Economic Principles

REVIEW QUESTIONS CHAPTER 1 1. What is the difference between microeconomics and macroeconomics? Micro and macroeconomics are both branches of economics, but have different objects of study. Microeconomics is concerned with the behaviour of individual economic agents (decision makers), such as consumers, workers, firms, managers, households, industries, markets, labour unions or trade associations. In doing so, it provides a framework to analyse the impact of government actions on the economy and the role of government in the economy. Macroeconomics, on the other hand, is concerned with how an entire economy performs. It studies other variables, of a more aggregate nature, such as the level of income and employment, the relation between interest rates and prices, inflation and business cycles. 2. Why is economics often described as the science of constrained choice? It is believed that human wants are unlimited: all human beings always desire more. However, the resources available to produce the desired good and services are finite – scarce –, so their supply is limited. As a result, human beings are constrained to choose between which wants to satisfy, and in doing so, allocate resources to satisfy demand. Since it is economics that deals with the allocation of scarce resources to satisfy unlimited human wants, economics is considered the science of constrained choice. 3. How does the tool of constrained optimization help decision makers make choices? What roles do the objective function and constraints play in a model of constrained optimization? The tool of constrained optimization helps decision makers make choices by taking into account all possible restrictions and limitation on those choices. To do that, it has two components: the constraints (restrictions and limitations) and an objective function. The objective function is the relationship the economic agent wants to either maximise of minimise. It is, in fact, what the agent cares about. So, constrained optimization points out to the relationship to be maximised or minimised, while accounting for possible limitations and restrictions. 4. Suppose the market for wheat is competitive, with an upward-sloping supply

curve, a downward-sloping demand curve, and an equilibrium price of $4.00 per bushel. Why would a higher price (e.g., $5.00 per bushel) not be an equilibrium price? Why would a lower price (e.g., $2.50 per bushel) not be an equilibrium price? If the market is in equilibrium at a price of $4.00 per bushel, a higher price ($5.00) would result in excess supply (Q4-Q2), with producers wanting to sell more wheat (Q4) than at $4.00 per bushel, but consumers wanting to buy less wheat (Q2). Conversely, at a price of $2.50 per bushel, consumers would want to buy more wheat (Q5), but producers would be willing to sell less wheat (Q1) – there would be excess demand (Q5-Q1). In either situation, the market does not clear.

Price Supply 5.00 4.00 2.50 Demand Q1Q2

Q*

Q4 Q5

Quantity

5. What is the difference between an exogenous variable and an endogenous variable in an economic model? Would it ever be useful to construct a model that contains only exogenous variables (and no endogenous variables)? An exogenous variable is one whose value is taken as given in a model. It is therefore, determined by some process outside the model being examined. An endogenous variable, on the other hand, is a variable whose value is determined within the model being studied. The objective of any model is to represent relationships between endogenous variables given values of the exogenous variables. So it makes no sense to have a model constructed simply with given values; it would show no meaningful relationships. 6. Why do economists do comparative statics analysis? What role do endogenous variables and exogenous variables play in comparative statics

analysis? Economists do comparative statics analysis to study the impact a change in an exogenous variable has in the level of an endogenous variable. So, the endogenous variables represent the objective function and the exogenous variables represent the constraints. The objective of the model is to represent is the behaviour and relationships of endogenous variables given the values of the exogenous variables. 7. What is the difference between positive and normative analysis? Which of the following questions would entail positive analysis, and which normative analysis? a) What effect will Internet auction companies have on the profits of local dealerships? b) Should the government impose special taxes of merchandise made over the Internet? In an economics setting, positive analysis attempts to explain how an economic models works and how it will change over time (answers explanatory and predictive questions), while normative analysis attempts to answer prescriptive questions, such as how to act in order to obtain a certain outcome – typically related to social welfare. Question a) is a matter of positive analysis, because it entails a prediction of what will happen should a certain policy be put in practice. Question b), on the other hand, is a matter of normative analysis, because it attempts to answer a prescriptive question – should a policy be put in place –, one imagines in order to obtain a certain social welfare outcome.

CHAPTER 2 1. Explain why a situation of excess demand will result in an increase in the market price. Why will a situation of excess supply result in a decrease in the market price? Considering the market was in equilibrium, a situation of excess demand or excess supply will result in the market failing to clear. At any situation other than equilibrium, there are pressures for the market price to change. In a situation of excess demand, the quantity demanded exceeds the supply at that price. As a result, buyers procure more than is available in the market, and there is pressure for the price to rise. As the price rises, the quantity suppliers are willing to sell also rises, but the quantity demanded falls, leading the market to an equilibrium. With higher price and lower quantity, the market moves towards an equilibrium, therefore eliminating the excess demand. In a situation of excess supply, the quantity supplied exceeds the demand at that price. As a result, producers can't sell as much as they would like, and this will create pressures for the price to go down. As the price falls, consumers are willing to buy a greater quantity, but producers are only willing to sell less of the product. With lower price and greater quantity, the market moves towards an equilibrium, therefore eliminating the excess supply. The predictions in either case only apply for a perfectly competitive market. 2. Use supply and demand curves to illustrate the impact of the following events on the market for coffee: a) The price of tea goes up by 100 percent

2P*

P*

Q2

Q*

When price rises from P* to 2P*, quantity demanded drops from Q* to Q2. The

result is excess supply. b) A study is released that links consumption of caffeine to the incidence of cancer The result of this study is, predictably, a reduction of the amount of coffee demanded by consumers relatively to equilibrium (Q*), to Q2:

P2 P*

Q2

Q*

As a result, the price will increase, from P* to P2, because of excess supply. c) A frost kills half of the Colombian coffee bean crop

P2 P*

Q2

Q*

As a result of the loss of part of the crop, the quantity available in the market drops from Q* to Q2, causing an excess demand and an increase in price, from P* to P2.

d) The price of styrofoam coffee cups goes up by 300 percent The price of styrofoam coffee cups probably account for just a small part of the price of coffee cups will cause the demand for coffee to shift. As a result of the price increase, a smaller amount of coffee-product will be in demand.

P* P2

Q2

Q*

This is a derived demand; however, the demand for the coffee-commodity by manufacturers is impacted by the consumer demand for the coffee-product, and so the quantity of coffee demanded in world market will drop, even if slightly, from Q* to Q2:

P* P2

Q2 Q* As a result, the price of the coffee-commodity will decrease.

