The following 16 questions cover some of the material that is relevant for the third exam.
The exact questions given below will not be on the exam. Questions that are similar to (at least) some of them will be. Understanding the answers to these questions will therefore help you prepare for the exam.
Answers and explanations for all 16 questions are found at the bottom of this page. The link after each question takes you to the relevant answer. Please note that while checking the answer to question 3 (for example), you may also be able to see the answer to question 4. If you prefer not to see an answer before you've read the corresponding question, you may wish to look over all the questions before checking any answers.
Please note that studying for the third exam should entail more than merely reviewing this page. The exam itself has 17 questions, and while these sample questions cover some of what we've done in class, there will certainly be topics appearing on the exam that do not appear in these example questions. Make sure to also study your class notes and the homework questions, and read the material on the (web-page) outside reading list.
If you want to print out the questions on this page, but not the lengthy answers, here's a questions-only version.
Question 1 answer is: a. equals its marginal cost ; exceeds its total cost by the largest possible amount
Explanation: This question shows the importance of understanding the difference between the meanings of marginal revenue and marginal cost and the meanings of total revenue and total cost.
Total revenue and total cost tell us how much, in total, the firm has received from selling a certain number of units of its product, and how much, in total, it cost to produce that number of units. Since profit equals total revenue minus total cost, a firm makes the largest profit it can possibly earn by selling the number of units for which total revenue exceeds total cost by the largest amount.
Marginal revenue and marginal cost tell us how total revenue and total cost change as a result of a change in the number of unit. More precisely, marginal revenue describes how total revenue changes when one more unit is sold, and marginal cost describes how total cost changes when one more unit is produced.
Because of the way profit is defined, saying that (producing and) selling one more unit increases a firm's profit is equivalent to saying that selling that unit increases the firm's total revenue by more than it increases its total cost.
Or, merely rephrasing the above, saying that selling one more unit increases a firm's profit is also equivalent to saying that selling that unit produces a marginal revenue that is larger than the marginal cost of producing it. Note that profit rises whenever MR exceeds MC, even if the difference between the two is only $1 (or 1 cent).
Furthermore, note that if a firm wants to maximize its profit, it should take advantage of any opportunity to sell a unit for which MR exceeds MC. Here's an example. Suppose the MR of unit 3 is $10 and the MR of unit 4 is $8, while the MC of unit 3 is $6 and the MC of unit 4 is $7. Selling the 3rd unit increases the firm's profit (since MR exceeds MC), and selling the 4th unit also increases the firm's profit (since MR exceeds MC). The rise is profit is bigger for the 3rd unit than it is for the 4th (because the difference between MR and MC is bigger for unit 3 than it is for unit 4), but both units produce a rise in profit.
A firm that wishes to maximize its profit thus should not stop selling at the point where MR exceeds MC by the largest amount (which is what answer (c) implies). Doing so means that the firm has missed an opportunity to increase its profit. In the example above, a firm that stopped when MR exceeded MC by the most would miss the chance to increase its profit (by only $1, but a dollar's a dollar) by selling the 4th unit.
Rather, a firm maximizes its profit (makes the difference between TR and TC as big as it can be) by selling every unit for which MR exceeds MC. This last statement is true regardless of whether MR exceeds MC by a lot, or only by a little.
Since the proper strategy for a firm that wants to maximize its profit is to sell every unit for which MR exceeds MC, the firm should continue to sell until the MR and MC of the last unit sold are equal (or as equal as possible) to each other.
Thus, by continuing to sell up to the point where MR equals MC, the firm guarantees that its TR exceeds it TC by the largest possible amount.
Question 2 answer is: c. exceed (or be equal to) the marginal cost of producing the 20th unit, while the MR from the 21st unit must be less than the MC of that unit
Explanation: The question tells us that when the first sells 20 units, it earns a bigger profit than it would earn if it sold 19 units, or 21 units, or any other quantity. In other words, the firm maximizes its profit by selling 20 units.
