Chapter 1 Economics: Foundations and Models Problem Set

1) What is equity, and how does it differ from efficiency?

Answer: Equity refers to the fair distribution of economic benefits. In economics, efficiency
refers to least cost production (productive efficiency) and producing according to human
preferences (allocative efficiency).

2) What is opportunity cost?

Answer: Opportunity cost refers to the highest-valued alternative that must be given up to
engage in an activity. For example, the opportunity cost of taking this economics class is what
you are giving up to take the class, which may be taking another class such as accounting or
psychology, working extra hours at your job, or extra sleep (whichever is your highest-valued
alternative).

3) Define productive efficiency. Does productive efficiency imply allocative efficiency? Explain.

Answer: Productive efficiency is an efficiency criterion that describes a situation in which goods
and services are produced at the lowest possible cost. It does not imply allocative efficiency
which is a criterion associated with producing goods and services that consumers value most. For
example, a manufacturer may be able to produce typewriters at the lowest possible cost of $200,
but this does not necessarily mean that consumers are willing to pay $200 for a typewriter.

4) What is a centrally planned economy?

Answer: A centrally planned economy is an economy in which the government decides how
economic resources will be allocated.

4a) What is voluntary exchange?

Answer: Voluntary exchange is a situation that occurs in markets when both the buyer and seller
of a product are made better off by the transaction.

5) What is a mixed economy?

Answer: A mixed economy is an economy in which most economic decisions result from the
interaction of buyers and sellers in markets but in which the government plays a significant role
in the allocation of resources.

5a) Every society faces trade-offs. Explain the concept of trade-offs.

Answer: Trade-offs refer to the idea that, because of scarcity, producing more of one good or
service means producing less of another good or service.

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6) Trade-offs force society to make choices when answering what three fundamental questions?

Answer:
1. What goods and services will be produced?
2. How will the goods and services be produced?
3. Who will receive the goods and services produced?

7) What is the difference between economic efficiency and equity?

Answer: Economic efficiency is concerned with maximizing the value of output that can be
generated by a given resource base while equity deals with the distribution of society's total
output among the sectors and individuals of society.

8) What is a market economy?

Answer: A market economy is an economy in which the decisions of households and firms
interacting in markets allocate economic resources.

9) Define allocative efficiency. Explain the significance of this concept in economics?

Answer: Allocative efficiency is an efficiency criterion that describes a situation where the
marginal benefit (or marginal valuation) of the last unit purchased is equal to the marginal cost of
producing that unit. In other words, allocative efficiency occurs when production reflects
consumer preferences. This is a significant concept in that all societies face scarcity which
necessitates that societies make choices about what goods and services to produce. To maximize
society's wealth, resources must flow to their highest valued use. This value is determined by
consumers.

10) What is the difference between positive economic analysis and normative economic
analysis? Give one example each of a positive and normative economic issue or question or
statement.

Answer: Positive economic analysis is concerned with what is. Positive economic analysis
reaches conclusions based on verifiable statements. Normative economic analysis, on the other
hand, is concerned with what ought to be. Normative analysis reaches conclusions based on
opinions. (Students will give many different examples.)

11) Explain why economics is considered a social science.

Answer: Economics is a social science because it studies the actions of individuals. As a social
science, economics considers human behavior, particularly decision-making behavior, in every
context.

12) What is an economic variable?

Answer: An economic variable is something measurable that can have different values, such as
the wages of software programmers.
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13) Which of the following are positive economic statements and which are normative economic
statements?

a. An increase in the price of gasoline will decrease the quantity of gasoline purchased.
b. The government should eliminate the minimum wage.
c. All states should raise the minimum wage to at least $10 per hour.
d. The government should scrap its current income tax structure in favor of a flat tax.
e. Unemployment has increased since the onset of the recession.
f. The government should not bail out investment banks during a financial crisis.

Answer: Statements a and e are positive economic statements. Statements b, c, d, and f are
normative economic statements.

14) Which of the following are positive economic statements and which are normative economic
statements?

a. An increase in the minimum wage causes unemployment.

b. The government should raise the minimum wage above $7.25 per hour.
c. The prolonged recession has caused the unemployment rate to reach a 30-year high.
d. Interest rates need to be lower for the economy to emerge from the recession.
e. Inflation has decreased since the onset of the recession.
f. Once the recession has ended, interest rates should increase to assure that inflation does not
go up.

Answer: Statements a, c, and e are positive economic statements. Statements b, d, and f are
normative economic statements.

15) Which of the following are primarily macroeconomic topics and which are primarily
microeconomic topics?
a. gasoline prices
b. unemployment
c. inflation
d. health care costs
e. air pollution
f. economic growth

Answer: b, c, and f are primarily macroeconomic topics.

a, d, and e are primarily microeconomic topics.

16) Define microeconomics.

Answer: Microeconomics is the study of how households and firms make choices, how they
interact in markets, and how the government attempts to influence their choices.

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17) Define macroeconomics.

Answer: Macroeconomics is the study of the economy as a whole, including topics such as
inflation, unemployment, and economic growth.

18) How does the study of microeconomics differ from that of macroeconomics? Give one
example each of an issue studied in microeconomics and in macroeconomics.

Answer: Microeconomics is the study of how household and businesses make choices, how they
interact in markets, and how the government attempts to influence their choices while
macroeconomics is the study of the economy as a whole, including topics like unemployment,
inflation and economic growth. (Students will give many different examples.)

19) List the four main factors of production.

Answer: The five main factors of production are labor, capital, natural resources, and
entrepreneurial ability.

20) Explain the difference between a firm's revenue and its profit.

Answer: A firm's revenue is the total amount received for selling a good or service. It is
calculated by multiplying the price per unit by the number of units sold. A firm's profit is the
difference between its revenue and its costs.

21) What is the difference between goods and services?

Answer: Goods are tangible merchandise such as cell phones or automobiles. Services are
activities done for others, such as providing medical care or legal advice.

22 If the price of milk was $2.50 a gallon and it is now $3.25 a gallon, what is the percentage
change in price?

A) 13 percent
B) 30 percent
C) 75 percent
D) 77 percent

Answer: B

23) In 2015, Hooverville consumed 205,000 tons of sugar. In 2016, sugar consumption rose to
245,000 tons. Calculate the percentage change in sugar consumption.

A) 8.37%
B) 11.95%
C) 19.51%
24) 26.33%

Answer: C
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Figure 1.1

25) Refer to Figure 1-1. Using the information in the figure above, calculate the percentage
change in sales of alcoholic beverages between 2013 and 2016.
A) 23.1%
B) 23.8%
C) 30%
D) 42.9%
Answer: D

26) Refer to Figure 1-1. Using the information in the figure above, calculate the percentage
change in sales of alcoholic beverages between 2012 and 2016.
A) 30%
B) 50%
C) 66.7%
D) 100%

Answer: D

27) Refer to Figure 1-1. Using the information in the figure above, calculate the percentage
change in sales of alcoholic beverages between 2013 and 2015.
A) 23.8%
B) 40%
C) 42.9%
D) 73.3%

Answer: A

Figure 1-2
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28) Refer to Figure 1-2. Calculate the area of the triangle A.
A) $1.3 million
B) $2.6 million
C) $3.4 million
D) $5.2 million
Answer: B

Figure 1-5

29) Refer to Figure 1-5. Calculate the area of the triangle A.

A) $8.4 million
B) $6.3 million
C) $3.15 million
D) $2.1 million
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Answer: C

Figure 1-6

30) Refer to Figure 1-6. Calculate the area of the trapezoid X.

A) $361
B) $450
C) $1,020
D) $1,140
Answer: C

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Chapter 2 Trade-offs, Comparative Advantage, and the Market System

1) What is meant by the term opportunity cost?

Answer: Opportunity cost is the highest-valued alternative that must be given up to engage in an
activity.

2) What is economic growth?

Answer: Economic growth refers to the ability of the economy to increase the production of
goods and services.

3) What is a production possibilities frontier? What do points along the frontier represent? What
do points inside and outside the frontier represent?
Answer: A production possibilities frontier is a curve showing the maximum attainable
combinations of two products that may be produced with available resources and current
technology. Points along a production possibilities frontier are attainable with the resources
available and are efficient. Points inside the frontier are attainable but inefficient. Points outside
the frontier are unattainable.

4) What shape does a production possibilities frontier take if it displays increasing opportunity
costs? What shape does a production possibilities frontier take if it displays constant opportunity
costs? Which shape is most common in production situations?
Answer: A production possibilities frontier which displays increasing opportunity costs is
bowed outward. A production possibilities frontier which displays constant opportunity costs is
linear. A bowed-out production possibilities frontier is most common in production situations.

5)
a. Draw a production possibilities frontier for a country that produces two goods, beer and
pretzels. Assume that resources are equally suited to both tasks.
b. Define opportunity costs.
c. Use your production possibilities frontier graph to demonstrate the principle of opportunity
costs.
Answer:
a. The PPF is linear to reflect the fact that resources are equally suited to both tasks.

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b. Opportunity cost is defined as the highest-valued alternative that must be forgone by taking
an action.
c. In the PPF graph in part (a), suppose the country is currently producing at point X and wishes
to move to point Y so that it can produce more beer. The only way it can obtain more beer is to
give up some amount of pretzels.

Table 2-6

Apples Pears
Possible Output
(thousands of (thousands of
Combinations
pounds) pounds)
A 70 0
B 60 20
C 50 36
D 40 48
E 30 56
F 20 60
G 10 63
H 0 65

6) Refer to Table 2-6. The Fruit Farm produces only apples and pears. The table above shows
the maximum possible output combinations of the two fruits using all resources and currently
available technology.

a. Graph The Fruit Farm's production possibilities frontier. Put apples on the horizontal axis
and pears on the vertical axis. Be sure to identify the output combination points on your diagram.
b. Suppose The Fruit Farm is currently producing at point D. What is the opportunity cost of
producing an additional 8,000 pounds of pears?
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c. Suppose The Fruit Farm is currently producing at point D. What happens to the opportunity
cost of producing more and more pears? Does it increase, decrease, or remain constant? Explain
your answer.
d. Suppose The Fruit Farm is currently producing at point G. What happens to the opportunity
cost of producing more and more apples? Does it increase, decrease, or remain constant? Explain
your answer.
e. Suppose The Fruit Farm is plagued by the apple maggot infestation which destroys apple
trees but not pear trees. Show in a graph what happens to its PPF.

Answer:
a.

b. 10,000 pounds of apples

c. It increases. For example to move to E, The Fruit Farm has to give up 10,000 pounds of
apples to produce an additional 8,000 pounds of pears. For each additional 10,000 pounds of
apples foregone, the payoff in terms of pears gets progressively smaller.
d. It increases. Each time it wants to produce an additional 10,000 pounds of apples, more and
more pears must be given up.

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e.

Table 2-7

Shrimp Oysters
Possible Output
(thousands of (thousands of
Combinations
pounds) pounds)
A 35 0
B 30 20
C 25 35
D 20 47
E 15 57
F 10 64
G 5 68
H 0 70

7) Refer to Table 2-7. The Shellfish Shack produces only shrimp and oysters. The table above
shows the maximum possible output combinations of the two types of shellfish using all
resources and currently available technology.

a. Suppose The Shellfish Shack is currently producing at point E. What is the opportunity cost
of producing an additional 11,000 pounds of oysters?
b. Suppose The Shellfish Shack is currently producing at point E. What happens to the
opportunity cost of producing more and more shrimp? Does it increase, decrease, or remain
constant? Explain your answer.
c. Suppose The Shellfish Shack is currently producing at point B. What happens to the
opportunity cost of producing more and more oysters? Does it increase, decrease, or remain
constant? Explain your answer.
d. Suppose The Shellfish Shack is plagued by a disease which destroys oyster beds but not
shrimp habitats. What would happen to its PPF?
Answer:
a. 10,000 pounds of shrimp
b. It increases. For example to move to D, The Shellfish Shack has to give up 10,000 pounds of
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oysters to produce an additional 5,000 pounds of shrimp. For each additional 5,000 pounds of
shrimp produced, more and more oysters must be given up.
c. It increases. Each time it gives up 5,000 pounds of shrimp, fewer and fewer oysters can be
produced.
d. Its PPF would rotate inward, with maximum shrimp production staying the same but
maximum oyster production being reduced.

8) What causes a production possibilities frontier to shift outward?

Answer: A production possibilities curve shifts outward with economic growth, which occurs
with an increase in resources or a positive technology change.

9) What causes a production possibilities frontier to shift inward?

Answer: A production possibilities curve shifts inward with economic decline, or negative
growth. This occurs with a decrease in resources or a negative technology change.

10) How are efficiency and inefficiency represented on a production possibilities frontier?
Answer: Efficiency is represented by points along the production possibilities frontier.
Inefficiency is represented by points inside the production possibilities frontier.

11) What does the term "increasing marginal opportunity cost" mean? How are increasing
marginal opportunity costs represented on a bowed out production possibilities frontier?
Answer: Increasing marginal opportunity costs means that as more and more of a product is
made, the opportunity cost of making each additional unit rises. They are represented by moving
down a bowed out production possibilities frontier.

12)
a. Draw a production possibilities frontier for a country that produces two goods, wine and
cheese. Assume that resources are not equally suited to both tasks.
b. Define opportunity costs.
c. Use your production possibilities frontier graph to demonstrate the principle of opportunity
costs.
Answer:
a. The PPF is concave (bowed away from the origin) to reflect the fact that resources are not
equally suited to both tasks.

12
b. Opportunity cost is defined as the highest valued alternative that must be forgone by taking
an action.
c. In the PPF graph in part (a), suppose the country is currently producing at point A and wishes
to move to point B so that it can produce more wine. The only way it can obtain more wine is to
give up some amount of cheese.

Table 2-8

Cashews Almonds
Possible Output
(thousands of (thousands of
Combinations
pounds) pounds)
A 35 0
B 30 20
C 25 35
D 20 47
E 15 57
F 10 64
G 5 68
H 0 70

13) Refer to Table 2-8. The Nut House produces only cashews and almonds. The table above
shows the maximum possible output combinations of the two nuts using all resources and
currently available technology.

a. Graph The Nut House's production possibilities frontier. Put almonds on the horizontal axis
and cashews on the vertical axis. Be sure to identify the output combination points on your
diagram.
b. Suppose The Nut House is currently producing at point C. What is the opportunity cost of
13
producing an additional 12,000 pounds of almonds?
c. Suppose The Nut House is currently producing at point C. What happens to the opportunity
cost of producing more and more almonds? Does it increase, decrease or remain constant?
Explain your answer.
d. Suppose The Nut House is currently producing at point F. What happens to the opportunity
cost of producing more and more cashews? Does it increase, decrease or remain constant?
Explain your answer.
e. Suppose The Nut House is plagued by a variety of white root-rot disease, which destroys
cashew trees but not almond trees. Show in a graph what happens to its PPF.

