Lesson Topics. A.8 Competitive Markets Review Questions

Transcription

1 Lesson Topics Competitive Price and Quantity starts with price set to the competition, then quantity set where marginal cost equals price provided that production is better than shutting down. Efficient Quantity is implied when price and willingness to pay equals marginal cost. So, after your market purchases, there is no deal between you and an electronics supplier that can benefit you both. Competitive Entry and Exit (4) are determined by profits. Positive profit causes entry, slightlynegative profit causes exit in the long run, and significantly-negative profit causes exit in the short run. 1

2 Competitive Entry and Exit Question. In the aftermath of a hurricane, an entrepreneur is considering taking a one-month leave of absence (without pay) from her $3,000 per month job in order to operate a kiosk to sell fresh drinking water. If she takes off the month from work, she could pay the government $2,000 in kiosk rent and purchase water from a local wholesaler at a price of $1.50 per gallon. Consumers would be willing to pay $3.50 per gallon for fresh drinking water for up to 3,000 gallons. a. Determine her total cost function, and determine how many gallons she would have to sell to make a profit. b. Would she benefit if she sold the water? c. What would happen if $3.50 per gallon is considered price gouging, and so the government imposed a cap of $2.50 per gallon? 2

3 Answer to Question: a. Taking into account both implicit and explicit costs, the total fixed cost from operating the kiosk is $5,000 = the $2,000 in rent plus the $3,000 in forgone earnings. Variable costs are $1.50 per gallon. Thus, the cost function is C(Q) = 5, Q for Q > 0, with fixed cost of $5000. The sunk cost C(0) generally depends on whether the entrepreneur has already paid the fixed cost. In this case, the entrepreneur is still considering options, so C(0) = $0. The entrepreneur will make a profit when revenues exceed costs, which occurs when 3.5Q > 5, Q. Solving for Q implies the entrepreneur makes a profit when she sells Q > 5,000/2 gallons, or 2,500 gallons. b. Would she benefit if she sold the water? Answer: Definitely yes if selling more than 2,500 gallons of water is not any harder or distasteful to her than her usual job. c. What would happen if $3.50 per gallon is considered price gouging, and the government imposed a cap of $2.50 per gallon? Answer: At $2.50 per gallon, the entrepreneur will make a profit when revenues exceed costs, which occurs when 2.5Q > 5, Q. Solving for Q implies the entrepreneur makes a profit when she sells Q > 5,000 gallons, which is over the maximum demand of 3,000 gallons. Since she is still considering her options (she has not already taken the leave of absence and has not already paid the kiosk rent), she is currently outside the water-reselling industry and would not enter since profits would be negative. That is, she cancels the water selling enterprise and stays with her regular job, and the local people lose any consumer surplus from her business. 3

4 Competitive Entry and Exit Question. In the aftermath of a tornado, an entrepreneur is considering taking a one-month leave of absence (without pay) from her $4,000 per month job in order to operate a kiosk to sell fresh drinking water. If she takes off the month from work, she could pay the government $2,000 in kiosk rent and purchase water from a local wholesaler at a price of $2 per gallon. Consumers would be willing to pay $4 per gallon for fresh drinking water for up to 4,000 gallons. a. Determine her total cost function, and determine how many gallons she would have to sell to make a profit. b. Would she benefit if she sold the water? c. What would happen if $4 per gallon is considered price gouging, and so the government imposed a cap of $3 per gallon? d. How would your answer to questions a, b, c change if the entrepreneur has already taken the leave of absence and has already paid the kiosk rent? 4

5 Answer to Question: a. Taking into account both implicit and explicit costs, the total fixed and sunk cost from operating the kiosk is $6,000 = the $2,000 in rent plus the $4,000 in forgone earnings. Variable costs are $2 per gallon. Thus, the cost function is C(Q) = 6, Q for Q > 0, with fixed cost of $6000. The sunk cost C(0) generally depends on whether the entrepreneur has already paid the fixed cost. In this case, the entrepreneur is still considering options, so C(0) = $0. The entrepreneur will make a profit when revenues exceed costs, which occurs when 4Q > 6, Q. Solving for Q implies the entrepreneur makes a profit when she sells Q > 3,000 = 6,000/2 gallons. b. Would she benefit if she sold the water? Answer: Definitely yes if selling more than 3,000 gallons of water is not any harder or distasteful to her than her usual job. c. What would happen if $4 per gallon is considered price gouging, and the government imposed a cap of $3 per gallon? Answer: At $3 per gallon, the entrepreneur will make a profit when revenues exceed costs, which occurs when 3Q > 6, Q. Solving for Q implies the entrepreneur makes a profit when she sells Q > 6,000 gallons, which is over the maximum demand of 4,000 gallons. Since she is still considering her options (she has not already taken the leave of absence and has not already paid the kiosk rent), she is currently outside the water-reselling industry and would not enter since profits would be negative. That is, she cancels the water selling enterprise and stays with her regular job, and the local people lose any consumer surplus from her business. d. How would your answer to questions a, b, c change if the entrepreneur has already taken the leave of absence and has already paid the kiosk rent? Since she has already taken the leave of absence and has already paid the kiosk rent, she is currently inside the water-reselling industry and faces the short-run decision of whether to exit the industry. 5

6 The answer to (a) is the same as before, except sunk cost C(0) = $6,000. The answer to (b) is now that she benefits no matter how much water she sells because the price of $4 is greater than the average variable cost of 2. And the answer to (c) is now that she stays in business and sells the maximum amount 4,000 gallons of water because the price of $3 is greater than the average variable cost of $2. 6

