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103 views88 pages

Solution To Pindyck

solution to Robert s Pindyck

Uploaded by

Ashish Shah
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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INSTRUCTOR’S MANUAL Nora Underwood University of Central Florida plngesolxonmrosblogepotcam CONTENTS. PART 1: Introduction: Markets and Prices Chapter 1 Preliminaries Chapter2 ‘The Basies Of Supply And Demand PART 2: Producers, Consumers, and Competitive Markets Chapter’ Consumer Behavior Chaptor 4 Individual And Market Demand Chapter 4 Appendix Chaptor 5 Uncortainty and Consumer Behavior Chapter 6 — Production Chapter 7 The Cost Of Production Chaptor7 — Appendix Chapter 8 Profit Maximization And Competitive Supply Chapter® The Analysis Of Competitive Markets PART 5: Market Structure and Competitive Strategy Chapter 10 Market Power: Monopoly and Monopsony Chapter 11 Pricing With Market Power Chapter 11 Appendix Chapter 12 Monopolistic Competition And Oligopoly Chapter 13 Game Theory And Competitive Strategy Chapter 14 Markets For Factor Inputs Chapter 15 Investment, Time, And Capital Markets ve, and the Role of Government Chapter 16 General Equilibrium And Economic Efficiency Chaptor 17 Markets With Asymmetric Information Chapter 18 Hxternalities And Public Goods epsingesolxcrarosniogrpotcam 23 aL 58 64 “ sa 98 102 ut 138 160 185, 191 a7 232 242 255 267 278 plngesolxonmrosblogepotcam Chapter 1: Preliminaries PARTI INTRODUCTION: MARKETS AND PRICES CHAPTER 1 PRELIMINARIES ‘TEACHING NOTES ‘The first two chapters reaccuaint students with the mieroceonomics that they leamned in their Introductory course: Chapter 1 focuses on the general subject of economies, while Chapter 2 develops supply and demand analysis. ‘The use of examples in Chapter 1 fucilitates students’ complete ‘understanding of abstract cconomie concepts. Examples in thie chapter discass markets for preseription drugs (Section 1.2, introduction of a new automobile (Section 1, design of automobile emission standards (Section 1.4}, the minimum wage (Section L’), the market for sweeteners (Section 1.2), and real and nominal prices of eges and education (Section 1). Discussing some of these, ot another, example is useful way bo review some important economic concepts such as scarcity, making tradeofls, building economic models to explain how consumers and firms make decisions, ond the Uistinction between competitive and non-competitive markets. Parts [and Il of the text assume competitive markets, market power is discussed in Patt Ill, and some consequences of market power ‘ane discussed in Part IV ofthe text Review Question (2) illustrates the difference between postive and normative eeanonsies and provides for a productive class diseussion. Other examples for diseussion are available in Kear, Pope, Whiting, and Wimmer, “A Confusion of Ecanomista,” American Economie Review (May 1979) ‘The chapter concludes with a discussion of real and nominal prices. Given our teliance on dollar prices inthe chapters that follow, students should understand that we ate concerned with prices relative toa standard, which in this case is dollar for a particular year. QUESTIONS FOR REVIEW 1. Tt is often said that a good theory is one that ean be refuted by an empirical, data- oriented study. Explain why a theory that cannot be evaluated empirically is not & good theory. ‘There are two steps to consider when evaluating a theory: frst, you should examine the reasonability of the theory's assumptions: second, you should test the theory's ‘predictions by comparing them with facts. If a thecry exnnot be tested, st eannot be accepted oF rejected. Therefore, it contributes ite to our understanding of reality 2. Which of the following two statements involves positive economic analysis and which normative? How do the two kinds of analysis differ? Gasoline rationing (allocating to each individual a maximum amount of gasoline that can be purchased each year) isa poor social policy because it interferes with, the workings of the competitive market system. Positive economic analysis describes what ia. Normative economic analysis describes what ought to be. Statement (a) merges both types of analysis. Fist statement (a) ‘makes a positive statement that gasoline rationing “interferes with the workings of the ‘competitive market systems.” We Itow from economic analysis that a constenint placed fon supply will change the market equilibrium. Second, statement (a) makes the normative statement (Le, a value judgment) that gasoline rationing isa “poor social poles.” Thus, statement (a) makes a normative eamment based on a enelusion derived from positive economic analyst af the policy epsingesolxcrarosniogrpotcam plngesolxonmrosblogepotcam Chapter 1: Preliminaries b. Gasoline rationing is a policy under which more people are made worse off than are made better off Statement (b) is positive becauee it states what the effect of gasoline rationing is ‘without making a value judgment about the desirability ofthe rationing policy. 8. Suppose the price of unleaded regular octane gasoline were 20 cents per gallon higher in. ‘New Jersey than in Oklahoma. Do you think there would be an opportunity for arbitrage (Gio, that firms could buy gas in Oklahoma and then sell it at a profit in New Jersey)? Why or why not? Oklahoma and New Jersey represent separate geographic markets for gasoline because of high transportation costs, If transportation costs were zoro,a price inereage in New Jersey would prompt arbitrsgeurs to buy gasoline in Oklahoma and sell it in New ‘Jersey, Tt is unlikely in this eas chat the 20 cents per gallon difference in costs would be high enough to erate a profitable opportunity for arbitrage, given beth transactions costs and transpartation costs 4. In Example 1.3, what economic forces explain why the real price of egus has fallen while the real price of a college education has Increased? How have these changes affected consumer choices? ‘The price and quantity of goods (e.g exas) and services (ea cole education) are determined by the interaction of supply and demand. The real peice of eggs fell from 1970 to 1985 because of either a reduction in demand (consumers switched to lower cholesterol food), a reduction in production costs (improvements in egy production technology), oF both. In response, the price of eggs relative to other foods deereased, ‘The real price of «college education rose because of either an increase in demand (e.. ‘more people recognized the value of an education), an increase in the cost of education (Increase in staff salaries), oe bath 5. Suppose that the Japanese yen rises against the US. dollar that is, it will take more dollars to buy any given amount of Japanese yen. Explain why this increase simultaneously increases the real price of Japanese cars for U.S. consumers and lowers the real price of US. automobiles for Japanese consumers, ‘As the value of the yen grows relative to the dollar, mone dollars exchange for fewer yen. Assume that the costs of production for both Japanese and US. automebiles emain unchanged. ‘Then using the new exchange rate, the purchase of a Japanese automobile priced in yen requires more dollars. Similarly, the purchase of a U.S ‘automobile pried in dollars require fewer yen. 6, ‘The price of long-distance telephone service fell from 40 cents per minute in 1996 to 22 1999, a 45-percent (18 cents/40 cents) decrease. The Consumer Price sreased by 10-pereent over this period, What happened to the real price of telephone serviee? Let the CPI for 1996 equal 1 and the CPI for 1999 equal 11, whieh reflects a 10% increase in the overall prie level, To find the real price of telephone service in each period, divide the nominal price by the CPI for that sear. For 1996, we have 4D/l or 40 fonts, and for 1999, we have 22/11 or 20 cents. The real price therefore fel fom 40 to ‘2Deunte, a 50% decline. epsingesolxcrarosniogrpotcam plngesolxonmrosblogepotcam Chapter 1: Preliminaries EXERCISES: 1. Decide whether each of the following statements is true or false and explain why: a. Fast food chains like MeDonale’s, Burger King, and Wendy's operate all over the United States. Therefore the market for fast food is a national market. ‘This statement is false. People generally buy fastfood within their current lecation and do not travel large distances acres the Unived States just to buy a cheaper fast food meal. Given thore is little potential for arbitrage betvcon fast food restaurants ‘hat ane leated some distance fiom each other, there are likely to be maliple fast fod markets oerose the country b. People generally buy clothing in the city in which they live. ‘Therefore there is a clothing market in, say, Atlanta that is distinct from the clothing market in Los Angeles, "This statement is false, Although consumers are unlikely to travel across the country to bay clothing, suppliers ean easly move clothing from ene part of the country to another. ‘Thus, if clothing is more expensive in Atlanta than Las Angeles, clothing ‘companies could shift upplies to Atlanta, which would reduce the price in Atlanta, ‘ceasionaly, there may bon market for a specific dothing item in a faraway market that results in a great opportunity for arbitrage, such as the market for blue jeans in the old Soviet Union, cc. Some consumers strongly prefer Pepsi and some strongly prefer Coke, Therefore there is no single market for cols. ‘This statement is false. Although some people have strong preferences for @ particular brand of cola, the diferent brands are similar enough that they constitute one market, ‘There are consumers who do nat have string preferences for one type of cola, and there are consumers who may have a preference, but who will also be infkienced by price Given these possibilities, the price of eola drinks will not tend to differ by very much, particularly for Coke anvi Peps 2. The following table shows the average retail price of butter and the Consumer Price Index from 1980 to 2001. Tos) 198 1990105 —~ BDO 0OT crr 100 130.88 158562 18495 208.98 214.98 Retail Price ofbutter $1.88 $2.12«$1.89 $161 82.52 $8.80 (alted, rade AA, per lb) a. Calculate the real price of butter in 1980 dollars. Has the veal price inereased/decreased/stayed the same since 1980? Ph, Real price of butter in year X= 78. nominal price in year X 1980 1985 1990 1995 2000 2001, SISS $1.62 $125 $087 S121 $15 Since 1980 the real pre of butter has decreased epsingesolxcrarosniogrpotcam plngesolxonmrosblogepotcam Chapter 1: Preliminaries Ws War ith prcntge change nol pric (dali) om BT Conese CPtin890= 10 and een heel eet tern 08 ls mile New 1980 631 Real priceof mille 1980 $2.98 1985 28 ess §2.58 1990100 1990 $1.99 19951166 1995 $1.28 2000 131.8 2000 $1.91 20011356 2001 $2.48 4d. What is the percentage change in the real price (1990 dollars) from 1980 to 2001? Compare this with your answer in (b). What do you notice? Explain. 243-298) 295 answer is almost identical (except for rounding ero) to the answer received for part b Tt does not matter which years chosen asthe base yea Percentage change in real price from 1980 to 200 0.18 =-18%. This 3. At the time this book went to print, the minimum wage was $5.15. ‘To find the cmrent. minimum wage, go to httpziwws:[Link]/[Link] Click on: Consumer Price Index- All Urban Consumers (Current Series) Select: US. All items ‘This will give you the CPI from 1913 to the present. ith these values, calculate the current real minimum wage in 1990 dollars. Plas 1307 real minimum wage 2008 = STH + 5.15— Pligg 163 b. What is the percentage change in the real minimum wage from 1985 to the present, stated in real 1990 dollars? *5.15= $4.13, 1985 was 88:35. Then, , _1307 Assume the minimum wage fo veal minimum wage 1985 = Plo «35-307 4 5.35 4.07 ee CPs 107.6 s "The pereentage change in the real minimum wage is therefore $134.07 _ 6.0147, or about 1.5%. ‘407 epsingesolxcrarosniogrpotcam plngesolxonmrosblogepotcam Chapter 2: The Basies of Supply ond Demand CHAPTER 2 THE BASICS OF SUPPLY AND DEMAND ‘TEACHING NOTES "This chapter veviews the basics of supply and demand that students should he familiar with from their introductory economies elass. The instructor ean choose to spend more or Tess time on this chapter depending on how much of @ review the students require, ‘This chapter departs from the Standard treatment of supply and demand basics found in most other intermediate microsconomics texthooks by discussing some of the world's most important markets (wheat, gasoline, and automobiles) and teaching students how to analyze these markete with the tools of supply and demand. ‘The real ‘world applications ofthis theory ean be enlightening for students. Some problems plague the understanding of supply and demand analyeis. One of the most ‘common sources of confision is between movements along the demand curve and shifts in demand. ‘Through a discussion of the cxteris paribus assumption, stress that when representing a demand function (either with a graph cr an equation), all other variables are held constant. Movements alang the demand eurve aceur onty with changes in price. As the omitted factors change, the entire demand function shifts. Tt may also be helpful to present an example of a demand function that depends not ‘only on the price of the good, but also on income and the price of other goods directly. ‘This helps Students understand that these other variables are actually in the demand function, and are merely Iumped into the intercept term of the simple linear demand function. Example 29 includes an example of a demand and supply function which each depend on the price of a. substitite good Shudents may also find a review of how to solve two equations with to unknowns helpful. In general, it isa good idea at thie point to decide on the level of math that you will ue in the class, Ifyou plan to use a Tot ofalgebra and calculus it isa good idea to introduce and review it early on. ‘To streas the quantitative aspects of the demand curve to students, make the distinction between quantity demanded as a function of price, Q'= D(P). and the inverse demand function, where price is a funetion of the quantity demanded, P= D"(Q). This may larity the positioning of price on the Yeas and quantity on the Xai. Shudents may also question how the market adjusts to a new equilibrium. One simple mechanism is the partialadjustment oabweb model. discussion of the exbwcb model ¢hased on trauitiona corm hog eyele or any ether example) add a eortain walism to the diseussion and is much appreciated by students. If you decide to write down the demand function 20 that income and other prices are visible variables in the demand function, you ean also do some interesting examples, which explore the linkages bebween markets and how changes in one market affect price and quantity in other markets Although this chapter introduces demand, income, and exoss-prce elasticities, you may find it ‘mace appropriate to return to income and eos-pree elasticity after demand elastiety is reintroduced in Chapter 4. Students invariably have a dificult time with the concept of elasticity. It is helpfal to fplain clearly why a firm may be interested in estimating elasticity. Use concrete examples. Por example, a Wall Street Journal article hack in the spring of 1998 discussed how elasticity could be used bby the movie industry so that different movies could have different ticket prices. This example tends to 0 over well as college students watch a lot of movies. This type of discussion can also be postponed “until revenue is discussed epsingesolxcrarosniogrpotcam plngesolxonmrosblogepotcam Chapter 2: The Basies of Supply ond Demand QUESTIONS FOR REVIEW 1. Suppose that unusually hot weather causes the demand curve for ice cream to shift to the right. Why will the price of ice cream rise to a new market-clearing level? Assume the supply eurve is fixed. ‘The unusually hot weather will eause a rightward shift in the domand curve, creating short-run excoss demand at the current price Consumers will begin to bid against each other for the ice cream, putting upward prrossure on the pries. The price of ee cream will rise until the quantity demanded and ‘the quantity supplied are equal Price @ Quantity lee Cream Figure 21 2. Use supply and demand curves to illustrate how each of the following events would affect the price of butter and the quantity of butter bought and sold: a. Aninerease in the price of margarine. Most people consider butter and margarine tobe substitute goods. An increase in the price of margarine will cause people to inerease their consumption of butter, thersby shifting the demand curve for butter out from D, to D, in Figure 22a. ‘This shift in demand will eause the equilibrium price to rise from P, to P, and the equilibrium quantity to increase from Q, to Q. epsingesolxcrarosniogrpotcam plngesolxonmrosblogepotcam Chapter 2: The Basies of Supply ond Demand Price ef---- a ‘Quantity of Butter Figure 22a ‘An increase in the price of milk, Miles the main ingeediont in butter, An nerease in the price of mille wil increase the cost of producing butter. ‘The supply curve fr butter wll shi frm S,toS, in Figure 22}, resulting ina higher eyulbrium price, #, covering the higher production ests, and a lower equilibrium quantity, Price @@ Quantity of Butter Figure 22 ‘Note: Given that butter is in fact made from the fat that is ekimmed off of the mill batter and mill ave jot products. Ie you ave aware ofthis relationship, then your answer will change. In this ease, as the price of milk increases, so does the quantity supplied. As the quantity supplied of mill increases, there isa larger supply of fat available to make butter. ‘Tis wil shift the supply of butter curve tothe right and ‘the price of butter wil fall epsingesolxcrarosniogrpotcam plngesolxonmrosblogepotcam Chapter 2: The Basies of Supply ond Demand fe. — Adeerease in average income levels. Assume that butter it a normal good. A decrease in the average income level willeause ‘the demand curve for butter to shift from D, to D, Tis will result in a decline in the ‘equilibrium price from P, to P, and a deline in the equilibrium quantity from Q, to Qa See Figure 2:26 Price @ @ ‘Quantity of Butter Figure 22¢ 3. Ia S:percent increase in the price of corn flakes eauses a 6-percent decline in the ‘quantity demanded, what is the elasticity of demand? "The elasticity of demand is the percentage change in the quantity demanded divided by Sh yong changin th pi. Th tt ofan crn ki “= ‘This is equivalent to saying that a 1% increase in price leads to a 2% decrease in quantity demanded. This isin the elastic region of the demand curve, where the clasticity of domand exeoods “1.0 4. Explain the difference between a shift in the supply curve and a movement along the supply curve. ‘A movement along the supply curve is caused by a change in the price or the quantity ‘of the good, since these ate the variables on the axes. A shif of the eupply curve in caused by any other relevant variable that causes a change in the quantity supplied at any given price. Some examples are changes in production costs and an inerease in the numberof firms supplying the produc. 