chapter 10 answers to end of chapter problems and...
TRANSCRIPT
Chapter 10
Answers to End of Chapter Problems and Applications
2.
Quantity of Workers Total Output Marginal Product of Labor Average Product of Labor
0 0 — —
1 400 400 400
2 900 500 450
3 1500 600 500
4 1900 400 475
5 2200 300 440
6 2400 100 400
7 2300 –100 329
4. a. Variable cost = total cost – fixed cost = $30,000 - $10,000 = $20,000.
b. AVC = VC/Q = $20,000/10,000 = $2; AFC = FC/Q = $10,000/10,000 = $1
c. The gap must get smaller as output rises because ATC = AVC + AFC and AFC falls as output
rises.
6. As long as Sally’s GPA for a semester is below her cumulative GPA, her cumulative GPA will
fall.
8. Jill’s reasoning is faulty. If she could rent out her current building for $4,000 per month, then
she incurs an opportunity cost of that amount by using the building herself.
10. Although Franklin had no explicit expense when he advertised in his own paper, he did incur
a cost. The space for his own advertisements could have been used for paid advertisements by
other firms.
12. Fixed costs are like a lump-sum tax because both are fixed amounts that do not change as
output changes. Because AFC = FC/Q, a tax becomes smaller per unit of output as output rises.
14. a. Jill’s costs will be lower with a smaller store.
b. Her costs will be lower with a larger store.
c. Because of the effects of economies of scale.
16. AFC should be downward sloping, not U-shaped. ATC should be above AVC.
18. Ford would have ended up as the only automobile producer. Other producers would have had
higher costs and, therefore, would not have been able to match his price cuts.
20. There must be economies of scale in book publishing.
22. Morita’s short-run cost curve is described in the chapter opener. Its lowest point is at outputs
between 10,000 and 30,000. If he wanted to produce more than 75,000, he would have built an
additional factory, or, if there were economies of scale in manufacturing transistor radios, he
would have built a larger factory.
24. eToys built the large distribution center represented by ATC2 because they expected their
sales to be Q2. In that case, their average costs would have been AC1. In fact, their sales were
only Q1, which meant their costs were AC3. If they had known how low their actual sales would
have been, they would have been better off building the smaller distribution center represented by
ATC1. This would have lowered their average costs to AC2. This is what the author meant when
he wrote that eToys “needed to generate much higher sales to justify its costs.”
26. DuPont had expected to be on ATC1, in which case as production of paint increased from Q1
to Q2, average cost would have decreased from AC1 to AC2. In fact, they were on ATC2, so
average cost actually increased from AC3 to AC4, as production expanded.
28. The investors were expecting the long-run average cost curve to fall as output rose from the
initial level, Q1, to the post-merger level Q2, as shown by LRAC2. Instead, long-run average costs
didn’t fall. LRAC1 reflects the actual long-run average cost curve because average costs are no
lower at Q1 than at Q2.
Answers to Appendix Problems and Applications
2. a. If total cost is $2000 and wage and rent price = $100, the isocost curve’s endpoints are at 20
and 20. Along this isocost curve, the cost-minimizing point for producing 5000 copies is at point
A.
b. If wage rate is one-fourth the rental price of capital, then we must be on the isocost curve
whose endpoints are where capital = 10 and labor = 40 – since we can buy four times as much
labor, with total cost of $1,000. Along this isocost curve the cost-minimizing point for producing
5000 copies is at point B.
c. In this case the isocost curve’s endpoint are at 40 and 40, so the cost-minimizing point for
producing 12,000 copies is at point C.
4. Positive technological change will enable Jill to produce 20,000 copies with fewer inputs than
before. The isoquant curves will shift inward. Along the new Q* = 20,000 isoquant, she can
produce 20,000 copies with fewer inputs than before – for example, 9 workers and 4 machines at
point B. At her initial input level, point A, she will be able to produce more than 20,000 copies –
in this example, she can now produce 22,000 copies using 10 workers and 5 machines. (The
shapes of the isoquant curves may change, as well, but this isn’t shown here.)
