Chapter 10 Answers to End of Chapter Problems and Applicationswps.prenhall.com/wps/media/objects/5398/5528571/hu… ·  · 2008-03-01Answers to End of Chapter Problems and Applications

Chapter 10

Answers to End of Chapter Problems and Applications

2.

Quantity of Workers Total Output Marginal Product of Labor Average Product of Labor

0 0 — —

1 400 400 400

2 900 500 450

3 1500 600 500

4 1900 400 475

5 2200 300 440

6 2400 100 400

7 2300 –100 329

4. a. Variable cost = total cost – fixed cost = $30,000 - $10,000 = $20,000.

b. AVC = VC/Q = $20,000/10,000 = $2; AFC = FC/Q = $10,000/10,000 = $1

c. The gap must get smaller as output rises because ATC = AVC + AFC and AFC falls as output

rises.

6. As long as Sally’s GPA for a semester is below her cumulative GPA, her cumulative GPA will

fall.

8. Jill’s reasoning is faulty. If she could rent out her current building for $4,000 per month, then

she incurs an opportunity cost of that amount by using the building herself.

10. Although Franklin had no explicit expense when he advertised in his own paper, he did incur

a cost. The space for his own advertisements could have been used for paid advertisements by

other firms.

12. Fixed costs are like a lump-sum tax because both are fixed amounts that do not change as

output changes. Because AFC = FC/Q, a tax becomes smaller per unit of output as output rises.

14. a. Jill’s costs will be lower with a smaller store.

b. Her costs will be lower with a larger store.

c. Because of the effects of economies of scale.

16. AFC should be downward sloping, not U-shaped. ATC should be above AVC.

18. Ford would have ended up as the only automobile producer. Other producers would have had

higher costs and, therefore, would not have been able to match his price cuts.

20. There must be economies of scale in book publishing.

22. Morita’s short-run cost curve is described in the chapter opener. Its lowest point is at outputs

between 10,000 and 30,000. If he wanted to produce more than 75,000, he would have built an

additional factory, or, if there were economies of scale in manufacturing transistor radios, he

would have built a larger factory.

24. eToys built the large distribution center represented by ATC2 because they expected their

sales to be Q2. In that case, their average costs would have been AC1. In fact, their sales were

only Q1, which meant their costs were AC3. If they had known how low their actual sales would

have been, they would have been better off building the smaller distribution center represented by

ATC1. This would have lowered their average costs to AC2. This is what the author meant when

he wrote that eToys “needed to generate much higher sales to justify its costs.”

26. DuPont had expected to be on ATC1, in which case as production of paint increased from Q1

to Q2, average cost would have decreased from AC1 to AC2. In fact, they were on ATC2, so

average cost actually increased from AC3 to AC4, as production expanded.

28. The investors were expecting the long-run average cost curve to fall as output rose from the

initial level, Q1, to the post-merger level Q2, as shown by LRAC2. Instead, long-run average costs

didn’t fall. LRAC1 reflects the actual long-run average cost curve because average costs are no

lower at Q1 than at Q2.

Answers to Appendix Problems and Applications

2. a. If total cost is $2000 and wage and rent price = $100, the isocost curve’s endpoints are at 20

and 20. Along this isocost curve, the cost-minimizing point for producing 5000 copies is at point

A.

b. If wage rate is one-fourth the rental price of capital, then we must be on the isocost curve

whose endpoints are where capital = 10 and labor = 40 – since we can buy four times as much

labor, with total cost of $1,000. Along this isocost curve the cost-minimizing point for producing

5000 copies is at point B.

c. In this case the isocost curve’s endpoint are at 40 and 40, so the cost-minimizing point for

producing 12,000 copies is at point C.

4. Positive technological change will enable Jill to produce 20,000 copies with fewer inputs than

before. The isoquant curves will shift inward. Along the new Q* = 20,000 isoquant, she can

produce 20,000 copies with fewer inputs than before – for example, 9 workers and 4 machines at

point B. At her initial input level, point A, she will be able to produce more than 20,000 copies –

in this example, she can now produce 22,000 copies using 10 workers and 5 machines. (The

shapes of the isoquant curves may change, as well, but this isn’t shown here.)

