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**Solution Manual Microeconomics 7th Pindyck & Rubinfeld**

**CHAPTER 1: PRELIMINARIES**

1. It is often said that a good theory is one that can be refuted by an empirical, data- oriented study. Explain why a theory that cannot be evaluated empirically is not a good theory.

2. Which of the following two statements involves positive economic analysis and which normative? How do the two kinds of analysis differ?

a. Gasoline rationing (allocating to each individual a maximum amount of gasoline that can be purchased each year) is a poor social policy because it interferes with the workings of the competitive market system.

b. Gasoline rationing is a policy under which more people are made worse off than are made better off.

3. Suppose the price of regular-octane gasoline were 20 cents per gallon higher in New Jersey than in Oklahoma. Do you think there would be an opportunity for arbitrage (i.e., that firms could buy gas in Oklahoma and then sell it at a profit in New Jersey)? Why or why not?

4. In Example 1.3, what economic forces explain why the real price of eggs has fallen while the real price of a college education has increased? How have these changes affected consumer choices?

5. Suppose that the Japanese yen rises against the U.S. dollar that is, it will take more dollars to buy any given amount of Japanese yen. Explain why this increase simultaneously increases the real price of Japanese cars for U.S. consumers and lowers the real price of U.S. automobiles for Japanese consumers.

6. The price of long-distance telephone service fell from 40 cents per minute in 1996 to 22 cents per minute in 1999, a 45-percent (18 cents/40 cents) decrease. The Consumer Price Index increased by 10 percent over this period. What happened to the real price of telephone service?

EXERCISES

1. Decide whether each of the following statements is true or false and explain why:

a. Fast-food chains like McDonalds, Burger King, and Wendys operate all over the United States. Therefore the market for fast food is a national market.

b. People generally buy clothing in the city in which they live. Therefore there is a clothing market in, say, Atlanta that is distinct from the clothing market in Los Angeles.

c. Some consumers strongly prefer Pepsi and some strongly prefer Coke. Therefore there is no single market for colas.

2. The following table shows the average retail price of butter and the Consumer Price Index from 1980 to 2000, scaled so that the CPI = 100 in 1980.

1980 1985 1990 1995 2000

CPI 100 130.58 158.56 184.95 208.98

Retail price of butter

(salted, grade AA, per lb.)

$1.88

$2.12

$1.99

$1.61

$2.52

a. Calculate the real price of butter in 1980 dollars. Has the real price increased/decreased/stayed the same since 1980?

b. What is the percentage change in the real price (1980 dollars) from 1980 to 2000?

c. Convert the CPI into 1990 = 100 and determine the real price of butter in 1990 dollars.

d. What is the percentage change in the real price (1990 dollars) from 1980 to 2000? Compare this with your answer in (b). What do you notice? Explain.

3. At the time this book went to print, the minimum wage was $5.85. To find the current value of the CPI, go to http://www.bls.gov/cpi/home.htm. Click on Consumer Price Index- All Urban Consumers (Current Series) and select U.S. All items. This will give you the CPI from 1913 to the present.

a. With these values, calculate the current real minimum wage in 1990 dollars.

b. Stated in real 1990 dollars, what is the percentage change in the real minimum wage from 1985 to the present?

**CHAPTER 2: THE BASICS OF SUPPLY AND DEMAND**

1. Suppose that unusually hot weather causes the demand curve for ice cream to shift to the right. Why will the price of ice cream rise to a new market-clearing level?

2. Use supply and demand curves to illustrate how each of the following events would affect the price of butter and the quantity of butter bought and sold:

a. An increase in the price of margarine.

b. An increase in the price of milk.

c. A decrease in average income levels.

3. If a 3-percent increase in the price of corn flakes causes a 6-percent decline in the quantity demanded, what is the elasticity of demand?

4. Explain the difference between a shift in the supply curve and a movement along the supply curve.

5. Explain why for many goods, the long-run price elasticity of supply is larger than the short-run elasticity.

6. Why do long-run elasticities of demand differ from short-run elasticities? Consider two goods: paper towels and televisions. Which is a durable good? Would you expect the price elasticity of demand for paper towels to be larger in the short run or in the long run? Why? What about the price elasticity of demand for televisions?

7. Are the following statements true or false? Explain your answers.

a. The elasticity of demand is the same as the slope of the demand curve.

b. The cross-price elasticity will always be positive.

c. The supply of apartments is more inelastic in the short run than the long run.

8. Suppose the government regulates the prices of beef and chicken and sets them below their market-clearing levels. Explain why shortages of these goods will develop and what factors will determine the sizes of the shortages. What will happen to the price of pork? Explain briefly.

9. The city council of a small college town decides to regulate rents in order to reduce student living expenses. Suppose the average annual market-clearing rent for a two- bedroom apartment had been $700 per month, and rents were expected to increase to $900 within a year. The city council limits rents to their current $700-per-month level.

a. Draw a supply and demand graph to illustrate what will happen to the rental price of an apartment after the imposition of rent controls.

b. Do you think this policy will benefit all students? Why or why not?

10. In a discussion of tuition rates, a university official argues that the demand for admission is completely price inelastic. As evidence, she notes that while the university has doubled its tuition (in real terms) over the past 15 years, neither the number nor quality of students applying has decreased. Would you accept this argument? Explain briefly. (Hint: The official makes an assertion about the demand for admission, but does she actually observe a demand curve? What else could be going on?)

EXERCISES

1. Suppose the demand curve for a product is given by Q = 300 2P + 4I, where I is average income measured in thousands of dollars. The supply curve is Q = 3P 50.

a. If I = 25, find the market clearing price and quantity for the product.

b. If I = 50, find the market clearing price and quantity for the product.

c. Draw a graph to illustrate your answers.

2. Consider a competitive market for which the quantities demanded and supplied (per year) at various prices are given as follows:

Price

(Dollars) Demand

(Millions) Supply

(Millions)

60 22 14

80 20 16

100 18 18

120 16 20

a. Calculate the price elasticity of demand when the price is $80 and when the price is $100.

b. Calculate the price elasticity of supply when the price is $80 and when the price is $100.

c. What are the equilibrium price and quantity?

d. Suppose the government sets a price ceiling of $80. Will there be a shortage, and if so, how large will it be?

3. Refer to Example 2.5 (page 38) on the market for wheat. In 1998, the total demand for U.S. wheat was Q = 3244 283P and the domestic supply was QS = 1944 + 207P. At the end of 1998, both Brazil and Indonesia opened their wheat markets to U.S. farmers. Suppose that these new markets add 200 million bushels to U.S. wheat demand. What will be the free- market price of wheat and what quantity will be produced and sold by U.S. farmers?

