Problems PDF
Problems PDF
Problems PDF
or countries. That is, we add the quantities demanded the percentage change in the quantity supplied in
by each individual at a given price to determine the response to a given percentage change in price. Given
total quantity demanded. estimated elasticities, we can forecast the compara-
tive statics effects of a change in taxes or other vari-
2. Supply. The quantity of a good or service supplied
ables that affect the equilibrium.
by firms depends on the price, the firm’s costs, gov-
ernment regulations, and other factors. The market 6. effects of a Sales Tax. The two common types of
supply curve need not slope upward but it usually sales taxes are ad valorem taxes, by which the gov-
does. A change in price causes a movement along the ernment collects a fixed percentage of the price paid
supply curve. A change in the price of an input or per unit, and specific taxes, by which the government
government regulation causes a shift of the supply collects a fixed amount of money per unit sold. Both
curve. The total supply curve is the horizontal sum of types of sales taxes typically raise the equilibrium
the supply curves for individual firms. price and lower the equilibrium quantity. Also, both
usually raise the price consumers pay and lower the
3. Market equilibrium. The intersection of the demand
price suppliers receive, so consumers do not bear
curve and the supply curve determines the equilib-
the full burden or incidence of the tax. The effects
rium price and quantity in a market. Market forces—
on quantity, price, and the incidence of the tax that
actions of consumers and firms—drive the price and
falls on consumers depend on the demand and sup-
quantity to the equilibrium levels if they are initially
ply elasticities. In competitive markets, the impact of
too low or too high.
a tax on equilibrium quantities, prices, and the inci-
4. Shocking the equilibrium: Comparative Statics. A dence of the tax is unaffected by whether the tax is
change in an underlying factor other than price collected from consumers or producers.
causes a shift of the supply curve or the demand
curve, which alters the equilibrium. Comparative 7. Quantity Supplied need not equal Quantity
statics is the method that economists use to analyze Demanded. The quantity supplied equals the quantity
how variables controlled by consumers and firms— demanded in a competitive market if the government
such as price and quantity—react to a change in envi- does not intervene. However, some government poli-
ronmental variables such as prices of substitutes and cies—such as price floors or ceilings—cause the quan-
complements, income, and prices of inputs. tity supplied to be greater or less than the quantity
demanded, leading to persistent excesses or shortages.
5. elasticities. An elasticity is the percentage change in
a variable in response to a given percentage change in 8. When to Use the Supply-and-Demand Model. The
another variable, holding all other relevant variables supply-and-demand model is a powerful tool to
constant. The price elasticity of demand, ε, is the per- explain what happens in a market or to make predic-
centage change in the quantity demanded in response tions about what will happen if an underlying factor
to a given percentage change in price: A 1% increase in a market changes. However, this model is appli-
in price causes the quantity demanded to fall by ε%. cable only in competitive markets with many buyers
Because demand curves slope downward according and sellers, in which firms sell identical goods, par-
to the Law of Demand, the elasticity of demand is ticipants have full information, transaction costs are
always negative. The price elasticity of supply, η, is low, and firms can easily enter and exit.
exeRCISeS
If you ask me anything I don’t know, I’m not going to answer. —Yogi Berra
= exercise is available in MyEconLab; * = answer appears at the back of this book; M = mathematical problem.
1. Demand *1.2 Suppose that the inverse demand function (where
*1.1 Using the estimated demand function for processed the demand curve is rearranged so that price is a
pork in Canada, Equation 2.2, show how the function of quantity) for movies is p = 120 - Q1
quantity demanded, Q, at a given price changes for college students and p = 120 - 2Q2 for other
as per capita income, Y, increases slightly (that town residents. What is the town’s total demand
is, calculate the partial derivative of the quantity function (Q = Q1 + Q2 as a function of p)? Use a
demanded with respect to income). How much does diagram to illustrate your answer. (Hint: By looking
Q change if income rises by $100 a year? M at your diagram, you’ll see that the total demand
76 CHApTEr 2 Supply and Demand
function has a kink, so care must be used in writing per ton. In 2002, pt = 110. What is the demand
the total demand function.) M function for processing tomatoes, where the quan-
1.3 In the application “Aggregating the Demand for tity is solely a function of the price of processing
Broadband Service” (based on Duffy-Deno, 2003), tomatoes? Solve for the equilibrium price and the
the demand function is Qs = 5.97p-0.563 for small quantity of processing tomatoes (rounded to two
firms and Ql = 8.77p-0.296 for larger firms, where digits after the decimal point). Draw the supply and
price is in cents per kilobyte per second and quan- demand curves (note that they are not straight lines),
tity is in millions of kilobytes per second (Kbps). and label the equilibrium and axes appropriately. M
What is the total demand function for all firms? If
the price for broadband service is 40¢ per Kbps, 4. Shocking the equilibrium: Comparative Statics
what is the equilibrium quantity demanded by small 4.1 The 9/11 terrorist attacks caused the U.S. airline
firms, large firms, and all firms? M travel demand curve to shift left by an estimated
30% (Ito and Lee, 2005). Use a supply-and-
2. Supply demand diagram to show the likely effect on price
2.1 Given the pork supply function in Equation 2.6, and quantity (assuming that the market is com-
how does the supply function that is only a function petitive). Indicate the magnitude of the likely equi-
of price, Equation 2.7, change if the price of hogs librium price and quantity effects—for example,
doubles to $3 per kg? M would you expect equilibrium quantity to change
2.2 If the U.S. supply function of corn is Qa = 10 + 10p by about 30%? Show how the answer depends on
and the supply function of the rest of the world is the shape and location of the supply and demand
Qr = 5 + 20p, what is the world supply function? curves.
(Hint: Note that there is a kink in the world supply 4.2 Ethanol, a fuel, is made from corn. Ethanol produc-
function.) tion increased more than 8.5 times from 1,630 mil-
*2.3 Between 1971 and 2006, the United States from lion gallons in 2000 to 13,900 million gallons in
time to time imposed quotas or other restrictions 2011 (www.ethanolrfa.org/pages/statistics). Use a
on importing steel. A quota says that no more than supply-and-demand diagram to show the effect of
Q 7 0 units of steel can be imported into the coun- this increased use of corn for producing ethanol on
try. Suppose both the domestic supply curve of steel, the price of corn and the consumption of corn as
Sd, and the foreign supply curve of steel for sale in food.
the United States, Sf, are upward-sloping straight *4.3 The supply function is Q = 20 + 3p - 20r, and
lines. How did a quota set by the United States on the demand function is Q = 220 - 2p, where r is
foreign steel imports of Q affect the total American the rental cost of capital. How do the equilibrium
supply curve for steel (domestic and foreign supply price and quantity vary with r? (Hint: See Solved
combined)? Problem 2.1.) M
4.4 Using calculus, determine the effect of an increase in
3. Market equilibrium
the price of beef, pb, from $4 to $4.60 on the equi-
*3.1 Use a supply-and-demand diagram to explain the librium price and quantity in the Canadian pork
statement “Talk is cheap because supply exceeds example. (Hint: Conduct an analysis that differs
demand.” At what price is this comparison being from that in Solved Problem 2.1 in that the shock
made? is to the demand curve rather than to the supply
3.2 If the demand function is Q = 110 - 20p, and the curve.) Illustrate your comparative statics analysis
supply function is Q = 20 + 10p, what are the in a figure. M
equilibrium price and quantity? M 4.5 Due to a recession that lowered incomes, the 2008
*3.3 Green, Howitt, and Russo (2005) estimate market prices for last-minute rentals of U.S. beach-
the supply and demand curves for California front properties were lower than usual. Suppose that
processing tomatoes. The supply function is the inverse demand function for renting a beach-
ln Q = 0.2 + 0.55 ln p, where Q is the quantity front property in Ocean City, New Jersey, during
of processing tomatoes in millions of tons per year the first week of August is p = 1,000 - Q + Y/20,
and p is the price in dollars per ton. The demand where Y is the median annual income of the peo-
function is ln Q = 2.6 - 0.2 ln p + 0.15 ln pt, ple involved in this market, Q is quantity, and p
where pt is the price of tomato paste (which is what is the rental price. The inverse supply function is
processing tomatoes are used to produce) in dollars p = Q/2 + Y/40.
Exercises 77
a. Derive the equilibrium price, p, and quantity, Q, price of cigarettes to jump 45¢ (21%) in November
in terms of Y. 1998. Levy and Meara (2006) find only a 2.65%
b. Use a supply-and-demand analysis to show the drop in prenatal smoking 15 months later. What is
effect of decreased income on the equilibrium the elasticity of demand for prenatal smokers? M
price of rental homes. That is, find dp/dY. Does 5.2 Calculate the elasticity of demand, if the demand
a decrease in median income lead to a decrease function is
in the equilibrium rental price? (Hint: See Solved a. Q = 120 - 2p + 4Y, at the point where
Problem 2.1.) M p = 10, Q = 20,
4.6 Lewit and Coate (1982) estimated that the price b. Q = 10p-2. (Hint: See Solved Problem 2.2.) M
elasticity of demand for cigarettes is -0.42. Sup-
5.3 In the application “Aggregating the Demand for
pose that the daily market demand for cigarettes in
Broadband Service” (based on Duffy-Deno, 2003),
New York City is Q = 20,000p-0.42 and that the
the demand function is Qs = 5.97p-0.563 for small
inverse market supply curve of cigarettes in the city
firms and Ql = 8.77p-0.296 for larger ones. As the
is p = 1.5pw, where pw is the wholesale price of
graph in the application shows, the two demand
cigarettes. (That is, the inverse market supply curve
functions cross. What are the elasticities of demand
is a horizontal line at a price, p, equal to 1.5pw.
for small and large firms where they cross? Explain.
Retailers sell cigarettes if they receive a price that is
(Hint: This problem can be answered without doing
50% higher than what they pay for the cigarettes so
any calculations. See Solved Problem 2.2.) M
as to cover their other costs.)
5.4 When the U.S. government announced that a
a. Assume that the New York retail market for cig-
domestic mad cow was found in December 2003,
arettes is competitive. Calculate the equilibrium
analysts estimated that domestic supplies would
price and quantity of cigarettes as a function of
increase in the short run by 10.4% as many other
the wholesale price. Let Q* represent the equi-
countries barred U.S. beef. An estimate of the price
librium quantity. Find dQ*/dpw.
elasticity of beef demand is -0.626 (Henderson,
b. Now suppose that New York City and State 2003). Assuming that only the domestic supply
each impose a $1.50 specific tax on each pack curve shifted, how much would you expect the
of cigarettes, for a total of $3.00 per pack on price to change? (Note: The U.S. price fell by about
all cigarettes possessed for sale or use in New 15% in the first month, but that probably reflected
York City. The retailers pay the tax. Using both shifts in both supply and demand curves.) M
math and a graph, show how the introduction of
5.5 According to Borjas (2003), immigration to the
the tax shifts the market supply curve. How does
United States increased the labor supply of working
the introduction of the tax affect the equilibrium
men by 11.0% from 1980 to 2000, and reduced the
retail price and quantity of cigarettes?
wage of the average native worker by 3.2%. From
c. With the specific tax in place, calculate the equi- these results, can we make any inferences about
librium price and quantity of cigarettes as a the elasticity of supply or demand? Which curve
function of wholesale price. How does the pres- (or curves) changed, and why? Draw a supply-and-
ence of the quantity tax affect dQ*/dpw? M demand diagram and label the axes to illustrate
*4.7 Given the answer to Exercise 2.3, what effect does what happened.
a U.S. quota on steel of Q 7 0 have on the equi- 5.6 Keeler et al. (2004) estimate that the U.S. Tobacco
librium in the U.S. steel market? (Hint: The answer Settlement between major tobacco companies and
depends on whether the quota binds: is low enough 46 states caused the price of cigarettes to jump by
to affect the equilibrium.) 45¢ per pack (21%) and overall per capita cigarette
4.8 Suppose the demand function for carpen- consumption to fall by 8.3%. What is the elasticity
ters is Q = 100 - w, and the supply curve is of demand for cigarettes? Is cigarette demand elas-
Q = 10 + 2w - T, where Q is the number of car- tic or inelastic? M
penters, w is the wage, and T is the test score required 5.7 In a commentary piece on the rising cost of health
to pass the licensing exam. By how much do the equi- insurance (“Healthy, Wealthy, and Wise,” Wall
librium quantity and wage vary as T increases? Street Journal, May 4, 2004, A20), economists John
Cogan, Glenn Hubbard, and Daniel Kessler stated,
5. elasticities “Each percentage-point rise in health-insurance
5.1 The U.S. Tobacco Settlement Agreement between the costs increases the number of uninsured by 300,000
major tobacco companies and 46 states caused the people.” Assuming that their claim is correct,
78 CHApTEr 2 Supply and Demand
demonstrate that the price elasticity of demand for amount of the tax cut was passed on to consumers
health insurance depends on the number of people for all commodities and services that were studied
who are insured. What is the price elasticity if 200 for which the taxes were collected at the retail level
million people are insured? What is the price elas- (except admissions and club dues) and for most com-
ticity if 220 million people are insured? M modities for which excise taxes were imposed at the
*5.8 Calculate the price and cross-price elastici- manufacturer level, including face powder, sterling
ties of demand for coconut oil. The coconut oil silverware, wristwatches, and handbags (Brownlee
demand function (Buschena and Perloff, 1991) is and Perry, 1967). List the conditions (in terms of the
Q = 1,200 - 9.5p + 16.2pp + 0.2Y, where Q is elasticities or shapes of supply or demand curves)
the quantity of coconut oil demanded in thousands that are consistent with 100% pass-through of the
of metric tons per year, p is the price of coconut oil in taxes. Use graphs to illustrate your answer.
cents per pound, pp is the price of palm oil in cents per 6.3 Essentially none of the savings from removing the
pound, and Y is the income of consumers. Assume federal ad valorem tax were passed on to consum-
that p is initially 45¢ per pound, pp is 31¢ per pound, ers for motion picture admissions and club dues
and Q is 1,275 thousand metric tons per year. M (Brownlee and Perry, 1967; see Exercise 6.2). List
5.9 Show that the supply elasticity of a linear supply the conditions (in terms of the elasticities or shapes
curve that cuts the price axis is greater than 1 (elas- of supply or demand curves) that are consistent
tic), and the coefficient of elasticity of any linear with 0% pass-through of the taxes. Use graphs to
supply curve that cuts the quantity axis is less than illustrate your answer. M
1 (inelastic). (Hint: See Solved Problem 2.3.) M *6.4 Do you care whether a 15¢ tax per gallon of milk is
collected from milk producers or from consumers at
5.10 Solved Problem 2.4 claims that a new war in the
the store? Why or why not?
Persian Gulf could shift the world oil supply curve
to the left by 3 million barrels a day or more, caus- 6.5 Green et al. (2005) estimate that for almonds, the
ing the world price of oil to soar regardless of demand elasticity is -0.47 and the long-run sup-
whether we drill in the ANWR. How accurate is ply elasticity is 12.0. The corresponding elasticities
this claim? Use the same type of analysis as in the are -0.68 and 0.73 for cotton and - 0.26 and 0.64
solved problem to calculate how much such a shock for processing tomatoes. If the government were to
would cause the price to rise with and without the apply a specific tax to each of these commodities,
ANWR production. M what would be the consumer tax incidence for each
of these commodities? M
6. effects of a Sales Tax 6.6 A subsidy is a negative tax through which the gov-
6.1 What effect does a $1 specific tax have on equilib- ernment gives people money instead of taking it
rium price and quantity, and what is the incidence from them. If the government applied a $1.05 spe-
on consumers, if the following is true: cific subsidy instead of a specific tax in Figure 2.12,
what would happen to the equilibrium price and
a. The demand curve is perfectly inelastic.
quantity? Use the demand function and the after-
b. The demand curve is perfectly elastic. subsidy supply function to solve for the new equi-
c. The supply curve is perfectly inelastic. librium values. What is the incidence of the subsidy
d. The supply curve is perfectly elastic. on consumers? M
6.7 Canada provided a 35% subsidy of the wage of
e. The demand curve is perfectly elastic and the
supply curve is perfectly inelastic. employees of video game manufacturers in 2011.
(“Video game makers say subsidies are vital,” CBC
Use graphs and math to explain your answers. News, June 4, 2011.)
(Hint: See Solved Problem 2.5.) M
a. What is the effect of a wage subsidy of the equi-
6.2 On July 1, 1965, the federal ad valorem taxes on librium wage and quantity of workers?
many goods and services were eliminated. Compar-
b. What happens when the wage subsidy rate falls?
ing prices before and after this change, we can deter-
mine how much the price fell in response to the tax’s c. What is the incidence of the subsidy?
elimination. When the tax was in place, the tax per *6.8 Use calculus to show that an increase in a specific
unit on a good that sold for p was αp. If the price sales tax τ reduces quantity less and tax revenue
fell by αp when the tax was eliminated, consum- more, the less elastic the demand curve. (Hint: The
ers must have been bearing the full incidence of the quantity demanded depends on its price, which in
tax. Consequently, consumers got the full benefit turn depends on the specific tax, Q(p(τ)), and tax
of removing the tax from those goods. The entire revenue is R = p(τ)Q(p(τ)).) M
Exercises 79
7. Quantity Supplied need not equal Quantity than comparable households in states without usury
Demanded laws (Villegas, 1989). Why? (Hint: The interest rate
7.1 After Hurricane Katrina damaged a substantial por- is the price of a loan, and the amount of the loan is
tion of the nation’s oil-refining capacity in 2005, the quantity.)
the price of gasoline shot up around the country. In *7.4 An increase in the minimum wage could raise the
2006, many state and federal elected officials called total wage payment, W = wL(w), where w is the
for price controls. Had they been imposed, what minimum wage and L(w) is the demand function
effect would price controls have had? Who would for labor, despite the fall in demand for labor ser-
have benefited, and who would have been harmed vices. Show that whether the wage payments rise or
by the controls? Use a supply-and-demand diagram fall depends on the elasticity of demand of labor. M
to illustrate your answers.
8. When to Use the Supply-and-Demand Model
7.2 The Thai government actively intervenes in mar-
kets (Limsamarnphun, Nophakhun, “Govt Imposes 8.1 Are predictions using the supply-and-demand
Price Controls in Response to Complaints,” The model likely to be reliable in each of the following
Nation, May 12, 2012). markets? Why or why not?
a. The government increased the daily minimum a. Apples
wage by 40% to Bt300 (300 bahts L $9.63). b. Convenience stores
Show the effect of a higher minimum wage on c. Electronic games (a market dominated by three
the number of workers demanded, the supply of firms)
workers, and unemployment if the law is applied
to the entire labor market. d. Used cars
b. Show how the increase in the minimum wage 9. Challenge
and higher rental fees at major shopping malls
9.1 In the Challenge Solution, we could predict the
and retail outlets affected the supply curve of
change in the equilibrium price of crops but not
ready-to-eat meals. Explain why the equilibrium
the quantity when GM seeds are introduced. Are
price of a meal rose to Bt40 from Bt30.
there any conditions on the shapes of the supply
c. In response to complaints from citizens about and demand curves (or their elasticities) such that
higher prices of meals, the government imposed we could predict the effect on quantity?
price controls on 10 popular meals. Show the
*9.2 Soon after the United States revealed the discovery
effect of these price controls in the market for
of a single mad cow in December 2003, more than
meals.
40 countries slapped an embargo on U.S. beef. In
d. What is the likely effect of the price controls on addition, some U.S. consumers stopped eating beef.
meals on the labor market? In the three weeks after the discovery, the quan-
*7.3 Usury laws place a ceiling on interest rates that tity sold increased by 43% during the last week of
lenders such as banks can charge borrowers. Low- October 2003, and the U.S. price in January 2004
income households in states with usury laws have fell by about 15%. Use supply-and-demand dia-
significantly lower levels of consumer credit (loans) grams to explain why these events occurred.
03 Summary 119
individual’s utility is maximized when the following to predict the consumer’s optimal choice of goods
equivalent conditions hold: as a function of the consumer’s income and market
prices.
n The consumer buys the bundle of goods that is on
the highest obtainable indifference curve.
5. Behavioral Economics. Using insights from psychol-
n The indifference curve between the two goods is ogy and empirical research on human cognition and
tangent to the budget constraint. emotional biases, economists are starting to modify the
n The consumer’s marginal rate of substitution (the rational economic model to better predict economic
slope of the indifference curve) equals the marginal decision making. While adults tend to make transi-
rate of transformation (the slope of the budget line). tive choices, children are less likely to do so, especially
n The last dollar spent on Good 1 gives the con- when novelty is involved. Consequently, some people
sumer as much extra utility as the last dollar spent would argue that the ability of children to make eco-
on Good 2. nomic choices should be limited. Consumers exhibit
an endowment effect if they place a higher value on
However, consumers do not buy some of all possible a good that they own than on the same good if that
goods, so their optimal bundles are corner solutions. they are considering buying it. Such consumers are less
At a corner, the last dollar spent on a good that is sensitive to price changes and hence less likely to trade
actually purchased gives a consumer more extra util- goods, as predicted by the standard consumer choice
ity than would a dollar’s worth of a good the con- model. Many consumers fail to pay attention to sales
sumer chose not to buy. taxes unless they are included in the product’s final
We can use our model in which a consumer maxi- price, and thus ignore them when making purchasing
mizes his or her utility subject to a budget constraint decisions.
ExErCISES
= exercise is available on MyEconLab; * = answer appears at the back of this book; M = mathematical problem.
between these two goods? (Hint: Look at Solved 4.4 Mark consumes only cookies and books. At his cur-
Problem 3.2.) M rent consumption bundle, his marginal utility from
2.8 Phil’s quasilinear utility function is books is 10 and from cookies is 5. Each book costs
U(q1, q2) = ln q1 + q2. Show that his MRS is the $10, and each cookie costs $2. Is he maximizing his
same on all of his indifference curves at a given q1. utility? Explain. If he is not, how can he increase his
(Hint: Look at Solved Problem 3.3.) M utility while keeping his total expenditure constant? M
4.5 Some of the largest import tariffs, the tax on
3. Budget Constraint imported goods, are on shoes. Strangely, the higher
*3.1 What is the effect of a 50% income tax on Dale’s the tariff, the cheaper the shoes. The highest U.S.
budget line and opportunity set? tariff, 67%, is on a pair of $3 canvas sneakers,
3.2 What happens to a consumer’s optimal choice of whereas the tariff on $12 sneakers is 37%, while
goods if all prices and the consumer’s income dou- $300 Italian leather imports have no tariff. (Adam
ble? (Hint: What happens to the intercepts of the Davidson, “U.S. Tariffs on Shoes Favor Well-
budget constraint?) Heeled Buyers,” National Public Radio, June
12, 2007.) Laura buys either inexpensive, canvas
*3.3 Governments frequently limit how much of a good
sneakers ($3 before the tariff) or more expensive
a consumer can buy. During emergencies, govern-
gym shoes ($12 before the tariff) for her children.
ments may ration “essential” goods such as water,
Use an indifference curve-budget line analysis to
food, and gasoline rather than let their prices rise.
show how imposing the unequal tariffs affects the
Suppose that the government rations water, setting
bundle of shoes she buys compared to what she
quotas on how much a consumer can purchase. If a
would have bought in the absence of tariffs. Can
consumer can afford to buy 12,000 gallons a month
you confidently predict whether she’ll buy rela-
but the government restricts purchases to no more
tively more expensive gym shoes after the tariff?
than 10,000 gallons a month, how do the consum-
Why or why not?
er’s budget line and opportunity set change?
4.6 Helen views raspberries and blackberries as perfect
3.4 What happens to the budget line if the government
complements. Initially, she buys five pints of each
applies a specific tax of $1 per gallon on gasoline
this month. Suppose that the price of raspberries
but does not tax other goods? What happens to the
falls while the price of blackberries rises such that
budget line if the tax applies only to purchases of
the bundle of five pints of each lies on her budget
gasoline in excess of 10 gallons per week?
line. Does her optimal bundle change? Explain.
4. Constrained Consumer Choice (Hint: See Solved Problem 3.4.)
4.1 Suppose that Boston consumers pay twice as much 4.7 Use indifference curve-budget line diagrams to illus-
for avocados as they pay for tangerines, whereas trate the results in Table 3.2 for each of these utility
San Diego consumers pay half as much for avo- functions.
cados as they pay for tangerines. Assuming that 4.8 For the utility function U(q1, q2) = qρ1 + qρ2, solve
consumers maximize their utility, which city’s con- for the optimal q1 and q2. (Hint: See Solved Prob-
sumers have a higher marginal rate of substitution lem 3.5.) M
of avocados for tangerines? Explain your answer.
4.9 The application “Indifference Curves Between Food
4.2 Elise consumes cans of anchovies, q1, and boxes of and Clothing” postulates that there are minimum
biscuits, q2. Each of her indifference curves reflects levels of food and clothing necessary to support
strictly diminishing marginal rates of substitution. life. Suppose that the amount of food one has is F,
Where q1 = 2 and q2 = 2, her marginal rate of the minimum level to sustain life is F, the amount
substitution between cans of anchovies and boxes of clothing one has is C, and the minimum neces-
of biscuits equals -1. Will she prefer a bundle with sary is C. We can then modify the Cobb-Douglas
three cans of anchovies and a box of biscuits to a utility function to reflect these minimum levels:
bundle with two of each? Why? M U(C, F) = (C - C)a(F - F)1 - α, where C Ú C
*4.3 Andy purchases only two goods, apples (q1) and F Ú F. Using the approach similar to that in
and kumquats (q2). He has an income of Solved Problem 3.6, derive the optimal amounts of
$40 and can buy apples at $2 per pound and food and clothing as a function of prices and a per-
kumquats at $4 per pound. His utility function is son’s income. To do so, introduce the idea of extra
U(q1, q2) = 3q1 + 5q2. What is his marginal utility income, Y*, which is the income remaining after
for apples, and what is his marginal utility for paying for the minimum levels of food and cloth-
kumquats? What bundle of apples and kumquats ing: Y* = Y - pC C - pFF. Show that the optimal
should he purchase to maximize his utility? quantity of clothing is C = C + aI*/pC and that the
Why? M optimal quantity of food is F = F + (1 - a)I*/pF.
Exercises 121
Derive formulas for the share of income devoted to 4.16 Ann’s utility function is U = q1q2/(q1 + q2). Solve
each good. M for her optimal values of q1 and q2 as a function of
p1, p2, and Y. M
4.10 A function f(X, Y) is homogeneous of degree
γ if, when we multiply each argument by a 4.17 Wolf’s utility function is U = aq0.5
1 + q2. For given
constant α, f(αX, αY) = αγf(X, Y). Thus, if prices and income, show how whether he has an
a function is homogeneous of degree zero, interior or corner solution depends on a. M
f(αX, αY) = α0f(X, Y) = f(X, Y), because α0 = 1. 4.18 Given that Kip’s utility function is
Show that the optimality conditions for the Cobb- U(qc, qm) = q0.5
c + q0.5, what is his expenditure
m
Douglas utility function in Solved Problem 3.6 are function? (Hint: See Solved Problem 3.8.) M
homogeneous of degree zero. Explain why that
result is consistent with the intuition that if we dou- 5. Behavioral Economics
ble all prices and income the optimal bundle does 5.1 Illustrate the logic of the endowment effect using a
not change. M kinked indifference curve. Let the angle be greater
4.11 Diogo’s utility function is U(q1, q2) = q0.75 0.25
1 q2 ,
than 90°. Suppose that the prices change, so the slope
where q1 is chocolate candy and q2 is slices of pie. of the budget line through the endowment changes.
If the price of a chocolate bar, p1, is $1, the price a. Use the diagram to explain why an individual
of a slice of pie, p2, is $2, and Y is $80, what is whose endowment point is at the kink will only
Diogo’s optimal bundle? (Hint: See Solved Prob- trade from the endowment point if the price change
lem 3.6.) M is substantial.
4.12 In 2005, Americans bought 9.1 million home radios b. What rules can we use to determine the optimal
for $202 million and 3.8 million home-theater-in-a- bundle? Can we use all the conditions that we
box units for $730 million (TWICE, March 27, 2006, derived for determining an interior solution?
www.twice.com/article/CA6319031.html). Suppose
that the average consumer has a Cobb-Douglas util- 6. Challenge
ity function and buys these two goods only. Given 6.1 Use a graph to show how the analysis changes in
the results in Solved Problem 3.7, estimate a plausible the Challenge if Max and Bob view e-books and
Cobb-Douglas utility function such that the consumer printed books as imperfect substitutes.
would allocate income in the proportions actually
observed. M *6.2 In previous years, gasoline was less expensive in the
United States than in Canada, but now, due to a
4.13 According to a 2010 survey of British students change in taxes, gasoline costs less in Canada than in
(www.leedsuniversityunion.org.uk/helpandadvice/ the United States. How will the gasoline-purchasing
money/costofliving), a typical student had a budget behavior of a Canadian who lives near the border
of £18.8 per week to spend on mobile telephones, and can easily buy gasoline in either country change?
Internet access, and music. That student spent about Your answer should include an indifference curve-
45% on phones, 28% on Internet access, and 27% budget line diagram.
on music. Estimate the student’s Cobb-Douglas util-
6.3 Einav et al. (2012) found that people who live in
ity function for these three goods. (Hint: See Solved
high sales tax locations are much more likely than
Problem 3.7.) M
other consumers to purchase goods over the Inter-
*4.14 David’s utility function is U = q1 + 2q2. Describe net because Internet purchases are generally exempt
his optimal bundle in terms of the prices of q1 and from the sales tax if the firm is located in another
q2. M state. They found that a 1% increase in a state’s
sales tax increases online purchases by that state’s
*4.15 Vasco likes spare ribs, q1, and fried chicken, q2. His
residents by just under 2%. Is the explanation for
utility function is U = 10q21q2. His weekly income
this result similar to that in the Challenge Solution?
is $90, which he spends on ribs and chicken only.
Why or Why not?
a. If he pays $10 for a slab of ribs and $5 for a
6.4 Salvo and Huse (2012) found that roughly one-
chicken, what is his optimal consumption
fifth of flexible-fuel (cars that can run on a mix of
bundle? Show his budget line, indifference curve,
ethanol and gasoline) car owners choose gasoline
and optimal bundle, e1, in a diagram.
when the price of gas is 20% above that of ethanol
b. Suppose the price of chicken doubles to $10. (in energy-adjusted terms) and, similarly, one-fifth
How does his optimal consumption of chicken of motorists choose ethanol when ethanol is 20%
and ribs change? Show his new budget line and more expensive than gasoline. What can you say
optimal bundle, e2, in your diagram. M about these people’s tastes?
156 ChAPTeR 4 Demand 04
utility does not change. The direction of the substi- is positive), and positive if the good is inferior (the
tution effect is unambiguous: A compensated rise in income elasticity is negative).
a good’s price always causes consumers to buy less
4. Cost-of-living adjustment. The government’s major
of the good. Without compensation, an increase in
index of inflation, the Consumer Price Index (CPI), over-
price rise reduces the consumer’s opportunity set:
estimates inflation by ignoring the substitution effect.
The consumer can now buy less than before with the
same income, which harms the consumer. Suppose 5. Revealed Preference. If we observe a consumer’s
instead that the prices are held constant, but the con- choice at various prices and income levels, we can
sumer’s income is reduced by an amount that harms infer the consumer’s preferences: the shape of the
the consumer by as much as the price increase. The consumer’s indifference curves. We can also use the
income effect is the change in the quantity demanded theory of revealed preference to show that a con-
due to such an income adjustment. The income effect sumer substitutes away from a good as its price
is negative if a good is normal (the income elasticity rises.
ExERCISES
= exercise is available on MyEconLab; * = answer appears at the back of this book; m = mathematical problem.
17
We estimated the Cobb-Douglas utility function using budget share information and obtained prices and quantities from
www.leesmovieinfo.net, the New York Times, and ce.org.
Exercises 157
Those gifts are about one-fifth of what they give happens to his consumption of eggs? Draw a graph
their children under 18 and spend on their college and explain your diagram. Does the change in his
education. Illustrate how an increase in your parents’ consumption reflect a substitution or an income
income affects their allocations between bequests to effect?
you and all other goods (“fun”) in two related graphs, 3.4 Are relatively more high-quality navel oranges sold
where one shows an income-consumption curve and in California or in New York? Why? (Hint: See
the other shows an Engel curve for bequests. Solved Problem 4.3.)
*2.2 Guerdon always puts half a sliced banana, q1, on *3.5 Draw a figure to illustrate the answer given in
his bowl of cereal, q2—the two goods are perfect Solved Problem 4.3. Use math and a figure to show
complements. What is his utility function? Derive whether applying an ad valorem tax rather than a
his demand curve for bananas graphically and specific tax changes the analysis.
mathematically. (Hint: See Solved Problem 4.1.) m
3.6 Lucy views Bayer aspirin and Tylenol as perfect
2.3 According to the U.S. Consumer Expenditure
substitutes. Initially the aspirin is cheaper. However,
Survey for 2008, Americans with incomes below
a price increase makes aspirin more expensive than
$20,000 spend about 39% of their income on hous-
Tylenol. Show the substitution, income, and total
ing. What are the limits on their income elasticities
effect of this price change in a diagram.
of housing if all other goods are collectively nor-
mal? Given that they spend about 0.2% on books *3.7 Philip’s quasilinear utility function is
and other reading material, what are the limits on U = 4q0.5
1 + q2 . His budget for these goods is
their income elasticities for reading matter if all Y = 10. Originally, the prices are p1 = p2 = 1.
other goods are collectively normal? (Hint: See However, the price of the first good rises to p1 = 2.
Solved Problem 4.2.) m Discuss the substitution, income, and total effect on
the demand for q1. m
*2.4 Given the estimated Cobb-Douglas utility func-
tion in Exercise 1.7, U = q0.6 0.4 3.8 Remy views ice cream and fudge sauce as perfect
1 q2 , for CDs, q1, and
DVDs, q2, derive a typical consumer’s Engel curve complements. Is it possible that either of these
for movie DVDs. Illustrate in a figure. m goods or both of them are Giffin goods? (Hint: See
Solved Problem 4.4.)
2.5 Derive the income elasticity of demand for individu-
als with (a) Cobb-Douglas, (b) perfect substitutes, *3.9 Sylvia’s utility function is U(q1, q2) = min(q1, jq2).
and (c) perfect complements utility functions. m Derive her compensated (Hicksian) demand and
2.6 Ryan has a constant elasticity of substitution utility expenditure functions. m
function U = q ρ1 + q ρ2. Derive his Engel curve. m 3.10 Bill’s utility function is U = 0.5 ln q1 + 0.5 ln q2.
2.7 Sally’s utility function is U(q1, q2) = 4q0.5 What is his compensated demand function for q1?
1 + q2.
Derive her Engel curve. m (Hint: See Solved Problem 4.5.) m
3.11 Sylvan’s utility function is U(q1, q2) = q1 + 2q2.
Derive his compensated (Hicksian) demand and
3. Effects of a Price Increase expenditure functions. m
3.1 Under what conditions does the income effect rein-
force the substitution effect? Under what conditions 4. Cost-of-living adjustment
does it have an offsetting effect? If the income effect *4.1 Alix consumes only coffee and coffee cake and only
more than offsets the substitution effect for a good, consumes them together (they are perfect comple-
what do we call that good? In a figure, illustrate ments). If we calculate a CPI using only these two
that the income effect can more than offset the sub- goods, by how much will this CPI differ from the
stitution effect (a Giffen good). true cost-of-living index?
