Microeconomics FRQ revision document (Answers)

Chapter 1: Basic economic concepts

1.

a) i. Alice has absolute advantage in preparing sandwiches.

ii. Alice has absolute advantage in preparing burgers.

b) Each sandwich is given up for 1/2 burgers for Alice and 1/2 burgers for Roy. Therefore, there will
be no beneficial trade (since the opportunity costs are identical).

2.

a. 200 baseballs/100 helmets = 2 baseballs

b. Zanadu.

c. Zanadu has a comparative advantage in the production of baseballs since it has a lower
opportunity cost of producing a baseball than Atlantis (1/4 is less than 1/2).

d. Yes, since the terms of trade fall between the opportunity cost of producing helmets in the two
countries (between 2 baseballs in Atlantis and 4 baseballs in Zanadu).

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Chapter 2: Demand, supply, market equilibrium and welfare analysis.

1. (a), (b), (c)

2.

a) The demand will shift to the left, resulting in lower prices and quantities.

b) The demand will shift to the right, resulting in higher prices and quantities.

c) The supply will shift to the left, resulting in higher prices and lower quantities.

d) The demand will shift to the left, resulting in lower prices and quantities.

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Chapter 3: Elasticity.
1.
a.

b. Consumer surplus increases as prices have decreased.

c. Total revenue will increase.

2. Examine the table below, which shows the demand for a signature chocolate bar at different
prices.

Price ($) Quantity demanded

(chocolate bars per
week)

10 20

8 40

6 60

4 80

2 100

a. Suppose that the price falls from £8 to £6. The percentage change is –25%. In response, quantity
increases from 40 to 60, i.e. by 50%. The elasticity of demand is therefore +50 / –25 = –2. demand is
elastic.

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b. Suppose that the price falls from £6 to £4. The percentage change is –33%, In response, quantity
increases from 60 to 80 by 33%. The elasticity of demand is therefore +33 / –33 = –1. Therefore,
demand is unit elastic.

c. Suppose that the price falls from £4 to £2. The percentage change is –50%. In response, quantity
increases from 80 to 100 by 25%. The elasticity of demand is therefore +25 / –50 = –0.5. Demand is
inelastic.

3. a. Jam is an inferior good.

b. -0.04/0.10 = -0.4, Which means jam and chocolate are complements

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Chapter 4: Price controls and government taxes.
1.

a. Indonesia is importing 12 million pounds.

b. 6 million pounds.

c. Domestic consumer surplus = ½ [($9 - $4) × 10] = $25 million.

d. The revenue from the tariff = ($4 - $2) (10 - 6) = $8.

e. The per-unit tariff that maximizes the sum of consumer and producer surplus is $0.

2.

a.
i. P = 12 and Q = 100
ii. Producer surplus before tax: D+E+G or $100
b. the price paid by buyers does not rise by the full amount of the tax. P increases by $1 and the tax
is $2 per unit.
c.
i. price = $11.
ii. Tax revenue = B+C+D or $160.
iii. Consumer surplus is A.
iv. Deadweight loss = F+G or $20.

3. In each of the following parts, assume that the government imposes a per unit sales tax and that
the supply is upward sloping.

a.

Since producers can raise the price by the full amount of the tax, the tax falls entirely on buyers.

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b.

The tax falls entirely on sellers, since they can’t charge more and thus must absorb the entire
amount of the tax.

c.

4. a. 10 + 8 + 6 + 4= 28

b. 3 burgers and 5 video games.

This combination where the marginal utility per dollar spent on burgers is equal to the marginal
utility per dollar spent on video games.

c. Clara’s demand will not change since the buns’ price affects supply not demand.

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Chapter 5: Firm structure and costs.

1.

a. A= 8 and B= 25
b. AVC is at its highest at the first bagel produced.
c. MC decreases from 3 to 1

2. Assume that a product has a perfectly inelastic supply and that 1,000,000 units of that product are
produced. The marginal cost of the last unit is $1. The equilibrium price of the unit is $4.

a.

b. consumer surplus is triangle $4, a, b.

c. (4-1) x 1,000000 = $3,000,000

d.

i. ceiling shown at $3.

