Problem Set Answers
Chapter 1
Chapter 11
Chapter 2
Chapter 13
Chapter 3
Chapter 14
Chapter 4
Chapter 15
Chapter 7
Chapter 16
Chapter 5
Chapter 17
Chapter 6
Game Theory
Chapter 10
 

Chapter 1 
Mankiw, pp 16-17, Questions for Review ("Q4R") # 2 & 3 and Problems and Applications ("P&A") # 6 & 14

Q4R 2.  The opportunity cost of seeing a movie includes the monetary cost of admission plus the time cost of going to t he theater and attending the show.  The time cost depends on what else you might do with that time;  if it's staying home and watching TV, the time cost may be small, but if it's working an extra three hours at your job, the time cost is the money you could have earned.

Q4R 3.  The marginal benefit of a glass of water depends on your circumstances.  If you've just run a marathon, or you've been walking in the desert sun for three hours, the marginal benefit is very high.  But if you've been drinking a lot of liquids recently, the marginal benefit is quite low.  The point is, that even the necessities of life, like water, don't always have large marginal benefits.

P&A 6.  Harry suggests looking at whether productivity would rise or fall.  Productivity is certainly important, since the more productive workers are, the lower the cost per gallon of potion.  Ron wants to look at average cost.  But both Harry and Ron are missing the other side of the equation--revenue.  A firm wants to maximize its profits, so it needs to examine both costs and revenues.  Thus, Hermione is right--it is best to examine whether the extra revenue would exceed the extra costs.  In addition, Hermione is the only one who's thinking at the margin.

And anyone who's read Harry Potter knows that Hermione is always right.

P&A 14.  If Americans save more and its leads to more spending on factories, there will be an increase in production and productivity, since the same nmber of workers will have more equipment to work with.  The benefits from higher productivity will go to both the workers, who will get paid more since they're producing more, and the factory owners, who will get a return on their investments.

There's no such thing as a free lunch, though, because when people save more, they're giving up spending.  They get higher incomes at the cost of buying goods.



Chapter 2 

1.  Mankiw, pp 34-35, Q4R #4 and P&A #7

Q4R #4   If a disease kills half of the economy's cow population, less milk production is possible, so the PPF shifts inward (PPF2).  Note that if the economy produces all cookies, so it doesn't need any cows, then the production is unaffected.  But if the economy produces any milk at all, then there will be less production possible after the disease hits.

 

P&A #7  Positive statements are descriptive and make a claim about how the world IS, while normative statements are prescriptive and make a claim about how the world OUGHT TO BE.  Here's an example.  Positive:  A rapid growth rate of money is the cause of inflation.  Normative:  The government should keep the growth rate of money low.

2.  a.  Construct graphically the production possibilities frontier for the city of Detroit, using the data given in the following table:

Detroit's Production Possibilities in 2001

Paintings
Automobiles (Thousands)
75
0
60
6
45
11
30
15
15
18
0
20
 a.



b.  Opportunity cost represents tradeoffs--you have to give up one thing to get another.  The PPF shows this, in that when you want more autos produced, you must produce fewer paintings, or when more paintings are to be produced, you must give up some automobile production.

c.  Efficient points are when society is producing the most that it can, given its resources, and is ON the PPF.  Inefficient points are inside the PPF, when society is letting some resources go unused, so they are not producing as much as is possible.  Unattainable points are outside of the PPF--the region where society would *like* to be, but is unable because of limited resources
.
d.  If Detroit's automobile production technology improved next year the PPF would shift out along the Automobile axis, as shown by the darker line.

3.(from the Study Guide).  The following table represents Joe's demand for cups of gourmet coffee.  Use this information to answer the questions found below. 

Price per cup of coffee
Quantity demanded of coffee
$5
2 cups
4
4
3
6
2
8
1
10
a.  Plot and connect the points from the table on a set of axes with "Price of coffee" on the y-axis and "Quantity demanded of coffee" on the x-axis.



b.  The slope of Joe's demand curve for coffee in the price range of $5 and $4 is:
(5-4)/(2-4) = -1/2

c.  In the price range of $2 and $1 it is:  (2-1)/(8-10) = -1/2
d.  The price of coffee and Joe's quantity demanded of coffee are negatively correlated.  We can tell this because we have a downward sloping line (or the slope is negative, or as price rises, quantity falls).
e.  If the price of coffee moves from $2 per cup to $4 per cup, the quantity demanded will fall from 8 cups to 4 cups.  This is a movement along the demand curve.
 f.  If Joe's income doubles from $20,000 to $40,000 per year, his demand curve shifts out, as shown by the dark line in the graph above.
g.  The doubling of Joe's income causes a shift in his demand curve, because income changed--and income is not a variable which is measured on either axis.
 



