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# Answers to Chapter 1 Problems

1. Let \$X be the amount Chris earns in a day on his job. The cost to Chris of going to the park is then
\$15 (admission fee) + \$5 (gas & parking) + \$10 (the lost satisfaction from not working) + \$X (lost
salary) = \$30 + \$X. The benefit of going to the park is \$45. He should go to the park if his salary
is \$10/day, and shouldn't go if his salary is \$20/day. At a salary of \$15/day, he is indifferent
between going and not going.
2. If Tom kept the \$200 and invested it in additional mushrooms, at the end of a year's time he would
have an additional \$400 worth of mushrooms to sell. Dick must therefore give Tom \$200 of
interest in order for Tom not to lose money on the loan.
3. It is reasonable to assume that everybody has decreasing satisfaction from each pound of food as
consumption level increases. In University A, everybody will eat until the benefit from eating an
extra pound of food is equal to \$0, since this is the cost of each pound of food. In University B,
people will eat until the benefit decreases to \$2. Thus, everybody will eat less if they are at
University B. So, not just average consumption but also each individuals personal consumption
will be lower. Note that to reach this conclusion we need the assumption that the students at both
universities have the same appetites.
4. The only costs that vary with mileage are fuel, maintenance, and tires, which average \$0.25/mile.
The cost of driving will thus be \$250, and since this is less than the cost of the bus, you should
drive.
5. The band and hall rental fees are fixed costs. The caterers charge at the rate of \$7/guest (\$5
catering bill/\$2 drink). So an extra 10 guests will increase total costs by only \$70.
6. You gave up the \$60 you wold have earned if the money was in your savings account. This
assumes that your tax rate on interest earned is zero
7. Bill has already bought his ticket, so his cost-benefit calculation when it is time to go is as
follows: benefit of seeing game vs. cost of the drive + time costs, etc. Joe, not having bought his
ticket, faces a different calculation: benefit of seeing game vs. \$30 + cost of the drive + time costs,
etc. Since the benefits are the same in each case, but the costs are larger for Joe at the moment of
decision, he is less likely to go.
8. A plane of either type--large or small--should use the state-of-the-art device if the extra benefits of
that device exceed its extra costs. Because the device will save more lives in large planes than in
small planes, its benefits are larger in large planes than in small ones. Your original
recommendation was presumably based on the calculation that the benefits for the larger planes
justified the extra cost, but did not do so in the case of the smaller planes. Airline passengers are
like other people insofar as their willingness to invest in extra safety is constrained by other
pressing uses for their scarce resources. Where extra safety is relatively cheap, as in large planes,
they will rationally choose to purchase more than when it is relatively more expensive, as in small
planes.
9. With more than a week to go, the \$100 driver's fee and the \$50 bus cancellation fee are sunk costs.
If the trip takes place, the additional costs will be the remaining \$450 of the bus fee plus the \$75 in
tolls, for a total of \$525 in additional costs. If at least 30 tickets will be sold, it makes sense to
continue the trip, since total revenue (\$540) will exceed the additional cost.
10. Assuming that residents are required to recycle cans, they simply cannot put them with the
regular trash. In the first case, the fixed cost of \$6/week is a sunk cost. Therefore, for the residents,
the cost of disposing an extra can is \$0. In the tag system, the cost of disposing an extra can is \$2,
regardless of the number of cans. Therefore, since the costs are higher and the benefit of setting

out a can is assumed to be the same in both cases, you expect less cans to be collected in the tag
system.
11. The benefit of the 1st megabyte is \$200, the 2nd is \$100, the 3rd is \$50, the 4th is \$25, the 5th is
\$12.50, the 6th is \$6.25, the 7th is \$3.125 and the 8th is \$1.5625. You should purchase 7 megabytes.
At higher levels, the benefit is less than the cost. At lower levels, benefit exceeds the cost. To buy
8 megabytes would lower total net benefit.
Price
200.00
100.00
50.00

20.00

10

2.50
1

9 Memory (Mbyte)

12. When the price falls, you consume 8 MB (rather than 7 MB at the higher price.) When your
benefit rises also, you consume 9 MB of RAM.
Problem 1-12
Price
200.00
100.00
50.00

20.00

10

## Marginal Benefit for # 11

2.50
1

9 Memory (Mbyte)

13. False. The fact that she would have chosen the party before she bought her ticket means that she
prefers a party to an event that costs \$40. Now her choice is between two events that she can
attend with no further payment.
14.
Benefit

Ani DiFranco
Bp

Dave Matthews
Br

Cost (initial)
Cost (final)

\$75
\$75

\$75
\$50

## In the problem, we are given that

Bp - \$75 > Br - \$75
or
Bp > Br
(*)
Now, we need to find out whether the following is true or not:
Bp - \$75 > Br - \$50
which is the same as
Bp > Br + \$25
(**)
Notice that (*) does not necessarily imply (**). For example, if B p=\$80 and Br=\$60, then (*)
holds while (**) does not. So we can conclude that you should not go to the Ani DeFranco concert
in the above scenario if you are a rational utility maximizer.
Your decision will depend on the relative values of Bp and Br. The fact that you would have
bought a Ani DeFranco ticket means that the benefit of attending the Ani DeFranco concert,
denoted Bp, must be greater than \$75. Let Bs denote the benefit of going to the Dave Matthews
concert. The fact that you would have chosen the Ani DeFranco concert before receiving your
Dave Matthews concert ticket means that Bp > Bs. But this does not imply that you should go to
the Ani DeFranco concert. Suppose Bp = \$80 and Bs = \$60. When you now choose between the
two concerts, the opportunity cost of attending the Dave Matthews concert is \$50, so the net
benefits of attending each concert are given by Bd - \$75 =\$5 and Bs - 50 = \$10, which means you
should go to the Dave Matthews concert. So FALSE.
15. Safari provides \$10,000+/yr more enjoyment than a business job. \$70,000 = gross benefit of
10,000 opportunity cost of loan
50,000 lost salary as safari leader
10,000+ lost enjoyment from safari job
\$70,000+ total cost of taking of business job > benefit, so don't take the job.
If business salary was \$70,001/yr, he would have taken it.
16. True. If you got \$15,000 for the Taurus and paid that plus \$5,000 more for the Camry, the entire
Camry expense would have cost you \$25,000. Since you have already shown that you did not
want the Camry for \$25,000, why would you spend that for it now?

## Answers to Chapter 2 Problems

1. a) The imposition of the ceiling price on tea causes a reduction in the quantity of tea bought,
from Q1 to Q2 (left panel). The result is a leftward shift in the demand for lemons, resulting
in a reduction in both price and quantity (right panel).
Price

Price
S

S
P1l

P1t
P2t

P2l

D1

D
Q2 t Q1 t

D2
Q2 l Q1 l

Tea

Lemons

1. b) The ceiling price for tea lowers the quantity people are able to buy from Q1t to Q2t.
There is excess demand for tea at the ceiling price P2t, and some of this excess demand spills
over to substitute products such as coffee. The result is that the equilibrium price of coffee
rises. (Note: This result may seem inconsistent with the claim that a fall in the price of a
good's substitute reduces the demand for that good. But this claim refers to a fall in the
equilibrium price of the good, not a price reduction caused by a ceiling. Because of the
quantity reduction caused by the ceiling, tea buyers would be willing to pay P3t for tea. So
the price ceiling actually raises the opportunity cost of additional units of tea.)
Pcoffee

P tea

St

Sc

t
P3
P1t
Pt
2

Pc
2
c
P
1
D
Qt Qt
1
2

Qtea

D
1
Qc Q c
1
2

D2

Qcoffee

12

## CHAPTER 2: Supply and demand

2. a) At prices of 35 and 14, there will be 7 DVDs traded in the market. At P=35, sellers are
dissatisfied. At P=14, buyers are dissatisfied.
2. b) The supply and demand curves, shown in the diagram, intersect at P=28, Q=14
Price
42

35
28
21
14
7
D
Quantity
7

14

21

28

35

42

## 2. c) Total revenue is (28)(14) = 392.

3. a-b) A reduction in the price of hardware would raise demand for software and thus cause
equilibrium price and quantity of software to rise. On the other hand, a rise in the price of
software would reduce demand for hardware and thus cause the equilibrium price and
quantity of hardware to fall.

P(toys)
S
P1
P2
D1
D2
Q2

Q1

Q(toys)

13

P(battery)
S
P1
P2
D1
D2
Q2

Q(battery)

Q1

P(yo-yos)
S
P2
P1

D2
D1
Q1

Q2

Q(yo-yos)

14

P(oil)
S2
S1

P2
P1
D

Q(oil)
Q2

Q1

P(air)
S
P1
P2
D1
D2
Q2

Q(air)

Q1

P(rail)
S
P2
P1

D2
D1
Q1

Q2

Q(rail)

15

P(hotel)
S
P1
P2
D1
D2
Q2

Q(hotel)

Q1

## 5. e) The price goes down, the quantity goes up.

P(milk)
S1
S2

P1
P2
D

Q(milk)
Q1

6.
6.
6.
6.
6.

a)
b)
c)
d)
e)

Q2

In quantity demanded.
In demand.
In demand.
In demand.
In quantity demanded.

7.

a) The equilibrium quantity is Q = 90,000 seats and the equilibrium price is P = 1900
(1/50)(90,000) = 1900 1800 = \$100.

7.

## b) At a price ceiling of P = \$50, quantity demanded is found by solving 50 = 1900 (1/50)Q

for Q = 92,500 seats. Since the stadium only holds Q = 90,000 seats, there will be 92,500
90,000 = 2,500 dissatisfied fans who want to buy a ticket at P = \$50 but cannot find one
available.

7. c) Quantiy demanded for the higher demand is found by solving 50 = 2100 (1/50)Q for
Q = 102,500 seats. Now there will be 102,500 90,000 = 12,500 dissatisfied fans who want
to buy a ticket at P = \$50 but cannot find one available. The excess demand is
12,500 2,500 = 10,000 seats more than for the not so big game.

16

## CHAPTER 2: Supply and demand

7. d) Normally a price ceiling both raises quantity demanded and lowers quantity supplied.
Here, only the first effect is present because the stadium capacity is fixed.
Problem 2-17
S
Price (\$)
350
300
D
D
100
50
0

80

90
92.5
Quantity of seats per game (000)

102.5

105

8. a) Under the original demand curve, quantity demanded was Q = 900 units and quantity
supplied Q = 300 units, so excess demand was 900 300 = 600 units. With the larger
demand, quantity demanded becomes Q = 1100 units, so excess demand becomes
1100 300 = 800 units. Excess demand has grown by 800 600 = 200 units.
8. b) Quantity demanded is Q = 1400 P; quantity supplied is Q = P. Subtracting quantity
supplied form quantity demanded gives excess demand of 1400 2P units. Set excess
demand equal to the original level of 600 and solve 600 = 1400 2P for the required price
floor of P = \$400. If the government accommodates the increase in demand by raising the
rent control form \$300 to \$400, the degree of excess demand will be unchanged.
Price (\$)
600
S

400
300

300 400
Quantity (units/month)

900

1000 1100

1400

9. a) With a price support of P = \$500/ton and the original supply of P = Q, quantity supplied
must be Q = P = 500 tons. Meanwhile, quantity demanded is Q = 100 tons, so excess supply
is 500 100 = 400 tons. With the expanded supply of P = (1/2)Q, quanity supplied grows to
Q = 2P = 1000 tons. Quanity demanded is still Q = 100 tons, so excess supply grows to
1000 100 = 900 tons.

