T HE E CONOMICS

R EGULATION

OF

HOMEWORK PROBLEMS

December 12, 2016

http://rasmusen.org/g406/reg-rasmusen.htm
http://rasmusen.org/g406/999-answers.pdf

erasmuse@indiana.edu

C HAPTER 1: M ARKETS
1.1

Suppose the monopoly in the diagram below chose a price of 25.

(a) What would be the deadweight loss from allocative inefficiency?

(b) What would be the consumer surplus if the price were 10?
(a) The deadweight loss is .5(25-10)(30-15) = .5(15)(15)= 112.5.
(b) The consumer surplus at a price of 10 would be .5(40-10)(30-0)
= 450.
1.2

In Shakespeares play The Merchant of Venice Shylock says:

Youll ask me, why I rather choose to have
A weight of carrion flesh than to receive
Three thousand ducats: Ill not answer that:
But, say, it is my humour: is it answerd?
What if my house be troubled with a rat
And I be pleased to give ten thousand ducats
To have it baned? What, are you answerd yet?
Is this consistent with the idea of surplus maximization? Explain.
Yes. Shylock has his own tastes. He is willing to give up 3000
ducats to keep some carrion flesh. That is what maximizes his surplus. We cannot say that he is wrong, because we cant know that
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he would get more happiness spending the money some other way.
Similarly, if he were willing to pay 10,000 ducats to get rid of rats
because he hates them so much, we cannot say he would be happier if he spent the money on beautiful paintings or trips to Greece
instead. De gustibus non est disputandum.
1.3

Explain why the equilibrium price and quantity maximize total

surplus.
At that price and quantity, every buyer who values the good more
than the price is able to purchase and every seller whose cost is less
is able to sell, so every possible trade that would create surplus does
happen. In the diagram below, you can see how at the equilibrium
price and quantity every potential buyer and seller that creates surplus does. If any more units were sold, it would have to be with a
buyer who values the good at less than the cost to the seller.

Common mistakes:
A. The equilibrium maximizes surplus because surplus is highest
there. That is a tautology. The classic example of this is when
a doctor in Molieres 17th century play, The Hypochondriac, says
something like, Opium causes sleep in people because of its virtus
dormativa (that is, its sleep-inducing principle).
B. The equilibrium maximizes surplus because it is a stable outcome. That is why it is the equilibrium, why it is what happens,
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but that does not explain why it maximizes surplus.

C. The equilibrium maximizes surplus because there is no deadweight loss. That is another tautology, because deadweight loss is
difference between the maximum possible surplus and the actual
surplus, so that answer says that the equilibrium maximizes surplus because there is no difference between the equilibrium surplus
and the maximum possible surplus.
1.4

We know that there is a limited number of parking spaces in downtown Indianapolis, and they will all be taken each morning. Suppose
it turns out that it costs more to check the parking meters than is
collected in revenue. Explain why total surplus might nonetheless fall
if we make parking free.
Yes, it would fall. The quantity wouldnt change, so there
wouldnt be the standard kind of triangle loss, but some of the people who found parking spots when there was excess demand would
be people who didnt think it was worth it at the original price.
Since they get less surplus than the people who were parking before, and the people they push out get zero, total surplus has fallen.
In the figure, person y takes a free parking spot instead of person x,
who values it more.

1.5

Suppose demand for corn is given by Q=18-P, and supply is given

by Q= 2(P-3) if the price exceeds 3 and Q=0 otherwise.
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(a) Draw the curves and calculate the equilibrium price (not necessarily to scale. Label the curves and show the values where the curves
cross the axes.
(b) If output were restricted to 4, what is the loss in total surplus?
(a) The equilibrium is found from 18-P = 2(P-3), so 18-P= 2P-6,
so 24=3P and P=8. Then Q=10. The supply curve cuts the axis at
(Q=0, P=3) and the demand curve at (Q=0, P=18) and (Q=18, P=0).
(b) The supply curve price would be 5 and the demand curve price
would be 14. The loss would be .5(14-5)(10-4)= 27.

1.6

Suppose demand for widgets is given by Q = 24 P, and supply is

given by Q = 3( P 4) if the price exceeds 4 and Q = 0 otherwise.
(a) Draw the curves and calculate the equilibrium price and quantity
(not necessarily to scale, but showing the shapes and labelling the
values where the curves cross the axes).
(b) If the government forbids sale of widgets at a price of less than 12,
what is the change in producer surplus? Give a numerical answer.
(a) The equilibrium is found from 24-P = 3(P-4), so 24 P = 3P
12, so 36 = 4P and P = 9. Then Q=15. The supply curve cuts
the axis at (Q=0, P=4) and the demand curve at (Q=0, P=24) and
(Q=24, P=0).

(b) If P=12, sales are from the demand curve, at Q = 24 P = 12.

The original producer surplus is area A+B+C. This has height (9-4)
and width 15, so its area is .5(5)(15) = 37.5.
The new producer surplus is area A+B+D. If Q=12, the price on
the supply curve is found from 12= 3(P-4), so 12=3P-12 and P=8.
Thus, area A = .5(8-4)(12) = 24 and areas B+D= (12-8)(12) = 48 and
the total producer surplus is 24+48=72. That means the increase is
72-37.5 = 34.5. Producers are helped because they are not allowed
to compete the price down, and the high price compensates for the
loss of sales.
1.7

Show on a supply-and-demand diagram the deadweight loss if the

federal government required the price of health insurance to drop at
least 10% below the current market price.
This is a price ceiling, quantity traded will drop, resulting in
the deadweight loss of L shown in the diagram.

1.8

The market price of wheat in a country has risen from $2/bushel

to $6/bushel because of a famine. To help the poor, the government
imposes a cap of $4/bushel on the price of wheat. How does this affect
the poor? Does whether rationing is efficient or inefficient make a
difference? Illustrate using one or more diagrams.
When the government imposes the price cap, sellers wont want
to sell as much, so the quantity sold will fall and there will be excess
demand. Thus, on average people wont have as much to eat. On
the other hand, those who can actually buy at the cheaper price
are benefitted. Will those be rich, or poor? If rationing is efficient,
the people willing to pay the most are the ones who will get the
wheat, which probably means the rich. The poor go from buying
at $6 to not being able to buy at all, so they starve. If rationing is
inefficient, then the people willing to pay the least (but willing to
pay $4) will get the wheat. That probably means poor people, so
inefficient rationing helps the poor. One caveat, though: Maybe the
rich people are willing to pay the most for the first bushel of wheat
they eat for bread, but they also are willing to pay more than $4 for
extra wheat that they can use to make cake. In that case, it might

actually be the rich who benefit from inefficient rationing.

1.9 (a) Suppose the quantity of snow rakes supplied is Q = 12 + 2P for

P > 6 and 0 for P < 6. You do not know the demand curve. The
market is currently in equilibrium at a price of 7. What quantity of
rakes is sold? What is one possible demand equation that would yield
that quantity?
(b) A snowstorm hits and the demand curve changes to Q = 48-4P.
What is the new equilibrium quantity and consumer surplus?
(c) The attorney-general declares a price ceiling of 7. What is the new
consumer surplus?
(a) Q = -12 + 2(7) = -12+14=2 rakes. The demand curve, if linear
(nonlinear examples are OK too) must satisfy Qs = 12 + 14 =
a 7b One demand curve yielding that is Qd = 2, perfectly inelastic
demand. Another is Qd = 16 2P.
(b) Equating supply and demand, 48-4P = -12 + 2P so 60 = 6P and
P =10. Then Q = -12 + 20 =8. The consumer surplus is .5(12-10)(8)
= 8.
(c) Q = 2 from the supply curve if P = 7. At a quantity of 2, the
price on the demand curve is 46/4 = 11.5 so consumers surplus is
.5(12 11.5)(2) + (11.5. 7)(2) = .5 + 9 = 9.5.

1.10

Suppose a city imposes a price floor on hamburgers sold at restaurants.

(a) On a diagram show the resulting loss of total social surplus if
rationing is efficient.
(b) Explain how the loss of total surplus would change if rationing
were inefficient.
(c) Show on a diagram how total surplus changes if rationing is perfectly inefficient that is, the highest-cost sellers are the ones who get
the customers. Assume that output originally is 100, that the quantity
demanded falls to 60 at the price ceiling, and that at the price ceiling
the quantity supplied is 180.
(a) The lowest-cost firms will be the ones that produce under efficient rationing. The loss in surplus will be Z+X after the price rises
from P0 to P1 . Producer surplus will rise to V+Y. The lowest-cost
firms will produce those with costs between C0 and C1 .

(b) The loss would increase. Some of the low-cost firms, those with
costs between C0 and C1 would not be able to find buyers. Instead,
some of the firms with costs between C1 and P0 will produce and
sell. Those high-cost firms wont earn as high a surplus, so total
surplus will fall.
(c) See the diagram below.

1.11 A regulation adds $1,000 and $500 to the incomes of Brown and Smith,
but subtracts $300 and $600 from the incomes of Lee and Brown.
According to surplus maximization, the result is
(a)
(b)
(c)
(d)
(e)

A definite improvement.
A definite worsening.
Neither an improvement nor a worsening.
Both an improvement and a worsening.
None of the above.

1.12 Suppose that at first there is efficient rationing under a binding minimum wage. If rationing becomes inefficient, how does surplus change?
(a)
(b)
(c)
(d)
(e)

Employer surplus rises and worker surplus falls.

Employer and worker surplus fall.
Employer and worker surplus rise.
Employer surplus falls and worker surplus rises.
None of the above.

The employer surplus is unchanged, since so are the wage and

number of workers hired. Worker surplus falls.
1.13 Let supply be Q = 12 + P and demand be P = 32 Q. The equilibrium price is
(a) Less than 1
(b) 1.1-3.
(c) 3.1-8.
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(d) 8.1-12.
(e) More than 12.
Q 12 = 32 Q so 2Q = 44 so Q = 22 and P = 10
1.14 Let supply be perfectly inelastic at Q=6 and let demand be Q =
32 P/2. The equilibrium price is in which interval?
(a) Less than 4
(b) 4.1 to 8
(c) 8 to 24
(d) Between 24 and 28.
(e) More than 28.
6 = 32 P/2 so P/2 = 26 and P = 52.
1.15 If nobody can sell lemons below a certain higher-than-market governmentfixed price, one source of lost surplus is
(a) High-cost lemon producers can survive in the market.
(b) Some high-demand consumers may not be able to buy lemons.
(c) The market will be more easily monopolized.
(d) (a) and (b).
(e) None of these things will happen and reduce surplus.
1.16 If demand for movies shifts out because producers make better movies
then surplus will rise and
(a) Equilibrium price and quantity of movies watched per
person will increase.
(b) Equilibrium price will increase, but not quantity.
(c) Equilibrium quantity will increase, but not price
(d) Both quantity and price will fall.
(e) None of the above.
1.17 The price of bread is currently 5. Suppose a bad harvest is coming and
the supply of bread will be Q = 0 if P < 2 and Q = P 2 otherwise.
Demand is Q=18-2P. The prime minister announces a price ceiling of
7 just before he calls for an election. Total surplus will
(a) Rise.
(b) Stay the same.
(c) Fall, but by less than 3.
(d) Fall between 3 and 5.
(e) Fall by more than 5.

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1.18 Suppose that 1 million people would each lose $2 if the government
requires a bicycle safety feature, but 100 other people would each save
$5,000 in medical costs. Requiring the feature
(a) Is inefficient
(b) Reduces total surplus
(c) Does not result in a Pareto improvement
(d) (a), (b), and (c).
(e) None of the above.
1.19 Consumer surplus is
(a) The dollar value of the utility consumers get from a product.
(b) The difference between what consumers would be willing to pay and what they actually pay.
(c) The value in utils that consumers get from a product.
(d) The value in excess of producer surplus that consumers get from
a product.
(e) The difference between the price and the supply curve.
1.20 In a dictatorship, let the supply of kale be perfectly elastic at a price
of 8 and let demand be Q = 24 2P. If the dictator orders consumers
to buy Q = 12 and orders producers to charge P = 10, how much
surplus is lost relative to having a free market?
(a) E+F+G.
(b) C.
(c) F.
(d) G.
(e) F+G.

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The lost surplus is the difference between the cost of the extra kale
to farmers and the benefit to consumers. That is the area under the
supply curve and above the demand curve, which is F+G.
You can also figure this out by looking at producer and consumer
surplus under the free market and under the policy, but that is
more difficult. Producer surplus rises from H to H+B+C+D+E.
Consumer surplus falls from A+B+C to A-G.
C HAPTER 2: M ARKET FAILURE
2.1

Why does the equilibrium output in a market with a negative externality not maximize total surplus?
If there is a negative externality, then the social marginal cost
is greater than the private marginal cost. The sellers will look only
at the private marginal cost, and in equilibrium that equals the
marginal benefit to consumers. If output were reduced, total surplus would rise because the social marginal cost at the competitive
output is greater than the marginal benefit to consumers.

2.2

What is the difference between a marginal benefit curve and a

demand curve?
The marginal benefit curves height measures the actual benefit the consumer receives from buying a unit of a product the
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amount he would pay if he were perfectly-informed while the demand curve shows how much he is willing to pay in his current
state of information. Thus, if a consumer is perfectly informed, his
demand curve will be equivalent to his marginal benefit curve.
2.3

In a neighborhood of homes with small children, Smith builds a

concrete swimming pool in his backyard. Explain why this could create
both positive and negative externalities.
This would create positive externalities because Smith could
invite his neighbors to swim in his pool. It could create negative
externalities because of the dirt and noise from construction and
because the pool might be dangerous to neighborhood children who
went uninvited and swam alone.

2.4

If unregulated, paper manufacturing creates water pollution. Suppose that if paper sales are Q then the cost of the water pollution
to people downstream is 3Q, and that supply and demand take their
conventional moderately price-elastic shapes.
(a) Draw a diagram to show the levels of paper sales under laissez faire
equilibrium and under optimal regulation.
(b) Show how much total surplus increases going from laissez faire to
optimal regulation, and how the total cost of water pollution changes.
(a) The cost of the water pollution to people downstream is 3 per
unit of paper sold; if amount Q is sold, the cost is 3Q. Thus, the
social cost is always 3 higher than the supply curve, as shown in the
diagram above. The supply and demand curves take their typical
shapes, neither being perfectly elastic (flat). The initial output is
where the supply and demand curves cross, Q(no reg.). The optimal
regulation would reduce sales to Q(reg.), where the marginal social
cost crosses the demand curve.

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(b) Total surplus increases by area C going from laissez faire to

optimal regulation, because the units between Q(reg) and Q(no reg.)
have a social cost in excess of the their social benefit, the height of
the demand curve. The pollution cost to third parties is the area
between the social cost curve and the supply curve. That is area
A+B+C under laissez faire, since output is Q(no reg.), and it falls
to area A under regulation.
2.5

Explain how a regulation that ends up reducing sales of a product

could increase total surplus. Assume that the good has no externalities.
Suppose the good has lower quality than consumers believe. For
convenience, suppose it has zero value. It still is costly to produce,
so the marginal benefit is less than the marginal cost and a reduction in sales will increase surplus. For example, if a worthless
product is sold for $5, the consumer has lost $5 in surplus. The
producer may spend $2 to produce this worthless product, so the
producer surplus is $3. Summed together, the total surplus (producer surplus + consumer surplus) of this transaction is -$2.

2.6

Although lack of clear property rights leads to market failure, we

see many examples of it in the world where people have decided not
to assign an asset to a single person yet there seems to be no problem
maximizing surplus. Often that is because assigning and protecting
property rights incurs transactions costs. What would be the effect of
requiring the following property rights to be owned by an individual
person, and why isnt it done?
(a) A house jointly owned by husband and wife.

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(b) The right to sit in the third seat from the left in the back row of
the classroom.
(c) The public street in front of your house.
(a) The husband and wife trust each other and it is convenient for
each of them to be able to control and sell the house. If the husband
dies, for example, the wife still owns the house, whereas if it was in
the husbands name, a court would have to examine his will and
decide whether she should retain it. Also, if the husband is not
home, it is useful for the wife to have the property-owners right
to tell trespassers to leave, which if she were merely a guest might
require her to have a signed document from the owner. (In actuality,
the law deals with this by a complex set of rules as to who can act
in lieu of the owner when he is absent.)
(b) The right to sit in a particular place in a classroom actually
does often have an individual owner, morally if not legally. If
you have been sitting in that spot for six weeks, you may feel miffed
if someone else sits there, and he may feel guilty. We do not want
this right to be very strong, though, because then everyone would
have to remember which seats were owned, and if they had some
special reason to sit there on a particular day they would have to
buy the seat, which incurs transaction costs. Also, we may wish
to avoid a rush the first day to acquire ownership of good seats.
(c) If the house-owner also owns the street, he could exclude people
from driving there. Each house-owner could create a bottleneck
from spite because he doesnt like certain people or in order to each
collect a toll, which would create large transaction costs because
drivers would have to find the owner and the price and arrange to
pay him.
2.7

The true value of cough medicine to consumers is the typical

smooth downward-sloping line. The highest-valuing 900 customers
overestimate the value by 3 dollars per bottle but the lowest-valuing,
with values from $10 to $0, know their true values. Supply is flat at
$8 per bottle. The orginal quantity sold in the market is 1,200 units.
(a) Draw the supply curve, the demand curve, and the marginal benefit
curve.
(b) Show the area of the consumer surplus after the government informs the high valuers of their mistake.
16

(a) The supply curve is flat at 8 dollars. The marginal benefit curve
slopes down and hits the $8 level at somewhere greater than 900,
since we know that there are informed buyers with values of up to
$10. The demand curve is the same as the marginal benefit curve
for those buyers with values between $0 and $10. It then jumps to
$3 higher than the marginal benefit curve for all higher values.
(b) The consumer surplus is the same regardless of whether consumers are informed. It is the area between the marginal benefit
curve and the price of $8.

2.8

Currently Apex, Inc. has a monopoly on widgets because it first

introduced the products. A widget is too close to a wodget to be
patentable, though, so next year Apex will lose its monopoly. Apexs
costs are $10/widget for the first 100 units of widgets and $16 for
any greater amount. The entrants will all have costs of $16/widget.
Currently, Apex is selling 180 units at $22/unit. Market demand at a
price of $16/unit is 240 units.
(a) What is the current producer surplus?
(b) How much will total surplus rise after entry becomes possible?

17

(a) To find the current producer surplus, start with the priceof $22
and the quantity of 180, which yields revenue of $3,960. The producers cost is 100*10 for the first 100 units and 80*16 for the rest,
which comes to 1000+ 1280= 2280. Thus, producer surplus is 39602280 = $1680.

(b) After entry, the price will fall to $16/unit and the quantity will
rise to 240. The figure shows that surplus will rise by the amount
of the triangle of length 240-180 and height 22-16, which is .5 (60)
(6) = 180.
2.9

Read the Wall Street Journal article, FTC Bars Pom Juices
Health Claims. http://online.wsj.com/article/SB10001424127887323468604578245740405648024.
html.
(a) Analyze the FTCs case against Pom using marginal benefit and
demand curves.
(b) How did Poms ad quoting the judges words affect the marginal
benefit and demand curves?
(c) What would be the effect on other food companies if the FTC obtains an injunction against Pom but does not make them pay monetary
damages?
(a) The FTC says Pom is deceiving consumers into thinking that
pomegranate juice prevents premature aging, heart disease, stroke,
Alzheimers, and cancer by using misleading and outright false advertising. In that case, consumers will buy according to the demand
curve in the diagram below, which is above the marginal benefit
curve. As a group, consumers will have surplus of C-B, but they will
be expecting surplus of A+C. The Q2 consumers who buy at Poms
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price do not all regret their purchase (the first Q1 do not), but they
all are disappointed. Note, however, that pomegranate juice does
taste good even if it has no health benefit, so the marginal benefit
curve is not flat at 0.