Chapter 3

P&A 4 

Pizza
Root Beer
Pat
2 hours
4 hours
Chris
4 hours
6 hours
a.  OC of making a pizza-- Pat's OC is 1/2 root beer, Chris's OC is 2/3 root beer.
   Pat has the absolute advantage in making Pizza since she can produce it in absolutely less time.
   Pat also has the comparative advantage in pizza, since she has to give up less root beer to make one more pizza.

b.  Pat will trade away pizza in exchange for the root beer that Chris will make.

c.  The most a pizza will go for is 2/3 of a root beer, and the least that a pizza will go for is 1/2 root beer.  These are simply the opportunity costs for Chris and Pat.  If the price of a pizza is too high (more than 2/3 root beer) nobody will want a pizza and then no trade will occur.  If the price of pizza is too low (less than 1/2 root beer) nobody will want to produce root beer, and only pizza will be made.

P&A5
a.  The opportunity cost of producing one car in anada is 15 bushels of wheat.  The opportunity cost of producing one more bushel of wheat is 1/15th of a car.  The opportunity costs are reciprocals of each other.

b.

If Canada consumes 10 million cars and does not trade, they will consume 150 million bushels of wheat.  (Basically, 5 million workers would be required in the car sector, leaving another 5 million in the wheat sector.  Each of these five million make 30 bushels each, for a total of 150 million bushels.)

c.  If Canada accepts this trade, and they produce only cars (20 million cars), they have a total consumption of 10 million cars and 200 bushels of wheat.  This was an unattainable point without trade, and thus they SHOULD accept the US's offer.

P&A 6
It IS sensible.  Although the professor has an ABSOLUTE advantage in both writing chapters and gathering data, trade should be based on COMPARATIVE advantage.  The professor is going to be a MUCH better writer, and a student can adequately find data (although it will take him or her more time than it would the professor).

The key is that the student is a *relatively* better data gatherer, and the professor is a *relatively* better writer.
 


Chapter 4 
1.  Show how the following demand curves are likely to shift in response to the indicated changes:
In words:
a.  drought:  will lessen consumers need for umbrellas (tastes change).  This will lower demand, shifting the demand curve to the left.

b.  high popcorn prices:  If we assume that popcorn and movie tickets are complements, then an increase in popcorn prices means lower popcorn AND movie ticket consumption.  This is a decrease in the demand for movie tickets, and is shown by a leftward shift of the demand curve.

c.  increased price of tea:  if Coffee and tea are substitutes, then an increase in the price of tea means less tea consumption and more coffee consumption.  This increase in Demand will cause the demand curve to shift out or to the right.

d.  higher income/computers:  If computers are a normal good, the increase in consumer income will increase the demand for computers, shifting the demand curve to the right.

e.  higher income/Ramen:  If Ramen is an inferior good, then the increase in consumer income will decrease the demand for Ramen noodles, shifting the demand curve to the left.
 

P&A # 1
a.  cold snap will cause a shortage of oranges, so as supply of oranges falls, the price of oranges rises.  As oranges are the leading input into orange juice, the supply of orange juice will decrease because of the higher price of oranges.  This will shift supply left, increasing the price and decreasing the quantity.

b.  New England's warm weather will lower the demand for Caribbean hotels (fewer people will be trying to escape the cold, and will stay in New England).  This shifts the demand curve to the left, which lowers the price of a caribbean hotel.

c.  War in the Middle East will decrease our supply of oil (as they export a majority of oil for the world).  Supply shifts left, increasing the price.
Furthermore, the increased price of gas influences the market for used Cadillacs in the following way.  Gas is a complement good to Caddilacs.  When the price of the compliment rises (gas prices rose) the demand for used Cadillacs will fall.  This shifts the demand curve left, lowering price.  IN ADDITION. . .more people will want to switch from driving a Cadillac to a more fuel-efficient car.  They sell their Cadillacs, increasing the supply of used Cadillacs as well.  Supply shifts right, further lowering the price.

Note:  since we had a shift of both supply and demand curve for Cadillacs, we cannot be certain how the quantity of used Cadillacs will change.  We CAN be certain of the decrease in price.

P&A3 Minivans
   a.  More kids means tastes for minivans improve.  Demand increases, shifting right.  Price and quantity increase.
   b.  increase steel prices--input prices rise, lowering supply.  Supply shifts left, increasing price and decreasing quantity.
   c.  New technology will increase supply.  Supply shifts right, decreasing price and increasing quantity.
   d.  Prices of stations wagons rise--this is a substitute to the minivan.  Fewer people will buy station wagons, so more will buy minivans.  This increases the demand for minivans, shifting demand right and increasing price and quantity
   e.  lower wealth will decrease the demand for minivans.  This shifts the demand curve left, lowering both price and quantity.