*3.2 Don spends his money on food and operas. Food 4.2 Jean views coffee and cream as perfect comple-
is an inferior good for Don. Does he view an opera ments. In the first year, Jean picks an optimal
performance as an inferior or a normal good? Why? bundle of coffee and cream, e1. In the second year,
In a diagram, show a possible income-consumption inflation occurs, the prices of coffee and cream
curve for Don. change by different amounts, and Jean receives
3.3 Pat eats eggs and toast for breakfast and insists on a cost-of-living adjustment (COLA) based on
having three pieces of toast for every two eggs he the consumer price index (CPI) for these two
eats. Derive his utility function. If the price of eggs goods. After the price changes and she receives
increases but we compensate Pat to make him just the COLA, her new optimal bundle is e2. Show
as “happy” as he was before the price change, what the two equilibria in a figure. Is she better off,
158 ChAPTeR 4 Demand
worse off, or equally well off at e2 compared to are p1 = $2 = p2, she buys q1 = 10 and q2 = 5.
e1? Explain. After the prices change to p1 = $1 and p2 = $3,
4.3 Ann’s only income is her annual college scholar- she purchases q1 = 6 and q2 = 8. Draw her bud-
ship, which she spends exclusively on gallons of get lines and choices in a diagram. Use a revealed
ice cream and books. Last year, when ice cream preference argument to discuss whether or not she
cost $10 and used books cost $20, Ann spent her is maximizing her utility before and after the price
$250 scholarship on 5 gallons of ice cream and 10 changes.
books. This year, the price of ice cream rose to $15 5.2 Analyze the problem in Exercise 5.1 making use of
and the price of books increased to $25. So that Equation 4.16. m
Ann can afford the same bundle of ice cream and 5.3 Felix chooses between clothing, q1, and food, q2.
books that she bought last year, her college raised His initial income is $1,000 a month, p1 = 100, and
her scholarship to $325. Ann has the usual-shaped p2 = 10. At his initial bundle, he consumes q1 = 2
indifference curves. Will Ann change the amount and q2 = 80. Later, his income rises to $1,200 and
of ice cream and books that she buys this year? If the price of clothing rises to p1 = 150, but the price
so, explain how and why. Will Ann be better off, of food does not change. As a result, he reduces his
as well off, or worse off this year than last year? consumption of clothing to one unit. Using a revealed
Why? preference reasoning (that is, knowing nothing about
4.4 The Economist magazine publishes the Big Mac his indifference curves), can you determine how he
Index, which is based on the price of a Big Mac at ranks the two bundles?
McDonald’s in various countries over time. Under
what circumstances would people find this index to 6. Challenge
be as useful as or more useful than the consumer 6.1 In the Challenge Solution, suppose that housing
price index in measuring how their true cost of liv- was relatively less expensive and entertainment was
ing changes over time? relatively more expensive in London than in Seattle,
4.5 During his first year at school, Guojun buys eight so that the LL budget line cuts the LS budget line
new college textbooks at a cost of $50 each. Used from below rather than from above as in the Chal-
books cost $30 each. When the bookstore announces lenge Solution’s figure. Show that the conclusion
a 20% price increase in new texts and a 10% increase that Alexx is better off after his move still holds.
in used texts for the next year, Guojun’s father offers Explain the logic behind the following statement:
him $80 extra. Is Guojun better off, the same, or “The analysis holds as long as the relative prices
worse off after the price change? Why? differ in the two cities. Whether one price or the
4.6 Use a graph to illustrate that the Paasche cost-of- other is relatively higher in London than in Seattle
living index (see the Application “Fixing the CPI is irrelevant to the analysis.”
Substitution Bias”) underestimates the rate of 6.2 Jim’s utility function is U(q1, q2) = min(q1, q2). The
inflation when compared to the true cost-of-living price of each good is $1, and his monthly income is
index. $4,000. His firm wants him to relocate to another
4.7 Cynthia buys gasoline and other goods. The gov- city where the price of q2 is $2, but the price of q1 and
ernment considers imposing a lump-sum tax, + his income remain constant. Obviously, Jim would be
dollars per person, or a specific tax on gasoline of worse off due to the move. What would be his equiv-
τ dollars per gallon. If + and τ are such that either alent variation or compensating variation? m
tax will raise the same amount of tax revenue from 6.3 Jane’s utility function is U(q1, q2) = q1 + q2.
Cynthia, which tax does she prefer and why? Show The price of each good is $1, and her monthly
your answer using a graph or calculus. m income is $4,000. Her firm wants her to relocate
to another city where the price of q2 is $2, but the
5. Revealed Preferences price of q1 and her income remain constant. What
5.1 Remy spends her weekly income of $30 on choco- would be her equivalent variation or compensating
late, q1, and shampoo, q2. Initially, when the prices variation? m
05 Exeriises 191
keep the consumer on the original indifference curve. of a good, food stamps, or a child-care price subsidy
The equivaleot variatioo is the amount of money one creates a kink in a consumer’s budget constraint,
would have to take from a consumer to harm the which affects how much consumers purchase and
consumer by as much as the price increase would. For their well-being. Many, but not all, consumers would
small price changes, the three measures of the effect be better off if the government gave them an amount
of a price increase on a consumer’s well-being—the of money equal to the value of the food stamps or the
change in consumer surplus, the compensating varia- child-care subsidy instead of these subsidies.
tion, and the equivalent variation—are typically
5. Deriving labor Supply Curves. Using consumer
close. The smaller the income elasticity or the smaller
theory, we can derive a person’s daily demand curve
the budget share of the good, the smaller the differ-
for leisure (time spent on activities other than work),
ences between these three measures.
which shows how hours of leisure vary with the wage
3. Market Consumer Surplus. The market consumer rate, which is the price of leisure. The number of hours
surplus—the sum of the welfare effect across all con- that a person works equals 24 minus that person’s
sumers—is the area under the market inverse demand leisure hours, so we can determine a person’s daily
curve above the market price. The more revenue that labor supply curve from that person’s demand curve
is spent on the good and the less elastic the demand for leisure. The labor supply curve is upward sloping
curve is, the larger the market consumer surplus. if leisure is an inferior good and backward bending if
it is a normal good. Whether a cut in the income tax
4. effects of government Policies on Consumer rate will cause government tax revenue to rise or fall
Welfare. A government quota on the consumption depends on the shape of the labor supply curve.
exerCISeS
= exeriise is available oo MyEconLab; * = aoswer appears at the baik of this book; M = mathematiial problem.
fewer times than if you did not join? For simplicity, bundle is e1. Show in a diagram. During a drought,
assume that the price of all other goods is $1. the government limits the number of gallons per week
that he may purchase to 10,000. Using diagrams, dis-
3. Market Consumer Surplus cuss under which conditions his new optimal bundle,
3.1 Compare the welfare effects on a consumer between e2, will be the same as e1. If the two bundles differ,
a lump-sum tax and an ad valorem (percentage) can you state where e2 must be located?
tax on all goods that raise the same amount of tax 4.2 Ralph usually buys one pizza and two colas from
revenue. M the local pizzeria. The pizzeria announces a special:
3.2 Use the numbers for the alcohol and tobacco cat- All pizzas after the first one are half price. Show the
egory from Table 5.2 to draw a figure that illus- original and new budget constraints. What can you
trates the roles that the revenue and the elasticity say about the bundle Ralph will choose when faced
of demand play in determining the loss of consumer with the new constraint?
surplus due to an increase in price. Indicate how the 4.3 Since 1979, low-income recipients have been given
various areas of your figure correspond to the equa- food stamps without charge. However before 1979,
tion derived in footnote 8. M people bought food stamps at a subsidized rate.
3.3 Suppose that the inverse market demand for For example, to get $1 worth of food stamps, a
an upcoming Bruce Springsteen concert at household paid about 20¢ (the exact amount var-
Philadelphia’s 20,000-seat Wachovia Center is ied by household characteristics and other factors).
p = 1,000 - 0.04Q. Mr. Springsteen is concerned Show the budget constraint facing an individual if
about the well-being of his fans. He considers that individual is allowed to buy up to $100 per
whether to auction the tickets to the concert. The month in food stamps at 20¢ per each $1 coupon.
auction works as follows: An auctioneer orders the Compare this constraint to the original budget con-
bids from highest to lowest, and the price of each straint (original income is Y) with no assistance and
ticket equals the 20,000th highest bid. The tickets the budget constraint if the individual receives $100
go to the highest bidders. In the auction, assume of food stamps for free.
that each person bids his or her willingness to pay. 4.4 Is a poor person more likely to benefit from $100
a. What is the price of the tickets? What is the mar- a month worth of food stamps (that can be used
ket consumer surplus? only to buy food) or $100 a month worth of cloth-
b. Instead, suppose that Mr. Springsteen, for the ing stamps (that can be used only to buy clothing)?
benefit of his fans, decides to sell each ticket for Why?
$100. Based on the demand function, 22,500 4.5 If a relatively wealthy person spends more on food
people are willing to pay $100 or more. So, than a poor person before receiving food stamps, is
not everyone who wants to see the concert at the wealthy person less likely than the poor person
the $100 price can purchase a ticket. Of these to have a tangency at a point such as f in Figure 5.7?
22,500 people, suppose that all of the 20,000 4.6 Federal housing assistance programs provide
people who acquire a ticket have a lower will- allowances that can be spent only on housing. Sev-
ingness to pay than all of the 2,500 people who eral empirical studies find that recipients increase
do not. What is the consumer surplus? their non-housing expenditures by 10% to 20%
c. Suppose Bruce Springsteen’s objective in choos- (Harkness and Newman, 2003). Show that recipi-
ing whether to auction the tickets or to set a ents might—but do not necessarily—increase their
price of $100 is to maximize the market con- spending on non-housing, depending on their
sumer surplus. Which does he choose: an auc- tastes.
tion or a $100 ticket price? M 4.7 Federal housing ($44 billion in 2011) and food
*3.4 Two linear demand curves go through the initial stamp subsidy ($78 billion in 2011) programs are
equilibrium, e1. One demand curve is less elastic than two of the largest in-kind transfer programs for
the other at e1. For which demand curve will a price the poor. Many poor people are eligible for both
increase cause the larger consumer surplus loss? programs: 30% of housing assistance recipients
also used food stamps, and 38% of FSP partici-
4. effects of government Policies on Consumer pants also received housing assistance (Harkness
Welfare and Newman, 2003). Suppose Jill’s income is $500
4.1 Max chooses between water and all other goods. If a month, which she spends on food and housing.
he spends all his money on water, he can buy 12,000 The prices of food and housing are each $1 per unit.
gallons per week. At current prices, his optimal Draw her budget line. If she receives $100 in food
Exeriises 193
stamps and $200 in a housing subsidy (which she 5.6 Taxes during the fourteenth century were very pro-
can spend only on housing), how do her budget line gressive. The 1377 poll tax on the Duke of Lan-
and opportunity set change? caster was 520 times that on a peasant. A poll tax is
4.8 Educational vouchers are increasingly used in vari- a lump-sum (fixed amount) tax per person, which is
ous parts of the United States. Suppose that the independent of the hours a person works or earns.
government offers poor people $5,000 education Use a graph to show the effect of a poll tax on the
vouchers that can be used only to pay for educa- labor-leisure decision. Does knowing that the tax
tion. Doreen would be better off with $5,000 in was progressive tell us whether a nobleman or a
cash than with the educational voucher. In a graph, peasant—assuming they have identical tastes—
determine the cash value, V, Doreen places on the worked more hours?
education voucher (that is, the amount of cash that 5.7 Today, most developed countries have progressive
would leave her as well off as with the voucher). income taxes. Under such a taxation program, is
Show how much education and “all other goods” the marginal tax higher than, equal to, or lower
she would consume with the educational voucher than the average tax?
versus the cash payment of V. *5.8 Several political leaders, including some past presi-
dential candidates, have proposed a flat income
5. Deriving labor Supply Curves
tax, where the marginal tax rate is constant. As of
5.1 Under a welfare plan, poor people are given a 2009, 24 countries—including 20 formerly cen-
lump-sum payment of L. If they accept this welfare trally planned economies of Central and Eastern
payment, they must pay a high marginal tax rate, Europe and Eurasia—switched to a flat personal
α = 12, on anything they earn. If they do not accept income tax rate (Duncan and Peter, 2009). Show
the welfare payment, they do not have to pay a tax that if each person is allowed a “personal deduc-
on their earnings. Show that whether an individual tion” where the first $10,000 earned by the person
accepts welfare depends on the individual’s tastes. is untaxed, the flat tax can be a progressive tax in
5.2 If an individual’s labor supply curve slopes forward which rich people pay a higher average tax rate
at low wages and bends backward at high wages, is than poor people.
leisure a Giffen good? If so, is leisure a Giffen good 5.9 Inheritance taxes are older than income taxes. Cae-
at high or low wage rates? sar Augustus instituted a 5% tax on all inheritances
5.3 Bessie, who can currently work as many hours as (except gifts to children and spouses) to provide
she wants at a wage of w, chooses to work 10 hours retirement funds for the military. During the last
a day. Her boss decides to limit the number of hours couple of decades, congressional Republicans and
that she can work to 8 hours per day. Show how Democrats have vociferously debated the wisdom of
her budget constraint and choice of hours change. cutting income taxes and inheritance taxes (which
Is she unambiguously worse off as a result of this the Republicans call the death tax) to stimulate the
change? Why or why not? economy by inducing people to work harder. Pre-
5.4 Originally when he could work as many hours as sumably, the government cares about a tax’s effect
he wanted at a wage w, Roy chose to work seven on work effort and tax revenues.
hours a day. The employer now offers him w for a. George views leisure as a normal good. He works
the first eight hours in a day and an over-time at a job that pays w an hour. Use a labor-leisure
wage of 1.5w for every hour he works beyond a analysis to compare the effects on the hours he
minimum of eight hours. Show how his budget works from a marginal tax rate on his wage, α,
constraint changes. Will he necessarily choose to or a lump-sum tax (a tax collected regardless of
work more than seven hours a day? Would your the number of hours he works), T. If the per-
answer be different if he originally chose to work hour tax is used, he works 10 hours and earns
eight hours? (1 - α)10w. The government sets T = α10w,
5.5 Jerome moonlights: He holds down two jobs. The so that it collects the same amount of money
higher-paying job pays w, but he can work at most from either tax.
eight hours. The other job pays w*, but he can b. Now suppose that the government wants to raise
work as many hours as he wants. Show how Jerome a given amount of revenue through taxation by
determines how many total hours to work. Now imposing either an inheritance tax or an income
suppose that the job with no restriction on hours (wage) tax. Which is likely to reduce George’s
was the higher paying job. How do Jerome’s budget hours of work more, and why? (Hiot: See Solved
constraint and behavior change? Problem 5.4.)
194 ChAPTER 5 oosumer elfare aond oliicy oalcysis
*5.10 Prescott (2004) argued that U.S. employees work b. Joe’s utility function for goods per day (Y) and
50% more than do German, French, and Ital- hours of leisure per day (N) is U = Y + 240N0.5.
ian employees because European employees face After winning the lottery, does Joe continue to
lower marginal tax rates. Assuming that workers work the same number of hours each day? What
in all four countries have the same tastes toward is the income effect of Joe’s lottery gains on the
leisure and goods, must it necessarily be true that amount of goods he buys per day? M
U.S. employees work longer hours? Use graphs to
illustrate your answer, and explain why it is true or 6. Challenge
is not true. Does Prescott’s evidence indicate any- 6.1 Governments generally limit the amount of the
thing about the relative sizes of the substitution and subsidy. For example, in Yukon, Canada, the 2012
income effects? Why or why not? maximum subsidy for an infant is $625 per month.
*5.11 Originally, Julia could work as many hours as she In 2009, a family’s maximum child-care subsidy
wanted at a wage of w. She chose to work 12 hours was 85% of the cost of care in Nevada and 70%
per day. Then, her employer told her that, in the in Louisiana, $72.50 per week in Alabama, 10% of
future, she may work as many hours as she wants gross income in Maine, and $153 per month plus
up to a maximum of 8 hours (and she can find no $5 per month for each extra child in Mississippi.
additional part-time job). How does her optimal A binding limit on the subsidy creates a kink in the
choice between leisure and goods change? Does this budget constraint. Show how a limit changes the
change hurt her? analysis in the Challenge Solution.
exeRCISeS
= exercise is available in MyEconLab; * = answer appears at the back of this book; M = mathematical problem.
1. The Ownership and Management of Firms short run if its production function is q = 10L + K.
1.1 What types of firms would not normally try to (See Solved Problem 6.1.) M
maximize profit? *3.4 Suppose that the Cobb-Douglas production func-
1.2 What types of organization allow owners of a firm tion is q = L0.75K0.25.
to obtain the advantages of limited liability? a. What is the average product of labor, holding
capital fixed?
2. Production
b. What is the marginal product of labor?
2.1 With respect to production functions, how long is
c. What are the APL and MPL when K = 16? (See
the short run?
Solved Problem 6.1.) M
3. Short-Run Production: One Variable and One 3.5 If the Cobb-Douglas production function is
Fixed Input q = L0.75K0.25, and K = 16, what is the elasticity
*3.1 If each extra worker produces an extra unit of out- of output with respect to labor? (See Solved Prob-
put, how do the total product of labor, the average lem 6.2.) M
product of labor, and the marginal product of labor
vary with the number of workers? 4. Long-Run Production: Two Variable Inputs
3.2 Each extra worker produces an extra unit of out- 4.1 What are the differences between an isoquant and
put, up to six workers. After six, no additional out- an indifference curve?
put is produced. Draw the total product of labor, 4.2 Why must isoquants be thin?
average product of labor, and marginal product of 4.3 Suppose that a firm has a fixed-proportions produc-
labor curves. tion function in which 1 unit of output is produced
3.3 In the short run, a firm cannot vary its capital, using one worker and 2 units of capital. If the firm
K = 2, but it can vary its labor, L. It produces out- has an extra worker and no more capital, it still can
put q. Explain why the firm will or will not experi- produce only 1 unit of output. Similarly, 1 more
ence diminishing marginal returns to labor in the unit of capital produces no extra output.
226 CHApTeR 6 Firms and Production
a. Draw the isoquants for this production function. 4.12 Michelle’s business produces ceramic cups using
b. Draw the total product of labor, average product labor, clay, and a kiln. She can manufacture 25 cups
of labor, and marginal product of labor curves a day with one worker and 35 cups with two work-
(you will probably want to use two diagrams) ers. Does her production process illustrate dimin-
for this production function. ishing returns to scale or diminishing marginal
returns to scale? Give a plausible explanation for
*4.4 To produce a recorded CD, q = 1, a firm uses one why output does not increase proportionately with
blank disc, D = 1, and the services of a recording the number of workers.
machine, M = 1, for one hour. Draw an isoquant
4.13 By studying, Will can produce a higher grade, GW,
for this production process. Explain the reason for
on an upcoming economics exam. His produc-
its shape.
tion function depends on the number of hours he
4.5 What is the production function if L and K are per- studies marginal analysis problems, A, and the
fect substitutes and each unit of q requires 1 unit of number of hours he studies supply and demand
L or 1 unit of K (or a combination of these inputs problems, R. Specifically, GW = 2.5A0.36R0.64. His
that equals 1)? M roommate David’s grade production function is
4.6 The production function at Ginko’s Copy Shop is GD = 2.5A0.25R0.75.
q = 1,000 * min(L, 3K), where q is the number of a. What is Will’s marginal productivity from studying
copies per hour, q, L is the number of workers, and supply and demand problems? What is David’s?
K is the number of copy machines. As an example, b. What is Will’s marginal rate of technical substi-
if L = 4 and K = 1, then min(L, 3K) = 3, and tution between studying the two types of prob-
q = 3,000. lems? What is David’s?
a. Draw the isoquants for this production function. c. Is it possible that Will and David have different
b. Draw the total product of labor, average product marginal productivity functions but the same
of labor, and marginal product of labor curves marginal rate of technical substitution functions?
for this production function for some fixed level Explain. M
of capital. 4.14 Show that the CES production function q =
4.7 Why might we expect the law of diminishing mar- (aLρ + bKρ)1/ρ can be written as q = B(ρ)[cLρ +
ginal product to hold? (1 - c) * Kρ]1/ρ. M
*4.8 At L = 4 and K = 4, the marginal product of labor 4.15 What is the MRTS of the CES production function
is 2 and the marginal product of capital is 3. What is q = (aLρ + bKρ)d/ρ? (See Solved Problem 6.3.) M
the marginal rate of technical substitution? M 4.16 What is the elasticity of substitution, σ, of the CES
*4.9 Mark launders his white clothes using the production function q = (aLρ + bKρ)d/ρ? (See
production function q = B + 0.5G, where B is Solved Problem 6.4.) M
the number of cups of Clorox bleach and G is 5. Returns to Scale
the number of cups of generic bleach that is half
as potent. Draw an isoquant. What are the mar- 5.1 To speed relief to isolated South Asian communi-
ginal products of B and G? What is the marginal ties that were devastated by the December 2004
rate of technical substitution at each point on an tsunami, the U.S. Navy doubled the number of
isoquant? helicopters from 45 to 90 soon after the first ship
arrived. Navy Admiral Thomas Fargo, head of the
4.10 Alfred’s Print Shop can use any one of three fixed- U.S. Pacific Command, was asked if doubling the
proportion technologies. Each involves one printer number of helicopters would “produce twice as
and one worker. Describe the possible shapes of the much [relief].” He replied, “Maybe pretty close to
firm’s isoquant. (Hint: Review the discussion in the twice as much.” (Vicky O’Hara, All Things Con-
application “A Semiconductor Integrated Circuit sidered, National Public Radio, NPR, January 4,
Isoquant.”) 2005). Identify the inputs and outputs and describe
4.11 Draw a circle in a diagram with labor services on the production process. Is the admiral discussing a
one axis and capital services on the other. This circle production process with nearly constant returns to
represents all the combinations of labor and capital scale, or is he referring to another property of the
that produce 100 units of output. Now, draw the production process?
isoquant for 100 units of output. (Hint: Remember 5.2 Show in a diagram that a production function can
that the isoquant includes only the efficient combi- have diminishing marginal returns to a factor and
nations of labor and capital.) constant returns to scale.
Exercises 227
5.3 Under what conditions do the following production Postrel, “What Separates Rich Nations from Poor
functions exhibit decreasing, constant, or increasing Nations?” New York Times, January 1, 2004).
returns to scale? Where it used to take an Indian hand-spinner
a. q = L + K, a linear production function, 50,000 hours to hand-spin 100 pounds of cotton,
an operator of a 1760s-era hand-operated cotton
b. q = ALaKb, a general Cobb-Douglas produc-
mule spinning machine could produce 100 pounds
tion function,
of stronger thread in 300 hours. After 1825, when
c. q = L + LaKb + K, the self-acting mule spinner automated the process,
d. q = (aLρ + [1 - a]Kρ)d/ρ, a CES production the time dropped to 135 hours, and cotton became
function. (See Solved Problem 6.5) M an inexpensive, common cloth. Was this technologi-
*5.4 The production function for the automotive and cal progress neutral? In a figure, show how these
parts industry is q = L0.27K0.16M0.61, where M technological changes affected isoquants.
is energy and materials (based loosely on Klein, 6.2 In a manufacturing plant, workers use a special-
2003). What kind of returns to scale does this pro- ized machine to produce belts. A new labor-saving
duction function exhibit? What is the marginal machine is invented. With the new machine, the firm
product of energy and materials? (See Solved Prob- can use fewer workers and still produce the same
lem 6.5) M number of belts as it did using the old machine.
5.5 As asserted in the comment to Solved Problem 6.5, In the long run, both labor and capital (the
show that γ is a scale elasticity. M machine) are variable. From what you know, what
is the effect of this invention on the APL, MPL, and
5.6 Is it possible that a firm’s production function
returns to scale? If you require more information to
exhibits increasing returns to scale while exhibit-
answer this question, specify what else you need to
ing diminishing marginal productivity of each of
know.
its inputs? To answer this question, calculate the
marginal productivities of capital and labor for the 6.3 Does it follow that, because we observe that the
production of electronics and equipment, tobacco, average product of labor is higher for Firm 1 than
and primary metal using the information listed in for Firm 2, Firm 1 is more productive in the sense
the application “Returns to Scale in U.S. Manufac- that it can produce more output from a given
turing.” M amount of inputs? Why or why not?
5.7 A production function is said to be homogeneous of *6.4 Firm 1 and Firm 2 use the same type of produc-
degree γ if f(xL, xK) = xγf(L, K), where x is a posi- tion function, but Firm 1 is only 90% as productive
tive constant. That is, the production function has as Firm 2. That is, the production function of Firm
the same returns to scale for every combination of 2 is q2 = f(L, K), and the production function of
inputs. For such a production function, show that Firm 1 is q1 = 0.9f(L, K). At a particular level of
the marginal product of labor and marginal prod- inputs, how does the marginal product of labor dif-
uct of capital functions are homogeneous of degree fer between the firms? M
γ - 1. M
5.8 Show that with a constant returns to scale produc- 7. Challenge
tion function, the MRTS between labor and capi-
7.1 If a firm lays off workers during a recession, how
tal depends only on the K/L ratio and not on the
will the firm’s marginal product of labor change?
scale of production. (Hint: Use your result from
Exercise 5.7.) M *7.2 During recessions, American firms lay off a larger
5.9 Prove Euler’s theorem that, if f(L, K) is homo- proportion of their workers than Japanese firms do.
geneous of degree γ (see Exercise 5.7), then (It has been claimed that Japanese firms continue to
L( 0 f/ 0 L) + K( 0 f/ 0 K) = γf(L, K). Given this result, produce at high levels and store the output or sell it
what can you conclude if a production function at relatively low prices during recessions.) Assum-
has constant returns to scale? Express your results ing that the production function remains unchanged
in terms of the marginal products of labor and over a period that is long enough to include many
capital. M recessions and expansions, would you expect the
average product of labor to be higher in Japan or in
6. Productivity and Technical Change the United States? Why?
6.1 Until the mid-eighteenth century, when spin- 7.3 For the CES production function q = (aLρ +
ning became mechanized, cotton was an expen- [1 - a]Kρ)d/ρ, does 0 APL/ 0 L have an unambiguous
sive and relatively unimportant textile (Virginia sign? M
264 CHApTEr 7 Costs 07
the lowest isocost line to touch the relevant isoquant, long-run cost can never be greater than its short-run
which is tangent to the isoquant. Equivalently, to cost. Because some factors are fixed in the short run,
minimize cost, the firm adjusts inputs until the last the firm, to expand output, must greatly increase its
dollar spent on any input increases output by as use of other factors, a relatively costly choice. In the
much as the last dollar spent on any other input. If long run, the firm can adjust all factors, a process
the firm calculates the cost of producing every pos- that keeps its cost down. Long-run cost may also be
sible output level given current input prices, it knows lower than short-run cost if technological progress or
its cost function: Cost is a function of the input prices learning by doing occurs.
and the output level. If the firm’s average cost falls
5. Cost of Producing Multiple goods. If it is less
as output expands, its cost function exhibits econo-
expensive for a firm to produce two goods jointly
mies of scale. If the firm’s average cost rises as output
rather than separately, there are economies of scope.
expands, it exhibits diseconomies of scale.
With diseconomies of scope, it is less expensive to
4. lower Costs in the long Run. The firm can always produce the goods separately.
do in the long run what it does in the short run, so its
exeRCISeS
= exercise is available on MyEconLab; * = answer appears at the back of this book; M = mathematical problem.
1. Measuring Costs *1.3 “There are certain fixed costs when you own a
1.1 You have a ticket to go to a concert by one of your plane,” former tennis star Andre Agassi explained,
favorite groups, the Hives, which you cannot resell. “so the more you fly it, the more economic sense it
However, you can buy a ticket for $30 to attend a makes. . . . The first flight after I bought it, I took
talk by Steven Colbert, at the same time as the con- some friends to Palm Springs for lunch.” (Ostler,
cert. You are willing to pay up to $90 to hear Col- Scott, “Andre Even Flies like a Champ,” San Fran-
bert. Given that there are no other costs involved cisco Chronicle, February 8, 1993, C1.) Discuss
in attending either event, what is your opportunity whether Agassi’s analysis is reasonable.
cost of attending the Hives concert? (Hint: See
Solved Problem 7.1.) 2. Short-Run Costs
1.2 Many corporations allow CEOs to use their firm’s 2.1 A firm’s short-run cost function is C(q) =
corporate jet for personal travel. The Internal Rev- 200q - 6q2 + 0.3q3 + 400. Determine the fixed
enue Service (IRS) requires that the firm report per- cost, F; the variable cost function, AVC; the average
sonal use of its corporate jet as taxable executive cost, AC; the marginal cost, MC; and the average
income, and the Securities and Exchange Commis- fixed-cost, AFC. (Hint: See Solved Problem 7.2.) M
sion (SEC) requires that publicly traded corpora- 2.2 Give the formulas for and plot AFC, MC, AVC, and
tions report the value of this benefit to shareholders. AC if the cost function is
A firm may use any one of three valuation tech-
a. C = 10 + 10q,
niques. The IRS values a CEO’s personal flight at or
below the price of a first-class ticket. The SEC val- b. C = 10 + q2,
ues the flight at the “incremental” cost of the flight: c. C = 10 + 10q - 4q2 + q3. (Hint: See Solved
the additional costs to the corporation of the flight. Problem 7.2.) M
The third alternative is the market value of charter-
2.3 A firm’s cost curve is C = F + 10q - bq2 + q3,
ing an aircraft. Of the three methods, the first-class
where b 7 0.
ticket is least expensive and the chartered flight is
most expensive. a. For what values of b are cost, average cost, and
average variable cost positive? (From now on,
a. What factors (such as fuel) determine the mar-
assume that all these measures of cost are posi-
ginal explicit cost to a corporation of an execu-
tive at every output level.)
tive’s personal flight? Does any one of the three
valuation methods correctly determine the mar- b. What is the shape of the AC curve? At what out-
ginal explicit cost? put level is the AC minimized?
b. What is the marginal opportunity cost to the c. At what output levels does the MC curve cross
corporation of an executive’s personal flight? the AC and the AVC curves?
Exercises 265
d. Use calculus to show that the MC curve must c. Derive the long-run total cost curve equation as
cross the AVC at its minimum point. M a function of q.
2.4 The only variable input a janitorial service firm uses 2.10 A firm has two plants that produce identical out-
to clean offices is workers who are paid a wage, w, put. The cost functions are C1 = 10q - 4q2 + q3
of $8 an hour. Each worker can clean four offices and C2 = 10q - 2q2 + q3.
in an hour. Use math to determine the variable cost,
a. At what output level does the average cost curve
the average variable cost, and the marginal cost of
of each plant reach its minimum?
cleaning one more office. Draw a diagram similar to
Figure 7.1 to show the variable cost, average vari- b. If the firm wants to produce four units of output,
able cost, and marginal cost curves. how much should it produce in each plant? M
*2.5 A firm builds wooden shipping crates. How does 2.11 The estimated short-run cost function of a Japanese
the cost of producing a 1-cubic-foot crate (each side beer manufacturer is C(q) = 0.55q1.67 + 800/q (see
is 1 foot square) compare to the cost of building an the application Short-Run Cost Curves for a Japa-
8-cubic-foot crate if wood costs $1 per square foot nese Beer Manufacturer). At what positive quantity
and the firm has no labor or other costs? More gen- does the average cost function reach its minimum?
erally, how does cost vary with volume? If a $400 lump-sum tax is applied to the firm, at
what positive quantity is the after-tax average cost
2.6 Gail works in a flower shop, where she produces
minimized? M
10 floral arrangements per hour. She is paid $10 an
hour for the first eight hours she works and $15 an *2.12 What is the effect of a lump-sum franchise tax l on
hour for each additional hour. What is the firm’s the quantity at which a firm’s after-tax average cost
cost function? What are its AC, AVC, and MC curve reaches its minimum, given that the firm’s
functions? Draw the AC, AVC, and MC curves. M before-tax average cost curve is U-shaped?
2.7 In 1796, Gottfried Christoph Härtel, a German
music publisher, calculated the cost of printing 3. long-Run Costs
music using an engraved plate technology and used
*3.1 What is the long-run cost function if the production
these estimated cost functions to make produc-
function is q = L + K? M
tion decisions. Härtel figured that the fixed cost
of printing a musical page—the cost of engraving *3.2 A bottling company uses two inputs to produce
the plates—was 900 pfennigs. The marginal cost bottles of the soft drink Sludge: bottling machines,
of each additional copy of the page was 5 pfennigs K, and workers, L. The isoquants have the usual
(Scherer, 2001). smooth shape. The machine costs $1,000 per day
to run, and the workers earn $200 per day. At the
a. Graph the total cost, average total cost, average
current level of production, the marginal product
variable cost, and marginal cost functions.
of the machine is an additional 200 bottles per
b. Is there a cost advantage to having only one day, and the marginal product of labor is 50 more
music publisher print a given composition? Why? bottles per day. Is this firm producing at minimum
c. Härtel used his data to do the following type of cost? If it is minimizing cost, explain why. If it is
analysis: Suppose he expected to sell exactly 300 not minimizing cost, explain how the firm should
copies of a composition at 15 pfennigs per page. change the ratio of inputs it uses to lower its cost.
What is the highest price the publisher would be (Hint: See Solved Problem 7.3.) M
willing to pay the composer per page of the com- 3.3 In 2003, Circuit City Stores, Inc., replaced skilled
position if he wants to at least break even? M sales representatives who earned up to $54,000
2.8 A U.S. chemical firm has a production function per year with relatively unskilled workers who
of q = 10L0.32K0.56 (Hsieh, 1995). It faces factor earned $14 to $18 per hour (Carlos Tejada and
prices of w = 10 and r = 20. What are its short- Gary McWilliams, “New Recipe for Cost Savings:
run marginal and average variable cost curves? M Replace Highly Paid Workers,” Wall Street Journal,
2.9 A glass manufacturer’s production function is June 11, 2003). Suppose that sales representatives
q = 10L0.5K0.5 (Hsieh, 1995). Suppose that its wage, sold one specific Sony high-definition TV model.
w, is $1 per hour and the rental cost of capital, r, is $4. Let q represent the number of TVs sold per hour,
s the number of skilled sales representatives per
a. Draw an accurate figure showing how the glass hour, and u the number of unskilled representatives
firm minimizes its cost of production. per hour. Working eight hours per day, each skilled
b. What is the equation of the (long-run) expansion worker sold six TVs per day, and each unskilled
path for a glass firm? Illustrate in a graph. worker sold four. The wage rate of the skilled
266 CHApTEr 7 Costs
workers was ws = $26 per hour, and the wage rate 3.10 For a Cobb-Douglas production function, how does
of the unskilled workers was wu = $16 per hour. the expansion path change if the wage increases
a. Show the isoquant for q = 4 with both skilled while the rental rate of capital stays the same?
and unskilled sales representatives. Are they (Hint: See Solved Problem 7.5.) M
substitutes? 3.11 The Bouncing Ball Ping Pong Company sells table
b. Draw the isocost line for C = $104 per hour. tennis sets, which include two paddles and one
net. What is the firm’s long-run expansion path
c. Using an isocost-isoquant diagram, identify the
if it incurs no costs other than what it pays for
cost-minimizing number of skilled and unskilled
paddles and nets, which it buys at market prices?
reps to sell q = 4 TVs per hour.
How does its expansion path depend on the rela-
*3.4 You have 60 minutes to complete an exam with tive prices of paddles and nets? (Hint: See Solved
two questions. You want to maximize your score. Problem 7.5.)
