CH-11-13 Behind the Supply Curve: Inputs and Costs – Microeconomics : Book Guide

This Document Contains Chapters 11 to 13 Behind the Supply Curve: Inputs and Costs Chapter 11 1. Changes in the prices of key commodities have a significant impact on a company’s bottom line. For virtually all companies, the price of energy is a substantial portion of their costs. In addition, many industries—such as those that produce beef, chicken, high-fructose corn syrup and ethanol—are highly dependent on the price of corn. In particular, corn has seen a significant increase in price. a. Explain how the cost of energy can be both a fixed cost and a variable cost for a company. b. Suppose energy is a fixed cost and energy prices rise. What happens to the company’s average total cost curve? What happens to its marginal cost curve? Illustrate your answer with a diagram. c. Explain why the cost of corn is a variable cost but not a fixed cost for an ethanol producer. d. When the cost of corn goes up, what happens to the average total cost curve of an ethanol producer? What happens to its marginal cost curve? Illustrate your answer with a diagram. 1. a. Energy required to keep a company operating regardless of how much output is produced represents a fixed cost, such as the energy costs of operating office buildings, factories, and stores that must be maintained independent of the amount of output produced. In addition, energy is a variable cost because producing more output almost always requires using more energy. b. When fixed costs increase, so will average total costs. The average total cost curve will shift upward. In panel (a) of the accompanying diagram, this is illustrated by the movement of the average total cost curve from its initial position, ATC1, to its new position, ATC2. The marginal cost curve is not affected if the variable costs do not change. So the marginal cost curve remains at its initial position, MC. (a) A Rise in the Price of Energy Cost of unit MC ATC2 ATC1 Quantity (b) A Rise in the Price of Corn Cost of unit MC2 MC1 ATC2 ATC1 Quantity c. Since corn is an input into the production of ethanol, producing a larger quantity of ethanol requires a larger quantity of corn, making corn a variable cost. d. When variable costs increase, so do average total costs and marginal costs. Both curves will shift upward. In panel (b) of the accompanying diagram, the movement of the average total cost curve is illustrated by the shift from its initial position, ATC1, to its new position, ATC2. The movement of the marginal cost curve is illustrated by the shift from its initial position, MC1, to its new position, MC2. 11 2. Marty’s Frozen Yogurt is a small shop that sells cups of frozen yogurt in a university town. Marty owns three frozen-yogurt machines. His other inputs are refrigerators, frozen-yogurt mix, cups, sprinkle toppings, and, of course, workers. He estimates that his daily production function when he varies the number of workers employed (and at the same time, of course, yogurt mix, cups, and so on) is as shown in the accompanying table. Quantity of labor (workers) Quantity of frozen yogurt (cups) 0 0 1 110 2 200 3 270 4 300 5 320 6 330 a. What are the fixed inputs and variable inputs in the production of cups of frozen yogurt? b. Draw the total product curve. Put the quantity of labor on the horizontal axis and the quantity of frozen yogurt on the vertical axis. c. What is the marginal product of the first worker? The second worker? The third worker? Why does marginal product decline as the number of workers increases? 2. a. The fixed inputs are those whose quantities do not change as the quantity of output changes: frozen-yogurt machines, refrigerators, and the shop. The variable inputs are those whose quantities do change as the quantity of output changes: frozen-yogurt mix, cups, sprinkle toppings, and workers. b. The accompanying diagram illustrates the total product curve. Quantity of frozen yogurt (cups) 350 TP 300 250 200 150 100 50 0 1 2 3 5 6 4 Quantity of labor (workers) c. The marginal product, MPL, of the first worker is 110 cups. The MPL of the second worker is 90 cups. The MPL of the third worker is 70 cups. The MPL declines as more and more workers are added due to the principle of diminishing returns to labor. Since the number of frozen-yogurt machines is fixed, as workers are added there are fewer and fewer machines for each worker to work with, making each additional worker less and less productive. 3. The production function for Marty’s Frozen Yogurt is given in Problem 2. Marty pays each of his workers $80 per day. The cost of his other variable inputs is $0.50 per cup of yogurt. His fixed cost is $100 per day. a. What is Marty’s variable cost and total cost when he produces 110 cups of yogurt? 200 cups? Calculate variable and total cost for every level of output given in Problem 2. b. Draw Marty’s variable cost curve. On the same diagram, draw his total cost curve. c. What is the marginal cost per cup for the first 110 cups of yogurt? For the next 90 cups? Calculate the marginal cost for all remaining levels of output. 3. a. Marty’s variable cost, VC, is his wage cost ($80 per worker per day) and his other input costs ($0.50 per cup). His total cost, TC, is the sum of the variable cost and his fixed cost of $100 per day. The answers are given in the accompanying table. Quantity of frozen yogurt (cups) Quantity of labor (workers) VC TC 0 0 $0 $100 110 1 1 × 80 + 110 × 0.5 = 135 235 200 2 2 × 80 + 200 × 0.5 = 260 360 270 3 3 × 80 + 270 × 0.5 = 375 475 300 4 4 × 80 + 300 × 0.5 = 470 570 320 5 5 × 80 + 320 × 0.5 = 560 660 330 6 6 × 80 + 330 × 0.5 = 645 745 MC of cup $1.23 1.39 1.64 3.17 4.50 8.50 b. The accompanying diagram shows the variable cost and total cost curves. Cost $800 TC VC 600 400 200 0 50 100 350 150 200 250 300 Quantity of frozen yogurt (cups) c. Marginal cost, MC, per cup of frozen yogurt is shown in the table in part a; it is the change in total cost divided by the change in quantity of output. 4. The production function for Marty’s Frozen Yogurt is given in Problem 2. The costs are given in Problem 3. a. For each of the given levels of output, calculate the average fixed cost (AFC), average variable cost (AVC), and average total cost (ATC) per cup of frozen yogurt. b. On one diagram, draw the AFC, AVC, and ATC curves. c. What principle explains why the AFC declines as output increases? What principle explains why the AVC increases as output increases? Explain your answers. d. How many cups of frozen yogurt are produced when average total cost is minimized? 4. a. The average fixed cost, average variable cost, and average total cost per cup of yogurt are given in the accompanying table. (Numbers are rounded.) Quantity of frozen yogurt (cups) 0 VC TC AFC of cup AVC of cup ATC of cup $0 $100 — — — 110 135 235 $0.91 $1.23 $2.14 200 260 360 0.50 1.30 1.80 270 375 475 0.37 1.39 1.76 300 470 570 0.33 1.57 1.90 320 560 660 0.31 1.75 2.06 330 645 745 0.30 1.95 2.26 b. The accompanying diagram shows the AFC, AVC, and ATC curves. Cost of cup $2.50 ATC AVC 2.00 1.50 1.00 0.50 0 AFC 100 150 200 250 300 350 Quantity of frozen yogurt (cups) c. AFC declines as output increases due to the spreading effect. The fixed cost is spread over more and more units of output as output increases. AVC increases as output increases due to the diminishing returns effect. Due to diminishing returns to labor, it costs more to produce each additional unit of output. d. Average total cost is minimized when 270 cups of yogurt are produced. At lower quantities of output, the fall attributable to the spreading effect dominates changes in average total cost. At higher quantities of output, the rise attributable to the diminishing returns effect dominates changes in average total cost. 5. Labor costs represent a large percentage of total costs for many firms. According to data from the Bureau of Labor Statistics, U.S. labor costs were up 2.0% in 2015, compared to 2014. a. When labor costs increase, what happens to average total cost and marginal cost? Consider a case in which labor costs are only variable costs and a case in which they are both variable and fixed costs. An increase in labor productivity means each worker can produce more output. Recent data on productivity show that labor productivity in the U.S. nonfarm business sector grew by 1.7% between 1970 and 1999, by 2.6% between 2000 and 2009, and by 1.1% between 2010 and 2015. b. When productivity growth is positive, what happens to the total product curve and the marginal product of labor curve? Illustrate your answer with a diagram. c. When productivity growth is positive, what happens to the marginal cost curve and the average total cost curve? Illustrate your answer with a diagram. d. If labor costs are rising over time on average, why would a company want to adopt equipment and methods that increase labor productivity? 5. a. When labor costs are a variable cost but not a fixed cost, an increase in labor costs leads to an increase in both average total cost and marginal cost. When labor costs are a variable cost and a fixed cost, the result is the same: both the average total cost and the marginal cost increase. b. When productivity growth is positive, any given quantity of labor can produce more output, causing the total product curve to shift upward. Since each unit of labor can produce more output, the marginal product of labor will increase and the marginal product of labor curve will shift upward. In panel (a) of the accompanying diagram, the upward shift of the total product curve is illustrated by the movement from its initial position, TP1, to its new position, TP2. In panel (b), the upward shift of the marginal product of labor curve is illustrated by the movement from its initial position, MPL1, to its new position, MPL2. (a) Total Product Curves (b) Marginal Product Curves Quantity TP2 Marginal product of labor TP1 MPL2 MPL1 Quantity of labor Quantity of labor c. When productivity growth is positive, the marginal cost curve and the average total cost curve will both shift downward, assuming labor costs have not changed. In the accompanying diagram, the movement of the average total cost curve is illustrated by the shift from its initial position, ATC1, to its new position, ATC2. The movement of the marginal cost curve is illustrated by the shift from its initial position, MC1, to its new position, MC2. Cost of unit MC1 MC2 ATC1 ATC2 Quantity d. Rising labor costs will shift the average total cost and marginal cost curves upward. Productivity growth will counteract this, shifting the average total cost and marginal cost curves downward. 