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Microeconomics 7th Edition, Pindyck Solution Manual

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Solution Manual For Microeconomics 7th Edition, Pindyck. Note: This is not a text book. Description: ISBN-13: 978-0935726855, ISBN-10: 0935726853.

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Solution Manual Microeconomics 7th Pindyck & Rubinfeld

CHAPTER 1: PRELIMINARIES
1. It is often said that a good theory is one that can be refuted by an empirical, data- oriented study. Explain why a theory that cannot be evaluated empirically is not a good theory.
2. Which of the following two statements involves positive economic analysis and which normative? How do the two kinds of analysis differ?
a. Gasoline rationing (allocating to each individual a maximum amount of gasoline that can be purchased each year) is a poor social policy because it interferes with the workings of the competitive market system.
b. Gasoline rationing is a policy under which more people are made worse off than are made better off.
3. Suppose the price of regular-octane gasoline were 20 cents per gallon higher in New Jersey than in Oklahoma. Do you think there would be an opportunity for arbitrage (i.e., that firms could buy gas in Oklahoma and then sell it at a profit in New Jersey)? Why or why not?
4. In Example 1.3, what economic forces explain why the real price of eggs has fallen while the real price of a college education has increased? How have these changes affected consumer choices?
5. Suppose that the Japanese yen rises against the U.S. dollar – that is, it will take more dollars to buy any given amount of Japanese yen. Explain why this increase simultaneously increases the real price of Japanese cars for U.S. consumers and lowers the real price of U.S. automobiles for Japanese consumers.
6. The price of long-distance telephone service fell from 40 cents per minute in 1996 to 22 cents per minute in 1999, a 45-percent (18 cents/40 cents) decrease. The Consumer Price Index increased by 10 percent over this period. What happened to the real price of telephone service?
EXERCISES
1. Decide whether each of the following statements is true or false and explain why:
a. Fast-food chains like McDonald’s, Burger King, and Wendy’s operate all over the United States. Therefore the market for fast food is a national market.
b. People generally buy clothing in the city in which they live. Therefore there is a clothing market in, say, Atlanta that is distinct from the clothing market in Los Angeles.
c. Some consumers strongly prefer Pepsi and some strongly prefer Coke. Therefore there is no single market for colas.
2. The following table shows the average retail price of butter and the Consumer Price Index from 1980 to 2000, scaled so that the CPI = 100 in 1980.
ˇ 1980 1985 1990 1995 2000
CPI 100 130.58 158.56 184.95 208.98
Retail price of butter
(salted, grade AA, per lb.)
$1.88
$2.12
$1.99
$1.61
$2.52
a. Calculate the real price of butter in 1980 dollars. Has the real price increased/decreased/stayed the same since 1980?
b. What is the percentage change in the real price (1980 dollars) from 1980 to 2000?
c. Convert the CPI into 1990 = 100 and determine the real price of butter in 1990 dollars.
d. What is the percentage change in the real price (1990 dollars) from 1980 to 2000? Compare this with your answer in (b). What do you notice? Explain.
3. At the time this book went to print, the minimum wage was $5.85. To find the current value of the CPI, go to http://www.bls.gov/cpi/home.htm. Click on Consumer Price Index- All Urban Consumers (Current Series) and select U.S. All items. This will give you the CPI from 1913 to the present.
a. With these values, calculate the current real minimum wage in 1990 dollars.
b. Stated in real 1990 dollars, what is the percentage change in the real minimum wage from 1985 to the present?

CHAPTER 2: THE BASICS OF SUPPLY AND DEMAND
1. Suppose that unusually hot weather causes the demand curve for ice cream to shift to the right. Why will the price of ice cream rise to a new market-clearing level?
2. Use supply and demand curves to illustrate how each of the following events would affect the price of butter and the quantity of butter bought and sold:
a. An increase in the price of margarine.
b. An increase in the price of milk.
c. A decrease in average income levels.
3. If a 3-percent increase in the price of corn flakes causes a 6-percent decline in the quantity demanded, what is the elasticity of demand?
4. Explain the difference between a shift in the supply curve and a movement along the supply curve.
5. Explain why for many goods, the long-run price elasticity of supply is larger than the short-run elasticity.
6. Why do long-run elasticities of demand differ from short-run elasticities? Consider two goods: paper towels and televisions. Which is a durable good? Would you expect the price elasticity of demand for paper towels to be larger in the short run or in the long run? Why? What about the price elasticity of demand for televisions?
7. Are the following statements true or false? Explain your answers.
a. The elasticity of demand is the same as the slope of the demand curve.
b. The cross-price elasticity will always be positive.
c. The supply of apartments is more inelastic in the short run than the long run.
8. Suppose the government regulates the prices of beef and chicken and sets them below their market-clearing levels. Explain why shortages of these goods will develop and what factors will determine the sizes of the shortages. What will happen to the price of pork? Explain briefly.
9. The city council of a small college town decides to regulate rents in order to reduce student living expenses. Suppose the average annual market-clearing rent for a two- bedroom apartment had been $700 per month, and rents were expected to increase to $900 within a year. The city council limits rents to their current $700-per-month level.
a. Draw a supply and demand graph to illustrate what will happen to the rental price of an apartment after the imposition of rent controls.
b. Do you think this policy will benefit all students? Why or why not?
10. In a discussion of tuition rates, a university official argues that the demand for admission is completely price inelastic. As evidence, she notes that while the university has doubled its tuition (in real terms) over the past 15 years, neither the number nor quality of students applying has decreased. Would you accept this argument? Explain briefly. (Hint: The official makes an assertion about the demand for admission, but does she actually observe a demand curve? What else could be going on?)

EXERCISES
1. Suppose the demand curve for a product is given by Q = 300 – 2P + 4I, where I is average income measured in thousands of dollars. The supply curve is Q = 3P – 50.
a. If I = 25, find the market clearing price and quantity for the product.
b. If I = 50, find the market clearing price and quantity for the product.
c. Draw a graph to illustrate your answers.
2. Consider a competitive market for which the quantities demanded and supplied (per year) at various prices are given as follows:
Price

(Dollars) Demand

(Millions) Supply

(Millions)
60 22 14
80 20 16
100 18 18
120 16 20
a. Calculate the price elasticity of demand when the price is $80 and when the price is $100.
b. Calculate the price elasticity of supply when the price is $80 and when the price is $100.
c. What are the equilibrium price and quantity?
d. Suppose the government sets a price ceiling of $80. Will there be a shortage, and if so, how large will it be?
3. Refer to Example 2.5 (page 38) on the market for wheat. In 1998, the total demand for U.S. wheat was Q = 3244 – 283P and the domestic supply was QS = 1944 + 207P. At the end of 1998, both Brazil and Indonesia opened their wheat markets to U.S. farmers. Suppose that these new markets add 200 million bushels to U.S. wheat demand. What will be the free- market price of wheat and what quantity will be produced and sold by U.S. farmers?
4. A vegetable fiber is traded in a competitive world market, and the world price is $9 per pound. Unlimited quantities are available for import into the United States at this price. The U.S. domestic supply and demand for various price levels are shown as follows:
a. What is the equation for demand? What is the equation for supply?
b. At a price of $9, what is the price elasticity of demand? What is it at a price of $12?
c. What is the price elasticity of supply at $9? At $12?
d. In a free market, what will be the U.S. price and level of fiber imports?
5. Much of the demand for U.S. agricultural output has come from other countries. In 1998, the total demand for wheat was Q = 3244 – 283P. Of this, total domestic demand was QD = 1700 – 107P, and domestic supply was QS = 1944 + 207P. Suppose the export demand for wheat falls by 40 percent.
a. U.S. farmers are concerned about this drop in export demand. What happens to the free-market price of wheat in the United States? Do the farmers have much reason to worry?
b. Now suppose the U.S. government wants to buy enough wheat to raise the price to $3.50 per bushel. With the drop in export demand, how much wheat would the government have to buy? How much would this cost the government?
6. The rent control agency of New York City has found that aggregate demand is QD = 160 – 8P. Quantity is measured in tens of thousands of apartments. Price, the average monthly rental rate, is measured in hundreds of dollars. The agency also noted that the increase in Q at lower P results from more three-person families coming into the city from Long Island and demanding apartments. The city’s board of realtors acknowledges that this is a good demand estimate and has shown that supply is QS = 70 + 7P.
a. If both the agency and the board are right about demand and supply, what is the free-market price? What is the change in city population if the agency sets a maximum average monthly rent of $300 and all those who cannot find an apartment leave the city?
b. Suppose the agency bows to the wishes of the board and sets a rental of $900 per month on all apartments to allow landlords a “fair” rate of return. If 50 percent of any long-run increases in apartment offerings come from new construction, how many apartments are constructed?
7. In 1998, Americans smoked 470 billion cigarettes, or 23.5 billion packs of cigarettes. The average retail price was $2 per pack. Statistical studies have shown that the price elasticity of demand is –0.4, and the price elasticity of supply is 0.5. Using this information, derive linear demand and supply curves for the cigarette market.
8. In Example 2.8 we examined the effect of a 20-percent decline in copper demand on the price of copper, using the linear supply and demand curves developed in Section 2.6. Suppose the long-run price elasticity of copper demand were –0.75 instead of –0.5.
a. Assuming, as before, that the equilibrium price and quantity are P* = $2 per pound and Q* = 12 million metric tons per year, derive the linear demand curve consistent with the smaller elasticity.
b. Using this demand curve, recalculate the effect of a 20-percent decline in copper demand on the price of copper.
9. In Example 2.8 (page 52), we discussed the recent increase in world demand for copper, due in part to China’s rising consumption.
a. Using the original elasticities of demand and supply (i.e. ES = 1.5 and ED = –0.5), calculate the effect of a 20-percent increase in copper demand on the price of copper.
b. Now calculate the effect of this increase in demand on the equilibrium quantity, Q*.
c. As we discussed in Example 2.8, the U.S. production of copper declined between 2000 and 2003. Calculate the effect on the equilibrium price and quantity of both a 20- percent increase in copper demand (as you just did in part a) and of a 20-percent decline in copper supply.
10. Example 2.9 (page 54) analyzes the world oil market. Using the data given in that example:
a. Show that the short-run demand and competitive supply curves are indeed given by D = 35.5 – 0.03P SC = 18 + 0.04P.
b. Show that the long-run demand and competitive supply curves are indeed given by D = 47.5 – 0.27P SC = 12 + 0.16P.
c. In Example 2.9 we examined the impact on price of a disruption of oil from Saudi Arabia. Suppose that instead of a decline in supply, OPEC production increases by 2 billion barrels per year (bb/yr) because the Saudis open large new oil fields. Calculate the effect of this increase in production on the supply of oil in both the short run and the long run.

