ECON 002 - Principles of Microeconomics
Drake University, Fall 2017
William M. Boal

EXAM 4 ANSWER KEY

Version A

I. Multiple choice

(1)b. (2)a. (3)b. (4)b. (5)b. (6)d. (7)a. (8)b.

II. Problems

(1) [Economy-wide efficiency: 12 pts]

  1. $7 (= marginal cost).
  2. $14 (= marginal cost).
  3. Firm A (because it has lower marginal cost).
  4. 12 thousand, so that marginal costs are equal.
  5. 8 million, so that marginal costs are equal.
  6. $10, because each firm will then maximize its own profit by choosing its output level so that its marginal cost equals this price.

(2) [Economy-wide efficiency: 14 pts]

  1. 1/2 units of clothing.
  2. 2 units of food.
  3. $12, because in competitive equilibrium, prices reflect opportunity costs for the economy as a whole: if the opportunity cost of a unit of clothing is 2 units of food, then the price of a unit of clothing must be 2 times the price of a unit of food.
  4. Amy's budget line should have intercepts at 60/6=10 units of food and 60/12=5 units of clothing.
  5. 1/2 units of clothing, same as PP curve.
  6. 2 units of food, same as PP curve.
  7. -1/2, because Amy's preferred bundle is at a tangency between her budget line and the highest indifference curve she can reach, and at a tangency the slope of her indifference curve must equal the slope of her budget line.

(3) [Monopoly, price discrimination: 22 pts]

  1. Since demand curve is linear, MR curve must have same intercept and twice the slope. So MR curve should have intercept at $14 on price axis, and slope = -2/1 thousand.
  2. 4 thousand, where MR=MC.
  3. $10, on demand curve.
  4. $24 thousand = TR - TC = (price × quantity) - (AC × quantity).
  5. $8 thousand.
  6. $4 thousand.
  7. 6 thousand, where the demand curve intersects the marginal cost curve, because anyone willing to pay at least the marginal cost will be served.
  8. $66 thousand, because with every customer paying a different price, revenue = area of the trapezoid under demand curve from zero to 6 thousand.
  9. $36 thousand = TR - TC = $66 thousand - (AC × quantity).
  10. $0, because consumer surplus is defined as willingness-to-pay minus price, but with perfect price discrimination willingness-to-pay equals price for every customer.
  11. $0, because with perfect price discrimination, everyone willing to pay the marginal cost is served.

(4) [Monopoly price discrimination: 4 pts]

  1. $6 = MC / (1 + (1/ε)), where &epsilon = elasticity for children.
  2. $9 (same formula, where &epsilon = elasticity for adults).

(5) [Competition versus collusion: 16 pts]

  1. 12 million.
  2. $7 (= marginal cost).
  3. $7.
  4. Since demand curve is linear, MR curve must have same intercept and twice the slope. So MR curve should have intercept at $13 on price axis, and slope = -1/1 million.
  5. 8 million, where MR = MC.
  6. $5 (= marginal cost).
  7. $9, on demand curve.
  8. $8 million.

(6) [Monopolistic competition: 16 pts]

  1. differentiated products.
  2. 80 cones.
  3. loss, since P < average cost.
  4. $80, since profit = TR - TC = (P × Q) - (AC × Q).
  5. Since demand curve is linear, MR curve must have same intercept and twice the slope. So MR curve should have intercept at $20 on price axis, and slope = -2/10.
  6. 50 cones, where MR=MC.
  7. $6, on demand curve.
  8. $1 on marginal cost curve.
  9. $6, on average cost curve.
  10. The most plausible explanation is that free entry has driven economic profit to zero. If Brianna had been making economic profits earlier, this would have attracted ice cream stands to enter the market, pushing Brianna's demand curve toward the origin. New ice cream stands would stop entering the market only when profits fell to zero (P=AC).

III. Critical thinking [4 pts]

(1) Adobe and Microsoft offer big discounts to students because they are monopolies, each producing a unique product. These discounts are examples of price discrimination, which is only possible if firms have monopoly power--that is, only if individual firms face downward-sloping demand. Adobe and Microsoft enjoy monopoly power because they are natural monopolies with downward-sloping average cost curves due to large upfront costs of creating new software but negligible costs of distribution, and also because their software is protected by patents and copyrights.

