(If you find mistakes, please tell me. Robert Schenk, schenk@saintjoe.edu
1. a) Suppose there are 30 people in a room with the average age
of 40 years. A 15-year-old boy walks in and the average age of the
group becomes 40.5. Is this possible?
No. The average must
decrease.
b) A firm is producing 30 units of output at an average cost of
$40. Adding another unit will increase costs by $15 (this is the
marginal cost) and the average cost will rise to $40.5. Is this
possible?
No. The average must
decrease.
c) If average cost is falling, what must be true of marginal cost?
It lies below the average.
2. Use the following table for the next four questions:
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a) What is the marginal cost of the third unit of output?
($17.00-$13.00)=$4.00
b) What is the average cost of four units of output?
$22.50/4 = $5.625
c) What is profit or loss when output is 4?
$32.00-$22.50 = $9.50
d) Where are profits maximized?
At an output of 5. Until then marginal
mevenue exceeds marginal cost.
3. The table of the reading (reproduced below) showed a seller maximizing profit at three units of output. Suppose that the government puts a price ceiling of $15 on this seller.
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Output |
Total Cost |
Price |
Total Revenue |
Marginal Revenue |
Marginal Cost |
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a) Recompute the total revenue and marginal revenue columns of the table. (Hint: What is the highest price the seller can charge if it sells only one unit? If it sells six units? Be careful.)
b) What is the profit-maximizing level of output with the price
ceiling?
4 (without price controls, the profit
maximizing output was 3. The third one added $14 in revenue and $12
in cost. The fourth added $12 in revenue but $13 in cost, so was not
worth producing.)
c) Using supply and demand curves, we showed that price ceilings reduced output. However, the price ceiling in this problem is not reducing output. What is going on? (Hint: Check the section on supply and demand for assumptions on the number of buyers and sellers needed for supply and demand curves.)
In supply and demand, we assumed that there were many sellers, and no one seller had any effect on price. In jargon, was assumed sellers were price takers. Here the seller is not a price taker. If he sells more, he must lower price. With different assumptions, we get different results. Price controls make this seller act more like a price taker.
4. The table in the reading (reproduced below) illustrates two different ways to compute the profit-maximizing position for a firm. The profit-maximizing firm will hire four units of labor and produce 31 units of output.
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Marginal Revenue Product |
Marginal Resource Cost |
Labor |
Output |
Marginal Product |
Marginal Revenue |
Marginal Cost |
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a) Suppose that there are fixed costs of $15.00 that must be paid
to capital. (Recall that capital is held fixed at two units.) What
will the profit of the firm be? (Hint: Compute the total revenue and
total cost columns in the following table, and then subtract the
latter from the former to find profit.)
We hire four labor and produce 31. Total
revenue is 31*$2.10 or $65.10. Total cost is $40 for labor plus fixed
costs of $15, or $55. Hence, total profit is $10.10.
b) What will happen to the profit-maximizing output if fixed costs
are decreased to 10? If they are eliminated? (Hint: What will a
change in fixed costs do to the marginals in the table?)
Fixed costs do not affect marginal costs.
Hence, changing them does not alter the profit-maximizing
output.
c) Suppose that the workers run the firm, and that they want to
maximize profit per worker, not total profit. How much will they
produce and how many workers will the firm hire, assuming that fixed
costs are $15? (Hint: Compute the profit-per-worker column in the
following table.)
Best for the worker-run factory would be an
output of 2. Best for the profit-maximizing factory is 4. This
example exposes a serious incentive problem with a system in which
workers own enterprises. It was almost entirely ignored by those who
advocated such systems. That advocacy seems to have diminished in
recent decades, but sooner or later it will revive. Even bad ideas
keep coming back.
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(Comment: Before the fall of communism, Yugoslavia tried to implement a system of worker management. One problem that plagued them was high unemployment.)
5. Following are two tables that are similar to a table in the readings but with different numbers.
a) Complete the tables and find the profit-maximizing levels of output and labor.
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Marginal Revenue Product |
Marginal Resource Cost |
Labor |
Output |
Marginal Product |
Marginal Revenue |
Marginal Cost |
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Marginal Revenue Product |
Marginal Resource Cost |
Labor |
Output |
Marginal Product |
Marginal Revenue |
Marginal Cost |
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b) Compute the supply curve of labor that exists for the first table, and the demand curve for output that exists for the second table.
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1. The final test for Economics 98 is at 3:00 on the last Friday before vacation starts. Barb Bright suggests to Professor Smith that because it does not matter to him when the test is held, it would be economically efficient for the class to pay him $20.00 and he could reschedule the test for Wednesday evening. The entire class agrees with Barb that this would be a good idea.
a) Is Ms. Bright right that this move would increase economic
efficiency?
She is correct.
b) If she is correct that such a transaction would improve
economic efficiency, why would this transaction violate the rules of
virtually all colleges?
It is too easy to have similar transactions that do nasty things,
such as professors selling grades. Rather
The potential for abuse is large. If the
professors can accept money for changing test times, for what else
will the begin accepting money? The administration could monitor on a
case-by-case basis, but the cost of such monitoring is large. Hence,
the solution is simply to ban all exchanges of money between students
and professors.
(We can find a similar situation in the way police are required to treat prisoners. By putting restrictions on what the police can do, we sometimes let guilty people go free. However, by not putting restrictions on what the police can do, we invite a lot of police misconduct.)
2. Suppose that John thinks one banana is worth four apples and
Sue thinks one banana is worth two apples. If they both have apples
and bananas, what trade will take place?
Yes. For John bananas are more valuable
than for Sue. At a price of one banana equals three apples, Sue would
sell bananas and John would buy them, and both would be better
off.
3. If some of the concerns of efficiency sound familiar, it may be because we have met them before, hiding under different concepts. In fact, one way to explore efficiency is with producer and consumer surplus.
Assume that the market for Windies is made up of the fourteen people shown in the following table. Seven do not have a Windie, and the maximum price they are willing to pay is shown in the first two columns. (Alice is willing to pay up to $20 to get a Windie.) Seven people have a Windie, and the lowest price they will accept to sell their Windie is given in the last two columns. (If Holly is offered $4.00 or more, she will sell.)
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a) Ignore the sellers for a minute and consider only the buyers.
If only one item is available and it is sold at auction, what price
should it fetch?