CHAPTER 3: CONSUMER BEHAVIOR
1. What are the four basic assumptions about individual preferences? Explain the significance or meaning of each.
2. Can a set of indifference curves be upward sloping? If so, what would this tell you about the two goods?
3. Explain why two indifference curves cannot intersect.
4. Jon is always willing to trade one can of Coke for one can of Sprite, or one can of Sprite for one can of Coke.
a. What can you say about Jon’s marginal rate of substitution?
b. Draw a set of indifference curves for Jon.
c. Draw two budget lines with different slopes and illustrate the satisfaction- maximizing choice. What conclusion can you draw?
5. What happens to the marginal rate of substitution as you move along a convex indifference curve? A linear indifference curve?
6. Explain why an MRS between two goods must equal the ratio of the price of the goods for the consumer to achieve maximum satisfaction.
7. Describe the indifference curves associated with two goods that are perfect substitutes. What if they are perfect complements?
8. What is the difference between ordinal utility and cardinal utility? Explain why the assumption of cardinal utility is not needed in order to rank consumer choices.
9. Upon merging with the West German economy, East German consumers indicated a preference for Mercedes-Benz automobiles over Volkswagens. However, when they converted their savings into deutsche marks, they flocked to Volkswagen dealerships. How can you explain this apparent paradox?
10. Draw a budget line and then draw an indifference curve to illustrate the satisfaction- maximizing choice associated with two products. Use your graph to answer the following questions.
a. Suppose that one of the products is rationed. Explain why the consumer is likely to be worse off.
b. Suppose that the price of one of the products is fixed at a level below the current price. As a result, the consumer is not able to purchase as much as she would like. Can you tell if the consumer is better off or worse off?
EXERCISES
1. In this chapter, consumer preferences for various commodities did not change during the analysis. Yet in some situations, preferences do change as consumption occurs. Discuss why and how preferences might change over time with consumption of these two commodities:
a. cigarettes
b. dinner for the first time at a restaurant with a special cuisine
2. Draw indifference curves that represent the following individuals’ preferences for hamburgers and soft drinks. Indicate the direction in which the individuals’ satisfaction (or utility) is increasing.
a. Joe has convex preferences and dislikes both hamburgers and soft drinks.
b. Jane loves hamburgers and dislikes soft drinks. If she is served a soft drink, she will pour it down the drain rather than drink it.
c. Bob loves hamburgers and dislikes soft drinks. If he is served a soft drink, he will drink it to be polite.
d. Molly loves hamburgers and soft drinks, but insists on consuming exactly one soft drink for every two hamburgers that she eats.
e. Bill likes hamburgers, but neither likes nor dislikes soft drinks.
f. Mary always gets twice as much satisfaction from an extra hamburger as she does from an extra soft drink.
3. If Jane is currently willing to trade 4 movie tickets for 1 basketball ticket, then she must like basketball better than movies. True or false? Explain.
4. Janelle and Brian each plan to spend $20,000 on the styling and gas mileage features of a new car. They can each choose all styling, all gas mileage, or some combination of the two. Janelle does not care at all about styling and wants the best gas mileage possible. Brian likes both equally and wants to spend an equal amount on each. Using indifference curves and budget lines, illustrate the choice that each person will make.
5. Suppose that Bridget and Erin spend their incomes on two goods, food (F) and clothing (C). Bridget’s preferences are represented by the utility function U( F,C ) = 10FC , while Erin’s preferences are represented by the utility function U( F,C ) = .20F 2 C 2 .
a. With food on the horizontal axis and clothing on the vertical axis, identify on a graph the set of points that give Bridget the same level of utility as the bundle (10,5). Do the same for Erin on a separate graph.
b. On the same two graphs, identify the set of bundles that give Bridget and Erin the same level of utility as the bundle (15,8).
c. Do you think Bridget and Erin have the same preferences or different preferences? Explain.
6. Suppose that Jones and Smith have each decided to allocate $1000 per year to an entertainment budget in the form of hockey games or rock concerts. They both like hockey games and rock concerts and will choose to consume positive quantities of both goods. However, they differ substantially in their preferences for these two forms of entertainment. Jones prefers hockey games to rock concerts, while Smith prefers rock concerts to hockey games.
a. Draw a set of indifference curves for Jones and a second set for Smith.
b. Using the concept of marginal rate of substitution, explain why the two sets of curves are different from each other.
7. The price of DVDs (D) is $20 and the price of CDs (C) is $10. Philip has a budget of $100 to spend on the two goods. Suppose that he has already bought one DVD and one CD. In addition there are 3 more DVDs and 5 more CDs that he would really like to buy.
a. Given the above prices and income, draw his budget line on a graph with CDs on the horizontal axis.
b. Considering what he has already purchased, and what he still wants to purchase, identify the three different bundles of CDs and DVDs that he could choose. For this part of the question, assume that he cannot purchase fractional units.
8. Anne has a job that requires her to travel three out of every four weeks. She has an annual travel budget and can travel either by train or by plane. The airline on which she typically flies has a frequent-traveler program that reduces the cost of her tickets according to the number of miles she has flown in a given year. When she reaches 25,000 miles, the airline will reduce the price of her tickets by 25 percent for the remainder of the year. When she reaches 50,000 miles, the airline will reduce the price by 50 percent for the remainder of the year. Graph Anne’s budget line, with train miles on the vertical axis and plane miles on the horizontal axis.
9. Debra usually buys a soft drink when she goes to a movie theater, where she has a choice of three sizes: the 8-ounce drink costs $1.50, the 12-ounce drink, $2.00, and the 16-ounce drink $2.25. Describe the budget constraint that Debra faces when deciding how many ounces of the drink to purchase. (Assume that Debra can costlessly dispose of any of the soft drink that she does not want.)
10. Antonio buys five new college textbooks during his first year at school at a cost of $80 each. Used books cost only $50 each. When the bookstore announces that there will be a 10 percent increase in the price of new books and a 5 percent increase in the price of used books, Antonio’s father offers him $40 extra.
a. What happens to Antonio’s budget line? Illustrate the change with new books on the vertical axis.
b. Is Antonio worse or better off after the price change? Explain.

CHAPTER 4: INDIVIDUAL AND MARKET DEMAND
1. Explain the difference between each of the following terms:
a. a price consumption curve and a demand curve
b. an individual demand curve and a market demand curve
c. an Engel curve and a demand curve
d. an income effect and a substitution effect
2. Suppose that an individual allocates his or her entire budget between two goods, food and clothing. Can both goods be inferior? Explain.
3. Explain whether the following statements are true or false.
a. The marginal rate of substitution diminishes as an individual moves downward along the demand curve.
b. The level of utility increases as an individual moves downward along the demand curve.
c. Engel curves always slope upwards.
4. Tickets to a rock concert sell for $10. But at that price, the demand is substantially greater than the available number of tickets. Is the value or marginal benefit of an additional ticket greater than, less than, or equal to $10? How might you determine that value?
5. Which of the following combinations of goods are complements and which are substitutes? Can they be either in different circumstances? Discuss.
a. a mathematics class and an economics class
b. tennis balls and a tennis racket
c. steak and lobster
d. a plane trip and a train trip to the same destination
e. bacon and eggs
6. Suppose that a consumer spends a fixed amount of income per month on the following pairs of goods:
a. tortilla chips and salsa
b. tortilla chips and potato chips
c. movie tickets and gourmet coffee
d. travel by bus and travel by subway
If the price of one of the goods increases, explain the effect on the quantity demanded of each of the goods. In each pair, which are likely to be complements and which are likely to be substitutes?
7. Which of the following events would cause a movement along the demand curve for
U.S. produced clothing, and which would cause a shift in the demand curve?
a. the removal of quotas on the importation of foreign clothes
b. an increase in the income of U.S. citizens
c. a cut in the industry’s costs of producing domestic clothes that is passed on to the market in the form of lower prices
8. For which of the following goods is a price increase likely to lead to a substantial income (as well as substitution) effect?
a. salt
b. housing
c. theater tickets
d. food
9. Suppose that the average household in a state consumes 800 gallons of gasoline per year. A 20-cent gasoline tax is introduced, coupled with a $160 annual tax rebate per household. Will the household be better or worse off under the new program?
10. Which of the following three groups is likely to have the most, and which the least, price-elastic demand for membership in the Association of Business Economists?
a. students
b. junior executives
c. senior executives
EXERCISES
1. An individual sets aside a certain amount of his income per month to spend on his two hobbies, collecting wine and collecting books. Given the information below, illustrate both the price-consumption curve associated with changes in the price of wine and the demand curve for wine.
Price
Wine Price
Book Quantity
Wine Quantity
Book Budget
$10 $10 7 8 $150
$12 $10 5 9 $150
$15 $10 4 9 $150
$20 $10 2 11 $150

2. An individual consumes two goods, clothing and food. Given the information below, illustrate both the income-consumption curve and the Engel curve for clothing and food.
Price
Clothing Price
Food Quantity
Clothing Quantity
Food Income
$10 $2 6 20 $100
$10 $2 8 35 $150
$10 $2 11 45 $200
$10 $2 15 50 $250

3. Jane always gets twice as much utility from an extra ballet ticket as she does from an extra basketball ticket, regardless of how many tickets of either type she has. Draw Jane’s income-consumption curve and her Engel curve for ballet tickets.
4. a. Orange juice and apple juice are known to be perfect substitutes. Draw the appropriate price-consumption curve (for a variable price of orange juice) and income- consumption curve.
b. Left shoes and right shoes are perfect complements. Draw the appropriate price consumption and income-consumption curves.
5. Each week, Bill, Mary, and Jane select the quantity of two goods, X1 and X2, that they will consume in order to maximize their respective utilities. They each spend their entire weekly income on these two goods.
a. Suppose you are given the following information about the choices that Bill makes over a three-week period:
x1 x2 P1 P2 I
Week 1 10 20 2 1 40
Week 2 7 19 3 1 40
Week 3 8 31 3 1 55
Did Bill’s utility increase or decrease between week 1 and week 2? Between week 1 and week 3? Explain using a graph to support your answer.
b. Now consider the following information about the choices that Mary makes:
x1 x2 P1 P2 I
Week 1 10 20 2 1 40
Week 2 6 14 2 2 40
Week 3 20 10 2 2 60
Did Mary’s utility increase or decrease between week 1 and week 3? Does Mary consider both goods to be normal goods? Explain.
c. Finally, examine the following information about Jane’s choices:
x1 x2 P1 P2 I
Week 1 12 24 2 1 48
Week 2 16 32 1 1 48
Week 3 12 24 1 1 36

Draw a budget line-indifference curve graph that illustrates Jane’s three chosen bundles. What can you say about Jane’s preferences in this case? Identify the income and substitution effects that result from a change in the price of good X1.
6. Two individuals, Sam and Barb, derive utility from the hours of leisure (L) they consume and from the amount of goods (G) they consume. In order to maximize utility, they need to allocate the 24 hours in the day between leisure hours and work hours. Assume that all hours not spent working are leisure hours. The price of a good is equal to $1 and the price of leisure is equal to the hourly wage. We observe the following information about the choices that the two individuals make:
Sam Barb Sam Barb
Price of G Price of L L (hours) L (hours) G ($) G ($)
1 8 16 14 64 80
1 9 15 14 81 90
1 10 14 15 100 90
1 11 14 16 110 88

Graphically illustrate Sam’s leisure demand curve and Barb’s leisure demand curve. Place price on the vertical axis and leisure on the horizontal axis. Given that they both maximize utility, how can you explain the difference in their leisure demand curves?
7. The director of a theater company in a small college town is considering changing the way he prices tickets. He has hired an economic consulting firm to estimate the demand for tickets. The firm has classified people who go the theater into two groups, and has come up with two demand functions. The demand curves for the general public ( Qgp ) and students ( Qs ) are given below:
Qgp = 500 − 5P Qs = 200 − 4 P
a. Graph the two demand curves on one graph, with P on the vertical axis and Q on the horizontal axis. If the current price of tickets is $35, identify the quantity demanded by each group.
b. Find the price elasticity of demand for each group at the current price and quantity.
c. Is the director maximizing the revenue he collects from ticket sales by charging $35 for each ticket? Explain.
d. What price should he charge each group if he wants to maximize revenue collected from ticket sales?
8. Judy has decided to allocate exactly $500 to college textbooks every year, even though she knows that the prices are likely to increase by 5 to 10 percent per year and that she will be getting a substantial monetary gift from her grandparents next year. What is Judy’s price elasticity of demand for textbooks? Income elasticity?
9. The ACME Corporation determines that at current prices the demand for its computer chips has a price elasticity of –2 in the short run, while the price elasticity for its disk drives is –1.
a. If the corporation decides to raise the price of both products by 10 percent, what will happen to its sales? To its sales revenue?
b. Can you tell from the available information which product will generate the most revenue? If yes, why? If not, what additional information do you need?
10. By observing an individual’s behavior in the situations outlined below, determine the relevant income elasticities of demand for each good (i.e., whether the good is normal or inferior). If you cannot determine the income elasticity, what additional information do you need?
a. Bill spends all his income on books and coffee. He finds $20 while rummaging through a used paperback bin at the bookstore. He immediately buys a new hardcover book of poetry.
b. Bill loses $10 he was going to use to buy a double espresso. He decides to sell his new book at a discount to a friend and use the money to buy coffee.
c. Being bohemian becomes the latest teen fad. As a result, coffee and book prices rise by 25 percent. Bill lowers his consumption of both goods by the same percentage.
d. Bill drops out of art school and gets an M.B.A. instead. He stops reading books and drinking coffee. Now he reads The Wall Street Journal and drinks bottled mineral water.

