Part II/Solutions

PART II
SOLUTIONS
CHAPTER 1
WHAT IS ECONOMICS?
DISCUSSION QUESTIONS
1. Think about a way you would construct a model of how your college is governed. Which
officers and administrators would you include and exclude from your model if the
objective were one of the following:
a. To explain how decisions on financial aid are made
b. To explain the quality of the faculty
Relate this to the map example in the chapter.
This question is designed to make students construct their own version of the map
example. A good answer is one in which (i) the people who are principally involved in
the decision are identified, (ii) the flow of information and persuasion between those
people is outlined and (iii) extraneous detail is eliminated. The “model” is likely to be
quite different for part (a) and part (b). Thus decisions on financial aid may depend upon
the trustees, who set overall policy and attempt to raise funds; the president, who
allocates the college budget; the admissions office, which determines what portion of
each class is financially needy; and the counselors in the financial aid office, who make
decisions about individual cases. Information about policy flows from the top of the
bureaucratic hierarchy, and information about need from the bottom. In part (b), faculty
quality may be determined by the trustees, who may be responsible for setting salary
levels; the president or dean, who must agree to each faculty appointment and promotion;
and the faculty committees in each department and division, that search for potential
appointees. Instructors who assign this question may be amazed at the image of their
institution’s structure held by the students.

2. Relate the process of abstraction to the way you take notes in a lecture. Why do you not
try to transcribe every word uttered by the lecturer? Why don’t you write down just the
title of the lecture and stop there? How do you decide, roughly speaking, on the correct
amount of detail?
Most students are familiar with the need to abstract from detail, and take notes only about
the essential points. The student will want enough detail to be able to reconstruct the
instructor’s argument, but not so much detail as to obscure the main point. It is unlikely
that simply writing down the title of the lecture will enable the student to recall the main
arguments at a later date. The choices of how much detail, and what particular detail, are
similar to the choices an economist makes in thinking about a problem, that is to say, in
constructing a model. [This is a good opportunity to discuss note-taking with the
students. While most understand the basic idea, few are skilled at it. Take a look at a few
students’ lecture notes, and ask whether you would be comfortable learning economics
from those notes.]

3. Explain why a government policy maker cannot afford to ignore economic theory.
 Without theory, an economist (or anyone else) can only assemble facts, but she cannot
understand the relationship between those facts, in particular the cause-and-effect
relationships. For example, a person who ignores theory can notice that average prices
sometimes rise a short time after the country’s money supply increases, but has no way of
knowing whether there is a causal relationship between those two phenomena, or whether
they are just coincidences. A government policy maker who wants to change something
in the country only has a few policy “tools” to use, and so she must have a theory to
indicate to her whether changing one of those tools is likely to have the desired result in
the country.

APPENDIX—USING GRAPHS: A REVIEW

TEST YOURSELF
1. Portray the following hypothetical data on a two variable diagram:
Academic Year Total Enrollment Enrollment in
Economics Courses
2008–2009 3,000 300
2009–2010 3,100 325
2010–2011 3,200 350
2011–2012 3,300 375
2012–2013 3,400 400

Measure the slope of the resulting line, and explain what this number means

Slope is 100 interpreted as 100 new students each academic year.

Slope is 25 interpreted as 25 new economics students each academic year.

2. From Figure 5, calculate the slope of the curve at point M.

Slope is 0.
3. Colin believes that the number of job offers he will get depends on the number of
courses in which his grade is B+ or better. He concludes from observation that the
following figures are typical:
 Number of grades of B+ 0 1 2 3 4
or better
Number of job offers 1 3 4 5 6

Put these numbers into a graph like Figure 1(a). Measure and interpret the slopes between
adjacent dots.

A marginal increase in the number of job offers is relatively larger with the first good
grade compared to additional good grades.

4. In Figure 6, determine the values of X and Y at point K and at point E . What do you
conclude about the slopes of the lines on which K and E are located?

K = (2,2); E = (2,1)
The slope of 1 for the line on which K is located indicates that this is the steeper of the
two curves. On this curve, the variable on the vertical axis responds more significantly to
a change in the variable on the horizontal axis.

5. In Figure 8, interpret the economic meaning of points A and B. What do the two
points have in common? What is the difference in their economic interpretation?

A => 30 hours labor and 40 yds. cloth = 20 units of output.

B => 40 hours labor and 28 yds. cloth = 20 units of output.
Common: 20 units of output; Difference: Amount of labor and cloth charge—more labor,
less cloth.
CHAPTER 2
THE ECONOMY: MYTH AND REALITY
DISCUSSION QUESTIONS
1. Which is the biggest national economy on earth? Why has it remained bigger than
other countries with much larger labor forces or those with higher per capita
incomes?
The United States is the country with the largest economy in the world. The relatively
large population in the U.S. is a contributing factor but productivity of workers and
accumulated wealth are significant reasons why the U.S. economy is so large.
2. What is meant by a “factor of production”? Have you ever sold any on a market?
A factor of production, or input, is something that is used to produce a finished good
known as “output.” There are several possible answers, but probably most students have
been employed in some capacity (babysitter, paperboy, or a campus job), so they have
sold their labor in the market to produce output.
3. Why do you think per capita income in Connecticut is nearly double that in New
Mexico?
There are several possible answers to this question—the question is designed to get
students to think about these differences before using models. One straightforward
answer is that the factors of production in Connecticut produce output that is worth more
than what is produced in New Mexico. This could be because labor is more productive in
Connecticut because of a better educated workforce. Another answer is that the cost of
living is higher in Connecticut than it is in New Mexico.
4. Roughly speaking, what fraction of U.S. labor works in factories? In service
businesses? In government?
Roughly 14 percent produce goods, 70 percent are service workers, and approximately 16
percent work in federal, state, and local government.
5. Most American businesses are small, but most of the output is produced by large
businesses. That sounds paradoxical. How can it be true?
While there are many small businesses in the U.S. economy, the value of what they
produce is relatively small. For example, a local grocer cannot produce the same amount
as a large national grocery store. It would take several small grocers to match the
production of a large store. So, while a large retailer like Wal-Mart is considered to be
one business, its production exceeds that of a smaller business.
6. What is the role of government in a mixed economy?
The government is a referee—it enforces laws and establishes order. The government is a
business regulator—it imposes restrictions on businesses on society’s behalf. The
government provides security through national defense. The government levies taxes to
finance its spending. Finally, the government redistributes income from high income
households to lower-income ones.
CHAPTER 3
THE FUNDAMENTAL ECONOMIC PROBLEM:
SCARCITY AND CHOICE
TEST YOURSELF
1. A person rents a house for $24,000 per year. The house can be purchased for
$200,000, and the tenant has this much money in a bank account that pays 4 percent
interest per year. Is buying the house a good deal for the tenant? Where does
opportunity cost enter the picture?
This question asks the students to apply opportunity cost to a straightforward decision: to
rent or buy. After buying the house, the person would no longer have to pay $24,000
annual rent. On the other hand, she would lose the $8,000 she currently earns in interest
from her bank account. She would be ahead by $16,000, and the purchase is therefore a
good deal. In order to get a service (housing) for which she had been willing to pay
$24,000, she only has to give up (that is, the opportunity cost is) goods and services
worth $8,000. It is worth pointing out to students that if she did continue to rent the
house, it must be because the services she receives from the landlord are worth more than
$16,000. Also, it is important to realize that this question is very simplified—it ignores
home equity, property taxes, etc.
2. Graphically show the production possibilities frontier for the nation of Stromboli,
using the data given in the following table. Does the principle of increasing cost hold
in Stromboli?
Stromboli’s 2018 Production Possibilities
Pizzas per Year Pizza Ovens per Year
75,000,000 0
60,000,000 6,000
45,000,000 11,000
30,000,000 15,000
15,000,000 18,000
0 20,000
Figure 1 shows the production possibilities frontier. The principle of increasing cost
holds, because the curve is concave. For example, begin at the point of producing 20
pizza ovens and 0 pizzas. To produce 15 pizzas we must give up the production of 2
pizza ovens; this brings us the point of 18 pizza ovens and 15 pizzas. To gain another 15
pizzas, we must now give up the production of 3 pizza ovens. As we continue to produce
more pizzas we must give up increasing quantities of pizza ovens. There are diminishing
returns as resources are shifted from pizzas to pizza ovens, or vice versa.
 FIGURE 1 (Pizza numbers are in millions, ovens are in thousands)

3. Consider two alternatives for Stromboli is 2018. In one case (a) its inhabitants eat 60
million pizzas and build 6,000 pizza ovens. In case (b), the population eats 15million
pizzas but builds 18,000 ovens. Which case will lead to a more generous production
possibilities frontier for Stomboli in 2018?
In case (b), the production possibilities frontier will be further from the origin in future
years, since Stromboli will have more pizza ovens with which it can produce more
pizzas.
4. Jasmine’s Snack Shop sells two brands of potato chips. She produces them by
buying them from a wholesale supplier. Brand X costs Jasmine $1 per bag, and
Brand Y costs her $1.40. Draw Jasmine’s production possibilities frontier if she has
$280 budgeted to spend on the purchase of potato chips from the wholesaler. Why is
it not “bowed out”?
Figure 2 shows the production possibilities frontier. It is a straight line rather than a
curve, because for each additional box of brand X that Jasmine buys, no matter how
many boxes she already has, she must cut her purchases of Brand Y by the same amount.
The production possibilities frontier in this question is really like a budget constraint.
Brand X is $1.00, Brand Y is $1.40.
FIGURE 2
DISCUSSION QUESTIONS
1. Discuss the resource limitations that affect
a. the poorest person on earth
b. the richest person in the United States
c. a farmer in Kansas
d. the government of Indonesia
(a) The poorest person on earth has access to so few resources that she is in danger of
perishing. The opportunity cost of any additional good or service is life threatening.
For example, if she takes the time to cut and sharpen a stick for hunting, she may not
be able to gather the food she needs to stay alive.
(b) Even the richest person in America faces resource limitations. If he buys a shipping
company, he will lack the resources to buy an oil company. He is constantly
approached for philanthropic donations; he cannot support them all, and if he
increases his donations, he may lack the funds to expand into new business ventures.
(c) A farmer in Kansas (or anywhere) has limited resources with which to produce goods,
and therefore hard choices to make. If she produces more wheat, she will have to cut
back its production of soybeans.
(d) The government of Indonesia has the authority to command the use of a certain
amount of labor and other productive resources. If it decides to increase the
production of petroleum, it will have to shift some productive resources away from
another use, thereby causing the output of coffee, for example, to fall.
2. If you were president of your college, what would you change if your budget were cut
by 10 percent? By 25 percent? By 50 percent?
This question will help students begin to develop a better understanding of their
institution. They may be surprised to learn that about 90 percent of the college’s budget
goes to wages and benefits—and that therefore a reduction in the budget implies a
reduction in programs and the laying off of people. An important trade-off to consider is
between the level of services per student on the one hand and the size of the student body
on the other.
3. If you were to leave college, what things would change in your life? What, then, is the
opportunity cost of your education?
The answer to this question obviously depends upon the student. Students should be
encouraged to think broadly. A student who leaves college would not have to pay tuition
and fees, nor the college room and board expenses (on the other hand, these may be paid
currently by her parents, so they would not represent a savings to her). She would earn
money from a job, but she might have to pay for her own living expenses. The point to
stress is that the opportunity cost of a college education includes indirect items (such as
income foregone from a job) as well as costs that the student pays directly.
4. Raising chickens requires several types of feed, such as corn and soy meal. Consider a
farm in the former Soviet Union. Try to describe how decisions on the number of
chickens to be raised, and the amount of each feed to use in raising them, were made
under the old communist regime. If the farm is now privately owned, how does the
market guide the decisions that used to be made by the central planning agency?
Under the former communist regime, the farmer was allocated a certain amount of each
type of feed, at a fixed cost, and was also given a quota for the number of chickens to be
produced. The farmer did as he was told, and took few if any risks or innovations. Under
 private enterprise now, the farmer can get richer by producing more chickens. He is free
to buy any combination of feed grains, subject only to the limit of his budget, at the going
market prices. Through a process of trial and error, he will select the combination of feed
grains that maximizes his profit—and if the price of soy meal rises, he will shift toward
corn. The price of soy meal will in fact rise if soy meal becomes scarcer in the economy
as a whole. Thus the market system leads the farmer to economize in his use of a resource
that is becoming increasingly scarce—a task that used to be the responsibility of the
central planning agency.
5. The United States is one of the world’s wealthiest countries. Think of a recent case
in which the decisions of the U.S. government were severely constrained by scarcity.
Describe the trade-offs that were involved. What were the opportunity costs of the
decisions that were actually made?
There are countless good answers to this question. An increase in defense purchases, for
example, may require a reduction in educational expenditures. For some students, it may
also be important to note that a larger deficit now may lead to a decrease in expenditures
in the future.
CHAPTER 4
SUPPLY AND DEMAND: AN INITIAL LOOK
TEST YOURSELF
1. What shapes would you expect for the following demand curves?
a. A medicine that means life or death for a patient
b. French fries in a food court with kiosks offering many types of food
(a) The demand curve for a medicine that means life or death for a patient will be
vertical. One would not expect a decline in quantity demanded as the price rises, if
that decline meant that the patient would die.
(b) The demand curve for french fries in a food court with many other stands will be
fairly flat, perhaps even horizontal. If the firm raises its price at all, many if not most
of its customers will just move to a different stand. Thus a small change in price
results in a large change in the amount of fries bought.
2. The following are the assumed supply and demand schedules for hamburgers in
Collegetown:
Demand Schedule Supply Schedule
Price Quantity Price Quantity
Demanded Supplied
per Year per Year
(thousands) (thousands)

