Economics, 11th canadian edition, answers to even numbered questions

Chapter 3: Demand, Supply, and Price Question 2 a The reduction in the size of the peach harvest due to bad weather is a decrease in the supply of peaches  a leftward shift of the supp

Chapter 1: Economic Issues and Concepts

Question 2

Traditional systems: Behaviour is based primarily on tradition, custom, and habit

Command systems: Decisions about production and consumption are determined by a

central planning authority

Free-market systems: Production and consumption decisions are made privately, by

decentralized producers and consumers

Mixed systems: Economic systems in which there are elements of tradition, command,

and free markets

Question 4

a) At point A, 2.5 tonnes of clothing and 3 tonnes of food are being produced per year At point B, annual production is 2.5 tonnes of clothing and 7 tonnes of food At point C, annual production is 6.5 tonnes of clothing and 3 tonnes of food

b) At point A the economy is either using its resources inefficiently or it is not using all

of its available resources Point B and C represent full and efficient use of available resources because they are on the PPB

c) At point B, the opportunity cost of producing one more tonne of food (and increase from 7 to 8) is the 2.5 tonnes of clothing that must be given up The opportunity cost of producing one more tonne of clothing (from 2.5 to 3.5) appears, from the graph, to be approximately 0.75 tonnes of food

d) Point D is unattainable given the economy’s current technology and resources Point D can become attainable with a sufficient improvement in technology or increase in available resources

Question 6

a) As the table shows, there are only 250 workers in Choiceland, and to construct the production possibilities boundary we must imagine all the combinations of workers in each sector Using the two middle columns from the table, we can plot the output levels

on a graph to get the following:

b) If the economy is already producing 60 units of X and 600 units of Y, then 10 extra units of X can only be produced by reducing the production of Y by 250 units The opportunity cost of 10 units of X is therefore 250 units of Y (or 25 units of Y per unit of X) If the economy is already producing 70 units of X, the opportunity cost of producing

an additional 5 units of X is the forgone 350 units of Y (or 70 units of Y per unit of X) Thus, we see that the opportunity cost of X rises when more of X is already being produced

c) If any given amount of labour can now produce 10 percent more of good Y, then the PPB shifts up in a particular way Specifically, the Y values increase by 10 percent for any given X value, as shown below

Question 8

In general, the opportunity cost for any activity includes three things:

• the direct cost of the activity, plus

• whatever you give up in order to do the activity, minus

• whatever “savings” the activity generates

In this case, the direct cost of transportation, lift tickets and accommodation of $300 is definitely included The income of $120 that you give up also counts Finally, we must

deal with the restaurant meals of $75 Surely you would have eaten some food even if

you hadn’t gone skiing, so the full $75 is not included But given the relatively high price

of restaurant meals compared to buying your own groceries, you will probably include most of the $75 Thus the opportunity cost of the ski trip is $420 plus some (large)

fraction of the $75

Chapter 2: How Economists Work

Question 2

a) These data are best illustrated with a time-series graph, with the month shown on the horizontal axis and the interest rate shown on the vertical axis

b) These cross-sectional data are best illustrated with a bar chart

c) These cross-sectional data are best illustrated in a scatter diagram; the “line of best fit”

is clearly upward sloping, indicating a positive relationship between average investment rates and average growth rates

Question 4

Given the tax-revenue function T = 10 + 25Y, the plotted curve will have a vertical intercept of 10 and a slope of 0.25 The interpretation is that when Y is zero, tax revenues will be $10 billion And for every increase in Y of $100 billion, tax revenues will rise by

$25 billion The diagram is as shown below:

Question 6

a) Using Calgary as the “base university” means that we choose $6.25 as the base price This means dividing all prices by $6.25 and then multiplying by 100 In this way, we will determine, in percentage terms, how prices at other universities differ from Calgary prices The index values are as follows:

c) The university with the least expensive pizza is Manitoba, at $5.50 per pizza The index value for Manitoba is 88, indicating that the price of pizza there is only 88 percent

of the price at Calgary It is therefore 12 percent cheaper than at Calgary

d) These are cross-sectional data The variable is the price of pizza, collected at different places at a given point in time (March 1, 2004) If the data had been the prices of pizza at

a single university at various points in time, they would be time-series data

b) To solve this problem, we construct a weighted average unemployment rate We do so

by constructing a weight for each region equal to that region’s share in the total labour

force These weights are:

West: weight = 5.3/17.2 = 0.308 Centre: weight = 8.4/17.2 = 0.488 East: weight = 3.5/17.2 = 0.203 These weights should sum exactly to 1.0, but due to rounding they do not quite do so Using these weights, we now construct the average unemployment rate as the weighted sum of the three regional unemployment rates