CHAPTER 5: UNCERTAINTY AND CONSUMER BEHAVIOR
1. What does it mean to say that a person is risk averse? Why are some people likely to be risk averse while others are risk lovers?
2. Why is the variance a better measure of variability than the range?
3. George has $5000 to invest in a mutual fund. The expected return on mutual fund A is 15 percent and the expected return on mutual fund B is 10 percent. Should George pick mutual fund A or fund B?
4. What does it mean for consumers to maximize expected utility? Can you think of a case in which a person might not maximize expected utility?
5. Why do people often want to insure fully against uncertain situations even when the premium paid exceeds the expected value of the loss being insured against?
6. Why is an insurance company likely to behave as if it were risk neutral even if its managers are risk-averse individuals?
7. When is it worth paying to obtain more information to reduce uncertainty?
8. How does the diversification of an investor’s portfolio avoid risk?
9. Why do some investors put a large portion of their portfolios into risky asset, while others invest largely in risk-free alternatives? (Hint: Do the two investors receive exactly the same return on average? If so, why?)
10. What is an endowment effect? Give an example of such an effect.
11. Jennifer is shopping and sees an attractive shirt. However, the price of $50 is more than she is willing to pay. A few weeks later, she finds the same shirt on sale for $25 and buys it. When a friend offers her $50 for the shirt, she refuses to sell it. Explain Jennifer’s behavior.
EXERCISES
1. Consider a lottery with three possible outcomes:
• $125 will be received with probability .2
• $100 will be received with probability .3
• $50 will be received with probability .5
a. What is the expected value of the lottery?
b. What is the variance of the outcomes?
c. What would a risk-neutral person pay to play the lottery?
2. Suppose you have invested in a new computer company whose profitability depends on two factors: (1) whether the U.S. Congress passes a tariff raising the cost of Japanese computers and (2) whether the U.S. economy grows slowly or quickly. What are the four mutually exclusive states of the world that you should be concerned about?
3. Richard is deciding whether to buy a state lottery ticket. Each ticket costs $1, and the probability of winning payoffs is given as follows:
Probability Return
0.50 $0.00
0.25 $1.00
0.20 $2.00
0.05 $7.50
a. What is the expected value of Richard’s payoff if he buys a lottery ticket? What is the variance?
b. Richard’s nickname is “No-Risk Rick” because he is an extremely risk-averse individual. Would he buy the ticket?
c. Richard has been given 1000 lottery tickets. Discuss how you would determine the smallest amount for which he would be willing to sell all 1000 tickets.
d. In the long run, given the price of the lottery tickets and the probability/return table, what do you think the state would do about the lottery?
4. Suppose an investor is concerned about a business choice in which there are three prospects – the probability and returns are given below:
What is the expected value of the uncertain investment? What is the variance?
5. You are an insurance agent who must write a policy for a new client named Sam. His company, Society for Creative Alternatives to Mayonnaise (SCAM), is working on a low-fat, low-cholesterol mayonnaise substitute for the sandwich-condiment industry. The sandwich industry will pay top dollar to the first inventor to patent such a mayonnaise substitute. Sam’s SCAM seems like a very risky proposition to you. You have calculated his possible returns table as follows:
a. What is the expected return of Sam’s project? What is the variance?
b. What is the most that Sam is willing to pay for insurance? Assume Sam is risk neutral.
c. Suppose you found out that the Japanese are on the verge of introducing their own mayonnaise substitute next month. Sam does not know this and has just turned down your final offer of $1000 for the insurance. Assume that Sam tells you SCAM is only six months away from perfecting its mayonnaise substitute and that you know what you know about the Japanese. Would you raise or lower your policy premium on any subsequent proposal to Sam? Based on his information, would Sam accept?
6. Suppose that Natasha’s utility function is given by u( I ) = 10I , where I represents annual income in thousands of dollars.
a. Is Natasha risk loving, risk neutral, or risk averse? Explain.
b. Suppose that Natasha is currently earning an income of $40,000 (I = 40) and can earn that income next year with certainty. She is offered a chance to take a new job that offers a .6 probability of earning $44,000 and a .4 probability of earning $33,000. Should she take the new job?
c. In (b), would Natasha be willing to buy insurance to protect against the variable income associated with the new job? If so, how much would she be willing to pay for that insurance? (Hint: What is the risk premium?)
7. Suppose that two investments have the same three payoffs, but the probability associated with each payoff differs, as illustrated in the table below:
a. Find the expected return and standard deviation of each investment.
b. Jill has the utility function U = 5I , where I denotes the payoff. Which investment will she choose?
c. Ken has the utility function U = 5 I . Which investment will he choose?
d. Laura has the utility function U = 5I 2 . Which investment will she choose?
8. As the owner of a family farm whose wealth is $250,000, you must choose between sitting this season out and investing last year’s earnings ($200,000) in a safe money market fund paying 5.0 percent or planting summer corn. Planting costs $200,000, with a six-month time to harvest. If there is rain, planting summer corn will yield $500,000 in revenues at harvest. If there is a drought, planting will yield $50,000 in revenues. As a third choice, you can purchase AgriCorp drought-resistant summer corn at a cost of $250,000 that will yield $500,000 in revenues at harvest if there is rain, and $350,000 in revenues if there is a drought. You are risk averse, and your preference for family wealth (W) is specified by the relationship U(W ) = W . The probability of a summer drought is 0.30, while the probability of summer rain is 0.70. Which of the three options should you choose? Explain.
9. Draw a utility function over income u(I) that describes a man who is a risk lover when his income is low but risk averse when his income is high. Can you explain why such a utility function might reasonably describe a person’s preferences?
10. A city is considering how much to spend to hire people to monitor its parking meters. The following information is available to the city manager:
• Hiring each meter monitor costs $10,000 per year.
• With one monitoring person hired, the probability of a driver getting a ticket each time he or she parks illegally is equal to .25.
• With two monitors, the probability of getting a ticket is .5; with three monitors, the probability is .75; and with four, it’s equal to 1.
• With two monitors hired, the current fine for overtime parking is $20.
a. Assume first that all drivers are risk neutral. What parking fine would you levy, and how many meter monitors would you hire (1, 2, 3, or 4) to achieve the current level of deterrence against illegal parking at the minimum cost?
b. Now assume that drivers are highly risk averse. How would your answer to (a) change?
c. (For discussion) What if drivers could insure themselves against the risk of parking fines? Would it make good public policy to permit such insurance?

CHAPTER 6: PRODUCTION
1. What is a production function? How does a long-run production function differ from a short-run production function?
2. Why is the marginal product of labor likely to increase initially in the short run as more of the variable input is hired?
3. Why does production eventually experience diminishing marginal returns to labor in the short run?
4. You are an employer seeking to fill a vacant position on an assembly line. Are you more concerned with the average product of labor or the marginal product of labor for the last person hired? If you observe that your average product is just beginning to decline, should you hire any more workers? What does this situation imply about the marginal product of your last worker hired?
5. What is the difference between a production function and an isoquant?
6. Faced with constantly changing conditions, why would a firm ever keep any factors fixed? What criteria determine whether a factor is fixed or variable?
7. Isoquants can be convex, linear, or L-shaped. What does each of these shapes tell you about the nature of the production function? What does each of these shapes tell you about the MRTS?
8. Can an isoquant ever slope upward? Explain.
9. Explain the term “marginal rate of technical substitution.” What does a MRTS = 4 mean?
10. Explain why the marginal rate of technical substitution is likely to diminish as more and more labor is substituted for capital.
EXERCISES
1. The menu at Joe’s coffee shop consists of a variety of coffee drinks, pastries, and sandwiches. The marginal product of an additional worker can be defined as the number of customers that can be served by that worker in a given time period. Joe has been employing one worker, but is considering hiring a second and a third. Explain why the marginal product of the second and third workers might be higher than the first. Why might you expect the marginal product of additional workers to diminish eventually?
2. Suppose a chair manufacturer is producing in the short run (with its existing plant and equipment). The manufacturer has observed the following levels of production corresponding to different numbers of workers:
Number of chairs Number of workers
1 10
2 18
3 24
4 28
5 30
6 28
7 25
a. Calculate the marginal and average product of labor for this production function.
b. Does this production function exhibit diminishing returns to labor? Explain.
c. Explain intuitively what might cause the marginal product of labor to become negative.
3. Fill in the gaps in the table below.
4. A political campaign manager must decide whether to emphasize television advertisements or letters to potential voters in a reelection campaign. Describe the production function for campaign votes. How might information about this function (such as the shape of the isoquants) help the campaign manager to plan strategy?
5. For each of the following examples, draw a representative isoquant. What can you say about the marginal rate of technical substitution in each case?
a. A firm can hire only full-time employees to produce its output, or it can hire some combination of full-time and part-time employees. For each full-time worker let go, the firm must hire an increasing number of temporary employees to maintain the same level of output.
b. A firm finds that it can always trade two units of labor for one unit of capital and still keep output constant.
c. A firm requires exactly two full-time workers to operate each piece of machinery in the factory
6. A firm has a production process in which the inputs to production are perfectly substitutable in the long run. Can you tell whether the marginal rate of technical substitution is high or low, or is further information necessary? Discuss.
7. The marginal product of labor in the production of computer chips is 50 chips per hour. The marginal rate of technical substitution of hours of labor for hours of machine capital is 1/4. What is the marginal product of capital?
8. Do the following functions exhibit increasing, constant, or decreasing returns to scale? What happens to the marginal product of each individual factor as that factor is increased and the other factor held constant?

a. q = 3L + 2K
b. q = (2L + 2K ) 2
c. q = 3LK 2
1 1
d. q = L2 K 2

1
e. q = 4L2 + 4 K

9. The production function for the personal computers of DISK, Inc., is given by q = 10K0.5L0.5, where q is the number of computers produced per day, K is hours of machine time, and L is hours of labor input. DISK’s competitor, FLOPPY, Inc., is using the production function q = 10K0.6L0.4.
a. If both companies use the same amounts of capital and labor, which will generate more output?
b. Assume that capital is limited to 9 machine hours, but labor is unlimited in supply. In which company is the marginal product of labor greater? Explain.
10. In Example 6.3, wheat is produced according to the production function q = 100(K0.8L0.2).
a. Beginning with a capital input of 4 and a labor input of 49, show that the marginal product of labor and the marginal product of capital are both decreasing.
b. Does this production function exhibit increasing, decreasing, or constant returns to scale?

CHAPTER 7: THE COST OF PRODUCTION
1. A firm pays its accountant an annual retainer of $10,000. Is this an economic cost?
2. The owner of a small retail store does her own accounting work. How would you measure the opportunity cost of her work?
3. Please explain whether the following statements are true or false.
a. If the owner of a business pays himself no salary, then the accounting cost is zero, but the economic cost is positive.
b. A firm that has positive accounting profit does not necessarily have positive economic profit.
c. If a firm hires a currently unemployed worker, the opportunity cost of utilizing the worker’s services is zero.
4. Suppose that labor is the only variable input to the production process. If the marginal cost of production is diminishing as more units of output are produced, what can you say about the marginal product of labor (the variable input)?
5. Suppose a chair manufacturer finds that the marginal rate of technical substitution of capital for labor in her production process is substantially greater than the ratio of the rental rate on machinery to the wage rate for assembly-line labor. How should she alter her use of capital and labor to minimize the cost of production?
6. Why are isocost lines straight lines?
7. Assume that the marginal cost of production is increasing. Can you determine whether the average variable cost is increasing or decreasing? Explain.
8. Assume that the marginal cost of production is greater than the average variable cost. Can you determine whether the average variable cost is increasing or decreasing? Explain.
9. If the firm’s average cost curves are U-shaped, why does its average variable cost curve achieve its minimum at a lower level of output than the average total cost curve?
10. If a firm enjoys economies of scale up to a certain output level, and cost then increases proportionately with output, what can you say about the shape of the long-run average cost curve?
EXERCISES
1. Joe quits his computer programming job, where he was earning a salary of $50,000 per year, to start . He opens his own computer software business store in a building that he owns and was previously renting out for $24,000 per year. In his first year of business he has the following expenses: mortgage $18,000, salary paid to himself, $40,000; rent, $0; other expenses, $25,000. Find the accounting cost and the economic cost associated with Joe’s computer software business.
2. a. Fill in the blanks in the table on page 262 of the textbook.
b. Draw a graph that shows marginal cost, average variable cost, and average total cost, with cost on the vertical axis and quantity on the horizontal axis.
3. A firm has a fixed production costs of $5,000 and a constant marginal cost of production of equal to $500 per unit produced.
a. What is the firm’s total cost function? Average cost?
b. If the firm wanted to minimize the average total cost, would it choose to be very large or very small? Explain.
4. Suppose a firm must pay an annual tax, which is a fixed sum, independent of whether it produces any output.
a. How does this tax affect the firm’s fixed, marginal, and average costs?
b. Now suppose the firm is charged a tax that is proportional to the number of items it produces. Again, how does this tax affect the firm’s fixed, marginal, and average costs?
5. A recent issue of Business Week reported the following:
During the recent auto sales slump, GM, Ford, and Chrysler decided it was cheaper to sell cars to rental companies at a loss than to lay off workers. That’s because closing and reopening plants is expensive, partly because the auto makers’ current union contracts obligate them to pay many workers even if they’re not working.
When the article discusses selling cars “at a loss,” is it referring to accounting profit or economic profit? How will the two differ in this case? Explain briefly.
6. Suppose the economy takes a downturn, and that labor costs fall by 50 percent and are expected to stay at that level for a long time. Show graphically how this change in the relative price of labor and capital affects the firm’s expansion path.
7. The cost of flying a passenger plane from point A to point B is $50,000. The airline flies this route four times per day at 7 AM, 10 AM, 1 PM, and 4 PM. The first and last flights are fulfilled l to capacity with 240 people. The second and third flights are only half full. Find the average cost per passenger for each flight. Suppose the airline hires you as a marketing consultant and wants to know which type of customer it should try to attract ! the off-peak customer (the middle two flights) or the rush-hour customer (the first and last flights). What advice would you offer?
8. You manage a plant that mass-produces engines by teams of workers using assembly machines. The technology is summarized by the production function q = 5 KL where q is the number of engines per week, K is the number of assembly machines, and L is the number of labor teams. Each assembly machine rents for r = $10,000 per week, and each team costs w = $5000 per week. Engine costs are given by the cost of labor teams and machines, plus $2000 per engine for raw materials. Your plant has a fixed installation of 5 assembly machines as part of its design.
a. What is the cost function for your plant — namely, how much would it cost to produce q engines? What are average and marginal costs for producing q engines? How do average costs vary with output?
b. How many teams are required to produce 250 engines? What is the average cost per engine?
c. You are asked to make recommendations for the design of a new production facility. What capital/labor (K/L) ratio should the new plant accommodate if it wants to minimize the total cost of producing at any level of output q?
9. The short-run cost function of a company is given by the equation TC = 200 + 55q, where TC is the total cost and q is the total quantity of output, both measured in thousands.
a. What is the company’s fixed cost?
b. If the company produced 100,000 units of goods, what would be its average variable cost?
c. What would be its marginal cost of production?
d. What would be its average fixed cost?
e. Suppose the company borrows money and expands its factory. Its fixed cost rises by $50,000, but its variable cost falls to $45,000 per 1000 units. The cost of interest (i) also enters into the equation. Each 1-point increase in the interest rate raises costs by $3,000. Write the new cost equation.
10. A chair manufacturer hires its assembly-line labor for $30 an hour and calculates that the rental cost of its machinery is $15 per hour. Suppose that a chair can be produced using 4 hours of labor or machinery in any combination. If the firm is currently using 3 hours of labor for each hour of machine time, is it minimizing its costs of production? If so, why? If not, how can it improve the situation? Graphically illustrate the isoquant and the two isocost lines for the current combination of labor and capital and for the optimal combination of labor and capital.