## CHAPTER 2: Supply and demand

17

9. b) The extra 900 400 = 500 tons the govenrment has to buy of excess supply costs the
government \$500/ton, so the added expenditure is 500(500) = \$250,000.
Price (\$)
600
S
500
S

D
0

100

500
Quantity (tons/yr)

1000

10. The supply curve becomes P = 2 + 2Q and the demand remains P = 8 2Q. By setting the
two equations equal to each other and solving for Q we have Q = 1.5. Substituting 1.5 into the
demand equation results in a price of 5.

1. The supply curve after the tax is shown as S' in the diagram. The new equilibrium quantity
will fall to 2. The equilibrium price paid by the buyers is now \$4/oz. The price received by
the sellers is now \$2/oz.
Price (\$/ounce)
6

S'
S

5
4
3
2
1
D
1

Quantity
6 (tons/year)

2. The supply curve tells us that at a quantity of 2 tons/yr, suppliers will be willing to supply
additional titanium at a price of \$2/oz. At that same quantity, buyers are willing to pay

18

## CHAPTER 2: Supply and demand

\$4/oz. Suppose a supplier sells one ounce to a new buyer at a price of \$3. This will make the
supplier better off by \$1. The buyer will also be better off by \$1.

3. With the tax of T = \$2/oz on sellers, the supply curve shifts up by the amount of the tax from
P = Q to P = 2 + Q. The intersection of the tax-ridden supply curve and the new demand
curve is found by solving 8 Q = 2 + Q for Q = 3 tons. Inserting the quantity into the
demand curve yields a price buyers pay of P = 8 3 = 5 an ounce and hence a price sellers
receive of P = 5 2 = 3 an ounce. The government collects revenue of TQ = 2(3) = \$6. Prior
to the increase in demand, the government collected the tax on only 2 ounces, so its total
revenue collected was \$4. Thus, government revenue has grown by 6 4 = \$2 due to the
expansion in demand for titanium. See the graph below
Price of Titanium (\$)
8

5
3
0
3
8
Quantity of Titanium (tons/yr)
4. At a price floor of P = \$4/oz, quantity supplied would be Q = 2 tons. Using demand P = 6
Q and P = \$4/oz, quantity demanded is also Q = 2 tons. Thus, the reduction in supply raises
the equilibrium price to the level of the price floor, so the price floor isn no longer binding.
Price of Titanium (\$)
S
6
S
4
D
0

## Quantity of Titanium (tons/yr)

5. a) The effect of the tax is to shift the supply curve upwards by \$9 as shown in the diagram on
the next page. The quantity sold falls to 11 units.
5. b) The new market price is 31, of which the seller gets to keep only 22.
5. d)The government collects 11(9) = 99.

## CHAPTER 2: Supply and demand

19

5. e)

s'
Price
42

35
28
21
14
7
D
Quantity
7

14

21

28

35

42

6. a-b) The seller's share is the fall in price received by the seller divided by the total tax:
ts = 6/9=2/3. The buyer's share is the increase in price divided by the total tax: tb = 3/9=1/3.
7. In the diagram below, P* and Q* are the original equilibrium price and quantity of Japanese
cars sold in the U. S. If a quota of Q1 is imposed, Japanese car makers will be able to
charge P1 for their cars. To get the same quantity reduction by means of a tax, the after tax
supply curve must intersect the demand curve at Q1 . The result is a price to the U. S. buyer
of P1, the same as in the quota case. The difference in the two policies is that in the quota
case the price increase goes to Japanese car makers, while in the tariff case it goes to the U.
S. government.
S'

Price

P
1
P*
P1-T

D
Quantity
Q1

Q*

20

8.
Price

S(tax)
S

120
90
60
45
30
D

Quantity
15

30

60

Q=30

P=60

## 8. b) After tax supply curve: P = 60 + 2Q

Equilibrium: 120 - 2Q = 60 + 2Q
Q = 15
Price, including tax = 90
Price received by seller (net of tax) = 45.
8. c) Sellers share = 60 45 = 15

Buyers share = 90 60 = 30

9. a-c) With the tax on sellers, supply rises by the amount of the tax to P = 4 + 4Q. the
equilibrium is found by solving 20 = 4 + 4Q for Q = 4 units. Buyers pay P = \$20 and sellers
receive 20 4 = \$16. Sellers pay the full tax because demand is perfectly elastic, which
means that buyers cannot be forced to pay any of the tax.
Supply + tax
Supply
Price (\$) 28
20
16

Quantity (units/wk)

## CHAPTER 2: Supply and demand

21

10. a-c) With the tax on buyers, demand falls by the amount of the tax to P = 24 Q. The
equilibrium is found by solving 20 = 24 Q for Q = 4 units. Sellers receive P= \$20, and
buyers pay 20 + 4 = \$24. Buyers pay the full tax because supply is perfectly elastic, which
means that sellers cannot be forced to pay any of the tax.
Problem A2-10
Price (\$)
28
24

20

S
D

=
0

4
Quantity (units/wk)

## Answers to Chapter 3 Problems

1.
Y(\$/wk)
100
80
60
40
20
Seeds (lbs/wk)
20

40

60

80

100

2.
Y(\$/wk)
100
80
60
40
20
Seeds (lbs/wk)
20

40

60

80

100

3. a) Pecans are equally preferred to macadamias, which are preferred to almonds, which are
preferred to walnuts, so by transitivity it follows that pecans are preferred to walnuts.
3. b) Macadamias are preferred to almonds and cashews are preferred to almonds. Transitivity
tells us nothing here about the preference ranking of macadamias and cashews.
4. True (see diagram on next page). Each price increases by 15%, so that Px/Py is unchanged.

28

Y
M/80
M/92

## Slope = 138/92 =3/2

M/138 M/120

5. a)
Y
150

60

Milk Balls

5. b) The opportunity cost of an additional unit of the composite good is 1/2.5 = 0.4 bags of
milk balls.
6. a)

Y
150

100

60

Milk Balls

6. b) The opportunity cost of a unit of the composite good is now 0.6 bags of milk balls.

## CHAPTER 3: Rational consumer choice

7. a)

29

Y
150

90 Milk Balls
7. b) The opportunity cost of a unit of the composite good is again 0.6 bags of milk balls.
8. a) To get any enjoyment from them, Picabo must consume skis and bindings in exactly the
right proportion. This means that the satisfaction Picabo gets from the bundle consisting of 4
pairs of skis per year and 5 pairs of bindings will be no greater than the satisfaction provided
by the bundle (4, 4). Thus the bundle consisting of 4 pairs of skis per year and 5 pairs of
bindings lies on exactly the same indifference curve as the original bundle. By similar
reasoning, the bundle consisting of 5 pairs of skis per year and 4 pairs of bindings lies on this
indifference curve as well. Proceeding in like fashion, we can trace out the entire
indifference curve passing through the bundle (4, 4), which is denoted as I1 in the diagram.
Skis (pairs/yr) 20
16

I4

12

I3

8
5
4

I2

I1
4

8
5

12

16

20 Bindings (pairs/yr)

30

## CHAPTER 3: Rational consumer choice

b) Skis (pairs/yr)

20
16

I4

12

I3

I2

I1
0

12

16

18

20 Bindings (pairs/yr)

9. Picabo's budget cnstraint is B = 15 - 2S. Initially, she needs the same number of pairs of skis
and bindings S = B. Inserting this consumption equation into her budget constraint yields B =
15 - 2B, or 3B = 15, which solves for B = 5 pairs of bindings (and thus S = 5 pairs of skis).
As an aggressive skier, she needs twice as many skis as bindings S = 2B. Inserting this
consumption equation into her budget constraint yields B = 15 - 4B, or 5B = 15, which
solves for B = 3 pairs of bidings (and thus S = 6 pairs of skis). She consumes more skis and
fewer bindings as an aggressive skier than as a recreational skier. See graph below.
Pairs of Bindings per Year (B)
15
B = 15 2S

B+S
5
B = S/2
3
0

5
6
Pairs of Skis per year (S)

7.5

## CHAPTER 3: Rational consumer choice

31

10. Alexi's budget constraint is T = 75 - (3/4)C. Her perfect substitute preferences yield linear
indifference curves with slope equal to negative one, such as T = 75 - C and T = 100 - C. By
cnsuming 90/0.90 = 100 cups of coffee each month, she reaches a higher indifference curve
than consuming 90/1.20 = 75 cups of tea (or any affordable mixture of coffee and tea). Thus
Alexi buys 100 cups of coffee and no tea. Any increase in the price of coffee would force
Alexi to a lower indifference curve, and thus lower her standard of living.
Cups of Tea/month
(T)
100
T = 100 C
75
T = 75 (3/4)C

100
Cups of Coffee per month (C)

11. In the diagram, suppose we start at bundle A and then take away P units of pears. How
many more units of apples would we have to give Eve to make her just as happy as at A?
The answer is none, because she didn't care about pears in the first place, and therefore
suffered no loss in satisfaction when we took P units of pears away. Bundle B is thus on
the same indifference curve as bundle A, as are all other bundles on the horizontal line
through A. All of Eve's indifference curves are in fact horizontal lines, as shown.
Apples (lbs/wk)

Increasing satisfaction

B A
P

Pears (lbs/wk)

32

## CHAPTER 3: Rational consumer choice

12. Again start at a given bundle, such as A in the left panel of the diagram below. Then take
away a small amount of food, F, and ask what change in smoke, S, would be required to
restore Koop's original satisfaction level. In the standard case, when we take one good away
we need to add more of the other. This time, however, we compensate by taking away some
of the other good. Thus, when we take F units of food away from Koop, we must reduce
the smoke level by S in order to restore his original satisfaction level. This tells us that the
indifference curve through A slopes upward, not downward. Koop would be just as happy
with a smaller meal served in a restaurant with a no-smoking section as he would with a
larger meal served in a restaurant without one.
It is usually possible to translate the consumer's indifference curves into ones with the
conventional downward slope by simply redefining the undesirable good. Thus, if we might
focus not on smoke, an undesirable good, but on cleanliness (the absence of smoke), which is
clearly desirable. So doing would recast the indifference map in the left panel of the diagram
as the much more conventional-looking one in the right panel.

