UMGC – Landstuhl u. Rota+ Economics 203

Fall (ii) 2020 Exercise 6

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**Exercise Set 6 (25 points; 10 points individual, 10 points class bonus)**

**Last Name, First Name:**

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**Individual Score: (- = + /15**

**Class Score: + /10**

**Total Score: + /25**

- Question #1 Score = (- ) = + / 3.0

(Application of social welfare analysis to price floors)

In Week 2 we discussed the concept of a price floor. To jog your memory, a price floor is a minimum price that a governing body sets in order to prevent the price from falling to an unacceptable lower value. (We often see this use to sustain higher prices for agricultural goods so that farmers receive more for their produce than they otherwise would if the market were allowed to clear.) So now that you know something about consumer, producer, and social surplus, you can analyze the impact of a price floor on consumer welfare.

Consider below the market for homegrown tomatoes of a small, arid nation. The government, wishing to guarantee farmers a minimum tomato price, introduces a $6 price floor for tomatoes. That is, the market price cannot fall below $6. So now, consumers purchase 10000 tomatoes at the new price floor (price) of $6. Note that the original pre-floor market-clearing equilibrium price = $4; the original market-clearing quantity, 20000. (Remember: the area of a rectangle = (base) x (height); the area of a triangle,

½ * (base) * (height).) (3 points; 0.6 points per segment)

S

D

Quantity

- Calculate consumer surplus at the original market-clearing equilibrium of P = $4, Q = 20000. (-

**Answer: **

Calculate producer surplus at the original market-clearing equilibrium of P =$4; Q = 20000. (-

**Answer: **

Calculate the social surplus at the original market-clearing equilibrium of P = $4, Q = 20000. (-

**Answer: **

- Calculate the consumer surplus at the new price floor of $6. (Hint: this is the area of the triangle under the demand curve
**above**the price floor of $6.) (-

**Answer: **

- Calculate producer surplus at the new price floor of $6 (Hint: for Q = 10000, it’s all of the area above the supply curve and below P = $6. So you’ll have to calculate the area of a rectangle and a triangle.) (-

**Answer: **

- So what is the social surplus at the new price floor of $6? (-

**Answer: **

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(e) Compare your answer to (d) with your final answer to (a). Has social surplus increased or decreased? And how can we show this on the diagram above. So are price floors good policy? Why or why not? (-

**Answer: **

- Question #2 Score = (- ) = + /3.0

You’ll find below graphical representations of the three market structures we reviewed in class: perfect competition, monopoly and monopolistic competition. (You can determine, of course, which graph corresponds to each of these market structures.) (2 points; .4 points per segment)

**(A)**

MC

P P

AC

D =AR

MC

P

AC

D = AR = MR

q

For each of the conditions shown below, identify which of the three graphs shown above, (A), (B), and/or (C), apply. (More than one can apply, of course.) So your task is simply to write the letter of the graph that corresponds to each of the conditions outlined below. (3 points; .6 points per segment)

- Marginal Revenue = Marginal Cost (-

Answer:

- Price = Marginal Cost (-

Answer:

(c) Economic Profit > 0 (-

Answer:

(d) Price = Average Revenue (-

Answer:

(e) Price > Marginal Revenue (-

Answer:

- Question #3 Score = (- ) = + / 3.0

Consider differential mark-ups of firms with a great deal of market power (monopolies or quasi-monopolies, for our purposes) that face relatively elastic and relatively inelastic demand curves. For example, no doubt many of you have found pricing peculiarities as you’ve searched for competitive airline fares. To make this question more applicable, we’ll consider a real-world example.

First, consider the two diagrams below, **Graph A and Graph B**, which show the demand for air tickets to two different cities faced by a monopoly (or quasi monopoly). We assume that marginal costs (MC) are constant for both destinations, so that MC = AC. Given that the monopolist maximizes profits where MR = MC and sets a price corresponding to that profit-maximizing Q, the vertical distance between the demand (AR) curve and AC curve is simply the mark-up over average cost (AC) that the monopolist charges. (3 points; 0.75 points per segment)

**Graph A**

$

Mark-up = AR – AC

D = AR

MC = AC

MR Q

**Graph B **

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$

D=AR Mark-up = AR – AC

MC = AC

Q

MR

- Examining the two diagrams, what is the relationship between the monopolist’s mark-up and the elasticity of demand? Specifically, is the mark-up greater the relatively more elastic the demand? Or is the mark-up greater the relatively more inelastic the demand? (Note: We know that a monopolist chooses to produce only along the elastic segment of its demand curve. So here, you’re asked to consider simply the overall shape of the demand curve.) (-

Answer:

