study guide economics 2

Study Guide

Economics 2

INSTRUCTIONS TO STUDENTS 1

LESSON ASSIGNMENTS 5

LESSON 1: THE ECONOMICS OF THEPUBLIC SECTOR 7

EXAMINATION—LESSON 1 19

LESSON 2: FIRM BEHAVIOR AND MONOPOLIES 23


LESSON 3: OLIGOPOLY, MONOPOLISTIC COMPETITION, AND THE FACTORS OF PRODUCTION 41


LESSON 4: LABOR MARKETS; FURTHERAPPLICATIONS OF MICROECONOMICS 57


ACTIVITY ANSWERS 79

SELF-CHECK ANSWERS 85

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YOUR COURSEWelcome to Economics 2! This course is designed to introduceyou to the world of economics. If you’re not planning onbecoming an economist, you may wonder, why bother learningabout economics? Well, the author of your textbook, Principlesof Microeconomics, offers a few very convincing and practicalreasons. First, you’ll gain a better understanding of the worldin which you live. For instance, after completing this courseyou’ll know why airlines charge less for a round-trip ticket if a traveler stays over a Saturday night and why an NFLquarterback makes so much money. Second, when you havea fundamental knowledge of economics, you’re an informedparticipant in the economy. This knowledge will help you tomake better decisions on how much of your income to spend,how much to save, and how to invest your savings. Third,you’ll be better equipped to make logical voting decisions if youunderstand the potential and limits of economic policy. As avoter, you choose the candidate who makes the policies thatguide the allocation of society’s resources. Economic questionsare considered when making decisions about taxation, welfareprograms, and free trade. As you can see, the principles ofeconomics are useful in many of life’s everyday situations.

OBJECTIVESWhen you complete this course, you’ll be able to

■ Use economic data to measure the cost of living

■ Describe the forces that determine key economic variables

■ Explain the importance of the monetary systems indetermining the long-run behavior of nominal variables

■ Identify the significant factors in a nation’s economicinteractions with other nations

■ Explain short-run economic fluctuations

KNOW YOUR TEXTBOOKYour textbook, Principles of Microeconomics, is the heart ofthis course. It’s very important that you read the material inthe text and study it until you’re completely familiar with it.This is the material that your examinations will be based on.

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Instructions to Students2

Now that you have an idea of what to expect from your course,take a moment to read through the following description ofthe learning materials that you received.

1. Your textbook, Principles of Microeconomics, FourthEdition, by N. Gregory Mankiw, will introduce you to the basic concepts of microeconomics. It contains theassigned readings and review exercises that are assignedas self-checks.

2. This study guide, which includes an introduction to yourcourse and presents a summary of the material you’llcover in each lesson. This guide also contains the following features:

■ An assignments page that lists all of the readingassignments for your textbook

■ Introductions to your lessons

■ Self-checks for each lesson

■ Suggested Activities for each lesson

■ Answers to the self-checks and Suggested Activities (at the back of this study guide)

■ The examinations for your course

A STUDY PLAN

We’ve divided the contents of Principles of Microeconomicsinto four lessons for you to study. You’ll note that the lessonassignments in this study guide begin with Chapter 10. (Thefirst nine chapters in the textbook are identical to the firstnine chapters you studied if you completed the Economics 1course. Before you start this course, you may want to reviewthose chapters.)

For each lesson, you’ll read part of the textbook. Then, you’ll complete an examination on the material you read forthe lesson. This study guide contains a list of your lessonassignments as well as the lesson examinations. Be sure toread all the material in both the textbook and the study guidebefore you attempt to complete your examinations.

Instructions to Students 3

To get the most benefit out of each of your lessons, we suggest that you follow these steps:

Step 1: Start by reading the introduction to Lesson 1 in this study guide. Then, begin to read Assignment 1.This is the first reading assignment of Lesson 1.Pay attention to the new ideas and concepts thatare introduced, and carefully note the pages inyour textbook where the reading assignmentbegins and ends.

Step 2: Very briefly, skim the assigned pages in your textbook to get a general idea of their contents.

Step 3: Now, read the assigned pages in the textbook. Try to see the “big picture” of the material duringthis first reading.

Step 4: Next, go back and study the assigned pages inyour textbook carefully. Pay careful attention to all details, including the graphs that are includedin the textbook. It’s a good idea to take notes onthe important points and terms in a notebook. We also encourage you to enter your self-checkanswers and suggested activity answers in thesame notebook. Your notebook will be a helpfulstudy tool.

Step 5: At the end of each reading assignment, reviewwhat you’ve learned by completing the self-check.The self-checks consist of selected Questions forReview and Problems and Applications from yourtextbook. Write out the answers to these questionsin your notebook or on a separate piece of paper.Try to answer the questions on your own withoutlooking in the textbook. Don’t worry about makinga mistake. The purpose of answering these questionsis to review the material and to help you recognizethe areas that you may need to study again.

When you’ve completed each self-check, check youranswers against those provided at the back of thisstudy guide. If you answered any of the questionsincorrectly, go back and review the material for that

Instructions to Students4

topic until you’re sure that you understand it.Remember that the self-checks are provided only for you to review your learning. You won’t begraded on these questions in any way. Do notsend your answers to the school.

Step 6: Next, complete the Suggested Activities that are provided at the end of selected reading assignments. The Suggested Activities are prac-tical application exercises that allow you to use the knowledge and information you’ve gained fromthe reading assignments. Write out the answers to the Suggested Activities in your notebook or on a separate piece of paper.

When you’ve completed the Suggested Activities foreach lesson, check your answers against those pro-vided at the back of this study guide. You won’t begraded on your Suggested Activity work. Do notsend your answers to the school.

Step 7: Repeat Steps 1 through 6 for each of the remaining reading assignments in the lesson.

Step 8: When you’ve finished reading all of the assigned textbook pages for a lesson and you’re sure that you’re comfortable with the material, com-plete the examination for that lesson. The lesson examinations are contained in this study guide.

Step 9: Repeat these steps until all four lessons have been completed.

Remember, you may e-mail your instructor for help wheneveryou need it.

Now, look over the lesson assignments. Then, begin yourstudy of Principles of Microeconomics with Lesson 1.

Good luck with your course!

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Lesson 1: The Economics of the Public Sector

For: Read in the Read instudy guide: Principles of

Microeconomics:

Assignment 1 Pages 8–11 Pages 203–220



Examination 05066700 Material in Lesson 1

Lesson 2: Firm Behavior and Monopolies


Microeconomics:





Lesson 3: Oligopoly, Monopolistic Competition, and theFactors of Production


Microeconomics:





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Lesson Assignments6

Lesson 4: The Economics of Labor Markets


Microeconomics:






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The Economics of thePublic Sector

INTRODUCTION

In Economics 1, we developed the rationale for the market as a means to maximize society’s well-being. Markets are anefficient way to decide how to use society’s scarce resources.You learned that voluntary exchange is a win-win situationin which both parties (and society as a whole) are made better off.

Now, in this lesson, we’ll consider the situation in which themarket doesn’t perform efficiently. This occurs when decisionmakers don’t bear all the costs or realize all the benefits oftheir actions. Government plays a role in correcting suchmarket imperfections. We’ll also look at government’s role inthe allocation of public goods, which are those that are avail-able free of charge. Public goods aren’t subject to the marketforces that would normally allocate resources. You’ll learnabout the government’s role in regulating public goods thatare consumed simultaneously by multiple users who don’tpay for them.

Obviously, the government must generate revenues to payfor its expenditures in correcting the problems caused byexternalities and public goods. This is done through taxes.We’ll analyze the characteristics and economic impact of the U.S. tax system. You’ll learn about the efficiency cost or deadweight loss from taxes, the incidence of taxes, andthe equity effects of taxation.

OBJECTIVES

When you complete this lesson, you’ll be able to

■ Explain why externalities can make market outcomes inefficient

■ Discuss private solutions and government solutions to problems of externalities

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■ Explain graphically the effects of positive and negative externalities

■ Use the Coase theorem to explain when an externality can be negotiated through the market

■ List the defining characteristics of a public good and a common resource

■ Evaluate cost-benefit analysis as it applies to government programs

■ Discuss the significance of poorly defined propertyrights in overconsumption of common resources

■ Describe how the U.S. government raises and spends money

■ Describe the tradeoff between efficiency and equityin the design of a tax system

■ Identify the major sources of revenue for our government at the federal, state, and local level

ASSIGNMENT 1Read this introduction to Assignment 1. Then, studyChapter 10, “Externalities,” on pages 203–220 in the textbook Principles of Microeconomics.

So far in your study of microeconomics, we’ve assumed thatthe producer bears all costs of production and the buyercaptures all benefits of consumption. In reality, a third partycan be affected by an activity, either by bearing some of thecosts or by receiving some of the benefits. We call this impacton the third party an externality.

The market equilibrium isn’t efficient when these externalitiesoccur. When externalities exist, decision makers make choiceswithout taking into account all of the marginal effects oftheir actions, namely, the effects on others. If externalitiesare negative (as in the case of pollution), production will beexcessive because the external portion of the marginal cost of production is ignored.

The supply curve represents the private costs of the decisionmaker without taking into account the external social cost ofpollution. For the outcome to be socially optimal, the supplycurve must include all the social costs of production, even

Lesson 1 9

those that are external to the producer. These additionalcosts would reduce the supply (shift the supply curve to theleft), reducing equilibrium quantity and raising price. Inshort, negative externalities result in too much productionbeing sold at too low a price for efficiency.

When positive externalities exist, the market underproduces.In the case of consumption externalities, the private valuefrom the product is less than the social value, including benefits to third parties. The result is a private demandcurve that understates the benefits of the product to society.An example is education. Much of the benefit from educa-tion goes to society at large. Consequently, without a publicsubsidy, an individual would look only at his or her personalbenefits and underconsume education relative to society’soptimal level.

Remember that the inefficiency from externalities resultsbecause the marginal costs and marginal benefits to the indi-vidual fail to include effects on a third party. If a change inbehavior would benefit a third party, then it’s reasonable tothink that the third party could negotiate with the decisionmakers to change their behavior. If the change in behavior is worth more to the third party than it would cost the deci-sion makers, then together they should be able to make adeal that would benefit everyone concerned. This is the basicpremise of the Coase theorem: When the interested partiescan get together to negotiate, they can work out a voluntarydeal that makes everyone better off and increases society’swell-being. For example, those who are hurt by pollutionfrom a paper mill can negotiate a solution with the com-pany. They can either pay the mill to cut back on pollutionor negotiate compensation for the damage that they incurfrom the mill’s pollution in its future production decisions.Once a deal is struck, the externality disappears.

Unfortunately, such private solutions don’t always work.Negotiating involves cost, especially when it requires coordi-nating the actions of a large number of people throughout a large geographic area. Private solutions work best whenthere are small numbers of third-party victims who are easilyidentified and can be organized to work together in negotiat-ing a solution.

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Traditional control of externalities such as pollution hasbeen in the form of direct regulation. With regulation, thegovernment simply mandates the level of cleanup that mustoccur. This works reasonably well in cases in which theexternal costs to society are so high that fine-tuning the levelof cleanup isn’t as important as simply stopping pollutionquickly. For example, after the publication in 1969 of RachelCarson’s book Silent Spring, which described the long-termenvironmental damage done by certain pesticides, the gov-ernment banned the use of the pesticide DDT. In most cases,however, the proper level of cleanup is difficult to determine.Direct regulation puts the entire burden for measuring socialcosts and benefits on the government, and it provides noincentive for polluters to develop better cleanup technology.On the contrary, if producers develop new technology, thegovernment might respond simply by tightening the environ-mental standards.

Instead of regulation, society can use market-based policiesthat provide incentives for individual decision makers to takeinto account all of the relevant costs of production. Theseincentives can take the form of pollution taxes, subsidies, or tradable pollution permits. Each of the policies has thesame effect. It causes the decision makers to internalize the external cost of pollution by raising the opportunity costof polluting. Instead of mandating the level of reduction ofsulfur dioxide by a paper mill, for example, the EPA couldimpose a $5 tax on each unit of pollutant emitted. Clearly,this would raise the private opportunity cost of polluting by $5/unit. However, as suggested by the Coase theorem, a $5-per-unit subsidy to not pollute would have the sameeffect as a $5 tax on each unit of pollution. If pollutingmeans giving up a $5 subsidy, then the opportunity cost of polluting is still $5 under the subsidy, just as it wouldhave been under the tax.

Similarly, if the EPA distributes pollution permits that aretradable, then the opportunity costs of using a permit torelease sulfur into the atmosphere is the foregone incomefrom selling the permit. If the permit has a market value of$5, then the opportunity costs of polluting is still $5.

In each case, the market-based policy internalizes the cost of pollution. Unlike the case of direct regulation, such market-based policies also provide an incentive for the polluter to

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develop better technology to reduce the internal cost of pollution. In the previous example, every one-unit reductionin pollution saves the firm $5, unlike direct regulation, whichprovides no financial incentive to reduce the quantity of pollution below the mandated maximum level.

After you’ve carefully read pages 203–220 in Principlesof Microeconomics, complete Self-Check 1. Check youranswers with those provided at the back of this studyguide. When you’re sure that you understand the mate-rial from Assignment 1, move on to Assignment 2.

ASSIGNMENT 2Read this introduction to Assignment 2. Then, readChapter 11, “Public Goods and Common Resources,” onpages 223–237 in the textbook Principles of Microeconomics.

In this chapter, you’ll learn how governments can sometimesimprove market outcomes. Private market forces aren’t atwork when a good doesn’t have a price attached to it. Thesegoods aren’t necessarily produced and consumed in theproper amounts. To understand which type of good is regu-lated by a competitive marketplace and which type of goodisn’t, you must know how goods are categorized.

Self-Check 1

At the end of each section of Economics 2, you’ll be asked to pause and check your under-standing of what you’ve just read by completing a “Self-Check.” Writing the answers to thesequestions will help you review what you’ve studied so far. Please complete Self-Check 1 now.

Write a definition for each of the Key Concepts listed on page 220 of your textbook. Then,answer Questions for Review 2, 5, and 6 on pages 220–221 of your textbook. Finally, in the Problems and Applications section on pages 221–222, solve Problem 11.

Check your answers against those on page 85.

Economics 2

For the market to allocate goods efficiently, the goods mustbe both excludable and rival. An excludable good is one thatother people can be prevented from using. A rival good is agood for which one person’s consumption takes away fromanother’s enjoyment. Goods can be categorized according tothose criteria. Consider the following classifications: Privategoods are those that are both excludable and rival, such ashamburgers. Public goods are neither excludable nor rival,such as national defense. Common resources are goods thatare rival but not easily excludable, such as whales in theocean. A natural monopoly exists when there’s a market for agood that’s excludable but not rival, such as cable-televisionsignals.

A public good is available to everyone free of charge. Publicgoods are neither excludable nor rival in consumption. Itisn’t feasible to exclude those who don’t pay for a publicgood, and additional users can consume the good withoutdetracting from the satisfaction received by consumers.National defense is a public good. The security provided bya nuclear submarine, for example, is nonexcludable in thesense that it protects the entire country, not just those whopaid for it. It’s also nonrival in that it can protect a growingpopulation without reducing the benefits received by theoriginal consumers.

Because it’s not feasible to exclude those who don’t pay fornational defense, there’s a “free-rider” problem (some userswon’t pay their share) when the production of nationaldefense is left to the private market. Governments may alsoprovide goods that are essentially private (excludable andrival), such as a congested state campground. Similarly,markets may provide goods that are essentially public(nonexcludable and nonrival). Commercial television signals,for example, are essentially public goods, with infeasibleexclusion (without using different broadcast technology) andnonrival consumption (additional viewers don’t detract fromothers’ enjoyment). To avoid the free-rider problem, broad-casters use commercial advertising to pay for the good.

Other goods that don’t have a price tag are commonresources. Common resources share the characteristic ofnonexcludability with public goods. Unlike public goods,however, common resources are rival. One person’s

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consumption of a common resource detracts from other people’s consumption. Common resources differ from privategoods in that they lack clearly defined and enforced propertyrights. This makes exclusion difficult or impossible. To betterunderstand this, consider two children who must share abox of popcorn at the movies. Each child might prefer to eat slowly, making the popcorn last for the entire movie. IfChild A eats too slowly, however, Child B may finish off thepopcorn and get a larger share of it. This possibility promptsboth children to eat faster to make sure that each gets a fair share.

Another example of a common resource is undergroundpetroleum reserves. If one company pumps the oil out ofthe ground, then that oil is no longer available for others.However, it’s difficult to define and protect the propertyrights to underground oil. Not only can it extend underseveral owners’ property, but drillers can drill diagonallyto reach oil under someone else’s land. Iraq made this claimabout Kuwait’s petroleum exploration just before invadingKuwait. If property rights to underground petroleum wereclear-cut, then petroleum reserves would be a simple caseof a private good that the market could allocate efficiently.Because oil reserves are a common resource, the markettends to overproduce under the “use it or lose it” mentality.

After you’ve carefully read pages 223–237 in Principlesof Microeconomics, complete Self-Check 2. Check youranswers with those provided at the back of this studyguide. When you’re sure you understand the materialfrom Assignment 2, move on to Assignment 3.

Lesson 1 13

Self-Check 2

Write a definition for each of the Key Concepts listed on page 237 of your textbook. Then,answer Questions for Review 1, 2, and 4 on page 237 of your textbook. Finally, in theProblems and Applications section on pages 237–239, solve Problems 1 and 6.

Check your answers with those on pages 87.

ASSIGNMENT 3Read this introduction to Assignment 3. Then, readChapter 12, “The Design of the Tax System,” pages241–261 in the textbook Principles of Microeconomics.

According to Ben Franklin, the only things that are certain inour lives are death and taxes. This assignment takes a closerlook at one of these certainties—our tax system. The UnitedStates has a system of fiscal federalism in which federal, state,and local governments collectively comprise “the government.”The federal government uses roughly two-thirds of all taxesthat we pay to fund federal programs. The federal governmentrelies primarily on the individual income tax, followed closelyby payroll taxes. A third source of federal revenue is the cor-poration income tax. These revenues are used to fund SocialSecurity, national defense, welfare, interest on the nationaldebt, Medicare, health, and other programs (in order of great-est expenditure). State and local governments rely primarilyon sales taxes, followed closely by property taxes, and thenfederal funding, as revenue sources. The individual incometax ranks fourth as a source of state revenue, with corporateincome taxes a distant fifth.

