REVIEW QUESTIONS

CHAPTER 1

1. What is the difference between microeconomics and macroeconomics?

Micro and macroeconomics are both branches of economics, but have different objects of
study. Microeconomics is concerned with the behaviour of individual economic agents
(decision makers), such as consumers, workers, firms, managers, households, industries,
markets, labour unions or trade associations. In doing so, it provides a framework to
analyse the impact of government actions on the economy and the role of government in
the economy.
Macroeconomics, on the other hand, is concerned with how an entire economy performs.
It studies other variables, of a more aggregate nature, such as the level of income and
employment, the relation between interest rates and prices, inflation and business cycles.

2. Why is economics often described as the science of constrained choice?

It is believed that human wants are unlimited: all human beings always desire more.
However, the resources available to produce the desired good and services are finite –
scarce –, so their supply is limited. As a result, human beings are constrained to choose
between which wants to satisfy, and in doing so, allocate resources to satisfy demand.
Since it is economics that deals with the allocation of scarce resources to satisfy unlimited
human wants, economics is considered the science of constrained choice.

3. How does the tool of constrained optimization help decision makers make
choices? What roles do the objective function and constraints play in a model
of constrained optimization?
The tool of constrained optimization helps decision makers make choices by taking into
account all possible restrictions and limitation on those choices. To do that, it has two
components: the constraints (restrictions and limitations) and an objective function.
The objective function is the relationship the economic agent wants to either maximise of
minimise. It is, in fact, what the agent cares about. So, constrained optimization points out
to the relationship to be maximised or minimised, while accounting for possible limitations
and restrictions.

4. Suppose the market for wheat is competitive, with an upward-sloping supply

 curve, a downward-sloping demand curve, and an equilibrium price of $4.00
per bushel. Why would a higher price (e.g., $5.00 per bushel) not be an
equilibrium price? Why would a lower price (e.g., $2.50 per bushel) not be an
equilibrium price?
If the market is in equilibrium at a price of $4.00 per bushel, a higher price ($5.00) would
result in excess supply (Q4-Q2), with producers wanting to sell more wheat (Q4) than at
$4.00 per bushel, but consumers wanting to buy less wheat (Q2). Conversely, at a price of
$2.50 per bushel, consumers would want to buy more wheat (Q5), but producers would be
willing to sell less wheat (Q1) – there would be excess demand (Q5-Q1). In either
situation, the market does not clear.

Price

Supply

5.00
4.00

2.50

Demand

Q1Q2 Q* Q4 Q5 Quantity

5. What is the difference between an exogenous variable and an endogenous

variable in an economic model? Would it ever be useful to construct a model
that contains only exogenous variables (and no endogenous variables)?
An exogenous variable is one whose value is taken as given in a model. It is therefore,
determined by some process outside the model being examined. An endogenous variable,
on the other hand, is a variable whose value is determined within the model being studied.
The objective of any model is to represent relationships between endogenous variables
given values of the exogenous variables. So it makes no sense to have a model
constructed simply with given values; it would show no meaningful relationships.

6. Why do economists do comparative statics analysis? What role do

endogenous variables and exogenous variables play in comparative statics
 analysis?
Economists do comparative statics analysis to study the impact a change in an exogenous
variable has in the level of an endogenous variable. So, the endogenous variables
represent the objective function and the exogenous variables represent the constraints.
The objective of the model is to represent is the behaviour and relationships of
endogenous variables given the values of the exogenous variables.

7. What is the difference between positive and normative analysis? Which of the
following questions would entail positive analysis, and which normative
analysis?
a) What effect will Internet auction companies have on the profits of local
dealerships?
b) Should the government impose special taxes of merchandise made over
the Internet?
In an economics setting, positive analysis attempts to explain how an economic models
works and how it will change over time (answers explanatory and predictive questions),
while normative analysis attempts to answer prescriptive questions, such as how to act in
order to obtain a certain outcome – typically related to social welfare.
Question a) is a matter of positive analysis, because it entails a prediction of what will
happen should a certain policy be put in practice. Question b), on the other hand, is a
matter of normative analysis, because it attempts to answer a prescriptive question –
should a policy be put in place –, one imagines in order to obtain a certain social welfare
outcome.
CHAPTER 2

1. Explain why a situation of excess demand will result in an increase in the

market price. Why will a situation of excess supply result in a decrease in the
market price?
Considering the market was in equilibrium, a situation of excess demand or excess supply
will result in the market failing to clear. At any situation other than equilibrium, there are
pressures for the market price to change.
In a situation of excess demand, the quantity demanded exceeds the supply at that price.
As a result, buyers procure more than is available in the market, and there is pressure for
the price to rise. As the price rises, the quantity suppliers are willing to sell also rises, but
the quantity demanded falls, leading the market to an equilibrium. With higher price and
lower quantity, the market moves towards an equilibrium, therefore eliminating the excess
demand.
In a situation of excess supply, the quantity supplied exceeds the demand at that price. As
a result, producers can't sell as much as they would like, and this will create pressures for
the price to go down. As the price falls, consumers are willing to buy a greater quantity, but
producers are only willing to sell less of the product. With lower price and greater quantity,
the market moves towards an equilibrium, therefore eliminating the excess supply.
The predictions in either case only apply for a perfectly competitive market.

2. Use supply and demand curves to illustrate the impact of the following events
on the market for coffee:
a) The price of tea goes up by 100 percent

2P*

P*

Q2 Q*

When price rises from P* to 2P*, quantity demanded drops from Q* to Q2. The
 result is excess supply.
b) A study is released that links consumption of caffeine to the incidence of
cancer
The result of this study is, predictably, a reduction of the amount of coffee
demanded by consumers relatively to equilibrium (Q*), to Q2:

P2

P*

Q2 Q*

As a result, the price will increase, from P* to P2, because of excess supply.

c) A frost kills half of the Colombian coffee bean crop

P2

P*

Q2 Q*

As a result of the loss of part of the crop, the quantity available in the market drops from
Q* to Q2, causing an excess demand and an increase in price, from P* to P2.
 d) The price of styrofoam coffee cups goes up by 300 percent
The price of styrofoam coffee cups probably account for just a small part of the price of
coffee cups will cause the demand for coffee to shift. As a result of the price increase, a
smaller amount of coffee-product will be in demand.

P*

P2

Q2 Q*

This is a derived demand; however, the demand for the coffee-commodity by

manufacturers is impacted by the consumer demand for the coffee-product, and so the
quantity of coffee demanded in world market will drop, even if slightly, from Q* to Q2:

P*

P2

Q2 Q*

As a result, the price of the coffee-commodity will decrease.

 3. Suppose we observe the price of soybeans goes up, while the quantity of
soybeans goes up as well. Use supply and demand curves to illustrate two
possible explanations for this pattern of price and quantity changes

We will consider this is a perfectly competitive market.

The first possible explanation is a shift in the demand curve, from D1 to D2, with people
wanting more soybean products (Q* to Q2) and being willing to pay more for them (P* to
P2):

P2

P* D2

D1

Q* Q2

Another possibility is a shift in the supply curve, from S1 to S2, resulting in an overall
increase of the amount available in the market, coupled with a shift in the demand from D1
to D2:

S2

P2 S2

P1
D2
D1

Q1 Q2
 4. A 10 percent increase in the price of automobiles reduces the quantity of
automobiles demanded by 8 percent. What is the price elasticity of demand
for automobiles?
ϵQ,P = % change (Q) / % change (P) = -8/10 = -0.8
The price elasticity of demand for automobiles is -0.8.

