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Short Questions from Lesson I-7: Minimizing Cost, Lesson I-8: Competitive Markets, and Lesson I-9: Monopolistic

Markets

Short Questions and Answers from Lesson I-7: Minimizing Cost, Lesson I-8: Competitive Markets, and Lesson I-9: Monopolistic Markets
1. Congress is considering legislation that will provide additional investment tax credits to businesses. Effectively, an investment tax credit reduces the cost to firms of using capital in production. Would you expect labor unions to lobby for or against such a bill? (Hint: What impact would such a plan have on the capital-to-labor ratio at the typical firm?) An investment tax credit would reduce the price of capital relative to labor. Other things equal, this would increase w/r, thereby making the isocost line more steep. This means that the cost-minimizing input mix will now involve more capital and less labor, as firms substitute towards capital. If labor unions are concerned that this higher capital/labor ratio will translate into lost jobs, they will likely oppose the investment tax credit. On the other hand, the marginal product of labor will likely rise as a result of the greater use of capital, so those workers employed might receive higher wages. If the union values higher wages, they might favor the legislation.

Short Questions from Lesson I-7: Minimizing Cost, Lesson I-8: Competitive Markets, and Lesson I-9: Monopolistic Markets

2. You have been hired to replace the manager of a firm that used only two inputs, capital and labor, to produce output. The firm can hire as much labor as it wants at a wage of $5 per hour and can rent as much capital as it wants at a price of $50 per hour. After you look at the company books, you learn that the company has been using capital and labor in amounts that imply a marginal product of labor of 50 and a marginal product of capital of 100. Do you know why the firm hired you? Explain. Before the manager is hired, the marginal rate of technical substitution is 1/2. However, the relative input price is 1/10. This means that either more workers or less physical capital should be used. Hence, you are hired to change this input ratio in order to minimize costs.

3. An accountant for a car rental company was recently asked to report the firm's costs of producing various levels of output. The accountant knows that the most recent estimate available of the firm's cost function is , where costs are measured in thousands of dollars and output is measured in thousands of hours rented. a. What is the average fixed cost of producing 2 units of output? b. What is the average variable cost of producing 2 units of output? c. What is the average total cost of producing 2 units of output? d. What is the marginal cost of producing 2 units of output? e. What is the relation between the answers to (a), (b), and (c) above? Is this a general property of average cost curves? a. AFC(2) = 100/2 = $50. b. AVC(2) = [(10)(2) + (2)2]/2 = $12. c. ATC(2) = AFC(2) + AVC(2) = $62. d. MC(2) = 10 + 2(2) = $14. e. AVC + AFC = ATC. This holds for all output levels, not just Q = 2.

Short Questions from Lesson I-7: Minimizing Cost, Lesson I-8: Competitive Markets, and Lesson I-9: Monopolistic Markets

4. The total costs for Morris Industries are summarized in the following table. Based on this information, fill in the missing entries in the table for fixed cost, variable cost, average fixed cost, average variable cost, average total cost, and marginal cost.

Short Questions from Lesson I-7: Minimizing Cost, Lesson I-8: Competitive Markets, and Lesson I-9: Monopolistic Markets

5. The following table summarizes the short-run production function for your firm. Your product sells for $5 per unit, labor costs $5 per unit, and the rental price of capital is $20 per unit. Complete the following table, and then answer the accompanying questions.

a. Which inputs are fixed inputs? Which are the variable inputs? b. How much are your fixed costs? c. What is the variable cost of producing 20 units of output? d. How many units of the variable input should be used to maximize profits? e. What are your maximum profits? f. Over what range of variable input usage do increasing marginal returns exist? g. Over what range of variable input usage do decreasing marginal returns exist? h. Over what range of variable input usage do negative marginal returns exist?

Short Questions from Lesson I-7: Minimizing Cost, Lesson I-8: Competitive Markets, and Lesson I-9: Monopolistic Markets

a. Labor is the fixed input while capital is the variable input. b. Fixed costs are (5)($5) = $25. c. Assume that capital is indivisible, (that is, it must be rented in an integer number of units). Then the required variable cost is (2)($20), which equals $40. d. Using the VMPK = r rule, six units of capital should be used to maximize profits. e. The maximum profits are ($5)(95) - ($20)(6) - ($5)(5) = $330. f. There are increasing marginal returns when K is less than or equal to 3. g. There are decreasing marginal returns when K is greater than 3. h. There are negative marginal returns when K is greater than 7.