Toward the end of the exam, the more time you 3.12 Suppose that your firm’s production function has
spend on either question, the fewer extra points constant returns to scale. What is the long-run
per minute you get for that question. How should expansion path?
you allocate your time between the two questions?
(Hint: Think about producing an output of a score 3.13 A production function is homogeneous of degree
on the exam using inputs of time spent on each γ and involves three inputs, L, K, and M (materi-
of the problems. Then use an equation similar to als). The corresponding factor prices are w, r, and e.
Equation 7.11.) Derive the long-run cost curve. M
3.5 Suppose that the government subsidizes the cost of 3.14 In Solved Problem 7.6, Equation 7.26 gives the long-
workers by paying for 25% of the wage (the rate run cost function of a firm with a constant-returns-
offered by the U.S. government in the late 1970s to-scale Cobb-Douglas production function. Show
under the New Jobs Tax Credit program). What how, for a given output level, cost changes as the
effect does this subsidy have on the firm’s choice of wage, w, increases. Explain why. M
labor and capital to produce a given level of output? 3.15 A water heater manufacturer produces q water
heaters per day, q, using L workers and S square
*3.6 The all-American baseball is made using cork from
feet of sheet metal per day, using a constant
Portugal, rubber from Malaysia, yarn from Aus-
elasticity of substitution production function,
tralia, and leather from France, and it is stitched
q = (L-2 + S-2/40)-0.5. The hourly wage rate is
(108 stitches exactly) by workers in Costa Rica. To
$20, and the price per square foot of sheet metal is
assemble a baseball takes one unit of each of these
50¢.
inputs. Ultimately, the finished product must be
shipped to its final destination—say, Cooperstown, a. What is the marginal product of labor? What is
New York. The materials used cost the same in any the marginal product of capital?
location. Labor costs are lower in Costa Rica than b. What is the expansion path equation? Draw the
in a possible alternative manufacturing site in Geor- expansion path.
gia, but shipping costs from Costa Rica are higher. c. Derive the long-run cost function.
Would you expect the production function to
exhibit decreasing, increasing, or constant returns d. Suppose the price of sheet metal decreases to
to scale? What is the cost function? What can you 25¢. Draw the new expansion path. Discuss the
conclude about shipping costs if it is less expensive magnitude of the shift in the expansion path due
to produce baseballs in Costa Rica than in Georgia? to this price decrease. M
3.7 A firm has a Cobb-Douglas production function, 3.16 California’s State Board of Equalization imposed
Q = ALaKb, where a + b 6 1. What proper- a higher tax on “alcopops,” flavored beers con-
ties does its cost function have? (Hint: Compare taining more than 0.5% alcohol-based flavor-
this cost function to that of the Japanese beer ings, such as vanilla extract (Guy L. Smith, “On
manufacturer.) M Regulation of ‘Alcopops,’ ” San Francisco Chron-
icle, April 10, 2009). Such beers are taxed as dis-
3.8 Replace the production function in Solved Problem 7.4 tilled spirits at $3.30 a gallon rather than as beer
with a Cobb-Douglas q = ALaKb, and use calculus to at 20¢ a gallon. In response, manufacturers refor-
find the cost minimizing capital-labor ratio. M mulated their beverages to avoid the tax. By early
3.9 Derive the long-run cost function for the con- 2009, instead of collecting a predicted $38 mil-
stant elasticity of substitution production function lion a year in new taxes, the state collected only
q = (Lρ + Kρ)1/ρ. (Hint: See Solved Problem 7.4.) M about $9,000. Use an isocost-isoquant diagram to
Exercises 267
explain the firms’ response. (Hint: Alcohol-based Asian plant, the firm will pay a 10% lower wage
flavors and other flavors may be close to perfect and a 10% higher cost of capital: w* = 10/1.1
substitutes.) and r* = 1.1 * 10 = 11. What are L and K, and
what is the cost of producing q = 100 units in both
4. lower Costs in the long Run countries? What would be the cost of production in
4.1 A U-shaped long-run average cost curve is the enve- Asia if the firm had to use the same factor quantities
lope of U-shaped short-run average cost curves. On as in the United States? M
what part of the curve (downward sloping, flat, or 6.4 A U.S. apparel manufacturer is considering moving
upward sloping) does a short-run curve touch the its production abroad. Its production function is
long-run curve? (Hint: Your answer should depend q = L0.7K0.3 (based on Hsieh, 1995). In the United
on where the two curves touch on the long-run States, w = 7 and r = 3. At its Asian plant, the firm
curve.) will pay a 50% lower wage and a 50% higher cost
*4.2 A firm’s average cost is AC = αqβ, where α 7 0. of capital: w = 7/1.5 and r = 3 * 1.5. What are L
How can you interpret α? (Hint: Suppose that and K, and what is the cost of producing q = 100
q = 1.) What sign must β have if this cost function units in both countries? What would be the cost of
reflects learning by doing? What happens to aver- production in Asia if the firm had to use the same
age cost as q increases? Draw the average cost curve factor quantities as in the United States? M
as a function of output for particular values of α 6.5 Rosenberg (2004) reports the invention of a new
and β. M machine that serves as a mobile station for receiv-
ing and accumulating packed flats of strawberries
5. Cost of Producing Multiple goods close to where they are picked, reducing workers’
5.1 What can you say about Laura’s economies of scope time and the burden of carrying full flats of straw-
if her time is valued at $5 an hour and her produc- berries. A machine-assisted crew of 15 pickers pro-
tion possibility frontier is PPF 1 in Figure 7.10? duces as much output, q*, as that of an unaided
crew of 25 workers. In a 6-day, 50-hour work-
6. Challenge week, the machine replaces 500 worker hours.
*6.1 In the Challenge Solution, show that for some At an hourly wage cost of $10, a machine saves
wage and rental cost of capital the firm is indiffer- $5,000 per week in labor costs, or $130,000 over
ent between using the wafer-handling stepper tech- a 26-week harvesting season. The cost of machine
nology and the stepper technology. How does this operation and maintenance expressed as a daily
wage/cost-of-capital ratio compare to those in the rental is $200, or $1,200 for a 6-day week. Thus,
C 2 and C 3 isocosts? the net savings equal $3,800 per week, or $98,800
for 26 weeks.
6.2 If it manufactures at home, a firm faces input prices
for labor and capital of wn and nr and produces qn a. Draw the q* isoquant assuming that only two
units of output using Ln units of labor and Kn units technologies are available (pure labor and labor-
of capital. Abroad, the wage and cost of capital are machine). Label the isoquant and axes as thor-
half as much as at home. If the firm manufactures oughly as possible.
abroad, will it change the amount of labor and b. Add an isocost line to show which technology
capital it uses to produce qn ? What happens to its the firm chooses. (Be sure to measure wage and
cost of producing qn ? M rental costs on a comparable time basis.)
*6.3 A U.S. electronics firm is considering moving its c. Draw the corresponding cost curves (with and
production to a plant in Asia. Its estimated pro- without the machine), assuming constant returns
duction function is q = L0.5K0.5 (based on Hsieh, to scale, and label the curves and the axes as
1995). In the United States, w = 10 = r. At its thoroughly as possible.
306 ChAPTER 8 Competitive Firms and Markets 08
average cost. If firms differ, entry is difficult or costly, increase with output and slopes downward if input
or input prices vary with output, the long-run mar- prices decrease with output. The long-run market
ket supply curve has an upward slope. The long-run equilibrium price and quantity are different from the
market supply curve slopes upward if input prices short-run price and quantity.
exeRCISeS
= exercise is available on MyEconLab; * = answer appears at the back of this book; M = mathematical problem.
advances, the minimum average variable cost of 3.15 Given the information in the previous exercise,
processing oil sands dropped from $25 a barrel in what effect does a specific tax of $2.40 per unit
the 1960s to $18 today. In a figure, show how this have on the equilibrium price and quantities? (Hint:
change affects the supply curve of a typical com- See Solved Problem 8.3.) M
petitive firm and the supply curve of all the firms
producing oil from oil sands. 4. Competition in the long Run
*3.9 For Red Delicious apple farmers in Washington, 4.1 Redraw Figure 8.10 to show the situation where the
2001 was a terrible year (Linda Ashton, “Bumper short-run plant size is too large, relative to the opti-
Crop a Bummer for Struggling Apple Farmers,” mal long-run plant size.
San Francisco Chronicle, January 9, 2001, C7). The *4.2 What is the effect on firm and market equilibrium of
average price for Red Delicious apples was $10.61 the U.S. law requiring a firm to give its workers six
per box, well below the shutdown level of $13.23. months’ notice before it can shut down its plant?
Many farmers did not pick the apples. Other farm- 4.3 Each firm in a competitive market has a cost func-
ers bulldozed their trees, getting out of the Red tion of C = q + q2 + q3. There are an unlimited
Delicious business for good, removing 25,000 acres number of potential firms in this market. The mar-
from production. Why did some farmers choose ket demand function is Q = 24 - p. Determine the
not to pick apples, and others to bulldoze their long-run equilibrium price, quantity per firm, mar-
trees? (Hint: Consider the average variable cost and ket quantity, and number of firms. How do these
expectations about future prices.) values change if a tax of $1 per unit is collected from
3.10 When gasoline prices spike, producers consider each firm? (Hint: See Solved Problem 8.3) M
using oil fields that once had been passed over 4.4 The major oil spill in the Gulf of Mexico in 2010
because of the high costs of extracting oil. caused the oil firm BP and the U.S. government to
a. In a figure, show what this statement implies greatly increase purchases of boat services, vari-
about the shape of the oil extraction cost function. ous oil-absorbing materials, and other goods and
b. Use the cost function you drew in part a to show services to minimize damage from the spill. Use
how an increase in the market price of gasoline side-by-side firm and market diagrams to show the
affects the amount of oil that a competitive firm effects (number of firms, price, output, profits) of
extracts. Show the change in the firm’s equilib- such a shift in demand in one such industry in both
rium profit. the short run and the long run. Explain how your
answer depends on whether the shift in demand is
*3.11 If a competitive firm’s cost function is C(q) = a + bq expected to be temporary or permanent.
+ cq2 + dq3, where a, b, c, and d are constants,
*4.5 Derive the residual supply elasticity in Equation 8.17
what is the firm’s marginal cost function? What is
using the definition of the residual demand function
the firm’s profit-maximizing condition? (Hint: See
in Equation 8.16. What is the formula if there are n
Solved Problem 8.2.) M
identical countries? M
3.12 A Christmas tree seller has a cost function *4.6 The federal specific tax on gasoline is 18.4¢ per
C = 6,860 + (pT + t + 7/12)q + 37/27,000,000q3, gallon, and the average state specific tax is 20.2¢,
where pT = $11.50 is the wholesale price of each ranging from 7.5¢ in Georgia to 25¢ in Connecti-
tree and t = $2.00 is the shipping price per tree. cut. A statistical study (Chouinard and Perloff,
What is the seller’s marginal cost function? What is 2004) finds that the incidence of the federal specific
the shutdown price? What is the seller’s short-run tax on consumers is substantially lower than that
supply function? If the seller’s supply curve is S(q, t), from state specific taxes. When the federal specific
what is 0 (q, t)/ 0 t? Evaluate it at pT = $11.50 and tax increases by 1¢, the retail price rises by about
t = $2.00. (Hint: See Solved Problem 8.2) M 0.5¢, so that retail consumers bear half the tax inci-
*3.13 Many marginal cost curves are U-shaped. Conse- dence. In contrast, when a state that uses regular
quently, the MC curve can equal price at two out- gasoline increases its specific tax by 1¢, the retail
put levels. Which is the profit-maximizing output? price rises by nearly 1¢, so that the incidence of the
Why? tax falls almost entirely on consumers. (Hint: See
Chapter 2 on tax incidence.)
3.14 Each of the 10 firms in a competitive market
has a cost function of C = 25 + q2. The market a. What are the incidences of the federal and state
demand function is Q = 120 - p. Determine the specific gasoline taxes on firms?
equilibrium price, quantity per firm, and market b. Explain why the incidence on consumers differs
quantity. M between a federal and a state specific gasoline
308 ChAPTER 8 Competitive Firms and Markets
tax, assuming that the market is competitive. 4.11 In 2009, the voters of Oakland, California, passed
(Hint: Consider the residual supply curve facing a measure to tax medical cannabis (marijuana),
a state compared to the supply curve facing the effectively legalizing it. In 2010, the City Coun-
nation.) cil adopted regulations permitting industrial-scale
c. Using the residual supply elasticity in Equation marijuana farms with no size limits but requiring
8.17, estimate how much more elastic is the each to pay a $211,000 per year fee.17 One pro-
residual supply elasticity to one state than is the posal calls for a 100,000 square foot farm, the size
national supply elasticity. (For simplicity, assume of two football fields. Prior to this legalization,
that all 50 states are identical.) M only individuals could grow marijuana. These small
farmers complained bitterly, arguing that the large
4.7 To reduce pollution, the California Air Resources
firms would drive them out of the industry they
Board in 1996 required the reformulation of gaso-
helped to build due to economies of scale. Draw a
line sold in California. Since then, every few years,
figure to illustrate the situation. Under what condi-
occasional disasters at California refineries have
tions (such as relative costs, position of the demand
substantially cut the supply of gasoline and con-
curve, number of low-cost firms) will the smaller,
tributed to temporary large price increases. Envi-
higher-cost growers be driven out of business? (In
ronmentalists and California refiners (who had
2012, the federal government brought an end to
sunk large investments to produce the reformulated
this business, at least for now.)
gasoline) opposed imports from other states, which
would have kept prices down. To minimize fluctua- 4.12 The Application “Upward-Sloping Long-Run
tions in prices in California, Severin Borenstein and Supply Curve for Cotton” shows a supply curve
Steven Stoft suggest setting a 15¢ surcharge on sell- for cotton. Discuss the equilibrium if the world
ers of standard gasoline. In normal times, none of demand curve crosses this supply curve in either
this gasoline would be sold, because it costs only (a) a flat section labeled “Brazil” or (b) the vertical
8¢ to 12¢ more to produce the California ver- section to its right. What do farms in the United
sion. However, when disasters trigger a large shift States do?
in the supply curve of gasoline, firms could profit- 4.13 Cheap handheld video cameras have revolu-
ably import standard gasoline and keep the price in tionized the hard-core pornography market.
California from rising more than about 15¢ above Previously, making movies required expensive
prices in the rest of the United States. Use figures to equipment and some technical expertise. Today,
evaluate Borenstein and Stoft’s proposal. (Hint: See anyone with a couple hundred dollars and a mod-
Solved Problem 8.4.) erately steady hand can buy and use a video cam-
4.8 Is the long-run supply curve for a good horizontal era to make a movie. Consequently, many new
only if the long-run supply curves of all factors are firms have entered the market, and the supply
horizontal? Explain. curve of porn movies has slithered substantially to
4.9 Navel oranges are grown in California and Ari- the right. Whereas only 1,000 to 2,000 video porn
zona. If Arizona starts collecting a specific tax per titles were released annually in the United States
orange from its firms, what happens to the long-run from 1986 to 1991, that number grew to 10,300
market supply curve? (Hint: You may assume that in 1999 and to 13,588 by 2005.18 Use a side-by-
all firms initially have the same costs. Your answer side diagram to illustrate how this technological
may depend on whether unlimited entry occurs.) innovation affected the long-run supply curve and
the equilibrium in this market.
4.10 A 2010 law requires that people who buy food or
alcohol in Washington, D.C., have to pay an extra 4.14 In late 2004 and early 2005, the price of raw coffee
nickel for every paper or plastic bag the store pro- beans jumped as much as 50% from the previous
vides them. Does such a tax affect marginal cost year. In response, the price of roasted coffee rose
(and of what good)? If so, by how much? How much about 14%. Similarly, in 2012, the price of raw
of the tax is likely to be passed on to consumers? beans fell by a third, yet the price of roasted coffee
17
Matthai Kuruvila, “Oakland Allows Industrial-Scale Marijuana Farms,” San Francisco Chronicle, July 21, 2010; Malia Wollan,
“Oakland, Seeking Financial Lift, Approves Giant Marijuana Farms,” New York Times, July 21, 2010.
18
“Branded Flesh,” Economist, August 14, 1999: 56; internet-filter-review.toptenreviews.com/internet-pornography-statistics-pg9
.html (viewed May 19, 2012).
Exercises 309
fell by only a few percentage points. Why would the pilot program during the Bush administration,
roasted coffee price change less than in proportion which was ended during the Obama administra-
to the rise in the cost of raw beans? tion). What would be the short-run and long-run
effects of allowing entry of Mexican drivers on
5. Challenge market price and quantity and the number of U.S.
5.1 In the Challenge Solution, would it make a differ- truckers?
ence to the analysis whether the lump-sum costs 5.4 In a perfectly competitive market, all firms are iden-
such as registration fees are collected annually tical, there is free entry and exit, and an unlimited
or only once when the firm starts operation? number of potential entrants. Now, the government
How would each of these franchise taxes affect starts collecting a specific tax τ, how do the long-
the firm’s long-run supply curve? Explain your run market and firm equilibria change?
answer. *5.5 The finding that the average real price of abortions
5.2 Answer the Challenge for the short run rather has remained relatively constant over the last 25
than for the long run. (Hint: The answer depends years suggests that the supply curve is horizontal.
on where the demand curve intersects the original Medoff (1997) estimated that the price elasticity of
short-run supply curve.) demand for abortions ranges from - 0.70 to -0.99.
5.3 The North American Free Trade Agreement pro- By how much would the market price of abortions
vides for two-way, long-haul trucking across the and the number of abortions change if a lump-sum
U.S.-Mexican border. U.S. truckers have objected, tax is assessed on abortion clinics that raises their
arguing that the Mexican trucks don’t have to meet minimum average cost by 10%? Use a figure to
the same environmental and safety standards as illustrate your answer. M
U.S. trucks. They are concerned that the combina- *5.6 Answer the Challenge problem using calculus.
tion of these lower fixed costs and lower Mexican (Note: This comparative statics problem is difficult
wages will result in Mexican drivers taking business because you will need to solve two or three equa-
from them. Their complaints have delayed imple- tions simultaneously, and hence you may need to
mentation of this agreement (except for a small use matrix techniques.) M
09 Exercises 343
exeRCISeS
= exercise is available on MyEconLab; * = answer appears at the back of this book; M = mathematical problem.
1. Zero Profit for Competitive Firms in the Long Run 2. Producer Surplus
1.1 Only a limited amount of high-quality wine-growing 2.1 For a firm, how does the concept of producer sur-
land is available. The firms that farm the land are plus differ from that of profit?
identical. Because the demand curve hits the market 2.2 If the supply curve is q = 2 + 2p, what is the pro-
supply curve in its upward sloping section, the firms ducer surplus if the price is 10? (Hint: See Solved
initially earn positive profit. Problem 9.1.) M
a. The owners of the land raise their rents to cap- 2.3 If the supply function is q = apη, what is the pro-
ture the profit. Show how the market supply ducer surplus if price is p*? (Hint: See Solved Prob-
curve changes (if at all). lem 9.1.) M
b. Suppose some firms own the land and some rent.
Do these firms behave differently in terms of 3. how Competition Maximizes Welfare
their shutdown decision or in any other way? 3.1 If society cared only about the well-being of con-
1.2 The reputations of some of the world’s most presti- sumers so that it wanted to maximize consumer sur-
gious museums have been damaged by accusations plus, would a competitive market achieve that goal
that they obtained antiquities that were looted or given that the government cannot force or bribe
stolen in violation of international laws and treaties firms to produce more than the competitive level of
aimed at halting illicit trade in art and antiquities output? How would your answer change if society
(Ron Stodghill, “Do You Know Where That Art cared only about maximizing producer surplus?
Has Been?” New York Times, March 18, 2007). A 3.2 Suppose that the market demand for 32-oz. wide
new wariness among private and public collectors mouth Nalgene bottles is Q = 50,000p-1.076,
to buy works whose provenance has not been rigor- where Q is the quantity of bottles per week and
ously established jeopardizes the business of even p is the price per bottle. The market supply is
the most established dealers. Conversely, this fear Q = 0.01p7.208. What is the equilibrium price and
has increased the value of antiquities that have a quantity? What is the consumer surplus? What is
solid ownership history. The Aboutaam brothers, the producer surplus? M
who are among the world’s most powerful dealers
3.3 Suppose that the inverse market demand for sili-
of antiquities, back an international ban on trade in
cone replacement tips for Sony EX71 earbud head-
excavated antiquities. As Hicham Aboutaam said,
phones is p = pN - 0.1Q, where p is the price per
“The more questionable works entering the antiqui-
pair of replacement tips, pN is the price of a new
ties market, the less their value and the larger the
pair of headphones, and Q is the number of tips per
dark cloud that hangs over the field. That affects
week. Suppose that the inverse supply function of
prices negatively. I think we could put an end to the
the replacement tips is p = 2 + 0.012Q.
new supply, and work comfortably with what we
have.” a. Find the effect of a change in the price of a new
pair of headphones on the equilibrium price of
a. What would be the effect of the ban on the cur-
replacement tips at the equilibrium, dp/dpN.
rent stock of antiquities for sale in the United
States and Europe? b. If pN = $30, what are the equilibrium p and Q?
What is the consumer surplus? What is the pro-
b. Would such a ban differentially affect estab-
ducer surplus? M
lished dealers and new dealers?
3.4 The U.S. Department of Agriculture’s (USDA)
c. Why would established dealers back such a
minimum general recommendation is five servings
ban?
of fruits and vegetables a day. Jetter et al. (2004)
d. Discuss the implications of a ban using the con- estimated that if consumers followed that guideline,
cept of an economic rent. the equilibrium price and quantity of most fruits
1.3. Explain the reasoning in the Application “Tiger and vegetables would increase substantially. For
Woods’ Rents” as to why Tiger Woods was able to example, the price of salad would rise 7.2%, output
capture essentially all the rents from some compa- would increase 3.5%, and growers’ revenues would
nies but not from others. jump 7.3% (presumably, health benefits would
344 CHaPTEr 9 Applications of the Competitive Model
occur as well). Use a diagram to illustrate as many *5.5 Suppose that the government gives rose produc-
of these effects as possible and to show how con- ers a specific subsidy of s = 11. per stem. (Figure
sumer surplus and producer surplus change. Dis- 9.5 shows the original demand and supply curves.)
cuss how to calculate the consumer surplus (given What is the effect of the subsidy on the equilibrium
that the USDA’s recommendation shifts consumers’ prices and quantity, consumer surplus, producer
tastes or behavior). surplus, government expenditures, welfare, and
3.5 Use an indifference curve diagram (gift goods on deadweight loss?
one axis and all other goods on the other) to illus- 5.6 What is the welfare effect of an ad valorem sales
trate that one is better off receiving cash than a gift. tax, α, assessed on each competitive firm in a
(Hint: See the discussion of gifts in this chapter and market?
the discussion of food stamps in Chapter 5.) Relate *5.7 What is the long-run welfare effect of a profit tax
your analysis to the Application “Deadweight Loss (the government collects a specified percentage of a
of Christmas Presents.” firm’s profit) assessed on each competitive firm in a
market?
4. Policies That Shift Supply Curves
*5.8 What is the welfare effect of a lump-sum tax, l,
4.1 The government imposes a restriction on firms that assessed on each competitive firm in a market?
shifts the supply curve in Figure 9.3 so that it inter- (Hint: See the Challenge Solution in Chapter 8.)
sects the demand curve at e2. Discuss the effects on
5.9 The United States not only subsidizes producers of
CS, PS, welfare, and DWL.
cotton (in several ways, including a water subsidy
4.2 The park service wants to restrict the number of visi- and a price support) but also pays $1.7 billion to
tors to Yellowstone National Park to Q*, which is U.S. agribusiness and manufacturers to buy Ameri-
fewer than the current volume. It considers two poli- can cotton. It has paid $100 million each to Allen-
cies: (a) raising the price of admissions and (b) setting berg Cotton and Dunavant Enterprises and large
a quota. Compare the effects of these two policies on amounts to more than 300 other firms (Elizabeth
consumer surplus and welfare. Use a graph to show Becker, “U.S. Subsidizes Companies to Buy Sub-
which policy is superior according to the welfare sidized Cotton,” New York Times, November 4,
criterion. 2003, C1, C2). Assume for simplicity that specific
subsidies (dollars per unit) are used. Use a diagram
5. Policies That Create a Wedge Between Supply to show how applying both subsidies changes the
and Demand Curves equilibrium from the no-subsidy case. Show who
5.1 If the inverse demand function for books is gains and who loses.
p = 60 - q and the supply function is q = p, what *5.10 Suppose that the demand curve for wheat is
is the initial equilibrium? What is the welfare effect q = 100 - 10p and the supply curve is q = 10p.
of a specific tax of τ = $2 per unit on the equilib- The government imposes a price support at p = 6
rium, CS, PS, welfare, and DWL? M using a deficiency payment program.
5.2 Suppose that the demand curve for wheat is a. What is the quantity supplied, the price that
Q = 100 - 10p and that the supply curve is clears the market, and the deficiency payment?
Q = 10p. What are the effects of a specific tax of
b. What effect does this program have on consumer
τ = 1 per unit on the equilibrium, government tax
surplus, producer surplus, welfare, and dead-
revenue, CS, PS, welfare, and DWL? M
weight loss? (Hint: See Solved Problem 9.2.) M
5.3 The initial equilibrium is e, where the linear supply
5.11 Suppose that the demand curve for wheat is
curve intersects the linear demand curve. Show the
Q = 100 - 10p and the supply curve is Q = 10p.
welfare effects of imposing a specific tax τ. Now
The government imposes a price ceiling of p = 3.
suppose the demand curve becomes flatter, but still
goes through point e, so that it is more elastic at a. Describe how the equilibrium changes.
e than originally. Discuss how the tax affects the b. What effect does this ceiling have on consumer sur-
equilibrium, CS, PS, welfare, and DWL differently plus, producer surplus, and deadweight loss? M
than with the original demand curve. 5.12 The government wants to drive the price of soybeans
5.4 Suppose that the demand curve for wheat is above the equilibrium price, p1, to p2. It offers grow-
Q = 100 - 10p and that the supply curve is ers a payment of x to reduce their output from Q1
Q = 10p. What are the effects of a subsidy (negative (the equilibrium level) to Q2, which is the quantity
tax) of s = 1 per unit on the equilibrium, govern- demanded by consumers at p2. Show in a figure how
ment subsidy cost, CS, PS, welfare, and DWL? M large x must be for growers to reduce output to this
Exercises 345
level. What are the effects of this program on con- 6.3 Canada has 20% of the world’s known freshwa-
sumers, farmers, and total welfare? Compare this ter resources, yet many Canadians believe that the
approach to (a) offering a price support of p2, (b) country has little or none to spare. Over the years,
offering a price support and a quota set at Q1, and U.S. and Canadian firms have struck deals to export
(c) offering a price support and a quota set at Q2. bulk shipments of water to drought-afflicted U.S.
5.13 What were the welfare effects (who gained, who cities and towns. Provincial leaders have blocked
lost, what was the deadweight loss) of the gasoline these deals in British Columbia and Ontario. Use
price controls described in Chapter 2? Add the rel- graphs to show the likely outcome of such barri-
evant areas to a drawing like Figure 2.14. (Hint: See ers to exports on the price and quantity of water
Solved Problem 9.3.) used in Canada and in the United States if markets
for water are competitive. Show the effects on con-
5.14 What are the welfare effects of a binding minimum
sumer and producer surplus in both countries.
wage? Use a graphical approach to show what hap-
pens if all workers are identical. Then describe in 6.4 In Solved Problem 9.4, if the domestic demand
writing what is likely to happen to workers who dif- curve is Q = 20p-0.5, the domestic supply curve is
fer by experience, education, age, gender, and race. Q = 5p0.5, and the world price is 5, use calculus to
determine the changes in producer surplus, consumer
5.15 A mayor wants to help renters in her city. She con-
surplus, and welfare from eliminating free trade. M
siders two policies that will benefit renters equally.
One policy is a rent control, which places a price *6.5 Based on the estimates of the U.S. daily oil demand
ceiling, p, on rents. The other is a government hous- function in Equation 9.3 and supply function in
ing subsidy of s dollars per month that lowers the Equation 9.4, use calculus to determine the change
amount renters pay (to p). Who benefits and who in deadweight loss from a marginal increase in a
loses from these policies? Compare the effects of the tariff, evaluated where the tariff is initially zero.
two policies on the quantity of housing consumed, (Hint: You are being asked to determine how an
consumer surplus, producer surplus, government area similar to that of C + E in Figure 9.8 changes
expenditure, and deadweight loss. Does the compar- when a small tariff is initially applied. See Solved
ison of deadweight loss depend on the elasticities of Problem 9.5.) M
supply and demand? (Hint: Consider extreme cases 6.6 The U.S. government claimed that China and Viet-
and see Solved Problem 9.3.) If so, how? nam were dumping shrimp in the United States at
a price below cost, and proposed duties as high as
6. Comparing Both Types of Policies: Trade 112%. Suppose that China and Vietnam were sub-
6.1 Although 23 states barred the sale of self-service sidizing their shrimp fisheries. In a diagram, show
gasoline in 1968, most removed the bans by the who gains and who loses in the United States (com-
mid-1970s. By 1992, self-service outlets sold nearly pared to the equilibrium in which those nations do
80% of all U.S. gas, and only New Jersey and Ore- not subsidize their shrimp fisheries). The United
gon continued to ban self-service sales. Johnson and States imposed a 10.17% antidumping duty (essen-
Romeo (2000) estimated that the ban in those two tially a tariff) on shrimp from these and several
states raised the price of gasoline by approximately other countries. Use your diagram to show how the
3¢ to 5¢ per gallon. Why did the ban affect the large tariff would affect government revenues and
price? Illustrate using a figure and explain. Show the welfare of consumers and producers.
the welfare effects in your figure. Use a table to 6.7 Show that if the importing country faces an upward-
show who gains and who loses. sloping foreign supply curve (excess supply curve),
6.2 The U.S. Supreme Court ruled in May 2005 that a tariff may raise welfare in the importing country.
people can buy wine directly from out-of-state 6.8 Given that the world supply curve is horizontal at
vineyards. The Court held that state laws requiring the world price for a given good, can a subsidy on
people to buy directly from wine retailers within the imports raise welfare in the importing country?
state violate the Constitution’s commerce clause. Explain your answer.
a. Suppose the market for wine in New York is 6.9 After Mexico signed the North American Free Trade
perfectly competitive both before and after the Agreement (NAFTA) with the United States in 1994,
Supreme Court decision. Use the analysis of Sec- corn imports from the United States doubled within
tion 9.6 to evaluate the effect of the Court’s a year, and today U.S. imports make up nearly one-
decision on the price of wine in New York. third of the corn consumed in Mexico. According to
b. Evaluate the increase in New York consumer Oxfam (2003), the price of Mexican corn has fallen
surplus, producer surplus, and welfare. more than 70% since NAFTA took effect. Part of
346 CHaPTEr 9 Applications of the Competitive Model
the reason for this flow south of our border is that as much as in Europe. According to Irwin (2005),
the U.S. government subsidizes corn production to the welfare cost of the embargo was at least 8% of
the tune of $10 billion a year. According to Oxfam, the GNP in 1807. Use graphs to show the effects
the 2002 U.S. cost of production was $3.08 per of the embargo on a market for an exported good
bushel, but the export price was $2.69 per bushel, and one for an imported good. Show the change in
with the difference reflecting an export subsidy of equilibria and the welfare effects on consumers and
39¢ per bushel. The U.S. exported 5.3 metric tons. firms.
Use graphs to show the effect of such a subsidy on 6.12 A government is considering a quota and a tariff,
the welfare of various groups and on government both of which will reduce imports by the same
expenditures in the United States and Mexico. amount. Why might the government prefer one of
6.10 In the first quarter of 2012, the world price for raw these policies to the other?
sugar, 24¢ per pound, was about 70% of the domes-
tic price, 34¢ per pound, because of quotas and tar- 7. Challenge
iffs on sugar imports. Consequently, American-made 7.1 In 2002, Los Angeles imposed a ban on new bill-
corn sweeteners can be profitably sold domestically. boards. Owners of existing billboards did not
A decade ago, the U.S. Commerce Department esti- oppose the ban. Why? What are the implications
mated that the quotas and price support reduce of the ban for producer surplus, consumer surplus,
American welfare by about $3 billion a year, so, and welfare? Who are the producers and consum-
each dollar of Archer Daniels Midland’s profit from ers in your analysis? How else does the ban affect
selling U.S. sugar costs Americans about $10. Model welfare in Los Angeles? (Hint: The demand curve
the effects of a quota on sugar in both the sugar and for billboards shifts to the right over time.)
corn sweetener markets.
7.2 There are many possible ways to limit the number
6.11 During the Napoleonic Wars, Britain blockaded of cabs in a city. The most common method is an
North America, seizing U.S. vessels and cargo and explicit quota using a fixed number of medallions
impressing sailors. At President Thomas Jefferson’s that are good forever and can be resold. One alter-
request, Congress imposed a nearly complete—per- native is to charge a high license fee each year, which
haps 80%—embargo on international commerce would reduce supply by as much as would a medal-
from December 1807 to March 1809. Just before lion or license that lasts only a year. A third option
the embargo, exports were about 13% of the U.S. is to charge a daily tax on taxicabs. Using figures,
gross national product (GNP). Due to the embargo, compare and contrast the equilibrium under each
U.S. consumers could not find acceptable substitutes of these approaches. Discuss who wins and who
for manufactured goods from Europe, and produc- loses from each plan, considering consumers, driv-
ers could not sell farm produce and other goods for ers, the city, and (if relevant) medallion owners.
382 CHAPteR 10 General Equilibrium and Economic Welfare
exerCISeS
10
= exercise is available on MyEconLab; * = answer appears at the back of this book; M = mathematical problem.
and the new allocation B. Draw some indifference been drawn so that it was convex to the origin.
curves that are consistent with this trade being opti- How do we know which of these two ways of
mal for both Michael and Tony. drawing the PPF to use?
2.2 Explain why point e in Figure 10.3 is not on the *4.2. Pat and Chris can spend their non-leisure time work-
contract curve. (Hint: See Solved Problem 10.2.) ing either in the marketplace or at home (preparing
2.3 The two people in a pure exchange economy have dinner, taking care of children, doing repairs). In the
identical utility functions. Will they ever want to marketplace, Pat earns a higher wage, wp = $20,
trade? Why or why not? than Chris, wc = $10. Discuss how living together
is likely to affect how much each of them works in
2.4 Two people trade two goods that they cannot pro-
the marketplace. In particular, discuss what effect
duce. Suppose that one consumer’s indifference
marriage would have on their individual and com-
curves are bowed away from the origin—the usual
bined budget constraints and their labor-leisure
type of curves—but the other’s are concave to the
choices (see Chapter 5). In your discussion, take
origin. In an Edgeworth box, show that a point of
into account the theory of comparative advantage.
tangency between the two consumers’ indifference
curves is not a Pareto efficient bundle. (Identify 4.3 Suppose that Britain can produce 10 units of cloth
another allocation that Pareto dominates.) or 5 units of food per day (or any linear combina-
tion) with available resources and that Greece can
2.5 Adrienne and Stephen consume pizza, Z, and cola,
produce 2 units of food per day or 1 unit of cloth (or
C. Adrienne’s utility function is UA = ZACA, and
any combination). Britain has an absolute advantage
Stephen’s is UA = Z0.5 0.5
s C s . Their endowments are over Greece in producing both goods. Does it still
ZA = 10, CA = 20, ZS = 20, and CS = 10.
make sense for these countries to trade? Explain.
a. What are the marginal rates of substitution for
4.4 If Jane and Denise have identical, linear production
each person?
possibility frontiers (see the Jane and Denise exam-
b. What is the formula for the contract curve? ple in the text), are there gains to trade? Explain.
