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Solutions to Lesson 1 Questions

Solutions to Review Questions

1.1. "People are rational" is the assumption that decision makers explicitly or implicitly weigh
the benefits and costs of each action, and then choose an action only if the benefits are expected
to outweigh the costs. "People respond to incentives" means that people respond to economic
incentives - they may change their behaviour if the expected benefits or costs of an action change
by enough. "Optimal decisions are made at the margin" means that most decisions are not 'all or
nothing', but involve doing a little more or a little less of an activity. Thus, the optimal decision
is to continue any activity up to the point where the marginal benefit equals the marginal cost.

1.2. Scarcity is the situation in which unlimited wants exceed the limited resources available to
fulfil those wants. Economics is the study of the choices consumers, business managers and
government officials make to attain their unlimited wants, given their scarce resources. Scarcity
is central to economics because scarcity requires people to make choices and trade-offs about
how to use their resources to best fulfil their wants.

2.1. As resources are in limited supply and wants are unlimited, choices must be made by people
and society about how to use their resources to best fulfil their wants. When analysing the
decision between choices, the concept of opportunity cost is used. Opportunity shows the
highest-valued alternative that must be given up to engage in an activity. Consideration of
opportunity cost provides the information needed to make informed decisions between choices.

2.2. The three economic questions that every society must answer are: 1) What goods and
services will be produced? 2) How will the goods and services be produced? 3) Who will receive
the goods and services? In a centrally planned economy, most of these decisions are made by the
government. In a market economy, almost all of these decisions are made by the decentralised
interaction of households and firms in markets. In a mixed economy, most economic decisions
result from the interaction of buyers and sellers in markets, but government plays a significant
role in the allocation of resources.

2.3. Productive efficiency occurs when a good or service is produced using the least amount of
inputs. Allocative efficiency means that what is produced reflects consumer preferences – every
good or service is produced up to the point at which the last unit provides a marginal benefit to
consumers equal to the marginal cost of producing it. Dynamic efficiency refers to the use of
new technologies and production techniques over time, and the innovation of new products.

2.4. Efficiency is concerned with producing the goods and services that people want at the lowest
cost. Equity is ‘fairness’, a concept that can differ dramatically from person to person.
Government policy makers often want to make economic outcomes ‘fairer’, but this often
involves redistributing income from one group to another, which usually (but not always)
hampers efficiency because it reduces incentives to produce and drives up production costs.

Solutions to Problems and Applications 1.8 & 2.5

1.8. Your friend is failing to think at the margin. It doesn’t matter how much time has already
been spent studying psychology. What matters is the marginal benefit to be received from
studying psychology relative to the marginal cost, where cost is measured as the opportunity cost
of lower grades in other subjects. If the course is required, that may raise the marginal benefit.

2.5. Yes, even Bill Gates faces scarcity because his wants exceed his resources. He has
established a foundation with billions of dollars to spend on worthy causes like eradicating
malaria and reducing homelessness. However, there are an unlimited number of worthy causes
that Gates desires to fund, so even he faces scarcity. Secondly, even Gates has only twenty-four
hours in a day, so he must make choices about how to spend his scarce time. Everyone faces
scarcity, because human desires are virtually unlimited.

Last modified: Tuesday, 23 January 2018, 8:41 PM

Solutions to Lesson 2 Questions

Solutions to Review Questions

3.1. Economists use models for the same reason that any other scientist (and indeed everyone
else) does – to make the complicated world simple enough so that it can be understood and
analysed, so that questions about it can be usefully answered. Useful models will generate
testable predictions. If these predictions accord with economic data, then the model isn’t rejected
and can be used to understand the economy. Testing models with data can be very difficult,
however, because the economy is always changing – it is virtually impossible to conduct
controlled economic experiments.

3.2. In arriving at a useful economic model, these five steps are followed: 1) decide on the
assumptions to be used; 2) formulate a testable hypothesis; 3) use economic data to test the
hypothesis; 4) revise the model if it fails to explain well the economic data; and 5) retain the
revised model to help answer similar economic questions.

3.3. Positive economic analysis concerns what is, i.e. it deals with how the economy actually
behaves. Normative economic analysis concerns what ought to be. Economics is mainly
concerned with positive analysis – conceptualising and measuring the costs and benefits of
different courses of action. However, decision makers (including voters and government
officials) will want to use the trade-offs identified by positive economic analysis in normatively
deciding what course of action should be taken.

4.1. Microeconomics is the study of how households and firms make choices, how they interact
in specific markets, and how the government influences their choices. ‘Micro’ means small, and
microeconomics deals with individual decision makers. Macroeconomics is the study of the
economy as a whole. ‘Macro’ means large, and macroeconomics deals with economy-wide
outcomes, such as the inflation rate, the unemployment rate, and the economic growth rate.

Solutions to Problems and Applications 3.4 & 4.2

3.4. The model should be revised in light of its failure to explain or predict real-world events.

4.2. (a) and (d) are microeconomic questions; (b) and (c) are macroeconomic questions.

Last modified: Monday, 2 February 2015, 10:57 AM

Solutions to Lesson 3 Questions

Solutions to Review Questions

1.1. Scarcity is the situation in which wants exceed the limited resources available to fulfil those
wants. Ultimately, all things are scarce, as they are in limited supply. Some things at a point in
time are relatively more scarce than others. For example, oxygen in the air is generally available
and is less scarce than pink diamonds.

1.2. The production possibility frontier is a curve showing all the attainable combinations of two
products that may be produced with available resources. Combinations of goods that are on the
frontier are efficient because all available resources are being fully utilised, and the fewest
possible resources are being used to produce a given amount of output. Inefficiency is shown by
points inside the production possibility frontier, because the maximum output is not being
obtained from the available resources. A production possibility frontier will shift to the right if
the amount of resources available for making the products rises, or if technology improves so
that we can make more output with the initial amount of inputs.

1.3. Increasing marginal opportunity costs means that as more and more of a product is made, the
opportunity cost of making each additional unit rises. It occurs because the first units of a good
are made with the resources that are best suited for making it but, as more and more are made,
resources must be used that are best suited for producing something else. Increasing marginal
opportunity costs implies that the production possibility frontier is bowed outward from the
origin – its slope gets steeper and steeper as you move down the production possibility frontier.
2.1. Absolute advantage is the ability to produce more of a good or service than competitors
using the same amount of resources. Comparative advantage is the ability to produce a good or
service at a lower opportunity cost than other producers. It is possible to have a comparative
advantage in producing a good even if someone else has an absolute advantage in producing that
good (and every other good). Unless the two producers have exactly the same opportunity costs
of producing two goods – the same trade-off between the two goods – one producer will have a
comparative advantage in making one of the goods and the other producer will have a
comparative advantage in making the other good.

2.2. The basis for trade is comparative advantage. If each party specialises in making the product
in which it has the comparative advantage, they can arrange a trade that makes both of them
better off. Each party will be able to obtain the product made by its trading partner at a lower
opportunity cost than before.

Solutions to Problems and Applications 1.4 & 2.3

1.4a. The production possibility frontiers in the figure are bowed to the right from the origin
because of increasing marginal opportunity costs. The drought causes the production possibility
frontier to shift inwards (leftwards).

b. The genetic modifications would shift to the right the maximum barley production (doubling
it), but not the maximum wheat production.
2.3a. New Zealand has the comparative advantage in producing oranges. New Zealand’s
opportunity cost of producing 1000 tonnes of oranges is giving up 1000 tonnes of apples.
Whereas for Australia, the opportunity cost of producing 1000 tonnes of oranges is giving up
3000 tonnes of apples. Australia has the comparative advantage in producing apples. In
Australia, the opportunity cost of producing 1000 tonnes of apples is giving up only 1000/3 of a
tonne of oranges, whereas for New Zealand the opportunity cost is giving up 1000 tonnes of
oranges to produce 1000 tonnes of Apples.

b. Neither country has an absolute advantage in making both goods. Australia has the absolute
advantage in producing apples, but New Zealand has the absolute advantage in producing
oranges.

c. If both countries specialise in the good in which they have a comparative advantage and then
trade with the other, they can both be better off. Let’s use the case in which each trades half of
what it makes for half of what the other makes. Australia will specialise by producing 12 000
tonnes of apples and New Zealand will specialise by producing 6000 tonnes of oranges. Since
each gets half of the other’s production, they both end up with 6000 tonnes of apples and 3000
tonnes of oranges. This means they are better off than before trading, since they end up with the
same amount of oranges, but twice as many apples. Others trades will make them better off as
well.

Last modified: Monday, 2 February 2015, 11:03 AM

Solutions to Topic 1 Tutorial Questions

1. Jackie faces a trade-off between going to classes and sleeping in. The reason why she has to
make this trade-off is because of scarcity; in this case, the time constraint is the source of
scarcity. This is also an example of opportunity cost. Opportunity cost is defined as the value of
the next-best alternative foregone. In this case, the opportunity cost of going to the tutorial is the
sleep foregone. Similarly, the opportunity cost of sleep in is the tutorial foregone. Because Jackie
is certain that the microeconomics tutorial will be covering areas that she is comfortable with,
she is more likely to sleep in, because her marginal benefit, or the additional benefit from
attending the tutorial (in this case, learning new things), is less than her marginal cost, or the
additional cost from attending the tutorial (in this case, to sleep in). In contrast, if the morning
tutorial is on another unit, say, accounting, and Jackie is not comfortable with the materials, then
she is more likely to forego the sleep in, and attend the tutorial instead. Scarcity forces people to
make trade-offs between competing alternatives. Opportunity costs are always incurred
whenever economic choices are made. The cost-benefit analysis dictates how these choices are
made.

2. (a) and (c) are positive statements; (b) and (d) are normative statements. Positive economic
analysis concerns what is, i.e. it deals with how the economy actually behaves. Normative
economic analysis concerns what ought to be. Economics is mainly concerned with positive
analysis – conceptualising and measuring the costs and benefits of different courses of
action. However, decision makers (including voters and government officials) will want to use
the trade-offs identified by positive economic analysis in normatively deciding what course of
action should be taken.

3a. The groups that are most likely to get the tickets will be those for whom the expected
marginal benefit of going to the Town Hall on Monday morning is greater than the expected
marginal costs. These might include people who have a very low opportunity cost of travelling
to the Town Hall and standing in line, such as people who don’t have a job in the morning and
those who live or work very close by. These might also include people who see a large benefit
from going to get the tickets, such as die-hard football fans or professional ticket scalpers.
b. The major opportunity cost of distributing the tickets this way is the cost to the people who
attempt to get the tickets – the cost of travel to the Town Hall, the activities that cannot be done
(such as earning money at work) when one is standing in line, and the costs to all those people
who try to get tickets but don’t get there soon enough. (There may also be the cost of people
blocking traffic in and around the Town Hall.)

c. This isn’t an efficient way to distribute the tickets, since it wastes time and resources. Perhaps
the most efficient way to distribute the tickets is to hand them out unannounced to people
walking by – this would take only a few minutes. Alternatively, the police could sell them back
to the original organisation selling the tickets and have them distribute the tickets.

d. Equity is hard to define. Some people will see this as equitable, since only the deserving, true
fan will put up with the hassle of getting the tickets. Others will disagree, saying that no money
was raised for the taxpayers, who deserve to get the benefits of selling the tickets since they fund
the police department.