Answer:
a.

b. 5,000 pounds of cashews

c. It increases. For example to move to D, The Nut House has to give up 5,000 pounds of
cashews to produce an additional 10,000 pounds of almonds. For each additional 5,000 pounds
of cashews foregone, the payoff in terms of almonds gets progressively smaller.
d. It increases. Each time it wants to produce an additional 5,000 pounds of cashews, more and
more almonds must be given up.

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e.

14) What is comparative advantage? What is absolute advantage?

Answer: Comparative advantage is the ability of an individual, firm, or country to produce a
good or service at a lower opportunity cost than competitors. Absolute advantage is the ability of
an individual, firm, or country to produce more of a good or service than competitors, using the
same amount of resources.

15) Is it possible for a firm to have an absolute advantage in producing something without having
a comparative advantage? Why or why not?
Answer: Yes, a firm can have an absolute advantage without having a comparative advantage. A
firm may be able to produce more of a good or service than its competitors, but that does not
necessarily mean it can produce the good or service at a lower opportunity cost than its
competitors.

16) Suppose that in Belize, the opportunity cost of producing a sailboat is 5 hang gliders. In
Honduras, the opportunity cost of producing a sailboat is 8 hang gliders.
a. What is the opportunity cost of producing a hang glider for Belize?
b. What is the opportunity cost of producing a hang glider for Honduras?
c. Which country has a comparative advantage in the production of hang gliders?
d. Which country has a comparative advantage in the production of sailboats?
Answer:
a. For Belize, the opportunity cost of producing a hang glider is 1/5 of a sailboat.
b. For Honduras, the opportunity cost of producing a hang glider is 1/8 of a sailboat.
c. Honduras has a comparative advantage in the production of hang gliders.
d. Belize has a comparative advantage in the production of sailboats.

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17) Suppose that in Germany, the opportunity cost of producing a gallon of beer is 5 gallons of
wine. In Italy, the opportunity cost of producing a gallon of beer is 3 gallons of wine.
a. What is the opportunity cost of producing a gallon of wine for Germany?
b. What is the opportunity cost of producing a gallon of wine for Italy?
c. Which country has a comparative advantage in the production of beer?
d. Which country has a comparative advantage in the production of wine?
Answer:
a. For Germany, the opportunity cost of producing a gallon of wine is 1/5 of a gallon of beer.
b. For Italy, the opportunity cost of producing a gallon of wine is 1/3 of a gallon of beer.
c. Germany has a comparative advantage in the production of wine.
d. Italy has a comparative advantage in the production of beer.

Table 2-21

Digital Camera Wheat (bushel)

China 100 hours 5 hours
South Korea 90 hours 3 hours

18) Refer to Table 2-21. This table shows the number of labor hours required to produce a digital
camera and a bushel of wheat in China and South Korea.
a. Assume each country has a total of 9,000 labor hours to devote to the production of the two
goods and draw the production possibilities frontier for each country. Put "Digital Camera" on
the horizontal axis and "Wheat" on the vertical axis. Be sure to identify the intercept values on
your graphs.
b. Suppose each country allocates 60% of its labor hours to wheat production and 40% to the
production of digital cameras. Complete Table 2-22 below to show each country's output of the
two products.

Table 2-22: Production and Consumption with no Trade

Digital Camera Wheat Output
Output (bushels)
China
South Korea
Total

c. If the two countries do not trade and consume whatever they produce, identify the current
production and consumption point for each country on their respective production possibilities
frontiers. Label China's consumption point "C" and South Korea's consumption point "K."
d. Suppose the two countries specialize and trade. Which country should produce digital
cameras and which should produce wheat? Explain your answer.
e. Complete Table 2-23 below to show each country's output with specialization.

Table 2-23: Output with Specialization

Digital Camera Wheat Output
Output (bushels)
China
South Korea
Total
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f. Did specialization increase the combined output for the two countries without any increase in
resources? If so, by how much?
g. Suppose China and South Korea agree to trade so that in exchange for 1,200 bushels of
wheat, the exporter of wheat receives 48 digital cameras. Complete Table 2-24 below to show
each country's consumption bundle after trade.

Table 2-24: Consumption with Trade

Digital Wheat
Cameras (bushels)
China
South Korea

h. Show the consumption points after trade on each country's production possibilities frontier.
Label these points "B" for China and "J" for South Korea.
i. Has trade made the two countries better off? Explain your answer.
Answer:
a.

b.

Table 2-22: Production and Consumption with no Trade

Digital Camera Wheat Output
Output (bushels)
China 36 1,080
South Korea 40 1,800
Total 76 2,880

c. See graph in part (a)

d. China should specialize in producing digital cameras because it has a lower opportunity cost
of 20 bushels of wheat as opposed to South Korea's 30 bushels of wheat. South Korea should
specialize in producing wheat because it has a lower opportunity cost of 0.03 units of a digital
camera as opposed to China's 0.05 units of a digital camera.

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e.

Table 2-23: Output with Specialization

Digital Camera Wheat Output
Output (bushels)
China 90 0
South Korea 0 3,000
Total 90 3,000

f. Yes, digital camera output increased by 14 units (from 76 to 90) and wheat output increased
by 120 bushels (from 2,880 to 3,000).
g.

Table 2-24: Consumption with Trade

Digital Wheat
Cameras (bushels)
China 42 1,200
South Korea 48 1,800

h. See graph in part (a).

i. Yes, trade has enabled the two countries to consume outside their PPFs.

Table 2-25

One Motorcycle One Guitar

Ireland 10 hours 2.5 hours
Scotland 9 hours 2 hours

19) Refer to Table 2-25. This table shows the number of labor hours required to produce a
motorcycle and a guitar in Ireland and Scotland.
a. Which country has an absolute advantage in the production of motorcycles?
b. Which country has an absolute advantage in the production of guitars?
c. What is Ireland's opportunity cost of producing one motorcycle?
d. What is Scotland's opportunity cost of producing one motorcycle?
e. What is Ireland's opportunity cost of producing one guitar?
f. What is Scotland's opportunity cost of producing one guitar?
g. If each country specializes in the production of the product in which it has a comparative
advantage, which country should produce motorcycles?
h. If each country specializes in the production of the product in which it has a comparative
advantage, which country should produce guitars?
Answer:
a. Scotland has an absolute advantage in the production of motorcycles.
b. Scotland has an absolute advantage in the production of guitars.
c. Ireland's opportunity cost of producing one motorcycle is 4 guitars.
d. Scotland's opportunity cost of producing one motorcycle is 4.5 guitars
e. Ireland's opportunity cost of one guitar is 0.25 motorcycles.
f. Scotland's opportunity cost of one guitar is 0.22 motorcycles.
g. Ireland should specialize in producing motorcycles.
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h. Scotland should specialize in producing guitars.

Table 2-21

Digital Camera Wheat (bushel)

China 100 hours 5 hours
South Korea 90 hours 3 hours

20) Refer to Table 2-21. This table shows the number of labor hours required to produce a digital
camera and a bushel of wheat in China and South Korea.
a. Which country has an absolute advantage in the production of digital cameras?
b. Which country has an absolute advantage in the production of wheat?
c. What is China's opportunity cost of producing one digital camera?
d. What is South Korea's opportunity cost of producing one digital camera?
e. What is China's opportunity cost of producing one bushel of wheat?
f. What is South Korea's opportunity cost of producing one pound of wheat?
g. If each country specializes in the production of the product in which it has a comparative
advantage, who should produce digital cameras?
h. If each country specializes in the production of the product in which it has a comparative
advantage, who should produce wheat?
Answer:
a. South Korea has an absolute advantage in the production of digital cameras.
b. South Korea has an absolute advantage in wheat production.
c. China's opportunity cost of producing one digital camera is 20 bushels of wheat.
d. South Korea's opportunity cost of producing one digital camera is 30 bushels of wheat
e. China's opportunity cost of one bushel of wheat is 0.05 units of a digital camera.
f. South Korea's opportunity cost of one bushel of wheat is 0.03 units of a digital camera.
g. China should specialize in producing digital cameras.
h. South Korea should specialize in producing wheat.

21) Is it possible for a firm to have a comparative advantage in producing something without
having an absolute advantage? Why or why not?
Answer: Yes, a firm can have a comparative advantage without having an absolute advantage if
it can produce a good or service at a lower opportunity cost than competitors, even if it is not
able to produce more of the good or service than its competitors.

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22) Should countries specialize in producing goods and services based on having a comparative
advantage or an absolute advantage? Why?
Answer: Countries should specialize in producing products based on comparative advantage
because this allows countries to produce those products and services at a lower opportunity cost
than competitors.

23) Suppose in Belgium, the opportunity cost of producing a trombone is 8 clarinets. In

Denmark, the opportunity cost of producing a trombone is 6 clarinets.
a. What is the opportunity cost of producing a clarinet for Belgium?
b. What is the opportunity cost of producing a clarinet for Denmark?
c. Which country has a comparative advantage in the production of clarinets?
d. Which country has a comparative advantage in the production of trombones?
Answer:
a. For Belgium, the opportunity cost of producing a clarinet is 1/8 of a trombone.
b. For Denmark, the opportunity cost of producing a clarinet is 1/6 of a trombone.
c. Belgium has a comparative advantage in the production of clarinets.
d. Denmark has a comparative advantage in the production of trombones.

Table 2-31

Lumber (board
Cell Phone feet)
Estonia 20 hours 5 hours
Finland 18 hours 4 hours

24) Refer to Table 2-31. This table shows the number of labor hours required to produce a cell
phone and a board foot of lumber in Estonia and Finland.

a. Which country has an absolute advantage in the production of cell phones?

b. Which country has an absolute advantage in the production of lumber?
c. What is Estonia's opportunity cost of producing one cell phone?
d. What is Finland's opportunity cost of producing one cell phone?
e. What is Estonia's opportunity cost of producing one board foot of lumber?
f. What is Finland's opportunity cost of producing one board foot of lumber?
g. If each country specializes in the production of the product in which it has a comparative
advantage, who should produce cell phones?
h. If each country specializes in the production of the product in which it has a comparative
advantage, who should produce lumber?
Answer:
a. Finland has an absolute advantage in the production of cell phones.
b. Finland has an absolute advantage in lumber production.
c. Estonia's opportunity cost of producing one cell phone is 4 board feet of lumber.
d. Finland's opportunity cost of producing one cell phone is 4.5 board feet of lumber
e. Estonia's opportunity cost of one board foot of lumber is 0.25 units of a cell phone.
f. Finland's opportunity cost of one board foot of lumber is 0.22 units of a cell phone.
g. Estonia should specialize in producing cell phones.
h. Finland should specialize in producing lumber.

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25) Refer to Table 2-31. This table shows the number of labor hours required to produce a cell
phone and a board foot of lumber in Estonia and Finland.

a. If each country has a total of 3,600 labor hours to devote to the production of the two goods,
draw the production possibilities frontier for each country. Put "Cell Phone" on the horizontal
axis and "Lumber" on the vertical axis. Be sure to identify the intercept values on your graphs.
b. Suppose each country allocates 55% its labor hours to lumber production and 45% to the
production of cell phones. Complete Table 2-34 below to show each country's output of the two
products.

Table 2-32: Production and Consumption with no Trade

Cell Phone Lumber Output
Output (board feet)
Estonia
Finland
Total

c. If the two countries do not trade and consume whatever they produce, identify the current
production and consumption point for each country on their respective production possibilities
frontiers. Label Estonia's consumption point "E" and Finland's consumption point, "F."
d. Suppose the two countries specialize and trade. Who should produce cell phones and who
should produce lumber? Explain your answer.
e. Complete Table 2-35 below to show each country's output with specialization.

Table 2-33: Output with Specialization

Cell Phone Lumber Output
Output (board feet)
Estonia
Finland
Total

f. Did secialization increase the combined output for the two countries without any increase in
resources? If so, by how much?
g. Suppose Estonia and Finland agree to trade so that in exchange for 400 board feet of lumber,
the exporter of lumber receives 90 cell phones. Complete Table 2-36 below to show each
country's consumption bundle after trade.

Table 2-34: Consumption with Trade

Lumber
Cell Phone (board feet)
Estonia
Finland

h. Show the consumption points after trade on each country's production possibilities frontier.
Label these points "X" for Estonia and "Y" for Finland.
i. Has trade made the two countries better off? Explain your answer.

21
Answer:
a.

b.
Table 2-32: Production and Consumption with no Trade
Cell Phone Lumber Output
Output (board feet)
Estonia 81 396
Finland 90 495
Total 171 891

c. See graph in part (a)

d. Estonia should specialize in producing cell phones because it has a lower opportunity cost: 4
board feet of lumber as opposed to Finland's 4.5 board feet of lumber. Finland should specialize
in producing lumber because it has a lower opportunity cost: 0.22 units of a cell phone as
opposed to Estonia's 0.25 units of a cell phone.
e.
Table 2-33: Output with Specialization
Cell Phone Lumber output
Output (board feet)
Estonia 180 0
Finland 0 900
Total 180 900

f. Yes, cell phone output increased by 9 units (from 171 units to 180 units) and lumber output
increased by 9 board feet (from 891 board feet to 900 board feet).

22
g.
Table 2-34: Consumption with Trade
Lumber
Cell Phone (board feet)
Estonia 90 400
Finland 90 500

h. See graph in part (a)

i. Yes, trade has enabled the two countries to consume outside their PPFs. (Compare Table 2-
36 with Table 2-34)

26) What is the difference between product markets and factor markets?
Answer: Product markets are markets for goods and services. Factor markets are markets for the
factors of production, which are the inputs used to make goods and services.

27) How do firms and households interact in markets?

Answer: Firms supply goods and services to households, and buy factors of production from
households. Households supply factors of production to firms, and buy goods and services from
firms.

28) What is meant by the term "free market"?

Answer: A free market is a market with few government restrictions on how a good or service
can be produced or sold or on how factors of production can be employed.

