Handbook Midterm PE

INTERNATIONAL SCHOOL OF BUSINESS
Revision on Principle of
Microeconomics
BY ISB ACADEMIC TEAM
Chapter 1: Ten Principles of Economics 1
Chapter 1:
Ten Principles of Economics
Scarcity
Economics: a study of how society manages its scarce resources
scarce resources are not allocated by dictators, but through combined
choice of households and firms
Principle 1: People Face Trade-Offs
Get something you like, give up something else you also like
Common expressions:
Guns and Butter: Trade-off between a nati
Efficiency and Equity
Efficiency: Getting the most it can from resources (How large the pie is)
Equity: Distributing prosperity uniformly among citizens (How the pie is
divided)
Principle 2: The Cost of Something is What You Give Up to Get It

The cost of doing something includes Opportunity Cost: Whatever must be given
up to obtain something.
Opportunity Cost is something you would have done if the initial option had not
existed
E.g.: You have $100, you can buy A, B, C or D. You choose A. But, if A did not
exist, you would choose B. So the Opportunity Cost of buying the good A is the good B
Principle 3: Rational People Think at The Margin
Rational People do the best they can to achieve their objectives.
Marginal Change: an incremental change to an existing plan.
Making decision: Comparing between Marginal Cost and Marginal Benefits
E.g.: Plane tickets problem:
_The plane got 500 seats; the airport has already sold 497 seats at the price of $90 each.
Near departure time, a passenger comes and wants to buy a ticket. At this point, the
airport would accept any price higher than $0 because the plane will take off whether
with or without the new passenger. Doing that will maximize the profit (or minimize the
cost) for the airport.

Principle 4: People Respond to Incentives
Incentive: something that induces people to act, play a central role in the study of
economics.
When policymakers want to apply new law, they must consider also less obvious,
indirect effects that work through incentives.
Principle 5: Trade Can Make Everyone Better Off
Trade allows people to specialize.
People would not be better off isolating themselves.
Principle 6: Markets Are Usually a Good Way to Organize Economics
Activity
Market Economy: allocates resources through decentralized decisions of
households and firms as they interact.
People are interested in their own well-being => Promote overall well-being =>
Market Price maximizes well-being as a whole, reflects value of goods to the society
and cost of society to make them.

Principle 7: Governments Can Sometimes Improve Market Outcomes
Property Rights: Ability of an individual to own and exercise control over resources.
Policies aim at promoting Efficiency or Equity.
Market Failure: A market left on its own fails to allocate scarce resources efficiently.
Including Externalities and Market Power
Externalities: Impact on the well-being of bystanders. E.g.: Pollution affects
citizens living nearby
Market Power: Single economic actor has a substantial influence on market
prices. E.g.: Monopoly
Produce Goods and Services
Productivity: Quantity of goods and services produced from each unit of labor
input, primary determinant of a -being.

Growth rate of productivity determines the growth rate of average income.
Principle 9: Prices Rise When Government Prints Too Much Money
Inflation: An increase in overall level of price
When a government creates a large quantity of money, the value of money falls.
Principle 10: Society Faces a Short-run Trade-off between Inflation and
Unemployment
Amount of money increases => Overall spending increases => Demand for goods
and services increased => Sellers produce more goods => Hire more workers =>
Unemployment falls
EXERCISE
1. Economists use the phrase "There is no such thing as a free lunch," to
illustrate the principle that
a. inflation almost always results in higher prices over time.
b. nothing is free in a market economy.
c. making decisions requires trading off one goal against another.
d. if something looks too good to be true, it probably is not worth pursuing.
2. Which of the following statements best represents the principle represented by
the adage, "There is no such thing as a free lunch"?
a. Melissa can attend the concert only if she takes her sister with her.
b. Greg is hungry and homeless.
c. Brian must repair the tire on his bike before he can ride it to class.
d. Kendra must decide between going to Colorado or Cancun for spring break.
3. When society requires that firms reduce pollution, there is
a. a tradeoff because of reduced incomes to the firms' owners and workers.
b. a tradeoff only if some firms are forced to close.

c. no tradeoff, since the cost of reducing pollution falls only on the firms affected
by the requirements.
d. no tradeoff, since everyone benefits from reduced pollution.
4*. A construction company has built 50 houses so far this year at a total cost to
the company of $8 million. If the company builds a 51st house, its total cost will
increase to $8.18 million. Which of the following statements is correct?
a. For the first 50 houses, the average cost per house was $160,000.
b. The marginal cost of the 51st house, if it is built, will be $180,000.
c. If the company can experience a marginal benefit of $190,000 by building the
51st house, then the company should build it.
d. All of the above are correct.
5. When you calculate your true costs of going to college, what portion of your
room-and-board* expenses should be included?
*room-and-board: the meals and room that are provided when someone pays to
stay somewhere, for example when working or studying away from home.
a. Your full room-and-board expenses should always be included.
b. None of your room-and-board expenses should ever be included.

c. You should include only the amount by which your room-and-board expenses
exceed the income you earn while attending college.
d. You should include only the amount by which your room-and-board expenses
exceed the expenses for rent and food if you were not in college.
6. The average cost per seat on the 50-passenger Floating-On-Air Bus
served, is $45. In advance of a particular trip, three seats remain unsold. The bus
company could increase its profit only if it
a. charged any ticket price above $0 for the three remaining seats.
b. charged at least $15 for each of the three remaining seats.
c. charged at least $45 for each of the three remaining seats.
d. paid three people to occupy the three remaining seats.
7. Which is the most correct statement about the invisible hand?
a. The invisible hand always ensures both equity and efficiency.
b. The invisible hand is more effective at ensuring equity than it is at ensuring
efficiency.
c. The invisible hand is more effective at ensuring efficiency than it is at ensuring
equity.
d. Market power is the instrument with which the invisible hand directs economic
activity.
8. Which of these activities will most likely result in a positive externality?
a. A college student buys a deck of cards to play solitaire in her dorm room.
b. An elderly woman plants a flower garden on the vacant lot next to her house.
c. An executive purchases a book to read on a business trip.
d. A ten-year-old uses his allowance to buy new Nike shoes.
9. Which of the following is the most correct statement about the relationship
between inflation and unemployment?
a. In the short run, falling inflation is associated with falling unemployment.
b. In the short run, falling inflation is associated with rising unemployment.
c. In the long run, falling inflation is associated with falling unemployment.
d. In the long run, falling inflation is associated with rising unemployment.

ANSWER AND EXPLANATION
1. c. making decisions requires trading off one goal against another.
Explanation: According to Principle 1 & 2.
2. d. Kendra must decide between going to Colorado or Cancun for spring break.
Explanation: Because the adage illustrates the principle of trading off. Also, Kendra in
the situation D is forced to choose Colorado and give up going to Cancun or vice versa.
Thus, D is the most appropriate answer => choose D.
3. a. a tradeoff because of reduced incomes to the firms' owners and workers.
Explanation: Laws that require firms to reduce pollution raise the cost of producing
goods and services. Because of these higher cost, the firms end up earning small profits,
paying lower wages, changing higher prices or some combination of these three. Thus,
they come at the cost of reduced incomes to the firms' owners and workers.
4. d. All of the above are correct
Explanation:
a. The average cost per house = = $160,000
b. The marginal cost of the 51st house = $8 million - $8.18 million

= 0.18 million = $180,000
c. Because $190,000 > $180,000
Take the action
5. d. You should include only the amount by which your room-and-board expenses
exceed the expenses for rent and food if you were not in college.
Explanation: The cost of an item is what you give up to get this item. Even if you quit
school, you still need a place to sleep and food to eat. Room and board are costs of going
to college only to the extent that they are more expensive than elsewhere.
6. a. charged any ticket price above $0 for the three remaining seats.
Explanation: Because if it has empty seats, the cost of adding one more passenger is
tiny. The average cost per seat is $45, but the marginal cost is approximately $0 because
no refreshments are served. As long as the three remaining seats are paid more than the
marginal cost ($0), selling them is profitable.
7. c. The invisible hand is more effective at ensuring efficiency than it is at ensuring
equity.
Explanation: The invisible hand can lead to efficient outcomes, but it does not ensure
equality. (See the second paragraph bottom-up, p.12, PE textbook)
8. b. An elderly woman plants a flower garden on the vacant lot next to her house.
Explanation: an external benefit is a positive externality, which is the impact of one
-being of bystander. As an elderly woman plants a flower
garden on the vacant lot next to her house, the house next door, the street or people
surrounding can also have benefits.
9. b. In the short run, falling inflation is associated with rising unemployment.
Explanation: Principle 10
Chapter 2: Thinking Like an Economist 13
Chapter 2:
Thinking Like an Economist
1. The Economist as Scientist
- Economists approach the study of the economy by devising theories, collecting
data, and then analyzing these data in an attempt to verify or refute their theories
(The Scientific-Method)
- In economy, conducting experiments is impractical. Economists have to make do
with the data the world happens to give them
- Assumptions simplify the complex world and make it easier to understand
- For studying short-run effects: assume that prices do not change much or are
completely fixed
- For studying long-run effects: assume that all prices are completely flexible
2. Economic Models
The models: to show how the economy is organized and how participants in the
economy interact with one another

+ First Model: Circular-Flow Diagram: a visual model of the economy that
shows how dollars flow through markets among households and firms
- Factors of production: the inputs used in producing goods and services such as
labor, land, and capital (buildings and machines)
- Markets for goods and services: households are buyers, firms are sellers
- Markets for the factors of production: households are sellers, firms are buyers
+ Second Model: Production Possibilities Frontier: a graph that shows the
combinations of output that the economy can possibly produce given the available
factors of production and the available production technology
E.g.: an economy that produces only 2 goods cars and computers.
- The economy can produce any combination on or inside the frontier; but
cannot produce at points outside the frontier
- Efficient outcome: the economy is getting all it can from the scarce resources it
has available points on the frontier represent efficient levels of production
(point A, B, F, E)
- Inefficient outcome: the economy produces less than it could from the
available resources points inside the frontier represent inefficient levels of
production (point D)
- The slope of the graph measures the opportunity cost
- Opportunity cost: the cost of something is what you give up to get it
- The Production Possibilities Frontier is usually bowed outward because
, that is, some are better at producing particular goods
rather than other goods
- Shifts in the Production possibilities frontier
Economy grows outward
3. Microeconomics and Macroeconomics
- Microeconomics: the study of how households and firms make decisions and
how they interact in markets
- Macroeconomics: the study of economy-wide phenomena, including inflation,
unemployment, and economic growth
- Microeconomics and Macroeconomics are closely intertwined

4. The Economist as Policy adviser
Positive versus normative analysis
- Positive statements: claims that attempt to describe the world as it is
- Normative statements: claims that attempt to prescribe how the world should be
5. Why Economists disagree
- Differences in scientific judgments
- Differences in values
- Perception versus reality

EXERCISE
A A
Markets for Goods

B and Services B
Firms Households
C C
Markets for Factors

D of Production D
Figure 1
01. Refer to Figure 1.
a. Which arrow shows the flow of goods and services?
b. Which arrow shows the flow of spending by households?
c. Which arrow shows the flow of the factors of production?
d. Which arrow shows the flow of income payments?
02. The curved shape of the production possibilities frontier can be explained by
a. increasing cost of production.
b. constant cost of production.

c. scarcity.
d. economic growth.
03. When a production possibilities frontier is linear it shows
a. a truer picture of real life than a bowed out production possibilities frontier.
b. that resources are perfectly shiftable from the production of one good to
another.
c. an example of increasing opportunity cost.
04. Production possibilities frontiers can shift outward if
a. government increases the amount of money in the economy.
b. there is an increase in technology.
c. resources can be moved from the production of one good to another.
d. Both b and c are correct.
05. When a production possibilities frontier shifts outward, it is demonstrating the
concept of
a. trade-offs.
b. efficiency.
c. economic growth.
d. opportunity cost.
06. Production is efficient if the economy is producing at a point
a. On the production possibilities frontier.
b. Outside the production possibilities frontier.
c. On or inside the production possibilities frontier.
d. Inside the production possibilities frontier.
07. Which of the following concepts can not be illustrated by the production
possibilities frontier?
a. Efficiency
b. Opportunity cost
c. Equity
d. Trade-offs
08. Production possibilities frontier are usually bowed outward. This is because
a. The more resources a society uses to produce one good, the fewer resources it has
available to produce another good.

b. It reflects the fact that the opportunity cost of producing a good decreases as more
and more of that good is produced.
c. Of the effects of technological change.
d. Resources are specialized, that is, some are better at producing particular goods
rather than other goods.
09. Here are some production possibilities for an imaginary economy for a given
year.
Cars Newspapers
10 400
12 360
14 ?
If the production possibilities frontier is bowed outward
a. 340
b. 330
c. 320
d. 310
10. Unemployment would cause an economy to
a. Produce inside its production possibilities frontier.
b. Produce on its production possibilities frontier.
c. Produce outside its production possibilities frontier.
d. Experience an inward shift of its production possibilities frontier.
Figure 2 below is used to answer Question 11-14:
11. Refer to Figure 2. If the economy moves from point A to point D, the
opportunity cost is
a. 10 toasters.
b. 20 toasters.
c. 30 toasters.
d. 30 toothbrushes
12. Refer to Figure 2. The opportunity cost of obtaining 15 additional toasters by
moving from point D to point C is
a. 10 toothbrushes
b. 20 toothbrushes
c. 30 toothbrushes
d. None of the above is correct.
13. Refer to Figure 2. The opportunity cost of obtaining 10 additional toasters by
moving from point B to point A is
a. 10 toothbrushes
b. 20 toothbrushes
c. 30 toothbrushes

14. Refer to Figure 2. Suppose the economy is producing at point B. Which of the
following statements would best explain this situation?
a. The economy lacks the resources to produce at a more desirable point.
b.
desirable point.
c. There is widespread unemployment in the economy.
Figure 3 below is used to answer Question 15 & 16:
15. Refer to Figure 3. If the economy move from point C to point B, then which of
the following statement is correct?

a. The economy benefited from a technological advance in the production of
baseballs.
b. The opportunity cost of each additional baseball is 2 bananas.
c. The opportunity cost of each additional banana is 2 baseballs.
d. The move involves no opportunity cost; it simply reflects the desires of the
eco
16. Refer to Figure 3. If the economy move from point A to point B, then which of
the following statements is correct?
a. The economy has moved from a point of inefficient production to a point of
efficient production.
b. The economy has experienced economic growth.
c. The opportunity cost of each additional banana is 50 baseballs.
17. In a certain economy, peanuts and books are produced, and the economy
currently operates on its production possibilities frontier. Which of the following
events would allow the economy to produce more peanuts and more books,
relative to the quantities of those goods that are being produced now?
a. Unemployment labour is put to work producing peanuts and books.

b. The economy puts its idle capital to work producing peanuts and books.
c. The economy experiences economic growth.
Figure 4 below is used to answer Question 18 & 19:
18. Refer to Figure 4. Which of the following would most likely have caused the
production possibilities frontier to shift outward from A to B?
a. An increase in the availability of capital-producing resources.
b. A technological advance in the consumer goods industries.
c. A general technological advance in both goods.
d. A decrease in unemployment.
19. Refer to Figure 4. The shift of the production possibilities frontier from A to B
can best be described as
a. A downturn in the economy.
b. Economic growth.
c. An enhancement of equity.
d. An improvement in the allocation of resources.
Figure 5 below is used to answer Question 20:
20. Refer to Figure 5. Which of the following events would explain the shift of the
production possibilities frontier from A to B?
a. The economy experienced a technological advance in the production of batteries.

b. More labor became available in the economy.
c. The economy experienced a general technological advance.
d.
1. ANS: (according to PE textbook, figure 1 page 23)
a) Arrow B
b) Arrow A
c) Arrow C
d) Arrow D
2. ANS: a. increasing cost of production. (According to PE textbook page 25 last
paragraph and page 26 first paragraph.)
3. ANS: b. that resources are perfectly shiftable from the production of one good to
another. (When ppf is linear, its slope is constant => Opportunity cost is constant, so one
good is shiftable at a constant rate with the other.)
4. ANS: b. there is an increase in technology. (according to PE textbook page 26
paragraph 2)
5. ANS: c. economic growth. (according to PE textbook page 26 paragraph 3)
6. ANS: a. On the production possibilities frontier.
(According to PE textbook page 25 paragraph 2)
7. ANS: c. Equity (according to PE textbook page 26, the last paragraph. Answer a, b, d
is illustrated)
8. ANS: d. Resources are specialized, that is, some are better at producing particular
goods rather than other goods.
(According to PE textbook page 25, the last paragraph)
9. ANS: d. 310
(Explaining: The key information here is that the production possibilities frontier
(PPF) is bowed outward, which mean the opportunity cost for producing two additional
cars will be larger as we move down the PPF.

- The opportunity cost when we increase the production of cars from 10 to 12 is 40
newspapers (400 - 360).
- As the opportunity cost increase, the opportunity cost for producing the next two
additional cars will be larger than 40. (360 - ? > 40 ? < 320)
News-
papers
400
360
?
10 12 14
Cars
10. ANS: a. Produce inside its production possibilities frontier.
(According to PE textbook page 25 paragraph 2)
11. ANS: b. 20 toasters.
(Explaining: At point A, the economy produces 30 toasters and 30 toothbrushes. At
point D the economy produces 10 toasters and 60 toothbrushes. Therefore, the
opportunity cost to produce 30 more toothbrushes is 20 less toasters.
12. ANS: d. None of the above is correct.

(Explaining: Because point C is outside the production possibilities frontier, the
economy cannot move from point D to point C.)
(Explaining: Because point B is inside the production possibilities frontier, the
economy has the additional resources to produce 10 additional toasters. The opportunity
cost is Zero.)
14. ANS: c.There is widespread unemployment in the economy.
(Explaining: Point B is inside PPF. According to PE textbook page 25 paragraph 2 the
answer is c)
15. ANS: b.The opportunity cost of each additional baseball is 2 bananas.
(Explaining: Answer a and d are incorrect because point C and B are both on PPF,
there is no technological advance and there will be opportunity cost.
At point B the economy produce 150 baseballs and 200 bananas. At point C the
economy produce 100 baseballs and 300 bananas. Which means to produce 50 more
baseballs, the economy has to give up 100 bananas, or to produce 1 more baseballs, the
economy has to give up 2 bananas. Answer b is correct. On the other hand, to produce 1
more banana, the economy has to give up ½ baseballs. Answer c is incorrect.)

(Explaining: Point A and B are both on the PPF, so two points are both efficient (a is
incorrect), and there is no economic growth (b is incorrect). Point A (200 baseballs and
0 banana), point B (150 baseballs and 200 bananas). Therefore to produce 200 more
bananas, the economy has to give up 50 baseballs, or to produce 1 more bananas, the
economy has to give up ¼ baseballs. (c is incorrect). )
17. ANS: c. The economy experiences economic growth.
(Explaining: The key information here is that the economy currently operates on its
production possibilities frontier. So the economy is using all of its resources, so there is
no unemployment (a is incorrect). Idle capital is the old and ineffective one but the
question is to increase production (b is incorrect). Therefore, in order to increase
production of both goods there could only be economic growth.)
18. ANS: c. A general technological advance.
(Explaining: the figure shows that the production of both goods increases. Answer A
can only increase Capital good, answer B can only increase consumer goods. Decrease
in unemployment does not cause PPF to shift.)
19. ANS: b. Economic growth. (according to PE textbook, page 26, paragraph 3)
20. ANS: a. The economy experienced a technological advance in the production of
batteries.
(Explaining:
production of batteries so there is only the technological advance in the production of

batteries, answer A is correct. Answer C is that there is the technological advance in
both goods, so C is incorrect. The cause PPF to shift.)

Chapter 3: Interdependence and the Gain from Trade 34
Chapter 03:
Interdependence and the Gain from Trade
1. A Parable for the Modern Economy
- To understand why people choose to depend on others for goods and services and
how this choice
- Simple economy:
Only two goods: meat and potatoes.
Only two people: a cattle named Ruby and a farmer named Frank, both
would like to eat both meat and potatoes.
Without specialization and trade
- Panel (a) shows the production opportunities available to Frank the farmer and
Ruby the rancher.

Minutes Minutes Amount of Amount of
needed to needed to make meat potatoes
make 1 ounce 1 ounce of produced in produced in 8
of meat potatoes 8 hours hours
Frank the 60 minutes per 15 minutes per 8 ounces 32 ounces
farmer ounce ounce
Ruby the 20 minutes per 10 minutes per 24 ounces 48 ounces
rancher ounce ounce
frontier
With specialization and trade:
potatoes potatoes
Production and 4 ounces 16 ounces 12 ounces 24 ounces
consumption
without trade
Production with 0 ounces 32 ounces 18 ounces 12 ounces
trade
Trade Gets 5 Gets 15 Gets 5 Gets 15
ounces ounces ounces ounces
Consumption with 5 ounces 17 ounces 13 ounces 27 ounces
trade
Increase in +1 ounce +1 ounce +1 ounce +3 ounces
consumption with
gain from trade

=> Through trade they are able to move outside their production possibility
curves. People benefit from trade.
2. Comparative Advantage:
a. Absolute advantage is ability to produce a good using fewer inputs than another
producer.
b. Opportunity cost is whatever must be given up to obtain something. It measures
the trade-off between the two goods that each producer faces
c. Comparative advantage:
- The ability to produce a good at a lower opportunity cost than another
producer.
- One person can have absolute advantage in both goods but cannot have
comparative advantage in both goods
- Principle of comparative advantage is that each good should be produced by
specialize according to comparative advantage.
- Trading determinant is comparative advantage
- The principle of comparative explains the interdependence and gains from
trade.
Note:
_ Trade can benefit everyone in society because it allows people to specialize in
activities in which they have a comparative advantage.
_ When people trade with each other, they can obtain good at a price lower than their
opportunity cost.
_In the situation where there are only 2 economic actors, if one has comparative
advantage in one good, then the other one must have comparative advantage in the
remaining good.
_For both parties to gain from trade, the price at which they trade must lie between the
two opportunity costs

EXERCISE
possibilities frontier if
a. additional resources become available.
b. there is an increase in the level of technology.
c. the country engages in trade.
2. The difference between production possibilities frontiers that are bowed
out and those that are linear is that
a. bowed out production possibilities frontiers illustrate tradeoffs where linear
production possibilities frontiers do not.
b. bowed out production possibilities frontiers show increasing opportunity
cost where linear ones show constant opportunity cost.
c. bowed out production possibilities frontiers are the result of perfectly
shiftable resources where linear production possibilities frontiers are not.
d. linear production possibilities frontiers illustrate real world conditions more
than bowed out production possibilities frontiers.
The graph below is used to answer Question 3 & 4:

3. According to the graph, if Paul divides his time equally between corn and
wheat, he will be able to produce.
a. 2 bushels of wheat and 2 bushels of corn.
b. 3 bushels of wheat and 3 bushels of corn.
c. 4 bushels of wheat and 5 bushels of corn.
d. 4 bushels of wheat and 6 bushels of corn.
4. According to the graph, assume that both Paul and Cliff divide their time
equally between the production of corn and wheat, and they do not trade. If they
were the only producers of corn and wheat, then total production of wheat and
corn would be
a. 8 bushels of wheat and 7 bushels of corn.

b. 7 bushels of wheat and 6 bushels of corn.
c. 6 bushels of wheat and 8 bushels of corn.
d. 7 bushels of wheat and 7 bushels of corn.
5. Mike and Sandy are two woodworkers who both make tables and chairs. In
one month, Mike can make 4 tables or 20 chairs, where Sandy can make 6 tables
or 18 chairs. Given this, we know that
a. Mike has an absolute advantage in chairs.
b. Mike has a comparative advantage in tables.
c. Sandy has an absolute advantage in chairs.
d. Sandy has a comparative advantage in chairs.
6. The only two country in the world, Alpha and Omega, face the following
production possibilities frontiers

a. Assume that each country decides to use half of its resources in the production
of each good. Show these points on the graphs for each country as point A.
b. If these countries choose not to trade, what would be the total world production
of popcorn and peanuts?
c. Now suppose that each country decides to specialize in the good in which each
has a comparative advantage. By specializing, what is the total world production
of each product now?
d. If each country decides to trade 100 units of popcorn for 100 units of peanuts,
show on the graphs the gain each country would receive from trade. Label these
points B.
1. ANSWER: c. the country engages in trade.
(Explanation: Because trade allows people to specialize in what they do best. As a
result of specialization and trade, people are able to consume more than they produce.)
2. ANSWER: b. bowed out production possibilities frontiers show increasing
opportunity cost where linear ones show constant opportunity cost.

