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Acemoglu Solutions Manual

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Chapter 7
Perfect Competition and the Invisible
Hand
Questions
1. All else equal, does a steep or flat demand curve result in higher social surplus? How does steepness
of supply affect social surplus?
Answer: Everything else equal, a steep demand curve will result in higher social surplus. As can be
seen in the following figures, social surplus (shown by the triangles A and B) is higher in the market
with a steep demand curve.

Similarly, other things remaining the same, social surplus (shown by the triangles A and B) is higher
in a market with a steeper supply curve.

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2. Explain the concept of Pareto efficiency. How does it relate to social surplus? Commented [A1]: Social surplus does not directly relate to
Pareto efficiency. Errata will be corrected in subsequent reprints.
Answer:An outcome is Pareto efficient if no individual can be made better off without making
someone else worse off. When the competitive market equilibrium is Pareto efficient, the social
surplus is maximized.

3. How will the invisible hand move corn prices in response to:
a. a flood that destroys a great deal of the corn crop?
b. a rise in the price of wheat (a substitute for corn)?
c. a change in consumer tastes away from corn dogs toward hot dogs?
d. an increase in the number of people with access to the corn market?
Answer:
a. Since a great deal of the corn crop has been destroyed by the flood, the supply curve for corn
will shift leftwards and the price of corn will increase.
b. When the price of a substitute such as wheat increases, the demand for corn will increase.
The demand curve will shift rightwards and the price of corn will increase.
c. Corn (not surprisingly) is an important input in the production of corn dogs. If consumers
prefer fewer corn dogs, the demand curve for corn will shift leftwards and the price of corn
will fall.
d. As more buyers enter the market, the demand for corn will increase. The demand curve will
shift rightwards and the price of corn will increase.

4. How will the social surplus change if the quantity sold is restricted below the equilibrium quantity?
Answer: If the quantity sold is restricted below the equilibrium quantity, the social surplus will
become smaller due to the presence of deadweight loss.

5. The market for economics textbooks is in equilibrium. The government decides to relax export
restrictions on paper, leading to an increase in the demand for paper. How does social surplus in the
market for textbooks change? Why? Present a diagram as part of your explanation.
Answer: An increase in the demand for paper would also lead to an increase in the price of paper. As
the price of paper increases, the cost of producing a textbook will increase. This will shift the supply
curve for textbooks to the left. The equilibrium price of a textbook will increase while the equilibrium
quantity will fall. Consumer surplus and social surplus must fall; it is not clear if producer surplus
will rise or fall.

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The diagram above shows demand and supply in the textbook market. The increase in the price of
paper shifts the supply curve for textbooks from S1 to S2. At the old price of paper consumer
surplus was A + B + C + E, producer surplus was F + G + H, and social surplus was A + B + C +
E + F + G + H. At the new higher price for paper consumer surplus is A, producer surplus is B +
F, and social surplus is A + B + F. Therefore consumer surplus and social surplus both fell; the
impact on producer surplus is ambiguous.

6. Can the government do the job of the invisible hand? Explain your answer with the case of Korea
discussed in the chapter.
Answer: North Korea is a command economy, where a centralized authority determines the goods and
services produced, whereas South Korea is a market economy based upon price signals and strong
economic incentives. Exhibit 7.16 in the chapter shows that the growth rates of the real per capita
GDP in North Korea and South Korea from 1950 to 2008 are 33% [($1,133 - $850)/$850 × 100] and
2059% [($18,356 - $850)/$850 × 100] respectively. This dramatic difference indicates the inability of
the government to do the job of the invisible hand.

7. There are always debates on minimum wages between policymakers and economists. While the
policymakers may support to raise the minimum wage, the economists usually object to it. What is
the rationale behind them?
Answer: The policymakers support a higher minimum wage because they aim to increase equity by
redistributing incomes from high-income groups to low-income groups. However, the economists
usually object to it because they aim to increase efficiency by allowing the labor market to operate
under the invisible hand.

8. Suppose the need for babysitters increases in all countries. How does it cause different consequences
in the market economies and the planned economies?
Answer: In market economies, the increase in the demand for babysitters raises the price and the
quantity of babysitters. However, in the planned economies, the government may not be willing or
able to meet the need as rewards are based on meeting quantity targets, not prices. If it is the case,

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 Chapter 7 | Perfect Competition and the Invisible Hand 72

there will be a shortage of babysitters. On the other hand, if the government is willing to meet the
need it can assign more people to be babysitters, which would increase their supply. Therefore, the
price of babysitters does not change, while the quantity increases.

