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52 visualizzazioni77 pagineSolutionManual Micro Economie EUR

Nov 18, 2016

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SolutionManual Micro Economie EUR

© All Rights Reserved

52 visualizzazioni

SolutionManual Micro Economie EUR

© All Rights Reserved

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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

20.00

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

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

business job salary.

Costs of Business Job

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?

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

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

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

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.

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

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.

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

$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

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.

3. c)Buyers now spend 11(31)=341.

5. d)The government collects 11(9) = 99.

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

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)

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)

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

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.

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

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

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

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

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

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

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

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

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.

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

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

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

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

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

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.

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

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

This year's bundle

34

30

20

70

170 X

C2

Budget constraint when r = 0.20

462

430.5

210

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

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

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

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

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

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.

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

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

graduate had smartness level of Sh and the average college graduate had Sc, where Sc>Sh.

Since the monetary costs of education went down, more people are getting education,

76

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.

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

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

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

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

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

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.

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

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.

1. The graphs below answer question

a.

Q

Q=8+3L

20

b.

2

Q=16L

Q

144

64

8

16

L

L

4

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

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)

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.

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. 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

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

LRM C

220

LRAC

120

260/3

Q

20/3

10

AVC = Q

AFC = 10/Q

MC = dLRTC/dQ = 2Q

MC

10

ATC

AVC

AFC

1

114

115

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

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.

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

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.

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

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. 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.

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

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

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

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

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

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

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

Answer to the Apendix Problem

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.

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

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

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

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

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

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

200

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