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7 April 2013

Questions in Micro to test your use of the tools we have learned. These will be discussed in class over
the days ahead.

Chapter9

1. Fromtimetotime,Congresshasraisedtheminimumwage.Somepeoplesuggestedthata
governmentsubsidycouldhelpemployersfinancethehigherwage.Thisexerciseexaminesthe
economicsofaminimumwageandwagesubsidies.Supposethesupplyoflowskilledlaboris
givenbyLS10w,whereLSisthequantityoflowskilledlabor(inmillionsofpersons
employedeachyear),andwisthewagerate(indollarsperhour).Thedemandforlaboris
givenbyLD8010w.
a. Whatwillbethefreemarketwagerateandemploymentlevel?Supposethegovernment
setsaminimumwageof$5perhour.Howmanypeoplewouldthenbeemployed?
Inafreemarketequilibrium,LSLD.Solvingyieldsw$4andLSLD40.Iftheminimum
wageis$5,thenLS50andLD30.Thenumberofpeopleemployedwillbegivenbythelabor
demand,soemployerswillhireonly30millionworkers.

b. Supposethatinsteadofaminimumwage,thegovernmentpaysasubsidyof$1perhour
foreachemployee.Whatwillthetotallevelofemploymentbenow?Whatwillthe
equilibriumwageratebe?
Letwsdenotethewagereceivedbythesellers(i.e.,theemployees),andwbthewagepaidbythe
buyers(thefirms).Thenewequilibriumoccurswheretheverticaldifferencebetweenthesupply
anddemandcurvesis$1(theamountofthesubsidy).Thispointcanbefoundwhere

1
LD(wb)LS(ws),and
wswb1.
Writethesecondequationaswbws1.Thisreflectsthefactthatfirmspay$1lessthanthe
wagereceivedbyworkersbecauseofthesubsidy.Substituteforwbinthedemandequation:
LD(wb)8010(ws1),so
LD(wb)9010ws.
Notethatthisisequivalenttoanupwardshiftindemandbytheamountofthe$1subsidy.Now
setthenewdemandequaltosupply:9010ws10ws.Therefore,ws$4.50,andLD90
10(4.50)45.Employmentincreasesto45(comparedto30withtheminimumwage),butwage
dropsto$4.50(comparedto$5.00withtheminimumwage).Thenetwagethefirmpaysfallsto
$3.50duetothesubsidy.

2
3. Japanesericeproducershaveextremelyhighproductioncosts,dueinparttothehigh
opportunitycostoflandandtotheirinabilitytotakeadvantageofeconomiesoflargescale
production.AnalyzetwopoliciesintendedtomaintainJapanesericeproduction:(1)aperpound
subsidytofarmersforeachpoundofriceproduced,or(2)aperpoundtariffonimportedrice.
Illustratewithsupplyanddemanddiagramstheequilibriumpriceandquantity,domesticrice
production,governmentrevenueordeficit,anddeadweightlossfromeachpolicy.Which
policyistheJapanesegovernmentlikelytoprefer?WhichpolicyareJapanesefarmerslikelyto
prefer?
Wehavetomakesomeassumptionstoanswerthisquestion.Ifyoumakedifferentassumptions,you
maygetdifferentanswers.AssumethatinitiallytheJapanesericemarketisopen,meaningthat
foreignproducersanddomestic(Japanese)producersbothsellricetoJapaneseconsumers.The
worldpriceofriceisPW.ThispriceisbelowP0,whichistheequilibriumpricethatwouldoccurin
theJapanesemarketifnoimportswereallowed.Inthediagrambelow,Sisthedomesticsupply,Dis
thedomesticdemand,andQ0istheequilibriumquantitythatwouldprevailifnoimportswere
allowed.ThehorizontallineatPWistheworldsupplyofrice,whichisassumedtobeperfectly
elastic.InitiallyJapaneseconsumerspurchaseQDriceattheworldprice.JapanesefarmerssupplyQS
atthatprice,andQDQSisimportedfromforeignproducers.
NowsupposetheJapanesegovernmentpaysasubsidytoJapanesefarmersequaltothedifference
betweenP0andPW.ThenJapanesefarmerswouldsellriceontheopenmarketforPWplusreceive
thesubsidyofP0PW.Addingthesetogether,thetotalamountJapanesefarmerswouldreceiveisP0
perpoundofrice.AtthispricetheywouldsupplyQ0poundsofrice.ConsumerswouldstillpayPW
andbuyQD.ForeignsupplierswouldimportQDQ0poundsofrice.Thispolicywouldcostthe
government(P0PW)Q0,whichisthesubsidyperpoundtimesthenumberofpoundssuppliedby
Japanesefarmers.ItisrepresentedonthediagramasareasBE.Producersurplusincreasesfrom
areaCtoCB,soPSB.ConsumersurplusisnotaffectedandremainsasareaABEF.
DeadweightlossisareaE,whichisthecostofthesubsidyminusthegaininproducersurplus.