9. Sofia, a political science student, thinks that the government should intervene to revive declining
industries like video rentals and print newspapers. The government, she reasons, can resolve the
coordination problem of getting the agents in these markets to trade. Do you agree with her? Explain
your answer.
Answer: Sofia’s reasoning is flawed because declining industries do not face a coordination problem.
A coordination problem results when economic agents with coinciding interests cannot be brought
together to trade. However, in this case, falling demand is responsible for the decline of industries like
video rentals and print newspapers. Even if the government attempted to bring together economic
agents in these industries, it is unlikely that demand for rented videos and newspapers will increase.

10. Is the introduction of unemployment insurance a policy to increase efficiency or equity? Explain.
Answer: Unemployment insurance can increase equity because it redistributes incomes from working
people to unemployed people as the premium is paid by the employed population.

11. Are there real-world markets that resemble double oral auctions? Suppose you had to organize a
double oral auction for a good that has perfectly elastic demand. Do you expect prices to approach the
competitive equilibrium?
Answer: Double oral auctions are similar to how trading actually works on stock exchanges—traders
announce bids and asks and if they match, a trade is executed.
Double oral auction experiments with many different market variants - including varying the
elasticity of supply and demand and the numbers of buyers and sellers - have shown that the
equilibrium price in the market will be very close to where the supply and demand curves intersect.
So, the price in a double oral auction for a good with perfectly elastic demand is also expected to
approach the equilibrium price.
12. Imagine you are a buyer in a double oral auction with a reservation value of $10 and there is a seller
asking $8.
a. How much will you gain from accepting this offer?
b. If you are the only buyer, and you know that the lowest ask price is $2, should you accept this
offer?
Answer:
a. By accepting this offer, you will gain $2 ($10 – $8).
b. Yes. By accepting this offer, you will gain $8 ($10 – $2). If you choose to accept an offer
from a different seller, your surplus will be lower. By accepting the lowest ask price of $2,
you will maximize your surplus from this trade.

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Problems
1. The following diagram shows the market demand and market supply for sweaters. Calculate
consumer surplus, producer surplus, and social surplus in this market.

Answer: Producer surplus is the area of triangle I and is equal to ½ x 100 x (60 – 20) = 2000.
Consumer surplus is the area of triangle II and is equal to ½ x 100 x (90 - 60) = 1500. Social surplus
is the sum of consumer surplus and producer surplus and is equal to 1500 + 2000 = 3500.

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2. Suppose the market for live lobsters is perfectly competitive. After the lobsters are caught, the
fishermen have to sell them as soon as they can before the lobsters die. Assume that no one buys
dead lobsters from the fishermen, and therefore, the price of dead lobsters is zero. Explain the price
elasticity of supply of live lobsters at the daily market.
Suppose that no consumers are willing to pay $50 or higher for each kilogram of live lobsters, and
2800 kilograms of live lobsters are traded at the price of $20 per kilogram every day. Calculate the
consumer surplus, producer surplus, and social surplus.

Answer:

At the daily market, the fishermen are willing to sell all the live lobsters at any prices because it is
assumed that no one buys dead lobsters. Therefore, the price elasticity of supply of live lobsters is
perfectly inelastic.

Consumer surplus = [($50 - $20) × 2800]/2 = $42,000

Producer surplus = $20 × 2800 = $56,000

Social surplus = consumer surplus + producer surplus

= $42,000 + $56,000 = $98,000

3. There are four consumers willing to pay the following amounts for an electric car:
Consumer 1: $70,000 Consumer 2: $20,000 Consumer 3: $80,000 Consumer 4: $40,000
There are four firms that can produce electric cars. Each can produce one car at the following costs:
Firm A: $30,000 Firm B: $60,000 Firm C: $40,000 Firm D: $20,000
Each firm can produce at most one car.
Suppose we wanted to maximize the difference between consumers’ willingness to pay for electric
cars and the cost of producing those cars, i.e., we wanted to maximize social surplus.
a. How many electric cars should we produce?
b. Which firms should produce those cars?
c. Which consumers should purchase those cars?
d. Find the maximum social surplus in the electric car market.
Answer:
a. We should produce three cars. The value of the fourth car would be just $20,000 and would
cost $60,000 to produce.
Consumers Firms
(I) (II)
$80,000 3 $20,000 D
$70,000 1 $30,000 A
$40,000 4 $40,000 C
$20,000 2 $60,000 B

