Solutions to Exercises and Problems

Solutions to Exercises and Problems

Microeconomics for Business Decisions

Chapter Solutions 1

Chapter 1 Solutions

1.1 Statements a, c, e, g, and h deal with what are generally considered to macroeconomic issues — inflation, fiscal and monetary policy, government spending, and unemployment. Statements a, a, d, f, and j deal with what are typically regarded as microeconomic issues — the impact of unions and minimum wages on labor markets, antitrust laws, rent controls, import tariffs and quotas, pollution control, and income distribution.

Statements b, c, f, g, and j are positive statements, describing what is or what can be done. Statements a, d, e, h, and i are normative statements, describing what ought to be done. There is much more disagreement among economists where normative issues are concerned.

1.2 By law, nonprofit firms are not allowed to keep the profits that they generate. Profit can be used to provide additional goods or services, or to enhance the quality of service in future periods, however, thus giving the firms an incentive for profit maximization and efficient operation. There are additional benefits to performing efficiently; for example, charities that lower their operating expenses may attract more donors, and universities that lower tuition (while maintaining the quality of education) can attract better students.

1.3 Only a hypothesis that accurately predicts under conditions for which the prediction was made can be considered valid. The farmer’s hypothesis was easy to test. For three straight mornings the farmer gagged his rooster, thereby preventing the bird from crowing. Needless to say, the sun rose each of those three mornings, forcing the farmer to admit that his hypothesis was invalid.

1.4 This was not a good model to use. In the early 1980s, stock prices rose tremendously, but hemlines did not. While the pre-1980s data failed to refute a theory, they did not prove a theory. This example illustrates what is referred to as the false-cause fallacy: assuming cause-and-effect from two correlated, yet unrelated, occurrences. Even though stock prices and hemlines may have been highly correlated for fifty years, it does not follow that one event caused, or is caused by, the other.

1.5 You should agree — if not now, at least by the time you finish reading this textbook. As one example, consider the effect of inclement weather on agricultural markets. By causing a reduction in supply, higher equilibrium prices and lower equilibrium quantities are expected. This model can explain the jump in coffee prices between 1974 and 1975, when a frost damaged a large portion of Brazil’s coffee crop in 1974. In addition, the same model allows one to predict what will happen, for example, to U.S. orange prices in 1993 if both the Florida and California orange groves are damaged by frost in the winter of 1992, or to wheat prices in 1994 if U.S. wheat farms suffer from a long-lasting drought in the summer of 1993. Clearly, this model has both explanatory power and predictive ability.

1.6 Pure competition describes a market situation in which a homogeneous product is traded by many small buyers and sellers. Under perfect competition, two additional characteristics are present: easy entry and exit, and perfect knowledge.

Effective competition describes a market structure in which buyers and sellers act independently, even though the market is not pure or perfect. To be effective, the competitors must be comparable and the competitive process open and free. In a 1982 article entitled, “Cause of Increased Competition in the U.S. Economy, 1939-1980,” economist William G. Shepherd shows that between 1958 and 1980, the share of U.S. economic activity occurring in effectively competitive industries increased from 56.4 percent to 76.7 percent. Shepherd defines effective competition as a situation in which the four largest firms have less than forty percent of the market, market shares are unstable, pricing is flexible, there is little collusion, and profit rates and entry barriers are low.

1.7 A perfectly competitive market is characterized by many buyers and sellers, a homogeneous product, easy entry and exit, and readily available market information. The baseball card market meets all of these requirements. It is characterized by a large number of buyers and sellers — millions of baseball fans and serious collectors buy, sell, and trade baseball cards each year. The cards, which are certainly homogeneous, can be easily bought and sold through mail order advertisers and hobby publications, or by attending sport collectibles shows or conventions. Finally, numerous hobby publications release detailed, up-to-date card price information, and detailed player performance information is available from the sports sections of most major newspapers.

1.8 If barriers to entry were removed, the number of taxis in New York City would undoubtedly increase. Over time, the number of cabs would probably fluctuate, with more cabs on the streets during economic recessions, and fewer taxis around during economic booms. (Can you think of why this pattern would emerge?) The price of a medallion would obviously fall, perhaps to near zero.

1.9 Disputes over Indian water rights currently affect the availability of water for urban use in many western U.S. cities, including Tucson, Phoenix, Albuquerque, and Salt Lake City; for the expansion of hydro-power sources for Seattle and Tucson; and for the maintenance of non-Indian agricultural development in Arizona, Nevada, and Washington. Until these water rights are determined, the sale and transfer of existing rights will be severely impeded, since the prospective buyers cannot be certain they are receiving secure property rights.