A bit more than $15.00. Once the price
exceeds $15, only Alice is left to bid.
b) Suppose that a price of $12.00 is established and all
transactions must take place at this price. How many will be
exchanged? Explain how a mutually beneficial trade could be made at a
different price.
Only two would be bought, by Alice and
Bill. However, there would be six offered for sale. One of the
disappointed sellers would be willing to sell his item to Carol, who
is willing to pay up to $11.00.
c) Suppose that a price of $5.00 is established and all
transactions must take place at this price. How many will be
exchanged? Explain how a mutually beneficial trade could be made at a
different price.
There are six potential buyers, but only
three willing sellers, so only three would be exchanged. Karen would
be willing to sell at $7.00, and one of the disappointed buyers would
be willing to accept that.
d) Find the price at which it is impossible for any mutually
beneficial trade to be made at any other price once it is
established.
At a price of $8.00 there are five willing
buyers and five willing sellers.
e) What is the equilibrium price and quantity in this market?
At a price of $8.00, five will be
sold.
f) At this equilibrium, compute total value to buyers, total
revenue, consumer surplus, and producer surplus.
Total value to buyers = $20+$15+$11+$9+$8 =
$63. Total revenue = 5*$8=40. Consumers' surplus = $63-$40=$23.
Producers' surplus =
($8-$4)+$(8-$4)+$(8-$5)+$(8-$7)+$(8-$8)=$4+$4+$3+$1 +0 = $12. Total
surplus = $23 + $12=$35.
g) Suppose the sellers collude so that Holly, Ingrid, and Jane
agree to pay Karen $4.10 and Larry $3.10 to stay out of the market.
Can they make enough extra with the higher price that will result to
make these payments? What happens to consumer and producer surpluses?
What happens t o the sum of consumer and producer surplus?
We will reduce the number of sellers to
three. If only three are sold, the price will rise to $11.00. Holly,
Ingrid and Jane gain a total of $9.00, which is enough to pay the
$7.20 to Karen and Larry. They have $1.80 to split among themselves.
Total surplus to sellers is ($11-$4)+($11-$4)+($11-$5)= $7 + $7 + $6
= $20. However, surplus to consumers is now ($20-$11) + ($15-$11) +
($11-$11) = $9 + $4 = $13. Total surplus has dropped from $35 to
$33.
h) Suppose that Alice, Bill, Carol, and Dave pay Erin $1.10 to not
buy. What happens to the price and to producer and consumer
surpluses? Is this change good or bad? Explain.
We reduce buyers to 4, pushing down price
to $7.00. Alice, Bill, Carol, and Dave each gain $1.00 in surplus,
part of which is used to pay Erin. Holly, Ingrid, Jane, and Karen
each lose $1.00 in surplus. In this case here, the marginal buyer and
seller had no surplus, so eliminating them does not change the total.
Normally, eliminating a seller or buyer by collusion will eliminate
some surplus, as it did in part g.
i) Suppose that a government regulator sees this market and
decrees that Nancy must sell to Alice (and Alice buy from Nancy),
Mark and Bill must exchange, etc. If he pairs buyers and sellers in
this way, the amount exchanged will be seven. Explain why this decree
will be opposed by an economist.
The goal is not to maximize transactions.
It is to get the items to those who value them most. Fred ends up
with an item that he values at only $5.00, but we made Nancy give up
the same item and she values it at $13.00.
4. Cuba is one of the poorest nations in the world. However, it
produces a large number of athletes who capture Olympic medals. Is
this athletic prowess an indication of success for the Cuban way of
life, or is it a sign of folly and foolishness? Whatever position you
take, argue your position in terms of the production-possibilities
frontier.
Cuba devotes a large amount of resource
into producing athletes, resource that could have been used to
produce other goods and services. If having good athletes is more
important than having good food or good roads, then they have made a
good choice. If ample food and clothing are more important than good
athletes, they have made a poor choice.
1. Banks and savings and loan associations have often been accused
of "redlining," that is, refusing to make any mortgage loans in
certain segments of a city. Why might they redline?
Redlining could be a cheap way of
screening. If people from certain areas of the city are more likely
to default on loans than residents from other areas, an easy way to
reduce defaulted loans is to avoid lending to the high-risk areas.
Today, redlining is against the law in the United
States.
2. In some transactions, there is a real risk that one party may
cheat the other. People do not trust traveling salesmen, and there is
good reason for that distrust. (Can you explain why traveling
salesmen have a greater incentive to cheat customers than the local
merchant?)
(Repeat business is not important for the
traveling salesman, so the cost of cheating is low.)
As the Internet grew, it became possible for people all over the world to buy and sell from one another. However, commerce was limited by the cheating problem. How could you as a buyer trust someone who offered something for sale on the Internet? The author remembers buying and selling on usenet in the early 1990s, and dishonest sellers (and to a lesser extent, dishonest buyers) were a common and serious problem.
A solution to the cheating problem was discovered by the people
who established the eBay auction site. Their solution made buying
from and selling to individuals much less risky, and they were
rewarded with a very successful company. Visit www.ebay.com and see
if you can discover the way they discovered that allows buyers and
sellers, who are complete strangers, to have some confidence that
they are dealing with people who will not cheat them. (Comment: the
method they discovered is now routine on auction sites in which
anyone can buy or sell.)
They implemented a feedback rating system.
A seller with a feedback rating of 1000 has had at least 1000
transactions in which the other party to the transaction was happy. A
person with a feedback rating of -1 has one more complaint than
compliment, and it may be risky doing business with him. Feedback is
reputation. It is hard to fake. A seller with a high feedback rating
and an absence of negative comments will be able to sell at a higher
price than a seller who no feedback.
3. a) Why is there no private insurance for unemployment?
Moral hazard and adverse selection are
serious problems. Unemployment is something people have a lot of
control over.
b) There is no market that insures against mentally or physically
handicapped babies. Yet when people have children, there is a
significant risk that they will have a child with such a handicap.
How can you explain this gap in insurance coverage?
My explanation is that there would be some
people who would intentionally damage their children to collect, and
that behavior is unacceptable. To avoid the case of moral hazard, we
do not offer this insurance. You may have another
explanation.
c) In Britain, virtually all blood used in transfusions is donated.
In the United States, much is purchased. Typical sellers include
college students, slum dwellers, and drug addicts--all groups that
can use the extra cash. The United States has had a much harder time
keeping its blood supply free of infectious disease than has had
Britain. Why?
