Microeconomics Exercise Sheet 1

PRINCIPLES OF MICROECONOMICS
EXERCISE SHEET (MANKIW)

PREPARED BY: ASHIQUR RAHMAN SHIHAB (25th BATCH)
Stay Out of My Territory – Walter White
1
Contents
Chapter 4 ......................................................................................................................... 5
Problems and Applications ........................................................................................... 5
(1) ....................................................................................................................................... 5
(2) ....................................................................................................................................... 9
(3) ..................................................................................................................................... 10
(4) ..................................................................................................................................... 15
(5) ..................................................................................................................................... 16
(6) ..................................................................................................................................... 17
(7) ..................................................................................................................................... 20
(8) ..................................................................................................................................... 20
(9) ..................................................................................................................................... 22
(10) ................................................................................................................................... 22
(11) ................................................................................................................................... 23
Chapter 5 ....................................................................................................................... 26
Problems and Applications ......................................................................................... 26
(1) ..................................................................................................................................... 26
(2) ..................................................................................................................................... 27
(3) ..................................................................................................................................... 28
(4) ..................................................................................................................................... 30
(5) ..................................................................................................................................... 30
(6) ..................................................................................................................................... 31
(7) ..................................................................................................................................... 32
(8) ..................................................................................................................................... 35
(9) ..................................................................................................................................... 36
(10) ................................................................................................................................... 37
(11) ................................................................................................................................... 38
(12) ................................................................................................................................... 38
Chapter 6 ....................................................................................................................... 39
(1) ..................................................................................................................................... 39
(2) ..................................................................................................................................... 39
(3) ..................................................................................................................................... 40
(4) ..................................................................................................................................... 41
(5) ..................................................................................................................................... 41
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(6) ..................................................................................................................................... 42
(7) ..................................................................................................................................... 42
(8) ..................................................................................................................................... 44
(9) ..................................................................................................................................... 45
(10) ................................................................................................................................... 46
Chapter 7 ....................................................................................................................... 49
(1) ..................................................................................................................................... 49
(2) ..................................................................................................................................... 49
(3) ..................................................................................................................................... 50
(4) ..................................................................................................................................... 51
(5) ..................................................................................................................................... 53
(6) ..................................................................................................................................... 55
(7) ..................................................................................................................................... 56
(8) ..................................................................................................................................... 59
(9) ..................................................................................................................................... 60
(10) ................................................................................................................................... 63
(11) ................................................................................................................................... 65
Chapter 13 ..................................................................................................................... 67
(1) ..................................................................................................................................... 67
(2) ..................................................................................................................................... 67
(3) ..................................................................................................................................... 67
(4) ..................................................................................................................................... 70
(5) ..................................................................................................................................... 75
(6) ..................................................................................................................................... 75
(7) ..................................................................................................................................... 77
(8) ..................................................................................................................................... 78
(9) ..................................................................................................................................... 80
(10) ................................................................................................................................... 82
Chapter 16 ..................................................................................................................... 85
(1) ..................................................................................................................................... 85
(2) ..................................................................................................................................... 85
(3) ..................................................................................................................................... 86
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(4) ..................................................................................................................................... 87
(5) ..................................................................................................................................... 88
(6) ..................................................................................................................................... 88
(7) ..................................................................................................................................... 89
(8) ..................................................................................................................................... 91
(9) ..................................................................................................................................... 92
(10) ................................................................................................................................... 92
Chapter 21 ..................................................................................................................... 95
(1) ..................................................................................................................................... 95
(2) ..................................................................................................................................... 97
(3) ..................................................................................................................................... 98
(4) ..................................................................................................................................... 99
(5) ..................................................................................................................................... 99
(6) ................................................................................................................................... 101
(7) ................................................................................................................................... 101
(8) ................................................................................................................................... 106
(9) ................................................................................................................................... 109
(10) ................................................................................................................................. 110
(11) ................................................................................................................................. 110
(12) ................................................................................................................................. 111
4
Chapter 4
Problems and Applications
(1)
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6
7
8
(2)
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(3)
10
11
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13
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(4)
Consider the markets for DVDs, TV screens, and tickets at movie theatres.
a. For each pair, identify whether they are complements or substitutes:
• DVDs and TV screens
• DVDs and movie tickets
• TV screens and movie tickets
b. Suppose a technological advance reduces the cost of manufacturing TV screens. Draw a
diagram to show what happens in the market for TV screens.
c. Draw two more diagrams to show how the change in the market for TV screens affects the
markets for DVDs and movie tickets
Answer:
(a) DVDs and TV screens are complements.
DVDs and movies tickets are substitutes.
TV screens and movie tickets are substitutes.
(b) As the cost of manufacturing TV screens reduces due to technological advances, the supply
of TV screens will increase. This increase in supply makes the price fall as demand remains
constant. This is shown in the diagram below.
The increase in supply of TV screens is shown by a rightward shift in the supply curve from
S1S1 to S₂S₂. The quantity supplied increases from Q₁ to Q₂ and the price reduces from P 1 to P₂
(c) Since TV screens and DVDs are complements, the fall in price of TV screens leads to an
increase in the demand for DVDs. The increased demand for DVDS causes its price to rise.
TV screens and movie tickets are substitutes. As the price of TV screens reduces, the demand
for movie tickets decreases. The decreased demand for movie tickets causes its price to fall.
These are shown in the diagrams below
The effect on the DVD market as follows
1) TV screens and DVDs are complements
15
Due to a fall in the price of TV screens, the demand of DVDs increases from D 1D₁ to D₂D₂
shown by a rightward shift. The price of DVDs increases from P1 to P2 and the quantity
demanded increases from Q₁ to Q2
The effect on the market for movie tickets is as follows
2) Tv Screens and Movie Tickets are Substitutes
Due to a fall in the price of TV screens, the demand curve of movie tickets shifts left from D1D₁
to D₂D₂. The price of movie tickets decreases from P1 to P₂. The quantity decreases from Q1
to Q₂.
(5)
Over the past 40 years, technological advances have reduced the cost of computer chips. How
do you think this has affected the market for computers? For computer software? For
typewriters?
Answer:
Demand is an individual's willingness and ability to buy goods and services from the market.
A good is said to be complement when it has a negative cross elasticity of demand. It means
that the demand is decreased when the price of another good is decreased.
Two goods are said to be perfect substitutes if the utility gained from one good is equal to the
utility gained from the other good. The indifference curve for a perfect substitute good is
straight shape.
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Given that the technological advances have reduced the cost of computer chips
Effect of the market for Computers:
With reduction in the cost of input good, that is, the computer chip in the production of
computers would incentivize the firms to produce more computers. The supply curve would
shift out to the right. The resultant would be decreased price and increased quantity of
computers As, the supply curve shifts to the right the price of the computers decreases and
the quantity increases.
Thus, more computers would be produced in the economy
Effect of the market for Computer Software:
Computer softer being a complementary good to computers, the increased demand for
computers would increase the demand for computer software as well. Hence a decrease in
the price of computers would result in an increase in the demand for the computer software.
Effect of the market for Type writers:
Typewriter is a substitute to computer. Increased quantity of computers in the market, with
lesser price, would reduce the demand for typewriters. Hence a decrease in the price of
computers would result in a decrease in the demand for the typewriters.
(6)
Using supply-and-demand diagrams, show the effect of the following events on the market for
sweatshirts.
a. A hurricane in South Carolina damages the cotton crop.
b. The price of leather jackets falls.
c. All colleges require morning exercise in appropriate attire.
d. New knitting machines are invented.
Answer:
a) Cotton is the raw material for sweatshirts. Consider a hurricane in South Carolina that
damages the cotton crop. The price of cotton will increase and the manufacturing cost of
sweatshirts will also increase. Producers will reduce the supply of sweatshirts at a high cost
of production. With demand being constant, a decrease in supply leads to an increase in the
price of sweatshirts. As a result, the supply of sweatshirts shifts to the left, as shown in the
figure.
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The supply of sweatshirts decreases and is shown by a leftward shift in the supply curve from
S₁S1 to S₂S₂. The quantity decreases from Q₁ to Q₂ and the price increases from P 1 to P₂.
(b) Leather jackets are substitutes for sweatshirts. As the price of leather jackets fall, the
demand for sweatshirts will also fall. With the supply being constant, a fall in the demand for
sweatshirts causes the price of sweatshirts to fall. This is shown in the diagram below.
A fall in the demand of sweatshirts causes a leftward shift in the demand curve from D1D1 to
D₂D₂ with the supply being constant, a fall in the demand decreases the price from P1 to P2.
The quantity decreases from Q1 to Q₂
c) Compulsion to wear appropriate attire for morning exercise by all colleges will make the
demand for sweatshirts increase. Supply being constant, an increase in demand will increase
the price of sweatshirts, as shown below.
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The increase in demand of sweatshirts is shown by a rightward shift in the demand curve from
D1D1 to D₂D₂. This leads to an increase in the price from P1 to P2 and an increase in the
quantity from Q₁ to Q₂
d) The invention of new knitting machines is an improvement of technology in the production

of sweatshirts. This leads to an increase in the supply of sweatshirts. With the demand being
constant, an increase in the supply of sweatshirts causes a decrease in the price. This is shown
below in the diagram.
The increase in the supply of sweatshirts is shown by a rightward shift in the supply curve
from S₁S1 to S₂S₂. This increases the quantity from Q1 to Q₂ and decreases the price from P1 to
P2
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(7)
Ketchup is a complement (as well as a condiment) for hot dogs. If the price of hot dogs rises,
what happens in the market for ketchup? For tomatoes? For tomato juice? For orange juice?
Answer:
It is known from the fact that hot dogs and ketchup are complimentary goods. In case of
complimentary goods, an increase in price of one commodity leads to fall in the quantity
demanded of the other commodity.
In this case, as the price of hot dogs rises, the quantity demanded of ketchup falls. The
equilibrium price and quantity of ketchup falls.
Now because of fall in quantity of ketchup, the producer of ketchup demands less of tomatoes
(an important input in the production of ketchup). Thus, both the price and the quantity of
tomato falls.
But tomato is also a major input used in the production of tomato juice. As the price of tomato
falls, the producer of tomato juice increased its production because the input price is lower
and profitable. Thus, the supply of the tomato juice increases leading to fall in the price of
tomato juice and increase in quantity of tomato juice.
Since tomato juice and orange juice are substitute goods. Substitute goods are those which
are used in place of each other leaving the consumer indifferent or leaving them with the
same level of utility. Now, as the price of the tomato juice falls, the quantity of orange juice
falls.
Thus, on a concluding note, rise in price of hot dogs leads to fall in price and quantity of
orange juice.
(8)
The market for pizza has the following demand and supply schedules
a. Graph the demand and supply curves. What are the equilibrium price and quantity in this
market?
b. If the actual price in this market were above the equilibrium price, what would drive the
market toward the equilibrium?
c. If the actual price in this market were below the equilibrium price, what would drive the
market toward the equilibrium?
Answer:
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DD is the demand curve and SS is the supply curve.
The equilibrium price is at $6.
The equilibrium quantity is at 81 pizzas (where Qd = Qs).
If the actual price is above the equilibrium price, there will be a surplus because the quantity
exceeds the quantity demanded. Suppliers try to increase the sale of pizzas by cutting the
price of a pizza, thereby moving the price toward the equilibrium level.
If the actual price is below the equilibrium price, there will be a shortage because the quantity
demanded exceeds the quantity supplied. With too many buyers chasing too few pizzas, the
suppliers of pizzas can increase the price and make the market move toward the equilibrium
of supply and demand.
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(9)
Consider the following events: Scientists reveal that eating oranges decreases the risk of
diabetes, and at the same time, farmers use a new fertilizer that makes orange trees produce
more oranges. Illustrate and explain what effect these changes have on the equilibrium price
and quantity of oranges.
Answer:
If oranges decrease risk of diabetes, that will shift the demand to the right, increasing price
and quantity. If farmers become more productive, that increases supply, increasing quantity
but decreasing price. So, we know that quantity increases but we don't know what happens
to price because the two shifts affect price differently and we don't know the magnitude of
each.
Graph:
(10)
Because bagels and cream cheese are often eaten together, they are complements.
a. We observe that both the equilibrium price of cream cheese and the equilibrium quantity of
bagels have risen. What could be responsible for this pattern: a fall in the price of flour or a fall
in the price of milk? Illustrate and explain your answer.
b. Suppose instead that the equilibrium price of cream cheese has risen but the equilibrium
quantity of bagels has fallen. What could be responsible for this pattern: a rise in the price of
flour or a rise in the price of milk? Illustrate and explain your answer.
Answer:
a) A fall in the price of flour makes the production cost of bagels fall. Thus, the price of bagels
will decrease. The demand for bagels and cream cheese (complements) will increase due to
the price reduction of bagels.
With the supply being constant, the equilibrium quantity of bagels will rise. As the demand
for cream cheese increases, the demand for milk will also increase. Because milk is an
ingredient in cream cheese, the fall in the price of milk leads to an increase in the supply of
cream cheese. This leads to a decrease in the price of cream cheese, rather than a rise in the
price of cream cheese. Therefore, the fall in the price of milk could not have been responsible
for the pattern observed
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At the increased demand, the equilibrium price of cheese and milk will also increase.
Therefore, a fall in the price of flour leads to rise of the equilibrium price of cream cheese and
the equilibrium quantity of bagels.
b) A rise in the price of milk makes the production cost of cream cheese rise.
Suppliers will buy less cream cheese at its high cost. Demand being constant, decrease in
supply causes an increase in the equilibrium of cream cheese.
A rise in the price of milk makes the cost of cream cheese and bagels increase. At high cost,
the equilibrium quantity of bagels will fall because at high cost, the demand for bagels will
fall. Therefore, a rise in the price of milk is responsible for the rise in the equilibrium price of
cream cheese and the fall in the equilibrium quantity of bagels.
(11)
Suppose that the price of basketball tickets at your college is determined by market forces.
Currently, the demand and supply schedules are as follows:
Price Quantity Demanded Quantity Supplied