29) Identify whether each of the following transactions will take place in the factor market or in
the product market.
a. Graciela buys a Tesla Motors Model X.
b. Lashan works 60 hours a week at a law firm.
c. Tito sells his family's farmland to a housing developer.
d. Tesla Motors increases employment at its Fremont, California plant.
Answer: a takes place in the product market.
b, c, and d take place in the factor market.

30) Identify whether each of the following transactions will take place in the factor market or in
the product market:
a. Shondra buys a Harley-Davidson Softail motorcycle.
b. Aimee works 20 hours a week at a grocery store.
c. Gustavo sells a warehouse to a produce delivery company.
d. Ocean Spray increases employment at its Middleboro, Massachusetts plant.
Answer: a takes place in the product market. b, c, and d take place in the factor market.

23
Chapter 3 Where Prices Come From: The Interaction of Demand and Supply

1) What are the two effects that explain the law of demand? Briefly explain each effect.
Answer: The two effects that explain the law of demand are the income effect and the
substitution effect. The income effect is the change in quantity demanded of a good that results
from a change in purchasing power due to a change in the good's price. The substitution effect is
the change in quantity demanded of a good that results from the effect of a change in the good's
price making the good more or less expensive relative to other goods that are substitutes.

2) Explain the difference between a normal good and an inferior good.

Answer: A normal good is something for which the demand increases when income rises and
the demand decreases when income falls. An inferior good is something for which the demand
decreases when income rises and the demand increases when income falls.

3) For each of the following pairs of products, state which are complements, which are
substitutes, and which are unrelated.
a. Digital camera and memory stick
b. 7Up and Mountain Dew
c. Swimsuits and flip-flops
d. Tylenol and cat food
e. Photocopier and paper
Answer:
a. Complements
b. Substitutes
c. Complements
d. Unrelated
e. Complements

4) What are the five variables that will shift the demand curve?
Answer:
1. Income
2. Price of related goods
3. Tastes
4. Population and demographics
5. Expected future prices

5) For each of the following pairs of products, state which are complements, which are
substitutes, and which are unrelated.
a. Blu-ray discs and video-on-demand
b. Fiat 500 and Mini Cooper S
c. Toothpaste and toothbrush
d. Popcorn and snowboards
e. Razors and razor blades
Answer:
a. Substitutes
b. Substitutes
c. Complements
d. Unrelated
24
e. Complements

6) Use the following demand schedule for apples to draw a graph of the demand curve. Be sure
to label the demand curve and each axis, and show each point on the demand curve.

Price Quantity
(dollars per (thousands of
bushel) bushels)
30 20
25 40
20 60
15 80
10 100

Answer:

7) Draw a demand curve and label it D1. On the graph, illustrate an increase in demand and a
decrease in demand, and label the curves D2 and D3, respectively. Starting on demand curve D1,
explain the shift that would result from each of the following events:
a. an increase in income and the good is a normal good
b. an increase in income and the good is an inferior good
c. a decrease in the price of a substitute good
d. a decrease in the price of a complementary good
e. an increase in the taste for the good
f. a decrease in population
g. an increase in the expected future price of the good
Answer:

25
a, d, e, and g would increase demand, causing a shift from D1 to D2
b, c, and f would decrease demand, causing a shift from D1 to D3

8) What is the difference between a "change in demand" and a "change in quantity demanded"?
Answer: A "change in demand" means the demand curve has shifted. This is caused by a change
in any variable other than price that can influence the market demand of the good in question. A
"change in quantity demanded" refers to a movement along the demand curve and this is caused
by a change in the price of the good in question.

9) Explain the Law of Demand.

Answer: The law of demand is the rule that, holding everything else constant, when the price of
a product falls, the quantity of the product demanded will increase, and when the price of a
product rises, the quantity of the product demanded will decrease.

10) What is the difference between a demand schedule and a demand curve?
Answer: A demand schedule is a table that shows the relationship between the price of a product
and the quantity of the product demanded. A demand curve is a curve that shows the relationship
between the price of a product and the quantity of the product demanded.

12) Explain the difference between substitutes and complements.

Answer: Substitutes are goods and services that can be used for the same purpose. Complements
are goods and services that are used together.

13) Use the following demand schedule for cherries to draw a graph of the demand curve. Be
sure to label the demand curve and each axis, and show each point on the demand curve.

Price Quantity
(dollars per (thousands of
bushel) bushels)
60 40
50 80
40 120
30 160
20 200

26
Answer:

14) Draw a demand curve and label it D1. On the graph, illustrate an increase in demand and a
decrease in demand, and label the curves D2 and D3, respectively. Starting on demand curve D1,
explain the shift that would result from each of the following events:

a. a decrease in income and the good is a normal good

b. a decrease in income and the good is an inferior good
c. an increase in the price of a substitute good
d. an increase in the price of a complementary good
e. a decrease in the taste for the good
f. an increase in population
g. a decrease in the expected future price of the good
Answer:

a, d, e, and g would decrease demand, causing a shift from D1 to D3

b, c, and f would increase demand, causing a shift from D1 to D2

27
15) What is the law of supply? What does this law imply about the shape of the supply curve?
Answer: The law of supply states that, holding everything else constant, an increase in price
causes an increase in quantity supplied. The positive relationship between price and quantity
supplied gives rise to an upward-sloping supply curve.

16) Indicate whether each of the following situations would shift the supply curve to the left, to
the right, or not at all.
a. An increase in the number of firms in the market
b. An increase in the current price of the product
c. A decrease in productivity
d. An increase in the expected future price of a product
e. A decrease in the price of an input
Answer:
a. Shift to the right
b. No shift
c. Shift to the left
d. Shift to the left
e. Shift to the right

17) Use the following supply schedule for cherries to draw a graph of the supply curve. Be sure
to label the supply curve and each axis, and show each point on the supply curve.

Price (dollars Quantity (thousands

per bushel) of bushels)
4 25
8 50
12 75
16 100
20 125

Answer:

18) What are the five most important variables that shift the market supply curve?
28
Answer: Prices of inputs; Technological change; Prices of substitutes in production; The number
of firms in the market; Expected future prices

19) Would a change in the price of in-line skates cause a change in the supply of in-line skates?
Why or why not?
Answer: No, a change in the price of in-line skates would not cause a change in the supply of in-
line skates. Rather, it would cause a change in the quantity supplied. Supply changes only when
there is a change in any variable other than the price that would affect the supply of the good in
question.

20) Indicate whether each of the following situations would shift the supply curve to the left, to
the right, or not at all.

a. An increase in the price of an input

b. An increase in productivity
c. An increase in the price of a substitute in production
d. A decrease in the expected future price of a product
e. A decrease in the current price of the product
Answer:
a. Shift to the left
b. Shift to the right
c. Shift to the left
d. Shift to the right
e. No shift

21) Use the following supply schedule for cherries to draw a graph of the supply curve. Be sure
to label the supply curve and each axis, and show each point on the supply curve.

Price (dollars Quantity (thousands

per bushel) of bushels)
8 50
16 100
24 150
32 200
40 250

Answer:

29
22) In 2004, hurricanes destroyed a large portion of Florida's grapefruit crop. How did this affect
the market price and market quantity of grapefruit?
Answer: The supply curve for grapefruit shifted to the left resulting in a higher equilibrium price
and lower equilibrium quantity.

23) If the price of a product is above equilibrium, what forces it down?

Answer: When the price is above equilibrium, a surplus occurs. Some producers who are unable
to sell the product will have an incentive to offer to sell the product at a lower price. A lower
price will simultaneously decrease the quantity supplied and increase the quantity demanded.
This downward pressure on price continues until the surplus is eliminated and equilibrium is
achieved.

24) Draw a supply and demand graph showing an equilibrium price of $50 and an equilibrium
quantity of 200 units. Explain what would happen if the selling price was $75, and illustrate this
on the graph. Explain what would happen if the selling price was $25, and illustrate this on the
graph. Be sure to label each axis and curve on the graph.
Answer:

30
Table 3-5

Price per Quantity Demanded Quantity Supplied

Bushel (bushels) (bushels)
$3 36,000 0
6 30,000 3,000
9 24,000 6,000
12 19,000 10,000
15 15,000 15,000
18 10,000 21,000
21 7,000 28,000
24 4,000 36,000

25) Refer to Table 3-5. The table contains information about the corn market. Use the table to
answer the following questions.
a. What are the equilibrium price and quantity of corn?
b. Suppose the prevailing price is $9 per bushel. Is there a shortage or a surplus in the market?
c. What is the quantity of the shortage or surplus?
d. How many bushels will be sold if the market price is $9 per bushel?
e. If the market price is $9 per bushel, what must happen to restore equilibrium in the market?
f. At what price will suppliers be able to sell 24,000 bushels of corn?
g. Suppose the market price is $21 per bushel. Is there a shortage or a surplus in the market?
h. What is the quantity of the shortage or surplus?
i. How many bushels will be sold if the market price is $21 per bushel?
j. If the market price is $21 per bushel, what must happen to restore equilibrium in the market?
Answer:
a. Equilibrium price = $15; Equilibrium quantity = 15,000 bushels.
b. There is a shortage.
c. Shortage = 24,000 - 6,000 = 18,000 bushels.
d. Quantity sold = 6,000 bushels.
e. Price must rise.
f. At $9 per bushel.
g. There is a surplus.
31
h. Surplus = 28,000 - 7,000 = 21,000 bushels.
i. Quantity sold = 7,000 bushels.
j. Price must fall.

26) What is a surplus? What is a shortage?

Answer: A surplus is a situation in which the quantity supplied is greater than the quantity
demanded. A shortage is a situation in which the quantity demanded is greater than the quantity
supplied.

27) What is the difference between a market equilibrium and a competitive market equilibrium?
Answer: A market equilibrium is a situation in which quantity demanded equals quantity
supplied. A competitive market equilibrium is a market equilibrium with many buyers and
sellers.

Table 3-6

Quantity Quantity
Price per
Demanded Supplied
Bushel
(bushels) (bushels)
$2 40,000 0
4 36,000 4,000
6 30,000 8,000
8 24,000 16,000
10 20,000 20,000
12 18,000 28,000
14 12,000 36,000
16 6,000 40,000

28) Refer to Table 3-6. The table contains information about the sorghum market. Use the table
to answer the following questions.

a. What are the equilibrium price and quantity of sorghum?

b. Suppose the prevailing price is $6 per bushel. Is there a shortage or a surplus in the market?
c. What is the quantity of the shortage or surplus?
d. How many bushels will be sold if the market price is $6 per bushel?
e. If the market price is $6 per bushel, what must happen to restore equilibrium in the market?
f. At what price will suppliers be able to sell 36,000 bushels of sorghum?
g. Suppose the market price is $14 per bushel. Is there a shortage or a surplus in the market?
h. What is the quantity of the shortage or surplus?
i. How many bushels will be sold if the market price is $14 per bushel?
j. If the market price is $14 per bushel, what must happen to restore equilibrium in the market?
Answer:
a. Equilibrium price = $10; Equilibrium quantity = 20,000 bushels.
b. There is a shortage.
c. Shortage = 30,000 - 8,000 = 22,000 bushels.
d. Quantity sold = 8,000 bushels.
e. Price must rise.
f. At $4 per bushel.
32
g. There is a surplus.
h. Surplus = 36,000 - 12,000 = 24,000 bushels.
i. Quantity sold = 12,000 bushels.
j. Price must fall.

28) Discuss the correct and incorrect economic analysis in the following statement.

"If good weather in Hawaii creates a bumper crop of pineapples, the supply of pineapples will
increase. This will result in a price decrease, which will then cause the supply of pineapples to
decrease."
Answer: The supply of pineapples will increase resulting in a lower equilibrium price and a
higher equilibrium quantity but the lower price will not shift the supply curve for pineapples.

29) Explain how it would be possible for the equilibrium price and equilibrium quantity to both
increase in the market for motorcycles if consumer preference for motorcycles increases and the
number of motorcycle manufacturers decreases.
Answer: An increase in consumer preference will shift the demand curve to the right, which
increases the equilibrium price and the equilibrium quantity. A decrease in the number of
manufacturers will shift the supply curve to the left, which will increase the equilibrium price
and decrease the equilibrium quantity. In both cases, the equilibrium price increases. For the
equilibrium quantity to increase, the rightward shift in demand resulting from the increase in
consumer preference must be more than the leftward shift in supply which results from the
decrease in manufacturers.

30) In each of the following situations, list what will happen to the equilibrium price and the
equilibrium quantity for a particular product, which is a normal good.
a. The population increases and the price of inputs increase.
b. The price of a complement increases and technology advances.
c. The number of firms in the market increases and income increases.
d. Price is expected to increase in the future.
e. Consumer preference increases and the price of a substitute in production decreases.
Answer:
a. Price increases; Quantity may increase or decrease.
b. Price decreases; Quantity may increase or decrease.
c. Quantity increases; Price may increase or decrease.
d. Price increases; Quantity may increase or decrease.
e. Quantity increases; Price may increase or decrease.

33
31) In each of the following situations, list what will happen to the equilibrium price and the
equilibrium quantity for a particular product, which is an inferior good.
a. The population increases and productivity increases.
b. Income increases and the price of inputs decrease.
c. The number of firms in the market decreases and income increases.
d. Consumer preference increases and the price of a complement decreases.
e. The price of a substitute in consumption decreases and the price of a substitute in production
decreases.
Answer:
a. Quantity increases; Price may increase or decrease.
b. Price decreases; Quantity may increase or decrease.
c. Quantity decreases; Price may increase or decrease.
d. Price increases; Quantity increases.
e. Price decreases; Quantity may increase or decrease.

32) According to the Australian Wool Innovation, severe drought conditions in Australia
contributed to the lowest level of wool production in 50 years. This record low production has
driven up prices sharply in Australian wool markets. Meanwhile, the price of raw cotton
increased significantly for the first time in many years.
a. Illustrate this observation with one demand and supply graph for the market for Australian
wool and another demand and supply graph for raw cotton.
b. Make sure that your graphs clearly show (1) the initial equilibrium before the decrease in the
supply of Australian wool and (2) the final equilibrium.
c. Use arrows to indicate any shifts in the demand and supply curves for each market.
d. Label your graphs fully and write an explanation of your work.
Answer: a., b., and c. See the figure below.

d. In the Australian wool market, the supply curve shifts to the left as a result of the drought.
This leads to an increase in the equilibrium price of wool and a decrease in the equilibrium
quantity. The higher price of wool causes buyers to substitute cotton for wool, thereby increasing
the demand for cotton. In the cotton market, the demand curve for cotton moves to the right
along a given supply curve resulting in a higher equilibrium price and higher equilibrium
quantity of cotton.

