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15
Market Failure and Government Intervention

OVERVIEW
This chapter reviews several reasons for direct government intervention in private markets. In general, government intervention is economically justied when private market fail to provide socially-optimal level of goods and services. Three important sources of market failure are market power, externalities, and public goods. This chapter also focuses on specic government remedies to problems arising from production and allocation inefciencies. Firms, or group of rms, have market power when they are able to charge a price that exceeds marginal cost of production. When rms or groups of rms have market power, they are able to earn economic prots by reducing consumer surplus. Not all of the reduced consumer surplus is captured by rms in the form of higher prots. The loss of consumer surplus not captured by rms is referred to as consumer deadweight loss. Moreover, since the rms exercising market power do not produce at minimum per unit cost there is a producer deadweight loss. This represents the loss to society from the inefcient allocation of productive resources. Total deadweight loss is the sum of the loss of consumer and producer surplus for which there are no offsetting gains to society. The failure of the market to maximize the total benets to society occurs when rms attempt to maximize industry prots by individually or collusively exercising market power. Government can reduce or eliminate total deadweight loss by making it illegal for rms to exercise market power. Antitrust laws attempt to move industries closer to the ideal of perfectlycompetitive prices and output levels.
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Copyright 2003 by Academic Press. All rights of reproduction in any form reserved.

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Market failure also occurs when third parties are positively or negatively affected by a market transaction. These third party effects are called externalities. In the case of negative externalities, too much of a good or service is being produced. In the case of positive externalities, too little of a good or service is being produced. This chapter focused on the problems arising from negative externalities, such as environmental pollution. In the case of negative externalities, there are generally two ways in which the government promotes a more socially benecial outcome. On the one hand, the government can establish conditions whereby the market determines an efcient solution to the externality problem through the assignment of well-dened private property rights. The theoretical justication for this approach to the externality problem is the Coase theorem. In the absence of well-dened property rights, governments can intervene directly to resolve the problems of negative externalities through the use of regulations, permits, and taxes. Governments also intervene in private markets to provide public goods. Public goods are distinguished from private goods by the characteristics of non-excludability and non-depletability. A good or service is nonexcludable if no one can be excluded from its consumption. A good or service is non-depletable if the consumption of a good or service by one person does not reduce the amount of that good or service available for consumption by some other person. Since no one can be excluded from their consumption, individuals will not have an incentive to purchase public goods. Instead, individuals will rely on others to pay for the good. This is the free rider problem. Governments overcome the free-rider problem by providing public goods on behalf of society. Governments will generally nance the provision of public goods by levying taxes. In general, governments do not provide socially efcient amounts of public goods because of an inability to accurately assess societys preferences for these products. An interesting application of the free-rider problem is political rentseeking behavior. Political rent seeking occurs when one group attempts to use government to divert consumer or producer surplus away from another group for its own benet. An example of political rent-seeking behavior is when legislators attempt to regulate monopoly prices at their perfectly competitive level. From the point of view of the consumer, the potential gain in consumer surplus can be viewed as a public good. While the potential increase in consumer surplus for the group is substantial, the gain to any individual consumer may be insignicant. Thus, each individual consumer has an incentive to wait for others to underwrite the lobbying effort. On the other hand, economic prots confer private benets on the monopolist. Thus, it is in the monopolists best interest to incur substantial costs to prevent price regulation.

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Multiple Choice Questions

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MULTIPLE CHOICE QUESTIONS

15.1 Market failure is usually the result of: A. Market power. B. Externalities. C. Public goods. D. Asymmetric information. E. All of the above. Consumer surplus is: A. The difference between the quantities of goods or service purchased and the quantities of goods and services consumed. B. The savings received from purchasing bulk quantities of a good or service. C. The difference between what consumers are willing to pay for a given quantity of a good or service and the amount that they actually pay. D. The difference between consumer expenditures calculated using wholesale versus retail prices for nal goods and services. Producer surplus is: A. The difference between the total revenues and what the rm would have been willing to accept for the production and sale of a given quantity of output. B. The same thing as normal prot. C. The value of the area below the producers marginal cost curve. D. The difference between the total revenues and total economic cost. E. All of the above. Total deadweight loss is: I. The sum of consumer and producer deadweight loss. II. The loss of consumption and production efciency resulting from noncompetitive market structures. III. The loss of consumer and producer surplus when a monopolist charges a price that is greater than the marginal cost of production. Which of the following is correct? A. I only. B. II only. C. III only. D. I and II only. E. I, II and III.

