SOME FOCUS QUESTIONS FOR PREPARATION FOR ECONOMICS 3010 EXAM 2

(CHS. 5 – 8)

1. Given the production function Y = 1.2 + 6L + 2.3K, for Y = output, L = labor,

and K = capital, derive the marginal products of both labor and capital and
indicate whether the properties of this production function indicate
constant returns to scale (constant costs), increasing returns to
scale(decreasing costs) or decreasing returns to scale(increasing costs),
and explain.

MP(L) = 6, AND MP(K) = 2.3, BY JUST TAKING THE DERIVATIVE OF THE

PRODUCTION FUNCTION WITH RESPECT TO LABOR,L, AND CAPITAL, K. ADD
UP THE OUTPUT ELASTICITIES( (∂y/∂L)(L/Y), AND (∂Y/∂K)(K/Y) , WHICH GIVES
(6L/Y + 2.3K/Y ) = ( 6L + 2.3K)/Y = (6L + 2.3K)/(1.2 + 6L + 2.3K) < 1 BECAUSE Y =
1.2 + 6L + 2.3K. SO WE HAVE DECREASING RETURNS TO SCALE (OR
INCREASING COSTS). ***ASK YOURSELF WHAT THE RETURNS TO SCALE
CONDITION WOULD BE IF Y = 6L + 2.3K ? IN SUCH CASE THE SUM OF THE
PRODUCTION ELASTICITIES GIVES (6L + 2.3K)/ Y = (6L + 2.3K)/ (6L + 2.3K) = 1 –
SO NOW WHAT? ONE HAS A PRODUCTION FUNCTION WITH TECHNOLOGY OF
THE CONSTANT RETURNS TO SCALE VARIETY (OR CONSTANT COST CASE)***

2. Montclair Satellite produces satellite services, Y1, and webhosting services,

Y2. The total cost function for Montclair is given by C = 450,000 – 2.6Y1Y2 +
0.3Y12 + 0.08Y22.
a) What are the fixed and variable cost components of this cost
function?
FIXED COMPONENT IS 450,000, AND VARIABLE COMPONENTS ARE -2.6Y1Y2 +
0.3Y12 + 0.08Y22

b) Does Montclair enjoy economies of scope and cost

complementarity? Why or why not?

ECONOMIES OF SCOPE SINCE 450,000 – 2.6Y1Y2 > 0 OR 450,000 >

-2.6Y1Y2 ------ COMPLEMENTARIITES SINCE MC(Y1) = -2.6Y2 + 0.6Y1.
AND MC(Y2) = -2.6Y1 + 0.16Y2 AND MC OF BOTH PRODUCTS ARE
GOING DOWN AS MORE OF THE OTHER PRODUCT IS PRODUCED
BECAUSE THE CHANGE IN MC(Y1) WITH RESPECT TO A CHANGE IN
Y2 = -2.6 < 0 SO MC IS DECLINING IN Y2, AND SIMILARLY FOR
CHANGE IN MC(Y2) WITH RESPECT TO A CHANGE IN Y1 BEING -2.6<
0.
 c) Derive the supply function for webhosting services.

USE THE WEBHOSTING MARGINAL COST, OR MC(Y2) = -2.6Y1 +

0.16Y2 = PY2, AND SOLVE Y2 = (PY2 + 2.6Y1 )/0.16 AS SUPPLY OF Y2,
SINCE SUPPLY DERIVES FROM PROFIT MAXIMIZATION OF
SETTING MC = MR.

3. CAN YOU GIVE AN EXPLANATION FOR WHY TOYOTA MANUFACTURES

ITS OWN ENGINES, BUT MASSEY FERGUSON LTD. (TRACTORS AND
EQUIPMENT) AND PACCAR CORPORATION (KENWORTH AND PETERBILT
TRUCKS) HAVE LONG TERM CONTRACTS WITH, RESPECTIVELY,
PERKINS DIESEL ENGINES, AND CUMMINS ENGINES FOR THEIR
ENGINES?

TOYOTA HAS VERTICALLY INTEGRATED INTO THE ENGINE

MANUFACTURING OPERATIONS SINCE IT IS CHEAPER TO
MANUFACTURE THEIR OWN ENGINES WITH MANY DIFFERENT
SPECIFICATIONS AND SPECIALIZED INVESTMENT COSTS. SUCH
VERTICAL INTEGRATION LOWERS THE TRANSACTIONS COSTS OF
COMPLEX CONTRACTING FOR OUTSOURCING ENGINES WITH
DIFFERENT SPECIFICATIONS.