34
Chapter 4 Economic Efficiency, Government Price Setting, and Taxes

1) What is producer surplus? What does producer surplus measure? What area on a supply and
demand graph represents consumer surplus?
Answer: Producer surplus is the difference between the lowest price a firm would be willing to
accept for a good or service and the price it actually receives. Producer surplus measures the net
benefit received by producers from participating in a market. Consumer surplus is the area below
the demand curve and above the market price.

2) What is marginal benefit? Which curve is also referred to as a marginal benefit curve?
Answer: Marginal benefit is the additional benefit to a consumer from consuming one more unit
of a good. The demand curve is also referred to as a marginal benefit curve.

3) Assume the market price for lemon grass is $4.00 per pound, but most buyers are willing to
pay more than the market price. At the market price of $4.00, the quantity of lemon grass
demanded is 1,500 pounds per month, and quantity demanded does not reach zero until the price
reaches $30.00 per pound. Construct a graph showing this data, calculate the total consumer
surplus in the market for lemon grass, and show the consumer surplus on the graph.
Answer:

The total consumer surplus is (1/2 × $26 × 1,500) = $19,500.

4) The marginal cost for Java Joe's to produce its first cup of coffee is $0.75. Its marginal cost to
produce its second cup of coffee is $1.25. Its marginal cost increases by $0.50 for each additional
cup of coffee it produces. Suppose the market price for coffee is $2.25. Construct a graph
showing the producer surplus for each cup of coffee Java Joe's will sell. How many cups of
coffee will Java Joe's sell? What is the value of the producer surplus Java Joe's receives for each
cup of coffee it sells?
Answer:

35
Java Joe's will sell 3 cups of coffee. The producer surplus of the first cup of coffee is $1.50. The
producer surplus of the second cup of coffee is $1.00. The producer surplus of the third cup of
coffee is $0.50.

5) What is consumer surplus? Why would policy makers be interested in consumer surplus?
Answer: Consumer surplus is the difference between what a consumer is willing to pay for a
product and what she actually pays for the product. Since consumer surplus measures the benefit
that consumers receive from a good as they themselves perceive it, it serves as a good measure of
economic well-being. Thus, if policy makers care about consumer preferences, they could use
this measure to make normative judgments about market outcomes.

6) What is marginal cost? Which curve is also referred to as the marginal cost curve?
Answer: Marginal cost is the additional cost to a firm of producing one more unit of a good or
service. The supply curve is also referred to as the marginal cost curve.

7) Assume the market price for tangerines is $18.00 per bushel. At the market price, tangerine
growers are willing to supply a quantity of 12,000 bushels per week. The quantity supplied drops
to zero when the price falls to $5.00 per bushel. Construct a graph showing this data, calculate
the total producer surplus in the market for tangerines, and show the total producer surplus on the
graph.
Answer:

36
The total producer surplus is (1/2 × $13 × 12,000) = $78,000.

8) The market price for coffee is $2.25 per cup. Austin is willing to pay $5.00 per cup, Colin is
willing to pay $4.00 per cup, Lucy is willing to pay $3.00 per cup, and Ike is willing to pay $2.00
per cup. Construct a graph showing the consumer surplus for each cup of coffee purchased. How
many cups of coffee will be purchased? What is the value of the consumer surplus each of the
four consumers receives from their coffee purchases?
Answer:

3 cups of coffee will be purchased. Austin's consumer surplus is $2.75. Colin's consumer surplus
is $1.75. Lucy's consumer surplus is $0.75. Ike receives no consumer surplus since he will not be
willing to purchase a cup of coffee.

37
9) What is economic surplus? When is economic surplus at a maximum?
Answer: Economic surplus is sum of consumer surplus and producer surplus. Economic surplus
is at a maximum when the market is in equilibrium.

10) Will equilibrium in a market always result in an outcome that is economically efficient?
Explain.
Answer: An economically efficient outcome means that at the equilibrium price the marginal
benefit of the last unit of output sold is equal to its marginal cost. This will occur only in markets
that are competitive (many buyers and many sellers) and there are no price controls.

11) The graph below represents the market for walnuts. Identify the values of the marginal
benefit and the marginal cost at the output levels of 2,000 pounds, 4,000 pounds, and 6,000
pounds. At each of these output levels, state whether output is inefficiently high, inefficiently
low, or economically efficient.

Answer: Output level = 2,000 lbs: marginal benefit = $3.50, marginal cost = $2.50, output is
inefficiently low.
Output level = 4,000 lbs: marginal benefit = $3.00, marginal cost = $3.00, output is economically
efficient.
Output level = 6,000 lbs: Marginal benefit = $2.50, marginal cost = $3.50, output is inefficiently
high.

12) The graph below represents the market for lychee nuts. The equilibrium price is $7.00 per
bushel, but the market price is $5.00 per bushel. Identify the areas representing consumer
surplus, producer surplus, and deadweight loss at the equilibrium price of $7.00 and at the
market price of $5.00.

38
Answer: At the equilibrium price of $7.00:
Consumer surplus is represented by area A + B.
Producer surplus is represented by area C + D + E.
There is no deadweight loss.

At the market price of $5.00:

Consumer surplus is represented by area A + C.
Producer surplus is represented by area E.
Deadweight loss is represented by area B + D.

13) What is deadweight loss? When is deadweight loss equal to zero?

Answer: Deadweight loss is the reduction in economic surplus resulting from a market not being
in competitive equilibrium. Deadweight loss is equal to zero when the sum of consumer surplus
and producer surplus is maximized, which occurs when the market is in competitive equilibrium.

14) The graph below represents the market for alfalfa. The market price is $7.00 per bushel.
Identify the areas representing consumer surplus, producer surplus, and economic surplus.

39
Answer: Consumer surplus is represented by area A.
Producer surplus is represented by area B.
Economic surplus is represented by area A + B.

15) The graph below represents the market for alfalfa. The equilibrium price is $7.00 per bushel,
but the market price is $9.00 per bushel. Identify the areas representing consumer surplus,
producer surplus, and deadweight loss at the equilibrium price of $7.00 and at the market price of
$9.00.

Answer: At the equilibrium price of $7.00:

40
Consumer surplus is represented by area A + B + C.
Producer surplus is represented by area D + E.
There is no deadweight loss.

At the market price of $9.00:

Consumer surplus is represented by area A.
Producer surplus is represented by area B + D.
Deadweight loss is represented by area C + E.

16) What is the difference between a price ceiling and a price floor? Compared to the
competitive equilibrium price, where must price ceilings and price floors be set to have an effect
on the market.
Answer: A price ceiling is a legally determined maximum price that sellers may charge for a
good or service. A price floor is a legally determined minimum price that sellers may receive for
a product or service. To have an effect on a market, price ceilings must be set below the
competitive equilibrium price, and price floors must be set above the competitive equilibrium
price.

17) What is a black market?

Answer: A black market is a market in which buying and selling take place at prices that violate
government price regulations.

18) What is the difference between scarcity and a shortage?

Answer: Scarcity is a situation in which unlimited wants exceed the limited resources available
to fulfill those wants. A shortage of a good occurs only if the quantity demanded is greater than
the quantity supplied at the current price.

Figure 4-12

19) Refer to Figure 4-12 which shows the market for vitamins. Suppose the government
imposes a price ceiling of Pv. How will the price ceiling affect the quantity supplied, quantity
demanded, and quantity exchanged?
41
Answer: The price ceiling will have no effect on the market outcome. An effective price ceiling
must lie below the free market equilibrium. Thus, in this case the market outcome will be
determined by forces of demand and supply.

Table 4-9

Price per Quantity Quantity

Bushel Demanded Supplied
(dollars) (bushels) (bushels)
$2 40,000 0
4 34,000 4,000
6 28,000 8,000
8 24,000 16,000
10 20,000 20,000
12 18,000 28,000
14 12,000 36,000
16 6,000 40,000

Table 4-9 above contains information about the corn market. Answer the following questions
based on this table.

20) Refer to Table 4-9. An agricultural price floor is a price that the government guarantees
farmers will receive for a particular crop. Suppose the federal government sets a price floor for
corn at $12 per bushel.
a. What is the amount of shortage or surplus in the corn market as result of the price floor?
b. If the government agrees to purchase any surplus output at $12, how much will it cost the
government?
c. If the government buys all of the farmers' output at the floor price, how many bushels of corn
will it have to purchase and how much will it cost the government?
d. Suppose the government buys up all of the farmers' output at the floor price and then sells the
output to consumers at whatever price it can get. Under this scheme, what is the price at which
the government will be able to sell off all of the output it had purchased from farmers? What is
the revenue received from the government's sale?
e. In this problem we have considered two government schemes: (1) a price floor is established
and the government purchases any excess output and (2) the government buys all the farmers'
output at the floor price and resells at whatever price it can get. Which scheme will taxpayers
prefer?
f. Consider again the two schemes. Which scheme will the farmers prefer?
g. Consider again the two schemes. Which scheme will corn buyers prefer?
Answer:
a. 10,000 surplus.
b. $12 × 10,000 = $120,000.
c. 28,000 bushels × $12 = $336,000.
d. $6 per bushel and government receives $6 × 28,000 = $168,000.
e. Taxpayers prefer scheme (1).
f. In terms of revenue, farmers are indifferent between the two schemes.
g. Corn buyers prefer scheme (2).

42
Figure 4-13

21) Refer to Figure 4-13 which shows the market for watermelons. Suppose the government
imposes a price floor of Pw. How will the price floor affect the quantity supplied, quantity
demanded, and quantity exchanged?
Answer: The price floor will have no effect on the market outcome. An effective price floor
must lie above the free-market equilibrium. Thus, in this case the market outcome will be
determined by forces of demand and supply.

Table 4-10

Price Per Quantity Quantity

Bushel Demanded Supplied
(dollars) (bushels) (bushels)
$3 36,000 0
6 30,000 2,000
9 25,000 5,000
12 20,000 10,000
15 16,000 16,000
18 13,000 23,000
21 8,000 30,000
24 3,000 36,000

Table 4-10 above contains information about the wheat market. Answer the following questions
based on this table.

43
22) Refer to Table 4-10. An agricultural price floor is a price that the government guarantees
farmers will receive for a particular crop. Suppose the federal government sets a price floor for
wheat at $21 per bushel.
a. What is the amount of shortage or surplus in the wheat market as result of the price floor?
b. If the government agrees to purchase any surplus output at $21, how much will it cost the
government?
c. If the government buys all of the farmers' output at the floor price, how many bushels of
wheat will it have to purchase and how much will it cost the government?
d. Suppose the government buys up all of the farmers' output at the floor price and then sells the
output to consumers at whatever price it can get. Under this scheme, what is the price at which
the government will be able to sell off all of the output it had purchased from farmers? What is
the revenue received from the government's sale?
e. In this problem we have considered two government schemes: (1) a price floor is established
and the government purchases any excess output and (2) the government buys all the farmers'
output at the floor price and resells at whatever price it can get. Which scheme will taxpayers
prefer?
f. Consider again the two schemes. Which scheme will the farmers prefer?
g. Consider again the two schemes. Which scheme will wheat buyers prefer?
Answer:
a. 22,000 surplus.
b. $21 × 22,000 = $462,000.
c. 30,000 bushels × $21 = $630,000.
d. $6 per bushel and government receives $6 × 30,000 = $180,000.
e. Taxpayers prefer scheme (1).
f. In terms of revenue, farmers are indifferent between the two schemes.
g. Wheat buyers prefer scheme (2).

Figure 4-14

Figure 4-14 shows the market for taxi rides. The following question(s) are based on this figure.

44
23) Refer to Figure 4-14. To legally drive a taxicab in New York City, you must have a
medallion issued by the city government. Assume that only 13,200 medallions have been issued.
Let's also assume this puts an absolute limit on the number of taxi rides that can be supplied in
New York City on any day, because no one breaks the law by driving a taxi without a medallion.
Assume as well that each taxi provides 6 trips per day. In that case, the quantity of taxi rides
supplied is 79,200 (or 6 rides per taxi × 13,200 taxis). This is shown in the diagram with a
vertical line at this quantity. Assume that there are no government controls on the prices that
drivers can charge for rides.
a. What would the equilibrium price and quantity be in this market if there was no medallion
requirement?
b. If there was no medallion requirement, indicate the area that represents consumer surplus.
c. If there was no medallion requirement, indicate the area that represents producer surplus.
d. If there was no medallion requirement, indicate the area that represents economic surplus.
e. What are the price and quantity with the medallion requirement?
f. With a medallion requirement in place, what area represents consumer surplus?
g. With a medallion requirement in place, what area represents producer surplus?
h. With a medallion requirement in place, what area represents the deadweight loss?
i. Based on your answers to parts (c) and (g), are taxicab drivers better off with the medallion
requirement for taxicabs than without?
j. Are consumers better off with or without the medallion requirement for taxicabs?
Answer:
a. P = $20, Q = 100,000 rides.
b. Consumer Surplus = A + B + H.
c. Producer Surplus = C + D + J.
d. Economic Surplus = A + B + C + D + H + J.
e. P = $30, Q = 79,200.
f. Consumer surplus with medallion = A.
g. Producer surplus with medallion = B + C + D.
h. Deadweight loss = H + J.
i. Taxi drivers are better off with the requirement because producer surplus is greater by the
area of B - J.
j. Consumers are better off without the medallion requirement.

24) Using a supply and demand graph, illustrate the market for rent-controlled apartments with
the following data:

Equilibrium rent without rent control: $1,500

Rent with rent control: $700
Quantity of apartments demanded with rent control: 50,000
Quantity of apartments supplied with rent control: 20,000

What is the value of the initial shortage of apartments with rent control?

Now assume rent control leads to a reduction in the supply of apartments, and the new quantity
supplied is now 15,000. Illustrate this on your graph.

What is the value of the shortage of apartments following the decrease in supply?
Answer:
45
The initial shortage of apartments is (50,000 - 20,000) = 30,000.
The reduction in supply is shown by the shift from S1 to S2.
The shortage following the decrease in supply is (50,000 - 15,000) = 35,000.

