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Mankiw-PrinciplesofMicroeconomics:Questions&Answers
Principles of microeconomics – a policy perspective (Copenhagen Business School)
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Microeconomics- Principles and Applications
Chapter 4 – The Market Forces of Supply and Demand
Q1. Explain each of the following statements using supply-and-demand diagrams.
a. “When a cold snap hits Florida, the price of orange juice rises in supermarkets
throughout the country.”
- See Figure A
- When a cold snap hits Florida, it will damage the orange crop, leading to a decline in
the supply of oranges, shown by a shift to the left of the supply curve of orange juice.
This will result in a higher equilibrium price, and a lower equilibrium quantity.
b. “When the weather turns warm in New England every summer, the price of hotel
rooms in Caribbean resorts plummets.”
- See Figure A
- When the weather is warm in New England every summer, the demand for hotel
rooms in the Caribbean will decline as fewer people want to escape New England for
good weather. This fall in demand is shown by a shift to the left of the demand curve
for hotel rooms, and results in a lower equilibrium price, and a lower equilibrium
quantity.
c. “When a war breaks out in the Middle East, the price of gasoline rises, and the price
of a used Cadillac falls.”
- See Figure A
- When a war breaks out in the Middle East, several markets are affects. As a large
proportion of oil production takes place there, the supply of gasoline falls, shown by a
shift to the left of the supply curve. This leads to an increase in equilibrium price and
decline of equilibrium quantity of gasoline.
- As a result of a higher price for gasoline, the cost of running a used Cadillac will
increase. This will lead to a decline in the demand for used Cadillacs as they will be
less attractive, and more people will try to sell them. This will lead to a shift to the left
of the demand curve and a shift to the right of the supply curve, and will result in a
lower equilibrium price.
Q2. “An increase in the demand for notebooks raises the quantity of notebooks
demanded but not the quantity supplied.” Is this statement true or false? Explain.
- See Figure A
- This statement is in general false. As shown in Figure A, due to an increase in the
demand for notebooks, the supplier will also raise the quantity of notebooks supplied.
The could only be true if the supply curve was a vertical line, with a constant supply.
Q4. Consider the markets for DVDs, TV screens, and tickets at movie theaters.
a. For each pair, identify whether they are complements or substitutes:
- DVDs and TV screens - Complements
- DVDs and movie tickets - Substitutes
- TV screens and movie tickets – Substitutes
b. Suppose a technological advance reduces the cost of manufacturing TV screens. Draw
a diagram to show what happens in the market for TV screens.
- See Figure A
- Due to technological developments, the cost of manufacturing TV screens falls. This
leads to an increase in the supply of TV screens, shown by a shift to the right in the
supply curve. This then leads to a decline in equilibrium price, and an increase in
equilibrium quantity of TV screens.
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Microeconomics- Principles and Applications
c. Draw two more diagrams to show how the change in the market for TV screens
affects the markets for DVDs and movie tickets.
- See Figure A
- As TV screens and movie tickets are substitutes, a decline in the price of TV screens
leads to a fall in the demand for movie tickets, shown by a shift to the left of the
demand curve. This leads to a decline in equilibrium price and equilibrium quantity of
movie tickets.
Q5. Over the past 30 years, technological advances have reduced the cost of computer
chips. How do you think this has affected the market for computers? For computer
software? For typewriters?
- See Figure B
- As computer chips have reduced in price, the input costs to produce computers will
fall. This will lead computers to fall in price, and an increased demand for computers,
shown by a shift to the right of the demand curve. This increased demand will lead to
an increase in equilibrium price and equilibrium quantity of computers.
- As computer software and computers are complementary goods, a decline in price of
computers will lead to an increased demand for computer software, shown by a shift
to the right of the demand curve. This increased demand will lead to an increase in
equilibrium price and equilibrium quantity of computer software.
- As computers and typewriters are substitute goods, a decline in price of computers
will lead to a decrease in demand for computers, shown by a shift to the left of the
demand curve. This decreased demand will lead to a decline in equilibrium price and
equilibrium quantity of typewriters.
Q6. Using supply-and-demand diagrams, show the effect of the following events on the
market for sweatshirts.
a. A hurricane in South Carolina damages the cotton crop.
- See Figure B
- When a hurricane in South Carolina damages the cotton crop, it will raise the input
prices for making sweatshirts. Therefore, the supply of sweatshirts shifts to the left.
The new equilibrium price is higher, and the new equilibrium quantity is lower.
b. The price of leather jackets falls.
- See Figure B
- As leather jackets and sweatshirts can be substitute goods, when the price of leather
jackets fall it leads more people to buy leather jackets. Therefore, fewer people will
buy sweatshirts, and there will be a fall in demand with the demand curve shifting to
the left. The new equilibrium price and equilibrium quantity will be lower.
c. All colleges require morning exercise in appropriate attire.
- See Figure B
- Colleges requiring morning exercise in appropriate attire will increase the demand for
sweatshirts, shifting it to the right. The new equilibrium price and equilibrium
quantity will be higher.
d. New knitting machines are invented.
- See Figure B
- The invention of new knitting machines will increase the supply of sweatshirts due to
the technological development. This will lead to a decrease in the new equilibrium
price and an increase in the equilibrium quantity.