MASSEY FERGUSON AND PACCAR APPARENTLY FIND THAT LONG

TERM CONTRACTS FOR ENGINES OF CERTAIN PRESET SPECIFICATIONS
IS CHEAPER TO ACQUIRE THE ENGINES THAN UNDER VERTICAL
INTEGRATION. THE LONG TERM CONTRACTS ALLOW THESE
COMPANIES TO CUT DOWN ON TRANSACTIONS COSTS THAT ARE
ASSOCIATED WITH RECONTRACTING, OR CONTRACTING ON A SHORT
TERM BASIS.

4. THE PRODUCTION FUNCTION FOR SHOES MANUFACTURED IN BRAZIL IS

GIVEN BY Q = L0.8K0.2 FOR Q = SHOE OUTPUT, L = LABOR, AND K=
OPERATING CAPITAL. a) DERIVE THE MARGINAL PRODUCTS OF LABOR
AND CAPITAL. b) ARE BRAZILIAN SHOES MANUFACTURED UNDER
INCREASING, DECREASING OR CONSTANT COST CONDITIONS? DERIVE
YOUR ANSWER. C) WHAT IS THE DERIVED WAGE RATE IN BRAZILIAN
REAL IF THE PRICE OF SHOES IS 20 REAL AND THE AVERAGE PRODUCT
OF LABOR, Q/L = 18 AND THE SHOES ARE SOLD IN PERFECTLY
COMPETITIVE MARKETS?
 a) THE MARGINAL PRODUCTS ARE EASY IN THIS CASE, SINCE ONE
TAKES THE DERIVATIVE OF OUTPUT, Q, WITH RESPECT TO
LABOR, L, TO GET 0.8L0.8-1K0.2 = 0.8Q/L = MARGINAL PRODUCT OF
LABOR, AND THEN THE DERIVATIVE OF Q WITH RESPECT TO
CAPITAL, K, TO GET (AGAIN BY REDUCTION) 0.2L0.8K0.2-1 = 0.2Q/K =
MARGINAL PRODUCT OF CAPITAL.

b) INCIDENTALLY, NOTICE THAT THE SHOES ARE PRODUCED UNDER

CONDITIONS OF CONSTANT COSTS (OR CONSTANT RETURNS TO
SCALE) SINCE THE SUM OF THE PRODUCTION ELASTICITIES ARE
0.8 + 0.2 = 1 .

c) THE DERIVED WAGE IS JUST THE VALUE OF THE MARGINAL

PRODUCT OF LABOR, SINCE WE KNOW FROM THE PROFIT
MAXIMIZATION CONDITIONS THAT PQ(MARGINAL PRODUCT OF
LABOR) = WAGE, FROM PROFIT MAXIMIZATION CONDITIONS.
THAT IS, MARGINAL REVENUE = MARGINAL COST AT PROFIT
MAXIMIZATION AND WHERE MARGINAL REVENUE = PQ = THE
PRICE OF Q (SHOES) = MARGINAL COST WHICH IS EQUAL TO W,
OR WAGE, DIVIDED BY THE MARGINAL PRODUCT OF LABOR, AS
W/(0.8Q/L) = MARGINAL COST. SO SOLVE FOR WAGE = PQ(0.8Q/L).
THE PRICE OF SHOES, PQ = 20 REAL, WHILE THE AVERAGE
PRODUCT OF LABOR, Q/L, IS 18. SO PUT THIS ALL TOGETHER TO
GET 20(0.8)(18) =288 REAL.

5. DEFINE WHAT IS MEANT BY A “SITE SPECIFIC INVESTMENT.”

A SITE SPECIFIC INVESTMENT IS CREATED WHEN A BUYER AND SELLER OF

AN INPUT MUST LOCATE THEIR PLANTS CLOSE TO EACH OTHER TO BE ABLE
TO ENGAGE IN EXCHANGE.

6. DEFINE THE HERFINDAHL-HIRSCHMAN INDEX (HHI) OF INDUSTRY

CONCENTRATION, AND THEN TELL US HOW THE ANTITRUST DIVISION
OF THE U.S. DEPARTMENT OF JUSTICE USE THIS INDEX TO DETERMINE
WHETHER THEY WOULD BLOCK OR ALLOW A MERGER AMONG FIRMS
IN A CONCENTRATED INDUSTRY.

