Microeconomics CH-7 - solutions PDF

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Microeconomics Chapter 7 1. Melissa buys an iPod for $120 and gets consumer surplus of $80. a. What is her willingness to pay? b. If she had bought the iPod on sale for $90, what would her consumer surplus have been? c. If the price of an iPod were $250, what would her consumer surplus have been? Step-by-step solution 1. Step 1 of 4 Consumer surplus is given by the difference between the willingness of the consumer to pay and the actual price he pays. Consumer surplus= Maximum price willing to pay by the buyer – Actual price paid. 2. Step 2 of 4 a) M’s consumer surplus= $80, Actual price paid or market price= 120. Maximum willing price can be calculated by submitting these values in the formula. Consumer surplus= Maximum price willing to pay by the buyer – Actual price paid. $80 = Maximum price willing to pay by the buyer – $120 Maximum price willing to pay by the buyer= $80 +$ 120 = $ 200. Maximum price willing to pay by the M is = $200 3. Step 3 of 4 b) When actual price paid is $90. Consumer surplus= Maximum price willing to pay by the buyer – Actual price paid. Actual price paid= $90 Maximum willing price =$ 200 Consumer surplus= $200 -$90 = $ 110. Thus, when actual price is $90, consumer surplus is $110 4. Step 4 of 4 c) If the actual market price is $250, then the consumer surplus is zero because the price of product is greater than the willingness to pay of the consumer. Thus, consumer surplus is zero. 2. An early freeze in California sours the lemon crop. Explain what happens to consumer surplus in the market for lemons. Explain what happens to consumer surplus in the market for lemonade. Illustrate your answers with diagrams. Step-by-step solution

1. Step 1 of 6 Market for Lemon crop: If an early freeze in Cal City sours the lemon crop, then this leads to a decrease in the supply of lemon in the market. Therefore, the supply curve will shift upwards implying decreasing supply at every price level. This is illustrated in the figure below. The initial supply of lemon is given by curve S1, due to freeze the supply curve shifts towards left to form S2 and the new equilibrium point is E2. At this point, the equilibrium price increases to P2. 2. Step 2 of 6 Consumer surplus: It is the difference between the willingness to pay for the commodity and price of the commodity. In graphical terms, the area above the price line and below the demand curve shows the consumer surplus. In this case, before freeze, the consumer surplus is given by the area A+B+C. Due to a decrease in the supply the new consumer surplus is A. The main reason of this decrease in consumer surplus is increase in price of the lemon due to shortages of lemons in the market. Thus, the consumer surplus in the lemon market decreases by B+C. 3. Step 3 of 6 Market for Lemons

Initially the market of lemon is in equilibrium at point E1 and the equilibrium price is P1. The consumer surplus at this price is A+B+C. Now as the supply contracts, the supply curve shifts from S1 to S2. The new equilibrium is attained at E2 and the new equilibrium price is P2. The consumer surplus also contracts and it becomes A. Decrease in supply leads to decrease in consumer surplus 4. Step 4 of 6 Market for Lemonade: Lemons are the key ingredient for lemonade. Therefore, a decrease in the supply of lemons will decrease the supply of lemonade. This results in a shift in the supply curve of lemonades towards left forming S2. Moreover, the new equilibrium is attained ta point E2 where the price is P2 which is higher than the previous level.

Initially the market of lemonades is in equilibrium at point E1 and the equilibrium price is P1. The consumer surplus at this price is G+H+K. Now as the supply contracts, the supply curve shifts from S1 to S2. The new equilibrium is attained at E2 and the new equilibrium price is P2. The consumer surplus also contracts and it becomes G. Decrease in supply leads to decrease in consumer surplus 5. Step 5 of 6 Consumer surplus: Before freeze, the consumer surplus of lemonade is given by the area G+H+K in the above figure. Due to a decrease in the supply the new consumer surplus is G. Thus the consumer surplus in the lemonade market decreases by G+K. We can observe that an event that occurs in one market will affect the consumer surplus in other market also. 6. Step 6 of 6 Thus, due to a freeze the consumer surplus will be reduced both in the lemon and the lemonade market.

