Problem Set 3

Extra practice problems (completely optional; no points awarded)
A. (a) Fill out the following table for a competitive firm that can sell its product for \$90 a unit.
Total Cost Fixed Cost Variable Cost Average Total Cost Average Variable Cost Marginal Cost Total Revenue Marginal Revenue

Quantity 0 1 2 3 4 5

Profit -\$30 \$0 \$50 \$60 \$50 \$20

(b) What quantity will this firm produce? Why? (c) In the short run, at what price would this firm break even? At what price would the firm shut down? Explain briefly. B. Answer the following questions using the production function information in the following table. Assume that 1 unit of labor costs \$5 and 1 unit of capital costs \$10. (a) Derive the marginal product (MP) schedule. Does it obey the law of diminishing returns? (b) Derive the short-run cost schedules (fixed cost, variable cost, total cost, and marginal cost). (c) Derive the MP and short-run cost schedules if labor productivity doubles (with 1 labor unit, for example, being used to produce an output of 10 units instead of 5 units). (d) Explain why the short-run cost curves shift if the amount of capital input changes. Labor(units) 0 1 2 3 4 5 Capital(units) 2 2 2 2 2 2 Output(units) 0 5 15 20 23 24

C. Taylor (fourth edition), chapter 13, page 340, problem 2.

D. In the year 2000, economist Jeffrey K. Sarbaum reported on the Northeast Interstate Dairy Compact (NIDC), “a price floor system that guarantees Northeastern dairy farmers a minimum price for their milk, typically above what the equilibrium market price would bring them if the NIDC were not in place. Regional price supports such as the NIDC have resulted in an over production of milk that, historically, has been purchased by the Federal Government at a cost, in the 1980's, of over two billion dollars a year. More recently, Congress has been attempting to eliminate regional milk price supports by initiating a federal program that will gradually reduce milk prices to their fair market value. One consequence of this move has been increased volatility in the price of milk across the country as some regions of the nation, such as the Midwest, embrace the new regulations while others, like the NIDC, fight in court to maintain their current system. For example, in October of 1999 a gallon of milk in Dallas sold for \$2.34 on average while a gallon of milk in New York sold for \$3.03 on average, an increase of almost 30%.” (a) Graphically show how the Northeast Interstate Dairy Compact increases the price of milk and creates a production surplus. (b) Show the consumer surplus, producer surplus, and the deadweight loss caused by the Northeast Interstate Dairy Compact. Your answer should take into account what the government may do with the surplus milk. (c) Opinion: if economic analysis shows that price floors have negative welfare effects for society, why do you think they still exist? E. Imagine that a major freeze destroys this year’s crop of oranges in Florida. (a) What are the short-run effects on the orange juice market? (b) In the absence of other freezes or external effects, what will happen in the long run? For both parts, your verbal and graphical explanations should include the effects on equilibrium price and quantity, as well as any shifts in demand, supply, and cost curves, changes in levels of profits for the typical firm, and number of firms in the market. You can assume that the orange juice market was at a long-run equilibrium before the freeze hit Florida.

Problem Set 3 Answer Key 1.
Quantity Total Cost 18 27 32 33 40 60 Fixed Cost 18 18 18 18 18 18 Variable Cost 0 9 14 15 22 42 Average Total Cost -27 16 11 10 12 Average Variable Cost -9 7 5 5.5 8.4 Marginal Cost -9 5 1 7 20 Total Revenue 0 13 26 39 52 65 Marginal Revenue -13 13 13 13 13 Profit

0 1 2 3 4 5

-18 -14 -6 6 12 5

a. The firm will produce 4 units because that is where Profit is maximized. b. Profit=12 c. The market is not in long term equilibrium because the firm is making profits. In the long term, firms in a competitive market make 0 economic profits. Also, in the long run, competitive firms produce at the minimum point of the Average Total Cost which is not the case here. d. Breakeven Price=10 since minimum ATC is 10 e. Shutdown Price=5 since minimum AVC is 5

2 a) The general graphical setup for the problem is shown below. Note that the initial equilibrium price for the oral vaccine should be less than the initial equilibrium price for the injected vaccine. Similarly, the initial equilibrium quantity for the oral vaccine should be greater than the equilibrium quantity for the injected vaccine.

