Exam Q4

Question 1

What are “Sunk Costs”?

What should be the decision reaction towards these costs?

Which decisions do they help?

Answer 1

Sunk costs are money already spent.
They are costs that have occured / have to occur without choice and cannot be avoided anymore.

They should be tried to be minimised as much as possible.

Cannot be included in the decisions of whether to enter the market or how much to produce.

Question 2

How does a Firm decide to produce or not?

When will a Firm enter the Market? (entry decision)

Answer 2

If the Average Costs per unit is lower then the Price that will be received for selling the unit, the firm will be making a profit off this sale.
So it produces / enters the market.

Question 3

How does the marginal cost curve look like? …why?

Answer 3

MC-Q

Sloping down first, then shoots up

Question 4

▪ How do the AC curves look like?

Answer 4

All on Cost-q
AFC: Like an L sloping down
AVC. Like MC, starting lower
ATC: Like MC, startin High and not at Cost but at middle

Question 5

What is the Objective of a Firm?

Answer 5

To maximise profits

Question 6

What are some other Theories of the Firm?

Answer 6

Original: Maximise Profit
Others:
Maximise Sales Revenue
= Manager Salaries related to Sales Revenue, so Higher Output but Lower Profits
Maximise Growth
= Manager income related to Growth of the Firm, so Higher Output but Lower Profits (depending on profit constraints). Valuation of firm may fall, becoming a target of Takeovers. A Profit Constraint helps this issue.
Maximise Managerial Discretion
=Output & Profit somewhere between Profit Max and Growth Max, costs may increase
All Suggest
= A firm may be unable to maximise profits because managers may have different objectives than shareholders
=Principal-Agent Problem!

Question 7

What are the Problems & Limitations of Theory of the Firm?

Answer 7

Ignores incentive problems within the firm (due to separation of ownership and control)

Says nothing about the internal organization of the firm (nothing about the hierarchical structure, how decisions are made, who has the authority within the firm)

Tells nothing about the boundaries of the firm

Question 8

What makes theory of the firm valuable?

Answer 8

Analytically tractable
Delivers testabel hypotheses
Starting point for “additional theories”

Question 9

Where does the price p(q) come from and how does it relate to demand?

Answer 9

p(q) reflects the preference of the buyers
=Willingness to Pay for q units of a good (WTP)
p(q) also varies with the q that a firm produces
These factors determine the demand!

Question 10

How does the quantity demanded change if the price changes?

Answer 10

Price elasticity of demand: % variation in quantity demanded by the %
variation in price

Question 11

What are possible values of the price elasticity of demand?

What are these called?
ε=0 
0<ε<1 
ε=1 
ε>1 
ε=∞
Visualize graphs for all! (p <=> Q)

Answer 11

ε=0 Perfectly Inelastic: Independently of the price, the same Quantity of Q will be demanded
0<ε<1 Inelastic: The change in Quantity will be lower than the change in price
ε=1 Elasticity equals to 1: The change in Quantity will be the same as the change in price
ε>1 Elastic: The change in Quantity will be higher than the change in price
ε=∞ Perfectly Elastic: A small change in the price will lead to a decrease of the demanded Quantity to zero

Question 12

What is the Meaning of Demand?

Answer 12

Price given by the inverse demand for a quantity is the consumer’s Willingness To Pay WTP per unit, if the consumer buys the amount of quantity.

Question 13

What do we mean by the “horizontal sum” of demands?

Answer 13

Horizontal sum means the process going from individual demand to market demand by adding them up. Horizontal as the demand (quantity) lies in the x axis.

Question 14

How do we algebraically find the minimum market price at which a firm would be willing to start producing?

Answer 14

MR = MC

The MC curve is the one necessary to figure out the price to produce
Other curve, AC is responsible for the entry decision

Finding the minimum of the curve gives the answer of the question. You derive the curve function.

FOC is not sufficient for an optimal solution, but we will not look at the second order condition and will stay with the FOC.

Question 15

Given a market demand function D(p) and a cost function C(q),
how do we find the equilibrium (p, Q)? What are the 2 Equilibrium Conditions in the Short-Run?

Answer 15

1. MC(q) = p (firms choose profit max q level)

2. nq* = D(p*) (market clears: supply=demand)

Question 16

Given a market demand function D(p) and a cost function C(q),
how do we find the equilibrium (p, Q)? What are the 3 Equilibrium Conditions in the Long-Run?

