QA = 2QB or 3QB =300. Solving yields QB =100 and QA =200.

12.
If a multiplant monopolist maximizes profit by producing twice as much output at plant A than at plant B, we can be sure that Your Answer: the marginal cost at plant A is twice that at plant B. Correct Answer: the marginal cost at plant A is equal to that at plant B. Incorrect. Since the firm is maximizing profit, the marginal cost at all plants are equal.

13.
The Lerner Index of monopoly power increases when Your Answer: fixed costs increase. Correct Answer: demand becomes more price inelastic.

Incorrect. The Lerner Index will equal 1/(-e). As demand becomes more inelastic, the Lerner Index will rise.

14.
Suppose the total cost function for a monopolist is TC = 100 + 4Q2. If the demand for the monopolist's output can be expressed as P = 120 2Q, the Lerner Index of monopoly power is equal to Your Answer: 5. Correct Answer: 0.20. Incorrect. The firm maximizes profit by setting MR=MC or 120-4Q = 8Q or Q=10. At this level of output, P = 120-2(10) = 100 and MC = 8(10) =80. The Lerner Index equals (10080)/100 = .20.

15.
Last year, the price elasticity of demand for a monopolist's output was 2. This year, the price elasticity of demand for the same monopolist's output is 4. From last year to this year, the monopoly power of this firm has Your Answer: increased. Correct Answer: decreased. Incorrect. The Index has gone from 1/2 to 1/4. The firm's monopoly power has decreased.

16.
Which one of the following firms is definitely a natural monopolist? Your Answer: TC=10Q Correct Answer: TC =10Q1/2 Incorrect. AC =10. There is no cost advantage to a monopolist.

17.
For a newly developed product, demand can be represented as P = 100 100Q and long-run total cost equals TC =10Q 2Q2 + Q3. Is the market for this product currently a natural monopoly? Your Answer: Yes, and it will be so for all levels of output. Correct Answer: Yes, but this would change if the demand curve shifts to the right. Incorrect. The firm would maximize profit by setting MR = MC. MR = 100 200Q. The profit maximizing level of output will be less than 1/2 for this to hold. AC = 10 2Q + Q2. The change in average cost given a change in output equals -2 + 2Q. For Q < 1/2, the slope of

the AC curve is negative. Thus, given the current state of market demand, this is a natural monopoly.

18.
Demand for water in a small town is P = 112 Q. The local monopoly water company has the following cost function: TC = 1000 + 2Q. If government regulators wish to maximize the output of water while guaranteeing a fair rate of return to the water company, then the price of water will be set at Your Answer: 110. Correct Answer: 102. Incorrect. Setting P=AC yields 112 Q = 1000/Q + 2 or 110 = 1000/Q + Q or Q =10. P=112-10 =102.

19.
The XYZ Computer Company is the sole purchaser of a certain type of memory chip. If the supply of chips is P = 10 + Q and XYZ's demand for chips is P = 100 Q, then what price will XYZ pay for these chips? Your Answer: 37.50 Correct Answer: 40 Incorrect. If the supply price is P = 10 + Q, then total expenditure TE = (10 + Q)Q = 10Q + Q2. Marginal expenditure ME = 10 + 2Q. Setting ME=MV yields 10 + 2Q = 100 Q or 3Q = 90 or Q =30. Suppliers are willing to sell 30 chips for a price 40 each. P =40.

20.
The XYZ Computer Company is the sole purchaser of a certain type of memory chip. If the supply of chips is P = 10 + Q and XYZ's demand for chips is P = 100 Q, then what is the deadweight loss to society of XYZ's monopsony power in the market for these chips? Your Answer: 450 Correct Answer: 225

## Chapter 12: Monopolistic Competition and Oligopoly

1.
In monopolistic competition, the amount of monopoly power wielded by a firm depends on Your Answer: All of the above. Correct Answer: its success in differentiating its product. Incorrect. The characteristics listed above are typical of various types of market structures, not just monopolistic competition.

2.
In the long run, monopolistic competition differs from perfect competition in that the monopolistically competitive firm has Your Answer: economic profit. Correct Answer: excess capacity. Incorrect. Due to free entry and exit, monopolistically competitive firms have zero profit.

3.
Monopoly power refers to the firm's ability to Your Answer: set price above marginal cost. Correct. Monopoly power refers to the firm's ability to set price above marginal cost.

4.
Fill in the blank. Monopolistically competitive firms are usually ______________ Your Answer: unregulated becuase their market power is usually small. Correct. In most monopolistically competitive markets, power is small and deadweight losses will therefore be small. They also provide important benefits in the form of product diversity, which may outweigh the inefficiency costs.

5.
In the long run, the monopolistically competitive firm earns zero economic profit because

Your Answer: it is easy to enter and exit the industry. Correct. Any short-run profit induces other firms to enter the market. Because of free entry and exit, these outsiders are able to enter. This causes the demand for the incumbent firm's output to shift leftward until profit equals zero.

6.
Nash equilibrium refers to: Your Answer: strategies in which a firm does not take into account its competitor's actions. Correct Answer: actions in which a firm does the best it can given its competitor's actions. Incorrect. Nash equilibrium refers to actions in which a firm does the best it can given its competitor's actions.

7.
A relationship between a firm's profit-maximizing output and the amount it thinks its competitors will produce is called: Your Answer: A reaction curve. Correct. The schedule of how much a firm thinks that another firm will produce is a reaction curve.

8.
Demand for gasoline in a small isolated town can be expressed as P = 10 - Q. There are two gasoline stations in town, A and B, so that QA+QB =Q. At firm A, TC = 5 +QA. At firm B, TC = 5 + QB. Write an expression for firm A's reaction function in the Cournot model of oligopoly. Your Answer: QA = 4.5 - 0.5QB. Correct. Profit for firm A equals (10 - QA - QB)QA - 5 - QA. Set the change in profit given a change in the output of A equal to zero. Or 10 - 2QA - QB - 1 =0. Solve for QA = 4.5 -0.5QB.

9.
Demand for gasoline in a small isolated town can be expressed as P = 10 - Q. There are two gasoline stations in town, A and B, so that QA+QB =Q. At firm A, TC = 5 +QA. At firm B, TC = 5 + QB. In Cournot's duopoly model, what will the price of gasoline be? Your Answer: \$6. Correct Answer: \$4.

Incorrect. A = (10 - QA - QB)QA - 5 - QA. Set dA/dQA = 10 - 2QA - QB - 1 =0. Solve for QA = 4.5 -0.5QB. Likewise at firm B, B = (10 - QA - QB)QB - 5 - Q3. Set d/dQB= 10 - 2QB - QA - 1 =0. Solve for QB = 4.5 -0.5QA. To find where the two reaction curves intersect, substitute this equation for QB into firm A's reaction function, QA = 4.5 - 2.25 + 0.25QA. Rearranging yields QA = 3. Substituting this into firm B's reaction function yields QB = 3. Market price P = 10 - 6 = 4.

