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S O L U T I O N S T O2 . 3 SC OEN SLU MEE RCC HTO IEC EDW I T HPCRO MO
POSITE GOODS
BLEMS

CHAPTER 1 d) Because you may choose the plan, the plans are endoge-
nous. Note, though, that the details of the individual plans
1.1. While the claim that markets never reach an equilib- are exogenous.
rium is probably debatable, even if markets do not ever
e) Because you may choose the plan and the plans imply a
reach equilibrium, the concept is still of central importance.
total cost given a fixed level of videos, you are implicitly
The concept of equilibrium is important because it provides
choosing the level of total expenditure. Total expenditures
a simple way to predict how market prices and quantities
are therefore endogenous.
will change as exogenous variables change. Thus, while we
may never reach a particular equilibrium price, say because
a supply or demand schedule shifts as the market moves to- CHAPTER 2
ward equilibrium, we can predict with relative ease, for exam- 2.1. a) When the price of nuts goes up, quantity de-
ple, whether prices will be rising or falling when exogenous manded falls for all levels of price (demand shifts left). Beer
market factors change as we move toward equilibrium. As and nuts are demand complements.
exogenous variables continue to change we can continue to
b) When income rises, quantity demanded increases for all
predict the direction of change for the endogenous vari-
levels of price (demand shifts rightward).
ables, and this is not “useless.’’
c)
1.13. a) With I1 ! 20, we had Q s ! P and Q d ! 30 " P,
which implied an equilibrium price of 15.
With I2 ! 24, we have Q s ! P and Q d ! 34 " P. Find-
ing the point where Q s ! Q d yields
Q s ! Qd P, price
P ! 34 " P 800
2P ! 34
P ! 17
b) Plugging the result from part a) into the equation for Q s
reveals the new equilibrium quantity is Q ! 17. 1600
1.14. a) Formulate each plan as a function of V, the number Q, quantity
of videos to rent. 2.3. a)
TCA ! 3V
TCB ! 50 # 2V
TCC ! 150 # V
Then we have
P, price

300
TCA (75) ! 225
TCB (75) ! 200
S
TCC (75) ! 225
Plan B provides the lowest possible cost of $200 if you will 50
purchase 75 videos. D
300 500 600
b) TCA(125) ! 375
Q, quantity
TCB (125) ! 300
TCC (125) ! 275 b) 600 " 2P ! 300 # 4P
300 ! 6P
Plan C provides the lowest possible cost of $275 if you will
purchase 125 videos. 50 ! P
c) In this case, the number of videos rented is exogenous Plugging P ! 50 back into either the supply or demand
because we are choosing a plan given a fixed level of videos. equation yields Q ! 500.

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750 S O L U T I O N S TO S E L E C T E D P R O B L E M S

2.11. a) When P ! 300, Q d ! 19,400. This implies an elasticity


equal to
S
300
!Q,P ! "2a b ! "0.0309
19,400
S'
P 2.28. The scare in 1999 would shift demand to the left,
identifying a second point on the supply curve. The infor-
PC

mation implies that price fell $0.50 while quantity fell 1.5
P' million. This implies

".5 1
b! !
D "1.5 3
Using a linear supply curve we then have
Q Q'
1
Q, quantity P ! a # Qs
3

An increase in rainfall will increase supply, lowering the 1


5!a# (4)
equilibrium price and increasing the equilibrium quantity. 3
b) 11
a!
3
Finally, plugging these values for a and b into the supply
equation results in
S
11 1
P! # Qs
P 3 3
3P ! 11 # Q s
P'
Q s ! "11 # 3P
PC

The floods in 2000 will reduce supply. The shift in supply


D
will identify a second point along the demand curve. Be-
D' cause the scare of 1999 is over, assume that demand has re-
turned to its 1998 state. The changes in price and quantity
Q' Q in 2000 imply that price increased $3.00 and that quantity
fell 0.5 million.
Q' quantity
Performing the same exercise as above we have

A decrease in disposable income will reduce demand, shift- 3


"b ! ! "6
ing the demand schedule left, reducing both the equilib- "0.5
rium price and quantity.
Using the 1998 price and quantity information along with
d
2.21. a) QU ! 10,000 " 100(300) # 99(300) this result yields
d
QU ! 9700 P ! a " bQ d
Using PU ! 300 and QdU ! 9700 gives 5 ! a " 6(4)
300 a ! 29
!Q,P ! "100 a b ! "3.09
9700 Finally, plugging these values for a and b into a linear de-
b) Market demand is given by Q d ! Q dU # QAd . Assuming mand curve results in
the airlines charge the same price we have P ! 29 " 6Q d
d
Q ! 10,000 " 100PU # 99PA # 10,000 " 100PA # 99PU 6Qd ! 29 " P
d
Q ! 20,000 " 100P # 99P " 100P # 99P 29 1
Qd ! " P
Q d ! 20,000 " 2P 6 6
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CHAPTER 3 e, f )

3.4. a) Since U increases whenever x or y increases, more


of each good is better. This is also confirmed by noting that
MUx and MUy are both positive for any positive values of x
and y.
b) Since MUx ! (1/2)1x , as x increases (holding y con-
stant), MUx falls. Therefore the marginal utility of x is
diminishing. However, MUy ! 1x. As y increases, MUy is

Y
constant. Therefore the preferences exhibit a constant, not
diminishing, marginal utility of y.
3.6.
U1 U2

3.18. a) Yes, the “more is better” assumption is satisfied


Sweet'N Low

for both goods since U(x, y) increases when the amount of


Chill

either good increases.


b) The marginal utility of x is positive but declines as the
U2
consumer buys more x.
U1 U1 U2
.4( y0.6/x0.6) 0.4y
(a) Hot Dogs (b) Sugar c) MRSx, y ! !
.6(x0.4/y0.4) 0.6x
d) As the consumer substitutes x for y, the MRSx,y will
decline.
e) See figure.
Ice Cream

U2
f ) See figure.
Jelly

2 U2 U1
160
1 U1
140 U2
2 4 Nuts
(c) Peanut Butter (d) 120
100
U1 80
Y

U2 60
U1
Liver

40
20

0 5 10 15 20 25 30 35
(e) Apples X

3.20. a) Yes, the “more is better” assumption is satisfied


for both goods since U(x, y) increases when the amount of
3.15. a) Yes, the “more is better” assumption is satisfied either good increases.
for both goods since U(x, y) increases when the amount of b) The marginal utility of x is positive and increases as the
either good increases. consumer buys more x.
b) The marginal utility of x remains constant at 3. 2x x
c) MRSx, y ! !
c) MRSx, y ! 3 2y y
d) The MRSx, y remains constant moving along the indif- d) As the consumer substitutes x for y, the MRSx, y will
ference curve. increase.
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752 S O L U T I O N S TO S E L E C T E D P R O B L E M S

