CHAPTER 8COMPETITIVE MARKET POLICY

MULTIPLE CHOICE

1.In competitive market equilibrium, social welfare is measured by:

a.

the difference of net benefits derived by consumers and producers.

b.

the sum of net benefits derived by consumers and producers.

c.

net benefits derived by consumers.

d.

net benefits derived by producers.

ANS:B

2.No externalities exist when:

a.

private costs exceed social costs.

b.

private costs and benefits equal social costs and benefits.

c.

private benefits are less than social benefits.

d.

private benefits exceed social benefits.

ANS:B

3.A government policy that addresses market failures caused by positive externalities is:

a.

patent grants.

b.

subsidies for pollution reduction.

c.

tax policy.

d.

the establishment of operating controls.

ANS:A

4.The burden of a per unit tax on a product will fall primarily on producers when:

a.

the tax is collected from customers.

b.

demand is highly elastic with respect to price.

c.

demand is highly inelastic with respect to price.

d.

the tax is collected from producers.

ANS:B

5.A per unit tax will cause output prices to increase least when:

a.

marginal cost is constant.

b.

marginal cost is falling.

c.

average cost is falling.

d.

marginal cost is rising.

ANS:D

6.Failure by market structure can occur when:

a.

joint products are produced in variable proportions.

b.

joint products are produced in fixed proportions.

c.

externalities exist.

d.

few buyers or sellers are present.

ANS:D

7.In competitive markets:

a.

high-wage workers tend to be those that are most productive.

b.

companies earn excess profits by better serving customer needs.

c.

fairness is sacrificed in the interest of efficiency.

d.

firms dictate the quantity and quality of goods and services provided.

ANS:A

8.Consumer sovereignty reflects:

a.

buyer power.

b.

failure by market structure.

c.

failure by incentive.

d.

externalities.

ANS:A

9.Competition in the cable television service industry is furnished by:

a.

imports.

b.

potential entrants.

c.

large numbers of providers in local markets.

d.

government regulation.

ANS:B

10.Producer surplus is the:

a.

amount paid to sellers above and beyond the value received by consumers.

b.

amount paid to sellers above and beyond the required minimum.

c.

amount paid to sellers.

d.

cost of production.

ANS:B

11.The welfare loss triangle depicts:

a.

deadweight losses suffered by consumers.

b.

deadweight losses suffered by producers.

c.

deadweight losses suffered by consumers and producers.

d.

lost profits.

ANS:C

12.Profits stemming from market power reflect:

a.

high prices.

b.

superior efficiency.

c.

exceptional capability.

d.

rapid industry growth.

ANS:A

13.Failure by market structure is caused by:

a.

positive spillover effects.

b.

positive externalities.

c.

negative externalities.

d.

none of these.

ANS:D

14.Externalities are:

a.

differences between social costs and social benefits.

b.

differences between social benefits and private benefits.

c.

social costs.

d.

social benefits.

ANS:B

15.Undue market power is indicated when buyer influence results in:

a.

higher than competitive prices.

b.

less than competitive output.

c.

less than competitive costs.

d.

excess profits.

ANS:C

16.Utility price and profit regulation is designed to address:

a.

failure by incentive.

b.

failure by market structure.

c.

positive externalities.

d.

negative externalities.

ANS:B

17.A per unit tax on pollution:

a.

results in deadweight loss.

b.

raises private benefits.

c.

lowers social benefits.

d.

lowers private costs.

ANS:A

18.From an economic perspective, imposition of a per unit tax is only advantageous if:

a.

the social benefits derived from added tax revenues are sufficient to overcome the social costs at a risk-adjusted rate of return..

b.

the social benefits derived from added tax revenues are sufficient to overcome the private costs at a risk-adjusted rate of return..

c.

the benefits derived from added tax revenues are sufficient to overcome the economic costs tied to the deadweight loss in social welfare.

d.

positive tax revenues are generated.

ANS:C

19.Society's right to a clean environment is asserted through:

a.

fines.

b.

tradeable emission permits.

c.

subsidy policy.

d.

price and profit regulation.

ANS:A

20.Who pays the economic cost of a tax is answered at the point of tax:

a.

burden.

b.

assessment.

c.

collection.

d.

incidence.

ANS:A

21.The costs of pollution taxes are shared by consumers and producers when:

a.

supply is perfectly elastic.

b.

supply is perfectly inelastic.

c.

demand is perfectly inelastic.

d.

none of the above.

ANS:D

22.A price ceiling is a costly and seldom used mechanism for:

a.

restraining excess supply.

b.

restraining excess demand.

c.

counteracting the effects of falling productivity.

d.

counteracting the effects of rising productivity.

ANS:B

23.A price floor is a costly and commonly used mechanism for:

a.

restraining excess supply.

b.

restraining excess demand.

c.

counteracting the effects of falling productivity.

d.

counteracting the effects of rising productivity.

ANS:D

24.Economic rents are profits due to:

a.

luck.

b.

uniquely productive inputs

c.

monopoly power.

d.

regulation.

ANS:B

25.Above-normal returns earned in the time interval that exists between when a favorable influence on industry demand or cost conditions first transpires and the time when competitor entry or growth finally develops are called:

a.

disequilibrium profits.

b.

a normal rate of return on investment.

c.

disequilibrium losses.

d.

economic rents.

ANS:A

PROBLEM

1.Social Welfare Concepts. Indicate whether each of the following statements is true or false, and explain why.

A.

Producer surplus tends to fall as the supply curve becomes more elastic.

B.

Consumer surplus tends to rise as demand becomes more elastic.

C.

The market demand curve indicates the minimum price buyers are willing to pay at each level of production.

D.

The market supply curve indicates the minimum price required by sellers as a group to bring forth production.

E.

Consumer surplus is the amount that consumers are willing to pay for a given good or service above and beyond the amount actually paid.

ANS:

A.

True. Whereas consumer surplus is closely related to the demand curve for a product, producer surplus is closely related to the supply curve for a product. It measures the amount by which the total revenues exceeds the marginal costs of production. As the supply curve becomes more elastic, the amount of producer surplus can be expected to fall.

B.

False. Consumer surplus is the area under the demand curve that lies above the market price. It represents the amount that consumers are willing to pay for a given good or service minus the amount that they are required to pay. As the demand curve becomes more elastic, the difference between perceived value and market prices tends to diminish, and consumer surplus falls.

C.

False. The market supply demand curve indicates the maximum price buyers are willing to pay to bring forth each level of production. The height of the market demand curve measures the maximum value placed on production by buyers at each production level.

D.

True. The market supply curve indicates the minimum price required by sellers as a group to bring forth production. The height of the market supply curve measures minimum production cost at each and every activity level.

E.