$4 10 000 Tickets 8 000 Tickets
a) Draw the demand and supply curves. What is unusual about this supply curve? Why might
this be true?
b) What are the equilibrium price and quantity of tickets?
c) Your college plans to increase total enrolment next year by 5,000 students. The additional
students will have the following demand schedule:
Now add the old demand schedule and the demand schedule for the new students to calculate
the new demand schedule for the entire college. What will be the new equilibrium price and
quantity?
Answer:
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a) Graph of the demand supply curve will be shown below
DD is the demand curve and SS is the supply curve.

The supply curve is parallel to the price line because at all the different prices, the quantity
supplied is constant at 8000 tickets. This is called perfect inelastic supply.
Here, the number of tickets supplied by the college is constant regardless of the ticket price
since the available seats are 8000 and the college administration is ready to accept any price
determined by the market.
(b) The equilibrium point is where the quantity demanded is equal to the quantity supplied.
Here, Qd = Qs is at 8000 tickets
At equilibrium quantity, price = $8
So, Equilibrium quantity = 8000 tickets and
Equilibrium price = $8
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Chapter 5
(1)
For each of the following pairs of goods, which good would you expect to have more elastic
demand and why?
a. required textbooks or mystery novels
b. Beethoven recordings or classical music recordings in general
c. subway rides during the next 6 months or subway rides during the next 5 years
d. root beer or water
Answer:
a) Mystery novels have more elastic demand than required textbooks, because mystery
novels have close substitutes and are a luxury good, while required textbooks are a necessity
with no close substitutes. If the price of mystery novels were to rise, readers could substitute
other types of novels, or buy fewer novels altogether. But if the price of required textbooks
were to rise, students would have little choice but to pay the higher price. Thus, the quantity
demanded of required textbooks is less responsive to price than the quantity demanded of
mystery novels
b) Beethoven recordings have more elastic demand than classical music recordings in general.
Beethoven recordings are a narrower market than classical music recordings, so it is easy to
find close substitutes for them. If the price of Beethoven recordings were to rise, people could
substitute other classical recordings, like Mozart. But if the price of all classical recordings
were to rise, substitution would be more difficult (a transition from classical music to rap is
unlikely!). Thus, the quantity demanded of classical recordings is less responsive to price than
the quantity demanded of Beethoven recordings.
c) Subway rides during the next five years have more elastic demand than subway rides during
the next six months. Goods have a more elastic demand over longer time horizons. If the fare
for a subway ride was to rise temporarily, consumers could not switch to other forms of
transportation without great expense or great inconvenience. But if the fare for a subway ride
was to remain high for a long time, people would gradually switch to alternative forms of
transportation. As a result, the quantity demanded of subway rides during the next six months
will be less responsive to changes in the price than the quantity demanded of subway rides
during the next five years.
d) Root beer has more elastic demand than water. Root beer is a luxury with close substitutes,
while water is a necessity with no close substitutes. If the price of water were to rise,
consumers have little choice but to pay the higher price. But if the price of root beer were to
rise, consumers could easily switch to other sodas. So the quantity demanded of root beer is
more responsive to changes in price than the quantity demanded of water.
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(2)
Suppose that business travellers and vacationers have the following demand for airline tickets
from New York to Boston:
a. As the price of tickets rises from $200 to $250, what is the price elasticity of demand for (i)
business travellers and (ii) vacationers? (Use the midpoint method in your calculations.)
b. Why might vacationers have a different elasticity from business travellers?
Answer:
27
b) The price elasticity of demand for vacationers is higher than the elasticity for business
travellers because vacationers can choose a different mode of transportation (like driving or
taking the train) more easily. Business travellers are less likely to do so because time is more
important to them and their schedules are less flexible.
(3)
Suppose the price elasticity of demand for heating oil is 0.2 in the short run and 0.7 in the long
run.
a. If the price of heating oil rises from $1.80 to $2.20 per gallon, what happens to the quantity
of heating oil demanded in the short run? In the long run? (Use the midpoint method in your
calculations.)
b. Why might this elasticity depend on the time horizon
Answer:
a) Given that the price elasticity of demand for heating oil is 0.2 in the short run and 0.7 in the
long run.
The price of heating oil rises from $1.80 to $2.20 per gallon. Thus, the change in the quantity
demanded in the short run and long run is shown below:
First, calculate the change in the quantity demanded in the short run:
Given the formula for price elasticity of demand, substitute the given values in the above
formula
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Hence, if the price elasticity of demand is 0.2 in the short run, and price increases by 2%, then
the quantity demand will fall by 0.04 or 4% in the short run.
Now, let us calculate the quantity of demand in the long run:
29
Therefore, if the price elasticity of demand is 0.7, and price increases by 2%, the quantity
demand will fall by 0.14 or 14% in the long run.
b) It is clear from the above calculations that, the heating oil is more price-elastic in the long
run as compared to the short run.
In the short run, the quantity demanded by people decreases by a very small percentage (4%)
because, the consumers cannot find alternative sources to heating oil in the short run.
However, in the long run, people can find several alternatives of heating oil. Therefore, they
shift to those alternatives (like using electric power) which leads to a substantial fall in the
quantity demanded of heating oil (i.e. 14%).
(4)
A price change causes the quantity demanded of a good to decrease by 30 percent, while the
total revenue of that good increases by 15 percent. Is the demand curve elastic or inelastic?
Explain.
Answer:
As per demand law, quantity demanded is inversely proportional to price for normal goods.
Quantity demanded decreased by 30%. This means there is an increase in the price.
Another effect is, revenue increases by 15% due to this change. Price increased and
consequently revenue has also increased.
When the direction of price change and the direction of revenue change happen in the same
direction, product is inelastic.
Here the price increased and due to this revenue has also increased, making the product
inelastic to the changes in price.
So, the product is inelastic.
(5)
Cups of coffee and donuts are complements. Both have inelastic demand. A hurricane destroys
half the coffee bean crop. Use appropriately labeled diagrams to answer the following
questions.
a. What happens to the price of coffee beans?
b. What happens to the price of a cup of coffee? What happens to total expenditure on cups of
coffee?
c. What happens to the price of donuts? What happens to total expenditure on donuts?
Answer:
Demand is the inverse relationship between the price and the quantity demanded.
Complementary goods are those goods which are consumed together.
a) The destruction of coffee bean crop due to the hurricane would shift the supply curve for
coffee bean to the left as less of beans are available now for producing coffee. As a result, the
price of beans would increase and the quantity would fall.
30
b) The key input price of coffee production has increased, resulting into increased price of the
output too. The price of coffee would go up. The demand being inelastic, the increased price
would reduce the demand by a very less proportion, so the total expenditure, which is price
times the output, would increase.
C) Since donuts are consumed along with the coffee, and the demand for coffee has reduced
slightly, so the demand for donuts would also fall slightly and the price of donuts would
reduce. The demand being inelastic, the total expenditure on donuts would fall.
(6)
The price of coffee rose sharply last month, while the quantity sold remained the same. Five
people suggest various explanations:
Leonard: Demand increased, but supply was perfectly inelastic.
Sheldon: Demand increased, but it was perfectly inelastic.
Penny: Demand increased, but supply decreased at the same time.
Howard: Supply decreased, but demand was unit elastic.
Raj: Supply decreased, but demand was perfectly inelastic.
Who could possibly be right? Use graphs to explain your answer.
Answer:
Demand is the inverse relationship between the price and the quantity demanded.
Leonardo is right in explaining this scenario. Perfectly inelastic supply implies that the supply
curve is unrelated to price and hence is a vertical curve. Increase in demand would only
increase the price with no change in the quantity,
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(7)
Suppose that your demand schedule for pizza is as follows:
a. Use the midpoint method to calculate your price elasticity of demand as the price of pizza
increases from $8 to $10 if (i) your income is $20,000 and (ii) your income is $24,000.
b. Calculate your income elasticity of demand as your income increases from $20,000 to $24,000
if (i) the price is $12 and (ii) the price is $16.
Answer:
Elasticity of demand measures the responsiveness of change in demand due to change in
price.
a) The mid-point formula for calculating the elasticity of demand is given as below:
32
Where,
Initial quantity is represented by Q1
Final quantity is represented by Q2
Initial price is represented by P1 and
Final price is represented by P2
33
Initial quantity is represented by Q1
Final quantity is represented by Q2
Initial price is represented by Y1 and
Final price is represented by Y2
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(8)
The New York Times reported (Feb. 17, 1996) that subway ridership declined after a fare
increase:
“There were nearly four million fewer riders in December 1995, the first full month after the
price of a token increased 25 cents to $1.50, than in the previous December, a 4.3 percent
decline.”
a. Use these data to estimate the price elasticity of demand for subway rides.
35
b. According to your estimate, what happens to the Transit Authority’s revenue when the fare
rises?
c. Why might your estimate of the elasticity be unreliable?
Answer:
a) Price elasticity of demand measures the responsiveness of quantity demanded of a good
due to change in price level. Mathematically, it is the percentage change in quantity
demanded due to the percentage change in price.
which is very inelastic.