Canadian unemployment rate = (.308 × 5.5) + (.488 × 7.2) + (.203 × 12.5) = 7.75 This is a better measure of the Canadian unemployment rate because it correctly weights each region’s influence in the national total Keep in mind, however, that for many situations the relevant unemployment rate for an individual or a firm may be the more local one rather than the national average

Chapter 3: Demand, Supply, and Price

Question 2

a) The reduction in the size of the peach harvest due to bad weather is a decrease in the supply of peaches  a leftward shift of the supply curve For a given demand curve, this leads to an increase in equilibrium price

b) An increase in income leads to an increase in the demand for all normal goods Assuming beef is a normal good, there will be a rightward shift in the demand curve for beef For a given upward-sloping supply curve, this shock leads to an increase in the equilibrium price and quantity of beef This is an increase in the quantity supplied of beef (caused by the price increase)

c) Technological improvements in microchips reduce the cost of producing computers and therefore cause an increase in supply — a rightward shift of the supply curve for computers This causes a fall in the equilibrium price and an increase in equilibrium quantity

d) Greater awareness of the health risks leads to a reduction in demand for cigarettes and thus, for a given supply curve, to a reduction in the equilibrium price and quantity As price falls, there is a reduction in the quantity of cigarettes supplied

Question 4

Keep in mind for this question that we must distinguish between variables whose changes will cause a shift in the demand for chicken and a change in the price of chicken that will move us along the demand curve for chicken

a) The finding that eating chicken can improve your health should lead to an increase in the demand for chicken (and presumably a reduction in the demand for less healthy meats) This will be shown by a rightward shift in the demand curve for chicken

b) As the price of beef rises, consumers will substitute away from beef and toward other meats, including chicken This will be shown by a rightward shift in the demand for chicken

c) If chicken is a normal good — meaning that consumers want more of it when their real income rises — then the rise in household income leads to an increase in the demand for chicken This will be shown by a rightward shift in the demand curve for chicken

Question 6

The apparent contradiction is solved when we recognize the difference between an increase

in supply and an increase in quantity supplied As the price of beef rises, say from p 0 to p 1, ranchers will sell more cattle to slaughterhouses This is an increase in the quantity of beef supplied, as indicated by a movement from A to B along the supply curve in the figure below An increase in the supply of beef, caused perhaps by a reduction in the price of

cattle feed, will shift the supply curve to the right (from S to S′) and reduce the equilibrium

price from p 1 to p 3, a move from A to C along the stable demand curve in the figure

Question 8

The quotation describes demand as becoming more “voracious” each year—this suggests that demand for cocoa is growing The fungal and viral diseases suggest a reduction in supply as producers find it more expensive to grow cacao trees and thus deliver cocoa to market Since demand is shifting to the right and supply is shifting to the left, it is clear that equilibrium price should be rising in the future What happens to equilibrium quantity depends on the relative sizes of the shifts of demand and supply

Chapter 4: Elasticity

Question 2

a) The table should be completed as shown below Note that elasticities are computed

“between the rows,” reflecting the change in quantity and prices between points on the

b) The diagram of the demand curve is shown below

c) At points higher up the demand curve, price is relatively high and quantity demanded

is relatively low Thus a given ∆p (such as the $2 increment shown in the table above) is

a small percentage change, whereas a given ∆Q (such as the 2-unit increment shown in

the table) is a large percentage change These same absolute changes will be different in

percentage terms as we move to the right along the demand curve (larger for ∆p and smaller for ∆Q) Since elasticity is a ratio of the percentage change in quantity demanded

to the percentage change in price, it follows that elasticity falls as we move to the right along a linear demand curve

Question 4

The key to this question is to recognize that own-price elasticity of demand is determined mostly by the availability of substitutes Notice that the products are listed in order of decreasing generality That is, item (e) is a subset of (d), which is a subset of (c), which is

a subset of (b), which in turn is a subset of (a) This means there are fewer substitutes for food than for leafy vegetables sold at your local supermarket on Wednesdays Thus we would expect demand for (a) to be the least elastic and demand for (e) to be the most elastic

Question 6

a) The concept is that of the own-price elasticity of demand, since we are considering changes in the price and quantity of ticket sales The measure of elasticity in this case is the percentage change in quantity demanded divided by the percentage change in price The average quantity is 1275 and the average price is $12.50 Thus, we have:

η = (150/1275)/(3/12.50) = 0.49 b) The concept is that of the income elasticity of demand because we are relating changes

in income to changes in quantity demanded The measure of income elasticity is the percentage change in quantity demanded divided by the percentage change in income The average quantity is 61,500 Note that we are given the percentage change in income equal to 10 percent or 0.10 Thus, we have:

ηY = (11,000/61,500)/(0.10) = 1.79 The positive sign reveals that Toyota Camrys are a normal good since a rise in income leads to an increase in quantity demanded

c) The concept is that of the cross-price elasticity of demand because we are relating changes in the price of coffee to changes in the quantity demanded of tea The measure of cross-price elasticity is the percentage change in the quantity demanded of tea divided by the percentage change in the price of coffee The average coffee price is $3.90 and the average quantity of tea is 7 750 kg Thus, we have:

ηXY = (500/7,750)/(1.80/3.90) = 0.14 The positive sign reveals that coffee and tea are substitute goods since a rise in the price

of coffee (which presumably reduces the quantity demanded of coffee) leads people to demand more tea

d) The concept is the Canadian own-price elasticity of supply because we are relating changes in the world price of pulp to changes in the quantity of pulp supplied by Canadian firms The measure of supply elasticity is the percentage change in (Canadian)

quantity supplied divided bythe percentage change in the world price The average quantity is 9.5 million tons Note that we are given the percentage increase in the price equal to 14 percent, or 0.14 Thus we have:

ηS = (3/9.5)/(0.14) = 2.26

Question 8

a) The four scale diagrams are shown below Note that all four diagrams have the same

scale on the vertical axes but different scales on the horizontal axes

b) The own-price elasticity of supply is equal to the percentage change in quantity supplied divided by the percentage change in the price The calculations for cases (i) through (iv) are :

i) average p = $30, average Q = 15 ηS = (10/15)/(20/30) = 1

ii) average p = $30, average Q = 7.5 ηS = (5/7.5)/(20/30) = 1

iii) average p = $30, average Q = 6 ηS = (4/6)/(20/30) = 1

iv) average p = $30, average Q = 3 ηS = (2/3)/(20/30) = 1

Note that in each case the supply curve is a straight line from the origin As we mentioned

in footnote #1 in the chapter, the elasticity of all such supply curves, no matter what the slope, is equal to one

c) As we saw in part (b), the elasticity of supply of each of the four supply curves is one But the slopes of the four curves are different The slope of the curve is measured by the change in price per unit change in quantity supplied The slopes are: (i) 20/10 = 2; (ii) 20/5

= 4; (iii) 20/4 = 5; and 20/2 = 10 The difference between slope and elasticity is that the first is measured in absolute changes whereas the second is measured as percentage changes This question should make it clear that this difference matters!

Chapter 5: Markets in Action

Question 2

a) With a binding price ceiling, the excess demand means that consumers must somehow

be rationed by means other than price This situation often encourages rationing by “sellers’ preferences,” including rationing by:

• religious beliefs or affiliation

c) If the government views the product in question as a necessity, it may introduce a price ceiling in the hope that it will improve consumers’ access to the product However, to the extent that the quantity supplied will fall, overall access will be reduced by such a policy d) If the government views the sellers of the product as deserving of support, a price floor may be seen as a desirable policy (This is the motivation for a legislated minimum wage.) However, to the extent that quantity demanded for the product will fall, some sellers of the product may see their markets disappear

Question 4

a) The free-market equilibrium is where quantity demanded equals quantity supplied From the table this occurs at a price of $800 per month and a quantity of 70 000 units

b) Any ceiling on the price of rental apartments must be below the free-market equilibrium

price to have any effect on the market Thus the highest it can be is just below $800

c) At a ceiling of $500 per month, quantity demanded is 100 000 units and quantity supplied is 60 000 units There is excess demand (a shortage) of 40 000 units There has also been a reduction in the equilibrium quantity exchanged (from 70 000 to 60 000 units) d) At a quantity of 60 000 units, the maximum price that consumers are willing to pay is

$900 per month for rental accommodation If all units were supplied on the black market,

$900 would be the black-market price

Question 6

a) For the supply curve: QS= 20 + 8p, the diagram is as follows:

b) As the world price of oil rises, two things are happening First, more oil is being extracted from existing oil wells Second, new oil wells are being explored and drilled c) At a high price of $16 per barrel, Canadian supply equals 148 million barrels per month The monthly income of producers is therefore $2.368 billion At a low price of $9 per barrel, Canadian supply is 92 million barrels per month Monthly income is therefore $828 million On the diagram this is shown as the movement between points A and B on the Canadian supply curve