6.
Long-run average cost = (total cost)/Q.
The long-run average cost curve exhibits economies of scale (average cost falling as output rises)
up to 45,000 copies per day, but diseconomies of scale at levels higher than 45,000 copies per
day.
8. The isoquant curve shows that there are innumerable combinations of workers and machines
that can pick the same quantity of oranges per day. In the U.S., firms select a point like A – using
a lot of capital and very little labor – because the isocost curves they face are very steep, due to
the fact that labor is relatively expensive in comparison to capital in the U.S. In Brazil, firms
select a point like B – using lots of labor and very little capital – because the isocost curves they
face are very float, due to the relatively low price of labor in comparison to capital in Brazil.
Chapter 11
Answers to End of Chapter Problems and Applications
2. The remark confuses the market demand for wheat with the demand facing one farmer selling
wheat. Remember that the units used in drawing the market demand curve are much greater than
the units used in drawing the individual farmer’s demand curve.
4. No, because the opportunity cost to your sister of using the copiers is $1,500, which is equal to
your cost of renting them.
6. The company is a price taker because it is in a very competitive industry. The company
should charge the market price.
8.
a. Total cost = A + B + C
b. Total revenue = A + B
c. Variable cost = A
d. Loss = C
The firm will continue to produce in the short run because it has revenue greater than its variable
costs.
10. Disagree – no matter how great demand may be, if there are no barriers to firms entering the
industry, profits will be competed away in the long run.
12. This argument is incorrect. In order to maximize profit, the firm should produce up to the
point where marginal revenue equals marginal cost. By producing only Q1, the firm will miss out
on all the profits to be made on units between Q1 and Q2.
14. As shown in the figure, the cost curves have shifted upward so that the price of fertilizer is
now below the minimum point on the average variable cost curve.
16. Airlines, like other businesses, will continue to operate so long as they can cover their
variable costs. The statement that “revenues will cover a large part of their cost,” refers to total
costs. If revenues covered only a large part, but not all, of the firm’s variable costs, it would shut
down. These revenues seem to cover all of the variable costs plus some of the fixed costs.
18. In perfectly competitive markets, firms may temporarily earn greater profits from a reduction
in costs. However, in the long run, lower costs result in lower prices, which benefit consumers,
but not higher profits.
20. The remark is incorrect because the student has confused accounting profit and economic
profit. Zero economic profit includes a normal rate of return on the investment of the owners of
the firm.
22. The increase in the demand for laptop computers causes the demand curve to shift from D1 to
D2, temporarily driving the price up to P3. As the production of laptops increases, more orders
are placed for laptop displays. As production of laptop displays increases, their cost and price
falls because of economies of scale. With increased demand and lower costs, the firms that
assemble laptops can make economic profits at P3. The result is that new firms enter the industry,
the industry supply curve shifts from S1 to S2, driving down the price to P2 and eliminating
economic profits. Because the price of laptop computers declines as output increases, the long-
run supply curve is downward sloping. This is a decreasing-cost industry.
Chapter 12
2. Profit = Revenue – Cost = Quantity x (price – average cost) = 350 x ($3.25 – $3.00) = $87.50.
4. Remember that minimizing average costs is not the same as maximizing profits. Often where
profits are maximized, average costs are not minimized. In this case, we do not have the
information on the firm’s revenues that would be necessary to calculate the profit-maximizing
highway speed, nor do we know how other costs – such as labor costs – are related to the average
highway speed.
All subsequent questions have been renumbered.
6. Profit = Revenue – Total Cost. Since profit fell, total costs must have increased faster than
revenue increased.
8. The graph shows that when the marginal and average total cost curves shift up, the profit-
maximizing price rises from P1 to P2. Germano seems to be assuming that demand is perfectly
inelastic, which it is unlikely to be. If a publisher does not raise the price of a book following an
increase in its production cost, its marginal revenue from the last few copies will be less than the
marginal cost – so it will earn a smaller profit than it would at a higher price.
10. In this context, “making goods in large quantity” means making more than the profit-
maximizing quantity – making so many that the marginal cost exceeds the marginal revenue.