6.

Long-run average cost = (total cost)/Q.

The long-run average cost curve exhibits economies of scale (average cost falling as output rises)

up to 45,000 copies per day, but diseconomies of scale at levels higher than 45,000 copies per

day.

8. The isoquant curve shows that there are innumerable combinations of workers and machines

that can pick the same quantity of oranges per day. In the U.S., firms select a point like A – using

a lot of capital and very little labor – because the isocost curves they face are very steep, due to

the fact that labor is relatively expensive in comparison to capital in the U.S. In Brazil, firms

select a point like B – using lots of labor and very little capital – because the isocost curves they

face are very float, due to the relatively low price of labor in comparison to capital in Brazil.

Chapter 11

Answers to End of Chapter Problems and Applications

2. The remark confuses the market demand for wheat with the demand facing one farmer selling

wheat. Remember that the units used in drawing the market demand curve are much greater than

the units used in drawing the individual farmer’s demand curve.

4. No, because the opportunity cost to your sister of using the copiers is $1,500, which is equal to

your cost of renting them.

6. The company is a price taker because it is in a very competitive industry. The company

should charge the market price.

8.

a. Total cost = A + B + C

b. Total revenue = A + B

c. Variable cost = A

d. Loss = C

The firm will continue to produce in the short run because it has revenue greater than its variable

costs.

10. Disagree – no matter how great demand may be, if there are no barriers to firms entering the

industry, profits will be competed away in the long run.

12. This argument is incorrect. In order to maximize profit, the firm should produce up to the

point where marginal revenue equals marginal cost. By producing only Q1, the firm will miss out

on all the profits to be made on units between Q1 and Q2.

14. As shown in the figure, the cost curves have shifted upward so that the price of fertilizer is

now below the minimum point on the average variable cost curve.

16. Airlines, like other businesses, will continue to operate so long as they can cover their

variable costs. The statement that “revenues will cover a large part of their cost,” refers to total

costs. If revenues covered only a large part, but not all, of the firm’s variable costs, it would shut

down. These revenues seem to cover all of the variable costs plus some of the fixed costs.

18. In perfectly competitive markets, firms may temporarily earn greater profits from a reduction

in costs. However, in the long run, lower costs result in lower prices, which benefit consumers,

but not higher profits.

20. The remark is incorrect because the student has confused accounting profit and economic

profit. Zero economic profit includes a normal rate of return on the investment of the owners of

the firm.

22. The increase in the demand for laptop computers causes the demand curve to shift from D1 to

D2, temporarily driving the price up to P3. As the production of laptops increases, more orders

are placed for laptop displays. As production of laptop displays increases, their cost and price

falls because of economies of scale. With increased demand and lower costs, the firms that

assemble laptops can make economic profits at P3. The result is that new firms enter the industry,

the industry supply curve shifts from S1 to S2, driving down the price to P2 and eliminating

economic profits. Because the price of laptop computers declines as output increases, the long-

run supply curve is downward sloping. This is a decreasing-cost industry.

Chapter 12

2. Profit = Revenue – Cost = Quantity x (price – average cost) = 350 x ($3.25 – $3.00) = $87.50.

4. Remember that minimizing average costs is not the same as maximizing profits. Often where

profits are maximized, average costs are not minimized. In this case, we do not have the

information on the firm’s revenues that would be necessary to calculate the profit-maximizing

highway speed, nor do we know how other costs – such as labor costs – are related to the average

highway speed.

All subsequent questions have been renumbered.

6. Profit = Revenue – Total Cost. Since profit fell, total costs must have increased faster than

revenue increased.

8. The graph shows that when the marginal and average total cost curves shift up, the profit-

maximizing price rises from P1 to P2. Germano seems to be assuming that demand is perfectly

inelastic, which it is unlikely to be. If a publisher does not raise the price of a book following an

increase in its production cost, its marginal revenue from the last few copies will be less than the

marginal cost – so it will earn a smaller profit than it would at a higher price.

