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Questions and Exercises
Chapter 1 Questions
11. Why is it nonsense to talk about urgent, critical, crying, vital, basic, minimal, social, or
private needs?
12. Economists would disappear only in a universe where time is unlimited. True or false?
Explain.
13. Is it inconsistent to state that the United States is the wealthiest nation, but scarcity is still a
problem? Explain.
14. Some people contend that Americans live in a post-scarcity economy. In terms of normative
and positive economics, explain the statement.
15. Theory is okay for eggheads, but I’m a hard-boiled woman. Give me the facts and they’ll
speak for themselves. How do facts speak for themselves?
16. What is the role of assumptions in model construction?
17. What is the difference among the terms postulate, assertion, assumption, hypothesis, theory,
paradigm, and model?
18. The major difference between natural sciences and social sciences is that laboratory
experimentation is possible in the natural sciences but not in the social sciences. True or
false? Explain.
19. If a model predicts, can it also be used for control?
20. For prediction, a theory must yield empirically validated predictions. Assume you are asked
to evaluate a 100-year-old theory that has not yielded an accurate prediction. Supporters of
the theory advocate that not enough time has elapsed to validate the theory. Should this
theory be accepted or rejected? Explain.
Chapter 1 Exercises (none)
Chapter 2 Questions (none)
Chapter 2 Exercises
11. Consider a group of people A, B, C, . . . and the relation “at least as tall as.”
a. Is this relation transitive?
b. Is it complete?
12. What is the marginal rate of substitution between nickels and dimes? Illustrate the result.
13. Demonstrate which preference axioms are satisfied and not satisfied by the following
statements.
a. I reach a point at which I am satiated with one good but not the other.
b. “. . . to pursue mathematical analysis while at the same time turning one's back on its
applications and on intuition is to condemn it to hopeless atrophy.” R. Courant.
c. It takes two to tango.
d. I prefer a mixture of town and country life to being restricted to one or the other.
e. There is not enough money to make me eat a raw oyster.
f. Georgia always eats hot dogs in a bun with 1 ounce of mustard.
g. I may reach a point at which I am satiated with both goods I am consuming.
h. Peanut butter and jelly go together like a horse and carriage.
i. With an auto, the more gasoline the better. Without an auto, who cares?
j. I prefer a mixture of town and country life to being restricted to one or the other.
However, whichever I choose, I know I'll be sorry.
k. There is a quantity for each commodity up to which it is a good and beyond which it is a
bad.
l. Popcorn is addictive; the more you eat, the more you want.
m. Mosquitoes ruin a nice day at the beach.
n. A day without wine is like a day without sunshine.
o. I am indifferent between brown eggs and white eggs, but I am superstitious and believe
terrible events will happen if I possess both simultaneously.
p. I’d rather be “A,” where A could be golfing, skiing, or bowling.
q. A 13-year-old girl just started smoking. It seems that as she smokes she wants to give up
more of other commodities for one more smoke.
r. I like both milk and orange juice but get less pleasure from a mixture of the two.
s. I don't want a Martini unless it is exactly five parts gin to one part vermouth.
t. Taste tests reveal that Burp Cola is exactly as good as the nationally known Burpup
brand.
u. Live fast, love hard, die young, and leave a beautiful corpse.
v. I like both Burp and Burpup Cola, but the more Burp I have the more I am willing to give
up Burpup to get one more Burp.
w. I like drinking and driving equally well, but it is against the law to mix them so I never
do.
x. I like ice cream, but frozen yogurt makes me sick.
y. Love thy neighbor as thyself.
z. I do not care whether I have regular coffee or decaffeinated coffee, as long as it is coffee.
Chapter 3 Questions
11. Consider a poor household on welfare consuming only food and housing. Should welfare
payments be in the form of payments in kind (weekly allocation of food) or money? Discuss.
Chapter 3 Exercises
11. Kimberly is cramming for finals in economics, mathematics, and chemistry and only has six
hours of study time remaining. Her objective is to obtain the highest average grade possible
on the three exams. The grades depend on the number of hours devoted to each subject
according to the following schedule.
Grade
Hours of Study
Economics
Mathematics
0
50
40
1
60
45
2
70
50
3
80
60
4
85
80
5
95
90
How should Kimberly allocate her time? Explain.
Chemistry
30
45
45
50
60
75
12. Demonstrate that if thick indifference curves exist, utility may be maximized with less than a
household’s total income. Which preference axiom rules out the possibility of thick
indifference curves?
13. Assume the utility function
3/5
U(x1, x2) = x3/5
1 x1 .
If p1 = p2 = 2 and I = 14, how much x1 and x2 should be purchased to maximize utility?
14. Assume the utility function
1/3
U = Ax1/2
1 x2 .
If p1 = 4, p2 = 1, and I = 20, how much x1 and x2 should be purchased to maximize utility?
15. Assume the utility function
1/4
U = x1/3
1 x2 .
If p1 = 3, p2 = 4, and I = 7, how much x1 and x2 should be purchased to maximize utility?
16. Assume the following utility function
1/2
U = x1/4
1 x2 .
a. Graph the indifference curves.
b. The price of x1 is $2, the price of x2 is $1, and the household is currently consuming one
unit of x1 and two units of x2. What should it do?
17. Paul, a novice wine connoisseur, has $500 to spend on a cheap French wine, F, at $10 per
bottle and a quality California varietal wine, C, at $50 per bottle. His preferences for the two
wines are represented as
U(C, F) = CF1/4.
a. What is the utility-maximizing allocation of California and French wines?
b. Fortunately for Paul, the store is currently having a sale on the fine California wine at two
bottles for the price of one. How does this sale affect his utility-maximizing allocation?
18. Miss Fragrant likes both bath pearls, B, and perfume, F, according to the following
preferences
U(B, F) = lnB + ln(2 + F).
At prices pB = $5 and pF = $35, and income I = $100, determine Miss Fragrant’s optimal
bundle of bath pearls and perfume.
19. Assume two individuals Marj, M, and Tony, T, face budget constraints
IM = pM1xM1 + pM2xM2,
IT = pT1xT1 + pT2xT2,
where pM1/pM2 > pT1/pT2 and IM = IT.
a. Graph both budget constraints on the same set of axes.
b. Assume Marj and Tony marry and form a single household by pooling their incomes and
consumption. With the ability to continue purchasing separately at the two sets of prices,
determine the household budget constraint.
c. Will Marj and Tony specialize in purchasing commodities? Explain.
20. A supermarket is considering two pricing options. The first option reduces the price of soap
by 50% for every unit sold. The second option is buy one and get one free. Illustrate the
household’s budget constraints for the two options and tell which option a household would
prefer.
21. Consider Eugene’s utility function and nonlinear constraint
U = 3x1 + x2,
s.t. x21 + 2x2 = 16.
a. Graph the indifference curves and budget line.
b. Derive the Lagrangian multiplier, , and interpret the result. How much x1 and x2 should
Eugene consume?
22. Douglas collects baseball cards. Sometimes he buys cards for his collection and sometimes
he sells cards from his collection. Suppose he is currently in equilibrium, where he is neither
buying nor selling baseball cards. Show that he will be better off if prices for baseball cards
change by either rising or falling. Explain why this is the case.
23. Assume a household’s utility function for two commodities x1 and x2 is
U(x1, x2) = (4/5)lnx1 + (2/5)lnx2.
a. Does this utility function represent convex preferences? Explain.
b. Now consider the transformation of this utility function
V(x1, x2) = {exp[U(x1, x2)]}5/2.
where exp(x) = ex. Show that the marginal rate of substitution is the same as in part (a).
24. Consider the utility function
3/4
U = 10x2/3
1 x2 + 23.7.
a. Geometrically illustrate the indifference curves.
b. On the graph in part (a), illustrate the F.O.C. for maximizing the utility function subject
to an income constraint, and then derive the associated mathematical conditions.
c. If p1 = 8, p2 = 3, and the household's income is 17, how much x1 and x2 should be
purchased to maximize utility?
d. Provide a mathematical and economic interpretation of the Lagrangian multiplier, .
25. Every school day Brain eats lunch at school. He only eats ice cream, C, and apple wedges, A.
Brain’s utility function for these two commodities is represented by
U(C, A) = CA.
a. If an ice cream costs $0.50 and an apple wedge costs $0.25, how will Brain maximize his
utility with the $2.00 his mother gives him?
b. If the school tries to discourage ice cream consumption by raising the price to $1.00, by
how much will Brain's mother have to increase his lunch allowance to provide him with
the same level of utility he received in part (a)?
26. Assume that in addition to paying a price per unit for a commodity, a household also pays a
transactions cost for using a market. Analyze the implications for the household's optimal
choice, assuming the transactions cost is paid as a fixed lump sum not dependent on the
quantities of the commodities purchased.
27. Assume that a per-unit subsidy on commodity x1 is only allowed up to some maximum
number of units purchased, xº1, and a household will always purchase more than this
maximum number. Show that a household is indifferent between a lump-sum subsidy that
results in the same income for the household as the per-unit subsidy. Generally, food stamps
cover less than a welfare household’s total expenditure on food.
28. Tim’s family recently immigrated to America, and his father wants him to understand the
great American pastime of baseball by attending more games. Tim’s preferences for baseball
games are illustrated in the indifference map. His only source of income is an allowance from
his father and with this allowance he will attend Bo baseball games. Illustrate the various
alternatives his father has for encouraging him to attend baseball games. Which alternatives
would Tim prefer? Which would his father most likely select?
a. In-kind gift. His father gives him some baseball tickets.
b. Subsidy. His father is willing to pay some portion of the ticket price.
c. Allowance. His father provides him with additional allowance equal to the same level of
satisfaction as the subsidy.
d. Subsidy and allowance reduction. His father provides a subsidy along with an allowance
reduction so his satisfaction remains unchanged.
Chapter 4 Questions (none)
Chapter 4 Exercises (none)
Chapter 5 Questions
11. A rise in the price of a commodity from $5 to $10 reduces quantity demanded from 40,000 to
30,000 units. What is the price elasticity of demand at the mean values of price and quantity
demanded.
12. What is the relationship between the factors that account for a downward-sloping demand
curve and the elasticity of demand?
13. The price elasticity of demand for a given commodity is larger in absolute value if
a. the more numerous and closer the substitutes.
b. if it is a luxury rather than a necessary good.
c. if it accounts for a large portion of the consumption budget.
d. at high prices rather than low.
What is the rational for each case?
14. Sara is given a choice between paying $15,000 for either a cruise around the world or a
brand-new compact automobile. She chooses the automobile. However, just as Sara is
about to pay for the automobile, she is informed she can have her choice at no charge.
Given this information, Sara promptly changes her mind and chooses the around-theworld cruise. Why?
15. The elasticity of demand for automobiles is generally inelastic; however, for a specific
make and model it may be elastic. Why?
