PRACTICE QUESTIONS

1. A sales tax of 10 percent is placed on half the firms (the polluters) in

a competitive industry. The revenue is paid to the remaining firms
(the nonpolluters) as a 10 percent subsidy on the value of output
sold.
a. Assuming that all firms have identical constant long-run average
costs before the sales tax-subsidy policy, what do you expect to
happen (in both the short run and the long run), to the price of the
product, the output of firms, and industry output?

b. Can such a policy always be achieved with a balanced budget in

which tax

revenues are equal to subsidy payments. Why or why not?

Explain.

2. An Airbnb in Bangalore holds the following financial records in 2019:

Total Revenue: ₹ 300,00,00

Wages paid to hire staff: ₹500,000

Utility expenses (electricity, water, etc.): ₹100,000
Maintenance and housekeeping costs: ₹90,000
Purchases of linens, toiletries, and other supplies: ₹78,000
Owner's salary: ₹20,000
Property Insurance: ₹55,000

a. The owner of the Airbnb has two alternative investment

opportunities. One is to expand the current hotel by adding more
rooms and amenities, which is estimated to increase revenue by
₹1,50,00,000 per year with additional operating costs of
₹80,00,000 per year. The other opportunity is to invest in a
nearby restaurant business, which is expected to generate a net
income of ₹75,00,000 per year after all expenses.

b. If the hotel were to be closed temporarily for renovation, the

owner could save on operating costs but would incur renovation
expenses of ₹2,50,00,000. Additionally, during the renovation
period, the owner estimates a loss of potential revenue at
₹2,00,00,000.
Calculate the accounting profit and economic profit for Airbnb in (a)
and (b).
3. ABC Corporation produces smartphones. They can manufacture
each smartphone either using automated assembly robots or
manual labor. Each smartphone can be assembled in 10 minutes by
a robot or in 30 minutes by a worker. The corporation can also
choose to produce some smartphones using robots and some using
manual labor. Both methods are perfect substitutes, and they are
the only inputs necessary for smartphone production.

a) It costs ABC Corporation $50 per hour to use the automated

assembly robots and $20 per hour to hire a worker. The corporation
aims to produce 200 smartphones. What is the cost-minimizing
input quantities? Present your answer with a clearly labelled graph.

b) What are the cost-minimizing input quantities if it costs ABC

Corporation $40 per hour to use the automated assembly robots
and $20 per hour to hire a worker? Present your answer with a
graph.

4. A shipping company offers two types of services: air cargo service

and sea cargo service. The stand-alone cost for air cargo service is
TC1 = 1000 + 2Q1, where Q1 equals the number of ton-miles of
cargo transported by air each day, and TC1 is the total cost in
thousands of dollars per day. The stand-alone cost for sea cargo
service is TC2 = 500 + Q2, where Q2 equals the number of ton-
miles of cargo transported by sea each day, and TC2 is the total cost
in thousands of dollars per day. When the shipping company offers
both services jointly, its total cost is TC (Q1, Q2) = 3000 + 2Q1 +
Q2.

Does the provision of air and sea cargo services exhibit economies
of scope? –

5. Suppose a competitive, profit-maximizing firm operates at a point

where its short-run average cost curve is upward sloping. What
does this imply about the firm’s economic profits? If the profit-
maximizing firm operates at a point where its short-run average cost
curve is downward sloping, what does this imply about the firm’s
economic profits?

6. In a perfectly competitive pizza delivery industry, there are currently

12 identical firms. Each firm operates in the short run with a total
fixed cost of F and a total variable cost of 2Q^2, where Q is the
number of pizzas delivered by each firm. The marginal cost for each
 firm is MC = 3Q. Each firm also has non-sunk fixed costs of 150.
Each firm would just break even (earn zero economic profit) if the
market price were $15 per pizza. (Note: The equilibrium price is not
necessarily $15 when there are 12 firms in the market.)
The market demand for pizzas is QM = 200 - 4P, where QM is the
total quantity demanded in the entire market.

a) How large are the total fixed costs for each pizza delivery firm?
Explain.

b) What would be the shutdown price for each firm? Explain.

c) With the cost structure assumed for each firm in this problem, how
many firms

would be in the market at an equilibrium in which every firm’s

economic profits

are zero?

7. In the parts of UK, there is a growing concern about the

environmental impact of large corporations' activities, particularly
those related to carbon emissions. The government and
international organizations are striving to reduce carbon emissions
while ensuring economic stability and energy security.

To address this challenge, a coalition of countries led by the UK has

implemented a novel policy: a carbon price cap on large corporations. The
policy allows companies to emit carbon dioxide only if they adhere to a
specific cap on carbon prices set by the government.

a) Using appropriate economic models and graphs, explain the

rationale behind the implementation of a carbon price cap by UK
and the coalition. Discuss the potential economic, environmental,
and social implications of such a policy on large corporations,
consumers, and the overall economy.
b) Investigate the potential challenges and limitations associated
with enforcing the carbon price cap policy on large corporations.
Discuss the role of government regulation, monitoring mechanisms,
and international cooperation in ensuring compliance and
effectiveness of the policy.

