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Microeconomics 1 (University of New South Wales)

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Australian School of BusinessSchool of Economics

ECON1101MICROECONOMICS 1

TUTORIAL PROGRAM SEMESTER 1 2009


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TUTORIAL PROGRAMTUTORIALS BEGIN IN WEEK 1.

Students must attend only the tutorial in which they are officially enrolled. Attendanceat other tutorials will not be recorded. Failure to attend the correct tutorial may lead to

failure in the course.Each weekly tutorial consists of Problem Questions and Submission Questions. Thepurpose of these questions is to cover the core principles of a topic, provide somepractice in using the principles for economic analysis and to identify the style ofquestions to be used in the final exam paper.

Problem QuestionsThe Problem Questions consist of selected end –of- chapter problems and exercisesfrom the textbook, Frank, Jennings and Bernanke and other problem exercises. Youshould attempt each week’s set of questions before the tutorial. You should ask yourtutor to explain any that you had difficulty with. You can also address these questionsin PITSTOP or PASS or with your lecturer in their consultation hours.

The answers to each week’s tutorials will be posted on the subject website the weekafter the tutorial.

Submission QuestionsWeekly Submission Questions have been set for this course. In the first tutorial youwill be assigned one Submission Question. You can elect to talk about yourSubmission Question in the relevant tutorial and to use about 10-15 minutes of thetutorial time to talking about it and asking the whole class how they think it should beanswered. You can use the time to ask your tutor for guidance. Where two studentsare assigned the same question, the class discussion on the particular topic shouldtake no more than 15 minutes. When deciding whether to use the class time for yourquestions you should keep in mind that you can not seek help on the topic from the

lecturers, tutors, PITSTOP or PASS at a later date.You should type up your final answer in the form of a report of about 500 words.Where appropriate you should include diagrams. This report should be attached tothe signed Assignment Cover Sheet (SEE AT THE BACK OF THIS DOCUMENT)and given to your tutor in the following tutorial. This will be marked and returned toyou in the following tutorial. Make sure you fill in all the details.If the assignment is not received in the following tutorial it will receive a mark of zerounless a suitable medical certificate (or equivalent) is attached. In this case youshould notify the Course Administrator Thai Vinh [email protected]

Under no circumstances will reports be accepted via email.While only one or two students will be assigned a Submission Question each week,you should come to class prepared to participate in class discussion. Constructingpractice answers is the best preparation for the written questions in the final exam..Class Test Week 7 Tutorial 7 (Week commencing 27th April) A class tests will be conducted in Week 7. There will be no Submission Questions inthe tutorial that week although there will be a number of Problems assigned. The testwill last 45 minutes. Failure to attend will result in a zero mark unless absence iscovered by an acceptable medical certificate submitted to the tutor. Absences from these tests on grounds other than medical reasons will not beaccepted. EMPLOYMENT AND SPORTING OBLIGATIONS ARE NOT REASONS

FOR MISSING CLASS TESTS.


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TUTORIAL SCHEDULE

WEEK 1 TUTORIAL 1

In this tutorial, allocation of Submission Questions will be made, and your tutorwill explain the requirements for submission.

The tutor will also explain the aims of the Problem Questions and of theTutorial Program in general.


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WEEK 2 TUTORIAL 2

INTRODUCTION TO THE TUTORIAL PROGRAM

THINKING AS AN ECONOMIST

ReadingText: Ch 1Review Questions: 1, 2, 3, 4, 5, 6 and 7

Problems: 1, 2, 3, 4, 10, and 11

There is no Submission Question this week.


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WEEK 3 TUTORIAL 3

COMPARATIVE ADVANTAGE: THE BASIS FOR TRADE

Reading Text: Ch 2 and Ch 8 pp204-219

Problems: 1, 6, 7, 9, and 10

Submission Question 1

Utopia and Myopia can both produce cars and cotton under conditions ofconstant per unit costs. The opportunity cost of a car in Utopia is 50 units ofcotton. The opportunity cost of a car in Myopia is 300 units of cotton .The

most cotton Utopia can possibly produce is 100,000 units and the most cottonMyopia can produce is 300,000.

(a) Graph the production possibilities curve for each country.(b) If the two countries sign a trade agreement to specialize according to

their comparative advantage, what should each country produce?(c) If these are the only two countries in the world that are open to trade,

what are the maximum and minimum prices that can prevail to maketrade worthwhile on the world market for a bushel of wheat (in terms ofcars)?

(d) Discuss the limits to specialization.

See the course website for the weekly self assessment quiz.


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WEEK 5 TUTORIAL 5

ELASTICITYReading:Text: Ch 4

Review Questions: 1, and 2 Problems: 2, 4, 6, 7 and 10


Recently attention has been drawn to the increasing abuse of alcohol byteenagers in the form of binge drinking.The Rudd Government announced a 70 per cent increase in tax for pre-mixeddrinks, (coined the “alcopop” tax) saying a price hike in ready-to-drink spiritswould help curb teenage binge-drinking?

Assuming the tax raises the price of alcopop, use the demand and supplymodel

(a) To explain how the increase in price could lead to more money beingspent on alcopop by teenagers.

(b) If the demand for alcopop is elastic explain how the increase in pricecould lead to more alcohol being consumed by teenagers.

See the course website for the weekly self assessment quiz.

There is a Public Holiday on the Friday of this week (Friday April 10). If youclass is on Friday you should attend any other tutorial that week. You will bemarked as present on your roll.


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WEEK 6 TUTORIAL 6

DEMAND AND THE BENEFIT SIDE OF THE MARKET

ReadingText: Ch. 5 and Ch. 6

Submission Questions: 4 and 5Ch 5, Problems: 2, 3, 6, 7and 10Ch 6, Review Questions: 1, 4, 5 and 6. Problems: 2and 5


We observe that Stella buys 1 kilogram of chicken thigh fillets each week and2 kilograms of chicken wings each week. If the price of chicken thigh fillets

falls by 20% explain why we might observe that Stella buys more of bothchicken thigh fillets and chicken wings. (Use the rational spending rule andincome and substitution effects to explain your answer)


Kewell limited manufactures footballs from leather supplied to it by Cow HideCo. Each ball can be sold for $10. Kewell’s only costs are the wages ofmachinists and a building with a machine for sewing the balls.The number of balls it produces depends on the number of employee hours-per day as shown in the table below.

Number of balls per day Number of employee- hours perday

0 05 110 215 420 725 1130 16

35 22

(a) If the wage is $15 per hour and Kewell’s fixed cost for the machine andbuilding is $60, what is the profit maximising quantity of balls?

(b) What would the profit maximising number of balls be if the firm’s fixedcosts were not $60 but $30

(c) How would the profit maximising level of output be affected if thegovernment imposed a tax of $10 per day on the company

(d) What would the profit maximising level of output be if the governmentimposed a tax of $2 per ball?

(e) Why do these two taxes have such different effects?

See the course website for the weekly self assessment qu iz.


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WEEK 7 TUTORIAL 7

EFFICIENCY AND EXCHANGE

Reading:Text: Ch 7Ch 7 Problems: 1, 2, 5, 8 and 9 Answers for this week’s tutorials will be put up the week before the class.

Tutorial Test material from Lectures 1-6 inclusive (Tutorials 1-6)

There will be no submission Questions this week.

A class test will be conducted in tutorials and will cover the materials inTutorials 1 to 6. It will be worth 20 per cent of total marks for the course andwill include multiple choice questions and short answer questions to becompleted in 45 minutes. The purpose of this assessment is to test yourknowledge of core concepts and principles and your ability to use economicreasoning to make deductions and to perform simple calculationsYou must attend the tutorial in which you are officially enrolled. If you attendany other tutorial your paper will not be marked.If you do not attend the test and do not have adequate reason for yourabsence you will be awarded a mark of zero. Documentary evidence for anabsence (e.g. medical certificate or equivalent) must be provided to theLecturer-in-charge. If approved, you will have your final mark re-weightedaccording to the weight of the missed piece of assessment. There will be nosupplementary exam for this component of the evaluation.


