Micro Paper 3 Workbook

Welker’s Wikinomics
practice activities
1.1 Markets, Demand and Supply
Linear Demand and Supply functions

Introduction:
The following activity is designed to accompany the HL sections of the textbook
Pearson Baccalaureate’s Economics for the IB Diploma Chapters 2 and 3 sections 2.4, 2.7 and
3.2 and 3.4

Part 1 Linear Demand Equations:
a. Assume the demand for ski poles in a small town is represented in the table below:
Price Quantity
(dollars) Demanded
0 200
4 180
8 160
12 140
16 120
20 100
24 80
28 60
32 40
36 20
40 0

b. Using the information in the demand schedule above, derive the demand function for ski
poles, expressed as Qd=abP, where:
i. Qd is the quantity demanded
ii. ‘a’ is the quantity intercept, or the amount that is demanded at a price of zero
iii. ‘b’ is the price coefficient of demand, or the change in quantity demanded
resulting from a $1 change in price
iv. ‘P’ is the price of ski poles.

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c. Draw a graph showing the demand for ski poles on the axes provided below

d. Assume that due to an increase in the popularity of snowboarding, the demand for ski
poles decreases, and at each of the prices on the original demand schedule, the quantity
demanded is now 40 units lower than it was previously. Create a new demand schedule
representing the lower demand for ski poles.
Price Quantity
(dollars) demanded
0
4
8
12
16
20
24
28
32
36
40

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e. Derive a new demand function based on the information in the new demand schedule
above.

f. On the axes below, plot the original demand curve (from part ‘b’) and the new demand
curve (from part ‘e’).

g. Now assume that due to rising incomes, skiers in the small town become less
responsive to changes in the price of ski poles, therefore for every $1 change in price,
the quantity demanded changes by less than it did before. The new demand schedule is:
Price Quantity
(dollars) Demanded
0 200
4 184
8 168
12 152
16 136
20 120
24 104
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28 88
32 72
36 56
40 40

h. Derive a new demand function from the schedule above. Explain what has changed
about demand based on your new demand function.

i. On the axes below, plot the original demand curve (from part ‘b’) and the new demand
curve based on the function you derived in part ‘h’.

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Part 2 Linear Supply Equations:

a. Assume the supply of ski poles in a small town is represented by the table below:
Price Quantity
(dollars) supplied
0 100
4 60
8 20
12 20
16 60
20 100
24 140
28 180
32 220
36 260
40 300

b. Using the supply schedule above, derive a supply function for ski poles in the form,
Qs=c+dP, where:
i. Qs is the quantity supplied
ii. ‘c’ is the quantity intercept, or the quantity that would be supplied if the price were
zero
iii. ‘d’ is the price coefficient of supply, or the change in the quantity supplied
resulting from a $1 change in the price
iv. ‘P’ is the price of ski poles.

c. Draw a graph showing the supply of ski poles on the axes below:
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d. Now assume that there is a significant increase in the costs of production of ski poles
and the quantity supplied therefore decreases at each price by 30 units. Create a new
supply schedule demonstrating the impact of the higher production costs for ski poll
manufacturers:
Price Quantity
(dollars) supplied
0
4
8
12
16
20
24
28
32
36
40

e. Derive a new supply function based on the supply data in the table above.

f. Plot the original supply curve and the new supply curve on the axes below. Explain what
has happened to the supply of ski poles next to your graph:
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g. Now assume that due to and improvement in supplychain efficiency, ski poll producers
are able to be more responsive to changes in the demand for ski poles, therefore are
able to increase or decrease the quantity they supply more easily as the price changes.
The new supply schedule looks like this:
Price Quantity
(dollars) supplied
0 100
4 50
8 0
12 50
16 100
20 150
24 200
28 250
32 300
36 350
40 400

h. Derive a new supply function based on the new supply schedule for ski poles.
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i. Graph the supply curve based on the new function, along with the original supply curve
(from part ‘b’) on the axes below.

Part 3 Finding Equilibrium using Linear Supply and Demand Equations:
a. On the axes below, plot the original demand and the original supply for ski poles (using
the equations you derived in parts ‘b’ in the two sections above).
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b. Use the original demand and supply equations to calculate the equilibrium price and
quantity of ski poles.

c. Calculate the quantities supplied and demanded for ski poles at a price of $28. Explain
why market forces make a price of $28 unrealistic.

d. Calculate the quantities supplied and demanded for ski poles at a price of $12. Explain
why market forces make a price of $12 unrealistic.

e. Assume the demand for ski poles decreases as described in #1, d. At the lower level of
demand, calculate the quantity demanded at the original equilibrium price. How does this
compare to the quantity supplied at the original equilibrium price?
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f. Demand has fallen, but supply remains unchanged. Determine the new equilibrium price
and quantity of ski poles using the demand equation you derived in #1, d and the original
supply equation.