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Q13. Suppose that the price of basketball tickets at your college is determined by
market forces. Currently, the demand and supply schedules are as follows:
Price
Quantity Demanded
Quantity Supplied
$4
10,000 tickets
8,000 tickets
8
8,000
8,000
12
6,000
8,000
16
4,000
8,000
20
2,000
8,000
a. Draw the demand and supply curves. What is unusual about this supply curve? Why
might this be true?
- See Figure B
- The supply curve is unusual because it is vertical and it doesn’t increase with
increased demand. The constant supply supplied does make sense, because in the
basketball arena there will be a fixed number of seats.
b. What are the equilibrium price and quantity of tickets?
- The equilibrium price is $8. The equilibrium quantity is 8,000.
c. Your college plans to increase total enrollment next year by 5,000 students. The
additional students will have the following demand schedule:
Quantity Demanded
Price
$4
4,000 tickets
8
3,000
12
2,000
16
1,000
20
0
Now add the old demand schedule and the demand schedule for the new students to
calculate the new demand schedule for the entire college. What will be the new
equilibrium price and quantity?
- See Figure B
- The new equilibrium price is $12. The new equilibrium quantity is 8,000.
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Microeconomics- Principles and Applications
Chapter 5 – Elasticity
Q1. For each of the following pairs of goods, which good would you expect to have more
elastic demand and why?
a. required textbooks or mystery novels
- Mystery novels.
- I would expect mystery novels to have a more elastic demand than required textbooks
because mystery novels would generally be perceived as luxuries, whereas required
textbooks would be perceived as necessities as therefore more inelastic. Whether the
good is a necessity or luxury depends on the preferences of the buyer.
b. Beethoven recordings or classical music recordings in general
- Beethoven recordings.
- I would expect Beethoven recordings to have a more elastic demand than classical
music recordings in general because Beethoven recordings is a more narrowly defined
market than classical music recordings. It is easier to find close substitutes for
narrowly defined categories such as Beethoven recordings, whereas it’s less easy to
find a substitute for classical music recordings in general.
c. Subway rides during the next six months or subway rides during the next five years
- Subway rides during the next five years.
- I would expect subway rides during the next five years to be more elastic because
goods tend to have more elastic demand over longer time horizons.
d. Root beer or water
- Root beer.
- I would expect root beer to be more elastic than water because goods with a close
substitute such as root beer tend to have more elastic demand because it is easier for
consumers to switch from that good to others. This however is not the case with
water. In addition, water is a necessity, whereas root beer is more of a luxury, which
again has more elastic demand.
Q5. The equilibrium price of coffee mugs rose sharply last month, but the equilibrium
quantity was the same as ever. Three people tried to explain the situation. Which
explanations could be right? Explain your logic.
Billy: Demand increased, but supply was totally inelastic.
Marian: Supply increased, but so did demand.
Valerie: Supply decreased, but demand was totally inelastic.
- Billy: Demand increased, but supply was totally inelastic.
- This explanation could be right because when the supply is perfectly inelastic, an
increase in demand will increase the price keeping the quantity constant. The
equilibrium point will then shift up. This leads to an increased price.
Q7. You have the following information about good X and good Y:
 Income elasticity of demand for good X: –3
 Cross-price elasticity of demand for good X with respect to the price of good Y: 2
Would an increase in income and a decrease in the price of good Y unambiguously
decrease the demand for good X? Why or why not?
- Yes, an increase in income and a decrease in the price of good Y will decrease the
demand for good X.
- This is because a decrease in the price of good Y will lead to a decrease in the
quantity demanded of good X. This is due to the cross-price elasticity of demand
being positive meaning that the goods are substitutes, and typically used in place of
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Microeconomics- Principles and Applications
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one another. As the price of one good decreases, the quantity demanded of the other
good also decreases.
Also as there is an increase in income, and the income elasticity of demand for good
X is negative. This means that an increase in income leads to a lower quantity of good
X demanded.
Q13. Pharmaceutical drugs have an inelastic demand, and computers have an elastic
demand. Suppose that technological advance doubles the supply of both products (that
is, the quantity supplied at each price is twice what it was).
a. What happens to the equilibrium price and quantity in each market?
- See Figure C
- In both markets, the increase in supply of both products will reduce the equilibrium
price and increase the equilibrium quantity. The equilibrium price reduction will be
greater in the pharmaceutical drugs market (inelastic demand) and the equilibrium
quantity increase will be greater in the computers market (elastic demand).
b. Which product experiences a larger change in price?
- In the pharmaceutical drugs market with inelastic demand, the increase in supply of
products leads to a larger decline in equilibrium price, and a smaller increase in
equilibrium quantity.
c. Which product experiences a larger change in quantity?
- In the computers market with elastic demand, the increase in supply of products leads
to a larger increase in equilibrium quantity and a smaller decline in equilibrium price.
d. What happens to total consumer spending on each product?
- In the pharmaceutical drugs market, the demand is inelastic, therefore the percentage
increase in quantity will be lower than the percentage decrease in price; therefore,
total consumer spending will decline.
- In the computers market, the demand is elastic, therefore the percentage increase in
quantity will be greater than the percentage decrease in price; therefore, total
consumer spending will increase.