CHAPTER 4 consumer spent $12. By giving up one unit of clothing the


consumer saves $2 which can than be used to purchase two
4.3. a) See figure. units of food (they each cost $1). This will result in a new
basket (6, 3), total utility of 18, and spending of $12. By re-
allocating spending toward the good with the higher “bang
30 for the buck” the consumer increased total utility while re-
25 maining within the budget constraint.
20 4.6. If Jane is currently at an optimum, the tangency con-
Clothing

dition must hold. In particular, it must be the case that


15
Optimum at F = 6, C = 3.
10 MUH PH
"
MUM PM
5
From the given information we know that PH " 3, PM " 1,
and MRSH,M " 2. Plugging this into the condition above
0 5 10 15 20 25 30 35
Food implies
3
2 6
1
b) The tangency condition implies that
Since these are not equal, Jane is not currently at an opti-
MUF PF mum. In addition, since the “bang for the buck” from milk-
" shakes is greater than the “bang for the buck” from
MUC PC
hamburgers, Jane can increase her total utility by reallocating
Plugging in the known information results in her spending to purchase fewer hamburgers and more
C 1 milkshakes.
"
F 2 4.13. a)
2C " F
Substituting this result into the budget line, F ! 2C " 12,
yields 10,000

2C ! 2C " 12
4C " 12 A
Other

C"3
Finally, plugging this result back into the tangency condi- 5,000
tion implies F " 6. At the optimum the consumer chooses
6 units of food and 3 units of clothing. C
c) At the optimum, MRSF, C " C/F " 3/6 " 1/2. Note that B
this is equal to the ratio of the price of food to the price of
10 35
clothing. This is seen in the graph above as the tangency
Round Trips
between the budget line and the indifference curve for
U " 18.
d) The tangency condition requires b) Toni is better off with the frequent-flyer program than
she would be without it at point B. Without the frequent-
MUF MUC
" flyer program the best she could achieve is point C on an
PF PC extension of the budget line without the program with a
If the consumer purchases 4 units of food and 4 units of lower level of total utility. With this set of indifference
clothing, then curves she is better off with the program.
MUF MUC c) Toni is no better off with the frequent-flyer program
7 than she would be without it at point A. At this point, her
PF PC
indifference curve is tangent to a portion of the budget line
This implies that the consumer could reallocate spending where the frequent-flyer program does not apply (less than
by purchasing more food and less clothing to increase total 10 round trips). With this set of indifference curves she is
utility. In fact, at the basket (4, 4) total utility is 16 and the no better off with the program.
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4.21. b) Yes, clothing is a normal good. Holding Py constant, if I


increases y will also increase. See figure.
160.00
140.00 D2
120.00
B

Price (Y )
100.00
C 80.00
Other

60.00
D1
A 40.00
BL2 20.00
BL1 0.00
0 5 10 15 20 25
Y
c) The cross-price elasticity of demand of food with respect
to the price of clothing must be zero. Note in part (a) that
H
with this utility function the demand for y does not depend
With the initial budget line, BL1, Sally chooses point A. on the price of x. Similarly, the demand for x does not de-
When her incomes increases and the price of housing in- pend on the price of y. In fact, the consumer divides her in-
creases, the budget line rotates to BL2 at which time she come equally between the two goods regardless of the price
chooses point B. From this information we can deduce that of either. Since the demands do not depend on the prices of
! the other goods, the cross-price elasticity must be zero.
B A. This is true because (1) B is at least as preferred as
C since B was chosen when C cost the same amount as B, 5.9. a)
and (2) C is strictly preferred to A since C lies to the northeast
of A. By transitivity, B must be strictly preferred to A.

CHAPTER 5
5.2.
B B
Y

Y
100
C A A
90
80
70 C
Income

60
50
40 X X
30
20 Income Substitution Income Substitution
10 effect effect effect = 0 effect
(a) (b)
0 2 4 6 8 10 12
Clothing

5.6. a) At the consumer’s optimum we must have


MUx MUy
"
Px Py
y x B
Y

" B
Px Py A A
C
Substituting into the budget line, Px x ! Py y " I, gives
C
Py
Px a y a b b ! Py y " I
Px X
X
2Py y " I
Income Substitution Income Substitution
I effect effect effect effect
y"
2Py (c) (d)
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754 S O L U T I O N S TO S E L E C T E D P R O B L E M S

5.15. a) b) Yes, the values will be $30. When the income consump-
tion curve is vertical, the consumer’s utility function has no
income effect. As stated in the text, when there is no income
effect, compensating and equivalent variation will be
identical and these will also equal the consumer surplus
measured as the area under the demand curve.
Doughnuts

B
CHAPTER 6
BL1
6.4. a)

A AP and MP with K = 600


BL2 200,000
100,000 AP
0

AP, MP
Coffee –100,000 100 200 300 400 500 600 700

In the diagram above, the consumer consumes the same –200,000


amount of coffee and more doughnuts after the price of –300,000
MP
coffee falls. –400,000 Labor
b) No, this behavior is not consistent with a quasi-linear
utility function. While it is true that there is no income ef-
fect with a quasi-linear utility function, the substitution Total Product with K = 600
40,000,000
effect would still induce the consumer to purchase more
Total Product

coffee when the price of coffee falls. 30,000,000


20,000,000
5.27. a) If the income consumption curve is vertical, the
utility function has no income effect. This will occur, for ex- 10,000,000
ample, with a quasi-linear utility function. This utility func-
tion will have the same marginal rate of substitution for any 0 200 400 600 800
particular value of tea regardless of the level of total utility. If Labor
the price of tea falls, flattening the budget line, the consumer
will reach a new optimum where the marginal rate of substi- Based on the figure, it appears that the average product
tution is equal to the slope of the new budget line. Since the reaches its maximum at Q ! 300. The marginal product
budget line has flattened, this cannot occur at the previous curve appears to reach its maximum at Q ! 200.
optimum amount of tea. The substitution effect implies that b)
this new optimum level of tea will be greater than the previ-
ous level. Thus, when the price of tea falls, the quantity of tea
demanded increases, implying a downward sloping demand Total Product with K = 1200
300,000,000
curve. This can be seen in the following figure.
Total Product

200,000,000

100,000,000
Income consumption
curve 0 500 1000 1500
Labor
Other

AP and MP with K = 1200


1,000,000
Level of tea 500,000
consumption increases AP
0
AP, MP

–500,000 200 400 600 800 1000 1200 1400


Price of tea falls
–1,000,000
–1,500,000
MP
–2,000,000 Labor
Tea
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Based on the figure, it appears that the average product These L-shaped isoquants imply that once you have the
curve reaches its maximum at Q ! 600. The marginal product correct combination of inputs, say 2 frames and 4 tires, ad-
curve appears to reach its maximum at Q ! 400. ditional units of one resource without more units of the
c) In both instances, for low values of L the total product other resource will not result in any additional output.
curve increases at an increasing rate. So in both cases the b) Mathematically, this production function can be written
production function exhibits increasing marginal returns to
L over some range. 1
Q ! min aF, Tb
6.5. a) Incorrect. When MP " AP we know that AP is in- 2
creasing. When MP # AP we know that AP is decreasing. where F and T represent the number of frames and tires.
b) Incorrect. If MP is negative, MP # AP. This only implies
that AP is falling. In fact, AP can never be negative because 6.21. a) To determine the nature of returns to scale, in-
total product can never be negative. crease all inputs by some factor $ and determine if output
c) Incorrect. Average product is always positive, so this tells goes up by a factor more than, less than, or the same as $.
us nothing about the change in total product.
Ql ! 50 2lMlL ' lM ' lL
d) Incorrect. If total product is increasing, we know that
MP " 0. If diminishing marginal returns have set in, however, ! 50l 2ML ' lM ' lL
marginal product will be positive but decreasing. ! l [502ML ' M ' L]
6.10. ! lQ
By increasing the inputs by a factor of $, output goes up
7.0 by a factor of $. Since output goes up by the same factor as
6.0 Q = 50 the inputs, this production function exhibits constant re-
turns to scale.
5.0
Q = 10 (b) The marginal product of labor is
Capital