b) Since price elasticity is 0.215, which is less than 1, demand is inelastic. Therefore, the price
and the total revenue move in the same direction, i.e., when prices rise with inelastic demand,
the total revenue will increase.
c) The elasticity might be unreliable because the data is given for only the first month after an
increase in the price. Thus, the elasticity is measured in the short-run. However, in the long-
run, elasticity may increase as individuals may switch to other transportation as a result of an
increase in the price.
(9)
Two drivers, Walt and Jessie, each drive up to a gas station. Before looking at the price, each
places an order. Walt says, “I’d like 10 gallons of gas.” Jessie says, “I’d like $10 worth of gas.”
What is each driver’s price elasticity of demand?
Answer:
When one person says that he would like to have 10 gallons of gas at a gas station, it means
no matter whatever the price per gallon of gas, the quantity demanded of gas is 10 gallons.
This indicates that the demand curve is perfectly inelastic at 10 gallons of gas.
Hence, the price elasticity of demand is 0
When the person says that he would like to have $10 worth of gas, it means that so many
units of gallon would be demanded at the given price, as much as the person could afford to
have in $10. That means, when the price is $1 per gallon of gas, the units of gas demanded by
the person is 10 gallons. When the price of the gas is $5 per gallon, the units of gas demanded
is 2 gallons. Since, the total expenditure is fixed at $10 the demand curve of the person is unit
elastic. Hence, the price elasticity of demand is 1
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(10)
Consider public policy aimed at smoking.
a. Studies indicate that the price elasticity of demand for cigarettes is about 0.4. If a pack of
cigarettes currently costs $5 and the government wants to reduce smoking by 20 percent, by
how much should it increase the price?
b. If the government permanently increases the price of cigarettes, will the policy have a larger
effect on smoking 1 year from now or 5 years from now?
c. Studies also find that teenagers have a higher price elasticity of demand than adults. Why
might this be true?
Answer:
Elasticity of demand measures the responsiveness of change in demand due to change in
price.
a)
b) This increased price policy would have a larger effect in the long run because the price
elasticity of demand is inelastic in the short run and elastic in the long run because of
availability of close substitutes. Moreover, smoking is an addiction which takes time to break
in the short run.
c) Teenagers are generally dependent financially on their guardians; however, adults are
financially independent, making adult's price elasticity to be inelastic relative to teenagers.
37
Also, adults become habitual or addicted by the time they become financially independent
making their habit permanent.
(11)
You are the curator of a museum. The museum is running short of funds, so you decide to
increase revenue. Should you increase or decrease the price of admission? Explain.
Answer:
Museums are located at different locations with their unique features. In order to determine
whether you should raise or lower the price of admissions, you need to know if the demand
is elastic or inelastic. If demand is elastic, a decline in the price of admissions will increase
total revenue. If demand is inelastic, an increase in the price of admissions will cause total
revenue to rise.
(12)
Explain why the following might be true: A drought around the world raises the total revenue
that farmers receive from the sale of grain, but a drought only in Kansas reduces the total
revenue that Kansas farmers receive.
Answer:
Supply and Demand:
When the supply or demand of a product changes, there is a new equilibrium price and
quantity in the market. At this new equilibrium point, the change in a supplier's revenue
depends on demand's price elasticity.
This is because grains, being a necessary good, face inelastic demand. Because of this, when
the price of grains rises as a result of reduced supply, the increase in revenue brought about
by the increased prices is higher than the decrease in revenue brought about by the fall in
quantity sold. The net effect is that the total revenue rises.
On the other hand, grains from a particular region, like Kansas, face competition from grains
from other areas. Because of this, the grains from Kansas have elastic demand, and their
revenue falls when the price increases as a result of a fall in supply.
38
Chapter 6
(1)
Lovers of classical music persuade Congress to impose a price ceiling of $40 per concert ticket.
As a result of this policy, do more or fewer people attend classical music concerts? Explain
Answer:
If the price ceiling of $40 per ticket is below the equilibrium price, then quantity demanded
exceeds quantity supplied, so there will be a shortage of tickets. The policy decreases the
number of people who attend classical music concerts, because the quantity supplied is lower
because of the lower price.
(2)
The government has decided that the free-market price of cheese is too low.
a. Suppose the government imposes a binding price floor in the cheese market. Draw a supply-
and demand diagram to show the effect of this policy on the price of cheese and the quantity of
cheese sold. Is there a shortage or surplus of cheese?
b. Producers of cheese complain that the price floor has reduced their total revenue. Is this
possible? Explain.
c. In response to cheese producers’ complaints, the government agrees to purchase all the
surplus cheese at the price floor. Compared to the basic price floor, who benefits from this new
policy? Who loses?
Answer:
a. The imposition of a binding price floor in the cheese market is shown in Figure 3. In the
absence of the price floor, the price would be P1 and the quantity would be Q1. With the
floor set at Pf, which is greater than P1, the quantity demanded is Q2, while quantity
supplied is Q3, so there is a surplus of cheese in the amount Q3 – Q2.
39
b. The farmers’ complaint that their total revenue has declined is correct if demand is
elastic. With elastic demand, the percentage decline in quantity would exceed the
percentage rise in price, so total revenue would decline.
c. If the government purchases all the surplus cheese at the price floor, producers benefit
and taxpayers lose. Producers would produce quantity Q3 of cheese, and their total
revenue would increase substantially. However, consumers would buy only quantity Q2 of
cheese, so they are in the same position as before. Taxpayers lose because they would
be financing the purchase of the surplus cheese through higher taxes.
(3)
A recent study found that the demand-and-supply schedules for Frisbees are as follows:
a. What are the equilibrium price and quantity of Frisbees?

b. Frisbee manufacturers persuade the government that Frisbee production improves scientists’
understanding of aerodynamics and thus is important for national security. A concerned
Congress votes to impose a price floor $2 above the equilibrium price. What is the new market
price? How many Frisbees are sold?
c. Irate college students march on Washington and demand a reduction in the price of Frisbees.
An even more concerned Congress votes to repeal the price floor and impose a price ceiling $1
below the former price floor. What is the new market price? How many Frisbees are sold?
Answer:
a. The equilibrium price of Frisbees is $8 and the equilibrium quantity is six million Frisbees.
b. With a price floor of $10, the new market price is $10 because the price floor is binding.
At that price, only two million Frisbees are sold, because that is the quantity demanded.
c. If there’s a price ceiling of $9, it has no effect, because the market equilibrium price is
$8, which is below the ceiling. So, the market price is $8 and the quantity sold is six
million Frisbees.
40
(4)
Suppose the federal government requires beer drinkers to pay a $2 tax on each case of beer
purchased. (In fact, both the federal and state governments impose beer taxes of some sort.)
a. Draw a supply-and-demand diagram of the market for beer without the tax. Show the price
paid by consumers, the price received by producers, and the quantity of beer sold. What is the
difference between the price paid by consumers and the price received by producers?
b. Now draw a supply-and-demand diagram for the beer market with the tax. Show the price
paid by consumers, the price received by producers, and the quantity of beer sold. What is the
difference between the price paid by consumers and the price received by producers? Has the
quantity of beer sold increased or decreased?
Answer:
a) Figure 4 shows the market for beer without the tax. The equilibrium price is P1 and the
equilibrium quantity is Q1. The price paid by consumers is the same as the price received
by producers.
b) When the tax is imposed, it drives a wedge of $2 between supply and demand, as shown
in Figure 5. The price paid by consumers is P2, while the price received by producers is
P2 – $2. The quantity of beer sold declines to Q2.
(5)
A senator wants to raise tax revenue and make workers better off. A staff member proposes
raising the payroll tax paid by firms and using part of the extra revenue to reduce the payroll
tax paid by workers. Would this accomplish the senator’s goal? Explain.
Answer:
Reducing the payroll tax paid by firms and using part of the extra revenue to reduce the
payroll tax paid by workers would not make workers better off, because the division of the
burden of a tax depends on the elasticity of supply and demand and not on who must pay the
41
tax. Because the tax wedge would be larger, it is likely that both firms and workers, who share
the burden of any tax, would be worse off.
(6)
If the government places a $500 tax on luxury cars, will the price paid by consumers rise by more
than $500, less than $500, or exactly $500? Explain.
Answer:
Unless the demand for luxury cars is perfectly inelastic, the price paid by consumers should
rise by less than $500. This is because some of the $500 would be passed off to producers.
We know the demand for luxury goods tends to be elastic and thus the answer is less than
$500.
(Luxury Goods: Luxury goods in economics tend to have high elasticities of demand, this means the quantity
demanded of a luxury good is highly sensitive to changes in the price of the good)
(7)
Congress and the president decide that the United States should reduce air pollution by reducing
its use of gasoline. They impose a $0.50 tax on each gallon of gasoline sold.
a. Should they impose this tax on producers or consumers? Explain carefully using a supply-and-
demand diagram.
b. If the demand for gasoline were more elastic, would this tax be more effective or less effective
in reducing the quantity of gasoline consumed? Explain with both words and a diagram.
c. Are consumers of gasoline helped or hurt by this tax? Why?
d. Are workers in the oil industry helped or hurt by this tax? Why?
Answer:
a. It does not matter whether the tax is imposed on producers or consumers⎯the effect will
be the same. With no tax, as shown in Figure 6, the demand curve is D1 and the supply
curve is S1. If the tax is imposed on producers, the supply curve shifts up by the amount of
the tax (50 cents) to S2. Then the equilibrium quantity is Q2, the price paid by consumers is
P2, and the price received (after taxes are paid) by producers is P2 – 50 cents. If the tax is
instead imposed on consumers, the demand curve shifts down by the amount of the tax
(50 cents) to D2. The downward shift in the demand curve (when the tax is imposed on
consumers) is exactly the same magnitude as the upward shift in the supply curve when
the tax is imposed on producers. So again, the equilibrium quantity is Q2, the price paid by
consumers is P2 (including the tax paid to the government), and the price received by
producers is P2 – 50 cents.
42
b. The more elastic the demand curve is, the more effective this tax will be in reducing the
quantity of gasoline consumed. Greater elasticity of demand means that quantity falls more
in response to the rise in the price of gasoline. Figure 7 illustrates this result. Demand curve
D1 represents an elastic demand curve, while demand curve D2 is more inelastic. The tax will
cause a greater decline in the quantity sold when demand is elastic.
c. The consumers of gasoline are hurt by the tax because they get less gasoline at a higher
price.
d. Workers in the oil industry are hurt by the tax as well. With a lower quantity of gasoline
being produced, some workers may lose their jobs. With a lower price received by producers,
wages of workers might decline.
43
(8)
A case study in this chapter discusses the federal minimum-wage law.
a. Suppose the minimum wage is above the equilibrium wage in the market for unskilled labour.
Using a supply-and-demand diagram of the market for unskilled labour, show the market wage,
the number of workers who are employed, and the number of workers who are unemployed.
Also show the total wage payments to unskilled workers.
b. Now suppose the secretary of labour proposes an increase in the minimum wage. What effect
would this increase have on employment? Does the change in employment depend on the
elasticity of demand, the elasticity of supply, both elasticities, or neither?
c. What effect would this increase in the minimum wage have on unemployment? Does the
change in unemployment depend on the elasticity of demand, the elasticity of supply, both
elasticities, or neither?
d. If the demand for unskilled labour were inelastic, would the proposed increase in the
minimum wage raise or lower total wage payments to unskilled workers? Would your answer
change if the demand for unskilled labour were elastic?
Answer:
a. The market for unskilled labour is given. It is given that the minimum wage applies to this
market. The graph is shown below:
The graph illustrates a labor market with a binding minimum wage.