By contrast, Dell, HP, and Gateway cannot offer big discounts because they are competitors, producing computers that are nearly perfect substitutes in the eyes of most consumers. As competitors, they must take market price as given, so they do not have monopoly power and cannot engage in price discrimination.

(2) When a cartel collapses, the market becomes competitive and price falls back to marginal cost. Firms in the cartel lose and consumers win. Since the gain in consumer surplus is greater than the loss of producer surplus, society wins. Put differently, society wins because the deadweight loss from cartel pricing is eliminated. (Full credit requires a graph similar to problem (5).)

Version B

I. Multiple choice

(1)a. (2)e. (3)b. (4)d. (5)d. (6)b. (7)c. (8)c.

II. Problems

(1) [Economy-wide efficiency: 12 pts]

  1. $14 (= marginal cost).
  2. $5 (= marginal cost).
  3. Firm B (because it has lower marginal cost).
  4. 7 thousand, so that marginal costs are equal.
  5. 13 million, so that marginal costs are equal.
  6. $8, because each firm will then maximize its own profit by choosing its output level so that its marginal cost equals this price.

(2) [Economy-wide efficiency: 14 pts]

  1. 1/3 units of clothing.
  2. 3 units of food.
  3. $2, because in competitive equilibrium, prices reflect opportunity costs for the economy as a whole: if the opportunity cost of a unit of food is 1/3 units of clothing, then the price of a unit of food must be 1/3 times the price of a unit of clothing.
  4. Amy's budget line should have intercepts at 30/2=15 units of food and 30/6=5 units of clothing.
  5. 1/3 units of clothing, same as PP curve.
  6. 3 units of food, same as PP curve.
  7. -1/3, because Amy's preferred bundle is at a tangency between her budget line and the highest indifference curve she can reach, and at a tangency the slope of her indifference curve must equal the slope of her budget line.

(3) [Monopoly, price discrimination: 22 pts] 2 pts each for parts (a) through (i), 1 pt each for parts (j) and (k).

  1. Since demand curve is linear, MR curve must have same intercept and twice the slope. So MR curve should have intercept at $13 on price axis, and slope = -1/1 thousand.
  2. 6 thousand, where MR=MC.
  3. $10, on demand curve.
  4. $36 thousand = TR - TC = (price × quantity) - (AC × quantity).
  5. $9 thousand.
  6. $3 thousand.
  7. 8 thousand, where the demand curve intersects the marginal cost curve, because anyone willing to pay at least the marginal cost will be served.
  8. $88 thousand, because with every customer paying a different price, revenue = area of the trapezoid under demand curve from zero to 8 thousand.
  9. $48 thousand = TR - TC = $88 thousand - (AC × quantity).
  10. $0, because consumer surplus is defined as willingness-to-pay minus price, but with perfect price discrimination willingness-to-pay equals price for every customer.
  11. $0, because with perfect price discrimination, everyone willing to pay the marginal cost is served.

(4) [Monopoly price discrimination: 4 pts]

  1. $5 = MC / (1 + (1/ε)), where &epsilon = elasticity for children.
  2. $12 (same formula, where &epsilon = elasticity for adults).

(5) [Competition versus collusion: 16 pts]

  1. 6 million.
  2. $6 (= marginal cost).
  3. $6.
  4. Since demand curve is linear, MR curve must have same intercept and twice the slope. So MR curve should have intercept at $12 on price axis, and slope = -2/1 million.
  5. 4 million, where MR = MC.
  6. $4 (= marginal cost).
  7. $8, on demand curve.
  8. $4 million.

(6) [Monopolistic competition: 16 pts]

  1. differentiated products.
  2. 40 cones.
  3. loss, since P < average cost.
  4. $80, since profit = TR - TC = (P × Q) - (AC × Q).
  5. Since demand curve is linear, MR curve must have same intercept and twice the slope. So MR curve should have intercept at $10 on price axis, and slope = -1/20.
  6. 80 cones, where MR=MC.
  7. $6, on demand curve.
  8. $2 on marginal cost curve.
  9. $6, on average cost curve.
  10. The most plausible explanation is that free entry has driven economic profit to zero. If Brianna had been making economic profits earlier, this would have attracted ice cream stands to enter the market, pushing Brianna's demand curve toward the origin. New ice cream stands would stop entering the market only when profits fell to zero (P=AC).

III. Critical thinking

Same as Version A.

[end of answer key]