PRINCIPLES OF ECONOMICS

Question #1 (19 points)
Consider a firm operating in a perfectly competitive industry. The firm has the following Ushaped cost curves:
Suppose that the market price is currently $13 and that the above firm is maximizing profits.
a. Should this firm stay open or shut down temporarily in the short-run? Explain clearly how
you know this. Be precise. (5 points)
Question #1 continues on the next page.
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b. Now suppose that a major earthquake puts many of the firms in this market out of business
while leaving the above firm unaffected. Enough firms are left for the industry to still be
perfectly competitive. What will happen to this firm’s price and quantity after the earthquake
in order to continue to maximize profits in the short run? Why? Explain clearly and be precise.
(6 points)
c. Assuming that the above firm is an average firm in this industry, what will happen to this
firm’s price, quantity, and profit in the long run? Explain and illustrate below. Be precise and
concise in terms of explaining and illustrating the entire process to the long-run state. What will
be the market price when the industry is in long-run equilibrium state? (8 points)
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Question #2 (12 points)
Airlines often find themselves in price wars. Consider the following game: Delta and United are
the only two airlines flying the route from Houston to Omaha. Each firm has two strategies: charge
a high price or charge a low price. The payoff matrix is below.
a. What is the dominant strategy for each firm? Explain how you know this. (4 points)
b. What is the equilibrium of this game? Explain how you determined that this was equilibrium.
(4 points)
c. Is there a better outcome than the one you selected in part (b)? Why don’t the firms end up at
this other outcome? Explain. Be very clear. (4 points)
356 CHAPTER 14 | Oligopoly: Firms in Less Competitive Markets
Copyright © 2017 Pearson Education, Inc.
Question
The following appeared in an article in the Wall Street Journal: “Last week, true to discount roots dating
to 1971, Southwest [Airlines] launched a summer fare sale on domestic flights, with one-way prices as
low as $49. As in the past, major competitors were forced to follow suit.” Why would other airlines be
“forced” to follow Southwest’s fare decrease? Does your answer change if you learn that this fare
decrease took place during an economic recession, when incomes and the demand for airline travel were
falling? Briefly explain.
Source: Mike Esterl, “Southwest Airlines CEO Flies Uncharted Skies,” Wall Street Journal, March 25, 2009.
Answer
The airline industry is an oligopoly, and as game theory demonstrates, the other airlines were “forced”
into lowering their fares in order to compete with Southwest. By matching Southwest’s lower fares, the
other airlines were choosing the best strategy for maximizing profits given Southwest’s strategy. Your
answer would not change if the fare decrease took place during a recession because the airlines would still
be choosing the best strategy given Southwest’s strategy. It is particularly difficult for airlines to avoid
price cutting during a recession, however, because demand has declined and a failure to match
competitors’ price cuts would likely result in planes flying with many empty seats.
Question
Airlines often find themselves in price wars. Consider the following game: Delta and United are the only
two airlines flying the route from Houston to Omaha. Each firm has two strategies: charge a high price or
charge a low price.
a. What (if any) is the dominant strategy for each firm?
b. Is this game a prisoner’s dilemma?
c. How could repeated playing of the game change the strategy each firm uses?
Answer
a. A dominant strategy is a strategy in which a player is better off playing regardless of which
strategy the other player chooses. To analyze Delta’s strategy: Suppose Delta knew that United
was going to charge a high price. In that case, Delta could also charge a high price and receive a
payoff of $20,000, or it could charge a low price and receive a payoff of $30,000. Clearly, Delta
would be better off charging a low price if it knew United was going to charge a high price. Now
suppose that Delta knew that United was going to charge a low price. In that case, Delta could
charge a high price and receive a payoff of í$10,000, or it could charge a low price and receive a
payoff of $0. Clearly, Delta would be better off charging a low price if it knew United was going
to charge a low price. Because Delta’s best strategy is to charge a low price regardless of what
United does, charging a low price is a dominant strategy for Delta. To analyze United’s strategy:
Suppose United knew that Delta was going to charge a high price. In that case, United could also