Food (lbs/wk)

Increasing Satisfaction

Food

Increasing Satisfaction

B
A
F

I3
I2
I1

I3
I2

Smoke (micrograms/wk)

I1
Cleanliness

13. You prefer to maximize profit, which is the same under the two rate structures, making you
indifferent between them.
14. a)

M ovies
36
30
24
21
15

B0

B
1
5

10

12 Plays

14. b) If plays cost \$12 and movies cost \$4, the budget line is Bo, which has exactly the same
slope as Paula's indifference curves. She will be indifferent between all the bundles on B 0.

33

## 14. c) On B1, she will consume 10 plays.

15.
Y

Increasing
satisfaction

Y
Increasing
Satisfaction

Garbage

Garbage

16. Let C = coffee (ounces/week) and M = milk (ounces/week). Because of Boris's preferences,
C = 4 M. At the original prices we have:
4M(l) + M(0.5) = 9
4.5M = 9
So M=2 and C=8
Let M' and C' be the new values of milk and coffee. Again, we know that C'=4M'. With the
new prices we have:
(4M')(3.25) + M'(.5) = 9
13M' + 0.5M' = 9, 13.5M' = 9, M' = 2/3
C = 8/3

34

## CHAPTER 3: Rational consumer choice

17. An unrestricted cash grant would correspond to the budget B1 in the diagram. On B1 the
university would want to spend more than 2M on non-secular activities anyway, so the
restriction will have no effect. This result is analogous to the result in the text concerning the
restriction that food stamps not be spent on cigarettes. Provided the recipient would have
spent more on food than he received in stamps, such a restriction has no effect.
Non-secular Activities
14
12
10

B0

B1

8
6
4
2
0

10

18.

## 19 a) 10(0) + 10(0.25) = 2.50

19. b) 10(0.25) + 10(0.50) = 2.50 + 5.00 = 7.50.

12

14

16 Secular Activities

## CHAPTER 3: Rational consumer choice

35

20. Your budget constraint is Y = 360 - 40C for 0 < C < 5 days of car rental (when you pay the
daily rate), constant at Y = 160 for 5 < C < 7 days of car rental (when you switch to the
weekly rate and thus additional days up to one week are free), and then Y = 160 - 40(C - 7) =
440 - 40C for 7 < C < 11 (when again you have to pay by the day for each day beyond the
one week). a) If y = 140C, then inserting this equation into the first leg of the budget
constraint yields 140C = 360 - 40C or 180C = 360, which solves for C = 2 days of car rental
and thus Y = 280 worth of other goods. b) If instead you will trade a day of car rental for
\$35, then you would consume a week's rental C = 7 and thus Y = 160 worth of other goods.
Your seven days of car rental are equivalent to 7(35) = \$245 according to your preferences,
which when added to the \$160 remaining, yields \$405. This beats the \$360 if you consume
no rental days and also beats the 11(35) = \$385 if you consume the maximum rental days you
can afford (as well as beating any other affordable combination of C and Y.
Composite Good
per trip (Y)
360

Problem 20a
Y = 140C
Y = 360 40C

280

Y = 160
160
Y = 440 40C
0

Composite Good
per trip (Y)
360

5
7
11
Days of Car Rental per trip (C)
Problem 20b
Y = 405 35C
Y = 360 40C
Y = 160

160
Y = 440 40C
0

5
7
11
Days of Car Rental per trip (C)

21. With diminishing MRS, to decrease pizza consumption from 3 to 2 slices, the consumer has
to be given more than 1 beer (since that was the amount needed to decrease pizza
consumption from 4 to 3 slices and stay on the same indifference curve). So he would be
indifferent between the bundles (3 slices of pizza, 2 beers) and (2 slices of pizza, X beers)
where X>3. However, we know that he prefers (1 slice of pizza, 3 beers) to (3 slices of pizza,
2 beers), so he should also prefer that bundle to (2 slices of pizza, X beers). But this violates
the more-is-better assumption.

36

## 22. Budget set under Plan A:

composite(\$/week)

12

calls(number/wk)
240
Budget set under Plan B:

composite(\$/week)

12 .
10

calls(number/wk)
30

230

Notice that Plan A is superior to Plan B since its budget constraint is above the budget
constraint of Plan B.

## CHAPTER 3: Rational consumer choice

37

23.
comp osite good

12
11

.
.

10

8
7

.
.

4
3

.
.

.
1

.
10 11 12 13 14 15 16

## Quantity of Soft Drinks

Note that the budget constraint is not a line but rather the set of points that are shown in the
diagram and the ones that are below them. To construct this, for each level of composite
good, from 0 to 12, determine the maximum number of bottles you can buy with the leftover
money. For example, for Y=4, you have \$8 left. The best you can do is 1 large and 1 small,
which gives 11 tickets. Remember that you can't buy a fraction of a set. Notice that point
(0,12) is also on the budget constraint.
24. Assume that the quality of the food is the same in both restaurants, so that price is the only
difference that matters to consumers. In the first restaurant, the \$15 flat tip is a fixed cost: it
does not affect the cost of additional items ordered from the menu. In the second restaurant,
by contrast, the price will be 15 percent higher for each extra item you order. The marginal
cost is higher. The average meal is \$100 in the first restaurant, which with tip comes to \$115.
The same amount of food would cost the same in the second restaurant. But because the cost
of each additional item is higher there, we expect that less food will be consumed in the
second restaurant. Note the similarity of this problem to the pizza experiment described in
Chapter 1.
25. Bo is Plane's budget constraint last year. By selling all his grapes he would have an income of
\$14,000. By spending all his income on grapes he would have 7000 bu. This year's budget
constraint is B1. It starts at 16 on the Y axis and hits the grapes axis at 16/3, passing through
Y = 10, G = 2, last year's bundle. Since last year's indifference curve (ICo) was tangent to B0
at Y = 10, G = 2, and since this year's budget constraint is steeper than last year's, we know
that some part of last year's IC lies within B1. In particular, a part of ICo that lies above Y =
10, G = 2 is within B1. This means that Plane will consume more Y and less G than he did
last year. (See graph on next page.)

38

Y (1000s)
16
14
10

IC0
B1
2

B0
5.33

39

## Answers to Chapter 3 Appendix Problems

1. Solve the budget constraint, 100 = 4X + l0Y, to get Y = 10 0.4X, then substitute into the
utility function to get U = X(10 0.4X ) = 10X 0.4X2. Equating aU/aX to zero we have
10 0.8X = 0, which solves for X = 12.5. Substituting back into the budget constraint and
solving for Y, we get Y = 5.
2. The result of solving the budget constraint for Y and substituting back into the utility
function is now U=X1/2(10 0.4X)1/2.
U / X = (1/2)X-1/2(10 0.4X)1/2 + X1/2(1/2)(10 0.4X)-1/2( 0.4) = 0
Rearranging terms, we get (10 0.4X)/X = 0.4, which solves for X = 12.5. Plugging back
into the budget constraint, we get Y = 5. Thus the optimal bundle is (12.5, 5), the same as in
problem 1.
3. Note that the utility function in Problem 1 is simply the square root of the utility function in
Problem 2. Since the square root function is an increasing function, it follows that the values
of X and Y that maximize utility in Problem 1 will also maximize utility in Problem 2.
4. Since we are given the marginal utility per last dollar spent on each good, the prices, per se,
do not matter. If Sue spent \$1 less on clothing and \$1 more on food, her total utility would
change by 9 +12=3. So, no, she cannot be maximizing utility.
5. For Albert to be a utility maximizer, he must allocate his allowance so that the extra utility
per dollar is the same for both the last CD he purchased and the last movie he rented. As
shown in the table, this condition is satisfied when he purchases 2 CDs and rents 3 movies.
And since this bundle costs exactly his weekly allowance (2x4 + 3x3 = 17), he is maximizing
his utility.
N U(N)
MU(N) MU(N)/PN M U(M)
MU(M)
MU(M)/PM
__________________________________________________________________
0
0
0
0
12
3
21
7
1
12
1
21
8
2
12
4
2
20
2
33
4
1
6
2
3
24
3
39
4
1
3
1
4
28
4
42

## Answers to Chapter 4 Problems

1. Sams budget constraint is 2OJ + AJ = 6 or OJ = 3 (1/2)AJ. Sams indifference curves are
straight lines with constant MRS = 1/3. Sams optimal bundle is to consume no apple juice
and three cups of orange juice. When the price of apple juice doubles, Sam would not need
any additional income to afford his original comsumption bundle, since he does not consume
any apple juice.
Orange Juice in
Cups
3

Bs = B1

B0
ICs
3
6
9
Apple Juice in cups/week
2. Bruces budget constraint is the same as Sams, but his indifference curves have constant
MRS = 1. Thus Bruces optimal bundle is to consume six cups of apple juice per week and
no orange juice. To afford his original consumption bundle, Bruce would need additional
income (PAJ PAJ)AJ = (2 1)6 = \$6/wk. At his new income of \$12/wk and facing the
higher price of apple juice, Bruces budget constraint would become OJ + 2AJ = 12 or
OJ = 6 AJ, which contains Bruces original consumption point of six cups of apple juice
and no orange juice.
0

Orange Juice in
cups/week
6

ICB = BB
3
B1

3
Apple Juice in cups per week

B0

3. Maureens budget constraint is the same as Sam and Bruces but her indiffernece curves are
right angles (L-shaped) at bundles where the cups of orange juice and apple jiuce consumed
are the same. Setting OJ = AJ in her budget constraint gives OJ = AJ = 2 as her optimal
consumption bundle: two cups of orange jiuce and two cups of apple juice per week. To
afford her original consumption bundle, Maureen would need additional income (PAJ
PAJ)A = (2 1)2 = \$2/wk. At her new income of \$8/wk and facing the higher price of apple
juice , Maureens budget constraint would become OJ + 2AJ = 8 or OJ = 4 AJ, which

46

## CHAPTER 4: Individual and market demand

contains Maureens original consumption point of two cups of apple juice and two cups of
orange juice per week.
Orange Juice
in cups/week
4
OJ = AJ
3
2
1
B1
0

B0
BM

2
3
4
Apple Juice in cups/week

4. First solve the demand curve for Q and multiply the result by 10. Then solve back in terms of
P to get P = 101 Q for the market demand. At price \$1/cup the individual consumes 10
cups and the market consumes 100 cups.
Price
101

10.1

101 Cups
-0.5)] = -0.2

5. b)
P

P stays the same, Q increases, and the slope stays the same. Therefore, elasticity
decreases.