4. a. The production possibility frontier will be concave because some economic inputs are likely
to be more productive when making capital goods, and others are likely to be more productive
when making consumption goods. In other words production possibility frontiers are usually
bowed out because of increasing marginal opportunity costs.

b.
c. Because it will have more machinery and equipment, Country B is likely to experience more
rapid growth.
Last modified: Tuesday, 23 January 2018, 9:39 PM

Topic 1 Tutorial Questions

1. Jackie’s alarm clock buzzes. She reaches over to the small table next to her bed and turns it off.
As she pulls the covers back up, Jackie thinks about her 9:00am microeconomics tutorial. Should
she go to the tutorial today or sleep a little longer? She worked late last night and really hasn’t
had enough sleep. Besides, she’s fairly sure her tutor will be discussing a subject she already
knows well. Maybe it would be okay to miss the tutorial today. Is Jackie more likely to miss some
tutorials than she is to miss other tutorials? What determines which tutorials Jackie will attend
and which tutorials she won’t attend?
2. Explain which of the following statements represent positive analysis and which represent
normative analysis.
1. A $2 per-packet tax on cigarettes will reduce smoking by teenagers by 12 per cent.
2. The federal government should spend more on cancer research.
3. Rising paper prices will increase textbook prices.
4. The price of coffee at a café is too high.
3. Problems and Applications Question 2.11, Hubbard et al. 2017, page 17.
4. Problems and Applications Question 1.7, Hubbard et al. 2017, page 50.

Last modified: Friday, 2 March 2018, 12:31 PM


Solutions to Topic 1: Chapter 1 Appendix Questions

1. 1a. Negative

b.

c. The slope = –1.

2. a.
b. At $2.50, the total revenue equals rectangles A + B = $250 000. At $1.25, the total revenue
equals rectangles B + C = $250 000.

3. The triangle’s area = 0.5 x 60 000 x $0.75 = $22 500.

4.

Year Houses sold Percentage change


1 285 -
2 335 17.54
3 305 -8.95
Percentage change from year 1-2 =

Percentage change from year 2-3 =

Last modified: Thursday, 15 February 2018, 2:14 PM

Topic 1 Lesson 5-Chapter 1 Appendix Questions

1. Problems and Applications Question 1A.1, Hubbard et al. 2017, page 30.
2. Problems and Applications Question 1A.2, Hubbard et al. 2017, page 30.
3. Problems and Applications Question 1A.5, Hubbard et al. 2017, page 30.
4. Use the following information to calculate the percentage change in the quantity of houses sold
in Armidale from one year to the next.

Year (as at June) Houses sold Percentage change


1 285
2 335
3 305
Last modified: Thursday, 15 February 2018, 2:13 PM

Solutions to Lesson 4 Questions

Solutions to Review Questions

3.1. The two main categories of market participants are households and firms. Households as
consumers are the most important in determining what goods and services are produced. If they
don’t want to buy something, there is no reason for the firms to make it.
3.2. A free market is one with few government restrictions on how goods or services can be
produced or sold, or on how factors of production can be employed. Economic decisions are
made by buyers and sellers in the market place. In a command economy, the government – rather
than households and firms – makes almost all the economic decisions. Free market economies
have a much better track record of providing people with rising standards of living.

3.3. An entrepreneur operates a business. Entrepreneurs play a key role in the economy by
bringing together factors of production – labour, capital and natural resources – to produce goods
and services for sale. Entrepreneurs decide what to produce and how to produce it. They put their
own funds or borrowed funds at risk when they start a business.

3.4. Firms are likely to produce more of a good or service if consumers demand more of it. As
consumer demand rises, the price will rise, which will induce firms to produce more. If demand
falls, the price will fall; firms will have less reason to produce the good and will cut back
production.

4.1. Private property rights are the rights individuals or firms have to the exclusive use of their
property, including the right to buy or sell it. If individuals and firms believe that property rights
are insecure, they will be unwilling to produce goods or services or pay others to produce goods
or services. Therefore, the enforcement of property rights and contracts is vital for the
functioning of the economy.

4.2. Independent courts are crucial because property rights and contracts will only be enforced if
judges make impartial decisions based on the law, rather than partial decisions in favour of
powerful or politically connected individuals.

Solutions to Problems and Applications 3.7 & 4.3

3.7. Adam Smith realised – as economists today realise – that people’s motives can be complex.
But in analysing people in the act of buying and selling, economists have concluded that, in most
instances, the motivation of financial reward provides the best explanation for the actions people
take. Moreover, being self-interested – looking out for your own wellbeing and happiness – and
being selfish – caring only about yourself – are not exactly the same things. Many successful
business people are, in fact, generous: donating to charity, volunteering for activities, and
otherwise acting in a generous way. This is not inconsistent with making business decisions that
maximise profits for their companies.

4.3. Having secure property rights would enable the owners to use their resources in more
efficient ways, because they would spend less time on activities such as guarding their property.
Owners would also be able to make improvements to their property without fear that someone
would seize the property. They would also be more likely to be able to use their property as
collateral for a loan. If individuals and firms believe that property rights are insecure, they will
be reluctant to risk their wealth by opening up businesses.

Last modified: Monday, 2 February 2015, 11:04 AM


Solutions to Lesson 1 Questions

Solutions to Review Questions 1-4

1. The demand schedule is an inverse relationship between the price of a product or service and
the quantity of the product or service demanded. A demand curve is a graph that plots the
demand schedule.

2. Ceteris paribus means ‘everything else being equal’ – that is, holding everything else constant
when examining the relationship between two variables.

3. A ‘change in demand’ refers to a shift in a demand curve, while a ‘change in the quantity
demanded’ refers to a movement along an unshifting demand curve.

4. The law of demand states that, holding everything else constant, when the price of a product
falls, the quantity demanded of the product will increase (and when the price of a product rises,
the quantity demanded of the product will decrease). The main variables that will cause a
demand curve to shift include: 1) changes in income, 2) changes in the prices of a related good –
substitutes or complements, 3) changes in tastes, 4) changes in population or demographics, and
5) changes in expected future prices.

Solutions to Problems and Applications 1, 3 & 4

1 a. Substitutes

b. Complements

c. Substitutes (assuming they are substitutes in the market for spreads)

d. Probably unrelated

3 a. The demand curve for Big Mac burgers will shift to the left.

b. There will be a movement down the demand curve for Big Macs.

c. The demand curve for Big Macs will shift to the left (assuming that Big Macs and fries are
complements).

d. The demand curve for Big Macs will shift to the right.

See page 61 of the textbook for graphs that shift to the right and to the left.
4. Cheap chocolates and sweets are inferior goods. The relatively cheaper prices of chocolates
and sweets compared to more expensive confections makes them a more attractive substitute
when someone’s income declines, such as during a time of unemployment and economic
uncertainty.

Last modified: Monday, 2 February 2015, 3:21 PM

Solutions to Lesson 2 Questions

Solutions to Review Questions 2.1-2.3

2.1. The supply schedule is a table that shows the positive relationship between the price of a
product and the quantity supplied. The supply curve is the upward-sloping plot of the supply
schedule.

2.2. A ‘change in supply’ refers to a shift of the supply curve, while a ‘change in quantity
supplied’ refers to a movement along the supply curve as a result of a change in the product’s
price.

2.3. The law of supply states that, holding everything else constant, an increase in price causes an
increase in the quantity supplied (and a decrease in price causes a decrease in the quantity
supplied). The main variables that will cause a supply curve to shift include: 1) changes in the
prices of inputs used to make the product, 2) technological changes, 3) changes in the prices of
substitutes in production (other things that the producers could be making), 4) changes in the
number of firms in the market, and 5) changes in expected future prices.

Solutions to Problems and Applications 2.4 & 2.5

2.4.a. Change in quantity supplied: a movement up the supply curve.

b. Change in supply: the supply curve shifts to the right.

c. Change in supply: the supply curve shifts to the left.

2.5. A movement along the supply curve from point A to point B would be caused by an increase
in the price of rib eye steaks. A shift to the right of the supply curve from point A to point C
could be caused by a decrease in the price of feed for cattle, a technological advance in
processing cattle, an increase in the number of cattle farms, or other factors that cause an
increase in supply.

Last modified: Monday, 2 February 2015, 3:21 PM


Solutions to Lesson 3 Questions

Solutions to Review Questions 3.1, 3.2, 3.3, 4.1, 4.2

3.1. Market equilibrium is the situation in which the quantity demanded equals the quantity
supplied.

3.2. A shortage is a situation in which the quantity demanded is greater than the quantity
supplied, and a surplus is the situation in which the quantity demanded is less than the quantity
supplied.

3.3. If the current price is above equilibrium, the quantity supplied will be greater than the
quantity demanded, and there will be a surplus. A surplus causes the market price to fall toward
equilibrium. If the current price is below equilibrium, the quantity demanded will be greater than
the quantity supplied, and there will be a shortage. A shortage causes the market price to rise
toward equilibrium.

4.1 a. When the demand curve shifts to the right, the equilibrium price and equilibrium quantity
both rise. Figure 4.1a below illustrates this case.

b. When the supply curve shifts to the left, the equilibrium price rises, but the equilibrium
quantity falls. Figure 4.1b below illustrates this case.
4.2. If the
demand
curve shifts
to the right
more than
the supply
curve does,
the
equilibrium
price will
rise as
shown in
Figure 4.2a
below. If the
supply curve
shifts to the
right more
than the
demand
curve, the
equilibrium
price will
fall as
shown in
Figure 4.2b
below.
Solutions to Problems and Applications 4.3, 4.5, 4.8, 4.13
4.3 a. Scenario a. is shown in Figure 4.3a – demand for Pepsi increases because the falling
supply of Coke will raise the price of Coke, which is a substitute for Pepsi.

b. Scenario b. is also shown in Figure 4.3a – demand for Pepsi increases when incomes rise
because Pepsi is a normal good.

c. Scenario c. is shown in Figure 4.3c – an improvement in technology shifts the supply curve to
the right.

d. Scenario d. is shown in Figure 4.3b – a rise in an input’s price shifts the supply curve to the
left.
Note: The Figure 4.3d does not relate to any scenarios.

4.5 a. Complements

b. See the following two graphs:

4.8. The drought significantly reduced the supply of wheat, which shifted the supply curve for
domestically produced wheat to the left, raising the equilibrium price of wheat. The higher price
of wheat led to the price of wheat flour rising. As wheat flour is the major production input for
bread production, the supply curve for bread shifted leftwards, leading to an increase in the
equilibrium price of bread and a decrease in the equilibrium quantity of bread.
4.13. The rising costs will cause the supply curve to shift to the left, from S1 to S2, while the
improvement in quality will cause the demand curve to shift to the right, from D1 to D2. Because
we don’t know if demand shifts to the right more than supply shifts to the left, we don’t know if
the equilibrium quantity purchased will increase or decrease. If the shift in the supply curve is
greater, as shown in the figure, the equilibrium quantity will fall.

