ECON 251:

EXAM 2 REVIEW

Spring 2020
Kelly Blanchard
OVERVIEW
• Exam 2 covers chapters 7-12
• General suggestions for studying:
• Look at “Detailed Learning Objectives” on Blackboard for
each chapter
• Work through fall 2019 and spring 2019 exams
• Note that fall 2019 only covered through chapter 10
• Review homework assignments on MyEconLab
• Work through Hotseat questions for all 3 sections, not just
your own section’s Hotseat question
• Look at Eeman’s SI supplements with lectures on
Blackboard
CHAPTER 7
• Main idea: Utility is maximized where marginal utility per
dollar is equal across all goods.

• With 2 goods→ (MUx/Px) = (MUy/Py)

• Budget line measures a consumer’s consumption
possibilities
• income = PxQx + PyQy
• Slope of budget line = -Px/Py, where Px/Py reflects the “relative
price” of good x
CHAPTER 7 EXAMPLE Q MU/P MU/P
#2 on fall 2019: (clubs golf cham-
General rule to apply: Utility is maximized by or clubs pagne
comparing the marginal utility per dollar spent across cham-
the two goods.
pagne)
Steps:
1) Calculate marginal utility first, then divide 1 20 20
marginal utilities by the relevant prices to get 2 16 17.5
marginal utility per dollar spent (MU/P). (see table)
2) Compare marginal utility per dollar spent 3 10 16.25
across the two goods, and purchase goods with the 4 8 8.75
higher marginal utility per dollar spent until income is
exhausted where $360 is spent on 4 golf clubs and 4 5 6 5
bottles of champagne. (Note: limitation to purchase
only whole quantities doesn’t allow for exact equality 6 4 3
between marginal utilities per dollar spent) 7 2 2
Hints: Eliminate answers that don’t use up the
budget or cost more than the budget.
CHAPTER 8
• Main idea: Utility is maximized where the budget line is
tangent to the indifference curve (or, equivalently,
where the marginal rate of substitution (MRS) is equal
to the relative price (Px/Py)
• MRS is the amount of good y a consumer is willing to give up
for one more unit of good x. It is measured as the magnitude
of the slope of the indifference curve
• Changes in price affect both the “relative price” and
“real income”, and substitution and income effects
measure the impact of those changes:
SUBSTITUTION AND INCOME EFFECTS
• Substitution effect=effect of a change in the “relative price” on
the quantity purchased
• Quantity demanded falls for a good with a higher relative price and
rises for a good with a lower relative price
• On indifference curve/budget line graphs, the substitution effect is
measured as the change in quantity resulting from change in the slope
of the budget line, holding utility constant (staying on the original IC)

• Income effect=effect of a change in “real income” on the

quantity purchased
• Quantity demanded of a normal good falls when real income falls, but
quantity demanded of an inferior good rises when real income falls
• On indifference curve/budget line graphs, the income effect is
measured as the change in quantity resulting from change to a new IC
 CHAPTER 8
EXAMPLES
#8 and #9 fall 2019 Exam 2
#8
General rule to apply: Utility is
maximized where IC and budget line
are tangent
Steps: Movement from B1 to B2 implies
the price of pumpkin pie fell so
consumer goes from buying 3 pumpkin Note: On B1, consumer can buy a maximum
pies to 5 pumpkin pies. of 6 pies. With $120 of income, that must
mean pies cost $20 each. On B2, consumer
Either (3, $20) or (5, $12) would be can buy a maximum of 10 pies, so the price
points on the demand curve has fallen to $12.
 CHAPTER 8 EXAMPLES
#9 fall 2019 Exam 2
General rule to apply: Substitution effect measures
the change in quantity purchased as a result of
change in the relative price (slope of the budget line),
and income effect measures the change in quantity
purchased as a result of change in real income (the
move to a new IC).
Steps: Always start with the substitution effect, and
look for a line with the same slope as the NEW
budget line (so it reflects the new relative price) but
that is still tangent to the ORIGINAL indifference
curve (so you’re keeping utility constant)→
Dashed line is parallel to new budget line, B2, and is
tangent to IC2 (original IC) at a quantity of 4, so the
substitution effect measures the change from 3 to 4.
Hint: Don’t forget to look over the 3 cases in
The income effect measures the change in real the Income and Substitution Effects document
income. The dashed line kept real income at its that’s posted on Blackboard. In this example,
original level, but lower prices actually shift the budget pumpkin pie was a normal good because both
line out to the new budget line, B2. The change from the substitution effect and the income effect
the hypothetical budget line (the dashed line) to the encouraged the consumer to buy more pie
new budget line pushes the consumer from a quantity when the price of pie fell.
of 4 to a quantity of 5, so that’s the income effect.
CHAPTER 9
Main idea: Firms have maximizing profit as a goal