## CHAPTER 4: Individual and market demand

47

6. a)

elastic

unit-elastic

inelastic

50

100

6. b) At (1, 50), total revenue is maximized since this is the unit-elastic point. At higher prices,
revenue decreases since it is the elastic region. At lower prices, revenue again decreases
since it is the inelastic region.
7. a) P=\$3, Q=8000, Revenue=\$21,000
7. b) Ep

-1000) = - 3/7

7. c) A price increase will increase revenue since current price is in the inelastic region.
7. d) Since substitution chances are increased, demand for the bridge will become more elastic.
8. We cant know. We are only given that income elasticity of demand for safety (Ei) is
positive. For necessities, we have 0 < Ei< 1, and for luxury goods we have Ei> 1.
9. QA=25-0.5P, QB=50-P, So Q=QA+QB=75 + 1.5P and hence P=50-(2/3)Q.
Price

Price
50

Price
50

DA

25

50

DB

QA

50

QB

75 Q

## 10. Elasticity at A =(PA/QA)( Q/ P)=(400/300)(-20/200)=-40/300=-2/15. Elasticity at

B=(PB/QB)( Q/ P)=(600/280)(-20/200)=-60/280=-3/14.

48

## CHAPTER 4: Individual and market demand

Price
B

600

Change in P = 200
A

400

Change in quantity = 20
280 300

Quantity

11. Price elasticity = -CE/AC =-3/7 (using segment-ratio method). Because demand is inelastic
with respect to price, total revenue will go up with an increase in price.

Price (\$/calculator)
100

A
total revenue = \$2100/mo.
C

30

A
Q (calculators/mo.)
12. Total expenditure = PQ=27Q-Q3, which is shown in the diagram on the next page. It attains
its maximum value, 54, when Q=3.
Total Expenditure
54

Quantity
1

For students who have had calculus, an easier approach is to set d(PQ)/dQ=0:
d(PQ)/dQ=27-3Q2=0,

## CHAPTER 4: Individual and market demand

49

which solves for Q=3. Plugging Q=3 back into the equation for the demand curve, we
have P=27-32=18, and this is the price that maximizes total expenditure.
13. a) 300 = 1800 - 15P, so P = 100, which gives TR = 100(300) = 30000 cents/day.
13. b) Expressing the demand curve in terms of price, we have P = 120 - Q/15. Price elasticity =
(P/Q) (1/slope) = (1/3)(-15) = -5 .
13. c) Since demand is elastic with respect to price, a reduction in price will increase total
revenue.
13. d) Maximum total revenue occurs where price elasticity = -1.
(P/Q)(1/slope) = (P/Q)(-15) = -1, so maximum TR will occur when P = Q/15.
Substituting P = Q/15 back into the demand curve we get Q/15 = 120 - Q/15, or
2Q/15 = 120, which solves for Q = 900. At Q = 900, we have P = 60.
14. In absolute value terms, where price elasticity = Ep
Ep A = Q2A/AP2 = 2
Ep B = Q2B/P2B = 1
Ep C = Q1C/P1C = 1
Ep D = Q1D/P1D = 3
Ep E = Q1E/P2E = 1
So Ep D > Ep A > Ep B = Ep C = Ep E
15. The income elasticity for food is positive but less than 1; for Hawaiian vacations, greater
than 1; for cashews probably greater than 1; and for cheap sneakers, less than 0. These
elasticity values are reflected in the Engel curves shown below.
food in general

cashews

food

vacations

cheap sneakers

## 16. a) Tennis balls and tennis racquets are complements, so negative.

16. b) Negative, same reason.
16. c) Hot dogs and hamburgers are substitutes, so positive.
17. The cross price elasticity of good X with respect to good Y is 4/5 for the point represented
by 2001. This is calculated by taking the location and slope of a function representing the
quantity of X in terms of the price of Y and putting that data into the standard elasticity

50

## CHAPTER 4: Individual and market demand

equation. Accordingly, EpXY = (Py/X)(dQx/dPy) = (Py/X)(1/slope) = 10/400)[1/(1/50)] =
5/4. The graph below illustrates this situation, but it is an unusual graph which can not be
interpreted as a typical demand curve since the price of the vertical axis is not for the product
on the horizontal axis.
Py
12
14

300 400

Quantity of X

18. Wheat and rice are perfect substitutes for Smith, and her indifference curves are shown as the
heavy downward-sloping 45 lines in the diagram. The lighter downward-sloping straight
lines, B1_B4, are the budget constraints that correspond to four arbitrarily chosen prices of
wheat, namely, \$12/lb, \$4/lb, \$2/lb, and \$1.50/lb, respectively. The first two of these prices
exceed the price of rice, so Smith ends up spending all of her food budget on rice. Bundle A
denotes the optimum purchase of wheat when the price of wheat is \$12/lb (budget constraint
B1); and bundles C, D, and F are the corresponding bundles for the remaining prices (budget
constraints B2, B3, and B4, respectively). As noted, the amount of wheat in both A and C is
zero. Once the price of wheat falls below the price of rice, Smith does best to spend all of her
food budget on wheat. When wheat costs \$2/lb, for example, she will buy
(\$24/wk)/(\$2/lb)=12 lbs/wk (bundle D on B3); and at \$1.50/lb, she will buy 16 lbs/wk
(bundle F on B4). The heavy line labeled PCC is Smith's price-consumption curve.

Rice (lbs/wk)
18
16
14
12
PCC

10
8

AC

6
4

B1

B4

B3

B2
0

D
10

12

14

16

18

20

22

Wheat (lbs/wk)
To construct Smith's demand curve for wheat, we can retrieve the price-quantity pairs
from her PCC and plot them in a separate diagram, just as before. But an even easier

## CHAPTER 4: Individual and market demand

51

way is available in this particular case. It is to note that her behavior may be summarized
by the following purchase rule: when the price of wheat, PW, is below the price of rice,
she will buy \$24/PW pounds of wheat, and when PW is above the price of rice, she will
buy no wheat at all. The demand curve that corresponds to this purchase rule is plotted
as the heavy line in the diagram below.
P (\$/lb)
W
Demand curve for wheat

6
5
4
Price of rice =

3
2
1.5
1

Wheat (lbs/wk)

0
4

12

16

20

24

52

19.

Rice (lbs/wk)
12
PCC

10
8
6
4
2
0

24/9
2

24/5

24/3

Wheat (lbs/wk)

24/2

3 4 5

## Price of Wheat (\$/lb)

9
8
7
6
5
4
3
2
D

Wheat (lbs/wk)

0
1

20. a) The new policy represents a decline in the price of cappuccino by less than 20% (the
nominal price, including the \$.50 for the milk, declines by exactly 20% but the implicit cost
of the effort of buying the milk separately must now be added to the nominal price),
accompanied by a quantity increase of 60%. It follows that the absolute value of the price
elasticity of demand for cappuccino is greater than 3. So false.

## CHAPTER 4: Individual and market demand

53

20. b) The policy has the effect of making milk more valuable to those users who supply their
own milk to receive the discount. At a given price of milk, the quantity demanded will rise,
and hence total revenue will rise, no matter what the value of the price elasticity of demand
for milk. So false.

## Answers to Chapter 5 Problems

1.
Other goods (\$/year)
Yr - Pe

Yr - 2Pe
Yp - Pe

Yp - 2Pe

Y*
Quality of Education

(Yr - Pe)/Pe

The rich family has income (Yr), the poor family has income (Yp), where Yr>Yp. The two
families have the same indifference maps. The rich family's budget constraint is the heavy
line, and the poor familys budget constraint in the thinner one. The poor family maximizes
utility by purchasing only public education (i.e., 1 unit of quality), but the rich family buys
Y*>1 units of private education.
2.
Other goods (\$/year)
M + 1000

a
b
1000

M/2

c
(M + 1000)/2
Gas(gallons/year)

Assume the consumer's original income was M. His original budget constraint is a; after the
gas price increase, it is b; and after the money from his uncle it is c. At the very end, he can
afford the original bundle he bought. But his indifference curve at the original optimum is
below his new budget constraint. By decreasing his gas consumption and increasing other
goods consumption, he can reach a higher indifference curve. (see dotted indifference curve)

60

## CHAPTER 5: Applications of rational choice and demand theories

3. The loss in consumer's surplus is 5, the area of the shaded trapezoid in the diagram:

P
4

2
1
Q
4

4.

20

4
Q
8

10

P= \$4/movie, Q=8 movies/year, consumer surplus = \$64. So maximum he will pay for
membership is \$64.
5. Since her demand for caviar is inelastic at all prices, the increase in the price of caviar will
cause her total spending on it to go up. The money left over for hot dogs will decrease. Since
their price stays the same, consumption of hot dogs will decrease.

## CHAPTER 5: Applications of rational choice and demand theories

61

6. The two budget lines and last year's optimal bundle are shown in the diagram. A closer look
at the tangency point for last year's bundle shows that this year Jones can afford a bundle he
prefers to last year's.
Y
42

## Last year's bundle

This year's bundle

34
30

20

70

170 X

## 7. PV = 210 + 210/1.05 = 210 + 200 = 410 .

C2
Budget constraint when r = 0.20

462
430.5

210

C1
210

385

410

62

## CHAPTER 5: Applications of rational choice and demand theories

7. 1-for-1 substitutes means MRTP = 1 (slope of indifference curves = -1). In this case, Smith
will consume all of his resources in the next period.
C

430.5
indifference curve

budget constraint

210

430.5
C

210

410

## 8. From Problem 7, Smith's intertemporal budget constraint is C2 = 430.5 - 1.05C1. Since

Smith views current and future consumption as one-to-one complements, he will consume
equal amounts in both periods C1 = C2. Setting C1 = C2 in his intertemporal budget constraint
C2 = 430.5 - 1.05C1 yields C2 = 430.5 - 1.05C2, which solves for C1 = C2 = 210.
10. a) Facing an interest rate r = 0, Karen's intertemporal budget constraint is C2 = 150,000 - C1.
Her constraint has endpoints (C1 = 150,000, C2 = 0) and (C1 = 0, C2 = 150,000).
Future Consumption
(\$000) 150
C2 = 150000 C1

75

75
Current Consumption (\$000)

150

63

## 9. b) Facing an interest rate r = 0.1, Karen's new intertemporal budget constraint is

C2 = 157,500 - 1.1C1. Her new constraint has endpoints (C1 = 143,182, C2 = 0) and (C1 = 0,
C2 = 157,500).
Future Consumption
(\$000) 157.5
C2 = 157,500 1.1C1
75

75
Current Consumption (\$000)

143.2

## 11. a) \$50,000/1.08 = \$46,296;

10. b) \$50,000/1.1 = \$45,455;
11. c) \$50,000/1.12 = \$44,643.
12. a) The highest attainable indifference curve passes through the bundle (100, 100).
C2
budget constraint

200
190

optimal bundle
100
indifference curve for 1-to-1
substitutes

100

200

C1

64

## CHAPTER 5: Applications of rational choice and demand theories

12. b) Now the optimal bundle is to consume everything in the future. The bold line is the budget
line and the normal line is the indifference curve with an .8 MRTP.
C2
Optimal bundle
190

100

100

237.5

## 13. Kathy's intertemporal budget constraint is C2 = (1 + r)55,000 + 60,000 - (1 + r)C1. Her

maximum current consumption would occur by setting C2 = 0 and solving for C1 = 55,000 +
60,000/(1 + r). To achieve C1 = 105,000, then 55,000 + 60,000/(1 + r) = 105,000 implies
60,000/(1 + r) = 50,000, which solves for r = 0.2 (20% interest). Similarly, her maximum
future consumption would occur by setting C1 = 0 and solving for C2 = (1 + r)55,000 +
60,000. If C2 = 1200,500, then (1 + r)55,000 + 60,000 = 120,500, and so (1 + r)55,000 =
60,000, which solves for r = 0.1 (10% interest).
14. True

100

100

The enlarged picture would look like the one above. The original intertemporal budget
constraint is A (with slope -1.1), and the new constraint is B (with slope -1.2). The original
decision was point a. The new budget constraint also passes through a. But she can do much
better by choosing point b. The increase in interest rate causes her to save today and consume
more next period.