(Explanation: The production possibilities frontier shows one trade-off that society
faces. In other words, it shows the opportunity cost of one good as measured in terms
of the other good. Once we have reached an efficient point on the frontier, the only way
of producing more of one good is to produce less of the other. In that case, the rate at
which society could trade one good for the other depended on the amounts that were
being produced, which reflects the bowed out shape of production possibilities
frontiers. (Read page 24 26 for further understanding)
In a situation where it allows producer to switch between two goods at constant rate
regardless of how much he is already producing, the production possibilities frontiers is
a straight line. (Read page 49 50 for further understanding ).
3. ANSWER: c. 4 bushels of wheat and 5 bushels of corn.
(Explanation: When producer divides half of his resources equally between 2 products,
he will produce half of the maximum amount that he can produce if he devotes all
resources to it.)
4. ANSWER: d. 7 bushels of wheat and 7 bushels of corn.
(Explanation: Because they equal their time to produce so the total production of wheat
and corn would be:

5. ANSWER: a. Mike has an absolute advantage in chairs.
(Explanation: Because with the same amount of input (1 month), Mike can produce
more chairs than Sandy can
We cannot determine the comparative advantage here because there is not enough
data to calculate Opportunity Cost.)
6. ANSWER:
a. Alpha would be producing 125 units of peanuts and 75 units of popcorn (point
A on its production possibilities frontier) and Omega would be producing 50 units of
peanuts and 150 units of popcorn (point A on its production possibilities frontier).
b. The total world production of peanuts would be 175 units and the total world
production of popcorn would be 225 units. (The sum of goods produced in each
country)
c. In country Alpha, the opportunity cost of 1 peanut is 0.6 popcorn. In country
Omega, the opportunity cost of 1 peanut is 3 popcorn. So country Alpha has the
comparative advantage in producing peanuts and country Omega will have comparative
advantage in producing popcorn. As a result, country Alpha will specialize in producing
peanuts and country Omega will specialize in producing popcorn.
The total world production of peanuts would now be 250 units and the total world
production of popcorn would now be 300 units.
d. Alpha would trade 100 peanuts for 100 popcorns. Alpha will now have 150
peanuts and 100 popcorns.
Omega would trade 100 popcorns for 100 peanuts. Omega will now have 100
peanuts and 200 popcorns.

Chapter 4: The Market Forces of Supply and Demand 46
Chapter 4:
The Market Forces of Supply and Demand
Market and Competition:
A market is a group of buyers and sellers of a particular good and service
+ Buyers determine the demand for the product
+ Sellers determine the supply of the product
Competitive market is a market where there are many buyers and sellers so that each
has an insignificant impact on the market price
Demand:
Quantity demanded: the amount of a good that buyers are willing and able to purchase
Law of demand: the claim that, other things being equal, the quantity demanded of a
good falls when the price of the good rises
Demand schedule: a table that shows the relationship between the price of a good and
the quantity demanded

Demand curve: a graph of the relationship between the price of a good and the quantity
demanded
+ The line demand curve relating price and quantity demanded slopes
downward
+ If something happens and affects the quantity demanded at any given price, the
demand curve shifts or the point moves along the curve
Ex: Scientists explore the outstanding benefit of some medicine in
treating the specific disease, then many people will purchase a large quantity of the
medicine at each price INCREASE the quantity demanded
A change in price determinants of demand causes a movement along the curve
A change in non-price determinants of demand (number of buyers, income, price
shifts the curve
Increase in demand: Shifts the demand curve to the right

Decrease in demand: Shifts the demand curve to the left
*NOTE:
Normal good: Income INCREASES demand for normal good INCREASES
shifts the curve to the RIGHT
Inferior good: Income INCREASES demand for inferior good DECREASES
shifts the curve to the LEFT
Substitutes: Two goods are substitutes if an increase in the price of one good causes
an increase in demand for the other good
Complements: Two goods are complements if an increase in the price of one good
causes a fall in demand for the other good
Supply:
Quantity supplied: the amount of a good that sellers are willing and able to sell
Law of supply: the claim that, other things being equal, the quantity supplied of a
good rises when the price of the good rises
Supply schedule: a table that shows the relationship between the price of a good and
the quantity supplied

Supply curve: a graph of the relationship between the price of a good and the quantity
supplied
+ The line supply curve relating price and quantity demanded slopes upward
+ Because the market supply curve is drawn holding other things constant, when
one of these factors changes, the supply curve shifts
A change in price determinants of supply causes a movement along the curve
A change in non-price determinants of supply (input prices, technology, number
shifts the curve
Increase in supply: Shifts the supply curve to the right
Decrease in supply: Shifts the supply curve to the left
Demand and Supply Together:
Equilibrium: a situation in which the market price has reached the level at which
quantity supplied equals the quantity demanded

Equilibrium price: the price that balances quantity supplied and quantity demanded
Equilibrium quantity: the quantity supplied and the quantity demanded at the
equilibrium price
(p and q in the graph in order are equilibrium price and equilibrium quantity)
There are some actions of buyers and sellers making the market price not equal to the
equilibrium price.
+ Surplus: a situation which quantity supplied is greater than quantity demanded
(happens when the market price is higher than the equilibrium price)
+ Shortage: a situation in which quantity demanded is greater than quantity supplied
(happens when the market price is lower than the equilibrium price)
Law of supply and demand: the claim that the price of any good adjusts to bring the
quantity supplied and the quantity demanded for that good into balance
Three steps to analyze Changes in Equilibrium
1. Decide whether the event shifts the supply or demand curve (or perhaps both)
2. Decide in which direction the curve shifts
3. Use the supply-and-demand diagram to see how the shift changes the equilibrium
price and quantity.

EXERCISE
1. Which of the following statements is correct?
A. Buyers determine supply and sellers determine demand
B. Buyers determine demand and sellers determine supply.
C. Buyers and sellers as one group determine supply, but only buyers
determine demand.
D. Buyers and sellers as one group determine demand, but only sellers
determine supply.
2. If the price of a good is low,
A. firms would increase profit by increasing output.
B. the quantity supplied of the good could be zero.
C. the supply curve for the good will shift to the left.
D. firms can and should raise the price of the product.
3. A downward-sloping demand curve illustrates the
A.
the good in question, provided the good is inferior.
B. negative relationship between quantity demanded and quantity supplied.

C. idea that the more of one good that a consumer buys, the less income she
has to spend on other goods.
D. law of demand.
4. Refer to Figure 4-3. The graph shows the demand for bread. The arrows
are consistent with which of the following events?
A. Bread and peanut butter are complements and the price of peanut butter
decreased.
B. Bread and cereal are substitutes and the price of cereal decreased.
C. The price of bread increased.
D. The arrows are consistent with all of these events.

5. An increase in the price of rubber coincides with an advance in the
technology of tire production. As a result of these two events,
A. the demand for tires increases and the supply of tires decreases.
B. the supply of tires decreases and the demand for tires is unaffected.
C. the supply of tires increases and the demand for tires is unaffected.
D. none of the above is necessarily correct.
6. Refer to Figure 4-6. Suppose the supply curves that are drawn represent supply
curves for single-family residential houses. Then the movement from S to S1 could
be caused by
A. an increase in the price of apartments (a substitute for single-family houses
for many people looking for a place to live).

B. a newly-formed expectation by house-builders that prices of houses will
increase significantly in the next six months.
C. a decrease in the price of lumber.
D. All of the above are correct.
7/ Refer to figure 4-8, in this market, equilibrium price and quantity,
respectively, are:
A. $14 and $70
B. $12 and $40
C. $10 and $50
D. $8 and $50
8/ Refer to figure 4-8, if price in this market is currently $14, there would be a:
A. Shortage of 20 units and the law of demand predicts that the price will rise
from $14 to a higher price
B. Excess supply of 20 units and the law of supply and demand predicts that
the price will fall from $14 to a lower price
C. Shortage of 40 units and the law of supply predicts that the price will fall
from $14 to a lower price
D. Surplus of 40 units and the law of supply and demand predicts that the
price will fall from $14 to a lower price
9/ Refer to figure 4-8, if there is currently a shortage of 30 units of a good, then:
A. The law of demand predicts that the price will rise by $5 to eliminate the
shortage
B. The law of supply predicts that the price will rise by $5 to eliminate the
shortage
C. The law of supply and demand predicts that the price will rise by $3 to
eliminate the shortage
D. The law of supply and demand predicts that the price will fall from its
current level by an indeterminate amount, exacerbating the shortage
10. Suppose the number of buyers in a market increases and a technological
advancement occurs also. What would we expect to happen in the market?

A. The equilibrium price would increase, but the impact on the amount sold in the
market would be ambiguous.
B. The equilibrium price would decrease, but the impact on the amount sold in
the market would be ambiguous.
C. Equilibrium quantity would increase, but the impact on equilibrium price
would be ambiguous.
D. Both equilibrium price and equilibrium quantity would increase.

11/ Refer to figure 4-10, which of the four graphs represents the market for
peanut butter after a major hurricane hits the peanut-growing south?
A. A
B. B
C. C
D. D
12. Refer to figure 4-10, which of the four graphs represents the market for
winter coats as we progress from winter to spring?
A. A
B. B
C. C
D. D
13. Suppose that a decrease in the price of good X results in fewer units of good
Y being sold. This implies that X and Y are
A. complementary goods.
B. normal goods.
C. inferior goods.
D. substitute goods
14. Which of the following would not be a determinant of the demand for a
particular good?
a. prices of related goods
b. income
c. tastes
d. the prices of the inputs used to produce the good
15. If Francis experiences a decrease in his income, we would expect that, as a
a. each good he purchases will remain unchanged.
b. normal goods will decrease.
c. luxury goods will increase.
d. inferior goods will decrease.
16. You love peanut butter. You hear on the news that 50 percent of the peanut
crop in the South has been wiped out by drought, and that this will cause the price
of peanuts to double by the end of the year. As a result,
a. your demand for peanut butter will increase, but not until the end of the year.
b. your demand for peanut butter increases today.
c. your demand for peanut butter decreases as you look for a substitute good.
d. you will wait for the price of jelly to change before altering your demand for peanut
butter.
17. Bread and peanut butter are complements. As an economist, how you would
predict the demand for peanut butter if the price of bread increases?
A. Peanut butter demand curve will shift to the right
B. Peanut butter demand curve will shift to the left
C.
D. An
will rise.
18. Which of the following events will shift the supply curve of rice to the right:
(i) Price of rice increases
(ii) Rice and ramen are substitutes. The price of ramen decreases
(iii) A new type of tractor enables farmers to produce rice more efficiently
(iv) News reports that the price of rice is expected to be cut by half in the next year
(v) The price of seeds increases unexpectedly.
(vi) Rice and meat are complements. The price of meat increases
(vii) There are now more farmers planting rice.

(viii) Stock market booms resulting in an increased income in each household.
A. All of the above
B. (iii), (iv), (vii)
C. (i), (ii), (v), (vi), (viii)
D. None of the above
1. B (Explain: Theoretical Information)
2. B Explanation:
At the showing point, when the price is too low, the quantity of the good could be zero
A is wrong. According to the law of supply, low price will lead to low output
C is wrong. Change in price only causes shift along the curve
D is wrong. As a producer, the only thing you can control completely is the quantity
of output, not the price
3. D . Explanation: Law of demand: other things being equal, the quantity
demanded of a good falls when the price of the good rises
4. C Explanation: A and B are wrong. Because when there is a change in price of a
related product, it will change the demand of the product, not quantity demanded. So
C is correct.
5. D Explanation: Rubber is input of tire, so if the price of rubber increase, the
supply will decrease. But an advance in the technology happen at the same time
the exact answer about supply. The
related to the demand.)
6. C (Explain:
A is wrong. An increase in price of substitute will only affect the demand curve
B is wrong. An expectation that the house price will increase in the future, so in the
present the sellers will retain the goods and sell it later => Supply curve shift to the left
C is correct. A decrease in the price of input will shift the supply curve to the right)
7. C (Explain: The point at the intersection of demand curve and supply curve is
equilibrium point; this point shows the equilibrium price and equilibrium quantity is
$10 and 50 respectively)
8. D Explanation: Quantity supplied subtract Quantity demanded = 40 and according to
Law of supply and demand; when Quantity supplied increases and Quantity demanded
decreases, price decreases.
9. C Explanation: When the price is below equilibrium. The law of supply predicts that
quantity supplied will increase, the law of demand predicts that quantity demanded will
decrease. Altogether, the price will increase back to the equilibrium.
10. C Explanation: When the number of buyers in a market increases and a
technological advancement occurs, both the demand curve and supply curve shifts right.
But the effect on equilibrium price depends on the displacement of demand curve
compared to supply curve.
11. D Explanation: A hurrican
supply curve to the left
12. B Explanation:
left
13. D Explanation: Substitute goods: an increase in the price of one good causes an
increase in demand for the other good

14. D Explanation: The prices of the inputs is a determinant of the supply not the
demand.
15. B Explanation: According to the definition of normal good and inferior goods:
-Normal good is a good for which an increase in income leads to an increase in
demand.
- Inferior good is a good for which an increase in income leads to a decrease in
demand.
In this case, the opposite happen. Francis experiences a decrease in his income, so his
demand for normal goods will decrease (B is correct), for inferior goods will increase
used to be (A is incorrect). Luxury goods must be decrease (C is incorrect).
16. B. Explain: according to PE textbook, page 70, two last line:
about the future may affect your demand for a good or services today
You hear from the news that 50 percent of the peanut crop in the South has been wiped
out by drought, and that this will cause the price of peanuts to double by the end of the
year.
This news has given you the expectation in the future and will affect your demand for
peanut butter today. Because you love peanut butter, it is not easy for you to substitute
something you love, so when you know the price will increase in the future, you will
buy more peanut butter today when the price is still low.
17. B. Explain: According to definition of complements:

The two goods are called complements when an increase in the price of one good leads
to a decrease in the demand for the other good.
Therefore, because bread and peanut butter are complements, the price of bread
increases will lead to a decrease in demand for peanut butter, which shift the peanut
demand curve to the left.
18. B. Explain:
(i) Price of rice increases - move along the supply curve, not shift
(ii) Rice and ramen are substitutes. The price of ramen decreases - rice and ramen
are substitutes, so if the price of ramen decreases, the demand for rice will decreases.
This will shift the demand curve to the left, not the supply curve.
(iii) A new type of tractor enables farmers to produce rice more efficiently - the
advance in technology help the farmer to produce more, so he can supply more rice to
the market, the supply curve shift to the right.
(iv) News reports that the price of rice is expected to be cut by half in the next year.
- the news will affect the expectation of suppliers. If they know the price will be lower in
the future, they will supply more today when the price is still high. Which leads to the
shift to the right of supply curve.
(v) The price of seeds increases unexpectedly. - seeds is the inputs of rice. If the price
of input is higher, farmers will produce less rice, which will shift the supply curve to the
left.
(vi) Rice and meat are complements. The price of meat increases - If rice and meat
are complements, an increase in the price of meat will lead to a decrease in the demand
of rice. Which will shift the demand curve to the left, not the supply curve.
(vii) There are now more farmers planting rice - farmers are also considered as
suppliers of rice, so when there are more suppliers in the market, the supply will
increase. Which shift the supply curve to the right.
(viii) Stock market booms resulting in an increased income in each household. -
This will affect the demand curve not the supply curve.
Chapter 5: Elasticity and its Application 67
Chapter 5:
Elasticity and its Application
I. What is Elasticity?
Elasticity is a numerical measure of the responsiveness of quantity demanded or
quantity supplied to a change in one of its determinants.
II. The Elasticity of Demand:
1. The Price Elasticity of Demand:
Definition: Price Elasticity of Demand is a measure of how much the quantity
demanded of a good responds to a change in the price of that good.
Formula:
P
P2
% P
= P1
D
Q2 Q1 Q
% Q
With:
: Price elasticity of demand for good X
% : Percentage change in quantity demanded of good X
% : Percentage change in price of good X
Example: Suppose 10% increase in the price of a bowl of Pho causes the amount of Pho
you buy to fall by 30% . Calculate your Price Elasticity of Demand for Pho:
Price elasticity of demand: = = =3
*Note: Price and Quantity Demanded of one good are negatively related to each other.
For this reason, the price elasticity of demand is sometimes reported as a negative
number. However, we will use the absolute value to report price elasticity of demand in
this course.
Formula using the Midpoint
Method: P
B
P2
A
P1
D
Q2 Q1 Q
With:
Q1: quantity demanded at the price of P1
Q2: quantity demanded at the price of P2
Example: Khanh wants to earn some money to buy some ice-cream, so he sells
lemonade. He realizes that if he sets the price at $4 per cup, people will buy 50 cups of
lemonade. So he raises the price to $6 per cup and sold 30 cups of lemonade. Calculate
Price elasticity of demand for Kh
Price elasticity of demand: = =
= 1.25
Determinants of Price Elasticity of Demand:
- Availability of Close Substitutes: Goods with close substitutes tend to have
higher price elasticity of demand because it is easy for consumers to switch
from that good to others.
Example: Breakfast Cereal vs. Sunscreen
Breakfast Cereal has many close substitutes such as Pancakes, Waffles,... so consumers
can easily switch if its price rises. However, Sunscreen has no close substitutes so even
if its price rises, buyers would probably not buy much less.
- Necessities versus Luxuries: Necessities tend to have lower price elasticity
of demand than luxuries.
Example: Insulin vs. Caribbean Cruises
To millions of diabetics, insulin is a necessity. A rise in its price would cause little or no
decrease in demand. A cruise is a luxury, so if the price rises, some people will forego
it.
- Definition of the Market: Narrowly defined markets tend to have higher
price elasticity of demand than broadly defined markets because it is easy
to find close substitutes for narrowly defined goods.
Example: Vanilla Ice-cream vs. Food

For narrowly defined good such as Vanilla ice-cream, there are many substitutes
(Chocolate ice-
- Time Horizon: Goods tend to have higher price elasticity of demand in the
long run than in the short run because people have more time to react to
changes in price.
Example: Gasoline in the Short run vs. Gasoline in the Long run
If price of gasoline rises, there is not much people can do in the short run. However,
over time, people could buy fuel-efficient cars, switch to public transportation or move
SUMMARY:
The price elasticity of demand depends on:
The extent to which close substitutes are available.
Whether the good is a necessity or a luxury.
How broadly or narrowly the good is defined.
The time horizon elasticity is higher in the long run than the short run.
The Variety of Demand Curves:
- The price elasticity of demand is closely related to the slope of the demand curve.
- Rule of thumb:
+ The flatter the curve, the bigger the elasticity.
+ The steeper the curve, the smaller the elasticity.
- There are FIVE classifications of D curves:
1) Perfectly Inelastic Demand
Demand curve: Vertical
None
Elasticity: 0 ( = 0)
2) Inelastic Demand
Demand curve: Relatively
steep
Relatively low
Elasticity: < 1 (% <
% )
3) Unit Elastic Demand
Demand curve: Intermediate
slope
Intermediate
Elasticity: 1
(% =% )
4) Elastic Demand
Demand curve: Relatively flat
Relatively high
Elasticity: > 1 (% >
% )
5) Perfectly Elastic Demand
Demand curve: Horizontal
Extreme
Elasticity: Infinity
(% = 0)
Total Revenue and the Price Elasticity of Demand:
Total Revenue: TR = P x Q
Price Elasticity of Demand: =
1) If the Price Elasticity of Demand < 1 (% <% ), the
demand is inelastic. The fall in revenue from lower Q is smaller than the increase
in revenue from higher P, so revenue rises.

2) If the Price Elasticity of Demand > 1 (% >% ), the
demand inelastic. The fall in revenue from lower Q is greater than the increase in
revenue from higher P, so revenue falls.
3) If the Price Elasticity of Demand = 1 (% =% ), the
demand is unit elastic. The fall in revenue from lower Q is equal to the increase in
revenue from higher P, so revenue remains constant.

SUMMARY:
1) < 1, Demand is inelastic.
The increase (decrease) in price leads to the increase (decrease) in total
revenue.
2) > 1, Demand is elastic.
The increase (decrease) in price leads to the decrease (increase) in total
revenue.
3) = 1, Demand is unit elastic.
Total revenue remains constant when the price changes.
Elasticity along a Linear Demand Curve:
- The slope of a linear demand curve is constant, but its elasticity is not. Because
the slope is the ratio of changes ( ) in the two variables, whereas the elasticity
is the ratio of percentage changes ( ) in the two variables.
+ At points with a low price and high quantity, the demand curve is inelastic.
+ At points with a high price and low quantity, the demand curve is elastic.
Example:
-
2. The Income Elasticity of Demand:
Definition: Income Elasticity of Demand is a measure of how much the quantity
Formula:
With
: Income Elasticity of Demand for good X
increase (decrease), people buy more (less)
of good X
> 0, X is a normal good

increase (decrease), people buy less (more)
of good X
< 0, X is an inferior good
Example: increased 10% so she buys 20% more of
oranges but 15% less of lemons. Calculate the income elasticity of demand for oranges
and lemon. Oranges and Lemons are normal goods or inferior goods?
Solution:
Income elasticity of demand for oranges: = =
=2
Because = 2 > 0, oranges are normal goods.
Income elasticity of demand for lemons: = =
= -1.5
Because = -1.5 < 0, lemons are inferior goods.
3. The Cross - Price Elasticity of Demand:
Definition: Cross - Price Elasticity of Demand is a measure of how much the
quantity demanded of a good responds to a change in the price of another good.
Formula:
With
: Cross - Price Elasticity of Demand for good X
% : Percentage change in the price of good Y

Price of good Y increase (decrease), people buy more (less)
of good X
> 0, X and Y are substitutes
Price of good Y increase (decrease), people buy less (more)
of good X
< 0, X and Y are complements
Example: The price of tea has increased 10% this month. In the market, the purchase of
honey has decreased 15%, whereas the purchase of coffee has increased 20%. Calculate
the cross-price elasticity of demand between tea and honey, and between tea and coffee.
Tea and honey are substitutes or complements? Tea and coffee are substitutes or
complements?
Solution: The Cross-Price Elasticity of Demand
Between tea and honey: = = = -1.5 < 0
Tea and honey are complements.

Between tea and coffee: = = =2>0
Tea and coffee are substitutes.
III. The Elasticity of Supply
Definition: The price elasticity of supply measures how much the quantity
supplied responds to changes in the price.
- Supply of a good is elastic if the quantity supplied responds substantially to
changes in the price.
- Supply of a good is inelastic if the quantity supplied responds only slightly to
Key determinant: the flexibility of sellers to change the amount of the good they
produce.
Main determinant: time period
- Supply is usually more elastic in the long run than in the short run.
Example: The supply of houses in the short run vs. the supply of houses in the long run
Suppose that the price of houses has increased recently. The rise in the price of houses
creates incentives for construction companies to build more houses. In the short run,
since they do not have enough labors and constructing machine, the supply of houses
responds only slightly to the increase in the price. Over time, the companies have
increased the size of their factory and thus, respond more substantially to the rise in the
price.
Formula:
price elasticity of supply =
- Formula using the midpoint method:
B S
P2
A
P1
Q1 Q2 Q
price elasticity of supply =
With:
Q1: quantity supplied at the price of P1
Q2: quantity supplied at the price of P2

* Note: Since price and quantity supplied have a positive relationship, the price
elasticity of supply is always positive.
The variety of supply curves
- Rule of thumb:
+ The flatter the curve, the bigger the elasticity.
+ The steeper the curve, the smaller the elasticity.
1) Perfectly Inelastic Supply
Supply curve: Vertical
None
Elasticity: 0
2) Inelastic Supply
Supply curve: Relatively steep
Relatively low
Elasticity: < 1
3) Unit Elastic Supply
Supply curve: Intermediate
slope
Intermediate
Elasticity: 1
4) Elastic Supply
Supply curve: Relatively flat
Relatively high
Elasticity: > 1
5) Perfectly Elastic Supply
Supply curve: Horizontal
Extreme
Elasticity: Infinity
- In some markets, the elasticity of supply is not constant but varies over the supply
curve.
Explanation:
- Resources are scarce.
- At low level of quantity supplied, the price elasticity of supply is high.
used full production capacity, such as plants or equipment.
- At high level of quantity supplied, the price elasticity of supply is low.
slightly to changes in the price because once the
production capacity is fully used.

* Note: This phenomenon only occurs in the short run as the firms do not have
enough time to respond to changes in the price once they fully use their capacity of
production. However, in the long run, as the firms now have enough time to raise their
production capacity, the supply becomes more elastic.
IV. Three Applications of Supply, Demand, and Elasticity
Can Good News for Farming Be Bad News for Farmers?
The discovery of a new hybrid of wheat that raises the amount farmers can
produce
increases at any given price
the demand curve remains the same
than the initial one
Wheat is a basic foodstuff

Paradox of public policy: Induce farmers not to plant crops on all of their lands
uce the quantity supplied
Why Did OPEC Fail to Keep the Price of Oil High?
In the short run:
OPEC countries agreed to reduce the quantity supplied of oil.
Supply: The quantity of known oil reserves and the capacity of oil extraction
cannot be changed quickly.
astic.
Demand: Consumers cannot change their consuming habit immediately to
The decrease in supply causes a large increase in the price in the short run.
In the long run:
Supply: Producers outside OPEC increase oil exploration and build new
extraction capacity.
Demand: Consumers switch to public transportation or replace old
inefficient car by a newer fuel-efficient car.

The decrease in supply causes a small increase in the price in the long run.
Does Drug Interdiction Increase or Decrease Drug-Related
Crime?
Drug Interdiction: (aim at reducing the supply of drug)
Supply: When the government stops illegal drugs from entering the market
and arrest the smugglers, the quantity of drugs supplied in the market drop
at any given price.

