CH-11-12 Costs and Profit Maximization Under Competition – Modern Principles: Microeconomics : Book Guide

This Document Contains Chapters 11 to 12 CHAPTER 11 Modern Principles of Economics: Costs and Profit Maximization Under Competition Facts and Tools 1. You’ve been hired as a management consultant to four different companies in competitive industries. They’re each trying to figure out if they should produce a little more output or a little bit less in order to maximize their profits. The firms all have typical marginal cost curves: They rise as the firm produces more. Your staff did all the hard work for you of figuring out the price of each firm’s output and the marginal cost of producing one more unit of output at their current level of output. However, they forgot to collect data on how much each firm is actually producing at the moment. Fortunately, that doesn’t matter. In your final report, you need to decide which firms should produce more output, which should produce less, and which are producing just the right amount: a. WaffleCo, maker of generic-brand frozen waffles. Price = $4 per box, marginal cost = $2 per box. b. Rio Blanco, producer of copper. Price = $32 per ounce, marginal cost = $45 per ounce. c. GoDaddy.com, domain name registry. Price = $5 per website, marginal cost = $2 per website. d. Luke’s Lawn Service. Price = $80 per month, marginal cost = $120 per month. Solution 1. When P ˃ MC, produce more. When P ˂ MC, produce less. So produce more in parts a and c, and produce less in parts b and d. 2. In the competitive electrical motor industry, the workers at Galt Inc. threaten to go on strike. To avoid the strike, Galt Inc. agrees to pay its workers more. At all other factories, the wage remains the same. a. What does this do to the marginal cost curve at Galt Inc.? Does it rise, does it fall, or is there no change? Illustrate your answer in the figure. b. What will happen to the number of motors produced by Galt Inc.? Indicate the “before” and “after” levels of output on the x-axis in the figure. c. In this competitive market, what will the Galt. Inc. labor agreement do to the price of motors? d. Surely, more workers will want to work at Galt Inc. now that it pays higher wages. Will more workers actually work at Galt Inc. after the labor agreement is struck? Why or why not? Solution 2. a, b. The marginal cost curve will shift up (a shift to the left captures the same intuition). The number of motors sold will fall. c. Nothing will happen to the price of motors. The fall in supply represented by the higher cost at one firm, Galt Inc., is too small to raise the price of motors noticeably. d. No, fewer workers will work at Galt Inc. after the deal is struck. The higher marginal cost means fewer motors get sold, which means fewer jobs making motors. 3. In Figure 11.8, you saw what happens in the long run when demand rises in a constant cost industry. Let’s see what happens when demand falls in such an industry: For instance, think about the market for gasoline or pizza in a small city after the city’s biggest textile mill shuts down. In the figure below, indicate the price and quantity of output at three points in time: I. In the long run, before demand falls. II. In the short run, after demand falls. III. In the long run, after demand falls. Also, answer the following questions about the market’s response to this fall in demand. a. When will the marginal cost of production be lowest: At stage I, II, or III? b. When firms cut prices, they often do so in dramatic ways. During which stage will the local pizza shops begin making “Buy one, get one free” offers? During which stage will the local gas stations be more likely to offer “Free car wash with fill-up”? c. When is P ˃ AC? P ˂ AC? P = AC? d. Restating the previous question: When are profits positive? Negative? Zero? e. Roughly speaking, will the long-run response mostly involve firms leaving the industry, or will it mostly involve individual firms shrinking? The Firm column of Figure 11.8 should help you with the answer. Solution a. Marginal cost is lowest in stage II. There are many firms still in the industry, but they are each producing less, which reduces MC. A newspaper or magazine writer might say that “dramatic cost-cutting” is going on. b. Stage II again: Price is lower in the short run, right after the fall in demand. In the real world, marketing and advertising seem to matter quite a lot, so firms will repackage a price cut as something else much more glamorous: Two for one, “limited time offer,” free gift card with $40 purchase, etc. c. In this market, price is never greater than average cost. Price equals cost in stages I and III, and price is less than average cost in stage II. d. Profits aren’t positive in this question. They are zero in stages I and III, and negative in stage II. e. The question talks about the long-run effect on the firms. The closed mill will put people out of a job; the result will be a reduction in demand for pizza and gasoline, so we might see that a few firms who are not able to cover their variable cost will exit in the short run. However, we won’t see the exodus of firms in the long run. Because each firm’s marginal cost curve is in the same place as before, when the price rises back to long-run average cost the remaining firms will go back to running their shops just as they did before: no “half-price sales,” no coupons, no sales gimmicks, and so on. 4. We mentioned that carpet manufacturing looks like a decreasing cost industry. In American homes, carpets are much less popular than they were in the 1960s and 1970s, when “wall-to-wall carpeting” was fashionable in homes. Suppose that carpeting became even less popular than it is today: What would this fall in demand probably do to the price of carpet in the long run? Solution 4. When demand falls in a decreasing cost industry, the prices rise. It’s expensive to have just a few carpet manufacturers: Society loses all of the scale efficiencies discussed in the chapter. Average cost is pushed up when the scale is small. 5. Replacement parts for classic cars are expensive, even though these parts aren’t any more complicated than parts for new cars. a. What kind of industry is the market for old car parts: An increasing cost industry, a constant cost industry, or a decreasing cost industry? How can you tell? b. If people began recycling old cars more in the United States—repairing them rather than sending them off to junkyards—would the cost of spare parts probably rise or probably fall in the long run? Why do you think so? Solution 5. a. It will be a case of an increasing cost industry. Price is higher for rare things than, in this case, new-car parts, which are not rare. Something that’s rare is very expensive. We can tell because the price is high in the old-car parts market, higher than in the market for new-car parts. b. Ironically, the long-run price of old-car parts would probably fall if demand increased. The market for old-car parts would reap the same kind of scale effects and learning externalities that influence the market for carpet. 