Solutions to Problems 385

CHAPTER 12
1.1 If oil prices were to rise at the same time as the subsidy was given to ethanol production, the
demand for ethanol, and subsequently the demand for the corn used to produce ethanol would
increase, shifting the demand curve for corn to the right (D0 to D1 in Figure 1) and raising the
price of corn. This change in the market would also increase the value of farmland due to an
increase in demand for the land (D0 to D1 in Figure 2). Since more land would be used to produce
corn, less would be available to produce other agricultural products such as wheat. Therefore, the
supply of wheat would decrease, shifting the supply curve for wheat to the left (S0 to S1 in Figure
3) and raising the price of wheat.
If oil prices were to fall, the demand for corn-based ethanol would decrease, decreasing the
demand for corn (D1 to D0 in Figure 1), which would decrease the demand for land to produce
corn (D1 to D0 in Figure 2), and make more land available to grow wheat, which would increase
the supply of wheat (S1 to S0 in Figure 3). The prices of corn, wheat, and farmland would all
decrease.

Price of
corn S

P1

P0
D1

D0

Figure 1

Price of
farmland S

P1

D1
P0

D0

Q Quantity of farmland

Figure 2

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386 Case/Fair/Oster, Principles of Microeconomics, 12th Edition

Price of
wheat S1

P1
S0
P0

Q1 Q0 Quantity of wheat

Figure 3
1.2 Answers will vary, but each story should take into consideration basic information about labor
and capital markets discussed in previous chapters:
Factor demand curves are derived from information on technology and output prices.
Factor demand curves shift due to (1) change in demand for outputs, (2) change in
complementary or substitutable inputs, (3) changes in prices of other inputs, and (4)
technological change.
Investment by firms is the demand for capital. Saving by households is the supply of capital.
Saving increases a households net worth.
Investment increases the stock of capital.
If product demand declines, product price will fall and marginal revenue product (factor
demand) will decrease (and vice versa).
Following is a list of what may take place in each of the three situations.
For the situation in part a, rising home values cause household wealth to increase, which will
increase savings (capital supply). This will decrease interest rates and increase investment (capital
demand). Output demand has also increased, which could ultimately lead to an increase in labor
demand.
In part b, the increase in health care costs will decrease savings (capital supply). This will
increase interest rates and decrease investment (capital demand). Output demand is increasing
and the health care industry is growing, which leads to an increase in labor demand. The
expansion of the health care industry will increase the demand for capital.
In part c, the increase in credit availability to home buyers will increase investment in new
homes, increasing the demand for capital. The resulting decrease in the quantity of available
houses in the market could increase the demand for labor. An increase in the demand for labor
will increase savings (capital supply).
1.3 The cost of chicken is likely to go up. Substitutes for chicken include fish, turkey, and perhaps
pork and beef. In each of these markets, the demand curve will shift right and both equilibrium
price and equilibrium quantity will rise. Complements might include rice and canned and

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 Solutions to Problems 387

packaged chicken gravy. The demand curves for these goods would shift left, causing equilibrium
price and quantity to decrease. In the market for farmland, we might see more acreage devoted to
substitutes when the anchovies disappear because the demand for substitutes will increase, as will
their equilibrium prices.
2.1 Disagree. Even if shareholders are made worse off, the breakup could be a potential Pareto
improvement. The term efficient change is often used to describe changes in which some
shareholders are made better off and others are made worse off but in which those who gain
receive benefits that are greater than the costs imposed on those who lose. The theory of the court
is that consumers will gain more than shareholders lose, making the breakup efficient.
2.2 (a) First, calculate MP and MRP (P MP)
MRP
Workers Vegi-Dogs MP (P x MP)
0 0 --- ---
1 12 12 60
2 20 8 40
3 26 6 30
4 30 4 20
5 32 2 10
6 33 1 5
7 30 3 15
At a wage of $14 per hour, 4 workers should be hired. The fifth worker would produce less
value in an hour ($10) than his/her wage.
(b) When the price of vegi-dogs rises to $9, the last column must be recalculated.
Now, 5 workers should be hired.
MRP
Workers Vegi-Dogs MP (P x MP)
0 0 --- ---
1 12 12 108
2 20 8 72
3 26 6 54
4 30 4 36
5 32 2 18
6 33 1 9
7 30 3 27
(c) If the wage rises to $20 per hour, assuming vegi-dogs still cost $9, only 5 workers should be
hired. (If vegi-dogs still cost $5, as in the first example, only 4 workers would be hired.)
(d) Yes, the allocation of labor would be efficient because each firm would hire labor until the
wage was equal to the value of the marginal revenue product. If all firms paid the same wage,
they would all have the same marginal product of labor, and no reallocation of labor could
increase total output.

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388 Case/Fair/Oster, Principles of Microeconomics, 12th Edition