3. Suppose we observe the price of soybeans goes up, while the quantity of soybeans goes up as well. Use supply and demand curves to illustrate two possible explanations for this pattern of price and quantity changes We will consider this is a perfectly competitive market. The first possible explanation is a shift in the demand curve, from D1 to D2, with people wanting more soybean products (Q* to Q2) and being willing to pay more for them (P* to P2):

P2 P*

D2 D1 Q*

Q2

Another possibility is a shift in the supply curve, from S1 to S2, resulting in an overall increase of the amount available in the market, coupled with a shift in the demand from D1 to D2:

S2 S2

P2

P1 D1 Q1

Q2

D2

4. A 10 percent increase in the price of automobiles reduces the quantity of automobiles demanded by 8 percent. What is the price elasticity of demand for automobiles? ϵQ,P = % change (Q) / % change (P) = -8/10 = -0.8 The price elasticity of demand for automobiles is -0.8. 5. A linear demand curve has the equation Q=50-100P. What is the choke price? The choke price is the price at which quantity demanded is 0 0 = 50-100P P= 0.5 The choke price is 0.5 (units of currency) 6. Explain why we might expect the price elasticity of demand for speedboats to be more negative than the price elasticity of demand for light bulbs. There are three characteristics of the products that impact on price elasticity of demand: the availability of substitutes, the percentage of the total consumer's expenditure that product represents and the product being seen by consumers as a necessity or not. As such, we would expect speedboats – which would account for a larger percentage of consumer's available income than light bulbs and that are easily seen as less necessary than light bulbs to have a more negative price elasticity of demand – the demand for them is more elastic and more price-sensitive. 7. Many business travellers receive reimbursement by their companies when they travel by air, whereas vacation travelers pay for their trips out of their own pockets. How would this affect the comparison between the price elasticity of demand for air travel for business travelers versus vacation travelers? We would expect that, for the same ticket at the same price, a company would have a less negative price elasticity of demand (be less sensitive to price), since for them that price would account for a much smaller percentage of the income when compared to a (typical) individual vacation traveler. Also, the company might see the travel as a necessity, while the individual traveler sees it as an avoidable expenditure (such as hobby or vacation). Finally, for the business traveller there might be little or no substitute than travelling to be in the place at a given moment, such as on short notice or because of the fact that the opportunity cost of using a slower means an air travel is cheaper), while the vacations

traveller can choose to use another means of transportation to go to the destination. 8. Explain why the price elasticity of demand for an entire product category (such as yoghurt) is likely to be less negative than the price elasticity of demand for a typical brand (such as Danone) within that product category. The market-level price elasticity of demand is usually more inelastic (less negative) than the brand-level elasticity of demand because other brands acts as close to perfect substitutes. If only Danone increases its prices, consumers might react by switching to the now lower price brands (like Yoplait), achieving a degree of utility quite similar (consuming the same amount of yoghurts, albeit slightly different ones). If all brands increased their prices by the same percentage at the same time, the consumer wouldn't have substitutes available and, to maintain his utility, will have to buy the now more expensive yoghurt – so the market-level PED will be less negative. 9. What does the sign of the cross-price elasticity of demand between two goods tell us about the nature of the relationship between those goods? If the cross-price elasticity of demand is positive, increased price for one product increases the demand for the other – the two products are demand substitutes. On the other hand, if the cross-price elasticity of demand is negative, it means that an increase in price of one product diminishes the demand for the other. This means these products' demand rise and drop together, so the products are demand complements. 10. Explain why a shift in the demand curve identifies the supply curve and not the demand curve A shift in the demand curve moves the market along the supply curve. If we know the shape of the supply curve (for example, if we admit it is roughly a straight line) we can identify two points along that line (the market equilibrium before and after the shift), which allows us to determine the slope of the supply curve, which did not shift.

CHAPTER 3 1. What is a basket (or a bundle) of goods? A basket or bundle of goods is a collection of goods and services that an individual might consume. 2. What does the assumption that preferences are complete mean about the consumer's ability to rank any two baskets? It means that the consumer is able to rank those two baskets, either by preferring one over the other or by being indifference between the two baskets. 3. Consider Figure 3.1. If the more is better assumption is satisfied, is it possible to say which of the seven baskets is least preferred by the consumer? No, we cannot. We don't have further information about the consumer's preferences, so we can't say, for instance, if he prefers D to E. In both these points total consumption is equal, but the amount of each good is different. We would need the specific consumer preferences for each good in order to be able to decided which of these two bundles is least prefered. 4. Give an example of preferences (i.e., a ranking of baskets) that do not satisfy the assumption that preferences are transitive. A ranking of preferences that violates the transitivity principle would be A>B, B>C but C>A. 5. What does the assumption that more is better imply about the marginal utility of a good? It implies that the marginal utility of a good is always greater than 0. That way, more of the good always increases the total utility for the consumer. If the marginal utility was ever 0 or negative, the consumer would not accept that more is better, because the total utility would either be constant or diminishing. 6. What is the difference between an ordinal ranking and a cardinal ranking? Both kinds of rankings give us information about the order in which a consumer ranks baskets. However, the ordinal ranking only gives qualitative information – the order of the baskets – while the quantitative ranking gives quantitative information, concerning the intensity of preference, therefore showing how much more a basket is preferred over the other.

7. Suppose Debbie purchases two hamburgers. Assume that her marginal utility is always positive and diminishing. Draw a graph with total utility on the vertical axis and the number of hamburgers on the horizontal axis. Explain how you would determine marginal utility at any given point on your graph. Total Utility

3

Number of Hamburgers

At any given point on this graph, the marginal utility is the slope of a line tangent to the curve on that point. So, the marginal utility from consuming 3 hamburgers is the slope of the depicted line. 8. Why can't you plot the total utility and marginal utility curves on the same graph? Marginal and total utility curves cannot be drawn on the same graph because the dimensions in the y-axis are not the same. A graph of marginal utility depicts the utility derived by a certain number or hamburgers, while the total utility is the sum of all the utility obtained from all the hamburgers consumed up to that one. 9. Adam consumes two goods: housing and food. a) Suppose we were given Adam's marginal utility of housing and his marginal utility of food at the basket he currently consumes. Can we determine his marginal rate of substitution of housing for food at that basket? Yes, we can. If MUH is the marginal utility of housing for Adam and MUF is his marginal utility of food, we know that MRSH,F (Adam's Marginal Rate of Substitution of housing for food) is given by: MRSH,F = MUH / MUF

b) Suppose we were given Adam's marginal rate of substitution of housing for food at the basket he currently consumes. Can we determine his marginal utility of housing and his marginal utility of food at that basket? No, we would need more information. In the case pointed , we have 2 variables (MU H and MUF), but only one equation (MRSH,F = MUH / MUF) to work on. We would need, at least, to know the utility function function for Adam and the currently level of utility he devises. That way, knowing the MRSH,F is the slope at that point, we could calculate MUH and MUF. 10. Suppose Michael purchases only two goods, hamburgers (H) and Cokes (C). a) what is the relationship between MRSH,C and the marginal utilities MUH and MUC? MRSH,C = MUH / MUC b) Draw a typical indifference curve for the case in which the marginal utilities of both goods are positive and the marginal rate of substitution of hamburgers for Cokes is diminishing. Using your graph, explain the relationship between the indifference curve and the marginal rate of substitution of hamburgers for Cokes. Cokes

3

2

Hamburgers

The straight line depicts the MRSH,C is tangent to the indifference curve at point (2, 3). The slope of the line equals the MRS at that point.

c) Suppose Michael always wants two hamburgers along with every coke. Draw a typical indifference curve. In this case, are hamburgers and Cokes perfect substitutes or perfect complements? In this case, hamburgers and Cokes are perfect complements – for each coke, Michael wants to have 2 hamburgers.