6. Arguing about economics late one night in your dorm room, your friend says, “In a free market economy, if people are willing to pay a lot for something, then businesses will charge a lot for it.” One way to translate your friend’s words into a model is to think of a product with highly inelastic demand: items like life-saving drugs or basic food items. Let’s consider a market where costs are roughly constant: perhaps they ride a little or fall a little as the market grows, but not by much. a. In the long run, is your friend right? b. In the long run, what has the biggest effect on the price of a good that people really want: the location of the average cost curve or the location of the demand curve? Solution 6. a. Except for life-saving drugs and basic food items, both of which are more of a necessity, and for products that do not have many substitutes in the long run, price will be determined by the average cost curve. But here, since price doesn’t vary much, there won’t be much effect on price. b. The location of the average cost curve matters much more. See the next question for further discussion. 7. a. In the highly competitive TV-manufacturing industry, a new innovation makes it possible to cut the average cost of a 50-inch LCD TV from $1,000 to $600. Most TV manufacturers quickly adopt this new innovation, earning massive short-run profits. In the long run, what will the price of a 50-inch LCD TV be? b. In the highly competitive flash drive industry, a new innovation makes it possible to cut the average cost of a 64-gigabyte flash drive, small enough to fit in your pocket, from $5 to $4. In the long run, what will the price of a 64-gigabyte flash drive be? c. Assume that the markets in parts a and b are both constant cost industries. If demand rises massively for these two goods, why won’t the price of the goods rise in the long run? d. In constant cost industries, does demand have any effect on price in the long run? e. When average cost falls in any competitive industry, regardless of cost structure, who gets 100 percent of the benefits of cost cutting in the long run: consumers or producers? Solution 7. a. P = AC in the long run in a competitive industry, so the price of 50-inch LCD TVs will stay at $600. b. Since average cost has come down from $5 to $4, the price of 64-GB flash drives in the long run will be $4 (equal to AC). c. If demand rises, price would generally rise, but this does not happen in the case of constant cost industries because there are already many sellers in the market; the presence of profits entices potential sellers to come and join the market, thereby keeping the AC curve to its lowest and newer value. d. No, it doesn’t. Demand has an effect on quantity but not on price in constant cost markets. e. Consumers get all of the benefits: Firms keep entering the industry as long as profits are positive. Firms end up earning whatever profits they were earning due to their innovation until now. Therefore, firms that consistently innovate and improve will have an edge and can reap profits for a longer time. Consumers will benefit from innovative products at reasonable prices. 8. On January 27, 2011, the price of Ford Motor Company stock hit an almost 10-year high at $18.79 per share. (Two years prior, in January 2009, Ford stock was trading for about a tenth of that price.) a. Suppose that on January 27, 2011, you owned 10,000 shares of Ford stock (a small fraction of the almost 3.8 billion shares). You offered to sell your stock for $18.85 per share, just slightly above the market price. Would you have been successful? b. What if, on January 27, 2011, you wanted to sell your 10,000 shares of Ford stock but you reduced your asking price to $18.75 per share? Would you have found a lot of willing buyers? c. What do your answers for parts a and b tell you about the demand curve that you, as an individual seller of Ford stock, face? Solution 8. a. You would fail. Your stock is no different from any of the other 3.8 billion shares out there, so no one would pay a higher price for yours. If you could sell at $18.85 per share, the price would be $18.85, not $18.79. b. Lots of people in the market would be eager to buy all of your shares because at that price the buyer could buy all your shares and turn around and resell them at $18.79 for a 4-cent-per-share profit, or $400 in total (minus transaction costs of around $20). c. The demand curve that an individual seller of the stock faces is horizontal—that is, perfectly elastic. In other words, since there are plenty of perfect substitutes for any seller’s shares, an individual trader (who is a small share of the market) can sell as many shares as he or she wants at the market price. 9. In November 2010 Netflix announced a new lower price for streaming video direct to home televisions. At the time, Netflix had no serious competitors—Netflix’s share of the digital download market was more than 60% (the second firm’s was only 8%). Just three months later, Amazon announced that it was entering the market for streaming video. How are these two announcements related? Solution 9. Even though Netflix had no serious competitors in the market in November 2010, it had a number of serious potential competitors. Netflix knew this and it worked hard to keep prices low and service quality high. A high market share is not necessarily a sign of little competition—a subject we will discuss further in Chapter 16. 10. The chapter pointed out that whenever money is used to purchase capital, interest costs are incurred. Sometimes those costs are explicit—like when Alex borrowed the money from the bank—and sometimes those costs are implicit— like when Tyler had to forgo the interest he could have earned had he left his funds in a savings account. If an economist and accountant calculated Alex and Tyler’s costs, for whom would they have identical numbers and for whom would the numbers differ? Solution 10. The economist and the accountant would have the same calculation of costs and profit in Alex’s case, because his interest costs were explicit—he makes interest payments directly to the bank. The numbers would be different for Tyler (the economist would calculate a higher cost). Thinking and Problem Solving 11. Suppose Sam sells apples picked from his apple tree in a competitive market. Assume all apples are equal in quality, but grow at different heights on the tree. Sam, being fearful of heights, demands greater compensation the higher he goes: So for him, the cost of grabbing an apple rises higher and higher the higher he must climb, as shown in the Total Cost column in the following table. The market price of an apple is $0.50. a. What is Sam’s marginal revenue for selling apples? b. Which apples does Sam pick first? Those on the low branches or high branches? Why? c. Does this suggest that the marginal cost of apples is increasing, decreasing, or staying the same as the quantity of apples picked increases? Why? d. Complete the table. e. How many apples does Sam pick? Solution 11. a. His marginal revenue is the same as the price: $0.50. b. He would pick from the low branches first because those are cheapest for him to harvest. c. The marginal cost is increasing as Sam is forced to climb greater and greater heights. d. e. He picks four apples, where marginal revenue equals marginal