Basic Formulas:
Profit = TR – TC (remember cost reflects total opportunity cost) or profit = Qx(P-ATC) on a graph
APL= Q/L
MPL = change in output/change in labor
TC = FC + VC
AFC = FC/Q
AVC = VC/Q = wage/APL
ATC = TC/Q = AFC + AVC
MC = change in total cost/change in quantity = change in variable cost/change in quantity = wage/MPL

• LRAC measures average cost in the long run when firms can adjust all of their resources. In the
short run, at least one input is fixed.
CHAPTER 9 EXAMPLE
#25 on fall 2019 exam 2

General rule to apply: Use the cost formulas

Steps: 1) Always start by filling in numbers for fixed costs first. AFC=FC/Q implies that
$4=FC/40 so FC=$160 here. Then fill in the rest of the AFC column
2) You’re trying to find the total cost at Q=50, and total cost is the sum of FC and VC.
FC=$160 so you just need VC. To find the AVC at Q=50, use the total cost at Q=40 and the
MC of $5 at Q=50. Total cost at Q=40 is $280 =(AFC+AVC)xQ = FC+VC. If MC=$5, each of
the 10 units between Q=40 and Q=50 cost $5, so total cost at Q=50 must be $50 higher, so
total cost rises to $330.
Hint: Try adding a total cost column to the table and find total cost at each level of output.
Remember that TC=FC only when Q=0 so the MC=$1 for the first 10 units will increase
costs from $160 up to a total cost of $170 for 10 units.
CHAPTER 10
• Main idea: Perfectly competitive firms
maximize profit where MR=MC=P*, and
they earn profit =$0 in the long run.
• Perfectly competitive markets have
1) low concentration ratios and low HHIs
2) Demand curves facing each firm that are
perfectly elastic (these firms are “price
takers”)
3) No barriers to entry (this is the key to $0
profit in the long run)
CHAPTER 10 EXAMPLE
#28-#30 on fall 2019
#28 and #29
General rule(s): Profit is
maximized where MR=MC, and
MR=P* for firms in perfect
competition. Profit is measured as
TR-TC or qx(P-ATC).
Steps: 1) MR=$3 because P*=$3
2) Calculate MC
MC=MR=$3 at q*=90
3) Profit = ($3)(90)-110=$160.
 CHAPTER 10 EXAMPLE
#29 on fall 2019
General rule(s): Profit is maximized where MR=MC if the firm
produces at all, but if profit is negative, you have to check the
shutdown rule:
P>AVC→ stay in business
P<AVC→ shut down
Steps: 1) MR=$0.25, and the closest we can get to MR=MC
without MC becoming greater than MR is at q=20.
2) Profit at q=20 is ($0.25)(20)-12 = negative $7
3) AVC at q=20 is VC/q=7/20=$0.35, which is above the price,
so the firm shuts down. Alternatively, compare profit from
producing with profit from shutting down. If the firm shuts
down, profit = negative $5 (fixed costs still have to be paid,
even if q=0), which is a smaller loss than the negative $7
the firm earns if they continue to stay in business.
Hint: Watch for questions where the price changes, and you have
to find the profit-maximizing level of output a second time. There’s
usually a reason why I would ask the same kind of question with a
different price. That doesn’t mean the firm will always shut down if
the price falls, but you’re likely to need to check the shutdown
rule—so always check profit to see if you need to evaluate the
shutdown rule.
CHAPTER 11
• Main idea: Monopoly still maximizes profit where MR=MC,
but that’s not going to be at the same level of output that a
perfectly competitive industry would produce (i.e., there’s
going to be some deadweight loss associated with
monopoly).
• Single-price monopolies face market demand curves that
have a negative slope, and MR is always twice as steep as
demand. That also implies that MR<P for a monopolist.
• When MR>0, demand is elastic
• When MR<0, demand is inelastic
• When MR=0, demand is unit elastic
• Special cases=price discrimination and natural monopoly
CHAPTER 11
SPECIAL CASE: PRICE DISCRIMINATION
• Price discrimination=charging different prices for
different units (not related to production costs)
• Firms that practice perfect price discrimination
charge every customer a different price that is
exactly equal to their marginal benefit→
• Q*=Qeff (so DWL=$0), and CS=$0 if everyone is paying
exactly the highest price they would have willingly paid
• Charging different prices to different groups or for
different quantities purchased also allows
monopolies to increase producer surplus and profit
(at the expense of consumer surplus)
CHAPTER 11
SPECIAL CASE: NATURAL MONOPOLY
• Natural monopoly
• Natural monopolies arise if there are significant economies
of scale (lower LRAC as output increases in the long run)
that make it cheaper for one firm to produce ALL of the
industry’s output
• Natural monopolies are still not efficient so they are usually
regulated
• Marginal cost pricing regulation requires that firms charge a price
equal to marginal cost. This kind of regulation would result in a
level of output that satisfies allocative efficiency (output is
produced where MB=MC), but it will also push firms to earn
negative profit.
• Average cost pricing regulation requires that firms charge a price
equal to average cost. This kind of regulation keeps profit at $0
(it’s not negative), but it’s not going to satisfy allocative efficiency
(i.e., there will still be some deadweight loss).
CHAPTER 11 EXAMPLES
• #27-#29 on spring 2019 exam 2
#27:
General rule: Monopolies maximize profit where MR=MC, but
the price charged comes from the demand curve
Steps:
1) Find MR by rewriting demand in slope-intercept form
(y=mx+b or P= -Q+840 in this case), and then doubling the
slope so that MR = 840-2Q
2) Set MR=MC and solve for Q* to get Q*=270.
3) Plug Q* into DEMAND to find P*=$570.
CHAPTER 11 EXAMPLES $