16. Are the following statements true or false? Explain each answer.
a. A linear demand curve has constant elasticity of demand at every quantity level.
b. The demand for corn is inelastic, so social welfare can be enhanced by destroying
10% of the annual corn production.
17. Assume you are on the president’s staff at a large university. The university is currently
facing declining enrollments, so the president is considering a large decrease in tuition.
What factors would you consider in forecasting the effects of such a tuition reduction?
18. In 1982, Delta Airlines posted a quarterly deficit of $16 million. In the quarterly
statement, Delta stated the passenger-mile yield did respond to increased airfares,
increasing 4%, but the yield increase was not enough to offset the decline in air traffic.
Was the elasticity of demand elastic or inelastic? Explain.
19. If the elasticity of demand for Amtrak passenger service is unitary and the railroad is
operating at a loss, can the passenger service be made profitable by changing its price?
Explain.
20. On a radio program devoted to farm news, it was reported, “Farmers are receiving a high
price for cotton, but unluckily production is substantially off this season.” Thus, farmers were
not receiving the full benefit of the high price. Analyze this statement in terms of economic
theory.
Chapter 5 Exercises
11. A regional transit district is in a financial crisis. City and state subsidies for its operation
are being discontinued. To avoid this crisis, the transit authority increases fares by 100%.
After one year of this fare increase, the district reports a revenue increase of 70%.
a. Estimate the price elasticity of demand.
b. Estimate the percentage drop in ridership as a result of the fare increase.
12. For the linear demand function
Q1 = a + bp1 + oI + dp2,
where a, b, o, and d are parameters, show that at any point on the household's demand
curve the own elasticity of demand is independent of I and the other commodity’s price.
13. Use indifference curves and budget constraints to illustrate why Wippie, who loves
hamburgers and likes cola, has an inelastic demand curve for hamburgers.
14. Assume Brian’s income elasticity of demand for milk is 1, and he spends 1% of his
income on milk. If his price elasticity of demand for milk is –0.03, what is his
substitution price elasticity?
15. Given the market demand function
Q = a – bp,
where b and a are positive constants, what is the elasticity of demand at Q = 0, Q = a/b,
and Q = b/a?
16. Soft red wheat is produced in the Southeastern United States and primarily used as flour
for pastries. Thus, this wheat is considered a luxury good with an income elasticity
greater than 1—say, 2. In contrast, hard red wheat produced in the Midwestern United
States is used as flour for bread and thus is considered a necessary good with an income
elasticity less than 1—say, 1/2.
A newspaper article appearing in the Atlanta Journal stated that the increased
consumption of United States’ wheat by the then USSR would have no effect on
Southeastern wheat producers because the USSR was interested in purchasing hard red
winter wheat. With the additional assumption that the USSR’s share of expenditures
between hard and soft wheat is 95% and 5%, respectively, answer the following.
a. What is the assumed cross-price elasticity of demand for soft wheat, given a price
change in hard wheat? Is soft wheat a gross complement or gross substitute for hard
wheat?
b. What is the compensated cross-price elasticity of demand for soft wheat, given a price
change in hard wheat? Show that it is impossible for soft wheat to be a net
complement for hard wheat.
Chapter 6 Questions (none)
Chapter 6 Exercises
11. Miss Core has an apple orchard with no room for a vegetable garden. Mr. Vege has a
large vegetable garden but no orchard. Miss Core’s MRS(apples for vegetables) is 3. Mr.
Vege’s MRS(apples for vegetables) is 1/2. Determine how trade can make the two
individuals better off.
12. Assume Robinson’s and Friday’s utility functions for bread, x2, and fish, x1, are
UR = min(x2, x1/2),and UF = 4x2 + 3x1.
Initial endowments for Robinson are x2 = 20, x1 = 60 and for Friday x2 = 30, x1 = 40. At
the competitive equilibrium, what will be the equilibrium price ratio? Who will obtain the
gains from competitive trading?
13. Robinson has preferences represented by the utility function UR(x1, x2) = x1 + x2, and
Friday’s preferences are represented by UF(x1, x2) = min(x1, x2).
a. Illustrate these preferences in an Edgeworth box diagram.
b. What is the equilibrium price ratio?
c. What is the equilibrium allocation?
14. Lemons and limes are distributed between Ms. Pulp and Mr. Tart. Ms. Pulp’s marginal
rate of substitution of lemons for limes is 2 and Mr. Tart’s marginal rate of substitution is
1/2. In which direction should trade take place? How can this trade increase both Ms.
Pulp’s and Mr. Tart’s satisfaction?
15. Consider a two-household, two-commodity exchange economy with initial endowments,
(eR1, eR2, eF1, eF2) = (25, 100, 250, 10), and utility functions
UR(xR1, xR2) = (xR1)2 xR2 and
UF(xF1, xF2) = xF1 (xF2)2.
a. Derive the equation defining the contract curve.
b. Derive the offer curve equations.
c. Solve for the competitive-equilibrium allocation and prices.
Chapter 7 Questions
11. What did John Maynard Keynes mean when he wrote “in the long run we are all dead?”
12. Why would a firm ever keep any inputs fixed in the face of changing market conditions?
What determines which inputs are held fixed and which are allowed to vary?
13. Assume you are the manager of a pizza parlor. How would knowledge of your production
function aid in your management decisions?
14. A farmer purchases a fertilizer plant, so she now has access to a large amount of fertilizer
and spreads it over a fixed amount of land. What may happen to the marginal product of
land? Explain how input proportions affect the marginal products of inputs.
15. The United States is troubled more by agricultural surpluses than shortages. This shows
that Malthus’s Law of Diminishing Marginal Returns is an invalid concept. True or false?
Explain.
16. Assume you have a large flowerpot and all the water, seeds, sunlight, and nutrients you
required. Why will diminishing marginal returns still result?
17. If the Law of Diminishing Marginal Returns did not exist, the entire world’s supply of
food could be grown in a flowerpot. True or false? Explain.
18. Further efforts will be fruitless because you have reached the point of diminishing
returns. Is this common use of diminishing returns correct? Explain.
19. If a firm is operating in the region of diminishing returns, it should decrease its current
level of the variable input. True, false, or uncertain? Explain.
20. A student is observed not to study beyond the point of diminishing marginal returns while
preparing for the CPA examination. Do you think this student will make a good
economist?
21. Why is it feasible to operate somewhere in Stage II of production without knowing the
cost of the input?
22. If engineers prepared an equation yielding the technically efficient level of production for
a given set of inputs, can they then find the optimum proportion of inputs? Explain.
23. Are isoquants drawn convex due to theoretical and empirical reasons or because it is
convenient for making second-order conditions for constrained cost-minimization valid
for interior solutions? Explain.
24. Do firms tend to specialize or diversify in the employment of inputs? Are convex
isoquants consistent with your conclusion? What would be observed if isoquants were
concave to the origin?
25. In the long run, consider a firm with a production process characterized by perfectly
substitutable inputs. Is it possible to determine if the marginal rate of technical
substitution is high or low? Explain.
26. Are fixed-proportions production functions linear homogeneous?
27. If there is only one type of input in production, is it possible for constant or increasing
returns to scale to exist? Explain.
28. Compare the Law of Diminishing Marginal Returns with the concept of decreasing
returns to scale.
29. Is the Law of Diminishing Marginal Returns applicable in the long run?
Chapter 7 Exercises (none)
Chapter 8 Questions
11. Can there be production without costs? Explain.
12. In the United States, a large percentage of food is produced on family owned and
operated farms. This is more efficient than corporate owned farms, because family farms
do not have to pay for most of the labor input. True or false? Explain.
13. If a firm wants to estimate its cost function, does it have to know how much profit it
would make at each output level? Explain.
14. If a firm is producing where v1/MP1 > v2/MP2, what can it do to reduce costs but maintain
the same output level?
15. Is the problem of least-cost production for a given level of output important only for
producers or is it also important for consumers? Explain.
16. In terms of least-cost production, which is more efficient, Japanese agriculture with its
intensive use of land or United States agriculture with its far less intensive use of land?
How have relative prices in the two countries resulted in alternative types of farming?
17. During World War II the United States constructed airstrips in China employing local
labor. Without machinery, the workers mixed concrete and transported it to form the
runway. Why would it have not been more efficient to instead use machinery?
18. Would a firm always continue to increase production as long as it experienced economies
of scale?
19. If a firm could produce an output and maintain constant economies of scale at all levels
of output, what would be the shape of the firm’s long-run average cost curve? Would its
short-run average cost curves have the same shape?
20. Can the condition of long-run costs declining and then increasing be explained by
decreases and increases in input prices? Explain.
21. What is wrong with the following statement from an industrial plant manager?
My plant is working at its most efficient output level. However, a short-run increase
in demand can be covered by running the lines at a faster rate and deferring routine
maintenance. Thus, in the short run, my marginal cost is realistically zero.
22. State and explain the Law of Diminishing Marginal Returns. What bearing does this law
have upon short-run costs?
23. Refer to Exercise 3 in Chapter 7, concerning probability of a traffic accident. Caution is
costly, it requires time and alertness. Explain why drivers will generally not take
complete caution.
24. Long-run average cost involves the full cost of all inputs whereas short-run average
variable cost involves the cost of only those variable factors. However, short-run average
variable cost may exceed long-run average cost. Do you agree or disagree with this
statement? Explain.
25. For railroads, approximately 2/3 of total costs are fixed, with the remaining 1/3 variable,
so SAVC is only one-third of SATC. Thus, railroads will improve their profit position by
increasing rail traffic at rates lower than SATC. Is this statement valid? Explain.
26. Where there are two or more variable inputs, a supply curve is based on the assumption
that production is efficient. True or false? Explain. What about only one variable input?
27. What are the implications of a productive activity where marginal cost never increases?
Chapter 8 Exercises
11. Consider the production function
q = K1/4L1/3.
Derive the least-cost combination of K and L as a function of input prices and output.
Graph and explain the result.
12. A recent study estimates total farm output would remain constant if 5 tons of fertilizer
were substituted for 1 acre of land. If the price of 1 ton of fertilizer is $150, what is the
lowest rental price of 1 acre of land that induce farmers to substitute land for fertilizer?
13. A manufacturer of auto parts hires its assembly-line labor for $44 an hour, and the rental
cost of its machinery is $240 per hour. Assume an auto part can be produced in fixed
proportions of 4 hours of labor to 1 hour of machinery. If the firm is currently using 3
hours of labor for 1 hour of machine time, is it minimizing its costs of production?
Explain.
14. A firm’s expansion path is a 45o line when q = KL and  = , regardless of the values
for  and . Is this statement true or false? Explain.
15. Assume the long-run total cost function for a firm is
LTC = q + q2 + q3.
a. What is long-run total fixed cost (LTFC)?
b. Calculate LMC and LAC.
16. Assume a firm’s production function is given by q = KL with  = . Is it true w/MPL =
v/MPK = LMC and LMC is a constant? Explain.
