ECO 550 ALL CHAPTERS ANSWERS TO KEY QUESTIONS
ECO 550 ALL CHAPTERS ANSWERS TO KEY QUESTIONS fin571
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ECO 550 ALL CHAPTERS ANSWERS TO KEY QUESTIONS CHAPTER ONE APPENDIX 11 Use the economic perspective to explain why someone who is normally a light eater at a standard restaurant may become somewhat of a glutton at a buffetstyle restaurant which charges a single price for all you can eat. This behavior can be explained in terms of marginal costs and marginal benefits. At a standard restaurant, items are priced individually — they have a positive marginal cost. If you order more, it will cost you more. You order until the marginal benefit from the extra food no longer exceeds the marginal cost. At a buffet you pay a flat fee no matter how much you eat. Once the fee is paid, additional food items have a zero marginal cost. You therefore continue to eat until your marginal benefit becomes zero. 15 Explain in detail the interrelationships between economic facts, theory, and policy. Critically evaluate this statement: “The trouble with economic theory is that it is not practical. It is detached from the real world.” Economic theory consists of factually supported generalizations about economic behavior that can be used to formulate economic policies. Economic theory enables policymakers to formulate economic policies that are relevant to realworld goals and problems that are based upon carefully observed facts. 17 Indicate whether each of the following statements applies to microeconomics or macroeconomics: (a), (d), and (f) are macro; (b), (c), and (e) are micro. 18 Identify each of the following as either a positive or a normative statement: a. The high temperature today was 89 degrees. b. It was too hot today. c. Other things being equal, higher interest rates reduce the total amount of borrowing. d. Interest rates are too high. (a) and (c) are positive; (b) and (d) are normative. 19 Explain and give an illustration of (a) the fallacy of composition; and (b) the “after this, therefore because of this” fallacy. Why are causeandeffect relationships difficult to isolate in the social sciences? (a) The fallacy of composition is the mistake of believing that something true for an individual part is necessarily true for the whole. Example: A single auto producer can increase its profits by lowering its price and taking business away from its competitors. But matched price cuts by all auto manufacturers will not necessarily yield higher industry profits. (b) The “after this, therefore because of this” fallacy is incorrectly reasoning that when one event precedes another, the first even necessarily caused the second. Example: Interest rates rise, followed by an increase in the rate of inflation, leading to the erroneous conclusion that the rise in interest rates caused the inflation. Actually higher interest rates slow inflation. Causeandeffect relationships are difficult to isolate because “other things” are continually changing. CHAPTER TWO 25 Why is the problem of unemployment a part of the subject matter of economics? Distinguish between allocative efficiency and productive efficiency. Give an illustration of achieving productive, but not allocative, efficiency. Economics deals with the “limited resources—unlimited wants” problem. Unemployment represents valuable resources that could have been used to produce more goods and services—to meet more wants and ease the economizing problem. Allocative efficiency means that resources are being used to produce the goods and services most wanted by society. The economy is then located at the optimal point on its production possibilities curve where marginal benefit equals marginal cost for each good. Productive efficiency means the least costly production techniques are being used to produce wanted goods and services. Example: manual typewriters produced using the least cost techniques but for which there is no demand. 26 Here is a production possibilities table for war goods and civilian goods: Type of Production Production Alternatives A B C D E Automobiles 0 2 4 6 8 Rockets 30 27 21 12 0 a. Show these data graphically. Upon what specific assumptions is this production possibilities curve based? b. If the economy is at point C, what is the cost of one more automobile? One more rocket? Explain how this curve reflects increasing opportunity costs. c. What must the economy do to operate at some point on the production possibilities curve? (a) See curve EDCBA. The assumptions are full employment and productive efficiency, fixed supplies of resources, and fixed technology. Automobiles 8 6 4 2 0 E D C G H PPC2 PPC3 PPC1 B A 12 21 27 30 Question 26 Rockets waL74858_Ans_301318 6/18/01 1:24 PM Page 320 320 ANSWERS TO KEY QUESTIONS (b) 4.5 rockets; .33 automobiles, as determined from the table. Increasing opportunity costs are reflected in the concavefromtheorigin shape of the curve. This means the economy must give up larger and larger amounts of rockets to get constant added amounts of automobiles— and vice versa. (c) It must obtain full employment and productive efficiency. 29 Specify and explain the shapes of the marginalbenefit and marginalcost curves and use these curves to determine the optimal allocation of resources to a particular product. If current output is such that marginal cost exceeds marginal benefit, should more or less resources be allocated to this product? Explain. The marginal benefit curve is downward sloping, MB falls as more of a product is consumed because additional units of a good yield less satisfaction than previous units.The marginal cost curve is upward sloping, MC increases as more of a product is produced since additional units require the use of increasingly unsuitable resources. The optimal amount of a particular product occurs where MB equals MC. If MC exceeds MB, fewer resources should be allocated to this use. The resources are more valuable in some alternative use (as reflected in the higher MC) than in this use (as reflected in the lower MB). 