Price (\$)

Soral

Price (\$)

Sinjected

P*injected P*oral Dinjected Doral

Q*oral

Quantity of Oral Vaccine

Q*injected

Quantity of Injected Vaccine

b) The report will cause some consumers to reduce their demand for the oral vaccine for fear of possibly contracting polio—that is demand shifts down and to the left because of negative information. Note that demand for the oral vaccine does not fall to zero or become completely elastic—the oral vaccine was not shown to cause polio with 100% certainty; it only increases the chance that a patient may contract the disease from the vaccine. At the lower price shown in the oral vaccine graph, some patients may be willing to take on the extra risk of contracting the disease rather than pay the higher price for the injected form of the vaccine. The equilibrium price and quantity of oral vaccine both decline due to the new information. The new information also affects the market for the injected vaccine. This vaccine now appears to be relatively safer and therefore demand for it will increase at every price. Thus, the demand curve shifts up and to the right because the new information is positive in the injected vaccine market. Note however that since the two vaccines are substitutes, the fact that the price of the oral vaccine declined should cause the demand for the injected vaccine to decline as well (it is relatively more expensive). We do not have enough information to determine which of these effects (the substitution effect or the “safety” effect) will be larger. If the demand shift due to the increased relative safety is larger than the shift due to the increase in relative price, the net effect is a shift of the demand curve up and to the right. We will assume this is the case (although full credit was given if you showed a shift down and to the left and explained your reasoning correctly). Finally, note that the total quantity of vaccine used (oral plus injected) could decrease—people might find the cost of the injected too high and the risk of the oral too high such that they prefer not to vaccinate at all.

Price (\$)

Soral

Price (\$) P**injected P*injected

Sinjected

P*oral P**oral Dinjected Doral D’oral Q**oral Q*oral Quantity of Oral Vaccine Q*injected Q**injected Quantity of Injected Vaccine

3 Short Run In the short run, the labels will reduce demand for cigarettes, thereby shifting the demand curve down and to the left because of this new negative information about smoking. As shown in the market graph below, this reduces the price of cigarettes and therefore causes economic losses (i.e., negative profits) at individual firms. For this question we only asked for the effects in the market (not individual firms); hence, the firm graph was not necessary to receive full credit.
Price (\$) Losses P* P** MC ATC Price (\$) S

D2 q** q* Quantity Q** Q*

D1 Quantity

Individual Firm Market Long Run Because firms are making negative profits, firms will exit the industry in the long run. They will do so until economic profits are equal to zero—that is, until a competitive long run equilibrium is reached. Therefore, the supply curve for the market shifts up and to the left until the equilibrium price returns to the original equilibrium price (P*). The equilibrium price returns to P* because there have been no changes in the cost structure of the industry (no curves have shifted in the firm graph). Again, the individual firm graph was not required for full credit, but some discussion of economic profits return to zero was necessary to know when firms stop exiting the industry.
Price (\$) MC ATC P* = P*** P** Price (\$) S2 S1

D2 q** q* = q*** Quantity Q*** Q** Q*

D1 Quantity

Individual Firm

Market

4 From the perspective of the workers, accepting the reduced payment does not make sense. This is because the farmer’s threat to let the crop rot is not credible. If the farmer lets the crop rot, he will end up with net loss of \$20,000. This loss exceeds \$15,000, the amount he would lose by harvesting the crop and paying the workers the same amount as last year. This is illustrated in the table below: Farmer’s Decision and Payoffs Pay Full Wage and Harvest Let the Crop Rot Planting (Sunk Costs) -\$20,000 Labor Cost -\$30,000 Revenue \$35,000 Profit -\$15,000