17. Often the following graph will be observed in textbooks and presented in lectures.
Unfortunately, the relationship between SAVC and SMC is wrong. Explain why it is
wrong and construct the correct relationship. Note, STVC1 = SAVC1(q1), which is
represented by the area 0(SAVC1)Aq1; however, STVC1 also may be defined as
STVC1 = q01SMC dq, which is represented by area 0BAq1.
18. Derive short-run total variable cost, total fixed cost, total cost, average variable cost,
average total cost, and marginal cost curves under the following assumptions.
a. Production exhibits a constant marginal productivity of labor.
b. Production, at first, exhibits increasing marginal productivity of labor, but then
exhibits diminishing marginal productivity of labor.
c. All costs are fixed.
d. All costs are variable.
19. Assume the short-run total cost function for a firm is the cubic equation
STC =  + q + q2 + q3.
a. Calculate SATC.
b. Calculate SAVC.
c. Calculate SMC.
d. Show STC is consistent with U-shaped SATC, SAVC, and SMC curves for at least
some values of the parameters , ,  and .
20. Graph the SATC, SAVC, TFC, SMC, LAC, and LMC for the associated cost curves in the
figure.
Cost
STC"
LTC
STC'
STC
0
Output
21. Graph the LTC, STC, STVC, SATC, TFC, SMC, LAC, and LMC for a technology with all
three stages of production and returns to scale.
22. A perfectly-competitive firm has a cost function given by
STC = (1/2)q2 + 10q + 50.
a. What is its total variable cost and total fixed cost?
b. Graph the marginal and average cost curves.
c. Does this cost function represent increasing, decreasing, or constant marginal
productivity?
23. A producer has two factories producing identical products. Each factory has a production
unction given by
qj = (KjLj)1/2, j = 1, 2.
The firms differ in the amount of capital with factory 1 having K1 = 25 and factory 2
having K2 = 100. Rental rate for K and wage rate for L are w = v = 1.
a. How should output be allocated between the two factories to minimize short-run total
cost for a given level of total output Q?
b. Given that output is optimally allocated between the two factories, calculate the shortrun total, average, and marginal cost curves.
24. Consider the following short-run total cost function
STC(q, K) = q3 – 1/2q2 – Kq + K2.
a. Derive short-run average total cost and marginal cost functions, where K denotes the
level of fixed input.
b. Derive long-run total cost, average cost, and marginal cost from the short-run total
cost function you derived in part (a).
c. Geometrically illustrate the results.
25. Assume a firm's fixed costs are $100. One worker produces 10 units of output, and the
marginal product of labor increases at a rate of 2 additional units of output per additional
worker for the first 5 workers and then falls at a rate of 1 per additional worker. If the
wage rate is $20 per worker, calculate all the short-run costs over the first 12 workers
hired.
26. Consider the following cost functions.
i. LTC(q) = 3q3 – 6q2,
ii. STC(q) = 8q2 + 800.
For each function, answer the following
a. What is its total variable cost and total fixed cost?
b. At what output is average cost minimized?
c. Graph the marginal and average cost curves.
27. In a famous article [J. Viner, "Cost Curves and Supply Curves," Zeitschrift Fur
Nationalokonomie 3 (September 1931): pp. 23–46], J. Viner criticized his draftsman
because he could not draw a family of SATC curves whose points of tangency with the
LAC curve were also the minimum points on each SATC curve. The draftsman stated that
such a drawing was impossible to construct. Who was correct? What is the condition
where both would be correct?
28. For each allowable shape of the average cost curves, show the implied shape of the
marginal cost curves.
29. State a Slutsky type equation for a firm that maximizes profit subject to a cost constraint.
Chapter 9 Questions
11. An airline is considering adding an additional route to its schedule. It determines that the
ticket revenue from the route will cover fuel, maintenance, and labor, but will not cover
all of the costs. Should the airline add the route? Explain.
12. Why is it assumed that a firm’s objective is to maximize total profit rather than marginal
profit?
13. Why is it not sensible to close a business if it is earning zero pure profits?
14. A producer will determine whether to operate or not by considering her short-run average
variable costs, her profit level by considering her short-run average total cost, and her
optimal level of output by considering her short-run marginal cost. True or false?
Explain.
15. The greater my sales, the greater my profits. True or false? Explain.
16. Explain why a perfectly competitive firm does not expand its output without limit, given
that it can sell all of this output at the same per-unit price.
17. Douglas’s firm is currently operating at a loss. If the output price increases, he will not
increase quantity because if he did marginal cost would rise and he would be losing even
more. True or false? Explain.
18. Regardless of the amount of water used, the price per cubic foot the public utility charges
is the same. What then is the elasticity of supply for water? Explain.
19. When prices on the Tokyo stock exchange fall, financial reports indicate that the cause is
heavy selling. However, for every share sold a share is bought. Why not refer to it as
heavy buying?
20. Kenya is interested in discouraging the poaching of elephants for their ivory. When
contraband ivory is captured, what should the government do with the confiscated ivory?
21. It is claimed that on the first of the month, when welfare and Social Security checks are
paid in city ghettos, store owners never discount prices and thus earn higher profits. If
high profits are earned by these store owners, what may happen in the long run?
22. In a perfectly competitive market, why will all the benefits from a technology change
accrue to consumers in the form of lower prices?
23. A perfectly competitive firm can sell all the output it can at a given market price. Yet,
when there was an abundant cotton harvest, a farmer received a lower price when he sold
his large harvest. What happened?
24. The U.S. Department of Agriculture recently predicted bumper crops of corn and wheat,
but the assistant secretary for economics warned consumers not to expect prices to
decrease. He cited the rising cost of production and increased export demand rising as
reasons for his warning. The assistant secretary stated, “The classic pattern of supply and
demand won’t work this time.” Is his statement true or false? Explain.
25. Assume your current total revenue in farming is $120,000 per year and your costs are
$10,000 per year for seed and fertilizer, $12,000 for other supplies, and $15,000 interest
on machinery loans. You are offered another job that would pay $50,000 per year. If you
take it, you will sell your farm and machinery and earn $70,000 per year interest on the
money you had invested in land and machines. Should you take the other job? Explain.
26. Mr. Young only has the knack for always planting the best crop and consistently earns
higher profits than other farmers. Are these really higher profits or something else?
Explain.
27. Hazel is the production manager of an assembly line. The equipment on the line is under
a long-term leasing agreement with a rental rate as a function of the prime rate of interest.
Recently, the rental rate has gone up dramatically, so Hazel decides to reduce the
production rate along the line. Did she make the correct decision? Explain.
28. If at an equilibrium price, every firm in the industry is earning a zero pure profit, does
this imply that a fall in market price will result in all firms shutting down? Explain.
29. An agricultural experiment’s station director at a major college of agriculture in the
Southeastern United States stated that soybeans are currently not profitable due to low
prices. Thus, economists should investigate alternative crops for southeastern farmers.
Given continued low prices for soybeans, will soybean production remain unprofitable?
Explain.
30. Some economic historians claim the Industrial Revolution was caused by rising demand
that encouraged firms to expand production while others argue it was due to rapid
technological change increasing supply. What was the probable major cause and why?
31. The supply curve for a firm in the short run is the short-run marginal cost curve (above
the point of minimum average variable cost). However, the supply curve in the long run
is not the long-run marginal cost curve (above the point of minimum average total cost).
Why?
32. In the long run, a perfectly competitive firm always operates at the minimum level of
average costs for the optimal plant size to produce a given amount of output. True or
false? Explain.
33. Why, in the short run, is perfectly competitive equilibrium where p = SMC, while in the
long-run equilibrium it is where p = SMC = SATC.
34. If the long-run equilibrium for a firm is characterized by zero pure profit, why would
firms adopt new cost-reducing technologies?
35. It is argued that agricultural research benefits low-income households relatively more
than those with higher incomes. Why?
36. Diseconomies of scale are seldom observed in an industry. Why?
37. Economists have estimated the optimum size of a plant by investigating the existing plant
sizes, assuming that plants that have survived must be close to optimum size. Is this a
reasonable assumption? Explain.
38. Assume that an increase in the demand for movies increases the salaries of film artists
substantially. Is the long-run supply curve for movies likely to be horizontal or upward
sloping? Explain.
39. Suppose Congress passes a law providing a subsidy for every acre of land used for
growing tobacco. How does this program affect the long-run supply curve for tobacco?
40. It is inconsistent with the perfectly competitive model for a firm in a long-run equilibrium
to ever produce a positive quantity where its long-run average costs are continuously
declining. What are the implications of this for an industry where all firms have declining
average costs?
41. In the early part of the last century, chicken was considered something special, and was
mainly served only on special occasions or on Sunday. Today, chicken is quite common
and served throughout the week. Explain this increase in the popularity of chicken.
42. An Atlanta cab driver appears to be making a pure profit in the long run after accounting
for the operating and labor costs. Does this violate economic theory? Explain.
43. Perfectly-competitive industries do not really exist, so what is the point of studying them?
44. Assume that a firm is maximizing profit, in the short run, with variable labor input and a
fixed level of capital. If wages decline, what happens to the firm’s use of capital? What
happens to the firm’s level of profit?
Chapter 9 Exercises
11. Suppose the market demand for fingernail polish is
QD = –3p + 14,
and market supply is
QS = 2p2 – 15p + 30.
What are the equilibrium prices and quantities for this market? Which of these prices and
associated quantities represent a stable equilibrium? Explain.
12. A perfectly competitive market is composed of 1000 firms. The short-run supply function
for each firm is
q = –100 + 25p.
The market demand function is
QD = 80,000 – 5000p.
a. Calculate the short-run equilibrium price and market quantity.
b. Determine the demand curve facing any one firm.
c. At the equilibrium output, determine the elasticity of market demand and elasticity of
demand facing any one firm.
13. A perfectly competitive firm has a cost function given by
STC(q) = q2 + 8q + 1.
a. What are its STVC and TFC?
b. What is its supply curve?
c. What is the elasticity of supply?
d. At what output is SATC minimized?
e. If there are 500 identical firms in this industry, what is the industry's supply curve?
f. If the market demand function is QD = –50p + 1000, what are the equilibrium price
and quantity?
g. What is the elasticity of market demand and supply at the equilibrium price and
quantity?
h. What is the equilibrium level of output for an individual firm?
i. What is the elasticity of demand facing each individual firm?
j. Is a firm in this market earning a pure profit, a normal profit, or operating at a loss?
14. Twenty identical firms produce decks of cards in a perfectly competitive market each
with the following short-run total cost function
STC(q) = (1/4)q2 + (1/10)wq + 10.
a. If w = 5, what is the firm’s short-run supply curve?
b. What is the market supply curve?
c. How many card decks will be produced at a market price of $2 per unit?
15. Assume that the technology for producing a commodity using capital, K, and labor, L, is
q = f(K, L) = K1/2L1/2. In the short run, let capital be fixed at 4 units with the rent on
capital of 1 and a wage rate of 4. The firm is facing the following market demand
function
QD(p) = 60 – 5p,
with 10 competitive firms in this industry.
a. What are the short-run individual firm’s supply function and the industry supply
function?
b. What are the market equilibrium price and quantity and how much does each firm
supply? What is the level of profit for each firm?
