Economic 203

1. (Application of social welfare analysis to price floor)

In Week 2 we discussed the concept of a price floor. To jog your memory, a price floor is a mínimum price
that a governing body sets in order to prevent the price from falling to an unacceptable lower value. (We
often see these use to sustain higher prices for agricultural godos so that farmers receive more for their
produce than they otherwise would if the market were allowed to clear.) So now that you know something
about consumer, producer, and social surplus, you can analyze the impact of a price floor on consumer
welfare.

Consider below the market for home-grown tomatoes of a small, arid nation. The government, wishing to
guarantee farmers a mínimum tomato price, introduce a $3 price floor for tomatoes. That is, the market
price cannot fall below $3. So now, consumers purchase 10000 tomatoes at the new price floor (price) of
$3. Note that the original pre-floor market-clearing equilibrium price = $2; the original market-clearing
quantity, 20000.

Price

$4 S
$3

$2

$1
$4 D

Quantity
10000 20000

(a) Calculate consumer surplus at the original market-clearing equilibrium of P = $2, Q = 20000.

Calculate producer surplus at the original market-clearing equilibrium of P =$2; Q = 20000.

Calculate the social surplus at the original market-clearing equilibrium of P = $2, Q = 20000.

(b) Calculate the consumer surplus at the new price floor of $3. (Hint: this is the área of the triangle
under the curve bounded by the intersect at $4 and the price floor of $3.)

(c) Calculate producer surplus at the new price floor of $3. (Hint: it’s all of the área above the supply
curve at Q = 10000 and P = $3. So you’ll have to calculate the área of a rectangle and a triangle.)

(d) So what is the social surplus at the new price floor of $3?
 (e) Compare your answer to (d) with your final answer to (a). Has social surplus increased or
decreased? And how can we show this on the diagram above? (Prove to yourself that it’s the same
number!) So are price floors good policy? Why or why not?

2. Decide whether each of the following statements is true or false for each market structures given in the
question and depicted graphically below. And provide a one-sentence explanation defending your
choice. (So you’ll answer “true” or “false” 15 times and write 15 one-sentence answers!)

(A) (B) MC AC
MC
P P

AC

D =AR D = Ar
MR Q
Q

(C)
MC
P

AC

D = AR = MR

(a) Firms equate price and marginal cost.

Perfect competition?

Monopoly?

Monopolistic Competition?

(b) Firms equate marginal revenue and marginal cost.

Perfect competition?

Monopoly?

Monopolistic competition?

(c) Firms earn economic profit in the long run.

 Perfect competiton?

Monopoly?

Monopolistic competition?

(d) Firms produce the quantity that minimizes long-run average cost.

Perfect competition?

Monopoly?

Monopolistic competition?

(e) New firms are free to enter the industry.

Perfect competition?

Monopoly?

Monopolistic competition?

3. Consider the graph below that represents a donor kabab shop in Amberg.

MC
P
AC

D =AR

MR

(a) Explain why we know from the diagram that this firm is operating in a monopolistically competitive market
and not in a perfectly competitive market.

(b) The firm above is in short-run equilibrium. That is, something will change. What is it? And why?

(c) If this were a competitive market, identify the firm’s level of output, q, that would represent its long-run
equilibrium.
4. Consider the monopolist shown below. (Note that in this example, for simplicity, we’re assuming that AC is
constant. So if average “anything” is constant, then marginal “anything” equals the average. That is, MC = AC. )

400

D = AR (equation for demand curve? P = 400 - ½ Q)

MC = AC

100

300 600 800 Q

MR

(a) Identify the profit-maximizing quantity of output for this monopolist.

(b) As given above, the monopolist’s demand curve in this example is

P = 40 - 1/ 2 Q

So what price will this monopolist charge? (Simply substitute the value of Q you found in (a) into the
demand curve equation and solve for P.)

(c) At the profit-maximizing level of output, what is the value of consumer surplus?

(d) At the profit-maximizing level of output, what is the value of monopoly profits, which are the same as
producer surplus in this example?

(e) If this market were competitive, what would be the equilibrium level of output?
5. Prisoner’s dilemma applied to last year’s Republican Presidential Primary

For the skeptics who believe that microeconomics is conceptual and not as applicable to the “real world” as
macroeconomics might be, you might find this exercise of interest.

The question so many asked before the general election of last year was how Trump defeated all the other more
qualified candidates. One answer appeared in the Investor’s Daily News

Why, everyone in the political world wonders, have Jeb Bush, Marco Rubio, Ted Cruz and Chris Christie
(until he dropped out) spent so much time beating up each other? Why aren’t they jointly trying to
bring down this race’s 800-pound gorilla, Donald Trump?

(Moore, Stephen, Investor’s Daily (online), 17 Feb 2006)

The author then offers his answer, which I’m asking you to come up with! How? By examining the hypothetical
payoff matrix of vote shares (%s) below, where we assume a three-man race: John Kasich, Ted Cruz, and Donald
Trump. (The numbers reflect the percentage of the vote earned in any given state primary election.)

The question at hand is whether Kasich and Cruz should attack Trump or not attack Trump in advertisements,
debates, and so on. Each of the cells contains the expected payoff in terms of vote share.

(a) Assume Kasich thinks Cruz will attack Trump, what is Kasich’s best strategy?

Now assume Kasich thinks Cruz will not attack Trump, what is Kasich’s best strategy?

(b) Assume Cruz thinks Kasich will attack Trump, what is Cruz’s best strategy?

Now assume Cruz thinks Kasich will not attack Trump, what is Cruz’s best strategy?

(c) So does this game have a dominant strategy equilibrium? If so, what is it?

(d) So how does this explain why Trump was the Republican nominee?

(e) The author concludes his article with “What a way to learn an economics lesson!” Why do you think he
wrote that?
 Cruz

Attacks Trump Does not Attack Trump

Attacks Trump Kasich: = 29 Cruz = 29 Kasich = 22 Cruz = 30

Trump = 19 Trump = 25
Kasich
Kasich = 30 Cruz = 22 Kasich = 25 Cruz = 25
Does not Attack Trump Trump = 25 Trump = 35