Instead,supposethegovernmentimposesatariffratherthanpayingasubsidy.Letthetariffbethe
samesizeasthesubsidy,P0PW.NowforeignfirmsimportingriceintoJapanwillhavetosellatthe
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worldpriceplusthetariff:PW(P0PW)P0.Butatthisprice,JapanesefarmerswillsupplyQ0,
whichisexactlytheamountJapaneseconsumerswishtopurchase.Thereforetherewillbeno
imports,andthegovernmentwillnotcollectanyrevenuefromthetariff.Theincreaseinproducer
surplusequalsareaB,asitisinthecaseofthesubsidy.ConsumersurplusisareaA,whichisless
thanitisunderthesubsidybecauseconsumerspaymore(P0)andconsumeless(Q0).Consumer
surplusdecreasesbyBEF.DeadweightlossisEF:thedifferencebetweenthedecreasein
consumersurplusandtheincreaseinproducersurplus.
Undertheassumptionsmadehere,itseemslikelythatproducerswouldnothaveastrongpreference
foreitherthesubsidyorthetariff,becausetheincreaseinproducersurplusisthesameunderboth
policies.Thegovernmentmightpreferthetariffbecauseitdoesnotrequireanygovernment
expenditure.Ontheotherhand,thetariffcausesadecreaseinconsumersurplus,andgovernment
officialswhoareelectedbyconsumersmightwanttoavoidthat.Notethatifthesubsidyandtariff
amountsweresmallerthanassumedabove,sometariffswouldbecollected,butwewouldstillget
thesamebasicresults.

4
4. In1983,theReaganAdministrationintroducedanewagriculturalprogramcalledthe
PaymentinKindProgram.Toseehowtheprogramworked,letsconsiderthewheatmarket.
a. SupposethedemandfunctionisQD282PandthesupplyfunctionisQS44P,where
Pisthepriceofwheatindollarsperbushel,andQisthequantityinbillionsofbushels.
Findthefreemarketequilibriumpriceandquantity.
Equatingdemandandsupply,QDQS,
282P44P,orP$4.00perbushel.
Todeterminetheequilibriumquantity,substituteP4intoeitherthesupplyequationorthe
demandequation:
QS44(4)20billionbushels
and
QD282(4)20billionbushels.
b. Nowsupposethegovernmentwantstolowerthesupplyofwheatby25%fromthefree
marketequilibriumbypayingfarmerstowithdrawlandfromproduction.However,the
paymentismadeinwheatratherthanindollarshencethenameoftheprogram.The
wheatcomesfromvastgovernmentreservesaccumulatedfrompreviouspricesupport
programs.Theamountofwheatpaidisequaltotheamountthatcouldhavebeen
harvestedonthelandwithdrawnfromproduction.Farmersarefreetosellthiswheaton
themarket.Howmuchisnowproducedbyfarmers?Howmuchisindirectlysuppliedto
themarketbythegovernment?Whatisthenewmarketprice?Howmuchdofarmers
gain?Doconsumersgainorlose?
Becausethefreemarketsupplybyfarmersis20billionbushels,the25%reductionrequiredbythe
newPaymentInKind(PIK)Programmeansthatthefarmersnowproduce15billionbushels.
Toencouragefarmerstowithdrawtheirlandfromcultivation,thegovernmentmustgivethem
5billionbushelsofwheat,whichtheysellonthemarket,so5billionbushelsareindirectly
suppliedbythegovernment.
Becausethetotalquantitysuppliedtothemarketisstill20billionbushels,themarketpricedoes
notchange;itremainsat$4perbushel.Farmersgainbecausetheyincurnocostsforthe5
billionbushelsreceivedfromthegovernment.Wecancalculatethesecostsavingsbytakingthe
areaunderthesupplycurvebetween15and20billionbushels.Thesearethevariablecostsof
producingthelast5billionbushelsthatarenolongergrownunderthePIKProgram.Tofindthis
area,firstdeterminethepriceswhenQandwhenQ20.ThesevaluesareP$2.75andP
$4.00.Thetotalcostofproducingthelast5billionbushelsisthereforetheareaofatrapezoid
withabaseof20155billionandanaverageheightof(2.754.00)/23.375.Theareais
5(3.375)$16.875billion,whichistheamountfarmersgainundertheprogram.
ThePIKprogramdoesnotaffectconsumersinthewheatmarketbecausetheypurchasethe
sameamountatthesamepriceastheydidinthefreemarketcase.
c. Hadthegovernmentnotgiventhewheatbacktothefarmers,itwouldhavestoredor
destroyedit.Dotaxpayersgainfromtheprogram?Whatpotentialproblemsdoesthe
programcreate?
5
Taxpayersgainbecausethegovernmentdoesnotincurcoststostoreordestroythewheat.
AlthougheveryoneseemstogainfromthePIKprogram,itcanonlylastwhilethereare
governmentwheatreserves.Theprogramassumesthatlandremovedfromproductionmaybe
restoredtoproductionwhenstockpilesofwheatareexhausted.Ifthiscannotbedone,
consumersmayeventuallypaymoreforwheatbasedproducts.Anotherpotentialproblemis
verifyingthatthelandtakenoutofproductionisinfactcapableofproducingtheamountof
wheatpaidtofarmersunderthePIKprogram.Farmersmaytrytogamethesystembyremoving
lessproductiveland.

