Microeconomics FRQ revision document

Chapter 1: Basic economic concepts

1. Alice and Roy make identical sandwiches and burgers. The following table shows the time in
minutes taken by each to make both goods.

a) Who has an absolute advantage in the production of each of the following?

i. Sandwiches
ii. Burgers
b) If a trade is to take place between Alice and Roy, who will sell sandwiches?

2. Zanadu and Atlantis are potential trading partners. They can produce helmets and baseballs
as illustrated in the following PPCs:

a. Calculate the opportunity cost of one helmet for Atlantis. Show your work.
b. Which country has an absolute advantage in the production of baseballs?
c. Which country has a comparative advantage in the production of baseballs? Explain.
d. Would both countries be able to gain from trade if the terms of trade are 1 helmet for 3
baseballs? Explain.

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Chapter 2: Demand, supply, market equilibrium and welfare analysis.
1. Bananas are an input for muffins.

a. Draw a correctly labelled graph of the market for muffins indicating the equilibrium price and
quantity, labelled P0 and Q0, respectively.

b. On the graph in part (a), show the impact of an increase in the price of bananas on the muffin
market, labelling the new equilibrium price and quantity P1 and Q1, respectively.

c. On the same graph, completely shade the area that represents the change in the consumer
surplus caused by the increase in the price of bananas.

2. How does each of the following affect the equilibrium price and quantity of burgers?

a) There is an announcement that burgers cause heart problems.

b) There is an increase in the price of pizza, a substitute for burgers.

c) The price of beef increased.

d) consumers expect the price of burgers to drop next week.

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Chapter 3: Elasticity.
1. Assume that bread and butter are complementary goods. The government begins to subsidize the
production of wheat, which is an input in the production of bread.

a. For each of the following markets, draw correctly labeled supply and demand graphs and show
the effect of the subsidy on the equilibrium price and quantity in the short run.

i. the wheat market

ii. the bread market
iii. the butter market

b. Explain how the consumer surplus changes after a government subsidy is given.

c. If the demand for bread is price elastic, how will the total revenues for the bread producers
change as a result of the government subsidy?

2. Examine the table below, which shows the demand for a signature chocolate bar at different
prices.

Price ($) Quantity demanded

(chocolate bars per
week)

10 20

8 40

6 60

4 80

2 100

a. Calculate the price elasticity of demand when the initial price falls from $8 to $6 and comment on
its value.

b. Calculate the price elasticity of demand when the initial price falls from $6 to $4 and comment on
its value.

c. Calculate the price elasticity of demand when the initial price falls from $4 to $2 and comment on
its value.

3. a. Anna’s income elasticity for jam is – 0.2. Does the value of her income elasticity indicate that
jam is a normal good, inferior good, substitute, or complement?

b. Suppose that when the price of jam increases by 10 per cent, Anna buys 5 per cent fewer jam jars
and 4 per cent less of a different ingredient, chocolate. Calculate the cross price elasticity for jam
and chocolates and indicate if it is positive or negative, and comment on this value.

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Chapter 4: Price controls and government taxes.
1. Rice is freely traded in the world market. Assume that Indonesia is a price taker in the world
market for rice. Some of the rice consumed in Indonesia is locally produced, while the rest is
imported. The world price of rice is set at $2 per pound.

The following graph shows Indonesia’s rice market, with the world price at Pw.

a. How much is Indonesia importing at the world price?

b. If Indonesia imposes a per-unit tariff on rice imports and the new domestic price including the
tariff becomes $4. what would be the new level of domestic production?

c. If Indonesia imposes a per-unit tariff on rice imports and the new domestic price including the
tariff becomes $4. What would be the consumer surplus? Show your calculation.

d. If Indonesia imposes a per-unit tariff on rice imports and the new domestic price including the
tariff becomes $4. What would be the total tariff revenue collected by the government? Show your
work.

e. At the world price of $2, what per unit tariff would allow Indonesia to maximize the sum of
consumer and producer surpluses?