5. Explain why for many goods, the long-run price elasticity of supply is larger than the short-run elasticity. ‘Tho elasticity of supply is the percentage change in the quantity supplied divided by the percentage change in price. An metease in price induces an mcreare in the ‘quantity supplied by firms. Some firms in some markets may respond quiekly and cchoaply to price changes. However, other firms may be constrained by thoir production fapacity in the short mun, The firms with short-run capacity constraints will have a shortun supply elasticity that is less elastic. However, in the long run all firms ean increase their scale of production and thus have a larger long-run price elasticity epsingesolxcrarosniogrpotcam plngesolxonmrosblogepotcam Chapter 2: The Basies of Supply ond Demand 6. Why do long-run elasticities of demand differ from short-run elasticities? Consider two goods: paper towels and televisions. Which is a durable good? Would you expect the price lasticity of demand for paper towels to be larger in the short-run or in the long-run? Why? ‘What about the price elasticity of demand for televisions? Longerun and short-run elasticities differ based on how rapidly consumers respond to price changes and how many substitutes are available, If the pre of paper towel, a ‘non durable good, were to inereace, consumers might react only minimally in the short un. Inthe long nm, however, demand for paper towels would be more clastic aa new substitutes entered the market (auch as sponges or kitchen towels). In contrast the ‘quantity demanded of durable goods, such as televisions, might change dramsatially in the short run following a price change. For example, the initial result of a price increase for televisions would cause consumers to delay purchases because dutable goods are built to last longer, Bventually consumers must replace their televisions as ‘they wear out or become obsolete, and therefore, we expect the demand for durables to bbe more inelastic in the lang run, 7. Are the following statements true or false? Explain your answer. a. The elasticity of demand is the same as the slope of the demand curve. False. Elasticity of demand is the percentage change in quantity demanded for a given percentage change in the price of the product. ‘The slope of the demand curve is the change in price for a given change in quantity demanded, measured in unite of output. Though similar in definition, the units for each measure are differont. b. The cross price elasticity will always be positive. Falco. ‘The erors price elasticity monsures the percentage change in the quantity demanded of one product for a given percentage change in the price of snother product ‘This elasticity will be postive for substitutes (an inerease in the price of hot dogs is likely to cause an increase in the quantity demanded of hamburgers) and negative for ‘complements (an inerense inthe price of hot dogs is likely to cate a decrease in the ‘quantity demanded of hot dog buns) ‘The supply of apartments is more inelastic in the short run than the long run. ‘True. In the short-run it is difficult to change the supply of apartments in response toa change in price. Increasing the supply requires canstructing new apartment buildings, ‘hich ean take a year or more. Since apartments are a durable good, inthe long run a change in prio will induce cupplirs to create more apartments (f price increases) or delay construction if price decreases) 8, Suppose the government regulates the prices of beef and chicken and sets them below their market-clearing levels, Explain why shortages of these goods will develop and what factors will determine the sizes of the shortages. What will happen to the price of pork? Explain briefly. If the price of a commodity is set below its market-denring level, the quantity that firms are willing to supply is less than the quantity that consumers wish to purchase. ‘The extent of the excess demand implied by this response will depend on the relative clastcties of demand and supply. For instance, if both supply and demand are elastic the shortage is Langer than if both are inelastic. Factors such as the willingness of consumers to eat less meat and the ability of farmers to change the size of their herds land hence produce less will determine these elasticities and influence the sie of excess demand, Customers whose demands are not met will attempt to purchase substitutes, thus increasing the demand for substitutes and raising their prices, If the prices of beef and chicken are sct below mavkct-clearing levels, the price of pork will Tse, ‘assuming that pork sa substitute for beet and chieken, epsingesolxcrarosniogrpotcam plngesolxonmrosblogepotcam Chapter 2: The Basies of Supply ond Demand 9. The eity couneil of a small college town decides to regulate rents in order to reduce student living expenses. Suppose the average annual market-clearing rent for a two- bedroom apartment had been $700 per month, and rents are expected to increase to $900, within a year. The city council limits rents to their current $700 per month level. Draw a supply and demand graph to illustrate what will happen to the rental price ofan apartment after the imposition of rent controls. ‘The rental price will stay at the old equilibrium level of $700 per month. The expected increase to $900 per month may have been caused by an increase in demand. Given this is true, the price of $700 will be Below the new equilibrium and ‘there will bea shortage of apartments, b. Do you think this policy will benefit all students? Why or why not [t will benefit those students who get an apartment, though these students may also find thatthe costs of searching for an apartment are higher given the shortage of apartments. Those students who do not get an apartment may face higher asta asa result af having to live outside ofthe calleye town. ‘Their rent may be higher and the ‘transportation costs wil be higher. iscussion of tuition rates, a university official argues that the demand for ‘completely price inelastic, As evidence she notes that while the university has doubled its tuition (in real terms) over the past 15 years, neither the number nor quality of students applying has decreased, Would you accept this argument? Explain briefly. (Hint ‘The official makes an assertion about the demand for admission, but does she actually observe a demand curve? What else could be going on) If demand is fixed, the individual firm (4 university) may determine the shape of the demand curve it faces by raising the price and abserving the change in quantity sold, ‘The university official is not observing the entire demand curve, but rather only the equilibrium price and quantity over the last 15 years. If demand is shifting upward, az supply shifts upward, demand could have any elasticity. (See Figure 27, for example.) Domand could be shifting upward because the value of a colloge education has increased and students are willing to pay a high price for each opening. More market research would be required to support the eonelusion that demand is completely price Price Quantity Pigure 2.10 10 epsingesolxcrarosniogrpotcam plngesolxonmrosblogepotcam Chapter 2: The Basies of Supply ond Demand 1LL. Suppose the demand curve for a product is given by Q-10-2P+P., where P is the price of the product and P, is the price of a substitute good. The price of the substitute good is $200, a, Suppose P=$1.00. What is the price elasticity of demand? What is the cross- price elasticity of demand? First you nee to find the quantity demanded at the price of $1.00 Price elasticity of demand = "AG | Oar 0) 0-202 (Cross-price elasticity of demand: b. Suppose the priee of the good, P, goes to $2.00. Now what is the price elastielty of demand? What is the eross-price elasticity of demand? Firat you need to find the quantity demanded atthe prio of $200, Q=10.2(2)+2=8, Price clastiety of deman Cross-price elasticity of demand = ()=025 12, Suppose that rather than the declining demand assumed in Example 2.8, a decrease in the cost of copper production causes the supply curve to shift to the right by 40 percent. How will the priee of eopper change? If the supply curve shifts to the right by 40% then the new quantity supplied will be 140 perent of the old quantity supplied at every priee. The new supply eurve is therefore QU= 14%(4.5416P) = 6.54224P. To find the now equilibrium price of copper, set the ‘now supply equal to demand so that -6.2422.4P=18.5.8P, Selving for price results in PGs cents per pound for the new equilibrium price. ‘The price decreased by 10 cents per pound, or 13.3 18, Suppose the demand for natural gas is perfectly inelastic. What would be the effect, if any, of natural gas price controls? Ifthe demand for natural gas is perfectly inelaste, then the demand eurve is vertical Consumers will demand a eortain quantity and will pay any price for thie quantity. In ‘his ease, a pice control will have no effect on the quantity demanded. u epsingesolxcrarosniogrpotcam plngesolxonmrosblogepotcam Chapter 2: The Basies of Supply ond Demand EXERCISES 1 Suppose the demand eurve for a product is given by Q=800-2P-4I, where I average income measured in thousands of dollars. The supply curve is Q=IP-50. 2. 1125, find the market clearing price and quantity for the product. Given 195, the demand curve becomes Q=300-2P+1*25, or Q=400-2P. Setting demand ‘equal to supply wo ean solve for Pand then Q 4002P=3P-50 11-90, find the market clearing price and quantity for the product. Given 150, the demand eurve becomes Q=300-2P+1750, or Q=500-2P, Setting demand ‘equal to supply we can solvefor Pand then 500-2P=3P-50 P=110 Q=280. Draw a graph to illustrate your answers. Equilibrium price and quantity are found at the intersection ofthe demand and supply. ceurves. When the income lovel increases in partb, the demand curve will sift up and tothe right. The intersection of the new demand curve and the apply carve is the new ‘cquilibrium poi Consider a competitive market for which the quantities demanded and supplied (per year) at various prices are given as follows: Price Demand Supply ” nitions) nitions) 60 a “ 100 18 18 Calculate the price elasticity of demand when the price is $80 and when the price is $100. ‘We know that the price elasticity of demand may be caleulated using equation 2.1 from the test: 200 Qn P AQy POMP “Oy aP = ‘With cach price increase of $20, the quantity demanded decreases by 2. Therefore, (208) 2 ay roe AtP=80, quantity demanded equals 20 and 2 epsingesolxcrarosniogrpotcam plngesolxonmrosblogepotcam Chapt 2 he Basics of Supply onl Demand 30) £,-(2)-0y--040 (Boy Sindy at = 200, quatity demanded equals 18 and 100} 220) -a4 Gale Calculate the price elasticity of supply when the price is $80 and when the price is ‘100. ‘Theelasticty of supply is given by: 056. Qs GP AQ PSA oP - ‘Ws each voices of $20, quantity suppl increases hy. Therein (203) 2 (2:)-2-01 At P= 80, quantity supplied equals 16 and 1 £,-(!®)eo a What are the equilibrium price and quantity? ‘The equilibrium price and quantity are found where the quantity supplied equals the quantity demanded at the same price. As we see from the table, the equilibrium price is $100 and the equilibrium quantity is 18 milion, ‘Suppose the government sets a price ceiling of $80. Will there he a shortage, and if 0, how large will it be? With a price coiling of $80, consumers would like to buy 20 million, but producers will supply only 16 million. This will result ina shortage of 4 milion, 056, 3. Refer to Example 25 on the market for wheat, At the end of 1998, both Brazil and Indonesia opened their wheat markets to US. farmers. Suppose that these new markets ada 200 million bushels to U.S. wheat demand. What will he the free market price of wheat and what quantity will he produced and sold by U.S. farmers in this ea: ‘The ollowing equations deseribe the market for wheatin 1998: Q 44 + 207P and Q,=8244- 2807, 18 Beil and Indonesia ad an additional 200 milion bushels of wheat co US. wheat demand, the new demand eurve would be equal 9 @, +200, or p= (244-2830) +200= MAL 2807, Equating supply and the new demand, we may determine the new equiibsium price 1944 +207P 3444-2897. oF a epsingesolxcrarosniogrpotcam plngesolxonmrosblogepotcam Chapter 2: The Basics of Supply ond Demand 490P = 1500, or P* = $3.06122 per bushel ‘Tofind the equilibrium quantity, substitute the price into ether the supply or demand equation, eg Q.= 1944 + 078.0612) = 287 67 and y= 444 2839106122) =2,5767 4, A vegetable fiber is traded in a competitive world market, and the world price is $9 per pound. Unlimited quantities are available for import into the United States at this price. ‘The US. domestic supply and demand for various price levels are shown below. ive US Supply US Demand (nillion Ibs) (million tbs.) 2 ” 4 28 6 2 he 8 16 hs 0 10 lis 2 ‘ 1. What is the equation for demand? What is the equation for supply? "The equation for demand is ofthe farm Qra-bP. First find the slope, which is AQ _-6 PS Increases by 8, quantity demanded falls by 6 milion pounds, Demand is now Q=a-2P. ‘To find a, plug in any ofthe price quantity demanded points from the table: 28h so that a=d0 and demand is Q=i0-2P. 2=-b. You can figure this out by noticing that every time price ‘The equation for supply is ofthe form Q 422 aap 374 Yosean owes noticing that every ine einen by ‘quantity supplied increases by 2 million pounds, Supply is now Q= c+ P. Tofind 4+€P. First find the slope, which is day =2 scythe e228 2 2H 98n tsi ofan pias ©. Whats the price elasticity of supply at 85? AtS12? FQ _9(2) Oar 6 u Elasticity of supply at P=9 is epsingesolxcrarosniogrpotcam plngesolxonmrosblogepotcam Chapter 2: The Basics of Supply ond Demand PAaQ_12/2)_24 Elasticity of supply at P=azie £42 - 12(2)_24_ 19 ay eaupey ak OP 2G)" 4. Ina free market, what will be the US. price and level of fiber imports? With no restrictions on trade, world price wil be the price in the United States, so that 'P=$9, A this price, the domestic supply is 6 milion Ibs. while the domestic demand is ‘22million Iba. Imports make up the diference and are 16 million Ibs. 5, Much of the demand for US. agricultural output has come from other countries. In 1998, the total demand for wheat was Q= 3244 -283P. Of this, domestic demand was Q, = 1700 107P. Domestic supply was Q,= 1944 +207P. Suppose the export demand for wheat falls by 40 percent. & US. farmers are concerned about this drop in export demand. What happens to the free market price of wheat im the United States? Do the farmers have much reason, toworry? Given total demand, Q= 8244 - 283P, and domestie demand, Q,= 1700 -107P, we may subtract and determine export demand, Q,= 1544 - 176P. ‘The initial market equilibrium prie is found by seting total demand equal ta supply: 8244. 