Theory and problems d&sintro/demand/firm/mktstruc

Question 1

Explain the principles of demand fuction and supply fuction, as well as a demand (supply) curve, and law of demand (supply)

Answer 1

A demand function provides the qunaitiy demanded as a function of price of the good or service, the prices of related goods or services, and some measure of income.

A supply function provides the quantity supplied as a function of price of the good or service, the prices of productive inputs, and depends on the technology used to produce the good or service

Using values of all the variables other than price and inverting a demand (supply) functin produces a demand (supply curve)

The quantity supplied is greater at higher prices (law of supply).

The quantity demanded is greater at lower prices (law of demand).

Question 2

Describe the difference between movements and shifts along demand and supply curves

What are causes of shifts in the demand (supply curve)

Answer 2

A change in the quantity demanded (supplied) in response to a change in price represents a movement along a demand (supply) curve, not a change in demand (supply)

Changes in demand (supply) refer to shifts in a demand (supply) curve.

Demand is affected by changes in consumer tastes and typically increases (shifts to the right) with increases in income, increases in the price of substitue goods, or decreases in the price of complementary goods

Supply in creased (shifted to the right) by advances in production technology and by decreases in input prices (prices of factors of production)

Question 3

Describe the process of aggregating demand and supply curves, the concept of equilibrium, and mechanisms by which markets achieve equilibrium

Answer 3

The aggregate or market demand (supply) function is calculated by summing the quantities demanded (supplied) at each price for individual demand (supply) functions.

In free markets, the equilibrium price is the price at which the quantity demanded = the quantitiy supplied

When market price is greater than the equilibrium, the Q_s > Q_D, and competition between among suppliers for sales will drive the price down to equilibrium

When market price is less than equilibrium price, the Q_D > Q_S and competition for the product among buyers will drive the price up to equilibrium

Question 4

If 10,000 consumers have the demand function for gasoline:

Q_Dgas = 10.75 - 1.25P_gas + 0.02I + 0.12P_BT - 0.01P_auto

where income and car price are measured in thousands, and the price of bus travel is measured in average dollards per 100 miles traveled. Calculate the market demand curve if the price of bus travel is $20, income is $50,000, and the average automobile price is $30,000. Determine the slope of the market demand curve.

Answer 4

Market demand is:

Q_Dgas = 107,500 - 12,500P_gas + 200I + 1,200P_BT - 100P_auto

Insert values

Q_Dgas = 107,500 - 12,500P_gas + 200 * 50 + 1,200 * 20 - 100 * 30

Q_Dgas = 138,500 - 12,500P_gas

Invert

Pgas = 11.08 - 0.00008Q_Dgas

slope of demand is -0.00008

Question 5

Distinguish between stable and unstable equilibria and identify instances of such equilibria

Answer 5

A stable equilibrium is one for which movement of the price away from its equilibrium level results in forces that drive the price back towards equilibrium

An unstable equilibrium is one for which a movement of the price away from its equilibrium level results in forces that move the price futher from its equilibrium

If the supply curve is downward sloping and less steep than the demand curve, it is unstable

Question 6

Calculate and interpret individual and aggregate demand, inverse demand and supply functions and interpret individual and aggregate demand and supply curves

Calculate and interpret the amount of excess demand or excess supply associated with a non-equilibrium price

Answer 6

To calculate individual demand, insert the values into the function (i.e. Q_D = 2,000 - 125P)

To calculate aggregate demand, add functions together (i.e. if there are 50 consumers; Q_D = 50*5,000 - 50*125P)

Inverse demand, solve for P. You can also find the P if you have the function for Q_D and Q_s, make them equal to eachother

To calculate excess demand, solve the Q_D and Q_S functions and take the difference

Question 7

Describe the types of auctions and calculate the winning price(s) of an auction

common value auction, private value auction, ascending price auction, sealed bid auction, second price sealed bid auction, descending price auction

Answer 7

Common value auction, i.e. oil lease auctions. Bidders must estimate what the value is, the bidder who overestimates the value of the lease is the winner

Private value auction i.e. auction of art or collectibles, bidder places a value on the item

Ascending price auction or English auction, bidders can bid an amount greater than the previous high bid