10. In this context, “making goods in large quantity” means making more than the profit-

maximizing quantity – making so many that the marginal cost exceeds the marginal revenue.

Producing too many Rolls-Royce automobiles might also ruin their reputation for exclusiveness

and ultimately reduce the demand for them. This is not a problem with most products. On the

other hand, building a large factory that exhibits diseconomies of scale would be a problem for

any firm.

12. Competition in markets results in firms being forced to produce the goods most desired by

consumers and keeps most firms from earning more than a normal rate of return in the long run.

14. Consumers gain from the lower prices productivity gains make possible. The firms are not

more profitable because competition causes the prices they charge to fall to the level of the

average total costs.

16. Competition is a risk because it can reduce a firm’s profits. The barriers to entry are low in

retailing, so the competition is intense.

18. It will be very difficult to become rich by following the advice found in a book, because if the

book really has a good idea, then a lot of people will follow its advice. In the process, they will

compete away the profits from following the advice. Only those who pounce on the profit

opportunity quickly will earn great profits before imitators enter the market and eliminate the

profits. (In addition, if the author’s advice is really that valuable, he or she will probably want to

keep it secret, using it in his or her own business rather than telling rivals about it.)

20. This is a good way to find out what customers want, but it probably isn’t a good way to make

a profit because other firms already know this same information and are selling products to these

customers. Entering the market with products exactly like the competition will only work if your

firm somehow has lower costs than the other firms. On the other hand, firms who discover new

information about what customers want can temporarily make a profit supplying it until new

firms enter the market and competition drives profits back to zero.

22. The skeptics who think that “Starbucks’ game is almost over” think that other firms will soon

be copying Starbucks so well that the demand for Starbucks’ products will shrink and it won’t be

able to earn high economic profits any more.

Chapter 13

2. If a firm doesn’t match a price cut, its sales may fall considerably; if it doesn’t match a price

increase, its sales will rise.

4. a.

b. Confessing is a dominant strategy for Bob.

c. Confessing is a dominant strategy for Tom.

d. They will both confess, so they will both serve 10-year sentences. In this situation, this

outcome is difficult to avoid, but if they had both refused to confess, they would both have served

only 3-year sentences.

6. Early decision plans may have put “big-name” colleges in a prisoners’ dilemma.

8. If advertising is a prisoners’ dilemma, as in Solved Problem 13-1, then a ban on advertising

beer on television is likely to increase the profits of beer companies.

10. a. Wal-Mart doesn’t have a dominant strategy. If Target uses bar codes, Wal-Mart earns more

profit when it also uses bar codes, but if Target uses RFID tags, Wal-Mart’s best strategy is to use

RFID tags.

b. Target doesn’t have a dominant strategy. If Wal-Mart uses bar codes, Target earns more profit

when it uses bar codes, but if Wal-Mart uses RFID tags, Target earns more by using RFID tags.

c. Recall the definition of a Nash equilibrium: A situation where each firm chooses the best

strategy, given the strategies chosen by other firms. In this problem there are two Nash

equilibria: Both firms choosing bar codes or both firms choosing RFID tags. In either of these

situations, neither firm can increase its profits by changing its strategy, given the strategy chosen

by the other firm. An important point to note is that it is possible to have a Nash equilibrium

even when neither firm has a dominant strategy.

12. Economic structure would include whether there are economies of scale in the industry,

whether one or more firms owns a key input or raw material, whether there are government

imposed barriers to entry or competition, the threat of substitute goods or services, the bargaining

power of buyers and the bargaining power of suppliers. Most economists agree that economic

structure is the main determinant of the intensity of competition in an industry, but other factors,

like the personalities involved, might occasionally play a role.

14. As the personal computer industry evolved during the 1990s and early 2000s, differences

between the machines offered by the computer companies narrowed. So, personal computers

became more of a commodity business. In a commodity business, consumers are making their

decisions primarily on the basis of price. Therefore, a price ware is a worse strategy in a

commodity business because if one company cuts the price of its product, competitors have little

choice but to match the price cut.