g. Illustrate the effect of the decrease in demand for ski poles on the axes below:

h. Assume that following the decrease in demand for ski poles, the supply also decreases
as described in #2, d. Once demand and supply both decreased, calculate the new
equilibrium price and quantity of ski poles.

i. Illustrate the effect of the decreased supply on the equilibrium price and quantity on the
axes below:

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j. Besides the factors that caused the demand and supply for ski poles to change
described in this lesson, identify three additional determinants of demand and three
determinants of supply that could affect the ‘a’ and ‘c’ variables in the demand and
supply equations

Determinants of demand for ski poles: Determinants of supply for ski poles:

Part 4 Consumer and Producer Surplus in a linear demand and supply model

a. Redraw the graph showing the original equilibrium price and quantity of ski poles (the
graph you drew for #3, a). Outline the areas representing the consumer and producer
surplus in the market at the equilibrium price and quantity.
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b. Calculate the amount of consumer surplus and the amount of producer surplus in the
total welfare
market for ski poles. Calculate the amount of in the market for ski poles at
the equilibrium price and quantity.

Consumer surplus = ½(bxh) Producer surplus = ½(bxh) Total welfare
= the sum of
of the triangle below the of the triangle above the producer and consumer
demand curve and above the supply curve and below the surplus.
equilibrium price. You must equilibrium price. To
first calculate the ‘pintercept’ determine the height of this
of demand. To do this set the triangle, subtract the
quantity to zero and ‘pintercept’ of supply from
determine what the price the equilibrium price.
would be at when Qd=0.

c. Assume the price of ski poles was $28. Draw the graph showing the effect on quantity
demanded and quantity supplied, and outline the areas representing consumer and
producer surplus at a price of $28.
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d. Calculate the amount of consumer surplus and the amount of producer surplus at a price
of $28 (assuming the number of ski poles sold is equal to the quantity demanded at
$28). Calculate the amount of total welfare in the market at $28.

Consumer surplus = the Producer surplus = the total Total welfare in the ski poll
total area below the demand area below the price and market:
curve and above the price. above the supply curve (only
out to the quantity actually
being sold in the market)

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e. Assume the price of ski poles was $12. Draw the graph showing the effect on quantity
demanded and quantity supplied, and outline the areas representing consumer and
producer surplus at a price of $12

f. Calculate the amount of consumer surplus and the amount of producer surplus at a price
of $12 (assuming the number of ski poles sold is equal to the quantity demanded at
$12). Calculate the total welfare at a price of $12.

Consumer surplus = the Producer surplus = the total Total welfare in the ski poll
total area below the demand area below the price and market:
curve and above the price. above the supply curve
(only out to the quantity
actually being sold in the
market)

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g. Based on the calculations of total welfare you made above, explain why both $28 and
$12 are considered inefficient
. (Refer to the concepts of marginal benefit and marginal
cost in your explanation):

$28 is inefficient because: $12 is inefficient because:

most efficient
h. Explain why the equilibrium price and quantity of ski poles is the price in
the market. (refer to the concepts of marginal benefit and marginal cost in your
explanation).

The equilibrium price is efficient because:

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1.2 Elasticities
Price Elasticity of Demand

Part 1
PED is a measure of the responsiveness of consumers to a change in the price of a
particular good. With data from a demand schedule, we can calculate the PED for a good
between any two prices. For example, below is a table representing the demand for ski poles in
Zurich during the month of December

Quantity
Price (dollars)
Demanded
0 200
4 180
8 160
12 140
16 120
20 100
24 80
28 60
32 40
36 20
40 0

1. State the formula for determining PED between two prices

2. By how much does the quantity of ski poles demanded decrease for every $1 increase in
price of ski poles? How did you determine this value?

3. Assume the price of ski poles increases from $4 to $5.
a. How many ski poles are demanded at $4?
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b. How many ski poles are demanded at $5?

c. By what percentage did the quantity demanded fall?

d. By what percentage does price rise when it goes from $4 to $5?

4. Calculate the PED for ski poles between when the price increases from $4 to $5.

5. Assume price of ski poles increases from $28 to $29.
a. How many ski poles are demanded at $28?

b. How many ski poles are demanded at $29?

c. By what percentage did the quantity demanded fall?

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d. By what percentage does price rise when it goes from $28 to $29?

6. Calculate the PED for ski poles when the price increases from $28 to $29.

7. How does the PED for ski poles at high prices compare to the PED for ski poles at low
prices? What accounts for this difference?

Part 2
The responsiveness of consumers to price changes depends on many factors, which
can be summarized with a useful acronym:
S
the number of substitutes a good has
P
the proportion of consumers’ income a good represents
L
whether the good is a luxury or a necessity
A
whether the good is addictive
T
the amount of time consumers have to respond to a price change.

With these determinants of PED in mind, answer the following questions:

8. Assume there are 20 different manufacturers of ski poles. Why would demand for a
particular manufacturers ski poles be far more elastic than demand for
ski poles in
general? Explain your answer clearly.