288P = 1944 + 207P, or P=s2.85, ‘The best way to handle the 40 percent drop in export demand is to aasume that the export demand curve pivots down and to the left around the vertial intercept so that at all prices demand decreases by 40 pereent, and the reservation price (the maximum price thatthe foreign country is willing to pay) does not change. Ifyou instead shifted ‘the demand curve down to the lef in a parallel fashion the effect on price and quantity will be qualitatively the same, but wil differ quantitatively. ‘The new expart demand is 6Q.=0.6(1544. 176P)=826-4-105.6P. Graphically, export demand hoa pivoted inmearde as lustyated in figure 2a below ‘Total demand hecomes Qp= Q + 06Q. = 1700- 107P + 926.4-105.61 2626.4- 212.67. 877 Q 9264 1544 Figure 25a 1 epsingesolxcrarosniogrpotcam plngesolxonmrosblogepotcam Chapter 2: The Basics of Supply ond Demand quating total cupply and total demand, 1944+ 207P = 2626.4. 212.67, or P=S1.63, ‘whichis a significant drop from the market-clearing pve of $265 per bushel. At this Dice, the market-clearing. quantity is 228065 million bushels. Total revenue has Alecreased from $6614.6 million to $3709.0 million. Most farmers would worry ‘Now suppose the US. government wants to buy enough wheat each year to raise the pprice to $3.50 per bushel. With this drop in export demand, how much wheat would the government have to buy? How much would this cost the government? With a price of $9.50, the market is not in equilibrium. Quantity demanded and supplied are 1626.4-212.6(8,5)-18828, and 94+ 20718.5) = 26685. ® 4 Bycess supply is therefore 2668,5-1882.8=7862 millon bushels. ‘The government must ‘purchase this amount to support a price of $3.5, and will spend '§85(786.2 milion) =§2751.7 million per year 6. The rent control agency of New York City has found that aggregate demand is Qy= 160 -8P, Quantity is measured in tons of thousands of apartments. Price, the average ‘monthly rental rate, is measured in hundreds of dollars. The agency also noted that the increase in @ at lower P results from more three-person families coming into the city from Long Island and demanding apartments. The city’s board of realtors acknowledges that this is a good demand estimate and has shown that supply is Q, 0+ TP. Af both the agency and the board are right about demand and supply, what is the free market price?” What is the change in city population if the agency sets a ‘maximum average monthly rental of $300, and all those who cannot find an apartment leave the city? ‘Tofind the free market price for apartments, act supply equal to demand 160. SP = 70 + 7P, or P= $600, ince price is measured in hundreds of dllars, Substituting the equilibrium price into either the demand or supply equation to determine the equilibrium quantity and ‘We find that at the ental rate of $600, the quantity of apartments ronted is 1,120,000 If the rent contol ageney sets the rental vate at $00, the quantity supplied would ‘then be 910,000 (Q,= 70 + (7G) = 91), a deereace af 210,000 apartments from the free ‘market equilibrium. (Assuming three people per family per apartment, this would Imply a loss of 680,000 people) At the $800 rental rate, the demand for apartments is 1,360,000 units, and the weulting shortage is 450.000 unite (1,360,000-910,000). However, excess demand (supply shortages) and lower quantity demanded are not the same concepts. The supply shortage means that the market cannot accommodate the ‘now people who would have been willing to move into the city at the new lower price. ‘Therefore, the city population will only fall by 630,000, which is represented by the drop in the number of actual spartmenta from 1,120,000 (the old equilibrium value) to 910,000, or 210,000 apartments with 3 people each 16 epsingesolxcrarosniogrpotcam plngesolxonmrosblogepotcam Chapter 2: The Basics of Supply ond Demand ‘Suppose the agency bows to the wishes of the hoard and sets @ rental of $900 per ‘month on all apartments to allow landlords a “fair” rate of return, If 50 percent of any long-run increases in apartment offerings come from new construction, how ‘many apartments are constructed? ‘At a rental rate of $900, the supply of apartments would be 70 + 7(9) = 133, or 1,380,000 units, whieh isan inerease of 210,000 unite over the free market equilibrium ‘Therefore, (0.5}(210,000) = 105,000 units would be constructed. Note, however, that since demand is only 880,000 units, 450,000 unita would go unrentod, 7. Im 1998, Americans smoked 470 billion cigarettes, or 23.5 billion packs of cigarettes. The average retail price was $2 per pack. Statistical studies have shown that the price clasticity of demand is -0.4, and the price elasticity of supply is 0.5. Using this information, derive linear demand and supply curves for the cigarette market. Let the demand curve be of the general form Q=a-bP and the supply curve be of the general form Q=e-+dP, where, b,c, and d are the constants that you have to find from ‘the information given above. To bogin, reall the formula for the prio elasticity of demand ee OaP ‘You are given information about the value ofthe elasticity, P, and Q, whieh means that you ean slve fr the slope, which is bin the above formula forthe demand curve AO _ yf 235) ap ONT) ‘Tofind the constant a, substitute forQ, P, and b into the above formula co that 23. 47*2 and a=32.9. The equation for demand is therefore Q=s2.9-.7P. To find the supply curve, ecall the formula fr the elasticity of supply and foiow the same method. as above: AI 2b s PAD ap ‘Tofind the constant ¢, substitute for QP, and d into the above formula 20 that 23.5=c+5,879°2 and e=11.75. The equation for supply is therefore Q=11.7345 875. 8, In Example 2.8 we examined the effect of a 20 pereent decline in copper demand on the price of copper, using the linear supply and demand curves developed in Section 24. Suppose the long-run price elasticity of copper demand were 0.4 instead of 0.8. Assuming, as before, that the equilibrium price and quantity are PY = 75 cents per pound and @* = 7.5 million metric tons per year, derive the linear demand curve ‘consistent with the smaller elasticity. Following the method outlined in Section 2.6, we solve for @ and 6 in the demand equation Q, = a» BP. First, we know that for a linear demand function epsingesolxcrarosniogrpotcam plngesolxonmrosblogepotcam Chapter 2: The Basics of Supply ond Demand E, -if 2) Here Fy = 04 (the longarun price claticity, PY = 075 (the equilibrium price), and 5 (Uh equilibrium quantity). Solving or (ors -04 =-0( 3) or cr ‘To find the intercept, we substitute for b, Qy & Q"), and P (= P* in the demand equation: 75= a-()0.7,0ra= 105. ‘The linear demand equation consistent with a long-run price elasticity of 0. ix therefore Qy= 105 -4P. b. Using this demand curve, recalculate the effect of « 20 percent decline in copper demand on the price of copper. ‘The new demand is 20 percent below the original (using our convention that quantity demanded is reduced by 20% at every price) Q = 0aK105~47)= 84-227 Equatng this to suppl S4-29P=4.9+ 167, oF P=087. With the 20 percent decline in the demand, the price of copper falls to 67.2 cents per pound. 9, Example 2.9 analyzes the world oil market. Using the data give Show that the short-run demand and compet D=24.08-0.06P Sc= 174 +0072, ‘that example: /e supply curves are indeed given by First, considering [Link] supply: qr=1s. 18, B= (PQ) implies d= 0.07. ‘Substituting ford, $,, and Pin the supply equation, e= [Link] S, 11.74 + 0.077. Similarly, since Q,= 23, By = PQ") = 0.05, and b= 0.06, Substituting for b, Qy =23,and P = 18 inthe demand equation gives 23 = -0.06(18), so that a =2408, Hence Q,=2408 - 006? b. Show that the long-run demand and competitive supply curves are indeed given by D=s2.18-051P Sc=278+0.29P. Avabove, By= 0.4 and E,= -04: E,= dP*IQ* and K,,=-0(P*/Q4), implying 04 and 0.4 -b(1823), Sod =0.29 and b= 0.51 Next solve for cand a! S.=e+dP and Q,, a bP, implying 18= e+ (0.2918) and 2 osnas, 18 epsingesolxcrarosniogrpotcam 10, plngesolxonmrosblogepotcam Chapter 2: The Basics of Supply ond Demand So e= 71.78 and a= 92.18 In 2002, Saudi Arabia accounted for 8 billion barrels per year of OPEC's production. Suppose that war of revolution eaused Saudi Arabia to stop producing oil. Use the ‘model above to calculate what would happen to the price of oil in the short run and, the long run if OPEC's production were to drop by 3 billion barrels per year. With OPEC's supply reduced from 10 bhive to 7 bhiye, add this lower supply of 7 bbiyr to the short-run and long-run supply equations: 871+ DOTPand 7T+8,= 1478+ 0.20P. "These are equated with short un and [Link] demand, so that: 18.74 + 007P=24.08 - 006, ind 14.78 +029P=92.18- 0517, the long ran, [Refer to Example 2.10, which analyzes the effects of price controls on natural gas. Using the data in the example, show that the following supply and demand curves did indeed describe the market in 1975: Supply: @= 14427, + 0.25P, Demand: @=-5P, +8.75P, where P, and P, are the prices of natural gas and oil, respectively. Also, verify that if the price of oil is $8.00, these curves imply a free market price of $2.00 for natural es, ‘To solve this problem, we apply the analysis of Section 2.6 to the definition of eros price elasticity of demand given in Section 24. For example, the cross-priceclasicty of demand for natural gas with respect to the price of ol ($18) ) is the change inthe quantity of natural gar demanded benuse of 2 nal ( Change nthe pe fo Farrar demand eqns, (22) oant we M Ee represent demand os Gana: bP, +P tin tat name ee contan then (42) = Sain hin nt the com price clasticty, Ey =), whore PJ) and Qj are the equilibrium price and m4") ‘quantity. We kmow that P; = $[Link] Qj = 20 trillion cubie feet (Te). Solving fore, ise) erence. 19 epsingesolxcrarosniogrpotcam plngesolxonmrosblogepotcam Chapter 2: The Basics of Supply ond Demand ‘imilanly, if the gonoral form of the supply equation is represented as: Qua e+ dP + aP (2 ‘he cote pie elaiity of ply i g| OJ. which we know tobe O.. Solving for P ‘The values for d and b may be found with equations 2.a and 2.5b in Section 26, We Jknow that B= 02, P*=2, and Q* = 20. Therefore, nf 2 eae Alo, Ey =-0.5, 20 2) eo By substituting these values for dy g. 6, and e into our linoar supply and demand equations, we may solve fore and a 20=6+(2)2)+ 0.25)8),ore= U4 and 20= a (5X2) + (8.75), or a= 0. IE the price of oil is $800, these curves imply a free market price of $2.00 for natural gus. Substitute the price of oil in the supply and demand curves to verify these ‘equations, Thon set the curves equal to each other and solve forthe price of gas. 14+ 2P 5+ O25\8) =-5P, + THVS) Wad Pi, =82.00. Suppose the regulated price of gas in 1975 had been $1.50 per thousand cubic feet, Instead of $1.00. How much excess demand would there have been? With a regulated price of $1.50 for natural gas and a price of oil equal to $800 per barrel, Demand: Q,= (5)(1.50) + @.75N8)= 2235, and Supply: Q.= M+ 2\(.5) + ©2518) = 19. With a supply of 19 Tef and a demand of 2.5 Tet, there would be an excess demand of 35 Te. Suppose that the market for natural gas had not heen regulated. Ifthe price of ofl had increased from $8 to $16, what would have happened to the free market price of natural yas? the price of natural gas had not been regulated and the price of oil had increased from $8 v0 $16, then Demand: Q,=-5P,,+(875)(16)= 60-5P,, and Supply: Qs= 14+ 2P,+(025)(16)= 18+ 27. Bquating supply and demand and solving forthe equilibrium price, 18+ 2P, = 60- 5Pa, or P= $6. "Theprice of natural gas would have tripled from $2 to $6, 20 epsingesolxcrarosniogrpotcam plngesolxonmrosblogepotcam Chapter 2: The Basics of Supply ond Demand LL The table below shows the retail price and sales for instant coffee and roasted coffee for 1997 and 1998, Retail Price of Sales of Retail Price of Sales of Instant Coffee Instant Coffee | Roasted Coffee Roasted Coffee Year (sit) (million tbs) (smb Goillion bs) 1997 TOas 7 “0 30 1998 10as wo 3.76 $50 Using this data alone, estimate the short-run price elasticity of demand for roasted Coffee, Derive a linear demand eurve for roasted coffee. ‘Tofind elasticity, yous must first estimate th slope of the demand curve: AQ 820-850 30 ap 411-336-035 Given the slope, we can now estimate elasticity using the price and quantity data from ‘the above table. Since the demand curve is assumed to be linear, the elasticity will, dlfer in 1997 and 1998 because prio and quantity azo differnt. You can ealeulate the lasticity at both points and at the average point between the two Years: n PAG -857 043 038 3935 we 3935. 9520.40 5 Qy+Qn AP 835 85.7) = 040. 2 "To derive the demand curve for roasted coffee Q=a:bP. note thatthe slope af the ‘equation for the demand eurve ie therefore Q=11729.85.7P. b, Now estimate the short-run price elasticity of demand for instant coffee. Derive a inear demand curve for instant coffee, ‘Tofind elasticity, you must first estimate the slope of the demand curve AQ __75-70_ 385, AP” 1035-1048” 0.13 Given the slope, we ean now estimate clasticty using the price and quantity data from the above table. Since the demand curve Qa-bP is assumed tobe linear, the elasticity will differ in 1997 and 1998 because price and quantity are different, You can calculate the elasticity at both points and atthe average point between the two years 2p £8 BS a95)-531 oar 7s epsingesolxcrarosniogrpotcam plngesolxonmrosblogepotcam Chapter 2: The Basics of Supply ond Demand pe LAO ‘Todesive the demand curve for instant coffe, note that the slope of the demand carve is 88.5. To find the eoefieient a, use either of the data points from the table above so that a=75438.5°L0,35=473,5 or a=70+38.5°10.485473.5. The equation forthe demand curve is therefore Q-178.5.38.5P. Which coffee has the higher short-run price elasticity of demand? Why do you think this isthe ease? Instant cofee is significantly more elastic than roasted coffee. In fat, the demand for roosted coffe is inelastic and the demand for instant coffee i elastic. Roasted coffee may have ain inelastic demand in the short-run as many people think of cafee as a necessary good. Changes in the price of roasted coffee will not drastically affect demand beeause people must have this good. Many people, on the other band, may view instant cof, asa convenient, though imperfect, substitute for roasted coffee. For example, ifthe price rises ahitle, the quantity demanded will fall by alarge percentage ‘pecause people would rather drink roasted coffee instead of paying more for a low quality substitute. 