McGraw Hill BW Problem Set

Student Practice Manual
to Accompany
Microeconomics
B. Douglas Bernheim
Michael Whinston
Created by:
Jennifer Pate, Ph.D.
Loyola Marymount University
Table of Contents
Chapter 1 Page 3
Additional Exercises for Chapter 1 4
Chapter 2 5
Chapter 3 11
Chapter 4 18
Chapter 5 27
Chapter 6 44
Chapter 7 57
Chapter 8 65
Chapter 9 73
Chapter 10 82
Chapter 11 89
Chapter 12 99
Chapter 13 109
Chapter 14 115
Chapter 15 122
Chapter 16 128
Chapter 17 134
Chapter 18 141
Chapter 19 150
Chapter 20 155
2
Chapter 1
Sample Problems
1. Government intervention in markets is a politically divisive issue. What are some

potential justifications of government intervention in markets?
Answer:
Government intervention in markets is potentially justifiable when market failures
occur. In a case where there is little competition in a market, the government could
step in and regulate prices so that consumers are not unjustly hurt by lack of
competition in a market. The government could also intervene in markets to bridge the
gap between buyers and sellers created by a lack of information. In such cases, the
government could impose regulations and mandates on disclosure of information. Also,
inequality across customers in a market could justify a government to implement
policies to redistribute resources more equitably.
2. Simplifying assumptions are important when creating an economic model because it

helps economists focus on the most important reasons for a phenomenon. How does
assuming people are motivated by material self-interest simplify an economic model?
Answer:
Assuming material self-interest simplifies economic models because it means that
everyone is motivated by the same principles. There are no altruistic individuals. In
short it makes everyone similar and that allows models to be more broadly applicable.
3. Your roommate asks you for advice about what to do this Friday night. She has
narrowed her options to two different choices. She could go to a party with her new
friends, or she could attend an off-campus seminar on The Poetry of Robert Frost
which her English professor recommended as an event she would truly enjoy. To ease
her decision-making process, explain the trade-offs between her two choices.
Answer:
If she chooses to go to the party she will forgo the opportunity to experience the poetry
of Robert Frost which was highly recommended to her. If she goes to the seminar
3
instead of the party she will forgo a chance to bond with her new friends and the
possibility of having a good time. Her decision will involve an opportunity cost equal
to the forgone action.
Additional Exercises for Chapter 1
1. Which type of economy, communist or capitalist, is more closely described as a

free market system and why?
2. What are markets and why do they require property rights?
3. How does the principle of individual sovereignty allow economists to conduct

normative analysis?
4. How does the field of economics go beyond the study of money?
5. Why is it important to identify additional implications after formulating a theory?
6. What is the benefit to economists of using simplifying assumptions when

formulating a model?
7. List and briefly describe the three main categories of economic data.
8. Why might economists disagree about positive matters?
9. How does a natural experiment differ from a controlled experiment?
10. Given that people respond to incentives, how do changes in prices alter behavior?
11. How can trade benefit two people at the same time?
12. Why might it be useful to use economics to evaluate environmental policy?
4
Chapter 2
Sample Problems
1. Assume the demand for ice cream takes the following form:
cream 8.5 3Pice cream 4Pyogurt 3.5Pwaffle cone 0.0005M

D
Qice
If the price of yogurt is $4.00, the price of a waffle cone is $3.00 and the average
income is $32,000, what is the demand function for ice cream? Graph it below.
Answer:
To solve for the demand function, substitute in the prices for yogurt and waffle cones
and the average income, then simplify as in the equations below:
cream 8.5 3Pice cream 4($4.00) 3.5($3.00) 0.0005($32, 000)

D
Qice
cream 30 3Pice cream
D
Qice
To graph the equation, first find the endpoints. If Pice cream 0 , then Qice
D
cream 30 and
cream 0 , Pice cream $10.00 .

D
when Qice
18
16
14
QICD
PIC 10
Price ($)
12
3
10
8
6
4
2
3 6 9 12 15 18 21 24 27 30
2
Quantity (Gallons of ice cream)
2. Using the information from the previous question, at what Pice cream will the quantity
demanded of ice cream equal 18 gallons? How will this change if the price of waffle
cones decreases to $2.00?
5
Answer:
To find the price of ice cream where quantity demanded equals 18 gallons, set the
equation for quantity demanded to 18 and solve for Pice cream .
cream 30 3 Pice cream

D
Qice
18 30 3Pice cream
3Pice cream 12
Pice cream $4.00
If the price of waffle cones falls to $2.00, the demand function changes to
cream 8.5 3Pice cream 4($4.00) 3.5($2.00) 0.0005($32, 000)

D
Qice
cream 33.50 3Pice cream
D
Qice
To again find the price of ice cream where quantity demanded equals 18 gallons, set
the equation for quantity demanded to 18 and solve for Pice cream .
cream 33.50 3 Pice cream

D
Qice
18 33.50 3Pice cream
3Pice cream 15.5
Pice cream $5.17
3. If QICD 16 2 PIC , this means that if P $3.00 , then QD 10 and if P $4.00 ,
then Q D 8 . What is the elasticity of demand at a price of $3.00? What about at a

price of $4.00?
Answer:
At $3.00: d 2 3 3
0.6
1 10 5
At $4.00: d 2 4 1.
1 8
6
1. Assume the demand for French fries takes the following form:
fries 8 3PFrench fries 2Pfrying oil 1.5Ppotato flakes 0.0004M

S
QFrench
If the price of onion rings is $5.00, the price of ketchup is $4.00, and the average
income is $30,000, what is the demand function for French fries? Graph it below.
18
16
14
Price ($)
12
10
8
6
4
2
3 6 9 12 15 18 21 24 27 30
2
Quantity (millions of pounds)
2. Following from the information in question (1), at what PFrench fries will the quantity
demanded equal 15 million pounds? How will this change if the price of ketchup
increases to $5.00?
3. What happens to the demand curve for French fries if the average income
increases to $40,000, holding all else constant? Graph this new demand curve
alongside your answer from (1).
4. Given the demand function in (1), how can you determine whether French fries
and onion rings are substitutes or complements? Explain.
7
5. Assume the supply of French fries (FF) takes the following form:
fries 8 3PFrench fries 2Pfrying oil 1.5Ppotato flakes

S
QFrench
If the price of frying oil is $3.00 and the price of potato flakes is $5.00, what is
the supply function for French fries? Graph it below.
18
16
14
Price ($)
12
10
8
6
4
2
3 6 9 12 15 18 21 24 27 30
2
Quantity (millions of pounds)
6. Following from (5), at what PFrench fries will the quantity supplied equal 12.5 million
pounds? How will this change if the price of potato flakes falls to $3.00?
7. How does your answer from (6) demonstrate that French fries and potato flakes
are substitutes in production? Explain.
8. What happens to the supply curve for French fries if the price of frying oil
increases to $4.50? Graph this new supply curve alongside your answer from (5).
D
9. Assume the demand function for French fries takes the form: QFF 20 2 PFF and
S
the supply function takes the form: QFF 3PFF 10 . What is the equilibrium price
in this market? What are the amounts bought and sold?
8
10. Following from (9), what happens to the equilibrium price and quantity if demand
D
decreases to QFF 15 2 PFF ? Calculate the new equilibrium.
11. Starting again from (9), what happens to the equilibrium price and quantity if
S
supply increases to QFF 3PFF 5 ? Calculate the new equilibrium.
12. Finally, what happens to the equilibrium price and quantity if demand decreases
D
to QFF 15 2 PFF and supply increases to QFF
S
3PFF 5 ? Calculate the new
equilibrium. Does quantity increase, decrease, or stay the same and why?
13. Suppose the demand function for ice cream is: QICD 16 2 PIC and the supply
function is: QICS P 4. Find the equilibrium price in the market for ice cream.
What are the amounts that are bought and sold? Graph the supply and demand
functions below.
18
16
14
Price ($)
12
10
8
6
4
2
3 6 9 12 15 18 21 24 27 30
2
Quantity (Gallons of ice cream)
9
D
14. If QFF 15 2 PFF , this means that if P $3.50 , then QD 13 and if P $5.00 ,
then QD 10 . What is the elasticity of demand at a price of $3.50? What about at

a price of $5.00?
S
15. If QFF 3PFF 5 , this means that if P $3.50 , then QS 0.5 and if P $5.00 ,
then QS 5 . What is the elasticity of supply at a price of $3.50? What about at a

price of $5.00?
D
16. Considering the demand function QFF 20 2 PFF , at what price will total
expenditure be the largest?
10
Chapter 3
Sample Problems
1. In an effort to help him avoid the freshman 15, Jerrys parents bought him a gym
membership. To keep himself motivated Jerry wants to arrange personal trainer
sessions for the semester. Jerry can hire the trainer for up to 21 sessions in increments
of 3 sessions. The total benefit (TB) and total cost (TC) of the training sessions are in
the table below. Calculate the net benefit (NB) for each of Jerrys choices and use
your answer to identify his best option.
Number of Net
Benefit Cost
Sessions Benefit
0 0 0
3 115 90
6 245 174
9 396 252
12 525 324
15 563 390
18 608 450
21 649 504
Answer:
Number Net
Benefit Cost
of Sessions Benefit
0 0 0 0
3 115 90 25
6 245 174 71
9 396 252 144
12 525 324 201
15 563 390 173
18 608 450 158
21 649 504 145
The best choice for Jerry would be to hire the personal trainer for the number of
sessions that yield the highest net benefit. According to the table Jerrys best choice is
to hire the personal trainer for 12 sessions with a net benefit of 201.
11
2. Calculate the marginal benefit (MB) and marginal cost (MC) to fill in the table below.
How can you use your answers to identify the best choice?
Number Marginal Marginal

Benefit Cost
of Sessions Benefit Cost
0 0 0
3 115 90
6 245 174
9 396 252
12 525 324
15 563 390
18 608 450
21 649 504
Answer:
Number Marginal Marginal

Benefit Cost
of Sessions Benefit Cost
0 0 X 0 X
3 115 115 90 90
6 245 130 174 84
9 396 151 252 78
12 525 129 324 72
15 563 38 390 66
18 608 45 450 60
21 649 41 504 54
The best choice for Jerry according to this schedule is to hire a personal trainer for
twelve sessions. The twelve session mark is the last point at which the marginal
benefit exceeds the marginal cost.
3. Suppose that Jerry can hire a personal trainer for up to twenty-one sessions. The total
benefit of hiring the trainer is given by the function BS 154S 3S 2 and the total
cost is given by CS 2S 3S 2 . The corresponding functions for MB and MC

are M B 154 6S and M C 2 6S , respectively. What is Jerrys best choice?
Answer:
Using the Principle of No Marginal Improvement you can solve for Jerrys best
choice by setting MB = MC and solving for S:
12
M B 154 6S = 2 6S M C
S 12.67
So, Jerrys best choice is to hire a personal trainer for 12.67 (twelve and two-thirds of
a session) sessions.
4. Using the information from (3), what happens if the gym decides to charge Jerry a
one-time non-refundable service fee of $25 for the use of a new member-trainer
work-out area. How does this fee impact Jerrys choice of the best action in (3) and
why?
Answer:
Introducing a one-time non-refundable consultation fee of $25 would have the effect
of changing your total cost function from, CS 2S 3S 2 to Cnew S 25 2S 3S 2 .
On the graph from (8) the TC curve would be shifted up by 25 units. Despite this shift
in the TC curve this does not change the marginal cost curve. Since the MC function
and the MB function are the same you will find that your best choice from (8) is the
same, even after adding a one-time service fee. The service fee is what is known as a
sunk cost. Sunk costs have no effect on Jerrys best choice because regardless of how
many sessions he employs his trainer, the service fee is constant.
5. What do you think might happen to Jerrys cost schedule if the gym charged a new
fee of $5 per session for using the area? Do you think there might be a new best
choice?
Answer:
If the gym introduced a new $5 per session fee for the new member-trainer area
Jerrys cost schedule would be changed. The cost for each of Jerrys choices would
increase by 5 times the number of total sessions. It is also likely that Jerrys benefit
schedule could see and increase due to the new training area.
It is possible that if this new service fee was implemented that Jerry would be looking
at a new best choice depending on how much the benefits outweigh the costs at each
choice.
13
1. Assume you have a few hours free on a Saturday afternoon and youve ranked
your options, starting with your most preferred, as (1) going to see a movie, (2)
going to the gym, (3) reading a book or (4) watching grass grow. What is your
opportunity cost of going to see a movie and why?
2. Why is it important to make a decision based on the net benefit of your options
and not just the total benefit?
3. Suppose that you hire a mechanic to fix your motorcycle for up to six hours. The
total benefit and total cost of the repair work are in the table below. Calculate the
net benefit for each choice and use your answer to identify the best option.
Hours Benefit Cost Net Benefit
0 0 0
1 460 80
2 840 220
3 1140 420
4 1360 680
5 1500 1000
6 1560 1380
4. Using the information from (3), what happens if the mechanic decides to impose
an additional $50 hourly fee? What is the maximum net benefit now?
5. Calculate the marginal benefit and marginal cost to fill in the table below. How
can you use your answers to identify the best choice?
14
Marginal Marginal
Hours Benefit Cost
Benefit Cost
0 0 0
1 460 80
2 840 220
3 1140 420
4 1360 680
5 1500 1000
6 1560 1380
total benefit of the repair work is B( H ) 500H 40H 2 and the total cost
is C( H ) 50H 30H 2 . The corresponding functions for marginal benefit and

marginal cost are MB( H ) 500 80H and MC( H ) 50 60H , respectively.
What is your best choice?
7. The figure below displays the functions for total benefit and total cost for a
decision. How can you use this information to determine the best choice? What is
the maximum net benefit?
900
TC
800
Total benefit, total cost ($)
TB
700
600
500
400
300
200
100
1 2 3 4 5 6 7 8 9 10
Hours (H)
15
8. Suppose again that you hire a mechanic to fix your motorcycle for up to six hours.
The total benefit of the repair work is B( H ) 350H 15H 2 and the total cost
is C( H ) 40H 25H 2 . The corresponding functions for marginal benefit and

marginal cost are MB( H ) 350 15H and MC( H ) 40 50H , respectively.
What is your best choice?
total benefit and total cost of the repair work are in the table below. Calculate the
net benefit for each choice and use your answer to identify the best option.
0 0 0
1 335 65
2 640 180
3 915 345
4 1160 560
5 1375 825
6 1560 1140
10. Using the information from (8), what happens if the mechanic decides to charge a
one-time non-refundable consultation fee of $100? How does this fee impact your
choice of the best option in question (8) and why?
11. Why should sunk costs be ignored when finding the best choice from a set of
options?
12. How can the No Marginal Improvement Principle be used to find the best possible
choice over a set of options?
16
13. Suppose once more that you hire a mechanic to fix your motorcycle for up to six
hours. The total benefit of the repair work is B( H ) 110H 20H 2 and the total
cost is C( H ) 50H 70H 2 . The corresponding functions for marginal benefit

and marginal cost are MB( H ) 110 20H and MC( H ) 50 140H , respectively.
What is your best choice? What if the mechanic requires a 1-hour minimum
payment?
14. What is the difference between an interior action and a boundary action and why
is it important to eliminate the boundary choices?
15. Suppose that you find the largest net benefit for repairs to be 4.3 hours but the
mechanic requires that payments be made in one-hour increments, which forces
you to choose either 4 hours or 5 hours. Which choice do you make and why?
17
Chapter 4
Sample Problems
1. Jimmy is going to fraternity initiation dinner and has ranked his preference bundles
for rolls of sushi and number of enchiladas according to the table below. Using the
information on the table below, do Jimmys rankings show support for the More-Is-
Better Principle? Also, using the information on the table, can you tell whether
Jimmy prefers sushi to enchiladas, or enchiladas to sushi?
3 11 6 3 1
2 13 8 4 2
1 14 9 7 5
Sushi 0 15 14 12 10
(rolls) 0 1 2 3
Enchiladas
(Number of enchiladas)
Answer:
To check whether Jimmys preferences satisfy the more-is-better principle, notice that
in any particular column the numbers at the top are smaller than the numbers at the
bottom. Similarly, in any particular row, the numbers on the right-hand side are
smaller than the numbers on the left-hand side. These two aspects of Jimmys
preferences imply that if either the number of rolls of sushi (number of enchiladas) is
held constant Jimmy prefers more enchiladas (sushi).
2. Using the information from question (1) and starting with 2 rolls of sushi and 1
enchilada, will Jimmy
a) Swap 1 sushi roll for 1 more enchilada?
b) Swap 2 sushi rolls for 2 more enchiladas?
c) Swap 1 enchilada for 1 more sushi roll?
18
Answer:
a) Yes, he would swap 7 8.
b) No, he will not swap 8 10.

c) No, he will not swap 8 11.
3. The figure below contains two indifference curves one for Jimmy and another curve
for Ron, Jimmys new fraternity brother. The points represent their current
consumption bundles. Using the graphs, is trade favorable between the two? Explain
your answer.
Jimmy
4
3
Sushi
(rolls)
2
Ron
1 2 3 4
Enchiladas (Number of enchiladas)
Answer:
Jimmys current consumption bundle has him on the steep part of his indifference
curve where he is willing to forgo more sushi in return for some more enchiladas. In
contrast, Rons current consumption bundle has him on the flat part of his
indifference curve where he is willing to forgo more enchiladas in return for some
more sushi. Therefore, a trade in which Jimmy gives Ron some of his sushi in return
for a greater number of enchiladas than was previously possible would benefit both.
4. At their current consumption bundles, who has a greater marginal rate of substitution
for enchiladas with sushi, Jimmy or Ron? Use the graph in (3). Explain your answer.
19
Answer:
According to their indifference curves, enchiladas are worth more to Jimmy than to
Ron. This is evident from the slopes of both of their indifference curves. Jimmy is
less willing to forgo enchiladas for more sushi than Ron. Thus, Jimmys MRS for
enchiladas with sushi is higher than Rons.
5. Rons preferences for sushi (S) and enchiladas (E) in a month correspond to the utility
1 2
function U ( S , E ) 3S E . How does Ron rank the following alternatives?
4
a) 1 roll of sushi and 4 enchiladas.
b) 4 rolls of sushi and 1 enchilada.
c) 2 rolls of sushi and 2 enchiladas.
d) 3 rolls of sushi and 2 enchiladas.
Answer:
Use Rons utility function to find to help find the order of preference between the
alternatives.
1
For example for (a): U (1,4) 3(1) (4) 2 7. The rest are as
4
1 1
follows: U (4,1) 3(4) (1) 2 12.25, U (2,2) 3(2) (2) 2 7,
4 4
1
U (3,2) 3(3) (2) 2 10. Therefore, Rons preferences are as follows: 1st, 4 rolls of
4
sushi and one enchilada; 2nd, 3 rolls of sushi and 2 enchiladas; and lastly, both (a)
one roll of sushi and (c) 4 enchiladas, and 2 rolls of sushi and 2 enchiladas.
6. Given Rons utility function in question (5), find a formula for his indifference curves.
What is Rons marginal utility of sushi? What is Rons marginal utility of enchiladas?
What is her marginal rate of substitution for sushi with enchiladas?
Answer:
Given Rons utility function, the formula his indifference curves can be found by
rearranging the equation and solving for E, as such:
20
U S , E 3S
1 2
E
4
E U S , E 3S
1 2

4
E 2 4U S , E 12S
(1) E 2 U S , E 3S.
Rons marginal utility of sushi is MU S 3, (adding S increases the utility value by 3
U
so, 3. )
S
1 1
The marginal utility of enchiladas is MU E E, (adding E the utility value by E
2 2
U 1
so, E.)
E 2
Now, to find Rons marginal rate of substitution for sushi with enchiladas, use the
equations for finding the MRS with the information about the marginal utilities of
both sushi and enchiladas, as such:
MU S 3 6
MRS S , E .
MU E 1 E
E
2
6
Her MRS of sushi with enchiladas is enchiladas per roll of sushi.
E
1. Why is it important that consumers follow the Choice Principle? What would
happen if they didnt?
2. Stephanie is going to a birthday party and has ranked her preference bundles of
pieces of pie and scoops of ice cream according to the table below. Using the
information in the table, how do Stephanies rankings show support for the More-
is-Better Principle?
21
3 10 5 2 1
2 13 7 4 3
Pie
(pieces)
1 14 9 8 6
0 15 14 12 11
0 1 2 3
Ice Cream
(scoops)
3. Using the information in question (2) and starting with 1 piece of pie and 1 scoop
of ice cream, will Stephanie
a) swap 1 scoop of ice cream for 1 piece of pie?
b) swap 1 scoop of ice cream for 2 pieces of pie?
c) swap 1 piece of pie for 2 scoops of ice cream?
4. Does the Ranking Principle allow for ties? What does this mean about Stephanies
preferences for pie and ice cream in question (2)?
5. The figure below contains two indifference curves and several options for
consumption bundles for a consumer. Using this information, rank the bundles
from most preferred to least preferred according to this consumers preferences.
B D
4
3
Pie
(pieces)
C E
2
A
1
1 2 3 4
Ice Cream (scoops)
22
6. Suppose that Stephanies preferences for pieces of pie (P) and scoops of ice cream
U
(IC) follow the formula P . Plot three indifference curves for Stephanie when
IC
U 2 , U 4 , and when U 6 on the graph.
3
Pie
(pieces)
2
1 2 3 4
Ice Cream (scoops)
7. Now suppose that Stephanie will only eat pie and ice cream in a 1-to-1 ratio and
gains no additional benefit from any other combination. Draw a few examples of
this indifference curve on the graph. What is this type of preference called?
3
Pie
(pieces)
2
1 2 3 4
Ice Cream (scoops)
23
8. Now suppose that Stephanie is asked about her preferences regarding pie and cake.
She prefers pie and cake equally, but doesnt like to consumer them together. If
pie and cake are perfect substitutes for Stephanie, draw her indifference curves if
she has only 1 serving, 2 servings, or 3 servings of either pie or cake.
3
Pie
(pieces)
2
1 2 3 4
Cake (pieces)
9. Stephanie has brought her daughters Ashleigh and Taylor to the birthday party.
Ashleigh loves cake but hates pie, while Taylor loves pie but hates cake. Draw
Ashleigh and Taylors indifference curves on the graph if both girls each have 2
servings of their choice.
3
Pie
(pieces)
2
1 2 3 4
Cake (pieces)
24
10. Stephanies preferences for pie (P) and ice cream (IC) in a month correspond to
the utility function U ( P, IC) P2 2( IC) . How does Stephanie rank the following
alternatives:
a) 1 piece of pie and 4 scoops of ice cream
b) no pie and 5 scoops of ice cream
c) 4 pieces of pie and no ice cream
d) 2 pieces of pie and 3 scoops of ice cream
11. Given Stephanies utility function in question (10), find a formula for her
indifference curves. What is Stephanies marginal utility of pie? What is
Stephanies marginal utility of ice cream? What is her marginal rate of
substitution for pie with ice cream?
12. Given Stephanies utility function in question (10), plot her indifference curves
for U (P, IC) 5 , U (P, IC) 9 , and U ( P, IC) 10 on the graph below.
3
Pie
(pieces)
2
1 2 3 4
Ice Cream (scoops)
13. Stephanies husband Dave also likes pie and ice cream, but his utility function
takes the form U ( P, IC) P2/ 3 IC1/ 3 . Find a formula for Daves indifference
curves. What is Daves marginal utility of pie? What is Daves marginal utility of
ice cream? What is his marginal rate of substitution for pie with ice cream?
25
14. If Daves utility function is as in question (13) and he currently has 1 piece of pie
and 2 scoops of ice cream, would he be willing to trade his current bundle for 2
pieces of pie and 1 scoop of ice cream? Why or why not?
15. Suppose Stephanie and Dave have preferences according to their utility functions
in questions (10) and (13), respectively. If Stephanie has 4 scoops of ice cream
and Dave has 3 pieces of pie, is there a trade they could make to improve both of
their positions? Explain your answer.
26
Chapter 5
Sample Problems
1. In the Chapter 4 exercises we examined Jimmys preferences regarding rolls of sushi

and numbers of enchiladas. If a roll of sushi is $2.50 and an enchilada is $1.50, which
bundles can Jimmy afford if his income is $7.00? Fill in the table below with the total
cost of each bundle and identify his affordable options. What happens to the number
of affordable options if his income increases to $9.00?
2
Sushi
(rolls)
1
0 1 2 3
Enchiladas
Answer:
3 7.5 9 10.5 12
2 5 6.5 8 9.5
Sushi
(rolls)
1 2.5 4 5.5 7
0 0 1.5 3 4.5
0 1 2 3
Enchiladas
If Jimmys income is $7.00, his affordable options are lightly shaded.
If Jimmys income is $9.00, his affordable options increase to include all of the
lightly shaded options plus the new options which are more darkly shaded.
2. Suppose a sushi roll (S) costs $1.50 and an enchilada (E) costs $2.00, first plot
Jimmys initial budget line on the graph below when his income equals $6.00. Now
suppose the price of sushi rolls doubles to $3.00. Plot Jimmys new budget line and
27
calculate the horizontal intercept, the vertical intercept, and the slope of his budget
line. What happened to the number of affordable options and why?
3
Sushi
(Rolls)
2
1 2 3 4
Enchiladas
Answer:
2
S 2 E
3 3
Sushi
(rolls)
2
4
S 4 E
3
1
1 2 3 4
Enchiladas
2
If the price of sushi doubles to $3.00 the new budget line is S 2 E . His new
3
2
budget line has a slope of , with a horizontal intercept at 3 enchiladas, and a
3
vertical intercept at 2 rolls of sushi. The number of affordable options has decreased
28
due to the increase in the price of rolls of sushi. This increase in the price of sushi has
caused the original budget line to rotate inward from the origin (pivoting at the
intercept for enchiladas).
3. Taking her friends advice before the start of the next semester, Amy decides to
allocate $24 dollars per month of her income for the consumption of coffee and
energy drinks instead of $40 per month. Coffee (C) costs $6 per pound and energy
drinks (E) cost $12 per package. Fractions are allowed since the energy drink
packages can be split and Amy can purchase coffee in uneven increments. If Amys
1 E
marginal rate of substitution is MRSCE , how many pounds of coffee and
C
energy drink packages will she buy?
Answer:
First, derive the equation for the budget line as follows:
PB B PC C Income .
12E 6C 24
C 4 2E. (Budget line)
PC 1
.
PE 2
Now, use the tangency condition to help solve for C:
1 E 1 PC
MRSCE
C 2 PE
C 2 2E
Next, use the previous result along with the equation for the budget line to solve for C
and E:
C 4 2E & C 2 2E
4 2E 2 2E
1
E .
2
Now use E to find C.
29
C 4 2E
1
C 4 2
2
C 3.
If Amys marginal rate of substitutions for coffee with energy drinks
1 E 1
is MRSCE , then she should buy 3 pounds of coffee and package of energy
C 2
drinks.
4. As in question (3), Amy spends money on coffee and energy drinks for the spring
semester. Coffee (C) costs $6 per pound and energy drinks cost $12 per package.
Suppose Amys preferences correspond to the utility function U C, E E 2 3CE .
For that utility function, the marginal utility of coffee is 3E (the amount of coffee)
and the marginal utility of energy drinks is 2E 3C (the number of energy drink
packages). Fractions are still acceptable. Using M $24 , M $36 , and M $54 ,
draw Amys income-consumption curve and her Engel curves for coffee and energy
drinks.
48
36
Coffee
(lbs)
24
12
1 2 3 4
Energy Drinks (packages)
30
48
36
Income
($)
24
12
1 2 3 4
Energy Drinks (packages)
48
36
Income
($)
24
12
1 2 3 4
Coffee (lbs)
Answer:
To plot the Income-consumption curves we first need to find the budget lines. Since
the prices of coffee and energy drinks are constant and the only thing changing is
income it is fairly simple to find the budget lines:
If M $24 : 4 2E C; ( L1 )
If M $36 : 6 2E C; ( L2 )
If M $54 : 9 2E C. ( L3 )
31
Next, we need to find the optimal bundles for each budget line. To do this we use the
MU C 3E 6 PC 4
following equation: 6(2 E 3C ) 36 E C E
MU E 2 E 3C 12 PE 3
Using the previous result you can solve for the optimal bundles at each budget line.
The optimal bundles are as follows:
For L1 : E 1.2, C 1.6 , For L2 : E 1.4, C 2.4 , For L3 : E 2.7, C 3.6.
Now we have all of the information needed to plot the income-consumption curves
and the Engel curves.
6 Income-
Coffee Consumption
(lbs) Curve
4
L3
2
L1 L2
2 4 6 8
Energy Drink (packages)
48
Engel
Curve for
36 Energy
Income Drinks
($)
24
12
1 2 3 4
Energy Drink (packages)
32
48
Engel
Curve for
Coffee
36
Income
($)
24
12
1 2 3 4
Coffee (lbs)
1. In the Chapter 4 exercises we examined Stephanies preferences regarding pieces

of pie and scoops of ice cream. If a piece of pie is $2.00 and a scoop of ice cream
is $1.00, which bundles can Stephanie afford if her income is $4.00? Fill in the
table below with the total cost of each bundle and identify her affordable options.
What happens to the number of affordable options if her income increases to
$6.00?
2
Pie
(pieces)
1
0 1 2 3
Ice Cream
(scoops)
2. Using the information in question (1), plot Stephanies budget lines on the graph
below when her income is $4.00. Calculate the horizontal intercept, the vertical
intercept, and the slope of her budget line. What happens to her budget line if her
33
income increases to $6.00? Again, calculate the horizontal intercept, the vertical
intercept, and the slope of her budget line.
3
Pie
(pieces)
2
1 2 3 4 5
Ice Cream (scoops)
3. Using the information in question (1), first plot Stephanies initial budget line on
the graph below when her income equals $4.00. Now suppose the price of ice
cream doubles to $2.00. Plot Stephanies new budget line and calculate the
horizontal intercept, the vertical intercept, and the slope of her budget line. What
happened to the number of affordable options and why?
3
Pie
(pieces)
2
1 2 3 4
Ice Cream (scoops)
34
4. Using the information in question (1), first plot Stephanies initial budget line on
the graph below when her income equals $4.00. Now suppose that pie goes on
sale for $1. Plot Stephanies new budget line and calculate the horizontal intercept,
the vertical intercept, and the slope of her budget line. What happened to the
number of affordable options and why?
3
Pie
(pieces)
2
1 2 3 4
Ice Cream (scoops)
5. The table below reproduced from the Chapter 4 exercises shows Stephanies
preferences for pie and ice cream. First use your answer for question (1) when her
income is $4.00 to shade in the unaffordable bundles. Next identify which bundle
would maximize Stephanies utility.
3 10 5 2 1
2 12 7 4 3
Pie
(pieces)
1 14 9 8 6
0 15 14 13 11
0 1 2 3
Ice Cream
(scoops)
6. The table below reproduced from the Chapter 4 exercises shows Stephanies
preferences for pie and ice cream. First use your answer for question (1) when her
income is $6.00 to shade in the unaffordable bundles. Next identify which bundle
35
would maximize Stephanies utility. How does this choice compare to your
answer for question (5)?
3 10 5 2 1
2 12 7 4 3
Pie
(pieces)
1 14 9 8 6
0 15 14 13 11
0 1 2 3
Ice Cream
(scoops)
7. Continuing with the example, what would happen if pie was rationed to a
maximum of 2 pieces per person? Using the budget line below when the price of
pie is $2.00, the price of ice cream is $1.00, and Stephanies income is $8.00,
demonstrate the impact of this rationing. Using her preferences given in question
(5), how does pie rationing impact Stephanies decision?
3
Pie
(pieces)
2
2 4 6 8
Ice Cream (scoops)
8. Now suppose that Stephanies preferences are represented by three ranked