15.2

15.3

15.4

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All of the following are considered to be functions of government except: A. Provide a judicial system and legal framework to adjudicate contract disputes. B. To prevent industry abuse of monopoly power. C. To provide public goods. D. To reduce negative externalities. E. All of the above are considered to be functions of the government. The objective of antitrust legislation is to: A. Encourage the provision of public goods. B. To prevent industry abuse of market power. C. To eliminate the free rider problem. D. Eliminate externalities. E. All of the above. The Sherman Act prohibits all of the following practices except: A. Price discrimination. B. Rebates. C. Collusion. D. Division of markets among competitors. E. All of the above practices are prohibited. A shortcoming of the Sherman Act was: A. That no specic agency designated to enforce its provisions. B. The rule of reason did not specically dene unreasonable conduct. C. It did not clearly dene restraint of trade. D. All of the above are correct. E. None of the above are correct. The Clayton Act: A. Nullied many of the provisions of the Sherman Act. B. Strengthened the Sherman Act. C. Was completely unrelated to the Sherman Act. D. Permitted monopolistic practices by industries engaged in the national defense. E. Authorized the practice of a rm selling a particular good or service on the condition that customers buy other products from the same rm.

15.6

15.7

15.8

15.9

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15.10 Which of the following banned price discrimination? A. The Sherman Act. B. The Clayton Act. C. The Federal Trade Commission Act. D. The Willis-Graham Act. E. The Celler-Kefauver Act. 15.11 The Clayton Act outlawed: A. Price discrimination. B. Exclusive and tying contracts. C. Intercorporate stockholdings. D. Interlocking directorates. E. All of the above. 15.12 Which of the following gave the Federal Trade Commission the authority to prosecute companies that engaged in false and deceptive advertising. A. The Clayton Act. B. The Federal Trade Commission Act. C. The Willis-Graham Act. D. The Wheeler-Lea Act. E. The Celler-Kefauver Act. 15.13 Which of the following exempted telephone company mergers from antitrust review? A. The Clayton Act. B. The Federal Trade Commission Act. C. The Willis-Graham Act. D. The Wheeler-Lea Act. E. The Celler-Kefauver Act. 15.14 Which of the following gave the government the authority to prohibit vertical and conglomerate mergers provided that it can be shown that such mergers substantially reduced competition or tended to result in monopolies. A. The Willis-Graham Act. B. The Robinson-Patman Act. C. The Wheeler-Lea Act. D. The Celler-Kefauver Act. E. The Hart-Scott-Rodino Act.

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15.15 The U.S. government regulates which of the following industries? A. Transportation B. Communications C. Financial services D. Energy E. All of the above industries are regulated by the U.S. government. 15.16 According to U.S. Justice Department guidelines: I. Proposed mergers in any industry with a HerndahlHirschman Index of 1,000 or less will go unchallenged. II. Proposed mergers in any industry with a HerndahlHirschman Index between 1,000 and 1,800 will be challenged if, as a result of the merger, the index rises by more than 50 points. III. Mergers in any industry with a Herndahl-Hirschman Index is greater than 1,800 will be challenged if the index increases by more than 100 points. Which of the following is correct? A. I only. B. II only. C. III only. D. I, II and III. E. Neither I nor II nor III are correct. 15.17 Natural monopolies: A. Have a downward-sloping, long-run average total cost curve over a range of production that will satisfy total market demand for a good or service. B. One rm can provide a good or service more efciently than many competing rms. C. Exhibit signicant economies of scale. D. All of the above statements are true. E. None of the above statements are true. 15.18 In principle, the objective of price regulation is to: A. Provide consumers with essential services at fair prices. B. Eliminate deadweight loss arising from exercise of market power. C. Prevent rms from earning monopoly prots. D. Direct scarce resources to the production of more socially desirable goods and services. E. All of the above are correct.