Question 8

This question requires the student to solve a system of demand and supply curves as is done in the box near the end of Chapter 3

a) The free-market outcome is determined where quantity demanded equals quantity

supplied, QD = QS Setting p from the demand curve equal to p from the supply curve, we

b) At the guaranteed price of $2.00 per litre, quantity demanded is given by

200 = 225 – (15 ×QD) ⇒ QD = 1.67 (1.67 million litres)

At the same price, quantity supplied is given by

200 = 25 + 35QS ⇒ QS = 5 (5 million litres) c) Since the government has guaranteed to purchase any amount that the producers cannot sell, the producers will produce the full 5 million litres per month Thus, at the guaranteed price of $2.00 per litre, there is excess supply of 3.33 million litres per month This amount will be purchased by the government at a cost (to taxpayers) of $6.66 million per month d) The government purchase of milk is financed by taxpayers Taxpayers are clearly harmed since they must foot the direct bill for this system of price supports Consumers are also harmed since they consume less milk and must pay a higher price than would be available in the free market Milk producers are clearly better off Not only do they get a higher price per litre, but their surplus production is all purchased by the government

from S to S′ The immediate effect is to reduce the equilibrium price to p1 and raise

equilibrium quantity This is the move from E0 to E1 in the right-hand diagram

c) Sellers in the Eastern market now notice that cigarettes are more expensive in the Western market because taxes there have not fallen There is an incentive to smuggle cigarettes from the East to the West, selling them at the higher Western price This is illegal in Canada (though it happened in the event described in 1994) The effects of large-scale smuggling would be to shift the supply curve in the East to the left and shift

the supply curve in the West to the right This is the movement to E2 in both diagrams, where the prices of cigarettes are again equalized across the two markets

d) There are two limits on the extent of smuggling First, it is illegal The illegality of smuggling means that smugglers face some probability of being caught and punished The second limit is the direct cost of smuggling, including transactions and transportation costs Both aspects of smuggling mean that the price will not be exactly equalized across the two markets However, if there were no such limits on smuggling, then we would expect the price to be exactly equalized

Chapter 6: Consumer Behaviour

Question 2

a) The appropriate diagrams for (a) and (c) are shown below Note that the horizontal scales for both diagrams are the same but the vertical scales are different Note also that marginal utility is plotted between the integer values for the number of avocados

consumed because marginal utility measures the change in utility from consuming one

more avocado

b) The marginal utility is the change in utility divided by the change in the number of units consumed The marginal utilities are given in the following table:

Change in Consumption Marginal Utility

c) The graph of marginal utility is shown above

d) Brett likes avocados, and each extra avocado may well increase his total utility But after some point (and perhaps right away, as in this case), each successive avocado adds

less to his total utility (or satisfaction) than the previous one That is, the utility that Brett

gains from each extra avocado falls, though it may still be a positive amount Most of us

have experienced this phenomenon, whether it be with cold beverages on a sunny day, pieces of pizza, or meals at a nice restaurant

Question 4

a) The sum of Rupert’s willingness to pay for the first five pizzas is 18 + 16 + 13 + 9 + 4

= $60 Thus Rupert would be willing to pay $60 per week for these five pizzas — this is the total value that Rupert places on five weekly pizzas

b) Rupert will purchase pizzas until his willingness to pay for the next pizza is less than the market price At a price of $10 per pizza, Rupert will buy three pizzas per week c) The total value that Rupert places on the three pizzas is 18 + 16 + 13 = $47 The amount Rupert must spend to buy them is $10 per pizza times three pizzas, or $30 Thus Rupert’s consumer surplus is $17

Question 6

a) Consumer surplus at price p 0 is given by the triangle defined by points BCD

b) The new equilibrium price is p 1 and quantity is Q 1 Consumer surplus is now given by the triangle ACE

c) On the original Q 0 units, the lower price means more consumer surplus, given by the rectangle ABDF

d) The triangle FDE is the new consumer surplus earned o the new (Q 1 – Q 0) units

Question 8

This is a good question to emphasize the difference between total and marginal value and

to clarify how changes in market price are related to changes in either total or marginal value

a) The rightward shift of the demand curve reflects the fact that consumers now place more total value on this item (or, in other words, more value for any given quantity) Thus, for any given quantity of the product, the area under the demand curve has increased

b) In equilibrium, the marginal value of X has not changed, even though the total value has