Demand: Most drug addicts are less likely to break their destructive habit
and still demand drug at any given price.
The equilibrium price rises.
Since demand for drug is inelastic, an increase in price leads to the rise in total
revenue of the drug sellers.
Arguments:
Against:
- Drug sellers still sell illegal drugs because they realize a higher total
revenue.
- Addicts who already had to steal to support their habits would have
an even greater need for quick cash.
-related crimes.
For:
- Elasticity of demand depends on the time horizon.
- The demand for drug is inelastic in the short run and becomes more
elastic in the long run.
-related crimes in the short run but
decreases them in the long run.
Drug Education: (aim at reducing the demand for drug)
Supply: The supply of illegal drugs does not change when drug education is
applied.
Demand: Over time, the demand for drug will gradually decrease.
shifts to the left.
The equilibrium price drops.
The total revenue after this the government imposed the policy decreases.
Selling illegal drugs seems less attractive to the smugglers due to lower total
revenue.
EXERCISE
01. When the local used bookstore prices economics books at $15.00 each, they
generally sell 70 per month. If they lower the price to $7.00 each they sell 90. Given
this, we know that the elasticity of demand for economics books is
a. 2.91, the demand curve is relatively flat, so this store should lower price to raise
total revenue.
b. 2.91, the demand curve is relatively steep, so this store should raise price to
raise total revenue.
c. 0.34, the demand curve is relatively flat, so this store should lower price to raise
total revenue.
d. 0.34, the demand curve is relatively steep, so this store should raise price to
raise total revenue.
02. Elasticity of demand is closely related to the slope of the demand curve. The
more responsive buyers are to a change in price, the demand curve will be
a. steeper.
b. further to the right.
c. flatter.
d. closer to the vertical axis.
03. A perfectly elastic demand implies that
a. buyers will not respond to any change in price.
b. any rise in price above that represented by the demand curve will result in no
output demanded.
c. price and quantity demanded respond proportionally.

d. price will rise by an infinite amount when there is a change in quantity
demanded
04. Alice says that she would buy one banana split a day regardless of the price. If
she is telling the truth,
d. None of the above answers is correct.
05. Which of the following would have the most elastic demand?
a. clothing
b. blue jeans
d. All three would have the same elasticity of demand since they are all related
06. How does total revenue change as one moves down a linear demand curve and
where will the total revenue reach its maximum?
a. It increases, maximum total revenue is achieved at the lower end of the curve
b. It decreases, maximum total revenue is achieved at the upper end of the curve
c. It first increases, reaches maximum total revenue at the midpoint of the curve,
then decreases.
d. It is unaffected by a movement along the demand curve.
Graph 5.1
07. According to graph 5.1, when price falls from point $40 to $30 we know that
demand must be
a. elastic, since total revenue increases from $8000 to $9000.
b. inelastic, since total revenue increases from $8000 to $9000.
c. inelastic, since total revenue decreases from $9000 to $8000.
d. unit elastic, since total revenue decreases from $9000 to $8000.

08. If the demand curve is linear and downward sloping, which of the following
would NOT be correct?
a. The upper part of the demand curve is more elastic than the lower part.
b. Elasticity will change with a movement down the curve.
c. The lower part of the demand curve would be less elastic than the upper part.
d. Slope will change with a movement down the curve.
Graph 5.2
09. According to graph 5.2, between point A and point B we know that
a. the slope is equal to 1/4 and elasticity is equal to 2/3.
b. the slope is equal to 1/4 and elasticity is equal to 3/2.
c. the slope is equal to 3/2 and elasticity is equal to 1/4.
d. the slope is equal to 2/3 and elasticity is equal to ¼.
10. According to graph 5.2, between point A and point B on the graph, the
elasticity of demand is
a. perfectly elastic.
b. Inelastic.
c. unit elastic.
d. elastic.
11. Your younger sister needs $50 to buy a new bike. She has opened a lemonade
stand to make the money she needs. She currently is charging 25 cents per cup, but
wants to adjust her price to earn the money faster. If you know that the demand
for lemonade is elastic, what is your advice to her?
a. Leave the price the same and be patient.
b. Raise the price to increase total revenue.
c. Lower the price to increase total revenue.

d.
12. If a 6 percent increase in income results in a 10 percent increase in the quantity
demanded of pizza, then the income elasticity of demand for pizza is
a. negative and therefore pizza is an normal good.
b. negative and therefore pizza is an inferior good.
c. positive and therefore pizza is an inferior good.
d. positive and therefore pizza is a normal good.
Table 5.1
13. According to table 5.1, using the midpoint method, what is the income
elasticity of good Y?
a. 3.33
b. 2.33
c. 1.33
d. 2.33
14. Suppose the price elasticity of demand for basketballs is 1.20. A 15 percent
increase in price will result in
a. an 18 percent decrease in the quantity of basketballs demanded.
b. a 15 percent decrease in the quantity of basketballs demanded.
c. an 8 percent reduction in the number of basketballs demanded.
d. a 12.5 percent reduction in the number of basketballs demanded.
Table 5.2
15. According to table 5.2, which of the following would represent a more inelastic
supply curve?
a. supply curve A
b. supply curve B
c. supply curve C
d. There is no difference in the elasticity of the 3 supply curves.
16. The price elasticity of supply depends on:
a. the ability of sellers to change the price of the good they produce.
b. the number of firms in the market.
d. the ability of sellers to change the amount of the good they produce.
17. The main determinant of the price elasticity of supply is
a. time.
b. the definition of the market.
c. the number of close substitutes.
d. luxuries vs. necessities.
18. As elasticity rises and approaches infinity, the supply curve gets
a. Flatter until it is horizontal, then a small increase in Price will lead to an
infinite Quantity of goods supplied
b. Steeper until it is vertical, then a small change in Price will lead to no change of
Quantity of goods supplied
c. The supply curve does not get steeper or flatter

d. Flatter until it is horizontal, then a small increase in Price will lead to zero
Quantity of goods supplied
Graph 5.3
19. According to graph 5.3, what is the elasticity of supply between points D and
E?
a. 1.89
b. 1.26
c. 0.53
d. 0.34
20. The discovery of new hybrid wheat would tend to increase the supply of wheat.
Under what conditions would wheat farmers realize an increase in revenue?
a. if the supply of wheat is elastic
b. if the supply of wheat is inelastic
c. if the demand for wheat is inelastic
d. if the demand for wheat is elastic
21. You are in charge of the local city-owned golf course. You need to increase the
revenue generated by the golf course in order to meet expenses. The mayor advises
you to increase the price of a round of golf. The city manager recommends
reducing the price of a round of golf. You realize that
a. the mayor thinks demand is elastic and the city manager thinks demand is
inelastic.
b. both the mayor and the city manager think that demand is elastic.
c. both the mayor and the city manager think that demand is inelastic.
d. the mayor thinks demand is inelastic and the city manager thinks demand is
elastic.
22. Last month, sellers of Good Y took in $100 and sold 50 units of Good Y. This
month sellers of Good Y raised their price, took in $120 and sold 40 units of Good
Y. At the same time, the price of Good X stayed the same, but sales of Good X
increased from 20 units to 40 units. We can conclude that Goods X and Y are
a. substitutes, and have a cross-price elasticity of 0.60.
b. complements, and have a cross-price elasticity of 0.60.
c. substitutes, and have a cross-price elasticity of 3.67.
d. complements, and have a cross-price elasticity of 3.67.
1. Ans: D
Applying the midpoint method, we can calculate the price elasticity of demand for
economics books is: E= = = 0.34
< 1, demand is inelastic, the demand curve is relatively steep. So this store should raise
price to raise total revenue.
2. Ans: C. Because the more responsive buyers are to a change in price, the more elastic
the demand is. And the more elastic the demand is, the flatter the demand curve will be.
3. Ans: B. Because the perfectly elastic demand curve is horizontal

4. Ans: A. The quantity demanded for banana split is the same regardless of the price so
it is perfectly inelastic.
5. Ans:
demand
6. Ans: C. Figure 4 page 97 PE textbook.
7. Ans: A
The price elasticity of demand using midpoint method:
E= = = 2.33 >1, the
demand is elastic. At $40, revenue is $40 x 200 = $8000. At $30, revenue is $30 x 300 =
$9000.
8. Ans: D. Because the slope is not change.
9. Ans: B
The slope = = = 1/4; The price elasticity of demand =
= 3/2
10. Ans: D. The price elasticity of demand = = 3/2 > 1

11. Ans: C. Because the demand of lemonade is elastic, lower the price would increase
total revenue.
12. Ans: D. Because an increase in income leads to an increase in quantity demanded
for pizza. So the income elasticity of demand must be positive and pizza is normal good.
13. Ans: B. The income elasticity of good Y using midpoint method:
E= = -2.33
14. Ans: A. E= => % =Ex% = 1.2 x 15% = 18%. However,
price and quantity demanded is negatively related. Therefore, an increase in price will
lead to a decrease in quantity demanded.
15. A. Ans: The price elasticities of supply are:
EA = = 0.27
EB = = 0.4
EC = = 0.64
EA < EB < EC, so A is the most inelastic supply curve.

16. Ans: D (Explain:
17. Ans: A (Explain:
determinant of the price elastici
18. Ans: A
19. Ans:C. The price elasticity of supply between D and E is:
E= = 0.53
20. Ans: D. The discovery of new hybrid wheat shifts the supply curve to the right and
leads to a decrease in price of wheat. A decrease in price results in an increase in total
revenue if and only if the demand is elastic.
P
S1
D S2
P1
P2
Q1 Q2 Q
21. Ans: D
When demand is inelastic, price and total revenue move in the same direction.
Therefore, for the mayor, the demand for a round of golf is inelastic.
When the demand is elastic, price and total revenue move in opposite directions.
Therefore, for the city manager, the demand for a round of golf is elastic.
Ans: C. The cross-price elasticity of demand between good X and good Y, using the
midpoint method: = =
= 3.67 >0 => X, Y are substitutes.

Chapter 6: Supply, Demand and Government Policy 111
Chapter 06:
Supply, Demand and Government Policy
I/ Price controls:
- Price control often hurts those they are trying to help.
- Price control is imposed when policymakers sense the market price of a good or
service is unfair for buyers or sellers.
- Price control can create inequities.
1/ Price ceiling:
- The legal maximum of market price on a good or service.
- Binding price ceiling => Shortage (= Demand - Supply) => Sellers ration the
goods among buyers (Rationing Mechanism) => Market outcome is rarely
desirable.
Rent control:
- A type of price ceiling that sets the highest rent landlords can charge their tenants.
- Short-run: Supply of apartment is inelastic (Apartment cannot be built within a
short period)
Demand of apartment is inelastic (People take time to adjust their
housing arrangements)
=> Shortage of apartment
- Long-run: Both Supply and Demand are more elastic (Landlords respond to low
rents by not building more apartment, people respond to low rents by demanding
more apartment)
=> More shortage of apartment
2/ Price floor:
- The legal minimum of market price on a good or service.
- Binding price floor => Surplus (= Supply - Demand).

Minimum Wages:
- A type of price floor that sets the lowest price for labor that any employer may
pay.
- Causes labor surplus => Unemployment (unskilled workers gets fired).

II/ Tax:
- Tax raises revenue for public project.
- Tax incident: how the tax is share among participants.
- Tax revenue (collected for the government) = New equilibrium price * Tax size
- Taxes discourage market activities.
- Tax levied on Sellers: shifts Supply curve.
- Tax levied on Buyers: shifts Demand curve.
- Buyers and Sellers always share tax burden.
- Supply/Demand curve shifts by the exact amount of tax.

- Tax levied on Sellers vs. Tax levied on Buyers: Market outcome is the same.
The only difference is who sends the money to the government.

- More inelastic => More tax burden.
- Supply is more inelastic => Supply curve is steeper => Sellers carries more tax
burden.
- Demand is more inelastic => Demand curve is steeper => Buyers carries more tax
burden.
EXERCISE
1/ Refer to Figure 6-2, A price floor of $14 is imposed, choose the best answer
A. A price floor is said to be not binding, Shortage = 70 units
B. A price floor is said to be binding, Surplus = 40 units
C. A price floor is said to be binding, Shortage = 40 units
D. A price floor is said to be not binding, Surplus = 70 units
2/ Refer to figure 6-2, In which of the following case will the sellers have to develop
a rationing mechanism?
A. A price ceiling is set at $8.
B. A price ceiling is set at $12.

C. A price floor is set at $8.
D. A price floor is set at $10.
3/ When a tax is imposed on the buyers of a good, the demand curve shifts
A. downward by the amount of the tax.
B. upward by the amount of the tax.
C. downward by less than the amount of the tax.
D. upward by more than the amount of the tax.
4/ Refer to figure 6-14, the per-unit burden of tax on buyers is:
A. $16
B. $14
C. $8
D. $6
5/ Refer to figure 6-12, in which market will the majority of tax burden fall on the
buyer?
A. (a) B. (b) C. ( c ) D. All of the above
6/ Refer to figure 6-12, in which market will the majority of tax burden fall on the
seller?

7/ Refer to figure 6-12, in which market will the tax burden be most equally
divided between the buyer and the seller?
8/ Refer to Figure 6-8, what is the:
a. Size of the tax?
b. Deadweight Loss?
c. The effective price?
d. Tax burden on Buyers and Sellers?
e. The effect if the tax was levied on Sellers?
f. Elasticity of Demand comparing to Elasticity of Supply?

1. B (Explain: A price floor is binding because it is higher than the equilibrium price
(14 > 10). Surplus = Supply Demand = 60 40 = 20 units)
2. A (Explain: When a binding price ceiling is imposed in a competitive market,
Supply < Demand, so the sellers have to ration scarce goods among a large number of
buyers
B is wrong. Price ceiling is larger than equilibrium price => No effect on market
C is wrong. Price floor is less than equilibrium price => No effect on market
D is wrong. Price floor equals equilibrium price => No effect on market)
3. A (Explain: PE text book p. 124)
4. C (Explain: - Initial Equilibrium Price = 24 - 16
= $8)
5. B (Explain: Because the Demand curve is steeper than the Supply curve (ED < ES))
6. A ( Explain: Because the Supply curve is steeper than the Demand curve (ED > ES))
7. C (Explain: Because we can observe that the slopes of the Demand and Supply
curves are nearly the same)
8. A (Ans: Size of tax = Price Buyers pay Price Sellers get= 8 -5= $3)
B (Ans: ½ x 10 x 3 = 15)
C (Ans: Effective price is the price buyers pay after tax $8)
D (Ans: Tax burden of Buyers = Price buyers pay Initial Equilibrium Price
= 8 - 6 = $2
Tax burden of Sellers = Initial Equilibrium Price Price Sellers get
= 6 - 5 = $1)
E (Ans: Same effect, Explain: PE textbook p.125)
F (Ans: ED < ES since the tax burden on Buyers is larger than the tax burden on
Sellers)
Chapter 7: Consumers, Producer, and the Efficiency of Markets 124
Chapter 7:
Consumers, Producer, and the Efficiency of Markets
I- Welfare Economics:
The study of how the allocation of resources affects economic well-being.
II- Consumer Surplus: III- Producer Surplus:
Cost: the value of everything a seller
must give up producing a good
(opportunity cost). Includes cost of all
resources used to produce good,
Willingness to pay: the maximum amount
that a buyer will pay for a good, and it
measures how much that buyer values the

A seller will produce and sell the
good.
good/service only if the price exceeds his
or her cost.
Hence, cost is a measure of
willingness to sell.
Consumer Surplus: the amount a buyer Producer Surplus: the amount a seller is
is willing to pay for a good minus the paid for a good minus the of
amount the buyer actually pays for it. providing it.
Formula: Formula:
CS = WTP P PS = P - WTS
With With
CS: Consumer Surplus PS: Producer Surplus
P: The market price of that good. P: The market price of a good
WTP: Willingness to pay of a buyer to a WTS: Willingness to sell or cost of
good producing that good.
Marginal buyer: the buyer who Marginal seller: the seller who
would leave the market first if the would leave the market first if the
price was any higher. price was any lower.
The consumer surplus in a market is The producer surplus in a market is
measured by the area below the demand measured by the area below the price and
curve and above the price, which is the above the supply curve, which is the area
area of the triangle (CS= AB.BC). of the triangle (PS= AB.BC).
How a lower price raise Consumer How a lower price reduce Producer
Surplus? Surplus?
How a higher price reduce Consumer How a higher price raise Producer
Surplus? Surplus?
Example: Example:
B) Find CS for P = $30. B) Find total PS for P = $20.
Suppose P falls to $20. How much will Suppose P rises to $30. Find the increase
in PS due to:
C) Buyers entering the market. C) Selling 5 additional units.
D) Existing buyers paying lower price. D) Getting a higher price on the initial 10
units.
SOL:
SOL:
A) At Q = 10,
A) At Q = 10,
B) CS = ½ x 10 x $10 = $50 B) PS = ½ x 10 x $20 = $100
P falls to $20. P rises to $30.
C) CS for the additional buyers C) PS on additional units
= ½ x 10 x $10 = $50 = ½ x 5 x $10 = $25
D) Increase in CS on initial 10 units D) Increase in PS on initial 10 units
= 10 x $10 = $100 = 10 x $10 = $100
IV- Market Efficiency:
Efficiency means:
- The goods are consumed by the buyers who value them most highly.
- The goods are produced by the producers with the lowest costs.
- Raising or lowering the quantity of a good would not increase total surplus.
CS = (value to buyers) (amount paid by buyers)
market
PS = (amount received by sellers) (cost to sellers)
Total surplus = CS + PS
= total gains from trade in a market
= (value to buyers) (cost to sellers)
Evaluating the Market Equilibrium: (Is the Market Equilibrium efficient?)
An allocation of resources is efficient if it maximizes total surplus.

When Q1 < QE, Value to buyers is greater
than cost to sellers.
We can increase total surplus by

Total surplus = CS + PS
increasing Q.
= (value to buyers) (cost to sellers)
When Q2 > QE, Value to buyers is less than
= total gains from trade in a market
cost to sellers.
We can increase total surplus by
decreasing Q.
EXERCISE
1.
good,
a. consumer surplus for that good is maximized
b.
c. The price of the good exceeds the value that the buyer places on the good.
d. The buyer is indifferent between buying the good and not buying it.
2. Suppose Kate, Kendra, and Kristen each purchase a particular type of cell
willingness
Which of the following statements is correct?
a. For the three individuals together, consumer surplus amounts to $35.
b. Having bought the cell phone, Kristen is better off than she would have been had
she not bought it.
c. Had the price of the cell phone been $95 rather than $80, Kate and Kendra
definitely would have been buyers and Kristen definitely would not have been a
buyer.
d. The fact that all three individuals paid $80 for the same type of cell phone
indicates that each one placed the same value on the cell phone.
Table 1 below is used to answers question 3 & 4.
For each of three potential buyers of oranges, the table displays the willingness to
pay for the first three oranges of the day. Assume Alex, Bard, and Carlos are the
only three buyers of oranges.

First Orange Second Orange Third Orange
Alex $2.00 $1.50 $0.75
Bard $1.50 $1.00 $0.80
Carlos $0.75 $0.25 $0
3. Refer to Table 1. If the market price of an orange is $0.40,
a. 6 oranges are demanded per day and total consumer surplus amounts to $4.45.
b. 6 oranges are demanded per day and total consumer surplus amounts to $5.10.
c. 7 oranges are demanded per day and total consumer surplus amounts to $5.35.
d. 7 oranges are demanded per day and total consumer surplus amounts to $5.50.
4. Refer to Table 1. If the market price of an orange increase from $0.60 to $1.05,
total consumer surplus
a. Increases by $2.90.
b. Decreases by $2.55.
c. Decreases by $2.70.
d. Decreases by $3.85.
5. Suppose the market demand curve for a good passes through the point (quantity
demanded = 100, price = $25). If there are five buyers in the market, then
a.
b.
$25.
c. unit of the good is
$25.
d. All of the five buyers are willing to pay at least $25 for the 100th unit of the good.
Figure 1 below is used to answer question 6 to 9.
Figure 1
6. Refer to Figure 1. When the price is P1, consumer surplus is
a. A.
b. A+B.
c. A+B+C.
d. A+B+D.
7. Refer to Figure 1. When the price is P2, consumer surplus is
a. A.
b. B.
c. A+B.
d. A+B+C.
8. Refer to Figure 1. Area C represents
a. The decrease in consumer surplus that results from a downward-sloping demand
curve.
b. Consumer surplus to new consumers who enter the market when the price falls
from P2 to P1.
c. The increase in producer surplus when quantity sold increases from Q2 to Q1.
d. The decrease in consumer surplus to each consumer in the market when the price
increases from P1 to P2.
9. Refer to Figure 1. When the price rises from P1 to P2, which of the following
statements is not true?
a. The buyers who still buy the good are worse off because they now pay more.
b. Some buyers leave the market because they are not willing to buy the good at the
higher price.
c. Buyers place a higher value on the good after the price increase.
d. Consumer surplus in the market falls.
10. Sally sharpens knives in her spare time for extra income. Buyers of her service
are willing to pay $2.50 per knife for as many knives as Sally is willing to sharpen.
On a particular day, she is willing to sharpen the first knife for $1.75, the second
knife for $2.25, the third knife for $2.75, and the fourth knife for $3.25. Assume
Sally is rational in deciding how many knives to sharpen. Her producer surplus is
a. $0.25.
b. $0.50.
c. $1.00.
d. $1.75.
11. Suppose consumer income increases. If grass seed is a normal good, the
equilibrium price of grass seed will
a. Decrease, and producer surplus in the industry will decrease.
b. Increase, and producer surplus in the industry will increase.
c. Decrease, and producer surplus in the industry will increase.
d. Increase, and producer surplus in the industry will decrease.
12. The marginal seller is the seller
a. For whom the marginal cost of producing one more unit of output is the lowest
among all sellers, and the marginal buyer is the buyer for whom the marginal
benefit of one more unit of the good is the highest among all buyers.
b. Who supplies the smallest quantity of the good among all sellers, and the
marginal buyer is the buyer who demands the smallest quantity of the good
among all buyers.
c. Who would leave the market first if the price were any lower, and the marginal
buyer is the buyer is the buyer who would leave the market first if the price were
any higher.
d. Who has the largest producer surplus, and the marginal buyer is the buyer who
has the largest consumer surplus.
Figure 2 below is used to answer question 14 to 18

Figure 2
13. Refer to Figure 2. When the price is P2, producer surplus is
a. A.
b. A+C.
c. A+B+C.
d. D+E.
14. Refer to Figure 2. When the price is P1, producer surplus is
a. A.
b. C.
c. A+B.
d. C+D.
15. Refer to Figure 2. Area B represents
a. The combined profits of all producers when the price is P2.
b. The increase in producer surplus to all producers as the result of an increase in the
price from P1 to P2.
c. Producer surplus to new producers entering the market as the result of an increase
in the price from P1 to P2.
d. That portion of the increase in producer surplus that is offset by a loss in
consumer surplus when the price increases from P1 to P2
16. Refer to Figure 2. When the price falls from P2 to P1, which of the following
would not be true?
a. The sellers who still sell the good are worse off because they now receive less.
b. Some sellers leave the market because they are not willing to sell the good at the
lower price.
c. The total cost of what is now sold by sellers is actually higher than it was before
the decrease in the price.
d. Producer surplus would fall by area A+B.

17. Refer to Figure 2. Area A represents
a. Producer surplus to new producers entering the market as the result of an increase
in price from P1 to P2.
b. The increase in consumer surplus that results from an upward-sloping supply
curve.
c. The increase in total surplus when sellers are willing and able to increase supply
from Q1 to Q2.
d. The increase in producer surplus to those producers already in the market when
the price increases from P1 to P2.
18. Which of the following events would increase producer surplus?
a.
b. costs increase and the price of the good stay the same.
c.
19. Total surplus in a market is the total area
a. Below the demand curve and above the price.
b. Below price and up to the point of equilibrium.

c. Below the demand curve and above the supply curve, up to the equilibrium
quantity.
d. Below the demand curve and above the horizontal axis, up to the equilibrium
quantity.
Figure 3 below is used to answer question 21 to 24.
Figure 3
20. Refer to Figure 3. At the equilibrium price, total surplus is
a. $480.
b. $640.
c. $1,120.
d. $1,280.
21. Refer to Figure 3. The efficient price is
a. $22 and the efficient quantity is 40.
b. $22 and the efficient quantity is 110.
c. $16 and the efficient quantity is 80.
d. $8 and the efficient quantity is 40.
22. Refer to Figure 3. If 110 units of the good are being bought and sold, then
a. The cost to sellers is equal to the value to buyers.
b. The value to buyers is greater than the cost to sellers.
c. The cost to sellers is greater than the value to buyers.
d. Producer surplus is greater than consumer surplus.
23. Refer to Figure 3. If 40 units of the good are being bought and sold, then
a. Cost to sellers is equal to the value to buyers.

b. The value to buyers is greater than the cost to sellers.
c. The cost to sellers is greater than the value to buyers.
d. Producer surplus would be greater than consumer surplus.

1. ANS: d. The buyer is indifferent between buying the good and not buying it.
(Explain: Because when Willingness to Pay equals Price of the goods, the Consumer
Surplus is zero, so either options is fine to the buyers)
2. ANS: a. For the three individuals together, consumer surplus amounts to $35.
(Explaining: consumer surplus of three individual together: ($100-$80) + ($95-$80) +
($80-$80) = $20 + $15 +$0 = $35 (a is correct).
between buying the cell phone or not (b is incorrect).
Had the price of the cell phone been $95, it would have been equal to Kendra
willingness to pay, so she is indifferent between buying or not. Therefore it is not
definite that Kendra would buy it (c is incorrect).