8. In the early 2000s, when gasoline prices rose to $2.00 per gallon,
public policy makers considered cutting excise taxes by $0.10 per
gallon to lower prices for the consumer. In discussing the effects of
the proposed tax reduction, a news commentator stated that the
 effect of tax reduction should lead to a price of about $1.90 per
gallon, and, that if the price did not drop by as much, it would be
evidence that oil companies are somehow conspiring to keep
gasoline prices high. Evaluate this claim.

9. Imagine that Gillette has a monopoly in the market for razor blades
in Mexico. The market demand curve for blades in Mexico is P = 968
− 20Q, where P is
the price of blades and Q is annual demand for blades expressed in
millions. Gillette has two plants in which it can produce blades for
the Mexican market: one in Los Angeles and one in Mexico City. In
its L.A. plant, Gillette can produce any quantity of blades it wants at
a marginal cost of 8 per blade. Letting Q1
and MC1denote the output and marginal cost at the L.A. plant, we
have
MC1(Q1) = 8. The Mexican plant has a marginal cost function given
by
MC2(Q2) = 1 + 0.5Q2
a) Find Gillette’s profit-maximizing price and quantity of output for
the Mexican market overall. How will Gillette allocate production
between its Mexican plant and its U.S. plant?

b) Suppose Gillette’s L.A. plant had a marginal cost of 10 rather

than 8 per blade. How would your answer to part (a) change?

10. A bakery produces gourmet cupcakes, and the marginal cost

of preparing each cupcake is $2. Market research indicates that the
elasticity of demand for its cupcakes is constant, with a value of -2.
If the bakery aims to maximize profit from the sale of cupcakes,
what price should the bakery charge?

11. J. Cigliano (“Price and Income Elasticities for Airline Travel: The
North Atlantic Market,” Business Economics, September 1980)
estimated the price elasticity of demand for regular (full-fare) travel
in coach class in the North Atlantic market to be ϵ β = −1.3. He also
found the price elasticity of demand for excursion (vacation) travel
to be about ϵV = −1.8. Suppose Transatlantic Airlines faces these
price elasticities of demand, and that the elasticities are constant;
that is, they do not vary with price. Since both are coach fares, you
may also assume that the
 marginal cost of service is about the same for business and vacation
travellers. Suppose an airline facing these demand elasticities wants
to set PR (the price of a round trip ticket to regular business
travellers) and PV (the price of a round-trip ticket to vacation
travellers) to maximize profit. What prices should the firm charge if
the marginal cost of a round trip is 200?

12. An airline has 200 seats in the coach portion of the cabin of an
Airbus A340. It is attempting to determine how many seats it should
sell to business travellers and how many to vacation travellers on a
flight between Chicago and Dubai that departs on Monday morning,
January 25. It has tentatively decided to sell 150 seats to business
travellers and 50 seats to vacation travellers at $4,000 and $1,000,
respectively. It also knows:
a) To sell an additional seat it sells to business travellers, it would
need to reduce price by $25. To reduce demand by business
travellers by one seat, it would need to increase price by $25.
b) To reduce demand by 1 unit among vacation travellers, it would
need to increase price by $5. To sell an additional seat to vacation
travellers, it would need to reduce price by $5.
Assuming that the marginal cost of carrying either type of
passenger is zero, is the current allocation of seats profit
maximizing? If not, would you sell more seats to business travellers
or vacation travellers?

13. A company operates a popular amusement park on an island

near a major city. The company sells day passes for access to the
amusement park, including transportation to and from the island via
ferry. Due to limited capacity at the park, the company does not
want to sell more than 300 passes per day. The company identifies
two types of visitors: those who are willing to purchase tickets in
advance and those who prefer to buy tickets on the day of the visit.
Visitors who buy in advance are typically more price sensitive.
The demand curve for advance purchase tickets is described by:

𝑃1 =150 −0.3𝑄1, where 𝑄1 is the number of advance purchase

tickets sold at a price of 𝑃1.

The demand schedule for tickets purchased on the day of the visit is
represented by

𝑃2 = 250 −0.6𝑄2, where Q2 is the number of tickets sold at a price of 𝑃2

a) Suppose the marginal cost of providing transportation and access to
the amusement park is $70 per customer. What prices should the
company charge for its day passes?

b) If the marginal cost were high enough, the company would want to sell
fewer than 300 tickets. Suppose the marginal cost of providing
transportation and access to the amusement park is $100 per customer.
What prices should the company charge for its day passes?