Short Questions from Lesson I-7: Minimizing Cost, Lesson I-8: Competitive Markets, and Lesson I-9: Monopolistic Markets

6. Standard Enterprises produces an output that it sells in a highly competitive market at a price of $100 per unit. Its inputs include two machines (which cost the firm $50 each) and workers, who can be hired on an as-needed basis in a labor market at a cost of $2,800 per worker. Based on the following production data, how many workers should the firm employ to maximize its profits?

The relevant production data is as follows:

To maximize profits, the firm should continue adding workers so long as the value marginal product exceeds the wage. The value marginal product is defined as the marginal product times the price of output. Here, output sells for $100 per unit, so the value marginal product of the third worker is $100(29) = $2,900. The table above summarizes the VMPL for each possibility. Since the wage is $2,800, the profit maximizing number of workers is 3.

Short Questions from Lesson I-7: Minimizing Cost, Lesson I-8: Competitive Markets, and Lesson I-9: Monopolistic Markets

7. You are the manager of Telecall Inc., a small telemarketing company. Your company pays $10,000 per month for office space. A real estate agent has noticed that you are only using 75 percent of your available space and tells you that Telecall could add $800 per month to its bottom line by renting out the space it does not use. Telecall has been asked to do a new telemarketing campaign for a large credit card company, but this would require it to use the remaining office space. What is the opportunity cost of using the extra office space to handle the credit card company's promotion? The $800 per month that could be earned by renting out the excess office space.

8. You are the manager of a firm that sells output at a price of $40 per unit. You are interested in hiring a new worker who will increase your firm's output by 2,000 units per year. Several other firms also are interested in hiring this worker. a. What is the most you should be willing to pay this worker to come to your firm? b. What will determine whether or not you actually have to offer this much to the worker to induce him to join your firm? a. The extra revenue you will earn by hiring the worker is 2,000 x $40 = $80,000 per year. The most you should pay the worker is an annual salary of $80,000. b. It depends on how much the worker can get from other firms. For instance, if his opportunity cost is $60,000, you will only have to pay $60,000.01 to get him.

9. To open a new business, a manager must obtain a license from the city for $20,000. The license is transferable, but only $3,000 is refundable in the event the firm does not use the license. a. What are the firm's fixed costs? Sunk costs? b. Suppose the manager obtains a license but then decides against opening the business. If another firm offers the manager $2,000 for the license, should the manager accept the offer? a. Fixed costs are $20,000. Sunk costs are $17,000. b. No. The manager can get a refund of $3,000 from the city, and this exceeds the $2,000 that it would have earned by selling the license to another firm.

Short Questions from Lesson I-7: Minimizing Cost, Lesson I-8: Competitive Markets, and Lesson I-9: Monopolistic Markets

10. The management of Morris Industries is considering a plan to terminate a new employee. The action stemmed from documented evidence supplied by the firm's accounting department that this new employee did not add as much to the firm's overall output as did a worker hired two weeks earlier. Based on this evidence, do you agree that the latest worker hired should be fired? Explain. No. In order to maximize profits, firms should hire workers up to the point where the value marginal product equals the wage rate in the range of diminishing marginal returns. The data suggests that the last worker added less to total output that the previous worker, which means that the firm is indeed operating in the range of diminishing marginal returns, as it should. The worker should be fired if his or her value marginal product is less than the wage. Unfortunately, management is not considering this information. 11. Pic Industries produces plastic toothpicks that it sells to distributors in the Southwest. During the early 1990s, the price of the plastic it uses to produce toothpicks fell by 46 percent, due to a local glut of recycled plastic containers. Assuming that the market for plastic toothpicks most closely resembles that of perfect competition and that other firms in the industry do not experience similar cost savings in the short run, what impact would this have on the profit-maximizing output, price, and profits of Pic Industries? Other things equal, the fall in the price of plastic would shift Pic's marginal cost curve to the right. To maximize profits, Pic should increase its output. Since other firms in the industry do not enjoy the reduction in marginal costs, the market supply curve would not change and the market price of toothpicks would remain unchanged. Pic Industries would enjoy higher profits in the short-run.