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WEEK 8 TUTORIAL 8

PROFIT AND THE INVISIBLE HANDReading

Text: Ch. 9

Ch 7 Problems continued from last week

Ch 9 Problems: 1, 4, 5, 8 and 9

Submission Questions 6 and 7


(a) Write down the equations for the demand and supply curves for “fast

food” shown in the graph below.(b) Calculate the daily producer and consumer surplus for the market for

pizza whose demand and supply curves are shown in the graph.(c) Assume that Mr Rudd bans the advertising of pizza on TV and the daily

demand for pizzas is reduced by 50%. Draw the new demand andsupply curve and calculate the reduction in producer consumer surplus.

(d) Assume that instead of banning advertising the government places a$0.50 tax on the production of “fast food” What is the new producer andconsumer surplus.

(e) What can you conclude about the relative effects of these two differentpolicies?

Supply

Demand

6

Price ($ per piece)12

0 24 48 Quantity (1000’s pieces per day)


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Aaron is a skilled graphic designer who voluntarily leaves his job where hewas earning $25,000 per annum, in order to set up and run his own printingbusinessHe uses his savings of $20,000 to help buy $50,000 worth of equipment andborrows a further $30,000 from the bank at an interest rate of %10 per annum After one year of operation the equipment has a written down value of$49,000His operating costs are: $7,000His revenue is $37,000 per annum.What is his?

(a) Economic profit.(b) Accounting profit.(c) Should he remain in business?

What would his revenue have to reach for him to make a normal profit?



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WEEK 9 TUTORIAL 9

MONOPOLY AND OTHER FORMS OF IMPERFECT COMPETITION

Reading:Text: Ch10Review Questions: 4 and 5Problems: 1, 2, 3, 4, 6, 8 and 9


Assume that a market was served by an industry which was perfectly competitive whenone of the firms was able to gain exclusive control of an essential input so that all of theother businesses closed down leaving the owner of the raw material as the sole supplierin the industry. Assume that there is no change in the demand for the product and that all the costs of

production remain the same.(a) Use the demand and supply model to show if there is likely to be any significantinefficiencies in production and allocation of the economies resources when thereis only a single firm supplying the industry.

(b) Are there any circumstances when the single firm can lead to and efficientallocation of resources? Give reasons for your answer.



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WEEK 10 TUTORIAL 10

THINKING STRATEGICALLYReadingText: Ch 11

Ch 11 Problems: 1, 2, 3, 5, 7, 8,and 9


Suppose there is a market for rock salt served by only two firms, Sea and Sol. Each firmcan mine salt, free of charge, from mines located on its own land. Customers supplytheir own containers. Rather than compete with one another the two firms decide tocollude by selling salt at the price a profit maximising monopolists would charge. Eachfirm would sell half the quantity of salt demanded by the market at the monopoly price.Figure 1 shows the price and quantity which would maximise profits for a monopolist.

As the two firms are operating as a cartel, each firm has the option of charging less thanthe agreed price. If one firm sell for less than the agreed price it will capture the entirequantity demanded by the market at that lower price.a) Model this cartel agreement as a game. With the two available strategies being, “sell

at price $3.00 per bottle” and “sell at price $2.70 per bottle”b) Construct the pay-off matrix showing each firms profit under each different strategy.c) Assuming the game can be modelled as a single competitive game, if there is a Nash

equilibrium what is it?d) Explain whether this situation provides an incentive for collusion?If there is a collusive equilibrium is it likely to last? Give reasons for your answer.


Price$

3,000 6,000 Kilos per day

6.00

3.00

D

MR


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WEEK 11 TUTORIAL 11

EXTERNALITIES, COMMON RESOURCES AND PROPERTY RIGHTS

ReadingText: Ch 12

Ch 12 Problems: 2, 3, 4, 5, 6 and 8


A leather tanning factory located on the bank of a river uses water at no cost from theriver to process its leather and then releases the untreated water downstream whichthen runs into a lake. An oyster farming industry uses the lake to raise oysters. Assume that the answer can be represented in the competitive market model

a) Use the supply and demand model to explain why too much leather will beproduced to achieve efficient resource allocation.b) Explain whether there a market based solution to this externality? Use your

model to illustrate and give reasons for your answer.c) What might the government do correct the inefficiency of the market?


What is meant by the term the “tragedy of the commons”? Explain how by turningcommon property into private property the overuse of common property can be avoided.

Give an example to illustrate your answer.



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WEEK 12 TUTORIAL 12

PUBLIC GOODS AND THEIR FINANCINGECONOMICS OF INFORMATION

PRE EXAM REVIEW

ReadingText: Ch 13 and Ch 14

There are no submission Questions this weekCh 13 Problems: 1, 2, 5, 6, 7 and 9Ch14: Problems: 1, 2, 5, 6 and 7Course Review.



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Assignment Cover SheetEcon1101 Microeconomics 1

Student’s Name Tutors’ Name

Question Number Tutorial Number/timeDate of Submission:I declare that this assessment item is my own work except where acknowledged.I have read and understood the University rules with regard to plagiarism and academicmisconduct as set out in the Course Outline.

Student’s Signature:___________________________

CRITERIA Excellent Very Good Satisfactory Unsatisfactory

Structure: clear and well organised

Discussion of background information

Identification of relevant economic

theories

Application of the appropriateeconomic theories and information

Use of diagrams where required

Overall: was the question answered?

Length: kept within word limit

Marker’s Comments: Mark out of 15


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WEEK 2 TUTORIAL 2

INTRODUCTION TO THE TUTORIAL PROGRAM

THINKING AS AN ECONOMIST

ReadingText: Ch 1

Review Questions: 1, 2, 3, 4, 5, 6 and 7

They probably mean that, given the competing demands on their limited resources,there are other things (a holiday, private school fees, a new computer) that theychoose to spend their income on rather than a plasma screen television.

2 Your friend probably means that your tennis game will improve faster if youtake individual lessons instead of group lessons. However, individual lessons

are also more costly than group lessons, so those people who are less concernedabout how rapidly they improve may do better to take group lessons and spendwhat they save on other things that they value more.

3 False. The size of your monthly electricity bill should not matter in this case,assuming ceteris paribus. For the same effort, a $10 saving on your monthly billshould be equally attractive in both cases. The fact that a $10 saving will be alarger percentage saving on a small bill than on a large one is irrelevant. As therules of rational decision making suggest, it is absolute changes in costs and

benefits that matter, not proportional changes.

4 Because the price of a movie ticket is a cost the patron must pay explicitly, ittends to be more noticeable than the money that she would fail to earn by seeingthe movie. As Sherlock Holmes recognised, it’s easier to notice that a dog has

barked than that it has failed to bark.

5 You are wrong to suggest that the album cost you nothing. The astute economicthinker would know to ask the question ‘What would I otherwise have donewith the gift voucher?’ If the answer to this question was to let it expire unused,then you would be correct in treating the Black Eyed Peas album as free. It is,however, more likely that you would have used the voucher to buy some otheralbum. If so, the opportunity cost of the Black Eyed Peas album is yourreservation price for the album that you would have otherwise purchased.

6 If your tuition payment is non-refundable, it is a sunk cost. If the payment isrefundable until a certain date, it is not a sunk cost before that date but becomesone after it.

7 It is impossible to determine whether you should increase the number of timesyou visit the gym each week based on the information provided. While weknow the marginal cost of an additional visit to the gym each week ($15), weknow only the average benefit of gym visits at the current number of visits ($30

per week). Sound economic thinking requires that we compare marginal benefits and marginal costs when deciding whether to increase the number ofgym visits.


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Problems: 1, 2, 3, 4, 10, 11

1. The economic surplus from washing your dirty car is the benefit you receivefrom doing so ($6.00) minus your cost of doing the job ($3.50); that is, $2.50.

2. The benefit of adding an extra bag of compost is the extra revenue you will getfrom the extra tomatoes that result. The cost of adding a bag of compost is $5.Adding the fourth bag of compost will result in two extra kilos of tomatoes, or$6 in extra revenue, which more than covers the $5 cost of the extra bag ofcompost. However, adding the fifth bag of compost gives only one extra kiloof tomatoes, so the corresponding revenue increase ($3) is less than the cost ofthe compost. The cost-benefit principle suggests that you should add four bagsof compost and no more.