210 Label point G inside the production possibilities curve you have drawn for question 6. What does it indicate? Label point H outside the curve. What does this point indicate? What must occur before the economy can attain the level of production indicated by point H? G indicated unemployment, productive inefficiency, or both. H is at present unattainable. Economic growth—through more inputs, better inputs, improved technology—must be achieved to attain H. 211 Referring again to question 6, suppose improvement occurs in the technology of producing rockets but not in the production of automobiles. Draw the new production possibilities curve. Now assume that a technological advance occurs in producing automobiles but not in producing rockets. Draw the new production possibilities curve. Now draw a production possibilities curve that reflects technological improvement in the production of both products. See the graph for question 26. PPC1 shows improved rocket technology. PPC2 shows improved auto technology. PPC3 shows improved technology in producing both products. CHAPTER THREE 32 What effect will each of the following have on the demand for product B? a. Product B becomes more fashionable. b. The price of substitute product C falls. c. Income declines and product B is an inferior good. d. Consumers anticipate the price of B will be lower in the near future. e. The price of complementary product D falls. f. Foreign tariff barriers on B are eliminated. Demand increases in (a), (c), (e), and (f); decreases in (b) and (d). 35 What effect will each of the following have on the supply of product B? a. A technological advance in the methods of producing B. b. A decline in the number of firms in industry B. c. An increase in the price of resources required in the production of B. d. The expectation that equilibrium price of B will be lower in the future than it is currently. e. A decline in the price of product A, a good whose production requires substantially the same techniques as does the production of B. f. The levying of a specific sales tax upon B. g. The granting of a 50cent per unit subsidy for each unit of B produced. Supply increases in (a), (d), (e), and (g); decreases in (b), (c), and (f). 37 Suppose the total demand for wheat and the total supply of wheat per month in the Kansas City grain market are as follows: Thousands Price Thousand Surplus () of bushels per of bushels or demanded bushel supplied shortage () 85 $3.40 72 80 3.70 73 75 4.00 75 70 4.30 77 65 4.60 79 60 4.90 81 _____ a. What will be the market or equilibrium price? What is the equilibrium quantity? Using the surplusshortage column, explain why your answers are correct. b. Graph the demand for wheat and the supply of wheat. Be sure to label the axes of your graph correctly. Label equilibrium price “P” and the equilibrium quantity “Q.” c. Why will $3.40 not be the equilibrium price in this market? Why not $4.90? “Surpluses drive prices up; shortages drive them down.” Do you agree? d. Now suppose that the government establishes a ceiling price of, say, $3.70 for wheat. Explain carefully the effects of this ceiling price. Demonstrate your answer graphically. What might prompt the government to establish a ceiling price? Data from top to bottom: 13; 7; 0; 7; 14; and 21. $4.90 D P S Q S D 4.60 4.30 4.00 3.70 3.40 Price per bushelEquilibrium: P $4.00 Q 75 Shortage at $3.70 price ceiling Question 37 060 65 70 75 80 85 Quantity (thousands of bushels) (a) Pe $4.00; Qe 75,000. Equilibrium occurs where there is neither a shortage nor surplus of wheat. At the immediately lower price of $3.70, there is a shortage of 7,000 bushels. At the immediately higher price of $4.30, there is a surplus of 7,000 bushels. (See graph top of next page.) (b) Quantity (thousands) of bushels. (c) Because at $3.40 there will be a 13,000 bushel shortage which will drive the price up. Because at $4.90 there will be a 21,000 bushel surplus which will drive the price down. Quotation is incorrect; just the opposite is true. waL74858_Ans_301318 6/18/01 1:24 PM Page 321 ANSWERS TO KEY QUESTIONS 321 (d) A $3.70 ceiling causes a persistent shortage. This product may be a necessity and the government is concerned that some consumers might not being able to afford it. 38 How will each of the following changes in demand and/or supply affect equilibrium price and equilibrium quantity in a competitive market; that is, do price and quantity rise, fall, remain unchanged, or are the answers indeterminate, depending on the magnitudes of the shifts in supply and demand? You should rely on a supply and demand diagram to verify answers. a. Supply decreases and demand remains constant. b. Demand decreases and supply remains constant. c. Supply increases and demand is constant. d. Demand increases and supply increases. e. Demand increases and supply is constant. f. Supply increases and demand decreases. g. Demand increases and supply decreases. h. Demand decreases and supply decreases. (a) Price up; quantity down; (b) Price down; quantity down; (c) Price down; quantity up; (d) Price indeterminate; quantity up; (e) Price up; quantity up; (f) Price down; quantity indeterminate; (g) Price up, quantity indeterminate; (h) Price indeterminate and quantity down. CHAPTER FOUR 47 Assume that a business firm finds that its profits will be at maximum when it produces $40 worth of product A. Suppose also that each of the three techniques shown in the following table will produce the desired output. (b) Adopt technique 4 because its cost is now lowest at $32. (c) Technique 1 because its cost is now lowest at $27.50 (d) The statement is logical. Increasing scarcity causes prices to rise. Firms ignoring higher resource prices will become highcost producers and be competed out of business by firms switching to the less expensive inputs. The market system forces producers to conserve on the use of highly scarce resources. Question 8c confirms this: Technique 1 was adopted because labor had become less expensive. 49 Some large hardware stores such as Home Depot boast of carrying as many as 20,000 different products in each store.What motivated the producers of those products—everything from screwdrivers to ladders to water heaters—to make them and offer them for sale? How did producers decide on the best combinations of resources to use? Who made these resources available, and why? Who decides whether these particular hardware products should continue to get produced and offered for sale? The quest for profit led firms to produce these goods. Producers looked for and found the leastcost combination of resources in producing their output. Resource suppliers, seeking income, made these resources available. Consumers, through their dollar votes, ultimately decide on what will continue to be produced. CHAPTER FIVE 52 Assume that the five residents of Econoville receive incomes of $50, $75, $125, $250, and $500. Present the resulting personal distribution of income as a graph similar to Figure 52. Compare the incomes of the lowest and