Cokes

2 1 2

4

Hamburgers

11. Suppose a consumer is currently purchasing 47 different goods, one of which is housing. The quantity of housing is measure by H. Explain why, if you wanted to measure the consumer's marginal utility of housing (MUH) at the current basket, the level of the other 46 goods consumed would be held fixed. We assume the utility a consumer obtains from consuming a certain good depend on the characteristics of that good. So, we can study the utility derived from that good while keeping the level of consumption of the other goods constant.

CHAPTER 4 1. If the consumer has a positive marginal utility for each of the two goods, why will the consumer always choose a basket on the budget line? If the consumer has a positive utility for each of the two goods, more of any increases the total utility, so the consumer will apply the principle of more in better. However, he has a limit of how much he can spend, and that limit is given by the budget line. The budget line represents the set of all baskets a consumer can buy if he spends all his income. Consequently, the consumer can't go beyond the budget line; however, because the principle of more is better still applies, the consumer will consume as much as possible, spending all his income, so the basket he eventually chooses to buy is on the budget line, not below it. 2. How will a change in income affect the location of the budget line? If the consumer receives more income, the budget line will shift out, with the new budget line being parallel to the first. 3. How will an increase in the price of one of the goods purchased by a consumer affect the location of the budget line? The increase in the price of one of the goods will make the budget line rotate about the intersect in the axis where the quantity of the other good is represented. 4. What is the difference between an interior optimum and a corner point optimum in the theory of consumer choice? In an interior optimum solution, the consumer purchases a positive amount of both goods studies, say x and y. However, the consumer may choose not to buy good y, so his basket will be along the x axis. In this situation, the budget line may not be tangent to an indifference curve at the optimal basket. 5. At an optimal interior basket, why must the slope of the budget line be equal to the slope of the indifference curve? An interior optimum is expressed in the following matter: max(x,y) U(x,y) subject to: Pxx + Pyy <= I Meaning the consumer will maximize his utility by buying as much of x and y as his income allows – so we know the sum of all expenditure on x and all expenditure on y will equal I,

therefore being a point on the budget line. This, however, does not show us how much of x and y will the consumer choose to buy in order to maximise his utility. To do that, the consumer will choose to buy at the point where the highest possible utility level (achievable within budget) has the budget line as tangent. We also know that, for any point of the utility curve, the tangent equals the Marginal Rate of Substitution at that point. Consequently, at the utility maximizing condition, the Marginal Rate of Substitution equals the slope of the budget line, which in turn equals the slope of the utility curve. 6. At an optimal interior basket why must the marginal utility per dollar spent on all goods be the same? We have shown that, if the consumer buys a positive amount of both goods, the budget line is tangent to the indifference curve. We have also shown that, at the maximization point, the marginal rate of substitution equals the slope of the budget line. From the MRS's definition, we have MRSx,y = Px/Py Because MRSx,y also equals Mux/MUy, it means that, at the interior optimal, MUx/Px = MUy/Py As a result, at the interior optimal basket, the consumer chooses commodities so that the marginal utility per currency unit spent on each is the same. 7. Why will the marginal utility per dollar spent not necessarily be equal for all goods at a corner point? A situation with a corner solution means that a consumer is always willing, along his budget line, to substitute an amount of a good for an amount of the other good. If x is the good the consumer wants more of and y the commodity he is willing to forego, we have that MUx/Px > MUy/Py The utility per dollar of x is always larger than the utility per dollar of y. As a result, he will end up only buying x and completely foregoing y.

8. Suppose that a consumer with an income of $1000 finds that basket A maximises utility subject to his budget constraint and realises a level of utility U1. Why will this basket also minimise the consumer's expenditures necessary to realise a level of utility U1? In a problem of either utility maximization or expenditure minimization, a consumer will reach the same solution. Units of x B

BL2=1000 BL3=1200 A BL1=800

C U1 Units of x

Taken as a utility maximization problem, the consumer cannot achieve U1 unless he spends on BL2, point A – he cannot, for example, spend on BL1 and obtain BL1 and obtain U1. Taken as an expenditure minimization problem, the consumer could obtain U1 by sending, for instance, in BL2 – in points B or C – but his overall income only allows him to achieve BL2. So, the expenditure minimization and the utility maximization have the same solution, point A, which is the tangent between the utility level required – U1 – and the available income – BL2. The optimal solution – A – maximizes utility and minimizes expenditure. 9. What is a composite good? In order to facilitate the study the required amount of a commodity of interest in a x-y axis, we plot it against a collective good – a good that represents the collective expenditure on every other goos except the commodity being considered. By convention, we consider that the price of a composite good is 1.

10. How can revealed preference analysis help us learn about a consumer's preferences without knowing the consumer's utility function? Since we don't know the consumer's utility function, we can't determine the position if his indifference curves. However, keeping in mind the consumer behaviour principles (preferences are complete; more is better; transitivity), it is possible to obtain the consumer's ordinal preferences relating to different baskets. Faced with a budget line and an amount of possible baskets, combining different amounts of both commodities at study, the consumer will choose a basket. We will then know that the consumer strongly prefers that basket to every other basket that would be less costly, and that that basket is weakly preferred to every other basket on the budget line. If we then change the budget line, the consumer will choose a new basket and, by transitivity, we are able to determine the consumer's preferences. This analysis assumes the consumer always maximizes his utility, whatever the constraints of the budget line. If he fails to do so, we can detect that situation through the method as well.

CHAPTER 5 1. What is a price consumption curve for a good? The price consumption good is a price that connects all the baskets that are optimal as the price of one good changes, holding the price of the other good and the income constant. This curve connects the utility-maximizing baskets. The chart where it is drawn depicts the quantities of two good chosen by the consumer, and a budget line. 2. How does a price consumption curve differ from an income consumption curve? The income consumption curve, depicted in a similar chart as the price consumption curve, connects utility-maximizing baskets as income varies and prices are held contant – while in the price consumption curve it was the price of one of the goods that changed. 3. What can you say about the income elasticity of demand for a normal good? The income elasticity of demand in the percentage change in demand for the product as the income of the consumer changes. If the good is normal, an increase in income always makes the demand grow – so the income elasticity of demand for a normal good is always necessarily positive. 4. If indifference curves are bowed in towards the origin and the price of a good drops, can the substitution effect ever lead to less consumption of the good? The substitution effect accounts for the change in consumption of a good when its price changes, maintaining utility constant. If the the price of the good drops, the budget line will tilt outwards, from BL1 to BL2, and consumption will move from A to B: y