6. Magnificent Blooms is a florist specializing in floral arrangements for weddings, graduations, and other events. Magnificent Blooms has a fixed cost associated with space and equipment of $100 per day. Each worker is paid $50 per day. The daily production function for Magnificent Blooms is shown in the accompanying table. Quantity of labor (workers) Quantity of floral arrangements 0 0 1 5 2 9 3 12 4 14 5 15 a. Calculate the marginal product of each worker. What principle explains why the marginal product per worker declines as the number of workers employed increases? b. Calculate the marginal cost of each level of output. What principle explains why the marginal cost per floral arrangement increases as the number of arrangements increases? 6. a. MPL, shown in the accompanying table for the five workers, is the change in output resulting from the employment of one additional worker per day. MPL falls as the quantity of labor increases due to the principle of diminishing returns. Quantity of labor L (workers) 0 Marginal product of Variable Quantity labor MPL = cost VC = of floral ∆Q/∆L (floral number of arrangements arrangements workers ë Q per worker) wage rate 0 Total cost TC = FC + VC $0 $100 50 150 100 200 150 250 200 300 250 350 5 1 5 2 9 3 12 4 14 5 15 Marginal cost of floral arrangement MC = ∆TC/∆Q $10.00 (= 50/5) 4 12.50 (= 50/4) 3 16.67 (= 50/3) 2 25.00 (= 50/2) 1 50.00 (= 50/1) b. The marginal cost, MC, of floral arrangements is the change in total cost divided by the change in output. So, to compute MC, we first need to compute total cost, TC = FC + VC, as shown in the table. MC per floral arrangement is also shown in the table. MC increases as output increases due again to the principle of diminishing returns. 7. You have the information shown in the accompanying table about a firm’s costs. Complete the missing data. Quantity TC 0 $20 MC ATC AVC — — ? ? ? ? ? ? ? ? ? ? $20 1 ? 10 2 ? 16 3 ? 20 4 ? 24 5 ? 7. The accompanying table contains the complete cost data. The total cost of producing one unit of output is the total cost of producing zero units of output plus the marginal cost of increasing output from 0 to 1, and so forth. The average total cost is just the total cost divided by output. Since the total cost of producing zero output is $20, the variable cost is TC − $20. The average variable cost is then just the variable cost divided by output. Quantity of output TC 0 $20.00 MC of unit ATC of unit AVC of unit — — $40.00 $20.00 25.00 15.00 22.00 15.33 21.50 16.50 22.00 18.00 $20.00 1 40.00 10.00 2 50.00 16.00 3 66.00 20.00 4 86.00 24.00 5 110.00 8. Evaluate each of the following statements. If a statement is true, explain why; if it is false, identify the mistake and try to correct it. a. A decreasing marginal product tells us that marginal cost must be rising. b. An increase in fixed cost increases the minimum-cost output. c. An increase in fixed cost increases marginal cost. d. When marginal cost is above average total cost, average total cost must be falling. 8. a. True. If each additional unit of the input adds less to output than the previous unit (decreasing marginal product), then in order to produce additional output, the firm needs to use increasingly more of the input; that is, the marginal cost of production increases. b. True. As the fixed cost rises, the average fixed cost also rises; that is, the spreading effect is now larger. It is the spreading effect that causes average total cost to decline. Since this effect is now larger, it dominates the diminishing returns effect over a greater quantity of output. That is, average total cost decreases over a greater quantity of output. c. False. An increase in fixed cost does not change marginal cost. Marginal cost is the additional cost of producing an additional unit of output. Fixed cost does not change as output is increased, and so the additional cost of producing an additional unit of output is independent of the fixed cost. d. False. When marginal cost is above average total cost, average total cost must be rising. If the additional cost of producing one more unit of output is greater than what it costs to produce each unit of output on average, then producing that one more unit of output must increase the average total cost. 9. Mark and Jeff operate a small company that produces souvenir footballs. Their fixed cost is $2,000 per month. They can hire workers for $1,000 per worker per month. Their monthly production function for footballs is as given in the accompanying table. Quantity of labor (workers) Quantity of footballs 0 0 1 300 2 800 3 1,200 4 1,400 5 1,500 a. For each quantity of labor, calculate average variable cost (AVC), average fixed cost (AFC), average total cost (ATC), and marginal cost (MC). b. On one diagram, draw the AVC, ATC, and MC curves. c. At what level of output is Mark and Jeff’s average total cost minimized? 9. a. The AVC, AFC, ATC, TC, and MC are given in the accompanying table. Quantity of labor (workers) Quantity of footballs AVC of football AFC of football ATC of football TC of football — — — $2,000.00 0 0 1 300 $3.33 $6.67 $10.00 3,000.00 2 800 2.50 2.50 5.00 4,000.00 3 1,200 2.50 1.67 4.17 5,000.00 4 1,400 2.86 1.43 4.29 6,000.00 5 1,500 3.33 1.33 4.67 7,000.00 MC of football $3.33 2.00 2.50 5.00 10.00 b. The accompanying diagram shows the AVC, ATC, and MC curves. Cost of football MC $10 8 6 ATC 4 AVC 2 0 200 400 600 800 1,000 1,200 1,400 1,600 Quantity of footballs c. According to the table, Mark and Jeff’s average total cost is minimized at 1,200 footballs per month, where the ATC is $4.17. 10. You produce widgets. Currently you produce four widgets at a total cost of $40. a. What is your average total cost? b. Suppose you could produce one more (the fifth) widget at a marginal cost of $5. If you do produce that fifth widget, what will your average total cost be? Has your average total cost increased or decreased? Why? c. Suppose instead that you could produce one more (the fifth) widget at a marginal cost of $20. If you do produce that fifth widget, what will your average total cost be? Has your average total cost increased or decreased? Why? 10. a. Your average total cost is $40/4 = $10 per widget. b. If you produce one more widget, you are producing five widgets at a total cost of $40 + $5 = $45. Your average total cost is therefore $45/5 = $9. Your average total cost has decreased because the marginal cost of the additional widget is below the average total cost before you produced the additional widget. c. If you produce one more widget, you are producing five widgets at a total cost of $40 + $20 = $60. Your average total cost is therefore $60/5 = $12. Your average total cost has increased because the marginal cost of the additional widget is above the average total cost before you produced the additional widget. 11. In your economics class, each homework problem set is graded on the basis of a maximum score of 100. You have completed 9 out of 10 of the problem sets for the term, and your current average grade is 88. What range of grades for your 10th problem set will raise your overall average? What range will lower your overall average? Explain your answer. 11. Any grade for your 10th problem set greater than 88 will raise your overall average; any grade lower than 88 will lower it. This is the same principle at work as that for average total cost and marginal cost. If the marginal cost curve (the 10th grade) is above the average total cost curve (the average over the first 9 grades), then the average total cost is rising (that is, the average over the 10 sets is greater than the average over the 9 sets). And if the marginal cost curve (the 10th grade) is below the average total cost curve (the average over the first 9 grades), then the average total cost is falling (that is, the average over the 10 sets is lower than the average over the 9 sets). To see this arithmetically, note that your current average, 88, is found by Sum of grades for first 9 sets = 88 = Average over first 9 sets 9 Hence, Sum of grades for first 9 sets = 88 × 9 = 792 So your overall grade—the grade over all 10 problem sets—is 792 Grade for 10th set + = Overall average 10 10 If your 10th grade is 90, then your overall grade is 792 90 + = 79.2 + 9.0 = 88.2 10 10 which is greater than 88. And if your 10th grade is 86, then your overall grade is 792 86 + = 79.2 + 8.6 = 87.8 10 10 which is less than 88. 12. Don owns a small concrete-mixing company. His fixed cost is the cost of the concrete-batching machinery and his mixer trucks. His variable cost is the cost of the sand, gravel, and other inputs for producing concrete; the gas and maintenance for the machinery and trucks; and his workers. He is trying to decide how many mixer trucks to purchase. He has estimated the costs shown in the accompanying table based on estimates of the number of orders his company will receive per week. VC Quantity of trucks FC 20 orders 40 orders 60 orders 2 $6,000 $2,000 $5,000 $12,000 3 7,000 1,800 3,800 10,800 4 8,000 1,200 3,600 8,400 a. For each level of fixed cost, calculate Don’s total cost for producing 20, 40, and 60 orders per week. b. If Don is producing 20 orders per week, how many trucks should he purchase and what will his average total cost be? Answer the same questions for 40 and 60 orders per week. 12. a. The answers are given in the accompanying table. TC Quantity of trucks 20 orders 40 orders 60 orders 2 $8,000 $11,000 $18,000 3 8,800 10,800 17,800 4 9,200 11,600 16,400 b. Don should choose the number of trucks that minimizes average total cost for each level of output. Given this, Don should buy 2 trucks if he is producing 20 orders per week. His average total cost per order will be $400. He should buy 3 trucks if he is producing 40 orders per week. His average total cost per order will then be $270. He should buy 4 trucks if he is producing 60 orders per week. His average total cost per order will then be $273. 13. Consider Don’s concrete-mixing business described in Problem 12. Assume that Don purchased 3 trucks, expecting to produce 40 orders per week. a. Suppose that, in the short run, business declines to 20 orders per week. What is Don’s average total cost per order in the short run? What will his average total cost per order in the short run be if his business booms to 60 orders per week? b. What is Don’s long-run average total cost for 20 orders per week? Explain why his short-run average total cost of producing 20 orders per week when the number of trucks is fixed at 3 is greater than his long-run average total cost of producing 20 orders per week. c. Draw Don’s long-run average total cost curve. Draw his short-run average total cost curve if he owns 3 trucks. 