Producing too many Rolls-Royce automobiles might also ruin their reputation for exclusiveness
and ultimately reduce the demand for them. This is not a problem with most products. On the
other hand, building a large factory that exhibits diseconomies of scale would be a problem for
any firm.
12. Competition in markets results in firms being forced to produce the goods most desired by
consumers and keeps most firms from earning more than a normal rate of return in the long run.
14. Consumers gain from the lower prices productivity gains make possible. The firms are not
more profitable because competition causes the prices they charge to fall to the level of the
average total costs.
16. Competition is a risk because it can reduce a firm’s profits. The barriers to entry are low in
retailing, so the competition is intense.
18. It will be very difficult to become rich by following the advice found in a book, because if the
book really has a good idea, then a lot of people will follow its advice. In the process, they will
compete away the profits from following the advice. Only those who pounce on the profit
opportunity quickly will earn great profits before imitators enter the market and eliminate the
profits. (In addition, if the author’s advice is really that valuable, he or she will probably want to
keep it secret, using it in his or her own business rather than telling rivals about it.)
20. This is a good way to find out what customers want, but it probably isn’t a good way to make
a profit because other firms already know this same information and are selling products to these
customers. Entering the market with products exactly like the competition will only work if your
firm somehow has lower costs than the other firms. On the other hand, firms who discover new
information about what customers want can temporarily make a profit supplying it until new
firms enter the market and competition drives profits back to zero.
22. The skeptics who think that “Starbucks’ game is almost over” think that other firms will soon
be copying Starbucks so well that the demand for Starbucks’ products will shrink and it won’t be
able to earn high economic profits any more.
Chapter 13
2. If a firm doesn’t match a price cut, its sales may fall considerably; if it doesn’t match a price
increase, its sales will rise.
4. a.
b. Confessing is a dominant strategy for Bob.
c. Confessing is a dominant strategy for Tom.
d. They will both confess, so they will both serve 10-year sentences. In this situation, this
outcome is difficult to avoid, but if they had both refused to confess, they would both have served
only 3-year sentences.
6. Early decision plans may have put “big-name” colleges in a prisoners’ dilemma.
8. If advertising is a prisoners’ dilemma, as in Solved Problem 13-1, then a ban on advertising
beer on television is likely to increase the profits of beer companies.
10. a. Wal-Mart doesn’t have a dominant strategy. If Target uses bar codes, Wal-Mart earns more
profit when it also uses bar codes, but if Target uses RFID tags, Wal-Mart’s best strategy is to use
RFID tags.
b. Target doesn’t have a dominant strategy. If Wal-Mart uses bar codes, Target earns more profit
when it uses bar codes, but if Wal-Mart uses RFID tags, Target earns more by using RFID tags.
c. Recall the definition of a Nash equilibrium: A situation where each firm chooses the best
strategy, given the strategies chosen by other firms. In this problem there are two Nash
equilibria: Both firms choosing bar codes or both firms choosing RFID tags. In either of these
situations, neither firm can increase its profits by changing its strategy, given the strategy chosen
by the other firm. An important point to note is that it is possible to have a Nash equilibrium
even when neither firm has a dominant strategy.
12. Economic structure would include whether there are economies of scale in the industry,
whether one or more firms owns a key input or raw material, whether there are government
imposed barriers to entry or competition, the threat of substitute goods or services, the bargaining
power of buyers and the bargaining power of suppliers. Most economists agree that economic
structure is the main determinant of the intensity of competition in an industry, but other factors,
like the personalities involved, might occasionally play a role.
14. As the personal computer industry evolved during the 1990s and early 2000s, differences
between the machines offered by the computer companies narrowed. So, personal computers
became more of a commodity business. In a commodity business, consumers are making their
decisions primarily on the basis of price. Therefore, a price ware is a worse strategy in a
commodity business because if one company cuts the price of its product, competitors have little
choice but to match the price cut.