10.
Demand for gasoline in a small isolated town can be expressed as P = 10 - Q. There are two gasoline stations in town, A and B, so that QA+QB =Q. At firm A, TC = 5 +QA. At firm B, TC = 5 + QB. In Stackelberg's modek, how much gasoline will firm A (the leader) offer? Your Answer: 4.5 Correct. At firm B, B = (10 - QA - QB)QB - 5 - QA. Set d/dQB = 10 - 2QB - QA - 1 =0. Solve for QB = 4.5 -0.5QA. Knowing this, firm A will maximize = (10 - QA - (4.5 0.5QA)QA - 5 - QA. Then d/dQA = 10 - 2QA - 4.5 + QA -1 = 0. Rearranging yields 4.5 = QA.

11.
Demand for gasoline in a small isolated town can be expressed as P = 10 - Q. There are two gasoline stations in town, A and B, so that QA+QB =Q. At firm A, TC = 5 +QA. At firm B, TC = 5 + QB. If these firms collude to maximize joint profit, then the price of gasoline will be Your Answer: \$1. Correct Answer: \$5.50. Incorrect. Joint marginal revenue, MR = 10 - 2Q. Marginal cost, MC =1 at both firms. Setting MR=MC yields Q = 4.5 jointly. To sell these 4.5 units, price must be set to 5.50.

12.
In the Bertrand model of oligopoly, two duopolists compete by Your Answer: simultaneously choosing price. Correct. In the Bertrand model, two duopolists compete by simultaneiously setting price. The Nash equilibrium is the competitive outcome. Price equals marginal cost and economic profit equals zero.

13.
Assume that the demand for Zippy Cola can be expressed as Q = 20 - 4P1 + P2 where P1 is the price of Zippy Cola and P2 is the price of Zippy's only rival. Also, TC =Q. In Bertrand's model, Zippy's reaction function is

Your Answer: P1 = 3 + P2. Correct Answer: P1 = 3 + P2/8. Incorrect. Zippy's profit equals P1(20 - 4P1 + P2) - (20 - 4P1 + P2). The change in profit given a change in price for firm 1 equals 20 - 8P1 + P2 + 4 = 0. Rearranging to solve for P1 yields P1 = 3 + P2/8.

14.
Which of the following statements is correct? Your Answer: All of the above. Correct Answer: Oligopolistic firms often have a strong desire for price stability. Incorrect. Read the section in the chapter called "Price Rigidity."

15.
Fill in the blank. The kinked demand curve model is attractively simple _______________. Your Answer: but it doesn't take elasticity into account. Correct Answer: but it does not really explain oligopolistic pricing. Incorrect. The model breaks elasticity into two parts, above and below the initial price level.

16.
There are only two gasoline stations in a small isolated town. If both set a high price, they earn \$50 each . If they set a low price, they earn \$25 each . If one firm sets a low price while the other sets a high price, the low-price firm earns \$70 while the high-price firm earns \$10. Which of the following is a Nash equilibrium in this case? Your Answer: Both firms set the same price, which is an average of the high and the low price. Correct Answer: Both firms set a low price. Incorrect. When both firms set the low price, each firm is doing the best it can given what the other firm is doing.

17.
There are only two gasoline stations in a small isolated town. If both set a high price, they earn \$50 each . If both set a low price, they earn \$25 each . If one sets a low price while the other sets a high price, the low-price firm earns \$70 while the high-price firm earns \$10. The only way both firms will set a high price is if Your Answer: the owners of the two firms are rivals.

Correct Answer: prices are changed on a daily basis. Incorrect. As the pricing game is played over time, firms can signal each other their desire for a high price.

18.
Market demand for a good can be written as QD = 100 - P. The supply of the competitive fringe can be written as QS = -20 + P. If the dominant firm has a constant marginal cost of 20, what will be the market price? Your Answer: 80 Correct Answer: 40 Incorrect. To find the dominant firm's demand curve, QD - QS = 100 - P +20 - P = 120 -2P. Restating in terms of P, P = 60 - 0.5Q. MR = 60 -Q. To maximize profit we set MR = MC, which yields 60 - Q = 20 or Q =40. The dominant firm will charge a price of P = 60 - 0.5(40) = 40.

19.
Under which of the following conditions will a cartel be most successful? Your Answer: When market demand is price inelastic and the cartel is tightly organized. Correct. The cartel needs room to raise price. The steeper the market demand curve, the more inelastic is the demand curve and the greater is the room to raise prices. A stable cartel organization is also a necessary condition for cartel success.

20.
A cartel may be short lived if Your Answer: the cartel does not control most supply. Correct Answer: All of the above.

## Chapter 11: Pricing with Market Power

1.
The practice of charging different prices per unit for different quantities of the same good or service is called: Your Answer: Block pricing. Correct Answer: Second-degree price discrimination. Incorrect. Block pricing is a form of second-degree price discrimination, which consists of charging different prices for different quantities or "blocks" of a good.

2.
If a firm practices first-degree price discrimination, then which of the following is true? Your Answer: a deadweight loss is generated. Correct Answer: consumer surplus equals zero. Incorrect. Since the price of the last unit sold equals its marginal cost, no deadweight loss is generated.

3.
Johnny operates a used car dealership. He spends \$5,000 per month to rent the lot and office space. He obtains used cars for \$1,000 each. The demand for used cars can be written as P = 6,000 1,000Q where P is measured as \$ per used car and Q is measured as used cars per month. If Johnny can perfectly price discriminate, his monthly profit will equal Your Answer: \$7,500. Correct. Johnny will set the price of the last car sold equal to his marginal cost of \$1,000. That is, P = 6,000 1,000Q = 1,000, or Q =5. His producer surplus is the area [(6,0001,000)*5]/2 = 12,500. His profit equals 12,500 5,000 = \$7,500.

4.
A third-degree price discriminator sells the same cologne under two different labels. The price elasticity of demand for "High Class" is 2. The price elasticity of demand for "Splash-This-Stuff -On" is 5. Which one of the following statements is true? Your Answer: The price of "High Class" will be 8/5 times the price of "Splash-This-StuffOn". Correct. P1/P2 = (1 + 1/e2) / (1 + 1/e1). Letting good 1 be "High Class," P1/P2 = (1+ 1/(-5)) / (1 + 1/(-2)) = .8/.5 = 8/5.