25) What is "tax incidence"? What determines tax incidence in a competitive market?
Answer: Tax incidence refers to the actual division of the burden of a tax between buyers and
sellers in a market. In a competitive market, tax incidence is determined by the forces of supply
and demand in that market.

26) What do economists mean by an efficient tax?

Answer: A tax is efficient if it imposes a small excess burden relative to the tax revenue it raises.

27) Using a supply and demand graph, illustrate the effect of the addition of a $10.00 per-unit
unit tax on digital cameras, where the entire tax burden falls on the seller. Assume the
equilibrium price before the tax is $125 and the equilibrium quantity is 50,000. What happens to
the price and quantity after the tax is implemented?
Answer:

46
Price does not change and quantity decreases.

Figure 4-19

28) Refer to Figure 4-19. The figure above illustrates the markets for two goods, Good X and
Good Y. Suppose an identical dollar tax is imposed on sellers in each market.
a. Compare the consumer burden and producer burden in each market. Illustrate your answer
graphically.
b. If the goal of the government is to raise revenue with minimum impact to quantity consumed,
in which market should the tax be imposed?
c. If the goal of the government is to discourage consumption, in which market should the tax
be imposed?
Answer:
a. See the figure below.

47
b. The market for Good Y
c. The market for Good X

Figure 4-20

29) Refer to Figure 4-20. The figure above represents demand and supply in the market for
gasoline. Use the diagram to answer the following questions.
a. How much is the government tax on each gallon of gasoline?
b. What portion of the per-unit tax is paid by consumers?
c. What portion of the per-unit tax is paid by producers?
d. What is the quantity sold after the imposition of the tax?
e. What is the after-tax revenue per gallon received by producers?
f. What is the total tax revenue collected by the government?
g. What is the value of the excess burden of the tax?
h. Is this gasoline tax efficient?
Answer:
48
a. Tax = $0.60 per gallon
b. Consumer burden = $0.40
c. Producer burden = $0.20
d. Quantity sold = 30 billion
e. Net Price to seller = $3.20
f. Tax Revenue = $18 billion ($0.60 × 30 billion)
g. Excess burden (deadweight loss) = $1.5 billion (1/2 × $0.60 × 5 billion)
h. Yes, a tax is efficient if it imposes a small excess burden relative to the tax revenue it raises.

30) Is there a difference between the "true burden" of a tax and who is legally required to pay a
tax? Briefly explain.
Answer: There is a difference. The true burden of a tax refers to the tax incidence, or how much
of a tax is ultimately paid by the sellers and how much is paid by the buyers. The incidence of a
tax does not depend on whether the government collects a tax from the buyers of a good or from
the sellers.

31) Using a supply and demand graph, illustrate the effect of an increase in the federal cigarette
tax of $1.00 per pack, where the entire tax burden falls on the consumer. Assume the equilibrium
price before the tax is $5.00 per pack and the equilibrium quantity is 30 million packs.

After the implementation of the tax, what are the equilibrium price and equilibrium quantity?
Answer:

After the implementation of the tax, the equilibrium price will be $6.00 and the equilibrium
quantity will still be 30 million packs.

49
Figure 4-21

32) Refer to Figure 4-21. The figure above represents demand and supply in the market for
cigarettes. Use the diagram to answer the following questions.
a. How much is the government tax on each pack of cigarettes?
b. What portion of the unit tax is paid by consumers?
c. What portion of the unit tax is paid by producers?
d. What is the quantity sold after the imposition of the tax?
e. What is the after-tax revenue per pack received by producers?
f. What is the total tax revenue collected by the government?
g. What is the value of the excess burden of the tax?
h. Is this cigarette tax efficient?
Answer:
a. $1.25
b. Consumer burden = $1.00
c. Producer burden = $0.25
d. Quantity traded = 18 billion
e. Net Price to seller = $1.25
f. Tax Revenue = $22.5 billion ($1.25 × 18 billion)
g. Excess burden (deadweight loss) = $1.25 billion (1/2 × $1.25 × 2 billion)
h. Yes, a tax is efficient if it imposes a small excess burden relative to the tax revenue it raises.

33) You are given the following market data for Venus automobiles in Saturnia.
Demand is represented by: P = 200 - 0.25Q
Supply is represented by: P = 130 + 0.10Q where P = Price and Q = Quantity.

a. Calculate the equilibrium price and quantity.

b. Calculate the consumer surplus in this market.
c. Calculate the producer surplus in this market.
Answer:
a. Price = $150; Quantity = 200
50
b. Consumer surplus = $5,000
c. Producer Surplus = $2,000

34) You are given the following market data for apples.
Demand is represented by: P = 12 - 0.01Q
Supply is represented by: P = 0.02Q where P= price per bushel, and Q=quantity.

a. Calculate the equilibrium price and quantity.

b. Suppose the government guaranteed producers a price of $10 per bushel. What would be the
effect on quantity supplied? Provide a numerical value.
c. By how much would the $10 price change the quantity of apples demanded? Provide a
numerical value.
d. Would there be a shortage or surplus of apples?
e. What is the size of this shortage or surplus? Provide a numerical value.
Answer:
a. Q = 400 bushels, P = $8.
b. Quantity supplied would increase to 500 bushels.
c. Quantity demanded would fall to 200 bushels.
d. There would be a surplus.
e. Surplus = 300 bushels.

35) You are given the following market data for Venus automobiles in Saturnia.
Demand: P = 35,000 - 0.5Q
Supply: P = 8,000 + 0.25Q where P = Price and Q = Quantity.

a. Calculate the equilibrium price and quantity.

b. Calculate the consumer surplus in this market.
c. Calculate the producer surplus in this market.
Answer:
a. Quantity = 36,000: {35,000 - 0.5Q = 8,000 + 0.25Q.; 27,000 = 0.75Q; Q = 36,000.}
Price = $17,000: {P = 35,000 - 0.5(36,000); P = 35,000 - 18,000; P = $17,000.}
b. Consumer surplus = (0.5)($35,000 - $17,000) × 36,000 = $324 million
c. Producer Surplus = (0.5)(17,000 - 8,000) × 36,000 = $162 million.

51
36) The demand and supply equations for the peach market are:
Demand: P = 24 - 0.5Q
Supply: P = -6 + 2.5Q where P = price per bushel, and Q = quantity (in thousands).

a. Calculate the equilibrium price and quantity.

b. Suppose the government guaranteed producers a price of $24 per bushel. What would be the
effect on quantity supplied? Provide a numerical value.
c. By how much would the $24 price change the quantity of peaches demanded? Provide
a numerical value.
d. Would there be a shortage or surplus of peaches?
e. What is the size of this shortage or surplus? Provide a numerical value.
Answer:
a. Quantity = 10 thousand bushels: {24 - 0.5Q = -6 + 2.5Q; 30 = 3Q; Q = 10}
Price = $19: {P = 24 - 0.5(10); P = 24 - 5; P = $19}
b. Quantity supplied would increase to 12 thousand bushels: {24 = -6 + 2.5Q; 30 = 2.5Q; Q =
12}
c. Quantity demanded would fall to zero bushels: {24 = 24 - 0.5Q; 0 = -0.5Q; Q = 0}
d. There would be a surplus.
e. Surplus = 12,000 - 0 = 12 thousand bushels.

52
Chapter 6 Elasticity: The Responsiveness of Demand and Supply

1) What does price elasticity of demand measure? When is demand elastic? Inelastic? Unit
elastic?
Answer: Price elasticity of demand measures the responsiveness of the quantity of a product
demanded to a change in the price of the product. Demand is elastic when the percentage change
in quantity demanded is greater than the percentage change in price. Demand is inelastic when
the percentage change in quantity demanded is less than the percentage change in price. Demand
is unit elastic when the percentage change in quantity demanded is equal to the percentage
change in price.

2) Suppose the price of gasoline in July 2004 averaged $1.35 a gallon and 15 million gallons a
day were sold. In October 2004, the price averaged $2.15 a gallon and 14 million gallons were
sold. If the demand for gasoline did not shift between these two months, use the midpoint
formula to calculate the price elasticity of demand. Indicate whether demand was elastic or
inelastic.
Answer: Price elasticity of demand = [(14 - 15) / (15 + 14)/2 ] / [(2.15 - 1.35) / (1.35 + 2.15)/2]
= (-1 / 14.5) / (0.80 / 1.75) = (-0.069 / 0.457) = -0.15.
Price elasticity of demand equals 0.15 (in absolute value) indicating that demand was inelastic.

3) The current price of canvas messenger bags is $36 each and sales of the bags equal 400 per
week. If the price elasticity of demand is -2.5 and the price changes to $44, how many messenger
bags will be sold per week? Use the midpoint formula.
Answer: Using the midpoint formula: -2.5 = (400 - X) / [(X + 400) / 2] / (36 - 44) / [(36 + 44)/2]
-2.5 × -0.2 = (400 - X) / [(X + 400) / 2]
0.5 = (400 - X) / [(X + 400) / 2]
0.5(200 + 0.5X) = 400 - X
1.25X = 300
X = 240 bags.

4) List the five key determinants of price elasticity of demand and explain how each determinant
indicates if demand tends to be elastic or inelastic.
Answer:
1. Availability of close substitutes: If a product has more substitutes available, it will have more
elastic demand. If a product has fewer substitutes available, it will have less elastic demand.
2. Passage of time: The more time that passes, the more elastic the demand for a product
becomes.
3. Luxuries versus necessities: The demand curve for a luxury is more elastic than the demand
curve for a necessity.
4. Definition of the market: The more narrowly a market is defined, the more elastic demand
will be.
5. Share of a good in a consumer's budget: The demand for a good will tend to be more elastic
the larger the share of the good in the average consumer's budget.
AACSB: Analytical thinking

5) For each pair of items below determine which product would have the higher price elasticity
of demand (in absolute value).
a. Insulin for a diabetic or aspirin for someone suffering a headache.
53
b. A new Whirlpool 27 [Link]. side-by-side refrigerator or electricity to power your all-electric
home.
c. A can of Red Bull or soft drinks in general.
Answer:
a. The demand for aspirin is more price elastic (its elasticity has a higher absolute value) than
the demand for insulin. Insulin is more necessity than luxury and has virtually no substitutes.
There are substitutes for aspirin and it is not necessarily a necessity.
b. The demand for a new refrigerator is more price elastic than the demand for electricity to
power your home. The Whirlpool refrigerator has many substitutes. Electricity to power your all-
electric home is more necessity than luxury, and if your home is powered only by electricity,
few, if any, substitutes are available.
c. The demand for Red Bull is more price elastic than demand for soft drinks in general.
Narrowly defined markets (such as the Red Bull drink market) have many substitutes.

6) Explain the concepts of cross-price elasticity of demand and income elasticity of demand.
What do positive and negative values indicate for each of these demand elasticities?
Answer: Cross-price elasticity of demand measures the percentage change in quantity demanded
of one good based on the percentage change in the price of another good. If cross-price elasticity
is positive, the two goods are substitutes. If cross-price elasticity is negative, the two goods are
complements.

Income elasticity of demand measures the responsiveness of quantity demanded to changes in

income. If income elasticity is positive but less than one, the product is a normal good and a
necessity. If income elasticity is positive and greater than one, the product is a normal good and a
luxury. If income elasticity is negative, the product is an inferior good.

7) Suppose a 4 percent increase in income results in a 2 percent decrease in the quantity

demanded of a good. Calculate the income elasticity of demand for the good and determine what
type of good it is.
Answer: Income elasticity of demand = -0.5. The good is inferior.

8) When the price of Starbucks coffee increased by 8 percent, the quantity demanded of Peet's
coffee increased by 10 percent. Calculate the cross-price elasticity of demand between Starbucks
coffee and Peet's coffee. What is the relationship between the two products?
Answer: The cross price elasticity = 1.25. The two products are substitutes.

Table 6-7

Quantities Quantities
Purchased Purchased
Income Prices Good X Good Y
$30,000 Px = $6, Py = $3 2 20
50,000 Px = $6, Py = $4 5 10

9) Refer to Table 6-7.

a. Using the information in the table, calculate the income elasticity of demand for good X and
characterize the good. Use the midpoint formula.
b. Can you calculate the income elasticity of demand for good Y? If you can, show your
54
calculation and characterize the good. If you cannot, explain why.
Answer:
a. The income elasticity of demand for good X = (3 / 3.5) / (20,000 / 40,000) = (0.8571 / 0.5) =
1.71. X is both a normal good and a luxury.
b. Since both income and Py change, you cannot calculate the income elasticity for good Y. The
income elasticity can be measured if a change in income causes the quantity of Y purchased to
change, holding everything else constant.

10) Explain the economic concept of price elasticity of supply. How is price elasticity of supply
calculated?
Answer: Price elasticity of supply refers to the responsiveness of the quantity of a product
supplied to a change in price. Price elasticity of supply is calculated by dividing the percentage
change in the quantity of a product supplied by the percentage change in the product's price.

11) Suppose the current price of oil is $90 a barrel and the quantity supplied is 800 million
barrels per day. If the price elasticity of supply for oil in the short run is estimated at 0.5, use the
midpoint formula to calculate the percentage change in quantity supplied when the price of oil
rises to $98 a barrel.
Answer: The percentage change in quantity supplied = [(98 - 90) / (98 + 90) / 2] × 0.5 × 100 =
(8 / 94) × 0.5 × 100 = 4.26 percent.

12) Suppose the current price of copper is $3 per pound and the quantity supplied is 200 pounds
per day. If the price of copper falls to $2.50 per pound, the quantity supplied drops to 180 pounds
per day. Use the midpoint formula to calculate the price elasticity of supply for copper.
Answer: The price elasticity of supply for copper = (20 / 190) / (0.5 / 2.75) = (0.1053 / 0.1818) =
0.58.

13) For a given demand curve, will there be a greater loss of economic efficiency from a binding
price floor when supply is elastic or inelastic? Illustrate your answer with a demand and supply
graph. In your graph you must show two supply curves, one elastic and the other inelastic.
Answer:

55
See the figure above. SA is the elastic supply curve, and SB the inelastic supply curve. For a
given demand curve, a binding price floor at Pf creates a greater loss of economic efficiency
when supply is inelastic rather than elastic. This can be seen from the diagram: When the supply
curve is SA (elastic) the loss in economic efficiency is represented by the area abe while the loss
in economic efficiency is represented by the area ace when the supply curve is SB (inelastic).

