Intermediate Microeconomics

Assignment 3

Due 21/11/10

Assignment Policy

Late assignments are not accepted unless there is a medical excuse on the day the assignment is due. In that case, the assignment is accepted for only the first day the student returns to the university. As with any exams, for an excused absence the maximum grade a student can get on the assignment is a D.

Profit Maximization

  1. Define Profits

Profits = Total Revenue – Total costs

  1. Using a total revenue and total cost graph (as well as the total profits graph), show the quantity that maximizes profits.
  1. What is the difference between a price-take and a price-maker?

A price-taker is a firm that takes the market price as given. The firm is too small relative to the size of the market to have any influence on price.

A price-maker is a firm that makes, or determines, the market price. Such a firm has a substantial share of the market and thus has the power to determine price.

  1. Define Marginal Revenue? What is marginal revenue for a price-taker? What is marginal revenue for a price-maker?

Marginal revenue is the additional revenue earned when selling one more unit. Mathematically, .

Marginal revenue is in general given by the following expression:

Since a price-taker has no influence on price, , and thus MR = P.

For a price taker, MR is given by.

  1. Using the marginal revenue and marginal cost graph, show the quantity that maximizes profits for a price taker.
  1. Using the marginal revenue and marginal cost graph, show the quantity that maximizes profits for a price maker.
  1. Consider a firm maximizing its profits. Using the marginal revenue/marginal cost graph show the following cases on three different graphs:
  2. Positive Profits
  3. Zero Profits
  4. Negative Profits

To answer this question recall that profits = q(P-AC). Hence we must put the AC curve on the same graph as MC and MR. I will assume the firm is a price taker.

In the above graph since P > AC at q* it must be profits are positive.

In the above graph since P = AC at q* it must be profits are zero.

In the graph below, since P < AC at q* it must be profits are negative.

Competitive Markets

  1. What are the four conditions necessary for competitive markets?

(i)there are many firms

(ii)all firms produce an identical product

(iii)consumers have information on the prices charged by all firms

(iv)there are no barriers to entry

  1. What is the law of one price? Which conditions are necessary for the law of one price?

The law of one price states that there will only be one price in the market; that is, all firms charge the same price. The first three conditions are necessary for the law of one price. The fact that there are many firms implies no one firm controls the market. The fact that all firms produce an identical product implies the goods produced are all perfect substitutes, so no price difference can come from different products. The fact that consumers have access on prices charged by firms implies that no one firm can charge more than others. Putting all three together then there must only be one price.

  1. Explain the difference between economic and accounting profits.

Profits equal total revenue – total costs. Total revenue is the same for both economic and accounting profits. The difference is in total costs. In accounting, total costs are those explicit costs that derive from raw materials, wages of workers, etc. In economics, total costs include explicit costs, but also include implicit opportunity costs, which would be the accounting profits one could earn in another industry. This implies one can write

Economic Profits = Accounting Profits in Current Industry – Accounting Profits Elsewhere.

Hence economic profits that are positive would imply the profits are above average.

And economic profits that are negative are below average.

And economic profits that are zero are just average.

  1. What is a long-run equilibrium in a competitive market? Explain why in the long-run equilibrium economics profits are zero.

The long-run is a period of time long enough so that new firms can enter or existing firms can exit if they choose to. Hence a long-run equilibrium is when firms have no incentive to change their long-run behavior; that is, firms neither exit nor enter. This will occur when economic profits are zero.

  1. Using both the firm and market graph, derive the long-run supply curve for
  2. a constant cost industry
  3. an increasing cost industry
  4. a decreasing cost industry

See slides 31, 32, and 33 of chapter 8 of the power point slides.

  1. Demonstrate the effect on the long-run equilibrium from an increase in costs, assuming it is a constant cost industry.

In the graph above, we start at a long-run equilibrium (P0 = AC0). Then the cost curves shift up. Assuming each firm is still producing q0 and price is P0, the profits would now be negative (i.e. P0 < AC1 at q0). This causes some firms to exit the industry, so that n1 < n0. This, combined with the shift in MC curves, implies the short-run supply curve shifts to the left, as is shown. This causes price to go up, which then causes profits to begin rising. The process of firms leaving continues until profits are zero again. In the graph I have shown this occurring at P1 and with each firm producing the same amount as before.