The reason is that, in this case, the supply curve is perfectly elastic, and so the equilibrium

market price is unaffected by the increase in demand So consumers still consume X until

the marginal value is equal to the market price, but the latter is unchanged and thus so is the former

c) The total value that consumers place on a given quantity of Y is unchanged—the

demand curve for Y has not moved

d) The increase in supply drives down the price The reduction in price leads consumers

to consume more of Y until the marginal value is just equal to the price But since the price has fallen, the value of Y at the margin has also fallen, even though there has been

no change in preferences (the demand curve hasn’t moved at all)

Chapter 7: Producers in the Short Run

Question 2

a) law of (eventually) diminishing returns (to the variable factor)

b) marginal product (of the variable factor)

c) above; below

Question 4

The table is completed below Note that for marginal product (MP), the computation is done for the change in output and labour input between rows Thus, the first value in the table for MP reflects the change in output from 0 to 2 and the change in labour from 0 to 1; the marginal product is therefore equal to ∆TP/∆L = 2/1 = 2

a) By substituting the values of K and L into the production function provided

(Q = KL – 1L2), the values for Q are easily found The answers are:

b) The following diagram shows the relationship between L and Q, for K fixed and equal

to 10 Note that the curve goes through the origin because when L equals 0, Q also equals

0 (independent of the value of K)

c) If K increases to K = 20, then the values of Q will also increase (for any given value of

L) The re-computed values for Q are in the table below The new curve is shown in the

diagram above, indicated by K = 20

d) A larger capital stock means that any given amount of labour now has more capital to

work with, and thus can produce more output This increase in the average product of

labour is reflected simply by the upward shift in the curve shown above Note also,

however, that in this case (and in many others), the increase in K also increases the

marginal product of labour for any given level of labour input This is shown by the

increase in the slope of the curve for any level of L For example, for L = 25, the slope of

the K = 20 curve is greater than the slope of the K = 10 curve This shows that the increase

in K has made labour more productive at the margin

AVC

Average Variable Cost ($)

ATC

Average Total Cost ($)

d) The scale diagram is shown below Note that we have not graphed values greater than

70, so the top sections of the AFC and ATC curves are not shown

Average Product

Marginal Product

Chapter 8: Producers in the Long Run

Question 2

a) The ratios of marginal products to factor prices in this case are:

K: MP K /p K = 80/2 = 40 L: MP L /p L = 20/10 = 2

This firm is not minimizing its costs; to do so it should use more K and less L

b) The ratios in this case are:

K: MP K /p K = 80/20 = 4 L: MP L /p L = 20/5 = 4 This firm is minimizing its costs No further substitution is required

c) The ratios in this case are:

K: MP K /p K = 80/40 = 2 L: MP L /p L = 20/5 = 4

This firm is not minimizing its costs; to do so it should use less K and more L

b) Cost minimization requires the firm to adjust capital and labour use until the ratio of

marginal products equals the ratio of factor prices In this case, p K /p L = 8/4 = 2 So the

cost-minimizing production method is method B, which has MPK = 12 and MPL = 6

c) For method A, MPK/MPL = 14/3 which exceeds 2 Thus the firm should use more K and

less L For methods C through G, MPK/MPL is less than 2 In all these cases the firm should use less K and more L

d) At the new factor prices, p K /p L = 4/6 = 0.67 The new cost-minimizing production

method is D which uses more K and less L than method B It makes sense that as the price

of capital falls relative to the price of labour, the cost-minimizing firm substitutes toward capital and away from labour This is the principle of substitution

Question 6

a) With Plant #1 and output Q 1, average costs are equal to c1

b) At Q 1, the firm is experiencing decreasing costs because at this output level the LRAC curve is downward sloping

c) The decreasing costs in (b) are due to economies of scale

d) Now consider output Q 2 with Plant #2:

i) average costs are c2

ii) the LRAC curve is horizontal, and so there are constant costs iii) no further economies of scale

With output Q 3 and Plant #3:

i) average costs are c3

ii) the LRAC curve is upward sloping and so there are increasing costs iii) diseconomies of scale

Question 8

a) Economies of scale refers to what happens to unit costs as all factors of production are increased by the same proportion For example, if the firm increases its capital stock and its labour force by 10 percent, what happens to unit costs? Since all factors are variable in this exercise, it is clearly a long-run concept The most often cited explanation for economies of scale (unit costs decreasing as scale rises) is that as the scale of operation increases, the firm is better able to take advantage of the benefits of specialization and the division of labour These productivity gains imply a reduction in unit costs