5.
Suppose the demand for a movie ticket can be written as P = 10 - QS for senior citizens and P = 12 - QG for all other consumers. If the movie theater can offer tickets to a movie at zero marginal cost and can verify the purchaser's age, what prices will be charged? Your Answer: Seniors pay \$5; everyone else pays \$6. Correct. Seting MR = MC yields 12- 2QG = 0 and 10 - 2QS = 0. So, QG = 6 and QS = 5. The resulting prices are \$5 for seniors and \$6 for everyone else.

6.
At a local theater, the general public pays \$5 for a movie ticket while college students receive a \$1 discount when they show a college ID card. What does this practice say about the theater's perception of price elasticity of demand? Your Answer: College students' price elasticity of demand is 20% of that of the general public. Correct Answer: College students' demand for movie tickets is more price elastic than that of the general public. Incorrect. Since P1/P2 = (1 + 1/e2) / (1 + 1/e1), college students are assumed to be more price elastic since they are charged a lower price.

7.
XYZ Publishers introduces a new hardback spy novel at a price of \$35 each. A year later, a paperback version of the same book is released at a price of \$12 each. This behavior by the publisher reflects Your Answer: a smaller price elasticity of demand among buyers of new-release hardback books than that of people who wait. CORRECT. Increasing popularity over time would cause the price of the book to increase. The costs of paperback versus hardback are similar. People who are willing to wait have a more price elastic demand.

8.
Suppose that golfers have identical demand functions that can be expressed as P = 100 Q where P is \$ per round of golf and Q is the number of rounds of golf played per year. A local country club incurs a \$20 marginal cost for each round played due to repairing the course. If the club charges \$20 per round of golf, what annual membership fee maximizes the country club's profit? Your Answer: \$6,400 Correct Answer: \$3,200

Incorrect. At a price of \$20, golfers will play 80 rounds of golf. This generates consumer surplus equal to [(100-20)*80]/2 = 3,200. The club can set \$3,200 as an annual fee.

9.
When does bundling make more sense? Your Answer: When customers have homogeneous demands and when the firm can price discriminate. Correct Answer: When customers have heterogeneous demands and when the firm cannot price discriminate. Incorrect. Demands most be heterogeneous.

10.
Spring water flows at a local county park at zero marginal cost. Residents have identical demand for spring water that can be expressed as P = 5 (.01)Q where P is \$ per gallon and Q is gallons per year. The county government is considering fencing off the spring with a padlocked gate and selling keys to local residents to access the spring. Each person needs her own key. What price for keys will maximize the county government's amount collected? Your Answer: \$625 Correct Answer: \$1,250 Incorrect. Setting P =MC = 0 means that anyone with a key can get all of the water they want for free. Each consumer will take 500 gallons. This generates consumer surplus of [(50)*500]/2 = 1,250. An annual fee of \$1,250 for the key maximizes the government's collection.

11.
A famous fast food restaurant sells burgers, fries, and sodas separately, or jointly as an "Extra Value Meal" at a slightly reduced price. This pricing strategy is known as Your Answer: two-part tariff. Correct Answer: mixed bundling. Incorrect. Pure bundling requires that consumers purchase the products together. Mixed bundling gives consumers the option. A two-part tariff would require one payment to enter the restaurant and another payment for the food.

12.
Consumer A's reservation price is \$4 for a sandwich and \$1 for a bowl of soup. Consumer B's reservation price for a sandwich is \$3 and \$2 for a bowl of soup. Assuming all

reservation prices are above marginal cost, which of the following pricing strategies maximizes the restaurant's profit? Your Answer: Selling sandwiches for \$3 and soup for \$1. Correct Answer: A \$5 soup and sandwich special. Incorrect. Both consumers would buy soup and a sandwich, but revenue would only equal \$8. With the special, both consumers would buy the special, and revenue equals \$10.

13.
Consumer A's reservation price is \$5 for a sandwich and \$1 for a bowl of soup. Consumer B's reservation price for a sandwich is \$4 and \$3 for a bowl of soup. Consumer C's reservation price is \$1 for a sandwich and \$5 for a bowl of soup. If the marginal cost of soup is \$1.50 per bowl and the marginal cost of a sandwich is \$2.50, which of the following pricing strategies maximizes our restaurant's profit? Your Answer: \$4 for a sandwich, \$5 for a bowl of soup, \$6 for a soup and sandwich combo. Correct Answer: \$5 for a sandwich, \$5 for a bowl of soup, \$7 for a combo. Incorrect. A buys a sandwich, B buys the combo, and C buys combo. Revenue = 4 + 6 + 6 = 16. Cost = 2.50 + 4 + 4 = 10.50. Profit = 5.50. Profit is higher with option d.

14.
Consumer A's reservation price is \$4 for a sandwich and \$1 for a bowl of soup. Consumer B's reservation price for a sandwich is \$6 and \$3 for a bowl of soup. Assuming all reservation prices are above marginal cost, is there an advantage to a pure bundling strategy of a \$5 soup/sandwich lunch? Your Answer: Yes, because consumer A would not buy soup otherwise. Correct Answer: No, because revenue cannot be increased through bundling. Incorrect. Charging \$4 for a sandwich and \$1 for soup yields the same revenue that the \$5 bundle generates. Because the demands are positively correlated, there is no advantage to bundling.

15.
Consumer A's reservation price is \$5 for a sandwich and \$1 for a bowl of soup. Consumer B's reservation price for a sandwich is \$4 and \$3 for a bowl of soup. Consumer C's reservation price is \$1 for a sandwich and \$5 for a bowl of soup. Assuming all reservation prices are above marginal cost, which of the following strategies maximizes profit? Your Answer: \$4 for a sandwich, \$5 for a bowl of soup, \$6 for a soup and sandwich combo. Correct Answer: \$6 soup and sandwich combo; no individual pricing.

Incorrect. A buys a sandwich; B buys the combo, and C buys combo. Revenue = 4 + 6 + 6 = 16. Revenue is higher under option b.

16.
When a firm is interested in metering demand and thereby practice price discrimination more effectively it should use: Your Answer: Bundling. Correct Answer: Tying. Incorrect. This pricing strategy works well when demands are heterogeneous and the firm cannot price discriminate.

17.
The full marginal cost of an additional dollar of advertising is equal to Your Answer: \$1. Correct Answer: \$1 plus the change in cost associated with the change in output to meet the new demand. Incorrect. The full marginal cost equals \$1 plus the marginal cost of the extra output produced as a result of the increased demand.