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Multiple Choice Questions

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15.19 Government efforts to increase social welfare through price regulation may be handicapped due to: A. The rent-seeking behavior of special interest groups. B. The unwillingness of regulators to alienate big business. C. An inability to accurately determine the market supply and demand conditions. D. The tendency of regulators to succumb to popular pressure for unjustiably low prices. E. The existence of negative production externalities. 15.20 Consider Figure 1, which depicts a monopolist. The protmaximizing price and output level are indicated at points: A. D and I. B. C and I. C. C and K. D. B and I. E. None of the above. 15.21 Consider Figure 1, which depicts a prot-maximizing monopolist. Consumer deadweight loss is given by the area: A. ABF. B. ACJ. C. BCGF. D. FGJ. E. CDHJ.

FIGURE 1

15.22 Consider Figure 1, which depicts a prot-maximizing monopolist. Producer deadweight loss is given by the area: A. DEH. B. CEJ. C. BCGF. D. CDHJ. E. GHJ. 15.23 Consider Figure 1, which depicts a prot-maximizing monopolist. The monopolists total prot is given by the area: A. BEHF. B. BDHF. C. BCGF. D. CDHG. E. Cannot be determined from the information provided.

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15.24 Consider Figure 1, which depicts a prot-maximizing monopolist. At what price should the government regulate the monopolists price to eliminate total deadweight loss? A. A. B. B. C. C. D. D. E. E. 15.25 Consider Figure 1, which depicts a prot-maximizing monopolist. If the government were to regulate the price that the monopolist charges, the net gain to society is given by the area: A. AEJ. B. AEHF. C. FHJ. D. BDFH. E. BDHJF. 15.26 In the long run, unregulated, prot-maximizing, natural monopolies will always produce at an output level where: A. P = MC. B. P = ATCminimum. C. MC = MR. D. LRAC = MC. E. Both C and D are correct. 15.27 Which of the following is most likely to generate positive external economies? A. A system of K-12 public education. B. Private universities. C. The state university system of California. D. An interstate highway system. E. All of the above. 15.28 Which of the following is most likely to generate negative external economies? A. Drug trafcking. B. Smoking. C. Dumping industrial wastes into rivers, lakes, and oceans. D. State sponsored gambling, such as lotteries or off-track betting. E. All of the above will probably generate negative external economies.

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15.29 Suppose that in a perfectly-competitive industry, the activities of a single rm result in negative externalities. This would imply that: A. Too little of a good or service is being produced. B. The price of the good or service is too high, and is therefore not in the public interest. C. Too much of a good or service is being produce. D. Third party effects have been taken into account, thus causing the rms marginal production costs to be higher than otherwise. E. Third party effects have not been taken into account, thus causing the selling price of the product to be too low. 15.30 Negative externalities exist because: A. Private property rights to scarce productive resources are not well dened. B. Production invariably results in pollution. C. Bargaining and transaction costs are not zero. D. Third parties own the private property rights to scarce productive resources. E. All of the above. 15.31 Suppose that a chemical plant that produces sodium nitrate is discharging waste into a nearby mountain stream. Downstream from the chemical plant is a perfectly-competitive company that uses water from the mountain stream to produce soft drinks. As a result of the pollution, the water must be puried before use. Which of the following statements is true? A. To compensate for the higher production costs, the downstream company must produce an a greater than socially optimal output level to generate additional revenues to compensate for the higher production costs. B. The chemical plant is producing at a greater than socially optimal level because the water from the mountain stream is free. C. The downstream company will charge a higher price for its soft drinks sufcient to pay for the costs of water purication. D. The chemical plant must charge a higher price for its product to pay for the right to use the water from the mountain stream. E. None of the above are correct.