CHAPTER 8: PROFIT MAXIMIZATION AND COMPETITIVE SUPPLY
1. Why would a firm that incurs losses choose to produce rather than shut down?
2. Explain why the industry supply curve is not the long-run industry marginal cost curve.
3. In long-run equilibrium, all firms in the industry earn zero economic profit. Why is this true?
4. What is the difference between economic profit and producer surplus?
5. Why do firms enter an industry when they know that in the long run economic profit will be zero?
6. At the beginning of the twentieth century, there were many small American automobile manufacturers. At the end of the century, there were only three large ones. Suppose that this situation is not the result of lax federal enforcement of antimonopoly laws. How do you explain the decrease in the number of manufacturers? (Hint: What is the inherent cost structure of the automobile industry?)
7. Because industry X is characterized by perfect competition, every firm in the industry is earning zero economic profit. If the product price falls, no firms can survive. Do you agree or disagree? Discuss.
8. An increase in the demand for video films also increases the salaries of actors and actresses. Is the long-run supply curve for films likely to be horizontal or upward sloping? Explain.
9. True or false: A firm should always produce at an output at which long-run average cost is minimized. Explain.
10. Can there be constant returns to scale in an industry with an upward-sloping supply curve? Explain.
EXERCISES
1. The data in the table on page 307 give information about the price (in dollars) for which a firm can sell a unit of output and the total cost of production.
a. Fill in the blanks in the table.
b. Show what happens to the firm’s output choice and profit if the price of the product falls from $60 to $50.
2. Using the data in the table, show what happens to the firm’s output choice and profit if the fixed cost of production increases from $100 to $150 and then to $200. Assume that the price of the output remains at $60 per unit. What general conclusion can you reach about the effects of fixed costs on the firm’s output choice?
3. Use the same information as in Exercise 1.
a. Derive the firm’s short-run supply curve. (Hint: you may want to plot the appropriate cost curves.)
b. If 100 identical firms are in the market, what is the industry supply curve?
4. Suppose you are the manager of a watchmaking firm operating in a competitive market. Your cost of production is given by C = 200 + 2q2, where q is the level of output and C is total cost. (The marginal cost of production is 4q; the fixed cost is $200.)
a. If the price of watches is $100, how many watches should you produce to maximize profit?
b. What will the profit level be?
c. At what minimum price will the firm produce a positive output?
5. Suppose that a competitive firm’s marginal cost of producing output q is given by MC(q) = 3 + 2q. Assume that the market price of the firm’s product is $9.
a. What level of output will the firm produce?
b. What is the firm’s producer surplus?
c. Suppose that the average variable cost of the firm is given by AVC(q) = 3 + q. Suppose that the firm’s fixed costs are known to be $3. Will the firm be earning a positive, negative, or zero profit in the short run?
6. A firm produces a product in a competitive industry and has a total cost function C = 50 + 4q + 2q2 and a marginal cost function MC = 4 + 4q. At the given market price of $20, the firm is producing 5 units of output. Is the firm maximizing its profit? What quantity of output should the firm produce in the long run?
7. Suppose the same firm’s cost function is C(q) = 4q2 + 16.
a. Find variable cost, fixed cost, average cost, average variable cost, and average fixed cost. (Hint: Marginal cost is given by MC = 8q.)
b. Show the average cost, marginal cost, and average variable cost curves on a graph.
c. Find the output that minimizes average cost
d. At what range of prices will the firm produce a positive output?
e. At what range of prices will the firm earn a negative profit?
f. At what range of prices will the firm earn a positive profit?
8. A competitive firm has the following short-run cost function:
a. Find MC, AC, and AVC and sketch them on a graph.
b. At what range of prices will the firm supply zero output?
b. At what range of prices will the firm supply zero output?
d. At what price would the firm supply exactly 6 units of output?
9. a. Suppose that a firm’s production function is q = 9 x 2 in the short run, where there are fixed costs of $1000, and x is the variable input whose cost is $4000 per unit. What is the total cost of producing a level of output q? In other words, identify the total cost function C(q).
b. Write down the equation for the supply curve.
c. If price is $1000, how many units will the firm produce? What is the level of profit?
Illustrate on a cost curve graph.
10. Suppose that a competitive firm has a total cost function C(q) = 450 + 15q + 2q2 and a marginal cost function MC(q) = 15 + 4 q . If the market price is P = $115 per unit, find the level of output produced by the firm. Find the level of profit and the level of producer surplus.

CHAPTER 9: THE ANALYSIS OF COMPETITIVE MARKETS
1. What is meant by deadweight loss? Why does a price ceiling usually result in a deadweight loss?
2. Suppose the supply curve for a good is completely inelastic. If the government imposed a price ceiling below the market-clearing level, would a deadweight loss result? Explain.
3. How can a price ceiling make consumers better off? Under what conditions might it make them worse off?
4. Suppose the government regulates the price of a good to be no lower than some minimum level. Can such a minimum price make producers as a whole worse off? Explain.
5. How are production limits used in practice to raise the prices of the following goods or services: (a) taxi rides, (b) drinks in a restaurant or bar, (c) wheat or corn?
6. Suppose the government wants to increase farmers’ incomes. Why do price supports or acreage-limitation programs cost society more than simply giving farmers money?
7. Suppose the government wants to limit imports of a certain good. Is it preferable to use an import quota or a tariff? Why?
8. The burden of a tax is shared by producers and consumers. Under what conditions will consumers pay most of the tax? Under what conditions will producers pay most of it? What determines the share of a subsidy that benefits consumers?
9. Why does a tax create a deadweight loss? What determines the size of this loss?
EXERCISES
1. In 1996, Congress raised the minimum wage from $4.25 per hour to $5.15 per hour, and then raised it again in 2007. (See Example 1.3 [page 13].) Some people suggested that a government subsidy could help employers finance the higher wage. This exercise examines the economics of a minimum wage and wage subsidies. Suppose the supply of low-skilled labor is given by LS = 10w, where LS is the quantity of low-skilled labor (in millions of persons employed each year), and w is the wage rate (in dollars per hour). The demand for labor is given by LD = 80 – 10w.
a. What will be the free-market wage rate and employment level? Suppose the government sets a minimum wage of $5 per hour. How many people would then be employed?
b. Suppose that instead of a minimum wage, the government pays a subsidy of $1 per hour for each employee. What will the total level of employment be now? What will the equilibrium wage rate be?
3. Japanese rice producers have extremely high production costs, due in part to the high opportunity cost of land and to their inability to take advantage of economies of large-scale production. Analyze two policies intended to maintain Japanese rice production: (1) a per- pound subsidy to farmers for each pound of rice produced, or (2) a per-pound tariff on imported rice. Illustrate with supply-and-demand diagrams the equilibrium price and quantity, domestic rice production, government revenue or deficit, and deadweight loss from each policy. Which policy is the Japanese government likely to prefer? Which policy are Japanese farmers likely to prefer?
4. In 1983, the Reagan Administration introduced a new agricultural program called the Payment-in-Kind Program. To see how the program worked, let’s consider the wheat market.
a. Suppose the demand function is QD = 28 – 2P and the supply function is QS = 4 + 4P, where P is the price of wheat in dollars per bushel, and Q is the quantity in billions of bushels. Find the free-market equilibrium price and quantity.
b. Now suppose the government wants to lower the supply of wheat by 25 percent from the free-market equilibrium by paying farmers to withdraw land from production. However, the payment is made in wheat rather than in dollars – hence the name of the program. The wheat comes from vast government reserves accumulated from previous price support programs. The amount of wheat paid is equal to the amount that could have been harvested on the land withdrawn from production. Farmers are free to sell this wheat on the market. How much is now produced by farmers? How much is indirectly supplied to the market by the government? What is the new market price? How much do farmers gain? Do consumers gain or lose?
c. Had the government not given the wheat back to the farmers, it would have stored or destroyed it. Do taxpayers gain from the program? What potential problems does the program create?
5. About 100 million pounds of jelly beans are consumed in the United States each year, and the price has been about 50 cents per pound. However, jelly bean producers feel that their incomes are too low and have convinced the government that price supports are in order. The government will therefore buy up as many jelly beans as necessary to keep the price at $1 per pound. However, government economists are worried about the impact of this program because they have no estimates of the elasticities of jelly bean demand or supply.
a. Could this program cost the government more than $50 million per year? Under what conditions? Could it cost less than $50 million per year? Under what conditions? Illustrate with a diagram.
b. Could this program cost consumers (in terms of lost consumer surplus) more than $50 million per year? Under what conditions? Could it cost consumers less than $50 million per year? Under what conditions? Again, use a diagram to illustrate.
6. In Exercise 4 in Chapter 2 (page 62), we examined a vegetable fiber traded in a competitive world market and imported into the United States at a world price of $9 per pound. U.S. domestic supply and demand for various price levels are shown in the following table.
Price U.S. Supply
(million pounds) U.S. Demand
(million pounds)
3 2 34
6 4 28
9 6 22
12 8 16
15 10 10
18 12 4

Answer the following questions about the U.S. market:
a. Confirm that the demand curve is given by QD = 40 − 2P , and that the supply curve 2 is given by QS = 3 P .
b. Confirm that if there were no restrictions on trade, the United States would import 16 million pounds.
c. If the United States imposes a tariff of $3 per pound, what will be the U.S. price and level of imports? How much revenue will the government earn from the tariff? How large is the deadweight loss?
d. If the United States has no tariff but imposes an import quota of 8 million pounds, what will be the U.S. domestic price? What is the cost of this quota for U.S. consumers of the fiber? What is the gain for U.S. producers?
7. The United States currently imports all of its coffee. The annual demand for coffee by U.S. consumers is given by the demand curve Q = 250 – 10P, where Q is quantity (in millions of pounds) and P is the market price per pound of coffee. World producers can harvest and ship coffee to U.S. distributors at a constant marginal (= average) cost of $8 per pound. U.S. distributors can in turn distribute coffee for a constant $2 per pound. The U.S. coffee market is competitive. Congress is considering a tariff on coffee imports of $2 per pound.
a. If there is no tariff, how much do consumers pay for a pound of coffee? What is the quantity demanded?
b. If the tariff is imposed, how much will consumers pay for a pound of coffee? What is the quantity demanded?
c. Calculate the lost consumer surplus.
d. Calculate the tax revenue collected by the government.
e. Does the tariff result in a net gain or a net loss to society as a whole?
8. A particular metal is traded in a highly competitive world market at a world price of $9 per ounce. Unlimited quantities are available for import into the United States at this price. The supply of this metal from domestic U.S. mines and mills can be represented by the equation QS = 2/3P, where QS is U.S. output in million ounces and P is the domestic price. The demand for the metal in the United States is QD = 40 – 2P, where QD is the domestic demand in million ounces.
In recent years the U.S. industry has been protected by a tariff of $9 per ounce. Under pressure from other foreign governments, the United States plans to reduce this tariff to zero. Threatened by this change, the U.S. industry is seeking a voluntary restraint agreement that would limit imports into the United States to 8 million ounces per year.
a. Under the $9 tariff, what was the U.S. domestic price of the metal?
b. If the United States eliminates the tariff and the voluntary restraint agreement is approved, what will be the U.S. domestic price of the metal?
9. Among the tax proposals regularly considered by Congress is an additional tax on distilled liquors. The tax would not apply to beer. The price elasticity of supply of liquor is 4.0, and the price elasticity of demand is –0.2. The cross-elasticity of demand for beer with respect to the price of liquor is 0.1.
a. If the new tax is imposed, who will bear the greater burden – liquor suppliers or liquor consumers? Why?
b. Assuming that beer supply is infinitely elastic, how will the new tax affect the beer market?
10. In Example 9.1 (page 314), we calculated the gains and losses from price controls on natural gas and found that there was a deadweight loss of $5.68 billion. This calculation was based on a price of oil of $50 per barrel.
a. If the price of oil were $60 per barrel, what would be the free-market price of gas? How large a deadweight loss would result if the maximum allowable price of natural gas were $3.00 per thousand cubic feet?
b. What price of oil would yield a free-market price of natural gas of $3?