cost. 12. How long is the “long run”? It will vary from industry to industry. How long would you estimate the long run is in the following industries? a. The market for pretzels and soda sold from street carts in New York b. The market for meals at newly trendy Korean porridge restaurants c. The market for electrical engineers d. After 2012, the market for movies that are suspiciously similar to The Hunger Games. Solution 12. a. A few days at most: If there’s a big rise in demand because a new skyscraper is built, then it will only take a few days for street carts from elsewhere in New York to move down to lower Manhattan to sell pretzels and soda to the businesspeople. Word travels fast, and carts travel faster. b. This might take a year or two at most: If a new restaurant fad kicks in, other restaurants can switch over to putting the trendy items on the menu immediately, ethnic restaurants with only a few customers can change their name to “Porridge Shop #2,” and within a year new restaurants can open up in empty spaces at the mall. c. This takes several years, as most students should understand. Earning an engineering degree takes a lot of time. d. This takes several years, as well: There are often only a few firms that can use cutting-edge filmmaking technologies, and it takes time for new people to be trained in martial arts, special effects, new cameras, and so forth. Thus, for a few years, people who worked on The Hunger Games probably earned large profits—before their skills were replicated. 13. In this chapter, we discussed the story of Dalton, Georgia, and its role as the carpet capital of the world. A similar story can be used to explain why some 60% of the motels in the United States are owned by people of Indian origin or why, as of 1995, 80% of doughnut shops in California were owned by Cambodian immigrants. Let’s look at the latter case. In the 1970s, Cambodian immigrant Ted Ngoy began working at a doughnut shop. He then opened his own store (and later, stores). Ngoy was drawn to the doughnut industry because it required little English, startup capital, or special skills. Speaking the same language as your workers, however, helps a lot. a. As other Cambodian refugees came to Los Angeles fleeing the tyrannical rule of the Khmer Rouge, which group—the refugees or existing residents—was Ngoy more likely to hire from? Why? b. Did this make it more or less likely that other Cambodian refugees would open doughnut shops? Why? c. As more refugees came in, did this encourage a virtuous cycle of Cambodian-owned doughnut shops? Why? d. At this point in the story, what sort of cost industry (constant, increasing, or decreasing) would you consider doughnut shops owned by Cambodians to be? Why? e. Why did this cycle not continue forever? What kind of cost structure are Californian doughnut shops probably in now? Solution 13. a. He was more likely to hire from the Cambodian refugee population since they share a language. b. More likely, because these employees learned the trade from Ngoy and could then open their own shops. c. Yes. There were more Cambodians hiring Cambodians, and thus more people learning to make doughnuts and learning how to open their own shop. And with more Cambodians in the industry, this lowered the costs of being a Cambodian doughnut shop owner. d. Decreasing: As quantity expanded, the virtuous circle made the costs of being a Cambodian doughnut shop owner fall. e. Ngoy’s first doughnut shop lowered the costs for other Cambodians to become doughnut shop owners, but as the industry grew, the advantages to other Cambodians of another Cambodian opening a doughnut shop declined and eventually disappeared. Also, there are only so many Cambodian refugees to open shops and only so much demand for doughnuts. Thus, Cambodians are likely to dominate the California doughnut industry for a long time just like Dalton, Georgia, continues to dominate the carpet industry, but the costs of being a Cambodian doughnut maker no longer fall when another Cambodian enters the industry. The cost structure is now constant. 14. Ralph opened a small shop selling bags of trail mix. The price of the mix is $5, and the market for trail mix is very competitive. Ralph’s cost curves are shown in the figure below. a. At what quantity will Ralph produce? Why? b. When the price is $5, shade the area of profit or loss in the graph provided and calculate Ralph’s profit or loss (round up). c. If all other sellers of trail mix have the same marginal and average costs as Ralph, should he expect more or fewer competitors in the future? In the long run, will the price of trail mix rise or fall? How do you know? What will the price of trail mix be in the long run? Solution 14. a. Ralph will produce where marginal cost equals marginal revenue, or at 15 bags of trail mix. b. Profit is (P – AC) × Q. In this case ($5 − $4) × 15 = $15 as shown in the figure above (rounding up slightly). c. His (and his competitors’) profits will attract additional competition, which will push the price down. Profits are the signal to other firms that they should enter this market. The price of trail mix will fall to the minimum of the AC curve, the point at which profits are eliminated, or $4. 15. In the competitive children’s pajama industry, a new government safety regulation raises the average cost of children’s pajamas by $2 per pair. a. If this is a constant cost industry, then, in the long run, what exactly happens to the price of children’s pajamas? b. If this is an increasing cost industry, will the long-run price of pajamas rise by more than $2 or less? (Hint: The long-run supply curve will be shaped just like an ordinary supply curve from the first few chapters. If you treat this like a $2 tax per pair, you’ll get the right answer. c. If this is an increasing cost industry, how much will this new safety regulation change the average pajama maker’s profits in the long run? d. Given your answer to part c, why do businesses in competitive industries often oppose costly new regulations? Solution 15. a. The price rises by exactly $2: It’s an upward shift in long-run average cost of exactly that amount. b. The long-run price will rise by less than $2: The higher price will reduce quantity demanded (as in part a), and at a lower quantity demanded, higher-cost firms will drop out of the industry. This saves customers some money, so the price rises by less than $2. c. In all competitive industries, profits are zero in the long run, so profits will be zero in this industry in the long run: The industry cost structure doesn’t matter. d. Perhaps they oppose them because the short-run losses are very real: It’s accurate to say that a new entrant to the industry will earn zero economic profit, but for a firm currently in the industry, it’s costly to adjust to the new regulation. 