(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.
Why?
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
Abnormal
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).
College Board
bastard,, tricky.
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.
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| Thanks Nadia, good times in Vancouver. |