16. Assume a firm's short-run total cost function is
STC = (1/3)q3 – 4q2 + 22q + 100.
a. Determine the output level at which it maximizes profits if p = 10.
b. Is the firm earning a pure profit, normal profit or operating at a loss?
17. A perfectly competitive market is comprised of 1000 producers, each with the variable
cost function
STC(q) = 0.5q2 + 0.2q + 6.
The firms are facing the following market demand function
QD = 7,800 – 1,000p.
a. Derive the short-run supply function for an individual producer.
b. Derive the short-run market supply function.
c. What are the market equilibrium price and quantity?
d. What are the output and profit of each producer?
18. A competitive industry has 1,000 firms. In the market period, each of the firms has a
fixed supply of 50 units, and the market demand function is
QD = 75,000 – 5,000p.
a. Calculate the market equilibrium price.
b. Calculate the demand function facing any one firm.
c. At the equilibrium price and quantity, determine the elasticity of market demand and
the elasticity of the demand facing any one seller.
d. What are the new equilibrium prices if one seller decides to sell nothing or if one
seller doubles its output?
e. In the short run, assume each firm’s supply function is q = –100 + 20p.
Given this individual supply function, answer questions (a) through (d).
19. Derive the first-order conditions for a profit-maximizing firm and interpret the results
when the firm has a total expenditure constraint.
20. Prove that a profit-maximizing firm will always minimize cost.
21. To determine the profit-maximizing levels of output, q, and inputs, L and K, we can use
the following constrained maximization problem
max  = max(pq – wL – vK), s.t. q = f(L, K).
Employing the Lagrangian gives
 (q, L, K, ) = pq – wL – vK +  [q – f(L, K)].
a. Show that profit maximum can instead be achieved in two steps by first minimizing
cost subject to a given level of q and then maximizing over q. The Lagrangian is
 = max(pq – min{wL + vK + [q – f(L, K)]}).
b. Show that profit maximization implies cost minimization at the profit-maximizing
level of output.
22. Consider the utility-maximization problem
max U(max U(pq – wL – rk), s.t. q = f(L, K).
(L, K, q)
Assuming the utility function is monotonically increasing in dU/dderive the
F.O.C.s for maximizing utility. Do these conditions differ from the F.O.Cs of a firm
maximizing profits? Explain.
23. Consider a central authority who operates two firms with the objective of minimizing
short-run total cost for a given level of aggregate output, Q. Specifically,
min STC(Q) = min [STC1(q1) + STC2(q2)], s.t. q1 + q2 = Q.
a. Derive the first-order conditions for this cost-minimization problem.
b. Show that at the cost-minimizing production allocation, SMC(Q*) = SMC1(q) =
SMC2(q).
c. Show for all profit-maximizing firms with output price p = SMC(Q*) the same costminimizing allocation results.
24. Assume that the short-run total cost function for each cheese producer is
STC = q2 – 10q + 100,
and the market demand for cheese is
QD = –10p + 300.
a. For each cheese producer, what will be the long-run competitive-equilibrium output
associated with this STC function?
b. Assuming the cheese industry exhibits constant costs and all firms are identical, what
will be the long-run equilibrium price and market quantity of cheese? How many
firms, n, will be in this cheese industry?
25. Illustrate the long-run equilibrium for a perfectly competitive firm with economies of
scale over its entire range of output. What is the equilibrium level of output and profit?
26. A local government passes a law that prohibits additional firms from entering a constantcost industry. The existing firms in the industry have U-shaped long-run average cost
functions, and the industry was in long-run equilibrium before entry was blocked.
Determine the new long-run equilibrium of the industry and a representative firm after an
increase in market demand.
Chapter 10 Questions
11. Consider two steel plants, one in China and one in Europe. One plant employs five
workers per ton of steel; the other employs seven workers per ton. Can it be determined
which plant is more efficient in terms of technological efficiency? How about economic
efficiency? Explain.
12. In his Principles textbook, Alfred Marshall gave the following measure for consumer
surplus:
The amount a consumer would pay over which he does pay for a given amount of a
good rather than none at all.
Another consumer surplus measure is
The monetary equivalent of the fall in utility a consumer would experience if the right
to purchase the good at the market price were taken away.
What relationship, if any, exists between these two measures? Discuss.
13. Assume the market supply curve is vertical, S = 0. What is the deadweight loss of a sales
tax or a subsidy?
14. Why is p = MC such a big deal?
15. What is so hot about perfect competition?
16. In long-run equilibrium, p = LAC = LMC. Of what significance is p = LAC? How about
p = LMC? In answering, distinguish between technological, allocation, and scale
efficiency.
17. If half of a tropical rain forest is destroyed in a region, the value of the remaining forest
would be greater than the value of the whole forest prior to its destruction. Thus, the
whole is worth less than the half. This illustrates how the concept of value is distorted in
a market economy. True or false? Explain.
18. Explain the concept of consumer sovereignty.
19. Would it be correct to define an equilibrium price as the price at which the quantity
purchased equals the quantity sold? Explain.
20. Demand and supply are constantly changing to reflect market conditions such as
changing preferences and technologies. With changing market conditions, what is meant
when the popular press talks about shortages of teachers, computer programmers, or
housing?
21. Discuss the possible social advantages and disadvantages of a rise in the price of water
during a drought.
22. A Roman emperor declared there should be cheapness. For wherever his legions go,
prices for food increase manyfold. What will be the result of his declaration? Explain.
23. Why would anyone be against imposing price controls on necessary goods to protect the
poor when facing rapidly rising prices?
24. Price controls, designed for rationing available supply, generally work as hoped during a
national emergency. However, once the emergency has passed, such price controls are
less effective. True or false? Explain.
25. The demand for illegal drugs is generally highly inelastic and motivates a large
proportion of the crime committed in U.S. inner cities. If a social worker’s objective is to
reduce drug use without causing an increase in crime, would she support tougher
penalties for users or dealers? Explain.
26. If it is true that the demand for illegal drugs is highly inelastic, would users be in favor of
tighter or looser controls over drug traffic? Explain.
27. Will the establishment of minimum housing standards necessarily be in the best interest
of low-income households? What will be the effect of these standards on the quantity,
quality, and price of housing?
28. In the past the government regulated of U.S. petroleum industry by placing a price freeze
on old oil, where old oil was defined as petroleum in existing wells. Any development of
new wells would be considered new oil and not subject to the price freeze. It was
assumed that petroleum from existing wells would continue to be supplied even as the
price of new oil increased, and the higher price for new oil would encourage the
development of new wells. Was this assumption correct? Explain.
29. Explain what might have happened if the government had imposed a price ceiling on
coffee in the late 1970s after the price rose 400%?
30. In France, rent control from 1914 to 1948 resulted in limited, if any, residential
construction. Why did this result occur?
31. Given a ceiling price, does the black-market price indicate what the legal-market price
would be without the ceiling price? Explain.
32. Would the mafia deal in summer squash if it became an illegal commodity? Why or why
not?
33. How has the legalization of abortion influenced the demand, supply, price, quantity, and
quality of the service?
34. Recently a number of governments have imposed (or propose to) a stronger penalty for
drug dealers with a weaker penalty for users. What will likely happen to the price and
quantity of drugs consumed? Explain.
35. Great Britain has a national health care program where medical services are provided free
to individuals, with the cost paid through taxes. British physicians generally complain
that patients demand too high a level of services and patients complain they wait too long
for such services. As a result, a private medical services market has developed alongside
with the public system. Is such a dual system efficient?
36. Why did the government agricultural price-support programs result in huge stockpiles of
agricultural commodities?
37. Many farmers argue that crop restriction programs do not really improve their incomes
because the subsidy they receive per retired acre does not offset the loss of income from
producing less. What assumptions are they making about the price elasticity of demand?
38. Without government price supports, farmers could not afford to grow peanuts, so we
would not have any peanuts without such supports. True or false? Explain.
39. Assume that labor productivity in agriculture grows at twice the rate for the rest of the
economy. Given the continuing problem of surpluses in agricultural commodities, would
decreased productivity in agriculture be a desirable solution? Explain.
40. Assume that the supply of apartments is fixed in a market period, so the equilibrium rent
is determined solely by demand. If the property tax on apartments increases, how much
of this tax will be passed on to renters?
41. A sales tax is placed on a competitive firm’s output. How will this tax affect the cost
curves for the firm? What will happen to the firm's price, output, and profit in the short
run? What will happen in the long run?
42. A standard industry argument for protective tariffs and quotas is that its output is
essential for national defense. How does restricting imports ensure supplies of output
from such an industry? What alternative policies are available?
Chapter 10 Exercises
11. Assume the following market demand and supply functions:
QD = 500 – 2p, QS = p – 100.
a. Determine the market equilibrium price and quantity along with consumer and
producer surplus at this equilibrium.
b. If quantity is reduced to Q = 50 from this market equilibrium, what would be the
deadweight loss? Associated with Q = 50, at p = 225 what is the producer and
consumer surplus? How about at p = 150?
c. If quantity is increased to Q = 150, what would be the deadweight loss?
12. Assume the demand curve in Exercise 11 shifts outward to
QD = 800 – 2p.
a. Determine the new market equilibrium price and quantity along with consumer and
producer surplus at this new equilibrium.
b. If a ceiling price prevents any price rise, how would this shift in demand affect
consumer and producer surplus? What, if any, is the level of deadweight loss?
13. Compare the effect on a competitive firm's output and price decisions of a $1 tax per-unit
output versus a $1000 license fee regardless of output level.
14. In the long run, a sales tax imposed on a decreasing-cost industry will raise market price
by more than the tax. Explain why this will occur.
15. Assume a country importing a good is facing a positively sloping supply curve for
imports.
a. Graphically illustrate the equilibrium price, domestic supply and demand, and level of
imports.
b. Illustrate the changes in consumer and producer surplus along with the deadweight
loss from the implementation of a tariff.
Chapter 11 Questions
11. Explain the relationship between the production possibilities frontier and the definition of
economics.
12. Suppose a new invention causes a constant returns to scale production process for food to
become an increasing returns process. How does this change affect the production
contract curve and production possibilities frontier?
13. A perfectly competitive price that all agents take as given is the key to economic
efficiency. True or false? Explain.
Chapter 11 Exercises
11. Given the production function, q21 + q22 = LK1/2, determine the profit-maximizing levels of
q1, q2, L, and K, if p1 = 8, p2 = 4, w = 1, and v = 2.
12. Suppose 1 unit of food requires 3 units of labor and each unit of clothing requires 2 units
of labor. Given 24 total units of labor, determine the production possibilities frontier.
What type of opportunity cost does this frontier represent?
