Market and Efficiency
Practice Questions
ECON2113 Microeconomics (L1/L7)
Tutorial Four
Jeremy TO
Department of Economics, HKUST
Jeremy TO ECON2113 Microeconomics (L1/L7)
Market and Efficiency
Practice Questions
Resource Allocation Methods
Resources are scarce, so they somehow must be allocated.
Different methods of allocating resources include:
Market price: The people who are willing and able to buy a
resource get the resource.
Command: A command system allocates resources by the
order (command) of someone in authority.
Majority rule: Resources are allocated in accordance with
majority vote.
Contest: Resources are allocated to the winner.
First-come, first-serve: Resources are allocated to those who
are first in line.
Lottery: Resources are allocated to the people who pick the
winning number, choose the lucky card, etc.
Jeremy TO ECON2113 Microeconomics (L1/L7)
Market and Efficiency
Practice Questions
Demand, Willingness to Pay, and Value
The value of one more unit of a good or service is its marginal
benefit. Marginal benefit is the maximum price that people
are willing to pay for another unit of a good or service. And
the willingness to pay for a good or service determines the
demand for it. Consequently the demand curve for a good or
service is also its marginal benefit curve.
Consumer surplus: It is the value (or marginal benefit) of the
good minus the price paid for it, summed over the quantity
bought (the area under the demand curve and above the
price).
Diminishing Marginal Benefit: The more you already have
of a good, the less valuable an additional unit of that good is
to you.
Low prices are great for consumers: The lower the price,
the larger amount of consumer surplus can be obtained by
consumers.
Jeremy TO ECON2113 Microeconomics (L1/L7)
Market and Efficiency
Practice Questions
Supply, Cost, and Minimum Supply-Price
The cost of producing one more unit of a good or service is its
marginal cost. Marginal cost is the minimum price that
producers must receive to induce them to produce another unit
of the good or service. And the minimum acceptable price
determines the quantity supplied. Consequently the supply
curve for a good or service is also its marginal cost curve.
Producer surplus: It is the price of a good minus its minimum
supply-price (or marginal cost), summed over the quantity sold
(the area above the supply curve and below the price line).
Increasing marginal cost: Initially, firms use the cheapest
resources possible. As output expands, however, additional
resources will become increasingly costly.
High prices are great for producers: The higher the price,
the larger amount of producer surplus can be obtained by
producers.
Jeremy TO ECON2113 Microeconomics (L1/L7)
Market and Efficiency
Practice Questions
Efficiency of Competitive Equilibrium
When the efficient quantity of a good is produced, the sum of
the consumer surplus and producer surplus (total
surplus) is maximized.
Total surplus: The total area between the supply and
demand curve up to the point of equilibrium.
Invisible hand: Adam Smith, in his 1776 book The Wealth of
Nations, articulated how competition led self-interested
consumers and producers to make choices that unintentionally
promote the social interest as if they were led by an “invisible
hand”.
Jeremy TO ECON2113 Microeconomics (L1/L7)
Market and Efficiency
Practice Questions
Market Failure
Inefficiency can occur because either too little of an item is
produced (underproduction) or too much is produced
(overproduction).
In either case, a deadweight loss occurs. A deadweight loss is
the decrease in the consumer surplus and producer surplus
(decrease in total surplus) that results from producing at an
inefficient level of production.
Jeremy TO ECON2113 Microeconomics (L1/L7)
Market and Efficiency
Practice Questions
Sources of Market Failure
Externalities: An externality is a cost or a benefit that affects
someone other than the seller or the buyer.
Public Goods and Common Resources: A public good is a
good or service that is consumed simultaneously by everyone
even if they don’t pay for it. Public goods lead to a free-rider
problem, in which people do not pay for their share of the
good.
Monopoly: A monopoly is a firm that has sole control of a
market. To maximize its profit, a monopoly produces less than
the efficient quantity and so creates inefficiency.
High transactions costs: The opportunity costs of making a
trade are transactions costs. When these costs are high, a
market might underproduce because too few transactions take
place.
Jeremy TO ECON2113 Microeconomics (L1/L7)
Market and Efficiency
Practice Questions
Question 1
The table gives the demand and supply schedules for sandwiches
Price Quantity demanded Quantity supplied
(dollars per sandwich) (sandwiches per hour) (sandwiches per hour)
0 300 0
1 250 50
2 200 100
3 150 150
4 100 200
5 50 250
6 0 300
(1) What is the maximum price that consumers are willing to
pay for the 200th sandwich?
(2) What is the minimum price that producers are willing to
accept for the 200th sandwich?
(3) If 200 sandwiches a day are available, what is the total
surplus?
Jeremy TO ECON2113 Microeconomics (L1/L7)
Market and Efficiency
Practice Questions
Question 2
The Right Price for Digital Music Apple’s $1.29-for-the-latest-songs
model isn’t perfect and isn’t it too much to pay for music that
appeals to just a few people? What we need is a system that will
be profitable but fair to music lovers. The solution: Price song
downloads according to demand. The more people who download a
particular song, the higher will be the price of that song; the fewer
people who buy a particular song, the lower will be the price of that
song. That is a free-market solution—the market would determine
the price.
Source: Slate, December 5, 2005
Assume that the marginal social cost of downloading a song from
the iTunes Store is zero. (This assumption means that the cost of
operating the iTunes Store doesn’t change if people download more
songs.)
Jeremy TO ECON2113 Microeconomics (L1/L7)
Question 2
(1) Draw a graph of the market for downloadable music with a
price of $1.29 for all the latest songs. On your graph, show
consumer surplus and producer surplus.
(2) With a price of $1.29 for all the latest songs, is the market
efficient or inefficient? If it is inefficient, show the deadweight
loss on your graph.
(3) If the pricing scheme described in the news clip were
adopted, how would consumer surplus, producer surplus, and
the deadweight loss change?
(4) If the pricing scheme described in the news clip were
adopted, would the market be efficient or inefficient? Explain.
(5) Is the pricing scheme described in the news clip a
“free-market solution”? Explain.
Market and Efficiency
Practice Questions
Question 3
Breakfast Staples Face Surging Prices The price of orange juice is
surging because of global supply problems. Florida’s orange crop is
fore- cast to be the worst in almost a quarter of a century. A citrus
greening disease, which is transmitted by tiny insects that feed on
the leaves of oranges, is damaging the harvest.
Source: CNBC, March 21, 2014
(1) How is the price of orange juice determined?
(2) When the supply of orange juice decreases, explain the
process by which the market adjusts.
(3) On a graph, show the effect of the decrease in supply on
consumer surplus and producer surplus.
Jeremy TO ECON2113 Microeconomics (L1/L7)