2 epsingesolxcrarosniogrpotcam plngesolxonmrosblogepotcam Chapter 8 Consumer Behavior PART IL PRODUCERS, CONSUMERS, AND COMPETITIVE MARKETS CHAPTER 3 CONSUMER BEHAVIOR TEACHING NOTES Chapter 3 builds the foundation for deriving the demand curve in Chaptor 4. In order to ‘understand demand theory, students must have a firm grasp of indifference curves, the marginal ate ‘of substitution, the budget line, and optimal eonsimer choice. Tt is possible to disenss consumer eboice ‘without going into extensive detail on utility theory. Many’ students find tility functions to be a more abstract concept than preference relationships. However, if you plan to discuss uncertainty in Chapter 5, sou wll need to cover manginal utility (ection 2.5). Even if you cover utility theory only briefly, make sure students are comfortable withthe term utility beeause it appears frequently in Chapter 4 ‘When introducing indifforence curves, stress that physical quantities are roprecented on the ‘two axes. After discussing supply and demand, students may think that price should he onthe vertical taxis To illustrate the indifference curves, pick an initial bundle on the graph and ask which other bundles are ikely to be more preferred and less preferred to the initial bundle. ‘This will divide the fap nto four quadvants, and itis then easier for students to figure out the set of bundles hetween Whieh the consumer is indifferent, It is helpful to present alot of examples with different types of goods and see if the class can figure out how to draw the indifference curves. The examples are also ‘useful for explaining the significance of the assumptions made about preferences. In presenting different examples, you can ask which assumption would be violated Explaining utility follows naturally from the diseussion of indifference curves, ‘Though an abstract concept, it i possible to get students to understand the basic idea without spending too much ‘ime on the topic. You might point out that we as consumers have a goal in hfe, which is ta maximize our utility subject to our budget constraint. When we goto the store we piek the basket that we lke best and that stays within our budget. From this we derive demand curves. Emphasize that it is the ranking that is important and not the utility number, and point out that if we ean graph an indiference curve we can certainly find an equation to represent it, Finally, wht is most important is the rate at which consumers are willing to exchange goods (the marginal rate of substitution) and this is based on the relative satisfaction that they derive from each good at any particular time "The marginal rate of substitution, JMRS, ean be confusing to students, Some confuse the MRS with the rato of the two quantities, IC this isthe ease, point out that the slope is equal tothe ratio of the rise, AY, and the run, AX. This rato is equal tothe ratio ofthe intercepts of a line just tangent to the indifference curve. As we move along a eonves indifference curve, these intercepts and the MRS ‘change. Another problem is the terminology ‘of X for ¥” This ie confusing bocause we are not Substituting "X for "but ¥ for one unit of X- You nay want to present a variety of examples im class toexplain this important concept QUESTIONS FOR REVIEW 1. What are the four basic assumptions about individual preferences? Explain the significance or meaning of each. (2) Preferences are complete: this means that the consumer is able to compare and rank all possible baskets; @2) Preferences are transitive: this means that preferences are consistent, in that if bundle A is preferred to bundle B and bundle B is preferred tw bundle €, then we should be able to eonclode that bundle A is preferred to bundle C; @) More is preferred to lees: this means that all goods are desirable, and that the consumer will always prefer to have more ofa good; (4) Diminishing marginal rate of substitution: this means that indifference eurves are convex, and that the slope of ‘the indifference curve increaces (becomes lese negative) as we move down along the curve. Asa consumer moves dawn along her indifference curve she is willing to give 23 epsingesolxcrarosniogrpotcam plngesolxonmrosblogepotcam Chapter 8 Consumer Behavior ‘up fewer units of the good on the vertical axis in exchange for one more unit of the god on the horizontal axia. This assumption also means that balanced market Jhavkets are preferred to baskets that have a lot of one good and very little of the other good. 2, Can a set of indifference curves be upward sloping? If so, what would this tell you about the two goods? ‘A sot of indifference curves can be upward sloping if we violate assumption number tree; more is preferred to less. When a sot of indifference curves ie uporard sloping, it means one of the goods is a “bad” in that the consumer prefers less of tae good rather than more of the good. ‘The positive slope means that the consumer will, ‘socept more ofthe bad good only if she also eecivee more of the other good in return, “AS wwe move up along the indifference curve the consumer has more of the geod she likes, and also more ofthe pood she does not like. 3. Explain why two indifference curves cannot intersect. ‘The explanation is most easily achieved with the aid of a graph such as Figure 8.5 Which shove two indifference curves intorceeting at point A. We know from the definition of an indifference curve that a consumer has the same lovel of tility along any given curve. In thia case, the consumer is indifferent between bundles A and Bt because they both lie on indifference curve Uj. Similarly, the consumer is indifferent between bundles A and C because they both lie on indifference curve U. By the transitivity of preferences this consumer should also be indifferent between C and B. However, we see from the graph that C lies abave B, so C must be preferred to B. "Thus, the fact that indifference carves cannot intersect i proven, Good ¥ Figure 33 4, don is always willing to trade one can of cake for one can of sprite, oF one can of sprite for one can of cake. ‘What can you say about Jon's marginal rate of substitution? Jon's marginal rate of substitution can be defined as the number of cans of coke he would be willing to give up in exchange for acan of sprite. Since he is always willing twtrade one for one, his MRS is equal to 1. a4 epsingesolxcrarosniogrpotcam plngesolxonmrosblogepotcam Chapter 8 Consumer Behavior b. Draw a set of indifference eurves for Jon, Since Jon is always willing to trade one indifference curves amv linear with a slope af 1 of coke for one can of sprite, his fc. Draw two budget Hines with different slopes and illustrate the satisfaction- ‘maximizing choiee, What conclusion ean you draw? Jon's indifference curves are linear with a slope of ~1. Jon's budget Tine is also lineas, and will have a slope that reflects the ratio of the two prices, 1 Jon's budget line ts steeper than bis indifference curves then he will choose to consume only the good on the vertical axis. If Jon's budget line is latter than his indifference curves ‘then he will choose to consumer only the good on the horizontal axis, Jon will always choose a comer solution, unless iz budget line has the same slope as his indifference curves. In this ease any combination of Sprite and Coke that uses up his entire income with maximize his satisfaction, 5. What happens to the marginal rate of substitution as you move along a convex indifference curve? A linear indifference curve? ‘Tho MRS measures how much of a good you are willing to give up in exchange for fone more unit ofthe ether good, kesping utility con:tant. The MRS diminishes along ‘convex indifference curve in that as sou move dawn along the indifference curve, ‘you are willing to give up less and less of the one good in exchange for the other. The MRS in also the slope of the indiffarence curve, which increases (becomes leas negative) as you move down along the indifference curve. The MRS is constant along ‘8 linear indifference curve, since in this case the slope does not change. The consumer is always willing to trade the sume number of units of one good in ‘exchange for the other 6, Explain why an MRS between two goods must equal the ratio of the price of the goods for the consumer to achieve maximum satisfaction. "The MRS describes the rate at which the consumer is willing to trade one good for another to maintain the same level of satisfaction, The ratio of prices describes the tradeoff that the market is willing to make between the same two goods. The tangeney ofthe indifference eurve with the budget line represents the point at which ‘the tradeoffs are equal and consumer satisfaction is maximized. If the MRS between ‘ovo goode isnot equal to the ratio of prices, thon the consumer could trade one good for another at market prices to obtain higher levels of satisfaction. For example, if the slope of the budget line (the ratfo of the prices) is ~4 then the consumer ean trade 4 ‘units of good 2 for one unit of good 1. Ifthe MRS at the cwrent bundle is -6, then the consumer is willing to trade 6 units of good 2 for one wnt of good 1. Since the tro slopes ate not eqial the conmumer isnot maximiring her atisfacion. The consumer ia willing to trade 6 but only bas to trade 4, sa she should make the trade, ‘This trading continues until the highest level of satisfaction is achieved. As trades are made, the ‘MRS will change and become equal tothe price ratio. 7. Deseribe the indifference curves associated with two goods that are perfeet substitutes. What if they are perfect complements? "Two goods are perfect substitutes i the MRS of one for another is a constant number. Given the MRS is a constant number, the slope of the indifference curves will be constant, and the indifference curves are therefore Linear. If two goods are perfect complenonts, the indifference curves are L-shaped. In thi case the consumer wants [Link] the two goods in a fixed proportion, say one unit of goed | for every unit of good 2. If she has more of ane goad but not more ofthe ather then she does not get fany extra satisfaction. epsingesolxcrarosniogrpotcam plngesolxonmrosblogepotcam Chapter 8 Consumer Behavior 8. What is the difference between ordinal utility and cardinal utility? Explain why the assumption of cardinal utility is not needed in order to rank consumer choices. Ordinal utility impties an onlering among alternatives without regard for intensity of preference. For example, if the consumer's fist choice is preferred to their second choice, then utility from the first choice will be higher than utility from the second choice, “How much higher is not important. An ordinal utility function generates a ranking of bundles and no meaning is given to the utility number itself. Cardinal utility implies that the intensity of preferences may be quantified, and that the uti number itself has meaning. An ordinal ranking i all that is needed to rank consumer choices. It is not necessary to know how intensely a consumer prefers basket A over Dasket B: itis enough to know that A is preferred to B. 9. Upon merging with the West German economy, East German consumers indicated a preference for Mercedes-Benz automobiles over Volkswagen. However, when they converted their savings into deutsche marks, they flocked to Volkswagen dealerships. How can you explain this apparent paradox? ‘Three ansumptions are requived to addness this question: 1) that a Meneedes costs mane ‘than a Volkswagen; 2) that the East German consumers’ utility unetion comprises two goods, automobiles and all othor goods evaluated in deutsche marks and 3) that East ‘Germans have incomes. Based on these assumptions, we can surmise that while East German consumers may prefer a Mereedes to a Volkswagen, they either eannot afford a Mercedes or they prefer a bundle of other goods plus a Velkswagen to a Mercedes lone. While the marginal utility of consuming a Meveedes exceeds the marginal Utility of consuming a Volkswagen, the consumer will consider marginal utility per dollar for each good. ‘This means the marginal utility per dollar must have been higher {or the Vallswagen since consumers Nocked to the Volkswagen dealerships and not the Mercedes dealerships. 10. Draw a budget line and then draw an indifference curve to illustrate the satisfaction ‘maximizing choice associated with two products. Use your graph to answer the following questions. a. Suppose that one of the produets is rationed. Explain why the consumer is likely. to be worse off When goods are not rationed, the consumer ie able to choose the satisfaction ‘maximizing bundle where the slope of the budget line is equal to the slope of the indifference curve, or the price ratio is equal to the MRS. This is point Ain the graph below. If good 1 is now rationed the consumer will not be able to attain the utility ‘maxiasizing point, He or she will have to consume more of the other good instead, "This is point B below, geod 26 epsingesolxcrarosniogrpotcam plngesolxonmrosblogepotcam Chapter 8 Consumer Behavior b. Suppose now that the price of one of the products is fixed at a level below the current price. As a result, the consumer is not able to purchase as much as she would like of the produet. Can you tell ifthe consumer is better off or worse off? ‘When the price of the good ie fixed at a level below the current (equilibrium) pric, ‘heve will be a shortage of the good and the good will have tobe effectively rationed, ‘As in the question above, the consumer is worve off beeause she is not ale to attain hho utility maximizing point. 11. Based on his preferences, Bill is willing to trade 4 movie tickets for 1 ticket to a basketball game. If movie tickets cost $8 each and a ticket to the basketball game costs $40, should Bill make the trade? Why or why not? No Bill should not make the trade. If he gives up the 4 movie tickets then he will save $8 per ticket for a total of $82. However, thie is not enough for a basketball ticket. He would in fact have to give up 5 movie tickots if ho wanted te buy another ‘basketball ticket. Notice also, that the marginal tility per dollar is higher for movie tickete so Bill will be better aif if he consumes more movie tickete and fewer basketball tickets. To figure this out reeall that what Bill is willing todo defines his MRS. His MRS is 4 g0 this means that the marginal utility of a basketball game is 4 land the marginal utility ofa movie is 1: MRS i MU, 1 Now the marginal utility per dollar ean be computed: MU 4 Fy, 4010 MU 1 Prose ® ciple. Explain why this principle may not hold if increasing marginal utility is associated with the consumption of one or hoth goods. ‘The equal marginal principle states that the ratio of the marginal utility to price must be equal across all goods to obtain maximum satisfuction. In other words, uti ‘maximization is achioved when the budget is allocated so that the marginal utility per dollar of expenditure isthe same for each good. If the marginal utility per dollar is not equal then utility can be increased by allocating more dollars to the good seth the higher marginal utility per dollar. The consumer will obtain more “bang forthe buck” if they reallocate their dollars If marginal utility is increasing, the consumer maximizes satisfaction by consuming fever larger amounts of the good. Thus, the consumer would spend all income on anc ood, assuming a constant price, resulting ina come solution. ‘With a commer selon, ‘the equal marginal principle cannot hol. 18. The price of computers has fallen substantially over the past two decades. Use this drop in price to explain why the Consumer Price Index is likely to overstate substantially the cost-of-living index for individuals who use eomputers intensively. "The consumer price index mensutes the cast ofa typical basket of goods purchased by the consumer in the current year relative to the east of the basket in the base year Each good in the basket is assigned a weight, which reflects the importance af the gpod tw the consumer, and the weights are kept fied from year to year. The problem with fixing the weights is that consumers will shift their purchases from year to yeur to give ‘more weight to goods Whose prices have fallen, and less weight to goods whose prices Ihave risen, The CPI will therefore give too much weight to gous whove prices have a epsingesolxcrarosniogrpotcam plngesolxonmrosblogepotcam Chapter 8 Consumer Behavior risen, and too little weight to goods whose prices have fallen. For the individual who ‘uses computers intensively, the fixed weight for computers in the baaket will Unverstate the importance ofthis good, and will hence understate the effeet ofthe Ell in the price of computers, "The CVI will overstate the rise inthe cost of living for Uhis ‘ype efindivideal, 14. Explain why the Paasche index will generally understate the Ideal costofliving index. ‘The Paaache index measures the current cost ofthe current bundle of goods relative to the base year cost of the current bundle of goods. The Paasche index will understate the ideal cost of living heenuse it assumes the individual will buy the current year bundle in the base period. In reality, at base year prices the consumer ‘would have been able to attain the same level of utility at a lotrer cost by altering ‘their consumption bundle. Since the base year cost is overstated, the denominator will be largor and the index will be lower, or understated EXERCISES 1. In this chapter, consumer preferences for various commodities did not change during the analysis. Yet in some situations, preferences do change as consumption occurs. Discuss why and how preferences might change over time with consumption of these two commodities: a cigarettes ‘The assumption that preferences do not change is @ reasonable one if ches are independent across time It does not hold, however, when “habitsforming’ or addictive Jbohavior is involved, as in the ease of cigarettes the consumption of cigarettes in one period influences their consumption in the next peti. b, dinner for the fast time at a restaurant with a special cuisine "This example is parallel to examples of adventure secking. or some, a new dining experience creates enthusiasm to seek out more exciting and different cuisines and ddshes, For others, they develop a fondness for regularity and consistency or feur ofthe ‘new and unknown. In either ofthese cases, choioes change ax consumption occurs, 2. Draw indifference curves that represent the following individuals’ preferences for hamburgers and soft drinks, Indieate the direction in whieh the individuals’ satisfaction (or utility) is increasing. a. Joe has convex preferences and dislikes both hamburgers and soft drinks. ‘Since Joe dislikes both goods his set of indifference curves will he bowed inwards towards the origin instend of outwards, as in the normal case where more is preferred to lets. liven he dislikes both goods, his satisfaction is inereasing in the dirvetion ofthe origin. Convexity of preferences implies his indifference curves will Ihave the normal shape in that they are hosted towards the dircetion of increasing satisfaction, Convexity also implies that given any two bundles between whieh the consumer is indifferent, the “average” of the two bundles will be in the preferred st, for will leave him atleast