Last modified: Monday, 2 February 2015, 12:01 PM

Topic 2 Tutorial Questions


1. What happens in a market if the current price is above the equilibrium price? What will
happen if the current price is below the equilibrium price?

2. Using separate demand and supply diagrams illustrate and discuss the effects on the bottled
wine market equilibrium of the following impacts, ceteris paribus:

a) Average household income rises

b) An improvement in wine bottling technology

c) An increase in the price of wine grapes

3. At some restaurants there may be a month wait for a reservations on a Saturday evening, three
weeks for a Friday evening, two weeks for Tuesday through Thursday, and virtually no wait for
Sunday or Monday evening. How do you explain these events using demand and supply?

4. The demand for Krispy Kreme doughnuts in a small office is given by the equation

P = 12 – 2Q and the supply of doughnuts is given by P = 3 + Q, where P is the price of a


doughnut and Q is the number of doughnuts demanded and supplied per day. Graph the supply
and demand curves and find the equilibrium price and quantity of Krispy Kreme doughnuts.

Last modified: Monday, 11 August 2014, 1:33 PM

Solutions to Lesson 1 Questions

Solutions to Review Questions 1.1, 1.2, 1.3, 1.4, 2.1 & 2.2
1.1. Price elasticity of demand = (percentage change in quantity demanded)/(percentage change
in price). It isn’t measured by the slope of the demand curve because the slope depends
arbitrarily on what units you are using. Slope will change by a factor of 100 if you use cents
instead of dollars, for example.

1.2. The price elasticity = (percentage change in quantity demanded)/(percentage change in


price) = –25%/10% = –2.5. This is elastic.

1.3. In calculating the percentage change in price and quantity, the midpoint formula divides by
the average of the starting and ending values.

Percentage changes can also be calculated by using the starting or ending value without
averaging, but this gives different results depending on whether the starting or ending value is
used. The midpoint formula gives a consistent value regardless of whether the starting or ending
value is used, i.e. regardless of whether the price increases or decreases.

1.4. A perfectly inelastic demand curve is shown by a vertical line, as shown at the bottom of
Table 4-1. Such a good will have no substitutes; for example, a life-saving drug.

2.1. The factors determining the price elasticity of demand for a product include the availability
of substitutes, the passage of time, whether the good is a necessity or a luxury, how narrowly the
market for the good is defined, and the share of the good in the consumer’s budget.

2.2. The most important determinant of the price elasticity of demand is usually the availability
of substitutes for the product. If there are close substitutes, elasticity will be high because people
can switch away to another good as the product’s price rises. Other factors determining the price
elasticity of demand for a product include the passage of time, whether the good is a necessity or
a luxury, how narrowly the market for the good is defined, and the share of the good or service in
the consumer’s budget.

Solutions to Problems and Applications 1.5, 1.6 & 2.6


1.5. a. The percentage change in the quantity demanded = [(21 000 – 23 000)/23 000] = –0.087
or –8.7%.

The percentage change in the price = [($330 – $310)/$310] = -0.0645 or 6.45%.

Therefore –8.7%/6.45% = –1.35.

b. The percentage change in the quantity demanded in thousands = [(21 000 000 – 23 000
000)/23 000 000] = –0.087 or –8.7%.

The percentage change in the price = [($330 – $310)/$310] = –0.0645 or 6.45%.

Therefore –8.7%/6.45% = –1.35.

The outcome from a. and b. show that when measuring percentage changes, the result is
independent of the unit of measurement.

c. The midpoint formula for price elasticity of demand is given as [(Q2 – Q1)/(Q1 + Q2/2)] /
[(P2 – P1)]/(P1 + P2/2).

The percentage change in quantity demanded is: [(21 000 – 23 000)/(21 000 + 23 000/2)] =
–2000/22 000 = –0.091 or –9.1%.

The percentage change in price is: [(330 – 310) / 310 + 330/2)] = 0.0625 or 6.25%.

These values are very different from those calculated in a. and b.

In this case [(21 000 – 23 000)/(21 000 + 23 000/2)]/[(330-310) / 310+330/2)] = –1.456.

This equals –0.091/0.625 = –1.456.

1.6. Elasticity = -3/4 = -0.75. Because price rises and demand is price inelastic, revenue received
by suppliers has increased.

2.6. a. Soft drinks and canned soup are price elastic; cheese and toothpaste are price inelastic.
Cheese and toothpaste are probably necessities, perhaps with fewer substitutes, while soft drinks
and canned soup probably have more substitutes.

b. Soft drinks: 31.8% decline in quantity demanded; Canned soup: 16.2% decline in quantity
demanded; Cheese: 7.2% decline in quantity demanded; Toothpaste: 4.5% decline in quantity
demanded.

Last modified: Tuesday, 3 March 2015, 4:35 PM

Solutions to Lesson 2 Questions


Solution to Review Questions 3.1 & 3.2

3.1. If the demand for orange juice is inelastic, increasing the price of orange juice will increase
total revenue, as the price increase per unit will outweigh the loss in quantity demanded.

3.2. The demand for organic apples is elastic, as quantity demanded responded by a greater
proportion than the decrease in price, thus increasing apple growers’ total revenue.

Solutions to Problems and Applications 3.3 &3.7

3.3. a. Along D1 between points A and C, the price elasticity of demand is

Along D2 between points A and B, the elasticity of demand is

Because the quantity response is much larger to the same price cut, demand curve D1 is much
more elastic.

b. Along D1, revenue climbs from $3 x 200 = $600 to $2.50 x 300 = $750. Revenue rises as
the price is cut, because this demand curve is elastic. Along D2, revenue falls from $600 to $2.50
x 225 = $562.50. Revenue falls as the price is cut, because D2 is inelastic.

3.7. Manager 2’s reasoning is incorrect; pizza is a common fast-food staple and likely has a lot of
substitutes available. It is also a popular snack or meal choice with people with low incomes
who are likely to be more responsive to price increases. Therefore, a moderate price decrease as
suggested by Manager 1 is more likely to increase total revenue.

Last modified: Tuesday, 3 March 2015, 4:34 PM

Solutions to Lesson 3 Questions


Solutions to Review Questions 4.1, 4.2 & 5.1

4.1. Cross-price elasticity of demand equals the percentage change in quantity demanded of one
good divided by the percentage change in the price of another good. If the cross-price elasticity
is negative, the goods are complements; if it is positive, they are substitutes.

4.2. Income elasticity equals the percentage change in the quantity demanded divided by the
percentage change in income (normally, disposable income). If the income elasticity is greater
than zero, the good is normal; if it is less than zero, the good is inferior. Goods with income
elasticities between zero and one are necessities; those with income elasticities greater than one
are luxuries.

5.1. Increasing productivity in agriculture has brought about lower prices for food products.
Because the price elasticity of demand for food is low (relatively inelastic), the lower prices have
not caused a large increase in quantity demanded (in developed countries). The increase in
incomes over time has not increased the demand for food much because the income elasticity for
food in developed countries is low. Farmers therefore need to sell larger and larger quantities of
food at lower and lower prices to raise the same revenue. This means that small farms (which
usually have higher production costs) can no longer be profitable and family farms have been
disappearing.

Solutions to Problems and Applications 4.5, 4.6, 4.7 & 5.2

4.5 a. Positive, as Pepsi and Coca-Cola are substitutes

b. Negative, as they are complements

c. Positive, as they are substitutes

d. Negative, as they are complements

4.6 a. Petrol and cars are complements, so the cross-price elasticity in both cases is negative,
although it will not be the same in magnitude for small fuel-efficient cars and SUVs.

b. As stated in part a., petrol is a complement to both types of cars, whereas fuel-efficient
cars and SUV are substitutes for each other, although the extent to which the two can be thought
of as substitutes depends on how differentiated they are in the market for cars.

4.7. Bread, Pepsi, personal computers and Mercedes-Benz cars is the most likely order.
5.2. The low price elasticity of demand for most agricultural products increases the fluctuations
of the prices of agricultural products. Relatively small changes in production (quantity of output)
lead to proportionately large changes in the price level. Referring to Figure 5.2 below a decrease
in supply (e.g. due to a low rainfall year) would shift the supply curve from S1 to S2. As seen in
the graph, when demand is inelastic – D1 – price increases significantly following a decrease in
supply, from P1 to P3. However, when demand is relatively elastic – D2 – the decrease in supply
causes a relatively smaller increase in price, from P1 to P2.

Last modified: Tuesday, 3 March 2015, 4:35 PM

Solutions to Lesson 4 Questions

Solutions to Review Questions 6.1 & 6.2

6.1. Price elasticity of supply = (percentage change in quantity supplied)/(percentage change in


price). The price elasticity of supply is always positive as generally as the price of a product
increases, suppliers are willing to supply more. In this case, the elasticity of supply = 9%/10% =
0.9. This is slightly inelastic. The dividing point between elastic and inelastic is 1.0.

6.2. The main determinant of the price elasticity of supply is the amount by which production
costs rise as output levels rise. The following determinants of the price elasticity of supply relate
to this main one.
A. Length of time involved in production (short run/long run).

B. Type of industry.

C. Availability of inputs.

D. Existing capacity.

E. Inventories held.

Solutions to Problems and Applications 6.6 & 6.7

6.6. To find the cross-price elasticity, divide the percentage change in the quantity demanded of
rolls, ceteris paribus, by the percentage change in the price of hot dogs. At the initial price of
rolls ($1.20), the quantity demanded rises from 10 000 to 12 000, so this is the change in quantity
demanded that should be used.

Percentage change in quantity demanded = = 0.182 or 18.2%.

Percentage change in the price of hot dogs = = –0.2 or –20%.

The cross-price elasticity = = –0.91. As shown by the negative sign, these two goods are
complements.

b. To find the price elasticity of supply, divide the percentage change in the quantity of rolls
supplied by the percentage change in the price of rolls while moving along the S curve in the

figure. Percentage change in quantity supplied = = 9.5%. Percentage change in the

price of rolls = = 15.4%. The price elasticity of supply = = 0.62.

6.7.
Based on this information, we don’t know much at all about the price elasticity of demand for
roses. The demand curve has shifted, so the rise in the quantity of roses demanded is not caused
by the rise in their price – and we can’t calculate the price elasticity of demand. We have a
movement along the supply curve, so we could calculate the price elasticity of supply for roses.

The fact that the elasticity doesn’t have a negative sign is a reminder that with an upward-sloping
supply curve, increases in price to lead to increases in the quantity supplied, so the price
elasticity of supply must be positive.