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15.32 Suppose that a chemical plant that produces sodium nitrate is discharging waste into a nearby mountain stream. Downstream from the chemical plant is a perfectly-competitive company that uses water from the mountain stream to produce soft drinks. As a result of the pollution, the water must be puried before use. According to the Coase theorem, it should be possible to obtain socially optimal levels of sodium nitrate and soft drinks by assigning the private property rights to the mountain stream to: A. The chemical plant. B. Either the chemical plant or the soft-drink company. C. To the soft-drink company. D. Neither the chemical plant or the soft-drink company. E. None of the above are correct. The Coase theorem suggests that government can solve the pollution problem by levying an excise tax on sales of sodium nitrate. 15.33 If the production of a good or service results in a positive externality, then the activity should be: A. Taxed. B. Subsidized. C. Regulated. D. Prosecuted under the terms of the Wheeler-Lea Act. E. Discontinued. 15.34 The presence of external economies results in: A. A misallocation of productive resources. B. Larger consumer surpluses. C. Larger producer surpluses. D. Increased economies of scale. E. Efcient production. 15.35 In general, governments deal with the social costs arising from environmental problems through the use of: A. Price controls, quotas, pollution permits, and taxes. B. Price controls, emission standards, penalty fees, and taxes. C. Emission standards, penalty fees, emission standards, and quotas. D. Emission standards, penalty fees, pollution permits, and taxes. E. Price controls, penalty fees, emission standards, and pollution permits.

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15.36 Penalty fees and taxes to eliminate pollution are preferred to the implementation of emission standards because: A. There are fewer information requirements about the likely social costs. B. There are fewer information requirements about the likely social benets. C. They result in more efcient, market-determined outcomes that. D. All of the above. E. None of the above. 15.37 The optimal level of pollution: A. Is zero. B. Occurs at the output level where the marginal cost of pollution abatement is equal is equal to marginal cost of pollution. C. Occurs when the marginal loss of social benets from production is less than the marginal cost of pollution. D. Occurs when the marginal loss of social benets from production is greater than the marginal cost of pollution. E. None of the above. 15.38 One problem with the use of emission standards and penalty fees to encourage socially optimal levels of production is that A. Regulators rarely have complete information about production methods. B. Regulators tend to set emission standards and penalty fees too high to placate demand from environmental groups. C. Regulators are often former employees of the very companies that they are asked to regulate. D. All of the above. E. None of the above. 15.39 The sale of transferrable emission permits is the distinguishing feature of: A. The Clean Air Act. B. The Environmental Protection Act. C. The Occupational Safety and Health Act. D. The Health and Public Safety Act. E. The Resource Allocation Act.

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15.40 When producers are required to internalize the marginal external cost of pollution, the result is likely to be: A. Higher prices, increased output, and the negative external effects shifted from consumers of the product to society at large. B. Higher prices, increased output, and the negative external effects shifted from producers of the product to consumers of the product. C. Higher prices, decreased output, and the negative external effects shifted from society at large to producers of the product. D. Lower prices, increased output, and the negative external effects shifted from society at large to consumers of the product. E. Lower prices, lower output, and the negative external effects shifted from society at large to producers of the product. 15.41 Public goods differ from private goods because: A. Only public goods are nanced through taxation. B. Only public goods are provided for by the government. C. Public goods have the properties of non-excludability and nondepletability. D. The provision of private goods often suffers from the free rider problem, while the provision of public goods do not. E. All of the above. 15.42 A good or service may be described as a public good if: I. It is provided by the government. II. Consumption by one person does not reduce the amount available for consumption by some other person. III. No one can be excluded from its consumption. Which of the following is correct? A. I only. B. II only. C. III only. D. II and III only. E. I, II and III are correct. 15.43 Examples of public goods include: A. Public street lighting. B. Radio and television broadcasts. C. National defense. D. Police and re protection. E. All of the above.