16. Entrepreneurs hope to increase profitability by creating “big businesses.” Unless there are
significant economies of scale, they will not be successful, however. In the figure, firms
producing Q1 have the lowest average costs. If a firm tries to grow to a larger size, say Q2, it
average costs will rise – from C1 to C2 in this case.
18. Your answer does depend on the minimum rate of return owners of fast-food restaurants
require on their investment. For instance, suppose the minimum required return is 15 percent.
Then Burger King will enter whether McDonald’s builds a large store or a small store. So,
McDonald’s should build a small store, because it will receive a return of 20 percent, rather than
16 percent. But suppose the minimum required return is 20 percent. Then Burger King will not
enter if McDonald’s builds a large store. So, McDonald’s should build the large store, in which
case it will earn a return of 25 percent.
20. Having more flights, flying more different models of planes, and having areas for different
classes of passengers on each plane raises costs. Southwest Airlines avoids these costs by
pursuing the strategy outlined in Making the Connection 13-4.
22. “Being the competition” means copying the business model of another firm. “Being the
competition” sometimes makes sense. On example would be when there is no other option
available in the industry – such as in a perfectly competitive industry. Another case in which
“being the competition” makes sense is when their business model fits your firm better than their
own.
24. As Chandler suggests, there are many firms in these industries because smaller firms can
produce at a lower long-run average cost than larger firms.
26. a. There would be one or more firms like LittleAuto.
b. A single firm like BigAuto will probably dominate the market.
c. There will probably be two or more firms like BigAuto, depending on the how large demand is.
Chapter 14
Answers to End of Chapter Problems and Applications
2. The USPS is probably not a natural monopoly. If it were, it wouldn’t need a law banning
competition. It would be able to produce at a lower cost and charge a lower price than potential
competitors, so no one would want to enter the industry. If the current law banning competitors
were removed, firms would likely enter this market. They have already entered portions of the
market (such as package and overnight letter delivery) where competition isn’t banned and seem
eager to expand into additional sectors in the mail delivery business.
4. Extending the life of pharmaceutical companies’ patents would allow them to charge the
monopoly price for their drugs for a longer period and earn higher profits. This potential for
higher profits would encourage them to develop more new products. Consumers would gain
from having a wider range or medicines, but they would lose because their prices would stay high
longer.
6. You are likely to make a loss. If a profit was likely in this market, someone would probably
have already entered it.
8. There are only a limited number of countries in the world, which limits the number of
customers in this market. Also, printing currency that is difficult to counterfeit requires
specialized printing methods.
10a. The monopoly will produce 50 units and charge a price of $10.
10b. To achieve allocative efficiency, the regulatory agency should require the monopoly to
charge a price equal to marginal cost, which in this case would be a price of $7. The regulated
monopoly will produce 90 units. It will make a profit, because price is above average total cost.
12. We can calculate average total cost at every quantity.
Quantity
(per day)
(Q)
Total Cost
(TC)
Average Total Cost
⎟⎟⎠
⎞⎜⎜⎝
⎛QTC
30 $1,200 $40
40 1,400 35
50 2,250 45
60 3,000 50
In order for the firm to have a natural monopoly, it must be able to produce at a lower average
total cost than two firms. This is not the case here, because the firm’s average total cost begins to
increase after it has produced 40 units per day.
14a. In the short run Comcast will continue to sell 6 subscriptions at $14 each. Its revenue = $84,
but its cost is now $80 + $6, so its loss is $2. If this loss continues, in the long-run Comcast exit
the market.
14b. The new tax increases the marginal cost by $0.50 per subscriber, as shown in the table:
Price Quantity Total Revenue
Marginal Revenue
(MR = ∆TR/∆Q) Total Cost
Marginal Cost
(MC =
∆TC/∆Q)
$17 3 $51 – $57.50 –
16 4 64 $13 65.00 $7.50
15 5 75 11 73.50 8.50
14 6 84 9 83.00 9.50
13 7 91 7 93.50 10.50
12 8 96 5 105.00 11.50
Now Comcast will sell 5 subscriptions. It will charge a price of $15 per month, and earn profits
of $75 – $73.50 = $1.50.