P&A 6  In 2010, there will be a big need for baby sitters, so demand for babysitters rises.  This shifts the demand curve right, increasing the price of baby sitting services.

By 2020, the number of teenagers old enough to baby sit skyrockets, so that the supply of baby sitters rises.  This shift of supply to the right will lower the price of baby sitting services.
 

P&A12 (This was a tricky one.)  First, the "successful marketing campaign" aimed to change people's tastes for champagne.  As it was successful, it increased demand, shifting the demand curve to the right.  This caused the "stratospheric champagne prices" (higher prices) that the execs were "giddy" about.

Their fears about the high prices causing demand to plummet are incorrect, because they did not look at WHY prices rose.  They changed consumer tastes for the product (through the ad campaign) and thus increased customer demand for the product. . .meaning that consumers are now WILLING to pay more for their champagne.  The execs should not worry, but celebrate with some of that overpriced champagne.
 

P&A9:  Equilibrium price is $6 and the quantity is 81.  Even if you didn't draw this, you could have seen this on the supply schedule, since at a price of $6, both quantity demanded and quantity supplied are 81.

If the market price were too high, then there would be excess supply.  The suppliers would lower prices to get rid of inventories, and lower their production accordingly.  If the market price were too low, then there would be excess demand (shortage).  The consumers would be willing to pay a higher price to get the pizza, and would bid up the price accordingly.

3. a.  the price of cheeseburgers falls--substitute goods gets cheaper, so demand for pizza falls.  This shifts demand left, lowering both price and quantity.
    b.  the price of mozarella increases--input good price rises, so supply falls.  Supply shifts left, raising price and lowering quantity.
    c.  consumers' incomes rise--demand rises as incomes rise, WHEN pizza is a normal good.  Demand shifts right, increasing price and quantity.
    d.  new automated pizza-making technology is introduced--the new technology will increase supply.  Supply shifts right, decreasing price and increasing quantity.


Chapter 7 
1.   Twenty gallons of water will give you greater total utility, because the quantity is larger.  Our total utility rises as we consume more of a good.

2.  Twelve gallons of water will give you greater marginal utility, because our marginal utility decreases as we consumer more of the good.  By the 12th gallon, we've already had quite a bit of water.  By the 20th gallon we may actually be sick of water and will gain only very little from its consumption.

P&A # 1 The bad weather will decrease the supply of lemons available, which will cause the price to rise and the quantity to fall.  This LOWERS the amount of consumer surplus in the market for lemons.  The higher price of lemons will also decrease the supply of lemonade (as lemons are the main input into lemonade).  The lower supply of lemonade will increase the price and decrease the quantity of lemonade.  This also will LOWER the consumer surplus in the market for lemonade.  (In both the market for lemons or the market for lemonade, consumer surplus shrinks from the combined purple and blue sections, to ONLY the blue section, when the prices rise.)

P&A # 7.  Demand is in blue:  the horizontal stretches are at $8 (Sally Jessie), $7 (Jerry), $5 (Montel) and $2 (Oprah).  The supply curve is in red:  the horizontal stretches are at $2 (Firm D), $3 (Firm A), $4 (Firm C) and $6 (Firm B).

Efficiency:  Supply equals demand at a quantity of three haircuts.
Who cuts hair?  The lowest cost (most efficient) suppliers--Firms D, A and C, in this example.
Who gets a haircut?  Those who want it the most--Sally Jessie, Jerry and Montel, in this example.
Maximum Total Surplus is 11.  This is the area between supply and demand, summed up for each of the three haircuts.

NOTICE:  The question did not ask for price.  Why?  Because we cannot be certain.  We can say that price will be somewhere between $4 and $5, because that is the section where supply and demand are equal.  Without a set price, the individual consumer and producer surplus cannot be determined.

If I were to tell you that price ends up at $5, CS = 5 and PS = 6.  If Price were $4, then CS = 8 and PS = 3.  In either case TS = 11.  However, consumers do better with the lower price and producers do better with the higher price.
 


Chapter 5 
1.  a.  The price elasticity of demand describes how responsive the quantity demanded is to a change in the price of that good.  Large elasticities mean that there is a greater demand response (or it is more elastic).

    b.  Goods which have elastic demand curves:  there are many answers, but in general, they would be goods categorized as luxuries, goods over long time horizons, good with close substitutes and goods in narrowly defined markets.

    c.  Goods which have inelastic demand curves:  again, there are many answers, but in general, they would be goods categorized as necessities, goods over very short time horizons, goods without close substitutes, and goods in broadly defined markets.

    d.  Elastic demand curves are flat and inelastic demand curves are steep:  Elastic demand curves imply that the quantity demanded is very responsive (or very large) for a change in price.  If the slope is "rise over run", and the "rise" here is price and the "run" is quantity demanded, then elastic demand curves have a very large "run" for a given "rise."  If the denominator is larger, the slope will be smaller. . .or flatter as the question put it.  Alternatively, an inelastic demand curve is NOT very responsive.  So we'd see small changes in quantity demanded, or small "runs" for a given price change.  The smaller denominator makes the slope larger. . .implying a steeper demand curve.