The value of each buyers for the good is the willingness to pay, not the price (d is
incorrect).
3. ANS: d. 7 oranges are demanded per day and total consumer surplus amounts to
$5.50.
(Explaining: The price of an orange is $0.40, as long as the willingness to pay is larger
than the price, buyers will buy it. Alex buy 3 oranges, Bard buy 3 oranges, Carlos buy 1
orange. Therefore, there are 7 (3+3+1) oranges demanded per day. Total consumer
surplus = (2+ 1.5+ 0.75+ 1.5+ 1+ 0.8+ 0.75) - 7 x 0.4= $5.50)
4. ANS: b. Decreases by $2.55.
(Explaining: At the price of $0.60, consumer surplus is:
(2+ 1.5+ 0.75+ 1.5+ 1+ 0.8+ 0.75) - 7 x 0.6= $4.10
At the price of $1.05, consumer surplus is:
(2+ 1.5+ 0.75+ 1.5) - 4 x 1.05 = $1.55
Therefore, the consumer surplus decreases by $2.55 ($4.10 - $1.55)
5. ANS: a. The mar
$25.
(Explain
Willingness to Pay). The Demand curve passes through the point of Q= 100, P=25,
which means that there are marginal buyers who has the Willingness to Pay of $25 for
the 100th unit of goods)
6. ANS: c. A+B+C.
(Explain: The area below demand curve and above the price level P1)
7. ANS: a. A.
(Explain: The area below demand curve and above the price level P2)
8. ANS: b. Consumer surplus to new consumers who enter the market when the price
falls from P2 to P1. (see PE textbook figure 3 page 140)
9. ANS: c. Buyers place a higher value on the good after the price increase.
(Explaining:
Because P2 > P1, buyers pay more so the consumer surplus will be decreased for
buyers who stay in the market, so they worse off (a and d is correct).
leave the market (b is correct).
The willingness to pay of each buyers is different and it is not related to the price,
incorrect). )
10. ANS: c. $1.00.

(Explaining: buyers buy
$2.50, Sally only sharpens the first 2 knives. Her producer surplus is 2 x 2.5 - (1.75 +
2.25) = $1.00)
11. ANS: b. Increase, and producer surplus in the industry will increase.
(Explaining: Because grass seed is a normal good, when consumer income increases,
they will buy more grass seed, so demand curve shifts to the right which leads to the
increase in equilibrium price. Because price increase, producer surplus will increase
(producer surplus= price - cost) )
12. ANS: c. Who would leave the market first if the price were any lower, and the
marginal buyer is the buyer is the buyer who would leave the market first if the price
were any higher. (according to definition of marginal seller and marginal buyer.)
13. ANS: c. A+B+C. (the area below the price level P2 and above supply curve)
14. ANS: b. C. (the area below the price level P1 and above supply curve)
15. ANS: c. Producer surplus to new producers entering the market as the result of an
increase in the price from P1 to P2. (see PE textbook, figure 6, page 144)
16. ANS: c. The total cost of what is now sold by sellers is actually higher than it was
before the decrease in the price.
(Explain:
A is right because when the price falls from P2 to P1, the Producer Surplus falls
from area ABC to area A.
B is right because when the price falls, some sellers in the market will now have the
cost higher than the price, so they leave the market. The loss in area B represents the loss
in Producer Surplus due to some sellers leaving the market.
C is wrong. The area B represents the surplus of the sellers with less efficiency
(higher costs). So now, when the price reduces from P2 to P1, the amount reduced
includes area B, so these less efficient sellers will leave the market, reducing total costs.
D is right. When price reduces from P2 to P1, the Producer Surplus reduces from
ABC to C.)
17. ANS: d. The increase in producer surplus to those producers already in the market
when the price increases from P1 to P2.
(Explain: Area A represents the surplus of the sellers who were already selling Q1 of the
good at the lower price P1 are better off because the price increases to P2. They get more
than before for what they sell.

18. ANS:
(Explain: Use the formula Producer Surplus = Price Received - Willingness to Sell
to answer this question.
Price would increase Producer Surplus.
ucer Surplus decreases
Producer Surplus decreases)

19. ANS: c. Below the demand curve and above the supply curve, up to the equilibrium
quantity.
(Explain: Total surplus is the sum of Consumer Surplus and Producer Surplus. As
shown in the graph below, Total Surplus is the area of triangle ACE
20. ANS: c. $1,120.
(Explain: Total Surplus = Producer Surplus + Consumer Surplus
=S +S
=S
= ½ x 80 x 28 = 1,120)
21. ANS: c. $16 and the efficient quantity is 80.
(Explain: The efficient price and quantity are the equilibrium price and quantity)
22. ANS: c. The cost to sellers is greater than the value to buyers.
(Explain: The Demand curve reflects the value to buyers and the Supply curve reflects
the cost to sellers. Currently, there are 110 units of goods being sold and bought in the
market, the value to buyers is at point G, the cost to sellers is at point F. So the cost to
sellers is greater than the value to buyers.)
23. ANS: b. The value to buyers is greater than the cost to sellers.
(Explain: The Demand curve reflects the value to buyers and the Supply curve reflects
the cost to sellers. Currently, there are 40 units of goods being sold and bought in the
market, the value to buyers is at point H, the cost to sellers is at point J. So the value to
buyers is greater than the cost to sellers)
Note: Use this graph when dealing with question like 22, 23:
Chapter 8: Application: The costs of taxation 152
Chapter 8:
Application: The Costs of Taxation
I. The Deadweight Loss of Taxation

Tax on a good levied on buyers or on sellers
The Effects of a Tax

Price
Size of tax
Price buyers pay Supply
Price without tax
Price sellers
receive
Demand
Quantity with Quantity without Quantity

tax tax
Tax on a good levied on buyers Tax on a good levied on sellers
- Demand curve shifts - Supply curve shifts upward

downward by the size of by the size of tax.
tax.
- Price paid by buyers rises. - Price received by
falls.
- The quantity sold falls.
- The elasticities of supply and demand determine how the tax burden is
distributed between producers and consumers.
Economic Welfare
- Benefit received by buyers: consumer surplus
consumer surplus = the amount buyers are willing to pay for the
good - the amount they actually pay for it
- Benefit received by sellers: producer surplus
producer surplus = the amount sellers receive for the good - their
cost
- Government gets tax revenue
Tax Revenue
Price
Size of tax (T)

Price buyers pay
Supply
Tax revenue
(T x Q)
Price sellers
receive
Demand
Quantity sold
(Q)
Quantity Quantity Quantity

with tax without tax
total tax revenue = T x Q

T: The size of tax
Q: The quantity of good sold
How a Tax Affects Welfare
Without Tax With Tax

Change
Consumer Surplus
Producer Surplus A+B+C A - (B + C)
Tax Revenue D+E+F F - (D + E)
Total Surplus None B+D + (B + D)
A + B + C + D+E + F A+B+D+F - (C + E)
The area C + E show the fail in total surplus and is deadweight loss of tax.
Price
A
Price buyers
Supply
pay
B C
Price
without tax
D E
Price sellers
receive
F Demand
Quantity Quantity Quantity

with tax without tax
- Changes in Welfare:
Consumer surplus falls by the area B + C
Producer surplus falls by the area D + E
Tax revenue raises by the area B + D
Losses of surplus to buyers and sellers from a tax exceed the

revenue raised by the government.
- Deadweight loss: The fall in total surplus that results from a market
distortion, such as a tax
- Because taxes distort incentives, they cause markets to allocate resources
inefficiently
Deadweight Losses and Gains from Trade

- Taxes cause deadweight losses because they prevent buyers and sellers from
realizing some of gains from trade.
-
Once the tax is imposed, at every quantity between Q1 and Q2:

The gains from trade < the tax
These trades are not made
These lost gains from trade create deadweight loss.
The Source of a Deadweight Loss

Price
Lost gains
from trade
Supply
PB
Size of tax
Price without tax
PS
Demand
Cost to sellers
Value to
buyers
0 Q2 Q1 Quantity
Reduction in quantity due to the tax

II. The Determinants of the Deadweight Loss

Price elasticities of supply and demand
- More
III. Deadweight Loss and Tax Revenue as Taxes Vary

Deadweight loss Tax Revenue
0 0
Tax size Tax size
When the tax increase
- The deadweight loss increases even more rapidly than the size of the tax.
by X2 times)
-
(Because the higher tax drastically reduces the size of markets)
EXERCISE
1. Which of the following is the most correct statement about tax burdens?
a. A tax burden falls most heavily on the side of the market that is elastic.
b. A tax burden falls most heavily on the side of the market that is inelastic.
c. A tax burden falls most heavily on the side of the market that is closer to unit
elastic.
d. A tax burden is distributed independently of relative elasticities of supply and
demand.
2. A tax placed on a good
a. causes the price of the good to fall.
b. affects buyers of the good, but not sellers.
c. causes the size of the market for the good to shrink.
d. is usually borne entirely by the seller of the good.
3. The benefit from a tax is measured by the
the tax revenue.
b. cost of collecting (administering) the tax.
c. interest saved because the government did not borrow the funds.
4. Deadweight loss measures the

a. loss in a market to buyers and sellers that is not offset by an increase in
government revenue.
b. loss in revenue to the government when buyers choose to buy less of the
product.
c. loss of efficiency in a market as a result of government intervention.
d. lost revenue to businesses because of higher prices to consumers from the tax.
5. The larger the deadweight loss of taxation the
a. more people will choose to leave the market.
b. more the burden of the tax will fall on the buyer and not the seller.
c. more the burden of the tax will fall on the seller and not the buyer.
d. more people will join the market.
6. Assume that the demand for pretzels is relatively inelastic and that the demand
for potato chips is relatively elastic. If the same percentage tax were placed on
both goods, the tax on which product would create a larger deadweight loss?
a. the tax on pretzels
b. the tax on potato chips
c. The taxes would create the same amount of deadweight loss.

d. This question is impossible to answer without knowing the price of both
pretzels and potato chips.
7. The size of the tax and the deadweight loss of a tax are
a. positively related.
b. negatively related.
c. independent of each other.
d. equal to each other.
8*. Suppose a tax of $1 per unit is imposed on a good. The more elastic the supply
of the good, other things equal,
a. the smaller is the response of quantity supplied to the tax.
b. the larger is the tax burden on sellers relative to the tax burden on buyers.
c. the larger is the deadweight loss of the tax.
9. Suppose that policymakers are considering placing a tax on either of two
markets. In Market A, the tax will have a significant effect on the price consumers
pay, but it will not affect equilibrium quantity very much. In Market B, the same
tax will have only a small effect on the price consumers pay, but it will have a large
effect on the equilibrium quantity. Other factors are held constant. In which
market will the tax have a larger deadweight loss?
a. Market A
b. Market B
c. The deadweight loss will be the same in both markets.
d. There is not enough information to answer the question.
10. Consider a good to which a per-unit tax applies. The size of the deadweight
that results from the tax is smaller, the
a. less elastic is the demand for the good.
b. less elastic is the supply of the good.
c. smaller is the amount of the tax.
11*. Assume the price of gasoline is $2.00 per gallon and the equilibrium
quantity of gasoline is 10 million gallons per day with no tax on gasoline. Starting
from this initial situation, which of the following scenarios would result in the
largest deadweight loss?
a. The price elasticity of demand for gasoline is 0.1; the price elasticity of supply
for gasoline is 0.6; and the gasoline tax amounts to $0.20 per gallon.
b. The price elasticity of demand for gasoline is 0.1; the price elasticity of supply
c. The price elasticity of demand for gasoline is 0.2; the price elasticity of supply
d. There is insufficient information to make this determination.
12. Using the graph shown above, determine each of the following:
a. equilibrium price before the tax
b. consumer surplus before the tax
c. producer surplus before the tax

d. total surplus before the tax
e. consumer surplus after the tax
f. producer surplus after the tax
g. total tax revenue to the government
h. total surplus (consumer surplus + producer surplus + tax revenue) after the
tax
i. deadweight loss
13. Suppose that the equilibrium quantity in the market for widgets has been 200
per month. Then a tax of $5 per widget is imposed on widgets. The price paid by
buyers increases by $2 and the after-tax price received by sellers falls by $3. The
government is able to raise $750 per month in revenue from the tax. The
deadweight loss from the tax is
a. $250.
b. $125.
c. $75.
d. $50.
14. Assume that the demand for salt is relatively inelastic and that the demand for
orange juice is relatively elastic. Compared to the deadweight loss from the same
tax on orange juice, the deadweight loss from imposing a tax on salt would be
a. greater.
b. less.
c. neither greater nor less.
d. either greater or less.
1. ANSWER: b. A tax burden falls most heavily on the side of the market that is
inelastic.
(Explanation: Because the more inelastic side of the market has fewer opportunities to
consume or produce other goods, it has to bear a heavier tax burden.)
2. ANSWER: c. causes the size of the market for the good to shrink.
(Explanation: The buyers pay more, and the sellers receive less. Hence, a tax levied on
a good reduces the incentives of both sides of the market to consume or produce more
products.)
3. ANSWER:
expenditure of the tax revenue.
(Explanation: Tax revenue can be used to build public projects. The tax revenue does
not benefit the government but to whom the revenue is spent) (See 8-1a second
paragraph p.157 P.E. textbook)
4. ANSWER: a. loss in a market to buyers and sellers that is not offset by an increase
in government revenue.
(Explanation: Theoretical Information)
5. ANSWER: a. More people will choose to leave the market.
(Explanation: The larger the tax size, the larger the Deadweight Loss, the more it
prevent buyers and sellers to realize the gain from trade. So they will leave the market.)
6. ANSWER: b. the tax on potato chips
(Explanation: The tax on potato chips will create a larger deadweight loss because the
demand for chips is more elastic than pretzels)
7. ANSWER: a. positively related.
An X-times increase in the size of the tax leads to an X 2 times increase in the
deadweight loss.
8. ANSWER: c. the larger is the deadweight loss of the tax.

(Explanation: Because when the supply of the good is more elastic:
- The response of quantity supplied to the tax is greater.
- The tax burden on sellers (the side of the market that is more elastic) is smaller
(recall question 1).
- The deadweight loss is larger.)
9. ANSWER: b. Market B
(Explanation: In market A, big change in price leads to small change in quantity, so the
price elast inelastic. In market B, small change in
price leads to big change in quantity, so the price elasticity is larger than 1 elastic. So
the Deadweight Loss in Market B is larger due to higher elasticity)
10. ANSWER: d. All of the above are correct.
(Explanation: Theoretical Information)
11. ANSWER: c. The price elasticity of demand for gasoline is 0.2; the price elasticity
of supply for gasoline is 0.6; and the gasoline tax amounts to $0.30 per gallon.
(Explanation: Because the largest deadweight loss would result from)
- The most elastic the price of demand: 0.2
- The most elastic the price of supply: 0.6
- The largest tax size: $0.30

Choose c
12. ANSWER:
a. $10 (The intersection of the supply and demand curve)
b. ½ x 12 x 600 =$3600 (The area above price level and below demand curve)
c. ½ x 8 x 600 =$2400 (The area above supply curve and below price level)
d. 3600 + 2400 =$6000 (Sum of consumer surplus and producer surplus)
e. ½ x 6 x 300 =$900 (The area of the triangle above new Price paid by buyers and
below demand curve)
f. ½ x 4 x 300 =$600 (The area of the triangle above Supply curve and below new
Price received by sellers)
g. 10 x 300 =$3000 (= Tax size * New Equilibrium quantity)
h. $4500
i. ½ x 300 x 10 = $1500 (The area of the triangle bordered by Demand curve,
Supply curve, and the Tax size)
13. ANSWER: b. $125.
Explanation:
Given Qe=200
Size of tax T=5
Tax revenue =
= 150
Deadweight loss = = 125
14. ANSWER: b. less.

(Explanation: Because the demand for salt is relatively inelastic, the after-tax price
reduces quantities demanded a small number, which makes the deadweight loss from
imposing a tax on salt would be less than that of orange juice.)

Chapter 9: Application: International Trade 170
Chapter 9:
Application: International Trade
I/ World price and Comparative Advantage:
- Comparative Advantage: ability to produce a good at a lower opportunity cost
than other producers ( main determinant of trade)
- World price: the price of a good that prevails in the world market for that good,
is determined by buyers and sellers in the world
- Small economy: has
- Domestic price reflects opportunity cost
- Trade allowed domestic price = world price
- If World Price > Domestic Price Export
- If World Price <

II/ Exports:
- The market is still in equilibrium because there are now 3 economic actors:
Domestic Sellers, Domestic Buyers and the rest of the world
- Exports Sellers benefits, Buyers worse off but Total Surplus increases
- Gains exceed losses Raises economic well-being of a nation
- The World Price horizontal line represents the World Demand of that good
III/ Imports:
- Imports Buyers benefit, Sellers worse off but Total Surplus increases
- The World Price horizontal line represents the World Supply of that good.
- In both situations, whether a nation imports or exports, there will always be
winners and losers. In theory, winners could compensate the losers. But, in
practice, compensation for the losers from international trade is rare.

IV/ Tariff:
- Tariff (to protect domestic companies): tax on imported good
- Tariff reduces Q of imports and moves the domestic market closer to its
equilibrium without trade
Tariff cause Deadweight Loss = F + D
F: high price decrease demand (underconsumption)
D: Inefficiency of sellers waste scarce resources (overproduction)

- Tariff = tax: distort incentives, push allocation of resources away from optimum
- Tariff raises revenue for government = E
V/ Benefits of trade:
- Increased variety of goods
- Lower cost through economies of scale: large Q => lower cost
- Increased competition
- Flow of ideas
VI/ Arguments for restricting trade
1. Job:
- decrease decrease decrease employment, but
workers will eventually find jobs in other industries
- Even if all goods is cheaper abroad, a country only needs Comparative
Advantage gain from trade
2. National security:
- Argue that a particular good is vital for national defense

- Companies has incentives to exaggerate their role in national defense to obtain
protection from the government
3. Infant industry:
- New industry + old industry want protection from the government to help get
difficult to decide if it is necessary or
not
- For firm to make profit in the long-run short-run
4. Unfair competition:
- Firms in different countries subject to different laws => unfair
- But the trade case is the same as before
5. Protection as a bargaining chip
- Strategy: Country A will impose tariff if Country B
- Country A faced 2 bad options:
+ Impose tariff: decrease economy well-being
+ Back down: lose prestige

CASE STUDY: Trade Agreements and the World Trade Organization
A country can liberalize trade with either Unilateral or Multilateral approach.
- Unilateral approach: Remove trade restrictions
- Multilateral approach:
+ Other countries will also remove trade restrictions
+ Benefits: freer trade than unilateral; less trade restrictions at home and
abroad
+ ilateral
+ Political advantage: win political support
EXERCISE
01. If a country allows trade and, for a certain good, the domestic price without
trade is higher than the world price,
A. the country will be an exporter of the good.
B. the country will be an importer of the good.
C. the country will be neither an exporter nor an importer of the good.
D. Additional information is needed about the demand to determine whether the
country will be an exporter of the good, an importer of the good, or neither.

02. Suppose that Vietnam can produce rice at the lowest opportunity cost than any
other countries in Asia, but any other countries in Asia can produce more rice per
input than Vietnam. When trade is allowed, Vietnam will be more likely to:
A. import rice.
B. export rice.
C. be self-sufficient with rice.
D. There is not enough information given to answer this question.
03. If a country allows trade and the world price is higher than the domestic price.
Would a country be more likely to import or export? In that situation, what would
happen to the Domestic Producer, Consumer, and Total Surplus?
A. Export. Producer Surplus increases. Consumer Surplus decreases. Total Surplus
increases.
B. Import. Producer Surplus decreases. Consumer Surplus increases. Total Surplus
increases.
C. Export. Producer Surplus increases. Consumer Surplus decreases. Total Surplus
decreases.
D. Import. Producer Surplus increases. Consumer Surplus decreases. Total Surplus
decreases.
04. The World Price horizontal line in the graph represents:
A. It has no meaning.
B.
imports.
C. Domestic Demand when a country exports, Domestic Supply when a country
imports.
D. s Supply when a country
imports.
05. Refer to Figure 9-1. Without trade, Producer and Consumer Surplus are,
respectively:
A. F = 97.5 ; C + E = 210
B. B + D = 165 ; A = 80
C. C + E = 210 ; A + B + D = 245
D. B + C + D + E + F = 472.5 ; A = 80
06. Refer to Figure 9-1. When free trade is allowed, this country will:
A. exports 65 baskets.
B. imports 65 baskets.
C. exports 105 baskets.
D. imports 105 baskets.
07. Refer to Figure 9-1. When free trade is allowed, this country will:
A. sells 40 baskets domestically at the price of $10 and 65 baskets abroad at the price
of $7.
B. buys 65 baskets domestically at the price of $1 and sells 105 baskets abroad at the
price of $10.
C. sells 40 baskets domestically and 65 baskets abroad at the price of $10.

D. sells 65 baskets domestically and 40 baskets 40 baskets abroad at the price of $10.
08. Refer to Figure 9-1. When free trade is allowed, Domestic Producer,
Consumer, and Total Surplus, respectively, will be:
A. B + C + D + E + F = 472.5 ; A = 80 ; A + B + C + D + E + F = 552.5
B. A = 80 ; B + C + D + E + F = 472.5 ; A + B + C + D + E + F = 552.5
C. C + E = 210 ; A + B + D = 245 ; A + B + C + D + E = 455
D. C + E = 210 ; A + B + D = 245 ; F = 97.5

09. Refer to Figure 9-5. With free trade and without tariff, Total Surplus increases
by:
A. E = 200
B. H = 400
C. F + G = 200
D. F + E + H + G = 800
10. Refer to Figure 9-5. The country:
A. Exports carnations
B. Imports carnations
C. Is self-sufficient with carnations
D. There is not enough information in the graph to answer this question
11. Refer to Figure 9-5. The size of tariff is:
A. $6
B. $4
C. $2
D. $10
12. Refer to Figure 9-5. With free trade and with tariff imposed, how much dozens
of carnations will the country imports:
A. 200
B. 400
C. 4
D. 2
13. Refer to Figure 9-5. With free trade and with tariff imposed, what are the
Deadweight Loss and Government Revenue from the tariff, respectively:
A. F + G = 200 ; H + E = 600
B. Only F or G = 100 ; H = 400
C. F + G = 200 ; H = 400
D. F + H + G = 600 ; E = 200
14. Refer to Figure 9-5. With free trade and with tariff imposed, the Deadweight
Loss area F and G are respectively caused by what?
A. Overproduction and Underconsumption
B. Underconsumption and Overproduction
C. Overconsumption and Underproduction

D. Underproduction and Overconsumption
15. Aquilonia has decided to end its policy of not trading with the rest of the world.
When it ends its trade restrictions, it discovers that it is importing incense,
exporting steel, and neither importing nor exporting rugs. We can conclude that
-trade policy has
A. increased consumer surplus and producer surplus in the incense market.
B. increased consumer surplus in the steel market and left producer surplus in the
rug market unchanged.
C. decreased consumer surplus in both the steel and rug markets.
D. decreased consumer surplus in the steel market and increased total surplus in the
incense market.
16. Which of the following is not a commonly-advanced argument for trade
restrictions?
A. the jobs argument
B. the national-security argument
C. the infant-industry argument
D. the efficiency argument

17. Denmark is an importer of computer chips, taking the world price of $12 per
chip as given. Suppose Denmark imposes a $5 tariff on chips. Which of the
following outcomes is possible?
A. The price of chips in Denmark increases to $19; the quantity of Danish-produced
chips increases; and the quantity of chips imported by Denmark decreases.
B. The price of chips in Denmark increases to $17; the quantity of Danish-produced
C. The price of chips in Denmark increases to $17; the quantity of Danish-produced
chips increases; and the quantity of chips imported by Denmark increases.
D. The price of chips in Denmark increases to $15; the quantity of Danish-produced
18. A tariff on a product makes
A. domestic sellers are better off and domestic buyers are worse off.
B. domestic sellers are worse off and domestic buyers are worse off.
C. domestic sellers are better off and domestic buyers are better off.
D. domestic sellers are worse off and domestic buyers are better off
1. B (Explain: When the domestic price is higher than the world price, it is now more
profitable for domestic buyers and buyers abroad to buy goods from abroad. Due to the
demand, the country will import goods.)
2. B (Explain: Vietnam can produce rice at the lowest opportunity cost than any other
countries so they have a comparative advantage in producing rice. On the other hand,
any other countries in Asia can produce more rice per input than Vietnam, which means
that they have an absolute advantage over Vietnam. The determinant of trading is the
comparative advantage, so Vietnam will export rice.)
3. A (Explain
more profitable for buyers abroad and domest
that country will export. When a country exports goods, sellers better off and buyers
worse off, but the total surplus increases.)
4. D (Explain: Theoretical Information)
5. C (Explain: Producer surplus is the area above Supply curve and below the
equilibrium price level => C + E. Consumer surplus is the area above Equilibrium price
level and below Demand curve => A + B + D)
6. A. (Explain: The world price is higher than domestic price, so the country will export
goods when trading is allowed.