13. a. In the short run, producing 20 orders per week with 3 trucks, Don’s average total cost per order will be ($7,000 + $1,800)/20 = $440. If he instead produces 60 orders per week with 3 trucks, his average total cost per order will be $297. b. The long-run average total cost of producing 20 orders per week is $400 because Don would choose the number of trucks (2 trucks) that minimizes the total cost of producing 20 orders. His short-run average total cost is greater than the long-run minimum because, using 3 trucks, the level of the fixed input is greater than he needs to optimally produce 20 orders per week. c. The accompanying diagram shows Don’s LRATC and ATC. Cost of order $450 400 350 ATC LRATC 300 250 0 20 40 60 Quantity of orders 14. True or false? Explain your reasoning. a. The short-run average total cost can never be less than the long-run average total cost. b. The short-run average variable cost can never be less than the long-run average total cost. c. In the long run, choosing a higher level of fixed cost shifts the long-run average total cost curve upward. 14. a. True. The long-run average total cost is the average total cost you get by choosing the most favorable level of fixed cost in the long run; that is, it is the lowest average total cost that is possible when you can adjust how much of the fixed input you use. In other words, the long-run average total cost of producing a certain level of output is the lowest average total cost with which that level of output can be produced. b. False. The long-run average total cost is the lowest average total cost possible. But average variable cost will always be less than average total cost (it is lower than the average total cost by just the amount of the average fixed cost). So short-run average variable cost can be lower than long-run average total cost. c. False. In the long run, choosing a higher level of fixed cost allows you to move along and to the right on the long-run average total cost curve. In the long run, if you want to produce a larger quantity of output, you would optimally increase the level of fixed cost (this will decrease the average variable cost). You will do this in such a way as to spend the lowest possible average total cost; that is, you will be on the long-run average total cost curve but farther to the right (at a larger quantity of output). 15. Wolfsburg Wagon (WW) is a small automaker. The accompanying table shows WW’s long-run average total cost. Quantity of cars LRATC of car 1 $30,000 2 20,000 3 15,000 4 12,000 5 12,000 6 12,000 7 14,000 8 18,000 a. For which levels of output does WW experience increasing returns to scale? b. For which levels of output does WW experience decreasing returns to scale? c. For which levels of output does WW experience constant returns to scale? 15. a. WW’s long-run average total cost is decreasing over the range of output between 1 and 4 cars. So over that range, WW experiences increasing returns to scale. b. WW’s long-run average total cost is increasing over the range of output between 6 and 8 cars. So over that range, WW experiences decreasing returns to scale. c. WW’s long-run average total cost is constant over the range of output between 4 and 6 cars. So over that range, WW experiences constant returns to scale. WORK IT OUT Interactive step-by-step help with solving this problem can be found online. 16. The accompanying table shows a car manufacturer’s total cost of producing cars. Quantity of cars TC 0 $500,000 1 540,000 2 560,000 3 570,000 4 590,000 5 620,000 6 660,000 7 720,000 8 800,000 9 920,000 10 1,100,000 a. What is this manufacturer’s fixed cost? b. For each level of output, calculate the variable cost (VC). For each level of output except zero output, calculate the average variable cost (AVC), average total cost (ATC), and average fixed cost (AFC). What is the minimumcost output? c. For each level of output, calculate this manufacturer’s marginal cost (MC). d. On one diagram, draw the manufacturer’s AVC, ATC, and MC curves. 16. a. The manufacturer’s fixed cost is $500,000. Even when no output is produced, the manufacturer has a cost of $500,000. b. The accompanying table shows VC, calculated as TC − FC; AVC, calculated as VC/Q; ATC, calculated as TC/Q; and AFC, calculated as FC/Q. (Numbers are rounded.) The minimum-cost output is 8 cars, the level at which ATC is minimized. Quantity of cars TC 0 MC of car VC AVC of car ATC of car AFC of car — — — 40,000 $40,000 $540,000 $500,000 60,000 30,000 280,000 250,000 70,000 23,333 190,000 166,667 90,000 22,500 147,500 125,000 120,000 24,000 124,000 100,000 160,000 26,667 110,000 83,333 220,000 31,429 102,857 71,429 300,000 37,500 100,000 62,500 420,000 46,667 102,222 55,556 600,000 60,000 110,000 50,000 $500,000 $0 $40,000 1 540,000 20,000 2 560,000 10,000 3 570,000 20,000 4 590,000 30,000 5 620,000 40,000 6 660,000 60,000 7 720,000 80,000 8 800,000 120,000 9 920,000 180,000 10 1,100,000 c. The table also shows MC, the additional cost per additional car produced. Notice that MC is below ATC for levels of output less than the minimum-cost output and above ATC for levels of output greater than the minimum-cost output. d. The AVC, ATC, and MC curves are shown in the accompanying diagram. Cost of car $600,000 500,000 400,000 300,000 MC 200,000 ATC AVC 100,000 0 1 2 3 4 5 6 7 8 9 10 Quantity of cars Perfect Competition and the Supply Curve 1. For each of the following, is the business a price-taking producer? Explain your answers. a. A cappuccino café in a university town where there are dozens of very similar cappuccino cafés b. The makers of Pepsi c. One of many sellers of zucchini at a local farmers’ market 1. a. The cappuccino café is probably a price-taking producer, especially if there are a large number of cafés in town, since each will have a small market share and each produces a standardized product. b. There is only one manufacturer of Pepsi, and it works hard to differentiate its product from others in the minds of consumers. It is not a price-taking producer. c. Zucchini sellers at the farmers’ market are price-taking producers; there are many of them, none of whom can affect the market price for zucchini, which is a standardized product. 2. For each of the following, is the industry perfectly competitive? Referring to market share, standardization of the product, and/or free entry and exit, explain your answers. a. Aspirin b. Alicia Keys concerts c. SUVs 2. a. Yes, aspirin is produced in a perfectly competitive industry. Many manufacturers produce aspirin, the product is standardized, and new manufacturers can easily enter and existing manufacturers can easily exit the industry. b. No, Alicia Keys concerts are not produced in a perfectly competitive industry. There is not free entry into the industry—there is only one Alicia Keys. c. No, SUVs are not produced in a perfectly competitive industry. There are only a few manufacturers of SUVs, each holding a large market share, and SUVs are not a standardized product in the minds of consumers. Chapter 12 3. Bob produces Blu-ray movies for sale, which requires a building and a machine that copies the original movie onto a Blu-ray. Bob rents a building for $30,000 per month and rents a machine for $20,000 a month. Those are his fixed costs. His variable cost per month is given in the accompanying table. Quantity of Blu-rays VC 0 $0 1,000 5,000 2,000 8,000 3,000 9,000 4,000 14,000 5,000 20,000 6,000 33,000 7,000 49,000 8,000 72,000 9,000 99,000 10,000 150,000 a. Calculate Bob’s average variable cost, average total cost, and marginal cost for each quantity of output. b. There is free entry into the industry, and anyone who enters will face the same costs as Bob. Suppose that currently the price of a Blu-ray is $25. What will Bob’s profit be? Is this a long-run equilibrium? If not, what will the price of Blu-ray movies be in the long run? 3. a. Bob’s average variable cost, average total cost, and marginal cost are shown in the accompanying table. Quantity of Blu-rays 0 VC MC of Blu-ray $0.00 AVC of Blu-ray ATC of Blu-ray — — $5.00 1,000 5,000.00 $5.00 $55.00 4.00 29.00 3.00 19.67 3.50 16.00 4.00 14.00 5.50 13.83 7.00 14.14 9.00 15.25 11.00 16.56 15.00 20.00 3.00 2,000 8,000.00 1.00 3,000 9,000.00 5.00 4,000 14,000.00 6.00 5,000 20,000.00 13.00 6,000 33,000.00 16.00 7,000 49,000.00 23.00 8,000 72,000.00 27.00 9,000 99,000.00 51.00 10,000 150,000.00 b. At a price of $25, P = MC at a quantity of 8,000, and ATC = $15.25. Bob makes a profit of $25 − $15.25 = $9.75 per Blu-ray, for a total profit of 8,000 × $9.75 = $78,000. If there is free entry into the industry, this profit will attract new firms. As firms enter, the price of Blu-rays will eventually fall until it is equal to the minimum average total cost. Here, the average total cost reaches its minimum of $13.83 at 6,000 Blu-rays per month. So the long-run price of ­Blu-rays will be $13.83. 4. Consider Bob’s Blu-ray company described in Problem 3. Assume that Blu-ray production is a perfectly competitive industry. For each of the following questions, explain your answers. a. What is Bob’s break-even price? What is his shut-down price? b. Suppose the price of a Blu-ray is $2. What should Bob do in the short run? c. Suppose the price of a Blu-ray is $7. What is the profit-maximizing quantity of Blu-rays that Bob should produce? What will his total profit be? Will he produce or shut down in the short run? Will he stay in the industry or exit in the long run? d. Suppose instead that the price of Blu-rays is $20. Now what is the profitmaximizing quantity of Blu-rays that Bob should produce? What will his total profit be now? Will he produce or shut down in the short run? Will he stay in the industry or exit in the long run? 4. a. Bob’s break-even price is $13.83 because this is the minimum average total cost. His shut-down price is $3, the minimum average variable cost, because below that price his revenue does not even cover his variable cost. b. If the price of Blu-rays is $2, the price is below Bob’s shut-down price of $3. So Bob should shut down in the short run. c. If Blu-rays sell for $7, Bob should produce 5,000 Blu-rays because for any greater quantity his marginal cost exceeds his marginal revenue (the market price). His total profit will be −$35,000, a loss of $35,000, since he loses $7(price) − $14 (ATC) = $7 per Blu-ray produced. In the short run, he will produce because his short-run loss if he were to shut down would be greater; it would equal his fixed costs of $50,000. In the long run, he will exit the industry because his profit is negative: the price of $7 per Blu-ray is below his break-even price of $13.83. d. If Blu-rays sell instead for $20, Bob should produce 7,000 Blu-rays because at this quantity his marginal cost approximately equals his marginal revenue (the market price). His profit per Blu-ray is $20 (price) − $14.14(ATC) = $5.86, giving him a total profit of 7,000 × $5.86 = $41,020. In the short run, he will produce because he is covering his variable cost (the price is above the shutdown price). In the long run, he will stay in the industry because his profit is not negative (the price is above the break-even price). 