4. A vegetable fiber is traded in a competitive world market, and the world price is $9 per pound. Unlimited quantities are available for import into the United States at this price. The U.S. domestic supply and demand for various price levels are shown as follows:

a. What is the equation for demand? What is the equation for supply?

b. At a price of $9, what is the price elasticity of demand? What is it at a price of $12?

c. What is the price elasticity of supply at $9? At $12?

d. In a free market, what will be the U.S. price and level of fiber imports?

5. Much of the demand for U.S. agricultural output has come from other countries. In 1998, the total demand for wheat was Q = 3244 283P. Of this, total domestic demand was QD = 1700 107P, and domestic supply was QS = 1944 + 207P. Suppose the export demand for wheat falls by 40 percent.

a. U.S. farmers are concerned about this drop in export demand. What happens to the free-market price of wheat in the United States? Do the farmers have much reason to worry?

b. Now suppose the U.S. government wants to buy enough wheat to raise the price to $3.50 per bushel. With the drop in export demand, how much wheat would the government have to buy? How much would this cost the government?

6. The rent control agency of New York City has found that aggregate demand is QD = 160 8P. Quantity is measured in tens of thousands of apartments. Price, the average monthly rental rate, is measured in hundreds of dollars. The agency also noted that the increase in Q at lower P results from more three-person families coming into the city from Long Island and demanding apartments. The citys board of realtors acknowledges that this is a good demand estimate and has shown that supply is QS = 70 + 7P.

a. If both the agency and the board are right about demand and supply, what is the free-market price? What is the change in city population if the agency sets a maximum average monthly rent of $300 and all those who cannot find an apartment leave the city?

b. Suppose the agency bows to the wishes of the board and sets a rental of $900 per month on all apartments to allow landlords a fair rate of return. If 50 percent of any long-run increases in apartment offerings come from new construction, how many apartments are constructed?

7. In 1998, Americans smoked 470 billion cigarettes, or 23.5 billion packs of cigarettes. The average retail price was $2 per pack. Statistical studies have shown that the price elasticity of demand is 0.4, and the price elasticity of supply is 0.5. Using this information, derive linear demand and supply curves for the cigarette market.

8. In Example 2.8 we examined the effect of a 20-percent decline in copper demand on the price of copper, using the linear supply and demand curves developed in Section 2.6. Suppose the long-run price elasticity of copper demand were 0.75 instead of 0.5.

a. Assuming, as before, that the equilibrium price and quantity are P* = $2 per pound and Q* = 12 million metric tons per year, derive the linear demand curve consistent with the smaller elasticity.

b. Using this demand curve, recalculate the effect of a 20-percent decline in copper demand on the price of copper.

9. In Example 2.8 (page 52), we discussed the recent increase in world demand for copper, due in part to Chinas rising consumption.

a. Using the original elasticities of demand and supply (i.e. ES = 1.5 and ED = 0.5), calculate the effect of a 20-percent increase in copper demand on the price of copper.

b. Now calculate the effect of this increase in demand on the equilibrium quantity, Q*.

c. As we discussed in Example 2.8, the U.S. production of copper declined between 2000 and 2003. Calculate the effect on the equilibrium price and quantity of both a 20- percent increase in copper demand (as you just did in part a) and of a 20-percent decline in copper supply.

10. Example 2.9 (page 54) analyzes the world oil market. Using the data given in that example:

a. Show that the short-run demand and competitive supply curves are indeed given by D = 35.5 0.03P SC = 18 + 0.04P.

b. Show that the long-run demand and competitive supply curves are indeed given by D = 47.5 0.27P SC = 12 + 0.16P.

c. In Example 2.9 we examined the impact on price of a disruption of oil from Saudi Arabia. Suppose that instead of a decline in supply, OPEC production increases by 2 billion barrels per year (bb/yr) because the Saudis open large new oil fields. Calculate the effect of this increase in production on the supply of oil in both the short run and the long run.

**CHAPTER 3: CONSUMER BEHAVIOR**

1. What are the four basic assumptions about individual preferences? Explain the significance or meaning of each.

2. Can a set of indifference curves be upward sloping? If so, what would this tell you about the two goods?

3. Explain why two indifference curves cannot intersect.

4. Jon is always willing to trade one can of Coke for one can of Sprite, or one can of Sprite for one can of Coke.

a. What can you say about Jons marginal rate of substitution?

b. Draw a set of indifference curves for Jon.

c. Draw two budget lines with different slopes and illustrate the satisfaction- maximizing choice. What conclusion can you draw?

5. What happens to the marginal rate of substitution as you move along a convex indifference curve? A linear indifference curve?

6. Explain why an MRS between two goods must equal the ratio of the price of the goods for the consumer to achieve maximum satisfaction.

7. Describe the indifference curves associated with two goods that are perfect substitutes. What if they are perfect complements?

8. What is the difference between ordinal utility and cardinal utility? Explain why the assumption of cardinal utility is not needed in order to rank consumer choices.

9. Upon merging with the West German economy, East German consumers indicated a preference for Mercedes-Benz automobiles over Volkswagens. However, when they converted their savings into deutsche marks, they flocked to Volkswagen dealerships. How can you explain this apparent paradox?

10. Draw a budget line and then draw an indifference curve to illustrate the satisfaction- maximizing choice associated with two products. Use your graph to answer the following questions.

a. Suppose that one of the products is rationed. Explain why the consumer is likely to be worse off.

b. Suppose that the price of one of the products is fixed at a level below the current price. As a result, the consumer is not able to purchase as much as she would like. Can you tell if the consumer is better off or worse off?

EXERCISES

1. In this chapter, consumer preferences for various commodities did not change during the analysis. Yet in some situations, preferences do change as consumption occurs. Discuss why and how preferences might change over time with consumption of these two commodities:

a. cigarettes

b. dinner for the first time at a restaurant with a special cuisine

2. Draw indifference curves that represent the following individuals preferences for hamburgers and soft drinks. Indicate the direction in which the individuals satisfaction (or utility) is increasing.

a. Joe has convex preferences and dislikes both hamburgers and soft drinks.

b. Jane loves hamburgers and dislikes soft drinks. If she is served a soft drink, she will pour it down the drain rather than drink it.

c. Bob loves hamburgers and dislikes soft drinks. If he is served a soft drink, he will drink it to be polite.

d. Molly loves hamburgers and soft drinks, but insists on consuming exactly one soft drink for every two hamburgers that she eats.

e. Bill likes hamburgers, but neither likes nor dislikes soft drinks.

f. Mary always gets twice as much satisfaction from an extra hamburger as she does from an extra soft drink.