9. Assume SMITH manufacturers ski poles and that the number of competitors in the
industry has recently increased from 20 to 30.
a. How does the increase in competition affect consumers’ responsiveness to an
increase in the price of SMITH ski poles? Explain.
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b. What will happen to the equilibrium price and quantity of ski poles when the
number of manufacturers increases?

c. Based on your answer to (b), what should happen to the PED for ski poles in
general following the increase in the number of manufacturers in the industry?

10. Explain why skiers in Switzerland (a high income country) have a very different PED for
ski poles than consumers in India (a lower income country).

11. In some communities, skiing is a way of life. Why are consumers in these communities
less responsive to changes in the price of ski poles than those who live in communities
far from the mountains and only ski while on vacation?

12. Explain why the demand for goods like cigarettes and illegal drugs tends to be more
inelastic than demand for soft drinks or ice cream.

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Part 3 Practicing PED calculations: Using the simple equation for PED, answer each of the
following questions.

13. Assume the price of cigarettes increases by 50% due to a new law that raises the tax on
cigarettes.
a. In the short run, PED for cigarettes is 0.3. By what percentage will the quantity
demanded fall following a 50% increase in the price? Show your work.

b. In the longrun, PED for cigarettes is 0.8. By what percentage will the quantity
demanded fall in the longrun? Show your work.

c. Explain why PED for cigarettes is more elastic in the longrun than in the
shortrun.

14. Recently a drought caused a sharp decline in the corn harvest, reducing supply. The
price per bushel jumped from $40 to $70, while quantity fell from 12 million to 9 million
bushels.
a. Calculate the PED for corn

b. Is demand for corn elastic or inelastic between these prices? How do you know?

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c. Calculate the total amount spent on corn before the drought

d. Calculate the total amount spent on corn after the drought.

e. Overall were farmers hurt or helped by the drought? Explain?

15. Apples are currently selling for 3 CHF per kilogram and apple consumers are spending
1.5 million CHF per year. Lower taxes on imported apples push the price down to 2 CHF
per kilogram, and as a result total expenditures on apples falls to 1.2 million CHF.
a. How many apples were being bought prior to the decrease in import taxes?

b. How many apples are being bought after the decrease in import taxes?

c. Without solving for PED, determine whether demand for apples is inelastic, unit
elastic or elastic. How did you determine this?

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d. Now calculate the PED for apples using the prices given and the quantities you
determined in parts a) and b). Does your calculation support your answer to part
c)?

Part 4 PED and Linear Demand Equations IB Higher Level only

16. The weekly demand for airplane tickets between Zurich and London is represented by
the equation Qd = 2000 5P. The price of tickets recently increased from $200 to $250.
a. Calculate the original quantity demanded (at $200)

b. Calculate the new quantity demanded (at $250)

c. Calculate the PED for tickets from Zurich to London between $200 and $250

d. Describe the PED for plane tickets when the price rises from $200 to $250 and
explain how airlines revenues are likely affected by the price increase.

e. What is the PED for plane tickets if the price rises again from $250 to $300?

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f. Why does the PED change when the price of plane tickets rises?

17. Assume the demand for plane tickets changes to Qd = 2000 4P
a. Calculate the PED for plane tickets when the price rises from $200 to $250.

b. How does this value compare to the PED you calculated in 15(c)?

c. What is the relationship between the ‘b’ variable in the demand equation and
PED?

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1.3 Government Intervention
Calculating the Effects of Indirect Taxes

Introduction:
Assume the market for petrol is represented by the demand and supply equations
below (quantity is in litres, price is in dollars):

Qd = 10 0.4P Qs = 2+2P

1. Calculate the equilibrium price and quantity of petrol.

2. On the graph below, illustrate the market for petrol in equilibrium assuming no
government intervention.

3. Assume the government places a $3 tax on each litre of petrol bought and sold.
Determine the new supply equation for petrol.

4. On the graph below, show the effect of the $3 tax on petrol.
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5. Calculate the new equilibrium price consumers will pay for petrol.

6. Calculate the new price producers will get to keep after paying the $3 tax to the
government.

7. Calculate the new equilibrium quantity of petrol sold following the $3 tax.

8. On the graph you drew for #11, shade the area of consumer tax burden one color and
the area of producer tax burden another color. Explain what these areas represent.

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9. Who appears to bear the greater burden of the petrol tax, producers or consumers? Why
do you think this is the case?

10. Calculate the following:
a. The amount of tax paid by petrol consumers:

b. The amount of tax paid by petrol producers:

c. The total tax revenue generated by the petrol tax:

11. Why are petrol taxes so widely used in Europe as an important source of tax revenue for
governments?

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Unit 1.3 Government Intervention
Calculating the effects of price controls (HL Only)

Introduction: Assume the following equations represent the supply and demand for rice (in
rupees)
millions of kilograms) in India in relation to the price per kilogram (in Indian :

Qd = 80 10P Qs = 20 + 10P

1. Calculate the equilibrium price and quantity of rice in India.

2. On the graph below, illustrate the Indian rice market in equilibrium.

3. Assume that the government, in order to promote stable food price, places a price
ceiling in the rice market at 6 rupees per kg and a
price floor at 4 rupees per kg. Add
dotted lines on the graph you drew in #2 at these two prices. Explain whether these price
controls are effective or ineffective at the current equilibrium price.