## CHAPTER 5: Applications of rational choice and demand theories

65

15. Because Joe's initial bundle (A in the diagram) was given to him, as opposed to having been
chosen by him, there is no presumption that it was optimal for the initial prices. Indeed, it
may be that the initial bundle turns out to be optimal for the new budget constraint, as shown,
in which case Joe is not better off as a result of the price change. So false.
Price
100
75
50

3 Quantity

16. The original budget constraint and the post-change budget constraint are shown as B1 and
B2, respectively. Harry curtails his mileage from M1 to M2. The heavy line is the extra
revenue Tom and Karen collect from the higher mileage charge, which is less than \$10/wk.
Y
Y0 + 10
Y0

## Extra revenue from 40 cent fee < \$10

Y2

C
A

Y1
B1

B2
M1 M2
Y0/.2
(Y0 + 10/.4)

B
miles/wk

17. a) Let R be the buyer's reservation price for the right to use the book for one year. Let U be
the price of a used book. Then the reservation price for a new book is R + U/(1+r) = R + \$20
= \$50 => R=30.
Reservation price for book with disappearing ink = R= 30
18. b) Profits with normal ink: (N/2)(R+20-m) = 25N -mN/2 = A
Profits with disappearing ink: N(R-m) = 30N - mN = B
B - A = N(5 - m/2) > 0 if and only if m < 10.

66

## CHAPTER 5: Applications of rational choice and demand theories

18. The opportunity cost of Herb's time is the \$6/hr he can earn in the library. His optimal 2-part
tariff for tutoring is thus a \$6/hr fee plus a fixed fee given by the 8 units of consumer surplus
each tutee would receive if there were no fixed fee. Thus his tutoring fee is \$8 + \$6/hr.
Confronted by this fee schedule, each graduate student will want to purchase 4 hr/wk of
tutoring. This gives Herb his desired 12 hr/wk, with total earnings of \$96/wk. He should not
spend any time clerking in the library.
Price
10
area = 8
6

10 Quantity

19. If P0 is the tuition of other universities and Cornell provides a subsidy of kP0, CFCs will
have to pay only (1-k)P0 after the subsidy. The quantity (in 1000s) of CFCs attending other
universities in the absence of any subsidy is Q0 = 2-(P0/5). With the subsidy, this quantity
goes up to Q' = 2-((1-k)P0/5). The extra revenue Cornell will get (in \$1000s) by being to sell
the extra slots is
DTR = 15(Q'-Q0) = 15(kP0/5)= 3kP0.
Each subsidized CFC costs Cornell kP0. Since there are Q' students subsidized, the total
subsidy cost is equal to
S = kP0Q' = kP0 [2-((1-k)P0/5)] = 2kP0 -kP02/5 + k2P02/5 .
Cornell's goal is chose the value of k that maximizes
D = DTR - S = kP0 + kP02/5 - k2P02/5 .
The first order condition is
dD/dk = P0 +P02/5 -2kP02/5 = 0,
which solves for k* = (5+P0)/2P0 .
Thus, if tuition at other universities (in \$1000s) is P0 = 8, we have k* = 13/16.
Tuition in other universities (1000)
10

P0
(1-k) P0

2-P0/5 2-(1-k)P0/5

Q0 (1000)

## CHAPTER 5: Applications of rational choice and demand theories

67

20. For P0=4, we have k*= 9/8 (see problem 10), which means that Cornell should pay not only
100% of the outside tuition, but also give a cash bonus of \$500 to each CFC who attends an
outside university.
21. His optimal strategy is to sell popcorn at marginal cost and then add the consumer surplus
from popcorn to the consumer's reservation price for the movie ticket. Thus, the price of
popcorn should be \$1/qt, which yields a consumer surplus of \$4.50 from popcorn. The ticket
price should be \$5 + \$4.50 = \$9.50.

PC
4

CS = \$4.50

4 QC

## Answers to Chapter 6 Problems

1. If the general threshold for denying admission is 80, and if those who deny admission are
uniformly distributed between 80 and 100, then our best estimate of the messiness index of
someone who denies admission will be 90. The threshold will not be stable. Someone whose
messiness index is between 80 and 90 has good reason to let people in rather than be
assumed to have an index of 90. A threshold of 90 should be unstable for similar reasons, as
indeed will any disclosure threshold less than 100. In practice, the fact that some people do
refuse to let others see their messy apartments seems to indicate that actually seeing the mess
firsthand will be more damaging than having people conclude in the abstract that the
apartment is messy.
2. One salient fact about teenage males is that they have much higher automobile accident rates
than other groups. A company that charged the same rates to teenage males as it changes to
all other groups would therefore have to have higher premiums than those other companies
charge members of all other groups. There would then be no reason for these other group
members to remain with the company. In the end, the company with uniform rates for all
groups would have to charge a premium high enough to cover the expected losses of
members in the highest risk group.
3. If all consumers value nondefective cars at \$6000 and used cars sell for only \$1000, then no
nondefective cars will be offered for sale in the used market. The only used cars for sale will
be defective, so we know that the value consumers place on a defective car must be exactly
1000. Since consumers are risk neutral, the expected value of a new car, En, is simply the
sum of the expected values of nondefective and defective cars:
En = (1-d)(6000) + d(1000) = 4000, which solves for d = 0.4.
4. The expected value of a new motorcycle, En, is equal to En =9000 = (1-d) 1000 + d X,
where X is the price of a nondefective one and d is the proportion of defective motorcycles.
Therefore, 9000=0.8X + 0.2(1000), which solves for X=\$11,000.
5. You know your car is not a lemon; but if you try to sell it, the market will assume it is, and
you will be unable to get full value for it. This makes it more worth your while to fix the car.
6. Because social workers receive very low salaries relative to the amount of education they
have, it is a reasonably safe inference that most of them chose that line of work for reasons
other than money. And if the primary motive for cheating at cards is monetary gain, it
follows that a social worker is not very likely to cheat. In the case of the used car
salesperson, by contrast, there is no similar presumption of nondefective motivation.
Moreover, there is at least some indication that the capacity to dissemble is linked to success
in selling.
7. The college degree is a signal to the employer about the smartness of an employee.
Assume that the smartness of an employee is distributed between 0 and S. The only costs to
education are monetary costs and the difficulty of passing courses, which is lower for
smarter students. Thus, for any two people with the same wealth, the smarter one is likely to
have more education. At the beginning of the century, lets say that the average high-school
Since the monetary costs of education went down, more people are getting education,

76

## CHAPTER 6: Information and choice under uncertainty

especially the ones who were smart but could not afford it before. Also, smarter high school
graduates will now be getting college degrees. Assume the average smartness level of a high
school graduate now is Nh and of a college graduate is Nc. Then Nh<Sh and Nc<Sc. Of
these four quantities, Sc is the highest and Nh is the lowest, but we do not exactly know the
relationship between Sh and Nc. If Nc<Sh, then banks might raise their education criterion.

## 8. The expected value of one toss of a six-sided die is

EV = (1/6)(1+2+3+4+5+6)=21/6=3.5 .
9. The expected value of the gamble is given by
EV = (1/4)(20) + (1/4)(9) + (1/4)(-7) + (1/4)(-16) = +1.5 .
10. EU = (1/4) 36 + (1/4) 25 + (1/4) 9 + (1/4) 0 = 6/4 + 5/4 + 3/4 = 3.5.
Your utility without the gamble is 16 = 4.0; so you will not accept the gamble.
11. a) 40% with probability 0.3
-100% with probability 0.2
10% with probability 0.5
E(interest rate)= 0.3(0.4) + 0.2(-1) + 0.5(0.1) = -0.03 = -3%
11. b) EU(govt. bond) = (1.08x10,000)2 = 116, 640,000
EU(junk bond) = 0.3(1.4x10,000)2 + 0.2(0)2 + 0.5(1.1x10,000)2 = 119,300,000
Since EU(junk bond) > EU (govt. bond), you will invest in the junk bond.
11. c) EU(govt. bond) = (1. 08 x10, 000) = 103.92
EU(junk bond) = 0.3 (1. 4 x10, 000) + 0.2 0 + 0.5 (1.1x10, 000) = 87.94 .
Since EU(junk bond) < EU (govt. bond), you will invest in the govt. bond.
12. EU(with ticket) = 0.25(110)2 + 0.75 (100)2 = 10,525.
The wealth level to give the same utility for sure is w = 10525 = 102.59.
Thus you would be willing to sell the ticket for 2.59.
13. EU (without insurance) = 0.99999 400, 000 = 632.449 .
The wealth level to give the same utility is w = (632.449)2 = 399,992 .
So you would be willing to pay \$8 for this insurance.
14. With one trip, EU1 = (1/2) 100 + (1/2) 0 = 5
With two trips, there are four equally likely outcomes:

1.
2.

First Trip
0 break
500 break

Second Trip
0 break
0 break

Income
100
50

Probability
1/4
1/4

## CHAPTER 6: Information and choice under uncertainty

3.
4.

0 break
500 break

77

500 break
500 break

50
0

1/4
1/4

EU2 = (1/4) 100 + (1/4) 50 + (1/4) 50 + (1/4) 0 = 2.5 + 1.77 + 1.77 = 6.04 So it is
better to take two trips than one, even though the expected number of eggs broken is the
same either way. Moral: Don't put all your eggs in one basket!
15. a) EV = (1/2)15 - (1/2)13 = 1.0
15. b) EU = (1/2) 64 + (1/2) 36 = 4 + 3 = 7
15. c) EV = 0
EU = (1/2) 64 + (1/2) 34 = 4 + 5.83/2 = 6.91
Without gamble U = 7 .
15. d) Let x = the most you would pay to get out of the gamble. Then
49-x = 47.75
x = 1.25

( 49 x ) = 6.91

16. a) EU = ( 144 )/2 + ( 81 )/2 = 10.5 < 111 = 10.536, so Smith will not make the
investment.
16. b) With 2 equal partners, EU = [ (111 11) ] /2 + ( 101) /2 = 10.55 >
so Smith will make the investment.