Q14. Several years ago, flooding along the Missouri and the Mississippi rivers
destroyed thousands of acres of wheat.
a. Farmers whose crops were destroyed by the floods were much worse off, but farmers
whose crops were not destroyed benefited from the floods. Why?
- See Figure C
- A decrease in the supply of wheat will lead to an increase in the equilibrium price.
Therefore, the farmers whose crops were not destroyed will benefit from a higher
equilibrium price of the good as a result of the decreased supply.
- In addition, wheat is a good that tends to have an inelastic demand. This is because it
is a necessity good, has a broadly defined market and there are few substitutes for it.
- As wheat has an inelastic demand, a decrease in supply will lead to a small decline in
the equilibrium quantity of the good demanded, but a large increase in the equilibrium
price. Please refer to Figure X.
b. What information would you need about the market for wheat to assess whether
farmers as a group were hurt or helped by the floods?
- You would need to know the size of the price elasticity of demand. Then you could
calculate whether the total revenue received by all the farmers as a group rose or
declined comparable to prior to the floods.
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Microeconomics- Principles and Applications
Chapter 7 – Consumers, Producers and the Efficiency of Markets
Q1. Melissa buys an iPod for $120 and gets consumer surplus of $80.
a. What is her willingness to pay?
- Her willingness to pay is $200.
- This is because the consumer surplus is the amount the buyer is willing to pay for a
good minus the amount the buyer actually pays for it.
o $80= (willing to pay) - $120
o Therefore, the amount Melissa is willing to pay is $200.
b. If she had bought the iPod on sale for $90, what would her consumer surplus have
been?
- Her consumer surplus would have been $110.
- Consumer surplus = $200 - $90
c. If the price of an iPod were $250, what would her consumer surplus have been?
- The consumer surplus is $0.
- As Melissa’s willingness to pay is only $200, she wouldn’t purchase the iPod at $250,
therefore there would be no consumer surplus as there is no transaction.
Q4. It is a hot day, and Bert is thirsty. Here is the value he places on a bottle of water:
- Value of first bottle
$7
- Value of second bottle
$5
- Value of third bottle
$3
- Value of fourth bottle
$1
a. From this information, derive Bert’s demand schedule. Graph his demand curve for
bottled water.
Bert’s demand schedule
Price
Quantity demanded
More than $7 0
$5-$7
1
$3-$5
2
$1-$3
3
$1or less
4
- See Figure D for a graph with the demand curve for bottled water.
b. If the price of a bottle of water is $4, how many bottles does Bert buy? How much
consumer surplus does Bert get from his purchases? Show Bert’s consumer surplus
in your graph.
- When the price of a bottle of water is $4, Bert buys 2 bottles.
- The consumer surplus from Bert’s purchases is $4. This is because for two bottles of
water, his willingness to pay is $7 and he pays $4, therefore the consumer surplus is
$3. Then for the third bottle of water his willingness to pay is $5 and he pays $4.
- When these are added together ($1+$3) the consumer surplus equals $4.
- The consumer surplus is displayed as area A on Figure D.
c. If the price falls to $2, how does quantity demanded change? How does Bert’s
consumer surplus change? Show these changes in your graph.
- When the price falls to $2, the quantity demanded changes to 3 bottles of water, an
increase of 1.
- The consumer surplus increases to $9.
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This is because the total consumer surplus is now A+B, as shown on Figure D.
A = $4.
B = $5.
o Bert’s willingness to pay for the first two bottles is $4 extra (on top of A), and
for the third bottle an extra $1. This leaves a total of $5.
Q9. One of the largest changes in the economy over the past several decades is that
technological advance reduces the cost of making computers.
a. Draw a supply-and-demand diagram to show what happens to price, quantity,
consumer surplus, and producer surplus in the market for computers.
- See Figure D.
- The declining cost of making computers results in a shift to the right in the supply
curve, as shown in Figure D.
- This leads to a decline in the equilibrium price, and an increase in the equilibrium
quantity of computers.
- The consumer surplus prior to the shift in supply is equal to A.
- The producer surplus prior to the shift in supply is equal to B+D.
- The consumer surplus after the shift in supply is equal to A+B+C+D
- The producer surplus after the shift is supply is equal to D+E+F.
b. Forty years ago, students used typewriters to prepare papers for their classes; today
they use computer’s. Does that make computers and typewriters complements or
substitutes? Use a supply-and-demand diagram to show what happens to price,
quantity, consumer surplus, and producer surplus in the market for typewriters. Should
typewriter producers be happy or sad about the technological advance in computers?
- See Figure E.
- Computers and typewriters are substitutes, as typewriters can be replaced by
computers.
- As they are substitutes, the declining cost of making computers will lead to the
substitution of type writers for computers. This will lead to a decline in demand for
type writers and a shift to the left of the demand curve, as shown in Figure E.
- This leads to a decline in the equilibrium quantity of type writers and a decline in the
equilibrium price.
- The consumer surplus prior to the shift in demand is equal to A+B.
- The producer surplus prior to the shift in demand is equal to C+D+E.
- The consumer surplus after the shift in supply is equal to B+C.