As the minimum wage set by the government is above the equilibrium wage rate it becomes
binding. Thus, the minimum wage itself is the market wage for the unskilled labor.
Number of workers employed: QD is the number of workers employed.
Number of workers supplied: QS is the number of workers employed.
Number of workers unemployed: The difference between quantity supplied and quantity
demanded (Qs-QD) are the number of workers unemployed.
44
Total Wage Payment:
In the above figure, the shaded rectangle OwsQD gives the total wage paid.
Total wage payment to unskilled workers:
= Minimum wage rate x Number of workers employed
= w × QD
Thus, the total wage payment in the above figure is equal to the shaded region OwsQD
numerically equal to
W x Qd
b. If the minimum wage is increased, it will decrease the number of employed workers.
Change in employment depends on the elasticity of demand. If the demand curve is
elastic, there will be more of a decrease in labour employed with an increase in wage rate.
If the demand for labour is inelastic, there will be less of a decrease in labour employed
with an increase in wage rate. However, the elasticity of supply does not play much role
as the market is in surplus.
c. The increase in the minimum wage would further increase the unemployment. Moreover,
the size of the rise in unemployment depends on both the elasticities of supply and
demand as the elasticity of demand determines the quantity of labor demanded, and the
elasticity of supply determines the quantity of labor supplied. Indeed, the shifts in these
curves depend on their elasticity. Farther the shifts the higher will be the surplus and
unemployment. Thus, the difference between the quantity supplied and quantity
demanded of labor formed due to higher minimum wage is equal to the number of
unemployed and it further depends on the elasticity's of both the labor supply and
demand curves.
d. If the demand for unskilled labor were inelastic:

Due to inelastic demand, the percentage decline in the quantity demanded of the labor
or employment would be lower than the percentage increase in the wage rate. Therefore,
the total wage payments increase to the unskilled labor.
If the demand for unskilled labor were elastic:

On the other hand, if the labor demand is elastic, the percentage decline in the quantity
demanded of the labor or employment would be higher than the percentage increase in
the wage rate. Therefore, the total wage payments to the unskilled labor would decline.
(9)
At Fenway Park, home of the Boston Red Sox, seating is limited to about 38,000. Hence, the
number of tickets issued is fixed at that figure. Seeing a golden opportunity to raise revenue,
the City of Boston levies a per ticket tax of $5 to be paid by the ticket buyer. Boston sports fans,
a famously civic-minded lot, dutifully send in the $5 per ticket. Draw a well-labelled graph
showing the impact of the tax. On whom does the tax burden fall—the team’s owners, the fans,
or both? Why?
Answer:
45
Equilibrium in the market is attained where the demand equals the supply. An imposition of
tax in the market leads to shift of the demand curve downwards.
It is known that the seating is limited at the park to 38,000, this means that the supply curve
is inelastic at the level 38,000. However, the demand curve is a normal downward sloping
curve. An imposition of tax of $5 on buyers would shift the demand curve downwards to the
left, by the amount of tax.
The price at equilibrium is P. After the tax is levied, the fans still pay a price of P but the team
owners receive a price of p*, hence team owners are the sole bearer of tax of (P-P*) = $5
because the supply is perfectly inelastic and the demand is relatively elastic.
(10)
A market is described by the following supply and demand curves:
Qs = 2P
QD = 300 - P
a. Solve for the equilibrium price and quantity.
b. If the government imposes a price ceiling of $90, does a shortage or surplus (or neither) develop?
What are the price, quantity supplied, quantity demanded, and size of the shortage or surplus?
c. If the government imposes a price floor of $90, does a shortage or surplus (or neither) develop?
What are the price, quantity supplied, quantity demanded, and size of the shortage or surplus?
d. Instead of a price control, the government levies a tax on producers of $30. As a result, the new
supply curve is:
QS 5 2(P − 30).
Does a shortage or surplus (or neither) develop? What are the price, quantity supplied, quantity
demanded, and size of the shortage or surplus?
Answer:
46
c) When the government sets the price floor at $90, when the equilibrium price is $100, the
price floor is not binding because $90 is the minimum price that can be charged by the sellers
and the market would eventually move towards the equilibrium price, where the demand
equals the supply. The price and demand would be $100 and 200 units respectively. Neither
shortage nor surplus would develop.
d) Imposition of tax on the suppliers would shift the supply curve to the left, by the amount
of tax. The price consumers pay is more than what is received by the sellers and the difference
of the two goes to the government in the form of tax revenue. Pd = Ps +t , Pd is the price the
consumer's pay. Ps is the price sellers receive and t is the tax.
Re-arranging the demand and supply equations as follows:
47
48
Chapter 7
(1)
Melissa buys an iPhone for $240 and gets consumer surplus of $160.
a. What is her willingness to pay?
b. If she had bought the iPhone on sale for $180, what would her consumer surplus have been?
c. If the price of an iPhone were $500, what would her consumer surplus have been?
Answer:
a) The difference between the willingness to pay and the price paid is the consumer surplus.
Given that Person M pays a price of $240 and her consumer surplus is $160.
Calculate the willingness to pay as follows:
So, the willingness to pay is 400

b) Calculate the consumer surplus as follows:
Consumer surplus = Willingness to pay - Actual price
= $400 − $180
=$220
Thus, the consumer surplus would increase because she paid lesser price than her willingness
to pay.
Thus, the consumer surplus is $220
C) Calculate the consumer surplus as follows:
Consumer surplus = Willingness to pay - Actual price
= $400 − $500
= − $100
Thus, the consumer surplus is −$100
Person M would not buy this phone as her surplus from it is negative.
(2)
An early freeze in California sours the lemon crop. Explain what happens to consumer surplus in
the market for lemons. Explain what happens to consumer surplus in the market for lemonade.
Illustrate your answers with diagrams
Answer:
If an early freeze in California sours the lemon crop, the supply curve for lemons shifts to the
left, as shown in the following Figure. The result is a rise in the price of lemons and a decline
in consumer surplus from A + B + C to just A. So, consumer surplus declines by the amount B
+ C.
49
In the market for lemonade, the higher cost of lemons reduces the supply of lemonade, as
shown in the following Figure. The result is a rise in the price of lemonade and a decline in
consumer surplus from D + E + F to just D, a loss of E + F. Note that an event that affects
consumer surplus in one market often has effects on consumer surplus in other markets.
(3)
Suppose the demand for French bread rises. Explain what happens to producer surplus in the
market for French bread. Explain what happens to producer surplus in the market for flour.
Illustrate your answers with diagrams.
Answer:
A rise in the demand for French bread leads to an increase in producer surplus in the market
for French bread, as shown in the following Figure. The shift of the demand curve leads to an
increased price, which increases producer surplus from area A to area A + B + C.
50
The increased quantity of French bread being sold increases the demand for flour, as shown
in the following Figure. As a result, the price of flour rises, increasing producer surplus from
area D to D + E + F. Note that an event that affects producer surplus in one market leads to
effects on producer surplus in related markets
(4)
It is a hot day, and Bert is thirsty. Here is the value he places on each bottle of water:
Value of first bottle $7
Value of second bottle $5
Value of third bottle $3
Value of fourth bottle $1
a. From this information, derive Bert’s demand schedule. Graph his demand curve for bottled
water.
b. If the price of a bottle of water is $4, how many bottles does Bert buy? How much consumer
surplus does Bert get from his purchases? Show Bert’s consumer surplus in your graph.
51
c. If the price falls to $2, how does quantity demand change? How does Bert’s consumer surplus
change? Show these changes in your graph.
Answer:
a) Bert’s demand schedule:
Demand curve of bottled water
(b) If the price of a bottle is $4, Bert will buy 2 bottles.

Bert's consumer surplus
= Price willing to pay-Actual payment
= 7+5 - 4x2
12- 8 = $4
52
In the balance graph, the consumer surplus at P=$4 is the bounded area AEFGHI.
(c) If the price falls to $2. the quantity demanded will increase to 3 bottles Bert's consumer
surplus will increase to $9.
Price willing to pay for 3 bottles - Actual payment
= $(7+5+3) − $(2×3)
=15- 6 =$9
In the above graph, the consumer surplus at P = $2 is the bounded area ABCJGHI
(5)
Ernie owns a water pump. Because pumping large amounts of water is harder than pumping
small amounts, the cost of producing a bottle of water rises as he pumps more. Here is the cost
he incurs to produce each bottle of water:
Cost of first bottle $1
Cost of second bottle $3
Cost of third bottle $5
Cost of fourth bottle $7
a. From this information, derive Ernie’s supply schedule. Graph his supply curve for bottled water.
b. If the price of a bottle of water is $4, how many bottles does Ernie produce and sell? How much
producer surplus does Ernie get from these sales? Show Ernie’s producer surplus in your graph.
c. If the price rises to $6, how does quantity supplied change? How does Ernie’s producer surplus
change? Show these changes in your graph
Answer:
a) Ernie’s supply schedule for water is:
The graph is as follows:
53
54
(6)
Consider a market in which Bert from problem 4 is the buyer and Ernie from problem 5 is the
seller.
a. Use Ernie’s supply schedule and Bert’s demand schedule to find the quantity supplied and
quantity demanded at prices of $2, $4, and $6. Which of these prices brings supply and demand
into equilibrium?
b. What are consumer surplus, producer surplus, and total surplus in this equilibrium?
c. If Ernie produced and Bert consumed one fewer bottle of water, what would happen to total
surplus?
d. If Ernie produced and Bert consumed one additional bottle of water, what would happen to
total surplus?
Answer:
a) From the above table we can see that the quantity demanded equals to quantity supplied
at a price of $4.
Therefore, $4 is the market clearing price or equilibrium price. In addition, the quantity
demanded at this price is the equilibrium quantity.
Thus, equilibrium price is $4 and equilibrium quantity is two bottles.
(b and c)
55
(7)
The cost of producing flat-screen TVs has fallen over the past decade. Let’s consider some
implications of this fact.
a. Draw a supply-and-demand diagram to show the effect of falling production costs on the
price and quantity of flat-screen TVs sold.
b. In your diagram, show what happens to consumer surplus and producer surplus.
56
c. Suppose the supply of flat-screen TVs is very elastic. Who benefits most from falling
production costs consumers or producers of these TVs?
Answer:
a) A fall in production costs of flat TV screens will increase the supply consequently making a
shift in the supply curve towards its right as shown in the below diagram. S1 is the initial supply
curve, and due to decrease in cost of production supply increases forming S₂ The new
equilibrium point is formed at a lower level at E₂ than the previous point of equilibrium E₁. At
this new level of equilibrium E₂, the quantity increases from Q₁ to Q₂ and the price reduces
from P1 to P₂.
Thus, falling production costs decreases the equilibrium price of TV's and thus, increases the
equilibrium quantity.
b) Consumer Surplus:
Initial Consumer surplus is given by the area under demand curve and above the price P₁, that
is the area under M. Furthermore, final Consumer surplus due to decreased cost of
production is given by the area under demand curve and above the price P 2: that is
(M+N+O+P).
Thus, the consumer surplus rises by (N+O+P).
Consumer and Producer surplus:
57
Producer Surplus:
Similarly initial producer surplus is given by the area above the supply curve S1 and below the
price P₁ ; that is N+Q. However, due to a production cost decline, the area above the new
supply curve S2 and below the new price P2; that is, (Q+R+S) give the producer surplus
Thus, the producer surplus changes by the amount (R+S−N); in fact, the change in producer
surplus may be positive or negative, it depends on the increase in quantity versus decline in
price, an increase in quantity increases producer surplus, while the decline in the price
reduces producer surplus.
Total Surplus:
Furthermore, as the consumer surplus rises by N+O+P and producer surplus rises by R + S - N₁
total surplus rise is calculated as shown below.
Total Surplus = (N+O+P) + (R+S−N)
=O+P+R+S
Thus, the total surplus rises by (O+P +R+ S)
c) If the supply of flat TV screens is very elastic, then the shift of the supply curve benefits the
consumers.
For instance, let us assume in the extreme condition that the supply is perfectly elastic; then
the supply curve will be horizontal as shown in the below figure; furthermore, due to the
horizontal position of the supply curve there is zero producer surplus. However, as shown in
the below figure, the consumers capture all the benefits of falling production costs, the
consumer surplus increases from initial M to M+N+O.
58
(8)
There are four consumers willing to pay the following amounts for haircuts:
Gloria: $35 Jay: $10 Claire: $40 Phil: $25
There are four haircutting businesses with the following costs:
Firm A: $15 Firm B: $30 Firm C: $20 Firm D: $10
Each firm has the capacity to produce only one haircut. To achieve efficiency, how many haircuts
should be given? Which businesses should cut hair and which consumers should have their hair
cut? How large is the maximum possible total surplus?
Answer:
Demand schedule is the tabular representation that shows the quantity demanded of the
good at various price levels.
Supply schedule represents the relationship between the prices that the suppliers are willing
to sell a quantity of good.
Represent the demand schedule as follows:
59
Represent the supply schedule as follows:
Firms A, C and D should do the haircut.

