Economics 2106 (Fall 2012) — Prof. Greg Trandel — Homework Ass.docx

Economics 2106 (Fall 2012) — Prof. Greg Trandel —
Homework Assignment # 4 (first part)
Answers due: Beginning of class, Friday, November 9th.
Instructions/Information: Depending on how much material is
covered in class by Wednesday,
November 7th, it’s possible that students won’t have to answer
the last question on this assignment.
A definite announcement will be made in class.
1. Suppose that a firm is currently charging $45 for its product.
The firm knows that its marginal
cost of producing the product is $25, and it believes that the
elasticity of demand for the
product (at least at its current price) equals 3. Given this belief,
does it appear that setting its
price at $45 is a profit-maximizing decision? If not, and if the
firm’s goal is indeed to maximize
its current profit, should the firm raise or lower its price?
2. Suppose that a monopoly firm produces a good at a constant
marginal cost of $30 per unit
(to keep things simple, assume that the firm has no fixed cost,
so that its average total cost
of production also always equals $30). The firm sells its product
to consumers in two di!erent
markets. [Market A and Market B are two completely separate
markets; the firm can charge a
di!erent price is each.] Market A has the following
characteristic: if the firm wants to increase
its sales in that market by one unit, it can do so only by
lowering its price in that market by

$1. In order to sell one additional unit in Market B, in contrast,
the firm must lower its price
there by only $.50.
(a) Use the information given above
and the formula (from class) for
marginal revenue to complete
the accompanying table.
Market A Market B
Marginal Marginal
Unit Price Revenue Unit Price Revenue
8 46 39 8 41 37.5
9 45 37 9 40.5 36.5
10 44 35 10 40 35.5
11 43 11 39.5
12 12
13 13
14 14
15 15
16 16
(b) Considering Market A alone,
what quantity should the firm
sell in that market in order to
maximize its profit there?
What price should it charge in
that market? What profit does
the firm make on its sales in
Market A?
(c) Considering Market B alone,
what quantity should the firm
sell in that market in order to
maximize its profit there? What price should it charge in that

market? What profit does
the firm make on its sales in Market B?
(d) Assume that the firm can charge di!erent prices in each
market, and that a consumer
located in one market can only buy at the price set in that
market (i.e., a consumer in the
market in which the firm sets the higher price can’t switch to
the other market in order
to buy at the lower price). In other words, assume that the firm
can practice direct price
di!erentiation; that it can simply maximize its profit by
charging the prices (and earning
the profits) found in parts (b) and (c). Adding together those
profit values, what total
profit does a price-di!erentiating firm make on its sales?
(e) In contrast, suppose that the firm has to charge the same
price to all its customers (i.e.,
it can’t practice price discrimination). In this case, the
following table shows the quantity
and price combinations at which the firm can sell.! Given the
numbers in the MR column,
what quantity this firm should sell to maximize its profit. When
it sells this Q, what is
the firm’s profit?
!Here’s an example of how the numbers in the table are
computed: to sell a total quantity of 24, the firm sets a
price of $40 and sells 14 units to customers in Market A and 10
units in Market B.
(f) How would the ability to price discriminate
a!ect the profit that this firm can earn? [In

other words, how do your answers to parts (d)
and (e) compare?]
Quantity Price Marg. Rev.
18 42 3613
19 4123 35
2
3
20 4113 35
21 41 3413
22 4023 33
2
3
23 4013 33
24 40 3213
25 3923 31
2
3
26 3913 31
27 39 3013
28 3823 29
2
3
29 3813 29
30 38 2813
(g) Considering a small change in price around the
profit-maximizing Market-A price you found in