111,

17. Expected utility without info = max[ 81 , (.2 900 + .8 25 )] = max (9, 10) = 10.
So without info, he will choose to become a lawyer.
Suppose info costs P;

Pay P
Interview
"You'll become a partner."
prob = 0.2
Choose law
earn 900

prob = 0.8

Choose teaching
earn 81

## Expected utility with info = 0.2 (900 P) + 0.8 (81 P)

Set EU with info = EU without info = 10 and solve for P:
P = 53.68. For any price less than this amount, he should pay Smith for his evaluation.
18. Assume that Smith has the policy that he will charge only if he tells the person he will
become a lawyer, and also assume that he never lies since he wants to make a reputation to
stay in this business. Thus, he charges \$p with probability 0.2 and charges \$0 with
probability 0.8. The maximum amount John will be willing to pay for this deal will be given
by,

78

## EU(with info) = EU(without info)

0.2 (900 p) + 0.8 81 = 10 which solves for p = \$704. So Smith would do much better
if he employs this policy!
19. a) For group 1, the reservation price of insurance is found by solving
(100 x1 ) = .5 100 + .5 64 = 9, which yields x1 = 19.
For group 2, we get

## (100 x2 ) = .9 100 + .1 64 = 9.8, which yields x2 = 3.96.

19. b) If members of the two groups are indistinguishable, an insurance company will have to
charge the same premium to each. If its policyholders consisted of equal numbers of people
from each group, this premium would have to cover the expected loss, which is
[(.5)(36)+(.1)(36)]/2=10.8. Since this exceeds the reservation price of members of group 2,
nobody from that group would buy insurance. And with only group 1 members remaining in
the insured pool, the premium would have to rise to 18 in order to cover the expected loss for
members of that group.
19. c) If a company has the test described, and the test says a person is a member of group 2, then
the expected benefit payout from insuring that person is
x(.1)(36) + (1-x)(.5)(36) = 18 - 14.4x = E(L). Setting E(L) equal to the reservation price for
group 2 we get 18 - 14.4x = 3.96, or x = .975. The test would have to be accurate 97.5% of
the time in order for a member of group 2 to find insurance an acceptable buy.
20. a) Let X1 denote the reservation price for members of group 1. X1 must satisfy the equation
(144 X1 ) = .5 100 + .5 144 = 11, which solves for X1 = 23. The reservation price for
group 2 must satisfy

## (144 X2 ) = .1 100 + .9 144 = 11.8, which solves for X2=4.76.

20. b) The most an insurance company can charge and still include group 2 members is
X2=4.76. Let p be the proportion of group 1 members in the potential client pool. If the
price is low enough to attract group 2 members, it will necessarily also attract members of
group 1. The expected benefit payouts for members of the two groups, denoted B1 and B2,
are given by B1=.5(44)=22 and B2=.1(44)=4.4. The expected benefit payment per client, B,
is thus a weighted average of these expected payouts, where the weights are the respective
population shares in the client pool: B=p(22) + (1-p)(4.4)= 4.4 + 17.6p. Equating this
expected benefit payment to the reservation price X2, we have 4.4 + 17.6p = 4.76, which
solves for p = .36/17.6 = .02. Thus, if more than 2% of the potential client pool consists of
members of group 1, it will be impossible to include members of group 2.
21. Let m be Smith's initial wealth, and u be his utility function.
Picking A over B => uA = u(m+100) > EuB = .8u(m+150) + .2u(m)
Picking D over C => EuD = .4u(m+150) + .6u(m) > EuC = .5u(m+100) + .5u(m)
Rearranging terms of the last inequality, we have .5u(m+100) < .4u(m+150) + .1u(m).
Dividing both sides by .5 gives u(m+100) < .8u(m+150) + .2u(m), which is the reverse order
of the inequality implied by the choice of A over B, hence
the inconsistency.

79

## Answers to Chapter 6 Appendix Problems

1. If the current wage offer is w, the probability of getting a better offer on the next draw is
(8-w)/3. If you do get a better offer, its expected value is (8+w)/2, which is (8-w)/2 better
than the current offer. So the expected gain from sampling another offer is [(8-w)/3][(8w)/2] = (8-w)2/6. Setting this equal to the cost of sampling another offer we have (8-w)2/6
= .06, which solves for W* = 7.4. So the rule should be to keep searching until you get an
offer at least as high as 7.4.
2. The expected value of the largest of 100 estimates is (100/101)(C). If you win the auction,
your estimate will be the largest of the 100. If its value is 50, your best estimate of C will be
C* = (101/100) 50 = 101/2. Since the expected value of the money is C/2, you should bid
C*/2 = 101/4.
3. If your company bids P and X is greater than P, then Bumbler will refuse the offer and the
deal is off. Your company earns zero profit in that case. If Bumbler accepts your company's
offer, then we know that X<P. Since X is uniformly distributed between 0 and 100, the
expected value of X, given that X<P, is P/2. This means that the expected value of
Bumbler's oil field to your company is P/2 + 40.
a) If your company bids P and Bumbler accepts, then the expected profit of your company
will be P/2 + 40 - P = 40 - P/2. Equating this expression to zero, we see that the most your
company can bid without expecting to make a loss is 80.
b) The probability your company acquires Bumbler at a bid of P is equal to the probability
that X is less than P, which is P/100. If your company fails to acquire Bumbler (i.e., if X >
P), then your company's profits from transaction will be zero.
Expected profit from a bid of P is thus given by
E ( ) = (P/100) (40 - P/2) + (1 - P/100) (0) = 40P/100 - P2/200.
The first-order condition for maximum expected profit is given by
dE ( ) /dP = 40/100 - P/100 = 0, which solves for P* = 40.
4. Assume the offer you have is w. The probability of getting a better offer is (150-w)/75. The
expected value of the offer will be (150+w)/2, which is (150-w)/2 bigger than the current
offer. The expected gain is EG = (150-w)/75 x (150-w)/2 = (150-w)2/150. At the optimum,
EG = cost of a search = 2 , which solves for w = 150 - 300 =132.68.
5. Assume the current date you have has an index v. The probability of getting a better date is
(100-v)/100. The expected index of the new date, if better, will be (100+v)/2, which is
(100-v)/2 bigger than the current date. The expected gain is
EG = (100-v)/100 x (100-v)/2 = (100-v)2/200.
Thus, the expected gain in terms of dollars will be EG(\$) = EG x 50 = (100-v)2/4.
At the optimum, EG(\$) = cost of a search = 100, which solves for v = 100 - 400 = 80.
6. The expected value of the largest of 20 estimates is (20/21)C. If yours is the largest, your
best estimate of C is C = 200 x (21/20) = \$210. Since the expected value is C/2, you should
bid \$105.

## Answers to Chapter 7 Problems

1. Let rf denote the share of friendlies in the population, so that 1-rf denotes the share of
aggressives. Since the two types interact at random with other members of the population,
the expected payoff for friendlies is given by E(X|F) = 3rf + 1(1-rf) = 1 + 2rf. The
corresponding expected payoff for aggressives is E(X|A) = 5rf + 0(1-rf) = 5rf. The
population mix is in equilibrium when the expected payoffs of the two types are the same.
If rf* denotes the equilibrium share of friendlies, we have 1 + 2rf* = 5rf* , which solves for
rf* = 1/3. The equilibrium share of aggressives is 1-rf* = 2/3.
2. a) First we must see whether it pays the Cs to buy the goggles. If it is in the interest of any
one of them to do so, it will be in the interest of all. If all Cs have goggles, they can identify
one another and interact selectively, leaving the Ds to interact with one another. In this case,
the payoff to each C will be 6-1=5. If the Cs do not buy goggles, they will interact at random
with other members of the population. If rc denotes the share of Cs in the population, their
expected payoff when they don't buy goggles is given by E(X|C, don't buy) = rc 6 + (1-rc) 0
= 6rc. Equating the expected payoff of the Cs when they buy goggles to their expected payoff
when they do not, we get the break-even level of rc: rc' = 5/6 . For rc < 5/6, the Cs have a
higher expected payoff if they buy the goggles. For rc > 5/6, they have a higher expected
payoff if they simply take their chances. For rc < 5/6, the Cs will have goggles, which means
that the Ds will be forced to interact with one another, which gives the Ds a payoff of 4.
Once rc > 5/6, however, the Cs stop buying goggles, and the expected payoff for the Ds
becomes E(X|D, Cs don't buy) = rc 8 + (1-rc) 4 = 4 + 4 rc. Thus the average payoff for Cs
is greater than for Ds whenever rc< 5/6, while the expected payoff for Ds exceeds that of Cs
whenever rc > 5/6, as shown in the diagram.

Average Payoff
for Defectors

8
44/6

Average Payoff
for Cooperators

6
5
4
3
2

5/6

1.0

Share of
Cooperators (r c )

The result is that if we start with rc > 5/6, the population share of Cs will shrink to 5/6,
because the growth rate of Ds will be faster than that of Cs. If we start with r c < 5/6, the
population share of Cs will grow to 5/6.
2. b) If Ds each received 5.5 when they were paired together they will receive a higher payoff
than the Cs at all population proportions so the Cs will eventually die out.

86

## CHAPTER 7: Explaining tastes: the importance of altruism

3. For a given total income for the two, Alphonse's utility function, UA = MAMG, is
maximized when MA=MG, as shown in Example 7.1. Given Alphonse's budget constraint
(see diagram), this happens when MA=MG = 60. So Alphonse will give Gaston 40 of his
initial 100.

4. If they do not do the project, each person will have a utility level of 102/10 = 10. If they do
the project and Abdul gets P, Benjamin will get 10-P. Abdul's total wealth will then be
10+P, Benjamin's 20-P. The minimum acceptable value of P for Abdul will satisfy
UA = (10+P)2/(20-P) = 10. Solving for P, we have P = 3.028.
Since the problem is symmetric, this is also the minimum payment that would be acceptable
to Benjamin. And since the total gain from doing the project is more than enough for each
person to get 3.028, they will do it. (Verify, for example, that if each takes 5, each will be
better off than before.)
5. If Benjamin accepts Abdul's 1-unit offer, his utility will be UB = (10+1)2 = 121. If he
refuses, his utility level will be only 102 = 100, so he will accept Abdul's offer. There is no
point in refusing in hopes of a better bargain, since if Abdul gives Benjamin more than 1
unit, the contract will require him to give 20 to a cause he opposes, which would lower his
utility below his original level.
they are less likely to commit aggression in the first place. One disadvantage of having such
a leader is that he or she may engage in costly retaliation even after an unintended act of
aggression by an opponent.
7. Let t represent the length of the line at the polls, measured in hours. Then the total time
required to vote, including travel time, is equal to (t + 1/3) hours. Given that he can earn

## CHAPTER 7: Explaining tastes: the importance of altruism

87

\$30/hr at his job, the opportunity cost of his voting is thus (30t + 10) dollars. And since she
gets 3 units of utility from each unit of consumption of the composite good, the opportunity
cost of voting in utility terms is equal to 90t + 30 units. On the benefit side, he stands to gain
60 units of utility by voting. The maximum length of the polling line is the value of t that
equates the costs and benefits of voting in utility terms: This value of t is found by solving
the equation, 90t + 30 = 60, which yields t = 1/3 hour, or 20 minutes.