(b) That ad was one source of the shifting out of the demand curve
beyond the marginal benefit curve. It would not affect the marginal
benefit curve, just the demand curve.
(c) In that case, Pom will have come out ahead. They will no longer
be able to use misleading advertising, but since they arent punished for their past advertising, their profits will have at least temporarily been raised. Other food companies will see this and may
imitate Pom, thinking that they can lie for free until the FTC tells
them to stop.
2.10

Suppose hunting has negative externalities due to accidental shootings. Someone proposes reducing the price of hunting licenses to cure
the market failure. Is this a good idea? Explain carefuly.
No, it is a bad idea. Because there are negative externalities, the
amount of hunting is probably too big to begin with (though maybe
the initial price of licenses is enough to overcome that). Reducing
the price will just increase the amount of hunting, increasing the
amount of externalities.
Note that it doesnt matter how producer and consumer surplus
change in response to a subsidy. That is more complicated. Both
will rise, but the government will lose money just the opposite of
what happens with a tax.

2.11 Which of the following most commonly causes sales to be above the
19

surplus-maximizing level?
(a) Market power.
(b) Good property rights.
(c) Negative externalities.
(d) Taxes.
(e) High quality.
2.12 If killing cockroaches has positive externalities, the market failure is
that
(a) Cockroaches will be eliminated too soon.
(b) Too few cockroaches will be killed.
(c) City regulation will be imposed on restaurants so they are forced
to kill more cockroaches than is efficient.
(d) People will not know that they should kill cockroaches.
(e) None of the above.
2.13 At Indianas Holiday World amusement park, soft drinks are free.
What is the likely reason for this?
(a) Inefficient rationing.
(b) Positive externalities.
(c) Asymmetric information.
(d) Transaction costs.
(e) Market power.
2.14 Network externalities arise most in
(a) Social media.
(b) Car assembly.
(c) Electrical power generation.
(d) Banking.
(e) Petroleum distillation.
2.15 A monopolys allocative inefficiency refers to what?
(a) The monopolys profits are too high.
(b) The monopoly uses some of its assets to protect its monopoly.
(c) Too few production inputs are used to produce the monopolized product compared to other products.
(d) The monopolys costs are higher than they need to be.
(e) The monopoly is engaged in rent-seeking.
2.16 Without regulation, which of the areas in the diagram of demand and
marginal benefit are deadweight loss?
(a) A+C+D+E
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(b) D+E
(c) B+E
(d) E
(e) E+H

2.17 Which of the following is not a situation of market failure?

(a) An employee slacking off while his boss isnt looking.
(b) A house being sold with heavy termite damage known to the seller.
(b) A house being sold with heavy termite damage not known
to the seller.
(d) The Acme gas station sells at a higher price than the Basic gas
station because people just passing through town dont know that they
can wait a block and buy from Basic.
(e) A company sells its new blade buddy razor strop at a low price
because men dont know how good it is till they try it.
2.18 Which concepts are associated with public goods?
(a) Nonrivalrousness
(b) Nonexcludability
(c) Positive externalities
(d) (a), (b), and (c)
(e) (a) and (b)
2.19 When there are externalities or poor information
(a) Government regulation can definitely raise consumer surplus by
more than it reduces producer surplus.
(b) There often is an opportunity for a business to profit
by helping people to deal with the problem.
(c) Output is too high.
(d) Quantity supplied does not equal quantity demanded.
(e) None of the above.
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2.20 Which of the following create real externalities, not pecuniary externalities?
(a) A new restaurant opens up and drives an old restaurant out of
business.
(b) Mr. Smith decides to walk to work without wearing any clothes.
(c) Mr. Smith operates noisy equipment in a strip mall outlet next
to a coffeeshop.
(d) (b) and (c)
(e) (a), (b), and (c).
C HAPTER 3: G OVERNMENT FAILURE
3.1

Explain how the ideas of the tyranny of the majority and rational
ignorance are alike and unlike each other.
The idea of the tyranny of the majority is that the majority of
voters in a democracy can impose their will on the minority. The
idea of rational ignorance is that voters will not become informed
about their vote unless they think it is worth the cost to become
informed, and so will often remain ignorant.
Both of these things lead to government failure, but in different
ways. The problem with the tyranny of the majority is that a policy
will pass a vote even if it hurts the minority more than it helps
the majority. The problem with rational ignorance is that even the
majority might vote the wrong way, or not vote at all, if the voters do
not bother to become informed. The problem of rational ignorance
will often lead to something like tyranny of the minority, because
the minority will often have more concentrated interests and thus
more incentive to become informed than the majority.

3.2

Read the Wall Street Journal article, Beijing Wields Big Stick
Against Megaships.
(a) Evaluate the claims that there is vicious competition and overcapacity in the Chinese shipping industry and that the new Vale ships
will affect that competition very little.
(b) Where should Vale look for political support as it tries to get
permission for its ships to operate, besides the Brazilian government?
(a) If there is vicious competition and overcapacity, why would Vale
enter with new ships? Price would be below average total cost. If
22

the new Vale ships would not affect competition much, why would
the Chinese shippers complain? Thus, all three claims are silly.
(b) The Chinese steel industry is a potential ally.
3.3

Springville currently has three movie theatres, which sell equal

numbers of tickets. Two of them wish to merge, which would raise
the price from $10 to $16. The merged company would keep both
theatres and still sell 2/3 of the tickets. The marginal cost of serving a
customer is $6, less than the price because the market is not perfectly
competitive and the theatres generally avoid price wars. The demand
curve is Q = 20 .5P, where quantity is measured in thousands of
tickets per year.
(a) Who would lose as a result of the merger? How much per year
would they pay to prevent it if there is no free-riding problem?
(b) Who would win as a result of the merger? How much per year
would they pay to lobby to get the antitrust authorities to allow it if
there is no free-riding problem?
(c) What kind of free-riding or other problems might cause each side
to pay less than the amount it wins or loses?
(d) Why is it better to have a single anti-monopoly law administered
by a government agency rather than have the legislature evaluate each
merger individually?
(a) Consumers would lose. To get consumer surplus, start by finding the inverse demand curve, P = 40 2Q. That shows that the
maximum consumers will pay is $40. They actually pay $10 originally, for a quantity of Q = 20 .5(10) = 15, so their original
consumer surplus is .5(40 10)(15) = 225, which is $225,000/year.
After the price increase, their consumer surplus is .5(40 16)(12) =
144, which is $144,000/year. Thus, consumers would pay up to
$81,000/year to prevent the merger.
(b) All three theatres would win, even the one that is not merging, because all three would gain from the price rise. Producer
surplus starts at (10 6)15 = 60, $60,000/year. It would rise
to (16 6)12 = 120, $120,000/year. So the theatres would pay
$60,000/year to be able to merge.
(c) There are many movie-goers, each with a small amount at stake.
Thus, many or most will be rationally ignorant and will not be

23

active in a move to block the merger. There are only three theatres,
so each would be willing to lobby up to $10,000 individually.
(d) If they look at each merger individually, each will be subject to
political influence and the problem of rational ignorance. A government agency will not be so subject to political pressure.
3.4

In the United States, about 4,500 sugar beet and sugarcane farms
produce sugar, but sugar is also imported from countries such as Brazil.
Imports are subject to a quota of about 2 billion pounds per year.
Suppose that in a given year the world price of sugar is 20 cents/lb
but the U.S. price is 30 cents/lb, and that though 20 billion pounds
per year is currently sold in the U.S., that would rise to 25 billion
pounds if the price fell to the world level. You may assume that the
product cost of U.S. producers is constant at 25 cents/lb and that the
transportation cost to import sugar is negligible.
(a) How much do the sugar farmers benefit from the quota, and how
much would they be willing to spend to keep it in place if there were
no free-rider problem?
(b) Who else benefits from the quota, and how much would they be
willing to spend to keep it in place if there were no free-rider problem?
(c) Who is hurt by the quota, and how much would they be willing to
spend to abolish it if there were no free-rider problem?
(d) Why do the quotas continue to exist if they hurt Americans by
more dollars than they help them?
Source: Number of farms in 2012 United States Department of Agriculture U.S. Sugar Production.
(a) The sugar farmers benefit. The price is raised by 5 cents/lb and
they sell 18 billion pounds, so they benefit by .9 billion dollars per
year.
(b) Whoever gets to import the 2 billion pounds also benefits. That
might be merchants who ship sugar, or foreign producers, depending on how the exporting countrys quota is administered. The
value of buying at the world price and selling at the US price is
10 cents/lb, so the certificates are worth $.2 billion, which is 200
million dollars per year.
(c) Consumers are hurt. If the quota were abolished, the price
would fall to the world price, a drop of 10 cents per pound. Thus,
24

they would save 2 billion dollars per year on the 20 billion pounds
they buy now. The quantity would expand by 5 billion pounds,
however. If we assume linear demand, this creates extra consumer
surplus of .5*(10 cents/lb)*(5 billion lb) = .25 billion dollars.
(d) Sugar farmers are a small and concentrated group, so they find
it easier to organize, lobby, and base their votes on sugar policy
than do consumers, who are numerous and who each have little at
stake.
3.5

Read The Huffington Posts Chicago Food Trucks: City Council

Overwhelmingly Approves Mayors Ordinance.
(a) What effect would banning food trucks have on the supply and
demand curves for fast food generally and for brick-and-mortar fast
food by itself?
(b) Why might we expect government failure in the regulation of food
trucks?
(c) Think of some form of market failure that restaurants could use as
an excuse to justify the banning of food trucks.
(a) If we are talking about the market for all kinds of fast food, the
ban would shift back the supply curve, but leave the demand curve
largely unaffected (though to some extent it would shift the demand
curve back too, since there would be less selection for consumers). If
we just talk about the market for brick-and-mortar-restaurant food,
the supply curve would be unaffected in the short run, but demand
would shift out. In the long run, the supply curve would shift out
too.
(b) Restaurant owners will be more politically aware than food
truck owners. Consumers will be rationally ignorant, not paying
very much attention to regulation. Thus, the political forces will be
weighted toward regulation to help restaurant owners even if that
hurts consumers more.
It is not a correct answer to say because the regulation will
reduce surplus. That is the definition of government failure, and
the question here is why government failure would occur why
the government would impose regulations that do not maximize
surplus.
(c) If the safety of the food from trucks cannot be monitored well
enough by the city health department, that could be a reason to
25

ban them based on asymmetric information. If the trucks create

congestion in the streets, that would be the market failure of negative externalities.
The fact that food truck competition drives down restaurant
profits is not market failure. That is how market works to maximize surplus. Any profits lost by the restaurants are gained by the
food trucks or by consumers. This is a very important point.
3.6

Read the Wall Street Journal article,How Washington Ruined

Your Washing Machine: The Top-Loading Washer Continues To Disappear, Thanks to the Usual Nanny State Suspects.
(a) Why did the federal government impose regulations that prohibited
most of the washing machines existing in 1996?
(b) Why did the Dept. of Energy say that washing machine quality
and cost would not fall under the new regulations?
(a) The public reason, and undoubtedly part of the explanation,
is that the government wanted people to use less energy and less
water. Why this is desirable is unclear. Some people thought that
consumers were irrational in preferring cheaper and more effective
machines that used more water and energy. Others think that it
is good to use less energy and more capital and labor. It reduces
surplus to force people to use less energy, but some citizens seem to
think that using less energy is a goal in itself, even if there is no
material benefit. Still another reason is that using labor and capital instead of energy might result in less carbon dioxide emission,
which may be a negative externality.
A less public reason is that the government action benefitted
whichever companies were best at making water-economizing washers
most likely the companies that made upper-end machines and had
better research departments. The extra cost would be similar for
all washers, high-end and low, which meant a bigger percentage
increase for low-end machines bought by the less affluent. They
value money more and environmentalism less, but they are also
less politically aware than rich people.
In answering a question like this, it is important to consider
both public-interest and private-interest reasons, and to look for
whether there really is a market failure to be addressed. Even more
important: dont believe everything you see written in the newspa26

pers. The surface reasons people give for policies are not always the
real reasons and when they are not, they often do not make sense.
(b) They lied. It was obvious that to meet the new standards, the
machines would cost more. If it was cheaper, the manufacturers
would already have been doing it. They did not want to say anything negative about the policy, or anything that would hint at how
it would be particularly hard on the poor, so, as governments often do, they pretended their regulation was Pareto-improving. Another advantage of that for the government officials is that they can
blame the industry for price increases. Most consumers will have
no idea that it was government regulation that drove up prices.
Still another consideration is that Energy Dept. officials have short
time horizons and a regulation that looked good would help their
careers. As in part (a), dont believe everything you read, and think
about the incentives of government officials as well as of corporations.
3.7

Read the KSL.com article, Liberal Tax Leaves Bitter Taste in

Some Smoothie Drinkers Mouths.
(a) What are the two possible motivations for the liberal tax?
(b) Does the tax on liberals maximize social surplus?
(a) One motivation is the owners tastes. He may be willing to sacrifice some profits in order to serve fewer liberals. A second possibility
is that he believes profits will rise from getting more conservative
customers (or that he will get more customers generally, because of
all the free publicity).
(b) The tax does maximize social surplus. The owner would not impose it unless it increased his utility. Either he is willing to forego
the loss of liberal customers and profit in which case his utility
must be increasing or his money profit will increase because he is
able to charge non-liberal customers more or attract more of them
as result of the tax.

3.8 The government has encouraged renewable energy in a variety of ways

guarantees to pay off loans if the company defaults, guaranteed power
purchases, required use of renewable energy by public utilities, simple cash grants, exemption from property taxes, and depreciation tax
breaks.
(a) Why does it use so many different ways instead of just one?
27

(b) What are the advantages to the government decisionmakers of each

kind of subsidy relative to simple cash for producing more renewable
energy?
(a) First, note that the question is not why the government encourages renewable energy, but why it does so in a variety of ways rather
than picking the best way and doing it on a larger scale. The answer does not require addressing why the government wants to encourage renewable energy.
It is hard to explain the variety of programs using good government arguments. Why not simply subsidize the price of energy
produced using renewable energy sources using direct cash per unit
produced, if the goal is to get more renewable energy?
One possibility is that elected officials wish to conceal how much
is being spent on these programs. Using a single program such as
larger cash grants, the voter is more likely to see the true cost. Using
a variety of programs, many with hidden price tags (such as loan
guarantees and advance purchases), voters have a hard time seeing the total cost. In the same vein, the various complex programs
make it easier to conceal that particular people have preferential
access to the programs. A second possibility is that different elected
officials want claim credit for doing something about renewable
energy, so each one wants his own program even if expanding an
existing program would make more sense.
(b) The question is not why the decisionmakers use subsidies, but
why they prefer each kind relative to a simple cash subsidy. The
answer is not that cash would not encourage renewable energy; the
cash is a subsidy for company actions rather than just a gift to
anybody who asks, even if they do nothing in return. Loan guarantees have no immediate cost and can be be targeted to favored
companies. Guaranteed power purchases do not require tax increases, since they are paid via higher electricity prices, which can
be blamed on the private utility. The same is true of required use
of renewable energy. Exemption from property taxes requires no
cash outlay by the government, though it must raise other taxes to
compensate, so the subsidy is somewhat concealed, which offends
voters less. The same is true of depreciation tax breaks.
All of these methods eventually will raise taxes, even if the cash
flow is not immediate or certain. Tax breaks, for example, mean
28

that some other kinds of tax, on other people or companies, has to

be increased to make up for the lost revenue. To be sure, some subsidies can end up costing zero ex post, but they have even higher costs
ex ante. A loan guarantee, for example, ends up costing nothing in
cash flow if the company is able to pay back its loans. With some
probability the company wont be able to though (if that probability
were zero, the guarantee would be worthless to it), in which case
the government bears a huge cash burden. It is like the choice between the government paying $50 million for sure or taking a 50-50
gamble of $0 or $100 million. The gamble is not only riskier for the
government, it also creates more triangle loss because the triangle
loss from raising $100 million is more than twice that from raising
$50 million.
3.9 Read the article, Get Your Kitchen Out of My Parking Space! City
Governments across the Country are Threatening to Kill the Food
Truck Revolution with Dumb Regulations, Slate, Matthew Yglesias
(2012).
(a) Use supply-and-demand analysis to show how the producer surplus
of restaurants would be affected by food trucks, and how much the
restaurants would pay for a law to ban them.
(b) If allowing food trucks would increase total surplus, how is it that
a ban on them could succeed in getting passed by the city council?

(a) Getting rid of the food trucks can be looked at in two ways. In the
top diagram it is as a demand shift when the product is restaurant
food. Demand increases when the food trucks are restricted, so both
price and quantity rise for the restaurants.

29

In the bottom diagram, it is as a supply shift when the product is food from restaurants and food trucks. Restricting the food
trucks shifts the supply back to be composed entirely of restaurants.
The price rises, and though the quantity of food in total falls, the
quantity of food sold by restaurants rises.
(b) A ban would not be passed if every person had equal weight in
politics. Restaurant owners would have more influence, though, because they are longer established than food trucks and thus would
have better knowledge and connections, and consumer losses are
too diffused for consumers to notice, so rational ignorance would
reduce their power.
Reasons such as the health of children are bogus, mere excuses.
Dont believe everything you read in the newspapers.
3.10

The U.S. government is banning production of conventional light

bulbs in 2014, saying that they use too much electricity. This is one
possible response if consumers underestimate the value of the new,
more expensive light bulbs. Why might the government have chosen
this particular policy?
Banning conventional light bulbs will make consumers buy the
new light bulbs instead. One reason for doing this is if consumers
underestimate the value of the new light bulbs, and so would not
buy them otherwise. This is odd, though, since the sellers have
plenty of incentive to advertise the value of the new bulbs. We usually dont need the government to ban inferior old products.
This particular policy is just one way to overcome information
asymmetry. Why would the government choose it over others? One
other way would be for the government to provide information to
consumers. Another way would be for the government to require
light bulb packaging to list the electricity savings from the new
bulbs. The most likely reason the government has chosen the new
policy, however, is that even fully informed consumers would not
want to buy the new bulbs, because they are not surplus-maximizing.
Environmentalists and light bulb companies would therefore lobby
the government for a regulation to force consumers to buy the bulbs
to achieve their objectives of less electricity usage and higher profits. Since they are concentrated interests and consumers are not,
government failure seems likely.

30

This question points to one of the most important things you

should learn in this course: regulations are frequently imposed for
the good of special interests, not the general good, but special interests will never openly say that they want a regulation just for their
own benefit.
3.11 The
new
(a)
(b)
(c)
(d)
(e)

incentives of the agency setting electrical standards for wiring in

houses will lead it to
Overly strict requirements.
Overly lax requirements.
Overly rapid changes in requirements.
Impose higher requirements on the party not in office.
Impose lower requirements on foreign firms.

3.12 The governments Center for Disease Controls incentives are likely to
lead it to
(a) Say that the risk of swine flu is less than it really is.
(b) Say that the risk of swine flu is greater than it really
is.
(c) Ignore swine flu.
(d) Blame swine flu on the Democratic Party.
(e) Blame swine flu on poor handwashing habits.
3.13 Regulatory capture refers to
(a) The regulation of essential industries.
(b) Regaining lost surplus via regulation.
(c) Mistaken regulation due to government incompetence.
(d) Control of a regulator by the regulated industry.
(e) All of the above.
3.14 The problem in regulatory capture is that
(a) Output will be inefficiently high.
(b) Regulations inefficiently transfer surplus from consumers
to sellers.
(c) Rational ignorance will be overcome, but at high information cost.
(d) The incentive for innovation is reduced.
(e) All of the above.
3.15 Which kind of government regulation is most likely to fall prey to
government failure? One with:
(a) Long-term costs and benefits.
(b) Short-term costs and benefits.
31

(c) Long-term costs and short-term benefits.