7 Competitive Entry and Exit Question. Gilead Sciences Inc. is considering developing an HIV/AIDS drug. The drug is expected to cost $10 million to develop and $10 per dose to produce and distribute. Consumers would be willing to pay $400 per dose for medication for up to 30,000 doses. a. Determine Gilead s total cost function. b. Determine whether Gilead will develop the drug. And if so, determine profit. c. What would happen if $400 per dose is considered price gouging, and so the government imposed a cap of $100 per dose? d. How would your answer to questions a, b, c change if Gilead Sciences Inc. has already developed the drug? 7

8 Answer to Question: a. The fixed and sunk cost from offering the drug is $10,000,000. Variable costs are $10 per dose. Thus, the cost function is C(Q) = 10,000, Q for Q > 0, with fixed cost of $10,000,000. The sunk cost C(0) generally depends on whether the entrepreneur has already paid the fixed cost. In this case, the entrepreneur is still considering options, so C(0) = $0. b. The firm will develop the drug and make a profit when revenues exceed costs, which occurs when 400Q > 10,000, Q. Solving for Q implies the firm makes a profit when it sells Q > 25,641 = 10,000,000/390 doses. And total profit from selling all Q = 30,000 doses is 400Q (10,000,000+10Q) = 390(30,000)-10,000,000, or Π = $1,700,000. c. What would happen if $400 per dose is considered price gouging, and the government imposed a cap of $100 per dose? Answer: At $100 per dose, the firm will make a profit when revenues exceed costs, which now occurs when 100Q > 10,000, Q. Solving for Q implies the firm makes a profit when it sells Q > 111,111 = 10,000,000/90 doses, which is over the maximum demand of 30,000 doses. Put another way, the maximum profit Π = -$7,300,000 = $90(30,000) - $10,000,000 is negative. Since the firm is still considering its options (it has not already developed the drug), the firm is currently outside the HIV/AIDS drug industry and would not enter since profits would be negative. That is, the firm cancels the development of the new drug, and the potential consumers lose any consumer surplus from buying the drug. d. How would your answer to questions a, b, c change if the firm has already taken developed the drug? Since the drug is already developed, the firm is currently inside the HIV/AIDS drug industry and faces the short-run decision of whether to exit the industry. The answer to (a) is 8

9 the same as before, except sunk cost C(0) = $10,000,000. The answer to (b) is now that the firm benefits no matter how many doses it sells because the price of $100 is greater than the average variable cost of $10. And total profit from selling all Q = 30,000 doses is 100Q (10,000,000+10Q) = 90(30,000)-10,000,000, or a loss of Π = - $6,300,000. And the answer to (c) is now that the firm stays in business and sells the maximum amount 30,000 doses because the price of $100 is greater than the average variable cost of $10. 9

10 Competitive Entry and Exit Question. Monsanto Inc. is considering developing a new biotechnology cotton seed. The seed is expected to cost $20 million to develop and $20 per bag to produce and distribute. Farmers would be willing to pay $300 per bag for up to 100,000 bags. a. Determine Monsanto s total cost function. b. Determine whether Monsanto will develop the seed. And if so, determine profit. c. What would happen if $300 per bag is considered price gouging, and so the government imposed a cap of $240 per bag? d. How would your answer to questions a, b, c change if Monsanto has already developed the seed? 10

11 Answer to Question: a. Taking into account both implicit and explicit costs, the fixed and sunk cost from offering the product is $20,000,000. Variable costs are $20 per unit. Thus, the cost function is C(Q) = 20,000, Q for Q > 0, with fixed cost of $20,000,000. The sunk cost C(0) generally depends on whether the entrepreneur has already paid the fixed cost. In this case, the entrepreneur is still considering options, so C(0) = $0. b. The firm will develop the product and make a profit when revenues exceed costs, which occurs when 300Q > 20,000, Q. Solving for Q implies the firm makes a profit when it sells Q > 71,428 = 20,000,000/280 units. And total profit from selling all Q = 100,000 units is 300Q (20,000,000+20Q) = 280(100,000)-20,000,000, or Π = $8,000,000. c. What would happen if $300 per unit is considered price gouging, and the government imposed a cap of $240 per unit? Answer: At $240 per unit, the firm will make a profit when revenues exceed costs, which occurs when 240Q > 20,000, Q. Solving for Q implies the firm makes a profit when it sells Q > 90,909 = 20,000,000/220 units, which is under the maximum demand of 100,000 units. Put another way, the maximum profit Π = $2,000,000 = $220(100,000) - $20,000,000 is positive. Since the firm is still considering its options (it has not already developed the product, the firm is currently outside the industry and would enter since profits would be positive. That is, the firm commits to the development of the new product. d. How would your answer to questions a, b, c change if the firm has already taken developed the drug? Since the new product is already developed, the firm is currently inside the industry and faces the shortrun decision of whether to exit the industry. The answer to (a) is the same as before, except sunk cost C(0) = $20,000,000. The answer to 11

12 (b) is now that the firm benefits no matter how many units it sells because the price of $240 is greater than the average variable cost of $20. And total profit from selling all Q = 100,000 units is 240Q (20,000,000+20Q) = 220(100,000)-20,000,000, or a profit of Π = $2,000,000. And the answer to (c) is now that the firm stays in business and continues to sell the maximum amount 100,000 units because the price of $240 is greater than the average variable cost of $20. 12