Draw an Edgeworth box and indicate the con- (Hint: See Solved Problem 10.5.)
tract curve. (Hint: See Solved Problem 10.3.) M
4.5 Modify Solved Problem 10.5 to show that the PPF
2.6 Continuing with Exercise 2.5, what are the competi- more closely approximates a quarter of a circle if
tive equilibrium prices, where one price is normalized there are six people. One of these new people, Bill,
to equal one? (Hint: See Solved Problem 10.4.) M can produce five cords of wood, or four candy bars,
2.7 In a pure exchange economy with two goods, G or any linear combination. The other, Helen, can
and H, the two traders have Cobb-Douglas util- produce four cords of wood, or five candy bars, or
ity functions. Suppose that Tony’s utility function any linear combination.
is Ut = GtHt and Margaret’s utility function is 4.6 Mexico and the United States can both produce
Um = Gm(Hm)2. Between them, they own 100 units food and toys. Mexico has 100 workers and the
of G and 50 units of H. Solve for their contract United States has 300 workers. If they do not
curve. (Hint: See Solved Problem 10.4.) M trade, the United States consumes 10 units of food
2.8 Continuing with Exercise 2.7, determine p, the com- and 10 toys, and Mexico consumes 5 units of food
petitive price of G, where the price of H is normal- and 1 toy. The following table shows how many
ized to equal one. (Hint: See Solved Problem 10.4.) M workers are necessary to produce each good:
3. Competitive exchange
Mexico United States
3.1 In an Edgeworth box, illustrate that a Pareto-
efficient equilibrium, point a, can be obtained by Workers per pound of food 10 10
competition, given an appropriate endowment. Do Workers per toy 50 20
so by identifying an initial endowment point, b,
located somewhere other than at point a, such that a. In the absence of trade, how many units of food
the competitive equilibrium (resulting from com- and toys can the United States produce? How
petitive exchange) is a. Explain. many can Mexico produce?
4. Production and Trading b. Which country has a comparative advantage in
*4.1 In panel c of Figure 10.5, the joint production pos- producing food? In producing toys?
sibility frontier is concave to the origin. When the c. Draw the production possibility for each coun-
two individual production possibility frontiers are try and show where the two produce without
combined, however, the resulting PPF could have trade. Label the axes accurately.
384 CHAPteR 10 General Equilibrium and Economic Welfare
d. Draw the production possibility frontier with to consumers, what happens to prices and quanti-
trade. ties of peaches sold for each use?
e. Show that both countries can benefit from trade. 6.2 A central city imposes a rent control law that places
(Hint: See Solved Problem 10.5.) M a binding ceiling on the rent that can be charged
for an apartment. The suburbs of this city do not
5. efficiency and equity have rent control. What happens to the rental prices
5.1 A society consists of two people with utili- in the suburbs and to the equilibrium number of
ties U1 and U2, and the social welfare function is apartments in the total metropolitan area, in the
W = α1U1 + α2U2. Draw a utility possibilities city, and in the suburbs? (For simplicity, you may
frontier similar to the ones in Figure 10.8. Use cal- assume that people are indifferent as to whether
culus to show that where social welfare is maxi- they live in the city or in the suburbs.)
mized, as α1/α2 increases, Person 1 benefits, and 6.3 Initially, electricity is sold in New York and in other
Person 2 is harmed. M states at a competitive single price. Now suppose
5.2 Give an example of a social welfare function that that New York restricts the quantity of electricity
leads to the egalitarian allocation that everyone that its citizens can buy. Show what happens to the
should be given exactly the same bundle of goods. price of electricity and the quantities sold in New
5.3 Suppose that society used the “opposite” of a Rawl- York and elsewhere.
sian welfare function: It tried to maximize the well- 6.4 A competitive industry with an upward-sloping sup-
being of the best-off member of society. Write this ply curve sells Qh of its product in its home country
welfare function. What allocation maximizes wel- and Qf in a foreign country, so the total quantity it
fare in this society? sells is Q = Qh + Qf . No one else produces this
product. There is no shipping cost. Determine the
6. Challenge equilibrium price and quantity in each country.
6.1 Peaches are sold in a competitive market. There are Now the foreign government imposes a binding
two types of demanders: consumers who eat fresh quota, Q ( 6 Qf at the original price). What hap-
peaches and canners. If the government places a pens to prices and quantities in both the home and
binding price ceiling only on peaches sold directly the foreign market?
424 CHAPTEr 11 Monopoly and Monopsony
11
6. Monopoly Decisions over Time and Behavioral period but is maximizing the sum of its profits over
economics. If a good has a positive network exter- all periods.
nality so that its value to a consumer grows as the
number of units sold increases, then current sales 7. Monopsony. A profit-maximizing monopsony—a
affect a monopoly’s future demand curve. A monop- single buyer—sets its price so that the marginal value
oly may maximize its long-run profit—its profit over to the monopsony equals the firm’s marginal expendi-
time—by setting a low introductory price in the first ture. because the monopsony pays a price below the
period that it sells the good and then later raising its competitive level, fewer units are sold than in a com-
price as its product’s popularity ensures large future petitive market, producers of factors are worse off, the
sales at a higher price. consequently, the monopoly monopsony earns higher profits than it would if it were
is not maximizing its short-run profit in the first a price taker, and society suffers a deadweight loss.
exeRCISeS
= exercise is available on MyEconLab; * = answer appears at the back of this book; M = mathematical problem.
1.12 Show why a monopoly may operate in the upward- $99 in 2005. According to iSuppli, Apple’s per-unit
or downward-sloping section of its long-run aver- cost of manufacturing the Shuffle was $45.37. What
age cost curve but a competitive firm operates only was Apple’s price/marginal cost ratio? What was its
in the upward-sloping section. Lerner Index? If we assume (possibly incorrectly)
1.13 Are major-league baseball clubs profit-maximizing that Apple acted like a short-run profit-maximizing
monopolies? Some observers of this market con- monopoly in pricing its iPod Shuffle, what elasticity
tend that baseball club owners want to maximize of demand did Apple believe it faced? M
attendance or revenue. Alexander (2001) said that 2.6 Suppose that all iPod owners consider only two
one test of whether a firm is a profit-maximizing options for downloading music to their MP3
monopoly is to check whether it is operating in the players: purchasing songs from iTunes or copy-
elastic portion of its demand curve, which, accord- ing songs from friends. With these two options,
ing to his analysis, is true. Why is that a relevant suppose the weekly inverse market demand
test? What would the elasticity be if a baseball club for the Rolling Stones’ song “Satisfaction” is
were maximizing revenue? p = 1.98 - 0.00198Q. The marginal cost to Apple
Inc. of downloading a song is zero.
2. Market Power and Welfare
a. What is Apple’s optimal price of “Satisfaction”?
2.1 Under what circumstances does a monopoly set its How many downloads of “Satisfaction” does
price equal to its marginal cost? Apple sell each week?
*2.2 In 2009, the price of Amazon’s Kindle 2 was $359, b. Now suppose that Apple sells a version of the
while iSuppli estimated that its marginal cost was iPod equipped with software in which songs
$159. What was Amazon’s Lerner Index? What played on the iPod must be downloaded from
elasticity of demand did it face if it was engaging in iTunes. For this iPod, the inverse market demand
short-run profit maximization? M for “Satisfaction” is p = 2.58 - 0.0129Q.
2.3 The U.S. Postal Service (USPS) has a constitution- What is Apple’s optimal price of downloads of
ally guaranteed monopoly on first-class mail. In “Satisfaction” for this new player? How many
2012,it charged 44¢ for a stamp, which was not the downloads of “Satisfaction” does Apple sell
profit-maximizing price—the USPS goal, allegedly, each week? M
is to break even rather than to turn a profit. Fol- 2.7 Draw an example of a monopoly with a linear
lowing the postal services in Australia, britain, can- demand curve and a constant marginal cost curve.
ada, Switzerland, and Ireland, the USPS allowed
a. Show the profit-maximizing price and output, p*
Stamps.com to sell a sheet of twenty 44¢ stamps
and Q*, and identify the areas of consumer sur-
with a photo of your dog, your mommy, or what-
plus, producer surplus, and deadweight loss. Also
ever image you want for $18.99 (that’s 94.95¢ per
show the quantity, Qc , that would be produced if
stamp, or a 216% markup). Stamps.com keeps the
the monopoly were to act like a price taker.
extra beyond the 44¢ it pays the USPS. What is the
firm’s Lerner Index? If Stamps.com is a profit-maxi- b. Now suppose that the demand curve is a smooth
mizing monopoly, what elasticity of demand does it concave-to-the-origin curve (which hits both
face for a customized stamp? axes) that is tangent to the original demand
*2.4 When the iPod was introduced, Apple’s constant curve at the point (Q*, p*). Explain why this
marginal cost of producing its top-of-the-line iPod monopoly equilibrium is the same as with the
was $200 (iSuppli), its fixed cost was approxi- linear demand curve. Show how much output
mately $736 million, and I estimate that its inverse the firm would produce if it acted like a price
demand function was p = 600 - 25Q, where Q taker. Show how the welfare areas change.
is units measured in millions. What was Apple’s c. How would your answer in part a change if the
average cost function? Assuming that Apple was demand curve is a smooth convex-to-the-origin
maximizing short-run monopoly profit, what curve (which hits both axes) that is tangent to
was its marginal revenue function? What were its the original demand curve at the point (Q*, p*)?
profit-maximizing price and quantity, profit, and 2.8 Suppose that many similar price-taking consum-
Lerner Index? What was the elasticity of demand ers (such as Denise in chapter 10) have a single
at the profit-maximizing level? Show Apple’s profit- good (candy bars). Jane has a monopoly in wood,
maximizing solution in a figure. so she can set prices. Assume that no production
2.5 In addition to the hard-drive-based iPod, Apple pro- is possible. Using an Edgeworth box, illustrate the
duces a flash-based audio player. Its 512Mb iPod monopoly optimum and show that it does not lie on
Shuffle (which does not have a hard drive) sold for the contract curve (that is, it isn’t Pareto efficient).
426 CHAPTEr 11 Monopoly and Monopsony
Show the equilibrium price and quantity and the should the monopsony engage in this advertising?
consumer and producer surplus in a graph. Now (Hint: See the analysis of monopoly advertising.)
the government imposes a price ceiling of $30. 7.2 What happens to the monopsony equilibrium if the
Show how the equilibrium, consumer surplus, and minimum wage is set slightly above or below the
producer surplus change. What is the deadweight competitive wage? (Hint: See Solved Problem 11.6.)
loss, if any, from this price control?
7.3 can a monopsony exercise monopsony power—
5.4 The price of wholesale milk dropped by 30.3% in that is, profitably set its price below the competi-
1999 when the Pennsylvania Milk Marketing board tive level—if the supply curve it faces is horizontal?
lowered the regulated price. The price to consumers Why or why not?
fell by substantially less than 30.3%. Why? (Hint:
7.4 What effect does a price support have on a monop-
Show that a monopoly will not necessarily lower
sony? In particular, describe the equilibrium if the
its price by the same percentage as its constant mar-
price support is set at the price where the supply
ginal cost drops.)
curve intersects the demand curve.
6. Monopoly Decisions over Time and Behavioral 7.5 A monopsony faces a supply curve of p = 10 + Q.
economics What is its marginal expenditure curve? If the
monopsony has a demand curve of p = 50 - Q,
*6.1 A monopoly produces a good with a network exter-
what are the equilibrium quantity and price? How
nality at a constant marginal and average cost of
does this equilibrium differ from the competitive
$2. In the first period, its inverse demand curve is
equilibrium? M
p = 10 - Q. In the second period, its demand is
p = 10 - Q unless it sells at least Q = 8 units in *7.6 For general functions, solve for the monopsony’s
the first period. If it meets or exceeds this target, first-order condition if it is also a monopoly in the
then the demand curve rotates out by β (that is, it product market. M
sells β times as many units for any given price), so
that its inverse demand curve is p = 10 - Q/β. The 8. Challenge
monopoly knows that it can sell no output after the 8.1 A country has a monopoly that is protected by a spe-
second period. The monopoly’s objective is to maxi- cific tariff, τ, on imported goods. The monopoly’s
mize the sum of its profits over the two periods. In profit-maximizing price is p*. The world price of
the first period, should the monopoly set the output the good is pw, which is less than p*. because the
that maximizes its profit in that period? How does price of imported goods with the tariff is pw + τ, no
your answer depend on β? (Hint: See the discussion foreign goods are imported. Under WTO pressure
about introductory prices in Section 11.8.) M the government removes the tariff so that the supply
6.2 A monopoly chocolate manufacturer faces two types of foreign goods to the country’s consumers is hori-
of consumers. The larger group, the hoi polloi, loves zontal at pw. Show how much the former monopoly
desserts and has a relatively flat, linear demand produces and what price it charges. Show who
curve for chocolate. The smaller group, the snobs, gains and who loses from removing the tariff. (Hint:
is interested in buying chocolate only if the hoi Look at the effect of government price regulation
polloi do not buy it. Given that the hoi polloi do on a monopoly’s demand curve in Section 11.7 or
not buy the chocolate, the snobs have a relatively the figure in the challenge Solution.)
steep, linear demand curve. Show the monopoly’s 8.2 bleyer Industries Inc., the only U.S. manufacturer
possible outcomes—high price and low quantity, or of plastic Easter eggs, once manufactured 250 mil-
low price and high quantity—and explain the con- lion eggs each year. However, imports from china
dition under which the monopoly chooses to cater cut into its business. In 2005, bleyer filed for bank-
to the snobs rather than to the hoi polloi. ruptcy because the chinese firms could produce the
eggs at much lower costs (“U.S. Plastic Egg Industry
7. Monopsony a Shell of Its Former Self,” San Francisco Chronicle,
7.1 Suppose that the original labor supply curve, S1, January 14, 2005). Use graphs to show how a com-
for a monopsony shifts to the right to S2 if the firm petitive import industry could drive a monopoly out
spends $1,000 in advertising. Under what condition of business.
Exercises 463
12
SummaRy
1. Conditions for Price Discrimination. A firm can 4. nonlinear Pricing. Some firms charge customers dif-
price discriminate if it has market power, knows ferent prices depending on how many units they pur-
which customers will pay more for each unit of out- chase. If consumers who want more water have less
put, and can prevent customers who pay low prices elastic demands, a water utility can increase its profit
from reselling to those who pay high prices. A firm by using declining-block pricing, in which the price
earns a higher profit from price discrimination than for the first few gallons of water is higher than that
from uniform pricing because (a) the firm captures for additional gallons.
some or all of the consumer surplus of customers
who are willing to pay more than the uniform price 5. Two-Part Pricing. By charging consumers one fee for
and (b) the firm sells to some people who would not the right to buy and a separate price per unit, firms
buy at the uniform price. may earn higher profits than if they charge only for
each unit sold. If a firm knows its customers’ demand
2. Perfect Price Discrimination. To perfectly price dis- curves, it can use two-part pricing (instead of perfect
criminate, a firm must know the maximum amount price discrimination) to capture the entire consumer
each customer is willing to pay for each unit of out- surplus. Even if the firm does not know each cus-
put. If a firm charges customers the maximum that tomer’s demand curve or cannot vary two-part pric-
each is willing to pay for each unit of output, the ing across customers, it can use two-part pricing to
monopoly captures all potential consumer surplus make a larger profit than it could get if it set a single
and sells the efficient (competitive) level of output. price.
Compared to competition, total welfare is the same,
consumers are worse off, and firms are better off 6. Tie-In Sales. A firm may increase its profit by using
under perfect price discrimination. a tie-in sale that allows customers to buy one prod-
uct only if they also purchase another product. In a
3. group Price Discrimination. A firm that does not
requirement tie-in sale, customers who buy one good
have enough information to perfectly price discrimi- must make all of their purchases of another good
nate may know the relative elasticities of demand of or service from that firm. With bundling (a package
groups of its customers. Such a profit-maximizing tie-in sale), a firm sells only a bundle of two goods
firm charges groups of consumers prices in propor- together. Prices differ across customers under both
tion to their elasticities of demand, the group of types of tie-in sales.
consumers with the least elastic demand paying the
highest price. Welfare is less under group price dis- 7. advertising. A monopoly advertises or engages in
crimination than under competition or perfect price other promotional activities to shift its demand curve
discrimination but may be greater or less than that to the right or to make it less elastic so as to raise its
under single-price monopoly. profit (taking account of its advertising expenses).
exeRCISeS
= exercise is available on MyEconLab; * = answer appears at the back of this book; m = mathematical problem.
1. Conditions for Price Discrimination *1.3 Spenser’s Superior Stoves advertises a one-day sale
1.1 As of 2012, the pharmaceutical companies Abbott on electric stoves. The ad specifies that no phone
Laboratories, AstraZeneca, Aventis Pharmaceuticals, orders will be accepted and that the purchaser must
Bristol-Myers Squibb Company, Eli Lilly, Glaxo- transport the stove. Why does the firm include these
SmithKline, Janssen, Johnson & Johnson, Novartis, restrictions?
Ortho-McNeil, and Pfizer provide low-income, *1.4 Many colleges provide students from low-income
elderly people with a card guaranteeing them dis- families with scholarships, subsidized loans, and
counts on many prescription medicines. Why would other programs so that they pay lower tuitions than
these firms do that? students from high-income families. Explain why
1.2 Alexx’s monopoly currently sells its product at a universities behave this way.
single price. What conditions must be met so that 1.5 Disneyland price discriminates by charging lower
he can profitably price discriminate? entry fees for children than for adults and for local
464 CHAPtEr 12 Pricing and Advertising
residents than for other visitors. Why does it not concert hall, where the number of tickets sold is
have a resale problem? on the horizontal axis. Be sure to show T*.
1.6 The 2002 production run of 25,000 new Thun- b. If the monopoly can charge a single market
derbirds included only 2,000 cars for Canada. Yet price, does the concert’s failure to sell out prove
potential buyers besieged Canadian Ford dealers. that the monopoly set too high a price? Explain.
Many hoped to make a quick profit by reselling the c. Would your answer in part b be the same if the
cars in the United States. Reselling was relatively monopoly can perfectly price discriminate? Use
easy, and shipping costs were comparatively low. a graph to explain.
When the Thunderbird with the optional hardtop
2.5 A firm is a natural monopoly (see Chapter 11).
first became available at the end of 2001, Canadi-
Its marginal cost curve is flat, and its average cost
ans paid C$56,550 for the vehicle, while U.S. cus-
curve is downward sloping (because it has a fixed
tomers spent up to C$73,000 in the United States.
cost). The firm can perfectly price discriminate.
Why? Why did Ford require Canadian dealers to
Use a graph to show how much the monopoly pro-
sign an agreement that prohibited moving vehicles
duces, Q*. Show graphically and mathematically
to the United States?
that a monopoly might shut down if it can only set
1.7 On July 12, 2012, Hertz charged $126.12 to rent a single price but operate if it can perfectly price
a Nissan Altima for one day in New York City, but discriminate. m
only $55.49 a day in Miami. Is this price discrimi-
nation? Explain.
3. group Discrimination
2. Perfect Price Discrimination 3.1 A monopoly has a marginal cost of zero and faces
two groups of consumers. At first, the monopoly
2.1 If a monopoly faces an inverse demand curve of
could not prevent resale, so it maximized its profit
p = 90 - Q, has a constant marginal and aver-
by charging everyone the same price, p = $5. No
age cost of 30, and can perfectly price discrimi-
nate, what is its profit? What are the consumer one from the first group chose to purchase. Now the
surplus, welfare, and deadweight loss? How would monopoly can prevent resale, so it decides to price
these results change if the firm were a single-price discriminate. Will total output expand? Why or why
monopoly? (Hint: See Solved Problem 12.1.) m not? What happens to profit and consumer surplus?
2.2 Using the information in the Application “Botox 3.2 A firm charges different prices to two groups.
Revisited,” determine how much Allergan loses by Would the firm ever operate where it was suffering
being a single-price monopoly rather than a per- a loss from its sales to the low-price group? Explain.
fectly price-discriminating monopoly. Explain. 3.3 A monopoly sells in two countries, and resale
2.3 See the Application “Google Uses Bidding for Ads between the countries is impossible. The demand
to Price Discriminate,” which discusses how adver- curves in the two countries are p1 = 100 - Q1 and
tisers on Google’s Web site bid for the right for their p2 = 120 - 2Q2. The monopoly’s marginal cost
ads to be posted when people search for certain is m = 30. Solve for the equilibrium price in each
phrases. Should a firm that provides local services country. m
(such as plumbing or pest control) expect to pay 3.4 Hershey Park sells tickets at the gate and at
more or less for an ad in a small town or a large local municipal offices. There are two groups
city? Why? of people. Suppose that the demand function
2.4 To promote her platinum-selling CD Feels Like for people who purchase tickets at the gate is
Home in 2005, singer Norah Jones toured the coun- QG = 10,000 - 100pG and that the demand func-
try giving live performances. However, she sold an tion for people who purchase tickets at municipal
average of only two-thirds of the tickets available offices is QG = 9,000 - 100pG. The marginal cost
for each show, T* (Robert Levine, “The Trick of of each patron is 5.
Making a Hot Ticket Pay,” New York Times, June a. If Hershey Park cannot successfully segment the
6, 2005, C1, C4). Suppose that the local promoter two markets, what are the profit-maximizing
is the monopoly provider of each concert. Each price and quantity? What is its maximum pos-
concert hall has a fixed number of seats. sible profit?
a. Assume that the promoter’s cost is independent b. If the people who purchase tickets at one loca-
of the number of people who attend the con- tion would never consider purchasing them at
cert (Ms. Jones received a guaranteed payment). the other and Hershey Park can successfully price
Graph the promoter’s marginal cost curve for the discriminate, what are the profit-maximizing
Exercises 465
price and quantity? What is its maximum pos- where the elasticity of demand is - 5. Its marginal
sible profit? m cost is 10. At what price does the monopoly sell its
*3.5 A patent gave Sony a legal monopoly to produce a good in each country if resale is impossible? m
robot dog called Aibo (“eye-BO”). The Chihuahua- 3.10 How would the analysis in Solved Problem 12.2
sized robot could sit, beg, chase balls, dance, and change if m = 7 or if m = 4? (Hint: Where m = 4,
play an electronic tune. When Sony started selling the marginal cost curve crosses the MR curve
the toy in July 1999, it announced that it would sell three times—if we include the vertical section. The
3,000 Aibo robots in Japan for about $2,000 each single-price monopoly will choose one of these
and a limited litter of 2,000 in the United States three points where its profit is maximized.)
for about $2,500 each. Suppose that Sony’s mar- *3.11 A monopoly sells to n1 consumers in Country 1
ginal cost of producing Aibos is $500. Its inverse and n2 in Country 2, where each person in Coun-
demand curve was pJ = 3,500 - 12 QJ in Japan and try 1 has a constant elasticity demand function
pA = 4,500 - QA in the United States. Solve for the of q1 = pε1and every person in Country 2 has a
equilibrium prices and quantities (assuming that U.S. demand function of q2 = pε2. Thus, the country
customers cannot buy robots from Japan). Show demand functions are Q1 = n1pε1 and Q2 = n2pε2.
how the profit-maximizing price ratio depended on Output can be manufactured at constant marginal
the elasticities of demand in the two countries. What cost m. What prices does the monopoly charge in
are the deadweight losses in each country, and in the two countries if it can group price discriminate?
which is the loss from monopoly pricing greater? m If the monopoly cannot price discriminate, what
*3.6 A monopoly sells its good in the U.S. and Japanese price does it charge?
markets. The American inverse demand function is 3.12 Show that the equilibrium elasticities in the two
pA = 100 - QA, and the Japanese inverse demand countries must be equal in Solved Problem 12.3. m
function is pJ = 80 - 2QJ, where both prices, pA
and pJ, are measured in dollars. The firm’s mar- 3.13 According to a report from the Foundation for Tax-
ginal cost of production is m = 20 in both coun- payer and Consumer Rights, gasoline costs twice as
tries. If the firm can prevent resale, what price will much in Europe than in the United States because
it charge in both markets? (Hint: The monopoly taxes are higher in Europe. However, the amount per
determines its optimal [monopoly] price in each gallon net of taxes that U.S. consumers pay is higher
country separately because customers cannot resell than that paid by Europeans. The report concludes
the good.) m that “U.S. motorists are essentially subsidizing Euro-
pean drivers, who pay more for taxes but substan-
3.7 Universal Studios sold the Mamma Mia! DVD
tially less into oil company profits” (Tom Doggett,
around the world. Universal charged $21.40 in “US Drivers Subsidize European Pump Prices,” Reu-
Canada and $32 in Japan—more than the $20 it ters, August 31, 2006). Given that oil companies have
charged in the United States. Given that Universal market power and can price discriminate across coun-
had a constant marginal cost of $1, determine what tries, is it reasonable to conclude that U.S. consumers
the elasticities of demand must be in Canada and in are subsidizing Europeans? Explain your answer.
Japan if Universal was profit maximizing. m
3.14 Does a monopoly’s ability to price discriminate
*3.8 Warner Home Entertainment sold the Harry Pot-
between two groups of consumers depend on its
ter and the Prisoner of Azkaban two-DVD movie
marginal cost curve? Why or why not? [Consider
set in China for about $3, which was only one-fifth
two cases: (a) the marginal cost is so high that the
the U.S. price, and sold about 100,000 units. The
monopoly is uninterested in selling to one group;
price was extremely low in China because Chinese
(b) the marginal cost is low enough that the monop-
consumers are less wealthy and because (lower-
oly wants to sell to both groups.]
quality) pirated versions were available in China for
72¢–$1.20, compared to the roughly $3 required to
purchase the legal version (Jin Baicheng, “Power- 4. nonlinear Price Discrimination
ful Ally Joins Government in War on Piracy,” China 4.1 Are all the customers of the monopoly that uses
Daily, March 11, 2005, 13). Assuming a marginal block pricing in panel a of Figure 12.4 worse off
cost of $1, what is the Chinese elasticity of demand? than they would be if the firm set a single price
Derive the demand function for China and illustrate (panel b)? Why or why not?
Warner’s policy in China using a figure similar to 4.2 In panel b of Figure 12.4, the single-price monopoly
panel a in Figure 12.3. m faces a demand curve of p = 90 - Q and a con-
3.9 A monopoly sells its good in the United States, stant marginal (and average) cost of m = $30. Find
where the elasticity of demand is -2, and in Japan, the profit-maximizing quantity (or price) using
466 CHAPtEr 12 Pricing and Advertising
math. Determine the profit, consumer surplus, wel- separately with each person who joins the club and
fare, and deadweight loss. m can therefore charge individual prices. This manager
4.3 Suppose that the nonlinear price discriminating has a good idea of what Joe’s demand curve is and
monopoly in panel a of Figure 12.4 can set three offers Joe a special deal, where Joe pays an annual
prices, depending on the quantity a consumer pur- membership fee and can play as many rounds as he
chases. The firm’s profit is wants at $20, which is the marginal cost his round
imposes on the club. What membership fee would
π = p1Q1 + p2(Q2 - Q1) + p3(Q3 - Q2) - mQ3, maximize profit for the club? The manager could
have charged Joe a single price per round. How
where p1 is the high price charged on the first Q1 much extra profit does the club earn by using two-
units (first block), p2 is a lower price charged on the part pricing? m
next Q2 - Q1 units, p3 is the lowest price charged
5.4 Joe in Question 5.3 marries Susan, who is also an
on the Q3 - Q2 remaining units, Q3 is the total
enthusiastic golfer. Susan wants to join the North-
number of units actually purchased, and m = $30
lands Club. The manager believes that Susan’s inverse
is the firm’s constant marginal and average cost.
demand curve is p = 100 - 2q. The manager has a
Use calculus to determine the profit-maximizing
policy of offering each member of a married couple
p1, p2, and p3. m
the same two-part prices, so he offers them both a
4.4 Consider the nonlinear price discrimination analy- new deal. What two-part pricing deal maximizes the
sis in panel a of Figure 12.4. club’s profit? Will this new pricing have a higher or
a. Suppose that the monopoly can make consumers lower access fee and per unit fee than in Joe’s origi-
a take-it-or-leave-it offer. The monopoly sets a nal deal? How much more would the club make if it
price, p*, and a minimum quantity, Q*, that a charges Susan and Joe separate prices? m
consumer must pay to be able to purchase any 5.5 As described in the Application “Pricing iTunes,”
units at all. What price and minimum quantity Shiller and Waldfogel (2011) estimated that if iTunes
should it set to achieve the same outcome as it used two-part pricing charging an annual access fee
would if it perfectly price discriminated? and a low price per song, it would raise its profit by
b. Now suppose that the monopoly charges a price about 30% relative to what it would earn using uni-
of $90 for the first 30 units and a price of $30 for form pricing or variable pricing. Assume that iTunes
subsequent units, but requires that a consumer buy uses two-part pricing and assume that the marginal
at least 30 units to be allowed to buy any units. cost of an additional download is zero. How should
Compare this outcome to the one in part a and to iTunes set its profit-maximizing price per song if all
the perfectly price-discriminating outcome. m consumers are identical? Illustrate profit-maximizing
two-part pricing in a diagram for the identical con-
5. Two-Part Pricing sumer case. Explain why the actual profit-maximizing
5.1 Using math, show why two-part pricing causes cus- price per song is positive.
tomers who purchase few units to pay more per
unit than customers who buy more units. m 6. Tie-In Sales
5.2 Knoebels Amusement Park in Elysburg, Pennsyl- 6.1 A monopoly sells two products, of which consumers
vania, charges an access fee, l, to enter its Crys- want only one. Assuming that it can prevent resale,
tal Pool. It also charges p per trip down the pool’s can the monopoly increase its profit by bundling
water slides. Suppose that 400 teenagers visit the them, forcing consumers to buy both goods? Explain.
park, each of whom has a demand function of 6.2 A computer hardware firm sells both laptop com-
q1 = 5 - p, and that 400 seniors also visit, each puters and printers. Through the magic of focus
of whom has a demand function of q2 = 4 - p. groups, their pricing team determines that they have
Knoebels’ objective is to set l and p so as to maxi- an equal number of three types of customers, and
mize its profit given that it has no (non-sunk) cost that these customers’ reservation prices are
and must charge both groups the same prices. What
are the optimal l and p? m
Laptop Printer Bundle
5.3 Joe has just moved to a small town with only one
golf course, the Northlands Golf Club. His inverse Customer A $800 $100 $900
demand function is p = 120 - 2q, where q is the Customer B $1,000 $50 $1,050
number of rounds of golf that he plays per year.
The manager of the Northlands Club negotiates Customer C $600 $150 $750
Exercises 467
exeRCISeS
= exercise is available on MyEconLab; * = answer appears at the back of this book; M = mathematical problem.
1. Static games
*1.1 Show the payoff matrix and explain the reason- Firm 1
ing in the prisoners’ dilemma example where Larry
Low Medium High
and Duncan, possible criminals, will get one year in
prison if neither talks; if one talks, one goes free and 1 21 12
the other gets five years; and if both talk, both get Low
two years. (Note: The payoffs are negative because 11 19 6
they represent years in jail, which is a bad.) 25 2 4
1.2 Show that advertising is a dominant strategy for Firm 2 Medium
both firms in both panels of Table 13.3. Explain 16 3 23
why that set of strategies is a Nash equilibrium. 24 26 11
*1.3 Two firms must simultaneously decide which qual- High
ity to manufacture. The profit matrix (in tens of 5 14 17
thousands of euros) is
Exercises 497
Identify all the Nash equilibria in this game. (See weekend in 2003 that Warner released its movie
Solved Problem 13.1.) Matrix 2. Suppose that Warner had not purchased
1.4 Suppose Procter & Gamble (PG) and Johnson & the distribution rights to T-3 and that the film’s
Johnson (JNJ) are simultaneously considering new producer retained the rights. Warner would have
advertising campaigns. Each firm may choose a had to decide whether to release Matrix 2 on the
high, medium, or low level of advertising.What are July 4 weekend or on the July 18 weekend. Simul-
each firm’s best responses to its rival’s strategies? taneously, T-3’s producer would have had to decide
Does either firm have a dominant strategy? What which of those two weekends to release its film.
is the Nash equilibrium in this game? (See Solved The payoff matrix (in millions of dollars) of the
Problem 13.1.) simultaneous-moves game would have been
PG Warner Bros.
High Medium Low
July 4 July 18
1 2 3
High 50 35
1 3 5 July 4
3 4 5 50 80
T-3
JNJ Medium
Producer
2 4 6 90 20
5 6 5 July 18
Low 30 20
3 5 7
Given these payoffs, Firm 2 wants to match Firm included a van Gogh, a Cézanne, and an early Picasso
1’s price, but Firm 1 does not want to match Firm (Vogel, Carol, “Rock, Paper, Payoff,” New York
2’s price. What, if any, are the pure-strategy Nash Times, April 29, 2005, A1, A24). He resolved the
equilibria of this game? issue by having the two auction houses’ representa-
*1.8 What is the mixed-strategy Nash equilibrium for tives compete in the playground game of rock-paper-
the game in Exercise 1.7? M scissors. A rock (fist) breaks scissors (two extended
fingers), scissors cut paper (flat hand), and paper
*1.9 Suppose that Toyota and GM are considering enter-
smothers rock. At stake were several million dollars in
ing a new market for electric automobiles and that
commissions. Christie’s won: scissors cut paper.
their profits (in millions of dollars) from entering or
staying out of the market are a. Show the profit or payoff matrix for this rock-
paper-scissors game. (Hint: You may assume
that the payoff is - 1 if you lose, 0 if you tie, and
GM 1 if you win.)
Enter Do Not Enter b. Sotheby’s expert in Impressionist and modern
art said, “[T]his is a game of chance, so we
–40 0 didn’t really give it much thought. We had no
Enter strategy in mind.” In contrast, the president of
Christie’s in Japan researched the psychology
10 250
Toyota of the game and consulted with the 11-year-old
200 0 twin daughters of the director of the Impression-
Do Not ist and modern art department. One of these
Enter girls said, “Everybody knows you always start
0 0
with scissors. Rock is way too obvious, and scis-
sors beats paper.” The other opined, “Since they
If the firms make their decisions simultaneously, were beginners, scissors was definitely the saf-
which firms enter? How would your answer change est.” Evaluate these comments on strategy. What
if the U.S. government committed to paying GM a strategy would you recommend if you knew that
lump-sum subsidy of $50 million on the condition your rival was consulting with 11-year-old girls?
that it would produce this new type of car? In general, what pure or mixed strategy would
1.10 In the battle of the sexes game, the husband likes you have recommended, and why? M
to go to the mountains on vacation, and the wife 1.12 Suppose that Panasonic and Zenith are the only two
prefers the ocean, but they both prefer to take their firms that can produce a new type of 3D TV. The
vacations together. payoff matrix shows the firms’ profits (in millions
of dollars):
Husband Panasonic
Mountains Beach
Enter Do Not Enter
1 –1
Mountains –40 0
Enter
2 –1
Wife –40 250
–1 2 Zenith
Beach 250 0
Do Not
–1 1 Enter
0 0
What are the Nash equilibria? Discuss whether this
game and equilibrium concept make sense for ana- a. If both firms move simultaneously, does either
lyzing a couple’s decisions. How might you change firm have a dominant strategy? Explain.
the game’s rules so that it makes more sense? M b. What are the Nash equilibria given that both
1.11 Takashi Hashiyama, president of the Japanese elec- firms move simultaneously?
tronics firm Maspro Denkoh Corporation, was torn c. The U.S. government commits to paying Zenith
between commissioning Christie’s or Sotheby’s to auc- a lump-sum subsidy of $50 million if it enters
tion the company’s $20 million art collection, which this market. What is the Nash equilibrium?