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b. The three lowest cost firms should produce: Firms A, C, and D

c. The three consumers who value electric cars the highest should own electric cars: Consumers
1, 3, and 4.
d. Willingness to pay of the consumers = $80,000 + $70,000 + $40,000 = $190,000
Total Cost = $20,000 + $30,000 + $40,000 = $90,000
Social surplus = $190,000 – $90,000 = $100,000
4. Let us continue with the electric car example from problem 3. Suppose the market for electric cars is
competitive.
a. Show that the equilibrium price in this market is $40,000.
b. Which firms will produce an electric car if the price is $40,000?
c. Which consumers will buy an electric car when the price is $40,000?
d. Calculate consumer, producer surplus, and social surplus when the price is $40,000.
e. Compare your answers to those for problem 3.
Answer:
a. When the price is $40,000, three consumers (all except 2) are willing to buy an electric car
because their willingness to pay is greater than or equal to price. Three firms (all except B)
are willing to sell an electric car since their cost is less than or equal to the price. Therefore
supply equals demand when the price is $40,000.
b. Firms A,C, and D
c. Consumers 1,3 and 4
d. Consumers 1, 3, and 4 are willing to pay a total of $80,000 + $70,000 + $40,000 = $190,000
for three cars. At a price of $40,000 they will pay 3 x $40,000 = $120,000 for those cars.
Therefore consumer surplus equals $190,000 - $120,000 = $70,000. It will cost Firms D, A,
and C a total of $20,000 + $30,000 + $40,000 = $90,000 to produce those cars. At a price of
$40,000 their revenues equal 3 x $40,000 = $120,000 Therefore producer surplus equals
$120,000 - $90,000 = $30,000. Social surplus is the sum of consumer and producer surplus.
Therefore social surplus equals $70,000 + $30,000 = $100,000.
e. The point here is that competitive markets lead to efficiency. The market outcome here leads
to the maximum social surplus we found in problem 3.
5. The following figure shows the demand and supply of television sets in a city. Since TVs are
considered normal goods, demand increases from D1 to D2 in response to an increase in the income
level.

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a. Use the figure to complete the table below:

Before Income Rose After Income Rose Change

Consumer Surplus

Producer Surplus

Social Surplus

b. Use your answers to part (a) of this problem to answer the following questions:
i. Did consumer surplus definitely rise, definitely remain constant, definitely fall, or is the
direction of the change in consumer surplus unclear?
ii. Did producer surplus definitely rise, definitely remain constant, definitely fall, or is the
direction of the change in producer surplus unclear?
iii. Did social surplus definitely rise, definitely remain constant, definitely fall, or is the
direction of the change in social surplus unclear?
Answer:
a. The completed table is as follows:
Before Income Rose After Income Rose Change

Consumer Surplus A+C A+B B–C

Producer Surplus F F+C+D C+D

Social Surplus A+C+F A+B+F+C+D B+D

b. As shown in the table:

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77 Acemoglu, Laibson, and List | Microeconomics

i. The change in consumer surplus is B – C. We do not know if B is greater than or less

than C and so we do not know if consumer surplus rose or fell.
ii. Producer surplus rises by C + D.
iii. Social surplus rises by B + D.
6. The market for electric drills in a certain country is characterized by a large number of buyers and
sellers and every buyer who wants a drill and can afford one has bought one. In other words, the
market for drills is in equilibrium.
a. Does this also mean that it is Pareto efficient? Explain your answer.
b. If some of the buyers in this market are now willing to pay more than they did earlier, would your
answer change?
c. Compared to the market for cars, the market for vintage buttons has fewer buyers and sellers.
Social surplus is likely to be higher in the market for cars than in the vintage button market. Is it
then correct to assume that the outcome in the car market is Pareto efficient while in the vintage
button market it is not? Explain.
Answer:
a. An outcome is Pareto efficient if no individual can be made better off without making
someone else worse off. A competitive market maximizes social surplus and so the market
outcome is Pareto efficient. Assuming that none of the large number of sellers has enough
market share to influence price, the market for electric drills is competitive, social surplus is
at its maximum and so, the market outcome is Pareto efficient.
b. The level of social surplus might increase if buyers are now willing to pay more than they did
earlier but as long as the competitive market equilibrium holds, the market outcome is still
Pareto efficient.
c. While social surplus in the market for vintage buttons is lower than in the market for cars, it
is incorrect to assume that the equilibrium in the car market is Pareto efficient while the
equilibrium in the vintage button market is not. The size of the social surplus in the market
does not determine whether the market is Pareto efficient or not. Pareto efficiency would only
depend on whether an individual can be made better off without making someone else worse
off.
7. The following tables show a small firm’s long-run average cost of manufacturing a good at two
different plants:
Plant 1
Quantity Total Cost Average Cost Marginal Cost
1 50
2 106
3 164
4 224
5 287
6 355
7 430
8 520
9 618