Thus, for efficiency, 3 haircuts should be given.
Consumer G. C and P should have their haircut as they have the maximum possible total
surplus.
Calculating the maximum total surplus as follows:
The maximum total surplus is 55
(9)
One of the largest changes in the economy over the past several decades is that technological
advances have reduced the cost of making computers.
a. Draw a supply-and-demand diagram to show what happened to price, quantity, consumer
surplus, and producer surplus in the market for computers.
b. Forty years ago, students used typewriters to prepare papers for their classes; today they use
computers. Does that make computers and typewriters complements or substitutes? Use a
supply-and-demand diagram to show what happened to price, quantity, consumer surplus, and
producer surplus in the market for typewriters. Should typewriter producers have been happy
or sad about the technological advance in computers?
c. Are computers and software complements or substitutes? Draw a supply-and-demand
diagram to show what happened to price, quantity, consumer surplus, and producer surplus in
the market for software. Should software producers have been happy or sad about the
technological advance in computers?
d. Does this analysis help explain why software producer Bill Gates is one of the world’s richest
people?
Answer:
Consumer surplus is the difference between the price the consumer is willing to pay and the
price that the consumer actually pays. Producer surplus is the difference between the amount
received by the sellers and the cost to the sellers.
a) With technological advancement which has reduced the cost of making computers, would
shift the supply curve to the right because as the cost of input used in the production falls, as
60
sellers get more encouraged to produce that good. The resultant would be reduced price and
increased output.
Represent the graph as follows:
The consumer surplus would increase due to the fall in the price. The above diagram shows
the initial consumer surplus is AEB and after technological advances, consumer surplus
increases to AEC.
The producer surplus would decrease as the sellers would get less revenue by selling another
unit. The above diagram shows the initial producer surplus is BED and after technological
advances, consumer surplus increases to CE'F.
b) Typewriters and computers are substitutes to each other because, rather being used
together, they are used in place of each other. With the technological advancement, the
demand for typewriters over a period of time has reduced because recent technology
developed computers are more into use.
61
Due to more use of computers, the demand curve of typewriters would shift to the left, the
price would fall and so would the quantity. The consumer surplus would decrease. The above
diagram shows that the initial consumer surplus is AEB and after more use of computers and
fall in demand for typewriters, the consumer surplus decrease to FE'C.
The producer surplus would decrease. The above diagram shows that the initial producer
surplus is BED and after more use of computers and fall in demand for typewriters, the
producer surplus falls to CE'D.
The typewriter producers would be sad with this technological advancement because the
demand for typewriter has reduced and so have their surplus.
c) Computer software and computers are complementary to each other because they are
used together. With the improvement in the technology of producing computers, the demand
for software will increase.
An increase in the demand for computers would increase the demand for software as well,
and the demand curve would shift to the right. The price and the quantity for software would
increase.
The consumer surplus would increase. The above diagram shows that the initial consumer
surplus is AEB and after technological advancement, the consumer surplus increases to FE'C.
The producer surplus would increase. The above diagram shows that the initial producer
surplus is BED and after technological advancement, the producer surplus increases to CE'D.
The software producers would be happy with this advancement of technology because it has
brought business to them which increased their surplus.
d) With the recent advancement in technology has brought computers into much use.
Moreover, computers available at cheaper rate have made it more popular. Software, being
a complementary good, is also in demand, making Person B rich.
62
(10)
A friend of yours is considering two cell phone service providers. Provider A charges $120 per
month for the service regardless of the number of phone calls made. Provider B does not have
a fixed service fee but instead charges $1 per minute for calls. Your friend's monthly demand
for minutes of calling is given by the equation QD=150−50P, where P is the price of a minute.
a. With each provider, what is the cost to your friend of an extra minute on the phone?
b. In light of your answer to (a), how many minutes would your friend spend on the phone with
each provider?
c. How much would he end up paying each provider every month?
d. How much consumer surplus would he obtain with each provider? (Hint: Graph the demand
curve and recall the formula for the area of a triangle.)
e. Which provider would you recommend that your friend choose? why?
Answer:
Suppose cell phone service provider A charges a fixed price of $120 per month regardless of
the number of calls made and does not charge any variable fee. Provider B charges a variable
fee of $1 per minute for calls and does not charge any fixed fee.
a) With Network A, the person can talk for more number of minutes on a phone call without
incurring any cost of an extra minute.
However, with network B, a person can talk for less minutes and he/she incurs an additional
cost of $1 on the phone for an additional minute.
Therefore, network A is a better option for the consumer.
63
(C)
Payment to Network-A is $120 as it is fixed charge made by the user irrespective of the
number of calls made.
Payment to Network-B is $100 as the network charges $1 per every call made. The person
spends 100 minutes on the calls, then the cost incurred is $100 (100 minutes $1).
e) Based on the consumer surplus, Network A provides a consumer surplus of $105 and does
not charge any per-minute fee to the consumer.
On the other hand, Network B provides a consumer surplus of $100 and charges per-minute
fee as well.
64
After taking into account all the costs, it is inferred that Network A should be selected as it
gives a higher consumer surplus to the consumer.
(11)
Consider how health insurance affects the quantity of health services performed. Suppose that
the typical medical procedure has a cost of $100.00, yet a person with health insurance pays
only $20.00 out of pocket. Her insurance company pays the remaining $80. (The insurance
company recoups the $80 through premiums, but the premium a person pays does not depend
on how many procedures that person chooses to undertake.)
a. Draw the demand curve in the market for medical care (in your diagram, the horizontal axis
should represent the number of medical procedures.) Show the quantity of procedures
demanded if each procedure has a price of $100.00.
b. On your diagram, show the quantity of procedures demanded if consumers pay only $20.00
per procedure. If the cost per procedure to society is truly $100 and if individuals have health
insurance as just described will the number of procedures performed maximize total surplus?
Explain.
c. Economists often blame the health insurance system for excessive use of medical care. Given
your analysis, why might the use of care be viewed as "excessive"?
d. What sort of policies might prevent this excessive use?
Answer:
In the following Figure illustrates the demand for medical care. If each procedure has a price
of $100, quantity demanded will be Q1 procedures
b) If consumers pay only $20 per procedure, the quantity demanded will be Q2 procedures.
Because the cost to society is $100, the number of procedures performed is too large to
maximize total surplus. The quantity that maximizes total surplus is Q1 procedures, which is
less than Q2.
65
c) The use of medical care is excessive in the sense that consumers get procedures whose
value is less than the cost of producing them. As a result, the economy’s total surplus is
reduced
d) To prevent this excessive use, the consumer must bear the marginal cost of the procedure.
But this would require eliminating insurance. Another possibility would be that the insurance
company, which pays most of the marginal cost of the procedure ($80, in this case) could
decide whether the procedure should be performed. But the insurance company does not get
the benefits of the procedure, so its decisions may not reflect the value to the consumer.
66
Chapter 13
(1)
This chapter discusses many types of costs: opportunity cost, total cost, fixed cost, variable cost,
average total cost, and marginal cost. Fill in the type of cost that best completes each sentence:
a. What you give up in taking some action is called the ______.
b. _____ is falling when marginal cost is below it and rising when marginal cost is above it.
c. A cost that does not depend on the quantity produced is a(n) ______.
d. In the ice-cream industry in the short run, ______ includes the cost of cream and sugar but not the
cost of the factory.
e. Profits equal total revenue minus ______.
f. The cost of producing an extra unit of output is the ______.
Answer:
a. opportunity cost; b. average total cost; c. fixed cost; d. variable cost; e. total cost; f. marginal
cost.
(2)
Your aunt is thinking about opening a hardware store. She estimates that it would cost $500,000
per year to rent the location and buy the stock. In addition, she would have to quit her $50,000
per year job as an accountant.
a. Define opportunity cost.
b. What is your aunt’s opportunity cost of running the hardware store for a year? If your aunt
thinks she can sell $510,000 worth of merchandise in a year, should she open the store? Explain.
Answer:
a) The opportunity cost of something is what must be given up to acquire it.
b) The opportunity cost of running the hardware store is $550,000, consisting of $500,000 to
rent the store and buy the stock and a $50,000 opportunity cost, because your aunt would
quit her job as an accountant to run the store. Because the total opportunity cost of $550,000
exceeds revenue of $510,000, your aunt should not open the store, as her profit would be
negative
(3)
A commercial fisherman notices the following relationship between hours spent fishing and the
quantity of fish caught
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a) What is the marginal product of each hour spent fishing?
b) Use these data to graph the fisherman’s production function. Explain its shape.
c) The fisherman has a fixed cost of $10 (his pole). The opportunity cost of his time is $5 per
hour. Graph the fisherman’s total-cost curve. Explain its shape.
Answer:
b) In the following graph, the production function will be shown
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The shape of the production function gets flatter as the number of labor hours increases,
which reflects diminishing marginal product.
c) After calculating the total cost, we find that
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(4)
Nimbus, Inc., makes brooms and then sells them door to door. Here is the relationship between
the number of workers and Nimbus’s output during a given day:
a. Fill in the column of marginal products. What pattern do you see? How might you explain it?
b. A worker costs $100 a day, and the firm has fixed costs of $200. Use this information to fill in the
column for total cost.
c. Fill in the column for average total cost. (Recall that ATC 5 TC/Q.) What pattern do you see?
d. Now fill in the column for marginal cost. (Recall that MC 5 ΔTC/ΔQ.) What pattern do you see?
e. Compare the column for marginal product with the column for marginal cost. Explain the
relationship.
f. Compare the column for average total cost with the column for marginal cost. Explain the
relationship.
Answer:
a) Marginal product is given by change in output for an additional unit of labor. In the below
blank table workers and output is given with a formula to calculate marginal product.
Workers 0 1 2 3 4 5 6 7
Output 0 20 50 90 120 140 150 155
Marginal Product - 20 30 40 30 20 10 5
(ΔOutput/ΔWorkers)
From the above table, it is evident that the marginal product increases initially up to certain
level as the number of workers increase that is up to three units of workers. However, as we
further increase the workers beyond three units the marginal product starts declining, a
showing diminishing marginal product.
b) The computation of total cost is as follows
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Total cost = Fixed cost + Variable cost
Variable cost is calculated by multiplying number workers with the wage rate of $100 per
worker.
c) Computation of Average Total Cost (ATC): ATC is calculated by dividing total cost with
output or total product.
𝑇𝑜𝑡𝑎𝑙 𝐶𝑜𝑠𝑡
ATC = 𝑂𝑢𝑡𝑝𝑢𝑡
When the output or total product is low, ATC is high and reaches a minimum between 120
and 140 units of output; however, a further increase in output causes the ATC to increase
gradually giving a U-shaped curve. The below figure shows a U-shaped ATC curve.
ATC Curve:
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Marginal cost is U-shaped in this case. This cost shows a declining trend up to 90 units. Above
90 units of production, this cost starts rising. A steep increase can be seen at output levels of
150 and 155 units. It crosses ATC at an output of 140 units. Furthermore, the pattern of
Average Total Cost (ATC) and Marginal Cost (MC) are shown in the below diagram. We can
see that the MC is cutting the ATC from its minimum point.
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e) As sown in the below table at low levels of output (up to 90 units), there an increasing
marginal product, and the marginal cost curve falls. However, at higher levels of output (more
than 90 units), the marginal product is diminishing whereas the marginal cost starts to rise.
Therefore, the marginal cost is inversely proportional to the marginal product.
Workers 0 1 2 3 4 5 6 7
Output 0 20 50 90 120 140 150 155
Marginal Product - 20 30 40 30 20 10 5
(ΔOutput/ΔWorkers)
Marginal Cost - 5 3.33 2.5 3.33 5 10 20
f) Comparison of Average Total Cost and Marginal Cost

