# Chapters 15-16

Extra Stuff . . Chapter 15 . . Chapter 16

Answers to the questions of July, 2006

# Chapter 15 Efficiency and Monopoly

### Exploring Monopoly

1. Below is a table showing sales and marginal revenue. Compute total revenue and average revenue.

 Sales Marginal Revenue Sales Total Revenue Average Revenue First \$12 1 Second 11 2 Third 10 3 Fourth 9 4

If average costs are constant at \$9.50, the firm will maximize profits when sales are _______.

2. Below is a table showing sales and price (average revenue). Compute total revenue and marginal revenue.

 Sales Marginal Revenue Sales Total Revenue Price First 1 \$10 Second 2 9 Third 3 8 Fourth 4 7

If marginal costs are constant at \$8.50, the firm will maximize profits when sales are _______.

3. The first two columns in table below show a firm's supply curve for labor. Use them to compute the marginal resource cost column.

 Wage # of Workers Marginal Resource Cost Marginal Revenue Product \$10 1 \$10 \$17 \$11 2 \$12 \$15 \$12 3 \$14 \$13 \$13 4 \$16 \$11

What is the profit-maximizing number of workers to hire? What wage will the firm pay? 2, \$11
Suppose a union negotiates a wage rate of \$12.50. How many workers will the firm hire? 3 (Marginal resource cost is \$12.50 for the first three workers and \$14.50 for the fourth.)
Suppose a union negotiates a wage rate of \$15.50. How many workers will the firm hire? 1 (Marginal resource cost is \$15.50 for all four workers.)

4 Answer the following questions based on the following table, which contains cost and demand data for a monopolist.

 Quantity Marginal Cost Price Consumers Will Pay Marginal Revenue 1 \$7.40 \$10.00 \$10 2 7.40 9.50 9 3 7.40 9.00 8 4 7.40 8.50 7 5 7.40 8.00 6 6 7.40 7.50 5 7 7.40 7.00 4 8 7.40 6.50 3

a) If the price of this good is set at \$7.40, what will the size of the consumer surplus be?
Total value - Amount paid = \$(10+9.5+9+8.5+8+7.5)- 6*\$7.4 = \$52.5-\$44.4 = \$8.1
b) If this firm can charge only one price, what amount will it produce to maximize profits? (Hint: You need to compute marginal revenue.)
It will produce three. The fourth unit adds \$7 to revenue but \$7.40 to cost.
c) What price will it charge?
\$9.00
d) What is the size of the consumers' surplus in this case?
(\$10-\$9) + (\$9.5-\$9) + (\$9-\$)9 = \$1.50
e) How much of the consumer surplus from part a does the monopolist capture in this case?
3* (9.00-\$7.40) = 3*\$1.60 = \$4.80
f) Explain why this result will not be economically efficient.
Total surplus is \$1.50 to consumers plus \$4.80 that the seller captures, a total of \$6.30. A total of \$8.10 is possible. There is a deadweight loss of \$1.80 because the fourth, fifth, and sixth items are not purchased. The loss there is (\$8.50-\$7.40) + (\$8.00 - \$7.40) + (\$7.50- \$7.40) = \$1.10 + \$.60 + \$.10 = \$1.80.
g) If this firm can price-discriminate perfectly, how much will it produce?
It will produce six, charging \$10.00 for the first, \$9.50 for the second, etc. It will capture all the surplus value.
h) Explain why this result will be economically efficient.
There is no left-over value.

5. A firm can produce one million light bulbs at a total cost of \$1,000,000. It sells them for \$1.10 each, making a profit of ten cents per bulb. One of the executives finds that if they produce two million bulbs, total cost rises to \$1,500,000. This executive also finds that the company can sell these light bulbs abroad for \$.65 each. He argues that the firm should expand production and sell the extra bulbs abroad. Other executives argue that this plan is nonsense. They point out that if the firm produces two million bulbs, the average cost per bulb is \$.75. They state that no company can make a profit by selling its product for less than the cost of production.