The spreading of overhead refers to the behaviour of average fixed costs as the level

of output rises For a given amount of fixed costs (capital costs, product development costs, etc.), average fixed costs clearly decline as the level of output rises Since this concept clearly relies on the existence of fixed costs (which means there are some fixed factors of production), it is clearly a short-run concept This is an important reason for declining average total costs in the short run Even if average variable costs have started to rise due to

diminishing marginal product, a large enough decline in AFC can still make ATC decline b) See the diagram below that shows an LRAC curve as well as an SRATC curve At output equal to Q*, long-run average costs are falling, indicating economies of scale Also, at Q* short-run average total costs are falling Note that even though MC is shown to be rising at

Q*, and thus diminishing returns to the variable factor has already set in, SRATC is still

falling This must be due to the continued spreading of overhead, as reflected by an AFC curve that is falling as Q rises (not shown)

d) See the diagram below The (absolute value of the) slope of the isocost line is the ratio

of factor prices, p L /p K = 3/6 = 0.5 The cost-minimizing production method at these factor

prices is either method C or D (since they are the same) Thus the isocost line passes

through both points C and D in the diagram above, but lies below points A, B, E, and F The interpretation is that production methods A, B, E, and F cannot be achieved at the same low cost as methods C and D The horizontal and vertical intercepts of the isocost line are K = 408/6 = 68; and L = 408/3 = 136

e) If the price of labour rises from $3 to $5 per unit, a cost-minimizing firm will substitute away from labour and toward capital In the diagram above, this will be a movement up and to the left along the isoquant (we are told it still wants to produce 500 tires per day) With the new factor prices, it is easy to recompute the total costs in the table above The isocost line becomes steeper—its new slope will be 5/6 = 0.833 The cost-minimizing

method of production is now method F, with a total cost of $470 (Remember that the rise

in the price of labour makes all production methods more expensive, but the least

expensive is now the most capital-intensive method.)

Chapter 9: Competitive Markets

Question 2

a) average variable costs

b) shut down and exit the industry

c) reduce

d) equal; maximized

e) greater than; increase

Question 4

a) Let the equilibrium market price be p* Any firm that tried to charge a higher price

would make no sales whatsoever, since consumers would simply make their purchases from other (lower-price) sellers

b) Each firm can sell as much as it wants at the price p* Thus selling at a lower price

would not increase sales but would reduce profits So no firm has the incentive to charge

any price below p*

c) Each individual firm is very small relative to the market (check Figure 9-1 again and compare the units on the quantity axes in the two parts of the figure) Thus for any change

in output that is realistic for the firm, there would be no significant or noticeable effect on

the industry level of output and thus no significant effect on the market price Thus, each firm sees that it can sell any reasonable amount at the given market price (Read Applying

Economic Concepts 9-1 to see an application — we show that even though the market

demand for wheat is quite inelastic, the demand for any individual farmer’s wheat is almost perfectly elastic.)

Question 6

a) The completed table is shown below The firm’s supply curve is determined by its MC curve above the minimum of the AVC curve Profits are determined by the difference between price and average total cost, ATC

Price ($) Firm’s Output Is price > ATC? Is Price > AVC? Profits positive?

b) The firm shuts down when the market price falls below the minimum of the AVC curve

In this case, when the price falls below $4, the firm will shut down The reason is that when

price < AVC, the firm cannot cover even its variable costs, and so the firm is better off to

close down rather than produce and increase its losses

c) The firm’s supply curve is its MC curve above the minimum point of AVC There will

be no production when price < AVC, for the reason given in part (b) For prices above

AVC, profit maximization requires the firm to produce until marginal revenue (which

equals market price) is equal to marginal cost Thus the MC curve above the AVC curve

is the firm’s supply curve

Question 8

a) The diagrams are shown below The left-hand diagram shows the initial industry

equilibrium at price p0 and quantity Q0

b) The right-hand diagram above shows a typical firm when the industry is in long-run

equilibrium The typical firm is producing q0 units of output It is not only earning zero

economic profits (p = SRATC), but it also has no unexploited economies of scale — that

is, it is at the minimum of its LRAC curve

c) See the diagram above The increase in demand for barley shifts the demand curve to

D′ and raises the short-run equilibrium price to p1 The increase in market price causes

each firm to increase its own output along its MC curve, to output q1 for the typical firm shown The profits at this new high price are shown by the shaded area

d) The positive profit in part (c) leads other firms to enter this industry As new barley farmers enter the industry, the industry supply curve shifts to the right and reduces the equilibrium market price Entry continues until existing firms are not making any economic profits As long as technology has not changed, firms’ cost curves do not shift and so supply shifts eventually to S′, where the market price has returned to p0 At this

point, the typical firms are again making zero economic profits (The assumption of a constant-cost industry ensures that the change in scale of the industry does not lead to changes in the firms’ cost curves.)