18.
Suppose the demand for a certain brand of jeans is Q = 30 P + A0.5 where P is measured as \$/pair, Q as thousands of pairs per year, and A as thousands of dollars spent on advertising per year. If the marginal cost of producing jeans is constant at \$10, what level of advertising maximizes the firm's profit? Your Answer: \$3,000 Correct Answer: \$4,000 Incorrect. First, profit equals (P-10)*(30-P+A0.5)-A. The change in profit given a change in advertising equals 0.5*(P-10)A-0.5-1=0. The change in profit given a change in price equals 30-2P+A0.5+10=0. Solving for the change in profit given a change in advertising yields A0.5=(P-10)/2. Substituting this into the change in profit given a change in price yields P=14. Substituting P=14 back into the change in profit given a change in advertising yields A=4. So, A=\$4,000 per year.

19.
In the market for trading cards, a 10% increase in advertising expenditures yields a 3% increase in quantity sold. If the price elasticity of demand for trading cards is -1.5, then the profit maximizing advertising budget as a percent of sales is

20.
Chapter 3: Consumer Behavior

.
Indifference curves cannot intersect because of the assumption that Your Answer: marginal utility diminishes as more of that good is consumed. Correct Answer: preferences are transitive. Incorrect. While this is true, it does not keep indifference curves from intersecting.

2.
Fill in the blanks. Along an indifference curve, total utility __________ while the marginal rate of substitution __________. Your Answer: remains constant...decreases Correct. An indifference curve shows combinations of two goods for which the consumer is indifferent. This means combinations that yield the same total utility. Under the assumption of marginal diminishing returns in consumption, as we move downward along an indifference curve, the marginal rate of substitution decreases.

3.
The amount of a good that a consumer is willing to give up in order to obtain one additional unit of another good is called Your Answer: an indifference map. Correct Answer: the marginal rate of substitution. Incorrect. An indifference map is a graph containing a set of indifference curves showing the market baskets among which a consumer is indifferent.

4.
Indifference curves between nickels and dimes are Your Answer: negatively sloped and straight. Correct. Two nickels are perfect substitutes for one dime. The indifference curves would therefore be straight lines with a constant slope of 2.

5.
Indifference curves between left shoes and right shoes are Your Answer: L-shaped. Correct. These shoes are good only in pairs of one each. Additional left shoes alone do not make the consumer better off, and additional right shoes alone do not make the consumer better off. The indifference curves are therefore L-shaped.

6.
Suppose Tim enjoys coffee (C) but is sickened by tea (T). Which of the following utility functions would best represent Tim's utility function for coffee and tea? Your Answer: U = T / C Correct Answer: U = C / T Incorrect. For this function, additional units of tea make Tim better off.

7.
A utility function that describes how much of one market basket is preferred to another is called Your Answer: an ordinal utility function. Correct Answer: a cardinal utility function. Incorrect. This is a function that generates a ranking of market baskets in order of most to least preferred, or in order of preference.

8.
If Leon's marginal rate of substitution of chicken for steak is 2, then we know that Your Answer: he is willing to give up 2 units of chicken to get the next unit of steak. Correct Answer: he is willing to give up 2 units of steak to get the next unit of chicken.

Incorrect. Marginal rate of substitution of x for y tells us how much y one is willing to give up to get the next unit of x.

9.
When Sally had only one gallon of water in the cupboard, she said she was willing to give up a week's worth of television to get another gallon. Now that she has ten gallons of water in the cupboard, she refuses to part with anything when offered another gallon of water. Sally's behavior demonstrates Your Answer: irrationality. Correct Answer: a diminishing marginal rate of substitution. Incorrect. It is completely rational to have a diminishing marginal rate of substitution.

10.
The vertical intercept of the budget line represents Your Answer: the most money the consumer can spend on the good measured on the vertical axis. Correct Answer: the consumer's real income in terms of the price of the good measured on the vertical axis. Incorrect. The intercept is I/PY, which represents the consumer's real income in terms of good Y being measured on the vertical axis.

11.
Liz has \$10 to spend on soda (S) and pretzels (P). Sodas cost \$1 each and pretzels cost \$0.50 each. Which of the following represents Liz's budget constraint? Your Answer: P =10 2S Correct Answer: P = 20 2S Incorrect. P = (10/0.5) (1/0.5)S = 20 2S.

12.
Suppose that the quantity of pretzels consumed is measured on the vertical axis and the quantity of soda consumed is measured on the horizontal axis. If the budget line becomes flatter while the vertical intercept is unchanged, then which of the following may have occurred? Your Answer: The price of pretzels increased while other things remained constant. Correct Answer: The price of soda decreased while other things remained constant.

Incorrect. For the slope to become flatter, either the price of soda fell or the price of pretzels rose. If the price of pretzels rose, then income must have risen.

13.
If a consumer's budget line for food (F) and clothing (C) can be written as F = 500 4C, then we know that Your Answer: food costs 4 times as much as clothing. Correct Answer: clothing costs 4 times as much as food. Incorrect. The intercept (500) is nominal income divided by the price of food. The slope (4) is the price of clothing divided by the price food.

14.
If both prices and income increase by 5%, then what will happen to the budget line? Your Answer: Nothing. Correct. Since, the budget line for two goods, X and Y, is Y = I/PY (PX/PY)X, then neither the slope nor the intercept would change. In real terms, the consumer's buying opportunities have not changed.

15.
By selecting the combination of goods for which MRS = PX/PY, the consumer is saying Your Answer: All of the above. Correct Answer: "I get the same marginal utility from the last dollar I spend on X as I do from the last dollar I spend on Y." Incorrect. Answers a and b are not generally true.

16.
Mary and Sue each consume apples and chocolate. They each pay the same price for each of the two goods, and both women claim to be in equilibrium. It must be true that Your Answer: Mary and Sue have the same marginal rate of substitution of apples for chocolate. Correct. At equilibrium, a consumer sets MRS= PX/PY. Since they face the same prices, their MRS must be the same.

17.

When the marginal rate of substitution between two goods is equal to the ratio of prices, Your Answer: marginal benefit equals marginal cost. Correct. When the marginal rate of substitution (or marginal benefit) between two goods is equal to the ratio of prices (or marginal cost), the consumer is in equilibrium, and it is impossible to increase utility by altering the quantities of goods currently selected.

18.
Rocky thinks that a sip of Coke and a sip of Pepsi are perfect substitutes. If Coke sells for \$4 per case and Pepsi sells for \$2 per case, then Your Answer: Rocky will buy equal amounts of Coke and Pepsi. Correct Answer: Rocky will not buy any Coke. Incorrect. The slope of the indifference curve is 1. The slope of the budget line is 2. Rocky will reach the highest indifference curve at a corner solution where he spends his entire cola budget on Pepsi and buys no Coke.

19.
In a corner solution, the marginal rate of substitution Your Answer: is not the same as the slope of the budget line. Correct. This is the only instance in which satisfaction is maximized when the MRS is not equal to the ratio of prices.