Donor are unlikely to donate if they knows
their blood is tainted. Donation takes place when people want to help
others. People selling blood are much more likely to be only
self-interested. They may not care if tainted blood harms someone.
This example illustrates adverse selection.
4. Some life insurance will not pay if the cause of death is
suicide within two years of buying the policy, and others will never
pay for suicide. Why? No life insurance will pay if the cause of
death is a world war. Why?
Moral hazard and adverse selection for
suicide. If a person decides he will commit suicide, he would have a
tendency to buy the policy to help a friend (adverse selection.) Or
if a person has a policy that pays for suicide, he may decide that
his best option is to help his family by dying (moral hazard). In the
case of world war, the scale of death could be so large that it would
financially wipe out the insurance company.
5. Stew D. Much is an enterprising student who is always trying to
make a buck. He decides to sell grade insurance to his fellow
students. He will pay $500 to any student policyholder who gets an F.
Because only 2% of all grades are Fs, Stew computes that he can break
even if he charges students $10 per class. To make a profit, he
decides to charge $15.
a) Is his arithmetic correct in computing the break-even point?
(Ignore other problems.)
yes.
b) Will he face a free rider problem? Explain.
no. If you do not pay, you do not get
benefits.
c) Will he face a screening problem? Explain.
yes. Students who are likely to get low
grades would want to buy; students who are unlikely to get low grades
will not buy. He could solve this by charging based on previous
GPA.
d) Will he have a problem with moral hazard? Explain.
Yes. A person who is getting a D- may now
plead with the instructor to fail him so that he collect. Instead of
trying to bring up low grades, students my try to bring them
down.
6. The judgment of quality by price seems to be important in many
markets for services. For example, suppose that there is a surplus of
doctors or lawyers. The model of supply and demand suggests that this
surplus should reduce price. What problems would a doctor or lawyer
face who cuts his prices in order to attract more customers?
If people interpret low prices as an
indication of low quality, lowering prices might drive away customers
rather than attract them.
7. Karl Marx defined classes in terms of property relations
because then all members of the class would have common interests. He
assumed that because all members of the class had common interests,
and because they would be aware of these common interests, he could
talk about how classes would behave. In their Communist
Manifesto Marx and Engels also assumed self-interest: "The
bourgeoisie...has left remaining no other nexus between man and man
than naked self-interests, than callous 'cash payment'."
a) Suppose that it is in the interests of capitalists as a class to
restrict investment to raise the rate of return on capital. Will it
be in the individual capitalist's interest to do so?
No. The capitalist is interested only in
his bottom line, not the aggregated bottom line.
b) Suppose that it is in the class interests of the proletariat to
work together to seize political power. Will it be in the interests
of the individual worker to do so?
No. It would be better for the individual
worker to free ride. Let others face the risk of death on the
battlefield. The benefits will be enjoyed by all.
c) Marx assumed that self-interest translated into class interests
because all members of the class had common interests. Can you see a
free rider problem that he and Engels did not see? (Comment: This
question is adapted from Mancur Olson's Logic of Collective
Action (Harvard Univ. Press, 1965, p. 102-110.)
You should be able to. It is another
example of the prisoner's dilemma.
8. A Chicago public television station that gets part of its funds
through subscription drives, claims that only 10% of those who watch
the station contribute. What is more puzzling to an economist, why
90% do not contribute, or why 10% do? Explain.
Most viewers free ride. One of the ways to
reduce free riding is to give gifts (CDs are very popular) to those
who donate money. People seem to be more likely to pay the exorbitant
price for a special CD than to just donate. There are interesting
issues here that I do not understand.
9. Bob Saylor notices that ships often wreck on a rocky reef off
the coast where he lives. Reasoning that shippers would like to
reduce the risk of shipwreck, he tells them that he will build a
lighthouse if they will pay him.
a) Will he face a free-rider problem? Explain.
Yes. Once the lighthouse is built, all
benefits whether or not they paid. Historically, a way around this
was to get the insurers to pay since there were only a few of
them.
b) Will he face a problem of adverse selection? Explain.
No. Adverse selection is not an issue with
a public goods.
c) Will he have a problem with moral hazard? Explain.
No. He will not suffer if people become
more reckless as a result of the lighthouse.
10. The standard typewriter keyboard (the QWERTY arrangement of
keys) was developed in the 19th century to prevent typists from
typing too fast. When typists typed too fast, the keys would jam.
With modern electronic typing, this problem has been eliminated. Why
doesn't the world switch to a more efficient keyboard? (Hint: Look at
the costs and benefits for a single individual making the switch.
Recall that a typist may not always type on the same machine. Is
there a free-rider type of problem here?)
If I learn an alternative keyboard, I will
be lost when I encounter a QWERTY keyboard, which I do almost every
day. Hence, it is not in my interests to learn an alternative. Many
people react the same way. Unless a critical mass of the alternative
get established, it will die. But it will never reach the critical
mass.
11. The success of eBay led to the establishment of many auction sites on the web, Most of them copied the structure and policies of eBay, yet none of the imitators is nearly as successful as eBay. Yahoo, for example, is one of the biggest of the Web companies, yet its auction site, which does not charge sellers commissions, is small compared to eBays.
If you were a seller, would it not be better to list at Yahoo, which does not charge anything for listing or selling, than to list at eBay, which charges a $.25 listing fee and a commission of up to 5% on sales? The services that Yahoo offers both buyers and sellers are almost identical to those on eBay, yet the Yahoo auctions are empty compared to those on eBay.
Visit both auction sites, www.ebay.com and auctions.yahoo.com. Look at the number of auctions in each and the number of bids that items get. Come up with a hypothesis about why eBay is bigger than Yahoo (or any of the other auction sites.) (Hint: The last section argued that in some industries, bigness begets bigness. Once you get big, you stay big. Why would this happen in an auction site?)
If you are a seller, you want to go where they buyers are, which is to the biggest site. You will get more bids, so you are likely to sell your product for a higher price. If you are a buyer, you want to go where the sellers are because you will get a bigger selection. If you have time, you can visit the smaller sites, but the variety is not there. In the auction business, once you are big, you tend to stay big.