- The producer surplus after the shift is supply is equal to E.
- Typewriter producers may be sad about the technological advances in computers,
because the demand for their product will decline and the market will decrease in size.
c. Computers and software are complements. Draw a supply-and-demand diagram to
show what happens to price, quantity, consumer surplus, and producer surplus in the
market for software. Should software producers be happy or sad about the
technological advance in computers?
- See Figure E.
- As computers and software are complements, the declining cost of making computers
will lead to the increased demand for computer software, and the demand curve will
shift to the right.
- This will lead to an increase in the equilibrium quantity and equilibrium price of
computer software.
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The consumer surplus prior to the shift in demand is equal to A+B.
The producer surplus prior to the shift in demand is equal to C+D+E.
The consumer surplus after the shift in supply is equal to B+C.
The producer surplus after the shift is supply is equal to E.
Software producers will be happy about the technological advances in computers,
because it will increase the demand and the market for their products.
d. Does this analysis help explain why software producer Bill Gates is one of the world’s
richest men?
- Yes
- As one of the biggest changes of the past few decades has been the reduction in cost
of producing computers, the demand for the complementary market of computer
software has increased significantly. He founded Microsoft, one of the largest
producers of computer software.
Q11. Consider how health insurance affects the quantity of healthcare services
performed. Suppose that the typical medical procedure has a cost of $100, yet a person
with health insurance pays only $20 out of pocket. Her insurance company pays the
remaining $80. (The insurance company recoups the $80 through premiums, but the
premium a person pays does not depend on how many procedures that person chooses
to undertake.)
a. Draw the demand curve in the market for medical care. (In your diagram, the
horizontal axis should represent the number of medical procedures.) Show the quantity
of procedures demanded if each procedure has a price of $100.
- Displayed in Figure F (Q1).
b. On your diagram, show the quantity of procedures demanded if consumers pay only
$20 per procedure. If the cost of each procedure to society is truly $100, and if
individuals have health insurance as just described, will the number of procedures
performed maximize total surplus? Explain.
- Displayed in Figure F (Q2).
- The number of procedures performed will not maximize total surplus.
- The allocation of the resources won’t maximize total surplus because it doesn’t
exhibit efficiency. Some of the potential gains from trade among buyers and sellers in
this case are not being realized. For example, the procedures are not being consumed
by buyers who value it most higher.
- It doesn’t maximize total surplus because the cost to society is $100, the number of
procedures performed will be too large when they at Q2 ($20 per procedure) to
maximize the total surplus. The quantity that maximizes total surplus is Q1
procedures, this is less than Q2.
c. Economists often blame the health insurance system for excessive use of medical
care. Given your analysis, why might the use of care be viewed as “excessive”?
- Care might be viewed as excessive when individuals have medical procedures whose
value to the consumer is less than the cost of producing them.
- This results in a reduction of total surplus in society as the value to buyers is much
lower than the cost to sellers.
d. What sort of policies might prevent this excessive use?
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One possible policy would be to increase the excess that individual users had to pay
for medical procedures. This would limit the likelihood of them opting to have a
procedure unless necessary.
Making the consumer pay for the cost of the procedure and thus eliminating insurance
would also be an option.
Allowing the insurance company to choose whether or not a procedure should be
performed could also be an option, but this wouldn’t take into account the value of the
procedure to the consumer.
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Microeconomics- Principles and Applications
Chapter 9 – International trade
Q1. The world price of wine is below the price that would prevail in Canada in the
absence of trade.
a. Assuming that Canadian imports of wine are a small part of total world wine
production, draw a graph for the Canadian market for wine under free trade. Identify
consumer surplus, producer surplus, and total surplus in an appropriate table.
- Shown in Figure G.
b. Now suppose that an unusual shift of the Gulf Stream leads to an unseasonably cold
summer in Europe, destroying much of the grape harvest there. What effect does this
shock have on the world price of wine? Using your graph and table from part (a), show
the effect on consumer surplus, producer surplus, and total surplus in Canada. Who are
the winners and losers? Is Canada as a whole better or worse off?
- Shown in Figure G.
o The world price increases to P2 as some of the grape harvest is destroyed.
- Winners are producers as the world price increases. Losers are the consumers as
prices increase.
- As a whole Canada is worse off as the total surplus is lower after the shift of the Gulf
Stream.
Q2. Suppose that Congress imposes a tariff on imported autos to protect the U.S. auto
industry from foreign competition. Assuming that the United States is a price taker in
the world auto-market, show on a diagram: the change in the quantity of imports, the
loss to U.S. consumers, the gain to U.S. manufacturers, government revenue, and the
deadweight loss associated with the tariff. The loss to consumers can be decomposed
into three pieces: a gain to domestic producers, revenue for the government, and a
deadweight loss. Use your diagram to identify these three pieces.
- Shown in Figure G.
Q5. The nation of Textilia does not allow imports of clothing. In its equilibrium without
trade, a T-shirt costs $20, and the equilibrium quantity is 3 million T-shirts. One day,
after reading Adam Smith’s The Wealth of Nations while on vacation, the president
decides to open the Textilian market to international trade. The market price of a Tshirt falls to the world price of $16. The number of T-shirts consumed in Textilia rises to
4 million, while the number of T-shirts produced declines to 1 million.
a. Illustrate the situation just described in a graph. Your graph should show all the
numbers.