4. Assume that due to a particularly fertile growing season, the supply of rice in India
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increases to Qs = 10 + 20P . The demand remains at
Qd = 80 10P
. Illustrate the effect
of this increase in supply on the market for rice.

5. Calculate the new equilibrium price and quantity for rice following the increase in supply.

6. Explain the effect of the government’s price controls on the market for rice following the
increase in supply. Calculate the amount of excess supply created by the 4 rupee price
floor.

7. Assuming the government takes no action to enforce the minimum price of 4 rupees,
how will the free market likely resolve the disequilibrium that exists in the rice market due
to the price floor?

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8. Next, assume that the Indian government decides to intervene in the rice market to make
sure the price remains at the desired level of 4 rupees. How much would it cost the
government (and therefore taxpayers) to buy the surplus rice at the desired price of 4
rupees per kilogram?

9. Assume that during the following growing season, severe droughts cause the supply of
rice to fall to
Qs = 25 + 5P
. Demand remains at
Qd = 80 10P
. Illustrate the effects of
this decrease in supply on the graph below.

10. Calculate the new equilibrium price and quantity of rice following the decrease in supply.

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11. Explain the effect of the government’s price controls on the market for rice following the
decrease in supply. Calculate the amount of excess demand created by the 6 rupee
price ceiling.

12. Assuming the government takes no action to enforce the maximum price of 6 rupees,
how will the free market likely resolve the disequilibrium that exists in the rice market due
to the price ceiling?

13. Next, assume the Indian government decides to intervene in the rice market to maintain
the desired maximum price of 6 rupees. How much rice would the government have to
release into the market to push the equilibrium price down to within the desired price
range.

14. Who benefits from maximum price controls in the markets for goods such as rice? Who
suffers?

15. Who benefits from minimum price controls? Who suffers?

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16. What are some disadvantages of price controls schemes such as that described in
India’s rice market?

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1.5 Theory of the Firm
Costs of Production

1. Assume that the firm below experiences increasing marginal returns until it produces its
third unit of output, then experiences diminishing marginal returns. Draw the firm’s MC,
AVC and ATC curves assuming...
○ the MC and the AVC of the first unit of output is $5
○ the MC is minimized at $3
○ the total fixed cost is $4
○ the firm’s ATC is minimized at $5.80 at a quantity of 5 units.

2. Briefly explain the relationships between:
a. The MC curve and the average cost curves

b. AVC and ATC:
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3. Assume rent increases, increasing the firm’s fixed costs to $6. Show and explain the
effect the higher fixed cost would have on the firm’s shortrun cost curves.

Explain:

4. Now assume the wages the firm had to pay its workers decreases.
Show the effect of
the lower wage rate on the firm’s costs of production.
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Explain:

5. Assume the government levies a per unit tax
of $2 on the firm’s output. Show and
per unit
explain the effect a tax levied by the government will have on the firm’s shortrun
cost curves.
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Explain:

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6. Next assume the government eliminates a $1 lump sum tax on the firm. A lump sum tax
is a fixed amount paid by the firm to the government regardless of its level of output.
Show and explain how the reduction of such a tax would affect the firm’s shortrun costs
of production.

Explain:

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7. Assume this firm sells its product in a perfectly competitive market and is just one of a
thousand firms selling a homogeneous product, and the equilibrium price of its product is
$7 and equilibrium quantity of 6,000 units. In the graph on the left, illustrate the market
equilibrium price and output level. In the graph on the right, illustrate the individual firm’s
demand and marginal revenue curve based on the market equilibrium. (you must change
the labels in the graph on the left to “P” instead of “C” and “Q in thousands” instead of
“Q”)

8. Explain the relationship between the price in the market and the Demand and Marginal
Revenue experienced by the individual firm:

9. On the graph you drew in #7, identify the quantity of output the firm will wish to produce
to maximize its economic profits. (Profit maximization occurs when a firm produces
where its marginal cost equals the marginal revenue).

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10. Identify the firm’s average total cost at the profit maximizing level of output, and shade
the area on the graph representing the firm’s economic profits or losses.

11. Knowing that perfectly competitive markets have very low barriers to entry and exit, and
all firms
that the firm in your graph represents in this particular market, explain what will
happen to the number of firms in the longrun given the existence of the economic profits
or losses you identified on your graph.

12. Show in the graph on the left (below) the changes that will occur in the longrun
described in your answer to #12. In the graph on the right, show how these changes
affect the typical firm in the market.