3. A 2 per cent saving on a $100 000 bills is $2000. A 15 per cent saving on a$10 000 bills is $1500. For the same investment the café’s owner should

prefer the 2 per cent saving on $100 000 rather than the 15 percent saving on

$10 000. The rules of sound economic thinking suggest that it is the absolutechange in the value of costs and benefits that matter, not the proportionalchange

4. Lucy’s statement reflects one of the pitfalls of economic thinking: namely,failing to account for all opportunity costs. Lucy must ask herself, ‘Whatwould I otherwise be doing if I didn’t work in my own business?’ The value ofthe opportunity that she is foregoing is an implicit cost of doing business andshould be included when assessing the profitability of Lucy’s business.

10. According to the cost-benefit criterion, the two women should make the samedecision. After all, the benefit of seeing the play is the same in both cases, andthe cost of seeing the play — at the moment each must decide — is exactly$10. Many people seem to feel that in the case of the lost ticket, the cost ofseeing the play is not $10 but $20, the price of two tickets. In terms of thefinancial consequences, however, the loss of a ticket is clearly no differentfrom the loss of a $10 bill. In each case, the question is whether seeing the

play is worth spending $10. If it is, you should see it; otherwise not.Whichever the answer, it must be the same in both cases.

11. Since you have already bought your ticket, the $30 you spent on it is a sunkcost. It is money you cannot recover, whether or not you go to the game. Indeciding whether to see the game, then, you should compare the benefit ofseeing the game (as measured by the largest dollar amount you would bewilling to pay to see it) only to those additional costs you must incur to see thegame (the opportunity cost of your time and whatever cost you assign todriving through the hailstorm). However, you should not include the cost ofyour ticket; that is $30 you will never see again, whether you go to the gameor not.

Joe, too, must weigh the opportunity cost of his time and the hassle of the

drive in deciding whether to attend the game. But he must also weigh the $25he will have to spend for his ticket. At the moment of deciding, therefore, the


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remaining costs Joe must incur to see the game is $25 higher than theremaining costs for you. And since you both have identical tastes — that is,since your respective benefits from attending the game are exactly the same —Joe should be less likely to make the trip. You might think the cost of seeingthe game is higher for you, since your ticket cost $30, whereas Joe’s will cost

only $25. But at the moment of deciding whether to make the drive, the $25 isa relevant cost for Joe, whereas your $30 is a sunk cost — and hence anirrelevant cost for you.


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WEEK 3 TUTORIAL 3

COMPARATIVE ADVANTAGE: THE BASIS FOR TRADE

Reading Text: Ch 2, and Ch 8 (pp204-210 Ch 2 Problems: 1, 6, 7, 9, 10 Ch 8; Review Questions 1, and 4Problems: 2 and 3

Problems

1 In the time it takes Ted to wash a car he can wax one-third of a car. Thus, the

opportunity cost to Ted of washing one car is one-third of a wax job. In the time

it takes Dan to wash a car, he can wax one-half of a car; the opportunity cost to

Dan of washing one car is one-half of a wax job. Because Ted’s opportunity

cost of washing a car is lower than Dan’s, Ted has a comparative advantage in

washing cars.

6 Point a is unattainable. Point b is efficient and attainable. Point c is attainable

but inefficient.

0

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Dresses

per day

Loaves of bread

per day

a

bc

3216 24

28

16

18

7. The new machine doubles the value of the vertical intercept of Helen’s PPC, but

leaves the horizontal intercept unchanged.


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0

32

64

Dresses

per day

Loaves of bread

per day

64

9. The upward rotation of Helen’s PPC means that, for the first time, she is nowable to produce at any of the points in the shaded region. Not only has her

menu of opportunity increased with respect to dresses, but it has increased

with respect to bread as well.

10 a The maximum possible coffee output is 36 kilos per day (12 from Peng,

24 from Jara).

b Their maximum possible output of nuts is also 36 kilos per day (12 from

Jara, 24 from Peng).

c Peng should be sent to pick nuts, since his opportunity cost (half a kilo of

coffee per kilo of nuts) is lower than Jara’s (two kilos of coffee per kilo of

nuts). Since it would take Peng only one hour to pick four kilos of nuts, he

can still pick 10 kilos of coffee in his five working hours that remain.

Added to Jara’s 24 kilos, they will have a total of 34 kilos of coffee per

day.

d Jara should be sent to pick coffee, since her opportunity cost (half a kilo

of nuts per kilo of coffee) is lower than Peng’s (two kilos of nuts per kiloof coffee). It will take Jara two hours to pick eight kilos of coffee, which

means that she can still pick eight kilos of nuts, giving a total between

them of 32 kilos per day of nuts.

e To pick 26 kilos of nuts per day, Peng should work full time picking nuts

(24 kilos per day) and Jara should spend one hour per day picking nuts

(two kilos per day). Jara would still have five hours available to devote to

coffee picking, so she can pick 20 kilos of coffee per day.


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Ch 8 Review Questions

1 The figure below shows the PPC for a four-worker economy. Point A, the

vertical intercept, shows the maximum number of hot dogs the economy can

produce (with all four workers producing only hot dogs). Similarly, point B, the

horizontal intercept, shows the maximum number of hamburgers that can be

produced. In the region AC, only the worker with the greatest comparative

advantage in producing hamburgers is making hamburgers; the slope of that

segment reflects that worker’s opportunity cost, in terms of hot dogs forgone per

hamburger produced. In region CD, the first worker is producing only

hamburgers and the worker with the second greatest comparative advantage has

also begun to produce hamburgers. The slope in region CD equals the

opportunity cost of hamburgers of the second worker. Similarly, the slope of DE

measures the opportunity cost of hamburgers of the worker with the third

greatest comparative advantage in hamburgers, and the slope of EB reflects the

opportunity cost of the worker with the greatest opportunity cost of producing

hamburgers.

4 False. Even though a country may have an absolute advantage in every sector,

there are likely to be sectors in which the neighbouring country has a

comparative advantage, that is, in which the neighbouring country is relatively

more efficient (that is, relatively less inefficient than the first country). If the

home country exports goods in which it has a comparative advantage, and

imports goods in which its neighbour has a comparative advantage, its

consumption possibilities will be improved.


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Ch 8 Problems

2 a Suppose the PPC is drawn with coffee on the vertical axis and computers

on the horizontal axis (see figure below). Carlos and Maria can produce

between them 250 kilos of coffee per week, or 12 500 kilos per year. So12 500 is the vertical intercept of the PPC (point A). Similarly, if Carlos

and Maria produce only computers, they can produce 2 computers per

week or 100 computers per year (point B).

Opportunity costs are –100 kilos coffee/computer for Carlos and –150

kilos coffee/computer for Maria, so Carlos has the lower opportunity cost

of producing computers. Thus, starting from point A where the economy

is producing only coffee, Carlos will be the first worker to produce

computers. The slope of the PPC starting at point A equals Carlos’s

opportunity cost (–100 kilos coffee/computer). At the point where Carlos

has just reached his limit in computer production (point C), the economy

is producing 50 computers (by Carlos) and 7500 kilos of coffee (by

Maria). Beyond point C, Maria must produce computers if the economy is

to expand computer production further. The slope between point C and

point B reflects Maria’s opportunity cost of computers (–150 kilos per

computer). If both workers specialise according to their comparative

advantage, they will produce a total of 50 computers and 7500 kilos of

coffee (point C).

b The opportunity cost of a computer on the world market, –125 kilos per

computer, lies between the opportunity costs of Carlos and Maria.

Consumption possibilities are shown in the figure above by a straight line

with slope –125 kilos coffee per computer, which touches the PPC at

point C. Brazil should produce at point C and trade toward its desired

consumption combination. For example, if Brazil wants more computers,Maria’s coffee can be traded for computers at the rate of 125 kilos per


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computer. If all of Maria’s coffee is traded for computers, total computer

consumption in Brazil equals the 50 computers produced by Carlos at

point C plus the 7500/125 = 60 computers obtained in exchange for

Maria’s coffee, for a total of 110 computers. 110 computers is thus the

horizontal intercept of the consumption possibilities line. If Brazil wants

more coffee, Carlos’s computers should be traded abroad for coffee at therate 125 kilos per computer. If Brazil consumes only coffee, it will be able

to consume 7500 kilos produced by Maria at point C plus 50 × 125 = 6250

kilos obtained by trading Carlos’s computers for coffee, giving a total of

13 750 kilos (the vertical intercept of the consumption possibilities line).