Taxes reduce private purchasing power. They also imposeefficiency costs on the economy in the form of deadweightlosses (when they alter people’s behavior), levy complianceand administrative costs, and impose compliance andadministrative burdens. There are expenses involved inadministering taxes. Like the deadweight loss, the adminis-trative cost is an efficiency loss because there’s a cost to oneperson without an offsetting gain to someone else. The timethat you spend filling out your tax forms benefits nobody.

Although we can imagine hypothetical taxes that cause nodeadweight loss to society, all real-world taxes impose effi-ciency losses on the economy. Taxes that reduce inefficiencyoften violate society’s standards of equity. A lump-sum taxwould avoid the distortion of individuals’ behavior because it would be unavoidable, but it would be unacceptable onequity grounds. It would require the billionaire and thehomeless person to pay the same number of dollars in taxes.On equity grounds, the individual income tax is more accept-able to most people, even though there may be a deadweight

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loss when a high marginal tax rate (the rate on the last dollar earned) discourages work effort. This efficiency loss is especially pronounced under the progressive tax rates that many people support on ability-to-pay grounds.

If efficiency were the only consideration, tax policy would bemuch easier to implement. However, tax equity is also a majorcriterion for evaluating tax proposals. Unfortunately, equityis difficult to assess because fairness is very subjective.

One way to determine the fairness of a tax is through thebenefits principle, which states that taxes should be assessedaccording to the benefits that people receive from the govern-ment programs that these taxes finance. Unfortunately, mosttaxes go into general revenue funds and can’t easily belinked to the benefits received.

An alternative way to determine the fairness of a tax is theability-to-pay principle, which states that taxes should beassessed according to taxpayers’ financial capability. Thegoal is both vertical and horizontal equity. Vertical equitymeans that taxpayers with more ability to pay should paymore taxes. Horizontal equity means that taxpayers with similar ability to pay should pay similar taxes.

Taxes can be proportional (all taxpayers pay the same percentof income), progressive (the rich pay a higher percent), orregressive (the rich pay a lower percent). To determine taxequity, you must first determine the tax incidence—whoactually pays the taxes. For example, many people argue for increasing corporate tax rates without realizing that thepeople ultimately pay those taxes. Consumers pay throughhigher prices, employees pay through lower wages, andstockholders pay through lower profits and lower dividends.

The tradeoff between equity and efficiency is one of thebiggest issues in economics, so it shouldn’t be surprising tofind that this tradeoff is a major obstacle to reaching consen-sus on proper tax policy. People often disagree because theyweigh these two goals differently. Political leaders differ intheir views, and economics alone can’t determine the bestsolution to balancing equity and efficiency. Economics canoffer insight on understanding the tradeoffs society faces and help us avoid policies that are inequitable.

Lesson 1 15

After you’ve carefully read pages 241–261 in Principlesof Microeconomics, complete Self-Check 3. Check youranswers with those provided at the back of this studyguide. When you’re sure that you completely understandthe material from Assignment 3, go to the SuggestedActivities for Lesson 1.

Suggested Activities for Lesson 1Read through these Suggested Activities, then write out theanswers to the questions in your notebook or on a separatepiece of paper.

Activity 1: Externalities on a River

As little children, we learn that our actions have conse-quences. This principle is the premise of the economic exter-nality, which produces external costs and market failures.This exercise will demonstrate negative externalities.

Instructions: Follow these steps to complete the activity.

Step 1: On a separate piece of paper, draw a simple pictureof a river. (Two curving lines are sufficient.) Add a rectangle labeled “FACTORY” at one end of theriver. Draw a stick figure of a person about half-way down the river. Add another rectangle labeled“BREWERY” at the other end of the river.

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Self-Check 3

Write a definition for each of the Key Concepts listed on page 261 of your textbook. Then,answer Questions for Review 1, 3, 4, 5, 6, and 7 on page 261 of your textbook. Finally, in the Problems and Applications section on pages 262–263, solve Problems 9 and 10.

Check your answers with those on page 88.

Your drawing represents three users of a naturalresource. Tiffany owns a sweater factory on the river.Dan enjoys going to a beach on the river. Pat ownsa brewery that uses water from the river. Draw anarrow from the river into the brewery. Add a beachumbrella on the side of the river for Dan. Draw anarrow pointing away from the factory into the riverto represent a discharge pipe.

Step 2: Next, on another sheet of paper, draw a demandcurve for Tiffany’s sweaters. The market for hersweaters is based on consumers’ tastes, incomes,the prices of substitutes and complements, and the number of consumers in the market.

Step 3: Add the supply curve for Tiffany’s sweaters to yourgraph, based on all of the costs of production.Label this “Supply with production costs.”

Step 4: Write out the answers to these questions.

1. How would the supply curve shift if Tiffany got her materials for free?

2. How would the supply curve shift if she didn’t have topay her workers?

Step 5: One of the by-products of sweater production istoxic sludge. This sludge is dumped in the river.Draw thick lines representing the sludge from thefactory’s discharge pipe. Draw more thick lines ofsludge over the stick figure and into the brewery.So, here are some consequences: Dan’s day at thebeach is ruined. He’s covered with sludge. Pat’sbeer is ruined—the entire production run has beencontaminated. These are real costs associated withTiffany’s sweater production, but Dan and Pat paythese costs. Tiffany doesn’t consider these externalcosts when making supply decisions. Return toyour supply-and-demand graph and add a newsupply curve labeled “Supply with social costs.”Keeping these facts in mind, answer the followingquestion.

3. Your graph illustrates a negative externality to production.How would you explain the new optimum productionpoint in terms of quantity of sweaters and price?

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Activity 2: Taxes, Taxes

Two things in life are certain—death and taxes. There’s alwaysplenty of heated debate over tax issues. This exercise exam-ines a new tax and how it will affect the taxpayer. You’ll seethe importance of classifying a tax as progressive, regressive,or proportional.

Instructions: Congress has just approved a new tax to fundscientific research on clones. Everyone will pay $1,000 ayear. Keeping these facts in mind, write out the answers tothe following questions.

1. Is this tax progressive, regressive, or proportional?Explain your answer in terms of income percentages of Taxpayer A, who makes $1,000 per year, as opposedto Taxpayer B, who makes $100,000 per year.

2. If Taxpayer A and Taxpayer B had to pay 1 percent,what would each owe? Would this tax be progressive,regressive, or proportional?

When you’ve completed the Suggested Activities for Lesson 1,check your answers with those provided at the back of thisstudy guide. When you’re sure that you completely under-stand the material from these three assignments, you cancomplete the examination for Lesson 1.

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Lesson 1

The Economics of the Public Sector

When you feel confident that you have mastered the material inLesson 1, go to http://www.takeexamsonline.com and submityour answers online. If you don’t have access to the Internet, youcan phone in or mail in your exam. Submit your answers for thisexamination as soon as you complete it. Do not wait until anotherexamination is ready.

Questions 1–20: Select the one best answer to each question.

1. Which of the following statements about marginal and averagetax rates is correct?

A. Marginal tax rates are a better measure of taxpayer sacrifice.

B. Average tax rates are a better measure of tax effects onincentives.

C. Marginal tax rates are a better measure of tax effects onincentives.

D. Average tax rates are used to determine deadweight lossfrom a tax.

2. Goods that are nonrival in consumption

A. are congested in consumption.B. are typically consumed jointly.C. can’t be provided in the private sector.D. are always excludable.

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EXAMINATION NUMBER:

05066700Whichever method you use in submitting your exam

answers to the school, you must use the number above.

For the quickest test results, go to http://www.takeexamsonline.com

Examination, Lesson 1 20

3. To encourage the production of honey, several beekeepers place their beehives in afarmer’s orchards and fields. As the bees gather nectar to make honey, they pollinate the orchards and fields, thereby increasing the yields of the fruit and grain crops. This arrangement results in

A. a positive externality that benefits the farmer.B. no significant additional benefit to anyone.C. a positive externality that benefits the consumer.D. a negative externality for which the farmer should be compensated.

4. Which of the following statements is correct?

A. Tradable pollution permits exempt a firm from paying for its pollution.B. Pigovian taxes from polluting firms are used to fund pollution permits.C. There are no advantages to allowing a market for pollution permits.D. Tradable pollution permits may be preferred to Pigovian taxes in some cases.

5. Deadweight costs from taxation are associated with

A. taxes that influence the decisions that people make.B. taxes that target expenditures on survivor benefits for Social Security.C. taxes that have no efficiency losses.D. lump-sum taxes.

6. When the government reverts to command-and-control policy to solve an externality, it

A. is usually the most effective policy option available.B. creates policies that directly regulate behavior.C. usually involves taxing consumption of a commodity.D. typically refers to the Coase theorem to structure the policy.

7. Which of the following would be considered a nonrival but excludable good?

A. A viewing of a movie in a crowded theaterB. An ice-cream coneC. A visit to a noncrowded museumD. A fish in the ocean

8. Environmentalists argue that we should protect the environment as much as possible,regardless of the cost involved. Which of the following is one of these costs?

A. Lower levels of nutrition and inadequate health careB. A higher standard of living, but less available housingC. Increasing technological advancementD. More expensive utilities, but lower taxes


9. Which of the following goods would not be subject to the Tragedy of the Commons?

A. A small public park C. The game animals in a small forestB. A stream passing through a town D. A fishing hole on private land

10. Which of the following statements about lump-sum taxes is correct?

A. Lump-sum taxes are most frequently used to tax real property.B. Lump-sum taxes aren’t distortionary.C. Lump-sum taxes are the most distortionary tax.D. Lump-sum taxes are used in taxing sales.

11. In the presence of externalities, society’s interest in a market outcome includes the well-being of

A. buyers and sellers only. C. bystanders and regulatory agencies.B. bystanders only. D. buyers, sellers, and bystanders.

12. One reason that markets fail to allocate common resources efficiently is that

A. prices change in irregular ways.B. social optimum doesn’t occur at market equilibrium.C. property rights aren’t well established.D. social welfare isn’t maximized at market equilibrium.

13. Which of the following is based on a person’s taxable income?

A. Federal tax return C. Social insurance taxB. Tax liability D. Consumption tax

14. Imagine that Steve owns a lion whose roaring annoys Steve’s neighbor Terri. Suppose thatthe benefit of owning the lion is worth $500 to Steve and that Terri bears a cost of $700from the roaring. Which of the following is a possible private solution to this problem?

A. Terri pays Steve $450 to get rid of the lion.B. Steve pays Terri $650 for her inconvenience.C. Terri pays Steve $650 to get rid of the lion.D. There’s no private solution that will improve this situation.

15. Which of the following would be considered to be a public good?

A. A pizzaB. Half-time entertainment at the Super BowlC. A local dance clubD. A light bulb


16. In which of the following situations does an externality exist?

A. When the government intercedes in the operation of private marketsB. When markets aren’t able to reach equilibriumC. When a firms sells its product in a foreign marketD. When one person’s actions affect the well-being of a bystander

17. When goods provided by individuals or firms have problems with “free riders,” the

A. ability to generate revenue from sales is negatively impacted.B. revenue from sales will always be greater than cost.C. revenue from sales must exceed private benefit to the individual (or firm)

providing the good or service.D. cost will always exceed the private benefit to the individual (or firm) providing the

good or service.

18. When externalities exist, buyers and sellers

A. neglect the external effects of their actions, and the market equilibrium is efficient.B. don’t neglect the external effects of their actions, and the market equilibrium is efficient.C. neglect the external effects of their actions, and the market equilibrium isn’t efficient.D. don’t neglect the external effects of their actions, and the market equilibrium isn’t

efficient.

19. A tax on cigarettes is designed to encourage consumers to consume fewer cigarettes.Which of the following will occur if this tax is imposed?

A. Social well-being will improve.B. The burden of this tax will fall entirely on cigarette producers.C. This distortion will cause a deadweight loss.D. The tax will be considered nondistortional.

20. Markets are inefficient when negative externalities are present because

A. social costs equal private costs at the private market solution.B. social costs exceed private costs at the private market solution.C. private benefits exceed social costs at the private market solution.D. externalities prevent the market from reaching equilibrium.

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Firm Behavior andMonopolies

INTRODUCTIONThis lesson focuses on a detailed analysis of the market system, examining its business structure and operation. The first assignment of the lesson looks at a firm’s cost ofproduction, revenue, and profit. It also examines how eco-nomic cost and profit differ from traditional accounting costand profit. You’ll learn how all firms, from the largest to thesmallest, behave under different types of market conditions.Assignment 5 discusses the analysis used by competitivefirms to achieve profit maximization in the short and long run. A competitive market exists if each buyer and seller is small compared to the size of the market. Assignment 6extends market analysis to look at the operation of a monop-oly. Monopolies occur when barriers to market entry protecta single seller from competition. These barriers to entry allowmonopolists to earn economic profit in the long run. Themonopolist, as you’ll learn, is a price maker. The competitivefirm is a price taker.

OBJECTIVESWhen you complete this lesson, you’ll be able to

■ Calculate average total cost and marginal cost anddiscuss their relationship to one another

■ Describe short-run and long-run costs of a firm■ Use total cost to derive both marginal and average

cost■ Describe the characteristics and operation of a

competitive market■ Explain the profit-maximization rule for

competitive firms■ Explain why firms decide to enter or leave a

competitive market■ Discuss why some markets have only one seller

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■ Analyze how a monopoly determines what quantityto produce and what price to charge

■ Compare and contrast profit maximization for perfect competitors and monopolists

■ Explain how and why the monopolist uses price discrimination

ASSIGNMENT 4Read this introduction to Assignment 4. Then, readChapter 13, “The Costs of Production,” on pages 267–284in the textbook Principles of Microeconomics.

This chapter provides the tools you need to understandhow all firms, from the largest to the smallest, behave underdifferent types of market conditions. A firm’s goal is to maxi-mize profit. Profit is simply the total revenue that it receivesfrom selling its product minus the total cost of producingthat product. Total revenue is simply the price of an itemtimes the quantity sold.

Total costs can be a bit tricky to calculate, however. To aneconomist, cost means opportunity cost. It includes the explicitcosts or money outlays that comprise accounting costs, ofcourse, but it also includes implicit costs of resources usedby the firm that could have been used elsewhere. A smallbusiness that shows an accounting profit actually may belosing money in an economic sense, if we deduct all of theimplicit costs of resources that the owner ties up in the firmrather than using elsewhere. The owner’s labor, for example,is a real cost of operating the business even if no actual salaryis paid. The cost is the earnings the owner gives up by notworking for someone else, rather than the owner’s actualsalary from his or her own business. Similarly, the lost interestincome on money the owner invests in the business is a realcost of doing business even though it’s not an accounting cost.

You’ll also learn how a firm’s production process is related to its costs. The production function shows the relationshipbetween inputs and outputs. In the short run, this meanslooking at the relationship between the amount of labor usedand the amount of output produced. We define the short run

Lesson 2 25

as a time period that’s too short to allow increases in otherinputs. Adding more labor increases output, although atsome point additional workers are subject to diminishingmarginal product. The property of diminishing marginal product means that the last unit of labor hired adds less to total output than did the previous one. Imagine growingstrawberries in your backyard in a plot that’s only 20 feet by 10 feet. You might be able to pick three pints of strawber-ries in 15 minutes. However, additional workers in the samesmall plot couldn’t be expected to maintain that level of output per worker. Eventually, the marginal product of anadditional worker will fall because land and capital are fixed.The marginal product actually becomes negative when thepatch is so crowded that workers are getting in each other’sway and trampling the berries. Diminishing marginal productoccurs when workers are added without additional capitaland land.

In the long run, expansion doesn’t always result in diminishingmarginal product because land, labor, and capital can beincreased simultaneously. As marginal product diminishes,the firm’s total cost begins to rise at a more rapid ratebecause additional units of output cost more to produce.That is, the same wage per worker results in less additionaloutput, so the cost per additional unit produced rises.

The costs of production, as you’ll see, are analyzed in boththe short and long run. Because we define the long run asthe time period long enough to vary capital and all otherinputs, all costs become variable in the long run. As a result,diminishing marginal product is no longer a problem. Thereare no fixed inputs. Given enough time, firms can vary theirscale of operation by acquiring more land and building morefactories in addition to hiring more labor. They also can cutback on their use of all inputs. It’s helpful to understandthat the distinction between short run and long run in eco-nomics is somewhat arbitrary. The short run is a period inwhich some inputs (typically capital and land) are fixed whileat least one (typically labor) is variable. Although arbitrary, itmakes a lot of sense: a firm that desires to increase outputquickly could expand labor immediately, but it would take awhile to build a new factory.

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After you’ve read pages 267–284 in Principles ofMicroeconomics carefully, complete Self-Check 4.Check your answers against those provided at the back of this study guide. When you’re sure that you completely understand the material from Assignment 4,move on to Assignment 5.

ASSIGNMENT 5Read this introduction to Assignment 5. Then, readChapter 14, “Firms in Competitive Markets,” on pages289–307 in the textbook Principles of Microeconomics.

You’re familiar with the idea of competition from the world ofsports. This assignment focuses on the perfectly competitivemarket. This exists when there are so many buyers and sell-ers of a standardized good that no individual buyer or sellercan influence price. In addition, competitive markets have no barriers to entry, so firms can enter or exit the industryeasily in response to changing market conditions.

Just as other firms do, competitive firms desire to maximizeprofit. Let’s take a closer look at one of the Ten Principles ofEconomics that rational people use to make decisions at themargin. Everyone (individuals, firms, and societies) seeks tomaximize well-being by following a general decision-makingrule: Do anything as long as marginal benefit is greater thanor equal to marginal costs, and stop when the marginal benefitequals the marginal costs. For a business trying to maximizeprofit, this rule becomes: Produce as long as the marginal rev-enue is equal to or greater than the marginal costs, and stopwhen marginal revenue equals marginal cost.

Self-Check 4

Write a definition for each of the Key Concepts listed on page 285 of your textbook. Then,answer Questions for Review 1, 2, 5, and 7 on page 284 of your textbook. Finally, in theProblems and Applications section on page 285, solve Problems 1, 6, and 9.