13. Explain why firms in perfectly competitive markets are only able to earn a normal profit in
the longrun.

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From shortrun productivity to shortrun costs

Introduction: A factory that manufactures bicycle wheels can produce between 0 and 800
wheels per day, depending on how many workers it hires. The factory already owns three wheel
building robots (which must be operated by workers) and must pay a wage rate of $10 per day
to the workers it hires. Assume that the number of machines the factory owns and the size of
the factory are fixed. Only the number of workers is variable.

The production table below shows the number of workers needed to produce 0 to 800 wheels
per day.

Task: Calculate the following for the firm as it increases its production from 0 to 800 wheels. Fill
in the blank boxes in the table below.

● Total Variable Cost (TVC) : This is the total cost of the variable resource (in this case,
labor). T V C = # of workers × wage rate
● Marginal Product (MP): This is the average output of each of the additional workers
△Q of output
hired as the firm increases its output. M P = △# of workers
● Marginal Cost (MC): This is the average cost of each additional unit of output as the
△TV C
firm increases its output. M C = △Q of output
Q of output
● Average Product (AP):
This is the output per worker. AV C = # of workers
● Average Variable Cost (AVC):
This is the labor cost per unit of output. AV C = TV C
Q of output

Q (output) # of workers TVC MP MC AP AVC
0 0 0
100 6
200 10
300 13
400 17
500 23
600 32
700 44
800 62
Graph: On the graph below, plot the firm’s
Marginal and Average Variable Costs (MC and AVC)
Marginal and Average Products (MP and AP).
and its Notice the dual vertical axis. The ‘C’
values represent the firm’s costs and the ‘P’ values represent productivity.
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Questions:
1. Why does the number of workers needed to produce each additional hundred units
change as output increases?

marginal returns
2. Over what range of output do the of labor increase? Explain why this
happens.

3. Beyond what level of output does the firm begin experiencing
diminishing marginal
returns
? Explain why this happens.
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4. Describe and explain the relationship between marginal product and marginal cost in
your graph.

5. Describe and explain the relationship between average product and average variable
cost in your graph.

6. Describe and explain the relationship between MC and AVC.

7. Are the costs in this graph the firm’s r its
shortrun costs o Explain.
longrun costs?

8. At what level of output is this firm’s average variable costs minimized (at its lowest)?

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9. Besides the wages firms pay their workers, what other costs do firms face?

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10. Assume this firm paid $200 for its machinery and factory space (this is the firm’s
Total
Fixed Cost) . Calculate the firm’s t each level of output.
Average Fixed Cost (AFC) a
Total Fixed Cost
AF C = Q of output

AVC
Q of output AFC (from table ATC
above)
0
100
200
300
400
500
600
700
800

Total Costs (TC)
11. A firm’s is the sum of its Variable Costs and its Fixed Costs. You have
determined the wheel factory’s Average Variable Costs Average Fixed Costs.
and its To
Average Total Costs
find the firm’s (which is the product’s per unit cost), simply add the
AVC and the AFC at each level of output. Calculate the ATC at each level of output and
add it to the table above.

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12. You have now determined all of this firm’s shortrun production costs, including its
Marginal Cost, Average Variable Cost, Average Fixed Cost and Average Total Cost. In
the graph below, draw these four shortrun cost curves together.

13. If you have done all your calculations and drawn your graph correctly, then you have
Shortrun Costs of Production.
now completed your first graph of a firm’s Explain one
Law of Diminishing Returns
last time the importance of the in determining a firm’s
shortrun production costs.

14. What other information, besides its production costs, would a firm need to know before
determining the best level of output.

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Unit 1.5. Theory of the Firm
Perfect Competition

1. On the axes below, draw graphs for a perfectly competitive market for apples and an
individual farmer in that market. Assume the market is producing at its longrun
equilibrium level of output. Explain the situation experience by the individual farmer when
the market is in its longrun equilibrium.

Explain:

2. The price of pears, a close substitute for apples, rises. Illustrate and explain the
shortrun effect of higher pear prices on the market for apples and for a typical apple
farmer.
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Explain:

3. How will the apple market adjust to the higher prices of pears in the longrun? Show and
explain the effect on the market for apples and on an individual apple farmer in the
longrun.

Explain:

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4. A new technology which increases the productivity with which apples can be harvested
is adopted widely across the farming sector. Show and explain the effect this new
technology has on an individual apple farmer and in the apple market in the longrun.

Explain:

5. Tariffs on imported tropical fruits are removed, reducing their prices. Show and explain
the effect that a fall in tropical fruit prices will have on the market for apples and the
typical apple farmer in the shortrun.

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Explain:

6. Show and explain the effect that lower tropical fruit prices will have on the market for
apples and apple farmers in the longrun.

Explain:

7. The state government in California, where only 5% of America’s apples are grown,
imposes a very large perunit tax on apple growers. Assume this increases the growers’
average variable costs (AVC) above the equilibrium price. Show the effect the state tax
will have on a typical California apple farmer in the shortrun.
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Explain:

8. How will California growers respond to the state apple tax you illustrated in #7 in the
longrun?

9. Explain whether the apple market was achieving allocative efficiency and productive
efficiency in the scenarios you illustrated in each of the following questions from this
activity:
a. Question 2:
i. Allocative efficiency?

ii. Productive efficiency?