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2. The graph below shows the market for a good that is subject to a per-unit tax. The letters in the
graph represent the enclosed areas.

a. Using the labeling on the graph, identify each of the following:

i. The equilibrium price and quantity before the tax.

ii. The area representing the producer surplus before the tax.
b. Assume that a tax is now imposed. Based on the graph, does the price paid by the buyers rise by
the full amount of the tax? Explain.
c. Using the labeling on the graph, identify each of the following after the imposition of the tax:
i. The net price received by the sellers.
ii. The amount of tax revenue.
iii. The area representing the consumer surplus
iv. The area representing the deadweight loss.

3. In each of the following parts, assume that the government imposes a per unit sales tax and that
the supply is upward sloping.
a. In industry X, consumers buy the same quantity no matter what the price is.
i. Using a correctly labeled graph, show what happens to the quantity sold when the tax is
imposed.
ii. How will the burden of the tax be distributed between buyers and sellers?
b. In industry Y, the market demand curve is perfectly elastic.
i. Using a correctly labeled graph, show what happens to the price of the good that the
consumers pay when tax is imposed.
ii. How will the burden of the tax be distributed between buyers and sellers?
c. In industry Z, the market demand curve is downward sloping, using a correctly labeled graph,
shade the area that represents total tax revenue.

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4. Clara consumes burgers and video games. The following table shows the quantities consumed
with the marginal utilities of each:

Quantity of burgers Marginal utility from Quantity of video Marginal utility from
burgers (utils) games video games (utils)

1 8 1 10

2 7 2 8

3 6 3 6

4 5 4 4

5 4 5 3

6 3 6 2

a. What is Clara’s total utility from purchasing four video games?

b. If Clara’s weekly income is $11 and the price of a burger is $2, and the price of a video game is $1.
What combination will maximize Clara’s utility if she spends her entire weekly income on burgers
and video games? Use marginal analysis to explain your answer.

c. Assume that the price of burger buns, an input in burger production, increases. Will Clara demand
more, less or the same amount of burgers? Explain

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Chapter 5: Firm structure and costs.

1. Consider the following table that represents the various short run costs of a firm producing bagels.

a. Fill in the table by finding the values of A and B.

b. At which output is the average variable cost the highest?
c. What happens to marginal cost as firm produces 3 bagels instead of 2 bagels?

2. Assume that a product has a perfectly inelastic supply and that 1,000,000 units of that product are
produced. The marginal cost of the last unit is $1. The equilibrium price of the unit is $4.
a. Draw a graph of the market for that product, illustrate the equilibrium price and quantity on your
graph.
b. Illustrate the consumer surplus at the equilibrium price.
c. What is the economic profit realized?
d. Assume that an effective price ceiling is established at a price of $3.
i. Illustrate this price ceiling on the graph.
ii. Explain the effect on output created by the price control.

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Chapter 6: Perfect competition.

The table below shows the total variable costs faced by julia’s accessories store for different
quantities of good E sold.

Julia’s accessories store sells good E in a perfectly competitive market with a downward sloping
demand curve and an upward sloping supply curve. The market price is $62 per unit, and the total
fixed cost is $152.
a. Identify the profit maximising quantity. Explain using marginal analysis.
b. Calculate the economic profit at the profit maximising quantity you identified in part (a). Show
your work.
c. Calculate the average fixed cost of producing 8 units. Show your work.
d. Based on your answer in part (b), will the number of firms in the industry increase, decrease or
stay the same in the long run? Explain.
e. Based on your answer in part (b), will the market price increase, decrease, or stay the same in the
long run? Explain.
f. The income elasticity of good E is -1.2, and the cross price elasticity of demand for bracelets with
respect to the price of good E is 0.6. Based on your answer in part (e), what will happen to the
demand for bracelets? Explain.
g. Now assume that the market in which Julia’s accessories store operates is in long run equilibrium.
i. Suppose the market demand for good E decreases. Will the profit maximising quantity of
good E for Julia’s accessories store increase, decrease or stay the same in the short run? Explain
ii. Suppose instead the wages that Julia’s accessories store pays its workers increase. Will the
profit maximising quantity of good E, increase, decrease, or stay the same in the short run? Explain.