20.
Revealed preference means that a consumer chooses one market basket over another and Your Answer: the chosen market basket is more expensive than the alternative. Chapter 4: Individual and Market Demand

1.
Assuming convex indifference curves for two goods, as the price of one good falls, a consumer will always Your Answer: consume more of both goods. Correct Answer: reach a higher level of utility. Incorrect. As the price of a good decreases, the budget line rotates outward. In real terms, the consumer is able to purchase more. Therefore, the consumer will reach a higher level of

utility. How the consumer allocates her budget depends on the actual shape of the indifference curves.

2.
A price-consumption curve traces the utility-maximizing combinations of two goods as Your Answer: the consumer's preferences change. Correct Answer: the price of one good changes. Incorrect. The price-consumption curve traces the utility-maximizing combinations of two goods as the price of one changes.

3.
Along an individual demand curve for food, which one of the following is not held constant? Your Answer: The price of all other goods. Correct Answer: The consumer's level of utility. Incorrect. The demand curve for a good is derived by mapping out the equilibrium quantities of that good that result from changing the price of that good, holding income and the price of all other goods constant.

4.
Suppose that the quantity of food is measured on the horizontal axis and the quantity of clothing is measured on the vertical axis. If the price consumption curve for food is vertical then Your Answer: the demand for food is unit elastic. Correct Answer: the demand for food is perfectly inelastic. Incorrect. A vertical price consumption path implies that the quantity of food demanded is the same at every price.

5.
Which two variables are in the axes of a graph that shows an incomeconsumption curve? Your Answer: Income in one axis and the quantity of one good on the other. Correct Answer: The quantities of two goods. Incorrect. The income-consumption curve traces the utility-maximizing combinations of two goods as a consumer's income changes.

6.
If food is an inferior good, then Your Answer: its Engel curve will be negatively sloped. Correct. An inferior good is defined as a good for which quantity demanded decreases as income increases. The Engel curve shows the relationship between income and quantity demanded.

7.
Fill in the blanks. The substitution effect shows the change in consumption of a good associated with a __________ price and a _________ level of utility. Your Answer: constant...changing Correct Answer: changing...constant Incorrect. The substitution effect is the change in consumption of a good associated with a change in its price, with the level of utility held constant.

8.
Fill in the blanks. The income effect shows the change in consumption of a good associated with a _________ relative price and a _________ purchasing power. Your Answer: constant...changing Correct. The income effect is the change in consumption of a good resulting from an increase in purchasing power, with relative price held constant.

9.
The income and substitution effects of a decrease in the price of an inferior good are such that Your Answer: both effects contribute to an increase in quantity demanded. Correct Answer: the substitution effect is positive but the income effect is negative. Incorrect. The income effect is negative but not greater than the (positive) substitution effect.

10.
Suppose that the substitution effect of a decrease in the price of food is the same for both Harry and Sally. However, Harry feels that food is an inferior good while Sally feels that food is a normal good. As a result,

Your Answer: Harry's demand curve for food will be steeper than Sally's. Correct. For a given price decrease, both Harry and Sally experience an increase in real income. Since food is an inferior good for Harry, he will not increase his quantity demanded of food as much as Sally will increase hers. Thus, Harry's demand curve is steeper because the income effect is less for Harry than for Sally.

11.
A Giffen good is characterized by Your Answer: a large negative income effect. Correct Answer: All of the above. Incorrect. This answer is correct, however other choices are also correct.

12.
When the price of food increases, Jimmy spends more of his fixed income on food than he did before. It must be true that Jimmy's demand for food Your Answer: is unit elastic. Correct Answer: is relatively inelastic. Incorrect. Total expenditure on a good will increase when the price of a good increases if demand is relatively inelastic.

13.
The price of grapes is different each week at the supermarket. Yet, Marge spends exactly \$10 on grapes each week. It must be true that Marge's demand for grapes Your Answer: is perfectly inelastic. Correct Answer: is unit elastic. Incorrect. Total expenditure on a good will not change when the price of a good changes if demand is unit elastic.

14.
Martha's demand for spring water has a price elasticity of 3.0. A recent tax that caused the price of spring water to increase by 20% will cause Martha to decrease her quantity demanded of spring water by Your Answer: 600%. Correct Answer: 60%.

Incorrect. Since price elasticity of demand is the percent change in quantity divided by the percent change in price, % change in Q /20% = -3. Rearranging yields % change in Q = 60%.

15.
Greg, Bobby, and Peter are the only consumers of camera film in a certain small town. Greg's demand is Q = 100 2P. Bobby's demand is Q = 25 P. Peter's demand is Q = 75 7P. The market demand for film in that town is Your Answer: Q = 200 10P. Correct. QMARKET = QGREG + QBOBBY + QPETER = (100 2P) + (25 P) + (75 7P) = 200 10P

16.
The market demand for photo film in a given town is Q = 500 10P where Q is measured as rolls of film developed per week and P is the price per roll. If the price is \$5, how much is the consumer surplus in the market for film? Your Answer: \$2,250 Correct Answer: \$10,125 Incorrect. At that price, 450 rolls will be purchased. The demand intersects the vertical axis at a reservation price of \$50. Consumer surplus is the area [(\$50 - \$5) * 450] / 2 = \$10,125.

17.
Sam is willing to part with his old car for no less than \$5,000. Bob likes the car and would pay as much as \$8,000 for it. After lengthy negotiations, they agree on a price of \$7,000. As a result of the deal, Bob will enjoy a consumer surplus equal to Your Answer: \$3,000. Correct Answer: \$1,000. Incorrect. Bob actually pays \$7,000 and is willing to pay \$8,000. The difference is \$1,000.

18.
Suppose the demand for bridge crossings at a certain remote site is P = 100 2Q where Q is measured as crossings per year and P is measured as \$ per crossing. What is the value to consumers of building a bridge at that site? Your Answer: \$1,250 Correct Answer: \$2,500

Incorrect. The total value to consumers is the area under the demand curve. The demand intersects the horizontal axis at a quantity of 50. Thus the area under the demand curve is (100 * 50) / 2 = \$2,500.

19.
In response to a growth in demand, the quantity demanded of a good with a (mild) negative network externality Your Answer: sometimes rises and sometimes declines. Correct Answer: rises but by less than it would without the externality. Incorrect. As price decreases and quantity demanded increases, demand decreases. See figure 4.17 in the textbook.

20.
An isoelastic demand curve is one in which Your Answer: price elasticity and income elasticity remain constant.

## Chapter 7: The Cost of Production

1.
Doctor Brown has just graduated from medical school and will open her own family practice. She will begin to repay the loan on her tuition. With respect to her new business, these loan payments represent Your Answer: a variable cost. Correct Answer: a sunk cost. Incorrect. Since the tuition is to be paid whether she starts her own business or not, has been incurred and cannot be recouped, the loan repayments represent a sunk cost.