We saw in part a that the maximum amount of coffee Brazil can consume

without trade is 12 500 kilos, and the maximum number of computers is

100. Thus trade enhances Brazil’s opportunities to consume both goods.

c If a computer can be purchased on the international market for 80 kilos of

coffee, both Carlos and Maria should specialise strictly in coffee, as bothhave an opportunity cost greater than 80 kilos of coffee per computer. The

figure below shows Brazil’s PPC (as derived in part a) and its

consumption possibilities (assuming 80 kilos of coffee trades for one

computer). Because Brazil has a comparative advantage in coffee even

when fully specialised in coffee, the maximum amount of coffee it can

consume is not increased by the opportunity to trade (the consumption

possibilities line intersects the PPC at point A below). However, Brazil

can now consume as many as 12 500/80 = 156.3 computers by trading all

its coffee for computers (point D below).


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b

3 Weekly production for the three workers is as follows:

Carlos Maria Pedro

Coffee (kilos) 100 150 140or

Computers (number) 1 1 1

Carlos’s opportunity cost of producing a computer is 100 kilos of coffee,

Maria’s is 150 kilos of coffee, and Pedro’s is 140 kilos of coffee. Thus Carlos

has the greatest comparative advantage (lowest opportunity cost) of producing

computers, Pedro has the next lowest opportunity cost, and Maria has the

highest opportunity cost.

a The PPC in the figure below has three rather than two segments. Let A

correspond to the vertical intercept, B to the horizontal intercept, and C

and D to the two ‘kink’ points.

If all three workers produce only coffee, they produce 390 kilos per

week, times 50 weeks, or 19 500 kilos per year (the vertical intercept,

point A). If all three workers produce only computers, they produce three

computers per week, times 50 weeks, or 150 computers (the horizontal

intercept, point B).


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The slopes of the three segments correspond to the opportunity costs of

the three workers in producing computers, starting with the lowest

opportunity cost (Carlos) as we read from left to right. The slope of

segment AC is –100 kilos/computer, Carlos’s opportunity cost; the slope

of segment CD is –140 kilos/computer, Pedro’s opportunity cost; and the

slope of segment DB is –150 kilos/computer, Maria’s opportunity cost.Thus the PPC has the typical bowed shape.

If the opportunity cost of a computer on the world market is 125 kilos of coffee,

Carlos should continue to produce computers, as his opportunity cost is

less than 125 kilos; but Pedro and Maria, whose opportunity costs exceed

125 kilos of coffee per computer, should produce only coffee.

If Brazil wishes to consume only computers, Pedro and Maria should

trade their 290 × 50 = 14 500 kilos of coffee production for computers,

receiving 14 500/125 = 116 computers in exchange. Together with 50

computers produced by Carlos, this gives Brazil a maximum computer

consumption of 166 computers, more than the 150 computers Brazilianscan consume in autarky (see part a). If Brazil wishes to consume only

coffee, Carlos should trade his fifty computers for 50 × 125 = 6250 kilos

of coffee. Together with the 14 500 kilos produced by Pedro and Maria,

this yields a maximum coffee consumption of 20 750 kilos of coffee,

compared to 19 500 kilos of coffee per year without trade.

c If a computer trades for 200 kilos of coffee, all three workers should

produce computers, since all have opportunity costs lower than 200 kilos

per computer. The maximum number of computers Brazil can consume

equals its maximum production of 150 computers (it doesn’t pay to

produce coffee to trade for computers). Thus, access to internationalmarkets will not increase the number of computers that Brazilians can


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consume. However, if the three workers want to consume only coffee,

they can trade their 150 computers for 200 × 150 = 30 000 kilos of coffee,

much more than the 19 500 kilos they can produce on their own.


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WEEK 4 TUTORIAL 4

SUPPLY AND DEMAND; AN INTRODUCTION

Reading

Text: Ch 3Review Questions: 3, 4

Problems: 1 to 11

Review Questions

3 When we interpret the demand curve from a horizontal perspective we start with price on the vertical axis and read the corresponding quantity demanded on thehorizontal axis. This is consistent with the demand curve telling us how much ofa good buyers want to purchase in a given period of time at various prices. Thedemand curve can also be interpreted in a second way, which is to start withquantity on the horizontal axis and then read the marginal buyer’s reservation

price on the vertical axis. This vertical perspective is consistent with the demandcurve showing marginal benefits and being used to measure the gains toconsumers of being able to participate in the market.

4 When price is below its equilibrium level the quantity that buyers want to purchase exceeds the quantity that sellers are willing to offer for sale. There isexcess demand or a shortage. Frustrated buyers will respond by bidding up thegood’s price which will, in turn, result in an increase in the quantity of the goodsupplied and a decrease in the quantity of the good demanded. If the price of thegood were prevented by regulations from rising, we would expect to seesymptoms of excess demand, such as queues and illegal trading of the good.

When price is above its equilibrium level, the quantity that buyers want to purchase falls short of the quantity that sellers are willing to offer for sale. Thereis excess supply or a surplus. Frustrated sellers will respond by lowering thegood’s price which will, in turn, result in a decrease in the quantity of the goodsupplied and an increase in the quantity of the good demanded. If the price ofthe good were prevented by law from falling, we would expect to see stockpilesor quantitative restrictions on output (quotas) emerging.

Problems

1 a Substitutes, since playing squash and playing tennis serve broadly thesame purpose.

b Complements, since DVDs and DVD players are always used together.

c Substitutes, since public schools and private schools are alternative providers of essentially the same good.

d Substitutes, since disposable nappies can be used in place of clothnappies.

2 The supply curve would shift to the:

a right. The discovery is a technological improvement. The improved

technique would enable more wheat to be produced with the same inputs.


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b left. Fertiliser is an input, and higher input prices mean that less wheatwill be supplied at each price.

c right. The drought relief makes farming relatively more profitable than before. Thus those who were employed in a job that was just a little betterthan being a wheat farmer would switch to wheat farming.

d left. Droughts reduce productivity and destroy crops.

3 a Demand curve shifts right: income has risen and overseas vacations are anormal good.

b Demand curve shifts left: the health scare causes preferences to shift awayfrom mobile phones.

c Demand curve shifts right: CD players and MP3 players are substitutes.

d Demand curve shifts left; the price of a complementary good has risen.

4 The supply of apples will fall as the cost of an input rises, leading to a leftward

shift in the supply curve for apples (S to S'). There will be no change in thedemand for apples. The result will be an increase in equilibrium price (P to P')and a fall in equilibrium quantity (Q to Q').

5 The demand for childcare will increase as the birth rate rises, leading to a

rightward shift in the demand curve for childcare (D to D'). No change in thesupply curve of childcare will occur. The result will be an increase in theequilibrium price of childcare (P to P') and an increase in the equilibriumquantity (Q to Q').


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6 Automobile insurance and automobiles are complements. An increase in thecost of car insurance will thus shift the demand curve for cars to the left. Therewill be no change in the supply of cars. The result will be a fall in theequilibrium price of cars (P to P') and a fall in the equilibrium number of carssold (Q to Q').

7 Compared with the rest of the year, more people want to stay in hotel roomsnear campus during graduation week. Thus the demand curve shifts to the rightduring these weeks. This implies a higher equilibrium price for hotel rooms(and, of course, a higher equilibrium quantity of rooms rented).


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8 The discovery of the cold-fighting property causes an increase in demand, asshown by a rightward shift in the demand curve for apples (D to D'); the funguscauses a decrease in supply, as shown by the leftward shift in the supply curve(S to S'). The equilibrium price of apples will rise (P to P'), but the equilibriumquantity may go either up (Case 1) or down (Case 2) depending on the relativemagnitude of the two effects.

