chp 11 econ

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Chapter 11

PERFORMANCE AND STRATEGY IN COMPETITIVE MARKETS

QUESTIONS AND ANSWERS

Q11.1 Your best income-earning opportunity appears to be an offer to work for a localdeveloper during the month of June and earn $2,000. owever, before taking the !ob, you accept a surprise offer from a competitor. "f you actually earn $2,#00 during themonth, how much producer surplus have you earned %&plain.

Q11.1 ANSWER

$600. Producer surplus is the amount a seller is paid minus the seller’s marginal costof production. In this case, the opportunity cost of $2,000 is the relevant marginal costof deciding to work for the competitor, and producer surplus is the amount receivedaove and eyond that amount. !he amount received, $2,600, represents a $600 premium over the amount that would have een received from your ne"t#estemployment opportunity and represents the value of your producer surplus.

Q11.2 'ssume that you are willing to pay $(,(00 for a new personal computer that has all the)bells and whistles.* +n the "nternet, you buy one for the bargain price of $00.nbeknownst to you, the "nternet retailers marginal cost was only $/0. ow much

consumer surplus, producer surplus, and net addition to social welfare stems from your purchase %&plain.

Q11.2 ANSWER

onsumer surplus is the amount that consumers are willing to pay for a good or serviceminus the amount that they are re%uired to pay. onsumer surplus represents valuederived from consumption that consumers are ale to en&oy at 'ero cost. It alsodescries the net enefit derived y consumers from consumption, where net enefit ismeasured in the eyes of the consumer. If you are in the market for a new personalcomputer and willing to pay up to $(,(00, ut you uy one for the argain price of$)00, you reali'e consumer surplus of $200. onsumer surplus represents thedifference etween the price you were willing to pay and the price paid.

*hereas consumer surplus is closely related to the demand curve for a product, producer surplus is closely related to the supply curve for a product. Producer surplusis the amount paid to sellers minus the cost of production. It represents the amount paid to sellers aove and eyond the re%uired minimum and is the net enefit derived y producers from production. If you paid $)00 and the Internet retailer’s marginal

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cost was $+0, the amount of producer surplus is $(0, or the difference etween theminimum price a seller would e willing to accept and the price received.

In competitive market e%uilirium, social welfare is measured y the sum of net enefits derived from trade y consumers and producers. -ocial welfare is the sum ofconsumer surplus and producer surplus. In this case, the total gains from trade are$0. !he gain from trade reali'ed y the consumer is $200/ the gain from tradereali'ed y the producer is $(0.

Q11.3 'fter having declined during the (/0s and (30s, the proportion of teenage smokers

in the nited 4tates has risen sharply since the early-(0s. 5o reverse this trend,advertising programs have been launched to discourage teenage smoking, penalties for selling cigarettes to teenagers have been toughened, and the e&cise ta& oncigarettes has been increased. %&plain how each of these public policies affectsdemand for cigarettes by teenagers.

Q11.3 ANSWER

ike any drug interdiction program, advertising programs designed to discourageteenage smoking can have a favorale effect y causing an inward shift in the demandcurve for cigarettes. -imilarly, to the e"tent that penalties for selling cigarettes toteenagers preclude some underage smokers, the demand curve for cigarettes will shiftinward. In oth cases, a reduction in demand for cigarettes y teenagers will e noted.1ollowing a e"cise per unit3 ta" increase, the price of cigarettes will rise and cause adecrease in the %uantity demanded as shown y an upward movement along thedemand curve.

-ignificant evidence suggests that teenage smoking is in fact susceptile toeconomic considerations. 4conomists 5onathan ruer and 5onathan 7inman find thata ma&or e"planation for the rise in youth smoking over the ())0s was a sharp decline incigarette prices in the early ())0s, caused y a price war among the toaccocompanies. ruer and 7inman find that young people are very sensitive to the priceof cigarettes in their smoking decisions. !he authors estimate that for every (0 percentdecline in the price, youth smoking rises y almost + percent, a much stronger pricesensitivity than is typically found for adult smokers. !he price decline of the early())0s can e"plain aout a %uarter of the rise in smoking from ())2 through ())+.-imilarly, the significant decline in youth smoking oserved in ())8 is at least partiallye"plainale y the first steep rise in cigarette prices since the early ())0s. 9owever,

price does not appear to e an important determinant of smoking y younger teens whoare e"perimental smokers. :estrictions on access to cigarette purchases can lower the%uantity that younger teens smoke, ut the most influential tool that policymakers haveto reduce youth smoking is clearly e"cise ta"es that raise the price of cigarettes. -ee;5onathan ruer and 5onathan 7inman, ?4: *orking Paper >o. ++803.

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Q11.4 "n 2001, +6% reduced the 8uantity of oil it was willing to supply to world markets. %&plain why the resulting price increase was much larger in the short run than in the

long run.

Q11.4 ANSWER

!he supply and demand for oil are relatively inelastic in the short run, ut fairly elasticin the long run. In the short run, oil supply is %uite inelastic ecause it takes time todrill new wells, uild additional pipelines, and arrange for ship cargo transportation.-imilarly, in the short run, the demand for oil is %uite inelastic ecause consumers havefi"ed needs for gasoline to power their cars, fuel to heat their homes, and so on. In thelong run, supply conditions in the oil market can e rather elastic ecause @P4memers tend to cheat on their cartel agreements to restrict output, and ecause non#@P4 producers respond to higher oil prices y e"panding production. @il demandalso tends to e more elastic in the long run ecause consumers respond to higher oil prices y uying high#mileage automoiles, increasing home insulation, and so on.

Q11.5 5he demand for basic foodstuffs, like feed grains, tends to be inelastic with respect to price. se this fact to e&plain why highly fertile farmland will fetch a relatively high price at any point in time, but that rising farm productivity over time has a negativeoverall influence on farmland prices.

Q11.5 ANSWER

At any point in time, farmers with especially fertile farmland earn economic rents ecause of the superior productivity of their soil. 4ven in competitive long#rune%uilirium, especially fertile soil has the potential to generate durale economic rents.*ith an aility to generate durale aove#normal profits, especially fertile land willgenerate an aove#normal price in the real estate market. In fact, especially fertile soilwill attract a sufficiently high market price as to afford the uyer nothing more than arisk#ad&usted normal rate of return on the uyer’s investment.

9owever, the long#term profit#making potential of farmland is limited y the factthat the demand for asic foodstuffs, like feed grains, tends to e inelastic with respectto price. *ith rising farm productivity over time, the supply of asic foodstuffs tendsto rise faster than stagnant demand causing stagnant to declining prices for farm products. @ver time, increasing farm productivity in the =nited -tates has had an

adverse effect on farm prices and farmer incomes in the =nited -tates.

Q11.6 "n (0, ongress adopted a lu&ury ta& to be paid by buyers of high-price cars, yachts, private airplanes, and !ewelry. 6roponents saw the levy as an effective meansof ta&ing the rich. ritics pointed out that those bearing the hardship of a ta& may ormay not be the same as those who pay the ta& 9the point of ta& incidence:. %&plainhow the elasticities of supply and demand in competitive markets can have directimplications for the ability of buyers and sellers to shift the burden of ta&es imposed

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upon them. 'lso e&plain how elasticity information has implications for the amount of social welfare lost due to the deadweight loss of ta&ation.

Q11.6 ANSWER

*hen ongress passed the lu"ury ta", the goal was to raise revenues from those whocould most easily afford to pay for government services, the rich. =nfortunately, ecause the demand for new lu"ury items produced and sold in the =nited -tates isrelatively elastic, uyers of such lu"ury items can choose to postpone such purchases,or uy them from producers not su&ect to ta", in order to minimi'e their discretionaryta" payments. *hen demand is elastic and supply is inelastic, as in the case of yacht production, for e"ample, the largest share of ta" urden falls on producers rather than uyers. In the case of yachts, the lu"ury ta" caused a steep decline in domestic production. Producer profits plummeted and workers got laid off. !hey, rather thanrich customers, tended to suffer. It is important to keep in mind that the economichardship of a ta" ta" urden3 can seldom e inferred y simply referencing the partyresponsile for paying the ta" ta" incidence3.