indifference curves in the figure below. If pie and ice cream are $2.00 each and
Stephanies income is $8.00, which bundle will she choose? Plot her budget line
and identify which indifference curve achieves this utility-maximizing bundle.
36
4
3
Pie
(pieces)
2
I3
1
I2
I1
1 2 3 4
Ice Cream (scoops)
9. Why is it important that the budget line be tangent to the indifference curve at a
utility-maximizing bundle for interior solutions? Why are boundary solutions
excluded from the tangency condition?
10. Holly teaches second grade and has a budget of $50 per month to spend on candy
and balloons for class parties. Candy (C) costs $5 per pound and balloons cost
$10 per package. Fractions are allowed since the balloon packages can be split
and Holly can purchase candy in uneven increments. If Hollys marginal rate of
B
substitution is MRSCB , how many pounds of candy and balloon packages will
C
she buy?
11. Using the information in question (10), how many pounds of candy and balloon
B
packages will Holly buy if her marginal rate of substitution is MRSCB ?
2C
12. As before, Holly is buying candy and balloons for her class. Her preferences
correspond to the utility function U (C, B) C B . For that utility function, the
marginal benefit of candy is B (the number of balloon packages) and the marginal
benefit of balloons is C (the amount of candy). Fractions are still acceptable. If
37
candy (C) costs $5 per pound and balloons cost $10 per package and Hollys
budget is $50, how many of each good will she buy for her classroom?
13. Using the information in question (12), calculate the utility-maximizing amounts
of candy and balloons if Hollys utility function is U (C, B) 2C CB . For that
utility function, the marginal benefit of candy is MUC 2 B and the marginal
benefit of balloons is MU B C . If candy (C) costs $5 per pound and balloons

cost $10 per package and Hollys budget is $50, how many of each good will she
buy for her classroom?
14. As in question (10), Hollys marginal rate of substitution for candy and balloons
B
is MRSCB . Hollys budget is $50 and the price of candy is $5. Calculate her
C
optimal amounts of candy and balloons when the price of balloons is $5 and when
the price of balloons is $10. Draw her price-consumption curve and her demand
curve for balloons on the graphs below.
6
Candy
(lbs)
4
1 2 3 4
Balloons (packages)
38
12
9
Price of
Balloons
($) 6
2 4 6 8
Balloons (packages)
15. Assume Hollys marginal rate of substitution for candy and balloons is
2 B
MRSCB . Hollys budget is $50 and the price of candy is $5. Calculate her
C
optimal amounts of candy and balloons when the price of balloons is $5 and when
the price of balloons is $10. Draw her price-consumption curve and her demand
curve for balloons on the graphs below.
6
Candy
(lbs)
4
1 2 3 4
Balloons (packages)
39
12
9
Price of
Balloons
($) 6
2 4 6 8
Balloons (packages)
16. As in question (10), Holly spends money on candy and balloons for class parties.
Candy (C) costs $5 per pound and balloons cost $10 per package. Suppose
Hollys preferences correspond to the utility function U (C, B) C B . For that
utility function, the marginal benefit of candy is B (the number of balloon
packages) and the marginal benefit of balloons is C (the amount of candy).
Fractions are still acceptable. Using M $50 , M $75 , and M $100 , draw
Hollys income-consumption curve and her Engel curves for candy and balloons.
16
12
Candy
(lbs)
8
2 4 6 8
Balloons (packages)
40
100
75
Income
($)
50
25
2 4 6 8
Balloons (packages)
100
75
Income
($)
50
25
4 8 12 16
Candy (lbs)
17. As in question (16), Holly spends money on candy and balloons for class parties.
Candy (C) costs $5 per pound and balloons cost $10 per package. Suppose
Hollys preferences correspond to the utility function U (C, B) 2C CB . For that
utility function, the marginal benefit of candy is MUC 2 B and the marginal
benefit of balloons is MU B C . Fractions are still acceptable. Using M $50 ,
M $75 , and M $100 , draw Hollys income-consumption curve and her Engel
curves for candy and balloons.
41
16
12
Candy
(lbs)
8
2 4 6 8
Balloons (packages)
100
75
Income
($)
50
25
2 4 6 8
Balloons (packages)
42
100
75
Income
($)
50
25
4 8 12 16
Candy (lbs)
18. How can the income-consumption curve be used to identify whether a good is
normal or inferior?
43
Chapter 6
Sample Problems
1. Starting a new semester, Amy has budgeted $24 per month to spend of coffee (C) and
energy drinks (E). Coffee costs $6 per pound and energy drinks cost $12 per pack.
Fractions are allowed as energy drink packs may be split and coffee may be
purchased in uneven increments. Amy marginal rate of substitution
1 E
is MRSCE , and the formula for her indifference curve is U C , E E 3CE.
C
Suppose the price of energy drinks falls from $12 to $6. What is the uncompensated
effect of her purchases of coffee and energy drinks? What is the compensated effect?
How much compensation is involved? Decompose the uncompensated price change
into the substitution and income effects.
Answer:
To find the uncompensated effect of Amys purchases of coffee and energy drinks
first use the tangency condition to solve for the E and C using a generic form of a
budget constraint as follows:
M EPE
M PC C PE E M EPE CPC C . (Budget line)
PC PC
Tangency condition:
1 E PC E EPE
MRSCB C.
C PE PC PC
Now use the previous two results to solve for E and C:
M P M 1
E C & E.
2 PC 2 2 PE 2
1
So, with M $24, PC $6, PE $12, she chooses C , E 8, . If the price of
2
energy drinks falls to $6.00 she chooses C , E 5,1.5 .This uncompensated price
1
reduction raises Amys energy drink package purchases from to 1.5 and decreases
2
the amount of coffee she buys from 8 to 5.
44
Next, to find the compensated effect we need to used the tangency condition and find
the relationship between coffee and energy drinks at their new prices.
If M $24, PC $6, PE $6 , the relationship between candy and balloons is:
C 1 E.
Amys best choice with a compensated price change also lies on the indifference
1
curve that passes through the bundle C , E 8, . Using the formula for her
2
U
indifference curve E , the value of U that runs through the
1 3C
1
bundle C , E 8, is 12.5, which implies that Hollys formula for this indifference
2
12.5
curve is: E
1 3C
A bundle can satisfy both the tangency condition formula and the indifference curve
12.5
formula only if: C 1 . Solving for C using the quadratic equation C 3.07 .
C
Using the tangency condition, we get that E 2.07 . So the compensated price effect
1
shifts Holly from the bundle C , E 8, to the bundle C , E 3.07,2.07 .
2
At the new prices, Amy needs $30.42 to buy the bundle C , E 3.07,2.07 . Since
her income is $24, we would have to give Amy $6.84 to compensate for the price cut.
To break up the uncompensated price change into substitution effects and income
effects. Note that the substitution effect is the same as the effect of the compensated
price change. The income effect is what is known as the residual; it shifts Amy from
1
the bundle C , E 8, to the bundle C , E 3.07,2.07 .
2
2. Assume that Amy has a budget of $24 a month to spend on coffee (C) and energy
drinks (E). Coffee cost $6 per pound and energy drinks cost $12 per package. Amys
45
1 E
marginal rate of substitution is MRSCE and the formula for her indifference
C
U
curve is E. After being recommended by her doctor to stop drinking coffee
1 3C
for one month, Amy was left with only energy drinks to keep her up during late night
study sessions and early morning classes. Her friends know how much Amy likes
coffee so they would like to help her through the month. Calculate her compensating
variation.
Answer:
First we must use the budget line and the tangency condition to solve for optimal
values of coffee and energy drinks.
C 4 2E (Budget line)
Tangency condition:
1 E 1 PC
MRSCE C 2 2E
C 2 PE
1
Solving for C and E we get E &C 3
2
Next, use the utility function in its functional form to solve for U with the optimal
bundle:
U U 1
E U 5
1 3C 1 3(3) 2
5
Amys indifference curve formula through this bundle is: E
1 3C
If the Amy is not allowed to have any coffee, then C 0. Therefore, to place Amy on
the same indifference curve, we must pick the value of E for
5
which E . Solving for E, we get E 5. To buy 5 packages of energy drinks
1 3(0)
Amy would need $60.00, so her friends would have to lend her $36.00 to compensate
for not having coffee for one month. This is Amys compensation variation.
46
3. Suppose that Eric is buying coffee and energy drinks for the last month of the
semester. His preferences correspond to the utility function U C , E C 2 E 2 .When

1 1
coffee costs $6 per pound and energy drinks cost $12 per package and Erics budget
is $24, he buys 2 pounds of coffee and 1 package of energy drinks. Find the
compensated demand curve for energy drinks that passes through this point and graph
it.
10
6
Price
($)
4
2 4 6 8
Coffee (pounds)
Answer:
10
6
Price
($)
4
Compensated
Demand Curve
2
2 4 6 8
Coffee (lbs)
47
To find the equation of the compensated demand curve first take the formula for the
tangency condition and set the price of coffee equal to 10:
E PC CP
MRSCE CPC 12 E E C .
C 12 12
Next, rewrite the utility function as follows using the bundle given:
U 2,1 2 1 2. E
2
.
C
Now set the tangency condition formula equal to the indifference curve formula equal
to each other and solve for C:
2 CPC 24
C.
C 12 PC
This is the compensated demand curve.
4. Tom is a college senior that wants to analyze the change in cost of living over the
four years he spent in college. He tracked his purchases and the change in prices of a
bundle consisting of coffee, cereal, and pizza.
2004 2005 2006 2007
Coffee 97 cups at 120 cups at 155 cups at 190 cups at
$1.65 $1.70 $1.70 $1.75
Cereal 45 boxes at 35 boxes at 43 boxes at 50 boxes at
$2.45 $2.60 $2.70 $2.75
Pizza 50 pizzas at 40 pizzas at 35 pizzas at 25 pizzas at
$7.00 $7.50 $7.80 $8.00
a) Using 2004 as the base period, create a Laspeyres price index to determine how Toms
cost of living changed. How did his cost of living change according to this measure?
b) Repeat part (a) first using 2005 as the base period and then using 2006 as the base period.
c) Do the price indexes you found in parts (a) and (b) imply an increase in Toms cost of
living over time? If not, by how much do they differ?
Answer:
a) 2004 (base period)- use 2004 quantity and prices
97 $1.65 45 $2.45 50 $7.00
$160.05 $110.25 $350.00
$620.30
48
2005- use 2004 quantity and 2005 prices
97 $1.70 45 $2.60 50 $7.50
$164.90 $117.00 $375.00
$656.90
97 $1.70 45 $2.70 50 $7.80
$164.90 $121.50 $390.00
$676.40
97 $1.75 45 $2.75 50 $8.00
$169.75 $123.75 $400.00
$693.50
Lasperyres index using 2004 as base year
$620.30
2004: 1
$620.30
$656.90
2005: 1.0590
$620.30
$676.40
2006: 1.0904
$620.30
$693.50
2007: 1.1180
$620.30
b) 2005 Base Period

120 $1.65 35 $2.45 40 $7.00
$198.00 $85.75 $280.00
$563.75
2005 (base period) - use 2005 quantity and 2005 prices
120 $1.70 35 $2.60 40 $7.50
$204.00 $91.00 $300.00
$595.00
49
120 $1.70 35 $2.70 40 $7.80
$204.00 $94.50 $312.00
$610.50
120 $1.75 35 $2.75 40 $8.00
$210.00 $96.25 $320.00
$626.25
$563.75
2004: 0.9475
$595.00
$595.00
2005: 1
$595.00
$610.50
2006: 1.0261
$595.00
$626.25
2007: 1.0525
$595.00
2006 Base Period
155 $1.65 43 $2.45 35 $7.00
$255.75 $105.35 $245.00
$606.10
155 $1.70 43 $2.60 35 $7.50
$263.50 $111.80 $262.50
$637.80
2006 (base period)- use 2006 quantity and 2006 prices
155 $1.70 43 $2.70 35 $7.80
$263.5 $116.10 $273.00
$652.60
155 $1.75 43 $2.75 35 $8.00
$271.25 $118.25 $280.00
$669.50
50
$606.10
2004: 0.9287
$652.60
$637.80
2005: 0.9773
$652.60
$652.60
2006: 1
$652.60
$669.50
2007: 1.0259
$652.60
c) No, the indexes found in (a) and (b) do not imply the same percentage increases in
Toms cost-of-living over time. If 2004 is treated as the base year, then the percentage
change in the cost-of-living from 2004 to 2007 was 11.8%. If 2005 was treated as the
base year, then the percentage change increase was 10.5%. Finally, for base year
2006, the percentage change increase was 9.72%. So between the different base years
they differed by a matter of about 2.8%.
1. What is the difference between the substitution effect of a price change and the
income effect of a price change? How do they relate to an uncompensated price
change?
2. Holly teaches second grade and has a budget of $50 per month to spend on candy
and balloons for class parties. Candy (C) costs $5 per pound and balloons cost
$10 per package. Fractions are allowed since the balloon packages can be split
and Holly can purchase candy in uneven increments. Hollys marginal rate of
B
substitution is MRSCB and the formula for her indifference curve is
C
U (C, B) C B . Suppose the price of balloons falls from $10 to $5. What is the
uncompensated effect of her purchases of candy and balloons? What is the
compensated effect? How much compensation is involved? Decompose the
uncompensated price change into the substitution and income effects.
51
3. Hollys options and budget are as in question (2), except her marginal rate of
2 B
substitution is now MRSCB and the formula for her indifference curve is
C
U (C, B) 2C CB . Suppose the price of balloons falls from $10 to $5. What is
the uncompensated effect of her purchases of candy and balloons? What is the
compensated effect? How much compensation is involved? Decompose the
uncompensated price change into the substitution and income effects.
4. The graph below shows the impact of an increase in the price of good X.
Demonstrate the income effect by drawing the compensated budget line. Identify
the substitution effect by labeling the bundle chosen before the price change, the
bundle chosen after the price change, and the bundle chosen on the compensated
budget line.
Good Y
Good X
5. The graph below shows the impact of a decrease in the price of good Y.
Demonstrate the income effect by drawing the compensated budget line. Identify
the substitution effect by labeling the bundle chosen before the price change, the
bundle chosen after the price change, and the bundle chosen on the compensated
budget line.
52
Good Y
Good X
6. Explain why the income effect is negative for a price increase if a good is normal
and positive for a price increase if a good is inferior.
7. What is a Giffen good and how could a good with these characteristics violate the
Law of Demand?
8. Assume that everything is as in question (2) and Holly has a budget of $50 per
month to spend on candy and balloons for class parties. Candy (C) costs $5 per
pound and balloons cost $10 per package. Hollys marginal rate of substitution
B
is MRSCB and the formula for her indifference curve is U (C, B) C B .
C
When Holly gets to the store she finds that they are out of balloons. Since Holly is
a loyal customer, the store owner would like to know how much it would cost to
make up for this issue. Calculate the compensating variation.
9. Assume that everything is as in question (2) and Holly has a budget of $50 per
month to spend on candy and balloons for class parties. Candy (C) costs $5 per
pound and balloons cost $10 per package. Hollys marginal rate of substitution
2 B
is MRSCB and the formula for her indifference curve is U (C, B) 2C CB .
C
53
When Holly gets to the store she finds that they are out of balloons. Since Holly is
a loyal customer, the store owner would like to know how much it would cost to
make up for this issue. Calculate the compensating variation.
P
10. The formula for Hollys monthly demand curve for pencils is Q 80 .
0.025
Suppose that pencils cost $1.00 each. First graph the demand curve and shade in
the area representing Hollys consumer surplus. Calculate her consumer surplus.
What if the price of pencils falls to $0.50? Calculate the change in consumer
surplus and show this change in surplus on the graph.
1.50
Price
($)
1
0.50
20 40 60 80
0
Quantity of Pencils
11. The formula for Hollys monthly demand curve for bottles of paint is
P
Q 8 . Suppose that bottle of paint cost $6.00 each. First graph the demand
1.25
curve and shade in the area representing Hollys consumer surplus. Calculate her
consumer surplus. What if the price of paint increases to $7? Calculate the change
in consumer surplus and show this change in surplus on the graph.
54
10
6
Price
($)
4
2 4 6 8
Quantity of Paint
12. What is a cost-of-living index? How does the Laspeyres price index possibly
overstate the increase in the cost of living?
13. Explain how an increase in the wage rate could either increase or decrease the
quantity of labor supplied. When would each of these responses be likely to
occur?
14. What is the difference between an uncompensated and a compensated demand

curve? When would they be the same and when would they differ?
correspond to the utility function U (C, B) C B .When candy costs $5 per pound
and balloons cost $10 per package and Hollys budget is $50, she buys 5 pounds
of candy and 2.5 packages of balloons. Find the compensated demand curve for
candy that passes through this point and graph it.
55
10
6
Price
($)
4
2 4 6 8
Candy (lbs)
correspond to the utility function U (C, B) 2C CB .When candy costs $5 per
pound and balloons cost $10 per package and Hollys budget is $50, she buys 7
pounds of candy and 1.5 packages of balloons. Find the compensated demand
curve for candy that passes through this point and graph it.
10
6
Price
($)
4
2 4 6 8
Candy (lbs)
56
Chapter 7
Sample Problems
1. The family of isoquants for a firm hiring interns with a bachelors degree in
Economics and interns with a bachelors in Business Administration appears in the
graph below. What does this graph demonstrate about the substitutability of the inputs
for this firm? Explain.
40
30
Interns with degrees
in Economics
20
10
20 40 60 80 100
Interns with degrees in
Business
Answer:
The graph above shows that for this firm Economics majors are perfect substitutes for
Business majors. The firm is willing to substitute one Economics major for 3 business
majors.
2. Alex and Jessica own a coffee shop close to the local college campus. Their long run
production function is Q F L, K 25L 5 K
4 2
5
the marginal product of labor is
2 4
20K 5
25L 5
MPL 1 and the marginal product of capital is MPK 3 . Calculate the
L5 K 5
marginal rate of technical substitution for labor with capital, MRTSL, K . Does their
technology have increasing, decreasing, or constants returns to scale?
57
Answer:
2
20 K 5
1
2K
L 4
5
MRTS LK
10 L 5
L
3
K 5
Since Alex and Jessicas production function is a Cobb-Douglas production function
of the form A AL K finding whether their technology has increasing, decreasing,
or constant returns to scale becomes a matter of checking the sum of the exponents
and .
45 25 65 1
Therefore Alex and Jessicas technology exhibits increasing returns to scale.
3. Suppose Alex and Jessica close their coffee shop two hours early for one whole week
to train their baristas to make better coffee at a faster rate, so their production of labor
doubles relative to their production of capital. What happens to the shops MRTS? Is
this a factor-neutral technical change? Explain.
Answer:
The MRTS changes in its slope, because labor is more productive relative to capital.
This cannot be a factor-neutral technical change because the MRTS changed due to
the improvement of labor production.
4. Alex and Jessica own two coffee shops that supply coffee to the local university.
Labor is their only variable input. Suppose the marginal product of labor in Shop A is
MPLA 22 LA , where L A is the number of workers allocated to Shop A. The
marginal product of labor of Shop B is MPLB 20 LB , where L B is the number of

laborers assigned to Shop B. Suppose that Alex and Jessica employ a total of 10
workers. What is the best assignment of the 10 workers to the two shops?
Answer:
First, write the MPLB as a function of the number of laborers assigned to Shop A, LA:
MPLB 20 10 LA 10 LA
58
Next, find the level of LA, that equates the MPL in the two shops. This can be done by
setting MPLA MPLB .
22 LA 10 LA L*A 6
So Alex and Jessica should assign 6 workers to Shop A, and the other 4 workers to
Shop B.
1. Giselle owns a specialty lemonade stand called Pucker Up. Her production
options for several amounts of labor appear in the table below. First, identify
which combinations are efficient and which are inefficient. What characteristic
determines whether a production method is inefficient?
Production Units of
Output Efficient?
Method Labor
A 1 48
B 2 124
C 2 112
D 3 205
E 3 216
F 4 312
G 4 295
2. How is a firms efficient production frontier from its production possibilities set?
Why should a firm aim to achieve a point on its efficient production frontier?
3. Giselle can produce her specialty lemonade at Pucker Up daily according to the
production function Q F ( L) 2L3 20L2 30L . How many cups of lemonade
can Giselle produce daily with one worker? What happens when she adds a
second unit of labor? What do your answers show about the marginal product of
labor at low levels of inputs?
59
4. Assume Giselle can produce her specialty lemonade according to the production
function Q F ( L) 3L3 25L2 20L . How many cups of lemonade can Giselle
produce daily with one worker? What happens when she adds a second unit of
labor? What do your answers show about the marginal product of labor at low
levels of inputs?
5. Giselle can produce lemonade at Pucker Up according to the production function

Q F ( L) 2L3 20L2 30L . Graph Giselles production function for up to 5
workers, supposing that the number of workers is finely divisible (meaning
Giselle can hire workers part-time, full-time, etc.) Shade in Giselles production
possibilities set and identify her efficient production frontier.
400
300
Output
(cups/day)
200
100
1 2 3 4 5
Labor, L
6. Given Giselles production function in question (5), where

Q F ( L) 2L3 20L2 30L , what is the maximum amount of labor that Giselle
would choose to hire? Why would she not hire any additional workers beyond this
level?
7. Giselle can produce lemonade at Pucker Up according to the production function

Q F ( L) 3L3 25L2 20L . Graph Giselles production function for up to 5
workers, supposing that the number of workers is finely divisible (meaning
60
Giselle can hire workers part-time, full-time, etc.) Shade in Giselles production
possibilities set and identify her efficient production frontier.
400
300
Output
(cups/day)
200
100
1 2 3 4 5
Labor, L
8. What is an isoquant and why is it that an isoquant must not slope upward?
9. Use Giselles production function [ Q F ( L) 2L3 20L2 30L ] for Pucker Up

to fill in the table below. Calculate the output, the marginal product of labor
( MPL ) and the average product of labor ( APL ) for each level of labor input. What
do you notice about the MPL as the number of workers increases?
Units of MPL APL

Output
Labor
0
61
10. Use Giselles production function [ Q F ( L) 2L3 20L2 30L ] for Pucker Up
to graph the marginal product of labor ( MPL ) and the average product of labor
( APL ) for each level of labor input. How are the marginal product of labor and the
average product of labor related?
100
75
Output
(cups/day)
50
25
1 2 3 4 5 6
Labor, L
11. Suppose that Giselle is making a long run decision and can now vary both the
quantity of labor, L, and her capital, K, which is the number of juicing machines
3 1
she uses at Pucker Up. Her new production function is Q F ( L, K ) 48 L 4 K 4
.
Fill in the table below for a given number of workers and number of juicers.
Using your answers, what can you say about the productivity of labor and capital
at Pucker Up?
Units of Units of
Output
Labor Capital
1 1
1 2
2 1
2 2
2 3
3 2
3 3
62
3 1
12. For Giselles long run production function Q F ( L, K ) 48 L 4 K 4
the marginal
1
4
36 K
product of labor is MPL 1
and the marginal product of capital is
L4
3
36L 4
MPK 3
. Calculate the marginal rate of technical substitution for labor with
4
K
capital, MRTSLK . Would the isoquant exhibit a declining marginal rate of
substitution in this case? Why or why not?
13. The family of isoquants for a firm producing pre-made peanut butter and jelly
sandwiches appears in the graph below. What does this graph demonstrate about
the substitutability of inputs for this firm? Explain.
10
6
Jelly
(oz)
4
2 4 6 8
Peanut Butter (oz)
14. Giselle can produce her specialty lemonade according to the production function
3 1
Q F ( L, K ) 48 L 4 K 4
. Does her technology have increasing, decreasing, or
constant returns to scale? What if instead her production function was
1 1
Q F ( L, K ) 48 L 2 K 4
? Compare your answers. Why are they the same or why
do they differ?
63
15. Now suppose Giselle moves Pucker Up to a new location and increases her
3 1
productivity to Q F ( L, K ) 72 L 4 K 4
. What happened to her marginal rate of
technical substitution after the improvement? What is this type of productivity
improvement called?
64
Chapter 8
Sample Problems
1. Alex and Jessica own a coffee shop near campus. Suppose that their daily production
function for workers, L, and capital K, is Q F L, K 2 L 2 K 2 . The wage rate is

1 3
$100 daily and a unit of capital costs $50 daily. What is Alex and Jessicas least-cost
input combination to make 145 cups of coffee per day? What is their total cost?
Answer:
We know that the MRTSLK for the Cobb-Douglas production
K
function Q F L, K 2L K is MRTS LK , which is a declining MRTS.
L
To locate an interior point combination, set the MRTSLK equal to the input price ratio:
K w
and substitute the values for 1 2 , 3 2 , w $100 , r $50 . Thus,
L r
1 K
2 100 1

K
2 K 6L
3 L 50 3 L
2
When Alex and Jessica use L units of labor and 6L units of capital, output is
Q F L, K 2 L 6 L 2
1 3
2
1 3 3
Q 2L 2 6 2 L 2
Q 2 216 L

Q 12 6 L
145
So to produce 145 cups of coffee per day requires workers (about 5 workers, L
12 6
= 5). Since K 6L , they need 30 units of capital. Their total cost is, $2000 per
day 5100 3050 .
65
2. Using the information given in question (1) derive the cost function C Q ?
Answer:
In problem (1) we found that to produce Q cups of coffee Alex and Jessica need the

amount of labor L that solves the formula: Q 12 6 L and she needs 6 times the
Q Q
amount of capital. Thus, Alex and Jessica need workers and units of capital.
12 6 2 6
The cost of producing Q units is therefore,
Q Q
C Q 100 50
12 6 2 6
C Q
25Q 25Q

3 6 6
C Q
100Q
.
3 6
3. Suppose Alex and Jessica decided to open a new coffee shop to service the local
Q2 3Q 2
business center. Their production costs are C1 at the first shop and C1 at
2 2
the second shop, where Q1 and Q2 are the number of cups of coffee produced daily at
each shop. The corresponding marginal costs are MC1 Q1 and MC2 3Q2 . If Alex
and Jessica want to produce 400 cups of coffee per day efficiently, how many cups
should each shop produce? What is their total cost of production?
Answer:
We know that with a least-cost plan that assigns a positive amount of output to each
shop, marginal cost must be the same at both locations. Thus Alex and Jessica need to
divide production between their two stands so that their marginal costs are equal.
Doing this means choosing Q1 and Q2 so that MC1=MC2. Since total output equals 400
cups of coffee, we know Q2 400 Q1 so we can express MC2 as follows:
MC2 3(400 Q1 )
Next, to find how much each stand will produce, set MC1=MC2:
Q1 3400 Q1
66
Q1 1200 3Q1
4Q1 1200
Q1 300
Q2 400 300
Q2 100
Therefore, Alex and Jessica must produce 300 cups of coffee in shop 1 and 100 cups
in shop 2. Their total cost of production will be:
C Q
3002 31002 $60,000
2 2
Q2
4. Suppose a firm faces the cost function C Q 250 10Q . What is the fixed cost
2
F? What is the variable cost, V Q ? Derive the average cost (AC), the average
variable cost (AVC) and the average fixed cost (AFC).
Answer:
The fixed cost for the firm is $250, since it is the only part of the cost function that
does not depend on Q. The variable cost, V Q , in the function above
Q2
is V Q 100Q , because these are the parts of the cost function that vary with
2
changes in Q.
To find the average cost (AC) use the fact that AC Q

C
. In this firms case it is:
Q
Q2
250 10Q
AC (Q) 2 and simplifying: AC Q 250 10 Q
Q Q 2
To find the AVC and AFC use the following equation:

C VC FC VC FC
AC AVC AFC
Q Q Q Q
67
Q2 Q2
200 10Q 10Q
Now, AC 2 250 2 . Thus, AFC 250 and
Q Q Q Q
Q
AVC 10 .
2
5. Suppose Alex and Jessica decide to make blended ice drinks Q2 as well as
Q1Q2 Q12
coffee Q1 at their shops. Their new cost function is C Q1 , Q2 350 .
4 2
Does Alexs and Jessicas firm exhibit economies of scope at the production
bundle Q1 100, Q2 75 , if the cost functions for two competing firms in the
industry specializing in either coffee or blended ice drinks are
Q12 Q22
C Q1 ,0 100 (Firm 1) and C 0, Q2 175 (Firm 2)?
2 2
Answer:
Economies of scope would occur in this example if Alexs and Jessicas firm
produced both coffee and blended ice drinks more cheaply than the other two firms.
In other words, for the bundle Q1 100, Q2 75 , C Q1 , Q2 C Q1 ,0 C 0, Q2 .
In this example evaluate as follows:
Alexs and Jessicas firm,

100 75 100 2
C 100,75 350 $7225
4 2
For the other two firms,

100 2 75 2
C 100,0 C 0,75 100 175 $8087.50
2 2
Thus Alexs and Jessicas firm produces the bundle Q1 100, Q2 75 more cheaply
than both firm 1 and firm 2 combined, demonstrating economies of scope.
68
1. What characteristic distinguishes a sunk fixed cost from an avoidable fixed cost?
Why is it important to understand the difference?
2. Giselle owns a specialty lemonade stand called Pucker Up. Her short-run
production function is Q F ( L) 4 L . Giselle faces costs of $10 per hour in
wages and sunk costs of $75 to lease her stand. What is her short-run cost
function for producing cups of lemonade?
3. Giselles lemonade stand has a short-run production function is Q F ( L) L2 .

Giselle faces costs of $10 per hour in wages and sunk costs of $75 to lease her
stand. What is her short-run cost function for producing cups of lemonade?
4. Assume Giselle can vary both the quantity of labor, L, and capital, K, which is the
number of juicing machines she uses at Pucker Up. The wage rate is $80 per day
and a unit of capital costs $40 per day. Using the formula wL rK C , derive the
isocost line for a total cost of $1200. What if C $1000 ? What if C $1400 ?
Graph this family of isocost lines.
40
30
Output
(cups/day)
20
10
5 10 15 20 25
Labor, L
69
5. Giselles daily production function for workers, L, and capital, K, is
1 1
Q F ( L, K ) 15 L 2 K 2 . The wage rate is $80 daily and a unit of capital costs
$40 daily. What is Giselles least-cost input combination to make 150 cups of
lemonade per day? What is her total cost?
6. What if Giselles daily production function for workers, L, and capital, K, is

3 1
$40 daily. What is Giselles least-cost input combination to make 130 cups of
lemonade per day? What is her total cost?
7. Using the information given in questions 5 and 6, derive the cost functions
C (Q) for each question.
8. Giselle is considering opening a specialty fruit punch stand called Fruityland. If

she can find a space with at least 1,000 square feet, her daily production is
Q F ( L) 4 L . Additional space will not increase her production capabilities.
If the wage rate is $10 per hour and the space rents for $75 per day, what is her
daily cost function for producing cups of fruit punch? Graph Giselles cost
function below.
200
150
Total Cost
($)
100
50
Output, Q
70
9. Giselle is considering opening a specialty fruit punch stand called Fruityland. If
she can find a space with at least 1,000 square feet, her daily production is
Q F ( L) L2 . Additional space will not increase her production capabilities. If
the wage rate is $10 per hour and the space rents for $75 per day, what is her daily
cost function for producing cups of fruit punch? Graph Giselles cost function
below.
200
150
Total Cost
($)
100
50
Output, Q
10. What does it mean for a firm to produce at its efficient level of production? Does
a firm always have to produce at this level of output?
11. Now Giselle has decided to expand her specialty lemonade at Pucker Up to
multiple locations. Her production costs are C1 4Q12 at the first stand and
C2 2Q22 at the second stand, where Q1 and Q2 are the number of cups of
lemonade produced daily at each stand. The corresponding marginal costs are
MC1 8Q1 and MC2 4Q2 . If Giselle wants to produce 225 cups of lemonade per
day efficiently, how many cups should each stand produce? What is her total cost
of production?
71
12. Again, Giselle has decided to expand her specialty lemonade at Pucker Up to
multiple locations. The production costs are C1 5Q12 at her first stand and
C2 2Q22 at her second stand, where Q1 and Q2 are the number of cups of
lemonade produced daily at each stand. The corresponding marginal costs are
MC1 10Q1 and MC2 4Q2 . If Giselle wants to produce 350 cups of lemonade
per day efficiently, how many cups should each stand produce? What is her total
cost of production?
13. Suppose a firm faces the cost function C 100 8Q 2Q2 . What is the fixed cost,
F? What is the variable cost, V(Q)? Derive the average cost (AC), the average
variable cost (AVC) and the average fixed cost (AFC).
3 1
14. Giselles daily production function at Pucker Up is Q F ( L, K ) 12 L 4 K 4 . The
wage rate is $80 daily and a unit of capital costs $40 daily. Suppose Giselle is
currently using 8 juicing machines (K=8) to produce 130 cups of lemonade daily.
What are Giselles short-run and long-run cost functions?
15. Assume now that Giselles daily production function at Pucker Up is

1 1
$40 daily. Suppose Giselle is currently using 10 juicing machines (K=10) to
produce 150 cups of lemonade daily. What are Giselles short-run and long-run
cost functions?
16. Suppose a firm faces the cost function TC(Q) 250Q 5Q2 . If the firm increases
its output from Q to 2Q, will the firm experience economies of scale,
diseconomies of scale, or constant returns to scale? Explain.
72
Chapter 9
Sample Problems
1. The weekly demand for Lulus leather boots is described by the demand function
Q d DP 150
P
. What price must Lulu charge if she wants to sell 60 pairs of
2
leather boots per week? What is Lulus inverse demand function?
Answer:
To determine the price at which Q d 60 , solve for P such that
P
150 60
2
P $180
We can find the inverse demand function PQ by solving
P
150 Q
2
P 300 2Q
for P, which gives us PQ 300 2Q .
2. When a firm is a price taker, changes in its sales quantity have no effect on the price
P it can change. What does this imply about a price takers marginal revenue and
marginal cost?
Answer:
When a firm is a price taker this implies that the firms marginal revenue curve is
equal to the price, because the firm can only sell at the market price. Because MR =
MC is a firms profit-maximizing quantity and MR = P for a price-taking firm; it
follows that P = MC.
73
3. Lewis owns a company that specializes in boxed wine. The market price for a box of
wine is $8, and Lewis is a price taker in the market. His daily cost of producing boxed
Q2
wine is C Q 4Q
Q
, and his marginal cost is MC 4 . How many boxes
32 16
of wine should Lewis sell each day? What if he has an avoidable fixed cost of $650
per day?
Answer:
Use the quantity rule. Thus, Lewis best positive sales quantity solves the formula
P MC , or
Q
8 4
16
Q
4
16
64 Q
Now we must check the shut-down rule, by calculating the profit from producing 64
boxes of wine daily.