$2.75 14 $2.75 32
2.50 18 2.5 30
2.25 22 2.25 28
2 26 2 26
1.75 30 1.75 24
1.5 34 1.5 22
a. Plot the supply and demand curves and indicate the equilibrium price and quantity.
b. What effect would a decrease in the price of beef (a hamburger input) have on the
equilibrium price and quantity of hamburgers, assuming all other things remained
constant? Explain your answer with the help of a diagram.
c. What effect would an increase in the price of pizza (a substitute commodity) have on
the equilibrium price and quantity of hamburgers, assuming again that all other things
remain constant? Use a diagram in your answer.
The answers to all three parts are shown in Figure 1.
(a) Initially, the equilibrium price is $2.00, and the equilibrium quantity is 26,000
hamburgers, as shown by the intersection of D0 and S0.
(b) The decrease in the price of beef increases the supply of hamburgers, from S0 to S1.
So the equilibrium price falls and the equilibrium quantity rises.
(c) Returning to the original supply curve, an increase in the price of pizza raises the
demand for hamburgers, to D1. This raises the price and raises the quantity.
 FIGURE 1

3. Suppose the supply and demand schedules for bicycles are as they appear in the
following table.
Price Quantity Quantity
Demanded Supplied per
per Year Year
(millions) (millions)
$170 43 27
210 39 31
250 35 35
300 31 39
330 27 43
370 23 47
a. Graph these curves and show the equilibrium price and quantity.
b. Now suppose that it becomes unfashionable to ride a bicycle, so that the quantity
demanded at each price falls by 8 million bikes per year. What is the new equilibrium
price and quantity? Show this solution graphically. Explain why the quantity falls by
less than 8 million bikes per year.
c. Suppose instead that several major bicycle producers go out of business, thereby
reducing the quantity supplied by 8 million bikes at every price. Find the new
equilibrium price and quantity, and show it graphically. Explain again why quantity
falls by less than 8 million.
d. What are the equilibrium price and quantity if the shifts described in Test Yourself
Questions 3(b) and 3(c) happen at the same time?
The answers to all three parts are shown in Figure 2.
(a) Initially, the equilibrium price is $250, and the equilibrium quantity is 35 million
bicycles, as shown by the intersection of D0 and S0.
(b) If demand falls by 8 million bikes per year, the new demand curve is D1. The price
falls to $210, and the quantity falls to 31 million, as shown by the intersection of D1
and S0. Although demand falls by 8 million at each price, the quantity exchanged falls
 by only 4 million because the price fall has induced a movement out along the new
demand curve, as well as a movement back along the old supply curve.
(c) If supply falls by 8 million bikes per year, the new supply curve is S1. The price rises
to $300, and the quantity falls to 31 million, as shown by the intersection of D0 and
S1. Although supply falls by 8 million at each price, the quantity exchanged falls by
only 4 million because the price increase has induced a movement out along the new
supply curve, as well as a movement back along the old demand curve.
(d) If demand and supply each fall by 8 million bikes per year, the equilibrium price is
$250, and the equilibrium quantity is 27 million bicycles, as shown by the
intersection of D1 and S1.

FIGURE 2

4. The following table summarizes information about the market for principles of
economics textbooks:
Price Quantity Quantity
Demanded per Supplied per
Year Year
$45 4,300 300
55 2,300 700
65 1,300 1,300
75 800 2,100
85 650 3,100
a. What is the market equilibrium price and quantity of textbooks?
b. To quell outrage over tuition increases, the college places a $55 limit on the price of
textbooks. How many textbooks will be sold now?
c. While the price limit is still in effect, automated publishing increases the efficiency of
textbook production. Show graphically the likely effect of this innovation on the
market price and quantity.
The answers to all three parts are shown in Figure 3.
(a) In market equilibrium, the price is $65 and the quantity is 1,300, as shown by the
intersection of D0 and S0.
 (b) When the price ceiling of $55 is imposed, the quantity sold falls to 700, because this
is all that sellers are willing to offer, even though buyers would prefer to buy 2,300
books.
(c) When the efficiency of publishing improves, the supply curve will move out, perhaps
to S1. As shown, the price is still $55, the quantity supplied has risen above 1,300, and
there is still a shortage. There are two other possibilities, however. Supply could
increase enough to intersect with demand at a price of $55, in which case 2,300 books
would be sold and the shortage would disappear. If the increase in supply were even
greater, the price ceiling would be ineffective, the price would fall below $55 and the
quantity sold would rise above 2,300.

FIGURE 3

5. How are the following demand curves likely to shift in response to the indicated
changes?
a. The effect of a drought on the demand curve for umbrellas
b. The effect of higher popcorn prices on the demand curve for movie tickets
c. The effect on the demand curve for coffee of a decline in the price of Coca-Cola
 The same diagram, Figure 4, can be used for all three cases, because they all entail a
decline in demand, from D0 to D1. Price falls from P0 to P1, and quantity falls from Q0 to
Q1.
(a) In a drought, people have less need for umbrellas, so demand falls.
(b) Popcorn is a complement for movie tickets, so when popcorn prices rise, the demand
for tickets falls.
(c) Coca-Cola is a substitute for coffee, so when the price of the soda falls, the demand
for coffee falls.

FIGURE 4

6. The two accompanying diagrams show supply and demand curves for two substitute
commodities: regular cell phones and smartphones.
a. On the right-hand diagram, show what happens when rising raw material
prices make it costlier to produce regular cell phones.
b. On the left-hand diagram, show what happens to the market for
smartphones.
 (a) As Figure 5 (b) shows, the supply of regular cell phones falls from S0 to S1. This leads
to an increase in price to P1 and a reduction in quantity to Q1.
(b) In Figure 5 (a), the demand for smartphones, a substitute for regular cell phones, rises
when the price of regular cell phones rises. Therefore there is both a higher price and
a higher quantity of smartphones.

FIGURE 5

7. Consider the market for beef discussed in this chapter (Tables 1 through 3 and Figures
1 and 8). Suppose that the government decides to fight cholesterol by levying a tax of
50 cents per pound on sales of beef. Follow these steps to analyze the effects of the tax:
a. Construct the new supply schedule (to replace Table 2) that relates quantity
supplied to the price that consumers pay.
b. Graph the new supply curve constructed in Test Yourself Question 7(a) on the
supply-demand diagram depicted in Figure 7.
c. Does the tax succeed in its goal of reducing the consumption of beef?
d. Is the price rise greater than, equal to, or less than the 50-cent tax?
e. Who actually pays the tax, consumers or producers? (This may be a good question
to discuss in class.)
(a) With a 50-cent tax per pound of beef, Table 2 in the text must be adjusted:
Price Paid by Consumers Price Received by Farmers Quantity Supplied
(dollars per pound) (dollars per pound) (pounds per year)
8.00 7.50 90
7.90 7.40 80
7.80 7.30 70
7.70 7.20 60
7.60 7.10 50
7.50 7.00 40
7.40 6.90 30

(b) Using the new Table 4-2, Figure 6 shows that the new supply curve, S1 lies above
the original curve, S0, by a distance of 50 cents at each output. The new equilibrium
price is approximately $7.53, and the new equilibrium quantity is approximately 43
pounds.
 FIGURE 6

(c) Yes, beef consumption falls by approximately 17 pounds.

(d) The equilibrium price rises by approximately 23 cents, which is less than the tax.
(e) Both consumers and producers will be paying the tax. Consumers pay a greater
portion because demand was more inelastic, meaning that the quantity demanded
did not change as much as the price changed. Producers pay a smaller portion
because supply was somewhat more elastic meaning that the quantity supplied
changed a bit more as price changed.
8. (More difficult) The demand and supply curves for T-shirts in Touristtown, U.S.A.,
are given by the following equations:
Q = 24,000 − 500P Q = 6,000 + 1,000P
where P is measured in dollars and Q is the number of T-shirts sold per year.
a. Find the equilibrium price and quantity algebraically.
b. If tourists decide they do not really like T-shirts that much, which of the following
might be the new demand curve?
Q = 21,000 − 500P Q = 27,000 + 500P
Find the equilibrium price and quantity after the shift of the demand curve.
c. If, instead, two new stores that sell T-shirts open up in town, which of the
following might be the new supply curve?
Q = 4,000 + 1,000P Q = 9,000 + 1,000P
Find the equilibrium price and quantity after the shift of the supply curve.
(a) In equilibrium, quantity demanded equals quantity supplied:
24,000 – 500P = 6,000 + 1,000P
1,500P = 18,000
P = 12
Substitute P = 12 in either the supply or the demand equation to derive Q = 18,000.
(b) If tourists like t-shirts less, the new demand curve might be Q = 21,000 – 500P. Using
the same method as in part (a), in equilibrium, P = 10 and Q = 16,000.
(c) Opening of the new stores might lead to an increase in the supply curve to Q = 9000
+ 1000P. Set equal to the original demand curve, and using the method of part (a),
this yields equilibrium price and quantity of P = 10 and Q = 19000.
DISCUSSION QUESTIONS
1. How often do you rent videos? Would you do so more often if a rental cost half as
much? Distinguish between your demand curve for home videos and your “quantity
demanded” at the current price.
This question is intended to help students develop an intuitive sense of the origins of the
demand curve. If you deal with this question in class or discussion section, it will be
revealing to aggregate the students’ answers, and derive a “market” demand curve. It is
also interesting to see whose purchases are sensitive to the price increase, and whose are
not, and to speculate upon the reasons for the difference.
2. Discuss the likely effects of the following:
a. Rent ceilings on the market for apartments
b. A price floor in the market for wheat
Use supply-demand diagrams to show what may happen in each case.
(a) Figure 7 (a) is the market for apartments. Without rent control, the equilibrium rent is
PE and the equilibrium quantity is QE. When the rent ceiling of PC is imposed, the
quantity offered on the market falls, eventually, to QC. At this low rent, there is
considerable excess demand, or a shortage, for apartments.
(b) 7 (b) is the market for wheat. Without a price floor, the equilibrium price is PE and
the equilibrium quantity is QE. When the price floor of PF is imposed, the quantity
demanded in the market falls to QF. At this high price, there is an excess supply of
wheat, and if the government is determined to maintain the price floor, it will have to
absorb this surplus in one way or another.