1.10 Property rights play a key role in this transformation. For several generations, much of these nations’ productive assets have been owned by the state. If free markets and private enterprise are to replace the old command system, unambiguous and enforceable property rights must be assigned to a wide variety of economic factors of production and to existing economic and business organizations.

1.11 Probably not all the way to zero. Pollution levels could be reduced to zero, but only at a prohibitive cost. The Los Angelesbasin of Southern California, for example, could probably rid itself of most pollution simply by banning all automobiles, buses, and trucks, and by closing down all private and public industry. Clearly, the price for zero pollution is unacceptable to most people. More likely, each society will find some level of pollution that is acceptable, given the opportunity cost involved.

1.12 If property rights to air are assigned to the nonsmokers, smokers might try to pay the nonsmokers to let them smoke. If smokers held the rights, however, nonsmokers would have to pay smokers to not smoke. Transactions costs would probably prohibit any effective bargaining, however. By the time the passengers separated into groups (smokers and nonsmokers), elected spokespersons, and carried out negotiations, the plane would be ready to land!

Chapter 2 Solutions

2.1 When Robinson Crusoe is alone on the island, he must certainly face the first two fundamental questions: What to produce (fish and/or coconuts); How to produce (catch fish with a spear, with a net, with his hands). Since he is the only member of the economy, however, he doesn’t have to worry about the third question — For whom to produce? Anything he produces will be for his own consumption. Once Friday arrives on the island, all three economic questions are relevant.

2.2 Since efficiency involves using resources without waste, the situation in Spain cannot be considered as one of efficient production. With 20 percent of the labor force unemployed, the nation is certainly not getting the most output possible from its available labor resources. At 4 percent, however, this economy may be operating efficiently since a certain amount of “frictional” unemployment is required as resources are reallocated to alternative uses.

2.3 The distribution in an ideal communist state would be much more equal than the type of distribution generated in a capitalist society. For a strictly capitalist society, a more appropriate rule might be “to each according to ability — from each according to need.”

2.4

(a)

(b) If 800 turtles are being caught, 29 tons of fish can be caught, assuming efficient production (the island is operating on its PPC). If 84 tons of fish are being caught, the maximum number of turtles that can be caught is 300.

(c) With 300 turtles, you can catch 84 fish. If you get 100 more turtles, you can only catch 75 fish. You give up 84 – 75 = 9 fish.

(d) You must give up 100 turtles to get 6 fish. Therefore, to get 1 fish, you give up about 100/6, or 16 2/3, turtles.

(e) Consider the opportunity cost of catching turtles, starting at the point where the nation is catching 105 tons of fish and no turtles: to gain the 1st 100 turtles, you must give up 6 fish; to gain the 2nd 100 turtles, you must give up 7 fish; to gain the 3rd 100 turtles, you must give up 8 fish. Turtles are getting more expensive — the law of increasing opportunity cost does hold.

(f) At point E, inside the PPC, unemployment, under utilization, or inefficient use of their resources is taking place.

(g) Since this combination is outside the PPC, it is currently unattainable. The island would need more workers, more boats, a new technology, or perhaps specialization and trade with another island to reach point F.

2.5

(a) The first 1,000 Sno-Cones cost 15,000 – 10,000 = 5,000 sweaters.

(b) The third 1,000 Sno-Cones cost 6,000 – 3,000 = 3,000 sweaters.

(d) This does not seem realistic. It implies that, starting at point A, Freon would first divert those resources least suited to sweater production.

2.6 (a)

X:012345678910

Y:1009996918475645136190

(b) When X = 1, MRT = 2; when X = 4, MRT = 8; and when X = 8, MRT = 16.

(c) As you move down the PPC, the opportunity cost of producing more X increases. Note: The first unit of X costs 1 unit of Y; the last unit of X costs 19 units of Y.

(d) MRT = –(slope of PPC) = –∂Y/∂X = 2X.

2.7

(a, b) The opportunity costs (trade-offs) are constant: 1 fish for 3 coconuts for Robinson Crusoe, and 1 fish for 5 coconuts for Friday. See the graphs below.

(d) Robinson Crusoe: 1 more fish costs 3 coconuts; Friday: 1 more fish costs 5 coconuts. Robinson Crusoe has the comparative advantage in fishing; Friday has the comparative advantage in collecting coconuts (for Friday, 1 coconut costs 1/5 of a fish; for Robinson Crusoe, 1 coconut costs 1/3 of a fish).