part (b) produces the following values: "Q = .2,
"P = .2, Q = 12, and P = 42. Inserting these
values into the elasticity formula from earlier in
the year [("Q/Q)/("P/P)] tells us that
the demand elasticity at the profit-maximizing
price in Market A equals 3.5. Use this elasticity
to find the profit-maximizing price with the
P = [elas./(elas. ! 1)] " MC formula. Do the two
ways to find the profit-maximizing price produce
the same answer?
(h) The corresponding values at the profit-maximizing
Market-B price are: "Q = .4, "P = .2, Q
̄ = 15,
and P̄ = 37.5. Using these numbers shows that the elasticity of
demand in market B at
the profit-maximizing price equals 5. Again use this elasticity
in the appropriate formula
to compute the profit-maximizing price and confirm that the
formula method gives you
the same value for profit-maximizing price you found earlier.
3. The following passage appears in a story (“Seeking Perfect
Prices, CEO Tears Up The Rules”
by Timothy Aeppel) that appeared in the March 27, 2007 edition
of The Wall Street Journal.
For as long as anyone at the 89-year-old [Parker Hannifin
Corp.] could recall, Parker
used the same simple formula to determine prices of its 800,000
parts — from heat-
resistant seals for jet engines to steel valves that hoist buckets
on cherry pickers.
Company managers would calculate how much it cost to make
and deliver each
product and add a flat percentage on top, usually aiming for
about 35%. Many

managers liked the method because it was straightforward.
While straightforward, the described pricing system was
unlikely to maximize the selling firm’s
profit. How would you recommend that the company change its
pricing method in order to
attain more profit?
4. Think about the goods and services one might purchase for a
wedding ceremony/reception: a
banquet hall, a photographer, flowers, musicians (or a d.j.), etc.
Some people have observed
that the purchasers of apparently identical items are charged
more when tell the seller they are
planning a wedding than they would have been charged if they
said they were planning some
other type of party/gathering. Explain why this might happen.
5. For some of its ticket o!ers, Universal Orlando Resort o!ers a
lower price to residents of Florida
than it o!ers to residents of other states (and appears to o!er a
lower price to residents of the
United States and Canada than to those who live elsewhere in
the world). [At least as this ques-
tion is being written, see:
http://www.universalorlando.com/Theme-Park-Tickets/Flor-
ida-Resident-Tickets.aspx and
http://www.universalorlando.com/Theme-Park-Tickets
/General-Admission.aspx for examples of such pricing policies.]
(a) Is such a pricing pattern better viewed as an example of
direct or of indirect price dis-
crimination?
(b) Does this pricing pattern imply that Universal believes that
the elasticity of demand of

Florida residents is larger or smaller than the elasticity of
demand of residents of other
states?
(c) Can you speculate on a reason why the elasticity of demand
for tickets to Universal might
(on average) di!er depending on state of residence in the way
you described in part (b)?
6. Universal studio also o!ers (for $20 to $30 for one day) an
Express Pass option; buyers can
use the pass to bypass the regular waiting lines. Is such a
pricing scheme better viewed as an
example of direct or of indirect price discrimination?
7. When the purchase of a product qualifies the buyer for a
rebate, he or she often has to mail
a form and wait to receive a check in the mail. An alternative
approach would be for the
manufacturer to reduce the price it charges the retail
establishment, and then require the
retailer to lower the price it charges customers. Explain one
reason (and there may be more
than one) why a manufacturer would choose the rebate
approach.
8. Watch the Priceline commercial archived at:
http://www.adstorical.com/commercial/369/
priceline-com-big-deal-no-one-deals-like-we-do. Which
characteristic(s) that makes
an item a strong candidate for price discrimination is
emphasized in the script of the commer-
cial?

9. In class, we identified senior citizens, students, and members
of the military as groups that are
often o!ered lowered prices for certain products. Obviously,
members of all three of these groups
may also (on average) have lower incomes than do those
working full time. Our explanation
for why firms profit from price discrimination, though, didn’t
focus on how much money the
members of a group had; rather it focused on di!erences in the
behavior of these groups relative
to the behaviors of the rest of the population.
(a) Basing your answer on behaviors, explain why sellers might
o!er lower prices to the
members of the three relevant groups.
(b) Explain the connection between those behaviors and the
limited incomes possessed by
many members of the three groups.
10. Ignoring a few quite-small industries (like oil royalty
traders (don’t ask me)), the two industries
that had the largest values for ad-spending-as-a-percent-of-sales
revenue in 2011 were perfumes,
cosmetics, and other toilet preparations (SIC code 2844) and
transportation services (code
4700). [Data for over 300 industries is available at:
http://www.wensmedia.com/assets/Media
%20Free%20Stuff/ADtoSalesRatios2011.pdf.] What
characteristic do these two industries
share that likely distinguishes them from many other industries?
[To guide your answer, you’ll
probably want to think about the formula (presented in class)
for a firm’s profit-maximizing
level of advertising.]