3. Suppose the demand for French bread rises. Explain what happens to producer surplus in the market for French bread. Explain what hap-pens to producer surplus in the market for flour. Illustrate your answers with diagrams. Step-by-step solution 1. Step 1 of 5 The increase in demand for French bread raises its price in the market. A higher price raises the producer surplus. Producer surplus for flour also increases as the price also rises due to a higher demand for French bread in which flour is a raw material. 2. Step 2 of 5

Figure (a) 3. Step 3 of 5

Figure (b) 4. Step 4 of 5 Figure (a): At price ABC.

and quantity

, the producer surplus equals the area of triangle

5. Step 5 of 5 Figure (b): When the price rises from to , the quantity supplied rises from and the producer surplus rises to the area triangle ADF.

to

4. It is a hot day, and Bert is thirsty. Here is the value he places on a bottle of water:

a. From this information, derive Bert's demand schedule. Graph his demand curve for bottled water. b. If the price of a bottle of water is $4, how many bottles does Bert buy? How much consumer surplus does Bert get from his purchases? Show Bert's consumer surplus in your graph. c. If the price falls to $2, how does quantity demanded change? How does Bert's consumer surplus change? Show these changes in your graph. Step-by-step solution 1. Step 1 of 6 (a) Bert’s demand schedule 2. Step 2 of 6 Price

Quantity Demanded

More than $7 0 (Bottles) $5 to $7

1

$3 to $5

2

$1 to $3

3

$1 or less

4

3. Step 3 of 6 Demand curve of bottled water 4. Step 4 of 6

5. Step 5 of 6 (b) If the price of a bottle is $4, Bert will buy 2 bottles. Bert’s consumer surplus Price willing to pay

Actual payment

12 In the balance graph, the consumer surplus at

is the bounded area AEFGHI.

6. Step 6 of 6 (c) If the price falls to , the quantity demanded will increase to 3 bottles. Bert’s consumer surplus will increase to $9. Price willing to pay for 3 bottles

Actual payment

In the above graph, the consumer surplus at

is the bounded area ABCJGHI.

5. Ernie owns a water pump. Because pumping large amounts of water is harder than pumping small amounts, the cost of producing a bottle of water rises as he pumps more. Here is the cost he incurs to produce each bottle of water:

a. From this information, derive Ernie's supply schedule. Graph his supply curve for bottled water. b. If the price of a bottle of water is $4, how many bottles does Ernie produce and sell? How much producer surplus does Ernie get from these sales? Show Ernie's producer sur-plus in your graph. c. If the price rises to $6, how does quantity supplied change? How does Ernie's producer surplus change? Show these changes in your graph. Step-by-step solution 1. Step 1 of 4 (a) The supply schedule is a table that represents the quantity supplied at different price level. The person-E’s supply schedule is as follows:

2. Step 2 of 4 The graph is as follows:

3. Step 3 of 4 (b) If the price of a bottled water is , person-E will produce and sell 2 bottles. The producer surplus is calculated below:

In the above graph, Ernie’s producer surplus is the bounded area ABCDEF. 4. Step 4 of 4 (c) If the price rises to , the quantity supplied will increase to 3 bottles. The producer surplus is calculated below:

The person-E’s producer surplus is $9. In the above graph, person-E’s producer surplus is the bounded area ABCDEGHI. 6. Consider a market in which Bert from Problem 3 is the buyer and Ernie from Problem 4 is the seller. a. Use Ernie's supply schedule and Bert's demand schedule to find the quantity sup-plied and quantity demanded at prices of $2, $4, and $6. Which of these prices brings sup-ply and demand into equilibrium? b. What are consumer surplus, producer sur-plus, and total surplus in this equilibrium? c. If Ernie produced and Bert consumed one fewer bottle of water, what would happen to total surplus? d. If Ernie produced and Bert consumed one additional bottle of water, what would hap-pen to total surplus? Step-by-step solution 1. Step 1 of 7 Supply and demand schedules of Ernie and Bert can be summarized as under the below table,

2. Step 2 of 7 From the above table we can see that the quantity demanded equals to quantity supplied at a price of $4. Therefore, $4 is the market clearing price or equilibrium price. In addition, the quantity demanded at this price is the equilibrium quantity. Thus, equilibrium price is $4 and equilibrium quantity is two bottles.

3. Step 3 of 7 At equilibrium consumer surplus and producer surplus are same. Hence, the consumer and producer surplus would be $4. Total surplus at equilibrium: Total surplus is the sum of total consumer and producer surpluses;

If consumption and production of water bottles are reduced by 1 unit, then the consumer and producer has surplus on the first bottle only. Consumer surplus on first bottle:

Similarly, producer surplus on the first bottle is,

4. Step 4 of 7 Therefore, the total surplus is;

Thus, the total surplus if one fewer is produced and consumed is $6. 5. Step 5 of 7 d) If one extra bottle is consumed and produced above the equilibrium quantity of two bottles and price of $4 than both the consumer and producer surplus will decline. Consumer Surplus: The price of the bottle is $4 but the value derived by the consumer on the third bottle is only $3. Thus, the consumer surplus on third bottle will be negative as shown below.