16. In the ancient Western world, incense was one of the first commodities transported long distances. It grew only in the south of the Arabian Peninsula (modern-day Yemen, known then as Arabia Felix) and was transported by camel to Alexandria and the Mediterranean civilizations, notably the Roman Republic. As the republic expanded into a richer and larger empire, the demand for incense grew and planters in Arabia added a second and then a third annual crop (though this incense was not as high in quality). Cultivation also crossed to the Horn of Africa (modern-day Oman) even though such fields were farther away from Rome. a. How does the lower quality of the additional annual crops illustrate incense as an increasing cost industry? (Hint: Think in terms of an amount of good crop produced per unit of currency.) b. How does the added distance of incense grown in the Horn of Africa illustrate incense as an increasing cost industry? c. It’s more costly to grow incense in Eastern Africa than in Arabia Felix. Which region would you expect to see more incense grown in? Solution 16. a. Growers started with the best growing season and, when they moved to less desired seasons, they received a lesser crop. The quantity of quality crop per unit of currency spent is increasing. b. As the region produces more incense, growers move to farther-away places, which adds transportation expense to the cost of incense in the Roman market. c. More incense would be grown in Arabia Felix. 17. You run a small firm. Two management consultants are offering you advice. The first says that your firm is losing money on every unit that you produce. To reduce your losses, the consultant recommends that you cut back production. The second consultant says that if your firm sells another unit, the price will more than cover your increase in costs. In order to reduce losses, the second consultant recommends that you should increase production. a. As an economist, can you explain why both facts that the consultants rely on could be true? b. Which consultant is offering the correct advice? Solution 17. a. In the following figure, note that at quantity Q1, AC > Price (point a is above point b) so the firm is making a loss (given by the gray rectangle). The first con¬sultant was correct in saying that you are “losing money on every unit that you produce.” At Q1, however, the price is greater than MC (point b is greater than point c); thus, the second consultant is correct that if you sell another unit, the price will more than cover your increase in costs. b. The diagram shows that it is the second consultant who is correct. To maximize profit, you should produce until P = MC, which means producing until point d. If you do so, your losses will turn into profits! 18. Paulette, Camille, and Hortense each own wineries in France. They produce inexpensive, mass-market wines. Over the last few years, such wines sold for 7 euros per bottle; with a global recession, however, the price has fallen to 5 euros per bottle. Given the information below, let’s find out which of these three winemakers (if any) should shut down temporarily until times get better. Remember: Whether or not they shut down, they still have to keep paying fixed costs for at least some time (that’s what makes them “fixed”). To keep things simple, let’s assume that each winemaker has calculated the optimal quantity to produce if they decide to stay in business; your job is simply to figure out if she should produce that amount or just shut down. a. First, calculate each winemaker’s profit. b. Which of these women, if any, earned a profit? c. Who should stay in business in the short run? Who should shut down? d. Fill in the blank: Even if profit is negative, if revenues are _____________ variable costs, then it’s best to stay open in the short run. e. For which of these wineries, if any, is P > AC? You don’t need to calculate any new numbers to answer this. Solution 18. a. The formula for profit is just total revenue minus total cost, so the completed table should look like the one below. Annual Income Statement When Price = 5 Euros
Winemaker Fixed Costs Variable Costs Recession Revenues Profits
Paulette 50,000 80,000 120,000 −10,000
Camille 100,000 40,000 70,000 −70,000
Hortense 200,000 250,000 200,000 −250,000
b. None of the women earned a positive profit; they have all suffered losses. c. Paulette and Camille should stay in business in the short run. Hortense should shut down. Since the fixed costs have to be paid whether or not the winemaker produces, the fixed costs show us the magnitude of the losses from shutting down. If Paulette shuts down, she will lose her $50,000 fixed costs, but she only loses $10,000 by producing, so producing is a better option. The same is true for Camille. However, if Hortense shuts down she will lose only her $200,000 fixed costs, which is less than the $250,000 she loses by producing. d. “Even if profit is negative, if revenues are greater than variable costs, then it’s best to stay open in the short run.” Looking at the table, we see that for Paulette and Camille, their revenues (even in the recession) are more than enough to cover their variable costs. When these two winemakers produce, they earn more than enough money to pay for the variable production costs. They can use the excess of revenues over variable costs to help pay for part of their fixed costs. For Hortense, this is not the case. e. This is true for none of the wineries. If we multiply both sides of P > AC by quantity (Q), it becomes P × Q > AC × Q. The left-hand side is just the formula for total revenue, price times quantity. The right-hand side is equal to total cost, because the formula for average cost is TC/Q. Therefore, P > AC is just another way of saying that total revenue is greater than total cost, which means that profit is positive. According to the completed table from part a, all three wineries are suffering losses, so for none of them is total revenue greater than total cost. Note: It’s a simple calculation if TR > TC, then profitable ven-ture. Here, all the entrepreneur’s TC (Fixed cost + Variable cost) > TR, so no need to calculate anything else. It’s a plain and simple case. 19. Let’s explore the relationship between marginal and average a little more. Suppose your grade in your economics class is composed of 10 quizzes of equal weight. You start off the semester well, then your grades start to slip a little, but then you get back into the swing of things, your grades pick up, and you finish off the semes¬ter with a bang. Your 10 quiz grades, in order, are: 82, 74, 68, 72, 77, 83, 86, 88, 90, and 100. Graph your marginal grades, along with your average grade, after each quiz. What do you notice about the relationship between marginal and averages? Your grades start improving with your fourth quiz grade; does your average also start increasing with your fourth quiz grade? Why or why not? Solution 19. The averages and marginal are given in the table below. When the marginal is below the average, it pulls the average down; when the marginal is greater than the average, it pulls the average up. It can be seen in the graph that the marginal curve intersects the average curve at its minimum (just like marginal and average cost). The average does not start to improve as soon as the marginal begins to rise, because even though the marginal rises from 68 to 72, the average at that point is 74.67, so the 72 actually pulls the average down. The direction in which the marginal grade is going doesn’t matter—only whether it is higher or lower than the average grade. 