A B BL1

BL2

x As a result, and can be seen from the chart, a substitution effect alone never accounts for

a reduction in consumption of a good whose price drops. 5. Suppose a consumer purchases only three goods, food, clothing and shelter. Could all three goods be normal? Could all three goods be inferior? Explain. For a good to be normal, its income elasticity of demand must be positive, meaning that, as the consumer's income increases, so does his consumption of the good. For some regions of the demand curves, we can expect all the goods to be good. However, after a certain amount of each good is purchased, the consumer might decide to substitute some of the quantity of one of the goods – making it an inferior good for that region of the demand curve – to purchase more if one of the goods, increasing his total utility in the process. However, if we assume that the utility of all goods is positive, if all goods were to be inferior – and the consumer would buy less of all of them as the income increased – the total utility would in the end decrease with the increase in income, which is hardly a rational outcome for a rational consumer, who works by the “more is better” principle. 6. Does economic theory require that a demand curve always be downward sloping? In not, under what circumstances does the demand curve have an upward slope over some region of prices? No, it does not. A demand curve can be upward sloping in the case of Giffen goods – goods so strongly inferior that the income effect outweighs the substitution effect. In these cases alone, the demand curve is upward sloping over some region of prices, in which the demand increases as the price increases. 7. What is consumer surplus? Consumer surplus is the difference between how much a consumer pays for a good and how much he would be willing to pay. It represents how much better off the consumer is in practice. 8. Two different ways of measuring the monetary value that a consumer would assign to the change in price of the good are (1) the compensating variation and (2) the equivalent variation. What is the difference between the two measures, and when would these measures be equal? The compensating variation is a measure of how much money a consumer would be willing to give up after reduction in the price of a good, in order to be just as well off as

before the price decrease. On the other hand, the equivalent variation is a measure of how much additional money a consumer would need before a price reduction to be as well off as after the price decrease. In general, they are the same, or else the price change would have a zero income effect. The only situation where it happens is if the Utility function is quasi-linear, in which case the utility curves are parallel and the vertical distance between two points is the same for any value of x. 9. Consider the following statements. Which might be an example of a positive network externality? Which might be an example of a negative externality? (i) people eat hot dogs because they like the taste, and hot dogs are filling. (ii) as soon as Zack discovered that everybody else was eating hot dogs, he stopped buying them Negative network externality – snob effect (iii) Sally wouldn't think of buying hot dogs until she realised all her friends were eating them Positive network externality – bandwagon effect (iv) When personal income grew by 10%, hot dog sales fell. 10. Why might an individual supply less labor (demand more leisure) as the wage rate rises? If the individual's demand utility function depends on the consumption of composite goods (for which he needs income, equal to the sum of all the hourly wages he makes working Lw) and leisure (which is the result of the subtracting the working hours, L, from total hours in a day, 24, which means it is 24-L), the individual gets ever more income the more hours he works (L increasing) and the more the hourly rate w. However, the more hours he works the less the leisure time he can enjoy, because the total number of hours in a day is fixed (24). So, as the wage rate increases, the consumer gets ever more income, which reduces the number of hours he needs to work in order to be able to buy one unit of the composite good. This leads to a substitution effect and an income effect. The former demands that the individual substitutes more composite good for more leisure, therefore working more and having more leisure. The latter makes the individual demand more leisure and less labour. When then income effect is larger than the substitution effect, the individual will start supplying less labour in order to enjoy more leisure.

CHAPTER 6 1. We said that the production function tells us the maximum output that a firm can produce with its quantities of inputs. Why do we include the word maximum in this definition? Because the total output could be some level beneath the maximum, in case of technical efficiency. 2. Suppose a total product function has the “traditional shape” shown in figue 6.2. Sketch the shape of the corresponding labour requirements function (with quantity of output on the horizontal axis and quantity of labour on the vertical axis). Q

100

200

L

3. What is the difference between average product and marginal product? Can you sketch a total product function such that the average and marginal product functions coincide with each other? The average product of labour is the average amount of output per unit of labour. On the other hand, the marginal product of labour is the rate at which total output changes as the quantity of labour the firm chooses is changed. The only way the average and marginal production functions could coincide was in case the marginal product of labour was constant. That, in which case dQ/dL would be constant, and so would be the average product function. This case is not realistic, so we assume it is not possible to sketch such function.

4. What is the difference between diminishing total returns to an input and diminishing marginal returns to an input? Can a total product function exhibit diminishing marginal returns but not diminishing total returns? In a situation of diminishing marginal returns to an input, total output increases with a further unit, but at a decreasing rate. In a situation of diminishing total returns to an input, the output actually diminishes if a further unit of input is added. 5. Why must an isoquant be downward sloping when both labour and capital have positive marginal products? Because, if marginal product for either input is positive, it is possible to substitute a number of units of one of them for a number of units of the other while maintaining output constant. Since along an isoquant line output is constant and it is the quantity of inputs that changes, as long as the isoquant is downward sloping, both inputs have positive marginal products. 6. Could the isoquants corresponding to two different levels of output ever cross? No, because if they crossed, it would mean they had the same level of output at a certain point, but not on others. An isoquant maintains output quantities constant along its line. 7. Why would a firm that seeks to minimize its expenditure on inputs not want to operate on an uneconomic portion of an isoquant? Because, while operating on the uneconomic portion of the isoquant, a firm would be operating in ar area where it would be using too many of one input to compensate for excess of another input. The same firm, with the same production function, could produce the same quantity with a lower quantity of the input in excess, reducing costs, if it worked on the economic region of the isoquant. 8. What is the elasticity of substitution? What does it tell us? The elasticity of substitution is a measure of how easy it is for a firm to substitute one input for another. It is the result of dividing the percentage change in the inputs ratio by the percentage change in the Marginal Rate of Technical Substitution. It tells us about the firm's input substitution opportunities, measuring how quickly the MRTS changes as we move along an isoquant. With this information we can, for example, identify the shape of the production function.

9. Suppose the production of electricity requires just two inputs, capital and labour, and that the production function is Cobb-Douglas. Now consider the isoquants corresponding to three levels of output: Q=100,000 kilowatt-hours, Q?200,000 kilowatt-hours, and Q=400,000 kilowatt-hours. Sketch these isoquants under three different assumptions about returns to scale: constant returns to scale, increasing returns to scale and decreasing return to scale. a) constant returns to scale (doubling the level of both inputs results in doubling the output):

Capital

Q=400,000

400

200 Q=200,000 100 Q=100,000 100

200

400

Labour

b) diminishing returns to scale (doubling the level of both inputs results in less than double outputs)

Capital

400 Q=200,000

Q=400,000

200

100 Q=100,000 100

200

400

Labour

c) increasing marginal returns (doubling the level of both inputs more than doubles the level of output): Capital