13. Assume that the allocation of capital and labor to the production of commodities q1 and
q2 is not Pareto efficient. Show what the input price ratio must be if the firm that
produces q1 is minimizing cost and if the firm that produces q2 is minimizing cost. Will
the factor price ratio be different for the two firms?
14. Complete the following table.
Price of A
Marginal Cost of A
8
10
Marginal Cost of B
Price of B
12
48
5
30
4
16
12
3
15
6
1
9
32
15. Consider an economy with the following technology for the production of fish and bread:
F = min(L, K), and B = min(L/2, K).
a. Assume that capital is unlimited, but labor is limited to 100. Derive and graph the
production possibilities frontier. Now assume that labor is unlimited, but capital is
limited to 75. Derive and graph the production possibilities frontier.
b. With K = 75 and L = 100, derive and graph the production possibilities frontier.
c. Explain the convexity of the production possibilities frontier in part (b).
d. Explain why production of fish and bread is exactly the same for the price ratios 1/2 <
pF /pB < 1.
16. Suppose Robinson produces and consumes bananas, B, and coconuts, C. Also, assume
during a certain week he has decided to work 32 hours and is indifferent as to whether he
spends this time gathering bananas or coconuts. Robinson’s production for bananas is B =
1B/2 and for coconuts is C = 1C/2, where B and C are the number of hours spent gathering
bananas or coconuts. Robinson’s utility for bananas and coconuts is U = BC.
a. If Robinson cannot trade with the rest of the world, how will he choose to allocate his
labor? What are the optimal levels of B and C? What is the MRPT(B for C). What is
his level of utility?
b. Now assume that trade is possible and Robinson can trade bananas and coconuts at a
world price ratio of pB/pC = 2. If Robinson continues to produce the quantities of B
and C in part (a), what will he choose to consume? What is his new level of utility?
c. How does the answer to part (b) change if Robinson optimally adjusts his production
given the world price ratio?
17. Consider a one-consumer, one-producer economy. Determine the equilibrium prices and
consumption, given that the production function for commodity q is q = 1/2, the utility
function is U(h, q) = hq, and the total endowment of time is T = 27 with T =  + h.
18. Consider a three-household, three commodity economy. Each household is initially
endowed with 1 unit each of the three commodities. Households A and B have identical
preferences and care only about commodity 1, so they do not derive any utility from
consuming commodities 2 and 3. In contrast, household C cares only about commodities
2 and 3. Determine the Pareto-efficient allocations and the competitive-equilibrium
prices.
19. For the production possibilities frontier
125 = q21 + q22,
determine the optimal output levels for q1 and q2, if p1 = 1 and p2 = 2. Illustrate the
solution graphically.
Chapter 12 Questions
11. Firm A is a price taker and can sell all of its output at a price of $5. In contrast, firm B
has to lower its price from $6 to $5 to sell more output. Why isn’t the marginal revenue
for firm A the same as the marginal revenue for firm B?
12. What is the condition of a single firm in an industry selling at a lower price than would be
possible if there were many smaller firms? Explain.
13. The following graph is meant to describe the situation of a monopoly. What’s wrong with
it?
14. Why is the price of an extra unit sold by a firm with monopoly power greater than the
extra revenue received?
15. On most weekdays, theater matinees are almost empty. Why do managers of theaters not
lower their ticket prices to fill up their theaters?
16. A firm with monopoly power will charge the highest price it can get. True or false?
Explain.
17. A monopoly has no competition, so it can charge whatever price it wishes and it always
enhances profit by increasing its price. True or false? Explain.
18. A profit-maximizing monopoly never produces an output in the range where the price
elasticity of demand is less than 1 in absolute value. Why?
19. Assume a firm knows the demand curve for its product. If the firm’s objective is to
maximize profit, explain why it will price its output so the price elasticity of demand is
less than –1. What is the assumption about the cost of production? If production cost is
zero, what is the elasticity of demand at the profit-maximizing output level? If total cost
declines at a decreasing rate with increases in output, what is the elasticity?
20. A monopoly produces 10,000 units of some output, and the price elasticity of demand at
this level of output is –1/2. What should the monopoly do and why?
21. The market demand curve for cocaine is said to be highly inelastic. Cocaine is also said
to be monopolized by street gangs, and it is assumed they attempt to maximize profit. Are
these two views consistent?
22. We know that the Lerner Index, LI, a percentage markup of price over marginal cost, is (p
– MC)/p. Why can this markup be viewed as a measure of monopoly power?
23. Compared to a manager of a firm with monopoly power, a manager of a perfectly
competitive firm has an easy job—because she does not have to be concerned about
setting the price. True or false? Explain.
24. The more profitable a firm, the greater its monopoly power. Analyze this statement.
25. If a street gang can effectively monopolize an illegal drug, would you expect to observe
more or less crime? Explain.
26. Would a monopoly always continue to increase production as long as it is experiencing
economies of scale?
27. A firm should always produce at an output at which long-run average cost is minimized.
True or false? Explain.
28. What is meant by the statement, “Monopolies concoct scarcity”?
29. Monopoly is bad for consumers but good for producers. Thus, on balance we cannot
determine if it lowers social welfare. True or false? Explain.
30. What is wrong with exercising monopoly power? What is right about it?
31. If monopolies are inefficient, why do governments often try to protect certain sellers
against potential competitors wishing to enter a market?
32 Microsoft has taken advantage of its dominant position in the operating system software
industry and made huge profits. Thus, it would be perfectly just to impose a special tax
on Microsoft as a way of recovering for society some of the exorbitant past profits. True
or false? Who would pay for this tax? Explain.
33. The sole objective in dealing with monopoly power is eliminating excess profit. This is
done by setting price equal to average cost. True or false? Explain.
34. What problems face a regulatory agency attempting to force a monopoly to charge the
perfectly competitive price?
35. The Southern Power Administration, a publicly owned utility, determined that a 50%
increase in rates would generate an additional revenue of $729 million per year. What
does this indicate about the price elasticity of demand? Is the utility maximizing profit? Is
it maximizing social welfare? Explain.
36. Regulatory commissions frequently require public utilities to set a price that yields the
going rate of return by equating price to long-run average cost. In terms of efficiency,
economists suggest instead that price should equal marginal cost. What problems exist
with the selection of either of these two pricing options?
37. Even through their prices are regulated, public utilities generally engage in governmental
lobbying efforts. Why do they do so and what do they lobby for?
Chapter 12 Exercises
11. Assume that firms within an industry are characterized by increasing returns to scale.
Demonstrate how a profit-maximizing monopoly might charge a lower price than would
a competitive industry composed of a number of firms earning zero short-run pure
profits.
12. Suppose a monopoly faces the demand function QD = 85 – p. If its cost function is STC =
Q3 + 10, what is its optimal level of output and price?
13. Dr. Out has just written the first textbook on interplanetary trade. The market demand
function for this book was estimated to be Q = 1000 – 100p. It will cost $500 in fixed
cost to typeset the book and a marginal cost of $1 per book for every book printed.
a. Determine the total revenue function for Dr. Out’s book.
b. Determine the total cost function for producing the book.
c. How many copies of the book should be printed for Dr. Out to maximize profits?
What will one copy of the book sell for?
14. Assuming the price elasticity of demand is equal at every level of quantity, graph the
demand curve and the marginal revenue curve. If the marginal cost of production is
positive, what is the profit-maximizing output?
15. Suppose Congress wants to correct the inefficient allocation effects of a monopoly with a
subsidy.
a. Why would a lump-sum subsidy, S, not achieve Congress’s objective?
b. Graphically illustrate how a per-unit subsidy, s, on output may achieve Congress’s
objective.
16. The price a monopoly can charge is regulated by some government agency. Determine
what regulated price maximizes the total number of units sold. How much would a firm
be willing to pay for the right to be a monopoly?
17. Ms. Opt, the manager of a monopoly, must not only make the output and price decisions
but also the decision about investing in cost reducing technologies, . Investing in  will
lower her constant short-run marginal cost of production, SMC(). The per-unit cost of
the  is v.
a. Derive the first-order conditions for Ms. Opt’s optimal levels of Q and .
b. Compare the monopoly’s optimal choice of Q and  with that of a government
regulator who can control both Q and .
c. If the regulator can only determine  with the monopoly being allowed to choose Q,
how do the optimal values of  and Q differ between the regulator and the monopoly?
Chapter 13 Questions
11. Mr. Rural lives in the country and Mrs. Urban lives in city central. More gas is required
to deliver a newspaper to Mr. Rural than to Mrs. Urban, but the price of the paper is the
same for both. Is this a type of price discrimination? Explain.
12. Assume all firms except one are perfectly competitive, and the remaining firm is a
perfectly price-discriminating monopoly. Explain why the Pareto-efficiency conditions
will still be satisfied. What differences in allocation and distribution of income result
from the one firm not being a perfect competitor?
13. Will a monopoly ever provide a Pareto-efficient level of output on its own?
14. Assume a firm’s demand curve is below its short-run average total cost curve at all levels
of output. Can you conceive of any cases where production may still be profitable?
Explain.
15. A physician states that she is helping her low-income patients by charging lower fees
than she charges her higher-income patients. Who else is she helping? Explain.
16. Why do identical books usually sell for so much more in hardcover than in soft-cover?
Explain.
17. Why is the price of tickets to sporting events and concerts typically lower for children
than for adults? Explain.
18. A manager of a local movie theater is setting the price schedule for the movies based on
the day of the week, time of day, and type of costumer. How should he set prices? Would
the pricing schedule be different if the theater was the only one in town rather than one of
a number of competing theaters? Explain.
19. Is price discrimination socially desirable? Explain.
20. Sandra says, “A monopoly will produce a product of higher quality because cutthroat
competition will lead to a decline in quality.” Paul says, “A monopoly produces a smaller
quantity of product than would a competitive industry and, by the same logic, will also
produce a product of lesser quality.” Who is correct? Or are they both wrong? Explain.
Chapter 13 Exercises
11. Suppose a monopoly can produce any level of output it wishes at a constant marginal and
average cost of $10 per unit. Assume the monopoly sells its output in two separate
markets. The demand function in the first market is q1 = 50 – p1, and in the second market
is q2 = 60 – 2p2.
a. What level of output will the monopoly produce in each market and what will be the
prices?
b. What is consumer and producer surplus in each of the markets? What is the resulting
deadweight loss?
c. What is the effect on consumer and producer surplus if the firm also adopted a linear
two-part tariff?
12. An amusement park has a monopoly within a given region. The demand function for
rides within the park is illustrated in the graph. The per-unit cost of supplying rides is
composed of c (the labor and maintenance cost) and d (the cost of printing and collecting
tickets for each ride). Each per-unit cost is independent of the number of rides offered at
the park. The managers of the park are considering the following two pricing strategies
Strategy 1. An entrance fee and a per-unit charge for each ride.
Strategy 2. Just an entrance fee.
a. Given the graph, what is the entrance fee, price per ride, total number of rides
supplied, and total profits under each strategy?
b. Under what conditions will profits under strategy 2 exceed profits under strategy 1?