4.0
Q = 20
3.0 M
MPL ! 25 '1
2.0 BL
1.0 Suppose M " 0. Holding M fixed, increasing L will have
0.0 the effect of decreasing MPL. The marginal product of
0 20 40 60 80 labor is decreasing for all levels of L. The MPL, however, will
Labor never be negative since both components of the equation
above will always be greater than or equal to zero. In fact,
Because these isoquants are convex to the origin, they do for this production function, MPL ( 1.
exhibit diminishing marginal rate of technical substitution. 6.24. a) For a CES production function of the form
6.17. a) The isoquants for this situation will be L-shaped s&1 s&1
s&1
s
as in the following diagram Q ! c aL s ' bK s d
the elasticity of substitution is %. In this example we have a
CES production function of the form

Q ! [K 0.5 ' L0.5 ] 2


6 Q=3
To determine the elasticity of substitution, either set
(! & 1)/! ! 0.5 or !/( ! & 1) ! 2 and solve for !.
Tires

4 Q=2 s&1
! 0.5
s
s & 1 ! 0.5s
2 Q=1
0.5s ! 1
s!2
1 2 3
Frames In either case, the elasticity of substitution is 2.
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756 S O L U T I O N S TO S E L E C T E D P R O B L E M S

(b) Ql " [ (lK )0.5 # (lL)0.5 ] 2 MPK MPL MPK MPL


" and "
" [ (l )(K0.5 0.5
# L )] 0.5 2 r1 w1 r2 w2
0.5 0.5 2 Unless these pairs of prices are proportional, it is not possible
" l[ K #L ]
" lQ for both of these equations to hold. Therefore, it is not
possible for the expansion paths to cross unless the prices
Since output goes up by the same factor as the inputs, this are proportional, in which case the two expansion paths will
production function exhibits constant returns to scale. be identical.
(c) Ql " [100 # (lK )0.5 # (lL)0.5 ] 2 7.8. At the optimum
" [100 # l0.5(K0.5 # L0.5)] 2
2
MPK MPL
100 "
" lc # K 0.5 # L0.5 d 6 lQ r w
l0.5
For this example, that implies
When the inputs are increased by a factor of !, output goes
up by a factor less than !, implying decreasing returns to [ L1/2 # K 1/2 ]K $1/2 [ L1/2 # K 1/2 ] L$1/2
scale. Intuitively, in this production function, while you can "
r w
increase the K and L inputs, you cannot increase the
1 1
constant portion. So output cannot go up by as much as the "
inputs. r2K w 2L
w2L " r 2K
K w2
CHAPTER 7 L
" 2
r
7.4. At the optimum we must have Given that w " 10 and r " 1, this implies
MPK MPL K
" 100 "
r w L
In this problem we have 100L " K

200 1000 Returning to the production function and assuming


7 Q " 121,000 yields
0.25 10
800 7 100 121,000 " [L1/2 # K 1/2) ] 2
121,000 " [L1/2 # (100L)1/2 ] 2
This implies that the firm receives more output per dollar
spent on an additional machine hour of fermentation capacity 121,000 " [L1/2 # 10L1/2 ] 2
than for an additional hour spent on labor. Therefore, 121,000 " [11L1/2 ] 2
the firm could lower cost while achieving the same level 121,000 " 121L
of output by using fewer hours of labor and more hours of
fermentation capacity. 1000 " L
Since K " 100L, K " 100(1000) " 100,000. The cost-
7.7. No, if the MRTS is diminishing, the expansion path
minimizing quantities of capital and labor to produce
for different input price combinations cannot cross. To un-
121,000 airframes is K " 100,000 and L " 1000.
derstand why, imagine for the moment that they did cross
at some point. Recall that the expansion path traces out the 7.13. The tangency condition requires
cost-minimizing combinations of inputs as output increases. MPL w
Essentially the expansion path traces out all of the tangencies "
MPK r
between the isocost lines and isoquants. These tangencies
occur at the point where For this production function, MPK " L and MPL " K.
Therefore
MPL w
"
MPK r K w
"
L r
If the expansion paths cross at some point, then the cost-
minimizing combination of inputs must be identical with w
K " a bL
both sets of prices. This would require that r
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Substituting into the production function yields 8.14. a) Starting with the tangency condition we have
Q ! LK MPL w
!
w MPK r
Q ! La b L
r [ L1/2 " K 1/2 ] L%(1/2) 2
!
w [ L1/2 " K 1/2 ]K %(1/2) 1
Q ! a b L2
r K
!4
r Q 1/2 L
L!a b
w K ! 4L
This represents the input demand curve for L. Since Plugging this into the production function yields
w Q ! [ L1/2 " (4L)1/2 ] 2
K ! a bL
r Q ! [ 3L1/2 ] 2
we have Q ! 9L
1/2 Q
w rQ
K ! a ba b L!
r w 9
wQ 1/2 Inserting this back into the solution for K above gives
!a b
r 4Q
K!
This represents the input demand curve for K. 9
Q 4Q 2Q
CHAPTER 8 b) TC ! 2a b " !
9 9 3
8.5. Starting with the tangency condition, we have TC 2Q 2
c) AC ! ! a b 'Q !
MPL Q 3 3
w
! d) When Q # 9, the firm needs no labor. If Q $ 9, the firm
MPK r
does hire labor. Setting K ! 9 and plugging in for capital
K 2
! in the production function yields
L 1
Q ! [ L1/2 " 91/2 ] 2
K ! 2L
Q1/2 ! L1/2 " 3
Substituting into the production function yields
L1/2 ! Q1/2 % 3
Q ! LK L ! [ Q1/2 % 3] 2
Q ! L(2L)
Thus,
Q
L! (Q1/2 % 3)2 when Q 7 9
B2 L! e
0 when Q & 9
Plugging this into the expression for K above gives
2(Q1/2 % 3)2 " 9 when Q 7 9
Q e) TC ! e
K!2 9 when Q & 9
B2
Graphically, short-run and long-run total costs are shown
Finally, substituting these into the total cost equation in the figure.
results in
30.00
Q Q
TC ! 2a b " 2a b 25.00
B2 B2
Total Cost

20.00 SRTC
Q 15.00
! 4a b ! 28Q
B2 10.00
and average cost is given by 5.00 LRTC
TC 28Q 8
AC ! ! ! 0 5 10 15 20 25 30
Q Q BQ Q
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8.27. See figure. Since each of these short-run average cost b) Ron’s profit is given by ! ! TR # TC.
curves reaches a minimum at an average cost of 2.0, the p ! 20(50) # (40 " 10(50) " 0.10(50)2) ! 210
long-run average cost curve associated with these short-run
curves will be a horizontal line, tangent to each of these c)
curves, at a long-run average cost of 2.0.
2500
2000

