Answers

to midterm review questions

1. Chapter 13 Costs of production - Q4

a. See the table for marginal product. Marginal product rises at first, then declines because of
diminishing marginal product.
b. See the table for total cost.
c. See the table for average total cost. Average total cost is U-shaped. When quantity is low, average
total cost declines as quantity rises; when quantity is high, average total cost rises as quantity rises.
d. See the table for marginal cost. Marginal cost is also U-shaped, but rises steeply as output increases.
This is due to diminishing marginal product.
e. When marginal product is rising, marginal cost is falling, and vice versa.
f. When marginal cost is less than average total cost, average total cost is falling; the cost of the last unit
produced pulls the average down. When marginal cost is greater than average total cost, average total
cost is rising; the cost of the last unit produced pushes the average up.

2. Chapter 14 - Q4

a. The firm should produce five or six units to maximize profit.
b. Marginal revenue and marginal cost are graphed in Figure 4. The curves cross at a quantity between
five and six units, yielding the same answer as in Part (a).

c. This industry is competitive because marginal revenue is the same for each quantity, meaning that the
firm is a price taker. The industry is not in long-run equilibrium, because profit is not equal to zero.
3. Chapter 14 - Q10
a. The table below shows TC and ATC for a typical firm:

b. At a price of $11, quantity demanded is 200. Since marginal revenue is $11, each firm will choose to
produce 5 pies. Therefore, there will be 40 firms (= 200/5). Each producer will earn total revenue of $55
($11 5), total cost is $39, so profit is $16.
c. The market is not in long-run equilibrium because firms are earning positive economic profit. Firms
will want to enter the market.
d. With free entry and exit, long-run equilibrium will occur when price is equal to minimum average total
cost ($7). At that price, 600 pies are demanded. Each firm will only produce 3 pies, meaning that there
will be 200 firms in the market.
4. Chapter 14 - Q13
a. Figure 8 shows the current equilibrium in the market for pretzels. The supply curve, S1, intersects the
demand curve at price P1. Each stand produces quantity q1 of pretzels, so the total number of pretzels
produced is 1,000 q1. Stands earn zero profit, because price is equal to average total cost.


b. If the city government restricts the number of pretzel stands to 800, the market supply curve shifts to
S2. The market price rises to P2, and individual firms produce output q2. Market output is now 800 q2.
Now the price exceeds average total cost, so each firm is making a positive profit. Without restrictions
on the market, this would induce other firms to enter the market, but they cannot because the
government has limited the number of licenses.
c. If the city charges a license fee for the licenses, it will have no effect on marginal cost, so it will not
affect the firm's output. It will, however, reduce the firm's profits. As long as the firm is left with a zero
or positive profit, it will continue to operate. Thus, as long as the market supply curve is unaffected, the
price of pretzels will not change.
d. The license fee that brings the most money to the city is equal to (P2 ATC2) q2, which is the
amount of each firm's profit.
5. Chapter 15 - Q1
a. A profit-maximizing publisher would choose a quantity of 400,000 at a price of $60 or a quantity of
500,000 at a price of $50; both combinations would lead to profits of $18 million.
b. Marginal revenue is always less than price. Price falls when quantity rises because the demand curve
slopes downward, but marginal revenue falls even more than price because the firm loses revenue on all
the units of the good sold when it lowers the price.

c. Figure 4 shows the marginal-revenue, marginal-cost, and demand curves. The marginal- revenue and
marginal-cost curves cross between quantities of 400,000 and 500,000. This signifies that the firm
maximizes profits in that region.

d. The area of deadweight loss is marked DWL in the figure. Deadweight loss means that the total
surplus in the economy is less than it would be if the market were competitive, because the monopolist
produces less than the socially efficient level of output.
e. If the author were paid $3 million instead of $2 million, the publisher would not change the price,
because there would be no change in marginal cost or marginal revenue. The only thing that would be
affected would be the firms profit, which would fall.
f. To maximize economic efficiency, the publisher would set the price at $10 per book, because that is
the marginal cost of the book. At that price, the publisher would have negative profits equal to the
amount paid to the author.

6. Chapter 15 - Q5
Lester wants to sell as many drinks as possible without losing money, so he wants to set quantity where
price (demand) equals average total cost, which occurs at quantity QL and price PL in Figure 9. Felicia
wants to bring in as much revenue as possible, which occurs where marginal revenue equals zero, at
quantity QC and price PC. Ashley wants to maximize profits, which occurs where marginal cost equals
marginal revenue, at quantity QM and price PM.

7. Chapter 17 Q6
a. The payoffs are


b. The likely outcome is that both of you will shirk. If your classmate works, youre better off shirking,
because you would rather have 30 units of happiness rather than 15. If your classmate shirks, you are
better off shirking because you would rather have 10 units of happiness rather than 5. So your dominant
strategy is to shirk. Your classmate faces the same payoffs, so he or she will also shirk.
c. If you are likely to work with the same person again, you have a greater incentive to work, so that
your classmate will work, and you will both be better off. In repeated games, cooperation is more likely.
d. The payoff matrix would become:

Work is a dominant strategy for this new classmate. Therefore, the Nash equilibrium will be for you to
shirk and your classmate to work. You would get a B and thus would prefer this classmate to the first.
However, he would prefer someone with a dominant strategy of working as well so that he could get an
A.
8. Chapter 17 - Q9

a. If Kona enters, Big Brew would want to maintain a high price. If Kona does not enter, Big Brew would
want to maintain a high price. Thus, Big Brew has a dominant strategy of maintaining a high price.
If Big Brew maintains a high price, Kona would enter. If Big Brew maintains a low price, Kona would not
enter. Kona does not have a dominant strategy.
Because Big Brew has a dominant strategy of maintaining a high price, Kona should enter.
b. There is only one Nash equilibrium. Big Brew will maintain a high price and Kona will enter.
c. Little Kona should not believe this threat from Big Brew because it is not in Big Brews interest to carry
out the threat. If Little Kona enters, Big Brew can set a high price, in which case it makes $3 million, or
Big Brew can set a low price, in which case it makes $1 million. Thus the threat is an empty one, which
Little Kona should ignore; Little Kona should enter the market.