Exports = Qsupplied domestically - Qdemanded domestically = 105 - 40 = 65)
7. C (Explain: When trading is allowed, the market reaches new equilibrium price =
$10.
Qsold domestically = Qdemanded domestically = 40
Qsold abroad = Exports = 65)
8. A (Explain: Similar to Question 05)
10. B (Explain: Because the world price is less than the non-trade equilibrium price, so
it is now more profitable for domestic buyers to buy carnations abroad. As a result, the
country will import carnations)
11. C (Explain: From the graph, we can see that when the tariff is imposed, the free
trade equilibrium price increases from $4 to $6, so the size of tariff is $2 per unit)
12. A (Explain: Imports = Qdemanded domestically - Qsupplied domestically = 400 - 200 = 200)
13. C (Explain: Theoretical Information)
14. A. (Explain: The area F is caused by Overproduction: When the tariff raises the
price of import, more sellers with higher production cost will be encourage to join the
market due to higher price. The Deadweight Loss F is created by the inefficiency of
these sellers. The area G is cause by Underconsumption: When the tariff raises the price
of import, some buyers will leave the market due to higher price. The Deadweight Loss
G is created by some buyers leaving the market.)
15. D (Explain: When Aquilonia imports incense, Consumer Surplus increases,
Producer Surplus decreases, Total Surplus increases. When Aquilonia exports steel,
Consumer Surplus decreases, Producer Surplus increases, Total Surplus increases.
When Aquilonia neither imports nor exports, Surplus is left unchanged.)
17. B (Explain: A $5 tariff imposed on imported good will increase the price of good to
12 + 5 = $17. Since the import price increases, Danish people will buy fewer chips
abroad and more homemade chips.)
18. A (Explain: Tariff pushes the price nearer to the non-trade equilibrium price,
creating effects which are OPPOSITE to what Import does to a country. As a result,
domestic sellers better off and domestic buyers worse off.)

Chapter 13: The Costs of Production 188
Chapter 13
The Costs of Production
I- What are costs?
1/ Total Revenue, Total Cost and Profit:
- maximize Profit.
Profit = Total Revenue - Total Cost
- Total Revenue: the amount a firm receives for the sale of its output.
- Total Cost: the market value of the inputs a firm uses in production.
- Profit: total revenue minus total cost.
2/ Explicit costs and Implicit costs:
- Explicit costs: input costs that require a layout of money by the firm.
Ex: Paying wages to workers; Paying material and rent...
- Implicit costs: input costs that do not require a layout of money by the firm.
Ex:
Example: Calculate the cost of starting your business.
a. You borrow $100,000 from the bank while you can put that same amount in the
bank with the interest rate of 5%.
b. You use $40,000 of your savings, and borrow $60,000 from the bank. The
interest rate for borrowing and saving of the bank are both 5%.
Solution:
a. Explicit cost = $5000 interest on loan
b. Explicit cost = $3000 (5%) interest on the loan of $60,000
Implicit cost = $2000 (5%) foregone interest you could have earned on your
$40,000.
3/ Economic Profit and Accounting Profit:
- Economic Profit: total revenue minus total cost, including both explicit and
implicit costs.
- Accounting Profit: total revenue minus total explicit cost.
Accounting Profit > Economic Profit
(because Accounting Profit ignores Implicit Costs).
Example: The equilibrium rent on office space has just increased by $500/month.
Determine the effects on accounting profit and economic profit if
a. you rent your office space.
b. you own your office space.

Solution:
The rent on office space increases $500/month.
a. You rent your office space:
- Explicit costs increase $500/month.
- Accounting profit & economic profit each fall $500/month.
b. You own your office space:
- Explicit costs do not change, so accounting profit does not change.
Implicit costs increase $500/month (opportunity cost of using your space instead
of renting it), so economic profit falls by $500/month.
II- Production and Costs:
1/ The Production Function:
- Definition: The Production Function shows the relationship between the quantity
of inputs used to produce a good and the quantity of output of that good.
It can be represented by a table, equation, or graph.
- Marginal Product: the increase in output that arises from an additional unit of
input.
- Diminishing Marginal Product: The property whereby the marginal product of
an input declines as the quantity of the input increases.
Example: Farmer Jack grows wheat. He has 5 acres of land. He can hire as many
workers as he wants. His Production Function is
If Jack hires one more worker, his output rises by the marginal product of labor.
Marginal Product of Labor (MPL) =
= Slope of Production Function
- MPL is important. Because when Farmer Jack hires an extra worker, his costs rise
by the wage he pays the worker, his output rises by MPL. Comparing those helps
Jack decide whether he should hire the worker.
- MPL getting smaller and smaller as Jack adds more and more workers. Because
the average worker has less land to work with and will be less productive.
The Production Function gets flatter as the number of workers increases,
reflecting diminishing marginal product.
2/ Total Cost Curve:
- Definition: The Total Cost Curve shows the relationship between the quantity of
output produced and total cost of production.
Example: Farmer Jack must pay $1000 per month for the land, regardless of how much
wheat he grows. The market wage for a farm worker is $2000 per month. So Farmer
The Total Cost Curve gets steeper as the quantity of output increases, reflecting
diminishing marginal product.
III- The Various Measures of Cost:
1/ Fixed Costs and Variable Costs:
- Fixed costs (FC): costs that do not vary with the quantity of output produced.
Ex: Cost of equipment, loan payments, rent...

- Variable costs (VC): costs that vary with the quantity of output produced.
Ex:
Total cost (TC) = FC + VC
Example:
2/ Average Cost, Marginal Cost and their Curve Shapes:
a) Marginal Cost (MC): the increase in Total Cost that arises from an extra unit of
production.
Marginal Cost (MC) =
Example:
Usually, MC rises as Q rises, due to diminishing marginal product.
Sometimes (as here), MC falls before rising. (In other examples, MC may be constant.)
b) Average fixed cost (AFC): fixed cost divided by the quantity of output:
Average fixed cost (AFC) =
Notice that AFC falls as Q rises: The firm is spreading its fixed costs over a larger and
larger number of units.
Example:
c) Average variable cost (AVC): variable cost divided by the quantity of output:
Average variable cost (AVC) =
As Q rises, AVC may fall initially. In most cases, AVC will eventually rise as output
rises because of the property of diminishing marginal product.
Example:
d) Average total cost (ATC): total cost divided by the quantity of output:
Average total cost (ATC) =
Also,
ATC = AFC + AVC
Example:
Usually, as in this example, the ATC curve is U-shaped. Because:
ATC = AFC + AVC
AFC always decrease as Q increases (The firm is spreading its fixed costs over a
larger and larger number of units).
AVC typically rises as Q increases (Diminishing marginal product).
At very low levels of Q (Q=1, Q=2), ATC is high because AFC is high (fixed cost is
spread over only a few units), even though AVC is low.

Q (rapidly at first)
(more slowly) and
The U-shaped ATC curve.
3/ Various Cost Curves Together:
In some example, MC curve and AVC curve are This is Typical Cost Curves.
linear.
Where MC curve and AVC curve are
MC and AVC rise as Q rises because of U-shaped.
diminishing marginal product.

Because in reality, marginal product does not
start to fall immediately.
Depending on the production process, team of
workers can divide tasks and work more
But eventually, firms experience Diminishing
4/ The Relationship between Marginal Cost and Average Total Cost:
- When MC < ATC, ATC is falling.
- When MC > ATC, ATC is rising.
- Efficient scale: The quantity that minimizes ATC.

Example:
The cost curves show three features that are most important to remember:
Marginal Cost eventually rises with the quantity of output.
The Average Total Cost curve is U-shaped.
The Marginal Cost curve crosses the Average Total Cost curve at the
minimum of average total cost.
IV- Costs in the Short Run and in the Long Run:

- Short run: Some inputs are fixed (e.g., factories, land). The costs of these inputs
are FC.
- Long run: All inputs are variable (e.g., firms can build more factories,
or sell existing ones).
In the long run, ATC at any Q is cost per unit using the most efficient mix of
inputs for that Q (e.g., the factory size with the lowest ATC).
Example: Long-run Average Total Cost curve with 3 factory sizes
Firm can choose from three factory sizes: S, M,
L.
Each size has its own Short-run Average Total
Cost curve.
The firm can change to a different factory size
in the long run, but not in the short run.

To produce less than QA, firm will choose size
S in the long run.
To produce between QA and QB, firm will
choose size M in the long run.
At QA, is the firm keeps on increasing Q
without changing its size to M, it will
experience Diminishing Marginal Product.
To produce more than QB, firm will choose
size L in the long run.
Connect three options, we have the
Long-run average total cost curve.
- A Typical Long-run Average Total Cost Curve: In the real world, factories
come in many sizes, each with its own SRATC curve. So a typical LRATC curve
looks like this:

How ATC Changes as the Scale of Production Changes:
Economies of scale:
ATC falls as Q increases.
Economies of scale occur
when increasing production
allows greater specialization:
workers more efficient when
focusing on a narrow task.

More common when Q is
low.
Constant returns to scale:
ATC stays the same as Q
increases.
Diseconomies of scale:
ATC rises as Q increases.
Diseconomies of scale are
due to coordination problems
in large organizations.
E.g., management becomes

More common when Q is
high.
EXERCISE
Scenario 1: Tony is a wheat farmer, but he also spends part of his day teaching
guitar lessons. Due to the popularity of his local country western band, Farmer
Tony has more students requesting lessons than he has time for if he is to also
maintain his farming business. Farmer Tony charges $25 an hour for his guitar
lessons. One spring day, he spends 10 hours in his fields planting $130 worth of
seeds on his farm. He expects that the seeds he planted will yield $300 worth of
wheat.
1. Refer to Scenario 1. What is the total cost of the day that Farmer Tony
incurred for his spring day in the field planting wheat?
a. $130
b. $250
c. $300
d. $380
2.
a. $ 80.
b. $130.
c. $170.
d. $260.
a. $ 130.
b. $ 80.
c. $130.
d. $170.
4. Dolores used to work as a high school teacher for $40,000 per year but quit in
order to start her own catering business. To buy the necessary equipment, she
withdrew $20,000 from her savings, (which paid 3 percent interest) and borrowed
$30,000 from her uncle, whom she pays 3 percent interest per year. Last year she
paid $25,000 for ingredients and had revenue of $60,000. She asked Louis the
accountant and Greg the economist to calculate her profit for her.
a. Louis says her profit is $34,100 and Greg says her profit is $6,500.
b. Louis says her profit is $34,100 and Greg says she lost $6,500.
c. Louis says her profit is $35,000 and Greg says she lost $5,000.
d. Louis says her profit is $33,500 and Greg says her profit is 33,500.
5. One would expect to observe diminishing marginal product of labor when
a. crowded office space reduces the productivity of new workers.
b. workers are discouraged about the lack of help from other workers.
c. only new workers are trained in using the most productive capital.
d. union workers are told to reduce their work effort in preparation for a new round
of collective bargaining talks.
The figure below depicts a production function for a firm that produces cookies.
Use the figure to answer questions 6 and 7.

6. As the number of workers increases,
a. total output increases, but at a decreasing rate.
b. marginal product increases, but at a decreasing rate.
c. marginal product increases at an increasing rate.
d. total output decreases.
7. With regard to cookie production, the figure implies
a. diminishing marginal product of workers.
b. diminishing marginal cost of cookie production.

c. decreasing cost of cookie production.
d. increasing marginal product of workers.
The figure below depicts a total cost function for a firm that produces cookies.
Use the figure to answer questions 8 through 9.
8. Which of the following is true of the production function (not pictured) that
underlies this total cost function?
(i) Total output increases as the quantity of inputs increases, but at a decreasing rate.
(ii) Marginal product is diminishing for all levels of input usage.

(iii) The slope of the production function decreases as the quantity of inputs
increases.
a. (i) only
b. (ii) and (iii)
c. (i) and (iii)
9. The changing slope of the total cost curve reflects
a. decreasing average variable cost.
b. decreasing average total cost.
c. decreasing marginal product.
d. increasing fixed cost.
10. Which of these assumptions is often realistic for a firm in the short run?
a. The firm can vary both the size of its factory and the number of workers it
employs.
b. The firm can vary the size of its factory, but not the number of workers it
employs.
c. The firm can vary the number of workers it employs, but not the size of its factory.
d. The firm can vary neither the size of its factory nor the number of workers it
employs.
11. Let L represent the number of workers hired by a firm and let Q represent
function are (L = 12, Q = 122) and (L = 13, Q = 130). Then the marginal product of
the 13th worker is
a. 8 units of output.
b. 10 units of output.
c. 122 units of output.
d. 130 units of output.
12. On a 100-acre farm, a farmer is able to produce 3,000 bushels of wheat when
he hires 2 workers. He is able to produce 4,400 bushels of wheat when he hires 3
workers. Which of the following possibilities is consistent with the property of
diminishing marginal product?
a. The farmer is able to produce 5,600 bushels of wheat when he hires 4 workers.
b. The farmer is able to produce 5,800 bushels of wheat when he hires 4 workers.
c. The farmer is able to produce 6,000 bushels of wheat when he hires 4 workers.

The curves below reflect information about the cost structure of a firm. Use the
figure to answer questions 13 through 18.
13. Refer to the Figure. Which of the curves is most likely to represent average
total cost?
a. A
b. B
c. C
d. D
fixed cost?
a. A
b. B
c. C
d. D
variable cost?
a. A
b. B
c. C
d. D
16. Refer to the Figure. Which of the curves is most likely to represent marginal
cost?
a. A
b. B
c. C
d. D
17. Refer to the Figure. This particular firm is necessarily experiencing increasing
marginal product when curve
a. A is falling.
b. B is falling.
c. C is falling.
d. D is falling.
18. Refer to the Figure. Curve A is U-shaped because of
a. diminishing marginal product.
b. increasing marginal product.
c. the fact that increasing marginal product follows decreasing marginal product.
d. the fact that decreasing marginal product follows increasing marginal product.
For questions 19 through 22, assume that a given firm experiences decreasing
marginal product of labor with the addition of each worker regardless of the current
output level.
19. Refer to the scenario. Average total cost will be

a. always rising.
b. always falling.
c. constant.
d. U-shaped.
20. Refer to the scenario. Average fixed cost will be
a. always rising.
b. always falling.
c. U-shaped.
d. constant.
21. Refer to the scenario. Average variable cost will be
a. always rising.
b. always falling.
c. U-shaped.
d. constant.
22. Refer to the scenario. Marginal cost will be
a. always rising.
b. always falling.
c. U-shaped.
d. constant.
Use the following information to answer questions 23 through 25.
instructional materials for disabled children in public school districts. The owner
rents several small rooms in an office building in the suburbs for $600 a month
and has leased computer equipment that costs $480 a month.
23. What is the average variable cost for the month if six instructional modules are
produced?
a. $180
b. $533.33
c. $700
d. $713.33
24. How many instructional modules are produced when marginal cost is $1,300?
a. 4
b. 5
c. 7
d. 8
25. One month, Teacher's Helper produced 18 instructional modules. What was
the average fixed cost for that month?
a. 60
b. 108
c. 811
d. It can't be determined from the information given.

1. ANSWER: d. $380
(Explain: Instead of planting, Tony can teach guitar for 10 hours more => implicit cost:
10 x 25 = $250
Explicit cost = $130
=> Total cost: explicit cost + implicit cost = 130 + 250= 380)
2. ANSWER: c. $170.
(Explain: Accounting profit = TR - explicit cost = 300 - 130 = $170)
3. ANSWER: b. $ 80.
(Explain: Economics profit = Total Revenue - Total Cost = 300 - 380 = -80
4. ANSWER: b. Louis says her profit is $34,100 and Greg says she lost $6,500.
(Explain: Louis is an accountant so he will calculate Accounting Profit
AP = $60,000 - $25,000 - ($30,000 x 3%) = $34,100
Greg is an economist so he will calculate Economic Profit
EP= $60,000 - $40,000 - ($20,000 x 3%) - ($30,000 x 3%) - $25,000 = -$6,500)

5. ANSWER: a. crowded office space reduces the productivity of new workers.
(Explain: The more input put in production, the less the marginal product. When the
workplace is crowded with workers, the efficiency of workers is lower)
6. ANSWER: a. total output increases, but at a decreasing rate.
(Explain: As you put more input into production, the firm will experience Diminishing
Marginal Product where the quantity of output increases but at a decreasing rate when
input increases)
7. ANSWER: a. diminishing marginal product of workers.
(according to the information besides figure 2, PE text book page 264)
8. ANSWER: d. All of the above are correct.
(Explain: (i) is correct, because the cost curve is getting steeper as Q increases, which
reflects diminishing marginal product.
(ii) is correct, because the slope of the curve is not constant as Q increases, reflecting
that the total cost increases more rapidly the quantity
(iii) is correct. The relationship between total cost function and production function
is that as the cost function getting steeper because of diminishing marginal product, the
production function is getting flatter. Therefore the slope will decrease.)
9. ANSWER: c. decreasing marginal product.

(Explain: As firms produces more, total cost increases more rapidly due to Diminishing
Marginal Product)
10.ANSWER: c. The firm can vary the number of workers it employs, but not the size
of its factory.
(Explain: In the short run, labor can be hired more. Size of factory, on the other hand,
cannot be changed over a short period of time)
11. ANSWER: a. 8 units of output.
(Explain: Marginal Products of 13th workers = 130 - 122 = 8 (total product of 13
workers - total product of 12 workers) )
12. ANSWER: a. The farmer is able to produce 5,600 bushels of wheat when he hires 4
workers.
(Explain: Marginal product of the 2nd labor: 4,400-3,000=1,400 bushels of wheat. Due
to diminishing marginal product, the next unit of labor will produce less than 1,400
bushels of wheat. Answer a: MC = 1,200. Answer b: MC =1,400. Answer c: MC =
1,600. Only answer A represent the diminishing marginal product.)
13. ANSWER: b. B (according to Figure 5, PE textbook page 271)
(Explain: ATC curve is U-shaped)
14. ANSWER: d. D (according to Figure 5, PE textbook page 271)

(Explain: Since Fixed cost is unchanged, when quantity increases, the Fixed cost is
spread among large quantity of good. Therefore, AFC decreases as Quantity increases)
15. ANSWER: c. C (according to Figure 5, PE textbook page 271)
(Explain: AVC curve is U-shaped)
16. ANSWER: a. A (according to Figure 5, PE textbook page 271)
(Explain: Due to Diminishing Marginal Product, MC increases rapidly as Quantity
increases, resulting in a sharper U-shape)
Notes: ATC curve and AVC curve have similar U-shape. But AVC curve is always
below ATC curve because ATC = AVC + AFC. The MC curve intersects AVC and
ATC at their minimum
17. ANSWER: a. A is falling.
(Explain: Curve A is MC curve, so when it is falling, marginal cost is falling, which
also means rising marginal product.)
18. ANSWER: d. the fact that decreasing marginal product follows increasing marginal
product.
(Explain: Curve A is Marginal Cost curve, it is U-shaped because at the beginning,

wded, Diminishing
A and B is wrong because Diminishing/Increasing Marginal Product property only
explain the increase/decrease of MC curve, not its U-shape)
19. ANSWER: d. U-shaped. (according to PE textbook page 269)
(Explain: ATC = AFC + AVC. AFC always decreases as Quantity increases. In this
scenario, AVC always increases because the firm always experience decreasing
marginal product of labor. In order to produce more, the variable cost increases)
20. ANSWER: b. always falling. (according to PE textbook page 269)
(Explain: AFC is spread among large quantity of product as Quantity increases)
21. ANSWER: a. always rising.
(according to PE textbook page 269, and the scenario said that the firm always
experienced diminishing marginal product. This means that as Quantity increases, the
variable cost will increase)
22. ANSWER: a. always rising.
(according to PE textbook page 269, and the scenario said that the firm always
experienced diminishing marginal product. This means that as Quantity increases, the
Marginal Cost for each Marginal Product increases) )

23. ANSWER: b. $533.33
(Explain: At 6 output, FC = $1,080; TC= $4,280
=> VC= TC-FC = $4,280 - $1,080= $3,200
=> AVC= VC/Q = $3200/6= $533.33)
24. ANSWER: d. 8
(Explain: We first look at the 4 answers and the table. Realize that at 6 output, MC
=700. So the quantity at which MC = $1,300 must be larger than 6.
At Q=6, VC6= $3200 (question 24). At Q=7, VC7=$4,100. Marginal cost of producing
unit 7th: VC7 - VC6 = $4,100 - $3,200 = $900.
The same at Q=8.
Marginal cost of producing unit 8th: VC7 - VC8 = $5,400 - $4,100 = $1,300)
25. ANSWER: a. 60
(Explain: AFC= 1080/18 = 60)

Chapter 14: Firms in Competitive Markets 228
Chapter 14
Firms in Competitive Markets
I/ What is a competitive market:
Competitive Market:
+ Many buyers and sellers
+ Identical products
+ Free entry and exit (without cost)
+ Price taker
1/ The revenue of a competitive firm:
Because a competitive firm is small compared to the world market, it is the price
taker. As a competitive firm changes its quantity supplied, the price stays the same.
Price does not depend on quantity
Total Revenue ~ Quantity ( Total Revenue increases as Quantity increases and vice
versa)
Examining the statistics of a competitive firm, we can conclude that:
For all types of firms:
Price = Average Revenue ( = Total Revenue / Quantity Sold)
For competitive firms only:
Price = Marginal Revenue (the change in total revenue from an additional
unit sold)
2/ Profit Maximization and the competitive firm supply curve:
Costs
and
Profit-maximizing MC
Revenue
quantity
P = MR
Qmax Quantity
MR > MC MR < MC
should increase Q should decrease Q
The Price line is horizontal because a competitive firm is a price taker. The price of
When Marginal Revenue > Marginal Cost, you should increase Quantity because
what you get (Marginal Revenue) is more than what you give up (Marginal Cost) and
vice versa. Eventually, firms will adjust its Q to Qmax.

Profit-Maximization or Loss-Minimization Quantity is determined by the
intersection of Marginal Revenue and Marginal Cost curves. This method of finding
Profit Maximization Quantity is applied to all types of firm
-cost curve determines the quantity of the good the firm
is willing to supply at any price, Marginal Cost curve is the Supply curve.
3/ Shut-down:
+ Happens in the short-run
+ Halt producing
+ Still bear fixed cost
When a firm shut down, it will save Variable Cost for not producing, but still bear
Cost.
Shutdown if Total Revenue < Variable Cost
Or Price < Average Variable Cost
When shut down, the firms still loses money (for paying Fixed Cost), but it would
lose even more by staying open.

In the short-run, the Marginal Cost curve shows the Quantity produced at any level
of Price, but no
Short-run supply curve = part of MC curve above AVC curve
Sunk cost
should be ignored when making decision
E.g.: Fixed cost in the short-run is sunk cost.

4/ Exit and Entrance:
Exit the market:
+ Happens in the long-run.
+ Will not bear fixed cost.
Exit if Total Revenue < Total Cost ( = Fixed Cost + Variable Cost)
or Price < Average Total Cost
Conversely,
Enter if Total Revenue > Total Cost
Or Price > Average Total Cost

In the long-run, the Marginal Cost curve shows the Quantity produced at any level
Long-run supply curve = part of MC curve above ATC curve
Profit = Total Revenue - Total Cost
= (Price - Average Total Cost) × Quantity
The quantity produced by a competitive firm is determined by the intersection
between MC and MR curves. When P is above ATC, the competitive firm gains profit
and is producing at the profit-maximizing quantity. When P is below ATC, the
competitive firm incurs loss and is producing at the loss-minimizing quantity.

II/ The supply curve in a competitive market:
Over short periods of time, it is often difficult for firms to enter and exit. But over long
periods of time, the number of firms can adjust to changing market conditions. So:
+ Short run: with fixed number of firms
+ Long run: with Entry and Exit
1/ Short-run:
The market
together the quantity supplied at any price level)

2/ Long-run:
curves.
- When (+) Entry P and
profits
- When (-) Exit P and profits
- When process of entry and exit ends, firms that remain in the market must be
making Zero economic profit (P = ATC) No incentive to enter or exit the
market.
- The process of entry and exit ends only when price and average total cost are
driven to equality.
P = ATC (when process of entry and exit ends)
and P = MC (characteristic of Competitive firms mentioned above)
TC = MC only at the minimum of ATC.
In the long-run equilibrium of a competitive market with free entry and exit, once the
process of entry and exit ends, firms must be operating at their efficient scale and
making zero profit.