TR, TC Profit
3 1500 TR
3 1000 STC
2
500 Profit
Cost

2
SAC10 SAC20 SAC30 0
1
–500 20 40 60 80 100 120
1 Q
0 35
0 15 30 45 60 SMC
30
Q
25 SAC

Profit, MC
20 Price
15
8.28. With some inputs fixed, it is likely that the fixed level 10
is not optimal given the firm’s size. Therefore, it may be 5
more expensive to produce additional units in the short run 0
than in the long run when the firm can employ the optimal 0 20 40 60 80 100 120
(i.e., cost minimizing) quantity of the fixed input. Q

8.30. Economies of scope exist if


TC(Q1, Q2) # TC(Q1, 0) 6 TC(0, Q2) # TC(0, 0) d) First, find the minimum of AVC by setting AVC ! SMC.

In this case 10Q " 0.1Q2


AVC ! ! 10 " 0.1Q
Q
TC(Q1, Q2) ! 1000 " 2Q1 " 3Q2
10 " 0.1Q ! 10 " 0.2Q
TC(Q1, 0) ! 1000 " 2Q1
Q!0
TC(0, Q2) ! 1000 " 3Q2
TC(0, 0) ! 0 The minimum level of AVC is thus 10. For prices
below 10 the firm will not produce, and for prices above 10
So, economies of scope exist if supply is found by setting P ! SMC.
(1000 " 2Q1 " 3Q2) # (1000 " 2Q1) 6 1000 " 3Q2 P ! 10 " 0.2Q
3Q2 6 1000 " 3Q2
Q ! 5P # 50
Yes, in this case the cost of adding a movie channel when
The firm’s short-run supply curve is thus
the firm is already providing a sports channel is less costly
(by $1,000) than a new firm supplying a movie channel 0 if P 6 10
s (P ) ! e
from scratch. Economies of scope exist for this satellite TV 5P # 50 if P % 10
company.
e) If all fixed costs are nonsunk, as in this case, the shut-
down rule is P $ SAC.
STC 40
SAC ! ! " 10 " 0.1Q
CHAPTER 9 Q Q
The minimum point of SAC occurs where SAC ! SMC.
9.9. a) In order to maximize profit, Ron should operate at
the point where P ! MC. 40
" 10 " 0.1Q ! 10 " 0.2Q
20 ! 10 " 0.20Q Q
Q ! 50 Q ! 20
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The minimum level of SAC is thus 14. For prices below 14, d) Since each firm is producing 9 units, to double the number
the firm will not produce. For prices above 14, supply is of firms in the market to 200, total demand would need to be
found by setting P ! SMC as before. 1800 units. This implies 1800 ! A " 100P. Since P ! 13,
0 if P 6 14 1800 ! A " 100(13)
s (P ) ! e
5P " 50 if P $ 14 A ! 3100
9.10. a) First, find the minimum of AVC by setting AVC ! With A ! 3100, the number of firms in the industry would
SMC. double.
TVC Q2 9.35. a) Minimum efficient scale occurs at the point where
AVC ! !
Q Q average cost reaches a minimum. This point occurs where
MC ! AC.
AVC ! Q
Q ! 2Q ! 0 144
2Q ! #Q
Q
The minimum level of AVC is thus 0. When the price is 0
the firm will produce 0, and for prices above 0 find supply Q ! 12
by setting P ! SMC. At Q ! 12,
P ! 2Q 144
AC ! # Q ! 24
1 Q
Q! P
2 b) In the long-run, the equilibrium price will be deter-
mined by the minimum level of average cost of firms with
Thus,
average CEOs. Thus, P ! 24. At this price, firms having av-
1 erage CEOs will earn zero economic profit and firms with
s (P ) ! P
2 exceptional CEOs will earn positive economic profit.
b) Market supply is found by horizontally summing the c) At the price, the firms with an average CEO will pro-
supply curves of the individual firms. Since there are 20 duce where P ! MC
identical producers in this market, market supply is given by 24 ! 2Q
S (P ) ! 20s (P ) ! 10P Q ! 12
c) Equilibrium price and quantity occur at the point where The firms with an exceptional CEO will also produce
S(P ) ! D(P). where P ! MC

10P ! 110 " P Q ! 24


P ! 10 d) At this price, D(P ) ! 7200 " 100P ! 4800.
Substituting P ! 10 back into D(P ) implies equilibrium e) Since there are 100 exceptional CEOs and assuming
quantity is Q ! 100. So at the equilibrium, P ! 10 and they are all employed, the total supply from exceptional
Q ! 100. CEO firms will be SE ! 100(24) ! 2400.
This leaves Q ! 4800 " 2400 ! 2400 units to be sup-
9.24. a) In a long-run equilibrium all firms earn zero eco- plied by firms with average CEOs. Thus,
nomic profit implying P ! AC, and each firm produces
2400
where P ! MC. Thus, NA ! ! 200
12
1
40 " 12Q # Q2 ! 40 " 6Q # Q2 f ) To calculate the exceptional CEO’s economic rent, we
3 must compute the highest salary the firm would pay this
Q!9 CEO. This salary is the amount that would drive eco-
nomic profit to zero. Call this amount S*. Since the
If Q ! 9, P ! 40 " 12(9) # 92 ! 13.
exceptional CEO firm is producing Q ! 24, the firm’s
b) At P ! 13, each firm will produce Q ! 9 units. average cost is
c) Since D(P) ! 2200 " 100P, 144 1
AC ! # (24) ! 18
D(P ) ! 2200 " 100(13) ! 900 24 2
If each firm produces 9 units, the market will have 100 Since P ! 24, the exceptional CEO has produced a $6 per
firms in equilibrium. unit cost advantage. This implies
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760 S O L U T I O N S TO S E L E C T E D P R O B L E M S

S* 144 10.17. a) Setting Q d " Q s results in


# "6
24 24
10 # P " #4 % P
S* " 288
P " $7 per bushel
Economic rent is the difference between this salary,
Substituting this result into the demand equation gives
$288,000, and the reservation wage of $144,000. Thus, the
Q " 3 million bushels.
exceptional CEO’s economic rent is $144,000.
b) At the equilibrium, consumer surplus is (1/2) $
g) Firms that hire exceptional CEOs for $144,000 will gain
(10 # 7)3 " 4.5 and producer surplus is (1/2) $
all of the CEO’s economic rent and will therefore earn eco-
(7 # 4)3 " 4.5 (both measured in millions of dollars).
nomic profit of $144,000.
There is no deadweight loss in this case, and total net ben-
h) In a long-run competitive equilibrium, exceptional CEO efits equal $9 million. See figure; area A represents con-
salaries should be bid up as other firms attempt to split the sumer surplus, and area B represents producer surplus.
economic rent with the CEOs. Thus firms should bid up the
salary of the CEOs until economic profits for firms with ex- 15.00
ceptional CEOs are driven to zero. Thus, exceptional CEO
salaries should approach $288,000 in a long-run equilibrium.
10.00 Demand Supply
CHAPTER 10 A