2. Assume that pencils are manufactured in a perfectly competitive market that is in long-run
equilibrium.
a. Draw a correctly labelled side by side graphs for the pencil market and for a representative firm
and show each of the following:
i. The market price and quantity, Labeled PM and QM, respectively.
ii. The firm’s profit maximising price and quantity, labelled PF and QF, respectively.
b. What is the relationship between PM and PF? Explain.

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c. Rent on the factory building is an important fixed cost in the production of pencils, and the
industry experiences significant increases in rent.
i. What will happen to the firm’s profit maximising quantity in the short run? Explain.
ii. On your graph in part (a), show the impact of the rent increase and completely shade the
area representing the firm’s profit or loss in the short run.
d. As a result of the rent increase, what will happen to each of the following in the long run?
i. The number of firms in the market. Explain.
ii. The market equilibrium quantity relative to QM and the market equilibrium price relative
to PM. Explain.

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Chapter 7: Monopolies.

1. XYZ is the only supplier of cable TV services offering a wide range of TV channels. XYZ is an
unregulated firm and is currently earning an economic profit. Assume that XYZ does not practice
price discrimination.
a. Draw a correctly labeled graph for XYZ and show each of the following.
i. The profit maximizing quantity of cable services, labeled as Q*.
ii. The profit maximizing price, labeled as P*.
iii. The area of economic profit completely shaded.
b. Assume that the government grants XYZ a lump-sum subsidy of $1million. Will this policy change
XYZ’s profit maximizing quantity of cable services? Explain.
c. Instead of granting a subsidy, assume now that the government chooses to require the firm to
produce the quantity at which XYZ earns zero economic profit. On the graph you drew in part (a),
label this quantity QR.
d. At Qr, is the firm’s accounting profit positive, negative or zero? Explain.

2. Bob’s Beans is a perfectly competitive soybean producer. The short run price of soybean is
currently below average total cost, but above Bob’s shut down point.
a. Using two correctly labeled graphs show the soybean market side by side with Bob’s Beans. In
your graph, identify:
i) Price and quantity in the soybean market.
ii) Price and quantity for Bob’s Beans.
iii) The area of economic profit or loss for Bob’s Beans.
b. In a new set of side by side graphs for both the market and Bob’s Beans, show the long run
adjustment in each of the following:
i) Price and quantity in the soybean market.
ii) Price and quantity of Bob’s beans.
c. Now suppose that Bob’s Beans is a monopoly producer of soybeans. In a correctly labeled graph,
show a profit maximizing monopolist and indicate each of the following:
i) Price.
ii) Output.
iii) The area of economic profit or loss for Bob’s Beans.

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3. The following graph represents a monopolist’s demand, marginal revenue, and cost curves.

a. Assume that the monopolist wants to maximize profit. Is Allocative efficiency achieved?

b. Between the prices $16 and $18, is the monopolist in the elastic, inelastic, or unit elastic portion
of its demand curve?

c. Assume that regulators set an output of 11 units.

i) Is the monopolist earning positive economic profit? Explain.

ii) Is the monopolist earning positive accounting profit?

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4. The diagram below shows the cost and revenue curves for a monopoly.

a. How does a monopolist determine its profit maximization level of output and price?

b. Suppose that the industry in the graph became perfectly competitive without changing the
demand or cost curves. Identify the equilibrium price and output that would prevail in the perfectly
competitive market.

c. Using the information in the graph, identify the area of consumer surplus for each of the
following:

i) Profit maximizing monopoly.

ii) Perfectly competitive industry.

d. To be allocatively efficient, what level of output should the monopolist produce?

e. Should the government use a per-unit tax or a per-unit subsidy to lead the monopolist to produce
the allocatively efficient level of output? Explain how the tax or subsidy would achieve the Allocative
efficiency.

