Practice Free Response Questions

1) Assume that a profit-maximizing firm in a monopolistically competitive industry is in long-run equilibrium.

(a) Draw a correctly labeled graph that shows the profit-maximizing firm’s price and output.i. Difference between a competitive output, price & profit

MCATC

D

MRQty

P

Q1

P1A

------------

B

Quantity0

Price

P = MC P = MR(demand

curve)

P = MC P = MR(demand

curve)

Perfectly Competitive Firm

MCMCATCATC

Quantity produced =Efficient scale

Quantity produced =Efficient scale

B

(b) The city eliminates the business license fee (a fixed cost) for all firms in this industry. How does the elimination of the license fee affect:

i) Output/Price does NOT change

WHY: a ∆ in fixed costs

does not ∆ marginal costs ormarginal revenue.

i. Output ii. Profit iii. Modify Graph

MCATC

D

MRQty

P

Q1

P1A

MCATC

D

MRQty

P

Q1

P1A

MCATC

D

MRQ

P

Q

P

ii) As fixed costs ↓ ATC

Shifts downward => profits ↑ (from zero to shaded Area)

c) In long run this would attract more competition-Demand would shift left-Profit would = ZERO-Quantity would fall

ATC1EconomicProfits

(c) continued

i. Output ii. Profit iii. Modify Graph

A

D

MR

-----------------

Unit ElasticElastic range

Inelastic Range

●

Demand Curve & Elasticity

1) Firms Operate in Elastic Portion of Demand

2) Elasticity = 1 when MR = 0

Practice Free Response Question #2

Watsonia

Marginal Cost

Average Total Cost

Demand

Marginal Revenue

ATTENDANCEQ1 Q2 Q3 Q4 Q5 Q6 Q70

P1

P2

P3P4P5

P6

PR

ICE

/CO

ST

1. There is one art museum on the island of Watsonia. The museum’s demand and cost curves are shown in the graph above. The museum currently relies on an admission charge for some of its funding. Its directors are debating about how to set the admission charge.

Marginal Cost

Average Total Cost

Demand

Marginal Revenue

ATTENDANCEQ1 Q2 Q3 Q4 Q5 Q6 Q70

P1

P2

P3P4P5

P6

PR

ICE

/CO

ST

a) Identify the price and quantity associated:

i) The museum maximizes its profit. P5 Q2

Marginal Cost

Average Total Cost

Demand

Marginal Revenue

ATTENDANCEQ1 Q2 Q3 Q4 Q5 Q6 Q70

P1

P2

P3P4P5

P6

PR

ICE

/CO

ST

ii) The museum maximizes its total revenue P3 Q4

Marginal Cost

Average Total Cost

Demand

Marginal Revenue

ATTENDANCEQ1 Q2 Q3 Q4 Q5 Q6 Q70

P1

P2

P3P4P5

P6

PR

ICE

/CO

ST

iii) The museum maximizes the sum of consumer and producer surplus (total welfare)

P4 Q3

Marginal Cost

Average Total Cost

Demand

Marginal Revenue

ATTENDANCEQ1 Q2 Q3 Q4 Q5 Q6 Q70

P1

P2

P3P4P5

P6

PR

ICE

/CO

ST

iv) The museum maximizes its attendance, as long as it breaks even.

P2 Q5

Marginal Cost

Average Total Cost

Demand

Marginal Revenue

ATTENDANCEQ1 Q2 Q3 Q4 Q5 Q6 Q70

P1

P2

P3P4P5

P6

PR

ICE

/CO

ST

b) When the attendance is Q1, is the demand price elastic, inelastic, or unit elastic? Explain.

Demand is elastic at Q1.MR is greater than zero; Q1 is left of the mid-point

or in the upper half of the demand.

Elastic

Inelastic

Marginal Cost

Average Total Cost

Demand

Marginal Revenue

ATTENDANCEQ1 Q2 Q3 Q4 Q5 Q6 Q70

P1

P2

P3P4P5

P6

PR

ICE

/CO

ST

c) Assume that the price is set at P2. Assuming the existence of an opportunity cost, indicate whether the museum’s accounting profits would be positive, negative, or zero. Explain why.

Accounting profits are positive.

Marginal Cost

Average Total Cost

Demand

Marginal Revenue

ATTENDANCEQ1 Q2 Q3 Q4 Q5 Q6 Q70

P1

P2

P3P4P5

P6

PR

ICE

/CO

ST

c) Assume that the price is set at P2. Assuming the existence of an opportunity cost, indicate whether the museum’s accounting profits would be positive, negative, or zero. Explain why.

Economic profit is zero and opportunity costs exist.

Marginal Cost

Average Total Cost

Demand

Marginal Revenue

ATTENDANCEQ1 Q2 Q3 Q4 Q5 Q6 Q70

P1

P2

P3P4P5

P6

PR

ICE

/CO

ST

c) Assume that the price is set at P2. Assuming the existence of an opportunity cost, indicate whether the museum’s accounting profits would be positive, negative, or zero. Explain why.

Economic profit is zero and ATC includes opportunity costs.Or--

Marginal Cost

Average Total Cost

Demand

Marginal Revenue

ATTENDANCEQ1 Q2 Q3 Q4 Q5 Q6 Q70

P1

P2

P3P4P5

P6

PR

ICE

/CO

ST

d) Assume that the government decides the museum should charge no admission and agrees to subsidize the museum for any losses.

i) Using the labeling in the graph, identify the museum’s attendance under that circumstance. Q7

http://www.youtube.com/watch?v=azNo8ttSCiY

Innovation in Schools

Marginal Cost

Average Total Cost

Demand

Marginal Revenue

ATTENDANCEQ1 Q2 Q3 Q4 Q5 Q6 Q70

P1

P2

P3P4P5

P6

PR

ICE

/CO

ST

d) Assume that the government decides the museum should charge no admission and agrees to subsidize the museum for any losses.ii) Would the outcome be allocatively efficient? Explain.

Outcome is NOT allocatively efficient.

Marginal Cost

Average Total Cost

Demand

Marginal Revenue

ATTENDANCEQ1 Q2 Q3 Q4 Q5 Q6 Q70

P1

P2

P3P4P5

P6

PR

ICE

/CO

ST

d) Assume that the government decides the museum should charge no admission and agrees to subsidize the museum for any losses.ii) Would the outcome be allocatively efficient? Explain.

MC > P or MSC > MSB

isgreater

than