Who is right in this case? Explain.
This is adapted from an situation Thomas Edison found himself in. The first executive is looking at marginal cost and revenue, which is the proper way. The extra revenue is \$.65 and the extra cost is \$.50. It is worth producing them. The other executives are looking at average cost and revenue, which is almost always a disastrous way to analyse the problem.

6. In order to price-discriminate, a seller must be able to separate its market into two parts. One part must contain those who are sensitive to price, and the other must contain those who are not. Explain how each of the following strategies separates buyers into these two groups:

a) A home computer maker offers a \$50.00 discount to any buyer who trades in another home computer or video game.
If those who already have a system are more price sensitive, then this method works.
b) Movie theaters charge a reduced admission for children under 12.
Children are usually are not willing to pay as much as adults, and parents of children are often not willing to pay as much for a child, who only understands parts of a movie, as they will for themselves.
c) Grocery stores charge lower prices on some items if people have coupons that they clipped from the paper.
Clipping coupons is a hurdle. Those who have the time clip them are usually more price sensitive.
d) Colleges that are prestigious and expensive give scholarships on the basis of need.
Without a price cut, few poor people will attend an expensive college.
e) Colleges that are not prestigious and not expensive give scholarships on the basis of academic ability.
Without a price cut, many students with high academic ability will not attend unprestigious colleges.
f) Economics journals charge libraries higher subscription rates than they charge individuals.
Individuals are more price sensitive--they can always go to the library to read the journal. If a library is at a research university, its mission is to provide the journals.
g) The American Economic Association has membership rates that are higher for those who earn large incomes than for those who earn small incomes.
High-income economists tend to be at research institutions, and they tend to get more benefit from the AEA. Hence, they are willing to pay more.

7) One of the most recognized names on the Internet is Priceline.com. It owes its success entirely to price discrimination.

Log onto <http://www.priceline.com/> and see how you would use it to buy airline tickets.

A key to effective price discrimination is to separate people willing to pay a lot for a good or service from those willing to pay only a little. Why would a person willing to pay a lot for an airline ticket be unlikely to buy it on Priceline.com? (Hint: What are the conditions Priceline imposes? Why are they imposed?)

Can you find any indication of how they decide which prices to accept and which to reject?

Why does Priceline offer the assortment of items that it does? Why does it not offer a different assortment of goods and services?

What prevents other companies from doing what Priceline does?

Tickets bought on Priceline.com cannot be refunded. They allow no discretion on time of departure or on the airline. If one wants flexibility, one cannot get it on Priceline.com. There is nothing to prevent other companies from price discriminating, which may mean that in a few years Priceline.com may no longer be here.

8. You are working for a small museum that is struggling to survive. Their daily costs of staying open are \$350 per day, and it does not matter how many people come. The museum tried charging a low entry fee of \$3 and attracted an average of 100 people per day. They then decided to charge more, \$10, but only attracted 30 people per day. They noticed at the higher price, they lost almost all visitors with children, but kept almost all the older visitors. What would you advise them to try next? Explain.

Price discriminate--give a discount to children.

9. Several years ago, Amazon.com was accused of "dynamic pricing." Search the internet for "dynamic pricing" and explain what they were supposedly trying to do.

They were trying to price discriminate.

10. Search the internet for the terms {"international editions" textbooks} and {"gray market" textbooks}. You should find an example of price discrimination. Explain what is going on.

Book companies price discriminate by charging different prices in the U.S. and in foreign countries. Some have tried to make a profit from the price difference with arbitrage.

11. Throughout the 1980s and during most of the 1990s, there were very few antitrust cases. At the end of the 1990s, however, the U. S government brought a case against Microsoft. In 2000, the trial judge found that Microsoft had behaved in ways that violated the law, and Microsoft appealed this verdict. Search on the Web to find the present status of the case, the central argument of the government, and the central argument of Microsoft.
The status of the case will change. The government argued that Microsoft used its near-monopolistic position in operating systems to create new positions of near monopoly elsewhere, which is illegal. Microsoft argued that it was innovating and serving the consumer.