Lesson 2

Keep in mind that fixed costs are irrelevant for makingfuture decisions. Economists refer to fixed costs as sunkcosts because once they’re incurred, they can’t be recovered.In the short run, a business can’t avoid its fixed costs evenby shutting down. This is why it’s rational for a business tocontinue to produce at a loss in the short run as long as itsrevenues cover the variable costs. Any revenues in excess ofthe variable cost will offset part of the fixed cost and reducelosses. However, if the firm shuts down, it will incur lossesequal to the full fixed cost. A firm determines how much out-put to produce by equating marginal revenue and marginalcost, neither of which is affected by fixed cost.

A competitive firm must consider that all sales occur at themarket price, which doesn’t change as the firm increasesoutput. As a result, in perfect competition, average revenueequals marginal revenue equals price. That is,

AR = MR = P

To maximize profit using marginal analysis, the perfectlycompetitive firm produces until marginal revenue equalsprice equals marginal cost (see Figure 1 on page 294 in yourtextbook).

MR = P = MC

So for any price, the firm will choose the quantity suppliedby looking at the marginal-cost curve (MC), which makes thatcurve the firm’s supply curve. The only qualification is thatfirms won’t sell at a price below the average variable cost. Ifprice is below average variable cost, the firm is losing moremoney than if it were to shut down. Therefore, the competi-tive firm’s supply curve in the short run is the portion of the marginal-cost curve above the average variable cost. The analysis is similar in the long run, except that all costs are variable.

Consequently, the profit-maximizing firm in the long runwon’t produce below the average-total-cost curve (ATC). WithP less than ATC, the firm is incurring losses and will go outof business. On the other hand, if P is greater than ATC, thefirm will earn an economic profit, encouraging it to stay inbusiness and encouraging other firms to enter the industry.

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Keep in mind the difference between economic profit andaccounting profit. Economic profit includes all opportunitycosts of time and capital. When a firm has zero economicprofit, it’s enjoying a normal accounting profit. It’s for thisreason that firms are willing to continue to produce at apoint of zero economic profit. In addition, any positive economic profit provides an incentive for firms to enter the industry.

Market supply is the summation of all of the individual supplycurves. Long-run market supply includes potential as well as current competitors. If economic profits exist, new firmswill enter the market in the long run, increasing supply anddriving down price until the economic profits disappear. Ifeconomic losses exist, firms will exit the industry in the longrun, decreasing supply and resulting in rising prices untileconomic losses disappear. The situation stabilizes in thelong run only when economic profit equals zero, whichmeans that price equals average total cost. This long-runequilibrium occurs at minimum average total costs, witheach firm operating at its efficient scale.

Thinking at the margin is what distinguishes economistsfrom noneconomists. This assignment elaborates on whatthat really means. A business that’s maximizing profit ignoresfixed costs. This would indicate that in the short run (whenthere are some fixed costs), a business that just replaced anexpensive piece of equipment or made an expensive repairwon’t find it profitable to raise prices even by a slightamount. This is probably counterintuitive, but rememberthat the firm is already charging whatever the market willbear, up to the point at which MC equals MR. Just ask your-self this question: If it’s profitable for the firm to raise pricesnow to recoup the cost, why wasn’t it profitable to raiseprices before the big investment just to make more profit?The answer is that if the firm could raise prices to makemore profit, it would have already done so! If it’s a rational-thinking firm, it wouldn’t make the decision based on sunkcosts. Similarly, if you go to a concert that turns out to be awaste of time, you shouldn’t stay until the end just becauseyou paid $50 for a ticket. After all, the $50 is gone, so whymake yourself even more miserable by sitting through aworthless concert?

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Lesson 2 29

After you’ve read pages 289–307 in Principles of Micro-economics carefully, complete Self-Check 5. Check youranswers against those provided at the back of this studyguide. When you’re sure that you completely understandthe material from Assignment 5, move on to Assignment 6.

ASSIGNMENT 6Read this introduction to Assignment 6. Then, read Chapter 15,“Monopoly,” on pages 311–339 in the textbook Principles ofMicroeconomics.

Assignment 5 introduced market structure by investigatingthe characteristics of perfect competition. This assignmentdiscusses the opposite of the perfectly competitive market, a situation known as a monopoly. A monopoly exists whenthere are barriers to market entry that protect a single sellerfrom competition. A monopolist is the sole seller of a productwithout close substitutes.

Monopolists can continue to earn economic profit in the longrun due to barriers to entry that prevent new competitorsfrom entering the industry and driving down price and profit.Such barriers to entry usually arise for one of three reasons:(1) control over a key resource, (2) exclusive-rights grants bygovernment, or (3) a falling average total cost that makes asingle producer more efficient than many smaller firms.

The primary difference between monopoly and competition is control over price. Monopolists are price setters who canalter price within the constraints of the demand curve.

Self-Check 5

Write a definition for each of the Key Concepts listed on page 307 of your textbook. Then,answer Questions for Review 2, 3, and 4 on page 307 of your textbook. Finally, in the Problems and Applications section on pages 308–309, solve Problems 2 and 12.


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Competitors are price takers who have no control over price.A monopolist’s marginal revenue is always less than theprice. This is because the partial offsetting of the outputeffect that raises total revenue when output rises is a priceeffect that lowers total revenue because of the cut in pricerequired to sell the extra output. This occurs because inorder to sell more units, the monopolist must cut price onall its sales, not just the additional units.

For example, suppose that Ben is a monopolist who sellswidgets for $5.00 each. At $5.00, he can sell 20 widgets perday. If he wants to sell more, he must cut the price. To sellone more widget, he must cut the unit price to $4.80. Theproblem is that his marginal revenue from the 21st widgetis much less than the price. The 21st widget sold brings in$4.80, but he loses $0.20 in revenue on each of the first 20widgets (or $4.00 in total) by cutting the price from $5.00 to$4.80. The net effect on his revenue is an increase of $4.80minus a decrease of $4.00, for a net increase, or marginalrevenue, of $0.80.

$4.80 – $4.00 = $0.80

Another way to see this is to look at total revenue for 20units, as follows:

$5.00 � 20 = $100

Then, compare that with the total revenue from 21 units, asshown here:

$4.80 � 21 = $100.80

The $0.80 difference is the marginal revenue of the 21stunit.

Monopoly imposes efficiency costs on society in the form ofdeadweight losses from underproduction of the good. Societymaximizes well-being whenever output expands up to thepoint at which the extra value, or marginal benefit, is justequal to the marginal cost. This maximizes the sum of theconsumer and producer surplus, or the value of the good to the consumer minus the cost of making the good.

The competitive firm produces the efficient level of output,but the monopolist produces less than the efficient output.The outcome is a reduction in the total surplus that would

result from producing at the efficient output level. The dead-weight loss is the lost surplus on the withheld output. Thatis, the monopolist fails to produce some output that societyvalues more than it costs to produce. Although monopolycauses a social welfare loss, its seriousness is limited bythe inherent market controls over monopoly power. Not evena monopoly can charge whatever it wants if it cares aboutthe quantity that it sells. Monopolists can charge whateverthe market will bear, but are ultimately constrained by thedemand curve. Total and permanent barriers to entry arerare, and even in the cases of true monopoly, there areusually relatively close substitutes for the product.

Governments attempt to limit the inefficiency associatedwith monopoly in a variety of ways. To make monopoliesbehave more competitively, the government passes a seriesof antitrust laws, which tend to control monopoly power andpromote competition. Under these laws, government can pre-vent mergers that would lead to monopoly or near-monopoly,it can prevent price fixing and other anticompetitive behavior,and it can even split up large firms in extreme cases, suchas the breakup of AT&T in 1984.

Another alternative is to regulate monopoly pricing and otherbehaviors. It’s common for the government to regulate theprices charged by natural monopolies such as power compa-nies. However, it’s not possible to force them to set priceequal to marginal cost, as occurs in perfect competition,without driving them out of business.

The third option, public ownership, is common with naturalmonopolies in some countries, but not in the United States.Although it could eliminate the problem of underproductionif taxpayers were willing to make up the difference betweenprice and average total costs, we would lose the advantage of the profit motive to hold down cost. The final option,which is doing nothing, is the choice of those who feel thatthe inefficiency of monopoly underproduction is less than the inefficiency resulting from politically established economicpolicies, or that the good of society in general isn’t the propercriterion for establishing economic policy.

Lesson 2 31

A monopoly can also engage in price discrimination, whichmeans charging different prices to different customers for the same good. For example, airlines typically offer steeplydiscounted prices to customers who purchase in advanceand stay through a Saturday night. This is a way to discountfares to leisure travelers with highly elastic demand whilecontinuing to charge high fares to business travelers withinelastic demand who are unlikely to want to stay throughthe weekend. Firms price-discriminate in an attempt to getthe output effect from cutting price without the price effectthat would result if they lowered price to everyone. In thewidget case described earlier, if Ben could have sold the 21stunit for $4.80 while continuing to sell the first 20 units for$5.00 each, then marginal revenue would have equaled the$4.80 price.

Interestingly, price discrimination can actually improve economic well-being. Remember that the monopolist under-produces because of the price effect of expanding output and moving down the demand curve. If everyone is charged adifferent price, then there’s no price effect, and the monopo-list will produce at the socially efficient output level.

After you’ve read pages 311–339 in Principles of Microeconomics carefully, complete Self-Check 6.Check your answers against those provided at the back of this study guide. When you’re sure that you completely understand the material from Assignment 6,move on to the Suggested Activities for Lesson 2.

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Self-Check 6

Write a definition for each of the Key Concepts listed on page 339 of your textbook. Then,answer Questions for Review 3, 4, 5, and 8 on pages 339 of your textbook. Finally, in the Problems and Applications section on pages 340–343, solve Problems 5, 6, and 8.


Lesson 2 33

Suggested Activities for Lesson 2Read through these Suggested Activities, then write out theanswers to the questions in your notebook or on a separatepiece of paper.

Activity 1: A Profitable Opportunity

This exercise reinforces the importance of marginal cost indecision making. It will show you how average costs can bemisleading.

Imagine that you’ve recently graduated from college and havelanded a job in production management for Sekin SneakersInc. You’re responsible for the entire production on weekends.Your costs are shown in the following table.

Your current level of production is 500 pairs of sneakers perweekend. All 500 units for the current weekend have beenordered by your regular customers. The phone rings. It’s anew customer who wants to buy 1 pair of sneakers. Thismeans that you would have to increase production to 501units. Your potential new customer offers to pay $50 for theone pair of sneakers.

1. Should you accept the new customer’s offer?

2. Calculate the marginal cost of producing 501 pairs ofsneakers.

3. Re-examine your decision as to whether or not to accept the new customer’s offer. Explain your decision in termsof marginal revenue and profits.

Activity 2: Price Discrimination and Time Travel

In Economics 1, you completed a time-travel activity. Now,we’ll take another look at time travel. This example illustrateshow a price-discriminating monopolist can earn even higherprofits than a monopolist charging a single price. You’ll useyour knowledge about calculating consumer surplus to look at monopoly profits.

ytitnauQ tsoClatoTegarevA

005 01$105 11$

Economics 2 34

Here are the specifics on some time-travel customers. Stevewants to travel back in time to see the dinosaurs, and he’swilling to pay as much as $200 to use the time machine.Joyce wants to relive her entire senior year in high school,and she’s willing to pay up to $150 to use the time machine.Chip can’t wait for this economics course to end, so he’swilling to pay as much as $125 to use the time machine.Dawn just wants this day to be over. She’s willing to pay upto $100 to use the time machine.

The demand curve for time travel is shown in the followingtable.

The marginal cost of time travel is $100. Keeping all of thisinformation in mind, write out the answers to the followingquestions.

1. Assume that time travel is a competitive industry. Whatwould be the price of a time-travel trip, and how manytrips would be sold to the above customers?

2. What would be the consumer surplus using the scenario presented?

3. What would be the profit made using the scenario presented?

4. Now, let’s say that time travel is a patented product, giving the firm complete monopoly control. The monopo-list will equate marginal cost and marginal revenue tofind the profit-maximizing quantity. What would be thetotal revenue and marginal revenue for the demandcurve information shown in the following table? Fill inthe blank spaces in the following table.

ecirP ytitnauQ

002$ 1051$ 2521$ 3001$ 4

ecirP ytitnauQ euneveRlatoTlanigraMeuneveR

002$ 1051$ 2521$ 3001$ 4

Lesson 2 35

5. What price will the single-price monopolist choose tocharge the time-travel customer?

6. What would be the consumer surplus and profit madeby the monopolist?

7. Time travel is now being controlled by a price-discrimi-nating monopolist who will charge each consumer at his or her maximum willingness to pay. What would be the total revenue and marginal revenue for this new demand curve information? Fill in the blank spaces in the following table.

8. The price-discriminating monopolist also operates at a point where marginal cost equals marginal revenue.How many trips will the monopolist sell?

9. What would be the consumer surplus and the profitmade by the price-discriminating monopolist?



002$ 1051,002$ 2

521,051,002$ 3001,521,051,002$ 4

NOTES

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Lesson 2

Firm Behavior and Monopolies



1. The Wheeler Wheat Farm sells wheat to a grain broker inSeattle, Washington. Since the market for wheat is perfectlycompetitive, the Wheeler Farm

A. doesn’t choose the quantity of wheat to produce.B. doesn’t have any fixed costs of production.C. isn’t able to earn an accounting profit.D. doesn’t choose the price at which it sells its wheat.

2. Since monopolies have a downward-sloping demand curve,regulating monopolies by setting price equal to marginal costwould

A. cause the monopolist to operate at less than maximum profit.

B. maximize producer surplus.C. result in a less-than-optimal total surplus.D. cause many new firms to enter the market.

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EXAMINATION NUMBER:





3. When a producer is operating at the bottom of a U-shaped average-total-cost curve, theproducer is said to be operating at

A. decreasing returns to scale. C. the efficient scale.B. the inefficient scale. D. increasing returns to scale.


A. In a perfectly competitive market, changes in demand cause short-term changes inprice, and no changes in quantity supplied to the market.

B. In a perfectly competitive market, changes in demand cause no long-term changes inprice, and permanent changes in quantity supplied to the market.

C. In a perfectly competitive market, changes in demand cause no changes in price, andlong-term changes in quantity supplied to the market.

D. In a perfectly competitive market, changes in demand cause no changes in price, andpermanent changes in quantity supplied to the market.

5. A competitive firm will choose to increase production when marginal cost is less than

A. marginal revenue. C. average variable cost.B. the marginal average. D. average total cost.

6. The purpose of antitrust laws is to

A. increase competition.B. create government-controlled monopolies.C. protect and promote copyright and patent laws.D. limit the public’s trust in a monopoly.

7. Which of the following statements about fixed cost is correct?

A. Fixed cost is always large in the long run.B. Fixed cost is seldom larger than variable cost.C. Fixed cost is a short-run phenomenon.D. Fixed cost can never exceed variable cost in a profitable firm.

8. One problem with monopolies is that they can

A. profiteer at the expense of consumers.B. price their product at a level that forces consumers to pay more than they can afford.C. buy political favors with their excessive profits.D. restrict output below the socially efficient level of production.


9. If a firm pays employees by the hour and guarantees every employee 40 hours of work perweek, how would the firm categorize its labor costs?

A. Fixed and independent of how many hours each employee worksB. Variable and independent of how many hours each employee worksC. Fixed if each employee works no more than 40 hoursD. Variable if each employee works no more than 40 hours

10. A perfectly competitive firm realizes an average revenue of $11 and an average total costof $10. Its marginal-cost curve crosses the marginal-revenue curve at an output level of100 units. The current profit is $100. What is likely to occur in this market?

A. The price will go down. C. Costs will go up.B. Firms will leave the market. D. Costs will go down.

11. When a monopolist faces a downward-sloping market demand curve, its

A. average revenue is always less than marginal revenue.B. marginal revenue is greater than the price of the units it sells.C. average revenue is less than the price of its product.D. marginal revenue is always less than the price of the units it sells.

12. In a perfectly competitive market where all firms have identical cost structures, the marketsupply curve would be equal to the

A. sum of supply curves for all firms in the market.B. product of supply curves for all firms in the market.C. sum of average variable cost curves for all firms in the market.D. sum of average total cost curves for all firms in the market.


A. In the short term, land is a variable cost.B. In the short term, electricity is a fixed cost.C. In the short term, raw materials are a fixed cost.D. In the short term, buildings are a fixed cost.

14. An example of an industry that benefits society by government-created monopoly is the

A. cable TV industry. C. pharmaceutical industry.B. local telephone industry. D. precious stones industry.

15. An example of an explicit cost of production would be

A. the cost of foregone labor earnings for an entrepreneur.B. the cost of stone for a sculptor.C. the value a business derives from using the owner’s computer to keep payroll records.D. all of the inputs to production.

Examination, Lesson 240

16. The production decisions of perfectly competitive firms follow the principle of economicswhich states that rational people

A. make the same production decisions in all markets.B. think at the margin.C. equate prices to the costs of production.D. eventually leave markets that experience zero profit.


A. A firm with fixed costs always has losses for low levels of output.B. A firm with fixed costs must incur economic losses if it chooses not to produce output.C. A firm with fixed costs can’t maximize profit in the short run.D. A firm with fixed costs is always able to sell its product for a price that exceeds

marginal revenue.

18. The cost to produce an additional unit of output is a firm’s

A. variable cost. C. marginal cost.B. average variable cost. D. opportunity cost.

19. By using the concept of total surplus as a measure of well-being, it’s possible to show that

A. profit-maximizing natural monopolists always make society better off.B. producer surplus for a perfectly competitive firm always exceeds that of a monopolist.C. consumer surplus in a monopoly market always exceeds consumer surplus in a

perfectly competitive market.D. society is worse off when monopolists set a price that maximizes their profit.

20. Firms in a perfectly competitive market are said to be price takers, because

A. if a firm charges more than the going price, it would sell all of its goods.B. a firm has no incentive to charge less than the going price.C. each firm can sell as much as it wants at a reduced price.D. select firms can take the market for their particular good.