Last modified: Tuesday, 3 March 2015, 4:36 PM

Topic 3 Tutorial Questions


Topic 3 Tutorial Questions

1. The Powerhouse Motel is the only first-class motel in Armidale. The motel owners hired
economics advisers for advice about improving the motel’s profitability. They suggested the
hotel could increase this year’s revenue by raising prices. The owner asked, “Won’t raising
prices reduce the quantity of motel rooms demanded and increase vacancies?” What do you think
the advisers replied? Why would they suggest increasing prices?

2. On most days the price of a small box of chocolates is $3 and 8,000 boxes are purchased. On
Valentine’s Day, the price jumps to $7 a box and 30,000 boxes are purchased.

a) Draw a demand and supply diagram that shows why the price jumps.

b) Based on this information, can we calculate the price elasticity of demand and the price
elasticity of supply? If so, what are their values? If not, explain why you can’t calculate these
values.

3. Two main policies to reduce the use of child labour in developing economies have been
proposed. “Supply-side” policies seek to reduce the supply of child labour, and “demand-side”
policies are intended to reduce demand for child labour by employers. Which type of policies
will be more effective in reducing the use of child labour in developing economies? Why?

4. Refer to the demand curve in the figure below.


a) Calculate the price elasticity of demand for a price increase from $4 to $6.

b) Calculate the price elasticity of demand for a price decrease from $6 to $4.

c) Calculate the price elasticity of demand between the two points using the midpoint formula.
What is the advantage of the midpoint formula?

d) If the price increased from $4 to $6, what would happen to total revenues?

Last modified: Monday, 11 August 2014, 1:34 PM

Solutions to Lesson 1 Questions

Solutions to Review Questions 1.1, 1.2, 1.3 & 1.4

1.1. Marginal benefit is the additional benefit to a consumer from consuming one more unit of a
good or service. The demand curve shows consumers’ willingness to pay for a product. The
amount that they are willing to pay will equal the extra benefits they will receive from
consuming it; therefore, the demand curve equals the marginal benefit curve for consumers.

1.2. Marginal cost is the additional cost to a firm of producing one more unit of a good or
service. Supply curves show the willingness and ability of firms to supply a product at different
prices. The willingness and ability to supply a product depends on the cost of producing it. The
lowest price a firm is willing and able to accept is the additional cost of making the good; thus,
the supply curve equals the marginal cost curve.

1.3. Consumer surplus is the difference between the highest price a consumer is willing and able
to pay and the price the consumer actually pays. As the equilibrium price falls, consumer surplus
grows both because the gap between the willingness and ability to pay and the price grows, and
because more is purchased. As the price rises, consumer surplus shrinks.

1.4. Producer surplus is the difference between the lowest price a firm would have been willing
and able to accept and the price it actually receives. As the equilibrium price of the good rises,
producer surplus rises. As the price falls, producer surplus falls.

Solutions to Appendix Review Questions 5A.1, 5A.2, 5A.3 & 5A.4

5A.1. In a linear demand equation, the intercept on the price axis tells us the price at which the
quantity demanded is zero. No consumer is willing to pay this price or above for the product.
Similarly, in a linear supply equation, the intercept on the price axis tells us the price at which
the quantity supplied is zero. No firm is willing to produce the good at this price or less.

5A.2. The price that maximises total surplus is the equilibrium price. At this price there is no
deadweight loss.

5A.3. Consumer surplus measures net benefit by subtracting the price paid from the total benefits
received from the good or service.

5A.4. Deadweight loss is an interesting turn of phrase. It measures the loss of surplus, the gains
to consumers and producers that could have easily been realised but were ‘killed’ by the price
control (or some other policy) and drag us away from efficiency like a heavy ‘weight’ pulling the
economy down.

Solutions to Problems and Applications 1.6, 1.8 & 1.10


1.6. The student is confusing consumer surplus with marginal benefit (willingness to
pay). Consumer surplus is defined as the difference between the maximum price a consumer is
willing to pay for a good or service and the price that they actually pay. Graphically, this
consumer surplus will be given by the area under the demand curve up to the equilibrium price
line. Therefore, at equilibrium, there will be a net benefit to consumers in the form of consumer
surplus, as on all previously purchased units, the willingness to pay exceeds equilibrium price.

1.8. The consumer surplus in this case is infinite as the price charged for the cancer-fighting drug
has absolutely no impact on the quantity demanded, so the price could be anything and quantity
demanded will stay the same. As the drug is perfectly price inelastic, the nature of the consumer
surplus is an exception rather than the norm as demand curves for most products are not perfectly
inelastic, hence consumer surplus for most products is also not infinite.

1.10. The producer surplus in this case is a rectangle rather than a triangle (as is typical in most
markets). The quantity supplied cannot change – it is fixed at 15 000 (at least in the short
run). This is different than for most markets, where supply is not perfectly inelastic. The
producer surplus = price x 15 000, so all of the revenue is producer surplus because the marginal
cost of supplying the concert is zero.

Solutions to Appendix Problems and Applications 5A.6, 5A.7 & 5A.8

5A.6. The minimum wage will have the larger impact in the first figure. Because its demand
curve is so flat (elastic), employers will reduce the quantity of labour demanded considerably
more than in the second figure.

5A.7. The equilibrium price is $20 and the equilibrium quantity is 5. The consumer surplus is A
in the figure, whose area is 0.5 x 5 x $2.50 = $6.25. The producer surplus is B, whose area is 0.5
x 5 x $5 = $12.50.
5A.8a. Deadweight loss = C + E. C = 0.5 x $1 x 10 000 = $5000. E = 0.5 x $1 x 10 000 = $5000.

b, c and d. Consumer surplus without the price floor is A + B + C, and with the price floor
remaining, consumer surplus is A. Producer surplus without the price floor is D + E + F, and
with the price floor it is B + D + F. Thus area B of consumer surplus is transferred from
consumers to producers. B = $1 x 10 000 = $10 000. D = $1 x 10 000.

Last modified: Monday, 9 March 2015, 12:50 PM


Solutions to Lesson 2 Questions

Solutions to Review Questions 2.1 & 2.2

2.1. Economic surplus is the sum of consumer surplus and producer surplus. Deadweight loss is
defined as a loss in economic surplus; it is a pure loss to society as it is not enjoyed by either
consumers or producers but is a loss of benefit or surplus that is borne by all of society.

2.2. Economic efficiency occurs when the marginal benefit to consumers of the last unit
produced is equal to its marginal cost of production, and where the sum of consumer surplus and
producer surplus is maximised. Economists define economic efficiency this way because when
it occurs, society puts its resources to their highest valued uses.

Solutions to Problem and Applications 1.9 & 2.6

1.9.a. Price = $20, Quantity = 5000.

b. Price = $30, Quantity = 3000.

c. With no licence requirement, consumer surplus = A + B + C, and producer surplus = D + E +


F.

d. With the licence requirement, consumer surplus = A, producer surplus = B + D + F, and


deadweight loss = C + E.
2.6. At Q1, marginal benefit is greater than the marginal cost, so increasing output would
increase economic surplus. At Q3, marginal cost is greater than marginal benefit, so reducing
output would increase economic surplus.

Last modified: Monday, 9 March 2015, 12:50 PM

Solutions to Lesson 3 Questions

Solutions to Review Questions 3.1, 3.2, 3.3 & 3.4

3.1. Some consumers gain from price controls, specifically a price ceiling, because they can buy
the product at a lower price, but others lose because they can no longer buy the product due to
the shortages that arise.

3.2. Producers tend to favour price floors that are set above the equilibrium price, but only if
producer surplus rises – as would be the case when the price rises a lot but sales don’t fall
much. Producers tend to loathe price ceilings that are set below equilibrium because sales fall
and the price received falls, shrinking producer surplus.
3.3. A ‘black market’ is one in which buyers and sellers violate government price regulations. A
‘black market’ will arise if there are gains to some buyers and some sellers from violating a price
floor or price ceiling.

3.4. Economic analysis will allow one to see the trade-offs involved from imposing price ceilings
and price floors, but it won’t provide a final answer to the appropriateness of the policy because
people differ about the goals of such policies. Some people may have the goal of maximising
economic surplus, for example, but others may care mostly about the wellbeing of certain
consumers or producers and care less about the wellbeing of other consumers or producers.

Solutions to Problems and Applications 3.5 & 3.8

3.5.a. After the imposition of the price floor, 28 million crates of apples will be sold.

b. Due to the price floor, 34 million crates are supplied whereas only 28 million are demanded;
thus, in this case, the price floor will create a surplus of 6 million crates of apples.

c. The apple producers will benefit from the price floor as they are guaranteed a higher than
equilibrium price for their apples. They thereby capture some consumer surplus, which increases
their producer surplus. Their revenue will increase from $8 x 30 000 000 = $240 000 000, to $10
x 28 000 000 = $280 000 000.

3.8.a. In the absence of control, the equilibrium price is $800 and the equilibrium quantity is 300
000. In this case, every renter who is willing to pay the market price of $800 will find an
apartment and every landlord willing to accept the market price of $800 will find a renter. The
demand and supply curve are shown in the figure, along with the equilibrium price (PE) and
quantity (QE).

b. At a price ceiling of $600, the quantity demanded is 350 000 but the quantity supplied is only
250 000, so there is a shortage of 100 000 apartments.

c. If all landlords abide by the law, the quantity sold will fall to 250 000. As shown in the figure,
consumer surplus with the price ceiling enforced is A + C, producer surplus is E, and deadweight
loss is B + D.

d. If landlords supply only 250 000 apartments and ignore the price ceiling, they can charge
$1000. This is the amount that renters are willing to pay for the 250 000th apartment.
Last modified: Monday, 9 March 2015, 12:51 PM

Solutions to Lesson 4 Questions

Solutions to Review Questions 4.1, 4.2 & 4.3

4.1. Tax incidence refers to the actual division of the burden of a tax – how much the tax pushes
up the price paid by the buyers in comparison to how much it pushes down the price received by
the sellers. The person who officially sends the tax revenue to the government need not be the
one who actually pays the tax. For most taxes, the seller sends the money to the government, but
buyers and sellers both pay part of the tax. The share paid by each depends on the shapes of the
supply and demand curves.

4.2. A tax is efficient if it imposes a small excess burden (deadweight loss) relative to the tax
revenue it raises.

4.3. The person who officially sends the tax revenue to the government need not be the one who
actually bears the burden of the tax. For most taxes, the seller sends the money to the
government, but buyers and sellers both pay part of the tax. The share paid by each depends on
the slopes of the supply and demand curves and not on who is officially responsible for sending
the tax to the government.

Solution to Problem and Application 4.7


4.7. Sellers are usually better equipped to collect the tax with respect to resources and
skills. Considering the fact that in a market there are usually more buyers than sellers, it also
makes sense to place the responsibility of paying the tax on sellers rather than individual
consumers. (Note: Collection of taxation is not the same as the burden or incidence of
taxation. The cost of a tax is borne by both producers and consumers.)