12. Beta Industries manufactures floppy disks that consumers perceive as identical to those produced by numerous other manufacturers. Recently, Beta hired an econometrician to estimate its cost function for producing boxes of one dozen floppy disks. The estimated cost function is . a. What are the firm's fixed costs? b. What is the firm's marginal cost? Now suppose other firms in the market sell the product at a price of $10. c. How much should this firm charge for the product? d. What is the optimal level of output to maximize profits? How much profit will be earned? e. In the long run, should this firm continue to operate or shut down? Why?

Short Questions from Lesson I-7: Minimizing Cost, Lesson I-8: Competitive Markets, and Lesson I-9: Monopolistic Markets

a. Fixed costs = 20. b. Marginal costs = 4Q. c. P = $10. d. The firm should produce such that MC = P, or 4Q = 10. This implies that Q = 2.5 units. Profits are ($10)(2.5) - 20 - 2(2.5)2 = -$7.5. e. Since the firm is earning losses, in the long-run it will shut down if the market conditions do not change.

13. Keds - the traditional maker of white canvas tennis shoes - was near oblivion in the early 1980s because competitors like Nike, Reebok, Adidas, and Brooks took away many of its customers. If you were at the helm of Keds, what would you have done to turn the company around? The market for tennis shoes is one that approximates that of monopolistic competition. Thus, a sensible strategy for Keds would have been to for Keds to increase variety in terms of color and style, while keeping to a simple comfortable canvas design. At the same time, it could increase advertising to emphasize the price and color advantages of its canvas design over the competition. In fact, this is precisely what Keds did, and as a result sales increased by tenfold from 1982 to 1988. By differentiating its product from competitors, it was able to amass some short-run profits. (See Laura Jereski, "Back in the Game," Forbes, October 31, 1988).

14. Manufacturers of laundry detergent and dishwashing soap reinvest a relatively large percentage of their sales revenues on advertising campaigns. Most of these advertisements that appear on television stress the fact that their product is "New and Improved." Why? The market for many of these products is monopolistically competitive, and thus the tendency is for the firms to earn long-run economic profits of zero. The firms hope that by continually advertising new and improved features of their products, they can reap some short-term profits.

15. Suppose the cost function for your firm is: . a. What is the average fixed cost of producing 5 units of output? b. What is the average variable cost of producing 5 units of output? c. What are the average total cost and marginal cost of producing 5 units of output? a. AFC(5) = $50/5 = $10. b. AVC(5) = [4(5) + 2(5)2]/5 = $14. c. ATC(5) = AVC(5) + AFC(5) = $24; MC(5) = 4 + 4(5) = $24.

Short Questions from Lesson I-7: Minimizing Cost, Lesson I-8: Competitive Markets, and Lesson I-9: Monopolistic Markets

16. U.S. Airways experienced huge losses for several years in the 1990s, yet it continued to operate its fleets. Why didn't U.S. Airways shut down its operations to avoid the losses? It was covering its variable costs (the cost of fuel, pilots, mechanics, flight attendants, and the like). Had it shut down its operations, losses would have been even higher, due to the high fixed costs associated with its fleet of aircraft. 17. Suppose you are the manager of Alpha Enterprises - a firm that holds a patent that makes it the exclusive manufacturer of bubble memory chips. Based on the estimates provided by a consultant, you know that the relevant demand and cost functions for bubble memory chips are . a. What is the firm's inverse demand function? b. What is the firm's marginal revenue when producing 4 units of output? c. What are the levels of output and price when you are maximizing profits? d. What will be the level of your profits? a. P = 50 - 2Q. b. MR(Q) = 50 - 4Q; MR(4) = 50 - 4(4) = $34. c. Setting MR = MC yields 50 - 4Q = 2, or Q = 12. P = 50 - 2(12) = $26. d. Profits are ($26)(12) - 74 = $238. 18. Why does the government grant patents to investors? Why does the government give monopoly power to utility companies? The rationale behind granting monopoly power to a new inventor is based on the following argument. Inventions take many years and considerable sums of money to develop. Once an invention becomes public information in the absence of a patent system, other firms could produce the product and compete against the firm that developed it. In the absence of a patent system, there would be a reduced incentive on the part of firms to develop new products. The government gives monopoly power to utility companies because they are assumed to be a natural monopoly.

19. Would you expect an industry to be monopolistically competitive if consumers did not value variety in the market? Explain. If consumers did not value variety in the market, then firms in a "monopolistically competitive market" would produce homogeneous goods. That is, the market would be perfectly competitive rather than monopolistically competitive.