Q=400,000

400

200 Q=200,000 Q=100,000

100 100

200

400

Labour

CHAPTER VII 1. A biotechnology firm purchased an inventory of test tubes at a price of $0.50 per tube at some point in the past. It plans to use these tubes to clone snake cells. Explain why the opportunity cost of using these test tubes might not equal the price at which they were acquired. The opportunity cost faced by a firm is the value of the best alternative forgone when another alternative is chosen. The biotechnology has invested in the tubes, and that is an sunk cost, so it does not count to calculate the opportunity cost. Because opportunity cost is forward looking, the firm faces a decision whether to produce clone snake cells, or for instance, sell or lease lease the tubes for a certain amount of money. To decide on the course of action, the firm will calculate how much money it will receive from the production of clone snake cells and compare it with the price it would get from selling or leasing the tubes to, say, lease or sell the tubes to produce clone monkey cells. If the opportunity cost from producing the clone snake cells is larger than the opportunity cost of leasing or selling the tubes, it will lease or sell the tubes and not produce. 2. You decide to start a business that provides computer consulting for students in your dormitory. What would be an example of an explicit cost you would incur in operating your business? What would be an example of an implicit cost you would incur in operating this business? The explicit costs faced are all costs that involve a direct monetary outlay – tools, computer, parts and publicity of the service. The implicit costs are all costs that do not involve outlay of cash, like time and investment in knowing more about computers to be able to perform the service. 3. Why does the “sunkness” and “unsunkness” of a cost depend on the decision being made? A sunk cost is a cost that has already been incurred, and thus cannot be recovered, while an nonsunk cost is a cost that is incurred only if a particular decision is made. When deciding to build a factory, the price of construction is a nonsunk cost, because the owner can still decide whether or no to go ahead with it. However, after the plant has been built, the cost becomes sunk and the decision is to keep the factory open or close it. So, the same cost – building the factory – was nonsunk before, but becomes sunk after the plant is built, and shouldn't impact on the decision of keeping it open or closing it.

4. How does an increase in the price of an input affect the slope of an isocost line? The isocost line represents a set of combinations of inputs that yield the same cost for the firm. As one of the inputs increases in price, and the cost of the other input stays the same, the only way for the cost to remain constant is to decrease the quantity of the input whose price increases, and increase the quantity of the input whose price stays the same. As a result, the isocost line will have to tilt to accommodate these different quantities: Capital

Labour

In this example, as the price of capital increases, the quantity is capital used is diminished and the quantity of labour is increased. The blue isocost line depicts the first situation, the red isocost line the final state. In both cases, the slope of the line are given by the ratio of respective prices, -w/r. 5. Could the solution to the firm's cost-minimization problem ever occur off the isoquant representing the required level of output? No, it cannot. If the total inputs of the firm result in a point outside the isoquant line, the production is technically inefficient, because it is using too much inputs for an output that could be achieved with less. 6. Explain why, at an interior optimal solution to the firm's cost-minimization problem, the additional output that the firm gets from a dollar spent on labor equals the additional output from a dollar spent on capital. Why would this condition not necessarily hold at a corner point optimal solution? At an interior optimum, and as long as the amount of both inputs used is positive, the firm's

cost-minimizing solution is on the isoquant, at the point where that line is tangent to the lowest possible isocost line. At that point, the slope of the isocost line equals the slope of the isoquant, which in turn equals the marginal rate of technical substitution between inputs. We also know that the marginal rate of technical substitution equals the rate between the Marginal product of the inputs, and the ration of input prices. As a result, because the ration of marginal products of inputs equals the ratio of their relative prices, substituting a dollar worth of one input (labour) for a dollar worth of the other input (capital) results on output being the same. In the case of corner solutions this does not apply. In these cases, the firm does not use one of the inputs, relying solely on the other, because the rate between the marginal product of one input and its price is always larger than the other, so there are always gains from trading one for the other until the second is 0, not used. 7. What is the difference between the expansion path and the input demand curve? The expansion path is a line that connects the cost-minimizing input combinations as the quantity of output varies. It traces the various optimal combinations of inputs for different outputs. The input demand curves are curves that show the demand for specific inputs of the production function. They show how the cost-minimizing quantity of an input varies as its price varies. 8. In Chapter 5 you learned that, under certain conditions, a good could be a Giffen good: an increase in the price of the good could lead to an increase, rather than a decrease, in the quantity demanded. In the theory of cost minimization, however, we learned that, an increase in the price of an input will never lead to an increase in the quantity of the input used. Explain why there cannot be “Giffen inputs”. If there was a Giffen input, we would see that, as its price would rise, so would the demand for it. But, as a result, all things being equal, the firm would maintain the quantity of the other input used ans the quantity of output produced, so would now be producing the same but using more or a more product input. This would mean the firm would be technically efficient, and as such there cannot be “Giffen goods”

9. For a given quantity of output, under what conditions would the short-run quantity demanded for a variable input (such as labour) equals the quantity demanded in the long-run? In the short run, a firm is not able to fully adjust its production to have the lowest possible costs, whereas it can do it in the long run. As a result, the only situation where the shortrun quantity demanded for a variable input equals the quantity demanded in the long run is when the company happens to get the quantity of that input it uses just right.

CHAPTER 8 1. What is the relationship between the solution to the firm's long-run costminimization problem and the long-run total cost curve? A long-run total cost curve shows how total cost varies with output, holding input prices fixed and choosing all inputs to minimize cost. So, it represents the relationship between output and minimized total cost. Consequently, the various points in the long-run total cost curve are the cost-minimizing conditions for every quantity of output. 2. Explain why an increase in the price of an input typically causes an increase in the long-run total cost of producing any particular level of outcome? Of the company is in a cost-minimizing condition (as it is supposed to be, in the long-run), increase in the cost of one of the inputs will prompt a tilt in the isocost line, so that the marginal products of inputs are the same. Even considering that the other input's cost stays the same, as long as the output is maintained constant as well, the total cost will have to increase. 3. If the price of labour increases by 20 percent, but all other input prices remain the same, would the long-run total cost of a particular output level go up by more than 20 percent, less than 20 percent or exactly 20 percent? If the prices of all inputs went up by 20 percent, would the long-run total cost curve go up by more than 20 percent, less than 20 percent, or exactly 20 percent? Maintaining output level constant, and the prices of other inputs fixed, a 20% increase in the price of an input will result in a less than 20% increase in the long-run cost because the optimal input combination will change towards more of the other inputs, until the marginal product of all inputs is the same again, partially offsetting the 20% increase in the cost of that input. If all input's prices increase by 20%, to maintain the total output the total cost will have to increase by 20%, because the input combination will be the same – the marginal product if each input is the same. 4. How would an increase in the price of labour shift the long-run average cost curve? Considering all other input costs stayed the same, the increase in the price of labour would make the long-run average cost curve shift up by less than the percentage increase in the

price of labour. 5. a) if the average cost curve is increasing, must the marginal cost curve lie above the average cost curve? Why or why not? Yes, it must. The average cost curve only starts increasing after the point where the marginal cost curve intersects it. b) if the marginal cost curve is increasing, must the marginal cost curve lie above the average cost curve? Why or why not? It can be either above or below the average cost curve. The marginal cost curve inflects and starts increasing while below the average cost curve, intersects it while increasing and goes on increasing while above the average cost curve. 6. Sketch the long-run marginal cost curve for the “flat-bottomed” long-run average cost curve shown in Figure 8.11. AC/MC

MC AC

Q'

Q''

Quantity

7. Could the output elasticity of total cost ever be negative? The output elasticity of total cost is the percentage change in total cost per 1 percent change in output. If it was ever negative, it would mean that, while producing more, the company would have a smaller total cost. In this situation, the company wouldn't have been in a technically efficient situation in the first place. So, the output elasticity of total cost cannot be negative.