In general, the urden of a ta" tends to fall on that side of the market that tendsto e relatively less elastic. 4lasticity also has implications for the amount of socialwelfare lost due to the deadweight loss of ta"ation. 9olding the elasticity of demandconstant, the deadweight loss of a ta" is small when supply is relatively inelastic.*hen supply is relatively elastic, the deadweight loss of a ta" is large. -imilarly,holding supply elasticity constant, the deadweight loss of a ta" is small when demandis relatively inelastic. *hen demand is relatively elastic, the deadweight loss of a ta"is large.

Q11.7 ;oth employers and employees pay 4ocial 4ecurity 9

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If laor demand is inelastic, employees will find it easy to pass along the urden of payroll ta"es to employers. In this case, employers will e forced to ear a large share

of the economic urden of 1IA ta"es. If laor demand were perfectly elastic,employees would ear the entire economic urden of 1IA ta"es. If laor demandwere perfectly inelastic, employers would ear the entire economic urden of 1IAta"es.

@n the other hand, holding the elasticity of laor demand constant, the economic urden of payroll ta"es tends to shift from employees towards employers as theelasticity of supply increases. If laor supply were perfectly elastic, employers would ear the entire economic urden of 1IA ta"es. If laor supply were perfectlyinelastic, employees would ear the entire economic urden of 1IA ta"es. >one ofthese circumstances are likely, however, and some sharing in the economic urden of1IA ta"es is to e e"pected etween employers and employees. In general, ta" urdens fall more heavily on the side of the market that is less elastic.

Q11.8 5he

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!he income effect of an increase in the minimum wage is an empirical %uestion.Go'ens of economic studies confirm that unskilled laor demand is elastic, and suggest

that an increase in the minimum wage will decrease worker incomes.

Q11.9 5he Aew York ity Bent 4tabiliCation ?aw of (# established ma&imum rental rates for apartments in Aew York ity. %&plain how such controls can lead to shortages,especially in the long run, and other economic costs. Despite obvious disadvantages,why does rent control remain popular

Q11.9 ANSWER

@stensily, the goal of rent control is to make housing more affordale, especially forthe elderly and the poor. -ince the supply of apartments is fi"ed perfectly inelastic3 inthe short run, imposition of rent controls has little effect on short#run supply. In thelong run, however, landlords can decided whether or not to e"it the rental usiness.!his gives rise to an upward sloping long#run supply curve for apartments. Ifcontrolled rental rates are elow the e%uilirium market price, as is true in >ew ew

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and ad&ustment costs were immaterial, instantaneous ad&ustments to competitive firmand industry capacity would insure that dise%uilirium profits were minimal and

fleeting. Gise%uilirium profits are sustainale for the typical firm only wheninformation is imperfect and ad&ustment costs are significant. *al#Jart has sustaineda superior rate of profitaility in a cut#throat usiness for more than 0 years. *hilethe company has clearly enefited from rapid change in discount retailing technology,and therey earned some dise%uilirium profits, 0 years is a very long time, andsomething more than &ust dise%uilirium profits are at work.

Guring the last %uarter of the twentieth century, *al#Jart grew to dominate thediscount retailing usiness and ecame one of the most enormous success stories incorporate America. *al#Jart is clearly much more efficient than the typical retailer,and earns superior profits economic rents3 in recognition of this superior productivity.1or e"ample, *al#Jart was among the first to estalish an HIntranet to link its retailstores with suppliers to etter meet customer demand and minimi'e inventory costs.!he efficiency of *al#Jart’s management information system is legendary. *al#Jart also closely links employee pay with performance. !he manager of Pet -upplies,for e"ample, earns a onus depending upon the sales and profit performance of thats%uare footage. Pet -upply managers watch inventory closely, and oth shopliftingand employee theft at *al#Jart is far elow industry norms. -o long as *al#Jart canmaintain such advantages, it will earn superior rates of return in a savagely competitive usiness.

SELF-TEST PROBLEMS AND SOLUTIONS

ST11.1 So!"# W$#%"&$. ' number of domestic and foreign manufacturers producereplacement parts and components for personal computer systems. =ith e&acting user specifications, products are standardiCed and price competition is brutal. 5o illustratethe net amount of social welfare generated in this hotly competitive market, assumethat market supply and demand conditions for replacement tower cases can bedescribed asE

F4 G -(/H (2.6 97arket 4upply:

F D G (2 - 2.6 97arket Demand:

where F is output in thousands of units and 6 is price per unit.

A. Iraph and calculate the e8uilibrium price>output solution.

B. se this graph to help you algebraically determine the amount of consumer surplus, producer surplus and net social welfare generated in this market.

ST11.1 SOLUTION

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A. !he market supply curve is given y the e%uation

K- D #(+ L (2.P

or, solving for price,

(2.P D (+ L K-

P D $(M L $0.08K-

!he market demand curve is given y the e%uation

KG D (2 # 2.P


2.P D (2 # KG

P D $0 # $0.MKG

raphically, demand and supply curves appear as follows;

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Algeraically, to find the market e%uilirium levels for price and %uantity, simply set

the market supply and market demand curves e%ual to one another so that K - D KG. !ofind the market e%uilirium price, e%uate the market demand and market supply curveswhere %uantity is e"pressed as a function of price;

-upply D Gemand

#(+ L (2.P D (2 # 2.P

(P D 00

P D $20

!o find the market e%uilirium %uantity, set e%ual the market supply and marketdemand curves where price is e"pressed as a function of %uantity, and K- D KG;

-upply D Gemand

$(M L $0.08K D $0 # $0.MK

Replacement Compter To!er E"#l#$r#m

$0

$(0

$20

$0

$M0

$0

$60

0 (0 20 0 M0 0 60 +0 80 )0 (00 ((0 (20

%ant#t& '((()

P r # c e -upply

P D $(M L $0.08K-

Gemand

P D $0 # $0.MKG

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0.M8K D 6

K D +0003

!he e%uilirium price#output comination is a market price of $20 with ane%uilirium output of + 0003 units, as shown in the figure.

*. !he value of consumer surplus is e%ual to the region under the market demand curvethat lies aove the market e%uilirium price of $20. ?ecause the area of such a triangleis one#half the value of the ase times the height, the value of consumer surplus e%uals;

onsumer -urplus D N O+ $0 # $203Q

D $(,(2 0003

In words, this means that at a unit price of $20, the %uantity demanded is + 0003units, resulting in total revenues of $(,00 0003. !he fact that consumer surpluse%uals $(,(2 0003 means that customers as a group would have een willing to payan additional $(,(2 0003 for this level of market output. !his is an amount aove and eyond the $(,00 0003 paid. ustomers received a real argain.

!he value of producer surplus is e%ual to the region aove the market supplycurve at the market e%uilirium price of $20. ?ecause the area of such a triangle isone#half the value of the ase times the height, the value of producer surplus e%uals;

Producer -urplus D N O+ $20 # $(M3Q

D $22 0003

At a unit price of $20, producer surplus e%uals $22 0003. Producers as a groupreceived $22 0003 more than the asolute minimum re%uired for them to produce themarket e%uilirium output of + 0003 units. Producers received a real argain.

In competitive market e%uilirium, social welfare is measured y the sum of net enefits derived y consumers and producers. -ocial welfare is the sum of consumersurplus and producer surplus;

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-ocial *elfare D onsumer -urplus L Producer -urplus

D $(,(2 L $22

D $(,0 0003

ST11.2 P&!$ '$!#!()*. 5he local government in a =est oast college town is concernedabout a recent e&plosion in apartment rental rates for students and other low-incomerenters. 5o combat the problem, a proposal has been made to institute rent controlthat would place a $00 per month ceiling on apartment rental rates. 'partment supply and demand conditions in the local market areE

F4 G -100H 26 97arket 4upply:

F D G ,#00 - 16 97arket Demand:

where F is the number of apartments and 6 is monthly rent.

A. Iraph and calculate the e8uilibrium price>output solution. ow much consumer surplus, producer surplus, and social welfare is produced at this activity level

B. se the graph to help you algebraically determine the 8uantity demanded,8uantity supplied, and shortage with a $00 per month ceiling on apartmentrental rates.