The above information tells us that when Firm XYZ increases its sales from 19 units to 20 units, its profit must rise, but when the firm increases its sales from 20 units to 21 units, its profit must fall. The first of these facts tells us that the firm's marginal revenue from selling its 20th unit must exceed its marginal cost of producing that unit (which is why selling unit #20 raises its profit). The second fact tells us that the firm's marginal revenue from selling its 21st unit must be less than its marginal cost of producing that unit (which is why selling unit #21 lowers its profit).
Note that MR > MC for unit 20, and MR < MC for unit 21 is all the information in the question tells us. We are told only that selling unit 20 increases the firm's profit, but we are not told by how much profit rises. We therefore do not know by how much MR exceeds MC. Correspondingly, knowing only that selling unit 21 decreases the firm's profit does not tell us by how much MC exceeds MR.
As was the case for the last question, you may get into trouble if you misunderstand the relationships between profit, total revenue and total cost, and marginal revenue and marginal cost. The question tells us that Firm XYZ earns a bigger profit when it sells 20 units than it would earn if it sold 19 units or 21 units. This is equivalent to saying that the difference between the firm's total revenue and its total cost when it sells 20 units is bigger than is the difference between its TR and TC when it sells 19 or 21. Knowing something about profit tells us something about the gap between TR and TC. In contrast, knowing how profit is changing tells us something about MR compares with MC.
Answer (a) states that knowing that profit is maximized at 20 units tells us that the marginal revenue of the 20th unit exceeds its marginal cost by more than MR exceeds MC for any other unit. This is incorrect. Here are the statements that are correct. First, when the firm sells 20 units, its total revenue exceeds its total cost by more than TR exceeds TC for 19 or 21 or any other number of units. Second, the marginal revenue of selling the 20th unit exceeds the marginal cost of producing it by some amount (but perhaps by a fairly small amount).
Question 3 answer is: c. 5
Explanation: There's more than one way to answer this question, but the method I'd suggest involves comparing marginal revenue and marginal cost. Remember from class (and from the answers to earlier questions) that a firm maximizes its profit by selling every unit for which marginal revenue exceeds marginal cost (even if it MR exceeds MC by just a little bit).
In this question, marginal revenue is always $20. We know this because the problem tells us that Betty can sells as many units of the output as she wishes at $20 per unit, which means that every time Betty sells one more unit her total revenue rises by $20.
The table in the question gives Betty's total cost of producing the first five units of output. Since marginal cost is defined as the change in total cost that results from producing the last unit, it's easy to compute the marginal cost of producing each output. For example, when Betty increases her production from 1 unit to 2 units, her total cost rises from $37 to $45. Thus, the marginal cost of producing the second unit is $8.
The accompanying table gives the marginal cost of producing units 2 through 7. It also shows (as noted above) that the marginal revenue of every unit equals $20.
Given these numbers, it is clearly in Betty's interest to sell the the second unit, the third unit, the fourth units, and the fifth . Consider unit number five, for instance. Selling that unit causes Betty's revenue to rise by $20, and her cost to rise by $18. Since MR exceeds MC by $2, selling this unit raises Betty's profit. Note that selling the fifth unit doesn't increase Betty's profit by as much as did selling the fourth unit, but the fifth unit does raise her profit.
If Betty increased her sales from five units to six units, however, her revenue would rise by $20 while her cost rose by $25. Selling the sixth unit would thus decrease Betty's profit. [Note that Betty's profit would still be positive; it just wouldn't be as large as it could be.] In order to maximize her profit. therefore, Betty should thus sell five units, but no more.
Note: as a general rule in answering questions of this type, you should take whatever information is given, and convert that information into marginal revenue and marginal cost. MR and MC can be directly compared, but you'll always run into trouble if you try to compare marginal revenue with total cost (or total revenue with marginal cost).
Question 4 answer is: a. rise
Explanation: This is a question about whether a business should "open" or "close" in order to maximize its profit. The important point in this question is that the rent cost is not relevant to Frank's decision about whether or not to open on Sunday. Frank is committed to paying the same amount for rent regardless of his open-or-close-on-Sunday decision. His rent payment is thus independent of the decision on which we are focusing, and should therefore play no role in that decision.