FIGURE 7

3. U.S. government price supports for milk led to an unceasing surplus of milk. In an
effort to reduce the surplus about a decade ago, Congress offered to pay dairy farmers
to slaughter cows. Use two diagrams, one for the milk market and one for the meat
market, to illustrate how this policy should have affected the price of meat. (Assume
that meat is sold in an unregulated market.)
 In Figure 8 (a), the equilibrium price of milk is PE. The government wishes to raise the
price to PF, and it therefore pays farmers to slaughter cattle. As a consequence, the supply
curve falls to S1 and the price rises. The market for meat is shown in (b), where the added
slaughters increase the supply to S1, cut the price to P1 and raise the quantity to Q1.

FIGURE 8

4. It is claimed in this chapter that either price floors or price ceilings reduce the actual
quantity exchanged in a market. Use a diagram or diagrams to test this conclusion, and
explain the common sense behind it.
Figure 9 shows three different prices. P1 is an effective price ceiling, at which the
quantity demanded, G, exceeds the quantity supplied, F. P2 is the equilibrium price, at
which the quantity supplied and the quantity demanded are equal, at E. P3 is an effective
price floor, at which the quantity supplied, I, exceeds the quantity demanded, H. Consider
first the price ceiling, P1. Since supply curves are positively sloped, at this price the
quantity supplied must be less than at the equilibrium P2. And since sellers cannot be
forced to sell any more than they wish, the quantity exchanged will be F, which is lower
than the equilibrium quantity E, in spite of the fact that buyers wish to buy more, G.
Consider next the price floor, P3. Since demand curves are negatively sloped, the quantity
demanded at this high price will be less than the quantity demanded at the equilibrium.
Since buyers cannot be forced to buy more than they want, the quantity exchanged at this
price is H, which is less than the equilibrium quantity E. These results follow from the
common-sense observation that exchange is voluntary. At any price above or below the
market equilibrium price, the quantity exchanged is less than it would be at the
equilibrium.
 FIGURE 9

5. The same rightward shift of the demand curve may produce a very small or a very
large increase in quantity, depending on the slope of the supply curve. Explain this
conclusion with diagrams.
Figures 10 (a) and (b) show the same increase in the demand curve, from D0 to D1. In (a)
the supply curve is quite flat, and the resulting quantity increase, from Q0 to Q1, is large,
while in (b) the supply curve is steep, and the quantity increase small. The difference is
that in (a) the quantity supplied is very sensitive to small changes in price, while in (b) it
is hardly sensitive at all.

FIGURE 10

6. In 1981, when regulations were holding the price of natural gas below its free-market
level, then-Congressman Jack Kemp of New York said the following in an interview
with The New York Times: “We need to decontrol natural gas, and get production of
natural gas up to a higher level so we can bring down the price.” Evaluate the
congressman’s statement.
One part of the congressman’s statement was incorrect. Removing the price controls
through deregulation would lead to an increase in price to Pe in figure 11 below. Such
deregulation would also cause an increase in the quantity supplied (movement along the
existing supply curve) and eliminate the shortage but it would do so at a higher price.
 The other part of the congressman’s statement may be correct depending on the
interpretation. If we could get production of natural gas to increase – by any means other
than an increase in price – we would expect to see an increase in supply which would be
depicted as a movement to an entirely new supply curve like S1 depicted below. That
would lead to a decrease in the equilibrium price to P1

FIGURE 11

7. From 2000 to 2010 in the United States, the number of working men fell by 0.6 percent,
while the number of working women grew by almost 4 percent. During this time,
average wages for men grew by roughly 3 percent, whereas average wages for women
grew by slightly more than 6 percent. Which of the following two explanations seems
more consistent with the data?
a. Women decided to work more, raising their relative supply (relative to men).
b. Discrimination against women declined, raising the relative (to men) demand for
female workers.
Explanation (b) is more consistent with the data. If the principal change in the market had
been an increase in supply of female workers, i.e., explanation (a), then female wages
would have fallen. The fact that they increased while employment also increased means
that demand for female workers must have grown.
CHAPTER 5
CONSUMER CHOICE: INDIVIDUAL AND
MARKET DEMAND
TEST YOURSELF
1. Which gives you greater total utility: 14 gallons of water per day or 22 gallons per day?
Why?
The total utility from 22 gallons is greater, since it is equal to the total utility (or
usefulness) of the first 14 gallons, plus the total utility of the next 8.
2. At which level do you get greater marginal utility: 14 gallons per day or 22 gallons per
day? Why?
The marginal utility at 12 gallons is greater. You use the first 12 gallons for your highest
priorities. The next gallons are used for purposes of decreasing importance. This is the
“law” of diminishing marginal utility.
3. Which of the following items are likely to be normal goods for a typical consumer?
Which are likely to be inferior goods?
a. Expensive perfume
b. Paper plates
c. Secondhand clothing
d. Overseas trips
Normal: a and d. Inferior: b and c.
4. Emily buys an air conditioner that costs $700. Because the air in her home is cleaner, its
use saves her $250 in curtain cleaning costs over the lifetime of the air conditioner. In
money terms, what is the opportunity cost of the air conditioner?
Since the $700air conditioner saves Emily $250 in cleaning costs, the opportunity cost of
the air conditioner is only $450.
5. Suppose that strawberries sell for $3 per basket. Jim is considering whether to buy zero,
one, two, three, or four baskets. On your own, create a plausible set of total and
marginal utility numbers for the different quantities of strawberries (as we did for
pizza in Table 1), and arrange them in a table. From your table, calculate how many
baskets Jim would buy.
Baskets Marginal Utility ($) Total Utility ($)
0 — —
1 6 6
2 4 10
3 3 13
4 1 14
At a price of $3 per basket Jim will buy 3 baskets.
6. Draw a graph showing the consumer’s surplus Jim would get from his strawberry
purchase in Test Yourself Question 5, and check your answer with the help of your
marginal utility table.
 Figure 1 shows that Jim buys 3 boxes of berries, where marginal utility equals price. On
the first box, his consumer’s surplus is the excess of MU (6) above P (2), or the dotted
line AB. Similarly his surplus on the second box is CD (4 - 2), and the total consumer’s
surplus is the sum of the two lines, 4 + 2, or 6.

FIGURE 1

7. Consider a market with two consumers, Jasmine and Jim. Draw a demand curve for
each of the two consumers, and use those curves to construct the demand curve for
the entire market.

FIGURE 2

DISCUSSION QUESTIONS
1. Describe some of the different ways you use water. Which would you give up if the price
of water were to rise a little? If it were to rise by a fairly large amount? If it were to rise
by a very large amount?
In descending order of importance, water is used for drinking, for cooking, for bathing, to
feed pets, to wash clothes, to water lawns, to store in swimming pools, etc. (the students’
order may differ). As the price of water rose, you might give up some of these uses,
beginning at the end of the list. Alternatively, you might retain all or most of these uses,
but cut down on the amount for each.
2. Suppose that you wanted to measure the marginal utility of a commodity to a consumer
 by directly determining the consumer’s psychological attitude or strength of feeling
toward the commodity rather than by seeing how much money the consumer would
give up for the commodity. Why would you find it difficult to make such a
psychological measurement?
You could ask the consumer to construct a scale, from 1 to 100, then reveal where on the
scale each commodity falls. Or you could try measuring blood pressure or pulse as the
consumer gets different commodities. But there is no guarantee that either procedure
would be meaningful. The self-constructed scale might be biased and inconsistent; the
consumer’s physiological response might have little to do with satisfaction. There are
some obvious (and not so obvious) objections to using the amount of money a person is
willing to give up as a measure of utility, but there does not seem to be a better solution.
3. Some people who do not understand the optimal purchase rule argue that if a consumer
buys so much of a good that its price equals its marginal utility, the consumer could not
possibly be behaving optimally. Rather, they say, the consumer would be better off
quitting while ahead or buying a quantity such that marginal utility is much greater
than price. What is wrong with this argument? (Hint: What opportunity would the
consumer then miss? Is it maximization of marginal or total utility that serves the
consumer’s interests?)
It is reasonable to assume that rational consumers are trying to get the most possible
consumer’s surplus for themselves, that is, the most total utility less expenditure—not the
most possible average utility per good or marginal utility. If a consumer quit buying
when the marginal utility was higher than the price, then he or she would be forgoing the
opportunity to increase consumer’s surplus: By buying one more unit, the consumer
could accumulate more utility than he or she would be giving up in terms of money
forgone. This will continue to be true until so much is bought that the marginal utility of
the next good has fallen to a level equal to the price.
4. What inferior goods do you purchase? Why do you buy them? Do you think you will
continue to buy them when your income is higher?
Students are particularly well situated to answer this question, since many of them are
living on quite low incomes that they can reasonably expect to rise in the future. They
may buy lots of macaroni and cheese, inferior cuts of meat, used clothes, and have small
living quarters and old cars, the purchases of all of which will fall as their incomes rise.
5. A bottle of wine you bought 15 years ago for $20 now has a market value of $1,500.
Would you sell your bottle at that price or keep it for an important occasion? Would
you purchase another bottle of such old wine at that high price?
It may be more rational (or at least consistent) to take one of the following actions: Do
not buy another bottle at the currently high price and sell the one you have; alternatively,
you could keep your bottle and at least seriously consider buying another at $1,500 price.
6. You have $20,000 to invest in the stock market, which has been rising rapidly for the
past 18 months. What course of action seems rational?
Perhaps you should invest in the stock market now on the expectation that stock prices
will continue to rise. On the other hand, if you expect prices to fall then you would want
to wait to purchase stock.
ANSWERS TO APPENDIX QUESTIONS
TEST YOURSELF
1. John Q. Public spends all of his income on tacos and hot dogs. Draw his budget line
under several conditions:
a. His income is $100, and one taco and one hot dog each cost $2.
b. His income is $150, and the two prices remain the same.
c. His income is $100, hot dogs cost $2 each, and tacos cost $2.50 each.

FIGURE 3

2. Draw some hypothetical indifference curves for John Q. Public on a diagram

identical to the one you constructed for Test Yourself Question 1.
a. Approximately how many tacos and how many hot dogs will Mr. Public buy?
b. How will these choices change if his income increases to $150? Is either good an
inferior good?
c. How will these choices change if the price of a taco rises to $3.00?

FIGURE 4

(a) 25 tacos and 25 hot dogs.