13. A monopoly supplier of clothing has zero production and transportation costs with sales
located in two different regions. The demand functions for each region are q1 = 1 – p1,
and q2 = 1/2 – p2.
a. Assuming the monopoly must charge a uniform (linear) price to the two regions,
calculate the profit-maximizing uniform price and quantity. What is the resulting
profit?
b. Now assume the monopoly can engage in third-degree price discrimination. Calculate
the profit-maximizing price and quantity for each region. What is the resulting profit?
c. Assume the monopoly is selling clothing at the wholesale level, so the demand
functions are derived demands for the intermediate product of two competitive
downstream retail outlets. If third-degree price discrimination is not possible, show
that the monopoly can obtain the same result by integrating forward into one of the
downstream markets. In other words, instead of only selling wholesale, it will sell at
the retail level in one of the markets. Which one should it integrate into? Why?
14. A monopoly sells its output to two groups having constant elasticity of demand curves 1
and 2. If the marginal cost of production is constant at c, what price is charged to each
group?
15. International-trade restrictions result in an electronics manufacturer enjoying monopoly
power in its domestic market, but in the world market faces perfect competition. What
effect does the imposition of a sales tax, both foreign and domestic, have on the domestic
price and quantity?
Chapter 14 Questions (none)
Chapter 14 Exercises
11. Consider the following game
Player B
Player A
Left
Right
Top
(2, 2)
(–1, –1)
Bottom
(–1, –1)
(1, 1)
a. Determine all the pure-strategy Nash equilibria.
b. Do any of the pure-strategy Nash equilibria dominate any of the others?
c. Suppose player A moves first and commits to either top or bottom. Are the strategies in
parts (a) and (b) still Nash equilibria?
12. An alternative to the maximin criterion for selecting strategies is the minimax regret
criterion. For this criterion, a maximum regret table is constructed that lists, for each possible
strategy of the other player, the difference between the payoff obtainable for a given strategy
and the highest payoff possible with a given strategy for the other player. A final choice is
then determined by choosing the strategy where the maximum regret is as small as possible.
Evaluate the Prisoners’ Dilemma game with the minimax regret criterion. Does this criterion
change the solution?
13. Consider the following payoff matrix.
Firm 2
Share the Market
(50, 50)
(75, 25)
Cheat
(25, 75)
(35, 35)
Share the Market
Cheat
a. Determine the Nash equilibrium.
b. Explain how a policy of meeting a competitor’s price changes the equilibrium outcome.
Firm 1
14. Two tigers are poised to solely claim a territory. Each tiger can choose to either fight or
retreat, and a tiger’s ability to fight is either strong or weak with equal probability. Each tiger
knows his own ability but not the ability of the other tiger. The territory is worth U if solely
claimed. A tiger can claim the territory by either seizing the territory when its rival does not
or fighting when he is strong but his rival is weak. If the tigers are of equal strength and
choose to fight, neither gets the territory. A tiger has a cost of TCs for fighting if he is strong
and TCw if he is weak with TCs < TCw. There is no cost of attacking if his rival retreats.
Identify all pure-strategy Bayesian Nash equilibria for this game.
15. Two couples agree to meet for dinner and, prior to ordering, each couple agrees to pay the
average of the total bill. After the couples return home, they complain about how much
dinner cost and how much they overate. What is the cause for this result? How is this related
to Prisoners’ Dilemma?
16. Determine all the Nash equilibria in the following game of matching pennies.
Mark Twain
Heads
Tails
Huckleberry Finn
Heads
(1, –1)
(–1, 1)
Tails
(–1, 1)
(1, –1)
17. Construct a numerical example of a Prisoners’ Dilemma game where retaliation for breaking
an agreement is possible. Does this result in a Nash equilibrium that is Pareto efficient?
18. There are three possible outcomes in a zero-sum game (if one player gains, the other player
must lose) where each player has but two strategies: both players have a dominating strategy,
only one player has a dominating strategy, or neither player has a dominating strategy.
Provide an example for each of these three outcomes.
19. (Class game.) Players (students) choose a number between 0 and 100 with the objective of
guessing the highest integer that is no higher than two-thirds of the average of all the guesses.
Chapter 15 Questions
11. Would a perfectly competitive firm engage in advertising? Explain
12. In the early 1980s Nissan Motor’s promotion for one of its automobiles was, “You need
this car!” What was this type of advertising designed to do?
13. Monopolistic competition is a monopoly up to the point where households become
willing to buy close substitutes and competitive beyond this point. True or false? Explain.
14. In the past, some industry watchers predicted that the big national beer companies would
increase their market share and the smaller regional companies would disappear.
However, there are still a large (and possibly growing number) of small beer companies.
Why?
15. What stops a firm with monopoly power from offering an infinite number of product
varieties? Under what circumstances will only a single variety be offered?
16. Suppose all the firms in a monopolistically competitive industry were merged into one
large firm. Would this new firm produce as many different brands? Would it produce
only a single brand? Explain.
17. How do the characteristics of monopolistic competition lead to the existence of idle
capacity.
18. Compare monopolistic competition with perfect competition in terms of economic
efficiency.
19. Do oligopolies produce an efficient level of output? Explain.
20. Why should firms in monopolistic competition allocate resources toward advertising if a
large portion of advertising has canceling effects?
21. A competitive industry is in long-run equilibrium, where all firms are earning zero pure
profits. All firms in this industry and potential entrants have identical average cost
curves. A large increase in demand is forecasted for this industry. The industry
association, concerned that this increase in demand could worsen pollution emissions by
the industry, lobbies government legislators to adopt new environmental regulations for
this industry. The association lobbies that any new plant in the industry should be
equipped with emission controls involving a completely different plant design than is
currently used in existing plants. Also the association suggests existing plants should be
exempted from this regulation because it is not technologically feasible to retrofit. Why
would an industry association suggest that their own industry be subjected to such
environmental regulation?
22. Consider a cartel where each firm has identical and constant marginal costs. If the cartel
maximizes total industry profits, how will it divide output among the firms? Explain.
23. Suppose U.S. wheat producers decide to form a cartel and restrict their output. Will their
cartel result in an increase in total revenue and profits for its members? Explain.
24. During Prohibition in the 1920s, various gangs in Chicago fought for control of
distributing illegal alcohol. At times the gangs would meet to settle their disputes and
determine who would control which parts of the city. Why did these settlements generally
not last long?
25. Some economists say that cartels combine the worst social results of monopoly power
with none of the advantages. Do you agree or disagree? Explain.
Chapter 15 Exercises
11. Assume there are three identical firms in the industry. The market demand is p = 1 – Q,
where Q = q1 + q2 + q3 and firms’ marginal costs are zero.
a. Compute the Cournot equilibrium.
b. Show that if two of the three firms merge, transforming the industry into a duopoly,
the profit of these firms decreases. Explain.
c. What happens if all three firms merge?
12. The inverse demand function for a product is p = 100 – Q with four identical Cournot
firms supplying the market. Their individual marginal cost is constant at 5, and half of the
firms are foreign firms supplying in this domestic market. The government has imposed
an import quota on foreign suppliers equal to their current imports.
a. What are the profit-maximizing output and price for each Cournot competitor?
b. Will imposing an import quota on the foreign firms affect the domestic firms’ output
decisions? Explain.
13. A monopoly can produce at a constant average and marginal cost of SAVC = SMC = 5
with a fixed cost of 100. The firm faces the market demand curve Q = 35 – p.
a. Calculate the monopoly’s profit-maximizing price and quantity and the resulting
profit.
b. Assume a second firm enters the market. Let q1 be the output of firm 1 and q2 the
output of firm 2. Market demand is now (q1 + q2) = 35 – p. Assuming firm 2 has the
same costs as firm 1 and both firms behave as Cournot firms, calculate the profitmaximizing quantities and price along with the resulting profit.
14. Suppose each duopolist expects its rival to match any change in its output. Given p = a –
bQ, and MC1 = MC2 = c, where Q = q1 + q2, show how this will result in the monopoly
output.
15. Let the inverse market demand for wood, produced at zero cost, be p = 60 – (q1 + q2),
where q1 and q2 represent outputs for two firms.
a. Determine the F.O.C.s for profit maximization.
b. Solve for the Cournot equilibrium.
c. State the Stackelberg conjectural variations.
16. Suppose you are a duopolist producer of a homogeneous commodity, and both you and
your competitor have zero marginal costs. The market demand curve is p = 15 – Q, where
Q = q1 + q2 with q1 as your output and q2 as your competitor’s output.
a. You and your competitor must announce your outputs at the same time. Once
announced, you cannot make changes. What will be your level of output and your
expected profit?
b. Suppose you are told you must announce your output before your competitor does.
What output level will you set, how much do you expect your competitor to produce,
and what do you expect your profit to be? Is announcing first an advantage or
disadvantage? Explain.
17. Consider an industry with an incumbent monopoly and a potential entrant. There are two
possible production technologies for producing the commodity. Technology I has a
marginal cost of 1 with an associated fixed cost of 11, and technology II has a marginal
cost of 3 and fixed cost of 3. Once a technology is selected, it cannot be changed. This
technology choice is known to all firms. There are two production periods, with demand
in each period represented as Q = 9 – p. In the first period, the incumbent firm is a
monopoly. The monopoly begins this period by selecting its technology and then
producing. In the second period, the entrant decides whether to enter or not. If it does
enter, it selects its technology, and then the two firms compete as Cournot firms. If it
does not enter, then the incumbent maintains its monopoly. For simplicity, assume a zero
discount rate.
a. Assuming no threat of entry, what technology would the monopoly select?
b. If the monopoly selects the technology in part (a), will the entrant enter? If so, with
which technology?
c. Is there a technology the incumbent could pick in the first period that would block the
entry of the entrant?
d. Given the threat of entry, what is the optimal course of action for the monopoly?
Chapter 16 Questions
11. A competitive firm signs a 10-year lease on a building. The landlord requires annual rent
increases based on the rate of inflation of 3% per year. How will the rent increase affect
the firm’s prices for its products?
12. Retailers in upscale shopping malls often use their high rents as justification for their high
prices. Is this a correct statement of the relationship between rent and product prices?
Explain.
13. Why does rock star Madonna earn more than a firefighter?
14. Provide two examples of inputs receiving economic rent, where one receives a large
economic rent and the other small. What is the relationship between economic rent and
barriers to entry?
15. Marginal productivity does not determine wages, it only determines how many workers
will be employed at a given wage. Thus, marginal productivity analysis is a theory of
demand for labor, not a theory of distribution. What does determine wages? Does
marginal productivity affect such determinants? Explain
16. Is the value of the marginal product equal to the input price a firm’s input demand curve?
Explain.
17. Employers pay unskilled workers low wages and pay no more than necessary. This
indicates that low pay has nothing to do with low productivity. True or false? Explain.