(d) Long-term costs being greater than long-term benefits.
(e) None of these things matter.
3.16 The paradox of voting is that
(a) No single voter is likely to make a difference.
(b) If everyone votes, then your vote will not matter.
(c) A single voters likely impact is much less than his material benefits
(d) Voting can result in inefficient outcomes.
(e) When everyone votes, the outcome is better than if a random 50%
were allowed to vote.
It is true that no single voter is likely to make a difference, but it
is also true that the amount of money at stake can be huge. That
amount is going to be split among many many voters, whereas the
bother of voting is borne by the one voter, so the real question is why
he does not free-ride.
3.17 A government decision is least likely to lead to government failure if
(a) Its costs are concentrated and its benefits are diffused.
(b) Its benefits are concentrated and its costs are diffused.
(c) Its costs and benefits are both diffused.
(d) Its costs are long run and its benefits are short run. .
(e) Its costs are short run and its benefits are long run.
3.18 The problem of where to put a nuclear power plant is most subject to
which problem?
(a) The principal-agent problem.
(b) NIMBY.
(c) Excess supply.
(d) Rent-seeking.
(e) Monopoly.
3.19 A political entrepreneur is someone who
(a) Obtains control of a regulatory agency.
(b) Starts a business in a foreign country.
(c) Expands his company by using political contacts
(d) Informs an interest group about a political issue and
organizes them.
(e) None of the above.
3.20 Which of the following is not part of the three-part test for regulation?
(a) Is there a regulation that would solve the market failure?
32

(b) Is there market failure?

(c) Would there be government failure if we tried to pass a regulation?
(d) Would there be market failure if we tried to pass a regulation?
(e) Could government failure solve the market failure??
C HAPTER 4: G OVERNMENT D ESIGN
4.1

Market demand for tires is Q = 12 P and market supply is Q =

2P. To cover the costs of pollution cleanup, a tax of $1/unit is imposed,
to be paid by the sellers out of their sales revenue. How much will the
prices firms charge rise or fall?
In the pretax equilibrium, 12-P=2P, so P=4. After the tax is
imposed, the sellers receive only P-1 per unit sold, not P, so the
supply curve changes to Q= 2(P-1). Equating this to the demand
curve, 12-P=2(P-1) so 12-P = 2P-2, 14 = 3P, P = 4 2/3. The price
has risen by 2/3.

4.2

Let the supply curve be P = Q and the demand curve be P =

24 2Q.
(a) If a tax of 3 per unit is imposed on buyers, what is the change in
the equilibrium price and quantity, producer and consumer surplus,
and tax revenue?
(b) If a tax of 3 per unit is imposed on sellers instead, what is the
result?
(a) First, figure out what happens if there is no tax. Equating supply and demand, Ps = Qs so
Qs = 24 2Qd ,
so Q=8. In that case, using either demand or supply, P=8 too.
The producer surplus is .5(8-0)(8)=32 and the consumer surplus
is .5 (24-8)(8) = 64. Total surplus is 96.
Next, figure out what happens if a tax of 3 is imposed on buyers.
The demand curve will shift in, towards zero with the tax, theyre
less eager to buy. A good way to think about it is to ask at what
price theyll demand exactly Q=0. Before, that was at P=24. Now,
they have to pay the tax of 3, so even if the price is 3 lower, at
33

P=21, theyll demand zero. Thus, it must be that the new demand
equation is Pd + 3 = 24 2Qd , so Pd = 21 2Qd , so if Q=0, P=21.
Equate supply and demand using the new demand curve, so
Qs = 21 2Qd
and Q=7. That means P=7 too, since Ps = Qs . As a result, PS =
.5(7)(7) = 24.5, and CS = .5(21-7)7 = 49. Tax revenue is the tax of 3
per unit times the output of 7, so it equals 21. Adding those three
things up yields 94.5 in total surplus. Thats down by 1.5 from the
pre-tax surplus, so the deadweight loss is 1.5.

(b) Now lets put the tax on the seller. The supply curve will shift,
because sellers are less eager to sell. Before, if the price rose above 0,
thered be positive supply. Now, since they have to pay the tax of 3,
quantity supplied would be zero at that price. The price has to rise
to 3 before quantity supplied becomes positive. So now, Ps 3 = Qs ,
so Ps = Qs + 3 and if P=3, Q=0. Equate supply and demand using
the new supply curve and the original demand curve so
Qs + 3 = 24 2Qd
and Q=7. Using the supply curve, P = 7 + 3 = 10.
Producer surplus is .5(10-3)(7) = 24.5. Consumer surplus is .5
(24-10)(7) = 49. Government revenue is (3)(7)=21. So everything is
the same as with the tax being on buyers, including total surplus of
94.5 and deadweight loss of 1.5.
4.3

Suppose jam is initially untaxed, but then the Indiana General Assembly imposes a special sales tax of 3% on it, paid by the consumer
at the cash register.
34

(a) Show on a diagram how this affects the equilibrium price, and show
the triangle loss in social surplus.
(b) Next the General Assembly adds a 3% value-added tax on jam,
paid by the seller, while retaining the 3% tax on consumers. Show on
a diagram what further effect this has on the equilibrium price and
the triangle loss.
(a) The price falls from P0 to P1 . Total surplus falls by the amount
of the triangle A + B because of the smaller output. The new curve
is slanting because this is a percentage tax, not a dollars per unit
tax. Thus, the amount of tax per unit is higher when the price is
high.

(b) The price will rise compared to with just the tax on buyers to
P2 . We cant say how much it could even rise above the original
price before any taxes were imposed. That depends on the shapes
of the supply and demand curves. It will definitely reduce output further, though, and the triangle loss will increase by amounts
C+D+E+F+G. You can use the original supply and demand curve
to find the lost surplus, because they reflect the social benefit and
the social cost of sales.

35

4.4

The government of Nowheristan imposes a tax on bread, which is

30% of the spending of the people affected. Afterwards, the amount of
bread they buy is unchanged. I claim there is actually a deadweight
loss from the tax nonetheless, and that a lump-sum tax (a tax of
$X/person) with the same revenue would leave social surplus higher.
Am I right? Explain.
Yes, there is a deadweight loss. Imposing the tax effectively reduces the income of the people, whether it is a lump sum tax or a
tax on bread. This shifts the demand for bread out, because bread
is an inferior good. But if it is a sales tax, people distort their consumption away from bread to other things, and we have the usual
triangle loss. It is tricky because (a) having to pay the tax means
the consumers are poorer, and want to eat more bread because they
cant afford meat, (b) but if bread is taxed, that cuts down on the
amount of bread they eat, and (c) the two first effects cancel each
other out.

4.5

The state decides to impose a $0.20/gallon tax on milk, paid by the

seller.
(a) Show on a diagram how this affects the equilibrium price, and show
the loss in social surplus that results.
(b) Next, the State decides to use the revenue to subsidize milk. It
creates a special subsidy of $0.20/gallon on milk, paid to the consumer
at the cash register. Show on a diagram what further effect this has
on the equilibrium price and the triangle loss.
(a) It is as if the supply curve shifted up by the amount of the tax.
No transaction that yields less than $.20/gallon consumer plus
36

producer surplus will take place, so the surplus from those transactions is lost the triangle on the diagram.

(b) This will cancel out the previous tax exactly, but shifting the
demand curve out (not in, as a tax does), so the ultimate price a
consumer pays and a producers receives stays the same. The consumer will now pay a higher price, but with the subsidy the net
price for him is the same as at the beginning. The producer will
now receive a higher price, but the net price after he pays the tax is
the same as the beginning.
4.6

The Uber taxi company ran into trouble in Virginia:

In a Thursday in June, bureaucrats from Virginias
Department of Motor Vehicles made their move against Uber
Technologies. The fast-growing ride-for-hire company was
told that its popular service was, in fact, illegal and that
the firm needed to immediately cease all operations in the
state.
Far from being intimidated, Uber was ready to fight
back... A notice sent to Uber users in Virginia included
the e-mail address and phone number of the ordinarily lowprofile official in charge of the decision. The notice instructed the companys supporters to demand that the DMV
stand up for you.
Hundreds of them did and, by Sunday, Commissioner
Richard Holcombs inbox was flooded. Holcomb did his best
to respond working through the weekend, even crafting emails to irate Uber customers as he lay in bed at home.

37

(Uber Pressures Regulators by Mobilizing Riders and Hiring Vast Lobbying Network, The Washington Post)
(a) How is this an example of overcoming rational ignorance?
(b) Do we need to worry about companies having increased power because of the ease in the Information Age of mobilizing their customers,
workers, and suppliers in political campaigns? Should corporations be
banned from spending money on web- based campaigns to exert political pressure?
(a) The Web, and, more generally, deep informational connections
between firms and customers, allows firms to enlist customers in
their lobbying. Here, Uber was very cheaply able to tell its customers that the service they liked was being threatened, and to tell
them how to contact the official in charge. If they had not done
so, very few of their customers would have the motivation to learn
about local taxi regulations, but Uber reduced the cost of learning immensely. As a result, many voters decided it was worth the
trouble to contact government officials. This kind of tactic is particularly is helpful to firms in direct contact with consumers, who
can provide broad political pressure.
Note that the biggest change is not in the cheapness of contacting the government. People could always write letters. In fact,
the government actually pays less attention to each message it receives now. Rather, its that Uber was able to inform the customers
cheaply and quickly.
(b) When the cost of lobbying falls, that can be either good or bad.
Here, the lobbyists we are thinking about are the customers, suppliers, and employees. This reduces the likelihood that the lobbying will be harmful, because the campaign is not directed solely
at increasing the profits of the shareholders of the company. Also,
this means of influencing government is so public that the danger
of such things as bribery or giving jobs to government officials is
miniscule. Uber will not tell its thousands of customers in a town
to give bribes to the mayor. Thus, this form of corporate political
pressure seems to be surplus-increasing.
4.7

Why should we expect charities to have more trouble keeping costs

low and productivity high than a private company? Assume the private company is not a publicly traded corporation.
38

Companies are trying to earn profits, a relatively simple goal.

Keeping score in money allows them to measure productivity much
better than a charity, although companies do still have to worry
about acts that raise profits in the short run but reduce them in the
long run. Also, the people who control the charity do not own it, so
they cannot keep the cost savings they make, unlike in a business.
In a business, the owners keep careful watch on operations because
their own money is at stake.
4.8

What is the point of the United States or an individual state having both a House of Representatives and a Senate? Why not just
simplify and have one legislature composed of people elected for fouryear terms?
Having two legislatures slows down the passage of new laws,
because both must vote for them. The laws therefore get lengthier consideration and it is harder to push through a law backed
mainly by one person who has power in his branch, which reduces
rent-seeking because laws need broader support. Having two-year
terms for some legislators and 6-year terms for others helps by making some legislators highly aware of the need to be re-elected and
others less concerned. Those who have two-year terms (or are in the
last 2 years of their 6-year term) will respond more to what voters
want and have incentive to work harder. Those who have six-year
terms do not need to spend as much time campaigning and are
more concerned about the long-term effect of what they do. Having a mixture of such people, it is hoped, will achieve a desirable
balance.

4.9

Three methods of choosing state judges are to elect them, to let

the governor appoint them, and to let the state bar association (an
association of lawyers) choose them.
(a) What is one advantage of each method for maximizing surplus?
(b) What is one disadvantage of each method?
(a) An advantage of elections is that the judges will do what the
citizens want because they wish to be elected and re-elected. An
advantage of having the governor appoint them is that the governor
has the expertise to choose a good candidate for judge and he will
do what the citizens want because he wishes to be elected and reelected. An advantage of letting the state bar association choose is
39

that lawyers know which candidate knows the law best.

(b) A disadvantage of elections is that the judges will be responsive
to special interests who give them contributions and other support
for election. A disadvantage of having the governor appoint them is
that the governor may use the position as a way to reward friends.
A disadvantage of letting the state bar association choose is that
they will choose someone who represents the interests of lawyers,
not of the rest of the citizens. It was not correct to answer that
choice by the state bar association, a tiny minority of the population, would lead to tyranny of the majority.
4.10

Every university has a legal department. These departments are

known for the difficulties they create for hiring foreign faculty and for
the stringency of the requirements they suggest for making sure that
researchers comply with Federal regulations about not abusing human
subjects. Indeed, the university rules often go much further than the
regulations, which in turn go much further than the statute. Why
would this be?
The question is not why universities obey the law. The question
is why the legal departments make rules that are stricter than the
law and make the running of the university less efficient. Fear of
publicity is not a good answer universities are not different from
private companies in that respect, and it is not clear that bad publicity about these things (as opposed to sex and money scandals)
would hurt a university. One reason is that the legal department
gets blamed if the university gets into trouble, but bears none of
the costs of following the stringent rules. Always ask Cui bono?
It also may be the case that the university wants to have stringent
policies anyway, and uses the federal regulations as an excuse.

4.11 Which of the following is a major principle of administrative law?

(a) Opportunity for public comment.
(b) Transparency.
(c) Regulations being made by the executive branch.
(d) Judicial deference to the agencys interpretation of regulations.
(e) All of the above.
4.12 Transparency refers to
(a) Making regulations simple to understand.
(b) Making regulations last only a limited period of time.
40

(c) Reducing the time period during which the public can comment
on a regulation.
(d) Letting the public see all the comments and lobbying
input when regulations are made.
(e) Making regulations apply to government agencies as well as the
public.
4.13 The function of the Office of Management and the Budget in making
pollution regulations is
(a) Nothing.
(b) To write the first draft.
(c) To review the drafts written by the Environmental Protection Agency.
(d) To make public comment on every regulation so as to give the
Presidents view.
(e) To send finalized new regulations to Congress.
4.14 When the federal government makes a regulation,
(a) It announces and starts enforcing the regulation, but it allows
comment.
(b) It announces and start enforcing the regulation, but does not
allow comment for 60 days.
(c) It announces the regulation and starts enforcing it, but only the
OMB may comment.
(d) It announces a regulation but does not start enforcing
it till after a public comment period.
(e) None of the above.
4.15 Every regulation must be reviewed by the
(a) SEC.
(b) OMB.
(c) CEA.
(d) Dept. of Justice.
(e) White House.
4.16 Which type of official is most likely to be looking for a promotion to
a job in a different agency?
(a) A careerist.
(b) A professional.
(c) A politician.
(d) A civil servant.
(e) All of these are about equally likely.

41

Careerists look to a career in the one agency. Professionals are concerned about professional standards, not so much about what their
bosses think of them. Politicians are looking to impress their bosses
or voters and get a promotion somewhere else in government. All of
them are civil servants.
4.17 It is generally better to tax a particular good if
(a) Demand is elastic.
(b) If it is imposed on buyers.
(c) There is a positive externality
(d) Supply is elastic.
(e) None of the above.
4.18 Suppose tobacco is initially untaxed, but then the Federal government
imposes a 5% tax on it, paid by the seller. Later, the State of Indiana
imposes an additional tax of 7%, a sales tax paid by the buyer on top
of the price. What happens after the second tax is imposed?
(a) Prices and sales rise.
(b) Prices rise but sales fall.
(c) Prices and sales fall.
(d) Prices fall but sales rise.
(e) None of the above.
4.19 Social security taxes are a percentage of the workers salary, part paid
by the employer, part by the worker. If we increased the employers
percentage by 3% and reduced the workers percentage by 3%, the
long-run effect would be
(a) An increase in the surplus of workers.
(b) A reduction in the surplus of workers.
(c) A reduction in the surplus of employers.
(d) No change in the surplus of workers.
(e) Either an increase or a decrease in the surplus of workers, depending on elasticities.
The burden of a tax does not depend on whether it is paid by the
buyer or the seller.
4.20 Hotel rooms and steel each have an elasticity of demand of .5 and an
elasticity of supply of 1.2. Plan X is to tax hotels 10% and steel 0%,
while Plan Y is to tax each industry 5%.
(a) Plan X will result in more revenue but also more deadweight loss.
(b) Plan X will result in less revenue and more deadweight
42

loss.
(c) Plan X will result in less revenue but also less deadweight loss.
(d) Plan X will result in more revenue and less deadweight loss.
(e) Plans X and Y will result in the same revenue and deadweight loss.
C HAPTER 5: T IME AND L IFE
5.1

The EPA is considering a regulation that will require $200 million

in immediate costs and cost $20 million per year in maintenance, but
will save 3 lives per year, valued at $10 million each. Ignoring OMB,
they are using a discount rate of 5.1 percent. What is the present
discounted value of the regulation?
The present value is 200 + 30r 20 , which is a little below200 +
10
.05 , which equals zero, so the value is slightly negative.

5.2

Someone is wondering what $100/year in dividends would be worth

if the risk is the same as that of large-company stocks from 1926 to
2007. What discount rate would you use, and what is the answer?
Use the real (not nominal) discount rate on large-company stocks
from 1926 to 2007. This is like a perpetuity of $100/year at a nominal discount rate of 9.2%, so it would be worth 100/.092, about
$1090. The reason to use the real rate rather than the nominal
rate is that we want to know what the flow is worth in present-day
dollars.

5.3

A company can comply with a new OSHA workplace safety rule by

installing safety features equal to 30% of the cost of each new structure
it builds or via worker training program that is estimated to cost 4%
of the structures cost each year.
(a) What discount rate would make both options equally attractive?
To solve the equation you come up with, go to the free web program
Wolfram Alpha at http://www.wolframalpha.com/. It has a box saying
Enter what you want to calculate or know about: where you can
enter your equation like this:
32 + rX == (1/r )( 23)(1/x ),
where the right-hand side means 1/r to the 23rd power times 1/x
which is not the correct equation, just an example. You need to use
double equals signs to means happens to equal here as in many
computer languages because a single equals sign means is assigned
43

the value of. The solution will be a bit down the webpage under
Real solutions:.
(b) Suppose an alternative is a more intensive training program that
will cost 5% of the structures cost each year for 10 years but can be
discontinued at that point because the safe behavior will have become
habitual. What discount rate would make the two training options
equally attractive?
(a)
(b) Let C be the building cost. The two options are equal if
10

.3C =

.05C

(1 + r ) t

t =1

where r is the discount rate.

This can also be expressed as

.3C =

.05C
r




1

1
1+r

10 
.

The discount rate r that solves this is about .16.

5.4

A company has to choose between two ways of complying with a

pollution regulation. One way costs 5 million dollars immediately to
construct a new building and then 2 million dollars at the end of the
second year and each succeeding year. The other way costs nothing
immediately, but costs 30 million dollars two years from today. Set up
equations to show to show how the company should calculate which
method to use. You do not need to solve the equations.
The first way has a present value cost of
 
1
2
5+
1+r r
The perpetual stream of payments is only discounted one year,
because the perpetuity formula gives the value today of a payment
one year from today, two years, three years, and so forth. Here, the
stream starts in two years, so it is like an end-of-year perpetuity
security worth 2/r that you receive at the end of 1 year.
44

The second way has a present value of



1
1+r

2

(30)

The company should use the second method if

1
5+
1+r
5.5

  
2
2
1
(30)
>
r
1+r

The government is considering two projects. One is a new computer

that will save the Social Security Administration $10 million/year. The
other is a new sanitation regulation for chicken slaughter that will save
$10 million per year in health costs from salmonella outbreaks. Both
have a one-time cost of $180 million. All these amounts are in current
dollars, adjusted for inflation. The nominal rate on treasury bonds is
4%. Explain why one, both, or neither project should be implemented.
Both regulations have present values of 10/r 180, but they
should use different values of r. The new computer is supposed to
save the government money, so it is a cost-effectiveness calculation
and should use the governments cost of capital. That cost is 4%
in nominal terms, but since all of our other numbers are constantdollar, we need to subtract expected inflation. Inflation of 3.1% is
a reasonable guess based on 20th-century inflation. That results
in a discount rate of 0.9% and a present value of 1,111-80, which
is positive. For the chicken regulation, it should be 7%, as OMB
directs. The present value is 143-180, which is negative. So only
the computer project should be undertaken.

5.6

The directors of Apex Corporation are worried about what will

happen if the CEO, John Doe, dies suddenly. One director suggests
they buy key man insurance, which would pay the company a lump
sum if he died. The directors expect Doe to retire in 15 years, and
they estimate that his death would cost the company an immediate 5
million dollars in disruption plus 1 million per year from not having
his special abilities. The company is currently borrowing at an interest
rate of 10%. One director thinks that the inflation rate ought to enter
their decision somehow.
(a) If zero inflation is expected, how much insurance should they buy?