highest fifth of the income receivers. The distribution of income is quite unequal. The highest 20 percent of the residents receive 10 times more income than the lowest 20 percent. Resource Units Required Resource Price per unit of resource Technique No. 1 Technique No. 2 Technique No. 3 Labor $3 5 2 3 Land 4 242 Capital 2 245 Entrepreneurial ability 2 424 a. With the resource prices shown, which technique will the firm choose? Why? Will production entail profits or losses? Will the industry expand or contract? When is a new equilibrium output achieved? b. Assume now that a new technique, technique No. 4, is developed. It entails the use of 2 units of labor, 2 of land, 6 of capital, and 3 of entrepreneurial ability. Given the resource prices in the table, will the firm adopt the new technique? Ex Personal income received (percent) 50 40 30 20 10 5.0 7.5 12.5 25.0 50.0 Question 52 0 plain your answers. c. Suppose now that an increase in labor supply causes the price of labor to fall to $1.50 per unit, all other resource prices being unchanged. Which technique will the producer now choose? Explain. d. “The market system causes the economy to conserve most in the use of those resources which are particularly scarce in supply. Resources that are scarcest relative to the demand for them have the highest prices. As a result, producers use these resources as sparingly as is possible.” Evaluate this statement. Does your answer to part c, above, bear out this contention? Explain. (a) Technique 2. Because it produces the output with least cost ($34 compared to $35 each for the other two). Economic profit will be $6 ( 40 $34), which will cause the industry to expand. Expansion will continue until prices decline to where total revenue is $34 (equal to total cost). Lowest Second Middle Fourth Highest 20% 20% 20% 20% 20% Income group 54 What are the major legal forms of business organization? Briefly state the advantages and disadvantages of each. How do you account for the dominant role of corporations in the U.S. economy? The legal forms of business organizations are: sole proprietorship, partnership, and corporation. Proprietorship advantages: easy to start and provides maximum freedom for the proprietor to do what she/he thinks best. Proprietorship disadvantages: limited financial resources; the owner must be a JackorJillofalltrades; unlimited liability. Partnership advantages: easy to organize; greater specialization of management; and greater financial resources. Disadvantages: financial resources are still limited; unlimited liability; B APublic goods waL74858_Ans_301318 6/18/01 1:24 PM Page 322 322 ANSWERS TO KEY QUESTIONS possibility of disagreement among the partners; and precarious continuity. Corporation advantages: can raise large amounts of money by issuing stocks and bonds; limited liability; continuity. Corporation disadvantages: red tape and expense in incorporating; potential for abuse of stockholder and bondholder funds; double taxation of profits; separation of ownership and control. The dominant role of corporations stems from the advantages cited, particularly unlimited liability and the ability to raise money. 59 What are the basic characteristics of public goods? Explain the significance of the exclusion principle. By what means does government provide public goods? Public goods are indivisible (they are produced in such large units that they cannot be sold to individuals) and the exclusion principle does not apply to them (once the goods are produced nobody—including free riders—can be excluded from the goods’ benefits). The freerider problem explains the significance of the exclusion principle. The exclusion principle separates goods and services which private firms will supply (because those who do not pay for them can be excluded from their benefits) and goods and services which government must supply (because people can obtain the benefits without paying). Government must levy taxes to get revenues to pay for public goods. 510 Draw a production possibilities curve with public goods on the vertical axis and private goods on the horizontal axis. Assuming the economy is initially operating on the curve, indicate the means by which the production of public goods might be increased. How might the output of public goods be increased if the economy is initially functioning at a point inside the curve? On the curve, the only way to obtain more public goods is to reduce the production of private goods (from C to B). An economy operating inside the curve can expand the production of public goods without sacrificing private goods (say, from A to B) by making use of unemployed resources. Question 510 C 0 515 Suppose in Fiscalville there is no tax on the first $10,000 of income, but earnings between $10,000 and $20,000 are taxed at 20 percent and income between $20,000 and $30,000 at 30 percent. Any income above $30,000 is taxed at 40 percent. If your income is $50,000, how much in taxes will you pay? Determine your marginal and average tax rates. Is this a progressive tax? Total tax $13,000; marginal tax rate 40% average tax rate 26%. This is a progressive tax; the average tax rate rises as income goes up. CHAPTER SIX 64 The following are production possibilities tables for South Korea and the United States. Assume that before specialization and trade the optimal productmix for South Korea is alternative B and for the United States alternative U.F Private goods South Korea’s production possibilities Product A B C D E F Radios (in 1000s) 30 24 18 12 6 0 chemicals (tons) 0 6 12 18 24 30 U.S. production possibilities Product R S T U V W Radios (in 1000s) 10 8 6 4 2 0 chemicals (tons) 0 4 8 12 16 20 a. Are comparative cost conditions such that the two areas should specialize? If so, what product should each produce? b. What is the total gain in radio and chemical output that results from this specialization? c. What are the limits of the terms of trade? Suppose actual terms of trade are 1 unit of radios for 112 units of chemicals and that 4 units of radios are exchanged for 6 units of chemicals. What are the gains from specialization and trade for each area? d. Can you conclude from this illustration that specialization according to comparative advantage results in more efficient use of world resources? Explain. (a) Yes, because the opportunity cost of radios is less (1R 1C) in South Korea than in the United States (1R 2C). South Korea should produce radios and the United States should produce chemicals. (b) If they specialize, the United States can produce 20 tons of chemicals and South Korea can produce 30,000 radios. Before specialization South Korea produced alternative B and the United States alternative U for a total of 28,000 radios (24,000 4,000) and 18 tons of chemicals (6 tons 12 tons). The gain is 2,000 radios and 2 tons of chemicals. (c) The limits of the terms of trade are determined by the comparative cost conditions in each country before trade: 1R 1C in South Korea and 1R 2C in the United States. The terms of trade must be somewhere between these two ratios for trade to occur. If the terms of trade are 1R 11/2C, South Korea would end up with 26,000 radios ( 30,000 4,000) and 6 tons of chemicals. The United States would have 4,000 radios and 14 tons of chemicals ( 20 6). South Korea has gained 2,000 radios. The United States has gained 2 tons of chemicals. (d) Yes, the world is obtaining more output from its fixed resources. 