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Short Questions from Lesson I-7: Minimizing Cost, Lesson I-8: Competitive Markets, and Lesson I-9: Monopolistic Markets

20. What is the primary facet of monopolistic competition that does not allow for the presence of long-run profits? If firms are making short-run profits in a monopolistically competitive industry, what will eventually occur that will cause longrun economic profits to be zero? The driving force of zero long-run profits is free entry, which allows new firms to come to compete for the positive profits. Since this entry stops only when the profits return to zero, this ensures the long-run economic profits are zero.

21. You are a manager in a perfectly competitive market. The price in your market is $35. Your total cost curve is . a. What level of output should you produce in the short run? b. What price should you charge in the short run? c. Will you make any profits in the short run? d. What will happen in the long run? How would your answer change if your costs were ?

a. Setting price equal to marginal cost implies $35 = 2 + Q. The short-run output level is Q = 33. b. $35 per unit. c. Profits are ($35)(33) - [10 + 2(33) + .5(33)2] = $534.5. d. New firms will enter and price will be lowered until profit is zero. With this cost function, short-run output falls to Q = .5, but price remains at $35. In the shortrun, profits are - $72.5. The firm will shut down in the long run in the absence of a change in market conditions.

22. You are the manager of a firm that has an exclusive license to produce your product. The inverse market demand curve is . Your cost function is . Determine the output you should produce, the price you should charge, and your profits. Here, MR = 900-3Q and MC = 2 + 2Q. Setting MR = MC yields 900 - 3Q = 2 + 2Q. Solving for Q gives us Q = 179.6. Inserting this into the inverse demand function yields P = 9001.5(179.6) = $630.60. Your maximum profits are thus PQ - C(Q) = ($630.60)(179.6) [2(179.6) + (179.6)2] = $80,640.40.

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Short Questions from Lesson I-7: Minimizing Cost, Lesson I-8: Competitive Markets, and Lesson I-9: Monopolistic Markets

23. Monsanto, the maker of Nutrasweet, owned the patent to aspartame, the official name of the sweetener. In 1987 Monsanto's patent expired in Europe, allowing other firms to produce aspartame under other brand names. What impact do you think this had on the market for aspartame and Monsanto's profits? When the patent expired in Europe, new firms entered the market to produce aspartame under other names. Most likely, there is some brand loyalty and consumers probably do not view these new products as perfect substitutes for Nutrasweet. Consequently, the market for aspartame probably moved from monopoly to monopolistic competition, and Monsanto's profits fell as a result of the increased entry. 24. If a monopolist has an own-price demand elasticity of -.8, is it maximizing profits? Explain. No. An inelastic demand implies negative marginal revenue. Since profit maximization requires marginal revenue to equal marginal cost, the firm is producing too much output (marginal cost cannot be negative).

25. You are a monopolist with the following cost and demand conditions: and . a. Determine the profit-maximizing output and price. b. Graph this solution. c. Show your profits and the deadweight loss to society in your graph. d. Determine the actual amount of deadweight loss.

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Short Questions from Lesson I-7: Minimizing Cost, Lesson I-8: Competitive Markets, and Lesson I-9: Monopolistic Markets

a. Equating MR and MC yields 100 - 4Q = 2Q. Solving for Q yields Q = 16 2/3. By plugging this back in to the inverse demand equation, we get P = $66 2/3.

Figure 8-19 b. See Figure 8-19. c. See Figure 8-19. d. Under perfect competition, market equilibrium is where the demand curve intersects industry marginal cost. Thus, the competitive price is $50, and the quantity is 25 units. The deadweight triangle in Figure 8-19 is.5(66.67 - 33.33)(25 - 16.67) = $138.86.

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Short Questions from Lesson I-7: Minimizing Cost, Lesson I-8: Competitive Markets, and Lesson I-9: Monopolistic Markets

26. You are the manager of a monopolistically competitive firm. The present demand curve you face is . Your cost function is a. What level of output should you choose to maximize profits? b. What price should you charge? c. What will happen in your market in the long run? Explain. .

a. Setting MR = MC yields Q = 4. b. P = 100 - 4(4) = $84 per unit. c. Profits are 84(4) - [50 + 8.5(16)] = $150. Since profits are greater than zero, new firms will be attracted to the industry until profits fall to zero.

