Exam (elaborations) TEST BANK FOR Microeconomics 7th Edition By Robert S. Pindyck and Daniel L. Rubinfeld (Instructor Solution Manual)

Exam (elaborations) TEST BANK FOR Microeconomics 7th Edition By Robert S. Pindyck and Daniel L. Rubinfeld (Instructor Solution Manual) INSTRUCTOR’S MANUAL Nora Underwood University of Central Florida CONTENTS P A R T 1: Introduction: Markets and Prices Chapter 1 Preliminaries 1 Chapter 2 The Basics Of Supply And Demand 5 P A R T 2: Producers, Consumers, and Competitive Markets Chapter 3 Consumer Behavior 23 Chapter 4 Individual And Market Demand 41 Chapter 4 Appendix 58 Chapter 5 Uncertainty and Consumer Behavior 64 Chapter 6 Production 74 Chapter 7 The Cost Of Production 84 Chapter 7 Appendix 98 Chapter 8 Profit Maximization And Competitive Supply 102 Chapter 9 The Analysis Of Competitive Markets 117 P A R T 3: Market Structure and Competitive Strategy Chapter 10 Market Power: Monopoly and Monopsony 138 Chapter 11 Pricing With Market Power 160 Chapter 11 Appendix 185 Chapter 12 Monopolistic Competition And Oligopoly 191 Chapter 13 Game Theory And Competitive Strategy 217 Chapter 14 Markets For Factor Inputs 232 Chapter 15 Investment, Time, And Capital Markets 242 P A R T 4: Information, Market Failure, and the Role of Government Chapter 16 General Equilibrium And Economic Efficiency 255 Chapter 17 Markets With Asymmetric Information 267 Chapter 18 Externalities And Public Goods 278 Chapter 1: Preliminaries 1 PART I INTRODUCTION: MARKETS AND PRICES CHAPTER 1 PRELIMINARIES TEACHING NOTES The first two chapters reacquaint students with the microeconomics that they learned in their introductory course: Chapter 1 focuses on the general subject of economics, while Chapter 2 develops supply and demand analysis. The use of examples in Chapter 1 facilitates students’ complete understanding of abstract economic concepts. Examples in this chapter discuss markets for prescription drugs (Section 1.2), introduction of a new automobile (Section 1.4), design of automobile emission standards (Section 1.4), the minimum wage (Section 1.3), the market for sweeteners (Section 1.3), and real and nominal prices of eggs and education (Section 1.3). Discussing some of these, or another, example is a useful way to review some important economic concepts such as scarcity, making tradeoffs, building economic models to explain how consumers and firms make decisions, and the distinction between competitive and non-competitive markets. Parts I and II of the text assume competitive markets, market power is discussed in Part III, and some consequences of market power are discussed in Part IV of the text. Review Question (2) illustrates the difference between positive and normative economics and provides for a productive class discussion. Other examples for discussion are available in Kearl, Pope, Whiting, and Wimmer, “A Confusion of Economists,” American Economic Review (May 1979). The chapter concludes with a discussion of real and nominal prices. Given our reliance on dollar prices in the chapters that follow, students should understand that we are concerned with prices relative to a standard, which in this case is dollars for a particular year. QUESTIONS FOR REVIEW 1. It is often said that a good theory is one that can be refuted by an empirical, dataoriented study. Explain why a theory that cannot be evaluated empirically is not a good theory. There are two steps to consider when evaluating a theory: first, you should examine the reasonability of the theory’s assumptions; second, you should test the theory’s predictions by comparing them with facts. If a theory cannot be tested, it cannot be accepted or rejected. Therefore, it contributes little to our understanding of reality. 2. Which of the following two statements involves positive economic analysis and which normative? How do the two kinds of analysis differ? a. Gasoline rationing (allocating to each individual a maximum amount of gasoline that can be purchased each year) is a poor social policy because it interferes with the workings of the competitive market system. Positive economic analysis describes what is. Normative economic analysis describes what ought to be. Statement (a) merges both types of analysis. First, statement (a) makes a positive statement that gasoline rationing “interferes with the workings of the competitive market system.” We know from economic analysis that a constraint placed on supply will change the market equilibrium. Second, statement (a) makes the normative statement (i.e., a value judgment) that gasoline rationing is a “poor social policy.” Thus, statement (a) makes a normative comment based on a conclusion derived from positive economic analysis of the policy. Chapter 1: Preliminaries 2 b. Gasoline rationing is a policy under which more people are made worse off than are made better off. Statement (b) is positive because it states what the effect of gasoline rationing is without making a value judgment about the desirability of the rationing policy. 3. Suppose the price of unleaded regular octane gasoline were 20 cents per gallon higher in New Jersey than in Oklahoma. Do you think there would be an opportunity for arbitrage (i.e., that firms could buy gas in Oklahoma and then sell it at a profit in New Jersey)? Why or why not? Oklahoma and New Jersey represent separate geographic markets for gasoline because of high transportation costs. If transportation costs were zero, a price increase in New Jersey would prompt arbitrageurs to buy gasoline in Oklahoma and sell it in New Jersey. It is unlikely in this case that the 20 cents per gallon difference in costs would be high enough to create a profitable opportunity for arbitrage, given both transactions costs and transportation costs. 