66 True or false? “U.S. exports create a demand for foreign currencies; foreign imports of U.S. goods generate supplies of foreign currencies.” Explain. Would a decline in U.S. consumer income or a weakening of U.S. preferences for foreign products cause the dollar to depreciate or appreciate? Other things equal, what would be the effects of that depreciation or appreciation on U.S. exports and imports? The first part of this statement is incorrect. U.S. exports create a domestic supply of foreign currencies, not a domestic demand for them. The second part of the statement is accurate. The foreign demand for dollars (from U.S. exports) generates a supply of foreign currencies to the United States. A decline in U.S. incomes or a weakening of U.S. preferences for foreign goods would reduce U.S. imports, reducing U.S. demand for foreign currencies. These currencies would depreciate (the dollar would appreciate). Dollar appreciation means U.S. exports would decline and U.S. imports would increase. 610 Identify and state the significance of each of the following: (a) WTO; (b) EU; (c) euro; and (d) NAFTA. What commonality do they share? waL74858_Ans_301318 6/18/01 1:24 PM Page 323 ANSWERS TO KEY QUESTIONS 323 (a) The WTO oversees trade agreements reached by member nations and arbitrates trade disputes among them. (b) The EU is a trading bloc of 15 European countries who have agreed to abolish tariffs and import quotas on most products and have liberalized the movement of labor and capital within the EU. (c) The euro is the common currency that will be used by 11 of the 15 EU countries. (d) NAFTA is a trade bloc made up of the United States, Canada, and Mexico whose purpose is to reduce tariffs and other trade barriers among the three countries. All of the above have the goals of increasing international trade and leading to a better allocation of the world’s resources. CHAPTER SEVEN 72 Graph the accompanying demand data and then use the midpoints formula for Ed to determine price elasticity of demand for each of the four possible $1 price changes. What can you conclude about the relationship between the slope of a curve and its elasticity? Explain in a nontechnical way why demand is elastic in the northwest segment of the demand curve and inelastic in the southeast segment. Product Quantity price demanded $5 1 42 33 24 15 TR 10 8 6 4 2 TR 0 12345 Q 75 How would the following changes in price affect total revenue. That is, would total revenue increase, decline, or remain unchanged? a. Price falls and demand is inelastic. b. Price rises and demand is elastic. c. Price rises and supply is elastic. d. Price rises and supply is inelastic. e. Price rises and demand is inelastic. f. Price falls and demand is elastic. g. Price falls and demand is of unit elasticity. Total revenue would increase in (c), (d), (e), and (f); decrease in (a) and (b); and remain the same in (g). 76 What are the major determinants of price elasticity of demand? Use these determinants and your own reasoning in judging whether demand for each of the following products is elastic or inelastic: (a) bottled water, (b) toothpaste; (c) Crest toothpaste; (d) ketchup, (e) diamond bracelets; (f) Microsoft Windows operating system. Substitutability, proportion of income; luxury versus necessity, and time. Elastic: (a), (c), (e). Inelastic: (b), (d), and (f). 710 In November 1998 Vincent van Gogh’s selfportrait sold at auction for $71.5 million. Portray this sale in a demand and supply diagram and comment on the elasticity of supply. Comedian George Carlin once mused, “If a painting can be forged well enough to fool some experts, why is the original so valuable”? Provide an answer. The supply is perfectly inelastic—vertical—at a quantity of 1 unit. The $71.5 million price is determined where the downward sloping demand curve intersected this supply curve. If more than one picture where available (all but one having to be a copy), the demand would likely decrease enormously. 712 Suppose the cross elasticity of demand for products A and B is 3.6 and for products C and D it is 5.4. What can you conclude about how products A and B are related? Products C See the graph accompanying the answer to 74. Elasticities, top to bottom: 3; 1.4; 714; .333. Slope does not measure elasticity. This demand curve has a constant slope of 1 (11), but elasticity declines as we move down the curve. When the initial price is high and initial quantity is low, a unit change in price is a low percentage while a unit change in quantity is a high percentage change. The percentage change in quantity exceeds the percentage change in price, making demand elastic. When the initial price is low and initial quantity is high, a unit change in price is a high percentage change while a unit change in quantity is a low percentage change. The percentage change in quantity is less than the percentage change in price, making demand inelastic. 74 Calculate totalrevenue data from the demand schedule in question 2. Graph total revenue below your demand curve. Generalize on the relationship between price elasticity and total revenue. See the graph. Total revenue data, top to bottom: $5; $8; $9; $8; $5. When demand is elastic, price and total revenue move in the opposite direction. When demand is inelastic, price and total revenue move in the same direction. P 5 4 3 2 1 D Question 74 0 12345 Q and D? A and B are substitutes; C and D are complements. 