True. Consumer surplus is the area under the demand curve that lies above the market price. It represents the amount that consumers are willing to pay for a given good or service minus the amount that they are required to pay. Consumer surplus represents value derived from consumption that consumers are able to enjoy at zero cost. It also describes the net benefit derived by consumers from consumption, where net benefit is measured in the eyes of the consumer. From the standpoint of society as a whole, consumer surplus is an attractive measure of the economic well-being of consumers.

2.Competitive Market Equilibrium. Suppose demand and supply conditions in the competitive market for unskilled labor are as follows:

QD = 66.25 - 5P

(Demand)

QS = -27.5 + 10P

(Supply)

where Q is millions of hours of unskilled labor and P is the wage rate per hour.

A.

Calculate the industry equilibrium wage/employment combination.

B.

Confirm your answer graphically.

ANS:

A.

Algebraically,

QD = QS

66.25 - 5P = -27.5 +10P

15P = 93.75

P = $6.25

Both demand and supply equal 35 because:

Demand: QD = 66.25 - 5(6.25) = 35

Supply: QS = -27.5 +10(6.25) = 35

B.

From the graph, it is clear that QD = QS = 35 at a wage rate of $6.25 per hour. Thus, P = $6.25 and Q = 35 is the equilibrium wage/employment combination.

3.Competitive Market Equilibrium. Assume demand and supply conditions in the competitive market for unskilled labor are as follows:

P = $15 - 0.3QD

(Demand)

P = $0.2QS

(Supply)

where Q is millions of hours of unskilled labor and P is the wage rate per hour.

A.

Illustrate the industry equilibrium wage/employment combination both graphically and algebraically.

B.

Calculate the level of excess supply (unemployment) if the Federal minimum wage is raised from $5.15 to $6 per hour.

ANS:

A.

From the graph, it is clear that the competitive market equilibrium occurs when QD = QS = 30(000) at a wage rate of $6 per hour. Thus, P = $6 and Q = 30 is the equilibrium wage/employment combination. Algebraically,

P = P

$15 - 0.3Q = $0.2Q

0.5Q = 15

Q = 30

Both demand and supply equal 30 when P = $6 because:

Demand: P = $15 - 0.3(30) = $6 per hour

Supply: P = $0.2(30) = $6 per hour

B.

If the market equilibrium wage rate for unskilled labor is $6 per hour, an increase in the minimum wage from $5.15 to $6 will have no economic effect. The wage rate of $6 and the equilibrium employment of 30(000) million hours will be maintained.

4.Competitive Market Surplus. Suppose demand and supply conditions in the competitive market for unskilled labor are as follows:

P = $15 - 0.3QD

(Demand)

P = $3 + $0.1QS

(Supply)

where Q is millions of hours of unskilled labor and P is the wage rate per hour.

A.

Illustrate the industry equilibrium wage/employment combination both graphically and algebraically.

B.

Calculate the level of excess supply (unemployment) if the Federal minimum wage is raised from $5.15 to $7 per hour.

ANS:

A.

Algebraically,

P = P

$15 - 0.3Q = $3 + $0.1Q

0.4Q = 12

Q = 30

Both demand and supply equal 30 when P = $6 because:

Demand: P = $15 - 0.3(30) = $6 per hour

Supply: P = $3 + $0.1(30) = $6 per hour

From the graph, it is clear that the competitive market equilibrium occurs when QD = QS = 30(000) at a wage rate of $6 per hour. Thus, P = $6 and Q = 30 is the equilibrium wage/employment combination.

B.

If the market equilibrium wage rate for unskilled labor is $6 per hour, an increase in the minimum wage from $5.15 to $7 will have a material economic effect on both employment and the wage received by low-wage workers. At a minimum wage of $7, supply of 45(000) million hours of unskilled labor is forthcoming, but demand falls to 25(000) million hours. Unemployment of 20(000) million hours of unskilled labor is created (see graph).

5.Competitive Market Surplus. Assume demand and supply conditions in the competitive market for unskilled labor are as follows:

QD = 66.25 - 5P

(Demand)

QS = -27.5 + 10P

(Supply)

where Q is millions of hours of unskilled labor and P is the wage rate per hour.

A.

Illustrate the industry equilibrium price/output combination both graphically and algebraically.

B.

How many low-wage workers will get laid off if the Federal minimum wage is raised from $5.15 to $7.25 per hour?

ANS:

A.

From the graph, it is clear that QD = QS = 35 at a wage rate of $6.25 per hour. Thus, P = $6.25 and Q = 35 is the equilibrium wage-employment combination.

Algebraically,

QD = QS

66.25 - 5P = -27.5 +10P

15P = 93.75

P = $6.25

Both demand and supply equal 35 because:

Demand: QD = 66.25 - 5(6.25) = 35

Supply: QS = -27.5 +10(6.25) = 35

B.

With an increase in the minimum wage from $5.15 to $7 per hour, 5(000) million worker hours will get laid off. If the market equilibrium wage rate for unskilled labor is $6.25 per hour, an increase in the minimum wage from $5.15 to $7 will have a material economic effect on both employment and the wage received by low-wage workers. At a minimum wage of $7.25, supply of 45(000) million hours of unskilled labor is forthcoming, but demand falls to 30(000) million hours. Unemployment of 15(000) million hours of unskilled labor is created. Total unemployment of 15(000) million hours is comprised of 5(000) million hours that get laid off plus 10(000) million hours of new labor looking for first-time employment. These are the unemployed that were never before hired, but are now looking for employment (see graph).

6.Per Unit Tax and Elastic Demand. Assume that the supply of tickets to an outdoor music festival in Thousand Oaks, California, is a function of price such that:

QS = 1P

(Supply)

where Q is the number of tickets (in thousands) and P is the ticket price. Also assume that the demand for such concert tickets is perfectly elastic at a price of $30. This means that the ticket demand curve can be drawn as a horizontal line that passes through $30 on the Y-axis.

A.

Graph the ticket demand and supply curves using the price of tickets as a function of quantity (Q). On this same graph, draw another ticket supply curve based upon the assumption that a local municipality imposes a $5 tax on each ticket sold to pay for police protection and clean-up costs.

B.

Calculate the ticket price and quantity effects of the municipal tax. With perfectly elastic demand, who pays the economic burden of such a tax?

ANS:

A.

If QS = 1P, then P = $1QS. Given a perfectly elastic demand at a price of $30, demand and supply curves can be drawn as follows:

B.

From the graph, it is clear that the equilibrium ticket price of $30 is maintained both before and after the local tax to pay for police protection and clean-up costs. However, because demand is perfectly elastic, the quantity demanded falls from 30 thousand to 25 thousand units. Price remains the same before and after the imposition of the local tax. Given the drop in output, producers bear the entire burden of paying for the local tax in the form of lost ticket sales opportunities. If ticket demand is less than perfectly elastic, and it surely is in the long run, then it is reasonable to expect both producers (through lost sales opportunities) and customers (through higher prices) to bear the costs of a tax imposed on producers.