Exercises 499
1.13 Two guys (suffering from testosterone poisoning) a. What is the Nash equilibrium? Is the game a
engage in the game of chicken. They drive toward prisoners’ dilemma? Explain.
each other in the middle of a road. As they approach b. Suppose that one athlete’s utility of taking ste-
the impact point, each has the option of continuing roids is -12, while the other’s remains at -6.
to drive down the middle of the road or to swerve. What is the Nash equilibrium? Is the game a
Both believe that if only one driver swerves, that prisoners’ dilemma? M
driver loses face (payoff = 0) and the other gains
1.18 Acura and Volvo offer warranties on their automo-
in self-esteem (payoff = 2). If neither swerves,
biles, where wA is the number of years of an Acura
they are maimed or killed (payoff = - 10). If both
warranty and wV is the number of years of a Volvo
swerve, no harm is done to either (payoff = 1).
warranty. The revenue for Firm i, i = A for Acura
Show the payoff matrix for the two drivers engaged
and V for Volvo, is Ri = 27,000wi/(wA + wV). Its
in this game of chicken. Determine the Nash equi-
cost of providing the warranty is Ci = 2,000wi.
libria for this game. M
Acura and Volvo participate in a warranty-
1.14 Modify the payoff matrix in the game of chicken setting game in which they simultaneously set
in Exercise 1.13 so that the payoff is - 2 if neither warranties.
driver swerves. How does the equilibrium change? M
a. What is the profit function for each firm?
1.15 In the novel and film The Princess Bride, the vil- b. Suppose Acura and Volvo can set warranties in
lain Vizzini kidnaps the princess. In an attempt to year lengths only, with a maximum of five years.
rescue her, the hero, Westley, challenges Vizzini to a Fill in a 5 * 5 payoff matrix with Acura’s and
battle of wits. Consider this variation on the actual Volvo’s profits.
plot. (I do not want to reveal the story.) In the battle,
Westley puts two identical glasses of wine behind his c. Determine the Nash equilibrium warranties.
back, out of Vizzini’s view, and adds iocane powder d. Compare the Nash equilibrium warranties. If
to one glass. Iocane is “odorless, tasteless, dissolves the two manufacturers offer the same warranty,
instantly in liquid, and is among the more deadly explain why. If they offer different warranties,
poisons known to man.” Westley decides which explain why.
glass to put on a table in front of Vizzini and which e. Suppose Acura and Volvo collude in setting war-
to put on the table in front of himself. Then, with ranties. What warranties do they set?
Westley’s back turned so that he cannot observe
f. Suppose Acura’s cost of offering warranties
Vizzini’s move, Vizzini decides whether to switch the
decreases to CV = 1,000wV. What is the new
two glasses. Assume the two simultaneously drink
Nash equilibrium? Explain the effect of the
all the wine in their respective glasses. Assume also
decrease in Volvo’s cost function on the equilib-
that each player’s payoff from drinking the poisoned
rium warranties. M
wine is -3 and the payoff from drinking the safe
wine is +1. Write the payoff matrix for this simulta- 2. Dynamic games
neous-moves game. Specify the possible Nash equi- 2.1 Two firms are planning to sell 10 or 20 units of
libria. Is there a pure-strategy Nash equilibrium? Is their goods and face the following profit matrix:
there a mixed-strategy Nash equilibrium? M
1.16 Suppose that you and a friend play a “matching Firm 2
pennies” game in which each of you uncovers a
penny. If both pennies show heads or both show 10 20
tails, you keep both. If one shows heads and the
other shows tails, your friend keeps them. Show 30 35
the payoff matrix. What, if any, is the pure-strategy 10
Nash equilibrium to this game? Is there a mixed- 30 50
strategy Nash equilibrium? If so, what is it? M Firm 1
40 20
1.17 The 100-meter Olympic gold medalist and the 200-
meter Olympic gold medalist have agreed to a 150- 20
meter duel. Before the race, each athlete decides 60 20
whether to improve his performance by taking ana-
bolic steroids. Each athlete’s payoff is 20 from win-
ning the race, 10 from tying, and 0 from losing. a. What is the Nash equilibrium if both firms make
Furthermore, each athlete’s utility of taking steroids is their decisions simultaneously?
- 6. Model this scenario as a game in which the play- b. How does your analysis change if the government
ers simultaneously decide whether to take steroids. imposes a lump-sum franchise tax of 40 on each firm
500 CHAPTEr 13 Game Theory
(that is, the payoffs in the matrix are all reduced by Leader Follower Profits
Sets Output Sets Output (π1, π2)
40). Explain how your analysis would change if the
48
firms have an additional option of shutting down (64.9, 64.8)
and avoiding the lump-sum tax rather than produc- 180 64
Firm 2 (54.0, 72.0)
ing 10 or 20 units and paying the tax. 96
(32.1, 64.8)
c. Draw the game tree if Firm 1 can decide first (and 48
(72.0, 54.0)
there is no tax). What is the outcome? Why?
240 64
Firm 1 Firm 2 (57.6, 57.6)
d. Draw the game tree if Firm 2 can decide first. What 96
(28.8, 43.2)
is the outcome? Why?
48
(64.8, 32.4)
2.2 In a repeated game, how does the outcome differ
360 64
if firms know that the game will be (a) repeated Firm 2 (43.2, 28.8)
96
indefinitely, (b) repeated a known, finite number of (0, 0)
times, (c) repeated a finite number of times but the
firms are unsure as to which period will be the last 2.7 A thug wants the contents of a safe and is threat-
period? ening the owner, the only person who knows the
code, to open the safe. “I will kill you if you don’t
*2.3 If the airline game in Table 13.1 is repeated, what
open the safe, and let you live if you do.” Should
happens if the players know the game will last five
the information holder believe the threat and open
periods? What happens if the game is played indefi-
the safe? The table shows the value that each person
nitely but one or both firms care only about current
places on the various possible outcomes.
profit?
2.4 A small tourist town has two Italian restaurants, Thug Safe’s Owner
Romano’s and Giardino’s. Normally both restau- Open the safe, thug does not kill 4 3
rants prosper with no advertising. Romano’s could
take some of Giardino’s customers by running radio Open the safe, thug kills 2 1
ads and Giardino’s could do the same thing. The Do not open, thug kills 1 2
one-month profit matrix (showing payoffs in thou- Do not open, thug does not kill 3 4
sands of dollars) is
Such a game appears in many films, including Die
Romano’s Hard, Crimson Tide, and The Maltese Falcon.
a. Draw the game tree. Who moves first?
Do Not Advertise Advertise
b. What is the equilibrium?
3 4 c. Does the safe’s owner believe the thug’s threat?
Do Not
d. Does the safe’s owner open the safe?
Advertise 3 0
Giardino’s 2.8 Levi Strauss and Wrangler are planning new gen-
0 1 eration jeans and must decide on the colors for their
Advertise products. The possible colors are white, black, and
violet. The payoff to each firm depends on the color
4 1
it chooses and the color chosen by its rival, as the
profit matrix shows:
a. What is the Nash equilibrium in the static (one
month) game? Levi Strauss
b. Describe one or more possible Nash equilibria if
White Black Violet
the game is repeated indefinitely.
10 30 40
c. Are there multiple equilibria if the game is
White
repeated indefinitely?
10 20 30
2.5 In Solved Problem 13.2, suppose that Mimi can
20 0 35
move first. What are the equilibria, and why? Now Wrangler Black
repeat your analysis if Jeff can move first.
30 0 15
2.6. Solve for the Stackelberg subgame-perfect Nash
15 20 0
equilibrium for the following game tree. What is the
Violet
joint-profit maximizing outcome? Why is that not
the outcome of this game? 40 35 0
Exercises 501
a. Given that the firms move simultaneously, iden- a large quantity in the second period, it does not
tify any dominant strategies in this game, and enter. Draw a game tree to illustrate why an incum-
find any pure strategy Nash equilibria. bent would produce more in the first period than
the single-period profit-maximizing level. Now
b. Now suppose the firms move sequentially, with
change the payoffs in the tree to show a situation in
Wrangler moving first. Draw a game tree and
which the firm does not increase production in the
identify any subgame perfect Nash equilibria in
first period. (See Solved Problem 13.3.)
this sequential move game.
2.13 From the ninth century BC until the proliferation
*2.9 A monopoly manufacturing plant currently uses
of gunpowder in the fifteenth century AD, the ulti-
many workers to pack its product into boxes. It
mate weapon of mass destruction was the catapult
can replace these workers with an expensive set of
(Wilford, John Noble, “How Catapults Married
robotic arms. Although the robotic arms raise the
Science, Politics and War,” New York Times, Feb-
monopoly’s fixed cost substantially, they lower its
ruary 24, 2004, D3). Hero of Alexandria pointed
marginal cost because it no longer has to hire as
out in the first century AD that it was not enough to
many workers. Buying the robotic arms raises its
have catapults. You needed your potential enemies
total cost: The monopoly can’t sell enough boxes
to know that you had catapults so that they would
to make the machine pay for itself, given the mar-
not attack you in the first place. As early as the
ket demand curve. Suppose the incumbent does not
fourth century BC, rulers set up what were essen-
invest. If its rival does not enter, it earns $0 and the
tially research and development laboratories to sup-
incumbent earns $900. If the rival enters, it earns
port military technology. However, unlike today,
$300 and the incumbent earns $400. Alternatively,
there was a conspicuous lack of secrecy. According
the incumbent invests. If the rival does not enter, it
to Alex Roland, a historian of technology at Duke
earns $0 and the incumbent earns $500. If the rival
University, “Rulers seemed to promote the technol-
enters, the rival loses $36 and the incumbent makes
ogy for immediate payoff for themselves and had
$132. Show the game tree. Should the monopoly buy
not yet worked through the notion that you ought
the machine anyway? (See Solved Problem 13.3.)
to protect your investment with secrecy and restric-
*2.10 Suppose that an incumbent can commit to produc- tions. So engineers shopped their wares around,
ing a large quantity of output before the potential and information circulated freely among coun-
entrant decides whether to enter. The incumbent tries.” Given this information, describe a ruler’s
chooses whether to commit to produce a small optimal strategy with respect to catapult research,
quantity or a large quantity. The rival then decides development, deployment, and public announce-
whether to enter. If the incumbent commits to the ments. Should the strategy depend upon the coun-
small output level and if the rival does not enter, the try’s wealth or size? What role does credibility of
rival makes $0 and the incumbent makes $900. If it announcements play?
does enter, the rival makes $125 and the incumbent
2.14 In 2007, Italy announced that an Italian journal-
earns $450. If the incumbent commits to producing
ist who had been held hostage for 15 days by the
the large quantity, and the potential entrant stays out
Taliban in Afghanistan had been ransomed for five
of the market, the potential entrant makes $0 and
Taliban prisoners. Governments in many nations
the incumbent makes $800. If the rival enters, the
denounced the act as a bad idea because it rewarded
best the entrant can make is $0, the same amount it
terrorism and encouraged more abductions. Use an
would earn if it didn’t enter, but the incumbent earns
extensive-form game tree to analyze the basic argu-
only $400. Show the game tree. What is the subgame
ments. Can you draw any hard and fast conclusions
perfect Nash equilibrium? (See Solved Problem 13.3.)
about whether the Italians’ actions were a good or
*2.11 Before entry, the incumbent earns a monopoly bad idea? (Hint: Does your answer depend on the
profit of πm = $10 (million). If entry occurs, the relative weight one puts on future costs and benefits
incumbent and entrant each earn the duopoly relative to those today?)
profit, πd = $3. Suppose that the incumbent can
induce the government to require all firms to install 3. Auctions
pollution-control devices that cost each firm $4.
3.1 Suppose that Anna, Bill, and Cameron are the only
Show the game tree. Should the incumbent urge the
people interested in the paintings of the Bucks
government to require pollution-control devices?
County artist Walter Emerson Baum. His painting
Why or why not? (See Solved Problem 13.3.)
Sellers Mill is being auctioned by a second-price
2.12 Due to learning by doing (Chapter 7), the more that sealed-bid auction. Suppose Anna’s value of the
an incumbent firm produces in the first period, the painting is $20,000, Bill’s is $18,500, and Camer-
lower its marginal cost in the second period. If a on’s is $16,800. Each bidder’s consumer surplus is
potential entrant expects the incumbent to produce vi - p if he or she wins the auction and 0 if he or
502 CHAPTEr 13 Game Theory
she loses. The values are private. What is each bid- the responder then decides to accept or reject the
der’s optimal bid? Who wins the auction, and what offer. The total amount available is $50 if agree-
price does he or she pay? M ment is reached but both players get nothing if the
3.2 At the end of performances of his Broadway play responder rejects the offer.
“Cyrano de Bergerac,” Kevin Kline, who starred 4.2 A prisoners’ dilemma game is played for a fixed
as Cyrano, the cavalier poet with a huge nose, number of periods. The fully rational solution is
auctioned his prosthetic proboscis, which he and for each player to defect in each period. However,
his co-star, Jennifer Garner, autographed (www in experiments with students, players often cooper-
.nytimes.com/2007/12/09/business/09suits.html) ate for a significant number of periods if the total
to benefit Broadway Cares in its fight against AIDS. number of periods is fairly large (such as 10 or 20).
An English auction was used. One night, a televi- What explanation can you give for this behavior?
sion producer grabbed the nose for $1,400, while
the next night it fetched $1,600. On other nights, it 5. Challenge
sold for $3,000 and $900. Why did the value fluc- 5.1 In the game between Intel and AMD in the Chal-
tuate substantially from night to night? Which bid- lenge Solution, suppose that each firm earns a profit
der’s bid determined the sales price? How was the of 9 if both firms advertise. What is the new sub-
auction price affected by the audience’s knowledge game perfect Nash equilibrium outcome? Show in a
that the proceeds would go to charity? game tree.
5.2 Derive the mixed strategy equilibrium if both Intel
4. Behavioral game Theory and AMD act simultaneously in the game in the
4.1 Draw a game tree that represents the ultima- Challenge Solution. What is the expected profit
tum game in which the proposer is a first mover of each firm? (Hint: see Solved Problems 13.1 and
who decides how much to offer a responder and 13.2 and the Challenge Solution.) M
546 ChAPTEr 14 Oligopoly 14
5. Bertrand Oligopoly Model. In many oligopolistic or 6. Monopolistic Competition. In monopolistically
monopolistically competitive markets, firms set prices competitive markets after all profitable entry occurs,
instead of quantities. If the product is homogeneous there are few enough firms such that each firm faces a
and firms set prices, the Nash-Bertrand equilibrium downward-sloping demand curve. Consequently, the
price equals marginal cost (which is lower than the firms charge prices above marginal cost. These mar-
Nash-Cournot equilibrium price). If the products are kets are not perfectly competitive because there are
differentiated, the Nash-Bertrand equilibrium price is relatively few firms—possibly because of high fixed
above marginal cost. Typically, the markup of price costs or economies of scale that are large relative to
over marginal cost is greater the more the goods are market demand—or because the firms sell differenti-
differentiated. ated products.
exerCISeS
= exercise is available on MyEconLab; * = answer appears at the back of this book; M = mathematical problem.
to per-passenger-per-day cost? (Hint: Suppose that *3.11 The viatical settlement industry enables ter-
duopoly firms face a linear inverse market demand minally ill consumers, typically HIV patients,
function p = a - bQ and their marginal costs are to borrow against equity in their existing life
m, solve for the equilibrium price, then show how insurance contracts to finance their consump-
the equilibrium price changes as m changes.) M tion and medical expenses. The introduction
*3.5 In a Nash-Cournot equilibrium, each of the n firms and dissemination of effective anti-HIV medica-
faces a constant marginal cost m, the inverse market tion in 1996 reduced AIDS mortality, extending
demand function is p = a - bQ, and the govern- patients’ lives and hence delayed when the viati-
ment assesses a specific tax of τ per unit. What is cal settlement industry would receive the insur-
the incidence of this tax on consumers? M ance payments. However, viatical settlement
*3.6 Your college is considering renting space in the stu- payments (what patients can borrow) fell more
dent union to one or two commercial textbook stores. than can be explained by greater life expectancy.
The rent the college can charge per square foot of The number of viatical settlement firms dropped
space depends on the profit (before rent) of the firms from 44 in 1995 to 24 in 2001. Sood et al.
and hence on whether there is a monopoly or a duo- (2005) found that an increase in market power of
poly. Which number of stores is better for the college viatical settlement firms reduced the value of life
in terms of rent? Which is better for students? Why? insurance holdings of HIV-positive persons by
about $1 billion. When marginal cost rises and the
3.7 Connecticut sets a maximum fee that bail-bond busi-
number of firms falls, what happens to the Nash-
nesses can charge for posting a given-size bond (Ayres
Cournot equilibrium price? Use graphs or math to
and Waldfogel, 1994). The bail-bond fee is set at vir-
illustrate your answer. (Hint: If you use math, it
tually the maximum amount allowed by law in cities
may be helpful to assume that the market demand
with only one active firm (Plainville, 99%; Stamford,
curve has a constant elasticity throughout.) M
99%; and Wallingford, 99%). The price is as high
in cities with a duopoly (Ansonia, 99.6%; Meriden, *3.12 Why does differentiating its product allow an oli-
98%; and New London, 98%). In cities with three gopoly to charge a higher price?
or more firms, however, the price falls well below the
3.13 A duopoly faces an inverse market demand function
maximum permitted price. The fees are only 54% of
of p = 120 - Q. Firm 1 has a constant marginal
the maximum in Norwalk (3 firms), 64% in New
cost of 20. Firm 2’s constant marginal cost is 40.
Haven (8 firms), and 78% in Bridgeport (10 firms).
Calculate the output of each firm, market output,
Give possible explanations for this pattern.
and price if there is (a) a collusive equilibrium or
3.8 In 2005, the prices for 36 prescription painkillers (b) a Nash-Cournot equilibrium. (Hint: See Solved
shot up as much as 15% after Merck yanked its Problem 14.1.) M
once-popular arthritis drug Vioxx from the market
due to fears that it caused heart problems (“Prices 3.14 Graph the best-response curve of the second firm in
Climb as Much as 15% for Some Painkillers,” Los Solved Problem 14.1 if its marginal cost is m and
Angeles Times, June 3, 2005, C3). Can this prod- if it is m + x. Add the first firm’s best-response
uct’s exit be the cause of the price increases if the curve and show how the Nash-Cournot equilibrium
prices reflect a Nash-Cournot equilibrium? Explain. changes as its marginal cost increases.
3.9 Consider the Cournot model with n firms. 3.15 In 2012, Southwest Airlines reported that its “cost
The inverse linear market demand function is per available seat mile” was 13.0¢ compared to
p = a - bQ. Each of the n identical firms has the 13.8¢ for United Airlines. Assuming that Southwest
same cost function C(qi) = Aqi + 12 Bq2i , where and United compete on a single route, use a graph
a 7 A. In terms of n, what is each firm’s Nash equi- to show that their equilibrium quantities differ.
librium output and profit and the equilibrium price? (Hint: See Solved Problem 14.1.)
As n gets very large (approaches infinity), does each
firm’s equilibrium profit approach zero? Why? M 3.16 How would the Nash-Cournot equilibrium change
in the airline example if United’s marginal cost were
3.10 The application “Deadweight Losses in the Food
$100 and American’s were $200? (Hint: See Solved
and Tobacco Industries” shows that the dead-
Problem 14.1.) M
weight loss as a fraction of sales varies substantially
across industries. One possible explanation is that *3.17 To examine the trade-off between efficiency and
the number of firms (degree of competition) varies market power from a merger, consider a market
across industries. Using Table 14.2 and other infor- with two firms that sell identical products. Firm 1
mation from the chapter, show how the deadweight has a constant marginal cost of 1, and Firm 2 has a
loss varies in the airline market as the number of constant marginal cost of 2. The market demand is
firms increases from one to three. M Q = 15 - p.
548 ChAPTEr 14 Oligopoly
a. Solve for the Nash-Cournot equilibrium price, subsidizes its domestic firm by s per unit. The
quantities, profits, consumer surplus, and dead- other government does not react. In the absence of
weight loss. (Hint: See Solved Problem 14.1.) government intervention, the market has a Nash-
b. If the firms merge and produce at the lower Cournot equilibrium. Suppose demand is linear,
marginal cost, how do the equilibrium values p = 1 - q1 - q2, and each firm’s marginal and
change? average costs of production are constant at m. Gov-
ernment 1 maximizes net national income (it does
c. Discuss the change in efficiency (average cost of
not care about transfers between the government
producing the output) and welfare—consumer
and the firm, so it maximizes the firm’s profit net of
surplus, producer surplus (or profit), and dead-
the transfers). Show that Government 1’s optimal s
weight loss. M
results in its firm producing the Stackelberg leader
3.18 The firms in a duopoly produce differentiated prod- quantity and the other firm producing the Stack-
ucts. The inverse demand for Firm 1 is p1 = 52 - elberg follower quantity in equilibrium. (Hint: See
q1 - 0.5q2. The inverse demand for Firm 2 is Solved Problem 14.3.) M
p2 = 40 - q2 - 0.5q1. Each firm has a marginal
cost of m = 1. Solve for the Nash-Cournot equilib- 5. Bertrand Oligopoly Model
rium quantities. (Hint: See Solved Problem 14.2.) M 5.1 What happens to the homogeneous-good Nash-
*3.19 An incumbent firm, Firm 1, faces a potential entrant, Bertrand equilibrium price if the number of firms
Firm 2, that has a lower marginal cost. The market increases? Why?
demand curve is p = 120 - q1 - q2. Firm 1 has a *5.2 Will price be lower if duopoly firms set price or if
constant marginal cost of $20, while Firm 2’s is $10. they set quantity? Under what conditions can you
a. What are the Nash-Cournot equilibrium price, give a definitive answer to this question?
quantities, and profits if there is no government *5.3 Suppose that identical duopoly firms have constant
intervention? marginal costs of $10 per unit. Firm 1 faces a demand
b. To block entry, the incumbent appeals to the function of q1 = 100 - 2p1 + p2, where q1 is Firm
government to require that the entrant incur 1’s output, p1 is Firm 1’s price, and p2 is Firm 2’s price.
extra costs. What happens to the Nash-Cournot Similarly, the demand Firm 2 faces is q2 = 100 -
equilibrium if the legal requirement causes the 2p2 + p1. Solve for the Nash-Bertrand equilibrium. M
marginal cost of the second firm to rise to that of 5.4 Solve for the Nash-Bertrand equilibrium for the
the first firm, $20? firms described in Exercise 5.3 if both firms have a
c. Now suppose that the barrier leaves the mar- marginal cost of $0 per unit. M
ginal cost alone but imposes a fixed cost. What 5.5 Solve for the Nash-Bertrand equilibrium for the
is the minimal fixed cost that will prevent entry? firms described in Exercise 5.3 if Firm 1’s marginal
(Hint: See Solved Problem 14.3.) M cost is $30 per unit and Firm 2’s marginal cost is
$10 per unit. M
4. Stackelberg Oligopoly Model
5.6 In the Coke and Pepsi example, what is the effect of
*4.1 Duopoly quantity-setting firms face the market a specific tax, τ, on the equilibrium prices? (Hint:
demand What does the tax do to the firm’s marginal cost?
p = 150 - q1 - q2. You do not have to use math to provide a qualita-
tive answer to this problem.)
Each firm has a marginal cost of $60 per unit. 5.7 At a busy intersection on Route 309 in Quakertown,
Pennsylvania, the convenience store and gasoline
a. What is the Nash-Cournot equilibrium?
station, Wawa, competes with the service and gaso-
b. What is the Stackelberg equilibrium when Firm line station, Fred’s Sunoco. In the Nash-Bertrand
1 moves first? M equilibrium with product differentiation competi-
4.2 Determine the Stackelberg equilibrium with one tion for gasoline sales, the demand for Wawa’s gas is
leader firm and two follower firms if the market qW = 680 - 500pW + 400pS, and the demand for
demand curve is linear and each firm faces a con- Fred’s gas is qW = 680 - 500pS + 400pW. Assume
stant marginal cost, m, and no fixed cost. M that the marginal cost of each gallon of gasoline is
4.3 Show the effect of a subsidy on Firm 1’s best- m = $2. The gasoline retailers simultaneously set
response function in Solved Problem 14.3 if the their prices.
firm faces a general demand function p(Q). M a. What is the Bertrand-Nash equilibrium?
4.4 Two firms, each in a different country, sell homo- b. Suppose that for each gallon of gasoline sold,
geneous output in a third country. Government 1 Wawa earns a profit of 25¢ from its sale of salty
Exercises 549
snacks to its gasoline customers. Fred sells no qV = a - bpV + cpA; the demand for ATI’s chip
products that are related to the consumption is qA = a - bpA + cpV, where pV is nVidia’s
of his gasoline. What is the Nash equilibrium? price, pA is ATI’s price, and a, b, and c are coef-
(Hint: See Solved Problem 14.3.) M ficients of the demand function. Suppose each
5.8 In February 2005, the U.S. Federal Trade Commis- manufacturer’s marginal cost is a constant, m.
sion (FTC) went to court to undo the January 2000 What are the values of a, b, and c for which the
takeover of Highland Park Hospital by Evanston equilibrium profit of each chip manufacturer
Northwestern Healthcare Corp. The FTC accused is zero? In answering this question, show that
Evanston Northwestern of antitrust violations by despite differentiated products, duopoly firms
using its post-merger market power in the Evan- may earn zero economic profit. M
ston hospital market to impose 40% to 60% price
6. Monopolistic Competition
increases (Bernard Wysocki, Jr., “FTC Targets Hos-
pital Merger in Antitrust Case,” Wall Street Journal, 6.1 What is the effect of a government subsidy that
January 17, 2005, A1). Hospitals, even within the reduces the fixed cost of each firm in an industry in
same community, are geographically differentiated a Cournot monopolistic competition equilibrium?
as well as possibly quality differentiated. Suppose 6.2 In the monopolistically competitive airlines model,
that the demand for an appendectomy at Highland what is the equilibrium if firms face no fixed
Park Hospital is a function of the price of the pro- costs?
cedure at Highland Park and Evanston Northwest-
6.3 In a monopolistically competitive market, the gov-
ern Hospital: qH = 50 - 0.01pH + 0.005pN. The
ernment applies a specific tax of $1 per unit of out-
comparable demand function at Evanston North-
put. What happens to the profit of a typical firm in
western is qN = 500 - 0.01pN + 0.005pH. At each
this market? Does the number of firms in the mar-
hospital, the fixed cost of the procedure is $20,000
ket change? Why?
and the marginal cost is $2,000.
6.4 Does an oligopoly or a monopolistically competi-
a. Use the product-differentiated Bertrand model
tive firm have a supply curve? Why or why not?
to analyze the prices the hospitals set before the
(Hint: See the discussion in Chapter 11 of whether a
merger. Find the Nash equilibrium prices of the
monopoly has a supply curve.)
procedure at the two hospitals.
*6.5 Show that a monopolistically competitive firm max-
b. After the merger, find the profit-maximizing
imizes its profit where it is operating at less than full
monopoly prices of the procedure at each hospi-
capacity or minimum efficient scale, which is the
tal. Include the effect of each hospital’s price on
smallest quantity at which the average cost curve
the profit of the other hospital.
reaches its minimum (the bottom of a U-shaped
c. Does the merger result in increased prices? average cost curve). The firm’s minimum efficient
Explain. M scale is the quantity at which the firm no longer
5.9 Firms in some industries with a small number of benefits from economies of scale.
competitors earn normal economic profit. The Wall 6.6 Exercise 6.5 shows that a monopolistically competi-
Street Journal (Gomes, Lee, “Competition Lives tive firm maximizes its profit where it is operating
On in Just One PC Sector,” March 17, 2003, B1) at less than full capacity. Does this result depend
reports that the computer graphics chips industry is upon whether firms produce identical or differenti-
one such market. Two chip manufacturers, nVidia ated products? Why?
and ATI, “both face the prospect of razor-thin prof-
6.7 In Solved Problem 14.4, what fixed cost would
its, largely on account of the other’s existence.”
result in four firms operating in the monopolisti-
a. Consider the Bertrand model in which each cally competitive equilibrium? What are the equilib-
firm has a positive fixed and sunk cost and zero rium quantities and prices?
marginal cost. What are the Nash equilibrium
prices? What are the Nash equilibrium profits? 7. Challenge
b. Does this “razor-thin” profit result imply that 7.1 In the Challenge Solution’s mathematical model,
the two manufacturers necessarily produce chips how much does Firm 1’s best-response curve shift as
that are nearly perfect substitutes? Explain. the subsidy, s, increases?
c. Assume that nVidia and ATI produce dif- 7.2 Using the Challenge Solution’s mathematical model,
ferentiated products and are Bertrand com- how much does Firm 1’s profit (ignoring the sub-
petitors. The demand for nVidia’s chip is sidy) change as the subsidy, s, increases?
Exercises 581
15
SuMMaRY
1. Factor Markets. Any firm maximizes its profit by To compare a payment made in the future to one
choosing the quantity of a factor such that the mar- made today, we can express the future value in terms
ginal revenue product (MRP) of that factor—the of current dollars—its present value—by discounting
marginal revenue times the marginal product of the the future payment using the interest rate. Similarly,
factor—equals the factor price. The MRP is the firm’s a flow of payments over time is related to the pres-
factor demand. A competitive firm’s marginal rev- ent or future value of these payments by the interest
enue is the market price, so its MRP is the market rate. A firm may choose between two options with
price times the marginal product. The factor demand different cash flows over time by picking the one with
curves of a noncompetitive firm lie to the left of those the higher present value. Similarly, a firm invests in a
of a competitive firm. The firm’s long-run factor project if its net present value is positive or its inter-
demand is usually flatter than its short-run demand nal rate of return is greater than the interest rate.
because the firm can adjust more factors, and thus
3. exhaustible Resources. Nonrenewable resources
benefit from more flexibility. The market demand for
such as coal, gold, and oil are depleted over time
a factor reflects how changes in factor prices affect
and cannot be replenished. If these resources are
output prices and hence output levels in product mar-
scarce, the marginal cost of mining them is constant
kets. The intersection of the market factor demand
or increasing, and the market structure remains
curve and the market factor supply curve determines
unchanged, their prices rise rapidly over time because
the factor market equilibrium.
of positive interest rates. However, if the resources
2. Capital Markets and Investing. Inflation aside, most are abundant, the marginal cost of mining falls over
people value money in the future less than money time, or the market becomes more competitive, non-
today. An interest rate reflects how much more peo- renewable resource prices may remain constant or
ple value a dollar today than a dollar in the future. fall over time.
exeRCISeS
= exercise is available on MyEconLab; * = answer appears at the back of this book; M = mathematical problem.
*1.8 A competitive firm has a constant elasticity produc- 2.4 Pacific Gas and Electric sent its customers a com-
tion function, q = (Lρ + Kρ)1/ρ. What is its mar- parison showing that a person could save $80
ginal revenue product of labor? q = (Lρ + Kρ)1/ρ per year in gas, water, and detergent expenses by
1.9 Suppose that a firm’s production function is replacing a traditional clothes washer with a new
q = L + K. Can it be a competitive firm? Why? tumble-action washer. Suppose that the interest rate
is 5%. You expect your current washer to die in five
1.10 A monopoly with a Cobb-Douglas production
years. If the cost of a new tumble-action washer is
function, Q = (Lρ + Kρ)1/ρ, faces a constant elas-
$800, should you replace your washer now or in
ticity demand curve. What is its marginal revenue
five years? Explain. M
product of labor? M
2.5 You plan to buy a used refrigerator this year for
1.11 How does a monopoly’s demand for labor shift if a
$200 and to sell it when you graduate in two years.
second firm enters its output market and the result
Assuming that you can get $100 for the refrigerator
is a Cournot duopoly equilibrium?
at that time, there is no inflation, and the interest
1.12 Does a shift in the supply curve of labor have a rate is 5%, what is the true cost (your current out-
greater effect on wages if the output market is com- lay minus the resale value in current terms) of the
petitive or if it is monopolistic? Explain. refrigerator to you? M
1.13 What is a monopoly’s demand for labor if it uses 2.6 You want to buy a room air conditioner. The price
a fixed-proportions production function in which of one machine is $200. It costs $20 a year to oper-
each unit of output takes one unit of labor and one ate. The price of another air conditioner is $300,
unit of capital? but it costs only $10 a year to operate. Assuming
1.14 In Solved Problem 15.2, show how the results that both machines last 10 years, which is a better
change if the share of workers killed by the Black deal? (Do you need to do extensive calculations to
Death was one-half. answer this question?) M
1.15 An economic consultant explaining the effect on *2.7 Two different teams offer a professional basketball
labor demand of increasing health care costs, inter- player contracts for playing this year. Both con-
viewed for the Wall Street Journal’s Capital column tracts are guaranteed, and payments will be made
(Wessel, David, “Health-Care Costs Blamed for even if the athlete is injured and cannot play. Team
Hiring Gap,” March 11, 2004, A2), states, “Medi- A’s contract would pay him $1 million today. Team
cal costs are rising more rapidly than anything else B’s contract would pay him $500,000 today and $2
in the economy—more than prices, wages or prof- million 10 years from now. Assuming that there is
its. It isn’t only current medical costs, but also the no inflation, that our pro is concerned only about
present value of the stream of endlessly high cost which contract has the highest present value, and
increases that retards hiring.” that his personal discount rate is 5%, which con-
a. Why does the present value of the stream of tract does he accept? Does your answer change if
health care costs, and not just the current health the discount rate is 20%? M
care costs, affect a firm’s decision whether to cre- 2.8 You are buying a new $20,000 car and have the
ate a new position? option to pay for the car with a 0% loan or to
b. Why should an employer discount future health receive $500 cash back at the time of the pur-
care costs in deciding whether to create a new chase. With the loan, you pay $5,000 down when
position? M you purchase the car and then make three $5,000
payments, one at the end of each year of the
2. Capital Markets and Investing loan. You currently have $50,000 in your savings
account.
*2.1 How does an individual with a zero discount rate
compare current and future consumption? How a. The rate of interest on your savings account
does your answer change if the discount rate is is 4% and will remain so for the next three
infinite? years. Which payment method should you
choose?
