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Intermediate Microeconomic Theory (3550)
Homework 4 - Answers
Due Thursday, October 16, 2008
This homework covers chapter 5 in your Landsburg text.
1.
Read the slate column listed under chapter 5 in the front cover of your textbook Price
Theory (column available at http://slate.msn.com/id/2070182). Explain in no more than
one paragraph: do we know that marginal analysis always works? What should we do
when we believe it doesn’t?
We have not found an instance in which it does not work; therefore, we are fairly
confident in stating that we do know marginal analysis always works. “If it seems
not to be working, the right question is not, ‘Why doesn’t the marginal analysis
work?’ Instead, the right question is, ‘How am I failing to understand the marginal
analysis?’”
2.
Why do we not plot marginal benefit and marginal cost on the same graph as total benefit
and total cost?
Marginal benefit is the added benefit from the last unit of an activity; marginal cost
is the added cost associated with the last unit of an activity. They must be measured
per unit. Total benefit is the sum of all benefits and total cost is the sum of fixed and
variable costs.
3.
A comic book company pays an annual licensing fee of $10,000 for the rights to an
artist’s character. Which would have the bigger effect on the readers of that character’s
comic: an increase in printing costs or an increase in the artist’s licensing fee? Explain
your answer.
Higher printing costs would increase marginal cost, which would lower the profitmaximizing quantity and (assuming demand for the character’s comic is downward
sloping) raise the price of comic books. The artist’s licensing fee is a fixed cost, so
an increase in it will not affect marginal cost, quantity produced, or the price
charged (unless the increase is so large that it drives the company out of business).
As long as the increase in the licensing fee is not excessive, higher cost of printing
will have the bigger effect because it will raise the price paid by the readers.
4.
Explain why a rent increase at Tony’s Pizza Parlor would not cause Tony to raise his
prices, but a rent increase at Tony’s competitors may cause him to raise prices.
Tony’s rent is not affected by the number of pizzas produced, so it is a fixed cost.
Changes in fixed costs do not affect marginal cost, so a rent increase does not affect
the profit-maximizing price and quantity, as long as the rent increase is not too
large. Tony would simply shut down operations in that case. If the competitor’s
higher rents do cause some of them to shut down, this would increase the demand
and (in most cases) increase the marginal revenue for Tony’s product. (Note:
marginal revenue could fall when demand increases if demand becomes sufficiently
less elastic). The increase in marginal revenue will increase the profit-maximizing
quantity, and the higher demand will (in most cases) allow Tony to raise his prices.
5.
a.
Suppose the government imposes new regulations that force tire manufacturers to
incur some one-time expenses for factory safety improvements. Will the new regulations
raise the price of tires? Why or why not?
The one-time safety improvements are a fixed cost for tire manufacturers. Changes
in fixed costs do not impact a firm’s marginal cost. As long as all tire
manufacturers find it sufficiently profitable to remain in business, the new
regulations will not affect the price of tires. If the new regulations are so costly that
some manufacturers leave the industry, then the remaining firms will see higher
demands for their products, which would raise the price of tires.
b.
Suppose that government imposes new regulations that force tire manufacturers to
adopt cleaner production methods that raise the production cost by $10 per tire. Will the
new regulations raise the price of tires? Why or why not?
The new regulations raise the marginal cost of tire production by $10 per tire. To
earn the maximum profit, tire manufacturers reduce their output. The law of
demand implies that the price of tires will rise as tire manufacturers sell fewer tires.
6.
Which of the following can affect a firm’s behavior and in what way?
a.
A change in variable costs.
This will affect firm’s behavior because variable costs are analogous to marginal
costs; they depend on the quantity produced.
b.
A change in fixed costs.
This will not affect firm’s behavior because a change in fixed costs does not affect
marginal cost.
c.
A change in the demand for the firm’s product.
This will change the demand schedule, changing the marginal revenue (i.e., what
consumers are willing to pay for an additional unit of the good).
d.
A competitor leaving the industry.
This may affect a firm’s behavior, if the absence of the competitor allows the firm to
gain some market power. Increased demand would allow the firm to raise its prices.
7.
The government has undertaken a highway project that was originally projected to cost
$1 billion and provide benefits of $1.5 billion. Unfortunately, the costs have been much
higher than anticipated. The government has spent $1.2 billion so far and now expects
that it will cost an additional $1.2 billion to finish the project. Should the project be
abandoned completely?
If the benefits are still $1.5 billion and the cost of continuing is $1.2 billion with
certainty, then the project should be completed.
8.
There is only one doctor in the town of Erewhon. Every time she treats a patient, she
must use a pair of disposable rubber gloves, which costs her $1. She also finds it
necessary to keep an X-ray machine in her office, which she rents for $500 a year. The
town council has decided to help the doctor meet expenses and is undecided between two
plans. Under Plan A, they will provide the doctor with unlimited free rubber gloves;
under Plan B, they will provide her with a free X-ray machine. Which plan is better for
the doctor’s patients, and why?
The X-ray machine rental is a fixed cost, so it does not affect the price of medical
care.