713 The income elasticities of demand for movies, dental services, and clothing have been estimated to be 3.4, 1.0, and 0.5 respectively. Interpret these coefficients. What does it mean if the income elasticity coefficient is negative? All are normal goods—income and quantity demanded move in the same direction. These coefficients reveal that a 1 percent increase in income will increase the quantity of movies demanded by 3.4 percent, of dental services by 1.0 percent, and of clothing by 0.5 percent. A negative coefficient indicates an inferior good—income and quantity demanded move in the opposite direction. CHAPTER EIGHT 82 Complete the following table and answer the questions below: Units consumed Total utility Marginal utility 0 0 1 10 10 2 8 3 25 __ 4 30 __ 5 3 6 34 __ a. At which rate is total utility increasing: a constant rate, a decreasing rate, or an increasing rate? How do you know? b. “A rational consumer will purchase only 1 unit of the product represented by these data, since that amount maximizes marginal utility.” Do you agree? Explain why or why not. c. “It is possible that a rational consumer will not purchase any units of the product represented by these data.” Do you agree? Explain why or why not. Missing total utility data, top to bottom: 18; 33. Missing marginal utility data, top to bottom: 7; 5; 1. (a) A decreasing rate; because marginal utility is declining. (b) Disagree. The marginal utility of a unit beyond the first may be sufficiently great (relative to product price) to make it a worthwhile purchase. (c) Agree. This product’s price could be so high relative to the first unit’s marginal utility that the consumer would buy none of it. 84 Columns 1 through 4 of the accompanying table show the marginal utility, measured in terms of utils, which Ricardo would get by purchasing various amounts of products A, B, C, and D. Column 5 shows the marginal utility Ricardo gets from saving. Assume that the prices of A, B, C, and D are $18, $6, $4, and $24, respectively, and that Ricardo has a money income of $106. Y will you now purchase? Using the two prices and quantities for X, derive a demand schedule (pricequantitydemanded table) for X. Units of X MUx Units of Y MUy 1 10 1 8 2 8 2 7 3 6 3 6 4 4 4 5 5 3 5 4 6 2 6 3 Buy 2 units of X and 5 units of Y. Marginal utility of last dollar spent will be equal at 4 ( 8/$2 for X and 4/$1 for Y) and the $9 income will be spent. Total utility 48 ( 10 8 for X plus 8 7 6 5 4 for Y). When the price of X falls to $1, the quantity of X demanded increases from 2 to 4. Total utility is now 58 ( 10 8 6 4 for X plus 8 7 6 5 4 for Y). Demand schedule: P $2; Q 2. P $1; Q 4. CHAPTER EIGHT APPENDIX 8A3 Using Figure 4, explain why the point of tangency of the budget line with an indifference curve is the consumer’s equilibrium position. Explain why any point where the budget line intersects an indifference curve will not be equilibrium. Explain: “The consumer is in equilibrium where MRS PB/PA.” The tangency point places the consumer on the highest attainable indifference curve; it identifies the combination of goods yielding the highest total utility. All intersection points place the consumer on a lower indifference curve. MRS is the slope of the indifference curve; PB/PA is the slope of the budge line. Only at the tangency point are these two slopes equal. If MRS PB/PA or MRS PB/PA, adjustments in the combination of products can be made to increase total utility (get to a higher indifference curve). Column 1 Column 2 Column 3 Column 4 Column 5 CHAPTER NINE Units of A 1 2 MU 72 54 Units of B 1 2 MU 24 15 Units of C 1 2 MU 15 12 Units of D 1 2 MU 36 30 No. of $ saved 1 2 MU 5 4 92 Gomez runs a small pottery firm. He hires one helper at $12,000 per year, pays annual rent of $5,000 for his shop, and materials cost $20,000 per year. Gomez has $40,000 of his 3 4 5 6 7 8 45 36 27 18 15 12 3 4 5 6 7 8 12 9 7 5 2 1 3 4 5 6 7 8 8 7 5 4 3.5 3 3 4 5 6 7 8 24 18 13 7 4 2 3 4 5 6 7 8 3 2 1 1/2 1/4 1/8 own funds invested in equipment (pottery wheels, kilns, and so forth) that could earn him $4,000 per year if alternatively invested. Gomez has been offered $15,000 per year to work as a potter for a competitor. He estimates his entrepreneurial talents are worth $3,000 per year. Total annual revenue from pot a. What quantities of A, B, C, and D will Ricardo purchase in maximizing his utility? b. How many dollars will Ricardo choose to save? c. Check your answers by substituting them into the algebraic statement of the utilitymaximizing rule. (a) 4 units of A; 3 units of B; 3 units of C, and 0 units of D. (b) Save $4. (c) 36/$18 12/$6 8/$4 2/$1. The marginal utility per dollar of the last unit of each product purchased is 2. 85 You are choosing between two goods, X and Y, and your marginal utility from each is as shown below. If your income is $9 and the prices of X and Y are $2 and $1, respectively, what quantities of each will you purchase in maximizing utility? What total utility you will realize. Assume that, other things remaining unchanged, the price of X falls to $1. What quantities of X and tery sales is $72,000. Calculate accounting profits and economic profits for Gomez’s pottery. Explicit costs: $37,000 ( $12,000 for the helper $5,000 of rent $20,000 of materials). Implicit costs: $22,000 ( $4,000 of forgone interest $15,000 of forgone salary $3,000 of entreprenuership). Accounting profit $35,000 ( $72,000 of revenue $37,000 of explicit costs); Economic profit $13,000 ( $72,000 $37,000 of explicit costs $22,000 of implicit costs). 94 Complete the following table by calculating marginal product and average product from the data given. Plot total, marginal, and average product and explain in detail the relationship between each pair of curves. Explain why marginal product first rises, then declines, and ultimately becomes negative. What bearing does the law of diminishing returns have on shortrun costs? Be specific. “When marginal product is rising, marginal waL74858_Ans_301318 6/18/01 1:24 PM Page 325 cost is falling. And when marginal product is diminishing, marginal cost is rising.” Illustrate and explain graphically. Inputs Total Marginal Average of labor product product product 0 0 1 15 2 34 3 51 4 65 5 74 6 80 7 83 8 82 Marginal product data, top to bottom: 15; 19; 17; 14; 9; 6; 3; 1. Average product data, top to bottom: 15; 17; 17; 16.25; 14.8; 13.33; 11.86; 10.25. Your diagram should have the same general characteristics as text Figure 92. MP is the slope—the rate of change—of the TP curve.When TP is rising at an increasing rate, MP is positive and rising. When TP is rising at a diminishing rate, MP is positive but falling. When TP is falling, MP is negative and falling. AP rises when MP is above it; AP falls when MP is below it. MP first rises because the fixed capital gets used more productively as added workers are employed. Each added worker contributes more to output than the previous worker because the firm is better able to use its fixed plant and equipment. As still more labor is added, the law of diminishing returns takes hold. Labor becomes so abundant relative to the fixed capital that congestion occurs and marginal product falls. At the extreme, the addition of labor so overcrowds the plant that the marginal product of still more labor is negative—total output falls. Illustrated by Figure 96. Because labor is the only variable input and its price (its wage rate) is constant, MC is found by dividing the wage rate by MP. When MP is rising, MC is falling; when MP reaches its maximum, MC is at its minimum; when MP is falling, MC is rising. 