(b) approximately 37.5 tacos and 37.5 hot dogs; Since the consumption of both goods
increased when his income increased, both goods are normal goods which means that
neither is an inferior good.
(c) approximately 16 tacos and 26 hot dogs
3. Explain the information that the slope of an indifference curve conveys about a
consumer’s preferences. Use this relationship to explain the typical U-shaped
curvature of indifference curves.
The slope of an indifference curve is the maximum number of units of the good on the Y-
axis (say, cookies) the consumer is willing to give up to get one more unit of the good on
the X-axis (say, compact discs). An indifference curve that is U-shaped with respect to
the origin has a relatively large slope towards the upper left side and a relatively small
slope towards the lower right. This indicates that a consumer who has many cookies but
few compact discs is willing to give up a lot of cookies in order to get one more compact
disc—but when the tables are turned, the consumer who has many compact discs and
only a few cookies is willing to give up only a small number of cookies to get an
additional compact disc. This is consistent with the idea of diminishing marginal utility in
the case of one good considered alone.
CHAPTER 6
DEMAND AND ELASTICITY
TEST YOURSELF
1. What variables other than price and advertising are likely to affect the quantity
demanded of a product?
The answer depends upon the product, but general variables include tastes, prestige value
of the product, income levels, population, prices of substitutes and complements, and new
uses to which the product can be put.
2. Describe the probable shifts in the demand curves for
a. Airplane trips when airlines’ on-time performance improves
b. Automobiles when airplane fares double
c. Automobiles when gasoline prices double
d. Electricity when the average temperature in the United States rises during a
particular year (Note: The demand curve for electricity in Maine and the demand
curve for electricity in Florida should respond in different ways. Why?)
(a) Increase: shift to the right. Airplane trips are more attractive when their punctuality
improves.
(b) Increase: shift to the right. Airplane trips are a substitute for automobiles; thus
automobiles are more attractive when airplane fares increase.
(c) Reduction: shift to the left. Gasoline is a complement to automobiles; thus
automobiles are less attractive when gasoline prices increase.
(d) Demand will decrease (shift to the left) in Maine because less electricity will be
wanted for heating buildings in winter. Demand will increase (shift to the right) in
Florida, because more electricity will be wanted for air conditioning. The rise in
temperature is unlikely to have much effect on air conditioning in Maine or on home
heating in Florida.
3. Taxes on particular goods discourage their consumption. Economists say that such taxes
“distort consumer demands.” In terms of the elasticity of demand or elasticity of supply
for the commodities in question, what sort of goods would you choose to tax to achieve
the following objectives?
a. Collect a large amount of tax revenue
b. Distort demand as little as possible
c. Discourage consumption of harmful commodities
d. Discourage production of polluting commodities
(a) Goods with low price elasticity of demand (inelastic demand).
(b) Goods with low price elasticity of demand (inelastic demand).
(c) Goods with high price elasticity of demand (elastic demand).
(d) Goods with high price elasticity of demand (elastic demand).
4. Give examples of commodities whose demand you would expect to be elastic and
commodities whose demand you would expect to be inelastic.
Elastic: Any particular food, like carrots or pork chops (since there are close substitutes),
apartments in a particular building (since they require a lot of a consumer’s budget, and
 since there are close substitutes), vacation trips to the Caribbean (since they are not really
needed, and since there are close substitutes).
Inelastic: Food in general (there is no substitute), housing in general (people resist
reducing the quality of their housing when prices rise), salt (so insignificant in a budget
that one hardly notices a price change), tobacco and liquor (many consumers are
addicted).
5. A rise in the price of a certain commodity from $20 to $25 reduces quantity demanded
from 25,000 to 10,000 units. Calculate the price elasticity of demand.
Using the formula in the text, (change in quantity/change in price) times (price/quantity),
where price and quantity are the average of the beginning and ending values, the
elasticity is (15,000/17,500) / (5/22.5) = 0.857/0.222 = 3.86
6. If the price elasticity of demand for gasoline is 0.3 and the current price is $3.20 per
gallon, what rise in the price of gasoline will reduce its consumption by 10 percent?
The elasticity is the percentage change in quantity divided by the percentage change in
price and is equal to 0.3. Since the desired percentage change is quantity is 10%, the
percentage change in price is 10%/0.3 = 33.3%. In finding the new gasoline price,
however, there is an ambiguity. A 33.3% increase above $1.20 a gallon would bring the
price to $1.60. On the other hand, the text recommends that the base for calculating a
percentage change should be half way between the beginning and ending values. In that
case (P1 – P0)/[(P1 + P0)/2] = 0.33; (P1 – P0) = 0.33[(P1 + P0)/2]; therefore (P1 –
$1.20)/[(P1 + $1.20)/2] = 0.33; and the new price is $1.68.
7. Which of the following product pairs would you expect to be substitutes, and which
would you expect to be complements?
a. Shoes and sneakers
b. Gasoline and sport-utility vehicles
c. Bread and butter
d. Compact discs and digital music files
Complements: (b) and (c)
Substitutes: (a) and (d)
8. For each of the product pairs given in Test Yourself Question 7, what would you guess
about the products’ cross elasticity of demand?
a. Do you expect it to be positive or negative?
b. Do you expect it to be a large or small number? Why?
Shoes and sneakers: The cross elasticity is positive because they are substitutes, but likely
to be rather low because the two are normally used on quite different occasions for very
different purposes.
Gas and sport utility vehicles: The cross elasticity is negative because they are
complements, and high, because when gas prices rise it becomes much more expensive to
operate a sport utility vehicle.
Bread and butter: The cross elasticity is negative because they are complements, but low
because there are many uses for each which do not require the other.
Instant and regular film: The cross elasticity is positive because they are substitutes, and
probably quite high because the degree of substitutability is high; both can produce quite
good pictures.
DISCUSSION QUESTIONS
1. Explain why elasticity of demand is measured in percentages.
Elasticity is calculated in percentages so that it can be a measure of responsiveness that is
not influenced by the units chosen. Suppose, for example, that the quantity of steel
bought rises from 1 to 3 tons when the price falls from $300 to $100. Calculating the
absolute change in units divided by the absolute change in price gives a value of 2/200 =
0.01. If, instead, steel is measured in pounds, the value is 4000/200 = 20. No one could
say which is the true measure of elasticity. If the changes in both quantity and price are
measured in percentage terms, then it does not matter what units are used—the
percentage change in quantity divided by the percentage change in price (using the
numbers in this example) will always be 200%/200% = 1.
2. Explain why the elasticity of demand formula normally eliminates minus signs.
In the calculation of the price elasticity of demand, the sign of the percentage price
change is almost always the opposite of the sign of the percentage quantity change: if one
goes up, the other goes down. Therefore the ratio of the two would always have a minus
sign. Since this is well understood, it is convenient to omit the minus sign. Thus a higher
value of elasticity indicates that quantity is more responsive to price.
3. Explain why the elasticity of a straight-line demand curve varies from one part of the
curve to another.
Along a straight-line demand curve, the same absolute price reduction (say, $1) is always
associated with the same absolute quantity increase (say, 2 pounds). When price is high
and quantity low, a reduction in price of $1 is a small percentage change in the price, but
an increase in quantity of 2 pounds is a large percentage increase in quantity, so the
elasticity is high. When price is low and quantity high, on the other hand, the situation is
reversed, and the elasticity is low. The price elasticity of demand falls as one moves
down along a straight-line demand curve.
4. A rise in the price of a product whose demand is elastic will reduce the total revenue of
the firm. Explain.
Revenue is equal to price times quantity. When the demand curve is elastic, the
percentage decline in quantity exceeds the percentage rise in price, and therefore the
product of the two falls. In other words, if demand is elastic and the seller increases
price, a large percentage of existing customers will no longer purchase that good. The
remaining customer will pay the higher price. However, the substantial number of
customers that no longer purchase the good will result in a decrease in total revenue.
5. Name some events that will cause a demand curve to shift.
Changes in tastes, incomes, population, prices of substitutes and complements,
advertising, uses of the product, etc.
6. Explain why the following statement is true: “A firm with a demand curve that is
inelastic at its current output level can always increase its profits by raising its price
and selling less.” (Hint: Refer back to “Price Elasticity of Demand: Its Effect on Total
Revenue and Total Expenditure.”
If the demand curve is inelastic, the percentage decline in quantity will be less than the
percentage increase in price. Therefore revenue will rise when price rises. Costs will not
increase as quantity declines; at the very least they will stay constant, and they will
probably decline. If revenues rise while costs stay constant or decline, profits must rise.
CHAPTER 7
PRODUCTION, INPUTS, AND COSTS: BUILDING
BLOCKS FOR SUPPLY ANALYSIS
TEST YOURSELF
1. A firm’s total fixed cost is $360,000. Construct a table of its total and average fixed
costs for output levels varying from zero to six units. Draw the corresponding TFC
and AFC curves.
TFC AFC
(thousands (thousands
Output of dollars) of dollars)
0 360 —
1 360 360
2 360 180
3 360 120
4 360 90
5 360 72
6 360 60

FIGURE 1

2. With the following data, calculate the firm’s AVC and MVC and draw the graphs for
TVC, AVC, and MVC. Why is MVC the same as MC?
Quantity Total
Variable
Costs
1 $ 40,000
2 80,000
3 120,000
4 176,000
5 240,000
6 360,000
 TVC AVC MVC
(thousands (thousands (thousands
Output of dollars) of dollars) of dollars)
1 40 40 40
2 80 40 40
3 120 40 40
4 176 44 56
5 240 48 64
6 360 60 120

FIGURE 2

MVC is the change in TVC divided by the change in output. MC is the change in TC
divided by the change in output. Since fixed costs by definition do not change as output
changes, the only change in TC will be the change in TVC.

3. From the data in Test Yourself Questions 1 and 2, calculate TC and AC for each of
the output levels from one to six units and draw the two graphs.

TC AC
(thousands (thousands
Output of dollars) of dollars)
0 360 —
1 400 400
2 440 220
3 480 160
4 536 134
5 600 120
6 720 120
 FIGURE 3

4. If a firm’s commitments in 2011 include machinery that will need replacement in

five years, a factory building rented for 12 years, and a three-year union contract
specifying how many workers it must employ, when, from its point of view in 2011,
does the firm’s long run begin?
The firm’s long run begins in 12 years, in 2023, when the last of its commitments, its
building lease, has ended.

5. If the marginal revenue product of a gallon of oil used as input by a firm is $2.20
and the price of oil is $2.07 per gallon, what can the firm do to increase its profits?
It can raise its profits by increasing its use of oil. Adding 1 gallon of oil will raise its
revenues by $2.20, and its cost by only $2.07. It should continue increasing its use of oil
as long as the marginal revenue product is greater than the cost.

6. A firm hires two workers and rents 15 acres of land for a season. It produces
150,000 bushels of crop. If it had doubled its land and labor, production would have
been 325,000 bushels. Does it have constant, decreasing, or increasing returns to
scale?
Increasing returns to scale: when inputs double, output more than doubles.
7. Suppose that wages are $20,000 per season per person and land rent per acre is
$3,000. Calculate the average cost of 150,000 bushels and the average cost of 325,000
bushels, using the figures in Test Yourself Question 6. (Note that average costs
increase when output increases.) What connection do these figures have with the
firm’s returns to scale?
 150,000 Bushels 325,000 Bushels
Wages $40,000 $80,000
Rent $45,000 $90,000
Total Cost $85,000 $170,000
Average Cost 0.57 0.52
The lower average cost at 325,000 confirms the previous conclusion that there was
increasing returns to scale since. Essentially the firm is getting more out of each unit of
input which drives down the cost per unit.
8. Suppose that wages are $20,000 per season per person and land rent per acre is
$3,000. Calculate the average cost of 150,000 bushels and the average cost of 325,000
bushels, using the figures in Test Yourself Question 6. (Note that average costs
increase when output increases.) What connection do these figures have with the
firm’s returns to scale?
When Naomi bought a great deal of feed, the MPP of feed was low because of
diminishing returns. The ratio of feed to chicks was high: More feed could not produce
much more output. Now, she buys more chicks. This reduces the ratio of feed to chicks,
and raises the MPP of feed because there is less feed per chick and diminishing returns
have not proceeded as far. The conclusion is that the MPP of a factor is inversely related
to the proportion of that factor to other factors.
9. Labor costs $12 per hour. Nine workers produce 180 bushels of product per hour,
whereas 10 workers produce 196 bushels. Land rents for $1,200 per acre per year.
With 10 acres worked by nine workers, the marginal physical product of an acre of
land is 1,400 bushels per year. Does the farmer minimize costs by hiring nine
workers and renting 10 acres of land? If not, which input should he use in larger
relative quantity?
For labor, the MPP is 16, the price is $12, and the ratio of the two is a bit more than 1.3;
for land, the MPP is 1,400, the price is $1,200, and the ratio of the two is less than 1.2.
Since the two ratios are not equal, the farmer is not minimizing costs. She should use a
larger relative quantity of labor.
10. Remember Al, the builder of inexpensive garages? Suppose that his total costs
increase by $5,000 per year at every input level. Modify Table 2 to show how this
change affects his total and average costs.