20. Given the cost function in the following table for Simon, a housepainter in a com¬petitive local market, answer the questions that follow. (You may want to calculate average cost.) What is the minimum price per room at which Simon would be earning positive economic profit? At prices below this price, what will Simon’s long-run plan be? Solution 20. It is not necessary to create the following table, but it is helpful. To earn an economic profit, total revenue has to be greater than total cost. Stated differently, price has to be greater than average cost. The minimum average cost (seen in the table) is $48.33, so as long as price is greater than this, Simon can earn a profit by choosing the right (profit-maximizing) quantity. If the price is lower than this, Simon will want to exit the house-painting industry in the long run. 21. Sandy owns a firm with annual revenues of $1,000,000. Wages, rent, and other costs are $900,000. a. Calculate Sandy’s accounting profit. b. Suppose that instead of being an entrepreneur, Sandy could get a job with one of the following annual salaries: (i) $50,000, (ii) $100,000 or (iii) $250,000. Assume that a job would be as satisfying to Sandy as being an entrepreneur. Calculate Sandy’s economic profit under each of these scenarios. Solution 21. a. Sandy has an accounting profit of $100,000. b. To calculate Sandy’s economic profit we must subtract all costs from revenues, including the opportunity cost of Sandy’s time, which is given by the potential salary that Sandy could earn in alternative employment. Thus, under the three scenarios of annual wages of (i) $50,000, (ii) $100,000 or (iii) $250,000, Sandy’s profits are: i. $100,000 − $50,000 = $50,000 ii. $100,000 − $100,000 = $0 iii. $100,000 − $250,000 = −$150,000 Under scenario i, Sandy makes a profit, a return above her opportunity costs. In scenario ii, Sandy earns a zero or normal economic profit. Notice that Sandy has no reason to switch employment even though she is earning “zero” profit. Under scenario iii, however, Sandy would be wise to close up shop and take the job. She is making a paper profit but an economic loss, i.e., it becomes a loss once opportunity costs are correctly taken into account. 22. You and your roommate are up one night studying microeconomics, and your roommate looks puzzled. You ask what is wrong, and you get this response: “The book says that in the short run fixed costs are an expense but not a cost—but that doesn’t make any sense. How can something be an expense but not a cost?” How do you respond? Solution 22. In economics, we want to understand choices. If, for example, we want to understand a firm’s short-run choice to produce or not, then we need to understand the cost of the choice to produce or not, the opportunity cost. But in the short run, the firm’s choice to produce or not does not influence its fixed costs. The fixed costs are thus not an opportunity cost of the choice and so are irrelevant to this choice. Although the fixed costs are irrelevant in the short run for the production choice, they are still important for determining profits, so we can call the fixed costs an expense in the short run but not a cost. 23. Use the variable cost information in the following table to calculate average variable cost and average cost (assume fixed cost is $350), and then use this data to answer the questions that follow. One of them might not have an answer. a. Give an example of a price at which this firm would want to produce and sell output in both the short run and the long run. b. Give an example of a price at which this firm would want to produce and sell output in neither the short run nor the long run. c. Give an example of a price at which this firm would want to produce and sell output in the long run but not in the short run. d. Give an example of a price at which this firm would want to produce and sell output in the short run but not in the long run. Solution 23. The completed table will look like this.
Q FC VC AVC AC
10 $350 $100 $10.00 $45.00
20 $350 $180 $9.00 $26.50
30 $350 $240 $8.00 $19.67
40 $350 $300 $7.50 $16.25
50 $350 $450 $9.00 $16.00
60 $350 $630 $10.50 $16.33
70 $350 $840 $12.00 $17.00
a. Any price higher than $16.00 would work here. b. Any price between $0 and $7.50 would work here. c. This one is a trick question. No such price exists to cause this confusing result. If it is best for the firm to produce in the long run, the firm must also produce in the short run. d. Any price between $7.50 and $16.00 would work here. 24. Look carefully at Figure 11.6. What is represented by the space in between the average cost (AC ) and average variable cost (AVC ) curves? Why do they get closer together as quantity increases? Will they ever meet? Solution 24. The space in between them is the average fixed cost (AFC). This is because TC = VC + FC. If we divide by Q, we see that AC = AVC + AFC. They get closer and closer as quantity increases because fixed costs don’t change; thus, as quantity rises, the AFC asymptotes to zero. However, AFC never reaches exactly zero, so AC and AVC will never meet. Challenges 25. The demand for most metals tends to increase over time. Moreover, as we discussed in this chapter and also in Chapter 5, these types of natural resource industries tend to be increasing cost industries. And yet the price of metals compared with other goods has tended to fall slowly over time (albeit with many spikes in between). The following figure, for example, shows an index of prices for aluminum, copper, lead, silver, tin, and zinc from 1900 to 2003 (adjusted for inflation). The trend is downward. Why do you think this is the case? Solution 25. Although the demand for metals has increased over time, the supply has increased at an even faster pace, so the price has fallen. Why has supply increased? Better technology has led to a decrease in costs. A decrease in costs for an “increasing cost industry” illustrates a subtle point about terminology. An increasing cost industry means that costs increase with quantity, holding technology and all other factors constant. When we say that better technology decreases costs, we mean that the costs of production are reduced, holding quantity constant. In this figure we show how costs can fall in an “increasing cost” industry. An increasing cost industry means that—holding all else constant—costs increase with quantity so that the supply curve is upwardly sloped. Over time it’s possible for costs to fall in an “increasing cost” industry if all else is not held constant—for example, if there are new cost-saving technologies or reductions in input prices. More generally, better ideas and technologies are the essence of economic growth. 