5. A linear demand curve has the equation Q=50-100P. What is the choke price?
The choke price is the price at which quantity demanded is 0
0 = 50-100P
P= 0.5
The choke price is 0.5 (units of currency)

6. Explain why we might expect the price elasticity of demand for speedboats to
be more negative than the price elasticity of demand for light bulbs.
There are three characteristics of the products that impact on price elasticity of demand:
the availability of substitutes, the percentage of the total consumer's expenditure that
product represents and the product being seen by consumers as a necessity or not. As
such, we would expect speedboats – which would account for a larger percentage of
consumer's available income than light bulbs and that are easily seen as less necessary
than light bulbs to have a more negative price elasticity of demand – the demand for them
is more elastic and more price-sensitive.

7. Many business travellers receive reimbursement by their companies when

they travel by air, whereas vacation travelers pay for their trips out of their
own pockets. How would this affect the comparison between the price
elasticity of demand for air travel for business travelers versus vacation
travelers?
We would expect that, for the same ticket at the same price, a company would have a less
negative price elasticity of demand (be less sensitive to price), since for them that price
would account for a much smaller percentage of the income when compared to a (typical)
individual vacation traveler. Also, the company might see the travel as a necessity, while
the individual traveler sees it as an avoidable expenditure (such as hobby or vacation).
Finally, for the business traveller there might be little or no substitute than travelling to be
in the place at a given moment, such as on short notice or because of the fact that the
opportunity cost of using a slower means an air travel is cheaper), while the vacations
traveller can choose to use another means of transportation to go to the destination.

8. Explain why the price elasticity of demand for an entire product category
(such as yoghurt) is likely to be less negative than the price elasticity of
demand for a typical brand (such as Danone) within that product category.
The market-level price elasticity of demand is usually more inelastic (less negative) than
the brand-level elasticity of demand because other brands acts as close to perfect
substitutes. If only Danone increases its prices, consumers might react by switching to the
now lower price brands (like Yoplait), achieving a degree of utility quite similar (consuming
the same amount of yoghurts, albeit slightly different ones). If all brands increased their
prices by the same percentage at the same time, the consumer wouldn't have substitutes
available and, to maintain his utility, will have to buy the now more expensive yoghurt – so
the market-level PED will be less negative.

9. What does the sign of the cross-price elasticity of demand between two
goods tell us about the nature of the relationship between those goods?
If the cross-price elasticity of demand is positive, increased price for one product increases
the demand for the other – the two products are demand substitutes. On the other hand, if
the cross-price elasticity of demand is negative, it means that an increase in price of one
product diminishes the demand for the other. This means these products' demand rise and
drop together, so the products are demand complements.

10. Explain why a shift in the demand curve identifies the supply curve and not
the demand curve
A shift in the demand curve moves the market along the supply curve. If we know the
shape of the supply curve (for example, if we admit it is roughly a straight line) we can
identify two points along that line (the market equilibrium before and after the shift), which
allows us to determine the slope of the supply curve, which did not shift.
CHAPTER 3

1. What is a basket (or a bundle) of goods?

A basket or bundle of goods is a collection of goods and services that an individual might
consume.

2. What does the assumption that preferences are complete mean about the
consumer's ability to rank any two baskets?
It means that the consumer is able to rank those two baskets, either by preferring one over
the other or by being indifference between the two baskets.

3. Consider Figure 3.1. If the more is better assumption is satisfied, is it possible

to say which of the seven baskets is least preferred by the consumer?
No, we cannot. We don't have further information about the consumer's preferences, so
we can't say, for instance, if he prefers D to E. In both these points total consumption is
equal, but the amount of each good is different. We would need the specific consumer
preferences for each good in order to be able to decided which of these two bundles is
least prefered.

4. Give an example of preferences (i.e., a ranking of baskets) that do not satisfy

the assumption that preferences are transitive.
A ranking of preferences that violates the transitivity principle would be A>B, B>C but C>A.

5. What does the assumption that more is better imply about the marginal utility
of a good?
It implies that the marginal utility of a good is always greater than 0. That way, more of the
good always increases the total utility for the consumer. If the marginal utility was ever 0 or
negative, the consumer would not accept that more is better, because the total utility would
either be constant or diminishing.

6. What is the difference between an ordinal ranking and a cardinal ranking?

Both kinds of rankings give us information about the order in which a consumer ranks
baskets. However, the ordinal ranking only gives qualitative information – the order of the
baskets – while the quantitative ranking gives quantitative information, concerning the
intensity of preference, therefore showing how much more a basket is preferred over the
other.
 7. Suppose Debbie purchases two hamburgers. Assume that her marginal utility
is always positive and diminishing. Draw a graph with total utility on the
vertical axis and the number of hamburgers on the horizontal axis. Explain
how you would determine marginal utility at any given point on your graph.
Total
Utility

3 Number of Hamburgers

At any given point on this graph, the marginal utility is the slope of a line tangent to
the curve on that point. So, the marginal utility from consuming 3 hamburgers is the slope
of the depicted line.

8. Why can't you plot the total utility and marginal utility curves on the same
graph?
Marginal and total utility curves cannot be drawn on the same graph because the
dimensions in the y-axis are not the same. A graph of marginal utility depicts the utility
derived by a certain number or hamburgers, while the total utility is the sum of all the utility
obtained from all the hamburgers consumed up to that one.

9. Adam consumes two goods: housing and food.

a) Suppose we were given Adam's marginal utility of housing and his
marginal utility of food at the basket he currently consumes. Can we
determine his marginal rate of substitution of housing for food at that basket?
Yes, we can. If MUH is the marginal utility of housing for Adam and MUF is his marginal
utility of food, we know that MRSH,F (Adam's Marginal Rate of Substitution of housing for
food) is given by:
MRSH,F = MUH / MUF
 b) Suppose we were given Adam's marginal rate of substitution of housing for
food at the basket he currently consumes. Can we determine his marginal
utility of housing and his marginal utility of food at that basket?
No, we would need more information. In the case pointed , we have 2 variables (MU H and
MUF), but only one equation (MRSH,F = MUH / MUF) to work on. We would need, at least, to
know the utility function function for Adam and the currently level of utility he devises. That
way, knowing the MRSH,F is the slope at that point, we could calculate MUH and MUF.

10. Suppose Michael purchases only two goods, hamburgers (H) and Cokes (C).
a) what is the relationship between MRSH,C and the marginal utilities MUH and
MUC?
MRSH,C = MUH / MUC

b) Draw a typical indifference curve for the case in which the marginal utilities
of both goods are positive and the marginal rate of substitution of
hamburgers for Cokes is diminishing. Using your graph, explain the
relationship between the indifference curve and the marginal rate of
substitution of hamburgers for Cokes.