8(64) 4 64 32
2
64
512 384
$128
Lewis should go ahead and produce 64 boxes of wine. If Lewis also has an avoidable
cost of $650 per day his profit at Q = 64 would be $522, and the shut-down rule
would tell Lewis to stop producing boxed wine all together.
74
4. Using the information in (3), what is Lewis supply function if he has no avoidable
cost? What if his avoidable fixed cost is $650 per day?
Answer:
The best positive sales quantity, Q, is found when the price P is set equal to the
marginal cost, so that
Q
P 4
16
Solving for Q, we find that
Q 16P 64
If Lewis has no avoidable fixed cost, AC min $4 .
Q2 Q
C Q 4Q ; AC Q 4 Note, $4 is the minimum because AC(Q) is and
32 32
increasing function. So using the shut-down rule, Lewis supply function is
16P 64 if P 4
S P
0 if P 4
When we add an avoidable fixed cost of $650 per day, this does not change marginal
revenue or marginal cost, but it does change when Lewis wants to stay in business.
We need to determine the new level of ACmin . This is done by setting AC = MC to
determine the new efficient scales of production.
Q 650 Q
MC 4 4 AC
16 Q 32
Solving for Q, we find Q 144.22 . Substituting this quantity into the equation for
650 144.32
average cost shows us that ACmin 4 $13.01
144.22 32
75
So Lewis supply function is now
16P 64 if P 13.01
S P
0 if P 13.01
5. Lewis produces both an award-winning bottle wine, and a boxed wine, and he is a
price taker. His cost function for his bottled wine is
CW QW , QB 20QW QW2 QW QB and his marginal is MCW 20 2QW QB ,
where QW and QB are his output levels of bottled and boxed wine respectively. His cost
function for boxed wine is C B QW , QB 12QB QB2 QB QW and his marginal cost
function is MCB 12 2QB QW . The price of a bottle of award-winning wine, PW ,
is $50; the price of boxed wine, PB , is $15. What are Lewis profit- maximizing sales
quantities?
Answer:
First, start by applying the quantity rule to find the sales quantities for both the award-
winning wine and the boxed wine, where P = MC.
(1) 50 20 2QW QB
and, (2) 15 12 2QB QW
Now with equations (1) and (2) we can solve for QW and QB . This can be done in
several ways but we will proceed as follows:
Rewrite (1) and (2) as (1) 30 2QW QB and (2) 3 2QB QW
Substitute (1) into (2) and solve for QW .
3 2 30 2QW QW
76
63 3QW , 21 QW
Solve for QB : 30 221 QB , QB 12
Lewis profit is: R C
21 50 12 15 20 21 212 2112 12 12 122 2112
$585
Applying the shut down rule, we have to compare this profit not only to Lewis profit
if he would shut-down his operation, but also, his profit if he would shut-down
production of either of his products and only would produce one product.
If Lewis does not produce his award-winning bottled wine so that QW 0 , his cost
function becomes CB QB 12QB QB2 and MC B 12 2QB . The best quantity of
boxed wine is QB 1.5 , which yields $2.25 profit which is less than Lewis makes if
he produces both products.
This was found by setting P = MC:
15 12 2QB , QB 1.5
Lewis profit is,
1.5 15 12 1.5 1.52 , $2.25
If Lewis stops producing the boxed wine so that QB 0 , his cost function
becomes CW QW 20QW QW2 and MCW 20 2QW . Set P = MC:
50 20 2QW
QW 15
Lewis profit is, 15 50 20 15 152 $225
77
Again, this is less than Lewis would make if he produced both boxed wine and his
award-winning bottled wine, so Lewis should produce the profit-maximizing sales
quantities of QW 21 and QB 12 .
1. Megan owns and operates ECON-TS4U which produces popular Economics T-

shirts. Consumer demand for the T-shirts is given by Q 80 2P . What is the
inverse demand function? If Megan plans to sell 40 shirts, what price should she
set? What if Megan wanted to sell 50 shirts?
2. Megan produces popular Economics T-shirts. Consumer demand for the T-shirts
is given by Q 120 3P . What is the inverse demand function? If Megan plans to
sell 60 shirts, what price should she set? What if Megan wanted to sell 75 shirts?
3. Why is the demand curve horizontal for a price-taking firm?
4. Suppose that Megan also produces and sells blank T-shirts on the side. In this
2
market, she is a price taker. Her cost of making shirts is C (Q) 2Q Q 50 and
her marginal cost is MC 2 Q 25 . If the market price of a blank t-shirt is $6,
how many shirts should Megan sell? Calculate Megans profit. What if she has an
avoidable fixed cost of $150?
5. Suppose that Megan is a price taker in the market for blank T-shirts. Her cost of
2
making shirts is C (Q) 3Q Q 60 and her marginal cost is MC 3 Q 30 . If the
market price of a blank t-shirt is $6.60, how many shirts should Megan sell?
Calculate Megans profit. What if she has an avoidable fixed cost of $200?
78
6. If Megan is a price taker in the market for blank t-shirts and her marginal cost
is MC 2 Q , what is her supply function? How would this change if she

25
faced an avoidable fixed cost of $150?
7. If Megan is a price taker in the market for blank t-shirts and her marginal cost
is MC 3 Q , what is her supply function? How would this change if she

30
faced an avoidable fixed cost of $200?
8. If Megans supply function for T-shirts is S ( P) 50P 150 , what is the minimum
price at which Megan will choose to sell a positive number of units? Graph the
supply function below.
6
Total Cost
($)
4
50 100 150 200

Output, Q
9. If Megans supply function for T-shirts is S ( P) 45P 225 , what is the minimum
price at which Megan will choose to sell a positive number of units? Graph the
supply function below.
79
8
6
Total Cost
($)
4
50 100 150 200

Output, Q
10. How does an increase in the price of a major input affect a firms supply
function? How is this effect different from that of an increase in an avoidable
fixed cost? Explain.
2
11. If Megans short-run and long-run cost functions are CSR (Q) 1, 000 Q 2 and
CLR (Q) 150Q then her short-run and long-run marginal cost functions
are MCSR Q and MCLR 150 . What are her short-run and long-run supply
functions?
2
12. If Megans short-run and long-run cost functions are CSR (Q) 2,500 Q 2 and
2
CLR (Q) Q then her short-run and long-run marginal cost functions
100
are MCSR Q and MC LR Q 50 . What are her short-run and long-run supply
functions?
13. Use the information in the graph below to calculate the producer surplus given the
supply function and market price, $6. What if the firm faced a sunk cost of $100?
80
8
6
Price
($)
4
50 100 150 200

Output, Q
14. Assume the supply function for Megans price-taking business

is S ( P) 50P 150 and the market price is $7. First, calculate Megans producer
surplus. What if Megans business required an annual non-refundable, non-
transferable permit fee is $200? Calculate her producer surplus with this sunk cost.
15. Suppose Megan produces T-shirts and hats printed with I ECON and she is a
price taker. Megans cost function for T-shirts is CS (QS , QH ) 4QS QS2 QS QH
with marginal cost MCS 4 2QS QH . Her cost function for hats is
CH (QS , QH ) 2QH QH2 QH QS with marginal cost MCH 2 2QH QS . The
price of a T-shirt is $18 and the price of a hat is $10. What are Megans profit-
maximizing quantities of shirts and hats?
81
Chapter 10
Sample Problems
1. Suppose you won the lottery and have the option of taking your prize in one lump
sum payment of $125 million minus 8% of the lump sum, or by getting payments of
$6.25 million for the next 20 years. Assuming an interest rate of 4%, which option is
the better choice?
Answer:
To calculate which option is your best choice, use the formula for PDV for a constant
stream:
20 year payment option:
F 1
PDV 1
R (1 R)T
6,250,000 1
PDV 1
20
.04 (1 .04)
PDV $115,872,030.80
Lump Sum:
L.Sum 125,000,000 (125,000,000)(.08)
L.Sum $115,000,000
Therefore, the best option is the 20 year payment option.
2. Suppose you are buying a car that costs $18,000. The dealer offers you a payment
plan that consists of a $0 down-payment with annual payments of $3,000 for the next
6 years at a 7% interest rate. Another dealer has offered you the same car for $18,750,
with a payment plan that consists of making a $3,750 down-payment with annual
payments of $3,000 for the next 5 years at a 7% interest rate. Which dealer is offering
the better deal?
Answer:
To figure out which dealer is offering the best deal, calculate the PDV of each offer:
82
For the 1st offer:
3000 3000 3000
PDV 0
(1 .07) (1 .07) 2
(1 1.07) 6
PDV $14,299.62
For the 2nd offer:
4000 4000 4000 4000
PDV 2,750
(1 .07) (1 .07) 2
(1 .07) 3
(1 .07) 4
PDV $16,298.85
So, the first dealer is offering the better deal for the car.
3. Dannys baby nephew Alex is about to celebrate his 1st birthday. He decides that he
wants to insure that Alex has money for college, so he invests money in a college
fund that will belong to Alex on his 18th birthday. How much money would Danny
have to invest today so that there is a balance of $10,000 in Alexs college fund when
he turns 18 years, if the interest rate is 7%?
Answer:
To solve this problem use the formula for present discounted value:
FT
PDV
(1 R)T
The formula is adapted for the fact that Danny will only make a one-time payment in
todays dollars, and 17 years from now Alex will have $10,000 in his college fund.
10,000
PDV
(1 0.07)17
PDV $3,165.74
Danny will need to deposit $3.165.74 today.
4. Over the next 4 years you plan to save money in a savings account so that you can go
on a backpacking trip through Europe when you graduate. You plan to save $350
freshman year, $400 your sophomore year, $450 your junior year, and $500 your
senior year. Your bank gives you an interest rate of 2.5% on your savings. In todays
terms, how much money will you have saved when you graduate?
83
Answer:
To calculate how much in present dollars you will have in your savings account when
you graduate, use the formula for PDV:
F1 F2 FT
PDV F0
1 R 1 R 2
1 R T
350 400 450 500
PDV 0
(1 .025) (1 .025) 2
(1 .025) 3
(1 .025) 4
PDV $1,593.03
In todays terms you will have saved $1,593.03.
5. Craig has the opportunity to invest in one of two possible projects. Project A requires
an initial investment of $5,000 in the first year and will produce a positive net cash
flow of $1,500 a year for the next 5 years. Project B requires an initial investment of
$5,500 in the first year and will produce a positive net cash flow of $2,000 a year for
the next 3 years. Assuming an interest rate of 8%, calculate the net present value
(NPV) of each project. Calculate the payback period. Which project should Craig
choose? How might your answer change if the interest rate increased to 9.5%?
Answer:
To calculate the (NPV) of each project use the formula:
NCF1 NCF2 NCFT
NPV NCF0
(1 R) (1 R) 2
(1 R)T
For project A:
1500 1500 1500 1500 1500
NPV 5000
(1 .08) (1 .08) 2
(1 .08) 3
(1 .08) 4
(1 .08) 5
NPV $989.07
For project B:
2000 2000 2000 2000
NPV 5500
(1 .08) (1 .08) 2
(1 .08) 3
(1 .08) 4
NPV $1124.25
The payback period for project A is greater than 4 years but less than 5 years.
The payback period for project B is greater than 3 years but less than 4 years.
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The payback periods can be found by figuring out at what T value the investment will
recoup the initial investment:
NCF1 NCF2 NCFT
NCF0
(1 R) (1 R) 2
(1 R)T
Therefore, at an interest rate of 8% project B is the better investment because of the
higher NPV and a faster payback period.
If the interest rate was to increase to 9.5%, project B would still be the better
investment with a higher NPV than project A, at $908.96 and $759.56 respectively.
1. When considering saving, borrowing and interest, what is compounding and why
is it important to factor compounding into a saving or borrowing decision?
2. Calculate the present discounted value (PDV) of $1 received in one year with an
interest rate of 5%, 10% and 20%. Plot your findings on the graph below. What is
the relationship between the PDV and the interest rate? Why?
1.00
0.80
PDV of $1
received in 0.60
one year
($)
0.40
0.20
5 10 15 20
Interest Rate, R
3. Calculate the PDV of $100 received in 5 years when the interest rate is 5%, 10%,
and 20%.
85
4. Calculate the PDV of $1 received in one year, 5 years, 10 years, and 20 years if
the interest rate is 5%.
5. Suppose you borrow $1000 today from a friend and agree to the following
payment plan: $200 in one year, $250 in two years, $300 in three years, and $400
in four years. If the interest rate is 5%, how much do you owe in todays dollars?
6. You just bought a new car and have agreed to make payments of $5000 annually
for 6 years starting one year from now. If the interest rate is 7%, how much do
you owe in todays dollars? How does that compare to the unadjusted payment of
$30,000? Explain.
7. Suppose you are offered the following options for your new car purchase. (1) Pay
$25,000 now, (2) Make annual payments of $9,000 for 3 years, or (3) Make
annual payments of $6,000 for 5 years. If the interest rate is 8%, which option
offers the lowest price in current dollars?
8. Calculate the PDV of promised payments for a 10 year bond with a coupon of $50
and a face value of $5,000 at an interest rate of 5%. Repeat this calculation with
an interest rate of 10% and 15%. How would your answers change if the coupon
was reduced to $0?
9. If the nominal interest rate is 6.5 percent and the rate of inflation is 2 percent,
what is the real interest rate? What would happen if the rate of inflation grew to
3.5 percent?
10. If the real interest rate is 4 percent and the inflation rate is 3.5 percent, what is the
nominal interest rate?
86
11. Assume that Brian will earn $1000 this year and nothing next year. Considering
his preferences given by his indifference curve in the graph below, will Brian
choose to save or borrow to maximize his preferences? How do you know?
1100
750
Money
spent next
year 550
($)
250
250 500 750 1000

Money spent this year ($)
12. Using the income and substitution effects, explain how an increase in the interest
rate could either increase or decrease a consumers savings rate.
13. Suppose Brians only expense is food and he plans his consumption for two year
periods. His food consumption this year is F0, his food consumption next year is
F0
F1, and his marginal rate of substitution across years is . Suppose Brian earns
F1
$2,400 this year and nothing next year. If food costs $1 per pound and the interest
rate is 5%, how much will Brian consume this year and how much will he save?
How would your answer change if Brian now earned $2,400 this year and $1,200
next year? Write a formula for his saving as a function of the interest rate.
F0
F1, and his marginal rate of substitution across years is F1
. Suppose Brian earns
87
nothing this year and $2,400 next year. If food costs $1 per pound and the interest
rate is 5%, how much will Brian consume this year and how much will he save?
Write a formula for his saving as a function of the interest rate.
F0
F1, and his marginal rate of substitution across years is . Suppose Brian
2 F1
earns $2,000 this year and $1,000 next year. If food costs $1 per pound and the
interest rate is 5%, how much will Brian consume this year and how much will he
save? Write a formula for his saving as a function of the interest rate.
16. You have the opportunity to invest in one of two possible projects. Project A
requires an initial investment of $15,000 in the first year and will produce a
positive net cash flow of $5,000 a year for the next 4 years. Project B requires an
initial investment of $10,000 in the first year and will produce a positive net cash
flow of $4,350 a year for the next 3 years. Assuming an interest rate of 10%,
calculate the net present value (NPV) of each project. Calculate the payback
period and the internal rate of return. Which project would you choose? How
might your answer change if the interest rate increased to 12%?
88
Chapter 11
Sample Problems
1. Suppose you have a loaded coin that increases the chances of heads appearing from
50% to 75%. Unaware of the existence of your loaded coin, your younger sibling
proposes a bet in which he selects tails. The bet promises $5 to the winner, to be paid
by the loser of the bet. What is your expected payoff? What is your siblings expected
payoff?
Answer:
To find your expected payoff set up the following function:
EP 0.755 (0.25)(0) $3.75
Your siblings expected payoff function is:
EP 0.750 (0.25)(5) $1.25
Your expected payoff is $3.75 and your siblings is $1.25, however, you should tell
him about your unfair advantage.
2. Suppose that Penelope sells pretzels at the local professional basketball stadium. If
the team wins enough games they will go to the playoffs providing Penelope
with PW dollars in profit, if they lose Penelope will have PL dollars. The probability of
the team winning and Penelope receiving PW in profit is , and the probability of
losing and receiving PL is (1 ) , making the expected profit EP , such

that EP PW (1 ) PL . If EP is $250, derive the expected profit line PL (, PW ) .
What is the slope of this line if 2 5 ? What if 3 5 ?
Answer:
To derive the constant expected profit line PL (, PW ) , set up the expected profit
equation with EP = $250, and proceed to solve for PL in terms of and PW .
ES PW (1 ) PL
250 PW (1 ) PL
89
Solving for PL :
250 PW
PL
(1 ) (1 )
If 2 :
5
2 P
250
5
W
PL
(1 ) (1 )
2 2
5 5
PL 150 2 PW
3
The slope of the line is negative two-thirds.
If 3 5 :
3 P
250
5
W
PL
(1 3 ) (1 3 )
5 5
PL 150 3 PW
2
The slope of the line is negative 3/5.
3. Suppose Penelopes indifference curve is given by 4 5 PW 15 PL C . PW 169 ,
and PL 49 . If the probability of a win, PW , is 4 5 , what is Penelopes expected
profit? What is the certainty equivalent of this risky bundle? What is the risk
premium?
Answer:

Penelopes expected profit is 4 5 169 15 49 $145 . To calculate the certainty
equivalent, find the level of guaranteed profit, P, that places Penelope on the same IC
curve as the risky bundle.
4
5
169 15 49 4 5 P 15 P
11.8 P
P $139.24
So the certainty equivalent is $139.24. Since 145 139.24 5.76 , the risk premium is
$5.76.
90
4. Again, Penelope has a 4 chance of earning PW and a 1 chance of PL . His indifference
5 5
curve is given by a formula 4 PW 1 PL C . For these indifference curves, the

5 5
4 PL
marginal rate of substitution is MRSWL . Without insurance, Penelope can
PW
profit $256 if the team wins and $0 if the team loses. She can purchase insurance for a
premium of 50 cents for each dollar of promised benefit. Will Penelope buy
insurance? How much will it cost and what is the value?
Answer:
(1 R)
Penelopes available choices lie on the budget line . In this case R = 0.5, so
R
the slope of the budget line is l. The formula for Penelopes budget line is
thus PL C PW where C is a constant. Penelopes budget line must pass through the
point, ( PW , PL ) (256, 0) , we know that 0 C (256) so C =256.
At any best choice point, the slopes of the budget line and the indifference curve must
be the same. Therefore,
4 PL
1 MRSWL
PW
Using this formula, then solve for PL which gives you, PL .0625PW .
Now we can use both PL 256 PW and PL .0625PW to find Penelopes best choice,
by solving algebraically.
.0625PW 256 PW
256
PW $240.94
1.0625
Penelope profits $240.94 if the team wins. Since Penelope started with $256 he did
buy insurance. She spent $15.06 on insurance. This means that Penelopes insurance
benefit must be $30.12 (since 0.5 15.06 30.12 ). If Penelope gets the low state PL ,
she profits PL 0 30.12 15.06 $15.06 .
91
After purchasing insurance, Penelopes risky bundle is ( PW , PL ) (240.94,15.06) .
Points on the indifference curve that run through this bundle satisfy the
formula 4 PW 1 PL 4 240.94 1 15.06 13.19 . To find a risk-less

5 5 5 5
bundle on this indifference curve (where PW PL ), we solve:
4 P 1 P 13.19
5 5
B 13.19
B 173.98
B = $173.98 is the certainty equivalent of Penelopes risky bundle after purchasing

insurance.
Penelopes initial bundle is ( PW , PL ) (256, 0) . This bundle satisfies the
formula 4 5 PW 15 PL 4 5 256 12.8 . Like before we need to find the risk-
less bundle on this indifference curve, by solving:

4 P 1 P 12.8
5 5
P 12.8
P 163.84
$163.84 represents the certainty equivalent of Penelopes initial risky bundle. The
value of the insurance is $10.14, since 173.98 163.84 10.14 .
5. The Super Bowl is around the corner and Andy is looking to bet on the game. He has
4
5
$1000 and seeks to maximize his expected benefit, X . He can either keep his $1000
or he can invest the $1000 on Team A that has a 25% chance of winning but would
give him a return of $2500, and a 75% chance of losing leaving Andy without money.
Andy can also bet on Team B which has a 75% chance of winning giving Andy a
return of $1500. Betting on Team B has a 25% chance of returning $0 (if Team B
losses). Andy has a final option which consists of betting $600 on Team B and $400
on Team A, which will earn him $900 if Team B wins and $1000 if Team A wins.
Rank Andys options from most profitable to least profitable. Which should he
choose?
92
Answer:
4
If Andy keeps the $1000, he is guaranteed a benefit of 251.19 ( 1000 5
251.19 ), and
a certainty equivalent of $1000. Betting $1000 on Team A will produce an expected
benefit of,
0.252500 5 0.75(0)
4 4
5
130.70
Andys certainty equivalent is the amount X that solves X 5 130.70 , so X

4

=441.92.
If Andy bets $1000 on Team B this will produce an expected benefit of,
0.250 5 0.75(1500)
4 4
5
260.58

4

=1046.95.
If Andy bets $400 on Team A and $600 on Team B this will produce an expected
benefit of:
0.251000 5 0.75(900)
4 4
5
235.96

4

=$924.80. So Andys best option would be to bet $1000 on Team B to win. His
second best option would be the hedging bet of betting on both teams. The least
preferable choice would be to bet $1000 on Team A.
1. Assume that a coin flip is equally likely to land on heads (with probability 0.5) or
tails (with probability 0.5). If the state is heads, you win $1 and if the state is tails,
you lose $1. Calculate your expected payoff of one coin flip. What is your total
expected payoff of flipping the coin 10 times?
93
2. The dreaded check engine light comes on and you take your car to a mechanic.
The mechanic tells you there is a 70% chance that it could be the battery, a 20%
chance its the fuel injection, and a 10% chance that the engine will need to be
replaced. Replacing the battery costs $150, fixing the fuel injection costs $600,
and replacing the entire engine would cost $1,450. What is your expected cost of
repairs? What if this mechanic used a subjective probability and the real
probabilities are 60%, 25%, and 15%, respectively? Now what is the expected
cost of repairs?
3. Suppose that Michael is a gambling man and has placed his bets accordingly. If
Michael wins, hell have BW dollars and if he loses, hell have BL dollars. The
probability of winning and having BW is and the probability of losing and
receiving BL is 1-, making the expected consumption, EC , such
that EC BW (1 ) BL . If the expected consumption is $400, derive the
constant expected consumption line, BL (, BW ) . What is the slope of this line
if 1 2 ? What if 1 3 ?
4. Suppose Michaels indifference curve is given by 3 4 BW 1 4 BL C .
BW 100 and BL 36 . If the probability of a win, BW , is 3 4 , what is Michaels
expected consumption? What is the certainty equivalent of this risky bundle?

What is the risk premium?
5. Again, Michaels indifference curve is given by 3 4 BW 1 4 BL C .
BW 144 and BL 36 . If the probability of a win, BW , is 3 4 , what is Michaels
expected consumption? What is the certainty equivalent of this risky bundle?

What is the risk premium?
94
6. Suppose Michaels preferences can be represented according to the expected
utility function W ( B) B . The probability of Michael winning his bet and
earning BW is 3 and the probability of Michael losing his bet and earning BL is 1 .
4 4
Graph Michaels indifference curve that intersects the point ( BW , BL ) (100,100) .
Graph the constant expected consumption line through (100,100). Would

Michaels risk preferences be described as risk averse, risk neutral, or risk loving?
200
Michael
loses the 150
bet, BL
100
50
50 100 150 200

Michael wins the bet, BW
7. Michaels preferences are now represented according to the expected utility

function W ( B) B . The probability of Michael winning his bet and
earning BW is 3 4 and the probability of Michael losing his bet and earning BL is 1 4 .

95
200
Michael
loses the 150
bet, BL
100
50
50 100 150 200

8. Michaels preferences are now represented according to the expected utility

function W ( B) B2 . The probability of Michael winning his bet and
earning BW is 3 4 and the probability of Michael losing his bet and earning BL is 1 4 .

200
Michael
loses the 150
bet, BL
100
50
50 100 150 200

96
9. The graph below shows the expected utility function for Michael according to his
preferences, U ( BW , BL ) 3 BW 1 BL . The probability of Michael

4 4
winning his bet and earning BW is 3 and the probability of Michael losing his bet
4
and earning BL is 1 . Using the values BW 400 and BL 100 , first identify the
4
benefit from each state. Next, calculate the expected consumption and identify
W ( EC ) on the graph. Finally, illustrate the certainty equivalent and the risk
premium on the graph.
20
15
Benefit, U
10
100 200 300 400

Money, $
10. What does it mean for an insurance policy to be actuarially fair? Why would
someone be willing to purchase insurance that is actuarially fair?
11. Michael has a 3 4 chance of winning BW and a 1 4 chance of winning BL . His
indifference curves are given by the formula 3 4 BW 1 4 BL C . For these
3 BL
indifference curves, the marginal rate of substitution is MRSWL . Without
BW
insurance, Michael can spend $324 if he wins and $64 if he loses. He can
97
purchase insurance for a premium of 40 cents for each dollar of promised benefit.
Will Michael buy insurance? How much will it cost and what is the value?
12. Again, Michael has a 3 chance of winning BW and a 1 chance of winning BL . His
4 4
indifference curves are given by the formula 3 BW 1 BL C . For these

4 4
3 BL
indifference curves, the marginal rate of substitution is MRSWL . Without
BW
insurance, Michael can spend $400 if he wins and $0 if he loses. He can purchase
insurance for a premium of 40 cents for each dollar of promised benefit. Will
Michael buy insurance? How much will it cost and what is the value?
13. What is the difference between hedging and diversification? Briefly explain how
each can be used to mitigate risk.
14. Michael has $400 and seeks to maximize his expected benefit, X . He can either
keep the $400 or he can invest $200 in a company that will double his investment
with probability 0.5, with a 50% chance of failing and paying out $0. Calculate
the certainty equivalent of each option. Which option will Michael choose?
15. Michael has $400 and seeks to maximize his expected benefit, X . He can either
keep the $400 or he can invest the $400 in a company that has a 30% chance of
doubling his money ($800), a 40% chance of returning even money ($400), and a
30% chance of failing and paying out $0. Which option will Michael choose? Is
there a level of investment under $400 that would improve the investment option?
98
Chapter 12
Sample Problems
1. Suppose there are two coffee shops servicing the local university, but they are own by
two separate firms. Both vendors can price either high or low prices. Use the payoff
matrix below to find the Nash equilibrium, if it exists. Explain how you found it. If
you found a Nash equilibrium, was it the best possible outcome for both firms?
FIRM 1
PL PH
150 75
PL
150 395
FIRM 2
395 325
PH
75 325
Answer:
To find the Nash equilibrium we start by looking at one firms best response when the
other firms choice is held constant:
Lets look at Firm 1:

If Firm 2 chooses PH , then Firm 1 will prefer to price low.
If Firm 2 chooses PL , then Firm 1 will prefer to price low.
Lets looks at Firm 2:
If Firm 2 chooses PH , then Firm 1 will prefer to price low.
If Firm 2 chooses PL , then Firm 1 will prefer to price low.
Therefore the Nash equilibrium is for both firms to price low. This outcome is not the
best possible outcome for both firms. They could have done better if both would price
high.
99
2. What is the Winners curse and in which situations is it likely to arise?
Answer:
The winners curse is a phenomenon in certain types of auctions, in which
unsophisticated bidders tend to overpay whenever they win. The winners curse is
likely to arise whenever an item with a commonly perceived value depends on
information that may not be known to all bidders.
3. Danny and Krystin are having a friendly disagreement about what to do for fun
tomorrow. They agree that the best way to solve the dispute is with a game of heads
and tails. Both will each place a coin down facing the side of their choosing
simultaneously and if the coins match (heads-heads, or tails-tails) then Krystin wins
and John pays for a night of ballroom dancing. If the coins come up different (heads-
tails, or tails-heads), then Krystin pays to go to the car show. Use the table below to
indicate the Dannys and Krystins best responses. Is there a Nash equilibrium? Are
any strategies strictly or weakly dominated? Solve for mixed strategies.
Krystin
Heads Tails
-2 10
Heads
5 -5
Danny
10 -2
Tails
-5 5
Answer:
For pure strategies, there are no Nash equilibria, and also, every strategy is strictly
dominated.
For mixed strategies, in equilibrium a player will not choose a dominated strategy as
a best response. In the matrix above every choice can be dominated by the other
players response, therefore Danny and Krystin must randomize their choices. Let Q
represent the probability that Danny selects heads. Let P represent the probability that
100
Krystin selects heads. Dannys expected payoff from selecting heads is
5Q 5(1 Q) , while his expected payoff from selecting tails is 5Q 5(1 Q) .
Since Dannys choice of P has to make Krystin indifferent between selecting heads or
tails (so that shes willing to randomize between the two), we know that
5Q 5(1 Q) 5Q 5(1 Q) , which means that Q 1 2 . Krystins expected payoffs
are similar to Dannys: For selecting heads her expected payoff is 2P 10(1 P) and
for selecting tails her expected payoff is 10P 2(1 P) . Equating the two expected
payoffs we get that P 1 . Therefore, the mixed strategy equilibrium is: Danny
2
selects heads and tails with 50% probability; Krystin selects heads and tails with 50%
probability.
4. Suppose the company Andys Sandwiches is competing with Genevas Foot-longs.