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Oligopoly, MonopolisticCompetition, and theFactors of Production

INTRODUCTION

In the previous lesson, you learned about perfect competitionand monopoly. These market structures provide useful infor-mation about how markets operate, even though most real-world industries are somewhere between the two extremes.The beginning of this lesson introduces you to imperfectcompetition, which includes a variety of firms between the two extremes. There are two types of imperfectly competitivefirms: oligopolies and monopolistic competitors.

An oligopoly is a market structure in which there are fewsellers who offer similar or identical products. Each of thesellers in this case has a large impact on price and industryoutput.

The other market situation that exists in the gray areabetween monopoly and competition is monopolistic competition.This category includes fast-food restaurants, gasoline stations,and the corner market. Many of the businesses we deal withevery day are monopolistic competitors, sharing some of the characteristics of a monopoly and some of a perfectlycompetitive industry.

This lesson ends with an explanation of the behavior of labormarkets. Specifically, how labor, land, and capital are com-pensated for the roles they play in the production process. At equilibrium, each factor of production earns the value of its marginal contribution to the production of goods andservices. The wages of workers reflect the market prices ofthe goods they produce.

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■ Describe possible market outcomes of an oligopoly

■ Apply the prisoners’ dilemma to oligopolies andother market situations

■ Evaluate the effectiveness of antitrust laws in promoting competition

■ Explain how product differentiation affects the pricing and output decisions of firms

■ Compare monopolistic competition to perfect competition

■ Analyze labor demand of competitive, profit-maximizing firms

■ Explain why equilibrium wages equal the value of the marginal product of labor

■ Discuss how changes in the supply of a factor ofproduction affect the value of the marginal product of other factors

ASSIGNMENT 7Read this introduction to Assignment 7. Then, read Chapter 16,“Oligopoly,” on pages 345–367 in Principles of Microeconomics.

Most businesses in the real world fall somewhere betweenthe extremes of perfect competition and monopoly. A marketstructure that contains elements of both competition andmonopoly is known as imperfect competition.

As you’ll learn in this assignment, imperfectly competitivefirms can be either monopolistic competitors or oligopolists.A monopolistically competitive industry has many firms withsome control over price. An oligopolistic industry has fewfirms, each of which has substantial impact on price andindustry output. A major characteristic of oligopoly is inter-dependence. Each firm knows that its decisions will affectdecisions by other firms.

Lesson 3 43

Oligopolies come in different sizes, but each one faces thesame obstacle—a lack of cooperation within the group. Thesimplest type of oligopoly is duopoly, which is a market withonly two sellers. If the duopolists cooperate to set price andoutput, they’ll produce where marginal revenue equals mar-ginal cost and set price from the demand curve (chargingwhatever the market will bear). To accomplish this, theduopolists would need to cooperate and form a cartel. Theproblem for the duopolist is reaching an agreement throughcollusion that satisfies each firm and is enforceable. Bothfirms have an incentive to try to cheat on the agreement andundercut the other firm to gain a larger share of the market.

When the duopolists set their production levels and corre-sponding prices, they choose the best strategy based on thestrategies that they expect their competitor to choose. Thisproduces an outcome known as a Nash equilibrium. Theresult is an output greater than the monopoly output butless than the competitive output. As the number of sellersrises, the output approaches the competitive level and priceapproaches marginal cost.

A good example of the problems inherent in an oligopoly is the Organization of Petroleum Exporting Countries (OPEC).This cartel of mainly Middle Eastern oil-producing countrieswas effective in reducing output to near-monopoly level inthe 1970s. The energy crisis of 1973 was a result of OPECefforts to restrict the supply of oil to the West. In 1979, afterthe overthrow of the Shah of Iran, OPEC was again able torestrict exports of petroleum and cause another energy cri-sis. However, members had a tremendous incentive to cheatin order to earn greater profits. The result is that the cartelis no longer effective, and world petroleum production is relatively competitive.

In this assignment, we’ll examine how people behave whencooperation is desirable, but difficult to attain. The study of how people behave in strategic situations is called game theory. In these situations, a person makes decisions by tak-ing into account the possible responses by others. A simpleexample of game theory is the prisoners’ dilemma. In its original version, police interrogate two accused criminalsseparately to get a confession. Even though they gain collec-tively when they refuse to confess, they eventually do confess.

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This is because if either one caves in and confesses, he orshe will be far better off. If each could be sure that the otherwould honor the agreement not to confess, they both wouldgain by refusing to cooperate with the police. However, eachhas an individual incentive to confess because his or herindividual gain is maximized by confessing (regardless of the strategy chosen by the opponent). This action is some-times called the dominant strategy, which is an action that’sclearly superior no matter which alternative is chosen by theother person.

Oligopolists face incentives that are similar to those in the prisoners’ dilemma. Each seller individually has anincentive to overproduce relative to the monopoly output,even though collectively there’s an incentive to restrict out-put to the monopoly level. Self-interest leads to the eventualbreakdown of cooperation.

One of the Ten Principles of Economics states that govern-ments can sometimes improve market outcomes. With thisin mind, policymakers try to push firms in an oligopoly tocompete rather than cooperate. Beginning with the ShermanAntitrust Act of 1890, public policy has treated price fixingand other actions that restrain trade as criminal conspiracy.Some actions, such as price fixing, are clearly illegal and notin society’s interest. Other business actions are less clear-cut in terms of both legality and impact on society.

For example, resale price maintenance by producers prohibitsretailers from discounting price. In another example, tyingagreements are often used to increase sales of supplies oraccessories to be used with a piece of equipment. Criticsargue that both of these actions restrain trade and limit competition. Supporters argue that both actions are justifi-able. They point out that resale price maintenance and tyingagreements may be necessary to protect the reputation of the producer.

Competition between oligopolists along with antitrust lawsprevent the firms from colluding and jointly behaving likemonopolists. Antitrust laws can promote competition, butthey can also be used inappropriately, leading to a lesseningof competition.


ASSIGNMENT 8Read this introduction to Assignment 8. Then, read Chapter 17,“Monopolistic Competition,” on pages 373–387 in the textbookPrinciples of Microeconomics.

Earlier, you learned about the notion of market structure,which can range from competition (many buyers and sellers)to monopoly (a single seller). These extreme cases are usefulfor analyzing the various assumptions about markets, butthey’re a bit unrealistic for the real world, which is rarely thatblack and white. In this assignment, you’ll learn about the“gray area” between monopoly and competition. Businessesin this gray area include fast-food restaurants, gasoline serv-ice stations, and corner markets. You’ll see that monopolisticcompetition contains characteristics of both a monopoly anda perfectly competitive industry.

The following are three major characteristics of monopolisticcompetition:

1. Many sellers competing for the same group of buyers

2. Free entry into (or exit from) the market, which meansthat there are no restrictions for sellers

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Self-Check 7

Write a definition for each of the Key Concepts listed on page 367 of your textbook. Then,answer Questions for Review 1, 2, 3, 6, 7, and 8 on page 367 of your textbook. Finally, inthe Problems and Applications section on pages 368–371, solve Problems 3, 5, and 8.


3. Product differentiation in the market, with each selleroffering a slightly different version of the product

The first two characteristics make monopolistic competitionsimilar to perfect competition. In fact, because of free entry,long-run economic profits are driven to zero, as in the com-petitive case. The third characteristic, product differentiation,is the reason for the monopolistic competitor’s control overprice. By differentiating its product, the firm is able to controlits price within some range.

The ability to differentiate its product allows the monopolisticcompetitor to act like a monopolist to some extent. In fact, itsets price and quantity in the same manner that a monopolistdoes: output occurs where MC equals MR, and the maximumprice it can charge is determined by the demand curve (whatthe market will bear).

In the long run, the situation changes. Unlike monopolists,monopolistic competitors face competition from new entrantswhenever economic profit is positive. The result is an ATCcurve that’s just tangent to the demand curve in long-runequilibrium. Economic profit is zero, as in the perfectly com-petitive case. However, unlike the perfect competitor, themonopolistic competitor faces a downward-sloping demandcurve. Therefore, the tangency is at an output below the effi-cient scale, and the firm has excess capacity (it could lowerATC by increasing output). Also, because MR is less than P,the firm faces a price effect that discourages production at the socially desirable competitive level. Unlike the perfectcompetitor, it has no incentive to produce where MC equals P.

The monopolistic competitor has mixed effects on efficiency.On the one hand, it adds to the variety of products availablefor consumers. However, it also produces above minimumATC, suggesting that there are too many firms in the industry,each producing below the efficient scale. Even though price inmonopolistic competition is higher than would be the case inperfect competition, price itself isn’t the source of inefficiency.Rather, it’s the lower quantity that results from the higherprice. By itself, the higher price merely redistributes incomefrom buyers to sellers. The efficiency effect occurs becausepeople buy fewer units of the product at the higher price.

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How do firms in monopolistic competition convince you tobuy their product? The answer is with a bombardment ofadvertising. However, just as monopolistic competition hasmixed effects on economic efficiency, so does advertising.Advertising can impede competition and distort consumers’wants. On the other hand, advertising can be a valuablesource of information for consumers. Also, a big advertisingcampaign provides some evidence that a seller has confi-dence in its product and will stand behind it.


ASSIGNMENT 9Read this introduction to Assignment 9. Then, read Chapter 18,“The Markets for the Factors of Production,” on pages 393–410in the textbook Principles of Microeconomics.

In this assignment, you’ll learn how input markets work. The demand for an input, or factor of production, is a deriveddemand. That is, it’s derived from the demand for the finalproduct. This assignment analyzes the demand for factors of production by competitive, profit-maximizing firms.

The first input we’ll consider is labor. Firms value labor notfor itself, but for what it can produce. Nevertheless, the basicprinciple still applies—rational people think at the margin.When an employer is deciding how much labor to hire, it

Self-Check 8

Write a definition for each of the Key Concepts listed on page 387 of your textbook. Then,answer Questions for Review 3, 4, and 6 on page 387 of your textbook. Finally, in the Problems and Applications section on pages 388–389 solve Problems 1, 6, and 7.


must compare the cost of adding workers to the benefits ofincreased output. The general rule for decision making stillapplies: do anything as long as the marginal benefit is atleast equal to the marginal cost. In terms of labor, thismeans that it’s good to hire additional workers as long as they add less to cost than they add to revenue.

In a competitive environment, the cost of adding a worker is simply the worker’s wage. The added revenue is the dollarvalue of the extra worker’s output. This added revenue isknown as the value of the marginal product. Specifically, thevalue of the marginal product is the marginal product timesthe price of the product. The value of the marginal productbegins to decline when the marginal product itself begins todecline. Because the profit-maximizing firm is willing to hireworkers up to the point at which the wage (the price of labor)equals the value of the marginal product, the value of themarginal product is the firm’s demand curve for labor.

For the overall labor market, the wage is the price of labor,and it adjusts to bring supply and demand into balance. In addition, the wage must always equal the value of themarginal product. Therefore, any change in supply anddemand that affects the wage must also change the value of the marginal product by the same amount. For example, if the supply of labor falls, the wage rises.

The intersection of the old demand curve and the new supplycurve will be a point on the demand curve with a higher valueof the marginal product. Similarly, if the value of the marginalproduct of labor increases (either because of an increase inproductivity or an increase in product price), the rightwardshift in labor demand will increase equilibrium wages andemployment.

Again, the value of the marginal product and the wage rateincrease together. Because wages equal productivity (the valueof the marginal product), higher productivity leads to a higherstandard of living. Countries that have more physical capital,human capital, and technological knowledge tend to havehigher productivity and higher wages, providing a higherstandard of living.

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As firms hire labor, they also make decisions about otherinputs to production. They must acquire land and capital,which economists define as the equipment and structuresneeded to produce goods. The analysis of wage determinationin labor markets has a parallel in the markets for land andcapital. However, it’s important to separate the purchaseprice of land and capital from the rental price. Just as theprice of labor (the wage) is essentially a rental price, theprices of land and capital are rental prices for the use ofresources. Producers essentially rent (or buy the services of)land, labor, and capital when they buy productive resources.

The demand for capital is the value of the marginal product of capital. The same is true for land. Producers will use any resources as long as an additional unit adds at least asmuch to revenues as it adds to cost. The value of the marginalproduct of any factor of production is related to the supply of other factors of production. Labor productivity is affected by the amount of capital and land that are available, just as land productivity and capital productivity are affected byavailability of the other factors. As a result, an increase inthe supply of a factor of production will reduce the value ofits marginal product while raising the value of the marginalproduct of other factors of production.

After you’ve read pages 393–410 in Principles of Micro-economics carefully, complete Self-Check 9. Check youranswers against those provided at the back of this studyguide. When you’re sure that you completely understandthe material from Assignment 9, move on to theSuggested Activities for Lesson 3.

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Self-Check 9

Write a definition for each of the Key Concepts listed on page 410 of your textbook. Then,answer Questions for Review 1 and 5 on page 411. Finally, in the Problems and Applicationssection on pages 411–412, solve Problems 3 (parts a and b only), 4, and 7 (part A only).


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Suggested Activities for Lesson 3Read through these Suggested Activities and write out theanswers to the questions in your notebook or on a separatepiece of paper.

Activity 1: Brand Names

One day after coming home from preschool, a four-year-old child told his mother that he would like a pair of “nick”sneakers like his friend in school wears. When she respondedthat she didn’t know what kind of sneakers he meant, heimpatiently replied, “You know, the ‘nick’ sneakers like thebasketball players in the TV commercial wear!” Of course, he meant Nike sneakers. The point of this story is that evensmall children are very aware of brand names, even if theycan’t pronounce them correctly.

Instructions: Just for fun, try to complete the following quiz.Circle the brands that are made by each company identified.

1. Which of the following bottled water brands does theNestle company make?

Perrier Arrowhead Poland Spring Vittel Contrex

2. Which of the following pet food brands does the Quaker company make?

Gravy Train Gaines Burgers Kibbles ‘n Bits Ken-L-Ration

3. Which of the following consumer electronics brands doesthe Matsushita company make?

Panasonic Technics Quasar National

Check your answers against those provided at the back ofthis booklet. Then, write out the answer to the followingquestion.

4. The quiz you just took illustrates product differentiation. What is product differentiation, and how was it attained in the products that were listed?

Activity 2: How Much Are Those Blue Jeans in theWindow?

This exercise examines why market supply-and-demandgraphs give an oversimplified picture of price when productsare differentiated.

Instructions: On a separate piece of paper, draw a supply-and-demand curve for blue jeans. Next, label the equilibriumprice with a real dollar figure. The amount should be whatyou last paid for a pair of jeans.

On your demand curve, identify your best guess at the following: (a) the price that a single mom with four kidswould pay for a pair of children’s jeans; (b) the price that a teenager from a prosperous family would pay for a pair of jeans; and (c) the price that a wealthy supermodel wouldpay for a pair of jeans.

Now, answer these questions.

1. List two factors that might affect the price of blue jeans.

2. If you were a manufacturer of blue jeans, how would you determine the price for your wide-leg jeans?


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Lesson 3

Oligopoly, Monopolistic Competition,

and the Factors of Production



1. A monopolistically competitive firm chooses the

A. price, but output is determined by cartel production quota.B. quantity of output to produce and the price at which it will

sell its output.C. quantity of output to produce, but the market determines

price.D. price, but competition in the market determines the quantity.

2. Cooperation between the two prisoners in the prisoners’ dilemmagame is difficult to maintain, because

A. the prisoners are questioned separately.B. criminals know they can’t trust one another.C. choosing the dominant strategy is individually rational.D. cooperation is individually rational.

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3. Assuming competitive markets, a worker’s contribution to revenue is given by the

A. production function.B. marginal product minus the marginal cost.C. value of the marginal cost of labor.D. value of the marginal product of labor.

4. Government laws that restrict cooperative agreements are called

A. cartel laws. C. tort laws.B. antitrust laws. D. corporate laws.

5. The business-stealing externality associated with monopolistic competition arises becausein monopolistically competitive markets, firms

A. always charge a price higher than marginal cost.B. produce differentiated products.C. are few barriers to entry.D. produce at less than efficient scale.


A. If wages fall, profit-maximizing firms in competitive markets will increase employment,and the marginal product of labor will fall.

B. If wages fall, profit-maximizing firms in competitive markets will increase employment,and the marginal product of labor will rise.

C. If wages fall, profit-maximizing firms in competitive markets will decrease employment,and the marginal product of labor will rise.

D. If wages fall, profit-maximizing firms in competitive markets will decrease employment,and the marginal product of labor will fall.

7. The market for wine is likely to be characterized by which form of market structure?

A. Monopoly C. Perfect competitionB. Oligopoly D. Monopolistic competition


A. As the number of firms in an oligopoly increases, the oligopoly becomes more like a duopoly.

B. As the number of firms in an oligopoly increases, the oligopoly becomes more like a monopoly.

C. As the number of firms in an oligopoly increases, the oligopoly becomes more competitive.

D. As the number of firms in an oligopoly decreases, the oligopoly becomes more competitive.

9. A key determinant of recent labor productivity has been

A. family size. C. information technology.B. equilibrium wages. D. an increase in product demand.


10. The deadweight loss that’s associated with monopolistically competitive markets is a result of

A. operating in a constant-cost industry.B. advertising costs.C. pricing below marginal cost in order to increase market share.D. pricing above marginal cost.

11. The practice of selling a product to retailers and requiring the retailers to charge a specificprice for the product is called

A. fixed retail pricing. C. resale price maintenance.B. unfair trade. D. cost-plus pricing.

12. When advertising fosters brand loyalty, critics claim that it

A. impedes competition.B. lowers the quality of goods in the market.C. alters a firm’s supply curve.D. increases competition in the market.

13. The profit-maximizing employment rule for a competitive firm ensures that

A. output price will equal marginal cost.B. revenue will be maximized.C. total costs will be minimized.D. price will always exceed cost of production.


A. Over time, government has been less lenient toward advertising in order to enhancethe ability of markets to allocate resources efficiently.

B. Over time, government has been more lenient toward advertising in order to enhancecompetition in markets.

C. Over time, government has been more lenient toward advertising in order to enhancebrand loyalty.

D. Over time, government has been less lenient toward advertising in order to decreaseelasticity of demand for specific products.

15. When the number of firms in a market is small, firms

A. generally organize as a cartel.B. are less concerned about competitors’ behavior, since there’s always sufficient

demand to keep all firms happy.C. are guaranteed an economic profit.D. must generally consider how competing firms respond to their decisions.


