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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
10
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
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
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
Q1
Q(toys)
13
Q(battery)
Q1
D2
D1
Q1
Q2
Q(yo-yos)
14
P2
P1
D
Q(oil)
Q2
Q1
Q(air)
Q1
D2
D1
Q1
Q2
Q(rail)
15
P(hotel)
S
P1
P2
D1
D2
Q2
Q(hotel)
Q1
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.
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 = $50 but cannot find one available. The excess demand is
12,500 2,500 = 10,000 seats more than for the not so big game.
16
7. d) Normally a price ceiling both raises quantity demanded and lowers quantity supplied.
Here, only the first effect is present because the stadium capacity is fixed.
Problem 2-17
S
Price ($)
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.
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.
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
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
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
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)
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)
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
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.
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
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
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
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
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
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.
12
14
16 Secular Activities
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) = $385 if you consume the maximum rental days you
can afford (as well as beating any other affordable combination of C and Y.
Composite Good
per trip (Y)
360
Problem 20a
Y = 140C
Y = 360 40C
280
Y = 160
160
Y = 440 40C
0
Composite Good
per trip (Y)
360
5
7
11
Days of Car Rental per trip (C)
Problem 20b
Y = 405 35C
Y = 360 40C
Y = 160
160
Y = 440 40C
0
5
7
11
Days of Car Rental per trip (C)
21. With diminishing MRS, to decrease pizza consumption from 3 to 2 slices, the consumer has
to be given more than 1 beer (since that was the amount needed to decrease pizza
consumption from 4 to 3 slices and stay on the same indifference curve). So he would be
indifferent between the bundles (3 slices of pizza, 2 beers) and (2 slices of pizza, X beers)
where X>3. However, we know that he prefers (1 slice of pizza, 3 beers) to (3 slices of pizza,
2 beers), so he should also prefer that bundle to (2 slices of pizza, X beers). But this violates
the more-is-better assumption.
36
composite($/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.
37
23.
comp osite good
12
11
.
.
10
8
7
.
.
4
3
.
.
.
1
.
10 11 12 13 14 15 16
38
Y (1000s)
16
14
10
IC0
B1
2
B0
5.33
39
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
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.
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=$21,000
7. b) Ep
-1000) = - 3/7
7. c) A price increase will increase revenue since current price is in the inelastic region.
7. d) Since substitution chances are increased, demand for the bridge will become more elastic.
8. We cant know. We are only given that income elasticity of demand for safety (Ei) is
positive. For necessities, we have 0 < Ei< 1, and for luxury goods we have Ei> 1.
We need more information to determine whether Ei> 1 or not.
9. QA=25-0.5P, QB=50-P, So Q=QA+QB=75 + 1.5P and hence P=50-(2/3)Q.
Price
Price
50
Price
50
DA
25
50
DB
QA
50
QB
75 Q
48
Price
B
600
Change in P = 200
A
400
Change in quantity = 20
280 300
Quantity
11. Price elasticity = -CE/AC =-3/7 (using segment-ratio method). Because demand is inelastic
with respect to price, total revenue will go up with an increase in price.
Price ($/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,
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
50
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
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
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 $.50 for the milk, declines by exactly 20% but the implicit cost
of the effort of buying the milk separately must now be added to the nominal price),
accompanied by a quantity increase of 60%. It follows that the absolute value of the price
elasticity of demand for cappuccino is greater than 3. So false.
53
20. b) The policy has the effect of making milk more valuable to those users who supply their
own milk to receive the discount. At a given price of milk, the quantity demanded will rise,
and hence total revenue will rise, no matter what the value of the price elasticity of demand
for milk. So false.
Yr - 2Pe
Yp - Pe
Yp - 2Pe
Y*
Quality of Education
(Yr - Pe)/Pe
The rich family has income (Yr), the poor family has income (Yp), where Yr>Yp. The two
families have the same indifference maps. The rich family's budget constraint is the heavy
line, and the poor familys budget constraint in the thinner one. The poor family maximizes
utility by purchasing only public education (i.e., 1 unit of quality), but the rich family buys
Y*>1 units of private education.
2.
Other goods ($/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
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.
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
34
30
20
70
170 X
C2
Budget constraint when r = 0.20
462
430.5
C1
210
385
410
62
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
75
75
Current Consumption ($000)
150
63
75
Current Consumption ($000)
143.2
200
190
optimal bundle
100
indifference curve for 1-to-1
substitutes
100
200
C1
64
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
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.
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
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
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)
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
76
1.
2.
First Trip
0 break
500 break
Second Trip
0 break
0 break
Income
100
50
Probability
1/4
1/4
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
Choose teaching
earn 81
78
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
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
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
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.
6. The advantage is that if opposing nations know this leader's preferences about retaliation,
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
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.
b.
2
Q=16L
Q
144
64
8
16
L
L
4
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
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
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.
12
VC
6
FC
Q
18
$/Q
2.0
AFC
ATC
AVC=M C
1/3
18
112
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
LRM C
220
LRAC
120
260/3
Q
20/3
10
MC
10
ATC
AVC
AFC
1
114
115
Q
8
18
$/Q
1
LAC
LM C
Q
2
18
ATC
48
MC
profit (6x4)
AVC
Price
32
26
16
6
Quantity
10
2. FC = 8.
3.
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
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.
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
charges outside advertisers.
14
a) PH = 15; PL = 10
142
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
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.
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
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
B
Firm 2
Small car
A
Firm 1
Small car
Big car
Small car
C
Firm 2
N = 2, t = 4/5
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
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
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
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
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.
180
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
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
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
higher level of output of both goods than we had to start with.
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
trade
Food
25
20
Opportunity set
with international
trade
15
10
5
Original
optimal
bundle
(production &
consumption)
Optimal
consumption
bundle with
trade
Original
PP curve
0 5
10
15
20
25
30
60
Clothing
12.
Opportunity set
with international trade
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
200