6. Step 6 of 7 Producer Surplus: Similarly, producer surplus also will be negative upon production of the third bottle. The third bottle costs $5, but the price received on it will be only $4. Therefore, the producer surplus will be negative on the third bottle.

7. Step 7 of 7 Thus, the total surplus will be sum of consumer and producer surpluses of all the three bottles.

Thus, the total surplus will be $6. Thus, the total surplus fall by $2. 7. The cost of producing flat-screen TVs has fallen over the past several decades. Let’s consider some implications of this fact. a. Draw a supply-and-demand diagram to show the effect of falling production costs on the price and quantity of flat-screen TVs sold. b. In your diagram, show what happens to consumer surplus and producer surplus. c. Suppose the supply of flat-screen TVs is very elastic. Who benefits most from falling production costs—consumers or producers of these TVs? Step-by-step solution 1. Step 1 of 7 A fall in production costs of flat TV screens will increase the supply consequently making a shift in the supply curve towards its right as shown in the below diagram. S1 is the initial supply curve, and due to decrease in cost of production supply increases forming S2. The new equilibrium point is formed at a lower level at E2 than the previous point of equilibrium E1. At this new level of equilibrium E2, the quantity increases from Q1 to Q2 and the price reduces from P1 to P2. 2. Step 2 of 7 Demand – Supply of Flat TV

3. Step 3 of 7 Thus, falling production costs decreases the equilibrium price of TV’s and thus, increases the equilibrium quantity. 4. Step 4 of 7 b) Consumer Surplus: Initial Consumer surplus is given by the area under demand curve and above the price P1; that is the area under M. Furthermore, final Consumer surplus due to decreased cost of production is given by the area under demand curve and above the price P2; that is (M+N+O+P). Thus, the consumer surplus rises by (N+O+P). Consumer and Producer surplus:

5. Step 5 of 7 Producer Surplus: Similarly initial producer surplus is given by the area above the supply curve S1 and below the price P1; that is N+Q. However, due to a production cost decline, the area above the new supply curve S2 and below the new price P2; that is, (Q + R + S) give the producer surplus Thus, the producer surplus changes by the amount (R + S – N); in fact, the change in producer surplus may be positive or negative, it depends on the increase in quantity versus decline in price, an increase in quantity increases producer surplus, while the decline in the price reduces producer surplus. 6. Step 6 of 7 Total Surplus: Furthermore, as the consumer surplus rises by N+O+P and producer surplus rises by R + S – N, total surplus rise is calculated as shown below;

Thus, the total surplus rises by (O+P +R + S). 7. Step 7 of 7 c) If the supply of flat TV screens is very elastic, then the shift of the supply curve benefits the consumers.

For instance, let us assume in the extreme condition that the supply is perfectly elastic; then the supply curve will be horizontal as shown in the below figure; furthermore, due to the horizontal position of the supply curve there is zero producer surplus. However, as shown in the below figure, the consumers capture all the benefits of falling production costs, the consumer surplus increases from initial M to M+N+O.

8. There are four consumers willing to pay the following

There are four haircutting businesses with the following costs:

Each firm has the capacity to produce only one haircut. For efficiency, how many haircuts should be given? Which businesses should cut hair and which consumers should have their hair cut? How large is the maximum possible total surplus? Step-by-step solution 1. Step 1 of 6 Firm D is charging $2 for one haircut, as willingness to pay of all customers is more than or equal to this, they will all go for the haircut. However, one firm can provide only one haircut therefore, at $2; quantity demanded will be 4 while quantity supplied is only 1. Firm A is charging $3 for one haircut. If price of haircut increases to $3, firm A will join the market and quantity supplied will increase to 2 haircuts. As willingness to pay of three customers is more than $3, quantity demanded at $3 will be three. Firm C is charging $4 for one haircut. If price of haircut increases to $4, firm C will join the market and quantity supplied will increase to 3 haircuts. As willingness to pay of three customers is more than $4, quantity demanded at $4 will also be three. Firm D is charging $6 for one haircut. If price of haircut increases to $6, firm D will join the market and quantity supplied will increase to 4 haircuts. As willingness to pay of the two customers is more than $6, quantity demanded at $6 will be two. 2. Step 2 of 6 Following table presents the above information in tabular manner –