b) Marginal revenue is equal to the change in total revenue divided by the change in

quantity In the table above it is shown for a change from one row to the next For any given quantity, marginal revenue is less than price This is because in order to sell more output, price on all units must fall Thus the price on the new units is not equal to marginal revenue — we must subtract from this new price the amount that we lose on the previous units by having to reduce their price

c) The scale diagram is shown below Note that the MR curve is plotted at the midpoint of

the intervals of quantity demanded

d) The scale diagram is shown below When TR reaches its maximum, an increase in

quantity (and a reduction in price) leads to no change in total revenue Thus marginal revenue at this point is exactly zero At larger quantities than this, marginal revenue is negative

Question 4

a) For any firm, profits are maximized at that level of output where marginal revenue

equals marginal cost In the diagram, MR equals MC at output of Q0 At this level of

output, the monopolist charges the price p4

b) Profits per unit are equal to price minus average total cost Thus the profits are the

rectangle defined by the points p2p4BC Since price exceeds average total cost, the monopolist’s profits are positive

c) Consumer surplus is the triangle defined by the points p4AB As always, it is the area below the demand curve and above the price line

d) If the industry were instead a perfectly competitive one, equilibrium price and quantity would be determined by the intersection of demand and supply, where the industry

supply curve would be given by the summation of the firms’ MC curves Thus point D would be the competitive equilibrium, with price p3 and quantity Q2

e) Consumer surplus in part (d) would be the triangle defined by points p3AD, the area under the demand curve and above the (competitive) price line

Question 6

a) The two diagrams are shown below Note that the horizontal scale is different on the

two diagrams The left-hand diagram shows industry output, Q; the right-hand diagram shows the firm’s level of output, q

b) If the farmers could successfully collude to restrict output, they would collectively act

like a monopolist, choosing output such that MR equals MC They would collectively produce output equal to QM and charge price pM

c) In the right-hand diagram, we see that the cartel’s restriction of output requires the

typical farmer to produce output equal to only qM (Since QM is roughly one-half of Q0, it

must be the case that for the typical firm qM is roughly half of q0, as shown in the

right-hand diagram.) The high price of pM means that the typical farmer earns profits given by the light shaded area

d) Yes, it is definitely profitable for each individual farmer to increase its output rather to

leave output at qM Given that all other farmers are restricting their output, the industry

price of pM becomes each individual farmer’s MR curve But MC is much lower than pM,

so each individual farmer would like to cheat on the agreement and produce more

e) Given the cartel price of pM, each individual farmer has the incentive to increase output

all the way to q*, where the cartel price is equal to MC In this case, profits for the

individual cheating farmer would be the sum of the two shaded areas

f) If all firms cheated in this way, the industry output would rise significantly and the

market price would fall below the cartel price pM This is exactly why cartels tend to be unstable; all individual cartel members have the incentive to cheat on the agreement, and this cheating essentially eliminates the output-restricting behaviour of the cartel

Question 8

a) With perfect price discrimination, the monopolist would choose output where the

demand curve intersects the MC curve, and so would sell 600 games per week The price

on the last game would be $40

b) Without price discrimination, the single-price monopoly output yields consumer surplus

given by the triangle cde

c) With perfect price discrimination, the consumer surplus is zero because each unit is sold

at the highest price consumers are willing to pay for that unit (the height of the demand curve)

d) It is difficult to practise perfect price discrimination because the monopolist would need

to know consumers’ willingness to pay for every unit and would also have to be able to prevent arbitrage More likely forms of price discrimination might include:

• different prices for different customer “groups” such as business vs leisure

• different price on different days of the week

• different prices for different times of the day

• “bulk purchase” discounts in which customers buy several games in advance for a

lower price per game than is available when customers buy a single game

Question 10

a) Arbitrage is prevented because the product (movie viewing) is a service rather than a good; an “adult” can not purchase a “senior” ticket and then see the movie because the ticket will easily be checked at the theatre entrance Without price discrimination, seniors would be worse off and adults would be better off because the single price would probably

be between the two discriminatory prices

b) This is “hurdle pricing”, where the hurdle that must be cleared to get the low price is to wait 6–12 months before buying the book Impatient people (inelastic demand) will buy the hardcover book at a high price; patient people (elastic demand) will wait and buy the paperback book at a low price Note that in this case the products are also slightly different, and thus the price differential partly reflects differences in cost (hardcover books are more expensive to produce than paperbacks) It is difficult to determine who would be better off and worse off without price discrimination in this case because there is a difference in the products If publishers were forced to sell only one type of book (at a single price), then the single price would likely be between the hardcover and paperback prices

c) This is “hurdle pricing” where the hurdle is to reveal that you are prepared to haggle Each side of the transaction (buyer and seller) typically tries to extract as much surplus as possible from the other side, and the relative success in haggling determines the final price

