Chapter 7 Solutions PDF

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Problems Chapter 7 1.

Explain why the following statements are true or false: a. The economic maxim ‘There’s no cash on the table’ means that there are never any unexploited economic opportunities. b. Firms in competitive environments make no accounting profit when the market is in longrun equilibrium.

c. Firms that can introduce cost-saving innovations can make an economic profit in the short run. 1a. False: the maxim tells us that there are no unexploited economic opportunities when the market is in long-run equilibrium. b. False: firms in long-run equilibrium have to make an accounting profit in order to cover the opportunity cost of resources supplied by their owners. c. True: These firms can earn economic profits until other firms adopt their innovations. As the innovations spread, the industry supply curve will shift down, causing the market price of the good to fall and eroding the short-term economic profit. 2. Explain why new software firms that give away their software products at a short-run economic loss are nonetheless able to sell their stock at positive prices. 2. The reason these firms' shares are valuable is that once their products have established a market niche, the firms will cease to give them away. The anticipated future profits of such companies lead investors to bid for their shares now.

John Jones owns and manages a café whose annual revenue is €5,000. The annual expenses are as in the table below. 3.

Expense Labour Food and drink Electricity Vehicle lease Rent Interest on loan for equipment

€ 2,000 500 100 150 500 1,000

a. Calculate John’s annual accounting profit. b. John could earn €1,000 per year as a recycler of aluminium cans. However, he prefers to run the café. In fact, he would be willing to pay up to €275 per year to run the café rather than to recycle cans. Is the café making an economic profit? Should John stay in the

business? Explain. c. Suppose the café’s revenues and expenses remain the same, but recyclers’ earnings rise to €1,100 per year. Is the café still making an economic profit? Explain. d. Suppose John had not had to get a €10,000 loan at an annual interest rate of 10 per cent to buy equipment, but instead had invested €10,000 of his own money in equipment. How would your answers to parts (a) and (b) change? e. If John can earn €1,000 a year as a recycler, and he likes recycling just as well as running the café, how much additional revenue would the café have to collect each year to earn a normal profit? 3a. John's accounting profit is his revenue minus his explicit costs, or €750 per week. b. Yes: his opportunity cost of his labour to run the café is €1,000 - €275, or €725 per week. Adding this implicit cost to the explicit costs implies that the café is making an economic profit of €25 per week. And since €25>0, John should stay in business. c. John's opportunity cost rises by €100, to €825 per week. The café is thus now making an economic loss of €75 per week. d. The accounting profit would now be €1,750/yr. The answer to part b. would not change. If John had €10,000 of his own to invest in the café, he would forgo €1,000/yr in interest by not putting the money in a savings account. That amount is an opportunity cost that must be included when calculating economic profit. e. To earn a normal profit, the café would have to cover all its implicit and explicit costs. The opportunity cost of John's time is €1,000/yr, whereas the café's accounting profit is only €750/yr. Thus, the café would have to earn additional revenues of €250/yr to make a normal profit. 4. A city has 200 advertising companies, 199 of which employ designers of normal ability at a salary of €100,000 a year. Paying this salary, each of the 199 firms makes a normal profit on €500,000 in revenue. However, the 200th company employs Janus Jacobs, an unusually talented designer. This company collects €1,000,000 in revenues because of Jacobs’ talent. a.

How much will Jacobs earn? What proportion of his annual salary will be economic rent?

b. Why will the advertising company for which Jacobs works not be able to earn an economic profit? 4a. Jacobs will earn €600,000/yr, the normal salary for a designer plus the economic rent he collects for his special talent. 5/6 of his salary is economic rent. b. If Jacobs’s employer withholds some of the additional revenue it takes in as a result of hiring him, some other advertising company will offer him a higher salary and still manage to earn an economic profit. Bidding for Jacobs will continue until firms are indifferent between paying him €600,000 and hiring any other designer for €100,000.

