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ECON 1001 AB Introduction to Economics I Dr. Ka-fu WONG Eighth week of tutorial sessions KKL 925, KKL 1010, K812, KKL 106 Clifford CHAN KKL 1109 [email protected]
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Page 1: Solution 008

ECON 1001 ABIntroduction to

Economics IDr. Ka-fu WONG

Eighth week of tutorial sessions

KKL 925, KKL 1010, K812, KKL 106

Clifford CHANKKL 1109

[email protected]

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Covered and to be covered Covered last week

Dr. Wong finished up to kf008.ppt and slide #7 of kf010.ppt You should have at least read up to Chapter 8 The Quest for

Profit and the Invisible Hand If not, please press hard on it. Start reading Chapter 10 Monopoly

and Other Forms of Imperfect Competition

To be covered in the tutorial sessions this week Problems in chapter 8: #1, #3, #5, #7 and #9 An extra question relevant to Chapter 8 You are advised to work on the even ones as well

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Problem #1, Chapter 8 Explain why the following statements are true or false A) The economic maxim: “There’s no cash on the table.”

That means there are never any unexploited economic opportunities

False This statement is kind of tricky It is wrong that there are never any unexploited economic

opportunity In the short run, there are normal unexploited economic

opportunities to be drawn from so new entries are attracted by a positive economic profit

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Solution to Problem #1 (1) However, as the number of suppliers grows in the long

run, all participating firms will earn a zero economic profit However, as the number of suppliers grows in the long

run, the market price will be driven down and all the participating firms will eventually earn a zero economic profit

Only in the long run, there are no unexploited economic opportunities

But there are exploited economic opportunities in the short run so that new suppliers are encouraged to enter the market!

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Solution to Problem #1 (2) B) Firms in competitive environments making no

accounting profit when the market is in long-run equilibrium

False Firms in competitive environments make a positive

accounting profit in the long-run equilibrium so that it can be used to cover the opportunity cost of resources supplied

However, firms in competitive environments make no economic profit in the long-run equilibrium!

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Solution to Problem #1 (3) C) Firms that can introduce cost-saving innovations can

make an economic profit in the short run True In the short run, market price of a good has not yet been

adjusted, but firms experience a reduction in production cost due to the innovations, and thus they enjoy a higher economic profit

The supply curve will shift to the right due to the replication of innovation and the increasing number of suppliers in the market

The market price will be driven down until the economic profit gets down to zero

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Problem #3, Chapter 8 Labour $2000Food and drink $500Electricity $100Vehicle lease $150Rent $500Interest on loan for equipment $1,000

John Jones owns and manages a café in Collegetown whose annual revenue is $5,000. Annual expenses are as above

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Solution to Problem #3 (1) A) Calculate John’s annual accounting profit Recall the difference between accounting profit and

economic profit Accounting profit = Total revenue – Total explicit cost Economic profit = Total revenue – Total explicit and implicit costs Economic profit is always less than accounting profit

In this question, the total annual revenue is $5,000 The total explicit cost is the sum of the annual expenses Total explicit cost = Labour + Food and drink + Electricity

+ Vehicle lease + Rent + Interest on loan for equipment Total explicit cost = $4250

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Solution to Problem #3 (2) Annual accounting profit = $5000 - $4250 = $750 B) John could earn $1000 per year as a recycler of

aluminum cans. However, he prefers to run the café. In fact, he would be willing to pay up to $275 per year to run the café rather than to recycle. Is the café making an economic profit? Should John stay in the café business? Explain.

Considers the two options for John: Running a café or Being a recycler

If he runs the café, he will forgone the annual income ($1000) that he can potentially earn from being a recycler

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Solution to Problem #3 (3) In addition, if he runs the café, he will receive benefit

which is equivalent to $275 per year Therefore, if he runs the café, he will forgo the potential

income earned from recycling minus the benefits he receives from the café

His true opportunity cost is $1000 - $275 = $725 Economic profit = Accounting profit – Implicit cost (OC) Economic profit = $750 - $725 = $25 Since John’s annual economic profit is greater than 0, he

should run the business

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Solution to Problem #3 (4) Suppose the café revenues and expenses remain the

same, but the recyclers’ earnings rise to $1,100 per year. Is the café still making an economic profit? Explain.

If the earnings from recycling increases to $1,100, that means the true opportunity cost becomes $1100 - $275 = $825

Again, economic profit = accounting profit – opportunity cost

New economic profit = $750 - $825 = -$75 Since the new economic profit is less than zero, John will

suffer from an annual economic loss of $75 from running the cafe

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Solution to Problem #3 (5) D) Suppose John had not had to get a $10,000 loan at

an annual interest rate of 10 percent to buy equipment, but instead had invested $10,000 of his own money in equipment. How would your answer to parts a and b change?

If John did not borrow a loan to finance the equipment, he could save the interest on loan for equipment

As a result, the total explicit cost would be decreased by $1000 to $3250

Therefore, the new annual accounting profit = $5000 - $3250 = $1750

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Solution to Problem #3 (6) However, the economic profit in part b would not change

(assuming that the interest rate one has to pay on bank loan is the same as that one gets from bank deposits.)

There would be a new opportunity cost for the interest income of $1000 that John would forgo by investing his money in the equipment

The increase in the accounting profit in part a would be offset by the new opportunity cost when we calculate the new economic profit for part b

New economic profit = new accounting profit – new opportunity cost

New economic profit = $1750 – ($1000 - $275 +$1000) New economic profit = $1750 - $1725 = $25 (No change!)

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Solution to Problem #3 (7) E) If John can earn $1000 a year as a recycler, and he

likes recycling just as well as running the café, how much additional revenue would the café have to collect each year to earn a normal profit?