8. Explain why the short-run marginal cost curve must intersect the average variable cost curve at the minimum point of the average variable cost curve. The short-run average cost curve is a vertical sum of the average variable cost and the average fixed cost. Since the fixed cost is constant, its average will be diminishing as the quantity increases, spreading the cost per more units. As a result, it is the average variable cost that changes as the quantity increases, so it is the main determinant of the short-run average cost curve. As a result, the short-run marginal cost curve will intersect it at the minimum point, reflecting the same relationship between average and marginal curves as seen in the long-run. 9. Suppose the graph of the average variable cost curve is flat. What shape would the short-run marginal cost curve be? What shape would the short-run average cost curve be? The short-run marginal cost curve will be flat, and equal to the short-run average cost. The short-run average cost curve will have the same shape as the short-run fixed cost curve: downward sloping curve. Its distance of the average fixed curve will remain constant, equal to the short-run average variable cost. 10. Suppose the minimum level of short-run average cost was the same for every possible plant size. What would that tell you about the shapes of the long-run average and long-run marginal cost curves? In that situation, the short-run marginal cost curve would be straight, horizontal line, and so would the long-run average and marginal cost curves, all with the same value of cost. 11. What is the difference between economies of scope and economies of scale? Is it possible for a two-product firm to enjoy economies of scope but not economies of scale? Is it possible for a firm to have economies of scale but not economies if scope? Economies of scale are a characteristic of a production function where the average cost decreases as the output increases, so each unit is, in average, cheaper to produce the more a producers produces of it. On the other hand, economies of scope are a production situation where the total cost of producing two products in the same firm is less than the total cost os producing them in two different single-product firms. The former is about the average cost of a product, and arises from efficiencies in the production process, while the later concerns the total cost of production of a batch of two

products, and results from the physical properties of products, specialization of labour or the need to work with indivisible inputs. They exist up to the point where the marginal cost equals the average cost. The later arise in situations where variety brings more advantage than specialization, especially if a firm is available to use one common input for both products. As long as there are no managerial diseconomies and the firm in question is a costminimizer, it will enjoy economies of scale in both products, although these might be smaller that the economies of scale from just one product. It is perfectly possible for a firm to have economies of scale but not economies of scope. Any firm producing only one product and enjoying economies of scale will do so. 12. What is an experience curve? What is the difference between economies of experience and economies of scale? An experience curve translates the relationship between the average variable cost and the cumulative production volume, used to transmit the notion of economies of experience. This cost will be decreasing as more units of the product are produced. There are two differences towards economies of scale: first, unlike economies of scale, economies of experience do not have a “diseconomies of experience” area, in which the average cost climbs again. In fact, these curves might reach a point where the slope is 0 and there is are no more gains from experience to be had, but it will never be a negative slope. The other difference is the root cause of economies of experience: these arise from learning-by-doing, an accumulation of experience that results in the honing of processes, while economies os scale arise from specialization of labour, physical properties of processing units or the need to employ indivisible inputs.

CHAPTER 9 1. What is the difference between accounting profit and economic profit? How could a firm earn positive accounting profit but negative economic profit? The economic profit is the difference between a firm's sales revenue and the sum of all its economic costs, including opportunity costs. The accounting profit is the difference between the firm's sales revenue and the sum of (only) the accounting costs – the historical explicit costs (money outlays). Therefore, a fir can earn positive accounting profit is the sum of all its sales revenue is larger than the explicit costs – if there's more money coming in than going out. However, it is possible that, in that situation, the firm might have had a better use for the money than the one it did, so it is incurring an opportunity cost by doing what it is doing, and as a result obtain a negative economic profit. 2. Why is the marginal revenue of a perfectly competitive firm equal to the market price? The marginal revenue is the rate at which the total revenue changes with respect to output. It gives us the price of producing one more unit. Since the firm, in a perfectly competitive market, is a price taker, it takes P as given and needs to decide on the Q to produce in order to maximize its profits. Because P is taken, the marginal revenue equals the price in the market. A price taker, profit-maximizing firm will operate at the point at which marginal revenue equals market price. 3. Would a perfectly competitive firm produce if price were less than the minimum level of average variable cost? Would it produce if price were less than the minimum level of short-run average cost? A perfectly competitive firm, that faces all costs as sunk (TFC=SFC), will not produce where the price in the market is less that the minimum level of average variable cost, because in that situation not only would it have its total sunk costs, it would also lose the difference between the price and the short-run marginal cost in each rose. In this situation, the firm will face a smaller loss not producing than producing. Not producing, it only pays the sunk, unavoidable costs, and avoids the variable costs Yes, it will produce if price is less than the minimum level of the short-run average cost, as long as it is above the minimum level of the average variable cost, because in that situation the firm will have a smaller loss by producing than by not producing.

4. What is the shut-down price when all fixed costs are sunk? What is the shutdown price when all fixed costs are nonsunk? When all costs are sunk, the shut-down price is the minimum of the average variable cost curve. Below this quantity, the company does not produce, because it faces a larger loss by producing than by shutting down. If all fixed costs are nonsunk, the firm will be better off not producing if the market price is smaller than its average nonsunk fixed costs. So, the shut-down price is the minimum of its average nonsunk costs. Since all fixed costs are nonsunk (there are no sunk costs), The firm will not produce of the price is below the minimum short-run average cost. 5. How does the price elasticity of supply affect changes in the short-run equilibrium price that results from an exogenous shift in the market demand curve? An exogenous shift in the market supply curve will result in the quantity demanded being changed from the initial state to the new equilibrium state. The price elasticity of supply gives us the percentage change in quantity for each percentage change in price, holding all other determinants of supply constant. The larger it is, the larger the price increase will be for a determinate shift in the supply curve. The supply curve will be steeper the larger the price elasticity of supply. 6. Consider two perfectly competitive industries – Industry 1 and Industry 2. Each faces identical demand and cost conditions except the minimum efficient scale output in Industry 1 is twice that of Industry 2. In a long-run perfectly competitive equilibrium, which industry will have more firms? In the long-run, firms can choose to enter or leave the market. Considering demand is the same for both industries, in Industry 1, when all producers try to produce at least at the minimum scale output, they will create excess supply and a consequent drop in prices. As a result, the market price will drop, and for some producers it will be below their average cost curve, forcing them to stop producing and leave the market. 7. What is economic rent? How does it differ from economic profit? The economic rent is the economic return a firm gets from an extraordinarily productive input whose supply is scarce. It is the difference between how much the firm is willing to pay for the input and the return the owner of the input could by deploying it elsewhere in the industry – the input owner's opportunity cost.