2.
Jack is a high school senior thinking about becoming an economics research assistant. Jill just graduated with an economics degree and is also looking for the same job. For whom is the college tuition an opportunity cost? Your Answer: Jill only. Correct Answer: Jack only. Incorrect. For Jack, the tuition could be spent doing something else. Therefore, it is part of his opportunity cost. For Jill, college tuition is over and done and cannot be avoided. Therefore, the tuition is an opportunity cost for Jack only.

3.
TMB Associates, a local consulting firm purchased computer software for \$10,000. After discovering errors in the program, the software producer offered to fix the problems for a fee of \$2,000. TMB found competing software without errors available from another company for \$6,000. Should TMB buy the new software from the other company? Your Answer: No, since \$6,000 is more than \$0. Correct Answer: No, since \$6,000 is more than \$2,000. Incorrect. TMB can get the old software up and running for an additional \$2,000. TMB can get the new software up and running for \$6,000. Since \$6,000 is more than \$2,000, TMB should not buy the new software.

4.
Which of the following measures actual expenses plus depreciation charges for capital equipment? Your Answer: Economic cost. Correct Answer: Accounting cost. Incorrect. Economic cost is the cost to a firm utilizing economic resources in production, including opportunity cost.

5.
Suppose the short-run cost function can be written as TC = 250 + 10Q. Average fixed cost equals Your Answer: 250. Correct Answer: 250/Q. Incorrect. Average fixed cost = 250/Q.

6.
Suppose the short-run cost function can be written as TC = 250 + 10Q. Marginal cost equals Your Answer: 250. Correct Answer: 10. Incorrect. Each 1-unit increase causes total cost to rise by 10. Thus, marginal cost equals 10.

7.

Tommy rents office space for \$12,000 per year. He uses the office to fill out tax return forms for his clients. He fills out 1,000 tax returns per year. If the owner of the building raises Tommy's rent to \$13,000 per year, the marginal cost of filling out tax returns will Your Answer: increase by \$1. Correct Answer: not change. Incorrect. The rent increase represents a change in fixed cost. The additional cost of filling out an additional tax return has been unaffected.

8.
Suppose that the short-run total cost function is TC = 50 + 12Q. Which of the following statements is true at all levels of production? Your Answer: AFC > MC Correct Answer: MC = AVC Incorrect. AFC = 50/Q. MC =12. For Q > 4.16, this statement is not true.

9.
Suppose that the short-run production function is Q = 10L. If the wage rate is \$4 per unit of labor, then average variable cost equals Your Answer: 40Q. Correct Answer: .4. Incorrect. AVC = 4/10. AVC = w/APL, and the average product of labor is the amount of output produced per unit of labor used, or 10 units.

10.
If marginal cost is rising, it must be true that Your Answer: marginal product of labor is falling. Correct. Since MC = w/MPL, if MC is rising, MPL must be falling.

11.
The user cost of capital is the same as Your Answer: economic depreciation. Correct Answer: the sum of economic depreciation and the interest that could have been earned elsewhere.

Incorrect. The user cost of capital is the sum of the annual cost of owning and using a capital asset, equal to economic depreciation plus forgone interest.

12.
If average variable cost is minimized, it must be true that Your Answer: MC = AVC. Correct. When AVC is minimized, MC = AVC.

13.
Suppose that short-run total cost can be written as TC = 1000 + 100Q 10Q2 + Q3. Then, AVC is minimized at what level of production? Your Answer: Q = 100. Correct Answer: Q =5. Incorrect. AVC = 100 10Q + Q2. Then, the change in AVC given a change in output equals the first derivative of the AVC function, or Q = -10 + 2Q. Setting the slope equal to 0 yields Q = 5.

14.
Consider the following total cost equation: C = wL + rK. The slope of the isocost line associated with it equals Your Answer: -(w/r). Correct. The slope of the isocost line equals the ratio of input prices.

15.
In the long run, if a firm with convex isoquants has minimized its total cost of producing a certain level of output, then it must be true that Your Answer: L = K. Correct Answer: MRTS = w/r. Incorrect. Total costs are minimized when the isoquant is tangent to an isocost curve. The slope of the isoquant is MRTS, and the slope of the isocost is w/r. (L=K) would only be true for certain specific production functions.

16.
Suppose that the production function can be written as Q = K0.6 L0.3 . In the long run,

Your Answer: the marginal product of capital is twice the marginal product of labor. Correct Answer: LRAC is positively sloped for all levels of output. Incorrect. Since this production function has decreasing returns to scale, LRAC is positively sloped. MPL = .3(Q/L) and MPK = .6(Q/K). So, MPL = 2MPK only when K = 2L.

17.
The long run total cost curve is derived from an expansion path involving Your Answer: least-cost combinations of labor and capital. Correct Answer: All of the above. Incorrect. This answer is correct, however, other choices are also correct.

18.
Suppose that a production function can be written as Q = K0.6 L0.3 . If w/r = 2, then which of the following must be true? Your Answer: The firm will hire four times as much capital as labor. Correct. The firm minimizes cost when the isoquant is tangent to the isocost. The slope of the isocost is 2. The slope of the isoquant is MPL/MPK. MPL = .3(Q/L). MPK = .6(Q/L). MPL/MPK = -K/2L. MPL/MPK = -2 when K/L =4 or K = 4L.

19.
Suppose L and K are perfect substitutes and the production function is Q = 10(L + K). If w =5 and r = 10, the firm will Your Answer: hire twice as much labor as capital. Correct Answer: hire all labor and no capital. Incorrect. If K and L are perfect substitutes, the firm minimizes costs by hiring the lowest priced input. In this case, the firm hires all labor and no capital.

20.
Suppose the total cost of producing two outputs, X and Y, can be written as C = (X,Y). Recent experience yields the following 10=C(50,0) 20 = C(50,10) 15 = C(0,10) 20 = C(100,0) 30 = C(0,15). Which of the following is true? Your Answer: There are economies of scale producing Y. Correct Answer: There are economies of scope producing X and Y.

Chapter 6: Production

## 1. The production decisions of a firm focus on Your Answer: input choices.

Correct Answer: All of the above. Incorrect. This answer is correct, however, other choices are also correct.

2. A production function shows Your Answer: combinations of inputs that can be used to produce a given amount of output.

Correct Answer: the highest output that a firm can produce for every specified combination of inputs. Incorrect. A production function shows the highest output that a firm can produce for every specified combination of inputs.