7.Percentage Tariff and Elastic Demand. Assume that the supply of imported personal computers (PCs) from China is given by the expression:

QS = 0.03125P

(Supply)

where Q is the number of PCs sold (in thousands) and P is the PC price. Given the availability of PCs on the Internet, assume that the demand for PCs is perfectly elastic at a price of $800. This means that the PC demand curve can be drawn as a horizontal line that passes through $800 on the Y-axis.

A.

Graph the PC demand and supply curves using price as a function of quantity (Q). On this same graph, draw another supply curve based upon the assumption imports form China are subject to an 25% import tariff (tax) that is not imposed on imports from other countries.

B.

Calculate the PC price and quantity effects of the 25% import tariff. With perfectly elastic demand, who pays the economic burden of such a tax?

ANS:

A.

From the supply curve,

QS = 0.03125P

P = $32QS

The effect of the 25% import tariff is to shift the supply curve upward. With the 25% tariff:

P = 1.25($32QS)

= $40QS

B.

From the graph, it is clear that the equilibrium PC price of $800 is maintained both before and after imposition of the import tariff. Because demand is perfectly elastic, the quantity demanded falls from 25 thousand to 20 thousand units. Price remains the same before and after the imposition of the import tax. Given the drop in output, Chinese producers bear the entire burden of paying for the import tariff in the form of lost sales opportunities. If PC demand is less than perfectly elastic, and it surely is in the long run, then it is reasonable to expect both producers (through lost sales opportunities) and customers (through higher prices) to bear the costs of any such tax imposed on producers.

8.Sales Tax and Elastic Demand. Assume that the supply of a best-selling book at local book stores throughout the United States is a function price such that:

QS = -50 + 5P

(Supply)

where Q is the number of books sold (in thousands) and P is the book price. Given the availability of this book on amazon.com for $20, demand is perfectly elastic at a price of $20.

A.

Derive the book supply curve where price is expressed as a function of output. Calculate the equilibrium level of output and local bookstore sales revenue.

B.

Derive a second book supply curve based upon the assumption local sales are subject to an 8% sales tax that is not imposed on Internet sales. Calculate the book price and quantity effects of the local 8% sales tax. With perfectly elastic demand, who pays the economic burden of such a tax?

ANS:

A.

With perfectly elastic demand at a price of $20, the supply curve indicates the equilibrium level of output as:

QS = -50 + 5P

= -50 + 5(20)

= 50(000)

TR = 50($20)

= $1,000(000)

B.

From the supply curve, when price is expressed as a function of output:

QS = -50 + 5P

5P = 50 + QS

P = $10 + $0.2QS

The effect of the sales tax is to shift the supply curve upward. With the 8% sales tax, the new supply curve is:

P = 1.08($10 + $0.2QS)

= $10.8 + $0.216QS

0.216QS = -10.8 + P

QS = -50 + 4.63P

With perfectly elastic demand at a price of $20, this post-tax supply curve indicates the equilibrium level of output as:

QS = -50 + 4.63P

= -50 + 4.63(20)

= 42.6(000)

TR = 42.6($20)

= $852(000)

= $852(000)

It is clear that the equilibrium book price of $20 is maintained both before and after imposition of the sales tax. Because demand is perfectly elastic, the quantity demanded from local bookstores falls from 50 thousand to 42.6 thousand units. Price remains the same before and after the imposition of the sales tax. Given the drop in local sales, local bookstores bear the entire burden of paying for the sales tax in the form of lost sales opportunities. In the long run, demand tends to be somewhat elastic and it is reasonable to expect both producers (through lost sales opportunities) and customers (through higher prices) to bear the costs of any such tax imposed on producers.

9.Recycling Fee and Elastic Demand. Assume that the weekly supply of 16-ounce bottles of soda at convenience stores in the Twin Cities of Minneapolis and St. Paul is a function of price such that:

QS = -20 + 80P

(Supply)

where Q is the number of sodas sold in convenience stores (in thousands) and P is the soda price. Assume demand is perfectly elastic at a price of $1.

A.

Derive the soda supply curve where price is expressed as a function of output. Calculate the equilibrium level of output and convenience store sales revenue.

B.

Derive a second curve based upon the assumption convenience store sales become subject to a 5 cent recycling fee. Calculate the price and quantity effects of the recycling fee. With perfectly elastic demand, who pays the economic burden of such a fee

ANS:

A.

With perfectly elastic demand at a price of $1, the supply curve indicates the equilibrium level of output as:

QS = -20 + 80P

= -20 + 80(1)

= 60(000)

TR = 60($1)

= $60(000)

B.

From the supply curve, when price is expressed as a function of output:

QS = -20 + 80P

80P = 20 + QS

P = $0.25 + $0.0125QS

The effect of the recycling fee is to cause a parallel upward shift the supply curve. With the 5 cent recycling fee, the new supply curve is:

P = $0.25 + $0.0125QS + $0.05

= $0.3 + $0.0125QS

0.0125QS = -0.3 + P

QS = -24 + 80P

With perfectly elastic demand at a price of $1, this post-recycling fee supply curve indicates the equilibrium level of output as:

QS = -24 + 80P

= -24 + 80(1)

= 56(000)

TR = 56($1)

= $56(000)

It is clear that the equilibrium soda price of $1 is maintained both before and after imposition of the recycling fee. Because demand is perfectly elastic, the quantity demanded from local convenience stores falls from 60 thousand to 56 thousand units per week. Price remains the same before and after the imposition of the recycling fee. Given the drop in sales, convenience stores bear the entire burden of paying for the recycling fee in the form of lost sales opportunities. In the long run, demand tends to be somewhat elastic and it is reasonable to expect both producers (through lost sales opportunities) and customers (through higher prices) to bear the costs of any such fee imposed on consumers.

10.Franchise Tax and Inelastic Demand. Assume the supply of broadband services in the City of Williamsburg can be described as:

QS = 1P

(Supply)

where Q is thousands of homes served per month with broadband service, and P is the price per month. Also assume that broadband service demand is perfectly inelastic at a quantity of 30(000). This means that the broadband demand curve can be drawn as a vertical line that passes through 30(000) on the X-axis.

A.

Graph the broadband demand and supply curves using price as a function of the quantity of service demanded (Q). On this same graph, draw another supply curve based upon the assumption that the City of Williamsburg imposes a franchise tax that increases provider costs by $5 per customer every month.

B.

Calculate the price and output effects of the City of Williamsburg franchise tax. With perfectly inelastic elastic demand, who pays the costs of this tax?

ANS:

A.

If QS = 1P, then P = $1QS if price is expressed as a function of quantity. Given a perfectly inelastic demand for broadband at a quantity of 30(000), broadband demand and supply curves can be drawn as follows:

B.