'. se the graph to help you algebraically determine the amount of consumer and producer surplus with rent control.

D. se the graph to help you algebraically determine the change in social welfareand deadweight loss in consumer surplus due to rent control.

ST11.2 SOLUTION

A. !he competitive market supply curve is given y the e%uation

K- D #M00 L 2P


2P D M00 L K-

P D $200 L $0.K-

!he competitive market demand curve is given y the e%uation

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KG D ,600 # MP


MP D ,600 # KG

P D $(,M00 # $0.2KG

!o find the competitive market e%uilirium price, e%uate the market demand andmarket supply curves where %uantity is e"pressed as a function of price;

-upply D Gemand

#M00 L 2P D ,600 # MP

6P D 6,000

P D $(,000

!o find the competitive market e%uilirium %uantity, set e%ual the market supplyand market demand curves where price is e"pressed as a function of %uantity, and K - DKG;

-upply D Gemand

$200 L $0.K D $(,M00 # $0.2K

0.+K D (,200

K D (,600

!herefore, the competitive market e%uilirium price#output comination is amarket price of $(,000 with an e%uilirium output of (,600 units.

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!he value of consumer surplus is e%ual to the region under the market demand

curve that lies aove the market e%uilirium price of $(,000. ?ecause the area of sucha triangle is one#half the value of the ase times the height, the value of consumersurplus e%uals;

onsumer -urplus D N O(,600 $(,M00 # $(,0003Q

D $20,000

In words, this means that at a unit price of $(,000, the %uantity demanded is (,600units, resulting in total revenues of $(,600,000. !he fact that consumer surplus e%uals$20,000 means that customers as a group would have een willing to pay an

additional $20,000 for this level of market output. !his is an amount aove and eyond the $(,600,000 paid. ustomers received a real argain.!he value of producer surplus is e%ual to the region aove the market supply

curve at the market e%uilirium price of $(,000. ?ecause the area of such a triangle isone#half the value of the ase times the height, the value of producer surplus e%uals;

Producer -urplus D N O(,600 $(,000 # $2003Q

Apartment Rental E"# l #

$0

$200

$M00

$600

$800

$(,000

$(,200

$(,M00

$(,600

0 2 00 M00 600 80 0 ( ,000 (, 20 0 ( ,M00 ( ,60 0 ( ,800 2,000

A p ar tm e n t n

M o n t h l & r e n t a l p r # c e

G e ma nd

P D $ ( , M00 # $0 . 2KG

-upply

P D $200 L $0 . K-

A

?

G

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D $6M0,000

At a rental price of $(,000 per month, producer surplus e%uals $6M0,000. Producers asa group received $6M0,000 more than the asolute minimum re%uired for them to

produce the market e%uilirium output of (,600 units. Producers received a real argain.In competitive market e%uilirium, social welfare is measured y the sum of net

enefits derived y consumers and producers. -ocial welfare is the sum of consumersurplus and producer surplus;


D $20,000 L $6M0,000

D $)60,000

*. !he market demand at the $)00 price ceiling is

KG D ,600 # M)003

D 2,000 units

!he market supply at the $)00 price ceiling is

K- D #M00 L 2)003

D (,M00 units

!he market shortage created y the $)00 price ceiling is

-hortage D KG # K-

D 2,000 # (,M00

D 600 units

C. =nder rent control, the ma"imum amount of apartment supply that landlords arewilling to offer at a rent of $)00 per month is (,M00 units. 1rom the market demandcurve, it is clear that renters as a group are willing to pay as much as or have areservation price of3 $(,00 per month to rent (,M00 apartments;

P D $(,M00 # $0.2(,M003

D $(,00

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=nder rent control, the value of consumer surplus has two components. A firstcomponent of consumer surplus is e%ual to the region under the market demand curvethat lies aove the price of $(,00 per month. !his amount corresponds touncompensated value otained y renters willing to pay aove the market price all the

way up to $(,M00 per month. As in the case of an uncontrolled market, the area of sucha triangle is one#half the value of the ase times the height. A second component ofconsumer surplus under rent control is the uncompensated value otained y renterswilling to pay as much as $(,00 per month to rent (,M00 apartments, and who aredelighted to rent for the controlled price of $)00 per month. !his amount correspondsto the amount of revenue represented y the rectangle defined y the prices of $(,00and $)00 and the %uantity of (,M00 units. >otice that this second component ofconsumer surplus includes some value privately measured as producer surplus. =nderrent control, the total amount of consumer surplus is;

:ent#ontrolled onsumer -urplus D N O(,M00 $(,M00 # $(,003Q

L O(,M00 $(,00 # $)003Q

D $2M,000 L $2(0,000

D $M,000

In this case, consumer surplus rises from $20,000 to $M,000, a gain of $(,000 asa result of rent control.

!he value of producer surplus is e%ual to the region aove the market supplycurve at the rent#controlled price of $)00. ?ecause the area of such a triangle is one#half the value of the ase times the height, the value of producer surplus e%uals;

Producer -urplus D N O(,M00 $)00 # $2003Q

D $M)0,000

At a rent#controlled price of $)00 per month, producer surplus falls from $6M0,000 to$M)0,000, a loss of $(0,000.

D. !he change in social welfare caused y rent control is measured y the change in net enefits derived y consumers and producers. !he change in social welfare is thechange in the sum of consumer surplus and producer surplus;

-ocial *elfare hange D onsumer -urplus hange

L Producer -urplus hange

D $(,000 # $(0,000

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D #$(,000 a loss3

!his $(,000 deadweight loss in social welfare due to rent control has twocomponents. 1irst, there is a deadweight loss of consumer surplus from consumers

unale to find a rent#controlled apartment ut willing to pay upwards from the priormarket e%uilirium price of $(,000 per month up to $(,00 per month. !his amount ise%ual to the area shown in the graph as A?G. ?ecause the area of such a triangle isone#half the value of the ase times the height, the first component of deadweight lossin consumer surplus e%uals;

Geadweight oss in onsumer -urplus D N O(,600 #(,M003 $(,00 # $(,0003Q

D $,000

-econd, there is a deadweight loss of producer surplus from landlords forced to rent at

the rent#controlled price of $)00 per month rather than the market e%uilirium price of$(,000 per month. !his amount is e%ual to the area shown in the graph as ?G.?ecause the area of such a triangle is one#half the value of the ase times the height,the second component of deadweight loss in consumer surplus e%uals;

Geadweight oss in Producer -urplus D N O(,600 #(,M003 $(,000 # $)003Q

D $(0,000

PROBLEMS AND SOLUTIONS

P11.1 So!"# W$#%"&$ 'o($+,*. "ndicate whether each of the following statements is true or false, and e&plain why.

A. "n competitive market e8uilibrium, social welfare is measured by the net benefitsderived from consumption and production as measured by the differencebetween consumer surplus and producer surplus.

B. 5he market supply curve indicates the minimum price re8uired by sellers as a group to bring forth production.

'. onsumer surplus is the amount that consumers are willing to pay for a given good or service minus the amount that they are re8uired to pay.

D. =hereas consumer surplus is closely related to the supply curve for a product, producer surplus is closely related to the demand curve for a product.

E. 6roducer surplus is the net benefit derived by producers from production.

P11.1 SOLUTION

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A. 1alse. In competitive market e%uilirium, social welfare is measured y the sum of net enefits derived y consumers and producers. -ocial welfare is the sum of consumersurplus and producer surplus.

*. !rue. !he market supply curve indicates the minimum price re%uired y sellers as agroup to ring forth production. !he height of the market supply curve measuresminimum production cost at each and every activity level.

C. !rue. onsumer surplus is the area under the demand curve that lies aove the market price. It represents the amount that consumers are willing to pay for a given good orservice minus the amount that they are re%uired to pay. onsumer surplus representsvalue derived from consumption that consumers are ale to en&oy at 'ero cost. It alsodescries the net enefit derived y consumers from consumption, where net enefit ismeasured in the eyes of the consumer. 1rom the standpoint of society as a whole,

consumer surplus is an attractive measure of the economic well#eing of consumers.