Cokes

2 Hamburgers

The straight line depicts the MRSH,C is tangent to the indifference curve at point (2, 3). The
slope of the line equals the MRS at that point.
 c) Suppose Michael always wants two hamburgers along with every coke.
Draw a typical indifference curve. In this case, are hamburgers and Cokes
perfect substitutes or perfect complements?
In this case, hamburgers and Cokes are perfect complements – for each coke, Michael
wants to have 2 hamburgers.

Cokes

2 4 Hamburgers

11. Suppose a consumer is currently purchasing 47 different goods, one of which

is housing. The quantity of housing is measure by H. Explain why, if you
wanted to measure the consumer's marginal utility of housing (MUH) at the
current basket, the level of the other 46 goods consumed would be held fixed.
We assume the utility a consumer obtains from consuming a certain good depend on the
characteristics of that good. So, we can study the utility derived from that good while
keeping the level of consumption of the other goods constant.
CHAPTER 4

1. If the consumer has a positive marginal utility for each of the two goods, why
will the consumer always choose a basket on the budget line?
If the consumer has a positive utility for each of the two goods, more of any increases the
total utility, so the consumer will apply the principle of more in better. However, he has a
limit of how much he can spend, and that limit is given by the budget line. The budget line
represents the set of all baskets a consumer can buy if he spends all his income.
Consequently, the consumer can't go beyond the budget line; however, because the
principle of more is better still applies, the consumer will consume as much as possible,
spending all his income, so the basket he eventually chooses to buy is on the budget line,
not below it.

2. How will a change in income affect the location of the budget line?
If the consumer receives more income, the budget line will shift out, with the new budget
line being parallel to the first.

3. How will an increase in the price of one of the goods purchased by a

consumer affect the location of the budget line?
The increase in the price of one of the goods will make the budget line rotate about the
intersect in the axis where the quantity of the other good is represented.

4. What is the difference between an interior optimum and a corner point

optimum in the theory of consumer choice?
In an interior optimum solution, the consumer purchases a positive amount of both goods
studies, say x and y. However, the consumer may choose not to buy good y, so his basket
will be along the x axis. In this situation, the budget line may not be tangent to an
indifference curve at the optimal basket.

5. At an optimal interior basket, why must the slope of the budget line be equal
to the slope of the indifference curve?
An interior optimum is expressed in the following matter:
max(x,y) U(x,y) subject to: Pxx + Pyy <= I
Meaning the consumer will maximize his utility by buying as much of x and y as his income
allows – so we know the sum of all expenditure on x and all expenditure on y will equal I,
therefore being a point on the budget line.
This, however, does not show us how much of x and y will the consumer choose to buy in
order to maximise his utility. To do that, the consumer will choose to buy at the point where
the highest possible utility level (achievable within budget) has the budget line as tangent.
We also know that, for any point of the utility curve, the tangent equals the Marginal Rate
of Substitution at that point. Consequently, at the utility maximizing condition, the Marginal
Rate of Substitution equals the slope of the budget line, which in turn equals the slope of
the utility curve.

6. At an optimal interior basket why must the marginal utility per dollar spent on
all goods be the same?
We have shown that, if the consumer buys a positive amount of both goods, the budget
line is tangent to the indifference curve. We have also shown that, at the maximization
point, the marginal rate of substitution equals the slope of the budget line. From the MRS's
definition, we have
MRSx,y = Px/Py
Because MRSx,y also equals Mux/MUy, it means that, at the interior optimal,
MUx/Px = MUy/Py
As a result, at the interior optimal basket, the consumer chooses commodities so that the
marginal utility per currency unit spent on each is the same.

7. Why will the marginal utility per dollar spent not necessarily be equal for all
goods at a corner point?
A situation with a corner solution means that a consumer is always willing, along his
budget line, to substitute an amount of a good for an amount of the other good. If x is the
good the consumer wants more of and y the commodity he is willing to forego, we have
that
MUx/Px > MUy/Py
The utility per dollar of x is always larger than the utility per dollar of y. As a result, he will
end up only buying x and completely foregoing y.
 8. Suppose that a consumer with an income of $1000 finds that basket A
maximises utility subject to his budget constraint and realises a level of utility
U1. Why will this basket also minimise the consumer's expenditures
necessary to realise a level of utility U1?
In a problem of either utility maximization or expenditure minimization, a consumer will
reach the same solution.

Units of x
B

BL2=1000
BL3=1200

C
BL1=800
U1

Units of x

Taken as a utility maximization problem, the consumer cannot achieve U1 unless he

spends on BL2, point A – he cannot, for example, spend on BL1 and obtain BL1 and
obtain U1.
Taken as an expenditure minimization problem, the consumer could obtain U1 by sending,
for instance, in BL2 – in points B or C – but his overall income only allows him to achieve
BL2.
So, the expenditure minimization and the utility maximization have the same solution, point
A, which is the tangent between the utility level required – U1 – and the available income –
BL2. The optimal solution – A – maximizes utility and minimizes expenditure.

9. What is a composite good?

In order to facilitate the study the required amount of a commodity of interest in a x-y axis,
we plot it against a collective good – a good that represents the collective expenditure on
every other goos except the commodity being considered. By convention, we consider that
the price of a composite good is 1.
 10. How can revealed preference analysis help us learn about a consumer's
preferences without knowing the consumer's utility function?
Since we don't know the consumer's utility function, we can't determine the position if his
indifference curves. However, keeping in mind the consumer behaviour principles
(preferences are complete; more is better; transitivity), it is possible to obtain the
consumer's ordinal preferences relating to different baskets.
Faced with a budget line and an amount of possible baskets, combining different amounts
of both commodities at study, the consumer will choose a basket. We will then know that
the consumer strongly prefers that basket to every other basket that would be less costly,
and that that basket is weakly preferred to every other basket on the budget line. If we
then change the budget line, the consumer will choose a new basket and, by transitivity,
we are able to determine the consumer's preferences.
This analysis assumes the consumer always maximizes his utility, whatever the
constraints of the budget line. If he fails to do so, we can detect that situation through the
method as well.
CHAPTER 5
1. What is a price consumption curve for a good?
The price consumption good is a price that connects all the baskets that are optimal as the
price of one good changes, holding the price of the other good and the income constant.
This curve connects the utility-maximizing baskets. The chart where it is drawn depicts the
quantities of two good chosen by the consumer, and a budget line.

2. How does a price consumption curve differ from an income consumption

curve?
The income consumption curve, depicted in a similar chart as the price consumption
curve, connects utility-maximizing baskets as income varies and prices are held contant –
while in the price consumption curve it was the price of one of the goods that changed.

3. What can you say about the income elasticity of demand for a normal good?
The income elasticity of demand in the percentage change in demand for the product as
the income of the consumer changes. If the good is normal, an increase in income always
makes the demand grow – so the income elasticity of demand for a normal good is always
necessarily positive.

4. If indifference curves are bowed in towards the origin and the price of a good
drops, can the substitution effect ever lead to less consumption of the good?
The substitution effect accounts for the change in consumption of a good when its price
changes, maintaining utility constant.
If the the price of the good drops, the budget line will tilt outwards, from BL1 to BL2, and
consumption will move from A to B:
y

A
B

BL1 BL2
x
As a result, and can be seen from the chart, a substitution effect alone never accounts for
a reduction in consumption of a good whose price drops.

