Economics Model Answers Twelve - 2013
1. Which concept in Economics do you think is the best self-motivator, which you might use to achieve more?
- Answers vary, but could include a discussion of opportunity costs, the benefits of competition, efficiency, maximizing marginal utility, Gresham's law, the Coase theorem, economic profits (as opposed to accounting profits), advantages of long run planning, how time is equivalent to money, etc.
2. Which is true about the average fixed costs (AFC) of a firm?
(a) A firm can eliminate these costs by shutting down in the short run.
(b) As output increases, AFC decreases.
(c) As output increases, AFC increases.
(d) AFC is part of average variable costs.
Briefly explain your answer.
- B is the correct answer, because AFC is fixed costs divided by total output: FC/Q. As Q increases, the outcome decreases.
3. What is one of the primary responsibilities of the Federal Reserve Bank?
- Control the interest rates of banks (which controls the flow of money), and keep banks from failing.
4. Review: Suppose that after completing this course, you start a new company. In your first year, you "broke even" (had zero profits), and in your second year you want to increase your revenue and profits. After careful study of your market, you decide that you can increase your revenue by increasing your price. Therefore your good must be price elastic/inelastic (choose one).
- The good must be price inelastic.
- "The good is price inelastic. After all, my revenue is PQ. Due to the law of demand, when P increases, Q decreases. However, my study of the market reveals that increasing P will increase my revenue: thus, Q must not decrease very much in response to the increase in price. This characterizes a price inelastic good." (by student JA)
5. A monopolistic competitive firm has the following characteristic that is lacking for a perfectly competitive firm:
(a) There are low barriers to entry.
(b) MR = MC in the long run.
(c) P > MC
(d) There are many competitors.
Choose one of the above and explain your answer.
- The correct answer is "C". A monopolistic competitive firm has the characteristic "P > MC", which is not true for a perfectly competitive firm. A monopolistic competitive firm does not have to repeatedly lower its prices to keep up wih the competition.
- "A monopolistic competitive firm has the characteristic of P>MC, which is not true for a firm in perfect competition. This characteristic arises because the goods in monopolistic competitive firms are not perfect substitutes, and the price can be set higher than the marginal cost without a loss in revenue." (by student NL)
6. If you were to loan someone money, why would you want him to pay you something extra (interest) when he pays back the loan? Give at least one reason.
- Here are two reasons: the time value of money, and something extra to compensate you for taking the risk that your loan will not be paid back.
7. Review: is the cost of the bus for the March for Life trip to D.C. a "fixed cost" or a "variable cost"? Explain, assuming for the purpose of this question that one and only one bus can be used (in reality, we used several buses).
- The cost of the bus is a fixed cost, because it is the same cost whether there is one person on the bus (or no one), and whether there are 47 people on the bus. The cost does not "vary" with the output.
8. Suppose I will pay you $1000 in two years, and the interest rate is 10% per year, compounded annually. How much should you pay me today to receive $1000 in two years? Show your work.
- Work backwards: at 10% interest, $1000 in two years is the same as $1000/1.1=$909.09 in one year. That is because $909.09 generates $1000 in one year at 10% interest.
- Then we have to work backwards one more year to get to "today": $909.09/1.1=$826.45. So the answer is $826.45 - that is what we would need to receive today for it to be the same as $1000 in two years, at 10% interest compounded annually.
- Check our answer: $826.45 times 10% = $82.65. Add that and our total in one year is it would require $1000/1.1=$909.10. Repeat that process for the second year and the total is $909.10 plus $90.91=$1000.01 (the extra penny is due to rounding error).
9. Explain why in long-run equilibrium the price charged in monopolistic competition is greater than marginal cost but equal to average total cost.
- In monopolistic competition there are almost no barriers of entry. A new firm can easily enter the market if products were selling above average total cost. If they charged more than ATC they would be undersold by the competition, and if they charged less then they would loss money overall.
- "In a firm in monopolistic competition, the long-run equilibrium price is equal to average total cost (ATC) because there are very few barriers to entry into the market. If price were greater than average total cost, then other firms would set their price lower (equal to ATC) in order to compete. In contrast, the price need not be equal to marginal cost (MC) in the short run since not all of the goods are perfect substitutes." (by student NL)
10. Economics is sometimes called the “dismal science” because economists predicted population to grow faster than the food supply, marginal returns to diminish, and profits to vanish. But, in fact, there is an abundance of food and profits have not vanished. Why is economics not so dismal after all?
- Because new inventions and hard work by people create wealth, charity, ingenuity, and so on.
11. What is "Keynesian economics" and what is your view of it?
- Keynesian economics claims that government interference, and especially government spending, is good for the economy.
12. An agreement by different firms with each other to reduce output is illegal. Why should that be illegal?
- Yes, because reducing output is harmful to the public. In economic terms, reducing output causes a "deadweight loss."
13. Nash equilibrium, revisited: What is the Nash equilibrium for two gas stations (an oligopoly) that are situated immediately across the street from each other? In other words, what price do they sell at, expressed in terms of one of their cost measures? Explain the process that reaches that "equilibrium".
- They sell at MR=MC. If one firm were to sell higher, than the other firm would boost its profits by reducing its price to where MR=MC.
- "The outcome would be when MR = MC. One gas station could lower its original price to get more business, but then the second station would lower its price as well so it doesn’t lose business. This would continue until both gas stations lower their prices to where cost equals price." (by student CM)