Short Answer FINAL Flashcards
Suppose the market demand function facing three firms is Q = 500 − 2p. Each firm has
a marginal cost of $5 per unit. What is the cartel solution? Suppose instead that one of
the firms could supply up to 100 units at MC = 4, and the other two firms had a marginal
cost of $5. How would this alter the final output, price, and profit? Does this complicate
the division of profits? How?
In a cartel solution the firm sets a monopoly price using MC=MR
MR=250-Q
MC=5
Q=245
p=127.5
If one firmcan supply the first 100 at MC=4, price and quantity remain unchanged, but profits are increased by $100. This complicates the division of profits because the firms must now agree on how the profits are to be divided, given that they are not generated by equal contributions of each firm.
Consider a market where the inverse demand function is P = 100 − Q. All firms in the
market have a constant marginal cost of $10 and no fixed costs. Compare the deadweight
loss in a monopoly, a Cournot duopoly with identical firms, and a Bertrand duopoly with
homogeneous products.
We first need to find the equilibrium quantities and prices in each scenario. The inverse demand
function given is P=100−Q, and all firms have a constant marginal cost (MC) of $10 with no
fixed costs.
Monopoly: In a monopoly, the firm’s profit maximization condition equates marginal revenue
(MR) with marginal cost (MC). First, calculate the total revenue TR=PQ=(100−Q)Q and then
the marginal revenue by differentiating TR with respect to Q: 𝑀𝑅=𝑑/𝑑𝑄(100𝑄−𝑄2)=100−2𝑄
Set MR equal to MC to find the equilibrium quantity: 100−2Q=10, thus 2𝑄=90, i.e.. 𝑄𝑀=45
The monopoly price PM is then: PM=100−QM=100−45=55
Cournot Duopoly: In a Cournot duopoly with identical firms, each firm chooses its output
assuming the other firm’s output is fixed. Let Q1 and Q2 be the outputs of the two firms, so
Q=Q1+Q2. The inverse demand function becomes: P=100−(Q1+Q2) Each firm maximizes its profit πi=(100−Q1−Q2) Qi−10Qi. The first-order condition for firm 1
is:
∂Q1/∂π1=100−2Q1−Q2−10=0, thus 90−2Q1−Q2=0
Assuming symmetry (i.e., Q1=Q2=q), we have: 90−2q−q=0
90−3q=0, this implies q=30 So, QC=60 and PC=100−60=40.
Bertrand Duopoly: In a Bertrand duopoly with homogeneous products, firms compete on price.
Given identical marginal costs and no capacity constraints, the price in equilibrium falls to the
marginal cost: PB=MC=10
QB=100−PB=100−10=90
Deadweight Loss: Deadweight loss is the loss of economic efficiency when the equilibrium
outcome is not the social optimum where P=MC. The social optimum occurs at: 100−Q=10
Q∗=90 and P∗=10
Now, calculate the deadweight loss for each case:
Monopoly: Q∗−QM=90−45=45
Cournot: Q∗−QC=90−60=30
Bertrand: Q∗−QB=90−90=0
The deadweight loss from a monopoly is the light gray area and the darker gray area, 1/2 × 45
× 45 = 1,012.5.
The deadweight loss from a Cournot duopoly is 1/2 × 30 × 30 = 450.
There is no deadweight loss from a Bertrand duopoly with homogeneous products because it is
the same as the competitive equilibrium.
Suppose you are selling kites on the boardwalk at the New Jersey shore as your summer
job. Every fourth person who passes you selects a kite at random and buys it. Half of your
kites sell for $8, and the other half sell for $4. If 100 people per hour pass by, what is your
expected revenue for six hours work?
Answer: Expected revenue would be the product of expected sales (100 × 0.25 × 6) and expected
price (0.5 × $4 + 0.5 × $8), or $900.
What would be the price of fair insurance for a $20,000 motor home for one year,
assuming that during that year there is a 2% chance that it will be destroyed in an accident,
leaving a $3,000 salvage value and no chance of any partial loss? Assume that the owner
keeps the salvage value.
Answer: The expected value of the motor home is $19,660 = (0.02 × $3000 + 0.98 × $20,000).
Thus, fair insurance for the motor home would cost $340 = (0.02 × $17,000), where $17,000 is
the net loss from an accident
Case 1: Consider a two-stage game. In the first stage, there is a 75% chance to end the
game without winning anything and a 25% chance to move to the second stage. For the
people who reach the second stage, there is a choice between A, a sure win of $40, and B,
an 80% chance to win $55. People have to make this choice before the outcome of the first
stage is known.
Case 2: People are asked to choose between C, a 25% chance to win $40, and D, a 20%
chance to win $55.
What will be your choice in Case 1? What will be your choice in Case 2?
Case 1 Analysis:
Option A: The chance of reaching the second stage is 25%, and if reached, winning $40 is certain.
So, the probability of winning $40 is: 0.25×1.00=0.250.25×1.00=0.25
Option B: The chance of reaching the second stage is 25%, and there’s an 80% chance of winning
$55 thereafter. So, the probability of winning $55 is: 0.25×0.80=0.200.25×0.80=0.20
Case 2 Analysis:
Option C: Directly offers a 25% chance to win $40.
