Managerial Economics (MGCR 293)

Practice Questions for the Final Examination

2016-2017
(Part 1)

1. Why would a firm that incurs losses choose to produce rather than shut down?
Losses occur when revenues do not cover total costs. Revenues could be
greater than variable costs, but not total costs, in which case the firm is better
off producing in the short run rather than shutting down, even though they
are incurring a loss. The firm should compare the level of loss with no
production to the level of loss with positive production, and pick the option,
which results in the smallest loss. In the short run, losses will be minimized
as long as the firm covers its variable costs. In the long run, all costs are
variable, and thus, all costs must be covered if the firm is to remain in
business.
2. What is the difference between economic profit and producer surplus?
While economic profit is the difference between total revenue and total cost,
producer surplus is the difference between total revenue and total variable
cost. The difference between economic profit and producer surplus is the
fixed cost of production.
3. Why do firms enter an industry when they know that in the long run economic
profit will be zero?
Firms enter an industry when they expect to earn economic profit. These
short-run profits are enough to encourage entry. Zero economic profits in
the long run imply normal returns to the factors of production, including the
labour and capital of the owners of firms. For example, the owner of a small
business might experience positive accounting profits before the foregone
wages from running the business are subtracted from these profits. If the
revenue minus other costs is just equal to what could be earned elsewhere,
then the owner is indifferent to staying in business or exiting.

Practice questions for the final exam, Part One 1

4. At the beginning of the twentieth century, there were many small American
automobile manufacturers. At the end of the century, there are only three large ones.
Suppose that this situation is not the result of lax federal enforcement of antimonopoly
laws. How do you explain the decrease in the number of manufacturers? (Hint: What
is the inherent cost structure of the automobile industry?)
Automobile plants are highly capital-intensive. Assuming there have been
no impediments to competition, increasing returns to scale can reduce the
number of firms in the long run. As firms grow, their costs decrease with
increasing returns to scale. Larger firms are able to sell their product for a
lower price and push out smaller firms in the long run. Increasing returns
may cease at some level of output, leaving more than one firm in the
industry.
5. Industry X is characterized by perfect competition, so every firm in the industry is
earning zero economic profit. If the product price falls, no firms can survive. Do you
agree or disagree? Discuss.
Disagree. As the market price falls, firms cut their production. If price falls
below average total cost, firms continue to produce in the short run and cease
production in the long run. If price falls below average variable costs, firms
cease production in the short run. Therefore, with a small decrease in price,
i.e., less than the difference between the price and average variable cost, the
firm can survive. With larger price decrease, i.e., greater than the difference
between price and minimum average cost, the firm cannot survive. In
general, we would expect that some firms will survive and that just enough
firms will leave to bring profit back up to zero.
6. An increase in the demand for video films also increases the salaries of actors and
actresses. Is the long-run supply curve for films likely to be horizontal or upward
sloping? Explain.
The long-run supply curve depends on the cost structure of the industry. If
there is a fixed supply of actors and actresses, as more films are produced,
higher salaries must be offered. Therefore, the industry experiences
increasing costs. In an increasing-cost industry, the long-run supply curve is
upward sloping. Thus, the supply curve for videos would be upward
sloping.
7. True or false: A firm should always produce at an output at which long-run average
cost is minimized. Explain.
False. In the long run, under perfect competition, firms should produce
where average costs are minimized. The long-run average cost curve is
formed by determining the minimum cost at every level of output. In the
short run, however, the firm might not be producing the optimal long-run
output. Thus, if there are any fixed factors of production, the firm does not
always produce where long-run average cost is minimized.

Practice questions for the final exam, Part One 2

8. The government passes a law that allows a substantial subsidy for every acre of
land used to grow tobacco. How does this program affect the long-run supply curve
for tobacco?
A subsidy on tobacco production decreases the firm’s costs of production.
These cost decreases encourage other firms to enter tobacco production, and
the supply curve for the industry shifts out to the right.
9. From the data in the following table, show what happens to the firm’s output choice
and profit if the price of the product falls from $40 to $35.
The table below shows the firm’s revenue and cost information when the
price falls to $35.
Q P TR TC  MC MR TR MR 
P = 40 P = 40 P = 40 P = 40 P = 35 P = 35 P = 35
0 40 0 50 -50 ___ ___ 0 ___ -50
1 40 40 100 -60 50 40 35 35 -65
2 40 80 128 -48 28 40 70 35 -58
3 40 120 148 -28 20 40 105 35 -43
4 40 160 162 -2 14 40 140 35 -22
5 40 200 180 20 18 40 175 35 -5
6 40 240 200 40 20 40 210 35 10
7 40 280 222 58 22 40 245 35 23
8 40 320 260 60 38 40 280 35 20
9 40 360 305 55 45 40 315 35 10
10 40 400 360 40 55 40 350 35 -10
11 40 440 425 15 65 40 385 35 -40