(e) Robinson Crusoe should produce fish.

(f) 1 F for 1 C wouldn’t be acceptable to Crusoe. 1 F for 8 C wouldn’t be acceptable to Friday. In each case, they could each do better without trading. An acceptable exchange rate would be 1 fish for 4 coconuts (anything between 1 F for 3 C and 1 F for 5 C would be acceptable.)

(g) Crusoe can produce 16 F, trade 4 to Friday for 16 C, and Friday winds up with 4 F and 24 C.

2.8

(a) U.S.: 1 more unit of wheat costs 1 unit of oil; Saudi Arabia: 1 more unit of wheat costs 3 units of oil. The U.S. has a comparative advantage in wheat production; the Saudis have a comparative advantage in oil production.

(b) Acceptable terms of trade: 1 wheat for 2 oil. The U.S. can get 8 units of oil for their 4 units of wheat, giving them 96 wheat and 58 oil. Saudi Arabia ends up with 92 oil and 54 wheat.

2.9

(a) Point A represents unemployment, under utilization, or inefficient use of some resources.

(b) Point B represents a currently unattainable point.

(c) More natural gas can be produced with the existing level of resources. Since this increase in natural gas production does not influence fish production, the PPC will rotate as shown:

2.10 In 20 years, Thriftland’s economy will probably have enjoyed a higher rate of growth due to their larger investment in capital goods. This will enable them to produce more of both types of goods. See the following figure.

2.11

(a) Yes, for instance, Japan has high saving and investment rates while the U.S. does not.

(b) The scatter plot does show a strong positive correlation between investment rates and growth rates.

2.12 In the Soviet Union, the State Committee for Economic Planning (GOSPLAN) was responsible for drawing up and implementing the state’s economic plans. A key component of these plans was the materials balance — achieving a balance between Qd and Qs for all raw materials and intermediate goods used in the production of final consumer and capital goods. With literally billions of raw materials and intermediate goods to consider, the plans for materials balances alone filled 70 volumes, or 12,000 pages, each year.

2.13

(a) Sales = (125 x $1.00) + (75 x $0.60) + (20 x $0.75) + (10 x $1.00) = $195.00.

(b) TC = $40 + $3 + $13 + $2 + $4.50 [$4,500/1,000] + (125 x $0.36) + (75 x $0.33) + (20 x $0.33) + (10 x $0.40) = $142.85.

(d) Include forgone earnings = $60 ( = 8 hours x $7.50/hr). He is not earning an economic profit. TR – TC = $195 – $202.85 = $ –7.85.

(e) A typical implicit cost, forgone interest on money used to start the business, does not apply to Louie’s situation. His money would earn no interest in its next best alternative use — sitting under his mattress!

2.14 Some alternatives include: sales maximization, management utility maximization, and satisficing.

2.15

Chapter 3 Solutions

3.1

(a) Slope = –1/2. For every dollar increase in price, Qd falls by 500,000 bushels.

(b) Qd. = 25 million; Qd. = 20 million; Qd. = 17.5 million.

(d) $60.

(e) Inverse demand: p = 60 – 2Qd..

(f) Qd = 55 million; Qd = 50 million; Qd = 47.5 million.

(g) a normal good; an increase in demand.

3.2

Huey’sDewey’sLouie’sMarket

PriceDemandDemandDemandDemand

$2.00100010

1.50128020

1.001412834

0.5016161042

0.0018201250

3.3 The article confuses a change in demand with a change in quantity demanded. Lower prices do not cause an increase (shift) in demand, but merely a movement along a demand curve.

3.4 Some typical examples are macaroni & cheese, hamburgers, potatoes, and generic brand goods. Of course, just because you behave as if some good were inferior (your demand decreases when your income increases) doesn’t mean that the whole market will react the same way.

3.5

(a) QC = 24 – 25(2) + 8(2) + 10(4) = 30 pounds. (b) QC = 24 – 25pC + 16 + 40 = 80 – 25pC. (c) QC = 24 – 50 + 8M + 40 = 14 + 8M. See the figure. (d) ordinary demand curve; Engel curve. (e) QC = 24 – 50 + 16 + 10pB = –10 + 10pB. See the figure.

(f) ordinary demand; cross-price demand.

3.6 The demand for solar power and hydroelectric power — substitute goods — will probably increase. The demand for large cars — complementary goods — will probably decrease.

3.7

(a) Slope = 3. For every dollar increase in price, Qs rises by 3 million bushels. (b) Qs = 4.5 million bushels; Qs = 6 million bushels; Qs = 9 million bushels. (c) p = $2. (d) See graph.