CHAPTER 10: MARKET POWER: MONOPOLY AND MONOPSONY
1. A monopolist is producing at a point at which marginal cost exceeds marginal revenue. How should it adjust its output to increase profit?
2. We write the percentage markup of prices over marginal cost as (P – MC)/P. For a profit- maximizing monopolist, how does this markup depend on the elasticity of demand? Why can this markup be viewed as a measure of monopoly power?
3. Why is there no market supply curve under conditions of monopoly?
4. Why might a firm have monopoly power even if it is not the only producer in the market?
5. What are some of the different types of barriers to entry that give rise to monopoly power? Give an example of each.
6. What factors determine the amount of monopoly power an individual firm is likely to have? Explain each one briefly.
7. Why is there a social cost to monopoly power? If the gains to producers from monopoly power could be redistributed to consumers, would the social cost of monopoly power be eliminated? Explain briefly.
8. Why will a monopolist’s output increase if the government forces it to lower its price? If the government wants to set a price ceiling that maximizes the monopolist’s output, what price should it set?
9. How should a monopsonist decide how much of a product to buy? Will it buy more or less than a competitive buyer? Explain briefly.
10. What is meant by the term “monopsony power”? Why might a firm have monopsony power even if it is not the only buyer in the market?
EXERCISES
1. Will an increase in the demand for a monopolist’s product always result in a higher price? Explain. Will an increase in the supply facing a monopsonist buyer always result in a lower price? Explain.
2. Caterpillar Tractor, one of the largest producers of farm machinery in the world, has hired you to advise it on pricing policy. One of the things the company would like to know is how much a 5-percent increase in price is likely to reduce sales. What would you need to know to help the company with this problem? Explain why these facts are important.
3. A monopolist firm faces a demand with constant elasticity of –2.0. It has a constant marginal cost of $20 per unit and sets a price to maximize profit. If marginal cost should increase by 25 percent, would the price charged also rise by 25 percent?
4. A firm faces the following average revenue (demand) curve: P = 120 – 0.02Q
where Q is weekly production and P is price, measured in cents per unit. The firm’s cost function is given by C = 60Q + 25,000. Assume that the firm maximizes profits.
a. What is the level of production, price, and total profit per week?
b. If the government decides to levy a tax of 14 cents per unit on this product, what will be the new level of production, price, and profit?
5. The following table shows the demand curve facing a monopolist who produces at a constant marginal cost of $10:
Price Quantity
18 0
16 4
14 8
12 12
10 16
8 20
6 24
4 28
2 32
0 36
a. Calculate the firm’s marginal revenue curve.
b. What are the firm’s profit-maximizing output and price? What is its profit?
c. What would the equilibrium price and quantity be in a competitive industry?
d. What would the social gain be if this monopolist were forced to produce and price at the competitive equilibrium? Who would gain and lose as a result?
6. Suppose that an industry is characterized as follows:
C = 100 + 2q2 each firm’s total cost function
MC = 4q firm’s marginal cost function
P = 90 – 2Q industry demand curve
MR = 90 – 4Q industry marginal revenue curve

a. If there is only one firm in the industry, find the monopoly price, quantity, and level of profit.
b. Find the price, quantity, and level of profit if the industry is competitive.
c. Graphically illustrate the demand curve, marginal revenue curve, marginal cost curve, and average cost curve. Identify the difference between the profit level of the monopoly and the profit level of the competitive industry in two different ways. Verify that the two are numerically equivalent.
7. Suppose a profit-maximizing monopolist is producing 800 units of output and is charging a price of $40 per unit.
a. If the elasticity of demand for the product is –2, find the marginal cost of the last unit produced.
b. What is the firm’s percentage markup of price over marginal cost?
c. Suppose that the average cost of the last unit produced is $15 and the firm’s fixed cost is $2000. Find the firm’s profit.
9. A drug company has a monopoly on a new patented medicine. The product can be made in either of two plants. The costs of production for the two plants are MC1 = 20 + 2Q1 and MC2 = 10 + 5Q2. The firm’s estimate of demand for the product is P = 20 – 3(Q1 + Q2). How much should the firm plan to produce in each plant? At what price should it plan to sell the product?
10. One of the more important antitrust cases of the 20th century involved the Aluminum Company of America (Alcoa) in 1945. At that time, Alcoa controlled about 90 percent of primary aluminum production in the United States, and the company had been accused of monopolizing the aluminum market. In its defense, Alcoa argued that although it indeed controlled a large fraction of the primary market, secondary aluminum (i.e., aluminum produced from the recycling of scrap) accounted for roughly 30 percent of the total supply of aluminum and that many competitive firms were engaged in recycling. Therefore, Alcoa argued, it did not have much monopoly power.
a. Provide a clear argument in favor of Alcoa’s position.
b. Provide a clear argument against Alcoa’s position.
c. The 1945 decision by Judge Learned Hand has been called “one of the most celebrated judicial opinions of our time.” Do you know what Judge Hand’s ruling was?

CHAPTER 11: PRICING WITH MARKET POWER
1. Suppose a firm can practice perfect, first-degree price discrimination. What is the lowest price it will charge, and what will its total output be?
2. How does a car salesperson practice price discrimination? How does the ability to discriminate correctly affect his or her earnings?
3. Electric utilities often practice second-degree price discrimination. Why might this improve consumer welfare?
4. Give some examples of third-degree price discrimination. Can third-degree price discrimination be effective if the different groups of consumers have different levels of demand but the same price elasticities?
5. Show why optimal, third-degree price discrimination requires that marginal revenue for each group of consumers equals marginal cost. Use this condition to explain how a firm should change its prices and total output if the demand curve for one group of consumers shifts outward, causing marginal revenue for that group to increase.
6. When pricing automobiles, American car companies typically charge a much higher percentage markup over cost for “luxury option” items (such as leather trim, etc.) than for the car itself or for more “basic” options such as power steering and automatic transmission. Explain why.
7. How is peak-load pricing a form of price discrimination? Can it make consumers better off? Give an example.
8. How can a firm determine an optimal two-part tariff if it has two customers with different demand curves? (Assume that it knows the demand curves.)
9. Why is the pricing of a Gillette safety razor a form of two-part tariff? Must Gillette be a monopoly producer of its blades as well as its razors? Suppose you were advising Gillette on how to determine the two parts of the tariff. What procedure would you suggest?
10. In the town of Woodland, California, there are many dentists but only one eye doctor. Are senior citizens more likely to be offered discount prices for dental exams or for eye exams? Why?
EXERCISES
1. Price discrimination requires the ability to sort customers and the ability to prevent arbitrage. Explain how the following can function as price discrimination schemes and discuss both sorting and arbitrage:
a. Requiring airline travelers to spend at least one Saturday night away from home to qualify for a low fare.
b. Insisting on delivering cement to buyers and basing prices on buyers’ locations.
c. Selling food processors along with coupons that can be sent to the manufacturer for a $10 rebate.
d. Offering temporary price cuts on bathroom tissue.
e. Charging high-income patients more than low-income patients for plastic surgery.
2. If the demand for drive-in movies is more elastic for couples than for single individuals, it will be optimal for theaters to charge one admission fee for the driver of the car and an extra fee for passengers. True or false? Explain.
3. In Example 11.1 (page 400), we saw how producers of processed foods and related consumer goods use coupons as a means of price discrimination. Although coupons are widely used in the United States, that is not the case in other countries. In Germany, coupons are illegal.
a. Does prohibiting the use of coupons in Germany make German consumers better off or worse off?
b. Does prohibiting the use of coupons make German producers better off or worse off?
4. Suppose that BMW can produce any quantity of cars at a constant marginal cost equal to
$20,000 and a fixed cost of $10 billion. You are asked to advise the CEO as to what prices and quantities BMW should set for sales in Europe and in the United States. The demand for BMWs in each market is given by:
QE = 4,000,000 – 100 PE and QU = 1,000,000 – 20PU
where the subscript E denotes Europe, the subscript U denotes the United States. Assume that BMW can restrict U.S. sales to authorized BMW dealers only.
a. What quantity of BMWs should the firm sell in each market, and what should the price be in each market? What should the total profit be?
b. If BMW were forced to charge the same price in each market, what would be the quantity sold in each market, the equilibrium price, and the company’s profit?
5. A monopolist is deciding how to allocate output between two geographically separated markets (East Coast and Midwest). Demand and marginal revenue for the two markets are:
P1 = 15 – Q1 MR1 = 15 – 2Q1
P2 = 25 – 2Q2 MR2 = 25 – 4Q2
The monopolist’s total cost is C = 5 + 3(Q1 + Q2 ). What are price, output, profits, marginal revenues, and deadweight loss (i) if the monopolist can price discriminate? (ii) if the law prohibits charging different prices in the two regions?
6. Elizabeth Airlines (EA) flies only one route: Chicago-Honolulu. The demand for each flight is Q = 500 – P. EA’s cost of running each flight is $30,000 plus $100 per passenger.
a. What is the profit-maximizing price that EA will charge? How many people will be on each flight? What is EA’s profit for each flight?
b. EA learns that the fixed costs per flight are in fact $41,000 instead of $30,000. Will the airline stay in business for long? Illustrate your answer using a graph of the demand curve that EA faces, EA’s average cost curve when fixed costs are $30,000, and EA’s average cost curve when fixed costs are $41,000.
c. Wait! EA finds out that two different types of people fly to Honolulu. Type A consists of business people with a demand of QA = 260 – 0.4P. Type B consists of students whose total demand is QB = 240 – 0.6P. Because the students are easy to spot, EA decides to charge them different prices. Graph each of these demand curves and their horizontal sum. What price does EA charge the students? What price does EA charge other customers? How many of each type are on each flight?
d. What would EA’s profit be for each flight? Would the airline stay in business?
Calculate the consumer surplus of each consumer group. What is the total consumer surplus?
e. Before EA started price discriminating, how much consumer surplus was the Type A demand getting from air travel to Honolulu? Type B? Why did total consumer surplus decline with price discrimination, even though total quantity sold remained unchanged?
7. Many retail video stores offer two alternative plans for renting films:
• A two-part tariff: Pay an annual membership fee (e.g., $40) and then pay a small fee for the daily rental of each film (e.g., $2 per film per day).
• A straight rental fee: Pay no membership fee, but pay a higher daily rental fee (e.g., $4 per film per day).
What is the logic behind the two-part tariff in this case? Why offer the customer a choice of two plans rather than simply a two-part tariff?
8. Sal’s satellite company broadcasts TV to subscribers in Los Angeles and New York. The demand functions for each of these two groups are
QNY = 60 – 0.25PNY QLA = 100 – 0.50PLA
where Q is in thousands of subscriptions per year and P is the subscription price per year. The cost of providing Q units of service is given by
C = 1000 + 40Q
where Q = QNY + QLA.
a. What are the profit-maximizing prices and quantities for the New York and Los Angeles markets?
b. As a consequence of a new satellite that the Pentagon recently deployed, people in Los Angeles receive Sal’s New York broadcasts, and people in New York receive Sal’s Los Angeles broadcasts. As a result, anyone in New York or Los Angeles can receive Sal’s broadcasts by subscribing in either city. Thus Sal can charge only a single price. What price should he charge, and what quantities will he sell in New York and Los Angeles?
c. In which of the above situations, (a) or (b), is Sal better off? In terms of consumer surplus, which situation do people in New York prefer and which do people in Los Angeles prefer? Why?
9. You are an executive for Super Computer, Inc. (SC), which rents out super computers. SC receives a fixed rental payment per time period in exchange for the right to unlimited computing at a rate of P cents per second. SC has two types of potential customers of equal number – 10 businesses and 10 academic institutions. Each business customer has the demand function Q = 10 – P, where Q is in millions of seconds per month; each academic institution has the demand Q = 8 – P. The marginal cost to SC of additional computing is 2 cents per second, regardless of volume.
a. Suppose that you could separate business and academic customers. What rental fee and usage fee would you charge each group? What would be your profits?
b. Suppose you were unable to keep the two types of customers separate and charged a zero rental fee. What usage fee would maximize your profits? What would be your profits?
c. Suppose you set up one two-part tariff – that is, you set one rental and one usage fee that both business and academic customers pay. What usage and rental fees would you set? What would be your profits? Explain why price would not be equal to marginal cost.
10. As the owner of the only tennis club in an isolated wealthy community, you must decide on membership dues and fees for court time. There are two types of tennis players. “Serious” players have demand Q1 = 10 – P
where Q1 is court hours per week and P is the fee per hour for each individual player. There are also “occasional” players with demand Q2 = 4 – 0.25P.
Assume that there are 1000 players of each type. Because you have plenty of courts, the marginal cost of court time is zero. You have fixed costs of $10,000 per week. Serious and occasional players look alike, so you must charge them the same prices.
a. Suppose that to maintain a “professional” atmosphere, you want to limit membership to serious players. How should you set the annual membership dues and court fees (assume 52 weeks per year) to maximize profits, keeping in mind the constraint that only serious players choose to join? What would profits be (per week)?
b. A friend tells you that you could make greater profits by encouraging both types of players to join. Is your friend right? What annual dues and court fees would maximize weekly profits? What would these profits be?
c. Suppose that over the years young, upwardly mobile professionals move to your community, all of whom are serious players. You believe there are now 3000 serious players and 1000 occasional players. Would it still be profitable to cater to the occasional player? What would be the profit-maximizing annual dues and court fees? What would profits be per week?