as wel off 28 epsingesolxcrarosniogrpotcam plngesolxonmrosblogepotcam Chapter 8 Consumer Behavior hamburger x \\ elt dink Jane loves hamburgers and dislikes soft drinks. If she is served a soft drink, she will pour it down the drain rather than drink it. ‘Since Jane can freely dispove of the soft drink if is given to her, she considers it to be a neutral good. ‘This means she docs ict care about sft drinks one way of the other. With hamburgers on the vertical axis, her indifference eurves are horizontal lines. Her satisfaction increases in the upward direction, hamburger soft di Bob loves hamburgers and dislikes soft drinks, Ifhe is served a soft drink, he will drink it to be polite. Since Bob will drink the soft drink in oer to be polite, it can be thought of as a “bad”. When serves another soft drink, he will require more hamburgers at the same time in onder to keep his satisfaction constant. More soft drinks without more hamburgers wil worsen his utility. More hamburgers and fewer soft drinks will fnerease bis uly, hamburger Ky soft rin Molly loves hamburgers and soft drinks, but insists on consuming exactly one soft drink for every two hamburgers that she eats. Molly wants to consume the two goods in a fixed proportion co her indifference curves are L-shaped. For any given amount of one good, che gets no extra satisfaction from having more of the other good. She will only increase her satisfaction if she has more of both goods, 29 epsingesolxcrarosniogrpotcam plngesolxonmrosblogepotcam Chapter 8 Consumer Behavior [LX elt din Bill Likes hamburgers, but neither likes nor dislikes soft drinks. Like Jane, Bill considers soft drinks to be a neutral good. Since he does not cure about coft drinks ane way oF the other we can assume that no matter haw many he has, his utility will be the same. His level of satisfaction depends entirely on how ‘many hamburgers he has. hamburger How much extra satisfaction Mary gains from an extra hamburger or soft drink tells tus something about the marginal utilities of the two goods, or about her MRS. If she always receives twice the satisfaction from an extra hamburger then hee marginal utility fom consuming an oxtra hamburger is twice hor marginal utility om Consuming an extia soft drink. Her MRS, with hambiagers on the vertical axis 18 V2, Her indifference curves are straight lines with a slope of 1/2, ‘hamburger ; elt dink epsingesolxcrarosniogrpotcam plngesolxonmrosblogepotcam Chapter % Consumer Behavior 8. If Jane is currently willing to trade 4 movie tickets for 1 basketball ticket then she ‘must like basketball hetter than movies, True or false? Explain. ‘This statement is not necessarily true. If she is alway willing to trade 4 movie tickets for 1 basketball tickot then yes she likoe basketball bettor because she will always gain the same satisfaction from 4 movie tickets as she doos from 1 basketball ticket. However, it eould be that she has convex preferenoss (diminishing marginal rate of substitution) and is at a bundle where she has alot of movie tickets relative to basketball tickets. ‘This would make her willing to give up more movie tiekets to get another basketball ticket. It would not mean though that she liked basketball better Her willingness to give up a good would in this ease depend on the quantity of each good in her current basket 4, Janelle and Brian each plan to spend $20,000 on the styling and gas mileage features of @ new ear. They ean each choose all styling, all gas mileage, or some combination of the two. Janelle does not care at all about styling and wants the best gas mileage possible. Brian likes both equally and wants to spend an equal amount on the two features. Using indifference curves and budget lines; illustrate the choice that each person will make. 5. Suppose that Bridget and Eri Assume styling is on the vertical axis and gas mileage is on the horizontal axis, ‘Janelle has indiflerence curves that are vertical. Ifthe styling ie there she will take it, but she otherwise does not eave ahout it. Asher indifference curves move over to the right, she gains more gas mileage and more satisfaction. She will spend all $20,000 on gas mileage. Brian has indifference curves that are L-shaped. He will rot spend move on one feature than on the other feature. He will spend $10,000) on styling and $10,000 on gas mileage. spend their income on two goods, food (F) and clothing (C). Bridget’s preferences are represented by the utility funetion U(F,C)=10FC, while Erin's preferences are represented by the utility function U(F.C)= .20F°C’. On a graph, with food on the horizontal axis and clothing on the vertical axis, identify the set of points that give Bridget the same level of utility as the bundle (10,5), Do the same for Erin on a separate graph. Bridget receives a utility of 10105500 from this bundle. The indifference curve is represented by the equation 10FC=500 or FC=50, Some bundles on this indi curve are (5.10), (10.5), (25.2), and (225). Brin receives a utility of 210° 10° from the bundle (10,3). Her indifference curve is represented by the equation 500=.2F'C’, or 50=KC. Thi is the same indifference curve as Bridget. Both indifference curves have the normal, conver shape. On the same two graphs, identify the set of bundles that give Bridget and Brin the ‘same level of utility as the bundle (15,8). For each person, plig in F=15 and C=8 into their respective utility funetions. For Bridget, this gives her a utility of 1200, so her indifference curve is given by the equation 10FC=1200, or FC=120. Some bundles on this indifference curve are 0), 10,12), @.A0), and (40,3). For Bein, thia bundle gives her a utility of 2880, 30 hor indifference curve is given by the equation 2880 2F7C*,or FC=120. ‘This is the same indifference euve as Bvidget Do you think Bridget and Brin have the same preferences or different preferences? Explain. ‘They have the same preferences because for any given bundle they have the same level of utility. This means that they will rank all bundles in the same order. Note however, that itis not necessary that they receive the sume level of utility to have the same set of preferences. All that is necessary is that they rank the bundles in ‘the same order epsingesolxcrarosniogrpotcam plngesolxonmrosblogepotcam Chapter % Consumer Behavior 6. Suppose that Jones and Smith have each decided to allocate $1,000 per year to an entertainment budget in the form of hockey games or rock concerts. They both like hockey games and rock concerts and will ehoose to consume positive quantities of both goods. However, they differ substantially in their preferences for these two forms of entertainment. Jones prefers hockey games to rock concerts, while Smith prefers rock concerts to hockey games, 4. Draw a set of indifference curves for Jones and a second set for Smith. Given they each like both good> and they will each choose to consume positive ‘quantities of bath goods, we can assume their indifference curves have the normal convex shape, However since Jones has an overall preference for hoekey and Smith Jnas an overall preference for rock concerte, their two sete of indiference curves will have different slopes. Suppose that we place rack concerts on the vertical axis and Iheckey games on the horizontal axis, Jones will have a larger MRS than Smith ‘Jones ie willing to give up moze rock concerts in exchange for a hockey game since he [prefers hockey games, ‘The indifference carves for Janes will be steeper. b. Using the concept of marginal rate of substitution, explain why the two sets of ‘curves are different from each other. ‘At any combination of hockey games and rock concerts, Jones is willing to give up more rock concerts for an additional hockey game, whereas, Smith is willing to give up fewer roek concerts for an additional hockey game. Since the MRS is a measure of how many. of one good (vock concerts) an individual is willing to give up for an additional unit of ‘the other good (hockey games), then the MRS, and hence the slope of the indifference curves willbe different forthe two individuals 17. The price of DVDs (D) is $20 and the price of CDs (C) is $10. Philip has a budget of $100 to spend on the two goods, Suppose that he has already bought one DVD and one CD. In addition there are 3 more DVDs and 5 more CDs that he would really like to buy. &. Given the above prices and income, draw his budget line on a graph with CDs on the horizontal axis. His budget line is F,D-+P,C= I, or 20D+10C=100. Ihe spends his entire income fon DVD's he could afford to buy 5. If he spends his entire imcame on CD's he could afford to buy 10. b. Considering what he has already purchased, and what he still wants to purchase, identify the three different bundles of CDs and DVDs that he could choose. Assume that he cannot purchase fractional units for this part of the question Given he has already purchased ane of each, fora total of $80, he has $70 let. Since ‘ho wants 8 more DVD's he ean buy those for $60 and spond his remaining $10 on 1 (CD. This isthe frst bundle below. He could also choose to buy only 2 DVD's for $40 and spend the remaining $80 on 3 CD's. He ean choose the fellowing bundles: Purchaced Quantities ‘Total Quantities Dc pc 31 2 6 2 3 a4 1 5 a8 epsingesolxcrarosniogrpotcam plngesolxonmrosblogepotcam Chapter % Consumer Behavior 8. Anne has a job that requires her to travel three out of every four weeks. She has an annual travel budget and can either travel by train or by plane. The airline she typically. fies with has a frequent traveler program that reduces the cost of her tickets depending: the number of miles she has flowa in a given year. When she reaches 25,000 miles the irline will reduce the price of her tickets by 26!. for the remainder of the year. When she reached 50,000 miles, the airline will reduce the price of her tickets by 50% for the remainder of the year. Graph Anne's budget line, with train miles on the vertical axis, and plane miles on the horizontal axis, ‘The typical budget lin is linear (with a constant slope) because the prices ofthe to ods do not change as the consumer buys more or less of particular good. In this case, the price of airline miles will change depending on how many miles she pparchases. As the price changes, the slope of the budget line will change. Since ‘here are three prices, there will be three slopes, or two kinks, to the budget line Since the price falls as she flies more miles, the budget line will become flatter with every price change. See the graph in the problem below. 9. Debra usually buys a soft drink when she goes to a movie theater, where she has a choice of three sizes: the 8 ounce drink eosts $1.50, the 12 ounce drink, $2.00, and the 16 ounce drink, $2.25. Deseribe the budget constraint that Debra faces when deciding how ‘many ounces of the drink to purchase. (Assume that Debra can costlessly dispose of any of the soft drink that she does not want. First notice that asthe size ofthe drink inereases, the price per ounce decreases. Wied take SE 0 par. Ms buys the 12-ounce size she pays $0.17 per ounce, and when she buys the 16-ounce size, she pays $0.14 per ounce, Given that there are three different prices per ounce fofsoft drink, the budget line will have to kinks in it, as illustzated below. Notice ‘that at each kink the slope ofthe budget line vets Matter (due to the decreasing cost per ounce relative to the “other good” on the vertical axis) 8 2 16 Ounces of Soft Drink epsingesolxcrarosniogrpotcam plngesolxonmrosblogepotcam Chapter 8 Consumer Behavior 10. Antonio buys 5 new college texthooks during his first year at school at a cost of $80 cach. Used hooks cost only $50 each. When the bookstore announces that there will be a 10% inevease in the priee of new books and a 5% increase in the price of used books, Antonio's father offers him $40 extra. a. What happens to Antonio's budget line? Illustrate the change with new books on the vertical axis Inthe first sear he spends $80 each on 5 new books far a total of $400, For the same amount of money he could have bought 8 used textbooks. His budget lin is therefore SD! New+50)"Used=100. ter the price change, new books cost $48, used books cost $52.5, and he has an income of $140, Ihe spends all of his income on new books he can still afford to buy 5 new books, but can now afford to buy 8.4 used books if he bays only used hooks. ‘The nev budget line is 88° New+52.5°Used=H10. The budget Tine has changed its slope and become fatter ifwe place used books on the horizontal b. Is Antonio worse or better off after the price change? Explain, ‘The first year he bought 5 books at a cost of $80 each for a total of $400. The new price of books is $88 and the cost of 5 new books ix now $440. The $40 extra income ‘ill cover the pries inerease. Antonio ix definitely not worse aff sinee he can still afford the same number of new books, He may in fact be better off if he decides to Switch to used books 11. Consumers in Georgia pay twice as much for avocados as they do for peaches. However, avocados and peaches are equally priced in California. If consumers in both states maximize utility, will the marginal rate of substitution of peaches for avocados be the same for consumers in both states? If not, which will be higher? ‘The marginal rate of substitution of peaches for avocados is the amount of avocados that a person is willing to give up to obtain one additional peach. When consumers ‘maximize utility, they act their marginal rate of eubetitution equal to the price rai, Pros which im this cose is T=" In Goorgla, Pha, =2P, 1+ Which means that when connor se msiingi MRS-= Fet 1, ty ain, a= nts ‘marginal rate of substitution is therefore not the same in both states, and will be higher in California 12, Ben allocates his lunch budget between two goods, pizza and burritos. Illustrate Ben's optimal bundle on a graph with pizza on the horizontal axis. ‘This is the standard graph, where Ben's budget line is Linear and he eonsumes at the point shore his indillerence curve is tangent to his budget line. This places him on ‘he highest possible indifference curve. b. Suppose now that pizza is taxed, causing the price to increase by 20%, Mustrate Ben’s new optimal bundle. When the price of pizza increases, the budget line will pivot inwards. This will shrink the tize of Ben's budget set and he will no longer be able to afford his old hnundle, His new optimal bundle is where the indifference curve is tangent to his new budget line and this indifference curve is below his original indifference curve. epsingesolxcrarosniogrpotcam plngesolxonmrosblogepotcam Chapter % Consumer Behavior c. Suppose instead that pizza is rationed at a quantity less than Ben's desired ‘quantity, Illustrate Ben's new optimal bundle, Rationing the quantity of pizza that ean be purchased will result in Ben not being able to choose his optimal bundle, He will have to choose a bundle on the budget line ‘that is above his original bundle. ‘This new bundle will have a lower level of utility. bumite tioned bundle x sina bundle 13, Brenda wants to buy a new car and has a budget of $25,000, She has just found a ‘magazine that assigns cach car an index for styling and an index for gas mileage. Each index runs from 1-10, with 10 representing either the most styling or the best gas mileage, ‘While looking at the list of cars, Brenda observes that on average, as the style index rises by one unit, the price of the car increases by 85,000. She also observes that as the gas mileage index rises by one unit, the price of the car increases by $2,500. a, Illustrate the various combinations of style (S) and gas mileage (G) that Brenda could select with her $25,000 budget. Place gas mileage on the horizontal asi: For every $5,000 she spends om style the index rises by one so the most she ean achieve isa eur with a style index of 5. For every’ $2,500 she spends on gas mileage, the index rises by one oo the most she ean achieve ie a car with a gas mileage index of 10. The slope of her “budget line” i -/2. b. Suppose Brenda's preferences are such that she always receives three times as ‘much satisfaction from an extra unit of styling as she does from gas mileage. What type of ear will Brenda choose’ If Brenda always receives three times as much satisfaction fiom an extra unit of styling as she does from an extra unit of gas mileage then she is willing to trade one ‘unit of styling for three units of gas mileage, and still maintain the same level of satisfaction. ‘This is her MRS or the slope af her indifference curves, which is fonstant. ‘Since the MRS is 1/3 and the slope of her budget line is -1/2, Brenda will choose all styling. You can also compute the marginal utility por dollar for styling land gas mileage and note that styling will be higher. In the graph belove, she will rove up to the highest possible indifference curve where she chooses al styling and ‘no gas mileage. oa mileage epsingesolxcrarosniogrpotcam plngesolxonmrosblogepotcam © Sovpe a Bre gal ef ation GF fa meng or Hin) wor egualo 2 What value och nde wuld he Hts ner ‘To find the optimal value of each index, set MRS equal tothe price ratio of U2 and cross multiply to get S=20, Now substitute into the budget 50005+25000=25000 to 14. Connie has a monthly and potatoes. ‘Suppose meat costs $4 per pound and potatoes cost $2 per pound. Draw her budget constraint. Let f= meat and P= potatoes. Connie's budget constrain is $200=4M+2P, or (M=50-05P. ‘Ac chown in the figure below, with M on the vertical axis, the vertical intercept is 50. ‘The horizontal intercept may be found by setting MI= 0 and solving for P. Meat ‘ome of $200, which she allocates between two goods: meat Budget Constraint Lavi Bnein 2 8075109125 Potatons b, Suppose also that her utility function is given hy the equation u(M, P) = 2M + P. What combination of meat and potatoes should she buy to maximize her utility? (Hint: Meat and potatoes are perfect substitutes.) ‘When the two goods are perfect substitutes, the indiference curves are linear, ‘To find the slope ofthe indifference curve, choose level of utility and find the equation for a representative indifference curve. Suppose u=30, then 2M+P=50, or M=25.0.5P. "Therefore, Connie budget line and her indifference curves have the same slope Connie's silty is equal to 100 when she buys 50 pounds of meat and no potatoes or no ‘meat and 100 pound of potatove. The indifference eurve for U= 100 coincides with her ‘budget constzaint. Any combination of meat and petataos along this line will provide ‘hee with maximum utility 36 epsingesolxcrarosniogrpotcam plngesolxonmrosblogepotcam Chapter % Consumer Behavior ©. Connie's supermarket has a special promotion. If she buys 20 pounds of potatoes (at ‘$2 per pound), she gets the next 10 pounds for free. This offer applies only to the first 20 pounds she buys. All potatoes in excess of the first 20 pounds (excluding bonus potatoes) are still $2 per pound. Draw her budget constraint. ‘Assume that potatoes are on the horizontal axis, Connie's budget constyaint has a Slope of -1/2 until Connie has purchased twenty pounds of potatoes, ie then fat from 20 to 80 pounde of potatoes, since the ton next pounds of potatooe are fee, and thon has a slope of 2 until it intereepta the potato axis at 110. 