Price
7.00
10.1. a) The market will clear. The excise tax will alter B
5.00
equilibrium price and quantity, but there will be no excess 4.00
demand or excess supply.
b) The market will clear. The subsidy will alter equilibrium
0.00
price and quantity, but there will be no excess demand or 0 2 4 6 8 10
excess supply. Quantity (millions of bushels)
c) The market will not clear. A price floor set above the
equilibrium price will create excess supply. c) If the government imposes an excise tax of $2, the new
d) The market will not clear. A price ceiling set below the equilibrium will be
equilibrium price will create excess demand. 10 # (P s % 2) " #4 % P s
e) The market will not clear. A quota limiting output below
P s " $6 per bushel
the equilibrium level will create excess supply since the
price will be driven above the equilibrium price. Since P d " P s % 2, we have P d " 8, and substituting P s into
the supply equation implies Q " 2 million.
10.3. The incidence of a tax can be summarized quantita-
tively by d) Now the consumer surplus is (1/2)(10 # 8)2 " 2, the
producer surplus is (1/2)(6 # 4)2 " 2, the tax receipts are
¢P d !Q s, P 2(2) " 4, and the deadweight loss is (1/2)(8 # 6) (3 # 2) " 1
s "
¢P !Q d, P (all measured in millions of dollars). See figure; area A rep-
resents consumer surplus, area B represents producer sur-
From the given information, !PD " 4, !PS " 0, and
plus, areas C % D represent government tax receipts, and
ED " #0.5. These price changes imply that 100% of the
area E represents the deadweight loss.
burden of the tax is borne by the consumer, implying the
elasticity of supply must be equal to infinity. Supply is per-
fectly elastic. 14.00
Supply + 2
10.11. The height of the deadweight loss triangle is the tax 12.00
T. The length of the deadweight loss triangle is the reduc- 10.00 Demand
tion in quantity due to the tax, relative to the no-tax equi- A
8.00 Supply
librium. With a linear demand curve and a linear supply
Price

C D E
curve, this reduction in quantity, !Q, varies in linear pro- 6.00
portion to the change in the tax, i.e., !Q " kT, where k is a B
4.00
constant whose value depends on the slopes of the demand
and supply curves. Thus, the area of the deadweight loss 2.00
triangle due to the tax is kT 2. If T doubles, the deadweight 0.00
loss will become k(2T ) 2 " 4kT 2, and so the deadweight loss 0 2 3 4 6
will go up by a factor of 4. Quantity (millions of bushels)
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e) If the government provides a subsidy of $1, the new Tax Minimum Price
equilibrium will be
What area represents the B B#C#E
10 " (P s " 1) ! "4 # P s largest producer surplus
P s ! $7.5 per bushel under the policy?
Substituting back into the equation for P d yields P d ! 6.5, What area represents the B G#H#L#T
and substituting P s into the supply equation implies Q ! smallest producer surplus
3.5 million. under the policy?
f ) Now the consumer surplus is (1/2)(10 " 6.5)3.5 ! What area represents C#E Zero
6.125; the producer surplus is (1/2)(7.5 " 4)3.5 ! 6.125; government receipts?
the subsidy paid is "1(3.5) ! "3.5 (negative since the gov- What area represents G#L G#L
ernment is paying this amount); and the deadweight loss is smallest deadweight loss
(1/2)(7.5 " 6.5)(3.5 " 3) ! 0.25 (all measured in millions of possible under the policy?
dollars). See figure; areas A # B # E represent consumer
If demand is perfectly inelastic, the demand curve will be a
surplus, areas B # C # F represent producer surplus, areas
vertical line. The price will rise by exactly $2 after the tax is
B # C # D # E represent the government subsidy pay-
imposed and consumers will take on 100 percent of the tax
ment, and area D represents the deadweight loss.
burden. Consumer surplus will fall by $2 times the market
quantity, which will be the same as the pretax quantity given
12.00
the vertical demand curve. Government tax receipts will in-
Demand Supply crease by $2 times the market quantity, completely offset-
10.00 C
ting the reduction in consumer surplus. Producer surplus
8.00 A will remain the same because consumers have 100 percent
B Supply – 1 of the burden of the tax. Thus, since government receipts
Price

6.00
F completely offset the reduction in consumer surplus, there
D is nothing lost to society. There is no deadweight loss from
4.00 E an excise tax when the demand curve is perfectly inelastic.
2.00

0.00
0 2 3.5 4 6
CHAPTER 11
Quantity (millions of bushels)
11.1. a) If demand is given by Q ! 100 " 5P, inverse
demand is found by solving for P. This implies inverse
demand is P ! 20 " (1/5)Q.
g) For part b, potential net benefits are 4.5 # 4.5 # 0 # b) Average revenue is given by
0 ! 9; for part d, potential net benefits are 2 # 2 # 4 #
1 ! 9; and for part f, potential net benefits are 6.125 # TR PQ
AR ! ! !P
6.125 " 3.5 # 0.25 ! 9. Thus, in each case, potential net Q Q
benefits are the same (and, as above, all are measured in
Therefore, average revenue will be P ! 20 " (1/5)Q.
millions of dollars).
c) For a linear demand curve P ! a " bQ, marginal rev-
10.21. a) Based on the graph, the government would need
enue is given by MR ! a " 2bQ. In this instance demand is
to set a tax of $2.00 per unit to achieve the government’s tar-
P ! 20 " (1/5)Q, implying marginal revenue is MR !
get of 600 units sold. By setting a tax at $2.00, the supply
20 " (2/5)Q.
curve will shift upward by $2.00 and intersect the demand
curve at P ! $3.00 and Q ! 600, the new market equilibrium. 11.6. If marginal cost is independent of Q, then marginal
b) cost is constant. Assume MC ! c. Then in the winter the
firm will produce where MR ! MC.
Tax Minimum Price
a1 " 2bQ ! c
What price per unit would $3.00 $3.00 a1 " c
consumers pay? Q!
2b
What price per unit would $1.00 $3.00
producers receive? At this quantity the price charged will be
What area represents F F a1 " c a1 # c
P ! a1 " b a b!
consumer surplus? 2b 2
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In the summer the firm will also produce where MR ! MC. equal, and since the first plant in this example has a constant
marginal cost of 8, the profit-maximizing solution will
a2 # 2b Q ! c have MC ! 8 at both plants. To compute total output, set
a2 # c MR ! MC. With demand P ! 968 # 20Q, marginal rev-
Q! enue is MR ! 968 # 40Q. This implies
2b
968 # 40Q ! 8
At this quantity the price charged will be
Q ! 24
a2 # c a2 $ c
P ! a2 # b a b! At this quantity, the firm will charge a price of P ! 968 #
2b 2 20(24) ! 488. Therefore, the price for one razor will be
$4.88 and Gillette will supply 24 million blades.
Since we are told that a2 " a1, the price charged during the The allocation between plants will require MC ! 8 at
summer months will be greater than the price charged dur- both plants. At plant 2, MC ! 1 $ 0.5Q2. Setting this equal
ing the winter months. to 8 implies Q2 ! 14. Then, since total output is 24, the
11.12. a) With demand P ! 210 # 4Q, MR ! 210 # 8Q. firm will produce 10 at plant 1.
Setting MR ! MC implies b) If MC ! 10 at plant 1, the setting MR ! MC implies