2.3 There will likely be trade between Emerald Island and Tropical Springs. Emerald Island will
produce only bananas and no mangoes, and Tropical Springs will produce only mangoes and no
bananas. Emerald Island will then trade some of its bananas for mangoes from Tropical Springs.
(At the same time, Tropical Springs is trading some of its mangoes for bananas from Emerald
Island.) This is Pareto-efficient because each good is being produced by its more efficient
producer and both countries are likely to have more of both goods with trade than without trade.
2.4 Any trade in which two or more people voluntarily exchange goods or services, without having
any effect on third parties, must be efficient. When a transaction is completed is it revealed that
both parties benefit. If they did not, the trade would not take place. Individual buyers and sellers
determine what a product or a ticket is worth. What a person is willing to pay is determined by
individual tastes, preferences, and income. Whether or not the parties are rich or poor is not a
matter of efficiency; it is a matter of fairness. Even if you say that it is not fair, the question is
should you block a transaction with anti-scalping laws, when the poor show that they may want
the money more than they want the ticket.
2.5 All are examples of potentially Pareto-efficient changes.
(a) Simple elimination of waste is clearly efficient.
(b) Monopolist is hurt but gains to consumers are greaterenough to compensate losers.
(c) Both parties are better off; no one else is worse off.
(d) If we assume that the taxes were being used wisely, this still might be an efficient change.
Let assume that the revenues are made up by a new tax that does not distort consumer
choices. The argument here is that taxes produce extra or excess burdens when they distort
consumer choices. As a result of the elimination of the tax, some people buy airline tickets,
gaining utility over what they were buying before.
2.6 (ab) The coin toss is more equitable, because both parties have the same chance of winning,
regardless of their incomes. However, with the coin toss, there is no guarantee that the party who
places a higher value on the ticket most will get it. Selling the ticket to the higher bidder is more
efficient, because whoever places the higher value on the ticket will get it, but it is less
equitable, because it favors those with higher incomes. You could argue that both are efficient
because in the coin toss even if the low bidder gets the ticket he will sell to that high bid.
On the other hand, the coin toss will also be efficient if the winner can sell the ticket to the loser.
In this case, if the party who places a lesser value on the ticket wins the toss, he or she can sell the
ticket to the other party.
2.7 Demand for G shifts left (from D0 to D1), driving down the price of G from P0 to P1 and creating
losses in the short run for firms in G. Demand for S shifts to the right, causing the price of S to
rise from P0 to P1 and creating short-run profits for firms in S. In the long run, firms exit G,
shifting the supply curve left (from S0 to S1), driving the price of G back up to P0 and eliminating
the losses. At the same time, firms will enter S, shifting the supply curve to the right (from S0 to
S1) and driving price back down to P0, eliminating the profits. In the long run, employment will
expand in S and shrink in G.

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 Solutions to Problems 389

2.8 (a) Not Pareto efficient. You may be better off since you are enjoying the music, but you are also
adding to noise pollution that will make some other drivers worse off.
(b) Not Pareto efficient. Not a voluntary exchange, since your neighbor never returned the
lawnmower, and you are worse off.
(c) Pareto efficient. Both you and the store benefit.
(d) Pareto efficient. You are better off (you were willing to pay the inflated price) and the ticket
scalper is better off. This is a voluntary exchange.
2.9 The allocation of labor is inefficient. Since each golf course is hiring the profit maximizing
number of workers (where W = PX MPL), the marginal revenue product of labor at Ocean Oaks
is $12, whereas that at Luxury Links is $11, and at Pacific Paradise it is $14. If workers were
moved from Ocean Oaks and Luxury Links to Pacific Paradise, the value of total output would
rise.
2.10 Resources are allocated efficiently among firms in a perfectly competitive market because of the
assumption of profit maximization. For firms to maximize profits, they must minimize the cost of
producing their chosen levels of output, so firms must choose production technology that
produces the desired output at the lowest cost. Maximizing profit also means hiring an input up
until the marginal revenue product of the input is equal to its price. If all firms pay the same input
prices, the marginal revenue product of the last unit of an input hired will be the same in all firms,
so they are also allocated efficiently.
Output is distributed efficiently among households in perfectly competitive markets because
households will buy goods as their willingness to pay for goods is greater than or equal to their

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390 Case/Fair/Oster, Principles of Microeconomics, 12th Edition

prices. As long as households are free to choose how to spend their incomes, they cannot end up
with the wrong combinations of goods. Competitive markets ensure that households don't end up
with the wrong goods and services.
2.11 Society will benefit from more of a good being produced when the price of a good is greater than
the marginal cost to produce that good. If the price of a good is less than the marginal cost to
produce the good, society would benefit from less of the good being produced.
3.1 (a) Disagree. Nutritional food can be limited to those who pay for it. Therefore, the private
market will supply it.
(b) Disagree. Imperfect markets produce less product than they would if they were perfectly
competitive and therefore charge a price greater than marginal cost.
(c) Agree. It is difficult for consumers to evaluate the skills of a financial planner or to judge the
advice a financial planner gives them.
3.2 (a) Public goodthere is no way to limit the benefits of the new fire engines to those who pay,
so the market will not provide it.
(b) Imperfect competitionthese firms are not acting like price-takers. Their decision to raise
prices above marginal cost will restrict output (gasoline sales) below the efficient level.
(c) Imperfect informationyou dont know enough about electrical repairs to recognize whether
you need to replace the breaker box.
(d) Negative externalitythere is a by-product to this activity that affects (harms) parties outside
the transaction of refusing to get the children vaccinated.
3.3 When Clarice had the new drainage ditch installed, the decision was based on the utility she
expected to receive from paying to have the work done. Since the drainage ditch also keeps
neighboring properties from flooding, Clarice is not the only person to receive utility from the
purchase. Clarices neighbors also receive a benefit from her paying to have the ditch installed, so
its true social value will not be reflected in the price, and therefore too few drainage ditches will
be installed.
3.4 Items a, c, and d are public goods because they bestow collective benefits on members of society
and no one is excluded from enjoying their benefits.
Items b, e, and f can be excluded from anyone who does not pay for their use, so they are not
public goods.
3.5 A positive externality is a benefit bestowed on an individual or a group who is outside, or
external, to the transaction. A negative externality is a cost imposed on an individual or a group
who is outside the transaction. Both positive and negative externalities can result in market failure
because they can misallocate resources, causing waste or lost value.

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