Both companies must decide whether they will price their sandwiches high, medium,
or low. Because Andy is well-established in the area the company makes pricing
decisions before Geneva. Use backward induction on the tree below to find the Nash
equilibrium.
Andys Sandwiches
PL
PM PH
Genevas Foot-longs
PL PH PL PM PH PL PH
PM PM
100 145 250 75 150 80 250 160 200
100 75 50 125 150 160 50 80 200
Answer:
To find the Nash equilibrium using backward induction we must first focus on
Genevas choices holding Andys choices constant. If Andy prices low initially,
Genevas best option is to price low (payoff = 100). If Andy prices medium initially,
Genevas best choice is to price high (payoff = 160). If Andy prices high, Genevas
best choice is to price low (payoff = 250). Now, we can focus on Andys best
decision based on what we know Geneva will do. If Andy prices low, given what we
101
know of Geneva, his payoff will be 100. If Andy prices medium, given what we know
of Geneva, his payoff will be 80. If Andy prices high, given what we know of Geneva,
his payoff will be 50. As a result, the Nash equilibrium is for both Andys
Sandwiches and Genevas Foot-longs to price low.
1. The matrix below describes the game of Chicken. Two players drive their car
down the center of the road towards each other and each must choose whether to
STAY or SWERVE. Staying wins peer approval and a payoff of 4 if the other
player chooses to SWERVE. Swerving makes you look like a chicken (hence the
name of the game) if the other player STAYS, and you lose popularity equal to
payoff -2. However, if both players decide to STAY, then they crash and each
receives -6. If they both SWERVE, then at least they tried, although each receives
-2. Use this information to fill in the matrix.
PLAYER A
STAY SWERVE
STAY
PLAYER B
SWERVE
2. The matrix below describes two firms deciding which price level to set: low price,
middle price, or a high price. If they both set high prices, they each earn $500
million. If they both set middle prices, they each earn $250 million. If they both
set low prices, they each earn $100 million. When the prices diverge, the firms
receive payoffs as following: ( PL , PM ) ($600,$50) , ( PL , PH ) ($800,$0) ,
( PM , PH ) ($300,$200) . Assume the payoffs are symmetric, use this information

to fill in the matrix.
102
FIRM A
PL PM PH
PL
FIRM B PM
PH
3. The matrix below describes a game between two people attempting to maximize
their payoffs. Player A has two possible options: left or right. Player B has two
possible options: up or down. Does either player have a dominant strategy?
Which one(s)? Explain how you know.
PLAYER A
LEFT RIGHT
15 7
UP
12 20
PLAYER B
11 16
DOWN
9 8
4. What does it mean for a dominant strategy to be weakly dominated? How is this
different from a strictly dominated strategy?
5. The matrix below describes a game between two people attempting to maximize
their payoffs. Player A has two possible options: left or right. Player B has two
possible options: up or down. Find the Nash equilibrium or explain why one does
not exist.
103
PLAYER A
LEFT RIGHT
15 7
UP
12 20
PLAYER B
11 16
DOWN 9 8
6. The matrix below describes a game between two firms attempting to maximize
their profits. Each firm must choose whether to set a low price or a high price.
Find the Nash equilibrium or explain why one does not exist. How is this game
similar to a Prisoners Dilemma?
FIRM A
PL PH
150 100
PL
150 400
FIRM B
400 300
PH
100 300
7. Two students, Nina and Margaret, have been paired up to complete a problem set
for their Microeconomics class. They decide to each take half of the problems and
then combine their answers when they turn in the assignment. They do this
simultaneously and neither will know how hard the other has worked until they
receive their score. When Nina works X hours and Margaret works Y hours, they
receive a benefit of 24(2 X 2Y ) ( X Y )2 . The marginal benefit of spending
extra time is 48 2( X Y ) , regardless of who puts in the additional time. The
cost to Nina is 2X 2 , making her marginal cost equal to 4X . The cost to Margaret
is 2Y 2 , making her marginal cost equal to 4Y . What is the Nash equilibrium? Is
there a more preferred outcome for Nina and Margaret?
104
8. Nina and Margaret have been paired up to complete a problem set for class. They
decide to each take half of the problems and then combine their answers when
they turn in the assignment. They do this simultaneously and neither will know
how hard the other has worked until they receive their score. When Nina works X
hours and Margaret works Y hours, they receive a benefit of
18(2 X Y ) ( X Y )2 . The marginal benefit of spending extra time for Nina
is 36 2( X Y ) and the marginal benefit for Margaret is 18 2( X Y ) . The cost
to Nina is 2X 2 , making her marginal cost equal to 4X . The cost to Margaret is Y 2 ,

making her marginal cost equal to 2Y . What is the Nash equilibrium? Is there a
more preferred outcome for Nina and Margaret?
9. What is a mixed strategy equilibrium? In what type of games would this type of
strategy be used?
10. Instead of dividing up the problem set, Nina and Margaret decide to play a game
of odds and evens to make one person complete the entire homework assignment.
In this game, each player holds up either one or two fingers at the same time as
the other player. If the sum of the number of fingers is even, Nina loses and has to
do the entire problem set. If the sum of the number of fingers is odd, Margaret
loses and has to do the problem set. The game and payoffs in terms of an
increase/decrease in utility for each person are shown in the matrix below. Find
all of the Nash equilibria in pure and mixed strategies.
MARGARET
Two
One finger
fingers
10 -2
One finger
-2 10
NINA
Two -2 10
fingers 10 -2
105
11. Again, Nina and Margaret decide to play a game of odds and evens to make one
person complete the entire homework assignment. In this game, each player holds
up either one or two fingers at the same time as the other player. If the sum of the
number of fingers is even, Nina loses and has to do the entire problem set. If the
sum of the number of fingers is odd, Margaret loses and has to do the problem set.
Since Nina would spend more time on the problem set, it is a worse outcome for
her if she loses, although it is a better outcome for Margaret since they get a
higher score. The game and payoffs in terms of an increase/decrease in utility for
each person are shown in the matrix below. Find all of the Nash equilibria in pure
and mixed strategies.
MARGARET
Two
One finger
fingers
10 -2
One finger
-4 8
NINA
Two -2 10
fingers 10 -4
12. The tree below describes a multi-stage game of Chicken, assuming that Player A
can see what Player B is going to do just before they must decide. The two
players drive their cars down the center of the road towards each other and each
must choose whether to STAY or SWERVE. Staying wins peer approval and a
payoff of 4 if the other player chooses to SWERVE. Swerving makes you look
like a chicken (hence the name of the game) if the other player STAYS, and you
lose popularity equal to payoff -2. However, if both players decide to STAY, then
they crash and each receives -6. If they both SWERVE, then at least they tried,
although each receives -2. Solve for the Nash equilibrium using backward
induction.
106
Player A
Stay Swerve
Player B Player B
Swerve
Stay
Stay Swerve
-6 4 -2 1
-6 -2 4 1
13. Centipede is a well-known game where two players have a chance to grab a
dollar. Player 1 moves first and Player 2 moves second. The game begins with
$1 sitting on a table. Player 1 can either take the $1 or wait. If Player 1 takes the
$1 the game is over, and Player 1 gets to keep the dollar. If Player 1 waits, the $1
quadruples to $4. Now it is Player 2s turn. Player 2 can either take the entire $4
or split is evenly with Player 1, $2 each. If Player 2 waits in the second round,
then the money on the table quadruples again and Player 1 can now take it all or
split it evenly, $8 each. Draw the game tree and solve for the equilibrium using
backward induction. Would allowing additional rounds change the equilibrium
outcome? Why or why not?
14. What is a grim strategy in multiple stage games? Could a grim strategy be used in
the game of Chicken described in question #12? Why or why not?
15. The matrix below describes a game between two firms attempting to maximize
their profits. Each firm must choose whether to set a low price or a high price.
Given the rules and payoffs, first solve for the Nash equilibrium. Could a grim
strategy be devised to help foster cooperation between the two firms? What is the
goal and how could it be accomplished?
107
FIRM A
PL PH
50 80
PL
50 375
FIRM B
375 300
PH
80 300
108
Chapter 13
Sample Problems
1. What is Neuroeconomics? How could the study of the neural process help with
economic modeling?
Answer:
Neuroeconomics is a new field that that studies the human neural system, with the
purpose of discovering new principles of economic decision making.
Neuroeconomics research studying the issue of self-control has identified a likely
source of dynamic inconsistency. Dynamic inconsistency is something that standard
economic theory has not accounted for traditionally, so knowing the source of this
phenomenon would undoubtedly help make economic models involving a consumers
choices (for example) more realistic.
2. What is the trust game and why is it important to research in the field?
Answer:
A trust game involves two players, in which one player (the trustor) who starts out
with a fixed amount of money, which he can keep or invest. The second player (the
trustee) divides up the principal and earnings. The trust game has real-world
applications to situations where legally binding contracts dont work well. The trust
game helps economists understand one reason why this approach works.
3. What is the voluntary contribution game and what is the possible shortcoming of
game theory that it highlights?
Answer:
The voluntary contribution game is a multi-player game in which each member has a
choice whether or not to contribute to a common pool. Each players contribution
benefits everyone, but the contributors cost exceeds the players individual return.
Results from two-stage voluntary contribution games have shown that despite the
game theoretic best response being zero contribution, the contribution rate in
experiments continued to increase throughout rounds. Game theory assumes that
109
players care only about their own monetary rewards, but in fact players may also care
about other issues, like fairness.
4. What is the sunk cost fallacy and how might this apply to why people buy expensive
exercise equipment that they wont use but are unwilling to throw it away?
Answer:
The sunk cost fallacy refers to the belief that, if you paid more for something, it must
be more valuable to you. When people are reluctant to throw away expensive exercise
equipment, this is an example of how people fall for the sunk cost fallacy. Some
exercise equipment is so expensive that people find it hard to throw it away because
the high price paid to acquire it is tied to the worth of the object, despite the fact that
they will probably never use it.
5. Adriana evaluates her risky options based on prospect theory according to the
following equation: [W ( P) V ( X1 )] [W (1 P) V ( X 2 )] where X 1 and X 2 are the
potential payoffs associated with the probabilities P and 1 P , respectively. For
positive values of X, her valuation function is V ( X ) 4500 X 1 4 X 2 . For negative
values of X, her valuation function is V ( X ) 850 X X 2 . Adrianas probability

weighting function is W ( P) 0.001 0.995P . Would Adriana take an investment that
pays $1000 with probability P 0.72 and -$1000 with probability P 0.28 ?
Answer:
We need to solve for the expected valuation of each risky prospect using expressions
for positive and negative values of X. If X = 1000, then
V (1000) 4500(1000) 1 (1000) 2 4,250,000 . The weight attached

4
to V (1000) is W (0.72) 0.001 0.995(0.72) 0.7174 , while the weight attached
to V (1000) 850(1000) (1000) 2 150,000 is

W (0.28) 0.001 0.995(0.28) 0.2796 .The value of this option
is [0.7174 4,250,000] [0.2796 150,000] 3,007,010 .
Adriana will take part in the investment in question because it offers a positive payoff.
110
1. Briefly explain how experiments can be used to gain additional insight into
human behavior beyond the standard economic theories.
2. What are two advantages and two disadvantages with economic experiments?
What are two methods used to overcome the disadvantages of laboratory
experiments?
3. Suppose that you are offered the following options: $100 with certainty or a
gamble with a 1 in 10 chance of winning $900 and a 9 in 10 chance of winning $0.
Being a college student, you decide to go with the guaranteed cash and take the
$100. However, when asked to state a dollar amount that is just as good as the
gamble, you answer $150. How does this violate standard economic theory? Why
might this still be considered rational behavior?
4. Briefly explain the concept of anchoring. How might choosing lottery numbers
based on birthdates, anniversaries, etc. fall under this category?
5. Suppose your professor has offered three options for the final exam: a take-home
exam, an in-class exam, or a term paper. The professor wants to allow students to
choose the option that maximizes their skills, but the professor would also prefer
for most students choose the in-class exam because it is the easiest to grade. How
could this professor use their knowledge of the default effect to direct students
towards the in-class exam? How do you know this would likely be effective?
6. What is the endowment effect and how does it demonstrate a bias towards the
status quo?
7. Suppose that Jason is shopping for a new television and DVD player. The store
closest to Jason has the television for $3,500 and the DVD player for $300. Now
consider two different scenarios. In the first scenario, the salesman tells Jason that
111
the television is on sale for $3,350 at a store 10 miles away. In the second
scenario, the salesman tells Jason that the DVD player is on sale for $150 at a
store 10 miles away. Using the concept of narrow framing, explain why Jason
would be more likely to take advantage of the sale in the second scenario and why.
8. What is one possible solution for people who are dynamically inconsistent? Apply
this solution to the case of someone who is trying to quit smoking.
9. Every week, Brian has to give his cat Vincent a bath. Its a frustrating task and on
the day he does it, his utility is reduced by 6. However, having Vincent nice and
clean increases Brians utility on the following day. If he bathes Vincent on
Monday, his payoff is 16; if he does it Tuesday, his payoff is 13; if he does it
Wednesday, his payoff is 10; if he does it Thursday, his payoff is 7; and if he does
it Friday, his payoff is 4. Each day he attempts to maximize his utility according
to the utility function 2PN PF , where PN is his payoff on that day and PF is the
sum of his payoff on future days. As of Sunday, what day would Brian pick to
wash Vincent? Will he actually choose to wash Vincent on that day? Why or why
not?
10. Every week, Brian has to scoop his cats litter box. Its an unpleasant task and on
the day he does it, his utility is reduced by 2. However, a clean litter box is much
nicer than a dirty one and this increases Brians utility on the following day. If he
scoops the box on Monday, his payoff is 10; if he does it Tuesday, his payoff is 8;
if he does it Wednesday, his payoff is 6; if he does it Thursday, his payoff is 4;
and if he does it Friday, his payoff is 2. Each day he attempts to maximize his
utility according to the utility function 2PN PF , where PN is his payoff on that
day and PF is the sum of his payoff on future days. As of Sunday, what day would
Brian pick to scoop the litter box? Will he actually choose to scoop it on that day?
Why or why not?
112
11. Again, every week Brian has to scoop his cats litter box. Its an unpleasant task
and on the day he does it, his utility is reduced by 2. However, a clean litter box is
much nicer than a dirty one and this increases Brians utility on the following day.
If he scoops the box on Monday, his payoff is 10; if he does it Tuesday, his payoff
is 8; if he does it Wednesday, his payoff is 6; if he does it Thursday, his payoff is
4; and if he does it Friday, his payoff is 2. Each day he attempts to maximize his
utility according to the utility function 3PN 2PF , where PN is his payoff on that
day and PF is the sum of his payoff on future days. As of Sunday, what day would
Brian pick to scoop the litter box? Will he actually choose to scoop it on that day?
Why or why not?
12. Use the concept of a projection bias to explain why people tend to wish theyd
had even just 5 more minutes with a loved one after they pass away.
13. Suppose Jason takes a trip to Las Vegas and begins his weekend playing roulette.
In this game, he bets either red or black. Assume that red and black are equally
likely to hit, so the ball will land on a red number 50% of the time and a black
number 50% of the time. Jason comes across a table that has hit 10 red numbers
in a row. If he believes in a gamblers fallacy, will he bet on red or black next?
What will he bet if he believes in the hot-handed fallacy? Is one bet better than the
other?
14. Brian evaluates his risky options based on prospect theory according to the

positive values of X, his valuation function is V ( X ) 20 X X 2 and for negative
values of X, his valuation function is V ( X ) 25 X X 2 . Brians probability

weighting function is W ( P) 0.001 0.998P . Would Brian take part in a gamble
that pays $10 with probability P 0.5 and -$10 probability P 0.5 ? Would he
accept a gamble that pays $100 and -$100 with equal probability?
113
15. Brian evaluates his risky options based on prospect theory according to the

positive values of X, his valuation function is V ( X ) 40 X X 2 and for negative
values of X, his valuation function is V ( X ) 25 X 2 X 2 . Brians probability

weighting function is W ( P) 0.001 0.998P . Would Brian take part in a gamble
that pays $10 with probability P 0.5 and -$10 probability P 0.5 ? Would he
accept a gamble that pays $100 and -$100 with equal probability?
16. What is the difference between the dictator game and the ultimatum game? How
do these games allow for emotional behavior?
114
Chapter 14
Sample Problems
1. Daphnes demand for breakfast burritos is QDaphne

d
18 3P below $6, and zero at
prices above $6. Joaquins demand function is QJoaquin

d
24 6P at prices below $4,
and zero at prices above $4. What is the market demand function?
Answer:
At prices below the $4 the market demand is
Q d QDaphne
d
QJoaquin
d
(18 3P) (24 6P) 42 9P . For prices between $4 and
$6, only Daphne purchases breakfast burritos, so the market demand function
is QMd 18 3P . At prices above $6, neither Joaquin nor Daphne will buy burritos.
0 if P $6

Q 18 3P if 4 P 6
d
42 9 P if P 4

2. What are the three properties of long-run competitive equilibrium with free entry, and
why is it that a firm earning zero economic profit is not necessarily doing poorly?
Answer:
The three properties of long-run competitive equilibrium in a market with free entry
are: the equilibrium price must be equal to the AC min , firms earn zero profit, and each
active firm produce at its efficient scale of production.
When we take economic costs into account we are including all opportunity costs into
account. So, when a firm is making zero economic profit the owner(s) of the firm are
being fully compensated for their all of their costs (explicit and implicit), which
means that the firm cannot make more money doing anything else.
3. The market demand function for desk lamps is Q d 36 4P and the market supply
function is Q S 3P 18 , with both quantities are measured in millions of lamps per

year. What are the aggregate surplus, consumer surplus, and producer surplus at the
115
competitive market equilibrium? What would be the deadweight loss if the desk lamp
suppliers only produced 4.5 million lamps?
Answer:
First, we must find the market equilibrium. This is done by rearranging both supply
and demand function in terms of Q rather than P. Then it is just a matter of equating
the two functions and solving for Q.
d S
( Q d 36 4P P 9 Q and Q S 3P 18 P Q 6 ).
4 3
9Q Q 6
4 3
3 7Q
12
Q 5.14 million
If Q = 5.14, then P 9 5.14 4 $7.72 .
Now, to find the consumer surplus take the area above the horizontal line at P = $7.72
d
but below P 9 Q ,
4
CS 1 (9 7.72)(5.14) 3.29
2
To find the producers surplus take the area below the horizontal line at P = $7.72 but
S
above P Q 3 6 ,
PS 1 (7.72 6)(5.14) 4.42

2
Aggregate surplus equals the sum of consumer surplus and producer surplus. Thus,
AS 4.42 3.29 7.71
If the producers in this market were to produce only 4.5 million lamps, then the
deadweight loss would be the area between the quantities 4.5 and 5.14 and
S d
above P Q 3 6 but below P 9 Q 4 . Also we need to find P for both
116
S d
functions when Q = 4.5 ( P Q 6 P 4.5 6 7.5 and P 9 Q
3 3 4
P 9 4.5 7.88 ). Thus,

4
DWL 1 (7.88 7.5)(5.14 4.5) 0.1216

2
$0.1216 million is the deadweight loss if the producers in this market only produce
4.5 million desk lamps per year.
4. Daphne and Joaquin both love burritos. Daphnes demand for burritos is
d
QDaphne 18 3P and Joaquins demand for burritos is QJoaquin
d
24 6P . What is
Daphnes willingness to pay for 6 burritos? What is Joaquins willingness to pay for
10 burritos?
Answer:
To find Daphnes willingness to pay for 6 burritos, find the vertical intercept and
evaluate at Q = 6. If Q = 6, then 6 18 3P P 4 . The P-intercept is 18. Her
willingness to pay is the area under the line from the vertical-intercept to where P = 4.
WTPDaphne (6 4) 1 ((18 4)(6)) $66

2
If Q = 10, then 6 24 6P P 3 . Joaquins willingness to pay for 6 burritos is:
WTPJoaquin (6 4) 1 ((18 3)(6)) $69

2
1. What are the three main characteristics of a perfectly competitive market? How
does the presence of these three factors lead to price taking behavior by firms?
2. Marie and Jerry both enjoy pizza. Maries demand for pizza slices is
QMd 7 P and Jerrys demand for pizza slices is QJd 12 2 P . Assuming they
are the only people in this market, what is the market demand function? Graph the
market demand curve below.
117
8
6
Price
($)
4
5 10 15 20
Quantity, Q
QMd 10 2 P and Jerrys demand for pizza slices is QJd 18 3P . Assuming they
are the only people in this market, what is the market demand function? Graph the
market demand curve below.
6
Price
($)
4
10 20 30 40
Quantity, Q
4. The supply function for a perfectly competitive firm making slices of pizza
is Q S 40 P 20 . Assuming there are three firms in this market, what is the
market supply curve? Graph it below.
118
8
6
Price
($)
4
100 200 300 400

Quantity, Q
2
5. Suppose that a pizza firms long run variable costs are VC 2Q Q . The
40
marginal cost is thus MC 2 Q 20 . Assume the firm faces an avoidable fixed
cost of $45 per day and there is free entry into the market in the long run. What is
the long-run market supply curve?
2
6. Suppose that a pizza firms long run variable costs are VC 3Q Q 32 . The
marginal cost is thus MC 3 Q 16 . Assume the firm faces an avoidable fixed
cost of $25 per day and there is free entry into the market in the long run. What is
the long-run market supply curve?
7. Assume the daily market demand for pizza slices is Q d 650 100 P , where P is
the price for one slice of pizza. The daily costs for a firm making pizza slices are
2
variable cost VC 2Q Q 40 and an avoidable fixed cost of $45. The firms
marginal cost is MC 2 Q 20 . Suppose that there is free entry in the long run.
What are the long-run market equilibrium price and quantity? How many firms
are in this market and how many slices of pizza does each firm produce?
119
8. Assume the daily market demand for pizza slices is Q d 495 60 P , where P is
the price for one slice of pizza. The daily costs for a firm making pizza slices are
2
variable cost VC 3Q Q and an avoidable fixed cost of $25. The firms
32
marginal cost is MC 3 Q . Suppose that there is free entry in the long run.
16
What are the long-run market equilibrium price and quantity? How many firms
are in this market and how many slices of pizza does each firm produce? If the
market demand increases to Q d 990 120 P , what is the new short-run
equilibrium?
9. Suppose there is a competitive market with free entry. If demand doubles will the
long-run price always remain the same? Why or why not?
QMd 7 P and Jerrys demand for pizza slices is QJd 12 2 P . What is Maries
willingness to pay for 4 slices? What is Jerrys willingness to pay for 4 slices?
11. The supply function for a perfectly competitive firm making slices of pizza
is Q S 40 P 20 . Calculate the firms avoidable cost of making 180 slices. What
is the avoidable cost of making 220 slices?
12. What is deadweight loss and when does it arise?
13. The market demand function for down blankets is Q d 200 P and the market
supply function is Q S 2 P 100 . Calculate the consumer surplus, producer
surplus and aggregate surplus at the competitive market equilibrium.
120
14. The market demand function for pizza slices is Q d 28 5P and the market
supply function is Q S 10 P 2 . Calculate the consumer surplus, producer surplus
and aggregate surplus at the competitive market equilibrium.
15. The market demand function for refrigerator magnets is Q d 13 3P and the
market supply function is Q S 7 P 2 . Calculate the consumer surplus, producer
surplus and aggregate surplus at the competitive market equilibrium.
121
Chapter 15
Sample Problems
1. In a perfectly competitive market, how is the burden of a tax shared and what
determines the incidence of tax?
Answer:
In a perfectly competitive market, the burden of a tax is shared by consumers and
firms. The incidence of the tax is dependent on the elasticities of both the demand and
supply curves.
2. The market demand function for beach cruiser bicycles is Q d 420 3P and the
market supply function is Q S 2P 30 . Suppose that the government imposes a $12

tax on each cruiser sold. What will be the effects on aggregate surplus, consumer
surplus, and producer surplus? What is the deadweight loss caused by the tax?
Answer:
First find the equilibrium price without taxes, by equating supply and demand.
420 3P 2 P 30
5P 450
P 90 Q 150
Consumer surplus is: CS 0.5( 140-90)(150-0)=3750. Producer surplus
is: PS 0.5(90 15)(150 0) 5625 . Aggregate surplus is thus equal to $9375.
Now to find the new equilibrium with taxes, we need to find the new market supply
function after taxes.
Q S 2( Pb 12) 30
Q S 2 Pb 24 30
Q S 2 Pb 54
where Pb is the price paid by consumers. As before, the equilibrium level of Pb is
found by equating supply and demand:
2 Pb 54 420 3Pb
Pb 94.8
122
This means that sellers receive PS = $82.8 (or 94.8-12). So buyers pay $4.8 more and
sellers receive $7.20. Substituting $94.8 into the market demand function tells us that
135.6 bicycles are bought and sold with the tax.
The consumer surplus after the tax is:
CS 1 (140 94.8)(135.6) 3064.56

2
The producer surplus after the tax is:
PS 1 (82.8 15)(135.6) 4596.84

2
Thus, aggregate surplus is 7661.4.
The deadweight loss caused by the tax is calculated as follows:
DWL 1 (150 135.6)(94.8 82.8) 86.4

2
3. Suppose the government is trying to balance its budget, but needs to raise taxes so
that they can cover the amount they have allocated on infrastructure expenditures.
The government has decided to tax both gasoline and diary milk, but legislators are
uncertain which to tax more heavily. The government is also concerned about
minimizing the deadweight loss to producers and consumers. If the elasticity of
demand for gasoline is -4.5, and the elasticity of demand for diary milk is -3.2 which
product should the government tax more heavily?
Answer:
If the government in question was trying to minimize the deadweight loss of taxation,
it would want to tax goods that have more inelastic demands and supplies. In this case,
the demand for gasoline is much more inelastic than the demand for diary milk, so it
follows that this government should tax gasoline much more heavily than diary milk.
4. In what situation would it be beneficial, in terms of aggregate surplus, to impose a

trade barrier on an importing supplier? Explain why.
Answer:
A trade barrier can sometimes increase a domestic countrys aggregate surplus if the
supply curve of the importing supplier is upward sloping. For instance, if this was the
123
case, then imposing a tariff on an importing supplier would have the same effect as
taxing a domestic producer. The difference in this situation is that the domestic
government will not concern itself with the loss of surplus of a foreign producer. This
can sometimes produce a domestic benefit that exceeds the deadweight loss created
by a trade barrier.
1. For each of the following, state whether the tax is a specific tax or an ad valorem
tax: (1) an 18 cent tax on each gallon of gas, (2) a 7.56 percent payroll tax, (3) an
8.25 percent sales tax, and (4) a $1.25 tax on cigarettes.
2. For each of the following sets of elasticities [ E S , E D ] state which group, either
consumers or producers, will bear the greater burden of a small tax: (1) [5, 1.2],
(2) [2, 0.2], (3) [0.8, 1], (4) [1, 1.4], (5) [1.3, 1.3].
supply function is Q S 2 P 100 . Suppose the government imposes a $15 tax on

the sellers of each down blanket. Calculate the consumer surplus, producer
surplus and aggregate surplus at the competitive market equilibrium for before
and after the tax. What is the deadweight loss of the tax?
supply function is Q S 10 P 2 . Suppose the government imposes a $0.30 tax on

the sellers of each pizza slice. Calculate the consumer surplus, producer surplus
and aggregate surplus at the competitive market equilibrium for before and after
the tax. What is the deadweight loss of the tax?
124
market supply function is Q S 7 P 2 . Suppose the government imposes a $0.50
tax on the sellers of each refrigerator magnet. Calculate the consumer surplus,
producer surplus and aggregate surplus at the competitive market equilibrium for
before and after the tax. What is the deadweight loss of the tax?
6. Which of the following sets of elasticities [ E S , E D ] would result in the largest

deadweight loss: (1) [5, 1.2], (2) [2, 0.2], (3) [0.8, 1], (4) [1, 1.4]? Briefly explain
why.
supply function is Q S 10 P 2 . Suppose the government grants an 18 cent
subsidy for the sellers of each pizza slice. Calculate the consumer surplus,
producer surplus and aggregate surplus at the competitive market equilibrium for
before and after the subsidy. What is the deadweight loss of the subsidy?
supply function is Q S 10 P 2 . Suppose the government wants to raise the price
of a slice of pizza to $3.00 and is debating between a price floor, a price support
program, a quota, and a voluntary production reduction program. They hire an
economist (you!) to describe what each action would entail. Briefly explain how
each program would work for this market and calculate the resulting deadweight
loss.
9. The market demand function for pizza slices is Q d 200 P and the market
supply function is Q S 2 P 100 . Suppose the government wants to raise the
price of a down blanket to $120 and is debating between a price floor, a price
support program, a quota, and a voluntary production reduction program. They
hire an economist to describe what each action would entail. Briefly explain how
125
each program would work for this market and calculate the resulting deadweight
loss.
market supply function is Q S 7 P 2 . Suppose the government wants to raise the

price of a refrigerator magnet to $2.00 and is debating between a price floor, a
price support program, a quota, and a voluntary production reduction program.
They hire an economist to describe what each action would entail. Briefly explain
how each program would work for this market and calculate the resulting
deadweight loss.
supply function is Q S 2 P 100 . Suppose the government wants to lower the

price of a down blanket to $85. Explain how a price ceiling would achieve this
goal. Graph the market and price ceiling below and calculate the resulting
deadweight loss.
200
150
Price
($)
100
50
50 100 150 200

Quantity, Q
126
12. Suppose the United States is contemplating restricting the amount of sugar cane
imported into the country. Explain how they could do this using a tariff or a quota.
How would each action affect domestic surplus?
13. Assume the market demand function for a good is Q d 28 5P and the domestic
supply function is Q S 10 P 2 . Suppose the good is also imported and the import
supply curve is infinitely elastic at a price of $1.00. How would an import tariff of
50 cents impact social welfare?
14. Assume the market demand function for a good is Q d 200 P and the domestic
supply function is Q S 2 P 100 . Suppose the good is also imported and the
import supply curve is infinitely elastic at a price of $75. How would an import
tariff of $15 impact social welfare?
15. Assume the market demand function for a good is Q d 13 3P and the domestic
supply function is Q S 7 P 2 . Suppose the good is also imported and the import
supply curve is infinitely elastic at a price of $1.00. How would an import tariff of
25 cents impact social welfare?
127
Chapter 16
Sample Problems
1. What is a lump sum transfer and how are they different from other taxes and
transfers?
Answer:
With a lump-sum transfer, a consumer receives or surrenders a fixed amount of
resources; it does not depend on the consumers choices. Lump-sum transfers differ
from other taxes and transfers in that they dont compromise efficiency because they
dont distort choices.
2. Suppose the following formulas describe the supply and demand for coffee
(where Q Cd is in millions of pounds demanded and Q CS stands for millions of pounds
supplied), PC stands for the price of coffee, and PD stands for the price of doughnuts.
QCd 71 6 PC 4 PD
QCS 6 PC 1
Also suppose the following formulas describe the supply and demand for doughnuts
(where Q Dd is in millions of doughnuts demanded and Q DS stands for millions of
doughnuts supplied), PC stands for the price of 16oz coffee, and PD stands for the
price of a dozen doughnuts.
Q Dd 69 5 PD 6 PC
Q DS 4 PD 12
Solve algebraically for the general equilibrium effects. Also solve for the general
equilibrium effect if there is a $1.50 sales tax on coffee.
Answer:
First we must find the market clearing formulas for both coffee and doughnuts. This
is done by equating supply and demand in each market.
Coffee:
71 6 PC 4 PD 6 PC 1
PD
PC 6 (market-clearing function for coffee)
3
128
Doughnuts:
69 5PD 6 PC 4 PD 12
2 PC
PD 9 (market-clearing function for doughnuts)
3
Next, we must solve for the prices that satisfy both market-clearing formulas at the
same time. This is done by substituting one into the other, like so:
PC 6 1 9 C
2P
3 3
PC 27 $3.85
7
The price of doughnuts is therefore,
PD 9 2(3.85) $6.43
3
Plugging these values into either the supply or demand function, we find that in the
general equilibrium, consumers buy 22.1 million cups of 16oz coffee, and 13.7
million boxes of a dozen doughnuts.
If the government imposes a $1.50 tax per cup of 16oz coffee, this changes the supply
function for coffee to:
PC 6( P 1.50) 1 6P 10
Once again equate demand and supply in the coffee market to find:
71 6 PC 4 PD 6 PC 10
2 PD
PC 6.75 (market-clearing function for coffee)
5
We can now proceed as before, substituting P H into PP:
PC 6.75 2 9 C
2P
5 3
PC $3.63
The price for doughnuts is thus:
PD 9 2(3.63) $6.58
3
general equilibrium, consumers buy 11.8 million cups of 16oz coffee, and 14.3
million boxes of a dozen doughnuts.
129
3. What is output efficiency? What does the output efficiency condition say and when
does it apply?
Answer:
Output efficiency means that for allocations that satisfy exchange and input efficiency,
it is not possible to make one consumer better off without harming anyone else by
shifting production from one good to another.
The output efficiency condition states that an allocation satisfies the condition if, for
every set of goods, every consumers marginal rate of substitution equals the
marginal rate of transformation.
4. What does exchange economy require to be efficient? Why are some allocations
efficient while others are inefficient?
Answer:
In an exchange economy if an allocation is inefficient, there will surely be a potential
for gains from trade. Thus, efficiency in an exchange economy results in there being
no potential for gains from trade (meaning the economy is a Pareto optimum).
Allocations vary between efficient and inefficient because if all possible allocations
were efficient there would be no need to trade anything. This is of course is not
realistic.
1. What is the difference between partial equilibrium analysis and general

equilibrium analysis? What is the advantage to using general equilibrium
analysis?
2. What would completely general analysis require and why is this impractical?
3. Given the market-clearing curve for cake and ice cream in the graph below, what
is the relationship between ice cream and cake? Explain.
130
8.00
Ice
Cream 6.00
Price
($)
4.00
2.00
2.00 4.00 6.00 8.00

Cake Price ($)
4. Suppose the demand and supply functions for slices of pizza are
QPd 34 2 PP 2 PH and QPS 10 PP 2 (where QPd is millions of slices demanded,
QPS is millions of slices supplied, and PP is the price per slice of pizza). Also
suppose the demand and supply functions for hamburgers are
QHd 46 4 PH 2 PP and QHS 8PH 2 . First find the prices and quantities of pizza
slices and hamburgers sold in the general equilibrium. What happens if the
government imposes a 35 cent tax per slice of pizza? Solve for the new general
equilibrium prices and quantities of pizza and hamburgers.
5. Suppose the demand and supply functions for deli turkey meat are
QTd 34 2 PT 4 PR and QTS 10 PT 2 (where QTd is millions of pounds
demanded, QTS is millions of pounds supplied, and PT is the price per pound). Also
suppose the demand and supply functions for deli roast beef are
QRd 58 4 PR 4 PT and QRS 8PR 2 . First find the prices and quantities of turkey
and roast beef sold in the general equilibrium. What happens if the government
imposes a 48 cent tax per pond of turkey? Solve for the new general equilibrium
prices and quantities of turkey and roast beef.
131
6. Briefly explain what it means for an economy to be Pareto efficient. Can Pareto
efficiency exist in an economy where one person owns 100% of all resources?
7. Which points on the graph below are Pareto efficient? If a point is not Pareto
efficient, briefly explain why.
B
Maries
Utility
C
Jerrys Utility
8. What is the difference between a process-oriented notion if equity and an

outcome-oriented notion of equity? Which one is associated with a market-based
system?
9. What is the difference between utilitarianism and Rawlsianism? What is difficult

about implementing either outcome-oriented principle?
10. What is the first welfare theorem? How can an Edgeworth box be used to
demonstrate this theorem?
11. What does the contract curve identify in an Edgeworth box? Why is this useful?
12. Marie and Jerry must divide 10 pounds of food and 10 gallons of water. Suppose
Maries preferences for food (F) and water (W) are represented by the utility
function U M min{FM ,WM } . Jerrys preferences are represented by the utility
132
1 1
function U J FJ 2WJ 2 , with a corresponding marginal rate of substitution for
1
2
WJ
food with water MRS J 1
. If the initial endowments for Marie and Jerry are
2
2 FJ
FM 5, FJ 5,WM 3,WJ 7 , to which allocation will Marie and Jerry trade?