4. In Example 1.3, what economic forces explain why the real price of eggs has fallen while the real price of a college education has increased? How have these changes affected consumer choices? The price and quantity of goods (e.g., eggs) and services (e.g., a college education) are determined by the interaction of supply and demand. The real price of eggs fell from 1970 to 1985 because of either a reduction in demand (consumers switched to lowercholesterol food), a reduction in production costs (improvements in egg production technology), or both. In response, the price of eggs relative to other foods decreased. The real price of a college education rose because of either an increase in demand (e.g., more people recognized the value of an education), an increase in the cost of education (e.g., increase in staff salaries), or both. 5. Suppose that the Japanese yen rises against the U.S. dollar- that is, it will take more dollars to buy any given amount of Japanese yen. Explain why this increase simultaneously increases the real price of Japanese cars for U.S. consumers and lowers the real price of U.S. automobiles for Japanese consumers. As the value of the yen grows relative to the dollar, more dollars exchange for fewer yen. Assume that the costs of production for both Japanese and U.S. automobiles remain unchanged. Then using the new exchange rate, the purchase of a Japanese automobile priced in yen requires more dollars. Similarly, the purchase of a U.S. automobile priced in dollars requires fewer yen. 6. The price of long-distance telephone service fell from 40 cents per minute in 1996 to 22 cents per minute in 1999, a 45-percent (18 cents/40 cents) decrease. The Consumer Price Index increased by 10-percent over this period. What happened to the real price of telephone service? Let the CPI for 1996 equal 1 and the CPI for 1999 equal 1.1, which reflects a 10% increase in the overall price level. To find the real price of telephone service in each period, divide the nominal price by the CPI for that year. For 1996, we have 40/1 or 40 cents, and for 1999, we have 22/1.1 or 20 cents. The real price therefore fell from 40 to 20 cents, a 50% decline. Chapter 1: Preliminaries 3 EXERCISES 1. Decide whether each of the following statements is true or false and explain why: a. Fast food chains like McDonald’s, Burger King, and Wendy’s operate all over the United States. Therefore the market for fast food is a national market. This statement is false. People generally buy fast food within their current location and do not travel large distances across the United States just to buy a cheaper fast food meal. Given there is little potential for arbitrage between fast food restaurants that are located some distance from each other, there are likely to be multiple fast food markets across the country. b. People generally buy clothing in the city in which they live. Therefore there is a clothing market in, say, Atlanta that is distinct from the clothing market in Los Angeles. This statement is false. Although consumers are unlikely to travel across the country to buy clothing, suppliers can easily move clothing from one part of the country to another. Thus, if clothing is more expensive in Atlanta than Los Angeles, clothing companies could shift supplies to Atlanta, which would reduce the price in Atlanta. Occasionally, there may be a market for a specific clothing item in a faraway market that results in a great opportunity for arbitrage, such as the market for blue jeans in the old Soviet Union. c. Some consumers strongly prefer Pepsi and some strongly prefer Coke. Therefore there is no single market for colas. This statement is false. Although some people have strong preferences for a particular brand of cola, the different brands are similar enough that they constitute one market. There are consumers who do not have strong preferences for one type of cola, and there are consumers who may have a preference, but who will also be influenced by price. Given these possibilities, the price of cola drinks will not tend to differ by very much, particularly for Coke and Pepsi. 2. The following table shows the average retail price of butter and the Consumer Price Index from 1980 to 2001. ˇ CPI 100 130.58 158.62 184.95 208.98 214.93 Retail Price of butter $1.88 $2.12 $1.99 $1.61 $2.52 $3.30 (salted, grade AA, per lb.) a. Calculate the real price of butter in 1980 dollars. Has the real price increased/decreased/stayed the same since 1980? Real price of butter in year X = CPI1980 CPIyear X * nominal price in year X . $1.88 $1.62 $1.25 $0.87 $1.21 $1.54 Since 1980 the real price of butter has decreased. Chapter 1: Preliminaries 4 b. What is the percentage change in the real price (1980 dollars) from 1980 to 2001? Percentage change in real price from 1980 to 2001 = 1.54  1.88 1.88  0.18  18%. c. Convert the CPI into 1990 = 100 and determine the real price of butter in 1990 dollars. To convert the CPI into 1990=100, divide the CPI for each year by the CPI for 1990. Use the formula from part (a) and the new CPI numbers below to find the real price of milk. New CPI 1980 63.1 Real price of milk 