210 # 8Q ! 10 968 # 40Q ! 10


Q ! 25 Q ! 23.95

With Q ! 25, price will be P ! 210 # 4Q ! 110. At this At this quantity, price will be $4.89. The allocation between
price and quantity, total revenue will be TR ! 110(25) ! plants will require MC ! 10 at both plants. Setting MC !
2750. 10 at plant 1 implies 10 ! 1 $ 0.5Q2 implying Q2 ! 18.
b) If MC ! 20, then setting MR ! MC implies Since total output is 23.95, the firm will produce 5.95 at
plant 1.
210 # 8Q ! 20 11.26. a) With demand P ! 100 # 2Q, MR ! 100 # 4Q.
Q ! 23.75 Setting MR ! MC implies
At Q ! 23.75, price will be P ! 115. At this price and quan- 100 # 4Q ! 0.5Q
tity, total revenue will be TR ! 115(23.75) ! 2731.25.
Therefore, the increase in marginal cost will result in lower Q ! 22.2
total revenue for the firm. At this quantity, price will be P ! 55.6.
c) If all firms in a competitive market had MC ! 10, set- b) With marginal cost pricing the firm sets P ! MC as in a
ting P ! MC (the optimality condition for a perfectly com- competitive environment. In this example
petitive firm) implies
100 # 2Q ! 0.5Q
210 # 4Q ! 10
Q ! 40
Q ! 50
At this quantity, price will be P ! 20.
At this quantity, price will be P ! 10. c) For the monopolist, consumer surplus is 0.5(100 # 55.6)
d) If all firms in a competitive market had MC ! 20, then 22.2 ! 493.83 and producer surplus is 0.5(11.1)22.2 $
setting P ! MC implies (55.6 # 11.1)22.2 ! 1111.11. For the competitive firm, con-
sumer surplus is 0.5(100 # 20)40 ! 1600 and producer surplus
210 # 4Q ! 20 is 0.5(20)40 ! 400. The sum of consumer and producer surplus
Q ! 47.50 under monopoly is 1604.94, and the sum of consumer and pro-
ducer surplus under competition is 2000. Therefore, the dead-
At this quantity, price will be P ! 20. When MC ! 10, TR !
weight loss due to monopoly is 395.06.
10(50) ! 500. With MC ! 20, TR ! 20(47.50) ! 950.
Thus, total revenue increases for the perfectly competitive d) If demand is P ! 180 # 4Q, MR ! 180 # 8Q. The mo-
firm after the increase in marginal cost. nopolist sets MR ! MC, which gives

11.21. a) Since the profit-maximizing firm will always 180 # 8Q ! 0.5Q


allocate output among plants so as to keep marginal costs Q ! 21.18
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At this quantity, price will be 95.29. A competitive firm will ! ! 26. Producer surplus is just total revenue nonsunk cost,
set P ! MC, which gives or, in this case total revenue " total variable cost. Thus,
producer surplus is 75 " 52 ! 50.
180 " 4Q ! 0.5Q
b) With perfect first-degree price discrimination, the firm
Q ! 40 sets P ! MC to determine the level of output.
At this quantity, price will be 20. 20 " Q ! 2Q
With monopoly, consumer surplus will be 0.5(100 "
95.29)21.18 ! 49.88 and producer surplus will be Q ! 6.67
0.5(10.59)21.18 # (95.29 " 10.59)21.18 ! 1906.09. With The price charged to each consumer, however, will vary.
perfect competition, consumer surplus will be 1600 and The price charged will be the consumer’s maximum will-
producer surplus will be 400, as before. Now, the sum of ingness to pay and will correspond with the demand curve.
consumer and producer surplus with perfect competition is Total revenue will be 0.5(20 " 13.33)(6.67) # 13.33(6.67) !
2000 and with monopoly is 1955.97. Therefore, the dead- 111.16. Since the firm is producing a total of 6.67 units,
weight loss in this case is 44.03. total cost will be TC ! 68.49. Profit is then ! ! 42.67,
Although the competitive solution is identical with both while producer surplus is total revenue " total variable cost !
demand curves, the deadweight loss in the first case is far 111.16 " 6.67 ! 66.67.
greater. This difference occurs because with the second de-
c) By being able to employ perfect first-degree price dis-
mand curve demand is less elastic. If consumers are less
crimination, the firm increases profit and producer surplus
willing to change quantity as prices change, the firm will be
by 16.67.
able to extract more surplus from the market. In this exam-
ple, the demand in the second case implies a Lerner Index 12.14. a) With third-degree price discrimination the firm
is 88.9 percent (compared with 80 percent with the first should set MR ! MC in each market to determine price and
demand curve) indicating extensive market power for this quantity. Thus, in Europe setting MR ! MC.
firm.
70 " 2QE ! 10
QE ! 30
CHAPTER 12
At this quantity, price will be PE ! 40. Profit in Europe
12.1. a) Third degree—the firm is charging a different is then !E ! (PE " 10)QE ! (40 " 10)(30) ! 900. Setting
price to different market segments, individuals and li- MR ! MC in the United States implies
braries.
b) First degree—each consumer is paying near his or her 110 " 2QU ! 10
maximum willingness to pay. QU ! 50
c) Second degree—the firm is offering quantity discounts.
As the number of holes played goes up, the average expen- At this quantity, price will be PU ! 60. Profit in the U.S.
diture per hole falls. will then be !U ! (PU " 10)QU ! (60 " 10)(50) ! 2500.
Total profit will be ! ! 3400.
d) Third degree—the firm is charging different prices for
different segments. Business customers (M–F) are being b) If the firm can only sell the drug at one price, it will set
charged a higher price than those using the phone on Sun- the price to maximize total profit. The total demand the
day (e.g., family calls). firm will face is Q ! QE # QU. In this case
e) Second degree—the firm is offering a quantity discount. Q ! 70 " P # 110 " P
f ) Third degree—the airline is charging different prices to Q ! 180 " 2P
different segments. Those who can purchase in advance pay
one price, while those who must purchase with short notice The inverse total demand is then P ! 90 " (1/2)Q.
pay a different price.
Since MC ! 10, setting MR ! MC implies
12.2. a) If price discrimination is impossible, the firm will
set MR ! MC. 90 " Q ! 10
20 " 2Q ! 2Q Q ! 80
Q!5 At this quantity price will be P ! 50. If the firm sets price
At this quantity, price will be P ! 15, total revenue will at 50, the firm will sell QE ! 20 and QU ! 60. Profit will be
be TR ! 75, total cost will be TC ! 49, and profit will be ! ! 50(80) " 10(80) ! 3200.
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c) The firm will sell the drug on both continents under ei- CHAPTER 13
ther scenario. If the firm can price discriminate, consumer
surplus will be 0.5(70 ! 40)30 " 0.5(110 ! 60)50 # 1700 13.5. a) With two firms, demand is given by P # 300 !
and producer surplus (equal to profit) will be 3400. Thus, 3Q1 ! 3Q2. If Q2 # 50, then P # 300 ! 3Q1 ! 150 or
total surplus will be 5100. If the firm cannot price discrim- P # 150 ! 3Q1. Setting MR # MC implies
inate, consumer surplus will be 0.5(70 ! 50)20 " 0.5 150 ! 6Q1 # 100
(110 ! 50)60 # 2000, and producer surplus will be equal to
Q1 # 8.33
profit of 3200. Thus, total surplus will be 5200.
If Q2 # 20, then P # 240 ! 3Q1. Setting MR # MC implies
12.27. a) Without bundling, the best the firm can do is set
the price of airfare at $800 and the price of the hotel at $800. 240 ! 6Q1 # 100
In each case the firm attracts a single customer and earns
Q1 # 23.33
profit of $500 from each, for a total profit of $1,000. The
firm could attract two customers for each service at a price b) For Firm 1, P # (300 ! 3Q2) ! 3Q1. Setting MR # MC
of $500, but it would earn profit of $200 on each customer implies
for a total of $800 profit, less profit than the $800 price.
(300 ! 3Q2) ! 6Q1 # 100
b) With bundling, the best the firm can do is charge a price
of $900 for the airfare and hotel. At this price the firm will Q1 # 33.33 ! 0.5Q2
attract all three customers and earn $300 profit on each, for Since the marginal costs are the same for both firms, sym-
a total profit of $900. The firm could raise its price to $1,000, metry implies Q2 # 33.33 ! 0.5Q1. Graphically, these reac-
but then it would only attract one customer and total profit tion functions appear as shown in the figure.
would be $400. Notice that with bundling the firm cannot do
as well as it could with mixed bundling. This is because while 70
(a) the demands are negatively correlated, a key to increasing 60
profit through bundling, (b) customer 1 has a willingness to
Firm 2 Quantity