1. Suppose that you are a head of a large government agency. The
legislature wants to cut your budget and you do not want it cut. They
ask for proposals on how you could cut spending by 10%. What should
you do: try to find the least useful things your agency does, or
propose cutting the most valuable things your agency does? Explain
the rationale for each strategy.
Cutting the most valuable things puts
pressure on the legislature to restore your funding.
2. Congressman Snaggle helps 500 of his constituents each year get
checks from the government to which they are legally entitled, but
which have gotten lost in the bureaucracy. These people are very
grateful to Congressman Snaggle and express this gratitude on
election day. Dr. Gutnews, a respected efficiency expert, has figured
out a way to eliminate the bureaucratic delays that make these 500
seek Congressman Snaggle's help each year. True or False: Congressman
Snaggle will be an enthusiastic supporter of this reform measure
because it will help his constituents.
The congressman may lose by having the
bureaucracy more efficient. If he does, he will not be an
enthusiastic supporter, unless there are plenty of other
opportunities for him to help his constituents.
3. Taxes and subsidies are not the only things that can be
shifted. An interesting case of shifting occurred with slavery. Draw
supply and demand curves for cotton. Now, suppose that slavery is
introduced and that slavery is productive. What will this do to the
graph that you have drawn? What will happen to the sizes of the
consumers' and producers' surpluses? What do you conclude about the
primary beneficiaries of slavery?
Slavery probably shifted the supply curve
for cotton to the right, lowering price and increasing quantity. The
consumers' surplus increased. Much of that surplus was obtained by
people in Europe. England was very tempted to enter the U.S. Civil
War on the side of the South.
4. The topic of rent seeking has some interesting things to say
about the efficiency of theft. It may seem shocking, but at first
glance, there is no economic cost to theft. If, for example, a thief
steals $1000 from you, there is no change in value in the system. You
have lost value, but it is still there, only in someone else's
pockets. To make a case against theft on the grounds of economic
efficiency, we need to go deeper.
a) A burglar steals goods that you value at $1000, but he can only
sell them for $500. Explain why his actions now result in economic
inefficiency.
He has transferred an item from a high-valued use to a low valued
use. Value is lost, which means economic inefficiency.
b) To prevent burglars from stealing, you and all your neighbors
install locks that cost $100. Explain why such a response makes theft
economically inefficient.
People are making expenditures that they
would not have to make in a world of complete honesty. The other
things that they would have done with that money (or resources used
to produce locks) is a cost of crime.
c) Suppose that the thief treats crime as a business. Instead of
doing honest work, he steals. Explain why making crime a business
instead of a hobby makes it economically inefficient.
He could be producing something of value.
His life as a thief only transfers value. The lost production is a
cost.
d) If crime is economically inefficient, can a thief find that crime
is a profitable occupation?
Yes. Economic efficiency is concerned about
the group-wide implications of various situations.
(Comment: Do you not like the rent-seeking approach to crime? Here is a different approach. Some economists argue that social capital, though nebulous and hard to measure, is essential for economic prosperity. Social capital is the set of shared values and norms that allow a group to cooperate. Trust is an important part of social capital, and societies in which people trust only family members have been slow to develop economically. What will high crime rates or the perception of high crime rates do to trust? If trust is reduced, what effects will that have on economic activity? Can you see how the argument would be constructed?)
1. In the past century both population and wages have risen. How
can this be explained in terms of a graph showing wages depending on
marginal product?
The rise in population shifts the supply
curve to the right, which should lower wages. However, the rise in
population also creates a demand for output, which shifts the demand
curve to the right, which should raise wages. During the past
century, we have had great technological change, making people much
more productive. This has shifted the demand curve for labor (which
depends on productivity) to the right, which has raised wages. This
last factor seems to have been the most important.
2. In the 1970s and 1980s there was considerable discussion of
something called comparable worth. If you search the Internet,
you can find a variety of information and viewpoints on this topic.
What was the basic idea of comparable worth? Very few economists had
good things to say about comparable worth. Why would economists be
hostile to this idea?
Economists think the market is more likely
to measure value of a worker accurately and a
bureaucrat.
3. Economics can be perverse. It often suggests that government efforts to help people are ineffective.
Suppose that the government passes a law that forces businesses in a particular industry to make their workplace safer. Further, suppose that the effect of the law is to actually make the workplace safer. Will the workers be better off? Perhaps not.
If people recognized that this particular type of work was risky,
would they have taken that risk into account? Suppose there are two
jobs that are almost identical. The only difference is that one is
more dangerous, with a greater chance that a person will be injured
on the job. Will these two jobs pay the same amount?
(rhetoical)
The idea of Compensating Differentials says that when
people realize that a job is risky or unpleasant, they will take that
risk or unpleasantness into consideration so that in equilibrium the
riskier or more unpleasant job must pay a premium. Roofers work under
extremely unpleasant conditions. What should we expect about their
pay? Many forms of construction work have seasonal interruptions or
are at the mercy of weather. What should this do to the pay? Many
people think working in a national park is fun. What should this do
to the pay of national park rangers? Most people prefer day shifts to
night shifts. What should we expect about pay for night work?
Roofers should earn a lot relative to jobs
that are similar in skill level; construction work with weather
interruptions should earn more relative to jobs that are similar
level; it should not cost much to hire park rangers (though the pay
effects may be obscured because pay is set by the government, not the
market); night shifts should pay a premium.
What would you expect the long run effect of the effective safety
regulation to be on the wages in the affected industry?
If a job becomes safer, the equilibrium
wage should fall.
Suppose that a sociologist finds that unpleasant jobs have low
pay. Has he shown that compensating differentials are a figment of
the economist's imagination?
Compensating differentials are only one
factor in determining pay, and often not the most important. If he
has found a way to control for the other factors and then finds that
unpleasant jobs have low pay, then he may have found something
interesting. But if most unpleasant jobs require very low skill and
most pleasant jobs require high skill, we should not be surprised
that the unpleasant jobs pay less than the pleasant
jobs.
4. Television has created a national market for much entertainment. As a result of that national market, there are a few entertainers who earn tremendous sums of money. Most entertainers, however, do not earn more than people in other lines of work.