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Longer Problems

279
SHORTER PROBLEMS

15.1

A monopolists market demand and total cost equations are: Q = 10,000 - 10P TC = 100 + 0.125Q2 A. What is the monopolists prot-maximizing price and output? B. What is the value of consumer deadweight loss? What is the value of producer deadweight loss? Calculate the value of total deadweight loss to society.

15.2

A group of MBA students from the Hobgoblin School of Business have decided to offer a GMAT preparation course to undergraduates. One of the members of the group, who is a management science major, has estimated the following demand equation for the groups services. Q = 150 - 1.5P where Q represents the number of students demanding the course, and P the registration fee. The management science major estimates that the marginal cost of providing the course is $5 per student. The group has decided to charge each student $25 to take the course. A. Calculate the value of consumer, producer, and total surplus. B. Is the price and output level efcient? Explain.

LONGER PROBLEMS
15.1 Suppose that the demand and supply curves for a perfectly competitive market are given by the following linear equations: QD = 1250 - 25P QS = -150 + 15P A. Determine the equilibrium price and output level. B. At the perfectly competitive equilibrium price and output level calculate consumer surplus, producer, and total surplus. C. Suppose that the above industry is organized as a monopoly. Assuming that the industry supply curve represents the monopolists marginal cost of production, determine the protmaximizing price and output level. D. Given your answer to part C, calculate consumer, producer, and total surplus. E. Given your answers to parts B and C, calculate total deadweight loss.

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Market Failure and Government Intervention

Suppose that the demand equation for a rms product is: Q = 640 - 8P The rms cost equation has been estimated as: TC = 85 + 5Q + 0.1875Q2 A. Suppose that the rm is an unregulated monopoly. Determine the prot-maximizing price and output level. What is the rms total prot at this output level? B. Suppose that the government decides to regulate the price of the rms product to maximize social welfare. At what price should the government regulate the rms price? At this price what is the market demand for the rms product? What is the rms prot at this output level? C. In terms of the general social welfare, how does your answer to part A compare with your answer to part B? D. What is the price elasticity of demand for the rms product at the prot-maximizing price and output level calculated in part A? What is the price elasticity of demand for the rms product at the regulated price and output level calculated in part B?

15.3

Universal Telephone & Telegraph (UTT), the sole provider of telecommunications services in the country of Ancient Elam, is being targeted by the federal government for possible price regulation. Researchers at the Ancient Elam Telecommunications Network Agency (AETNA) have estimated the following demand equation for local telephone service: QD = 500 - 2.5P where QD is the demand for local telephone service in millions of minutes and P is the price of telephone service in Ancient Elam dollars (AE$). AETNA researchers have also determined that UTTs total cost equation is TC = 50Q -5Q2 + 0.5Q3

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A. What is UTTs prot-maximizing price and quantity? B. What is UTTs prot at the prot-maximizing price and quantity? C. What price should AETNA regulate the price of telephone service so that UTT earns only a normal prot? D. Given your answer to part C, what is UTTs prot? E. What is the socially optimal price of local telephone service? F. At the socially optimal price of local telephone service, what is UTTs prot? G. Given your answers to parts A, C, and E, should AETNA regulate the price of local telephone service, and at what price? 15.4 The MKUltra Company produces aromatic hydrocarbon that is used in the manufacture of plastics, detergents, pesticides, and other chemicals. This hydrocarbon has been identied as a cancer causing carcinogen. Suppose that the marginal private cost of producing benzene is MPC = 5Q If the manufacture of the hydrocarbon is not properly controlled, the marginal externality cost is MEC = 3Q Finally, suppose that market demand for the hydrocarbon is Q = 70 - 0.5P A. What is the perfectly competitive price and output level? B. If this industry was dominated by a single rm, what would be the prot-maximizing price and output level? C. What is the socially optimal price and output level? D. Given your answer to part C, what per unit tax on output should be levied by the government to achieve a socially desirable output level? E. What are government revenues at the socially optimal output level?