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7. TheUnitedStatescurrentlyimportsallofitscoffee.TheannualdemandforcoffeebyU.S.
consumersisgivenbythedemandcurveQ25010P,whereQisquantity(inmillionsof
pounds)andPisthemarketpriceperpoundofcoffee.Worldproducerscanharvestandship
coffeetoU.S.distributorsataconstantmarginal(average)costof$8perpound.U.S.
distributorscaninturndistributecoffeeforaconstant$2perpound.TheU.S.coffeemarketis
competitive.Congressisconsideringatariffoncoffeeimportsof$2perpound.
a. Ifthereisnotariff,howmuchdoconsumerspayforapoundofcoffee?Whatisthe
quantitydemanded?
Ifthereisnotariffthenconsumerswillpay$10perpoundofcoffee,whichisfoundbyadding
the$8thatitcoststoimportthecoffeeplusthe$2thatitcoststodistributethecoffeeinthe
UnitedStates.Inacompetitivemarket,priceisequaltomarginalcost.Atapriceof$10,the
quantitydemandedis150millionpounds.
b. Ifthetariffisimposed,howmuchwillconsumerspayforapoundofcoffee?Whatisthe
quantitydemanded?
Nowadd$2perpoundtarifftomarginalcost,sopricewillbe$12perpound,andquantity
demandedisQ25010(12)130millionpounds.
c. Calculatethelostconsumersurplus.
Lostconsumersurplusis(1210)(130)0.5(1210)(150130)$280million.
d. Calculatethetaxrevenuecollectedbythegovernment.
Thetaxrevenueisequaltothetariffof$2perpoundtimesthe130millionpoundsimported.
Taxrevenueistherefore$260million.
e. Doesthetariffresultinanetgainoranetlosstosocietyasawhole?
Thereisanetlosstosocietybecausethegain($260million)islessthantheloss($280million).

8. Aparticularmetalistradedinahighlycompetitiveworldmarketataworldpriceof$9per
ounce.UnlimitedquantitiesareavailableforimportintotheUnitedStatesatthisprice.The
supplyofthismetalfromdomesticU.S.minesandmillscanberepresentedbytheequation
QS2/3P,whereQSisU.S.outputinmillionouncesandPisthedomesticprice.Thedemand
forthemetalintheUnitedStatesisQD402P,whereQDisthedomesticdemandinmillion
ounces.

InrecentyearstheU.S.industryhasbeenprotectedbyatariffof$9perounce.Under
pressurefromotherforeigngovernments,theUnitedStatesplanstoreducethistarifftozero.
Threatenedbythischange,theU.S.industryisseekingavoluntaryrestraintagreementthat
wouldlimitimportsintotheUnitedStatesto8millionouncesperyear.
a. Underthe$9tariff,whatwastheU.S.domesticpriceofthemetal?
Witha$9tariff,thepriceoftheimportedmetalintheU.S.marketwouldbe$18;the$9tariff
plustheworldpriceof$9.The$18price,however,isabovethedomesticequilibriumprice.
Todeterminethedomesticequilibriumprice,equatedomesticsupplyanddomesticdemand:

7
2
P 40 2 P , or P $15.
3

8
Becausethedomesticpriceof$15islessthantheworldpriceplusthetariff,$18,therewillbe
noimports.Theequilibriumquantityisfoundbysubstitutingthepriceof$15intoeitherthe
demandorsupplyequation.Usingdemand,
Q D 40 (2)(15) 10 millionounces.
b. IftheUnitedStateseliminatesthetariffandthevoluntaryrestraintagreementis
approved,whatwillbetheU.S.domesticpriceofthemetal?
Withthevoluntaryrestraintagreement,thedifferencebetweendomesticsupplyanddomestic
demandwouldbelimitedto8millionounces,i.e.,QDQS8.Todeterminethedomesticprice
ofthemetal,setQDQS8andsolveforP:
2
(40 2P ) P 8, or P $12.
3
AtaU.S.domesticpriceof$12,QD16andQS8;thedifferenceof8millionounceswillbe
suppliedbyimports.

9. AmongthetaxproposalsregularlyconsideredbyCongressisanadditionaltaxondistilled
liquors.Thetaxwouldnotapplytobeer.Thepriceelasticityofsupplyofliquoris4.0,andthe
priceelasticityofdemandis0.2.Thecrosselasticityofdemandforbeerwithrespecttothe
priceofliquoris0.1.
a. Ifthenewtaxisimposed,whowillbearthegreaterburdenliquorsuppliersorliquor
consumers?Why?
ES
ThefractionofthetaxbornebyconsumersisgiveninSection9.6as ,whereESisthe
ES E D
ownpriceelasticityofsupplyandEDistheownpriceelasticityofdemand.SubstitutingforES
andED,thepassthroughfractionis
4 4
0.95.
4 ( 0.2) 4.2
Therefore,justover95%ofthetaxispassedthroughtoconsumersbecausesupplyishighly
elasticwhiledemandisveryinelastic.Soliquorconsumerswillbearalmostalltheburdenof
thetax.
b. Assumingthatbeersupplyisinfinitelyelastic,howwillthenewtaxaffectthebeermarket?
Withanincreaseinthepriceofliquor(fromthelargepassthroughoftheliquortax),some
consumerswillsubstituteawayfromliquortobeerbecausethecrosselasticityispositive.
Thiswillshiftthedemandcurveforbeeroutward.Withaninfinitelyelasticsupplyforbeer
(ahorizontalsupplycurve),theequilibriumpriceofbeerwillnotchange,andthequantityof
beerconsumedwillincrease.