14) The current price of canvas messenger bags is $36 each and sales of the bags equal 400 per
week. If the price elasticity of demand is -2.5 and the price changes to $44, how many messenger
bags will be sold per week? Use the midpoint formula.

Answer: Using the midpoint formula: -2.5 = (400 - X) / [(X + 400) / 2] / (36 - 44) / [(36 + 44)/2]
-2.5 × -0.2 = (400 - X) / [(X + 400) / 2]
0.5 = (400 - X) / [(X + 400) / 2]
0.5(200 + 0.5X) = 400 - X
1.25X = 300
X = 240 bags.

15) The U.S. government's focus on supply reduction efforts in its "war on drugs" has been
relatively unsuccessful at addressing illegal drug use. Some economists believe that a successful
anti-drug program must concentrate on reducing demand; for example, through drug education
and voluntary treatment programs for addicts.
a. What will happen to the equilibrium price, quantity, and total revenue from cocaine sales if
the government succeeds in its efforts to reduce demand? What is likely to happen to the
incentive to sell cocaine?
b. Suppose the government continues to concentrate its efforts on supply reduction and is able to
reduce the supply of cocaine. As a result of the reduction in supply the price of cocaine increases
by 25 percent. If the price elasticity of demand is -0.5, what is likely to happen to the incentive to
sell cocaine?
c. Based on your answers, explain why one approach might be preferred over the other.

Answer:
a. A decrease in demand will lead to a decrease in price, quantity, and total revenue. Reduced
revenue is likely to deter drug trafficking.
b. The increase in price increases revenue when demand is inelastic; this will increase the
incentive to sell cocaine.
c. If people respond to incentives, the government will have more success is reducing cocaine
consumption if it uses anti-drug programs that concentrate on reducing demand rather than
programs that concentrate on reducing supply.

16) Which of the following products comes closest to having a perfectly inelastic demand?
A) gasoline
B) cholesterol medication in general
C) iPhones
D) bus rides
Answer: B

56
17) According to a study of the price elasticities of products sold in supermarkets, the price
elasticity of demand for toothpaste is estimated at -0.45. Which of the following could explain
why the price elasticity of demand for toothpaste is so low?
A) The toothpaste industry is highly competitive.
B) Toothpaste is relatively inexpensive.
C) Toothpaste is heavily endorsed by dentists.
D) There are few close substitutes for toothpaste.
Answer: D

18) Holding everything else constant, the demand for a good tends to be more elastic
A) the more substitutes there are for the good.
B) the shorter the time period involved.
C) the more consumers perceive the good to be a necessity.
D) the less important the product is in consumers' budgets.
Answer: A

57
Chapter 10 Consumer Choice and Behavioral Economics

1) What is marginal utility and what is the law of diminishing marginal utility?
Answer: Marginal utility is the change in total satisfaction a person receives from consuming
one additional unit of a good or service. The law of diminishing marginal utility is the principle
that consumers experience diminishing additional satisfaction as they consume more of a good or
service during a given period of time.

2) The increase in consumption of a good when its price falls is caused by two effects. What are
these two effects? Explain the difference between these effects.
Answer: The two effects are the substitution and income effects. According to the substitution
effect, more is consumed when the price of a good falls because the price of the good in question
is now lower relative to the prices of other goods. In addition, the fall in price increases the
consumer's purchasing power causing the quantity demanded to increase for a normal good and
decrease for an inferior good. This is the income effect. For most goods, the income effect is
small relative to the substitution effect which is why the overall effect of a price decrease is an
increase in quantity demanded.

3) Eliza consumes 12 cappuccinos and 8 apple turnovers per week. The price of a cappuccino is
$4 each and apple turnovers are $1 each.
a. What is the amount of income allocated to cappuccino and apple turnover consumption?
b. What is the price ratio (the price of cappuccinos relative to the price of apple turnovers)?
c. Explain the meaning of the price ratio you computed.
d. If Eliza maximize utility, what is the ratio of the marginal utility of cappuccinos to the
marginal utility of apple turnovers?
e. If the price of apple turnovers falls, will Eliza consume more apple turnovers, fewer apple
turnovers, or the same amount of apple turnovers? Explain your answer using the rule of equal
marginal utility per dollar.
Answer:
a. Income = $56
b. Price of cappuccino / price of apple turnovers = $4 / $1 = 4
c. To buy a cappuccino, Eliza has to give up 4 apple turnovers.
d. MUcappuccinos / MUapple turnovers = Price of cappuccinos / Price of apple turnovers = $4
/ $1 = 4
e. If the price of apple turnovers falls, the marginal utilities per dollar will not be equal.
Specifically, MUcappuccinos / Price cappuccinos < MUapple turnovers / Price apple turnovers.
Eliza can raise her total utility by buying more apple turnovers and fewer cappuccinos.

4) Arnie Ziffel has $20 per week to spend on any combination of pineapples and green tea. The
price of a pineapple is $4 and the price of a bottle of green tea is $2. The table below shows
Arnie's utility values. Use the table to answer the questions that follow the table.

Marginal Quantity Marginal

Quantity of Total Marginal Utility per of Green Total Marginal Utility per
Pineapples Utility Utility Dollar Tea Utility Utility Dollar
1 32 1 28
2 52 2 46
3 64 3 54
58
 4 68 4 60
5 70 5 64
6 71 6 66
7 71 7 67

a. Complete the table by filling in the blank spaces.

b. Suppose Arnold purchases 4 pineapples and 2 bottles of green tea. Is he consuming the
optimal consumption bundle? If so, explain why. If not, what combination should he buy and
why?
Answer:
a.
Quantity Marginal Quantity Marginal
of Total Marginal Utility per of Green Total Marginal Utility per
Pineapples Utility Utility Dollar Tea Utility Utility Dollar
1 32 32 8 1 28 28 14
2 52 20 5 2 46 18 9
3 64 12 3 3 54 8 4
4 68 4 1 4 60 6 3
5 70 2 0.5 5 64 4 2
6 71 1 0.25 6 66 2 1
7 71 0 0 7 67 1 0.5

b. If Arnold purchases 4 pineapples and 2 bottles of green tea, he is not maximizing his utility.
The marginal utility per dollar spent on pineapples = 1 and the marginal utility per dollar spent
on green tea = 9. His total utility from this bundle is 114 utils. If he buys 3 pineapples and 4
bottles of green tea, he will equate his marginal utilities per dollar and the total utility from this
bundle = 124.

5) What is an indifference curve? Why can indifference curves never cross?

Answer: An indifference curve shows the combination of consumption bundles that give the
consumer the same utility. Indifference curves never cross because we assume consumers have
transitive preferences. If a consumer prefers consumption bundle A to consumption bundle B,
and he prefers consumption bundle B to consumption bundle C, then he must prefer bundle A to
bundle C. If indifference curves cross, this assumption is violated.

6) Farah has $100 to spend each month on bread and chicken. Suppose the price of bread is $4 a
loaf and the price of chicken is $5 per pound.
a. Draw her budget constraint and label it BC0. Put bread on the horizontal axis and chicken on
the vertical axis. Be sure to identify the intercept values.
b. Suppose Farah is a utility maximizer and she consumes 10 loaves of bread and 12 pounds of
chicken. On the same graph you drew in part (a), draw an indifference curve to identify her
optimal bundle. Label this bundle "E."
c. Is her budget exhausted? Verify your answer.
d. Now suppose Farah's income falls to so that she can now devote $80 to the two goods. Prices
however remain unchanged. In the same diagram, graph her new budget constraint and label it
BC1. Be sure to identify any new intercept values.
e. Following the change in income, can Farah consume the same bundle "E"? Explain your
59
answer.
f. What must happen to her total utility following the decrease in her income?
Answer:
a. See the figure below
b. See the figure below.
c. Yes, her budget is exhausted. She spends ($4 × 10) + ($5 × 12) = $100.
d. See figure below.
e. No, the bundle "E" is no longer affordable. It lies outside her budget line.
f. Her total utility falls.

7) Grant has $200 to spend each month on restaurant meals and jazz performances at his
neighborhood jazz club. The price of a typical restaurant meal is $20 and the price of a jazz
performance ticket is $10. Grant is maximizing his utility by consuming 6 restaurant meals and
attending 8 jazz performances. Suppose Grant still has $200 to spend, but the price of restaurant
meal rises to $25, while the price of jazz performance ticket drops to $8. Can it be determined if
Grant is better off or worse off than he was before the price change? Use a budget
constraint/indifference curve graph to illustrate your answer.
Answer: Initially, when the price of a typical restaurant meal is $20 and the price of a jazz
performance ticket is $10, Grant consumes the bundle "A" on BC1. Following the price changes,
Grant's new budget line is BC2. He is no longer able to afford this same bundle "A" as shown in
the figure below, but without having information to plot his new indifference curve, it is
uncertain whether he is better off or worse off than he was before the price change.

60
8) The Wong family consumes 3 pounds of fish and 5 pounds of chicken per month. The price of
fish is $8 per pound and chicken is $4 per pound.
a. What is the amount of income allocated to fish and chicken consumption?
b. What is the price ratio (the price of fish relative to the price of chicken)?
c. Explain the meaning of the price ratio you computed.
d. If the Wongs maximize utility, what must the ratio of the marginal utility of fish to the
marginal utility of chicken be equal to?
e. If the price of chicken rises, will the Wong family consume more chicken, less chicken, or the
same amount of chicken? Explain your answer using the rule of equal marginal utility per dollar.

Answer:
a. Income = $44
b. Price of fish / price of chicken = $8 / $4 = 2
c. To buy a pound of fish the family has to give up 2 pounds of chicken.
d. MUfish / MUchicken = Price of fish / Price of chicken = $8 / $4 = 2
e. If the price of chicken rises, the marginal utilities per dollar will not be equal. Specifically,
MUfish / Price fish > MUchicken / Price chicken. The family can raise its total utility by buying
less chicken and more fish.

9) Lilly Davis has $5 per week to spend on any combination of ice cream and candy. The price
of an ice cream cone is $2 and the price of a candy bar is $1. The table below shows Lilly's
utility values. Use the table to answer the questions that follow the table.

Quantity of Marginal
Total Marginal Quantity Total Marginal
Ice Cream Utility per
Utility Utility of Candy Utility Utility
Cones Dollar
1 20 1 20
2 38 2 38

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 3 52 3 48
4 62 4 54

a. Complete the table by filling in the blank spaces.

b. Suppose Lilly purchases 2 ice cream cones and 1 candy bar. Is she consuming the optimal
consumption bundle? If so, explain why. If not, what combination should she buy and why?

Answer:
a.
Quantity of Marginal
Total Marginal Quantity Total Marginal
Ice Cream Utility per
Utility Utility of Candy Utility Utility
Cones Dollar
1 20 20 10 1 20 20
2 38 18 9 2 38 18
3 52 14 7 3 48 10
4 62 10 5 4 54 6

b. If Lilly purchases 2 ice cream cones and 1 candy bar she is not maximizing her utility. The
marginal utility per dollar spent on ice cream cones = 9 and marginal utility per dollar spent on
candy bars = 20. Her total utility from this bundle is 58 utils. If she buys 1 ice cream cone and 3
candy bars, she will equate her marginal utilities per dollar and the total utility from this bundle =
68.

10) Gowri has $6 per day to purchase lunch. She spends all of her lunch money on pizza and iced
tea. The price of pizza is $2.00 per slice and iced tea costs $1 per bottle.
a. Draw Gowri's budget constraint and label it BC0. Put pizza on the horizontal axis and iced
tea on the vertical axis. Be sure to identify the intercept values.
b. If the price of iced tea rises to $1.20 per bottle, show what will happen to her budget
constraint in your diagram. Be sure to indicate any new intercept values.

Answer:
a.

62
b. BC1 in the figure above represents the effect of an increase in the price of iced tea.

63
Chapter 11 Technology, Production, and Costs

1) In economics, what is the difference between the short run and the long run?
Answer: In economics, the short run refers to the period of time during which at least one of a
firm's inputs is fixed. The long run refers to the period of time in which a firm can vary all its
inputs, adopt new technology, and increase or decrease the size of its physical plant.

2) What is the difference between explicit costs and implicit costs? List three examples each of
explicit costs and implicit costs that may be experienced by a small business.
Answer: Explicit costs are costs that involve spending money. Implicit costs are nonmonetary
opportunity costs. Explicit costs experienced by a small business may include wages, utility
costs, and rent. Implicit costs experienced by a small business may include foregone salary,
foregone interest, and economic depreciation.

3) Sally quit her job as an auto mechanic earning $50,000 per year to start her own business. To
save money she operates her business out of a small building she owns which, until she started
her own business, she had rented out for $10,000 per year. She also invested her $20,000 savings
(which earned a market interest rate of 5% per year) in her business. You are given the following
information about the first year of her operations.

Total revenue $120,000

Cost of labor 40,000
Cost of materials 15,000
Equipment rental 5,000

a. Calculate her economic costs.

b. Calculate her accounting costs.
c. Calculate her implicit costs.
d. Sally tells you that she would really like to move to a location closer to town but she decided
against it because "right now I don't pay any rent and it will cost me $10,000 a year to rent near
town." Do you agree with her reasoning?
Answer:
a. $121,000 = 40,000 (labor) + 15,000 (materials) + 5,000 (equipment)+ 10,000 (opportunity
cost of building) + 1,000 (5% of 20,000, the opportunity cost of her savings) + 50,000
(opportunity cost of Sally's labor)
b. $60,000 = 40,000 (labor) + 15,000 (materials) + 5,000 (equipment)
c. $61,000 = 10,000 (opportunity cost of building) + 1,000 (5% of 20,000, the opportunity cost
of her savings) + 50,000 (opportunity cost of Sally's labor)
d. No. Although she does not incur a monetary cost for her garage space now, it is an
opportunity cost and part of the economic cost of doing business. Sally could just as well rent her
space out now, collect the rent and move closer to town.

4) What is the marginal product of labor and what is the average product of labor.
Answer: The marginal product of labor is the additional output a firm produces as a result of
hiring one more worker. The average product of labor is the total output produced by a firm
divided by the quantity of workers. The average product of labor is the average of the marginal
products of labor.

64
5) Describe the relationship between marginal cost and average total cost.
Answer: If marginal cost for a given output is below average total cost, average total cost will
decrease as output increases but if marginal cost is above average total cost, average total cost
will increase as output increases. If marginal cost equals average total cost, average total cost is
at its minimum value.