- Shown in Figure H.
b. Calculate the change in consumer surplus, producer surplus, and total surplus that
results from opening up trade. (Hint: Recall that the area of a triangle is 1 ⁄2 * Base *
Height).
- Shown in Figure H.
- The consumer surplus rises by $14 million.
- The producer surplus declines by $8 million.
- The total surplus rises by $6 million.
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Microeconomics- Principles and Applications
Q11. Consider a small country that exports steel. Suppose that a “pro-trade”
government decides to subsidize the export of steel by paying a certain amount for each
ton sold abroad. How does this export subsidy affect the domestic price of steel, the
quantity of steel produced, the quantity of steel consumed, and the quantity of steel
exported? How does it affect consumer surplus, producer surplus, government revenue,
and total surplus? Is it a good policy from the standpoint of economic efficiency? (Hint:
The analysis of an export subsidy is similar to the analysis of a tariff.)
- Shown in Figure H.
- How does it affect the domestic price of steel?
o Domestic consumers can still import steel and pay the world price, so it
doesn’t change.
- How does it affect the quantity of steel produced?
o It increases the quantity produced of steel.
- How does it affect the quantity of steel consumed?
o It quantity of steel consumed is unchanged (QD1).
- How does it affect the quantity of steel exported?
o The quantity exported rises (QS2 –QD1).
- How does it affect consumer surplus, producer surplus, government revenue, and total
surplus?
o Consumer surplus = no change
o Producer surplus = +(B+C)
o Government revenue = - (B+C+D)
o Total surplus = - D
- Is it a good policy from the standpoint of economic efficiency?
o No because there is a decline in total surplus.
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Microeconomics- Principles and Applications
Chapter 10 – Externalities
Q1. Consider two ways to protect your car from theft. The Club (a steering wheel lock)
makes it difficult for a car thief to take your car. Lojack (a tracking system) makes it
easier for the police to catch the car thief who has stolen it. Which of these types of
protection conveys a negative externality on other car owners? Which conveys a positive
externality? Do you think there are any policy implications of your analysis?
- The Club (a steering wheel lock) makes it difficult for a car thief to take your car. This
conveys a negative externality on other car owners as thieves won’t attempt to steal a
car with The Club visibly in place. This means they may move on to another car.
- Lojack (a tracking system) conveys a positive externality on other car owners. This is
because thieves don’t know which cars have the technology, and are therefore less
likely to steal any car.
- Policy implications of the analysis could be to offer a subsidy for those who use the
Lojack technology to encourage more people to do so.
Q2. Consider the market for fire extinguishers.
a. Why might fire extinguishers exhibit positive externalities?
- Fire extinguishers may exhibit positive externalities because they have a beneficial
impact on bystanders of providing protection against potential fires, but the bystander
doesn’t pay for this effect. Individuals who buy them exhibit positive protection
effects on those surrounding them.
b. Draw a graph of the market for fire extinguishers, labeling the demand curve, the
social-value curve, the supply curve, and the social-cost curve.
- Shown in Figure I.
c. Indicate the market equilibrium level of output and the efficient level of output. Give
an intuitive explanation for why these quantities differ.
- Shown in Figure I.
- In the presence of a positive externality, as in the market of fire extinguishers, the
social value of the good exceeds the private value. Therefore, the optimal quantity,
Qoptimum, is larger than the equilibrium quantity Qmarket.
- The optimal quantity is found where the social value curve and the supply curve
intersect. The socially optimal quantity is greater than the quantity that the private
market would naturally reach on its own.
d. If the external benefit is $10 per extinguisher, describe a government policy that
would yield the efficient outcome.
- As the external benefit is $10 per extinguisher, a government policy could be to
subsidise people $10 for every fire extinguisher they buy.
- This would shift the demand curve up to the social value curve, and in turn would
increase the Qmarket to Qoptimum.
Q4. Greater consumption of alcohol leads to more motor vehicle accidents and, thus,
imposes costs on people who do not drink and drive.
a. Illustrate the market for alcohol, labeling the demand curve, the social-value curve,
the supply curve, the social-cost curve, the market equilibrium level of output, and the
efficient level of output.
- Shown in Figure I.
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b. On your graph, shade the area corresponding to the deadweight loss of the market
equilibrium. (Hint: The deadweight loss occurs because some units of alcohol are
consumed for which the social cost exceeds the social value.) Explain.
- Shown in Figure I.
Chapter 11 – Public goods
Q1. Think about the goods and services provided by your local government.
a. Using the classification in Figure 1, explain which category each of the following
goods falls into:
- Police protection
o Likely to be a club good. It is excludable, as the police is likely to ignore
certain neighbourhoods. It is not rival in consumption, unless the force is
overworked – in this case it may be a private good.
- Snow ploughing
o Likely to be a common resource. Once a street is plowed, it is not excludable.
However, it is rival good, especially right after a big snowfall, because
ploughing one street means not ploughing another street.
- Education
o At university, it is likely to be a private good as it is excludable if it’s a paying
institution. If someone doesn’t pay they can be prevented from taking classes.