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b. Question 5:


c. Question 1:


10. Explain why producers in perfectly competitive markets are likely to earn only a normal
level of profit in the longrun.

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Monopoly Graphing Challenge

Instructions: Sketch a graph for a monopolist illustrating each of the following scenarios.

1. Maximizing its profits
2. Minimizing its losses (but still operating). Identify two factors that could turn a
profitearning monopolist into a lossminimizing monopolist.
3. Minimizing its losses (but about to shut down)
4. Maximizing its revenues
5. Not maximizing its profits and producing in the elastic range of its demand curve.
6. Not maximizing its profits and producing in the inelastic range of its demand curve.
Explain why this firm could do better by raising its price.
7. Producing at the profitmaximizing quantity but just breaking even.
8. A natural monopoly producing at its profitmaximizing quantity and price. Give an
example of a natural monopoly that produces an essential good and explain why such
an outcome would be harmful to society as a whole.
9. A regulated natural monopoly producing at the fair return
price and quantity. What kind
of government regulation would achieve this?
10. A regulated natural monopoly producing at the socially optimal price and quantity. What
kind of regulation(s) would achieve this?

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Unit 1.5 Theory of the Firm
Price Discrimination and Natural Monopoly

Part 1 Natural Monopoly:
1. On the graph to the left below, illustrate a singlprice, profitmaximizing monopoly
earning economic profits. On the graph to the right, illustrate a natural monopoly,
producing at its profit maximizing level and earning economic profits

a. What is the difference between a regular monopolistic firm and a natural
monopoly?

b. Give an example of an industry that tends to be naturally monopolistic. Explain.

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2. Redraw the graph for the natural monopoly below.

a. Assume the government wished to regulate the natural monopoly to assure that it
charged no higher than the price at which society’s marginal benefit equaled the
firm’s marginal cost. Draw a horizontal line at this price on your graph above.

i. Explain why this price would be considered “socially optimal”?

ii. Shade the area on the graph above representing the natural monopolist’s
economic profits or losses when forced to charge the socially optimal
price by the government.

iii. How will the imposition of the price ceiling affect the firm in the longrun?

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iv. Is a price ceiling at the socially optimal price an effective means of
regulating a natural monopolist? Why or why not?

b. Next assume that the government chose to impose a price ceiling which required
the firm to sell its output at a price no higher than its average total cost (where
demand = ATC). Redraw the natural monopoly graph below and indicate the
new price ceiling.

i. How does the new price ceiling affect the firm’s economic profits or
losses?

ii. How does the firm’s level of output under this new price ceiling compare
to the level of output it would produce if left unregulated?

iii. How does the firm’s level of output under this new price ceiling compare
to the socially optimal level of output?
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iv. Is a price ceiling set at the firm’s ATC effective at achieving a socially
optimal level of output of the natural monopolists’ product? Why or why
not?

c. If the government wishes to promote a socially optimal level of output by a
natural monopolist producing a necessary good (such as water, electricity,
natural gas, garbage collection or sewage treatment), should it tax the firm or
subsidize the firm? Explain your answer.

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Part 2 Price Discrimination:
3. Define price discrimination and give three examples of firms practicing price
discrimination that you have witnessed personally:

a. Definition:

b. Example 1:

c. Example 2:

d. Example 3:

4. Briefly identify the three conditions that must be met in order for a firm to price
discriminate

a. Condition 1:

b. Condition 2:

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c. Condition 3:

5. Briefly describe the three degrees of price discrimination and provide one example of a
firm practicing each type:

a. Third degree:

b. Second degree:

c. First degree:

6. On the graph to the left below, illustrate a singleprice, profitmaximizing monopoly
earning economic profits. On the graph on the right, illustrate a perfectly price
discriminating monopolist.
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a. Describe the relationship between Marginal Revenue and Price for:

i. The singleprice monopolist:

ii. The perfectlyprice discriminating monopolist:

b. Explain how the ability to price discriminate affects each of the following:
i. The monopolist’s level of economic profits:

ii. The amount of consumer surplus in the market:

iii. The level of output in the market:
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iv. The amount of total welfare in the market:

v. Allocative efficiency in the market:

7. Which degrees of price discrimination are most common? Why?

8. Who are the winners and losers from price discrimination?

a. Winners:

b. Losers:

practice activities
Unit 1.5 Theory of the Firm
Pure Monopoly

1. Assume that Welcorp is a purely monopolistic publisher of Economics textbooks. All
econ texts available are published by the firm. The table below shows the quantity of
textbooks the firm expects to sell at a range of prices. Calculate Total Revenue (P*Q)
and Marginal Revenue at each level of output, filling in the blank boxes in the table.