Number of
Carpenters Old Old New New
(Input) Total Cost Average Cost Total Cost Average Cost
0 0 0 5,000 0
1 50,000 12,500 55,000 13,750
2 100,000 8,333 105,000 8,750
3 150,000 6,250 155,000 6,458
4 200,000 6,250 205,000 6,406
5 250,000 7,143 255,000 7,286
6 300,000 10,000 305,000 10,167
DISCUSSION QUESTIONS
1. A firm experiences a sudden increase in the demand for its product. In the short
run, it must operate longer hours and pay higher overtime wage rates to satisfy this
new demand. In the long run, the firm can install more machines instead of
operating fewer machines for longer hours. Which do you think will be lower, the
short-run or the long-run average cost of the increased output? How is your answer
affected by the fact that the long-run average cost includes the new machines the
firm buys, whereas the short-run average cost includes no machine purchases?
The long-run average cost will be lower than the short-run average cost, even though the
former includes the cost of new machines. In the long run, the firm will have lower labor
costs because it does not have to pay higher overtime wages, and it will avoid the costs of
machines breaking down because they are being worked too intensively. These savings
will outweigh the added costs of new machines. If the long-run average cost were not less
than the short-run average cost, the firm would not buy the new machines.

ANSWERS TO APPENDIX QUESTIONS

TEST YOURSELF
1. Compound Consolidated Corporation (CCC) produces containers using two inputs:
labor and glue. If labor costs $10 per hour and glue costs $5 per gallon, draw CCC’s
budget line for a total expenditure of $100,000. In this same diagram, sketch a
production indifference curve indicating that CCC can produce no more than 1,000
containers with this expenditure.

FIGURE 4
2. With respect to Test Yourself Question 1, suppose that wages rise to $20 per hour
and glue prices rise to $6 per gallon. How are CCC’s optimal input proportions
likely to change? (Use a diagram to explain your answer.)
The price ratio of glue to labor falls from 0.5 to 0.3. The slope of the budget line flattens,
as shown in Figure 4. Consequently, the ratio of glue to labor employed will rise.

3. What happens to the location of the expansion path of the firm in Test Yourself
Question 2?
When the price ratio of glue to labor falls, the ratio of glue to labor used rises. Therefore,
the expansion path, which shows the amounts of glue and labor used as output rises,
given unchanging factor prices, becomes flatter, or closer to the glue axis.
CHAPTER 8
OUTPUT, PRICE, AND PROFIT: THE
IMPORTANCE OF MARGINAL ANALYSIS
TEST YOURSELF
1. Suppose that the firm’s demand curve indicates that at a price of $10 per unit, customers
will demand 2 million units of its product. Suppose that management decides to pick
both price and output; the firm produces 3 million units of its product and prices
them at $18 each. What will happen?
Unfortunately for the firm, exchange is voluntary. Assuming that the demand curve is
negatively sloped, when the firm prices its product at $18, it will find buyers for less than
2 million units, and it will discover its inventory rising by more than 1 million units.

2. Suppose that a firm’s management would be pleased to increase its share of the market
but if it expands its production, the price of its product will fall. Will its profits
necessarily fall? Why or why not?
If the firm was previously in a profit-maximizing situation, then a decision to expand
output and reduce price will lower profits. But it may have been in a non-optimal
position. If so, it may be able to expand output and, even thought its price falls, earn
marginal revenue from the new output that is greater than its marginal costs. If so, its
profits will rise.

3. Why does it make sense for a firm to seek to maximize total profit rather than to
maximize marginal profit?
One presumes that the owners of the firm would like to get as rich as possible. As such
their goal is not to make as much profit as possible on one unit which would be the result
if they maximized marginal profit. Their goal is to make as much profit as possible
which would mean looking for any additional profit on any additional units. A marginal
profit greater than zero implies that the owners can make more money by increasing
output.

4. A firm’s marginal revenue is $133 and its marginal cost is $90. What amount of profit
does the firm fail to pick up by refusing to increase output by one unit?
$43 ($133 - $90 = $43)

5. Calculate average revenue (AR) and average cost (AC) in Table 3. How much profit does
the firm earn at the output at which AC = AR? Why?
 Garages TR AR TC AC TP
0 0 0 12 -- –12
1 30 30 40 40 –10
2 56 28 56 28 0
3 78 26 66 22 12
4 96 24 74 18.5 22
5 110 22 80 16 30
6 120 20 87 14.5 33
7 126 18 96 13.7 30
8 128 16 112 14 16
9 126 14 144 16 –18
10 120 12 190 19 –70
When average cost is equal to average revenue (at 2 garages in this example), the firm
makes no profit. This is because for average revenue to equal average cost total revenue
must equal total cost.

6. A firm’s total cost is $1,000 if it produces one unit, $1,600 if it produces two units, and
$2,000 if it produces three units of output. Draw up a table of total, average, and
marginal costs for this firm.

Total Average Marginal

Output Cost Cost Cost
1 1000 1000 1000
2 1600 800 600
32000 667 400

7. Draw an average and marginal cost curve for the firm in Test Yourself Question 6.
Describe the relationship between the two curves.
At one unit, average and marginal cost are identical. Beyond one unit, since average cost
is falling; marginal cost lies below average cost, as shown in Figure 1.
FIGURE 1

8. A firm has the demand and total cost schedules given in the following table. If it
wants to maximize profits, how much output should it produce?

Quantity Price Total Cost

1 $6 $ 1.00
2 5 2.50
3 4 6.00
4 3 7.00
5 2 11.00
Profits are maximized at an output of 2 units, where revenue is 10, cost is 2.5 and profit is
7.5. At any output level greater than 2, marginal revenue is less than marginal cost and
total profit declines.

DISCUSSION QUESTIONS
1. “It may be rational for the management of a firm not to try to maximize profits.”
Discuss the circumstances under which this statement may be true.
Some firms are non-profit firms, and they definitely do not maximize profits. A non-
profit hospital may maximize service to its community, while a worker-owned
cooperative may maximize wages. But even for-profit firms may have other objectives as
well as profits—such as size of the firm, community responsibility, or avoidance of
risk—any of which may conflict with profit maximization. The managers of the firm may
have goals such as salary maximization, prestige or job security, and these may lead them
to decisions that are not necessarily in the best interests of the stockholders who may
wish to maximize profits. So rational behavior is not necessarily equivalent to profit
maximization. One way of defining rational behavior, however, is to say that the decision
maker has some goal in mind, and acts in such a way as to optimize, or maximize, with
respect to that goal.
ANSWERS TO APPENDIX QUESTIONS
TEST YOURSELF
1. Suppose that the following table is your record of exam grades in your Principles of
Economics course.

Exam Date Grade Comment

September 30 65 A slow start
October 28 75 A big improvement
November 26 90 Happy Thanksgiving!
December 13 85 Slipped a little
January 24 95 A fast finish!

Use these data to make up a table of total, average, and marginal grades for the five
classes.

Total Average Marginal

Date Grade Grade Grade
9/30 65 65 65
10/28 140 70 75
11/26 230 77 90
12/13 315 79 85
1/24 410 82 95
Note: numbers are rounded for simplicity.

2. From the data in your exam-grade table in Test Yourself Question 1, illustrate each of
the rules mentioned in this appendix. Be sure to point out an instance where the
marginal grade falls but the average grade rises.
Rule 1a is illustrated on each line of the table. For example, on 11/26, the average grade,
77, is equal to the total grade, 230, divided by the number of exams, 3. Rule 1b is
illustrated on each line. On 1/24, the total grade, 410, is equal to the average grade, 82,
times the number of exams, 5. Rule 2a: The marginal grade of the third exam, 90, is equal
to the total grade after three exams, 230, minus the total grade after two exams, 140. Rule
2b: The total grade of three exams, 230, equals the marginal grade of the first exam, 65,
plus the marginal grade of the second, 75, plus the marginal grade of the third, 90. Rule
3: On 9/30, the marginal, average and total grades are all equal for the first exam, at 65.
Rule 4: After the first exam, the marginal grade exceeds the average grade for each exam,
and therefore the average rises continuously. Note that the marginal grade falls on the
fourth exam, but because it is still above the average, it pulls the average up.
CHAPTER 9
SECURITIES, BUSINESS FINANCE, AND THE
ECONOMY: THE TAIL THAT WAGS THE DOG?
TEST YOURSELF
1. Suppose that interest rates are 6 percent in the economy and a safe bond promises to pay
$3 per year in interest forever. What do you think the price of the bond will be? Why?
The value of the bond times the interest rate (0.06) equals the annual payment ($3.00). So
the price of the bond is the annual payment divided by the interest rate: $3.00/0.06 =
$50.00.
2. Suppose that in the economy described in Test Yourself Question 1, interest rates
suddenly fall to 3 percent. What will happen to the price of the bond that pays $3 per
year?
In this case, the price of the bond will rise; the new price will be $3.00/0.03 = $100.00.
3. For whom are stocks riskier than bonds? For whom are bonds riskier than stocks?
For corporations, bonds are riskier than stocks. For individual investors, stocks are riskier
than bonds.
4. Explain the role of subprime mortgages and mortgage-based securities in the financial
crisis of 2007–2009.
Subprime mortgages to borrowers with limited abilities to repay were packages and sold
to financial institutions as mortgage-backed securities in an effort to diversify risk.
However, when the entire housing market experienced a significant decline with a
substantial number of foreclosures, the value of the mortgage-backed securities dropped
tremendously creating an extremely adverse effect for all institutions holding these
securities.
5. Jenny purchases some stocks of Company X that initially cost $1,000 and pays for
them in cash. Jim makes the same purchase but leverages his investment by borrowing
$500 for the purpose at 10 percent interest, using the stocks as security for repayment.
If the stock’s price rises 20 percent, how much money do Jenny and Jim each make on
their investments? If the stock declines in value by 20 percent, how much money will
Jenny and Jim each have? (Remember that, in both instances, Jim must repay his $500
loan with interest.)
When the price of the stock rises by 20 percent, Jenny makes $200 on top of her original
$1,000 investment—a 20 percent profit on her investment. Jim’s investment also makes a
direct gain of $200, but after he has paid back his $500 loan (plus $50 interest), he is
actually left with $650—a 30 percent profit ($150) on the $500 of his own money that he
invested. In contrast, when the value of the stock declines by 20 percent, Jenny loses
$200 and is left with $800, or 80 percent, of her initial investment. Jim also loses $200,
but after he pays back his loan with interest ($550), he is left with only $250—that is, he
is left with only 50 percent, of his original $500 investment.
6. If the price of a company’s stock constitutes a random walk, next year its price will
equal today’s price plus what?
With a random walk pricing model of stocks, next year’s price will be equal to this year’s
price plus or minus a random and therefore, unpredictable amount.