Last modified: Monday, 9 March 2015, 12:51 PM

Topic 4 Tutorial Questions

1. A student makes the following argument: “When a market is in equilibrium there is no


consumer surplus. We know this because in equilibrium the market price is equal to the price
consumers are willing to pay for the good.” Briefly explain whether you agree with the student’s
argument.

2. Recently, a prominent politician in Australia called for the government to impose a price
ceiling on mortgage rates charged by banks. Is it a sound economic policy or more of a political
rhetoric? Will consumers actually benefit from such a price ceiling? Why or why not?

3. Why would the price elasticity of demand be an important consideration for policy makers in
determining the most appropriate products on which to impose an excise tax in an effort to raise
additional revenue? Explain.

4. Use the diagram below of the market for cigarettes to answer the following questions.

a) How much is the government tax on cigarettes?

b) What price do producers receive after paying the tax?

c) How much tax revenue does the government collect?

d) Calculate the tax incidence borne by consumers and producers. Who bears the greatest
burden of the tax – consumers or producers?
Last modified: Monday, 11 August 2014, 1:35 PM

Solutions to Lesson 1 Questions

Solutions to Review Questions 1.1, 1.2, 2.1, 2.2, 2.3 & 2.4

1.1.Technology is the process a firm uses to turn inputs into outputs of goods and services.
Technological change is a change in the ability of a firm to produce a given level of output with
a given quantity of inputs.

1.2. Examples of technological change are use of new improved physical capital or inventions
such as computers and ATMs, managers reorganising labour and capital to improve efficiency
and improving human capital through education and training.

2.1. In the short run at least one of the firm’s inputs is fixed, but in the long run the firm can vary
all of its inputs, adopt new technology and change the size of its physical plant. The amount of
time that it takes to move from the short run to the long run varies from firm to firm.
2.2. Fixed costs are costs that remain constant as output changes, and variable costs are costs that
change as output changes. An example of a fixed cost is the lease payment for a factory or retail
store; an example of a variable cost is the cost of raw materials.

2.3. Implicit costs are nonmonetary opportunity costs, such as the wages the owner of a firm
could have earned if he or she worked for someone else. Explicit costs involve spending money.

2.4. The production function shows the relationship between the inputs employed by a firm and
the maximum output it can produce with those inputs. The short-run production function holds
constant fixed inputs (such as the number of ovens in the pizza restaurant in the example in the
chapter).

Solutions to Problems and Applications 1.4, 1.5 & 2.7

1.4. Options (b), (c) and (d) are examples of positive technological change because they enable a
firm to produce more output with the same quantity of inputs. Choice (a) describes a change in
production costs that is the result of a change in the price of an input, not a change in technology.
Choice (e) is not an example of technological change because the same quantity of inputs is used
to produce the same quantity of output.

1.5.You should disagree. This is an example of business reorganisation and optimisation to gain
greater output per unit of input, hence it is considered technological change.

2.7. Examples (a), (d) and (e) are fixed costs because they do not change as the quantity of pizzas
produced increases; (b) and (c) are variable costs because they increase as the quantity of pizzas
produced increases. The time period under consideration is important. In the long run, all of
these costs are variable.

Last modified: Monday, 23 March 2015, 9:23 AM

Solutions to Lesson 2 Questions

Solutions to Review Questions 3.1, 3.2 & 3.3

3.1.
Marginal product normally increases at first due to specialisation and division of labour, but it
eventually decreases because of the law of diminishing returns. The amount of capital per worker
declines as more labour is hired to work with a fixed amount of capital. Therefore, the marginal
product of labour falls. When the marginal product of labour is greater than the average product
of labour, the average product of labour increases. When the marginal product of labour is less
than the average product of labour, the average product of labour decreases. The marginal
product of labour is equal to the average product of labour when the average product of labour is
at its maximum value.

3.2.The marginal product of labour initially increases, due to specialisation and division of
labour, as the number of workers hired increases. However, after a point the gains from
specialisation and the division of labour disappear and the marginal product of labour starts to
decline.

3.3. The law of diminishing returns is the principle that, at some point, adding more of a variable
input (for example, labour) to the same amount of a fixed input (such as capital) will cause the
marginal product of the variable input to decline. It doesn’t apply in the long run because in the
long run none of the inputs are fixed; all can vary.

Solutions to Problems and Applications 3.4, 3.5 & 3.8

3.4.

Marginal Product of Average Product of


Quantity of Workers Total Output Labour Labour
0 0 — —
1 400 400 400
2 900 500 450
3 1500 600 500
4 1900 400 475
5 2200 300 440
6 2400 200 400
7 2500 100 357

3.5.

3.8. No. Anything that increases the marginal product of labour must also increase the average
product of labour.

Last modified: Monday, 23 March 2015, 9:24 AM


Solutions to Lesson 3 Questions

Solutions to Review Question 4.1, 4.2, 4.3, 5.1 & 5.2.

4.1. Average cost is total cost divided by the quantity of output produced; marginal cost is the
change in a firm’s total cost from producing one more unit of a good or service.

4.2. If the marginal product of labour is rising, it means that each additional worker is
contributing more additional output than the previous worker. As a result, the additional, or
marginal, cost of output must be falling because the additional output takes fewer additional
workers to produce. Marginal product and marginal cost are mirror images of each other: When
marginal product increases, marginal cost falls, and vice versa.

4.3. When marginal costs are below average, they pull average variable costs down, so we are on
the downward-sloping section of the U-shaped average variable cost curve. When output
expands enough, marginal costs rise to equal and then exceed average variable costs. When
marginal costs are above average, they pull average variable costs up, so we are on the upward-
sloping section of the U-shaped average variable cost curve. Thus, at the point where marginal
costs equal average variable costs, the average variable cost curve stops sloping downward but
hasn’t begun sloping upward – that is, the average variable cost curve is at its lowest point when
the marginal cost curve equals (or intersects) it.

5.1. The AFC curve should be downward sloping, not U-shaped. Because AFC = TFC/Quantity,
and because total fixed cost does not change, AFC will decrease as quantity increases.

5.2. The difference between average total cost and average variable cost is average fixed cost.
Average fixed cost decreases as output increases, so the difference between average total cost
and average variable cost must also continuously decrease. ATC = AVC + AFC, so ATC − AVC
= AFC. As AFC continuously decreases, so does ATC − AVC.

Solutions to Problems and Applications 4.4, 5.5 & 5.6.

4.4. Yes. As long as marginal cost is below average total cost, average total cost will be
decreasing, even if marginal cost is increasing.

5.5. The AFC curve should be downward sloping, not U-shaped. Because AFC = TC/Quantity,
and because total fixed cost does not change, AFC will decrease as quantity increases. The curve
labelled AFC is actually the marginal cost (MC) curve. ATC should be above AVC. Because ATC
= AFC + AVC, it will always be above the AFC and AVC curves. The ATC and AVC curves have
been reversed.
5.6.a. Marginal cost, average variable cost and average total cost will all increase; average
fixed cost is unaffected.

b. Marginal cost, average variable cost and average total cost will all increase; average fixed
cost is unaffected.

c. Average fixed cost and average total cost will increase; marginal cost and average variable
cost will be unaffected.

d. Average fixed cost and average total cost will increase; marginal cost and average variable
cost will be unaffected.

Last modified: Monday, 23 March 2015, 9:25 AM

Solutions to Lesson 4 Questions

Solutions to Review Questions 6.1, 6.2, 6.3, 6.4 & 6.5.

6.1. In the short run, Total cost = Variable cost + Fixed cost; but in the long run, Total cost =
Variable cost because there are no fixed costs in the long run.

6.2. Minimum efficient scale is the lowest level of output at which all economies of scale have
been exhausted. In other words, minimum efficient scale is where the long-run average cost
curve stops sloping downward. In the long run, firms that don’t reach minimum efficient scale
will have higher average costs than competitors that do reach minimum efficient scale, so they
will probably be driven out of business.

6.3. Economies of scale exist when a firm’s long-run average costs fall as the firm increases
output. Firms may experience economies of scale because: (1) a firm’s technology may allow it
to increase production with a smaller proportional increase in at least one input; (2) both workers
and managers can become more specialised as output expands; (3) large firms may be able to
purchase inputs at lower costs than smaller firms can; and (4) as a firm expands, it may be able to
borrow money at a lower interest rate, thereby lowering its costs.

6.4. Diseconomies of scale exist when a firm’s long-run average costs rise as the firm increases
output. Diseconomies of scale eventually arise because managing a store or factory above a
certain size is simply too complicated.

6.5. Because short-run average cost includes at least one input that is fixed in quantity, it can
never be less than long-run average cost (where there are no fixed inputs or fixed costs).
Solutions to Problems and Applications 6.6, 6.7 & 6.10

Solutions to Lesson 4 Questions

Solutions to Review Questions 6.1, 6.2, 6.3, 6.4 & 6.5.

6.1. In the short run, Total cost = Variable cost + Fixed cost; but in the long run, Total cost =
Variable cost because there are no fixed costs in the long run.

6.2. Minimum efficient scale is the lowest level of output at which all economies of scale have
been exhausted. In other words, minimum efficient scale is where the long-run average cost
curve stops sloping downward. In the long run, firms that don’t reach minimum efficient scale
will have higher average costs than competitors that do reach minimum efficient scale, so they
will probably be driven out of business.

6.3. Economies of scale exist when a firm’s long-run average costs fall as the firm increases
output. Firms may experience economies of scale because: (1) a firm’s technology may allow it
to increase production with a smaller proportional increase in at least one input; (2) both workers
and managers can become more specialised as output expands; (3) large firms may be able to
purchase inputs at lower costs than smaller firms can; and (4) as a firm expands, it may be able to
borrow money at a lower interest rate, thereby lowering its costs.

6.4. Diseconomies of scale exist when a firm’s long-run average costs rise as the firm increases
output. Diseconomies of scale eventually arise because managing a store or factory above a
certain size is simply too complicated.

6.5. Because short-run average cost includes at least one input that is fixed in quantity, it can
never be less than long-run average cost (where there are no fixed inputs or fixed costs).

Solutions to Problems and Applications 6.6, 6.7 & 6.10

Solutions to Lesson 4 Questions

Solutions to Review Questions 6.1, 6.2, 6.3, 6.4 & 6.5.


6.1. In the short run, Total cost = Variable cost + Fixed cost; but in the long run, Total cost =
Variable cost because there are no fixed costs in the long run.

6.2. Minimum efficient scale is the lowest level of output at which all economies of scale have
been exhausted. In other words, minimum efficient scale is where the long-run average cost
curve stops sloping downward. In the long run, firms that don’t reach minimum efficient scale
will have higher average costs than competitors that do reach minimum efficient scale, so they
will probably be driven out of business.

6.3. Economies of scale exist when a firm’s long-run average costs fall as the firm increases
output. Firms may experience economies of scale because: (1) a firm’s technology may allow it
to increase production with a smaller proportional increase in at least one input; (2) both workers
and managers can become more specialised as output expands; (3) large firms may be able to
purchase inputs at lower costs than smaller firms can; and (4) as a firm expands, it may be able to
borrow money at a lower interest rate, thereby lowering its costs.