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ii. Output remains at 1,000,000.

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Chapter 6: Perfect competition.

1.

a. The profit-maximizing quantity is 9 units because that the 9th unit is the last unit where the
marginal revenue ($62) is greater than the marginal cost ($61); the firm will not produce the 10th
unit because the marginal cost of producing it ($77) is greater than the marginal revenue earned
($62).
b. Economic Profit=TR−TC=9($62)−($421+$152)=−$15
c. AFC=TFC/Q=$152/8=$19
d. the number of firms in the industry will decrease because the negative economic profit will cause
firms to exit the industry.
e. The market price will increase since with the exit of firms, the market supply will decrease, causing
the price to increase.
f. The demand for bracelets will increase because the positive cross-price elasticity of demand for
bracelets with respect to the price of Good E means that the goods are substitutes; therefore, an
increase in the price of Good E will lead to an increase in the demand for bracelets.
g.
i. the profit-maximizing quantity of Good E will decrease because the decrease in market demand
will decrease the market price (the firm’s marginal revenue), which will shift the marginal revenue
curve downward at each quantity so that marginal cost will intersect marginal revenue at a lower
quantity.
ii. the profit-maximizing quantity of Good E will decrease because wages are a variable cost, so an
increase in wages will shift the marginal cost curve upward at each quantity so that marginal cost
will intersect marginal revenue at a lower quantity.
2.
a.

b. PM=PF, because the firm is a price taker OR the firm accepts the market equilibrium price as
given.
c.
i. the firm’s output will not change in the short run, because a change in a fixed cost will not affect
the firm’s marginal cost OR that rent is not a variable cost AND will not affect the firm’s marginal
cost.
ii. refer to the graph in part (a).
d.
i. The number of firms in the market will decrease, because some firms will exit the market as a
result of the losses incurred in the short run.

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ii. The new market equilibrium quantity will decrease relative to QM and the new market
equilibrium price will increase relative to PM because the market supply will shift to the left.

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Chapter 7: Monopolies.

1.

a.

b. lump sum subsidies will have no impact on the quantity of services produced, the subsidy will not
affect MC.
c. Refer to the graph in part a.
d. the firm’s accounting profit is positive. since accounting profit excludes implicit costs.

2. Bob’s Beans is a perfectly competitive soybean producer. The short run price of soybean is
currently below average total cost, but above Bob’s shut down point.

a.

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b.

c.

3.

a. No because price is not equal to MC or MC is not equal to demand.

b. it is inelastic because MR is negative.
c.
i) No positive economic profit is made, because P = ATC
ii) Yes.

4.

a. Output at MR=MC and price at the demand curve.

b. Q2 and P 4, or point C on the graph
c.
i) ABP5
ii) ACP4 for perfect competition
d. Q2
e. A per unit subsidy; subsidies lower marginal cost OR increase marginal revenue OR shifts the
demand curve outwards.

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5. The graph below shows the demand, marginal revenue, marginal cost, and average total cost
curves for a profit maximizing monopolist.

a.
i. Output Q1 and price P3
ii. P3acP1
iii. acf
b.
i. Q3
ii. P4fQ30
c.
Socially efficient quantity Q3 and socially efficient quantity P4fP1
d. Zero economic profit as total revenue equals total cost or because price equals ATC
e. Inelastic as marginal revenue is less than zero or negative.

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6. a.

b. Total revenue will decrease because demand is elastic on the range given, where MR > 0
c. the quantity will increase because the subsidy will cause the MC curve to shift downward and
intersect the MR curve at a larger quantity.
d. The deadweight loss will not change because the lump sum subsidy does not change the profit-
maximizing quantity.

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Chapter 8: Monopolistic competition.

1.

a.

b. No, it is price elastic since MR is positive so that TR rises if P is decreased.

c. The demand curve for the typical firm would shift to the left, because the entry of new firms
reduces the market share of existing firms.
d.

e. No
f. No because at the long-run equilibrium, P > MC.