Option D: Directly offers a 20% chance to win $55.
Comparison: In both cases, the probabilities for the payouts are indeed:
A 25% chance of winning $40 and A 20% chance of winning $55.
Thus, yes, it is true that both cases are identical in terms of the probability of winning the same
prizes. Each scenario offers the same ultimate probabilities for each prize despite the structural
differences in how choices are presented and decisions made (two-stage game vs. direct
probability game).
Therefore to be consistent, you should either choose A and C, or B and D
Twenty years ago, almost no one wore helmets while downhill skiing. Now many skiers
wear them. What could have caused such a change?
There are several possible reasons. The first is that downhill skiing might be more dangerous
than it was 20 years ago (an increase in the probability of injury). Second, the risk may be the
same, but skiers may be more aware of the risks (better information). Finally, skiers may be more
risk averse than they were 20 years ago and so are less willing to risk an injury
Explain how the Coase theorem would apply to a factory polluting a stream and a spring
water producer located downstream
Without the establishment of property rights, the factory and the spring water firm are unable
to negotiate a solution. However, if property rights are established in either’s favor, bargaining
may occur. For example, if the factory has the right to pollute the stream rather than internalize
the waste at a cost of $1 million per year but the pollution costs the spring water firm $2 million
per year, the spring water firm will be willing to pay the waste disposal costs for the factory
because they still end up $1 million better off. If the rights are reversed, then no bargaining
occurs because it is cheaper for the factory to dispose of the waste at a cost of $1 million than to
pay off the spring water firm for the right to pollute
Choose a law designed to curb negative externality related to driving. Explain the
externality the law is designed to reduce and discuss its effectiveness.
Many answers are possible, including restrictions on blood-alcohol levels, speed limits, and even
stopping for traffic signals. In most cases, traffic laws are designed to reduce the possibility of
injury to person and property. Damage to the driver represents private costs. Damage to other
passengers, individuals in other cars, property, and pedestrians represents an external cost.
Explain why many countries subsidize education. Try to relate this to the concept of
externality.
Education, as a form of private investment in human capital, will increase people’s future earning
potential. In addition to that, it also makes those receiving it better citizens in various aspects.
Hence, education has a positive externality. Therefore, it is welfare improving for the
government to subsidize education.
Discuss Moral Hazard and Asymmetric Information, understand the role of Signaling
and Screening.
Suppose you are vacationing on a sunny Caribbean Island. You walk to the beach to rent
a sailboat for an hour. A nice gentleman tells you that he has “the best rental prices on the
island. You can search the entire island and you won’t find a better deal than this.” Under
what circumstances should you rent a sailboat from him?
The claim may be partly true if all sellers are charging the monopoly price or a price that exceeds
the cost of searching. (All sellers charge the same; thus, there is no better price on the island.)
The claim is cheap talk; the seller incurs very little cost. Similar to the example in Table 19.1b,
the seller in this case has the incentive to claim that they have the lowest price regardless of their
true costs. The buyer on the other hand, would prefer to buy from the lowest price seller, so the
seller has an incentive to lie if their prices are not truly the lowest. You should rent a sailboat
from him if his price does not exceed your expectation of the price you would find elsewhere plus
the search costs from having to look around.
At some urban universities, many students and faculty eat at lunch trucks that are
parked along the streets surrounding the campus. Before going there for lunch one day,
you ask two people where you should eat. Neither individual you ask has ever been to
either truck. One says, “Just pick the one with the shortest line.” The other says, “Pick
the one with the longest line.” Which advice should you follow?
Two outcomes are possible. Most of the customers at these restaurants eat at the campus on a
regular basis. Information about restaurant quality travels fast through the student and faculty
community. Thus, all restaurants that want to stay in business for any length of time have an
incentive to serve high-quality meals, and you could save time by getting in the shortest line. If,
however, either the restaurants or the cooks at the restaurants turn over frequently, regular
patrons will have an information advantage, and the longest line is the best bet. Of course, this
assumes that any expected difference in quality outweighs your disutility from standing in line.
Under what circumstances would receiving your college degree in two years have a
negative effect on your employability or salary?
If employers use years of education as a signal of quality, an individual who has 14 years of
schooling may be viewed as inferior to an individual with 16. The sheepskin effect (completing
the degree) would likely eliminate this disadvantage. Another reason for a negative effect would
be the signal regarding the quality of the education that an individual received given that he or
she was able to complete in two years a degree that normally takes four years.
Standardized tests are sometimes criticized by parents who claim that their kids spend
too much time studying for them. Under what circumstances is this a valid claim?
Standardized test scores serve as a signal for both students and schools. Students can signal
ability through high scores. Secondary schools use test scores as a signal of school quality. If
schools spend class time taking practice tests and other preparations for tests such as the SAT
and ACT exams, the amount of time spent on regular curriculum is reduced. This may not be the
most efficient way to spend students’ time if the information learned from studying for tests is
not as productive as what could otherwise be learned.