9
Chapter10

9. Adrugcompanyhasamonopolyonanewpatentedmedicine.Theproductcanbemadein
eitheroftwoplants.ThecostsofproductionforthetwoplantsareMC1202Q1andMC2
105Q2.ThefirmsestimateofdemandfortheproductisP203(Q1Q2).Howmuch
shouldthefirmplantoproduceineachplant?Atwhatpriceshoulditplantoselltheproduct?
First,noticethatonlyMC2isrelevantbecausethemarginalcostcurveofthefirstplantliesabovethe
demandcurve.

ThismeansthatthedemandcurvebecomesP203Q2.Withaninverselineardemandcurve,we
knowthatthemarginalrevenuecurvehasthesameverticalinterceptbuttwicetheslope,orMR
206Q2.Todeterminetheprofitmaximizinglevelofoutput,equateMRandMC2:
206Q2105Q2,orQ20.91.
Also,Q10,andthereforetotaloutputisQ0.91.Priceisdeterminedbysubstitutingtheprofit
maximizingquantityintothedemandequation:
P203(0.91)$17.27.

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11. AmonopolistfacesthedemandcurveP11Q,wherePismeasuredindollarsperunitand
Qinthousandsofunits.Themonopolisthasaconstantaveragecostof$6perunit.
a. Drawtheaverageandmarginalrevenuecurvesandtheaverageandmarginalcostcurves.
Whatarethemonopolistsprofitmaximizingpriceandquantity?Whatistheresulting
profit?CalculatethefirmsdegreeofmonopolypowerusingtheLernerindex.
Becausedemand(averagerevenue)isP11Q,themarginalrevenuefunctionisMR11
2Q.Also,becauseaveragecostisconstant,marginalcostisconstantandequaltoaveragecost,
soMC6.
Tofindtheprofitmaximizinglevelofoutput,setmarginalrevenueequaltomarginalcost:
112Q6,orQ2.5.
Thatis,theprofitmaximizingquantityequals2500units.Substitutetheprofitmaximizing
quantityintothedemandequationtodeterminetheprice:
P112.5$8.50.
Profitsareequaltototalrevenueminustotalcost,
TRTCPQ(AC)(Q),or
(8.50)(2.5)(6)(2.5)6.25,or$6250.
Thediagrambelowshowsthedemand,MR,AC,andMCcurvesalongwiththeoptimalprice
andquantityandthefirmsprofits.
ThedegreeofmonopolypoweraccordingtotheLernerIndexis:
P MC 8.5 6
0.294.
P 8.5

11
b. Agovernmentregulatoryagencysetsapriceceilingof$7perunit.Whatquantitywillbe
produced,andwhatwillthefirmsprofitbe?Whathappenstothedegreeofmonopoly
power?
Todeterminetheeffectofthepriceceilingonthequantityproduced,substitutetheceilingprice
intothedemandequation.
711Q,orQ4.
Therefore,thefirmwillchoosetoproduce4000unitsratherthanthe2500unitswithoutthe
priceceiling.Also,themonopolistwillchoosetosellitsproductatthe$7priceceilingbecause
$7isthehighestpricethatitcancharge,andthispriceisstillgreaterthantheconstantmarginal
costof$6,resultinginpositivemonopolyprofit.
Profitsareequaltototalrevenueminustotalcost:
7(4000)6(4000)$4000.
Thedegreeofmonopolypowerfallsto
P MC 7 6
0.143.
P 7
c. Whatpriceceilingyieldsthelargestlevelofoutput?Whatisthatlevelofoutput?Whatis
thefirmsdegreeofmonopolypoweratthisprice?
Iftheregulatoryauthoritysetsapricebelow$6,themonopolistwouldprefertogooutof
businessbecauseitcannotcoveritsaveragevariablecosts.Atanypriceabove$6,the
monopolistwouldproducelessthanthe5000unitsthatwouldbeproducedinacompetitive
industry.Therefore,theregulatoryagencyshouldsetapriceceilingof$6,thusmakingthe
monopolistfaceahorizontaleffectivedemandcurveuptoQ5(i.e.,5000units).Toensurea
positiveoutput(sothatthemonopolistisnotindifferentbetweenproducing5000unitsand
shuttingdown),thepriceceilingshouldbesetat$6,whereissmall.
Thus,5000isthemaximumoutputthattheregulatoryagencycanextractfromthemonopolist
byusingapriceceiling.Thedegreeofmonopolypoweris
P MC 6 6
0 as 0.
P 6 6