What is the ratio of the price of food to the price of water in a competitive
equilibrium?
13. Marie and Jerry must divide 10 pounds of food and 10 gallons of water. Suppose
Maries preferences for food (F) and water (W) are represented by the utility
function U M FM WM . Jerrys preferences are represented by the utility
function U J FJ2WJ , with a corresponding marginal rate of substitution for food
2WJ
with water MRS J . If the initial endowments for Marie and Jerry are
FJ
FM 7, FJ 3,WM 2,WJ 8 , to which allocation will Marie and Jerry trade?

What is the ratio of the price of food to the price of water in a competitive
equilibrium?
14. How is input efficiency similar to Pareto efficiency? What condition must be
satisfied to have input efficiency?
15. What is the laissez-faire approach to efficiency and how might this fail?
16. What is the second welfare theorem and why does it reflect an optimistic point of
view?
133
Chapter 17
Sample Problems
1. Tokushige Software is a competition free company that sells computer operating

system software. Suppose that its annual variable costs of VC 100Q 0.002Q 2 and
marginal costs of MC 100 0.004Q , where Q is the number of computer operating
system software they sell per month. The quantity demand function for its operating
software is Q d 6000 20P . In addition, it has and avoidable cost of $25,000 per
month. What is its profit-maximizing sales quantity and price?
Answer:
First, start by finding the inverse demand function. In this case inverse demand
is P 300 Q 20 , and its marginal revenue is found by using the formula:
P
MR P(Q) Q (300 Q ) ( 1 )
Q 20 20
MR 300 Q
10
We can proceed to find the its most profitable positive sales quantity and the
associated price by equating MR = MC (by the quantity rule).
300 Q 100 0.004Q

10
Q 1923 units
Substituting Q, into the inverse demand function we find that the price per unit of
operating system software is
P(1923.0769) 300 1923.0769 $203.84

20
Now all that is left is to apply the shut-down rule. In doing so, observe that Tokushige
Softwares profit at a the price $203.84 is $167,288.46, which equals its total revenue
of $391,984.32, minus the variable cost of selling 1923 units of software and the
$25,000 avoidable cost. Since Tokushige Software earns nothing by shutting down, it
will prefer to stay in business at its profit-maximizing price of $203.84.
134
2. What is the deadweight loss from monopoly pricing in sample problem (1)?
Answer:
To calculate the deadweight loss we need to first calculate the competitive
equilibrium price and quantity. This can be found by setting equating marginal cost
and the demand function for computer operating system software.
MC 100 0.004Q = P 300 Q 20
0.054Q 200
Q 3704 units
Thus, price in the competitive equilibrium is:
P(3704) 300 3704 $114.80

20
From question (1) we retrieve that the monopolistic profit-maximizing equilibrium is

Q = 1923 and P = $203.84. We are now set to find the deadweight loss (Note: this is a
simple matter in this example because the MC curve and demand curve are linear
functions).
DWL 1
2
203.84 114.803704 1923 79,290.12
3. What is the pass-through rate and in what units is it measured? Suppose the demand
curve has a constant elasticity of E d 1.5 , what can you say about the price a
monopolist would charge in this market?
Answer:
The pass-through rate represents an increase in the price that occurs due to a small
increase in the marginal cost, measured per dollar of increase in marginal cost. A
monopolist firm would set a price of 1.5 times the marginal cost, because the
monopolists price is a multiple of its marginal cost.
4. Why would it be profitable for a firm to use advertising? Would advertising be useful
to a firm in a competitive market? What in controversial about the welfare analysis of
advertising?
135
Answer:
Under certain circumstances advertising would help a firm differentiate their product
or perhaps inform consumers about their product and its benefits. In this case
advertising might be useful. However, it would not be useful for a firm in a
competitive market because each firm perceives itself as capable of selling as much
as it wants at the market price.
The welfare analysis of advertising is divisive in that the evaluation of its effect on
aggregate surplus depends on why advertising has succeeded in shifting demand. If
advertising is informing people about a product, then the shift in demand will not
affect aggregate surplus negatively. If on the other hand, advertising is being done to
deceive and mislead consumers, this will cause a negative effect on social welfare
despite the shift in demand.
1. What characteristic identifies a firm as possessing market power? How does this
apply to a monopolist?
2. The graph below shows the demand function, marginal revenue, and marginal cost for
a particular market. What quantity will a profit-maximizing monopolist choose to
produce? What price will they charge? What price would result in a competitive
equilibrium?
136
MC
8.00
Price 6.00
($)
4.00
2.00
D
MR
200 400 600 800

Quantity
3. Boiler Pizza is a local monopolist selling pizza slices. They face the hourly demand
function Q d 28 5P . What is Boiler Pizzas marginal revenue when it sells 5 slices?
What price would Boiler Pizza set when selling 5 slices? Graph the demand and
marginal revenue curves below.
8.00
6.00
Price
($)
4.00
2.00
10 20 30 40
Quantity, Q
137
4. DownTown blankets is a local monopolist selling handmade winter blankets. They
face the demand function Q d 200 P . What is DownTowns marginal revenue
when it sells 100 blankets? What price would DownTown set when selling 100
blankets? Graph the demand and marginal revenue curves below.
200
150
Price
($)
100
50
50 100 150 200

Quantity, Q
function Q d 28 5P . Suppose that Boiler Pizza has variable costs
2
VC 1 Q Q and marginal cost MC 1 5 Q 5 . What is its profit-maximizing
5 10
sales quantity and price?

face the demand function Q d 200 P . Suppose that DownTown has variable costs
2
VC 25Q Q and marginal cost MC 25 Q 2 . DownTown also has an
4
avoidable fixed cost of $5,000. What is its profit-maximizing sales quantity and
price?
138
7. Assume a monopolist decides to sell 500 units at a price of $10.00 and has a marginal
cost MC 1.25 Q . Use the Lerner Index to calculate the mark-up and elasticity
80
of demand when Q 500 .
8. Assume a monopolist decides to sell 8,500 units at a price of $55 and has a marginal
cost MC 2 Q . Use the Lerner Index to calculate the mark-up and elasticity of
250
demand when Q 8,500 .
function Q d 28 5P . Suppose that Boiler Pizza has variable costs
2
VC 1 Q Q and marginal cost MC 1 Q . Given its profit-maximizing
5 10 5 5
sales quantity and price found in #5, calculate the deadweight loss.
face the demand function Q d 200 P . Suppose that DownTown has variable costs
2
VC 25Q Q and marginal cost MC 25 Q 2 . DownTown also has an
4
avoidable fixed cost of $5,000. Given its profit-maximizing sales quantity and price
found in #6, calculate the deadweight loss.
11. What is rent-seeking and how could it result in additional losses beyond the standard
deadweight loss from a monopoly market?
12. Marty Mart is a monopsonist importer of household products specializing in toaster

ovens. The market supply of toaster ovens is Q S 20 P 1000 . What is Marty Marts
marginal expenditure when it buys 2000 toaster ovens? What is the price per toaster
oven when Q S 2000 ?
139
13. Now assume the market supply of toaster ovens for the monopsonist Marty Mart
is Q S 10 P 1200 . What is Marty Marts marginal expenditure when it buys 2000
toaster ovens? What is the price per toaster oven when Q S 2000 ?
14. Marty Mart is a monopsonist importer of household products specializing in toaster

ovens. The market supply of toaster ovens is Q S 20 P 1000 . Suppose that the
demand for its toaster ovens is Q d 1500 5P . What is the profit-maximizing price
and quantity of toaster ovens? What price and quantity would result in a competitive
equilibrium?
15. Now assume the market supply of toaster ovens for monopsonist Marty Mart
is Q S 10 P 1200 . Suppose that the demand for its toaster ovens is Q d 2000 10 P .
What is the profit-maximizing price and quantity of toaster ovens? What price and
quantity would result in a competitive equilibrium?
16. What is a natural monopoly? How would the government regulate a natural monopoly
using first-best or second-best regulation?
140
Chapter 18
Sample Problems
1. In terms of production and consumption, what does perfect price discrimination have
in common with a perfectly competitive market?
Answer:
A monopolist produces exactly the same quantity and each consumer consumes
exactly the same quantity as would occur in a perfectly competitive market. Thus
with perfect price discrimination there is no deadweight loss, and markets are
efficient.
2. The local tavern in a rural area acts like a monopolist. The tavern serves 250
consumers, each of whom has a weekly demand for pints of beer of Q d 15 3P ,
where P is the price per pint in dollars. The marginal cost of providing the beer is
$1.75 per pint. If the tavern charges $3.50 per pint, how large of a fixed fee can it
charge and still have customers coming back for more? What will they charge each
customer? What are the monopolists fixed fee and profit if it charges $1.75 per
minute? Which of these two-part tariffs produces a larger profit?
Answer:
At a price of $3.50 per pint, each customer will buy Q d 15 3(3.50) 4.5 pints per
week. Before the fixed fee, consumer surplus is (5 3.50)(0.5)(4.5) 3.38 . So the
tavern could charge a fixed fee of $3.38 without discouraging consumers from buying
more pints. In addition to the fixed fee profit, they make $1.75 on each of the 4.5
pints it sells to a customer, for an additional $7.88 in profit. The tavern thus makes
$7.88 + $3.38 = $11.26 on each customer. Total profit is 11.26 250 $2,815 .
We need to do the same calculations for P = $1.75. Q d 15 3(1.75) 9.75 pints per
week. Consumer surplus before the fixed fee is (5 1.75)(9.75)(0.5) $15.84 . So the
tavern could charge a fixed fee of $15.84 without discouraging customers from
buying. Notice that the tavern will not make any profit on the pints they sell because
141
they are pricing at their marginal cost. Total profits are 15.84 250 $3,960 . Pricing
at marginal cost yields a profit $1,145 higher.
3. Suppose the monopolist tavern from the previous problem sells pints of beer to
regulars (R) and to social drinkers (S). The demand function for regulars
is QRd 24 4P and the demand for social drinkers is QSd 15 3P . If marginal cost
per pint is $1.75 what price can the tavern set when it can and cant price
discriminate? How will price discrimination affect the monopoly profit?
Answer:
First, lets find the profit maximizing price and profit associated with this price. The
inverse demand function for regulars is P 6 0.25QR . Recall now, what how we
have been calculating marginal revenue MR PR P Q R QR in previous chapters.
MR 6 0.5Q
Now set MR = MC:
MR 6 0.5Q 1.75
Q Rd 8.5
Substitute the profit-maximizing quantity into the inverse demand function to find the
profit-maximizing price.
PR 6 8.5
4
PR $3.88
Therefore profit is, (3.88 1.75)(8.5) $18.06 .
Similarly we can find the profit-maximizing price for social drinkers. First, take the
QS
social drinkers inverse demand function P 5 and use it to find their marginal
3
revenue function MR 5 2 3 Q S . Now set MR = MC.
MR 5 2 QS 1.75
3
QS $4.88
142
Substitute the profit-maximizing quantity into the inverse demand function to find the
profit-maximizing price.

PS 5 4.88
3
$3.38
Therefore profit is (3.88 1.75)(4.88) $7.95 . Total profit for the tavern with
price discrimination is $26.01.
Now we need to find the taverns profit without price discrimination. Find the market
demand, inverse market demand and marginal revenue. Market demand is calculated
just as it was in previous chapters.
24 4 P for P 5
Qd
39 7 P for P 5
Inverse demand:
6 0.25Q for Q 4.75
P Q
5.57 7 for Q 4.75
Marginal demand:
6 0.5Q for Q 4.75
MR
5.57 2 7 Q for Q 4.75
To find the profit-maximizing price, set MR = MC to determine which plan offers the
highest profit. There are two cases to consider:
If Q 4.75 :
6 0.5Q 1.75
Q 8.5
This quantity yields the price $3.88 and a profit of $18.06.
If Q 4.75 :
5.57 2 Q 1.7
7
Q 13.37
This quantity yields the price $3.66 and a profit of (3.66 1.75)(13.37) $25.54 .
Thus the profitable price is $3.66. From the demand function we know that regulars
143
will buy Q d 24 4(3.66) 9.36 pints. Social drinkers will
buy QS 15 3(3.66) 4.02 pints.
Total profit with price discrimination is $26.01, without price discrimination $25.55
which is obviously less profitable.
4. What is mixed bundling and how could firms use mixed bundling to avoid
discontinuing a low demand product?
Answer:
When a firm sells several products together as a package while also offering the same
products for sale individually, this practice is known as mixed bundling. For example,
inkjet cartridges are often sold as a bundle, selling both black and colored ink in one
package as well as separately.
When a product is not selling well a monopolist can choose to bundle the under
performing or low demand product with another that is more popular, in addition to
selling the under performing product individually at a lower price. The reduced price
will be less that what it would cost a monopolist to stop producing the under
performing product all together. By doing this the monopolist will cater to consumers
who find the bundle attractive, as well as those consumers who demand the product
sold separately. Thus mixed bundling can be used to avoid discontinuing the firms
under performing product.
1. What is perfect price discrimination? Why might this be difficult for a firm to
achieve?
2. What is a two-part tariff? How is a two-part tariff an example of a type of

quantity-dependent pricing?
144
3. If a firm can use price discrimination based on observable customer
characteristics, which group will pay a higher price: consumers with low elasticity
of demand or consumers with a high elasticity of demand? Explain.
4. Dollys Pet Shop has a dog food program where pet owners can buy a special tub
and then fill the tub at a reduced price per pound. There are 200 consumers, each
with demand Q d 120 25P . Dollys marginal cost per pound is $1.50. Which
two-part tariff of a price per unit and initial tub fee will maximize Dollys profit?
How much will Dolly earn?
5. Dollys Pet Shop has a dog food program where pet owners can buy a special tub
and then fill the tub at a reduced price per pound. There are 200 consumers, each
with demand Q d 80 15P . Dollys marginal cost per pound is $0.50. Which
two-part tariff of a price per unit and initial tub fee will maximize Dollys profit?
How much will Dolly earn?
6. Dollys Pet Shop has two types of customers for cat food; people with a single cat
(S) and those with multiple cats (M). The single-cat owners demand for cat food
is QSd 10 2 P , where Q is pounds of cat food. The owners with multiple cats
have demand for cat food equal to QMd 18 3P . The marginal cost is $2.00 per
pound. What price per pound should Dolly set if she cannot discriminate between
the two groups? If Dolly can separate the groups, what price per pound should
she charge to the members of each group? Compare Dollys profits with and
without discrimination.
7. Dollys Pet Shop still has two types of customers for cat food; people with a
single cat (S) and those with multiple cats (M). The single-cat owners demand
for cat food is QSd 10 2 P , where Q is pounds of cat food, and the owners with
multiple cats have demand for cat food equal to QMd 18 3P . The marginal cost
145
is $2.00 per pound. Compare consumer surplus and aggregate surplus with and
without discrimination. Which situation maximizes surplus?
8. Suppose that soft drink manufacturer JP-Cola is conducting a 10-day test of a new
type of vending machine that charges a price according to the outside temperature.
On hot days, demand for vending machine soft drinks is QHd 3 0.02P . On
cool days, demand for vending machine soft drinks is QCd 2 0.02 P . The
marginal cost is $0.20. What price should JP-Cola charge on hot days? What price
should JP-Cola set on cool days? Suppose that, on average, half of the days are
hot and half of the days are cool. What price should the JP-Cola set if they instead
charged a single price? Compare JP-Colas profits with and without price
discrimination.
9. Suppose that soft drink manufacturer JP-Cola is still conducting a 10-day test of a
new type of vending machine that charges a price according to the outside
temperature. On hot days, demand for vending machine soft drinks
is QHd 3 0.02P and on cool days, demand for vending machine soft drinks
is QCd 2 0.02P . The marginal cost is $0.20. Compare consumer surplus and
aggregate surplus with and without price discrimination. Which situation

maximizes surplus?
10. Could price discrimination result in greater consumer surplus? What would cause
this to occur?
11. Dollys Pet Shop has decided to extend its dog food refill program to include cat
food. There is an initial fee to purchase the tub and then customers can refill the
tub at a per-pound rate. Again, Dolly has two types of customers for cat food;
people with a single cat (S) and those with multiple cats (M). The 200 single-cat
owners demand for cat food is QSd 10 2 P , where Q is pounds of cat food. The
100 owners with multiple cats have demand for cat food equal to QMd 18 3P .
146
The marginal cost is $2.00 per pound. If Dolly sells to both types of customers,
which of the following per-pound prices is the most profitable: $1.00, $1.50,
$2.00, or $2.50? What are the associated tub (or fixed) fees for each price per
pound?
12. Following from question (9), if instead of a single fee, Dollys Pet Shop has
decided to offer a pair of two-part tariffs. The plan for the 100 owners with
multiple cats (where demand is QMd 18 3P ) is to offer the cat food at $2.00 per
pound. The plan for the 200 single cat owners (with demand QSd 10 2 P ) will be
capped at the quantity of cat food a single cat owner decides to purchase given the
per-pound price in that plan. Dollys marginal cost is $2.00 per pound. Which of
the following per-pound prices in the plan intended for single cat owners is the
most profitable: $1.50, $2.00, $2.50, or $3.00? What are the associated tub (or
fixed) fees for each price per pound for each type of consumer?
13. Dollys Pet Shop has again decided to extend its dog food refill program to
include cat food, but with a revised number of each customer type. There is an
initial fee to purchase the tub and then customers can refill the tub at a per-pound
rate. Dolly has two types of customers for cat food; people with a single cat (S)
and those with multiple cats (M). The 200 single-cat owners demand for cat food
is QSd 10 2 P , where Q is pounds of cat food. The 300 owners with multiple
cats have demand for cat food equal to QMd 18 3P . The marginal cost is $2.00
per pound. If Dolly sells to both types of customers, which of the following per-
pound prices is the most profitable: $1.00, $1.50, $2.00, or $2.50? What are the
associated tub (or fixed) fees for each price per pound?
14. Following from question (11), if instead of a single fee, Dollys Pet Shop has
again decided to offer a pair of two-part tariffs. The plan for the 300 owners with
multiple cats (where demand is QMd 18 3P ) is to offer the cat food at $2.00 per
pound. The plan for the 200 single cat owners (with demand QSd 10 2 P ) will be
147
capped at the quantity of cat food a single cat owner decides to purchase given the
per-pound price in that plan. Dollys marginal cost is $2.00 per pound. Which of
the following per-pound prices in the plan intended for single cat owners is the
most profitable: $1.50, $2.00, $2.50, or $3.00? What are the associated tub (or
fixed) fees for each price per pound for each type of consumer?
15. What is bundling? How can a firm use bundling to extract additional consumer
surplus?
148
Chapter 19
Sample Problems
1. Lea and Gayle are duopolists each owning a tourist guide service in a popular scenic
town. The market demand function is Q d 42,000 350P , where P is the price of
tours around the towns main attractions and Q d is the number of tours demanded per
year. The marginal cost is $75 per tour. Competition in the market is described by the
Cournot model. What are Leas and Gayles equilibrium outputs? What is the price?
What do they each earn in profits? How does the price compare to marginal cost?
How do these profits compare to the monopoly price and profit?
Answer:
First note that inverse demand is P 120 0.003Q d . Given Leas (L) and Gayles (G)
outputs, Q L and QG the price is
P 120 0.003(QL QG )
The residual demand is,
PL (120 0.003QL ) 0.003QG
PG (120 0.003QL ) 0.003QG
To find the Nash equilibrium:
Find Leas best response function by deriving her marginal revenue, then set up profit
maximizing conditions.
MRL P P Q Q
MRL 120 0.006Q L 0.003QG
120 0.006Q L 0.003QG 75

Set MR = MC:
Q L 7500 0.5QG
By the symmetrical nature of the problem we can deduce without calculation that
Gayles best-response function is QG 7500 0.5QL . Thus the Nash equilibrium is:
QG 7500 0.5(7500 0.5QG )

QG 5,000
Substituting Gayles output into Leas best-response function we find that Leas
output is also 5000. Using this information we can recover the market
149
price: P 120 0.003(10,000) $90 per tour. Both Lea and Gayle will each earn a
profit of (90 75) 5,000 $75,000 per year.
Note that P = $90 is higher than the perfectly competitive price of $75. To find what
the price would be if there was a monopoly in this market use the same inverse
demand curve without partitioning it into residual demand curves, then find the
marginal revenue and set up the profit-maximizing condition:
MR 120 0.006Q 75
MR 120 0.006Q and set MR = MC:
Q 7500
Substituting this quantity we find that P = $97.5 and profit for the monopoly firm is
$168,750 per year.
2. What factors affect the number of firms entering a market and what are economists
referring to when they say a market has intense competition?
Answer:
There are several factors that can affect the number of firms entering a market. If the
fixed costs associated with becoming active in the market decrease, firms have an
incentive to enter. However, this depends on the size of the market as well. If the
market is relatively small then there is a greater incentive to enter the market because
it is likely that there is still room to make a positive profit.
Another factor that can affect the entry of firms into a market is what is known as
intensity of competition. Economists declare competition is more intense in one
market than another if given any number of firms, the equilibrium price in the first
market is lower than the price in the second market.
3. When does monopolistic competition occur?

Answer:
Monopolistic competition occurs in a market characterized by free entry and a large
number of firms, each of which produces a unique product (i.e. heterogeneous goods),
prices are set above marginal cost, and firms earn (close to) profit net of its fixed
costs.
150
4. The market demand function for tourist guide services is Qd 42,000 350 , where P
is the price of tour around the towns main attractions and Q d is the number of tours
demanded per year. The marginal cost is $75 per tour. Suppose Lea enters this market
first and chooses her output. How much larger is her profit compared to the situation
in question (3) described by the Cournot model. How do Gayles profits in the two
cases compare?
Answer:
Recall Leas residual demand curve from problem (1).
PL (120 0.003QL ) 0.003QG
Recall also, Gayles best-response function: QG 7500 0.5QL . By substituting
Gayles best-response into Leas inverse residual demand function, we get a formula
characterizing the price Lea receives at any output she might produce, while taking
into account Gayles response to her choice:
PL (120 0.003QL ) 0.003(7500 0.5QL )
PL 97.5 0.0015QL
Now derive Leas marginal revenue:

MR 97.5 0.0015QL 0.0015QL
MR 97.5 0.003QL
To maximize her profit Lea will set MR = MC.

MR 97.5 0.003QL 75
QL 7500
Gayles best response is QG 7500 0.5(7500) 3750 . At a total market output of
11,250 the market price is P 120 0.003(11,250) $86.25 . This price implies that
Leas profit is $84,375 per year, while Gayles profit is $42,187.50. Lea makes
$9,375 more, and Gayle made $32,812.50 less, than in the case characterized by the
Cournot model.
151
1. What is the Nash equilibrium in the Bertrand oligopoly model? How many firms
in a single market are needed to reach this equilibrium?
2. What oligopoly model involves choosing quantities? How is this model related to
the possible existence of a capacity constraint?
3. Kristin and Megan are each producers of environmentally friendly handbags in a

duopoly market. The market demand function is Q d 500 10 P . The marginal
cost is $20 per bag. If competition in this market follows the Bertrand model,
what is the equilibrium price? How many handbags are bought and sold? What do
they earn in profits?
4. Kristin and Megan are each producers in a duopoly market facing the market
demand function Q d 500 10 P . The marginal cost is $20 per bag. If competition
in this market follows the Cournot model, the corresponding best response
functions are QKristin 150 1 2 QMegan and QMegan 150 1 2 QKristin . What is the
Nash equilibrium output? What is the equilibrium price? What do they each earn
as profit?
5. Kristin and Megan are duopolists in the handbag market. The market demand
function is Q d 500 10 P . The marginal cost is now $30 per bag. If competition
in this market follows the Cournot model, what is the Nash equilibrium output?
What is the equilibrium price? What do they each earn as profit?
6. Kristin and Megan are duopolists in the handbag market. The market demand
function is now Qd 200 5P . The marginal cost is $10 per bag. If competition
in this market follows the Cournot model, what is the Nash equilibrium output?
What is the equilibrium price? What do they each earn as profit?
152
7. Suppose a small town is served by two competing hamburger stands, Joes
Burgers and Burgers by Bob, who face the daily demand functions
QJoe 150 25PJoe 100( PBob PJoe ) and QBob 150 25PBob 100( PJoe PBob ) . The
marginal cost is $1.00. What are the Nash equilibrium prices when the two firms
set their prices simultaneously? What are the quantities sold by each stand and
what are their resulting profits?
8. Two competing hamburger stands, Joes Burgers and Burgers by Bob, face the
daily demand functions QJoe 150 25PJoe 300( PBob PJoe ) and
QBob 150 25PBob 300( PJoe PBob ) . The marginal cost is $1.00. What are the
Nash equilibrium prices when the two firms set their prices simultaneously? What
are the quantities sold by each stand and what are their resulting profits?
9. Assume that Kristin and Megan each sell designer handbags and share the
monthly collusive profit of $10,000 equally, $5,000 each. If Kristin undercuts
Megan, she will earn an additional $5,000 that month, but Megan will
immediately cut her price to marginal cost in all future months. What interest rate
will make this cooperative arrangement supportable?
10. Again assume that Kristin and Megan each sell designer handbags, but now they
share the monthly collusive profit of $16,000 equally, $8,000 each. If Kristin
undercuts Megan, she will earn an additional $8,000 that month, but Megan will
immediately cut her price to marginal cost in all future months. What interest rate
will make this cooperative arrangement supportable?
11. What is the difference between explicit collusion and tacit collusion? Why is a
tacitly collusive agreement harder to maintain?
12. What is business stealing and how might this lead to excessive entry into a
market?
153
duopoly market facing the market demand function Q d 500 10 P . The marginal
cost is $20 per bag. Suppose Kristin enters this market first and chooses her
output before Megan. What is Kristins profit-maximizing output? What is her
profit at that output? What is Megans profit-maximizing output in response?
What are Megans profits? Finally, compare Kristins profit in this case to her
profit when quantities were chosen simultaneously (in question #4).
duopoly market facing the market demand function Qd 200 5P . The marginal
cost is $10 per bag. Suppose Kristin enters this market first and chooses her
output before Megan. What is Kristins profit-maximizing output? What is her
profit at that output? What is Megans profit-maximizing output in response?
What are Megans profits? Finally, compare Kristins profit in this case to her
profit when quantities were chosen simultaneously (in question #6).
15. What is a horizontal merger and why would this be more effective than fixing
prices?
154
Chapter 20
Sample Problems
1. What does Coases theorem say? Why might the assumptions of frictionless
bargaining be unreasonable?
Answer:
Coases theorem says that if bargaining is frictionless, then it does not matter how
property rights are assigned and voluntary agreements between private parties will
remedy the market failures associated with externalities and restore economic
efficiency.
Assuming that bargaining is frictionless is a critical assumption that is often made

unreasonable by the fact that the act of bargaining is rarely frictionless. Bargaining is
often impractical, requiring time and effort as well as money if lawyers become
necessary. Aside from these setbacks of bargaining, parties that are negotiating with
one another have limited information about the others costs and benefits. Another
feature that slows down bargaining is the difficulty encountered when trying to
enforce these contracts.
2. What is a tradable emissions permit, and why would such a permit promote least-cost
abatement?
Answer:
A tradable emissions permit gives a firm the right to pollute a given amount of a
specified pollutant. This permit is transferable, meaning that one firm may sell it to
another firm if they wish.
Emissions permits promote least cost abatement because they are easily transferable.
A firm with low marginal cost of abatement can sell some of their permits to any firm
with higher marginal cost of abatement. This puts imposes a market system structure
on pollution which forces firms to take pollution generation into account when
maximizing production and ultimately profits.
155
3. You live by the local airport which until recently only allowed single engine propeller
planes. In an effort to increase revenue, the airport signed a deal that will allow
private jets to land at the airport. Now you and your neighbors are dealing with the
constant nuisance of take-off noise. Let D stand for the noise level of planes taking
off in decibels, B is the benefit to the airport, and C represents your costs. For any
given volume of noise the local airports benefit is B 550D 3D 2 which means that
the airports marginal benefit is MB 50 6 D . Your cost is C D 0.0025D2 ,
which means your marginal cost is MC 1 0.005D . Given these costs and benefits,
what is the efficient noise limit? What is the efficient Pigouvian tax?
Answer:
Set MB = MC:
550 6 D (1) 0.005D
D 90.2 decibels
The efficient noise limit is 90.2 decibels. At this socially efficient level your marginal
cost is 1 0.005(90.2) $1.45 . Therefore, the efficient Pigouvian tax is $1.45 per
decibel. With such a tax the airport will choose 90.2 decibels of noise, paying a total
of $130.79.
4. What would the government need to do to operate a Groves mechanism? Would a

citizen have an incentive to over-represent his/her need of a public good?
Answer:
The government would have to ask each citizen to report the total benefit he/she
would receive from the public good at any possible level of provision, so that it could
calculate every individuals marginal benefit. The government would take the
information given by each citizen as a true representation of their benefit.
A Groves mechanism is designed in such a way that citizens would have no incentive
to exaggerate their need of a public good. If a citizen were to exaggerate her need for
a public good, she would be faced with a higher mandatory contribution to the public
good, which would not be proportional to her actual preferences.
156
1. What is a negative production externality and how does it create a deadweight

loss?
supply function is Q S 2 P 100 , as seen in the graph below. Suppose that the
production of down blankets creates an external cost per blanket equal to $50.
Illustrate the social cost curve on the graph below and shade in the deadweight
loss from the external cost.
200
150
S
Price
($)
100
50
D
50 100 150 200

Quantity, Q
3. Again, the market demand function for down blankets is Q d 200 P and the
market supply function is Q S 2 P 100 , as seen in the graph below. Suppose that
the production of down blankets creates a marginal external cost MEC 25 Q .