Normal profit refers to the opportunity cost of the resources owned by the firm

To earn a normal profit, the café would have to cover all its implicit and explicit costs

After all explicit costs are taken into account, the opportunity cost of running the café is $1000

The accounting profit of running the café is $750 Therefore, the café would have to earn an additional

annual revenue of $250 to earn a normal profit of zero

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Problem #5, Chapter 8 Explain carefully why, in the absence of a patent, a

technical innovation invented and pioneered in one tofu factory will cause the supply curve for the entire tofu industry to shift to the right. What will finally halt the rightward shift?

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Solution to Problem #5 (1) Since the question does not specific for the market

structure, we assume that the tofu industry is a perfectly competitive industry in which participating firms are earning a zero economic profit in the long run

If one of the firms introduces an innovation on the production technology, its cost (average cost and marginal cost, etc.) at each production level will be reduced

In the short run where price has not yet been adjusted, the innovating firm will earn a positive economic profit

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Solution to Problem #5 (2) As the innovation is not patented, other participating

firms or potential firms will try to reap the positive economic profit by replicating the innovation and produce more to the market

As a result, the market supply will increase because of the non-patented innovation

When the market supply increases, the supply curve will continue shifting to the right (driving down the price)

The fall in price of tofu will finally halt when the price falls to a level which generate zero economic profit to the participating firms

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Problem #7, Chapter 8 Unskilled workers in a poor cotton-growing region must

choose between working in a factory for $6000 a year and being tenant cotton farmer. One farmer can work at a 120-acre farm, which rents for $10000 a year. Such farms yield $20,000 worth of cotton each year. The total non-labour cost of producing and marketing the cotton is $4000 a year. A local politician whose motto is “working people come first” has promised that if he is elected, his administration will fund a fertilizer, irrigation, and marketing scheme that will triple cotton yields on tenant farms at no charge to tenant farmers

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Solution to Problem #7 (1) A) If the market price of cotton would be unaffected by

this policy and no new jobs would be created in the cotton-growing industry, how would the project affect the incomes of tenant farmers in the short run? In the long run?

In the short run, a cotton farmer will make an economic profit as follows

Recall economic profit = total revenue – total explicit and implicit costs

Note: in the question, it says the marketing scheme will triple the cotton yields on tenant farms

Hence, new total revenue = $20000 * 3 = $60000

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Solution to Problem #7 (2) Economic profit = $60000 total revenue - $10000 rent -

$4000 marketing cost - $6000 opportunity cost Economic profit = $40000 per year Since the economic profit is greater than zero, factory

workers will switch to being a cotton farmer in the long run As the number of cotton farmers increases, the rent of

cotton farmland will increase Once the rent of cotton farmland reaches to $50000 per

year, cotton farmers will earn an economic profit of zero in the long run

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Solution to Problem #7 (3) Who would reap the benefit of the scheme in the long

run? How much would they gain each year? Landowner In the last part, we have shown that in the long run, the

rent on cotton farmland will increase There will be no new cotton farmers when the rent of on

cotton farmland reaches $50000 for which it was $10000 before the scheme

Thus, landowners in the long run earn an additional rent of $40000 per 120-acre farmland

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Problem #9, Chapter 8 You have an opportunity to buy an apple orchard that

produces $25,000 per year in total revenue. To run the orchard, you would have to give up your current job, which pays $10,000 per year. If you would find both jobs equally satisfying, and the annual interest rate is 10 percent, what is the highest price you would be willing to pay for the orchard?

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Solution to Problem #9 (1) If you buy the apple orchard, you will incur an opportunity

cost of forgoing the alternative use of money like investment

Given in the question, the annual interest rate is 10% That means if you buy the apple orchard, you will incur an

opportunity cost that is equivalent to 10% of the price of the apple orchard

In addition, you will have to forgo the potential income you earn from your current job, which is $10,000 per year

Recall economic profit = total revenue – total explicit and implicit costs

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Solution to Problem #9 (2) Total revenue = $25,000 per year Total cost = $10,000 forgone income + (Priceappleorchard *

10% annual interest rate) You are willing to pay for the apple orchard up to a value

that makes a zero economic profit $25,000 = $10,000 + (0.10*Priceappleorchard) Priceappleorchard = $150,000

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Extra question #1, Chapter 8 Is the following statement true or false? Explain. Even if there is a non-patented cost-saving technology

introduced, all firms will eventually earn a zero economic profit in the long run. The economy in the long run is thus just as well off as in the past

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Solution to Extra #1 (1) False The technology will generate a positive economic profit

for existing firms in the short run, and it will also attract new entries to the industry to reap that positive profit

The supply curve will then shift to the right until the positive economic profit is once again dissipated

All the participating firms will eventually receive a zero economic profit in the long run

Even so, the economy is still better off than in the past The technology does create a larger pie for both

consumers and producers in the market

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Solution to Extra #1 (2) Consumers benefit from a new lower price because of

the new technology Consumers capture a larger consumer surplus as the

supply curve shifts to the right Though producers earns a lower market price, they enjoy

a higher volume because of the new technology Producers capture a larger producer surplus as the

supply curve shifts to the right As a result, the total economic surplus in the long run is

increased Hence the economy in the long run is actually better off

than in the past!

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Solution to Extra #1 (3)

P

Q0

S

D

Q*

CS

PSP*

P

Q0

S’ w/ new technology

D

Q*’

P*’

S

Q*

P* CS’

PS’

CS’ > CS and PS’ > PS; total economic surplus increases

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The end

Thanks for coming! See you next week!!!