It is also a rival good, because the presence of an additional student in a class
reduces the benefits to others.
o If schools are free and provided by the state (primary and secondary), it is a
common resource because it is non-excludable but is rival in consumption.
- Rural roads
o Public goods because rural roads are not excludable and there is not a rival in
consumption. Rural roads are generally uncongested; therefore, one person’s
use of the rural road doesn’t diminish another person’s use of it.
- City streets
o Common resources because city streets are not excludable, but there is usually
rival in consumption. City streets are often congested; therefore, one person’s
use of the city street diminishes another person’s use of it.
b. Why do you think the government provides items that are not public goods?
The government may provide goods that are not public goods, such as education, because of
the positive externalities associated with them, whereby the marginal social benefit is greater
than the marginal private benefit.
Q9. Many transportation systems, such as the Washington, D.C., Metro (subway),
charge higher fares during rush hours than during the rest of the day. Why might they
do this?
Transportation systems, such as the Washington D.C. Metro may be public goods in non-rush
hour. However, during rush hour, they become private goods as the good is rival in
consumption, as one person’s use of it diminishes another person’s use of it. For example,
when all seats are taken, some people must stand. Or if there isn't any room to stand, some
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people must wait for a train that isn't as crowded. During rush hour using the Metro has
negative externalities for other passengers. Therefore, by increasing the fare, this externality
can be internalised, giving buyers and sellers in the market an incentive to take into account
the external negative effects of their actions.
Q10. The federal government tests the safety of car models and provides the test results
free of charge to the public. Do you think this information qualifies as a public good?
Why or why not?
- Yes, this information qualifies as a public good. This is because it is not excludable as
it is provided to the public free of change. The information is also not rival in
consumption because one person’s use of the information does not reduce another
person’s ability to use it.
Chapter 13 – Firm Behaviour: Costs of Production
Q5. You are the chief financial officer for a firm that sells digital music players. Your
firm has the following average-total-cost schedule:
Average Total Cost
Quantity
600 players $300
601
301
Your current level of production is 600 devices, all of which have been sold. Someone
calls, desperate to buy one of your music players. The caller offers you $550 for it.
Should you accept the offer? Why or why not?
- In this example, the total cost of production for 600 devices is $180,000.
o 600*300 = $180,000
- The total cost of production for 601 devices is $180,901.
o 601*301 = $180,901.
- Therefore, the marginal cost for 601 devices is $180,901-$180,000 = $901.
- $901 > $550; therefore, the chief financial officer should not accept the offer from the
caller.
Q11. Jane’s Juice Bar has the following cost schedules:
Quantity
Variable Cost
Total Cost
0 vats of juice
$0
$30
1
10
40
2
25
55
3
45
75
4
70
100
5
100
130
6
135
165
a. Calculate average variable cost, average total cost, and marginal cost for each
quantity.
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Quantity
(vats of juice)
0
1
2
3
4
5
6
Variable
Cost ($)
0
10
25
45
70
100
135
Total Cost
($)
30
40
55
75
100
130
165
Average
variable cost ($)
-10
12.5
15
17.5
20
22.5
Average
total cost ($)
-40
27.5
25
25
26
27.5
Marginal
cost ($)
-10
15
20
25
30
35
b. Graph all three curves. What is the relationship between the marginal-cost curve and
the average-total-cost curve? Between the marginal-cost curve and the averagevariable-cost curve? Explain.
- Shown in Figure J.
- Relationships between curves
o The marginal cost curve is below the average total curve when output is less
than 4 and average total cost is declining (on the left side of the U curve).
o The marginal cost curve lies above the average variable cost and does not
cross.
Chapter 15 – Monopoly
Q3. Johnny Rockabilly has just finished recording his latest CD. His record company’s
marketing department determines that the demand for the CD is as follows:
Price Number of CDs
$24
10,000
22
20,000
20
30,000
18
40,000
16
50,000
14
60,000
The company can produce the CD with no fixed cost and a variable cost of $5 per CD.
a. Find total revenue for quantity equal to 10,000, 20,000, and so on. What is the
marginal revenue for each 10,000 increase in the quantity sold?
Number of CDs
Total Revenue
Marginal revenue
10,000
240,000
N/A
20,000
440,000
$20
30,000
600,000
$16
40,000
720,000
$12
50,000
800,000
$8
60,000
840,000
$4
b. What quantity of CDs would maximize profit? What would the price be? What would
the profit be?
Number of CDs
Total Revenue
Marginal revenue
Total Cost
Profit
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10,000
20,000
30,000
40,000
50,000
60,000
240,000
440,000
600,000
720,000
800,000
840,000
N/A
$20
$16
$12
$8
$4
50,000
100,000
150,000
200,000
250,000
300,000
190,000
340,000
450,000
520,000
550,000
540,000
Profits are maximized at a quantity of 50,000, at a price of $16, with a profit of $550,000.
c. If you were Johnny’s agent, what recording fee would you advise Johnny to demand?
$550,000 so that he receives all the profit, and not the recording company.