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Plant 2
Quantity Total Cost Average Cost Marginal Cost
1 20
2 52
3 90
4 130
5 175
6 227
7 285
8 345
9 407

a. Complete the third and fourth columns of each table.

b. Suppose the price of the good is $60. How much should the firm produce in each plant in order to
maximize the firm’s profit? Find the firm’s profit.
c. A new manager is assigned to the production department. He thinks that the firm can profitably
move all production to Plant 2 since the average cost of production is lower in Plant 2 than in
Plant 1. If the firm only uses Plant 2, how much should it produce in order to maximize profits?
Find the firm’s profit. Assume zero fixed cost.
Answer:
a.
Plant 1
Quantity Total Cost Average Cost Marginal Cost
1 50 50.00 50
2 106 53.00 56
3 164 54.67 58
4 224 56.00 60
5 287 57.40 63
6 355 59.17 68
7 430 61.43 75
8 520 65.00 90
9 618 68.67 98

Plant 2
Quantity Total Cost Average Cost Marginal Cost
1 20 20.00 20
2 52 26.00 32

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3 90 30.00 38
4 130 32.50 40
5 175 35.00 45
6 227 37.83 52
7 285 40.71 58
8 345 43.13 60
9 407 45.22 62
b. Since the price of the good is $60, profits are maximized when marginal cost of production is
equal to $60 at both plants. This occurs when 4 units are produced at Plant 1 and 8 units are
produced at Plant 2. The firm’s revenue will be 12 x $60 = $720, its total costs will be $224 +
$345 = $569, and it will earn a profit of $720 - $569 = $151.
c. If the firm uses just Plant 2 it would maximize profits by producing just 8 units (since price
equals marginal cost in Plant 2 at 8 units). Its revenue will be 8 x $60 = $480, its cost will be
$345, and its profit will be $480 - $345 = $135.
8. The following figure shows a firm’s marginal and average costs of production.

a. The equilibrium price in this market is $5. At this price, does the firm earn profits or is it making
losses?
b. From the given information, can you conclude whether the firm is operating in a competitive
market? Explain your answer.
c. The price of the good increases to $8. How does this change your answer to parts a and b?
Answer:
a. At a price of $5, the firm produces 60,000 units of the good. It does not earn profits or losses.
Total revenue from 60,000 units = $300,000
Total costs of producing 60,000 units = $300,000
Since total costs = total revenues, profits are equal to zero.

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b. Firms in competitive markets earn zero economic profits in the long run. At a price of $5, this
firm earns zero economic profits. So from the given information, we can conclude that the
firm may be operating in a competitive market.
c. If the market price increases to $8, the firm will produce 80,000 units of the good.
Total revenue from 80,000 units = $640,000
Total costs of producing 80,000 units = $440,000
Since total revenue exceeds total costs by $200,000, the firm earns economic profits. In the long run,
competitive firms earn zero economic profits. This firm makes positive economic profits when the
price is $8. This is however, not sufficient to conclude that the firm is not operating in a competitive
market. This firm might be operating in the short run where new firms have not entered the market
and competed away its profits.

9. Masumi is a Japanese company producing 10,000 pairs of chopsticks every month in Madagascar at
the average total cost (ATC) of $0.8. The manager of the company has found that while the ATC of
producing 3,000 pairs of chopsticks in Japan is $1.2, the ATC of producing 7,000 pairs of chopsticks
in Madagascar is $0.5. Should Masumi shift the production line of 3,000 pairs of chopsticks to Japan?
Explain.
Answer: If Masumi produces 10,000 pairs of chopsticks in Madagascar, the total cost will be 10,000 ×
$0.8 = $8,000. However, if Masumi moves the production line of 3,000 pairs of chopsticks to Japan
and produces 7,000 pairs in Madagascar, the total cost will be 3,000 × $1.2 + 7,000 × $0.5 = $7,100,
which is smaller than $8,000. Therefore, Masumi should shift the production line of 3,000 pairs of
chopsticks to Japan.