14. XYZ Corporation and ABC Inc. are the only two firms in the
market for electric vehicles (EVs), operating in a Cournot duopoly.
Both firms face a downward-sloping market demand curve for EVs.
Each firm has identical marginal costs that are independent of
output. Analyze how the following factors will affect XYZ
Corporation's and ABC Inc.'s reaction functions and the Cournot
equilibrium quantities produced by both firms.
a) A new government policy is introduced mandating that all public
transportation fleets must be electrified by 2030, leading to a surge
in demand for EVs.

b) XYZ Corporation and ABC Inc. both rely heavily on rare earth metals for
manufacturing EV batteries. However, a supply shortage of one critical
rare earth metal, cobalt, drives up its price significantly.

c) XYZ Corporation's main manufacturing facility undergoes a major

renovation, resulting in a substantial increase in its total fixed costs.

d) The government imposes a carbon tax on EVs produced by XYZ

Corporation, but not on those produced by ABC Inc., as part of its climate
change mitigation efforts.

15. The Baldonian shoe market is served by a monopoly firm. The

demand for shoes in Baldonia is given by Q = 10 − P, where Q is
millions of pairs of shoes (a right shoe and left shoe) per year, and P
is the price of a pair of shoes. The marginal cost of making shoes is
constant and equal to $2 per pair.

a) At what price would the Baldonian monopolist sell shoes? How

many shoes are purchased?
b) Baldonian authorities have concluded that the shoe seller’s
monopoly power is not a good thing. Inspired by the U.S.
government’s attempt several years ago to break Microsoft into two
 pieces, Baldonia creates two firms: one that sells right shoes and
the other that sells left shoes. Let P1be the price charged by the
right-shoe producer and P2 be the price charged by the left-shoe
producer. Of course, consumers still want to buy a pair of shoes (a
right one and a left one), so the demand for pairs of shoes continues
to be 10 − P1 − P2. If you think about it, this means that the right-
shoe producer sells 10 − P1− P2 right shoes, while the left-shoe
producer sells 10 − P1 − P2 left shoes. Since the marginal cost of a
pair of shoes is $2 per pair, the marginal cost of the right-shoe
producer is $1 per shoe, and the marginal cost of the left-shoe
producer is $1 per shoe.

i) Derive the reaction function of the right-shoe producer (P1 in

terms of P2)

ii) What is the Bertrand equilibrium price of shoes? How many

pairs of shoes are purchased?

iii) Has the breakup of the shoe monopolist improved consumer

welfare?

16. Suppose market demand is P = 130 − Q.

a) If two firms compete in this market with marginal cost c = 10,
find the Cournot equilibrium output and profit per firm.

b) Find the monopoly output and profit if there is only one firm with
marginal cost c = 10.

c) Using the information from parts (a) and (b), construct a 2 × 2 payoff
matrix where the strategies available to each of two players are to
produce the Cournot equilibrium quantity or half the monopoly quantity.

d) What is the Nash equilibrium (or equilibria) of the game you

constructed in part (c)?

17. Boeing and Airbus are competing to fill an order of jets for
Singapore Airlines. Each firm can offer a price of $10 million per jet
or $5 million per jet. If both firms offer the same price, the airline
will split the order between the two firms, 50–50. If one firm offers a
higher price than the other, the lower-price competitor wins the
entire order. Here is the profit that Boeing and Airbus expect they
could earn from this transaction:
Boeing
 P = $ 5M P = $10 M

30,30 270,0
0,270 50,50

(Payoffs are in millions of dollars.)

a) What is the Nash equilibrium in this game?

b) Suppose that Boeing and Airbus anticipate that they will be competing
for orders like the one from Singapore Airlines every quarter, from now to
the foreseeable future. Each quarter, each firm offers a price, and the
payoffs are determined according to the table above.

The prices offered by each airline are public information. Suppose that
Airbus has made the following public statement:

To shore up profit margins, in the upcoming quarter we intend to be

P = $ 5M
Airbus statesmanlike in the pricing of our aircraft and will not cut price simply to
P = $ 10
win an order. However, if the competition takes advantage of our
M
statesmanlike policy, we intend to abandon this policy and will compete
all out for orders in every subsequent quarter.

Boeing is considering its pricing strategy for the upcoming quarter. What
price would you recommend that Boeing charge? Important note: To
evaluate payoffs, imagine that each quarter, Boeing and Airbus receive
their payoff right away. (Thus, if in the upcoming quarter, Boeing chooses
$5 million and Airbus chooses $10 million, Boeing will immediately receive
its profit of $270 million.)

Furthermore, assume that Boeing and Airbus evaluate future payoffs in

the following :

way: A stream of payoffs of $1 starting next quarter and received in every

quarter thereafter has exactly the same value as a one-time payoff of $40
received immediately this quarter.

c) Suppose that aircraft orders are received once a year rather than once
a quarter. That is, Boeing and Airbus will compete with each other for an
order this year (with

payoffs given in the table above), but their next competitive encounter
will not occur for another year. In terms of evaluating present and future
payoffs, suppose that each

firm views a stream of payoffs of $1 starting next year and received every
year thereafter as equivalent to $10 received immediately this year. Again
assuming that Air bus will follow the policy in its public statement above,
what price would you recommend that Boeing charge in this year and
beyond