Price Quantity Total Marginal
(in Revenue Revenue
thousands of (in ( ΔT R
ΔQ )
textbooks) thousands of
dollars)
100 1
90 2
80 3
70 4
60 5
50 6
40 7
30 8
20 9
10 10

a. Derive a demand equation for Welcorp’s Economics textbooks. (video lesson on
deriving demand equations from data
can be viewed here
)

b. Explain the relationship between the price of textbooks and Welcorp’s marginal
revenue at different levels of output.

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2. Welcorp’s shortrun costs of production are shown on the table below. Calculate and fill
in the boxes for the firm’s total cost (TC), marginal cost (MC) and average total cost
(ATC).

Quantity (in Total Variable Total Fixed Total Cost (in Marginal Cost Average Total
thousands) Cost Cost thousands of ( ΔT C
ΔQ) ) Cost
(in thousands (in thousands dollars) ( TQC )
of dollars) of dollars) (TVC+TFC)
1 40 40
2 70 40
3 100 40
4 140 40
5 190 40
6 250 40
7 320 40
8 400 40
9 490 40
10 590 40

3. Plot Welcorp’s Demand and Marginal Revenue curves, and its Marginal Cost and
Average Total Cost curves on the graph below:

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a. Identify Welcorp’s profit maximizing quantity and price on the graph above.
Explain how you determined this quantity and price.

b. Shade the area representing the firm’s economic profit or loss. Indicate whether
Welcorp is earning profits, losses or breaking even.

c. Calculate the firm’s economic profit or loss (show your calculation):

4. What will happen to Welcorp’s profits or losses in the longrun, assuming demand for
Economics textbooks remains constant? Explain.

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5. Now assume that a new firm, Maley Inc, begins publishing Economics textbooks. The
new competition causes demand for Welcorp’s texts falls by 2,000 books at every price.
Assume Welcorp’s costs remain unchanged. Create a new demand schedule for
Welcorp, and calculate the firm’s total and marginal revenues:
Price Quantity Total Marginal
(in Revenue Revenue
thousands of (in ( ΔT R
ΔQ )
textbooks) thousands of
dollars)
100
90
80
70
60
50
40
30
20
10

6. Plot Welcorp’s new Demand and Marginal Revenue curves, and its Marginal Cost and
Average Total Cost curves on the graph below:

practice activities
a. Identify Welcorp’s new profit maximizing quantity and price on the graph above.
How did they change compared to the firm’s original quantity and price?

b. Shade the area representing the firm’s new level of economic profit or loss.
Indicate whether the firm is earning profits, losses or breaking even.

c. Calculate the firm’s new economic profit or loss (show your calculation):

practice activities

7. Assume that Maley Inc is forced to shut down due to a corruption scandal involving its
CEO. Demand returns to its original level for Welcorp’s textbooks. In addition, Welcorp
has acquired new printing technology that reduces its total costs (including its fixed
costs) by half at every level of output. Create a new cost table for Welcorp reflecting the
firm’s new total, marginal and average total costs.

Quantity Total Cost Marginal Cost Average Total
(in (in ( ΔT C
ΔQ) ) Cost
thousands of thousands of ( TQC )
textbooks) dollars)
1
2
3
4
5
6
7
8
9
10

8. Plot Welcorp’s Demand and Marginal Revenue curves, along with its new Marginal Cost
and Average Total Cost curves on the graph below:
practice activities

a. Identify Welcorp’s new profit maximizing quantity and price on the graph above.
How did they change compared to the firm’s original quantity and price?

b. Shade the area representing the firm’s new level of economic profit or loss.
Indicate whether the firm is earning profits, losses or breaking even.

c. Calculate the firm’s new economic profit or loss (show your calculation):

9. Using the graph you drew for number 8, explain whether or not the market for
Economics textbooks is allocatively efficient.
practice activities

10. Using the graph you drew for number 10, explain whether or not Welcorp, the
monopolistic textbook publisher, is achieving productive efficiency.

11. A new application comes out which allows anyone to publish their own digital, etextbook
and to sell it in an online market for $15 or less. The large profits earned by Welco lead
hundreds of profitseeking Economics teachers to write their own etexts and to put them
for sale in the online market. On the graph below, show the effect of the entrance of
hundreds of new textbook authors into the market on the demand, marginal revenue,
and economic profits earned by Welcorp. Assume the equilibrium price in the market for
textbooks falls to $15 but the firm’s costs remain constant.

practice activities
12. At the equilibrium price of $15, will Welcorp be earning economic profits, losses, or
breaking even? Explain.

13. How will the entrance of new Economics textbooks into the market affect Welcorp in the
longrun assuming its costs of production remain constant?

14. How will the entrance of new Economics textbooks into the market affect:

a. allocative efficiency in the market for Economics texts?

b. productive efficiency among the publishers of Economics texts?

c. “Perfect competition is always a more desirable market structure than monopoly”
Provide three arguments for this claim and three arguments against this claim.