12. From Edupage for July 31, 2000 (http://listserv.educause.edu):
"JUDGE BANS FORD FROM WEB CAR SALES IN TEXAS
"Ford will not be able to sell used cars over the Internet in Texas, and the Texas Department of Transportation acted within the law to crack down on the company's Web site, a federal judge ruled recently. Judge Sam Sparks said Ford's Preowned.com site was in violation of a state law that prevents carmakers from selling cars to consumers without a third-party dealer."

Texas consumers should be very happy that their state officials are so concerned about their well-being, and take quick action to protect them from the greed of big businesses such as Ford. Do you agree or disagree? Why or why not?
It is hard to see how this ruling will aid consumers. It is easy to see how it will aid car dealers. An economist would suspect that the original law was supported by the car dealers.

 Web ingrimayne.com

Extra Stuff . . Chapter 15 . . Chapter16

# Chapter 16 Transport Costs and Borders

1. Suppose that there are three sellers on the Hotelling beach. If initially each has one-third of the customers, where will they be located? Can anyone increase his share by moving? Why is the middle a poor place to begin? If the middle wants to survive, what must he eventually do? Can you see any equilibrium if all three continue to exist?
Initially they will be at 1/6. 1/2. and 5/6. The ends will move to the middle, squeezing its share. Eventually the middle must jump to the outside. There seems to be no equilibrium because whoever is in the middle wants to get out.

2 Answer the next three question using the production-possibilities frontiers of two countries given below:
 Purland Rurland Without trade, the best each country could do would be: a) 15 chocolate and 15 textiles. b) 20 chocolate and 20 textiles. c) 30 chocolate and 30 textiles. d) 60 chocolate and 60 textiles. Chocolate Textiles . . . Chocolate Textiles 30 0 . . . 60 0 20 20 . . . 40 40 15 30 . . . 30 15 10 40 . . . 20 20 0 60 . . . 0 30
If we unite these two countries and find their merged production-possibilities frontier, what do we get?

 Chocolate Textiles If they specialized and traded, each country could have which of the following bundles? a) 15 chocolate and 15 textiles. b) 20 chocolate and 20 textiles. c) 30 chocolate and 30 textiles. d) 60 chocolate and 60 textiles. 90 0 80 20 70 40 60 60 40 70 20 80 0 90

3. Jack can fetch 4 pails of water an hour or pick four pecks of peppers. Jill can fetch 2 pails of water an hour or pick three pecks of peppers. Each works by himself or herself for four hours. Derive their production-possibilities frontiers:

 Jack Jill Water Peppers Water Peppers 16 0 8 0 12 4 6 3 8 8 4 6 4 12 2 9 0 16 0 12

Jack wants to consume four pails of water every four hours. How many peppers can he consume? 12 Jill also wants four pails of water every four hours. How many peppers can she consume? 6 Explain how they can specialize (only partially for one of them) and trade and both be better off.

They are currently producing a total of 8 water and 18 peppers. If Jack produces 8 water and 8 peppers, and Jill produces zero water and 12 peppers, their totals are 8 water and 20 peppers. If Jill trades away 5 of her peppers for 4 water, she is left with 4 water and 7 peppers, an improvement. Jack will end with 4 water and 12 peppers, also an improvement.
Are they equally well off before trade? No Are they equally well off after trade? No Do the rich get richer and the poor get poorer, or do both the rich and the poor get richer?

Both improve.

Reflect on the implications of this example and the notion of comparative advantage. Does they say that only the best and brightest are useful in society, or that even people who are not very productive can be useful parts of society?

Even people who are not very productive can contribute and lift the living standard of society.