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2.

a. The firm’s economic profit is negative (economic loss) because the price is below the ATC.
b. The firm should decrease its price because when demand is elastic (the portion of the demand
curve where marginal revenue is greater than zero), a lower price leads to more total revenue, or at
$15 the firm produces the quantity where marginal revenue is zero and total revenue is maximized.
c. The deadweight loss will increase and because the firm produces farther away from the
allocatively efficient quantity, where marginal cost equals price.
d. The firm’s profit-maximizing quantity is 6 units because at that quantity marginal revenue is equal
to marginal cost.
The firm’s profit-maximizing price is $21 because it is the price on the demand curve at the profit-
maximizing quantity (where marginal revenue is equal to marginal cost).
e. Total Cost = Average Total Cost ×Quantity = $27 ×6=$162

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Chapter 9: Oligopoly and game theory.

1.

a. north will be better for Blue Mart, since Blue Mart earns a higher profit by locating north than it
does by locating south ($4000 versus $1000)

b. south is not a dominant strategy for red shop. Because if Blue Mart chooses south, Red shop is
better off choosing north as Red shop’s best strategy depends on Blue Mart’s move.

c. Red shop chooses south and Blue Mart chooses north.

d.

2. Jim and Bob decide to attend either the soccer game or the baseball game. They prefer to meet
on the same event but they both have exams at different times, so they do not meet each other
after the exams. The events are on opposite sides of the town and Jim and bob must each choose
one event to attend without knowing where the other will be. Bob will receive 10 utils if he ends up
at the baseball game with Jim and 5 utils at the baseball game without Jim. Jim will receive 8 utils if
he finds Bob at the baseball game and 6 utils at the baseball without him. Bob will receive 12 utils at
the soccer game with Jim and 4 utils at the soccer game without him. Jim will receive 10 utils at the
soccer game with Bob and 3 utils at the soccer game without him.

a.

b. The preferred strategy for both is to attend soccer together, because each will receive the highest
possible utility from that strategy.
c. No
d. Either both go to the baseball game OR both go to the soccer game.

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3.

a. Piazzo should advertise , it makes $250 which is greater than $180.

b. There is no dominant strategy for Lapiazza . If Piazzo advertises, Lapiazza doesn’t. If Piazzo does
not advertise, Lapiazza does.
c.
i. $450
ii. $300

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Chapter 10: Factor market.

1.

a. 3d worker
b. Diminishing marginal returns: as more units of a variable input (labor) are employed with a fixed
input, output will eventually increase at a decreasing rate.
c. Because MRP<0 or negative returns or output falls or negative marginal product.
d. MPxP = $6 x15 = $90
e. i) no change in the marginal product curve for machine hours.
ii) MRP curve for machine-hours will decrease (shift left) because the decrease in demand
decreases the price of washing a car.

2.

a.

b. Profits are maximized where MR=MC of the 5th worker is $90, the MR from the fifth worker is
5units x$20 = $100. The MC of the 6th worker is $90 but the MR = 4 units x $20 = $80. So 5 workers
should be hired, producing 75 units.
c.
i. quantity of labor hired will increase, because marginal product of labor increases at each
input level OR D curve for labor shifts to the right
ii. Wages remain constant.

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Chapter 11: Externalities and the role of the government.

1.

a.
i) In the chemical industry at the unregulated level of output the marginal social cost of
production exceeds the marginal social benefit. With this negative externality there is a
misallocation of resources in the form of over production meaning the output level is
greater than the efficient level.
ii) Tax on output, or quantity restriction, or permits, or liability and lawsuit.
b.
i) National defence is a public good and individuals have the incentive to withhold their true
demand “free rider concept” the level of marginal benefit of national defence exceeds the
marginal cost of national defiance.
ii) Public production of national defence or tax to finance public production of national defence
or subsidy if there are private producers of national defence.

2.

a. “positive externality”, MSB is greater than MPB or the equilibrium quantity is less than he socially
optimal quantity.
b. the market equilibrium price is $6 and the market equilibrium quantity is 16 units.
c. the area of the deadweight loss is DEF.
d. $4 is the per unit subsidy.
e. i. 8 units.
ii. no because:
 The quantity exchanged in the market will be less than the socially optimal quantity.
 MSB is greater than MSC at a quantity of 8 units.
 Deadweight loss increased after the price floor.

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