18. The supply of labor in a perfectly competitive market is reduced. What are the effects on
the wage rate, the quantity of labor employed, and output market price and quantity?
Explain
19. If the marginal revenue product of 1 kilowatt-hour of electric power is $0.10 and the cost
of producing this kilowatt-hour is $0.15, what should the firm do? Explain.
20. Babe Ruth was probably the greatest baseball player of all time. However, after adjusting
for inflation even below-average ball players today earn more in real terms than the Babe
ever did. Why?
21. How does perfect competition cause individuals to receive income proportional to their
effort?
22. University professors are highly educated, but their salaries are low relative to this
education level. Is this an example where economic theory does not apply? Explain.
23. Explain why women might tend to have fewer children as their wage rates increase.
24. What does the demand for labor have in common with the demand for a product?
25. If a firm hires an unemployed worker, is the opportunity cost of the worker’s productivity
zero? Explain.
26. Why is a firm’s labor demand curve more inelastic when the firm has monopoly power in
the output market than when the firm is producing competitively?
27. Consider a profit-maximizing firm producing a commodity sold in a competitive market.
When the price of the output increases, the firm hires additional skilled workers but fewer
unskilled workers. If the unskilled workers unionize and succeed in getting their wage
increased, what will happen to the firm’s demand for unskilled workers? What will
happen to its supply of output?
Chapter 16 Exercises (none)
Chapter 17 Questions
11. Agricultural scientists in California have developed a variety of tomatoes that can be
picked by a machine. Who benefits and who is harmed from this research? Explain.
12. Can a demand curve for an input be derived if the employer of the input is a monopsony?
Why or why not?
13. Under what conditions will the wage rate be equal to the marginal input cost? When will
it be less than its marginal input cost?
14. When is a factor exploited? What is monopoly exploitation and what is monopsony
exploitation?
15. Firms with monopoly power in their output market pay a wage rate less than workers’
VMP and perfectly competitive firms in their output market pay a wage equal to workers’
VMP, so workers in the same labor market will receive a lower wage from the former and
a higher wage from the latter. True or false? Explain.
16. Do labor unions reduce wages and income of some workers? Explain.
17. At times union officials have asked their members to take a cut in wages or benefits.
Why?
18. The Clayton Act states, “The labor of a human being is not a commodity or article of
commerce.” As a result, workers are allowed to organize into unions and jointly seek
higher wages. Should such union organization be exempted from the antitrust laws?
Explain.
19. A legislature concerned with the nonunionized workers’ welfare decides to pass a law
requiring all workers to be unionized. What will happen to the wage rates of formerly
nonunionized workers and those workers who were originally unionized? What
assumptions can be drawn about a union’s behavior?
20. Why is it easy to become a member of some unions and very difficult to become a
member of others?
21. What are some of the economic effects of featherbedding?
22. Under what conditions would you expect the imposition of a minimum wage to have no
effect on wages or on the number of workers employed. Increase wages and leave the
number of workers unchanged? Increase wages and decrease the number of workers?
Increase in both wages and the number of workers?
Chapter 17 Exercises
11. Suppose a firm is a monopoly in the supply of some output. Using labor, L, the firm can
produce an output with the technology Q = 2L. The inverse demand for the monopoly’s
output is p = 100 – Q, and the monopoly is facing the inverse supply curve for labor w =
80 + 2L.
a. What is the profit-maximizing level of output, number of workers hired, output price,
and wage rate?
b. If the firm behaved competitively in both the output and labor markets, how would
the solution from part (a) compare?
12. A university in a small college town has the inverse supply, LS, function for secretaries w
= 5000 + 50LS, and is facing the inverse demand, LD, function w = 20,000 – 50LD.
a. What wage will it pay and what is the elasticity of supply at this equilibrium?
b. Could any supply curve exist where the equilibrium occurs at an elasticity of supply
less than unity?
13. Suppose a monopoly has the marginal revenue and marginal cost functions MR = 200 –
4Q and MC = Q, respectively.
a. Determine the equilibrium price and output for the monopoly.
b. What would be the monopsony price and output?
14. A certain monopsony only employs labor, L, to produce output, q, which is then sold in a
competitive market at p = 5. Let the monopsony’s production and labor supply functions
be q = 120L – L2 and w = 5L.
a. Determine at what values of L, q, and w the monopsony’s profit is maximized.
Calculate the monopsony’s surplus and labor’s economic rent.
b. Determine the values of L, q, and w if labor organized with the objective of
maximizing economic rent. Calculate the monopsony’s surplus and economic rent for
this case.
c. Determine the perfectly competitive solution and calculate the rents (monopsony’s
surplus and labor’s economic rent).
15. Given that q(X) = 5X – (1/2)X2, MC(X) = 2 + X, and the output price, p, for q is 2,
compare price and output decisions along with any difference in consumer surplus and
economic rent of a revenue-maximizing supplier of X facing a monopsony.
Chapter 18 Questions (none)
Chapter 18 Exercises
11. Forecasters predict there is a 50% probability the upcoming growing season will be a
drought. Given this forecast, let a farmer’s expected utility function be
U(IR, ID) = 0.5lnIR + 0.5lnID,
where IR and ID represent her income in the states of normal rainfall and drought
conditions. Assume the farmer has the choice between two crops with the payoffs
(incomes)
Crop
IR
ID
Watermelon $50,000
$10,000
Tomatoes
$30,000
$18,000
a. If she can only plant one crop, which crop should she plant?
b. Assume the farmer can instead plant half her land with each crop. Should she do so?
Explain.
c. What mix of crops would maximize her expected utility?
d. Would watermelon insurance, which costs $20,000 and pays off $40,000 in a drought
cause her to change her choices in parts (a) through (c)?
12. Assume a household with a swimming pool has an initial wealth of $1 million with a
1/1000 probability of incurring a half-million-dollar loss from an accidental drowning.
The cost of insuring against this loss is 1/750 per dollar of insurance. Determine the
optimal level of insurance if the household has a logarithmic utility function.
13. Graph a utility function that exhibits risk-seeking preferences for small gambles but riskaverse preferences for large gambles. Is such a set of preferences possible?
14. Bernice has a level of utility Uo from driving and not getting a ticket and U' when
obtaining a ticket, so Uo > U'. The probability of receiving a ticket, based on Bernice’s
speed, s, is
 = 3.14 – 0.11s + 0.001s2, 25 < s < 90.
If her speed is too slow or too fast, she will receive a ticket.
a. Show, in this case, maximizing expected utility is the same as minimizing the risk of
receiving a ticket.
b. Determine the speed which will minimize the risk of getting a ticket.
15. Radar detection devises vary in their ability to detect radar used for highway speed
enforcement. As the quality of the detector increases, the probability of getting a
speeding ticket decreases. Let this relationship be represented by  = 1/Q, where Q is the
level of radar quality. Assuming a teenager (Erica) is risk neutral, if the per-unit price of
detector quality is p = 50 and damage from speeding tickets is 250, what level of quality
detection will she purchase? What is the probability of her getting speeding tickets?
Chapter 19 Questions
11. What are the problems in defining capital as a resource and what do different types of
capital have in common? What does the price of capital pay for?
12. What distinguishes an impatient consumer from a patient consumer?
13. If, as in many developing countries, lending and borrowing are not possible, what would
happen to current and future consumption for a borrower and his level of utility? How
about for a lender?
14. Income taxes are said to be biased against labor income by failing to allow any
deductions for depreciation of a worker’s productivity over time. What would be the
result of allowing such deductions?
15. How can promotional expenditures be regarded as an investment? How does this relate to
the concept of such expenditures operating to maintain barriers to entry?
16. Do economists view the total return on capital investment as profit? Explain.
17. Money itself is not a resource and is thus unproductive. Why should agents be willing to
pay a price (interest rate) for acquiring it?
18. Are output and profit measured as a flow or a stock?
Chapter 19 Exercises
11. Assume U(x1, x2) = x1 x2. Maximize this utility function subject to the wealth constraint
W = x1 + x2(1+ i)–1, where W = 10 and i = 10%.
12. Net benefits, at the end of each year, from a project lasting three years are $10,000,
$3000, and $7000 in years 1, 2, and 3, respectively. Given a 10% discount rate, what is
the present value of net benefits?
Chapter 20 Questions
11. Consider a rent-subsidy program that varies the rent of an apartment for households
based on income. Such a program results in inefficiency, with the economy operating
somewhere inside the production possibility frontier. Can such a program be justified on
the basis of Pareto efficiency? Can it be justified on the basis of a social-welfare
function? Is there any program that cannot be justified on the basis of some socialwelfare function?
12. Agricultural scientists at the University of California, Davis have developed a tomato
variety that can be picked mechanically. How is this an improvement in production
efficiency? Is this also an improvement in social welfare?
13. If people were reasonable, strikes and wars would not occur. Do you agree or disagree
with this statement? Explain.
14. Is maximizing profit an evil or beneficial behavior in a free-market system? Explain.
15. Under what circumstances might government subsidies or taxes result in an increase in
social welfare?
16. “An economist can identify inefficiency and provide options for correcting the
inefficiency. However, beyond this her professional expertise is exhausted.” Evaluate this
statement critically.
17. Determining a policy choice will always involve the adjudication of conflicting claims
among agents. True or false? Explain.
18. Explain why each of the following statements is either true or false.
a. Perfect competition results in maximum social welfare.
b. The invisible hand always results in Pareto optimality.
c. The economy can be at a Pareto-optimal point when households are free to undertake
all the exchanges they wish.
d. Society can move from one point on a production possibilities frontier to another by
redistributing wealth using an inheritance tax.
19. Arrow’s Impossibility Theorem states that a social-welfare function must be either
democratic or consistent, but it cannot be both. True or false? Explain.
20. Capitalism and democracy are very complementary in the sense that they together put
some rationality into equality and some humanity into efficiency. Analyze this statement.
21. Some critics that argue modern government has become Robin Hood, taking from the
rich and giving to the poor. Should governments play Robin Hood? Explain.
22. Why should a government policymaker not ignore economic theory? Explain.
23. Is a normative argument required to state that perfect competition will generate a Paretoefficient allocation? Does it require a normative argument to state that perfect
competition is the best for society? Explain each answer.
24. With so many famine-stricken people in the world it may be ethically wrong for us not to
produce all the food we can. Should U.S. farmers produce all the food they can? Explain.
25. What is market failure and what causes it to occur? Given market failure, should the free
market be replaced with government control over prices and output?
26. What is undesirable about voting that cycles?
27. Some advocates of free markets and a minimal role for government in an economy state
that perfect competition is an ideal system because it yields the condition of the greatest
good for the greatest number of people. Is this condition an efficiency or equity criterion
for economic welfare? Will perfect competition generate this condition? Explain.
28. Why is economic efficiency a necessary condition for maximizing social welfare? Is it
the only necessary condition?
29. Market socialists state that an economic planning agency could simulate competitivemarket forces with equations and solve the equations to arrive at equilibrium prices and
outputs. This would be more efficient than the tâtonnement of free markets. True or
false? Explain.