-\$20,000 0 0 -\$20,000

This is a good example of the economic concept of sunk costs. The farmer’s \$20,000 expenditure three months ago is “sunk” because it can no longer be recovered. Like the fixed costs for a firm, such costs do not impact short-run production decisions. The farmer is still interested in maximizing profits (or minimizing losses in this case). Thus, the workers have no reason to concede to the farmer’s demands. (Another way to see this problem is to note that while the farmer would be below his breakeven point if he harvests, he is still above his shutdown point, which is -\$20,000. So long as he can walk away with something better than -\$20,000, the farmer has an incentive to harvest the crop, even at a loss). 5. Correct Answer 1: The claim is not correct because the person confuses accounting profits with economic profits. The opportunity cost must be subtracted from accounting profits to obtain economic profits. If the opportunity cost is \$1 million, then the family is indeed making zero economic profits. Correct answer 2: The claim is not necessarily correct because the industry may be in the short-run, or subject to demand fluctuations. Economic profits may be earned in the short-run but will disappear with the entry of new firms, which may be the situation of the family. Demand fluctuations may cause firms to have profits in some years and losses in others, but zero profits on average. Long-run perfectly competitive model is then a good approximation of this industry.
6. It may seem counterintuitive that as one raises prices, revenues fall. However, an

economics wizard knows that revenues are PxQ, thus an increase in price may not always lead to an increase in revenues, since quantity demanded is likely to change when prices increase. The demand curve tells us the relationship between any price and the amount that all consumers in the market will consume. Since we have shown that all normal demand curves slope downward, we know that consumers will consume fewer license plates when the price goes up. How much fewer depends on the price elasticity of the demand

curve. If the curve is unit elastic (i.e., the elasticity is 1) where the market equilibrium is, the change will produce the same amount of revenues. Since the change under discussion produced lower revenues, we may say that the demand for personalized license plates in Texas is relatively price elastic. A percentage change in price leads to a larger percentage change in consumption. As the name suggests, “vanity” plates aren’t exactly a necessity. Therefore, if price goes up a little people would be likely to drop their consumption quickly. 7 A maximum wage is a price ceiling on the price of labor—the wage. One might presume, first, that if Firmland is implementing a maximum wage, that the equilibrium wage in the market exceeds the mandatory maximum wage (otherwise, there would be no need for the law).1 If the equilibrium is indeed above the maximum wage, when we turn to our supply and demand model (here, the laborers are “suppliers” and the firms are consumers), we will find a shortage of labor (see diagram) in response to this effective price ceiling. Firms will demand a great deal more work than the labor market is willing to supply. Notice an important subtlety to the logic here (not necessary for a correct answer). When we map the market “supply” curve for labor, we are looking at workers’ marginal cost of supplying labor. As we have seen in so many cases, that cost is defined by the workers’ opportunity cost—their next-best alternative. Since every firm in Firmland must pay the same wages, you could argue that a laborer’s opportunity cost is constant once it reaches the maximum wage, and thus that there would be no shortage. However, first, as you may remember from our economics case example in class, for some people, the next-best alternative is leisure, not work. These people will choose to, say, go to the beach instead of working. Also, the people of Firmland may emigrate to Laboria, where workers are more appreciated! Knowing that the that opportunity of emigration exists means the opportunity cost is still there. We might expect both of these factors to cause the labor supply curve to still be upward sloping above the maximum wage. Now we know that there is a shortage, that there will be less employment, and that firms will hire fewer people at equilibrium, but this alone doesn’t tell us who is better or worse off. The only way to know who is better or worse off as a result of the wage ceiling is to look at producer (workers) and consumer (firms) surplus.

1

If you assume otherwise, you do not get the question wrong, BUT to get credit using this alternative assumption, your answer must be consistent. Since the outcome is very straightforward when we assume that the maximum wage is above the market equilibrium wage (answer: there is no effect), partial credit was very difficult to give for any wrong answers.