45

(b) How would inflation matter for how much insurance they should
buy?
(a) The company wants to cover the present value of John Doe to the
company plus the disruption cost. The present value can be seen as
a perpetual value of $1 million per year minus a perpetual value of
$1 million that has to be given up 15 years from now, so it is:


1
1
5+
1(
)15 = 5 + 10(1 .76) = 8.4
.10
1 + .10
Thus, it should buy $8.4 million in coverage.
(b) The value of $8.4 million will diminish over time because of
inflation, so by 15 years from now, their insurance coverage would
be too low. Thus, they will want to buy more insurance, or make
a deal with the insurance company to have the amount rise over
time.
5.7

How does the forensic approach to the value of life differ from the
value-of-a-statistical-life approach?
Under the forensic approach, the analyst estimates the present
value of future earnings of the person. Under the statistical life
approach he sees how much the person is willing to spend to avoid
small risks and uses the probability of those small risks to scale up
to the value of a life.

5.8

A study finds that 2 million people are paying in aggregate $12

million for the motorcycle warning light that several manufacturers
offer that cut the number of deaths from accidents in that group from
7 to 4 for the lifetime of the motorcycle. The value of a statistical life
for these people is dfsdfsdfsdf
They are paying $12 million for a reduction of 3 deaths, so they
value the warning light at least at $4 million, but if they valued
it more, they would still only have to pay $4 million since manufacturers compete down the price and allow them some consumer
surplus. Since there is either a light or not, it is not like looking at
a continuous job or product characteristic, where people are buying
a quantity where the price equals the marginal benefit of the last
unit they buy.

5.9

The Bush Administration of 2001-2009 was accused of devaluing

human life because it reduced the value of a statistical life used in
46

pollution regulations. How could an honest better economic study

cause the Environmental Protection Agency to reduce the value of a
statistical life?
An honest study could cause the EPA to reduce the value of a
statistical life is if a hedonic regression was run on different data
than the original study and it happened to show that the wage premium for a dangerous job was lower than that estimated from the
data in the original study. When doing empirical estimation, the
data can change, and even if it does not, the same data can be interpreted different ways, to a certain extent. You cant honestly say the
result is any number you want, but if two datasets show different
results, honest men can disagree as to which is more reliable.
5.10

Explain why if every person in a group of 1,000 people had a value

of a statistical life of 6.9 million dollars, it would make sense to use
that finding for pollution regulations even though if you offered any
one of them 6.9 million dollars in exchange for certainty of death, we
know they all would refuse.
Someone might rationally accept $6,900 to do something that
had a 1 in 1,000 risk of death but refuse $6.9 million to die for
sure. Suppose he does not care about his heirs. Then he might
want be willing to accept the $6,900 because he can spend it if he
lives, but he will think that if hes dead the $6.9 million will be
useless to him. Thus, it is quite rational to accept different prices
per 1% chances of death for different levels of risk.

5.11 The average rate of inflation from 1926 to 2007 was closest to which
number?
(a) 2%.
(b) 3%.
(c) 5%.
(d) 8%.
(e) 10%.
5.12 The after-inflation return on Treasury bills from 1926 to 2007 was
closest to which number?
(a) 0%.
(b) 1%.
(c) 2%.
47

(d) 3%.
(e) 5%
5.13 The federal government chooses a discount rate for government bridge
projects that
(a) Equals the governments cost of capital.
(b) Is lower than the governments cost of capital.
(c) Is close to the private sectors aftertax return on investment.
(d) Is close to the private sectors pretax return on investment.
(e) None of the above.
5.14 If a new regulation has a one-time cost of 12 million dollars and the
discount rate is 5%, that is equivalent to what annual cost in perpetuity?
(a) Between 0 and .9 million dollars.
(b) Between .9 and 2.9 million dollars.
(c) Between 2.9 and 3.9 million dollars
(d) Between 3.9 and 4.9 million dollars.
(e) Above 4.9 million dollars.
5.15 If a regulation requires 100 million dollars in compliance costs immediately and 2 million each year thereafter, and the discount rate is 10%,
what is the present value of its total cost?
(a) 0-110 million dollars
(b) 110-121 million dollars.
(c) 122-132 million dollars.
(d) 132-139 million dollars.
(e) More than 140 million dollars.
5.16 The Ruritania Dept. of the Interior in has estimated 10 million Ruritarian dollars as the value of a human life in setting the permissible
arsenic limit to 30 ppm. The Dept. of Agriculture has estimated 5
million dollars as the value of life in setting the permitted atrazine
limit to 70 ppm. The prime minister can raise total surplus by
(a) Relaxing both regulations to 29 and 69.
(b) Tightening both regulations to 31 and 71.
(c) Relaxing the arsenic regulation and tightening the atrazine
regulation.
(d) Tightening the arsenic regulation and relaxing the atrazine regulation.
48

(e) We do not have enough information to say.

5.17 If the total wages for crabfishing over 10 years are $3,000 higher than
wages in fishing jobs that have 1 in 1,000 fewer deaths over that time
period, the value of a statistical life for crab fishermen is
(a) Less than $2 million.
(b) Between $2.1 million and $5 million.
(c) Between $5.1 million and $6.1 million.
(d) Between $6.1 million and $19.1 million.
(e) More than $20 million.
The value is $3 million
5.18 In figuring out the forensic value of a life,
(a) The value should differ depending on the regulation.
(b) The value must be the same for all countries.
(c) The value depends on the discount rate chosen.
(d) The value is higher if wages are expected to fall.
(e) None of the above is true.
5.19 Which of the following will increase the dollar value of a statistical life
as measured by a hedonic regression?
(a) A fall in the discount rate.
(b) A rise in the discount rate.
(c) A fall in wages.
(d) A reduction in other risks in the economy.
(e) None of the above.
If the discount rate falls, people will value their future utility
more in dollar terms, so they will require higher wages for dangerous jobs or lower prices for dangerous products.
5.20 Hedonic regressions are used
(a) The calculate a companys cost of capital.
(b) To estimate the effect of government failure.
(c) To calculate the amount of producer surplus.
(d) To calculate the amount of consumer surplus.
(e) To calculate the value of a human life.
They can also be used to calculate the value the marginal consumer of a product puts on a particular feature of the product, e.g.
mileage per gallon for a car. That does not estimate the consumer
surplus, though, just the price of that feature.
49

C HAPTER 6: E XTERNALITIES
6.1

Suppose the externality cost of sulfur dioxide pollution from steel

production is $2/ton, the supply curve is P = 2 + Q/2 if P > 2 and
Q=0 for P < 2, and the demand curve is P = 34 Q. What steel
output level maximizes surplus?
The supply equation can be written as P= 2+ Q/2. The externality cost adds 2 to that, so marginal social cost is MSC= 4+ Q/2.
The demand equation can be written as P = 34-Q. Equating the two
yields 4+Q/2 = 34-Q, so 3Q/2 = 30 and Q=20.

6.2

The supply curve for vodka is Q = P and the demand curve is

Q = 18 2P. Vodka has a negative externality of 3 per unit bought,
and the government is thinking about its optimal policy.
(a) What is the producer surplus, consumer surplus, and third-party
loss in equilibrium?
(b) Suppose the government imposes a tax on vodka, paid by the
sellers, to maximize surplus. How much will the price rise, how much
revenue will the government raise, and how much will total welfare
rise?
(a) The equilibrium has P = 18 2P, so P = 6. In that case, Q = 6
from the supply curve. The consumer surplus is .5 (9-6)6 = 9. The
producer surplus is .5 (6)(6) =18. The externality cost is 6(3) = 18.
(b) The tax should equal the externality amount, 3. With the tax,
the supply curve becomes Q = 0 if the price is less than 3, Q =
( P 3) otherwise. Thus, the new equilibrium is at P-3 = 18-2P, so
3P = 21 and P = 7. The quantity according to the demand curve
is 18 2P = 4. Producer surplus is .5 (7- 3) (4)= 8. The consumer
surplus is .5 (9 - 7) 4= 4. The externality cost is 4(3) = 12. Tax
revenue is 3Q, which equals 21.

50

6.3

Suppose the supply curve is Ps = 2Qs , the demand curve is Pd =

48 3Qd , and each transaction creates an externality with marginal
cost X = Q .
(a) What is the equilibrium quantity without regulation?
(b) Draw a diagram to show the shape of the supply curve, the marginal
externality level, the marginal social cost, and the demand curve.
(c) What quantity yields the greatest possible social surplus?
(d) What pollution tax size would yield the greatest possible social
surplus?
(a) Setting price on the demand curve to price on the supply curve,
2Q = 48 3Q so Q = 48/5 = 9.6.
P
50
40

Demand
Marginal Social Cost

30
20
Supply
10

(b)

Externality
2

10

12

14

(c) The marginal social cost is MSC = 3Q. Equating this to the
price on the demand curve yields 3Q = 48 3Q so Q = 8.
(d) The pollution tax needs to be equal to the size of the externality
when Q = 8, so it should equal 8.
51

6.4

Read The SuperFreakonomics Global-Warming Fact Quiz.

(a) Why does Professor Levitt say that we should use climate engineering instead of a carbon tax?
(b) Levitt omits a major reason why global engineering is a more
practical solution than carbon taxes. What is that? Discuss.
(c) Would a higher discount rate make Levitts solution for global
warming more attractive or less attractive relative to cap-and-trade?
Discuss.
(a) He has two reasons. (1) A carbon tax will reduce emissions,
but that will only delay warming, not stop it. Warming will continue for many years, and eventually reach the same high temperatures it would without the carbon tax. (2) Reducing emissions is
very expensiveover a trillion dollars per yearwhereas geoengineering is extremely cheap by comparison. Thus, if the goal is to
maximize net benefit or reduce net cost, geoengineering is superior.
(b) He omits the difficulty of implementation because of the international free rider problem. Carbon taxes must be imposed worldwide, or some countries will keep on increasing their emissions. In
fact, the non-taxing countries will increase emissions all the faster,
because their industries will be advantaged and will export carbonheavy goods to the high-tax countries. The non-taxing countries
will see no need to tax if other countries are doing the taxing, and
no country can benefit by unilaterally imposing a carbon tax. In
addition, some countries will prefer global warming to a carbon
tax even if a carbon tax could be imposed worldwideIndia and
Russia, for example. Geoengineering, on the other hand, can be
done unilaterally, and it is cheap enough that one medium-sized
country could find it profitable to do it even if it had to bear the
entire cost itself.
He also omits the advantage that geoengineering can be tried on
a smaller scale, and later, so that if warming turns out not to be
such a problem, large costs have not been incurred.
(c) With a high discount rate, geoengineering is more attractive because its cost could be delayed till many years from now, whereas
to significantly delay global warming a cap-and-trade policy would
have to start in the next fifty years. On the other hand, if discount
rates are very low, cap-and-trade has the problem that without exorbitant cost it doesnt seem to be a permanent solution, and if the
52

discount rate is low, the costs of warming further out than 100 years
would matter more than with a high discount rate.
6.5

The market will supply zero to 10 units of cough syrup at a price

of 8, 10 to 20 units at a price of 11, and any number of units at a price
of 15. Cough syrup is sometimes bought by meth dealers to use as a
raw ingredient, and this has a marginal externality equal to 2Q when
Q units of cough syrup are sold. The demand curve for cough syrup,
bought for legal or illegal uses, is 24 Q.
(a) Graph supply, demand, and the marginal externality.
(b) What is the equilibrium price and quantity?
(c) What is the equilibrium total surplus?
(d) What quantity would maximize social surplus, and what would
the total (not marginal) amount of externality cost be at that level of
cough syrup?
(e) What tax on cough syrup would be optimal?
(a) The graph is:

(b) If P =11, the quantity demanded will be 13, and sellers are willing to supply that quantity at that price, so that is the equilibrium.
(c) At a price of 11 and quantity of 13, consumer surplus is .5(2411)(13) = .5(169)= 84.5. Producer surplus is 10(11-8) + 3(11-11)
= 30. The externality is the area under the externality curve from
0 to 5.33, which is .5(13)(26)=169. Another way to think of it is
that since the marginal externality is 2Q and it is the derivative
of the total externality, the total externality must be Q2 , which is
169 (That idea is the same as integrating the marginal externality
53

function probably the only time youd take an integral in undergraduate economics.) Thus, total surplus is 84.5+ 30- 169= -54.5.
(d) The marginal social cost is 2Q + 8 for quantities less than 10,
2Q + 11 for quantities between 10 and 20, and2Q + 15 for greater
quantities. We want this to equal the price from the demand curve,
P = 24 Q.24 Q = 2Q + 8 solves to 16 = 3Q, Q = 16/3 5.33,
which is less than 10, so it is in the appropriate region of Q for
2Q+8. At Q = 5.33, the total dollar amount of externality is the
area under the externality curve from Q = 0 to Q = 5.33, which
is .5(16/3)(32/3) or 256/9 28.4. If we tried setting 2Q + 11 =
24 Q, we would get 3Q = 13, so Q 4.33, which is inappropriate
for 2Q + 11 since that only applies for Q between 10 and 20.
(e) Set the tax equal to the marginal cost of the externality at the
optimal quantity of 5.33. The marginal cost of the externality is
2Q, so the tax should equal 32/3 10.66.
6.6

Contract law in Nowhereistan says that if the buyer breaches a

contract by refusing to accept delivery of the goods, he must not only
compensate the seller for lost profits, but be publicly flogged by the
seller. Transactions costs are zero, so the Coase Theorem applies.
What will be the effect of the flogging privilege on contract language,
the amount of non-acceptance of goods, and social surplus?
If there are no transaction costs, each time people make a contract they can easily include a clause to override the law and waive
the right to flog. Good contract law matters because it reduces
transaction costs. Or, if contracts do not include that clause, then
the price for the goods will be lower, and when the buyer wants to
refuse delivery, he will negotiate to pay money to the seller in place
of the flogging, except perhaps for the occasional Shylock who likes
flogging better than money (but a rational buyer wouldnt make
a contract with such a seller). In the end, the amount of nonacceptance will be the same as without the flogging rule, so social
surplus will be the same too.

6.7

The Bigmountain Basin Pollution Authority currently is served by

two power companies. Apex Power emits 200 tons of sulfur dioxide
per year and Brydox Electric emits 300 tons. It would cost Apex 1
thousand dollars to reduce its emissions by one ton, and it would cost
Brydox 2 thousand dollars. It would cost Apex 3 thousand dollars to
reduce emissions by one ton if it had already reduced its emissions to
54

100 tons, and 5 thousand if it was down to 50 tons. It would cost

Brydox 3 thousand dollars per ton to reduce emissions by one ton if
it were down to 100 tons, and 4 thousand if it were down to 50 tons.
(a) Draw a pair of graphs to show the marginal benefit of emissions
for Apex and Brydox.
(b) The Pollution Authority decides to make emissions allowances
tradeable. As best as you can tell, how much will each company pollute
in equilibrium, and what quantity will be traded at what price?
(a) You only have 3 points to work with, so there are various shapes
the curves could have, but theyre downward sloping.
MB a

MB b

50

100

150

200

250

300

350

50

100

150

200

(b) The initial situation is not an equilibrium, because Apexs marginal

benefit is less than Brydoxs. Thus, we know Apex would be willing
to sell some allowances to Brydox at a price above $1 and below
$2. We know that if Apex sold 100 allowances, its marginal benefit
would be $3 and Brydoxs would be less than $3 (because Brydoxs
marginal benefit only is as high as $3 if it has 100 or fewer allowance). Thus, we also know that less than 100 allowances will
be sold. As Apex sells allowances to Brydox, Brydoxs marginal
benefit will fall below $2 and Apexs will rise above $1. Thus, the
equilibrium price will be somewhere between those values.
6.8

Zoning regulations control what landowners can do with their property. A city zoning rule might say, for instance, that in a particular
neighborhood you cannot operate a business or build a house on a
lot less than 1/2 acre in size. What externality argument is used to
justify zoning? Construct a numerical example to show how a zoning
rule against businesses could increase property values in a neighbor-

55

250

300

350

hood even if each homeowner would prefer that he be allowed to run

a business from his home.
The argument for zoning is that restricting one persons right to
use his property can avoid negative externalities for everyone else.
The person who opens a gas station in a residential neighborhood,
for example, would make much more from his land than if he build
a house on it. The neighborhood would become less attractive for
homes, though. If the gas station is placed next to other businesses,
on the other hand, it creates less of a negative externality and might
even create a positive externality if another business finds the car
traffic bring him more customers.
As a numerical example, suppose that each of 100 residential
homes is worth $200,000 if they are all used as homes, but the value
drops to $100,000 if one or more is torn down and replaced with a
gas station. If one person turns his home into a gas station, his
gas station is worth $300,000, but if two more people do that, each
gas station is only worth $90,000. With zoning, the total value of
the properties is 100* $200,000 = $20 million. Without zoning, the
first person to build a gas station will have $300,000, and each of
the others would only have $90,000 if he, too, built a gas station, so
he would keep his house. The total value would only be $300,000
+ 99*$100,000 = $10.2 million. Thus, surplus is maximized by
forbidding gas stations.
You could also construct an example in which building gas stations made every property owner worse off, because when there are
more than one gas station, each is worth $110,000. In that case,
everybody would build a gas station and the total value would be
$11 million.
Note that if the Coase Theorem applied, the neighbors would
all sign a contract not to turn their property into a gas station, but
with this many people, bargaining costs would be high.
6.9

Suppose that if we do not reduce the amount of carbon dioxide

in the atmosphere by using a carbon tax, the cost will be $1,000 billion/year ($1 trillion) starting 50 years from now, but that the welfare
loss from the tax would be $90 billion/year forever starting immediately. All these numbers are in constant dollars, zero inflation.
(a) If the discount rate is 7%, what is the present discounted value
of the carbon tax policy? Some computations that might be relevant
56

are:

90
.07

1285, 1000
.07 14, 285, ...

(b) If you had $90/billion per year income and invested it at a return
of 7%, what total sum would you have 50 years from now?
(c) If the discount rate is 1%, what is the present discounted value of
the carbon tax policy?
(d) Which discount rate is more appropriate to use?
(e) Suppose that there is a 50% probability that increased carbon
dioxide will turn out not to affect the world temperature enough to
create clear costs or benefits, and we will discover that in 40 years.
By that time, though, we would need to impose a bigger carbon tax,
that would create $200 billion/year in triangle losses. Using the 1%
discount rate, is it worth waiting?

50
90
1
1000
(a) The value would be .07 + 1.07
.07 90 14.28 + .0339
1000 14.28 1285.2 + 484.1 801.1 billion.
(b) The present value of $90/billion at a 7% discount rate is $1285,
computed in part (a). A dollar invested today at 7% would rise to
(1.07)50 in 50 years, which is about 29.46. Thus, the value in 50
years would be $37,843.

50
90
1
1000
(c) The value would be .01 + 1.01
.01 90 100 + .608
1000 100 9000 + 60, 800 = 51, 800 billion.
(d) The better discount rate to use is 7%. That is about the return on
private investment. If we could invest the avoided $90 billion in tax
triangle loss at 7%, then part (b) showed that the value would rise
to $37,843 billion in 50 years, which is more than the present value
of the warming would be at that time (which is $1000*14.28 billion
from part (a)). In other words, if we kept investing the $37,843
billion, it would yield more than $1,000 billion/year

50
90
1
1000
(e) Now the net benefit of starting to tax now is .01 + .5 1.01
.01

90 100 + (.5).608 1000 100 9000 + 30, 400 = 21, 400 billion.