11. Each of two movie studios has to pick the week during
which it
will begin showing (or “open”) its potential summer block-
buster movie. There are three possible weeks during
which the movies could open. Suppose that the
interaction between the studios can be con-
sidered a simultaneous game, and that the
accompanying table shows the payo!
(the profit over the whole summer)
that each studio receives for each
possible combination of opening weeks.
[In each box, the lower, left-hand number is
the payo! of Studio X and the upper, right-
hand number is the payo! of Studio Y.] Use
the equilibrium-finding technique demonstrated
in class to find the equilibrium (actually, to find
all the equilibria) of this “game.”
Studio Y:
week 1 week 2 week 3
45 55 50
week 1
55 70 65
Studio 60 45 55
X: week 2
65 55 55
55 50 40
week 3
60 60 50

12. Other things equal, Sam prefers to spend the evening
at a game rather than at a movie. Other things equal,
Jordan prefers to spend the evening at a movie rather
than at a game. Both Sam and Jordan, other
things equal, prefer to be with the other
person rather than spend the evening alone.
The accompanying game table shows one
set of payo!s that is consistent with all these
preferences. Assume that both players know how
each ranks the game’s four possible outcomes.
Jordan
movie game
4 1
movie
Sam 3 1
2 3
game
2 4
(a) What is (what are) the equilibrium (equilibria) of this game?
(b) Suppose that Sam and Jordan did not finalize their plans for
the evening and therefore
did not agree on what event to attend. If it’s impossible for
either person to communicate
with the other, is it obvious to what event either player should
go?
(c) Now suppose that, before each person has to make his or her
independent decision about
which event to attend, it’s — for some unknown reason —

possible for Sam to get a
message to Jordan, but it’s impossible for Jordan to get a
message to Sam. When this is
true, which player is likely to be able to attain his or her
highest-possible payo!? What
message should be sent to enable that player to attain that
highest payo!?
13. The accompanying table is also consistent with the prefer-
ences described in the previous question. The change in
the table is due to a change in the relative importance
of Jordan’s two desires. Again assume that both
players know all the payo! values in the full
game table.
Jordan
movie game
4 1
movie
Sam 3 1
3 2
game
2 4
(a) Does either player have a dominant
strategy in this game? If so, which player,
and which strategy?
(b) What is the equilibrium of the game?
(c) Suppose that only one player can communicate with the
other before each has to make
an independent decision about which event to attend. Is that

communication likely to
change either player’s action?
14. This question concerns two pairs of roommates — Andi and
Bobbi are one pair; Charley and
Danny are the other. Each of these people has to decide whether
to devote the time needed
to “Clean” the apartment, or “Not” to clean. A person’s level of
satisfaction depends on both
the choice that person makes and on the choice made by his or
her roommate.
Each of Andi and Bobbi
agree that the four pos-
sible outcomes are
ranked in this order.
Best my roommate does all the cleaning jobs; I do none
2nd best my roommate and I both share the cleaning jobs
2nd worst I do all the cleaning; my roommate does none
Worst neither my roommate nor I do any cleaning
Each of Charley and
Danny, in contrast,
agree that the outcomes
are ranked in this order.
Best my roommate does all the cleaning jobs; I do none
2nd best my roommate and I both share the cleaning jobs
2nd worst neither my roommate nor I do any cleaning
Worst I do all the cleaning; my roommate does none
(a) Using a “4” to represent the best outcome, and a “1” to
represent the worst, put payo!

numbers (for both players) in the following game tables to make
them consistent with the
rankings described above.
Bobbi
Clean Not
Clean
Andi
Not
Danny
Clean Not
Clean
Charley
Not
(b) Is the “game” between Andi and Bobbi best described as a
prisoners’ dilemma or as a
chicken game? How about the game between Charley and
Danny?
15. Suppose now that Andi and Danny (from the
previous question) live together.
(a) Based on the preferences given above, fill in
the payo!s 1–4 (for both players) in the accom-
panying game table.
(b) Find the equilibrium of the game between
Andi and Danny.
(c) We’ve analyzed games by assuming that each