16. Entrepreneurs hope to increase profitability by creating “big businesses.” Unless there are

significant economies of scale, they will not be successful, however. In the figure, firms

producing Q1 have the lowest average costs. If a firm tries to grow to a larger size, say Q2, it

average costs will rise – from C1 to C2 in this case.

18. Your answer does depend on the minimum rate of return owners of fast-food restaurants

require on their investment. For instance, suppose the minimum required return is 15 percent.

Then Burger King will enter whether McDonald’s builds a large store or a small store. So,

McDonald’s should build a small store, because it will receive a return of 20 percent, rather than

16 percent. But suppose the minimum required return is 20 percent. Then Burger King will not

enter if McDonald’s builds a large store. So, McDonald’s should build the large store, in which

case it will earn a return of 25 percent.

20. Having more flights, flying more different models of planes, and having areas for different

classes of passengers on each plane raises costs. Southwest Airlines avoids these costs by

pursuing the strategy outlined in Making the Connection 13-4.

22. “Being the competition” means copying the business model of another firm. “Being the

competition” sometimes makes sense. On example would be when there is no other option

available in the industry – such as in a perfectly competitive industry. Another case in which

“being the competition” makes sense is when their business model fits your firm better than their

own.

24. As Chandler suggests, there are many firms in these industries because smaller firms can

produce at a lower long-run average cost than larger firms.

26. a. There would be one or more firms like LittleAuto.

b. A single firm like BigAuto will probably dominate the market.

c. There will probably be two or more firms like BigAuto, depending on the how large demand is.

Chapter 14

Answers to End of Chapter Problems and Applications

2. The USPS is probably not a natural monopoly. If it were, it wouldn’t need a law banning

competition. It would be able to produce at a lower cost and charge a lower price than potential

competitors, so no one would want to enter the industry. If the current law banning competitors

were removed, firms would likely enter this market. They have already entered portions of the

market (such as package and overnight letter delivery) where competition isn’t banned and seem

eager to expand into additional sectors in the mail delivery business.

4. Extending the life of pharmaceutical companies’ patents would allow them to charge the

monopoly price for their drugs for a longer period and earn higher profits. This potential for

higher profits would encourage them to develop more new products. Consumers would gain

from having a wider range or medicines, but they would lose because their prices would stay high

longer.

6. You are likely to make a loss. If a profit was likely in this market, someone would probably

have already entered it.

8. There are only a limited number of countries in the world, which limits the number of

customers in this market. Also, printing currency that is difficult to counterfeit requires

specialized printing methods.

10a. The monopoly will produce 50 units and charge a price of $10.

10b. To achieve allocative efficiency, the regulatory agency should require the monopoly to

charge a price equal to marginal cost, which in this case would be a price of $7. The regulated

monopoly will produce 90 units. It will make a profit, because price is above average total cost.

12. We can calculate average total cost at every quantity.

Quantity

(per day)

(Q)

Total Cost

(TC)

Average Total Cost

⎟⎟⎠

⎞⎜⎜⎝

⎛QTC

30 $1,200 $40

40 1,400 35

50 2,250 45

60 3,000 50

In order for the firm to have a natural monopoly, it must be able to produce at a lower average

total cost than two firms. This is not the case here, because the firm’s average total cost begins to

increase after it has produced 40 units per day.

14a. In the short run Comcast will continue to sell 6 subscriptions at $14 each. Its revenue = $84,

but its cost is now $80 + $6, so its loss is $2. If this loss continues, in the long-run Comcast exit

the market.

14b. The new tax increases the marginal cost by $0.50 per subscriber, as shown in the table:

Price Quantity Total Revenue

Marginal Revenue

(MR = ∆TR/∆Q) Total Cost

Marginal Cost

(MC =

∆TC/∆Q)

$17 3 $51 – $57.50 –

16 4 64 $13 65.00 $7.50

15 5 75 11 73.50 8.50

14 6 84 9 83.00 9.50

13 7 91 7 93.50 10.50

12 8 96 5 105.00 11.50

Now Comcast will sell 5 subscriptions. It will charge a price of $15 per month, and earn profits

of $75 – $73.50 = $1.50.