Workers 0 1 2 3 4 5 6 7
Output 0 20 50 90 120 140 150 155
Average Total Cost - 15 8 5.56 5 5 5.33 5.81
Marginal Cost - 5 3.33 2.5 3.33 5 10 20
When MC is less than ATC (up to 140 units), ATC is falling. However, when MC is greater than
ATC (more than 140 units), ATC is rising. Furthermore, the MC curve crosses the ATC curve at
its minimum (i.e., when output = 140 units, ATC =$5). This point of intersection is the
minimum of ATC and is called the efficient scale.
Finally, the below table shows all the fields
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(5)
You are the chief financial officer for a firm that sells digital music players. Your firm has the
following average-total-cost schedule:
Your current level of production is 600 devices, all of which have been sold. Someone calls,
desperate to buy one of your music players. The caller offers you $550 for it. Should you accept
the offer? Why or why not?
Answer:
The total cost of 600 players is
= 600 × $300
= $180,000
The total cost of 601 players is
= 601 × $301
= $180,901
Now the marginal cost for 601 players is $901 which has a significance difference between
the $180,000 and $180,901 that is higher than the offered price i.e $550
Therefore, the offer should not be accepted
(6)
Consider the following cost information for a pizzeria:
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a. What is the pizzeria’s fixed cost?
b. Construct a table in which you calculate the marginal cost per dozen pizzas using the
information on total cost. Also, calculate the marginal cost per dozen pizzas using the
information on variable cost. What is the relationship between these sets of numbers? Explain.
Answer:
a) When output is nil, variable cost is also nil.
Total cost = VC + FC
TC = 0 + FC = $300
FC = $300
b) Calculation of Marginal Cost
in the above table, MC is calculated using TC and VC. We observe that MC under both the
methods is the same. We can conclude that
MC = Rate of change of TC = Rate of change of VC with respect to output
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(7)
Your cousin Vinnie owns a painting company with fixed costs of $200 and the following schedule
for variable costs:
Calculate average fixed cost, average variable cost, and average total cost for each quantity.
What is the efficient scale of the painting company?
Answer:
The calculation of Average FC, Average VC, and Average TC are shown in the table below
considering the known values of fixed cost and the variable costs at different levels of output.
Computation Table
From the table, observe that ATC is minimum at 4 units of output with ATC = $70
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(8)
The city government is considering two tax proposals:
• A lump-sum tax of $300 on each producer of hamburgers.
• A tax of $1 per burger, paid by producers of hamburgers.
a. Which of the following curves—average fixed cost, average variable cost, average total cost,
and marginal cost—would shift as a result of the lump-sum tax? Why? Show this in a graph.
Label the graph as precisely as possible.
b. Which of these same four curves would shift as a result of the per-burger tax? Why? Show
this in a new graph. Label the graph as precisely as possible.
Answer:
The two tax proposals by the government are:
i) lump-sum tax of $300 on each producer, and
ii) per-unit tax of $1 on hamburgers.
(a)
Lump-sum tax:
A lump-sum tax is a tax of a fixed amount that has to be paid by every producer regardless of
the production level. Firms producing hamburgers look at lump-sum tax as extra cost added
to fixed costs.
Therefore, average fixed cost curve will shift.
Since increase in fixed costs will not affect the variable costs and therefore will not shift the
average variable cost and will not shift marginal cost curve
Total cost is the summation of fixed cost and variable cost. As fixed cost has increased due to
lump-sum tax, the total cost also increases and as a result the average total cost curve shift.
The graph is as follows.
b) Per-unit tax:
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Per-unit tax is a tax imposed on the producer for producing each unit.
In other words, the producer pays taxes only for those units which it has produced. For firms,
per-unit tax is a variable cost as it increases with increase in production.
Thus, the average variable cost curve will shift and hence the marginal cost curve also shifts.
Demand for labor refers to the quantity of labor employed by firms at a given price. When
demand for labor changes for factors other than price, it is said to have shift in the demand
for labor.
Total cost is the summation of fixed cost and variable cost. As variable cost has increased due
to per-unit tax, the total cost also increases and as a result the average total cost curve shift.
Since it has no influence on fixed cost, the average fixed cost curve will not shift. The graph is
shown below:
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(9)
Jane’s Juice Bar has the following cost schedules:
a. Calculate average variable cost, average total cost, and marginal cost for each quantity.
b. Graph all three curves. What is the relationship between the marginal-cost curve and the
average-total-cost curve? Between the marginal-cost curve and the average-variablecost
curve? Explain
Answer:
Average variable cost: The average variable cost is obtained by dividing the variable cost by
the quantity of output by.
Mathematically expressed as:
Average variable cost (AVC) = Variable Cost (VC)/ Quantity of Output (Q)
From the above table, it is clear that, at the first level, variable cost is $10 and the quantity is
1vats. Thus, the AVC is $10 i.e, (10/1)
Now Calculate the AVC for all level of quantity in the same manner
Average total cost: The average total cost is obtained by dividing the total costs by the
quantity
of output.
Average variable cost (ATC)= Total cost (TC)/Quantity of output(Q)
From the above table, it is clear that, at the first level, total cost is $40 and the quantity is
10vats i.e, (40/1)
Thus, the ATC is $40 i.e.
Now Calculate the ATC for all level of quantity in the same manner
Marginal cost: It is the increase in the total cost due to the production of an extra unit.
Marginal cost= (Change in total cost/Change in quantity)
i.e. MC = ATC/AQ
From the above table, at change in total cost is $10 ($40-$30) and the change in quantity is
1vats (0-1). Thus, the MC is $10 i.e, (10/1)
Now Calculate the MC for all level of quantity in the same manner
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b) Graph of the above curves
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It is clear from the above graph that, the MC curve crosses the ATC curve at its minimum. This
point of intersection is the efficient scale.
The relation between MC and ATC is:
- When MC< ATC. ATC is falling, and
- When MC> ATC. ATC is rising.
Remember, both MC and AVC curves rise with an increase in output However, MC rises more
than AVC because MC is affected by change in the total cost.
(10)
Consider the following table of long-run total costs for three different firms:
Does each of these firms experience economies of scale or diseconomies of scale?

Answer:
The firm is said to experience economies of scale, if with an increase in the output there is a
subsequent fall in the average total cost of the firm. The average total cost is the per unit total
cost.
The firm is said to experience diseconomies of scale, if with an increase in the output there is
an increase in the average total cost of the firm.
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The LAC curves are as follows:
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The long run average cost (LAC) of firm A is declining with an increase in output. This shows
firm A has economies of scale.
The long run average cost (LAC) of firm B is rising with an increase in output. It shows firm B
diseconomies of scale.
The long run average cost (LAC) of firm C is declining up to 3 units, showing economies of
scale.
However, with output above 3 units, the average total cost rises, showing diseconomies of
scale.
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Chapter 16
(1)
Among monopoly, oligopoly, monopolistic competition, and perfect competition, how would
you classify the markets for each of the following drinks?
a. tap water
b. bottled water
c. cola
d. beer
Answer:
(a) Tap water has a monopoly market. The owner of the tap has the monopoly to use the tap
water and if the owner wants to sell the water, a price of his or her choice will be charged.
(b) Bottled water has a monopolistic competitive market because the market has many sellers
who slightly differentiate the product that is bottled water produced by each seller are look
similar yet not perfect substitutes. It can have perfect competitive market also as there are
many producers in the market.
(c) Cola has a monopolistic competitive market because it has distant substitutes available in
the market. Consumers are even bothered about a slight taste change - so each producer tries
to bring differentiation in the product sold. It can be considered for oligopolistic market
because there are only few sellers in the market.
(d) Beer has also monopolistic competitive market because many brands are available in the
market with difference in taste and quality.
(2)
Classify the following markets as perfectly competitive, monopolistic, or monopolistically
competitive, and explain your answers.
a. wooden no. 2 pencils
b. copper
c. local electricity service
d. peanut butter
e. lipstick
Answer:
(a) Wooden no. 2 pencil

The market for wooden no. 2 pencil would be perfectly competitive market since, wooden no
2 pencils are homogenous no matter even if it were produced by different firms. There is also
large number of buyers and firms in wooden no.2 pencil market, such that no one is in the
position to dictate the market price of such pencil and that the demand curve for this good
faced by each firm is perfectly elastic.
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(b) Copper
The market for copper would be perfectly competitive market since, copper is homogenous
no matter even if it were produced by different firms. There is also large number of buyers
and firms in the copper market; such that no one is in the position to dictate the market price
of copper and that the demand curve for this good faced by each firm is perfectly elastic.
(c) Local electricity service

The market for local electricity service is monopolistically competitive market as the
consumer of these services also gets after sales customer service, a practice possible with
monopolistically competitive firm in quest for maximizing market share in this service.
(d) Peanut butter