HHI = 10,000 X (SUM OF THE SHARES OF EACH FIRM SQUARED)

IF THE HHI IS GREATER THAN 1800 EITHER PRIOR TO A MERGER OR AS
RESULT OF THE MERGER, THEN DOJ WILL EXAMINE THE MERGER AND
POSSIBLY BLOCK THE MERGER. ADDITIONALLY, IF THE MERGER INCREASES
THE HHI BY OVER 100, EVEN IF THE HHI IS LESS THAN 1800, THEN THERE IS
CLEAR EVIDENCE TO WARRANT INVESTIGATION AND POSSIBLE
DISALLOWANCE OF THE MERGER.

7. HOUSTON ACIDS, INC. OF THE CHEMICAL INDUSTRY HAS A MARGINAL

COST OF $200 AND CHARGES $700 FOR A KEG OF “NASTY ACID” WHICH
NEUTRALIZES THE LEAD IN LEAD PAINTS. DERIVE THE LERNER INDEX
FOR THIS FIRM IN ITS SALES OF ACID AND THE MARKUP FACTOR OF
“NASTY ACID.”

LERNER INDEX = (P – MC)/P = (700 -200)/700 = 500/700 = 0.7143

THE MARKUP FACTOR IS 1/(1 – L) = 1/(1 – 0.7143) = 3.5002, SO THE MARKUP IS

250% OR SO.

8. WHAT IS THE TRADEOFF AND DIFFERENCE IN REVENUE GENERATION

BETWEEN HAVING A PRODUCT WITH AN OWN-PRICE ELASTICITY OF
DEMAND OF -3.682 AND A PRODUCT WITH AN OWN-PRICE ELASTICITY
OF DEMAND OF -1.006? WHAT WOULD BE THE PRICING STRATEGY
ASSOCIATED WITH THESE TWO DEMAND ELASTICITY EFFECTS?

WITH AN ELASTICITY OF -3.682 A FIRM WOULD INCREASE REVENUES RATHER

DRAMATICALLY WITH A SLIGHT PRICE REDUCTION ( A SALE) SINCE QUANTITY
DEMANDED WOULD INCREASE MUCH GREATER THAN THE PRICE DECLINE.
THE MARKUP WITH SUCH AN ELASTICITY VALUE WOULD BE (E/(1+E)), WHERE
E = THE ELASTICITY OF DEMAND AT -3.682, AND THE VALUE OF THE MARKUP
WOULD BE (-13.682/(1-3.682) = 1.372 OR 37.2% MARKUP, SINCE MARKUP OVER
MARGINAL COST WOULD BE E/(1-E) FROM PRICE x (1 + E)/E = MARGINAL COST
YIELDING THE MARKUP OVER MARGINAL COST OF (E/(1-E)), SINCE E < 0.

THE MARKUP USING THE SAME CONCEPT BASED ON AN OWN-PRICE

ELASTICITY OF DEMAND OF -1.006 WOULD BE (E/(1-E) = -1.006/(1 – 1.006) =
167.67, OR ASTRONOMICAL. ONE WOULD THEN RELY ON AN EXTREMELY
HIGH MARKUP OVER MARGINAL COST FOR INCREASING REVENUES IN THIS
LATTER CASE.
9. WOULD YOU PROJECT THAT THE RESTAURANT SECTOR OF SALT LAKE
CITY IS A PERFECTLY COMPETITIVE MARKET, A MONOPOLY, OR A
SECTOR OF MONOPOLISTIC COMPETITORS? PROVIDE YOUR
EXPLANATION.

THERE IS PROBABLY REASONABLY FREE ENTRY INTO THE

RESTAURANT BUSINESS IN SALT LAKE CITY AND THE RESTAURANT
PRODUCTS, FOOD AND DRINK, ARE ENGAGED IN PRODUCT
DIFFERENTIATION SINCE THERE ARE SEVERAL STYLES AND CUISINE
TYPES IN THE RESTAURANT INDUSTRY IN SALT LAKE CITY. SO THE
RESTAURANT SECTOR IS PROBABLY MONOPOLITICALLY COMPETITIVE
AS A MARKET IN SALT LAKE CITY. THE MENUS ARE DIFFERENTIATED.