2.  If the price elasticity of demand for a good is elastic, its price should be decreased in order to increase total revenue.  The elastic good would see a larger increase in quantity demanded compared to the decrease in price.  Although the firm would be making less money on each good that they sell, they would be more than compensated by selling many, many more goods.

3.  Mankiw P&A #1
a.  Mystery novels, because they are a luxury, not a necessity.
b.  Beethoven, because it is a narrowly defined market and there are more close substitutes like Bach or Brahms.
c.  Heating oil over the next five years, because of the longer time frame. People will evenually switch out of oil heat to gas heat.
d.  Root beer, as it is a "luxury" item compared to water.

4.  Mankiw P&A #3a
i.the price elasticity of demand for consumers with incomes of $10,000 is unit elastic.

ii.the price elasticity of demand for consumers with incomes of 12,000 is inelastic.

Mankiw #3b
i.  When price is $12, the income elasticity is:

ii.  When price is $16, the income elasticity is:

5.  Mankiw P&A # 8
a. If we recall that the elasticity is equal to the percentage change in quantity demanded by the percentage change in price, we can solve for the percentage change in price.  We were given information that the elasticity was 0.4 and that the desired change in quantity demanded was 20%.

This implies that they should increase price by 50%, or increase it from $2 to $3.

b.  Five years from now.  The higher prices now will cause some people to eventually quit smoking (or not start) so that demand will fall much more in the long run than it will in the short run.

c.  Teens should have a larger price elasticity of demand for cigarettes because this is when most people begin smoking.  If prices are higher, fewer teens will become addicted in the upcoming years, and quantity demanded will be more affected later than it can be now.

6.  The elasticity of supply of lawnmowers would be larger over the span of one year.  Supply is more flexible over longer time horizons since it takes time to increase production (hire more workers, order more equipment, etc.).  Over the short run, you can only change the quantity supplied by what you have already built (and these days, inventories are kept relatively small).

7.  Mankiw P&A # 11, page 116.
a.  As seen in the figure below, both the equilibrium price and the equilibrium quantity will increase when demand increases.
b.  The Beachfront properties will experience a larger change in price (and a smaller change in quantity) because of the inelastic supply.
c.  The Auto market will experience a larger change in quantity (and a smaller change in price) because of the elastic supply.
d.  Consumer spending (Price x Quantity) increases in both cases, since both price and quantity increase.  (However, we cannot say precisely which will increase more.)

 


Chapter 6
1. Mankiw P&A #2, page 136, with some changes. . .

First, the competitive equilibrium is drawn on the left.  There is no deadweight loss when we are at the competitive equilibrium because we are selling the efficient quantity at the efficient price.

a. The new equilibrium is on the right.  The price will increase and the quantity will decrease, compared to the competative equilibrium.  There is a surplus of cheese (excess supply).  There is a deadweight loss as a result of the price floor, because the quantity is restricted.  Therefore, we cannot get any surplus on the items that are never sold.

b.  It is definitely possible that the farmers can lose revenue (Price x Quantity) when the price floor is increased.  Although the price does rise, if the quantity falls by a greater percentage than the increased price, the farmers Total Revenue will fall.  The more elastic is the demand for Cheese, the higher is the probability that they will lose TR as a result of the price floor. (Recall that when demand is Elastic, price increases will DECREASE total revenue.

2.  Mankiw P&A #4
a.  without the tax:  Price paid for beer by consumer is P*, Price recieved by sellers is also P*, Quantity of beer sold is Q*.  There is NO difference between the price paid by consumers and the price received by sellers.

b. with the $2 tax:  Price paid by consumers is Pb, Price received by sellers is Ps, quantity sold is Qt.  The difference between the consumer and seller prices is (Pb-Ps) which is equal to $2 in this case (the size of the tax).  The quantity of beer sold has decreased with the tax in place.  Ttotal welfare has decreased when the tax is imposed.  Both producer and consumer surplus shrink, and the government revenue does not equal this loss in CS and PS.  There is a deadweight loss.



3. Mankiw P&A #6, page 137.
The $500 tax on luxury cars will be split between consumers and sellers, such that the price that consumers pay will rise, but not by the full $500.