From the graph, it is clear that the equilibrium monthly output level of 30(000) homes served is maintained both before and after imposition of the City of Williamsburg franchise tax. However, because the demand for broadband service is perfectly inelastic, the service price rises from $30 to $35 per month. The number of homes served remains the same but consumer prices rise after the imposition of the City of Williamsburg franchise tax. Given the $5 rise in service prices, consumers bear the whole burden of paying for the City of Williamsburg franchise tax when demand is perfectly inelastic. In the long run, demand tends to be somewhat elastic and it is reasonable to expect both producers (through lost sales opportunities) and customers (through higher prices) to bear the costs of any such tax imposed on producers. Of course, the theoretical case of perfectly inelastic demand is the polar opposite of the perfectly elastic demand curve faced by firms in perfectly competitive markets. Consideration of this polar extreme is a helpful means for understanding the effect of the price elasticity of demand on prices, marginal costs and supply in competitive markets.

11.Franchise Tax and Inelastic Demand. Assume the supply of sewer and water services in the City of Portland can be described as:

QS = -20 + 0.5P

(Supply)

where Q is thousands of homes served per month with sewer and water service, and P is the price per month. Also assume that sewer and water service demand is perfectly inelastic at a quantity of 25(000). This means that the sewer and water demand curve can be drawn as a vertical line that passes through 25(000) on the X-axis.

A.

Graph the sewer and water demand and supply curves using price as a function of the quantity of service demanded (Q). On this same graph, draw another supply curve based upon the assumption that the City of Portland imposes a franchise tax that increases provider costs by $10 per customer every month.

B.

Calculate the price and output effects of the City of Portland franchise tax. With perfectly inelastic demand, who pays the costs of this tax?

ANS:

A.

From the supply curve, before imposition of the franchise tax:

Q S = -20 + 0.5P

0.5P = 20 + QS

P = $40 + $2QS

After imposition of the franchise tax,

P = $40 + $2QS + $10

= $50 + $2QS

Given a perfectly inelastic demand for sewer and water at a quantity of 25(000), sewer and water demand and supply curves can be drawn as follows:

B.

From the graph, it is clear that the equilibrium monthly output level of 25(000) homes served is maintained both before and after imposition of the City of Portland franchise tax. However, because the demand for sewer and water service is perfectly inelastic, the service price rises from $90 to $100 per month. The number of homes served remains the same but consumer prices rise after the imposition of the City of Portland franchise tax. Given the $10 rise in service prices, consumers bear the whole burden of paying for the City of Portland franchise tax when demand is perfectly inelastic. In the long run, demand tends to be somewhat elastic and it is reasonable to expect both producers (through lost sales opportunities) and customers (through higher prices) to bear the costs of any such tax imposed on producers. Of course, the theoretical case of perfectly inelastic demand is the polar opposite of the perfectly elastic demand curve faced by firms in perfectly competitive markets. Consideration of this polar extreme is a helpful means for understanding the effect of the price elasticity of demand on prices, marginal costs and supply in competitive markets.

12.Franchise Tax and Inelastic Demand. Assume the supply of sewer and water services in the City of Greenville, North Carolina, can be described as:

QS = -150 + 2P

(Supply)

where Q is thousands of homes served per month with sewer and water service, and P is the price per month. Also assume that sewer and water service demand is perfectly inelastic at a quantity of 50(000).

A.

Derive the sewer and water service supply curve where price is expressed as a function of output. Calculate the equilibrium level of output and sewer and water utility sales revenue.

B.

Derive a second sewer and water service supply curve based upon the assumption that every month the City of Greenville imposes a $25 per customer franchise tax. Calculate the equilibrium level of output and sewer and water utility sales revenue with the tax. With perfectly inelastic demand, who pays the economic burden of such a tax?

ANS:

A.

With perfectly inelastic demand at a quantity of 50(000), the supply curve indicates the equilibrium price as:

QS = -150 + 2P

2P = 150 + QS

P = $75 + $0.5QS

= $75 + $0.5(50)

= $100

TR = 50($100)

= $5,000(000)

B.

The effect of a $25 per customer franchise fee is to shift the supply curve upward in a parallel fashion. With the franchise fee:

P = $75 + $0.5QS + $25

= $100 + $0.5(50)

= $125 (including the $25 tax)

TR = 50($100)

= $5,000(000)

With perfectly inelastic demand and a quantity of 50(000), water and sewer utility revenues are unaffected by the franchise tax which is wholly passed along to consumers. The price to consumers jumps to $125 per month, but the revenue received by the utility remains fixed at $100 per customer. Because demand is perfectly inelastic, the customer bears all of the economic burden of the tax. In the long run, demand tends to be somewhat elastic and it is reasonable to expect both producers (through lost sales opportunities) and customers (through higher prices) to bear the costs of any such tax imposed on producers. Of course, the theoretical case of perfectly inelastic demand is the polar opposite of the perfectly elastic demand curve faced by firms in perfectly competitive markets. Consideration of this polar extreme is a helpful means for understanding the effect of the price elasticity of demand on prices, marginal costs and supply in competitive markets.

13.Percentage Tax and Inelastic Demand. Assume the supply of cable TV services in the City of San Marcos, Texas, can be described as:

QS = -5 + 0.5P

(Supply)

where Q is thousands of homes served per month with cable TV service, and P is the price per month. Also assume that cable TV service demand is perfectly inelastic at a quantity of 25(000).

A.

Derive the cable TV service supply curve where price is expressed as a function of output. Calculate the equilibrium level of output and cable TV utility sales revenue.

B.

Derive a second cable TV service supply curve based upon the assumption that every month the City of San Marcos imposes a 25% of revenues franchise tax on the local cable TV company. Calculate the equilibrium level of output and cable TV sales revenue with the tax. With perfectly inelastic demand, who pays the economic burden of such a tax?

ANS:

A.

With perfectly inelastic demand at a quantity of 25(000), the supply curve indicates the equilibrium price as:

QS = -5 + 0.5P

0.5P = 5 + QS

P = $10 + $2QS

= $10 + $2(25)

= $60

TR = 25($60)

= $1,500(000)

B.

The effect of a 25% of revenues franchise fee is to shift the supply curve upward. With the franchise fee:

P = 1.25($10 + $2QS)

= $12.5 + $2.5(25)

= $75 (including taxes of $15)

TR = 25($60)

= $1,500(000)

With perfectly inelastic demand and a quantity of 25(000), cable TV company revenues are unaffected by the franchise tax which is wholly passed along to consumers. The price to consumers jumps to $75 per month, but the revenue received by the utility remains fixed at $60 per customer. Because demand is perfectly inelastic, the customer bears all of the economic burden of the tax. In the long run, demand tends to be somewhat elastic and it is reasonable to expect both producers (through lost sales opportunities) and customers (through higher prices) to bear the costs of any such tax imposed on producers. Of course, the theoretical case of perfectly inelastic demand is the polar opposite of the perfectly elastic demand curve faced by firms in perfectly competitive markets. Consideration of this polar extreme is a helpful means for understanding the effect of the price elasticity of demand on prices, marginal costs and supply in competitive markets.