16. The statement is incorrect. The monopolist charges the price that allows him to sell the level

of output where marginal revenue equals marginal cost. He is able to charge a higher price, but

would not be maximizing profit if he did.

18. No, to maximize revenue or production, the monopolist would have to charge a price that is

lower than the profit-maximizing price.

20. Under federal law, the Antitrust Division of the Department of Justice is given the

responsibility of policing mergers to make sure that they don’t substantially reduce competition.

If two large airlines merge, there will be less competition in the airline industry, which will result

in higher ticket prices.

22.

Before the merger the price was Pc and the quantity was Qc, so consumer surplus equaled A + B

+ C + D + E and producer surplus was area F + G + H + K + L + M. After the merger, price fell

to Pmerge and quantity rose to Qmerge, so consumer surplus equaled A + B + C + D + E + F + G + H

+ I + J and producer surplus became area K + L + M + N + O + P + Q + R.

24a. We need to calculate the Herfindahl-Hirschman Index (HHI). Before the merger: 20 x 52 =

500. After the merger: (15 x 52) + 202 = 375 + 400 = 775. Because the post-merger HHI is below

1,000 the merger will not be opposed.

24b. HHI before the merger: 5 x 202 = 2,000. After the merger: (3 x 202) + 402 = 1200 + 1600 =

2,800. Both before and after the merger, the HHI is above 1,800 so the merger will be opposed.

26. HHI before the merger, assuming 11 firms in the “other” category, each with a 1 percent share

of the market: 372 + 352 + 172 + 11(12) = 2,894. So, even if no company other than Coca-Cola,

Pepsi-Cola, and Cadbury Schweppes has a market share greater than 1 percent, the Department of

Justice and the Federal Trade Commission would be likely to oppose a merger between two of the

leading three firms.

28. The figure as drawn shows a monopoly producing the efficient level of output. Using

different demand curves (and different sizes for the negative externality), it is possible to show

that a monopoly may also produce an inefficiently high or low level of output in the presence of a

negative externality.

Chapter 15

Answers to End-of-Chapter Problems and Applications

2. Valerian might be suspicious of eBay because many of its users buy at a low price to resell at a

high price. However, if he were to find an item that had great value to him on eBay, he might

temper his judgment. Valerian’s worry seems to be that arbitragers are making unfairly high

profits, but eBay actually helps increase competition, thus eliminating the middleman’s economic

profits, while increasing consumer surplus.

4. This appears to be a case of price discrimination, unless the costs of selling autos is $30,142 –

$27,939 = $2203 higher in Dallas than in Oklahoma.

6. It must consider the price elasticity of demand for U.S. consumers to be higher.

8. To practice price discrimination, the airlines also need to keep the people who buy at the low

price from reselling at the high price.

10. In each case, Disney is attempting to set price so as to maximize profits given differing price

elasticities of demand.

12. a. The firm will charge $8 and sell 20 units in Market 1.

b. The firm will charge $10 and sell 60 units in Market 2.

14. We have seen that price discrimination results in lower prices for consumers with a high price

elasticity of demand and higher prices for consumers with a lower price elasticity of demand.

One way in which airlines and hotels separate high price elasticity consumers from low price

elasticity consumers is on the basis of their flexibility. In this case, flexibility usually means a

willingness to make a reservation well in advance or to change plans at the last second and to stay

over Saturday or during other periods when business travelers do not like to stay.

16. If this explanation of odd pricing is correct, you would expect to see it used more often among

people who are gullible, innumerate, or uneducated. Banning the practice probably wouldn’t

make much of a difference. Consumers might make slightly wiser choices, but they would have

to pay slightly more and a few would lose the feeling of having made a great deal. In competitive

markets, firms do not make economic profits in the long run.

18. a. This is a variation of the Disney World, two-part tariff problem. The team will make more

profit by keeping the season ticket prices low.

b. After the first year, the team no longer collects revenue from seat licenses, so it would have an

incentive to raise the price of season tickets.

c. If it still has some seat licenses unsold, then it will not raise season tickets as much as it would

if it sold them all the first year.