Chapter 10

 

1. There are too many possibilities here!  See the text and class notes for examples. . .

2. Mankiw P&A # 2, pp 222-223.
a.  Fire extinguishers exhibit a positive externality because fires can spread from one person's apartment or house to another persons.  So if Mr. A has a fire extinguisher and uses it on a fire in his apartment, he saves Ms. B from having his fire spread to her apartment and messing up her things.

b.  See the graph below.  The private supply and social costs supply curves are one in the same.  This is a Consumption externality, which means that the demand curve will be different.  There is a larger "social demand" function.

c.  The Efficient price and quantity are Pe and Qe in the graph above.  the Market price and quantity are P* and Q*.  Since Mr. A doesn't take into account the problems a fire in his place would cause for Ms. B, his willingness to pay (demand) does not take HER benefits into account.  Therefore, fewer fire extinguishers are purchased, in a market equilibrium, than is socially optimal.

d.  The government could subsidize the price of a fire extinguisher. . .give everyone who purchases one a $10 rebate on their taxes or something.  The lower price would induce more individuals to buy the fire extinguisher, so we'd get to the efficient quantity, Qe.
 

3. Mankiw P&A #4, page 223.
a.  Noise pollution is the externality.  The fact that Ringo's music is so loud that it disturbs Luciano.

b.  The landlord could do a couple of things. . .he could put a "noise limit" in effect like many communitites do.  (College Park, Maryland had police that would roam around on friday and saturday nights with a machine that reads decibels.  Any party louder than the decibel limit got shut down.)  He could completely forbid stereos in the building, but that would probably be too extreme for both parties.

This policy could still be inefficient. . .if Luciano isn't home (out performing in Milan) then Ringo should be able to play his music as loud as he would like.

c.  Ringo and Luciano could figure out a payment scheme to allow for an efficient outcome, or a time schedule whereby Ringo could play the music loud at the times of the day that Luciano is away from the apartment.

If Luciano only speaks Italian and Ringo only speaks english, then they might have a hard time reaching an agreement.
 


Chapter 11

 

1.This is another question with lots of possible answers. . .

2.  Mankiw P&A #2
a. Police protection--Natural monopoly (so long as there is not TOO much crime)--Excludable because the police can choose to not protect certain neighborhoods or sections of society, and Non-rival, in most cases.  If there was a lot of crime--so that policemen could not get to the crime quickly--then it would be rival, and therefore it would be a private good (both excludable and rival).

snow plowing--common resource--plowed roads are non-excludable (as are most roads), but it can be rival. . .If there is a lot of snow, the plowing of your street may hinder the truck from getting to my street.

education--private good (with a positive consumption externality)--it IS excludable, in the sense that you have to pay to attend even public universities.  (Or have a taxpaying parent in the neighborhood to go to a particular grade school).  It is also rival, in the sense that one more student means that less of the teacher's time is going to be spent on the students who were already there.

rural roads--public good--they are not excludable and are not rival (unless they are congested, but most rural roads are not)

city streets--common resources when congested, public goods when not congested.  They are always non-excludable, but can be rival or non-rival depending on the time of day.

b.  The government may provide certain goods that are not public goods (such as education) because of the externalities associated with them.

8.  Mankiw P&A #3
a.  Charlie is a Free Rider

b.  The government could help solve the problem by sponsoring the show, or by supporting public television in general (which they do. . .anybody out there listen to NPR?)

c.  The private market could also solve the problem by making people watch commercials that are incorporated into the program.  Parents don't like this for children's shows, so it becomes more difficult.  "Product placement" inside the TV program would also work (Seinfeld did a LOT of this. . .making sure that the Wheaties box was in plain view when they were in the kitchen, or the Pepsi can on the coffee table, yadda, yadda, yadda. . .)

Cable TV changes all of this. . .They make television excludable, making it a . . .natural monopoly.


Chapter 13


1.  Mankiw Q4R #2.  Several answers are possible, including the wages or salary that the entrepreneur could have earned had he or she gone to another job;  any lost interest on savings that they put into the business;   day care costs if they have children and were previously staying at home with them. . .

2.  Mankiw P&A #2
a.  opportunity costs, in the production sense, are all of those things that must be foregone in order to produce the product.  These include both explicit costs (which require money to physically leave the firm) and implicit costs (things like wages and interest that are lost when a person starts a new business).

b.  The opportunity cost of your aunt's opening the store, would (at a minimum) be the $500,000 to run the place (explicit costs) and the $50,000 it costs her in lost salary (implicit cost).  If she could only sell $510,000 worth of merchandise, she should not open the store, since it will not cover BOTH the explicit and the implicit costs ($550,000).

