ECO 110M (1645)
Fall 1999
ANSWERS TO HOMEWORK #4

1) Since a new customer is offering to pay $300 for one dose, marginal revenue between 200 and 201 doses is $300. So we must find out if marginal cost is greater than or less than $300. To do this, calculate total cost for 200 doses and 201 doses, and calculate the increase in total cost. Multiplying quantity by average total cost, we find that total cost rises from $40,000 to $40,401, so marginal cost is $401. So your roommate should not make the additional dose.

2) Once you've ordered the dinner, its cost is sunk, so it doesn't represent an opportunity cost. As a result, the cost of the dinner shouldn't influence your decision about stuffing yourself.

3) The rise in the price of petroleum increases production costs for individual firms and thus shifts the industry supply curve up, as shown in figure 1. The typical firm's initial marginal-cost curve is MC₁ and its average-total-cost curve is ATC₁. In the initial equilibrium, the industry supply curve, S₁, intersects the demand curve at price P₁, which is equal to the minimum average total cost of the typical firm. Thus the typical firm earns no economic profit.

The increase in the price of oil shifts the typical firm's cost curves up to MC₂ and ATC₂, and shifts the industry supply curve up to S₂. The equilibrium price rises from P₁ to P₂, but the price doesn't increase by as much as the increase in marginal cost for the firm. As a result, price is less than average total cost for the firm, so profits are negative.

In the long run, the negative profits lead some firms to exit the industry. As they do so, the industry supply curve shifts to the left. This continues until the price rises to equal the minimum point on the firm's average-total-cost curve. The long-run equilibrium occurs with supply curve S₃, equilibrium price P₃, industry output Q₃, and firm's output q₃. thus, in the long run, profits are zero again and there are fewer firms in the industry.

FIGURE 1

4)a Figure 2 illustrates the situation in the U.S. textile industry. With no international trade, the market is in long-run equilibrium. Supply intersects demand at quantity Q₁ and price $30, with a typical firm producing output q₁.

FIGURE 2

b The effect of imports at $25 is that the market supply curve follows the old supply curve up to a price of $25, then becomes horizontal at that price. As a result, demand exceeds domestic supply, so the country imports textiles from other countries. The typical domestic firm now reduces its output from q₁ to q₂, incurring losses, since the large fixed costs imply that average total cost will be much higher than the price.

c In the long run, domestic firms will be unable to compete with foreign firms because their costs are too high. All the domestic firms will exit the industry and other countries will supply enough to satisfy the entire domestic demand.

5)a Figure 3 shows the current equilibrium in the market for pretzels. The supply curve, S₁, intersects the demand curve at price P₁. Each stand produces quantity q₁ of pretzels, so the total number of pretzels produces is 1,000 x q_1. Stands earn zero profit, since price equals average total cost.

FIGURE 3

b If the city government restricts the number of pretzel stands to 800, the industry supply curve shifts to S₂. The market price rises to P₂, and individual firms produce output q₂. Industry output is now 800 x q₂. Now the price exceeds average total cost, so each firm is making a positive profit. Without restrictions on the market, this would induce other firms to enter the market, but they can't, since the government has limited the number of licenses.

c The city could charge a license fee for the licenses. Since it's a lump-sum fee for the license, not based on the quantity of sales, such a tax has no effect on marginal cost, so won't affect the firm's output. It will, however, reduce the firm's profits. As long as the firm is left with a zero or positive profit, it will continue to operate. So the license fee that brings the most money to the city is to charge each firm the amount (P₂ - ATC₂, the amount of the firm's profit.

6)a Figure 4 shows cost curves for a California refiner and a non-California refiner. Since the California refiner has access to lower-cost oil, its costs are lower.

FIGURE 4

b In the long-run equilibrium, the price is determined by the costs of non-California refiners, since California refiners can't supply the entire market. The market price will equal the minimum average total cost of the other refiners; they will thus earn zero profits. Since California refiners have lower costs, they will earn positive profits, equal to (P^* - ATC_c) x Q_c.

c Yes, there is a subsidy to California refiners that is not passed on to consumers. The subsidy accounts for the long-run profits of the California refiners. It arises simply because the oil can't be exported.