16. The statement is incorrect. The monopolist charges the price that allows him to sell the level
of output where marginal revenue equals marginal cost. He is able to charge a higher price, but
would not be maximizing profit if he did.
18. No, to maximize revenue or production, the monopolist would have to charge a price that is
lower than the profit-maximizing price.
20. Under federal law, the Antitrust Division of the Department of Justice is given the
responsibility of policing mergers to make sure that they don’t substantially reduce competition.
If two large airlines merge, there will be less competition in the airline industry, which will result
in higher ticket prices.
22.
Before the merger the price was Pc and the quantity was Qc, so consumer surplus equaled A + B
+ C + D + E and producer surplus was area F + G + H + K + L + M. After the merger, price fell
to Pmerge and quantity rose to Qmerge, so consumer surplus equaled A + B + C + D + E + F + G + H
+ I + J and producer surplus became area K + L + M + N + O + P + Q + R.
24a. We need to calculate the Herfindahl-Hirschman Index (HHI). Before the merger: 20 x 52 =
500. After the merger: (15 x 52) + 202 = 375 + 400 = 775. Because the post-merger HHI is below
1,000 the merger will not be opposed.
24b. HHI before the merger: 5 x 202 = 2,000. After the merger: (3 x 202) + 402 = 1200 + 1600 =
2,800. Both before and after the merger, the HHI is above 1,800 so the merger will be opposed.
26. HHI before the merger, assuming 11 firms in the “other” category, each with a 1 percent share
of the market: 372 + 352 + 172 + 11(12) = 2,894. So, even if no company other than Coca-Cola,
Pepsi-Cola, and Cadbury Schweppes has a market share greater than 1 percent, the Department of
Justice and the Federal Trade Commission would be likely to oppose a merger between two of the
leading three firms.
28. The figure as drawn shows a monopoly producing the efficient level of output. Using
different demand curves (and different sizes for the negative externality), it is possible to show
that a monopoly may also produce an inefficiently high or low level of output in the presence of a
negative externality.
Chapter 15
Answers to End-of-Chapter Problems and Applications
2. Valerian might be suspicious of eBay because many of its users buy at a low price to resell at a
high price. However, if he were to find an item that had great value to him on eBay, he might
temper his judgment. Valerian’s worry seems to be that arbitragers are making unfairly high
profits, but eBay actually helps increase competition, thus eliminating the middleman’s economic
profits, while increasing consumer surplus.
4. This appears to be a case of price discrimination, unless the costs of selling autos is $30,142 –
$27,939 = $2203 higher in Dallas than in Oklahoma.
6. It must consider the price elasticity of demand for U.S. consumers to be higher.
8. To practice price discrimination, the airlines also need to keep the people who buy at the low
price from reselling at the high price.
10. In each case, Disney is attempting to set price so as to maximize profits given differing price
elasticities of demand.
12. a. The firm will charge $8 and sell 20 units in Market 1.
b. The firm will charge $10 and sell 60 units in Market 2.
14. We have seen that price discrimination results in lower prices for consumers with a high price
elasticity of demand and higher prices for consumers with a lower price elasticity of demand.
One way in which airlines and hotels separate high price elasticity consumers from low price
elasticity consumers is on the basis of their flexibility. In this case, flexibility usually means a
willingness to make a reservation well in advance or to change plans at the last second and to stay
over Saturday or during other periods when business travelers do not like to stay.
16. If this explanation of odd pricing is correct, you would expect to see it used more often among
people who are gullible, innumerate, or uneducated. Banning the practice probably wouldn’t
make much of a difference. Consumers might make slightly wiser choices, but they would have
to pay slightly more and a few would lose the feeling of having made a great deal. In competitive
markets, firms do not make economic profits in the long run.
18. a. This is a variation of the Disney World, two-part tariff problem. The team will make more
profit by keeping the season ticket prices low.
b. After the first year, the team no longer collects revenue from seat licenses, so it would have an
incentive to raise the price of season tickets.
c. If it still has some seat licenses unsold, then it will not raise season tickets as much as it would
if it sold them all the first year.