27. You are the manager of a monopolistically competitive firm. The inverse demand for your product is given by and your marginal cost is . a. What is the profit-maximizing level of output? b. What is the profit-maximizing price? c. What are the maximum profits? d. What do you expect to happen to the demand for your product in the long run? Explain. a. Setting MR = MC yields 200 - 20Q = 5 + Q, or Q = 9.29. b. P = 200 - 10(9.29) = $107.1. c. This part will be hard for most students. Total cost is the integral of marginal cost: or C(Q) = 5Q + Q2/2 + FC. Thus, profits are $905.36 - FC. d. If fixed costs are lower than $905.36, the positive profits will induce entry. In the long run, this will decrease the demand for your product.

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Short Questions from Lesson I-7: Minimizing Cost, Lesson I-8: Competitive Markets, and Lesson I-9: Monopolistic Markets

28. Genentech owns a patent on tissue plasminogen activator (TPA), which is an enzyme that helps the body break down blood clots. TPA is particularly valuable to cardiac patients, since it often allows heart problems to be treated with medication rather than surgery. Recently, however, firms in the medical industry have come under fire by some members of Congress and the press for charging high prices and earning monopoly profits. Do you think cardiac patients would benefit if the government stripped Genentech and other pharmaceutical firms of their patents? Explain. In the short run, eliminating the patent might allow other firms to enter and lower the price to cardiac patients. In the long run, however, it is not at all clear that cardiac patients would benefit. Absent patent protection, firms like Genentech would be unwilling to invest the substantial sums in R&D that are required to develop products like TPA. The monopoly profits earned by Genentech are its reward for developing the new product, and taking away that reward would likely harm cardiac patients in the long run.

29. You are the general manager of TU modems Inc., and your accounting department has provided you with the following information about the total cost of producing three potential quantities of a commercial-grade modem:

The market is saturated with modems, and your sales department has been able to identify only one potential buyer of your modems. This customer has numerous alternative options and as a result is only willing to pay $300 per modem for an order of 100,000 modems. You must decide whether to sign a contract under these terms or simply shut down your operations. What is your optimal decision? The only costs relevant for making this decision are your variable costs of producing 100,000 units. These relevant costs include materials ($250,000) and labor ($10,000). The depreciation reflects a charge for expenditures already made, and thus this amount will be lost regardless of your decision. By signing the contract, your revenues increase by $30,000,000 and your variable costs increase by only $260,000. You should sign the contract because doing so adds $29,740,000 to your bottom line that you will not get if you shut down your operation.

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Short Questions from Lesson I-7: Minimizing Cost, Lesson I-8: Competitive Markets, and Lesson I-9: Monopolistic Markets

30. The XYZ company produces output using labor (which it purchases on an as-needed basis in the market for unskilled workers at a wage of $5 per hour) and one machine (which it is obligated to lease at a rental rate of $300 per hour). The planning horizon precludes XYZ from renting or purchasing any additional machines, as the current machine has a capacity of 80 units of output per hour, which exceeds the projected demand for the firm's product. The firm has no alternative use for the machine it leases, and the contract precludes it from subleasing it to another party. The company currently employs one worker who produces 10 units of output per hour. A recent report from the engineering department reveals that, given the plant's current capacity, two workers could produce 20 units of output per hour, three workers could produce 30 units of output per hour, and four workers could produce a total of 40 units of output per hour. a. Complete the following

table: b. Suppose that XYZ can sell up to 40 units of output per hour at a price of $.60 per unit but cannot even get a penny for units produced in excess of 40 units per hour. How much output should XYZ produce each hour in order to maximize profits? c. At what price would XYZ find it profitable to shut down its operation?

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Short Questions from Lesson I-7: Minimizing Cost, Lesson I-8: Competitive Markets, and Lesson I-9: Monopolistic Markets

a. Hourly Cost Data, XYZ Company

b. 40 units, since MB = $0.60 > MC = $0.50 for all units below 40, and MB = 0 for units produced in excess of 40. c. Part (b) revealed that if the firm operates, it should produce 40 units. It should shut down if the profits from operating are less than the profits it would earn by shutting down. The calculations are: i. Profits if the firm operates and charges a price of "P" for 40 units: 40 P - 300 - 20. ii. Profits if the firm shuts down: -$300. Shut down if -$300 > 40 P - 300 - 20. iii. Solving for P gives us: "Shut down if P < $0.50."

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