3. In the theory of the firm, how long does the short run last? Your Answer: One year.

Correct Answer: None of the above. Incorrect. The short run and the long run have more to do with the variability of inputs than with the period of time involved.

4. Suppose that the short-run production function at Skip's Pottery can be represented as Q = 100L L2 where Q is clay pots produced per week and L is the number of hours Skip works per week. If Skip works 40 hours per week, what is his marginal product of labor?

Your Answer: 20 Correct. MPL = change in Q/change in L = 100 2L. When L =40, MPL = 20.

5. Suppose that the short-run production function at Skip's Pottery can be represented as Q = 100L L2 where Q is clay pots produced per week and L is the number of hours Skip works per week. If Skip works 40 hours per week, what is his average product of labor? Your Answer: 20

Correct Answer: 60 Incorrect. APL = Q/L. When L = 40, Q = 4000 1600 =2400. APL = 2400/40 = 60.

6. If the marginal product of labor is below the average product of labor, it must be true that Your Answer: the average product of labor is falling. Correct. Marginal product of labor is the extra output produced by the next unit of labor. If the next unit produces at a rate below the average, the average will be pulled down.

7. The average product of labor is maximized when the marginal product of labor Your Answer: None of the above.

Correct Answer: equals the average product of labor. Incorrect. APL rises until it intersects MPL and then APL falls. Therefore, when they intersect, that is when APL = MPL, APL is maximized.

8. As one moves along a convex isoquant, which of the following does not change?

## The marginal rate of technical substitution.

Correct Answer: The level output produced. Incorrect. An isoquant shows the combinations of capital and labor that produce the same level of output. If the isoquant is convex, then the MRTS diminishes as labor increases.

## 9. A technological improvement Your Answer: has no impact on the production function.

Correct Answer: shifts the short-run production function upward. Incorrect. single production function is drawn on the assumption of a constant state of technology. Changing that assumption causes the production function to shift.

10. For the production function, Q = L1/3 K1/3, what shape will the isoquants have? Your Answer: negatively sloped and convex. Correct. MPL = 1/3(L-2/3 K1/3) = 1/3(Q/L). MPK = 1/3(L1/3 K-2/3) = 1/3(Q/K). The slope of the isoquant equals (MPL/MPK) = -K/L. As L increases and K decreases, the slope becomes smaller (in absolute terms). Thus, the isoquants are negatively sloped and convex.

11. The production function, Q = L1/3 K1/3, exhibits Your Answer: increasing returns to scale initially, then decreasing returns to scale.

Correct Answer: decreasing returns to scale at all levels of production. Incorrect. Suppose initially L = L1 and K = K1 and Q = Q1. Now increase both inputs by the same factor 2. The new level of output equals 2L11/3 2K11/3= 22/3 L11/3 K11/3 = 22/3Q1. Thus, while inputs were doubled, the increase in output is less than double. This is true for all levels of L1 and K1. Thus, there are decreasing returns to scale at all levels of production.

12. Labor is measured on the horizontal axis, and capital is measured on the vertical axis. If an isoquant is relatively flat at a certain combination of capital and labor, we know that Your Answer: the amount of labor hired is high relative to the amount of capital hired.

Correct Answer: the marginal product of labor is less than the marginal product of capital. Incorrect. Since the slope equals MPL/MPK, a relatively flat isoquant means that MPL is less than MPK.

13. If the isoquants for two different types of inputs are negatively sloped straight lines, then Your Answer: the two inputs are perfect substitutes for one another. Correct. If the isoquants have a constant slope, then the one input can always be substituted for the other at the same rate no matter how much of each input is used. The two inputs are, therefore, perfect substitutes.

14. If decreasing returns to scale are present, then if all inputs are increased by 10%, Your Answer: output will decrease by 10%.

Correct Answer: output will increase by less than 10%. Incorrect. Decreasing returns to scale means that a proportionate increase in all inputs results in a less than proportionate increase in output.

15. With input combinations (L = 25, K =6), Alma harvested 200 bushels of wheat. After one of the machines broke, she hired more labor. As a result, with input combinations (L = 30, K = 5), she still harvested 200 bushels. One can conclude from these results that

## All of the above.

Correct Answer: the marginal product of labor is less than the marginal product of capital. Incorrect. The slope of the isoquant between these two points is 1/5. Thus, we can conclude that MPL is 1/5 MPK. However, there is not enough information to draw a conclusion about returns to scale or the convexity of the isoquant.

16. The manager at Skip's Pottery knows the marginal product of labor equals 6 and the marginal product of capital equals 30. Skip will be purchasing one more unit of capital. If the firm wishes to keep the level of output unchanged, then the manager must Your Answer: increase labor hired by 1/5 unit.

Correct Answer: decrease labor hired by 5 units. Incorrect. The increase in capital will raise output by 30 units. To reduce output by 30 units, thus leaving output unchanged, labor must decrease 5 units.

17. A production function can be written as Q = F(L,K). After various combinations of inputs were used, the following results were obtained: 1000 = F(120,6) 2000 = F(200,10) 3000 = F(300,15) 4000 = F(400,20) 5000 = F(500, 25) 6000 = F(700,35). Over which range of output are there constant returns to scale? Your Answer: 1000 to 3000 units of output only.

Correct Answer: 2000 to 5000 units of output only. Incorrect. From 1000-2000 units of output, it takes a less than doubling of inputs to double output. From 2000-3000 units of output, a 50% increase in inputs yields a 50% increase in output. From 3000-4000, a 33% increase in inputs yields a 33% increase in output. From 4000-5000, a 25% increase in inputs yields a 25% increase in output. From 5000-6000, a 40% increase in inputs yields a 20% increase in output. Thus, constant returns to scale exist only in the range of 2000-5000 units.

18.

A production function can be written as Q = F(L,K). After various combinations of inputs were used, the following results were obtained: 1000 = F(120,6) 2000 = F(200,10) 3000 = F(300,15) 4000 = F(400,20) 5000 = F(500, 25) 6000 = F(700,35). Increasing returns to scale are present over which range of output? Your Answer: Up to 2000 units of output only. Correct. From 1000-2000 units of output, it takes a less than doubling of inputs to double output. From 2000-3000 units of output, a 50% increase in inputs yields a 50% increase in output. From 3000-4000, a 33% increase in inputs yields a 33% increase in output. From 4000-5000, a 25% increase in inputs yields a 25% increase in output. From 5000-6000, a 40% increase in inputs yields a 20% increase in output. Thus, increasing returns to scale exist only in the range of 1000-2000 units.