5. Suppose a consumer purchases only three goods, food, clothing and shelter.
Could all three goods be normal? Could all three goods be inferior? Explain.
For a good to be normal, its income elasticity of demand must be positive, meaning that,
as the consumer's income increases, so does his consumption of the good.
For some regions of the demand curves, we can expect all the goods to be good.
However, after a certain amount of each good is purchased, the consumer might decide to
substitute some of the quantity of one of the goods – making it an inferior good for that
region of the demand curve – to purchase more if one of the goods, increasing his total
utility in the process.
However, if we assume that the utility of all goods is positive, if all goods were to be inferior
– and the consumer would buy less of all of them as the income increased – the total utility
would in the end decrease with the increase in income, which is hardly a rational outcome
for a rational consumer, who works by the “more is better” principle.

6. Does economic theory require that a demand curve always be downward

sloping? In not, under what circumstances does the demand curve have an
upward slope over some region of prices?
No, it does not. A demand curve can be upward sloping in the case of Giffen goods –
goods so strongly inferior that the income effect outweighs the substitution effect. In these
cases alone, the demand curve is upward sloping over some region of prices, in which the
demand increases as the price increases.

7. What is consumer surplus?

Consumer surplus is the difference between how much a consumer pays for a good and
how much he would be willing to pay. It represents how much better off the consumer is in
practice.

8. Two different ways of measuring the monetary value that a consumer would
assign to the change in price of the good are (1) the compensating variation
and (2) the equivalent variation. What is the difference between the two
measures, and when would these measures be equal?
The compensating variation is a measure of how much money a consumer would be
willing to give up after reduction in the price of a good, in order to be just as well off as
before the price decrease. On the other hand, the equivalent variation is a measure of how
much additional money a consumer would need before a price reduction to be as well off
as after the price decrease.
In general, they are the same, or else the price change would have a zero income effect.
The only situation where it happens is if the Utility function is quasi-linear, in which case
the utility curves are parallel and the vertical distance between two points is the same for
any value of x.

9. Consider the following statements. Which might be an example of a positive

network externality? Which might be an example of a negative externality?
(i) people eat hot dogs because they like the taste, and hot dogs are filling.
(ii) as soon as Zack discovered that everybody else was eating hot dogs, he
stopped buying them
Negative network externality – snob effect
(iii) Sally wouldn't think of buying hot dogs until she realised all her friends
were eating them
Positive network externality – bandwagon effect
(iv) When personal income grew by 10%, hot dog sales fell.

10. Why might an individual supply less labor (demand more leisure) as the wage
rate rises?
If the individual's demand utility function depends on the consumption of composite goods
(for which he needs income, equal to the sum of all the hourly wages he makes working -
Lw) and leisure (which is the result of the subtracting the working hours, L, from total hours
in a day, 24, which means it is 24-L), the individual gets ever more income the more hours
he works (L increasing) and the more the hourly rate w.
However, the more hours he works the less the leisure time he can enjoy, because the
total number of hours in a day is fixed (24).
So, as the wage rate increases, the consumer gets ever more income, which reduces the
number of hours he needs to work in order to be able to buy one unit of the composite
good. This leads to a substitution effect and an income effect.
The former demands that the individual substitutes more composite good for more leisure,
therefore working more and having more leisure. The latter makes the individual demand
more leisure and less labour. When then income effect is larger than the substitution
effect, the individual will start supplying less labour in order to enjoy more leisure.
CHAPTER 6

1. We said that the production function tells us the maximum output that a firm
can produce with its quantities of inputs. Why do we include the word
maximum in this definition?
Because the total output could be some level beneath the maximum, in case of technical
efficiency.

2. Suppose a total product function has the “traditional shape” shown in figue
6.2. Sketch the shape of the corresponding labour requirements function
(with quantity of output on the horizontal axis and quantity of labour on the
vertical axis).

100 200 L

3. What is the difference between average product and marginal product? Can
you sketch a total product function such that the average and marginal
product functions coincide with each other?
The average product of labour is the average amount of output per unit of labour. On the
other hand, the marginal product of labour is the rate at which total output changes as the
quantity of labour the firm chooses is changed.
The only way the average and marginal production functions could coincide was in case
the marginal product of labour was constant. That, in which case dQ/dL would be constant,
and so would be the average product function. This case is not realistic, so we assume it is
not possible to sketch such function.
 4. What is the difference between diminishing total returns to an input and
diminishing marginal returns to an input? Can a total product function exhibit
diminishing marginal returns but not diminishing total returns?
In a situation of diminishing marginal returns to an input, total output increases with a
further unit, but at a decreasing rate. In a situation of diminishing total returns to an input,
the output actually diminishes if a further unit of input is added.

5. Why must an isoquant be downward sloping when both labour and capital
have positive marginal products?
Because, if marginal product for either input is positive, it is possible to substitute a
number of units of one of them for a number of units of the other while maintaining output
constant. Since along an isoquant line output is constant and it is the quantity of inputs that
changes, as long as the isoquant is downward sloping, both inputs have positive marginal
products.

6. Could the isoquants corresponding to two different levels of output ever

cross?
No, because if they crossed, it would mean they had the same level of output at a certain
point, but not on others. An isoquant maintains output quantities constant along its line.

7. Why would a firm that seeks to minimize its expenditure on inputs not want to
operate on an uneconomic portion of an isoquant?
Because, while operating on the uneconomic portion of the isoquant, a firm would be
operating in ar area where it would be using too many of one input to compensate for
excess of another input. The same firm, with the same production function, could produce
the same quantity with a lower quantity of the input in excess, reducing costs, if it worked
on the economic region of the isoquant.

8. What is the elasticity of substitution? What does it tell us?

The elasticity of substitution is a measure of how easy it is for a firm to substitute one input
for another. It is the result of dividing the percentage change in the inputs ratio by the
percentage change in the Marginal Rate of Technical Substitution.
It tells us about the firm's input substitution opportunities, measuring how quickly the
MRTS changes as we move along an isoquant. With this information we can, for example,
identify the shape of the production function.
 9. Suppose the production of electricity requires just two inputs, capital and
labour, and that the production function is Cobb-Douglas. Now consider the
isoquants corresponding to three levels of output: Q=100,000 kilowatt-hours,
Q?200,000 kilowatt-hours, and Q=400,000 kilowatt-hours. Sketch these
isoquants under three different assumptions about returns to scale: constant
returns to scale, increasing returns to scale and decreasing return to scale.
a) constant returns to scale (doubling the level of both inputs results in doubling the
output):

Capital

400 Q=400,000

200
Q=200,000

100
Q=100,000

100 200 400 Labour

b) diminishing returns to scale (doubling the level of both inputs results in less than double
outputs)

Capital

400
Q=200,000
Q=400,000

200

100
Q=100,000

100 200 400 Labour

c) increasing marginal returns (doubling the level of both inputs more than doubles the
level of output):

Capital

400 Q=400,000

200
Q=200,000

Q=100,000
100

100 200 400 Labour

CHAPTER VII

1. A biotechnology firm purchased an inventory of test tubes at a price of $0.50

per tube at some point in the past. It plans to use these tubes to clone snake
cells. Explain why the opportunity cost of using these test tubes might not
equal the price at which they were acquired.
The opportunity cost faced by a firm is the value of the best alternative forgone when
another alternative is chosen. The biotechnology has invested in the tubes, and that is an
sunk cost, so it does not count to calculate the opportunity cost. Because opportunity cost
is forward looking, the firm faces a decision whether to produce clone snake cells, or for
instance, sell or lease lease the tubes for a certain amount of money.
To decide on the course of action, the firm will calculate how much money it will receive
from the production of clone snake cells and compare it with the price it would get from
selling or leasing the tubes to, say, lease or sell the tubes to produce clone monkey cells. If
the opportunity cost from producing the clone snake cells is larger than the opportunity
cost of leasing or selling the tubes, it will lease or sell the tubes and not produce.