Sealed bid auction, each bidder provides one bid, highest bid wins

Second price or Vickrey sealed bid auction, the bidder submitting the highest bid wins the item but pays the amount bid by the second highest bidder

Descending price auction or dutch auction begins with a price greater than any bidder will pay and is reduced until a bidder agrees to pay it i.e. shares buyback

Question 8

Calculate and interpret consumer surplus, producer surplus, and total surplus

Answer 8

The difference between the total value to consumers of units of a good that they buy and the total amount they must pay is called consumer surplus

Producer surplus is the excess of the market price above the opportunity cost of production (supply curve); total revenue minus the total variable cost of producing those units

Question 9

Analyze the effect of government regulation and intervention on demand and supply:

price ceiling / price floor

quota, subsidy

tax

Answer 9

Imposition of an effective maximum price (price ceiling) by the government results in excess demand, while imposition of an effective minimum price (price floor) results in excess supply

Imposition of an effective quota reduces supply. Payment of a subisdy to producers increases supply.

Imposition of a tax on suppliers reduces supply. Imposition of a tax on consumers reduces demand.

Question 10

Forcast the effect of the introduction and the removal of a market interference (i.e. price floor or ceiling) on price and quantity)

Answer 10

Imposition of a price ceiling will reduce the price and decrease the traded quantity to the quantity supplied at the reduced price (i.e. rent control)

Imposition of a price floor will increase price and decrease the traded quantity to the quantity demanded at the increased price (i.e. minimum wage)

Imposition of taxes on either producers or consumers will increase price (including tax) above the previous equilibrium, decrease price (excluding tax) below the previous equilbrium level, and decrease the traded quantity to the same amount in either case

Question 11

Calculate and interpret price, income, and cross-price elasticities of demand and describe factors that affect each measure

Answer 11

Price elasticity is a measure of the responsiveness of the quantity demanded to a change in price

• when there are few or no good subsititues for a product, inelastic (i.e. drugs) and v.v.

Income elasticity is the sensitivity of quantity demanded to a change in income (i.e. normal goods and inferior goods)

Cross price elasticity of demand is the sensitivity of quantitiy demanded of one good, to the price change in a related goods

substitutes have positive elastiticy i.e. two brands of bread

compliments have negative elasticity i.e. cars and gasoline

Question 12

From the demand curve, calculate the price elasticity at a gasoline price of $3 per gallon

Q_Dgas = 138,000 - 12,500P_gas

Answer 12

Calculate Q_Dgas

= 138,000 - 12,500(3) = 101,000

EDemand = %ΔQ / %ΔP = (ΔQ/Q_o)(ΔP/P_o) = Po/Qo *ΔQ/ΔP

= (3/101,000)(-12,500)

=-0.37

For the demand function, at a price and quantity of $3 per gallon and 101,000 gallons, demand is inelastic

Question 13

An individual has the following demand function for gasoline:

Q_Dgas = 15 - 3P_gas + 0.02I + 0.11P_BT - 0.008P_auto

Assuming the average automobile price is $22,000, income is $40,000, the price of bus travel is $25, and the price of gasoline is $3, calculate and interpret the income elasticity of gasoline demand and the cross price elasticity of gasoline demand with respect to the price of bus travel.

Answer 13

Income elasticity

Q_Dgas = 15-3(3) + 0.02(income in thousands) + 0.11(25) - 0.008(22)

Q_Dgas = 8.6 + 0.02(income in thousands)

The slope term on income is 0.02, and for an income of 40,000, Q_Dgas = 9.4 gallons

%ΔQ / %ΔI = (I_o / Q_o)(ΔQ / ΔI)

(40/9.4)(0.02) = 0.085

For a 1% increase/decrease in income will lead to a 0.85% increase/decrease in the Q_Dgas

Cross-elasticity

QD_gas = 15 - 3(3) + 0.02(40) + 0.11P_BT - 0.008(22)

QD_gas = 6.6 + 0.11P_BT

QD_gas = 6.6 + 0.11(25) = 9.35 gallons

%ΔQ / %ΔP_BT = (P_BT / Qo)(ΔQ / ΔP_BT) = 25/9.35 * 0.11 = 0.294

Gas and bus travel are substitutes so the cross price ealsticity of demand is positive. 1% change in the price of bus travel will lead to a 0.294% change in Q_Dgas in the same direction