The Internet has the potential to radically alter education in
much the same way that television and radio has radically altered
entertainment. Suppose that students begin to get their lectures via
the Internet. How many different economics courses will prosper? If
50 people are offering courses, will all be equally attended? Suppose
that two or three are considered a little better than the rest. Maybe
they tell better jokes, have a bit more charisma, or are associated
with prestigious universities. Will they get only a little more of
the audience or will they get most of the audience? If you believe
that the Internet is going to revolutionize education, are you more
likely or less likely to pursue a career in education?
Just a guess, but I suspect that the
Internet has the potential to help top teachers a lot at the expense
of the great mass of teachers. Only time will tell.
5. Many years ago, I attended a college founded by Benedictine monks. My economics professor, the late Martin Schirber, OSB, recounted that in days past, the school tried to apply what the monks thought were Christian principles in determining compensation. People who needed more money should be paid more than people who needed less money. So when a worker had an extra child, that family would need more money, and the worker would get a raise. Today, very few people would consider attempts to pay people based on need as fair. If you think it is unfair, why do you think it is unfair?
If you think that the pay based on need is unfair, is it fair for the government to take need into account when determining taxes? The tax code gives deductions for extra children, and it also allows the deduction of large medical bills, which can be justified with a need argument. If you think it is not right for a private employer to take need into account in determining pay, why is it right for the government to take need into account when determining taxes?
This is a discussion question with many answers possible. It does seem that consensus on what is fair has changed during the past 100 years.
6. In competitive markets, survival is precarious. A firm that does not earn a profit, will eventually fail. This need for profit limits what a firm is able to do and has some interesting things to say about discrimination.
Suppose that there are two groups of people, Jorities and Norities.
a) Suppose that for reasons of culture or politics, Norities are
poorly educated. Norities are paid less than Jorities. Is a pay
differential sustainable with competitive markets? If you say it is
not, how can someone profit from a differential?
Differential sustainable because there is
not profit opportunity that arises.
b) Suppose that Jorities and Norities are equally productive.
However, some business owners do not like Norities and will hire them
only at reduced wages. Is a pay differential sustainable with
competitive markets? If you say it is not, how can someone profit
from a differential?
Not sustainable. If I want to make a
profit, I can enter the industry and get a bargain by hiring
Norities. As long as a profit opportunity exists, people will imitate
me. Only when wages are equalized will the profit opportunity
cease.
c) Suppose that Jorities and Norities are equally productive.
However, some customers do not like Norities and will not buy from
firms that hire them. Is a pay differential sustainable with
competitive markets? If you say it is not, how can someone profit
from a differential?
Sustainable. However, if there are plenty
of jobs behind the scenes where people do not know who is working,
this pay differential may not be of importance. Customer biases
should affect salesmen more than factory workers.
d) Suppose that Jorities and Norities are equally productive.
However, some Jorities refuse to work with Norities. Is a pay
differential sustainable with competitive markets? If you say it is
not, how can someone profit from a differential?
Pay differential is not sustainable, but
the workplace will be segregated. Some workplaces will be entirely
Jorities and others entirely Norities. (To some extent we see this
pattern in various occupations within workplaces.)
e) Suppose that a majority group does not like a minority group.
Should they count on the market as a way of keeping the minority in
its place, or should they look to government as a better way to
achieve their goals? Explain why you answer as you do.
Historically, majorities have relied on law
to enforce their dislikes and likes. Apartheid in South Africa was
based on law. In the South after the Civil War, segregation was
mandated by the Jim Crow laws.
7. Much discussion of issues of fairness and the ideal distribution of income is done in the language of social contract theory. This discussion recognizes a tradeoff between more equality and the total size of output; that is, it assumes that if everyone is guaranteed an equal share of total production, there is little incentive to work hard.
Suppose that you and four others are shipwrecked. As you approach a tiny island, you decide to form a social contract and these are your best guesses of what you are choosing from.
Option A: Share everything equally. Total output will be $10,000 and each will get $2000.
Option B: One-half of what each produces, each keeps; but the other half goes into a communal pot and is split up evenly. Total output will be $14,000. Before the split income will be $6000, $4000, $2000, $1000, and $1000. After the split ,the incomes will be $4400, $3400, $2400, $1900, and $1900.
Option C. Each gets to keep two-thirds of what each produces, and one third is shared equally. Total output will be $15,000, so $5000 will be divided up. Original income will be $6000, $4500, $2000, $1500, and $1000. Final income will be $5000, $4000, $2333, $2000, and $1667.
Option D. Each get to keep all he or she produces. Total output will be $18,000. Incomes will be $7000, $5000, $2500, $2500, and $1000.
(In options B, C and D, you have absolutely no idea which of the five you will be. You have an equal chance of being any one of them.)
a) Which of the four options would you prefer? Why?
b) How would the numbers have to change for you prefer more or less
redistribution?
c) Can you generalize your way of deciding what is best?
d) Could you rewrite this example using an allocation of dorm fines
or damages? (Should everyone bear the costs, or should N effort be
made to apply them to the parties that cause them? What would dorm
residents decide if they make that choice at the beginning of the
semester?)
This question is a discussion question that
has many possible answers.
8. Suppose that you are the head of a pollution-control agency and you desire to cut the pollution in Starry River by one-half. The polluters, the amount they pollute, and their marginal costs of reducing wastes are given in the following table. Your staff has proposed three options. With Option A, you require each firm to reduce wastes by one-half. With Option B, you require each firm to reduce wastes by five tons. With Option C, you put a tax on the discharge of $4.50 per ton.
What is the cost to society (how much in resources is required) to
clean up the river by one-half under each option? What is the cost to
business under each option? Which will economists be most likely to
propose? Which will the Chamber of Commerce support?
To society: A: $100; B: $115; C: $55
To business: A: $100; B: $115; C: $215
The economist will like option C since it uses the fewest resources.
The tax cost is not a cost to society because there is not value
lost. Funds are simply transferred from one pocket to another.
The Chamber of Commerce will probably support option A because it is
cheapest to business.
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Orion Ind. |
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Draco C. |
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Auriga Bros. |
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Hercules Int. |
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Pegasus Inc. |
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Scorpio Entpr. |
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9. The analysis of the last question was the way economists once approached the problem of pollution, and this analysis suggested that a pollution tax was a good idea. There are two problems with this solution. First, as you can see from the results, the companies consider a pollution tax the most expensive option, and hence will fight it. As a result, it is very difficult to enact pollution taxes. Second, the efforts that companies spend fighting the tax calls into question the assumption that taxes are simply a transfer that does not use resources. The notion of rent seeking suggests that people spend resources trying to obtain transfers or avoid paying them, and hence assuming transfers as "free" is dangerous.
