ECON 1001

1. ECON 1001 Tutorial 8

2. Q1) Smith is a corn farmer earning economic profits and Wesson is a wheat farmer receiving a normal profit. Wesson has an incentive to become a corn farmer because • His accounting profits are negative. • He is not currently covering his opportunity costs. • He could earn more than his next best alternative. • His accounting profits are zero. • He dislikes Smith and wants to undermine Smith’s profit. Ans: C

3. Economic π = Total Revenue – Total Cost • When we calculate the economic profit, the cost we use is the opportunity cost of factors of production. • In particular, the OC of whatever (may it be physical or psychological efforts) the farmer contributes to the production process is included • All rational farmers of course will choose the alternative that yields the highest economic profit. • Thus, Wesson will be attracted to corn farming. (C)

4. Q2) One difference between the long run and the short run in a perfectly competitive industry is that • πLR > πSR at all times. • πSR > πLR at all times. • Firms necessarily produce Q that minimises ATC only in the LR. • MR = P only in the LR • π are maximised when MR = MC only in LR Ans: C

5. Options A and B are wrong. • A counter-example is enough to illustrate that they are both wrong, i.e., the strict inequalities do not hold in some situations. • The example: If in the short run the market price is at the minimum ATC of the perfectly competitive firms, the firms will choose to produce Q where P=MC=min ATC, earning zero profit. Note that in the LR, firms will always produce at P=MC=min ATC. • In this case, πLR = πSR , not strict inequality as claimed in A and B. • Option D is wrong because perfect competitive firms take price as given and hence P=MR in both SR and LR.

6. A graphical illustration for the previous slide P, MC, ATC MC ATC PSR = PLR QSR=QLR Q

7. Option E is also obviously not true. In both SR and LR (at all times), the profit maximising condition is MR = MC. • Option C is the right answer. • In the LR in perfectly competitive market, entry and exit are free. Positive economic profits attract entry. Negative economic profits force firm to exit. Thus, in the LR, a perfect competition firm must earn zero economic profit, hence must be producing at Q that minimises ATC.

8. Q3) What is the sequence of changes resulted from how a perfectly competitive industry responds to a sudden increase in popularity of the product? The mkt D shifts to the right causing the market… C) Price to ↑. ↑π attracts new firms to enter, shifting supply to the left. LR market equilibrium will be at a higher quantity but same price as before.

9. Some features of a perfectly competitive industry: • Identical firms: all firms face the same cost curves. • Free entry and exit. New firms can enter and existing firms can leave freely. • Homogeneous products.

10. Demand increases – SR in Perfect Competition P, MC, ATC P D’ S MC D P2 ATC P1 q1 q2 q Q When there is an increase in demand (D shifts to the right), price increases. Note that entry and exit cannot happen in the short run. The only response will come from individual firms expanding the output (along the firms’ MC or supply curve).

11. Demand increases – SR in Perfect Competition P, MC, ATC P Profit D’ S MC D P2 ATC P1 q1 q2 q Q Suppose the market was originally at LR equilibrium so that each firm is earning zero economic profit and producing at the output corresponding to min ATC. As price has increased, the new price must be above ATC. Hence, all current firms are earning positive economic profits.

12. LR Adjustment – Supply Increases and Price Drops P, MC, ATC P D’ S MC D S’ ATC P2 P1 q1 q2 q Q

13. In LR, the positive economic profit will attract new comers to enter the market. It is because a positive profit means they can make more earnings than elsewhere. • As new firms enter the market, the quantity supplied at all prices rises. • This shifts the Supply Curve to the right.

14. As all firms are identical, their min ATC points are all the same. • New firms will continue to enter the market until the price is exactly = min ATC. • Therefore, the price returns to the original level. But since more firms are now in operation, the new MARKET quantity supplied is higher than the original level. (C) (Note: Individual firm produce q1 in the LR!)

15. Q4) Assume that the market is currently as shown in the graph on the left (i.e. current price is $8). In the LR equilibrium in this market under free entry and exit, • P=$5, 20 firms producing. • P=$5, 10 firms producing. • P=$8, 20 firms producing. • P=$5, Total Q=500, no. of firms unknown. • P=$2, Total Q=700, 70 firms producing 10 units each. Ans: A

16. At the current price of $8, each existing firm is earning a positive economic profit. • This is because P > ATC at the level of production. • A positive profit will attract new comers to join the industry. • As more firms are producing, the market supply shifts to the right.

17. Profit attracts new firms, causing market supply to increase. Market Price Individual Firm $ / unit Supply S’ MC 8 ATC 5 Demand Q 10 25 30 q

18. By how much will the market supply curve shifts rightwards? • As supply increases, market price drops and quantity transacted increases. • As all firms have identical cost functions, price will drop all the way to the break-even point – min ATC. The new eq. price will be $5.

19. Let’s look at the Market Demand schedule. • At P=$5, Qd = 500. • That means in the LR, the eq. P = $5 and eq. Q = 500. • Each firm produces 25 units at P=$5. • Hence, there will be 20 firms producing. (A)

20. Q5) Economic profits are earned by ? while economic rents are earned by ? . • Firms in perfect competition; landlords. • All inputs to production; only land and buildings. • Firms; unique inputs to production. • Workers; entrepreneurs buildings. • Firms in the long run; firms in the short run. Ans: C

21. If price is above ATC, then there is a profit. This profit is said to be earned by the firm. • One way to interpret the economic rent (not always right): If each factors of production is earning an income higher than the cost of producing this factor, then it is said that they are enjoying an economic rent. [E.g., the cost of producing land is zero. The income to the this factor is an economic rent.]