6.4. Diseconomies of scale exist when a firm’s long-run average costs rise as the firm increases
output. Diseconomies of scale eventually arise because managing a store or factory above a
certain size is simply too complicated.

6.5. Because short-run average cost includes at least one input that is fixed in quantity, it can
never be less than long-run average cost (where there are no fixed inputs or fixed costs).

Solutions to Problems and Applications 6.6, 6.7 & 6.10

6.6. a) Economies of scale occur when a firm’s long-run average costs fall as the firm increases
output. Mulally is saying that unless a company can take advantage of this, it is hard for them to
remain competitive.

b In order to obtain the advantage of economies of scale, Chinese car companies may need to
merge so that there will be fewer, but larger companies.

6.7. If the price of Japanese mobile phones is high because they are being produced in low
volume, this indicates that the Japanese firms were not yet at minimum efficient scale in the
mobile phone business. Minimum efficient scale is represented on the graph by quantity QM,
with an average total cost of ATCM. The current volume of mobile phones being produced by the
Japanese manufacturers is represented by QA, with an average total cost of ATCA.
6.10.You should disagree. The River Rouge plant exhibited diseconomies of scale, a long-run
concept, not diminishing returns, which is a short-run concept.

6.7. If the price of Japanese mobile phones is high because they are being produced in low
volume, this indicates that the Japanese firms were not yet at minimum efficient scale in the
mobile phone business. Minimum efficient scale is represented on the graph by quantity QM,
with an average total cost of ATCM. The current volume of mobile phones being produced by the
Japanese manufacturers is represented by QA, with an average total cost of ATCA.

6.10.You should disagree. The River Rouge plant exhibited diseconomies of scale, a long-run
concept, not diminishing returns, which is a short-run concept.

6.7. If the price of Japanese mobile phones is high because they are being produced in low
volume, this indicates that the Japanese firms were not yet at minimum efficient scale in the
mobile phone business. Minimum efficient scale is represented on the graph by quantity QM,
with an average total cost of ATCM. The current volume of mobile phones being produced by the
Japanese manufacturers is represented by QA, with an average total cost of ATCA.

6.10.You should disagree. The River Rouge plant exhibited diseconomies of scale, a long-run
concept, not diminishing returns, which is a short-run concept.

Last modified: Friday, 2 February 2018, 9:58 AM

Topic 5 Tutorial Questions

1. What are implicit costs? How are they different from explicit costs? Use the concepts of
implicit and explicit costs to answer the following question.

Your uncle owns a flower nursery including the land on which it is located. For the last five
years he claims that he has been losing money but his tax returns indicate that he makes a
reasonable profit. How might you explain this anomaly? Why would your uncle continue to
remain in business if he is incurring losses as he states?

2. Darrel’s Dahlia’s faces the following cost schedules:

Labour Output Total Total Total Marginal Average Average Average


Fixed variable Cost Cost Fixed Variable Total
Cost Cost Cost Cost Cost
0 0 200 200
1 20 250
2 44 300
3 60 350
4 72 400
5 80 450

a) Fill in the table and explain how you calculate the cost schedules.

b) From these cost schedules, can you tell where diminishing marginal product sets in?

3. Use the information in the following graph to find the values for the following at an output
level of 1000.

a) Marginal cost

b) Total cost

c) Variable cost

d) Fixed cost

4. a) What is minimum efficient scale? What is likely to happen in the long run to firms that do
not reach minimum efficient scale?

b) What are economies of scale? What are diseconomies of scale? Discuss the possibility that the
following statement is a consequence of economies of scale. “Some individuals decry the decline
of the small family farm and its replacement with the huge corporate mega farm.”
Last modified: Monday, 11 August 2014, 1:36 PM

Solutions to Lesson 1 Questions

Solutions to Review Questions 1.1, 1.2 & 1.3.

1.1. Perfectly competitive markets are characterised by 1) many buyers and sellers, 2) all firms
selling identical products, and 3) no barriers to firms entering the market.

1.2. A price taker is unable to affect the market price, but a price maker can. Most consumers
are price takers for most goods – for example, you can’t go to the supermarket and negotiate for
a price different than the one marked on the shelf. Because a firm in a perfectly competitive
market is very small relative to the market, and because it is selling exactly the same product as
every other firm, it can sell as much as it wants without having to lower its price. If the firm
raises its price, the firm will sell nothing. Therefore, firms in perfectly competitive markets are
price takers.

1.3. The graph will look like Figure 8.2 on page 231.

Solutions to Problems and Applications 1.4 &1.6.


1.4. (a) is the closest to perfectly competitive; (b), (c) and (d) are not perfectly competitive
because there are not enough sellers, products are not identical, or there are barriers to new firms
entering.

1.6. 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.

Last modified: Friday, 27 March 2015, 4:33 PM

Solutions to Lesson 2 Questions

Solutions to Review Questions 2.1, 2.2, 2.3, 3.1 & 3.2.

2.1. A firm in a perfectly competitive market is a price taker and can sell as many units as it
wishes at the market price P. By selling an additional unit, the firm receives additional (or
marginal) revenue of P. Because each unit is sold at P, the average revenue will also equal P,
and we get the result P = MR = AR.

2.2. As long as MR > MC, a firm should continue to expand production because doing so adds
more to its total revenue than to its total cost, thereby increasing total profit. When a firm reaches
the level of output at which marginal revenue equals marginal cost, it has reached the point
where producing that unit of output will add as much to its total revenue as it does to its total
cost, which means that total profit cannot be increased further and therefore must be at a
maximum.

2.3. In a perfectly competitive market, MR = P, making these two conditions equivalent.

3.1. The graph will be similar to the figure in Step 4 of Solved Problem 8.1 on page 241. In the
example below, the market is for basketballs.
3.2. The graph will be similar to the figure in Step 6 of Solved Problem 8.1 on page 241. In the
example below, the market is for basketballs.

Solutions to Problems and Applications 2.4, 2.5 & 3.6

2.4. You should disagree. A firm maximises profit by selling where marginal revenue is equal to
marginal cost. If a firm stops producing a quantity for which marginal revenue is greater than
marginal cost, then it could increase its profits by producing more. Firms are not interested in
maximising their profit per unit sold; they are interested in maximising their total profits.

2.5. Revenue is the total dollar amount of a firm’s sales. Firms are interested in what they have
left over from their revenues after they have paid all of the costs of producing the goods they
sell. Profit is what’s left over when you subtract total cost from total revenue. That is why firms
maximise profit rather than revenue. A revenue-maximising firm is likely to produce more
output than if it were maximising profit because for the typical firm, revenue is increasing past
the quantity where profit starts to decline.
3.6. This argument is incorrect. To maximise 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
profit to be made on units between Q1 and Q2.

Last modified: Friday, 27 March 2015, 4:34 PM

Solutions to Lesson 3 Questions

Solutions to Review Questions 4.1, 4.2 & 4.3.

4.1. In the short run, a firm will shut down if the price falls below the minimum point on its
average variable cost curve. In the long run, a firm will shut down (and exit the industry) if the
price is below the minimum point on its average total cost curve. In the short run, the firm is
willing to accept losses because it cannot do anything about its fixed costs—and must pay them
whether or not it is producing anything. In the long run, however, the firm will close down and
exit the industry if it expects continued losses.

4.2. The perfectly competitive firm’s supply curve can be directly derived from its marginal cost
curve. The firm will produce where P = MC if price is at or above the shutdown point at the
minimum of AVC.

4.3. The market supply curve is derived by adding up the quantity supplied (using the marginal
cost curves) by each firm in the market at each price.

Solutions to Problems and Applications 4.4 & 4.5.

4.4a.
b. Harry should produce 7 lamps, and he will make profit = $350 – $330 = $20.

c. No, Harry should only shut down if the price falls below the minimum point on his AVC
curve, which is $27.50.

4.5. Referring to Figure 4.5,


Total cost = A + B + C

Total revenue = A + B

Variable cost = A

Loss = C

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

Last modified: Friday, 27 March 2015, 4:34 PM

Solutions to Lesson 4 Questions

Solutions to Review Questions 5.1, 5.2 & 5.3

5.1. Economic profits lead firms to enter an industry; economic losses lead firms to exit an
industry.

5.2. A firm earning zero economic profit would continue to produce, even in the long run,
because it is earning as much as it would earn elsewhere – it is earning the going rate of return on
its investment.

5.3. The long-run supply curve in a perfectly competitive market will be a horizontal line if it is a
constant cost industry – that is, if the typical firm’s average cost curves are unchanged as the
industry expands or contracts. If it is an increasing-cost industry, the long-run supply curve will
slope upward; if it is a decreasing-cost industry, the long-run supply curve will slope
downward. Figure 8.10 (b) shows how a perfectly competitive constant cost industry adjusts to a
permanent decrease in demand.

Solutions to Problems and Applications 5.6 & 5.7

5.6. 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.
5.7. Referring to Figure 5.7, 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.

Last modified: Friday, 27 March 2015, 4:35 PM

Solutions to Lesson 5 Questions

Solutions to Review Questions 6.1, 6.2 & 6.3


6.1. If consumers want more of a product, the market will supply it. As demand increases, the
price of the product increases, and the profits firms earn rise. Higher profits lead existing firms to
expand production and new firms to enter the industry. If consumers want less of a product, the
market will supply less of it. As demand decreases, the price of the product falls and firms begin
to suffer losses. Losses lead existing firms to reduce production and some firms to leave the
industry. In this way, consumers are able to dictate to firms the quantities of each good or service
the firms produce.

6.2. Allocative efficiency is the state of the economy in which production reflects consumer
preferences; in particular, every good or service is produced up to the point where the last unit
provides a marginal benefit to consumers equal to the marginal cost of producing it. Productive
efficiency is the situation in which a given quantity of a good or service is produced using the
least amount of inputs. Productive efficiency deals with how a good is produced, while
allocative efficiency deals with producing the goods and services that consumers value
most. Dynamic efficiency is the ability of firms over time to develop and utilise technological
innovation, and to adapt their product to changes in consumer preferences and tastes.

6.3. Consumers purchase output up to the point where price equals marginal benefit. Under
perfect competition, firms produce up to the point where price equals marginal cost. Perfect
competition, therefore, generates an equilibrium output where marginal benefit equals marginal
cost, which represents allocative efficiency. In a perfectly competitive industry, free entry and
exit ensures that, in the long run, firms are producing where average costs are minimised, thereby
ensuring that productive efficiency is also achieved. Dynamic efficiency is thought to be
enhanced by competition because firms will always be seeking new products and ways to reduce
costs through innovation in order to earn economic profits.