In a market with free entry and exit, there is only one price consistent with zero
profit the minimum of average total cost Long-run market supply curve is
perfectly elastic (horizontal).
3/ Zero Profit:
Recall that Profit here is Economic Profit, including all the opportunity cost.
At zero-profit equilibrium, Total Revenue compensates for all opportunity costs:
Economic profit: Profit = 0
but Accounting profit (excluding Opportunity cost): Profit = (+)

4/ A shift in Demand in the Long-run and in the Short-run:
a/ Supposed that a Market begins in long run equilibrium (zero profit), Price equals
minimum Average Total Cost. The long-run equilibrium is point A, the quantity sold in
the market is Q1, and the price is P1
b/ An event cause Demand to rise
(shift to the right from D1 to D2)
-run Equilibrium shift from point A to point B
,P
c/ Firms in the market are making (+) profit, attracting other firms into the market
(Short-run supply curve shift to the right from S1 to S2)
, P to the minimum of Average Total Cost, firms stop entering
rger Q (because there are now more firms than before)

5/ Why the Long-Run Supply Curve Might Slope Upward?
The essence of our analysis is that there are a large number of potential entrants,
each of which faces the same costs. As a result, the long-run market supply curve is
horizontal at the minimum of average total cost.
Two reasons relating to cost that the long-run market supply curve might slope
upward:
+ Resources may be available to limited Q
E.g.: land is limited. More farmers P of product as
Q
+ Firms may have different costs
To increase the quantity of good supplied, additional entrants must be
encouraged to enter the market. Because these new entrants have higher costs, the
price must rise to make entry profitable for them.
Firms newly entered which has higher cost earn zero profit, but lower-cost
firms already in the market can earn profit
Free entry does not eliminate this profit because would-be entrants get
higher costs than firms already in the market the long-run market supply
curve slopes upward even with free entry into the market.
_ Long-run supply curve is more elastic short-run supply curve due to free entry and
exit.
EXERCISE
1. Suppose a firm in a competitive market received $1,000 in total revenue and
had a marginal revenue of $10 for the last unit produced and sold. What is the
average revenue per unit, and how many units were sold?
a. $5 and 50
b. $5 and 100
c. $10 and 50
d. $10 and 100
2. When marginal revenue equals marginal cost, the firm
a. should increase the level of production to maximize its profit.
b. may be minimizing its losses, rather than maximizing its profit.
c. must be generating positive economic profits.
d. must be generating positive accounting profits.
3. If ABC Company sells its product in a competitive market, then
a. the price of that product depends on the quantity of the product that ABC
sloping.
b. ABC Company's total revenue must be proportional to its quantity of output.
c. ABC Company's total cost must be proportional to its quantity of output.
d. ABC Company's total revenue must be equal to its average revenue.
Scenario 14-2
Assume a certain firm is producing Q = 1,000 units of output. At Q = 1,000, the
firm's marginal cost equals $15 and its average total cost equals $11. The firm sells
its output for $12 per unit.
4. Refer to Scenario 14-2. At Q = 1,000, the firm's profit amounts to
a. -$200.
b. $1,000.
c. $3,000.
d. $4,000.
5*. Refer to Scenario 14-2. At Q = 999, the firm's total cost amounts to
a. $10,985.
b. $10,990.
c. $10,995.
d. $10,999.
6*. Refer to Scenario 14-2. At Q = 999, the firm's profit amounts to
a. $993.
b. $997.
c. $1,003.
d. $1,007.
7. Refer to Scenario 14-2. To maximize its profit, the firm should
a. increase its output.
b. continue to produce 1,000 units.
c. decrease its output, but continue to produce.
d. shut down.
Figure 14-1
The graph below depicts the cost structure for a firm in a competitive market.
8. Refer to Figure 14-1. When price rises from P2 to P3, the firm finds that
a. marginal cost exceeds marginal revenue at a production level of Q2.
b. if it produces at output level Q3 it will earn a positive profit.
c. expanding output to Q4 would leave the firm with losses.
d. it could increase profits by lowering output from Q3 to Q2.
9. Refer to Figure 14-1. When price falls from P3 to P1, the firm finds that
a. fixed cost is higher at a production level of Q1 than it is at Q3.
b. it should produce Q1 units of output.
c. it should produce Q3 units of output.
d. it should shut down immediately.

10. Refer to Figure 14-1. When price rises from P3 to P4, the firm finds that
a. fixed costs are lower at a production level of Q4.
b. it can earn a positive profit by increasing production to Q4.
c. profit is still maximized at a production level of Q3.
d. average revenue exceeds marginal revenue at a production level of Q4.
11. Refer to Figure 14-1. If the firm is selling goods at a price P ( P2 < P < P3) and
at Q2, the firm is more likely:
a. Shut down is the short-run, Exit in the long-run
b. Continue producing in both short-run and long-run
c. Continue producing in the short-run, exit in the long-run
d. Shut down in the short-run, continue producing in the long-run
12. Refer to Figure 14-1. If the firm is producing at Q3 and selling at P3. The firm
is at:
a. Zero profit point. Economic profit = 0. Accounting profit > 0
b. Zero profit point. Economic profit > 0. Accounting profit = 0
c. Profit maximization point. Economic profit > 0. Accounting profit > 0
d. Loss Minimization point. Economic Profit < 0. Accounting profit <0

13*. A profit-maximizing firm in a competitive market is currently producing
200 units of output. It has average revenue of $9 and average total cost of $7. It
follows that the firm's
a. average total cost curve intersects the marginal cost curve at an output level of
less than 200 units.
b. average variable cost curve intersects the marginal cost curve at an output level of
less than 200 units.
c. profit is $400.
Figure 14-7
14. Refer to Figure 14-7. When the market is in long-run equilibrium at point A in
panel (b), the firm represented in panel (a) will
a. have a zero economic profit.
b. have a negative accounting profit.
c. exit the market.
d. choose to increase production to increase profit.
15. Refer to Figure 14-7. Assume that the market starts in equilibrium at point A
in panel (b). An increase in demand from Demand0 to Demand1 will result in
a. a new market equilibrium at point D.
b. an eventual increase in the number of firms in the market and a new long-run
equilibrium at point C.
c. rising prices and falling profits for existing firms in the market.
d. falling prices and falling profits for existing firms in the market.
16. Refer to Figure 14-7. If the market starts in equilibrium at point C in panel (b),
a decrease in demand will ultimately lead to
a. more firms in the industry, but lower levels of production for each firm.
b. fewer firms in the market.
c. a new long-run equilibrium at point D in panel (b).
d. lower prices once the new long-run equilibrium is reached.
17. Refer to Figure 14-7. Suppose a firm in a competitive market, like the one
depicted in panel (a), observes market price rising from P1 to P2. Which of the
following could explain this observation?
a. The entry of new firms into the market.
b. The exit of existing consumers from the market.
c. An increase in market supply from Supply0 to Supply1.
d. An increase in market demand from Demand0 to Demand1.

1. D (Explain: Firm in a competitive market: MR = P -> Price = $10. Since every good
sold bring the firm $10 of revenue, the average revenue per unit is $10. The quantity
sold = $1000 / $10 = 100)
2. B (Explain: There are two situations when MR = MC.
1/ When P > ATC, firm produces at the point where MR = MC to maximize profit
2/ When P < ATC, firm produces at the point where MR = MC to minimize loss.
3. B (Explain: a is wrong because the Demand curve in a competitive market is
horizontal.
b is correct because in a competitive market, P does not change when Q changes so
Total Revenue ( = P x Q ) is proportional to Quantity
c is wrong because in a competitive market, Marginal Cost increases as Quantity
increases. So Total Cost is not proportional to Quantity
d is wrong. In a competitive market, Average Revenue = Price but Total Revenue =
Price x Quantity.)
4. B (Explain: Profit = ( P - ATC ) x Q = ( 12 - 11 ) x 1000 = $1000)
5. A (Explain: At the 1000th unit, the Marginal Cost is $15. So Total Cost of Q=999 =
Total Cost of 1000 units - Marginal Cost of 1000th unit = ( $11 x 1000) - $15 = $10,985)
6. C (Explain: The revenue of 1000th unit is $12. The Marginal Cost for the 1000th unit
is $15 -> Marginal Profit for 1000th unit = $12 - $15 = -$3 - 99
is $1000 - (-$3) = $1003)
7. C (Explain: From Question 6, When we decrease the quantity produced by 1 unit, the
profit increases by $3. So it is more profitable for the firm to decrease its output)
8. C (Explain:
a is wrong because in a competitive market, at Q2, the price is P2 = Marginal
Revenue = Marginal Cost
b is wrong. When the firm produces at Q3, ATC = P3. Profit = (P3 - ATC) X Q3 = 0
c is correct. When the firm produces at Q4, ATC > P3. Profit = ( P3 - ATC) x Q4 =
(negative value)
d is wrong. When at Q2, ATC > P3. Profit = ( P3 - ATC) x Q2 = (negative value))
9. D (Explain:
a is wrong because fixed cost is constant
b is wrong. At Q1, ATC > P1 -> Profit is negative
c is wrong. At Q3, ATC > P1 -> Profit is negative
d is right. When at P1, P1 < AVC, so the firm should shut down)
10. B (Explain:
a is wrong because fixed cost is constant
b is correct. When at Q4, P4 > ATC -> Profit is positive
c is wrong. At P4, Q3, the profit is not maximized. The maximization of profit
occurs at Q3, P3, the lowest point of ATC curve.
d is wrong. At Q4, P4, Average Revenue = Marginal Revenue)
11. C (Explain: At Q2, the Price P > P2, which means it is higher than AVC, so it will
continue producing in the short-run; the price P < P3, which means it is less than ATC,
so the firm will exit the market in the long-run)

12. A. (Explain: The point (P3, Q3) is also the minimum point of the ATC curve. That
is where the firm makes zero profit. Economic profit = 0. Accounting profit > 0)
Note: When the firm is producing at the intersection of MR and MC curve which is:
1/ higher than the ATC curve: The firm is at Profit-Maximizing point.
2/ lower than the ATC curve; The firm is at Loss-Minimizing point.
13. D (Explain:
a is correct. ATC intersects MC curve at point A
b is correct. AVC intersects MC curve at point B
c is correct. Profit = ( P - ATC) x Q = ( 9 -7) x 200 = $400
)
14. A (Explain: When the market is in the long-run equilibrium, the firm will make zero
economic profit)
15. B (Explain: When the Demand curve shift to the right, the long-run equilibrium is at
point B, price increase from P1 to P2, generating positive profit for firms in the industry.
In the long-run, positive profit attracts new firms, Supply curve will shift to the right, the
long-run equilibrium is at point C.)
See 14-3d p.293 and Figure 8 p.294 PE textbook)
16. B (Explain: Opposite effect of Question 14)
17. D (Explain:
a is wrong. New firms entering will shift Supply curve to the right, price will
decrease to P0
b is wrong. Consumers exiting will shift Demand curve to the left, price will
decrease
c is wrong. (Explain like answer A)
d is right. Demand curve shifting to the right will increase the price from P1 to P2)
Chapter 15: Monopoly 255
Chapter 15:
Monopoly
I/ Why Monopoly Arises:
Monopoly
` maker (Not price taker like Perfectly Competitive
Market)
Monopoly causes barriers to entry
Monopoly Resources:
Single firm owns key resources
In reality, this rarely arises
Government - Created Monopolies:
Government gives one the exclusive right to produce
Patent and copyright: Government gives a producer an exclusive right to
manufacture and sell the products for a period of time

Benefits of patent and copyright: encourage to invent
Natural Monopolies:
A firm can supply with lower opportunity cost than could two or more firms.
Arise when there are Economies of Scales over the relevant range of output
(Higher output leads to lower cost). When the production is divided among firms,
output per firm will decline and the cost will increase. As a result, a single firm
can produce at any given quantity with the least cost.
Natural Monopoly is less concerned about new entrants (Monopoly profits
firm has natural monopoly is unattractive)

nopoly or not: As market
expands, a monopoly can evolve into competitive market.
II/ How Monopoly Make Production and Pricing Decisions:
1/ Difference between Monopoly and Competitive:
- Monopoly can influence price, Firms in competitive cannot.
- Difference in Demand curve:
competitive firm can sell a product with many perfect substitutes, the demand is
perfectly elastic. In other word, in the long-run, competitive firms make zero
profit, they can sell as much or as little as they want with this price, so the demand
curve is horizontal.
Downward-sloping Monopoly demand curve: Monopoly is a sole producer of a
product in a market, so its demand curve is the market demand curve. Quantity
demanded decreases as Price increases and vice versa.
2/ Monopoly Revenue:
Marginal Revenue < Price: because: sell more, lower price for all goods (because
Monopoly faces a downward-sloping demand curve)
When monopoly increases Quantity it sells, this action has 2 effects on Total
Revenue:
Output effect
Price effect
with no change in Price (Horizontal Demand curve)
Marginal Revenue of monopoly is negative when price effect > output effect
is always less than Price. Two curves start at the same point because the Marginal
Revenue of the first product equals Price.
3/ Profit Maximization:
A firm will adjust its Quantity Supplied until Marginal Revenue = Marginal Cost,
that is the point where profit is maximized.
profit-maximizing quantity of output is
determined by the intersection of the marginal revenue curve and the marginal-cost
curve.
Competitive Firm: P = MR = MC
Monopoly: P > MR = MC
4/ :
Profit = Total Revenue - Total Cost = ( Price - Average Total Cost) x Q.
III/ The Welfare Cost of Monopoly:
: monopoly is undesirable (because Price is higher)
: monopoly is desirable (Price is higher)
Monopoly fails to maximize economic well-being because it charges higher price.
1/ Deadweight Loss:
The demand curve reflects the benefits of buyers, the marginal cost curve reflects
the cost of the monopolist. In order to maximize both consumer and producer surplus,
the firm must produce at the Efficient Quantity.
But, the monopolist chooses to produce at the Monopoly Quantity (less than the
The area of the shaded triangle is the Deadweight Loss created by Monopoly
pricing. It is the reduction of economic well-being that results from the Monopoly using
its Market Power.
2/
When a monopolist increases its price by $1, the consumer is $1 worse-off and the
producer is $1 better-off. So the transfer of welfare from consumer to monopoly firms
does not affect the total surplus of consumers and producers. But the problem in a
monopolized market arises because the firm produces and sells a quantity of output
below the level that maximizes total surplus. The deadweight loss measures how much
the economic pie shrinks as a result.

IV/ Price discrimination:
Definition: Price discrimination is selling the same good at different prices to
different customers. Price discriminating monopolist charges each consumer Price
closer to WTP than is possible with a single price.
The characteristic used in price discrimination is willingness to pay (WTP): A firm
can increase profit by charging a higher price to buyers with higher WTP.
Price Discrimination is a rational decision for maximizing profit. However,
+ Not possible in competitive market
+ Must have market power condition: sell at different places, consumers,...
+ PD requires the ability to separate customers according to willingness to pay
+ Certain market forces can prevent PD: arbitrage (buy low price, re-sell at higher
price)
PD can raise economic welfare, eliminate inefficiency in monopoly pricing (higher
Producer Surplus)
a/ Normal Monopoly Pricing:
The monopolist charges the same price to all buyers.

b/ Price Discriminating Monopoly:
The monopolist produces at the competitive quantity, but charges each buyer his or her
WTP (Perfect Price Discrimination).
DWL.
In the real world, perfect price discrimination is not possible:
+ Buyers do not reveal WTP to sellers
So, firms divide customers into groups based on some observable trait that is likely
related to WTP, such as age (Imperfect Price Discrimination can raise, lower, or leave
One thing that is certain:

Examples of Price Discrimination:
Movie tickets: Discounts for seniors, students, and people who can attend during
weekday afternoons. They are all more likely to have lower WTP
than people who pay full price on Friday night.
Airline prices: Discounts for Saturday-night stay overs help distinguish business
travelers, who usually have higher WTP, from more price-sensitive leisure travelers.
Discount coupons: People who have time to cut out and organize coupons are more
likely to have lower income and lower WTP than others.
Need-based financial aid: Low income families have lower WTP for
-discriminate by offering
need-based aid to low income families.
Quantity discounts:
charge less per unit for large quantities than small ones. E.g.: A movie theater charges
V/ Public Policy toward Monopolies
Antitrust Laws
+ Aimed at reducing market power

+ Prevent mergers (two or more firms combine to increase market power)
+ Break up companies
+ Prevent coordinating of companies
Cost: Sometimes companies merge not to reduce competition but to lower costs through
more efficient joint production. These benefits are called synergies.
Regulation
+ Regulating behaviors of monopolist
+ Common in natural monopolies
+ Government regulate their prices
The first problem:
In order to maximize profit => P must lower to MC
Natural monopolies have Economies of Scales
Average total cost is declining
Marginal cost < average total cost
Loss if decrease Price

Government responds to loss by subsidizing loss with tax:
Government responds to loss by letting monopolist charges a higher price
profit
marginal cost.
The second problem: Give no incentive for monopolist to reduce cost.
Public Ownership
+ Government run the monopoly
+ But, unlike government-run firm, private ownership has incentive to
minimize cost
Doing Nothing
+ Policies have drawback
+ Might be best to do nothing
EXERCISE
1. A fundamental source of monopoly market power arises from
a. perfectly elastic demand.
b. perfectly inelastic demand.
c. barriers to entry.
d. availability of "free" natural resources, such as water or air.
2. When an industry is a natural monopoly,
a. it is characterized by constant returns to scale.
b. it is characterized by diseconomies of scale.
c. a larger number of firms may lead to a lower average cost.

d. a larger number of firms will lead to a higher average cost.
3. The key difference between a competitive firm and a monopoly firm is the
ability to select:
a. the level of competition in the market.
b. the level of production.
c. inputs in the production process.
d. the price of its output.
4. Marginal revenue can become negative for
a. both competitive and monopoly firms.
b. competitive firms, but not for monopoly firms.
c. monopoly firms, but not for competitive firms.
d. neither competitive nor monopoly firms.
Figure 15-3
The figure below illustrates the cost and revenue structure for a monopoly firm
5. Refer to Figure 15-3. If the monopoly firm is currently producing Q3 units of
output, then a decrease in output will necessarily cause profit to
a. remain unchanged.
b. Decrease.
c. increase as long as the new level of output is at least Q2.
d. increase as long as the new level of output is at least Q1.
6. Refer to Figure 15-3. Profit will be maximized by charging a price equal to
a. P0.
b. P1.
c. P2.
d. P3.
7. Refer to Figure 15-3. A profit-maximizing monopoly's profit is equal to
a. P3 × Q2.
b. P2 × Q4.
c. (P3 P0) × Q2.
d. (P3 P0) × Q4.
Table 15-2
Dreher's Designer Shirt Company, a monopolist, has the following cost and
revenue information.
8. Refer to Table 15-2. Which of the following quantities will achieve the
maximum profit?
a. 3
b. 4
c. 6
d. 7
9. The supply curve for the monopolist
a. is horizontal.
b. is vertical.
c. is upward sloping.
d. does not exist.
10. A monopoly market
a. always maximizes total economic well-being.
b. always minimizes consumer surplus.
c. generally fails to maximize total economic well-being.
d. generally fails to maximize producer surplus.
11. Which of the following statements is correct?
incurred by consumers of that firm's product.

b. The deadweight loss that arises in monopoly stems from the fact that the
profit-maximizing monopoly firm produces a quantity of output that exceeds the
socially-efficient quantity.
c. The deadweight loss caused by monopoly is similar to the deadweight loss
caused by a tax on a product.
d. The primary social problem caused by monopoly is monopoly profit.
12. Refer to Figure 15-6. To maximize total surplus, a benevolent social planner
would choose which of the following outcomes?
a. 100 units of output and a price of $10 per unit

b. 150 units of output and a price of $10 per unit
c. 150 units of output and a price of $15 per unit
d. 200 units of output and a price of $10 per unit
13. Refer to Figure 15-6. The monopolist's maximum profit
a. is $800.
b. is $1,000.
c. is $1,250.
d. cannot be determined from the diagram.
14. Refer to Figure 15-6. The deadweight loss caused by a profit-maximizing
monopoly amounts to
a. $150.
b. $200.
c. $250.
d. $300
15. One problem with government operation of monopolies is that
a. a benevolent government is likely to be interested in generating profits for
political gain.
b. monopolies typically have rising average costs.
c. the government typically has little incentive to reduce costs.
d. a government-regulated outcome will increase the profitability of the
monopoly
16. Antitrust laws allow the government to
a. prevent mergers.
b. break up companies.
c. promote competition.
17. Price discrimination is a rational strategy for a profit-maximizing monopolist
when
a. the monopolist finds itself able to produce only limited amounts of output.
b. consumers are unable to be segmented into identifiable markets.
c. the monopolist wishes to increase the deadweight loss that results from
profit-maximizing behavior.
d. there is no opportunity for arbitrage across market segments
18. If a monopolist is able to perfectly price discriminate,

a. consumer surplus is always increased.
b. total surplus is always decreased.
c. consumer surplus and deadweight losses are transformed into monopoly
profits.
d. the price effect dominates the output effect on monopoly revenue.
19. Which of the following can eliminate the inefficiency inherent in monopoly
pricing?
a. Arbitrage
b. Deadweight Loss cannot be eliminated
c. Price discrimination
d. Regulations that force monopolies to reduce their levels of output
Figure 15-7
The figure below depicts the demand, marginal revenue, and marginal cost curves
of a profit-maximizing monopolist.
20. Refer to Figure 15-7. If the monopoly firm perfectly price discriminates, then
consumer surplus amounts to
a. $0.
b. $250.
c. $500.
d. $1,000.
21. Refer to Figure 15-7. If there are no fixed costs of production, monopoly profit
without price discrimination equals
a. $500.
b. $1,000.
c. $2,000.
d. $4,000.
1. ANS: c. barriers to entry.
(Explain: Barriers to entry prevents other company from entering the market, which
help monopoly from competing with others so it has market power.)
2. ANS: d. a larger number of firms will lead to a higher average cost.
(Explain: Natural monopoly arises when one firm could produce with smaller cost than
many firms. Natural Monopoly experiences Economies of Scale, so when there are
many firms, total products are divided among many firms, resulting in a lower Quantity
produced per firm => Higher cost

3. ANS: d. the price of its output.
(Explain: Competitive firms are price taker, whereas Monopoly firms are price makers.
So the key difference here is the ability to set a price for its output.)
4. ANS: c. monopoly firms, but not for competitive firms.
(Explain:
Monopoly marginal revenue can be negative when the firm produces too many
products, whereas in competitive market, MR is horizontal and always equals the price
so it will never be negative.)
5. ANS: c. increase as long as the new level of output is at least Q2.
(Explain: At Q2, MR=MC => Profit is maximized at Q2. According to the figure Q3 >
Q2, therefore lowering output will make it closer to Q2, which will increase the profit. If
Quantity keeps lowering pass Q2, Profit will start decreasing.)
6. ANS: d. P3.
(Explain: At Q2, profit is maximized at the intersection of MR and MC curve. Reflect
Q2 on Demand Curve is P3, we will have the price of monopoly.)

7. ANS: c. (P3 P0) × Q2. (Explain: P0 = ATC at Q2. So to find the profit. Profit = ( P -
ATC) x Q = ( P3 - P0) x Q2)
8. ANS: c. 6
(Explain: to decide what quantities will achieve the maximum profit. We find the
quantities at which MR = MC. To be short, just calculate the MR and MC at quantities
of the given answer:
COSTS REVENUES
Quantity Marginal Cost Marginal Revenue
3 230 - 184= 46 140x3 - 150x2= 120
4 280 - 230= 50 130x4 - 140x3= 100
6 395 - 335= 60 110x6 - 120x5= 60
7 475 - 395= 80 100x7 - 110x6= 40
At Q=6, MR=MC. So Q=6 is the quantity that maximize profit.
9. ANS: d. does not exist. (according to FYI, PE textbook, page 308)
10. ANS: c. generally fails to maximize total economic well-being.

(Explain: Because Monopoly maximizes profit by setting higher price and lower
quantity than the competitive market, creating deadweight loss)
11. ANS: c. The deadweight loss caused by monopoly is similar to the deadweight loss
caused by a tax on a product.
(Explain:
A is wrong. The reduction in Consumer Surplus caused by Monopoly pricing results
in Monopoly profit and Deadweight Loss.
B is wrong. Monopoly causes Deadweight Loss by producing at a quantity lower
than Efficient Quantity

pay (as refle
supply curve). Because a monopoly exerts its market power by charging a price
above marginal cost, it creates a similar wedge.
D is wrong. The primary social problem caused by monopoly is Deadweight Loss.)
12. ANS: c. 150 units of output and a price of $15 per unit
(Explain: A benevolent social planner would choose to produce at an equilibrium of the
market, which is the intersection of MC curve and Demand curve. At which Q=150 and
P= $15.)
13. ANS: d. cannot be determined from the diagram.
(Explain: To find the profit of the monopolist, we need to know that ATC curve. Since
14. ANS: c. $250.

(Explain:
DWL = ½ x ($20 - $10) x (150-100) = $250.)
15. ANS: c. the government typically has little incentive to reduce costs.
(according to PE textbook, page 321, 15-5c)
16. ANS: d. All of the above are correct. (according to PE textbook page 319).
17. ANS: d. there is no opportunity for arbitrage across market segments
(Explain: Arbitrage can prevent Price Discrimination.)

18. C (Explain: When Monopoly practices Perfect price Discrimination, it produces at
a competitive Quantity and sells goods at the Price = Willingness to Pay of all
Consumers => All of the Consumer Surplus and Deadweight Loss are turned into
Monopoly Profit)
19. C (Explain: To eliminate the inefficiency inherent in monopoly pricing, the event
must eliminate the Deadweight loss.
A is wrong because Arbitrage means re-selling goods at a higher price -> Cannot
eliminate DWL
B is wrong because DWL caused by monopoly pricing can be eliminated by Perfect
price Discrimination
C is correct because Perfect price discrimination will turn Consumer Surplus and
Deadweight Loss into Monopoly Profit
D is wrong. Monopoly is causing Deadweight Loss because it is producing at Q
lower than Efficient Quantity. When the law forces Monopoly to reduce Q even more,
the DWL would be larger)
20. A (Explain: When the monopoly practices perfect price discrimination, it charges
Pr
Pay - Price, Consumer Surplus is now equals 0)

21. C (Explain: Without Price Discrimination, the monopoly now produces at Q=200,
P=$25. Profit of Monopoly = Area of Rectangle DEFB = 200 ($25 - $15) = $2000)
Chapter 16: Monopolistic Competition 289
Chapter 16:
Monopolistic Competition
I/ Imperfect Competition:
- Many firms are imperfect competition.
- Imperfect competition includes: Monopolistic Competition and Oligopoly.
II/ Monopolistic Competition:
- Monopolistic competition: each firm get monopoly over its product, other firms
make similar products to compete with.
+ Many sellers competing for the same customers
+ Product differentiation: products are at least slightly different
+ Not a price taker, each firm faces a downward-sloping demand curve.
+ Free entry and exit: no cost to enter or exit, no restriction, number of firms
adjust until economic profits driven to zero.