Question 14

Describe consumer choice theory and utility theory

Answer 14

Utility theory explains consumer behaviour based on preferences for various alternative combinations of goods, in terms of the relative level of satisfaction they provide i.e. bundle of goods

Consumer choice theory relates consumers’ wants and preferences to the goods and services they will actually buy

Question 15

Describe the use of indifference curves, opportunity sets, and budget constraints in decision making

Calculate and interpret a budget constraint

Answer 15

Indifference curves plot the combinations of two goods that provide equal utility to a consumer. The slope of the curve is known as the marginal rate of substitution. Rules are as follows:

1. Indifference curves for two goods slope downwards
2. Indifference curves are convex towards the origin
3. Indifference curves cannot cross i.e. if U(B) = U(A), and U(B) = U(C), then U(A) = U(C)

A budget contraint can be constructed based on the consumer’s income and the prices of the available goods. The area under the budget contraint is the combinations that are also affordable, known as the opportunity set.

Question 16

Determine a consumer’s equilibrium bundle of goods based on utility analysis

Answer 16

The optimal consumption bundle for a consumer is the point where the indifference curve I₁ is tangent to the budget line. This is the most preferred affoardable conbination of Good X and Good Y.

Question 17

Compare substitution and income effects

Answer 17

The substitution effect always acts to increase the consumption of a good that has fallen in price, while the income effect can either increase or decrease consumption of a good that has fallen in price

If the substiution effect is positive and the income effect is positive, consumption of Good X will increase

The substitution effect is positive and the income effect is negative, but smaller than the substituion effect, consumption of Good X will increase

The substitution effect is positive, and the income effect is negative and larger than the substitution effect, consumption of Good X will decrease

Question 18

Distinguish between normal goods and inferior goods, and explain Giffen goods and Veblen goods in this context. State 2 differences between them.

Answer 18

A normal good is one for which the income effect is positive

An inferior good is one for which the income effect is negative

A Giffen good is an inferior good for which the negative income effect outweighs the positive substitution effect when price falls. Is theoretical and has an upward sloping demand curve. At lower prices, a smaller quantity would be demanded

A Veblen good is one for which a higher price makes the good more desirable (i.e. Gucci bag)

2 differences:

1. Giffen goods are inferior goods (negative income effect) while Veblen goods are not
2. Giffen goods are theoretical and supported by the rules of consumer choice, while Veblen goods are not

Question 19

Calculate, interpret, and compare accounting profit, economic profit, normal profit, and economic rent

Answer 19

Accounting profit is net income; total revenue - total accounting (explicit) costs. Includes short-term debt but not payments to shareholders

Economic profit is abnormal profit is equal to accounting profit less implicit costs. Implicit costs are opportunity costs such as owner supplied capital or time and entrepreneurial ability of the firm’s owners

Normal profit is the accounting profit that makes economic profit zero

Economic rent is a payment to a resource in excess of the minimum payment to retain resources in their current use i.e. rent for land, the supply for land is fixed, so that supply is inelastic

Normal profit is a minimum requirement for a firm to continue operating in the long run

Question 20

Calculate and interpret and compare total, average, and marginal revenue

Answer 20

Total revenue (TR) for any firm that charges a single price to all customers is TR = P*Q

Average revenue (AR) is equal to total revenue divided by the quantity sold AR = TR/Q

Marginal revenue (MR) is the increase in total revenue from selling one more unit of a good or service

• for a firm in a perfectly competitive market, all units are sold at the same price regardless of quantity, so

AR = MR = price

Question 21

Given the demand curve for a firm’s product below, calculate the total revenue, average revenue, and the marginal revenue for the first through the eighth unit and draw the marginal revenue curve over this range.

Answer 21

Question 22

Describe the firm’s factors of production

Answer 22

Factors of production are the resources a firm uses to generate output. They include:

Land, labour, capital (plant and equipment), materials

Question 23

Calculate and interpret total, average, marginal, fixed, and variable costs

Answer 23

Total fixed costs is the cost of inputs that do not vary with the quantity of output and cannot be avoided over the period of analysis (i.e. property, plant, equipment, interest on debt, wages etc.). Remain the same with increased output.