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ANSWERS TO MULTIPLE CHOICE QUESTIONS

15.1 15.2 15.3 15.4 15.5 15.6 15.7 15.8 15.9 15.10 15.11 15.12 15.13 15.14 15.15 15.16 15.17 15.18 15.19 15.20 15.21 15.22 15.23 15.24 15.25 15.26 15.27 15.28 15.29 15.30 15.31 15.32 15.33 15.34 15.35 15.36 15.37 15.38 15.39 15.40 15.40 15.41 E. C. A. E. E. B. A. D. B. B. E. D. C. D. E. A. D. B. C. D. D. E. E. C. C. C. E. E. C. A. B. B. B. A. D. D. B. A. A. C. C. C. 15.42 D. 15.43 E.

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SOLUTIONS TO SHORTER PROBLEMS

15.1 A. P = 100 - 0.125Q TR = PQ = 100Q - 0.125Q2 MR = dTR/dQ = 100 - 0.25Q MC = dTC/dQ = 0.25Q To obtain the monopolists prot-maximizing level of output, equate marginal cost with marginal revenue, i.e., MC = MR Q = 100 - 0.25Q Q* = 80 P* = 100 - 0.25(80) = $80 B. The value of consumer deadweight loss is given by the area of the triangle ABE.

Consumer surplus = Area ABE = 1/2 (80 - 71.43)(285.71 - 80) = $881.47 The value of producer deadweight loss is given by the area of the triangle BCE. Producer surplus = Area BCE = 1/2 (71.43 - 20)(285.71 - 80) = $5,289.83 Total deadweight loss = Area ABE + Area BCE = $881.47 + $5,289.83 = $6,171.30 = Area ACE = 1/2 (80 - 20)(285.71 - 80) = $6,171.30

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Market Failure and Government Intervention

A. The situation depicted is illustrated in the following diagram.

Consumer surplus = 1/2 (100 - 25)(112.5) = $4,218.75 Producer surplus = (25 - 5)(138.75) = $2,250 Total surplus = Consumer surplus + Producer surplus = $4,218.75 + $2,250 = $6,468.75 B. The price and output level is not efcient because it does not maximize the sum of consumer and producer surplus. This will occur where P = MC. By lowering price from $25 to $5, the value of consumer surplus becomes Consumer surplus = 1/2 (100 - 5)(142.5) = $6,768.75 Total surplus = Consumer surplus + Producer surplus = $6,768.75 + $0 = $6,768.75 Thus, when P = $5 total surplus is maximized at $6,768.75.

SOLUTIONS TO LONGER PROBLEMS

15.1 A. QD = QS 1,250 - 25P = -150 + 15P 40P = 1,400 P* = $35 Q* = 1,250 - 25(35) = -150 + 15(35) = 875 These results are illustrated in the following diagram:

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B. Consumer surplus and producer surplus are represented by the shaded areas in the above gure. The value of consumer and producer surpluses are calculated as Consumer Surplus = 1/2 (50 - 35)375 = $2,812.50 Producer Surplus = 1/2 (35 - 10)375 = $4,867.50 Total Surplus = Consumer Surplus + Producer Surplus = $7,500 C. The monopolist maximizes prot by producing at an output level where marginal cost is equal to marginal revenue. The equation for total revenue is TR = PQ. Solving the demand for price, and substituting this result into the above equation for total revenue we obtain TR = (50 - 0.04Q)Q = 50Q - 0.04Q2 The equation for marginal revenue is MR = dTR/dQ = 50 - 0.08Q Equating marginal revenue with marginal cost yields the protmaximizing level of output for the monopolist. 50 - 0.08Q = 10 + 0.067Q Q* = 272.11 The prot-maximizing price is obtained by substituting the prot-maximizing output level into the demand equation. P* = 50 - 0.04(272.11) = $39.12 These results are illustrated in the following diagram:

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D. Consumer surplus and producer surplus under monopoly are represented by the shaded areas in the above gure. The value of consumer and producer surpluses are calculated as Consumer Surplus = 1/2 (50 - 39.12)272.11 = $1,480.29 Producer Surplus = (39.12 - 28.18)272.11 + 1/2 (28.18 - 10)272.11 = $2,976.88 + $2,473.48 = $5,450.36 Total Surplus = Consumer Surplus + Producer Surplus = $6,930.65 E. From the above gure, consumer deadweight loss and producer deadweight loss are calculated as Consumer Deadweight Loss = 1/2 (39.12 - 35)(375 - 272.11) = $211.95 Producer Deadweight Loss = 1/2 (35 - 28.18)(375 - 272.11) = $350.85 Total Deadweight Loss = $211.95 + $350.85 = $562.80 Alternatively, total deadweight loss may be calculated as the difference between total surplus before and after monopolization of the industry. Total Deadweight Loss = $7,500 - $6,930.65 = $569.35 which, except for rounding errors, is the same result as above. 15.2 A. P = 80 - 0.125Q TR = 80Q - 0.125Q2 p = TR - TC = (80Q - 0.125Q2) - (85 + 5Q + 0.1875Q2) = -85 + 75Q - 0.3125Q2 dp/dQ = 75 - 0.625Q = 0, i.e., the rst-order condition for p maximization. d2p/dQ2 = - 0.625 < 0, i.e., the second-order condition for p maximization is satised. Solving the rst-order condition for Q we obtain Q* = 120 units P* = 80 - 0.125(120) = $65 p* = -85 + 75(120) - 0.3125(120)2 = $4,415 B. The upward sloping portion of the marginal cost (MC) curve, above the average variable cost curve (AVC), is the supply curve of a perfectly competitive rm. The government determines the socially optimal, regulated price (Preg) equating marginal cost to demand. MC = dTC/dQ = 5 + 0.375Q

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Setting P = MC yield the market demand for the rms product. 80 - 0.125Q = 5 + 0.375Q 0.5Q = 75 Qreg = 150 Substituting this result into the demand equation yields the socially optimal, regulated price of papaya extract. Preg = 80 - 0.125(150) = 30 - 20 = $61.25 The rms prot at the regulated price is preg = -85 + 75(150) - 0.3125(150)2 = $4,133.75 C. As an unregulated monopoly, consumer, producer, and total surplus are: Consumer Surplus = 1/2 (80 - 65)120 = $900 Producer Surplus = (65 - 50)120 + 1/2 (50 - 5)120 = $1,800 + $2,700 = $4,500 Total Surplus = Consumer Surplus + Producer Surplus = $5,400 As a regulated monopoly, consumer, producer, and total surplus are: Consumer Surplus = 1/2 (80 - 61.25)150 = $1,406.15 Producer Surplus = 1/2 (61.25 - 5)150 = $4,218.75 Total Surplus = Consumer Surplus + Producer Surplus = $5,624.90 Total surplus increases by $224.90 from government regulation. D. The price elasticity of demand for the rmss product at the perfectly competitive price and output level is ep = (dQ/dP)(P/Q) = (-8)(61.25/150) = -3.27, i.e. demand is elastic. The price elasticity of demand at the monopolists protmaximizing price and output level is ep = (dQ/dP)(P/Q) = (-8)(65/120) = -4.33, i.e. demand is somewhat more elastic. 15.3 A. The prot-maximizing condition is given by the expression MR = MC. Solving the demand equation for P yields P = 200 - 0.4Q The respective total and marginal revenue equations are TR = PQ = 200Q - 0.4Q2 MR = dTR/dQ = 200 - 0.8Q The rms marginal cost equation is MC = dTC/dQ = 50 - 5Q + 1.5Q2 Substituting these results into the prot-maximizing condition yields 200 - 0.8Q = 50 - 5Q + 1.5Q2 -150 - 9.2Q + 1.5Q2 = 0

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B.

C.

D.