12
12. MichellesMonopolyMutantTurtles(MMMT)hastheexclusiverighttosellMutantTurtle
tshirtsintheUnitedStates.ThedemandforthesetshirtsisQ10,000/P2.Thefirmsshort
runcostisSRTC20005Q,anditslongruncostisLRTC6Q.
a. WhatpriceshouldMMMTchargetomaximizeprofitintheshortrun?Whatquantitydoes
itsell,andhowmuchprofitdoesitmake?Woulditbebetteroffshuttingdowninthe
shortrun?
MMMTshouldofferenoughtshirtssothatMRMC.Intheshortrun,marginalcostisthe
changeinSRTCastheresultoftheproductionofanothertshirt,i.e.,SRMC5,theslopeofthe
SRTCcurve.Demandis:
10,000
Q ,
P2
or,ininverseform,
P100Q1/2.
TotalrevenueisTRPQ100Q1/2.TakingthederivativeofTRwithrespecttoQ,MR
50Q1/2.EquatingMRandMCtodeterminetheprofitmaximizingquantity:
550Q1/2,orQ100.
SubstitutingQ100intothedemandfunctiontodetermineprice:
P(100)(1001/2)$10.
Theprofitatthispriceandquantityisequaltototalrevenueminustotalcost:
10(100)[20005(100)]$1500.
Althoughprofitisnegative,priceisabovetheaveragevariablecostof5,andthereforethefirm
shouldnotshutdownintheshortrun.Sincemostofthefirmscostsarefixed,thefirmloses
$2000ifnothingisproduced.Iftheprofitmaximizing(i.e.,lossminimizing)quantityis
produced,thefirmlosesonly$1500.
b. WhatpriceshouldMMMTchargeinthelongrun?Whatquantitydoesitsellandhow
muchprofitdoesitmake?Woulditbebetteroffshuttingdowninthelongrun?
Inthelongrun,marginalcostisequaltotheslopeoftheLRTCcurve,whichis6.
Equatingmarginalrevenueandlongrunmarginalcosttodeterminetheprofitmaximizing
quantity:
50Q1/26,orQ69.444
SubstitutingQ69.444intothedemandequationtodetermineprice:
P(100)(69.444)1/2(100)(1/8.333)12
TotalrevenueisTR12(69.444)$833.33andtotalcostisLRTC6(69.444)$416.67.
Profitistherefore$833.33416.67$416.66.Thefirmshouldremaininbusinessinthelong
run.
c. CanweexpectMMMTtohavelowermarginalcostintheshortrunthaninthelongrun?
Explainwhy.
13
Inthelongrun,MMMTcanchangeallitsinputswhenitchangesoutputlevel.Therefore,LRMC
includesthecostsofallinputsthatarefixedintheshortrunbutvariableinthelongrun.These
costsdonotappearinSRMC.AsaresultwecanexpectSRMCtobelowerthanLRMCinmany
cases.

14. Theemploymentofteachingassistants(TAs)bymajoruniversitiescanbecharacterizedasa
monopsony.SupposethedemandforTAsisW30,000125n,whereWisthewage(asan
annualsalary),andnisthenumberofTAshired.ThesupplyofTAsisgivenbyW1000
75n.
a. Iftheuniversitytakesadvantageofitsmonopsonistposition,howmanyTAswillithire?
Whatwagewillitpay?
Thesupplycurveisequivalenttotheaverageexpenditurecurve.Withasupplycurveof
W100075n,thetotalexpenditureisWn1000n75n2.Takingthederivativeofthe
totalexpenditurefunctionwithrespecttothenumberofTAs,themarginalexpenditurecurve