2. You decide to start a business that provides computer consulting for

students in your dormitory. What would be an example of an explicit cost you
would incur in operating your business? What would be an example of an
implicit cost you would incur in operating this business?
The explicit costs faced are all costs that involve a direct monetary outlay – tools,
computer, parts and publicity of the service. The implicit costs are all costs that do not
involve outlay of cash, like time and investment in knowing more about computers to be
able to perform the service.

3. Why does the “sunkness” and “unsunkness” of a cost depend on the

decision being made?
A sunk cost is a cost that has already been incurred, and thus cannot be recovered, while
an nonsunk cost is a cost that is incurred only if a particular decision is made. When
deciding to build a factory, the price of construction is a nonsunk cost, because the owner
can still decide whether or no to go ahead with it. However, after the plant has been built,
the cost becomes sunk and the decision is to keep the factory open or close it. So, the
same cost – building the factory – was nonsunk before, but becomes sunk after the plant
is built, and shouldn't impact on the decision of keeping it open or closing it.
 4. How does an increase in the price of an input affect the slope of an isocost
line?
The isocost line represents a set of combinations of inputs that yield the same cost for the
firm. As one of the inputs increases in price, and the cost of the other input stays the same,
the only way for the cost to remain constant is to decrease the quantity of the input whose
price increases, and increase the quantity of the input whose price stays the same. As a
result, the isocost line will have to tilt to accommodate these different quantities:

Capital

Labour

In this example, as the price of capital increases, the quantity is capital used is diminished
and the quantity of labour is increased. The blue isocost line depicts the first situation, the
red isocost line the final state.
In both cases, the slope of the line are given by the ratio of respective prices, -w/r.

5. Could the solution to the firm's cost-minimization problem ever occur off the
isoquant representing the required level of output?
No, it cannot. If the total inputs of the firm result in a point outside the isoquant line, the
production is technically inefficient, because it is using too much inputs for an output that
could be achieved with less.

6. Explain why, at an interior optimal solution to the firm's cost-minimization

problem, the additional output that the firm gets from a dollar spent on labor
equals the additional output from a dollar spent on capital. Why would this
condition not necessarily hold at a corner point optimal solution?
At an interior optimum, and as long as the amount of both inputs used is positive, the firm's
cost-minimizing solution is on the isoquant, at the point where that line is tangent to the
lowest possible isocost line. At that point, the slope of the isocost line equals the slope of
the isoquant, which in turn equals the marginal rate of technical substitution between
inputs.
We also know that the marginal rate of technical substitution equals the rate between the
Marginal product of the inputs, and the ration of input prices.
As a result, because the ration of marginal products of inputs equals the ratio of their
relative prices, substituting a dollar worth of one input (labour) for a dollar worth of the
other input (capital) results on output being the same.
In the case of corner solutions this does not apply. In these cases, the firm does not use
one of the inputs, relying solely on the other, because the rate between the marginal
product of one input and its price is always larger than the other, so there are always gains
from trading one for the other until the second is 0, not used.

7. What is the difference between the expansion path and the input demand
curve?
The expansion path is a line that connects the cost-minimizing input combinations as the
quantity of output varies. It traces the various optimal combinations of inputs for different
outputs.
The input demand curves are curves that show the demand for specific inputs of the
production function. They show how the cost-minimizing quantity of an input varies as its
price varies.

8. In Chapter 5 you learned that, under certain conditions, a good could be a

Giffen good: an increase in the price of the good could lead to an increase,
rather than a decrease, in the quantity demanded. In the theory of cost
minimization, however, we learned that, an increase in the price of an input
will never lead to an increase in the quantity of the input used. Explain why
there cannot be “Giffen inputs”.
If there was a Giffen input, we would see that, as its price would rise, so would the demand
for it. But, as a result, all things being equal, the firm would maintain the quantity of the
other input used ans the quantity of output produced, so would now be producing the
same but using more or a more product input. This would mean the firm would be
technically efficient, and as such there cannot be “Giffen goods”
 9. For a given quantity of output, under what conditions would the short-run
quantity demanded for a variable input (such as labour) equals the quantity
demanded in the long-run?
In the short run, a firm is not able to fully adjust its production to have the lowest possible
costs, whereas it can do it in the long run. As a result, the only situation where the short-
run quantity demanded for a variable input equals the quantity demanded in the long run is
when the company happens to get the quantity of that input it uses just right.
CHAPTER 8

1. What is the relationship between the solution to the firm's long-run cost-
minimization problem and the long-run total cost curve?
A long-run total cost curve shows how total cost varies with output, holding input prices
fixed and choosing all inputs to minimize cost. So, it represents the relationship between
output and minimized total cost. Consequently, the various points in the long-run total cost
curve are the cost-minimizing conditions for every quantity of output.

2. Explain why an increase in the price of an input typically causes an increase

in the long-run total cost of producing any particular level of outcome?
Of the company is in a cost-minimizing condition (as it is supposed to be, in the long-run),
increase in the cost of one of the inputs will prompt a tilt in the isocost line, so that the
marginal products of inputs are the same. Even considering that the other input's cost
stays the same, as long as the output is maintained constant as well, the total cost will
have to increase.

3. If the price of labour increases by 20 percent, but all other input prices remain
the same, would the long-run total cost of a particular output level go up by
more than 20 percent, less than 20 percent or exactly 20 percent? If the prices
of all inputs went up by 20 percent, would the long-run total cost curve go up
by more than 20 percent, less than 20 percent, or exactly 20 percent?
Maintaining output level constant, and the prices of other inputs fixed, a 20% increase in
the price of an input will result in a less than 20% increase in the long-run cost because
the optimal input combination will change towards more of the other inputs, until the
marginal product of all inputs is the same again, partially offsetting the 20% increase in the
cost of that input.
If all input's prices increase by 20%, to maintain the total output the total cost will have to
increase by 20%, because the input combination will be the same – the marginal product if
each input is the same.

4. How would an increase in the price of labour shift the long-run average cost
curve?
Considering all other input costs stayed the same, the increase in the price of labour would
make the long-run average cost curve shift up by less than the percentage increase in the
price of labour.

5. a) if the average cost curve is increasing, must the marginal cost curve lie
above the average cost curve? Why or why not?
Yes, it must. The average cost curve only starts increasing after the point where the
marginal cost curve intersects it.

b) if the marginal cost curve is increasing, must the marginal cost curve lie
above the average cost curve? Why or why not?
It can be either above or below the average cost curve. The marginal cost curve inflects
and starts increasing while below the average cost curve, intersects it while increasing and
goes on increasing while above the average cost curve.

