PROBLEM SET – ANSWER KEY

Part 1: Average product vs. marginal product

A farmer raises grain. Fertilizer is applied to improve the yield per acre. The table below shows
yield per acre over a range of fertilizer application. Complete the table by computing average
product and marginal product. Over what range would the farmer produce, in terms of minimum
and maximum application of fertilizer per acre? What defines the end points of this range?

Fertilizer Yield Average Marginal

lbs/acre lbs/acre Product Product
50 100 2
………………………………………………… 140
100 240 2.4
………………………………………………… 80
150 320 2.13
………………………………………………… 70
200 390 1.95
………………………………………………… 40
250 430 1.72
………………………………………………… - 25
300 405 1.35
………………………………………………… - 35
350 370 1.06
Part 2: Market concentration
Six health insurance companies sell health plans through Covered California for consumers in
Los Angeles. Below are the market shares for each of these health plans. Calculate the four-firm
concentration ratio and the Herfindahl-Hirschman Index and discuss what these measures of
concentration indicate about the individual health insurance market in Los Angeles

Blue Shield of California: 29.1%

Health Net: 22.7%
Kaiser Permanente: 21%
L.A. Care Health Plan: 19.1%
Molina Healthcare: 4.3%
Oscar Health Plan of California: 3.8%

- Four-Firm Concentration Ratio

29.1 + 22.7 + 21 + 19.1 = 91.9

- Herfindahl-Hirschman Index

29.12 + 22.72 + 212 + 19.12 + 4.32 + 3.82 = 2,200.84

A four-firm concentration ratio of 91.9 indicates a highly concentrated market, dominated

by a few firms, constituting an oligopoly. A Herfindahl-Hirschman Index of 2,200, on the
other hand, suggests a moderately competitive market. What this example shows is that
these measures often lead to slightly different conclusions and that is why it is generally
wise to calculate both in order to obtain different perspectives on the degree of
competitiveness of a market.
Part 3: Perfect competition
Describe the requirements of a market in perfect competition. Discuss how well or poorly the
hospital market meets these requirements. Give an example of an industry with a highly
competitive market.

Perfect competition is a theoretical construct of a market with the following characteristics:

1) Products are identical, regardless who produces/sells it.
2) There are numerous firms and numerous buyers, so that no single producer or consumer
can influence market forces.
3) There is no barrier to entry. Any individual or firm can enter the market at any moment.
4) Established firms have no advantages over new ones, whether in terms of information,
technology, legal matters or any factor of production.
5) There is full symmetry of information, both in the supply side and on the demand side. In
other words, consumers are fully informed on prices and goods’ characteristics and
producers are fully informed on production factors.
6) No firm can influence price. All firms are price-takers, not price setters.

The hospital market fails in virtually all these requirements of a perfectly competitive market.
Examples of highly competitive markets are the markets of crops, plastic bags, paper milling,
plumbing, painting, house cleaning. But they are not perfect competitive markets.
Part 4: Profit-maximization
The table below shows the total and marginal revenue and total and marginal costs for a firm that
produces milk in a perfectly competitive market. On a graph, draw the marginal revenue and
marginal costs curves for this firm. How many gallons of milk will the firm produce each week?
Why will the firm not produce more or less than this amount of milk per week?

Marginal cost
Gallons of Marginal
Total revenue Total costs (per additional
milk per week revenue
gallon)
0 0 - 1,000 -
1000 500 0.50 1,500 0.50
2000 1000 0.50 1,850 0.35
3000 1500 0.50 2,100 0.25
4000 2000 0.50 2,360 0.26
5000 2500 0.50 2,660 0.30
6000 3000 0.50 3,010 0.35
7000 3500 0.50 3,410 0.40
8000 4000 0.50 3,860 0.45
9000 4500 0.50 4,360 0.50
10000 5000 0.50 4,910 0.55

0.6
0.5
Value in Dollars

0.4
0.3
0.2 Marginal Revenue
Marginal Cost
0.1
0
0 1000 2000 3000 4000 5000 6000 7000 8000 9000 10000
Quantity (gallons of milk per week)

In a perfectly competitive market, a company maximizes its profit at the quantity where marginal
cost equals to marginal cost. Thus, this company will produce 9,000 gallons of milks per week.
Any quantity below or above this quantity will represent a decrease in profit.
Part 5: Economic Profit
Sara was a successful gerontologist. However, after many years working in the same industry,
she got tired of her work and decided to quit her job and start a podcast. At the end of her first
year, Sara tallied up her income and expenses:
Sales:
20 advertising contracts at $2,500 per contract $50,000
Costs:
Recording equipment $1,200
Editing software $800
Miscellaneous travel expenses for interviews $5,000
Looking at her calculations, Sara proudly told her husband “I made $43,000 in profit during this
first year of podcasting!”
Comment on Sara’s statement. How would an economist evaluate her first year of profits?
From a personal point of view, Sara may be happy with her new financial life and that is what
ultimately matters to individuals. She has focused solely on accounting profit and that is
perfectly fine. However, if we apply the notion of economic profit to analyze her case, we would
say that her economic profit is probably negative. Recall that economists take into account the
alternatives forgone when a given decision is made. As a gerontologist she was almost certainly
making more than $43,000 yearly. As economic profit equals total revenue minus total cost
(which measured as the opportunity cost of production), her total cost should have included the
monetary gains forgone by not working as a gerontologist. Let’s say, for example, that she was
making $100,000 as a gerontologist. This number would have been included as an incurring cost
in the calculation of economic profit. Thus, we would say that her economic profit was actually
-$57,000.
Part 6: Technical and economic efficiencies
Karen supervises a furniture factory which manufactures reproduction of early American
antiques. She is planning production of a new line of cabinets. Each piece can be completed with
varying combinations of hand labor ($10/hour) and machine fabrication (also $10/hour). Using
the data provided below, are there any methods that are technologically inefficient? Which is the
most economic efficient method of production? Calculate what it will cost to produce a new
cabinet under each technologically efficient method.

Machine
Method Output Labor hours
hours Cost ($)
A 1 34 5 390
B 1 30 7 370
C 1 26 9 350
D 1 20 9 290
E 1 14 19 330
F 1 9 28 370

In order to determine which method is technologically inefficient, we have to look for methods
that produce the same output and the same amount of either labor or capital. Note that C and D
produce the same output with the same amount of labor, but C requires more capital. Therefore,
C is technologically inefficient.
The most economically efficient method is D, which can produce the same output as any other
method, but has the least cost.