40
200
1
The net benefit of the bigger tax starting later is .5 .01 1.01
+

100
1
1000
1.01
.01 .5(20000) .671 + (.5).608 1000 100 6710 +
57

30, 400 = 23, 690 billion. Thus, the later tax is a better idea.
6.10

Andrew and Betty have been going out for six months, and like
each other, except that Betty really hates how Andrew always wears a
baseball cap, and she doesnt even think Andrew likes the cap that
much. Betty tells their mutual friend Cathy, and Cathy says, I
just learned in my economics class that the Coase Theorem says the
surplus-maximizing outcome is always achieved. What I mean is, since
you hate the cap and he doesnt care that much, you two ought to be
able to make a deal where you pay him $10 to stop wearing it or agree
to let him choose what movies you go to, and youll both be happier.
Betty admits the logic of how they could both be better off, but she
thinks it would be a bad idea to try.
(a) Whats wrong with Cathys idea? How does the Coase Theorem
fail here?
(b) Is there another way that Ann could be helpful in curing this
inefficient situation?
(a) The problem here is asymmetric information. If Betty suggests
this to Andrew, he will think shes weird, since he doesnt know her
all that well, and her main concern is not the cap: its that Andrew
think well of her. Betty may also be concerned that if she makes this
suggestion, Andrew will take it as a criticism of his personal taste
and interpret it as a sign she wants to break up. Or, he might think
she thinks he values money a lot, or that her offering money means
she doesnt want to accept favors from him, or that she thinks of life
in terms of money. If they both knew each other very well, the deal
could indeed go through.
(b) If Cathy approaches Andrew and tells him that Betty hates the
cap but would never mention it, then what Andrew learns is that
Betty has a friend who cares about her, which makes Betty look
good. Often an intermediary (say, a lawyer) can make offers that
would raise awkward questions coming directly from the offeror.

6.11 Smith has noisy parties at his house, which bothers neighbor Jones. If
the assumptions of the Coase Theorem are met, then the assignment
of who gets to control the noise
(a) Results in less noise.
(b) Does not affect the amount of noise.
(c) Increases the amount of noise.
(d) Helps Smith and not Jones.
58

(e) Helps Jones and not Smith.

Smith wants noise more than Jones dislikes it, so if Smith has
the control right he will keep on making noise, and if Jones does,
then Smith will pay Jones for permission.
6.12 If the marginal cost of tires is increasing, and the marginal cost of the
air pollution externality from making tires is rising faster, then the
optimal pollution tax:
(a) Will equal the private marginal cost of tires.
(b) Will equal the marginal benefit from tires.
(c) Will equal the externality cost at an output of zero tires.
(d) Will equal the marginal externality cost before the tax is imposed.
(e) Will equal the marginal externality cost once the tax is
imposed.
6.13 Which of the following would be the least costly way to halt global
warming?
(a) Geoengineering.
(b) Ending poverty in the Third World.
(c) Imposing limits on carbon dioxide emissions.
(d) Taxing carbon dioxide emissions.
(e) Banning the use of coal in power plants.
Ending poverty would speed up global warming, not reduce it,
sincer richer people consume more goods.
6.14 One reason why developing countries have more pollution is
(a) The value of life in dollar terms is lower.
(b) Agriculture is relatively less important.
(c) Low levels of education.
(d) Manufacturing is capital-intensive.
(e) All of the above.
6.15 Joe does not want to get married, though he really doesnt care very
much. His eccentric and untrustworthy millionaire uncle Ebenezer
very much wants Joe to get married. What does the Coase Theorem
say will be the case in five years?
(a) Joe will be unmarried.
(b) Joe will be married only if the law fails to enforce contracts.
(c) Joe will be married only if the law does a good job of
enforcing contracts.
(d) Joe will be married only if his preferences change.
59

If contracts are enforced, the uncle will pay Joe to marry, and
Joe will not breach the contract.
6.16 Apexs marginal benefit from being able to create more fine-particle
(soot) pollution is MBa = 40 A if it is already creating A pollution.
Brydoxs marginal benefit is MBb = 60 3B, where its output is B.
The government is auctioning off 20 permits and these are the only
two buyers. In equilibrium, how many permits does Brydox win in the
auction?
(a) Zero to 5
(b) 6 to 9.
(c) 10.
(d) 11 to 15.
(e) 16 to 20.
At the equilibrium price, the marginal benefits of the two buyers
are equal and 20 permits are sold. Thus we know
40 A = 60 3B
and
A + B = 20
Solving these together yields 40 (20 B) = 60 3B, so 40 20 +
B = 60 3B so 4B = 40 and B = 10.
6.17 Why would we expect India to be less inclined than Belgium to reduce
carbon dioxide emissions because of concern about global warming?
(a) India is poorer.
(b) India knows how to deal with heat already.
(c) Indias economy is growing faster.
(d) (a) and (b)
(e) (a) and (c)
(f) None of the above.
6.18 Suppose the marginal cost of widgets is 3Q and the demand is P =
120 Q. Each widget imposes an externality of 2Q on neighbors because widgets make such loud noises. What is the surplus-maximizing
quantity?
(a) Between 0 and 5.1.
(b) Between 5.1 and 10.1.
(c) Between10.1 and 14.1.
60

(d) Between 14.1 and 19.1.

(e) Between 19.1 and 24.1.
(f) More than 24.1
The marginal social costs of widgets is 3Q + 2Q = 5Q, so the optimal quantity is such that 5Q = 120 Q and therefore Q = 20.
6.19 Which of the following does not create real externalities?
(a) Burning the American flag in public.
(b) Smoking cigarettes in a hotel lobby.
(c) Buying Treasury bills and pushing up their price.
(d) Internet sites that sell faulty goods.
(e) Computer viruses.
(f) (a) and (c).
6.20 When more cars drive on a highway, traffic slows because of the congestion, which is an externality. Which of the following policies would
best address this?
(a) A higher gasoline tax.
(b) A tax on gas guzzlers, cars with especially consumption of gasoline
per mile travelled.
(c) A tax on new car purchases.
(d) A limit on how many miles a car can be driven per year.
(e) A tax on large cars.
(f) A subsidy for small cars.
C HAPTER 7: C ONSERVATION
7.1

The earth holds only a limited quantity of oil. If we continue

consuming it at the present rate, it will all be gone eventually. What
form of regulation is appropriate to deal with this threat?
No regulation is needed, and government intervention will be harmful, because there is no market failure. Just because a resource is
going to be used up is not a sign of market failure. Indeed, it would
be wasteful not to use up a resource, unless it is something that
can be used without reducing the quantity, e.g. a lake for swimming,where more swimming does not reduce the size of the lake.
The price of oil reflects its scarcity and its value compared to substitute sources of organic chemicals and energy. As it becomes scarcer,
the price of oil will rise and consumption will decline, unless the
61

economy grows at a fast enough rate that the value of using the oil
increases demand even if the price rises. As oil becomes higher in
price, substitutes will used, such as natural gas, ethanol, or synthetic oil.
7.2

Why is there a better case for government regulation of fishing than

for government regulation of copper mining?
Overfishing is a common-pool resource problem. If there is no
regulation, a prisoners dilemma exists in which each fisherman
will catch too many fish now, ruining future fishing. They would
all be better off if there were limits on the annual catch for each
person. Copper mining has no such problem. Each person can
mine the copper on his own land, and the only effect on others is to
slightly reduce the price of copper, which is a pecuniary externality,
not a real externality.

7.3

Chateau LaTour is one of only five premier grand cru red Bordeaux wines. In 2013 a bottle of the 2004 vintage cost $664 (http:
//www.wine-searcher.com/find/ch+latour/2004). It will be at its optimal age
to drink around 2020. What can you predict about the price of this
wine? Will it ever all be used up?
We can predict that the price of the wine will rise over time until
2020. It will rise at the discount rate for assets of moderate uncertainty, because if it was always at the 2020 price, nobody would
want to buy it before 2020, and if it jumped suddenly from 2019
to 2020, everybody would want to buy it in 2019 to make the easy
capital gain.

7.4

How does inefficiency arise in a common-pool resource problem, and

why does bargaining under the Coase Theorem not always prevent the
inefficiency? You may use an example or use a general case.
Consider the example of cod, a common pool resource. Without
regulation, each fisherman will catch as much as he can, because he
gets the entire benefit of his catch but he shares the loss in reproduction of new fish with other fishermen. That loss to other fishermen
is a negative externality, so he does too much of the activity fishing. Bargaining fails to solve the problem because the fisherman
are separated from each other and because any bargain would have
to include potential new fishermen too. Transaction costs are one
of the reasons efficiency fails under the Coase Theorem, and here
62

the transaction cost of negotiation for this large number of people

would prevent the bargain from occurring.
7.5

Explain how the price path of a nonrenewable resource over time

depends on the discount rate and the price of the backstop technology.
All of the resource must be used up when the price rises to
the price of the backstop technology, since nobody would want to
hold an asset that doesnt have dividends and doesnt rise in price.
While it is being used up, the price must rise at the discount rate.
If it rose more slowly, then owners would want to sell it since it
wouldnt yield as much as other investments, and that would make
the present price drop. If it rose faster, people would want to buy
more, so the price would rise and the rate of increase before the
price hit the backstop technology would have to fall.
It is not simply that the quantity of the product is declining
so the price rises. First, that doesnt explain why the discount
rates matters. Second, that confuses the total amount left of the
product which is declining with the amount consumed per year,
which depends on the price that year. We can imagine a declining
price path (not increasing) that would use up the resource, so that
each year more would be consumed. The problem with that is that
once the resource ran out, the price would jump to the price of the
backstop technology but if that were so, anybody who held back
some of the resource to sell would get a huge one-year profit, so
everybody would hold back and we couldnt have that big jump.

7.6

Read the article, U.S. Gas Exports Clear Hurdle: Study Citing
Benefits Could Hasten Approvals From Obama Administration, http://
online.wsj.com/article/SB10001424127887324001104578161461770971222.html.
(a) Would allowing companies to export natural gas from the United
States really slightly cut into the real wage of U.S. workers, or lead
to a massive wealth transfer from working Americans? Would it
really help total surplus in the U.S.? Credit will be given only for
explanations, not the yes/no answers.
(b) Are environmental groups correct that allowing exports of natural
gas would raise U.S. production?
(a) Allowing natural gas exports would slightly cut into the wage of
US workers, because it would increase the price of natural gas by
increasing demand for US natural gas. It would not be a massive
63

wealth transfer. It would increase total surplus in the US because

US owners of natural gas fields would benefit more than US consumers of natural gas would lose.
(b) Yes. By increasing the demand for U.S. natural gas, it would
increase the price and the equilibrium quantity.
7.7

In Sunnyvale, households may put out up to three garbage cans plus

a recycling bin for paper and glass, mixed together, for free (except
for their taxes). Private hauling is not allowed to compete with the
city curbside service. The city takes the nonrecycled garbage to a
private landfill that charges $50/ton for it. It takes recycled garbage
to a private recycling company that pays the city $5/ton for it. The
cost of the labor and trucks to get the garbage delivered to the private
companies is $10/ton for nonrecycled garbage and for recycled garbage
it is $15/ton.
(a) Explain one change the city could make to increase social surplus?
(b) Explain a second change the city could make to increase social
surplus.
The two best answers are:
(i) Allow competition from private companies, so costs will fall.
(ii) Require households to pay for their garbage hauling by the city,
and pay more if they have more hauled.
Another possibility is: (iii) Mandate that households recycle recyclables. That is an improvement over the status quo because currently households do not pay for the negative externality of not sorting out recyclables so that they have to be put in the landfill. The
ideal would be to make them pay $60/ton for ordinary garbage and
$10/ton for recyclables, to match the citys cost.
Still another possibility would be to subsidize recycling. Thats
an improvement over the status quo, because it too would encourage households to not put out garbage that will have to go in the
expensive landfill.
It is not a good answer to require households to limit the amount
of garbage they put out. That can be highly inefficient if a household generates a lot of garbage and would have to keep it in their
house because the city wouldnt pick it up and wouldnt allow private haulers either. Imagine a family with three kids in diapers!

64

7.8

In Germany, every household has a blue garbage can for paper,

a yellow one for metal and plastic, a brown one for biodegradable
kitchen scraps, and a gray one for other things. Also at various places
in the city are white, green, and brown bins for various colors of glass
and orange bins for batteries. (No, this is not a joke. See German Idiosyncrasies, Second Edition, and USAG Ansbach Recycling/SORT Guide. ) We are told that the governments cost of
dealing with recyclables is only 25% as for the same weight of nonrecyclables. What are the implications of this policy for Germanys
national surplus?
If Germans really enjoy recycling, regarding it as entertainment rather than a chore, then this policy will raise national surplus compared with requiring people to do their recycling privately,
though it would be best to allow people who did not enjoy recycling
to put everything into their gray garbage cans. It seems the German government loses money on both nonrecycled garbage and recycled garbage, so it would also make sense to make people who
throw out more things pay more for their garbage service, with a
higher price for gray-can garbage than for the other kinds. On the
other hand, a huge amount of home labor and space for ugly multicolored garbage cans is required, so if citizens would not recycle
voluntarily, it reduces national surplus to require them to use their
land and labor for this activity.

7.9

Suppose oil is costless to obtain from natural sources, that we can

synthetically produce oil at a cost of $200/barrel, that the current price
is $80/barrel, and that we expect the price of oil to hit $200/barrel in
2050.
(a) What combination of natural and synthetic oil will be used after
2050? Explain.
(b) This year, a new synthetic process is unexpectedly discovered that
only costs $180/barrel. What happens to the path of price and natural
oil consumption?
(a) Just synthetic, no natural. Since the price will no longer be
rising, it would be pointless to wait to sell your oil till 2050. Production will be chosen to exactly use up all natural oil in that year.
(b) There will immediately be a sharp drop in the price of oil to
below $80/barrel. The price will then resume rising until all the
oil is used up when the price reaches $180/barrel.
65

7.10

A number of local and state governments have started refusing to

allow old televisions to be thrown away in their landfills, and direct
that they be taken by the owner to special recycling centers instead. In
Human health and ecological toxicity potentials due to heavy metal
content in waste electronic devices with flat panel displays, Journal
of Hazardous Materials 177: 251-259 (2010) Seong-Rin Lim and Julie
M. Schoenung say:
... although a proper landfill liner system should contain
the metals for the short-term, the long term scale for landfill
treatment is on the order of 1000 years, and therefore landfill
treatment can ultimately return the constituents of waste to
the ecological cycle through chemical, physical, and biological reactions and transformation ... it is assumed that all
of the heavy metals included in e-waste have the potential
to impact human health and the ecosystem through water
medium...
There do not seem to be any findings of heavy metals (e.g. lead)
leaching from any landfills in the United States yet, only a fear that
it might happen, and landfills are highly regulated to prevent that. It
is nonetheless true that we do not know whether landfills will remain
safe for 1,000 years. Is the banning of televisions from landfills a wise
response to this concern?
The 1,000-year argument misses two things. First, it ignores
discounting. The discounted value of any harm that comes in 1,000
years is very small. Second, it ignores the possibility of waiting
and addressing the problem later, if the problem indeed turns out
to exist. If a landfill starts leaking 100 years from now, the problem
could be addressed at that point by repairing the landfill drainage.
The policy also ignores the incentives it creates for people with
old televisions. The policy makes it difficult to dispose of them in
landfills, so we need to be concerned that people will get rid of them
in other ways, e.g. to drop them off illegally in the woods, where
there is no landfill liner.

7.11 Which market failure justifies requiring export permits for natural gas?
(a) Poor information.
(b) Running out of nonrenewable resources.
(c) Market power.
(d) There is no market failure.
66

(e) Negative externalities.

7.12 The
(a)
(b)
(c)
(d)
(e)

single biggest cost of recycling paper is:

Transportation by the city truck to the recycling center.
The energy used at the paper mill.
The labor used at the paper mill.
The labor cost of the household doing the recycling.
The labor cost to the city of collecting recylables.

7.13 Nonrenewable resources

(a) Require government restriction on use for surplus to be maximized.
(b) Cause negative externalities.
(c) Are especially profitable investments because their prices will rise
as they run out.
(d) Are generally more expensive than renewable resources.
(e) None of the above.
7.14 In what country would you expect pollution controls to be most lax?
(a) A country dependent on foreign aid.
(b) A country ruled by elite oligarchs.
(c) A capitalist country.
(d) A democratic poor country that receives no foreign aid.
(e) A country wishing to join the European Union.
Richer people favor stricter environmental laws because they value
low pollution relatively more than things such as food and clothing.
A democratic poor country that receives no foreign aid will place
little value on pollution control.
7.15 In Springfield, it is clear that recycling by the city costs more in taxes
than it generates when the bottles and such as sold, and that it would
cost the city less to just put all garbage in the county landfill. Which
of the following is the best reason to continue the program anyway,
from the point of view of surplus maximization? (a) To reduce waste.
(b) To reduce use of natural resources.
(c) To reduce the amount of oil used.
(d) Because most citizens enjoy recycling even if it has no
material benefit.
(e) Because most citizens think the program is profitable, even though
they are wrong.
The city program is wasteful, and reducing use of natural resources
does not reduce surplus if it means using more expensive other resources such as labor. If most citizens simply like to recycle, though,
67

then their surplus goes up even if their taxes go up too recycling

is a consumption item for them, like playing tennis.
7.16 The value of the wood in each pine tree a lumber company plants in a
forest is V = 100T 2T 2 , where T is the age of the tree in years and
it costs 5 to plant a tree. The company has more land than it can use,
so that is not a constraint. The discount rate is zero. Which of the
following should be maximized to decide at what age to harvest trees?
(a) 100T 2T 2 5.
(b) (100T 2T 2 5)/T.
(c) 100 2T 2 5T
(d) (100 2T 2 5) T
(e) 100 4T
it The value of the wood from a tree is 100T 2T 2 5. We want to
maximize the value per year of wood produced. Thats (100T 2T 2
5)/T. The reason is that the lumber company will plant new trees
whenever it cuts down old trees. There will always be wood growing.
Thus, the company wants to maximize the value per year, which is the
net value of the wood produced by a tree T years old divided by T.
7.17 The year is 1770. Virginia Farmer Jones is trying to decide between
growing tobacco or wheat. Tobacco will generate 20 dollars per year,
but will exhaust the land and after 20 years it will have to be allowed
to go back to forest, with minimal dollar value. Wheat will generate 10
dollars per year forever. His friends make various arguments. Which
is the best one?
(a) Neighbor Brown says he should grow wheat, because thats a sustainable investment.
(b) Neighbor Smith says he should grow tobacco, because a forest is
sustainable too, and the tobacco will raise more money.
(c) Neighbor Quincy says that the wheat investment will be more profitable over a 50 year horizon, so he should grow wheat.
(d) Neighbor Roe says that the land will be worth more in 21 years if
he grows wheat, so that should be his choice.
(e) Neighbor Elliot says that since interest rates are high, it
would be better to grow tobacco, invest the proceeds, and
rely on the interest from the investments than to farm the
land after 20 years.
7.18 You are director of a vanadium mine company and need to decide to
much to mine per year in your Utah mine. If you mine at a rapid rate,
68

that will make the cost per ton smallest, but the vanadium will run
out in 10 years. If you mine at a slower rate, the vanadium will run
out in 20 years. Who will want you to decide on the rapid method?
(a) Other vanadium producers.
(b) The mineworkers.
(c) The CEO of the company.
(d) The shareholders of the company.
(e) None of the above.
7.19 Not written yet.
7.20 Which of the following is not a potential solution to problem of overhunting of tigers, if initially all that is required to hunt is that the
hunter be a resident of the country in which the tiger lives?
(a) An expensive licensing fee for each tiger killed, together with strict
enforcement.
(b) Assigning ownership of tigers to individual people who would control who is allowed to hunt a given tiger.
(c) Equal rights to hunt, regardless of ability to pay.
(d) Banning the sale of tiger skins.
(e) Two or more of the above are policies that will clearly
fail.
(c) and (d) will both fail. Allowing both rich and poor to hunt will
just make the problem worse. Banning the sale of tiger skins would
only prevent hunting for the purpose of selling skins, and most tiger
hunters hunt for sport, not for profit. In this respect, tigers are
different from elephants, which are often hunted for their tusks.

C HAPTER 8: M ONOPOLY
8.1

The demand curve for widgets is Q=24-P. Marginal cost is constant

at 4 and the fixed cost is 1. One firm has a monopoly. What price
will the firm choose?
The demand curve can be rewritten as P = 24 Q.Pro f it =
PQ 4Q 1 = (24 Q) Q 4Q 1 = 24Q Q2 4Q 1. The
derivative of profit with respect to Q is 24 2Q 4. Setting that
equal to zero, we get 20 2Q = 0 so Q = 10. From the demand
curve, the price is then P = 24 Q = 14.