10. THE OWN-PRICE DEMAND ELASTICITY FOR THE FOOD MARKET IS -1.0,
WHILE THE FOOD FIRM OWN-PRICE ELASTICITY OF DEMAND RUNS
AROUND -3.8. SIMILARY, THE OWN-PRICE DEMAND ELASTICITY OF THE
CHEMICAL MARKET IS -1.5 AND AT THE CHEMICALS FIRM LEVEL, THE
OWN-PRICE DEMAND ELASTICITY IS -1.51. DERIVE THE ROTHSCHILD
INDEX FOR BOTH THE FOOD AND THE CHEMICAL SECTORS AND THEN
TELL US WHICH SECTOR COULD BE CLASSIFIED AS MONOPOLISTIC
AND WHICH COULD BE CLASSIFIED AS LESS MONOPOLISTIC AND
PERHAPS EVEN OPERATED SIMILAR TO A COMPETITIVE MARKET.

FOR FOOD, THE ROTHSCHILD INDEX IS -1/-3.8 = 0.26, WHILE FOR THE
CHEMICAL SECTOR, THE ROTHSCHILD INDEX IS -1.5/-1.51 = 0.993. SO
THE FOOD SECTOR MARKET IS CLOSER TO THE OPERATIONS OF A
COMPETITIVE MARKET, I.E., ROTHSCHILD INDEX BEING CLOSER TO
ZERO. BUT THE CHEMICAL SECTOR ROTHSCHILD INDEX IS VERY
CLOSE TO 1, AND SO WOULD BE CONSIDERED A MONOPOLISTIC
MARKET CONDITION.
 11. LOOK AT THE GRAPH BELOW AND DESIGNATE, MARK, OR LABEL THE
AREAS OF MONOPOLY PROFITS (LONG TERM PROFITS) AND THE
DEADWEIGHT LOSS OF MONOPOLY.

M o n o p o ly
MONOPOLY PROFITS = THE SHADED RECTANGLE – DEADWEIGHT LOSS
IS THE AREA ABOVE MARGINAL COST AND BETWEEN THE AMOUNT
SUPPLIED BY THE MONOPOLIST AND BELOW THE DEMAND CURVE AS
HERE MARKED.

12. DEFINE THE PROFITS AND AVERAGE PROFITS OF A MONOPOLIST.

THERE ARE A FEW DEFINITIONS OF MONOPOLY PROFITS, ONE BEING

PROFIT = (PRICE – AVERAGE TOTAL COST) X (MONOPOLIST OUTPUT
LEVEL), AND ANOTHER BEING (GROSS RECEIPTS) – (TOTAL COSTS),

$
AND STILL ANOTHER BEING (TOTAL REVENUE) – (TOTAL COST), WHERE
TOTAL REVENUE = (PRICE) X (QUANITY SUPPLIED BY THE MONOPOLIST)

AVERAGE PROFITS OF A MONOPOLIST ARE GIVEN BY (PRICE) – (TOTAL

COST/QUANTITY SUPPLIED) WHICH IS EQUAL TO (PRICE) – (AVERAGE
TOTAL COST)

PM
AT C
13. GRAPH AND LABEL THE PERFECTLY COMPETITIVE MARKET AND THE
DEMAND, MARGINAL COST AND AVERAGE COST FACED BY AN
INDIVIDUAL FIRM IN THIS TYPE OF MARKET.

MARGINAL COSTT

AVERAGE COST

14. DESCRIBE THE CONDITIONS, ENVIRONMENT, AND IMPLICATIONS OF A

FIRM OPERATING IN A MONOPOLISTICALLY COMPETITIVE MARKET
ENVIRONMENT.

UNDER MONOPOLISTIC COMPETITION THERE ARE SEVERAL BUYERS

AND SELLERS. THERE IS EASY ENTRY INTO THE MARKET BY OTHER
MONOPOLISTIC COMPETITIVE FIRMS SEEKING PROFIT. THEREFORE
THE INCUMBENT FIRM MUST CONSTANTLY DIFFERENTIATE ITS
PRODUCT TO MAINTAIN SHARE IN THE MARKET AS OTHER
COMPETITORS ENTER THE MARKET. SINCE THERE IS THE EXISTENCE
OF PRODUCT DIFFERENTIATION, THEN EACH FIRM IN SUCH A MARKET
HAS A DOWNWARD SLOPING DEMAND CURVE AND MARGINAL
REVENUE IS DIFFERENT THAN THE DEMAND CURVE AND ALSO SLOPED

$
DOWNWARD AND TO THE RIGHT. CUSTOMERS OF THESE FIRM TYPES
VIEW THE DIFFERENTIATED PRODUCTS OF EACH FIRM AS CLOSE

S
SUBSTITUTES AND THERE IS WILLINGNESS ON THE PART OF
CONSUMERS TO SUBSTITUTE PRODUCTS SUPPLIED BY
MONOPOLISTICALLY COMPETITIVE FIRMS.