D. 1alse. *hereas consumer surplus is closely related to the demand curve for a product, producer surplus is closely related to the supply curve for a product.

E. !rue. Producer surplus is the amount paid to sellers minus the cost of production. Itrepresents the amount paid to sellers aove and eyond the re%uired minimum.Producer surplus is the net enefit derived y producers from production. 5ust asconsumer surplus is an appealing measure of consumer well#eing, producer surplus isan attractive measure of the economic well#eing of producers.

P11.2 L"o& Po#!. 6eople of many different age groups and circumstances take advantageof part-time employment opportunities provided by the fast-food industry. Iiven thewide variety of different fast-food vendors, the industry is fiercely competitive, as is theunskilled labor market. "n each of the following circumstances, indicate whether the proposed changes in government policy are likely to have an increasing, a decreasing,or an uncertain effect on employment in this industry.

A. %limination of minimum wage law coverage for those working less than 20hours per week.

B. 'n increase in spending for education that raises basic worker skills.

'. 'n increase in the employer portion of federally-mandated

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P11.2 SOLUTION

A. =ncertain. 4limination of minimum wage coverage for those working less than 20

hours per week will either increase or have no effect on employment opportunities inthe industry. If the minimum wage is aove the current market e%uilirium wage rate,elimination of the minimum wage for some workers will have the effect of increasingemployment opportunities. 9owever, if the minimum wage rate is elow the currentmarket e%uilirium wage rate, as has een true in many parts of the =.-., eliminatingthe minimum wage for some workers will have no effect.

*. Increase. An increase in spending for education that raises asic worker skills has theeffect of increasing the marginal productivity of workers, and the marginal revenue product generated for employers. A favorale impact on &o opportunities can ee"pected as a result of such an enhancement in worker efficiency.

C. Gecrease. An increase in the employer portion of federally#mandated 1IA insurancecosts has the effect of increasing the costs of worker employment. *ithout any similarenhancement in worker productivity, a negative impact on employment opportunitiescan e anticipated.

D. =ncertain. A re%uirement that employers install e"pensive new worker#safetye%uipment has an uncertain effect on employment opportunities. enerally speaking, areduction in employment opportunities can e e"pected following an increase in suchcosts. 9owever, if the mandated increase results in a rise in fi"ed costs only, and if theindustry earned aove#normal rates of return on investment, then employers might paysuch costs with no reduction in employment.

E. Gecrease. ike an increase in the employer portion of federally#mandated 1IAinsurance costs, a state re%uirement that employers pay 8R of wages to fund a newnational health care program has the effect of increasing the costs of workeremployment. *ithout any offsetting enhancement in worker productivity, a negativeimpact on employment opportunities can e anticipated.

P11.3 So!"# W$#%"&$. Aatural gas is in high demand as a clean-burning energy source forhome heating and air conditioning, especially in ma!or metropolitan areas where air8uality is a prime concern. 5he domestic supply of natural gas is also plentiful.Iovernment reports predict that gas recoverable with current technology fromdomestic sources is sufficient to satisfy production needs for more than 0 years. 6lentiful imports from anada are also readily available to supplement domestic production. 5o illustrate the net amount of social welfare generated in this vigorouslycompetitive market, assume that market supply and demand conditions are

F4 G -2,000 H 3006 97arket 4upply:

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F D G 1,00 - 006 97arket Demand:

where F is output in million ;tus 9in millions:, and 6 is price per unit. ' ;ritishthermal unit 9;tu: is an %nglish standard unit of energy. +ne ;tu is the amount of

thermal energy necessary to raise the temperature of one pound of pure li8uid waterby one degree

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P D $

!o find the market e%uilirium %uantity, set e%ual the market supply and market

demand curves where price is e"pressed as a function of %uantity, and K- D KG;

-upply D Gemand

$2. L $0.00(2K D $) # $0.002K

0.002K D 6.

K D 2,000 million3

!herefore, the e%uilirium price#output comination is a market price of $ with

an e%uilirium output of 2,000 million3 units.

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Natral Ga+ E"#l#$r#m

$0

$(

$2

$

$M

$

$6

$+

$8

$)

$(0

0 00 (000 (00 2000 200 000

%ant#t& '((( )

P r # c e

-upplyP D $2. L $0.00(2K-

Gemand

P D $) # $0.002KG

?. !he value of consumer surplus is e%ual to the region under the market demand curvethat lies aove the market e%uilirium price of $. ?ecause the area of such a triangleis one#half the value of the ase times the height, the value of consumer surplus e%uals;

onsumer -urplus D N O2,000 $) # $3Q

D $M,000 million3

In words, this means that at a unit price of $, the %uantity demanded is 2,000 million3units, resulting in total revenues of $(0,000 million3. !he fact that consumer surpluse%uals $M,000 million3 means that customers as a group would have een willing to pay an additional $M,000 million3 for this level of market output. !his is an amountaove and eyond the $(0,000 million3 paid. ustomers received a real argain.

!he value of producer surplus is e%ual to the region aove the market supplycurve at the market e%uilirium price of $. ?ecause the area of such a triangle is one#half the value of the ase times the height, the value of producer surplus e%uals;

Producer -urplus D N O2,000 $ # $2.3Q

D $2,00 million3At a unit price of $, producer surplus e%uals $2,00 million3. Producers as a group received$2,00 million3 more than the asolute minimum re%uired for them to produce the markete%uilirium output of 2,000 million3 units. Producers received a real argain.

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In competitive market e%uilirium, social welfare is measured y the sum of net enefits derived y consumers and producers. -ocial welfare is the sum of consumersurplus and producer surplus;


D $M,000 L $2,00

D $6,00 million3

P11.4 D$"/$!), Lo** o% T"",!o(. 5o many upscale homeowners, no other flooringoffers the warmth, beauty, and value of wood. Aew technology in stains and finishescall for regular cleaning that takes little more than sweeping and>or vacuuming, withoccasional use of a professional wood floor cleaning product. =ood floors are alsoecologically friendly because wood is both renewable and recyclable. ;uyers looking

for traditional oak, rustic pine, trendy mahogany, or bamboo can choose from a wideassortment. 't the wholesale level, wood flooring is a commodity-like product sold with rigid

product specifications. 6rice competition is ferocious among hundreds of domesticmanufacturers and importers. 'ssume that market supply and demand conditions formahogany wood flooring areE

F4 G -(0 H 26 97arket 4upply:

F D G K20 - 16 97arket Demand:

where F is output in s8uare yards of floor covering 9000:, and 6 is the market price per s8uare yard.

A. Iraph and calculate the e8uilibrium price>output solution before and afterimposition of a $ per unit ta&.

B. alculate the deadweight loss to ta&ation caused by imposition of the $ per unitta&. ow much of this deadweight loss was suffered by consumers versus producers %&plain.

P11.4 SOLUTION

A. !he market supply curve is given y the e%uationK- D #(0 L 2P


2P D (0 L K-

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P D $ L $0.K-


KG D 20 # MP


MP D 20 # KG

P D $80 # $0.2KG

!o find the market e%uilirium levels for price and %uantity, simply set the marketsupply and market demand curves e%ual to one another so that K- D KG. 1or e"ample,to find the market e%uilirium price, e%uate the market demand and market supply

curves where %uantity is e"pressed as a function of price;

-upply D Gemand

#(0 L 2P D 20 # MP

6P D 0

P D $


-upply D Gemand

$ L $0.K D $80 # $0.2K

0.+K D +

K D (00 0003

!herefore, the e%uilirium price#output comination is a market price of $with an e%uilirium output of (00 0003 units.

1ollowing imposition of a $) per unit ta", the new market supply curve is given y the e%uation

P D $ L $0.K- L ta"

D $ L $0.K- L $)

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D $(M L $0.K-or, solving for %uantity,

P D $(M L $0.K-

0.K- D #(M L P

K- D #28 L 2P


KG D 20 # MP


MP D 20 # KG

P D $80 # $0.2KG

!o find the market e%uilirium price, e%uate the market demand and marketsupply curves where %uantity is e"pressed as a function of price;

-upply D Gemand

#28 L 2P D 20 # MP

6P D M8

P D $8


-upply D Gemand

$(M L $0.K D $80 # $0.2K

0.+K D 66

K D 88 0003

!herefore, the e%uilirium price#output comination with a $) per unit ta" is amarket price of $8 with an e%uilirium output of 88 0003 units.