5. Explain carefully why, in the absence of a patent, a technical innovation invented and pioneered in one tofu factory will cause the supply curve for the entire tofu industry to shift to the right. What will finally halt the rightward shift? 5. Assuming that all tofu firms initially earn zero economic profit, the innovation will cause one tofu factory’s costs to fall. The firm that owns the factory will make an economic profit in the short run, because the market price of tofu will not change. As other firms adopt the innovation, they too will make an economic profit. This economic profit will attract new firms into the industry, and so the supply curve for tofu will begin to shift to the right, causing the market price of tofu to fall. The decline in price will continue as more firms enter, until there is no more economic profit to be made. 6. The government of the Republic of Self-Reliance has decided to limit imports of machine tools, to encourage development of locally made machine tools. To do so, the government offers to sell a small number of machine-tool import licences. To operate a machine-tool import business costs €30,000, excluding the cost of the import licence. An importer of machine tools can expect to earn €50,000 per year. If the annual interest rate is 10 per cent, for how much will the government be able to auction the import licences? Will the owner of a licence earn an economic profit? 6. If the import licenses were free and could not be transferred, owners of each license would make an economic profit of €20,000/yr. When the annual interest rate is 10 percent, the most a buyer will be willing to pay for a stream of economic profits of €20,000/yr is the amount of money that, put into a savings account, would earn that much interest each year. This sum of money is €200,000. If the import licenses are auctioned, they will sell for this price, and the government will earn an economic rent of €200,000 per license. The buyers of the licenses will make no economic profit.

7. Unskilled workers in a poor cotton-growing region must choose between working in a factory for €6,000 a year or being a tenant cotton farmer. One farmer can work a 120-hectare farm, which rents for €10,000 a year. Such farms yield €20,000 worth of cotton each year. The total non-labour cost of producing and marketing the cotton is €4,000 a year. A local politician whose motto is ‘working people come first’ has promised that, if he is elected, his administration will fund a fertiliser, irrigation and marketing scheme that will triple cotton yields on tenant farms at no charge to tenant farmers. a. If the market price of cotton would be unaffected by this policy and no new jobs would be created in the cotton-growing industry, how would the project affect the incomes of tenant farmers in the short run? In the long run? b. Who would reap the benefit of the scheme in the long run? How much would they gain each year? 7a. A cotton farmer would make a short-run economic profit of €60,000 revenue- €10,000 rent €4,000 marketing cost - €6,000 opportunity cost, or €40,000/yr. In the long run, factory workers

would want to move into cotton farming, and would thereby bid up the rent on cotton farms. The rent would continue to rise until it reached €50,000 per farm. At that point the incentive to leave a factory job would no longer exist, because cotton farmers would again be making zero economic profit. b. Landowners would reap the long-term benefits of the scheme. Their income would rise by €40,000/yr. per 120-acre plot.

8. You have a friend who is a potter. He holds a permanent patent on an indestructible teacup whose sale generates €30,000 a year more revenue than his production costs. If the annual interest rate is 20 per cent, what is the market value of his patent? 8. The question you should ask is: How much money would your friend need to put in the bank at 20 percent interest to generate annual earnings of €30,000? To find out, simply let X denote that amount in the equation X(.2) = €30,000 and solve: X = €30,000/.2 = €150,000. 9. You have an opportunity to buy an apple orchard that produces €25,000 per year in total revenue. To run the orchard, you would have to give up your current job, which pays €10,000 per year. If you would find both jobs equally satisfying, and the annual interest rate is 10 per cent, what is the highest price you would be willing to pay for the orchard? 9. If you pay €X for the orchard, the opportunity cost of your investment is (0.10)(€X)/yr. The opportunity cost of your time is €10,000/yr. The highest value of X for which you would be willing to own and manage the orchard is the value that yields zero economic profit. To find that value, solve €25,000/yr – (.10)(€X)/yr - €10,000/yr = 0: X = €150,000/yr. 10. Ludovico, a renowned chef, owns one of the 1,000 spaghetti restaurants in Sicily. Each restaurant serves 100 plates of spaghetti a night at €5 per plate. Ludovico knows he can develop a new sauce at the same cost as the current sauce, which would be so tasty that all 100,000 spaghetti eaters would buy spaghetti at €10 per plate. There are two problems: developing the new sauce would require some experimental cost; and the other spaghetti producers could figure out the recipe after one day. a.

What is the highest experimental cost Ludovico would be willing to incur?

How would your answer change if Ludovico could enforce a year-long patent on the new sauce? (Assume that the interest rate is zero.) 10a. The most Ludovico would be willing to pay in experimental costs is €500,000. He could charge all 100,000 patrons €5 more, but only for one night. After the first night, other producers would figure out the recipe and compete the price back down to €5 per plate. b.

b. With a patent that lasts one year, Ludovico would be willing to pay up to €182.5 million euros (€500,000/day)(365 days/year). He could charge an additional €5 per meal each night of the year before the other producers could copy the recipe....