2 Managerial Economics Questions

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2.  The firms in a perfectly competitive industry had been earning zero economic profits.  However, the firms have recently experienced a large decrease in the cost of energy that enables them to substantially reduce the marginal cost and average total cost of producing each unit of output.  The market demand for the product is pretty elastic.  On the other hand, short-run efforts to increase production run into severely diminishing returns with respect to the employment of additional variable inputs.

  Draw two average total cost curves (ATC) for a typical firm.  One curve should represent ATC before the fall in the cost of energy.  The other curve should represent ATC after the fall in the cost of energy. Assume that the fall in the cost of energy does not affect the minimum efficient scale (MES) of production.  Draw short-run marginal cost curves on the same diagram to show both the fall in the cost of energy and the severely diminishing returns to the employment of additional variable inputs.

  Next to the diagram for a typical firm, draw a supply-demand diagram for the industry.  The slope of the demand curve should reflect the elasticity of demand for the product.  The short-run supply curve should reflect the presence of severely diminishing returns with respect to the employment of additional variable inputs.  The original equilibrium price in this diagram should line up with the minimum point of the original ATC curve for a typical firm.

  Properly shift demand or supply to reflect the fall in the cost of energy.  Note the change in the market equilibrium.  How does the magnitude of the change in the market price compare to the magnitude of the shift in ATC?  Explain.  Do firms now experience short-run economic profits?  In the long-run, can entry of new firms be expected in this industry?  If we have a decreasing-cost industry, show in your diagrams where the cost curves, the market price, and the equilibrium market quantity end up.  Fully explain what has happened.  Does the equilibrium quantity end up changing much in comparison to the magnitude of the overall change in price?  Why or why not?

3.  Use your knowledge about two-part pricing to advise the company below.

A company has a bar and is trying to decide on the cover charge (if any) and price for each drink.  It has done a modest survey in which it asked customers to classify themselves as light drinkers or heavy drinkers and to indicate the number of drinks they would typically consume during the evening.

The estimate from the survey is that a change in the price equal to $1 per drink causes light drinkers to change their consumption on average by 0.5 drinks per night.  However, a change in price of $1 causes heavy drinkers to change their consumption on average by 1.0 drink per night.  For both groups a typical consumer will not consume anything once the price reaches $9 per drink. (They may instead go to another bar or not go to a bar at all.)

Draw a demand curve for a typical light drinker and for a typical heavy drinker on the same diagram.  Explain your diagram.  Write equations for the curves in slope-intercept form. The general form for such an equation is P = a + bQ, where P is the price for the drinks, Q is the quantity of drinks purchased, ‘a’ is the intercept on the vertical axis, and ’b’ is the slope. (In the case of a downward-sloping demand curve, the slope will be a negative number.)

If 300 people visit the bar on a typical evening, with 200 people being light drinkers and 100 people being heavy drinkers, draw an overall demand curve for all of the consumers combined.  (Figure out the intercept on the vertical axis; this intercept indicates the price at which nobody would purchase anything.  Also determine the intercept on the horizontal axis; this intercept indicates what the total quantity demanded would be if the price of drinks were zero.)

What is the slope and what is the intercept for this demand curve?  Write an equation in slope-intercept form.

Recall that, in the case of a straight-line demand curve, the slope of the marginal revenue line for a company that does not practice price discrimination is double the slope of the (total) market demand curve. 

If the marginal cost of making drinks (the alcohol, the bartender’s labor, and the amortized cost of purchasing glasses and cleaning them repeatedly) is constant at $5 per drink, and if no cover charge is assessed, what is the best price to charge for drinks?  How many drinks would be sold on a typical evening?  What would your profits be? Show your work.

If you cut your price by $1 per drink AND assess the maximum possible cover charge without causing a typical light drinker to refuse to enter the bar, would your profits improve?  How high would the cover charge be?  Calculate both the cover charge and your total profits.  Would the new pricing increase profits?  Explain your answer fully.

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