Workers We can be sure that, on the whole, workers are worse off. Some chose not to work at all and lose the surplus of working that they would have at an equilibrium wage. Those who continue to work (far left on the labor supply curve) lose a great deal of surplus in the difference between the equilibrium wage and the maximum wage. The result in terms of surplus is that workers overall begin with C+D+F and end up with only F; they are worse off. Firms Firms may or may not be better off, depending on the geometry of the curves. While they gain some of the surplus that would have gone to workers under the equilibrium wage (this gain is represented by rectangle C), they lose the deadweight loss triangle of B. If B < C, as it would probably be in most cases, the firms are better off. Society We measure losses to society in terms of deadweight loss (DWL). Here, the resulting DWL is represented by regions B and D. Its very existence shows us that society is worse off, because it lost the potential surplus. As a result, we may tell the government that • Firms will face labor shortages, but will probably make more surplus even at lower levels of production; • Many workers will choose not to work at all, but will spend their days at the beach and many others will earn a lot less than they used to in surplus, which may mean higher poverty even among those who have chosen to work; and • Firmland will probably see a flight of workers—especially those most in demand in a healthy economy, since Laboria and other countries will snap them up quickly. In addition to the “brain drain”, Firmland will lose a great deal of economic surplus as a result of the artificially low wage. Wage E A Equil. Wage C Max. Wage F Demand for Labor D B Supply of Labor2

Units of Labor
Note, of course, that the demand for leisure would make the upper register of this supply curve slope backwards.
2

Before maximum wage is implemented Firm Surplus = E + A + B Worker Surplus = C + D + F After maximum wage is implemented Firm surplus = E + A + C Workers’ Surplus = F ∆Firm Surplus = C-B ∆Worker Surplus = - C-D ∆Society Surplus (Deadweigh Loss) = - B – D

Problem Set 3 Practice Problems A. (a)
Quantity Total Cost 30 90 130 210 310 430 Fixed Cost 30 30 30 30 30 30 Variable Cost 0 60 100 180 280 400 Average Total Cost -90 65 70 77.5 86 Average Variable Cost -60 50 60 70 80 Marginal Cost -60 40 80 100 120 Total Revenue 0 90 180 270 360 450 Marginal Revenue -90 90 90 90 90 Profit

0 1 2 3 4 5

-30 0 50 60 50 20

(b) This firm will produce 3 units. This is the quantity that leads to the highest profits for the firm. (c) Breakeven Price=65. This is the minimum ATC. Shutdown Price=50. This is the minimum AVC. B. (a) MP Schedule
Labor (units) 0 1 2 3 4 5 Capital (units) 2 2 2 2 2 2 Output (units) 0 5 15 20 23 24 Marginal Product -5 10 5 3 1

Yes the MP schedule obeys the Law of diminishing returns. As more labor is added, the MP of labor declines i.e. the increase in output due to a unit increase in lahor declines with increasing labor input. (b) Short-run Cost Schedule
Labor (units) 0 1 2 3 4 5 Capital (units) 2 2 2 2 2 2 Output (units) 0 5 15 20 23 24 Labor Cost (VC) 0 5 10 15 20 25 Capital Cost (FC) 20 20 20 20 20 20 Total Cost 20 25 30 35 40 45 Marginal Cost -5 5 5 5 5

(c) MP and Short-run Cost Schedule if Labor Productivity doubles
Labor (units) 0 1 2 3 4 5 Capital (units) 2 2 2 2 2 2 Output (units) 0 10 30 40 46 48 Marginal Product -10 20 10 6 2 Labor Cost (VC) 0 5 10 15 20 25 Capital Cost (FC) 20 20 20 20 20 20 Total Cost 20 25 30 35 40 45 Marginal Cost -5 5 5 5 5