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10. The equilibrium rent in a town is $500 per month and the equilibrium number of apartments is 100.
The city now passes a rent control law that sets the maximum rent at $400. The diagram below
summarizes the supply and demand for apartments in this city.

a. Use the figure to complete the table below

Before Rent Control After Rent Control Change

Consumer Surplus

Producer Surplus

Social Surplus

b. Use your answers to part (a) of this problem to answer the following questions:
i. Did consumer surplus definitely rise, definitely remain constant, definitely fall, or is the
direction of the change in consumer surplus unclear?
ii. Did producer surplus definitely rise, definitely remain constant, definitely fall, or is the
direction of the change in producer surplus unclear?
iii. Did social surplus definitely rise, definitely remain constant, definitely fall, or is the
direction of the change in social surplus unclear?

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Answer:
a. The completed table is as follows:

Before Rent Control After Rent Control Change

Consumer Surplus I + II I + III III – II

Producer Surplus III + IV + V V – III – IV

Social Surplus I + II + III + IV + V I + III + V – II – IV

b. As shown in the table:

i. The change in consumer surplus is III – II and so it is not clear if consumer surplus rose
or fell. The consumers who rent those 60 apartments that are available under rent control
are better off because they now pay $400 per month instead of $500; this benefit is area
III. But the people who cannot find an apartment under rent control are worse off. They
lose the consumer surplus they realized from the 40 apartments that are no longer
available as a result of rent control; this loss is area II.
ii. Suppliers are unambiguously worse off as a result of price controls. They receive $400
per month instead of $500 per month for each of the 60 apartments they continue to offer
under rent control (area III) and they lose the producer surplus they realized from the 40
apartments they no longer offer (area IV).
iii. Total surplus falls by the sum of II (lost consumer surplus from the 40 apartments that are
no longer offered) and IV (lost producer surplus from those 40 apartments).
11. According to reports in the Chinese media, commuters in Beijing are facing a somewhat paradoxical
situation: they find it difficult to get a cab while hundreds of cabs lie idle during rush hour. The
demand for taxis in Beijing has increased as average incomes have risen. Government-determined
gasoline prices have also increased. But the government, worried about rising prices, has left the fares
cabs can charge their customers unchanged.
a. Use supply and demand curves to explain what has happened in the market for cabs in Beijing.
b. Based on your understanding of how the invisible hand works, what do you think should be done
to correct this problem?
Answer:
a. The following diagram shows the demand and supply curves for cabs in Beijing. The increase
in demand causes the demand curve to shift to the right. Since gasoline prices have increased,
the cost of running a cab in Beijing has also increased. This will shift the supply curve to the
left. The equilibrium quantity may or may not change depending on the degree to which both
curves shift but the equilibrium price in the market will increase. However, since the
government does not allow cab fares to increase, the number of cabs demanded exceeds the
supply. This explains why commuters are unable to find a cab when they need one.

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As can be seen in the figure, the increase in demand and decrease in supply have actually
increased the equilibrium price from P to P’. The equilibrium quantity should also have
increased from Q to Q’. The distance between Q0 and Q1 shows the extent by which demand
exceeds supply as a result of the price control.

Market for Cab Rides

b. An increase in demand combined with a decrease in supply implies an increase in price.

Therefore, to fix this problem, the cab fare must be allowed to increase. For the market to be
in equilibrium, fares must be allowed to increase to P’. At this price, quantity supplied will
equal demand at the quantity demanded.
See http://www.economist.com/node/21551537 and
http://www.theatlantic.com/international/archive/2013/01/its-harder-than-ever-to-catch-a-cab-in-
beijing/267239/

12. Carribea is an island country governed by the Communist Party. Since 1962, a food ration system has
been established in order to provide basic food to all citizens. With the booklet issued and distributed
by the government, Cubans can buy centrally regulated amounts of basic food, such as rice, oil, eggs,
chicken, sugar, and so on, from the food ration stores at prices that are even lower than the production
costs. Carribeans can also buy food at the market, where the prices are determined by the demand and
supply and are much higher than those at the food ration stores. Evaluate the food ration system and
the free market for food in Carribea from the perspectives of efficiency and equity.
Answer:Under the food ration system, Carribea has a higher level of equity because all citizens are
given the same amount of basic food. However, the level of efficiency is low because the food can be
traded at prices below the production costs, which means the producer surplus could be negative and
the social surplus is less than its maximum.

At the free market for food, the level of efficiency is high because the prices of food are determined
by the demand and supply, which means that the social surplus is maximized at the market
equilibrium. However, the free market lowers the level of equity because the people who are not able
to pay for the food will not get any of it.

© 2015 Pearson Education, Inc.