Table 11-6

Quantity of Quantity of foot Fixed Variable Total Average Marginal

workers massages per day cost cost cost total cost cost
0 0
1 10
2 25
3 45
4 60
5 70

6) Refer to Table 11-6. Alicia Gregory owns a foot massage business. She leases 4 computer-
controlled massage booths, for which she pays $125 per day. She cannot increase the number
machines she leases without giving the manufacturer 3 months notice. She can hire as many
workers as she wants at a cost of $75 per day per worker. These are the only two inputs she uses
in her business. Use this information to fill in the columns in the above table.
Answer:
Quantity of
Quantity of foot massages Fixed Variable Total Average Marginal
workers per day cost cost cost total cost cost
0 0 $500 $0 $500 --- ---
1 10 500 75 575 57.50 $7.50
2 25 500 150 650 26.00 5.00
3 45 500 225 725 16.11 3.75
4 60 500 300 800 13.33 5.00
5 70 500 375 875 12.50 7.50

7) As the level of output increases, what happens to the value of average fixed cost, and what
happens to the difference between the value of average total cost and average variable cost?
Answer: As the level of output increases, the value of average fixed cost decreases. The same
fixed cost is divided by a larger and larger output. The difference between average total cost and
average variable cost is average fixed cost, so as is stated above, the value decreases.

8) What are economies of scale? What are diseconomies of scale?

Answer: Economies of scale occur when a firm's long-run average costs fall as it increases
output. Diseconomies of scale occur when a firm's long-run average costs rise as the firm
increases output.

9) What is an isoquant? What is the slope of an isoquant?

Answer: An isoquant is a curve that shows all the combinations of two inputs, such as capital
and labor, that will produce the same level of output. Its slope is the rate at which a firm can

65
substitute one input for the other while keeping output constant, or the marginal rate of technical
substitution (MRTS).

10) What is an isocost line? What is the slope of an isocost line?

Answer: The isocost line shows all the combinations of two inputs, such as capital and labor,
that have the same total cost. The slope of the isocost line is equal to the ratio of the price of the
input on the horizontal axis divided by the price of the input on the vertical axis, multiplied by -
1.

11) Use the following graph to answer the following questions.

a. If the wage rate and the rental price of machines are both $50 and total cost is $800, is the
cost-minimizing point A, B, or C?
b. If the wage rate is $40, the rental price of equipment is $120, and total cost is $1,200, is the
cost-minimizing point A, B, or C?
c. If the wage rate is $60, the rental price of equipment is $90, and total cost is $1,800, is the
cost-minimizing point A, B, or C?
Answer:
a. If total cost is $800 and the wage rate and rental price of machines both equal $50, the
isocost line's endpoints are at 16 and 16. Along this isocost line, the cost minimizing point for
producing 6,000 units is at point A.
b. If the wage rate is one-third the rental price of machines, we must be on the isocost line
whose endpoints are where capital = 10 and labor = 30, because we can buy three times as much
labor with a total cost of $1,200. Along this isocost line the cost-minimizing point for producing
6,000 units is point B.
66
c. If the wage rate is two-thirds the rental price of machines, we must be on the isocost line
whose endpoints are where capital = 20 and labor = 30, because we can buy 1.5 times as much
labor with a total cost of $1,800. Along this isocost line the cost-minimizing point for producing
14,000 units is point C.

12) Describe the difference between technology and positive technological change.

Answer: A firm's technology refers to the processes it uses to turn its land, labor, capital and
entrepreneurial inputs into outputs of goods and services. When a firm experiences positive
technological change it is able to produce more output using the same inputs or the same output
using fewer inputs. Technological change can result from rearranging the layout of a store or
manufacturing plant, the installation of faster or more durable equipment or other factors.

13) Which of the following are examples of a firm experiencing a positive technological change?

a. A firm is able to reduce its inputs by 15 percent and still produce the same level of output.
b. A seminar attended by the firm's workers makes them more productive.
c. A firm adds 5 percent to its workforce and is able to maintain its initial level of output.
d. A firm restructures its distribution system and is able to save on its shipping times.
e. A firm rearranges its warehouse and finds that it can use fewer workers to maintain its
productivity level.

Answer: Examples a, b, d, and e are examples of positive technological change. Examples a and
e involve change that results in the firm being able to produce the same output with a smaller
quantity of inputs. Examples b and d involve change that results in the firm being able to produce
more output with the same amount of inputs. Example c is not an example of technological
change, because an increase in inputs is used to produce the same quantity of output.

14) Explain whether each of the following is a fixed cost or a variable cost for Damian
Dandridge's tattoo parlor.
a. The payment he makes to buy tattoo ink.
b. The wages he pays his employees.
c. The $500-per-month payment he makes to advertise his shop on highway billboards.
d. The lease payment he makes to the landlord who owns the building where his shop is located.
e. The payment he makes on his liability insurance policy.

Answer: c, d, and e are fixed costs because they do not change as the quantity of tattoos
produced increases. a and b are variable costs because they increase as the quantity of tattoos
produced increases. It is important to note that the time period under consideration is important.
In the long run, all of these costs are variable.

15) Damian owns a tattoo parlor and has hired three tattoo artists to work for him. The marginal
product of labor is 8 for the first artist, 12 for the second artist, and 7 for the third artist. What is
Damian's average product of labor for these three tattoo artists?
Answer: The average product of labor is the average of the marginal products of labor.
Therefore, Damian's average product of labor for these three artists is (8 + 12 + 7) / 3 = 9.

67
16) Table 11-4

Labor Quantity of Marginal Product

(hours) Fish (pounds) (pounds)
1 10
2 18
3 24
4 28
5 30
6 32

Refer to Table 11-4. The table above shows the following relationship between hours spent
fishing and the quantity of fish caught for Juan, a commercial fisherman.
a. Complete the Marginal Product column in Table 11-4.
b. Characterize the production function, i.e. does the production function display increasing
marginal returns, diminishing marginal returns, etc.
c. Using the data above, graph Juan's marginal product curve. Be sure to label the horizontal
and vertical axes. Is your graph consistent with your answer to part (b)? Explain.
d. Juan uses the following inputs for fishing — a small wooden boat (B), a fishing pole (P) and
of course, his labor (L). Treating the boat and the fishing pole as fixed inputs and using the data
above, graph Juan's Total Product of Labor curve. Be sure to label the horizontal and vertical
axes.
e. The opportunity cost of Juan's time is $8 per hour. If Juan receives $2 per pound for his fish,
what is the optimal number of hours he should spend fishing? Explain how you arrived at your
answer. Hint: Recall marginal benefit and marginal cost analysis.

Answer:
a.
Labor Quantity of Fish Marginal Product
(hours) (pounds) (pounds)
1 10 10
2 18 8
3 24 6
4 28 4
5 30 2
6 32 2

b. The production displays diminishing marginal returns and then constant marginal returns
with the 5th labor hour.

68
c. See graph of "Marginal Product" below. Yes, the marginal curve slopes downwards and is
horizontal for the 5th and 6th units of labor.

d.

e. If Juan can sell his fish for $2 per pound, he should work for a total of 4 hours, up to the point
where the marginal benefit from an additional unit of labor (i.e. marginal product × price per
pound) equals the marginal cost of his time.

17) Table 11-5

Marginal Office Labor

Number of Output Total Cost
Product of Rent Cost
Workers (boxes) (dollars)
Labor (dollars) (dollars)
0 0 --
1 220 400 200
2 250 800
3 680
69
 4 160 1,200
5 940 1,000
6 980 1,600

Refer to Table 11-5. Suzette's Fancy Packaging subcontracts with Sunshineland Pecans to box
dried fruit and nuts for Suzette's mail order business. Suzette rents space for her factory for $400
a week in a nearby strip mall. She can hire temporary workers for $200 a week. Table 11-5
above shows her output and cost data. Use the table to answer questions a-e.
a. Complete the table.
b. In the last week of summer Suzette closes her business to go on a family vacation. What are
her costs during that week?
c. In one week Suzette exactly breaks even. If her revenue for the week is $1,200, how many
boxes of fruit and nuts did she produce?
d. Judging from the marginal product of labor data, would you say that Suzette had to settle for
increasingly unproductive workers? Explain your answer.
e. Suzette has received an order for 1,500 boxes of nuts per week for the next 3 months. If she
expects the trend in the marginal product of labor will continue in the same direction, what do
you think she should do? Should she not commit until she can move to a larger space or should
she just hire more workers? Explain your answer.

Answer:
a.
Marginal
Number of Output Office Labor
Product of Total Cost
Workers (boxes) Rent Cost
Labor
0 0 -- $400 0 $400
1 220 220 $400 $200 $600
2 470 250 $400 $400 $800
3 680 210 $400 $600 $1,000
4 840 160 $400 $800 $1,200
5 940 100 $400 $1,000 $1,400
6 980 40 $400 $1,200 $1,600

b. $400
c. 840 boxes
d. Diminishing marginal product of labor does not imply that the workers are unproductive.
Rather, the marginal product declines because of the presence of a fixed factor, in this case the
mall space. After hiring the 3rd worker the other workers have begun to get in each other's way.
e. She should not commit to meeting the order until she can move to a larger space and hire
more workers.

70
18) Figure 11-8

Refer to Figure 11-8 above to answer the following questions.

a. Identify the curves in the diagram.
A ________ B ________ C ________
b. What is the numerical value of fixed cost when the quantity of output=10?
c. What is the numerical value of variable cost when the quantity of output=10?
d. What is the numerical value of total cost when the quantity of output =10?
e. What is the numerical value of average fixed cost when the quantity of output =10?
f. What is the numerical value of average total cost when the quantity of output =10?
g. On the graph identify the area that represents the total variable cost of production when the
quantity of output =10.
h. On the graph identify the area that represents the fixed cost of production when the quantity
of output =10.

Answer:
a. A=Marginal cost curve; B = Average total cost curve; C = Average variable cost curve.
b. $150
c. $70
d. $220
e. $15
f. $22
g. the area of the rectangle 0$7e10
h. the area of the rectangle $7$22de

71
19) Figure 11-9

Refer to Figure 11-9 above to solve the following problems.

a. Calculate the fixed cost of production.
b. Calculate the average total cost of production when the firm produces 20 units of output.
c. Calculate the average variable cost of production when the firm produces 20 units of output.
d. Calculate the average fixed cost of production when the firm produces 20 units of output.
e. Calculate the average fixed cost of production when the firm produces 15 units of output.
f. If the firm increases output from 15 to 20 units, what is the marginal cost of output?

Answer:
a. $100
b. $22.5
c. $17.5
d. $5
e. $6.67
f. $14

20) State the law of diminishing returns. How do diminishing returns differ from diseconomies
of scale? Be sure to define diseconomies of scale in your answer.

Answer: The law of diminishing returns states that at some point, adding more of a variable
input to the same amount of a fixed input will eventually cause the marginal product of the
variable input to decline. The law applies in the short run when there is at least one fixed factor
of production. Diseconomies of scale applies in the long run when a firm is free to vary all of its
inputs. Diseconomies of scale exist when a firm's long-run average cost rises as it increases
output.

72
21) What is minimum efficient scale? What is likely to happen in the long run to firms that do
not reach minimum efficient scale?

Answer: Minimum efficient scale is the lowest level of output at which all economies of scale
have been exhausted—that is, where the long-run average cost curve stops sloping downward. In
the long run, firms that don't reach minimum efficient scale will have higher average costs than
competitors that do reach minimum efficient scale, so they will probably be driven out of
business. However, firms that justify selling at premium prices due to product differentiation can
survive.

22) Suppose Argyle Sachs has to choose between building a smaller sweater factory and a larger
sweater factory. In the following graph, the relationship between costs and output for the smaller
factory is represented by the curve ATC1, and the relationship between costs and output for the
larger factory is represented by the curve ATC2.

a. If Argyle expects to produce 3,600 sweaters per month, should he build a smaller factory or a
larger factory? Briefly explain?
b. If Argyle expects to produce 5,000 sweaters per month, should he build a smaller factory or a
larger factory? Briefly explain.
c. If the average cost of producing sweaters is lower in the larger factory when Argyle produces
6,500 sweaters per week, why isn't it also lower when Argyle produces 4,000 sweaters per week?

Answer:
a. Argyle's costs will be lower with a smaller factory.
b. Argyle's costs will be lower with a larger factory.
c. Economies of scale often take the form of a larger factory allowing for lower average cost for
a large quantity, but actually higher average cost for a smaller quantity.

73
23) If the marginal product of labor is 45 units of output and the marginal product of capital is 56
units of output while the wage rate is $20 per worker and the cost of capital is $28 per machine,
are these two inputs being used in the least-cost combination and what should be done if they are
not?

Answer: The marginal product per dollar spent on labor is 2.25 units and the marginal product
per dollar spent on capital is 2 units. Therefore, the firm is not using the least-cost combination
of inputs. To reduce costs the firm should use more labor and less capital.

74
Chapter 12 Firms in Perfectly Competitive Markets

1) Why are individual buyers and sellers in perfect competition called price takers?
Answer: They are called price takers because each firm and customer are too small to influence
the market price and has to take the market price as given.

2) What assumptions are necessary for a market to be perfectly competitive? Explain why each
of these assumptions is important.
Answer: The assumptions necessary for a market to be perfectly competitive are:
1. There are many buyers and sellers, all of whom are small relative to the market. This
assumption ensures that each seller (or firm) and buyer is a price taker. A price taker cannot
affect the market price.
2. All firms sell identical products. This condition excludes the possibility of any product
differences which might justify different prices. Because the consumer cannot differentiate
between products of different producers, any firm that charges a higher price will lose all its
customers.
3. No barriers to new firms entering the market or exiting the market. This assumption
guarantees that economic profits earned in the short run will be eliminated in the long run. In the
long run, perfectly competitive firms will break even.

3) Of the following industries, which are perfectly competitive? For those that are not perfectly
competitive, explain why.
a. Restaurants
b. Corn
c. College education
d. Local radio and television
Answer:
a. Restaurants are not perfectly competitive. Although cities typically have many restaurants for
consumers to choose from, they do not sell identical products. They also differ in the services
they offer their customers. Some restaurants have take-out windows, some have servers while
others (McDonald's, Burger King) require customers to pick up their own orders.
b. The market for corn (and other agricultural commodities) is a perfectly competitive market.
Each buyer and seller is small relative to the total market. Although there are varieties of corn
(for example "number 2" corn) within these varieties one farmer's corn is indistinguishable from
any other farmer's corn.
c. The market for a college education is not perfectly competitive. This is an example of a
market that offers consumers (students) a differentiated product. Colleges and universities differ
in size, amenities, quality of instruction, location, and many other factors.
d. Local radio and television markets are not perfectly competitive. Radio and television
stations do not offer identical products. Some radio stations broadcast only classical music, while
others play classic rock, alternative rock, country music, etc. Television stations also offer
different programming including movies, sports, news, etc.