3.  Mankiw P&A #5

a.  Marginal product first increases--showing increasing returns to scale--and then decrecreases--showing diminishing returns to scale, for outputs beyond 90 or so units.

b.  Total cost = $200 + $100 * (# of Workers), or fixed cost plus variable costs.

c.  ATC = TC/Q.  ATC first falls, and then rises.

d.  MC = change in TC/change in Q, or since the change in TC is always $100, and you calculated MP (which IS the change in Q), you can simply divide $100/MP to get MC.


e.  MP & MC:  When MP is rising, MC is falling.  Also the reverse--when MP falls, MC rises.

f.  When the Marginal cost is less than the total cost, ATC is falling.  When MC is greater than ATC, ATC is rising.  We can also see this in the graph.

Notice that the MC curve does in fact cross the ATC curve at the minimum of the ATC curve (when we draw the MC point 'between' the two outputs).
 

4.  Mankiw P&A #9
As shown by the minimum of the ATC, the efficient scale for Vinnie's painting business is 4 houses.


 
 


Chapter 14 


1.   The characteristics of Perfect Competition:

cola & beer  are certainly not Perfectly Competitive, tap water  is probably not Perfectly Competitive. bottled water  is probably the best example of a Perfectly Competitive firm
2.  Mankiw P&A #6


a.  Profit = TR - TC.  This firm maximizes profit when they produce either 5 or 6 units of the good.

b.  MR = change in TR  (since the change in quantity is always 1),  MC = change in TC (since the change in quantity is always 1)  These curves cross between 5 and 6, which is the profit maximizing answer that we found in part a.


c.  This firm is in a perfectly competitive industry because the Marginal Revenue = Average Revenue = P.
This firm is NOT in a long run equilibrium, because a Perfectly Competitive firm earns zero profits in the long run.
 

3.  a.  The short-run equilibrium of a perfectly competative firm that is making a positive profit.  The shaded yellow area is the profit.

b.  The short-run equilibrium of a perfectly competative firm that is making a negative profit.  The shaded red area is a loss.

c.  The short-run equilibrium of a perfectly competative firm that should shut down.   The shaded red area is a loss.

d.  When price is above the minimum of ATC, the firm always make a positive profit, because the additional revenue per unit is greater than the cost per unit.  When price is below the minimum of AVC the firm should shut down, because it cannot even cover its variable costs.
 

4. Which characteristics of perfect competition is reponsible for zero profits in the long run?  FREE ENTRY & EXIT

If there are firms making profits


If there are firms making a loss. . .



 

5.  Mankiw P&A #3.
a.  The marginal cost of a string is $0.30.

b.  The industry is NOT in a long run equilibrium,

Chapter 15 


1 & 2. Mankiw Q4R #4 & 5, page 344.


3.  Mankiw P&A #1, page 344-345.

a.  See table below for numbers. . .
TR = Price times Quantity
TC = FC + VC = $2 million + ($10 * Quantity)
Profit = TR - TC

A profit maximizing publisher would choose to produce 500,000 books at a price of $50.  (Notice that the monopolist is indifferent (makes the same profit) at a price of $60 and quantity of 400,000.  The economists prefer the higher quantity. . .  it allows for greater consumer surplus.)

b. See table above for Marginal Revenue.  In this case, Marginal revenue is always less than price.  This is normal for a monopolist.

c.  See the graphs below.  Marginal Cost was a constant $10 per book, so it just a horizontal line at $10.  Units on the x-axis are in 100,000's.

As seen below, the MC and MR curves cross between 400,000 and 500,000 books.  This is the profit maximizing quantity for this monopolist.

d.  The deadweight loss is the purple triangle above.  This is the area between the Demand and Marginal Cost from the quantity that the Monopolist produces to the Competitive quantity (900,000).

The deadweight loss is the loss of total surplus to society, which results from the monopolist restricting output below the efficient quantity.

e.  If the Fixed cost rose from $2 million to $3 million, only the Total Cost and Profit figures would change.  Each of the TC numbers would rise by $1 million and each of the Profit numbers would fall by $1 million.  This leaves Marginal Cost AND Marginal Revenue unchanged, meaning that the Monopoly price and quantity will NOT change.

f.  If the publisher wanted to "maximize economic efficiency" they would be acting as a perfectly competitive market.  They would produce where P = MC.  Since MC = 10, they would produce at a price of $10, and publish 900,000 books.  In doing so, they would be earning a loss of $2 million.