There is, however, another policy option, one that has proven easier to enact. We can create a market in pollution rights. Again, suppose that we want to cut pollution by one-half. The total amount of pollution is 60, so we will allow 30. We grant each company a right to pollute five tons. If they want to pollute more, they can do so by buying pollution rights from another company. For example, Scorpio Enterprises finds it cheap to clean up, so if the price of pollution rights exceeds $1.00, it would make more money by selling its rights to someone else and cleaning up all of its pollution.
What will the equilibrium price of pollution rights be? Who will
buy and who will sell? What will the cost of this policy look like to
the companies? What will it look like to society as a whole?
The equilibrium price should be somewhere
between $4 and $5. Auriga, Pegasus, and Scorpio will sell their
rights once they are above $4 because will pay them to clean up. If
the price of the pollution rights is $4, the cost to the firms will
look like this:
Orion: $20 to buy rights
Draco: $40 to buy rights
Auriga: $0 (Sold rights for $20, but cost of cleanup was $20)
Hercules $0 (had enough rights given it; did nothing.)
Pegasus $0 (Sold rights for $20, but paid $20 to clean up)
Scropio gain of $5 (Sold rights for $20, but paid $15 to clean
up)
Net cost is $55. The incentives to clean up are the same as with the pollution tax, but the burden of the cost is very different.
10. Economists believe that only humans matter. Suppose that a
waste product is harmful to animals but does not harm humans. Can it
be pollution? Should we consider effects on animals and plants
independent of effects on humans? Some people believe that plants and
animals, as coinhabitors of the planet, have the same rights as
humans. Do you agree or disagree? (Comment: Here is another way to
get at this issue. Quite a few years ago, a child was born with a
defective heart. In an attempt to save the child, the doctors at the
hospital transferred a heart of a baby baboon into the human infant.
At the time, there was considerable controversy about whether this
was good medical practice, but we will ignore this question. There
was also a group of people who said it was morally wrong to kill the
baboon to save the human. They argued that the baboon had as much
right to life as the human did. Do you agree or disagree? Why?)
Discussion question with many possible
answers.
11. Explain why people can consider the following items to be
free. Then explain why (or when) they are in fact scarce. Explain the
problem that occurs, and give a possible solution to eliminate
it.
These are all cases of the problem of the
commons.
a) Ducks migrating south for the winter.
To prevent ducks from being hunted to
extinction, the government sets limits on the number that can be
shot.
b) Travel on a freeway during rush hour.
The problem is gridlock. A possible
solution is tolls.
c) Whales in the middle of the ocean.
The problem is possible extinction. The
solution has been international agreements limiting
hunting.
d) Water in a river running through an industrial area.
The problem is that the river will become a
sewer. Government prohibition of dumping raw waste is the normal
solution.
e) Water in an aquifer in a fertile but dry area.
The problem is that people pump the aquifer
dry, which is in the process of happening in several states. A
possible solution would be to limit the amount people can
pump.
f) Buffalo in the 19th century.
We almost killed them all. All buffalo are
now owned by someone, either private individuals or
governments.
g) Trees on public land on a heavily populated island that needs
firewood.
The problem is that all trees are cut and
the land then erodes. Easter Island in the Pacific is an example of
social collapse caused by this problem. There is no easy
solution.
h) Food in a college cafeteria for which students pay a fixed board
fee.
Students have little incentive to avoid
wasting food. A solution is to charge per item.
i) Mammoths to Ice-Age hunters.
They are extinct. Hunting may have been
part of the reason they are gone.
12. Mrs. Jones brings home a dozen candy bars each Monday and
tells her two children they can eat them whenever they want. Mrs.
Smith also brings home a dozen candy bars each Monday and tells her
two kids they can eat them, but she says that six are for the older
child and six are for the younger child.
a) What does economic theory predict about the life expectancy of
candy bars in these two households?
Candy bars will disappear in the Jones'
household.
b) The logic in this problem illustrates the logic in what economic
problem?
Problem of the commons.
c) What does this simple example suggest about property rights?
Appropriate property rights can solve the
problem of the commons.
13. Suppose that in Wayzata Sea the number of fish harvested depends on the number of boats that fish. The following table shows how the value of the catch increases as the number of boats increases. Suppose that it costs 65 to add a boat to the fishing fleet.
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a) If entry of boats is unrestricted, how many boats will tend to
fish in this sea?
As long average catch exceeds the cost, it
is worth adding boats. Certainly the third boat will go because it
will get average a catch of over 73, and the fourth boat will be
indifferent to going. I perhaps should have had the cost at 64 to
make that fourth boat go for sure.
b) If one company has the exclusive right to fish in this area, what
is the optimal number of boats it should use?
It will only use two. It will look at the
marginal catch. The third boad will only add 50 but cost
65.
c) What is the economically efficient number of boats in this
problem?
Two. This is an example of the problem of the commons.
14. We have been considering a resource bundle with three uses.
Use A has a value of $25 to people, use B has a value of $22, and use
C has a value of $20. A system of making a choice that delivers the
resources to use A was efficient, and that markets can be efficient.
However, markets may fail and allocate inefficiently. How will the
resources be used in the following cases?
a) An industry that has the problem of the commons finds that when
there are three producers, total revenue is $120. When there are
four, total revenue increases by $20 to $140. Use C is adding the
fourth producer.
Resources will go to C because in the
problem of commons, people look at average benefits (35), not
marginal.
b) An industry has positive externalities. If more is produced,
buyers will get benefits of $21, but there will be spillover benefits
of $4. This use of resources is use A.
Resources will go to B. Only $21 of the $25
in benefits for use A will be considered.
c) An industry has negative externalities. If more is produced,
buyers get benefits of $26, but there are spillover costs of $4. The
extra production is use B.
Resources will go to B. The spillover cost
will be ignored, and so use B will outbid use A.
1. Answer the following questions based on the following table, which contains cost and demand data for a monopolist.
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a) If the price of this good is set at $7.40, what will the size
of the consumer surplus be?
Total value - Amount paid =
$(10+9.5+9+8.5+8+7.5)- 6*$7.4 = $52.5-$44.4 = $8.1
b) If this firm can charge only one price, what amount will it
produce to maximize profits? (Hint: You need to compute marginal
revenue.)