CHAPTER 12: MONOPOLISTIC COMPETITION AND OLIGOPOLY
1. What are the characteristics of a monopolistically competitive market? What happens to the equilibrium price and quantity in such a market if one firm introduces a new, improved product?
2. Why is the firm’s demand curve flatter than the total market demand curve in monopolistic competition? Suppose a monopolistically competitive firm is making a profit in the short run. What will happen to its demand curve in the long run?
3. Some experts have argued that too many brands of breakfast cereal are on the market. Give an argument to support this view. Give an argument against it.
4. Why is the Cournot equilibrium stable? (i.e., Why don’t firms have any incentive to change their output levels once in equilibrium?) Even if they can’t collude, why don’t firms set their outputs at the joint profit-maximizing levels (i.e., the levels they would have chosen had they colluded)?
5. In the Stackelberg model, the firm that sets output first has an advantage. Explain why.
6. What do the Cournot and Bertrand models have in common? What is different about the two models?
7. Explain the meaning of a Nash equilibrium when firms are competing with respect to price. Why is the equilibrium stable? Why don’t the firms raise prices to the level that maximizes joint profits?
8. The kinked demand curve describes price rigidity. Explain how the model works. What are its limitations? Why does price rigidity occur in oligopolistic markets?
9. Why does price leadership sometimes evolve in oligopolistic markets? Explain how the price leader determines a profit-maximizing price.
10. Why has the OPEC oil cartel succeeded in raising prices substantially while the CIPEC copper cartel has not? What conditions are necessary for successful cartelization? What organizational problems must a cartel overcome?
EXERCISES
1. Suppose all firms in a monopolistically competitive industry were merged into one large firm. Would that new firm produce as many different brands? Would it produce only a single brand? Explain.
2. Consider two firms facing the demand curve P = 50 – 5Q, where Q = Q1 + Q2. The firms’ cost functions are C1(Q1) = 20 + 10Q1 and C2(Q2) = 10 + 12Q2.
a. Suppose both firms have entered the industry. What is the joint profit-maximizing level of output? How much will each firm produce? How would your answer change if the firms have not yet entered the industry?
b. What is each firm’s equilibrium output and profit if they behave noncooperatively?
Use the Cournot model. Draw the firms’ reaction curves and show the equilibrium.
c. How much should Firm 1 be willing to pay to purchase Firm 2 if collusion is illegal but a takeover is not?
3. A monopolist can produce at a constant average (and marginal) cost of AC = MC = $5. It faces a market demand curve given by Q = 53 – P.
a. Calculate the profit-maximizing price and quantity for this monopolist. calculate its profits. Also
b. Suppose a second firm enters the market. Let Q1 be the output of the first firm and Q2 be the output of the second. Market demand is now given by Q1 + Q2 = 53 – P.
c. Suppose (as in the Cournot model) that each firm chooses its profit-maximizing level of output on the assumption that its competitor’s output is fixed. Find each firm’s “reaction curve” (i.e., the rule that gives its desired output in terms of its competitor’s output).
d. Calculate the Cournot equilibrium (i.e., the values of Q1 and Q2 for which each firm is doing as well as it can given its competitor’s output). What are the resulting market price and profthe output of its competitor.its of each firm?
e. Suppose there are N firms in the industry, all with the same constant marginal cost, MC = $5. Find the Cournot equilibrium. How much will each firm produce, what will be the market price, and how much profit will each firm earn? Also, show that as N becomes large, the market price approaches the price that would prevail under perfect competition.
4. This exercise is a continuation of Exercise 3. We return to two firms with the same constant average and marginal cost, AC = MC = 5, facing the market demand curve Q1 + Q2 = 53 – P. Now we will use the Stackelberg model to analyze what will happen if one of the firms makes its output decision before the other.
a. Suppose Firm 1 is the Stackelberg leader (i.e., makes its output decisions before Firm 2). Find the reaction curves that tell each firm how much to produce in terms of the output of its competitor. Assuming that this second firm has the same costs as the first, write the profits of each firm as functions of Q1 and Q2.
b. How much will each firm produce, and what will its profit be?
5. Two firms compete in selling identical widgets. They choose their output levels Q1 and Q2 simultaneously and face the demand curve
P = 30 – Q
where Q = Q1 + Q2. Until recently, both firms had zero marginal costs. Recent environmental regulations have increased Firm 2’s marginal cost to $15. Firm 1’s marginal cost remains constant at zero. True or false: As a result, the market price will rise to the monopoly level.
6. Suppose that two identical firms produce widgets and that they are the only firms in the market. Their costs are given by C1 = 60Q1 and C2 = 60Q2, where Q1 is the output of Firm 1 and Q2 the output of Firm 2. Price is determined by the following demand curve:
P = 300 – Q
where Q = Q1 + Q2.
a. Find the Cournot-Nash equilibrium. Calculate the profit of each firm at this equilibrium.
b. Suppose the two firms form a cartel to maximize joint profits. How many widgets will be produced? Calculate each firm’s profit.
c. Suppose Firm 1 were the only firm in the industry. How would market output and Firm 1’s profit differ from that found in part (b) above?
d. Returning to the duopoly of part (b), suppose Firm 1 abides by the agreement, but Firm 2 cheats by increasing production. How many widgets will Firm 2 produce? What will be each firm’s profits?
7. Suppose that two competing firms, A and B, produce a homogeneous good. Both firms have a marginal cost of MC = $50. Describe what would happen to output and price in each of the following situations if the firms are at (i) Cournot equilibrium, (ii) collusive equilibrium, and (iii) Bertrand equilibrium.
a. Because Firm A must increase wages, its MC increases to $80.
b. The marginal cost of both firms increases.
c. The demand curve shifts to the right.
8. Suppose the airline industry consisted of only two firms: American and Texas Air Corp. Let the two firms have identical cost functions, C(q) = 40q. Assume the demand curve for the industry is given by P = 100 – Q and that each firm expects the other to behave as a Cournot competitor.
a. Calculate the Cournot-Nash equilibrium for each firm, assuming that each chooses the output level that maximizes its profits when taking its rival’s output as given. What are the profits of each firm?
b. What would be the equilibrium quantity if Texas Air had constant marginal and average costs of $25 and American had constant marginal and average costs of $40?
c. Assuming that both firms have the original cost function, C(q) = 40q, how much should Texas Air be willing to invest to lower its marginal cost from 40 to 25, assuming that American will not follow suit? How much should American be willing to spend to reduce its marginal cost to 25, assuming that Texas Air will have marginal costs of 25 regardless of American’s actions?
9. Demand for light bulbs can be characterized by Q = 100 – P, where Q is in millions of boxes of lights sold and P is the price per box. There are two producers of lights, Everglow and Dimlit. They have identical cost functions:
a. Unable to recognize the potential for collusion, the two firms act as short-run perfect competitors. What are the equilibrium values of QE, QD, and P? What are each firm’s profits?
b. Top management in both firms is replaced. Each new manager independently recognizes the oligopolistic nature of the light bulb industry and plays Cournot. What are the equilibrium values of QE, QD, and P? What are each firm’s profits?
c. Suppose the Everglow manager guesses correctly that Dimlit is playing Cournot, so Everglow plays Stackelberg. What are the equilibrium values of QE, QD, and P? What are each firm’s profits?
d. If the managers of the two companies collude, what are the equilibrium values of QE, QD, and P? What are each firm’s profits?
10. Two firms produce luxury sheepskin auto seat covers, Western Where (WW) and B.B.B. Sheep (BBBS). Each firm has a cost function given by C (q) = 30q + 1.5q2
The market demand for these seat covers is represented by the inverse demand equation
P = 300 – 3Q
where Q = q1 + q2, total output.
a. If each firm acts to maximize its profits, taking its rival’s output as given (i.e., the firms behave as Cournot oligopolists), what will be the equilibrium quantities selected by each firm? What is total output, and what is the market price? What are the profits for each firm?
b. It occurs to the managers of WW and BBBS that they could do a lot better by colluding. If the two firms collude, what will be the profit-maximizing choice of output? The industry price? The output and the profit for each firm in this case?
c. The managers of these firms realize that explicit agreements to collude are illegal.
Each firm must decide on its own whether to produce the Cournot quantity or the cartel quantity. To aid in making the decision, the manager of WW constructs a payoff matrix like the one below. Fill in each box with the profit of WW and the profit of BBBS. Given this payoff matrix, what output strategy is each firm likely to pursue?
d. Suppose WW can set its output level before BBBS does. How much will WW choose to produce in this case? How much will BBBS produce? What is the market price, and what is the profit for each firm? Is WW better off by choosing its output first? Explain why or why not.

CHAPTER 13: GAME THEORY AND COMPETITIVE STRATEGY
1. What is the difference between a cooperative and a noncooperative game? Give an example of each.
2. What is a dominant strategy? Why is an equilibrium stable in dominant strategies?
3. Explain the meaning of a Nash equilibrium. How does it differ from an equilibrium in dominant strategies?
4. How does a Nash equilibrium differ from a game’s maximin solution? When is a maximin solution a more likely outcome than a Nash equilibrium?
5. What is a “tit-for-tat” strategy? Why is it a rational strategy for the infinitely repeated prisoners’ dilemma?
6. Consider a game in which the prisoners’ dilemma is repeated 10 times and both players are rational and fully informed. Is a tit-for-tat strategy optimal in this case? Under what conditions would such a strategy be optimal?
7. Suppose you and your competitor are playing the pricing game shown in Table 13.8 (page 490). Both of you must announce your prices at the same time. Can you improve your outcome by promising your competitor that you will announce a high price?
8. What is meant by “first-mover advantage”? Give an example of a gaming situation with a first-mover advantage.
9. What is a “strategic move”? How can the development of a certain kind of reputation be a strategic move?
10. Can the threat of a price war deter entry by potential competitors? What actions might a firm take to make this threat credible?
EXERCISES
1. In many oligopolistic industries, the same firms compete over a long period of time, setting prices and observing each other’s behavior repeatedly. Given the large number of repetitions, why don’t collusive outcomes typically result?
2. Many industries are often plagued by overcapacity: Firms simultaneously invest in capacity expansion, so that total capacity far exceeds demand. This happens not only in industries in which demand is highly volatile and unpredictable, but also in industries in which demand is fairly stable. What factors lead to overcapacity? Explain each briefly.
3. Two computer firms, A and B, are planning to market network systems for office information management. Each firm can develop either a fast, high-quality system (High), or a slower, low-quality system (Low). Market research indicates that the resulting profits to each firm for the alternative strategies are given by the following payoff matrix:
a. If both firms make their decisions at the same time and follow maximin (low-risk) strategies, what will the outcome be?
b. Suppose that both firms try to maximize profits, but that Firm A has a head start in planning and can commit first. Now what will be the outcome? What will be the outcome if Firm B has the head start in planning and can commit first?
c. Getting a head start costs money. (You have to gear up a large engineering team.) Now consider the two-stage game in which, first, each firm decides how much money to spend to speed up its planning, and, second, it announces which product (H or L) it will produce. Which firm will spend more to speed up its planning? How much will it spend? Should the other firm spend anything to speed up its planning? Explain.
4. Two firms are in the chocolate market. Each can choose to go for the high end of the market (high quality) or the low end (low quality). Resulting profits are given by the following payoff matrix:
a. What outcomes, if any, are Nash equilibria?
b. If the managers of both firms are conservative and each follows a maximin strategy, what will be the outcome?
c. What is the cooperative outcome?
d. Which firm benefits most from the cooperative outcome? How much would that firm need to offer the other to persuade it to collude?
5. Two major networks are competing for viewer ratings in the 8:00!9:00 P.M. and 9:00!10:00
P.M. slots on a given weeknight. Each has two shows to fill this time period and is juggling its lineup. Each can choose to put its “bigger” show first or to place it second in the 9:00!10:00 P.M. slot. The combination of decisions leads to the following “ratings points”
results:
a. Find the Nash equilibria for this game, assuming that both networks make their decisions at the same time.
b. If each network is risk-averse and uses a maximin strategy, what will be the resulting equilibrium?
c. What will be the equilibrium if Network 1 makes its selection first? If Network 2 goes first?
6. Two competing firms are each planning to introduce a new product. Each will decide whether to produce Product A, Product B, or Product C. They will make their choices at the same time. The resulting payoffs are shown below.
a. Are there any Nash equilibria in pure strategies? If so, what are they?
b. If both firms use maximin strategies, what outcome will result?
c. If Firm 1 uses a maximin strategy and Firm 2 knows this, what will Firm 2 do?
7. We can think of U.S. and Japanese trade policies as a prisoners’ dilemma. The two countries are considering policies to open or close their import markets. The payoff matrix is shown below.
a. Assume that each country knows the payoff matrix and believes that the other country will act in its own interest. Does either country have a dominant strategy? What will be the equilibrium policies if each country acts rationally to maximize its welfare?
b. Now assume that Japan is not certain that the United States will behave rationally.
In particular, Japan is concerned that U.S. politicians may want to penalize Japan even if that does not maximize U.S. welfare. How might this concern affect Japan’s choice of strategy? How might this change the equilibrium?
8. You are a duopolist producer of a homogeneous good. Both you and your competitor have zero marginal costs. The market demand curve is P = 30 ! Q
where Q = Q1 + Q2. Q1 is your output and Q2 your competitor’s output. Your competitor has also read this book.
a. Suppose you will play this game only once. If you and your competitor must announce your outputs at the same time, how much will you choose to produce? What do you expect your profit to be? Explain.
b. Suppose you are told that you must announce your output before your competitor does. How much will you produce in this case, and how much do you think your competitor will produce? What do you expect your profit to be? Is announcing first an advantage or a disadvantage? Explain briefly. How much would you pay for the option of announcing either first or second?
c. Suppose instead that you are to play the first round of a series of 10 rounds (with the same competitor). In each round, you and your competitor announce your outputs at the same time. You want to maximize the sum of your profits over the 10 rounds. How much will you produce in the first round? How much do you expect to produce in the tenth round? In the ninth round? Explain briefly.
d. Once again you will play a series of 10 rounds. This time, however, in each round your competitor will announce its output before you announce yours. How will your answers to (c) change in this case?
9. You play the following bargaining game. Player A moves first and makes Player B an offer for the division of $100. (For example, Player A could suggest that she take $60 and Player B take $40). Player B can accept or reject the offer. If he rejects it, the amount of money available drops to $90, and he then makes an offer for the division of this amount. If Player A rejects this offer, the amount of money drops to $80 and Player A makes an offer for its division. If Player B rejects this offer, the amount of money drops to 0. Both players are rational, fully informed, and want to maximize their payoffs. Which player will do best in this game?
10. Defendo has decided to introduce a revolutionary video game. As the first firm in the market, it will have a monopoly position for at least some time. In deciding what type of manufacturing plant to build, it has the choice of two technologies. Technology A is publicly available and will result in annual costs of
CA(q) = 10 + 8q
Technology B is a proprietary technology developed in Defendo’s research labs. It involves a higher fixed cost of production but lower marginal costs:
CB(q) = 60 + 2q
Defendo must decide which technology to adopt. Market demand for the new product is P = 20 ! Q, where Q is total industry output.
a. Suppose Defendo were certain that it would maintain its monopoly position in the market for the entire product lifespan (about five years) without threat of entry. Which technology would you advise Defendo to adopt? What would be Defendo’s profit given this choice?
b. Suppose Defendo expects its archrival, Offendo, to consider entering the market shortly after Defendo introduces its new product. Offendo will have access only to Technology A. If Offendo does enter the market, the two firms will play a Cournot game (in quantities) and arrive at the Cournot-Nash equilibrium.
i. If Defendo adopts Technology A and Offendo enters the market, what will be the profit of each firm? Would Offendo choose to enter the market given these profits?
ii. If Defendo adopts Technology B and Offendo enters the market, what will be the profit of each firm? Would Offendo choose to enter the market given these profits?
iii. Which technology would you advise Defendo to adopt given the threat of possible entry? What will be Defendo’s profit given this choice? What will be consumer surplus given this choice?
c. What happens to social welfare (the sum of consumer surplus and producer profit) as a result of the threat of entry in this market? What happens to equilibrium price? What might this imply about the role of potential competition in limiting market power?