97 A firm has fixed costs of $60 and variable costs as indicated in the table at the bottom of the page. Complete the table. When finished, check your calculations by referring to question 4 at the end of Chapter 23. Costs a. Graph total fixed cost, total variable cost, and total cost. Explain how the law of diminishing returns influences the shapes of the total variablecost and totalcost curves. b. Graph AFC, AVC, ATC, and MC. Explain the derivation and shape of each of these four curves and their relationships to one another. Specifically, explain in nontechnical terms why the MC curve intersects both the AVC and ATC curves at their minimum points. c. Explain how the locations of each of the four curves graphed in question 7b would be altered if (1) total fixed cost had been $100 rather than $60, and (2) total variable cost had been $10 less at each level of output. The total fixed costs are all $60. The total costs are all $60 more than the total variable cost. The other columns are shown in Question 4 in Chapter 23. (a) See the graph. Over the 0 to 4 range of output, the TVC and TC curves slope upward at a decreasing rate because of increasing marginal returns. The slopes of the curves then increase at an increasing rate as diminishing marginal returns occur. (b) See the graph. AFC ( TFC/Q) falls continuously since a fixed amount of capital cost is spread over more units of output. The MC ( change in TC/change in Q), AVC ( TVC/Q), and ATC ( TC/Q) curves are Ushaped, reflecting the influence of first increasing and then diminishing returns. The ATC curve sums AFC and AVC vertically. The ATC curve falls when the MC curve is below it; the ATC curve rises when the MC curve is above it. This means the MC curve must intersect the ATC curve at its lowest point. The same logic holds for the minimum point of the AVC curve. $500 450 400 350 300 250 200 150 100 60 0 123456789 Q 10 TFC TVC TCQuestion 97a Total product (output) Total Total Average Average Average Total fixed variable Total fixed variable total Marginal product cost cost cost cost cost cost cost 0 $ $ 0 $ $ $ $ $ 1 45 2 85 3 120 4 150 5 185 6 225 7 270 8 325 9 390 10 465 waL74858_Ans_301318 6/18/01 1:24 PM Page 326 326 ANSWERS TO KEY QUESTIONS $110 MC ATC AVC AFC Question 97b Price $10 9 8 7 6 5 4 TR MR D Question 103b 100 90 80 70 60 50 Costs 40 30 20 10 0 12345678910 Q 3 Total product (output) 2 (c1)If TFC has been $100 instead of $60, the AFC and ATC 1 curves would be higher — by an amount equal to $40 divided by the specific output. Example: at 4 units, AVC $25.00 [($60 $40)/4]; and ATC $62.50 [($210 $40)/4]. The AVC and MC curves are not affected by changes in fixed costs. (c2)If TVC has been $10 less at each output, MC would be $10 lower for the first unit of output but remain the same for the remaining output.The AVC and ATC curves would also be lower— by an amount equal to $10 divided by the specific output. Example: at 4 units of output, AVC $35.00 [$150 $10)/4], ATC $50 [($210 $10)/4]. The AFC curve would not be affected by the change in variable costs. 910 Use the concepts of economies and diseconomies of scale to explain the shape of a firm’s longrun ATC curve. What is the concept of minimum efficient scale? What bearing may the exact shape of the longrun ATC curve have on the structure of an industry? The longrun ATC curve is Ushaped. At first, longrun ATC falls as the firm expands and realizes economies of scale from labor and managerial specialization and the use of more efficient capital. The longrun ATC curve later turns upward when the enlarged firm experiences diseconomies of scale, usually resulting from managerial inefficiencies. The MES (minimum efficient scale is the smallest level of output needed to attain all economies of scale and minimum long run ATC. If longrun ATC drops quickly to its minimum cost which then extends over a long range of output, the industry will likely be composed of both large and small firms. If longrun ATC descends slowly to its minimum cost over a long range of output, the industry will likely be composed of a few large firms. If longrun ATC drops quickly to its minimum point and then rises abruptly, the industry likely be composed of many small firms. CHAPTER TEN 103 Use the following demand schedule to determine total and marginal revenues for each possible level of sales: Product Quantity Total Marginal Price: $ Demanded Revenue: $ Revenue: $ 20 21 22 23 24 25 0 12345 Quantity a. What can you conclude about the structure of the industry in which this firm is operating? Explain. b. Graph the demand, totalrevenue, and marginalrevenue curves for this firm. c. Why do the demand and mariginalrevenue curves coincide? d. “Marginal revenue is the change in total revenue.’’ Explain verbally and graphically, using the data in the table. Total revenue, top to bottom: 0; $2; $4; $8; $10. Marginal revenue, top to bottom: $2, throughout. (a) The industry is purely competitive—this firm is a “price taker.’’ The firm is so small relative to the size of the market that it can change its level of output without affecting the market price. (b) See graph. (c) The firm’s demand curve is perfectly elastic; MR is constant and equal to P. (d) Yes. Table: When output (quantity demanded) increases by 1 unit, total revenue increase by $2. This $2 increase is the marginal revenue. Figure: The change in TR is measured by the slope of the TR line, 2 ($2/1 unit). 