3. If Jane is currently willing to trade 4 movie tickets for 1 basketball ticket, then she must like basketball better than movies. True or false? Explain.

4. Janelle and Brian each plan to spend $20,000 on the styling and gas mileage features of a new car. They can each choose all styling, all gas mileage, or some combination of the two. Janelle does not care at all about styling and wants the best gas mileage possible. Brian likes both equally and wants to spend an equal amount on each. Using indifference curves and budget lines, illustrate the choice that each person will make.

5. Suppose that Bridget and Erin spend their incomes on two goods, food (F) and clothing (C). Bridgets preferences are represented by the utility function U( F,C ) = 10FC , while Erins preferences are represented by the utility function U( F,C ) = .20F 2 C 2 .

a. With food on the horizontal axis and clothing on the vertical axis, identify on a graph the set of points that give Bridget the same level of utility as the bundle (10,5). Do the same for Erin on a separate graph.

b. On the same two graphs, identify the set of bundles that give Bridget and Erin the same level of utility as the bundle (15,8).

c. Do you think Bridget and Erin have the same preferences or different preferences? Explain.

6. Suppose that Jones and Smith have each decided to allocate $1000 per year to an entertainment budget in the form of hockey games or rock concerts. They both like hockey games and rock concerts and will choose to consume positive quantities of both goods. However, they differ substantially in their preferences for these two forms of entertainment. Jones prefers hockey games to rock concerts, while Smith prefers rock concerts to hockey games.

a. Draw a set of indifference curves for Jones and a second set for Smith.

b. Using the concept of marginal rate of substitution, explain why the two sets of curves are different from each other.

7. The price of DVDs (D) is $20 and the price of CDs (C) is $10. Philip has a budget of $100 to spend on the two goods. Suppose that he has already bought one DVD and one CD. In addition there are 3 more DVDs and 5 more CDs that he would really like to buy.

a. Given the above prices and income, draw his budget line on a graph with CDs on the horizontal axis.

b. Considering what he has already purchased, and what he still wants to purchase, identify the three different bundles of CDs and DVDs that he could choose. For this part of the question, assume that he cannot purchase fractional units.

8. Anne has a job that requires her to travel three out of every four weeks. She has an annual travel budget and can travel either by train or by plane. The airline on which she typically flies has a frequent-traveler program that reduces the cost of her tickets according to the number of miles she has flown in a given year. When she reaches 25,000 miles, the airline will reduce the price of her tickets by 25 percent for the remainder of the year. When she reaches 50,000 miles, the airline will reduce the price by 50 percent for the remainder of the year. Graph Annes budget line, with train miles on the vertical axis and plane miles on the horizontal axis.

9. Debra usually buys a soft drink when she goes to a movie theater, where she has a choice of three sizes: the 8-ounce drink costs $1.50, the 12-ounce drink, $2.00, and the 16-ounce drink $2.25. Describe the budget constraint that Debra faces when deciding how many ounces of the drink to purchase. (Assume that Debra can costlessly dispose of any of the soft drink that she does not want.)

10. Antonio buys five new college textbooks during his first year at school at a cost of $80 each. Used books cost only $50 each. When the bookstore announces that there will be a 10 percent increase in the price of new books and a 5 percent increase in the price of used books, Antonios father offers him $40 extra.

a. What happens to Antonios budget line? Illustrate the change with new books on the vertical axis.

b. Is Antonio worse or better off after the price change? Explain.

**CHAPTER 4: INDIVIDUAL AND MARKET DEMAND**

1. Explain the difference between each of the following terms:

a. a price consumption curve and a demand curve

b. an individual demand curve and a market demand curve

c. an Engel curve and a demand curve

d. an income effect and a substitution effect

2. Suppose that an individual allocates his or her entire budget between two goods, food and clothing. Can both goods be inferior? Explain.

3. Explain whether the following statements are true or false.

a. The marginal rate of substitution diminishes as an individual moves downward along the demand curve.

b. The level of utility increases as an individual moves downward along the demand curve.

c. Engel curves always slope upwards.

4. Tickets to a rock concert sell for $10. But at that price, the demand is substantially greater than the available number of tickets. Is the value or marginal benefit of an additional ticket greater than, less than, or equal to $10? How might you determine that value?

5. Which of the following combinations of goods are complements and which are substitutes? Can they be either in different circumstances? Discuss.

a. a mathematics class and an economics class

b. tennis balls and a tennis racket

c. steak and lobster

d. a plane trip and a train trip to the same destination

e. bacon and eggs

6. Suppose that a consumer spends a fixed amount of income per month on the following pairs of goods:

a. tortilla chips and salsa

b. tortilla chips and potato chips

c. movie tickets and gourmet coffee

d. travel by bus and travel by subway

If the price of one of the goods increases, explain the effect on the quantity demanded of each of the goods. In each pair, which are likely to be complements and which are likely to be substitutes?

7. Which of the following events would cause a movement along the demand curve for

U.S. produced clothing, and which would cause a shift in the demand curve?

a. the removal of quotas on the importation of foreign clothes

b. an increase in the income of U.S. citizens

c. a cut in the industrys costs of producing domestic clothes that is passed on to the market in the form of lower prices

8. For which of the following goods is a price increase likely to lead to a substantial income (as well as substitution) effect?

a. salt

b. housing

c. theater tickets

d. food

9. Suppose that the average household in a state consumes 800 gallons of gasoline per year. A 20-cent gasoline tax is introduced, coupled with a $160 annual tax rebate per household. Will the household be better or worse off under the new program?

10. Which of the following three groups is likely to have the most, and which the least, price-elastic demand for membership in the Association of Business Economists?

a. students

b. junior executives

c. senior executives

EXERCISES

1. An individual sets aside a certain amount of his income per month to spend on his two hobbies, collecting wine and collecting books. Given the information below, illustrate both the price-consumption curve associated with changes in the price of wine and the demand curve for wine.

Price

Wine Price

Book Quantity

Wine Quantity

Book Budget

$10 $10 7 8 $150

$12 $10 5 9 $150

$15 $10 4 9 $150

$20 $10 2 11 $150

2. An individual consumes two goods, clothing and food. Given the information below, illustrate both the income-consumption curve and the Engel curve for clothing and food.

Price

Clothing Price

Food Quantity

Clothing Quantity

Food Income

$10 $2 6 20 $100

$10 $2 8 35 $150

$10 $2 11 45 $200

$10 $2 15 50 $250

3. Jane always gets twice as much utility from an extra ballet ticket as she does from an extra basketball ticket, regardless of how many tickets of either type she has. Draw Janes income-consumption curve and her Engel curve for ballet tickets.

