ECONA231 F Revision Exercise 2 Suggested Solutions (1704) PDF

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School of Arts and Social Sciences ECON A231F Introduction to Microeconomics Revision Exercise 2 (Ch – Ch) 1. John runs a small restaurant in Stanley and the total-cost curve of his restaurant is as follows: Total-cost curve Total cost Quantity 0 (a) Does John’s restaurant operate in the long run or...

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School of Arts and Social Sciences

ECON A231F Introduction to Microeconomics Revision Exercise 2 (Ch.11 – Ch.14) 1.

John runs a small restaurant in Stanley and the total-cost curve of his restaurant is as follows: Total cost

Total-cost curve

Quantity

0

(a) Does John’s restaurant operate in the long run or short run? Explain your answer. Ans: John’s restaurant operates in the short run for the existence of fixed cost (i.e. the total cost is positive when the output level is zero).

(b) Is John’s restaurant facing diminishing marginal product? Briefly explain your answer. Ans: The total cost curve reflects a rising marginal costs, which implies diminishing marginal product.

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(c) During off-peak hours, John’s restaurant has only few customers. The revenue from the few customers cannot cover the total cost of running the restaurant. Explain why John still keeps his restaurant stay open during off-peak hours. Ans: During off-peak hours, John’s restaurant has only few customers. The revenue from the few customers cannot cover the total cost of running the restaurant. However, a number of costs in a restaurant, such as kitchen equipment, tables and plates, are fixed. Only the variable costs, the costs of staff and the costs of additional food, are relevant in deciding whether to open the restaurant during off-peak hours. Provided that the revenue during off-peak hours covers the variable costs, John will still open the restaurant though there are few customers. 2.

John is running a pizza restaurant and he says, “I am currently producing 10,000 pizzas per month at a total cost of $500. If I produce 10,001 pizzas, my total costs will rise to $500.11. Therefore, my marginal cost of producing pizzas must be increasing.” Is what John said right or wrong? Draw a graph to illustrate and explain your answer. Ans: Average total cost (ATC) is equal to total cost (TC) divided by total output. In this case, ATC is 0.05 (= $500.11 / 10001). Marginal cost (MC) is the change in TC divided by the change in output. In this case, MC is $0.11 (= $0.11/1). When MC is greater than ATC, MC must be rising. So what John said is right.

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3.

Suppose Cha Chaan Teng, Hong Kong style restaurants, are operating in a perfectly competitive market. Disregard all other food items, Silver Dragon Restaurant sells 600 cups of Hong Kong-style milk tea per day at $12 each and the average total cost (ATC) is $8 in the short run. (a) Calculate the short run economic profit of Silver Dragon Restaurant. Ans: Short run economic profit = (P – ATC) x Q = (12-8) x 600 = 2400

(b) Suppose all Cha Chaan Teng are facing identical cost curves. Based on your answer in (a), what will happen to the average revenue, ATC, and economic profit of Silver Dragon Restaurant in the long run. Briefly explain your answers. Ans: When short run economic profit exists, new firms enter the market. Supply increases and price falls. Since price is equal to average revenue (AR) in a competitive market. AR will fall as well. The adjustment process: It is possible that when more firms are in the market, the demand for factor inputs, such as labour, will increase. The ATC curve will shift upward. In the long run, after entry and exit, all firms earn zero economic profit. OR It is also possible that the adjustment process does not feature an upward shift in the ATC curve. In that case, in the long run the AR curve shifts down to become tangent to the ATC curve. Quantity produced by each firm is lowered, resulting in lower average total cost than before. In the long run, all firms earn zero economic profit, so the MC curve will also intersect AR at this new quantity, indicating P=MC.

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(c) In the long run, Silver Dragon Restaurant sells a cup of Hong Kong-style milk tea at $7 each. What will be its marginal cost and ATC? Briefly explain your answers. Ans: In the long run, all firms earn zero profit. Price (AR) is just equal to the minimum ATC. Since MC cuts ATC at the minimum, all firms will reach a long run equilibrium at which P = ATC = MC =$7.

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Suppose that in a perfectly competitive market, most new technology products, such as plasma TV, can earn short-run economic profit, but not in the long run. Explain this phenomenon with diagrams. Ans: When plasma televisions were first introduced, prices were high, and only a few firms were in the market. Panel (a) shows that the initial equilibrium price in the market for plasma televisions is P1. Panel (b) shows that at this price, the typical firm in the industry is earning an economic profit, which is shown by the shaded box. The economic profit attracts new firms into the industry. This entry shifts the market supply curve from S1 to S2 in panel (a) and lowers the equilibrium price from P1 to P2. Panel (b) shows that at the new market price, P2, the typical firm is breaking even. Therefore, plasma televisions are being produced at the lowest possible cost, and productive efficiency is achieved. That result implies that investors in these firms are also unlikely to earn an economic profit in the long run.

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5.

Justin Bieber, a Canadian pop singer, has just finished recording his latest CD. The record company can produce the CD with no fixed cost and a variable cost of $5 per CD. The demand for CD is shown as follows: Price 24 22 20 18 16 14

Number of CDs 10,000 20,000 30,000 40,000 50,000 60,000

Total Revenue

Marginal Revenue

(a) Construct the above table and fill in the remaining two columns. Ans: The following table shows total revenue, and marginal revenue, for each price and quantity sold: Price

Quantity

24 22 20 18 16 14

10,000 20,000 30,000 40,000 50,000 60,000

Total Revenue $240,000 440,000 600,000 720,000 800,000 840,000

Marginal Total Revenue Cost ---$50,000 $20 100,000 16 150,000 12 200,000 8 250,000 4 300,000

Marginal Cost ---$5 5 5 5 5

Profit $190,000 340,000 450,000 520,000 550,000 540,000

(b) To maximize profit, what would be the price and quantity of CDs? What is the amount of profit? Show and explain how you find the answer. Ans: To maximize profit, 50,000 CDs will be produced and the price is $16. Profits are maximized at $550,000 (= TR – TC = 800,000 - 250,000). (c) If you were Justin’s agent, what recording fee you would advise Justin to demand from the record company? Why? Ans: As Justin's agent, you should recommend that he demand a maximum of $550,000 from the record company, so he receives all of the profit (rather than the record company). Any amount higher than that would not be accepted by the company.

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6.

Suppose there are only two department stores, Jusco and Seiyu, selling a new model of PlayStation in Hong Kong. They can choose either to charge a high price ($2500) or a low price ($2000). Refer to the following payoff matrix. The first entry in the bracket is the payoffs (in $million) of Jusco and the second entry is the payoffs of Seiyu. What is the dominant strategy of Jusco and Seiyu? Explain. Seiyu

Jusco

High price

Low price

High price

(10,10)

(5,15)

Low price

(15,5)

(7.5,7.5)

Ans: If Seiyu charges a high price, then Jusco is better off with charging a low price, because it gets $15 million with low price and only $10 million with high price. If Seiyu charges a low price, then Jusco is better off with charging a low price, because it gets $7.5 million with low price and only $5 million with high price. So Jusco has a dominant strategy of charging a low price. If Jusco charges a high price, then Seiyu is better off with charging a low price, because it gets $15 million with low price and only $10 million with high price. If Jusco charges a low price, then Seiyu is better off with charging a low price, because it gets $7.5 million with low price and only $5 million with high price. So Seiyu has a dominant strategy of charging a low price.

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