5. Consider again Bob’s Blu-ray company described in Problem 3. a. Draw Bob’s marginal cost curve. b. Over what range of prices will Bob produce no Blu-rays in the short run? c. Draw Bob’s individual supply curve. In your graph, plot the price range from $0 to $60 in increments of $10. 5. a. Bob’s marginal cost curve is shown in the accompanying diagram. Cost of Blu-ray $60 MC 50 40 30 20 10 0 1 2 3 4 5 6 7 8 9 10 Quantity of Blu-rays (thousands) b. Bob will produce no Blu-rays if the price falls below $3 because $3 is the lowest point on the average variable cost curve—his shut-down price. c. The individual supply curve is shown in the accompanying diagram. It is his MC curve above the minimum average variable cost. At a price below $3, output is 0, shown by the solid vertical line at the origin. Price of Blu-ray $60 S 50 40 30 20 10 3 0 1 2 3 4 5 6 7 8 9 10 Quantity of Blu-rays (thousands) 6. a. A profit-maximizing business incurs an economic loss of $10,000 per year. Its fixed cost is $15,000 per year. Should it produce or shut down in the short run? Should it stay in the industry or exit in the long run? b. Suppose instead that this business has a fixed cost of $6,000 per year. Should it produce or shut down in the short run? Should it stay in the industry or exit in the long run? 6. a. In the short run, the business should produce. If it shuts down, the short-run annual loss will be $15,000, its fixed cost; but if it produces, the loss will be only $10,000. So the business minimizes its short-run loss by producing. In the long run, the business should exit the industry because it is incurring a loss. b. In the short run, the business should shut down. If it shuts down, the shortrun loss will be $6,000, its fixed cost; if it continues to produce, the loss will be $10,000. So the business minimizes its short-run loss by shutting down. In the long run, the firm should exit the industry because it is incurring a loss. 7. The first sushi restaurant opens in town. Initially people are very cautious about eating tiny portions of raw fish, as this is a town where large portions of grilled meat have always been popular. Soon, however, an influential health report warns consumers against grilled meat and suggests that they increase their consumption of fish, especially raw fish. The sushi restaurant becomes very popular and its profit increases. a. What will happen to the short-run profit of the sushi restaurant? What will happen to the number of sushi restaurants in town in the long run? Will the first sushi restaurant be able to sustain its short-run profit over the long run? Explain your answers. b. Local steakhouses suffer from the popularity of sushi and start incurring losses. What will happen to the number of steakhouses in town in the long run? Explain your answer. 7. a. The short-run profit of the sushi restaurant will rise, inducing others to open sushi restaurants. The number of sushi restaurants in town will increase. Over time, as the supply of sushi restaurants increases, the equilibrium price of sushi will decrease, lowering the short-run profit of the original sushi restaurant. b. The number of steakhouses in town will decrease in the long run, as owners incur losses and exit from the industry. 8. A perfectly competitive firm has the following short-run total cost: Quantity TC 0 $5 1 10 2 13 3 18 4 25 5 34 6 45 Market demand for the firm’s product is given by the following market demand schedule: Price Quantity demanded $12 300 10 500    8 800    6 1,200    4 1,800 a. Calculate this firm’s marginal cost and, for all output levels except zero, the firm’s average variable cost and average total cost. b. There are 100 firms in this industry that all have costs identical to those of this firm. Draw the short-run industry supply curve. In the same diagram, draw the market demand curve. c. What is the market price, and how much profit will each firm make? 8. a. This firm’s fixed cost is $5, since even when the firm produces no output, it incurs a total cost of $5. The marginal cost (MC), average variable cost (AVC), and average total cost (ATC) are given in the accompanying table. Quantity TC 0 $5.00 MC AVC ATC — — $5.00 $10.00 4.00 6.50 4.33 6.00 5.00 6.25 5.80 6.80 6.67 7.50 $5.00 1 10.00 3.00 2 13.00 5.00 3 18.00 7.00 4 25.00 9.00 5 34.00 11.00 6 45.00 b. This firm’s minimum average variable cost is $4 at 2 units of output. So the firm will produce only if the price is greater than $4, making its individual supply curve the same as its marginal cost curve above the shut-down price of $4. The same is true for all other firms in the industry. That is, if the price is $4, the quantity supplied by all 100 firms is 200. The quantity supplied by all 100 firms at a price of $6 is 300, and so on. The accompanying diagram illustrates this principle. Price $12 S 10 E 8 6 4 0 D 200 400 600 800 1,000 1,200 1,400 1,600 1,800 2,000 Quantity c. The quantity supplied equals the quantity demanded at a price of $10—the (short-run) market equilibrium price. So the quantity bought and sold in this market is 500 units. Each firm will maximize profit by producing 5 units of output—the greatest quantity at which price equals or exceeds marginal cost. At 5 units of output, each firm’s revenue is $10 × 5 = $50. Its total cost is $34. So it makes a profit of $16. 9. A new vaccine against a deadly disease has just been discovered. Presently, 55 people die from the disease each year. The new vaccine will save lives, but it is not completely safe. Some recipients of the shots will die from adverse reactions. The projected effects of the inoculation are given in the accompanying table: Percent of population inoculated Total deaths due to disease Total deaths due to inoculation 0 55 0 10 45 0 20 36 1 30 28 3 40 21 6 50 15 10 60 10 15 70 6 20 80 3 25 90 1 30 100 0 35 Marginal benefit of inoculation Marginal cost of inoculation “Profit” of inoculation — — — — — — — — — — — — — — — — — — — — — — — — — — — — — — a. What are the interpretations of “marginal benefit” and “marginal cost” here? Calculate marginal benefit and marginal cost per each 10% increase in the rate of inoculation. Write your answers in the table. b. What proportion of the population should optimally be inoculated? c. What is the interpretation of “profit” here? Calculate the profit for all levels of inoculation. 9. a. The “marginal benefit” is the additional lives saved due to inoculation. The “marginal cost” is the additional deaths due to inoculation. The values are given in the accompanying table. Percent of population inoculated Total deaths due to disease Total deaths due to inoculation    0 55 0 10 45 0 20 36 1 30 28 3 40 21 6 50 15 10 60 10 15 70 6 20 80 3 25 90 1 30 100 0 35 Marginal benefit of inoculation Marginal cost of inoculation 10 0 9 1 8 2 7 3 6 4 5 5 4 5 3 5 2 5 1 5 “Profit” of inoculation 0 10 − 0 = 10 19 − 1 = 18 27 − 3 = 24 34 − 6 = 28 40 − 10 = 30 45 − 15 = 30 49 − 20 = 29 52 − 25 = 27 54 − 30 = 24 55 − 35 = 20 b. People should be inoculated until the marginal cost equals the marginal benefit from the inoculations. This occurs when MB = MC = 5, at which point 50% or 60% of the population should be inoculated (both result in the greatest number of lives saved). c. “Profit” is total lives saved minus total lives lost. The profit at each level of inoculation in the population is shown in the table. The maximum number of lives saved is 30, which occurs at inoculation levels of both 50% and 60%. 10. Evaluate each of the following statements. If a statement is true, explain why; if it is false, identify the mistake and try to correct it. a. A profit-maximizing firm in a perfectly competitive industry should select the output level at which the difference between the market price and marginal cost is greatest. b. An increase in fixed cost lowers the profit-maximizing quantity of output produced in the short run. 10. a. False. For a profit-maximizing firm in a perfectly competitive industry, profit is maximized by producing a quantity at which marginal cost is equal to the market price. b. False. Changes in fixed cost do not affect marginal cost and so do not change the profit-maximizing quantity of output produced. Changes in fixed cost do, however, change the amount of profit earned and the firm’s break-even price: the higher the fixed cost, the higher the firm’s break-even price and the lower its profit. 11. The production of agricultural products like wheat is one of the few examples of a perfectly competitive industry. In this question, we analyze results from a study released by the U.S. Department of Agriculture about wheat production in the United States in 2016. a. The average variable cost per acre planted with wheat was $115 per acre. Assuming a yield of 44 bushels per acre, calculate the average variable cost per bushel of wheat. b. The average price of wheat received by a farmer in 2016 was $4.89 per bushel. Do you think the average farm would have exited the industry in the short run? Explain. c. With a yield of 44 bushels of wheat per acre, the average total cost per farm was $7.71 per bushel. The harvested acreage for wheat in the United States decreased from 48.8 million acres in 2013 to 43.9 million acres in 2016. Using the information on prices and costs here and in parts a and b, explain why this might have happened. d. Using the above information, what do you think will happen to wheat production and prices after 2016? 