2.2 If you buy a car for $100 down and $100 a year for
two more years, what is the present value of these b. What interest rate, i, makes you indifferent
payments at a 5% interest rate? If the interest rate between the two payment methods? M
is i? M 2.9 Discussing the $350 price of a ticket for one of her
2.3 How much money do you have to put into a bank concerts, Barbra Streisand said, “If you amortize
account that pays 10% interest compounded annu- the money over 28 years, it’s $12.50 a year. So is it
ally to receive annual payments of $200? M worth $12.50 a year to see me sing? To hear me
Exercises 583
sing live?”18 Under what condition is it useful for 6,000 miles a year. If the interest rate is 5% and
an individual to apply Ms. Streisand’s rule to decide you are interested only in saving money, should you
whether to go to the concert? What do we know buy a car now rather than wait until your current
about the discount rate of a person who makes such car dies? Would you make the same decision if you
a purchase? faced a 10% interest rate? M
2.10 If you spend $4 a day on a latte (in real dollars) for 2.17 As discussed in Solved Problem 15.3, Lewis Wolff
the rest of your life (essentially forever), what is your and his investment group bought the Oakland A’s
present discounted value at a 3% interest rate? M baseball team for $180 million in 2005. Reportedly,
2.11 At a 10% interest rate, do you prefer to buy a Hall-of-Famer Reggie Jackson offered $25 million
phone for $100 or to rent the same phone for $10 more but was rebuffed (Forbes, 2005). How would
a year? Does your answer depend on how long you the calculations in Solved Problem 15.3 change if
think the phone will last? M the sales price had been $205 million? M
*2.12 A firm is considering an investment in which its cash 2.18 To virtually everyone’s surprise, the Washington
flow is π1 = $1 (million), π2 = -$12, π3 = $20, Nationals baseball team earned a pretax profit of
and πt = 0 for all other t. The interest rate is 7%. $20 million in 2005, compared to a $10 million loss
Use the net present value rule to determine whether when the team was the Montreal Expos in 2004
the firm should make the investment. Can the firm (Heath, Thomas, “Nationals’ Expected ’05 Profit
use the internal rate of return rule to make this deci- Is $20 Million,” Washington Post, June 21, 2005,
sion? M A1). Major League Baseball, which bought the
franchise for $120 million in 2002, received eight
2.13 With the end of the Cold War, the U.S. government
bids of up to $400 million for the team. Report-
decided to downsize the military. Along with a pink
edly, most baseball teams sell for between two and
slip, the government offered ex-military person-
three times their revenue, so given that the Nation-
nel their choice of $8,000 a year for 30 years or
als’ projected revenue was $129 million in 2005,
an immediate lump-sum payment of $50,000. The
an offer of $400 million would be typical. If the
lump-sum option was chosen by 92% of enlisted
Nationals were expected to earn $20 million each
personnel and 51% of officers (Warner and Pleeter,
year in the future, what is the internal rate of return
2001). What is the break-even personal discount
on a $400 million investment for this club? (Hint:
rate at which someone would be indifferent between
See Solved Problem 15.4.) M
the two options? What can you conclude about the
personal discount rates of the enlisted personnel 2.19 If the government bars foreign lenders from loaning
and officers? M money to its citizens, how does the capital market
equilibrium change?
2.14 Dell Computer makes its suppliers wait 37 days on
average to be paid for their goods; however, Dell is 2.20 In the figure in Solved Problem 15.5, suppose that
paid by its customers immediately. Thus, Dell earns the government’s demand curve remains constant at
interest on this float, the money that it is implicitly D1g but the government starts to tax private earn-
borrowing. If Dell can earn an annual interest rate ings, collecting 1% of all interest earnings. How
of 4%, what is this float worth to Dell per dollar does the capital market equilibrium change? What
spent on inputs? M is the effect on private borrowers?
2.15 Many retirement funds charge an administrative fee
3. exhaustible Resources
equal to 0.25% on managed assets. Suppose that
Alexx and Spenser each invest $5,000 in the same 3.1 You can sell a barrel of oil today for p dollars.
stock this year. Alexx invests directly and earns 5% Assuming no inflation and no storage cost, how
a year. Spenser uses a retirement fund and earns high would the price have to be next year for you to
4.75%. After 30 years, how much more will Alexx sell the oil next year rather than now? M
have than Spenser? M 3.2 If all the coal in the ground, Q, is to be consumed in
*2.16 Your gas-guzzling car gets only 10 miles to the gal- two years and the demand for coal is Qt = A(pt)ε in
lon and has no resale value, but you are sure that it each year t where ε is a constant demand elasticity,
will last five years. You know that you can always what is the price of coal each year? M
buy a used car for $8,000 that gets 20 miles to 3.3 Trees, wine, and cattle become more valuable over
the gallon. A gallon of gas costs $2 and you drive time and then possibly decrease in value. Draw a
18
“In Other Words . . .” San Francisco Chronicle, January 1, 1995: Sunday Section, p. 3. She divided the $350 ticket price by 28
years to get $12.50 as the payment per year.
584 CHApTer 15 Factor Markets
figure with present value on the vertical axis and college still pay? Show how the figure in the Chal-
years (age) on the horizontal axis and show this lenge Solution changes. Illustrate how the pres-
relationship. Show in what year the owner should ent value calculation changes using a formula and
“harvest” such a good assuming that there is no cost variables.
to harvesting. [Hint: If the good’s present value is 4.3 Which is worth more to you: (a) a $10,000 payment
P0 and we take that money and invest it at interest today or (b) a $1,000-per-year higher salary for as
rate i (a small number such as 0.02 or 0.04), then long as you work? At what interest rate would (a)
its value in year t is P0(1 + i)t; or if we allow con- be worth more to you than (b)? Does your answer
tinuous compounding, P0eit. Such a curve increases depend on how many years you expect to work?
exponentially over time and looks like the curve
4.4 In 2012, the Clarkson Community Schools in Clark-
labeled “Price” in Figure 15.5. Draw curves with
son, Michigan paid its starting teachers $38,087
different possible present values. Use those curves to
employees with a bachelor’s degree and $41,802
choose the optimal harvest time.] How would your
with a master’s degree. (For simplicity, assume that
answer change if the interest rate were zero? Show in
these salaries stay constant and do not increase with
a figure. M
experience.) Suppose you know that you want to
work for this school district and want to maximize
4. Challenge
your life-time earnings. To get a master’s degree
4.1 If the interest rate is near zero, should an individual takes one extra year of schooling and costs $20,000.
go to college, given the information in the figure Should you get the master’s if you cannot work dur-
in the Challenge Solution? State a simple rule for ing that year? Should you get your master’s degree
determining whether this individual should go to if you can work while studying for your master’s?
college in terms of the areas labeled “Benefit” and In your calculations, assume that you’ll work for
“Cost” in the figure. 40 years and then retire and consider interest rates
4.2 At current interest rates, it pays for Bob to go to of 3% and 10%. (Hint: You can get a reasonable
college if he graduates in four years. If it takes an approximation to the answer by assuming that you
extra year to graduate from college, does going to work forever and use Equation 15.17.)
16 Exercises 615
attitude toward risk. People pick the option with 4. Investing Under Uncertainty. Whether an individual
the highest expected utility. Expected utility is the invests depends on the uncertainty of the payoff, the
probability-weighted average of the utility from the expected return, the individual’s attitudes toward
outcomes in the various states of nature. The larger risk, the interest rate, and the cost of altering the like-
an individual’s Arrow-Pratt measure of risk aversion, lihood of a good outcome. An investment pays for
the less likely that person will take a small gamble. risk-neutral people if the expected net present value
3. Reducing Risk. People reduce their risk in several is positive. Risk-averse people invest only if invest-
ways. They can avoid some risks, and take actions to ing raises their expected utilities. Thus, risk-averse
lower the probabilities of bad events. They might act to people make risky investments if those investments
reduce the harm from bad events. Investors make better pay higher rates of return than do safer investments.
choices if they have more information. Unless returns to If an investment takes place over time, a risk-neutral
the different investments are perfectly positively corre- investor invests if the expected net present value is
lated, diversification reduces risk. Insurance companies positive. People pay to alter the probabilities of vari-
diversify by pooling risks across many individuals. ous outcomes from an investment if doing so raises
their expected utility.
Insurance is fair if the expected return to the policy-
holder is zero: the expected payout equals the pre- 5. Behavioral economics and Uncertainty. Some peo-
mium paid. Risk-averse people fully insure if they are ple’s actions in uncertain situations are inconsistent
offered fair insurance. Because insurance companies with expected utility theory. Their choices may be
must earn enough income to cover their costs, they due to biased estimates of probabilities or different
offer insurance that is unfair. Risk averse people objectives than maximizing expected utility. Pros-
often buy unfair insurance, but they buy less than pect theory explains some of these puzzling choices.
full insurance. When buying unfair insurance, policy- Under this theory, people may care more about losses
holders exchange the risk of a large loss for the cer- than gains and weight outcomes differently than with
tainty of a smaller loss (paying the premium). the probabilities used in expected utility theory.
exeRCISeS
= exercise is available on MyEconLab; * = answer appears at the back of this book; m = mathematical problem.
1. assessing Risk will lose $1,000. The probability they will have to
1.1 In a neighborhood with 1,000 houses, 5 catch fire put in the piers is 25%. What is the expected value
(but are not damaged by high winds), 7 are dam- of this contract? Now, EZ learns that it can obtain
aged by high winds (but do not catch fire), and the a seismic study of the property that would specify
rest are unharmed during a one-year period. What whether piers have to be sunk before EZ must
is the probability that a house is harmed by fire or accept or reject this contract. By how much would
high winds? m the seismic study increase EZ’s expected value?
What is the most that it will pay for such a study?
*1.2 Asa buys a painting. There is a 20% probability (Hint: See Solved Problem 16.1.) m
that the artist will become famous and the paint-
1.5 What is the difference—if any—between an individ-
ing will be worth $1,000. There is a 10% prob-
ual gambling at a casino and gambling by buying a
ability that the painting will be destroyed by fire or
stock? What is the difference for society?
another disaster and become worthless. If the paint-
ing is not destroyed and the artist does not become *1.6 To discourage people from breaking the traffic
famous, it will be worth $500. What is the expected laws, society can increase the probability that some-
value of the painting? m one exceeding the speed limit will be caught and
punished, or it can increase the size of the fine for
*1.3 By next year, your stock has a 25% chance of being speeding. Explain why either method can be used to
worth $400 and a 75% probability of being worth discourage speeding. Which approach is a govern-
$200. What are the expected value and the variance? ment likely to prefer, and why?
1.4 The EZ Construction Company is offered a 1.7 Suppose that most people will not speed if the
$20,000 contract to build a new deck for a house. expected fine is at least $500. The actual fine for
The company’s profit if they do not have to sink speeding is $800. How high must the probability of
piers (vertical supports) down to bedrock will be being caught and convicted be to discourage speed-
$4,000. However, if they have to sink the piers, they ing? m
616 CHApTer 16 Uncertainty
2. attitudes Toward Risk 2.10 Lisa just inherited a vineyard from a distant relative.
2.1 Guojun offers to bet Kristin that if a six-sided die In good years (when there is no rain or frost during
comes up with one or two dots showing, he will harvest season), she earns $100,000 from the sale
pay her $3, but if it comes up with any other num- of grapes from the vineyard. If the weather is poor,
ber of dots, she’ll owe him $2. Is that a fair bet for she loses $20,000. Lisa’s estimate of the probability
Kristin? m of good weather is 60%.
2.2 Jen’s utility function with respect to wealth is a. Calculate the expected value and the variance of
U(W) = 2W. Plot her utility function. Use your Lisa’s income from the vineyard.
figure and calculus to show that Jen is risk averse. b. Lisa is risk averse. Ethan, a grape buyer, offers
(Hint: You can also use calculus to see if she is risk Lisa a guaranteed payment of $70,000 each
averse by determining the sign of the second deriva- year in exchange for her entire harvest. Will Lisa
tive of the utility function.) m accept this offer? Explain.
*2.3 Jen, in Exercise 2.2, may buy Stock A or Stock B. c. Why might Ethan make such an offer?
Stock A has a 50% chance of being worth $100 and
50% of being worth $200. Stock B’s value is $50 2.11 Joanna is considering three possible jobs. The fol-
with a change of a half or $250 with a probability lowing table shows the possible incomes she might
of 50%. Show that the two stocks have an equal get in each job.
expected value but different variances. Show that
Jen prefers Stock A to Stock B because her expected
Outcome A Outcome B
utility is higher with Stock A. m
2.4 Suppose that an individual is risk averse and has Probability Earnings Probability Earnings
to choose between $100 with certainty and a risky
option with two equally likely outcomes: $100 - x Job 1 0.5 20 0.5 40
and $100 + x. Use a graph (or math) to show that Job 2 0.3 15 0.7 45
this person’s risk premium is smaller, the smaller x
is (the less variable the gamble is). Job 3 1 30
*2.5 Given the information in Solved Problem 16.2,
Irma prefers to buy the stock. Show graphically For each job, calculate the expected value, the vari-
how high her certain wealth would have to be for ance and the standard deviation. If Joanna is averse
her to choose not to buy the stock. to risk (as measured by variance), what can you pre-
dict about her job choice? What if she is risk neutral?
2.6 In Solved Problem 16.3, what is Jen’s risk premium
if her utility function were ln(W)? m 2.12 Suppose that Irma’s utility function with respect to
wealth is U(W) = 100 + 100W - W 2. Show that
*2.7 Hugo has a concave utility function of
for W 6 10, Irma’s Arrow-Pratt risk-aversion mea-
U(W) = W 0.5. His only asset is shares in an Inter-
sure increases with her wealth. (Hint: See Solved
net start-up company. Tomorrow he will learn the
Problem 16.4.) m
stock’s value. He believes that it is worth $144 with
probability 23 and $225 with probability 13. What is 2.13 Carolyn and Sanjay are neighbors. Each owns a car
his expected utility? What risk premium would he valued at $10,000. Neither has comprehensive insur-
pay to avoid bearing this risk? (Hint: See Solved ance (which covers losses due to theft). Carolyn’s
Problem 16.3.) m wealth, including the value of her car is $80,000.
2.8 Mary’s utility function is U(W) = W 0.33, where
Sanjay’s wealth, including the value of his car is
W is wealth. Is she risk averse? Mary has an ini- $20,000. Carolyn and Sanjay have identical utility of
tial wealth of $27,000. How much of a risk pre- wealth functions, U(W) = W 0.4. Carolyn and Sanjay
mium would she require to participate in a gamble can park their cars on the street or rent space in a
that has a 50% probability of raising her wealth garage. In their neighborhood, there is a 50% prob-
to $29,791 and a 50% probability of lowering her ability that a street-parked car will be stolen during
wealth to $24,389? (Hint: See Solved Problem 16.3 the year. A garage-parked car will not be stolen.
and the discussion of the risk premium in Figure a. What is the largest amount that Carolyn is willing
16.2.) m to pay to park her car in a garage? What is the
2.9 Would risk-neutral people ever buy insurance maximum amount that Sanjay is willing to pay?
that was not fair (that was biased against them)? b. Compare Carolyn’s willingness-to-pay to San-
Explain. jay’s. Why do they differ? Include a comparison
Exercises 617
of their Arrow-Pratt measures of risk aversion. b. The agent advises wealthy people not to pur-
(Hint: See Solved Problem 16.4.) m chase insurance to protect against possible small
losses. Why? m
3. Reducing Risk 3.5 After Hurricane Katrina in 2005, the government
3.1 Lori, who is risk averse, has two pieces of jewelry, offered subsidies to people whose houses were
each worth $1,000. She plans to send them to her destroyed. How does the expectation that subsi-
sister’s firm in Thailand to be sold there. She is dies will be offered again for future major disasters
concerned about the safety of shipping them. She affect the probability that risk-averse people will
believes that the probability that any box shipped buy insurance and the amount they buy? Use a util-
will not reach its destination is θ. Is her expected ity function for a risk-averse person to illustrate
utility higher if she sends the articles together or in your answer. (Hint: See Solved Problem 16.5.)
two separate shipments? m
4. Investing Under Uncertainty
3.2 Helen, the owner of Dubrow Labs, worries about
the firm being sued for botched results from blood *4.1 Andy and Kim live together. Andy may invest
tests. If it isn’t sued, the firm expects to earn a profit $10,000 (possibly by taking on an extra job to earn
of 100, but if it is successfully sued, its profit will the additional money) in Kim’s MBA education this
be 10. Helen believes that the probability of a suc- year. This investment will raise the current value of
cessful suit is 5%. If fair insurance is available and Kim’s earnings by $24,000. If they stay together,
Helen is risk averse, how much insurance will she they will share the benefit from the additional earn-
buy? (Hint: You may only be able to express your ings. However, the probability is 12 that they will
answer as an inequality.) m split up in the future. If they were married and then
split, Andy would get half of Kim’s additional earn-
3.3 Jill possesses $160,000 worth of valuables. She faces
ings. If they were living together without any legal
a 0.2 probability of a burglary, where she would lose
ties and they split, then Andy would get nothing.
jewelry worth $70,000. She can buy an insurance
Suppose that Andy is risk neutral. Will Andy invest
policy for $15,000 that would fully reimburse the
in Kim’s education? Does your answer depend on
$70,000. Her utility function is U(X) = 4X0.5.
the couple’s legal status? m
a. What is the actuarially fair price for the insur-
4.2 Use a decision tree to illustrate how a risk-neutral
ance policy?
plaintiff in a lawsuit decides whether to settle a
b. Should she buy this insurance policy? claim or go to trial. The defendants offer $50,000 to
c. What is the most that she is willing to pay for an settle now. If the plaintiff does not settle, the plain-
insurance policy that fully covers it against loss? m tiff believes that the probability of winning at trial
3.4 An insurance agent (interviewed in Jonathan Cle- is 60%. If the plaintiff wins, the amount awarded is
ments, “Dare to Live Dangerously: Passing on Some x. How large can x be before the plaintiff refuses to
Insurance Can Pay Off,”Wall Street Journal, July settle? How does the plaintiff’s attitude toward risk
23, 2005, D1) states, “On paper, it never makes affect this decision? m
sense to have a policy with low deductibles or carry 4.3 Use a decision tree to illustrate how a kidney patient
collision on an old car.” But the agent notes that would decide whether to have a transplant opera-
raising deductibles and dropping collision cover- tion. The patient currently uses a dialysis machine,
age can be a tough decision for people with a low which lowers her utility. If the operation is success-
income or little savings. Collision insurance is the ful, her utility will return to its level before the onset
coverage on a policyholder’s own car for accidents of her kidney disease. However, there is a 5% prob-
where another driver is not at fault. ability that she will die if she has the operation. (If it
a. Suppose that the loss is $4,000 if an old car is will help, make up utility numbers to illustrate your
in an accident. During the six-month coverage answer.)
period, the probability that the insured person 4.4 Robert Green repeatedly and painstakingly applied
1
is found at fault in an accident is 36 . Suppose herbicides to kill weeds that would harm his beet
that the price of the coverage is $150. Should a crops in 2007. However, in 2008, he planted beets
wealthy person purchase the coverage? Should genetically engineered to withstand Monsanto’s
a poor person purchase the coverage? Do your Roundup herbicide. Roundup destroys weeds but
answers depend on the policyholder’s degree of leaves the crop unharmed, thereby saving a farmer
risk aversion? Does the policyholder’s degree of thousands of dollars in tractor fuel and labor
risk aversion depend on his or her wealth? (Andrew Pollack, “Round 2 for Biotech Beets,”New
618 CHApTer 16 Uncertainty
York Times, November 27, 2007). However, this Most people choose the sure $2,500 in the first
policy is risky. In the past when beet breeders case but flip the coin in the second. Explain why
announced they were going to use Roundup-resistant this behavior is not consistent. What do you con-
seeds, sugar-using food companies like Hershey and clude about how people make decisions concerning
Mars objected, fearing consumer resistance. Now, uncertain events? m
though, sensing that consumer concerns have sub- 5.2 What are the major differences between expected
sided, many processors have cleared their growers to utility theory and prospect theory?
plant the Roundup-resistant beets. A Kellogg spokes-
5.3 Draw an individual’s utility curve to illustrate that
woman said her company was willing to use such
the person is risk-averse with respect to a loss but is
beets, but Hershey and Mars declined to comment.
risk-preferring with respect to a gain.
Thus, a farmer like Mr. Green faces risks by switch-
ing to Roundup Ready beets. Use a decision tree to 5.4 Evan is risk-seeking with respect to gains and risk-
illustrate the analysis that a farmer in this situation averse with respect to losses. Louisa is risk-seeking
needs to do. with respect to losses and risk-averse with respect
to gains. Illustrate both utility functions. Which
4.5 In Solved Problem 16.6, advertising increases the
person’s attitudes toward risk are consistent with
probability of high demand to 80%. What is the
prospect theory?
minimum probability of high demand resulting
from advertising such that Gautam decides to invest 5.5 Is someone who acts as described in prospect theory
and advertise? m always more likely or less likely to take a gamble
than someone who acts as described by expected
5. Behavioral economics and Uncertainty utility theory? Why? Are there conditions (such as
on the weights) where you can answer this question
5.1 Before reading the rest of this exercise, answer the
definitively?
following two questions about your preferences:
a. You are given $5,000 and offered a choice 6. Flight Insurance
between receiving an extra $2,500 with certainty 6.1 Using information in the Challenge Solution, show
or flipping a coin and getting $5,000 more if how to calculate the price of fair insurance if the
heads or $0 if tails. Which option do you prefer? probability of being in a crash were as high as the
b. You are given $10,000 if you will make the fol- frequency in 2001, 0.00000077? Use a graph to
lowing choice: return $2,500 or flip a coin and illustrate why a risk-averse person might buy unfair
return $5,000 if heads and $0 if tails. Which insurance. Show on the graph the risk premium that
option do you prefer? the person would be willing to pay.
17 Exercises 649
social harm of a negative externality results in the Some goods lack one or both of these properties.
social optimum when applied to a competitive mar- Open-access common property, such as a fishery, is
ket, such a fee may lower welfare when applied to a nonexclusive, but is subject to rivalry. This lack of
noncompetitive market. exclusion causes overfishing because users of the fish-
ery do not take into account the costs they impose
5. allocating Property Rights to Reduce externalities.
on others (forgone fish) when they go fishing. A club
Externalities arise because property rights are not
good is nonrival but exclusive. For example, a swim-
clearly defined. According to the Coase Theorem,
ming club lacks rivalry up to capacity but can exclude
allocating property rights to either of two parties
nonmembers. A market failure occurs if a positive
results in an efficient outcome if the parties can bar-
price is charged for such a good while there is still
gain. However, the assignment of the property rights
extra capacity, because the marginal cost of provid-
affects income distribution because the rights are
ing the good to one more person is zero, which is less
valuable. Unfortunately, bargaining is usually not
than the price. A public good such as public defense
practical, especially when many people are involved.
is both nonrival and nonexclusive. The lack of exclu-
In such cases, using markets for permits to produce
sion causes a freerider problem in a market: People
externalities may overcome the externality problem.
use the good without paying for it. Therefore, poten-
6. Rivalry and exclusion. Private goods are subject to tial suppliers of such goods are not adequately com-
rivalry—if one person consumes a unit of the good it pensated and underprovide the good. Because private
cannot be consumed by others—and to exclusion— markets tend to underprovide nonprivate goods, gov-
others can be stopped from consuming the good. ernments often produce or subsidize such goods.
exeRCISeS
= exercise is available on MyEconLab; * = answer appears at the back of this book; M = mathematical problem.
2.3 Let H = G - G be the amount that gunk, G, is that drives down the private marginal cost of
reduced from the competitive level, G. The ben- production?
efit of reducing gunk is B(H) = AH α. The cost *3.7 Suppose that the inverse demand curve for paper is
is C(H) = H β. If the benefit is increasing but at p = 200 - Q, the private marginal cost (unregu-
a diminishing rate as H increases, and the cost is lated competitive market supply) is MC p = 80 + Q,
rising at an increasing rate, what are the possible and the marginal harm from gunk is MC g = Q.
ranges of values for A, α, and B? M
a. What is the unregulated competitive equilibrium?
2.4 Applying the model in Exercise 2.3, use calculus to
b. What is the social optimum?
determine the optimal level of H. M
c. What specific tax (per unit of output of gunk)
results in the social optimum? (Hint: See Solved
3. Regulating externalities
Problem 17.1.) M
3.1 Australia required that incandescent light bulbs
3.8 Connecticut announced that commercial fleet
be phased out by 2010 in favor of the more fuel-
operators would get a tax break if they converted
efficient compact fluorescent bulbs. Ireland’s ban
vehicles from ozone-producing gasoline to what the
started in 2009, and the United States started phas-
state said were cleaner fuels such as natural gas and
ing out incandescent bulbs in 2012. These restric-
electricity. For every dollar spent on the conversion
tions were designed to reduce carbon and global
of their fleets or building alternative fueling sta-
warming. What alternative approaches could
tions, operators could deduct 50¢ from their corpo-
be used to achieve the same goals? What are the
rate tax. Is this approach likely to be a cost-effective
advantages and disadvantages of a ban relative to
way to control pollution?
the alternatives?
3.9 If global warming occurs, output of three of the
3.2 Markowitz (2012) found that limiting the number
major U.S. cash crops could decline by as much as
of liquor stores reduces crime. To maximize welfare
80% according to Roberts and Schenkler (2010).
taking into account the harms associated with alco-
Crop yields increase on days when the temperature
hol sales, how should a regulatory agency set the
rises above 50°, but fall precipitously on days when
number of liquor licenses? Should the profit maxi-
it is above 86°. Given this relationship between agri-
mizing owner of a liquor store lobby for or against
cultural output and temperature, what would be the
tighter restrictions on licenses?
government’s optimal policy if it can predictably
3.3 In 1998, the National Highway Traffic Safety control pollution and hence temperature (and this
Administration distributed the film Without Helmet agricultural effect is the only externality from global
Laws, We All Pay the Price. Two reasons for this warming)? Can you use either a tax or an emissions
title are that some injured motorcyclists are treated standard to achieve your optimal policy? How does
at public expense (Medicaid) and that the depen- your policy recommendation change if the govern-
dents of those killed in accidents receive public ment is uncertain about its ability to control pollu-
assistance. tion and temperature or there are other externalities?
a. Does the purchase of a motorcycle by an individ- *3.10 Suppose that the government knows the marginal
ual who does not wear a helmet create a negative cost, MC, curve of reducing pollution but is uncer-
externality? Explain. tain about the marginal benefit, MB, curve. With
b. If so, how should government set a no-helmet equal probability, the government faces a relatively
tax that would lead to a socially desirable level high or a relatively low MB curve, so its expected
of motorcycle sales? MB curve is the same as the one in Figure 17.4.
*3.4 In the paper mill example in this chapter, what Should the government use an emissions fee or
are the optimal emissions fee and the optimal tax an emissions standard to maximize expected wel-
on output (assuming that only one fee or tax is fare? Explain. (Hint: Use an analysis similar to that
applied)? employed in Figure 17.4.)
3.5 In Figure 17.1, could the government use a price 4. Market Structure and externalities
ceiling or a price floor to achieve the optimal level 4.1 Suppose that the only way to reduce pollution from
of production? paper production is to reduce output. The govern-
3.6 In Figure 17.3, the government may optimally ment imposes a tax on the monopoly producer that
regulate the paper market by taxing output. Given is equal to the marginal harm from the pollution.
that the output tax remains constant, what are Show that the tax may raise welfare. (Hint: See
the welfare implications of a technological change Solved Problem 17.2.)
Exercises 651
4.2 In the following, use the model in Exercise 3.7. 6. Rivalry and exclusion
a. What is the unregulated monopoly equilibrium? 6.1 List three examples of goods that do not fit neatly
b. How could you optimally regulate the monop- into the categories in Table 17.3 because they are
oly? What is the resulting (socially optimal) not strictly rivalrous or exclusive.
equilibrium? (Hint: See Solved Problem 17.2.) M 6.2 Are heavily used bridges, such as the Bay Bridge,
Brooklyn Bridge, and Golden Gate Bridge, com-
5. allocating Property Rights to Reduce mons? If so, what can be done to mitigate external-
externalities ity problems?
5.1 List three specific examples where Coasian bargain- 6.3 Are broadcast TV and cable TV public goods? Is
ing may result in the social optimum. exclusion possible? If either is a public good, why is
it privately provided?
5.2 Analyze the following statement. Is garbage a posi-
tive or a negative externality? Why is a market solu- 6.4 To prevent overfishing, could one set a tax on fish
tion practical here? or on boats? Explain and illustrate with a graph.
Since the turn of the twentieth century, hog farm- 6.5 There are 240 automobile drivers per minute who
ers in New Jersey fed Philadelphia garbage to their are considering using the E-ZPass lanes of the Inter-
pigs. Philadelphia saved $3 million a year and state 78 toll bridge over the Delaware River that
reduced its garbage mound by allowing New Jer- connects Easton, Pennsylvania, and Phillipsburg,
sey farmers to pick up leftover food scraps for their New Jersey. With that many autos, and a 5 mph
porcine recyclers. The city paid $1.9 million to the speed restriction through the E-ZPass sensors, there
New Jersey pig farmers for picking up the waste is congestion. We can divide the drivers of these
each year, which was about $79 a ton. Otherwise, cars into groups A, B, C, and D. Each group has
the city would have had to pay $125 a ton for curb- 60 drivers. Each driver in Group i has the follow-
side recycling of the same food waste. ing value of crossing the bridge: vi if 60 or fewer
autos cross, vi - 1 if between 61 and 120 autos
5.3 To the dismay of business travelers, airlines discretely
cross, vi - 2 if between 121 and 180 autos cross,
cater to families with young children who fly first class
and vi - 3 if more than 180 autos cross. Suppose
(Rosman, Katherine, “Frequent Criers,” Wall Street
vA = $4, vB = $3, vC = $2 and vD = $1. The
Journal, May 20, 2005, W1). Suppose a family’s value
marginal cost of crossing the bridge, not including
is $4,500 from traveling in first class and $1,500 from
the marginal cost of congestion, is zero.
traveling in coach. The total price of first-class tickets
for the family is $4,000. Thus, the family’s net value of a. If the price of crossing equals a driver’s mar-
traveling in first class is $500 = $4,500 - $4,000. ginal private cost—the price in a competitive
Because the total price of coach tickets for the fam- market—how many cars per minute will cross?
ily is $1,200, the family’s net value of traveling in Which groups will cross?
coach is $300 = $1,500 - $1,200. A seasoned and b. In the social optimum, which groups of drivers will
weary business traveler who prefers to travel first cross? That is, which collection of groups crossing
class observes that a family is about to purchase first- will maximize the sum of the drivers’ utilities? M
class tickets. The business traveler quickly considers 6.6 You and your roommate have a stack of dirty
whether to offer to pay the family to fly in coach dishes in the sink. Either of you would wash the
instead. dishes if the decision were up to you; however,
a. Suppose that the business traveler knows the neither will do it, in the expectation (hope?) that
value that the family places on coach and first- the other will deal with the mess. Explain how this
class travel. What is the minimum price that the example illustrates the problem of public goods
traveler can offer the family not to travel in first and free riding.
class? 6.7 Do publishers sell the optimal number of intermedi-
b. Suppose the business traveler values peace and ate microeconomics textbooks? Discuss in terms of
quiet at $600. Will the business traveler and public goods, rivalry, and exclusion.
family reach a mutually agreeable price for the 6.8 Vaccinations help protect the unvaccinated from
family to move to coach? disease. Boulier et al. (2007) find that the marginal
c. If instead the business traveler values peace and externality effect can be greater than one case of
quiet at $200, can the business traveler and fam- illness prevented among the unvaccinated. Is vacci-
ily reach a mutually agreeable price for the fam- nation a public good? If so, what might the govern-
ily to move to coach? ment do to protect society optimally?
652 ChapTEr 17 Externalities and Public Goods
*6.9 According to the “What’s Their Beef?” application, 6.13 Anna and Bess are assigned to write a joint paper
collective generic advertising produces $5.67 in within a 24-hour period about the Pareto optimal
additional marginal revenue for every dollar con- provision of public goods. Let A denote the num-
tributed by producers. Is the industry advertising ber of hours that Anna contributes to the project
optimally (see Chapter 12)? Explain. and B the number of hours that Bess contributes.
6.10 Guards patrolling a mall protect the mall’s two The numeric grade that Anna and Bess earn is
stores. The electronics store’s demand curve for a function, 23 ln(A + B), of the total number
guards is greater at all prices than that of the ice- of hours that they contribute to the project. If
cream parlor. The marginal cost of a guard is $10 Anna contributes tA, then she has (24 - A) hours
per hour. Use a diagram to show the equilibrium, in the day for leisure. Anna’s utility function is
and compare that to the socially optimal equilib- UA = 23 ln(A + B) + ln(24 - A); and Bess’s util-
rium. Now suppose that the mall’s owner will pro- ity function is UB = 23 ln(A + B) + ln(24 - B). If
vide a subsidy of s per-hour-per-guard. Show in they choose the hours to contribute simultaneously
your graph the optimal s that leads to the socially and independently, what is the Nash equilibrium
optimal outcome for the two stores. number of hours that each will provide? What is
the number of hours each should contribute to the
6.11 Two tenants of a mall are protected by the guard ser-
project that maximizes the sum of their utilities? M
vice, q. The number of guards per hour demanded
by the electronics store is q1 = a1 + b1p, where p 7. Challenge
is the price of one hour of guard services. The ice-
cream store’s demand is q2 = a2 + b2p. What is the *7.1 Redraw panel b of the Challenge Solution figure to
social demand for this service? M show that it is possible for trade to increase wel-
fare even when pollution is not taxed or otherwise
6.12 In the analysis of the optimal level of a public
regulated.
good, suppose that each person’s utility function is
quasilinear: Ui(G) + Pi. Show that the optimal G *7.2 In the Challenge Solution, where there is no pollu-
is unique and independent of P1 and P2 if society tion as in panel a of the figure, how do we know
has adequate resources. (Hint: See Solved Problem that winners from trade can compensate losers and
17.3.) M still have enough left over to benefit themselves?
18 Exercises 677
4. Market Power from Price Ignorance. If consumers Potential employees may inform employers about
do not know how prices vary across firms, a firm can their abilities by using an expensive signal such as a
raise its price without losing all its customers. As a college degree. An unproductive signal (as when edu-
consequence, consumers’ ignorance about price cre- cation serves only as a signal and provides no train-
ates market power. In a market that would be com- ing) may be privately beneficial but socially harmful.
petitive with full information, consumer ignorance A productive signal (as when education provides
about price may lead to a monopoly price or a distri- training or leads to greater output due to more appro-
bution of prices. priate job assignments) may be privately and socially
beneficial. Firms may also screen. Job interviews,
5. Problems arising from Ignorance When hiring.
objective tests, and other screening devices that lead
Companies use signaling and screening to try to
to a better matching of workers and jobs may be
eliminate information asymmetries in hiring. Where
socially beneficial. However, screening by statisti-
prospective employees and firms share common
cal discrimination harms the discriminated-against
interests—such as assigning the right worker to the
groups. Employers who discriminate based on a par-
right task—everyone benefits from eliminating the
ticular group characteristic may never learn that their
information asymmetry by having informed job can-
discrimination is based on false beliefs because they
didates honestly tell the firms—through cheap talk—
never test these beliefs.
about their abilities. When the two parties do not
share common interests, cheap talk does not work.
exeRCISeS
= exercise is available on MyEconLab; * = answer appears at the back of this book; M = mathematical problem.