26. Frequent moviegoers often note that movies are rarely based on original ideas. Most of them are based on a television series, a video game, or, most commonly, a book. Why? To help you answer this question, start with the following. a. Does a movie or a book have a higher fixed cost of production? b. In 2005, American studios released 563 movies and American publishers produced 176,000 new titles. How does your answer in part a explain such a wide difference? Which is riskier: publishing a book or producing a movie? c. How does the difference in fixed costs and risk of failure explain why so many movies are based on successful books? As a result, where do you expect to see more innovative plots, dialogues, and characters: in novels or movies? Solution 26. a. A movie has a much higher fixed cost of production; even a low-budget movie can cost $1 million. A book can be published for much less. b. The public’s moviegoing budget is limited so higher fixed costs mean fewer firms in the industry. If a publisher pays for a book that does not sell, it may lose tens of thousands of dollars. If a movie studio pays for a movie that does not sell, it can lose tens of millions of dollars. Thus, the risks involved in making a movie are much greater than those involved in making a book. c. Using a proven success (at least in book format) mitigates some of the risk of movie production, so investors are much more likely to be willing to gamble that a successful book can be made into a movie than they are to gamble on a movie with no fan base. As a result, we can expect to see more innovation in novels, the low-fixed-cost industry. Low costs mean lots of entry. For more on the economics of the arts, see Cowen, Tyler and Alexander Tabarrok. 2000. An economic theory of avant-garde and popular art, or high and low culture. Southern Economic Journal 67(2): 232–253. 27. a. In the nineteenth century, economist Alfred Marshall wrote about decreasing cost industries, writing in his Principles of Economics (available free online) that “When an industry has thus chosen a locality for itself. . . . [t]he mysteries of the trade become no mysteries; but are as it were in the air.” In Chapter 10, we had a concept for benefits that are not internal to a firm but are “as it were in the air.” What specific concept from Chapter 10 is at work in a business cluster? b. In the twenty-first century, economist Michael Porter of the Harvard Business School writes about decreasing cost industries as well: He calls them “business clusters.” Porter’s work has been very influential among city and town governments that argue that carefully targeted tax breaks and subsidies can attract investment and create a business cluster in their town that will subsequently reap the benefits of decreasing costs. Is this argument correct? Be careful, it’s tricky! Solution 27. a. A business cluster (or a decreasing cost industry) is one kind of positive externality. b. You learned in Chapter 10 that subsidizing activities with positive externalities can increase social surplus. Since the benefits of business clusters are a type of positive externality, this appears to suggest that there is an argument for subsidizing local industries in order to build the cluster. But let’s think about this a little bit more. If Dalton, Georgia, were not the carpet capital of the United States, then surely some other town would be the carpet capital. Subsidies not only help form a business cluster where it is required, but they also have an effect on businesses that are established elsewhere. These establishments leave an area, being attracted to subsidies in the subsidized area, thereby affecting the welfare of people residing in that original area and actually causing a loss in consumer surplus. New York City, for example, subsidizes film and television production in New York, but rather than increasing social surplus, this primarily moves films and television shows that would be shot in LA or Chicago or Toronto to New York. In fact, by reducing the size of the industry in LA, the net effect of New York subsidies is likely a decrease in social surplus. 28. In Kolkata, India, it is very common to see beggars on the streets. Imagine that the visitors and residents of Kolkata become more generous in their donations, what will be the effect on the standard of living of beggars in Kolkata? Answer this question using supply and demand, making assumptions as necessary. Solution 28. We can think of donations as creating a demand for beggars (begging). The key question is whether begging is an increasing, decreasing, or constant cost in¬dustry. In Kolkata, India, the best assumption is that begging is a constant cost industry. In India, hundreds of millions of very poor people live in villages. If the wages to begging rise even a little bit above the wages that can be earned by subsistence farming, many people are ready and willing to move to the cities to beg. Thus, the supply curve for begging in Kolkata is highly elastic at the subsistence wage. An increase in demand, therefore, will increase the number of beggars in Kolkata, but it will not raise their standard of living, as shown in the following figure. The supply of beggars to Kolkata is high elastic (constant cost industry) at the subsistence wage. Increased generosity toward beggars will encourage people from the country to move to the city to beg and thus will increase the num¬ber of beggars from N1 to N2 but will not raise the incomes of beggars. The answer does not imply that all generosity in response to begging is foolish or counterproductive, but it does imply that to work well, such generosity must be tem¬pered with smarts. In particular, donations that raise the productivity of workers may ultimately produce better results than donations to beggars. For example, donations to build irrigation, improve eyesight with glasses or cataract surgery, to improve infant nutrition, and so forth may be more effective at reducing poverty than giving handouts. 29. Just to make sure you’ve gotten enough practice using the different formulas in this chapter, let’s try a challenging exercise with them. Very little information is given in the following table, but surprisingly, there’s enough information for you to fill in all of the missing values—if you remember all of the relationships and can think of creative ways to use them. Solution 29. The completed table should look like this: 30. The theologian Reinhold Niebuhr wrote the famous Serenity Prayer, which says: God, grant me the serenity to accept the things I cannot change, Courage to change the things I can, And wisdom to know the difference. At the risk of ruining a lovely prayer, how would you interpret this in economic terms? Solution 30. An economist might interpret the “serenity to accept the things I cannot change” as “ignore sunk costs!” (Also, ignore fixed costs in the short run.) “Courage to change the things I can” might be rewritten as “focus on marginal costs in the short run and average cost in the long run.” “The wisdom to know the difference” clearly means “read your textbook carefully!” CHAPTER 12 Modern Principles of Economics: Competition and the Invisible Hand Facts and Tools 1. Entrepreneurs shift capital and labor across industries in pursuit of profit. Let’s look at this a little more closely. Suppose there are two industries: a high-profit industry, Industry H, and a low-profit industry, Industry L. Answer the following questions about these two industries. a. If the two industries have similar costs, then what must be true about prices in the two industries? b. What does your answer to part a imply about the value of the output in the two industries? c. If labor and capital are