CHAPTER 14: MARKETS FOR FACTOR INPUTS
1. Why is a firm’s demand for labor curve more inelastic when the firm has monopoly power in the output market than when the firm is producing competitively?
2. Why might a labor supply curve be backward bending?
3. How is a computer company’s demand for computer programmers a derived demand?
4. Compare the hiring choices of a monopsonistic and a competitive employer of workers. Which will hire more workers, and which will pay the higher wage? Explain.
5. Rock musicians sometimes earn several million dollars per year. Can you explain such large incomes in terms of economic rent?
6. What happens to the demand for one input when the use of a complementary input increases?
7. For a monopsonist, what is the relationship between the supply of an input and the marginal expenditure on it?
8. Currently the National Football League has a system for drafting college players by which each player is picked by only one team. The player must sign with that team or not play in the league. What would happen to the wages of both newly drafted and more experienced football players if the draft system were repealed and all teams could compete for college players?
9. The government wants to encourage individuals on welfare to become employed. It is considering two possible incentive programs:
a. Give firms $2 per hour for every individual on welfare who is hired.
b. Give each firm that hires one or more welfare workers a payment of $1000 per year, irrespective of the number of hires.
To what extent is each of these programs likely to be effective at increasing the employment opportunities for welfare workers?
10. A small specialty cookie company, whose only variable input is labor, finds that the average worker can produce 50 cookies per day, the cost of the average worker is $64 per day, and the price of a cookie is $1. Is the company maximizing its profit? Explain.
EXERCISES
1. Suppose that the wage rate is $16 per hour and the price of the product is $2. Values for output and labor are in units per hour.
q L
0 0
20 1
35 2
47 3
57 4
65 5
70 6
a. Find the profit-maximizing quantity of labor.
b. Suppose that the price of the product remains at $2 but that the wage rate increases to $21. Find the new profit-maximizing level of L.
c. Suppose that the price of the product increases to $3 and the wage remains at $16 per hour. Find the new profit-maximizing L.
d. Suppose that the price of the product remains at $2 and the wage at $16, but that there is a technological breakthrough that increases output by 25 percent for any given level of labor. Find the new profit-maximizing L.
2. Assume that workers whose incomes are less than $10,000 currently pay no federal income taxes. Suppose a new government program guarantees each worker $5000, whether or not he or she earns any income. For all earned income up to $10,000, the worker must pay a 50-percent tax. Draw the budget line facing the worker under this new program. How is the program likely to affect the labor supply curve of workers?
3. Using your knowledge of marginal revenue product, explain the following:
a. A famous tennis star is paid $200,000 for appearing in a 30-second television commercial. The actor who plays his doubles partner is paid $500.
b. The president of an ailing savings and loan is paid not to stay in his job for the last two years of his contract.
c. A jumbo jet carrying 400 passengers is priced higher than a 250-passenger model even though both aircraft cost the same to manufacture.
4. The demands for the factors of production listed below have increased. What can you conclude about changes in the demands for the related consumer goods? If demands for the consumer goods remain unchanged, what other explanation is there for an increase in derived demands for these items?
a. Computer memory chips
b. Jet fuel for passenger planes
c. Paper used for newsprint
d. Aluminum used for beverage cans
5. Suppose there are two groups of workers, unionized and nonunionized. Congress passes a law that requires all workers to join the union. What do you expect to happen to the wage rates of formerly nonunionized workers? Of those workers who were originally unionized? What have you assumed about the union’s behavior?
6. Suppose a firm’s production function is given by Q = 12L ! L2, for L = 0 to 6, where L is labor input per day and Q is output per day. Derive and draw the firm’s demand for labor curve if the firm’s output sells for $10 in a competitive market. How many workers will the firm hire when the wage rate is $30 per day? $60 per day? (Hint: The marginal product of labor is 12 ! 2L.)
7. The only legal employer of military soldiers in the United States is the federal government. If the government uses its knowledge of its monopsonistic position, what criteria will it employ when determining how many soldiers to recruit? What happens if a mandatory draft is implemented?
8. The demand for labor by an industry is given by the curve L = 1200 ! 10w, where L is the labor demanded per day and w is the wage rate. The supply curve is given by L = 20w. What is the equilibrium wage rate and quantity of labor hired? What is the economic rent earned by workers?
9. Using the same information as in Exercise 8, suppose now that the only labor available is controlled by a monopolistic labor union that wishes to maximize the rent earned by union members. What will be the quantity of labor employed and the wage rate? How does your answer compare with your answer to Exercise 8? Discuss. (Hint: The union’s marginal revenue curve is given by MR = 120 ! 0.2L.)
10. A firm uses a single input, labor, to produce output q according to the production function q = 8 L . The commodity sells for $150 per unit and the wage rate is $75 per hour.
a. Find the profit-maximizing quantity of L.
b. Find the profit-maximizing quantity of q.
c. What is the maximum profit?
d. Suppose now that the firm is taxed $30 per unit of output and that the wage rate is subsidized at a rate of $15 per hour. Assume that the firm is a price taker, so the price of the product remains at $150. Find the new profit-maximizing levels of L, q, and profit.
e. Now suppose that the firm is required to pay a 20 percent tax on its profits. Find the new profit-maximizing levels of L, q, and profit.

CHAPTER 15: INVESTMENT, TIME, AND CAPITAL MARKETS
1. A firm uses cloth and labor to produce shirts in a factory that it bought for $10 million. Which of its factor inputs are measured as flows and which as stocks? How would your answer change if the firm had leased a factory instead of buying one? Is its output measured as a flow or a stock? What about profit?
2. How do investors calculate the net present value of a bond? If the interest rate is 5 percent, what is the present value of a perpetuity that pays $1000 per year forever?
3. What is the effective yield on a bond? How does one calculate it? Why do some corporate bonds have higher effective yields than others?
4. What is the Net Present Value (NPV) criterion for investment decisions? How does one calculate the NPV of an investment project? If all cash flows for a project are certain, what discount rate should be used to calculate NPV?
5. You are retiring from your job and are given two options. You can accept a lump sum payment from the company, or you can accept a smaller annual payment that will continue for as long as you live. How would you decide which option is best? What information do you need?
6. You have noticed that bond prices have been rising over the past few months. All else equal, what does this suggest has been happening to interest rates? Explain.
7. What is the difference between a real discount rate and a nominal discount rate? When should a real discount rate be used in an NPV calculation and when should a nominal rate be used?
8. How is risk premium used to account for risk in NPV calculations? What is the difference between diversifiable and nondiversifiable risk? Why should only nondiversifiable risk enter into the risk premium?
9. What is meant by the “market return” in the Capital Asset Pricing Model (CAPM)? Why is the market return greater than the risk-free interest rate? What does an asset’s “beta” measure in the CAPM? Why should high-beta assets have a higher expected return than low-beta assets?
10. Suppose you are deciding whether to invest $100 million in a steel mill. You know the expected cash flows for the project, but they are risky – steel prices could rise or fall in the future. How would the CAPM help you select a discount rate for an NPV calculation?

CHAPTER 16: GENERAL EQUILIBRIUM AND ECONOMIC EFFICIENCY
1. Why can feedback effects make a general equilibrium analysis substantially different from a partial equilibrium analysis?
2. In the Edgeworth box diagram, explain how one point can simultaneously represent the market baskets owned by two consumers.
3. In the analysis of exchange using the Edgeworth box diagram, explain why both consumers’ marginal rates of substitution are equal at every point on the contract curve.
4. “Because all points on a contract curve are efficient, they are all equally desirable from a social point of view.” Do you agree with this statement? Explain.
5. How does the utility possibilities frontier relate to the contract curve?
6. In the Edgeworth production box diagram, what conditions must hold for an allocation to be on the production contract curve? Why is a competitive equilibrium on the contract curve?
7. How is the production possibilities frontier related to the production contract curve?
8. What is the marginal rate of transformation (MRT)? Explain why the MRT of one good for another is equal to the ratio of the marginal costs of producing the two goods.
9. Explain why goods will not be distributed efficiently among consumers if the MRT is not equal to the consumers’ marginal rate of substitution.
10. Why can free trade between two countries make consumers of both countries better off?
EXERCISES
1. Suppose gold (G) and silver (S) are substitutes for each other because both serve as hedges against inflation. Suppose also that the supplies of both are fixed in the short run (QG = 75 and QS = 300) and that the demands for gold and silver are given by the following equations:
PG = 975 ! QG + 0.5PS and PS = 600 ! QS + 0.5PG.
a. What are the equilibrium prices of gold and silver?
b. What if a new discovery of gold doubles the quantity supplied to 150. How will this discovery affect the prices of both gold and silver?
2. Using general equilibrium analysis, and taking into account feedback effects, analyze the following:
a. The likely effects of outbreaks of disease on chicken farms on the markets for chicken and pork.
b. The effects of increased taxes on airline tickets on travel to major tourist destinations such as Florida and California and on the hotel rooms in those destinations.
3. Jane has 3 liters of soft drinks and 9 sandwiches. Bob, on the other hand, has 8 liters of soft drinks and 4 sandwiches. With these endowments, Jane’s marginal rate of substitution (MRS) of soft drinks for sandwiches is 4 and Bob’s MRS is equal to 2. Draw an Edgeworth box diagram to show whether this allocation of resources is efficient. If it is, explain why. If it is not, what exchanges will make both parties better off?
4. Jennifer and Drew consume orange juice and coffee. Jennifer’s MRS of orange juice for coffee is 1 and Drew’s MRS of orange juice for coffee is 3. If the price of orange juice is $2 and the price of coffee is $3, which market is in excess demand? What do you expect to happen to the prices of the two goods?
5. Fill in the missing information in the following tables. For each table, use the information provided to identify a possible trade. Then identify the final allocation and a possible value for the MRS at the efficient solution. (Note: there is more than one correct answer.) Illustrate your results using Edgeworth Box diagrams.
a. Norman’s MRS of food for clothing is 1 and Gina’s MRS of food for clothing is 4:

Individual Initial
Allocation
Trade Final
Allocation
Norman 6F, 2C 1F for 3C 5F, 5C
Gina 1F, 8C 3C for 1F 2F, 5C

b. Michael’s MRS of food for clothing is 1/2 and Kelly’s MRS of food for clothing is 3.
6. In the analysis of an exchange between two people, suppose both people have identical preferences. Will the contract curve be a straight line? Explain. Can you think of a counterexample?
7. Give an example of conditions when the production possibilities frontier might not be concave.
8. A monopsonist buys labor for less than the competitive wage. What type of inefficiency will this use of monopsony power cause? How would your answer change if the monopsonist in the labor market were also a monopolist in the output market?
9. The Acme Corporation produces x and y units of goods Alpha and Beta, respectively.
a. Use a production possibility frontier to explain how the willingness to produce more or less Alpha depends on the marginal rate of transformation of Alpha for Beta.
b. Consider two cases of production extremes: (i) Acme produces zero units of Alpha initially, or (ii) Acme produces zero units of Beta initially. If Acme always tries to stay on its production possibility frontier, describe the initial positions of cases (i) and (ii). What happens as the Acme Corporation begins to produce both goods?
10. In the context of our analysis of the Edgeworth production box, suppose that a new invention changes a constant-returns-to-scale food production process into one that exhibits sharply increasing returns. How does this change affect the production contract curve?