In other words, from the point of view of the open-or-close-on-Sunday decision, all of Fred's rent payments are fixed and sunk.
The only costs that are directly related to Frank's Sunday decision are those that depend on that decision -- wages, electricity, and cost of the things that are sold. These are costs that Frank can avoid if he chooses to open the store. In other words, these are variable costs over which Frank has control (costs that depend on his decision).
If Frank's revenue from opening on Sunday exceeds his variable cost of so doing, then opening on Sundays will increase his profit. If Frank's revenue from opening on Sunday is less than his variable cost, then so doing will lower his profit.
In this question, if Frank opens the store on Sunday, he incurs $280 in variable cost (wages plus electricity plus his costs of the products sold) and collects $300 in revenue. Frank would therefore increase his profit by opening on Sunday. The "$40 daily rent" cost is irrelevant to this decision because Frank has to pay it regardless of whether he opens the store or not.
Question 5 answer is: b. is currently earning a (total) profit that is greater than $500
Explanation: One of the definitions of profit is that profit = ( price - average total cost ) × quantity. Plugging in the question's values for P, ATC, and Q produces profit = ( 10 - 8 ) × 300 = 600. The firm is thus currently earning a profit that exceeds $500.
When this firm produced its 300th unit, the price at which it sold its product was $10. The firm's marginal cost of producing that unit was also $10.
If the firm is a price taker (meaning that marginal revenue = price), then unit 300 is the unit for which P = MR = MC. In other words, the firm maximizes its profit by selling 300 units. Increasing production to 310 units therefore can't lead to greater profits (after all, profits were as big as they could be when 300 units were sold). Furthermore, the question tells us that for all units beyond #300, MC will exceed price, which means that selling those units would decrease the firm's profit.
[If the firm were a price setter (meaning that marginal revenue < price) -- which isn't really relevant for this question -- it is again true that increasing sales from 300 to 310 units can't increase profit, since marginal cost will exceed price which exceeds marginal revenue.]
This question emphasizes the difference between the condition that indicates a firm is currently earning a profit (which this firm is -- its selling price exceeds its average cost of production), and the condition that indicates whether or not the firm would increase its profit by increasing its sales (in this case, raising sales won't raise profit, because the firm's marginal cost of producing the additional units would exceed its marginal revenue from selling them).
Question 6 answer is: c. 90
Explanation: As noted in class (and the textbook), one of the ways to measure profit is that profit = ( price - average total cost ) × quantity. Since that formula is of the form A × B, it is illustrated on a graph with a rectangle, the height of which measures the per-unit profit (P-ATC), and the width of which measures the quantity sold (Q), where both are measured at the quantity of output that allows the firm to earn its largest-possible profit.
In this problem, the firm mazimizes its profit by selling 30 units -- we know this because the firm's marginal cost curve hits the market price (which is also the marginal revenue of a price-taking firm) at Q = 30. At that quantity of output (Q = 30), the graph indicates that the firm's average total cost of production equals 13 -- it's three notches down from the market price of 16. Thus, the firm's profit -- as illustrated in the accompanying figure -- is (16-13) × 3 = 90 (a rectangle with height equal to 3 and width equal to 30).
The incorrect answers are based on the following calculations: (16-12) × 4 = 88 (but selling 12 units isn't a profit-maximizing decision); (16-12) × 4 = 120 (but when output is 30, ATC is 13 not 12); 16 × 22 = 352 and 16 × 30 = 480 (these are revenue calculations, not profit calculations.
Question 7 answer is: d. closer to ; a decrease
Explanation: When the sellers in a market are earning positive economic profits, it means that consumers value the good (i.e., they're willing to pay an amount to buy the good) that exceeds the (average) cost of producing it. In other words, the value of what is being produced exceeds the cost of the resources being used up to produce it. [This assumes none of the complications we'll discuss later in the semester.]
When the sellers in a market are earning positive economic profits, it also means that the "change" in the number of firms participating in the market will be a rise in the number of sellers.