69

8.2

The demand curve facing a firm is P= 6 - Q/2 and its marginal

cost is MC=2Q.
(a) What is the monopoly output?
(b) At the monopoly output, would an increase of 1% in the price
cause revenue to rise, or to decline?
(a) Marginal revenue is found from the demand curve, P = 6 Q/2.
It is MR = 6 Q, sloping down twice as fast so it hits the Q-axis
half as far down as the demand curve does. Or,
MR = (dP/dQ) Q + P = (.5) Q + (6 Q/2) = 6 Q.
Then MC = MR yields 2Q = 6 Q, so Q = 2.
Or, you could find the Q that maximizes total profit. If the
marginal cost is 2Q, then the total cost is Q2 . Having realized that,
and ignoring any possible fixed cost, profit is
PQ TC = (6 2/Q) Q Q2 .
Differentiating with respect to Q and setting the derivative equal
to zero yields
6 Q 2Q = 0
so Q=2.
(b) Revenue would decline. The decline in sales would be more
than 1%, because demand is always elastic at the monopoly price.
A firm with marginal cost of zero will maximize revenue, and so
will choose a price where the elasticity is -1, so any firm with positive cost will choose a price that makes demand elastic. If revenue
would rise from a decline in quantity and an increase in price, the
firm would have raised the price already, because that would both
increase revenue and reduce costs (because Q would fall).
You can see this from the Lerner Condition too, because it says
that at the monopoly price and output,

( P MC )/P = 1/(elasticity)
Since P MC < P, it must be that the elasticity is between 1
and in f inity, so it is elastic.
Or, you could see that (5 4)/5 = 1/5, so the elasticity is 5.
70

You could also compute out the actual elasticity, though I didnt
expect that much detail. The elasticity is (dQ/dP) (P/Q). Rewriting
demand by solving the demand equation for Q we get Q = 12
2P. Thus, dQ/dP = 2. If Q =2, then P=5, so the elasticity is
(2)(5/2) = 5, very elastic.
8.3

The company Apex has a total cost of TC = 2 + 4A and the

company Brydox has a total cost of TC = B, where A and B are their
outputs. The market demand facing both firms is Q = 36 P, where
Q = A + B.
(a) Find an equation for Apexs reaction curve.
(b) Find Apexs equilibrium output.
(c) What is the equilibrium price?
(a) Apexs profit function is
Pro f it( Apex ) =
=
=
=

PA TCa
(36 A B) A 2 4A
36A A2 BA 2 4A
32A A2 BA 2

Differentiating yields
dPro f it/dA = 32 2A B = 0,
so 32 B = 2A and A = 16 B/2, which is the reaction function.
(b) Brydoxs profit function is
Pro f it( Brydox ) = PB TCb = (36 A B) B B = 36B B2 BA B = 35B B2 BA
Differentiating yields
dPro f it/dB = 35 2B A = 0,
so 35-A = 2B and B= 17.5-A/2, which is the reaction function.
Solving this with As reaction curve yields:
A = 16 B/2
(17.5 A/2)
A = 16
2
A = 16 8.75 + A/4
3A
4 = 7.25
A = 9.67
71

(c) Since A = 9 23 , we can substitute into Brydoxs reaction function,

B = 17.5 A/2, to get B = 17.5 29/6 = 37/6 = 6.166.... The
demand curve is Q = 36 P, so (58/6 + 37/6) = 36 P and P =
20.1666....
8.4 Discuss whether the firm should raise its price in each of the following
situations:
(a) Demand facing the firm is inelastic.
(b) Total market demand is inelastic, but demand facing the firm is
perfectly elastic.
(c) The elasticity of demand is -3 and the firms marginal cost is 10.
(a) The firm should raise its price, because the percentage increase
in price will be greater than the percentage fall in quantity sold, so
revenue will rise and costs will fall.
(b) The firm should not raise its price. If it does so, it will sell
nothing, because other firms will be charging a lower price. Since
total market demand is inelastic, if all the firms raised their prices
together, theyd all make more profits, but if just one firm raises its
price, the market price stays the same.
(c) This ones not so clear. It depends on the firms current price. If
the firm raises its price, its revenue will go down but its costs will
go down too, because it wont have to produce as much.
The Lerner Rule says to set price so that ( P MC )/P = 1/elasticity.
Plugging what we know into that, ( P 10)/P = 1/(3), or 1
10/P = 1/3. Then 10/P = 2/3, and P/10 = 3/2 so P = 15. If the
price starts out higher than this, the firm should reduce it, and if
the price starts out lower, the firm shouldraise it.
Note that 15 probably is not the optimal price. If the price starts
out higher than 15, and the company lowers it, then demand will
probably get more inelastic because of the move down the demand
curve. Thus, in the end the optimal price might be 13 we dont
have enough information to tell exactly. I didnt take off points for
saying 15 was the optimal price, though.
8.5

Someone proposes to reduce the deadweight loss from a monopoly

by imposing a sales tax, paid by the seller. Discuss whether this plan
could work, using a diagram.
The plan will not work; deadweight loss will increase. The
monopoly is pricing higher than P = MC to begin with, pricing
72

at the Q0 where MC ( Q) = MR( Q). Adding a tax is like increasing

the MC of the monopoly, so it will reduce Q so that MC ( Q1 ) + T =
MR( Q1 ). Reducing the output moves Q further away from the efficient level, so deadweight loss rises by the grey shaded amount on
the diagram.
P
MC + Tax

60

40

Extra
Loss

Marginal Cost

Demand

20

Marginal Revenue
5Q1 Q0

8.6

10

15

Which of the following firms is violating the anti-trust laws? (there

might be more than one) Give at least a sentence of explanation for
each (this is not a multiple choice question)
(a) Acme has a profit margin of 80% of price over average cost.
(b) Brydox and Central, each with 4% of the market, have agreed to
each cut output by 10%.
(c) Dataco has a market share of 93%.
(d) Exron has grown to control half of the citys garbage collection by
sending death threats to its competitors and killing their pets.
(a) Acme is not violating; high profits are not illegal.
(b) Brydox and Central are violating agreements on quantity or
price are per se illegal.
(c) Dataco is legal; high market share is not against the law.
(d) Exron is illegal. This is an anti-trust offense of monopolization,
as well as a normal criminal offense (extortion, and Im sure theres
some law against killing dogs).

8.7

Let the demand curve be Q = 23 P if P 23 and 0 otherwise.

(a) If there is one firm, with a marginal cost of 1 for outputs less than
8, a marginal cost of 3 for outputs greater than 8, and a fixed cost of
2, what will be its output and price?
(b) If there are two firms with marginal costs of 1 each and fixed
costs of 2 each, what will be the output of each firm according to the
73

Cournot model? What will happen to output if the fixed costs increase
to 3 for each firm?
(a) Suppose output is less than 8, so MC=1. Revenue is PQ =
(23 Q) Q = 23Q Q2 , so, taking the derivative with respect to
Q, marginal revenue is MR = 23 2Q. If we try to set this equal
to MC=1, we would get 1 = 23 2Q and Q = 11, but that output is
too high for the MC=1 to be valid. Trying MC=3, if MC=MR then
3 = 23 2Q and Q=10. In that case, P = 13.
Note that the fixed cost is irrelevant to the price.
(b) Firm 1s profit function is 1 = PQ1 TC1 = (23 Q1 Q2 ) Q1
1Q1 2) = 23Q1 Q21 Q2 Q1 Q1 2 = 22Q1 Q21 Q2 Q1 -2.
Setting the derivative equal to zero, we get 22 2Q1 Q2 = 0, so
Q1 = 11 Q2 /2.
Since the firms are symmetric, Q1 = Q2 . Therefore, Q1 = 11
Q1 /2, so (1.5) Q1 = 11 and Q1 = 22/3, or 7.33...
An increase in the fixed cost will have no effect.
8.8

Two firms compete, setting quantities A and B. The first firm has
a marginal cost of 10 and a fixed cost of 20. The second firm has a
marginal cost of 0 and a fixed cost of 40. Demand is Q = 50-P/2.
(a) What is firm As reaction function?
(b) What is firm Bs reaction function?
(c) What is the equilibrium value of B?
(a) P = 100 2( A + B).Pro f it A = (100 2( A + B)) A 10A 20 =
100A 2A2 2AB 10A 20.
Differentiating to get the optimum, 100 4A 2B 10 = 0, so 90
2B = 4A.
This solves to the reaction function A = 45/2 B/2.
(b) P = 100 2( A + B). Pro f it = (100 2( A + B)) B = 100A
2A2 2AB.
Differentiating to get the optimum, 100 4A 2B = 0.
This solves to the reaction function B = 25 A/2.
(c) Substitute the optimum value of A into Bs reaction equation to
get B = 25 [45/2 B/2]/2.
Solve this, remembering that it comes to B = 25 45/4 + B/4, not
B/4, and you get B = 55/3, 18.33.
74

8.9

Suppose that in the benzene market the market shares of the three
top sellers are 20%, 30%, and 40% and the 10 remaining firms each
have market shares of 1%.
(a) What is the Herfindahl Index for this industry?
(b) Would the Justice Department and FTC be likely to allow merger
of the 10 small firms?
(a) 20*20+30*30+40*40 + 10*1*1 = 400+900+1600+10 = 2910.
(b) Merger of the 10 firms would change their contribution to the
Herfindahl from 10 to 1*10*10 = 100, an increase of just 90. The
Guidelines say that mergers that raise concentration by less than
100 are almost always permissible.

8.10

Two companies who propose to merge admit that prices might be

higher after the merger, but say that production costs would be much
lower.
(a) Is it possible that the merger would reduce prices? Explain.
(b) Show, using a diagram, a scenario under which the merger could
raise total surplus even if the price rose.
(a) The merger could reduce prices if the cost savings were great
enough. In a competitive market, price =MC, but if that MC is
lower in the monopolized market, the price at the quantity where
MC=MR might be even lower. For example, if the competitive MC
were high enough so that the quantity demanded were zero, a fall
in MC through merger could lead the merged firm to reduce the
price to where sales were positive.
(b) The diagram here is taken from Chapter 6. If the two firms
merge and marginal cost falls from C0 to C1 , but the price rises from
P0 to P1 , producers gain X+V-Z, while consumers lose W+Y. Then
net gain is X-Y-Z, which can be positive, as in the diagram: the
cost savings exceeds the increase in the triangle loss from monopoly
underproduction.

75

8.11 The demand curve facing a firm is Q = 340 0.5P. You do not know
its marginal cost. It is currently charging P = 200. What advice can
you give the firm?
(a) It should raise its price.
(b) It should reduce its price.
(c) It should keep its price the same.
(d) It should reduce its marginal cost.
(e) Without knowing the marginal cost, it is unclear whether the firm
is pricing correctly or not.
8.12 If the marginal cost is 3z*Q, where z is the price of steel, and the
demand curve is P = 24-Q, then if z = 2, the sellers profit-maximizing
price is
(a)8.
(b)12.
(c)16.
(d) 19.
(e) 21.
Revenue is (24-Q)Q which is24Q Q2 , so marginal revenue is 24
- 2Q. Marginal cost is 6Q, so at the optimum, 24-2Q= 6Q, so Q=3
and P = 21.
8.13 The demand facing a firm has elasticity of -2. Its price is 14 and its
marginal cost is 10. It should
(a) Reduce the price.
(b) Increase the price.
(c) Keep its price the same.
(d) Whether to increase or reduce the price depends on its fixed cost.
76

(e) Whether to increase or reduce the price depends on how the elasticity changes with price.
This is from the Lerner curve: ( P MC )/P < 11/elasticity
implies the price should increase. Here, (14 10)/14 < 1/2.
8.14 If demand is given by P = 12-Q and marginal cost is constant at 4,
what output maximizes the firms profit?
(a) 2.
(b) 4.
(c) 5.
(d) 6.
(e) More than 6.
Profit is (12-Q)Q - 4Q, so we can differentiate to get 12 -2Q - 4 =
0 so 8 = 2Q and Q=4.
8.15 In Europe, antitrust law is enforced by
(a) The Council of Ministers.
(b) The European Parliament.
(c) The European Trade Commission.
(d) The Competition Commission.
(e) The Council of Brussels.
8.16 A monopolist is currently charging 20 and the demand curve facing
him is Q = 240 - 3P. We do not know his cost function. What can we
say about his profit-maximizing policy?
(a) He should raise the price.
(b) He should reduce the price.
(c) He should increase output but not change the price.
(d) We do not know enough to advise him.
(e) None of the above.
Sales are Q=240-3P = 240- 60 = 180, so the elasticity is (dQ/dP)P/Q
= (-3) (20/180) = - 1/3. This is inelastic, so the monopolist should
increase his price. That will increase revenue and reduce costs,
whatever costs may be.
8.17 A merger is illegal if
(a) The companies are in banking.
(b) One company is about to fail.
(c) The companies are in the same market.
77

(d) The companies are conglomerates.

(e) It would tend to monopolize the market.
8.18 If an industry has 4 firms with market shares of 10% each and one
big firm captures the rest of the market then the Herfindahl Index is
closest to which number?
(a) 40.
(b) 1,600.
(c) 400.
(d) 16,000.
(e) 4,000.
8.19 Even before the Sherman Act, cartels had what problem?
(a) Price discrimination.
(b) Free riding.
(c) Rational ignorance.
(d) Predatory pricing.
(e) Exclusive dealing.
8.20 In the market for widgets, the firms have market shares of 10%, 5%,
22%, 3%, 8%, 2%, 41%, 9%, 5.452%, and 4.548%. The firms with
market shares of 5% and 10% are thinking of merging. How much
would that increase the Herfindahl Index?
(a) Less than 100.
(b) 100.
(c) Between 100 and 200.
(d) 200.
(e) More than 200.
If two firms with market shares of 5 and 10 merge, the Herfindahl rises 100 because they contributed 25+100 before and now they
contibute 225.

C HAPTER 9: N ATURAL M ONOPOLY

9.1

An electric utility has a marginal cost of 20 for both residential and

business customers. Business customers have more elastic demand.
The utility could charge 28 to all customers and it would break even,
earning enough to cover its fixed cost of 100, though a monopoly would
charge even more. Assume that at P=28, the quantity demanded by
business customers is the same as for residential customers. Explain
78

why the utility should use Ramsey pricing and charge more to residential customers if its goal is to maximize total surplus while not making
a loss.
If the utility charges more than 28 to residential customers, it
can charge less to business customers, but it must keep its total
profit from falling below zero.

We are told that business customers have more elastic demand.

As a result, if we lower the price to them by 1% and raise it by 1%
to residential customers, the gain in sales X to businesses will be
greater than the loss Y to residences (it might be a gain of X= 2%
from business sales and a loss of Y=.5% from residential sales, for
example). Thus, the utilitys revenue will actually rise.
The triangle loss from the business market will fall by .5(1%)(28)X.
The triangle loss from the residential market will rise by .5(1%)(28)Y.
The combination of triangle losses from both markets will fall, since
X is bigger than Y. Thus, the utility can actually make more profit
by charging more to residences and less to businesses while also
reducing total triangle losses.
9.2

A company has a fixed cost of 10 and a marginal cost that is

constant at 3. The demand curve is P = 24 Q. Explain why this is a
natural monopoly. Contrast regulation that sets the price at marginal
cost with regulation that sets it at average cost. How do the outputs
and surpluses differ? (You dont have to calculate the exact value of
the price, but do give a formula for it.)
This is a natural monopoly because the average cost curve is
downward sloping, so whatever firm is biggest has the lowest average cost and can underprice its competitors. If all firms priced at
79

marginal cost, theyd all price under average cost, which couldnt
be an equilibrium, and in fact it would be inefficient to have production by more than one firm since that would raise production
costs for the same output.

A regulator could set P=MC so P=3, but then the firm would have
profits of -10 from its fixed cost and would exit the industry. Thus,
marginal-cost pricing requires a subsidy of 10. Output would be
such that 3 = 24 Q, so Q=21.
A regulator could instead set P=AC. We need to compute average cost to find the value. Total cost is TC=10+3Q, so average
cost is AC=10/Q +3. If the price equals average cost, then from
the demand curve, 24 Q = 10/Q + 3. We can rewrite that as
21Q Q2 = 10. That yields a price above marginal cost, so there
will be a deadweight loss, with area equal to half of the increase in
price from P=AC to P = MC times the reduction in quantity.
You wouldnt have to compute output to get the answer, but it is
Q 20.5, so P 3.5 and AC 10/20.5 + 3 which is also about 3.5
(and would be exactly if we used Q=20.5125, the exact solution).
The deadweight loss would be about .5 (3.5-3)(21-20.5) = .125.
9.3

A water company has a fixed cost of 12 and a constant marginal

cost equal to 2. It faces the demand curve Q = 48 2P.
(a) Show using a diagram how the price would be determined under
rate-of-return regulation or a price cap. You do not need to calculate
the exact price.
(b) If the state bought the company and ran it, what price would
maximize social surplus, and what subsidy would be needed? Give
specific numbers.
80

(a) The regulatory commission would set the price so that at the
quantity demanded, the price would equal the average cost. Since
price equals average cost, the water company can break even and
continue to operate.

You can tell that the average cost curve is declining because there
is a fixed cost but the marginal cost is not rising.
(b) The price would be P=MC=2. There would be no triangle loss
then. To cover its fixed costs, the company would need a subsidy of
12, the size of its fixed cost. Note that a fixed cost is fixed, independent of the amount of output. Thus, the fixed cost is 12 no matter
what the quantity is thats the definition of fixed cost. It is not,
for example, equal to 12*Q.
9.4

Why do the forces of competition not achieve surplus maximization

in an industry that is a natural monopoly?
A natural monopoly has a downward sloping average cost curve.
Thus, if the price equals a firms marginal cost, it is less than average cost and the firm cannot survive. This means that firms undercutting each others prices cannot achieve an equilibrium with
P=MC. It is not enough to say that a monopoly has lower surplus
you need to explain why the forces of competition permit the monopoly
to persist.

9.5

A state park is selling firewood at $10/bundle and juice at $2/bottle. Firewood costs the park $7/bundle and juice costs $1/bottle. The
elasticities of demand for firewood and juice are 1.2 and 0.4. In what
direction could the park change prices to increase profit while leaving
consumer surplus unchanged?
81

Ramsey pricing says that Elasticity ( P MC )/P should be

the same for each good. Right now that expression is equal to
1.2(10-7)/10=.36 for wood and 0.4(2-1)/2=.2 for juice. The price of
wood should be lowered and the price of juice should be increased
so the two values come closer to each other. A common mistake was
to look just at the elasticities, but (P-MC)/P matters too. Also, the
aim is not to get Elasticity ( P MC )/P = 1, as it would be in a
monopoly it is just to get that expression equal for wood and for
juice.
9.6

The state is thinking of auctioning off a license for the right to

supply water to Middle City. Several companies are going to submit
sealed bids for a total payment to the city (not a price per unit to the
consumer) and the highest bid will win. The companies have different
cost curves, and dont know each others costs.
(a) Use a diagram to show the most the lowest-cost firm would be
willing to pay to get the license.
(b) Would the winner of the auction pay exactly the amount you found
for him in (a)?
(a) The lowest-cost firm would find the monopoly price by finding
Q such that MR=MC and then seeing what price that Q would support. This would allow it to calculate the monopoly profit, which is
the most it would be willing to pay. I also gave credit if you interpreted the question as asking about an auction in which the firms
did not pay for licenses, but rather offered a price at which they
would sell to consumers.

(b) The winner would pay something less than the value in (a).
If the lowest-cost firm bid (a), it would have zero surplus in the
82

end. Therefore it will bid less, hoping that it is still the highest
bidder. All firms would bid somewhat less than their maximum,
zero-surplus, ceilings.
9.7

If the government auctions off the right to provide toll road service and requires the winner to maintain the road quality but does
not regulate price, what are the implications for social surplus and
government revenue compared to rate-of-return regulation?
It raises government revenue (as with Indiana tollways) because
the firm will charge a monopoly price to drivers and reduce costs,
but they will charge a monopoly price and social surplus will fall
compared to rate-of-return regulation.