30. Ronald Reagan stated “The taxing power of the government must be used to provide
revenues for legitimate government purposes. It must not be used to regulate the
economy or bring about social change.” Comment on this statement.
Chapter 20 Exercises (none)
Chapter 21 Questions
11. If an economy is an organizational system for coordinating production, consumption and
distribution of commodities, what role is played by property rights? Explain.
12. How do class-action lawsuits contribute to the improvement of social welfare?
13. In some past societies, entitlements for using land could not be transferred to anyone else. A
farmer could acquire a new plot of land by clearing it and leave his old plot available for
some other individual. How would this type of entitlement affect land conservation compared
with land-ownership entitlements?
14. Are absentee landlords a potential source of soil-erosion problems? Explain.
15. Given a positive externality, the marginal cost function of firm A shifts downward when the
output of firm B increases. What is the appropriate per-unit subsidy to offer firm B?
16. Monopolies result in inefficient allocations and thus can negatively impact social welfare.
What are some of the market and social-welfare benefits of a monopoly in an industry where
production is associated with a negative externality?
17. Critics contend that the expansion of MARTA, the mass-transit system in Atlanta, will not
generate sufficient revenue to cover costs. Thus, expansion is not feasible. Is this argument
valid or invalid if the external effects generated by the transit system are considered?
Explain.
18. An externality exists when, as a result of generating air pollution, a firm increases the cost of
another firm. In contrast, it does not exist if the firm increases the cost of another firm by
bidding up the price of inputs. Explain the difference.
19. One particular type of externality is where there is only one seat left, say, on an airplane or
for a particular college course. The agents who are left out are directly affected by the actions
of the agent who gets the last seat. Determine a mechanism design that will result in a Paretoefficient outcome.
20. A farmer applying pesticides within a certain radius of an endangered species will disrupt the
species’ habitat. Apply the Coase Theorem to this situation. Does it make any difference in
the outcome whether the endangered species or the farmer has the property right?
21. Why are there oyster farms but no salmon farms? Explain.
22. Air-pollution problems could be resolved by specifying exclusive rights to air. Evaluate this
statement.
23. Steven Kelman in What Price Incentives? Economists and the Environment (Auburn House
Publishing Company, 1981) suggests that from an ethical point of view, the use of economic
incentives—including emissions charges or emissions permits—in environmental policy is
undesirable. He argues that transforming our mental image of the environment from a
sanctified preserve to a marketable commodity has detrimental effects not only on our use of
the environment but also on our attitude toward it. He points out that applying economic
incentives to environmental policy weakens and cheapens our traditional values with regard
to the environment. Comment on Kelman’s viewpoint.
24. Why do many firms have an incentive to lobby for pollution standards as opposed to taxes?
Chapter 21 Exercises
11. A coal-fired power plant is generating 6 tons of air pollution per week. The following table
lists the total benefits and costs to society of reducing this pollution to lower levels.
Pollution
Pollution (tons)
Total Benefit
Total Cost
5
$30
$5
4
50
9
3
64
23
2
74
42
1
80
72
0
84
116
a. What is the marginal cost of reducing pollution from 5 to 4 tons? What is the marginal
benefit?
b. From society’s perspective, what is the optimal level of pollution? Explain.
c. Why is zero not the optimal level of pollution?
12. A chemical plant on a lake produces 50 units of output per day. Its output is sold in a
perfectly-competitive market at $1 per unit and the plant has STC of $0.50 per unit. Plants on
this lake require clean water and any new plant will increase the pollution level, so all firms
will incur an additional cost to clean the water. This externality is $0.10 per unit of output for
each new plant.
a. Letting n equal the number of plants, determine how many new plants will be built.
b. What number of plants will maximize total profits for all producers?
13. Your neighbor has aversive barking dogs. You are able to mitigate the noise from these dogs
by shutting your windows. Your neighbor’s utility function is U1 = 6z – z2, where z measures
the dogs’ noise level. Your utility function is U2 = –(x + 3z/x), where x is the number of shut
windows.
a. Determine the independent decision-making choices for you and your neighbor.
b. What are the dependent decision levels of barking dogs and shut windows?
c. If you have the property rights to the level of noise, what fee would you charge your
neighbor? Determine the satisfaction levels for you and your neighbor.
d. If your neighbor has the property rights, how much would you pay to have your neighbor
hush the dogs? Again, determine the satisfaction levels for you and your neighbor.
e. What would be the optimal level of a tax on barking dogs and how is it related to your
shutting windows? What are the utility levels for you and your neighbor associated with
this tax?
Chapter 22 Questions
11. In many cases, lesser-developed countries reap the benefits of technological advances from
more-developed countries. Is this an example of the free-rider problem?
12. Consider the following solution to the allocation between two agents of a discrete public
good with cost TC. Each agent states a bid, bj, j = 1, 2. If b1 + b2 > TC, the good is provided
and each agent pays their bid amount; otherwise, the good is not provided and neither agent
pays anything. Will this mechanism yield an efficient allocation? Explain.
Chapter 22 Exercises
11. There are three households in Fundale. Each household has a utility function for the amount
consumed of the private good xj and a public recreational area R given by
Uj = xj – 4/R, j = 1, 2, 3,
where R is the number of acres of the recreational area and xj = Q. The cost of each
additional unit of R in terms of the amount of the private good given up is 1/12. Each
household is endowed with 5 units of the private good and 0 units of public recreation.
a. What is the MRS(xj for R) for each household and what is the MRPT(Q for R)?
b. What is the optimal level of R?
c. Assume every household pays an equal share of the recreational cost. If the size is R
acres, its total cost is R/12 and its cost per household will then be 1/3(R/12) = R/36.
Determine the individual’s budget constraint.
d. What value of R would each household vote for?
e. Is there an under- or oversupply of the recreational good relative to the efficient
allocation in part (b)? Explain.
12. Consider the utility functions for three consumers U1 = 2M1/2 + x1, U2 = M1/2 + x2, and U3 =
3M1/2 + x3, where M represents miles of a scenic river to be preserved and the price is 1 for
each good. Determine the equilibrium miles of scenic river and the price each consumer
pays.
13. Consider the inverse demand functions p1 = 20 – Q, p2 = 30 – Q, and p3 = 40 – Q for a public
good Q by three consumers
a. With MC = 78 for this public good, determine the Pareto-efficient level of Q and
associated Lindahl prices.
b. If each consumer pays one-third of the marginal cost for Q, what would be the amount of
the Clarke tax and who will pay it?
Chapter 23 Questions
11. Comment on the following statement: In a pooling equilibrium, only consumers who
unfortunately purchase a lemon are harmed.
12. How does the incidence of AIDS affect adverse selection?
13. Given asymmetric information in baseball, would you expect the salary offered to a free
agent to be lower than that paid to a similar player who remained with a team?
14. Is the number of commodities produced by a firm a signal as to the quality of the
commodities?
15. Why is some degree of ignorance optimal?
16. The expression “you get what you pay for” suggests using price as a screening device. The
higher the price, the better the quality. Under what conditions is this a strong screening
device? A weak screening device?
17. Relate the following law to adverse selection:
Gresham’s Law: Bad money drives out good.
Note: This law was derived from money in the form of gold coins, where bad coins resulted
from individuals removing some of the gold from a coin.
18. Do brand names reduce asymmetric information by providing a signal of quality to
consumers? Explain.
19. How does the Federal Trade Commission’s enforcement of truth in advertising affect firms’
signaling and Pareto efficiency?
20. Given the inefficiency associated with asymmetric information, should the government
subsidize the U.S. Postal Service instead of requiring it to be nonprofit? How about
subsidizing the Internet?
21. Comment on the following statement: Warranties can mitigate adverse selection but cause
moral hazard.
22. Determine which of the following conditions will result in adverse selection, moral hazard,
or both.
a. An AIDS victim purchases life insurance on the Internet.
b. A hobo locates in a city with an outstanding welfare system.
c. A wreck-less driver drives a fully insured truck.
d. A university is willing to accept any student with a high school degree.
e. An airline traveler plans to blow up the plane after taking out a flight insurance policy.
f. A novelist procrastinates after receiving an advance on a novel.
23. Cotton States Insurance Company provides a $150 discount to any policyholder who has a
security system that notifies the police in the case of an emergency or the fire department in
the event of a fire. Assuming an actuarially fair insurance policy, what is the expected
reduction in loss associated with such a system?
24. An alternative to a residual-claimant contract is a relative-performance contract where a
manager’s salary is tied to the performance of similar firms within an industry. In general,
when profits for an industry are down the manager is not penalized, but she is penalized
when her firm does poorly relative to the industry as a whole. What are the advantages of
relative performance versus residual claimant in terms of shirking?
25. A firm pays a low wage rate, but gives employees a large bonus at the end of the year. Why
would a firm adopt this policy?
Chapter 23 Exercises
11. Suppose there are two types of undergraduate college degrees, Ivy League degrees and all
others. One employer who pays $60,000 per year uses an Ivy League degree as a signal for
determining employees’ abilities and will only hire from Ivy League schools. Other
employers will hire from any college, but only pay $40,000 per year.
a. If the cost of obtaining an Ivy League degree is equivalent for all potential employees, is
there a separating equilibrium?
b. What is the maximum amount a high-ability worker would pay to attend an Ivy League
school?
c. Under what conditions will this signal by degree provide a separating equilibrium?
12. Reliable Used Cars and Affordable Used Cars are two automobile dealers located across the
street from one another. Reliable sells reliable used cars that, after any repairs and servicing,
cost Reliable on average $10,000. Affordable sells lemons after only minimal cosmetic
repair, so its cost is only $9000. Consumers are willing to pay $12,000 for a reliable
automobile and $10,000 for a lemon, and without any prior information on the two
dealerships are willing to pay on average $11,000 for an automobile. Assuming a 90-day
warranty will cost Reliable on average $100 and Affordable $2500, will the warranty result
in a separating equilibrium?
13. Five firms bidding on the same painting job offer the following bids.
Firm
Bids
1
$470
2
480
3
500
4
530
5
570
a. Determine the expected lowest bid for painting if a household received 1, 2, 3, 4, or 5
bids.
b. What is the marginal benefit of receiving each additional bid?
c. If a household’s marginal opportunity cost for obtaining an additional bid is $10.00, how
many bids will it request?
d. Why is it generally a good practice to obtain at least two bids?
14. The following table lists the three effort levels for a manager of a fast-food outlet along with
the firm’s profits and the manager’s total cost of effort.
Manager’s Effort
Firm’s Profit
Total Cost of Effort
E1
76
16
E2
146
64
E3
175
100
a. What is the firm’s profit-maximizing level when effort is observable?
b. If effort is unobservable and the firm does not consider an incentive-compatibility
constraint, what is the firm’s profit?
c. If the manager becomes the residual claimant on profits, what are the manager’s profit
and the fee he pays the firm?