4. a. Orange juice and apple juice are known to be perfect substitutes. Draw the appropriate price-consumption curve (for a variable price of orange juice) and income- consumption curve.

b. Left shoes and right shoes are perfect complements. Draw the appropriate price consumption and income-consumption curves.

5. Each week, Bill, Mary, and Jane select the quantity of two goods, X1 and X2, that they will consume in order to maximize their respective utilities. They each spend their entire weekly income on these two goods.

a. Suppose you are given the following information about the choices that Bill makes over a three-week period:

x1 x2 P1 P2 I

Week 1 10 20 2 1 40

Week 2 7 19 3 1 40

Week 3 8 31 3 1 55

Did Bills utility increase or decrease between week 1 and week 2? Between week 1 and week 3? Explain using a graph to support your answer.

b. Now consider the following information about the choices that Mary makes:

x1 x2 P1 P2 I

Week 1 10 20 2 1 40

Week 2 6 14 2 2 40

Week 3 20 10 2 2 60

Did Marys utility increase or decrease between week 1 and week 3? Does Mary consider both goods to be normal goods? Explain.

c. Finally, examine the following information about Janes choices:

x1 x2 P1 P2 I

Week 1 12 24 2 1 48

Week 2 16 32 1 1 48

Week 3 12 24 1 1 36

Draw a budget line-indifference curve graph that illustrates Janes three chosen bundles. What can you say about Janes preferences in this case? Identify the income and substitution effects that result from a change in the price of good X1.

6. Two individuals, Sam and Barb, derive utility from the hours of leisure (L) they consume and from the amount of goods (G) they consume. In order to maximize utility, they need to allocate the 24 hours in the day between leisure hours and work hours. Assume that all hours not spent working are leisure hours. The price of a good is equal to $1 and the price of leisure is equal to the hourly wage. We observe the following information about the choices that the two individuals make:

Sam Barb Sam Barb

Price of G Price of L L (hours) L (hours) G ($) G ($)

1 8 16 14 64 80

1 9 15 14 81 90

1 10 14 15 100 90

1 11 14 16 110 88

Graphically illustrate Sams leisure demand curve and Barbs leisure demand curve. Place price on the vertical axis and leisure on the horizontal axis. Given that they both maximize utility, how can you explain the difference in their leisure demand curves?

7. The director of a theater company in a small college town is considering changing the way he prices tickets. He has hired an economic consulting firm to estimate the demand for tickets. The firm has classified people who go the theater into two groups, and has come up with two demand functions. The demand curves for the general public ( Qgp ) and students ( Qs ) are given below:

Qgp = 500 5P Qs = 200 4 P

a. Graph the two demand curves on one graph, with P on the vertical axis and Q on the horizontal axis. If the current price of tickets is $35, identify the quantity demanded by each group.

b. Find the price elasticity of demand for each group at the current price and quantity.

c. Is the director maximizing the revenue he collects from ticket sales by charging $35 for each ticket? Explain.

d. What price should he charge each group if he wants to maximize revenue collected from ticket sales?

8. Judy has decided to allocate exactly $500 to college textbooks every year, even though she knows that the prices are likely to increase by 5 to 10 percent per year and that she will be getting a substantial monetary gift from her grandparents next year. What is Judys price elasticity of demand for textbooks? Income elasticity?

9. The ACME Corporation determines that at current prices the demand for its computer chips has a price elasticity of 2 in the short run, while the price elasticity for its disk drives is 1.

a. If the corporation decides to raise the price of both products by 10 percent, what will happen to its sales? To its sales revenue?

b. Can you tell from the available information which product will generate the most revenue? If yes, why? If not, what additional information do you need?

10. By observing an individuals behavior in the situations outlined below, determine the relevant income elasticities of demand for each good (i.e., whether the good is normal or inferior). If you cannot determine the income elasticity, what additional information do you need?

a. Bill spends all his income on books and coffee. He finds $20 while rummaging through a used paperback bin at the bookstore. He immediately buys a new hardcover book of poetry.

b. Bill loses $10 he was going to use to buy a double espresso. He decides to sell his new book at a discount to a friend and use the money to buy coffee.

c. Being bohemian becomes the latest teen fad. As a result, coffee and book prices rise by 25 percent. Bill lowers his consumption of both goods by the same percentage.

d. Bill drops out of art school and gets an M.B.A. instead. He stops reading books and drinking coffee. Now he reads The Wall Street Journal and drinks bottled mineral water.

**CHAPTER 5: UNCERTAINTY AND CONSUMER BEHAVIOR**

1. What does it mean to say that a person is risk averse? Why are some people likely to be risk averse while others are risk lovers?

2. Why is the variance a better measure of variability than the range?

3. George has $5000 to invest in a mutual fund. The expected return on mutual fund A is 15 percent and the expected return on mutual fund B is 10 percent. Should George pick mutual fund A or fund B?

4. What does it mean for consumers to maximize expected utility? Can you think of a case in which a person might not maximize expected utility?

5. Why do people often want to insure fully against uncertain situations even when the premium paid exceeds the expected value of the loss being insured against?

6. Why is an insurance company likely to behave as if it were risk neutral even if its managers are risk-averse individuals?

7. When is it worth paying to obtain more information to reduce uncertainty?

8. How does the diversification of an investors portfolio avoid risk?

9. Why do some investors put a large portion of their portfolios into risky asset, while others invest largely in risk-free alternatives? (Hint: Do the two investors receive exactly the same return on average? If so, why?)

10. What is an endowment effect? Give an example of such an effect.

11. Jennifer is shopping and sees an attractive shirt. However, the price of $50 is more than she is willing to pay. A few weeks later, she finds the same shirt on sale for $25 and buys it. When a friend offers her $50 for the shirt, she refuses to sell it. Explain Jennifers behavior.

EXERCISES

1. Consider a lottery with three possible outcomes:

$125 will be received with probability .2

$100 will be received with probability .3

$50 will be received with probability .5

a. What is the expected value of the lottery?

b. What is the variance of the outcomes?

c. What would a risk-neutral person pay to play the lottery?

2. Suppose you have invested in a new computer company whose profitability depends on two factors: (1) whether the U.S. Congress passes a tariff raising the cost of Japanese computers and (2) whether the U.S. economy grows slowly or quickly. What are the four mutually exclusive states of the world that you should be concerned about?