11. a. Since the yield is 44 bushels per acre, we know that producing 44 bushels of wheat is associated with an average variable cost of $115. So the production of 1 bushel of wheat is associated with an average variable cost of $115/44 bushels = $2.61 per bushel. b. We would not expect the average farm to have exited the industry in the short run because the price it received for wheat, $4.89 per bushel, was greater than the average variable cost of production, $2.61 per bushel. c. Because wheat production decreased over the period, we would expect the price from 2013 to 2016 to decrease below $7.71 per bushel, the average total cost of harvesting a bushel of wheat. The average farm would then decrease wheat production and farms will exit the industry in the long run because the price they receive per bushel is less than the average total cost of production. The farm would be experiencing an economic loss by operating. So the decrease in the harvested acreage of wheat should have been expected after 2013. Indeed the price of a bushel of wheat fell from $7.77 per acre in 2013 to $4.89 per acre in 2016. d. Assuming the cost of wheat production remains relatively constant, with current prices less than the average cost of production, we would expect more farmers to exit the wheat market or decrease their acreage of planted wheat. We should see the amount of harvested wheat decrease. 12. The accompanying table presents prices for washing and ironing a man’s shirt taken from a survey of California dry cleaners. Dry cleaner City Price A-1 Cleaners Santa Barbara $1.50 Regal Cleaners Santa Barbara 1.95 St. Paul Cleaners Santa Barbara 1.95 Zip Kleen Dry Cleaners Santa Barbara 1.95 Effie the Tailor Santa Barbara 2.00 Magnolia Too Goleta 2.00 Master Cleaners Santa Barbara 2.00 Santa Barbara Cleaners Goleta 2.00 Sunny Cleaners Santa Barbara 2.00 Casitas Cleaners Carpinteria 2.10 Rockwell Cleaners Carpinteria 2.10 Norvelle Bass Cleaners Santa Barbara 2.15 Ablitt’s Fine Cleaners Santa Barbara 2.25 California Cleaners Goleta 2.25 Justo the Tailor Santa Barbara 2.25 Pressed 4 Time Goleta 2.50 King’s Cleaners Goleta 2.50 a. What is the average price per shirt washed and ironed in Goleta? In Santa Barbara? b. Draw typical marginal cost and average total cost curves for California Cleaners in Goleta, assuming it is a perfectly competitive firm but is making a profit on each shirt in the short run. Mark the short-run equilibrium point and shade the area that corresponds to the profit made by the dry cleaner. c. Assume $2.25 is the short-run equilibrium price in Goleta. Draw a typical shortrun demand and supply curve for the market. Label the equilibrium point. d. Observing profits in the Goleta area, another dry cleaning service, Diamond Cleaners, enters the market. It charges $1.95 per shirt. What is the new average price of washing and ironing a shirt in Goleta? Illustrate the effect of entry on the average Goleta price by a shift of the short-run supply curve, the demand curve, or both. e. Assume that California Cleaners now charges the new average price and just breaks even (that is, makes zero economic profit) at this price. Show the likely effect of the entry on your diagram in part b. f. If the dry cleaning industry is perfectly competitive, what does the average difference in price between Goleta and Santa Barbara imply about costs in the two areas? 12. a. The average price per shirt washed and ironed, the sum of prices charged by each cleaner in that town divided by the number of cleaners in that town, is $2.25 in Goleta and $2.00 in Santa Barbara. b. The marginal cost curve (MC) cuts through the average total cost curve (ATC) at the lowest point of the ATC curve. Since California Cleaners is making a profit, price has to be above the break-even price (the minimum average total cost). Given this, California Cleaners maximizes its profit (shown by the shaded area) by producing quantity Q1 in the accompanying diagram—the quantity at which its marginal cost equals the market price. MC Price E1 $2.25 ATC Profit 0 Q1 Quantity c. The accompanying diagram shows the short-run market supply curve and the market demand curve. S1 Price EMKT $2.25 D 0 Q1MKT Quantity d. The entry of a new firm increases the quantity supplied at each price and shifts the supply curve to the right, as indicated by the move from S1 to S2 in the accompanying diagram. So the new equilibrium corresponds to a lower equilibrium price, $2.20, and a higher equilibrium quantity. S1 Price S2 EMKT $2.25 2.20 FMKT D 0 Q1MKT Q2MKT Quantity e. Since California Cleaners breaks even at $2.20 a shirt, it must be operating at the minimum of its average total cost curve. The likely effect on the diagram in part b is shown below. MC Price E1 $2.20 ATC E2 0 Q2 Quantity f. Since, in the long run, firms break even in a perfectly competitive industry, costs have to be higher in Goleta than in Santa Barbara. WORK IT OUT Interactive step-by-step help with solving this problem can be found online. 13. Kate’s Katering provides catered meals, and the catered meals industry is perfectly competitive. Kate’s machinery costs $100 per day and is the only fixed input. Her variable cost consists of the wages paid to the cooks and the food ingredients. The variable cost per day associated with each level of output is given in the accompanying table. Quantity of meals 0 VC $0 10 200 20 300 30 480 40 700 50 1,000 a. Calculate the total cost, the average variable cost, the average total cost, and the marginal cost for each quantity of output. b. What is the break-even price and quantity? What is the shut-down price and quantity? c. Suppose that the price at which Kate can sell catered meals is $21 per meal. In the short run, will Kate earn a profit? In the short run, should she produce or shut down? d. Suppose that the price at which Kate can sell catered meals is $17 per meal. In the short run, will Kate earn a profit? In the short run, should she produce or shut down? e. Suppose that the price at which Kate can sell catered meals is $13 per meal. In the short run, will Kate earn a profit? In the short run, should she produce or shut down? 13. a. From Kate’s variable cost (VC), the accompanying table calculates Kate’s total cost (TC), average variable cost (AVC), average total cost (ATC), and marginal cost (MC). Quantity of meals 0 VC $0.00 TC MC of meal $100.00 AVC of meal ATC of meal — — $20.00 $30.00 15.00 20.00 16.00 19.33 17.50 20.00 20.00 22.00 $20.00 10 200.00 300.00 10.00 20 300.00 400.00 18.00 30 480.00 580.00 22.00 40 700.00 800.00 30.00 50 1,000.00 1,100.00 b. Kate’s break-even price, the minimum average total cost, is $19.33, at an output quantity of 30 meals. Kate’s shut-down price, the minimum average variable cost, is $15, at an output of 20 meals. c. When the price is $21, Kate will make a profit: the price is above her breakeven price. And since the price is above her shut-down price, Kate should produce in the short run, not shut down. d. When the price is $17, Kate will incur a loss: the price is below her break-even price. But since the price is above her shut-down price, Kate should produce in the short run, not shut down. e. When the price is $13, Kate would incur a loss if she were to produce: the price is below her break-even price. And since the price is also below her shutdown price, Kate should shut down in the short run. Monopoly Chapter 1. Each of the following firms possesses market power. Explain its source. a. Merck, the producer of the patented cholesterol-lowering drug Zetia b. WaterWorks, a provider of piped water c. Chiquita, a supplier of bananas and owner of most banana plantations d. The Walt Disney Company, the creators of Mickey Mouse 1. a. Merck has a patent for Zetia. This is an example of a government-created ­barrier to entry, which gives Merck market power. b. There are increasing returns to scale in the provision of piped water. There is a large fixed cost associated with building a network of water pipes to each household; the more water delivered, the lower its average total cost becomes. This gives WaterWorks a cost advantage over other companies, which gives WaterWorks market power. c. Chiquita controls most banana plantations. Control over a scarce resource gives Chiquita market power. d. The Walt Disney Company has the copyright on animations featuring Mickey Mouse. This is another example of a government-created barrier to entry that gives the Walt Disney Company market power. 2. Skyscraper City has a subway system, for which a one-way fare is $1.50. There is pressure on the mayor to reduce the fare by one-third, to $1.00. The mayor is dismayed, thinking that this will mean Skyscraper City is losing one-third of its revenue from sales of subway tickets. The mayor’s economic adviser reminds her that she is focusing only on the price effect and ignoring the quantity effect. Explain why the mayor’s estimate of a one-third loss of revenue is likely to be an overestimate. Illustrate with a diagram. 2. A reduction in fares from $1.50 to $1.00 will reduce the revenue on each ticket that is currently sold by one-third; this is the price effect. But a reduction in price will lead to more tickets being sold at the lower price of $1.00, which ­creates additional revenue; this is the quantity effect. The accompanying ­diagram illustrates this. Price of ticket $1.50 Price effect Quantity effect 1.00 D 0 Quantity of tickets The price effect is the loss of revenue on all the currently sold tickets. The quantity effect is the increase in revenue from increased sales as a result of the lower price. 