4.  Mankiw P&A #9, pages 345-346.

Since Placebo Drugs holds a patent, they are by definition, a monopolist in this market.

a.  This is the basic monopolist graph.  Quantity is determined by the intersection of MC and MR.  Then Price is off the demand curve at the monopoly quantity.  Profits are the difference between price and ATC at the monopoly quantity, over all units that the monopolist sells.

b.  A PER BOTTLE tax will increase the marginal cost (as it did in our restaurant experiment).  A higher MC, means that the new intersection between MC and MR is at a lower quantity.  A lower quantity will mean a higher price.  (The old price & quantity are where the grey dashed lines are.  The new price & quantity are the solid lines.)

c.  This was tricky.  The tax definitely reduces profits.  Think of it this way. . .the could have produced the old quantity when the tax was Not imposed.  However, that was NOT a profit maximizing quantity.  So (irrespective of the tax) the profits at the quantity from part a were MORE than the profits from part b.  Then. . .they have to take into account the additional costs from the tax.  So profits are lower to begin with at the lower quantity, plus they have to give up more profits to pay the tax.

d.  The "lump sum" tax, or fixed amount, does not influence price or quantity to change, but only changes the Average Total Cost and Profits.  Basically, the fixed tax amount is a Fixed Cost, and will not change our Marginal cost OR the Marginal Revenue.  Since the old MC is the same as the old MR, the maximizing quantity is the same as in part a.  Price will also be the same because the quantity does not change.

However, profits WILL be lower with the lump sum tax.  They still earn the same Total Revenue (b/c same P & Q) , but Total Cost rises (b/c FC rises), lowering profits.

 

Mankiw P&A #12
a.  First, the patent gives this drug manufacturer a monopoly, so it prices the good as a monopolist does.  Total surplus is the sum of consumer surplus and Producer surplus, which is the difference between the Demand curve and the "Supply" curve (Marginal Cost, for the monopolist), over the goods that the monopolist sells.

b.  If the firm can perfectly price discriminate, the consumer surplus and deadweight loss disappear.  These both become additional producer surplus. . .such that it is easy to see that both producer surplus and total surplus rise.

2.  P&A #16

a.  See the graph.  Pm is the monopoly price without price discrimination.

b.  Areas X (monopoly profit, light blue), Y (Consumer Surplus, yellow), and Z (Deadweight loss, Purple) are shaded above.

c.  If the monopolist can perfectly price discriminate, the monopolist profits are X + Y + Z

d.  The change in monopoly profits due to price discrimination is  (Y + Z).  The change in total surplus is Z (the deadweight loss is gained).

The change in monopoly profits is larger, so long as Y > 0.  (Because Y + Z has to be larger than Z when Y is positive.)


e.  Monopolist pays a fixed price C to price discriminate.

They will earn X if they choose not to price discriminate.
They will earn (X + Y + Z) - C if they choose to price discriminate.

This implies that the business WILL bear the fixed cost to price discriminate IF:  (X +Y + Z) - C  >  X   (the earnings from PD > earnings from not discriminating)

Simplifying. . .the X drops out of both sides, so if (Y + Z) > C then the monopolist WILL choose to price discriminate.


f.  Now we look at Total Surplus (instead of monopoly profits)

If the monopolist does NOT price discriminate, then Total Surplus is X + Y
If the monopolist DOES price discriminate, then Total Surplus is (X + Y + Z) - C

So the social planner will have the monopolist price discriminate only IF:  (X + Y + Z) - C  >  X + Y.

Simplifying here is different. . .both the X and the Y drop out.  So the Social Planner will have the monopolist price discriminate when Z > C.


g.  There is a difference in outcomes when (Y + Z) > C > Z.

Or in Layman's terms, when the Cost to price discriminate is bigger than the DWL, but not bigger than the sum of the DWL plus the Consumer Surplus under the single price monopoly.  In this case, the Social planner WOULD NOT have the monopolist price discriminate, but the Monopolist making his own decision WOULD choose to do so.

So the Social planner has a smaller incentive for price discrimination than the monopolist acting alone does.   The monopolist might price discriminate, even if it is NOT socially optimal.


 

Chapter 16


Mankiw P&A #2, page 373.

a.  "many suppliers" implies perfect competition.  For PC firms, MR = P.  Since the Marginal Cost is $1,000 per diamond, MR = P = MC at a price of $1,000 and a quantity of 12,000,000 diamonds.

b.  "only one supplier" implies monopoly behavior.  For a monopoly, we need to calculate TR and MR for each price.  See the table for these figures.

For the monopolist, MR = MC at a price of $7,000 and quantity of 6,000.


c.  the cartel would split the monopoly quantity and sell at the monopoly price.  So price is $7,000 and South Africa and Russia EACH produce 3,000 diamonds.

In this case, South Africa's profit is (P - MC) * Q = (7,000 - 1,000) * 3,000 = 6,000 * 3,000 = $18,000,000

If South Africa increases production by 1,000, then the total quantity produced is (4,000 + 3,000) = 7,000.  At this quantity the price will fall to $6,000.  South Africa's new profit is (6,000 - 1,000) * 4,000 = 5,000 * 4,000 = $20,000,000.
 

d.  Since South Africa would make a higher profit by breaking the cartel quantity, he will.  Russia would have this same incentive, and thus they both end up breaking the cartel.  Basically, this is the tradeoff when it comes to Self-Interest--each country could do its best by agreeing to the cartel quantity, but self-interest drives them to produce more, driving prices and profits down.
 