14.Regulation Costs. Kingston Components, Inc., produces electronic components for cable TV systems. Given vigorous import competition, prices are stable at $4,500 per unit in this dynamic and very competitive market. Kingston's annual total cost (TC) and marginal cost (MC) relations are:

TC = $7,000,000 + $500Q + $0.5Q2

MC = TC/Q = $500 + $1Q

where Q is output.

Suppose the Occupational Health and Safety Administration (OSHA) has recently ruled that the company must install expensive new shielding equipment to guard against worker injuries. This will increase the marginal cost of manufacturing by $100 per unit. Kingston's fixed expenses, which include a required return on investment, will be unaffected.

A.

Calculate Kingston's profit-maximizing price/output combination and economic profits before installation of the OSHA-mandated shielding equipment.

B.

Calculate the profit-maximizing price/output combination and economic profits after Kingston has met OSHA guidelines.

C.

Compare your answers to parts A and B. Who pays the economic burden of meeting OSHA guidelines?

ANS:

A.

If prices are stable at $4,500 per unit, Kingston will maximize profits by setting MR = MC = $4,500. Before the OSHA-mandated increase in costs:

MR = MC

$4,500 = $500 + $1Q

Q = 4,000

Economic Profits = PQ - TC

= $4,500(4,000) - [$7,000,000 + $500(4,000) + $0.5(4,0002)]

= $1,000,000

Because economic profits are positive, this competitive market is not in long-run equilibrium.

B.

After the OSHA-mandated increase in costs of $100, Kingston's optimal activity level changes as follows:

MR = MC + $100

$4,500 = $600 + $1Q

Q = 3,900

Economic Profits = PQ - TC

= $4,500(3,900) - [$7,000,000 + $600(3,900) + $0.5(3,9002)]

= $605,000

C.

In this instance, Kingston and its employees pay the entire cost of meeting OSHA guidelines. The number of units sold falls from 4,000 to 3,900 in response to the $100 increase in marginal costs, from $500 to $600. Economic profits fall from $1 million to $605,000 per year, so the owners of Kingston suffer as a result of the OSHA mandate. Employees suffer too, because the drop in production will undoubtably lead to a drop in employment opportunities. Given the elastic nature of the firm' demand curve, prices do not rise at all. Customers bear none of the burden of the OSHA-mandated cost increase.

15.Compulsory Benefit Costs. Columbia Federal Savings & Loan, Inc. offers low-cost home mortgage refinancing services on the Internet. Each refinancing brings the company $250 in fees, and these fees are stable given the competitive nature of Internet marketing. Columbia's relies upon independent contractors (sales associates) who work on a commission-only basis. Weekly total cost (TC) and marginal cost (MC) relations are:

TC = $200,000 + $50Q + $0.05Q2

MC = TC/Q = $50 + $0.1Q

where Q is thousands of refinancing applications processed.

Suppose the US Department of Labor recently ruled that Columbia's sales associates must be considered employees entitled to benefits under the Employee Retirement Income Security Act (ERISA). As a result, Columbia's marginal cost of doing business will rise by $25 per unit. Columbia's fixed expenses, which include a required return on investment, will be unaffected.

A.

Calculate Columbia's profit-maximizing price/output combination and economic profits before meeting DOL guidelines.

B.

Calculate the profit-maximizing price/output combination and economic profits after Columbia has met DOL guidelines.

C.

Compare your answers to parts A and B. Who pays the economic burden of meeting DOL guidelines?

ANS:

A.

If prices are stable at $250 per unit, Columbia will maximize profits by setting MR = MC = $250. Before the DOL-mandated increase in costs:

MR = MC

$250 = $50 + $0.1Q

Q = 2,000

Economic Profits = PQ - TC

= $250(2,000) - [$200,000 + $50(2,000) + $0.05(2,0002)]

= $0

Because economic profits are zero, this competitive market is in long-run equilibrium.

B.

After the DOL-mandated increase in costs of $25, MC = $75 + $0.1Q. Therefore, Columbia's optimal activity level changes as follows:

MR = MC + $25

$250 = $75 + $0.1Q

Q = 1,750

Economic Profits = PQ - TC

= $250(1,750) - [$200,000 + $75(1,750) + $0.05(1,7502)]

= -$46,875

C.

With the DOL-mandated increase in marginal cost, Columbia's business model is broken. Columbia has moved from break-even on an economic basis to a point of suffering economic losses. In the short-run, Columbia and its employees will pay the entire cost of meeting DOL guidelines by cutting back on production, sacrificing revenues, and reducing employee compensation. The long-run prognosis is more dire. Because economic profits have fallen to -$46,875, the company is not able to earn the risk-adjusted normal rate of return necessary for long-run survival. Unless the company and its employees can find more efficient ways of doing business, the company will have to liquidate. Still, given the elastic nature of the firm' demand curve, prices do not rise at all. Customers bear none of the burden of the DOL-mandated cost increase.

16.Compulsory Benefit Costs. The Telemarketing Louisianan Company generates leads for a major credit card company using over-the-phone solicitations. Each lead generated brings TLC $10 in fees, and these fees are stable given the competitive nature of the telemarketing business. TLC's relies upon independent contractors (sales associates) who work on a commission-only basis. Weekly total cost (TC) and marginal cost (MC) relations are:

TC = $50,000 + $0.0005Q2

MC = TC/Q = $0.001Q

where Q is thousands of refinancing applications processed.

Suppose the US Department of Labor recently ruled that TLC's sales associates must be considered employees entitled to benefits under the Employee Retirement Income Security Act (ERISA). As a result, TLC's marginal cost of doing business will rise by $1 per unit. TLC's fixed expenses, which include a required return on investment, will be unaffected.

A.

Calculate TLC's profit-maximizing price/output combination and economic profits before meeting DOL guidelines.

B.

Calculate the profit-maximizing price/output combination and economic profits after TLC has met DOL guidelines.

C.

Compare your answers to parts A and B. Who pays the economic burden of meeting DOL guidelines?

ANS:

A.

If prices are stable at $10 per unit, TLC will maximize profits by setting MR = MC = $10. Before the DOL-mandated increase in costs:

MR = MC

$10 = $0.001Q

Q = 10,000

Economic Profits = PQ - TC

= $10(10,000) - [$50,000 + $0.0005(10,0002)]

= $0

Because economic profits are zero, this competitive market is in long-run equilibrium.

B.