The first paragraph implies that there would be a net benefit for society if more of the good was produced. The second paragraph tells us that entry will cause more of the good to be produced. Thus, the market outcome moves closer the economically-efficient outcome.
The entry of new firms causes an increase in market supply. The rightward movement of supply causes the market price to fall, which (other things unchanged) lowers the profits earned by the firms that were already in the market.
Question 8 answer is: a. flatter ; fall back towards the original price
Explanation: When the market price of a good rises, the quantity supplies rises. In the short run, the existing firms in the market can increase their output, but the extent to which each firm can do so is limited by the fact that the firm don't have enough time to change the quantity of the (at least one) input it has to use in a fixed amount. ["Short run" means that a firm doesn't have enough time to change its use of (at least) one fixed input.]
In the long run, firms can adjust their usage of all their inputs, and also the number of firms in the market can change. As a result, a given price change will create a larger change in quantity supplied in a market in the long run than in the short run. [For example, a price rise (as in this question) will cause existing firms to expand and new firms to enter the market.] The increased flexibility in the long run means that the long-run supply curve in a market will be flatter (or more elastic) than will the short-run supply curve.
An increase in demand will cause the market equilibrium to move up a supply curve. The after-demand-shift short-run equilibrium will be on the (steeper) short-run supply curve. The after-demand-shift long-run equilibrium will be on the (flatter) long-run supply curve. In other words, the short-run market equilibrium price will be higher than will the long-run equilibrium price. In response to the (permanent) increase in demand, the price first rises to (higher) short-run equilibrium level, and then drops somewhat back to its (lower) long-run equilibrium level.
Another way to describe the pattern of price movement is that the rise in demand causes the market equilibrium price to rise in the short run. This short-run rise in price leads the existing firms to expand their production and leads new firms to enter the market. As these changes occur, the short-run supply curve shifts to the right, which causes the price to fall back towards its original level. [Since the question says that the long-run supply curve is upward-sloping, we know that, while the expansion of production reverses some of the original price rise, the price doesn't fall all the way back to its original level.]
Question 9 answer is: e. fall somewhere in the range between $18.00 and $22.00
Explanation: One way to answer this question is to simply plug numbers into the formula for Marginal Revenue given in class. That formula shows that selling an additional unit affects the firm's revenue in two ways. First, the firm's gain in revenue equals the price at which it sells the new unit. In order to sell that unit, however, the firm had to reduce its selling price, which means that the firm collects less on all the sales it would have made anyway (without the price reduction).
When Tou's Company sells 41 units, it price (for all those units) is $29.75 (since increasing sales from 40 to 41 units requires a 25 cent reduction from a price of $30).
The marginal revenue formula illustrates these two effects. According to the formula, Tou's Marginal Revenue from selling a 41st unit is expressed as:
Note that the numbers on the right-hand side of the formula depend on the number on the left-hand side. For example, the MR from selling the 42nd unit would equal (P at which 42nd was sold) - (41) (drop in price needed to sell 42nd unit).
[While it's not relevant to this question, also note the following. If a firm can sell more units without having to decrease its price in order to do so, the "drop in price" term in the above formula is zero. The formula then tells us that Marginal Revenue equals Price. This is the case of a "price taker" firm that can sell as much as it wants without needing to lower its price in order to do so.]
Plugging in the numbers from the problem, we see that the MR from selling the 41st unit = $29.75 - (40 × $.25) = $29.75 - $10 = $19.75. [Remember the "order of operations" -- one has to do the multiplication before doing the subtraction.]
The alternate way to answer this question is to find Tou's Total Revenue when it sells 40 units (at a price of $30 each) and its TR when it sells 41 units (at a price of $29.75 each).
In this example, Total Revenue when 40 units are sold is TR = 40 × $30 = $1200, and TR when 41 units are sold is TR = 41 × $29.75 = $1219.75. Clearly, selling the 41st unit increases Tou's Total Revenue by $19.75; its Marginal Revenue from selling the 41st unit is therefore $19.75.