104 Assume the following unitcost data are for a purely competitive producer: Average Average Average Total fixed variable total Marginal Product cost cost cost cost 0 1 $60.00 $45.00 $105.00 $45 2 30.00 42.50 72.50 $40 3 20.00 40.00 60.00 35 4 15.00 37.50 52.50 30 5 12.00 37.00 49.00 35 6 10.00 37.50 47.50 40 7 8.57 38.57 47.14 45 8 7.50 40.63 48.13 55 9 6.67 43.33 50.00 65 10 6.00 46.50 52.50 75 a. At a product price of $56, will this firm produce in the short run? Why, or why not? If it does produce, what will be the profitmaximizing or lossminimizing ouput? Explain. What economic profit or loss will the firm realize per unit of output? b. Answer the questions of 4a assuming that product price is $41. c. Answer the questions of 4a assuming that product price is $32. waL74858_Ans_301318 6/18/01 1:24 PM Page 327 ANSWERS TO KEY QUESTIONS 327 d. In the table below, complete the shortrun supply sched(g) Equilibrium price $46; equilibrium output 10,500. Each ule for the firm (columns 1 to 3) and indicate the profit or loss firm will produce 7 units. Loss per unit $1.14, or $8 per firm. incurred at each output (column 3). The industry will contract in the long run. (1) (2) (3) (4) Quantity Quantity supplied, Profit () supplied, Price single firm or loss(l) 1500 firms $26 32 $ 38 41 46 56 66 106 Using diagrams for both the industry and representative firm, illustrate competitive longrun equilibrium. Assuming constant costs, employ these diagrams to show how (a) an increase and (b) a decrease in market demand will upset this longrun equilibrium. Trace graphically and describe verbally the adjustment processes by which longrun equilibrium is restored. Now rework your analysis for increasing and decreasingcost industries and compare the three longrun supply curves. See Figures 108 and 109 and their legends. See Figure 1011 for the supply curve for an increasing cost industry. The supply curve for a decreasing cost industry is below. SD3 D1 D2 P P3 0 Q3 Q1 Q2 Q P1 P2 Question 106 107 In longrun equilibrium, P minimum ATC MC. Of what significance for economic efficiency is the equality of P and minimum ATC? The equality of P and MC? Distinguish between productive efficiency and allocative efficiency in your answer. The equality of P and minimum ATC means the firm is achieving productive efficiency; it is using the most efficient technology and employing the least costly combination of resources. The equality of P and MC means the firm is achieving allocative efficiency, the industry is producing the right product in the right amount based on society’s valuation of that product and other products. CHAPTER ELEVEN 114 Use the demand schedule that follows to calculate total revenue and marginal revenue at each quantity. Plot the demand, totalrevenue, and marginalrevenue curves and explain the relationships between them. Explain why the marginal revenue of the fourth unit of output is $3.50, even though its price is $5.00. Use Chapter 20’s totalrevenue test for price elasticity to designate the elastic and inelastic segments of your graphed demand curve. What generalization can you make regarding the relationship between marginal revenue and elasticity of demand? Suppose that somehow the marginal cost of successive units of output were zero.What output would the profitseeking firm produce? Finally, use your analysis to explain why a monopolist would never produce in the inelastic region of demand. Price Quantity demanded Price Quantity demanded $7.00 6.50 6.00 5.50 5.00 0 1 2 3 4 $4.50 4.00 3.50 3.00 2.50 5 6 7 8 9 e. Explain: “That segment of a competitive firm’s marginal cost curve which lies above its average variablecost curve constitutes the shortrun supply curve for the firm.’’ Illustrate graphically. f. Now assume there are 1500 identical firms in this competitive industry; that is, there are 1500 firms, each of which has the same cost data as shown here. Calculate the industry supply schedule (column 4). g. Suppose the market demand data for the product are as follows: Total quantity Price demanded $26 17,000 32 15,000 38 13,500 41 12,000 41 10,500 56 9,500 66 8,000 What will equilibrium price be? What will equilibrium output be for the industry? For each firm? What will profit or loss be per unit? Per firm? Will this industry expand or contract in the long run? (a) Yes, $56 exceeds AVC (and ATC) at the loss— minimizing output. Using the MR MC rule it will produce 8 units. Profits per unit $7.87($56 $48.13); total profit $62.96. (b) Yes, $41 exceeds AVC at the loss—minimizing output. Using the MR MC rule it will produce 6 units. Loss per unit or output is $6.50( $41 $47.50). Total loss $39( 6 $6.50), which is less than its total fixed cost of $60. (c) No, because $32 is always less than AVC. If it did produce, its output would be 4—found by expanding output until MR no longer exceeds MC. By producing 4 units, it would lose $82 [ 4 ($32 $52.50)]. By Not producing, it would lose only its total fixed cost of $60. (d) Column (2) data, top to bottom: 0; 0; 5; 6; 7; 8; 9, Column (3) data, top to bottom in dollars: 60; 60; 55; 39; 8; 63; 144. (e) The firm will not produce if P AVC. When P AVC, the firm will produce in the short run at the quantity where P (MR) is equal to its increasing MC. Therefore, the MC curve above the AVC curve is the firm’s shortrun supply curve; it shows the quantity of output the firm will supply at each price level. See Figure 106 for a graphical illustration. (f) Column (4) data, top to bottom: 0; 0; 7,500; 9,000; 10,500; 12,000; 13,500. waL74858_Ans_301318 6/18/01 1:24 PM Page 328 328 ANSWERS TO KEY QUESTIONS Total revenue, in order from Q 0: 0; $6.50; $12.00; $16.50; $20.00; $22.50; $24.00; $24.50; $24.00; $22.50. Marginal revenue in order from Q 1: $6.50; $5.50; $4.50; $3.50; $2.50; $1.50; $.50; $1.50. See the accompanying graph. Because TR is increasing at a diminishing rate, MR is declining. When TR turns downward, MR becomes negative. Marginal revenue is below D because to sell an extra unit, the monopolist must lower the price on the marginal unit as well as on each of the preceding units sold. Four units sell for $5.00 each, but three of these four could have been sold for $5.50 had the monopolist been satisfied to sell only three. Having decided to sell four, the monopolist has to lower the price of the first three from $5.50 to $5.00, sacrificing $.50 on each for a total of $1.50. This “loss” of $1.50 explains the difference between the $5.00 price obtained on the fourth unit of output and its marginal revenue of $3.50. Demand is elastic from P $6.50 to P $3.50, a range where TR is rising. The curve is of unitary elasticity at P $3.50, where TR is at its maximum. The curve is inelastic from then on as the price continues to decrease and TR is falling. When MR is