3. Richard is deciding whether to buy a state lottery ticket. Each ticket costs $1, and the probability of winning payoffs is given as follows:

Probability Return

0.50 $0.00

0.25 $1.00

0.20 $2.00

0.05 $7.50

a. What is the expected value of Richards payoff if he buys a lottery ticket? What is the variance?

b. Richards nickname is No-Risk Rick because he is an extremely risk-averse individual. Would he buy the ticket?

c. Richard has been given 1000 lottery tickets. Discuss how you would determine the smallest amount for which he would be willing to sell all 1000 tickets.

d. In the long run, given the price of the lottery tickets and the probability/return table, what do you think the state would do about the lottery?

4. Suppose an investor is concerned about a business choice in which there are three prospects the probability and returns are given below:

What is the expected value of the uncertain investment? What is the variance?

5. You are an insurance agent who must write a policy for a new client named Sam. His company, Society for Creative Alternatives to Mayonnaise (SCAM), is working on a low-fat, low-cholesterol mayonnaise substitute for the sandwich-condiment industry. The sandwich industry will pay top dollar to the first inventor to patent such a mayonnaise substitute. Sams SCAM seems like a very risky proposition to you. You have calculated his possible returns table as follows:

a. What is the expected return of Sams project? What is the variance?

b. What is the most that Sam is willing to pay for insurance? Assume Sam is risk neutral.

c. Suppose you found out that the Japanese are on the verge of introducing their own mayonnaise substitute next month. Sam does not know this and has just turned down your final offer of $1000 for the insurance. Assume that Sam tells you SCAM is only six months away from perfecting its mayonnaise substitute and that you know what you know about the Japanese. Would you raise or lower your policy premium on any subsequent proposal to Sam? Based on his information, would Sam accept?

6. Suppose that Natashas utility function is given by u( I ) = 10I , where I represents annual income in thousands of dollars.

a. Is Natasha risk loving, risk neutral, or risk averse? Explain.

b. Suppose that Natasha is currently earning an income of $40,000 (I = 40) and can earn that income next year with certainty. She is offered a chance to take a new job that offers a .6 probability of earning $44,000 and a .4 probability of earning $33,000. Should she take the new job?

c. In (b), would Natasha be willing to buy insurance to protect against the variable income associated with the new job? If so, how much would she be willing to pay for that insurance? (Hint: What is the risk premium?)

7. Suppose that two investments have the same three payoffs, but the probability associated with each payoff differs, as illustrated in the table below:

a. Find the expected return and standard deviation of each investment.

b. Jill has the utility function U = 5I , where I denotes the payoff. Which investment will she choose?

c. Ken has the utility function U = 5 I . Which investment will he choose?

d. Laura has the utility function U = 5I 2 . Which investment will she choose?

8. As the owner of a family farm whose wealth is $250,000, you must choose between sitting this season out and investing last years earnings ($200,000) in a safe money market fund paying 5.0 percent or planting summer corn. Planting costs $200,000, with a six-month time to harvest. If there is rain, planting summer corn will yield $500,000 in revenues at harvest. If there is a drought, planting will yield $50,000 in revenues. As a third choice, you can purchase AgriCorp drought-resistant summer corn at a cost of $250,000 that will yield $500,000 in revenues at harvest if there is rain, and $350,000 in revenues if there is a drought. You are risk averse, and your preference for family wealth (W) is specified by the relationship U(W ) = W . The probability of a summer drought is 0.30, while the probability of summer rain is 0.70. Which of the three options should you choose? Explain.

9. Draw a utility function over income u(I) that describes a man who is a risk lover when his income is low but risk averse when his income is high. Can you explain why such a utility function might reasonably describe a persons preferences?

10. A city is considering how much to spend to hire people to monitor its parking meters. The following information is available to the city manager:

Hiring each meter monitor costs $10,000 per year.

With one monitoring person hired, the probability of a driver getting a ticket each time he or she parks illegally is equal to .25.

With two monitors, the probability of getting a ticket is .5; with three monitors, the probability is .75; and with four, its equal to 1.

With two monitors hired, the current fine for overtime parking is $20.

a. Assume first that all drivers are risk neutral. What parking fine would you levy, and how many meter monitors would you hire (1, 2, 3, or 4) to achieve the current level of deterrence against illegal parking at the minimum cost?

b. Now assume that drivers are highly risk averse. How would your answer to (a) change?

c. (For discussion) What if drivers could insure themselves against the risk of parking fines? Would it make good public policy to permit such insurance?

**CHAPTER 6: PRODUCTION**

1. What is a production function? How does a long-run production function differ from a short-run production function?

2. Why is the marginal product of labor likely to increase initially in the short run as more of the variable input is hired?

3. Why does production eventually experience diminishing marginal returns to labor in the short run?

4. You are an employer seeking to fill a vacant position on an assembly line. Are you more concerned with the average product of labor or the marginal product of labor for the last person hired? If you observe that your average product is just beginning to decline, should you hire any more workers? What does this situation imply about the marginal product of your last worker hired?

5. What is the difference between a production function and an isoquant?

6. Faced with constantly changing conditions, why would a firm ever keep any factors fixed? What criteria determine whether a factor is fixed or variable?

7. Isoquants can be convex, linear, or L-shaped. What does each of these shapes tell you about the nature of the production function? What does each of these shapes tell you about the MRTS?

8. Can an isoquant ever slope upward? Explain.

9. Explain the term marginal rate of technical substitution. What does a MRTS = 4 mean?

10. Explain why the marginal rate of technical substitution is likely to diminish as more and more labor is substituted for capital.

EXERCISES

1. The menu at Joes coffee shop consists of a variety of coffee drinks, pastries, and sandwiches. The marginal product of an additional worker can be defined as the number of customers that can be served by that worker in a given time period. Joe has been employing one worker, but is considering hiring a second and a third. Explain why the marginal product of the second and third workers might be higher than the first. Why might you expect the marginal product of additional workers to diminish eventually?

2. Suppose a chair manufacturer is producing in the short run (with its existing plant and equipment). The manufacturer has observed the following levels of production corresponding to different numbers of workers:

Number of chairs Number of workers

1 10

2 18

3 24

4 28

5 30

6 28

7 25

a. Calculate the marginal and average product of labor for this production function.

b. Does this production function exhibit diminishing returns to labor? Explain.

c. Explain intuitively what might cause the marginal product of labor to become negative.

3. Fill in the gaps in the table below.

4. A political campaign manager must decide whether to emphasize television advertisements or letters to potential voters in a reelection campaign. Describe the production function for campaign votes. How might information about this function (such as the shape of the isoquants) help the campaign manager to plan strategy?

