EC1000 Question Sheet 3 Week 8

Answers

1. H suggests looking at whether productivity would rise or fall. Productivity is certainly important,
since the more productive workers are, the lower the cost per gallon of beer. R wants to look at
average cost. But both H and R are missing the other side of the equationrevenue. A firm wants to
maximize its profits, so it needs to examine both costs and revenues. Thus, T is right its best to
examine whether the extra revenue would exceed the extra costs. T is the only one who is thinking at
the margin.

2. If the price of tap water rises, the demand for bottled water increases. This is shown in Figure 2 as
a shift to the right in the demand curve from D1 to D2. The corresponding marginal-revenue curves
are MR1 and MR2. The profit-maximizing level of output is where marginal cost equals marginal
revenue. Prior to the increase in the price of tap water, the profit-maximizing level of output is Q1;
after the price increase, it rises to Q2. The profit-maximizing price is shown on the demand curve: it is
P1 before the price of tap water rises, and it rises to P2 after. Average cost is AC1 before the price of
tap water rises and AC2 after. Profit increases from (P1 - AC1) x Q1 to (P2 - AC2) x Q2.

Figure 1 (you might want to draw a simpler figure with constant marginal = average cost)

3. a. The following table shows total revenue and marginal revenue for each price and quantity
sold:
EC1000 Question Sheet 3 Week 8

Price Quantity Total Marginal Total Profit

Revenue Revenue Cost

24 10,000 240,000 ---- 50,000 190,000

22 20,000 440,000 20 100,000 340,000

20 30,000 600,000 16 150,000 450,000

18 40,000 720,000 12 200,000 520,000

16 50,000 800,000 8 250,000 550,000

14 60,000 840,000 4 300,000 540,000

b. Profits are maximized at a price of 16 and quantity of 50,000. At that point, profit is
550,000.

c. As Jimmy's agent, you should recommend that he demand (slightly less than) 550,000 from
them, so he instead of the record company receives (almost) all of the profit.

4. Larry wants to sell as many drinks as possible without losing money, so he wants to set quantity
where price (demand) equals average cost, which occurs at quantity QL and price PL in Figure 3.
Curly wants to bring in as much revenue as possible, which occurs where marginal revenue equals
zero, at quantity QC and price PC. Moe wants to maximize profits, which occurs where marginal cost
equals marginal revenue, at quantity QM and price PM.

Figure 2 (you might want to draw a simpler figure with constant marginal = average cost)
EC1000 Question Sheet 3 Week 8

5. If a 10% increase in price would decrease demand by only 5%, the firm must be operating at a
point where marginal revenue is negative, and hence profits cannot possibly be maximised. In
particular, the output is above the profit maximising level. To avoid being fired, Paul might argue that
although this strategy does not maximise the firm profit in the short run, it is optimal in the long run
because it reduces future costs (e.g. through a learning by doing effect) or increases future demand
(e.g. by driving competitors out of the market).

6. a. If the products are sold separately, the profit maximising price is 8 and the total profit is 24
(that is, 12 on each product). The detailed calculation is simple: the alternative strategy of setting a
price of 10 results in selling two units, with a total revenue of 20 and total cost of 4, so the net profit is
16. Instead, setting a price of 8 leads to selling 4 units, with a total revenue of 32 and a total cost of 8.

b. If the firm bundles the two products, since the products are independent both consumers will have a
willingness to pay for the bundle equal to 18 (= 10 + 8 = 8 + 10). The unit cost of each bundle
would be 4. Clearly, the profit maximizing bundle price would be 18, with a total profit of 28. By
bundling the two products, the firms earns 4 extra profit.

7. The following table illustrates average fixed cost (AFC), average variable cost (AVC), and
average total cost (ATC) for each quantity. The efficient scale is 4 houses per month, since
that minimizes average total cost.

Quantity Variabl Fixed Total Average Average Average

e Cost Cost Cost Fixed Cost Variable Cost Total Cost

0 0 200 200 --- --- ---

1 10 200 210 200 10 210

2 20 200 220 100 10 110

3 40 200 240 66.7 13.3 80

4 80 200 280 50 20 70

5 160 200 360 40 32 72

6 320 200 520 33.3 53.3 86.7

7 640 200 840 28.6 91.4 120

8. Once you have ordered the dinner, its cost is sunk, so it does not represent an opportunity
cost. As a result, the cost of the dinner should not influence your decision about stuffing
yourself.

9. Though Britney Spears has a monopoly on her own singing, there are many other singers
in the market. If Spears were to raise her price too much, people would substitute to other
EC1000 Question Sheet 3 Week 8

singers. So there is no need for the government to regulate the price of her concerts.

10. a. Dropping the letter grade by two letters (e.g., A to C) if you have no fun gives the
payoffs shown in this table:

Your Decision
Work Shirk
Work You get a C You get a B

Classmate's Classmate gets a C Classmate gets a D

You get a D You get a D
Decision
Shirk
Classmate gets a B Classmate gets a D

b. The likely outcome is that both of you will shirk. If your classmate works, you're better off
shirking, because you would rather have an overall B (a B grade and fun) then an overall C
(an A grade and no fun). If your classmate shirks, you are indifferent between working for an
overall D (a B grade with no fun) and shirking for an overall D (a D grade and fun). So your
dominant strategy is to shirk. Your classmate faces the same payoffs, so will also shirk. But
if you are likely to work with the same person again, you have a greater incentive to work, so
that your classmate will work, so you will both be better off. In repeated games, cooperation
is more likely.