III/ Monopolistic competition firm in the short run:
- Since Monopolistic Competition faces a downward-sloping demand curve like
Monopoly, it follows the same rule as Monopoly in the short-run to maximize
profit.
- Similar rule to find profit-maximizing quantity: Produces quantity at which
marginal revenue equals marginal cost then uses its demand curve to find the
price at which it can sell that quantity.
- Profit = Total Revenue - Total Cost = (Price - Average Total Cost) x Quantity
- When P > ATC, monopolistically competitive firm generate positive profit. It is
said to be producing at Profit-maximizing Quantity.

- When P < ATC, monopolistically competitive firm generate negative profit. It
is said to be producing at Loss-minimizing Quantity.
IV/ Monopolistic competition firm in the long-run:
- Profit Entry Decrease D
each Decrease profit

- Losses Exit Increase D
each Increase profit
(decrease loss)
- Process of entry and exit ends when all firms achieve zero profit, no incentives to
enter or exit, no entries or exit

- In the long-run zero-profit equilibrium of a monopolistically competitive firm,
we can see that P = ATC > MC
- Monopoly can make positive profit in the long-run but Monopolistic Competition
makes zero profit in the long-run.
- In the short-run, monopolistically competitive firms may make zero-profit. But in
the long-run, a monopolistically competitive firms must make zero-profit.

V/ Monopolistic Competition versus Perfect Competition:
2 differences:
1/ Excess capacity:
- Monopoly competition produces at Q below Efficient Scale (Minimum of ATC)
while Perfect Competition produces at Efficient Scale.
- Monopolistic Competition can increase Q to eliminate excess capacity, but it is
more profitable for a monopolistic competitor to operate with excess capacity.

2/ Markup over marginal cost:
- Perfectly competitive firms sell at price = marginal cost, whereas
monopolistically competitive firms sell at price > marginal cost because the
firms have some market power.
- Markup is consistent with entry and exit.
- Is possible because the condition for zero profit in the LR is P=ATC, not P=MC
- In the long-run equilibrium, monopolistically competitive firms operate on the
declining portion of their average-total-cost curves, so marginal cost < average
total cost. Thus, for price = average total cost, price must > marginal cost.
=> Monopolistic competitors try to attract more consumers since P > MC
VI/ Monopolistic Competition and Market Welfare:
1/ Inefficiency: Markup over marginal cost
- Some consumers value goods higher than its production cost but less than their
=> Undesirable outcome
=> Policy Makers got no easy ways to fix the price:

- Monopolistically competitive firms are so common, regulating its price would be
overwhelming.
- Monopolistically competitive firms are making zero-profit. If policymakers force
these firms to lower price closer to MC, firms will incur loss.
2/ The number of firms are not ideal:
- Too much or too little entry.
- Entrants have 2 externalities:
+ Product-variety externality: Consumers get more Consumer Surplus on
new product, entry conveys positive externality on consumers.
+ Business-stealing externality: existing firms lose customers and profit;
negative externality on existing firms.
- Depending on which externality is larger, a monopolistically competitive market
could have either too few or too many products.
VII/ Advertising:
- Natural feature of monopoly competition firms (and some oligopoly).
1/ Critique of advertising:
- Psychological more than informational: Firms use advertisement to distort
- Advertising often create perception that product is more different than they truly
Decrease competition.
2/ Defense of advertising:
- Advertising provides information to buyers.
- Consumers make better choice.
firms to enter the industry more easily.
3/ Advertising as a signal of quality:

buyers regardless of what the ad said.
be high to ensure that the buyers
will buy again)
4/ Brand names:
- Firms with brand names spend more on ad and charge consumers higher.
- Provide consumers information when quality cannot be judged before
purchase.
E.g.:
everywhere.
- Firms have the incentive to maintain high quality to protect the brand name.
EXERCISE:
1/ Which of the following is not a characteristic of monopolistic competition?
a. A large number of sellers.
b. Firms are price takers.
c. There is free entry into the market.
d. Sellers offer products that are, in some way, different from their competitors'
products
2/ In a monopolistically competitive industry, firms set price
a. equal to marginal cost since each firm is a price taker.
b. below marginal cost since each firm is a price taker.
c. above marginal cost since each firm is a price maker.
d. always a fraction of marginal cost since each firm is a price maker.
3/ Monopolistic competition differs from perfect competition because in
monopolistically competitive markets:
a. there are barriers to entry.
b. all firms can eventually earn economic profits.
c. each of the sellers offers a somewhat different product.

d. strategic interactions between firms is vitally important.
4/ One way in which monopolistic competition differs from oligopoly is that
a. there are no barriers to entry in oligopolies.
b. in oligopoly markets there are only a few sellers.
c. all firms in an oligopoly eventually earn zero economic profits.
d. strategic interactions between firms are rarely evident in oligopolies.
5/ A similarity between monopoly and monopolistic competition is that, in both
market structures,
a. strategic interactions among sellers are important.
b. there are a small number of sellers.
c. sellers are price makers rather than price takers.
d. product differentiation is important
6/ In the short run, a firm in a monopolistically competitive market produces at
what Quantity and sells at what Price?
a. At whatever Quantity it wants and at Price = Marginal Revenue

b. At the quantity higher than Monopoly quantity but lower than Perfect
Competition Quantity, At the Price lower than Monopoly Price but higher than
Perfect Competition Price.
c. At the Quantity and Price just like a monopoly firm does.
d. Firm will not produce anything because the market is too competitive.
7/ Refer to Figure 17-6. The firm in this figure is monopolistically competitive.
Choose the correct answer.
a. The firm is currently in the short-run, making profit and other firms will be more
likely to enter the market.

b. The firm is currently in the long-run, incurring loss and other firms will be more
likely to exit the market.
c. The firm is currently in the short-run, incurring loss and other firms will be more
likely to enter the market.
d. The firm is currently in the long-run, earning zero profit and other firms have no
incentives to enter or exit the market.
8/ Refer to Figure 17-6. The firm in this figure is monopolistically competitive.
Calculate the profit generated by this firm
a. -$1000
b. $1000
c. $0
d. $1500
9/ Supposed the process of entry and exit has stopped in a monopolistically
a. Positive Profit
b. Negative Profit
c. There is no entry and exit in a monopolistically competitive market

d. Zero profit
10/ Refer to the Figure above. Respectively, what figure demonstrate the entry and
exit of firms in a monopolistically competitive market?
a. (a), (b)
b. (b), (a)
c. (d), (c)
d. (c), (d)
11/ Choose the correct answer about a monopolistically competitive firm:
a. In the short-run, the firm behaves like Competitive firm. But in the long-run, it
behaves like a Monopoly.
b.
c. In the long-
curve
d. In a monopolistically competitive market, there are only a few firms with
differentiated products.
12/ In the long-run, what is the difference between Monopolistically competitive
firms (Denoted as A) and Perfectly competitive firms (Denoted as B)?
a. A operates with Excess Capacity and Markup over Marginal Cost comparing to B
b. B operates with Excess Capacity and Markup over Marginal Cost comparing to A
c. A and B are exactly the same in the long-run
d. A operate with Excess Quantity and Markup over Average Total Cost comparing
to B
13/ A monopolistically competitive firm chooses
a. the quantity of output to produce, but the market determines price.

b. the price, but competition in the market determines the quantity.
c. price, but output is determined by a cartel production quota.
d. the quantity of output to produce and the price at which it will sell its output.
14/ Among the following situations, the one that is not apply to a monopolistically
competitive firm is that in which
a. profit is positive in the short run.
b. total cost exceeds total revenue in the short run.
c. profit is positive in the long run.
d. total revenue equals total cost in the long run.
15/ When firms in a monopolistically competitive market engage in price-related
advertising, defenders of advertising argue that
a. the quality of products sold in the market always increases.
b. customers are less likely to be informed about other characteristics of the product.
c. new firms are discouraged from entering the market.
d. each firm has less market power.
16. Critics of advertising argue that in some markets advertising may
a. attract products of lower quality into the market.

b. provide consumers with information..
c.
d. enhance competition in markets to an unnecessary degree.
17. Company A and B released ads for their new products. Consumers know that
company A spent $2 million and company B spent $6 million as budget for their
ads. If the consumers are considering trying out one new product, what product
would they be more likely to choose:
a. Company A
b. Company B
c. The consumers is indifferent about product A and B
d. There is not enough information given to answer
18. When consumers are exposed to additional choices that result from the
introduction of a new product,
a. their satisfaction is likely to be lowered as a result of their having to make
additional choices.
b. a product-variety externality is said to occur.
c. an advertising externality is said to occur.

d. consumers are likely to experience negative consumption externalities.
Scenario 17-1
Vacation Inns of America (VIA) has recently announced intentions of building
a new hotel/resort complex in Myrtle Beach, South Carolina. Assume that the
hotel/resort market in Myrtle Beach is characterized by monopolistic competition.
19. Refer to Scenario 17-1. As a result of the new VIA hotel/resort, tourists who
stay in Myrtle Beach are likely to experience a
a. product-variety externality, which harms consumers.
b. product-variety externality, which benefits consumers.
c. business-stealing externality, which harms consumers.
d. business-stealing externality, which benefits consumers.
20. Refer to Scenario 17-1. Existing hotels, motels, and lodging facilities in Myrtle
Beach are likely to experience what kind of externality as a result of the new VIA
hotel/resort?
a. Product-variety
b. Business-stealing
c. Competitive
d. Advertising
1. B (Explain: Monopolistically Competitive firms are not price takers, but rather price
makers)
2. C (Explain: Monopolistically Competitive firm has market power, so it can set the
price higher than marginal cost like Monopolist)
3. C (Explain: In monopolistic competition market, goods offered by each firm are
differentiated. In a perfect competition market, goods offered by each firm have many
other perfect substitutes)
4. B (Explain: Monopolistically competitive market has many firms, while oligopoly
market has only a few firms)
5. C (Explain: Both monopoly and monopolistic competition firms have market power,
so they are price makers rather than price takers)
6. C (Explain: In the short-run, monopolistically competitive firms determine their
production and price just like a monopolist)
7. Ans: A (Explain: At the point where MR intersects with MC curve, the Demand
curve is above the ATC curve, so the firm is earning positive profit => The firm is in the
short-run)
8. B (Explain: The MC curve intersects MR curve at the Quantity = 10. At Q = 10, Price
= $600, Average Total Cost = $500. Profit = (P - ATC ) x Q = (600 - 500) x10 = $1000)
9. D (Explain: After the process of entry and exit has ended, the firm is now in the
long-run and earning zero economic profit)
10. C (Explain: Figure (d) illustrates the decrease in demand. When more firms enter
the monopolistically competitive market, the demand of the consumers for each firm
decrease.
Same arguments for the increase in demand caused by the exit of firms in Figure (c))
11. C (Explain:
A is wrong. In the short-run, the firm behaves like a Monopolist. In the long-run, it earns
zero economic profit like a Competitive firm
Markup over Marginal Cost
C is correct. In the long-run, the firm will make zero economic profit => Price =
Average Total Cost => Demand curve must tangent with ATC curve
D is wrong. In a monopolistically competitive market, there are many firms with
differentiated products.)
12. Ans: A
(Explain: In the long-run, Monopolistically Competitive firm earns zero economic
profit like Competitive firm. But its production level is less than the Efficient Scale
(Excess Capacity) and its long-run price is still higher than Marginal Cost (Markup over
Marginal Cost)
13. D (Explain: A monopolistically competitive firm has market power, so that it has an
ability to determine Price and Quantity produced)
14. C (Explain:
A, B is correct. In the short-run, a monopolistically competitive firm can earn positive (
Total Revenue > Total Cost) or negative (TR < TC) profit
C is wrong. In the long-run, a monopolistically competitive firm earns zero economic
profit
D is correct. In the long-run, a monopolistically competitive firm earns zero economic
profit. So Total Revenue equals Total Cost)
15. D (Explain: Defenders of advertising argue that the ads provide consumers with
information so that consumers will make a better choice in choosing what products best
suit them. As a result, the competition in the market increase, individual firms now have
less market power)
16. C (Explain: Critics of advertising argue that ads are psychological rather than
information. They think ads can give consumers misperceptions about the product)
17. B (Explain: The willingness to spend on an ad of a company signals the quality of
its products to buyers. The ad budget of company B is larger than company A, so the
consumers will be more likely to try out product B)
18. B (Explain: When new firms enter the market, the consumers are now better off
because there are more product variety than before (product-variety externality))
19. B (Explain: The entrance of the new resort will create product-variety externality,
which benefits consumers by increasing the variety of products consumers can choose
from)
20. B (Explain: The entry of the new resort will steal the customers and profit from the
existing resorts)
Chapter 17: Oligopoly 312
Chapter 17:
Oligopoly
_Concentration ratio: % of total output supplied by the four largest firms.
_Oligopoly characteristics: Few sellers, identical products, action of one can have
impact on others
_Game theory: how people behave in strategic situations
_Key feature of oligopoly: tension between cooperation and self-interest (whether
firms in oligopoly should follow collusion or pursue own interest)
I/ Market with only a few sellers:
1/ Competition, Monopolies, and Cartel:
_Duopoly: Oligopolies with only 2 members.
_Collusion: agreement among firms on Q and P.
_Cartel: group of firms in unison agrees on total production and Q produced by each
member.
_When oligopolists form cartel, they act as a single monopoly (Oligopolists face the
same downward-sloping demand curve like Monopolists) => P > MC inefficient.
_Oligopolists form cartels and earn monopoly profits, but impossible because:
+ Agreement on Q each produced is difficult
+ Antitrust laws
2/ The equilibrium of oligopoly:
_Although the members of the cartel agreed on the Quantity each produced,
Oligopolists still pursue self-interest, each thinks that if they increase individual
Qtotal > Qmonopoly, Ptotal < Pmonopoly Profittotal and Pindividual <
Profitmonopoly
_Self- Nash equilibrium:
a situation in which economic actors interacting with one another choose best strategy
given the strat no incentive to make a different
decision.
_Oligopolists would be better off cooperating and reaching the monopoly outcome. Yet
because they pursue their own self-interest, they do not end up reaching the monopoly
outcome and maximizing their joint profit. At the same time, self-interest does not drive
the market all the way to the competitive outcome.
Oligopolists with self-interest: Qmonopoly < Q < Qcompetition
Pmonopoly > P > Pcompetition
3/ How the size of an Oligopoly affects market outcome:
_ harder to reach agreement.
_If oligopolists do not form cartel, when raise production, two effects will occur:
+ Output effect: because P > MC , when +1 Q raise profit.
+ Input effect: increase Q lower P, lower profit.
Output effect > Price effect: increase production.
Output effect < price effect: not raise production.
Oligopolist will continue until these two effects are equal.
_The larger the number of sellers, the less concerned about own impact on market
price.
_When there is very large number of firms in the market, the production decision of an
individual firm no longer affects the market price. In this extreme case, each firm takes
the market price as given when deciding how much to produce.
Number of sellers in oligopoly increase: look more like a competitive market. P
is closer to MC, Q closer to socially efficient level.
World trade:
Open trade
efficient.
II/ The economics of cooperation:
_Cooperation: desirable but difficult
_ captured prisoners that
illustrates why cooperation is difficult to maintain even when it is mutually beneficial.
_Dominant strategy: best strategy regardless of what others choose

explain why oligopolies are hard to maintain monopoly profits. Monopoly outcome
is rational, but each has incentive to cheat
Situation: Bonnie and Clyde are caught by the police. If one confesses, he will go free
and the other will get 20 years sentence. If both remain silent, both will get 1 year
sentence. If both confess, both will get 8 years sentence.
_Suppose that Bonnie and Clyde both pursue their own interest.
confess because 8 years sentence is better than 20 years. If Clyde remains silent, Bonnie
will confess because going free is better than 1 year sentence. So, regardless of what Clyde
strategy.
_Clyde will do the same and choose confessing as a dominant strategy.
_In the end, both Bonnie and Clyde confess, and both spend 8 years in jail. This outcome
is a Nash equilibrium: Each criminal is choosing the best strategy available, given the
strategy the other is following. If they had both remained silent, both of them would have
been better off, spending only 1 year in jail. Because each pursues his or her own interests,
the two prisoners together reach an outcome that is worse for each of them.
_Decision-making of oligopolists is the same. If Jack and Jill form a cartel and act as a
monopoly, they agreed on a production of 30 gallons and generating $1,800 of profit each.
But, each has an incentive to cheat. Their dominant strategy now is to increase production
to 40 gallons. As a result, both will get lower profits of $1,600 by pursuing their own
interest.
a/ Arms races:
_Consider the decisions of the United States and the Soviet Union about whether to build
new weapons or to disarm. Each country prefers to have more arms than the other because
a larger arsenal would give it more influence in world affairs. But each country also
prefers to live in a wor

_For the US, it does not know what USSR will do. If USSR arms, the US will choose to
arm because then US will still be at risk but not weak against USSR. If USSR disarms, the
US will choose to arm because now the US will be safe and powerful. We say that the US
dominant strategy is to arm.
_The same goes for USSR.
_At the end, both country will be at the Nash equilibrium and choose to arm in the pursuit
of own interest. The outcome is clearly worse than the safe outcome generated by both
countries choosing to disarm.
b/ Common resources:
_Imagine that two oil companies Exxon and Texaco own adjacent oil fields.
Under the fields is a common pool of oil worth $12 million. Drilling a well to
recover the oil costs $1 million. If each company drills one well, each will get half
of the oil and earn a $5 million profit ($6 million in revenue minus $1 million in
costs).
_Exxon does not know what Texaco will do. If Texaco drills two wells, Exxon will choose
to drill 2 wells because $4 million profit is better than $3 million. If Texaco drills 1 well,
Exxon will choose to drill 2 wells because $6 million profit is better than $5 million. We
_The same goes for Taxeco.
_In the end, both will be at Nash equilibrium and drill 2 wells and generate individual
profit of $4 million. By pursuing own interest, this outcome is worse than the outcome
where they both choose to drill 1 well and generate individual profit of $5 million.
when cooperation would make both players in the game better off.
- Depend on the circumstances that lack of cooperation could be good or bad.
+ The lack of cooperation could be bad for the society, for example, in the case of
arms-race.
+ But the lack of cooperation could be good for the society, for example, in the
case of oligopolists trying to maintain monopoly profits. When oligopolists fail
to cooperate increase competition Q closer to optimal level.
5/ Why People Sometimes Cooperate?
Cartel can maintain agreement if they play the game repeatedly.
III/ Public Policies toward Oligopolies:
- Antitrust Laws: price-fixing agreements among competing firms should be illegal.
- Controversies over Antitrust Policy
+ Resale Price Maintenance
Require retailers to sell at no less than $X
Present free-rider: Customers may enjoy benefits from a showroom ( a
retailers with Resale Price Maintenance) and then go to another store
without Resale Price Maintenance to buy that product.

Business practices that appear to reduce competition may have legitimate
goal.
+ Predatory Pricing
Price cut to eliminate smaller firm
Rarely profitable
+ Tying
Offer 2 products at a single price
A form of price discrimination

EXERCISE
Table 16-2
The following table shows the total output produced by the top six firms as well as
the total industry output for four industries.
1. Refer to Table 16-2. Which industry has the highest concentration ratio?
a. Industry A
b. Industry B
c. Industry C
d. Industry D
2. Refer to Table 16-2. Which industry has the lowest concentration ratio?
a. Industry A
b. Industry B
c. Industry C
d. Industry D
3. In markets characterized by oligopoly,
a. the oligopolists earn the highest profit when they cooperate and behave like a
monopolist.
b. collusive agreements will always prevail.
c. collective profits are always lower with cartel arrangements than they are without
cartel arrangements.
d. pursuit of self-interest by profit-maximizing firms always maximizes collective
profits in the market
4. Because each oligopolists cares about its own profit rather than the collective
profit of all the oligopolists together,
a. they are unable to maintain the same degree of monopoly power enjoyed by a
monopolist.
b. each firm's profit always ends up being zero.
c. society is worse off as a result.
d. Both a and c are correct.

5. The equilibrium quantity in markets characterized by oligopoly is
a. higher than in monopoly markets and higher than in perfectly competitive markets.
b. higher than in monopoly markets and lower than in perfectly competitive markets.
c. lower than in monopoly markets and higher than in perfectly competitive markets.
d. lower than in monopoly markets and lower than in perfectly competitive markets.
6. When oligopolistic firms interacting with one another each choose their best
strategy given the strategies chosen by other firms in the market, we have
a. a cartel.
b. a group of oligopolists behaving as a monopoly.
c. a Nash equilibrium.
d. the perfectly competitive outcome.
7. As the number of firms in an oligopoly market
a. decreases, the market approaches the cartel outcome.
b. decreases, the market approaches the competitive market outcome.
c. increases, the market approaches the competitive market outcome.
d. increases, the market approaches the monopoly outcome.

8. The theory of oligopoly provides another reason that free trade can benefit all
countries because
(i) as the number of firms within a given market increases, the price of the good
falls.
(ii) increased competition leads to smaller deadweight losses.
(iii) profit increases with the level of competition for oligopoly firms.
a. (i) only
b. (ii) only
c. (i) and (ii)
d. (i), (ii), and (iii)
9. Games that are played more than once generally
a. lead to outcomes dominated purely by self-interest.
b. lead to outcomes that do not reflect joint rationality.
c. encourage cheating on cartel production quotas.
d. make collusive arrangements easier to enforce.

Table 16-16
Consider a small town that has two grocery stores from which residents can
choose to buy a gallon of milk. The store owners each must make a decision to set a
high milk price or a low milk price. The payoff table, showing profit per week, is
provided below. The profit in each cell is shown as (Store 1, Store 2).
10. Refer to Table 16-16. If grocery store 2 sets a low price, what price should
grocery store 1 set? And what will grocery store 1's payoff equal?
a. Low price, $500
b. High price, $800
c. Low price, $100
d. High price, $100

11. Refer to Table 16-16. If grocery store 2 sets a high price, what price should
a. Low price, $800
b. High price, $650
c. Low price, $100
d. High price, $800
12. Refer to Table 16-16. If grocery store 1 sets a low price, what price should
a. Low price, $500
b. High price, $800
c. Low price, $100
d. High price, $650
13. Refer to Table 16-16. If grocery store 1 sets a high price, what price should
a. Low price, $800
b. High price, $100
c. Low price, $500

d. High price, $650
14. Refer to Table 16-16. What is grocery store 1's dominant strategy?
a. Grocery store 1 does not have a dominant strategy.
b. Grocery store 1 should always set a low price.
c. Grocery store 1 should always set a high price.
d. Grocery store 1 should set a low price when grocery store 2 sets a low price, and
grocery store 1 should set a high price when grocery store 2 sets a high price.
15. Refer to Table 16-16. What is grocery store 2's dominant strategy?
a. Grocery store 2 does not have a dominant strategy.
b. Grocery store 2 should always set a low price.
c. Grocery store 2 should always set a high price.
d. Grocery store 2 should set a low price when grocery store 1 sets a low price, and
grocery store 2 should set a high price when grocery store 1 sets a high price.
16. Refer to Table 16-16. What is the Nash Equilibrium of this price-setting game?
a. Grocery store 1: Low price
Grocery store 2: Low price
b. Grocery store 1: Low price

Grocery store 2: High price
c. Grocery store 1: High price
Grocery store 2: How price
d. Grocery store 1: High price
Grocery store 2: High price
17. The practice of tying is used to
a. enhance the enforcement of antitrust laws.
b. encourage the enforcement of collusive agreements.
c. control the retail price of a collection of related products.
d. package products to sell at a combined price closer to a buyer's total willingness to
pay.
18. To move the allocation of resources closer to the social optimum, policymakers
should typically try to induce firms in an oligopoly to
a. collude with each other.
b. form various degrees of cartels.
c. compete rather than cooperate with each other.
d. cooperate rather than compete with each other.