Illustrate the social cost curve on the graph below and shade in the deadweight
loss from the external cost.
157
200
150
S
Price
($)
100
50
D
50 100 150 200

Quantity, Q
4. Assume that 10 firms compete in the construction market, which produces silt that
pollutes the water supply. The total cost to each firm is TC 30 Q2 , where Q is
the monthly number of construction sites in progress. The marginal cost is
therefore MC 30 2Q . The external cost of the silt runoff is EC 10Q Q2 ,
making the marginal external cost MEC 10 2Q . The monthly demand for
construction is Q d 1200 25P . First solve for the competitive equilibrium price
and quantity. Next solve for the socially efficient quantity. Finally, calculate the
deadweight loss resulting from the negative externality.
5. Again assume that 10 firms compete in the construction market, which produces
silt that pollutes the water supply. The total cost to each firm is TC 30 Q2 ,
where Q is the monthly number of construction sites in progress. The marginal
cost is therefore MC 30 2Q . The external cost of the silt runoff is
EC 20Q Q2 , making the marginal external cost MEC 20 2Q . The monthly
demand for construction is Q d 1200 25P . First solve for the competitive
equilibrium price and quantity. Next solve for the socially efficient quantity.
Finally, calculate the deadweight loss resulting from the negative externality.
158
6. Assume that 10 firms compete in the post-construction beautification market,
which re-plants trees that had been cut down for the construction. The total cost to
each firm is TC 30 Q2 , where Q is the monthly number of construction sites in
progress. The marginal cost is therefore MC 30 2Q . The monthly marginal
benefit to owners of the land is MB 48 Q . However, other people who drive

25
down the street also benefit from the beautiful trees, creating an external benefit
2
EB 5Q Q , making the marginal external benefit MEB 5 Q . First solve
2
for the competitive equilibrium price and quantity. Next solve for the socially
efficient quantity. Finally, calculate the deadweight loss resulting from the
positive externality.
7. What are emissions standards? Why might both sides (both polluter and pollutee)
have an incentive to exaggerate their costs?
8. What is a Pigouvian tax and what must this tax be set equal to in order to achieve
the socially efficient outcome?
9. Your neighbor across the street loves to collect garden gnomes and has them
scattered all across her lawn. They are such an eyesore that you and the other
surrounding neighbors have determined your cost (in dollars) to be
C 2Q 1 Q 2 , with a marginal cost of MC 2 Q , where Q is the number of

2
garden gnomes. However, your neighbor loves her gnome collection and her
benefit is B 11Q 1 4 Q 2 , making her marginal benefit MB 11 1 2 Q . Given
this information, what is the efficient number of gnomes? If the neighborhood

association sought to issue a Pigouvian tax, what is the efficient tax per gnome?
10. Again, your neighbor across the street loves to collect garden gnomes and has
them scattered all across her lawn. They are such an eyesore that you and the
other surrounding neighbors have determined your cost (in dollars) to be
159
C 2Q 1 Q 2 , with a marginal cost of MC 2 Q , where Q is the number of
2
garden gnomes. Suppose the neighborhood association is considering weighing
cost and benefit to determine the efficient number of gnomes and, when asked,
your gnome-loving neighbor claims her benefit to be B 17Q 1 Q 2 , making

4
her marginal benefit MB 17 1 Q . How does her new estimate of her benefit
2
change the efficient number of gnomes? Why might she have an incentive to
overestimate her benefit?
11. How does a liability rule force polluters to internalize their external costs? What
other costs may be associated with the enforcement of such a rule?
12. How is a public good defined and what is the free-rider problem?
13. Suppose that some students value having potted plants in the classroom and
believe that plants help them relax and learn better. If there are 7 of these students
in the class and each has a marginal benefit MB 50 3Q , where Q is the number
of potted plants. If the marginal cost per plant is $14, how many plants would
each student choose individually? What is the socially efficient number of plants?
14. Suppose that some students value having potted plants in the classroom and
believe that plants help them relax and learn better. If there are 5 of these students
30
in the class and each has a marginal benefit MB , where Q is the number of
Q 1
potted plants. If the marginal cost per plant is $10, how many plants would each
student choose individually? What is the socially efficient number of plants?
15. What is the median voter theorem? What does this theorem require to result in a
socially efficient outcome?
160
Selected Solutions
Chapter 1
1. A capitalist economy is more closely described as a free market system. In a free

market system, the government usually lets markets operate freely with fewer
regulations. In contrast to communist economies, capitalist economies are
characterized by having a higher degree of decentralization, with the means of
production primarily owned and controlled for the profit of private individuals.
3. The principle of individual sovereignty enables economists to avoid paternalistic

judgments. Applying the principle of individual sovereignty allows economists to
turn a positive analysis into a normative analysis because invoking the principle of
individual sovereignty allows economists to assume individuals have full knowledge
of the consequences of their actions.
5. The best theories are ones that are generally applicable and specific in their
implications. Theories that identify additional implications are paramount to
developing a broadly applicable theory. In essence, a theory should try and explain as
many things as it can without explaining things that it cant.
7. The three main categories of economic data are: Surveys, Records, and Experiments.
Surveys are a method of collecting data that economists use because they can provide
data on virtually any subject. Economists main obtain survey data for a fee or free of
charge in many cases. Records on financial accounts, personal records, and customer
data, are typically kept by companies for their own research and analysis. Some of
these records are open to the public, particularly for publicly traded companies, and
they may be obtained for a fee or free of charge.
9. In a controlled experiment, economists isolate causal relationships by design,

whereby they typically have control and treatment groups. A natural experiment
differs from a controlled experiment primarily because they occur naturally without
design but they produce similar effects. Natural experiments create a situation where
by chance two otherwise identical groups may differ, creating the same effect as
separating subjects into controlled and treatment groups.
11. Trade can benefit two people at the same time for several reasons. Trade allows
people to exchange something they own that is of relatively lesser value, for a good or
service that is of relatively greater value. Trade also allows workers, countries,
companies, etc. to specialize in producing goods and or services they produce well.
161
Chapter 2
1.
18
16
14
Price ($)
12 D
QFF 27 2PFF
10
8
6
4
2
3 6 9 12 15 18 21 24 27 30
2
Quantity (pounds)
D
The function is: QFF 27 2PFF
Y-intercept (Price) = 13.5 & X-intercept (Quantity) = 27
3. The demand curve shifts to the right.
18
16 D
QFF 30 2 PFF
14
Price ($)
12
10
8
6
4 D
QFF 27 2PFF
2
3 6 9 12 15 18 21 24 27 30
2 Quantity (pounds)
162
5.
18
16
14
Price ($)
12
10
S
QFF 3PFF 5.5
8
6
4
2
3 6 9 12 15 18 21 24 27 30
2
Quantity (pounds)
The Y-intercept (Price) = 1.83
7. In the answer to (6) we see that as the price of potato flakes decreases, the quantity of
French fries supplied increases, demonstrating that the two goods are substitutes in
production.
9. PFF $6.00 ; QFF

D
8 million lbs.; QFF
S
8 million lbs.
11. PFF $5.00 ; QFF

D
10 million lbs.; QFF
S
10 million lbs.
13. The equilibrium price for the market is $4.00. At this price 8 gallons of ice cream are
bought and 8 gallons of ice cream are sold. See the graph below.
18
16
14
Price ($)
12
QICD
10
PIC 4
2 QICS
8 PIC 8
6
2
4
2
2 4 6 8 10 12 14 16 18 20
2 Quantity
4 (Gallons of ice cream)
8 20 2
163
10.5
15. Elasticity of supply at PFF $3.50 : 21
0.5
15
Elasticity of supply at PFF $5.00 : 3
5
Chapter 3
1. The opportunity cost of going to see the movie is not being able to go to the gym.
Working out at the gym represents your opportunity cost in this case because it is
your next best alternative according to your preference rakings. If going to see a
movie was not an option and you had chosen to go to the gym, your opportunity cost
would be time not spent reading your book.
3.
0 0 0 0
1 460 80 380
2 840 220 620
3 1140 420 720
4 1360 680 680
5 1500 1000 500
6 1560 1380 180
The best possible option here is the one with the highest net benefit. This would be
where you employ your mechanic for 3 hours and your net benefit is $720.
5.
Marginal Marginal
Hours Benefit Benefit Cost Cost
1 460 460 80 80
2 840 380 220 140
3 1140 300 420 200
4 1360 220 680 260
5 1500 140 1000 320
6 1560 60 1380 380
The best choice according to this schedule is to hire your mechanic for three hours.
The three hour mark is the last point at which the marginal benefit exceeds the
marginal cost. This is in accordance with the principle of No Marginal Improvement,
which states that at a best choice, the marginal benefit of the last unit must be at least
as large as the marginal cost, and the marginal benefit of the next unit must be no
greater than the marginal cost.
164
7. The graph below provides us with similar information as charts from previous
problems. To find the best choice we merely have to look for the largest vertical
distance between the total benefit and total cost curves (Note: the only relevant
portion of the graph is where TB > TC, because points that lie where TC < TB are
clearly not best choices) this strategy will ensure that we have identified the largest
net benefit.
900
TC
Total benefit, total cost ($) 800
TB
700
600
Best Choice
500
400
300
200
100
1 2 3 4 5 6 7 8 9 10
Hours (H)
9. According to the chart below, hiring your mechanic for 4 hours is the best choice,
because it has the largest net benefit of any of the possible choices.

0 0 0 0
1 335 65 300
2 640 180 460
3 915 345 570
4 1160 560 600
5 1375 825 550
6 1560 1140 420
11. Sunk costs should be ignored when finding the best choice from a set of options
because for one they are unavoidable. More importantly, sunk costs have no effect on
marginal costs.
13. The best choice is found by setting MB = MC (by No Marginal Improvement

Principle):
MB( H ) 110 20H = MC( H ) 50 140H
1 hours.
H
2
If the mechanic requires a 1-hour minimum payment then it would be better not to
take your car to the mechanic (choose H = 0). By the No Marginal Improvement
Principle, if you increased the units of H to 1 hour MB < MC and thus the net benefit
will be negative.
165
15. The choice you make will depend on which option (4 or 5 hours) gives you a higher
net benefit. If the MB grows smaller and MC grows larger as the number of hours
increase, then 4 hours would be a better choice.
Chapter 4
1. It is important that consumers follow the choice principle because it allows them to
select, among available alternatives, which one ranks highest. If the choice principle
did not apply we could not assume when formulating economic theories that
consumers are rational. Assuming consumers are rational is an important assumption
economists make when they model economic phenomena, as we saw from chapter 1.
3. a) No, she would swap 9 13 . b) No, she will not swap 9 10. c) No, she will not
swap 9 11.
5. D is most preferred (by the more-is-better principle). Both B and E are equally
preferred because they are on the same indifference curve (2 nd most preferred). 3rd
most preferred is C, and the least preferred bundle is A. This may also be represented
in the following form ( D B ~ E C A ).
7. This type of preference is called perfect complements.
3
Pie
(pieces)
2
1 2 3 4
Ice Cream (scoops)
166
9.
Ashleigh
4
3
Pie
(pieces)
2
Taylor
1
1 2 3 4
Cake (pieces)
The graphs shows that given 2 pieces of cake Ashleigh could not be made better off
by giving her any amount of pie. Conversely, the graph also shows that given 2 pieces
of pie Taylor could not be made better off by giving her any amount of cake.
11. Given Stephanies utility function the formula for her indifference curves can be
found by rearranging the equation and solving for IC, as such:
2
U ( P, IC) P2 2IC 2IC U ( P, IC) P2 IC U P .
2 2
Stephanies marginal utility of pie is MU Pie 2P, (adding P increases the utility
U
value by 2P so, 2P. The marginal utility of ice cream is MU IC 2, (adding
P
U
IC the utility value by 2 so, 2. Now, to find Stephanies marginal rate of
IC
substation for pie with ice cream use the equations for finding the MRS with the
information about the marginal utilities of both pie and ice cream, as such:
MU P 2 P
MRS P , IC P.
MU IC 2
Her MRS of pie with ice cream is P scoops of ice cream per piece of pie.
13. Finding the indifference curves is simply a matter of solving the utility function given
in terms of P like so (note: for simplicity U(P,IC) = U):
1/ 3
U U
U ( P, IC ) P 2/ 3
IC 1/ 3
IC 1/ 3
2/ 3 , IC 2 .
P P 3
167
To find Daves marginal utility of pies:
U ( P, IC ) P 2 / 3 IC 1 / 3
2
MU P P 1 / 3 IC 1 / 3 ,
3
1/ 3
2 IC
MU P .
3 P
Finding Daves marginal utility of ice cream can be done in the same fashion:
U ( P, IC ) P 2 / 3 IC 1 / 3
1
MU IC P 2 / 3 IC 2 / 3 ,
3
2/3
1 P
MU IC .
3 IC
Finding the MRS of pie with ice cream can be done as follows:
1/ 3
2 IC
1/ 3 2/3
MU P 3 P IC IC IC
MRS P , IC 2 2 .
P P P
2/3
MU IC 1 P

3 IC
15. There is certainly a trade that could improve both of their positions. This assertion
can be verified as follows: if Stephanie has 4 scoops of ice cream her utility function
is: U 0 2(4) 8. If Dave has 3 pieces of pie his utility function is:
U 3
1
0 . If Dave gives Stephanie 1 piece of pie for 1 scoop of ice cream,
2/3 3
(0)
Stephanies utility would increase to U 22 2(3) 10. Daves utility would also
increase to U 2
1
1.58 , therefore this trade is beneficial to both Stephanie
2/3 3
(1)
and Dave.
Chapter 5
1.
3 6 7 8 9
Pie 2 4 5 6 7
(pieces)
1 2 3 4 5
0 0 1 2 3
0 1 2 3
Ice Cream
(scoops)
168
If Stephanies income is $4.00 her affordable options are lightly shaded. If
Stephanies income is increased to $6.00 her affordable options increase to include
the lightly shaded regions and the more darkly shaded regions.
3. If the price of ice cream doubles to $2.00 the new budget line is P 2 IC . Her new
budget line has a slope of -1, with a horizontal intercept at 2 scoops of ice cream, and
a vertical intercept at 2 pieces of pie.
The number of affordable options has decreased due to the increase in the price of ice
cream scoops. This increase in the price of ice cream has caused the original budget
line to rotate inward from the origin (pivoting at the intercept for pie).
3
Pie P 2 IC
(pieces) IC
2 P 2
2
1 2 3 4
Ice Cream (scoops)
5. The unaffordable bundles are lightly shaded below. Of the affordable bundles, the one
that would give Stephanie the most utility is the bundle with 2 scoops of ice cream
and 1 piece of pie. This bundle corresponds to her highest ranking (8) affordable
option.
3 10 5 2 1
2 12 7 4 3
Pie
(pieces)
1 14 9 8 6
0 15 14 13 11
0 1 2 3
Ice Cream
(scoops)
169
7. The introduction of pie rationing forces to Stephanie to forgo her otherwise affordable
and highest ranked option (#2: 3 pieces of pie, 2 scoops ice cream), and accept her
next best option (#3: 2 pieces of pie, 3 scoops of ice cream).
3
Pie
(pieces)
2
2 4 6 8
Ice Cream (scoops)
9. It is important for the budget line to be tangent to the indifference curve at a utility-
maximizing bundle for interior solutions because an indifference curve going through
any interior choice that not satisfy the tangency condition thus creating an overlap
between the areas below the budget line and above the indifference curve. Boundary
solutions are excluded from the tangency condition because at a boundary solution
the slope of the budget line and the slope of the indifference curve are not equal.
11. Use the tangency condition to solve for B in terms of C:

B 1 PC
MRSCB
2C 2 PB
B C.
Now use the previous result and the budget line to solve for C and B:
C 10 2(C )
3C 10
10
C 3.33
3
Solving for B:
BC
10
B 3.33
3
With this marginal rate of substitution Holly should buy 3.33 pounds of candy and
3.33 packages of balloons.
170
13. First, substitute MUC 2 B , MU B C , PC $5, and PB $10 into the
MU C MU B
formula .
PC PB
MU C MU B 2 B C
2B C.
PC PB 5 10
Next, solve for B and C using the budget line.
C 10 2B 2B 10 2B B 1.5.
Solving for C:
C 10 2(1.5) C 7.
Therefore, Holly will buy 1.5 packages of balloons and 7 pounds of candy for her
classroom.
15. To calculate the optimal amounts of candy and balloons at $5 and $10 set up the
budget lines at the different prices of balloons:
If balloons cost $5: C 10 B
Next set up the following:
2 B 5 PC
MRSCB 2 B C.
C 5 PB
Use the budget line to solve for B and C:
2 B 10 B B 4.
C 6.
If balloons cost $10: C 10 2B.
Next set up the following:

2 B 5 PC
MRSCB 4 2B C.
C 10 PB
Use the budget line to solve for B and C:
4 2B 10 2B B 1.5.
C 7.
Use the information above to plot the graphs for the budget lines, optimal solutions,
and finally the price-consumption curve.
171
Price-
8 Consumption
Curve
6
Candy
(lbs)
4
1 2 3 4
Balloons (packages)
12
9
Price of Individual Demand
Balloons Curve
($) 6
2 4 6 8
Balloons (packages)
17. To plot the Income-consumption curves we first need to find the budget lines. Since
the prices of balloons and candy are constant and the only thing changing is income it
is fairly simple to find the budget lines:
If M $50 : 10 2B C; ( L1 )
If M $75 : 25 2B C; ( L2 )
If M $100 : 50 2B C ( L3 )
172
Next, we need to find the optimal bundles for each budget line. To do this we use the
MU C 2 B 5 PC
following equation: 4 2B C.
MU B C 10 PB
Using the previous result you can solve for the optimal bundles at each budget line.
The optimal bundles are as follows:

For L1 : B 1.5, C 7.
For L2 : B 5.25, C 14.5.
For L31 : B 11.5, C 27.
Now we have all of the information needed to plot the income-consumption curves
and the Engel curves.
20
15
Candy Income-
(lbs) Consumption
Curve
10
L3
5
L1 L2
5 10 15 20
Balloons (packages)
100
Engel
Curve for
Balloons
75
Income
($)
50
25
3 6 9 12
Balloons (packages)
173
100
Engel
Curve for
Candy
75
Income
($)
50
25
7 14 21 28
Candy (lbs)
Chapter 6
1. The difference between the substitution effect and income effect of a price change is
the substitution effect represents a change in relative prices that causes a consumer to
substitute one good for another. On the other hand, the income effect represents how
price change affects a consumers purchasing power. The effect of an uncompensated
price change comes in two parts: (1) the effect of a compensated price change and (2)
the effect of removing the compensation. In relation to the uncompensated price
change the substitution effect represents part (1) and the income effect represents part
(2).
3. To find the uncompensated effect of Hollys purchases of candy and balloons first use
the tangency condition to solve for the B and C using a generic form of a budget
constraint as follows:
M PC C PB B (Budget line)
Tangency condition:
2 B PC
PB 2 B PC C C B 2 B .
P
MRSCB
C PB PC
Now use the previous result and the generic budget line to solve for B and C:
M B 2 B PC BPB B
P M
2.
PC PB
Now, for C:
P M M
C B 2 2 C .
PC PB PC
174
So, with M $50, PC $5, PB $10, she chooses C , B 10,3 . If the price of
balloons falls to $5.00 she chooses C , B 10,8 .This uncompensated price
reduction raises Hollys balloon package purchases from 3 to 8 and leaves the
amount of candy she buys unchanged.
Next, to find the compensated effect we need to used the tangency condition and find
the relationship between candy and balloons at their new prices.
If M $50, PC $5, PB $5, the relationship between candy and balloons is:
C 2 B.
Hollys best choice with a compensated price change also lies on the indifference
curve that passes through the bundle C , B 10,3 . Using the formula for her
U
indifference curve B 2 , the value of U that runs through the
C
bundle C , B 10,3 is 50, which implies that Hollys formula for this indifference
curve is:
50
B 2.
C
A bundle can satisfy both the tangency condition formula and the indifference curve
50
formula only if: B 2 50 B 2 4 B 4. Using the quadratic formula
2 B
yields B 5.07.
Next, using the tangency condition, we get that C 7.07 . So the compensated price
effect shifts Holly from the bundle C , B 10,3 to the bundle C , B 5.07,7.07 .
(Note: you can check to see that both bundles are on the same indifference curve by
plugging in each bundle into the utility function; both bundles should have the same
utility).
At the new prices, Holly needs $60.70 to buy the bundle C , B 5.07,7.07 . Since
her income is $50, we would have to give her $10.70 to compensate for the price cut.
To break up the uncompensated price change into substitution effects and income
effects:
Note that the substitution effect is the same as the effect of the compensated price
change. The income effect is what is known as the residual; it shifts Holly from the
bundle C , B 10,3 to the bundle C , B 5.07,7.07 .
175
5.
L2
Good Y B
L1 C
Compensated
Budget line
Good X
The reduction of the price of good Y causes the rotation of L1 to L2 . Bundle A shown
on the graph above is the bundle chosen before the price decrease of good Y. The
arrow from A to C on the graph above shows the substitution effect of the change in
the price of good Y. Bundle B on the graph above is the bundle chosen after the price
decrease of good Y. The arrow from C to B on the graph depicts the income effect of
the price decrease; and bundle C represents the bundle chosen on the compensated
budget line after the price change putting the consumer back on their original
indifference curve.
7. A Giffen good is a good thats quantity sold increases as its price increases. The law
of demand says that for a normal good as the price of the good increases the quantity
sold decreases. So, a Giffen good would violate the law of demand.
9. First we must use the budget line and the tangency condition to solve for optimal
values of candy and balloons.
C 10 2B (Budget line)
Tangency condition:
2 B 1 PC
MRSCB 4 2B C.
C 2 PB
Solving for B and C we get B 1.5 & C 7.
Next, use the utility function in its functional form to solve for U with the optimal
bundle:
U U
2 B 2 1.5 U 24.5
C 7
Hollys indifference curve formula through this bundle is:

24.5
2 B.
C
176
If the store does not have balloons, B 0. Therefore, to place Holly on the same
24.5
indifference curve, we must pick the value of B for which 0 2. Solving for C,
C
we get C 12.25. To buy 12.25lbs of candy Holly would need $61.25, so the store
would have to pay her $11.25 to compensate for not having balloons in stock. This is
Hollys compensation variation.
11. The horizontally shaded triangle represents Hollys consumer surplus before the
price change, when the price of paint was $6. Here the consumer surplus
is: CS 10 63.2 0 6.4
1
2
The number 3.2 is found by evaluating the quantity sold at $6 using the demand
function.
If the price of paint increases to $7 then Hollys consumer surplus decreases, as is

depicted on the graph below by the entire shaded triangle. You can calculate the
change in the consumer surplus as follows:
Take the area of the triangle before the price change and subtract it by the area of the
triangle after the price change.
1 1
CS $10 $63.2 0 $10 $7 2.4 0 2.8
2 2
The number 2.4 is found by evaluating the quantity sold at $7 using the demand
function.
10
P = $7
6 P = $6
Price
($)
4
2 4 6 8
Quantity of Paint
177
13. An increase in the wage rate could increase the amount of labor supplied if the
increase in the wage rate increases the cost of leisure to a point where the laborer is
not willing to substitute leisure for less labor supplied.
An increase in the wage rate could decrease the amount of labor supplied if the
increase in the wage rate increases the purchasing power of a laborer sufficiently
enough to offset the increase in the cost of leisure to the point where leisure time
rises at the expense of labor supplied.
Both of these situations are possible with a backward bending supply curve.
15. To find the equation of the compensated demand curve first take the formula for the
tangency condition and the price of balloons equal to 10:
B P CP
MRSCB C CPC 10 B B C .
C 10 10
Next, rewrite the utility function as follows using the bundle given:
U 5.2.5 5 2.5 12.5
12.5
B .
C
Now set the tangency condition formula equal to the indifference curve formula
equal to each other and solve for C:
12.5 CPC 125
C.
C 10 PC
This is the compensated demand curve.
10
Compensated
Demand Curve
6
Price
($)
4
2 4 6 8
Candy (lbs)
178
Chapter 7
1. Use the graph to see which methods are inefficient.
Production Units of
Method Labor Output Efficient?
A 1 48 Yes
B 2 124 Yes
C 2 112 No
D 3 205 No
E 3 216 Yes
F 4 312 Yes
G 4 295 No
Production methods that are inefficient are characterized by lower levels of output per
unit of labor (or any other input).
3. To find how many cups of lemonade Giselle can produce daily with one worker, use
the production function provided, and evaluate it where L = 1:
Q F 1 21 201 301
3 3
2 20 30 48 cups of lemonade
If another worker is hired, then L = 2:
Q F 2 22 202 302
3 3
16 160 60 204 cups of lemonade
These answers show that at low levels of inputs the marginal product of labor is
increasing at an increasing rate.
5.
400
Efficient Production
Frontier
300
Output
(cups/day)
200
Production Possibilities
Frontier
100
1 2 3 4 5
Labor, L
179
Q F L 2L 20L 30L
3 2
if L = 0 Q 0
if L = 1 Q F 1 21 201 301 2 20 30 48
3 2
if L = 2 Q F 2 22 202 302 16 80 60 124

3 2
if L = 3 Q F 3 23 203 303 54 180 90 216

3 2
if L = 4 Q F 4 24 204 304 128 320 120 312

3 2
if L = 5 Q F 5 25 205 305 250 500 150 400

3 2
7.
400
Efficient Production
Frontier
300
Output
(cups/day)
200 Production Possibilities
Frontier
100
1 2 3 4 5
Labor, L
Q F L 3L2 2L2 20L MPL APL

if L = 0: Q 0
if L = 1: F 1 31 251 201 42
2 2
42 42
if L = 2: F 2 32 252 202 116
2 2
74 58
if L = 3: F 3 33 253 203 204
2 2
88 68
if L = 4: F 4 34 254 204 288
2 2
84 72
if L = 5: F 5 35 255 205 350
2 2
62 70
9. Notice that as the number of workers increases the MPL increases to a certain point,
and then begins to decrease.
180
Units of
Labor Output
MPL APL
0 0 0 0
1 48 48 48
2 124 76 62
3 216 92 72
4 312 96 78
5 400 88 80
6 468 68 78
11.
Units of Units of
Labor Capital Output
1 1 48.00
1 2 57.08
2 1 80.73
2 2 96.00
2 3 106.24
3 2 130.12
3 3 136.30
Looking at output levels associated with either an increase in a unit of labor, or a unit
of capital we see that labor is more productive than capital at Pucker Up.
13. This family of isoquants demonstrates that jelly and peanut butter are perfect
complements. The graph shows for example, at 2 oz. of jelly the firm cannot be made
better by having more peanut butter while jelly is at 2 oz.
10
6
Jelly
(oz)
4
2 4 6 8
Peanut Butter (oz)
181
15. Giselles MRTS remains unchanged. This type of productivity improvement is called
a factor-neutral technical change, which is characterized by having no affect on the
MRTS at any output combination. It only changes the output level associated with
each of the firms isoquants.
Chapter 8
1. The key characteristic that distinguishes an avoidable fixed costs from a sunk fixed
cost is that with the former a firm doesnt incur the cost (or can recuperate it) if it
produces not output. A sunk fixed cost is incurred even if the firm decides not to
operate.
3. First, solve for the number of hours of labor needed to produce Q cups of lemonade:
Q L2 Q L (take the square root of both sides)
Next, multiply the wage rate by the previous result to get the variable cost function
VCQ 10 Q . The short-run cost function is therefore CQ 75 10 Q .
5. We know the MRTSLK for the Cobb-Douglas production function

Q F L, K 15L K is MRTS LK KL which has a declining MRTSLK.

