Exercise questions
1. Suppose that you win two free tickets to a concert by calling into a radio show. Each ticket has a face value of $30 and originally sold for $30, but now the concert is sold out. People with tickets are currently asking $50 each for tickets to the concert. What is the opportunity cost of taking your boyfriend/girlfriend to the concert? Explain.
The opportunity cost of a good is the value of the next best alternative use of the good. In this case, the opportunity cost of taking a friend to the concert is the value that could be obtained by selling the tickets. In this case the opportunity cost is 2 * $50 = $100. The face value of the ticket or the fact that they were obtained without cost are not important in calculating the opportunity cost.
2. The following are the assumed supply and demand schedules for hamburgers in Collegetown:
Quantity Quantity
Price Demanded Supplied
$2.00 6,000 15,000
1.75 8,000 14,000
1.50 10,000 13,000
1.25 12,000 12,000
1.00 14,000 11,000
0.75 16,000 10,000
i) Plot the supply and demand curves and determine the equilibrium price and quantity.
ii) What effect would a decrease in the price of beef (a factor of production) have on the equilibrium price and quantity of hamburgers, ceterus paribus? Explain referring to the graph.
A decrease in the price of an input shifts the supply curve to the right.
iii) What effect would an increase in the price of pizza (a substitute commodity) have on the equilibrium price and quantity of hamburgers, again ceterus paribus? Explain referring to the graph.
A rise in the price of a substitute good increases the demand. This shifts the demand curve to the right.
3. Use small, well labelled, graphs to show the likely effect of the following events:
i) What is the effect of an increase in the price of popcorn on the number of movie tickets sold at Cinemaxx?
Popcorn and movie tickets are complement goods. When the price of a complement good increases, the demand for a good decreases. In the new equilibrium, the price and quantity are both lower.
ii) What is the effect of an increase of crude oil prices on gasoline prices ?
Oil is an input into producing gasoline. When the price of an input increases, then the supply decreases. This causes the equilibrium price to rise and the quantity to fall.
iii) What is the effect of increasing income levels on the use of mini (dolmus) buses?
The use of a mini bus is probably an inferior good. As income rises, people will likely buy their own cars, or take taxis. Rising income reduces the demand for inferior good. In equilibrium, both price and quantity of dolmus rides will likely fal l.
iv) What is the expected effect of an increase of coffee prices on the market for tea?
Coffee and tea are substitute goods.
When the price of coffee increases, the
demand for tea increases. In equilibrium,
both the price and quantity of tea increase.
4. Explain why the demand for cigarettes is more inelastic in the short run than in the long run.
The demand for most goods is more inelastic in the short run than in the long run. This can be explained by habits and the ability to change behavior quickly. With cigarettes, smokers get used to smoking a certain quantity per day or per week. It is difficult to quickly change the quantity demanded in response to a change of price. Over time, people can adjust their behavior however.
5. When the price of Widgets went from $0.80 to $0.90, the quantity of Gadgets demanded went from 140 to 155.
i) What is the (arc) cross-price elasticity between Widgets and Gadgets?
ii) Are these compliment or substitute goods? Explain.
Widgets and Gadgets are substitute goods because the cross-price elasticity is positive.
5. Briefly explain why most goods possess diminishing marginal utility. Also explain why this means that a typical individual’s demand curve for a good is downward sloping.
Diminishing marginal utility of consumption is related to the idea of satiation. That is, people tend to get satisfied with consuming a good. As more and more of the good is consumed, consumers get more and more satisfied with that particular good, and they get less benefit from consuming additional units of the good. Since the benefit is less, consumers are also less willing to pay for more of the good. This is why the demand curve is typically downward sloping.
6. Suppose that a consumer has selected a combination of goods X and Y such that she is spending her entire income, but such that .
i) Show such a situation on an indifference curve graph.
ii) To increase the utility of consumption, should the consumer consume ( more less ) good X, and ( more less ) good Y. Select the correct answers.
iii) What is true about the last dollar (or Lira) spent on each good at the optimal consumption point?
The last dollar spent on each good should bring the consumer the same increase in utility. If this were not true, then the consumer should spend a little less on the item which gives less increase in utility and a little more on the good which gives more utility. Note that measures the additional utility for one dollar spent on good X.
7. Why is an ounce of gold worth more than an ounce of water? Discuss using the concept of marginal utility.
Although water is necessary for life and gold is not, gold has a higher value per unit of weight because it is much more rare. The marginal value of water is relatively low because there is an abundant amount consumed. The marginal utility of additional water is low. Gold is scarce. Since there is so little gold, the marginal utility is high.
8. Consider the total cost and total revenue schedules of two firms:
Gulp and Devour Shady Enterprise
Output TC TR TC TR
1 100 135 50 160
2 200 260 125 300
3 300 375 225 420
4 400 480 350 520
5 500 575 500 600
6 600 660 675 660
7 700 735 875 700
8 800 800 1100 720
(a) For each firm, and each level of output, calculate marginal cost, average cost, marginal revenue, price, profit and marginal profit.
(b) On graph paper, plot all the variables in part (a).
(c) What is the profit maximizing output in each case? Show that three criteria are equivalent: marginal cost equals marginal revenue, maximum profit, and marginal profit equals zero.
For G&D it is 4 and SE it is 3.
(d) For each firm, describe the relationship between marginal cost and average cost, and between marginal revenue and price. How do you explain those relationships?
For G&D MC=AC because of constant returns to scale. As output increases, productivity doesn’t decrease, so TC increases at a constant rate. MR decreases indicating that the firm is not a perfect competitor. For SE MC and AC both are decreasing, but AC is less than MC since we never have increasing productivity in this example. SE also is not a perfect competitor.
9. The graph below shows the cost curves for a perfectly competitive firm. Assume that this firm’s cost curves are representative for all firms in the industry.
i) What is the long run equilibrium price for this industry? Explain why.
The long run equilibrium price is $20 per unit. At this price the firm has zero profit. Zero profits are required for long run equilibrium, only when the firm’s profits are zero, will there be no incentive for firms to enter or exit the industry.
ii) What is the minimum price at which this firm will continue to operate in the short run? Briefly explain why the firm would rather shutdown if the price falls below the minimum.
P < min AVC is the short run shut down condition for competitive firms. In this case the firm will shut down if the price falls below $10. When P < min AVC the firm’s revenues do not even cover its variable (labor) costs. The firm does better to let the workers go and save on this expense.
iii) Show graphically the equilibrium quantity that the firm will produce if the market price is 30. Also show the region on the graph which shows the firm’s profit or loss at this price.
iv) At P = 30, over a period of time, there is likely to be entry of new firms into the market, exit of existing firms from the market, or no change in the number of firms. State which of the above statements is correct and clearly state why.
When P = 30, the typical firm is profiting. Profit means that the revenue exceeds the economic cost. That is, the resources used in this industry get a better return than they could get if used in any other way. Since the return is better than any other for resources used, more firms will enter the market to enjoy that return.
10. Explain why the average cost of production is never higher in the long run than it is in the short run.
In the short run some factors of production, such as capital equipment, may be fixed so the firm cannot change the quantity of these inputs to achieve the best (cheapest) mix of inputs to attain a given level of output. In the long run the firm can vary all inputs to achieve a lower cost.