22. Another way to interpret the economic rent:(textbook: p 229) e.g. As a talented cook, your customers are willing to pay 50% more to dine in your restaurant. • Thus, your boss will be willing to pay, at the most, 50% higher salary than a normal cook. • In this case, your economic rent (as the ‘unique’ cook in town) is the difference in your wage minus the wage of a ‘normal’ cook.

23. In this case, your boss is paying all the extra revenue generated by you to you as a pay raise (to keep your loyalty) • Thus, how much is your boss’ economic profit? ZERO in this case! (p. 228, textbook) • Note: econ profit (earned by firm) econ rent (earned by the specific factor) • This question is about definitions and some basic concepts of production. Please refer to the lecture notes and the book for further details.

24. Q6) A new production technique that reduces costs in a perfectly competitive industry will result in • Widespread industry adoption and a lower price to consumers. • Industry consolidation. • Sustained economic profits for the first firms that adopt the technique. • A rightward shift in the demand curve. • Entry by new firms but a sustained economic profits for the existing firms. Ans: A

25. One of the features of perfect competition is perfect information. • That means everyone knows everything about production, demand and supply of the products. • A new technique in production invented will be immediately known to all producers in the industry.

26. P, MC, ATC MC ATC P1 ATC’ P2 q

27. Therefore, this new technique will be adopted by all firms. • All firms’ ATC will shift down to the same level and by the same extent. • This drives down the market price • As a result, (A) is the correct answer.

28. Background story for Questions 7 and 8: • Street vendors in Austin were making an Revenue of $150,000 and Costs were $85,000. • Now sellers need a permit to run their businesses. Permits are issued to existing vendors, but no new permits will ever be issued. • These permits are freely transferable, with no expiration date. • Interest rate = 10%

29. Q7) After regulation, street vendors who own permits earn • Economic profits of $65,000 • Accounting profits of $65,000. • Economic losses of $585,000. • Economic profits of 0. • Accounting profits of 0. Ans: D

30. Before regulation, each vendor was enjoying an economic profit of $65,000. • With the regulation, permits are issued to these existing vendors for free. • At this point, we can still say that each vendor is earning an econ π of $65,000.

31. However, permits can be bought and sold without restrictions. • That means existing vendors now have the option of quitting their businesses and selling their permits to new vendors. • The market price of the permit then becomes an implicit cost of production.

32. What is the market price of these permits? • It would be the highest amount that new vendors are willing to pay in order to join the industry. • This would be the before-regulation economic profit. • which is $65,000. • With this extra $65,000 of implicit cost, each street vendors will earn no economic profits. (D)

33. Q8) Max, one of the current street vendors, has gone from earning an economic profit to earning a normal profit because • Fewer people come to shop. • His explicit costs have risen by $65,000. • His revenues have fallen by $65,000. • His implicit costs have risen by $65,000. • His implicit costs have risen by $650,000 Ans: D (see Q7 for explanation)

34. Q9) The efficient market hypothesis suggests • Newsletters with stock tips and recommendations are helpful to investors. • A significant lag exists between new info and changes in stock price. • There is little incentive for insider trading. • Information in stock tip newsletters is too outdated to be useful. • Some stock tip newsletters are helpful, others are useless. Ans: D

35. What is the efficient market hypothesis? • At any moment, the market price of a firm’s stock reflects all currently available information. • All currently available information includes any information about the present value of the firm’s current and future accounting profits.

36. In other words, any information about stock prices, any tips published in newsletters, magazines and ‘hint-books’ is already known and digested. • The current stock price must have already reflected those tips and information. • Therefore, (D) is the answer.

37. Q10) Suppose a Ph.D. mathematician discovers “the formula” for picking stocks, using well- known statistical models and publicly available data. One can predict that • He will become the wealthiest man in the world. • He will always outperform the market. • Other investors will ignore his behaviour. • As his success becomes well known, other investors will mimic his choices and thereby drive his return down. • He can sustain his success forever. Ans: D

38. The approach of this PhD mathematician can be successful only if the market is inefficient, i.e., Efficient Market Hypothesis is violated. • That is, changes in accounting profits are not correctly reflected in the stock prices. • That means the PhD is exploiting the fact that stock prices do not correctly reflect all the market information – via a statistical models and the use of publicly know information.

39. Note that news and information travels fast in the world, especially in the financial world. • It will soon be known that this mathematician is making a lot of money in the stock market. • Once known, everyone will be wanting to discover his ‘secret’, to know how he makes so much money.

40. He may have protected his “formula” well, by means of intellectual properties or simply trade secret. • However, it is not difficult to follow his decisions (his buy and sell orders are observable), and we can earn similar profit. • These trades (that exploit the inefficiency in the market of incorporating the market information into stock prices) will help to make the stock prices moving toward its “fundamental value” (i.e., the price that will reflect all its accounting profit).

41. Once the market becomes more efficient, the ability of the “secret formula” to beat the market is lowered, and hence less return will be earned. • Hence (D) is the answer.