moved from Industry L to Industry H, what is given up? What is gained? d. Suppose instead that the prices in the two industries were identical. In this case, what must be true about the costs in the two industries? e. What does your answer to part d imply about the amounts of capital and labor required to produce one unit of output in each industry? f. If labor and capital are moved from Industry L to Industry H, are more units of output lost in Industry L or gained in Industry H? Solution 1. a. For profits to be higher in Industry H, the price in Industry H would have to be higher than in Industry L. b. The value in Industry H must be higher than the value in Industry L. c. If labor and capital moved from Industry L to Industry H, then low-value goods are given up and high-value goods are gained. d. If the prices were the same, then the costs in Industry H must be lower than in Industry L. e. If the costs in Industry H are lower, then a unit of output in Industry H must require fewer (or less valuable) units of capital and labor. f. If labor and capital move from Industry L to Industry H, then fewer units of output are given up in industry L than are gained in industry H. 2. Suppose that two industries, the pizza industry and the calzone industry, are equally risky, but rates of return on capital investments are only 5% in the pizza industry and 8% in the calzone industry. Which way will capital flow—from the pizza industry to the calzone industry, or from the calzone industry to the pizza industry? Solution 2. Capital will flow from the pizza industry to the calzone industry. 3. We’ve claimed that the efficient way to spread out work across firms in the same industry is to set the marginal cost of production to be the same across firms. Let’s see if this works in an example. Consider a competitive market for rolled steel (measured by the ton) with just two firms: SmallCo and BigCo. If we wanted to be more realistic, we could say there were 100 firms like SmallCo and 100 firms like BigCo, but that would just make the math harder without generating any insight. The two firms have marginal cost schedules like this: a. We’ll ignore fixed costs of starting up the firms just to make things a little simpler. What is the total cost at each firm of producing each level of output? Fill in the table. b. What’s the cheapest way to make 11 tons of steel? 5 tons? c. What would the price have to be in this competitive market for these two firms to produce a total of 11 tons of steel? 5 tons? d. Suppose that a government agency looked at BigCo and SmallCo’s cost curves. Which firm looks like the low-cost producer to a government agency? Would it be a good idea, an efficient policy, for the government to shut down the high-cost producer? In other words, could a government intervention do better than the invisible hand in this case? e. Let’s make part d more concrete: What would the total cost be if BigCo were the only firm in the market, and it had to produce 7 tons of rolled steel? What would marginal and total cost be if SmallCo and BigCo let the invisible hand divvy up the work between them? Solution 3. a. b. We already know that the right solution will be one in which marginal cost is the same across the two firms, so we might as well use that fact to get the answer. Only look at combinations of SmallCo output and BigCo output that have the same marginal cost. The cheapest way to make 11 tons of steel is to make 4 at SmallCo and 7 at BigCo. The cost, incidentally, is $230. For 5 tons, the low-cost method is 1 at SmallCo and 4 at BigCo, where the total cost is $50. c. Price would have to equal marginal cost: $40 brings forth 11 tons, and $10 brings forth 5 tons. d. BigCo surely looks like the low-cost producer. A government agency might be tempted to shut down SmallCo entirely. But this wouldn’t be a good idea: SmallCo can always produce at least a few tons of steel more cheaply than BigCo could. Dividing the work among the two firms is the low-cost solution. e. If BigCo had to do it alone, its marginal cost would be $40 and its total cost would be $130. If the invisible hand divides up the work, marginal cost is $20 and total cost is $90. 4. Let’s review the basic mechanism of the elimination principle. a. When demand rises in Industry X, what happens to profits? Do they rise, fall, or remain unchanged? b. When that happens, do firms, workers, and capital tend to enter Industry X, or do they tend to leave? c. Does this tend to increase short-run supply in Industry X or reduce it? d. In the long run, after this rise in demand, what will profits typically be in Industry X? Solution 4. a. Profits rise when demand rises. b. When profits are positive, firms enter the industry. c. This increases short-run supply in industry X. d. In the long run, profits are zero at the typical firm. Thinking and Problem Solving 5. The elimination principle discussed in this chapter tells us what we can expect in the long run from perfectly competitive markets: zero (normal) profits across industries. If this were the case, and this fate were unavoidable, going into business would seem to be a fairly dismal choice, given that the end result of normal profits is known right out of the gate. Despite this, we constantly see entrepreneurs working hard to earn profits. Is this a waste of time, given what we know about the elimination principle? Is the fate of zero profit unavoidable? What would Joseph Schumpeter say about all of this? Solution 5. The elimination principle tells us what happens in the long run, after the market adjusts. It is precisely the pressure of the elimination principle that forces firms to be innovative and creative, because complacency will lead, over time, to the erosion of profits. Entrepreneurs are inspired by this pressure; some even thrive under it. Plenty of profits are available to firms that innovate. This is consistent with the idea of creative destruction popularized by Joseph Schumpeter. He believed that the elimination of profits inspired the continual innovation, which is an important source of economic growth. Finally, don’t forget that normal profits are just that— normal—which means they are just the right incentive for normal products in normal times! 6. How can the market mechanism guarantee that the marginal cost of production will be the same across all firms if those firms have different owners, are in different locations, and have unique cost functions known only to the firms themselves? Why don’t these different firms need to have one shared owner or one shared manager to coordinate this “equal marginal cost” condition? Solution 6. Because the profit-maximizing condition is that price equals marginal cost, and in competitive markets, there will be one price, the market mechanism gives the result that marginal cost is the same across all firms. Each firm, in order to maxi¬mize its own profit, produces until marginal cost is equal to the same price that every other firm also faces. Not only is common ownership or other coordination not needed, but the market is actually a more effective means of accomplishing this, because it does not require any one person to have an incredible amount of information. 