6. Sketch the long-run marginal cost curve for the “flat-bottomed” long-run
average cost curve shown in Figure 8.11.

AC/MC

MC

AC

Q' Q'' Quantity

7. Could the output elasticity of total cost ever be negative?

The output elasticity of total cost is the percentage change in total cost per 1 percent
change in output. If it was ever negative, it would mean that, while producing more, the
company would have a smaller total cost. In this situation, the company wouldn't have
been in a technically efficient situation in the first place. So, the output elasticity of total
cost cannot be negative.
 8. Explain why the short-run marginal cost curve must intersect the average
variable cost curve at the minimum point of the average variable cost curve.
The short-run average cost curve is a vertical sum of the average variable cost and the
average fixed cost. Since the fixed cost is constant, its average will be diminishing as the
quantity increases, spreading the cost per more units. As a result, it is the average variable
cost that changes as the quantity increases, so it is the main determinant of the short-run
average cost curve. As a result, the short-run marginal cost curve will intersect it at the
minimum point, reflecting the same relationship between average and marginal curves as
seen in the long-run.

9. Suppose the graph of the average variable cost curve is flat. What shape
would the short-run marginal cost curve be? What shape would the short-run
average cost curve be?
The short-run marginal cost curve will be flat, and equal to the short-run average cost.
The short-run average cost curve will have the same shape as the short-run fixed cost
curve: downward sloping curve. Its distance of the average fixed curve will remain
constant, equal to the short-run average variable cost.

10. Suppose the minimum level of short-run average cost was the same for every
possible plant size. What would that tell you about the shapes of the long-run
average and long-run marginal cost curves?
In that situation, the short-run marginal cost curve would be straight, horizontal line, and so
would the long-run average and marginal cost curves, all with the same value of cost.

11. What is the difference between economies of scope and economies of scale?
Is it possible for a two-product firm to enjoy economies of scope but not
economies of scale? Is it possible for a firm to have economies of scale but
not economies if scope?
Economies of scale are a characteristic of a production function where the average cost
decreases as the output increases, so each unit is, in average, cheaper to produce the
more a producers produces of it. On the other hand, economies of scope are a production
situation where the total cost of producing two products in the same firm is less than the
total cost os producing them in two different single-product firms.
The former is about the average cost of a product, and arises from efficiencies in the
production process, while the later concerns the total cost of production of a batch of two
products, and results from the physical properties of products, specialization of labour or
the need to work with indivisible inputs. They exist up to the point where the marginal cost
equals the average cost. The later arise in situations where variety brings more advantage
than specialization, especially if a firm is available to use one common input for both
products.
As long as there are no managerial diseconomies and the firm in question is a cost-
minimizer, it will enjoy economies of scale in both products, although these might be
smaller that the economies of scale from just one product.
It is perfectly possible for a firm to have economies of scale but not economies of scope.
Any firm producing only one product and enjoying economies of scale will do so.

12. What is an experience curve? What is the difference between economies of

experience and economies of scale?
An experience curve translates the relationship between the average variable cost and the
cumulative production volume, used to transmit the notion of economies of experience.
This cost will be decreasing as more units of the product are produced.
There are two differences towards economies of scale: first, unlike economies of scale,
economies of experience do not have a “diseconomies of experience” area, in which the
average cost climbs again. In fact, these curves might reach a point where the slope is 0
and there is are no more gains from experience to be had, but it will never be a negative
slope.
The other difference is the root cause of economies of experience: these arise from
learning-by-doing, an accumulation of experience that results in the honing of processes,
while economies os scale arise from specialization of labour, physical properties of
processing units or the need to employ indivisible inputs.
CHAPTER 9

1. What is the difference between accounting profit and economic profit? How
could a firm earn positive accounting profit but negative economic profit?
The economic profit is the difference between a firm's sales revenue and the sum of all its
economic costs, including opportunity costs. The accounting profit is the difference
between the firm's sales revenue and the sum of (only) the accounting costs – the
historical explicit costs (money outlays).
Therefore, a fir can earn positive accounting profit is the sum of all its sales revenue is
larger than the explicit costs – if there's more money coming in than going out. However, it
is possible that, in that situation, the firm might have had a better use for the money than
the one it did, so it is incurring an opportunity cost by doing what it is doing, and as a result
obtain a negative economic profit.

2. Why is the marginal revenue of a perfectly competitive firm equal to the

market price?
The marginal revenue is the rate at which the total revenue changes with respect to
output. It gives us the price of producing one more unit.
Since the firm, in a perfectly competitive market, is a price taker, it takes P as given and
needs to decide on the Q to produce in order to maximize its profits. Because P is taken,
the marginal revenue equals the price in the market. A price taker, profit-maximizing firm
will operate at the point at which marginal revenue equals market price.

3. Would a perfectly competitive firm produce if price were less than the
minimum level of average variable cost? Would it produce if price were less
than the minimum level of short-run average cost?
A perfectly competitive firm, that faces all costs as sunk (TFC=SFC), will not produce
where the price in the market is less that the minimum level of average variable cost,
because in that situation not only would it have its total sunk costs, it would also lose the
difference between the price and the short-run marginal cost in each rose. In this situation,
the firm will face a smaller loss not producing than producing. Not producing, it only pays
the sunk, unavoidable costs, and avoids the variable costs
Yes, it will produce if price is less than the minimum level of the short-run average cost, as
long as it is above the minimum level of the average variable cost, because in that
situation the firm will have a smaller loss by producing than by not producing.
 4. What is the shut-down price when all fixed costs are sunk? What is the shut-
down price when all fixed costs are nonsunk?
When all costs are sunk, the shut-down price is the minimum of the average variable cost
curve. Below this quantity, the company does not produce, because it faces a larger loss
by producing than by shutting down.
If all fixed costs are nonsunk, the firm will be better off not producing if the market price is
smaller than its average nonsunk fixed costs. So, the shut-down price is the minimum of its
average nonsunk costs. Since all fixed costs are nonsunk (there are no sunk costs), The
firm will not produce of the price is below the minimum short-run average cost.

5. How does the price elasticity of supply affect changes in the short-run
equilibrium price that results from an exogenous shift in the market demand
curve?
An exogenous shift in the market supply curve will result in the quantity demanded being
changed from the initial state to the new equilibrium state.
The price elasticity of supply gives us the percentage change in quantity for each
percentage change in price, holding all other determinants of supply constant. The larger it
is, the larger the price increase will be for a determinate shift in the supply curve. The
supply curve will be steeper the larger the price elasticity of supply.

6. Consider two perfectly competitive industries – Industry 1 and Industry 2.

Each faces identical demand and cost conditions except the minimum
efficient scale output in Industry 1 is twice that of Industry 2. In a long-run
perfectly competitive equilibrium, which industry will have more firms?
In the long-run, firms can choose to enter or leave the market. Considering demand is the
same for both industries, in Industry 1, when all producers try to produce at least at the
minimum scale output, they will create excess supply and a consequent drop in prices. As
a result, the market price will drop, and for some producers it will be below their average
cost curve, forcing them to stop producing and leave the market.