5. For each of the following examples, draw a representative isoquant. What can you say about the marginal rate of technical substitution in each case?

a. A firm can hire only full-time employees to produce its output, or it can hire some combination of full-time and part-time employees. For each full-time worker let go, the firm must hire an increasing number of temporary employees to maintain the same level of output.

b. A firm finds that it can always trade two units of labor for one unit of capital and still keep output constant.

c. A firm requires exactly two full-time workers to operate each piece of machinery in the factory

6. A firm has a production process in which the inputs to production are perfectly substitutable in the long run. Can you tell whether the marginal rate of technical substitution is high or low, or is further information necessary? Discuss.

7. The marginal product of labor in the production of computer chips is 50 chips per hour. The marginal rate of technical substitution of hours of labor for hours of machine capital is 1/4. What is the marginal product of capital?

8. Do the following functions exhibit increasing, constant, or decreasing returns to scale? What happens to the marginal product of each individual factor as that factor is increased and the other factor held constant?

a. q = 3L + 2K

b. q = (2L + 2K ) 2

c. q = 3LK 2

1 1

d. q = L2 K 2

1

e. q = 4L2 + 4 K

9. The production function for the personal computers of DISK, Inc., is given by q = 10K0.5L0.5, where q is the number of computers produced per day, K is hours of machine time, and L is hours of labor input. DISKs competitor, FLOPPY, Inc., is using the production function q = 10K0.6L0.4.

a. If both companies use the same amounts of capital and labor, which will generate more output?

b. Assume that capital is limited to 9 machine hours, but labor is unlimited in supply. In which company is the marginal product of labor greater? Explain.

10. In Example 6.3, wheat is produced according to the production function q = 100(K0.8L0.2).

a. Beginning with a capital input of 4 and a labor input of 49, show that the marginal product of labor and the marginal product of capital are both decreasing.

b. Does this production function exhibit increasing, decreasing, or constant returns to scale?

**CHAPTER 7: THE COST OF PRODUCTION**

1. A firm pays its accountant an annual retainer of $10,000. Is this an economic cost?

2. The owner of a small retail store does her own accounting work. How would you measure the opportunity cost of her work?

3. Please explain whether the following statements are true or false.

a. If the owner of a business pays himself no salary, then the accounting cost is zero, but the economic cost is positive.

b. A firm that has positive accounting profit does not necessarily have positive economic profit.

c. If a firm hires a currently unemployed worker, the opportunity cost of utilizing the workers services is zero.

4. Suppose that labor is the only variable input to the production process. If the marginal cost of production is diminishing as more units of output are produced, what can you say about the marginal product of labor (the variable input)?

5. Suppose a chair manufacturer finds that the marginal rate of technical substitution of capital for labor in her production process is substantially greater than the ratio of the rental rate on machinery to the wage rate for assembly-line labor. How should she alter her use of capital and labor to minimize the cost of production?

6. Why are isocost lines straight lines?

7. Assume that the marginal cost of production is increasing. Can you determine whether the average variable cost is increasing or decreasing? Explain.

8. Assume that the marginal cost of production is greater than the average variable cost. Can you determine whether the average variable cost is increasing or decreasing? Explain.

9. If the firms average cost curves are U-shaped, why does its average variable cost curve achieve its minimum at a lower level of output than the average total cost curve?

10. If a firm enjoys economies of scale up to a certain output level, and cost then increases proportionately with output, what can you say about the shape of the long-run average cost curve?

EXERCISES

1. Joe quits his computer programming job, where he was earning a salary of $50,000 per year, to start . He opens his own computer software business store in a building that he owns and was previously renting out for $24,000 per year. In his first year of business he has the following expenses: mortgage $18,000, salary paid to himself, $40,000; rent, $0; other expenses, $25,000. Find the accounting cost and the economic cost associated with Joes computer software business.

2. a. Fill in the blanks in the table on page 262 of the textbook.

b. Draw a graph that shows marginal cost, average variable cost, and average total cost, with cost on the vertical axis and quantity on the horizontal axis.

3. A firm has a fixed production costs of $5,000 and a constant marginal cost of production of equal to $500 per unit produced.

a. What is the firms total cost function? Average cost?

b. If the firm wanted to minimize the average total cost, would it choose to be very large or very small? Explain.

4. Suppose a firm must pay an annual tax, which is a fixed sum, independent of whether it produces any output.

a. How does this tax affect the firms fixed, marginal, and average costs?

b. Now suppose the firm is charged a tax that is proportional to the number of items it produces. Again, how does this tax affect the firms fixed, marginal, and average costs?

5. A recent issue of Business Week reported the following:

During the recent auto sales slump, GM, Ford, and Chrysler decided it was cheaper to sell cars to rental companies at a loss than to lay off workers. Thats because closing and reopening plants is expensive, partly because the auto makers current union contracts obligate them to pay many workers even if theyre not working.

When the article discusses selling cars at a loss, is it referring to accounting profit or economic profit? How will the two differ in this case? Explain briefly.

6. Suppose the economy takes a downturn, and that labor costs fall by 50 percent and are expected to stay at that level for a long time. Show graphically how this change in the relative price of labor and capital affects the firms expansion path.

7. The cost of flying a passenger plane from point A to point B is $50,000. The airline flies this route four times per day at 7 AM, 10 AM, 1 PM, and 4 PM. The first and last flights are fulfilled l to capacity with 240 people. The second and third flights are only half full. Find the average cost per passenger for each flight. Suppose the airline hires you as a marketing consultant and wants to know which type of customer it should try to attract ! the off-peak customer (the middle two flights) or the rush-hour customer (the first and last flights). What advice would you offer?

8. You manage a plant that mass-produces engines by teams of workers using assembly machines. The technology is summarized by the production function q = 5 KL where q is the number of engines per week, K is the number of assembly machines, and L is the number of labor teams. Each assembly machine rents for r = $10,000 per week, and each team costs w = $5000 per week. Engine costs are given by the cost of labor teams and machines, plus $2000 per engine for raw materials. Your plant has a fixed installation of 5 assembly machines as part of its design.

a. What is the cost function for your plant namely, how much would it cost to produce q engines? What are average and marginal costs for producing q engines? How do average costs vary with output?

b. How many teams are required to produce 250 engines? What is the average cost per engine?

c. You are asked to make recommendations for the design of a new production facility. What capital/labor (K/L) ratio should the new plant accommodate if it wants to minimize the total cost of producing at any level of output q?

9. The short-run cost function of a company is given by the equation TC = 200 + 55q, where TC is the total cost and q is the total quantity of output, both measured in thousands.

a. What is the companys fixed cost?

b. If the company produced 100,000 units of goods, what would be its average variable cost?

c. What would be its marginal cost of production?

d. What would be its average fixed cost?

e. Suppose the company borrows money and expands its factory. Its fixed cost rises by $50,000, but its variable cost falls to $45,000 per 1000 units. The cost of interest (i) also enters into the equation. Each 1-point increase in the interest rate raises costs by $3,000. Write the new cost equation.