4. An outbreak of potato rot raises the price of potatoes to $4 per pound. The supermarket ends its promotion. What does her budget constraint look like now? What combination of meat and potatoes maximizes her utility? With the price of potatoes at $4, Connie may buy either 50 pounds of meat or 50 pounds of potatoes, oF some combination in between, See Figure 3.14. She maximizes utility at U'= 100 at point A when she consumes 50 pounds of meat a potatoos. This is «corner solution. Meat Budget Constraint Indifference Curve for U x 2% 507510915 Patatows Figure 314€ from days spent traveling on vacation domestically (D) and days spent traveling on vacation in a foreign country (F), as given by the utility function U(D.F)=10DF. Tn addition, the priee of a day spent traveling domestically is $100, the price of a day spent traveling in a foreign country is $400, and Jane's annual travel budget is $4,000, a. Ilustrate the indifference curve associated with a utility of $00 and the indifference curve associated with a utility of 1200. "The indiference curve with a utility of 800 has the equation 10DF=800, or DF=80, Choose combinations of D and F whose product is 80 to find a few bundles, ‘The indifference curve with a utility of 1200 has the equation 10DP=1200, or DP=120. ‘Choose combinations of D and whose product is 120 to find a few bundies b. Graph Jane’s budget line on the same graph. If Jane spends all of her budget on domestic travel she ean afford 40 days. If she spends all of her budget on foreign travel she ean afford 10 days epsingesolxcrarosniogrpotcam plngesolxonmrosblogepotcam Chapter % Consumer Behavior Can Jane afford any of the bundles that give her a utility of $00? What about a utility of 12007 ‘Yes she ean afford some of the bundles that give her a utility of 800 as part of this indifference curve lve below the budget line. She canpot afford any of the bundles that give her a utlity af 1200 as this whole indifference curve lies above the budget line. ind Jane's utility maximizing choice of days spent traveling domestically and days spent in a foreign country. "The optimal bundle is where the slope of the indifference curve is equal to the slope of the budget line, and Jane is spending her entire income. The slope of the budget Tine is Ra ‘The slope ofthe indifference curve is z ~D ‘We now have tivo equations and two unknowns: 4F=D 1O0D + 400F = 4000. Solving the above two equations gives D=20 and F=5. Utility is 1000. "This bundle ison an indifferenes curve between the two you had previously drawn, 16. Julio receives utility from consuming food (F) andl clothing (C) as given by the utility: function U(FC)= FC. In addition, the price of food is 82 per unit, the price of clothing is, $10 per unit, and Julio's weekly ineome is $50. What is Julio's marginal rate of substitution of food for clothing when utility is ‘maximized? Explain, Utility is maximized when MRS (lood for clothing) equals Po!Pr, the price ratio Given that clothing is om the borizontal axis and food is om the vertical axa, then the price ratios the slope of the budget line, whieh is pries af dlathing divided by the rice of food or “5 ‘Suppose instead that Julio is consuming a bundle with more food and less clothing than his utility maximizing bundle. Would his marginal rate of substitution of food for clothing be greater than or less than your answer in part a? Explain, In absolute value terms, the slope of his indifference curve at thie non-optimal bundle is greater than the slope of his budget line. He is willing to give up more food ‘than he has to at market prices to obtain one more unit of elothing. He will therefore find it optimal to give up some food in exchange for clothing. epsingesolxcrarosniogrpotcam plngesolxonmrosblogepotcam Chapter 8 Consumer Behavior fod camtent bale a optimatbonate lating 17. The utility that Meredith receives by consuming food F and clothing C is given by (F.C) = FC. Suppose that Meredith’ 1990 is $1,200 and the prices of food and clothing are S1 per unit for each. However, by 1995 the price of food has increased to $2 and the price of elothing to $3. Let 100 represent the cost of living index for 1990, Calculate the ideal and the Laspeyres cost-oFliving index for Meredith for 1995. (int: Meredith will spend equal amounts on food and clothing with these preferences.) First, we need to calculate F and C, which make up the bundle of feod and clothing which maximizes Meredith's utility given 1990 prices and her ineome in 1990, Use the hint to ‘simplify the problem: Since she spends equal amounts on both goods, PyF = P $1.00, ‘The siferonce nthe txpected roturn isnot enough to compensate Rick for the risk. For example if his Great is $10 and he buys $100 ticket, he would have $9.00, $1000, 314.00, and $iG50,reqpoctivels, unde the fou posbie outcomes Lst us assume that his til function ie U= W whore Wishis wealth, Then his expected uty EU= (05X9")+(025)(U0" "(OYA + (005)(6.5")= 3.157 ‘Thin sos han 3.162, hich tho uit ansocinted wth not busing the fcket, (Gli) 103.160, He would prefer thesure thing ie. 310. Suppose Richard was offered insurance against losing any money. If he buys 1.000 lottery tickets how much would be be willing to pay toimsuve his gamble? It Richard bays 1,00 tickets, ts ikely that he will have $1,025 nimus the $1,000 he aid, or $325, He would ne buy any inewance, ao the expocted return, $1,023, i {ater than tho cast, $1,000. He hav ineued hima, by buying a lange number of ‘kets Given tht Itchord io viek averse thourh, he may stil want fo buy insurance 1.025 e epsingesolxcrarosniogrpotcam plngesolxonmrosblogepotcam Chapter 5: Uncertainty and Consumer Behavior ‘The amount he woud be willing to pay i equal to the risk premium, whichis the mount of money that Richard would pay to avid the rise See figure 6.1 n the text ‘ocalealae the risk premium, you need to know the wtiityTuneion. IF the uit function is U'= W!, then fs expected uty fom the 1,000 ltery tice is EU= (0.5Y0"*)+ (0.25)(1000"*) + (0.2)(000"*)+-(0.05)(7500"")= 24.18, ‘This i lees than the ulility he would got ffom keoping bis $1000 which is 2.""To find the tsk premium, find the level of income that would 2 tity of 2118, which $4480. This means he would pay $1000 651-4 to naire his gamble. 4. Inthe long run, given the price of the lottery ticket and the probabitityreturn table, what de you think the state would do about the lottery? {the long rum, the sate lottery will bebankrupt! Given the price f the ticket and the ‘robabltes, the Iter in' money loner. ‘The state rns ithe raise the pice ofa {iket or lower the probability of postive payots 4. Suppose an investor is concerned about a business choice prospects, whose probability and returns are given below which there are three Probability Return oa $100 03 30 os -30 What is the expected value of the uncertain investment? What is the variance? "The expected value ofthe return on this investment is EV= (0.99100) + (0.8)(30) + (034-30) = S40. ‘The variance is = (0.41100 - 40? + 0.9),80 - 4092+ (0.3.80 - 4092 = $2,940. 5. You are an insurance agent who has to write a policy for a new client named Samm. His company, Society for Creative Alternatives to Mayonnaise (SCAM), is working on a low-fat, low-cholesterol mayonnaise substitute for the sandwich condiment industry. The sandwich industry will pay top dollar to whoever invents such a mayonnaise substitute first. Sam's SCAM seems like a very risky proposition to you. You have calculated his possible returns table as follows. Probability Return 999 $1,000,000 (he fails) 001 '$1,000,000,000 (he succeeds and sells the formula) ‘What is the expected return of his proje ‘The expected return, BR, of the investment is ER = (0.9994-1,000,000) + (0.001)(1,000,000,000 ‘The variance is (0.8999-1,000,000-1,000)* + (,002)1, 000,000,000 1,000), or 2 = 1,000,995,999,000,000, 68 epsingesolxcrarosniogrpotcam plngesolxonmrosblogepotcam Chapter 5: Uncertainty and Consumer Behavior What is the most Sam is willing to pay for insurance? Assume Sam is risk neutral, ‘Because Sam is risk neutral and because the expected cuteome is $1,000, Sam is ‘unmilling to buy insurance ‘Suppose you found out that the Japanese are on the verge of introducing their own, ‘mayonnaise substitute next month, Sam does not know this and has just turned down your final offer of $1,000 for the insurance. Assume that Sam tells you SCAM is only six months away from perfecting its mayonnaise substitute and that you now what you know about the Japanese, Would you raise or lower your policy premium on any subsequent proposal to Sam? Based on his information, would Sam accept? ‘The entry of the Japanese lowers Sam's probability of a high payoft. For example, assume that the probability of the billion dollar payoff is Jowered to zero, ‘Then the ‘expected outcome is (2,041,000, 000) + 0.0)(,000,000,000) = $1,000,000, ‘Therefore, you should raise the policy premium substantially. But Sam, not knowing about the Japanese entry, will continue to refuse your offers to insure his losses 6. Suppose that Natasha's utility famction is given by i(7)=~IOI, where I represents annual income in thousands of dollars. Is Natasha risk loving, risk neutral, or risk averse? Explain, Natasha is risk averse, ‘To shove this, assume that she has $10,000 and is offered a ‘gamble of a $1,000 gain with 50 porcent probability and a $1,000 loss with 30 pereent probability. Her utility of $10,000 i 10, (uC) = ¥1010 = 10), Her expected utility is EU = (0.54905) +(0,5(1108°) = 9.987 < 10. ‘She would avoid the gamble. Ifshe were risk neutral, she would be indiferent between ‘the $10,000 and the gamble; whereas, if she were risk loving, she would prefer the samble, You can alao sce that she is vsk averse by noting that the second devivative is nogative, implying diminishing marginal utility. ‘Suppose that Natasha is currently earning an income of $40,000 (I= 40) and can earn, ‘that income next year with certainty. She is offered a chance to take a new job that offers a .6 probability of earning $44,000, and a .4 probability of earning $33,000. Should she take the new job? ‘The utility of her current salary is 400%, which is 20. The expected utility of the new jobis EU (0.6(440") + (0.41880) = 19.85, ‘which is less than 20, ‘Therefore, che should not take the job, In 0), would Natasha be willing to buy insurance to protect against the variable income associated with the new job? If so, how much would she be willing to pay for that insurance? (Hint: What is the risk premium?!) Assuming that she takes the new jab, Natasha would be willing bo pas a risk premium equal to the diflerence between $40,000 and the utilty ofthe gamble so as to ensure ‘hat she obtains a level of wlity equal to 20. We know the utility of the gamble in equal to 19.85. Substituting into her utility funetion we have, 19.85 = (100%, and solving for I we find the income associated with the gamble to be $39,110. ‘Thus, Natasha would be willing to pay for insurance equal to the risk premium, $40,000 = $38,410 = $580, 69 epsingesolxcrarosniogrpotcam plngesolxonmrosblogepotcam Chapter 5: Uncertainty and Consumer Behavior 7. Suppose that two investments have the same three payaffs, but the probability. associated with each payoff differs, as illustrated in the table below: Payoft _Probabilities for Investment. A__ Probabilities for Investment B $300 0.0 030 $250 0.30 a0 $200 020 030 Find the expected return and standard deviation of each investment, ‘The expected value of the return on investment Ais BV= (0.19800) + (0.89250) + (0.24200) "The variance on investment A is 98 = (0.14800 - 250)! + (,8).250 250+ 0.14200 250)"= $600. ‘Tho expected value ofthe return on investment Bis EV =(0,3¥300) + (0.4250) + (0.84200) = $250, "The variance on investment Bis (0.3)(300 - 250} + (0.44250 - 2507+ (0.84200 - 250} = $1,500. b, ill has the utility function U = 57, where I denotes the payolT. Which investment ‘will she choose? Lil's expected utility from investment Ais BU=.1*(*300)+.845"250}+.1°6*200) JT's expected utility from investment Bis BUS.5*(64800)+.45"250}¢.3*65*200)= 250. ‘Since both investments give sill the same expected utility she willbe indifferent Ihetween the two, ¢.— Kenhas the utility fanetion U=-¥57. Whieh investment will he choose? Ken's expected utility from investment A is BU=1"(6"300)"54,8%G"250)04.19(5"200)9=85,52. Ken's expected utility from investment B is BI Ken will choose investment A since it has a higher expected utility. Notice that since ‘Kon ie risk averce, he will prefer the investment with les variability. 