After the DOL-mandated $1 increase in costs, TLC's optimal activity level changes as follows:

MR = MC + $1

$10 = $1 + $0.001Q

Q = 9,000

Economic Profits = PQ - TC

= $10(9,000) - [$50,000 + $1(9,000) + $0.0005(9,0002)]

= -$9,500

C.

With the DOL-mandated increase in marginal cost, TLC's business model is broken. TLC has moved from break-even on an economic basis to a point of suffering economic losses. In the short-run, TLC and its employees will pay the entire cost of meeting DOL guidelines by cutting back on production, sacrificing revenues, and reducing employee compensation. The long-run prognosis is more dire. Because economic profits have fallen to -$9,500, the company is not able to earn the risk-adjusted normal rate of return necessary for long-run survival. Unless the company and its employees can find more efficient ways of doing business, the company will have to liquidate. Still, given the elastic nature of the firm' demand curve, prices do not rise at all. Customers bear none of the burden of the DOL-mandated cost increase.

17.Tariffs. The Manchester Shoe Corporation is an importer and distributor of foreign-made footwear that is sold at popular prices in leading discount retailers. The U.S. Commerce Department recently informed the company that it will be subject to a new 25% tariff on the import cost of rubberized footwear originating from China. The company is concerned that the tariff will slow its sales growth, given the highly competitive nature of the footwear market where wholesale prices are stable at $5 per unit. Relevant total cost (TC) and marginal cost (MC) relations for this product are:

TC = $100,000 + $0.00005Q2

MC = TC/Q = $0.0001Q

A.

Calculate the optimal price/output combination and economic profit prior to imposition of the tariff.

B.

Calculate the optimal price/output combination and economic profit after imposition of the tariff.

C.

Compare your answers to Parts A and B. Who pays the economic burden of the import tariff?

ANS:

A.

The company will maximize profits by setting MR = MC. Prior to imposition of the tariff, marginal cost reflects import costs plus selling expenses only:

MR = MC

$5 = $0.0001Q

Q = 50,000

Economic Profits = PQ - TC

= $5(50,000) - [$100,000 + 0.00005(50,0002)]

= $25,000

B.

After imposition of the tariff, marginal cost reflects import costs, plus selling costs, plus the import fee:

MR = MC + Import fee

5 = 1.25($0.0001Q)

5 = $0.000125Q

Q = 40,000

Economic Profits = PQ - TC

= $5(40,000) - 1.25[$100,000 + $0.00005(40,000)2]

= -$25,000

C.

With the 25% import tariff on imports from China, this product is no longer viable. Manchester has moved from an economic profit on this product line to a point of suffering economic losses. In the short-run, Manchester and its employees will pay the entire cost of the import tariff by cutting back on production, sacrificing revenues, and reducing employee compensation. The long-run prognosis is more dire. Because economic profits have fallen to -$25,000, the company is not able to earn the risk-adjusted normal rate of return necessary from this product. Unless the company and its employees can find more efficient ways of doing business, the company will have to abandon this product line. Still, given the elastic nature of the firm' demand curve, prices do not rise at all. Customers bear none of the burden of the tariff-mandated cost increase.

18.Outsourcing Tariffs. The Seattle Software Company develops, manufactures, licenses, and supports a wide range of software products. Its software products include operating systems for servers, personal computers (PC), and intelligent devices; and server applications for distributed computing environments. To cut costs, the company has begun to outsource to various Asian markets a significant amount of code checking and software verification. The global code checking and software verification service market is fiercely price competitive with prices stable at $25 per hour for services provided by trained and experienced software engineers. Relevant total cost (TC) and marginal cost (MC) relations for a typical foreign supplier of code checking and software verification services (Q) are:

TC = $1,500,000 + $0.00005Q2

MC = TC/Q = $0.0001Q

A.

Calculate the optimal price/output combination and economic profit for a typical foreign supplier prior to imposition of the tariff.

B.

Calculate the optimal price/output combination and economic profit for a typical foreign supplier after imposition of the tariff.

C.

Compare your answers to parts A and B. Who pays the economic burden of the import tariff?

ANS:

A.

The typical supplier of code checking and software verification services will maximize profits by setting MR = MC. Prior to imposition of the tariff, set:

MR = MC

$25 = $0.0001Q

Q = 250,000(000)

Economic Profits = PQ - TC

= $25(250,000) - [$1,500,000 + $0.00005(250,0002)]

= $1,625,000

B.

After imposition of the tariff, marginal cost also reflects the import tariff:

MR = MC + Import fee

25 =1.25($0.0001Q)

25 =$0.000125Q

Q = 200,000

Economic Profits = PQ - TC

= $25(200,000) - 1.25[$1,500,000 + $0.00005(200,0002)]

= $625,000

C.

This competitive industry is in disequilibrium because economic profits are being earned by the typical foreign supplier of code checking and software verification services both before and after imposition of the export fee. The effects of the export duty on code checking and software verification services is to cut economic profits by $1 million per year for a typical firm, and to reduce output by 50,000 units per year. Owners of the company and its employees share the economic burden of paying for the export fee in terms of lost profits and lost employment opportunities, respectively. Given the elastic nature of the firm demand curve, prices do not rise at all. Seattle Software and other large customers bear none of the burden of the tariff-mandated cost increase.

19.Price Floors and Consumer Surplus. The U. S. wheat crop averages about 2 billion bushels per year, and is about 10 percent of the 20 billion-bushel foreign wheat crop. Typically, the market has a relatively good estimate of the wheat crop from the United States and Canada, but wheat crops from the Southern Hemisphere are much harder to predict. Argentina's wheat acreage varies dramatically from one year to another, for example, and Australia has hard-to-predict rainfall in key wheat production areas. To illustrate some of the cost in social welfare from agricultural price supports, assume the following market supply and demand conditions for wheat:

P = $2 + 0.001QS

(Market Supply)

P = $4,80 - $0.0004QD

(Market Demand)

where Q is output in bushels of wheat (in millions), and P is the market price per bushel.

A.

Graph and calculate the equilibrium price/output solution.

B.

Use this graph to help you algebraically determine the loss in consumer surplus due imposition of a $4.40 per bushel price support program. Explain.

ANS:

A.

To find the market equilibrium quantity, set equal the market supply and market demand curves where price is expressed as a function of quantity, and QS = QD:

Supply = Demand

$2 + $0.001Q = $4.8 - $0.0004Q

0.0014Q = 2.8

Q = 2,000 (million)

Therefore, the equilibrium price-output combination is a market price of $4 with an equilibrium output of 2,000 (million) bushels.

B.