DISCUSSION QUESTIONS
1. If you hold shares in a corporation and management decides to plow back the
company’s earnings some year instead of paying dividends, what are the advantages
and disadvantages to you?
The disadvantage of the plowback is that you do not get the cash income that you might
like, in the form of dividends. The advantage is that if the firm invests the funds
productively, the profitability of the firm will increase and with it the value of your
shares. At a later date, you will earn higher dividends or be able to sell your stock for a
higher price. Furthermore, you postpone paying taxes on your earnings until you get them
in the form of cash, and in the meantime your postponed tax payments can be working
for you.

2. Show in diagrams that if a speculator were to buy when price is high and sell when
price is low, he would increase price fluctuations. Why would it be in his best interest
not to do so? (Hint: Draw two supply-demand diagrams, one for the high-price period
and one for the low-price period. How would the speculator’s activities affect these
diagrams?)
Figure 1(a) shows a high price, Pa1, while Figure 1(b) shows a low price, Pb1. In (a), if
speculation raises demand from Da1 to Da2, the price will rise to Pa2, while in (b),
speculative sales will increase supply from Sb1 to Sb2, and lower the price to Pb2. With
speculation, the price change from Pa2 to Pb2 is greater than the price change would be
without speculation, from Pa1 to Pb1. A speculator who behaved in this way—buying at a
high price and selling at a low price—would lose money.

FIGURE 1

3. If stock prices really do take a random walk, can you nevertheless think of good
 reasons for getting professional advice before investing?

If stock prices really are a random walk, a professional advisor will not be able to help
you predict stock prices accurately. She may, however, be able to give you other
information that would be useful to you in making your decision—such as the likely
riskiness of the stock (how much its price has fluctuated), past decisions of the company
with respect to dividends versus plowback, and the social responsibility policies of the
company.

4. Hostile takeovers often end up in court when management attempts to block such a
maneuver and raiders accuse management of selfishly sacrificing the stockholders’
interests. The courts often look askance at “coercive” offers by raiders—an offer to
buy, say, 20 percent of the company’s stock by a certain date from the first
stockholders who offer to sell. By contrast, they take a more favorable attitude toward
“noncoercive” offers to buy any and all stock supplied at announced prices. Do you
think the courts are right to reject “coercive offers” and prevent management from
blocking “noncoercive” offers? Why?
Students will have various answers to this question. The argument against “coercive”
offers is that stockholders may feel pressured to make a decision to sell earlier than they
would prefer, before they have a chance to assess the pros and cons of the deal
adequately. On the other hand, one could argue that “coercive” offers are no different
from many other transactions in the economy. For example, you may have only an
uncertainly short time to buy tickets to a rock concert before they are sold out. In any
case, no one can force a stockholder to sell.

5. Discuss “herd behavior” among investors. Explain how it can sometimes take what
would otherwise have been a modest fall in the price of the stocks of a single company
and transform that into a precipitate collapse in the price of many stocks.
When a few investors begin to sell off stocks it can lead to other investors following the
same pattern. In such a case investors might be willing to sell their shares for any price
they can get, even if it is very low.

6. Some observers claim that laxity of the rules governing the creation, sale, and
purchase of some types of securities bear much of the guilt for the Great Recession of
the early twenty-first century. Can you suggest some specific types of activity that may
bear much of this responsibility? Explain how these activities may have increased the
problem, and suggest rules that could have reduced the severity of the financial crisis
of 2007–2009 and ensuing recession.
Answers may vary. Responses could focus on banking regulations and government
requirements on lending including loan-to-value and debt-to-income ratios. Responses
might also mention greater regulation of financial derivatives to prevent firms and other
investors from using these instruments to essentially gamble on the results in some
market like real estate.
APPENDIX
TEST YOURSELF
1. Company A sells heaters and Company B sells air conditioners. Which is the safer
investment, Company A stock, Company B stock, or a portfolio containing half of each?
Ultimately the answer to this question depends on whether or not either of these two
company stocks has no risk or infinite risk. Barring those possibilities, a portfolio
containing half of each will lower the risk.

2. If you make a lucky prediction about the prices of the stocks of the two companies in
Question 1, will you earn more or less if you invest in that company rather than the
portfolio?
If you make a lucky prediction about the weather trend or other trends within the
industry, you would make more money if you invested in the one stock that appreciated
more than if you had diversified into a portfolio with both stocks.

DISCUSSION QUESTIONS
1. In program trading, computers decide when to buy or sell stocks on behalf of large,
institutional investors. The computers then carry out those transactions with electronic
speed. Critics claim that this practice is a major reason why stock prices rose and fell
sharply in the 1980s. Is this idea plausible? Why or why not?
The idea is plausible because a very fast fall in demand, as guided by the computer, can
drive stock prices down with comparable speed and can frighten other investors to rush to
sell their securities, thereby speeding up any collapse of stock prices.
CHAPTER 10
THE FIRM AND THE INDUSTRY UNDER PERFECT
COMPETITION
TEST YOURSELF
1. Under what circumstances might you expect the demand curve of the firm to be
a. Vertical?
b. Horizontal?
c. Negatively sloping?
d. Positively sloping?
(a) A demand curve might be vertical for a good that is absolutely necessary to the
continuance of life, or for a good which is so cheap and which has so few close
substitutes that a rise in price would barely be noticed by the consumer.
(b) A demand curve facing a firm in a perfectly competitive industry is horizontal.
Because the products of the different firms are identical, and because there are so
many firms, no single firm can take a production decision that is large enough to
affect industry supply enough to alter the price.
(c) A firm’s demand curve will be negatively sloping if the firm’s output is a relatively
large portion of the industry’s output, or if the firm’s output is differentiated from the
output of the other firms and is identifiable. Under such circumstances, if the firm
seeks to sell a significantly higher output, it will have to lower its selling price in
order to attract new business.
(d) A firm’s demand curve might be positively sloping if it could somehow persuade the
public that the quality of the good it was selling was signaled by its price.
2. Explain why P = MC in the short-run equilibrium of the perfectly competitive firm,
whereas in long-run equilibrium P = MC = AC.
In the short run, a profit-maximizing firm sets output at a point where MR = MC. In the
case of a purely competitive firm, however, MR = P, and therefore the optimal output
level is where P = MC. In the long run, P is still equal to MC, but P is also equal to AC. If
P exceeded AC, profits would be positive, new firms would enter the industry and the
increase in supply would reduce P. If P were less than AC, profits would be negative,
firms would leave the industry and the reduction in supply would increase P. Therefore,
in long-run equilibrium, P = MC = AC.
3. Explain why it is not sensible to close a business firm if it earns zero economic profits.
If a firm is earning zero economic profit, the owner’s invested capital is earning the same
return it could earn in another use, while the owner’s labor (if she is working in the firm)
is earning the same income it could earn elsewhere, so the owner has no incentive to
close the firm.
4. If the firm’s lowest average cost is $52 and the corresponding average variable cost is
$26, what does it pay a perfectly competitive firm to do if
a. The market price is $51?
b. The price is $36?
 c. The price is $12?
(a) If the market price is $51, the firm should reduce output to produce at the point where
MC = $51. The firm will lose money, but the price is more than AVC, and therefore it
loses less money than if it quit altogether, and had to pay its fixed costs with no
income coming in. In the long run, when all costs are variable costs, the firm will shut
down.
(b) If the market price is $36, in the short run, the firm should cut back production, so
that MC is only $36. It will lose money, but the price exceeds AVC, and therefore it
loses less money than if it quit altogether, and had to pay its fixed costs with no
income coming in. In the long run, when all costs are variable costs, the firm will
close down.
(c) If the market price is $12, the firm cannot even cover its variable costs by producing.
It will lose less money if it quits business immediately, and only has to pay the fixed
costs, not a portion of the variable costs as well.
5. If the market price in a competitive industry were above its equilibrium level, what
would you expect to happen?
If the market price is above equilibrium, profits will attract new firms into the industry.
The increase in supply will reduce the price to its equilibrium, zero-profit level.

DISCUSSION QUESTIONS
1. Explain why a perfectly competitive firm does not expand its sales without limit if its
horizontal demand curve indicates that it can sell as much as it desires at the current
market price.
A profit-maximizing firm produces output at the point where marginal revenue equals
marginal cost. A perfectly competitive firm does not face the phenomenon of declining
marginal revenue, but it does experience rising marginal costs as its output rises. Once
marginal costs have reached the level of the price, any further expansion of output would
reduce profits.
2. Explain why a demand curve is also a curve of average revenue. Recalling that when
an average revenue curve is neither rising nor falling, marginal revenue must equal
average revenue, explain why it is always true that P = MR = AR for the perfectly
competitive firm.
The demand curve shows the price, P, at which different levels of output can be sold. But
P = PQ/Q, (where Q is output), and PQ is equal to total revenue, TR. Therefore, P =
TR/Q = AR, or average revenue. So the demand curve is a curve of average revenue.
When MR, marginal revenue, is less than AR, MR is pulling AR down and AR is falling;
when MR exceeds AR, AR is rising. Therefore, when AR is horizontal, as it is for a
purely competitive firm, MR = AR. More intuitively, P = MR for a purely competitive
firm, because each extra unit adds its full price to total revenue, and there is no deduction
from revenue caused by a declining price on earlier units. Thus: P = AR = MR.
3. Regarding the four attributes of perfect competition (many small firms, freedom of
entry, standardized product, and perfect information):
a. Which is primarily responsible for the fact that the demand curve of a perfectly
competitive firm is horizontal?
b. Which is primarily responsible for the firm’s zero economic profits in long-run
equilibrium?
 (a) The fact that all firms sell a standardized product is primarily responsible in that
customers have no reason to stay with one supplier if its price is higher than others.
Perfect information also plays a role in that consumers know the prices being charged
by different producers.
(b) The fact that there is freedom of entry is primarily responsible in that new
competitors can enter the industry easily if profits are positive.
4. We indicated in this chapter that the MC curve cuts the AVC (average variable cost)
curve at the minimum point of the latter. Explain why this must be so. (Hint: Because
marginal costs are, by definition, entirely composed of variable costs, the MC curve
can be considered the curve of marginal variable costs. Apply the general relationships
between marginals and averages explained in the appendix to Chapter 8.)
Total costs are equal to total fixed costs plus total variable costs. Marginal costs are equal
to the change in fixed costs plus the change in variable costs. However, since fixed costs,
by definition, do not vary, marginal costs are equal to marginal variable costs. So if MC
is less than AVC, it is pulling AVC down, while if MC is above AVC, it is pulling AVC
up—and consequently if MC is just equal to AVC, AVC must be neither rising nor
falling but at a minimum.
5. (More difficult) In this chapter we stated that the firm’s MC curve goes through the
lowest point of its AC curve and also through the lowest point of its AVC curve.
Because the AVC curve lies below the AC curve, how can both of these statements be
true? Why are they true? (Hint: See Figure 4.)
The MC curve consists only of variable costs, and so it goes through the low point of the
AVC curve. It also goes through the low point of the AC curve. The AC curve lies above
the AVC curve. Since the MC curve is positively sloped, this implies that the minimum
point of the AC curve occurs when output is higher than it is at the minimum point of the
AVC curve. This makes sense economically. The minimum point of the AC curve is
delayed, because declining average fixed costs keep exerting a downward pull on AC,
while they are not a part of and have no influence on AVC.
CHAPTER 11
MONOPOLY
TEST YOURSELF
1. Which of the following industries are pure monopolies?
a. The only supplier of heating fuel in an isolated town
b. The only supplier of IBM notebook computers in town
c. The only supplier of digital cameras
Explain your answers.
(a) Pure monopolist. There is no good substitute for heat (bulky sweaters don’t help a
great deal), and one firm controls the source.
(b) Not a pure monopolist. Consumers can buy close substitutes—that is to say, other
types of personal computers—from other firms.
(c) Not a pure monopolist. The one supplier of digital cameras is likely to have more
market power than the suppliers of some other goods, but still many other types of
cameras and even phones are substitutes for digital cameras.