3*(5"300)0%4.4NG*25I)% 365" 200)=85.25, 4. Laura has the utility function U = 5°. Which investment will she choose? Laura's expected utility from investment A is BU=.1%6*900'800)+.8°—5*250"250)4.1*(5%200*200) Laura's expected utility from investment Bis BU=.8%(6"3008800)+.4°¢5*250"250)+.3*(5*200*200)=820,000, Laura will choose investment B since it has a higher expected utility, 5,000 0 epsingesolxcrarosniogrpotcam plngesolxonmrosblogepotcam Chapter 5: Uncertainty and Consumer Behavior 8. As the owner of a family farm whose wealth is $250,000, you must choose between, sitting this season out and Investing last year's earnings ($200,000) in a safe money. ‘market fund paying 5.0% or planting summer corn. Planting costs $200,000, with a six- month time to harvest. If there is rain, planting summer corn will yield $500,000 in revenues at harvest. If there is a drought, planting will yield $50,000 in revenues at harvest. As a third choiee, you ean purchase AgriCorp drought-resistant summer eorn at fa cost of $250,000 that will yield $500,000 in revenues at harvest if there is rain, and $850,000 in revenues at harvest if there is a drought. You are risk averse and your preferences for family wealth (W) are specified by the relationship U(W)=VW . The probability of a summer drought is 0.20 and the probability of summer rain is 0.70. Which ofthe three options should you choose? Explain. ‘You need to calculate expected utility of wealth under the threo options. Wealth is equal tothe initial $250,000 plus whatever is eared om growing corn, or investing the safe financial asset. Expected utility under the safe option allowing forthe fact ‘that your initial wealth is $250,000 is: BO Bxpected utility with regular corn, 2g 250,000 + 200,000(1 + 05) n including your initial wealth B(U) = {250,000 + (500,000 -200,000)* + (250,000 + (60,000 - 200,000))9 = 619.13 +9487 =614 ors, Expected utility with drought-resistant com, again including your bi B(U) = .7(250,000 + (500,000 - 250,000))8 + .24250,008 + (850,000 - 250,0005)2 = 491,975 + 177489 = 672.46. cal wealth: You should choose the option with the highest expected utility, which is the safe option of not planting com. 9. Draw a utility function over income u(l) that has the property that a man is a risk lover when his Income is low but a risk averter when his income is high. Can you explain why such a utility function might reasonably deseribe a person's preferences? Consider an individual who needs a certain level of income, J, in order to stay alive ‘An increase in income above J will have a diminishing mavpinal wility. Below I, the Individual will bea risk lover and will take unfair gambles in an effort ro make large ‘ine in ineome. Above [*, the individual will purchase insurance against loses, a epsingesolxcrarosniogrpotcam plngesolxonmrosblogepotcam Chapter 5: Uncertainty and Consumer Behavior Usiliey Bigure5.9 10. A city is considering how much to spend monitoring parking meters. ‘The following information is available to the eity manager: i. Hiring each meter-monitor costs $10,000 per year. [Link] one monitoring person hired, the probability ofa driver getting a ticket cach time he or she parks illegally is equal to 25, Hi, With two monitors hired, the probability of getting a ticket is 5, with three ‘monitors the probability is.75, and with four the probability Is equal to 1. ‘The current fine for overtime parking with two metering persons hired is $20. ‘Assume first that all drivers are risk-neutral. What parking fine would you levy and how many meter monitors would you hire (I, 2,3, or 4) to achieve the current level of deterrence against illegal parking at the minimum cost? If drivers ave risk neutral, their behavior is ony inuenees hy the expected fine, With ‘wo metermonitors, the probability of detwetion is 0.5 and the fine ix $20, So, the ‘expected fine is $10 = (0.5)(820). Te maintain this expected fine, the ity ean hire one ‘metzr-monitor and inerease the fine to $40, or hire three meter-monitors and decrease ‘the fine to $15.38, or hire four meter-monitars and deensase the Fine to $10, If the only cost to be minimized isthe cost of hiring moter: monitors, ie, $10,000 per year, you 28 the city manager, should minimize the number of [Link]. Hine only one monitor and increase the fine to $40 to maintain the current level of deterrence. b. Now assume that drivers are highly risk averse. How would your answer to (a) chang Lf drivers are risk averse, their utility ofa certain outcome is greater than their utility of an expected value equal tothe certain outcome. ‘They will avoid the possibility of praying & parking fine more than would risk-neutral drivers, ‘Therefore a fine of less ‘han $40 wil maintain the current level of deterrence ©. (For discussion) What if drivers could insure themselves against the risk of parking: Fines? Would it make good publie poliey to permit such insurance? Drivers engage in many forms of behavior to insure themselves against the risk of parking fines, such as parking blocks away from their destination in a non-metored a epsingesolxcrarosniogrpotcam plngesolxonmrosblogepotcam Chapter 5: Uncertainty and Consumer Behavior spot or taking public transportation. A private incurance frm could offer an insurance policy to pay fines if a ticket i reesived. Of course, the premium far such insurance ‘Would be based on each driver's probability of receiving a parking ticket and on the opportunity cost of providing service. (Note: full insurance leads to moral hazard problems, to be discussedin Chapter 17) Public policy should attempt to maximize the difference between the benefits and costs to all parties. Private insurance may not be optimal, because of the increase in ‘mansactions casts. Instead, as the city manager, consider offering another form of insurance, et. the selling of parking stickers, and give tickets for inappropriately parked ears a epsingesolxcrarosniogrpotcam plngesolxonmrosblogepotcam Chapter 5: Uncertainty and Consumer Behavior LL. A moderately risk-averse investor has 50 percent of her portfolio invested in stocks and 50 percent invested in visk-free Treasury bills. Show how each of the following events will affect the investor's budget line and the proportion of stocks in her portfolio: a. The standard deviation of the return on the stock market increases, but the expected return, ‘on the stock market remains the same. From section 5.4, the equation forthe budget line is [= fem ‘whore Ry is the expected roturn on the porto, Ry is the expected retum on the risky set, Ris the expected return on the rskeftee asset, mis the standatd deviation of ‘the retum on the risky asact, and gy is the standard deviation of the return on the portfolio. The budget line shows the postive relationship between the return on the portfolio, Ry, and the standard deviation of the zeturn om the portili, oy. [In this easo, ifthe standard doviation of the return on the stock market increases, ‘the slope of the budget line will change and the budget line will beome flatter. At an aziven level of portfolio return, there is now a higher standard deviation associated with ‘that level ofeturn, You would expect the proportion of stacks inthe portfolio to fal, b. The expected return on the stock market increases, but the standard deviation stock market remains the same. In this cas, ifthe expeeted return on the stock market inereases, Ro, then the slope of ‘the budget lino will ehange and the budget line will bocome steoper. At any given lovel of standard deviation of return, 6, there is now a higher level ofvetum, K You would ‘expect the proportion ofstocksin the portfolio to rise. return on riskfree Treasury bil Im this case there is an increase in Rr. The budget line wil pivot and ahift, or in other words will shift up and become fatter. The proportion of stocks in the portfolio could go cither way. On the one hand, Treasury bills now have a higher return and so are Inwore attractive. On the other hand, the investor can now earn higher return from cach Treasiry bill so could hold fewer Treasury bills and still maintain the same return in terms of the total low or payment from the Treasury bills. In this second ease, the investor may be willing to place more of his savings into the riskier amet. It will depend on the particular preference of the investor, ax well ax the magnitude of the retums to the to assets. An analogy would be to consider what happens to savings ‘when the interest rate increases. On the one hand it goes up because the return is higher, but on the cther hand it ean go dowen because a perssn ean save less each period ‘and sill eome out with the same accumulation of savings at some fature date u epsingesolxcrarosniogrpotcam of the plngesolxonmrosblogepotcam Chapter 6: Production CHAPTER 6 PRODUCTION TEACHING NOTES Chapter 6 is the fist of the three chapters that present the basic theary of supply. It may be ‘beneficial to first review, oF summarize, the derivation of demand and present an overview of the theory of competitive supply. The review can be beneficial given the similarities between the theory of demand and the theory of supply. Students often find that the theory of supply is easier to understand because it is less abstract, and the concepts are mare familiar. This in turn can improve the students! ‘understanding of the theory of demand when they go back and review it again. In this chapter itis important to take the time to carefully go through the definitions, as this will be the foundation for what is done in the next two chapters. While the concept of a preduction funetion isnot dificult, the mathematica] and graphical representation ean sometimes be confusing. Te holpe to take the time'to do as many examples as you have time for. Whon describing and graphing ‘the production faction with output on the vertial axis and one input on the horizontal axe, point ot ‘thatthe prediction incon isthe equation forthe boundary of the production set, and hence defines the highest level of output for any given level of inputs. Technical efficieney is assumed throughout the discussion of the theory of supply. At any time you can introduce a discussion of the importance af ‘improving productivity and the concept of leaming by doing. Examples 1 and 2 in the text are also 00d for discussion Grophing the production function leads naturally to a discussion of marginal product and diminishing returns. Emphasize that diminishing rotums ext because come factors are fixed by definition, and that diminishing returns does not mean negative returns. I you have not discussed arginal utility, now isthe time to malke sure thatthe student knows the difference between average fand marginal. An example that caplures students’ attention is the relationship hetween average ard ‘marginal test scores. If their latest mid-term grade is greater than their average grade to date, this will increase their average Tsoquante are defined and discussed in section 6.3 of the chapter, Rely on the students understanding of indifference curves when discussing isoquanta, and point out that as with Inlference curves, isoquants are a twoddimensional representation ofa three-dimensional production function. Key concepts inthis section of the chapter are the marginal rate of technical substitution and returns to scale. Do as many concrete examples as you have time for to help explain these to Important concepts, Examples 6.3 and 6.4 help to give concrete meaning to MATS and returns to seale. Section 6.4 discusses returns to wale. QUESTIONS FOR REVIEW 1. What is a production function? How does a long-run production function differ from a short-run production function? ‘A production funetion represents how inputs are transformed into outputs by a firm, ‘We focus on the firm with one output and aggregate all inputs or factors of production into one of several categories, such as labor, capital, and materials. In the short run, ‘one o more factors of production eaimnot be changed, As time goes by, the frm has the ‘opportunity to change the levels ofall inputs. In the long-run production funetion, all inputs are variable. 2. Why is the might the mantinal product of labor lilcely to initially inerease initially in the short run as more of the variable Input is hired? ‘The marginal product of labor is Likely 10 ean-initially-inerease initially heeauscif when there are het-with-more- more workers, each worker able to specialize on one-an aspect of the production process in which ‘ne_or-she-is-partigulariy- skilled, For example, think of the typical fost food restaurant. If there is only one worker, he will need to propare the burgers, ries, u epsingesolxcrarosniogrpotcam plngesolxonmrosblogepotcam Chapter 6: Production ‘and sodas, as well as take the orders. Only so many customers can be served in am hour. With two or three workers, each is able to specialize and the marginal product (number of eustomers served per hour) is likely to increase as we move from one to ‘ovo to three workers. Eventually, there will be enough workers and there will be no ‘more gains from specialization. At this point the marginal product will diminish. 4 Why docs production flrms-eventually experience diminishing marginal returns to Inbor in the short run? "The marginal product of labor will eventually diminish because there will he atleast one ase ty sastmption-come fixed factor of production, such us capital. Bydeision. liber all-else-the-seme-—With capital fixed, the workplace will eventually become x0 ed, that the productivity of additional workers will decline. Also, with espital fixed, as more workers are added, they will need to share the fixed capital, which will eventually cause the marginal product of labor to diminish as the eapital is spread across too many workers. Think for example of an office where there are aniy three computers, As more and more employees must share the computers, the marginal product of each additional employee will diminish. 4. You are an employer seeking to fill a vacant position on an assembly line. Are you. ‘more concemed with the average product of labor or the marginal product of labor for the last person hired? If you observe that your average product is just beginning to decline, should you hire any more workers? What does this situation imply about the marginal product of your last worker hired? In filling a sneant position, you should be concerned with the marginal product of the last worker hired becauce the marginal product measurve the elfect on output, or total product, of hiring another wore. ‘This in tum wall help to determine the revente sonerated by hiring another worker, which ean then be compared to the cost of hiring ‘another worker. ‘The point at which tho average product begins to decline isthe point whore average oduct is eqal to marginal product. When average product declines, tae manginal Product of the last worker hived ie lower than the average product of previously hired. workers Although adding more workers results in a further decline in average product, total product continues to inerease, soit may sill be advantageous to hire another worker. 5. What is the ‘A production fumetion describes the maximum output that can be achieved with any fziven combination of inputs. An isoquant identifies all of the different combinations ofthe inputs that ean be used to produce one particular level of eutput, lifference between a production function and an isoquant? 6. Faced with constantly changing conditions, why would a firm ever keep any factors fixed? What criteria determine whether a factor is fixed or variable? ‘Whether a factor is fied or variable depends on the time horizon in consideration: all factors are fixed in the very short run! all factors are variable in the long ran. A stated in the text “All fied inputs in the short run represent outcomes of previous Tong-run decisions based on firms’ estimates of what they eould profitably produce and soll” Some factors are fixed in the short run, whotber the firm likoe it or not, simply because it takes time to adjust the level ofthe variables. For example, the firm may be legally hound by a lease on a building, some employees may have contract that must bb uphold, or construction of a new facility may take some number of months. Recall ‘that the short un ia not defined aa a specific number of months or years, but as that period of time where some inputs cannot be changed for reasons euch as those given above, epsingesolxcrarosniogrpotcam plngesolxonmrosblogepotcam Chapter 6: Produetion 7. Tsoquants ean be convex, linear, or L-shaped. What does each of these shapes tell you about the nature of the production function? What does each of these shapes tell you bout the MRIS? Convex isequants imply that within some range, some number of unite of one input can be substituted for a unit of the other input, and outpat ean be maintained at the same level, In this ease, the MTS is diminishing as we move down along the isoquant, Linear isoquante imply that the slope, or the MRTS, is constant. This ‘means that the sime number of units of one input can always be exchanged fora unit, of the other input and ouput ean be maintained. The inputs arv perfect substitutes [L-shaped isequants imply thatthe inputs are perfect complements, or that the frm is reducing under a fixed proportions type of technology’. In this case the firm cannot give up one input in exchange for the other and still maintain the same level of output. For example, the firm may require exactly 4 unite of capital for eaeh unit of Taber, in which ease one input cannot be substituted for the other. 8, Can an isoquant ever slope upwards? Explain. No. This would mean that if you inreased beth inputs then output would stay the same. Asa general rule, if the firm has more of all the inputs they can produce more output. 