Only the MP schedule changes. The cost schedules remain the same because productivity has changed, not the cost of labor. (d) Each short-run cost curve or schedule is based on a particular amount of capital. As capital changes, the cost structure of the firm as well as its output producing capabilities change which causes the short-run cost curves to shift. C. The interaction of supply and demand for labor determines the wage rate. For the moment, presume that the supply of labor in Mexico and the U.S. are relatively inelastic and identical. Since the demand for labor is based on the marginal product of labor, a higher marginal product in the U.S. than in Mexico would mean that there is a higher demand for U.S. labor than Mexican labor. Thus, according to the supply and demand model, differences in marginal product will be seen as differences in labor demand, ceteris paribus. One factor that might cause this difference in marginal product is the overall higher level of investment in human capital that takes place in the U.S. relative to Mexico. If higher education makes workers more productive, one has only to compare the distribution of education in the U.S. to that in Mexico to see why there is a higher worldwide demand for skilled workers in the U.S. relative to Mexico, an therefore a higher wage. Another factor that might explain the higher marginal product of labor in the U.S. is the higher level of capital investment in the U.S. relative to Mexico.

W

Mexican Labor Market Market
SM

US Labor
W SU

Wus Wus Wmx Wmx

DU

DM QL QL

D. The welfare loss of price controls: The Northeast Interstate Dairy Compact (NIDC) a) The price floor in the Northeast is illustrated in figure 1. The non-intervention free market equilibrium is revealed by the intersection of the standard supply and demand curves for milk in the Northeast, with suppliers selling all their production of milk, Qni, to consumers at a price Pni. Imposing a price floor Pf guarantees a price of milk we are told is “typically above what the equilibrium market price would bring”. This means Pf > Pni , as shown by the red line in figure 1. (Remember a price floor can be set below the market equilibrium price, in which case it does not affect the natural equilibrium. This could be used to reduce the volatility of prices for example). As the price is increased to the guaranteed price floor Pf, demand for milk falls to Qd whilst supply of milk increases to Qs, created a production surplus equal to Qs -Qd that is bought by the government at price Pf.

Price Surplus Pf Pni SMilk Price floor

DMilk Qd Qni Qs Quantit

Figure 1. The Northeast milk k t b) Determining the deadweight loss of the price floor is important to estimate the cost to society of intervening in the Northeast dairy market1. To make things obvious, the process can be broken down into two parts. Figure 2 shows the changes to consumer and producer surplus after introducing a price floor. There is a reduction in consumer surplus and an increase in producer surplus. Overall, there is a gain in the triangle F, as shown by the thick red line.

The crucial simplifying assumption is that consumer surplus, producer surplus and government expenditure are directly comparable.

1

Price

Without price floor

With price floor

SMilk Pf Pni C DMilk Qd Qni Qs Qd Qni Qs A B D E F

SMilk

DMilk Quantit

Consumer surplus Producer surplus Figure 2 Change in Consumer and Producer Surpluses Without price floor A+B+D C+E With price floor A B + D + F + C +E

Consumer Surplus Producer Surplus

In a second step, we are told the suppliers can produce a surplus and sell it because the government has agreed to buy the entire surplus. Since consumers are only buying Qd, the government buys the difference Qs – Qd at a total cost of (Qs – Qd) x Pf , or the shaded area DEFGI in figure 3 below. Price
Government intervention

SMilk Pf Pni D E G DMilk Qd Qs F I

Government expenditure Figure 3 The government i t

The net effect depends on what the government does with all the milk it has bought. At the extremes, it can: 1. Destroy the milk This sounds completely crazy and it is. Nevertheless, Europe did this on numerous occasions to protect its price floor! The European Common Agricultural Policy was the cause of many an infamous “beef and butter mountain”, or “wine and milk lake” in the 80s. In this case, the gain in consumer and producer surplus F is offset by government expenditure of DEFGI, leaving a deadweight loss to society of DEGI, as shown in figure 4.
Government destroys the milk

Government gives the milk

SMilk A Pf B C G DMilk Qd Qs Qd Qs G D E F I B F I

SMilk

D E

DMilk

2. Give the milk. The government can give the surplus to those who most value it, but can’t afford to pay price Pf. Since they get it for free, the extra consumer surplus is the whole area under the demand curve from Qd to Qs, represented by the blue area DEG in figure 4. The gains and losses are summarised in the following table. The difference between the total losses and total gains is I, the triangular area shaded on the right hand graph above. This deadweight loss is the same as the one portrayed in Taylor’s book on p174. Loss D+E+F+G+I Gain D+E+F+G I