50
pay for airfare below marginal cost and customer 3 has a will- Firm 1 reaction function
40
ingness to pay for hotel below marginal cost. The firm
30
should be able to do better with mixed bundling. 22.22 Firm 2 reaction function
20
c) Because customer 1 has a willingness to pay for airfare
10
below marginal cost and customer 3 has a willingness to pay
0
for hotel below marginal cost, the firm can potentially earn
0 20 22.22 40 60 80
greater profits through mixed bundling. In this problem, if the
Firm 1 Quantity
firm charges $800 for airfare only, $800 for hotel only, and
$1,000 for the bundle, then customer 1 will purchase hotel
only, customer 2 will purchase the bundle, and customer 3 will c) In equilibrium, both firms will choose the same level of
purchase airfare only. This will earn the firm $1,400 profit, im- output. Thus, we can set Q1 # Q2 and solve
plying that mixed bundling is the best option in this problem. Q2 # 33.33 ! 0.5Q2
12.29. a) Using the inverse elasticity price rule, which implies Q2 # 22.22.
P ! MC 1 Since both firms will choose the same level of output, both
#! firms will produce 22.22 units. Price can be found by sub-
P !Q, P
stituting the quantity for each firm into market demand.
P ! MC 1 This implies price will be P # 300 ! 3(44.44) # 166.67.
#!
P !3 d) If this market were perfectly competitive, then equilib-
P rium would occur at the point where P # MC # 100.
# 1.5
MC e) If the firms colluded to set the monopoly price, then
The firm should set price at 1.5 times marginal cost. 300 ! 6Q # 100
(b) The optimal advertising-to-sales ratio can be found by Q # 33.33
equating
At this quantity, market price will be P # 300 ! 3(200/6) #
A !Q, A 0.5 200.
#! #! # 0.167
PQ !Q, P !3
f ) If the firms acted as Bertrand oligopolists, the equilib-
Thus, advertising expense should be about 16 or 17 per- rium would coincide with the perfectly competitive equilib-
cent of sales revenue. rium of P # 100.
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g) Suppose Firm 1 has MC ! 100 and Firm 2 has MC ! 90. 40 R


For Firm 1, P ! (300 " 3Q2) " 3Q1. Setting MR ! MC Coke's Reaction
implies 30 Function R'

Pepsi's Price
Pepsi's Reaction
(300 " 3Q2) " 6Q1 ! 100 20 Function
Q1 ! 33.33 " 0.5Q2
10
For Firm 2, P ! (300 " 3Q1) " 3Q2. Setting MR ! MC
implies 0
0 5 10 15 20 25
(300 " 3Q1) " 6Q2 ! 90
Coke's Price
Q2 ! 35 " 0.5Q1
b) When Pepsi’s demand increases, Pepsi’s reaction func-
Solving these two reaction functions simultaneously yields
tion shifts upward. This will have the effect of increasing
Q1 ! 21.11 and Q2 ! 24.44. With these quantities, market
both Coke’s price and Pepsi’s price. See figure.
price will be P ! 163.36.
13.10. a) With four firms, demand is given by P ! 15 " 40
Q1 " Q2 " Q3 " Q4. Let X represent total output for Firms Coke's Reaction
30 Function

Pepsi's Price
2, 3, and 4. Then demand faced by Firm 1 is P ! (15 " X ) "
Pepsi's Reaction
Q1. Setting MR ! MC implies Function
20
(15 " X ) " 2Q1 ! 5
10 R'
Q1 ! 5 " 0.5X
R
Since all firms have the same marginal cost, the solution 0
will be symmetric. Letting Q* represent the optimal output 0 5 10 15 20 25
for each firm, Coke's Price

Q* ! 5 " 0.5(3Q*) 13.29. a) If American sets a price of $200, we can plug this
which implies Q* ! 2. price into United’s demand curve to get United’s perceived
demand curve.
Thus, total industry output will be 8, with each firm pro-
ducing 2 units of output. At this quantity, price will be P ! QU ! 1000 " 2PU # 200
15 " 8 ! 7. Profits for each firm will be ! ! TR " TC ! PU ! 600 " 0.5QU
7(2) " 5(2) ! 4.
To find United’s profit-maximizing price, set MR ! MC.
b) If two firms merge, then the number of firms in the mar-
ket will fall to three. The new quantity for each firm will be 600 " QU ! 10
found by solving
QU ! 590
Q* ! 5 " 0.5(2Q*)
At this quantity, United will charge a price PU ! 600 "
which implies Q* ! 2.5. 0.5(590) ! 305.
Now total industry output will be 7.5, with each of the b) If American sets a price of $400, then United’s perceived
three firms producing 2.5 units. At this quantity, price will demand curve is
be P ! 15 " 7.5 ! 7.5. Profit per firm will be ! ! TR "
QU ! 1000 " 2PU # 400
TC ! 7.5(2.5) " 5(2.5) ! 6.25.
Thus, while profit per firm does increase after the merger, PU ! 700 " 0.5QU
profits do not double and the merger nets the two firms a Equating MR to MC yields
smaller total profit. For each of the two firms not merging,
profit per firm increases after the merger because as the total 700 " QU ! 10
number of firms falls, each individual firm has greater market QU ! 690
power. This greater market power allows the firms to charge
a higher price, produce less, and earn greater profit per firm. At this quantity, United will charge a price PU ! 700 "
0.5(690) ! 355.
13.25. a) When Coca-Cola’s marginal cost increases, c) American’s demand can be rewritten as
Coke’s reaction function will shift away from the origin.
This will have the effect of raising both Coke’s price and 2PA ! (1000 # PU) " QA
Pepsi’s price. See figure. PA ! (500 # 0.5PU) " 0.5QA
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Setting MR ! MC implies From Boeing’s perspective, if it chooses to continue to