Arguments for:
d. #1:

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e. #2:

f. #3:

Arguments against:
a. #1:

b. #2:

c. #3:

practice activities
Unit 1.5 Teory of the Firm
Oligopoly, Kinked Demand and Payoff Matrixes

Part 1:
There are two rental car agencies in Zurich Switzerland, Ihr Auto Mein Auto.
and Both
firms have rental offices outside of the baggage claim area at the Zurich Airport. The firms do
not currently pay for advertisements in the terminal building. Both firms are currently renting out
50 cars per day at a rate of 60 Swiss francs. The managers are trying to determine if they
should raise, lower or keep the price at the current level.

Ihr Auto knows that any change in price for its rental cars will prompt a response from Mein
Auto. With this assumption in mind, Ihr Auto predicts that...
● if it lowers its price to 50 chf per day, the new quantity demanded will be 52 cars per day.
● if it raises its price to 70 chf per day, the new quantity demanded will be just 20 cars per
day.

1. Draw a graph showing the demand and marginal revenue curves for Ihr Auto
. Start with
a point at the current price and quantity and then add points for the two additioanl
price/quantity combinations described above.

practice activities

a. Calculate the price elasticities of demand for Ihr Auto’s rental cars when…
i. The firm lowers its price from 60 to 50 chf.

ii. The firm raises its price from 60 to 70 chf.

b. Explain why the PED for Ihr Auto’s
cars differs depending on whether the firm
raises or lowers its price.

c. Calculate the firm’s total revenues at…
i. 60 chf

ii. 50 chf

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iii. 70 chf

d. Explain the changes in Ihr Auto’s total revenues when it raises or lowers its price
from the current level of 60 chf.

e. Based on your analysis above, explain why neither firm is likely to change its
price from the current equilibrium of 60 chf per day.

2. Add a marginal cost curve to the graph above which intersects the marginal revenue
curve below the current equilibrium price of 60 chf and above the current quantity of 50
cars per day.
a. Assume the local government passes a new minimum wage that increases the
labor costs both firms must pay their workers. Show the effect of an increase in
minimum wages on Ihr Auto’s
marginal cost curve.
practice activities

b. Why is a change in marginal costs in a noncollusive oligopolistic industry less
likely to lead to an change in price and quantity than it would in a more
competitive industry?

c. Explain why the prices in noncollusive oligopolistic markets tend to be “sticky”
over time and rarely are increased or decreased.

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d. Explain why firms in oligopolistic markets choose to compete on nonprice
features such as product quality, customer service, location and other factors
rather than competing on prices.

3. The CEOs of Ihr Auto Mein Auto
and have recently held several meetings to discuss a
merger. Using the diagram below, show how a merger between the two firms would
affect the demand for the companies’ rental cars, the price charged, the quantity of cars
demanded and the firms’ economic profits.

a. Why might the government intervene to prevent the proposed merger?

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b. Would the proposed merger increase or decrease allocative efficiency in the
rental car market? Explain.

Part 2: Neither Ihr Auto
nor Mein Auto currently pay for advertisements in the terminal building,
but both firms are considering whether or not to pay for billboards to be installed in the terminal.

Assume the following:
● At present, each firm captures 50% of the business from people arriving at the Zurich
Airport, and since they are not paying for advertising, the firms enjoy a relatively high
level of economic profits (1,000 Swiss francs per day)
● Ihr Auto has determined that if it installs billboards in the terminal building, it will enjoy a
40% increase in its economic profits, since it will capture much of the business that
currently goes to Mein Auto .
● Ihr Auto has also determined that if it does not
install billboards, and its competitor does,
its own profits will fall by 50%.
● Finally, Ihr Auto has calculated that if both it and Mein Auto install billboards, neither
firm’s market share will increase, but the high advertising costs will cause profits to fall
by 25%.

4. Use the information above to fill in the payoff matrix provided below.

a. Based on the payoffs you’ve included in your matrix, determine which strategy
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advertise
would maximize the two car rental agencies’ total economic profits: or
don’t advertise
. Explain

b. Assume that neither firm is currently advertising. What strategy should
Ihr Auto
pursue to maximize its total profits? Explain.

Ihr Auto
c. Assume that Mein Auto
expects to begin an advertising campaign next
month. What should Ihr Auto
do in anticipation of this move by its competitor?
Explain.

d. Define Ihr Auto
“dominant strategy”1. Does have a dominant strategy? Does
Mein
Auto have a dominant strategy

1
http://www.gametheory.net/dictionary/DominantStrategy.html

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“Nash Equilibrium”2. Is there a Nash Equilibrium in the advertising game
e. Define
that you’ve created above? If so, what is it?

f. Calculate the total economic profits that the two firms are most likely to earn
based on your analysis of the game above assuming the firms do NOT collude
with one another.

g. What would the two firms choose to do if they were able to collude with one
another? Advertise or not advertise? Explain.

h. Why is the utcome an unstable equilibrium in the rental car market?
collusive o

2
http://www.gametheory.net/dictionary/NashEquilibrium.html

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