16. When a profit-maximizing firm makes a decision to employ a worker, that decision isbased on

A. the individual contribution that the worker makes to the profit of the firm.B. how much output the worker can produce.C. the familial relationship between the employer and the employee.D. the total output produced by the firm.

17. Why might it be rational to trust a brand name more than an unknown product?

A. Brand name products are lower-priced.B. Brand name products are better quality.C. Brand name companies have invested heavily in their reputations.D. Greater market share means greater quality.

18. For a perfectly competitive firm to maximize profit, any rise in the market wage must be

A. offset by a decrease in the value of marginal product.B. followed by an increase in employment.C. followed by a decrease in the marginal product of labor.D. followed by an increase in the marginal product of labor.

19. Markets that are characterized by a few sellers who sell similar or identical products aretypically referred to as

A. aggressive markets. C. monopoly markets.B. oligopoly markets. D. competitive markets.

20. Which of the following could decrease labor demand?

A. An increase in migrant workersB. A decrease in demand for the final product produced by laborC. A decrease in the labor supplyD. An increase in the marginal productivity of workers

57

Labor Markets; Further Applications of Microeconomics

Introduction

Why do some people earn so much, while others earn so little? The first two assignments of this lesson look at wagepatterns in the United States and discusses the factors thathelp explain differences in wages. Firms pay a premium forworkers who are more talented, more diligent, more experi-enced, and more educated because these workers are moreproductive. Firms pay less to those workers against whomcustomers discriminate because these workers contribute lessto revenue. Of course, this results in a distribution of incomein the United States that’s unequal. We’ll explore the range ofincomes in our country compared to others and evaluate ourefforts to deal with the problem of poverty.

The last two assignments in this lesson explore some inter-esting, and fairly recent, developements in microeconomics.First, we’ll deal with the theory of consumer choice. This theory aims to explain how people make decisions on whatthey’ll buy. We don’t make explicit optimization models foreverything we buy. Yet, we’re aware that our choices are constrained by financial resources. With these constraints in mind, we do the best we can to achieve the highest level of satisfaction. The theory of consumer choice tries to describethis thought process in a way that permits an economic study.This analysis uses indifference-curve analysis to depict consumer maximization of utility and its implications fordemand. Finally, in your last assignment, we’ll briefly sketchthe groundbreaking work microeconomists are doing in thefields of asymmetric information, political economy, andbehavioral economics. Though unfamiliar to you now, thesetopics could become the standard fare of tomorrow’s economicnews. So stay tuned!

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■ Explain the effect of wage differentials on jobs with unattractive characteristics

■ Explain the rationale for superstars’ mega-salaries

■ Describe comparable worth and discrimination in the competitive market

■ Describe economic inequality in our society

■ Describe political philosophies on government’s role in redistributing income

■ Evaluate minimum wages, traditional welfare, andtransfers as methods for redistributing income

■ Explain how a budget constraint represents thechoices a consumer can afford

■ Draw budget constraints and indifference curves

■ Interpret changes graphically on budget constraints and indifference curves

■ Discuss the microeconomic “frontier” topics of asymmetric information, political economy, and behavioral economics

ASSIGNMENT 10Read this introduction to Assignment 10. Then, read Chapter 19, “Earnings and Discrimination,” on pages413–428 in Principles of Microeconomics.

It’s necessary to understand the factors that determinewages in order to explain why some people are rich and some are poor. Wages are determined by labor supply anddemand, which in turn are determined by the many differentcharacteristics of workers and jobs. This assignment exam-ines why some jobs are more desirable than others and why these typically don’t need to pay as much as less attractivejobs to attract the same number of workers. As a result,wages tend to be higher the less attractive the job is, giventhat all other factors such as education and skills are heldconstant.

Lesson 4 59

Economists refer to wage differentials that arise from suchnonmonetary characteristics of different jobs as compensatingdifferentials. Wages also tend to be high for workers whohave invested more in human capital. Human capital is theaccumulation of investments in people, for example, in theform of education or health care.

The return to investment in education has grown in recentdecades, as the earnings gap between workers with high and low skills has grown. Other factors that affect earningsare natural ability, amount of effort, and luck.

This assignment also looks at the economics of discrimination,or how a person’s prejudice affects the earnings of differentgroups of workers. Discrimination results when labor marketopportunities vary for individuals who differ only by personalcharacteristics—such as race, sex, or age—that are irrelevantto job performance. Wage differentials exist between malesand females, and between blacks and whites. However, it’snot easy to measure how much of the differential is due todiscrimination rather than differences in human capital orjob characteristics.

One reason that women earn less than men do is that tradi-tionally male occupations pay more than traditionally femaleoccupations. One way to combat this is to develop a systemwhere comparably rated jobs would pay the same wage. This doctrine of comparable worth argues that jobs should be evaluated, and those that are judged comparable should offer the same pay. The problem is that the market alreadyevaluates jobs through supply and demand. Women who are the primary caregivers for their children may chooseoccupations that offer flexible hours, even though the pay is low. The pay gap may be a compensating differential.Without that differential, there will be surpluses of labor inthe pleasant occupations and shortages in the less desirableoccupations. Equalizing the pay artificially takes away thelabor market’s signal for more people to enter the higher-paying job.

Competition between employers can eliminate discrimination,because those who hire anyone other than the best personfor the job will be at a competitive disadvantage. It’s moredifficult to eliminate discrimination by customers.

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Employers who discriminate because their customersdemand it will have a competitive advantage over those whodon’t. Keep in mind that different pay for different peopledoesn’t always mean that discrimination exists. Differentjobs and different people have different characteristics thataffect the supply of and demand for labor. What seems to bea discriminatory wage differential may actually be a compen-sating differential that offsets a nonmonetary aspect of the job.

In competitive markets, workers receive a wage equal to the value of their marginal product. This marginal product is determined by factors such as workers’ training, ability,and experience. Demand for their product also helps deter-mine the marginal product. As a result, some workers earnmore than others do. Is this fair?

The answer to this question is debatable. An interestingexample is the amount of money that’s earned by some pro-fessional athletes and actors. People often react in horror tothe high salaries of superstars. For example, basketball starShaquille O’Neill recently earned $17 million a year to playon a professional team. Many people would probably respondthat Shaquille O’Neill is overpaid, that “nobody deserves thatmuch.” However, marginal productivity theory tells anotherstory: If O’Neill is paid $17 million, it’s because he’s worth at least that much to the team. Suppose that he brings in$34 million in additional ticket sales and advertising revenuesto his team. Is he overpaid or underpaid? There’s no easyanswer, but remember that in this case, he would be earningonly half of the value of his marginal product! Superstarscan earn supersalaries to a large extent because they canprovide a service to many fans simultaneously through tele-vision. They earn a lot because we’ve made them valuableproductive factors.

After you’ve read pages 413–428 Principles of Micro-economics carefully, complete Self-Check 10. Checkyour answers against those provided at the back of this study guide. When you’re sure that you completelyunderstand the material from Assignment 10, move onto Assignment 11.

ASSIGNMENT 11Read this introduction to Assignment 11. Then, read Chapter 20, “Income Inequality and Poverty,” on pages 431–450 in Principles of Microeconomics.

This assignment analyzes wage patterns in the United Statesand the government’s role in altering the distribution ofincome. Before we can consider income redistribution policy,it’s necessary to measure the degree of income inequality,identify those who live below the poverty line, explore howoften people move between income classes, and evaluate the measurement problems that make it difficult to measureinequality.

The degree of income inequality is measured most common-ly by calculating the percentage of income earned by each quintile, or one-fifth, of families. You’ll find that the distributionof pretax income isn’t much different than it was 60 yearsago. The top 20 percent earn roughly 50 percent of the income(51.7 percent in 1935, 46.9 percent in 1994), and the bottom20 percent earn just over 4 percent (4.1 percent in 1935, 4.2 percent in 1994).

However, this comparison disguises the patterns over time.Income inequality fell dramatically from 1935 to 1970 andthen increased from 1970 until the present. Actual disposable(spendable) income is more equally distributed than thesenumbers suggest, because the comparisons are made beforetaxes and transfer payments such as welfare.

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Self-Check 10Write a definition for each of the Key Concepts listed on page 428 of your textbook. Then,answer Questions for Review 1, 2, 3, and 8 on page 428 of your textbook. Finally, in theProblems and Applications section on page 429–430, solve Problems 3 and 7.


Economics 262

Another measure of the distribution of income is the povertyrate—the percentage of the population whose income fallsbelow an absolute level known as the poverty line. The federalgovernment defines the poverty line as three times the cost of providing a family with an adequate diet. The poverty linevaries with family size and is adjusted each year for inflation.In the mid-1990s, the poverty line was roughly $15,000 for a family of four. In the United States, those who are at thegreatest risk of being poor are the very young or the very old,blacks or Hispanics, and people in single-parent householdsheaded by a female.

There are a number of problems in trying to take accuratemeasurements of the patterns of income distribution and ofthe incidence of poverty. One problem is that income variesnaturally over a person’s lifetime, exaggerating the incomedifferences between people at a given point in time. Anotheris that temporary changes in income increase the measureddegree of income inequality, even though families can adjustto such temporary factors and base their standard of livingon permanent income, which is their normal, or average,income. Also, when we measure inequality, we don’t takeinto account in-kind transfers, or transfers to the poor in the form of goods and services rather than cash. It’s also difficult to measure inequality because economic mobility in the United States is quite high. It’s relatively common for people to move from one income bracket to another.

Even though poverty becomes a vicious cycle for some fam-ilies, this isn’t as common as is usually thought. Fewer than 3 percent of families are poor for eight or more years,compared with nearly 15 percent of all families who qualifyas poor. It’s important to keep in mind when designingpoverty programs that no more than roughly 20 percent of the poor are permanently poor.

What can our government do about economic inequality?This assignment discusses three views of economic justicethat play heavily in our policy decisions regarding the appro-priate level of income redistribution by government. The firstview we’ll look at is utilitarianism. Utilitarians argue for thegreatest good for the greatest number of people. That is, we should maximize the sum of the utility, or well-being, of everyone in society. Because of diminishing marginal

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utility, utilitarianism argues that redistributing wealth froma rich person to a poor person increases the social good. (The marginal dollars are worth more to the poor person.)

The second view is liberalism, which is an idea that’s statedclearly by political philosopher John Rawls. He argues that a just system is one that we would devise if we set up therules of the economic game before we know what part wewould play—if we could vote on the economic system beforewe were even born. According to Rawls, we would act tomaximize the utility of the least fortunate member of societybecause we might end up being that person. His view is calledthe maximum criterion. The maximum criterion doesn’t meantotal redistribution, however, because that would destroyincentives and make everyone worse off.

The third view is libertarianism. Libertarians believe thatsociety doesn’t earn income—individuals earn income.Society, therefore, has no right to take from some to give toothers. Philosopher Robert Nozick believes that the only rolefor government is to enforce individual rights so that everyonehas equality of opportunity, but not outcome. According toNozick, it’s inappropriate even to ask what level of inequalityis acceptable. He believes that the actual level of inequality isdetermined by the actions of individuals operating throughfree will. As long as the process is fair, the outcome is fair.

As a country, we’ve developed policies that are designed toreduce poverty. One of our laws with this goal in mind is the minimum-wage law. Although it raises wages for someworkers, the minimum wage also reduces employment opp-ortunities for others, making it unsatisfactory as a cure for poverty.

Another way we try to raise living standards for the poor is through welfare. Welfare provides cash assistance basedon certain “needs” tests. The problem is that existing pro-grams create incentives for people to change their behaviorin undesirable ways in order to qualify. For example, tradi-tional welfare programs often offer lower benefits if both parents are present, which can have the effect of “rewarding”families for breaking up. They also often penalize recipientswho want to work by reducing benefits dollar for dollarwhenever a welfare recipient earns income. This is like a100 percent income tax! Obviously, it will discourage peoplefrom working.

Our government also has the option of a negative income tax. Under this tax, families below a certain income levelwould receive a “negative” tax, or a transfer payment, fromthe government. This negative tax would be equal to a givenpercentage of the gap between earned income and a specifiedlevel. The only requirement for the program is that familieshave incomes below that specified level. A disadvantage isthat society would lose control over behavior. Even peoplewho are simply lazy could receive benefits. An advantageof this system is that there would be more of a financialincentive to work, because work would always lead to high-er income. Recipients would never pay a 100 percent tax rate on their earnings.

Another option that we exercise (when it’s politically popular)is to help the poor by providing them directly with goods andservices. Supporters of in-kind transfers argue that this typeof assistance directly provides for food, shelter, and healthcare, whereas cash handouts can be used to support alco-holism and drug addiction.

Perhaps the most basic tradeoff in economic policymaking is equity versus efficiency. Nowhere is this seen more clear-ly than in our attempts to use government to alter incomedistribution without causing serious distortions in behaviorthat reduce productivity and output. We might prefer a morenearly equal distribution of income, but as you’ll learn inthis assignment, we don’t know how to accomplish this goalwithout lowering the overall level of incomes. The dilemmawe always face is deciding how much inequality is desirable.

After you’ve read pages 431–450 in Principles of Microeconomics carefully, complete Self-Check 11. Check your answers against those provided at the back of this study guide. When you’re sure that you completelyunderstand the material from Assignment 11, move on toAssignment 12.

Economics 264

ASSIGNMENT 12Read this introduction to Assignment 12. Then, readChapter 21, “The Theory of Consumer Choice,” on pages455–478 in Principles of Microeconomics.

People generally would like to have more of the things they consume, but they’re limited by their incomes. In thisassignment you’ll learn about the budget constraint, whichshows the different combinations of goods and services thatare affordable. The opportunity cost of consuming more ofone good is the reduced amount of the other good that canbe purchased.

For example, suppose that Bob has $200 per month tospend on nights out and groceries. If an average night outcosts $20, then he could have ten nights out if he spends his whole budget on his social life. Alternatively, if groceriescost $10 per average small bag, he could have twenty smallbags of groceries if he uses all of his income for groceries. Ofcourse, he could also pick any of the in-between points, suchas 5 nights out for $100, plus ten bags of groceries for $100.In this example, the opportunity cost of one additional nightout is the two bags of groceries that he could have boughtwith the $20.

So, you can think of this as the cost of making a choice. Thebenefit of that choice depends on Bob’s preferences. Therefore,we still can’t tell how Bob should divide his income betweengroceries and partying. We use a tool known as the indifferencecurve to measure consumers’ relative preferences between

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Self-Check 11

Write a definition for each of the Key Concepts listed on page 450 of your textbook. Then,answer Questions for Review 4 and 5 on pages 450 of your textbook. Finally, in the Problemsand Applications section on pages 451–452, solve Problems 5, 6, and 10.


two goods. The indifference curve shows the bundles of consumption that make a consumer equally happy. In Bob’scase, an indifference curve would show different combinationsof nights out and groceries that would leave him equally satisfied. (That is, his total utility would be unchanged.)

Because more is always preferred to less, Bob would also like to reach a higher indifference curve. Bob likes to party,but he also likes to have some groceries around when he’s athome. In other words, he would like to have something leftfrom his $200 budget to spend on groceries. He went out sixtimes last month and bought eight small bags of groceries.His friends are complaining that he’s becoming boring andthat he should go out twice a week (or eight times a month).As much as he values his social life, two more nights outnext month would force him to give up four bags of groceries,and he’s not willing to bear that cost. Bob doesn’t need aneconomics course to figure out that if a night out costs twiceas much as a bag of groceries, he should pick the bundle ofnights out and groceries for which the night out is worth twiceas much as a bag of groceries. The general rule is that utility-maximizing consumers should rearrange their consumptionpatterns until the following rule is satisfied:

marginal rate of substitution = relative price

For Bob, maximizing utility means rearranging consumptionof nights out and groceries until the marginal rate of substi-tution is just equal to 2, which is the relative price of nightsout versus groceries. This is consistent with common sense.If a night out costs twice as much as a bag of groceries, andyou’re buying some of each, then a night out should be worthtwice as much as a bag of groceries to you. If it’s worth morethan twice as much, then nights out are a bargain and youshould buy more. If the night out is worth less than twice as much, then you might as well buy more groceries andstay home.

In this assignment, we’ll also take a look at how changes inprice affect a consumer’s choice. Let’s assume there’s beenan increase in the price of groceries for Bob. The budget con-straint becomes steeper. Therefore, Bob can no longer affordhis original bundle of nights out and groceries. If Bob spendsall of his money on nights out, the increase in the price of

Economics 266

groceries has no impact on his purchases. But once he startspurchasing groceries, the higher price per bag will leave himwith less money to spend on nights out. In the past, he wasable to afford eight bags of groceries and six nights out, but now if he wants to continue to purchase eight bags ofgroceries, Bob will have to have fewer than six nights out per month. He decides that he’ll have to buy fewer bags ofgroceries, cutting his consumption from eight bags to five.There are two reasons for this decrease in consumption ofgroceries when the price rises. First, he feels poorer, becausehis dollars don’t buy as much as they used to buy. This dropin his “real” income due to a price increase is known as theincome effect. Second, the relative price of groceries hasrisen, making nights out a better buy. This is known as the substitution effect.

This assignment concludes by applying the theory of con-sumer choice to some basic questions about how the economyworks. One of the questions that’s analyzed is, How do wagesaffect labor supply? As wages increase, there are two conflict-ing pressures on the quantity of labor supplied. The higherwage raises the effective price of leisure, because each hourof leisure means giving up an hour’s wages. This causes asubstitution effect away from leisure and in favor of morework. However, the higher wage also makes the worker feelricher. Because leisure is a normal good, the demand forwhich rises with income, there’s an income effect that dis-courages work. Whether the labor supply is upward-slopingdepends on the relative income and substitution effects. Ifthe income effect is greater, work effort decreases as wagesrise. If the substitution effect is greater, work effort rises aswages rise.

Another question explored is, How do interest rates affecthousehold saving? The interest rate represents the relativeprice of present versus future consumption. As the interestrate rises, the relative price of present consumption rises.This should discourage present consumption. However, the higher interest rate also makes the saver feel richer,encouraging more present and future consumption. Thus,the income effect has the opposite effect from the substitu-tion effect of a change in the interest rate. Obviously, people don’t make these theoretical calculations each time they

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buy groceries or have a night out. However, consumers dobehave this way when they simply act in their self-interest inmaximizing utility. Stated simply, people respond to economicincentives.