## Answers to Chapter 9 Problems

1. The graphs below answer question
a.
Q
Q=8+3L
20

b.

2
Q=16L

Q
144

64
8
16
L

L
4

## 3. The employer would prefer to pay MP.

4. The missing numbers for the total product columns are 0, 320, 480. The missing numbers for
the average product column are 180, 160, 140. The missing numbers for the marginal product
column are 180, 100, 60.

5. The allocation is 100 officers to Center City and 400 to West Philadelphia.
6. All 500 police officers should be sent to West Philadelphia.
7. a)
Q
9

L
2

## b) Maximum production (Q=9) occurs at L=6.

c) For 0<L<2, MPL is increasing. For 2<L<7, MPL is decreasing.
d) MPL < 0 for L>6.

8. Someone who earned 2 extra points from the last minute devoted to Problem 10, and 4
from the last minute devoted to Problem 8, ought to have spent less time on Problem
10 and more on Problem 8.

9.

Q
Q=4L

AP, M P
4

AP=M P=4
L

10. This production function shows constant returns from A to C, increasing returns from C to E,
and decreasing returns from E to G.

11. The overall average of the population need not change if physics was on the high side
of average and economics on the low side of average

1. a)
b)
c)
d)
e)
f)

## constant returns to scale and satisfies LDR

increasing returns to scale and does not satisfy LDR
constant returns to scale and does not satisfy LDR
constant returns to scale and does not satisfy LDR
increasing returns to scale and satisfies LDR
decreasing returns to scale and satisfies LDR

2. MP=dQ/dL=2L-2/3.
3. We cant have both properties within the same production function.
4. MPK = F(7, 5) - F(6, 5) = 14 12 = 2.
MPL=F(6, 6)-F(6, 5)=12-12=0.
5. r* = 14/40 = 0.35. At r*, the average gain per pass is 8+ 12(0.35) = 12.2 yards.
The average gain per run is 10 - 8(0.35) = 7.2 yards.
6. f = 1/2.
If more than 50 percent fastballs are thrown, the effect will be to raise the opponents'
overall batting average.

## Answers to Chapter 10 Problems

1.
Quantity Total
Fixed Variable
ATC AVC AFC
MC
of output cost
cost
cost
___________________________________________________________
0
24
24
0
---_____
______________________________________________________________
16
1
40
24
16
40
16
24
_____
______________________________________________________________
34
2
74
24
50
37
25
12
_____
______________________________________________________________
34
3
108
24
84
36
28
8
_____
______________________________________________________________
52
4
160
24
136
40
34
6
_____
______________________________________________________________
60
5
220
24
196
44
39.2
4.8
_____
______________________________________________________________
62
6
282
24
258
47
43
4
_____
______________________________________________________________
2.
\$/t
TC

12

VC
6

FC

Q
18

\$/Q

2.0
AFC
ATC

AVC=M C
1/3
18

112

## 4. a) Q1=6, Q2=2. The common value of marginal cost will be 2.4.

4. b) Note that for output levels less than 5, it is always cheapest to produce all units with
process 1.
5. .

Q1 Q2

Q3
L

6. .

Q3
Q2
Q1
L
7. Since this firm gets more output from the last dollar it spends on labor than from the last
dollar it spends on capital, it should buy less capital and more labor.
8. L=30 and K=20.
9. At the minimum-cost input bundle for producing Q*, we know that the extra output obtained
from the last dollar spent on labor is the same as the extra output obtained from the last
dollar spent on capital. Thus the two short-run marginal cost curves will take the same value
at Q*.
10. The LAC curve is the outer envelope of the firm's two SAC curves.
11. The LMC and SMC curves coincide at the output level for which LAC and SAC are equal.
If LMC SMC, it follows that SAC>LAC.

113

## 12. LRAC = LRTC/Q = Q2 - 20Q + 220.

LRMC = dLRTC/dQ = 3Q2 - 40Q + 220

LRM C

220

LRAC

120
260/3

Q
20/3

10

## 13. ATC = LTC/Q = Q + 10/Q

AVC = Q
AFC = 10/Q
MC = dLRTC/dQ = 2Q

MC
10

ATC
AVC

AFC
1

114

115

## Answers to Chapter 10 Appendix Problems

1. K = 1 and L = 4 are the cost-minimizing input values.
2.
\$/t
LTC
8

Q
8

18

\$/Q

1
LAC
LM C
Q
2

## This production function has increasing returns to scale.

3. a) K/L = 1/4.
3. b) K=25 and L=100.
4. PL = 1 and PK =4.
5. Thus the optimal ratio is K/L = 9/4

18

1.
Price
64

ATC

48

MC
profit (6x4)
AVC
Price

32
26
16

6
Quantity

10

2. FC = 8.
3.

## Consumer surplus = 4000.

Producer surplus = 2000.
Total loss in surplus = 6000.

4. In the long run, both the demand and supply curves will be more elastic than in the short run,
making the loss in both consumer and producer surpluses smaller.
5. Since P = SMC > AVC, the firm should continue at its current level of output in the short
run. In the long run, it should select the plant size for which P = LMC = SMC.
6. Q=5, P=11
7. The LAC curve for firms in this industry is given by LTC/Q=Q+4. The minimum value of
LAC now occurs at an output level of 0, where LAC takes the value 4. As a practical matter,
the notion of an infinitesimally small firm has no meaning. Because of indivisibilities, a
firm's LAC curve will increase beyond some point as Q shrinks toward zero.
8. 8 taxis and the equilibrium fare will be \$0.20/mile.
9. Medallions will sell in the market for \$20,000 each. A person who buys a medallion at this
price will earn zero economic profit.
10. Mm - M = 81 - 40.5 = 40.5.
11. a) The most you would be willing to pay for the patent is 16.25.
11. b) The investor would not be willing to sell exclusive rights to its use to one firm at that
price.
12. a) When AP=MP, it follows that MC=AVC.

126

## CHAPTER 11: Perfect competition

12. b) If the firm stays open in the short run, its loss will be equal to its fixed capital costs of
\$40/day, which is the same loss it would suffer if it were to shut down. So the firm is
indifferent between shutting down and remaining open in the short run.
13. Q = 27.5.
Profit = 121.25. Since the firm earns positive profit, it should stay open.
14. Lost consumer surplus is 238.88.
Lost producer surplus is 477.77.
15. 1) Since the supply curve faced by the individual firm is elastic, the advertisement (which
shifts the demand curve out) will increase quantity increase but leave price unchanged.
15. 2) The result will be a shift in the long-run supply curve. Price will increase and quantity
will decrease.
16. a) P = LAC = 140
16. b) There will be 172 firms.
16. c) In the long run P = LAC = 132.
17. a) At a world price of 30, domestic demand is 35 million bushels per year.
17. b) With a tariff of \$20/bu, the import price becomes \$50/bu. Because the domestic market
clears at \$40/bu.
17. c) The tariff has reduced consumer and producer surplus by \$75/yr.

18. (i) Costs will fall for all existing firms. At existing prices the firms will make positive
economic profits and increase output.
18. (ii) New firms will enter the industry because of profits.
18. (iii) The industry supply curve will shift out until profits are again driven down to zero. The
final result is that prices fall, quantity increases, and there are more firms than before. In
other words, consumers reap all the surplus from this innovation.

## Answers to Chapter 12 Problems

1. 1)
2)
3)
4)
5)

Increase output
Reduce output
Remain at current output.
Figures can't be right
Figures can't be right

2. Q* = 25, P* = 75
Q* = 25, P* = 75
4. Q* = 10, P* = 90
5. Qhome = 20, Qtotal = 30, Qforeign = 10, P = 80.
6. Q = 40, P = 60. efficiency loss = 800.
7. Q* = 8, PS = 320. The government could charge the firm any fixed fee up to 320.
8. PS* = 1/(1-1/4) = 4/3
PA* = 1/(1-1/2) = 2.
9. Q=220 and MR=220.
Iraq: Q = 400-MR = 180 ; P = 400-0.5Q = 310.
Iran: Q = 150-MR/2 = 40 and P = 300-Q = 260.
10. Since they have lower income, their demand is more price elastic than regular customers'. So
they are more willing to jump the hurdle to get a lower price. The hurdle is the coupon in this
case, and it is used to sort people according to their price elasticities of demand.
11. MC = 5.
12. false.
13. First look at how the Times prices its ads to outside advertisers, who have a downwardsloping demand curve for ad space. When the Times sets its price for outside ads, its rule is
to equate marginal revenue to marginal cost. Marginal cost is simply the cost of expanding
the paper to accommodate the extra ad. When the paper maximizes profit, the price it
charges outsiders for ads will thus be higher than the marginal cost of producing another ad.
When the Times advertises for its own features, its rule should be to continue placing more
ads until the marginal benefits (in terms of increased sales or higher prices) just equal the
cost of producing an extra ad. The opportunity cost to the Times of running another ad is
thus the marginal cost of producing the ad, which in general will be lower than the price it
14

a) PH = 15; PL = 10

142

## CHAPTER 12: Monopoly

14. b) = 15 + 10 - 5(2) - 15 = 0
14. c) = -3.75
14. d) With a single price, Harry would be forced out of business in the long run, and consumers
would lose the surplus they enjoy under the two-price arrangement.
15. false
16. false

## Answers to Chapter 13 Problems

1. Shared monopoly:
P = 9, Q1=Q2=3
1 = 2 = 18.
Cournot:
Q1 = Q2 = 4. P = 7
1 = 16 = 2
Bertrand:
P = MC = 3
Q1 = 6 = Q2
TR = 36
TC = 36
=0
Stackelberg:
Q1 = 6
Q2 = 3
P=6

1 = 18
2 = 9.
2.

Q1 = Q2 = 2.
P = 24.
1 = 12 = 2.

3.

P = 18 .
Q1 = Q2 = 3.
1 = 2 = = 0.

4.

Q1 = 3 and Q2 = 3/2.
P = 45/2.
1 = 27/2.
2 = 27/4.

5.

## change in profit = 3200 -3600 = - 400.

6.

Both have a dominant strategy of signing no matter what the other one does.

7. Each knows that the other will have nothing to lose by defecting on the last round. This robs
each party of an effective threat of retaliation on the third round, which means each also has
nothing to lose by defecting on round 3. The same reasoning extends backward to the second
and first rounds as well.
8. a) Neither firm has a dominant strategy. If one firm chooses to make a big car, the other has
an incentive to produce a small car, and vice versa.

154

## CHAPTER 13: Oligopoly and monopolistic competition

b) One firm producing a big car and the other producing a small car is a Nash equilibrium.