LIKE MONOPOLY FIRMS, THE MONOPOLISTIC COMPETITOR HAS

MARKET POWER OVER THEIR PRODUCT OR BRAND OF SIMILAR
PRODUCT OF OTHER COMPETITORS AND SETS PRICE. THIS TYPE OF
COMPETITOR MAXIMIZES PROFIT BY SETTING MARGINAL COST EQUAL
 TO MARGINAL REVENUE, BUT THE PRICE THAT IS SET COMES FROM
THE DEMAND CURVE AND PRICE > MARGINAL COST JUST AS IS THE
CASE FOR THE MONOPOLY FIRM. THIS TYPE OF MONOPOLIST HAS
POWER OVER THEIR BRAND AND MUST CONTINUALLY DIFFERENTIATE
IN ORDER TO STAY COMPETITIVE AND THEREFORE HAS LIMITED
MARKET POWER COMPARED TO A SINGLE MONOPOLIST, WHO IS THE
SOLE FIRM IN THE MARKET.

15. DESCRIBE WHAT HAPPENS TO MARKET SHARE AND DEMAND-

MARGINAL REVENUE CONDITIONS IN A MONOPOLISTICALLY
COMPETITIVE MARKET IN THE SHORT RUN AND IN THE LONG RUN
STEADY STATE AS MORE FIRM ENTER THE MARKET. YOU CAN
DESCRIBE THIS GRAPHICALLY IF YOU LIKE.

Short
DESCRIBE WHAT
IS HAPPENING
HERE IN THE
SHORT RUN
MONOPOLISTICA
LLY
COMPETITIVE

DESCRIBE WHAT

Long
IS HAPPENING

$ HERE IN THE
LONG RUN
STEADY STATE
MONOPOLISTICA
LLY

16. WHAT ARE THE MAIN PROBLEMS WITH MONOPOLY AND

MONOPOLISTICALLY COMPETITIVE FIRMS AND MARKETS? CONTRAST
THESE ISSUES OR CONDITIONS WITH THE PERFECTLY COMPETITIVE

Long R
MARKET.

PRICE IS ADMINISTERED BY THE MONOPOLIST OR MONOPOLISTICALLY

COMPETITIVE FIRM AND PRICE > MARGINAL COST, WHEREAS THE
COMPETITIVE FIRM TAKES PRICE AS GIVEN AND PROFIT MAXIMIZATION(P = AC
$ PM
 IS WHERE MARGINAL COST = PRICE = MARGINAL REVENUE. CLAIMS
ON MONOPOLY PROFITS CONTINUE IN THE LONG RUN, WHEREAS IN
THE PERFECTLY COMPETIVE MARKET THE FIRM’S PROFITS DISIPATE IN
THE LONG RUN WHERE PRICE = MARGINAL COST = AVERAGE COST.
THERE ARE DEADWEIGHT LOSSES THAT OCCUR IN MONOPOLISTIC
MARKETS BUT AT EQUILIBRIUM IN THE COMPETITIVE MARKET
CONSUMER SURPLUS IS MAXIMIZED. THE MAIN PROBLEM THAT
GOVERNMENTS HAVE WITH MONOPOLISTIC MARKETS IS THE LACK OF
COMPETITION AND THE FACT THAT PRICE > MARGINAL COST.

17. EXPLAIN THE SO-CALLED “SHUT DOWN” DECISION ASSOCIATED WITH A

FIRM OPERATING IN A PERFECTLY COMPETITIVE MARKET.

A PROFIT-MAXIMIZING FIRM SHOULD CONTINUE TO OPERATE (SUSTAIN

SHORT-RUN LOSSES) IF ITS OPERATING LOSS IS LESS THAN ITS FIXED
COSTS.

A) OPERATING RESULTS IN A SMALLER LOSS THAN CEASING

OPERATIONS.

DECISION RULE:

B) A FIRM SHOULD SHUTDOWN WHEN P < MIN AVC.

CONTINUE OPERATING AS LONG AS P ≥ MIN AVC.