(e) Qs = 7.5 million bushels; Qs = 9 million bushels; Qs = 12 million bushels.

(f) an increase in supply.

3.8 (a) pe = $2.00; Qe = 4 million. (b) Qd = 4.5 million; Qs = 2.5 million; shortage of 2 million. (c) Qd = 3 million; Qs = 7 million; surplus of 4 million. (d) See table. (e) higher pe; higher Qe.

PriceQd(after ads)

$1.00 7.0

1.50 6.5

2.00 6.0

2.50 5.5 <— pe = $2.50; Qe = 5.5 million.

3.00 5.0

3.9

(a) pe = $5; Qe = 20 million bushels.

(b) Qd = 16 million; Qs = 28 million; surplus of 12 million.

(d) pe = $4; Qe = 12 million bushels.

3.10

(a) Decrease in demand; pe and Qe both fall.

(b) Decrease in supply; higher pe and lower Qe..

(d) Decrease in demand; pe and Qe both fall.

(e) Decrease in demand; lower pe and lower Qe..

(f) Increase in demand; pe and Qe both rise.

3.11

(a) Increase in demand for dollars; value of dollar rises.

(b) Decrease in demand (or increase in supply) for dollars; value of dollar falls.

(d) Increase in demand (or decrease in supply) for dollars; value of dollar rises.

3.12

(a) He is willing to pay $10.50 for the 1st pancake breakfast.

(b) Value of the 2nd breakfast is $7.50.

(d) Total value = $10.50 + 7.50 + 4.50 + 1.50 = $24.

(e) Consumer surplus = $24 – 6 = $18.

(f)

3.13 400,000 people visit the park. Total monetary value = 0.5($20)(400,000) = $4 million.

3.14

(a) Qs = 6 million.

(b) Variable cost is equal to area acgh, or $18 million.

(d) Revenue = $4 x 6 million = $24 million, which is equal to variable cost + producer surplus.

3.15

(a) Consumer surplus = $250; producer surplus = $50.

(b) Upward. The new (inverse) supply is p = 26 + Q.

(c) New pe = $35; new Qe = 9 million bushels; price to consumers has risen $5; price received by producers has fallen $1.

(d) Consumers bear 5/6, or 0.833; producers bear 1/6, or 0.167.

(e) Tax revenue = $6(9) = $54.

(f) Consumer surplus = $202.50; Producer surplus = $40.50.

(g) CS has decreased by $47.50; PS has decreased by $9.50; the government collects $54; deadweight loss = $3.

3.16

(a) pe = 48, and Qe = 48. (b) See the following figure. Consumer surplus is area abv = [(96 – 48) x 48]/2 = 1,152 or $115,200 per week. Producer surplus is area vbs = [48 x 48]/2 = 1,152 or $115,200 per week.

(b) Consumer surplus is area abv = [(96 – 48) x 48]/2 = 1,152 or $115,200 per week. Producer surplus is area vbs = [48 x 48]/2 = 1,152 or $115,200 per week.

(d) At p = $24, Qs = 24. The quantity imported is 72 – 24 = 48.

(e) The new consumer surplus is area adt = [(96 – 240 x 72]/2 = 2,592. Consumers gain 2,592 – 1,152 = 1,440 or $144,000 per week. The new producer surplus is area gst = [24 x 24]/2 = 288 or $28,800 per week. Producers lose 1,152 – 288 = 864 or $86,400 per week. The gain to the domestic economy as a whole is area bdg = [(72 – 240 x (48 – 24)]/2 = 576 or $57,600 per week.

(f) The quantity of LUVs imported after the tariff is 60 – 36 = 24. Consumer surplus after the tariff is area acu = [(96 – 36) x 60]/2 = 1,800 or $180,000 per week. Domestic consumers are worse off after the tariff. Producer surplus after the tariff is area hsu = [36 x 36]/2 = 648 or $64,800 per week. Domestic producers are better off after the tariff.

(g) Total taxes = 12 x (60 – 360 = 288 or $28,800 per week. The domestic economy is worse off because consumer surplus after the tariff (1,800) plus producer surplus after the tariff (648) plus taxes (288) which totals 2,736 is less than consumer surplus with imports (2,592) plus producer surplus with imports (288) which totals 2,880.

(h) The deadweight loss is area cde + area hgf = 144 or $14,400 per week. The change in domestic welfare is 2,736 – 2,880 = –144, a $14,400 per week reduction.