Q13. Many schemes for price discriminating involve some cost. For example, discount
coupons take up the time and resources of both the buyer and the seller. This question
considers the implications of costly price discrimination. To keep things simple, let’s
assume that our monopolist’s production costs are simply proportional to output so that
average total cost and marginal cost are constant and equal to each other.
a. Draw the cost, demand, and marginal revenue curves for the monopolist. Show the
price the monopolist would charge without price discrimination.
- Shown in Figure K.
b. In your diagram, mark the area equal to the monopolist’s profit and call it X. Mark
the area equal to consumer surplus and call it Y. Mark the area equal to the deadweight
loss and call it Z.
- Shown in Figure K.
c. Now suppose that the monopolist can perfectly price discriminate. What is the
monopolist’s profit? (Give your answer in terms of X, Y, and Z.)
- If the monopolist can perfectly price discriminate, it produces Qs, and has a profit
equal to X+Y+Z, an increase in the amount Y+Z.
d. What is the change in the monopolist’s profit from price discrimination? What is the
change in total surplus from price discrimination? Which change is larger? Explain.
(Give your answer in terms of X, Y, and Z.)
- The change in the monopolist’s profit from price discrimination is +Y+Z.
- The change in total surplus is area Z (the deadweight loss).
- The rise in monopolist’s profit is larger as it is (+Y+Z) compared to (+Z).
e. Now suppose that there is some cost of price discrimination. To model this cost, let’s
assume that the monopolist has to pay a fixed cost C to price discriminate. How would a
monopolist make the decision whether to pay this fixed cost? (Give your answer in
terms of X, Y, Z, and C.)
- The monopolist would make the decision whether to pay this fixed cost based on
whether the increase in profits (Y+Z) exceeds C.
f. How would a benevolent social planner, who cares about total surplus, decide whether
the monopolist should price discriminate? (Give your answer in terms of X, Y, Z, and
C.)
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A benevolent social planner would want the monopolist to price discriminate only if Z
(the deadweight loss from monopoly) exceeded C (the fixed cost).
g. Compare your answers to parts (e) and (f). How does the monopolist’s incentive to
price discriminate differ from the social planner’s? Is it possible that the monopolist will
price discriminate even though it is not socially desirable?
- The benevolent social planner would want the monopolist to price discriminate if
Z>C, whereas the monopolist would want to price discriminate if Y+Z>C. Therefore
If Z<C, but Y+Z>C, the monopolist would still want to price discriminate even if it’s
not in the best interest of society.
Chapter 17 – Oligopoly
Q2. The New York Times (Nov. 30, 1993) reported that “the inability of OPEC to agree
last week to cut production has sent the oil market into turmoil . . . [leading to] the
lowest price for domestic crude oil since June 1990.”
a. Why were the members of OPEC trying to agree to cut production?
- The market was in equilibrium. They couldn’t agree to cut production. This increased
supply, leading to price reduction as same demand.
- To maintain a low supply point, with the same demand, to maximise profit.
- To create a monopoly market – try to reach a monopoly outcome.
- OPEC would like to maintain a high price for oil. A cartel – tries to raise the price of
its product through a coordinated reduction in quantity produced. OPEC tries to set
production levels for each of its member countries.
b. Why do you suppose OPEC was unable to agree on cutting production? Why did the
oil market go into “turmoil” as a result?
- The OPEC countries would like to maintain a high price for oil.
- But each member of the cartel is tempted to increase its production to get a larger
share of the total profit. OPEC members frequently agree to reduce production but
then cheat on their agreements.
- OPEC ineffective at maintaining cooperation and high prices. Oil producing nations
produce more to try to get a larger piece of the profit.
- They couldn’t agree to cut production. This increased supply, leading to price
reduction as same demand.
- Turmoil – everyone would produce more and try to maximise individual production
and profit. OPEC had no control. All competitors trying to produce more and gain
more of the market and profits.
c. The newspaper also noted OPEC’s view “that producing nations outside the
organization, like Norway and Britain, should do their share and cut production.” What
does the phrase “do their share” suggest about OPEC’s desired relationship with
Norway and Britain?
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Suggests that OPEC and other producing nations are in competition over prices.
They would like to cooperate with these nations too.
Moral hazard – OPEC, Norway and Britain.
OPEC would regulate production. This would increase prices. Norway and Britain
would benefit from the increased prices, they could then increase production. They
would be free riders from the control of the market of OPEC.
Q4. Consider trade relations between the United States and Mexico. Assume that the
leaders of the two countries believe the payoffs to alternative trade policies are as
follows:
a. What is the dominant strategy for the United States? For Mexico? Explain.
- Both always gain more with high tariffs. If strategy of the other player is not
considered.
o A strategy that is best for a player in a game regardless of the strategies chosen
by the other players.
b. Define Nash equilibrium. What is the Nash equilibrium for trade policy?
- A situation in which economic actors interacting with one another each choose their
best strategy given the strategies that all the other actors have chosen.
- High tariffs and high tariffs.
o Given that US is giving high tariffs, best outcome is for Mexico to have high
tariffs.
c. In 1993, the U.S. Congress ratified the North American Free Trade Agreement, in
which the United States and Mexico agreed to reduce trade barriers simultaneously. Do
the perceived payoffs shown here justify this approach to trade policy? Explain.