9.8

Only one company is distributing electricity in Smallsville. Its fixed

cost is 370 and its marginal cost is constant at MC=3. The demand
for electricity is Q = 90 - 2P.
(a) Show using a diagram how the price would be determined under
rate-of-return regulation or a price cap. You do not need to calculate
the exact price.
(b) Suppose instead of normal rate-of-return regulation, the state utility commission chose a price and a subsidy for the electric company.
What price would maximize social surplus and what subsidy would be
needed? Give specific numbers.
(a) The regulatory commission would set the price so that at the
quantity demanded, the price would equal the average cost. Since
price equals average cost, the water company can break even and
continue to operate. The intersection is where AC= 370/Q + 3 =
45-Q/2, since P= 45-Q/2 with this demand curve, though I didnt
require you to show the equation or to solve it. Solving it, Q=74 and
P=8.

83

You can tell that the average cost curve is declining because there
is a fixed cost but the marginal cost is not rising.
(b) The price would be P=MC=3. There would be no triangle loss
then. To cover its fixed costs, the company would need a subsidy
of 370, the size of its fixed cost. Note that a fixed cost is fixed,
independent of the amount of output. Thus, the fixed cost is 370
no matter what the quantity is thats the definition of fixed cost.
It is not, for example, equal to 370*Q.
9.9 An electric company is charging 12 for daytime and nighttime use
of electricity, and marginal cost is the same for both. Demand for
daytime electricity is Q = 60 2P and for nighttime electricity it is
Q = 24 P.
(a) What is the elasticity of demand for daytime electricity?
(b) How can the price be adjusted to keep total profits the same while
raising surplus?
(a) The quantity demanded of daytime electricity is 60-24=36. The
elasticity is (dQ/dP) P/Q = (2)(12/36) = 2/3.
(b) The Ramsey equation says that elasticity ( P MC )/P should
equal the same number for both day and night electricity. The
quantity demanded of nighttime electricity is 24-12=12. The elasticity for nighttime electricity is (-1) (12/12) = -1. Since the ( P
MC )/P parts of the Ramsey equation are the same at the starting
price, we should reduce the price of the more elastic good, nighttime electricity, and increase the price of the more inelastic good,
daytime electricity. The reduction in the marginal profit from the
nighttime electricity will be less, because if we reduce the price, the
84

quantity will increase more than the quantity of daytime electricity

falls when we increase its price.
9.10 Suppose Apex is the only company that has the capability to design
and build a new bomber plane for the Department of Defense. How is
the governments problem like that of a state utility regulatory commission? What are the advantages and disadvantages of a cost-plus
contract, one that pays Apex its cost plus a fixed percentage extra?
The Department of Defense wants to pay Apex as little as it can to
build the bomber, but enough so that Apex will take the contract. To
do so, it must estimate Apexs costs. It also must decide what rate of
return on capital will give Apex enough of a return that Apex will
accept the contract. Similarly, the state utility commission must try
to figure out the utilitys costs and what rate of return on capital is
required for the utility to be able to continue to raise capital.
A cost-plus contract has the obvious disadvantage that Apex will
want costs to be as high as possible. Two advantages are that it protects Apex against the risk of costs being higher than expected (and
possible bankruptcy) and does not discourage Apex from maintaining quality in order to keep costs down.
9.11 In rate-of-return regulation, an electric utility is guaranteed:
(a) A certain rate of return.
(b) A minimum rate of return.
(c) A maximum rate of return.
(d) A fixed sales level.
(e)A fixed price level.
9.12 Which of the following is part of the utility rate-setting process?
(a) Figuring out the rate of return on equity.
(b) Figuring out the probability of bankruptcy.
(c) Official comment by the Federal Energy Commission.
(d) Official comment by the governor
(e) Estimating the market value of the utilitys assets.
9.13 Under government ownership, a telephone company
(a) Has strong incentive to increase demand.
(b) Has little incentive to reduce costs.
(c) Has a strong incentive to find cheaper sources of capital.
(d) Has a strong incentive to use equity financing.
(e) Will tend to invest too much in marketing.
85

9.14 To balance its budget, the state is thinking of increasing the entrance
fee for Turkey Run Park and Shades Park. The elasticities of demand
are -1.2 and -.3 for Turkey Run and Shade. Costs are all fixed; they
do not change with the number of visitors. The best thing to do is to
(a) Raise both parks fees.
(b) Raise only Turkey Runs fees.
(c) Raise only Shadess fees.
(d) Reduce both parks fees.
(e) Raise Shadess fee and reduce Turkey Runs.
Shades has inelastic demand, so raising its fees raises more
revenue at less cost in deadweight loss. Reducing Turkey Runs
price will raise revenue there, since it has elastic demand.
9.15 The idea of Ramsey pricing is
(a) To reduce prices on all goods, thus reducing triangle losses.
(b) To increase prices on less elastic goods and reduce them
on more elastic goods.
(c) To reduce prices on less elastic goods and increase them on more
elastic goods.
(d) To reduce prices as marginal costs increase.
(e) None of the above.
9.16 The key feature of a natural monopoly is
(a) Costs rise with output.
(b) The marginal cost curve is upward sloping.
(c) The marginal cost curve is downward sloping.
(d) The average cost slopes up.
(e) The average cost slopes down.
9.17 In price cap regulation, the price the utility can charge
(a) Rises with output.
(b) Falls over time.
(c) Rises to the cap and then holds steady.
(d) Falls as the X-factor is increased.
(e) Is fixed at the cap.
9.18 Under rate of return regulation, if the companys dollar depreciation
is high that
(a) Increases the price it is allowed to charge.
(b) Increases the rate of return it is allowed.
(c) Increases the dollar amount of return on capital.
86

(d) Reduces the price it is allowed to charge.

(e) Has none of these effects.
9.19 In an ideal world in which taxes created no triangle loss, what price
of electricity would maximize total surplus?
(a) Zero.
(b) Marginal cost at the quantity demanded.
(c) Average cost at the quantity demanded.
(d) Average cost at its minimum.
(e) Marginal cost at the quantity where average cost crosses the demand curve.
9.20 According to the CAPM model, Apex Electric and Gass cost of capital
depends on
(a) The variance of its profits.
(b) The skewness of its profits.
(c) How its profits rise and fall compared with the stock
market.
(d) How its profits rise and fall compared with other public utilities.
(e) Its profit rate in the current year as compared with previous years.
C HAPTER 10: I NFORMATION
10.1

The supply of cheap beer is perfectly elastic at a price of 8. Demand

is given by P = 12-Q/2. The beer is worth 2 less than consumers
believe, however, because it causes liver disease.
(a) What is the free market equilibrium price?
(b) The government is trying to decide between two policies (i) Teach
consumers about liver disease, or (ii) Impose a tax of 2 per unit of
sales on the producers. What will be sales under each policy?
(a) The price is initially such that 8 = 12 Q/2 so Q/2 = 4 and
Q = 8 and P = 8. Or, simply note that if supply is perfectly elastic
at 8 then 8 has to be the market price.
(b) Informed of the true value, the demand curve changes to P =
10 Q/2, so 8 = 10 Q/2, Q/2 = 2, and Q = 4. Under the tax, the
price rises to 10 but the demand curve stays the same as before, so
10= 12 -Q/2. This solves to Q = 4, the same outcome.

87

10.2

Of the people interviewed for a banking position, 13% have enough

talent for the job, but the interviewer isnt sure which ones. 10% of
talented people and 4% of untalented people can answer his tough
question. He interviews Smith and Smith answers the tough question
correctly. Is the probability that Smith is talented over 50% or under
it?
The number would be under 50%. Imagine a talent pool of 1000
people. 130 would be talented, and 13 of them could answer the
question. 870 would be untalented, and around 30 of them (34.8,
to be exact) could answer it. Thus, the proportion of talented to total
answerers would be 13/(13+34.8), which is less than .5. This is an
example of Bayesian reasoning.

10.3

Mr. Jones has an individual demand curve for french fries with
equation Q= 48- 4P. He evaluates his benefit from french fries correctly
up to a quantity of 20, but beyond that his true value is only half what
he thinks, because he has forgotten about the indigestion factor. Draw
his demand and marginal benefit curves (not necessarily to scale).
The demand and marginal benefit curves are identical for quantities below 20, but at that point the marginal benefit curve falls to
half the height of the demand curve and slopes down to reach 0 at
the same quantity of 48.

10.4

Discuss the advantages and disadvantages of three different government policies for dealing with the dangers of muscle-building drugs.
Here are the three policies:
(a) Ban the drugs.
(b) Require each drug to be sold with a warning label about its dangers.
88

(c) Require each drug to be sold only if the buyer signs off on a special
paper saying he is aware of the dangers.
(a) Banning the drug will end the danger but will also prevent people from using it who are aware of the dangers but want the benefits.
(b) This will inform users, but will require some cost for the labels
and the warnings may not be understood or even read by many
users, especially if they just obtain pills from coaches or friends.
(c) This will also inform users, and will make it more likely that
they read the warnings. It will greatly increase the cost, tho, if this
paperwork has to be filed away as proof it was done.
10.5

In the 1980s, a man and his wife needed to get check-ups before
buying life insurance, including a test for AIDS. The doctor called up
the man and said, Im very sorry. The test was positive. You have
a 999 out of 1,000 chance of dying in the next five years from AIDS.
Where did the doctor go wrong? Say what information you would need
to compute a better estimate of the mans chances of death? You do
not need to perform any calculations.
You already have Prob(test positive). You need these items of information:
1. The proportion of married men in the population who have
AIDS, Prob (AIDS).
2. The probability that the test will have a false positive, saying
that someone has AIDS when the person really does not, Prob (test
positive|AIDS).
With that, you could use Bayess Rule to find the answer.
Prob( AIDS|testpositive) =

10.6

Prob(testpositive| AIDS) Prob( AIDS)

Prob(testpositive)

Not written yet.

Not written yet.

10.7

Using a diagram, show the deadweight loss if consumers systematically underestimate the value of a product, valuing it at 80% of its
true worth to them. Explain in words why that area is lost surplus.

89

The demand curve always gives a value 80% of the marginal

benefit curve. In ignorance of this, consumers buy too little. The
shaded area is lost surplus because it represents the excess of the
true benefit to consumers of consuming more over the cost to producers.
Note that even at the lower quantity, the consumer surplus is
measured using the marginal benefit curve, not the demand curve.
The consumers decide how much to buy using their estimated demand curve, but their actual satisfaction is given by the marginal
benefit curve.
10.8

Suppose people think organic cola prevents cancer, but it does not.
Use a diagram to show (a) the amount of consumer surplus and (b)
the amount by which total surplus would rise if people found out the
truth.
(a) Look back at Chapter 2. Consumers demand curve is greater
than their marginal benefit curve, because they overestimate the
value of the cola. They think they will get a high surplus when
they consume Q0 , but their actual surplus is lower it is only A-BC-D, because they are paying more for the last Q1 Q0 units than
those colas are worth to them. The demand curve is used to find the
equilibrium price, but the marginal benefit curve is used to find the
consumer surplus at that price and quantity.
(b) Once consumers learn the truth, demand shifts down to the
value of the cola. Quantity falls to Q1 . Area B was formerly part
of producer surplus, and negative surplus for consumers (a total
value of zero) but now it isnt part of anybodys surplus, positive or
negative. Areas C and D used to be a negative part of consumer
90

surplus and now it are not, so the total surplus rises by C+D.

10.9

Suppose the marginal benefit curve is P = 24-Q and the supply

curve is Q=P/2. Consumers, however, all believe that the value of the
product is 18.
(a) If consumers were perfectly informed instead, what would be the
equilibrium quantity and consumer surplus?
(b) If consumers are poorly informed, so they do believe the value is
18, what is the equilibrium quantity and price?
(c) If consumers are poorly informed, so they do believe the value is
18, what is the equilibrium consumer surplus?
(a) 24-P = P/2 so 1.5P = 24 so P=16. Then Q=8. The consumer
surplus would be .5(24-16)(8-0)=32.
(b) P=18 because the demand curve is flat, so Q = 18/2 =9.
(c) Consumer surplus uses the marginal benefit curve, so it is .5
(24-18)(6) - .5(18-15) (3) = 18-4.5 = 13.5.

10.10

What are the two types of error the Food and Drug Administration
makes, and which kind is more threatening to its employees careers?
One type is the false negative for safety, where the FDA turns
down a drug that is actually safe and effective. The other type is
the false positive for safety, where the FDA approves a drug that
is actually unsafe or ineffective. Both mistakes reduce surplus, but
the careers of FDA officials are more threatened by false positives
because drugs that are either unsafe or ineffective will be introduced into the marketplace and this can generate negative publicity for the FDA and could make those who work in the FDA look
91

bad. False negatives are less threatening to FDA officials careers

because if the FDA wrongly turns down a drug, it will not be used
and their mistake may never be discovered.
10.11 Suppose we buy 10% of our widgets from Apex and 90% from Brydox.
Apexs widgets fail with probability .5 and Brydoxs with probability
.1. A widget has just failed. What is the probability it is from Brydox?
(a)
(b)
(c)
(d)
(e)

0 to 5%.
5.1-10%.
10.1-13%.
13.1-20%.
Over 20%.

This is a Bayess Rule problem. We need Prob( Brydox | Failure).

Using the Rule,
Prob( Brydox | Failure) =

Prob( Failure| Brydox ) Prob( Brydox )

(.1)(.9)
.09
=
=
Prob( Failure)
(.1)(.9) + (.5)(.1)
.14

That comes to about .64, greater than 20%.

10.12 The FDA has determined that 20% of the patients in a hospital were
given the new drug Zoros and of the 10% of patients who suffered
from sudden headaches, 40% had taken Zoros and 60% had not. What
proportion of patients who took Zoros suffered sudden headaches?
(a) Between 0 and 20.1%, but not 10%.
(b) Between 20.1 and 30.1%.
(c) Between 30.1 and 50.1%.
(d) Over 50.1%.
(e) Exactly 10%.
Suppose there are 1,000 patients. 100 had headaches, and of
those, 40 took Zoros and 60 did not. 200 patients in total took Zoros.
So the proportion of patients who took Zoros and had headaches is
40/200 = 20%.
10.13 For reputation to work, it must be that:
(a) Costs must be sufficiently high.
(b) The price must equal marginal cost.
(c) The price must be below marginal cost.
(d) The price is above marginal cost.
(e) None of the above.

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10.14 If consumers drink a lot of energy drinks under the mistaken belief
that they reduce your chances of getting cancer, social surplus is best
raised by which policy?
(a) Impose a tax on energy drinks.
(b) Intensify price competition.
(c) Reduce the effect of reputation.
(d) Exaggerate small risks.
(e) Subsidize other drinks.
Subsidizing other drinks would reduce consumption of energy
drinks, which is good, but would require the use of tax revenue,
which increases the triangle loss from taxation.
10.15 Suppose 50% of Saudi Arabian immigrants and 1% of the general
population of the US are terrorists. A bomb explodes. The probability
the terrorist bomber is Saudi is
(a) 0 to 5%.
(b) 5.1-10%.
(c) 10.1-13%.
(d) 13.1-15%.
(e) Over 15.1%
There are very few Saudi immigrants to the U.S. The entire population is about 300 million, so 1 percent would be 3 million. 5
percent of that is 150,000, still a large number, and if that is only
50% of Saudi immigrants, there would have to be 300,000 of them.
You wouldnt have to know the exact number to answer this, but
Wikipedia says it is on the order of 40,000.
10.16 Identify three ways in which counterfeit, ineffective drugs reduce total
surplus.
(a) People pay too much.
(b) People do not buy the drugs they need.
(c) The production cost of the drugs is a social waste.
(d) (a), (b) and (c)
(e) (b) and (c).
It is bad that people pay too much, but that is just a transfer from
buyer to seller, not a reduction in total surplus. The surplus lost
is from buying the wrong product or from the wasted cost of the
production.
10.17 If an art museum is a merit good
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(a) It will have high attendance.

(b) It should charge a higher admission price.
(c) It is worth funding even if attendance is low.
(d) It is not a public good.
(e) Ordinary people do not value it.
A merit good can also be a public good. Ordinary people might
or might not value it; the distinguishing feature is that people do
not pay enough for it in the market.
10.18 Not written yet.
10.19 John Stuart Mills argument for why it is better to be a human being
dissatisfied than a pig satisfied is that
(a) Pigs cannot really be satisfied.
(b) Pig surplus is not counted in surplus maximization.
(c) A person would prefer to be the human to being the pig.
(d) We cannot know what goes on in a pigs head.
(e) A human being has more intrinsic value than a pig.
10.20 Someone who falls into the Gamblers Fallacy
(a) Thinks that because Apexs stock went down each of the
past three days it will go up tomorrow.
(b) Thinks that because Apexs stock went down each of the past three
days it will go down tomorrow.
(c) Neglects the houses edge in casino games.
(d) Believes that since he bet successfully on Red on the last roulette
roll he will bet successfully on the next roll.
(e) Believes that he has developed a system for betting on roulette
that will win.
C HAPTER 11: L ABOR
11.1

After the state of Indiana mandates that every employer provides

free daycare for its employees, will wages rise, fall, or stay the same?
Why?
Wages would fall. If they did not, then employers would demand
a lower quantity of labor than before the mandate, and workers
would supply a higher quantity, which would create excess supply
and downward pressure on wages as employers found they could
reduce wages and still attract as many workers. This is true whether
the regulation is efficient or inefficient.
94

11.2

In Smallville, 50 workers will work for as little as $10/hour and

200 workers will work for as little as $20/hour. The number of jobs
employers will offer is L where L = 100 2W.
(a) What is the equilibrium price and quantity of labor? Show this
using a diagram.
(b) What is the workers surplus in equilibrium?
(c) If a minimum wage of $30/hour is imposed, what is the workers
surplus?
(a) At a wage of 20, L= 100 - 2W = 60 units of labor will be hired.
Supply equals demand there, so it is an equilibrium.

(b) The first 50 workers are being paid 20 and they would have
worked for 10, so their surplus is 500. The last 10 workers are
earning zero surplus.
(c) Employment falls to L = 100 - 2W = 40. Those 40 workers have
a surplus of 40*20 = 800.
11.3

Italy at one time required employers to provide severance of about

one years salary for an employee who has worked for that employer for
13 years. What is the effect of this requirement on the annual salary,
employment, and worker surplus in the long run? Explain using a
graph.
The salary definitely falls, whether the severance pay is an efficient benefit or an inefficient one, because both the labor supply
and labor demand curves shift down, by y and x in the diagram
below. The effect on employment and surplus depends on whether
severance pay is efficient. We can deduce that it is not, because
95

otherwise employers would be providing it already. (Remember to

always first ask: Is there market failure?) As a result, labor demand will fall more than labor supply and the equilibrium salary
will fall more than the benefit of severance pay to a worker. Being
worse off from employment than before, fewer workers will offer to
work; employment will fall from L0 to L1 . With salary plus benefit
value and employment both down, worker surplus falls too.

11.4

Suppose some employers currently are not providing daycare to

their employees children. Show the effect of mandated employerprovided daycare on employment and wages.
If the fringe benefit is efficient it would reduce wages more than
it increased costs, and workers would be willing to accept the lower
wage in exchange for it. Thus, the employer would already be already providing it. Hence, we can assume that for firms presently
providing it, daycare is efficient and for those who are not, it is inefficient. The only effect of a mandate is to impose it on those who are
not providing it currently, so the effect would be purely inefficient.
Wages would fall whether it was efficient or not. We can conclude from the inefficiency of the mandate that employment will
fall too, as in the diagram below.