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, o o - F lo o r# n E" # l

$0

$( 0

$2 0

$ 0

$M 0

$, 0

$6 0

$+ 0

$8 0

$) 0

0 (0 20 0 M0 ,0 60 +0 80 )0 (00 ((0 (2

% an t# t& '( ( ( +

P r # c e

- u p p l y L t a "P D $ ( M L $ 0 . , K-

G e m a n d

P D $ 8 0 # $ 0 . 2 , KG

- u p p l y

P D $, L $ 0 . ,K-

A

?

G

*. !he amount of deadweight loss due to ta"ation suffered y consumers is given y thetriangle ounded y A?G. ?ecause the area of such a triangle is one#half the value ofthe ase times the height, the value of lost consumer surplus e%uals;

onsumer Geadweight oss D N O(00 # 883 $8 # $3Q

D $(8 0003

In the asence of a ta", a supply price of $M) OD $ L $0.883Q would e associatedwith a %uantity supplied of 88 0003 units. !herefore, amount of deadweight loss dueto ta"ation suffered y producers is given y the triangle ounded y ?G. ?ecausethe area of such a triangle is one#half the value of the ase times the height, the valueof lost producer surplus e%uals;

Producer Geadweight oss D N O(00 # 883 $ # $M)3Q

D $6 0003

!he total amount of deadweight loss due to ta"ation suffered y consumers and producers is given y the triangle ounded y AG. !he area of such a triangle issimply the amount of consumer deadweight loss plus producer deadweight loss;

!otal Geadweight oss D onsumer oss L Producer oss

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D $(8 0003 L $6 0003

D $M 0003

P11.5 L+ S T"$*. "n (3, alifornias newly deregulated power market beganoperation. 5he large power utilities in the state turned over control of their electrictransmission facilities to the new "ndependent 4ystem +perator 9"4+: to assure fairaccess to transmission by all generators. 5he new alifornia 6ower %&change9al6L: opened to provide a competitive marketplace for the purchase and sale ofelectric generation. 5he deregulation re8uired electric utilities to split their businessinto generation, transmission, and distribution businesses. 5he utilities continue toown all of the transmission and distribution facilities, but the "4+ controls all of thetransmission facilities. tilities provide all distribution services, but customers areallowed to choose their energy supplier. 5he utilities were re8uired to sell off 0 of

their generating facilities. "n addition, utilities have to sell all their electric generationto the 6ower %&change and purchase all power for their customers through the 6ower %&change. 5o illustrate the net amount of social welfare generated by a competitive power market, assume that market supply and demand conditions for electric energy inalifornia areE

F4 G -3/,00H (,206 97arket 4upply:

F D G 20,000 - (,0006 97arket Demand:

where F is output in megawatt hours per month 9in thousands:, and 6 is the market price per megawatt hour. ' megawatt hour is one million watt-hours, where watt-hours is a common measurement of energy produced in a given amount of time,arrived at by multiplying voltage by amp hours. 5he typical alifornia home uses onemegawatt hour of electricity per month.

A. Iraph and calculate the e8uilibrium price>output solution. se this graph tohelp you algebraically determine the amount of producer surplus generated inthis market.

B. alculate the ma&imum lump-sum ta& that could be imposed on producerswithout affecting the short-run supply of electricity. "s such a ta& apt to affectthe long-run supply of electricity %&plain.

P11.5 SOLUTION


K- D #8+,00 L (,20P

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(,20P D 8+,00 L K-

P D $+0 L $0.0008K-


KG D 20,000 # (,000P


(,000P D 20,000 # KG

P D $20 # $0.00(KG

!o find the market e%uilirium levels for price and %uantity, simply set the marketsupply and market demand curves e%ual to one another so that K- D KG. 1or e"ample,to find the market e%uilirium price, e%uate the market demand and market supplycurves where %uantity is e"pressed as a function of price;

-upply D Gemand

#8+,00 L (,20P D 20,000 # (,000P

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2,20P D +,00

P D $(0


-upply D Gemand

$+0 L $0.0008K D $20 # $0.00(K

0.00(8K D (80

K D (00,000 0003

!herefore, the e%uilirium price#output comination is a market price of $(0with an e%uilirium output of (00,000 0003 units.!he value of producer surplus is e%ual to the region aove the market supply

curve at the market e%uilirium price of $(0. ?ecause the area of such a triangle isone#half the value of the ase times the height, the value of producer surplus e%uals;

Producer -urplus D N O(00,000 $(0 # $+03Q

D $M,000,000 0003

At a unit price of $(0, producer surplus e%uals $M,000,000 0003. Producers as agroup received $M,000,000 0003 more than the asolute minimum re%uired for them to produce the market e%uilirium output of (00,000 0003 units. Producers received areal argain.

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Electr#c#t& Mar/et E"#l#$r

$0

$2

$0

$+

$(00

$(2

$(0

$(+

$200

$22

$20

0 2,000 0,000 + ,000 (00,000 (2 ,000 (0,000 (+,000

%ant#t& '((( me.a!att hor+ per

P r # c e

-upply

P D $+0 L $0.0008K-

Producer -urplus

o nsumer -urplus

Gemand

P D $20 # $0.00(KG

*. !he ma"imum lump#sum ta" that could e imposed on producers without affecting theshort#run supply of electricity is $M,000,000 0003, or the total amount of producersurplus. !his stems from the fact that the market supply curve indicates the minimum price re%uired y sellers as a group to ring forth production. In the short run, themarket supply curve e%uals the marginal cost of production, so long as marginal coste"ceeds average variale cost. In the long run, the market supply curve e%uals themarginal cost of production, so long as marginal cost e"ceeds average total cost.!a"ing away all producer surplus with a lump sum ta" will leave long#run supplyunaffected only if producers are still ale to earn a risk#ad&usted rate of return oninvestment. If the lump#sum ta" makes it impossile for the typical competitor to earna normal profit, then some e"it is to e e"pected and industry output will fall in thelong run.

P11.6 D$"(/ . S++# S*!/. "n 'frica, the continent where the polio epidemic hasbeen most difficult to control, international relief efforts aimed at disease eradicationoften work against a backdrop of civil unrest and war. "n some countries, temporarycease-fire agreements must be negotiated to allow vaccination and prevent seriousoutbreaks from occurring. During peacetime and during war, low incomes make paying for the vaccine a real problem among the poor. 5o make the oral polio vaccine

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more affordable, either consumer purchases 9demand: or production 9supply: can be subsidiCed. onsider the following market demand and market supply curves for a generic oral polio vaccineE

F D G 21,000 - (,#006 97arket Demand:

F4 G -2,000 H (,0006 97arket 4upply:

where F is output measured in doses of oral vaccine 9in thousands:, and 6 is themarket price in dollars.

A. Mouchers have a demand-increasing effect. Iraph and calculate the e8uilibrium price>output solution before and after the institution of a voucher systemwhereby consumers can use a $K.2 voucher to supplement cash payments.

B. 6er-unit producer subsidies have a marginal cost-decreasing effect. 4how andcalculate the e8uilibrium price>output solution after the institution of a $K.2 perunit subsidy for providers of the oral polio vaccine. Discuss any differencesbetween answers to parts ' and ;.

P11.6 SOLUTION

A. !he market demand curve is given y the e%uation

KG D 2M,000 # (,600P


(,600P D 2M,000 # KG

P D $( # $0.00062KG

!he market supply curve is given y the e%uation

K- D #2,000 L (,000P


(,000P D 2,000 L K-

P D $2 L $0.00(K-

!o find the market e%uilirium levels for price and %uantity, simply set the marketsupply and market demand curves e%ual to one another so that K- D KG. !o find the

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market e%uilirium price, e%uate the market demand and market supply curves where%uantity is e"pressed as a function of price;

-upply D Gemand

#2,000 L (,000P D 2M,000 # (,600P

2,600P D 26,000

P D $(0


-upply D Gemand

$2 L $0.00(K D $( # $0.00062K

0.00(62K D (

K D 8,000 0003

!herefore, the e%uilirium price#output comination is a market price of $(0with an e%uilirium output of 8,000 0003 units.