20. This is a variation of the Disney World, two-part tariff problem. The railroad companies

would maximize their combined profit from selling land and shipping freight by keeping freight

prices lower than they would if they did not also have land to sell. This was true because farmers

would be able to make greater profits – and, therefore, would be willing to pay more for land – if

freight charges were low.

Chapter 16

Answers to End of Chapter Problems and Applications

2. As your wage rises you’ll want less leisure because the price of an hour of leisure is now

higher (the substitution effect), but you’ll also want more leisure because you can now afford

more leisure (the income effect). Your labor supply curve is vertical if this substitution effect is

exactly the same size as the income effect.

4. He feared that an increase in labor supply would lower the equilibrium wage. In fact, labor

demand increased more than labor supply, and the equilibrium wage rose.

6. The shift from Labor Supply1 to Labor Supply2 shows the effect of the plague on the quantity

of sailors available at each wage. In the absence of government intervention, the wage would

have risen from W1 to W2, and the quantity of sailors employed would have fallen from L1 to L2.

The wage ceiling keeps the wage at W1, but causes the quantity of sailors employed to fall all the

way to L3.

8. It would probably have very little effect. The salaries of baseball players would still be much

greater than the salaries of college professors even if there were significantly more players on

each team. With expanded rosters, the superstars would still have the highest marginal revenue

products and would be paid over $10,000,000 per year. The new major leaguers wouldn’t get

very much playing time, wouldn’t have high marginal revenue products, and would earn less than

the league average – pulling down average pay somewhat, but not shrinking the gap between the

superstars and college professors.

10. Alex Rodriguez’s marginal revenue product – how much extra revenue he pulls in for his

employer – is obviously much higher than the marginal revenue product of this fan’s boss.

Rodriguez’s high pay is justified in an important sense because fans are willing to pay so much to

see a winning Major League Baseball team. Complaints about high salaries for professional

athletes amount to complaints that fan are willing to pay too much to view games. If A-Rod were

paid less, the big winner would be his employer, the New York Yankees.

12. The people who run the tennis tournaments in which the Williams sisters play sell tickets and

the right to broadcast the tournaments over television. So, the concept of marginal revenue

product is just as important in explaining their earnings as it is in explaining the earnings of

baseball players.

14. If economic discrimination were rampant against minority groups it would be unlikely that

Asian males would earn more than white males. However, it is important not to use average

wages to assess whether or not discrimination occurs. Differences in productivity are probably

the main factor determining differences in wages. Economic discrimination occurs when

someone is paid less due to an irrelevant characteristic which isn’t related to productivity.

16. Without comparable worth legislation, the equilibrium wage for economics professors is

$70,000 per year and the equilibrium number of economics professors hired is L1. Setting the

wage for economics professors below equilibrium at $60,000, reduces the number who are

willing to work in this occupation from L1 to L2, but increases the number demanded by

employers from L1 to L3. The result is a shortage of economics professors equal to L3 – L2, as

shown in the graph. Without comparable worth legislation, the equilibrium wage for English

professors is $50,000 and the equilibrium number hired is L1. Setting the wage for English

professors above equilibrium at $60,000, increases the number who want to work in this

occupation from L1 to L3, but reduces the number demanded by employers from L1 to L2. The

result is a surplus of English professors equal to L3 – L2, as shown in the graph.

18. Complete exclusion from an occupation is a sign that employees are the discriminators, rather

than employers. In occupations from which blacks were not excluded, equal pay for equal work

was almost inevitable, especially in a very competitive market with many employers, such as

agriculture. Employers who tried to pay black workers less would lose many of them to

employers who didn’t discriminate and would be at a competitive disadvantage. In addition,

paying workers doing the same jobs different wages may have reduced morale and productivity.

20. It will be higher under a piece-rate system, because the workers are willing to put in a greater

effort to earn more.

22. a.