At a price of $40, the firm should produce eight units of output to maximize
profit because this is the point closest to where price equals marginal cost
without having marginal cost exceed price. At a price of $35, the firm
should produce seven units to maximize profit. When price falls from $40 to
$35, profit falls from $60 to $23.

10. A sales tax of $1 per unit of output is placed on one firm whose product sells for $5
in a competitive industry.
a. How will this tax affect the cost curves for the firm?
With the imposition of a $1 tax on a single firm, all its cost curves shift up by
$1.
b. What will happen to the firm’s price, output, and profit?
Since the firm is a price-taker in a competitive market, the imposition of the
tax on only one firm does not change the market price. Since the firm’s
short-run supply curve is its marginal cost curve above average variable cost

Practice questions for the final exam, Part One 3

 and that marginal cost curve has shifted up (inward), the firm supplies less to
the market at every price. Profits are lower at every quantity.
c. Will there be entry or exit?
If the tax is placed on a single firm, that firm will go out of business. In the
long run, price in the market will be below the minimum average cost point
of this firm.
11. How does a car salesperson practice price discrimination? How does the ability to
discriminate correctly affect his or her earnings?
The relevant range of the demand curve facing the car salesperson is
bounded above by the manufacturer’s suggested retail price plus the
dealer’s mark-up and bounded below by the dealer’s price plus
administrative and inventory overhead. By sizing up the customer, the
salesperson determines the customer’s reservation price. Through a process
of bargaining, a sales price is determined. If the salesperson has misjudged
the reservation price of the customer, either the sale is lost because the
customer’s reservation price is lower than the salesperson’s guess or profit
is lost because the customer’s reservation price is higher than the
salesperson’s guess. Thus, the salesperson’s commission is positively
correlated to his or her ability to determine the reservation price of each
customer.
12. Why did Loews bundle Gone with the Wind and Getting Gertie’s Garter? What
characteristic of demands is needed for bundling to increase profits?
Loews bundled its film Gone with the Wind and Getting Gertie’s Garter to
maximize revenues. Because Loews could not price discriminate by
charging a different price to each customer according to the customer’s
price elasticity, it chose to bundle the two films and charge theatres for
showing both films. The price would have been the combined reservation
prices of the last theatre that Loews wanted to attract. Of course, this tactic
would only maximize revenues if demands for the two films were
negatively correlated.
13. How does tying differ from bundling? Why might a firm want to practice tying?
Tying involves the sale of two or more goods or services that must be used
as complements. Bundling can involve complements or substitutes. Tying
allows the firm to monitor customer demand and more effectively determine
profit-maximizing prices for the tied products. For example, a
microcomputer firm might sell its computer, the tying product, with
minimum memory and a unique architecture, then sell extra memory, the
tied product, above marginal cost.
14. How can a firm check that its advertising-to-sales ratio is not too high or too low?
What information does it need?
The firm can check whether its advertising-to-sales ratio is profit
maximizing by comparing it with the negative of the ratio of the advertising

Practice questions for the final exam, Part One 4

 elasticity of demand to the price elasticity of demand. The firm must know
both the advertising elasticity of demand and the price elasticity of demand.

15. Why does price leadership sometimes evolve in oligopolistic markets? Explain
how the price leader determines a profit-maximizing price.
Since firms cannot explicitly coordinate on setting price, they use implicit
means. One form of implicit collusion is to follow a price leader. The price
leader, often the dominant firm in the industry, determines its profit-
maximizing price by calculating the demand curve it faces: it subtracts the
quantity supplied at each price by all other firms from the market demand,
and the residual is its demand curve. The leader chooses the quantity that
equates its marginal revenue with marginal cost. The market price is the
price at which the leader’s profit-maximizing quantity sells in the market.
At that price, the followers supply the remainder of the market.

Practice questions for the final exam, Part One 5