4. Dawn Key is a very successful businesswoman. She is also skilled in the domestic arts. Though she could clean her house in two hours, she prefers to hire a cleaning lady who spends five hours doing the same job. Though she is a skilled cook, she hires a caterer when she hosts a party. The caterer takes ten hours to prepare the food, whereas Ms. Key could do the same work in only six. Why do Ms. Key's actions make sense in terms of comparative advantage?
If Ms Key makes \$100 per hour, it would cost her \$200 to clean her house and \$600 to prepare for her party. She can almost certainly hire someone to work for her for less than that, someone who cannot make \$100 per hour.

5. Suppose that Crusoe can either catch 10 fish or gather 10 coconuts in 10 hours, and Friday can catch either 8 fish or 4 coconuts every 10 hours.
a) In terms of hours, what is the cost of fish to Friday? What is the cost of fish to Crusoe?
A fish costs Friday 1.25 hours. It cost Crusoe 1 hour.
b) In terms of hours, what is the cost of coconuts to Friday? What is the cost of coconuts to Crusoe?
A coconut cost Friday 2.5 hours. It costs Crusoe 1 hour.
c) Explain why this is not the way an economist would measure costs. What would the cost of fish and coconuts be to Friday and Crusoe under this alternative measure?
When they catch fish, the give up the opportunity to gather coconuts. When they gather coconuts, the give up the opportunity to catch fish. Once we see that, we can see that one coconut cost Friday two fish, and one fish costs Friday one-half a coconut. One coconut costs Crusoe one fish, and one fish costs him one coconut. Coconuts are more expensive for Friday than for Crusoe, and fish are more expensive for Crusoe than for Friday.
d) Suppose that before trade, Friday and Crusoe both spend five hours fishing and five hours gathering coconuts. What will their production and consumption bundles look like?
Their production and consumption bundles are the same. Friday gets two coconuts and four fish. Crusoe gets five coconuts and five fish. The total for both is seven coconuts and nine fish.
e) Explain the changes they can make so they both end with more consumption.
If Friday only gathers coconuts, he can get eight. If Crusoe only fishes, he can get ten. With specialization they gain one coconut and one fish. Both can be made better off with specialization and trade.

6. Though Adam Smith advocated free trade, David Ricardo was the first to clearly explain the idea of comparative advantage. For his explanation, he began with production costs similar to those shown in the following table.

 England Portugal 1 barrel of wine requires 1 man-day 1 barrel of wine requires 2 man-days 1 bolt of cloth requires 1 man-day 1 bold of cloth requires 3 man-days

If it took 3 man-days to produce a barrel of wine in England instead of 1, there would clearly be gains from trade. England would then have an absolute advantage in cloth, and Portugal would have an absolute advantage in wine. Ricardo, however, said that with the numbers above, even though England could produce both items with less labor, there were gains from trade. Let's see if you can re-create his reasoning below.

a) Using these data, compute the opportunity costs of wine and cloth below:

 In England In Portugal To get 6 barrels of wine, it must give up 6 bolts of cloth. To get 6 barrels of wine, it must give up 4 bolts of cloth. To get 6 bolts of cloth, it must give up 6 barrels of wine. To get 6 bolts of cloth, it must give up 9 barrels of wine.

(Hint: Producing 6 barrels of wine requires how many man-days? (For Portugal, 12.) If these man-days are taken away from cloth production, how much cloth production is lost? (12/3=4) Using 6 keeps fractions out of the results and makes computation easier.)

b) Based on the opportunity costs you computed, which country produces wine more cheaply? Which cloth?
Portugal produces wine more cheaply, and England cloth.