positive, demand is elastic. When MR is zero, demand is of unitary elasticity. When MR is negative, demand is inelastic. If MC is zero, the monopolist should produce 7 units where MR is also zero. It would never produce where demand is inelastic because MR is negative there while MC is positive. Price $26 22 18 14 10 6 2 01 3 579 Quantity (MR curve approximated) D MR TRQuestion 114 115 Suppose a pure monopolist is faced with the demand schedule shown below and the same cost data as the competitive producer discussed in question 4 at the end of Chapter 10. Calculate the missing total and marginalrevenue amounts, and determine the profitmaximizing price and output for this monopolist. What is the monopolist’s profit? Verify your answer graphically and by comparing total revenue and total cost. Quantity total Marginal Price demanded revenue revenue Total revenue data, top to bottom, in dollars: 0: 100; 166; 213; 252; 275; 288; 294; 296; 297; 290. Marginal revenue data, top to bottom, in dollars: 100; 66; 47; 39; 23; 6; 2; 1; 7. Price $63; output 4; profit $42 [ 4($63 52.50)]. Your graph should have the same general appearance as Figure 11 4. At Q 4, TR $252 and TC $210 [ 4($52.50)]. 116 If the firm described in question 5 could engage in perfect price discrimination, what would be the level of output? Of profits? Draw a diagram showing the relevant demand, marginalrevenue, averagetotalcost, and marginalcost curves and the equilibrium price and output for a nondiscriminating monopolist. Use the same diagram to show the equilibrium position of a monopolist that is able to practice perfect price discrimination. Compare equilibrium outputs, total revenues, economic profits, and consumer prices in the two cases. Comment on the economic desirability of price discrimination. Perfect price discrimination: Output 6. TR would be $420 ( $100 $83 $71 $63 $55 $48). TC would be $285 [ 6(47.50)]. Profit would be $135 ( $420 $285). Your single diagram should combine Figure 118a and 11b in the chapter. The discriminating monopolist faces a demand curve that is also its MR curve. It will sell the first unit at f in Figure 118b and then sell each successive unit at lower prices (as shown on the demand curve) as it moves to Q2 units, where D ( MR) MC. Discriminating monopolist: Greater output; total revenue, and profits. Some consumers will pay a higher price under discriminating monopoly than with nondiscriminating monopoly; others, a lower price. Good features: greater output and improved allocative efficiency. Bad feature: more income is transferred from consumers to the monopolist. 1111 It has been proposed that natural monopolists should be allowed to determine their profitmaximizing outputs and prices and then government should tax their profits away and distribute them to consumers in proportion to their purchases from the monopoly. Is this proposal as socially desirable as requiring monopolists to equate price with marginal cost or average total cost? No, the proposal does not consider that the output of the natural monopolist would still be at the suboptimal level where P MC. Too little would be produced and there would be an under allocation of resources. Theoretically, it would be more desirable to force the natural monopolist to charge a price equal to marginal cost and subsidize any losses. Even setting price equal to ATC would be an improvement over this proposal. This fairreturn pricing would allow for a normal profit and ensure greater production than the proposal would. CHAPTER TWELVE 122 Compare the elasticity of the monopolistically competitor’s demand curve with that of a pure competitor and a pure monopolist. Assuming identical longrun costs, compare graphically the prices and output that would result in the long run under pure competition and under monopolistic competi tion. Contrast the two market structures in terms of productive $115 0$ $ and allocative efficiency. Explain: “Monopolistically competitive 1001$ $ industries are characterized by too many firms, each of which 832$ $ produces too little.” 71 3 $ $ Less elastic than a pure competitor and more elastic than 63 4 $ $ a pure monopolist. Your graphs should look like Figures 1012 and 121 in the chapters. Price is higher and output lower for 555$ $ the monopolistic competitor. Pure competition: P MC 486$ $ (allocative efficiency); P minimum ATC (productive effi 427$ $ ciency). Monopolistic competition: P MC (allocative effi37 8 $ $ ciency) and P minimum ATC (productive inefficiency). 33 9 $ $ Monopolistic competitors have excess capacity; meaning that fewer firms operating at capacity (where P minimum ATC) 2910$ $ could supply the industry output. waL74858_Ans_301318 6/18/01 1:24 PM Page 329 ANSWERS TO KEY QUESTIONS 329 127 Answer the following questions, which relate to measures of concentration:. a. What is the meaning of a fourfirm concentration ratio of 60 percent? 90 percent? What are the shortcomings of concentration ratios as measures of monopoly power? b. Suppose that the five firms in industry A have annual sales of 30, 30, 20, 10, and 10 percent of total industry sales. For the five firms in industry B the figures are 60, 25, 5, 5, and 5 percent. Calculate the Herfindahl index for each industry and compare their likely competitiveness. A fourfirm concentration ration of 60 percent means the largest four firms in the industry account for 60 percent of sales; a four firm concentration ratio of 90 percent means the largest four firms account for 90 percent of sales. Shortcomings: (1) they pertain to the nation as a whole, although relevant markets may be localized; (2) they do not account for interindustry competition; (3) the data are for U.S. products—imports are excluded; and (4) they don’t reveal the dispersion of size among the top four firms. Herfindahl index for A: 2,400 ( 900 900 400 100 100). For B: 4,300 ( 3,600 625 25 25 25). We would expect industry A to be more competitive than industry B, where one firm dominates and two firms control 85 percent of the market. 128 Explain the general meaning of the following profit payoff matrix for oligopolists C and D. All profit figures are in thousands. a. Use the payoff matrix to explain the mutual interdependence that characterizes oligopolistic industries. b. Assuming no collusion between C and D, what is the likely pricing outcome? c. In view of your answer to 8b, explain why price collusion is mutually profitable. Why might there be a temptation to chat on the collusive agreement?
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