Now set the MRTSLK equal to the input price ratio: KL wr where 1 2 , 1 2 ,
w = $80 per day, and r = $40.
12 K 80

12 L 40
K
2
L
The tangency condition holds at the point on the 150 cup per day isoquant where the
capital-labor ratio equals 2. When Giselle uses L units of labor and 2L units of
capital, the output is:
Q F L, 2 L 15 L 2 2 L 2
1 1
Q 15 2 L
Producing 150 cups of lemonade requires:

150 15 2 L
7.071 L L 7 workers
Because we rounded to 7 workers, the amount of capital (K) needed is 2L.
2(7) = 14 units of capital
So Giselles total cost for one day is $1120 7 80 14 40 .
182
7. In problem 5 we found that to produce Q cups of lemonade Giselle needs the amount
of labor L that solves the formula: Q 15 2 L and she needs 2 times the amount of
Q 2Q
capital. Thus Giselle needs workers and units of capital. The cost of
15 2 15 2
producing Q units is therefore,
Q 2Q
C Q 80 40
15 2 15 2
16Q 16Q 32Q
.
3 2 3 2 3 2
Similarly, in problem (6) Giselles formula for Q cups of lemonade, and L amounts

of labor: Q 12 4 2 3 L and she needs 2 3 the amount of capital. Thus, Giselle needs
Q 2 Q Q

12 34 2
workers and

3 12 3 18 4 2 3
4 2
units of capital.
The cost of producing Q units is therefore,

Q
C Q 80 40 Q

12 4 2
3
18 4 2
3

C Q
20Q 20Q

3 4 23 9 4 23
9. The relationship between Giselles labor input and her output of lemonade is the same
as was worked out in problem 3. So her cost function is
0 if Q 0
C Q
75 10 Q if Q 0
200
150
Total Cost
($)
100
50
5 10 15 20
Output, Q
183
11. We know that with a least-cost plan that assigns a positive amount of output to each
stand, marginal cost must be the same at both stands. Thus Giselle needs to divide
production between her two stands so that their marginal cost are equal. Doing this
means choosing Q1 and Q1 so that MC1=MC2. Since total output equals 225 cups of
lemonade, we know Q2 225 Q1 so we can express MC2 as follows:
MC2 4(225 Q1 ) .
Next, to find how much each stand will produce, set MC1=MC2:
8Q1 4225 Q1
8Q1 900 4Q1
12Q1 900
Q1 75
Q2 225 75
Q2 150
Therefore, Giselle must produce 75 cups of lemonade in stand 1 and 150 cups in
stand 2. Her total cost of production will be:
C Q 475 8150 $202,500
2 2
13. The fixed cost for the firm is $100. This number might represent a sunk cost, like the
cost to rent a building. A fixed cost will not depend on how much output is produced.
To identify firms variable cost V(Q) in the function, look at the parts of the equation
that are dependent on Q. IT follows that the V Q 8Q 2Q 2 .
To find the average cost (AC) use the fact that AC Q

C
. In this firms case it is:
Q
100 8Q 2Q 2
AC (Q)
Q
AC Q
100
8 2Q
Q
To find the AVC and AFC use the following fact:

C VC FC VC FC
AC AVC AFC
Q Q Q Q
100 8Q 2Q 2 100 8Q 2Q 2 100

Now, AC . Thus, AFC and
Q Q Q Q
AVC 8 2Q .
184
15. If Giselles capital is fixed at 10 units, to produce Q cups of lemonade the amount of
labor that solves the formula is:
Q 15 L 10
Q2
QL
15 10
2
Q2
L
2250
So her short-run cost function is,
2
150
C SR Q 4010 80 Q
2250
8Q 2
150
C SR 400
225
Giselles long-run cost function is, (as was found in problem 7).
C LR Q
32Q
3 2
Note that Giselles short-run and long-run costs are equal when Q=150. (Since
150
C SR 150 C LR
150
150.
Chapter 9
1. We can find the inverse demand function PQ by solving

Q 80 2P
Q
P 40
2
for P, which gives us
PQ 40
Q
2
To determine the price at which Q d 40 , solve for P such that
40
P 40
2
P $20
Megan should price each shirt at $20.
If Q d 50 , solve for P such that,
50
P 40
2
P $15
Megan should price each shirt at $15.
185
3. A price-taking firm cannot affect the market price for a good by any means. A price-
taking firm cannot change the price by selling their good at a higher or lower price
than the market price. Therefore, no matter how many units of a good a price-taking
firm sells they will always have the same price leading to the characteristic horizontal
demand curve.
5. Use the quantity rule. Thus, Megans best positive sales quantity solves the formula
P MC , or
Q
6.60 3
30
Q 108
Now we must check the shut-down rule, by calculating the profit from producing
108 T-shirts.
6.60(108) 3 108 60
2
108

712.80 518.40
$194.40
Megan should go ahead and produce 108 T-shirts. If Megan also has an avoidable
cost of $200 per day her profit at Q = 108 would be negative, and the shut-down rule
would tell Megan to stop producing T-shirts all together.
7. The best positive sales quantity, Q, is found when the price P is set equal to the
marginal cost, so that
Q
P 3
30
Solving for Q, we find that
Q 30P 90
Q2
If Megan has no avoidable fixed cost, ACmin $3 . Note: C Q 3Q ,
60
so AC Q 3
Q
. Since this is an increasing function we know that $3 is the
60
minimum. So using the shut-down rule, Megans supply function is
30P 90 if P 3
S P
0 if P 3
When we add an avoidable fixed cost of $200 per day, this does not change MR or
MC, but it does change when Megan wants to stay in business. We need to determine
the new level of ACmin . This is done by setting AC = MC to determine the new
efficient scales of production.
Q 200 Q
MC 3 3 AC
30 Q 60
186
Solving for Q, we find Q 109.50 . Substituting this quantity into the equation for
200 109.50
average cost shows us that ACmin 3 $6.65
109.50 60
So Megans supply function is now

30P 90 if P 6.65
S P
0 if P 6.65
9. The minimum price at which Megan will choose to sell is $5.
S
8
6
Total Cost
($)
4
50 100 150 200

Output, Q
11. Lets begin with Megans long-run supply function first. If the price is greater than
150, we have P > MC at every output level. Because they make a positive profit on
every unit they sell, they will want to sell an infinite amount. If P < 150, they will
want to sell Q = 0. If P 150 , the firm will be willing to supply any amount, since
they earn zero profit no matter how much they sell.
For Megans short-run supply curve, we must apply the quantity rule. The quantity at
which P = MC solves the formula P = Q. Thus, the most profitable quantity given the
price P is Q = P. At this quantity Megans revenue is P P P 2 and her avoidable
2
costs are P and she will produce in the short run as long as P > 0. The short run
2
supply function is therefore SSR ( P) P.
187
13. Before the avoidable cost this firms producer surplus is:
PS 6 2200 0 400.
1
2
With an avoidable fixed cost this firms producer surplus is the trapezoidal region A,
or equivalently:
PS 6 4200 100 6 4100 0 300.
1
2
S
6
Price
($) A
4
50 100 150 200

Output, Q
15. First, start by applying the quantity rule to find the sales quantities for both the shirt
and the hat, where P = MC.
(1) 18 4 2QS QH
and,
(2) 10 2 2QH QS
Now with equations (1) and (2) we can solve for QS and QH . This can be done in
several ways but we will proceed as follows:
Rewrite (1) and (2).
(1) 14 2QS QH
(2) 8 2QH QS
Substitute (1) into (2) and solve for QS .

8 2 14 2QS QS
36 3QS
12 QS
188
Solve for QH .
14 212 QH
QH 10
Megans profit is:

R C

12 18 10 10 4 12 122 12 10 2 10 102 12 10
$244
Applying the shut down rule, we have to compare this profit not only to Megans
profit if she would shut-down her operation, but also, her profit if she would shut-
down the production of either of her products, and only would produce one product.
If Megan is not producing her T-shirts such that QS 0 , her cost function
becomes CH QH 2QH QH2 and MC H 2 2QH . The best quantity of hats
is Q H 4 , which yields $16 profit which is less than what Megan makes if she
produces both products.
This was found by setting P = MC:

10 2 2QH
QH 4
Megans profit is,

4 10 2 4 4 2
$16
If Megan stops producing the hats so that QB 0 , her cost function

becomes C S QS 4QS QS2 and MCS 4 2QS . Set P = MC:
18 4 2QS
QS 7
Megans profit is,
7 18 4 7 7 2
$49
Again, this is less than Megan would make if she produced both the T-shirts and the
hats, so Megan should produce the profit-maximizing sales quantities
of QS 12 and QH 10 .
189
Chapter 10
1. Compounding refers to the payment of interest on a loan balance that includes

interest earned in the past. Compounding causes the loan balance to grow faster as
time passes. It is important to factor compounding interest when you are making a
saving decision because you should realize that you wont see immediate large
returns on your investment, but they will increase over time. If you are about to make
a borrowing decision it is important to factor compounding because as a borrower
you should understand that you will have a larger loan balance as more and more
time passes.
3. To calculate the PVD of $100 received in 5 years at the various interest rates shown,
we need to identify some variables from the formula:
FutureValue$ F
PVD
1 R T
Notice that, T, tells use in years how long it will take to received the future value F,
which is $100, and R, is the interest rate which will vary in this problem:
If the R = 5%:
$100
PDV $78.35
1 .055
If the R = 10%:
$100
PDV $62.09
1 .105
If the R = 20%:
$100
PDV $40.19
1 .205
5. To find out how much you would owe your friend in todays dollars, use the formula
for finding the present discounted value of a stream:
F1 F2 FT
PDV F0
1 R 1 R 2
1 R T
Therefore,
200 250 300 400
PDV 0
1 .05 1 .05 1 .05 1 .054
2 3
PVD 0 190.48 226.75 259.15 329.08

PVD $1005.46
So in todays dollars you will have to pay your friend $1005.46 to borrow $1000.
190
7. Option (1) requires no calculations; it is simply $25,000 in todays dollars.
To figure out how much option (2) will cost in todays dollars we must perform the
PDV calculation for a constant stream:
F 1
PDV 1
R 1 R T
9000 1
PDV 1
3
.08 1 .08
PDV $23,193.87
To calculate how much option (3) will cost in todays dollars we must perform the
PDV calculation for a constant stream:
6000 1
PDV 1
5
.08 1 .08
PDV $23,956.26
Therefore, with an interest rate of 8% option (2) is the lowest price option measuring
in todays dollars.
9. To find the real interest rate, use the formula:

R no min al INFL
R real
1 INFL
.065 .02
R real 4.4%
1 .02
If the rate of inflation grew to 3.5%, then the real interest rate would be:
.065 .035
R real 2.9%
1 .035
As the rate of inflation grows the real interest rate decreases.
11. Draw the 45 line on the graph. In relation to the 45 line Brians preference is above
the line according to his indifference curve. This tells us that Brian prefers to spend
more money next year than this year in order to maximize his preferences.
191
1100
750
Money
spent next
year 550
($)
250
250 500 750 1000

Money spent this year ($)
13. Start by identifying bundles that satisfy the tangency condition. The slope of Brians
F
indifference curve is 0 (his MRS times negative one); and the slope of his budget
F1
1
line is 1 R . Brians best choice is where the slope of his indifference curve is
1
equal (tangent) to his budget line, which is 0 1 R , or
F
F1
F0
equivalently F1 . This tangency condition informs us that Brian
1 R
consumes 1 R times as much food this year as next year.
The formula for Brians budget line is F0 F1 1 R 2400 . To find the bundle to
satisfy the tangency condition and the budget line formula, substitute for F1 in the
budget line formula using the tangency condition formula.
F0 F1 1 R 2400
F0
F0
1 R 2400
1 R
2 F0 2400
F0 1200
1200
So, this year Brian will spend $1200 and save $1200; next year he will spend .
(1 R)
Because the interest rate is 5%, Brian consumes 1200 pounds of food this year and
1142.85 pounds next year.
192
If Brian makes $2400 the first year and $1200 the next year, then Brians new budget
line is as follows:
F0 F1 1 R 2400
1200
1 R
F0
F0
1 R 2400 1200
1 R 1 R
600
F0 1200
1 R
600 600
So, this year Brian will spend 1200 and saves 2400 1200 ;next
1 R 1 R
1200 600
year he will spend . Because the interest rate is 5%, Brian
(1 R) (1 R) 2
consumes 1771.43 pounds of food this year, and 1687.07 pounds of food next year.
The formula for Brians savings can be written as S = 1200, because when Brian
makes $2400 in the first year and nothing the second year, his savings do not depend
on the interest rate.
The formula for Brians savings for the situation in which he makes money in both
years is the following:
600
S ( R) 2400 1200
1 R
1
S ( R) 600 2
(1 R)
In this instance we see that Brians savings rate depends on the interest rate.
15. Start by identifying bundles that satisfy the tangency condition. The slope of Brians
F
indifference curve is 0 (his MRS times negative one); and the slope of his budget
2F1
1
line is 1 R . Brians best choice is where the slope of his indifference curve is
1
equal (tangent) to his budget line, which is 0 1 R , or
F
2 F1
F0
equivalently F1 . This tangency condition informs us that Brian
21 R
consumes 21 R times as much food this year as next year.
193
The formula for Brians budget line is F0 F1 1 R 2000
1000
. To find the
(1 R)
bundle to satisfy the tangency condition and the budget line formula, substitute
for F1 in the budget line formula using the tangency condition formula.
F0 F1 1 R 2000
1000
(1 R)
F0
F0
1 R 2000 1000
21 R (1 R)
3 1
F0 1000 2
2 (1 R)
2000 1
F0 2
3 (1 R)
2000 1
So, this year Brian will spend 2 and
3 (1 R)
2000 1 2000 1000
save 2000 2 ; next year he will spend .
3 (1 R) 3(1 R) 6(1 R) 2
Because the interest rate is 5%, Brian consumes 1968.25 pounds of food this year
and 786.09 pounds next year.
Brians savings function is:

1 1
S ( R) 20001 2
3 (1 R )
Chapter 11
1. To calculate your expected payoff, set up the payoffs as follows:

EP (0.05)($1) (0.05)($1)
EP $0
$0 is your expected payoff. Flipping a coin 10 times will not change your total
expected payoff.
3. To derive the constant expected consumption line BL (, BW ) , set up the expected

consumption equation with EC = $400, and proceed to solve for B L in terms
of and BW .
EC BW (1 ) BL
400 BW (1 ) BL
194
Solving for B L :
400 BW
BL
(1 ) (1 )
If 1 :
2
1 BW
400
BL 2
(1 1 ) (1 1 )
2 2
BL 800 BW
The slope of the line is negative one.

If 1 :
3
1 B
400
2
W
BL
(1 1 ) (1 1 )
2 2
1
BL 600 BW
2
The slope of the line is negative one-half.

5. Michaels expected consumption is, 3 4 144 1 4 (36 $117 . To calculate the
certainty equivalent, find the level of guaranteed consumption, B, that places Michael
on the same IC curve as the risky bundle.
3
4

144 1
4

36 3
4

B 1
4
B
10.5 B
B 110.25
So the certainty equivalent is $110.25. Since 117 110.25 6.75 , the risk premium is
$6.75.
7. Michaels expected utility function is,

U BW , BL 3 BW 1 BL
4 4
Using this formula, plug-in the point ( BW , BL ) (100,100) to find
that U BW , BL 100 . So points on the indifference curve through the
point ( BW , BL ) (100,100) satisfy the formula 100 3 4 BW 1 4 BL . Now, solve
for B L .
100 3 BW 1 BL
4 4
1 BL 100 3 BW
4 4
BL 400 3BW
195
The constant expected consumption line that runs through the
point ( BW , BL ) (100,100) satisfies the formula 3 BW 1 BL 100 , which can be
4 4
rewritten as BL 400 3BW . Notice that the indifference curve is the same as the
constant expected consumption line at all points including the
point ( BW , BL ) (100,100) . Michael is therefore risk neutral.
Guaranteed
Consumption
Line
200
Michael
loses the 150 Indifference
bet, BL Curve
100
50
Constant Expected
Consumption Line
50 100 150 200

9. The benefit for the high state is represented by point A. The benefit for the low state
is represented by point B.
The expected benefit is 3 4 400 1 4 100 17.5 . The W ( EC ) is shown on the
graph, and as you can see it is characteristically higher than the expected benefit.
The risk premium and certainty equivalent are also shown on the graph.
W ( BW )
W (EC) A
20 D
Expected E C
15 Benefit E
W ( BL )
Benefit, U
Risk
10 Premium
B
Certainty
Equivalent

100 200 300 400
Money, $
196
(1 R)
11. Michaels available choices lie on the budget line . In this case R = 0.4, so
R
the slope of the budget line is l.5. The formula for Michaels budget line is
thus BL C 1.5BW where C is a constant. Michaels budget line must pass through
the point, ( BW , BL ) (324, 64) , we know that 64 C (1.5 324) so C =550.
Michaels best choice is the point where his budget line and indifference curves are
tangent to each other. At any best choice point, the slopes of the budget line and the
indifference curve must be the same. Therefore,
3 BL
1.5 MRSWL
BW
Using this formula, then solve for B L which gives you, BL .25BW .
Now we can use both BL 550 1.5BW and BL .25BW to find Michaels best
choice, by solving algebraically.
.25BW 550 1.5BL
550
BW $314.29
1.75
Michael spends $314.29 if he wins. Since Michael started with $324 he did
buy insurance. He spent $9.71 on insurance. This means that Michaels
insurance benefit must be $24.28 (since 0.4 24.28 9.71 ). If Michael gets the
low state BL , he spends BL 64 24.28 9.71 $78.57 .
After purchasing insurance, Michaels risky bundle is ( BW , BL ) (314.29, 78.57) .

Points on the indifference curve that runs through this bundle satisfy the
formula 3 4 BW 1 4 BL 3 4 314.29 1 4 78.57 15.51 . To find a risk-less
bundle on this indifference curve (where BW BL ), we solve:
3 B 1 B 15.51
4 4
B 15.51
B 240.56
B = $240.56 is the certainty equivalent of Michaels risky bundle after purchasing

insurance.
Michaels initial bundle is ( BW , BL ) (324, 64) . This bundle satisfies the
formula 3 4 BW 1 4 BL 3 4 324 1 4 64 15.5 . Like before we need to find
the risk-less bundle on this indifference curve, by solving:
197
3 B 1 B 15.5
4 4
B 15.5
B 240.25
$240.25 represents the certainty equivalent of Michaels initial risky bundle. The
value of the insurance is 31 cents, since 240.56 240.25 0.31 .
13. In practice, diversification involves undertaking many risky activities, each on a small
scale, whereas hedging refers to the undertaking of two risky activities with
negatively correlated financial payoffs. Hedging is a case in which diversification is
particularly effective at reducing risk. Diversification can be used to mitigate risk
because with diversification you would invest in many activities on small scale that
are uncorrelated so that the probability of having all your activities perform poorly is
small. Hedging helps reduce risk because you are essentially betting big on the only
two possible outcomes so that you will always have invested on the winning outcome.
Therefore, you would lose from the one investment, but ideally your other investment
would offset your loss.
15. As we saw in (14) if Michael keeps the $400, he is guaranteed a benefit of 20, and a
certainty equivalent of $400. Investing $400 in the company will produce an
expected benefit of,
0.3 800 0.4 400 0.3 0 16.49
Michaels certainty equivalent is the amount X that solves X 16.49 , so X =
271.92. So, Michaels best choice is to keep his money, and not invest. Any
investment that is under $400 will improve the investment option but not enough to
change the best choice of not investing.
Chapter 12
1.
PLAYER A
STAY SWERVE
-6 -2
STAY -6 4
PLAYER B
SWERVE 4 -2
-2 -2
198
3.
PLAYER A
LEFT RIGHT
15 7
UP
12 20
PLAYER B
11 16
DOWN 9 8
Player B has a dominant strategy of choosing up, because regardless of player As

decision player Bs best choice is still up. Player A does not have a dominant
strategy because his/her best strategy depends upon what player B chooses.
5. Regardless of whether player A chooses left or right, player Bs best response is to

choose up. If player Bs best response is up then player As best response is left.
Therefore the Nash Equilibrium is (up, left).
7. If Nina works X hours, then Margarets best response can be found by setting her
marginal benefit equal to her marginal cost: 4Y 48 2( X Y ) . Solving for Y,
produces the formula that describes the relationship between Ninas choices and
Margarets best responses:
Y 8 1 X
3
Now, if Margaret works Y hours, then Ninas best response can be found in a similar
fashion. Set marginal benefit equal to marginal cost, then solve for X:
X 8 1 Y
3
In order to find the Nash equilibrium, we need to find the values of X and Y that
satisfy both best response formulas at the same time. To do this, substitute the first
formula into the second formula:
X 8 1 (8 1 X )
3 3
X 8 8 1 X
3 9
8 X 16
9 3
X 144 6
24
Thus, we find that X = 6. Plugging this value for X into the first formula, we find
that Y = 6. So Nash equilibrium in this situation has both Nina and Margaret
working for 6 hours.
199
There are two more preferred outcomes for Nina and Margaret. The most preferred
outcome would have been for both Margaret and Nina to work 8 hours because each
would have received a net benefit of 384 which can be found by calculating the
benefit and subtracting the cost ( [24(2(8) 2(8)) (8 8) 2 2(8) 2 ] 384 ). The net
benefit for 6 hours of work is 360 which is less than the 384 net benefit of 8 hours
and the net benefit if both work 7 hours which is 378.
9. A mixed strategy equilibrium is a strategy in which each player chooses a mixed

strategy that is a best response to the mixed strategy chosen by the others. Mixed
strategies are best used in multi-staged games.
11. For pure strategies there are no Nash equilibria.
For mixed strategies, in equilibrium a player will not choose a dominated strategy as
a best response. In the matrix, every choice can be dominated by the other players
response, therefore Nina and Margaret must randomize their choices. Let Q represent
the probability that Nina holds up one finger. Let P represent the probability that
Margaret holds up one finger. Ninas expected payoff from holding up one finger
is 4Q 10(1 Q) , while her expected payoff from holding up two fingers
is 8Q 4(1 Q) .
Since Ninas choice of P has to make Margaret indifferent between holding one
finger or two fingers (so that shes willing to randomize between the two), we know
that 4Q 10(1 Q) 8Q 4(1 Q) , which means that Q 7 13 53.8% . Margarets
expected payoffs are 10Q 2(1 Q) for one finger and 2Q 10(1 Q) for two
fingers; and by similar method we find that P 1 2 . Therefore, the mixed strategy
equilibrium is: Nina holds up one finger with 53.8% probability and two fingers up
with 46.2% probability; Margaret holds up one finger and two fingers up with 50%
probability.
13. Using backward induction:

Start by looking at player 1s decision in the final round. 1s best decision is to take
the money. Using this information, we now focus on player 2s decision in the
second round knowing what 1 will do in round 3. Player 2s best choice is to take the
money and not wait.
Finally, we can now focus on player 1s decision in round 1, knowing how 2 will
react to if 1 waits. Therefore, the Nash equilibrium for this game is that player 1
takes the $1 in round one and ends the game.
Allowing for additional rounds would not change the outcome of the game because
backward induction would always lead us to the same outcome. The strategy of
wait is strictly dominated by the strategy of take.
200
15. There are two Nash equilibria: (80, 375) and (375, 80).
FIRM A
PL PH
50 80
PL
50 375
FIRM B
PH 375 300
80 300
A possible grim strategy that could be devised is one in which both firms agree to
charge high, and if one firm decides to price low the other firm will punish them
permanently by pricing low from that period on. This would only work in a multi- or
infinite-stage game, otherwise the threat of punishment would not be credible.
Chapter 13
1. Experiments have allowed economist to study things such as fairness, status and trust;
issues that standard economic theories did not account for. Experiments have also
allowed economists to gather information on a wide range of contexts that are
difficult to find in real world data.
3. Stating that $150 as the dollar amount that is just as good as the gamble when you
took the $100 with violates the ranking principle and represents a choice reversal: two
staples of standard economic theory. There is evidence that reversals decrease when
decisions are repeated so that people learn from the consequences of their choices.
5. The default effect refers to the fact that when given many alternative choices, people
often avoid making a choice and settle for the assigned default option. According to
the default effect, the professor should have the in-class exam on the syllabus, but
later offer the take-home exam and term paper as alternative options to the in-class
exam. Evidence from economic experiments has shown that if the professor employs
this strategy he/she should achieve the desired result.
7. Jason would be more likely to take advantage of the sale in the second scenario
because, according to the concept of narrow framing, Jason would view each scenario
as such: in (1) the TV is on sale, but it is less than 5% off, where in (2), the DVD
player is 50% off, making this seem like a better deal, even though both scenarios
offer a savings of $150.
201
9. First start by looking at Brians utility from Sundays perspective. Brians utility will
be 16 6 20 if he washes Vincent on Monday, 13 6 7 if he does it on
Tuesday, 10 6 4 if he does it on Wednesday, 7 6 1 if he does it on Thursday,
and 4 6 2 if he does it on Friday.
To determine what Brian will actually do, analyze a few hypothetical situations.
Suppose Wednesday arrives and Vincent is still dirty. Brian can either do it on
Wednesday or wait until Thursday to wash Vincent. If he does it on Wednesday, his
utility (from Wednesdays perspective) will be 2(6) 10 2 . Should he wait until
Thursday from Wednesdays perspective his utility will be 7 6 1 . Since 1 > -2, he
will not wash Vincent on Thursday.
Now, suppose Tuesday rolls around and Vincent is still dirty. Brian can either do it
on Tuesday or delay. If he does it on Tuesday, his utility (from Tuesdays
perspective) will be 2(6) 13 1. If he delays he will end up washing Vincent on
Wednesday, so his utility (from Tuesdays perspective) will be 10 6 = 4. Since 4 >
1, Brian will do the chore on Wednesday.
On Monday, Brian can either do the chore or delay. Should he wash Vincent on
Monday his utility from Mondays perspective will be 2(6) 16 4 . If he
postpones, Vincent wont be clean until Wednesday, so his utility (from Mondays
perspective) will be 10 6 =4. Since 4 = 4, he is indifferent between washing
Vincent on Monday or Wednesday.
As of Sunday Brian will want to wash Vincent on Monday. Based on the reasoning
above, Brian will wash Vincent on Monday. He is dynamically consistent, and he
will follow through on Sundays intentions.
11. First start by looking at Brians utility from Sundays perspective. Brians utility will
be 10 2 8 if he washes Vincent on Monday, 8 2 6 if he does it on
Tuesday, 6 2 4 if he does it on Wednesday, 4 2 2 if he does it on Thursday,
and 2 2 0 if he does it on Friday. So as of Sunday, Monday is the best option.
Suppose Wednesday arrives and the litter box still stinks. Brian can either do it on
Wednesday or wait until Thursday to clean the litter box. If he does it on Wednesday,
his utility (from Wednesdays perspective) will be 3(2) 2(6) 6 . Should he wait
until Thursday from Wednesdays perspective his utility will be 4 2 2 . Since 6 >
2, he will clean the litter box on Wednesday.
Now, suppose Tuesday rolls around and the litter box still stinks. Brian can either do
it on Tuesday or delay. If he does it on Tuesday, his utility (from Tuesdays
perspective) will be 3(2) 2(8) 10 . If he delays he will end up cleaning the litter
box on Wednesday, so his utility (from Tuesdays perspective) will be 8 2 6 .
Since 10 > 6, Brian will do the chore on Tuesday, because delaying would decrease
his utility.
202
On Monday, Brian can either do the chore or delay. Should he clean the litter box on
Monday his utility from Mondays perspective will be 3(2) 2(10) 16 . If he
postpones, the litter box will stink until Tuesday, so his utility (from Mondays
perspective) will be 8 2 6 . Since 16 > 6, he will clean the litter box Monday.
As of Sunday Brian want to clean the litter box on Monday. Based on the reasoning
above, Brian will clean the litter box on Monday. He is dynamically consistent, and
he will follow through on Sundays intentions.
13. If Jason believes in the gamblers fallacy he will bet on black because he will reason
that red is less likely. If Jason believes in the hot-handed fallacy he will bet on red
because he will think that red is more likely to come up because it keeps coming up.
The reasoning for both bets is in error, because the probability of red or black is
equally likely and independent of prior outcomes.
15. We need to solve for the expected valuation of each risky prospect using expressions
for positive and negative values of X.
If X = 10, then V (10) 40(10) (10)2 300 . The weight attached to V (10) is
W (0.5) 0.001 0.998(0.5) 0.5 , while the weight attached to
V (10) 25(10) 2(10)2 50 is W (0.5) 0.001 0.998(0.5) 0.5 .The value of
this option is [0.5 300] [0.5 50] 125 .
If X = 100, then V (100) 40(100) (100)2 6,000 . The weight attached to V (100)
is W (0.5) 0.001 0.998(0.5) 0.5 , while the weight attached to
V (100) 25(100) 2(100)2 17,500 is W (0.5) 0.001 0.998(0.5) 0.5 .The
value of this option is [0.5 6000] [0.5 17500] 11,750.
Jason would accept the first gamble that pays $10. He would not accept the $100
gamble because it offers negative payoffs.
Chapter 14
1. The three main characteristics of a perfectly competitive market are: buyers and
sellers dont have transaction costs; products are homogenous meaning that every
seller produces the same product and consumers cant tell what seller produced what;
and lastly, there are many sellers in the market such that every seller has a fraction of
the market supply.
The presence of these factors inhibits sellers from charging a price above the market
price. The large number of sellers in the market coupled with their lack of market
power means that each firm must price at the market price; any firm that prices
above the market price will lose their customers. The fact that goods are
homogenous means that if one firm decides to price above the market price
customers will not miss this firms product because every other firm in the market
offers the same good. Thus, firms in a perfectly competitive market are price takers.
203
3.
6
Price Market Demand
($)
4 0 if P 6

Q 18 3P if 5 P 6
d
28 5P if P 5
2
10 20 30 40
Quantity, Q
To find the market demand, first find the respective inverse demand functions and
solve for the P-intercept:
Q
QMd 10 2 P P 5 ; P-intercept = 5.
2
Q
QJd 18 3P P 6 ; P-intercept = 6.
3
Now we may proceed as follows:
At prices below $5 only the market demand

is Q d QMd QJd (10 2 P) (18 3P) 28 5P . For prices between $5 and $6
dollars, only Jerry buys pizza, so the market demand function is QJd 18 3P . At
prices above $6, neither Jerry nor, Marie demand pizza.
0 if P 6

Q 18 3P if 5 P 6
d
28 5P if P 5

5. To determine the long-run market supply curve first find the output level at which
marginal cost equals average cost.
MC 2 Q 45 2 Q AC
20 Q 40
Q 45
40 Q
Q 2 1800
Q 42.43
204
Substituting this quantity into the expression for average cost tells us that
ACmin 45 2 42.43 $4.12
42.43 40
is the price at which the long-run market supply curve is a horizontal line. At prices
under $4.12, the long-run supply is zero; and at prices above $4.12, it is infinite.
7. The long-run market equilibrium price equals the ACmin ; we found the price to be
$4.12, in problem (5). Now we need to find out how many pizzas are produced and
sold every day in equilibrium. To find this we must evaluate the total quantity
demanded at $4.12: Qd 650 100(4.12) 238 . Lastly, in a long-run equilibrium
each active firm produces 42.43 pizzas. This means that there are about 5.61 firms.
9. No, the long-run price will not always remain the same. If the demand in a market
doubles, the price would almost certainly increase; however, in the long-run in a
competitive and free entry market the increase in demand would attract new
producers that would dissolve the short-run producers surplus, driving the price
back-down to the competitive level.
11. In this instance the firms avoidable cost of making 180 slices can be found by
measuring the area under the market supply curve up to the quantity of 180. If Q =
180, then 180 40P 20 P $5 . The supply curve may be rewritten
as P Q 40 1 2 .
TAC 1 (180) 1 ((5 1 )(180)) 405
2 2 2
The avoidable cost of making 220 slices is,
TAC 1 (220) 1 ((5 1 )(220)) 605
2 2 2
13. First, solve for both inverse the demand and inverse supply functions.
S
Q d 200 P P 200 Q d and, Q S 2 P 100 P Q 2 50 . Equate the
function for price in terms of quantity demand to the function for price in terms of
quantity supply to solve for the market equilibrium P* $100 & Q* 100 .
If we were to draw a horizontal line from P* $100 , consumer surplus would be the
area above this line but below the curve P 200 Q d , thus
CS 1 ((200 100)(100)) 5000
2
If we were to take the same horizontal line from P* $100 , the producer surplus
S
would be the area below this line but above the curve P Q 2 50 , thus
PS 1 ((100 50)(100)) 2500
2
Aggregate surplus represents a total surplus which includes both CS and PS. Thus
aggregate surplus, AS = 7500.
205
15. First, solve for both inverse the demand and inverse supply functions.
d S
Q d 13 3P P 13 Q and, Q S 7 P 2 P Q 2 . Equate the
3 3 7 7
function for price in terms of quantity demand to the function for price in terms of
quantity supply to solve for the market equilibrium P* $1.50 & Q* 8.5 .
If we were to draw a horizontal line from P* $1.50 , consumer surplus would be the
d
area above this line but below the curve P 13 Q , thus
3 3
CS 1 ((13 1.5)(8.5)) 12.04
2 3
If we were to take the same horizontal line from P* $1.50 , the producer surplus
S
would be the area below this line but above the curve P Q 2 , thus
7 7
PS 1 ((1.5 )(8.5)) 5.16
2
2 7
Aggregate surplus represents a total surplus which includes both CS and PS. Thus
aggregate surplus, AS 12.04 5.16 17.2 .
Chapter 15
1. An 18 cent tax on each gallon of gas is a specific tax. A 7.56% payroll tax is and ad
valorem tax. An 8.25% sales tax is also an ad valorem tax. A $1.25 tax on cigarettes
is a specific tax.
3. To find the competitive market equilibrium set the market demand function equal to
the market supply function and find the equilibrium price, then use the price to find
the equilibrium quantity.
200 P 2 P 100
300 3P
P 100
If P = $100, then Q 200 (100) 100 .
Now we need to find the consumer surplus, producer surplus and aggregate surplus.
CS 1 (200 100)(100) 5000
2
PS 1 (100 50)(100) 2500
2
AS 5000 2500 7500
206
The $15 tax on each down blanket changes the market supply function to
Q S 2( Pb 15) 100 2 Pb 130
where Pb is the price paid by consumers. Now we need to find the equilibrium level
of Pb, and again we set demand equal to supply:
200 Pb 2 Pb 130
330 3Pb
Pb $110
If Pb = $110, then sellers must receive Ps = $95 per down blanket. Substituting Pb =
$110 we find that Q 200 110 90 blankets are sold.
Next, we need to find the consumer surplus, producer surplus, aggregate surplus, and
now the deadweight loss.
CS 1 (200 110)(90) 4050
2
PS 1 (95 50)(90) 2025
2
AS 4050 2025 6075
To find the deadweight loss we need to look at the difference in quantities pre- and
post-tax and the difference in prices between consumers and producers post-tax.
DWL 1 (100 90)(110 95) 75
2
The deadweight loss of this tax is $75.
5. To find the competitive market equilibrium set the market demand function equal to
the market supply function and find the equilibrium price, then use the price to find
the equilibrium quantity.
13 3P 7 P 2
10 15P
P 1.5
If P = $1.5, then Q 13 3(1.5) 8.5 .
Now we need to find the consumer surplus, producer surplus and aggregate surplus.
CS 1 (13 1.5)(8.5) 12.04
2 3
PS 1 (1.5 2 )(100) 5.16
2 7
AS 27.63 5.16 17.2
The $0.50 tax on each refrigerator magnet changes the market supply function to
Q S 7( Pb 0.50) 2 7 Pb 5.5
where Pb is the price paid by consumers.
207
Now we need to find the equilibrium level of Pb, and again we set demand equal to
supply:
13 3Pb 7 Pb 5.5
18.5 10 Pb
Pb $1.85
If Pb = $1.85, then sellers must receive Ps = $1 per refrigerator magnet. Substituting