It is not clear what a single price (no price discrimination) means in this situation, since most garage sales have only one unit of a large number of goods However, you might wonder what prices would be like if garage-sale operators committed to posting a single price for each good and not haggling That single posted price would probably be less than what would otherwise be the “starting” price, but greater than what the final (after

haggling) price would be Thus successful hagglers would be worse off with the single posted price, and poor hagglers would be better off

d) Typical business travellers do not want to stay over the Saturday night whereas typical non-business travellers do The former have less elastic demands, and so this pricing scheme is aimed at segmenting the two groups of customers Without price discrimination, the single price would probably be less than the discriminatory business price and greater than the discriminatory non-business price Thus business travellers would be better off and non-business travellers would be worse off without the price discrimination

Chapter 11: Imperfect Competition and Strategic Behaviour

positive profits (since at Q* price exceeds ATC) These profits attract new firms to enter

the industry As new firms enter, the demand curve shifts to the left and becomes flatter, because total industry output must now be divided among a larger number of firms Entry occurs until firms have zero profit in the long-run equilibrium, shown as a tangency

between ATC and the demand curve

Question 6

a) Free entry and exit implies that firms will enter if existing firms are making positive profits, and this entry will dissipate those profits Conversely, firms will exit if they are making negative profits (losses), and the exit will increase the profits (reduce the losses)

of the remaining firms Thus, firms in the long-run equilibrium of a monopolistically

competitive industry will have zero profits At point A, price is equal to average total

costs, and so profits are zero

b) Point B is the long-run equilibrium market price that would exist if the industry were

perfectly competitive, since it is at the minimum of the average cost curve

c) This firm’s long-run equilibrium price, pA, is greater than the price that minimizes its average costs, and in this sense there is an inefficiency compared to perfect competition But as we argued in the text, the higher unit cost is the price we pay for greater product diversity, and it may well be the case that consumers benefit more from the diversity than they lose from the higher prices, in which case we could not say that monopolistic competition is unambiguously worse than perfect competition

Chapter 12: Economic Efficiency and Public Policy

b) The establishment of a minimum wage at wM raises the wage that firms must pay and

thus reduces the quantity of labour demanded by firms to LM So LM is the new level of

employment At the new wage, there is unemployment equal to LML′

c) With the minimum wage in place, consumer surplus falls by the trapezoid w*wMAC

Producer surplus rises by the rectangle w*wMAD but falls by the triangle BDC The

rectangle w*wMAD is simply a redistribution from firms to those workers who are lucky

enough to remain employed after the policy comes into effect The triangle ABC is the net

loss in consumer and producer surplus as a result of the policy, and reflects the extent of the allocative inefficiency of the minimum-wage policy

Question 6

a) All points on the production possibilities boundary reflect productive efficiency both for firms and industries Thus if lime producers are not minimizing costs (productive

inefficiency), then only point A could represent this situation

b) All points on the production possibilities boundary reflect productive efficiency both

for firms and industries Thus points B, C and D are possible

c) At point B there is a monopolized lime industry but a competitive coconut industry Since point B is on the production possibilities boundary, we know that it is productively

efficient But the monopoly in the lime industry means it is not allocatively efficient At

point B there are too few limes being produced (and thus too many coconuts being

produced)

d) At point D there is a monopolized coconut industry but a competitive lime industry Since point D is on the production possibilities boundary, we know that it is productively

efficient But the monopoly in the coconut industry means it is not allocatively efficient

At point D there are too few coconuts being produced (and thus too many limes being

produced)

e) If point C is allocatively efficient, we know that price equals marginal cost in all

industries simultaneously In each industry, we are at the intersection of the competitive demand and supply curves, and total surplus is maximized

Question 8

a) See the diagram below If existing regulation forced average-cost pricing, then the

price would be p1 and quantity would be Q1

b) Since at Q1, price exactly equals average cost, the natural monopoly firm would be earning zero economic profits

c) Since with price p1 and quantity Q1 the price would exceed marginal cost (equal to c1), society would benefit by having more units of this good The outcome is allocatively inefficient

d) For regulation that forced marginal-cost pricing, price would be p2 and quantity would

is unsustainable without some form of financial support to the firm This shows the basic problem of achieving efficiency in cases of natural monopoly