November 2016

MN1017 Foundations of Economics

Seminar 6 Answer Key

The following is the answer key to the questions for Seminar 6.

Discuss 10.3: Policies

Regulation: This policy directly restricts the quantity.

• Weakness: It is difficult to determine and enforcing the right quota for each plantation.
• Strength: The costs of pollution the fishermen incur will be reduced directly, while the
plantations that cause pollution directly lose surplus.

Pigouvian Tax: This policy internalises the external costs.

• Weakness: It is not straightforward to measure the external costs (or the marginal social
costs).
• Strength: The costs of pollution imposed on the fishermen will be reduced directly, while
the plantations that cause pollution directly lose surplus (even more than by regulation).

Enforcing compensation: This policy also internalises the external costs.

• Weakness: It is difficult to measure the costs imposed on each fisherman and the costs of
pollution each planation is causing. Thus, it is not straightforward to determine how much
compensation each fisherman should receive and how much each plantation should pay.
• Strength: The costs of pollution imposed on the fishermen incur will be fully
compensated (more than the above two policies), while the surplus of the plantations will
be exactly the same as the social producer surplus.

Discuss 10.4: Incomplete Contracts

Incinerator: Difficult to measure the damage each residents nearby suffers from the fumes.

Loud music: Difficult to measure the damage the neighbours suffer from the loud music.

Training: Difficult to measure the benefits the worker and/or the new employer receives from
the training.

Irrigation: Difficult to measure the benefits each of other farmers receives from irrigation.

Climate change: Difficult to measure the benefits each of other countries receives from the
reduction in carbon emission by the country.

Discuss 10.5: Rivalry and Excludability

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A public lecture at a university: If the lecture is to be held in a lecture theatre, it is non-rival
with in the lecture theatre (as long as the audience do not cause noise). It is excludable
provided that the number of seats is limited and requires a prior registration.

Noise produced by aircraft around an international airport: It is non-rival and non-excludable

at least locally around the airport.

A public park: It is non-rival as long as it is not too crowded, and it is also non-excludable if
the access to the public park is not restricted.

A forest used by local people to collect firewood: It is rival, but is non-excludable if the forest
can be accessed without restrictions (no fences, etc.)

Seats in theatre: They are rival and excludable.

Bicycles available for hire to the public to travel around a city: It is rival, and excludable if
they are locked (and require a key), but may be non-excludable if they are without a lock.

Discuss 10.12: Market Failure

The Decision Market Failure Terms applied

Luxury designer clothing
Inoculating costly vaccination
Risky project using bank loans
Fishing in international waters
Increasing night-time departures
Contributing to Wikipedia
Government investment in nuclear
fusion research
Conspicuous consumption
(consuming too much luxury
clothing; public bad)
Too little vaccination
Higher loan interest rate and/or
credit rationing
Overfishing in international waters
(excessive reduction of fish stock)
Over-use of night-time flights that
does not reflect the costs of
pollution (noise)
Too little contribution
Too little or too much research if it
is done by the private sector
Negative externalities
(Veblen effect)
Public good, Positive externalities
Moral hazard (missing markets)
Negative externalities, (public bad)
Negative externalities, public bad
Public good, Positive externalities
Public good/bad, Positive/negative
externalities

Question 1:
!" !
(a) The average cost is 𝐴𝐶 = !
= ! + 0.1𝑄. Thus, if 𝐹 = 1000 and 𝑄 = 100, then it is 20.
The marginal cost is 𝑀𝐶 = 0.2𝑄; thus, it is 20 when 𝑄 = 100. To verify that the average
cost is lowest when 𝑄 = 100, we can check the average costs when 𝑄 = 99 and 𝑄 = 101:
!"""
When 𝑄 = 99, 𝐴𝐶 = !! + 9.9 ≈ 20.001, and 𝐴𝐶 ≈ 20.001 when 𝑄 = 101.

(b) If 𝐹 = 10,000,000 and 𝑄 = 10,000, then the average cost is 2,000. The marginal cost is
𝑀𝐶 = 0.2𝑄; thus, it is 2,000 when 𝑄 = 10,000. To verify that the average cost is lowest
when 𝑄 = 10,000, we can check the average costs when 𝑄 = 9999 and 𝑄 = 10001: When
!"""
𝑄 = 99, 𝐴𝐶 = !! + 9.9 ≈ 2000.00001, and 𝐴𝐶 ≈ 2000.00001 when 𝑄 = 10001.

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(c) For all 𝑄 ≤ 5,000, the average cost is decreasing in 𝑄; thus, Anglo’s technology exhibits
an increasing returns to scale.

(d) With increasing returns to scale, the average cost becomes lower by increasing the
quantity. Moreover, the average cost is higher than the marginal cost; thus, firms need to exit
the market if the price is the same as the marginal cost as in the case of perfect competition
(since it is below the average cost). What will happen is that only the firm that has the lowest
average cost (i.e. largest quantity/scale) survives, resulting in a monopoly.

(e) Since Anglo is in a natural monopoly, it can set the price by itself, i.e. it is not a price-
taker. The price will be better than a break-even price, so it must be higher than the average
cost. Since the average cost is higher than the marginal cost, the price must be higher than the
marginal cost, too

Note: The equilibrium price and quantity will be determined to maximise Anglo’s profit, and
the price is always higher than the marginal cost. A firm deemed to be in an industry that
would be in a natural monopoly is usually regulated so that the firm would not make
excessive profit by setting a price that is much higher than the average cost.