1. Problems Due to asymmetric Information sick is $1,000 for healthy people and $10,000
1.1 According to a 2007 study by the Federal Trade for unhealthy people. In a given year, any one per-
Commission, 4.8 million U.S. consumers were vic- son (regardless of health) either becomes sick or
tims of weight-loss fraud, ranging from a tea that does not become sick. The probability that any
promised to help people shed pounds to fraudulent one person gets sick is 0.4. Each person’s util-
clinical trials and fat-dissolving injections. Do these ity of wealth function is U(Y) = Y 0.5, where Y is
frauds illustrate adverse selection or moral hazard? the person’s wealth. Each worker’s initial wealth
is $30,000. Although each person knows whether
*1.2 California set up its own earthquake insurance pro-
he or she is healthy, the insurance company does
gram for homeowners. The rates vary by zip code,
not have this information. The insurance company
depending on the proximity of the nearest fault line.
offers complete, actuarially fair insurance. Because
However, critics claim that the people who set the
the insurance company cannot determine whether
rates ignored soil type. Some houses rest on bed-
a person is healthy or not, it must offer each per-
rock; others sit on unstable soil. What are the impli-
son the same coverage at the same price. The only
cations of such rate setting?
costs to the company are the medical expenses of
*1.3 A firm spends a great deal of money in advertis- the coverage. Under these conditions, the insur-
ing to inform consumers of the brand name of its ance company covers all the medical expenses of its
mushrooms. Should consumers conclude that its policyholders, and its expected profit is zero.
mushrooms are likely to be of higher quality than
a. If everyone purchases insurance, what is the
unbranded mushrooms? Why or why not?
price of the insurance?
1.4 A grocery advertises a low price on its milk as a
b. At the price you determined in part a, do healthy
“loss leader” to induce customers to shop there. It
people purchase the optimal amount of insurance?
finds that some people buy only milk there and do
their other grocery shopping elsewhere. Is that an c. If only unhealthy people purchase insurance,
example of adverse selection or moral hazard? what is the price?
1.5 While self-employed workers have the option to d. At the price you determined in part c, do
purchase private health insurance, many—especially unhealthy people purchase the optimal amount
younger—workers do not, due to adverse selec- of insurance?
tion. Suppose that half the population is healthy e. Given that each person has the option to pur-
and the other half is unhealthy. The cost of getting chase insurance, which type actually purchases
678 CHAPtER 18 Information
insurance? What is the price of the insurance? transaction cost is the value of their time to find a
Discuss the adverse selection problem. M car. What is the equilibrium? Is it possible that no
cars are sold? M
2. Responses to adverse Selection 3.5 Suppose that everyone in the used-car example in
2.1 Some states prohibit insurance companies from the text is risk neutral, potential car buyers value
using car owners’ home addresses to set auto insur- lemons at $2,000 and good used cars at $10,000,
ance rates. Why do insurance companies use home the reservation price of lemon owners is $1,500,
addresses? What are the efficiency and equity impli- and the reservation price of owners of high-quality
cations of forbidding such practices? used cars is $8,000. The share of current owners
2.2 You want to determine whether there is a lemons who have lemons is θ. For what values of θ do all
problem in the market for single-engine airplanes. the potential sellers sell their used cars? Describe
Can you use any of the following information to the equilibrium.(Hint: See Solved Problem 18.1.) M
help answer this question? If so, how? 3.6 It costs $12 to produce a low-quality electric stapler
a. Repair rates for original-owner planes versus and $16 to produce a high-quality stapler. Consum-
planes that have been resold, ers cannot distinguish good staplers from poor sta-
b. The fraction of planes resold in each year after plers when they make their purchases. Four firms
purchase. produce staplers. Consumers value staplers at their
cost of production and are risk neutral. Will any
2.3 According to Edelman (2011), the widely used
of the four firms be able to produce high quality
online “trust” authorities issue certifications with-
staplers without making losses? What happens if
out adequate verification, giving rise to adverse
consumers are willing to pay $36 for high quality
selection. Edelman finds that TRUSTe certified sites
staplers? (Hint: See Solved Problem 18.2.) M
are more than twice as likely to be untrustworthy as
uncertified sites. Explain why. 3.7 In the world of French haute cuisine, a three-star
rating from the Michelin Red Guide is a widely
3. how Ignorance about Quality Drives Out high- accepted indicator of gastronomic excellence.
Quality goods French consumers consider Gault Milleau, another
restaurant guide, to be less authoritative than the
3.1 If you buy a new car and try to sell it in the first
Michelin guide because Gault Milleau, unlike
year—indeed, in the first few days after you buy
Michelin, accepts advertising and its critics accept
it—the price that you get is substantially less than
free meals (Echikson, William, “Wish upon a Star,”
the original price. Use your knowledge about sig-
Wall Street Journal, February 28, 2003, A8).
naling and Akerlof’s lemons model to explain this
much-lower price. a. Why are guides’ ratings important to restaurant
owners and chefs? Discuss the effect of a restau-
3.2 Use Akerlof’s lemons model to explain why restau-
rant’s rating on the demand for the restaurant.
rants that cater to tourists are likely to serve low-
quality meals. Tourists will not return to the area, b. Why do advertising and free meals taint the
and they have no information about the relative credibility of Gault Milleau? Discuss the moral
quality of the food at various restaurants, but they hazard problem of Gault Milleau’s ratings.
can determine the relative price by looking at menus c. If advertising and free meals taint the credibil-
posted outside each restaurant. ity of Gault Milleau, why does the guide accept
*3.3 Many potential buyers value high-quality used advertising and free meals?
cars at the full-information market price of p1 and 3.8 Many wineries in the Napa Valley region of Cali-
lemons at p2. A limited number of potential sell- fornia enjoy strong reputations for producing high-
ers value high-quality cars at v1 … p1 and lemons quality wines and want to protect those reputations.
at v2 … p2. Everyone is risk neutral. The share of Fred T. Franzia, the owner of Bronco Wine Co.,
lemons among all the used cars that might poten- sold Napa-brand wines that do not contain Napa
tially be sold is θ. Under what conditions are all the grapes (Flynn, Julia, “In Napa Valley, Winemaker’s
cars sold? When are only lemons sold? Are there Brands Divide an Industry,” Wall Street Journal,
any conditions under which no cars are sold? (Hint: February 22, 2005, A1). Other Napa wineries sued
See Solved Problem 18.1.) M Mr. Franzia, contending that his wines, made from
3.4 Suppose that the buyers in Exercise 3.3 incur a lower-quality grapes, damaged the reputation of
transaction cost of $200 to purchase a car. This the Napa wines. Suppose that the wine market has
Exercises 679
2,000 wineries, and each sells one bottle of wine. 5.2 Some universities do not give letter grades. One
Half, 1,000, have Napa grapes that they can turn rationale is that eliminating the letter-grade system
into wine, and half have Central Valley grapes. The reduces pressure on students, thus enabling them to
marginal opportunity cost of selling a Napa wine is learn more. Does this policy help or hurt students?
$20, and the marginal opportunity cost of selling a (Hint: Consider the role grades play in educating
Central Valley wine is $5. A large number of risk- and signaling.)
neutral consumers with identical tastes are will-
5.3 Some firms are willing to hire only high school
ing to buy an unlimited number of bottles at their
graduates. Based on past experience or statistical
expected valuations. Each consumer values a wine
evidence, these companies believe that, on average,
made from Napa grapes at $25 and a wine made
high school graduates perform better than nongrad-
from Central Valley grapes at $10. By looking at the
uates. How does this hiring behavior compare to
bottles, consumers cannot distinguish between the
statistical discrimination by employers on the basis
Napa and the Central Valley wines.
of race or gender? Discuss the equity and efficiency
a. If all of the wineries choose to sell wine, what is implications of this practice.
a consumer’s expected value of the wine? If only
5.4 Suppose that you are given wh, wl, and θ in the edu-
the wineries with Central Valley grapes sell wine,
cation signaling model. For what value of c are both
what is a consumer’s expected value of the wine?
a pooling equilibrium and a separating equilibrium
b. What is the market equilibrium price? In the possible? For what value of c are both types of equi-
market equilibrium, which wineries choose to libria possible, and do high-ability workers have
sell wine? higher net earnings in a separating equilibrium than
c. Suppose that wine bottles clearly label where in a pooling equilibrium? (Hint: See Solved Problem
the grapes are grown. What are the equilibrium 18.4.) M
price and quantity of Napa wine? What are the 5.5 Education is a continuous variable, where eh is the
equilibrium price and quantity of wine made years of schooling of a high-ability worker and el
from Central Valley grapes? is the years of schooling of a low-ability worker.
d. Does the market equilibrium exhibit a lemons The cost per period of education for these types of
problem? If so, does clearly labeling the origin of workers is ch and cl , respectively, where cl 7 ch.
the grapes solve the lemons problem? M The wages they receive if employers can tell them
apart are wh and wl. Under what conditions is a
4. Market Power from Price Ignorance separating equilibrium possible? How much educa-
tion will each type of worker get? (Hint: See Solved
*4.1 In Solved Problem 18.3, if the vast majority of all
Problem 18.4.) M
consumers knows the true prices at all stores and
only a few shoppers have to incur a search cost to 5.6 In Exercise 5.5, under what conditions is a pool-
learn the prices, would the equilibrium be single- ing equilibrium possible? (Hint: See Solved Problem
price at the monopoly level, pm? 18.4.) M
4.2 Sometimes a firm sells the same product under two 5.7 In Exercises 5.5 and 5.6, describe the equilibrium if
brand names. For example, the Chevy Tahoe and cl … ch. (Hint: See Solved Problem 18.4.) M
the GMC Yukon are virtually twins (although the 5.8 When is statistical discrimination privately ineffi-
Yukon sells for $490 more than the Tahoe). Give an cient? When is it socially inefficient? Does it always
asymmetric information explanation as to why the harm members of the discriminated-against group?
firm might use pairs of brand names and why one Explain.
product might sell for more than the other.
5. Contract Choice. A principal may be able to pre- must reveal its actions to its employees, it is less
vent moral hazard problems from adverse selection likely to be able to take advantage of the employ-
by observing choices made by potential agents. For ees. To convey information, an employer may let
example, an employer may present potential employ- employees participate in decision-making meet-
ees with a choice of contracts, prompting hard- ings or audit the company’s books. Alternatively,
working job applicants to choose a contract that an employer may make commitments so that it is
compensates the worker for working hard and lazy in the employer’s best interest to tell employees the
candidates to choose a different contract that pro- truth. These commitments, such as laying off work-
vides a guaranteed salary. ers rather than reducing wages during downturns,
6. Checks on Principals. Often both agents and prin- may reduce moral hazards but lead to nonoptimal
cipals can engage in opportunistic behavior. If a firm production.
exeRCISeS
= exercise is available on MyEconLab; * = answer appears at the back of this book; M = mathematical problem.
1. Principal-agent Problem per biopsy and detect fewer cases of cancer than
1.1 California provides earthquake insurance. Because doctors who use outside labs (Weaver, Christopher,
the state agency in charge has few staff members, it “Prostate-Test Fees Challenged,” Wall Street Jour-
pays private insurance carriers to handle claims for nal, April 9, 2012). Explain these results. Do these
earthquake damage. These insurance firms receive results necessarily demonstrate moral hazard or is
9% of each approved claim. Is this compensation there another possible explanation?
scheme likely to lead to opportunistic behavior by 1.6 In 2012, a California environmental group found
insurance companies? Explain. What would be a that 14 plum and ginger candies imported from Asia
better way to handle the compensation? contained 4 to 96 times the level of lead allowed
*1.2 Some sellers offer to buy back a good later at some under California law (Lee, Stephanie M., “Lead
prespecified price. Why would a firm make such a Found in Asian Candies,” San Francisco Chroni-
commitment? cle, August 14, 2012). Some observers predicted
that U.S. consumers would face significant price
*1.3 A promoter arranges for various restaurants to set
increases if U.S. law were changed to require third-
up booths to sell Cajun-Creole food at a fair. Appro-
party testing by manufacturers and sellers. Sup-
priate music and other entertainment are provided.
pose instead that candies could be reliably labeled
Customers can buy food using only “Cajun Cash,”
“tested” or “untested,” and untested candy sold at
which is scrip that has the same denominations as
a discount. Would consumers buy cheaper, untested
actual cash and is sold by the fair promoter. Why
goods or would they fear a moral hazard problem?
aren’t the food booths allowed to sell food directly
Discuss.
for cash?
1.4 A flyer from one of the world’s largest brokers says, 2. Production efficiency
“Most personal investment managers base their fees *2.1 When I was in graduate school, I shared an apart-
on a percentage of assets managed. We believe this ment with a fellow who was madly in love with a
is in your best interest because your manager is paid woman who lived in another city. They agreed to
for investment management, not solely on the basis split the costs of their long-distance phone calls
of trading commissions charged to your account. equally, regardless of who placed the calls. (In those
You can be assured your manager’s investment deci- days, long-distance calls were expensive and billed
sions are guided by one primary goal—increasing separately from general phone service.) What was
your assets.” Is this policy in a customer’s best inter- the implication of this fee-sharing arrangement on
est? Why or why not? their total phone bill? Why?
1.5 A study by Jean Mitchell found that urologists *2.2 Zhihua and Pu are partners in a store in which they
in group practices that profit from tests for pros- do all the work. They split the store’s business profit
tate cancer order more of them than doctors who equally (ignoring the opportunity cost of their own
send samples to independent laboratories. Doctors’ time in calculating this profit). Does their business
groups that perform their own lab work bill Medi- profit-sharing contract give them an incentive to
care for analyzing 72% more prostate tissue samples maximize their joint economic profit if neither can
708 CHAPTEr 19 Contract Theory
force the other to work? (Hint: Imagine Zhihua’s all or none of it. The probability that Rachel detects
thought process late one Saturday night when he the entire fraud is t /(1 + t) and the probability that
is alone in the store, debating whether to keep the Rachel does not detect the fraud is 1 - t /(1 + t).
store open a little later or go out on the town. See Hence, Rachel’s probability of detecting fraud is
Solved Problem 19.1.) zero if John reports no fraudulent profit, increases
2.3 In Solved Problem 19.1, does joint profit increase, with the amount of fraudulent profit he reports, and
decrease, or remain the same as the share of revenue approaches 1 as the amount of fraud approaches
going to Arthur increases? infinity. If Rachel detects the fraud, then x 7 0.5 is
the fine that John pays Rachel per dollar of fraud.
*2.4 In the duck-carving example with full information
John’s expected fine of reporting fraudulent profit t
(summarized in the second column of Table 19.1),
is t 2x /(1 + t). In choosing the level of fraud, John’s
is a contract efficient if it requires Paula to give
objective is to maximize his expected earnings from
Arthur a fixed-fee salary of $168 and leaves all the
the fraud, 0.5t, less his expected fine, t 2x /(1 + t).
decisions to Arthur? If so, why? If not, are there
As a function of x, what is John’s optimal fraudu-
additional steps that Paula can take to ensure that
lent profit? (Hint: check the second-order condi-
Arthur sells the optimal number of carvings?
tion.) Show that 0 t / 0 x 6 0. Also show that as
2.5 In the duck-carving example with limited informa- x S , John’s optimal reported fraudulent profit
tion (summarized in the third and fourth columns goes to zero. (Hint: See Solved Problem 19.1.) M
of Table 19.1), is a fixed-fee contract efficient? If
2.9 In the National Basketball Association (NBA), the
so, why? If not, are there additional steps that Paula
owners share revenue but not costs. Suppose that
can take to ensure efficiency?
one team, the L.A. Clippers, sells only general-
2.6 The author of a science fiction novel is paid a roy- admission seats to a home game with the visiting
alty of β share of the revenue from sales, where Philadelphia 76ers (Sixers). The inverse demand for
the revenue is R = pq, p is the competitive mar- the Clippers-Sixers tickets is p = 100 - 0.004Q.
ket price for novels, and q is the number of copies The Clippers’ cost function of selling Q tickets and
of this book sold. The publisher’s cost of printing running the franchise is C(Q) = 10Q.
and distributing the book is C(q). Determine the
a. Find the Clippers’ profit-maximizing number of
equilibrium, and compare it to the outcome that
tickets sold and the price if the Clippers must
maximizes the sum of the payment to the author
give 50% of their revenue to the Sixers. At the
plus the firm’s profit. Answer using both math and
maximum, what are the Clippers’ profit and the
a graph. M
Sixers’ share of the revenues?
2.7 Suppose now that the publisher in Exercise 2.6 faces
b. Instead, suppose that the Sixers set the Clippers’
a downward-sloping demand curve. The revenue is
ticket price based on the same revenue-sharing
R(Q), and the publisher’s cost of printing and dis-
rule. What price will the Sixers set, how many
tributing the book is C(Q). Compare the equilibria
tickets are sold, and what revenue payment will
for the following compensation methods in which
the Sixers receive? Explain why your answers to
the author receives the same total compensation
parts a and b differ.
from each method:
c. Now suppose that the Clippers must share their
a. The author is paid a lump sum, l.
profit rather than their revenue. The Clippers
b. The author is paid α share of the revenue. keep 45% of their profit and share 55% with
c. The author receives a lump-sum payment and a the Sixers. The Clippers set the price. Find the
share of the revenue. Clippers’ profit-maximizing price and determine
Why do you think that authors are usually paid a how many tickets the team sells and its share of
share of the revenue? (Hint: See Solved Problem the profit.
19.1.) M d. Compare your answers to parts a and c using
2.8 John manages Rachel’s used CD music store. To marginal revenue and marginal cost in your
provide John with the incentive to sell CDs, Rachel explanation. (Hint: See Solved Problem 19.1.) M
offers him 50% of the store’s profit. John has the 2.10 Book retailers can return unsold copies to publish-
opportunity to misrepresent sales by fraudulently ers. Effectively, retailers pay for the books they order
recording sales that actually did not take place. Let only after they sell them. Dowell’s Books believes
t represent his fraudulent profit. John’s expected that it will sell, with 12 probability each, either zero
earnings from reporting the fraudulent profit is 0.5t. or one copy of The Fool’s Handbook of Macroeco-
Rachel tries to detect such fraud and either detects nomics. The bookstore also believes that it will sell,
Exercises 709
with 12 probability each, either zero or one copy of of insurance. With full insurance, Louisa pays the
The Genius’ Handbook of Microeconomics. The premium and gets the full $800 value of the bike
retail price of each book is $100. Suppose that the if it is stolen. Alternatively, with partial insurance,
marginal cost of manufacturing another copy of a Louisa receives only 75% of the bike’s value, $600,
book is $24. The publisher’s value of a returned if the bike is stolen. Which contract is more likely
copy is $0. The Microeconomics publisher charges to induce moral hazard problems? To break even
a $52 wholesale price and offers a full refund if an on consumers like Louisa, what price would the
unsold book is returned. While the Macroeconom- risk-neutral insurance company have to charge for
ics publisher charges a low $42 wholesale price, it full insurance? If we observe Louisa buying par-
pays a retailer only $32 if it returns an unsold book. tial insurance what can we say about the trade-off
Dowell’s places an order for one copy of each title. between moral hazard and efficient risk-bearing.
When the two books arrive, Dowell’s has space to 4. Monitoring to Reduce Moral Hazard
shelve only one. Which title does Dowell’s return?
4.1 Many law firms consist of partners who share prof-
Comment on how Dowell’s decision about which
its. On being made a partner, a lawyer must post a
title to return depends on the books’ wholesale
bond, a large payment to the firm that will be for-
prices and on the compensation from the publishers
feited on bad behavior. Why?
for returned unsold books. M
*4.2 In Solved Problem 19.3, a firm calculates the
3. Trade-Off Between efficiency in Production optimal level of monitoring to prevent stealing. If
and in Risk Bearing G = $500 and θ = 20%, what is the minimum
3.1 Traditionally, doctors have been paid on a fee-for- bond that deters stealing? M
service basis. Now doctors are increasingly paid 4.3 In Exercise 4.2, suppose that, for each extra $1,000
on a capitated basis: They get paid for treating a of bonding the firm requires a worker to post, the
patient for a year, regardless of how much treat- firm must pay that worker $10 more per period to
ment is required. In this arrangement, doctors form get the worker to work for the firm. What is the
a group and sign a capitation contract whereby minimum bond that deters stealing? (Hint: See
they take turns seeing a given patient. What are Solved Problem 19.3.) M
the implications of this change in compensation for
4.4 Starting in 2008, Medicare would not cover the
moral hazards and for risk bearing?
cost of a surgeon leaving an instrument in a patient,
3.2 Padma has the rights to any treasure on the sunken giving a patient transfusions of the wrong blood
ship the Golden Calf. Aaron is a diver who special- type, certain types of hospital-acquired infections,
izes in marine salvage. If Padma is risk averse and or other “preventable” mistakes (Liz Marlantes,
Aaron is risk neutral, does paying Aaron a fixed “Medicare Won’t Cover Hospital Mistakes: New
fee result in efficiency in risk bearing and produc- Rules Aimed at Promoting Better Hospital Care
tion? Does your answer turn on how predictable and Safety,” ABC News, August 19, 2007). Hos-
the value of the sunken treasure is? Would another pitals will have to cover these costs and cannot
compensation scheme be more efficient? (Hint: See bill the patient. These changes are designed to pro-
Solved Problem 19.2.) vide hospitals with a stronger incentive to prevent
3.3 Fourteen states have laws that limit whether a fran- those mistakes, particularly infections. The Centers
chisor (such as McDonald’s) can terminate a fran- for Disease Control and Prevention estimates that
chise agreement. Franchisees (such as firms that run 2 million patients are annually infected in hospi-
individual McDonald’s outlets) typically pay the tals, costing society more than $27 billion. Nearly
franchisor a fixed fee or a share of revenues. What 100,000 of those infections are fatal. Many of these
effects do such laws have on production efficiency infections could be prevented if hospitals more rig-
and risk bearing? (Hint: See Solved Problem 19.2.) orously follow basic infection control procedures,
3.4 Louisa is an avid cyclist who is currently work- including having doctors and nurses wash their
ing on her business degree. She normally rides an hands between every patient treatment. Is Medi-
$800 bike to class. If Louisa locks her bike care- care’s policy designed to deal with adverse selection
fully—locks both wheels—the chance of theft for or moral hazard? Is it likely to help? Explain.
the term is 5%, but this careful locking procedure is 4.5 When rental cars are sold on the used car market
time consuming. If she is less careful—just quickly they are sold for lower prices than cars of the same
locks the frame to a bike rack—the chance of theft model and year that were owned by individuals.
is 20%. Louisa is risk averse and is considering buy- Does this price difference reflect adverse selection or
ing theft insurance for her bike. There are two types moral hazard? Could car rental companies reduce
710 CHAPTEr 19 Contract Theory
this problem by carefully inspecting rental cars for only about her own income, what is her decision?
damage when renters return such cars? Why do car Should shareholders be happy with this compensa-
companies normally do only a cursory inspection? tion contract? Is there a contract that would be bet-
4.6 In 2012, Hewlett-Packard Co. announced that its ter for both Adrienne and the shareholders? (Hint:
new chief executive, Meg Whitman, would receive See Solved Problem 19.4.) M
a salary of $1 and about $16.1 million in stock
5. Contract Choice
options, which are valuable if the stock does well
(marketwatch.com, February 3, 2012). How would 5.1 List some necessary conditions for a firm to be able
you feel about this compensation package if you to sort potential employees by providing them with
were a shareholder? What are the implications for a choice of contracts.
moral hazard, efficiency, and risk sharing? (Hint:
See Solved Problem 19.4.) 6. Checks on Principals
4.7 Adrienne, a manager of a large firm, must decide 6.1 In the Application “Layoffs Versus Pay Cuts,” the
whether to launch a new product or make a minor firm either uses a pay cut or layoffs. Can you derive
change to an existing product. The new product has a superior approach that benefits both the firm and
a 30% chance of being a big success and generat- the workers? (Hint: Suppose that the firm’s profit or
ing profits of $20 million, a 40% chance of being some other variable is observable.)
fairly successful and generating profits of $5 mil-
lion, and a 30% chance of being a costly failure and 7. Challenge
losing $10 million. Making minor changes in the 7.1 A health insurance company tries to prevent the
old product would generate profits of $10 million moral hazard of “excessive” dentist visits by limiting
for sure. Adrienne’s contract gives her a bonus of the number of compensated visits that a patient can
10% of any profits above $8 million arising from make in a year. How does such a restriction affect
this decision. If Adrienne is risk neutral and cares moral hazard and risk bearing? Show in a graph.
Answers to Selected
Problems
I know the answer! The answer lies within the heart of all mankind! The answer is twelve?
I think I’m in the wrong building. —Charles Schultz
Chapter 2 S f, for prices less than p. At prices above p, foreign
suppliers want to supply more but are limited to Q.
1.1 The demand curve for pork is Q = 171 - 20p + Thus, the foreign supply curve with a quota, Sf is
20pb + 3pc + 2Y. As a result, 0 Q/ 0 Y = 2. A $100 vertical at Q for prices above p. The total supply
increase in income causes the quantity demanded to curve with the quota, S, is the horizontal sum of Sd
increase by 0.2 million kg per year. and Sf At any price above p, the total supply equals
the quota plus the domestic supply. For example at
1.2 To solve this problem, we first rewrite the inverse
p*, the domestic supply is Qd* and the foreign sup-
demand functions as demand functions and then add ply is Qf , so the total supply is Qd* + Qf . Above
them together. The total demand function is Q = p, S is the domestic supply curve shifted Q units
Q1 + Q2 = (120 - p) + 160 - 12 p2 = 180 - 1.5p. to the right. As a result, the portion of S above p
2.3 In the figure, the no-quota total supply curve, S in has the same slope as Sd. At prices less than or equal
panel c, is the horizontal sum of the U.S. domestic to p the same quantity is supplied with and without
supply curve, Sd, and the no-quota foreign supply the quota, so S is the same as S. At prices above p,
curve, S f. At prices less than p, foreign suppliers less is supplied with the quota than without one, so
want to supply quantities less than the quota, Q. As S is steeper than S, indicating that a given increase
a result, the foreign supply curve under the quota, in price raises the quantity supplied by less with a
S f, is the same as the no-quota foreign supply curve, quota than without one.
(a) U.S. Domestic Supply (b) Foreign Supply (c) Total Supply
– –
p, Price
per ton
p, Price
per ton
p, Price
per ton
Sf S
f
Sd S
S
p* p* p*
p– p– p–
– – – – –
Qd Qd* Qf Qf* Qd + Qf Qd* + Qf Qd* + Qf*
Qd , Tons per year Qf , Tons per year Q, Tons per year
742
Answers to Selected Problems 743
S (quota)
dR dp dQ dp dQ p dp
= ¢Q + p ≤ = Q¢1 + ≤= Q(1 + ε).
dτ dτ dp dτ dp Q dτ
S (no quota)
Thus, the effect of a change in τ on R depends on
e3
the elasticity of demand, ε. Revenue rises with the
p3 e2 tax if demand is inelastic ( -1 6 ε 6 0) and falls if
p2 demand is elastic (ε 6 -1).
7.3 A usury law is a price ceiling, which causes the
p– quantity that firms want to supply to fall.
p1 e1
7.4 We can determine how the total wage payment,
D h (high) W = wL(w), varies with respect to w by differen-
tiating. We then use algebra to express this result in
D l (low) terms of an elasticity:
Q1 Q3 Q2 Q,Tons of steel dW dL dL w
= L + w = L¢1 + ≤ = L(1 + ε),
per year dw dw dw L
744 Answers to Selected Problems
line at 10 thousand on the water axis indicates the
quota. The new opportunity set, area A, is bounded
S1 by the axes, the budget line, and the quota line.
Because of the rationing, the consumer loses part
S2
of the original opportunity set: the triangle B to the
e1 right of the 10-thousand-gallons quota line. The con-
p1 sumer has fewer opportunities because of rationing.
p 2 = 0.85p1 For Chapter 3, Exercise 3.3
e2
D1
D2
Other goods per week
Quota
Q 1 Q 2 = 1.43Q 1
Q, Tons of beef per year Budget line
Chapter 3
1.5 If the neutral product is on the vertical axis, the
indifference curves are parallel vertical lines.
2.2 Sofia’s indifference curves are right angles (as in panel b
of Figure 3.5). Her utility function is U = min(H, W), A B
where min means the minimum of the two arguments,
0 10 12
H is the number of units of hot dogs, and W is the
number of units of whipped cream. Water, thousand gallons per month
2.4 If we apply the transformation function F(x) = xρ 4.3 Andy’s marginal utility of apples divided by the
to the original utility function, we obtain the new price of apples is 3/2 = 1.5. The marginal utility
utility function V(q1, q2) = F(U(q1, q2)) = [(qρ1 + for kumquats is 5/4 = 1.2. That is, a dollar spent
Answers to Selected Problems 745
on apples gives him more extra utils than a dollar For Chapter 4, Exercise 1.7
spent on kumquats. Thus, Andy maximizes his util-
(a) Indifference Curves and Budget Constraints
ity by spending all his money on apples and buying
40/2 = 20 pounds of apples.
line L* is tangent to the indifference curve If. The million (as you should have shown in your figure in
consumer would buy Bundle e*. That is, the pure the answer to Exercise 1.3).
substitution effect (the movement from ef to e*) a. Given that the demand function is Q = Xp-1.6,
causes the consumer to buy relatively more firsts. the revenue function is R(p) = pQ = Xp-0.6.
The total effect (the movement from ef to eo) reflects Thus, the change in revenue, -$215 million,
both the substitution effect (firsts are now relatively equals R(39) - R(37) = X(39)-0.6 - X(37)-0.6 L
less expensive) and the income effect (the con- -0.00356X. Solving -0.00356X = - 215, we
sumer is worse off after paying for shipping). The find that X L 60,353.
income effect is small if (as seems reasonable) the b. We follow the process in Solved Problem 5.1
budget share of plates is small. An ad valorem tax 39
60,353 -0.6 39
L37
has qualitatively the same effect as a specific tax ∆ CS = - 60,353p-1.6dp1 = p 2
because both taxes raise the relative price of firsts to 0.6 37
seconds. L 100,588(39-0.6 - 37-0.6)
L 100,588 * ( -0.00356) L -358.
3.7 We can determine the optimal bundle, e1, at the
original prices p1 = p2 = 1 by using the demand This total consumer surplus loss is larger than
equation from Table 4.1: q1 = 4(p2/p1)2 = 4 and the one estimated by Hong and Wolak (2008)
q2 = Y/p2 - 4(p2/p1) = 10 - 4 = 6. This opti- because they used a different demand function.
mal bundle is on an indifference curve where Given this total consumer surplus loss, area B is
U = 4(4)0.5 + 6 = 14. $146 ( = 358 - 215) million.
At the new bundle, e2, where p1 = 2 and p2 = 1, 2.2 Because the good is inferior, the compensated demand
q1 = 4(1/2)2 = 1, and q2 = 10 - 4(1) = 8. This curves cut the uncompensated demand curve, D,
optimal bundle is on an indifference curve where from below as the figure shows. Consequently,
U = 4(1)0.5 + 8 = 12. CV = A, ∆CS = A + B, EV = A + B + C.
To determine e*, we want to stay on the origi- CV 6 ∆CS 6 EV .
nal indifference curve. We know that the tangency
condition will give the same q1 as at e2 because q1
depends on only the relative prices, so q1 = 1. The For Chapter 5, Exercise 2.2
question is what Y will compensate Phillip for the
p, $ per unit
higher price so that he can stay on the original indif-
ference curve. Because q2 = Y - 4(1/2) = Y - 4, p2 e2
the utility is U = 1 + (Y - 4) = Y - 3. So the Y
that results in U = 14 is Y = 17. Thus, the substi-
tution effect is - 3 (based on the movement from B
e1 to e*) and the income effect is 0 (the movement A
C
from e* to e2), so the total effect is -3 (movement
from e1 to e2). p1
e1 H EV
3.9 At Sylvia’s optimal bundle, q1 = jq2 (see Chapter 3).
Otherwise, she could reduce her expenditure on
one of the goods and attain the same level of utility. H CV
Because at the optimal bundle U = min(q1, jq2), the D
Hicksian demands are q1 = H1(p1, p2, U) = U and
q2 = H2(p1, p2, U) = U/j. The expenditure function q1, Units per quarter
is E = p1q1 + p2q2 = p1U + p2U/j = (p1 + p2/j)U.
4.1 The CPI accurately reflects the true cost of living 3.4 The two demand curves cross at e1 in the diagram.
because Alix does not substitute between the goods The price elasticity of demand, ε = (dQ/dp)(p/Q),
as the relative prices change. equals 1 over the slope of the demand curve, dp/dQ,
times the ratio of the price to the quantity. Thus, at e1
where both demand curves have the same price, p1,
Chapter 5 and the same quantity, Q1, the steeper the demand
curve, the lower the elasticity of demand. If the
1.1 At a price of 30, the quantity demanded is 30, so the price rises from p1 to p2, the consumer surplus falls
consumer surplus is 12 (30 * 30) = 450, because the from A + C to A with the relatively elastic demand
demand curve is linear. curve (a loss of C) and from A + B + C + D to
1.4 Hong and Wolak (2008) estimate that Area A is A + B (a loss of C + D) with the relatively inelastic
$215 million and area B is $118 ( = 333 - 215) demand curve.
Answers to Selected Problems 747
work fewer than eight hours. For her to do so, her
indifference curve I2 would have to be tangent to the
downward-sloping section of the new budget con-
straint. However, such an indifference curve would
have to cross the original indifference curve, I1, which
Relatively inelastic
demand (at e1)
is impossible: see Chapter 3.) Thus, forcing Julia to
restrict her hours lowers her utility: I2 must be below
I1.Comment: When I was in college, I was offered
B
a summer job in California. My employer said,
A e2 “You’re lucky you’re a male.” He claimed that, to
p2 protect women (and children) from overwork, an
e3 D
C archaic law required him to pay women, but not
p1
e1 men, double overtime after eight hours of work. As
Relatively elastic a result, he offered overtime work only to his male
demand (at e1)
employees. Such clearly discriminatory rules and
behavior are now prohibited. Today, however, both
females and males must be paid higher overtime
wages—typically 1.5 times as much as the usual
Q3 Q2 Q1 Q, Units per week
wage. Consequently, many employers do not let
employees work overtime.
who earns $20,000 has an average tax rate of 5%, constraint
whereas someone who earns $40,000 has an average
tax rate of 7.5%, so this tax system is progressive. L1
5.10 As the marginal tax rate on income increases, people
substitute away from work due to the pure substi-
tution effect. However, the income effect can be e1
either positive or negative, so the net effect of a tax Y1 = 12w
increase is ambiguous. Also, because wage rates dif-
fer across countries, the initial level of income dif- L2 e2 I1
Y2 = 8w
fers, again adding to the theoretical ambiguity. If I2
we know that people work less as the marginal
tax rate increases, we can infer that the substitu-
tion effect and the income effect go in the same
direction or that the substitution effect is larger.
24 H 1 = 12 H2 = 8 H, Work hours
However, Prescott’s (2004) evidence alone about per day
hours worked and marginal tax rates does not
allow us to draw such an inference because U.S. and
European workers may have different tastes and face 6.2 Parents who do not receive subsidies prefer that
different wages. poor parents receive lump-sum payments rather
5.11 The figure shows Julia’s original consumer equi- than a subsidized hourly rate for child care. If the
librium: Originally, Julia’s budget constraint was a supply curve for child-care services is upward slop-
straight line, L1 with a slope of - w, which was tan- ing, by shifting the demand curve farther to the
gent to her indifference curve I1 at e1, so she worked right, the price subsidy raises the price of child-care
12 hours a day and consumed Y1 = 12w goods. The for these other parents.
maximum-hours restriction creates a kink in Julia’s 6.3 The government could give a smaller lump-sum sub-
new budget constraint, L2. This constraint is the sidy that shifts the LLS curve down so that it is par-
same as L1 up to eight hours of work, and is horizon- allel to the original curve but tangent to indifference
tal at Y = 8w for more hours of work. The highest curve I2. This tangency point is to the left of e2, so
indifference curve that touches this constraint is I2. the parents would use fewer hours of child care than
Because of the restriction on the hours she can work, with the original lump-sum payment.