Chapter 17


1. Mankiw P&A #1, page 392.

Basically asked yourself the following. . .

  1.  Are there many sellers or only one seller?
        If you respond that there is only one seller. . .Then it is a Monopoly.

  2.  Are the goods the same?  Or are they different?
        If there is no difference, it is Perfectly Competitive.  If there are differences in taste, quality, brand names, etc, then it is Monopolistically Competitive.

a.  Pencils--Perfectly Competitive--there are a large number of manufacturers of pencils. . .and they are all pretty much the same.

b.  Bottled Water--Monopolistically Competitive--Water is mostly the same.  However, some people will argue that some bottled water tastes better than others, so it could be considered a Monopolistically Competitive industry.  If you make the assumption that all bottled water is exactly the same, then it would be a Perfectly Competitive industry.

c.  Copper--PC--All copper is identical (it has a scientific formula, no?) and there are a large number of producers.

d.  local telephone service--Monopolistic (in the vast majority of markets)--when you don't have mega-populations, like in NYC, telephone service is a natural monopoly:  it is cheaper for one firm to supply all of the output.

e.  Peanut Butter--Monopolistically Competitive--because different brand names exists (Peter Pan, Skippy, etc.) that have different quality characteristics.

f.  Lipstick--Monopolistically Competitive--lipstick from different firms differs slightly (stays on longer, better choices of colors, etc), but there are a large number of firms that can enter or exit without restrictions.
 

2.  Mankiw P&A #4

a.  See the graph below.  Qmc and Pmc are the profit maximizing output and price for Sparkle.
b.  Sparkle's profit is zero, because price equals the average total cost.
c.  Consumer surplus (CS) and Deadweight Loss (DWL) are shaded below.

d.  If Sparkle was forced to produce at the efficient level of output, the firm would end up exiting the market in the long run.  The efficient level would be where Demand equals Marginal Cost.  At that Quantity, Price is lower than Average Total Cost, and Sparkle would lose money.  Therefore, they would exit, rather than make negative profits year after year.  Sparkle's customers would lose their consumer surplus, because they would be unable to buy anymore of Sparkle's toothpaste.
 


Game Theory


3.  Mankiw P&A #5  (except part d), page 373.

a.  The dominant strategy for the US is to impose High Tariffs.  The dominant strategy for Mexico is to impose High Tariffs.  For both countries, regardless of what the other country chooses to do, it is better off imposing high tariffs than imposing low tariffs.

b.  Nash Equilibrium is a situation where economic actors interacting with each other choose their best strategy given the strategies that all the other actors have chosen.  The NE for Trade Policy is one in which both countries place high tariffs, resulting in a lower outcome for each country.

to think about it more slowly. . .
1.  If the US was Definitely going to charge LOW tariffs. . .Mexico would rather charge high tariffs and get $30 billion (instead of $25 billion.)

2.  If the US was Definitely going to charge HIGH tariffs. . .Mexico would rather charge high tariffs and get $20 billion (instead of $10 billion.)

3.  If Mexico was Definitely going to charge LOW tariffs. . .the US would rather charge high tariffs and get $30 billion (instead of $25 billion.)

4.  If Mexico was Definitely going to charge HIGH tariffs. . .the US would rather charge High tariffs and get $20 billino (instead of $10 billion.)

So the dominant strategy of both countries is to charge High Tariffs.

c.  Yes, NAFTA is justifiable, given the game presented above.  Only when barriers are reduced simeltaneously, will both countries agree to the change.  Neither one would reduce tariffs unilaterally, because they would lose $10 billion.  However, by reducing the tariffs at the same time they will both gain $5 billion.
 

4. Mankiw P&A #8, page 374

a.  Decision box below.

b.  The Nash Equilibrium is the situation where both airlines offer a low price, which results in low profits for both firms.

to think about it more slowly. . .
1.  If Braniff was Definitely going to charge a LOW price. . .American would rather charge a low price and get low profits (instead of very low profits).

2.  If Braniff was Definitely going to charge a HIGH price. . .American would rather charge a low price and get high profits (instead of very medium profits).

3.  If American was Definitely going to charge a LOW price. . .Braniff would rather charge a low price and get low profits (instead of very low profits).

4.  If American was Definitely going to charge a HIGH price. . .Braniff would rather charge a low price and get high profits (instead of very medium profits).

So the Dominant strategy for both firms is to charge a low price.