After you’ve read pages 455–478 in Principles of Micro-economics carefully, complete Self-Check 12. Check your answers against those provided at the back of this study guide. When you’re sure that you completelyunderstand the material from Assignment 12, move on to Assignment 13.

ASSIGNMENT 13Read this introduction to Assignment 13. Then read Chapter 22,“Frontiers of Microeconomics,” on pages 483–501 in Principlesof Microeconomics.

Your study of economics so far has taught you that marketsare, on the whole, an efficient way of using and distributingsociety’s scarce resources. When you studied externalities,the forms of imperfect competition, and poverty, you learnedabout some ways that economists have long known thatmarkets can fail and some government measures they rec-ommend (usually sparingly) to improve market outcomes. In Chapter 22, your textbook’s last chapter, you’ll learn howeconomic researchers are now introducing new factors intothis traditional picture to make it better fit human reality.

Self-Check 12

Write a definition for each of the Key Concepts listed on page 478 of your textbook. Then,answer Questions for Review 1, 2, 3, 4, 5, and 6 on pages 478–479 of your textbook. Finally,in the Problems and Applications section on pages 479–481, solve Problems 2 and 5.


Specifically, you’ll explore three attempts to flesh out themicroeconomic theory you’ve studied. First, you’ll read aboutasymmetric information, which shows how differences inknowledge between buyers and sellers in a market can be an additional source of undesirable market outcomes. Next,you’ll learn what researchers in political economy have learnedabout the limitations of government in improving market performance—or even in representing citizens’ wishes. Finally,you’ll discover how economists are borrowing insights fromanother social science, psychology, to prove that people aseconomic actors don’t behave as rationally, or with as fixed aconcern for their self-interest, as economists have traditionallyassumed.

You’ve no doubt heard the expression “what you don’t knowwon’t hurt you.” Unfortunately, there are probably as manycases where this is bad advice as where it’s good. Buying aused car is certainly one example—and economists whoresearch asymmetric information work hard to identify mar-kets where the difference in knowledge between buyers andsellers can definitely hurt the unknowing. Perhaps the key to understanding this topic is to try to imagine the types oftransactions that will attract buyers or, more frequently, sellerswho have something to hide. Since most people, especiallywhen unsupervised, have a built-in preference for “doing theirown thing” rather than what an employer would like them todo, the work situation is automatically one of these situa-tions. Without better information, employers are unlikely toknow nearly as much as potential hirees about the hirees’willingness to overcome this built-in preference. Since doingwhat you should, especially when it’s against your inclination,is termed “moral,” the term moral hazard has been coined toidentify the risks of labor buyers (and others, like insurancecompanies who depend on people to “behave”) when makingtransactions. Or, if the market is such that it’s likely to bringout sellers with defective products (like a used-car market or a low-wage labor market), economists have identified the buyers’ risks in these situations as adverse selection.Occasionally, adverse selection applies to markets in whichbuyers are likely to be the untrustworthy party; your text-book cites the example of health insurance markets. Anotherexample would be merchants who extend credit; buyers who

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Economics 2

can pay immediately are obviously more trustworthy. Soagain, think of markets where sellers or buyers have anadvantage by knowing something the other party doesn’t, and you have a good grasp of asymmetric information.

Since markets that attract people with something to hide have a long history of producing “rip-offs,” these markets have acquired a bad reputation. And this bad reputation can actually hurt sellers with good products to offer. Sincethese sellers have less to hide, they’re often willing to sacri-fice their knowledge advantage to help buyers learn that they have a good product. Economists have given the termsignaling to the various ways that informed parties try toreveal knowledge about their market offerings. In general,these methods involve going to trouble, expense, or both;buyers realize that sellers with defective products probablywouldn’t go to such trouble. One fascinating, if unromantic,application of this concept is your textbook’s discussion ofgifts as signals in romantic relationships. Briefly put, the“love market” has a bad reputation of producing “lemons,”and in addition, the stakes in this market are high. By goingto the expense and trouble of choosing an appropriate gift,rather than throwing cash in an envelope, the boyfriend orgirlfriend signals that he or she isn’t a “love lemon.”

Probably the simplest insight emphasized by researchers in political economy is the last one treated by your textbook,summarized by the heading “Politicians Are People Too.” You’llhave no trouble understanding that the government’s ability to nudge market outcomes toward overall social well-being is limited (to say the least) by politicians having interests other than overall social well-being. While this simple insight is important, it’s not as striking as the others covered here,which were arrived at by economic thinkers using mathemat-ics and logic. What makes these results striking, besidestheir not being obvious, is that they show that even our cherished democratic voting system has built-in limits inexpressing voters’ true preferences. Thus, the Condorect paradox proves that when voters must choose from manyalternatives, presented to them two at a time (so that eachsuccessful alternative is chosen by a majority), the ultimatewinner may depend on the order in which the alternativepairs are voted on, even if the ultimate winner is few voters’first choice! Besides proving the limits of majority voting to

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Lesson 4

express (and satisfy) voter preference, Condorect’s paradoxproves the importance of setting the political agenda—aninsight our politician are perhaps too well acquainted with.Similarly, Arrow’s impossibility theorem sets up a list of desirable characteristics in a voting system and then proves,again by logic, that no possible voting system can have allthese characteristics. But perhaps the most interesting result discussed here, because it so clearly explains many phenomena in American politics, is the median voter theorem. This theorem states that if political choices can be placed inorder on a number line, and the number of voters who favoreach choice then counted, the choice of the median voter (i.e.,the one who has equal numbers of voters to his or her leftand right on the number line) will always win. This theoremoffers insight into, among other things, why the Democratsand Republicans adopt middle-of-the-road positions andoften resemble each other, or why parties like the Greens or Libertarians, with “extreme” positions, have a hard timemaking headway in the United States. In economics, the theorem, shows that government actions to improve market outcomes, no matter how desirable for society, won’t occuruntil they’ve convinced a majority, or, failing that, themedian voter.

The final microeconomic “frontier” covered in Chapter 22 isbehavioral economics. Here, researchers have tried to redo,or at least supplement, traditional economic theory by cast-ing doubt on its assumptions about human behavior. Brieflyput, behavioral economists apply research or methods frompsychology to show that people may not be as rational or asself-interested as traditional economists have assumed. Oneof the first insights gained in behavioral economics is thatpeople, in seeking their advantage, tend not to be maximizersbut satisficers—they seek not what’s best but simply what’s“good enough.” In addition, people (even very bright ones)are prone to the decision-making errors and inconsistenciesdiscussed on pages 496–499 and 493. Finally, and perhapsmore endearingly, people care about fairness, as proved by the ultimatum game discussed on pages 497–498. Here,people reject the 99–1 split of $100 that game theory (recallChapter 16) would call most rational, in favor of some split(like 70–30), suggesting that people behave from some mix of self-interest and fairness, thereby diluting though not

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Economics 272

negating the assumptions of traditional economists. Youmight want to try out a “home version” of the ultimatumgame with your family and friends.

After you’ve read pages 483–501 in Principles ofMicroeconomics carefully, complete Self-Check 13.Check your answers against those at the back of thisstudy guide. When you’re sure that you completelyunderstand the material from Assignment 13, move on to the Suggested Activities for Lesson 4.

Suggested Activities for Lesson 4Read through these Suggested Activities and write out theanswers to the questions in your notebook or on a separatepiece of paper.

Activity 1: Even Money

This exercise will explore labor market issues by looking at a situation of complete equality. We’ll look at how this wouldaffect incentives and job differences.

Instructions: We’re going to replace the current U.S. economicsystem with a system whereby everyone is paid exactly thesame salary. We’ll assume that each family would receive anequal share of gross domestic product (GDP). For a typicalfour-person household, this would be over $90,000.

Self-Check 13

Write a definition for each of the Key Concepts listed on page 501 of your textbook. Then,answer Questions for Review 1, 2, 3, and 5 on page 501 of your textbook. Finally, in theProblems and Applications section on pages 501–503, solve Problems 1, 5, and 6.


Lesson 4 73

1. Describe at least three problems that would exist withthis system.

2. What mechanisms could be enacted to overcome these problems?

3. Would you rather be a doctor or an assembly-line workerunder this new system? Why?

Activity 2: The Utility Meter

This activity demonstrates how economists view consumption.The idea of diminishing marginal utility is illustrated by justhow many creme-filled donuts you consume!

Instructions: An economist who is an expert in electronicshas just developed a utility meter that measures satisfaction,or happiness from consuming a good. More astonishing, italso shows the marginal utility, or happiness from consumingan additional unit of a good. The following table shows theresults from a creme-filled-donut-eating experiment.

1. Explain why the marginal utility figures dropped witheach additional donut eaten.

2. Do economists need to account for negative marginalutility in their consumption models? Using our utilitymeter experiment, describe the situation of negativemarginal utility.


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Economics 274

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Lesson 4

Labor Markets; Further

Applications of Microeconomics



1. When two goods are perfect complements, the indifferencecurves are

A. straight lines. C. intersecting.B. right angles. D. upward-sloping.

2. In a state where voters directly decide the size of the educationbudget, 25 percent want no increase, 30 percent want a decrease,10 percent want a small increase, and 35 percent want a largeincrease. If the median voter theorem applies here, what budgetdecision will result?

A. No increaseB. DecreaseC. Small increaseD. Large increase

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EXAMINATION NUMBER:




Examination, Lesson 476

3. The wage difference between jobs that require education and those that don’t

A. isn’t likely to be related to productivity differences.B. encourages workers to bear the cost of acquiring education.C. is a barrier to obtaining an education.D. doesn’t affect the supply of workers in the different labor markets.

4. When leisure is a normal good, the income effect from an increase in wages is manifest in

A. a desire to consume more leisure.B. a desire to consume less leisure.C. the backward-bending portion of labor supply.D. a shift in labor demand.

5. The liberalism doctrine suggests that the focus of social policy would be to

A. elevate the well-being of all workers.B. elevate the well-being of those at the bottom of the income distribution.C. ensure an egalitarian distribution of income.D. expropriate the factors of production from the capitalist class.

6. Employers who operate in competitive product markets and choose to practice discrimination in hiring workers

A. will survive if they increase production and garner a larger market share.B. will eventually earn zero economic profits.C. are likely to eventually go out of business.D. will survive as long as they’re willing to have a smaller market share.

7. Goods that are difficult to substitute for each other will likely exhibit indifference curves that

A. are less bowed. C. are more bowed.B. cross less frequently. D. have a slope close to –1.

8. There’s an increasing gap in wages between unskilled and skilled workers in the UnitedStates. One hypothesis to explain the gap is that when the United States increased its participation in world markets, specialization and the pursuit of comparative advantage precipitated a

A. fall in domestic demand for unskilled labor.B. rise in domestic demand for unskilled labor.C. fall in domestic supply of unskilled labor.D. rise in domestic supply of unskilled labor.


9. An example of a transitory change in income is

A. the increase in income that results from a job promotion linked to your education.B. the increase in income of California orange growers due to an orange-killing frost

in Florida.C. the annual cost-of-living adjustment to your salary.D. an increase in income from personal investments.

10. When the income and substitution effects work in opposite directions,

A. it’s possible that the law of demand is violated.B. the substitution effect is always positive.C. the income effect is always positive.D. Giffen goods aren’t possible.

11. In a labor market where employers are cutting wages to control costs, from whose standpoint will the selection be “adverse”?

A. Good workers C. EmployersB. Poor workers D. Consumers

12. As a result of the tradeoff between income equality and incentives to work, an optimalredistribution policy

A. will rarely fall short of a full egalitarian society.B. is consistent only with transfers to the middle class.C. always falls short of a full egalitarian society.D. can never be funded through taxes on wage income.

13. The amount of a commodity that an individual is consuming

A. is affected only by prices.B. affects the rate at which he or she is willing to trade.C. is affected only by income.D. won’t affect the marginal rate of substitution.

14. Technology is an important factor in explaining the high incomes of superstars because

A. technology is available that can limit access to the superstars.B. only technologically literate superstars can earn super incomes.C. technology accounts for differences in incomes within all occupations.D. technology makes it possible for the best producer to supply every customer at low cost.


15. The notion of utility is fundamental to utilitarianism and describes the

A. method whereby wealth is stored as flat currency.B. method by which society chooses to allocate resources.C. optimal distribution of wealth in society.D. level of satisfaction derived from a person’s circumstances.

16. An optimizing consumer will select a consumption bundle in which utility is maximized

A. as long as prices are minimized.B. when income is maximized.C. if indifference curves are linear.D. subject to constraints imposed by the budget.

17. Taxi drivers in large cities are likely to earn more than taxi drivers in rural areas earn.One reason for this wage differential could be that

A. driving in a large city is more fun than driving in a rural area.B. driving in a large city is easier than driving in a rural area.C. a taxi driver in a large city is unlikely to hit or be hit by an animal.D. driving a taxi in a large city is more dangerous than driving in a rural area.

18. Which of the following statements about minimum-wage laws is correct?

A. Minimum-wage laws force a market imbalance between the supply and demand forlabor.

B. Minimum-wage laws increase the efficiency of labor markets.C. Minimum-wage laws are typically associated with a rise in employment among the

poor.D. Minimum-wage laws are most effective at alleviating poverty when labor demand is

highly elastic.

19. The slope of the budget constraint reveals information about the

A. level of income of the consumer.B. relative price of commodities represented on the axes.C. preferences of a consumer.D. endowment of productive resources.

20. If John says, “I didn’t want to waste my life deciding where to study, since Adam SmithCollege seemed good enough,” John is

A. overconfident. C. a satisficer.B. concerned about fairness. D. inconsistent over time.

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ACTIVITY ANSWERS

Lesson 1Activity 1: Externalities on a River

Part A of the figure shown below indicates what yourdrawing should look like. Part B of the figure is thegraph containing the demand curve and supply curvefor Tiffany’s sweaters.

1. See the figure below. The supply curve would shift to the right.

2. See the figure below. The supply curve would shift to the right.

3. See the figure below. Comparing the two intersections on the graph shows that consumers pay too low a pricefor sweaters and that too large a quantity is produced. If the external costs were considered, prices would behigher and the quantity lower.

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Activity 2: Taxes, Taxes

1. The tax is regressive, which can be demonstrated by thefact that the person earning $1,000 per year would havean effective tax rate of 100 percent and the person making$100,000 per year would pay an effective tax of 1 percent.

2. Taxpayer A would pay $10, and Taxpayer B would pay$1,000. This would be classified as a proportional taxbecause the low-income earner pays proportionally lessthan the high-income earner.

Lesson 2Activity 1: A Profitable Opportunity

1. No. It may sound like a good deal if you consider onlythat $50 seems like a good price for something thatcosts you only $11 to make. There’s more to consider,however, such as marginal costs.

2. Look at the following table.

marginal cost = change in total cost

marginal cost = $5,511 – $5,000

marginal cost = $511

3. It would be better not to accept the new customer’s offer.Marginal cost was calculated at $511, which is muchhigher than the $50 the customer offered to pay you. Ifyou accepted this offer, your company would lose $461in profits ($511 – $50).

Activity 2: Price Discrimination and Time Travel

1. The price would equal the marginal cost ($100) and fourtrips would be sold.

2. Consumer surplus = (200 – 100) + (150 – 100) + (125 – 100) + (100 – 100) = $175

Profit = 400 – 400 = 0

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Activity Answers 81

3. The completed table is shown here.

4. $150, because this is where marginal cost equalsmarginal revenue.

5. Consumer surplus = (200 – 150) + (150 – 150) = $50

Profits rise to $100. Profits = 300 – 200

6. The completed table is shown here.

7. Four trips

8. Consumer surplus = (200 – 200) + (150 – 150) + (125 – 125) + (100 – 100) = 0

Profit = 575 – 400 = $175

Lesson 3Activity 1: Brand Names

1. All of the brands



4. Product differentiation means that each product inthe particular market is at least slightly different fromthe others. These products differ primarily by brandname only.


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Activity Answers82

Activity 2: How Much Are Those Blue Jeans in theWindow?

The figure shown below indicates what your supply-and-demand curve for blue jeans should look like.

1. Quality, style, reputation, and retail outlet are possiblefactors that affect price.

2. You would analyze the demand and cost curves for thisparticular type of blue jeans. This would allow you todetermine prices and quantities accurately, rather thananalyzing the entire broad market for jeans.

Lesson 4Activity 2: Even Money

1. Numerous problems could arise. The national incomemay fall if the incentives to work are changed drastically.People may not work at all. Unpleasant jobs are unlikelyto be completed. Development of new technology andinventions could be hindered. Savings and investmentrates would be low. Education would become unimpor-tant. Immigration rates would increase.

Activity Answers 83

2. Income could still be denied to people who didn’t work,and workers could still be fired for inadequate effort. Allhouseholds could be required to participate in the laborforce. Unpleasant jobs could be modified to improvesafety, sanitation, or difficulty. Shorter hours could beassigned to those performing the least desirable work.

3. You may consider the assembly-line job to be undesir-able (because you may think that it’s too menial orunsafe) and choose instead to be a doctor (because youthink that this would involve better working conditions,higher levels of personal satisfaction, and more interest-ing challenges). On the other hand, you may think thatthe responsibility and sacrifice of time required to be a doctor isn’t worth the tradeoff when everyone makesthe same amount of money regardless of the job.

Activity 2: The Utility Meter

1. With each additional donut consumed there’s lesshunger and desire for the additional donut. Eating thesecond donut won’t give as much pleasure as eating thefirst, and the third doesn’t provide the satisfaction thatthe second did.

2. No. Economists assume that rational consumers won’tpay to make themselves feel worse. In our experiment,the point of negative marginal utility would be reachedwhen a person eats enough donuts to make himself orherself sick.

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The definitions for all of the Key Concepts that were assign-ed in the self-checks can be found in your textbook. Next toeach Key Concept in the book, a page reference was provided.Check your written definitions of each of the Key Conceptsagainst the definitions in the textbook.

This section provides answers to the Questions for Reviewand Problems and Applications that were assigned in the self-checks throughout this study guide. Compare your writtenself-check answers with those provided here. Read through theanswers carefully to make sure you understand them.