- Yes, because they both gain more ($5bn). The agreement reduces/eliminates the risk
of the other cheating on them/raising tariffs etc.
d. Based on your understanding of the gains from trade (discussed in Chapters 3 and 9),
do you think that these payoffs actually reflect a nation’s welfare under the four
possible outcomes?
- High tariffs and high tariffs.
- The payoffs in the upper left and lower right parts of the box do reflect a nation’s
welfare. Trade is beneficial and tariffs are a barrier to trade. However, the payoffs in
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the upper right and lower left parts of the box are not valid. A tariff hurts domestic
consumers and helps domestic producers, but total surplus (consumer +producer
surplus) declines, as we saw in Chapter 9. So it would be more accurate for these two
areas of the box to show that both countries’ welfare will decline if they imposed high
tariffs, whether or not the other country had high or low tariffs.
Chapter 18: The markets for the factors of production
2. Show the effect of each of the following events on the market for labor in the
computer manufacturing industry.
a. Congress buys personal computers for all U.S. college students.
- See Figure L.
- As there will be an increased demand for computers as Congress buys them for all US
college students, the demand for labour in the computer manufacturing industry will
increase, demonstrated by a shift to the right of the demand for labour curve. This will
lead to an increase in the equilibrium price and equilibrium quantity of labour in the
computer manufacturing industry.
b. More college students major in engineering and computer science.
- See Figure L.
- As there will be an increase in the number of computer science and engineering
graduates, there will be an increase in the supply of labour in the computer
manufacturing industry as many graduates will enter this industry. This increase in
supply is demonstrated by a shift to the right of the supply curve of labour. This will
lead to a decline in the equilibrium price and increase equilibrium quantity of labour
in the computer manufacturing industry.
c. Computer firms build new manufacturing plants.
- See Figure L.
- As computer firms build new manufacturing plants, there will be an increase in the
demand for computer manufacturing labour. This is shown in the shift to the right of
the demand curve for labour. This will lead to an increase in the equilibrium price and
equilibrium quantity of labour in the computer manufacturing industry.
Chapter 22: Frontiers of microeconomics
Q1. Suppose that the Live-Long-and-Prosper Health Insurance Company charges
$5,000 annually for a family insurance policy. The company’s president suggests that
the company raise the annual price to $6,000 to increase its profits. If the firm followed
this suggestion, what economic problem might arise? Would the firm’s pool of
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customers tend to become more or less healthy on average? Would the company’s
profits necessarily increase?
- The economic problem that may arise from this change in charges would be adverse
selection. This is a situation where the uninformed side of the transaction (the
insurance company) would get the wrong people (unhealthy people) purchasing the
policy. This is because the healthier people would be more likely to forego the policy
if the premium rises.
- The firm’s pool of customers would tend to be less healthy on average, as the healthy
customers may choose to forego the policy if the premium rises.
- As a result, the company’s profits wouldn’t necessary increase, the revenues may in
fact fall as fewer people take on the policy, but its costs could remain the same.
Therefore its profits could fall.
Q2. Each of the following situations involves moral hazard. In each case, identify the
principal and the agent, and explain why there is asymmetric information. How does
the action described reduce the problem of moral hazard?
a. Landlords require tenants to pay security deposits.
- The landlord is the principal and the tenant is the agent. There is asymmetric
information because the landlord does not know how well the tenant will take care of
the property.
- Having a tenant pay a security deposit increases the likelihood that the tenant will take
care of the property in order to receive his deposit back when he vacates the property.
- Moral Hazard: the informed party may take the “wrong action”, which affects benefits
received by uninformed party.
b. Firms compensate top executives with options to buy company stock at a given price
in the future.
- The stockholders of the firm (the owners) are the principals and the top executives are
the agents. The firm’s owners do not know in advance how well the top executives
will perform their duties. Tying some of the executives’ compensation to the value of
the firm provides incentive for the executives to work hard to increase the value of the
firm.
c. Car insurance companies offer discounts to customers who install antitheft devices in
their cars.
- The insurance company is the principal and the customer is the agent.
- Insurance companies do not know whether the car owner is likely to leave the vehicle
parked with the keys in it or park it in a high crime area. Individuals who will go to
the trouble of installing anti-theft equipment are more likely to take good care of their
vehicles.
- Offering a discount on insurance premiums will induce car owners to install such
devices.
Q4. A case study in this chapter describes how a boyfriend can signal to a girlfriend that
he loves her by giving an appropriate gift. Do you think saying “I love you” can also
serve as a signal? Why or why not?
- Saying I love you is not a good signal.
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To have an effective signal factor, it must be costly. It must be less costly or more
beneficial to the person with higher quality product. However, simply professing
someone’s love doesn’t meet this requirement.
Q5. Ken walks into an ice-cream parlor.
Waiter: “We have vanilla and chocolate today.”
Ken: “I’ll take vanilla.”
Waiter: “I almost forgot. We also have strawberry.”
Ken: “In that case, I’ll take chocolate.”
What standard property of decision making is Ken violating? (Hint: Reread the section
on Arrow’s impossibility theorem.)
- Ken is violating the property of independence of irrelevant alternatives.
- Adding a choice of strawberry after he chooses vanilla over chocolate should not lead
him to change his mind and prefer chocolate.
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