Pb = $1.85 we find that Q 13 3(1.85) 7.45 refrigerator magnets are sold.
CS 1 (13 1.85)(7.45) 9.25
2 3
PS 1 (1 2 )(7.45) 2.66
2 7
AS 9.25 2.66 11.91
post-tax and the difference in prices between consumers and producers post-tax.
DWL 1 (1.85 1.5)(8.5 7.45) 0.18
2
The deadweight loss of this tax is 0.18.
7. From, question (4) we know that the competitive equilibrium before the subsidy is P
= $2 and Q = 18.
From question (4) we also know that consumer surplus, producer surplus and
aggregate surplus are:
CS 1 (5.6 2)(18) 32.4
2
PS 1 (2 0.2)(18) 16.2
2
AS 32.4 16.2 50.4
The $0.18 subsidy on each slice of pizza changes the market supply function to
Q S 10( Pb 0.18) 2 10Pb 0.2
where Pb is the price paid by consumers. Now we need to find the equilibrium level
of Pb, and again we set demand equal to supply:
28 5Pb 10 Pb 0.2
28.8 15Pb
Pb $1.88
If Pb = $1.88, then sellers must receive Ps =$2.18 per pizza slice. Substituting Pb =
$1.88 we find that Q 10(1.88) 0.2 16.8 slices of pizza are sold.
208
CS 1 (5.6 1.88)(16.8) 31.25
2
PS 1 (2.18 0.2)(16.8) 18.14
2
AS 31.25 18.14 49.35
post-subsidy and the difference in prices between consumers and producers post-
subsidy.
DWL 1 (18 16.8)(2.18 1.88) 0.18
2
The deadweight loss of this pizza subsidy is 0.18.
9. As we found in question (3) the equilibrium without interventions has a price of

$100 per down blanket and 100 blankets are bought and sold each day. At a price of
$120, consumers demand 80 blankets while blanket producers will want to supply
140 down blankets. The price floor policy would state that a down blanket could not
be sold for more than $120. The price support program would have the government
purchase 60 blankets each year, which is the difference between the quantity
demanded and quantity supplied at $120. A quota would distribute permits to down
blanket producers for selling 80 down blankets. In a voluntary production reduction
program, the government would pay down blanket producers to reduce their
production from 140 blankets to 80 blankets per day.
Now we must calculate the deadweight loss for each type of intervention: (use Figure
15.13 on p.558 of your textbook)
Price floor:
DWL 1 (100 80)(120 90) 300 ($90 is the price suppliers would charge if
2
consumers would demand only 80 blankets)
Price support program:

DWL 300 1 (100 90)(100 80) 1 (100 60)(140 100)
2 2
(60 40) 1 (120 60)(100 40) 5400
2
A quota program:
DWL 1 (100 80)(120 90) 300
2
The voluntary reduction production program:

DWL 1 (100 80)(120 90) 300
2
209
11. A price ceiling at $85 for down blankets would restrict down blankets from being
sold at a price below $85. This would reduce the number of blankets produced by
suppliers and the amount demanded. Since supply is less than demand, the amount
supplied would determine the new equilibrium quantity
200
150 S
Price
($)
100
85
50
D
50 100 150 200

Quantity, Q
13. The impact on social welfare would be in the form of a deadweight loss to consumers.
Which may be calculated as follows (use Fig.15.18, on p.567 of the textbook):
DWL 1 (1.5 1)(13 8) 1 (1.5 1)(23 20.5) 1.88
2 2
15. The impact on social welfare would be in the form of a deadweight loss to consumers.
Which may be calculated as follows (use Fig.15.18, on p.567 of the textbook):
DWL 1 (6.75 5)(1.25 1) 1 (10 9.25)(1.25 1) .3125
2 2
Chapter 16
1. The difference between partial equilibrium analysis and general equilibrium analysis
is that general equilibrium analysis focuses on the competitive equilibrium in many
markets at the same time, as opposed to, partial equilibrium analysis which only
considers the equilibrium in a single isolated market.
The advantage of using general equilibrium analysis is that it allows economists to

understand the consequences of interdependence in markets. Through the use of
general equilibrium analysis economists can observe feedback between markets that
have an effect on each other (i.e. market for crude oil and the market for
automobiles).
210
3. First, notice that ice cream and cake are substitutes because the market-clearing curve
is upward sloping. So, an increase in the price of ice cream would increase the
demand for cake, which in turn increases the partial equilibrium price of cake.
5. First we must find the market clearing formulas for both deli turkey and roast beef.
This is done by equating supply and demand in each market.
Deli Turkey:
34 2 PT 4 PR 10 PT 2
PR
PT 3 (market clearing function for deli turkey)
3
Roast Beef:
58 4 PT 4 PR 8PR 2
PT
PR 5 (market clearing function for roast beef )
3
Next, we must solve for the prices that satisfy both market-clearing formulas at the
same time. This is done by substituting one into the other, like so:
PT 3 1 5 T
P
3 3
PT 54 $1.80
30
The price of roast beef is therefore,

PR 5 1.8 $5.60
3
general equilibrium, consumers buy 16 million pounds of deli turkey meat, and 42.8
million pounds of roast beef.
If the government imposes a 48 cent tax per pound of turkey meat, this changes the
supply function for deli turkey meat to:
PT 10( P .48) 2 10P 6.8
Once again equate demand and supply in the deli turkey market to find:
34 2 PT 4 PR 10 PT 6.8
PR
PT 3.4 (market clearing function for deli turkey)
3
We can now proceed as before, substituting PR into PT:

PT 3.4 1 5 PT
3 3
PT $1.56
211
The price for roast beef is thus:
PR 5 1.56 $5.52
3
general equilibrium, consumers buy 13.6 million pounds of deli turkey meat, and
42.16 million pounds of roast beef.
7. The northeast boundary of this area (in other words the curve above) represents the
utility possibilities frontier, which contains all the Pareto efficient allocations.
Therefore, we can say that point A, B, and D are all Pareto efficient, but point C is not.
It Marie and Jerry are starting off at point C then, we can make both better off by
moving to point B.
9. The main difference between utilitarianism and Rawlsianism is that utilitarianism

says that society should place equal weight on the well-being of every individual.
Whereas, Rawlsianism says that as a society we should place all weight on the well-
being of its worst-off member.
The difficulty in implementing either outcome-oriented principle is that they both
require that we know a persons cardinal utility; a feat that most economists agree is
an unachievable objective. Standard utility theory is based on the fact that we may
only know consumers ordinal preferences (which bundle they prefer when compared
to another bundle).
11. The contract curve of an Edgeworth box identifies every efficient allocation of
consumption goods. This turns out to be very useful because the contract curve shows
every Pareto efficient outcome of consumption goods.
13. Maries utility function is characteristic of goods that are deemed substitutable, thus
Maries food consumption does not have to equal her water consumption, but if the
price of one good should increase in comparison to the price of the other good, she
will consume less of that good and substitute it for the other good.
15. The laissez-faire approach to efficiency proposes that government should not interfere
with markets in the form of regulations, because markets are perfectly capable of
correcting themselves. Any form of government intervention in markets would
produce inefficiencies.
The laissez-faire approach typically fails when there are market failures. Market
failures are a source of inefficiency. Furthermore, real economies are hardly if ever
perfectly competitive. The laissez-faire approach may also fail because it can produce
inequitable results.
212
Chapter 17
1. A firm that possesses market power is a firm that can profitably charge a price above
its marginal cost. In a monopoly market there is only one seller, thus this monopolist
firm would have possession of this markets power.
3. First find the inverse demand function, which is P(Q) 28 Q , so

5 5
the P 1 . Using the formula MR P(Q) P Q , Boiler Pizzas
Q 5 Q
marginal revenue when it sells Q slices of pizza is:
5 5

MR 28 Q 1 Q
5
MR 28 2Q
5 5
So Boiler Pizzas marginal revenue when it sells 5 slices is $3.6. This is less than its
price at 5 slices of pizza, which is P (5) 28 5 (5) 5 4.6 .
8.00
6.00
Price
($)
4.00
2.00
MR D
10 20 30 40
Quantity, Q
5. In problem (3) we found that Boiler Pizzas inverse demand function

is P(Q) 28 5 Q 5 , and its marginal revenue is MR 28 5 2Q 5 . We can find its
profit maximizing sales quantity and the associated price by applying the quantity
rule and equating MR = MC:
MR 28 2Q MC 1 Q
5 5 5 5
27 3Q
5 5
Q9
213
Now, we can substitute this quantity into the inverse demand function. Thus, we find
the price associated with the profit maximizing quantity is
P(9) 28 9 $3.80
5 5
We still need to check the shut-down rule. Observe that Boiler Pizzas profit

is TR TC (9 3.80) 1 9 (9)
5
2
10

$24.3 per hour . Since Boiler

Pizza earns nothing by shutting down, it will choose to operate at its profit-
maximizing price of $3.80.
P MC
7. The Lerner Index says that the markup is equal to . To use this index we
P
need to find the MC (500), which is 7.5. Therefore the mark-up is:
10 7.5
.25 or 25%
10
P MC 1
To find the elasticity of demand d , use the fact that d . Thus, in our
P
1 1
example is d 4 .
mark up .25
9. To calculate the deadweight loss we need to first calculate the competitive

equilibrium price and quantity. This can be found by setting equating marginal cost
and the demand function for pizza.
MC 1 Q = P 28 Q
5 5 5 5
2Q 27
5 5
Q 13.5
Thus, price in the competitive equilibrium is:

P(13.5) 28 13.5 $2.90
5 5
From question (5) we retrieve that the monopolistic profit-maximizing equilibrium is

Q = 9 and P = $3.80. We are now set to find the deadweight loss (Note: this is a
simple matter in this example because the MC curve and demand curve are linear
functions).
214
11. Rent seeking refers to the social waste that is the effort made in securing a monopoly.
Rent seeking could result in losses beyond the standard deadweight loss of having a
monopoly market if the monopoly had to use their anticipated monopoly profit to
secure the monopoly.
13. To find Marty Marts marginal expenditure, ME, first find the inverse supply
function, and then evaluate how much they would have to pay to buy 2000 toaster
ovens.
Q S 10P 1200 P s (Q) Q 10 120
Thus, to buy 2000 toaster ovens Marty Mart would pay:

P s (2000) (2000) 120 80
10
Since P 1 for this inverse supply function, Marty Marts marginal
Q 10
expenditure is
ME P(Q) P
Q 10

Q Q 120 1 Q
10
ME 120 Q
5
So Marty Marts marginal expenditure when it buys 2000 toaster ovens is $280,
which is $200 more than it must pay to buy the 2000 toaster ovens.
15. To find the profit-maximizing number of toasters we need to derive the marginal
benefit, which is given by the value of the inverse demand for toaster ovens. Since
the demand curve is Q d 2000 10 P , then the inverse demand
d
is MB P 200 Q 10 . Now, we can proceed and find the profit-maximizing
number of toaster ovens by setting MB = ME (from problem #13 we
know ME 120 Q 5 ):
d
MB P 200 Q = ME 120 Q 5
10
Q 1066.67
The price to buy 1066.67 toaster ovens can be found by using the inverse demand
function:
P 200 1066.67
10
P $93.33
The price and quantity in a competitive equilibrium could be found by equating
supply and demand:
Q S 10 P 1200 = Q d 2000 10 P
P $40
Q 2000 10(40) 1600
215
Chapter 18
1. Perfect price discrimination is what can occur if a monopolist knows each consumers
willingness to pay for each unit he sells, and is thus able to charge different prices for
each unit. This is just about impossible to do because of the sheer amount of access to
personal information on each consumer a firm would need. Firms are always trying to
obtain more about their consumers, but perfect price discrimination is more of a
theoretical possibility rather than an actual possibility.
3. A firm would like consumers with the low elasticity of demand to pay a higher price
because they are more likely to accept increase in prices, because of their inelastic
demand. This is like the example of the business traveler who has to travel on a
moments notice and cant afford to look for a bargain.
5. To answer this question we first must solve for the quantity demand of each consumer
at the competitive equilibrium (P = MC). Each consumer will
demand Q d 80 15(0.50) 72.5 . To calculate consumer surplus we need the inverse
demand function P 5.33 Q . Consumer surplus is $175.09 which can be
15
calculated taking a height of 5.33 minus 0.5 and multiplying by the base 72.5 times
one-half (area of a triangle).
The consumer surplus represents the maximum amount that a monopolist firm could
set a two-part tariff at. Any amount past $175.09 will cause the consumer to demand
less quantity. Also, at a tariff of $175.09 Dolly will not be able to charge for a
subsequent fills of there special tub. Therefore, Dollys profit will be 200 times the
amount of consumer surplus or the two-part tariff, $35,018.
7. We found in the previous problem that price discrimination hurts multiple-cat owners
by increasing the price, but single-cat owners are helped by a lowering of the price.
The gain for single-cat owners is equal to the area of the trapezoid with height 3.80
minus 3.50, and one base equal to 2.4, while the other base is equal to 3 minus 2.4.
This yields a consumer surplus of,

CS S (3.80 3.50)(2.4) (3.8 3.5)(3 2.4) 1 0.81.
2
The loss in consumer surplus to multiple-cat owners is equal to the area of the
trapezoid with height 4 minus 3.8, and one base equal to 2.4, and the other base
equal to 6.6 minus 6. This yields a consumer surplus of,

CS M (4 3.80)(6) (6.6 6)(4 3.80) 1 1.26
2
The total net loss on consumer surplus due to the use of price discrimination
is 1.26 0.81 0.45 . The gain in profit, as we found in the previous problem, was 0.3.
So we can conclude that price discrimination lowers aggregate surplus by 0.15
( 0.45 0.3) .
216
9. We found in the previous problem that price discrimination hurts consumers on hot
days because it increases the price, but consumers on cold days are helped by a
lowering of the price. The gain for cold day consumers is equal to the area of the
trapezoid with height 0.626 subtract 0.501, and one base equal to 1.987, while the
other base is equal to 1.989 subtract 1.987 (note: to get the numbers for the base we
simply plug-in the prices ex-post and ex-ante of price discrimination with concerns
to cold day consumers). This yields a consumer surplus of,
2 0.2485.
CS C (0.626 0.501)(1.987) (0.626 0.501)(1.989 1.987) 1
The loss in consumer surplus consumers on hot day is equal to the area of the
trapezoid with height 0.75 minus 0.626, and one base equal to 2.985, and the other
base equal to 2.987 minus 2.985. This yields a loss of consumer surplus of,

CS H (0.75 0.626)(2.985) (0.75 0.626)(2.987 2.985) 1 .3703
2
The total net loss on consumer surplus due to the use of price discrimination
is 0.3703 0.2485 0.1218. The gain in profit, as we found in the previous problem,
was 0.065. So we can conclude that price discrimination lowers aggregate surplus by,
[ Loss in consumer surplus profit increase 0.1218 0.065 0.0568] .
11. The table below shows four different per pound prices, the quantities purchased by
each type of consumer, the fixed fee, the profits form sales to each type of consumer,
and the total profit. To calculate the quantity at a certain price just plug in the price
into the corresponding demand function that was given. The fixed fee is the same as
the quantity of single-cat owner consumer surplus. Profits per type of consumer are
calculated by multiplying the specific price and quantity, then adding the fixed fee
and finally subtracting the marginal cost times the number of pounds purchased. To
find total profit, take the profit for each type of consumer and aggregate it across the
whole market (i.e. all single-cat owners and multiple-cat owner).
According to the chart below the most profitable price for Dolly to charge would be
$2.00 earning them a profit of $3,900.
Price per pound

$1.00 $1.50 $2.00 $2.50
Pounds purchased
Single-cat owner 8 7 6 5
Multiple-cat owner 15 13.5 12 10.5
Fixed fee ($): $16 $12.25 $9 $6.25
Profits ($):
Single-cat owner $8 $8.75 $15 $8.75
Multiple-cat owner $16 $5.5 $9 $11.50
Total profit ($): $3,200 $2,300 $3,900 $2,900
217
13. The table below shows four different per pound prices, the quantities purchased by
each type of consumer, the fixed fee, the profits form sales to each type of consumer,
and the total profit.
To calculate the quantity at a certain price just plug in the price into the
corresponding demand function that was given. The fixed fee is the same as the
quantity of single-cat owner consumer surplus. Profits per type of consumer are
calculated by multiplying the specific price and quantity, then adding the fixed fee
and finally subtracting the marginal cost times the number of pounds purchased. To
find total profit, take the profit for each type of consumer and aggregate it across the
whole market (i.e. all single-cat owners and multiple-cat owner).
According to the chart below, the most profitable price for Dolly to charge would be
$2.00 earning them a profit of $5,700.
Price per pound

$1.00 $1.50 $2.00 $2.50
Pounds
purchased
Single-cat 8 7 6 5
owner
Multiple-cat 15 13.5 12 10.5
owner
Fixed fee ($): $16 $12.25 $9 $6.25
Profits ($):
Single-cat $8 $8.75 $15 $8.75
owner
Multiple-cat $16 $5.5 $9 $11.50
owner
Total profit $6,400 $3,400 $5,700 $5,200
($):
15. Bundling is the practice of selling several products together as package. Firms can
use bundling to extract additional consumer surplus because different consumers
willingness to pay for products that are negatively related. A monopolist will use
bundling to eliminate the variation in consumer valuations, allowing the monopolist
to extract the entire aggregate surplus as profit.
218
Chapter 19
1. The Nash equilibrium in a Bertrand oligopoly model is at P = MC. At any price

above MC a firm wont sell any output because they will be under-cut by other
another firm(s) that will price at MC. At any price below MC the firm will sell its
output but will lose money because P > MC. All that is needed in a single market for
this to happen is two firms.
3. In a Bertrand model the equilibrium price equal to marginal cost. In this case it is $20.
To find the equilibrium quantity set P = MC.
set
MC 20 P 50 Q
10
Q 300
Thus, 300 handbags will be bought and sold at a price of $20 in this market. Since,
both Kristen and Megan are pricing the handbags at marginal cost they will earn $0 in
economic profit. To see this numerically calculate revenue, which is the price,
multiplied by the quantity sold, which is $6000 in this example. Now, we have to
subtract marginal cost,$20, times the number of units sold 300. Thus profit is $6000 -
$6000 = 0.
5. In order to solve for the Nash equilibrium output there are several things which we
must do first. The market inverse demand is P 50 0.1Q . Given Kristin and
Megans outputs we find that the price is P 50 0.1(QK QM ) . We can rewrite this
expression in terms of residual demand as follows:
Kristin:
P (50 0.1QK ) 0.1QM , and similarly
Megan:
P (50 0.1QM ) 0.1QK .
Now we need to find Kristin and Megans best-response function which entails that
we find their respective marginal revenue functions as well as their profit
maximizing output. Remember that MR P P Q Q .

Kristin:
MRK (50 0.1QK 0.1QM ) 0.1QK
MR K 50 0.2QK 0.1QM
Kristins profit maximizing output can be found by setting MR = MC.
$30 50 0.2QK 0.1QM
QK 100 0.5QM
219
Because of the symmetrical nature of the problem we can deduce without calculation
that Megans best-response function is QM 100 0.5QK . (You can make sure this is
so, as an exercise).
To find the Nash equilibrium quantity we substitute Kristins best-response function

into Megans best-response function, or vice versa.
QM 100 0.5(100 0.5QM )
QM 100 50 0.25QM
QM 66.7
Substitute this quantity into Kristins best-response function and we find

that QK 66.7 , which gives us the Nash equilibrium quantity.
Substitute the equilibrium quantity into the inverse market demand

function P 50 (66.7) 10 $43.33 which is the equilibrium price (notice that it is
$30 above the marginal cost). Thus both Megan and Kristin each make a profit of
$13.33 times 66.7 (quantity), which is $890.04.
7. There are a few steps we must do before we solve for the Nash equilibrium. First
should rearrange the demand functions in a form that will better suit our analysis.
The functions for Joes and Bobs quantity demanded given above can be rewritten
as follows.
QJoe (150 100PBob ) 125PJoe
QBob (150 100PJoe ) 125PBob
Given this form above we can solve for both Joes and Bobs inverse demand
functions. They are
PJoe 1.2 0.8PBob 0.008Q Joe
PBob 1.2 0.8PJoe 0.008QBob
Now we proceed by finding Joes best response function, which will involve
deriving his marginal revenue (like we have done before), where P Q 0.008 ;
and solving for the profit maximizing quantity.
MRJoe 1.2 0.8PBob 0.016QJoe
Solving for the profit maximizing quantity requires that we set MR = MC.
set
MRJoe 1.2 0.8PBob 0.016QJoe 1
Rearranging terms will yield the profit-maximizing sales quantity

QJoe 12.5 50PBob
220
Next, we should solve for the profit-maximizing sales price. To accomplish this we
could simply substitute our profit-maximizing quantity into Joes inverse demand
function.
PJoe 1.2 0.8PBob 0.008(12.5 50 PBob )
PJoe 1.1 0.4 PBob
Again, we may use the symmetrical nature of the problem to conclude that Bobs
best response function is PBob 1.1 0.4PJoe . If you feel that you need more practice
you could derive Bobs profit-maximizing sales price in the same way we found
Joes.
Now, we can find the Nash equilibrium by substituting Joes profit-maximizing sales
price into Bobs profit-maximizing sales price, or vice a versa.
PBob 1.1 0.4(1.1 0.4 PBob ) 1.1 0.44 0.16 PBob
PBob $1.83 per hamburger
Similarly, the Nash equilibrium price for Joes is also $1.83 per hamburger.
To find what quantities will be sold by each stand we can substitute in our Nash
equilibrium prices into our original demand function.
Q Joe (150 100(1.83)) 125(1.83) 104.25
QBob (150 100(1.83)) 125(1.83) 104.25
To find how much profit will be made by each stand take the difference between the
equilibrium price and the marginal cost (0.83), and then multiply by the equilibrium
quantity (104.25) which will yield each stand a profit of about $86.53.
9. Kristen will not undercut Megan as long as the following holds:

1
5,
000 5,000
This months gain R
Pr esent discounted value of future loss
Equivalently, the inequality above can be expressed by R 1 . The 1 indicates an

interest rate of 100%, meaning that Kristen will not undercut Megan unless the
interest rate was 100% or higher.
11. The difference between tacit collusion and explicit collusion is that in the former
case colluding firms communicate with each other and have understood agreements,
whereas tacit collusion colluding firms do not communicate but an understanding is
reached implicitly.
Tacit collusion between firms is harder to maintain because they are made without
communication, which makes a mutual understanding between colluding firms very
difficult to achieve.
221
13. Recall Kristins inverse residual demand function from question 4.
P (50 0.1QK ) 0.1QM
Also, recall Megans best response function from question 4.
QM 150 0.5QK
If we substitute Megans best response function into Kristins inverse residual

demand function, the result will be a formula that describes the price Kristins
receives at each level of output, while taking into account what Megans best
response will be to her choice:
P (50 0.1QK ) 0.1(150 0.5QK )
P 35 0.05QK
From this relationship, Kristin can derive her marginal revenue, which is:
MR P (P Q)Q
MR 35 0.05QK 0.05QK
MR 35 0.1QK
Kristin will maximize her profit by choosing the output level Q K equates her marginal
revenue with her marginal cost:
20 35 0.1QK
QK 150
Megans best response to this output is QM 150 0.5(150) 75 . At a total output of
225 handbags the market price is $27.50. Kristins profit is $1,125 which is $875 less
than what she made if the two chose their inputs simultaneously, while Megan
profits $562.50 ($1437.50 less than in the Cournot example).
15. A horizontal merger is occurs when two or more competing firms merge (that is
combine) their operations, and become one firm. A horizontal merger would be more
effective than fixing prices because fixing prices involves an agreement between two
firms that must be enforced in order to properly fix a price. A horizontal merger
between the firms that were looking to fix prices would simplify the desired outcome
greatly.
Chapter 20
1. When an agent(s) action(s) create an externality it affects someone the agent has not
engaged in a related market transaction. A negative externality is simply an
externality that harms someone else.
Negative externalities tend to create deadweight losses, particularly in competitive

markets because competitive markets are usually unable allocate resources
efficiently under such circumstances.
222
3. Since we know the MEC curve and the MC in the market (given by the supply curve),
we can deduce from the formula MSC = MEC + MC, that MSC 75 3 Q. The
2
shaded region represents the deadweight-loss.
200
Price
150
S
($)
100
50
D
50 100 150 200

Quantity, Q
5. Let us first find the competitive equilibrium. To do so, rewrite the marginal cost
curve solving for P (solve for inverse demand of a single firm). Remember in
competitive equilibrium we set P = MC. We get that P 2 15 Q , which we now
have to have to multiply by 10 (10 firms in the market) to the market supply curve,
5P 150 Q . Now we can set supply equal to demand and find competitive
equilibrium quantities.
set
Q d 1200 25P 5P 150 Q s
P $45
Plugging in the price into either the demand or supply function shows that, Q = 75.
Now we must solve for the efficient quantity. To come to an efficient quantity we
know that the construction firms will be responsible for external costs of their
production. Thus, P = MSC = MC + MEC = 50 4Q firm . Solving for quantity in
terms of price we get Q P 4 12.5 . Multiplying this previous result by 10, we get
the market supply curve, Q S 5 2 P 125 . Now equate demand and supply.
set
Q S 5 P 125 1200 25P Q d
2
P $48.18
Substituting the price into the demand function we get that the efficient quantity
level is Q =-4.5, so it is best not to produce any more construction sites Q = 0.
223
The deadweight loss created the firms is shown is similar to that shown on figure
20.1 in your textbook (p.756). Take the 75 construction sites under competitive
equilibrium and substitute it in for Q in the MEC function, which yields 160. The
height of the triangle is the difference between the 75 sites in competitive
equilibrium and the 0 efficient quantity. The deadweight loss is found by computing
the area of the triangle.
DWL (75 0)(160)(0.5) $6,000
7. An emission standard is a legal limit on the amount of pollution that a person or entity
can produce from a particular activity. In order for the government to set an efficient
emission standard it needs to know precisely the polluters cost of abatement and the
social costs. Thus, both sides have an incentive to overestimate the costs. On the one
hand, the polluter will overestimate their cost of abatement so that the government
places higher emission standards. The pollutee has the incentive to overestimate the
social cost of emissions so that the government sets a lower emission standard.
9. The efficient number of gnomes is found by equating the marginal benefit to the
marginal cost.
MC 2 Q MB 11 1 Q
2
Q 6 gnomes
At the efficient level of gnomes your marginal cost is $8. Therefore, an efficient
Pigouvian tax is $8 per gnome. With such a tax your neighbor will choose to only 8
gnomes and will pay a total of $48 dollars to have the gnomes running free in the
garden.
11. A liability rule is a legal principle that forces polluters that create an externality to
compensate the affected parties for some or all of their losses. So a liability rule
would make a polluter internalize the marginal cost of the externality they create. One
of the difficulties that arise with implementing a liability rule are legal fees which are
costly and time consuming.
13. First, we must compute the MSB of having plants in the classroom.
MSB 7 (50 3Q) 350 21Q
Now we set MSB = MC:

350 21Q 14
Q 16
Thus the socially efficient number of plants is 16. To find what each student would
chose individually set MB =MC:
50 3Q 14
Q 12
224
Individually each student would choose to have 12 plants. If you notice, at Q = 16
the marginal cost exceeds the marginal benefit, such that each student will have an
incentive to reduce the number of plants. The break-even point between marginal
cost and marginal benefit is where Q = 12.
15. The median voter theorem is refers to voters with single-peaked preferences, in
which a majority of them prefer the median ideal policy to all other policies. This
theorem requires that the policy of the median voter coincide with the social benefit
policy. In reality, they rarely coincide.
225

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Student Practice Manual

1. Government intervention in markets is a politically divisive issue. What are some

2. Simplifying assumptions are important when creating an economic model because it

Additional Exercises for Chapter 1

1. Which type of economy, communist or capitalist, is more closely described as a

2. What are markets and why do they require property rights?

3. How does the principle of individual sovereignty allow economists to conduct

4. How does the field of economics go beyond the study of money?

5. Why is it important to identify additional implications after formulating a theory?

6. What is the benefit to economists of using simplifying assumptions when

8. Why might economists disagree about positive matters?

9. How does a natural experiment differ from a controlled experiment?

12. Why might it be useful to use economics to evaluate environmental policy?

cream 8.5 3Pice cream 4Pyogurt 3.5Pwaffle cone 0.0005M

cream 8.5 3Pice cream 4($4.00) 3.5($3.00) 0.0005($32, 000)

cream 0 , Pice cream $10.00 .

cream 30 3 Pice cream

cream 8.5 3Pice cream 4($4.00) 3.5($2.00) 0.0005($32, 000)

cream 33.50 3 Pice cream

3. If QICD 16 2 PIC , this means that if P $3.00 , then QD 10 and if P $4.00 ,

then Q D 8 . What is the elasticity of demand at a price of $3.00? What about at a

fries 8 3PFrench fries 2Pfrying oil 1.5Ppotato flakes 0.0004M

fries 8 3PFrench fries 2Pfrying oil 1.5Ppotato flakes

then QD 10 . What is the elasticity of demand at a price of $3.50? What about at

then QS 5 . What is the elasticity of supply at a price of $3.50? What about at a

Number Marginal Marginal

Number Marginal Marginal

cost is given by CS 2S 3S 2 . The corresponding functions for MB and MC

Hours Benefit Cost Net Benefit

is C( H ) 50H 30H 2 . The corresponding functions for marginal benefit and

is C( H ) 40H 25H 2 . The corresponding functions for marginal benefit and

Hours Benefit Cost Net Benefit

cost is C( H ) 50H 70H 2 . The corresponding functions for marginal benefit

b) No, he will not swap 8 10.

Rons marginal utility of sushi is MU S 3, (adding S increases the utility value by 3

Additional Exercises for Chapter 4

1. In the Chapter 4 exercises we examined Jimmys preferences regarding rolls of sushi

If Jimmys income is $7.00, his affordable options are lightly shaded.

Now use E to find C.

Additional Exercises for Chapter 5

1. In the Chapter 4 exercises we examined Stephanies preferences regarding pieces

8. Now suppose that Stephanies preferences are represented by three ranked

benefit of balloons is MU B C . If candy (C) costs $5 per pound and balloons

benefit of balloons is MU B C . Fractions are still acceptable. Using M $50 ,

semester. His preferences correspond to the utility function U C , E C 2 E 2 .When

This is the compensated demand curve.

b) 2005 Base Period

Additional Exercises for Chapter 6

14. What is the difference between an uncompensated and a compensated demand

technology have increasing, decreasing, or constants returns to scale?

marginal product of labor of Shop B is MPLB 20 LB , where L B is the number of

Additional Exercises for Chapter 7

5. Giselle can produce lemonade at Pucker Up according to the production function

6. Given Giselles production function in question (5), where

7. Giselle can produce lemonade at Pucker Up according to the production function

9. Use Giselles production function [ Q F ( L) 2L3 20L2 30L ] for Pucker Up

do you notice about the MPL as the number of workers increases?

Units of MPL APL

substitution in this case? Why or why not?

function for workers, L, and capital K, is Q F L, K 2 L 2 K 2 . The wage rate is

To find the average cost (AC) use the fact that AC Q

To find the AVC and AFC use the following equation:

Alexs and Jessicas firm,

For the other two firms,