20. This is a variation of the Disney World, two-part tariff problem. The railroad companies
would maximize their combined profit from selling land and shipping freight by keeping freight
prices lower than they would if they did not also have land to sell. This was true because farmers
would be able to make greater profits – and, therefore, would be willing to pay more for land – if
freight charges were low.
Chapter 16
Answers to End of Chapter Problems and Applications
2. As your wage rises you’ll want less leisure because the price of an hour of leisure is now
higher (the substitution effect), but you’ll also want more leisure because you can now afford
more leisure (the income effect). Your labor supply curve is vertical if this substitution effect is
exactly the same size as the income effect.
4. He feared that an increase in labor supply would lower the equilibrium wage. In fact, labor
demand increased more than labor supply, and the equilibrium wage rose.
6. The shift from Labor Supply1 to Labor Supply2 shows the effect of the plague on the quantity
of sailors available at each wage. In the absence of government intervention, the wage would
have risen from W1 to W2, and the quantity of sailors employed would have fallen from L1 to L2.
The wage ceiling keeps the wage at W1, but causes the quantity of sailors employed to fall all the
way to L3.
8. It would probably have very little effect. The salaries of baseball players would still be much
greater than the salaries of college professors even if there were significantly more players on
each team. With expanded rosters, the superstars would still have the highest marginal revenue
products and would be paid over $10,000,000 per year. The new major leaguers wouldn’t get
very much playing time, wouldn’t have high marginal revenue products, and would earn less than
the league average – pulling down average pay somewhat, but not shrinking the gap between the
superstars and college professors.
10. Alex Rodriguez’s marginal revenue product – how much extra revenue he pulls in for his
employer – is obviously much higher than the marginal revenue product of this fan’s boss.
Rodriguez’s high pay is justified in an important sense because fans are willing to pay so much to
see a winning Major League Baseball team. Complaints about high salaries for professional
athletes amount to complaints that fan are willing to pay too much to view games. If A-Rod were
paid less, the big winner would be his employer, the New York Yankees.
12. The people who run the tennis tournaments in which the Williams sisters play sell tickets and
the right to broadcast the tournaments over television. So, the concept of marginal revenue
product is just as important in explaining their earnings as it is in explaining the earnings of
baseball players.
14. If economic discrimination were rampant against minority groups it would be unlikely that
Asian males would earn more than white males. However, it is important not to use average
wages to assess whether or not discrimination occurs. Differences in productivity are probably
the main factor determining differences in wages. Economic discrimination occurs when
someone is paid less due to an irrelevant characteristic which isn’t related to productivity.
16. Without comparable worth legislation, the equilibrium wage for economics professors is
$70,000 per year and the equilibrium number of economics professors hired is L1. Setting the
wage for economics professors below equilibrium at $60,000, reduces the number who are
willing to work in this occupation from L1 to L2, but increases the number demanded by
employers from L1 to L3. The result is a shortage of economics professors equal to L3 – L2, as
shown in the graph. Without comparable worth legislation, the equilibrium wage for English
professors is $50,000 and the equilibrium number hired is L1. Setting the wage for English
professors above equilibrium at $60,000, increases the number who want to work in this
occupation from L1 to L3, but reduces the number demanded by employers from L1 to L2. The
result is a surplus of English professors equal to L3 – L2, as shown in the graph.
18. Complete exclusion from an occupation is a sign that employees are the discriminators, rather
than employers. In occupations from which blacks were not excluded, equal pay for equal work
was almost inevitable, especially in a very competitive market with many employers, such as
agriculture. Employers who tried to pay black workers less would lose many of them to
employers who didn’t discriminate and would be at a competitive disadvantage. In addition,
paying workers doing the same jobs different wages may have reduced morale and productivity.
20. It will be higher under a piece-rate system, because the workers are willing to put in a greater
effort to earn more.
22. a.