Question 10 answer is: e. None of (i), (ii), and (iii) is true.
Explanation: A monopolistically-competitive market has some features that are like those (and some unlike those) in a perfectly-competitive market, and some features that are like those (and some unlike those) in a monopoly market.
Firms in a perfectly-competitive market do have perfectly-horizontal firm demand curves. This is because perfectly-competitive firms are price takers; in other words, they can sell any quantity of output at the market price. Monopolistically-competitive firms, however, have some degree of market power, which implies that they can choose their selling price. Of course, such firms know that a higher price will lead to a drop in sales (but sales won't fall immediately to zero). In other words, monopolistically-competitive firms have downward-sloping firm demand curves. Statement (i) is thus not correct.
In a true monopoly, new firms are unable to enter the market. The existing firm can thus continue to earn monopoly profits. In a monopolistically-competitive market, however, it is possible for firms to enter the market, and these new firms will cause the profits of the existing firms to fall. Statement (ii) is thus not correct.
In a perfectly-competitive market, costs are indeed driven down to their lowest possible level (the minimum point of the Average Total Cost curve). In a monopolistically-competitive market, however, the long-run equilibrium exists when the firm demand curve is just tangent to the ATC curve (this is the condition for there to be zero economic profit). Since the firm demand curve is downward-sloping, this tangency must occur on the downward-sloping part (rather than at the minimum point) of the ATC curve. In other words, when the market is in long-run equilibrium, Average Total Cost is not as low as it could possibly be. Statement (iii) is thus not correct.
[The previous point is related to the variety-vs.-cost tradeoff covered in class. Start from the long-run equilibrium in a monopolistically-competitive market. If a firm raised its quantity of production, it would move down its ATC curve; as the firm grew, therefore, its average cost of production would fall. However, as some firms grow, others must disappear from the market. Thus, the long-run equilibrium outcome involves more variety, but higher costs of production; an outcome with a smaller number of bigger firms would have less variety (which is bad), but also lower production costs (which is good).]
Question 11 answer is: b. 51
Explanation: The simplest way to start solving this problem is to convert the information in it into the form of marginal revenue and marginal cost.
In this problem, the simplest way to find marginal revenue is probably to look at how selling one additional unit changes total revenue. [Alternatively, one could compute marginal revenue directly using the MR formula.] The marginal revenue of the 2nd unit, for example, is the change between TR when 2 units are sold and TR when 3 units are sold.
Marginal cost is simply given in the question, which states that MC = 40.
A firm that wants to maximize its profit should sell all units for which marginal revenue exceeds marginal cost (since selling that unit will raise its profit), and should not sell any unit for which MR is less than MC (since selling that unit will reduce its profit).
Applying this rule tells us that this firm maximizes its profit by selling 4 units. Returning to the question's original table, we see that if the firm wishes to sell 4 units, it should set its per-unit price at 51.
Question 12 answer is: e. both answers (b) -- decrease this firm's profit -- and (c) -- produce a net benefit for society; in other words, be efficient -- are correct.
Explanation: First, we need to compare the Marginal Revenue from selling the 9th unit with the Marginal Cost of producing it. The formula for Marginal Revenue says that
In this case, the MR from selling the 9th unit = 9.50 - 8 × (.50) = 5.50.
We can now compare Marginal Revenue (= $5.50) and Marginal Cost (= $7). Since MR is less than MC, we know that increasing sales from 8 units to 9 units will decrease the firm's profit (since the firm's revenue will rise by a smaller amount than its cost will rise).
Now, consider the "net benefit" part of the question. To answer this, we need to compare the value that a consumer places on the 9th unit with the cost of producing it. In this question, somebody would be willing to pay ($10 minus 50 cents =) $9.50 to buy the 9th unit. This tells us that the person who buys the 9th unit of the good must get $9.50 worth of value from consuming it. The marginal cost of producing that unit is only $7.
We conclude that producing and selling the 9th unit of the good would produce an increase in efficiency (would raise Total Surplus) for the overall society because the value that the customer would get from consuming that unit of the good exceeds the cost of producing it.