13 3. Bob, Bill, Ben, and Brad Baxter have just made a documentary movie about their basketball team. They are thinking about making the movie available for download on the internet, and they can act as a single-price monopolist if they choose to. Each time the movie is downloaded, their internet service provider charges them a fee of $4. The Baxter brothers are arguing about which price to charge customers per download. The accompanying table shows the demand schedule for their film. Price of download Quantity of downloads demanded $10 0 8 1 6 3 4 6 2 10 0 15 a. Calculate the total revenue and the marginal revenue per download. b. Bob is proud of the film and wants as many people as possible to download it. Which price would he choose? How many downloads would be sold? c. Bill wants as much total revenue as possible. Which price would he choose? How many downloads would be sold? d. Ben wants to maximize profit. Which price would he choose? How many downloads would be sold? e. Brad wants to charge the efficient price. Which price would he choose? How many downloads would be sold? 3. a. The accompanying table calculates total revenue (TR) and marginal revenue (MR). Recall that marginal revenue is the additional revenue per unit of output, that is, ∆TR/∆Q. Price of download Quantity of downloads demanded TR $10 0 $0 8 1 8 6 3 18 4 6 24 2 10 20 0 15 0 MR $8 5 2 -1 -4 b. Bob would charge $0. At that price, there would be 15 downloads, the largest quantity they can sell. c. Bill would charge $4. At that price, total revenue is greatest ($24). At that price, there would be 6 downloads. d. Ben would charge $6. At that price, there would be 3 downloads. For any more downloads, marginal revenue would be below marginal cost, and so further downloads would lose the Baxters’ money. e. Brad would charge $4. A price equal to marginal cost is efficient. At that price, there would be 6 downloads. 4. Mateo’s room overlooks, from some distance, a major league baseball stadium. He decides to rent a telescope for $50.00 a week and charge his friends and classmates to use it to peep at the game for 30 seconds. He can act as a single-price monopolist for renting out “peeps.” For each person who takes a 30-second peep, it costs Mateo $0.20 to clean the eyepiece. The accompanying table shows the information Mateo has gathered about the demand for the service in a given week. Price of peep Quantity of peeps demanded $1.20 0 1.00 100 0.90 150 0.80 200 0.70 250 0.60 300 0.50 350 0.40 400 0.30 450 0.20 500 0.10 550 a. For each price in the table, calculate the total revenue from selling peeps and the marginal revenue per peep. b. At what quantity will Mateo’s profit be maximized? What price will he charge? What will his total profit be? c. Mateo’s landlady complains about all the visitors coming into the building and tells him to stop selling peeps. But, if he pays her $0.20 for every peep he sells, she won’t complain. What effect does the $0.20-per-peep bribe have on Mateo’s marginal cost per peep? What is the new profit-maximizing quantity of peeps? What effect does the $0.20-per-peep bribe have on Mateo’s total profit? 4. a. Total revenue (TR) and marginal revenue (MR) are given in the accompanying table. Price of peep Quantity of peeps demanded TR $1.20 0 $0 1.00 100 100 0.90 150 135 0.80 200 160 0.70 250 175 0.60 300 180 0.50 350 175 0.40 400 160 0.30 450 135 0.20 500 100 0.10 550 55 MR $1.00 0.70 0.50 0.30 0.10 -0.10 -0.30 -0.50 -0.70 -0.90 b. Mateo’s profit will be maximized when he sells 250 peeps, since for the first 250 peeps his marginal revenue exceeds his marginal cost of $0.20. He will charge $0.70 per peep. His total profit is (250 × $0.70) − (250 × $0.20) − $50.00 = $75.00. c. When Mateo pays the landlady $0.20 per peep, his marginal cost increases to $0.40 per peep, so the profit-maximizing quantity decreases to 200 and the profit-maximizing price increases to $0.80. His total profit will now be (200 × $0.80) − (200 × $0.40) − $50.00 = $30.00. 5. Suppose that De Beers is a single-price monopolist in the market for diamonds. De Beers has five potential customers: Raquel, Jackie, Joan, Mia, and Sophia. Each of these customers will buy at most one diamond—and only if the price is just equal to, or lower than, her willingness to pay. Raquel’s willingness to pay is $400; Jackie’s, $300; Joan’s, $200; Mia’s, $100; and Sophia’s, $0. De Beers’s marginal cost per diamond is $100. This leads to the demand schedule for diamonds shown in the accompanying table. Price of diamond Quantity of diamonds demanded $500 0 400 1 300 2 200 3 100 4 0 5 a. Calculate De Beers’s total revenue and its marginal revenue. From your calculation, draw the demand curve and the marginal revenue curve. b. Explain why De Beers faces a downward-sloping demand curve and why the marginal revenue from an additional diamond sale is less than the price of the diamond. c. Suppose De Beers currently charges $200 for its diamonds. If it lowers the price to $100, how large is the price effect? How large is the quantity effect? d. Add the marginal cost curve to your diagram from part a and determine which quantity maximizes De Beers’s profit and which price De Beers will charge. 5. a. Total revenue (TR) and marginal revenue (MR) are given in the accompanying table. Price of diamond Quantity of diamonds demanded TR $500 0 $0 400 1 400 300 2 600 200 3 600 100 4 400 0 5 0 MR $400 200 0 −200 −400 The accompanying diagram illustrates De Beers’s demand curve and marginal revenue (MR) curve. Price of diamond $500 400 300 200 100 0 –100 D 1 2 MR 3 4 MC 5 Quantity of diamonds b. De Beers is the only producer of diamonds, so its demand curve is the market demand curve. And the market demand curve slopes downward: the lower the price, the more customers will buy diamonds. If De Beers lowers the price sufficiently to sell one more diamond, it earns extra revenue equal to the price of that one extra diamond. This is the quantity effect of lowering the price. But there is also a price effect: lowering the price means that De Beers also has to lower the price on all other diamonds, and that lowers its revenue. So the marginal revenue of selling an additional diamond is less than the price at which the additional diamond can be sold. c. If the price is $200, then De Beers sells to Raquel, Jackie, and Joan. If it ­lowers the price to $100, it will also sell a diamond to Mia. The price effect is that De Beers loses $100 (the amount by which it lowered the price) each from selling to Raquel, Jackie, and Joan. So the price effect lowers De Beers’s revenue by 3 × $100 = $300. The quantity effect is that De Beers sells one more diamond (to Mia), at $100. So the quantity effect is to raise De Beers’s revenue by $100. d. The marginal cost (MC) curve is constant at $100, as shown in the diagram. Marginal revenue equals marginal cost at a quantity of 2 diamonds. So De Beers will sell 2 diamonds at a price of $300 each. 6. Use the demand schedule for diamonds given in Problem 5. The marginal cost of producing diamonds is constant at $100. There is no fixed cost. a. If De Beers charges the monopoly price, how large is the individual consumer surplus that each buyer experiences? Calculate total consumer surplus by summing the individual consumer surpluses. How large is producer surplus? Suppose that upstart Russian and Asian producers enter the market and it becomes perfectly competitive. b. What is the perfectly competitive price? What quantity will be sold in this perfectly competitive market? c. At the competitive price and quantity, how large is the consumer surplus that each buyer experiences? How large is total consumer surplus? How large is producer surplus? d. Compare your answer to part c to your answer to part a. How large is the deadweight loss associated with monopoly in this case? 6. a. The monopoly price is $300. At that price Raquel and Jackie buy diamonds. Raquel’s consumer surplus is $400 − $300 = $100; Jackie’s is $300 − $300 = $0. So total consumer surplus is $100 + $0 = $100. Producer surplus is $300 − $100 = $200 for each diamond sold; 2 × $200 = $400. b. In a perfectly competitive market, P = MC. That is, the perfectly competitive price is $100, and at that price 4 diamonds will be sold—to Raquel, Jackie, Joan, and Mia. c. At the competitive price, Raquel’s consumer surplus is $400 − $100 = $300; Jackie’s, $300 − $100 = $200; Joan’s, $200 − $100 = $100; and Mia’s, $100 − $100 = $0. So total consumer surplus is $300 + $200 + $100 + $0 = $600. Since the price is equal to marginal cost, there is no producer surplus. d. Under perfect competition, the sum of consumer and producer surplus is $600 + $0 = $600. Under monopoly, the sum of consumer and producer surplus is $100 + $400 = $500. So the loss of surplus to society from monopoly— the deadweight loss—is $600 − $500 = $100. 7. Use the demand schedule for diamonds given in Problem 5. De Beers is a monopolist, but it can now price-discriminate perfectly among all five of its potential customers. De Beers’s marginal cost is constant at $100. There is no fixed cost. a. If De Beers can price-discriminate perfectly, to which customers will it sell diamonds and at what prices? b. How large is each individual consumer surplus? How large is total consumer surplus? Calculate producer surplus by summing the producer surplus generated by each sale. 7. a. If De Beers can price-discriminate perfectly, it will charge each customer that customer’s willingness to pay. That is, it will charge Raquel $400, Jackie $300, Joan $200, and Mia $100. De Beers does not want to sell to Sophia since she will only buy at a price of $0, and that would be below De Beers’s marginal cost. b. Since each consumer is charged exactly her willingness to pay, there is no consumer surplus. De Beers’s producer surplus is $400 − $100 = $300 from selling to Raquel; $300 − $100 = $200 from selling to Jackie; $200 − $100 = $100 from selling to Joan; $100 − $100 = $0 from selling to Mia. So producer surplus is $300 + $200 + $100 + $0 = $600. 8. Download Records decides to release an album by the group Mary and the Little Lamb. It produces the album with no fixed cost, but the total cost of creating a digital album and paying Mary her royalty is $6 per album. Download Records can act as a single-price monopolist. Its marketing division finds that the demand schedule for the album is as shown in the accompanying table. Price of album $22 Quantity of albums demanded 0 20 1,000 18 2,000 16 3,000 14 4,000 12 5,000 10 6,000 8 7,000 a. Calculate the total revenue and the marginal revenue per album. b. The marginal cost of producing each album is constant at $6. To maximize profit, what level of output should Download Records choose, and which price should it charge for each album? c. Mary renegotiates her contract and will be paid a higher royalty per album. So the marginal cost rises to be constant at $14. To maximize profit, what level of output should Download Records now choose, and which price should it charge for each album? 