Note that with a $4.40 price support, market demand will equal

Q D = 12,000 - 2,500P

= 12,000 - 2,500(4.40)

= 1,000 (million)

With a $4.40 government price support, the value of consumer surplus is equal to the region below the market demand curve yet above the price floor of $4.40. Because the area of a such a triangle is one-half the value of the base times the height, the value of consumer surplus equals:

Consumer SurplusPS = [1,000 ($4.80 - $4.40)]

= $200 (million)

In a free market, the value of consumer surplus is equal to the region above the market supply curve at the market equilibrium price of $4. Because the area of a such a triangle is one-half the value of the base times the height, the value of consumer surplus equals:

Consumer SurplusFM = [2,000 ($4.80 - $4)]

= $800 (million)

Therefore, the loss in consumer surplus caused by the $4.40 government price support program is:

Loss in Consumer Surplus = Consumer SurplusFM - Consumer SurplusPS

= $800 - $200

= $600 (million)

This loss in consumer surplus caused by the $4.40 government price support program is shown in the graph by the region $4$4.40AB.

20.Price Floors and Producer Surplus. The U. S. wheat crop averages about 2 billion bushels per year, and is about 10 percent of the 20 billion-bushel foreign wheat crop. Typically, the market has a relatively good estimate of the wheat crop from the United States and Canada, but wheat crops from the Southern Hemisphere are much harder to predict. Argentina's wheat acreage varies dramatically from one year to another, for example, and Australia has hard-to-predict rainfall in key wheat production areas. To illustrate some of the cost in social welfare from agricultural price supports, assume the following market supply and demand conditions for wheat:

QS = -2,000+ 1,000P

(Market Supply)

QD = 12,000 - 2,500P

(Market Demand)

where Q is output in bushels of wheat (in millions), and P is the market price per bushel.

A.

Graph and calculate the equilibrium price/output solution. Use this graph to help you algebraically determine the amount of surplus production the government will be forced to buy if it imposes a support price of $4.40 per bushel.

B.

Use this graph to help you algebraically determine the gain in producer surplus due to the price support program. Explain.

ANS:

A.

The market supply curve is given by the equation

QS = -2,000 + 1,000P

or, solving for price,

1,000P = 2,000 + QS

P = $2 + $0.001QS

The market demand curve is given by the equation

QD = 12,000 - 2,500P

or, solving for price,

2,500P = 12,000 - QD

P = $4.8 - $0.0004QD

To find the market equilibrium levels for price and quantity, simply set the market supply and market demand curves equal to one another so that QS = QD. To find the market equilibrium price, equate the market demand and market supply curves where quantity is expressed as a function of price:

Supply = Demand

-2,000 + 1,000P = 12,000 - 2,500P

3,500P = 14,000

P = $4

To find the market equilibrium quantity, set equal the market supply and market demand curves where price is expressed as a function of quantity, and QS = QD:

Supply = Demand

$2 + $0.001Q = $4.8 - $0.0004Q

0.0014Q = 2.8

Q = 2,000 (million)

Therefore, the equilibrium price-output combination is a market price of $4 with an equilibrium output of 2,000 (million) bushels. The effects of a government price support can be seen by noting that with a $4.40 market price supply will equal

QS = -2,000 + 1,000P

= -2,000 + 1,000(4.40)

= 2,400 (million)

With a $4.40 price support, market demand will equal

QD = 12,000 - 2,500P

= 12,000 - 2,500(4.40)

= 1,000 (million)

Therefore, with a $4.40 price support, surplus production is

Surplus Production = Q S - QD

= 2,400 - 1,000

= 1,400 (million)

B.

With a $4.40 government price support, the value of producer surplus is equal to the region above the market supply curve at the market price of $4.40. Because the area of a such a triangle is one-half the value of the base times the height, the value of consumer surplus equals:

Producer SurplusPS = [2,400 ($4.40 - $2)]

= $2,880 (million)

In a free market, the value of producer surplus is equal to the region above the market supply curve at the market equilibrium price of $4. Because the area of a such a triangle is one-half the value of the base times the height, the value of consumer surplus equals:

Producer SurplusFM = [2,000 ($4 - $2)]

= $2,000 (million)

Therefore, the gain in producer surplus caused by the $4.40 government price support program is $880 million and is shown in the graph by the region $4$4.40AB.:

Gain in Producer Surplus = Producer SurplusPS - Producer SurplusFM

= $2,880 - $2,000

= $880 (million)

21.Regulation Costs. Finlandia, Inc., manufacturers molded plastic products used to improve industrial productivity. Suppose the Occupation Health and Safety Administration (OSHA) has required the firm to enhance the durability of its popular safety helmet at a cost of $10 per unit. Prior to these costs, Finlandia's annual manufacturing costs of this item are:

TC = $225,000 + $20Q + $0.001Q2

MC = TC/Q = $20 + $0.002Q

where Q is units produced per year and TC includes a normal rate of return on investment.

A.

Calculate Finlandia's profit at the profit-maximizing activity level if prices in the industry are stable at $50 per unit, and therefore P = MR = $50.

B.

Calculate Finlandia's optimal price, output, and profit levels if the OSHA mandated cost increase can be fully passed onto customers.

C.

Determine the effect on output and profit if Finlandia is not able to pass onto consumers any of the projected cost increase, and must instead absorb it.

ANS:

A.

Set MR = MC to find the profit-maximizing activity level:

MR = MC

$50 = $20 + $0.002Q

0.002Q = 30

Q = 15,000

p = TR - TC

= $50(15,000) - $225,000 - $20(15,000) - $0.001(15,0002)

= $0

B.

If the $10 regulation-induced cost increase can be fully passed onto customers, then MR = $60 = $50 + $10. Therefore, the optimal P = MR = $60 and the optimal activity level is unaffected because:

MR + $10 = MC + $10

$60 = $30 + $0.002Q

0.002Q = 30

Q = 15,000

p = TR - TC

= $60(15,000) - $225,000 - $30(15,000) - $0.001(15,0002)

= $0

C.

In the short-run, prices remain at P = MR = $50 while marginal costs rise by $10 per unit and the company will be forced to curtail output and suffer losses:

MR = MC + $10

$50 = $30 + 0.0026Q

0.002Q = 20

Q = 10,000

p = TR - TC

= $50(10,000) - $225,000 - $30(10,000) - $0.001(10,0002)

= -$125,000 (a loss)

Given these annual losses, the company would no longer be earning a normal rate of return on investment, and would eventually be forced out of business.

22.Regulation Costs. Ottawa Construction, Ltd., is a medium-sized housing contractor located in eastern Ontario. The company is adversely affected by new local regulations requiring it to pay $10,000 to cover sewer and water hook-up charges for each new apartment Ottawa builds. Before such expenses, Ottawa's construction costs are described as:

TC = $100,000 + $50,000Q + $2,500Q2

MC = TC/Q = $50,000 + $5,000Q

where Q is the number of apartment units built per year and TC includes a normal rate of return on investment.

A.