The fact that the firm will choose not to produce and sell the 9th unit (because doing so would lower its profit), even though selling that unit would raise economic efficiency, tells us that this firm chooses to produce less than the efficient quantity of this good. This conclusion is, of course, consistent with what we've said about the output decisions made by monopoly firms.
Question 13 answer is: d. rise ; fall ; rise
Explanation: Starting from the monopoly-firm outcome, a rise in the quantity produced will cause the market price to fall. Since consumers will be buying more units at a lower price, their Consumer Surplus will rise.
Since the monopoly outcome is the one that maximizes Profit (or Producer Surplus), any movement away from that outcome -- in this case, an increase in output -- must reduce Producer Surplus.
The remaining question is whether or not the rise in Consumer Surplus and the fall in Producer Surplus offset each other, leaving Economic Surplus unchanged. They do not. Remember that the monopoly outcome is inefficient, because the quantity produced is ``too small''. [In order to make positive profits, the monopoly firm restricts its production.] An increase in production would move the outcome closer to the efficient outcome (which is the one that maximizes Economic Surplus). [In a "properly-functioning" competitive market, ES is maximized at the market-equilibrium output, which exceeds the monopoly output.]
If you draw the pictures for a monopoly market, you'll see that a rise in quantity helps consumers by more than it hurts producers, and causes Economic Surplus to rise.
Question 14 answer is: c. does ; doesn't currently ; consumers
Explanation: For a product that already exists, a profit-seeking monopoly will charge a Price above its Marginal Cost of production. As a result, it will sell an inefficently small quantity of the good. [In other words, it will stop producing the item before the point at which consumer Value for the good equals the Marginal Cost of producing it.] In contrast, when a (potential) product hasn't yet been discovered, the profits that might be available to a monopoiy firm could be the motivation needed to get some firm (or some person) to be willing to incur the expense needed to discover and develop the product.
The key phrase in this question is that "new firms are always able to enter" to market. When there's a reduction in the cost of producing a good, the firms producing it experience a rise in their profits. In order to get a share (or a bigger share) of those profits, new firms will enter the market (or existing firms will exapnd). This entry (and expansion) increases market supply and reduces the equilibrium market price. The positive profits that firms earned in the short run will disappear as time passes. As long as entry can't be blocked, the long-run outcome in a market system is that a rise in productivity most benefits the consumers of the good who gain from the lower market price.
Question 15 answer is: a. a higher price in Market A
Explanation: This is a question about price differentiation, which exists when a firm charges different customers different prices for the "same" good. In this question, customers are differentiated by the value of the elasticity of their demand curves.
Remember that the larger the value of the demand elasticity, the larger the reduction in the quantity demanded when the price rises. A firm is better off, therefore, with a lower value for the elasticity -- the smaller the elasticity, the smaller the loss in sales when the firm raises its price. A firm selling to a group of customers that has a lower demand elasticity will therefore find it profitable to charge a higher price. In contrast, a firm selling to a group of customers with a larger demand elasticity will be forced to charge a lower price (since a high price would lead to a big drop in sales).
In this question, the elasticity in Market A is 3; this is the "smaller" elasticity, so the firm should charge a higher price in Market A. The elasticity in Market B is 5; this is the "larger" elasticity, so the firm should charge a lower price in Market B.
Question 16 answer is: e. $12.50
Explanation: Given the information included in this question, the way to find a specific value for a profit-maximizing price is to use the formula from class that utilizes the firm's Marginal Cost of producing the good (here $10) and the elasticity of the firm's demand curve (in the relevant market).
The formula we developed in class is:
If we plug Elas = 5, and MC = 10 into the last formula, we get Price = (5/4) × 10 = $12.50.
[For the other market described in the previous questions, Elas = 3, which produces Price = (3/2) × 10 = $15.00. A higher price ($15) is indeed charged in the market with the lower elasticity (3), while a lower price ($12.50) is charged in the market with the higher elasticity (5).]