Total variable cost is the cost of all inputs that vary with output over the period of analysis (i.e. wages, raw materials). Increase with greater output.

Total cost is the sum of fixed and variable costs

Marginal costs is the addition to total cost of producing one more unit (change in total cost / change in output). Costs can be total, fixed, or variable.

The vertical distance between TC and TVC is equal to TFC

Question 24

Determine the and describe the breakeven and shut down prices of production under imperfect competition

Answer 24

under imperfect compeitition (price seeker), AR does not equal price so we look at total cost and total revenue (MR < P)

TR = TC; break even

TC > TR > TVC; firm should continue to operate in the short run but shut down in the long run

TR < TVC; firm should shut down in the short run and the long run

Question 25

For the last fiscal year, Legion Gaming reported total revenue of $700,000, total variable costs of $800,000, and total fixed costs of $400,000. Should the firm continue to operate in the short run?

Answer 25

The firm should shut down.

TR 700k < TC 1,200k and VC 800k

By shutting down, the firm will lose an amount equal to fixed costs of 400k. This is less than the loss of operating, which is TR - TC = 500k

Question 26

For the last fiscal year, Legion Gaming reported total revenue of $850,000, total variable costs of $800,000, and total fixed costs of $400,000. Should the firm continue to operate in the short run? Long run?

Answer 26

In the short run, TR > TVC, and the firm should continue operating. The firm should consider exiting the market in the long run, as TR is not sufficient to cover all the fix and variable costs (TC = 1,200k)

Question 27

Explain how economies of scale and diseconomies of scale affect costs

Answer 27

Economies of scale is the downward sloping segment of the long-run average total cost curve. Economies of scale result from factors such as labor specialization, mass production, and investment in efficient equipment and technology, and cost reduction

Disceconomies of scale is the upward segment of the LRATC. This may result from increasing bureaucracy of larger firms, problems motivating a larger workforce, barriers to innovation and entrepreneurial activity. A firm here will want to decrease the size of operations and ove back towards the minimum efficient scale (i.e. US auto industry)

Question 28

Describe approaches to determining the profit-maximizing level of output under perfect competition

Answer 28

under perfect competition, price = MR = AR

A firm can determine its profit-maximizing output by either comparing total cost to total revenue or by comparing marginal cost to marginal revenue. Profit can be maximized by:

• Producing up to a point where MR = MC and not producing additional units for which MR < MC
• Producing the quantity for which TR - TC is at a maximum

Question 29

Describe approaches to determining the profit-maximizing level of output under imperfect competition

Answer 29

imperfect competition (price seeker) = firms with down-ward facing demand curves and MR < P

A firm in imperfect compeitition maximizes profits by producing the quantity of output for which MR = MC, the same quantity for which TR - TC is at its max

Might be asked to look at a table with quantity, price, TR and TC given. Calculate profits (TR-TC), MR and MC to answer

Question 30

Distinguish between short-run and long-run profit maximization

Answer 30

The short run is a time period during which the quantities of some firm resources are fixed. A firm may continue to operate in the short run with economic losses as long as price is greater than AVC because the losses are less than total fixed costs. The firm is maximizing profit by minimizing losses.

In the long run, all factors of production are variable so a firm will maximize profits at the quantity for which marginal revenue equals the marginal cost as long as price is greater than ATC. If price is less than ATC, the firm has economic losses and will minimize losses in the long run by going out of business and reducing ongoing losses to zero.

Question 31

Distinguish amoung decreasing-cost, constant-cost, and increasing-cost industries and describe the long-run supply of each

Answer 31

Increasing cost industry is when firm enter the industry in pursuit of profits, the demand for the productive inputs specific to the industry increases, and their market prices increase as well (i.e. oil)

Decreasing cost industry, resource prices fall as the industry expands (i.e. flat planel tvs)

Constant-cost industry are ranges of industry output in which input prices do not increase or decrease, the industry demand curve is perfectly elastic at minimum average cost

Question 32

Minifone produces personal electronics, currently a decreasing-cost industry. Demand for the products has increased recently. What is most likely to happen in the long run to selling prices and per-unit costs?