Self-Check 1Chapter 10, Questions for Review

2. Figure 10-1 illustrates the effect of a negative externalityin production. The equilibrium quantity provided by themarket is QMARKET. Because of the eternality, the socialcost of production is greater than the private cost of production, so the social-cost curve is above the supplycurve. The optimal quantity for society is QOPTIMUM. The private market produces too much of the good, as QMARKET is greater than QOPTIMUM.

FIGURE 10-1

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5. According to the Coase theorem, you and your roommatewill bargain over whether your roommate will smoke inthe room. If you value clean air more than your room-mate values smoking, the bargaining process will lead to your roommate not smoking. If your roommate valuessmoking more than you value clean air, the bargainingprocess will lead to your roommate smoking. The out-come is efficient as long as transaction costs don’t pre-vent an agreement from taking place. The solution maybe reached by one of you paying the other not to smokeor for the right to smoke.

6. Corrective taxes are taxes enacted to correct the effectsof negative externalities. Economists prefer correctivetaxes over regulations as a way to protect the environ-ment from pollution because they can reduce pollutionat a lower cost to society. A tax can be set to reduce pollution to the same level as a regulation. The tax hasthe advantage of letting the market determine the leastexpensive way to reduce pollution. The tax gives firmsincentive to develop cleaner technologies, since doing so reduces the taxes they have to pay.

Chapter 10, Problems and Applications

11. a. International cooperation is needed because the externality from global warming is worldwide, so the benefits from solving the problem are worldwide.Further, the efficient solution to the problem involvesminimizing the costs to society; in this case, society means the entire world.

b. Since it would be efficient to reduce carbon dioxide most in countries where the cost of reducing carbondioxide emissions are low, some compensation scheme needs to be put in place to encourage the reduction of emissions. One possibility would bemonitorng emissions, taxing those countries whoseemissions are high and using the proceeds to subsidize those who reduce their emissions. This gives the incentive to reduce emissions in those areas where the cost of doing so is the least. In countries where the cost of reducing emissions is

Self-Check Answers 87

high, they’ll just pay the tax. A system of uniform emission reductions would impose high costs on some countries and low costs on others, and wouldn’t give anyone the incentive to reduce emissions beyond the mandated amount.


1. An excludable good is one that people can be preventedfrom using. A rival good is one for which one person’suse of it diminishes another person’s enjoyment of it.Pizza is both excludable (a pizza producer can preventsomeone who doesn’t pay for it from eating it) and rival(when one person eats it, no one else can eat it).

2. A public good is a good that’s neither excludable norrival. An example is national defense, which protects the entire nation. No one can be prevented from enjoyingthe benefits of it, so it isn’t excludable, and an additionalperson who benefits from it doesn’t diminish the value of it to others, so it isn’t rival. The private market won’tsupply the good, since no one would pay for it, sincethey can’t be excluded from enjoying it if they don’t pay for it.

4. A common resource is a good that’s rival but not excludable. An example is fish in the ocean. If some-one catches a fish, that leaves fewer fish for everyoneelse, so it’s a rival good. But the ocean is so vast, youcan’t charge people for the right to fish, or prevent themfrom fishing, so it isn’t excludable. Thus, without gov-ernment intervention, people will use the good too much,since they don’t account for the costs they impose onothers when they use the good.


1. a. (1) Police protection is a natural monopoly, sinceit’s excludable (the police may ignore some neigh-borhoods) and not rival (unless the police force isoverworked, they’re available whenever a crimearises). You could make an argument that policeprotection is rival, if the police are too busy to


respond to all crimes, so that one person’s useof the police reduces the amount available forother; in that case, police protection is a privategood.

(2) Snow plowing is most likely a common resource.Once a street is plowed, it isn’t excludable. But it is rival, especially right after a big snowfall, sinceplowing one street means not plowing anotherstreet.

(3) Education is a private good (with a positive externality). It’s excludable, since someone whodoesn’t pay can be prevented from taking classes.It’s rival, since the presence of an additional stu-dent in a class reduces the benefits to others.

(4) Rural roads are public goods. They’re neitherexcludable or rival since they’re uncongested.

(5) City streets are common resources whencongested. They aren’t excludable, since anyonecan drive on them. But they are rival, sincecongestion means every additional driver slowsdown the progress of other drivers. When theyaren’t congested, city streets are public goods,since they’re no longer rival.

b. The government may provide goods that aren’tpublic goods, such as education, because of the externalities associated with them.

6. When a person litters along a highway, others bear thenegative externality, so the private costs are low.Littering in your own yard imposes costs on you, so hasa higher private cost, and is thus rare.


1. Over the past several decades, government has grownmore rapidly than the rest of the economy. The ratio ofgovernment revenue to GDP has increased over time.


3. Corporate profits are taxed first when the corporateincome tax is taken out of a corporation’s income andagain when the profits are used to pay dividends to thecorporation’s shareholders, which are taxed by the individual income tax.

4. The burden of a tax to taxpayers is greater than the revenue received by the government because (1) taxesimpose deadweight losses by reducing the quantity ofgoods produced and purchased below their efficient level;and (2) taxes entail a costly administrative burden ontaxpayers.

5. Some economists advocate taxing consumption ratherthan income because taxing income discourages saving.A consumption tax wouldn’t distort people’s saving decisions.

6. Wealthy taxpayers should pay more taxes than poor tax-payers because (1) they benefit more from public services;and (2) they have a greater ability to pay.

7. Horizontal equity refers to the idea that families in thesame economic situation should be taxed equally. Theconcept of horizontal equity is hard to apply becausefamilies differ in many ways, so it isn’t obvious how totax them equitably. For examples, two families with thesame income may have different numbers of childrenand different levels of medical expenses.


9. a. The fact that visitors to many national parks pay an entrance fee is an example of the benefits principle,since people are paying for the benefits they receive.

b. The fact that local property taxes support elementaryand secondary schools is an example of the ability-to-pay principle, since if you own more expensive property you must pay more tax.

c. The setup of airport trust funds is an example of the benefits principle, since use of the airport generates a tax that pays for upkeep of the airport.


10. a. For the proportional tax system, the average rate is 25 percent whether a person earns income of $50,000, $100,000, and $200,000.

For the regressive tax system, the average tax rateis 30 percent for someone earning $50,000, 25percent for someone earning $100,000, and 20percent for someone earning $200,000.

For the progressive tax system, the average tax rate is 20 percent for someone earning $50,000, 25 percent for someone earning $100,000, and 30 percent for someone earning $200,000.

b. For the proportional tax system, the marginal tax rate as income rises from $50,000 to $100,000is the increase in taxes ($12,500) divided by the increase in income ($50,000) = 25%. The marginaltax rate as income rises from $100,000 to $200,000is the increase in taxes ($25,000) divided by theincrease in income ($100,000) = 25%.

For the regressive tax system, the marginal tax rateas income rises from $50,000 to $100,000 is the increase in taxes ($10,000) divided by the increase in income ($50,000) = 20%. The marginal tax rateas income rises from $100,000 to $200,000 is theincrease in taxes ($15,000) divided by the increasein income ($100,000) = 15%.

For the progressive tax system, the marginal tax rate as income rises from $50,000 to $100,000 isthe increase in taxes ($15,000) divided by theincrease in income ($50,000) = 30%. The marginaltax rate as income rises from $100,000 to $200,000is the increase in taxes ($35,000) divided by theincrease in income ($100,000) = 35%.


c. In the proportional tax system, the average tax rate equals the marginal tax rate. In the regressive tax system, the marginal tax rate is less than the averagetax rate and both tax rates decline as income rises.In the progressive tax system, the marginal tax rate is greater than the average tax rate and both tax rates rise as income rises. The marginal tax rate is relevant to someone deciding whether to accept a job that pays slightly more than her current job, since it tells her how much of the extra income she’llkeep after taxes. For judging the vertical equity of the tax system, the average tax rate is relevant, sincevertical equity suggests that people with a greater ability to pay should pay a larger amount.


1. The relationship between a firm’s total revenue, profit,and total cost is that profit equals total revenue minustotal costs.

2. An accountant wouldn’t count the opportunity cost of alternative employment as an accounting cost. Anexample is given in the text, in which Helen runs a cooking business, but she could instead work as a com-puter programmer. Because she’s working in her cookiefactory, she gives up the opportunity to earn $100 perhour as a computer programmer. The accountant ignoresthis opportunity cost because no money flow occurs. Butthe cost is relevant to Helen’s decision to run the cookiefactory.

5. Total cost consists of all the costs needed to produce a given quantity of output. It includes fixed costs andvariable costs. Average total cost is the cost of a typicalunit of output and is equal to total cost divided by thequantity produced. Marginal cost is the cost of producingan additional unit of output and is equal to the changein total cost divided by the change in quantity. An addi-tional relation between average total cost and marginalcost is that whenever marginal cost is less than averagetotal cost, average total cost is declining; whenever mar-ginal cost is greater than average total cost, average totalcost is rising.


7. In the long run, a firm can adjust the factors of productionthat are fixed in the short run; for example, it can increasethe size of its factory. As a result, the long-run average-total-cost curve has a much flatter U-shape than theshort-run average-total-cost curve. In addition, the long-run curve lies below all the short-run curves.


1. a. opportunity cost; b. Average total cost; c. fixed cost;d. variable cost; e. total cost; f. marginal cost.

6. a. The fixed cost is $300, since fixed cost equals totalcost minus variable cost.

b. Marginal cost equals the change in total cost or the change in variable cost. That’s because total cost equals variable cost plus fixed cost, and fixed cost doesn’t change as the quantity changes. So, as quantityincreases, the increase in total cost equals the increase in variable cost and both are equal to marginal cost.Look at the table shown here.

Q CT CV CM

0 003 005

1 053 0504

2 093 0903

3 024 02103

4 054 05104

5 094 09105

6 045 042


9. a. The following table shows average variable cost (AVC), average total cost (ATC), and marginal cost (MC) for each quantity.

b. Figure 13-1 graphs the three curves. The marginal-cost curve is below the average-total-cost curve when output is less than 4, as average total cost is declining. The marginal cost curve is above the average-total-cost curve when output is above 4, as average total cost is rising. The marginal-cost curve is always above the average-variable-cost curve, and average variable cost isalways increasing.

Q CV CT CVA CTA CM

0 0 03 — —01

1 01 04 01 0451

2 52 55 5.21 5.7202

3 54 57 51 5252

4 07 001 5.71 5203

5 001 031 02 6253

6 531 561 5.22 5.72

FIGURE 13-1



2. Figure 14-1 shows the cost curves for a typical firm. For a given price (such as P*), the level of output thatmaximizes profit is the output where marginal costequals price (Q*), as long as price is greater than aver-age variable cost at that point (in the short run), orgreater than average total cost (in the long run).

3. A firm will shut down temporarily if the revenue it wouldget from producing is less than the variable costs of pro-duction. This occurs if price is less than average variablecost.

4. A firm will exit a market if the revenue it would get if itstayed in business is less than its total cost. This occursif price is less than average total cost.

FIGURE 14-1



2.

(a)

(b) The rise in the price of petroleum increases productioncosts for individual firms and thus shifts the industrysupply curve up, as shown above in Figure 14-2. The typical firm’s initial marginal-cost curve is MC1 and its average-total-cost curve is ATC1. In the initial equi-librium, the industry supply curve, S1, intersects thedemand curve at a price P1, which is equal to the mini-mum average total cost of the typical firm. Thus the typical firm earns no economic profit.

The increase in the price of oil shifts the typical firm’scost curves up to MC2 and ATC2, and shifts the industrysupply curve up to S2. The equilibrium price rises from P1 to P2, but the price doesn’t increase by as much as the increase in marginal cost for the firm. As a result,price is less than average total cost for the firm, so profits are negative.

In the long run, the negative profits lead some firms to exit the industry. As they do so, the industry supply curve shifts to the left. This continues until the price rises to equal the minimum point on the firm’s average-total-cost curve. The long-run equilibrium occurs withsupply curve S3, equilibrium price P3, industry output Q3, and firms output q3. Thus, in the long run, profits are zero again and there are fewer firms in the industry.

FIGURE 14-2


12. a. Figure 14-3 illustrates the gold market (industry) and a representative gold mine (firm). The demand curve, D1, intersects the supply curve at industry quantity Q1 and price P1. Since the industry is in long-run equilibrium, the price equals the minimumpoint on the representative firm’s average-total-costcurve, so the firm produces output q1 and makes zero profit.

b. The increase in jewelry demand leads to an increase in the demand for gold, shifting the demand curve to D2. In the short run, the price rises to P2, industry output rises to Q2, and the representative firm’s output rises to q2. Since price now exceeds average total cost, therepresentative firm now earns positive profits.

c. Since gold mines are earning positive economic profits, over time other firms will enter the industry.This will shift the supply curve to the right, reducing the price below P2. But it’s unlikely that the price will fall all the way back to P1, since gold is in short supply. Costs for new firms are likely to be higher than for older firms, since they’ll have to discover new gold sources. So it’s likely that the long-run supply curve in the gold industry is upward sloping. That means the long-run equilibrium price will be higher than it was initially.

FIGURE 14-3



3. A monopolist’s marginal revenue is less than the price ofits product because (1) its demand curve is the marketdemand curve, so (2) to increase the amount sold, themonopolist must lower the price of its good for everyunit it sells, so (3) this cut in prices reduces revenue on the units it was already selling.

A monopolist’s marginal revenue can be negativebecause to get purchasers to buy an additional unit of the good, the firm must reduce its price on all units of the good. The fact that it sells a greater quantityincreases revenue, but the decline in price decreasesrevenue. The overall effect depends on the elasticity of the demand curve. If the demand curve is inelastic,marginal revenue will be negative.

4. Figure 15-1 shows the demand, marginal-revenue, andmarginal-cost curves for a monopolist. The intersectionof the marginal-revenue and marginal-cost curves determines the profit-maximizing level of output QM. The demand curve then shows the profit-maximizingprice, PM.

FIGURE 15-1


5. The level of output that maximizes total surplus inFigure 15-1 is where the demand curve intersectsthe marginal-cost curve, QC. The deadweight lossfrom monopoly is the triangular area between QC

and QM that’s above the marginal-cost curve andbelow the demand curve. It represents deadweight loss because society loses total surplus because ofmonopoly equal to the value of the good, measured by the demand curve, less the cost of production, givenby the marginal-cost curve, for the quantities QC – QM.

8. One example of price discrimination is in publishingbooks. Publishers charge a much higher price for hard-back books than for paperback books—far higher thanthe difference in production costs. Publishers do thisbecause die-hard fans will pay more for a hardback bookwhen the book is first released. Those who don’t valuethe book as highly will wait for the paperback version to come out. The publisher makes greater profit this waythan if it charged just one price.

A second example is the pricing of movie tickets. Theatersgive discounts to children and senior citizens becausethey have a lower willingness to pay for a ticket. Chargingdifferent prices helps the theater increase its profit abovewhat it would be if it charged just one price.


5. a. The following table shows total revenue and marginal revenue for each price and quantity sold.

b. Profits are maximized at a price of $16 and quantity of 50,000. At that point, profit is$550,000.

ecirP ytitnauQ euneveRlatoT

euneveRlanigraM

tsoClatoTtiforP

42 000,01 000,042 000,05 000,091 000,00222 000,02 000,044 000,001 000,043 000,06102 000,03 000,006 000,051 000,054 000,02181 000,04 000,027 000,002 000,025 000,0861 000,05 000,008 000,052 000,055 000,0441 000,06 000,048 000,003 000,045


c. As Johnny’s agent, you should recommend that he demand $550,000 from them, so he gets all the profit instead of the record company.

6. a. The following table shows revenue and marginal revenue for the bridge.

The profit-maximizing price would be where revenue is maximized, which will occur where marginal revenue equals zero, since marginal cost equals zero. This occurs at a price of $4 and quantity of 400. The efficient level of output is 800, since that’s where price equals marginal cost equals zero. The profit-maximizing quantity is lower than the efficient quantity because the firm is a monopolist.

b. The company shouldn’t build the bridge because its profits are negative. The most revenue it can earn is$1,600,000 and the cost is $2,000,000, so it would lose $400,000.

c. If the government were to build the bridge, it should set price equal to marginal cost to be efficient. But marginal cost is zero, so the government shouldn’t charge people to use the bridge.

ecirP ytitnauQ euneveRlanigraMeuneveR

8 0 0007

7 001 007005

6 002 002,1003

5 003 005,1001

4 004 006,1001-

3 005 005,1003-

2 006 002,1005-

1 007 007007-

0 008 0


d. Yes, the government should build the bridge, because it would increase society’s total surplus. As shown in Figure 15-2, total surplus has area1/2 � 8 � 800,000 = $3,200,000, which exceeds the cost of building the bridge.

8. Larry wants to sell as many drinks as possible withoutlosing money, so he wants to set quantity where price(demand) equals average cost, which occurs at quantityQL and price PL in Figure 15-3. Curly wants to bring in as much revenue as possible, which occurs wheremarginal revenue equals zero, at quantity QC and pricePC. Moe wants to maximize profits, which occurs wheremarginal cost equals marginal revenue, at quantity QM

and price PM.

FIGURE 15-2



1. If a group of sellers could form a cartel, they’d try to setquantity and price like a monopolist. They’d set quantityat the point where marginal revenue equals marginalcost, and set price at the corresponding point on thedemand curve.

2. Firms in an oligopoly produce a quantity of outputgreater than the level produced by monopoly at a priceless than the monopoly price.

3. Firms in an oligopoly produce a quantity of output lessthan the level produced by a perfectly competitive marketat a price greater than the perfectly competitive price.

6. The arms race, advertising, and common resources aresome examples of how the prisoners’ dilemma helpsexplain behavior. In the arms race in the Cold War, theUnited States and the Soviet Union couldn’t agree onarms reductions because each was fearful that aftercooperating for a while, the other country would cheat.In advertising, two companies would be better off if

FIGURE 15-3


neither advertised, but each is fearful that if it doesn’tadvertise, the other company will. When two companiesshare a common resource, they’d be better off sharing it.But fearful that the other company will overuse it, eachcompany overuses it.

7. Antitrust laws prohibit firms from trying to monopolize a market. The laws are used to prevent mergers thatwould lead to excessive market power in any single firmand to prevent oligopolists from acting together in waysthat would make their markets less competitive.