19. Predatory pricing occurs when a firm
a. exercises its oligopoly power by raising its price through the formation of a cartel.
b. exercises its monopoly power by raising its price.
c. cuts its prices in order make itself more competitive.
d. cuts its prices temporarily in order to drive out any competition.
1. ANSWER: a. Industry A
(Explanation: Recall that Concentration Ratio is the percentage of 4 largest firms in
the industry
Repeat: Concentration Ratio of Industry B = 39%
Concentration Ratio of Industry C = 22.74%
Concentration Ratio of Industry D = 45%)
2. ANSWER: c. Industry C
(Explanation: Same as Question 1)
3. ANSWER: a. the oligopolists earn the highest profit when they cooperate and
behave like a monopolist
(Explanation:
A is correct. Oligopolists form a cartel and act as a single monopolist will generate
highest profit. But once they pursue their own interest, profit will fall.
B is wrong. Collusive agreement will not always prevail since 1/ Agreement on
Quantity each produced is hard. 2/ Antitrust law prohibits cartel
C is wrong. When oligopolists form a cartel, they will make an agreement to produce a
quantity and sell at a price which maximizes profit. Only until they go against the
agreement and act as their own interest did the profit keep decreasing until it reach the
competitive market outcome (profit =0 < oligopoly profit). So it is not always.
D is wrong. Without an agreement, each will pursue their own interest to raise Quantity
produced (to increase individual profit), it may increase its profit first. Then, other
oligopolists see profit, they will also increase their quantity produced. When all
oligopolists increase Quantity, Price and Profit decrease. So it is not always maximizes
collective profits in the market.)
4. ANSWER: a. they are unable to maintain the same degree of monopoly power
enjoyed by a monopolist.
(Explanation: When oligopolists act as a monopoly, they earn monopoly profit. Each
of them has the incentive to increase production to increase their own profit. As a result,
Quantity as a whole increases, Price and collective profit decrease)
5. ANSWER: b. higher than in monopoly markets and lower than in perfectly
competitive markets.
(Explain: At first, a cartel agree on the quantity each produces. But each oligopolists
pursue their own interest and increase production. That is when they reach Nash
equilibrium, where each has no incentive to change (both lowering and increasing
quantity will potentially decrease profit. So Qmonopoly < Q < Qcompetition)
6. ANSWER: c. a Nash equilibrium.
(Explanation: Nash equilibrium definition)
7. ANSWER: c. increases, the market approaches the competitive market outcome.
(Explanation: When there is very large number of firms in the market, the production
decision of an individual firm no longer affects the market price. In this extreme case,
each firm takes the market price as given when deciding how much to produce.
Oligopolistic firms become a price taker and approach the competitive market outcome)
8. ANSWER: c. (i) and (ii)
(Explanation:
(i) is correct. When the number of sellers in a market increases, the market slowly
reaches a competitive market outcome. Oligopolistic firms now have less market power,
thus the P will slowly reach the competitive price (P = MR)
(ii) is correct. Recall that the perfectly competitive market outcome is socially efficient
(no deadweight loss). So, increased competition means that the market is slowly getting
more efficient.
(iii) is wrong. When competition increases, Price and Profit decreases.
9. ANSWER: d. make collusive arrangements easier to enforce.
(Explanation: If the game is played more than once, the oligopolistic firms know that
they will be better off just by sticking with the agreement, not pursuing own interest. As
a result, collusive arrangements in cartel are easier to enforce.)
10.ANSWER: a. Low price, $500
(Explanation: When Store #2 sets a low price, Store #1 will set a low price because
then it will get $500 rather than $100 generated by choosing to set high price)
11. ANSWER: a. Low price, $800

(Explanation: When Store #2 sets a high price, Store #1 will set a low price because
$800 is better than $650 generated by setting a high price)
(Explanation: When Store #1 sets a low price, Store #2 will set a low price because
(Explanation: When Store #1 sets a high price, Store #2 will set a low price because
14. ANSWER: b. Grocery store 1 should always set a low price.
(Explanation
Store #2 does, setting a low price is always profitable for Store #1. Mentioned in
Question 10, 11)
15. ANSWER: b. Grocery store 2 should always set a low price.
(Explanation minant strategy is setting a low price because whatever
Store #1 does, setting a low price is always profitable for Store #2. Mentioned in
Question 12, 13)
16. ANSWER: a. Grocery store 1: Low price
Grocery store 2: Low price

(Explanation: Nash equilibrium is where the economics actors have no incentive to
setting a low price. Since changing the decision results in a potential risk to the store,
both will keep the low price.)
17. ANSWER: d. package products to sell at a combined price closer to a buyer's total
willingness to pay.
(Explanation: Tying definition)
18. ANSWER: c. compete rather than cooperate with each other.
(Explanation: Policymakers usually induce firms to compete rather than cooperate so
firms exerting their market power makes the market outcome inefficient)
19. ANSWER: d. cuts its prices temporarily in order to drive out any competition.
(Explanation: Predatory Pricing means that a firm will heavily reduce its price in order
to steal all the consumers and drive the firms with weaker market power out of the
market.)
Chapter 21: The Theory of Consumer Choice 337
Chapter 21
The Theory of Consumer Choice
I- The budget constraint: What the consumer can afford:
- Definition: Budget constraint is the limit on the consumption bundles that a consumer
can afford. It shows the trade-off between one good and another good that the consumer
faces.
+ is a particular combination of the goods (e.g. 50 loaves
of bread & 200 bottles of water.)
- The slope of the budget constraint equals the relative price (the price of one good
compared to the price of the other) of the good on the X axis.
Example:
income is $1,000. The price of Pepsi is $2 and the price of Pizza is $10.
the horizontal axis.

- use
all of his income on Pizza. With the
income $1,000 and the price of Pizza is
$10. He can buy $1000/$10 = 100 pizzas.
Which is point A.
- use
all of his income on Pepsi. With the
income $1,000 and the price of Pepsi is
$2. He can buy $1000/$2 = 500 bottles of
Pepsi. Which is point B.
- If Shin spends the same amount of
income on both goods, he will spend $500
on each good. He can buy
+ $500/$10 = 50 pizzas.
+ $500/ $2 = 250 bottles of Pepsi.
Which is point C.
II- Preferences: What the Consumer Wants.
1/ Indifference Curve:
- Definition: Indifference Curve is a curve that shows consumption bundles that give
the consumer the same level of satisfaction.
- The consumer is equally happy at all points on the same indifference curve.
Example:
Bundle A and bundle B are on the same indifference curve, so the consumer is
indifferent between A and B. That means bundle A and bundle give the consumer the
same satisfaction.
Four property of indifference curve:
Example:
1) Higher indifference curves are
preferred to lower ones:
- People usually prefer to consume
more goods rather than less.
- Higher indifference curves
represent larger quantities of

The consumer prefers bundle D to bundle A,B and C.
goods than lower indifference
Because bundle D lie on the higher indifference
curve.
curve.
The consumers prefer being on
higher indifference curves.

Example:
2) Indifference curves are
downward sloping:
If the quantity of one good is reduced,
the quantity of the other good must
increase for the consumer to be equally
happy.
Indifference curve slope

From A to B: If the quantity of Pizza is reduced, the
downward.
quantity of Pepsi must be increased to keep the
consumer equally happy.
3) Indifference curves do not
cross:
- Suppose that two indifference curves
did cross,
+ A and B are on the same indifference
curve, so A and B will make a consumer

equally happy.
+ C and B are on the same indifference
curve, so C and B will make a consumer
equally happy.
+ As the satisfaction at A=B, and C=B.
We can imply that A and C will make a
consumer equally happy.
+ However, bundle C has more of both
goods than bundle A.
that consumer always prefers more of
both goods to less
- A situation like this can never happen.
Example:
4) Indifference curves are bowed
inward:
- The slope of an indifference curve is the

Marginal Rate of Substitution.
Marginal Rate of Substitution: the rate
at which a consumer is willing to trade
one good for another.
- People are more willing to trade away
goods that they have in abundance and
less willing to trade away goods of which
they have little.

At point A, the consumer has little pizza and much
The bowed-inward shape of the Pepsi, so she requires 6 units of Pepsi to induce her to
indifference curve reflects the give up 1 Pizza.
greater willingness to
Whereas at point B, the consumer already has lots of
give up a good that she already
pizza and little Pepsi, so she requires only 1 units of
has in large quantity.
Pepsi to induce her to give up 1 Pizza.
2/ Two Extreme Cases of Indifference Curve:

a. Perfect Substitutes:
- Definition: Perfect Substitutes is two
goods with straight-line indifference
curves.
Example: Nickels and Dimes
Consumer is always willing to trade two
nickels for one dime.
b. Perfect Complements:
- Definition: Perfect Complements is
two goods with right-angle indifference
curves.
Example: Left shoes & Right shoes{7
left shoes, 5 right shoes}is just as good as
{5 left shoes, 5 right shoes}

Less Extreme Cases: Close Substitutes and Close Complements
Indifference curves for close Indifference curves for close
substitutes are not very bowed. complements are very bowed.
III- Optimization: What The Consumer Chooses:
- The Optimum is the point on the budget constraint that touches the highest
possible indifference curve.
- The Slope of the Indifference Curve equals the Slope of the Budget Constraint
tangent to the Budget Constraint.

- The consumer chooses consumption of the two goods so that the marginal rate of
substitution equals the relative price.
MRS =
Example:
The Consumer chooses the point on her budget constraint that lies on the highest
indifference curve.
- In this case, the highest indifference curve the consumer can reach is I2.
- The consumer prefers point A, which lies on indifference curve I3. However, she
cannot afford this bundle of Pizza and Pepsi, because I3 lies above the consumer
budget constraint.
- Point B is affordable, but because it lies on a lower indifference curve, the
consumer does not prefer it.
* Utility: An Alternative Way to Describe Preferences and
Optimization.
At the optimum:
With:
MUx: marginal utility of good X
MUY: marginal utility of good Y
Px: price of good X
Py: price of good.

An increase in income shifts the budget constraint outward.
a/ Normal goods:
Example: If both goods are normal goods, the consumer responds to the increase in
income by buying more of both of them. Here the consumer buys more Pizza and more
Pepsi.
b/ An Inferior good:
Example: A good is inferior if the consumer buys less of it when her income rises. Here
Pepsi is an inferior good and Pizza is a normal good, because the consumer buys more
Pizza but less Pepsi when her income rises.

Example: The consumer income is $1000. Initially, the price of Pepsi is $2 and the
price of Pizza is $10. Then the price of Pepsi decreases to $1, but the consumer income
and the price of pizza remain the same.
- Initially with the income of $1000, the consumer can buy bundle B with 500
two-dollar Pepsi and 0 ten-dollar Pizza. Or bundle A with 0 two- dollar Pepsi
and 100 ten-

- When price of Pepsi decreases to $1, the consumer can now buy bundle D with
1000 one-dollar Pepsi and 0 ten-dollar Pizza. However, because the price of
ten-
A fall in the price of Pepsi rotates the budget constraint outward
l optimum to the new optimum
4/ Income and Substitution Effects:
- Income Effect: the change in consumption that results when a price change
moves the consumer to a higher or lower indifference curve.
- Substitution Effect: the change in consumption that results when a price change
moves the consumer along a given indifference curve to a point with a new
marginal rate of substitution.
Example: When the price of Pepsi falls.

- The movement from point A to B reflects the substitution effect as it moves along
the indifference curve I1.
- The movement from point B to C reflects the income effect as it moves to a higher
indifference curve I2.
- For Pepsi, both income effect and substitution effect increase quantity of Pepsi,
so the total effect increases the quantity of Pepsi.
- For Pizza, in this case, the substitution effect which decrease quantity of Pizza is
larger than the income effect which increase quantity of Pizza, so total effect
decrease the quantity of Pizza.

The substitution effect in two cases:
- In both graphs, the relative price changes by the same amount.
For close substitutes goods. For close complement goods.
- But the substitution effect is bigger for substitutes than complements.
The size of the substitution effect can be measured by how far the consumer moves
along her indifference curve in response to a given relative price change.

Previously, we saw that the income and substitution effects work in opposite
directions on the good whose price does not change.
What determines which effect is bigger? The answer depends on the extent to
which the goods are close substitutes or complements.
The closer the goods are to being perfect substitutes, the bigger the substitution
effect, and the more likely the substitution effect will be greater than the income
effect.
5/ Deriving the Demand Curve:
Example:
point A to point B, and the quantity of Pepsi consumed rises from 250 to 750
liters.
The Demand Curve reflects this relationship between price and the quantity
demanded.
IV - Three Applications:
1/ Do All Demand Curves Slope Downward?
Giffen good: a good for which an increase in the price raises the quantity demanded.
+ An inferior good.
+ The Income Effect dominates the Substitution Effect.
Demand Curve Slope Upward.
Example: Potatoes and Meat. Potatoes are a Giffen good.
- This happened because Potatoes are a strongly inferior good.
- When the price of Potatoes rises, the consumer feels poorer.

The Income Effect makes the consumer buy more Potatoes and less Meat.
- At the same time, when the price of Potatoes rises. The Potatoes have become
more expensive relative to meat.
The Substitution Effect makes the consumer buy less Potatoes and more Meat.
- In this case, however, the Income Effect is so strong that it exceeds the
Substitution Effect.
The consumer responds to the higher price of potatoes by buying more potatoes
and less meat.
2/ How Do Wages Affect Labor Supply?
Example: Consider the decision facing Carrie, a freelance software designer. Carrie is
awake for 100 hours per week. She spends some of this time enjoying and the rest to
work. For every hour she works developing software, she earn $50, which she spends on
consumption goods - food, clothing, etc.
- Her wages ($50/hour) reflect the trade-off Carrie faces between leisure and
consumption. For every hour of leisure she gives up, she works one more and
earns $50 of consumption.
- This figure b
consumption and leisure.

- Because she always prefers more leisure and more consumption, she prefers
points on higher indifference curves to points on lower ones. At the wages of $50
budget constraint that is on the highest possible indifference curve, I2.
- Suppose Carrie
outcomes showing in panel (a) and panel (b).
- In panel (a), Carrie responds to higher wage by enjoying less leisure.

curve slope upward substitution effect.
- In panel (b), Carrie responds by enjoying more leisure.

- Exp
as leisure and consumption are both normal goods, she tends to enjoy both
backward income effect.
Economic theory will either induce Carrie to work more or less when the wage rises.
If the substitution effect is greater than the income effect, Carrie will work more and
vice versa. Then the labor supply curve could be either upward or backward sloping.
3/ How Do Interest Rate Affect Household Saving?
Example:
consumption) vs.
account and earns interest from it) at the interest rate of 10 percent
Budget constraint:
- 0,000 when old
- all other intermediate possibilities on the linear curve
Indifference curves
Optimum: point on the budget constraint that is on the highest possible indifference
curve
* Suppose the interest rate rises to 20 percent
ses to the increase in interest rate:
+ Panel (a): lower consumption when young
(income - lower consumption when young)
+ Panel (b): higher consumption when young
(income - higher consumption when young)

* Explanation of the two different responses using the income and substitution effects
- Substitution effect:
Interest rate increases
young
s when young
- Income effect:
Interest rate increases
-being to enjoy higher consumption in
both periods, as long as the consumption in both periods consist of normal
goods
- substitution effect > income effect: save more
- Income effect > substitution effect: save less

The theory of consumer choice says that an increase in interest rate could either
encourage or discourage saving.
EXERCISE
1. If a consumer's income decreases, the budget constraint for CDs and DVDs
will
a. shift outward, parallel to the original budget constraint.
b. shift inward, parallel to the original budget constraint.
c. rotate outward along the CD axis because we can afford more CDs.
d. Rotate outward along the DVD axis because we can afford more DVDs.
2. Assume that a college student spends her income on books and pizza. The price
of a pizza is $8.00, and the price of a book is $15. If she has $100 of income, she
could choose to consume
a. 8 pizzas and 4 books.
b. 4 pizzas and 5 books.
c. 9 pizzas and 3 books.
d. 4 pizzas and 3 books.

3. The consumer's optimum choice is represented by (MU = Marginal Utility;
MRS = Marginal Rate of Substitution)
a. MUx/MUy = Px/Py
b. MUx/Px = MUy/Py
c. MRSxy = Px/Py
4. Refer to Figure 21-7. Assume that the consumer depicted in the figure has an
income of $20. The price of Skittles is $2 and the price of M&M's is $4. This
consumer will choose a consumption bundle where the marginal rate of
substitution is
a. 2.
b. 2/3.
c. 1/2.
d. 1/3.
income of $20. The price of Skittles is $2 and the price of M&M's is $2. This
consumer will choose to optimize by consuming
a. bundle A.
b. bundle B.
c. bundle C.
d. bundle D.
6. Refer to Figure 21-7. Assume that the consumer depicted in the figure faces
prices and income such that she optimizes at point B. According to the graph,
what change forces the consumer to move to point A?
a. a decrease in the price of Skittles.
b. a decrease in the price of M&M's.

c. an increase in the price of Skittles.
d. an increase in the price of M&M's.
income of $100 and currently optimizes at point A. When the price of
marshmallows decreases to $5, which point will the optimizing consumer choose?
a. Point A
b. Point B
c. Point C
d. Point D
income of $40. If the price of chocolate chips is $4.00 and the price of
marshmallows is $4.00, the optimizing consumer would choose to purchase
a. 9 marshmallows and 6 chocolate chips.
b. 10 marshmallows and 10 chocolate chips.
c. 5 marshmallows and 5 chocolate chips.
d. 3 marshmallows and 9 chocolate chips.
income of $40. Which of the following price-quantity combinations would be on
her demand curve for marshmallows if the price of chocolate chips is $4?
a. $2.00, 3
b. $2.00, 9
c. $4.00, 3
d. $4.00, 9
10. Ken consumes two goods, beer and pretzels. A beer costs $1 per bottle and he
consumes it to the point where the marginal utility he receives from his last beer is
3. Pretzels cost $2 per bag, and the relationship between the marginal utility he
gets from eating a bag of pretzels and the number of bags he eats per month is as
follows:
If Ken is maximizing his utility, how much does he spend on pretzels each month?
a. $2
b. $6
c. $8
d. $12
11. Consider the indifference curve map and budget constraint for two goods (B
and K). Suppose the good on the horizontal axis (K) is inferior and Giffen. When
the price of the inferior good on the horizontal axis (K) increases
a. the substitution effect causes an increase in the consumption of K and the
income effect causes a decrease in the consumption of K. However, the
substitution effect is less than the income effect.
b. the substitution effect causes a decrease in the consumption of K and the
income effect causes an increase in the consumption of K. However, the
substitution effect is greater than the income effect.
c. the substitution effect causes an increase in the consumption of K and the
income effect causes a decrease in the consumption of K. However, the
substitution effect is greater than the income effect.

d. the substitution effect causes a decrease in the consumption of K and the
income effect causes an increase in the consumption of K. However, the
substitution effect is less than the income effect.
12. When considering household saving, the relative price between "consuming
when young" and "consuming when old" is the
a. consumption rate.
b. interest rate.
c. prime rate.
d. federal funds rate.
13. The substitution effect of a wage decrease in the work-leisure model results in
the worker choosing to
a. work less than before.
b. work more than before.
c. possibly work more or less than before.
d. work more with a higher level of consumption.
14. Suppose Olivia is planning for retirement in a two-period world. In the first
period Olivia is young and earns $1million, and in the second period Olivia is old
and retired and earns nothing. The interest rate is initially 10 percent, but then it
falls to 7 percent. Which of the following must be true?
a. After the interest rate falls, the substitution effect will induce Olivia to
consume more when she is young.
b. After the interest rate falls, the substitution effect will induce Olivia to
consume less when she is young.
c. After the interest rate falls, the income effect will induce Olivia to consume
more when she is young.
d. After the interest rate falls, the income effect will induce Olivia to consume
less when she is young.
15. In the upward-sloping portion of the individual labor supply curve, the
substitution effect is
a. greater than the income effect.
b. less than the income effect.
c. equal to the income effect.
d. exactly offset by the income effect.

1. ANS: b. shift inward, parallel to the original budget constraint.
(Explain: When income decreases, the consumer would be able to buy less of both
goods. Therefore, budget constraint shift inward, parallel to the original budget
constraint)
2. ANS: d. 4 pizzas and 3 books.
(Explain: X is the number of pizzas consumed.
Y is the number of books consumed.
In order to buy a bundle of good
Replace the numbers in answer A,B,C,D.
We have Answer A used total of $124. Answer B used $107. Answer C used $117.
Answer D used $77.)
3. ANS: d. All of the above are correct.
(According to PE textbook, FYI, page 443.)
4. ANS: c. 1/2.
(Explain:
$4.
The budget constraint for the consumer is the line goes through point A and point A
is also the consumer optimum (where the budget constraint tangents the indifference
curve). At the optimum, marginal rate of substitution equals the slope of the budget
constraint, which is PSkittles/P = $2/$4 = ½. )
5. ANS: b. bundle B.
(Explain:
$2.
And if the consumer buys 0 Skittles, he will use
The budget constraint for the consumer is the line goes through points B, C, and D.
And point B is the consumer optimum (where the budget constraint tangents the
indifference curve).
6. ANS: d. an increase in the price of M&M's.
(Explain: The consumer currently optimizes at point B, but then she has to move to
point A, because her budget constraint rotates inward. If she was not able to buy as
7. ANS: b. Point B
(Explain: When the price of marshmallows decreases to $5, the consumer can now buy
20 marshmallows if she buys 0 Chocolate Chip. Which rotates the budget constraint
outward, and tangents the indifference curve I1 at point B. So point B is now the
consumer optimum.)
8. ANS: c. 5 marshmallows and 5 chocolate chips.
(Explain: With the income of $40, the price of chocolate chips is $4.00 and the price of
marshmallows is $4.00.
If the consumer buys 0 chocolate chip, he will use all his income to buy 10
marshmallows.
And if the consumer buys 0 marshmallow, he will use all his income to buy 10
chocolate chips.
The budget constraint for the consumer is the line goes through point A and point A
is also the consumer optimum (where the budget constraint tangents the indifference
curve I0). At point A, the bundles included 5 marshmallows and 5 chocolate chips.)
9. ANS: b. $2.00, 9.
(Explain: With the income of $40, the price of chocolate chips is $4.00.
If the consumer buys 0 marshmallow, he will use all his income to buy 10 chocolate
chips. There are 2 budget constraint satisfied the requirement. They are the budget
constraint went through point A and the budget constraint went through point B.
At point A, the bundle contains 5 marshmallows (no answer)
At point B, the bundle contains 9 marshmallows (answer b and d)
Slope of the budget constraint go through point B (Marginal rate of Substitution) is:
$4/ Pmarshmallows = 2
=> Pmarshmallows = $2 )
10. ANS: c. $8
(Explain: at the optimum, = =
= MUpretzel = 6. Compare with the table, when marginal
utility is 6, the consumer buy 4 bags of pretzels. Which will totally cost $8.)
11. ANS: d. the substitution effect causes a decrease in the consumption of K and the
income effect causes an increase in the consumption of K. However, the substitution
effect is less than the income effect.
(Explain: When the price of K increases, K is more expensive relative to B. Under the
substitution effect, the consumer buy more B and less K.
At the same time, because K is an inferior good, when the price of K increases, the
consumer will feel poorer. Under the income effect, he will buy more of good K and less
of good B.
According to the definition of Giffen good, Giffen good is an inferior good, which the
income effect dominate the substitution effect.)
12. ANS: b. interest rate.
(According to PE textbook page 454, 21-4c)
13. ANS: a. work less than before.
(Explain: When wage decreases
encourage the worker to spend more hour for leisure. So under the substitution effect,
the worker will work less.)
14. ANS: a. After the interest rate falls, the substitution effect will induce Olivia to
consume more when she is young.
(According to PE textbook page 455, figure 16)

15. ANS: a. greater than the income effect.
(According to PE textbook page 452, figure 14)

Reference
Mankiw, N.G. (2015). Principles of Economics (7th ed).
Mankiw, N.G. (2007). Test Bank: Principles of Microeconomics (4th ed).

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INTERNATIONAL SCHOOL OF BUSINESS

Ten Principles of Economics

Economics: a study of how society manages its scarce resources

scarce resources are not allocated by dictators, but through combined

choice of households and firms

Principle 1: People Face Trade-Offs

Guns and Butter: Trade-off between a nati

Efficiency and Equity

Equity: Distributing prosperity uniformly among citizens (How the pie is

Principle 2: The Cost of Something is What You Give Up to Get It

Principle 3: Rational People Think at The Margin

Rational People do the best they can to achieve their objectives.

Marginal Change: an incremental change to an existing plan.

Making decision: Comparing between Marginal Cost and Marginal Benefits

E.g.: Plane tickets problem:

cost) for the airport.

Principle 4: People Respond to Incentives

indirect effects that work through incentives.

Principle 5: Trade Can Make Everyone Better Off

Trade allows people to specialize.

People would not be better off isolating themselves.

Principle 6: Markets Are Usually a Good Way to Organize Economics

Market Economy: allocates resources through decentralized decisions of

households and firms as they interact.

and cost of society to make them.

Principle 7: Governments Can Sometimes Improve Market Outcomes

Policies aim at promoting Efficiency or Equity.

Including Externalities and Market Power

Externalities: Impact on the well-being of bystanders. E.g.: Pollution affects

citizens living nearby

Market Power: Single economic actor has a substantial influence on market

prices. E.g.: Monopoly

Produce Goods and Services

input, primary determinant of a -being.

Growth rate of productivity determines the growth rate of average income.

Principle 9: Prices Rise When Government Prints Too Much Money

Inflation: An increase in overall level of price

Principle 10: Society Faces a Short-run Trade-off between Inflation and

1. Economists use the phrase "There is no such thing as a free lunch," to

illustrate the principle that

a. inflation almost always results in higher prices over time.

b. nothing is free in a market economy.

c. making decisions requires trading off one goal against another.

d. if something looks too good to be true, it probably is not worth pursuing.

2. Which of the following statements best represents the principle represented by

the adage, "There is no such thing as a free lunch"?

b. Greg is hungry and homeless.

3. When society requires that firms reduce pollution, there is

a. a tradeoff because of reduced incomes to the firms' owners and workers.

b. a tradeoff only if some firms are forced to close.

d. no tradeoff, since everyone benefits from reduced pollution.

increase to $8.18 million. Which of the following statements is correct?

b. The marginal cost of the 51st house, if it is built, will be $180,000.

c. If the company can experience a marginal benefit of $190,000 by building the

51st house, then the company should build it.

d. All of the above are correct.

room-and-board* expenses should be included?