9 An increase in the price of music downloads reduces demand as shown by aleftward shift of the demand curve for MP3 players (D to D'). When the price of

microchips (used in the production of MP3 players) falls, supply will increase,as shown by the rightward shift in the supply curve (S to S'). The equilibrium


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price of apples will fall (P to P'), but the equilibrium quantity may go eitherdown (Case 1) or up (Case 2) depending on the relative magnitude of the twoeffects.

10 Dear Minister of Health,

I would like to draw your attention to the likely consequences of the two policies that you have proposed as ways of promoting a higher level of exercise.As Figure 1 shows, a price ceiling on gym memberships will result in excessdemand and a loss of economic surplus in the market. Importantly, althoughgym memberships will be cheaper (P PC), fewer people will take out gym

memberships (Q Q').

Figure 1

Figure 2 shows the effects of your second policy: namely, a campaign educating people about the benefits of increased exercise. This campaign is intended toincrease the demand for gym memberships, as shown by the rightward shift in

the demand curve. Note that although the cost of a gym membership has


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increased (P P'), this policy will have the effect of increasing gymmemberships as intended (Q Q').

Figure 2

I draw your attention to these likely effects so that you can make an informeddecision about which policy is best, based on a comparison of the costs and

benefits of the two alternatives.

Regards,

An economic naturalist.

11 If this transaction takes place, the buyers’ surplus will be $200 and the sellers’surplus will be $100, giving a total surplus of $300. This economic surpluswould be cash that is ‘left on the table’ if the transaction did not take place. Inother words, this amount of surplus would remain unrealised due to the

potentially surplus-enhancing opportunity remaining unexploited.


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WEEK 5 TUTORIAL 5

ELASTICITY

Reading:Text: Ch 4

Review Question 1, 2,Problems 2, 4, 6, 7, 10

Review Questions

1 Price changes affect quantity demanded for two reasons: they alter theattractiveness of substitute goods and they alter the real value of consumers’income, or their purchasing power. These are called the substitution and theincome effects of a price change. The second effect grows larger as the share ofconsumers’ budgets spent on the good increases. For example, a 10 per centchange in the price of salt, a good on which most consumers spend very little,will have a small effect on the purchasing power of a consumer’s income. At theother extreme, a similar change in price for a good such as housing, whichcomprises a large part of most people’s income, will have a large effect on the

purchasing power of a consumer’s income. A consumer will find it worthwhileseeking ways of mitigating the effect of the increase in the price of housing, butnot salt.

2 Elasticity of demand at any point on the demand curve is the price–quantityratio at that point (P/Q) times the reciprocal of the slope of the demand curve(1/slope). The slope, and hence its reciprocal, is constant along a straight-linedemand curve, but the price–quantity ratio – and hence price elasticity of

demand – declines as we move down the curve.

Problems

2 a


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b Price elasticity of demand is calculated as (P/Q) (1/slope). When P = 3, Q = 9and (1/slope) is 3. So elasticity = (3/9)3 = 1.

c If the price increases from $3.00 to $4.00, revenue will fall from $27 000 to $24000.

d Using the same formula as in part b, elasticity = (2/12)3 = 0.5.e If the price increases from $2.00 to $3.00, revenue will rise from $24 000 to $27

000.

4 The price elasticity of a good generally increases with the number of substitutesit has. It is easier to substitute a Ford or Toyota for a Subaru than it is tosubstitute a bus ride, motorcycle or a skateboard for a car. Thus the marketdemand curve for cars is likely to be less elastic with respect to price than themarket demand curve for Subarus.

6 The cross-price elasticity is calculated as the

(percentage change in Qsalsa /percentage change in Pnacho chips) = –4/2 = –2.Since this cross elasticity is negative, the two goods are complements.

7 The expression for supply elasticity is (P/Q) (1/slope). Since the slope of this

supply curve over the price range $4 to $6 is ΔP/ΔQ = 2/3, the elasticity ofsupply at A is (4/9) (3/2) =2/3. Using the same formula, the elasticity at B is(6/12) (3/2) =3/4.

10 What government officials failed to take into account was that people don’tdemand electricity for its own sake, but rather as a means to accomplish other

ends, such as producing cooler air for their homes. By requiring people to buyair conditioners that were more efficient, the government effectively reduced the

price of buying cooler air. If the demand for cool air is sufficiently elastic withrespect to its price, people may buy so much more cool air that they end upusing more electricity. This example highlights the fact that government policiesmay have unintended consequences and that economists must be skilled inrecognising the way in which a knowledge of elasticity can be used to predictthe magnitude of the effect of changes in market conditions on market outcomes


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WEEK 6 TUTORIAL 6

DEMAND AND THE BENEFIT SIDE OF THE MARKET

Reading

Text: Ch. 5 and Ch. 6

Ch 5, Problems 2, 3, 6, 7, 10Ch 6, Review Questions: 1, 4, And 5, 6. Problems: 2, 5

Ch 5, Problems

2 Since the marginal cost of an additional morsel of food is zero, a rational personwill continue eating until the marginal benefit of the last morsel (its marginalutility) falls to zero.

3 Martha is currently receiving (75 utils/glass)/ ($2.50/glass) = 30 utils per dollar

from her last dollar spent on orange juice, but only (50 utils/cup)/ ($2.00 /cup) =25 utils per dollar from her last dollar spent on coffee. Since the two are notequal, she is not maximising her utility. She should spend more on orange juiceand less on coffee.

6 a Even at twice the original price, the marginal utility per dollar of the 20th

train trip may be higher than the corresponding ratio for any other good thatAnn might consume, in which case she would be perfectly rational not to alterthe number of trips she takes. After all, missing a trip would mean missing awhole day’s work.

b The higher price of train tickets makes Ann poorer. The income effect of the price increase is what leads to the reduction in the number of restaurant mealsshe eats.

7 Consumer surplus is the area of the shaded triangle:

(1/2) bh = (1/2) × (80 000 litres/year) × ($8/litre) = $320 000/year.


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10 a The market demand curve (right panel) is the horizontal summation ofthe two individual demand curves (left and centre panels). For example,when the price of a ticket is $24, the first consumer will not want to buyany tickets while the second consumer wants to buy 16 tickets.

b Total consumer surplus is the sum of the three shaded areas:

Area of small triangle:

(1/2) bh = (1/2)×

(16 tickets/yr)×

($12/ticket) = $96/yrArea of rectangle:

bh = (16 tickets/yr) × ($12/ticket) = $192/yr

Area of large triangle:

(1/2) bh = (64 tickets/yr) × ($12/ticket) = $768/yr

Total consumer surplus:

$96/yr + $192/yr + $768/yr = $1056/yr

24

96

tickets/yr

Price($/ticket)

48

36

Price($/ticket)

tickets/yr

144

tickets/yr

Price($/ticket)36

2424

12 12

16 16

12

80


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Ch 6,Review Questions: 1, 4, 5, 6Problems: 2, 5

Review Questions

1 The principle of increasing opportunity cost, also known as the low-hanging-fruit principle, says that the least costly options should be exploited first, withmore costly options taken up only after the least costly ones have beenexhausted. At low prices, only those with low opportunity costs of producing a

product would find it worthwhile to offer it for sale. As prices rise, others withhigher opportunity cost could profitably enter the market. This positiverelationship between a product’s price and the quantity supplied is shown by anupward-sloping supply curve.

4 Explaining economic concepts to someone else is a very effective way of

checking your own understanding. The law of diminishing returns refers to thefact that, when some factor is fixed, successive units of a variable factoreventually yield smaller and smaller increments in output. The flip side of this isthat increasing output will eventually require ever-larger increases in theamount of the variable factor. Adding more labour to a machine, or morefertiliser to a field, will both eventually result in diminishing returns.

5 The u-shape of the short-run AVC curve reflects the law of eventuallydiminishing returns. When the average productivity of the variable factor rises,AVC will fall. When average productivity of the variable factor falls, AVC willrise. AVC reaches its minimum and has its turning point at the level of output

where average returns to the variable factor begin to diminish. Since ATC atany level of output is the sum of AVC and AFC, the u-shape of ATC alsoreflects the law of diminishing returns. The AVC reaches a minimum at a levelof output that is less than the level of output where ATC reaches a minimum,since AFC declines as output gets larger.

