Free-Response Question

1. Question

   Holly’s Cutlery is one of many producers of knives in a perfectly competitive market. Holly’s Cutlery is earning a greater than normal profit. Draw correctly labeled side-by-side graphs showing the market for knives and the marginal cost, average total cost, demand, and marginal revenue curves for Holly’s Cutlery.

   
   

   
   

   1. Show what will happen to each of the following in the long run:

      
      

      1. the industry supply curve for knives

         
         
      
      

      2. the price of knives

         
         
      
      

      3. Holly’s Cutlery’s output compared to the initial level

         
         
      
      

      
      

      
      
   
   

   2. On your graph for part a, shade the area that represents Holly’s Cutlery’s initial economic profit and explain what will happen to it in the long run.

      
      
   
   

   3. Now assume that in order to ensure overall public safety, the local government grants Holly’s Cutlery the exclusive right to produce knives. Draw a correctly labeled graph showing Holly’s Cutlery’s output level and price, assuming Holly’s Cutlery makes a greater than normal economic profit.

      
      
   
   

   4. Does Holly’s Cutlery produce the allocatively efficient level of output? Explain.

      
      

      Shade in the area of deadweight loss, if any, in the graph for part c.(14 points)

      
      
   
   

   Rubric for FRQ (14 points)

   1 point:Correctly labeled market graph with an upward-sloping supply curve and a downwardsloping demand curve

   1 point:Correctly labeled firm graph with a horizontal MR = D curve and a U-shaped ATC curve

   1 point:Initial output level labeled directly below where MR = MC

   1 point:Rightward shift in industry supply curve

   1 point:The price of knives decreases.

   1 point:Holly’s Cutlery produces less.

   1 point:Holly’s Cutlery’s initial economic profit is shaded as shown on the sample graph.

   1 point:Explanation that in the long run new firms will enter the market until the economic profit for each firm is zero

   1 point:Correctly labeled monopoly graph with a downward-sloping D curve and a MR curve below the D curve

   1 point:Output level labeled directly below where MR = MC and price labeled at the height of the D curve above the output level

   1 point:The ATC curve is U-shaped and lies below the price at the indicated level of output. A student can earn this point even if the wrong quantity was indicated for the previous point.

   1 point:Holly’s Cutlery does not produce at the allocatively efficient level.

   1 point:Explanation that monopolies are not allocatively efficient because their price exceeds marginal cost

   1 point:The correct deadweight loss area is shaded.