840 CS = (1/2)(270)(840-570)
#28:
MC
General rule: Producer surplus is the area between
the price and MC. This is a trapezoid for a single- 570
price monopoly DWL = (1/2)(405-270)(570-300)
Steps: 1) Draw the picture for a monopoly. Monopoly
pictures will always need D, MR, and MC.
300
2) Identify the area below the price and above MC PS = (270)(570-300)+(1/2)(300-30)(270)
(out to the Q* of 270). Separate that trapezoid into a
rectangle and a triangle as shown.
30
#29:
General rule: Deadweight loss measures the MR D=MB
decrease in total surplus as a result of inefficiency.
270 405 840 Q
Steps:
1) Using the same picture, identify the triangle of
deadweight loss between Q* and Qeff and
between MB (demand) and MC.
2) Calculate the efficient level of output (Qeff) by
finding the x coordinate of the intersection
between MB (demand) and MC. Here,
MB=840-Q and MC=Q+30, so Qeff =405
CHAPTER 12
• Main idea: Firms in monopolistic competition
face many competitors who produce similar
products, but product differentiation means
each firm faces a demand curve that is not
perfectly elastic (it still has some negative
slope). These firms still maximize profit where
MR=MC, but MR<P.
• With no barriers to entry, firms in monopolistic
competition will earn $0 profit in the long run.
 CHAPTER 12 EXAMPLE
#39 on spring 2019
General rule: Firms in monopolistic competition earn $0 in the
long run
Steps: Positive profits will encourage new firms to enter the
market. As new firms enter, existing firms will lose some of
their customers to the new firms, so firm demand will
decrease. Simultaneously, the new competition increases the
number of substitutes for the products existing firms produce,
and that will increase the price elasticity of demand facing
those firms (demand gets flatter). Flatter and lower demand
will both reduce the price that existing firms can charge, so
profit will fall. Profit will continue falling until profit is at a level
that stops encouraging enter of new firms, so profit will
continue falling until it get to $0.
 SIDE BY SIDE BY SIDE COMPARISON
OF THREE INDUSTRIES
Perfect Competition
--Many firms (low CR and low HHI)
--Products are perfect substitutes
for one another
--No barriers to entry
Profit maximized where MR=MC,
and MR=P*
In the long run, profit=$0 (P=ATC,
and P=MR=MC so MC=ATC and
ATC is minimized)
Market output satisfies both
production efficiency (AC is
minimized) and allocative efficiency
(MB=MC in the market)
Monopoly
--One firm (CR=100 and
HHI=10,000)
--No close substitutes
--Significant barriers to entry
Profit maximized where MR=MC,
but MR<P
In the long run, profit can stay
positive, but there’s no guarantee
Market output satisfies neither
production nor allocative efficiency
(DWL>$0).
Exception: If a monopolist can
practice perfect price discrimination,
DWL=$0
Monopolistic competition
--Many firms
--Products are slightly differentiated
--No barriers to entry
Profit maximized where MR=MC,
but MR<P
In the long run, profit=$0 (P=ATC,
but not min ATC)
Market output satisfies neither
production efficiency (each firm
produces with “excess capacity”)
nor allocative efficiency, although
the value of product variety/diversity
in the market as a whole may offset
some resulting DWL.