The market for peanut butter is monopolistically competitive market as there exists scope for
introducing product variation and differentiation and that there exist different brand names
specializing in its production and supply with its different variations.
(e) Lipstick
The market for lipstick is monopolistically competitive market as there exist a number of
scopes to introduce product differentiation and there is large number of firms and buyers in
the market who could enter or exit the market without any restrictions.
(3)
For each of the following characteristics, say whether it describes a perfectly competitive firm,
a monopolistically
competitive firm, both, or neither.
a. sells a product differentiated from that of its competitors
b. has marginal revenue less than price
c. earns economic profit in the long run
d. produces at the minimum of average total cost in the long run
e. equates marginal revenue and marginal cost
f. charges a price above marginal cost
Answer:
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(4)
For each of the following characteristics, say whether it describes a monopoly firm, a
monopolistically competitive firm, both, or neither.
Characteristic: Monopoly /Monopolistically Competitive
a) Faces a downward-sloping demand curve
b) Has marginal revenue less than price
c) Faces the entry of new firms selling similar products
d) Earns economic profit in the long run
e) Equates marginal revenue and marginal cost
f) Produces the socially efficient quantity of output
Answer:
a) Both Monopoly and Monopolistically competitiveness: demand is downward sloping, it
means more goods can be sold out at a lower price.
b) Under the monopoly and monopolistically competitive market, MR = MC is profit
maximization condition. Thus, the price is above the Marginal Revenue.
c) Neither, Entry of new firms selling a similar product is a feature of a perfectly competitive
market.
d) Firm in monopolistically competitive market structure, earn only normal profit or economic
profit over the long run. Monopoly can earn positive economic profit in long run as well.
e) Both, in these both market structure firms equate MR = MC.
f) Neither, Neither produce socially efficient level of output.
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(5)
You are hired as the consultant to a monopolistically competitive firm. The firm reports the
following information about its price, marginal cost, and average total cost. Can the firm
possibly be maximizing profit? If not, what should it do to increase profit? If the firm is profit
maximizing, is the firm in a long-run equilibrium? If not, what will happen to restore long-run
equilibrium?
a. P < MC, P > ATC
b. P > MC, P < ATC
c. P = MC, P > ATC
d. P > MC, P = ATC
Answer:
(6)
Sparkle is one firm of many in the market for toothpaste, which is in long-run equilibrium.
a. Draw a diagram showing Sparkle's demand curve, marginal-revenue curve, average-total-
cost curve, and marginal-cost curve. Label Sparkle's profit-maximizing output and price.
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b. What is Sparkle's profit? Explain.
c. On your diagram, show the consumer surplus derived from the purchase of Sparkle
toothpaste. Also show the deadweight loss relative to the efficient level of output.
d. If the government forced Sparkle to produce the efficient level of output, what would
happen to the firm? What would happen to Sparkle's customers?
Answer:
a) Figure 4 illustrates the market for Sparkle toothpaste in long-run equilibrium. The profit-
maximizing level of output is QM and the price is PM.
b) Sparkle's profit is zero, since at quantity QM, price equals average total cost.
c) The consumer surplus from the purchase of Sparkle toothpaste is area A + B. The efficient
level of output occurs where the demand curve intersects the marginal-cost curve, at QC. So
the deadweight loss is area C, the area above marginal cost and below demand, from QM to QC.
d) If the government forced Sparkle to produce the efficient level of output, the firm would
lose money because average cost would exceed price, so the firm would shut down. If that
happened, Sparkle's customers would earn no consumer surplus.
(7)
Consider a monopolistically competitive market with N firms. Each firm's business
opportunities are described by the following equations:
Demand: Q=100/N-P
Marginal Revenue: MR=100/N-2Q
Total cost: TC=50+Q(squared)
Marginal Cost: MC=2Q
a. How does N, the number of firms in the market, affect each firms demand curve? Why.
b. How many units does each firm produce? (The answer to this and the next two questions
depend on N.)
c. What price does each firm charge?
d. How much profit does each firm make?
e. In the long run, how many firms will exist in this market?
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Answer:
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(8)
The market for peanut butter in Nutville is monopolistically competitive and in long-run
equilibrium. One day, consumer advocate Skippy Jif discovers that all brands of peanut butter
in Nutville are identical. Thereafter, the market becomes perfectly competitive and again
reaches its long-run equilibrium. Using an appropriate diagram, explain whether each of the
following variables increases, decreases, or stays the same for a typical firm in the market.
a. price
b. quantity
c. average total cost
d. marginal cost
e. profit
Answer:
The market for peanut butter is Monopolistically Competitive and in long-run equilibrium.
After some changes, it will become as a Perfectly Competitive and again reaches its long-run
equilibrium. We can understand to this situation, to use shown below diagram:
In the above diagram, E, refers to Equilibrium point, P refers to price, Q refers to Quantity, D
refers to demand, and MR refers to Marginal Revenue of Monopolistic Competitive Market
for the peanut butter.
a) Price: The monopolistic competitive market price P will decrease to become P₁ in the
Perfectly Competitive Market
b) Quantity: The monopolistic competitive quantity of output produced, which is Q, will
increase to become Q1 in the perfectly competitive market. A monopolistic competitive firm
will produce at less than efficient level. e. where the average total cost is at minimum at point
E, while a perfectly competitive firm produces at the efficiency level. Therefore, the producing
quantity will increase, when the peanut butter market transfers into a perfectly competitive
market.
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c) Average Total Cost: The average total cost will decrease and it becomes less, when the
peanut butter market transfers into a perfectly competitive market because, a perfectly
competitive firm produces at the efficiency level, where the average total cost is minimized.
d) Marginal Cost: When the market for the peanut butter changes from monopolistic
competition market to a perfectly competitive market, then the marginal cost will increase.
e) Profit: In the long-run, there is zero economic profit and the profit levels are the same even
if there is a change in the market.
(9)
For each of the following pairs of firms, explain which firm would be more likely to engage in
advertising.
a. a family-owned farm or a family-owned restaurant
b. a manufacturer of forklifts or a manufacturer of cars
c. a company that invented a very comfortable razor or a company that invented a less
comfortable razor
Answer:
a. a family-owned restaurant - a restaurant needs customers on a daily basis, whereas a farm
usually needs to have ties with sellers who sell their product to the supermarkets.
b. a manufacturer of cars - cars are used commonly by the masses, so advertising would
increase the sales exponentially. For forklifts, it's not used commonly, and caters to the
construction sector and hence, a word of mouth would be enough.
c. a company that invented a very comfortable razor - they'll have some reality to their
advertisement, and would sell their razors around the 'comfortable factor' as the USP.
(10)
Sleek Sneakers Co. is one of many firms in the market for shoes.
a. Assume that Sleek is currently earning short-run economic profit. On a correctly labeled
diagram, show Sleek’s profit-maximizing output and price, as well as the area representing
profit.
b. What happens to Sleek’s price, output, and profit in the long run? Explain this change in
words, and show it on a new diagram.
c. Suppose that over time consumers become more focused on stylistic differences among shoe
brands. How would this change in attitudes affect each firm’s price elasticity of demand? In the
long run, how will this change in demand affect Sleek’s price, output, and profit?
d. At the profit-maximizing price you identified in part (c), is Sleek’s demand curve elastic or
inelastic? Explain.
Answer:
a) The market of shoes earning economic profits in the short-run is shown in the below
diagram.
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In the above diagram, D refers to Demand, MR refers to Marginal Revenue, MC refers to
Marginal Cost, ATC refers to Average Total Cost, P refers to Price, and Q refers to Quantity.
Remember, a monopolistic competitive firm maximizes its profit where MR-MC. Therefore,
the profit maximizing quantity for the Sleek Sneakers Co. is Q and the price is P. When the
price P exceeds the average total cost, the firm makes profit. The area representing the profit
is PQRS and it is in sky blue colour.
The profit maximizing output of this firms at OQ quantity and price is OP.
b) The shoes firm attracts to more firms into the market to avail the profits when it earns
economic profits in the short-run. When more firms enter in to the market, consumers have
choice of more similar products in the market when more firms enter in the market.
As a result, the firm starts experiencing a decline in the profit in the long run. The process of
entry of new firms continues until there is no scope of earning profits and that all the firms in
the industry earn zero economic profit. We can understand to this situation to use shown
below diagram:
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In the above diagram, the sleek sneakers demand curve will shift leftward, due to entry of the
new firms. In addition, the firm's output and price falls until it becomes equal to average total
cost. Consequently, the firm earns zero economic profits.
c) Here, when the consumers become more focused stylish oriented about their shoe brands,
consumers demand for new stylish shoes. This will not result in any significant change in
prices. Sometimes consumers are willing and ready to pay high prices for new brand shoes.
Therefore, the demand becomes price inelastic, which is a proportionate change in price that
brings less than change in demand.
In the long-run, the Sleek Sneakers Co. may earn normal profits and the stylish new brands
will operate as a barrier to the other firms and the prices increase above the average total
cost.
d) At the profit-maximizing level, the monopolistic competitive firm will sell the quantity of
output that makes marginal revenue is equal to marginal cost. In this situation, the marginal
cost must be positive as well as the marginal revenue is must also be positive. This is possible
when the demand curve is in the part of elastic. Hence, in this situation only the Sleek
Sneakers Co. will set its price.
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Chapter 21
(1)
Maya divides her income between coffee and croissants (both of which are normal goods). An
early frost in Brazil causes a large increase in the price of coffee in the United States.
a. Show the effect of the frost on Maya’s budget constraint.
b. Show the effect of the frost on Maya’s optimal consumption bundle assuming that the
substitution effect outweighs the income effect for croissants.
c. Show the effect of the frost on Maya’s optimal consumption bundle assuming that the income
effect outweighs the substitution effect for croissants
Answer
Substitution Effect:
Substitution effect can be defined as due to change in price of a good, the impact of this
change is on the quantity demanded.
Income Effect:
Income effect can be defined as due to relative change in income the impact of change in
price is on the quantity demanded of the good
Given that person M divides income between coffee and croissants which are normal goods.
An early frost in the country B resulted in a large increase in the price of the coffee in the
country US.
(a) Below graph shows the effect of frost on person Ms budget constraint:
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From the above graph it can be observed that the budget constraint curve BC 1 shows the
amount of coffee person M consumed with her income and the curve BC2 shows an increase
in the price of coffee due to the effect of frost. This shows that due to the effect of frost the
budget constraint curve shifts backwards.
b. Below graph shows the effect of frost on person M’s optimal consumption bundle
assuming that the substitution effect outweighs the income effect for croissants:
If the substitution effect is more compared to that of the income effect of croissants, then
person M is willing to buy more of croissant, and less of coffee. This results in the movement
of the indifference curve from point A to point B.
c) If the substitution effect is more compared to that of the income effect of croissants, then
person M is willing to buy more of croissant, and less of coffee. This results in the
movement of the indifference curve from point A to point B.
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If the income effect is more compared to that of the substitution effect of croissants, then
person M is willing to buy both products of less quantity. This results in the movement of the
indifference curve from point A to point B as shown in the above graph.
(2)
Compare the following two pairs of goods:
• Coke and Pepsi
• Skis and ski bindings
a. In which case are the two goods complements? In which case are they substitutes?
b. In which case do you expect the indifference curves to be fairly straight? In which case do you
expect the indifference curves to be very bowed?
c. In which case will the consumer respond more to a change in the relative price of the two
goods?
Answer:
a) Skis and ski bindings are complementary goods. The use of one force the simultaneous
use of other good. Coke and Pepsi are substitutes. One good can be used of other good.
b) Indifference curves between Coke and Pepsi are fairly straight, because there is little to
distinguish them, so they are nearly perfect substitutes. Indifference curves between skis
and ski bindings are very bowed, because they are complements
c) The consumer responds more to a change in the relative price of the two goods when the
goods are perfect substitutes like the case of Coke and Pepsi. A slight change in the price
of Coke leads to change in the consumption of Pepsi- that is when price coke falls,
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consumer stops the purchase of Pepsi and buy only coke, similarly when the price of coke
increases, consumer stops the purchase of coke and buy only Pepsi.
(3)
You consume only soda and pizza. One day, the price of soda goes up, the price of pizza goes
down, and
you are just as happy as you were before the price changes.
a. Illustrate this situation on a graph.
b. How does your consumption of the two goods change? How does your response depend on
income and substitution effects?
c. Can you afford the bundle of soda and pizza you consumed before the price changes?
Answer:
a) We know that, consumers purchase more goods and service when the price of goods and
service decrease. In our solution, the price of pizza goes down and the price of soda goes
up. is shown as below.
In the above diagram, the original budget constraint is BL and the consumer chooses the
optimal consumption at point A on indifference curve IC. When the price of soda increases
and the price of pizza falls, the demand of soda will decrease and the demand of pizza will
increase.
As a result, the budget constraint shifts from BL to BL₁ Since the consumer is just as happy as
before the change in prices, the consumer will choose the consumption package at point B on
the same indifference curve IC
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b) According to law of demand, price and demand are inversely related i.e. when the price
of commodity increases, the demand decreases and vice-versa. Hence, my consumption
of these two goods will change, as when the price of pizza will go down and price of soda
will go up I would like purchase more pizzas