6 False. An exception to the price equals marginal cost rule occurs when market price is so low that total revenue is less than variable cost, or price is less thanAVC, when price equals marginal cost. In this case, profit maximisationinvolves shutting down and producing nothing; the loss incurred is then equal tototal fixed costs alone.


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Problems

2 The marginal cost of each of the first six air conditioners produced each day isless than $120, but the marginal cost of the seventh air conditioner is $140. So

the company should produce six air conditioners per day to maximise its profit.

Air conditioners/day Total cost($/day)

Marginal cost($/air conditioner)

100

1 100

50

2 150

70

3 220

90

4 31095

5 405

105

6 510

140

7 650

150

8 800

5 The market supply curve (right) is the horizontal summation of the supplycurves of the individual market participants (left and centre).

Horizontal summation means holding price fixed and adding the correspondingquantities. For example, at a price of $4 per unit, a total of 2 + 2 = 4 units will

be supplied. If you want to derive the market supply curve algebraically, rewrite

each individual supply curve with quantity as the dependent variable and add.

6

3

P=2Q 1

4

P=2+Q2

1

4

2

6 6

4

22

4

4 722 1

P

Q

P

Q

P

Q1 2

S


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Pay careful attention to the region for which the supply curves don’t overlap(here, the region P2.

Expressed algebraically, the market supply curve is thus:

P = 2Q for P2


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WEEK 7 TUTORIAL 7

EFFICIENCY AND EXCHANGE

Reading:

Text: Ch 7 Ch 7 Problems: 1, 2, 5, 8 and 9 Answers for this week’s tutorials will be put up the week before the class.

Tutorial Test material from Lectures 1-6 inclusive (Tutorials 1-5)

There will be no submission Questions this week.

Ch 7 Problems: 1, 2, 5, 8, 9

1 a Consumer surplus is the triangular area between the demand curve and the

price line. Its area is equal to 0.5bh, where b is the base of the triangle andh is the height. In this example, the base is 6 units and the height is 1.5units, measured in dollars. Therefore, consumer surplus is:

0.5($1.50/unit)(6 units/week), or $4.50 per week.

b Producer surplus is the triangular area between the supply curve and the price line. Using the base-height formula, it is:

(0.5)($4.50/unit)(6 units/week), or $13.50 per week.

c The maximum weekly amount that consumers and producers togetherwould be willing to pay to trade in used DVDs is the sum of gains from

trading in used DVDs – namely, the total economic surplus generated perweek, which is $18 per week.

2 a At a price of $7.50, the quantity supplied per week equals 2 units. Thequantity demanded at this price is 18 per week, which implies a weeklyshortage of 16 used DVDs.

b The weekly economic surplus lost as a result of the price ceiling is thearea of the dark-shaded triangle in the diagram, or the sum of the areas ofthe two triangles ABC and ACD. Using the information given in thegraph, this amount is calculated as (0.5)(4)(1) + (0.5)(4)(3) = $8/week.

5 a The marginal cost curve for electric power in the town would look like this:

12

48

6

6 Quantity

Price

P=6+0.75Q

P=12-0.25Q

16

2

3

A

B

C

D

4


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b The city should charge 10 cents per unit since that is the marginal cost

when residents use at least 100 units/day, which they will if the citycharges 10 cents or less. It should charge 10 cents per unit to all users,even those who are receiving their power from the hydroelectric facility,since if those users were to cut their consumption, they would free uphydroelectric capacity, which could then be used to serve others who arecurrently receiving their power from the more costly steam generator.

8 At a price of $1 per litre, the island’s citizens will consume five million litres ofoil per year. The true marginal cost of oil for the nation is the international

price, which is $2 per litre. If citizens had been charged this price they would

have consumed only four million litres per year. The lost surplus fromconsuming the larger amount of oil is the cumulative difference between the costof the oil and the most they would have been willing to pay for it. This differenceis the area of the shaded triangle in the diagram, or $500 000 per year.

100

10

1 Units of power per day

Price (cents/unit)

Marginal cost of power


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9 a Each individual household’s demand curve is as shown in the diagram.

b With the subsidy, each family receives consumer surplus equal to the areaof triangle ADE. Without the subsidy, consumer surplus equals the area oftriangle ABC. The difference is the area BCED, which equals $4.50/year.

c The government’s oil subsidy per family is ($1/litre)(5 litres/year) = $5/year.The government could therefore cut each family’s taxes by $5/year by notsubsidising oil.

d The family’s net gain would be the $5 it saves in taxes minus the $4.50 itloses in consumer surplus from its heating oil purchases, or $0.50/year.

e The aggregate gain from the tax cut and the removal of the subsidy is$500 000 per year, the same as the loss in total consumer surplus thatresulted from the subsidy.


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WEEK 8 TUTORIAL 8

PROFIT AND THE INVISIBLE HANDReadingText Ch. 9

Ch 7 Problems continued from last week

Ch 9

Problem: 1,4,5 ,8,9

1 a False. The maxim tells us that there are no unexploited economic oppor-tunities when the market is in long-run equilibrium.

b False. Firms in long-run equilibrium have to make an accounting profit inorder to cover the opportunity cost of resources supplied by their owners.In long-run equilibrium they make a zero economic profit.

c True. These firms can earn economic profits until other firms adopt theirinnovations, as their costs will be lower than those of competitors yet their

product will command the same price.

d. False. As the innovations spread, the industry supply curve will shiftdown, causing the market price of the good to fall and eroding the short-term economic profit. Innovating firms will earn a zero economic profit inthe long-run.

4 a Jacobs will earn $600 000 per year. This is the normal salary for a designer($100 000) plus the economic rent ($500 000) that he collects for hisspecial talent. Five-sixths of his salary is economic rent.

b If Jacobs’s employer withholds some of the additional revenue it takes inas a result of hiring him, some other advertising company will offer him ahigher salary and still manage to earn an economic profit. Bidding forJacobs will continue until all firms are indifferent between paying him$600 000 and hiring any other designer for $100 000.

5 Assuming that all orchards initially earn zero economic profit, the innovationwill cause one orchardist’s costs to fall. The firm that owns the machine willmake an economic profit in the short run, because the market price of appleswill not change. As other firms adopt the innovation, they too will make aneconomic profit. This economic profit will attract new firms into the industry,and so the supply curve for apples will begin to shift to the right, causing themarket price of apples to fall. The decline in price will continue as more firmsenter, until there is no more economic profit to be made.

.

8 If you pay $ X for the orchard, the opportunity cost of your investment is(0.10)($ X )/year. The opportunity cost of your time is $100 000 per year. Thehighest value of X for which you would be willing to own and manage theorchard is the value that yields zero economic profit. To find that value, solve:

$250 000 – $100 000 – (.10)($ X ) = 0 X = $1 500 000.


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9 a The most Louisa would be willing to pay in experimental costs is $500 000.She could charge all 100 000 patrons $5 more, but only for one night.After the first night, other producers would figure out the recipe andcompete the price back down to $5 per plate.

b With a patent that lasts one year, Louisa would be willing to pay up to$182.5 million dollars ($500,000/day)(365 days/year). She could chargean additional $5 per meal each night of the year before the other producerscould copy her recipe.


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WEEK 9 TUTORIAL 9

MONOPOLY AND OTHER FORMS OF IMPERFECT COMPETITION

Reading:

Text Ch10Ch 10 Review Questions 4, 5

Problems: 1, 2, 3, 4, 6, 8, 9

Review Questions

4 Marginal revenue is the change in total revenue that occurs as a result of selling anextra unit of output. Given that it faces a downward-sloping demand curve, the single

price monopolist must cut price on all units in order to expand sales by a unit.Consequently, the resulting increase in total revenue will be less that the price. Sincethe perfectly competitive firm faces a perfectly elastic demand curve, they can sell anynumber of additional units at the market price. Hence, marginal revenue equals pricefor this firm.

