2009 Microeconomics FRQ #1
(A) Draw a CLG for CableNow and show each of the following.
(i) The profit maximizing quantity of cable services, labeled as Q*
(ii) The profit maximizing price, labeled as P*
(iii) The area of economic profit, completely shaded
(iv) The socially optimal level of cable service, assuming no externalities, labeled as QS
(B) Assume that the government grants CableNow a lump sum subsidy of $1 million. Will this policy change CableNow’s profit maximizing quantity of cable service? Explain. (Explain means Why??)
If the government grants a $1 million lump sum subsidy CableNow’s quantity produced will not change. Why? A lump-sum subsidy will not affect CableNow’s marginal costs.
A lump-sum subsidy is given to a firm whether the firm produces the good or not. If I own a coffee shop, and the government decides to give all coffee shop owners a $10,000. Does this increase the amount of coffee I sell? No. If I don’t sell anymore coffee then I don’t need to hire more employees. If I don’t hire more employees my marginal cost curve doesn’t shift. Lump-sum subsidies are often thought of as fixed costs. If your rent (a fixed cost) decreases would this cause you to employee less people? No. The demand for your coffee doesn’t change due to a change in fixed costs, so no one will be hired or fired. But, a decrease in your fixed costs or a lump-sum subsidy will cause your profits to increase or your losses to decrease.
Lets look at a graph using the above information.
In the graph above, notice that the ATC curve decreased as the lump sum subsidy is granted but the profit maximization point MR = MC wasn’t affected and therefore quantity didn’t change.
(C) Instead of a subsidy, the government requires CableNow to produce the quantity at which CableNow earns zero economic profit. On the graph you drew in part (a), label this QR.
Obviously, if you don’t know where the point is where zero economic profit is earned you can’t answer this question.
Know all the points on the graph below. You should be able to draw a monopoly graph and label each of these possible points. Practice, practice, practice and then do it again.
If we use the information in the question, and the graph in the question. Zero economic profit for a monopoly is at the Fair Return or Break-Even point where
P = ATC = Zero Economic Profit
(D) At QR, is the firm’s accounting profit, positive, negative or zero? Explain.
If a firm is earning zero economic profit it must be covering its accounting profit. Why?
Profit = TR (total revenue) minus (TC (total costs)
Total Costs = Explicit + Implicit Costs
Explicit costs are the costs that you can see; wages, electricity, rent, materials.
Implicit Cost is the monies that the entrepreneur demands to stay in this industry.
Accounting Costs are explicit costs, so as long as the firm is covering its explicit costs it is breaking even according to the accountant. If the firm is covering (earning) its explicit costs and covering its implicit costs then firm is making an accounting profit but only earning zero economic profit.
Confusing? Ok, lets back up and take a little trip.
Charles (the entrepreneur) has $50,000 and he wants to start a business. Charles can either invest the $50,000 into a new business or he can put the 50k in the bank where he will earn interest on his money.
$50,000 x .01 = $500 a year earned with zero risk and nothing to worry about.
$50,000 x .05 = $2,500 a year (that is $208 a month guaranteed) enough to pay for Yoga and Coffee
$50,000 x .08 = $4000 a year ($333 a month) that will pay your payment for a very nice car.
So, Charles has options and the higher the interest rate he can earn the more attractive it may be to keep the money in the bank.
Lets say the Bank will pay us 8% on our savings.
But Charles wants to open a coffee shop.
Our dismal Economist (David) looks at Charles and says, “ Charles, you must consider the opportunity cost of any action you take.”
“No I don’t”, says Charles, as he is naturally cantankerous and politically a libertarian and hates to be told what to do.
David - “Well sorry old chap, but economists look at any choices made and evaluate your next best alternative.”
Charles - “Well, I have two choices, I can put the money in the bank or I can invest the money in the coffee shop”. “If I invest in the coffee shop, I will spend the $50,000 and hopefully make 10% a year on my investment.
David - “If you only make 10% or $5,000 a year then an economist will say that you have really only earned 2% on your investment because you could have earned 8% of that 10% by keeping your cash in the bank.” “That 8% is the implicit cost that must be paid to keep you in the business of supplying coffee to people.” “If, Charles, you invested your $50,000 in the coffee shop and only made 8%, an economist would have said you broke-even as you just covered your explicit & implicit costs”. The accountant would have said that you had earned a profit as your explicit costs were paid and monies are left over.
Charles – “So let me get this straight. If I invest my $50,000 in the coffee shop, I pay all the wages to my employees, the rent, the electricity and I have $2,500 left over to pay to myself, an economist would say I have incurred an economic loss but the accountant would say I have made a profit. Who is right?
David – We both are? The accountant only looks at explicit costs, (rent, electricity, wages) the economist looks at explicit costs and implicit costs (what could have been earned by doing the next best alternative). “Really those accountants are far to optimistic and don’t look at the whole picture.”
The College Board wants you to understand that as economists we must consider the choices we didn’t take and consider them as a cost.
Accountant Loss – Can’t pay your rent, electricity or wages, or some combination.
Accountant Break-Even or Zero Accountant Profit– Can pay all the bills
Accounting Profit – Anything amount earned over the explicit costs
Economic Loss – Earnings below the sum of your explicit and implicit costs
Economic Break-Even – Earnings cover the explicit costs and implicit costs
Zero Economic Profit - Earnings cover the explicit costs and implicit costs
Positive Economic Profit – Earnings more than the explicit & implicit costs
(E) Assume that a new study reveals that there are external benefits (externalities) associated with watching TV. Will the socially optimal quantity of cable service now be larger than, smaller than, or equal to the QS, you identified in part (A)(iv).
If a positive externality is occurring you can know, that the market is producing to little of the good/the price is to high. Understand that producing to little/price is to high is the same thing. The market will produce the quantity where P = MC/ quantity of QS.
If the market is producing at QS but is producing to little then the Socially Optimal Quantity must be a larger quantity than QS.