2. The following are the demand and total cost schedules for Company Town Water, a
local monopoly:

Output in Price per Total

Gallons Gallon Cost

50,000 $0.28 $ 6,000

100,000 0.26 15,000

150,000 0.22 22,000

200,000 0.20 32,000

250,000 0.16 46,000

300,000 0.12 64,000

How much output will Company Town Water produce, and what price will it charge? Will
it earn a profit? How much? (Hint: First compute the firm’s MR and MC
schedules.)
From the data given, one can calculate total revenue, marginal revenue, marginal cost and
profit. For convenience, MR and MC per 50,000-gallon unit are shown, although students
may choose to calculate MR and MC per gallon:
 Output Price TR MR TC MC Profit
50,000 0.28 14,000 14,000 6,000 6,000 8,000
100,000 0.26 26,000 12,000 15,000 9,000 11,000
150,000 0.22 33,000 7,000 22,000 7,000 11,000
200,000 0.20 40,000 7,000 32,000 10,000 8,000
250,000 0.16 40,000 0 46,000 14,000 –6,000
300,000 0.12 36,000 –4,000 64,000 18,000 –28,000
The profit maximizing output is 150,000 gallons, where marginal revenue equals
marginal cost. The price charged is $0.22 a gallon, and the total profit is $11,000.

3. Show from the table in Test Yourself Question 2 that for the water company, marginal
revenue (per 50,000-gallon unit) is always less than price.

The price per 50,000-gallon unit is found by multiplying by 50,000. As the following table
shows, for each level of output, marginal revenue is less than price.
Output Price MR
50,000 14,000 14,000
100,000 13,000 12,000
150,000 11,000 7,000
200,000 10,000 7,000
250,000 8,000 0
300,000 6,000 –4,000

4. A monopoly sells Frisbees to two customer groups. Group A has a downward-sloping

straight-line demand curve, whereas the demand curve for Group B is infinitely elastic.
Draw the graph determining the profit-maximizing discriminatory prices and sales to the
two groups. What will be the price of Frisbees to Group B? Why? How is the price to
Group A determined?
Group B has an infinitely elastic demand curve; hence P = MR. Since the firm maximizes
profits, it sets output at, for example, QB, where MC = MR. To maximize overall profits,
the firm must have the same marginal revenue in both markets, and this must be equal to
PB. In Group A, when marginal revenue is equal to PB, the price is higher, as shown, PA.
FIGURE 1

DISCUSSION QUESTIONS
1. Suppose that a monopoly industry produces less output than a similar competitive
industry. Discuss why this may be considered socially undesirable. Is this because it
is always socially beneficial to produce more of some product?
There are many ways of discussing this question. For example:
(a) It is obvious that consumers are hurt if they get less output and at the same time have
to pay a higher price.
(b) The monopoly’s market power allows it to earn a profit in the long run, that is to say
an economic profit, over and above the income that would be necessary to attract the
firm into the industry. This is an unnecessary payment or penalty that consumers pay
the firm.
(c) The text shows that the price charged by the monopolist is greater than the marginal
cost. Therefore marginal utility exceeds marginal cost, and the monopolist is
restricting output below its optimal level.

2. If competitive firms earn zero economic profits, explain why anyone would invest
money in them. (Hint: What is the role of the opportunity cost of capital in economic
profit?)
If a firm earns zero economic profits, money invested in it earns just as high a return as it
would in its best alternate use. Thus the investment is just as good as another investment.
The point is that monopoly profits are not needed in order to attract capital into an
industry.

3. Suppose that a tax of $28 is levied on each item sold by a monopolist, and as a
result, it decides to raise its price by exactly $28. Why might this decision be against
its own best interests?
Any price increase by the monopolist will result in a reduction in sales, because of the
negatively sloping demand curve. When a tax of $28 per item is levied, if the monopolist
raises the price by $28, sales will be reduced to such an extent that marginal revenue will
exceed marginal cost (even though marginal cost has risen by $28). A more moderate
 price increase, with a smaller reduction in sales, will allow the monopolist to maximize
profits.

4. Use Figure 2 to show that Adam Smith was wrong when he claimed that a monopoly
would always charge “the highest price which can be got.”
The highest price a monopolist can charge is the price at which one unit is sold. Sales are
so low that profits are low, probably negative. A monopolist wishing to maximize profits
will not charge “the highest price which can be got,” but an intermediate price.

5. General Motors declared bankruptcy in 2009 but exited bankruptcy just 40 days
later, after streamlining its operations and selling the U.S. government a majority
stake in the company. If GM had gone out of business altogether, why might that
not have reduced the competition facing rival automaker Ford? (Hint: At what price
would the assets of the bankrupt companies be offered for sale?)
If General Motors went out of business, its assets would be offered for sale at relatively
low prices. This type of sale could allow an existing auto maker or a new firm to produce
and sell in the segment of the market vacated by GM. As such, a rival like Ford might not
see a substantial decrease in competition.

6. What does your answer to the previous question tell you about the ease or difficulty
of entry into the automobile industry?
Generally, there are significant barriers to entry into the automobile industry. The sale of
the assets of a firm exiting the market would be a unique situation that would greatly
reduce those barriers.

7. A firm cannot break even by charging uniform (nondiscriminatory) prices, but with
price discrimination it can earn a small profit. Explain why in this case consumers
must be better off if the firm is permitted to charge discriminatory prices.
The gains from exchange are mutual. Firms generate income for themselves, and
consumers benefit as well, gaining more in utility than they give up in payment for the
goods they buy. If they did not benefit, they would not buy. If a firm is forced to charge
uniform prices and as a consequence goes out of business, consumers are denied any
benefit at all from buying its products. If it is allowed to discriminate, and as a result
continues to exist, consumers will purchase its goods and therefore benefit.

8. It can be proved that, other things being equal, under price discrimination the price
charged to some customer group will be higher the less elastic the demand curve of
that group is. Why is that result plausible?
The more inelastic the demand, the more committed consumers are to buying the good,
regardless of its price. A firm can raise its price in such a market, without losing much
business. The lower the elasticity, therefore, the higher a price discriminator will push the
price.
CHAPTER 12
BETWEEN COMPETITION AND MONOPOLY
TEST YOURSELF
1. Using game theory, set up a payoff matrix similar to one that Volkswagen’s
management might employ in analyzing the problem presented in Discussion Question
5.
The payoff matrix for Ford might be Table 1:

TABLE 1
Volkswagon
Hire Singer Cut Price New Product
Hire Singer
Ford Cut Price
New Product

It is, of course, hard to tell what the entries in the payoff matrix will be.

2. Test Yourself Question 2 at the end of Chapter 11 presented cost and demand data for a
monopolist and asked you to find the profit-maximizing solution. Use these same
data to find the revenue-maximizing solution. In terms of the firm’s MR, explain
why the answers are different.
The revenue-maximizing solution occurs at an output of 250,000 gallons, where marginal
revenue is zero. At this output, total revenue is a maximum, $40,000. If the firm
expanded to an output of 300,000 gallons, marginal revenue would be negative, and total
revenue would fall to $36,000. The revenue maximizing output is higher than the profit
maximizing output of 150,000 gallons. To arrive at the latter, the firm set marginal
revenue equal to marginal cost; since marginal cost is positive, marginal revenue had to
be higher than zero, and (since marginal revenue has a negative slope) output was
consequently lower.
3. In the payoff matrix in Table 2, which is Firm B’s dominant strategy? Show the
calculation that leads to that conclusion.
In Table 2, we can see that if Firm A chooses the Low-Tech option, Firm B would be
better off choosing the High-Tech option since it would get a payoff of $12 million (vs.
$10 million if it chooses Low-Tech). If Firm A chooses the High-Tech option, Firm B
would be better off choosing the High-Tech option once again because it would get a
payoff of $3 million (vs. negative $2 million for the Low-Tech option). Therefore, High-
Tech is Firm B’s dominant strategy since it is the best strategy regardless of Firm A’s
strategy
4. You are given a payoff matrix for a zero-sum game. You see that for one pair of strategy
choices by the two firms, A’s payoff is 9 and B’s payoff is 6. For a second set of
strategy choices, A’s payoff is 7. What is B’s payoff?
Since it is a zero-sum game and A has lost 2 of its original payoff, B must have gained 2
and now will have a payoff of 8.