On the other hand, the economic profit is the difference between the firm's sales revenue and the sum of all relevant economic costs it faces. When deciding whether or not to deploy an extraordinarily productive input, the firm faces an opportunity cost: it will increase productivity, but will also result in greater costs, and in a perfectly competitive market the bidding for the special input might be such that it ends up capturing part of the economic profit. When al the economic profit is captured by the input, there is no economic rent to be won from employing the input. 8. What is the producer surplus for an individual firm? What is the producer surplus for a market when the number of firms in the industry is fixed and input prices do not vary as industry output changes? When in producer surplus equal to economic profit (for either a firm or an industry)? When producer surplus and economic profit are not equal, which is bigger? The producer surplus is a measure of the monetary benefit that producers derive from producing a good at a particular value. It is the difference between the price a producer would be willing to sell its product at, and the price it actually gets. For a single firm, the producer surplus is the difference between the total revenue and the nonsunk costs. For a market where the number of firms is fixed (short-run) and the input prices do not vary as industry output changes (constant cost industry), the market-level producer surplus is the difference between the total revenue of all firms in the market and their total nonsunk costs: the are between the market supply line and the actual price in the market. For either a firm or an industry, producer surplus equals economic profit when there are no sunk costs. Indeed, the economic profit equals total revenue minus sunk costs. So, when there are sunk costs, and so economic profit and producer surplus differ, producer surplus is larger than economic profit. In the long-run, all costs are sunk, so economic profit and producer surplus are always the same. 9. In the long-run equilibrium in an increasing-cost industry, each firm earns zero economic profits. Yet there is a positive area between the long-run industry supply curve and the long-run equilibrium price. What does this area represent? In the long run, economic profits equals zero, and producer surplus equals economic profits, so they are zero. So, that area corresponds to economic profit captured by a form that owns an extraordinarily productive input. As the price for this input is bid up, this are

will diminish. 10. Explain the difference between the following concepts: producer surplus, economic profit, and economic rent. The producer surplus gives a measure of the difference between the price the producer is willing to sell the product at, and the price it actually achieves. In the short run, it is the difference between total revenue and total nonsunk costs; on the long run, it is the difference between total revenue and total costs, and equals 0. Economic profit is the difference between a firm's total revenue and all its economic costs, including relevant economic profits. It is always the difference between total revenue and total cost, and in the long-run that difference will be 0. The economic rent is the rent a firm captures by employing an extraordinarily productive input. It is a competitive advantage over rival firms that do not enjoy the services of that specific input. If the industry is constant-cost, this will be positive. However, if there is intense bidding for the input, the industry will become increasing-cost, and eventually all rent will be captured by the owner of the extraordinarily productive input.

CHAPTER 10 1. What is the significance of the “invisible hand” in a competitive market? The significance of the “invisible hand” is that, left to its own volition, a perfectly competitive market will result in maximum efficiency and social welfare. This is the market that allocates resources the most efficiently. 2. What is the size of the deadweight loss in a competitive market with no government intervention? A perfectly competitive market, with no government intervention, does not have deadweight losses. The deadweight loss is, therefore, 0. 3. What is meant by the incidence of a tax? How is the incidence of an excise tax related to the elasticities of supply and demand in a market? The incidence of a tax measures the impact of the tax on the price consumers pay versus the price producers receive. It is a way to measure how much of the total amount of the tax is brunt by both sides of the equation. The higher the elasticity (of either supply or demand), the smaller the incidence of the excise tax on the respective side (producers or consumers). 4. In the competitive market for hard liquor, the demand is relatively inelastic and the supply is relatively elastic. Will the incidence of an excise tax of $T be greater for consumers or producers? Since demand is relatively inelastic and supply is relatively elastic, the incidence of the tax for consumers will be relatively higher than for producers. 5. Gizmos are produced and sold in a competitive market. When there is no tax, the equilibrium price is $100 per gizmo. The own-price elasticity of demand for gizmos is known to be about -0.9 and the own-price elasticity of supply is about 1.2. In commenting a proposed excise tax of $10 per gizmo, a newspaper article states that “the tax will probably drive the price of gizmos up by about $10.” Is this a reasonable conclusion? No, it is not. Since the elasticities are close, the increase in price caused by the tax will be spread between the consumers and the producers. 6. The cheese-making industry in Castoria is competitive, with an upward-

sloping supply curve

and a downward-sloping demand curve. The

government gives cheese producers a subsidy of $T for each kilogram of cheese they make. Will consumer surplus increase? Will producer surplus increase? Will there be a deadweight loss? In the situation where, in a perfectly competitive market, government gives a subsidy, there will always be increases in the consumer and in the producer surplus. However, there will be a deadweight loss, resulting in loss of efficiency. 7. Will a price ceiling always increase consumer surplus? Will a price floor always increase producer surplus? Regarding consumer surplus, it might happen that the consumers with the highest willingness to pay rent all available housing units. In that case, since they were willing to pay for more than they actually do, the consumer surplus is maximum, and actually bigger than without price ceilings. However, it might happen that not exactly the consumers with the biggest consumer surplus get the houses, and in that case the consumer surplus is smaller. It might even happen that only the consumers with the smallest of all willingness to pay get the houses, and in that case consumer surplus is smaller than without rent controls. A similar situation happens regarding producer surplus. In the case it is the most efficient producers that get to sell their product, a price floor will increase overall producer surplus. However, as less efficient producers sell their product, the price floor is detrimental of consumer surplus, and it might end up being less than without price floors in place. 8. Will a production quota in a competitive market always increase producer surplus? No, producer surplus may either increase or decrease with a quota. Because there is excess supply, the size of producer surplus will depend on which of the producers actually supplies the product. In case it's the least efficient suppliers, producer surplus will be smaller with than without a quota. 9. Why are agricultural price support programs, such as acreage limitation and government purchase programs, often very costly to implement? Because they involve direct money payments to farmers, either to reduce production or to buy a part of that production, and maintain the market price artificially low. However, this money must be found somewhere else in the economy, taxing other activities, and (in the

case of government purchases), selling the excess product, although this might end up decreasing the market price for the good, which is the contrary of what was intended with the program. 10. If an import tariff and an import quota lead to the same price in a competitive market, which one will lead to a larger domestic deadweight loss? The deadweight loss is larger in the case of the import quota. With tariff, there will be imports of product, simply at a larger price, while with the quota, these imports are restricted beyond a specific value, possibly creating shortages in the market. Besides, the tariff provides revenue for the government, which can be re-invested in the economy, therefore leading to potentially some beneficial effects. 11. Why does a market clear when the government imposes an excise tax of $T per unit? The market clears because producers are allowed to produce as much as consumers are willing to buy in the new, prevalent conditions. The effect is a shift in the demand line, so the consumers are willing to buy more at prices before the tax than after the tax. However, no shortages arise and the market clears. 12. Why does a market clear when the government gives producers a subsidy of $T per unit? The market clears because, with the subsidy, the consumers will be willing to buy a larger quantity of the cheaper product, and producers are willing to supply it. Therefore, the only effect is a shift in the demand line, with more product being available cheaply in the market, and so the market is allowed to clear in a new equilibrium. 13. Why does the market not clear with a production quota? When a production quota is put in place, the quantity supplied is limited, so some of the demand will go unanswered. As a result, the market will not clear. 14. With a price floor, will the most efficient producers necessarily be the one supplying the market? Not necessarily. Every manufacturer whose marginal cost of production is smaller than the price floor will be trying to supply the market, regardless of how smaller its marginal cost is. The most efficient suppliers end up losing their competitive advantage.