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5. The graph below shows the demand, marginal revenue, marginal cost, and average total cost
curves for a profit maximizing monopolist.

a. Assume that a profit maximizing monopolist is unregulated. Using the labeling in the graph,
identify each of the following:
i. The monopolist’s quantity of output and price.
ii. The profit earned by the monopolist.
iii. The deadweight loss.
b. Now assume that the monopolist can perfectly price discriminate. Using the labeling on the graph,
identify each of the following:
i. the quantity produced.
ii. the total revenue received by the monopolist.
c. Instead, assume the monopolist charges a single price and is regulated to produce the socially
efficient quantity. Using the labeling of the graph, identify each of the following:
i. The socially efficient quantity and the consumer surplus at the socially efficient quantity.
d. Is the monopolist facing the regulation in part c) earning a positive economic profit, zero
economic profit, or incurring a loss? Explain.
e. Is point “f” in the elastic, inelastic or unit elastic portion of the demand curve? Explain.

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6. SSteel, the only provider of submarine ships is currently incurring economic losses.

a. Using a correctly labelled graph, show each of the following:

- The loss minimizing price labeled Pm and quantity, Qm.

- The area of economic loss. Shade it completely.
- The allocative efficiency quantity, labeled Qe.

b. If SSteel raises the price above Pm, what will happen to total revenue? Explain.

c. Assume that SSteel is granted a per-unit subsidy. What will happen to its quantity? Explain your
answer.

d. Assume that a lump sum subsidy is provided instead. Will the deadweight loss increase, decrease,
or remain the same in the short run?

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Chapter 8: Monopolistic competition.

1. Assume that the cellular telephone industry is monopolistically competitive.

a. Assume that cellular telephone manufacturers are earning short run economic profits. Draw a
correctly labelled graph for a typical firm in the industry and show each of the following.
i. the profit maximising output and price.
ii. the area representing economic profit.
b. at the profit maximising price you identified in part (a), would the typical firm’s demand curve be
price inelastic? Explain.
c. Given the information in part (a), what happens to the demand curve for the typical firm in the
long run? Explain.
d. Using a new correctly labelled graph, show the profit maximising output and price for the typical
firm in the long run.
e. Does the typical firm produce an output level that minimizes its average total cost in the long run?
f. In the long run equilibrium, does the typical firm produce the allocatively efficient level of output?
Explain.

2.

The graph above shows the demand (D), marginal revenue (MR), marginal cost (MC), and average
total cost (ATC) curves for one of many profit maximising firms operating in the short run in an
industry in which there are no barriers to entry. Each firm sells a similar but no identical product.
a. Assume the firm produces 8 units. Will the firm’s economic profit be positive, negative or zero?
Explain.
b. If the firm charges $18, should this firm increase its price, decrease its price, or keep the price at
$18 in order to maximise its total revenue? Explain.
c. If the firm increases its price from $21 to $24, does the deadweight loss increase, decrease or
remain the same? Explain.
d. Assuming the firm produces a quantity greater than zero, identify the profit maximizing quantity
and price, and explain how you determined each.
e. Calculate the total cost of producing the profit maximizing quantity identified in part (d). Show
your work.

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Chapter 9: Oligopoly and game theory.

1. Two competing firms Red Shop and Blue Mart are studying potential locations for their new stores
in the suburbs of a major city. Each firm must choose between a location north of the city and a
location south of the city. The payoff matrix is shown below, with the first entry in each cell
indicating Red Shop’s daily profit and the second entry indicating Blue Mart’s daily profit. Both firms
know all of the information in the payoff matrix.

a. If Red Shop chooses a location south of the city, which location is better for Blue Mart? Explain.

b. Is choosing a location to the south of the city a dominant strategy for red shop? Explain.

c. If the two firms cooperate in choosing locations, where will each firm locate?

d. Assume that the south suburb has enacted an incentive package to attract new businesses. Any
firm that locates south to the city will receive a subsidy of $2,000 per day. Redraw the payoff matrix
to include the subsidy.

2. Jim and Bob decide to attend either the soccer game or the baseball game. They prefer to meet
on the same event but they both have exams at different times, so they do not meet each other
after the exams. The events are on opposite sides of the town and Jim and bob must each choose
one event to attend without knowing where the other will be. Bob will receive 10 utils if he ends up
at the baseball game with Jim and 5 utils at the baseball game without Jim. Jim will receive 8 utils if
he finds Bob at the baseball game and 6 utils at the baseball without him. Bob will receive 12 utils at
the soccer game with Jim and 4 utils at the soccer game without him. Jim will receive 10 utils at the
soccer game with Bob and 3 utils at the soccer game without him.

a. Draw and complete the payoff matrix to reflect the utility levels in each scenario given.

b. Where would Jim and Bob go if they were able to coordinate their strategies? Explain.

c. Does Bob have a dominant strategy in his game?

d. Identify one set of strategies in this scenario that represents Nash equilibrium.