75
4) Consider the market for wheat which is a perfectly competitive market. Is the market demand
curve the same as the demand curve facing an individual producer? If not, explain how and why
they are different? Illustrate your answer graphically.
Answer: The market demand is downward sloping while the demand for an individual firm's
output is horizontal at the equilibrium market price. This is because an individual producer is too
small to influence the market price and must take the market price as given. At the market price,
the individual seller can sell all the output she desires. The figure below shows the market
demand curve and the demand curve for a single firm.

5) How are market price, average revenue, and marginal revenue related for a perfectly
competitive firm and why?
Answer: They are all equal to each other. The market price for any firm equals average revenue.
This can be verified by noting that average revenue = total revenue ÷ quantity = (price ×
quantity) ÷ quantity. Further, a perfectly competitive firm faces a horizontal demand curve at the
market price which means that it does not need to reduce the price to sell more. Therefore, its
marginal revenue equals price.

6) Explain two different ways to determine the profit-maximizing level of output for a firm in a
perfectly competitive market.
Answer: One way is using total revenue and total cost. The profit maximizing level of output is
where the difference between total revenue and total cost is the greatest. Another way is using
marginal revenue and marginal cost. The profit-maximizing level of output is where marginal
revenue equals marginal cost.

7) Fill in the columns in the following table and use the values in the table to determine the
profit-maximizing level of output.

Total Total Marginal

Revenue Cost Revenue Marginal
Quantity (TR) (TC) Profit (MR) Cost (MC)
0 0 3
76
 1 5 5
2 10 6
3 15 8
4 20 11
5 25 15
6 30 21
7 35 30
8 40 42
9 45 60
10 50 85

Answer:

Total Total Marginal

Revenue Cost Revenue Marginal
Quantity (TR) (TC) Profit (MR) Cost (MC)
0 0 3 -3 --- ---
1 5 5 0 5 2
2 10 6 4 5 1
3 15 8 7 5 2
4 20 11 9 5 3
5 25 15 10 5 4
6 30 21 9 5 6
7 35 30 5 5 9
8 40 42 -2 5 12
9 45 60 -15 5 18
10 50 85 -35 5 25

The profit-maximizing level of output is 5 units.

8) Assuming a market price of $4, fill in the columns in the following table. What is the profit-
maximizing level of production? What are the two ways to determine the profit-maximizing
level of production?

Total Total Marginal

Revenue Cost Revenue Marginal
Quantity (TR) (TC) Profit (MR) Cost (MC)
0 3
1 5
2 6
3 9
4 14
5 20
6 28
7 40

77
Answer:

Total Marginal
Revenue Total Cost Revenue Marginal
Quantity (TR) (TC) Profit (MR) Cost (MC)
0 0 3 -3 --- ---
1 4 5 -1 4 2
2 8 6 2 4 1
3 12 9 3 4 3
4 16 14 2 4 5
5 20 20 0 4 6
6 24 28 -4 4 8
7 28 40 -12 4 12

The profit-maximizing level of production is 3 units, which can be determined by the greatest
difference between total revenue and total cost, which is equal to profit, and can also be
determined where marginal revenue is equal to marginal cost (or marginal revenue is the closest
to marginal cost, without being below marginal cost).

Figure 12-3

9) Refer to Figure 12-3. Suppose the prevailing price is P1 and the firm is currently producing
its loss-minimizing quantity. Identify the area that represents the loss.
A) P2 deP1
B) P3cbP1
C) P3caP0
D) 0P1 bQ1
Answer: B

78
Figure 12-4

Figure 12-4 shows the cost and demand curves for a profit-maximizing firm in a perfectly
competitive market.

10) Refer to Figure 12-4. If the market price is $30, the firm's profit-maximizing output level is
A) 0.
B) 130.
C) 180.
D) 240.
Answer: C

11) Refer to Figure 12-4. If the market price is $30 and if the firm is producing output, what is
the amount of its total variable cost?
A) $7,200
B) $6,480
C) $5,400
D) $3,960
Answer: D

12) Refer to Figure 12-4. What is the amount of its total fixed cost?
A) $1,080
B) $1,440
C) $2,520
D) It cannot be determined.
Answer: C

13) Refer to Figure 12-4. If the market price is $30 and the firm is producing output, what is the
amount of the firm's profit or loss?
A) loss of $1,080
79
B) profit of $1,440
C) loss of $2,520
D) profit of $1,300
Answer: A

14) Refer to Figure 12-4. If the market price is $30, should the firm represented in the diagram
continue to stay in business?
A) No, it should shut down because it is making a loss.
B) No, it should shut down because it cannot cover its variable cost.
C) Yes, because it is covering part of its fixed cost.
D) Yes, because it is making a profit.
Answer: C

Table 12-3

Average Marginal
Quantity Total Cost Total Cost Cost
0 $10.00 ----- -----
1 15.00 $15.00 $5.00
2 17.50 8.75 2.50
3 22.50 7.50 5.00
4 30.00 7.50 7.50
5 40.00 8.00 10.00
6 52.50 8.75 12.50
7 67.50 9.64 15.00
8 85.00 10.63 17.50
9 105.00 11.67 20.00

Arnie sells basketballs in a perfectly competitive market. Table 12-3 summarizes Arnie's output
per day (Q), total cost (TC), average total cost (ATC) and marginal cost (MC).

15) Refer to Table 12-3. What price (P) will Arnie charge and how much profit will he earn if
the market price of basketballs is $12.50?
A) Price and profit cannot be determined from the information given.
B) P = $12.50; profit = $52.50
C) P = $12.50; profit = $22.50
D) P = $20; profit = $75.00.
Answer: C

16) Refer to Table 12-3. What will Arnie's output be and how much profit will he earn if the
market price of basketballs is $5.00?
A) Q = 1; profit = -$10.
B) Q = 3; profit = -$7.50
C) Q = 0; profit = -$10.00
D) Price and profit cannot be determined from the information given.
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Answer: B

17) To maximize profit, a firm will produce the level of output where MR = MC. If a firm
actually makes a profit depends on the relationship of price to average total cost. What are the
three possible relationships between price and average total cost that determine if a firm will
make a profit, experience a loss, or break even?
Answer: If P > ATC, the firm makes a profit.
If P < ATC, the firm experiences a loss.
If P = ATC, the firm breaks even.
Diff: 3 Page Ref: 418-419

18) Suppose Veronica sells teapots in the perfectly competitive teapot market. Her output per
day and her costs are as follows:
Output per Day Total Cost
0 $20
1 32
2 37
3 48
4 61
5 75
6 92
7 113
8 136

Suppose the current equilibrium price in the teapot market is $10. To maximize profit, how many
teapots will Veronica produce, what price will she charge, and how much profit (or loss) will she
make? Draw a graph to illustrate your answer. Your graph should include Veronica's demand,
ATC, AVC, MC, and MR curves, the price she is charging, the quantity she is producing, and the
area representing her profit (or loss).
Answer: Veronica will produce 2 teapots per day. She will charge the market price of $10. She
will make a profit of $-17 (a loss of $17).

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19) Suppose Veronica sells teapots in the perfectly competitive teapot market. Her output per
day and her costs are as follows:
Output per Day Total Cost
0 $20
1 32
2 37
3 48
4 61
5 75
6 92
7 113
8 136

Suppose the current equilibrium price in the teapot market is $20. To maximize profit, how many
teapots will Veronica produce, what price will she charge, and how much profit (or loss) will she
make? Draw a graph to illustrate your answer. Your graph should include Veronica's demand,
ATC, AVC, MC, and MR curves, the price she is charging, the quantity she is producing, and the
area representing her profit (or loss).
Answer: Veronica will produce 6 teapots per day. She will charge the market price of $20. She
will make a profit of $28.

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20) Suppose Veronica sells teapots in the perfectly competitive teapot market. Her output per
day and her costs are as follows:
Output per Day Total Cost
0 $20
1 32
2 37
3 48
4 61
5 75
6 92
7 113
8 136

Suppose the current equilibrium price in the teapot market is $15. To maximize profit, how many
teapots will Veronica produce, what price will she charge, and how much profit (or loss) will she
make? Draw a graph to illustrate your answer. Your graph should include Veronica's demand,
ATC, AVC, MC, and MR curves, the price she is charging, the quantity she is producing, and the
area representing her profit (or loss).
Answer: Veronica will produce 5 teapots per day. She will charge the market price of $15. She
will break even and make a profit of $0.

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21) Under what conditions should a competitive firm shut down in the short run?
Answer: When market price is below average variable cost at the output where marginal
revenue equals marginal cost, the firm should shut down in the short run.

22) What is the difference between "shutting down temporarily" and "exiting the industry"?
Answer: The difference between the two has to do with fixed costs. In the short run a firm
cannot avoid its fixed costs. When price falls so low that the firm can no longer cover its variable
costs of production with the revenue it earns from selling its product it should shut down
temporarily and wait for economic conditions to improve. In the long run, all costs are variable.
If total revenue cannot cover all costs the firm will exit the industry.

23) Werner & Sons is a manufacturer of three-ring binders operating in a perfectly competitive
industry. Table 12-5 shows the firm's cost schedule.

Table 12-5

Average
Quantity Variable Total Marginal Average
Variable
(cases) Cost Cost Cost Total Cost
Cost
0 $0 $76
1 30 106
2 50
3 134
4 140
5 160
6 114
7 150
84
 8 190
9 316

Use the table to answer the following questions.

a. Complete Table 12-5 by filling in the blank cells.
b. Werner is selling in a perfectly competitive market at a price of $40. What is the profit
maximizing or loss-minimizing output?
c. Calculate the firm's profit or loss.
d. Should the firm continue to produce in the short run? Explain.
e. If the firm's fixed costs were $30 higher what would be the profit-maximizing output level in
the short run? Indicate whether the output level will increase, decrease, or remain unchanged
compared to your answer in b.
f. Suppose fixed cost remains at $76. If the price of three-ring binders falls to $20 what is the
profit-maximizing or loss-minimizing output?
g. Calculate the profit or loss. Should the firm continue to produce in the short run? Explain
your answer.
h. Suppose the fixed cost remains at $76. What price corresponds to the shut-down point?
i. Suppose the fixed cost remains at $76. What price corresponds to the break-even point?

Answer:
a.
Average
Quantity Variable Total Marginal Average
Variable
(cases) Cost Cost Cost Total Cost
Cost
0 $0 $76 -- -- $76
1 30 106 $30 $30 106
2 50 126 20 25 63
3 58 134 8 19.33 44.67
4 64 140 6 16 35
5 84 160 20 16.8 32
6 114 190 30 19 31.67
7 150 226 36 21.43 32.29
8 190 266 40 23.75 33.25
9 240 316 50 26.67 35.11

b. Quantity = 8 units.
c. Profit = $54.
d. Yes, it is earning an economic profit.
e. The profit-maximizing output will not change since marginal cost is not affected by changes
in fixed cost.
f. Quantity = 5 units.
g. Loss = $60. Yes, it is loss-minimizing.
h. The shut-down point corresponds to a price of $16 and an output of 4 units.
i. The break-even point occurs at a price $31.67 and an output of 6 units.

Figure 12-18

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24) Refer to Figure 12-18. Use the figure above to answer the following questions.
a. How can you determine that the figure represents a graph of a perfectly competitive firm? Be
specific; indicate which curve gives you the information and how you use this information to
arrive at your conclusion.
b. What is the market price?
c. What is the profit-maximizing output?
d. What is total revenue at the profit-maximizing output?
e. What is the total cost at the profit-maximizing output?
f. What is the profit or loss at the profit-maximizing output?
g. What is the firm's total fixed cost?
h. What is the total variable cost?
i. Identify the firm's short-run supply curve.
j. Is the industry in a long-run equilibrium?
k. If it is not in long-run equilibrium, what will happen in this industry to restore long-run
equilibrium?
l. In long-run equilibrium, what is the firm's profit maximizing quantity?
Answer:
a. The perfectly competitive firm is a price taker and therefore faces a perfectly elastic demand
curve which is also the MR curve.
b. Market price = $40
c. Profit maximizing output = 200
d. Total revenue = $40 × 200 = $8,000
e. Total cost = ATC × total output = $24 × 200 = $4,800
f. Profit = Total revenue - total cost = $8,000 - 4,800 = $3,200
g. Total fixed cost = AFC × total output = (ATC - AVC) × 150 = $6 × 150 = $900. (Note: fixed
cost has the same value at all output rates)
h. The total variable cost at the profit maximizing output level = ($4,800 - 900) = $3,900
i. The firm's short run supply curve is its MC curve above minimum AVC (from point b and
above).
j. No, the industry is not in a long-run equilibrium because the firm earns an economic profit.
k. Some firms will enter the industry, causing the industry supply curve to shift rightward. This
causes market price to fall. Entry stops when economic profits are eliminated and all firms break
even.
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l. In the long-run equilibrium the firm's profit maximizing quantity = 150, where price will
equal marginal cost.

Figure 12-19

25) Refer to Figure 12-19. The figure above shows the cost curves of a perfectly competitive
firm in the coffee market. Use the graph in Figure 12-19 to answer the following questions.
Assume the market price is $3 per pound.
a. What is the lowest price at which the coffee grower will supply output in the short run?
b. In the diagram draw the firm's demand curve (label this "MR" for marginal revenue).
c. What is the firm's profit-maximizing output?
d. Is the firm earning a profit or a loss? Identify the area in the graph that represents the firm's
profit or loss.
e. Explain how entry or exit will occur in the market to ensure that firms will break even in the
long run.
Answer:
a. $1.50 per pound. This represents the lowest point on the AVC curve, or the shut-down point.
b. See the figure below.
c. 225. This is the output where price (MR) equals MC.
d. The firm is earning a profit. See the figure below.

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e. Above normal profits attract new entrants into the industry, which will shift the industry
supply curve to the right and decrease the market price. This entry stops when all economic
profits are eliminated and price equals average total cost.

88