CHAPTER 17: MARKETS WITH ASYMMETRIC INFORMATION
1. Why can asymmetric information between buyers and sellers lead to market failure when a market is otherwise perfectly competitive?
2. If the used car market is a “lemons” market, how would you expect the repair record of used cars that are sold to compare with the repair record of those not sold?
3. Explain the difference between adverse selection and moral hazard in insurance markets. Can one exist without the other?
4. Describe several ways in which sellers can convince buyers that their products are of high quality. Which methods apply to the following products: Maytag washing machines, Burger King hamburgers, large diamonds?
5. Why might a seller find it advantageous to signal the quality of a product? How are guarantees and warranties a form of market signaling?
6. Joe earned a high grade-point average during his four years of college. Is this achievement a strong signal to Joe’s future employer that he will be a highly productive worker? Why or why not?
7. Why might managers be able to achieve objectives other than profit maximization, which is the goal of the firm’s shareholders?
8. How can the principal-agent model be used to explain why public enterprises, such as post offices, might pursue goals other than profit maximization?
9. Why are bonus and profit-sharing payment schemes likely to resolve principal-agent problems, whereas a fixed-wage payment will not?
10. What is an efficiency wage? Why is it profitable for the firm to pay it when workers have better information about their productivity than firms do?
EXERCISES
1. Many consumers view a well-known brand name as a signal of quality and will pay more for a brand-name product (e.g., Bayer aspirin instead of generic aspirin, Birds Eye frozen vegetables instead of the supermarket’s own brand). Can a brand name provide a useful signal of quality? Why or why not?
2. Gary is a recent college graduate. After six months at his new job, he has finally saved enough to buy his first car.
a. Gary knows very little about the differences between makes and models. How could he use market signals, reputation, or standardization to make comparisons?
b. You are a loan officer in a bank. After selecting a car, Gary comes to you seeking a loan. Because he has only recently graduated, he does not have a long credit history. Nonetheless, the bank has a long history of financing cars for recent college graduates. Is this information useful in Gary’s case? If so, how?
3. A major university bans the assignment of D or F grades. It defends its action by claiming that students tend to perform above average when they are free from the pressures of flunking out. The university states that it wants all its students to get As and Bs. If the goal is to raise overall grades to the B level or above, is this a good policy? Discuss this policy with respect to the problem of moral hazard.
4. Professor Jones has just been hired by the economics department at a major university. The president of the board of regents has stated that the university is committed to providing top-quality education for undergraduates. Two months into the semester, Jones fails to show up for his classes. It seems he is devoting all his time to research rather than to teaching. Jones argues that his research will bring prestige to the department and the university. Should he be allowed to continue exclusively with research? Discuss with reference to the principal-agent problem.
5. Faced with a reputation for producing automobiles with poor repair records, a number of American companies have offered extensive guarantees to car purchasers (e.g., a seven- year warranty on all parts and labor associated with mechanical problems).
a. In light of your knowledge of the lemons market, why is this a reasonable policy?
b. Is the policy likely to create a moral hazard problem? Explain.
6. To promote competition and consumer welfare, the Federal Trade Commission requires firms to advertise truthfully. How does truth in advertising promote competition? Why would a market be less competitive if firms advertised deceptively?
7. An insurance company is considering issuing three types of fire insurance policies: (i) complete insurance coverage, (ii) complete coverage above and beyond a $10,000 deductible, and (iii) 90 percent coverage of all losses. Which policy is more likely to create moral hazard problems?
8. You have seen how asymmetric information can reduce the average quality of products sold in a market, as low-quality products drive out high-quality products. For those markets in which asymmetric information is prevalent, would you agree or disagree with each of the following? Explain briefly:
a. The government should subsidize Consumer Reports.
b. The government should impose quality standards — e.g., firms should not be allowed to sell low-quality items.
c. The producer of a high-quality good will probably want to offer an extensive warranty.
d. The government should require all firms to offer extensive warranties.
9. Two used car dealerships compete side by side on a main road. The first, Harry’s Cars, always sells high-quality cars that it carefully inspects and, if necessary, services. On average, it costs Harry’s $8000 to buy and service each car that it sells. The second dealership, Lew’s Motors, always sells lower-quality cars. On average, it costs Lew’s only $5000 for each car that it sells. If consumers knew the quality of the used cars they were buying, they would pay $10,000 on average for Harry’s cars and only $7000 on average for Lew’s cars.
Without more information, consumers do not know the quality of each dealership’s cars. In this case, they would figure that they have a 50-50 chance of ending up with a high- quality car, and are thus willing to pay $8500 for a car.
Harry has an idea: He will offer a bumper-to-bumper warranty for all cars he sells. He knows that a warranty lasting Y years will cost $500Y on average, and he also knows that if Lew tries to offer the same warranty, it will cost Lew $1000Y on average.
a. Suppose Harry offers a one-year warranty on all of the cars he sells.
i. What is Lew’s profit if he does not offer a one-year warranty? If he does offer a one-year warranty?
ii. What is Harry’s profit if Lew’s does not offer a one-year warranty? If he does offer a one-year warranty?
iii. Will Lew’s match Harry’s one-year warranty?
iv. Is it a good idea for Harry to offer a one-year warranty?
b. What if Harry offers a two-year warranty? Will this generate a credible signal of quality? What about a three-year warranty?
c. If you were advising Harry, how long a warranty would you urge him to offer? Explain why.
10. As Chairman of the Board of ASP Industries, you estimate that your annual profit is given by the table below. Profit (Π) is conditional upon market demand and the effort of your new CEO. The probabilities of each demand condition occurring are also shown in the table.
Market Demand Low Demand Medium Demand High Demand

Market Probabilities .30 .40 .30
Low Effort Π=$5 million Π=$10 million Π=$15 million
High Effort Π=$10 million Π=$15 million Π=$17 million

You must design a compensation package for the CEO that will maximize the firm’s expected profit. While the firm is risk neutral, the CEO is risk averse. The CEO’s utility function is
Utility = W.5 when making low effort
Utility = W.5 – 100, when making high effort
where W is the CEO’s income. (The –100 is the “utility cost” to the CEO of making a high effort.) You know the CEO’s utility function, and both you and the CEO know all of the information in the preceding table. You do not know the level of the CEO’s effort at time of compensation or the exact state of demand. You do see the firm’s profit, however. Of the three alternative compensation packages below, which do you as Chairman of ASP Industries prefer? Why?
Package 1: Pay the CEO a flat salary of $575,000 per year
Package 2: Pay the CEO a fixed 6 percent of yearly firm profits
Package 3: Pay the CEO a flat salary of $500,000 per year and then 50 percent of any firm profits above $15 million

CHAPTER 18: EXTERNALITIES AND PUBLIC GOODS
1. Which of the following describes an externality and which does not? Explain the difference.
a. A policy of restricted coffee exports in Brazil causes the U.S. price of coffee to rise – an increase which in turn also causes the price of tea to rise.
b. An advertising blimp distracts a motorist who then hits a telephone pole.
2. Compare and contrast the following three mechanisms for treating pollution externalities when the costs and benefits of abatement are uncertain: (a) an emissions fee, (b) an emissions standard, and (c) a system of transferable emissions permits.
3. When do externalities require government intervention? When is such intervention unlikely to be necessary?
4. Consider a market in which a firm has monopoly power. Suppose in addition that the firm produces under the presence of either a positive or a negative externality. Does the externality necessarily lead to a greater misallocation of resources?
5. Externalities arise solely because individuals are unaware of the consequences of their actions. Do you agree or disagree? Explain.
6. To encourage an industry to produce at the socially optimal level, the government should impose a unit tax on output equal to the marginal cost of production. True or false? Explain.
7. George and Stan live next door to each other. George likes to plant flowers in his garden, but every time he does, Stan’s dog comes over and digs them up. Stan’s dog is causing the damage, so if economic efficiency is to be achieved, it is necessary that Stan pay to put up a fence around his yard to confine the dog. Do you agree or disagree? Explain.
8. An emissions fee is paid to the government, whereas an injurer who is sued and held liable pays damages directly to the party harmed by an externality. What differences in the behavior of victims might you expect to arise under these two arrangements?
9. Why does free access to a common property resource generate an inefficient outcome?
10. Public goods are both nonrival and nonexclusive. Explain each of these terms and show clearly how they differ from each other.
EXERCISES
1. A number of firms have located in the western portion of a town after single-family residences took up the eastern portion. Each firm produces the same product and in the process emits noxious fumes that adversely affect the residents of the community.
a. Why is there an externality created by the firms?
b. Do you think that private bargaining can resolve the problem? Explain.
c. How might the community determine the efficient level of air quality?
2. A computer programmer lobbies against copyrighting software, arguing that everyone should benefit from innovative programs written for personal computers and that exposure to a wide variety of computer programs will inspire young programmers to create even more innovative programs. Considering the marginal social benefits possibly gained by this proposal, do you agree with this position?
3. Assume that scientific studies provide you with the following information concerning the benefits and costs of sulfur dioxide emissions:
Benefits of abating (reducing) emissions: MB = 500 – 20A
Costs of abating emissions: MC = 200 + 5A
where A is the quantity abated in millions of tons and the benefits and costs are given in dollars per ton.
a. What is the socially efficient level of emissions abatement?
b. What are the marginal benefit and marginal cost of abatement at the socially efficient level of abatement?
c. What happens to net social benefits (benefits minus costs) if you abate one million more tons than the efficient level? One million fewer?
d. Why is it socially efficient to set marginal benefits equal to marginal costs rather than abating until total benefits equal total costs?
4. Four firms located at different points on a river dump various quantities of effluent into it. The effluent adversely affects the quality of swimming for homeowners who live downstream. These people can build swimming pools to avoid swimming in the river, and the firms can purchase filters that eliminate harmful chemicals dumped in the river. As a policy advisor for a regional planning organization, how would you compare and contrast the following options for dealing with the harmful effect of the effluent:
a. An equal-rate effluent fee on firms located on the river.
b. An equal standard per firm on the level of effluent that each can dump.
c. A transferable effluent permit system in which the aggregate level of effluent is fixed and all firms receive identical permits.
5. Medical research has shown the negative health effects of “secondhand” smoke. Recent social trends point to growing intolerance of smoking in public areas. If you are a smoker and you wish to continue smoking despite tougher anti-smoking laws, describe the effect of the following legislative proposals on your behavior. As a result of these programs, do you, the individual smoker, benefit? Does society benefit as a whole?
a. A bill is proposed that would lower tar and nicotine levels in all cigarettes.
b. A tax is levied on each pack of cigarettes.
c. A tax is levied on each pack of cigarettes sold.
d. Smokers would be required to carry government-issued smoking permits at all times.
6. The market for paper in a particular region in the United States is characterized by the following demand and supply curves
QD = 160, 000 − 2000P and QS = 40, 000 + 2000 P, where QD is the quantity demanded in 100-pound lots, QS is the quantity supplied in 100- pound lots, and P is the price per 100-pound lot. Currently there is no attempt to regulate the dumping of effluent into streams and rivers by the paper mills. As a result, dumping is widespread. The marginal external cost (MEC) associated with the production of paper is given by the curve MEC = 0.0006QS .
a. Calculate the output and price of paper if it is produced under competitive conditions and no attempt is made to monitor or regulate the dumping of effluent.
b. Determine the socially efficient price and output of paper.
c. Explain why the answers you calculated in parts (a) and (b) differ.
7. In a market for dry cleaning, the inverse market demand function is given by P = 100 − Q and the (private) marginal cost of production for the aggregation of all dry- cleaning firms is given by MC = 10 + Q . Finally, the pollution generated by the dry- cleaning process creates external damages given by the marginal external cost curve MEC = Q .
a. Calculate the output and price of dry cleaning if it is produced under competitive conditions without regulation.
b. Determine the socially efficient price and output of dry cleaning.
c. Determine the tax that would result in a competitive market producing the socially efficient output.
d. Calculate the output and price of dry cleaning if it is produced under monopolistic conditions without regulation.
e. Determine the tax that would result in a monopolistic market producing the socially efficient output.
f. Assuming that no attempt is made to monitor or regulate the pollution, which market structure yields higher social welfare? Discuss.
8. Refer back to Example 18.5 on global warming. Table 18.3 (page 668) shows the annual net benefits from a policy that reduces GHG emissions by 1 percent per year. At what discount rate is the NPV of this policy just equal to zero?
9. A beekeeper lives adjacent to an apple orchard. The orchard owner benefits from the bees because each hive pollinates about one acre of apple trees. The orchard owner pays nothing for this service, however, because the bees come to the orchard without his having to do anything. Because there are not enough bees to pollinate the entire orchard, the orchard owner must complete the pollination by artificial means, at a cost of $10 per acre of trees.
Beekeeping has a marginal cost MC = 10 + 5Q, where Q is the number of beehives. Each hive yields $40 worth of honey.
a. How many beehives will the beekeeper maintain?
b. Is this the economically efficient number of hives?
c. What changes would lead to a more efficient operation?
10. There are three groups in a community. Their demand curves for public television in hours of programming, T, are given respectively by W1 = $200 – T, W2 = $240 – 2T, W3 = $320 – 2T.
Suppose public television is a pure public good that can be produced at a constant marginal cost of $200 per hour.
a. What is the efficient number of hours of public television?
b. How much public television would a competitive private market provide?

AND MUCH MORE