c) Suppose that 6 barrels of wine trade for 5 bolts of cloth. (This is the same as 6 bolts of cloth trading for 7 1/5 barrels of wine.) Would England find it cheaper to buy wine or produce it? To buy cloth or produce it? Would Portugal find it cheaper to buy wine or produce it? To buy cloth or produce it? Could mutually advantageous trade take place?
England: Produce 6 cloth, get 7.2 barrels of wine, which is better than it can do on its own. Portugal: if it wants 6 bolts of cloth, it can produce them and give up 9 barrels of wine, or it can trade 7.2 barrels. It is cheaper to produce wine and trade for cloth. Hence mutually advantageous trade can take place.

d) Suppose that 6 barrels trade for 7 bolts. Would England find it cheaper to buy wine or produce it? To buy cloth or produce it? Would Portugal find it cheaper to buy wine or produce it? To buy cloth or produce it? Could mutually advantageous trade take place?
England now finds it better to produce wine. It can produce six barrels of wine and trade them for 7 bolts of cloth. If it is self sufficient, it has to give up 7 barrels of wine to get 7 bolts of cloth. However, Portugal also finds it best to produce wine. If it produces six wine and trades the wine, it can get 7 bolts of cloth. If it is self-sufficient, it must give up over 9 barrels of wine to get 7 bolts of cloth. Since both want to produce wine, trade cannot take place at this ratio.

7. In order to help domestic automobile producers during the 1970s, the U.S. government sought ways to restrict sales of foreign automobiles, especially those made in Japan. In terms of a supply-demand diagram, the market would have allowed in Qe automobiles, but the government wanted only Qr to be sold. A restriction that accomplishes this goal will redistribute parts of the consumer and producer surpluses. (The parts that will be affected are labeled a, b, c, and d on the graph.)

a) One way to restrict is with a tariff. What would happen to areas a, b, c, and d with a tariff?
The tariff that restricts imports to Qr will give areas a and c to the government. These areas are the amount of tax that is transferred from the producers and consumers to the government. Areas b and d are lost. They are the efficiency cost of the tariff.

b) Another way to restrict is with a quota. A quota requires that the right to import be rationed in some way. Suppose that the government gave the right to import to domestic automobile companies. How would such a program have affected the four areas in the graph?
Domestic automobile companies gain areas a from consumers and area c from foreign producers. Area b is lost to domestic consumers and area d is lost to foreign producers.

c) The government established neither a tariff nor a quota. Rather, it negotiated an agreement with the Japanese by which the Japanese automobile manufacturers voluntarily limited their sales to the U.S. How would such an agreement affect the four areas?
Foreign manufacturers keep area c and gain area a from domestic consumers. Area b is lost by domestic consumers and area d is lost by foreign manufacturers. If area a is greater than area d, Foreign manufacturers are better off.

d) While Ronald Reagan was president, the agreement with the Japanese expired and he did not renew it. The Japanese automobile manufacturers, however, decided to continue limiting their sales to the U.S. Does this action indicate that the Japanese are poor businessmen?
It indicates that area a was bigger than area d. Unfortunately, this sort of analysis is way, way beyond what any of the journalists seem to be able to do.

8. When should we protect losers and when should we let them sink? Should we stop the following changes? If so, why? If not, why not?

a) New technology reduces the need for assembly workers by one half.
b) New technology makes an old product obsolete, shutting down the plants that made it.
c) Wal-Mart sells more efficiently than mom-&-pop retailers, forcing the latter out of business.
d) MacDonalds outcompetes mom-&-pop cafes, forcing the latter out of business.
e) Call-center workers in India produce customer service more cheaply than call-center workers in Atlanta, leading to layoffs in Atlanta.
f) Textile workers in China can produce shirts at half the cost of workers in the U.S., leading to the elimination of shirt production in the U.S.

Answers will vary. This is normative.

9. In addition to tariffs and quotas, safety and environmental regulations can be used to restrict international trade. One of the advantages of this form of protectionism is that it may not be declared illegal by the WTO. Search the internet and find what the WTO is. And then search news and the web for "safety" and "protectionism" and see if you can find examples of countries using regulations in an effort to protect their domestic producers. (Make sure you include those urls!)