Government Change in consumer and producer surplus Net deadweight loss

These two deadweight losses are the maximum and minimum amounts of deadweight loss that will be caused by the price floor. The cost to society will ultimately depend on how much milk is not destroyed and how it is distributed to consumers. What is clear in this analysis is that a price floor is always detrimental to social welfare. c) There are unfortunately plenty of reasons why economically bad policies permeate society. Here are just some reasons why price floors still exist: i. The political process: Small, well organised and well funded groups often wield more political power than apathetic majorities. Agricultural groups such as the NIDC are particularly successful at influencing national policy. Consumers lose from having to pay higher prices for foodstuffs and from having to pay higher taxes to finance the Federal government’s purchase of surplus produce. However, consumers are often ill informed and too disorganised to launch an effective counter-strike. ii. Lack of information/ignorance: Politicians may truly believe they are acting in the best interest of the nation, but lack the economic training and the information necessary to choose the economically optimal policy. iii. Income distribution: What if dairy farmers were all earning a pittance, despite working 12 hour long shifts milking their beloved cows to provide milk to the nation’s children? A price floor could be used to rectify this “injustice” as a form of income redistribution based on the beliefs of the elected party. As an economist, you could suggest other forms of income support be used to prop up dairy farmers incomes instead of distorting the market. iv. Volatility: Uncertainty is often seen as a cost in economics and clouds rational decision making. Agricultural products are open to supply shocks such as weather and crop diseases that make it difficult to predict yields, the quantity supplied and final prices. Furthermore, the quantity supplied is slow to react to changes in price, since it takes many months to plant crops and years to raise cattle. The volatility of prices thus harms consumers and producers. Setting a price floor is one way of reducing this volatility and a potentially beneficial reason to intervene in the market.

E
a) Destruction of the orange crop will presumably cause an increase in the price of oranges. Assuming that oranges are an input into the production of orange juice (hopefully a reasonable assumption), the increase in the price of oranges will cause the marginal cost curve for each orange juice producing firm to increase. Since oranges are a variable cost as well as being proportional to the amount of orange juice that is produced, we can imagine this as a marginal cost curve shifting up. For the purposes of exposition here, let me just suppose that the increase in the price of oranges causes the marginal cost of orange juice to increase by 30 cents per gallon. In that case, we would get the following diagram for the firm’s cost.

Price

ATC1 P1 P0 MC1 MC0 Q* Quantity

ATC0

Notice that the ATC curve shifts up by EXACTLY the same amount as the MC curve. This makes sense because if, for instance, the marginal cost of each unit increased by 30 cents, this would mean that the average total cost would increase by exactly 30 cents as well. This implies that the breakeven point also increases by 30 cents, but stays at exactly the same quantity. In the market, the supply curve will also shift up by 30 cents (for any unit of production the cost will be 30 cents more.) Combining this with the supply diagram, we get the following:2

Even though it may not appear so, the MC1 is the same curve as MC0, shifted up by an equal amount at all points.

2

Orange Juice Firm Price MC1 MC0 ATC1 P1 P* P0 ATC0 Price

Orange Juice Market

S1 S0

Demand

Q1 Q0

Quantity

Quantity

Since the demand curve is downward sloping, the new intersection of demand and supply will occur at P*, which is a price that is above the original breakeven point, but BELOW the new breakeven point. Assuming that firms are identical, all firms will lose profits in the short-run. The equilibrium price will increase and the equilibrium quantity will go down. The number of firms in the market will be the same, assuming that price is above shutdown, so that firms won’t exit the market in the short-run. b) In the long run, we assume that the marginal cost curves shift back to their original places, and therefore the ATC and AVC shift back to its original location. Assuming that no firms were run out of the market, we also have the supply curve go back to its original location. We will then have exactly the same equilibrium price and quantity that we had before, as well as the same number of firms in the market.