Number
of
Machines
Output of
Pins (Boxes
per Week)
Marginal
Product of
Capital
Product
Price
(Dollars
per Box)
Total
Revenue
Marginal
Revenue
Product of
Capital
Rental
Cost per
Machine
Additional
Profit from
Renting One
Additional
Machine
0 0 — $100 0 — $550 —
1 12 12 100 $1200 $1200 550 $650
2 21 9 100 2100 900 550 350
3 28 7 100 2800 700 550 150
4 34 6 100 3400 600 550 50
5 39 5 100 3900 500 550 –50
6 43 4 100 4300 400 550 –150
Adam should rent 4 machines.
b. The demand curve for capital curve equals the marginal revenue product of capital.
Chapter 17
Answers to End-of-Chapter Problems and Applications
2. There are “lemon laws” for autos but not for televisions or toothbrushes because the size of the
losses sustained by buyers of bad cars led to political pressure to pass lemon laws for cars.
4. Perhaps. Some argue that Social Security does not involve offering insurance against difficult
to predict events like a fire or an illness, but that it is more like a program of forced saving for
retirement. Others argue that Social Security is an insurance system that insures against outliving
your savings due to the difficulty of predicting how long you are likely to live after retiring.
6. The system is necessary because society wants someone with enough money to be liable when
these drivers inflict damage on other people. The adverse selection problem means that insurance
companies are generally unwilling to offer insurance to these drivers at any rate. The state
government must force insurance companies to insure these bad drivers because the insurance
companies expect to lose money insuring these drivers, sot they wouldn’t insure them voluntarily.
8. Investors have been unwilling to buy the stocks and bonds of these firms because the adverse
selection problem means that the firms that most want to sell stocks or bonds to investors have
been the firms investors would least want to buy stocks or bonds from, if they knew the true state
of the firms’ financial health.
10. Yes. Congress was motivated to ban these loans because of the difficulty of determining
when they were in the best interests of shareholders and when they weren’t.
12. It is difficult for restaurant managers to monitor the performance of servers. Tips give servers
an incentive to provide good service. If tips were outlawed, the income of servers would be
likely to fall because the productivity of servers will decline.
14. Firms would divulge secrets to analysts to reduce the asymmetric information problem. Firms
have an incentive to provide outsiders with enough information that they may be willing to invest
in or lend to the firm.
16. Paying more than the going wage could increase or decrease profits. If employees respond to
the high pay by working harder, being more productive and quitting less frequently, the benefits
to the firm of the paying the above-market wage may exceed the costs. The higher pay may be an
efficiency wage, which gives workers an incentive to work harder. It may be a response to
asymmetric information.
18. The easier it is for bidders to estimate the true value of what they are bidding on, the less
likely they are to fall victim to the winner’s curse. Because Joe’s performance is steady,
Cleveland is likely to be paying him an amount that is justified by his performance. Sam’s
performance is more uneven, so Cincinnati is more likely to have fallen victim to the winner’s
curse by overestimating his performance, and to therefore be paying him a salary that turns out
not to be justified by his performance.
20. No. For the winner’s curse to apply, the winner must have overestimated the true value of
what is being bid on. If all bidders have perfect information, then this will not happen.
22. They suffer from the winner’s curse. The publisher that wins the auction is the publisher that
has most overestimated how many copies will be sold of the book being auctioned.
24. The marriage market is probably a combination of the two. There are certain aspects of
appearance and certain personality traits to which most people would assign the same value. On
the other hand, not every one evaluates appearance and personality the same way.
Chapter 18
Answers to End of Chapter Problems and Applications
2. A tax is regressive if people with lower incomes pay a higher percentage of their income in tax
than do people with higher incomes. So, a tax on cigarettes is likely to be regressive. A tax is
progressive if people with lower incomes pay a smaller percentage of their income in tax than do
people with higher incomes.
4. The statement means that laws saying that a particular group (for example, sellers) will pay a
tax have little bearing on who actually pays the tax. The statement is correct. Even though a law
may specify that a seller pays the whole tax, the economic logic explained in Figure 18-3
indicates that most taxes are borne partly by buyers and partly by sellers. After a tax is imposed,
the price paid by buyers will generally rise and the amount kept by sellers will generally fall. The
fraction of the tax borne by each group depends on the elasticity of supply relative to the
elasticity of demand.