7. What is economic rent? How does it differ from economic profit?

The economic rent is the economic return a firm gets from an extraordinarily productive
input whose supply is scarce. It is the difference between how much the firm is willing to
pay for the input and the return the owner of the input could by deploying it elsewhere in
the industry – the input owner's opportunity cost.
On the other hand, the economic profit is the difference between the firm's sales revenue
and the sum of all relevant economic costs it faces.
When deciding whether or not to deploy an extraordinarily productive input, the firm faces
an opportunity cost: it will increase productivity, but will also result in greater costs, and in
a perfectly competitive market the bidding for the special input might be such that it ends
up capturing part of the economic profit. When al the economic profit is captured by the
input, there is no economic rent to be won from employing the input.

8. What is the producer surplus for an individual firm? What is the producer
surplus for a market when the number of firms in the industry is fixed and
input prices do not vary as industry output changes? When in producer
surplus equal to economic profit (for either a firm or an industry)? When
producer surplus and economic profit are not equal, which is bigger?
The producer surplus is a measure of the monetary benefit that producers derive from
producing a good at a particular value. It is the difference between the price a producer
would be willing to sell its product at, and the price it actually gets.
For a single firm, the producer surplus is the difference between the total revenue and the
nonsunk costs.
For a market where the number of firms is fixed (short-run) and the input prices do not vary
as industry output changes (constant cost industry), the market-level producer surplus is
the difference between the total revenue of all firms in the market and their total nonsunk
costs: the are between the market supply line and the actual price in the market.
For either a firm or an industry, producer surplus equals economic profit when there are no
sunk costs. Indeed, the economic profit equals total revenue minus sunk costs. So, when
there are sunk costs, and so economic profit and producer surplus differ, producer surplus
is larger than economic profit. In the long-run, all costs are sunk, so economic profit and
producer surplus are always the same.

9. In the long-run equilibrium in an increasing-cost industry, each firm earns

zero economic profits. Yet there is a positive area between the long-run
industry supply curve and the long-run equilibrium price. What does this area
represent?
In the long run, economic profits equals zero, and producer surplus equals economic
profits, so they are zero. So, that area corresponds to economic profit captured by a form
that owns an extraordinarily productive input. As the price for this input is bid up, this are
will diminish.

10. Explain the difference between the following concepts: producer surplus,
economic profit, and economic rent.
The producer surplus gives a measure of the difference between the price the producer is
willing to sell the product at, and the price it actually achieves. In the short run, it is the
difference between total revenue and total nonsunk costs; on the long run, it is the
difference between total revenue and total costs, and equals 0.
Economic profit is the difference between a firm's total revenue and all its economic costs,
including relevant economic profits. It is always the difference between total revenue and
total cost, and in the long-run that difference will be 0.
The economic rent is the rent a firm captures by employing an extraordinarily productive
input. It is a competitive advantage over rival firms that do not enjoy the services of that
specific input. If the industry is constant-cost, this will be positive. However, if there is
intense bidding for the input, the industry will become increasing-cost, and eventually all
rent will be captured by the owner of the extraordinarily productive input.
CHAPTER 10
1. What is the significance of the “invisible hand” in a competitive market?
The significance of the “invisible hand” is that, left to its own volition, a perfectly
competitive market will result in maximum efficiency and social welfare. This is the market
that allocates resources the most efficiently.

2. What is the size of the deadweight loss in a competitive market with no

government intervention?
A perfectly competitive market, with no government intervention, does not have
deadweight losses. The deadweight loss is, therefore, 0.

3. What is meant by the incidence of a tax? How is the incidence of an excise

tax related to the elasticities of supply and demand in a market?
The incidence of a tax measures the impact of the tax on the price consumers pay versus
the price producers receive. It is a way to measure how much of the total amount of the tax
is brunt by both sides of the equation.
The higher the elasticity (of either supply or demand), the smaller the incidence of the
excise tax on the respective side (producers or consumers).

4. In the competitive market for hard liquor, the demand is relatively inelastic
and the supply is relatively elastic. Will the incidence of an excise tax of $T be
greater for consumers or producers?
Since demand is relatively inelastic and supply is relatively elastic, the incidence of the tax
for consumers will be relatively higher than for producers.

5. Gizmos are produced and sold in a competitive market. When there is no tax,
the equilibrium price is $100 per gizmo. The own-price elasticity of demand
for gizmos is known to be about -0.9 and the own-price elasticity of supply is
about 1.2. In commenting a proposed excise tax of $10 per gizmo, a
newspaper article states that “the tax will probably drive the price of gizmos
up by about $10.” Is this a reasonable conclusion?
No, it is not. Since the elasticities are close, the increase in price caused by the tax will be
spread between the consumers and the producers.

6. The cheese-making industry in Castoria is competitive, with an upward-

 sloping supply curve and a downward-sloping demand curve. The
government gives cheese producers a subsidy of $T for each kilogram of
cheese they make. Will consumer surplus increase? Will producer surplus
increase? Will there be a deadweight loss?
In the situation where, in a perfectly competitive market, government gives a subsidy, there
will always be increases in the consumer and in the producer surplus. However, there will
be a deadweight loss, resulting in loss of efficiency.

7. Will a price ceiling always increase consumer surplus? Will a price floor
always increase producer surplus?
Regarding consumer surplus, it might happen that the consumers with the highest
willingness to pay rent all available housing units. In that case, since they were willing to
pay for more than they actually do, the consumer surplus is maximum, and actually bigger
than without price ceilings. However, it might happen that not exactly the consumers with
the biggest consumer surplus get the houses, and in that case the consumer surplus is
smaller. It might even happen that only the consumers with the smallest of all willingness
to pay get the houses, and in that case consumer surplus is smaller than without rent
controls.
A similar situation happens regarding producer surplus. In the case it is the most efficient
producers that get to sell their product, a price floor will increase overall producer surplus.
However, as less efficient producers sell their product, the price floor is detrimental of
consumer surplus, and it might end up being less than without price floors in place.

8. Will a production quota in a competitive market always increase producer

surplus?
No, producer surplus may either increase or decrease with a quota. Because there is
excess supply, the size of producer surplus will depend on which of the producers actually
supplies the product. In case it's the least efficient suppliers, producer surplus will be
smaller with than without a quota.

9. Why are agricultural price support programs, such as acreage limitation and
government purchase programs, often very costly to implement?
Because they involve direct money payments to farmers, either to reduce production or to
buy a part of that production, and maintain the market price artificially low. However, this
money must be found somewhere else in the economy, taxing other activities, and (in the
case of government purchases), selling the excess product, although this might end up
decreasing the market price for the good, which is the contrary of what was intended with
the program.

10. If an import tariff and an import quota lead to the same price in a competitive
market, which one will lead to a larger domestic deadweight loss?
The deadweight loss is larger in the case of the import quota. With tariff, there will be
imports of product, simply at a larger price, while with the quota, these imports are
restricted beyond a specific value, possibly creating shortages in the market. Besides, the
tariff provides revenue for the government, which can be re-invested in the economy,
therefore leading to potentially some beneficial effects.