1ollowing the institution of a $.2 per unit demand voucher, the new voucher#aided market demand curve is given y the e%uation

P D $( # $0.00062KG L voucher

D $( # $0.00062KG L $.2

D $(8.2 # $0.00062KG

or, solving for %uantity,

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P D $(8.2 # $0.00062KG

0.00062KG D (8.2 # P

KG D 2),200 # (,600P

!o find the new market e%uilirium price, e%uate the new voucher#aided marketdemand and market supply curves where %uantity is e"pressed as a function of priceand K- D KG;

-upply D Gemand

#2,000 L (,000P D 2),200 # (,600P

2,600P D (,200

P D $(2


-upply D Gemand

$2 L $0.00(K D $(8.2 # $0.00062K

0.00(62K D (6.2

K D (0,000 0003

!herefore, the e%uilirium price#output comination with a $.2 per unitvoucher is a market price of $(2 with an e%uilirium output of (0,000 0003 units.

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Pol#o Vacc#ne E"#l#$r#m

$0

$2

$M

$6

$8

$(0

$(2

$(M

$(6

$(8

$20

0 2,00 ,000 +,00 (0,000 (2,00 (,000 (+,00

Do+e+ o0 Oral Vacc#ne '((()

P r # c

-upply P D $2 L $0.00(K -

Gemand

P D $( #

$0.00062K G

J # $.2

Gemand L $.2

*. 1ollowing the institution of a $.2 per unit producer susidy, the new susidy#aidedmarket supply curve is given y the e%uation

P D $2 L $0.00(K- # susidy

D $2 L $0.00(K- # $.2

D #$(.2 L $0.00(K-

or, solving for %uantity,

P D #$(.2 L $0.00(K-

0.00(K- D $(.2 L P

K- D (,20 L (,000P

!o find the new market e%uilirium price, e%uate the market demand andsusidy#aided market supply curves where %uantity is e"pressed as a function of priceand K- D KG;

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-upply D Gemand

(,20 L (,000P D 2M,000 # (,600P

2,600P D 22,+0

P D $8.+


-upply D Gemand

#$(.2 L $0.00(K D $( # $0.00062K

0.00(62K D (6.2

K D (0,000 0003

!herefore, the e%uilirium price#output comination with a $.2 per#unitsusidy is a market price of $8.+ with an e%uilirium output of (0,000 0003 units. >otice that this is the e"act same level of output as was achieved with the demandvoucher of $.2 in part A. Also notice that the market price of $(2 in part A results inan effective price to consumers of $8.+ D$(2 # $.23, the e"act same price as in part?. 9olding demand and supply elasticities constant, there is no economic difference etween an identical per unit susidy or ta"3 for uyers or seller.

P11.7 P&!$ F#oo&*. %ach year, about billion bushels of corn are harvested in the nited4tates. 5he average market price of corn is a little over $2 per bushel, but costs farmers about $K per bushel. 5a& payers make up the difference. nder the 2002$(0 billion, (0-year farm bill, 'merican ta&payers will pay farmers $1 billion a yearto grow even more corn, despite the fact that every year the nited 4tates is faced witha corn surplus. Irowing surplus corn also has unmeasured environmental costs. 5he production of corn re8uires more nitrogen fertiliCer and pesticides than any otheragricultural crop. Bunoff from these chemicals seeps down into the groundwater supply, and into rivers and streams. 'g chemicals have been blamed for a (2,000- s8uare-mile dead Cone in the Iulf of 7e&ico. +verproduction of corn also increases.4. reliance on foreign oil.

5o illustrate some of the cost in social welfare from agricultural price supports,assume the following market supply and demand conditions for cornE

F4 G -,000H ,0006 97arket 4upply:

F D G (0,000 - 2,006 97arket Demand:

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where F is output in bushels of corn 9in millions:, and 6 is the market price perbushel.

A. Iraph and calculate the e8uilibrium price>output solution. se this graph to

help you algebraically determine the amount of surplus production the government will be forced to buy if it imposes a support price of $2.0 perbushel.

B. se this graph to help you algebraically determine the gain in producer surplusdue to the support price program. %&plain.

P11.7 SOLUTION


K- D #,000 L ,000P


,000P D ,000 L K-

P D $( L $0.0002K-


KG D (0,000 # 2,00P


2,00P D (0,000 # KG

P D $M # $0.000MKG

!o find the market e%uilirium levels for price and %uantity, simply set themarket supply and market demand curves e%ual to one another so that K- D KG. !ofind the market e%uilirium price, e%uate the market demand and market supply curveswhere %uantity is e"pressed as a function of price;

-upply D Gemand

#,000 L ,000P D (0,000 # 2,00P

+,00P D (,000

P D $2

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-upply D Gemand

$( L $0.0002K D $M # $0.000MK

0.0006K D

K D ,000 million3

!herefore, the e%uilirium price#output comination is a market price of $2 withan e%uilirium output of ,000 million3 ushels.

!he effects of a $2.0 government price support can e seen y noting that at

that price market supply will e%ual

K- D #,000 L ,000P

D #,000 L ,0002.03

D +,00 million3

At the $2.0 price support, market demand will e%ual

KG D (0,000 # 2,00P

D (0,000 # 2,002.03

D ,+0 million3

!herefore, with a $2.0 price support, surplus production is

-urplus Production D K- # KG

D +,00 # ,+0

D ,+0 million3

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*. *ith a $2.0 government price support, the value of producer surplus is e%ual to theregion aove the market supply curve at the market price of $2.0. ?ecause the area ofsuch a triangle is one#half the value of the ase times the height, the value of consumersurplus e%uals;

Producer -urplusP- D N O+,00 $2.0 # $(3Q

D $,62 million3

In a free market, the value of producer surplus is e%ual to the region aove the market

supply curve at the market e%uilirium price of $2. ?ecause the area of such a triangleis one#half the value of the ase times the height, the value of consumer surplus e%uals;

Producer -urplus1J D N O,000 $2 # $(3Q

D $2,00 million3

Corn Mar/et E"#l#$r#m

$0.00

$0.0

$(.00

$(.0

$2.00

$2.0

$.00

$.0

$M.00

$M.0

$.00

0 (,20 2,00 ,+0 ,000 6,20 +,00 8,+0

*+hel+ o0 Corn 'm#ll#on+)

P r # c e

-upply

P D $( L $0.0002K-

Gemand

P D $M # $0.000MKG

?

A

Producer -urplus

onsumer -urplus

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!herefore, the gain in producer surplus caused y the $2.0 government price support program is;

ain in Producer -urplus D Producer -urplusP- # Producer -urplus1J

D $,62 # $2,00

D $,(2 million3

!his gain in producer surplus caused y the $2.0 government price support program isshown in the graph y the region $2$2.0A?.

P11.8 I+o&, 'o(,&o#*. ritics argue that if ongress wants to make the ta& code moree8uitable, a good place to start would be removing unfair tariffs and 8uotas. 5oday,there are more than eight thousand import tariffs, 8uotas, so-called voluntary import

restraints, and other import restrictions. 5ariffs and 8uotas cost consumers roughly$30 billion per year, or about $300 for every 'merican family. 4ome of the tightestrestrictions are reserved for food and clothing that make up a large share of low-income family budgets.

5he domestic shoe market shows the effects of import controls on a largecompetitive market. 'ssume market supply and demand conditions for shoes areE

F4 G -0H 2.6 94upply from . 4. 6roducers:

F

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D #0 L 2.P # 2 L 2.P

D #+ L P


P D + L K-

P D $( L $0.2K-


KG D + # 2.P


2.P D + # KG

P D $(0 # $0.MKG

!o find the market e%uilirium levels for price and %uantity, simply set themarket supply and market demand curves e%ual to one another so that K- D KG. !ofind the market e%uilirium price, e%uate the market demand and market supply curveswhere %uantity is e"pressed as a function of price;

-upply D Gemand

#+ L P D + # 2.P

+.P D M0

P D $60


-upply D Gemand

$( L $0.2K D $(0 # $0.MK

0.6K D (

K D 22 million3

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!herefore, the e%uilirium price#output comination is a market price of $60with an e%uilirium output of 22 million3 units.