play “P ! $10m,” then in every quarter it will receive a
(500 " 0.5PU) # QA ! 10
payoff of 50. If it chooses to lower its price to “P ! $5m,”
QA ! 490 " 0.5PU then in the first quarter it will receive 270. In all subsequent
At this quantity, American will charge a price quarters the best Boeing will be able to do is play “P !
$5m,” as will Airbus, and Boeing will receive 30. Thus,
PA ! (500 " 0.5PU) # 0.5(490 " 0.5PU)
Boeing’s two possible payoff streams look like
! 255 " 0.25PU
Since the firms have identical marginal cost and symmetric P = $5m 270 30 30 .... 30
demand curves, United’s price reaction function will be Boeing
PU ! 255 " 0.25PA. P = $10m 50 50 50 .... 50
d) The Bertrand equilibrium will occur where these price
reaction functions intersect. Substituting the expression for Boeing values a stream of payoffs of $1 starting next quar-
PU into the expression for PA implies ter as a payoff of $40 in the first quarter. Therefore, Boeing
PA ! 255 " 0.25(255 " 0.25PA) values the two payoff streams as
which implies PA ! 340.
Substituting into the expression for PU implies PU ! 340. P = $5m 270 + 40(30) 1470
So, in the Bertrand equilibrium, each firm charges a price P = $10m 50 + 40(50) 2050
of 340 and attracts a quantity of 660.

CHAPTER 14 Therefore, the value of “P ! $10m” in current dollars is


greater, so Boeing should select “P ! $10m” in this quarter
14.4.
and all subsequent quarters.
Pepsi c) Now Boeing values the payoff stream differently. In the
Aggressive Restrained current situation, Boeing values a stream of payoffs of $1
starting next year as equivalent to $10 received immedi-
Aggressive $100, $80 $170, $40
Coke ately. Thus, Boeing will now value this payoff stream as
Restrained $80, $140 $120, $100

In this game, “Aggressive” is a dominant strategy for both P = $5m 270 + 10(30) 570
firms. Thus, the Nash equilibrium strategy for both firms is P = $10m 50 + 10(50) 550
to choose “Aggressive.”
This game is an example of the prisoners’ dilemma. In
this game both players have a dominant strategy that leads Now “P ! $5m” has a higher value in current dollars than
to an outcome that does not maximize the collective payoffs “P ! $10m.” Thus, Boeing should select “P ! $5m” this
of the players in the game. If both players chose the “Re- year, receive the high payoff in the current year, and select “P !
strained” strategy, then both players would increase their $5m” thereafter, receiving a stream of payoffs of 30 each year.
profits and the collective payoff would be maximized.
14.21.
14.19.
Boeing Firm 2
P = $5m P = $10m Aggressive Passive
P = $5m 30, 30 270, 0 Aggressive 25, 9 33, 10
Airbus Firm 1
P = $10m 0, 270 50, 50 Passive 30, 13 36, 12

a) In this game both players have a dominant strategy to


choose “P ! $5m.” Thus, the Nash equilibrium outcome a) If both firms choose simultaneously, then Firm 1 will
occurs when Airbus chooses “P ! $5m” and Boeing choose its dominant strategy, “Passive.” Firm 2, knowing
chooses “P ! $5m.” Firm 1 has a dominant strategy, will assume Firm 1 will play
b) Airbus’s statement implies that it will play “P ! $10m” in this strategy and choose “Aggressive,” the best strategy
this quarter and all subsequent quarters as long as Boeing given Firm 1’s likely choice. The Nash equilibrium, there-
also plays “P ! $10m.” However, if Boeing ever plays “P ! fore, has Firm 1 selecting “Passive” and Firm 2 selecting
$5m,” Airbus will play “P ! $5m” in all future quarters. “Aggressive.”
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S O L U T I O N S TO S E L E C T E D P R O B L E M S 767

Firm 1 Firm 2 d) Utility ! 250(50) ! 50


Aggressive
25 9 The utility associated with the certain payoff of 50 is higher
Aggressive than the expected utility of the lottery with the same ex-
2
Passive pected payoff. Thus, with this utility function the decision
33 10
maker is risk averse, since the decision maker prefers the
1
Aggressive sure thing to a lottery with the same expected payoff.
30 13
Passive 15.12. If your utility function were U ! 2I, then the risk
2
Passive premium associated with Lottery A would be
36 12
0.9020 # 0.102400 ! 240 " R PA
b) If Firm 1 can choose first, then if it chooses “Aggressive” 240 " R PA ! 2
Firm 2 will choose “Passive” and Firm 1 will receive 33. If 40 " R PA ! 4
Firm 1 instead chooses “Passive,” then Firm 2 will select “Ag-
R PA ! 36
gressive” and Firm 1 will receive a payoff of 30. Therefore, if
Firm 1 can move first, it does best to select “Aggressive” in The risk premium associated with Lottery B would be
which case Firm 2 will select its best response “Passive” earn-
ing Firm 1 a payoff of 33 and Firm 2 a payoff of 10. 0.50230 # 0.50250 ! 240 " R PB
240 " R PB ! 6.27
40 " R PB ! 39.36
CHAPTER 15
R PB ! 0.64
15.1. a)
Lottery A has a risk premium of 36 and Lottery B has a risk
0.6 premium of 0.64.
0.5
15.24. a)
Probability

0.4
0.3
0.2 Approves
10
0.1 Sell rights
B
0
–30 –20 –10 0 10 20 30 Does not approve
2
Payoff
A Approves
50
b) EV ! 0.2("10) # 0.5(0) # 0.3(20) ! 4.0
Produce Self
c) Variance ! 0.2("10 " 4)2 # 0.5(0 " 4)2 # 0.3(20 " 4)2 B
Does not approve
Variance ! 124. –10
Standard deviation ! 2Variance ! 2124 ! 11.14
15.5. a) b) The expected payoff for “Sell rights” is 0.20(10) #
0.80(2) ! 3.60. The expected payoff for “Produce yourself ”
120 is 0.20(50) # 0.80("10) ! 2.0. Therefore, the company
100 should sell the rights with an expected payoff of 3.60.
80
Utility

60
CHAPTER 16
40
20
16.1. a) In equilibrium we must have quantity supplied
equal to quantity demanded in both the butter and mar-
0
garine markets. This implies in equilibrium we will have
0 50 100 150 200
I QdM ! QM
s
and QBd ! QBs
Substituting in the given curves implies
b) EV ! 0.75(0) # 0.25(200) ! 50.
c) Expected Utility ! 0.75250(0) # 0.25250(200) 20 " 2PM # PB ! 2PM
! 25 60 " 6PB # 4PM ! 3PB