It will produce three. The fourth unit adds
$7 to revenue but $7.40 to cost.
c) What price will it charge?
$9.00
d) What is the size of the consumers' surplus in this case?
($10-$9) + ($9.5-$9) + ($9-$)9 = $1.50
e) How much of the consumer surplus from part a does the monopolist
capture in this case?
3* (9.00-$7.40) = 3*$1.60 = $4.80
f) Explain why this result will not be economically efficient.
Total surplus is $1.50 to consumers plus
$4.80 that the seller captures, a total of $6.30. A total of $8.10 is
possible. There is a deadweight loss of $1.80 because the fourth,
fifth, and sixth items are not purchased. The loss there is
($8.50-$7.40) + ($8.00 - $7.40) + ($7.50- $7.40) = $1.10 + $.60 +
$.10 = $1.80.
g) If this firm can price-discriminate perfectly, how much will it
produce?
It will produce six, charging $10.00 for
the first, $9.50 for the second, etc. It will capture all the surplus
value.
h) Explain why this result will be economically efficient.
There is no left-over
value.
2. A firm can produce one million light bulbs at a total cost of $1,000,000. It sells them for $1.10 each, making a profit of ten cents per bulb. One of the executives finds that if they produce two million bulbs, total cost rises to $1,500,000. This executive also finds that the company can sell these light bulbs abroad for $.65 each. He argues that the firm should expand production and sell the extra bulbs abroad. Other executives argue that this plan is nonsense. They point out that if the firm produces two million bulbs, the average cost per bulb is $.75. They state that no company can make a profit by selling its product for less than the cost of production.
Who is right in this case? Explain.
This is adapted from an situation Thomas
Edison found himself in. The first executive is looking at marginal
cost and revenue, which is the proper way. The extra revenue is $.65
and the extra cost is $.50. It is worth producing them. The other
executives are looking at average cost and revenue, which is almost
always a disasterous way to analyse the problem.
3. In order to price-discriminate, a seller must be able to separate its market into two parts. One part must contain those who are sensitive to price, and the other must contain those who are not. Explain how each of the following strategies separates buyers into these two groups:
a) A home computer maker offers a $50.00 discount to any buyer who
trades in another home computer or video game.
If those who already have a system are more
price sensitive, then this method works.
b) Movie theaters charge a reduced admission for children under
12.
Children are usually are not willing to pay
as much as adults, and parents of children are often not willing to
pay as much for a child, who only understands parts of a movie, as
they will for themselves.
c) Grocery stores charge lower prices on some items if people have
coupons that they clipped from the paper.
Clipping coupons is a hurdle. Those who
have the time clip them are usually more price
sensitive.
d) Colleges that are prestigious and expensive give scholarships on
the basis of need.
Without a price cut, few poor people will
attend an expensive college.
e) Colleges that are not prestigious and not expensive give
scholarships on the basis of academic ability.
Without a price cut, many students with
high academic abiliity will not attend unprestigious
colleges.
f) Economics journals charge libraries higher subscription rates than
they charge individuals.
Individuals are more price sensitive--they
can always go to the library to read the journal. If a library is at
a research university, its mission is to provide the
journals.
g) The American Economic Association has membership rates that are
higher for those who earn large incomes than for those who earn small
incomes.
High-income economists tend to be at
research institutions, and they tend to get more benefit from the
AEA. Hence, they are willing to pay more.
4) One of the most recognized names on the Internet is Priceline.com. It owes its success entirely to price discrimination.
Log onto <http://www.priceline.com/> and see how you would use it to buy airline tickets.
A key to effective price discrimination is to separate people willing to pay a lot for a good or service from those willing to pay only a little. Why would a person willing to pay a lot for an airline ticket be unlikely to buy it on Priceline.com? (Hint: What are the conditions Priceline imposes? Why are they imposed?)
Can you find any indication of how they decide which prices to accept and which to reject?
Why does Priceline offer the assortment of items that it does? Why does it not offer a different assortment of goods and services?
What prevents other companies from doing what Priceline does?
Tickets bought on Priceline.com cannot be refunded. They allow no discretion on time of departure or on the airline. If one wants flexibility, one cannot get it on Priceline.com. There is nothing to prevent other companies from price discriminating, which may mean that in a few years Priceline.com may no longer be here.
5. Throughout the 1980s and during most of the 1990s, there were
very few antitrust cases. At the end of the 1990s, however, the U. S
government brought a case against Microsoft. In 2000, the trial judge
found that Microsoft had behaved in ways that violated the law, and
Microsoft appealed this verdict. Search on the Web to find the
present status of the case, the central argument of the government,
and the central argument of Microsoft.
The status of the case will change. The
government argued that Microsoft used its near-monopolistic position
in operating systems to create new positions of near monopoly
elsewhere, which is illegal. Microsoft argued that it was innovating
and serving the consumer.
6. From Edupage for July 31, 2000
(http://listserv.educause.edu):
"JUDGE BANS FORD FROM WEB CAR SALES IN TEXAS
"Ford will not be able to sell used cars over the Internet in Texas,
and the Texas Department of Transportation acted within the law to
crack down on the company's Web site, a federal judge ruled recently.
Judge Sam Sparks said Ford's Preowned.com site was in violation of a
state law that prevents carmakers from selling cars to consumers
without a third-party dealer."
Texas consumers should be very happy that their state officials
are so concerned about their well-being, and take quick action to
protect them from the greed of big businesses such as Ford. Do you
agree or disagree? Why or why not?
It is hard to see how this ruling will aid
consumers. It is easy to see how it will aid car dealers. An
economist would suspect that the original law was supported by the
car dealers.
1. Suppose that there are three sellers on the Hotelling beach. If
initially each has one-third of the customers, where will they be
located? Can anyone increase his share by moving? Why is the middle a
poor place to begin? If the middle wants to survive, what must he
eventually do? Can you see any equilibrium if all three continue to
exist?
Intially they will be at 1/6. 1/2. and 5/6.
The ends will move to the middle, squeezing its share. Eventually the
middle must jump to the outside. There seems to be no equilibrium
because whoever is in the middle wants to get out.