Thus, the demand of pizzas will increase and demand of soda will decrease due increasing and
decreasing price levels. The income effect of the price rise of soda restricts the real income,
thus, the consumption of soda decreases. Similarly, the fall in the price of pizza has both
income effect and substitution effect, which increases the real income of the consumer and
make the good cheaper than soda; by increasing the consumption of pizza.
c) Since the package A and B places same on the indifference curve, both the points give the
same level of happiness or satisfaction to the consumer. However, both the packages are
not on two different budget constraints, package A is on BL and package B is on BL 1,
package A cannot be afforded with BL1
(4)
Carlos consumes only cheese and crackers.
a. Could cheese and crackers both be inferior goods for Carlos? Explain.
b. Suppose that cheese is a normal good for Carlos while crackers are an inferior good. If the
price of cheese falls, what happens to Carlos’s consumption of crackers? What happens to his
consumption of cheese? Explain.
Answer:
Inferior goods are those goods whose demand falls as income increases.
a) Both Cheese and crackers cannot be inferior goods as when income increases
consumption of at least one good should increase or else the income expenditure curve
would slope downwards towards the origin. This is not possible as income is increasing.
b) Decrease in the price of cheese makes the consumer richer and cheese being a normal
good, more quantity of cheese is consumed. While cracker being an inferior good, less
quantity of it is consumed. This is the income effect.
With the decline in the price of cheese, cheese is relatively cheaper than cracker. Thus,
consumer substitutes away from cracker and towards cheese. The substitution effect causes
consumption of cheese to rise and that of cracker to fall.
Thus, the net result of the price change is that more of cheese and less of cracker is consumed.
(5)
Jacob buys only milk and cookies.
a. In year 1, Jacob earns $100, milk costs $2 per quart, and cookies cost $4 per dozen. Draw
Jacob’s budget constraint.
b. Now suppose that all prices increase by 10 percent in year 2 and that Jacob’s salary increases
by 10 percent as well. Draw Jacob’s new budget constraint. How would Jacob’s optimal
combination of milk and cookies in year 2, compare to his optimal combination in year 1?
Answer:
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The budget constraint is a diagrammatical representation of the possible combinations of
different goods a consumer can buy given her income and prices of the goods. The slope of
the budget constraint is the relative price of the goods
Change in price of one good causes budget line to rotate while change in income causes
budget line to shift.
a) Take Milk on X axis and cookies on Y axis
The budget Constraint is drawn below:
b) When prices of both the goods increase by 10 percent and income also increases by 10
percent, as long as preferences are assumed to remain monotonic, the optimal
consumption would just be same as original consumption. The budget constraint will
remain the same.
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Since the coordinates of the budget constraint remains unchanged, thus the optimal
consumption in year 2 would be same as that in year 1.
(6)
State whether each of the following statements is true
or false. Explain your answers.
a. “All Giffen goods are inferior goods.”
b. “All inferior goods are Giffen goods.”
Answer:
a) As you know, Giffen goods refer the goods for which an increase in the price raises the
quantity demanded. The famous British economist Sir Robert Giffen (1837-1910)
explained the concept of Giffen goods.
On the other hand, the inferior goods mean the goods whose demand increases when there
is a decrease in the consumer's income and vice-versa.
The statement "All Giffen goods are inferior goods" is true, because according to Giffen
paradox, with a change (either increase or decrease) in the price of minimum needed goods
and services, there is no change in the quantity of demanded. If that good happens to be
inferior, the income effect will be negative and may exceed the substitution effect. Thus, with
a fall in price, the consumer will buy less of the good. Thus, all Giffen goods are inferior goods.
b) The statement "All inferior goods are Giffen goods" is false. Because, inferior goods are
those goods for which income effect and substitution effect work in opposite direction.
When the price of an inferior good falls, the income effect will reduce the quantity
purchased, and the substitution effect will increase the quantity purchased. But for Giffen
goods, though income effect is negative, it is strong enough to outweigh the substitution
effect. Hence, all the inferior goods are not Giffen goods.
(7)
A college student has two options for meals: eating at the dining hall for $6 per meal, or eating
a Cup O’ Soup for $1.50 per meal. Her weekly food budget is $60.
a. Draw the budget constraint showing the trade-off between dining hall meals and Cups O’
Soup. Assuming that she spends equal amounts on both goods, draw an indifference curve
showing the optimum choice. Label the optimum as point A.
b. Suppose the price of a Cup O’ Soup now rises to $2. Using your diagram from part (a), show
the consequences of this change in price. Assume that our student now spends only 30 percent
of her income on dining hall meals. Label the new optimum as point B.
c. What happened to the quantity of Cups O’ Soup consumed as a result of this price change?
What does this result say about the income and substitution effects? Explain.
101
d. Use points A and B to draw a demand curve for Cup O’ Soup. What is this type of good called?
Answer:
a) Here know that, the Budget or Price line is indicates the purchasing combination of two
goods is when the prices of those two goods and the consumer's income are constant. In
our solution given that, the budget constraint for a college student can be drawn by
calculating the values for the horizontal and vertical intercepts. The value of vertical
intercept is calculated as show below:
By using the above values, we can draw a student budget constraint as shown below:
102
In the above diagram, the BL is the student's budget line. If the student assumed to spending
equal amounts on both goods as like meals at dining hall and cup O’ soup, then his budget
line is tangent to his indifference curve (IC), is at point A. This point A indicates the optimum
consumption of 5 meals at dining hall and 20 cups of O soups.
b) In our solution, if the price of Cups O' soup increases to $2, then the value of the horizontal
intercepts changes as follow:
As a result, the, the budget constraint BL shifts inwards to the left to BL1 as shown in the
following diagram.
103
In the above diagram, the new optimum point shown at B is on the new indifference curve.
This is due to increase price level of cups O soup from $1.50 to $2. At this level, student's
optimum combination is 3 meals at dining hall and 21 cups O' soups.
Now, if the student is assuming to spend only 30% of his food budget ($60) on dining hall
meals, then the amount will spend on meals at dining hall is,
So, the student will consume on dining hall meals is,
This new combination of goods having 3 dining hall meals is showed as point B on indifference
curve IC₁, is shown as below:
104
c) We have drawn the consumption of 3 meals at dining hall on indifference curve IC₁, the
bundle B will constitute an increased quantity of Cups O' soups. Thus, the quantity
consumed cups O' soups increases due to increase in price. The substitution effect of the
price rise makes the consumer buy less of soups, and the income effect makes the student
buy more of soups. In student point of view the cups O' soups is the inferior good, thus he
will purchase more cups. Hence, the income effect is negative and stronger than the
substitution effect.
d) We already discussed and indicate that the good Cups O' soup are a Giffen good. Since
there is a direct relation between the quantity demanded of the good and its price. Here,
increasing price leads to an increase in the demand for the good, thus the demand curve
for Giffen good is upward slope. Using the points A and B. we can draw the demand curve
for Cups O' soup as shown in the below diagram.
105
(8)
Consider your decision about how many hours to work.
a. Draw your budget constraint assuming that you pay no taxes on your income. On the same
diagram, draw another budget constraint assuming that you pay a 15 percent income tax.
b. Show how the tax might lead to more hours of work, fewer hours, or the same number of
hours. Explain.
Answer:
(a) The budget constraint BL in the below diagram shows all the combinations of goods that
the consumer can buy with the given income having no tax payments. While BL1 is the budget
106
constraint that assumes that the consumer is paying a tax of 15 percent. Since tax payments
reduces the consumer's income and his consumption, BL1 shifts downwards to the left.
b. It is the strength and power of the income effect or the substitution effect that determines
the number of working hours.
107
Tax leading to same number of hours
If the income effect which leads to less leisure is equals the substitution effect which leads to
more leisure, the overall effect of the taxation will be working same number of hours. This is
shown in the following diagram.
108
(9)
Anya is awake for 100 hours per week. Using one diagram, show Anya’s budget constraints if
she earns $12 per hour, $16 per hour, and $20 per hour. Now draw indifference curves such that
Anya’s labor-supply curve is upward-sloping when the wage is between $12 and $16 per hour
and backward-sloping when the wage is between $16 and $20 per hour.
Answer:
The time allocation problem is the trade-off between leisure and consumption. The budget
line shows the combination of leisure hours and consumption that the person can afford by
working. A has 100 hours per week to spend between leisure and consumption. Point L on
the X-axis shows this point
If A spends all 100 hours working, she earns $1,200, given the wage rate of $12 per hour, but
has no time for leisure. This gives the point A on y-axis and AL represents the budget
constraint when wage is $12 per hour.
If wage rate is $16 per hour, then A can earn $1,600 if she spends full time on work. This gives
the budget constraint BL.
If wage rate is $20 per hour, then A can earn $2.000 if she spends full time on work. This gives
the budget constraint CL.
The indifference curves I1 on AL, I2 on BL and, I3 on CL shows the preferences of A.
With increase in wages from $12 to $16, A is willing to work more and consume more and
spend less time on leisure. A substitute away from leisure and towards consumption. Thus,
the resulting supply curve is upward sloping in this range.
With further increase in wages from $16 to $20, A moves on a higher indifference curve. She
is now better off than she was. As long as consumption and leisure are normal goods, she
tends to use this increase in well-being to enjoy both higher leisure and higher consumption.
Income induces her to work less and hence the labor-supply curve slopes backward
109
(10)
Draw the indifference curve for someone deciding how to allocate time between work and
leisure. Suppose the wage increases. Is it possible that the person’s consumption would fall? Is
this plausible? Discuss. (Hint: Think about income and substitution effects.)
Answer:
The substitution effect of the price change will make a consumer to choose less leisure and
more working hours because leisure becomes more costly - that is a person has to forgo a
high wage earnings for an extra hour of leisure.
On the other hand, the income effect of a wage rise will make the consumer better off and
thus will induce him to have more of leisure and more amount of consumption. If the
substitution effect outweighs the income effect, the consumer will work more. If the income
effect outweighs the substitution effect, the consumer will work less. In such case only, the
consumption would decrease and this is possible only when the good is inferior.
(11)
Economist George Stigler once wrote that, according to consumer theory, “if consumers do not
buy less of a commodity when their incomes rise, they will surely buy less when the price of the
commodity rises.” Explain this statement using the concepts of income and substitution effects.
Answer:
Here, as you know that, the income effect is the change in consumption that results when a
price change moves the consumer to a higher or lower indifference curve. And the
110
substitution effect is the change in consumption that results when a price change moves the
consumer along a given indifference curve to a point with a new marginal rate of substitution.
Here, as given that the statement by economist George Stigler "if consumers do not buy less
of a commodity when their incomes rise, they will surely buy less when the price of the
commodity rises".
Here, a change in income affect is the consumer's choice. This means, there is no change in
the quantity of purchasing goods and services, and is due to increasing the consumer's
income. These goods are considered as normal goods, and sometimes these goods have
inverse relationship with changing price. Due to changing price, two effects are formed; those
are substitution effect and income effect. A rise in the price, goods becomes costlier and the
consumer will substitute to it with cheaper goods. This is due to increasing price, and it
considered as substitute effect. And a rise in prices reduces the purchasing power of the
consumer and thus forces him to consume less of the good. Thus, both the effects substitution
and income effect of a price rise encourages to the consumer to purchase less of a good.
(12)
Five consumers have the following marginal utility of apples and pears:
The price of an apple is $1, and the price of a pear is $2. Which, if any, of these consumers are
optimizing over their choice of fruit? For those who are not, how should they change their
spending?
Answer:
Consumer optimizes his consumption of goods when the Marginal Rate of Substitution (MRS)
equals the relative price of the goods. At this point the slope of the indifference curve equals
the slope of the budget line and the indifference curve is tangent to the budget line.
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Person C is optimizing her consumption as the MRS is equal to the price ratio
Person P is not optimized her consumption as the MRS is greater than the price ratio. He
needs to increase the consumption of apples so that MRS would be equal to the price ratio.
Person His not optimized her consumption as the MRS is greater than the price ratio. He needs
to increase the consumption of apples so that MRS would be equal to the price ratio.
Person A is optimizing her consumption as the MRS is equal to the price ratio
Person L is not optimized her consumption as the MRS is lower than the price ratio. He needs
to decrease the consumption of apples so that MRS would be equal to the price ratio.
The End
And I'm not going back to north
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Microeconomics Exercise Sheet 1

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PRINCIPLES OF MICROECONOMICS

EXERCISE SHEET (MANKIW)

Stay Out of My Territory – Walter White

d) The invention of new knitting machines is an improvement of technology in the production

Price Quantity Demanded Quantity Supplied

DD is the demand curve and SS is the supply curve.

which is very inelastic.

a. What are the equilibrium price and quantity of Frisbees?

The graph illustrates a labor market with a binding minimum wage.

d. If the demand for unskilled labor were inelastic:

If the demand for unskilled labor were elastic:

So, the willingness to pay is 400

Demand curve of bottled water

(b) If the price of a bottle is $4, Bert will buy 2 bottles.

The graph is as follows:

Firms A, C and D should do the haircut.

The maximum total surplus is 55

b) In the following graph, the production function will be shown

c) After calculating the total cost, we find that

b) The computation of total cost is as follows

f) Comparison of Average Total Cost and Marginal Cost

Does each of these firms experience economies of scale or diseconomies of scale?

(a) Wooden no. 2 pencil

(c) Local electricity service

(d) Peanut butter

The budget Constraint is drawn below:

So, the student will consume on dining hall meals is,

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