7. We’ve seen already from this chapter that dividing up output over multiple producers—even when one has higher costs than the other—can lead to lower industry costs, so long as output is divided up such that MC1 = MC2 = MCN. You’ve already done some practice in Facts and Tools question 3 with cost functions presented as tables. Let’s try to see how this works graphically. Take a look at the following two marginal cost functions: Based on the graphs of these two marginal cost functions, fill in the table, for industry-wide marginal cost, assuming that production is divided up among the two firms according to Invisible Hand Property 1. Then, create a graph of the industry marginal cost curve. To help you get started, take a look at the table and answer the following questions. Which firm produces the first unit of industry output? Which firm produces the second unit of industry output? Why? Solution 7. The first unit of industry output is produced by Firm 1 since it can produce that unit for $6, which is less than the $9 it would take Firm 2 to produce its first unit. The second industry unit is produced by Firm 2 since it can produce that unit (Firm 2’s first) for $9, which is less than the $10 it would cost Firm 1 to produce its second unit. The completed table looks like the one below. The graph of the MC curve should be a graph of these data. 8. In the process of creative destruction, what gets destroyed? Firms Workers Machines Buildings Business plans Valuable relationships Or some combination of these? The chapter itself contains quite a few ideas about how to answer this question, but you’ll have to think hard about the “opportunity cost” for each item on this list. Solution 8. Workers and machines (as far as equipment) don’t get destroyed. Workers in particular almost always switch over to other industries to work in new jobs. You’ll learn more about this in Chapter 14. Machines and buildings often have a tougher time in the resale market: We’ve all seen shutdown restaurants, factories, and warehouses that stay closed for years. It seems that workers are less specialized than many machines and buildings. The other three really get destroyed quite thoroughly in the process of creative destruction: The “firm”—really a network of valuable relationships—can get wiped out in the process of creative destruction. Sometimes firms switch over to other industries, sometimes not. Business plans and valuable relationships between banks and the firm, between workers at the firm who worked well together, between suppliers, customers, and the firm—all these can be destroyed in the process of creative destruction. There’s not much use for a business plan for a product that few people want. 9. Every year, American television introduces many new shows, only about one-third of which survive past their first season. The few shows that last, however, prove to be very profitable. a. How does creative destruction explain why studios bother to make new shows if most of them will fail? b. In the summer of 2002, American Idol premiered on television and became immensely popular. How did FOX and other networks respond to this surprise hit? c. What happened over the next several years to profits from American Idol? You don’t need to check FOX’s financial statements to get the answer, use the elimi¬nation principle! Solution 9. a. To stay profitable, studios have to keep trying new ideas—it’s the only way to find those ideas that are profitable enough that the studio can survive. As with new drugs, most television shows and films do not cover their costs, but the few big hits generate large profits. b. Shortly after American Idol became a hit, the other networks introduced dozens of their own reality shows (such as The Apprentice, The Bachelor, America’s Next Top Model, Big Brother, The Amazing Race, Project Runway, and many others). c. Because FOX found a successful genre, rivals copied them, making reality televi¬sion commonplace. The elimination principle means that profits attract entry, which diminishes the profit. To mix metaphors, Survivor had a bright moment in the sun before it was eclipsed by the competition. 10. Let’s suppose that the demand for allergists increases in California. How does the invisible hand respond to this demand? There is more than one correct answer to this question: Try to come up with two or three. Solution 10. An increase in the demand for allergists in California will increase the wages of California allergists, at least in the short run. In the long run, there will be many different responses to this increase in wages. • Allergists from other states (or countries) could move to high-wage California. • Surgeons, hematologists, and other doctors in California could switch over to allergy after some retraining. • New people could enter medical school, specialize in allergy, and move to California. • Finally, don’t forget that the invisible hand can always surprise us. The increase in the demand for allergists is really an increase in the demand to be free from allergies, so perhaps a new drug, air filter, or treatment will arise to fulfill this demand. Challenges 11. Let’s take a look at Invisible Hand Property 2 in action using a mathematical example. Suppose an industry is characterized by the equations in the following table. (We’re going to assume that all individual firms are identical to make this problem a little simpler.) a. Suppose 24 firms are in this industry. What is the equation for market supply? What is the equilibrium price and quantity (this can be found by setting QD = QS )? How much profit is each firm earning? According to the elimination principle, what should occur in this industry over time? b. Suppose 35 firms are in this industry. Answer the same questions from part a. c. The elimination principle says that profits will be eliminated in the long run, which means that AC = P. Using that fact, figure out how many firms will be in this industry in the long run (solve for n). Solution 11. a. If n = 24, then QS = 12 + 2.4P. Setting QD = QS means that price is $20 and Q is 60. That means each firm is producing 60/24 5 2.5 units of output. Plugging this into AC gives an average total cost of $17.18. So profit is 2.5 × ($20 − $17.18) = $7.05. In this industry, because there are positive profits, we would expect entry from other firms over time. b. If n = 35, then QS = 17.5 + 3.5P. Setting QD = QS means that the price is $15 and Q is 70. That means each firm is producing 70/35 = 2 units of output. Plugging this into AC gives an average total cost of $17.10. So profit is 2 × ($15 − $17.10) = −$4.20. In this industry, because there are negative profits, we would expect exit of firms over time. c. Rearranging the individual firm supply curve gives P = 10qS − 5. Solving AC = P using the previous expression for P gives qS = 2.2. Plugging this into the individual supply curve gives a market price of $17. Plugging this price into the demand curve gives Q = 66. So if n firms are each producing 2.2 units, for a market total of 66, n = 66/2.2 = 30. This makes sense because it is greater than 24, but less than 35. Solution Manual for Modern Principles: Microeconomics Tyler Cowen, Alex Tabarrok 9781319098766