Table 1 Price Quantity demanded Quantity supplied $2

4

1

$3

3

2

$4

3

3

$6

2

4

3. Step 3 of 6 As above table shows that market for haircut is in equilibrium when price is $4 per hair cut as at this price quantity demanded is equal to quantity supplied. When market is in equilibrium, it is efficient as well. Since, quantity supplied at equilibrium is 3 haircuts therefore for efficiency 3 haircuts should be given. Firm A, C, and D should give haircut as their cost is less than the price while customer 1, 3 and 4 should have their hair cuts as their willingness to pay is more than price charged. 4. Step 4 of 6 Calculating Producer Surplus – Producer Surplus of Firm A –

Thus, producer surplus of Firm A is $1. Producer Surplus of Firm C –

Thus, producer surplus of Firm C is $0. Producer Surplus of Firm D –

Thus, producer surplus of Firm D is $2.

Thus, total producer surplus is $3. 5. Step 5 of 6 Calculating Consumer Surplus – Consumer Surplus of buyer 1 –

Thus, consumer surplus of buyer 1 is $3. Consumer Surplus of buyer 3 –

Thus, consumer surplus of buyer 3 is $4. Consumer Surplus of buyer 4 –

Thus, consumer surplus of buyer 4 is $1.

Thus, total producer surplus is $8. 6. Step 6 of 6 Calculating Total Surplus –

Thus, the maximum possible total surplus is $11. 9. One of the largest changes in the economy over the past several decades is that technological advances have reduced the cost of making computers. a. Draw a supply-and-demand diagram to show what happened to price, quantity, consumer surplus, and producer surplus in the market for computers.

b. Forty years ago, students used typewriters to prepare papers for their classes; today they use computers. Does that make computers and typewriters complements or substitutes? Use a supply-anddemand diagram to show what happened to price, quantity, consumer surplus, and producer surplus in the market for typewriters. Should typewriter producers have been happy or sad about the technological advance in computers?

c. Are computers and software complements or substitutes? Draw a supply-and-demand diagram to show what happened to price, quantity, consumer surplus, and producer surplus in the market for software. Should software producers have been happy or sad about the technological advance in computers?

d. Does this analysis help explain why software producer Bill Gates is one of the world’s richest men? Step-by-step solution 1. Step 1 of 8 (a) Following graph shows the market for computers – Figure 1

2. Step 2 of 8 Initially, the market for computers is in equilibrium at point E with equilibrium price being P per computer and equilibrium quantity being Q computers. Consumer surplus is equal to area 1 and producer surplus is equal to area 2+7. It has been stated that technological advancement has reduced the cost of production of computers. This reduction in cost of production will increase the supply of computers. Increase in supply will shift the supply curve of computers rightwards from S to S1. New equilibrium is attained at point E1 with new equilibrium price being P1 per computer and new equilibrium quantity being Q1 computers. Consumer surplus is equal to area 1+2+3+4 and producer surplus is equal to area 5+6+7. Reduction in cost of production due to technological advancement has resulted in fall in price of computer from P to P1, increase in quantity from Q to Q1, increase in consumer surplus and producer surplus. 3. Step 3 of 8 (b) Following figure shows the market for typewriters – Figure 2

4. Step 4 of 8 Initially, the market for typewriters is in equilibrium at point E with equilibrium price being P per typewriters and equilibrium quantity being Q typewriters. Consumer surplus is equal to area 1+2 and producer surplus is equal to area 3+4+5. As students are using computers in place of typewriters, computers and typewriters are substitutes. In case substitute goods, rise in price of one leads to increase in quantity demanded of other and vice-versa. Price of computer has decreased (as shown in part (a)). Being substitutes, this fall in price of computers will decrease the quantity demanded of typewriters. This decrease in quantity demanded will shift the demand curve for typewriters from D to D1. New equilibrium is attained at point E1 with new equilibrium price being P1 per computer and new equilibrium quantity being Q1 computers. Consumer surplus is equal to area 2+4 and producer surplus is equal to area 5. 5. Step 5 of 8 Decrease in demand for typewriters due to fall in the price of its substitute (computer) has resulted in fall in price of typewriters from P to P1, decrease in quantity from Q to Q1, fall in both consumer surplus and producer surplus. As producer...