CHAPTER 11 1. Why is the demand curve facing a monopolist the market demand curve? Since the monopolist is the only seller in the market, and so can affect both the quantity and the price in the market, the monopolist faces the market demand curve. 2. The marginal revenue for a perfectly competitive firm is equal to the market price. Why is the marginal revenue for a monopolist less than the market price for positive quantities of input? Because the monopolist faces a downward-sloping demand curve, the decision to produce a larger quantity of the product means it will gain in total revenue (more units) but will slowly lose revenue, as more quantity is produce and the price drops. So, the marginal revenue for a monopolist is the market price minus the loss of revenue dues to price drop as production increases. 3. Why can a monopolist's marginal revenue be negative for some levels of output? Why is marginal revenue negative when market demand is relatively inelastic? Since the marginal revenue for a monopolist is smaller than the market price, as quantity increases, the revenue lost with each unit increases. Therefore, there may be a quantity at which the loss per unit is larger than the market price, so the marginal revenue is may become negative. Since for a monopolist faces a downward-sloping curve, in the relatively inelastic region of the demand curve, price will be lower than in the elastic region and the marginal revenue will be negative. 4. Assume that the monopolist's marginal cost is positive at all levels of output. a) True or False: when the monopolist operates on the inelastic region of the market demand curve, it can always increase profit by producing less output. True b) True of False: when the monopolist operates on the elastic region of the market demand curve, it can always increase profit by producing more output. True

5. At the quantity of output at which the monopolist maximizes total profit, is the monopolist's total revenue maximized? Explain. Yes, it is. Because the demand curve (downward-sloping) is also the price curve and the average revenue curve, the marginal revenue is a curve below it. At the profit maximizing condition, the Marginal Revue equals 0, and if the company goes on producing a larger quantity, the marginal revenue will be negative. Since total revenue is the area below the marginal revenue line, it is maximized at the point at which marginal revenue equals 0. 6. What is IEPR? How does it relate to the monopolist's profit-maximizing condition, MR=MC? The IEPR is the Inverse Elasticity of Price Rule, which states that the difference between the profit-maximizing price and marginal cost, expressed as a percentage of price, is equal to minus the inverse price elasticity of demand. It implies that the profit-maximizing monopolist, because it operates at MC=MR, will want to operate in the elastic region of prices, because that is the only way the IEPR term (1/PED) will be positive. 7. Evaluate the following statement: Toyota faces competition from many other firms in the world market for automobiles; therefore, Toyota cannot have market power. Toyota produces differentiated products from its competitors; automobiles are not perfectly standard-among-producers commodities, do in the mind of consumers Toyota's products are somehow different from their competitor's, and so they have less-than-perfect substitutes. As a result, Toyota enjoys a modicum of market power, although probably not so much as a monopolist would. 8. What rule does a multiplant monopolist use to allocate output among its plants? Would a multiplant perfect competitor use the same rule? If a monopolist uses more than one plant, it is normal that the marginal cost per unit produced will differ among plants. In that situation, as long as the marginal costs per plant differ, the monopolist will transfer production to the plant with the lowest marginal cost in order to maximize profits. Therefore, the rule used by the multiplant monopolist is MC(L)=MC(H) – production will de displaced along plants until the marginal costs are equal in all plants. A multiplant perfect competitor would use the same rule.

9. Why does a monopoly equilibrium give rise to a deadweight loss? Deadweight losses due to equilibrium arise because there is a quantity of output that the monopolist chooses not to produce because the respective marginal cost would exceed the marginal revenue. Production of these units would enhance social welfare but reduce the monopolist's profit, so he chooses not to.

S=MC

A

B

C E

D F

D=P MR

Perfect competition

Monopoly

Impact of Monopoly

Consumer surplus

A+B+C

A

-B-C

Producer surplus

D+E+F

B+D+F

B-E

A+B+D+F

-C-E

Net economic benefit A+B+C+D+E+F

So, the areas C+E represent the net welfare loss due to monopoly. 10. How does a monopsonist differ from a monopolist? Can a firm be both a monopolist and a monopsonist? A monopsonist differs from a monopolist in that it is the sole buyer and has many sellers, while a monopolist is the sole seller and has many buyers. The company can be both a monopolist and a monopsonist. For instance, it may be the only buyer of work in an area, in order to produce a certain product, and then be the sole producer and seller of that product to multiple buyers.

CHAPTER 17 1. What is the difference between a positive and a negative externality? Describe an example of each. An externality is the effect that an action has on the well-being of other consumers or producers, beyond the effects transmitted by changes in prices. A positive externality occurs when consumers or producers are helped without paying for it. For instance, one might have a flu vaccine and therefore be less prone to catch flu and to transmit it to others. The benefit others have from having a diminished possibility of catching the flu is a positive externality. A negative externality occurs when consumers or producers have costs or reduced benefits due to someone else's action. One's CO2 emissions, for instance, cause climate change and impose costs on everyone else. 2. Why does an otherwise competitive market with a negative externality produce more output than would be economically efficient? Since one part of the cost of an action is externalized, a profit-maximizing economic agent will have incentive to overproduce, since his marginal cost is smaller than the real marginal cost to society. 3. Why does an otherwise competitive market with a positive externality produce less output than would be economically efficient? Since the producer of the positive externality is not paid for the full benefit of his product, and considering the fact that in a perfectly competitive market a producer will produce at MC=MR, the marginal revenue does not translate the real economic benefit to society, resulting in undersupply. 4. When do externalities require government intervention, and when is such intervention unlikely to be necessary? Externalities require government intervention in situations where property rights are not conveniently assigned, or when 5. How might an emissions fee lead to an efficient level of output in a market with a negative externality?

6. How might an emissions standard lead to an efficient level of output in a market with a negative externality? 7. What is the Coase Theorem, and when is it likely to be helpful in leading a market with externalities to provide the socially efficient level of output? 8. How does a nonrival good differ from a nonexclusive good? 9. What is a public good? How can one determine the optimal level of provision of a public good? 10. Why does the free rider problem make it difficult or impossible for markets to provide public good efficiently?