Answer 16

1. MC(q) = p (firms choose profit max q level)
2. MC(q) = AC(q) (Free Entry Condition: AC minimising q*)
3. nq* = D(p*) (market clears: supply=demand)

Question 17

Will firms make profits in a Competitive EQ in the:

1) SR?
2) LR?

Answer 17

1) Firms can make a profit in the SR
2) If all firms are identical, firms make zero profit in the LR. If some firms produce more EFFICIENTLY than others, they can make a positive profit in the LR

Question 18

What is the effect of a Unit Tax on CS, PS and TS?

Answer 18

The tax drives a wedge between the p for consumers and producers. It increases the p consumers have to pay and decreases the p producers receive. The consumers will therefore demand less and producers will supply less relative to the Competitive EQ without the tax.

Consuming a lower q at a higher p reduces CS, and selling less at a lower p reduces PS. =Both reduced

The loss of CS and PS for each unit exchanged is Tax Revenue (which contributes to Total Welfare).

The loss of CS and PS from the units that are no longer exchanged is DWL and it is lost to society. DWL means a decrease in TS.

Question 19

What is necessary for a firm to be able to charge p>MC ?

Answer 19

Market Power

is the ability to charge a price above marginal costs

Question 20

Which values can the Lerner index take?

Answer 20

The Lerner index measures market power on the interval [0,1]
As the markup over MC increases, the Lerner index increases, max at 1
In a perfectly competitive market, L=0
Also; L=1/elasticity

Question 21

How does the price elasticity of demand relate to market power?

Answer 21

The higher the elasticity of demand the lower the ability of the firm to exert market power

The more consumers are willing to switch away from a given firm, the lower the ability of the firm to charge prices above MC

Question 22

How to find the MR?

Answer 22

Given: Inverse Demand Function => Multiply with quantity to find Revenue and take first derivative

Question 23

How to find the ME for a generic demand function?

Answer 23

Apply the “product rule” to the revenue:
R(q)=p(q)*q
MR=p+q(dp/dq)

Question 24

What is the sign of the marginal revenue?

How does the size of the marginal revenue relate to the price?

Answer 24

Positive or Negative but should be MR=<p> When the firm sells an extra unit, it gets p for it. But to sell an extra unit, it must lower the price by dp/dq for each unit sold!</p>

Question 25

How does the welfare loss caused by the monopoly relate to the price elasticity of demand?

Answer 25

The more “inelastic” the market demand, the larger this welfare loss

Question 26

What does price discrimination mean?

Answer 26

Price discrimination refers to any non-uniform pricing policy used by a firm with market power to maximize profits
=charging customers different prices for the same product
=charging a customer a price that varies depending on how many units the customer buys (2nd degree price discrimination, similar to a “volume discount”)

Question 27

Why do firms engage in price discrimination?

Answer 27

To increase its profits by trying to extract unexploited surplus (from the point of view of the firm) under uniform pricing

Question 28

How can price discrimination increase profits?

Answer 28

Think of a monopolist that charges a uniform price:

Given the inverse demand p(q), the monopolist sell q* such that MC(q)=MR(q)
Recall that MR is the sum of two effects:

1) Increase in revenue from selling one more unit
2) Decrease in revenue on all existing output

=All methods of price discrimination can be viewed as attempts to minimize this second effect on MR from expanding sales

Question 29

Under which conditions can a firm engage in price discrimination?

Answer 29

1) Market Power: A firm must have some market power (ability to set p>MC)
2) Identifying WTP: The firm must be able to identify whom to charge the higher price
e. g., to know the WTP for each unit (the height of consumer demand)
3) Resale: Ability to prevent or limit resale by customers who pay the lower price to those who pay the higher price

Question 30

Which type of buyers’ information can be used to price discriminate?

Answer 30

• Buyer characteristics such as student status/age/gender
• Location
• Buyers’ ability to be flexible about time
• By effort (case of coupons)
• The fact that some consumers are less informed than others

Question 31

How do profits and consumer surplus for each group change when a monopolist optimally decides to 3rd degree price discriminate instead of charging a uniform price?

Answer 31

Profits increase. Because the firm could choose a uniform price, but it does not do so. This indicates that profits are higher in the price discrimination!
Consumers in the market with lower elasticity are worse off, since the price in this market has increased (the CS triangle gets smaller)
Consumers in the market with higher elasticity are better off, since the price in this market has decreased (the CS triangle gets larger)