Number

of

Machines

Output of

Pins (Boxes

per Week)

Marginal

Product of

Capital

Product

Price

(Dollars

per Box)

Total

Revenue

Marginal

Revenue

Product of

Capital

Rental

Cost per

Machine

Additional

Profit from

Renting One

Additional

Machine

0 0 — $100 0 — $550 —

1 12 12 100 $1200 $1200 550 $650

2 21 9 100 2100 900 550 350

3 28 7 100 2800 700 550 150

4 34 6 100 3400 600 550 50

5 39 5 100 3900 500 550 –50

6 43 4 100 4300 400 550 –150

Adam should rent 4 machines.

b. The demand curve for capital curve equals the marginal revenue product of capital.

Chapter 17

Answers to End-of-Chapter Problems and Applications

2. There are “lemon laws” for autos but not for televisions or toothbrushes because the size of the

losses sustained by buyers of bad cars led to political pressure to pass lemon laws for cars.

4. Perhaps. Some argue that Social Security does not involve offering insurance against difficult

to predict events like a fire or an illness, but that it is more like a program of forced saving for

retirement. Others argue that Social Security is an insurance system that insures against outliving

your savings due to the difficulty of predicting how long you are likely to live after retiring.

6. The system is necessary because society wants someone with enough money to be liable when

these drivers inflict damage on other people. The adverse selection problem means that insurance

companies are generally unwilling to offer insurance to these drivers at any rate. The state

government must force insurance companies to insure these bad drivers because the insurance

companies expect to lose money insuring these drivers, sot they wouldn’t insure them voluntarily.

8. Investors have been unwilling to buy the stocks and bonds of these firms because the adverse

selection problem means that the firms that most want to sell stocks or bonds to investors have

been the firms investors would least want to buy stocks or bonds from, if they knew the true state

of the firms’ financial health.

10. Yes. Congress was motivated to ban these loans because of the difficulty of determining

when they were in the best interests of shareholders and when they weren’t.

12. It is difficult for restaurant managers to monitor the performance of servers. Tips give servers

an incentive to provide good service. If tips were outlawed, the income of servers would be

likely to fall because the productivity of servers will decline.

14. Firms would divulge secrets to analysts to reduce the asymmetric information problem. Firms

have an incentive to provide outsiders with enough information that they may be willing to invest

in or lend to the firm.

16. Paying more than the going wage could increase or decrease profits. If employees respond to

the high pay by working harder, being more productive and quitting less frequently, the benefits

to the firm of the paying the above-market wage may exceed the costs. The higher pay may be an

efficiency wage, which gives workers an incentive to work harder. It may be a response to

asymmetric information.

18. The easier it is for bidders to estimate the true value of what they are bidding on, the less

likely they are to fall victim to the winner’s curse. Because Joe’s performance is steady,

Cleveland is likely to be paying him an amount that is justified by his performance. Sam’s

performance is more uneven, so Cincinnati is more likely to have fallen victim to the winner’s

curse by overestimating his performance, and to therefore be paying him a salary that turns out

not to be justified by his performance.

20. No. For the winner’s curse to apply, the winner must have overestimated the true value of

what is being bid on. If all bidders have perfect information, then this will not happen.

22. They suffer from the winner’s curse. The publisher that wins the auction is the publisher that

has most overestimated how many copies will be sold of the book being auctioned.

24. The marriage market is probably a combination of the two. There are certain aspects of

appearance and certain personality traits to which most people would assign the same value. On

the other hand, not every one evaluates appearance and personality the same way.

Chapter 18

Answers to End of Chapter Problems and Applications

2. A tax is regressive if people with lower incomes pay a higher percentage of their income in tax

than do people with higher incomes. So, a tax on cigarettes is likely to be regressive. A tax is

progressive if people with lower incomes pay a smaller percentage of their income in tax than do

people with higher incomes.

4. The statement means that laws saying that a particular group (for example, sellers) will pay a

tax have little bearing on who actually pays the tax. The statement is correct. Even though a law

may specify that a seller pays the whole tax, the economic logic explained in Figure 18-3

indicates that most taxes are borne partly by buyers and partly by sellers. After a tax is imposed,

the price paid by buyers will generally rise and the amount kept by sellers will generally fall. The

fraction of the tax borne by each group depends on the elasticity of supply relative to the

elasticity of demand.