6. Excess burden is the deadweight loss from a tax. As the graph shows, the excess burden is
greater when the demand for a product is price elastic. The red-shaded triangle shows the excess
burden when demand is elastic and the smaller blue-shaded triangle shows the excess burden
when demand in inelastic.
8a.
For a given supply curve, if the government wants to minimize the excess burden from excise
taxes, the taxes should be imposed on goods that have price inelastic demand. See the figure from
problem 7, which illustrates this point.
8b. For a given supply curve, if the government wishes to maximize revenue, it should impose
excise taxes on goods that have price inelastic demand. As the figure below shows, with an elastic
demand curve the quantity sold will fall from QE to Q1, so revenue will be the area Q1 x (P3 – P1),
while the revenue will be Q2 x (P4 – P2) when the demand curve is inelastic. Q2 is much larger
than Q1, while (P4 – P2) = (P3 – P1) = the amount of the tax. Thus, the tax revenue is much larger
when the demand curve is inelastic, because the quantity sold is larger.
8c. If the government wishes to discourage use of the product, the tax will be more effective in
achieving the objective if the demand is price elastic. As shown in the figure, the quantity
demanded will fall more when the demand curve is elastic.
10. It is unlikely that this statement is true. The burden of a tax generally falls on both buyer and
seller. If the tax didn’t exist, it is likely that the list price would have been more than $300. Only
if the demand curve is vertical or the supply curve is horizontal, will buyers bear the entire burden
of the tax.
12. While policies to redistribute income may be desperately needed in the U.S., it doesn’t seem
to be true that the 12 percent of the population that is currently poor has no hope of ever climbing
above the poverty line. The chapter cites a study by the U.S. Census Bureau which found that
only 50.5 percent of people who were in poverty in 1996 remained in poverty in 1999. Likewise,
of the people who were in poverty at any time during 1996, 51.1 percent were in poverty for four
months or less and only 20.4 percent were in poverty for more than one year.
14.
The total income of this group is $250,000.
Quintile Share of Income Cumulative Share of Income
Lowest 20% (Jeff) 12% 12%
Second lowest 20% (Robert) 16% 28%
Middle 20% (Sharon) 20% 48%
Second highest 20% (Lena) 24% 72%
Highest 20% (David) 28% 100%
16. According to the marginal productivity theory of income distribution, the distribution of
income is based mainly on the marginal revenue product of the factors owned by households. To
equalize the distribution of income would require ending the inequality of ownership of resources
or ending the inequality of the payments to these resources (by, for example, making wage rates
equal). This would require a massive government intervention into the economy, greater even
than under the old communist governments of Russia and China, which never achieved complete
income equality. Such a policy would not be very desirable because it would destroy the
efficiency of the economy. There would be no incentives to work hard, save, become educated,
take entrepreneurial risks, and so forth, if people knew that their income would be the same as
everyone else’s whether or not they worked, saved, became educated or took risks.
18. Food is often exempt from taxation because of the ability-to-pay principle. Poorer households
generally spend a much larger fraction of their incomes on food, which is a necessity. In
satisfying these basic needs, they don’t have as great an ability to pay taxes as households with
higher incomes. The exemption of services from sales taxes is much harder to understand using
the principles of taxation. Taxing services at a lower rate than goods can undermine the goal of
achieving economic efficiency. It may be that the exemption of services is an effort to attain
other social objectives. It is much easier for tax collectors to keep an eye on the sales of goods,
so the exemption of sales may be a bow to the likelihood of tax evasion if services were taxed.
20. The poverty line is defined as an annual income equal to three times the amount necessary to
purchase the minimal quantity of food require for adequate nutrition – and it is calculated before
taxes and transfers. There are many reasons why consumption and ownership of these goods
could rise while poverty rates stay the same. Most importantly, the poverty rate is based on
income and consumption can differ from income, due to transfers, for example. Another reason
is that the definition of “adequate” nutrition seems to have risen over time, increasing the
purchasing power of those at the poverty line.