19. The local factory noticed that each of the following combinations of capital and labor produced the same level of output: (L=1, K=20) (L=2, K=15) (L=3, K=11) (L=4, K=8) (L=5, K=6) (L =6, K=5). In going from 5 units of labor to 6 units of labor along the isoquant, this evidence suggests that Your Answer: the isoquant is horizontal.

Correct Answer: the marginal product of labor equals the marginal product of capital. Incorrect. In this range, the slope of the isoquant equals 1. Thus, MPK = MPL.

20. The local factory noticed that each of the following combinations of capital and labor produced the same level of output: (L=1, K=20) (L=2, K=15) (L=3, K=11) (L=4, K=8) (L=5, K=6) (L =6, K=5). This evidence suggests that Your Answer: there are decreasing returns to scale.

## Chapter 8: Profit Maximization and Competitive Supply

1.
Which of the following is a basic assumption of the model of perfect competition? Your Answer: Product homogeneity. Correct Answer: All of the above. Incorrect. This answer is correct, however other choices are also correct.

2.
Which of the following is sufficient for an industry to approximate perfect competition? Your Answer: A highly elastic market demand curve. Correct Answer: None of the above. There is no simple rule or indicator of perfect competition. Incorrect. There is no single rule to estimate the existence of perfect competition.

3.
Suppose that TC = 20 + 10Q + Q2 for a firm in a competitive market and that output, Q, sells for a price, P, of \$90. How much output will the firm produce to maximize profit? Your Answer: 90 Correct Answer: 40 Incorrect. A firm maximizes profit when MR = MC but will shut down if it cannot cover its variable costs. MC = 10 + 2Q. Setting P = MC yields 90 = 10 + 2Q or Q =40. Since AVC = 10 + Q, AVC =50. P > AVC, the firm will set Q =40.

4.
Suppose that TC = 20 + 10Q + Q2 for a firm in a competitive market. What is the minimum price necessary for this firm to produce any output? Your Answer: greater than 12 Correct Answer: greater than 10 Incorrect. The firms will operate as long as P > AVC. That is, as long as P > 10 + Q. Thus, price must be greater than 10 for the firm to produce any output.

5.

Suppose that TVC = 100Q 18Q2 + 2Q3 and that TFC = 50. If price, P, equals 100, the firm's maximum profit is Your Answer: 146. Correct. A firm maximizes profit when MR = MC but will shut down if it cannot cover its variable costs. MC = 100 36Q + 6Q2. Setting MC = P yields 100 36Q + 6Q2 = 100, or Q(6Q 36) = 0, or Q = 6. AVC = 100 18Q + 2Q2 = 64. Profit equals (100-64)6 50 = 146.

6.
In what instance will a firm will shut down if price is less than average total cost? Your Answer: When there are no sunk costs. Correct. When there are no sunk costs, the firm's average total cost is equal to its average economic cost. A firm should shut down only if price is below average economic cost.

7.
Suppose that short-run MC = 10 + 2Q for an individual firm in a competitive market. If there are 100 identical firms in this market, then the short-run supply curve can be written as Your Answer: P = 1000 + 2Q. Correct Answer: P = 10 + 0.02Q. Incorrect. First, set P = MC and solve for Q. Q = P/2 5. Then, multiply by 100, the number of identical firms. Qmkt = 50P 500. Inverting to solve for P yields P = 10 + .02Q.

8.
If a perfectly competitive, profit-maximizing firm produces a level of output for which P < MC, the firm will Your Answer: maintain its current level of production. Correct Answer: decrease output. Incorrect. If P < MC, then the firm received revenue from the last unit produced that was less than the cost of making the last unit. Thus, the firm should decrease output.

9.
If a perfectly competitive firm realizes that ATC> P>AVC, the firm will Your Answer: operate at a loss in the short run. Correct. The firm will incur a loss since ATC > P; however, since P > AVC, this loss is less than the loss incurred if the firm shuts down. The firm will, therefore, operate at a loss.

10.
The response of a firm to an increase in input prices in the short run will be to Your Answer: do nothing. Correct Answer: reduce output as marginal cost rises. Incorrect. Since an increase in input prices shifts the marginal cost curve to the left, the profit-maximizing level of output must be adjusted accordingly.

11.
If market supply is relatively elastic in the short run, marginal costs Your Answer: remain constant as output increases. Correct Answer: increase slowly in response to increases in output. Incorrect. An elastic supply curve means that producers are highly responsive to price changes. In this case, a small price increase induces firms to produce much more.

12.
Producer surplus can be defined as the difference between Your Answer: revenue and total cost. Correct Answer: revenue and total variable cost. Incorrect. Producer surplus is the sum over all units produced by a firm of differences between market price of a good and marginal cost of production.

13.
Suppose that for the individual firm in a competitive market, LRAC = 100 20Q + 2Q2. If this is a constant cost industry and demand can be represented as P = 100 0.1Q, how much output will the individual firm produce at long-run equilibrium? Your Answer: 50 units Correct Answer: 5 units Incorrect. In the long run, each firm produces the level of output that minimizes LRAC. LRAC/ Q = -20 + 4Q. Setting the slope of LRAC = 0 yields Q = 5 as the level of output that minimizes LRAC.

14.

To find the long run level of output that maximizes profit, we look for the equality of: Your Answer: long run average total cost and long run marginal cost. Correct Answer: long run marginal cost and price. Incorrect. Profit maximization is achieved by setting the level of output where long-run marginal cost equals price. It is only a coincidence that the long run average cost will also be minimized at this level of output.

15.
When a firm earns zero economic profit, Your Answer: the firm is earning a competitive return on its money. Correct Answer: All of the above. Incorrect. This answer is correct, however other choices are also correct.

16.
In the long run, if a perfectly competitive firm does not maximize profit, then that firm Your Answer: can still earn some economic profit. Correct Answer: will definitely exit the industry. Incorrect. If the firm does not earn the maximum profit in the long run, it incurs a loss. Long-run losses are not sustainable and the firm is forced to exit the industry.

17.
If input prices increase as an industry expands, then the long-run supply curve will be Your Answer: negatively sloped. Correct Answer: positively sloped. Incorrect. If input prices increase as the industry expands, then this is an increasing cost industry and the long-run market supply curve is positively sloped.

18.
Accounting profit can be positive when economic profit is zero. Why? Your Answer: Because resource costs are based on historical values rather than current market value. Correct Answer: All of the above.

Incorrect. This answer is correct, however, other choices are also correct.

19.
The amount that firms are willing to pay for an input less the minimum amount necessary to obtain it is called Your Answer: economic profit. Correct Answer: economic rent. Incorrect. Economic profit refers to any profit above normal profit.

20.
Which of the following statements about the industry's long-run supply curve is correct? Your Answer: A constant cost industry has a horizontal long-run supply curve. Correct Answer: All of the above.