5 False. It is true that the natural monopolist, like any other type of monopolist, sets priceabove marginal cost. However, this does not guarantee the monopolist a positiveeconomic profit. At the level of output where marginal cost equals marginal revenue,average total cost may exceed, be equal to or be less than price. If average total costexceeds price the monopolist will experience an economic loss.

Problems

1 As shown in the following table, Volvo’s greater production volume gives it

substantially lower average production cost, and this advantage helps explain whyVolvo’s market share has in fact been growing relative to Saab’s.

Saab Volvo

Annual production 50 000 200 000

Fixed cost ($) 1 000 000 000 1 000 000 000

Variable cost ($) 500 000 000 2 000 000 000

Total cost ($) 1 500 000 000 3 000 000 000

Average cost per car ($) 30 000 15 000

2 a True. The market demand curve slopes downward in both cases, reflectingthe law of demand. However, from the individual, perfectly competitive firm’s

point of view, the demand curve is horizontal. Because the individual firm is toosmall to affect the market price, it can sell as many units as it wishes at that price.Since the monopoly firm is the only seller of a particular good, the demand curveit faces is the downward sloping market demand curve.

b True. A firm that sells its good in a perfectly competitive market is a price-taker.If the firm tries to charge a higher price it will lose all its business; if it charges alower price, it will not be maximising profit.


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c True. Declining average total cost as output increases is an essential feature ofnatural monopoly. In many cases this may reflect very high first-copy costs andlow marginal costs.

3 The answer is c. The monopolist chooses the output level at which marginal revenueequals marginal cost and then charges a price consistent with demand at that level ofoutput. Since price always exceeds marginal revenue, price is greater than marginalcost. There is no shortage; at the output chosen, demand and supply coincide, and themonopolist has no reason to maximise marginal revenue (which would require

producing zero units of output).

4 The answer is a. The demand curve and the marginal revenue curve would coincide, because the monopolist would sell each successive unit of output at exactly itsreservation price, so that unit would generate revenue identical to the reservation price.The final unit of output would be sold at a price equal to marginal cost, so e is notcorrect: the outcome would be socially efficient. Because two or more consumers mighthave the same reservation price, c is wrong.

6 The socially desirable price to charge is the one at which the marginal benefit toconsumers equals the marginal cost of production. However, natural monopolies areoften characterised by very large, indivisible first-copy costs and relatively lowmarginal costs. The high first-copy costs mean that average cost is greater thanmarginal cost, so that charging a price equal to marginal cost implies economic losses.An example is the London Underground, which incurred huge costs constructingtunnels, laying railway line, building stations and acquiring rolling stock. However, thistransport system incurs virtually no additional cost when an additional passenger travelsfrom Heathrow airport to Trafalgar Square. Charging a price equal to the marginal costwould thus fail to cover the average cost of a ride.

One way the London Underground deals with this problem is by offering a railcardthat entitles customers to unlimited travel within a certain period. With this card, themarginal cost to the consumer of an additional journey is zero.

8 a Using the fact that the single- price monopolist’s marginal revenue curvehas the same vertical intercept and is twice as steep as the demand curve, themarginal revenue curves are:

MR = 12 – 4Q MR = 8 – 6Q

and MR = 10 – 8Q, respectively.

b The cinema should profit-maximise by setting marginal revenue equal tomarginal cost in each sub-market, and then set the price as shown by the demandcurve. In the first market, Q is found by solving the expression:

2 = 12 – 4Q Q = 250 tickets.

Substituting this value into the demand curve gives P = 12 – (2)(2.5) = $7 perticket. The profit-maximising quantity in the other two markets is 100 tickets in

both cases. The corresponding prices on Sunday afternoons are $5 for childrenand $6 for adults.

9 a, b and c. Using the fact that the single- price monopolist’s marginal revenue

curve has the same vertical intercept and is twice as steep as the demand curve, MR = 80 – Q. The profit-maximising quantity is where MR = MC , or 80 – Q* =


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Q*. So Q* = 40 games. The price set by the firm will be the maximum price thatcan be charged in this market for 40 copies of the game, and is given by thedemand curve. It follows that when Q* = 40, P* = 80 – (40)/2 = $60 per game.

d Profit = total revenue – total cost. Total revenue is calculated as price timesquantity which is = (60)(40) = $2400. Total cost is the sum of fixed costs ($400)and variable costs, which in this case is calculated as the sum of marginal costsfor each of the 40 units produced. This is shown on the graph as the area underthe MC curve up to Q = 40, or (40)(40)/2 = $800. Profit therefore is 2400 – 400 – 800 = $1200 per period.

e Consumer surplus (CS) is shown graphically as the area under the demand curveand above the price line up to Q = 40. This is calculated as (1/2)(40)(20) = $400

per period.


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WEEK 10 TUTORIAL 10

THINKING STRATEGICALLY

ReadingText: Ch 11

Ch 11 Problems: 1, 2, 3, 5, 7, 8 and 9

Problems1 a

All others

Sam

-5 for Sam

-5 for others

-6 for Sam

10 for others

10 for Sam

-6 for others

-1 for Sam

-1 for others

Study a lot

Study a little

Study a lot Study a little

b All study a lot and receive an average grade. From the students’ perspective, for everyone to study a little would have been better.

2 a No; the best choice for each player depends on what the other player does.

b The top-left and bottom-right cells are both potential equilibria, because ineach of those cells neither player has any incentive to change strategies.

c No; the payoffs do not follow the pattern associated with a prisoner’sdilemma, because neither player has a dominant strategy.

d A knows that if he has the first move and buys a ballet ticket, so will B, inwhich case A will get a payoff of 2. If A buys a football ticket, so will B,in which case A will get a payoff of 3. So A will buy a football ticket, andso will B.

e This time they will both attend the ballet.

3 The information is worth nothing to Blackadder, who knows that Baldrick’sdominant strategy is to confess, and who in any event has a dominant strategy ofhis own.

choose the top branch at B.


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5 a

Other driver attemptsto steal your spot

You protest

You defer

$10 for you

$0 for other driver

$10 - $30 = -$20 for you

-$30 for other driver

$0 for you

$10 for other driver

A

B

b The top branch at A is unattractive to the other driver. Since you get a

higher payoff on the bottom branch at B, and the other driver knows it, theequilibrium outcome is that he gets the space and you keep waiting.

c Suppose the other driver believed that you would experience a psychological cost of $30 not only if you got into a dispute, but also if you failed to protest his unjust behaviour. In that case, he would think the netcost of your becoming involved in an argument would be $0. This beliefwould change your payoff in the ‘protest’ scenario to $10, so that youwould protest, giving him a payoff of –$30. Thus he would no longer have

anything to gain from attempting to take your parking space.

7 a The players are you and your friend. Your strategy choices are heads or tails.The following matrix describe the payoffs, measured as the change in thenumber of pennies each player owns.

You

Heads Tails

Heads1 for you

–1 for you

friend

–1 for you1 for you

friendYour Friend

Tails –1 for you1 for you

friend

1 for you –1 for you

friend

b and c There are no dominant strategies and there is no equilibrium, because ifyour friend plays one side, you want to match that side. However, if youmatch, your friend will want to change strategies.


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8 a Harry and Sally are the players. Harry’s strategies involve his choice of K,the number of quarters he offers Sally (K=1, 2, 3 or 4); Sally’s strategiesare to accept or refuse Harry’s offer. The decision tree for this game is:

Harry proposes K quarters

for Sally, 4-K for himself (K=1, 2, 3, or 4)

Sally accepts

Sally refuses

($0.25)K for Sally

($0.25)(4-K) for Harry

$0 for Sally

$0 for Harry

A B

b At B on the decision tree, Sally’s payoff will be higher if she accepts, no

matter what K is. So her best choice is to accept. Knowing that Sally willaccept no matter what, Harry gets the highest payoff by choosing K = 1.Sally accepts his offer; Harry’s payoff is $0.75 and Sally’s is $0.25.