6. Excess burden is the deadweight loss from a tax. As the graph shows, the excess burden is

greater when the demand for a product is price elastic. The red-shaded triangle shows the excess

burden when demand is elastic and the smaller blue-shaded triangle shows the excess burden

when demand in inelastic.

8a.

For a given supply curve, if the government wants to minimize the excess burden from excise

taxes, the taxes should be imposed on goods that have price inelastic demand. See the figure from

problem 7, which illustrates this point.

8b. For a given supply curve, if the government wishes to maximize revenue, it should impose

excise taxes on goods that have price inelastic demand. As the figure below shows, with an elastic

demand curve the quantity sold will fall from QE to Q1, so revenue will be the area Q1 x (P3 – P1),

while the revenue will be Q2 x (P4 – P2) when the demand curve is inelastic. Q2 is much larger

than Q1, while (P4 – P2) = (P3 – P1) = the amount of the tax. Thus, the tax revenue is much larger

when the demand curve is inelastic, because the quantity sold is larger.

8c. If the government wishes to discourage use of the product, the tax will be more effective in

achieving the objective if the demand is price elastic. As shown in the figure, the quantity

demanded will fall more when the demand curve is elastic.

10. It is unlikely that this statement is true. The burden of a tax generally falls on both buyer and

seller. If the tax didn’t exist, it is likely that the list price would have been more than $300. Only

if the demand curve is vertical or the supply curve is horizontal, will buyers bear the entire burden

of the tax.

12. While policies to redistribute income may be desperately needed in the U.S., it doesn’t seem

to be true that the 12 percent of the population that is currently poor has no hope of ever climbing

above the poverty line. The chapter cites a study by the U.S. Census Bureau which found that

only 50.5 percent of people who were in poverty in 1996 remained in poverty in 1999. Likewise,

of the people who were in poverty at any time during 1996, 51.1 percent were in poverty for four

months or less and only 20.4 percent were in poverty for more than one year.

14.

The total income of this group is $250,000.

Quintile Share of Income Cumulative Share of Income

Lowest 20% (Jeff) 12% 12%

Second lowest 20% (Robert) 16% 28%

Middle 20% (Sharon) 20% 48%

Second highest 20% (Lena) 24% 72%

Highest 20% (David) 28% 100%

16. According to the marginal productivity theory of income distribution, the distribution of

income is based mainly on the marginal revenue product of the factors owned by households. To

equalize the distribution of income would require ending the inequality of ownership of resources

or ending the inequality of the payments to these resources (by, for example, making wage rates

equal). This would require a massive government intervention into the economy, greater even

than under the old communist governments of Russia and China, which never achieved complete

income equality. Such a policy would not be very desirable because it would destroy the

efficiency of the economy. There would be no incentives to work hard, save, become educated,

take entrepreneurial risks, and so forth, if people knew that their income would be the same as

everyone else’s whether or not they worked, saved, became educated or took risks.

18. Food is often exempt from taxation because of the ability-to-pay principle. Poorer households

generally spend a much larger fraction of their incomes on food, which is a necessity. In

satisfying these basic needs, they don’t have as great an ability to pay taxes as households with

higher incomes. The exemption of services from sales taxes is much harder to understand using

the principles of taxation. Taxing services at a lower rate than goods can undermine the goal of

achieving economic efficiency. It may be that the exemption of services is an effort to attain

other social objectives. It is much easier for tax collectors to keep an eye on the sales of goods,

so the exemption of sales may be a bow to the likelihood of tax evasion if services were taxed.

20. The poverty line is defined as an annual income equal to three times the amount necessary to

purchase the minimal quantity of food require for adequate nutrition – and it is calculated before

taxes and transfers. There are many reasons why consumption and ownership of these goods

could rise while poverty rates stay the same. Most importantly, the poverty rate is based on

income and consumption can differ from income, due to transfers, for example. Another reason

is that the definition of “adequate” nutrition seems to have risen over time, increasing the

purchasing power of those at the poverty line.