10. A chair manufacturer hires its assembly-line labor for $30 an hour and calculates that the rental cost of its machinery is $15 per hour. Suppose that a chair can be produced using 4 hours of labor or machinery in any combination. If the firm is currently using 3 hours of labor for each hour of machine time, is it minimizing its costs of production? If so, why? If not, how can it improve the situation? Graphically illustrate the isoquant and the two isocost lines for the current combination of labor and capital and for the optimal combination of labor and capital.

**CHAPTER 8: PROFIT MAXIMIZATION AND COMPETITIVE SUPPLY**

1. Why would a firm that incurs losses choose to produce rather than shut down?

2. Explain why the industry supply curve is not the long-run industry marginal cost curve.

3. In long-run equilibrium, all firms in the industry earn zero economic profit. Why is this true?

4. What is the difference between economic profit and producer surplus?

5. Why do firms enter an industry when they know that in the long run economic profit will be zero?

6. At the beginning of the twentieth century, there were many small American automobile manufacturers. At the end of the century, there were only three large ones. Suppose that this situation is not the result of lax federal enforcement of antimonopoly laws. How do you explain the decrease in the number of manufacturers? (Hint: What is the inherent cost structure of the automobile industry?)

7. Because industry X is characterized by perfect competition, every firm in the industry is earning zero economic profit. If the product price falls, no firms can survive. Do you agree or disagree? Discuss.

8. An increase in the demand for video films also increases the salaries of actors and actresses. Is the long-run supply curve for films likely to be horizontal or upward sloping? Explain.

9. True or false: A firm should always produce at an output at which long-run average cost is minimized. Explain.

10. Can there be constant returns to scale in an industry with an upward-sloping supply curve? Explain.

EXERCISES

1. The data in the table on page 307 give information about the price (in dollars) for which a firm can sell a unit of output and the total cost of production.

a. Fill in the blanks in the table.

b. Show what happens to the firms output choice and profit if the price of the product falls from $60 to $50.

2. Using the data in the table, show what happens to the firms output choice and profit if the fixed cost of production increases from $100 to $150 and then to $200. Assume that the price of the output remains at $60 per unit. What general conclusion can you reach about the effects of fixed costs on the firms output choice?

3. Use the same information as in Exercise 1.

a. Derive the firms short-run supply curve. (Hint: you may want to plot the appropriate cost curves.)

b. If 100 identical firms are in the market, what is the industry supply curve?

4. Suppose you are the manager of a watchmaking firm operating in a competitive market. Your cost of production is given by C = 200 + 2q2, where q is the level of output and C is total cost. (The marginal cost of production is 4q; the fixed cost is $200.)

a. If the price of watches is $100, how many watches should you produce to maximize profit?

b. What will the profit level be?

c. At what minimum price will the firm produce a positive output?

5. Suppose that a competitive firms marginal cost of producing output q is given by MC(q) = 3 + 2q. Assume that the market price of the firms product is $9.

a. What level of output will the firm produce?

b. What is the firms producer surplus?

c. Suppose that the average variable cost of the firm is given by AVC(q) = 3 + q. Suppose that the firms fixed costs are known to be $3. Will the firm be earning a positive, negative, or zero profit in the short run?

6. A firm produces a product in a competitive industry and has a total cost function C = 50 + 4q + 2q2 and a marginal cost function MC = 4 + 4q. At the given market price of $20, the firm is producing 5 units of output. Is the firm maximizing its profit? What quantity of output should the firm produce in the long run?

7. Suppose the same firms cost function is C(q) = 4q2 + 16.

a. Find variable cost, fixed cost, average cost, average variable cost, and average fixed cost. (Hint: Marginal cost is given by MC = 8q.)

b. Show the average cost, marginal cost, and average variable cost curves on a graph.

c. Find the output that minimizes average cost

d. At what range of prices will the firm produce a positive output?

e. At what range of prices will the firm earn a negative profit?

f. At what range of prices will the firm earn a positive profit?

8. A competitive firm has the following short-run cost function:

a. Find MC, AC, and AVC and sketch them on a graph.

b. At what range of prices will the firm supply zero output?

b. At what range of prices will the firm supply zero output?

d. At what price would the firm supply exactly 6 units of output?

9. a. Suppose that a firms production function is q = 9 x 2 in the short run, where there are fixed costs of $1000, and x is the variable input whose cost is $4000 per unit. What is the total cost of producing a level of output q? In other words, identify the total cost function C(q).

b. Write down the equation for the supply curve.

c. If price is $1000, how many units will the firm produce? What is the level of profit?

Illustrate on a cost curve graph.

10. Suppose that a competitive firm has a total cost function C(q) = 450 + 15q + 2q2 and a marginal cost function MC(q) = 15 + 4 q . If the market price is P = $115 per unit, find the level of output produced by the firm. Find the level of profit and the level of producer surplus.

**CHAPTER 9: THE ANALYSIS OF COMPETITIVE MARKETS**

1. What is meant by deadweight loss? Why does a price ceiling usually result in a deadweight loss?

2. Suppose the supply curve for a good is completely inelastic. If the government imposed a price ceiling below the market-clearing level, would a deadweight loss result? Explain.

3. How can a price ceiling make consumers better off? Under what conditions might it make them worse off?

4. Suppose the government regulates the price of a good to be no lower than some minimum level. Can such a minimum price make producers as a whole worse off? Explain.

5. How are production limits used in practice to raise the prices of the following goods or services: (a) taxi rides, (b) drinks in a restaurant or bar, (c) wheat or corn?

6. Suppose the government wants to increase farmers incomes. Why do price supports or acreage-limitation programs cost society more than simply giving farmers money?

7. Suppose the government wants to limit imports of a certain good. Is it preferable to use an import quota or a tariff? Why?

8. The burden of a tax is shared by producers and consumers. Under what conditions will consumers pay most of the tax? Under what conditions will producers pay most of it? What determines the share of a subsidy that benefits consumers?

9. Why does a tax create a deadweight loss? What determines the size of this loss?

EXERCISES

1. In 1996, Congress raised the minimum wage from $4.25 per hour to $5.15 per hour, and then raised it again in 2007. (See Example 1.3 [page 13].) Some people suggested that a government subsidy could help employers finance the higher wage. This exercise examines the economics of a minimum wage and wage subsidies. Suppose the supply of low-skilled labor is given by LS = 10w, where LS is the quantity of low-skilled labor (in millions of persons employed each year), and w is the wage rate (in dollars per hour). The demand for labor is given by LD = 80 10w.

a. What will be the free-market wage rate and employment level? Suppose the government sets a minimum wage of $5 per hour. How many people would then be employed?

b. Suppose that instead of a minimum wage, the government pays a subsidy of $1 per hour for each employee. What will the total level of employment be now? What will the equilibrium wage rate be?