2. Dawn Key is a very successful businesswoman. She is also
skilled in the domestic arts. Though she could clean her house in two
hours, she prefers to hire a cleaning lady who spends five hours
doing the same job. Though she is a skilled cook, she hires a caterer
when she hosts a party. The caterer takes ten hours to prepare the
food, whereas Ms. Key could do the same work in only six. Why do Ms.
Key's actions make sense in terms of comparative advantage?
If Ms Key makes $100 per hour, it would
cost her $200 to clean her house and $600 to prepare for her party.
She can almost certainly hire someone to work for her for less than
that, someone who cannot make $100 per hour.
3. Suppose that Crusoe can either catch 10 fish or gather 10
coconuts in 10 hours, and Friday can catch either 8 fish or 4
coconuts every 10 hours.
a) In terms of hours, what is the cost of fish to Friday? What is the
cost of fish to Crusoe?
A fish costs Friday 1.25 hours. It cost
Crusoe 1 hour.
b) In terms of hours, what is the cost of coconuts to Friday? What is
the cost of coconuts to Crusoe?
A coconut cost Friday 2.5 hours. It costs
Crusoe 1 hour.
c) Explain why this is not the way an economist would measure costs.
What would the cost of fish and coconuts be to Friday and Crusoe
under this alternative measure?
When they catch fish, the give up the
opportunity to gather coconuts. When they gather coconuts, the give
up the opportunity to catch fish. Once we see that, we can see that
one coconut cost Friday two fish, and one fish costs Friday one-half
a coconut. One coconut costs Crusoe one fish, and one fish costs him
one coconut. Coconuts are more expensive for Friday than for Crusoe,
and fish are more expensive for Crusoe than for
Friday.
d) Suppose that before trade, Friday and Crusoe both spend five hours
fishing and five hours gathering coconuts. What will their production
and consumption bundles look like?
Their production and consumption bundles
are the same. Friday gets two coconuts and four fish. Crusoe gets
five coconuts and five fish. The total for both is seven coconuts and
nine fish.
e) Explain the changes they can make so they both end with more
consumption.
If Friday only gathers coconuts, he can get
eight. If Crusoe only fishes, he can get ten. With specialization
they gain one coconut and one fish. Both can be made better off with
specialization and trade.
4. Though Adam Smith advocated free trade, David Ricardo was the first to clearly explain the idea of comparative advantage. For his explanation, he began with production costs similar to those shown in the following table.
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1 man-day |
2 man-days |
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1 man-day |
3 man-days |
If it took 3 man-days to produce a barrel of wine in England instead of 1, there would clearly be gains from trade. England would then have an absolute advantage in cloth, and Portugal would have an absolute advantage in wine. Ricardo, however, said that with the numbers above, even though England could produce both items with less labor, there were gains from trade. Let's see if you can re-create his reasoning below.
a) Using these data, compute the opportunity costs of wine and cloth below:
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(Hint: Producing 6 barrels of wine requires how many man-days? (For Portugal, 12.) If these man-days are taken away from cloth production, how much cloth production is lost? (12/3=4) Using 6 keeps fractions out of the results and makes computation easier.)
b) Based on the opportunity costs you computed, which country
produces wine more cheaply? Which cloth?
Portugal produces wine more cheaply, and
England cloth.
c) Suppose that 6 barrels of wine trade for 5 bolts of cloth.
(This is the same as 6 bolts of cloth trading for 7 1/5 barrels of
wine.) Would England find it cheaper to buy wine or produce it? To
buy cloth or produce it? Would Portugal find it cheaper to buy wine
or produce it? To buy cloth or produce it? Could mutually
advantageous trade take place?
England: Produce 6 cloth, get 7.2 barrels
of wine, which is better than it can do on its own. Portugal: if it
wants 6 bolts of cloth, it can produce them and give up 9 barrels of
wine, or it can trade 7.2 barrels. It is cheaper to produce wine and
trade for cloth. Hence mutually advantageous trade can take
place.
d) Suppose that 6 barrels trade for 7 bolts. Would England find it
cheaper to buy wine or produce it? To buy cloth or produce it? Would
Portugal find it cheaper to buy wine or produce it? To buy cloth or
produce it? Could mutually advantageous trade take place?
England now finds it better to produce
wine. It can produce six barrels of wine and trade them for 7 bolts
of cloth. If it is self sufficient, it has to give up 7 barrels of
wine to get 7 bolts of cloth. However, Portugal also finds it best to
produce wine. If it produces six wine and trades the wine, it can get
7 bolts of cloth. If it is self-sufficient, it must give up over 9
barrels of wine to get 7 bolts of cloth. Since both want to produce
wine, trade cannot take place at this ratio.
5. In order to help domestic automobile producers during the 1970s, the U.S. government sought ways to restrict sales of foreign automobiles, especially those made in Japan. In terms of a supply-demand diagram, the market would have allowed in Qe automobiles, but the government wanted only Qr to be sold. A restriction that accomplishes this goal will redistribute parts of the consumer and producer surpluses. (The parts that will be affected are labeled a, b, c, and d on the graph.)
a) One way to restrict is with a tariff. What would happen to
areas a, b, c, and d with a tariff?
The tariff that restricts imports to Qr
will give areas a and c to the government. These areas are the amount
of tax that is transferred from the producers and consumers to the
government. Areas b and d are lost. They are the efficiency cost of
the tariff.
b) Another way to restrict is with a quota. A quota requires that
the right to import be rationed in some way. Suppose that the
government gave the right to import to domestic automobile companies.
How would such a program have affected the four areas in the
graph?
Domestic automobile companies gain areas a
from consumers and area c from foreign producers. Area b is lost to
domestic consumers and area d is lost to foreign
producers.
c) The government established neither a tariff nor a quota.
Rather, it negotiated an agreement with the Japanese by which the
Japanese automobile manufacturers voluntarily limited their sales to
the U.S. How would such an agreement affect the four areas?
Foreign manufacturers keep area c and gain
area a from domestic consumers. Area b is lost by domestic consumers
and area d is lost by foreign manufacturers. If area a is greater
than area d, Foreign manufacturers are better off.
d) While Ronald Reagan was president, the agreement with the
Japanese expired and he did not renew it. The Japanese automobile
manufacturers, however, decided to continue limiting their sales to
the U.S. Does this action indicate that the Japanese are poor
businessmen?
It indicates that area a was bigger than
area d. Unfortunately, this sort of analysis is way, way beyond what
any of the journalists seem to be able to do.