Calculate Ottawa's profit at the profit-maximizing activity level if prices in the industry are stable at $100,000 per unit, and therefore P = MR = $100,000.

B.

Calculate Ottawa's optimal price, output, and profit levels if the new regulation-induced cost increase can be fully passed onto customers.

C.

Determine the effect on output and profit if Ottawa is not able to pass onto consumers any of the projected cost increase.

ANS:

A.

Set MR = MC to find the profit-maximizing activity level:

MR = MC

$100,000 = $50,000 + $5,000Q

5,000Q = 50,000

Q = 10

p = TR - TC

= $100,000(10) - $100,000 - $50,000(10) - $2,500(102)

= $150,000

B.

If the $10,000 regulation-induced cost increase can be fully passed onto customers, then MR = $110,000 = $100,000 + $10,000. Therefore, the optimal P = MR = $110,000 and the optimal activity level is unaffected because:

MR + $10,000 = MC + $10,000

$110,000 = $60,000 + $5,000Q

5,000Q = 50,000

Q = 10

p = TR - TC

= $110,000(10) - $100,000 - $60,000(10) - $2,500(102)

= $150,000

C.

If prices remain at P = MR = $100,000 while marginal costs rise by $10,000 per unit, Ottawa will be forced to curtail output:

MR = MC + $10,000

$100,000 = $60,000 + $5,000Q

5,000Q = 40,000

Q = 8

p = TR - TC

= $100,000(8) - $100,000 - $60,000(8) - $2,500(82)

= $60,000

Because Ottawa is still making an excess profit, the company will continue to operate in the long-run.

23.Costs of Regulation. The Appalachian Coal Company sells coal to electric utilities in the southeast. Unfortunately, Appalachian's coal has high particulate content and, therefore, the company is adversely affected by state and local regulations governing smoke and dust emissions at its customer's electricity-generating plants. Appalachian's total cost and marginal cost relations are:

TC = $250,000 + $5Q + $0.0002Q2

MC = TC/Q = $5 + $0.0004Q

where Q is tons of coal produced per month and TC includes a normal rate of return on investment.

A.

Calculate Appalachian's profit at the profit-maximizing activity level if prices in the industry are stable at $25 per ton, and therefore P = MR = $25.

B.

Calculate Appalachian's optimal price, output, and profit levels if a new state regulation results in a $300,000 fixed cost increase that cannot be passed onto customers.

ANS:

A.

Set MR = MC to find the profit-maximizing activity level:

MR = MC

$25 = $5 + $0.0004Q

0.0004Q = 20

Q = 50,000

p = TR - TC

= $25(50,000) - $250,000 - $5(50,000) - $0.0002(50,0002)

= $250,0000

B.

If the $300,000 regulation-induced cost increase cannot be passed onto customers, then MR = $25 as before. Therefore, the optimal P = MR = $25 and the optimal activity level is unaffected because:

MR = MC

$25 = $5 + $0.0004Q

0.0004Q = 20

Q = 50,000

However, profit is affected because:

p = TR - TC

= $25(50,000) - $550,000 - $5(50,000) - $0.0002(50,0002)

= -$50,000 (a loss)

Given these monthly losses, Appalachian would no longer be earning a normal rate of return on investment, and would eventually be forced out of business.

24.Competitive Strategy. Carry Underwood runs Tax Preparation Services, Inc., a small firm that offers timely tax preparation services in Oklahoma City. Given the large number of competitors, the fact that tax preparers rely heavily upon standard tax-preparation software, and the lack of entry barriers, it is reasonable to assume that the tax form preparation market is perfectly competitive and that the average $150 price equals marginal revenue, P = MR = $150. Assume that TPS's annual operating expenses are typical of several such firms operating in the local market, and can be expressed by the following total and marginal cost functions:

TC = $830,000 + $10Q + $0.005Q2

MC = $10 + $0.01Q

where TC is total cost per year, MC is marginal cost, and Q is the number of clients served. Total costs include a normal profit and allow for Underwood's employment opportunity costs.

A.

Calculate TPS's profit-maximizing output level.

B.

Calculate TPS's economic profits at this activity level. Is this activity level sustainable in the long run?

ANS:

A.

The optimal output level can be determined by setting marginal revenue equal to marginal cost and solving for Q:

MR = MC

$150 = $10 + $0.01Q

0.01Q = 140

Q = 14,000 tax forms per year

B.

Because the cost of capital and owner-operator employment opportunity costs are already included in the total cost function, any excess of revenues over total cost represents economic profits. At this output level, maximum economic profits are

p = TR - TC

= $150Q - [$830,000 + $10Q + $0.005Q2]

= $150(14,000) - [$830,000 + $10(14,000) + $0.005(14,0002)]

= $150,000

The Q = 14,000 activity level results in economic profits of $80,000 per year, meaning that TPS is able to provide Underwood with an income level that is above Underwood's employment opportunity costs and also cover the normal or risk-adjusted rate of return on investment. Either the local market is in disequilibrium and Underwood is earning temporary disequilibrium profits, or Underwood is an especially capable tax preparer and is earning economic rents (Ricardian rents).

25.Competitive Strategy. Bob Ice owns and operates Bob's Music Center, Ltd., a small firm that offers music lessons in Huntsville, Alabama. Given the large number of competitors and the lack of entry barriers, it is reasonable to assume that the market for music lessons is perfectly competitive and that the average $60 per hour price equals marginal revenue, P = MR = $60. Assume that Bob's annual operating expenses are typical of several such firms and individuals operating in the local market, and can be expressed by the following total and marginal cost functions:

TC = $100,000 + $10Q + $0.005Q2

MC = $10 + $0.01Q

where TC is total cost per year, MC is marginal cost, and Q is the number lessons given. Total costs include a normal profit and allow for Bob's employment opportunity costs.

A.

Calculate Bob's profit-maximizing output level.

B.

Calculate Bob's economic profits at this activity level. Is this activity level sustainable in the long run?

ANS:

A.

The optimal output level can be determined by setting marginal revenue equal to marginal cost and solving for Q:

MR = MC

$60 = $10 + $0.01Q

0.01Q = 50

Q = 5,000 lessons per year

B.

Because the cost of capital and owner-operator employment opportunity costs are already included in the total cost function, any excess of revenues over total cost represents economic profits. At this output level, maximum economic profits per year are

p = TR - TC

= $60Q - [$100,000 + $10Q + $0.005Q2]

= $60(5,000) - [$100,000 + $10(5,000) + $0.005(5,0002)]

= $25,000

The Q = 5,000 activity level results in economic profits of $25,000, meaning that Bob's is able to provide its owner-manager with an income level that is above employment opportunity costs and also cover the normal or risk-adjusted rate of return on investment. Either the local market is in disequilibrium and Bob's is earning temporary disequilibrium profits, or Bob's is especially capable and earning economic rents (Ricardian rents).