748 Answers to Selected Problems
Chapter 6 during good times: Do they hire the same number of
extra workers? As a result, we cannot predict which
country has the higher average product of labor.
3.1 One worker produces one unit of output, two work-
ers produce two units of output, and n workers pro-
duce n units of output. Thus, the total product of Chapter 7
labor equals the number of workers: q = L. The
total product of labor curve is a straight line with a 1.3 If the plane cannot be resold, its purchase price is
slope of 1. Because we are told that each extra worker a sunk cost, which is unaffected by the number of
produces one more unit of output, we know that the times the plane is flown. Consequently, the average
marginal product of labor, dq/dL, is 1. By dividing cost per flight falls with the number of flights, but
both sides of the production function, q = L, by L, the total cost of owning and operating the plane
we find that the average product of labor, q/L, is 1. rises because of extra consumption of gasoline
3.4 (a) Given that the production function is
and maintenance. Thus, the more frequently some-
q = L0.75K0.25, the average product of labor, holding one has a reason to fly, the more likely that flying
capital fixed at K, is APL = q/L = L-0.25K0.25 = one’s own plane costs less per flight than a ticket
(K/L)0.25. (b) The marginal product of labor on a commercial airline. However, by making extra
is MPL = dq/dL = 34 (K/L)0.25. (c) At K = 16, (“unnecessary”) trips, Mr. Agassi raises his total
APL = 2L0.25 and MPL = 1.5L0.25. cost of owning and operating the airplane.
2.5 The total cost of building a 1-cubic-foot crate is $6.
4.4 The isoquant looks like the “right angle” ones in
It costs four times as much to build an 8-cubic-foot
panel b of Figure 6.3 because the firm cannot sub-
crate, $24. In general, as the height of a cube increases,
stitute between discs and machines but must use
the total cost of building it rises with the square of the
them in equal proportions: one disc and one hour of
height, but the volume increases with the cube of the
machine services.
height. Thus, the cost per unit of volume falls.
4.8 Using Equation 6.8, we know that the mar-
2.12 Because the franchise tax is a lump-sum tax that does
ginal rate of technical substitution is MRTS =
not vary with output, the more the firm produces,
- MPL/MPK = - 23.
the less tax it pays per unit, l/q. The firm’s after-tax
4.9 The isoquant for q = 10 is a straight line that hits average cost, AC a, is the sum of its before-tax average
the B axis at 10 and the G axis at 20. The marginal cost, AC b, and its average tax payment per unit, l/q.
product of B is MPB = 0 q/ 0 B = 1 everywhere Because the franchise tax does not vary with output,
along the isoquant. Similarly, MPG = 0.5. Given that it does not affect the marginal cost curve. The mar-
B is on the horizontal axis, MRTS = - MPB /MPG ginal cost curve crosses both average cost curves from
= -1/0.5 = - 2. below at their minimum points. The quantity, qa,
5.4 This production function is a Cobb-Douglas pro- at which the after-tax average cost curve reaches its
duction function. Even though it has three inputs minimum, is larger than the quantity qb at which the
instead of two, the same logic applies. Thus, we can before-tax average cost curve achieves a minimum.
calculate the returns to scale as the sum of the expo-
nents: γ = 0.27 + 0.16 + 0.61 = 1.04. That is, it For Chapter 7, Exercise 2.12
has (nearly) constant returns to scale. The marginal
Costs per unit, $
product of material is
0 q/ 0 M = 0.61L0.27 K0.16M-0.39 = 0.61q/M.
MC
6.4 The marginal product of labor of Firm 1 is only 90%
of the marginal product of labor of Firm 2 for a par-
ticular level of inputs. Using calculus, we find that
the MPL of Firm 1 is 0 q1/ 0 L = 0.9 0 f(L, K)/ 0 L
= 0.9 0 q2/ 0 L. /q AC a = AC b + /q
7.2 We do not have enough information to answer this
AC b
question. If we assume that Japanese and American
firms have identical production functions and pro-
duce using the same ratio of factors during good
times, Japanese firms will have a lower average
product of labor during recessions because they are
less likely to lay off workers. However, it is not clear
how Japanese and American firms expand output qb qa q, Units per day
Answers to Selected Problems 749
3.1 Let w be the cost of a unit of L and r be the cost increases with volume, β 6 0, so the average cost
of a unit of K. Because the two inputs are perfect falls with volume. Here, the average cost falls
substitutes in the production process, the firm uses exponentially (a smooth curve that asymptotically
only the less expensive of the two inputs. Therefore, approaches the quantity axis).
the long-run cost function is C(q) = wq if w … r; 6.1 If -w/r is the same as the slope of the line segment
otherwise, it is C(q) = rq. connecting the wafer-handling stepper and the step-
3.2 According to Equation 7.11, if the firm were mini- per technologies, then the isocost will lie on that line
mizing its cost, the extra output it gets from the last segment, and the firm will be indifferent between
dollar spent on labor, MPL/w = 50/200 = 0.25, using either of the two technologies (or any com-
should equal the extra output it derives from the last bination of the two). In all the isocost lines in the
dollar spent on capital, MPK/r = 200/1,000 = 0.2. figure, the cost of capital is the same, and the wage
Thus, the firm is not minimizing its costs. It would varies. The wage such that the firm is indifferent lies
save money if it used relatively less capital and more between the relatively high wage on the C 2 isocost
labor, from which it gets more extra output from line and the lower wage on the C 3 isocost line.
the last dollar spent. 6.3 The firm chooses its optimal labor-capital ratio using
3.4 You produce your output, exam points, using as Equation 7.11: MPL/w = MPK /r. That is, 12q/(wL) =
1
inputs the time spent on Question 1, t1, and the time 2 q/(rK), or L/K = r/w. In the United States where
spent on Question 2, t2. If you have diminishing mar- w = r = 10, the optimal L/K = 1, or L = K.
ginal returns to extra time on each problem, your The firm produces where q = 100 = L0.5K0.5 =
isoquants have the usual shapes: They curve away K0.5K0.5 = K. Thus, q = K = L = 100. The cost is
from the origin. You face a constraint that you may C = wL + rK = 10 * 100 + 10 * 100 = 2,000.
spend no more than 60 minutes on the two ques- At its Asian plant, the optimal input ratio is
tions: 60 = t1 + t2. The slope of the 60-minute iso- L*/K* = 1.1r/(w/1.1) = 11/(10/1.1) = 1.21. That
cost curve is -1: For every extra minute you spend is, L* = 1.21K*. Thus, q = (1.21K*)0.5(K*)0.5 =
on Question 1, you have one less minute to spend on 1.1K*. So K* = 100/1.1 and L* = 110. The cost is
Question 2. To maximize your test score, given that C* = [(10/1.1) * 110] + [11 * (100/1.1)] = 2,000.
you can spend no more than 60 minutes on the exam, That is, the firm will use a different factor ratio in
you want to pick the highest isoquant that is tangent Asia, but the cost will be the same. If the firm could
to your 60-minute isocost curve. At the tangency, the not substitute toward the less expensive input, its
slope of your isocost curve, - 1, equals the slope of cost in Asia would be C** = [(10/1.1) * 100] +
your isoquant, - MP1/MP2. That is, your score on [11 * 100] = 2,009.09.
the exam is maximized when MP1 = MP2, where the
last minute spent on Question 1 would increase your
score by as much as spending it on Question 2 would.
Therefore, you’ve allocated your time on the exam
Chapter 8
wisely if you are indifferent as to which question to
2.3 How much the firm produces and whether it shuts
work on during the last minute of the exam.
down in the short run depend only on the firm’s vari-
3.6 From the information given and assuming that able costs. (The firm picks its output level so that
there are no economies of scale in shipping base- its marginal cost—which depends only on variable
balls, it appears that balls are produced using a costs—equals the market price, and it shuts down
constant returns to scale, fixed-proportion produc- only if market price is less than its minimum aver-
tion function. The corresponding cost function is age variable cost.) Learning that the amount spent
C(q) = (w + s + m)q, where w is the wage for the on the plant was greater than previously believed
time period it takes to stitch one ball, s is the cost of should not change the output level that the man-
shipping one ball, and m is the price of all material to ager chooses. The change in the bookkeeper’s valu-
produce one ball. Because the cost of all inputs other ation of the historical amount spent on the plant
than labor and transportation are the same every- may affect the firm’s short-run business profit but
where, the cost difference between Georgia and Costa does not affect the firm’s true economic profit. The
Rica depends on w + s in both locations. As firms economic profit is based on opportunity costs—the
choose to produce in Costa Rica, the extra shipping amount for which the firm could rent the plant to
cost must be less than the labor savings in Costa Rica. someone else—and not on historical payments.
4.2 The average cost of producing one unit is α (regard- 2.5 The first-order condition to maximize profit is the
less of the value of β). If β = 0, the average cost derivative of the profit function with respect to q
does not change with volume. If learning by doing set equal to zero: 120 - 40 - 20q = 0. Thus,
750 Answers to Selected Problems
profit is maximized where q = 4, so that R(4) = the second term by Q/Q = 1 and the last term by
120 * 4 = 480, VC(4) = (40 * 4) + (10 * 16) = Qo/Qo = 1:
320, π(4) = R(4) - VC(4) - F = 480 - 320 - 200 =
dSr p dS p Q dDo p Qo
- 40. The firm should operate in the short run = - .
because its revenue exceeds its variable cost: dp Qr dp Qr Q dp Qr Qo
480 7 320. We can rewrite this expression as Equation 8.17 by
3.9 Some farmers did not pick apples so as to avoid noting that ηr = (dSt/dp)(p/Qr) is the residual sup-
incurring the variable cost of harvesting apples. ply elasticity, η = (dS/dp)(p/Q) is the market sup-
These farmers left open the question of whether they ply elasticity, εo = (dDo/dp)(p/Qo) is the demand
would harvest in the future if the price rose above elasticity of the other countries, and θ = Qr/Q is
the shutdown level. Other, more pessimistic farm- the residual country’s share of the world’s output
ers did not expect the price to rise anytime soon, (hence 1 - θ = Qo/Q is the share of the rest of the
so they bulldozed their trees, leaving the market for world). If there are n countries with equal outputs,
good. (Most farmers planted alternative apples such then 1/θ = n, so this equation can be rewritten as
as Granny Smith and Gala, which are more popular ηr = nη - (n - 1)εo.
with the public and sell at a price above the mini- 4.6 a. T
he incidence of the federal specific tax is shared
mum average variable cost.) equally between consumers and firms, whereas
3.11 The competitive firm’s marginal cost function is found firms bear virtually none of the incidence of the
by differentiating its cost function with respect to state tax (they pass the tax on to consumers).
quantity: MC(q) = dC(q)/dq = b + 2cq + 3dq2. b. From Chapter 2, we know that the incidence of
The firm’s necessary profit-maximizing condition is a tax that falls on consumers in a competitive
p = MC = b + 2cq + 3dq2. We can use the qua- market is approximately η/(η - ε). Although the
dratic formula to solve this equation for q for a spe- national elasticity of supply may be a relatively
cific price to determine its profit-maximizing output. small number, the residual supply elasticity facing
3.13 Suppose that a U-shaped marginal cost curve cuts a particular state is very large. Using the analysis
a competitive firm’s demand curve (price line) from about residual supply curves, we can infer that
above at q1 and from below at q2. By increasing out- the supply curve to a particular state is likely to
put to q1 + 1, the firm earns extra profit because be nearly horizontal—nearly perfectly elastic. For
the last unit sells for price p, which is greater than example, if the price in Maine rises even slightly
the marginal cost of that last unit. Indeed, the price relative to the price in Vermont, suppliers in Ver-
exceeds the marginal cost of all units between q1 mont will be willing to shift their entire supply to
and q2, so it is more profitable to produce q2 than Maine. Thus, we expect the nearly full incidence to
q1. Thus, the firm should either produce q2 or shut fall on consumers from a state tax but less from a
down (if it is making a loss at q2). We can derive this federal tax, consistent with the empirical evidence.
result using calculus. The second-order condition c. If all 50 states were identical, we could write
for a competitive firm requires that marginal cost the residual elasticity of supply, Equation 8.17,
cut the demand line from below at q*, the profit- as ηr = 50η - 49εo. Given this equation, the
maximizing quantity: dMC(q*)/dq 7 0. residual supply elasticity to one state is at least 50
times larger than the national elasticity of supply,
4.2 The shutdown notice reduces the firm’s flexibility,
ηr Ú 50η, because εo 6 0, so the -49εo term is
which matters in an uncertain market. If conditions
positive and increases the residual supply elasticity.
suddenly change, the firm may have to operate at
a loss for six months before it can shut down. This 5.5 Because the clinics are operating at minimum aver-
potential extra expense of shutting down may dis- age cost, a lump-sum tax that causes the minimum
courage some firms from entering the market initially. average cost to rise by 10% would cause the market
4.5 To derive the expression for the elasticity of the resid- price of abortions to rise by 10%. Based on the esti-
ual or excess supply curve in Equation 8.17, we dif- mated price elasticity of between -0.70 and -0.99,
ferentiate the residual supply curve, Equation 8.16, the number of abortions would fall to between
Sr(p) = S(p) - Do(p), with respect to p to obtain 7% and 10%. A lump-sum tax shifts upward the
average cost curve but does not affect the marginal
dSr dS dDo cost curve. Consequently, the market supply curve,
= - .
dp dp dp which is horizontal and the minimum of the average
cost curve, shifts up in parallel.
Let Qr = Sr(p), Q = S(p), and Qo = D(p). We
multiply both sides of the differentiated expres- 5.6 Each competitive firm wants to choose its output q to
sion by p/Qr, and for convenience, we also multiply maximize its after-tax profit: π = pq - C(q) - l.
Answers to Selected Problems 751
p, ¢ per stem
S
A
39¢
S − 11¢
C
s = 11¢ B
e1 F
30¢
D e2
28¢
E Demand
G
s = 11¢
1.25 1.34
Q, Billions of rose stems per year
and business profit is greater than economic profit, intersection of this horizontal supply curve with the
the profit tax raises firms’ after-tax costs and results demand curve. With a new, small tariff of τ, the U.S.
in fewer firms in the market. The exact effect of supply curve is horizontal at $14.70 + τ, and the
the tax depends on why business profit is less than new equilibrium quantity is determined by substi-
economic profit. For example, if the government tuting p = 14.70 + τ into the demand function:
ignores opportunity labor cost but includes all capi- Q = 35.41(14.70 + τ)p-0.37. Evaluated at τ = 0,
tal cost in computing profit, firms will substitute the equilibrium quantity remains at 13.1. The dead-
toward labor and away from capital. weight loss is the area to the right of the domestic
5.8 The Challenge Solution in Chapter 8 shows the supply curve and to the left of the demand curve
long-run effect of a lump-sum tax in a competitive between $14.70 and $14.70 + τ (area C + D + E
market. Consumer surplus falls by more than tax in Figure 9.9) minus the tariff revenues (area D):
revenue increases, and producer surplus remains 14.70 + τ
zero, so welfare falls.
L
DWL = [D(p) - S(p)]dp - τ[D(p + τ) - S(p + τ)]
5.10 a. The initial equilibrium is determined by equating
14.70
the quantity demanded to the quantity supplied:
100 - 10p = 10p. That is, the equilibrium is 14.70 + τ
L
p = 5 and Q = 50. At the support price, the = 33.54p-0.67 - 3.35p0.33 4 dp
quantity supplied is Qs = 60. The market clear- 14.70
ing price was p = 4. The deficiency payment
was D = (p - p)Qs = (6 - 4)60 = 120. - τ33.54(p + τ)-0.67 - 3.35(p + τ)0.33 4 .
b. Consumer surplus rises from CS1 = 12 (10 - 5)
To see how a change in τ affects welfare, we differ-
50 = 125 to CS2 = 12 (10 - 4)60 = 180. Pro-
entiate DWL with respect to τ:
ducer surplus rises from PS1 = 12 (5 - 0)50 = 125
to PS2 = 12 * (6 - 0)60 = 180. Welfare falls 14.70 + τ
L
from CS1 + PS1 = 125 + 125 = 250 to CS2 + dDWL d
= b [D(p) - S(p)]dp
PS2 - D = 180 + 180 - 120 = 240. Thus, the dτ dτ
14.70
deadweight loss is 10.
6.5 Without the tariff, the U.S. supply curve of oil - τ[D(14.70 + τ) - S(14.70 + τ)] r
is horizontal at a price of $14.70 (S1 in Figure
9.9), and the equilibrium is determined by the = [D(14.70 + τ) - S(14.70 + τ)] - [D(14.70 + τ)
Answers to Selected Problems 753
dD(14.70 + τ) dS(14.70 + τ) (or if Chris is better), then Pat has a comparative
- S(14.70 + τ)] - τ J - R advantage (see Figure 10.5) in working in the mar-
dτ dτ
ketplace, and Chris has a comparative advantage
dD(14.70 + τ) dS(14.70 + τ) in working at home. Of course, if both enjoy con-
= -τ J - R. suming leisure, they may not fully specialize. As an
dτ dτ
example, suppose that, before they got married,
If we evaluate this expression at τ = 0, we find that Chris and Pat each spent 10 hours a day in sleep and
dDWL/dτ = 0. In short, applying a small tariff to leisure activities, 5 hours working in the market-
the free-trade equilibrium has a negligible effect on place, and 9 hours working at home. Because Chris
quantity and deadweight loss. Only if the tariff is earns $10 an hour and Pat earns $20 an hour, they
larger—as in Figure 9.9—do we see a measurable collectively earned $150 a day and worked 18 hours
effect. a day at home. After they marry, they can benefit
from specialization. If Chris works entirely at home
and Pat works 10 hours in the marketplace and the
Chapter 10 rest at home, they collectively earn $200 a day (a
one-third increase) and still have 18 hours of work
1.7 A subsidy is a negative tax. Thus, we can use the
at home. If they do not need to spend as much time
same analysis that we used in Solved Problem 10.1
working at home because of economies of scale, one
to answer this question by reversing the signs of the
or both could work more hours in the marketplace,
effects.
and they will have even greater disposable income.
4.1 If you draw the convex production possibility fron-
tier on Figure 10.5, you will see that it lies strictly
inside the concave production possibility frontier. Chapter 11
Thus, more output can be obtained if Jane and
Denise use the concave frontier. That is, each should 1.4 For a general linear inverse demand function,
specialize in producing the good for which she has a p(Q) = a - bQ, dQ/dp = -1/b, so the elasticity is
comparative advantage. ε = -p/(bQ). The demand curve hits the horizontal
4.2 As Chapter 4 shows, the slope of the budget con- (quantity) axis at a/b. At half that quantity (the mid-
straint facing an individual equals the negative of point of the demand curve), the quantity is a/(2b),
that person’s wage. Panel a of the figure illustrates and the price is a/2. Thus, the elasticity of demand is
that Pat’s budget constraint is steeper than Chris’s ε = -p/(bQ) = - (a/2)/[ab/(2b)] = - 1 at the mid-
because Pat’s wage is larger than Chris’s. Panel b point of any linear demand curve. As the chapter
shows their combined budget constraint after they shows, a monopoly will not operate in the inelastic
marry. Before they marry, each spends some time section of its demand curve, so a monopoly will not
in the marketplace earning money and other time operate in the right half of its linear demand curve.
at home cooking, cleaning, and consuming leisure. 2.2 Amazon’s Lerner Index was (p - MC)/p =
After they marry, one of them can specialize in (359 - 159)/359 L 0.557. Using Equation 11.11,
earning money and the other at working at home. we know that (p - MC)/p L 0.557 = - 1/ε, so
If they are both equally skilled at household work ε L - 1.795.
LCombined
LP
LC
24 0 48 24 0
H, Work hours per day H, Work hours per day
754 Answers to Selected Problems
2.4 Given that Apple’s marginal cost was constant, its 16β. It pays for the firm to set a low price in the first
average variable cost equaled its marginal cost, period if the lost profit, 16, is less than the extra
$200. Its average fixed cost was its fixed cost profit in the second period, which is 16(β - 1).
divided by the quantity produced, 736/Q. Thus, Thus, it pays to set a low price in the first period if
its average cost was AC = 200 + 736/Q. Because 16 6 16(β - 1), or 2 6 β.
the inverse demand function was p = 600 - 25Q, 7.6 If a firm has a monopoly in the output market and
Apple’s revenue function was R = 600Q - 25Q2, is a monopsony in the labor market, its profit is
so MR = dR/dQ = 600 - 50Q. Apple maximized π = p(Q(L))Q(L) - w(L)L,where Q(L) is the pro-
its profit where MR = 600 - 50Q = 200 = MC. duction function, p(Q)Q is its revenue, and w(L)L—
Solving this equation for the profit-maximizing the wage times the number of workers—is its cost of
output, we find that Q = 8 million units. By sub- production. The firm maximizes its profit by setting
stituting this quantity into the inverse demand the derivative of profit with respect to labor equal to
equation, we determine that the profit-maximizing zero (if the second-order condition holds):
price was p = $400 per unit, as the figure shows.
The firm’s profit was π = (p - AC)Q = [400 - dpdQ dw
¢p + Q(L) ≤
- w(L) - L = 0.
(200 + 736/8)]8 = $864 million. Apple’s Lerner dQ dL dL
Index was (p - MC)/p = [400 - 200]/400 = 12.
Rearranging terms in the first-order condition, we
According to Equation 11.11, a profit-maximizing
find that the maximization condition is that the
monopoly operates where (p - MC)/p = - 1/ε.
marginal revenue product of labor,
Combining that equation with the Lerner Index
from the previous step, we learn that 12 = - 1/ε, or dpdQ
ε = -2. MRPL = MR * MPL = ¢p + Q(L) ≤
dQ dL
3.4 A tax on economic profit (of less than 100%) has 1 dQ
no effect on a firm’s profit-maximizing behavior. = p¢1 + ≤ ,
ε dL
Suppose the government’s share of the profit is β.
Then the firm wants to maximize its after-tax profit, equals the marginal expenditure,
which is (1 - γ)π. However, whatever choice of Q dw L dw
(or p) maximizes π will also maximize (1 - γ)π. ME = w(L) + L = w(L)¢1 + ≤
dL w dL
Figure 19.3 gives a graphical example where γ = 13.
Consequently, the tribe’s behavior is unaffected by 1
= w(L)¢1 + ≤,
a change in the share that the government receives. η
We can also answer this problem using calculus.
where ε is the elasticity of demand in the output
The before-tax profit is πB = R(Q) - C(Q), and
market and η is the supply elasticity of labor.
the after-tax profit is πA = (1 - γ)[R(Q) - C(Q)].
For both, the first-order condition is marginal reve-
nue equals marginal cost: dR(Q)/dQ = dC(Q)/dQ.
Chapter 12
4.1 Yes. The demand curve could cut the average cost
curve only in its downward-sloping section. Conse- 1.3 This policy allows the firm to maximize its profit by
quently, the average cost is strictly downward slop- price discriminating if people who put a lower value
ing in the relevant region. on their time (so are willing to drive to the store and
transport their purchases themselves) have a higher
6.1 Given the demand curve is p = 10 - Q, its marginal
elasticity of demand than people who want to order
revenue curve is MR = 10 - 2Q. Thus, the output
by phone and have the goods delivered.
that maximizes the monopoly’s profit is determined
by MR = 10 - 2Q = 2 = MC, or Q* = 4. At 1.4 The colleges may be providing scholarships as a
that output level, its price is p* = 6 and its profit form of charity, or they may be price discriminating
is π* = 16. If the monopoly chooses to sell 8 units by lowering the final price for less wealthy families
in the first period (it has no incentive to sell more), (who presumably have higher elasticities of demand).
its price is $2 and it makes no profit. Given that 3.5 See MyEconLab, Chapter Resources, Chapter 12,
the firm sells 8 units in the first period, its demand “Aibo,” for more details. The two marginal
curve in the second period is p = 10 - Q/β, so its revenue curves are MRJ = 3,500 - QJ and
marginal revenue function is MR = 10 - 2Q/β. MRA = 4,500 - 2QA. Equating the marginal
The output that leads to its maximum profit is revenues with the marginal cost of $500, we find
determined by MR = 10 - 2Q/β = 2 = MC, or that QJ = 3,000 and QA = 2,000. Substituting
its output is 4β. Thus, its price is $6 and its profit is these quantities into the inverse demand curves,
Answers to Selected Problems 755
belief about its rival’s behavior. For example, sup- dominant strategies. The subsidy does not affect
pose that Firm 1 believes that Firm 2 will choose a Toyota’s payoff, so Toyota still has a dominant
low price with a probability θn 2. If θn 2 is less than 13 strategy: It enters the market. With the subsidy,
(Firm 2 is relatively unlikely to choose a low price), GM’s payoff if it enters increases by 50: GM earns
it pays for Firm 1 to choose the low price because 10 if both enter and 250 if it enters and Toyota does
the second term in E(π1), (1 - 3θn 2)θ1, is positive, so not. With the subsidy, entering is a dominant strat-
as θ1 increases, E(π1) increases. Because the highest egy for GM. Thus, both firms’ entering is a Nash
possible θ1 is 1, Firm 1 chooses the low price with equilibrium.
certainty. Similarly, if Firm 1 believes θn 2 is greater 2.3 If the airline game is known to end in five periods,
than 13, it sets a high price with certainty (θ1 = 0). the equilibrium is the same as the one-period equi-
If Firm 2 believes that Firm 1 thinks θn 2 is slightly librium. If the game is played indefinitely but one
below 13, Firm 2 believes that Firm 1 will choose a low or both firms care only about current profit, then
price with certainty, and hence Firm 2 will also choose the equilibrium is the one-period one because future
a low price. That outcome, θ2 = 1, however, is not punishments and rewards are irrelevant to it.
consistent with Firm 1’s expectation that θn 2 is a frac- 2.9 The game tree illustrates why the incumbent may
tion. Indeed, it is only rational for Firm 2 to believe install the robotic arms to discourage entry even
that Firm 1 believes Firm 2 will use a mixed strategy though its total cost rises. If the incumbent fears
if Firm 1’s belief about Firm 2 makes Firm 1 unpre- that a rival is poised to enter, it invests to discour-
dictable. That is, Firm 1 uses a mixed strategy only if age entry. The incumbent can invest in equipment
it is indifferent between setting a high or a low price. that lowers its marginal cost. With the lowered mar-
It is indifferent only if it believes θn 2 is exactly 13. By ginal cost, it is credible that the incumbent will pro-
similar reasoning, Firm 2 will use a mixed strategy duce larger quantities of output, which discourages
only if its belief is that Firm 1 chooses a low price entry. The incumbent’s monopoly (no-entry) profit
with probability θn 1 = 57. Thus, the only possible drops from $900 to $500 if it makes the invest-
Nash equilibrium is θ2 = 57 and θ2 = 13 ment because the investment raises its total cost.
1.9 We start by checking for dominant strategies. Given If the incumbent doesn’t buy the robotic arms, the
the payoff matrix, Toyota always does at least as rival enters because it makes $300 by entering and
well by entering the market. If GM enters, Toyota nothing if it stays out of the market. With entry, the
earns 10 by entering and 0 by staying out of the incumbent’s profit is $400. With the investment,
market. If GM does not enter, Toyota earns 250 if the rival loses $36 if it enters, so it stays out of the
it enters and 0 otherwise. Thus, entering is Toyota’s market, losing nothing. (If the rival were to enter,
dominant strategy. GM does not have a dominant the incumbent would earn $132.) Because of the
strategy. It wants to enter if Toyota does not enter investment, the incumbent earns $500. Nonetheless,
(earning 200 rather than 0), and it wants to stay earning $500 is better than earning $400, so the
out if Toyota enters (earning 0 rather than - 40). incumbent invests.
Because GM knows that Toyota will enter (enter- 2.10 The incumbent firm has a first-mover advantage,
ing is Toyota’s dominant strategy), GM stays out. as the game tree illustrates. Moving first allows the
Toyota’s entering and GM’s not entering is a Nash incumbent or leader firm to commit to producing a
equilibrium. Given the other firm’s strategy, neither relatively large quantity. If the incumbent does not
firm wants to change its strategy. Next, we exam- make a commitment before its rival enters, entry
ine how the subsidy affects the payoff matrix and occurs and the incumbent earns a relatively low
profit. By committing to produce such a large output
level that the potential entrant decides not to enter
Chapter 14
because it cannot make a positive profit, the incum-
3.1 The inverse demand curve is p = 1 - 0.001Q. The
bent’s commitment discourages entry. Moving back-
first firm’s profit is π1 = [1 - 0.001(q1 + q2)]q1 -
ward in time (moving to the left in the diagram), we
0.28q1. Its first-order condition is dπ1/dq1 = 1 -
examine the incumbent’s choice. If the incumbent
0.001(2q1 + q2) - 0.28 = 0. If we rearrange the
commits to the small quantity, its rival enters and
terms, the first firm’s best-response function is
the incumbent earns $450. If the incumbent com-
q1 =360 - 12 q2. Similarly, the second firm’s best-
mits to the larger quantity, its rival does not enter
response function is q2 = 360 - 12 q1 By substitut-
and the incumbent earns $800. Clearly, the incum-
ing one of these best-response functions into the
bent should commit to the larger quantity because
other, we learn that the Nash-Cournot equilibrium
it earns a larger profit and the potential entrant
occurs at q1 = q2 = 240, so the equilibrium price
chooses to stay out of the market. Their chosen
is 52¢.
paths are identified by the darker blue in the figure.
2.11 It is worth more to the monopoly to keep the 3.5 Given that the firm’s after-tax marginal cost is m + τ,
potential entrant out than it is worth to the poten- the Nash-Cournot equilibrium price is
tial entrant to enter, as the figure shows. Before the p = (a + n [m + τ])/(n + 1),
pollution-control device requirement, the entrant
using Equation 14.17. Thus, the consumer incidence
would pay up to $3 to enter, whereas the incumbent
of the tax is dp/dτ = n/(n + 1) 6 1 ( = 100%).
would pay up to πi - πd = $7 to exclude the poten-
tial entrant. The incumbent’s profit is $6 if entry does 3.6 The monopoly will make more profit than the
not occur, and its loss is $1 if entry occurs. Because duopoly will, so the monopoly is willing to pay
the new firm would lose $1 if it enters, it does not the college more rent. Although granting monop-
enter. Thus, the incumbent has an incentive to raise oly rights may be attractive to the college in terms
costs by $4 to both firms. The incumbent’s profit is of higher rent, students will suffer (lose consumer
$6 if it raises costs rather than $3 if it does not. surplus) because of the higher textbook prices.
758 Answers to Selected Problems
the drop in the number of firms causes the markup 5.2 Given that the duopolies produce identical goods,
factor to rise to (1 + b)µ; then the change in price is the equilibrium price is lower if the duopolies set
[(1 + a)m * (1 + b)µ] - mµ = (a + b + ab)mµ. price rather than quantity. If the goods are heteroge-
That is, price increases by the fractional increase in neous, we cannot answer this question definitively.
the marginal cost, a, plus the fractional increase in the 5.3 Firm 1 wants to maximize its profit: π1 = (p1 - 10)
markup factor, b, plus the interaction of the two, ab. q1 = (p1 - 10)(100 - 2p1 + p2). Its first-order con-
3.12 By differentiating its product, a firm makes the dition is dπ1/dp1 = 100 - 4p1 + p2 + 20 = 0, so its
residual demand curve it faces less elastic every- best-response function is p1 = 30 + 14 p2. Similarly,
where. For example, no consumer will buy from Firm 2’s best-response function is p2 = 30 + 14 p1.
that firm if its rival charges less and the goods are Solving, the Nash-Bertrand equilibrium prices are
homogeneous. In contrast, some consumers who p1 = p2 = 40. Each firm produces 60 units.
prefer this firm’s product to that of its rival will 6.5 In the long-run equilibrium, a monopolistically
still buy from this firm even if its rival charges less. competitive firm operates where its downward
As the chapter shows, a firm sets a higher price the sloping demand curve is tangent to its average cost
lower the elasticity of demand at the equilibrium. curve as Figure 14.9 illustrates. Because its demand
3.17 You can solve this problem using calculus or the for- curve is downward sloping, its average cost curve
mulas in Solved Problem 14.1. must also be downward sloping in the equilibrium.
a. Using Equations 14.21 and 14.22 for the duopoly, Thus, the firm chooses to operate at less than full
q1 = (15 - 1 + 1)/3 = 5, q2 = (15 - 1 - 2)/3 = 4, capacity in equilibrium.
pd = 6, π1 = (6 - 1)5 = 25, π2 = (6 - 2)4 = 16.
Total output is Qd = 5 + 4 = 9. Total profit Chapter 15
is πd = 25 + 16 = 41. Consumer surplus is
CSd = 12(15 - 6)9 = 81/2 = 40.5. At the effi- 1.2 Before the tax, the competitive firm’s labor demand
cient price (equal to marginal cost of 1), the was p * MPL. After the tax, the firm’s effective
output is 14. The deadweight loss is DWLd = price is (1 - α)p, so its labor demand becomes
1
2 (6 - 1)(14 - 9) = 25/2 = 12.5. (1 - α)p * MPL.
b. The monopoly equates its marginal revenue
1.8 The competitive firm’s marginal revenue of labor is
and (its lowest) marginal cost: MR = 15 -
MRPL = pMPL = p(Lρ + Kρ)1/ρ - 1Lρ - 1.
2Qm = 1 = MC. Thus, Qm = 7, pm = 8, πm =
(8 - 1)7 = 49. Consumer surplus is CSm = 2.1 An individual with a zero discount rate views cur-
1 rent and future consumption as equally attractive.
2 (15 - 8)7 = 49/2 = 24.5. The deadweight loss
is DWLm = 12(8 - 1)(14 - 7) = 49/2 = 24.5. An individual with an infinite discount rate cares
c. The average cost of production for the duopoly only about current consumption and puts no value
is [(5 * 1) + (4 * 2)]/(5 + 4) = 1.44, whereas on future consumption.
the average cost of production for the monopoly 2.7 Because the first contract is paid immediately, its
is 1. The increase in market power effect swamps present value equals the contract payment of $1 mil-
the efficiency gain, so consumer surplus falls lion. Our pro can use Equation 15.15 and a calcu-
while deadweight loss nearly doubles. lator to determine the present value of the second
3.19 a. The Nash-Cournot equilibrium in the absence contract (or hire you to do the job for him). The
of government intervention is q1 = 30, q2 = 40, present value of a $2 million payment 10 years from
p = 50, π1 = 900, and π2 = 1,600. now is $2,000,000/(1.05)10 L $1,227,827 at 5%
Answers to Selected Problems 759
3.3 Because buyers are risk neutral, if they believe that
MC of abatement the probability of getting a lemon is θ, the most they
DWL2 are willing to pay for a car of unknown quality is
p = p1(1 - θ) + p2θ. If p is greater than both v1
f2 and v2, all cars are sold. If v1 7 p 7 v2, only lem-
ons are sold. If p is less than both v1 and v2, no cars
e
f are sold. However, we know that v2 6 p2 and that
MB 2 p2 6 p, so owners of lemons are certainly willing to
f1 DWL1 sell them. (If sellers bear a transaction cost of c and
Expected MB p 6 v2 + c, no cars are sold.)
of abatement 4.1 If almost all consumers know the true prices, and
MB 1
all but one firm charges the full-information com-
petitive price, then it does not pay for a firm to set
S1 S S2
a high price. It gains a little from charging ignorant
Units of gunk abated per day consumers the high price, but it sells to no informed
Answers to Selected Problems 761