E.

which can be solved using the quadratic equation Q1,2 = {-b (b2 - 4ac)}/2a where a = 1.5, b = -9.2, and c = -50. The solution values are Q1 = 13.53 Q2 = -7.39 Since output cannot be negative, the prot-maximizing output level is Qm = 13.53 million minutes. Substituting this result into the demand equation yields Pm = 200 -0.4(13.53) = AE$194.59 UTTs total prot is pm = TR - TC = (200Qm - 0.4Qm2) - (50Qm - 5Qm2 + 0.5Qm3) = 150Qm + 4.6Qm2 - 0.5Qm3 = 150(13.53) + 4.6(13.53)2 - 0.5(13.53)3 = 2,029.5 + 842.08 - 1,238.41 = AE$1,633.17 (million) Normal prot is determined at the output level where P = ATC Average total cost is ATC = TC/Q = 50 - 5Q + 0.5Q2 Substituting into the above condition yields 200 - 0.4Q = 50 - 5Q + 0.5Q2 -150 - 4.6Q + 0.5Q2 = 0 The solution values for this expression are Q1 = 22.52 Q2 = -13.32 Since output cannot be negative, the normal prot output level is Q = 22.52 million minutes. Substituting this result into the demand equation yields P = 200 - 0.4(22.52) = AE$190.99 UTTs total prot is p = TR - TC = (200Q - 0.4Q2) - (50Q - 5Q2 + 0.5Q3) = 150Q + 4.6Q2 - 0.5Q3 = 150(22.52) + 4.6(22.52)2 - 0.5(22.52)3 = 3,378 + 2,332.89 - 5,710.51 = AE$0 (million) In other words, at P = AE$190.99, UTT earns zero economic cost. UTT earns a positive normal prot, however, which is included in the rms total economic cost. The socially optimal price is determined at the output level where P = MC. Substituting into this condition yields 200 - 0.4Q = 50 - 10Q + 1.5Q2 -150 - 9.6Q + 1.5Q2 = 0 The solution values for this expression are Q1 = 13.7 Q2 = -7.3

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Since output cannot be negative, the socially optimal level is Q = 13.7 million minutes. Substituting this result into the demand equation yields P = 200 - 0.4(13.7)= AE$194.52 F. UTTs socially optimal prot is p = TR - TC = (200Qo - 0.4Qo2) - (50Qo - 5Qo2 + 0.5Qo3) = 150Qo + 4.6Qo2 - 0.5Qo3 = 150(13.7) + 4.6(13.7)2 - 0.5(13.7)3 = 2,055 + 863.37 - 1,285.68 = AE$1,632.69 (million) G. The above paradoxical results suggest that the price at which UTT earns only normal prots is lower, and output greater, than at the socially optimal price and output level. Clearly, consumer surplus is greater where P = AE$190.99. It could be argued, therefore, that AETNA will probably regulate the price of local telephone service at the price that generates only normal prots for UTT. 15.4 A. A perfectly competitive industry will produce at an output level where marginal private cost equals price, MPC = P. P = 140 - 2Q 5Q = 140 - 2Q Q* = 20 P* = 140 - 2(20) = $100 B. A monopolist maximizes prot by producing at an output level where marginal private cost equals marginal revenue, MPC = MR. TR = PQ = (140 - 2Q)Q = 140Q - 2Q2 MR =dTR/dQ = 140 - 4Q MPC = MR 5Q = 140 - 4Q Q* = 15.56 P* = 140 - 2(15.56) = $108.89 C. The socially optimal level of output occurs at an output level where marginal social cost (MSC) equals price. Marginal social cost is the sum of marginal private cost (MPC) and marginal externality costs (MEC). MSC = MPC + MEC = P 5Q + 3Q = 140 - 2Q Q* = 14 P* = 140 - 2(14) = $112 D. MPC = 5Q = 5(14) = $70 The per unit tax on output is t = P* - MPC = 112 - 70 = $42

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To verify that this tax will result in the socially optimal output level, equate marginal private cost plus the tax to price. MPC + t = P 5Q + 42 = 140 - 2Q Q* = 14 E. Total government revenues at the socially optimal output level is tQ* = 42(14) = $588