isME1000150n.Asamonopsonist,theuniversitywouldequatemarginalvalue(demand)
withmarginalexpendituretodeterminethenumberofTAstohire:
30,000125n1000150n,orn105.5.
Substitutingn105.5intothesupplycurvetodeterminethewage:
100075(105.5)$8,912.50annually.
b. If,instead,theuniversityfacedaninfinitesupplyofTAsattheannualwagelevelof
$10,000,howmanyTAswouldithire?
WithaninfinitenumberofTAsat$10,000,thesupplycurveishorizontalat$10,000.Total
expenditureis10,000(n),andmarginalexpenditureis10,000.Equatingmarginalvalueand
marginalexpenditure:
30,000125n10,000,orn160.
15. DaynasDoorstops,Inc.(DD)isamonopolistinthedoorstopindustry.Itscostis
C1005QQ2,anddemandisP552Q.
a. WhatpriceshouldDDsettomaximizeprofit?Whatoutputdoesthefirmproduce?How
muchprofitandconsumersurplusdoesDDgenerate?
Tomaximizeprofit,DDshouldequatemarginalrevenueandmarginalcost.Givenademandof
P552Q,weknowthattotalrevenue,PQ,is55Q2Q2.Marginalrevenueisfoundby
takingthefirstderivativeoftotalrevenuewithrespecttoQor:
dTR
MR 55 4Q.
dQ
Similarly,marginalcostisdeterminedbytakingthefirstderivativeofthetotalcostfunction
withrespecttoQor:
dTC
MC 2Q 5.
dQ
EquatingMCandMRtodeterminetheprofitmaximizingquantity,
14
554Q2Q5,orQ10.
SubstituteQ10intothedemandequationtofindtheprofitmaximizingprice:
P552(10)$35.
Profitsareequaltototalrevenueminustotalcost:
(35)(10)[1005(10)102]$200.
Consumersurplusisequaltoonehalftimestheprofitmaximizingquantity,10,timesthe
differencebetweenthedemandintercept(55)andthemonopolyprice(35):
CS(0.5)(10)(5535)$100.
b. WhatwouldoutputbeifDDactedlikeaperfectcompetitorandsetMCP?Whatprofit
andconsumersurpluswouldthenbegenerated?
Incompetition,profitsaremaximizedatthepointwherepriceequalsmarginalcost.Sosetprice
(asgivenbythedemandcurve)equaltoMC:
552Q2Q5,or
Q15.
SubstitutingQ15intothedemandequationtodeterminetheprice:
P552(15)$25.
Profitsaretotalrevenueminustotalcostor:
(25)(15)[1005(15)152]$125.
Consumersurplusis
CS(0.5)(15)(5525)$225.
Soconsumersurplusincreasesby$125andproducersurplusdecreasesby$75.
c. Whatisthedeadweightlossfrommonopolypowerinparta?
Thedeadweightlossisequaltotheareabelowthedemandcurve,abovethemarginalcostcurve,
andbetweenthequantitiesof10and15,ornumerically
DWL(0.5)(3515)(1510)$50.
d. Supposethegovernment,concernedaboutthehighpriceofdoorstops,setsamaximum
priceat$27.Howdoesthisaffectprice,quantity,consumersurplus,andDDsprofit?
Whatistheresultingdeadweightloss?
Withthepriceceiling,themaximumpricethatDDmaychargeis$27.00.Notethatwhena
ceilingpriceissetbelowthemonopolypricetheceilingpriceisthefirmsmarginalrevenuefor
eachunitsolduptothequantitydemandedattheceilingprice.
Substitutetheceilingpriceof$27.00intothedemandequationtodeterminetheeffectonthe
equilibriumquantitysold:
27552Q,orQ14.
Comparedtoparta,pricedropsfrom$35to$27andoutputincreasesfrom10to14.
Consumersurplusis
15
CS(0.5)(14)(5527)$196.
Profitsare
(27)(14)[1005(14)142]$152.
SoCSincreasesfrom$100to$196andprofitfallsfrom$200to$152.
ThedeadweightlossisDWL(0.5)(1514)(2723)$2
e. Nowsupposethegovernmentsetsthemaximumpriceat$23.Howdoesthisdecisionaffect
price,quantity,consumersurplus,DDsprofit,anddeadweightloss?
Withaceilingpricesetbelowthecompetitiveprice,DDsoutputwillbelessthanthe
competitiveoutputof15.Equatemarginalrevenue(theceilingprice)andmarginalcostto
determinetheprofitmaximizinglevelofoutput:
232Q5,orQ14.
Withthegovernmentimposedmaximumpriceof$23,profitsare
(23)(14)[1005(14)142]$96.

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Consumersurplusisrealizedon14doorsteps.Therefore,itisequaltotheconsumersurplusin
partd,whichwas$196,plusanadditionalareaduetothefactthatpriceisnow$23instead
of$27.Theadditionalamountis(2723)(14)$56.Therefore,consumersurplusis
$19656$252.
Comparedtopartd,priceis$4lessandquantityisthesame.Consumersurplusincreasesby$56
andDDsprofitdecreasesby$56,whichisalsothedropinproducersurplus.Sincetheincrease
inconsumersurplusequalsthedropinproducersurplus,deadweightlossisthesame
asbeforeat$2.00.
f. Finally,consideramaximumpriceof$12.Whatwillthisdotoquantity,consumersurplus,
profit,anddeadweightloss?
Withamaximumpriceofonly$12,outputdecreasesconsiderably:
122Q5,orQ8.5.
Profitsare
(12)(8.5)[1005(8.5)8.52]$27.75.
Eventhoughthefirmismakinglosses,itwillcontinuetoproduceintheshortrunbecause
revenue($102)isgreaterthantotalvariablecost($29.75).
Consumersurplusisrealizedononly8.5units.Notethattheconsumerbuyingthelastunit
wouldhavebeenwillingtopayapriceof$38(38552(8.5)).Therefore,
CS(0.5)(8.5)(5538)(8.5)(3812)$293.25.
DWL(0.5)(158.5)(3812)$84.50.
Theresultofthislowpriceisthatoutputfalls,consumersurplusincreases,profitdrops,and
deadweightlossincreases.Inthelongrun,thefirmwillshutdown,andthenoutput,consumer
surplus,andprofitwillalldroptozero.