11. Why does a market clear when the government imposes an excise tax of $T
per unit?
The market clears because producers are allowed to produce as much as consumers are
willing to buy in the new, prevalent conditions. The effect is a shift in the demand line, so
the consumers are willing to buy more at prices before the tax than after the tax. However,
no shortages arise and the market clears.

12. Why does a market clear when the government gives producers a subsidy of
$T per unit?
The market clears because, with the subsidy, the consumers will be willing to buy a larger
quantity of the cheaper product, and producers are willing to supply it. Therefore, the only
effect is a shift in the demand line, with more product being available cheaply in the
market, and so the market is allowed to clear in a new equilibrium.

13. Why does the market not clear with a production quota?
When a production quota is put in place, the quantity supplied is limited, so some of the
demand will go unanswered. As a result, the market will not clear.

14. With a price floor, will the most efficient producers necessarily be the one
supplying the market?
Not necessarily. Every manufacturer whose marginal cost of production is smaller than the
price floor will be trying to supply the market, regardless of how smaller its marginal cost
is. The most efficient suppliers end up losing their competitive advantage.
CHAPTER 11

1. Why is the demand curve facing a monopolist the market demand curve?
Since the monopolist is the only seller in the market, and so can affect both the quantity
and the price in the market, the monopolist faces the market demand curve.

2. The marginal revenue for a perfectly competitive firm is equal to the market
price. Why is the marginal revenue for a monopolist less than the market
price for positive quantities of input?
Because the monopolist faces a downward-sloping demand curve, the decision to produce
a larger quantity of the product means it will gain in total revenue (more units) but will
slowly lose revenue, as more quantity is produce and the price drops. So, the marginal
revenue for a monopolist is the market price minus the loss of revenue dues to price drop
as production increases.

3. Why can a monopolist's marginal revenue be negative for some levels of

output? Why is marginal revenue negative when market demand is relatively
inelastic?
Since the marginal revenue for a monopolist is smaller than the market price, as quantity
increases, the revenue lost with each unit increases. Therefore, there may be a quantity at
which the loss per unit is larger than the market price, so the marginal revenue is may
become negative.
Since for a monopolist faces a downward-sloping curve, in the relatively inelastic region of
the demand curve, price will be lower than in the elastic region and the marginal revenue
will be negative.

4. Assume that the monopolist's marginal cost is positive at all levels of output.
a) True or False: when the monopolist operates on the inelastic region of the
market demand curve, it can always increase profit by producing less output.
True

b) True of False: when the monopolist operates on the elastic region of the
market demand curve, it can always increase profit by producing more
output.
True
 5. At the quantity of output at which the monopolist maximizes total profit, is the
monopolist's total revenue maximized? Explain.
Yes, it is. Because the demand curve (downward-sloping) is also the price curve and the
average revenue curve, the marginal revenue is a curve below it. At the profit maximizing
condition, the Marginal Revue equals 0, and if the company goes on producing a larger
quantity, the marginal revenue will be negative. Since total revenue is the area below the
marginal revenue line, it is maximized at the point at which marginal revenue equals 0.

6. What is IEPR? How does it relate to the monopolist's profit-maximizing

condition, MR=MC?
The IEPR is the Inverse Elasticity of Price Rule, which states that the difference between
the profit-maximizing price and marginal cost, expressed as a percentage of price, is equal
to minus the inverse price elasticity of demand.
It implies that the profit-maximizing monopolist, because it operates at MC=MR, will want
to operate in the elastic region of prices, because that is the only way the IEPR term (-
1/PED) will be positive.

7. Evaluate the following statement: Toyota faces competition from many other
firms in the world market for automobiles; therefore, Toyota cannot have
market power.
Toyota produces differentiated products from its competitors; automobiles are not perfectly
standard-among-producers commodities, do in the mind of consumers Toyota's products
are somehow different from their competitor's, and so they have less-than-perfect
substitutes. As a result, Toyota enjoys a modicum of market power, although probably not
so much as a monopolist would.

8. What rule does a multiplant monopolist use to allocate output among its
plants? Would a multiplant perfect competitor use the same rule?
If a monopolist uses more than one plant, it is normal that the marginal cost per unit
produced will differ among plants. In that situation, as long as the marginal costs per plant
differ, the monopolist will transfer production to the plant with the lowest marginal cost in
order to maximize profits. Therefore, the rule used by the multiplant monopolist is
MC(L)=MC(H) – production will de displaced along plants until the marginal costs are
equal in all plants.
A multiplant perfect competitor would use the same rule.
 9. Why does a monopoly equilibrium give rise to a deadweight loss?
Deadweight losses due to equilibrium arise because there is a quantity of output that the
monopolist chooses not to produce because the respective marginal cost would exceed
the marginal revenue. Production of these units would enhance social welfare but reduce
the monopolist's profit, so he chooses not to.

A S=MC

B C

D E

F D=P
MR

Perfect competition Monopoly Impact of Monopoly

Consumer surplus A+B+C A -B-C
Producer surplus D+E+F B+D+F B-E
Net economic benefit A+B+C+D+E+F A+B+D+F -C-E

So, the areas C+E represent the net welfare loss due to monopoly.

10. How does a monopsonist differ from a monopolist? Can a firm be both a
monopolist and a monopsonist?
A monopsonist differs from a monopolist in that it is the sole buyer and has many sellers,
while a monopolist is the sole seller and has many buyers.
The company can be both a monopolist and a monopsonist. For instance, it may be the
only buyer of work in an area, in order to produce a certain product, and then be the sole
producer and seller of that product to multiple buyers.
CHAPTER 17

1. What is the difference between a positive and a negative externality?

Describe an example of each.
An externality is the effect that an action has on the well-being of other consumers or
producers, beyond the effects transmitted by changes in prices.
A positive externality occurs when consumers or producers are helped without paying for
it. For instance, one might have a flu vaccine and therefore be less prone to catch flu and
to transmit it to others. The benefit others have from having a diminished possibility of
catching the flu is a positive externality.
A negative externality occurs when consumers or producers have costs or reduced
benefits due to someone else's action. One's CO2 emissions, for instance, cause climate
change and impose costs on everyone else.

2. Why does an otherwise competitive market with a negative externality

produce more output than would be economically efficient?
Since one part of the cost of an action is externalized, a profit-maximizing economic agent
will have incentive to overproduce, since his marginal cost is smaller than the real marginal
cost to society.

3. Why does an otherwise competitive market with a positive externality

produce less output than would be economically efficient?
Since the producer of the positive externality is not paid for the full benefit of his product,
and considering the fact that in a perfectly competitive market a producer will produce at
MC=MR, the marginal revenue does not translate the real economic benefit to society,
resulting in undersupply.

4. When do externalities require government intervention, and when is such

intervention unlikely to be necessary?
Externalities require government intervention in situations where property rights are not
conveniently assigned, or when

5. How might an emissions fee lead to an efficient level of output in a market

with a negative externality?
6. How might an emissions standard lead to an efficient level of output in a
market with a negative externality?

7. What is the Coase Theorem, and when is it likely to be helpful in leading a

market with externalities to provide the socially efficient level of output?

8. How does a nonrival good differ from a nonexclusive good?

9. What is a public good? How can one determine the optimal level of provision
of a public good?

10. Why does the free rider problem make it difficult or impossible for markets to
provide public good efficiently?