player knows the payo! values of the other
player(s). Suppose that isn’t necessarily true.
In this game, which player has an incentive
to try to conceal his or her true rankings of
the various possible outcomes?
Danny
Clean Not
Clean
Andi
Not
16. An article entitled “Airlines, Now Flush, Fear a Downturn”
(New York Times, June 11, 2011)
is posted on eLC.
(a) According to the article, what happened to airline revenue
per passenger in the first few
months of 2011?
(b) One reason for the change you noted in part (a) is that
airlines changed their fares and
fees. One reason for the change in ticket prices is probably the
rise in fuel prices noted in
the article. The article, however, also mentions another factor
that might help to explain
why the airlines changed their ticket prices. What is this factor?
(c) Explain the possible connection between the factor you cited
in when answering (b) and
the fact “that mergers have left fewer airlines”.
(d) Using terminology from class, what is it that airlines
appeared to be doing more e!ectively

(in mid-2011) than they had done previously?
17. When we (earlier in the semester) studied a perfectly-
competitive market, we concluded that
when all sellers in a market are motivated by their own private
self interest, the resulting
outcome was the best possible one for the overall society. More
recently, when we studied a
prisoners’ dilemma, we concluded that when all sellers are
motivated by their own private self
interest, the resulting outcome was not the best possible one for
the the overall group. Explain
why these two conclusions are perfectly consistent with each
other.
18. The accompanying table contains data on three
things. The second column of the table shows the
marginal value that consumers receive from various
units of good Y that might be produced. The third
column shows the marginal private cost of pro-
ducing those units. The fourth column shows the
marginal external cost that results from a negative
externality that is associated with the production/
consumption of the good.
Unit MV MPC MEC MSC
100 $120 $83 $4
200 115 84 6
300 110 85 8
400 105 86 10
500 100 87 12
600 95 88 14
700 90 89 16
800 85 90 18

900 80 91 20
(a) Complete the table by filling in the marginal
social cost of producing each unit of Y.
(b) Assume that both firms and consumers ignore
the MEC associated with producing Y, and
that this market reaches a competitive outcome (i.e., goods are
produced as long as the
value of the good to consumers exceeds the cost to producers).
To the nearest hundred,
how many units of Y will be produced?
(c) To the nearest hundred, how much Y should be produced
into order to create the most
(socially-)e#cient possible outcome?
(d) Is the the market equilibrium quantity less than or more than
the e#cient quantity of
output? By (to the nearest hundred) how many units?
(e) Why is it privately profitable to produce some units of this
good even though the pro-
duction of those units makes society worse o! (i.e., reduces
social surplus)? not provide
positive social benefits?
19. The accompanying table shows data on the marginal
private value (or marginal benefit) that the buyers
of a good receive from various units of good Z that
might be produced, the marginal private cost of pro-
ducing those units, and the marginal external value
that results from a positive externality that is asso-
ciated with the production/consumption of good Z.
Unit MPV MPC MEV MSV

100 $90 $69 $22
200 86 70 21
300 82 71 20
400 78 72 19
500 74 73 18
600 70 74 17
700 66 75 16
800 62 76 15
900 58 77 14
(a) Complete the table by filling in the marginal
social value of each unit of Z.
(b) Assume that both firms and consumers ignore
the external value associated with Z, and that
this market reaches a competitive outcome (i.e.,
goods are produced only as long as the value
of the good to a buyer exceeds the cost to producers). To the
nearest hundred, how many
units of Z will be produced?
(c) To the nearest hundred, how much Z should be produced
into order to create the most
(socially-)e#cient possible outcome?
(d) Is the the market equilibrium quantity less than or more than
the e#cient quantity of
output? By (to the nearest hundred) how many units?
(e) Why is it not privately profitable to produce some units of
this good even though the
production of those units would make society better o! (i.e.,
would raise social surplus)?