Answer 32

Because Minifone operates in a decreasing-cost industry, the most likely equilibrium response to an increase in demand is for prices and per-unit production costs to decrease

Question 33

Calculate and interpret total, marginal, and average product of labour.

Answer 33

Total product of labour is the output for a specific amount of labour

Average product of labour per worker (or other unit of labour input) is the total product of labour divded by the number of workers (or units of labour employed)

Marginal product of labour is the addition to the total product of labour from emplying one more unit of labour

average product is a measure of overall efficiency, marginal product is the measure of productivity of an individual worker

* product is shirts and marginal/average product is per worker

Question 34

Describe the phenomenon of diminishing marginal returns and calculate and interpret the profit-maximizing utilization level of an output.

Answer 34

The MP of labour increases initially as additional units of labour are employed. For example four workers may produce more than twice the output of two workers. This is referred to as a situation in which the MPL is increasing

Holding physical capital constant, as labour is increased beyond some quantity, the incremental output from each additional worker declines. This is referred to as the point of diminishing marginal returns or decreasing marginal productivity.

Question 35

Determine the optimal combination of resources that minimizes cost

Answer 35

The optimal combination of labour and capital inputs is reached when MP_capital / P_capital = MP_labour / P_labour

When this condition is met, costs for the associated level of output are at a minimum. If MP_capital / P_capital < MP_labour / P_labour so that the output per dollar of capital is less than the output per dollar of labour, a firm can reduce costs by emplying more labour and less capital to produce the same out put

Question 36

Consider the following data for Centerline Industries. The firm’s inputs can be categorized as high technology equipment, unskilled labour, and highly trained workers. The MR, MP, and cost per day of the various inputs are summarized in the following table. Assume that the inputs can substitute for each other in the production process.

1. Is the firm operating at the cost-minimizing levels for its inputs?
2. Assuming diminishing marginal factors returns, what adjustments to its input mix, if any, should the firm make to increase profits?

Answer 36

1. Comparing marginal product per dollar of each resource we have:

MP_{high tech} / P_{high tech} = 30/800 = 0.03750

MP_unskilled / P_unskilled = 5/160 = 0.03125

MP_{high skill} / P_{high skill} = 15/450 = 0.03333

Because these are not equal, the condition for cost minimization is not met

2. Comparing the MRP for each resource to its price, we have:

MRP_{high tech} = 30*30 = 900 P_{high tech} = 800

MRP_unskilled = 5*30 = 150 P_unskilled = 160

MRP_{high skill} = 15*30 = 450 P_{high skill} = 450

The condition for the profit-maximinzing quantity of each resource, MRP = P is met only for highly skilled labour.

For high technology, the MRP (900) is greater than the unit cost (800), so the firm should employ more high tech equipment

For unskilled workers, the MRP (150) is less than the unit cost (160), so the firm should employ fewer unskilled workers

Question 37

Describe the characteristics of perfect competition, monopolistic competition, oligopoly, and pure monopoly

Answer 37

Perfect competition is characterized by:

• Many firms, each small relative to markets (i.e. wheat)
• Very low barriers to entry into or exit from the industry
• Homogenous products that are perfect substitutes, no advertising or branding
• No pricing power (price-takers)

Monopolisitc competition is characterized by:

• Many firms (i.e. toothpaste)
• Low barriers to entry into or exit from the industry
• Differentiated products, heavy advertising and marketing expenditure
• Some pricing power (price-searchers)

Oligopoly markets are characterized by:

• Few sellers (i.e. automobile industry)
• High barriers to entry into or exit from the industry
• Products that may be homogenous or differentiated by branding and advertising
• Firms that may have significant pricing power; firms are interdependent

Monopoly is characterized by:

• A single firm that comprises the whole market (i.e. utilitites)
• Very high barriers to entry into or exit from the industry
• Advertising used to compete with substitute products
• Significant pricing power

Question 38

Explain the relationships between price, marginal revenue, marginal cost, economic profit, and the elasticity of demand under each market

Answer 38

Perfect compeition:

• Price = MR = MC (in equilibrium)
• Perfectly elastic demand (horozontal), zero economic profit in equilibrium

Monopolisitic competition:

• Price > MR = MC (in equilibrium)
• Elasticity > 1 (highly elastic but not perfectly elastic), zero economic profit in long-run equilibrium

Oligopoly:

• Price > MR = MC (in equilibrium)
• Elasticity > 1 (elastic), may have positive economic profit in long-run equilibrium, but moves toward zero economic profit over time

Monopoly:

• Price > MR = MC (in equilibrium)
• Elasticity . 1 (elastic), may have positive economic profit in long-run equilibrium, profits may be zero because of expenditures to preserve monopoly

Question 39

Describe and determine the optimal price and output for firms under each market structure

Answer 39

All firms maximize profits by producing the quantity of output for which MC = MR. Under perfect competition (perfectly elastic demand), MR also equals price

Firms in monopolistic competition or that operate in oligopoly or monopoly markets all face downward-sloping demand curves. Selling price is determined from the price on the demand curve for the profit maximizing quantity of ouput

Question 40

Explain factors affecting long-run equilibrium under each market structure

Answer 40

An increase (decrease) in demand will increase (decrease) economic profits in the short run under all market structures.

Positive economic profits result in entry of firms into the industry unless barriers to entry are high.

Negative economic profits result in exit of firms from the industry unless barriers to exit are high.

When firms enter (exit) an industry, market supply increases (decreases) , resulting in a decrease (increase) in market price and an increase (decrease) in the equilibrium quantity traded in the market.

Question 41

Describe the firm’s supply function under each market structure

Answer 41

Under perfect compeitition, a firm’s short-run supply curve is the portion of the firm’s short-run MC curve above the AVC.

A firm’s long-run suply curve is the portion of the firm’s long-run MC curve aboe the ATC.

Firms operating under monopolistc competition, oligopoly, and monopoly do not have a well-defined supply functions becuase they have downward sloping demand curves, so neither MC curves nor AC curves are supply curves in these cases. Supply depends on the firm’s MC, demand, and MR (which change with quantity)

Question 42

Describe pricing strategy under each market structure

Answer 42

Whether a firm operates in perfect competition, monopolistic competition, or is a monopoly, profits are maximized by producing and sellng a quantity for which MR = MC.

Under perfect competition, price = MR

Under monopolistic competition or monopoly, firms face downward-sloping demand curves so that MR (and MC) is less than price, and the price charged at the profit-maximizing quantity is the price from the firm’s demand curve at the optimal (profit-maximizing) level of output.

Under oligopoly, the pricing strategy is not clear. Because firms decisions are interdependent, the optimal pricing and output strategy depands on the assumptions made about the other firms’ cost structures and about the competitiors’ responses to a firm’s price changes.

Question 43

Describe the use and limitations of concentration measures in identifying

Answer 43

Concentration measures are used as an indicator of a firms the degree of monopoly or market power.

i. e. N-firm concentration ratio, which is calculated as the sum or the percentrage market share of the largest N firms in a market. Limitation is that it may be insensitive to mergers of two firms with large market shares
i. e. Herfindahl-Hirschman Index (HHI) is calculated as the sum of the squares of the market shares of the largest firm in the market

another limitation is that barriers to entry are not considered in either case

Question 44

Given the market shares of the following firms, calculate the 4-firm concentration ratio and the 4-firm HHI, both before and after a merger to Acme and Blake.

Answer 44

Prior to merger, conc ratio is 25+15+15+10=65%

After merger, conc ratio is 40+15+10+5=70%

Although conc ratio has only increased slightly, the market power of the largest firm has increased significantly from 25% to 40%

Prior to merger, HHI is 0.25²+015²⁺0.15²+0.10²=0.1175

After the merger, HHI is 0.40²+0.15²+0.10²+0.05²=0.1950, a significant increase

Question 45

Describe 3 examples of oligopoly types

Answer 45

1. Kinked demand curve - based on the assumption that an increase in a firm’s product will not be followed by its competitors but a price decrease will. Face a more elastic demand curve above a certain price than it is below a given price
2. Cournot model - with only 2 firms competing , both have identical and constant marginal costs of production i.e. Nash equilibrium
3. Dominant firm model with a single firm with a significantly large market share due to greater scale and lower cost structure. Market price is determined by this firm.