- Given that American Airlines (AA) uses Dallas as a hub and services almost 85% of the direct flights at convenient times from Washington, D.C.- to Dallas-Ft. Worth International Airport (DFW), which of the two demand curves shown in the graphs above would most likely represent AA’s demand curve for flights to DFW? (Simply identify the corresponding graph.) Why? (-

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- Given that direct (non-stop) flights at convenient times from Washington, D.C. to San Francisco (SFO), however, are available on a number of additional carriers (Jet Blue, United, Delta), which of the two demand curves shown above would most likely represent AA’s demand for flights into SFO? (Simply identify the corresponding graph.) (.3 points) Why? (-

Answer:

(d) In the winter of 2014 American Airlines was selling a round-trip Washington, D.C.-Dallas ticket for $772, and a round-trip Washington D.C.-San Francisco ticket for $322. That it in itself, of course, is odd, given that San Francisco is a five-plus hour flight and Dallas, a three-hour flight. What makes this price differential even more peculiar is that the San Francisco flight stops in Dallas. (No doubt many of you have encountered such anomalies before.)

Referring to your answers to (a) through (c) and to the two diagrams, provide a cogent explanation to your friends as to why this apparent AA Washington D.C.-DFW air-ticketing anomaly exists? (-

Answer:

- Question #4 Score = (- ) = + / 3.0

Consider the monopolist shown below. (Note that in this example, for simplicity, we’re assuming that AC is constant. So if average “anything” is constant, then marginal “anything” equals the average, as you learned in our Week 6 class. That is, MC = AC.) (3 points; 0.6 points per segment)

$

800

D = AR (equation for demand curve? P = 800 – ½ Q)

MC = AC = 200

200

600 1200 1600 Q

MR

(a) Identify the profit-maximizing quantity of output for this monopolist. (-

Answer:

(b) As given above, the monopolist’s demand curve in this example is

P = 800 – 1/ 2 Q

So what price will this monopolist charge? (Simply substitute the value of Q you found in (a) into the demand curve equation and compute P.) (-

Answer:

(c) At the **profit-maximizing level of output**, what is the value of consumer surplus, i.e., the triangle above the price you computed in (b) bounded by the demand curve? (Remember, the area of a triangle = ½ base * height.) (-

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(d) At the profit-maximizing level of output, what is the value of monopoly profits, which are the same as producer surplus in this example?

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(e) If this market were competitive, what would be the market equilibrium level of output? Why? (-

Answer:

- Question #5 Score = (- ) = + / 3.0

Prisoner’s dilemma applied to 2016 Republican Presidential Primary Election (3 points; 0.6 points per segment)

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** **For those who believe that microeconomics is conceptual and not as applicable to the “real world” as macroeconomics might be, you might find this exercise of interest.

The question so many asked before the general election of 2016 was how Mr. Trump defeated all the other more (politically) experienced candidates. One answer appeared in the **Investor’s Daily News**

Why, everyone in the political world wonders, have Jeb Bush, Marco Rubio, Ted Cruz and Chris Christie (until he dropped out) spent so much time beating up each other? Why aren’t they jointly trying to bring down this race’s 800-pound gorilla, Donald Trump?

(Moore, Stephen, Investor’s Daily (online), 17 Feb 2006)

The author, who, by the way, was one of President Trump’s nominees to the seven-member Federal Reserve Board, who later withdrew his nomination, then offers his answer, which I’m asking you to replicate. How? By examining the hypothetical payoff matrix of vote shares (percentages) below, where we assume a three-man race: John Kasich, Ted Cruz, and Donald Trump. (The numbers reflect the percentage of the vote earned in any given state primary election.)

The question at hand is whether Kasich and Cruz should attack Trump or not attack Trump in advertisements, debates, and so on. Each of the cells contains the expected payoff in terms of vote share. (3 points; 0.6 points per segment)

- Assume Kasich thinks Cruz will attack Trump, what is Kasich’s best strategy? (-

Answer:

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Now assume Kasich thinks Cruz will not attack Trump, what is Kasich’s best strategy? (-

Answer:

(b) Assume Cruz thinks Kasich will attack Trump, what is Cruz’s best strategy? (-

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Now assume Cruz thinks Kasich will not attack Trump, what is Cruz’s best strategy? (-

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(c) So does this game have a dominant-strategy equilibrium? If so, what is it? (-

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(d) So how does this explain why Trump was the Republican nominee? (-

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(e) The author concludes his article with “What a way to learn an economics lesson!” Why do you think he wrote that? (-

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Answer:

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__Cruz__

__Attacks Trump__ __Does not Attack Trump__

__Attacks Trump__ Kasich: = 29 Cruz = 29 Kasich = 22 Cruz = 30

Trump = 19 Trump = 25

__Kasich__

** Kasich = 30 Cruz = 22 Kasich = 25 Cruz = 25**

__Does not Attack Trump__** Trump = 25 Trump = 35**

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