DISCUSSION QUESTIONS
1. How many real industries can you name that are oligopolies? How many operate
under monopolistic competition? Perfect competition? Which of these is most difficult
to find in reality? Why do you think this is so?
Some oligopolistic industries are wireless service, steel, chemicals, automobiles,
cigarettes, beer, petroleum, home appliances, aircraft and tires. Some industries in
monopolistic competition are groceries, shoemakers, laundries, print shops, novelty
stores, restaurants, gas stations and bicycle shops. It is hard to find a perfectly
competitive industry because it is a polar case; almost every firm has some distinguishing
feature. But the industries that come closest are farming and the sales of corporate stocks
and bonds.
2. Consider some of the products that are widely advertised on television. By what kind
of firm is each produced—a perfectly competitive firm, an oligopolistic firm, or
another type of firm? How many major products can you think of that are not
advertised on TV?
Most TV advertising is done by oligopolistic firms, for example beer, automakers, and
computer companies. A smaller firm, and particularly a perfect competitor, does not have
the resources to advertise and in any case it would not make sense for such a firm to
advertise on TV since most of the additional demand that was generated would go to
other firms in the industry. Goods that are not advertised, such as agricultural products,
are usually produced under conditions close to pure or monopolistic competition. (Note
that whenever such goods are advertised it is by a trade association or combination of
firms, not by a single small firm.)
3. In what ways may the small retail sellers of the following products differentiate their
goods from those of their rivals to make themselves monopolistic competitors:
hamburgers, radios, cosmetics?
In all three products, retailers differentiate themselves by the location and design of their
shops, by the service they provide and by their local advertising. Hamburger stores offer
different condiments and flavors and different side dishes. Radio stores offer products
that differ in certain features. Cosmetics retailers differ in their products and also in their
packaging.
4. Pricing of securities on the stock market is said to be carried out under conditions in
many respects similar to perfect competition. The auto industry is an oligopoly. How
often do you think the price of a share of Ford Motor Company’s common stock
changes? How about the price of a Ford Escape? How would you explain the
difference?
The price of Ford common stock changes many times a day. The price of a Ford Escape
changes usually once a year—perhaps more often if there are discount schemes or if there
is inflation. The continuous movements in supply and demand explain the frequent
changes in stock prices on the stock market. The stickiness of the auto price may be due
 to the “kinked demand curve.” Ford knows that if it raises its price, GM will not follow
suit, but if it lowers its price, GM will. Hence the demand curve is kinked and the
marginal revenue curve is discontinuous at the current output and price. Even if marginal
costs change, it will be advantageous for Ford to hold to its current price.
5. Suppose that Volkswagen hires a popular singer to advertise its compact
automobiles. The campaign is very successful, and the company increases its share of
the compact-car market substantially. What is Ford likely to do?
If Volkswagon’s advertising campaign succeeds in increasing its market share, Ford is
likely to take action to recover its market share. This may include increased advertising,
and may also include lowering its prices and developing new products. The point is that
Volkwagon has to expect retaliation.
6. A new entrant, Bargain Airways, cuts air fares between Eastwich and Westwich by 20
percent. Biggie Airlines, which has been operating on this route, responds by cutting
fares by 35 percent. What does Biggie hope to achieve?
This is an example of “predatory pricing.” Biggie hopes to set a price so low that Bargain
will be unable to compete and be driven out of business. Furthermore, other potential
entrants will be scared off. Biggie may actually suffer losses while this is happening.
Eventually however, when Bargain has left, Biggie hopes to act like a monopolist and set
a high price. This strategy will only be effective if Biggie can prevent new competitors
from entering the market.
7. If air transportation were perfectly contestable, why would Biggie Airlines (see
Discussion Question 6) fail to achieve the ultimate goal of its price cut?
If air transportation were perfectly contestable, Bargain could exit the industry while the
price was low, use its assets on some other routes for a while, then return to the Eastwich-
Westwich route when Biggie raised prices. So Biggie would never succeed in setting high
monopoly prices.
8. Which of the following industries are most likely to be contestable?
a. Aluminum production
b. Barge transportation
c. Computer manufacturing
d. Explain your answers.
Barge transportation is likely to be contestable, because barges can easily be moved into
or out of any geographical area, without a big expense. Aluminum and computer
production, however, require large fixed capital investments that are not easily mobile,
and therefore those two industries are unlikely to be contestable.
9. Since the deregulation of air transportation, a community served by a single airline is
no longer protected by a regulatory agency from monopoly pricing. What market
forces, if any, restrict the ability of the airline to raise prices as a pure monopolist
would? How effective do you think those market forces are in keeping airfares down?
A single airline serving a community is not a pure monopoly. It is restricted from setting
a monopoly price by the competition from other forms of transportation, such as cars,
buses, and trains. Furthermore, the barriers to entry into the market are not absolute, so if
the profits are sufficiently high the original airline is likely to face competition from
another airline. While they are not perfect, these market forces would be relatively
effective in keeping airfares from rising to exorbitant levels.
10. Explain, for a repeated game:
a. Why it may be advantageous to have the reputation of being a tough guy who
always takes revenge against anyone who harms your interests.
b. Why it may be advantageous to have a reputation of irrationality
(a) If Firm A is a “tough guy,” it will always strike back at hostile actions by Firm B,
even if those hostile acts harm its own interests. Once B becomes convinced that this
will happen, it may cease its hostile behavior against A, and A will benefit.
(b) If Firm A has a reputation for irrationality, Firm B may think it best to adopt a
conservative strategy, not threatening A’s profits, lest A strike out against it even at a
cost to itself. A may not do this, but B never knows.
CHAPTER 13
LIMITING MARKET POWER: REGULATION AND
ANTITRUST
DISCUSSION QUESTIONS
1. Why is an electric company in a city often considered to be a natural monopoly?
What would happen if two competing electric companies were established? How
about telephone companies? How can changes in technology affect your answer?
Electric companies and telephone companies usually have declining average costs as
more customers are added and more use is made of their services. A large part of the
costs are fixed, in the form of the distribution network. It would be wasteful to add a
second or third distribution network that covers the same routes as the first. Costs to
consumers would have to rise. So a monopoly can serve the public interest, provided that
the firm does not use its market power to exploit its customers. Changes in technology
can significantly alter the cost structure of an industry and potentially eliminate a natural
monopoly. An example is the impact of small satellite TV dishes on cable TV networks.
2. Suppose that a 20 percent cut in the price of coast-to-coast telephone calls brings in
so much new business that it permits a long-distance telephone company to cut its
charges for service from Chicago to St. Louis, but only by 2 percent. In your
opinion, is this practice equitable? Is it a good idea or a bad one?
If a cut in the price of coast-to-coast telephone calls brings in so much business that it
allows the long-distance carrier to reduce the price of Chicago to St. Louis calls, then
both the long-distance carrier and the consumers benefit. Other long-distance competitors
may be hurt, but then they have an added incentive to improve efficiency and provide
better service to the public. Most observers would endorse such a rate reduction.
3. In some regulated industries, regulatory agencies prevented prices from falling, and
as a result many firms opened for business in those industries. In your opinion, is
this kind of regulation competitive or anticompetitive? Is it a good idea or a bad
one?
When a regulatory agency imposes a price floor, it may encourage more firms to enter the
industry, but it does not really encourage competition. The point of having many firms
compete against each other is to force them to be efficient and to keep costs and prices
low. In the case of the regulated price floor, the regulatory agency creates the appearance
of competition, but at the expense of providing its benefits to the consumer.
4. Regulators are highly concerned about the prevention of “predatory pricing.” The
U.S. Court of Appeals has noted, however, that “the term probably does not have a
well-defined meaning, but it certainly bears a sinister connotation.” How might one
distinguish “predatory” from “nonpredatory” pricing? What would you do about
it?
A court should not find a price predatory and illegal simply because it is lower than other
competitors can meet, if the low price can be sustained by the company. In such a case,
consumers benefit in the long run. In contrast, if the firm with the lower price is
 incurring a sustained economic loss, that would be a better indication that the firm is
engaging in predatory pricing.
5. Do you think that it is fair or unfair for rural users of telephone service to be cross-
subsidized by other telephone users?
Students will have their own criteria for fairness. But it is helpful to approach this
question by thinking of what the alternative is to having urban telephone users subsidize
rural telephone users. One alternative is that rural rates would be higher than urban
rates—this could be seen as fairer (because rural average costs are higher than urban) or
less fair (because people are being charged different prices for the same service). One
consequence of higher rural rates might be that some rural households would choose to
go without telephone service, and students may feel this is an undue burden. Another
alternative, however, is that rural rates could be kept at the urban level by means of a
government subsidy—this would impose the burden of the subsidy upon all taxpayers, in
proportion to their capacity to pay income taxes, rather than upon urban phone users, and
students may feel that this is more fair.
6. To provide incentives for increased efficiency, several regulatory agencies have
eliminated ceilings on the profits of regulated firms but instead put caps on their
prices. Suppose that a regulated firm manages to cut its prices in half, but in the
process it doubles its profits. Should rational consumers consider this to be a good
or a bad development? Why?
Rational consumers should consider any fall in price to be a good development, because
it increases their utility. They are in no way harmed by the increase in the company’s
profitability. In fact, it may well have been the incentive of the increased profits that led
the firm to figure out how to reduce costs and prices.
7. A shopkeeper sells his store and signs a contract that restrains him from opening
another store in competition with the new owner. The courts have decided that this
contract is a reasonable restraint of trade. Can you think of any other types of
restraint of trade that seem reasonable? Can you think of any that seem
unreasonable?
An agreement between a library and construction firms under which the firms agree to
limit their hours of work in the neighborhood would seem to be a reasonable restraint on
trade. So would a voluntary agreement among owners of fishing boats to limit the size of
their catch in order to preserve the long-run yield of the fishery. But many commercial
agreements are deemed by the law to be unreasonable, for example a cartel arrangement
in which a small group of large firms agrees to limit their output in order to raise the
market price.
8. Which of the following industries do you expect to have high concentration ratios:
automobile production, aircraft manufacture, computer and electronics production,
pharmaceuticals, production of expensive jewelry? Compare your answers with the
data in Table 2.
As of 2007, aircraft manufacture had the highest concentration ratio (81.3), followed by
automobile production (67.6), then pharmaceuticals (34.5), then production of expensive
jewelry (28.5), and finally by computer and electronics production (17.3).
9. Why do you think the specific industries you selected in Discussion Question 8 are
highly concentrated?
Automobiles and aircraft are two industries that are highly mechanized and in which
huge fixed costs lead to substantial economies of scale. In these cases, therefore, large
companies have an advantage over small companies, and the industries tend to be quite
highly concentrated. The production of computers and electronics do not require
significant economies of scale and therefore these industries are relatively
unconcentrated. The pharmaceutical industry is characterized by very high research and
development costs as well as high sales costs. However, once created, many
pharmaceutical products can be produced at a low marginal cost. The result is the drug
industry is somewhat concentrated.
10. Do you think it is in the public interest to launch an antitrust suit that costs $1
billion? What leads you to your conclusion?
Costly antitrust suits may be justified if the activities they are attacking cause major harm
to the public. But since antitrust suits do tend to be very expensive, the Department of
Justice is well advised not to embark upon suits that are ill founded or frivolous.
11. In Japan and a number of European countries, the antitrust laws were once much
less severe than those in the United States. Do you think that this difference helped
or harmed American industry in its efforts to compete with foreign producers?
Why?
American companies argue that they are harmed in their competition with foreign
companies by the strict U.S. antitrust laws. They are sometimes correct, when American
laws seem to prevent cooperation between firms in research and development, market
research, and other areas. On the other hand, the intent of antitrust laws is to promote
competition and to keep prices low, and to the extent that they are effective they should
therefore help American companies to compete against foreigners.
12. Can you think of some legal rules that may discourage the use of antitrust laws to
prevent competition while at the same time not interfering with legitimate antitrust
actions?
Antitrust laws can discourage competition if they are used against a company that has
grown larger simply because it has performed better than other firms in the industry, by
developing better products, selling at a lower price, improving its marketing, etc. If the
management of a firm fears prosecution under these circumstances, it may decide against
innovation. The most obvious way to discourage the use of antitrust laws in such a way is
to insist that the criterion of prosecution be illegal conduct, not simply market structure.
Another possibility is to require the plaintiff to pay the legal costs of the defendant if the
plaintiff does not prevail.
13. During the oil crisis in the 1970s, long lines at gas stations disappeared soon after
price controls were removed and gas prices were permitted to rise. Should this event
be interpreted as evidence that the oil companies have monopoly power? Why or
why not?
Nothing in the question indicates that oil companies have monopoly power. The supply
and demand curves might be as shown in Figure 1 below. A price ceiling of PC might
cause a shortage, that is to say an excess of quantity demanded, QD, over quantity
supplied, QS, and consequently long lines at gas stations. When the ceiling is removed,
the price would naturally rise to its market equilibrium level, P1; this would increase the
 quantity supplied, reduce the quantity demanded and eliminate the shortage and the lines.
There is no evidence that the companies have monopoly power to raise prices.

FIGURE 1

14. Some economists believe that firms rarely attempt predatory pricing because it
would be a very risky act even if it were legal. Why may this be so?
Predatory pricing exists when a firm temporarily reduces its price below the profit-
maximizing level, in order to force other, weaker firms to reduce their prices, in the
expectation that those firms will go out of business, thus allowing the initial firm to have
greater power, set a higher price, gain market share and increase profits. The risk is that
the predatory firm itself may incur losses and even go out of business, because it has
chosen such low prices.
15. Firm X cuts its prices, and competing Firm Y soon goes out of business. How would
you judge whether this price cut was an act of legitimate and vigorous competition
or an anticompetitive act?
This is very similar to question 4 about predatory pricing. To distinguish between an
anticompetitive act and a legitimate competitive act one should identify potential barriers
to entry, determine if the market is contestable, estimate the relevant demand elasticities,
estimate the firm’s average and marginal cost curves, and identify the number of potential
and actual competitors. If Firm X is able to profitably sustain the new low price and if
new, more efficient firms enter the market this action was a result of legitimate
competition that resulted in the elimination of the inefficient Firm Y. If Firm X incurs a
loss as a result of the initially low price, raise its price after the exit of Firm Y and is able
to prevent new firms from entering the market, this price cut was an anti-competitive act.