9. a.
D
Big car
Big car

400 for Firm 2

B
Firm 2
Small car

800 for Firm 2

A
Firm 1

Small car

Big car

1000 for Firm 2

Small car

500 for Firm 2

C
Firm 2

## 9. b) The Nash equilibrium for this game occurs at point E.

10. a) 1= 50(25) = 1250. Firm 2's profit is 25(25)= 625.
10. b) Firm 2 is willing to pay at most 2 = 625 for the license that gives the right to move
second. Firm 1 is willing to pay at most 1 = 1250 for the license that gives the right to
move first.
11. I1* = I2* = R/4 .
12. true.
13. N = 50.
14.

N = 2, t = 4/5

## Answers to Chapter 14 Problems

1. Wages = \$4/hr which equals VMP at L = 30 hours. The VMP column numbers are 16, 12, 8,
4, and 0.
Wage (\$/hr)
16
VMP

w=4
MP

30

40

Labor (person-hrs/day)
2. The new budget constraint shares M = \$0 at h = 24 hours, but has twice the slope due to the
wage being twice as high. The M column numberw are 288, 216, 144, 72, and 0.
Income
(\$/day)
288
M

216
144
M
72

12
Liesure (hrs/day)

18

24

3. The monopsonist hires L = 20 units of labor, where VMP = MFC = \$8, and pays the wage
w = AFC = \$4/hr.
Wage (\$/hr)
16
VMP
MFC
8
AFC
4

20
Labor (person-hrs/day)

30

168

## CHAPTER 14: Labor

4. L = 20 units of labor.
5. he will accept the new job.
6. a)

Income (\$/day)
115.2
106
96

initial budget
constraint
10
leisure
11.5
6. b) Program I

## 7. a) Equilibrium occurs where MFC = demand:

4L = 12 - 2L, which solves for
L* = 2
W = 2L* = 4
7. b) L** = 5/2; W = 7
7. c) Lc = 3, Wc = 6
With min wage: L = 5/2;

W=7

8. L=10, W=60.
9. a) L = 4 and W = 7
9. b) At W = 17, we get L = 3.
10. He should hire less labor.
11. a) L = 15 and W = 10 + L = 25. Output = 15(5) = 75.
11. b) L = 5 and W = 10 + L = 15 and Q = 25 and P = 53.
11. c) At L=5, MRPL = 20
At L=6, MRPL = -78.
7
7

24

## CHAPTER 14: Labor

169

Since MRPL becomes negative, no matter what the wage is an extra worker will decrease
profits. So Ajax will not increase its labor force.
12. Comparing VMP with marginal willingness to pay for additional vacation time, we see that
the optimal vacation lengths for the two types of worker are
V*young = 2 weeks; V*old = 4 weeks.
Compared to the current arrangement (in which all workers get 5 weeks vacation), older
workers would be willing to cut their vacation to 4 weeks for only 150/yr more in pay. Since
the older worker's VMP is 175/wk the firm can meet this requirement with 25/yr left to spare.
Younger workers would be willing to switch to 2 weeks vacation for an increase in pay of
only 325/yr, and since the VMP of each younger worker is 150/wk, the 3 week/yr cut in
vacation time will generate 450/yr additional revenue, or 125/yr more than necessary to meet
the required pay hike. So the extra profit will be 25/yr for each older worker and 125/yr for
each younger worker.
13. a) E(VMP) given that test = 9 and applicant is blue: (1/3) (9) + (2/3) (6) = 7.
13. b) E(VMP) test = 9 and applicant is green: (1/3) (9) + (2/3) (12) = 11.
13. c) No. Statistical discrimination pulls members within each group toward the respective
group averages. It says nothing about why the group averages differ.
14. a) The wage schedule described in the diagram below pays the worker less than VMP in the
early years, more than VMP in the later years. A shirking employee will be reluctant to work
under such a schedule, because of the risk of getting caught and fired for shirking before
having a chance to cash in on premium wages. The non-shirker, by contrast, does not have
this reason to worry about being fired. Of course, if the probability of being caught were
zero, the threat of losing future premium wages would lose all force.
14. b) Workers run not only the risk of being fired for shirking but also the risk of being fired
because the firm doesn't want to pay the promised wage premiums. Any firm with a
reputation for not making good on such promises would have a very difficult time finding
workers to agree to work under a future-oriented pay schedule.
15. a) N1 = 50 and N2 = 80-50 = 30.
15. b) GNP= 5(100) + 30(10) = 800, which is the same as if sector 1 didn't exist!
15. c) N1' = 25 and N2' = 80-25 = 55. GNP= 5(100) + 55(10) = 1050.
16. MPL = Q / L = (1/2) ( K / L ) = 1/ L
VMPL = P MPL = 10/ L
17. MRPL = MR x MPL = (20-2Q) (1/ L ) = (20-4 L )/ L

170

## 1. The utility functions lead to the following payoff matrix:

Safe M ine

Safe M ine

Unsafe M ine

400
each

150 for B
500 for A

B
Unsafe M ine

500 for B
150 for A

300
each

1. a) These payoffs confront A and B with a prisoner's dilemma. The dominant strategy is to
choose the unsafe mine, yet each gets only 300 utils when that happens, as compared with
the 400 each would have gotten had each chosen the safe mine.
1. b) Accordingly, it is in their interests to enter a binding agreement to work in the safe mine.

## Deeltentamen april 2010Answers to Chapter 15 Problems

1. Its price must be P = 800/0.40 = \$2000.
2. The present value of the returns plus scrap value of the machine is given by
PV = 97.15 < 100.
Thus the machine is a bad investment.
3. The price of the bond at 5% interest would be P = 3000/0.05 = \$60,000. The price of the
bond at 6% interest would be P' = 3000/0.06 = \$50,000.
4. The interest rate on taxable government bonds will adjust so that the after-tax returns are the
same as for nontaxable government bonds. So the interest rate for nontaxable government
bonds will be 4%.
5. The interest rate on tax-exempt consoles would have been 5% when everyone's marginal tax
rate was 50%. It will rise to 7% when the marginal tax rate falls to 30%. If C denotes the
console's annual coupon payment, its original price was given by Po = C/.05. Its new price
will be P1 = C/.07, which tells us that P1 = (5/7) Po, or that the price of the tax-exempt
console will fall by 2/7 of its original value.
6. The rates of return should be the same for the two types of companies. If the return on
companies that did business in South Africa were higher, investors who don't mind that
would bid for their stocks, and the resulting market pressures would eventually equalize
returns.
7. The economically efficient price for a haircut at any moment is the amount it would cost to
produce another one at that moment. This marginal cost will be different at different times
of the day and week. On Saturday mornings and at other times when all four barbers and
chairs are busy, the marginal cost of a haircut is the labor time of the barber plus the
additional chair, shop space, clippers, and related capital equipment needed to serve another
customer. During less busy periods, by contrast, an additional haircut can be provided
without incurring these additional resource costs. And so for this reason, the price of
haircuts should be higher during busiest times.
8. The price should increase at the rate of interest. Therefore,
Pn = Po (1+i)n = 2000 (1+i)n.

180

## Answers to Chapter 15 Appendix Problems

1. If the price of oil rises at the real rate of interest, its price will reach \$2 in t* years, where t*
is found by solving (1.80)(1.05)t* = 2. This solves for t* = 2.16 years. Even without solving
the equation explicitly, it is clear that if the price of oil starts at \$1.80 and grows at 5%
annually, it will reach \$2.00 well before 10 years have passed. This means that at current
usage rates, there will still be oil left when its price reaches \$2.00. No one will want to hold
oil once that happens because its price will never rise again, given the availability of the
solar substitute. Owners will attempt to get rid of their oil at the current price, which will
drive that price downward.
2. The effects of the underground oil discovery are (1) to reduce the current price of
underground oil (in the diagram, from P0U to P'0U); (2) to extend the underground oil age
by t units; and (3) to postpone the onset of the offshore oil age by t units.
Neither the price at which offshore oil is first extracted nor the length of the offshore oil age
is affected by the discovery of the additional underground oil.
3. (dB/dt)/B = r,
(dB/dt)/B = (10/_t)/(20_t) = 1/2t = .05, so t* = 10 years.
5. Suppose people extracted the shale oil first. By switching to the underground oil, we could
then save on current extraction costs. If we put those savings in a bank account, we would get
back enough to extract the shale oil later, and in addition we would gain all the interest
payments. So we clearly do better by postponing the more costly extraction process as long
as possible.

1. and 2.

Ernie's clothing
20
15
10

30
20

Contract
Curve

Bert's
food
Ernie's
10 food

10
ParetoSuperior
Set

initial
allocation

20

30

20
15
10
Bert's clothing

## Equilibrium price ratio = 1.

3. This time the initial allocation lies on the contract curve, so there are no other allocations
Pareto superior to it. The equilibrium price ratio must again be 1.

30

Ernie's clothing
20
15
10

20

Bert's
food
Ernie's
10 food

10
initial
allocation
20

10

20
15
Bert's clothing

## 4. No equilibrium, price ratio PF/PC will have to fall.

5. No equilibrium, price ratio PF/PC again have to fall.

30

6.
Brian's Y
6

6
Sarah's X
4

IB

Pareto
Superior
Set
2
Brian's X

initial
allocation

4
IS
6

Sarah's Y

7. No efficiency
An MRTS of 4 in food production means that if we reduce capital by 1 unit in food
production, we need add only 1/4 unit of labor to maintain the original level of output. An
MRTS of 2 in clothing production means that if we take 1/4 unit of labor from food
production, we need add only 1/2 unit of capital to restore the original level of clothing
output. Transferring 1/4 unit of labor from clothing to food production thus leaves 1/2
unit of extra capital free to distribute between the two processes, which will give us a
8. No efficiency, everyone can be made better off if we produce less clothing and more food.
9, 10, and 11.
Optimal
production
bundle with

Food
25
20

Opportunity set
with international

15
10
5

Original
optimal
bundle
(production &
consumption)

Optimal
consumption
bundle with

Original
PP curve

0 5

10

15

20

25

30

60
Clothing

12.

Opportunity set

13. If the competitive firms form an effective cartel, they will be able to charge the monopoly
price. And since marginal cost and elasticity of demand are the same as in the monopoly
industry, the cartel price will be the same as the monopoly price, which means that the
equilibrium MRS will be 1. The equilibrium MRT will also be 1 because the marginal
costs are the same in the two industries. So the cartel proposal will indeed result in an
efficient product mix. We already know that there is efficiency in production and
consumption, even in the presence of monopoly. So the resultant allocation will be Pareto
optimal.
14.
Labor in Food
100
Capital in
Clothing
50

Capital in
Food

B
0

50

100
Labor in Clothing

150

## 15. yc = (KC + LC)/2 = (100 - yF + 200 - yF)/2 = 150 - yF.

16. yC = (K'C + LC)/2 = (200 - yF + 200 - yF)/2 = 200 - yF.

200