9. Explain the term “marginal rate of technical substitution"? What docs a MRTS=4 MTS is the amount by which the quantity of one input ean be reduosd when the other input ie inereased by one unit, while and til: maintaining the same level of output. If the MIETS is 4 then the one input ean be reduced by 4 units aa the other is increased by one unit and output will be the same. 10, Explain why the marginal rate of technical substitution is likely to diminish as more and more labor is substituted for eapital, ‘Phe MIPS itikelste-diminink-heeatmees the quantities ofthe inputs are changed the marginal product of exch input will change. Ax more and. marr labor is added, ‘the marginal product of labor is likely to diminish. Becauss Ae-eapital i= has been reduced, each unit of capital remaining is likely to be more productive. Theretore ‘more units of labor will be required to replace each unit of capital. Altematively, as wwe move down and to the right along an the-isoquant along sthieh tho MRTS i diminishing, we have to give up less capital for each unit per-unit-of labor added to eep output constant, 11. Diminishing returns to a single factor of production and constant returns to seale are not inconsistent, Discuss, Diminishing returns 9 @ single factor are observable in all production processes at some level of inputs. This fat is so pervasive that economists have name it the “law of diminishing marginal productivity.” By definition, the marginal product of an input is the additional output generated by employing one more unit of the input, all other inputs held fixed. The extra output, or returns, tothe single input diminish hecatse all, other inputs are held fixed. For example, when holding the lovel af eaptal constant, ‘each additional unit of labor hus lees eapital to work with, Unlike the returns to a single factor, returns to scale are proportional increases in all inputs While each factor by itself exhibits diminishing returns, output may more than double, less than double, or exactly double when all the inputs are doubled. The distinction again ie that with returns to scale, all inpute are increased in the eame proportion and no input is he fixed, 6 epsingesolxcrarosniogrpotcam plngesolxonmrosblogepotcam Chapter 6: Production 12, Can a firm have a production funetion that exhibits increasing returns to scale, constant returns to scale, and decreasing returns to scale as output increases? Discuss. ‘Most firms have production funetions that exhibit first increasing, then constant, and ultimately decreasing returns to scale, At Iw loves of output, a proportional increase in all impute may lead to a larger-than-propestianal inevease in output, based on 2m inerease in the opportunity for each factor to xpecalize. For example, if there are now ‘vo people and two computers, each person ean specialize by comploting those tasks ‘that they are best at, which allows output to move than double. Aa the firm grows, the ‘opportunities for specialization may diminish and a doubling ofall inputs will ead to only a doubling of output. When there are constant returns to scale, the frm is replicating what itis already doing. At some level of production, the firm will beso large that when inputs are doubled, output will less than double, a situation that can arise from management diseconomies. 13, Give an example of a production process in which the short run involves a day or a week and the long run any period longer than a week. Any small business where one input requires more than a week to change would be an example. The process of hiring more labor, which roquires announeing the pesition, intorviewing applicants, and nogotiating terms of employment, ean take a day, if dane ‘through a temporary employment agency. Usually, however, the process takes a weele for more. Expansion, requiring a largcr location, will also take longer than a week. EXERCISES | 1, The menu at Joe's coffee shop consists of a varicty of coffee espresso-type-drinks, pastries, and sandwiches. The marginal product of an additional worker can be defined as the number of customers that can be served by that worker in a given time period. Joe has been employing one worker, but is considering hiring a second and a third. Explain why the marginal product of the second and third workers might be higher than the first and second workers, respectively. Why might. would-you expect the marginal product of ‘anadditional workers to eventually diminish in-thiscase? ‘The maMarginal product could well may-inerease for the second and third workers, Since each of the first 2 oF 3 workers would be able to specialize in a different task. Th ‘there is only 1 worker, then that worker will have to take onders and peopare all the food. “Eventually, however, the marginal product would diminish because there ‘would be too many people behind the counter teying to accomplish the seme-taska limited number of tasks, 2. Suppose a chair manufacturer is producing in the short run (with its existing plant ‘and equipment), The manufacturer has observed the following levels of production corresponding to different numbers of workers: Number of chairs Number of workers 10 18 Py 2s 20 28 2% 7 epsingesolxcrarosniogrpotcam plngesolxonmrosblogepotcam Chapter 6: Production Calculate the marginal and average product of labor for this production function, Teves a, AP, etl 2, Te mg ptt bor, MP, ‘production process we have: LQ AP, MP, oo = = 1 10 0 10 2 8 ® 8 a 8 6 4 7 4 5 6 2 58 47 2 7 a6 a b. Does this production function exhibit diminishing returns to labor? Explain. ‘This production process exhibits diminishing returns to labor, ‘The marginal product of Jaber, the extra output produced by each additional worker, diminishes as worksrs are add, and is actually negative forthe sith and seventh workers, ¢. Explain intuitively what might cause the marginal product of labor to become negative, Labor's negative marginal product for L > 5 may arise from eongostion in the chair ‘manufacturer's factory, Since more laborers are using the sume, fixed amount of capital, itis poanible that they eould get in each cthar's was, deereasing efficiency and ‘the amount of output. Many firms also have to control the quality of output and the hhigh congestion of labor may produce output that is not of a high enough quality to be offered forsale, which ean contribute to-a negative marginal produc. 3, Fill in the gaps in the table below. Quantity of Total Marginal Product Average Product Variable Input Output of Variable Input of Variable Input ° ° _ _ 1 225 2 300 a 300 4 140 5 225 6 235 78 epsingesolxcrarosniogrpotcam plngesolxonmrosblogepotcam Chapter 6: Production Quantity of ‘Total Marginal Product Average Product Variable Input Output of Variable Input of Variable Input 0 ° _ _ l 25 235 2 2 600 375 300 3 900 300 800 4 140 240 285 5 1365 225 23 6 1350 15 5 4. A political campaign manager has to decide whether to emphasize television advertisements or letters to potential voters in a reelection campaign. Describe the production function for campaign votes, How might information about this function, (such as the shape of the isoquants) help the campaign manager to plan strategy? ‘The output of eoncem to the campaign manager is the mumber of votes, The production funetion uses to inputs, television advertising and direct mail. The use of ‘these inputs requires knowledge of the substitution possibilities between them. If te inputs are perfoct substitutes, the resultant isoquanta are line segments, and the ‘campaign manager will use only one input based an the relative prices, If the inputs fare not perfect substitutes, the jsoquants will have a convex shape. ‘The campaign manager will then use a combination ofthe to inputs 5. For each of the following examples, draw a representative isoquant, What ean you say about the marginal rate of technieal substitution in each case? a. Affirm can hire only fulltime permanent employees to produce its output, or it ean hire some combination of fulltime and parttime permanent-employees-and ‘vemporary- employees. For each full-time permanent worker let go, the firm must hire an increasing number of temporary employees hours-to maintain the same level of output. Place part time workers on the vertical axis and fll time workers on the horizontal axis, The slope of the ieoguant measures the number of part time workers that ean bbe exchanged for a fulltime worker, while still maintaining output, When we are at ‘the bottom end of the ioquant we have a let of full time workers and few part time workers, As we move up the isoquant and give up full time workers, we must hire ‘more and more part time workers to replace each full time worker. The slope Increases (in absolute value terms) as we move up the isoquant. ‘The isoquant is therefore convex and we have diminishing’ marginal rate of technical substitution Knowing this taformation-will help-the firm choose the right mie of permancnt-and temporaryemployeos b. Affirm finds they it can always trade two units of labor for one unit of eapital and still keep output constant. ‘The marginal rate of technical substitution measures the number of units of labor ‘that ean be exchanged for a unit of capital while stil maintaining output. Ifthe frm fan always trade two labor for one capital then the MRTS is constant and the ‘soquant i linear. A firm requires exactly (wo five fulltime workers to operate each piece of ‘machinery in the factory. 9 epsingesolxcrarosniogrpotcam plngesolxonmrosblogepotcam Chapter 6: Production ‘This firm gperates under a fixed proportions technology. and the isoquants are L. shaped. The firm cannet exchange any labor for capital and still maintain output ‘ees it must maintain a fixed 2:1 ratio of laborsapital 6, A firm has @ production process in which the inputs to production are perfectly. substitutable in the long run. Can you tell whether the marginal rate of technical substitution is high or low, or is further information necessary? Discuss. ‘The marginal rate of technical substitution, MRS, is the absolute value of the slope of fan isoquant. If the inputs are perfect substitutes, the iscquants will be linear. To calculate the dope ofthe isoquant, and hence the MJRTS, we need te know the rate at Which one input may be substituted for the other. In this case, we do not know whether the METS is high or low. ll we know is that itis a constant number. We need to know the marginal product ofeach input to determine the MRTS. 7. The marginal product of labor in the production of computer chips is 50 chips per hour. The marginal rate of technical substitution of hours of labor for hours of machine- capital is U4. What is the marginal product of capi ‘The marginal rate of technical substitution is defined at the ratio of the two maninal producta, Here, we are given the marginal product of Inbar and the marginal rate of ‘echnical substitution, To determine the marginal produet of capital substitute the ssiven values for the marginal product of labor and the marginal rate of technical Substitution into the following formals 1 @ Sar,” RTS. 0: sip = > _MP,, = 200 computer chips per hour. 8. Do the following functions exhibit imereasing, constant, or decreasing returns to seale? What happens to the marginal product of each individual factor as that factor is increased, and the other factor is held constant at some level? a g=3b2K ‘This function exhibite constant retums to scale. For example if L is 2 and K is 2 then q is 10. If Lis 4 and Kis 4 then q is 20. When the inputs are doubled, output will double. Hach marginal product is constant for this production funetion. When L. increases by 1 q will increase by 3. When K inereases by Tq will increase by 2 be g=Qb+2K) ‘This function exhibits decreasing returns to scale. For example, ifLis 2 and K is 2 thon qis 28. If Lie 4 and Kis 4 then q is 4. Whon the inputs are doubled, cutput will less than double. ‘The marginal product of each input is decreasing. This can be determined using caleulus by differentiating the production function with respeet to either input, while holding the other input constant, For example, the marginal produet of labor is 2(2L + 2K) Since Lisin the denominator, as L gets bigger, the marginal produet gets smaller. If you do not know caleulus, then you can choose several values for L, find q (for seme fixed value of K), and then find the marginal product. For example, if L=4 and then g=4. If L#5 and Ked then q=ii24. If L=6 and Kea then q= 447. Marginal ‘product of labor fall from 0.24 to 0.23 80 epsingesolxcrarosniogrpotcam a e plngesolxonmrosblogepotcam Chapter 6: Produetion ‘This function exhibits increasing returns to seale. For example, if L ie 2 and K is 2 then gis 24 IPL is and Kis d then q ix 192. When the inputs are doubled, output ‘will more than double. Notice also that ifwe inerease each input by the same factor A then we get the following: = HULVAKY = 231K = 2g Since A is raised toa power greater than 1, we have increasing returns to scale, ‘The marginal product of labor is constant and the marginal product of capital is increasing. For any given value of K, when L is increased by 1 unit, q will 20 up by 3K" units, which is a constant mumber. Using calculus, the marginal product of Capital is MPK=2°3+1L7K. As K increases, MPK will increase, Tf you do not know faleulus then you ean fix the value of L, choose a starting value for K. and find «, [Now increase K by 1 unit and find the new q. Do this afew more times and you can ealeulate marginal produet, This was dane in part b above, and is done in part d below. ae ‘This function exhibits constant retums to scale. For example if L is 2 and K is 2 then qis 2 IfLis4 and Kis {then q ia 4. When the inputs are doubled, output will ‘exactly double, Notice also that if we increase each input by the same factor 2 then we get the flowing: Since A is raised tothe power 1, we have constant returns to sale. ‘The marginal product of labor is decreasing and the marginal produet of capital is decreasing, Using caleulus, the marginal product of eapital is L pK = Pe For any given value of Las K increases, MPK will increase, If you do not know caleulus then you can fix the value of L, choose a starting value for K,and find q, Let Las for example. IfK is 4 then qis 4 if Kis then q Is 4.47, and if Kis 6 then qis 4499, The marginal product of the 5! unit of K is 4.47-4-047, and the marginal product of the 62 unit of K is 4.89-4.4770,42. Hence we have disinishing marginal Product of capital, You ean do the same thing for the marginal product of labor aL 44K ‘This function exhibits decreasing returns to scale. For example, if Lis 2 and K is 2 thon q is 1865. If Lia 4 and K is 4 then q is 24. When the inputs are doubled, output will less than double. ‘The marginal product of labor is decreasing and the marginal product of expital is constant. For any given value of L, when Kis increased by 1 unit, q will goup by 4 tunite, which is a constant number. To sce thot the marginal product of labor is decreasing, fis K=1 and choose values for L, If L=1 then a=8, if L=2 then @-8.65, and if L#3 then g=10.98. The marginal product of the second unit of labor is 9.65-81.65 land the marginal product of the third unit of labor i= 10.9-9.65=1.28 Marginal Droduet of labor is diminishing. SI epsingesolxcrarosniogrpotcam plngesolxonmrosblogepotcam Chapter 6: Production 9. The production function for the personal computers of DISK, Ine.,is given by = 10KSL25, where q is the number of computers produced per day, K is hours of machine time, and L Is hours of labor input. DISK’s competitor, FLOPPY, Inc, is using the production function q = 10K™Lé, If both companies use the same amounts of capital and labor, which will generate ‘more output? Let @ be the output of DISK, Ine, q,, be the output of FLOPPY, Inc, and X be the same oqual amounts of eaptal and labor for the two firme Then, according to Uhoir ‘roductien functions, i 10xs99= 10 and 9, LONER = LONE“ = 10K. Because q= a, both firms generate the same output with the same inputs. Note that if ‘the two firms both used the same amount of capital and the same amount of labor, but ‘the amount of eapital vas not equal to the amount of labor, then the two firms would ‘ot produce the samelovelof output. In fact, if K>L thon qq b. Assume that eapital is limited to 9 machine hours but labor is unlimited in supply. In. which company is the marginal product of labor greater? Explain. ‘With capital limited to 9 machine units the production functions become q =30L"* and 4, = STATIN To determine the production function with the highest marginal ‘productivity oflabor, consider the fllowing table: L q MP, 4 MP, Firm 1 Firm 1 Firm? Firm2 0 00 _ 0.00 1 30.00 30.00 an37 mat 2 12.48 12.43 4931 11.94 3 51.96 9.53 5800 869) 4 60.00 S04 6307 107 Foreach unit of labor above 1, the marginal productivity of labor is greater for the first firm, DISK, Ine 10. In Example 6.3, wheat is produced according to the production function = 100K1 82, Beginning with a capital input of 4 and a labor input of 49, show that the marginal product of labor and the marginal product of eapital are both decreasing. ‘For fixed labor and variable capital: K= 4 ¢= (200 )49"4) = 660.22 K=5=¢= (100(9%9)49") = 789.25 = MP, = 129.08 K 65 = (100)(6% (49%) = 15.19 = MP, = 128.94 K=7 = 4 = (100)(7\(49%4) = 1,035.04 = AMP, = 119.85, For fixed capital and variable labor: L= 499 = (100%8)49%*) = 68022 82 epsingesolxcrarosniogrpotcam plngesolxonmrosblogepotcam Chapter 6: Production 50= 9 = (100M 494)(60%") = 662.89 > MP, Notice that the marginal products of both capital and labor are decreasing as the variable input increases. Does this production function exhibit increasing, decreasing, or constant returns to seale? Constant Gnereasing, decreasing) retums to scale imply that proportionate inereases in Inputs lead to the same (more than, less than) proportionate increases in output. Thwe were to increase labor and capital by the same proportionate amount (2) in this ‘roductien function, output would change by the same propartionate amount: 2g = [Link]* 1)", oF dg = 1ODK™* 192300803 = gh, "Therefore, this production fonction exhibits constant returns to scale. 83 epsingesolxcrarosniogrpotcam

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