@n the other hand, if foreign goods are kept off the market, the domestic producer supply curve ecomes the market supply curve

K- D #0 L 2.P


2.P D 0 L K-

P D $20 L $0.MK-

!o find the market e%uilirium levels for price and %uantity in the face of importsupply restrictions, simply set the market supply and market demand curves e%ual to

one another so that K- D KG. !o find the market e%uilirium price, e%uate the marketdemand and market supply curves where %uantity is e"pressed as a function of price;

-upply D Gemand

#0 L 2.P D + # 2.P

P D M2

P D $8


-upply D Gemand

$20 L $0.MK D $(0 # $0.MK

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0.8K D (0

K D (62. million3

!herefore, the e%uilirium price#output comination with import supplyrestriction is a market price of $8 with an e%uilirium output of (62. million3 ushels.

*. In a free market, the value of consumer surplus is e%ual to the region under the market

demand curve that lies aove the market e%uilirium price of $60. ?ecause the area ofsuch a triangle is one#half the value of the ase times the height, the value of consumersurplus e%uals;

onsumer -urplus=-L1 D N O22 $(0 # $603Q

D $(0,(2 million3

*ith a an on foreign goods, the value of consumer surplus is e%ual to the regionunder the market demand curve that lies aove the market price of $8. ?ecause thearea of such a triangle is one#half the value of the ase times the height, the value ofconsumer surplus e%uals;

Shoe Mar/et E"#l#$r#m

$0$(0

$20

$0

$M0

$0

$60

$+0

$80

$)0

$(00

$((0$(20

$(0

$(M0

$(0

$(60

0 2 0 + (00 (2 (0 (+ 200 22 20 2+ 00 2

%ant#t& 'm#ll#on+)

P r # c

-upply =-

P D $20 L $0.MK -

Gemand

$(0 # $0.MK G

?

A

Producer -urplus

onsumer -urplus

-upply =-L1

P D $( L $0.2K -

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onsumer -urplus=- D N O(62. $(0 # $83Q

D $,28(.2 million3

!herefore, the loss in consumer surplus caused y foreign supply restriction is;

oss in onsumer -urplus D onsumer -urplus=-L1 # onsumer -urplus=-

D $(0,(2 # $,28(.2

D $M,8M. + million3

!he $M,8M.+ million3 loss in consumer surplus due to the foreign supplyrestriction has two components. 1irst, there is a transfer of consumer surplus to producer surplus. !his amount is shown as the area in the rectangle ordered y

$60$8A?; !ransfer to Producer -urplus D (62. $8 # $603

D $M,062. million3

-econd, there is a deadweight loss of consumer surplus e%ual to the area shown asA?. ?ecause the area of such a triangle is one#half the value of the ase times theheight, the value of consumer surplus e%uals;

Geadweight oss in onsumer -urplus D N O22 # (62.3 $8 # $603Q

D $+8(.2 million3

P11.9 P&o,$,!$ T"&!%%*. "n the nited 4tates, steel production has remained constant since

the (/0s at about (00 million tons per year. ?arge integrated companies, like .4.

4teel remain important in the industry, but roughly 0 of domestic production is now

produced by newer, nimble and highly efficient mini-mill companies.

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=here 5 is total cost, 7 is marginal cost, and F is output measured by tons of ot

Dipped IalvaniCed 4teel. ost figures and output are in thousands.

A. 'ssume prices are stable in the market, and 6 G 7B G $100. alculate the profit-

ma&imiCing price>output combination and economic profits for a typical producer incompetitive market e8uilibrium.

B. alculate the profit-ma&imiCing price>output combination and economic profits for a

typical producer if domestic market prices rise by K0 following introduction of

;ushs protective tariff.

P11.9 SOLUTION

A. !he profit#ma"imi'ing priceBoutput comination is found y setting J: D J;

J: D J

$M00 D $(00 L $0.K

0.K D 00

K D (,000 0003

4conomic Profits D P K # !

D $M00(,0003 # $(0,000 # $(00(,0003 # $0.((,00023

D $0 0003

In this competitive market, there are no economic profits in long#run e%uilirium for a

typical competitor.

*. 1ollowing introduction of the ?ush protective tariff, the domestic market price can e

e"pected to rise 0R and P D J: D $20 D (. $M003. !he profit#ma"imi'ing

priceBoutput comination is found y setting J: D J;

J: D J

$20 D $(00 L $0.K

0.K D M20

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K D (,M00 0003

4conomic Profits D P K # !

D $20(,M003 # $(0,000 # $(00(,M003 # $0.((,M0023

D $(MM,000 0003

Introduction of a protective tariff in this competitive market has the effect of raising

prices and creating aove#normal returns for producers. @f course, the forgotten

consumer is the one forced to pick up the ta.

P11.10 $($&! 'o+$,!,!o(. 5he NF G $(0.2 - $0.02F

5 G $#2 H $0.2F H $0.002F2

7 G N5>NF G $0.2 H $0.00F

where 5B is total revenue, F is output, 7B is marginal revenue, 5 is total cost,

including a risk-ad!usted normal rate of return on investment, and 7 is marginal

cost. 'll figures are in thousands.

A. 4et 7B G 7 to determine the profit-ma&imiCing price>output solution and economic

profits prior to the e&piration of patent protection.

B. alculate the firms competitive market e8uilibrium price>output solution and

economic profits following the e&piration of patent protection and onset of generic

competition.

P11.10 SOLUTION

A. !he profit#ma"imi'ing monopoly priceBoutput comination is found y setting J: D

J and solving for K;

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J: D J

$(0.2 # $0.02K D $0.2 L $0.00K,

0.02K D (0

K D M00 0003

P D !:BK D $(0.2 # $0.0(K

D $(0.2 # $0.0(M003

D $6.2

S D !: # !

D $(0.2K # $0.0(K2 # $62 # $0.2K # $0.002K2

D $(0K # $0.0(2K2 # $62

D $(0M003 # $0.0(2M0023 # $62

D $(,+ 0003

>ote; Profit is falling for K E M00 0003.3

*. If the onset of generic competition forces a competitive market solution, P D J: D

J at the average cost#minimi'ing output level. !o find the output level where

average cost is minimi'ed, set J D A and solve for K;

J D A

$0.2 L $0.00K D $62 L $0.2K L $0.002K23BK

$0.2 L $0.00K D $62K#( L $0.2 L $0.002K

62K#( D 0.002K

62K#2 D 0.002

K

622 D 0.002

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K D0.002

62

D 00 0003

A D $62B00 L $0.2 L $0.002003

D $2.+

At the average#cost minimi'ing output level, J D A D $2.+. ?ecause P D J: in a

competitive market e%uilirium;

P D J: D J D A D $2.+

S D !: # !

D $2.+K # $62 # $0.2K # $0.002K2

D $2.+003 # $62 # $0.2003 # $0.0020023

D $0 0003

>ote; Average cost is rising for K E 00 0003.3

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'ASE STUD FOR 'APTER 11

T$ Mo*, P&o%!,"#$ SP 500 'o+"(!$*

=hile net income is an obviously useful indicator of a firms profit-generating ability, it hase8ually obvious limitations. Aet income will grow with a simple increase in the scale of the

operation. ' 2 savings account will display growing interest income over time, but would

scarcely represent a good long-term investment. 4imilarly, a company that generates profit

growth of only 2 per year would seldom turn out to be a good investment. "n the same way,

investors must be careful in their interpretation of earnings per share numbers. 5hese numbers

are artificially affected by the number of outstanding shares.