charge a high price and receive a payoff of $20,000 or it could choose a low price and receive a
payoff of $30,000. Clearly, United would be better off charging a low price if it knew Delta was
going to charge a high price. Now suppose United knew that Delta was going to charge a low
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Question #3 (16 points)
A monopolist is deciding how to allocate output between two geographically separated markets
(East Coast and Midwest). The demand curves for each of the two markets are as follows:
East Coast (Market #1): Midwest (Market #2):
P1=15-Q1 P2=25-2Q2
The marginal cost (MC) in each market is $3.
a. If the monopolist is allowed to price discriminate, calculate the profit maximizing price (P)
and quantity (Q) in each market. (6 points)
b. Based on the prices you found in part (a), what can you say about the elasticity of demand in
the East Coast market relative to the Midwest market? No new calculations needed here. Just
explain in words. Be precise and concise. (5 points)
Question #3 continues on the next page.
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c. Suppose your friend says that the type of price discrimination that this monopolist is practicing
is great because with this type of discrimination there is no deadweight loss. Do you agree or
disagree with your friend? Explain why. You may use graphs to support your explanation. (5
points)
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Question #4 (24 points)
Consider a firm that operates in a monopolistically competitive industry. The firm is currently
in the short-run and is maximizing its profit. Price is equal to $60 and its total revenue is equal
to $1,200. Average fixed cost is equal to $25 and total cost is equal to $800.
a. In the space below, draw the firm’s demand, marginal revenue, marginal cost, average
variable cost, and average total cost curves. Also shade in the firm’s total economic profit or
loss in your graph. Assume that all cost curves have the usual U-shapes and the demand and MR
curves are downward sloping and make sure they are all consistent with the data above and with
each other. Label the axes and all relevant points, such as values for P, Q, ATC, and AVC on
your graph. Be precise and label each curve clearly. (12 points)
b. Should the firm continue to operate or shut down temporarily in the short-run? Explain how
you know this. (4 points)
Question #4 continues on the next page.
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c. Redraw your graph from part (a) below (you can leave out the AVC curve in your graph
below). On this same graph illustrate the movement from the short-run to the long-run for
this firm. You need to show on the same graph what happens to the firm’s price, output, and
economic profit as we move from the short-run to the long-run. You can use P2 and Q2 (not
actual numbers) to indicate the new price and output levels. Also make sure to denote any
changes in your curves, such as D2
, MR2
, ATC2
. Be clear and provide a brief explanation for
your graph. (8 points)
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Question #5 (10 points)
Briefly discuss one way in which the current social safety net program in the U.S. has worked to
help assist individuals or families during the pandemic and one way in which the current safety
net program has not worked well to help individuals and families in need. You can refer to the
article “Why the Safety Net Might Not Respond as Effectively to Covid-19 As it Should” which
we discussed in class and which you can find on moodle.
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Question #6 (19 points)
Consider an economy defined by the following functions (assume prices are fixed):
S = -760 + 0.15Yd
Ip = 320
G = 350
T = 200
X = 180
IM = 60 + 0.1Y
a. Find the aggregate expenditure (AEp) function for this economy, calculate the equilibrium
level of GDP (Ye
), and graph your AEp function below. Show your work and label all axes,
intercepts, and other relevant points (12 points)
Question #6 continues on the next page.
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b. Calculate the level of savings at the equilibrium level of output. (4 points)
c. Now suppose that income (GDP or Y) in this economy rises by $1 (starting at any initial
level). (3 points) (No calculation needed to report the changes)
i. By how much will the level of spending on all consumption goods change?
ii. By how much will the level of spending on imports change?
iii. By how much will the level of spending on domestic goods change?
End of the exam. Have a great weekend!
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Score
Question 1 /19
Question 2
/12
Question 3 /16
Question 4
/24
Question 5 /10
Question 6
/19
Total _/100

Sample Solution

ACED ESSAYS