8. a. Total revenue (TR) and marginal revenue per album (MR) is shown in the accompanying table. Quantity of albums demanded Price of album TR $22 0 $0 20 1,000 20,000 18 2,000 36,000 16 3,000 48,000 14 4,000 56,000 12 5,000 60,000 10 6,000 60,000 8 7,000 56,000 MR $20 16 12 8 4 0 −4 b. If the marginal cost of each album is $6, Download Records will maximize profit by producing 4,000 albums, since for each album up to 4,000, marginal revenue is greater than marginal cost. For any further albums, marginal cost would exceed marginal revenue. Producing 4,000 albums, Download Records will charge $14 for each album. c. If the marginal cost of each album is $14, Download Records will maximize profit by producing 2,000 albums, and it will charge $18 per album. 9. This diagram illustrates your local electricity company’s natural monopoly. It shows the demand curve for kilowatt-hours (kWh) of electricity, the company’s marginal revenue (MR) curve, its marginal cost (MC) curve, and its average total cost (ATC) curve. The government wants to regulate the monopolist by imposing a price ceiling. Price of kWh $1.30 0.80 0.50 0.40 0.30 ATC MC MR 0 D 13 5 8 10 Quantity of kWh (thousands) a. If the government does not regulate this monopolist, which price will it charge? Illustrate the inefficiency this creates by shading the deadweight loss from monopoly. b. If the government imposes a price ceiling equal to the marginal cost, $0.30, will the monopolist make profits or lose money? Shade the area of profit (or loss) for the monopolist. If the government does impose this price ceiling, do you think the firm will continue to produce in the long run? c. If the government imposes a price ceiling of $0.50, will the monopolist make a profit, lose money, or break even? 9. a. The monopolist would choose a price of $0.80. Deadweight loss is shaded and labeled in the accompanying figure. Price of kWh $1.30 Deadweight loss 0.80 0.50 0.40 0.30 ATC MC MR 0 D 13 5 8 10 Quantity of kWh (thousands) b. If the government imposes a price ceiling of $0.30, the quantity demanded is 10,000. The monopolist will incur a loss equal to the shaded rectangle in the accompanying figure. Since the firm is incurring a loss, in the long run it will exit the market. Price of kWh $1.30 0.80 0.50 0.40 0.30 ATC MC MR 0 D 13 5 8 10 Quantity of kWh (thousands) c. If the government imposes a price ceiling of $0.50, the quantity demanded is 8,000. The price equals the monopolist’s average total cost, and so the firm will make zero profit. 10. The Collegetown movie theater serves 900 students and 100 professors in town. Each student’s willingness to pay for a movie ticket is $5. Each professor’s willingness to pay for a movie ticket is $10. Each will buy only one ticket. The movie theater’s marginal cost per ticket is constant at $3, and there is no fixed cost. a. Suppose the movie theater cannot price-discriminate and charges both students and professors the same price per ticket. If the movie theater charges $5, who will buy tickets and what will the movie theater’s profit be? How large is consumer surplus? b. If the movie theater charges $10, who will buy movie tickets and what will the movie theater’s profit be? How large is consumer surplus? c. Now suppose that, if it chooses to, the movie theater can price-discriminate between students and professors by requiring students to show their student ID. If the movie theater charges students $5 and professors $10, how much profit will the movie theater make? How large is consumer surplus? 10. a. If the movie theater charges $5 per ticket, both students and professors will buy tickets. The movie theater will sell to 1,000 customers (students and professors), at a price of $5 each. Since the movie theater’s cost per ticket is $3, its profit is $2 per ticket for a total profit of 1,000 × $2 = $2,000. Students will experience no consumer surplus, but each of the 100 professors will experience consumer surplus of $10 − $5 = $5 for a total consumer surplus of 100 × $5 = $500. b. If the movie theater charges $10 per ticket, only professors will buy tickets. The movie theater will sell to 100 customers (professors) at a price of $10 each. Since the movie theater’s cost per ticket is $3, its profit is $7 per ticket for a total profit of 100 × $7 = $700. Students experience no consumer surplus since they do not buy any tickets. Each of the 100 professors experiences no consumer surplus since the price is equal to their willingness to pay. So consumer surplus is $0. c. If the movie theater charges students a price of $5, it sells 900 tickets at a profit of $5 − $3 = $2 each for a profit from selling to students of 900 × $2 = $1,800. Charging professors $10, it sells 100 tickets at a profit of $10 − $3 = $7 each for a profit from selling to professors of 100 × $7 = $700. So the theater’s total profit is $1,800 + $700 = $2,500. Since each customer is charged exactly his or her willingness to pay, there is no consumer surplus. 11. A monopolist knows that in order to expand the quantity of output it produces from 8 to 9 units it must lower the price of its output from $2 to $1. Calculate the quantity effect and the price effect. Use these results to calculate the monopolist’s marginal revenue of producing the 9th unit. The marginal cost of producing the 9th unit is positive. Is it a good idea for the monopolist to produce the 9th unit? 11. The quantity effect is $1 (the increase in total revenue from selling the 9th unit at $1). The price effect is 8 × (−$1) = −$8 (the decrease in total revenue from having to lower the price of 8 units by $1 each). So the marginal revenue of producing the 9th unit is $1 − $8 = −$7. Since marginal revenue is negative, producing the 9th unit is definitely not a good idea: it lowers revenue (since marginal revenue is negative) and increases the total cost (since marginal cost is positive). So it will definitely lower profit. Instead, the monopolist should produce less output. 12. In the United States, the Federal Trade Commission (FTC) is charged with promoting competition and challenging mergers that would likely lead to higher prices. Several years ago, Staples and Office Depot, two of the largest office supply superstores, announced their agreement to merge. a. Some critics of the merger argued that, in many parts of the country, a merger between the two companies would create a monopoly in the office supply superstore market. Based on the FTC’s argument and its mission to challenge mergers that would likely lead to higher prices, do you think it allowed the merger? b. Staples and Office Depot argued that, while in some parts of the country they might create a monopoly in the office supply superstore market, the FTC should consider the larger market for all office supplies, which includes many smaller stores that sell office supplies (such as grocery stores and other retailers). In that market, Staples and Office Depot would face competition from many other, smaller stores. If the market for all office supplies is the relevant market that the FTC should consider, would it make the FTC more or less likely to allow the merger? 12. a. If Staples and Office Depot create a monopoly, they will be able to reduce the quantity of output and raise prices, which would create inefficiency in the form of deadweight loss. Since the FTC is charged with challenging mergers that would likely lead to higher prices, you should think that the FTC would not allow this merger. And, in fact, in a court ruling in 1997, the FTC was able to prevent the merger. b. If the relevant market is the market for all office supplies, the merger between Staples and Office Depot would not create a monopoly, and the companies would not be able to raise prices to the same extent. If this were the relevant market, it would make the FTC more likely to allow the merger. This illustrates the importance of what economists call “market definition”—deciding what the correct market is: in this example, the office supply superstore ­market or the market for all office supplies. 13. Prior to the late 1990s, the same company that generated your electricity also distributed it to you over high-voltage lines. Since then, 16 states and the District of Columbia have begun separating the generation from the distribution of electricity, allowing competition between electricity generators and between electricity distributors. a. Assume that the market for electricity distribution was and remains a natural monopoly. Use a graph to illustrate the market for electricity distribution if the government sets price equal to average total cost. b. Assume that deregulation of electricity generation creates a perfectly competitive market. Also assume that electricity generation does not exhibit the characteristics of a natural monopoly. Use a graph to illustrate the cost curves in the long-run equilibrium for an individual firm in this industry. 13. a. The market for electricity distribution is shown in panel (a) of the accompanying diagram. Electricity distribution has the characteristics of a natural monopoly: the large fixed cost of building the electric grid, combined with the low marginal cost of routing electricity over the grid, give this industry increasing returns to scale over the relevant output range. If the government sets the price equal to average total cost, at PR* , the natural monopolist will produce quantity QR* . In this case, the monopolist will make zero economic profit. b. The cost curves of an individual electricity generator are shown in panel (b). Since the market is perfectly competitive, in the long run, price, PC , will be equal to minimum average total cost, and the individual generator will produce electricity at the quantity QC , where marginal cost is just equal to the market price. (a) Regulated Natural Monopolist Price, cost (b) Perfectly Competitive Firm Price, cost MC PR* ATC D QR* Quantity ATC MR PC QC Quantity 14. Explain the following situations. a. In Europe, many cell phone service providers give away for free what would otherwise be very expensive cell phones when a service contract is purchased. Why might a company want to do that? b. In the United Kingdom, the country’s antitrust authority prohibited the cell phone service provider Vodafone from offering a plan that gave customers free calls to other Vodafone customers. Why might Vodafone have wanted to offer these calls for free? Why might a government want to step in and ban this practice? Why might it not be a good idea for a government to interfere in this way? 14. a. Cell phone service is a good characterized by network externalities: the more people you can reach while they are away from their fixed-line phones, the greater your utility from having a phone that allows you to reach others when you are also away from your fixed-line phone. This is an industry that exhibits positive feedback: once the market reaches critical mass, the number of cell phones in use increases rapidly. So if a company gives away phones for free (or below cost), it can attract more customers and the market reaches critical mass more quickly. b. By offering free calls to other Vodafone subscribers, the company was attempting to tip the market and attract customers to its service. This can be seen as an anticompetitive practice that leads to monopolization, which is why a government might want to ban the practice. However, banning Vodafone from creating and exploiting its monopoly position might stifle the company’s incentive to innovate and invent new services. 