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5able ((.2 shows B+% data for K0 of the most consistently profitable companies found

within the 4tandard and 6oors 00 stock inde&. ;eer titan 'nheuser-;usch ompanies, "nc.O

personal products and drug manufacturer Johnson P Johnson, and consumer goods goliath

6rocter P Iamble o. are enormously profitable when profits are measured using B+%. 5o get

some useful perspective on the source of these enormous profits, it is worth considering theindividual economic factors that contribute to high levels of B+%E profit margin, total asset

turnover, and financial leverage. 'mong these three potential sources of high B+%, high profit

margins are the most attractive contributing factor because high profit margins usually mean that

high rates of B+% are sustainable for an e&tended period. 6rofit margins show the amount of

profit earned per dollar of sales revenue. +n a per unit basis, profit margins can be e&pressed as

Q>4ales G 6-'>6. =hen profit margins are high, the company is operating at a high level of

efficiency, competitive pressure is modest, or both. "n a competitive market, 6 G 7G', so

profit margins converge toward Cero as competitive pressures increase. onversely, 6 R 7 in

monopoly markets, so profit margins can be e&pected to rise as competitive pressures decrease.

igh profit margins are clear evidence that the firm is selling distinctive products.onsidering the effects of profit margins on the market value of the firm is a simple means

for getting some interesting perspective on the importance of profit margins as an indicator of the

firms ability to sustain superior profitability. 5he market value of the firm represents the stock

markets assessment of the firms future earnings power. "f high profit margins suggest attractive

profit rates in the future, then profit margins should have a statistically significant impact on the

current market value of the firm. 'n attractive way to measure the stock markets assessment of

profit margin data is to study the link between profit margins and the firms 6>% ratio. "n the 6>%

ratio, )6* stands for the companys stock price, and )%* stands for company earnings, both

measured on a per share basis. 6>% ratios are high when investors see current profits as high,

durable, and>or rapidly growingO 6>% ratios are low when investors see current profits as

insufficient, vulnerable, or shrinking.

5he 6>% ratio effects of B+%, profit margin, total asset turnover, and financial leverage for

consistently profitable corporate giants found within the 4P6 00 are shown in 5able ((.K.

A. Describe some of the advantages and disadvantages of B+% as a measure of corporate

profitability. =hat is a typical level of B+%, and how does one know if the B+%

reported by a given company reflects an ade8uate return on investment

B. Define the profit margin, total asset turnover, and financial leverage components of

B+%. Discuss the advantages and disadvantages of each of these potential sources of

high B+%.

'. ;ased upon the findings reported in 5able ((.K, discuss the relation between 6>%

ratios and profit margins, total asset turnover, and financial leverage. "n general,

which component of B+% is the most useful indicator of the firms ability to sustain

high profit rates in the future

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'ASE STUD SOLUTION

A. 1or successful large and small firms in the =nited -tates and anada, :@4 averages

roughly (0 to (R during a typical year. !his average :@4 is comprised of a typical

profit margin on sales revenue of roughly #(0R, a standard total asset turnover ratioof (.0 times, and a common leverage ratio of roughly 2;(. :@4 is an attractive

measure of firm performance ecause it shows the rate of profit earned on funds

committed to the enterprise y its owners, the stockholders. *hen :@4 is at or aove

(R per year, the rate of profit is generally sufficient to compensate investors for the

risk involved with a typical usiness enterprise. *hen :@4 consistently falls far

elow (0R per year, profit rates are generally insufficient to compensate investors for

the risks undertaken. @f course, when usiness risk is sustantially higher than

average, a commensurately higher return is re%uired. *hen usiness risk is somewhat

lower than average, a somewhat elow#average profit rate is ade%uate.

!his naturally suggests an important %uestion; 9ow is it possile to know if usiness profit rates in any given circumstance are sufficient to compensate investors

for the risks undertakenT !he answer to this difficult %uestion turns out to e rather

simple; &ust ask current and potential shareholders and ondholders. *hile it is

difficult to accurately assess usiness risk, and the prolem of accurately measuring

profit rates is always ve"ing, shareholders and ondholders implicitly inform

management of their riskBreturn assessment of the firm’s performance on a daily asis.

If performance is aove the minimum re%uired, the firm’s ond and stock prices will

rise/ if performance is elow the minimum re%uired, ond and stock prices will fall.

1or privately held companies, the market’s riskBreturn assessment comes at infre%uent

intervals, such as when new ank financing is re%uired. If performance is aove the

minimum re%uired, ank financing will e easy to otain/ if performance is elow the

minimum re%uired, ank financing will e difficult or impossile to procure.

!herefore, as a practical matter, firms must consistently earn a usiness profit rate or

:@4 of at least (R per year in order to grow and prosper. If :@4 consistently falls

elow this level, sources of financing tend to dry up and the firm withers and dies. If

:@4 consistently e"ceeds this level, new det and e%uity financing is easy to otain,

and growth y new and estalished competitors is rapid.

1inally, while :@4 may indeed e the most useful accounting indicator of

usiness profits, other accounting data should also e used to compare profit rates

across different lines of usiness, companies, and industries. In particular, investors

must e cautious in evaluating companies that report lofty :@4, ut only moderate profit margins and low :@A.

*. *hen profit margins are high, roust demand or stringent cost controls, or oth, allow

the firm to earn a significant profit contriution. 9olding capital re%uirements

constant, the firm’s profit margin is a useful indicator of managerial efficiency in

responding to rapidly growing demand andBor effective measures of cost containment.

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9owever, rich profit margins do not necessarily guarantee a high rate of return on

stockholders’ e%uity. Gespite high profit margins, firms in mining, construction, heavy

e%uipment manufacturing, cale !U, and motion picture production often earn only

modest rates of return on e%uity ecause significant capital e"penditures are re%uired

efore meaningful sales revenues can e generated. !hus, it is vitally important toconsider the magnitude of capital re%uirements when interpreting the si'e of profit

margins for a firm or an industry.

!otal asset turnover is sales revenue divided y the ook value of total assets.

*hen total asset turnover is high, the firm makes its investments work hard in the

sense of generating a large amount of sales volume. rocery and apparel retailing are

good e"amples of industries where high rates of total asset turnover can allow efficient

firms to earn attractive rates of return on stockholders’ e%uity despite modest profit

margins.

everage is often defined as the ratio of the ook value of total assets divided y

stockholders’ e%uity. It reflects the e"tent to which det and preferred stock are usedin addition to common stock financing. everage is used to amplify firm profit rates

over the usiness cycle. Guring economic ooms, leverage can dramatically increase

the firm’s profit rate/ during recessions and other economic contractions, leverage can

&ust as dramatically decrease reali'ed rates of return, if not lead to losses. Gespite

ordinary profit margins and modest rates of total asset turnover, :@4 in the

automoile, financial services and telecommunications industries can sometimes

enefit through use of a risky financial strategy that employs significant leverage.

9owever, it is worth rememering that a risky financial structure can lead to awe#

inspiring profit rates during economic e"pansions, such as that e"perienced during the

mid#())0s, ut it can also lead to huge losses during economic contractions or

recessions, such as that e"perienced during 200. In the financial services sector, high

rates of financial leverage can oost profits during periods of declining interest rates,

ut cause e"treme financial distress during period of rapidly fluctuating interest rates.

C. =sing a simple ordinary least s%uares regression approach to investigating the PB4#

profit aility relation, there is no simple and ovious positive effect of :@4 on PB4

ratios. !hese results are perhaps surprising ecause it is commonly perceived that

:@4 is the most attractive accounting measure of the firm’s wise use of operating and

financial leverage. Perhaps the distortions to :@4 numers caused y significant

corporate restructuring in recent years have reduced the utility of those numers for

investors.A high degree of correlation etween PB4 ratios and profit margins is clearly

evident for this sample of consistently profitale corporate giants found within the

-VP 00. !he statistically#significant slope coefficient in the simple PB4 D f profit

margin3 relation suggests that investors more highly capitali'e reported earnings for

high profit margin firms. >either total asset turnover nor financial leverage has a

similarly consistent and positive effect on PB4 ratios. -imilarly, profit margins are the

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only component of :@4 with a statistically significant effect on PB4 ratios in a

multiple regression model approach. Apparently, investors tend to rely upon high

profit margins as useful indicators of the firm’s aility to sustain aove#average profits

in the future.

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chp 11 econ