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3. There are two pizza restaurants in a town: Piazzo and Lapiazza. Each company must decide
whether to advertise or not to advertise. In the payoff matrix below, the first entry in each cell
indicates Piazzo’s daily profit, and the second entry indicates Lapiazza’s daily profit. Both firms have
complete information.

Lapiazza

Advertise Not advertise

Advertise $250, $200 $450, $300

Piazzo
Not advertise $180, $500 $390, $400

a. What strategy should Piazzo choose if Lapiazza chooses to advertise? Explain using the dollar
values in the payoff matrix.

b. What is the dominant strategy, if any, for Lapiazza? Explain using the dollar values in the payoff
matrix.

c. In the Nash equilibrium, determine each of the following:

i. Piazzo’s daily profit.

ii. Lapiazza’s daily profit.

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Chapter 10: Factor market.

1. A car wash company is a profit maximizing firm with the following information:

a. With which worker is marginal product maximized?

b. Identify and explain the economic principle that explains why marginal product eventually falls.
c. Explain why the car wash company would never hire the sixth worker.
d. If the company charges $6 for washing a car, what is the maximum daily wage that the company
will be willing to pay the fourth worker?
e. Assume the car company operates in a perfectly competitive market, hires a fixed number of
employees and rents its machines for a variable number of hours from a perfectly competitive
market. If the popularity of car washing declines, decreasing the demand for car wash, what will
happen to each of the following?
i) Marginal product curve for machines-hours.
ii) Marginal revenue product curve for machine hours.

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2. Assume that a company produces CD players as shown in the table below.

Number of unskilled Quantity of CD

workers hired players produced per
day

0 0

1 20

2 45

3 60

4 70

5 75

6 79

7 80

The firm can sell all of its CD players at a market price of $20 each and can hire all the unskilled labor
it needs at a wage of $90 per day per worker. Assume that labor is the only variable input.

a. Using the data in the table, draw a correctly labeled supply curve of the current supply of unskilled
labor.
b. What is the firm’s profit maximizing output level? Explain
c. Suppose now that the firm is the first to use a new technology that increases the productivity of its
unskilled workers.
i. How will the new technology affect the quantity of unskilled labor the firm hires? Explain.
ii. How will the new technology affect the wage paid to the firm’s unskilled workers?

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Chapter 11: Externalities and the role of the government.

1. The following graph shows the price P0 and quantity Q0 at which there is efficient allocation of
resources.

a. Assume the chemical industry is polluting the air.

i) Using marginal benefit and marginal cost analysis, explain how the chemical industry is
misallocating resources.
ii) Identify one policy or action the government could take to correct this market failure.
b. Assume it is difficult to exclude non-payers from enjoying the benefits of national defence.
i) Using marginal benefit and marginal cost analysis, explain how the private market will fail to
produce the efficient level of national defence.
ii) Identify one policy or action the government could take to correct this market failure.

2. Murphy’s water company sells eco-friendly water bottles. The graph below shows a perfectly
competitive market for water bottles. In the graph, MSB is the marginal social benefit, MPB is the
marginal private benefit, MPC is the marginal private cost, and MSC is the marginal social cost.

a. Identify the type of market failure illustrated by the graph. Explain.

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b. Using the numbers on the graph, identify the market equilibrium price and quantity.
c. Using the labeling on the graph, identify the area representing the deadweight loss at the quantity
identified in part (b).
d. Suppose the government is considering granting a subsidy to correct the market failure. What is
the dollar value of the per-unit subsidy that would achieve the socially optimal quantity?
e. Suppose the government does not grant the subsidy and instead imposes a price floor at $8.
i. How many units will consumers and producer exchange at the price floor?
ii. Does the price floor correct the market failure? Explain.

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