Solution to Problem and Application 6.4

6.4. The student is correct to note that a firm’s goal is to maximise profits and not consumer
welfare. However, consumers will never purchase past the point where marginal benefit equals
price, and given that firms produce up to the point where price equals marginal cost, we get the
efficient outcome the textbook states. Efficiency is achieved despite consumers and

Solutions to Lesson 2 Questions

Solutions to Review Questions 3.1, 3.2, 3.3, 4.1 & 4.2

3.1. The monopolist’s demand curve is the market demand curve. The marginal revenue curve is
derived from the demand curve. For a linear demand curve, the marginal revenue curve will be
below the demand curve (and it is also twice as steep as the demand curve, because in absolute
value, the slope of the marginal revenue curve will be twice the slope of the demand curve).

3.2. A monopolist is a price maker in the sense that if a monopolist raises its price it will lose
some, but not all, of its customers. However, to maximise profit, the monopolist would charge a
price that results in selling the quantity at which marginal revenue equals marginal cost.

3.3.

4.1. If a perfectly competitive industry is monopolised, the price will rise and the quantity
produced will fall. Consumer surplus will fall, producer surplus will rise and a deadweight loss
will arise. Figures 9.4 (a) and (b) on page 276 show this outcome.

4.2. Market power allows a firm to set its price above marginal cost, which creates a deadweight
loss. Research suggests that, in the United States, total deadweight loss from market power is
fairly small, perhaps less than 1 percent of GDP.

Solutions to Problems and Applications 3.4 & 4.3

3.4a.

Quantity

Price (per week) Revenue Marginal Revenue Total Cost Marginal Cost
$20 15 000 $300 000 — $330 000 —
19 20 000 380 000 $16 365 000 $7
18 25 000 450 000 14 405 000 8
17 30 000 510 000 12 450 000 9
16 35 000 560 000 10 500 000 10
15 40 000 600 000 8 555 000 11

b. Ted should charge $16 per cricket ball and produce 35 000 cricket balls per week. His weekly
profits will be $560 000 – $500 000 = $60 000.

c. Because the tax does not affect his marginal revenue or marginal cost, Ted should not change
the price he charges or the quantity he produces. His profits will fall by the amount of the tax,
from $60 000 to $10 000.

d. Because the tax does not affect his marginal revenue or marginal cost, Ted should not change
the price he charges or the quantity he produces. His profits will fall by the amount of the tax,
from a profit of $10 000 (when the tax is $50 000) to a loss of $10 000 (when the tax is $70 000).
If these losses continue, however, Ted will exit the market in the long run because firms are
unwilling to suffer losses in the long run.

4.3. The less elastic is the demand curve, the greater market power the firm has, the bigger is the
difference between the marginal benefit (which equals the price) and marginal cost of the last
unit produced and greater is the deadweight loss due to the monopoly.

Last modified: Tuesday, 21 April 2015, 8:22 AM

Solutions to Lesson 3 Questions

Solutions to Review Questions 5.1, 5.2 & 5.3

5.1. The main purpose of trade practices laws is to limit anti-competitive behaviour by
monopolists and firms attempting to collude. The Australian Competition and Consumer
Commission (ACCC) is responsible for enforcing these laws.

5.2. A horizontal merger is between firms in the same industry, while a vertical merger joins
firms at different stages of production of a good. Horizontal mergers are more likely to increase
the market power of the newly merged firm because these mergers reduce the number of firms
competing in the market for a particular good or service.
5.3. Charging a price equal to marginal cost means that output will be at the level at which
marginal cost equals marginal benefit (typically represented by price), which is the efficient level
of output. However, charging this price would mean that the typical regulated natural monopoly
would suffer an economic loss, as this price will be below average cost. If the regulator sets price
to equal average cost instead, some efficiency will be lost, but the natural monopoly will stay in
business and earn a normal profit.

Solutions to Problems and Applications 5.4 & 5.5

5.4a. The monopoly will produce 50 units and charge a price of $10.

b. 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.

5.5. Referring to Figure 5.5 below, before the merger the price was PC and the quantity was QC,
so consumer surplus equalled 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
equalled A + B + C + D + E + F + G + H + I + J and producer surplus became area K + L + M
+ N + O + P + Q + R.
Last modified: Tuesday, 21 April 2015, 8:23 AM

Solutions to Lesson 4 Questions

Solutions to Review Questions 1A.1, 1A.2, 1A.3 & 1A.4.

1A.1. Price discrimination is charging different prices to different customers for the same
product when the price differences are not due to differences in production costs. A firm can
successfully practice price discrimination if it possesses market power, if some consumers have a
greater willingness to pay than others and the firm can identify these different market segments,
and if the firm can divide up (or segment) the market so that consumers who buy the product at a
low price cannot resell it at a high price.

1A.2. Virgin Blue uses this strategy as a way of segmenting the market and practicing price
discrimination. Those who buy at least 10 days in advance are generally holiday travellers who
aren’t willing to pay as much for their flights. Those who cannot plan as far in advance are
generally business travellers who are willing to pay more.

1A.3. Perfect price discrimination (also called first-degree price discrimination) is the practice of
charging each consumer a price equal to the consumer’s willingness to pay. It is not likely to
ever occur because firms cannot know the exact amount most customers are willing to pay. It is
economically efficient, because output is increased to the point where marginal cost equals
marginal benefit. However, all consumer surplus is eliminated.

1A.4. Price discrimination is practiced over time. An example of price discrimination across
time is when early buyers – whose price elasticity is lower – are charged more than later buyers –
whose price elasticity is higher. This is what occurs in the book market.

Solutions to Problems and Applications 1A.6, 1A.8 & 1A.10.

1A.6. No, a firm in a perfectly competitive industry has no ability to charge different prices to
different consumers. Firms in perfect competition have no market power, are price takers, and
all firms charge all customers the same price. The demand curve for a perfectly competitive firm
is perfectly elastic.
1A.8. In each case, the theme park is attempting to set price so as to maximise profits given
differing price elasticities of demand for different age groups. Demand by children under the age
of 16, or by parents of children under the age of 16, is more likely to be price elastic, given the
greater expenses of parents with children in this age group. The price elasticity of demand for
children under the age of three is likely to be very high – parents will not be willing to pay very
much, if anything, for entry for such young children who are not likely to significantly enjoy the
benefits of the theme park and would be too small to be allowed on the rides. People over the
age of 16 may have their own income, and may gain a greater degree of enjoyment from the
theme park; therefore, demand by this group is likely to be more price inelastic.

1A.10. The perfect price discriminator sells Q3 units and charges a range of prices along the
demand curve – P1 to the person who is willing to pay P1 for unit Q1, P2 to the person who is
willing to pay P2 for unit Q2, and P3 to the person buying unit Q3, for example. Producer surplus
is the entire area of triangle A between the demand and marginal cost curves. There is no
deadweight loss and there is no consumer surplus. The marginal revenue curve equals the
demand curve.

Last modified: Tuesday, 21 April 2015, 8:28 AM

Topic 7 Tutorial Questions


1. Suppose that a perfectly competitive industry becomes a monopoly. Use a diagram to illustrate
and describe the effects of this change on consumer surplus, producer surplus and deadweight
loss.

2. Larry, Curly and Moe run the only pub in town. Larry wants to sell as many drinks as possible
without losing money. Curly wants the pub to bring in as much revenue as possible. Moe wants
to make the largest possible profits. Using a single diagram of the pub’s demand curve and cost
curves, show the price and quantity combinations favoured by each of the three partners.
Explain.

3. What is the socially desirable price for a natural monopoly to charge? Why will a natural
monopoly that attempts to charge the socially desirable price invariably suffer an economic
loss?

4. Under what circumstances can a firm successfully practice price discrimination? What is perfect
price discrimination? Is it ever likely to occur? Is perfect price discrimination economically
efficient? Explain.

Last modified: Monday, 11 August 2014, 1:37 PM

Solutions to Lesson 1 Questions

Solutions to Review Questions 1.1, 1.2, 1.3, 2.1, 2.2 & 2.3.

1.1. In both perfectly competitive and monopolistically competitive industries, there are many
firms and low barriers to entry. However, while products are identical in perfectly competitive
markets, products are similar—but not identical—in monopolistically competitive markets.
Wheat and many raw materials are sold in perfectly competitive markets; haircuts and restaurant
meals are sold in monopolistically competitive markets.

1.2. The local McDonald’s store faces a downward-sloping demand curve for Big Mac burgers
because if it increases its price, customers will substitute away from Big Macs and buy
something else – like burgers from another McDonald’s, from KFC or Hungry Jack’s. If it raises
its prices it won’t lose all of its customers, however, because it may be located more
conveniently for some people and some people may strongly prefer Big Macs to other similar
products.

1.3. Average revenue is equal to total revenue divided by quantity. Because total revenue is price
times quantity, dividing by quantity leaves just price. So, average revenue is equal to price. (Note
that price equals average revenue for every firm, not just for monopolistically competitive firms.)
For any firm that is a price setter, marginal revenue is less than price because when the firm
lowers price to sell an additional unit, it must lower the price on all units (not just the last unit).

2.1. Because P > MR for a monopolistically competitive firm, a profit-maximising


monopolistically competitive firm producing where MR = MC will necessarily produce where P
> MC.

2.2. If, by grooming another dog, Stephen adds $68.50 to his costs and only $60.00 to his
revenues, his profit will fall by $8.50 if he grooms 126 dogs rather than 125 dogs.

2.3. No, as changes in fixed costs will not affect marginal costs. As the profit-maximising rate of
output is found where MC = MR and as MC is not affected by any change in fixed costs then
firms do not have to take account of fixed costs when deciding how much to produce.

Solutions to Problems and Applications 1.5, 1.6, 2.4, & 2.6

1.5.

Movies downloaded per Average Marginal


Week Price Total Revenue Revenue Revenue

(Q) (P) (TR = P x Q) (AR = TR/Q) (MR = ΔTR/ΔQ)


0 $8.00 0 — —
1 7.50 $7.50 $7.50 $7.50
2 7.00 14.00 7.00 6.50
3 6.50 19.50 6.50 5.50
4 6.00 24.00 6.00 4.50
5 5.50 27.50 5.50 3.50
6 5.00 30.00 5.00 2.50
7 4.50 31.50 4.50 1.50
8 4.00 32.00 4.00 0.50

1.6. Disagree. The argument is incorrect. The student is forgetting that if the firm is facing a
downward-sloping demand curve, it must lower the price to all consumers in order to sell another
unit. Because the firm receives a lower price on all but the last unit, the marginal revenue
received from the last unit is less than the price.