96

11.5

The demand curve for labor is P = 48 2Q. Suppose all workers

will work for a wage of $12/hour initially, but the government mandates life insurance with a cost of $6/hour for the employer and a value
of $2/hour to the workers.
(a) What is employment and the wage before the mandate is imposed?
(b) What is employment and the wage after the mandate is imposed?
(a) The wage is $12/hour, so 12 = 48-2Q and Q=18. The supply
curve is flat.
(b) Now the employers will only pay P = 48 2Q 6. Workers will
work for $10/hour. The wage falls to $10/hour and employment
falls because 10 = 42 2Q so Q = 16. The supply curve is still flat,
but shifted down.

11.6

Who would benefit and who would lose from a rule that required
grocery stores to offer a bonus of three months extra pay to women
employees who have a baby?
In the short run, the winners would be the women employees who
had babies and the losers would be other employees, the employer,
and grocery customers, since wages would fall, but less than the
benefit of the bonus for employees who received it, producer surplus
would fall, and prices would rise because of the extra production
cost.
In the long run, the industry would shrink to where profits again
equalled the market rate of return on capital, so employers would
be unaffected. Prices would be higher, though, and wages would be
lower, so consumers and employees who did not have babies would

97

lose. The employer would hire fewer women who might have babies, since they cost more because of the bonus. Probably this effect
would be smaller than the effect of the bonus, so as a group the
women who expected to have babies would end up as long-run winners.
11.7

Apex Corporation has started paying for on-line MBAs for many of
its employees. Some of them then leave to go work for other companies.
On the other hand, some workers from other companies are attracted
to Apex because of the free training.
(a) Explain whether these spillover effects raise total surplus in the
economy or reduce it, overall.
(b) Is there any market failure in what Apex is doing?
(a) These spillover effects raise total surplus. Apex raises the employees surplus by giving them free training, while increasing its
own at the same time. When it attracts workers from other firms,
that is a pecuniary externality, like bidding up the price in an auction, and the benefit to Apex and the workers exceeds the loss to
other companies.
(b) Probably not, but possibly. There would be a positive externality
if Apex benefitted the workers by the free training, but since Apex
can reduce its wage at the same time, Apex has an incentive to give
workers the efficient amount of training. If somehow the workers
could not fully capture the value of their training when they went
to work for other companies, so the other companies benefitted, that
would be a positive externality and Apex would not be providing as
much training as would maximize surplus of the entire economy,
including the future employers.

11.8

Congress has been considering whether to increase the amount of

immigration to the United States, especially to increase the number
of farm workers and computer programmers. Who in America would
support such an increase? Who would oppose it?
Increased immigration will drive down wages in jobs for which
the immigrants compete, and raise profits for their employers. Note
that this is true even if there are no shortagesinitially. When employers complain about shortages, what they mean is they think
wages are too high. If they pay the market wage, they can find

98

workers. The bill in Congress has been heavily supported by farmers and ranchers big enough to need large numbers of farm workers
and by businesses that want to hire foreign skilled labor Silicon
Valley employers, in particular. It is opposed by labor unions and
people who do not want the lower wages that will result from increased immigration.
11.9

The supply of labor is given by W = 10, and the demand by

W = 24 L.
(a) What would be the wage and quantity of labor employed if the
workers organize as a union and try to maximize their surplus?
(b) Suppose the government mandates that companies provide childcare, which has a marginal cost of 4 to the company and a marginal
benefit of 2 to workers. The workers are still unionized. What is the
new wage and employment?
(a) The union acts as a monopoly, and so uses the employers marginal
revenue curve, W = 24-2L. Equating that to the workers marginal
cost their supply curve we get 10 = 24 - 2L, so 2L = 14 and L =
7, so W = 24-7-17.
(b) Now the firms demand curve shifts down to W = 24 - 4 - L = 20
- L, and the workers supply curve down to W = 10 - 2 = 8. Redoing
the calculations for monopoly pricing, we get 20 - 2L= 8, so 12 = 2L
and L = 6, so W = 20 - L = 14.
It isnt part of the question, but note that the workers are worse
off, because employment has fallen and the value of the wage plus
fringe benefit is now 14 + 2 = 16, which is less than the old value of
17.

11.10 The number of workers who will supply their labor at wage w is L =
w 12 for wages greater than 12 and 0 otherwise. Employer demand
for labor is L = 48 2w.
(a) What is the equilibrium wage and employment?
(b) Employers find that they can use bulk purchasing to buy bus passes
at a price of 1. Each employee is currently buying a bus pass at a price
of 2. If employers add bus passes as a fringe benefit, what is the new
equation for the supply of labor?
(c) What is the new equilibrium wage and employment once the fringe
benefit is included in the compensation package?
99

(a) w 12 = 48 2w so 3w = 60 and w = 20. Then L = 20 12 = 8.

(b) Before it was L = w 12, or w = 12 + L, so now it is w =
12 2 + L = 10 + L. Note that for labor supply it is the employees
benefit that matters., because they are doing the supplying.
(c) The old employer demand curve is L = 48 2w, or w = 24 L/2.
The new one is w = 23 L/2. The demand curve has shifted down
by 1 because employers bear the extra cost of the bus passes. Equate
supply and demand: 10 + L = 23 L/2, so 1.5L = 13 and L = 26/3
(8 and 2/3), so w = 10 + L = (18and2/3). Employment has risen
but the wage has fallen. A common mistake is to use the original
labor demand equation, L = 48 2w, forgetting that it changes
when employers have to pay for the bus passes.
11.11 Right-to-work states have:
(a) Looser child-labor laws.
(b) Higher minimum wages.
(c) Mandated health insurance.
(d) Stronger unions.
(e) Weaker unions.
11.12 If unionization increases in the sugar refining industry we would expect
that
(a) Employment increases.
(b) Sugar prices rise.
(c) Sugar output rises.
(d) Labor will be substituted for capital.
(e) None of the above.
11.13 A right-to-work law
(a) Guarantees jobs to all qualified workers.
(b) Allows workers to escape paying union dues.
(c) Is one way to reduce racial discrimination.
(d) Prevents the minimum wage from hurting teenagers.
(e) Makes it easier to unionize a company.
11.14 If the government requires employers to offer employees a benefit not
previously required, if all companies must provide health benefits,
what will happen to employment and wages at companies that currently do not offer those benefits?
(a) The wage will rise, but employment will fall.
(b) The wage and employment will fall.
100

(c) The wage will fall, but employment will rise.

(d) The wage will not change, but employment will fall.
(e) The wage and employment will both rise.
It will fall. Those benefits must be inefficient, or theyd be offered
now. Hence, they will reduce total compensation of the workers, who
will supply less labor.
11.15 Currently the supply function for retirement advisors is Q = 4 + 2( P
8) for P 4 and 0 otherwise, where P is their fee. The demand
function is Q = 40 2P. What is the amount of increase in the fee
in the long run if advisors are required to pay an extra amount 2 to
obtain a license?
(a) 1
(b) 2.
(c) 3.
(d) 4.
(e) None of the above.
The equilibrium price initially is found from 4 + 2( P 6) = 40
2P, so 8 + 2P = 40 2P, 4P = 48, P = 12. The supply curve
changes to Q = 6 + 2( P 9), which has supply of 0 at P = 6. Thus,
the equilibrium fee rises to 12 + 2P = 40 2P, 52 = 4P, P = 13.
That is an increase of 1.
11.16 The effect of requiring a license to practice law is
(a) A shift of both the demand and supply for legal services to the
left.
(b) A shift of both the demand and supply to the right.
(c) Uncertain for supply, but a shift of demand to the right.
(d) A shift of demand to the left and supply to the right.
(e) A shift of supply to the left and demand to the right.
11.17 A firms marginal product of labor is MPL = KL .5L2 . Currently,
K = 4. The price of output is 2 and the wage is 12. How much labor
should the firm hire?
(a) 1.
(b) 2.
(c) 4.
(d) 6.
(e) 8.
Set MPL P = w, so (4L .5L2 )2 = 12. This is solved by L = 6.
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11.18 Which feature of an industry below create market failure that might
justify regulation of workplace safety?
(a) Workers overestimate dangers.
(b) The marginal cost of adding safety features is low.
(c) Several serious dangers to workers are hard for them to
detect.
(d) Both (b) and (c).
(e) The marginal benefit of adding safety features is high.
Note: The marginal cost and benefit of regulation is relevant to setting the amount of regulation, but they do not create market failure.
If workers know the dangers, then employers will add the safety features if they are cost-justified. But if, for example, the marginal cost
of safety features is low but so is the marginal benefit, the optimal
amount of safety features is low.
11.19 An industrys demand curve for labor is L = 36 .5w, with employment measured in thousands. For 17 thousand workers, the alternative
is to work in the service industry for a wage of 10. For 13 thousand it
is to work in a manufacturing job for a wage of 20. What wage would
a union aim for if its aim were to maximize worker surplus?
(a) 20.
(b) 42.
(c) 48.
(d) 24.
(e) 36.
11.20 Suppose unskilled labor is a complement to both skilled labor and to
capital. The effect of immigration of unskilled labor will be to (a)
Reduce all wages, but increase the price of capital.
(b) Reduce the wages of skilled and unskilled labor and the price of
capital.
(c) Reduce just the unskilled wage, and increase the return
to capital and the wage of skilled labor.
(d) Increase all wages and the return to capital.
(e) Reduce all wages and the return to capital.
C HAPTER 12: R EGULATING C APITAL
12.1

Suppose that 80% of banks are solvent, of which only 20% have
invested in mortgage-backed securities. Of the insolvent banks, 60%
102

have invested in those securities. If a government bank examiner finds

that a particular bank has invested in those securities, what is the
probability that it is insolvent?
The total percentage of banks that have invested in those securities is .8(.2) + .2(.6) = .16 + .12 = .28. The percentage that are
insolvent and have invested in them is .12. Thus, the probability
an investing bank is insolvent is .12/.28 = 3/7.
12.2

Why does the government require banks to reach a minimum capital

ratio?
The government wants a high capital ratio for banks because
it provides them with deposit insurance, emergency Fed loans, and
bailouts, so if the bank is leveraged it is the government that bears
much of the risk. Also, the government would want systemic risk
to fall even if it didnt intervene in crises. The answer is not just
that a high capital ratio reduces the risk of bankruptcy, because the
same is true of all other companies too, but the government is not
concerned with the capitalization of companies such as Microsoft
and Kroger.

12.3

If an entrepreneur with capital of $1 million can borrow at a rate

of 4% and invest with a return of 9%, why does leverage increase his
expected profits?
Leverage is the borrowing of funds to increase the scale of operation from that allowed by initial capital. If he can borrow at 4%
and invest at 9%, his expected profits are bigger the more he borrows, though if the return is risky he runs a greater likelihood of
ending up with a negative return.

12.4

How is a bank run a common-pool resource problem?

The common pool resource problem is that more than one person
can take from the common pool, but if too much is taken too quickly,
the total available in the pool falls, so the people are in a prisoners
dilemma. In the case of a bank run, the problem is that depositors
will all rush to take their deposits out, but that reduces the amount
the bank can pay to them because it must sell of assets quickly.
In answering this question you need to talk about the commonpool resource problem, not just about banks.

103

12.5

Suppose a security yields $160 in profits in a good year, and $40

in a bad year, and both are equally likely. Demand for perfectly safe
securities is very high compared to demand for risky securities. Explain how the initial security can be divided into two other securities
to increase its value.
One way to do it is to create one security which yields $40 whether
the year is good or bad, and thus is perfectly safe, leaving the rest
in a second security which yields $120 in a good year and $0 in a
bad year. People will pay a premium for the safe security, and not
pay much less for the new risky security than they would have if it
had the same riskiness as the original security.

12.6

Why is there a stronger case for bailing out banks than there is for
bailing out steel companies or computer companies?
The failure of a bank creates systemic risk, which is not true for
other companies. Banks have lots of short-term debt, to depositors
and to other banks, but their assets are longer term and hard to
value mainly loans made for a number of years. Thus, when a
bank is in trouble, it faces a run from a multitude of holders of
short-term debt, who legally can demand their money back, and
even if the bank is fundamentally sound it may be unable to pay. A
steel or computer company, on the other hand, does not hold much
short-term debt and its physical assets are easier to value. Its value
as a company is as hard to value as a banks, but that is because
it is hard to forecast future sales, not because the assets it holds
today are hard to value. If a steel company goes bankrupt, it may
take down its suppliers with it, but even that is less likely to happen
since in bankruptcy the company will likely continue to operate and
give the suppliers business. A bank, on the other hand, has less
physical capital and so its bankruptcy may result in a decline in
the volume of banking.

12.7

The year is 1890. Apex Bank is facing a run from depositors,

though it is fundamentally sound. Brydox Railway Corporation has
$80 million in assets, but only $5 million of that is in cash or securities that are easy to sell. It owes $50 million to banks and has $40
million in bonds outstanding, of which $23 million must be repaid in
six months. Explain how the two financial situations of Apex and
Brydox are similar or different as regards surplus maximization in the
economy.
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The difference between the two companies is that surplus maximization requires Apex to continue operating, whereas that is less
clear with Brydox. Apex would make profits except for the run, so
it is producing its products at a cost less than the benefit to its customers. Brydox owes more than it is worth, but it might nonetheless
be surplus-maximizing for it to continue operating under new ownership, since it has already sunk the cost of its assets and we cant
get back that cost even if it was a bad decision originally. We dont
have enough information to know.
The similarity is that both companies have liquidity crises
they do not have enough money on hand to pay their short-run debt,
so they would have to sell long-term assets at low prices to pay it.
This would reduce surplus, since those long-term assets are probably worth more used in the original business than by being sold
off piecemeal. The creditors are in a prisoners dilemma, though,
because each wants to get his money back immediately, even if he
knows that by demanding it right now it reduces the ability of the
debtor to pay. Having a central bank play the role of lender of last
resort solves the problem for a bank run. Bankruptcy law solves
the problem for Brydox, because it allows Brydox to go to court and
delay paying its short-term debt while the court figures out an orderly way to sell the assets that will help the long-term creditors to
get back as much as possible of their money too.
12.8

When a bank forecloses on a mortgage, selling someones house so

that his loan from the bank can be repaid, is that a sign of market
failure? What about when a restaurant goes out of business?
Neither failure to repay a mortgage nor a restaurant going out
of business is a sign of market failure unless something special is
going on such as the bank being fooled by a borrower who lies about
his income or customers not knowing that the restaurant really has
good food. When someone borrows to buy a house, ordinarily both
he and the bank think the mortgage will be paid off. Unexpected
events such as unemployment or divorce happen, though, and the
borrower cant make his payments. The bank ordinarily gives the
borrower some slack, since it is costly for a bank to foreclose and
resell the house and they often cant get back the amount of the
loan. At some point, though, it is more efficient for the house to be
occupied by someone new who is willing and able to pay for a house

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that size. The foreclosure is efficient because it transfers the house

to such a person.
In the same way, if a restaurant is started, the owner expects to
make a profit. Nobody can predict whether he will with certainty,
however, and sometimes the owner will be wrong. In that case, his
cost of providing meals is greater than the benefit to customers, and
his continued operation reduces social surplus. It would be market
failure for him to continue to operate, so he closes the restaurant.
12.9

Why would bank shareholders want to take on more risk than bank
bondholders? Why might bank executives want to take more risks even
than bank shareholders?
Bank bondholders are owed a fixed amount of principal and interest, so if the bank makes extra profit from taking extra risk, they
do not benefit. All they care about is that the bank be able to repay the fixed amount. Shareholders, on the other hand, get all the
profit that remains after the bank pays its cost and debts, so they
keep any extra profit from extra risk. If the bank loses money, shareholders lose too, but their loss cannot exceed the value of the banks
capital net capital (after subtracting the debt that it owes). With
upside gains unlimited but downside losses limited, shareholders
favor risk, as long as the average return is not too low.
Bank executives might or might not want to take risk. It depends on how they are compensated. If they are paid a straight
cash salary, they would avoid risk, since it might cost them their
job in bankruptcy. If the bank pays them high bonuses for high
profits in order to get them to work hard, however, or if a lowerlevel executive thinks that a risky investment might give him the
success he needs for promotion, executives might have too much incentive to take risk. The shareholders need to carefully weigh the
incentives they give executives.

12.10

Why did Bagehot say that the central bank should lend at high
interest rates and only to banks that in normal times would be able
to repay the loans?
To maximize social surplus, we want to stop bank runs but allow banks to fail that have made bad business decisions such as
making too many risky loans. Otherwise there is the moral hazard
that banks will take extra risk or avoid minimizing costs because
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they know the central bank will bail them out. Thus, the central
bank should only lend to banks that are in trouble only because of
the current panic and not because of bad business decisions. Also,
it should make its assistance costly by charging high interest rate.
This will further deter moral hazard and it will prevent healthy
banks from taking out loans so that the central bank can use its
assets to help only banks that really need help.
12.11 What is the chief pressure elected officials have put on financial regulators?
(a) To allow institutions to lend to riskier borrowers to encourage home ownership.
(b) To enforce risk regulations strictly to avoid financial crises.
(c) To encourage banks to foreclose on mortgages quickly rather than
let bad debts accumulate.
(d) To pressure financial institutions to diversify by entering other
industries such as consulting.
(e) (a) and (c).
12.12 An entrepreneur has an idea that will yield 20% if it works and 2%
if it fails, both having equal probability, for any size of investment.
He can borrow at 5% and starts with 20 million dollars in assets. He
currently has 2.5 million dollars in personal debt. His expected profit
will be highest if he borrows
(a) Nothing.
(b) 0.1-2 million dollars.
(c) 2.1-4 million dollars.
(d) 4.1-17 million dollars.
(e) 17.1-19 million dollars.
12.13 Cutting a mortgage-backed security into risk tranches:
(a) Always reduces total risk.
(b) Always increases total risk.
(c) Always creates a new, less risky asset.
(d) Sometimes reduces total risk.
(e) Sometimes creates a new, less risky asset.
12.14 The loss in social surplus from someone being evicted for not paying
his mortgage equals:
(a) The market value of the house.
(b) His value for the house.
(c) The lost use of the house till someone new moves in.
(d) The remaining amount of his mortgage.
(e) The original amount of his mortgage.
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12.15 The difference between systemic risk and systematic risk is that
(a) Systemic risk refers to collapse of the system, whereas
systematic risk refers to overall investment risk.
(b) Systemic risk is unavoidable, whereas systematic risk can be avoided
by appropriate regulation.
(c) Systemic risk refers to overall investment risk, whereas systematic
risk refers to collapse of the system.
(d) Systematic risk applies to banking, whereas systemic risk applies
to the stock market.
(e) Systemic risk is created by the government, unlike systematic risk.
12.16 Which of the following will work best to maximize social surplus in
banking?
(a) Deposit insurance.
(b) Regulation of bank investments.
(c) Regulation of depositor investments.
(d) Both (a) and (b).
(e) Both (a) and (c).
Deposit insurance will cause big moral hazard problems without
regulation of risk, so we need to use both deposit insurance and
regulation of safety.
12.17 Congress was reluctant to let the Treasury take ownership of banks
during the 2008 Financial Crisis because it feared:
(a) Treasury would not operate banks as effectively as private owners.
(b) It would cost too much to take ownership.
(c) Treasury would abuse its power.
(d) Two of the above things would happen.
(e) (a), (b), and (c).
12.18 In a repurchase agreement
(a) The collateral is a home mortgage.
(b) The collateral is some security such as a bond.
(c) The collateral is cash.
(d) The collateral is the house itself.
(e) The collateral may be any physical asset.
12.19 The social opportunity cost of the Smith family living at 34 Maple
Street is:
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(a) The price at which they bought the house.

(b) That someone else cant live there if they do.
(c) The interest rate times the price at which they bought the house.
(d) The value of the land if a new house was built there today.
(e) The rent they would pay if they were living somewhere else.
12.20 Suppose a security has a cash flow that might be anywhere from $20 to
$80, with an expected value of $50. Which of the following promised
payoffs would be most profitable for the investment bank if it could
get a rating agency to rate the senior tranche of a derivative security
as AAA?
(a) $20.
(b) $30.
(c) $50.
(d) $55
(e) $40.
If the security will be rated AAA, the profit will be higher with the
biggest possible promised payoff, even though it wont actually be
paid in bad times.

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