Chapter11

Thisproblemisusefulinunderstanding#4onpage450

1. SupposeBoeingfacesthefollowingdemandcurveforthemonthlysalesofits787aircraft:
Q1200.5P

WhereQisairplanessoldpermonthandPisthepriceinmillionsofdollars.Theairplaneusesa
setofenginesmadebyGeneralElectric,andBoeingpaysGEapricePE(inmillionsofdollars)
foreachsetofengines.ThemarginalcosttoGEofproducingasetofenginesis20(million
dollars).Inadditiontopayingforengines,Boeingincursamarginalcostof100(milliondollars)
perplane.
a. WhatisBoeingsprofitmaximizingpriceofairplanes,givenapricePEfortheengines?
WhatistheprofitmaximizingpricethatGEwillchargeforeachsetofengines?Giventhat
priceofengines,whatpricewillBoeingchargeforitsairplanes?

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TofindBoeingsprofitmaximizingquantityandpriceofairplanes,firstsolvethedemandcurve
forP,whichgivestheinversedemandequation:
P2402Q.
SinceMRforalineardemandcurvehasthesameinterceptandtwicetheslope,BoeingsMR
curveis
MR2404Q.
Foreachairplaneproduced,Boeingsmarginalcostisitsownproductioncostof100plusthe
priceitpaysGEforonesetofengines.Therefore,Boeingsmarginalcostis
MC100PE.
SetBoeingsMRequaltoitsMCtofindtheprofitmaximizingquantityofairplanes.
2404Q100PE.
Therefore,Q350.25PE.
TofindBoeingsprofitmaximizingprice,substitutetheexpressionforQintoBoeingsinverse
demandcurve.
P2402(350.25PE)1700.5PE.
FromGEsperspective,thedemandforitsenginesistheexpressionwejustderivedfor
Boeingsoptimalnumberofairplanes.Sinceeachplanerequiresonesetofengines,Boeingwill
wanttopurchaseonesetofenginesperplane.Theoptimalnumberofplanesdependsonthe
priceGEchargesforenginesets,PE.Therefore,thederiveddemandforGEenginesis
Q350.25PE.
Solvingfortheinversedemandforengines,PE1404Q.Therefore,GEsmarginalrevenue
curveis
MR1408Q.
SinceGEsmarginalcostis20,settingMRequaltoMCgives1408Q20.Thus,GEsprofit
maximizingquantityandpriceofenginesis
Q15setsofengines,and
PE1404(15)$80million.
GivenGEsprice,wecanfindBoeingsprofitmaximizingquantityandpriceusingthe
expressionsderivedearlier.
Q350.25PE350.25(80)15planes,and
P1700.5PE1700.5(80)$210million.
Notethatthequantityofplanes(15permonth)equalsthequantityofenginesets,asitshould
be.
b. SupposeBoeingweretoacquireGEsenginedivision,sothatnowtheenginesand
airplanesaremadebyasinglecompany.Nowwhatpricewillthecompanychargeforits
airplanes?

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Becausetheproblemdoesnotsayotherwise,itseemsreasonabletoassumethatthemarginal
costperenginesetisstill$20millionafterBoeingacquirestheenginedivisionandthatthereis
nooutsidemarketfortheengines.Therefore,Boeingsmarginalcostperplaneis20perengine
setplus100inotherproductioncosts.Somarginalcostperplaneis120.Marginalrevenueis
MR2404Qasdeterminedinpart(a).BoeingsprofitmaximizingquantityiswhereMR
MC:
2404Q120,soQ30planes.
SubstitutingintotheinversedemandfunctiongivesBoeingsprice,whichis
P2402Q2402(30)$180million.

2.2. ReviewthenumericalexampleaboutRaceCarMotors.Calculatetheprofitearnedbythe
upstreamdivision,thedownstreamdivision,andthefirmasawholeineachofthethreecases
examined:(a)thereisnooutsidemarketforengines;(b)thereisacompetitivemarketfor
enginesinwhichthemarketpriceis$6000;and(c)thefirmisamonopolysupplierofengines
toanoutsidemarket.InwhichcasedoesRaceCarMotorsearnthemostprofit?Inwhichcase
doestheupstreamdivisionearnthemost?Thedownstreamdivision?
Examineeachcaseandthencompareprofits.WearegiventhefollowinginformationaboutRace
CarMotors:
Thedemandforitsautomobilesis
P20,000Q.
Thereforeitsmarginalrevenueis
MR20,0002Q.
Thedownstreamdivisionscostofassemblingcarsis
CA(Q)8000Q,
sothedivisionsmarginalcostisMCA8000.Theupstreamdivisionscostofproducingenginesis
C E (QE ) 2QE2 ,
sotheupstreamdivisionsmarginalcostisMCE4QE.
Case(a):Todeterminetheprofitmaximizingquantityofoutput,setthenetmarginalrevenuefor
enginesequaltothemarginalcostofproducingengines.Becauseeachcarhasoneengine,QEequals
Q,andthenetmarginalrevenueofenginesis
NMREMRMCA,or
NMRE(20,0002Q)800012,0002QE.
SettingNMREequaltoMCE:
12,0002QE4QE,orQE2000.
Thefirmshouldproduce2000enginesand2000cars.Theoptimaltransferpriceisthemarginalcost
ofthe2000thengine:

