2007 Microeconomics FRQ #1
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So, you must understand that a patent is a government sanctioned monopoly. Yes, I know that seems dramatic but a patent is a governmental guaranteed or privilege that allows you to sue anyone that copies your idea and the courts will find in your favour if you have a patent.
(A) Assume that GCR is making economic profit. Draw a correctly labeled graph and show the profit-maximising price and quantity.
(B) Assume that the government imposes a lump-sum tax on GCR.
(i) What will happen to the price and quantity? (Explain.)
(ii) What will happen to GCR profits?
Ok, so the important thing to know about lump-sum taxes is that they don't effect the MC curve.
What in the F&#$K does that mean Mr. Waugh, you say. It means, my dear friend that a lump sum tax is to be paid by any company in the industry no matter if they produce or not.
Let us make it personal. Mr Waugh owns a waffle cart outside of the school gate and every morning students stop by and buy coffee from the cart. The principle stops by at the end of the day and explains that I will have to give him a hundred dollars to keep selling coffee at the front gate.
Consider the $100 to be a lump sum tax. We think of lump-sum tax as a Fixed Cost.
A fixed cost affects your ATC (Average Total Cost) as ATC is a combination of fixed and variable costs. Remember - ATC = FC + VC
Since it is a lump-sum tax the ATC will shift up. Your fixed costs will increase and therefore mathematically your ATC must increase.
Answer (i) -You would not be producing anymore quantity of coffee because the principles $100 tax does not affect the demand for coffee. So quantity will not change and if quantity produced does not change you will not need to hire more people so VC (Variable Costs) will not change.
* When you see (VC) think (Labor) and you only need more labor to produce a higher quantity.
Answer (ii) - If you are taxed and your making profits, well now you are making less profits. Shifting the ATC straight up reduces your profits but doesn't affect quantity or price.
Check out the cheat sheet on Lump-sum taxes and subsidies. Here
(C) Assume instead that a per-unit subsidy is granted.
(i) What will happen to market price and quantity? Explain. (Explain means why!!!)
(ii) What will happen to profits?
OK, so per-unit subsidies or taxes are looked at as VC (variable costs) Remember (Think Labor)
So, VC will decrease meaning that the MC (marginal cost curve) will shift rightward.
Why, Mr. Waugh does a per-unit subsidy affect the MC curve. If I'm given cash for every cup of coffee that I sell at my coffee cart it lowers my costs and thus raises my profit per cup. More profit per cup means that I will want to produce more quantity. Lets look at a graph.
Answer - As we are given money (per-unit) our ATC curve decreases because the ATC curve is composed of FC and VC and Per-unit subsidies reduce our VC and therefore our ATC. A decrease in the VC shifts the MC curve rightward. Then we find a new Profit Max (MR=MC) and notice that price falls and quantity increases. Profit also increases.
(D) Now assume the Patent expires. What will happen to GCR's profit in the long run. Explain.
If GCR's patent goes away then other firms will be able to use GCR's anti-spyware. Profit attracts firms into the industry and therefore GCR's profits will decrease.