9 a The two possible equilibria are:

(1) Walkabout produces and Go-lightly does not

(2) Go-lightly produces and Walkabout does not.If the manufacturers found themselves in one of these two cells, neitherwould want change its strategy, because given that one company is

producing, the other will do better by not producing.

b

Go-lightly

Produce Don’t produce

Produce

20 for Go-lightly

–5 for

Walkabout

0 for Go-lightly

100 for

WalkaboutWalkabout

Don’t produce

125 for Go-lightly0 for

Walkabout

0 foreach

Because of the subsidy, producing is a dominant strategy for Go-lightly.Because Walkabout knows Go-lightly will produce, it will choose not to.

c Without the subsidy, either Walkabout or Go-lightly may produce, but wecannot determine which one (given that Walkabout and Go-lightly are

quite similar). The subsidy is a tool used by the New Zealand Governmentto ensure that Go-lightly is the one that will end up producing


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WEEK 11 TUTORIAL 11

EXTERNALITIES, COMMON RESOURCES AND PROPERTY RIGHTS

Reading

Text: Ch 12

Ch 12 Problems: 2, 3, 4, 5, 6 and 8

Problems

2 All parts. The socially optimal number of beehives could be greater or less thanthe privately optimal number, depending on the magnitude of the social marginalcost relative to the private marginal cost, as well as the magnitude of the socialmarginal benefit relative to the private marginal benefit. If the negativeexternality is negligible and the positive externality is large (see below right), thesocially optimal number of beehives (X*) exceeds the privately optimal number(X**). However, if the negative externality is large relative to the positiveexternality (see below left), the socially optimal number is smaller than the

privately optimal number.

Number of beehives

$/hive

Social MB

Private MB

Private MC

Social MC

X* X**

Number of beehives

$/hive

Social MB

Private MB

Private MC

Social MC

X*X**

3 The equilibrium quantity of surf ski rentals is found by solving the following:

5 + 0.1Q = 20 – 0.2Q for Q pvt = 50 units per day.

To find the socially optimal number of rentals we first find the Social MC curve by adding the $3 per unit noise cost to the Private MC curve:

Social MC = 8 + 0.1Q.

Equating Social MC to demand, we have 8 + 0.1Q = 20 – 0.2Q, which solvesfor Qsoc = 40 units per day, or 10 units less than the equilibrium number.

4 Imposition of this tax would shift the Private MC curve upward by $3 per unit,making it identical to the Social MC curve. The socially optimal number of surfskis would be rented, resulting in an overall increase in efficiency in thismarket.


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5 The most efficient outcome is for Jones to emit smoke, because the total dailysurplus in that case will be $600, compared to only $580 when Jones does notemit smoke. Since Smith has the right to insist that Jones emit no smoke, Joneswill have to compensate Smith for not exercising that right. If Jones pays Smith$30, each will be $10 better off than if Smith had forced Jones not to emitsmoke.

6 a Since Barton’s monthly payoff without soundproofing is $50 more thanwith it, his natural inclination is not to install soundproofing. Statlerwould have to pay Barton at least $50 to induce Barton to install it, butsince soundproofing is worth only $40 per month to Statler, Statler willnot do so. Since the joint payoff is $230 without soundproofing and $220with it, their choice is socially efficient.

b Barton will not install soundproofing. Instead, he will pay Statler $40 permonth to compensate for the noise damage. As in part a, this solution issocially efficient.

c No. The same result is obtained in both parts a and b.

8 The following table shows the total village income from grazing llamas,together with the marginal village income from the activity.

Number ofllamas on

thecommons

Price per 2-year-old

llama($)

Income perllama

($/year)

Total villageincome

($/year)

Marginalincome

($/year)

221 122 22 22

142 118 18 36

123 116 16 48

84 114 14 56

4

5 112 12 60 –6

6 109 9 54

a Three llamas will be sent onto the commons. The resulting net village incomewill be $48 from the llamas plus $45 from government bonds, or $93.

b The socially optimal number is only one llama. Villagers send threeinstead, because in deciding whether or not to send a llama, each villagerignores the impact of his or her llama’s presence on the other llamas’fleece quality. The total village income at the socially optimal number of

one llama is $22 from the llama and $75 from government bonds, or $97.


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c If a single villager could control access to the commons, she would sendonly a single llama, which she could sell after one year for $22 more thanshe paid for it. If the land were free, the owner would thus earn $22 peryear by raising one llama per year on it, or $7 more than she would haveearned had she used her $100 to buy a bond. The price of the land will be

bid up until owning the land is no better than putting the same amount inthe bank at 15 per cent interest. That price is the amount of money thatwould yield $7 per year if deposited at 15 per cent interest (0.15 X = $7),or X = $46.67. The new owner will graze one llama. Total village incomewill be the same as in part b.


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WEEK 12 TUTORIAL 12

PUBLIC GOODS AND THEIR FINANCING

ECONOMICS OF INFORMATION

PRE EXAM REVIEW

ReadingText Ch 13; Ch 14

Ch 13 Problems:1, 2, 5, 6, 7,and 9

Ch14: Problems: 1, 2, 5, 6and7

Problems Ch 13

1 a The most the guard can charge is $150, to be hired by Jill.

b The plan will not be approved because Jack will not vote for it. He wouldhave to pay a $60 tax for a service worth only $50 to him.

2 a A 1 per cent tax would imply that Jack pays $10 per month and Jill pays$110. Both Jack and Jill would vote for this tax.

b Suppose Jack pays the guard $ X and Jill pays him $Y . Then X and Y mustsatisfy the equations X + Y = 120 and 150 – Y = 50 – X . Solving, we get X = 10 and Y = 110, the same as in part a. Jill will agree to the scheme as shewould enjoy a net benefit of $150 – $110 = $40 per month.

c In order to implement the plan in part b, each party would have to reportthe most he or she would be willing to pay for the guard. The problem isthat Jack and Jill each have an incentive to understate that amount in thehope that the other has a higher willingness to pay and will therefore paymore of the total.

5 a, b To construct the demand curve, add the two demand curves vertically, asshown. The socially optimal quantity of broadcast opera on Saturdays occurswhere the marginal cost curve (MC) intersects the total demand curve (D inthe top panel). This occurs at three hours broadcast per Saturday. We get thesame result (Q = 3) using algebra by solving for P = MC, where P = 24 – 3Q

and MC = 15.

6 a The network will choose the programs that generate the most profit. Anepisode of The OC would attract an audience of 12 million viewers, whileone of Inspector Rex would attract only 8 million. Those audience sizeswould generate payments of $1.2 million and $800 000, respectively,from Colgate. Net of production costs, the network would thus earn $800000 for one episode of The OC , and only $400 000 for an Inspector Rex episode. The network would thus maximise its profit by filling one timeslot with The OC and the other with the weight-loss infomercial.


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b The economic surpluses from showing episodes of The OC and Inspector Rex are the areas under their respective demand curves – $48 million forThe OC , $64 million for Inspector Rex. Since both figures are far largerthan the surplus generated by the infomercial, the socially efficient resultwould be for the network to fill its two remaining slots with The OC and

Inspector Rex.

7 A pay TV network would set price at the point along its demand curve forwhich marginal revenue equals marginal cost. Since the marginal cost perviewer is zero, its profit-maximising price would be $8 per episode. Thenetwork would receive $32 million in revenue, and viewers would reapeconomic surplus of $16 million. In contrast, showing Inspector Rex free ofcharge on SBS would result in a viewer surplus of $64 million. Since

production costs of each episode would be the same under the twoarrangements, the total economic surplus per episode would be $16 millionlarger if broadcast on SBS than if shown on pay TV.

16

8

D

($/episode)

0

Masterpiece8

4MR

Q (millions of viewers/episode)

9 The answer is e. Although the incentive problem described in part c does exist

under the stated circumstances, it is not a cause of the free-rider problem.


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12

0

6

D

D

0

Smith

Jones

12

12

0

D

12

24

6

6

6

6

hours/Sat.

$/hr

$/hr

$/hr

hours/Sat.

hours/Sat.

3

15 MC

Problems Ch 14

1 a False. The information imparted by the expense of the advertisement, notthe message itself, is the more reliable signal of high quality. The

producer of a product who knew that consumers would be unlikely to buyits product a second time would gain little by spending millions to induce

them to try it.

b True. Because charging non-buyers for advice is often impractical, themarket generally provides less than the socially optimal amount of retailservice.

c

Documents

Tutorial Work 1 12