20. The growers of “standard” produce (fruits and vegetables)
use pesticides and fertilizers to in-
crease yield and decrease per-unit costs. Assume that some of
those pesticides/fertilizers soak
into the soil, are washed away by rainwater, accumulate in
lakes, rivers, or oceans, and harm
the organisms (perhaps including people) that rely on that
water. [I.e., fertilizer use can create
so-called “dead zones”.] [There is also the possibility that
harmful amounts of pesticides might
remain on produce when it is sold to consumers (and might,
therefore, directly harm buyers).
As far as this question is concerned, however, assume that
whatever pesticide residue is left on
the produce (if any) is not harmful (i.e., assume there isn’t any
direct impact on the purchaser
of the produce).] In contrast to these items, assume that
“organic” produce is grown without
the use of any artificial pesticides or fertilizers.
Quick observation at any grocery store indicates that consumers
must pay a higher price
to buy organic produce than to buy standard produce. This price
di!erential presumably (at
least in part) reflects the fact that it’s more expensive for a
grower to produce using organic
methods than to produce using standard methods. The existence
of this price di!erential, of
course, discourages consumers from buying organic produce.
Explain why the di!erence between the grocery-store consumer
prices of standard and or-
ganic produce does not accurately reflect the true di!erence in
the costs of producing these
products.

21. The accompanying graphs shows the demand and supply
curves for a particular good. The
right-hand graph also shows a marginal social cost curve
associated with the production of
the relevant good. The small numbers inside each figure give
numeric values for the sizes of
the relevant areas. Use these figures to answer the following
questions. To find answers for
economic surplus, add or subtract (if needed) the appropriate
areas.
!!!!!!!!!!!!!!!
""
""
""
""
""
""
""
"
100
60
20
800
D
S(=MPC)

$
Q
16000
16000
!!!!!!!!!!!!!!!
""
""
""
""
""
""
""
"
""
""
""
""
""
""
""
"
100

40
20
600 800
D
S(=MPC)
MSC
$
Q
18000
12000
2000
2000
(a) Assume that there is no external cost associated with the
production of this good. I.e.,
use the left-hand-side graph to answer this question. In this
case, how many units of the
good are produced, and what economic surplus is created?
(b) For the rest of the question, assume that the production of
the good does create a marginal
external cost. I.e., when you — as an independent, outside
analyst — evaluate (correctly)
the performance of this market, you need to use the right-hand-

side graph. Assuming that
firms and consumers totally ignore the external costs of their
actions, how many units of
the good are produced?
(c) In this market-equilibrium outcome, what economic surplus
(measured correctly) is cre-
ated?
(d) If the only way to reduce the extent of the external e!ect is
to reduce production of the
good, how many units of the good should be manufactured if
society’s goal is to create
the largest possible economic surplus? How big is that
economic surplus?
22. This question is optional. From an economic point of view,
is there some positive amount of
crime that could be considered to be the (socially) e#cient
amount of crime? If there is such
a thing, briefly explain how one could (conceptually) determine
the e#cient amount of crime.
23. Table I shows, for a variety of levels of industry-wide
(daily) output, the marginal value, the
marginal private cost, and marginal external cost created by the
production/consumption of a
good. This good is produced by a number of firms in a
competitive market.
Table I
Quantity MV MPC MEC
1000 63 27 4.5
2000 60 28 5

3000 57 29 5.5
4000 54 30 6
5000 51 31 6.5
6000 48 32 7
7000 45 33 7.5
8000 42 34 8
9000 39 35 8.5
10000 36 36 9
11000 33 37 9.5
Table II
With-Tax Marginal Private Cost
tax tax tax tax tax tax
Quantity = 0 = 2 = 4 = 6 = 8 = 10
1000 27 29 31 33 35 37
2000 28 30 32 34 36 38
3000 29 31 33 35 37 39
4000 30 32 34 36 38 40
5000 31 33 35 37 39 41
6000 32 34 36 38 40 42
7000 33 35 37 39 41 43
8000 34 36 38 40 42 44
9000 35 37 39 41 43 45
10000 36 38 40 42 44 46
11000 37 39 41 43 45 47
(a) Based on the numbers in Table I, if consumers and producers
ignore the external cost of
their actions, what quantity of the good would be produced and
sold?
(b) Based again on Table I, what is the (socially) e#cient
quantity of production of the good?
(c) Suppose that a tax is imposed on all the firms that produce

this good. The tax is a fixed
amount that any firm must pay for each unit of the good it
produces. Such a tax raises
the marginal private cost of producing the good (which in turn
shifts up the supply curve
of the good). Table II shows the with-tax marginal private cost
of the industry’s firms
for various levels at which the tax could be set. What size tax
will cause the with-tax
private-market outcome (demand = supply) to match the
(socially) e#cient outcome?
(d) Briefly explain how a tax set at the level you found in part
(b) will internalize the exter-
nality.

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