3. Japanese rice producers have extremely high production costs, due in part to the high opportunity cost of land and to their inability to take advantage of economies of large-scale production. Analyze two policies intended to maintain Japanese rice production: (1) a per- pound subsidy to farmers for each pound of rice produced, or (2) a per-pound tariff on imported rice. Illustrate with supply-and-demand diagrams the equilibrium price and quantity, domestic rice production, government revenue or deficit, and deadweight loss from each policy. Which policy is the Japanese government likely to prefer? Which policy are Japanese farmers likely to prefer?

4. In 1983, the Reagan Administration introduced a new agricultural program called the Payment-in-Kind Program. To see how the program worked, lets consider the wheat market.

a. Suppose the demand function is QD = 28 2P and the supply function is QS = 4 + 4P, where P is the price of wheat in dollars per bushel, and Q is the quantity in billions of bushels. Find the free-market equilibrium price and quantity.

b. Now suppose the government wants to lower the supply of wheat by 25 percent from the free-market equilibrium by paying farmers to withdraw land from production. However, the payment is made in wheat rather than in dollars hence the name of the program. The wheat comes from vast government reserves accumulated from previous price support programs. The amount of wheat paid is equal to the amount that could have been harvested on the land withdrawn from production. Farmers are free to sell this wheat on the market. How much is now produced by farmers? How much is indirectly supplied to the market by the government? What is the new market price? How much do farmers gain? Do consumers gain or lose?

c. Had the government not given the wheat back to the farmers, it would have stored or destroyed it. Do taxpayers gain from the program? What potential problems does the program create?

5. About 100 million pounds of jelly beans are consumed in the United States each year, and the price has been about 50 cents per pound. However, jelly bean producers feel that their incomes are too low and have convinced the government that price supports are in order. The government will therefore buy up as many jelly beans as necessary to keep the price at $1 per pound. However, government economists are worried about the impact of this program because they have no estimates of the elasticities of jelly bean demand or supply.

a. Could this program cost the government more than $50 million per year? Under what conditions? Could it cost less than $50 million per year? Under what conditions? Illustrate with a diagram.

b. Could this program cost consumers (in terms of lost consumer surplus) more than $50 million per year? Under what conditions? Could it cost consumers less than $50 million per year? Under what conditions? Again, use a diagram to illustrate.

6. In Exercise 4 in Chapter 2 (page 62), we examined a vegetable fiber traded in a competitive world market and imported into the United States at a world price of $9 per pound. U.S. domestic supply and demand for various price levels are shown in the following table.

Price U.S. Supply

(million pounds) U.S. Demand

(million pounds)

3 2 34

6 4 28

9 6 22

12 8 16

15 10 10

18 12 4

Answer the following questions about the U.S. market:

a. Confirm that the demand curve is given by QD = 40 2P , and that the supply curve 2 is given by QS = 3 P .

b. Confirm that if there were no restrictions on trade, the United States would import 16 million pounds.

c. If the United States imposes a tariff of $3 per pound, what will be the U.S. price and level of imports? How much revenue will the government earn from the tariff? How large is the deadweight loss?

d. If the United States has no tariff but imposes an import quota of 8 million pounds, what will be the U.S. domestic price? What is the cost of this quota for U.S. consumers of the fiber? What is the gain for U.S. producers?

7. The United States currently imports all of its coffee. The annual demand for coffee by U.S. consumers is given by the demand curve Q = 250 10P, where Q is quantity (in millions of pounds) and P is the market price per pound of coffee. World producers can harvest and ship coffee to U.S. distributors at a constant marginal (= average) cost of $8 per pound. U.S. distributors can in turn distribute coffee for a constant $2 per pound. The U.S. coffee market is competitive. Congress is considering a tariff on coffee imports of $2 per pound.

a. If there is no tariff, how much do consumers pay for a pound of coffee? What is the quantity demanded?

b. If the tariff is imposed, how much will consumers pay for a pound of coffee? What is the quantity demanded?

c. Calculate the lost consumer surplus.

d. Calculate the tax revenue collected by the government.

e. Does the tariff result in a net gain or a net loss to society as a whole?

8. A particular metal is traded in a highly competitive world market at a world price of $9 per ounce. Unlimited quantities are available for import into the United States at this price. The supply of this metal from domestic U.S. mines and mills can be represented by the equation QS = 2/3P, where QS is U.S. output in million ounces and P is the domestic price. The demand for the metal in the United States is QD = 40 2P, where QD is the domestic demand in million ounces.

In recent years the U.S. industry has been protected by a tariff of $9 per ounce. Under pressure from other foreign governments, the United States plans to reduce this tariff to zero. Threatened by this change, the U.S. industry is seeking a voluntary restraint agreement that would limit imports into the United States to 8 million ounces per year.

a. Under the $9 tariff, what was the U.S. domestic price of the metal?

b. If the United States eliminates the tariff and the voluntary restraint agreement is approved, what will be the U.S. domestic price of the metal?

9. Among the tax proposals regularly considered by Congress is an additional tax on distilled liquors. The tax would not apply to beer. The price elasticity of supply of liquor is 4.0, and the price elasticity of demand is 0.2. The cross-elasticity of demand for beer with respect to the price of liquor is 0.1.

a. If the new tax is imposed, who will bear the greater burden liquor suppliers or liquor consumers? Why?

b. Assuming that beer supply is infinitely elastic, how will the new tax affect the beer market?

10. In Example 9.1 (page 314), we calculated the gains and losses from price controls on natural gas and found that there was a deadweight loss of $5.68 billion. This calculation was based on a price of oil of $50 per barrel.

a. If the price of oil were $60 per barrel, what would be the free-market price of gas? How large a deadweight loss would result if the maximum allowable price of natural gas were $3.00 per thousand cubic feet?

b. What price of oil would yield a free-market price of natural gas of $3?

**CHAPTER 10: MARKET POWER: MONOPOLY AND MONOPSONY**

1. A monopolist is producing at a point at which marginal cost exceeds marginal revenue. How should it adjust its output to increase profit?

2. We write the percentage markup of prices over marginal cost as (P MC)/P. For a profit- maximizing monopolist, how does this markup depend on the elasticity of demand? Why can this markup be viewed as a measure of monopoly po

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