2.4a. We need to calculate marginal revenue and marginal cost, which can be done by adding
three new columns to the table:
Ciabatta bread Total Marginal Marginal
sold per hour Price Revenue Revenue Total Cost Cost

(Q) (P) (TR) (MR) (TC) (MC)


0 $6.00 0 — $3.00 —
1 5.50 $5.50 $5.50 7.00 $4.00
2 5.00 10.00 4.50 10.00 3.00
3 4.50 13.50 3.50 12.50 2.50
4 4.00 16.00 2.50 14.50 2.00
5 3.50 17.50 1.50 16.00 1.50
6 3.00 18.00 .50 17.00 1.00
7 2.50 17.50 –.50 18.50 1.50
8 2.00 16.00 –1.50 21.00 2.50

Maria should sell 5 loaves of ciabatta bread per hour. At this quantity, MC = MR. She should
charge a price of $3.50 per loaf of bread. Her profit will equal
TR - TC, or $17.50 – $16.00 = $1.50.

b. The marginal revenue from selling the profit-maximising loaf of bread is $1.50, which is the
same as the marginal cost of selling this loaf of bread.

2.6a. Profit = Total Revenue – Total Cost. Because American Airlines’ profit fell, total cost must
have increased faster than total revenue increased.

b. In Figure 2.6 below, a hypothetical airline is originally operating under cost structure ATC1
and MC1. Price is $300 per seat and 20 000 seats are sold; TR = $300 * 20 000 = $6 million; TC
= $345 * 20 000 = $6.9 million, giving a loss of $0.9 million shown in Figure 2.6 by the red
striped area. With the increase in costs to ATC2 and MC2, price has increased to $350 per seat
and quantity of seats sold has fallen to 18 000; total revenue (TR) has increased to $6.3 million
but total costs (TC) also increased. TC = $450 * 18 000 = $8.1 million, giving a loss of $1.8
million which is represented by the green shaded are in Figure 2.6.
Last modified: Friday, 2 February 2018, 1:22 PM

Solutions to Lesson 2 Questions

Solutions to Review Questions 3.1, 3.2 & 3.3.

3.1. New firms entering an industry cause the demand curves for the products of existing firms to
shift to the left. Existing firms will be able to sell less at every price, so their profits will decline.

3.2. As more firms enter the industry, an existing firm’s demand curve shifts to the left because
the firm will sell fewer units of output when there are additional firms in the area selling similar
products. The demand curve becomes more elastic because consumers have additional firms
from which to buy their products, so changes in price bring about larger changes in quantity
demanded.
3.3. Economic profits take into account opportunity costs. Accounting profits do not. So,
economic profits will typically be smaller than accounting profits. If a firm has zero accounting
profits, it will be making an economic loss, while a firm with zero economic profits will have
positive accounting profits.

3.4. Although a firm may initially continue to earn an economic profit as new firms enter the
market, its economic profit will be driven to zero in the long run. By taking advantage of
technological advances and by continuing to differentiate its product, a firm may again earn an
economic profit, but once again entry will tend to drive a firm’s economic profit to zero in the
long run.

Solutions to Problems and Applications 3.5 & 3.6

3.5.a. To maximise profit, Angelica should sell sandwiches up to the quantity where MC = MR.
So she should sell 55 sandwiches at a price of $4.50 each.

b. Her loss is equal to the difference between price and average total cost, multiplied by quantity
= ($4.50 − $5.50) × 55 = −$55.00. Because the price is greater than her minimum average
variable cost, she should continue to produce in the short run even though she is suffering a loss.

c. No, because she is suffering a loss. If such losses persist, she should shut down her store and
exit the industry.

3.6. The analysis is incorrect. The student has forgotten that economic costs include a normal
rate of return on the owners’ investment in the firm. Therefore, firms will not leave the industry
when earning zero economic profit. Also, in the long run, the price will be equal to average total
cost—which is the breakeven point—not above-average total cost as the student mentioned.

Last modified: Friday, 2 February 2018, 1:40 PM

Solutions to Lesson 3 Questions

Solutions to Review Questions 4.1, 4.2, 4.3 & 4.4.

4.1. In the long run, the perfectly competitive firm charges a price equal to the marginal cost of
making the product and it produces the quantity that minimises average total cost. It is
allocatively and productively efficient. Monopolistically competitive firms charge a price that is
above the marginal cost (not allocatively efficient) and produce a quantity that is less than the
amount that minimises average total cost (not productively efficient). Despite these differences,
in both perfect competition and monopolistic competition, in long-run equilibrium firms earn
zero economic profits.

4.2. A monopolistically competitive firm is not productively efficient because it does not
produce at minimum average total cost. Excess capacity stems from the fact that when a
monopolistically competitive firm produces where MR = MC, it produces a level of output that is
below the quantity for which average total cost is minimised.

4.3. A monopolistically competitive firm is not allocatively efficient because it charges a price
that is greater than marginal cost.

4.4. Monopolistic competition probably doesn’t cause a significant loss in economic wellbeing to
society. The loss or gain can be measured in total surplus. Although monopolistically
competitive firms reduce total economic surplus by producing less than the efficient amount
(creating a deadweight loss), they also increase consumer surplus because people are willing to
pay more for variety and for products that are more closely suited to their tastes.

Solution to Problem and Applications 4.5 & 4.6

4.5. There is no contradiction between producing where price is greater than marginal cost and
zero profit. Zero profit occurs when price equals average total cost, which holds in the long run
for both perfectly competitive and monopolistically competitive firms.

4.6.a. This graph shows a monopolistically competitive firm. We know this because the firm
faces a downward-sloping demand curve and a downward-sloping marginal revenue curve. A
perfectly competitive firm’s demand curve is the same as its marginal revenue curve, and the
curve would be horizontal.

b. The graph shows a short-run equilibrium because the demand curve is above the ATC. This
means that price is greater than average total cost, so the firm is earning an economic profit.
Monopolistically competitive firms only earn economic profits in the short run.

c. If the firm were perfectly competitive, it would produce the quantity where the MC crosses the
demand curve and ATC is minimised. On the graph, this quantity is 7.

Last modified: Wednesday, 15 April 2015, 12:03 PM

Solutions to Lesson 4 Questions


Solutions to Review Questions 5.1, 5.2, 6.1 & 6.3.

5.1. Marketing consists of all the activities that are necessary for a firm to sell a product to a
consumer. Marketing is not limited to advertising. For example, product placement and
defending a brand name are also forms of marketing.

5.2. Firms are concerned about brand management because maintaining their product’s unique
identity and its good reputation help to prevent competitors from attracting the firm’s customers.

6.1.. A monopolistically competitive firm’s profitability depends on its ability to differentiate its
products (especially to make them seem more desirable than competitors’ products) and to
produce its product at a lower average cost than competing firms.

6.2. A monopolistically competitive firm can earn an economic profit only if it always stays one
step ahead of its competitors by continually differentiating its product or lowering its costs.

Solutions to Problems and Applications 5.3, 5.5 & 6.3.

5.3.

Advertising is a fixed cost, so an increase in spending on advertising shifts up the ATC curve, but
not the MC curve. The firm’s profit-maximising price and quantity are unchanged, but its profit
is reduced.

5.5. A firm’s optimal level of advertising occurs where the marginal cost of advertising equals
the marginal revenue earned from advertising. The marginal revenue earned from advertising is
the additional revenue from the increased sales resulting from the advertising. There has been an
increase in recent years of advertising spending on the Internet as more consumers spend
increasing amounts of time on the Internet relative to listening to the radio, or watching
television. Internet advertising is also more flexible and can be easily targeted at certain
consumer segments. For Web advertising, firms can measure how often people click on their ads
and how many of those clicks lead to online sales. The payoff to television, radio and newspaper
advertisements is much harder to measure. Having more quantifiable information as to the
success of advertising on the Internet compared to other media forms may lead many firms to
prefer advertising on the Internet.

6.3. Competition is a risk because it can reduce a firm’s profits by driving down the price of its
products. The barriers to entry are low in retailing, so the competition is intense.

Last modified: Wednesday, 15 April 2015, 12:26 PM

Topic 8 Tutorial Questions

1. Draw a graph showing a monopolistically competitive firm in a short-run equilibrium where it is


earning positive economic profits. What must be true of price versus average total cost for such
a firm? What will happen to the firm’s demand curve as a result of the short-run profits?
2. How are monopolistically competitive firms and perfectly competitive firms similar? Why don’t
monopolistically competitive firms produce the same output in the long run as perfectly
competitive firms, which face similar costs?
3. Why is advertising more important for the success of chains such as Toys “R” Us and Officeworks
than for the corner barbershop?
4. Use the graph below to answer the following questions.

(a) The owner of this pie shop wants to maximise profits. How many pies should she sell and
what price should she charge? Briefly explain.

(b) How much economic profit is she making? Briefly explain.

(c) Is the owner likely to continue selling this number of pies in the long-run? Briefly explain.
Last modified: Monday, 11 August 2014, 1:38 PM

Topic 9 Tutorial Questions

1. Explain the difference between adverse selection and moral hazard in insurance markets. Can
one exist without the other? Explain how adverse selection and moral hazard can be reduced in
insurance markets.

2. In economic terms spam can be described as a modern example of the tragedy of the commons.
Do you agree or disagree? Explain. What does the Coase theorem suggest might be potential
problems in implementing market-based solutions to the spam problem?

3. It is often the case that the social benefits of new technologies far exceed what the person or
company is paid for creating them. Does this justify the government subsidising the production
of new technologies? If so, how might a government do this?

4. Suppose Manu and Leo run businesses in a location where they need the services of a security
guard. The demand and supply schedules for security guard services are in the following table.
Draw a graph showing the optimal level of security guard services. Make sure you label the
curves on your graph. Briefly explain why 8 hours of security guard protection is not an optimal
quantity.
Last modified: Monday, 11 August 2014, 1:38 PM

Topic 10 Tutorial Questions

1. Suppose Jack and Jenny both live alone on two small deserted Islands in the Pacific
Ocean. Both produce only two food products, mangoes and fish. If Jack spends all his time
fishing he can catch 8 kilograms of fish each week. If he spends all his time picking mangoes he
can pick 2 kilograms a week. If Jenny devotes all her time to fishing, she can catch two
kilograms of fish a week. If she spends all her time picking mangoes, she can pick 10 kilograms
a week. Currently, both devote half their time to fishing and half their time to picking mangoes.

a) Who has a comparative advantage in catching fish? Who has a comparative advantage in
picking mangoes?
b) Show that both Jack and Jenny can be better off if they specialise according to their
comparative advantages and then engage in trade.

2. As a result of changes to the Australian government quarantine regulations apple imports


have been allowed into Australia for the first time in 90 years. How will imports of apples into
Australia impact on the domestic apple market if the world price of apples is below the domestic
equilibrium price? Draw a graph to help explain your answer.
3. Assume the Australian government wants to control the volume of foreign apples that can
enter the domestic market. Would you recommend the Australian government impose an import
tariff or an import quota on foreign apples? Explain using a diagram.

4. Suppose that the government sets a price floor for mangoes that is above the competitive
equilibrium price.

a) Draw a graph showing this situation. Make sure that your graph shows the competitive
equilibrium price, the price floor, the quantity that would be sold in competitive equilibrium and
the quantity that is sold with the price floor.
b) Compare the economic surplus in this market when there is a price floor and when there is
no price floor.

Last modified: Monday, 11 August 2014, 11:40 AM