8. Resale price maintenance occurs when a wholesaler setsa minimum price that retailers can charge. This mightseem to be anticompetitive because it prevents retailersfrom competing on price. But that’s doubtful because(1) if the wholesaler has market power, it can exercise it through the wholesale price; (2) wholesalers have noincentive to discourage competition among retailers sincedoing so reduces the quantity sold; and (3) maintaininga minimum price may be valuable so retailers providecustomers good service.


3. a. If there were many suppliers of diamonds, price would equal marginal cost ($1 thousand), so quantity would be 12 thousand.

b. With only one supplier of diamonds, quantity would be set where marginal cost equals marginal revenue. The following table derives marginal revenue.

ecirP

)sdnasuoht$(

ytitnauQ

)sdnasuoht$(

euneveR

)snoillim$(

lanigraMeuneveR

)snoillim$(8 5 04

27 6 24

06 7 24

2-5 8 04

4-4 9 63

6-3 01 03

8-2 11 22

01-1 21 21


With marginal cost of $1 thousand per diamond, or $1 million per thousand diamonds, the monopoly will maximize profits at a price of $7 thousand and quantity of 6 thousand. Additional production would lead to marginal revenue (0) less than marginal cost.

c. If Russia and South Africa formed a cartel, they would set price and quantity like a monopolist, so price would be $7 thousand and quantity would be 6 thousand. If they split the market evenly, they’d share total revenue of $42 million and costs of $6 million, for a total profit of $36 million. So each would produce 3 thousand diamonds and get aprofit of $18 million. If Russia produced 3 thousanddiamonds and South Africa produced 4 thousand,the price would decline to $6 thousand. South Africa’s revenue would rise to $24 million, costswould be $4 million, so profits would be $20 million,which is an increase of $2 million.

d. Cartel agreements are often not successful because one party has a strong incentive to cheat to make more profit. In this case, each could increase profit by $2 million by producing an extra thousand diamonds. Of course, if both countries did this, both would lose profits.

5. a. If Mexico imposes low tariffs, then the United States is better off with high tariffs, since it gets $30 billion with high tariffs and only $25 billion with low tariffs. If Mexico imposes high tariffs, then the United States is better off with high tariffs, sinceit gets $20 billion with high tariffs and only $10 billion with low tariffs. So the United States has a dominant strategy of high tariffs.

If the United States imposes low tariffs, then Mexicois better off with high tariffs, since it gets $30 billion with high tariffs and only $25 billion with low tariffs. If the Unites States imposes high tariffs,then Mexico is better off with high tariffs, since it gets $20 billion with high tariffs and only $10 billionwith low tariffs. So Mexico has a dominant strategy of high tariffs.


b. A Nash equilibrium is a situation in which economicactors interacting with one another each choose their best strategy given the strategies others have chosen. The Nash equilibrium in this case is for each country to have high tariffs.

c. The NAFTA agreement represents cooperation between the two countries. Each reduces tariffs and both are better off as a result.

d. The payoffs in the upper left and lower right parts of the box reflect a nation’s welfare. Trade is benefi-cial and tariffs are a barrier to trade. However, thepayoffs in the upper right and lower left parts of thebox aren’t valid. A tariff hurts domestic consumersand helps domestic producers, but total surplusdeclines. So, it would be more accurate for theseparts of the box to show both countries’ welfaredecline if they imposed high tariffs, whether or notthe other country had high or low tariffs.

8. a. If Jones and Smith each have 10 cows (a total of 20cows), each cow produces $4,000 of milk. Since acow costs $1,000, profits would be $3,000 per cow,or $30,000 for each farmer.

If one farmer had 10 cows and the other had 20(a total of 30 cows), each cow produces $3,000 ofmilk. Profit per cow would be $2,000, so the farmer with 10 cows makes $20,000; the farmer with 20 cows makes $40,000.

If both farmers have 20 cows (a total of 40 cows),each cow produces $2,000 of milk. Profit per cowis $1,000, so each farmer’s profit is $20,000. Theresults are shown in the following table.

noisiceDs'htimS

swoC01 swoC02

s'senoJnoisiceD

swoC01 000,03$:senoJ 000,02$:senoJ

000,03$:htimS 000,04$:htimS

swoC02 000,04$:senoJ 000,02$:senoJ

000,02$:htimS 000,02$:htimS


b. If Jones had 10 cows, Smith would want 20 cows. If Jones had 20 cows, Smith would be indifferent (get the same profit) if he had 10 or 20 cows. So, Smith has a dominant strategy of having 20 cows.

If Smith had 10 cows, Jones would want 20 cows. If Smith had 20 cows, Jones would be indifferent (get the same profit) if he had 10 or 20 cows. So, Jones has a dominant strategy of having 20 cows.

The Nash equilibrium is for each farmer to have 20cows, since that’s the dominant strategy for each. They each make profits of $20,000. But they’d both be better off if they cooperated and each had only 10 cows; then profit would be $30,000 each.

c. Since people tend to overuse common fields, it’s more efficient for people to own their own portion of the field. So, over time, common fields have beendivided up and owned privately.


3. Figure 17-1 shows the long-run equilibrium in a monopolistically competitive market. Price equals average total cost. Price is above marginal cost.

FIGURE 17-1


4. Since, in equilibrium, price is above marginal cost, amonopolistic competitor produces too little output. But thisis a hard problem to solve because (1) the administrativeburden of regulating the large numbers of monopolisticallycompetitive firms would be high; and (2) because the firmsare earning zero economic profits, forcing them to price atmarginal cost. This means that firms would lose moneyunless the government subsidized them.

6. Advertising with no apparent informational content mightconvey information to consumers if it provides a signal of quality. A firm won’t be willing to spend much moneyadvertising a low-quality good, but will be willing to spendsignificantly more advertising a high-quality good.


1. a. The market for #2 pencils is perfectly competitive since pencils by any manufacturer are identical and there are a large number of manufacturers.

b. The market for copper is perfectly competitive,since all copper is identical and there are a largenumber of producers.

c. The market for local telephone service is mono-polistic because it’s a natural monopoly—it’scheaper for one firm to supply all the output.

d. The market for peanut butter is monopolistically competitive because different brand names exist with different quality characteristics.

e. The market for lipstick is monopolistically competitive because lipstick from different firms differ slightly, but there are a large number of firms who can enter or exit without restriction.


6. By sending Christmas cards to their customers, mono-polistically competitive firms are advertising themselves.Since they’re in a position in which price exceeds mar-ginal cost, they would like more customers to come in, as shown in Figure 17-2. Since the price, PM, exceedsmarginal cost, MCM, any additional customer who paysthe existing price increases the firm’s profits.

7. a. A family-owned restaurant would be more likely toadvertise than a family-owned farm because theoutput of the farm is sold in a competitive market, in which there’s no reason to advertise, while the output of the restaurant is sold in a monopolisti-cally competitive market.

b. A manufacturer of cars is more likely to advertise than a manufacturer of forklifts because there’s little difference between different brands of indus-trial products like forklifts, while there are greaterperceived differences between consumer productslike cars.

c. A company that invented a comfortable razor islikely to advertise more than a company thatinvented a less comfortable razor that costs thesame amount to make because the company withthe comfortable razor will get many repeat salesover time to cover the cost of the advertising;the company with the less comfortable razor won’t.

FIGURE 17-2



1. a. A firm’s production function describes the relationship between the quantity of labor used in productionand the quantity of output from production. The marginal product of labor is the increase in the amount of output from an additional unit of labor. Thus the marginal product of labor depends directly on the production function.

b. The value of the marginal product of labor is the marginal product of labor multiplied by the market price of the output.

c. A competitive, profit-maximizing firm hires workers up to the point where the value of the marginal product of labor equals the wage. As a result, the value-of-marginal-product curve is the labor-demand curve.

5. A large immigration would increase the supply of labor,thus reducing the wage. With more labor working withcapital and land, the marginal product of capital andland is higher, so rents earned by owners of land andcapital would increase.


3. a. The marginal product of labor is equal to the additional output produced by an additional unit of labor. The table below shows the marginal product of labor (MPL) for this firm:

Days of Labor Units of Output MPL VMPL

0 0 -- --

1 7 6 60

2 13 6 60

3 19 6 60

4 25 6 60

5 28 3 30

6 29 1 10

7 29 0 0


b. The value of the marginal product of labor (VMPL)is equal to the price multiplied by the marginalproduct of labor (MPL). It’s also reported in thetable.

4. Since your uncle is maximizing his profit, he must behiring workers such that their wage equals the value oftheir marginal product. Since the wage is $6 per hour,their value of marginal product must be $6 per hour.Since the value of marginal product equals the marginalproduct times the price of the good, and since the priceof a sandwich is $3, the marginal product of a workermust be two sandwiches per hour.

7. a. Figure 18-1 shows the U.S. capital market when there’s an inflow of capital from abroad. The inflow of capital shifts the supply curve to the right, from S1 to S2. The result is a reduction in the rental rate on capital from r1 to r2 and an increase in the quantity of capital from K1 to K2.


1. Coal miners get paid more than other workers with similar amounts of education. Their higher wage com-pensates them for the dirty and dangerous nature of coalmining, as well as their long-term health problems. As a result, they earn a sizable compensating differential.

FIGURE 18-1


2. Education is a type of capital because it represents anexpenditure of resources at one point in time to raiseproductivity in the future.

3. Education might raise a worker’s wage without raisingthe worker’s productivity if education provides a signalthat the worker has high ability.

8. Discrimination can persist in a competitive market ifcustomers have a preference for discrimination. Forexample, if customers prefer blonde waiters to brunettes,restaurants will prefer to hire blonde waiters and theywill discriminate against brunettes.


3. People with more experience usually have had more on-the-job training than others with the same formaleducation but less experience. Such training increasesthe value of the marginal product of their labor. Jobtenure is also valuable, since people gain job-specificknowledge or a specialization in knowledge that’s usefulto the firm.

7. Yes, his behavior is profit maximizing. He’s hiring labor at a lower cost. You might claim that Alan is despicable because he is discriminating against men.Some might claim that Alan is admirable, though, sincehe’s maximizing profit and giving women a better oppor-tunity to find a job. If more employers were like Alan, thewage differential between men and women would shrink,as employers would be competing for women workers, so women would have as many job options as men.Ultimately, the wage differential could disappear. Otherfirms at the time may not have followed his strategybecause their customers may have preferred male consultants.



4. Since people may have temporarily high or low incomeand since income varies over the life cycle (people’sincomes are lower when young and higher when older),annual income doesn’t represent true inequality in livingstandards.

5. A utilitarian would like everyone to have equal incomes,but would recognize that redistributing income distortsincentives, so would proceed only partway to that goal. A liberal would go further than a utilitarian in equalizingincomes, since a liberal would focus on how well off isthe worst-off person in society. A libertarian wouldn’tcare about equalizing incomes at all as long as theprocess of getting income is fair.


5. Community 1 has ten families with income of $100,000each and ten families with income of $20,000 each.Community 2 has ten families with income of $200,000each and ten families with income of $22,000 each.

a. Community 2 has more unpaid unequal income than community 1. In community 2 the rich have nearly ten times the income of the poor, while in community 1 the rich have only five times the income of the poor. However, the problems of poverty is likely to be slightly worse in community 1,since the poor have lower income.

b. Rawls would prefer the distribution of income in community 2, since the worst-off family has more income than in community 1.

c. Most people will prefer the income distribution of community 2, since both rich and poor families are better off than their counterparts in community 1, even though inequality is greater.

d. A utilitarian may prefer the income distribution ofcommunity 1 because income is more equal acrossits citizens.


6. a. Leaks in the bucket are caused by the administrativecosts of redistributing income, people who lie about their income to cheat the system, and the fact that labor supply is elastic, so that redistributive taxes reduce labor supply.

b. Generally, Republicans believe the redistributive bucket is more leaky than do Democrats. As a result, they think the government should do less redistribution of income than do Democrats

10. a. The following table shows pre-tax income, taxes paid to the government (a negative amount means money is received from the government), and after-tax income (all figures in thousands of dollars).

b. The marginal tax rate is 50 percent, since an increasein pre-tax income of $10,000 leads to higher taxes of $5,000. The maximum income at which a family receives money from the government is $20,000.

c. The change in the tax schedule gives a marginal tax rate of 25 percent. The maximum income at which a family receives money from the government is now $40,000.

d. The advantage of the first tax schedule is that the after-tax income distribution would be more equal.The advantage of the second tax schedule is that the marginal tax rate would be lower, so it wouldn’tcause as much of a distortion to labor supply.

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1. Figure 21-1 shows the consumer’s budget constraint.The intercept on the horizontal axis shows how muchcheese the consumer could buy if she bought onlycheese; with income of $3,000 and the price of cheese$6 a pound, she could buy 500 pounds of cheese. Theintercept on the vertical axis shows how much wine theconsumer could be if she bought only wine; with income$3,000 and the price of wine $3 a glass, she could by1,000 glasses of wine. With cheese on the horizontal axisand wine on the vertical axis, the budget constraint has aslope of 1,000 ÷ 500 = 2. Note that if you’d put wine onthe horizontal axis and cheese on the vertical axis, thebudget constraint would have a slope of 500 ÷ 1,000 = 1/2.

2. Figure 21-2 shows a consumer’s indifference curves forwine and cheese. Four properties of these curves are (1)higher indifference curves are preferred to lower onesbecause more is preferred to less; (2) indifference curvesare downward sloping because if the quantity of wine is reduced, the quantity of cheese must increase for theconsumer to be equally happy; (3) indifference curvesdon’t cross since a consumer prefers more to less; and (4)indifference curves are bowed inward since a consumer ismore willing to trade away wine if she has a lot of it andless willing to trade away cheese if she has little of it.

FIGURE 21-1


3. In Figure 21-2, the marginal rate of substitution (MRS)of one point on and indifference curve is shown. Themarginal rate of substitution shows the amount of winethe consumer would be willing to give up to get onemore pound of cheese.

4. Figure 21-3 shows the consumer’s budget constraintand indifference curves for wine and cheese. The con-sumer’s optimum consumption choice is shown as w*and c*. Since the marginal rate of substitution equalsthe relative price of the two goods at the optimum, themarginal rate is $6 ÷ $3 = 2.

FIGURE 21-2

FIGURE 21-3


5. Figure 21-4 shows the effect of an increase in income.The rise in income shifts the budget constraint out fromBC1 to BC2. If both wine and cheese are normal goods,consumption of both increases. If cheese is an inferiorgood, the increase in income causes the consumption of cheese to decline, as shown in Figure 21-5.

6. A rise in the price of cheesefrom $6 to $10 a poundmakes the horizontal inter-cept of the budget line declineform 500 to 300, as shown inFigure 21-6. The consumer’sbudget constraint shifts fromBC1 to BC2 and her optimalchoice changes from point A(c1 cheese, w1 wine) to point B(c2 cheese, w2 wine). To decom-pose this change into incomeand substitution effects, wedraw in budget constraint BC3,which is parallel to BC2 but Ato C represents the substitution effect. Since cheesebecame more expensive, the consumer substitutes winefor cheese as she moves from point A to C. The move-ment from point C to B represents an income effect. Therise in the price of cheese results in an effective declinein income.

FIGURE 21-4 FIGURE 21-5

FIGURE 21-6



2. a. Skis and ski bindings are complements. Coke andPepsi are substitutes.

b. Indifference curves between Coke and Pepsi arefairly straight, since there’s little to distinguishthem. Indifference curves between skis and skibindings are bowed, since they’re complements.

c. A consumer will respond more to a change in the relative price of Coke and Pepsi, possibly switch-ing completely from one to the other if the pricechanges.

5. Budget constraint BC1 in Figure 21-7 shows thebudget constraint if you pay no taxes. Budgetconstraint BC2 shows the budget constraint witha 15 percent tax.

b. Figure 21-8 shows indifference curves for which aperson will work more because of the tax. Figure 21-9shows indifference curves for which a person will workfewer hours because of the tax, and Figure 21-10shows indifference curves for which a person willwork the same number of hours after the tax.

FIGURE 21-7


FIGURE 21-8

FIGURE 21-9

FIGURE 21-10



1. Moral hazard is the tendency of a person who is imperfectlymonitored to engage in dishonest or otherwise undesirablebehavior. To reduce the severity of this problem, anemployer may respond with (1) better monitoring, (2) paying efficiency wages, (3) delaying part of a worker’scompensation.

2. Adverse selection is the tendency for the mix of unobservedattributes to become undesirable from the standpoint of an uninformed party. Examples of markets in whichadverse selection might be a problem include the marketfor used cars and the market for insurance.

3. Signaling is an action taken by an informed party to reveal private information to an uninformed party.Job applicants may use a college diploma as a signal of ability. Screening is an action taken by an uninformedparty to induce an informed party to reveal information.A life insurance company may require applicants to submit to a health examination so that the company will have more information on the person’s risk of death.

5. The median voter’s preferences will beat out any otherproposal in a two-way race because the median voterwill have more than half of the voters on his side.


1. a. The landlord is the principal and the tenant is the agent. There is asymmetric information because the landlord doesn’t know how well the tenant will take care of the property. Having a tenant pay a security deposit increases the likelihood that the tenant will take care of the property in order to receive his deposit back.

b. The stockholders of the firm (the owners) are the principals, and the top executives are the agents.The firm’s owners don’t know in advance how well the top executives will perform their duties. Tying some of the executives’ compensation to the value of the firm provides incentive for the executives to work hard to increase the value of the firm.


c. The insurance company is the principal and the customer is the agent. Insurance companies don’t know whether the car owner is likely to leave the vehicle parked with the keys in it or park it in a high-crime area. Individuals who will go to the trouble of installing antitheft equipment are more likely to ensure that their vehicle is taken care of. Offering a discount on insurance premiums will induce car owners to install such devices.

5. If the needy are given cash, they can use the cash topurchase whatever they most desire. This will increasetheir utility by more than if the government predeter-mines what they “need.” However, if the government is worried about how these individuals may spend thecash and wants to ensure that the needy receive propernutrition, they may want to provide free meals at a soupkitchen instead.

6. Ken is violating the property of independence of irrelevantalternatives. Adding a choice of strawberry after he choosesvanilla over chocolate shouldn’t induce him to changehis mind and prefer chocolate.

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