211 ECON71-600 Assignment 2 Answer Guide

1. Consider a firm that produces 1,000,000 units of output per year.

The total costs are $3,000,000 and the fixed costs are $1,000,000. At
this level of production marginal costs are $2. That is, if output
increased to 1,000,001 units, total costs would increase to $3,000,002.
Now suppose that output was increased to 1,000,001 units.
(a) Calculate, to the nearest cent, average total cost, average variable
cost, and average fixed cost. You must show your workings. (6
marks)
ATC=$3
AVC=$2
AFC=$1
(b) If the price per unit was set at the marginal cost (that is, $2) would
the firm be making zero economic profit? Carefully explain your
answer. (19 marks)
No, the firm would make a loss. The ATC is greater than MC. So,
MC pricing will result in a loss here. MC pricing can only be done
(without making a loss) when MC equals or exceeds ATC. In the long
run a firm in perfect competition will make zero economic profit (and
firms in perfect competition are always MC pricing). However, we
need to remember that many firms are not operating in perfectly
competitive markets.
2. You run a chain of movie theatres, so you commission a marketing
study that categorizes your potential customers into 10 equal-sized
groups according to what they are willing to pay for a movie ($10, $9,
$8, $7, $6, $5, $4, $3, $2, $1). It turns out that the low-value customer
groups, those with values ($5, $4, $3, $2, $1), are all over 65 years
old. All the costs of exhibiting movies are fixed except for the $3.50
royalty payment you must make to the film distributor for each ticket
sold. What price should you charge for movie tickets? Should you
offer senior citizen discounts? If so, what should be the price for
senior citizens? Carefully explain your answer. (25 marks)
You should charge $7.00 for movies and offer a $2.00 senior citizen
discount.
Optimal Price w/ No Price Discrimination

Price Quantity Revenue MR MC Profit

$10 1 $10 $10 $3.5 $6.50

9 2 18 8 3.5 11.00

8 3 24 6 3.5 13.50

7 4 28 4 3.5 14.00

6 5 30 2 3.5 12.50

5 6 30 0 3.5 9.00

4 7 28 -2 3.5 3.50

3 8 24 -4 3.5 -4.00

2 9 18 -6 3.5 -13.50

1 10 10 -8 3.5 -25.00
If you charge a single price, operating profits are largest at a price of
$7 and a quantity of 4. You earn $14.
Optimal Price for Low-Value Consumers

Price Quantity Revenue MR MC Profit

$5 1 $5 $5 $3.5 $1.50

4 2 8 3 3.5 1.00

3 3 9 1 3.5 -1.50

2 4 8 -1 3.5 -6.00

1 5 5 -3 3.5 -12.50

If you can offer senior citizens discounts, you want to offer a $2

discount for seniors, i.e. a price of $5. This allows you to gain an
additional $1.50 in profit.
3. Consider an experiment with two pigs in a long box. One of the
pigs is a small pig and the other pig is a large pig. At one end of the
box there is a lever and at the other end of the box there is a food tray;
pressing the lever fills the food tray. If the small pig presses the lever,
the big pig will get all of the food. If the big pig presses the lever, the
small pig will get some of the food before the big pig can run to the
food tray and push the small pig aside. The following payoffs apply:
small pig does press large pig does press (5, 15), small pig doesn’t
press large pig does press (18, 2), small pig does press large pig
doesn’t press (-1, 20), small big doesn’t press large pig doesn’t press
(0, 0). Note the first number in each pair refers to the respective
payoff for the small pig and the second number refers to the
respective payoff for the large pig.
(a) Assume the pigs are capable of game theoretic reasoning, set out
the game in normal form and find the Nash equilibrium. (10 marks)

The unique Nash equilibrium for this game is that the small pig
chooses the strategy of 'Don't Press' and the large pig chooses the
strategy of 'Press'. Think about it like this. By choosing 'Press' the
large pig is choosing its best strategy given that the small pig is also
choosing its best strategy which is 'Don't Press'.
(b) Explain why the large pig will know for certain what the small pig
will do. That is, there is no possibility of a player incorrectly
forecasting what the other player will do. (5 marks)
The large pig knows that the small pig has a dominant strategy which
is 'Don't Press'. That is, the small pig will be better-off by playing this
strategy no-matter-what strategy the large pig plays. Therefore, there
is no doubt that the small pig will choose 'Don't Press'.
(c) Now let’s drop the assumption that the pigs are capable of game
theoretic reasoning and allow the experiment to be played many
times. Explain why through a process of trial-and-error the two pigs
would begin to behave in the way that game theory predicts. (The neat
thing about this question is that it illustrates that game theory can
predict the behaviour of decision makers even when the decision
makers do not understand game theory.) (10 marks)
Imagine initially both pigs associate the lever with food and both of
them individually press the lever a lot. After some time, the small pig
realises that if he presses the lever, he does not get any food and
hence he stops pressing the lever. The large pig being hungry presses
the lever. So, this takes us eventually to the same equilibrium as we
saw in part (a).
4. Business customers are willing to pay an airfare of $1800, while
vacationers will pay at most $720. Vacationers do not mind staying
over the weekend. The opportunity cost to business customers of
staying over the weekend is $220. The cost of a seat to the airline,
which operates as a monopolist on this route, is $700. The airline
cannot observe whether a person is a business customer or a
vacationer. There is a probability of 0.5 that a person is a business
customer.
(a) Calculate the expected profit from the next potential customer to
walk in the door, if the only airfare (ticket) being offered is aimed at
business customers. (7 marks)
Expected profit = ($1800)(0.5) + ($0)(0.5) - $700 = $200
Alternatively:
Expected profit = ($1800 - $700)(0.5) + ($0)(0.5) = $550

(b) Calculate the expected profit from the next potential customer to
walk in the door, if there is one airfare designed to attract vacationers
and another airfare designed to attract business customers. (7 marks)
Expected profit = ($940)(0.5) + ($720)(0.5) - $700 = $130
Alternatively:
Expected profit = ($939)(0.5) + ($720)(0.5) - $700 = $129.50
The airfare intended for the vacationers is $720 and requires the
travellers to stay over the weekend.
The airfare intended for the business customers is $720 + $220 =
$940 and does not require the travellers to stay over the weekend.
Note that if this airfare was $941 the business customers would
choose the $720 deal that was designed for vacationers.
(c) Which option should the airline choose? Explain your answer. (11
marks)
Obviously, the airline should choose option (a). Note that the
information asymmetry here (combined with the airline's monopoly
position) has caused a 'market failure' in the sense that there is a
'missing market' for vacation flyers. That is, even though the
vacationers are prepared to pay a price that is higher than the airline's
cost, the vacationers do not get to fly to this particular destination.