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PEMCE4QE(4)(2000)$8000.
Theprofitmaximizingpriceofthecarsisfoundbysubstitutingtheprofitmaximizingquantityinto
thedemandfunction:
P20,000Q,orP20,0002000$18,000.
Theprofitsforeachdivisionareequalto
E(8000)(2000)2(2000)2$8,000,000,
and
A(18,000)(2000)(80008000)(2000)$4,000,000.
TotalprofitsareequaltoEA$12,000,000.
Case(b):Todeterminetheprofitmaximizinglevelofoutputwhenanoutsidemarketforengines
exists,firstnotethatthecompetitivepriceforenginesontheoutsidemarketis$6000,whichisless
thanthetransferpriceof$8000.Withthemarketpricelessthanthetransferprice,thismeansthat
thefirmwillbuysomeofitsenginesontheoutsidemarket.Todeterminehowmanycarsthefirm
shouldproduce,setthemarketpriceofenginesequaltonetmarginalrevenue.Weusethemarket
price,sinceitisnowthemarginalcostofengines,andtheoptimaltransferprice
600012,0002QE,orQE3000.
Thetotalquantityofenginesandautomobilesis3000.Thepriceofthecarsisdeterminedby
substitutingQEintothedemandfunctionforcars:
P20,0003000,orP$17,000.
Thecompanynowproducesmorecarsandsellsthematalowerprice.Todeterminethenumberof
enginesthatthefirmwillproduceandhowmanythefirmwillbuyonthemarket,setthemarginal
costofengineproductionequalto6000,solveforQE,andthenfindthedifferencebetweenthis
numberandthe3000carstobeproduced:
MCE4QE6000,orQE1500.
Thus,theupstreamEngineDivisionwillsupply1500enginesandtheremaining1500engineswill
beboughtontheexternalmarket.
Fortheenginebuildingdivision,profitsarefoundbysubtractingtotalcostsfromtotalrevenue:
ETRETCE($6000)(1500)2(1500)2$4,500,000.
Fortheautomobileassemblydivision,profitsarefoundbysubtractingtotalcostsfromtotalrevenue:
ATRATCA($17,000)(3000)(8,0006,000)(3000)$9,000,000.
Totalprofitforthefirmisthesumofthetwodivisionsprofits,
T$13,500,000.
Case(c):Inthecasewherethefirmisamonopolysupplierofenginestotheoutsidemarket,the
demandintheoutsidemarketforenginesis:
PE,M10,000QE,
whichmeansthatthemarginalrevenuecurveforenginesintheoutsidemarketis:

20
MRE,M10,0002QE.
Todeterminetheoptimaltransferprice,findthetotalnetmarginalrevenuebyhorizontallysumming
MRE,Mwiththenetmarginalrevenuefromsalestothedownstreamdivision,12,0002QE.For
outputofQEgreaterthan1000,thisis:
NMRE,Total11,000QE.
SetNMRE,Totalequaltothemarginalcostofproducingenginestodeterminetheoptimalquantityof
engines:
11,000QE4QE,orQE2200.
Nowdeterminehowmanyofthe2200enginesproducedwillbesoldtothedownstreamdivisionand
howmanywillbesoldontheexternalmarket.First,notethatthemarginalcostofproducingthese
2200engines,andthereforetheoptimaltransferprice,is4QE=$8800.Settheoptimaltransferprice
equaltothemarginalrevenuefromenginesalesintheoutsidemarket:
880010,0002QE,orQE600.
Therefore,600enginesshouldbesoldintheexternalmarket.
Todeterminethepriceatwhichtheseenginesshouldbesoldintheexternalmarket,substitute600
intodemandintheoutsidemarketforenginesandsolveforP:
PE,M10,000600$9400.
Finally,setthe$8800transferpriceequaltothenetmarginalrevenuefromthesalestothe
downstreamdivision:
880012,0002QE,orQE1600.
Thus,1600enginesshouldbesoldtothedownstreamdivisionforuseintheproductionof1600cars.
Todeterminethesalepriceofthecars,substitute1600intothedemandcurveforautomobiles:
P20,0001600$18,400.
Todeterminethelevelofprofitsforeachdivision,subtracttotalcostsfromtotalrevenue:
E[($8800)(1600)($9400)(600)]2(2200)2$10,040,000,
and
A($18,400)(1600)(80008800)(1600)$2,560,000.
Totalprofitsareequaltothesumoftheprofitsfromthetwodivisions,or
T$12,600,000.
Thetablebelowgivesprofitsearnedbyeachdivisionandthefirmforeachcase.

Upstream Downstream
Profitswith Division Division Total
(a)Nooutsidemarket 8,000,000 4,000,000 12,000,000
(b)Competitivemarket 4,500,000 9,000,000 13,500,000
(c)Monopolizedmarket 10,000,000 2,600,000 12,600,000

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Theupstreamdivision,buildingengines,earnsthemostprofitwhenithasamonopolyonengines.
Thedownstreamdivision,buildingautomobiles,earnsthemostwhenthereisacompetitivemarket
forengines.Becauseofthehighcostofengines,thefirmdoesbestwhenenginesareproducedatthe
lowestcostbyanoutside,competitivemarket.

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