15. In 2014, Time Warner and Comcast announced their intention to merge. This prompted questions of monopoly because the combined company would supply cable access to an overwhelming majority of Americans. It also raised questions of monopsony since the combined company would be virtually the only purchaser of programming for broadcast shows. Although the merger was ultimately disallowed, assume that it had occurred. In each of the following, determine whether it is evidence of monopoly, monopsony, or neither. a. The monthly cable fee for consumers increases significantly more than the increase in the cost of producing and delivering programs over cable. b. Companies that advertise on cable TV find that they must pay higher rates for advertising. c. Companies that produce broadcast shows find they must produce more shows for the same amount they were paid before. d. Consumers find that there are more shows available for the same monthly cable fee. 15. a. This is evidence of monopoly power by the combined cable company. It is capturing surplus from consumers by raising prices higher than an increase in the cost of production. b. This is evidence of monopoly power by the combined cable company. Companies that purchase cable advertising are consumers of cable airtime. They are losing surplus by being forced to pay higher prices. c. This is evidence of monopsony power by the combined cable company. The production companies have only one buyer of their goods, the combined cable company. The cable company is capturing surplus by paying the production company a lower price per show. d. This is evidence of neither monopoly or monopsony. Consumers are enjoying more surplus because there is more product available for the same price. 16. Walmart is the world’s largest retailer. As a consequence, it has sufficient ­bargaining power to push its suppliers to lower their prices so it can honor its ­slogan of “Save Money—Live Better” for its customers. a. Is Walmart acting like a monopolist or monopsonist when purchasing goods from suppliers? Explain. b. How does Walmart affect the consumer surplus of its customers? The producer surplus of its suppliers? c. Over time, what is likely to happen to the quality of products produced by Walmart suppliers? 16. a. Walmart is acting like a monopsonist. It behaves like a sole buyer with its ­suppliers, compelling them to lower their prices to Walmart. b. Walmart increases the consumer surplus to its customers because they are able to purchase goods at lower prices. It lowers the producer surplus going to its suppliers as they are required to sell at a lower price. c. Over time, the quality of products produced by Walmart suppliers is likely to decline as the suppliers are getting insufficient surplus to maintain quality. 17. For people with life-threatening allergies, carrying a device that can automatically inject epinephrine (called an autoinjector) is a necessity. In the summer of 2016, Mylan, the maker of the widely used autoinjector EpiPen, found itself with a virtual monopoly. A year earlier its primary competitor, Auvi-Q, had its product recalled amid fears that it would malfunction and deliver the wrong dose. In addition, the FDA denied the drug producer, Teva, from releasing a generic autoinjector. Prior to these events, a two-pack EpiPen sold for approximately $100. But during that summer, Mylan raised the price to over $600 per pack, leading to extensive news coverage, popular online petitions, and outrage on the part of consumers. Mylan countered that many consumers received their EpiPens through their medical insurance, hence they were protected from the price increase. For those who didn’t have insurance coverage and had to pay the full price, Mylan offered a $300 savings card. a. Draw a graph that shows consumer and producer surplus in a competitive market for epinephrine autoinjectors. Assume firms have a constant marginal cost of $100 per pack. b. Next, using that graph, show how much consumer surplus, producer surplus, and deadweight loss change after the Auvi-Q recall and the denied entry of Teva by the FDA. c. How is the savings card offered to those without insurance an example of price discrimination? (Hint: patients who are covered by medical insurance are like consumers who have high incomes and can therefore afford to pay full price.) Draw a graph showing how consumer and producer surplus will change under the savings card program. 17. a. The accompanying diagram illustrates the competitive market for epinephrine autoinjectors. With a constant marginal cost, firms will supply QC autoinjectors, where marginal cost intersects demand. Consumer surplus is equal to the blue shaded area above the marginal cost line and below the demand line. Since price is set equal to marginal cost, firms will have zero producer surplus. Price, cost of autoinjector $100 MC D Q C Quantity of autoinjectors b. As Mylan is able to capture most of the market, the company will have a downward sloping marginal revenue line. This is seen in the accompanying diagram. As a result, Mylan will reduce quantity to QM and increase price to $600 per pack. A higher price and lower quantity will cause consumer surplus to decrease, seen in the blue shaded area. Producer surplus will be the green-shaded area below the price of $600 and above the marginal cost line of $100 or ($600 − $100) × QM. Because the monopoly prevents mutually beneficial transactions from occurring, a portion of consumer surplus from the competitive market turns into deadweight loss for the monopoly, the yellow shaded area. Price, cost, marginal revenue of EpiPens $600 MC 100 D MR QM Quantity of EpiPens c. The savings card allows Mylan the ability to charge lower income families a lower price. Mylan is price discriminating because they are charging two prices for the same product. The accompanying graph shows how consumer and producer surplus change under the two-part pricing system. At a price of $600 per pack, only high income families were able to purchase an EpiPen, and consumer and producer surplus is the same as part b. With a savings card specifically given to lower income families, at a price of $300 consumer surplus increases by the area shaded blue and producer surplus increases by the area shaded green. The increase in sales reduces deadweight loss, as more mutually beneficial transactions occur. Price, cost of EpiPens Consumer surplus with the savings card Producer surplus with the savings card $600 300 MC 100 D QM Q SC QC Quantity of EpiPens WORK IT OUT Interactive step-by-step help with solving this problem can be found online. 18. Consider an industry with the demand curve (D) and marginal cost curve (MC) shown in the accompanying diagram. There is no fixed cost. If the industry is a single-price monopoly, the monopolist’s marginal revenue curve would be MR. Answer the following questions by naming the appropriate points or areas. Price A B C E J K N H L R F G I M O S MC D T Quantity MR a. If the industry is perfectly competitive, what will be the total quantity produced? At what price? b. Which area reflects consumer surplus under perfect competition? c. If the industry is a single-price monopoly, what quantity will the monopolist produce? Which price will it charge? d. Which area reflects the single-price monopolist’s profit? e. Which area reflects consumer surplus under single-price monopoly? f. Which area reflects the deadweight loss to society from single-price monopoly? g. If the monopolist can price-discriminate perfectly, what quantity will the perfectly price-discriminating monopolist produce? 18. a. In a perfectly competitive industry, each firm maximizes profit by producing the quantity at which price equals marginal cost. That is, all firms together produce the quantity S, corresponding to point R, where the marginal cost curve crosses the demand curve. Price will be equal to marginal cost, E. b. Consumer surplus is the area under the demand curve and above price. In part a, we saw that the perfectly competitive price is E. Consumer surplus in perfect competition is therefore the triangle ARE. c. A single-price monopolist produces the quantity at which marginal cost equals marginal revenue, that is, quantity I. Accordingly, the monopolist charges price B, the highest price it can charge if it wants to sell quantity I. d. The single-price monopolist’s profit per unit is the difference between price and the average total cost. Since there is no fixed cost and the marginal cost is constant (each unit costs the same to produce), the marginal cost is the same as the average total cost. That is, profit per unit is the distance BE. Since the monopolist sells I units, its profit is BE times I, or the rectangle BEHF. e. Consumer surplus is the area under the demand curve and above the price. In part c, we saw that the monopoly price is B. Consumer surplus in monopoly is therefore the triangle AFB. f. Deadweight loss is the surplus that would have been available (either to consumers or producers) under perfect competition but that is lost when there is a single-price monopolist. It is the triangle FRH. g. If a monopolist can price-discriminate perfectly, it will sell the first unit at price A, the second unit at a slightly lower price, and so forth. That is, it will extract from each consumer just that consumer’s willingness to pay, as indicated by the demand curve. It will sell S units, because for the last unit, it can just make a consumer pay a price of E (equal to its marginal cost), and that just covers its marginal cost of producing that last unit. For any further units, it could not make any consumer pay more than its marginal cost, and it therefore stops selling units at quantity Solution Manual for Microeconomics Paul Krugman, Robin Wells 9781319098780