1980 $2.98 1985 82.3 1985 $2.58 $1.99 1995 116.6 1995 $1.38 2000 131.8 2000 $1.91 2001 135.6 2001 $2.43 d. What is the percentage change in the real price (1990 dollars) from 1980 to 2001? Compare this with your answer in (b). What do you notice? Explain. Percentage change in real price from 1980 to 2001 =      2.43 2.98 0.18 18% 2.98 . This answer is almost identical (except for rounding error) to the answer received for part b. It does not matter which year is chosen as the base year. 3. At the time this book went to print, the minimum wage was $5.15. To find the current minimum wage, go to Click on: Consumer Price Index- All Urban Consumers (Current Series) Select: U.S. All items This will give you the CPI from 1913 to the present. a. With these values, calculate the current real minimum wage in 1990 dollars. real minimum wage 2003 = CPI1990 CPI1998 *5.15 130.7 163 *5.15 $4.13. b. What is the percentage change in the real minimum wage from 1985 to the present, stated in real 1990 dollars? Assume the minimum wage in 1985 was $3.35. Then, real minimum wage 1985 = CPI1990 CPI1985 *3.35 130.7 107.6 *3.35 $4.07. The percentage change in the real minimum wage is therefore 4.13  4.07 4.07  0.0147, or about 1.5%. Chapter 2: The Basics of Supply and Demand 5 CHAPTER 2 THE BASICS OF SUPPLY AND DEMAND TEACHING NOTES This chapter reviews the basics of supply and demand that students should be familiar with from their introductory economics class. The instructor can choose to spend more or less time on this chapter depending on how much of a review the students require. This chapter departs from the standard treatment of supply and demand basics found in most other intermediate microeconomics textbooks by discussing some of the world’s most important markets (wheat, gasoline, and automobiles) and teaching students how to analyze these markets with the tools of supply and demand. The realworld applications of this theory can be enlightening for students. Some problems plague the understanding of supply and demand analysis. One of the most common sources of confusion is between movements along the demand curve and shifts in demand. Through a discussion of the ceteris paribus assumption, stress that when representing a demand function (either with a graph or an equation), all other variables are held constant. Movements along the demand curve occur only with changes in price. As the omitted factors change, the entire demand function shifts. It may also be helpful to present an example of a demand function that depends not only on the price of the good, but also on income and the price of other goods directly. This helps students understand that these other variables are actually in the demand function, and are merely lumped into the intercept term of the simple linear demand function. Example 2.9 includes an example of a demand and supply function which each depend on the price of a substitute good. Students may also find a review of how to solve two equations with two unknowns helpful. In general, it is a good idea at this point to decide on the level of math that you will use in the class. If you plan to use a lot of algebra and calculus it is a good idea to introduce and review it early on. To stress the quantitative aspects of the demand curve to students, make the distinction between quantity demanded as a function of price, Q = D(P), and the inverse demand function, where price is a function of the quantity demanded, P = D -1(Q). This may clarify the positioning of price on the Y-axis and quantity on the X-axis. Students may also question how the market adjusts to a new equilibrium. One simple mechanism is the partial-adjustment cobweb model. A discussion of the cobweb model (based on traditional corn-hog cycle or any other example) adds a certain realism to the discussion and is much appreciated by students. If you decide to write down the demand function so that income and other prices are visible variables in the demand function, you can also do some interesting examples, which explore the linkages between markets and how changes in one market affect price and quantity in other markets. Although this chapter introduces demand, income, and cross-price elasticities, you may find it more appropriate to return to income and cross-price elasticity after demand elasticity is reintroduced in Chapter 4. Students invariably have a difficult time with the concept of elasticity. It is helpful to explain clearly why a firm may be interested in estimating elasticity. Use concrete examples. For example, a Wall Street Journal article back in the spring of 1998 discussed how elasticity could be used by the movie industry so that different movies could have different ticket prices. This example tends to go over well as college students watch a lot of movies. This type of discussion can also be postponed until revenue is discussed. Chapter 2: The Basics of Supply and Demand 6 QUESTIONS FOR REVIEW 1. Suppose that unusually hot weather causes the demand curve for ice cream to shift to the right. Why will the price of ice cream rise to a new market-clearing level? Assume the supply curve is fixed. The unusually hot weather will cause a rightward shift in the demand curve, creating short-run excess demand at the current price. Consumers will begin to bid against each other for the ice cream, putting upward pressure on the price. The price of ice cream will rise until the quantity demanded and the